CORPORATIONS OUTLINE - SPRING 2010
KEY TO OUTLINE
Notes
RULES TO KNOW
State and MBCA Statutes
Case Briefs
MAJOR SECTIONS
MINOR SECTIONS
CONTENTS
I. Introduction
1-16 .............................................................................................................................................. 4
Federal Income Taxation of Business Entities
Agency Issues
123-135 ..................................................................... 4
511-519................................................................................................................ 6
II. Closely Held Corporations ......................................................................................................................................... 6
A. Formation .................................................................................................................................................... 6
1. Basics
2. Ultra Vires Doctrine
212-227....................................................................................................... 7
227-236 .................................................................................................... 8
3. Premature Commencement of Business
B. Disregard of the Corporate Entity
C. Financial Matters
236-257................................................................ 10
258-288 ................................................................................. 12
314-338 ................................................................................................. 17
1. Equity Securities, Par Value, Watered Stock ............................................................................................. 17
2. Debt Financing
338-347 ................................................................................................. 19
3. Capital Structure Planning ......................................................................................................................... 20
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4. Preemption and Dilution
369-383..................................................................................... 20
5. Distributions
383-410 ................................................................................................. 23
D. Management and Control
419-433 .................................................................................... 25
1. Cumulative Voting
450-457 .......................................................................................... 27
2. S/H Voting Agreements
457-488 ..................................................................................... 29
3. Buy-Sell Agreements
490-491 ................................................................................................... 33
4. Deadlock
491-511 ............................................................................................................... 33
5. Sale of Controlling Shares
519-537 ..................................................................................... 36
III. Publicly Held Corporations
538-588 .................................................................................................. 39
IV. Duty of Care and Business Judgment Rule
V. Duty of Loyalty and Conflict of Interest
659-744 ................................................................................. 41
756-812 ..................................................................................... 49
VI. Federal Securities Law ........................................................................................................................................... 59
A. Rule 10b5-Introduction
1. Insider Trading
813-817 .................................................................. 59
841-891 ......................................................................................................... 59
2. Securities Fraud ......................................................................................................................................... 65
a. Materiality
619-623 ................................................................................................................ 65
b. Reliance
915-934 ........................................................................................................................ 67
c. Purchase or sale
817-820 ..................................................................................................... 68
d. Scienter
820-824 ................................................................................................................ 68
B. Section 14 - Proxy Regulation
C. Section 16
VII. Takeovers
589-609; 623-658 .......................................................................... 68
909-915....................................................................................................................... 73
974-989 .................................................................................................................................... 73
A. Defenses: Business Judgment Rule
B. Defenses: Poison Pills
C. Defenses: State Legislation
1026-1053 ................................................................................ 73
1004-1026 ...................................................................................... 75
989-1004 .......................................................................................... 78
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VIII. Indemnification and Insurance
951-973..................................................................................... 79
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I. INTRODUCTION
1.
2.
3.
4.
5.
1-16
Knowledge of Biz entity types to select best form suitable for the client.
a. Tax / Liability Variations
b. Partnership = default, no forms req
c. LP, LLC, etc. – all req filing docs.
Termination of a Partnership or Corp
a. Partnership – winding up process, “I want out” = sufficient to terminate
b. Corp – s/h control termination by majority vote
i. If parties have equal share then ≠ terminate, need majority
Types of Biz Orgs
a. CORP
i. Pro: Raise cap through stocks, limited liability
ii. Con: double tax (corp level as entity & personal level dividens), costly incorp & reporting
b. Sole Pro
i. Pro: all control & profit, easy to form, less gov’t restrictions
ii. Con: unlimited losses & liability, difficult to aquire cap, may lack tax advantages
iii. Common small biz owners, may have multiple investors (as long as investors = creditors)
c. Partnerships – 2+ ppl share control
i. Pro: no paperwork needed, but suggested., eaisier to raise capital, easy to dissolve
ii. Con: liability for all partners acts, dividing profits, disputes = pain in the ass, terminates
at death UTTC
iii. Goverened by Uniformed Partnership Act. RUPA has not been widly adopted (IL has with
minor changes)
d. LP – filed w/ state; at least 1 gen partner and 1 limit partner
i. Pro: lp are not subject to personal liability
ii. Presumed G.P. unless L.P. cert filed with sec of state
e. LLP
i. Atty may operate as LLP – atty not liablt for other atty liability unless under direct
supervision. Therefore, what defines “supervision” is still being expored by cts.
ii. Malpractice claims still held to the whole firm.
f. LLLP
g. LLC – limited liability of a corp w/ control & tax advantages of partnership
i. Pros: owners personal assets protected
ii. Cons: strict IRS Rules
AB Biz Q’s (A provides cap, B manages store)
a. Defaults to partnership evev w/o intent and w/o paperwork to contrary
b. B an agent of A?
i. S.P. = B agent of A
ii. GP = B agent of AB partnership
iii. Corp = B agent of Corp
c. Best to enter into partnership agreement  clearly est A&B’s relationship
d. A&B hires C (truck driver) who gets in accident
i. V sues A, B, AB partnership, and C if partnership
ii. V sues AB corp. & C if a corp (A & B personal assets protected)
1. Even w/ limited liability w/corp = still need insurance
Corp Chain of Life
a. S/H  BOD  O/D (ok to have corp with 1 person in all roles)
FEDERAL INCOME TAXATION OF BUSINESS ENTITIES
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123-135
1.
2.
3.
Close held corps can choose to be taxed as flow through rather than corp style taxation.
a. A corp who meets reqs can elect to become an “S” Corp, with similar taxation to a partnership.
This election allows s/h to treat earnings and profits as distributions and have them flow-through
to individual tax forms. If employee  “reasonable compensation for work performed”.
Partnerships always pays lower marginal and effective tax rate.
Which biz form is best for me from tax perspective?
a. Individual Rates – rate tables based on marital status; personal expenses ≠ deduct; certain
important expenses (medical, child care, morgate interest payments) = deduct
b. Partnership Rates -≠ partnership rates, eather individual reporting usinf the partnership net
income divisiable by the allotted partners investments
i. Partnership files an info tax return on who the partners are and who will be reporting
income from the partnership
c. Corp Rates – corps can deduct most expenses: salaries, inventory, supplies, etc.
i. Marginal – calculation tax rate
ii. Effective – final percentage of tax paid per dollar
iii. C Corp – all corps are C unless elect to be S and meet reqs
iv. S Corp – no corp taxes; taxed as partnership
1. Major issue for small corps; some start at S and move to C
2. REQ’S FOR S CORP
A. 75 OR LESS S/H (NORMALLY JUST A FEW)
B. ALL S/H US CITIZENS
C. ONE CLASS OF STOCKS
d. EXAMPLE: AB Software taxable income $200,000
i. No other income; even dist. Partnership
1. A & B both claim 100,000 individually
2. 21,850 tax due  78.150 net income (total bix tax is 43,7000)
ii. AB as Corp
1. 200,000 taxable income – 61,250 Tax = 138,750 left for A&B to share
2. 69,380 to each A&B in dividens x 15% (dividen tax rate) = 10,407
3. A & B both net 57,000 (total tax bill is 86,000)
iii. A has 500,000 other income: (better or A to have Corp., B to have partnership)
1. A 600,000; B 100,000 (partnership)
a. A pays 206,000 tax = Keeps 394,000
2. A 557,000; B 57,000 (Corp)
a. A pays 172,000 = Keeps 385,000
iv. “Zeroing out corp income” – salaries paid to partners deductible t corp
1. A&B get 90,000 salary  200,00-180,000 = corp taxable income 20,000
a. 3,000 tax paid = 17,000 net income not paid out on dividens becomes
retained earnings and is not taxed (carried over into next year)
2. However, A only investor/no salary
a. Select S Corp instead of zeroing out
3. Accumulation and Bailout
a. Corp income only taxed when paid out in dividens. Therefore, corp can
accumulate a lot of money that will be taxed eventually
b. Cant pay dividens to only one shareholder and not another. Two main
ways to get money out of corp salary and dividens.
c. A owns biz hires B; 500,000 cap invested in biz
i. A gets 500,000 stocks in biz
ii. Year 1: 100,000 taxable income – 22,500 tax = 77.500
retained earnings
iii. A has plenty other income so accumulates income
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iv. After 10 years of same: 775,000 total retained earnings
1. A sells 500,000 in stock + 775,000 = 1,275,000
2. 1,275,000 – 500,000 = 775,000 cap gains (15%)
3. Benefit to A even though paying ~110,000 tax in one
year
AGENCY ISSUES
1.
511-519
Corporation are stale entites that depend on agents to work (i.e. BOD, O/D, etc.)
a. BOD run the corp and are elected by s/h (have power to vote on resolutions & make bank
accounts.
In the Matter of Drive- In Development Corp
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QUESTION: The circumstances which may bind a corp to a guaranty of the obligations of a related corp
when it is contended that the corp officer who executed the guaranty had no actual authority to do so?
FACTS: Corp in question was a subsidiary of a parent holding corp that conducted no business of its own.
Officer induced Bank to make loan to the parent corp with a corp guarantee. Bank asked for and Officer
delivered a certificate of authorization, although no authorization was approved at a directors meeting.
Bank made sizable loan based on paperwork.
RULE: Duty of secretary to keep corp records.
Π ARGUMENT: Corp was collaterally estopped from denying officers authority because of the certificate
of authorization.
∆ ARGUMENT: Officer had no actual / implied authority to bind Corp.
CT HOLDING: STATEMENTS MADE BY AN OFFICER OR AGENT IN THE COURSE OF A
TRANSACTION IN WHICH THE CORP IS ENGAGED AND WHICH ARE WITHIN THE SCOPE OF
AUTHORITY ARE BINDING UPON THE CORP. ACTUAL AWARENESS IS NEEDED TO DEFEAT A
COLLATERAL ESTOPEL CLAIM.
Lee v. Jenkins Bros.
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QUESTION: Did officer of the corp have apparent authority to bind the corp to a pension plan? Was that
pension plan “extraordinary” when the π initially made $4,000 and the agreed pension was $1500?
FACTS: Officer orally offered a pension to a manager in order to hire him with the suggestion that he
would receive the pension “regardless of what happened.” Officer died without turning this promise into
a written K. Corp doesn’t want to pay pension.
Π ARGUMENT: Officer verbally offered him a pension “regardless of what happens” to induce π to leave
his previous employer.
∆ ARGUMENT: Officer of the corp had no authority to bind it to such an “extraordinary “ employment K.
CT HOLDING: IF A JURY FINDS APPARENT AUTHORITY AND THERE IS SUFFICIENT PROOF OF THE
MAKING OF THE PENSION AGREEMENT, THE CORP WILL BE BOUND BY OFFICERS PROMISE TO
THE PENSION PLAN.
II. CLOSELY HELD CORPORATIONS
A. FORMATION
1.
How incorporate
a. States have Gen Incorp Statutes
b. Deleware – won state race to generally have best factors, BUT not necessary for all corp
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b.
i. Pay taxes in Deleware and IL
ii. Can be sued in Deleware, likely not convienent for π
Can reincorp in a different state at any time
1. BASICS
212-227
(IL §§1.10, 2.10, 2.20, 2A.05, 4.05-.15, 8.10)
1.10 – FORMS, EXECUTION, ACKNOWLEDGEMENT & FILING
2.10 – ARTICLES OF INCORP – (must have) corp name, purpose, address of registered agent, name & address each
incorporator, # shares auth to issue, # and classes of shares & par value, if classes then definition of rights of each
class, definitios of serise. (optional) name and addy initial directors, provisions allowed by law, limiting/eliminating
personal laibility of O/D of corp or S/H for $ damages for breach of fudiciary duty [if not for (1) acts in bad faith. (2)
breaches of duty to corp or s/h. (3) consistent with other parts of act. (4) improper personal benifit]. Perputual
duration UTTC.
1.
2.
3.
4.
5.
6.
7.
Name
a. deceptively similar names not allowed
b. Corp, co, incorp, limited req
c. No banking/insurance names
d. Duration – perpetual
Registered Agent – service of process
Purpose
a. Historically : long and narrow
b. Today : broad « Transaciton of any lawful biz »
Powers
a. Same powers as an individual to carry out biz
# of Shares & Value
a. S Corp = common stock only
Initial directions/Incorporators
a. No liability for an incorporator, maybe for director
Initial Cap
a. Historically : required to back debt
b. Today : virtually eliminated
2.20 – ORGINAZATION OF CORP – inital meeting info
1.
Initial S/H Meeting
a. Minutes taken as consent procedure followed
i. E.g. Consent agreed in bylaws to disreard annual s/h meetings
b. BOD and bylaws established
2A.05 – FORMATION CLOSE CORP – must be called close corp in AOI
4.05 – CORPORATE NAME OF DOMESTIC OR FOREIGN CORP – Must have corp, incorp, etc. , special ‘bank’ reqs,
distinguishable name.
4.10 – RESERVED NAME – 90 days
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4.15 – ASSUMED CORP NAME
8.10 – NUMBER, ELECTION, AND RESIGNATION OF DIRECTIORS – one or more, # fixed in bylaws or in AOI, variable
range ok, yearly election unless staggered director terms, resigination effective when notice given UTTC.
(MBCA §§2.02, 2.05, 3.02, 8.03)
2.02 – ARTICLES OF INCORP – (Must have) Corp name, # shares auth, initial registered office & agent, name & addy
each incroporator. (may have) name & addy inital directors, provisions consistent with law, provision required or
allowed in by-laws, limits on liability or indemnifying O/D [execept when, personal financial benifit unentitled,
intentional infliction of harm on corp or s/h, violation of 8.33, intentional violation of crim law]
2.05 – ORGINIZATION OF CORP – Initial meeting (in or out of state)
3.02 – GENERAL POWERS – perputual duration ; power to sue/be sued, corporate seal, make/amend bylaws, buy
and sell property, power to make K, lend money, be promoter/partner/trust etc., conduct biz, elect O/D. pay
pensions, make donations, trasact in any lawful biz.
8.03 – NUMBER AND ELECTION OF DIRECTORS – one or more, specified number in AOI or bylaws,
increase/decrease ok, annual election UTTC.
2. ULTRA VIRES DOCTRINE
227-236
(IL §3.10-.15)
3.10 – GENERAL POWERS – perputual, sue/be sued, seal, buy/sell property, lend $, borrow $, conduct biz, elect
O/D, charitable donations, cease corp, make bylaws/amendments, donations, pensions, promoter/partner, joint
enterprise, etc. power to effect corp purpose.
3.15 – DEFENSE OF ULTRA VIRES – No act invalidated because corp was without power to act UNLESS : (a)
proceeding by S/H against Corp to enjoin act ; (b) suit by Corp against O/D ; (c) suit by State.
1. Catch 22 : Protect legit biz relationships v. protect innocent s/h
a. S/h may have incested in biz because of purpose, and if ppurposes changes (by K for other
purpose) and fails, unfair to s/h
(MBCA §3.04)
3.04 – ULTRA VIRES – validity of corp act ≠ challenged on grounds no power to act UNLESS : (a) suit by S/H to corp
enjoin act ; (b) suit by Corp ahainst O/D ; (c) suit by state. – Damages ok for loss suffered by corp.
711 Kings Highway Corp. v. FMI Marine Repairé Service
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QUESTION : Whether ultra vires doctrine can be used by Landlord π to invalidate lease with tenant ∆,
who has already tendered a $5,000 security deposit, where the premises have been ruined?
FACTS : L leased building to T for term of 15 yrs. Something happened to the building. T wanted to use the
building for operating a movie theather. L sought to invalidate the K by claiming that making the K was an
ultra vires act because the AOI only talked about maraine repair and rental.
Π ARGUMENT : Motion picture theater was outside of the authority conferred by T’s corp charter. T AOI
stated that it was formed to carry on marine activites.
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CT HOLDING : L CASE DID NOT FALL WITHIN ONE OF THE EXCEPTIONS LISTED, SO THE ULTRA
VIRES DOCTRINE COULD NOT BE INVOKED. Π failed to state a claim upon which relief could be
granted and therefore ∆’s motion for dismissal of the complaint for insufficiency was granted.
Theodora Holding v. Henderson
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SUMMARY : S/H filed a derivative action against a corporation and the president for mismanaged the
corporation, and engaged in several expenditures for his own benefit to the detriment of the
corporation. Such transactions included the purchase of a seat on the New York Stock Exchange and the
donation of monies to a charitable trust.
HOLDING: denied the request for a receiver because none of the separate transactions that the
stockholder relied on demonstrated gross mismanagement or a threat to the corporation's existence as a
viable business entity. The transactions, considered separately or cumulatively, not only failed to
demonstrate the type of corporate perversion or self-dealing which would warrant interference by a
court of equity, but the transactions were also shown to have been reasonable corporate acts within the
business judgment rule.
O ACTS W/IN BJR – MUST SHOW A FAILURE OF CORPORATE PURPOSE, A FRAUDULENT
DISREGARD OF THE MINORITY'S RIGHTS, OR SOME OTHER FACT WHICH INDICATES AN
IMMINENT DANGER OF GREAT LOSS RESULTING FROM FRAUDULENT OR ABSOLUTE
MISMANAGEMENT.
Sullivan v. Hammer
QUESTION : Whether the proposed settlement is fair and reasonable in light of the factual circumstances
of the case.
FACTS : The parties have submitted a settlement agreement for the court’s review. Occidental mailed to
stockholders a proxy statement reporting that a Special Committee of Occidental had approved a
proposal to provide financial support to The Armand Hammer Museum of Art and Cultural Center,
(Museum). Occidental is to donate a lump sum to the Armand Hammer Foundation and is to fund the
construction of the Museum, which is to be physically integrated with Occidental’s headquarters building.
Hammer is the founder and Chairman of the Board of Occidental. Plaintiffs filed this action asserting class
and derivative claims alleging that Occidental’s expenditures with regard to the Museum and its
obligations to the Armand Hammer foundation constitutes a gift and waste of corporate assets and that
Hammer had breached his duty of loyalty by causing Occidental to make these expenditures for his
personal benefit. Counsel for all the parties presented to the Court a fully executed Stipulation and
Agreement of Compromise, Settlement and Release.
∆ ARGUMENT : BJR is a presumption that in making a business decision the directors of a corporation
acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best
interest of the company. Presumption can only be overturned if π can show that a majority of the
directors :
o 1) expected to derive personal financial benefit from the transaction,
o 2) that they lacked independence,
o 3) that they were grossly negligent in failing to inform themselves, or
o 4) that the decision of the Board was so irrational that it could not have been the reasonable
exercise of the business judgment of the Board.
RULE : The court must consider the benefit to the class and whether the benefit is reasonable when
compared to the range of potential recovery. The potential for ultimate success on the merits is very
poor. The plaintiffs have not shown any facts that demonstrate that the directors have any self-interest
but rather, the record shows that the directors and the Special Committee gave due consideration to the
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transaction. The court must therefore review the claims of Plaintiffs against the presumption that the acts
of the directors are valid. THE TEST OF WHETHER A CORPORATION MAY MAKE A CHARITABLE
GIFT IS REASONABLENESS. The gift to the museum is within the range of reasonableness. The
consideration to be received by the class is speculative. However, it seems clear that Occidental will
receive good will from the gift and will be able to utilize the adjacent Museum in the promotion of its
business purposes.
3. PREMATURE COMMENCEMENT OF BUSINESS
236-257
(IL §2.15)
2.15 – EFFECT OF INCORP – Upon filing, corp existence begins, conculsive ev, except by state.
1. Promoter Liability
a. PROMOTER – person who does the start-up process for the biz
i. Work can (and usually needs) to be done BEFORE corp exists
b. ADOPTION of K by Corp
i. Actual or implied (when corp has benifited from K)
ii. ≠ relieve promoter of liability under K
C. NOVATION
i. Actual and written
ii. = relieves promoter of liability under K
1. Mere fact payments are made by 3rd pty and accepted by π is not sufficient to
est a novation. Any inference arising from payment by 3rd pty disappears when
in conflict with crediable ev.
iii. BOP on promoter to show intent of the 3rd pty to release promoter
2. Defective Incorporation
a. De Jure – formal req met
b. De Facto – colorabal attempt but defective incorp. Not recognized in attacks by state.
I. DE FACTO TEST
1. VALID LAW UNDER WHICH CORP CAN BE LAWFULLY ORG
2. ATTEMPT TO ORG UNDER THE LAW
3. ACTUAL USER OF THE CORP FRANCHISE
4. (OPTIONAL) GOOD FATH CLAIM TO BE AN IN DOING BIZ AS CORP
c. A corporation comes into existence ONLY when the cert has been issued. Before the cert issues,
there is no corp de jure, de facto, or by estoppel.
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Stanley J. How & Assoc., Inc. V. Boss
QUESTION : Should Boss be personally liable for the debts of the nonexistent corporation?
FACTS : Boss signed a contract with the plaintiffs, an architecture firm, to build a hotel. Boss signed it as
an agent for “Boss Hotels Company, Inc.”, which hadn’t been formed yet but was supposed to be formed
in Minnesota. Boss formed a company with a different name in Iowa instead. There were problems with
the building of the hotel. How sued Boss personally for unpaid fees. Both parties knew when entering
into the K that the corp had not been formed.
Π ARGUMENT : π performed required services and was entitled to a fee of $38,250, of which it had
recieved only $14,000. Boss should be personally liable
∆ ARGUMENT : ∆ signed as an agent of the new corp, and thus the K is an agreement that the new
coroporation is solely liable, not the agent.
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RULE : BOSS, AS A PROMOTER, WILL BE PERSONALLY RESPONSIBLE FOR THE DEBTS OF THE
CORPORATION HE WAS TO FORM UNLESS IT WAS UNDERSTOOD AND INTENDED THAT THE
NEW CORPORATION TO BE FORMED WILL BE THE SOLE OBLIGOR, ABSENT A NOVATION.
o EXCEPTION: The contract is treated as an option which can be accepted by the corporation when
it is formed, and the promoter agrees to form the corporation and give it the opportunity to pay.
o EXCEPTION: A novation with the corporation assuming the promoter’s liability and replacing him
in the contract.
o EXCEPTION: The promoter remains liable even after formation but only as a surety.
Robertson v. Levy
SHORT SUMMARY : Seller transferred the assets of a business and assigned a lease to an association that
had submitted articles of incorporation and was doing business in a corporate name. After the transfer
and assignment were completed a certificate of incorporation was issued and one payment was made on
the installment note for the assets. When the association ceased doing business the seller brought suit
for the balance of the note and the damages incurred in settling the lease. Ct. – Certificate of
incorporation was conclusive evidence of corporate existence, eliminating the concept of corporations
by estoppel, and it was immaterial that the seller believed he was dealing with a corporation. The
association's subsequent incorporation had not relieved it of personal liability.
FACTS : Martin Robertson and Eugene Levy entered an agreement in which Levy was to form the
corporation Penn Ave. Record Shack, Inc. which would then buy Robertson's business. Levy submitted
defective AOI and then, acting as president, entered into a lease with Robertson. The AOI were rejected,
but Levy, still acting as president of the corporation, executed a bill of sale for Robertson's business in
return for a note of installment payments. The certificate of incorporation was finally issued, and Levy
made one installment payment. After Penn Ave. Record Shack, Inc. stopped doing business, Robertson
sued Levy for the balance of the note plus additional expenses. Only Levy knew that the corp was not yet
formed but continued to act as though i twas incorp.
RULE : THE CERTIFICATE OF INCORPORATION WILL BE “CONCLUSIVE EVIDENCE” THAT ALL
CONDITIONS PRECEDENT HAVE BEEN PERFORMED AND ELIMINATES THE PROBLEMS OF
ESTOPPEL AND DE FACTO CORPORATIONS ONCE THE CERTIFICATE HAS BEEN ISSUED. IF AN
INDIVIDUAL OR GROUP ASSUMES TO ACT AS A CORPORATION BEFORE THE CERTIFICATE OF
INCORPORATION HAS BEEN ISSUED, JOINT AND SEVERAL LIABILITY ATTACHES.
QUESTION & HOLDING :
o (1) Can Levy, the corporation's president, be held personally liable for an obligation entered into
by the corporation before the certificate of corporation was issued?
 (1) Modern corporation statutes such as Model Act (1969) §§ 56 and 146 [the
predecessors to Model Act §§ 2.03 and 2.04, respectively] have effectively done away
with de facto corporations and corporations by estoppel favoring a single-event proof
of corporation formation by the issuance of the certificate of corporation. Persons
assuming to act as a corporation without authority to do so will be held personally
liable.
o (2) Does Robertson's receipt of one of the installments after the certificate of corporation was
issued and the corporation formed estop him from denying the existence of the corporation?
 (2) Someone who incurs statutory liability on an obligation under these codes is not
relieved of a liability if subsequent partial payment is accepted at a later time when the
corporation has come into existence.
Frontier Refining Company v. Kunkel’s, Inc.
FACTS : Kunkel approached B. L. Warren, zone manager of Appellant, to discuss taking over a filling
station and truck stop owned by Appellant. Kunkel stated he would approach Fairfield to see about
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raising the money to fund the venture. Kunkel approached Fairfield and Beach to discuss obtaining a loan.
Fairfield declined. There was a discussion about Kunkel incorporating and Beach and Fairfield taking stock
as an investment. Warren claims and Fairfield denies that he met Fairfield when Fairfield came to look
over the station and Fairfield told him the business would be a corporation. Warren advised Appellant by
memo that the business would be incorporated under the name of “Kunkel’s, Inc.” financed by Beach and
Fairfield. Appellant then executed several agreements signed either “C.D. Kunkel” or “Clifford D. Kunkel
dba Kunkel’s, Inc.” Unbeknownst to Fairfield or Beach, Kunkel took over the station and commenced
doing business. Fairfield and Beach put some $11,000 into the venture. However, neither knew Kunkel
had failed to incorporate. Appellant discovered that by mistake some equipment had been delivered to
Kunkel without receipt of payment. Appellant obtained from Kunkel a chattel mortgage naming Kunkel
individually as mortgagor. The mortgage disclosed on its face that it was not executed in the name or on
behalf of a corporation. Subsequently Fairfield obtained possession of the equipment and claimed
ownership. In a companion case, Appellant recovered possession of the property after the court ruled
that the mortgage was valid and entered judgment in favor of Appellant.
QUESTION : Whether Defendants are liable as partners operating a business under the name Kunkel’s
Inc ?
RULE : DEFENDANTS ARE NOT LIABLE BECAUSE THEY WERE CREDITOR OF KUNKEL’S INC. NOT
PARTNERS. ALL PERSONS WHO ASSUME TO ACT AS A CORPORATION WITHOUT AUTHORITY
TO DO SO SHALL BE JOINTLY AND SEVERALLY LIABLE FOR ALL DEBTS AND LIABILITIES
INCURRED OR ARISING AS A RESULT THEREOF.
Π ARGUMENT : The contribution of money by Fairfield and Beach created a partnership. This partnership
made them jointly and severaly liable for the expenses of the business. Ev. In memo by π’s employee
makes biz appear to be a partnership  P sues all.
∆ ARGUMENT : Neither Fairfield nor Beach held themselves out as a corporation. Appellant with full
knowledge that a corporation had not yet been formed chose to transact its business with Kunkel as an
individual and shall be held to its bargain. Further, Appellant in its companion case accepts the fruits of a
judgment that carries with it an inherent finding by the trial court that Kunkel, as an individual, was
Appellant’s debtor.
B. DISREGARD OF THE CORPORATE ENTITY
258-288
1. FRAUD DOCTRINE: IF CORP ENTITY WAS USED TO DEFRAUD/DECEIVE SOMEONE, THE PCV
a. (See Securities, 10b-5) Will also allow direct damages.
2. UNDERCAPITALIZATION THEORY: WAS THERE ENOUGH MONEY WHEN THE CORP BEGAN?
(SUBJECTIVE TEST)
a. Loans from s/h do not count
b. Cts more willing to PVC in tort cases rather than K cases
c. In addition to the alter ego or instrumentality doctrine, second major way.
d. Though in Walkovsky, insurance met minimum standard, sometimes assets are trifling and
excessive risk should not be encouraged.
e. If biz orged and run w/o funding, PVC is justified.
f. Coup should be expected to have enough $$ for biz purposes.
g. No working capital (cash on hand) at the start of a biz does NOT necessarily mean undercap 
still have FMV of assets.
h. In Radaszewski, insurance was used by the subsidiary to fufill the cap needs in the case.
3. ALTER EGO THEORY
a. Corp formalities:
i. Before PVC, generally, cts look at corp formalities such as s/h meetings, o/d meetings,
stock issuance, election of o/d, corp minutes, etc.
ii. Lack of corp formalities can demonstrate failure to respect the corp form by s/h, etc.
(Corp. is merely “shell”).
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b.
Other Gen Factors, Varying by Individual Case:
i. Commingling funds and not having sep bank accts
ii. Diversion of funds
iii. Identical equitable ownership in two entities
iv. Identy of O/D
v. Absence of sep held corp assets
vi. Individual ownership
vii. Biz and office location
viii. Similarity of employees, attys, etc
ix. Concealment or misrepresentations
x. Diversions of assets
xi. Use of corp as subterfuge
xii. Formation to assume anothers liabilities
4. FACTORS THAT INDICATE INJUSTICES AND INEQUITABLE CONSEQUENCES ALLOWING CT TO
PCV: (MOST IMPORTANT FACTORS IN GREEN)
a. Fradulent representation by corp O/D
B. UNDERCAP
C. FAILURE TO OBSERVE CORP FORMALITIES
d. Absence of corp records
e. Payment by the corp of individual obligations
F. USE OF THE CORP TO PROMOTE FRAUD/INJUSTICE/ILLEGALITIES
5. When are courts likely to PCV?
a. Biz is close corp
b. P is an involuntary (tort) creditor
c. D is a corp s/h
d. Insiders failed to follow corp formalities (alter ego theory)
e. Insiders commingled biz assets/affairs w/ individual assets/affairs
f. Insider did not adequately cap biz
i. Undercap (determined when biz formed)
ii. Purposeful insolvency may justify PVC
g. D actively participated in biz
h. Insiders deceived creditors (misrepresentation, fraud, & illegality)
6. ENTERPRISE LIABILITY DOCTRINE: DISREGARDS MULTI INCORPS OF THE SAME BIZ UNDER
COMMON OWNERSHIP
a. Pulls together biz assers to satisfy the liabilityes of any part of the enterprise; assets of individual
owners or managers are not exposed.
b. Case be used in “brother-sister” senarious)
c. Look at control & domination
d. Corp is liabile only up to their initial investment
7. INTERNAL AFFAIRS DOCTRINE: WHEN A CORP IS FORMED IN A STATE, THEY PRESUME THAT
THE LAWS OF THAT STATE APPLY TO THEM.
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Bartle v. Home Owners Co-op
FACTS: Defendant, a cooperative corporation, was organized to provide low income housing for its
veteran members. Defendant formed Westerlea to undertake construction to build housing for
Defendant’s members. Due to financial difficulty, creditors took over Westerlea’s construction
responsibilities, pursuant to an extension agreement. In October 1952, Westerlea was adjudicated
bankrupt. Plaintiff claims Westerlea did not act as an independent corporation. The trial court affirmed
the Appellate Division’s refusal to pierce the corporate veil finding that Westerlea and Defendant acted as
two separate corporations at all times.
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ISSUE: Whether the trial court erred refusal to pierce the corporate veil was proper?
HOLDING: Yes. The trial court did not err in refusing to pierce the corporate veil of Westerlea’s corporate
existence because Westerlea acted as a separate corporation and there was no fraud, misrepresentation
or fraud.
DISSENT: The corporate veil should be pierced because Westerlea was organized solely to benefit
Defendant, not to operate as a separate entity. Westerlea did not have a separate corporate identity
because it was Defendant’s wholly owned subsidiary that had the same directors and management as
Defendant. Westerlea was undercapitalized because Defendant provided Westerlea with small capital
and Westerlea maintained insufficient funds to cover the cost of building the homes. Westerlea’s purpose
was not to profit as a business, but to benefit Defendant’s stockholders by providing low cost housing to
them.
RULE: BECAUSE THE LAW PERMITS THE INCORPORATION OF BUSINESS TO FOR THE PURPOSE
OF ESCAPING PERSONALLY LIABILITY, THE COURT WILL ONLY “PIERCE THE CORPORATE VEIL”
TO PREVENT FRAUD OR ACHIEVE EQUITY.
DISSCUSSION: Although Defendant controlled Westerlea’s affairs, Westerlea maintained an outward
indicia of separate corporate identity at all times. Further, the creditors were not misled, there was no
fraud, and Defendant performed no act to cause injury to the creditors of Westerlea by depletion of
assets or otherwise.
Dewitt Truck Brokers v. W. Ray Flemming Fruit Co
FACTS: Flemming’s company worked as a middleman between farmers and purchasers of fruit. Flemming
paid the plaintiff trucking company to transport fruit. Flemming assured the trucking company that he
would guarantee to pay them back even if his corporation didn’t. Flemming didn’t pay them in time, and
the trucking company sued Flemming personally. Flemming tried to argue that he wasn’t personally
liable, but instead only the corporation was liable. The trucking company, on the other hand, argued that
they should be able to “pierce the corporate veil” so they could make Flemming personally liable. The
district court found for the plaintiffs and Flemming appealed.
ISSUE: Did the district court correctly find that it was appropriate to “pierce the corporate veil” and make
Flemming liable for the debts of his corporation?
CT HOLDING: Flemming personally liable. Complete disregard to corp formalities + undercap +
commingling funds+ prez made personal assurances. Pierceing the corporate veil is appropriate in this
situation.
RULE: WHEN A PERSON OWNS BASICALLY ALL THE STOCK IN A CORPORATION, PLUS SOME
OTHER FACTORS ARE PRESENT SUCH AS: A LACK OF CORPORATE FORMALITIES,
UNDERCAPITALIZATION AND NON-PAYMENT OF DIVIDENDS, THE CORP IS AN ALTER EGO.
THIS MEANS IF THE CORPORATION IS MORE OR LESS A FAÇADE FOR AN INDIVIDUAL, THE
CORPORATION MAY BE DISREGARDED FOR THE PURPOSES OF LIABILITY AND THE DOMINANT
STOCKHOLDER MAY BE HELD LIABLE.
Baatz v. Arrow Bar
FACTS: The Baatz were riding a motorcycle when they were struck by an automobile driven by Roland
McBride, who was intoxicated at the time. Baatz alleges that Defendant, Arrow Bar, Inc., is contributory
negligent because it served alcoholic beverages to McBride prior to the accident despite the fact that he
was already intoxicated. Arrow Bar Inc., was formed in May 1980 by Edmond and LaVella. Edmond and
LaVella contributed $50,000 to the corporation pursuant to a stock subscription agreement. In June 1980,
the corporation purchased the Arrow Bar for $155,000 with a $5,000 down payment from Edmond and
LaVella. They personally guaranteed the remaining $150,000 note. In 1983, the corporation obtained
financing from a bank to pay off the $145,000 purchase agreement, which Edmond and LaVella again
personally guaranteed. Edmond is the president of the corporation and Defendant, Jacquette Neuroth,
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serves as the manager of the business. The corporation did not have dram shop liability at the time of the
Baatz accident. In 1987, the trial entered summary judgment in favor of Defendants. Baatz appeal and
this court reversed and remanded to the trial court. Shortly before the new trial, Edmond, LaVella and
Jacquette moved for and obtained summary judgment dismissing them as individual defendants.
∆ ARGUMENT: Baatz claims that the corporate veil should be pierced in this instance, making Edmond
and LaVella individually liable as shareholders of the corporation. Baatz relies on several arguments to
support this claim: (1) Edmond and LaVella personally guaranteed corporate obligations; (2) the
corporation is their alter ego; (3) the corporation is undercapitalized, (4) the corporation failed to observe
corporate formalities.
ISSUE: Whether there is a genuine issue of material fact based on Baatz four arguments that supports
that the corporate veil should be pierced making Edmond and LaVella personally liable?
HOLDING: No. The trial court’s grant of summary judgment to dismiss the individual defendants is
affirmed because there are no facts to support that the corporate veil should be pierced based on the
four arguments above.
DISSENT: The corporation is an instrumentality of “three shareholders, officers, and employees.” Thus,
the “corporation has no separate existence,” but was incorporated as a “shield against individual
liability.”
RULE: FACTORS THAT COURTS WILL CONSIDER TO DETERMINE WHETHER TO PIERCE THE
CORPORATE VEIL ARE:
O 1) FRAUDULENT REPRESENTATION BY CORPORATION DIRECTORS;
O 2) UNDERCAPITALIZATION;
O 3) FAILURE TO OBSERVE CORPORATE FORMALITIES;
O 4) ABSENCE OF CORPORATE RECORDS,
O 5) PAYMENT BY THE CORPORATION OF INDIVIDUAL OBLIGATIONS; OR
O 6) USE OF THE CORPORATION TO PROMOTE FRAUD, INJUSTICE, OR ILLEGALITIES.”
DISSCUSSION: Baatz fails to demonstrate how the corporation is Edmond and LaVella’s alter ego because
he fails to show how the corporation was “an instrumentality through which [they were] conducting
[their] personal business.”Baatz fails to show that the corporation was undercapitalized because he offers
no evidence that the corporation’s capital was inadequate for the operation of the business. The
corporation did not fail to adhere to corporate formalities simply for its failure to indicate that it was a
corporation on its signs and advertising. It is sufficient that the corporate name includes the abbreviation
of incorporated. There is no evidence in the record to support factors 1), 4), or 6) above.
o PERSONAL GAURENTEE & TORT: A personal guarantee that imposes individual liability for a
corporate obligation supports the recognition of a corporate entity. The PERSONAL
GUARANTEE OF A LOAN IS A CONTRACTUAL AGREEMENT AND CANNOT BE ENLARGED
TO IMPOSE TORT LIABILITY.
Radasewski v. Telecom Corp.
FACTS: π attempted to PCV to hold π parent financially liable for subsidiary’s actions. This personal
injury suit was brought on behalf of Plaintiff who was injured in an automobile accident by an employee
of Contrux, Inc., a subsidiary of Defendant. The district court held that Contrux, Inc. was under capitalized
in the accounting sense. Most of the money contributed to it was in the form of loans and Defendant did
not pay for all of the stock that was issued to it. However, Contrux, Inc., had $1,000,000 in basic liability
coverage plus $10,000,000 in excess coverage. Unfortunately, Contrux, Inc.’s excess liability insurance
carrier became insolvent two years after the accident and is now in receivership.
ISSUE: Whether the corporate veil of Contrux, Inc. can be pierced to bring Defendant into the case.
HELD: No. Contrux, Inc. had $1,000,000 in basic liability coverage plus $10,000,000 in excess coverage
that was sufficient to satisfy federal financial-responsibility requirements and the second element of the
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Collet test. Π made no showing of material fact that ∆ parent fraudulently or wrongly undercaped ∆
subsidiary. The purchase of insurance demonstrated the financial responsibility necessary to defeat the
claim.
RULE: COLLETT TRIPARTATE TEST TO “PIERCE THE CORPORATE VEIL”
O CONTROL, COMPLETE DOMINATION OF FINANCES POLICY AND BUSINESS PRACTICE
SO THAT THE ENTITY IN THIS CASE HAD NO SEPARATE MIND, WILL, OR EXISTENCE OF
ITS OWN; AND
O CONTROL WAS USED BY ∆ TO COMMIT A FRAUD OR WRONG, IN ORDER TO VIOLATE A
STATUTORY OR OTHER POSITICE LEGAL DUTY, OR DISHONESTY AND UNJUST ACT IN
CONTRAVENTION OF Π’S LEGAL RIGHTS; AND
O THE CONTROL AND BREACH OF DUTY MUST PROXIMATELY CAUSE THE INJURY OR
UNJUST LOSS COMPLAINED OF.
DISSENT: Liability insurance is only a relevant factor to be considered but does not alone require a verdict
for the defendant.
DISSCUSSION: Under capitalization of a subsidiary is a proxy under Missouri law for the second element
of the tripartite test for piercing the corporate veil first set forth in Collet v. American National Stores,
Inc., 708 S.W.2d 273 (Mo.App.1986). The purpose of inquiring as to whether a subsidiary is “properly
capitalized,” is to determine its financial responsibility. Insurance meets this policy just as well if not
better than a health
Fletcher v. Atex, Inc.
FACTS: Atex (∆) was a wholly owner subsidiary of Kodak (∆) unti 1992, when Atex old substantially all of
its assets to another party. Atex then changed its name to 805 Middlesex Corp. Kodak continues as the
sole shareholder of Middlsex. Fletcher (π) and other claimants brought suit against Atex and Kodak to
recover for stress injuries they incurred from uitilizing the keyboards producre by Atex.
ISSUE: May the Court pierce the corporate veil of a company and hold its shareholders personally liable
only in cases involving fraud, or where the company is a mere instrumentality or alter ego of its parent
company?
HOLDING: In this case, parent courp remained separate from subsidiary even using cash management
accounting & common O/D on the two companies. Such a sustem does not rise to the level of
intermingling contemplated by the statute. Similiarly, an overlap in the two companies’ borads of
directors is not conclusive of Kodak’s domination over Atex (under alter ego theory). Fletcher failed to
demonstrate the degree of control necessary to pierce Atex’s corporate veil and hold Kodak liable.
∆ ARGUMENT: Kodak excerised undue control over Atex by using a cash management system, exerting
control over Atex’s major expenditures, and by dominating Atex’s board of directors.
RULE: Under New York law , the court may pierce the corporate veil of a company and hold its
shareholders personally liable ONLY in cases involving fraud mod where the company is a mere
instrumentality or alter ego of its parent corp. Factors the court may consider in making its determination
include:
o Adequacy of capitalization
o Corporations solvency
o Payment of dividens
o Observations of corporate formalities
o Intermingling of funds
RULE: A SUBSTANTIAL ASSISTANCE TORT CLAIM REQUIRES EV THAT:
O (1) ∆ KNOWS THAT THE OTHER’S CONDUCT CONSTITUTES A BREACH OF DUTY, AND
O (2) ∆ GIVES SUBSTANTIAL ASSISTANCE OR ENCOURAGEMENT TO THE OTHER’S
CONDUCT.
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DISCUSSION: Because Atex is a deleware corp, deleware law must be applied. Under Deleware law, an
alter ego claim is demonstrated by showing that the parent and its subsidiary acted as a single economic
entity, and it would be unjust or inequitable to treat them as distinct from each other. However, ct notes
that sometimes the use of the parents logo in the subsidiary promotional material can be dangerous.
ANALYSIS: It is not uncommon for publicaly held corporation to own numerous subsidiaries. Substidiaries
are est in order to operate in areas that are either unrelated to the parent’s main business, or that
necessitate more centralized organization. Here, Atex was in the business of manufacturing keyboards, an
interprise unrelated to Kodak’s primary business. Although Atez looked to Kodak for support on
significant transaxtions, it is not unusual for a parent corp or a majority shareholder to participate in such
transactions involdving the subsidiary.
C. FINANCIAL MATTERS
314-338
1. EQUITY SECURITIES, PAR VALUE, WATERED STOCK
(IL §§ 1.80(f), 6.30)
1.80(f) – DEFINITIONS – "Shares" means the units into which the proprietary interests in a corporation are divided.
6.30 – PAYMENT FOR SHARES - The consideration for the issuance of shares may be paid, in whole or in part, in
money, in other property, tangible or intangible, or in labor or services actually performed for the corporation.
Without actual fraud board of directors valuation of the consideration received for shares shall be conclusive
(MBCA §§ 1.40(21), 6.21, 6.22)
1.40(21)- DEFINITIONS – S/H means the person whose name shares are registered in the records of a corp or the
beneficial owner of shares to the extent of the rights granted by a nominee certificate on file with a corp.
6.21 – ISSUANCE OF SHARES – powers granted to BOD can be reserved by S/H in AOI. BOD may authorize shares to
be issued for consideration consisting of any tangible or intangible property or benefit to the corporation, including
cash, promissory notes, services performed, contracts for services to be performed, or other securities of the
corporation. That determination by the board of directors is conclusive insofar as the adequacy of consideration
for the issuance of shares relates to whether the shares are validly issued, fully paid, and nonassessable. The
corporation may place in escrow shares issued for a contract for future services or benefits or a promissory note,
or make other arrangements to restrict the transfer of the shares, and may credit distributions in respect of the
shares against their purchase price, until the services are performed, the note is paid, or the benefits received. If
the services are not performed, the note is not paid, or the benefits are not received, the shares escrowed or
restricted and the distributions credited may be cancelled in whole or part.
I.
II.
Capital Raised by Equity or Debt Financing
a. Equity – an ownership interest is gained and payments made in dividens
b. Debt – borrowed funds repaid principal and interst, regaredless of success of biz
Stock
a. Definitions
i. Shares – unit into which proprietary interest in corp is divided
ii. Common shares – shares w/o preference over any other shares with respect to
distribution of assets on liquidation or with respect to payment of dividens.
b. Primary rights
i. Voting
ii. Entitled to net assets by dividens or liquidation
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c.
III.
IV.
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Sup Ct elements that make up common stock
i. Dividens paid
ii. Negotiable instruement
iii. Pledge stock for loan
iv. Vote
v. Increase in value
d. Common – voting rights
e. Prefered
i. Gen w/o director voting rights
1. Sometimes if no dividens paid in x years, voting rights gaurenteed
ii. Convertible to common stock
iii. Preference to dividens/asserts upon dissolution
1. E.g. $5 preferd stock = paid $5 per year
iv. Cummulative – carryover if no profits in present year to pay dividens
v. Partially cumulative – dividens accumulate to the extent the corp had earnings
1. E.g. $5 perferred stock & co had $2 earning per share in year 1, only $2 can be
carried over to year 2.
vi. Non-cummulative – no carryover
vii. Downsides = corp does very well  common stock gets more while preferd will only get
ceiling amount.
viii. Therefore, value of stock will not increase dramatically.
Par Value
a. Historically, valye printed on stock cert and sold to initial investors for
b. Today, normally a nominal figure ($1 or 10 cents) and solely an accounting concept.
Water Stock – amount a buyer pays under the stocks par value.
a. E.g. par value = $1; A&B – 100 shares for 20; -> purchase value $200 per share (OK)
i. Can C come in and pay $10k for 100 shares? YES, above par value.
ii. Can D buy 100 shares for $50 from A? Yes, b/c A is not corp but S/H.
iii. Can D but 100 shares for $50 from corp? Yes, BUT watered stock so D has personal
liability of $50.
Hanewald v. Bryan’s Inc.
FACTS: After the Bryans (∆) incorp Bryan’s Inc (∆) to operate a general retail clothing store, they issues
stock to themselves, lent the corp some cash, and personally gaurenteed a bank loan. However, they
failed to pay the corp for the stock that was issued. Bryan’s Inc (∆) then purchased Hanewald’s (π)
inventory and assets in a dry goods store for cash and for a corp promissory note. It also signed a lease on
Hanewald’s store. When Bryan’s Inc closed after a few months, it paid off all of its creditors except
Hanewald, sending him a notice of recission in an attempt to avoid the lease. Hanewald sued Bryan’s Inc
and the Burans for breaching the lease and the promissory note seeking to hold the Bryans personally
liable. Trial court ruled against Bryan’s Inc but did not hold the Bryans personally liable.
ISSUE: Is a shareholder liable to corporate creditors to the extent his stock had not been paid for?
HOLDING & DISCUSSION: Yes. A s/h is liable to corp creditors to the extend his stock has not been paid
for. A corp that issues its stock as a gratuity commits a fraud upon creditors who deal with it on the faith
of its capital stock. Where, as here, a loan was repaid by the corp to the s/h before its operations were
abandoned, the loan cannot be considered a capital contribution. The Bryans had a statutory dury to pay
for shares that were issues to them by Bryan’s Inc. However, Bryan’s Inc. did not receive any payment,
either in labor, services, money, or property, for the stock issues to Keity and Joan Bryan. The Bryans have
not challeneged this finding of fact on appeal. Thus, the trial court erred as a matter of law in refusing to
hold the Bryans personally liable for the corps debt to Hanewald.
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ANALYSIS: The Bryans’ failure to pay for this shares in the corp made them personally liable under the
court’s application of MBCA §25. The court also applied Article XII, § 9, of the state’s constitution, stating
that no corp shall issue stock or bonds except for money, labor done, or money or property actually
received. The purpose of the constituteion and statutory provisions is to protect the public and those
dealing with the corp. A s/h loan is a debt not an asset of the corp. Where, the loan was repaid by the
corp to the s/h before its operations were abandoned, the loan cannot be considered a capital
contribution.
o P is trying to go after personal liability of the owners for the debt of $38k
o D owners got 1,000 shares at $100 each, but never paid $100k -> created debt to corp
 If they paid for the stock – they would not be liable for the $38k
 If they loaned $100k, but par value is only $10k on the stock, they would only pay $10k
instead of $38k
 Therefore max liability if what they should have paid for the stock. (Better to have a
lower par value)
RULE: A S/H IS LIABLE TO CORP CREDITORS TO THE EXTENT HIS STOCK HAS NOT BEEN PAID
FOR.
Torres v. Speiser
FACTS: ∆ promised to assist π in his creation of a check-cashing business. Π would also manage the corp
that controlled this business. Π sold his stock for below par value and the business agreement was
unclear as to the terms of this stock transfer
ISSUE: Whether a shareholder is protected under the Business Corporation Law (NY) Act when he agrees
to re-transfer his stock?
HOLDING: No. The ACT ONLY ENSURES THAT THE STOCK VALUE WILL BEAT PAR VALUE WHEN IT
IS FIRST ISSUED OR PAID FOR AT FULL PURCHASE PRICE; IT DOES NOT PROTECT THE
STOCKHOLDER WHEN THE STOCK IS RE-TRANSFERRED. Summary judgement could not be given
since there was an issue of fact as to if there was partial performance of the business agreement.
DISCUSSION: The act is specific as to when the sale of stock by S/h will be protected. It is only when the
stock is first issues that is cannot be sold below par value. But the Act does not protect the transactions
between S/H such as the re-issuing of stock.
2. DEBT FINANCING
I.
II.
III.
IV.
338-347
Secured Debt – bonds
a. E.g. your house mortgage is a secured debt with your house as security
Unsecured Debt – debenture
a. No security interest to collect on debt (credit card)
Business normally started w/ combo of debt and equity
a. May start with all equity, but not all debt
Leverage – created by 3rd pty debt
a. E.g. starting a donut shop for $500k
i. Alt A: $250k equity – 25,000 shares @ 10 + $250k loan
1. Y1 – 25,000 earnings = pay $20k interest first  $0.20/share
2. Y2 – 100,000 earnings = pay $20k interest first  $3.20/share
3. Y3 – 200,000 earnings = pay $20k interest first  $7.20/share
ii. Alt B: $500k stock – 50,000 shares @ $10
1. Y1 – 25,000 earnings = $0.50/share
2. Y2 – 100,000 earnings = $2/shares
3. Y3 – 200,000 earnings = $4/shares
b. Positive – earn more money per share, pay back the debt is non-taxable
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c.
Negative – accumulation of debt  IRS will reclassify debt as equity to disallow deductions too
great.
3. CAPITAL STRUCTURE PLANNING
1.
2.
Issues to consider for a capital structure
a. Stand up to legal attack or disagreement
b. Fit the desired results – e.g. person want unconditional annual payments shouldn’t be issued
preferred stock that may not pay dividen
c. Perferred tax treatment – S corp avaial?
d. Any unexpected liabilityies – par value & watered stock; PVC
e. Protect financial contributions w. fair treatment.
AB Software store: A gives $100k, B renders services for 50% control (completed after 2 years)
a. A&B issued 1,000 shares, par value $100. B have watered stock liability/.
i. MBC – future service is not payment for stock = YES watered stock liability
ii. IL – cannot get stock for future services
iii. Solve the watered stock
b. A 100 shares, $1 par for $100k; B gets 100 shares only after 2 years service. Solve watered stock
problems?
i. Does B earn shares as he works? Or in lump sum after 2 years?
ii. B has breach of K action against A if dissolves biz in 18 mo?
c. A 100 shares, $1 par for $100k; B issues promissory note for $100k payable in two years of
service.
i. MBC – promissory note ≠ payment for stock
ii. Some states allow – B becomes s/h and debtor
d. A 100 shares, $1 par for $100k; B 100 shares for $100.
i. Nothing illegal about it as long as above par value. Notice, cannot do it at initial issuance
of stock; may do it if buying from another
ii. Problem comes for B’s income tax
e. Class A & Class B stocks created with 1:1.000 voting rights difference
i. Allowable by MBC
f. A&B 10 shares, $1 par for $100; A loans company $99,800
i. Straight debt for corp?
ii. DEBT TO EQUITY ISSUE: ~ 500:1 ration and debt would be characterized from debt to
equit for tax/bankruptsy purposes
g. A 10 shares common for $100 & 9,980 shares preferred at $10 share for $99,800; B 10 shares
common for $100.
i. Must be a C corp (because 2 types of stock)
ii. How should dividens be divided?
iii. Why less attractive?
h. A 5,000 preferred for $50,000, loans $49,800
i. Better?
i. A 10 shares $50,000; B 10 shares $100; A lends remaining $49,900.
i. Best?
4. PREEMPTION AND DILUTION
(IL § 6.50)
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369-383
6.50 – SHAREHOLDERS PREEMPTIVE RIGHTS – Incorp after 1982 ≠ preemption unless in AOI. Old corps can change
AOI to limit preemption. Shares paid as compensation = no preemption. If preemption s/h have right to aquire
treasury shares to same extent they have right to aquire unissued shares.
(MBCA § 6.30)
6.30 – SHAREHOLDERS PREEMPTIVE RIGHTS – No preemptive right unless in AOI. If elected in AOI then BOD must
provide fair and reasonable opportunity for S/H to exercise preemptive right (proportial amount of unissued). S/H
can waive right in writing w/o consideration. No preemption right for stocks issued as compensation, conversion
options, and shares auth in AOI w/in first 6 mo, shares sold for other than $. No preemption on ≠ voting stock. No
preemption on preferred stock sales if holder owns common stock.
1. Prempptive rights most important in closely held, small corp
a. Share amounts can quickly change control
2. E.g. 3 s/h exist and 2 want ot expand biz costing $600k by issuing 30 new shares at $20k each while 3 rd
partner doesn’t want to.
a. Let the 2 supporting s/h buy the new stoxk and the 3rd can just continue (now as even more
minority s/h)
b. IF PARTNERSHIP, just dissolve partnership and let the 2 continue on OR let the 2 partners loan
the money and maintain interet in partnership for all 3 people.
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Stokes v. Continental Trust Co of City of New York
FACTS: Continental Trust Co (∆) has 500,000 shares of outstanding stock of which Stokes (π) owned 221
shares. The par value of the stock was $100, but the marked value was $550. Blair and Co offered to buy
500,000 newly issued shares of Continental at $450, if those shares were issued. Continental held a s/h
meeting, and the new issue as voted. Stokes demanded that he be sold enough of the new shares to
keep his percentage of stock ownership the same before and after the new issue. He also demanded
that he be sold these shares at par value; however, these demands were turned down.
ISSUE: Is a s/h entitled to purchase enough shares of newly issues stock to insure that his proportionate
share of ownership will remain consistant?
HOLDING & DISCUSSION: Yes. A corp must allow a s/h to purchase newly issued stock (at the fixed sales
price) to allow him to maintain his proportionate share of the stock of the corp. Stockholders may elect to
do so as a mater of right. Unless this opportunity is extended to each s/h and either executed or
efficiently waived, the corp may not issue new shares without at least incurring liability for the damage
done to the shareholder’s interest. If the s.h elects to but, however, he must do so at the fixed sales price,
not the par value (it would be unfair to allow him to buy at par, since thise would inflate his
proportionate interest). Here, Stokes, had a right to purchase a proportionate interest of new stock. Since
he offered to do so (though at the incorrect price), he cannot be said to have waived his right, so
damages are appropriate. Since again, however, his offer was at par, which was incorrect, his damages
must be messured as the difference between that price and the marked value.
RULE: A CORP MUST ALLOW A SHAREHOLDER TO PURCHASE NEWLY ISSUED STOCK AT THE
FIXED PRICE TO ALLOW HIM TO KEEP HIS PROPORTIONATE SHARE OF THE STOCK.
ANALYSIS: This case represents the common-law view on preemptice rights, or the right of first refusal of
new issues of stock. The prevailing view is that these rigts apply only to common stock.
Katzowitz v. Sidler
FACTS: Katzowitz (π), Sidler (∆), and Lasker (∆) were the sold shareholders and directors in the Sulburn
Corporation, a closed corp. Sidler and Lasker had joined forces in an attempt to oust Katzowitz from his
position in this corp, and by stipulation Katzowitz agreed to withdraw from active participation. At the
time of Katzowitz’s withdrawal, the corp owed each of the directors $2,500, and Sidler and Lasker
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proposed a new issuance of stock to ameliorate the debt. Over Katzowitz’s objections, they passed a
resolution whereby each of the three could purchase 25 shares at $100 per share when the stock was
actually worth $1,800 per share. Katwozitz did not opt to purchase and when the company was dissolved
he received $3.147.59 to Slider’s and Lasker’s $18,885.52. Katzowitz bought this action to set aside the
distribution to allow Sidler and Lasker the return of their purchase price of the 25 shares, and to compel
an equal distribution of the remaining assets.
ISSUE: Can a shareholder who did not purchase from a new issuance of shares set aside that issuance as
fraudulent where the new shares are offered in a close corp at a totally inadequate price causing dilution
of the s/h interest in the corp?
HOLDING & DISCUSSION: Yes. WHERE NEW SHARES ARE OFFERED IN A CLOSED CORP, EXISTING
S/H WHO DO NOT WANT TO OR ARE UNABLE TO PURCHASE THEIR SHARE OF THE ISSUANCE
ARE NOT STOPPED FROM BRINGING AN ACTION BASED ON A FRAUDULENT DILUTION OF
THEIR INTERESTS WHERE THE PRICE FOR SHARES WAS INADEQUATE. THE CONCEPT OF
PREEMPTIVE RIGHTS WAS FASHIONED BY THE CORTS TO PROTECT AGAINST DILUTION OF S/H
INTERESTS AND IS PARTICULARLY APPLICABLE TO THE SITUATION OF A CLOSED CORP.
Although the courts and the legislatire are reluctant to regulate the price at which shares can be offered,
if issuing stock for less than fair value results in a fraudulent dilution of the s/h interests, it will be set
aside. Here, Sidler and Lasker issued stock at $100 per share when the true value of the stock was over
$1,800 per share, knowing that katzowitz would not elect to purchase his proportionate share and
thereby diluting his interest. Thus, the issuance was fraudulent, and after allowing Sidler and Lasker the
amount they paid for the additional shares of stock, the remaining assets of the corp will be divided to
the s/h in proportion to their interests held before the issuance.
ANALYSIS: Althought the courts are reluctant to fiz prices at which corp stock can be issued, they can find
little justification for issuing stock far below its fair value. Gneerally, the only time stock can be issued far
below its book calue is when book vale is not reflective of the actual worth of the corp or where a
publicaly held corp experiences difficulties floaring a new issue. The MBCA § 26, provides that preemptice
rights exist only to the extent that such rights are provided, if at all, in the AOI. Directors, being
fiduciaries of the corporation, must, in issuing new stock, treat existing shareholders fairly. The power
to determine price much be exercised for the benefit of the corporation and in the interest of all the
stockholders.
Lacos Land Co v. Arden Group, Inc.
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FACTS:Briskin was an officer, director, and the main s/g of Arden Group (∆). A proposal was made to issue
a new class of voting stock. The stock was of a nature that only Briskin would be interested in purchasing.
The new class would concentrate control with Briskin. ∆ proxy statement was materially misleading
because it failed to disclose whether the plan gave the officer the power to single-handedly effectuate
certain voting decisions. At S/h meeting Briskin made it known that he might interfere with ventures
profitable to Arden (∆) if the recapitalization was not approved. Following approval, Lacos Land Co. (π)
and other s/h’s filed an action seeking to enjoin recapitalization.
ISSUE: Is adoption of a new class of stock voidable if the adoption was influenced by threats from a
fiduciary and if there are material misstatements in the proxy?
HOLDING & DISCUSSION: Yes. Adoption of a new class of stock is voidable if the adoption was influence
by threats from a fiduciary. A fiduciary is under an obligation, at all times, to act with the interests of the
corp uppermost in mind. While a s/h is not usually a fiduciary, a director and officer is. For an officer or
director to use the coercion upon the s/h od a corp to induce them to approve a measure is improper.
Here, Briskin, who was not onlya s/h but also a director and officer as well, made it clear he would block
beneficial transactions if he did not get his way. This was quite unseemly and clearly a breah of fiduxiary
duty. This makes the transaction approved by the coercion voidable.
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ANALYSIS: Coersion alone does not make a corp transaction invalid. Individual s/h’s can and often do use
coercive tactics in corp power struggles. Rather, it is IMPROPER COERCSION AND FAILURE TO
DISCLOSE FULLY AND FAIRLY PERTINENT INFORMATION WITHIN THE BOD CONTROL, HERE BY
AN O/D WITH A FIDUCIARY DUTY, BRINGS A TRANSACTION INTO QUESTION.
5. DISTRIBUTIONS
1.
2.
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383-410
Fiduciary Protections
a. BUSINESS PURPOSE RULE – little protection for S/H because majority can negate bad faith by
just showing some rational business purpose in freezing-out shareholders.
b. EQUAL OPPORTUNITY RULE – partners are co-agents of each other and cannot be removed
w/o payment for their interest
i. Business justifications are irrelevant
ii. Some Cts – partnership-like duties assigned to closed corps
1. Duties of “utmost good faith and loyalty”: minority S/H allowed to either sell
stock on same terms as majority s/h or seller to resind sale.
2. WILKES BALANCING TEST – CT MUST BALANCE
A. MAJORITY PROVEN LEGITIMATE BIZ PURPOSE AND
B. MINORITY SHOWS A LESS HARMFUL WAY TO ACHIEVE SAME
GOAL
Dissolving : minority s/h cannot cimply withdraw and force dissolution
a. w/o dissolution agreement, need to show bad faith in petition for involuntary dissolution to the
ct.
b. MBCA- need to show BOD and S/H deadlock or miscoundct (MBCA favors ongoing biz, not
dissolutions)
c. E.g. 3 partners exist. 2 partners want to freeze-out 3rd and issue $500k new stocks to themselves,
knowing 3rd cannot afford. Pass fudiciary test?
i. Traditional test: Yes, as long as rational biz purpose (e.g. raising new cap)
ii. Modern test: Maybe, minority still has equal opportunity… but the ct puts higher duty
on close corp  Wilkes alternative means test puts burden on majority S/H to justify
need for greater capital.
Gottfried v. Gottfried
FACTS: Gottfried Baking Corporation, (Gottfried), is a closely held family corporation. Most of its
stockholders are children of the founder of the business and their spouses. Until 1945 no dividends were
paid on the common stock although dividends had been regularly paid upon the preferred stock, and
intermittently upon the “A” stock. In 1945, dividends were paid on the common stock presumably
stimulated by the commencement of this suit. Hostility has existed for a long time between the Plaintiffs
and Defendants in this case. Plaintiffs contend that the Board of Directors are motivated by a desire to
coerce Plaintiffs to sell their stock to the majority interests at a grossly inadequate price and have
circumvented the need for dividends insofar as they are concerned by excessive salaries, bonuses and
corporate loans to themselves.
ISSUE: Whether ∆’s withheld the declaration of dividense in bad faith?
HOLDING: No. It may not be said that the directorate policy regarding common stock dividends at the
time the suit was brought was unduly conservative and inspired by bad faith.
RULE: IF AN ADEQUATE CORPORATE SURPLUS IS AVAILABLE FOR THE PURPOSE OF PAYING
DIVIDENDS, DIRECTORS MAY NOT WITHHOLD THE DECLARATION OF DIVIDENDS IN BAD
FAITH. THE TEST OF BAD FAITH IS TO DETERMINE WHETHER THE POLICY OF THE DIRECTORS IS
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DICTATED BY THEIR PERSONAL INTERESTS RATHER THAN THE CORPORATE WELFARE. CTS
UNLIKELY TO FIND BAD FAITH.
DISCUSSION: It is true that there is animosity between the majority and minority shareholders of
Gottfried. It is also true that several defendants have received substantial sums in compensation.
Substantial loans have also been made to several of the defendants. However, these were incurred in
large part prior to the controversy surrounding dividends. The evidence with respect to the financial
condition of the corporation and its business requirements does not sustain Plaintiff’s claims. Evidence
shows that expenditures included the retirement of the then outstanding preferred stocks in the sum
$165,000, in which Plaintiffs benefited proportionately. Further, despite the motivation, dividends were
paid in 1945 on common stock.
Dodge v. Ford Motor Co
FACTS: Ford Motor Co. had a surplus of almost $112 million. It declared a dividend of $1.2 million. The
Dodge Bros. were major shareholders, and wished to get some money to open a competing business.
Ford's Board of Directors refused to issue a larger dividend, claiming that the surplus was needed for
expansion and operating cushion.
ISSUE: Whether the refusal of the Ford board of directors to issue such a dividend in this case amounted
to a willful abuse of discretion?
HOLDING: Yes. IT IS WELL RECOGNIZED THAT THE POWER TO DECLARE A DIVIDEND, AND THE
AMOUNT OF THE DIVIDEND, IS EXCLUSIVELY WITHIN THE DISCRETION OF THE BOARD OF
DIRECTORS. HOWEVER, A BOARD MAY BE COMPELLED TO PAY A DIVIDEND IF THE FAILURE TO
DO SO WOULD BE A WILLFUL ABUSE OF THEIR DISCRETIONARY POWERS, OR FRAUD, OR
BREACH OF THE FIDUCIARY DUTY. Here, the surplus is so large, that even if Ford were to immediately
spend all of the money it planned for expansion, there would still be an obscene surplus.
DISCUSSION: case often cited for support that biz corp is orged and carried on primarily for the profit of
the s/h. The power of the O/D and BOD are to be employed for that end.
Wilderman v. Wilderman
FACTS: Elenor Wildermann (π) and her husband Joseph (∆) founded, and later incorporated the Marble
Cradt Co. The biz was engaged in the installation of ceramic tile and marble facings. Joseph performed
most of the duties of the biz while Eleanoe served as bookkeeper. After incorporation, J and E as the
companies only s/h elected themselves as directors (J = Prez; E = VP, Sec., Tresure). Both J and E received
salaries which had been fixed by agreement, although they did not pay themselves dividens because that
practice would have subjected them to double taxation. J increased the amont of compendation which
he paid to himself over amount auth by BOD. Althought J had been authorized to receive an annual
salary of only $28k he paid himself more than $90k in 1971, $35k in 1972, and $87k in 1973. E salary from
1971-1973 was $7k per year. During this period, the court appointed a custodian to assist in the
management of the company, and he succeded in having a $20,000 dividend declared, E & J dividing the
amount equally. But when the custodian’s intervention faield to eliminate or reduce the disparity in
salaries, E filed suit against both J and the Corp. Suing both individually and in her role as s/h, E sought
the return of excessive amount paid to J, and an injunction against additional unauthorized
disbursements, and an order directing that the co. management continue to be subject to the supervision
of the custodian. E also sought an order compelling the company to pay dividens and asked that the corp
pension plan be adjusted to reflect the fact that the excessive compensation paid to J had been declared
improper.
ISSUE: May the president of a corp arbitrarily pay himself more compendaiton than the company’s board
of directors has authorized?
HOLDING & DISCUSSION: No. IN THE ABSENCE OF A SPECIFIC AUTH BY THE COMPANIES BOD, A
CORPORATE EXECUTIVE MAY RECEIVE ONLY COMPENSATION THAT IS REASONABLY
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COMMENSURATE WITH HIS FUNCTIONS AND DUTIES. The authority to compensare corp D/O is
normally vested in the BOD. J was authorized to receive a salary of only $20,800 per year. Any agreement
pursuant to which he may hav been entitled to more compensation had been recinded prior to 1971.
Thus, the excessive amounts which he received in 72, 72, and 73 may be justified, if at all, only by
application of quantum meruit theory. And, on the basis of the ev. Presented, it does not appear that the
compensation to which J unilaterally and arbitratily declared himself entitled to was reasonable in light of
the services he preformed for the corp. An expert witness testified that $35,000 per year was the highest
salary which should reaonsbaly have been paid to J. Moreover, the IRS permitted Marble Craft to deduct
only $52,000 od the more than $92k that J received in 1971. Since J has produced no ev. That would
justify his recipet of compensation as generous as that which he paid himself, it is appropriate to require
the return of any excess over $45k received in any of the years in question. Appropriate adjustments in
the corporate pension fund mut also be made, and dividens may be declared at the insistence of the
company’s board of directors, or in the event of a deadloct, this custodian.
ANALYSIS: The salaries of corp exc’s are orginarly fixed by the companies BOD and are incorporated into
each exc’s employment K, whether it be oral or written. Any person who renders services for another has
some chance of recovering compensation if he brings an action based on quantum meruit. However, only
rarely would such suit prove beneficial to a corp exc since, in order to recoverm he would have to prove
this his services were performed on bahlf od the company but were in addition to the duries which were
required of him in the usual conduct of his employment.
Donahue v. Rodd Electrotype Co.
FACTS: Harry Rodd (Defendant), a controlling stockholder in Rodd Electrotype (Defendant) caused the
corporation to buy 45 of his shares for $800 per share. He also made gifts and sales of the rest of his
holdings to his children. A minority shareholder, Donahue (Plaintiff), who refused to ratify the actions of
Rodd (Defendant), was refused to sell her offered shares on the same terms as Rodd (Defendant).
Donahue (Plaintiff) brought an action to rescind the purchase of Rodd's (Defendant) stock and to make
him pay back the $36,000 purchase price with interest. The trial court dismissed the action for lack of
prejudice to Donahue (Plaintiff) and the appellate court affirmed the trial court's dismissal.
ISSUE: Whether in a close corporation a controlling stockholder must see to it that an equal offer to
purchase shares is made to other stockholders when the controlling stockholder causes the corporation
to purchase his shares?
HOLDING & DISCUSSION: Yes. A CONTROLLING STOCKHOLDER OF A CLOSE CORPORATION OWES
A FIDUCIARY DUTY TO THE MINORITY STOCKHOLDERS WHEN A CONTROLLING STOCKHOLDER
CAUSES THE CORPORATION TO PURCHASE HIS SHARES. A CLOSE CORPORATION IS TREATED
LIKE A PARTNERSHIP AND REQUIRES THE UTMOST TRUST AND LOYALTY AMONG THE
MEMBERS FOR SUCCESS OF THE CORPORATION. Donahue (Plaintiff) must be allowed to be given an
equal opportunity to sell her shares because there is not a ready market in a close corporation and
therefore in this case a greater fiduciary duty among the stockholders exists. Reversed and remanded.
RULE: In a close corporation, a controlling stockholder who causes the corporation to purchase his stock
owes a fiduciary duty to the minority stockholders to cause the purchase of their shares equally at the
same price.
D. MANAGEMENT AND CONTROL
419-433
(IL § 2A.40, 7.71)
2A.40 – WRITTEN AGREEMENTS AS TO CONDUCT OF CERTAIN AFFIARS OF CORP – Written agreements OK as to
management, dividens, officers/directors, restriction on share transfers, voting agreements, employment, binding
25
arbitration, etc. Agreements ≠ invalidated because attempts to treat corp as partnership. Agreements w/
restrictions on BOD OK as long as liability for actions shifts to S/H.
(MBCA § 7.32)
7.32 – SHAREHOLDER AGREEMENTS – Agreement can be inconsistent with other provisions of MBCA if it:
eliminates/restricts BOD, governs distributions, establishes O/D, voting agreement, stock transfer restrictions,
requires dissolution at occurance of certain event, governs corp management. UNLESS conflicts w/ public policy.
Agreement must be set forth in AOI/bylaws and approved by all persons who are S/H when agreement made.
Amended only if unanimous by S/H. valid for 10 years UTTC. Argeememt must be conspiculously on front/back of
stock cert, must recal certs if previously issued dosent have. Agreements under 7.32 cease when posted on NSE or
likely. Liability shifts from BOD to S/H if power shifts. Incorp and subscrivers can act as S/H if no shares have been
issued when agreement made.
1.
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Closed Corp
a. General Duties
i. Generall deals w/ state law.
II. SAME DUTIES AS PUBLICALLY TRADED IN RESPECT TO
1. LIMITED ELECTORAL RIGHTS
2. MANDATORY DISCLOSURE
3. FRAUD UNDER 10B-5.
b. Common factors
i. Intergration of ownership/management; S/H occupy most management positions
ii. Few S/H
iii. Little/No Market for the stock
iv. Similar to partnership (i.e. an incorp partnership)
c. Hightened Fudiciary Duties: In corp you can sell your shares (gen wall street rule). In close corp
basically incop partnership. No liquidity generally.
i. Freezout: Majority can isolate minority from participation
ii. Forceout: Majority can manipulate structure and push out minority. So because no
market for closed corp = heightened financial duties.
McQuade v. Stoneham
FACTS: In 1919, Plaintiff and Defendant John McGraw each purchased 70 shares of NEC stock from the
majority 1,306 shares that Stoneham owned. NEC was the company that owned the New York Giants. At
the time of purchase, the parties agreed to do everything in their power to keep Stoneham as president,
McGraw as vice-president and Plaintiff as treasurer. Plaintiff and Stoneham had a number of conflicts
concerning the operations of NEC, and in 1928, the 7-member board of directors of NEC voted in a new
treasurer (McGraw and Stoneham abstained from the vote). Plaintiff was not removed for any
misconduct or ineptitude, but rather for his conflicts with Stoneham. Plaintiff brought this action to be
reinstated as treasurer, and he cited the agreement that he entered with McGraw and Stoneham that
provided for each of them to use their “best endeavors” to keep each other in their respective positions.
Defendant argued that the agreement was invalid because it granted authority to shareholders for a
decision that is normally left to the judgment of directors. The lower court moved to reinstate Plaintiff.
ISSUE: The issue is whether the shareholder agreement between Plaintiff and Defendants to use their
best efforts to keep each of the parties in their respective positions is valid.
HOLDING & DISCUSSION: The Court of Appeals of New York held that the shareholder contract to keep
the parties in their positions within NEC was invalid as a matter of public policy. Shareholders should
not be able to usurp the decision-making normally left to the directors, and directors should be beholden
to the corporation and not the shareholders. Although the evidence indicated that Stoneham may have
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exercised bad faith in that Plaintiff was competent in his position and was ousted over personal
disagreements, the director’s intentions are irrelevant because the court does not want to put directors
in a position wherein they would have to defend future decisions. Plaintiff was also ineligible for
employment with NEC because he was a City Magistrate.
CONCURRENCE: The concurring opinion agreed that the reinstatement should be denied, but only
because Plaintiff was a City Magistrate. The contract, however, was valid because Stoneham as a
majority owner could elect the directors who elect the treasurer and was not therefore taking away any
powers from the directors that he already really had.
RULE: SHAREHOLDERS CAN NOT FORM AN AGREEMENT TO CONTROL THE DECISIONS
TRADITIONALLY VESTED IN THE JUDGMENT OF THE DIRECTORS OF A COMPANY.
DISCUSSION: The court affirms the validity of shareholders to agree to pool their votes, but they decline
to allow them to use their voting power but not pool the director’s powers. The power to unite is,
however, limited to the election of directors and is not extended to contracts whereby limitations are
placed on the power of directors to manage the business of the corporation by the selection of agents
at defined salaries
Galler v. Galler
FACTS: Plaintiff’s late husband and his brother, Isadore Galler, owned all but 12 shares of a close
corporation, Galler Drug (each of the brothers sold six shares to a third party that was subject to a
buyback provision allowing each brother to reclaim their six shares). The brothers, in an effort to provide
for their families if something were to happen to either brother, entered a shareholder agreement that
would guarantee that their spouses would be elected to the board and that each would have equal
representation on the board. The agreement also provided an annual payout to the spouses. There was
no set expiration date of the agreement provisions. After Plaintiff’s spouse’s death, Defendants tried to
destroy all copies of the agreement. Plaintiff sued to review the agreement in order to enforce the
provisions therein. ∆ argued that the shareholder agreement was unenforceable because it violated
state statutes that render invalid shareholder agreements that seek to control management decisions.
ISSUE: The issue is whether the shareholder agreement between the majority shareholding brothers was
invalid per statute or public policy.
HOLDING: The agreement was valid and Plaintiff should be entitled to specific performance and money
that was owed under the agreement. Galler was a closely held corporation, and therefore subject to
different circumstances than a shareholder of a large corporation. The court cited a number of prior
cases, including Dodge v. Clark, to support the premise that because this agreement did not harm the
public and was fair to the parties of the agreement, there is no offense to any public policy concerns.
RULE: A SHAREHOLDER AGREEMENT, PARTICULARLY IN CLOSED CORPORATIONS, THAT
CONTROLS THE VOTING FOR BOARD MEMBERS AND THE MEMBERS’ MANAGEMENT
DECISIONS, SHOULD NEVERTHELESS BE ENFORCED AS LONG AS THE AGREEMENT IS NOT
FRAUDULENT OR HARMFUL TO THE PUBLIC.
DISCUSSION: In a closely held corporation, a minority shareholder does not have the ability to easily
unload their shares as someone who held publicly traded shares, and therefore will have to resort to
detailed, comprehensive shareholder agreements in order to guarantee their rights. The court weighs this
public policy concern against the public policy concern of independent directors and decided not to
follow the statute that prohibits these agreements, reasoning that the state could not have meant for the
statute to apply in these cases.
1. CUMULATIVE VOTING
(IL § 7.40, 11.65(a)(3)(iii))
7.40 – VOTING OF SHARES – may limit or allow cumulative voting
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450-457
11.65(a)(3)(iii) – RIGHT TO DISSENT – can dissent to limits/eliminating cumulative voting; dissent forces company
to repurchase stock at FMV
(MBCA §7.28, 13.02(a)(5))
7.28 – VOTING FOR DIRECTIONS: CUMULATIVE VOTING – UTTC in AOI directors elected by plurality of votes cast
when quorm present, s/h do not have cumulative voting rights UNLESS in AOI.
13.02(a)(5) – RIGHT TO APPRASIAL – S/H entitled to appraisal and payment of fair value for shares if amendment
to AOI, merger, share exchange or disposition of assets provided for in AOI.
1.
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Voting
a. Quorum: # of s/h needed to have valid meeting
b. Proxies
i. Valid for 11 months
II. REVOCABLE UNLESS APPOINTMENT FORM STATES IT IS IRREVOCABLE OR IS
COUPLED W/ INTERST
III. REVOCABLE BY:
1. WRITTEN NOTICE OF INTENT TO REVOKE
2. APPOINTMENT OF ANOTHER PROXY SUBSEQUENT TO DATED PROXY
3. APPEARING IN PERSON TO VOTE
c. Votes per Share
i. One vote per share generally
ii. AOI can deivate from this standard
D. CUMMULATIVE V. STRAIGHT VOTING
i. Cummulative: procedure whereby minority s/h have greater opp to secure
representation on BOB
ii. Straight Voting: Vote the shares you have
e. Notice of Cummulative Voting – prevents bad faith voting by minority to gain control
i. E.g. A 5 shares; Z 4 shares; both nominate 5 candiates
1. A votes 5 votes for each of 5 candidates
2. Z votes cumulatively using 20 votes for 3 candidates
3.  Z controls 3 of 5 BOD.
Humphrys v. Winous Co.
FACTS. Appellant has the minimum number of three directors and their terms of office are for three
years, one to be elected each year. This classification of three directors into three classes each containing
one director effectively divests the minority shareholders of the ability to elect one member of the
board through cumulative voting. Appellees brought suit claiming that this classification restricted the
right their right to vote cumulatively as specifically guaranteed by Section 1701.58 and therefore the
classification was invalid.
ISSUE: Whether the classification of three directors into three classes each containing one director is
invalid because it restricts the right to vote cumulatively
HOLDING: No. This classification is not invalid because Section 1701.58 grants a right that may not be
restricted or qualified rather than one ensuring minority representation on the board of directors.
DISSENT. The legislature showed clearly that it intended to strengthen the cumulative voting provision by
adding the provision that prevents corporations from restricting cumulative voting. In the same act the
legislature provides for classification of directors. It could not have been intended that the exercise of
such a right could be so used as to nullify the right of cumulative voting as has been done in this case.
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RULE: MINORITY SHAREHOLDERS ARE GRANTED ONLY THE RIGHT OF CUMULATIVE VOTING
BUT ARE NOT NECESSARILY GUARANTEED THE EFFECTIVENESS OF THE EXERCISE OF THAT
RIGHT TO ELECT MINORITY REPRESENTATION ON THE BOARD OF DIRECTORS. CLASSIFICATION
OF BOD OK.
DISCUSSION. Section 1701.58 guarantees to minority shareholders only the right of cumulative voting
and does not necessarily guarantee the effectiveness of the exercise of that right to elect minority
representation on the board of directors. To hold otherwise would annihilate the provision for
classification because any such classification would necessarily be a restriction or qualification on the
effectiveness of cumulative voting.
2. S/H VOTING AGREEMENTS
457-488
(IL § 7.70)
7.70 – VOTING AGREEMENT – Voting agreements ok and are specifically enforceable.
(MBCA § 7.31(b))
7.31(b) – VOTING AGREEMENTS – Voting agreements specifically enforceable.
1.
2.
3.
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Voting Trusts
a. Actual trust which transfers legal ownership of shares to trustee
b. May contain any lawful provision consistant with trust purpose, trustee must vote shares in
accordance with the trust
Voting Agreements
a. S/H may enter into written agreements that provide for how to vote their shares
b. Specifically enforceable
S/H Agreements
a. S/H may enter into an agreement amoung themselves regarding almost any aspect of the
exercise of corp powers/management
b. Statutory requirements
i. Must be set forth un the AOI / by-laws and approved by all persons who are S/H at time
OR can be in writing and signed by all s/h at the time of agreement
c. Enforcability
i. Any party can enforce agreement
d. Termination of Effectiveness
i. When listed on NSE or the like
e. Agreement Does not Impose Personal Liability on S/H
i. Agreement doesn’t constitute a ground for imposing personal liability on any s/h for the
acts or debts of corp by other s/h.
Ringling Bros.-Barnum & Bailey Combined Shows v. Ringling
ISSUE. The issue is whether the agreement between Healey and Plaintiff to pool their votes was valid.
FACTS. Plaintiff and Haley each owned 315 out of 1000 shares of Defendant company, Ringling BrothersBarnum & Bailey Combined Shows, with the remaining 370 shares owned by another defendant, John
Ringling North. The company’s board was comprised of seven members, and if each shareholder voted
independently the most likely outcome would be for each shareholder electing two board members with
North selecting the extra member. However, in 1941 Plaintiff and Healey contracted to pool their votes,
wherein each selected two members and then used their remaining votes to select a fifth member of
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their choosing. The contract called for an arbitrator, Karl Loos, to resolve any disputes. The contract was
terminated a year later with the parties still bound by the arbitrator provision that called for Loos to help
decide how to vote. In 1946, Haley could not attend the meeting and sent her husband in her place, and
instead of following Loos’ advice he chose to move for adjournment. Plaintiff and Defendant voted their
shares, and Plaintiff brought this action to force Healey to vote according to Loos’ decision. Healey
argued that the agreement between her and Plaintiff was invalid as it took the voting power away from
the shareholders and gave it to a third party (Loos).
RULE: SHAREHOLDERS CAN AGREE TO POOL THEIR VOTES AND HAVE A THIRD PARTY
INTERCEDE WHEN THERE IS ANY DISAGREEMENT AS TO HOW TO VOTE.
HOLDING: The court held that it no other shareholder’s rights were violated and public policy was not
violated, as the result of a pooling agreement. Shareholders should be allowed to benefit as they see fit
from their voting rights, and this often means banding together to strengthen their position. However,
the court decided not to invalidate the voting and held that the members that were voted in by Healey
and North would remain.
DISSCUSSION: The court treats shareholder voting rights as a form of property rights.
Brown v. McLanahan
ISSUE: Whether it was beyond the powers vested in the trustees to amend the charter to benefit the
debenture holders at the expense of the preferred stockholders?
FACTS: Plaintiff is the holder of voting trust certificates representing 500 shares of the preferred stock of
the Company. Plaintiff brings a class actions against the voting trustees, the directors of the company, the
Company, the indenture trustee for the holder’s of the Company’s debentures, and the debenture
holders as a class (Defendants), seeking to set aside an amendment to the Company’s charter as
unlawful. The securities involved in this litigation were issued under a plan of reorganization of the United
Railways and Electric Company of Baltimore and The Maryland Electric Railways Company and Subsidiary
Companies. The securities issued were: debentures and preferred stock to holders of all first lien bonds;
and new common stock, without par value, were issued to the old common stockholders and unsecured
creditors. Voting rights were vested exclusively in the preferred and common stock holders. The common
stock holder had the exclusive right to vote for one director, while the preferred stock holders had the
exclusive right to vote for the remaining directors. Three shares of common stock entitled the holder to
one vote. The plan also provided for the establishment of a voting trust of all preferred and common
stock for a period of ten years. All the stock was issued to eight voting trustees, who were a majority of
the Company’s directors, under a voting trust agreement, which was to terminate on July 1, 1945. The
voting rights would revert to the certificate holders in proportion to the number of shares represented
upon termination. On June 21, 1944, without notice to the certificate holders, the directors amended the
Company Charter’s Voting Trust Agreement provision. The changes included the elimination of the
arrearage clause which had provided for exclusive voting rights in the preferred stock, it granted voting
rights to the holders of debentures, one vote for each $100 principal amount of debentures, which
created 221,000 new votes, and the common stockholders no longer had the exclusive right to elect one
director. Consequentially, these new amendments diluted the voting power of the stock; deprived the
voting trust certificate holders their right to control the management of the Company and the election
of its directors; while it gave the debenture holders, namely the voting trustees, the voting rights. The
District Court held in favor of the voting trustees. Plaintiff appeals.
Π ARGUMENT: Plaintiff contends the voting trustee’s action amounts to a breach of the fiduciary duty
owed to the certificate holders and seeks to (1) declare the June 21, 1944 amendment null and void; (2)
remove the voting trustees; (3) terminate the voting trust; or award damages in the alternative. Plaintiff
contends the amendment by the trustee was invalid because: (1) it was beyond the powers vested in the
trustees to diminish the certificate holder’s voting power and not return it in the same condition to the
them at the termination of the trust; (2) it was an abuse of trust to use the voting power to the advantage
of the debenture holders at the detriment of the preferred stockholders, both of whom were original
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beneficiaries of the trust; and (3) it was an abuse of trust to use the voting power for the voting trustees’
own benefit.
HOLDING: Yes. Reverse and remanded. Relief to be determined by the Dist Ct.
DISCUSSION: ALTHOUGH THE VOTING TRUSTEES HAVE THE POWER TO AMEND THE CHARTER
FOR PROPER PURPOSES, IT WAS IMPROPER TO EXERCISE THEIR POWER IN SUCH A WAY THAT
IT WOULD RESULT IN TAKING FROM THE CERTIFICATE HOLDERS THE VERY POWER WHICH
THEY CONFERRED TO THE TRUSTEES FOR THE HOLDERS BENEFIT IN THE FIRST PLACE. THE
TRUSTEE MAY NOT EXERCISE POWERS GRANTED TO THEM IN SUCH A WAY AS TO FAVOR ONE
CLASS AT THE EXPENSE OF ANOTHER CLASS.
Lehrman v. Cohen
FACTS: Giant Food Inc., (Giant), is controlled by the Lehrman and Cohen families each owning equal
voting stock designated as Class AC (held by the Cohen family) and Class AL (held by the Lehrmans). Each
class is entitled to elect two members of Giant’s four-member board of directors. A dispute arose within
the Lehrman family and to end the dispute, an arrangement was made permitting Plaintiff to acquire all
of the Class AL stock. In addition, the arrangement established, and the stockholders unanimously
ratified, a fifth directorship to resolve a dead lock which would have continued if the equal division of
voting power between the AL and AC stock were to continue. A third class of stock was created called
AD stock that had the power to elect one director but was not entitled to dividend or liquidation rights
except repayment of par value. By resolution of the board of directors, the third class of stock was issued
to Joseph B. Danzansky who elected himself as Giant’s fifth director. In 1964 the holders of AC and AD
stock voted together against the holders of AL stock to elect Danzansky president of Giant replacing
Defendant who had been president of Giant since its incorporation. Danzansky then resigned as director
and elected in his place, Millard F. West, Jr., a former AL director. Plaintiff then brought this suit.
ISSUE – 1: Whether the Class AD stock arrangement is illegal as a voting trust.
HOLDING – 1: No. The AD stock arrangement is not a voting trust because it does not separate the voting
rights of the AC or AL stock from the other attributes of ownership of those classes of stock.
ISSUE – 2: Whether the Class AD stock arrangement is sufficiently close to the substance and purpose of
Section:218 as to warrant its being subjected to the restrictions and conditions imposed by that statute.
HOLDING – 2: No. The statute only regulates trust and pooling agreements amounting to trusts, not other
arrangements possible among stockholders.
ISSUE – 3: Whether the creation of a class of stock having voting rights only and lacking any substantial
participating proprietary interest in the company violates public policy.
HOLDING – 3: No. The statute permits the creation of stock having voting rights only as well as stock
having property rights only.
ISSUE – 4: Whether the AD stock arrangement is illegal because it permits the AC and AL directors to
delegate their duties to the AD director.
HOLDING – 4: No. The AD stock arrangement is not invalid on the ground that it permits the AC and AL
directors of the company to delegate their statutory duties to the AD director.
RULE: THE TEST FOR A VOTING TRUST IS WHETHER 1) THE VOTING RIGHTS OF THE STOCK ARE
SEPARATE FROM THE OTHER ATTRIBUTES OF OWNERSHIP; 2) THE VOTING RIGHTS GRANTED
ARE INTENDED TO BE IRREVOCABLE FOR A DEFINITE PERIOD OF TIME; AND 3) THE PRINCIPAL
PURPOSE OF THE GRANT OF VOTING RIGHTS IS TO ACQUIRE VOTING CONTROL OF THE
CORPORATION.
DISCUSSION: The AD stock arrangement did not separate the voting rights of the AC or AL stock from the
other attributes of ownership. Each stockholder retained complete control over the voting of his stock.
The AD stock arrangement became a part of the capitalization of the company. It is true that the creation
of the AD stock may have diluted the voting power of the AC and AL stock but a voting trust is not
necessarily the result. Section:218 regulates trusts and pooling agreements amounting to trusts but not
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other types of arrangements possible among stockholders. The AD stock is neither a trust nor a pooling
agreement and therefore it is not controlled by the Voting Trust Statute. The creation of a class of stock
that has voting rights only does not violate public policy. First, there was no separation of the voting
rights of the AC or AL stock from the other attributes of ownership. Second, the purpose of the Voting
Trust Statute was to avoid secret uncontrolled combinations of stockholders formed to acquire voting
control of the corporation to the detriment of non-participating shareholders. The AD stock arrangement
did not violate this purpose. Thirdly, assuming the AD stock arrangement exposes a loophole in
Section:218 as it was intended to operate, it is up to the legislature to block it. The AD stock arrangement
had a proper purpose. Stockholders may protect themselves and their corporation by an otherwise
lawful plan against the fatal consequences of a dead lock in the directorate of the corporation. The
arrangement was created by the unanimous action of the stockholders of the company by amendment to
the certificate of incorporation. Therefore, assuming there is a delegation of duty, it was made by
stockholder action. BOD have fiduciary duties and here the BOD simply give the deadlock vote power
to vote, neither S/H controls HOW that power is used.
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Ling and Co. v. Trinity Sav. And Loan Ass’n
FACTS: Appellee brought suit against Bruce W. Bowman for the outstanding balance due on a promissory
note and to foreclose on a certificate for 1500 shares of Class A Common Stock in Appellant used to
secure the note. Appellant was made a party to the lawsuit because of its assertion that the transfer of
its stock was subject to conditions that had not been satisfied. In order to transfer the stock, the holder
must obtain written approval from New York Stock Exchange for the transfer and the holder must give
options to purchase the shares first to the corporation and then pro rata to the other holders of the Class
A Common Stock. Neither condition was fulfilled. The Trial Court granted summary judgment in favor of
Appellee and ordered the stock sold holding the restrictions invalid and of no effect. The Court of Appeals
affirmed.
RULE: A RESTRICTION IS NOTED CONSPICUOUSLY ON A SECURITY IF SOMETHING APPEARS ON
THE FACE OF THE CERTIFICATE TO ATTRACT THE ATTENTION OF A REASONABLE PERSON
WHEN HE LOOKS AT IT.
ISSUE – 1: Whether the content of the certificate complies with the requirements of the Texas Business
Corporations Act.
ISSUE – 2: Whether the restrictions on transferability are noted conspicuously on the security.
ISSUE – 3: Whether the restrictions on the transferability of the stock are unreasonable.
HOLDING – 1: Yes. The content of the certificate complies with the requirements of the Texas Business
Corporations Act.
HOLDING – 2: No. The restrictions on transferability are not noted conspicuously on the certificate
because the notations do not stand out.
HOLDING – 3: No. There is no proof in the record supporting the conclusion that the restrictions on the
transferability of the stock are unreasonable.
DISCUSSION: CORPORATION MAY IMPOSE RESTRICTIONS ON DISPOSITION OF ITS STOCK IF THE
RESTRICTIONS DO NOT UNREASONABLY RESTRAIN OR PROHIBIT TRANSFERABILITY. The Texas
Business Corporations Act requires that restrictions on the transfer of stock be expressly set forth in the
articles of incorporation and copied at length or in summary form on the face or if copied on the back,
referred to on the face of each certificate. Incorporation by reference on the face or back of the
certificate of the provisions of the articles of incorporation that restrict the transfer of stock is also
permissible. Here, reference is made on the face of the certificate to the reverse side. The reverse side
refers to the particular article of incorporation as requiring the holder to grant options to purchase the
shares first to the corporation and then pro rata to the other holders of the Class A Common Stock.
Therefore the certificate complies with the requirements of the Texas Business Corporations Act. The
print on the certificate that refers to the restrictions does not stand out and cannot be considered
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conspicuous. There is nothing to attract the attention of a reasonable person when he looks at it. There is
no proof in the record to support the conclusion that either of the restrictions is unreasonable. Rule 315
of the New York Stock Exchange requires approval of any sale or pledge of the stock. Further there is
nothing unusual or oppressive about the successive options to purchase and no proof given to dispel any
justification for contending that there is a reasonable corporate purpose in restricting the ownership.
3. BUY-SELL AGREEMENTS
1.
490-491
Planning for future events that will effect the life of the corp:
a. Bind s/h estates or heirs to sell back to corp shares at death  reduce disfavored parties w. corp
interests
b. STOCK REDEMPTION AGREEMENT – company will buy all stock from leaving or dead partner
c. CROSS PURCHASE AGREEMENT – each S/H agrees to personally purchase proportionate
share; corp cap remains unchanged.
d. LIFE INSURANCE TYPICALLY USED – Key employee insurance: co buys insurance on lives so
that corp will have money to buy back shares
e. TAX ISSUE – IRS closely examine a fathers agreement with children who are all s/h to make sure
shares not sold too inexpensively
4. DEADLOCK
491-511
1.
What can S/H do if there is deadlock?
a. MBCA 14.34 – Eleciton to purchase in lieu of dissolution. Derermine FMV (appraisal and what
person likely to receive from 3rd party)
IL 12.55 & 12.56 – S/H remedies for public (55) and non-public (56) corporations
2. WHEN CAN CT. INTERVENE?
A. DIR. DEADLOCKED WITH IRREPARABLE INJURY
B. S/H DEADLOCKED IN TWO CONSECUTIVE MEETINGS
C. DIR. ACTING ILLEGAL, OPPRESSIVE OR FRAUDULENT CONDUCT
D. CORP. ASSETS WASTED
3. Remedies?
a. 12 variations of remedies including provisional director, share buy-outs, remove officer/Dir.,
dissolution, etc.
MBCA 14.30 – Grounds for Judicial Dissolution
1. When can Ct. intervene?
a. Dir. deadlocked with irreparable injury (w/o timeframe)
b. Dir. acting illegal, oppressive or fraudulent conduct
c. S/H deadlock for 2 mtgs.
d. Corporate assets wasted
2. Remedies?
a. ONLY for dissolution, not other remedies!  14.32 & 14.34
i. 14.32 – receiver appointment (same as dissolution) OR appoint custodian to manage.
ii. (c) gives Ct. authority the rights/duties in mgt. business
iii. 14.34 – election to purchase in lieu of dissolution
IV. IL – CT. CAN ORDER BUY-OUT
V. MBCA – CORPORATION MAY ELECT BUY-OUT  SUIT COMES WHEN BUSINESS
IS DOING WELL AND THEY AREN’T GETTING MONEY OUT OF CORP.  THAT
S/H WANTS TO DISSOLVE AND START NEW CO. WITH HIS BUSINESS CONTACTS
vi. if majority elects to buy-out = 2 parties negotiate on price or ct. determines if can’t
agree
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Gearing v. Kelly
ISSUE: Whether justice requires the Court to order a new election.
FACTS: According to the bylaws of Radium Chemical Company, Inc., the board shall consist of four
directors, a majority of whom constitute a quorum. In 1961 the board consisted of Meacham, Kelly, Sr.
and Kelly Jr., Margaret E. Lee having resigned as the fourth director. Meacham did not attend the board
meeting held on March 6, 1961 for the sole purpose of preventing a quorum from assembling. At this
meeting, the two attending directors, Kelly, Sr. and Kelly, Jr. elected Julian Hemphill, the son-in-law of
Kelly Sr. as the fourth director. Stockholders including Meacham’s mother, Gearing, brought suit seeking
to set aside the election of Hemphill.
RULE: A VACANCY IN THE BOARD OF DIRECTORS MAY BE FILLED BY A MAJORITY VOTE EVEN
THOUGH LESS THAN A QUORUM IS PRESENT.
HOLDING: No. Appellants have failed to show that justice requires a new election in that they may not
now complain of an irregularity that they themselves have caused.
DISSENT: Two members of the board are insufficient to constitute a quorum according to the bylaws of
the company. Therefore, the election of Hemphill is void and must be set aside. This is a contest for
control and the Court should not assist either side. If the parties are deadlocked and choose to remain so,
they have other remedies and the court should not help one side by disregarding a bylaw that follows the
statute, particularly when it results in giving the Kellys complete control.
DISCUSSION: Meacham did not attend the meeting with the purpose of preventing a quorum from
assembling and with the intent to paralyze the board. The relief sought by appellants would be of no avail
to them for Meacham would then be required as evidence of her good faith to attend. Such a futile act
will not be ordered.
In Re Radom & Neidorff, Inc.
ISSUE: Whether dissolution will be beneficial to the stockholders and not injurious to the public.
FACTS: Radom & Neidorff, Inc. is a domestic corporation with two stockholders each holding eighty
shares. The two original stockholders were Henry Neidorff and Petitioner. When Henry Neidorff died, he
left his shares to Respondent, his wife, who also happens to be Petitioner’s sister. Petitioner brought this
proceeding requesting the corporation be dissolved. His complaint alleges that Respondent has refused
to cooperate with him as president and has refused to sign his salary checks. Further unresolved
disagreements have resulted in an inability of the stockholders to elect any directors. Respondent denies
any interference in Petitioner’s conduct of the business and states that she has signed all corporate
checks sent to her by him except those for his own salary. She declined to sign these because of a
stockholder’s derivative suit brought by her against Petitioner still pending, charging him with enriching
himself at the corporation’s expense. She alleges that Petitioner offered to purchase her stock for
$75,000. When she refused he threatened he would have the corporation dissolved and then buy it at a
low price or start a competing business if she were to purchase it. The corporation itself is solvent. The
profits average about $71,000 per year. There is about $300,000 on deposit in the bank. However,
dividends have not been declared nor distributed. Debts have not been paid.
RULE: AN ORDER FOR DISSOLUTION IS GRANTED ONLY WHEN THE COMPETING INTERESTS ARE
SO DISCORDANT AS TO PREVENT EFFICIENT MANAGEMENT AND THE OBJECT OF IS
CORPORATE EXISTENCE CANNOT BE ATTAINED. THE PRIMARY INQUIRY IS AS TO NECESSITY
FOR DISSOLUTION, THAT IS, WHETHER JUDICIALLY IMPOSED DEATH WILL BE BENEFICIAL TO
THE STOCKHOLDERS OR MEMBERS AND NOT INJURIOUS TO THE PUBLIC. THERE IS NO
ABSOLUTE RIGHT TO DISSOLUTION.
HOLDING: No. Dissolution will not be beneficial to the stockholders and will be injurious to the public.
DISSENT: Here the stockholders are deadlocked with regard to the election of a board of directors. If the
court has discretion to grant the order for dissolution then there is no ground for withholding it here, for
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there is no alternative corrective remedy. Petitioner could continue to remain as president and manager
without compensation or he could quit, which would not bode well for the corporation. It is difficult to
believe that the legislature could have intended to put someone in this position to such a choice. Further,
the deadlock is between the stockholders, not the directors. When the stockholders are deadlocked,
Section 103 calls for dissolution, not arbitration. Section 103 finds no relevance in the profits and losses
of the business but only in whether or not the stockholders are deadlocked.
DISCUSSION: The corporation has been and continues to be successful. Despite the feuding, there is no
deadlock as to corporate policies. Respondent has offered to have the third director named by the
American Arbitration Association, any Bar Association or any recognized and respected public body.
Dissolution is not necessary for the corporation or for either stockholder. The failure of Petitioner to
receive his salary did not frustrate the corporate business and is remediable by means other than
dissolution. This is not a case where dissolution is necessary.
Davis v. Sheerin
FACTS: In May of 1985, Appellee brought suit as an individual, and as a shareholder on behalf of the
corporation against Appellants based on allegations of Appellants’ oppressive conduct toward Appellee
as a minority shareholder and their breaches of fiduciary duties owed to Appellee and the corporation.
The corporation was incorporated by William, a 55 percent stockholder, and Appellee, in 1955. Appellee
and Appellants served as directors and officers of the corporation, with William serving as president.
Appellee was not employed by the corporation. In 1985, Appellants denied Appellee’s right to inspect
the corporate books, unless Appellee produced his stock certificate. Appellants claimed Appellee gifted
his 45 percent interest in the corporation to them in the late 1960’s. The trial court found that there was
a conspiracy to deprive Appellee of his stock and that Appellants acted oppressively against Appellee. It
ordered a “buy out” of Appellee’s 45 percent stock share for $550,000.
∆ ARGUMENTS: (1) Texas law does not allow a “buy out” as a remedy, and (2) even if such a remedy was
available, the trial court’s finding of “oppressive conduct” does not warrant application of a buy out.
RULE: A COURT, IN EQUITY, MAY ORDER A BUY OUT OF STOCK IF OPPRESSIVE CONDUCT IS
FOUND.
ISSUE: (1) Whether Texas law permits a “buy out” as a remedy? (2) If so, whether “oppressive conduct”
warrants the application of a buy out? (3) If so, whether oppressive conduct exists in this instant case?
HOLDING: (1) The trial court’s holding is affirmed. Yes, a buy out is a permitted remedy under the court’s
equity power. (2) Yes, oppressive conduct warrants the application of a buy out. (3) Yes, oppressive
conducts exists in this case to warrant a buy out.
DISCUSSION: Although the Texas Business Corporation Act (Act) does not expressly provide for a buy out,
Texas courts, under their general equity power, may decree a “buy out” in cases where less harsh
remedies are inadequate to protect the rights of the parties. Although the Act does not explicitly provide
for a buy out, it does recognize a cause of action for oppressive conduct. Furthermore, other jurisdictions
have recognized a buy out as an available remedy for oppressive conduct. Although the typical oppressive
“squeeze out” techniques used in closely held corporations do not exist here, the court finds that
Appellants’ actions to deprive Appellee of his interest in the corporation, breach of their fiduciary duties,
and attempt to silence Appellee’s voice in the corporation are considered oppressive
Abreu v. Unica Indus. Sales, Inc.
FACTS: Plaintiff is the president and 50% shareholder of Ebro Foods. Defendant Directors are the only
directors of Defendant La Preferida, Inc., the other 50% shareholder in Ebro Foods and a company that
distributes Ebro Food’s products. Plaintiff brings a derivative suit against Defendant Directors for
breaching their fiduciary obligations to Ebro Foods. Plaintiff alleges that Defendant Directors attempted
to procure trade secrets so that products utilizing them could be produced without going through Ebro
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Foods. The trial court held that Defendant Directors engaged in self dealing transactions and usurped the
corporate opportunity. It awarded Plaintiff injunctive and monetary relief, attorney fees, and appointed
Silvio Vega, plaintiff’s son-in-law, as a provisional director to oversee the new board of directors and
break any director deadlock. Defendants appeal.
RULE: THE TRIAL COURT HAS THE DISCRETION TO APPOINT A PROVISIONAL DIRECTOR THAT
WILL SERVE THE BEST INTEREST OF THE CORPORATION, TO OVERSEE SUCH AN
APPOINTMENT, TO AWARD ATTORNEY FEES IF A PARTY ACTS IN BAD FAITH DURING
LITIGATION, TO ISSUE A NARROWLY TAILORED INJUNCTION TO PROTECT THE
CORPORATION’S INTEREST AND TO AWARD APPROPRIATE DAMAGES.
ISSUES: (1)- Whether section 12.55(b) of the Illinois Business Corporation Act (IBCA) implicitly requires
the appointment of an impartial director and if so, did Vega’s appointment violate this section? (2)Assuming the appointment was appropriate, whether the trial court erred in refusing to remove Vega for
allegedly failing to carry out the trial court’s instructions and follow statutory guidelines? (3)- Whether
the trial court properly awarded attorney fees to Plaintiff separate from the damages award? (4)Whether the trial court’s injunction protecting the company’s product formulas is too broad? (5)Whether the trial court used the correct standard to award damages?
HOLDING: (1)- No. There is no strict impartiality requirement under section 12.55(b). The trial court need
only consider the corporation’s best interest. Vega’s appointment as provisional director was in the
corporation’s best interest because his experience, knowledge and involvement in the company made
him the best candidate. Furthermore, the appointment did not oppress Defendant Director’s rights to
vote, manage or participate in Ebro Food’s affairs. (2)- No. The trial court did not err in finding Vega’s
oversights insufficient to warrant removal. However, the trial court erred when it upheld Vega’s unilateral
appointment of a new auditor for Ebro and the board of director’s decision to approve attorney fees
because these actions are inconsistent with the duties of a provisional director. (3)- No. The award of
attorney fees to plaintiff were improper because the trial court did not find that Defendants acted
“arbitrarily, vexatiously or not in good faith” during litigation as required under section 12.55(h) of IBCA.
(4)- Yes. Although the injunction itself is proper, the language of the injunction is overbroad because it
can be interpreted to preclude any person from legally reverse engineering the product using publicly
disseminated information. Thus, the court remands this issue back to the trial court to delete the
following language from the injunction: “or from disseminating any data from which the formula may be
ascertained.” (5)- Yes. Because the parties failed to raise an objection to the “gross profit standard” used
by the trial court, the parties cannot now assert a new “net profit” standard to determine damages.
DISCUSSION: In a derivative suit, the trial court will consider the interests of the corporation first and
foremost to formulate its decisions regarding issues such as appointing a provisional director, issuing an
injunction and awarding damages. FACTORS that a trial court may balance in EVALUATING candidates
for PROVISIONAL DIRECTOR INCLUDE: DEGREE AND QUALITY OF PAST INVOLVEMENT IN THE
CORPORATION; AN UNDERSTANDING OF THE CORPORATION'S HISTORY AND CURRENT
SITUATION; EXPERIENCE AND ABILITIES IN PROVIDING A COOPERATIVE AND UNIFYING
ELEMENT; NEED FOR IMMEDIATE APPOINTMENT; DEGREE OF IMPARTIALITY; AND ABOVE
ALL, A TRUE INTEREST IN THE VIABILITY AND ADVANCEMENT OF THE CORPORATION AS AN
ENTITY AND NOT ALLEGIANCE TO ONE OF THE DEADLOCKED FACTIONS.
5. SALE OF CONTROLLING SHARES
1.
Controlling S/H is free to sell and purchaser free to buy- absent:
a. fraud,
b. bad faith,
c. looting,
d. conversion of corp assets
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DeBaun v. First Western Bank and Trust Co.
FACTS: Corporation was incorporated by Alfred S. Johnson in 1955 to process color photographs to be
reproduced in printed form. The 100 shares in Corporation were owed as follows: Johnson owned 70
shares; Respondent, James DeBaun, Corporation’s primary salesman, owned 20 shares; and Respondent,
Walter Stephens, its production manager, owned 10 shares. After Johnson’s death on January 15, 1965,
Bank became the trustee of Johnson’s trust, which included the 70 shares of Corporation. Respondents
retained managerial control. On October 27, 1996, Bank decided to sell its 70 shares in Corporation
without notifying DeBaun and Stephens. When Respondents found out, they refused to sell their interest
in Corporation. DeBaun submitted an offer for Bank’s 70 shares, but Bank rejected the offer as
inadequate. On May 15 and 20, 1968, Mattison, acting in the name of S.O.F. Fund, made an offer that
Bank rejected. Expecting a third offer to be made, Bank ordered a Dun & Bradstreet report on Mattison
and the fund. On May 24, 1968, the report indicated that Mattison had pending litigations,
bankruptcies, tax liens, and suggested S.O.F. Fund no longer existed. On May 27, 1968, Mattison made a
third offer. Bank counter-offered. The terms are as follows: the S.O.F. Fund would pay $250,000 for the
shares, $50,000 in marketable securities as a down payment with the balance payable over five-years,
Corporation would pay no dividends out of pre-sale retailed earnings. On June 4, 1968, McCarrol,
Mattison’s lawyer, proposed that Corporation use its assets to secure the $200,000 unpaid balance of the
purchase price rather than Mattison supplying the security in the form of marketable securities and
suggested the elimination of the restriction against dividends from pre-sale retained earnings. On June
27, Bank met with Mattison and McCarrol, so that Mattison could explain the poor Dun report. Bank also
requested a written report on the status of Mattison’s pending litigations. McCarrol suggested Bank look
into the public records for this information. However, Bank did not pursue its investigation into the
public record of Los Angeles County because a superior at Bank knew McCarrol as a former trust officer
of Bank’s predecessor in interest and because McCarrol received a warm welcome at the Jonathan
Club. As of July 1, 1968, the Los Angeles county public records had on record 38 unsatisfied judgments
against Mattison totaling $330,886.27, 54, pending actions claiming $373,588.67, 22 recorded abstracts
of judgments against Mattison totaling $285,704.11, and 18 tax liens aggregating $20,327.97. Bank
accepted the McCarrol modification despite the fact that it knew or should have known that Corporation
could not meet the $200,000 balance as scheduled in the McCarrol proposal and that Mattison could
make those payments only by resorting to distribution of pre-sale retained earnings and assets of
Corporation. A new board of directors was elected, in which Mattison had control and DeBaun and
Stephens remained as directors. Bank informed Respondents that a security agreement was in place to
protect Corporation in the event of Mattison’s death or default and that in such an event, Bank would
foreclose on the stock. Bank did not tell them that the corporate assets were security for Mattison’s debt
to Bank. Relying on these misrepresentations, they voted to approve the security agreement. At the time
of Bank’s sale to Mattison, Corporation was doing well. Mattison, however, immediately implemented a
scheme to loot Corporation’s assets. He diverted $73,144 in corporate cash to himself and MICO, a shell
company owned by him; he had Corporation assign to MICO all of Corporation’s asset in exchange for a
fictitious agreement for management services; he diverted Corporation’s mail to a post office box in his
control in order to extract all Corporate’s checks; he ceased paying trade creditors promptly or at all; he
delayed shipments on new orders; he removed the corporate books and records; he collected
employee payments on insurance premiums for a cancelled voluntary employee insurance plan; he
issued payroll checks without sufficient funds; and did not supply Bank with the required financial
reports. In September 1968, DeBaun left Corporation and in December 1968, Stephens left Corporation.
Bank was aware of Mattison’s misconduct, but took no action until April 25, 1969, when it filed an action
in the superior court seeking the appointment of a receiver. On June 20, 1969, Bank shut down
Corporation’s operations when Corporation was completely insolvent. Bank sold Corporation on July 10,
1969 for $60,000, paid $25,000 to release the federal tax lien on Corporation, and retained $25,000.
Corporation still owed $218,426 to creditors. Respondents filed a claim for damages and a stockholders
derivative suit against Bank. Bank demurred to both complaints, contending that Respondents, as
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shareholders, lacked capacity to pursue the first claim, and Bank was not liable for Corporation in the
derivative action. The trial court sustained the first demurrer without leave to amend, and overruled
second demurrer. The trial court held for Respondents, finding that Bank breached duties it owed as a
majority controlling shareholder to Corporation and awarding $473,836 in monetary damages, attorneys’
fees, and denied punitive damages. Bank appealed.
RULE: A CONTROLLING MAJORITY SHAREHOLDER MUST EXERCISE GOOD FAITH AND FAIRNESS
IN SELLING ITS CONTROLLING SHARES IN A COMPANY, WHICH INCLUDES THE DUTY TO
REASONABLY INVESTIGATE WHETHER A POTENTIAL BUYER IS A LOOTER.
ISSUE: (1) Whether Bank as the controlling majority shareholder had a duty to the Corporation and
minority shareholders to act as a reasonably prudent person in selling its controlling shares? (2) If so, did
Bank breach its duty? (3) If Bank breached its duty, whether the trial court properly awarded damages?
HOLDING: Affirmed. Remanded to determine additional amount payable to Respondents for Counsel fees
due as a result of the appeal. (1) Yes. Bank owed a duty to Corporation and its minority shareholders to
act as a reasonably prudent person with respect to its sale of its controlling shares of stock to ensure that
a potential buyer is in the best interests of the corporation, i.e., not a looter. (2) Yes. Bank breached its
duty because it failed to act as a reasonably prudent person when it failed to act reasonably in selling its
controlling shares to Mattison because it failed to investigate Mattison. (3) Yes. The trial court properly
determined total damage to Corporation as the sum “necessary to restore the negative net worth, plus
the value of its tangible assets, plus its going business value determined with reference to its future
profits reasonably estimated.”
DISCUSSION: Bank became directly aware of facts that would alert a prudent person that Mattison was
likely to loot the corporation. Such factors included: Bank knew from the Dun & Bradstreet report of
Mattison’s poor financial history; it knew of Mattison’s past fraudulent conduct; and it knew that
Mattison’s only method of paying for Corporation’s shares was in Corporation’s assets. Consequently,
Bank had a duty to Corporation and its minority shareholders to act as a reasonably prudent person to
further investigate Mattison.
Perlman v. Feldmann
ISSUE: whether Plaintiffs are entitled to a share of the premium paid by Wilport attributed to the sale of
corporate power.
FACTS: Plaintiffs and Defendants were shareholders in Newport Steel. Newport Steel provided steel
sheets typically to regional customers because their facilities were outdated. Due to the Korean War,
steel was at a premium and it turned Newport Steel into a more profitable venture. Newport began
updating their facilities, but a third party, Wilport Company, bought Defendants’ shares in an effort to
secure more steel output. The over-the-counter price for the shares was $12 and the book value was
$17.03, but Wilport paid $20 per share to Defendants. Plaintiffs sued to receive the same premium
(attributable to the sale of corporate power) for their shares, and the trial court denied their claims. The
trial court ruled that the premium was an inherent benefit of having a controlling ownership, and
alternatively, the burden was on Plaintiffs to prove the lesser value of the stock.
RULE: A MAJORITY SHAREHOLDER, PARTICULARLY WHEN THEY ALSO ARE THE PRESIDENT AND
CHAIRMAN OF THE BOARD, WHO SELLS HIS SHARES TO A THIRD PARTY WHO THEN OBTAINS
A CONTROLLING INTEREST, OWES THE MINORITY SHAREHOLDER THEIR SHARE OF THE
PREMIUM PAID BY THE THIRD PARTY FOR THE CONTROLLING INTEREST.
HOLDING: Plaintiffs are entitled to a share of the premium paid to Defendant shareholders. Feldmann
was the president and dominant shareholder, and in both positions he owes a fiduciary duty to
minority shareholders not to let a personal interest override the interests of all the shareholders. The
burden is on the shareholder to prove that this is not the case. The court is not holding that the dominant
shareholder is not able to sell his shares, but in this case Feldmann did not meet his duty in the sale of his
shares. The court noted that there only had to be a possibility that Defendants misappropriated a
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corporate opportunity and not an absolute certainty. The facts demonstrate that there was a shortage of
steel and Defendants took advantage of this to obtain a market premium for their shares.
DISSENT: The dissent does not argue that Feldmann owed Plaintiffs a fiduciary duty, but he argues that
Feldmann did not violate any duty here. As a majority shareholder, Feldmann is entitled to sell his shares
for the best price he can receive. There was no evidence that Wilport was going to abuse their control or
not act in the best interests of the other shareholders.
DISCUSSION: The dissent takes the position provided in Zetlin v. Hanson Holdings, Inc. which allows for a
majority shareholder to get the best price for their shares without having to account for any premium to
the minority shareholders.
III. PUBLICLY HELD CORPORATIONS
1.
2.
3.
4.
538-588
Social Responsibiliy
a. Corp as private property = can do what we want; make S/H as much money as possible.
b. Corp as tool for social change = what morally should corp do; creation of govt  adv society
i. Saftey
ii. Natural resources
c. IL 8.85 – Corp my consider social implications wit the purpose to prevent takeovers
Shareholders
a. Generally
i. Seperation of ownership and control
ii. S/H sell stock v. advocating for corp change
iii. Poor performance in stock normally = bad corp management
iv. Corps use proxy to control
b. Institutional Investory
i. Institutional Investor – large investor that control > 50% stock of the top 1000
companies.
1. Large ownership in shares allows “control” of stock
a. E.g. large sale  stock price drop
O/D
a. Most BOD have no hands on action in Corp
b. Have ability to hire/fire CEO who manages day to day
c. Majority of most BOD are independent directors.
Corp Governance in 2007
a. Biz failures and corp scandal
i. Collapse of dot.coms
ii. Collapse of telecoms
iii. Collapse of Enron
iv. Collapse of Aurther Anderson
v. Collapse of World Com
vi. Crisis at Adelphia
vii. Crisis at Quest
viii. Crisis at Global Crossing
ix. Crisis at Tyco
b. Response to substantial miscouduct
i. Collapse of dow jones
ii. Loss of investor confidence
iii. Increase in ethical corp reqs
c. Sarbanes-Oxley Act
i. General
1. Most sig reform in securities law
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2.
3.
d.
Purpose to restore confidence
Fundamental change in how Audit Committees, management and auditors
carry out resp and interact
4. Passed w/ remarkable speed
5. Specific in some areas; general framework in others req additional regulations
6. Increased liability risks
ii. Key Provisions
1. CEO must certifiy quarterly and annual reports
a. Penality for falsified report = 10-20 years in prison
2. Management must asses internal controls annually
iii. Defining Required Disclosure Controls
1. Reqs that corp maintain procedures for gathering, analyzing, and disclosing all
developments and risks info in timely matter (BOTH financial and non-financial)
iv. Audit Committee
1. Directly responsible for appointment, compensation and oversight of external
audit firm
2. Ability to engage independent counsel
3. Procedure for employee wistleblowing
4. At least 1 member financial expert
v. Summary Observations
1. Strengthens Audit Committee
2. Reinforces management responsibility for financial info
3. Elevates audit importance
4. Raises transparency
5. Strengthens oversight on accountants
Atty Conduct Under Sarbanes-Oxley
I. DUTY TO REPORT UP THE LADDER WHEN BECOMES AWARE OF EV THAT
MATERIAL VIOLATION OF FED/STATE LAW OCCURRED, IS OCCURRING, OR IS
ABOUT TO OCCUR
II. APPLIES TO ANY ATTORNEY WHO IS APPEARING AND PRACTICING BEFORE SEC
IN THE REPRESENTATION OF AN ISSURER
1. Atty
a. Admitted to bar
b. Internal and external atty included
c. Atty need not be in legal dept, but must be providing legal svcs
2. Appearing and practicing
a. Tranacting biz with SEC, including communications
b. Represent company in SEC proceedings or in investigation
c. Provides advice about security laws and SEC regs
d. EXCEPTION
i. Atty who conducts activity in context other than legal services
ii. Non appearing foreign atty
3. In representation of an issuer
a. Providing legal advise whether employed or retained by co
b. Issure – class of securities registered with SEC
iii. What triggers obligation to report?
1. Becomes aware of ev. Of a material violation by public corp by any O/D,
employees, or agents.
2. Ev. Material Violation
a. Crediable ev that prudent and competent atty concludes reasonably
likely that material violation occurring, occurred, about to occur
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b.
Material violation – violation of state/fed law or breach of fudiciary
duty
iv. How does atty satisfy report obligation?
1. Report to
a. Corp chief legal officer
b. Corp chief legal officer and CEO
c. A qualified legal compliance committee (QLCC)
2. If futile to go to CLO and CEO then up ladder to audit committee
3. If appropriate response from CLO in reasonable time, obligation ends
4. If ≠ appropriate response from CLO then to audit committee.
v. CLO obligations?
1. Begin inquiry that he/she believes appropriate to determine if violation
2. If determination of no violation, advise reporting atty
3. If determine of violation, responsible steps to cause corp to adopt appropriate
response, advise reporting atty
4. Alt, CLO may report to (QLCC), advise reporting atty of transfer to QLCC, CLO
relieved of other obligations
vi. QLCC – allowed, but not required
1. 1 member of audit & 2 independent counsel
2. Written procedures
3. Has powersgranted by BOD to enforce
4. Has power and authority to take action with majority vote
IV. DUTY OF CARE AND BUSINESS JUDGMENT RULE
659-744
(IL § 2.10(b)3, 7.80(b), 8.65(b))
2.10(b)(3) – ARTICLES OF INCORP – AOI may set forth limits on personal liability of O/D to corp or s/h for $
damages for breach of difuciary duty. UNLESS (1) breach of duty of loyalty to corp or s/h, (2) acts/ommisions ≠ in
good faith involving miscouncut of violaiont of law, (3) section 8.65 – liability of directors in certain cases, (4)
imporper personal benifit
7.80(b) – PROVISIONS RELATING TO ACTIONS OF SHAREHOLDERS – complaint brought by right of corp must be
plead with paticularity.
8.65 (b) – LIABILITY OF DIRECTORS IN CERTIAN CASES – Attendance at meeting is taken as conclusive proof of
assent UNLESS disent entered in meeting minutes or written dissent filed with secretary before meeting ends of
iommediatly after.
(MBCA §§ 8.24(d), 8.30, 8.31)
8.24(d) – QUORUM AND VOTING – director deemed to assent to actions at meeting UNLESS (1) objects at begining
of meeting to transacting biz at the meeting ; (2) Dissent or Abstenation from action in meeting minutes ; (3)
delivers written notice of dissent to presiding officer during or immediatly after adjournment.
8.30 – STANDARS OF CONDUCT FOR DIRECTORS – Directors must (1) act in good faith ; (2) reasonably actions in
best interest of corp. Additionally, make informed decisions, reasonably rely on preformance of someone
delegated authority,. Entitled to rely on (1) one or more officers that D reasonably believes competent, (2) legal
counsel, public accounts, and the like ; (3) committee of BOD when D not member of the committee.
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8.31 – STANDARDS OF LIABILITY FOR DIRECTORS – O/D not liabal unless π proves (1) AOI does not preclude
liability, (2) challngend conduct was result of (a) bad faith action ; (b) director was not reasonably informed ; (c)
director did not reasonably believe in best intrests of corp ; (d) lack of objectievet because of relationship ; (e)
sustained failure of oversight when reasonable D would ; (f) improper financial benifit.
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Litwin v. Allen
ISSUES: 1- Whether the directors breached a duty of care with respect to the Missouri Pacific Bond
Transaction. 2- Whether the directors should be liable for the total loss suffered when the bonds were
ultimately sold at an 81% loss. 3- Whether all of the directors shall be liable for the breach of the duty of
care.
FACTS : This is a stockholders derivative suit against the directors of Guaranty Trust Company, (Trust), its
subsidiary Guaranty Company of New York, (Guaranty), and J.P. Morgan & Co., (J.P.). The complaint
alleges the directors breached their duty of care when they entered into the Missouri Pacific Bond
Transaction. Alleghany Corporation, (Alleghany), had purchased certain properties the balance on which
was $10,500,000 due on October 16. Alleghany needed money to make the payment but because of
certain borrowing limitations in its charter, could not borrow the money. To overcome this limitation and
to enable Alleghany to complete the purchase, Alleghany was to sell some of the securities it held.
Alleghany held debentures, which were unsecured and subordinate to other Missouri Pacific bond issues.
J.P. purchased $10 million of these bonds at par giving an option to Alleghany to buy them back within
six months for the price paid. Trust committed to participate in the bond purchase and Guaranty
committed itself to Trust to take up the bonds if Alleghany failed to exercise its option to repurchase. In
October of 1929, the stock market crashed.
RULE : DIRECTORS OF A CORPORATION HAVE A DUTY TO ACT WITH HONESTY DILIGENCE AND
PRUDENCE. A DIRECTOR IS NOT LIABLE FOR LOSS OR DAMAGE OTHER THAN WHAT WAS
PROXIMATELY CAUSED BY HIS OWN ACTS OR OMISSIONS IN BREACH OF HIS DUTY.
HOLDINGS : 1- The directors plainly failed to bestow the care which the situation demanded because the
entire arrangement was so improvident, risky unusual and unnecessary as to be contrary to the
fundamental conceptions of prudent banking practice. 2- No. The directors should only be liable for the
portion of the loss which accrued within the six month option period. 3- No. All the directors who were
present and voted at the relevant meetings are liable.
DISCUSSION : It is against public policy for a bank to for a bank to purchase securities and give the seller
the option to buy them back at the same price thereby incurring the entire risk of loss with no
possibility of gain other than the interest derived from the securities in the interim. Any benefit of a rise
in price is assured to the seller and any risk of heavy loss s inevitably assumed by the bank. A director is
not liable for loss or damage other than what was proximately caused by his own acts or omissions in
breach of his duty. Once the option had expired, there was nothing to prevent the directors of the
Company that had taken over the bonds in accordance with its agreement from selling them. Any loss
that incurred after the option had expired was a result of the directors’ independent business judgment
in holding them. The further loss should not be laid at the door of the improper but expired repurchase
option. The ratification by the directors is equivalent to prior acquiescence and should result in liability.
The ratification prevented a possible later rescission on the ground that the directors did not authorize it.
Shlensky v. Wrigley
ISSUE : whether the court should overrule decisions made by Defendant absent a showing of fraud,
illegality or a conflict of interest.
FACTS : ∆ is the director of the Chicago National League Ball Club, which is the company that owns the
Chicago Cubs. Although every other major league team had installed lights, Defendant did not install
them for the Cubs because he was concerned that night baseball would be detrimental to the
surrounding neighborhood. Plaintiff argued that the team was losing money, and that the other Chicago
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team, the White Sox, had higher attendance during the weekdays because they played at night.
Therefore, reasoned Plaintiff, the Cubs would draw more people with weekday night games. Plaintiff
asserts that Defendant’s first concern should be with the shareholders rather than the neighborhood.
RULE : A COURT WILL NOT INTERFERE WITH AN HONEST BUSINESS JUDGMENT ABSENT A
SHOWING OF FRAUD, ILLEGALITY OR CONFLICT OF INTEREST.
HOLDING : The court will not overturn Defendant’s decision to not install lights at the ballpark. The court
cited some reasons why the light installation could be detrimental, such as lowering the property value of
the park itself, a lack of proof on behalf of Plaintiff that financing would be available for lights and would
be certain to be offset by increasing revenues. The court cites precedent that asserts that business
decisions should not be disturbed just because a defendant can make a reasonable case that the policy
chosen by the company may not be the wisest policy available.
DISCUSSION : The court notes that they were not necessarily agreeing with Wrigley’s position in refusing
to install lights, but that there was some reasons for doing so. The court stated that there was no
requirement to show all three factors of illegality, fraud or a conflict of interest, but there was not
evidence of any of the above in this case.
Smith v. Van Gorkom (IMPT CASE, KNOW BY NAME)
ISSUE : whether the business judgment by the Board to approve the merger was an informed decision.
FACTS : Trans Union had large investment tax credits (ITCs) coupled with accelerated depreciation
deductions with no offsetting taxable income. Their short term solution was to acquire companies that
would offset the ITCs, but the Chief Financial Officer, Donald Romans, suggested that Trans Union should
undergo a leveraged buyout to an entity that could offset the ITCs. The suggestion came without any
substantial research, but Romans thought that a $50-60 share price (on stock currently valued at a high of
$39 ½) would be acceptable. Van Gorkom did not demonstrate any interest in the suggestion, but shortly
thereafter pursued the idea with a takeover specialist, Jay Pritzker. With only Romans’ unresearched
numbers at his disposal, Van Gorkom set up an agreement with Pritzker to sell Pritzker Trans Union
shares at $55 per share. Van Gorkom also agreed to sell Pritzker one million shares of Trans Union at $39
per share if Pritzker was outbid. Van Gorkom also agreed not to solicit other bids and agreed not to
provide proprietary information to other bidders. Van Gorkom only included a couple people in the
negotiations with Pritzker, and most of the senior management and the Board of Directors found out
about the deal on the day they had to vote to approve the deal. Van Gorkom did not distribute any
information at the voting, so the Board had only the word of Van Gorkom, the word of the President of
Trans Union (who was privy to the earlier discussions with Pritzker), advice from an attorney who
suggested that the Board might be sued if they voted against the merger, and vague advice from Romans
who told them that the $55 was in the beginning end of the range he calculated. Van Gorkom did not
disclose how he came to the $55 amount. On this advice, the Board approved the merger, and it was also
later approved by shareholders.
RULE : UNDER THE BUSINESS JUDGMENT RULE, A BUSINESS JUDGMENT IS PRESUMED TO BE
AN INFORMED JUDGMENT, BUT THE JUDGMENT WILL NOT BE SHIELDED UNDER THE RULE IF
THE DECISION WAS UNADVISED.
HOLDING : THE DELAWARE SUPREME COURT HELD THE BUSINESS JUDGMENT TO BE GROSS
NEGLIGENCE, WHICH IS THE STANDARD FOR DETERMINING WHETHER THE JUDGMENT WAS
INFORMED. The Board has a duty to give an informed decision on an important decision such as a
merger and can not escape the responsibility by claiming that the shareholders also approved the
merger. The directors are protected if they relied in good faith on reports submitted by officers, but there
was no report that would qualify as a report under the statute. The directors can not rely upon the share
price as it contrasted with the market value. And because the Board did not disclose a lack of valuation
information to the shareholders, the Board breached their fiduciary duty to disclose all germane facts.
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2.
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DISSENT : The dissent believed that the majority mischaracterized the ability of the directors to act
soundly on the information provided at the meeting wherein the merger vote took place. The credentials
of the directors demonstrated that they gave an intelligent business judgment that should be shielded by
the business judgment rule.
DISCUSSION : The court noted that a director’s duty to exercise an informed business judgment is a duty
of care rather than a duty of loyalty. Therefore, the motive of the director can be irrelevant, so there is no
need to prove fraud, conflict of interests or dishonesty.
Directors must act with the care that an ordinary prudent person would reasonably expect to exercise in
like position.
Deleware = lax standard for BJR – Gross Negligence
a. reasonably informed
b. acts in good faith
In re Caremark International Inc. Derivative Litigation
ISSUE : whether the Board exercised an appropriate level of attention to the possibility of ARPL violations
FACTS : Defendant corporation, Caremark International, Inc., provides health care services and products
to patients who are often referred to them by a physician. Since the business is reliant on referrals, there
is a temptation by companies such as Caremark to compensate physicians. A federal law, the AntiReferral Payments Law (”ARPL”) is in place to prevent such a system, and in 1991 the Department of
Health and Human Services began investigating potential ARPL violations. The Department of Justice
joined the investigation soon thereafter, and by 1992 Caremark instituted several new policies and
procedures in attempt to find any internal wrongdoings. But in 1994, Caremark was indicted for violating
the ARPL. Plaintiffs initiated this suit that year, alleging that the Board of Directors did not exercise the
appropriate attention to this problem.
RULE : DIRECTORS ARE POTENTIALLY LIABLE FOR A BREACH OF DUTY TO EXERCISE
APPROPRIATE ATTENTION IF THEY KNEW OR SHOULD HAVE KNOWN THAT EMPLOYEES WERE
VIOLATING THE LAW, DECLINED TO MAKE A GOOD FAITH EFFORT TO PREVENT THE
VIOLATION, AND THE LACK OF ACTION WAS THE PROXIMATE CAUSE OF DAMAGES.
HOLDING : There was no evidence that the directors knew that there were ARPL violations, and there was
no systemic or sustained failure to exercise oversight. However, the terms of the settlement merely
required Caremark to institute policies to further assist in monitoring for violations. Therefore the
settlement was approved.
DISCUSSION : A breach of duty to exercise appropriate attention, as the court notes, is more difficult for
Plaintiffs to prove than a breach of the duty of loyalty. Most decisions that would come under this duty
will resemble many decisions shielded by the business judgment rule.
Stone v. Ritter
ISSUE : whether π s/h demand was excused under law because ∆ directors breached their oversite duty
and, as a result, faced a substantial likelihood of liability as a result of their « utter failure » to act in good
faith to put into place policied and procedures to ensure compliance with the Bank Secrecy Actm and
anti-money laundering regulations.
FACTS : S/H brought derivative action against ∆. S/H sought to recover sum of $50 million that the corp
had paid in fines and penalities to the fed govt to settle criminal and civil charges that the corp and its
wholly owned subsidiary (bank) had failed to file a report required by the Bank Secerecy Act. S/H filled
the derivative complaint without first making a pre-suid demand on the corp’s BOD. Court of Chancery
dismissed complaint because π did not plead that demand would have been futile.
RULE : 1) the standard articulated in Caremark was the appropriate standard for director duties with
respect to corporate compliance issues. 2) There is no duty of good faith that formed a basis, independnt
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of the duties of care and loyalty, for director liability. The result in Stone for director liability was whether
there was a sustained or systamatic failure of the BOD to exercise oversight.
HOLDING : Court of Chancery properly applied Caremark and DISMISSED THE SHAREHOLDERS’
DERIVATIVE COMPLAINT FOR FAILURE TO EXCUSE DEMAND BY ALLEGING PARTICULARIZED
FACTS that created reason to doubt whether the directors had accted in good faith in exercizing their
oversight responsibilities. Directors are not responsible for ensuring the legality of every act bu the corp’s
personnel, even if the illegal conduct disclosed a failure of the corp compliance program.
DISCUSSION : Because a showing of bad faith conduct was essential to establishing director oversight
liability, the fudicuary duty violated by that conduct was the duty of loyalty. Where directors failed to act
in the fact of a known duty to act, thereby demonstrating a conscious disregard for their responsibilities,
they breached their duty of loyalty by failing to discharge their fudiciary obligation to act in good faith.
The obligation to act in good faith did not estabiligh an independent fudiciary duty that stood on the
same footing as the duties of care and loyalty. Only the later two duties, when violated, could directly
result in liability, whereas a failure to act in good faith could do so, but indirectly.
Malone v. Brincar
ISSUE : Whether a director’s fiduciary duty arising out of misdiclosure is implicated in the absence of a
request for shareholders action.
FACTS : Appellants filed this individual class action alleging that Appellees breached their fiduciary duty
of disclosure by intentionally overstating the financial condition of the corporation on repeated
occasions to its shareholders. Appellants allege that as a direct result of these false disclosures, the
company lost virtually all of its value of about $2 billion. The Court of Chancery dismissed the complaint
with prejudice for failure to state a claim upon which relief may be granted.
RULE : WHENEVER DIRECTORS COMMUNICATE PUBLICLY OR DIRECTLY WITH SHAREHOLDERS
ABOUT THE CORPORATION’S AFFAIRS, WITH OR WITHOUT A REQUEST FOR SHAREHOLDER
ACTION, DIRECTORS HAVE A FIDUCIARY DUTY TO SHAREHOLDERS TO EXERCISE DUE CARE,
GOOD FAITH AND LOYALTY. WHEN DIRECTORS COMMUNICATE PUBLICLY OR DIRECTLY WITH
SHAREHOLDERS ABOUT CORPORATE MATTERS, THE SINE QUA NON OF DIRECTORS’
FIDUCIARY DUTY TO SHAREHOLDERS IS HONESTY
HOLDING : Yes. Directors who knowingly disseminate false information that results in corporate injury
or damage to an individual stockholder violate their fiduciary duty, and may be held accountable in a
manner appropriate to the circumstances.
DISCUSSION : The director’s fiduciary duty to both the corporation and its shareholders is a
combination of due care, good faith, and loyalty. The focus of the fiduciary duty of disclosure is to
protect shareholders as the “beneficiaries” of al material information disseminated by the directors.
Shareholders are entitled to rely upon the truthfulness of all information disseminated to them by the
directors elected to manage the corporation. Here, Appellants never expressly assert a derivative claim
on behalf of the corporation or allege compliance with the Court of Chancery Rule 23.1 which requires
pre-suit demand or cognizable and particularized allegations that demand is excused. Therefore the Court
of Chancery properly dismissed the complaint before it. However, Plaintiffs should have been permitted
to amend their complaint to state a cognizable cause of action.
Gall v. Exxon Corp
ISSUE : Whether summary judgment is proper when Plaintiff calls into question the disinterestedness and
bona fides of a litigation committee recommending dismissal.
FACTS : Exxon allegedly paid 59 million in corporate funds as political bribes to Italian political parties to
secure special political favors and other illegal commitments. Exxon’s Board of Directors established a
Special Committee on Litigation composed of Exxon Directors and referred to the Committee for the
determination of Exxon’s action the matters raised in this and other pending actions. The committee
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investigated and recommended that it would be contrary to the interests of Exxon and its shareholders
for Exxon or anyone on its behalf to bring legal action against any Exxon director or officer. The
Committee resolved to oppose and seek dismissal of all shareholder derivative actions relating to the
above-mentioned bribes.
RULE : ABSENT ALLEGATIONS OF FRAUD, COLLUSION, SELF-INTEREST, DISHONESTY OR OTHER
MISCONDUCT OF A BREACH OF TRUST NATURE, AND ABSENT ALLEGATIONS THAT THE
BUSINESS JUDGMENT EXERCISED WAS GROSSLY UNSOUND, THE COURT SHOULD NOT AT THE
INSTIGATION OF A SINGLE SHAREHOLDER INTERFERE WITH THE JUDGMENT OF THE
CORPORATE OFFICERS.
HOLDING : No. Plaintiff must be given the opportunity to test the bona fides and independence of the
Committee through discovery and if necessary at a plenary hearing.
DISCUSSION : Where it is the interests of the corporation which are at stake, it is the responsibility of
the directors of the corporation to determine, in the first instance, whether an action should be
brought on the corporation's behalf. It follows that the decision of corporate directors whether or not
to assert a cause of action held by the corporation rests within the sound business judgment of the
management. If a stockholder could compel the officers to enforce every legal right court instead of
officers would be the arbiters of the corporation’s fate. Plaintiff, however, alleges that the members of
the Committee may have been personally involved in the transactions in question or interested in the
alleged wrongdoing in a way calculated to impair their exercise of business judgment on behalf of the
corporation. Plaintiff must be given an opportunity to test its theory through discovery. Issues of intent,
motivation, and good faint are particularly inappropriate for summary disposition.
Zapata Crop v. Maldonado
ISSUE : whether the authorized committee should be permitted to dismiss pending derivative suit
litigation.
FACTS : Maldonado brought the derivative suit against ten officers and directors of Defendant, asserting
that they breached their fiduciary duties. Plaintiff did not demand that the Defendant officers bring the
action because all the directors at the time were named in the suit. After the suit, Defendant corporation
appointed an “Independent Investigation Committee” comprised of two directors who were not part of
the initial suit. The Committee decided that the derivative suits would be harmful to the company and
therefore moved to dismiss the litigation.
RULE : Zapata v. Maldonado established a procedure by which a company’s board of directors may obtain
dismissal of a shareholder’s derivative action even when a majority of the board is tainted by self interest.
Under Delaware law, according to the court, an independent committee of the board had authority to
seek dismissal of the derivative action, and the court would grant dismissal through a TWO-STEP
PROCESS OF DETERMINING (1) THAT THE COMMITTEE INDEED WAS INDEPENDENT AND
CONDUCTED A REASONABLE INVESTIGATION AND (2) THAT AS A RESULT OF THE COURT’S
EXERCISE OF ITS OWN BUSINESS JUDGMENT, dismissal should be granted.
Π ARGUMENT : Appellee stockholder’s position included the argument that if corporations could
consistently take bona fide derivative actions away from well-meaning derivative plaintiffs through the
use of the committee mechanism, the derivative suit would lose much, if not all, of its generallyrecognized effectiveness as an intra-corporate means of policing boards of directors
∆ ARGUMENT : Appellant corporation’s position included the argument that if corporations were unable
to rid themselves of meritless or harmful litigation or strike suits, the derivative action, created to benefit
the corporation, would produce harm to the corporation
HOLDING : An independent committee of the board of directors of the nominal defendant corporation in
a derivative action may cause the corporation to seek dismissal of the derivative action upon the court’s
confirmation of the committee’s independence and good faith and the court’s own independent business
46
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judgment striking a balance between legitimate claims of the corporation stated in the derivative action
and the best interests of the corporation as expressed by the independent committee.
DISCUSSION : An authorized committee of the BOD of the Corp ∆ in a S/H deriviatave action may seek
and obtain dismissal of the action upon determination by the court of the committee’s independence
and good faith and the court’s own independent business judgement striking a balance between
legitimate claims of the corp stated in the dericative aciotn and the best interests of the corp as
expressed by the independent committee. An independent committee possess the corp power to seek
termination of a derivative suit. Derivative suits enforce corp rights and any recovery obtained goes tyo
the corp.
Aronson v. Lewis
ISSUE : 1- Whether the demand was futile due to directors lack of independence ? 2- Whether the
demand was futile due to approval of employment agreement ? 3- Whether the demand was futile due
to hostility toward litigation ?
FACTS : Appellee stockholder filed a derivative suit against appellants, a corporation and its directors,
one of whom became a consultant for the corporation, seeking the cancellation of the consultant’s
employment contract and an accounting by the directors, including the consultant, for all damages
sustained by the corporation and for all profits derived by the directors and the consultant. Appellants
filed a motion to dismiss pursuant to Del. Ch. Ct. R. 23.1, for the stockholder’s failure to make a demand
upon the board of directors to redress the alleged wrong to the corporation or to otherwise demonstrate
its futility. The Court of Chancery (Delaware) denied the motion, ruling that the stockholder’s allegations
raised a reasonable inference that the directors' action was unprotected by the business judgment rule
and thus the board could not have impartially considered and acted upon the demand. Appellants sought
an interlocutory appeal of the chancellor’s decision.
Π ARGUMENTS : 1- Appellee stockholder argued that the appellant consultant’s employment contract
was approved only because the consultant personally selected each director and officer of the
corporation. He maintained that, having done so, the consultant, who owned 47 percent of the
corporation’s stock, controlled and dominated every member of the corporation’s board and each of its
officers, thereby making demand futile. He also argued that mere approval of the employment
agreement illustrated the consultant’s domination and control of the board. In addition, he argued on
appeal that the consultant’s 47 percent stock ownership, though less than a majority, constituted
control given the large number of shares outstanding. 2- corporation’s transactions with the consultant
had no valid business purpose and were a waste of corporate assets because the amounts to be paid
were grossly excessive, the consultant performed few, if any, services, and, because of his advanced age,
he could not be expected to perform any such services. He further claimed that a prior consulting
agreement with the corporation’s former parent company prevented the consultant from fulfilling his
contractual obligation to provide his best efforts on the corporation’s behalf and that unsecured loans
made to the consultant by the corporation were in reality additional compensation without any
consideration or benefit to the corporation. The stockholder argued that, because all of the directors
were named as defendants in the suit and had approved the wasteful agreement; if he prevailed on the
merits they would be jointly and severally liable and their interest in avoiding personal liability
automatically and absolutely disqualified them from passing on a shareholder's demand to bring suit. 3demand was futile because the institution of his action by the directors would have required them to
sue themselves, thereby placing the conduct of this action in hostile hands and preventing its effective
prosecution.
∆ ARGUMENTS : 1- Appellants countered that strict construction and enforcement of Del. Ch. Ct. R. 23.1
was required and that the stockholder’s allegations fell far short of the factual particularity required by
Rule 23.1. Specifically, the allegation that the consultant dominated and controlled the board lacked any
facts explaining how he selected each director. Moreover, with respect to the consultant’s stock interest,
appellants asserted that absent other facts, that allegation was insufficient to indicate domination and
47
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1.
2.
3.
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control. Finally, as to the provision in the employment agreement guaranteeing the consultant’s
compensation even if he was unable to perform any services, appellants contended that the trial court
read the provision out of context. 2- allegation that directorial approval of the agreement excused
demand was insufficient because it obviated the demand requirement in almost every case. 3Appellants argued that the claim of hostility to the stockholder’s suit ignored the possibility that the
directors had other alternatives, such as cancelling the challenged agreement
HOLDING : 1- Complaint failed to factually particularize any circumstances of control and domination to
overcome the presumption of board independence and thus render the demand futile. 2- The
stockholder had not alleged facts sufficient to render demand futile on a charge of corporate waste and
thus created a reasonable doubt that the board's action was protected by the business judgment rule. 3The stockholder’s bare claim of futility raised no legally cognizable issue under Delaware corporate law.
DISCUSSION : Sig. Case because it defines when a s/h demand upon a BOD to redress an alleged wront to
the cor pis excused as futile prior to the filing of a deravitive suit. Because the stockholder failed to make
a demand, and to allege facts with particularity indicating that such demand would have been futile, the
court reversed the chancery court’s denial of appellant’s motion to dismiss. The stockholder failed to
allege facts with particularity indicating that the corporation’s directors were tainted by interest, lacked
independence, or took action contrary to the corporation’s best interests in order to create a reasonable
doubt as to the applicability of the business judgment rule.
If S/H makes demand  later concedes that demand was not futile in later litigation
a. Therefore, S/H rarely make demands
IL 7.80(b)
a. Make demand on corp or include reason why no demand made
MBCA 7.42
a. Demand requirement.
b. If Corp accepts demand  risk of « sweetheart deal » between Corp and person charged.
In re Oricale Corp. Derivative Litigation
ISSUE : whether or not the two-member SLC was independent ?
FACTS : The corporation was successful, publicly held, and in the computer software business. The
directors sold shares prior to publication of the quarterly corporation's earnings. The earnings were lower
than expected by analysts, impacted by bugs in a newly released product, and affected by the stock
market's general decline. The sales were within the time limit established for insider's sales. One
director's sale was affected by his option exercise deadline and to raise cash for income taxes. None of
the four directors had an especially urgent cash crunch. Nevertheless, the chancery court's dispositive
issue was whether or not the two-member SLC was independent. The SLC did not meet its burden to
prove it, or either of the members, was independent. The chancery court's independence test was
whether the individual SLC member was incapable of making a decision with only the best interests of the
corporation in mind, or, as a corollary, without considering any way in which his decision would impact
him. The ties that the SLC members and directors had to one university, as alumni, tenured faculty
professors, very major contributors, and speakers were too vivid to be ignored.
RULE : The Zapata standard of review of a special litigation committee's (SLC) motion to terminate
requires the Delaware Chancery Court to determine whether, on the basis of the undisputed factual
record, the Chancery Court is convinced that the SLC is independent, acts in good faith, and has a
reasonable basis for its recommendation. If there is a material factual question about these issues
causing doubt about any of these grounds, Zapata and its progeny require a denial of the SLC's motion to
terminate
HOLDING : NO, the SLC was not independent because there where definate ties, that althought not
amounting to control and domination, were sufficient to color the SLC’s opinion as non-independent.
48
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DISCUSSION : The question of independence turns on whether a director is, for any substantial reason,
incapable of making a decision with only the best interests of the corporation in mind. That is, the
independence test ultimately focuses on impartiality and objectivity.
Cuker v. Mikalauskas
ISSUE : Whether the business judgment rule permits the board of directors of a corporation the right to
terminate derivative lawsuits brought by minority shareholders?
FACTS : PECO is a publicly regulated utility that sells electricity and gas to residential, commercial and
industrial customers in Philadelphia and four surrounding counties. Ernst & Young conducted a
comprehensive management audit of PECO and recommended changes in twenty-two areas in the
company including the credit and collection function. In May, 1993, one set of minority shareholders filed
a demand (Katzman demand) seeking authorization by the PECO board to litigate against PECO officers.
The Katzman demand alleged PECO officers damaged PECO by mismanaging PECO’s credit and
collection function. On June 28, 1993, PECO’s board created a special litigation committee (Committee)
comprised of non-PECO board members to investigate the Katzman allegations. Less than a month later,
a second group of minority shareholders filed a complaint (Cuker complaint) against the PECO officers
and directors, which made the same allegations as the Katzman allegations. The Committee undertook to
investigate the Cuker complaint as well. On January 26, 1994, the Committee held its final meeting and
prepared its report based on its conclusions. The 300 page detailed report concluded that there was “no
evidence of bad faith, self-dealing, concealment, or other breaches of the duty of loyalty by any of the
defendant officers.” It further concluded that the officers exercised their best judgment to further the
best interests of the company. As such, the report concluded that a derivative suit based on the Ernst &
Young findings would not be in PECO’s best interest. After two meetings where the PECO board debated
the Committee findings, it decided to reject the Katzman demand and to terminate the Cuker action.
PECO filed a motion for summary judgment seeking termination of minority shareholders derivative
actions. The court of common pleas denied the motion holding that as a matter of public policy, a
corporation cannot terminate a pending derivative litigation. Before the court is PECO’s petition seeking
extraordinary relief pursuant to Pa.R.A.P. 3009.
RULE : PA standard : THE BUSINESS JUDGMENT RULE PERMITS THE BOARD OF DIRECTORS TO
DISMISS A DERIVATIVE ACTION IF IT IS IN THE BEST INTEREST OF THE CORPORATION, IF
SATISFIES TEST :
O DISINTERESTED
O ASSISTED BY COUNSEL
O PREPARED WRITTEN REPORT
O INDEPENDENT
O ADEQUATE INVESTIGATION
O BEST INTEREST OF CORP/GOOD FAITH
HOLDING : Yes. The business judgment rule permits the board to terminate the derivative law suit.
Reverse and remanded.
DISCUSSION : The business judgment rule insulates “officers and directors from judicial intervention in
the absence of fraud or self-dealing, if challenged decisions were within the scope of the directors’
authority, if they exercised reasonable diligence, and if they honestly and rationally believed their
decisions were in the best interests of the company.”
V. DUTY OF LOYALTY AND CONFLICT OF INTEREST
(IL § 8.60)
49
756-812
8.60 – DIRECTORS CONFLICT OF INTEREST – Fair self-dealing transaction ok. Person asserting validity has burden of
proving (1) material facts disclosed or known to BOD or that committee approved ; (b) material facts of interests
were disclosed or known to s/h entitle to vote.
(MBCA §8.60 et seq)
8.60 – SUBCHAPTER DEFINITIONS – Conflict interest if (a) related person to transaction with dinancial interest, or
closly linked to those with interests required disclosure
Marciano v. Nakash

ISSUE : Whether loans made by some of the BOD officers to a wholly owned subsidiary of those officers
were voidable as a self-dealing tranaction, where the terms of the loands were favoriable.

FACTS : Both parties had entered into a joint venture to market designer jeans. Stock ownership and the
composition of the board were shared equally by the parties. Ultimately the board deadlocked over
policy issues and a court-approved plan of liquidation followed. Appellees had made loans to the
corporation upon which they asserted claims at liquidation. Appellants argued that the debt was
voidable under Del. Code Ann. tit. 8, § 144 because it originated in self-dealing transactions. On appeal,
appellants argued that the chancery court applied the wrong standard of review for self-dealing
transactions and thus its finding of full fairness was erroneous. The court held that relationship alone was
not the only factor to determine if an interested director transaction was void. Since the loans were made
on favorable terms, the loans were not automatically void under the intrinsic fairness test.

RULE : THE PRINCIPLE OF PER SE VOIDABLITITY FOR INTERESTED TRANSACTIONS DOES NOT
INVALIDATE TRANSACTIONS DETERMINED TO BE INTRINSICALLY FAIR.

HODLING : The court affirmed the decision of the chancery court, because although appellees' loans
originated in self-dealing transactions, the test of intrinsic fairness supported the validity of the loans in
light of the financial circumstances of the corporation.

DISCUSSION : Interested transactions should be subject to close scrutiny. Where the undisputed
evidence tended to show that the transaction would advance the personal interests of the directors at
the expense of stockholders, the stockholders, upon discovery, are entitled to disavow the transaction.
When directors of a Delaware corporation are on both sides of a transaction, they are required to
demonstrate their utmost good faith and the most scrupulous inherent fairness of the bargain.
1.
IL 8.60 – Fairness Standard Used Regardless of Interested Party
a. Transaction fair when auth ?
b. O/D involvement not grounds for invalidation
c. BOP – person asserting validity
i. UNLESS :
1. BOD had been informed and approved
2. S/H knowledgable and disinterested approve BUT
a. This only lessens risk of derivitate suit
b. Shifts BOP to S/H if they do sue
50
Heller v. Boylan

ISSUE : Whether and to what extent payments to the individual defendants under the bylaws constitute a
misuse and waste of the money of the corporation.

FACTS : Plaintiff stockholders filed a derivative action suit seeking to recover from defendant recipient
directors and defendant non-recipient directors for alleged improper payments arising from an incentive
compensation by-law of the company. Plaintiffs alleged that large bonus payments bore no relation to
the value of the services for which they were given and that defendants committed waste and spoliation in
giving away corporate property against the protest of plaintiffs. Plaintiffs also alleged that the company's
treasurer misinterpreted the by-law to defendants' undue enrichment.

RULE : THE DUTY OF THE DIRECTOR EXECUTIVES PARTICIPATING IN THE BONUS SEEMS PLAIN
– THEY SHOULD BE THE FIRST TO CONSIDER UNSELFISHLY WHETHER UNDER ALL THE
CIRCUMSTANCES THEIR BONUS ALLOWANCES ARE FAIR AND REASONABLE.

HOLDING : The court held that the incentive compensation payments should remain undisturbed, that
defendant recipient directors were to restore to the company $ 2,018,033.44 representing the total
overpayments made due to the treasurer's misinterpretation of the by-law, and that plaintiffs' objections to
all other payments as miscomputations were overruled. The court also held that the profits of the company
to be shared by defendants were restricted to those earned in the manufacture and sale of tobacco and that
profits of its subsidiaries not engaged in the business were excluded from compensation.

DISCUSSION : Predetermined incentive compensation to corporate officers based on a share of
profits in addition to salary has been an accepted and widespread practice both in the United States
and Europe during the past 20 years or more. No question is raised in the books but that a corporate
officer may be paid a percentage of profits and that such compensation, contingent upon net earnings, is a
cost of the enterprise and not a distribution of funds exclusively allocated to stockholders. Such plans, if
fair and not oppressive, have received both judicial and economic approval. Directors of a corporation
acting as a body in good faith have a right to fix compensation of executive officers for services
rendered to the corporation and ordinarily their decision as to the amount of compensation is final
except where the circumstances show oppression, fraud, abuse, bad faith, or other breach of trust. If
clear oppression, bad faith, or other breach of trust is shown, the courts will give redress and determine to
what extent the compensation is excessive. But plaintiffs must bring the case within one of the exceptions
that are in each case predicated on a breach of legal duty with consequent damage to the corporation. There
is no valid ground for disapproving what a great majority of stockholders have approved. The
stockholders who built and are responsible for the bonuses must be responsible for creating a ceiling
for these bonuses if they so desire.
Brehm v. Eisner I
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ISSUE :
o
1- Whether the complaint was sufficient in allegations that the directors were not disintrested or
independend ?
o
2 – Whether the directors have to be informed of every fact or just reasonably informed ?
51
o
3- Whether ∆’s expert testimony that the directors should have obtained additional informaiton
was valid and binding on the Old Borad ?

FACTS : Disney’s CEO, Michael Eisner, wanted to hire a personal friend, Ovitz, to the position of
president. Ovitz had no prior experience for that position but was sought after by other companies because
of his other successes in the entertainment business. Eisner personally and exclusively negotiated an
employment agreement with Ovitz. The 5-year agreement gave Ovitz a $1 million annual base pay plus
stock options that accrued annually (”A” options) or came due if Ovitz finished the term of employment
under the agreement (”B” options). There was a non-fault termination clause (termination not based of
gross negligence or malfeasance) that would pay Ovitz $10 million plus $7.5 million for every year
remaining in the agreement. 3 million A options would also immediately vest. This agreement was
reviewed and endorsed by a corporate compensation expert who later said that no one actually calculated
out the compensation that Ovitz would get if there was a non-fault termination. The Board then approved
the contract. Ovitz put in about unremarkable year with Walt Disney and then negotiated a non-fault
termination that paid him over $38 million, a higher amount than what he could have made by
working through the entire contract. This payout prompted Plaintiffs to file this action, claiming the
directors breached their fiduciary duty and committed waste.A corporation's stockholders alleged that:
(a) the corporation's board of directors, as it was constituted in 1995 (the Old Board) breached its fiduciary
duty in approving an extravagant and wasteful Employment Agreement of the corporation's president; (b)
the corporation's board of directors as it was constituted in 1996 (the New Board) breached its fiduciary
duty in agreeing to a nonfault termination of the president's Employment Agreement, a decision that was
extravagant and wasteful; and (c) the directors were not disinterested and independent. The Complaint
alleged that the Old Board failed properly to inform itself about the total costs and incentives of the
president's Employment Agreement, especially the severance package, and that the New Board committed
waste by agreeing to a shocking amount of severance worth over $ 140 million. The Court of Chancery
held that the stockholder derivative Complaint was subject to dismissal for failure to set forth
particularized facts creating a reasonable doubt that the director defendants were disinterested and
independent or that their conduct was protected by the business judgment rule. The stockholders appealed
and presented issues including: (1) the scope of review that applies to an appeal from the dismissal of a
derivative suit; (2) the extent to which the pleading standards required by Del. Chancery Ct. R. 23.1exceed
those required by Del. Chancery Ct. R. 8; and (3) the scope of the business judgment rule as it interacts
with the relevant pleading requirements.

RULE : The Delaware Supreme Court's scope of review of a decision of the Delaware Court of Chancery
on a Rule 23.1 motion to dismiss a derivative suit must be de novo. The facts supporting the stockholders'
claim that the New Board was not disinterested or independent were not supported by well-pleaded facts,
only conclusory allegations. The court agreed with the Chancery Court that the stockholders did not
demonstrate a reasonable doubt that the chairman of the board was disinterested in granting the president a
Non-Fault Termination.

HOLDING :
o
1 – NO. The complaint did not susessfully suggest that the BOD should have taken steps to assure
even greater independence of directors.
o
2- The standard for judging the information component of the directors’ decision making did not
mean that the Board had to be informed of every fact. The Board was responsible for considering
52
only material facts that were reasonably avaiable, not those that were immaterial or out of the
Board’s reasonable reach.

o
The s/h contention that the ∆ expert admission that he should ahve obtained additional information
was valid and binding was without merit because the Board’s expert wa retained ex ante for
purposes to advisinf the directors on the corps prez employment agreement, not as their agent to
make binding addmissions
o
The complaint did noot allege facts that would show the prez had in fact resigned before the Board
acted on his non-fault termination. S/h suggest there was a de facto resignation. But complaint
failed to alledge the prez had actually resigned.
o
None of the s/h allegatoins about the prez’s performance rose to the level of gross negligence or
malfeasance, as required by his Employment Agreement.
DISCUSSION : This case initially seemed to signal a more active role for the courts in shareholder
derivative litigation by clarifying that the standard of review on appeal from a motion to dismiss for failure
to satisfy Rule 23.1 was de novo, the end result was that the case was ultimately dismissed on the merits.
Despite the Delaware Supreme Court's apparent sympathy with the shareholders over the shocking
severance payment that the board of directors approved in this case, the court also agreed that the
shareholders' complaint was a "pastiche of prolix invective . . . permeated with conclusory allegations of
the pleader and quotations from the media, mostly of an editorial nature (even including a cartoon)." The
shareholders were ultimately able to submit an amended complaint that withstood a motion to dismiss, but
they were unable to prevail at trial due to the business judgment rule. It remains to be seen whether the
additional burden of defending cases like this on the merits rather than at the pleading stage will cause
corporate boards of directors to be any more diligent in scrutinizing executive compensation and
termination packages in the future.
Brehm v. Eisner II

ISSUE :
o
1- Whether ∆, former corporation president breached his fiduciary duties of care and loyalty to the
corporation by negotiating for and accepting the non-fault termination (NFT) severance provisions
of his employment agreement.
o
2- Whether the trial court erred when it concluded that the former president breached no corporate
fiduciary duty, including the duty of loyalty, by receiving the NFT payout upon his termination
because he played no part in the decision that he be terminated from the corporation without cause
o
3- Whether the business judgment rule protected the 1995 directors' actions in approving the
former president's employment agreement and electing him to office because these actions were
grossly negligent or not performed in good faith ?
o
4- Whether the 1995 directors outside of the compensation committee breached their duty of care
in electing the former president to office because they did not obtain sufficient information about
his employment agreement, especially with regard to the NFT provisions.
53

FACTS : After working only 14 months into a 5-year employment agreement with appellee
corporation, appellee former corporation president was terminated without cause and paid a
severance package valued at approximately $ 130 million. A month later, appellant corporation
shareholders filed derivative actions in the Court of Chancery of the State of Delaware, in and for New
Castle County, claiming that the $ 130 million severance payout was a waste of corporate assets that
resulted from contractual and fiduciary breaches by appellee former president as well as the breach of
fiduciary duties by appellee corporation directors. The stockholders' sought injunctive and rescissory or
other equitable relief on behalf of the corporation and its shareholders or, alternatively, damages. The
chancery court dismissed the shareholders' consolidated complaint. That dismissal was reversed in part on
appeal, and, upon remand to the chancery court, the shareholders filed a second amended complaint. The
chancery court denied appellees' motion to dismiss the second amended complaint because a complete
factual record was needed for a determination of whether the directors had breached their fiduciary duties.
After the completion of extensive discovery, the former president moved for summary judgment. The
chancery court granted that motion in part by dismissing the breach of fiduciary duty claims against the
former president that were based on conduct that predated his formal employment with the corporation.
The shareholders' remaining claims went to a bench trial before the chancery court. Following a 37-day
trial, the chancery court concluded that the directors did not breach their fiduciary duties or commit waste.
A judgment was entered in favor of all appellees on all claims alleged in the amended complaint. The
shareholders appealed from that judgment.

RULE :
o
AFFIRMANCE OF THE BJR : The court allowed the s/h a second-amended derivative complaint
to proceed on the basis that they pled sufficient facts to suggest that the corporation directors
exceeded the protections of the business judgment rule by breaching fiduciary duties. In the wake
of the collapse of Enron and WorldCom, commentators ventured that the chancery court's decision
could signal a loosening of the business judgment rule protections that shielded corporate
directors' decisions from judicial inquiry. However, the vigor of the business judgment rule was
strongly reaffirmed by the Delaware Supreme Court in In Re the Walt Disney Company
Derivative Litigation. Upholding the chancery court's judgment absolving the corporate directors
of liability despite their larger-than-life severance payment to the former corporate president
following his brief tenure in office, the decision made clear that no matter how mistaken the
decisions of corporate directors may appear in hindsight, such decisions will be respected by
Delaware courts so long as they were made without a conscious disregard of fiduciary duty.
o
DEFINITION OF CORPORATE FIDUCIARY BAD FAITH : The chancery court held that the
business judgment presumptions protected the directors' decisions, not only because they acted
with due care, but also because they acted with good faith. On appeal, the Delaware Supreme
Court upheld the chancery court's application of corporate good faith as a separate standard, in
addition to due care and loyalty, for measuring the directors' fiduciary conduct. Recognizing that
the contours of the duty of good faith were "shrouded in the fog of hazy jurisprudence," the court
provided considerable conceptual guidance to the corporate community on the subject. The court
explained that on the sliding scale of culpability, classic, unquestionable subjective bad faith was
shown on one end by conduct motivated by an intent to do harm. At the opposite end of the scale
was gross negligence, action caused without malevolent intent that equated to a lack of due care.
Noting the common law and statutory distinctions made between due care and good faith, the
court explained that gross negligence, without more, did not show bad faith. Falling in between
54
these two categories of conduct, intentional harm on the one end and gross negligence on the
other, was a third category that the chancery court's bad faith definition captured—intentional
dereliction of duty, a conscious disregard for one's responsibilities. The Delaware Supreme Court
held that this definition was an appropriate, though not exclusive definition of corporate bad faith,
and that such misconduct was properly treated as a non-exculpable violation of fiduciary duty not
subject to indemnity.

o
PRACTICLE INSIGHTS INTO DIRECTOR BEST PRACTICES : decision goes further to
provide practical advice on methods of prudent corporate governance. Among other things, it
shows the hazards of informal communications among directors and emphasizes the importance of
detailed board meeting minutes on the record. The decision also gives guidance as to the "best
practices" that should have been followed by the Disney directors' compensation committee in
approving the former president's employment agreement. In the best case scenario, the directors
should have received, well before the committee meeting, a spreadsheet prepared by a
compensation expert that detailed the pay amounts that the former president would have received
under various circumstances, including an early non-fault termination. Such spreadsheet should
have been explained to the committee by the expert and attached to the meeting minutes to show
the basis of the committee's decision.
O
CORPORATE WASTE - (1)EXCHANGE OF CORPORATE ASSETS FOR CONSIDERATION SO
DISPROPORTIONATELY SMALL AS TO LIE BEYOND THE RANGE AT WHICH ANY
REASONABLE PERSON MIGHT BE WILLING TO TRADE. (2)IF, HOWEVER, THERE IS ANY
SUBSTANTIAL CONSIDERATION RECEIVED + GOOD FAITH = NO WASTE (EVEN IF
TRANSACTION WAS UNREASONABLY RISKY
HOLDING :
o
1- The chancery court did not err in finding that the former president did not breach fiduciary
duties by entering into the employment agreement; the former president was not a de facto officer
subject to fiduciary duties prior to October 1, 1995, because he did not assume or purport to
assume the duties of the presidency before that date, and only immaterial revisions were made to
the employment agreement after October 1.
o
2- The chancery court did not err in concluding that the former president breached no corporate
fiduciary duty by taking the NFT payout; the record overwhelmingly supported the chancery
court's factual findings that the president did not leave the corporation voluntarily or negotiate for
a non-fault termination.
o
3- BJR protected and The chancery court committed no error in concluding that the directors did
not breach their fiduciary duties of due care and good faith in approving the former president's
employment agreement. The shareholders were not prejudiced by the chancery court's analytical
approach, the compensation committee was empowered by the corporation's charter and the
Delaware General Corporation Law to approve executive compensation without an affirmance by
the full board of directors, and the record demonstrated that, through the presentation of a term
sheet, spreadsheets, and a summary of a compensation consultant's analysis, the members of the
compensation committee were adequately informed about the non-fault termination provisions
such that they met the duty of due care in approving the employment agreement.
55
o

4- the 1995 directors had sufficient knowledge to meet their duty of due care in electing the
former president to office; the directors were entitled to rely upon the compensation committee's
approval of the former president's compensation, the directors were informed of the key terms of
the employment agreement, and the directors also knew of the former president's skills,
experience, and reputation.
DISCUSSION : In upholding the corporation directors' decisions to hire and fire the former
president as protected business judgments made without violation of fiduciary duties, despite the
unprecedented enormity of the former president's non-fault termination payout, the decision by the
Delaware Supreme Court reinforces the view that Delaware courts are hesitant to second-guess the
business judgment decisions made by independent and disinterested corporate directors.
Sinclair Oil Corp. V. Levien

ISSUE : whether Defendant was improperly engaging in self-dealing when they issued excessive
dividends and breached their contract with Sinven.

FACTS : Sinven was a subsidiary of Defendant with operations exclusively in Venezuela. Defendant, as
the majority shareholder of Sinven, caused Sinven to pay dividends that were so large that the
amount exceeded the earnings of Sinven. The dividends provided cash to Defendant as well as minority
shareholders, but it left no resources fro Sinven to expand its operations. Defendant also neglected to
meet the terms of the contract between them and Sinven. The agreement required Sinven to sell all of
its products to Defendant at specified prices, but Defendant was late in payments and did not fulfill their
minimum purchasing obligations. Plaintiff therefore brought this action, claiming the dividends were
excessive and that Defendant breached the contract with Sinven.

RULE : A STANDARD OF INTRINSIC FAIRNESS WILL BE APPLIED IN ANY SELF-DEALING
TRANSACTION BY A PARENT CORPORATION WHOSE MAJORITY OWNERSHIP PLACES A
FIDUCIARY DUTY UPON THE PARENT CORPORATION, BUT THE TRANSACTION ONLY BE SELFDEALING IF THE TRANSACTION IS TO THE DETRIMENT OF MINORITY SHAREHOLDERS.

HOLDING : Defendant did not engage in self-dealing by issuing large dividends but it did engage in
self-dealing when they breached the agreement. Defendant complied with Delaware statute 8 Del.C.
Section: 170, concerning the payment of dividends, and Defendant’s motives are not a factor when all
shareholders benefit from the transaction (not self-dealing). However, the contract breach was to the
detriment of Sinven and its minority shareholders with the positive effect being exclusive to Defendant, so
the breach is self-dealing.

DISCUSSION : Majority shareholders are held to a different standard than officers or directors such as in
Lewis v. S.L & E, Inc. In Lewis, any conflict of interest between a director and the corporation is voidable
unless the transaction is proven to be fair. In this case, a plaintiff has to prove that the majority
shareholders enjoyed an exclusive benefit to the detriment of the minority shareholders before the
burden is shifted to the defendants.
Weinberger v. UOP, Inc.
56

ISSUE : whether the majority shareholder breached their fiduciary duty to the minority shareholders by
withholding relevant information from non-Signal UOP directors and minority shareholders.

FACTS : Signal sold off a subsidiary company for $420 million in cash and desired to turn around and
reinvest the money. In 1975, Signal decided to purchase a majority stake in UOP. Signal paid $21 per
share (it was trading at around $14) to obtain 50.5% of UOP’s shares. In 1978, Signal still had a great
deal of money left over, and with no other attractive investments they decided to acquire all remaining
shares of UOP. At this point, Signal had placed seven directors, including the president and CEO James
Crawford, on the 13-member board. Two directors that served on both the board of Signal and of UOP,
Charles Arledge and Andrew Chitiea, performed a study using information obtained from UOP that
determined it would be in Signal’s interest to get the remaining shares of UOP stock for anything
under $24 per share. The Signal board decided to offer between $20-21. Signal discussed the proposal
with Crawford, and he thought the price was generous, provided that employees of UOP would have
access to decent benefits under Signal. He never suggested a price over $21. Crawford hired James
Glanville to render a fairness opinion despite the fact that Glanville’s firm also did work for Signal.
Glanville also had a short amount of time to prepare the opinion, and his number was the same as
Signal’s. The UOP board, using the fairness opinion as its guide but not the Arledge-Chitiea study,
voted unanimously to recommend the merger.

RULE : THE COURT HELD THAT IN A CASH-OUT MERGER, WHEN THE ONLY ALLEGATION WAS
THAT THE DIRECTORS FAILED TO APPROPRIATELY DETERMINE THE CASH VALUE OF THE
SHARES, THE APPRAISAL REMEDY WAS EXCLUSIVE WITH RESPECT TO CLAIMS BY DISSENTING
SHAREHOLDERS. HOWEVER, THE COURT LIMITED THE SCOPE OF THE APPRAISAL REMEDY BY
HOLDING IT MAY NOT BE APPLICABLE IN ACTIONS WHERE FRAUD, MISREPRESENTATION,
SELFDEALING, DELIBERATE WASTE OF CORPORATE ASSETS, OR GROSS AND PALPABLE
OVERREACHING WERE INVOLVED.

HOLDING : The Court held that because the feasibility study was prepared by two of the subsidiary’s
directors, using the subsidiary’s information for the exclusive benefit of the parent company, and nothing
was done to disclose it to the outside subsidiary directors or the minority shareholders, a question of
breach of fiduciary duty arose. The Court held that given the particulars of the case and the Delaware
law on the subject, the record did not establish that the transaction satisfied any reasonable concept of
fair dealing.

DISCUSSION : The record does not support a conclusion that the minority stockholder vote was an
informed one. Material information, necessary to acquaint those shareholders with the bargaining
positions of the parent and the subsidiary, was withheld under circumstances amounting to a breach
of fiduciary duty. Therefore the merger does not meet the test of fairness, at least as the Supreme Court of
Delaware addressed that concept, and no burden thus shifted to the shareholder by reason of the minority
shareholder vote. THERE IS AN INTRINSIC FAIRNESS TEST APPLICABLE TO PARENT-SUBSIDIARY
MERGERS. Particularly in a parent-subsidiary context, a showing that an action taken was as though each
of the contending parties had in fact exerted its bargaining power against the other at arm's length is strong
evidence that the transaction meets the test of fairness. The Court stressed that a component of fair
dealing was a duty of candor, and the obligation of one who possessed superior knowledge, not to
mislead any stockholder by using corporate information to which the stockholder is not privy.
1.
Today’s standard: Should create an independent negotiation committee to get fairness opinion on value
57
2.
Problems with appraisal remedy:
a. S/H must litigate for fair value & Co. has resources advantage
b. litigation leads to long time before getting paid
c. S/H pays own expenses for litigation
d. “Del. block” approach may not yield fair price
e. may not get interest on trial delay
3. FAIRNESS = FAIR DEALING + FAIR PRICE
a. Timing, how initiated, structured, negotiated, disclosed to the directors, and how the approvals
of the directors and the stockholders were obtained
b. Economic and financial considerations of the proposed merger, including all relevant factors:
assets, market value, earnings, future prospects, and any other elements that affect the intrinsic
or inherent value of a company's stock
Northeast Harbor Golf Club, Inc. V. Harris

ISSUE : Whether the trial court correctly applied the line of business test in determining that Appellee did
not usurp a corporate opportunity.

FACTS : Appellee was president of Appellant. Appellant’s major asset is was a golf course. The board
occasionally discussed but always shied away from the possibility of developing some of Appellant’s real
estate in order to raise money. Appellant, however, In 1979 a broker approached Appellee because of her
position with Appellant about three parcels located among the fairways of the golf course, one of which
was encumbered by an easement in favor of the Club. Appellee agreed to purchase the parcels in her own
name. She informed the board at the annual meeting of her purchase and intentions and they took no
action. In 1984, she learned of a parcel surrounded on three sides by the golf course that was available for
purchase. She informed several members of the board of her intent to acquire the parcel and at the annual
board meeting disclosed that she had purchased the property. The board took no formal action. In 1988,
Appellee began to develop the property. The board became divided concerning the propriety of the
development. Appellant filed a complaint against Appellee alleging that she breached her fiduciary duty in
regard to the purchases. The trial court found that Appellee had not usurped a corporate opportunity
because the acquisition was not in the Appellant’s line of business and because it lacked the financial
ability to purchase the real estate at issue.

RULE : TRADITIONAL TEST = LINE OF BIZ. MODERN = A CORPORATE OPPORTUNITY IS ONE
THAT IS CLOSELY RELATED TO A BUSINESS IN WHICH THE CORPORATION IS ENGAGED OR ONE
THAT ACCRUES TO THE FIDUCIARY AS A RESULT OF HER POSITION WITHIN THE
CORPORATION. THE FIDUCIARY MUST MAKE A FULL DISCLOSURE PRIOR TO TAKING
ADVANTAGE OF ANY CORPORATE OPPORTUNITY. THE CORPORATION MUST THEN FORMALLY
REJECT THE OPPORTUNITY. A GOOD FAITH BUT DEFECTIVE DISCLOSURE MAY BE RATIFIED
AFTER THE FACT ONLY BY AN AFFIRMATIVE VOTE OF THE DISINTERESTED DIRECTORS OR
SHAREHOLDERS.

HOLDING : No. The correct standard by which to judge a corporate opportunity is the ALI test.

DISCUSSION : The line of business test has two flaws. First, whether an opportunity is within a
corporation’s line of business is difficult to answer. Second, the evaluation of financial incapacity will
often unduly favor the inside director or executive who has command of the facts relating to the
finances of the corporation. The fairness test is also unhelpful because it lacks a principled content. The
58
combination of the two tests has resulted in compounding the flaws in both. The ALI test may bring
clarity to a murky area of the law because it provides a clear procedure whereby a corporate officer
may insulate herself through prompt and complete disclosure form the possibility of a legal
challenge. The case is remanded for proceedings consistent with this opinion.
VI. FEDERAL SECURITIES LAW
A. RULE 10B5-INTRODUCTION
1.
2.
813-817
Rule 10b-5
a. The SEC adopted new Rules 10b5-1 & 10b5-2 to resolve two insider trading issues where the
courts have disagreed. Rule 10b5-1 provides that a person trades on the basis of material
nonpublic information if a trader is "aware" of the material nonpublic information when
making the purchase or sale. The rule also sets forth several affirmative defenses or exceptions
to liability. The rule permits persons to trade in certain specified circumstances where it is clear
that the information they are aware of is not a factor in the decision to trade, such as pursuant to
a pre-existing plan, contract, or instruction that was made in good faith.
i. Publicly traded – applies
ii. Privately traded – need interstate commerce too for statute to apply
b. 10b-5(a) – “to employ any device, scheme, or artifice to defraud”
c. 10b-5(b) – “to make any untrue statement of a material fact or to omit to state a material
fact…”
i. “material” – whether a reasonable man would attach importance in determining his
choice of action in the transaction in question
ii. “omit” – omission only when there is a duty to disclose; e.g. a previous statement that
may be misleading without a subsequent statement duty to make statement
d. 10b-5(c) – act that is a fraud
Therefore, 2 main areas of 10b-5 = Insider Trading & Securities Fraud
1. INSIDER TRADING
1.
2.
3.
841-891
Rule 10b-5 & Insider Trading
a. Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary
duty or other relationship of trust and confidence, while in possession of material, nonpublic
information about the security. Insider trading violations may also include "tipping" such
information, securities trading by the person "tipped," and securities trading by those who
misappropriate such information.
Examples of insider trading cases that have been brought by the SEC are cases against:
a. Corporate officers, directors, and employees who traded the corporation's securities after
learning of significant, confidential corporate developments;
b. Friends, business associates, family members, and other "tippees" of such officers, directors, and
employees, who traded the securities after receiving such information;
c. Employees of law, banking, brokerage and printing firms who were given such information to
provide services to the corporation whose securities they traded;
d. Government employees who learned of such information because of their employment by the
government; and
e. Other persons who misappropriated, and took advantage of, confidential information from their
employers.
Because insider trading undermines investor confidence in the fairness and integrity of the securities
markets, the SEC has treated the detection and prosecution of insider trading violations as one of its
enforcement priorities.
59
SEC v. Texas Gulf Sulphur Co. (IMPORTANT CASE)

ISSUE: whether Defendants utilized material inside information when they purchase shares and calls of
Texas Gulf stock.

FACTS: Defendants were officers, employees or were closely tied to employees of Texas Gulf. Texas
Gulf, utilizing a geological survey, was conducting mining exploration in Canada. One area, called Kidd
55, was deemed promising by the survey, and a hole was drilled with the resulting core analyzed. The
analysis showed that the minerals present in the area were extremely rich in minerals. Several other
samples verified the findings. Defendants did not disclose the results of the analysis to outsiders,
including other officers of Texas Gulf. Defendants did proceed to purchase shares and calls once they
knew about the results. The trading activity and sample drilling did prompt rumors in the industry of a
significant find by Texas Gulf, and on April 12, 1964 Defendants sent out a misleading press release to
calm the speculation. The press release misrepresented the actual results of the samples. Defendants
decided to announce the results on April 15, although the news did not reach the public until April 16.
Defendants still traded between April 12 and the announcement. Defendants claimed that the
information was not material to the value of the company and therefore did not feel obligated to publicly
disclose the information. They also argued that any trading after they released the news at midnight of
April 16 was legitimate because technically the news was disseminated to the public.

RULE: INSIDERS CAN NOT ACT ON MATERIAL INFORMATION (INFORMATION THAT A
REASONABLE MAN WOULD DEEM IMPORTANT TO THE VALUE OF THE STOCK) UNTIL THE
INFORMATION IS REASONABLY, PUBLICLY DISSEMINATED.

HIOLDING: The Defendants withheld information that was material to shareholders and therefore
were acting on insider information when they purchased their shares and calls on Texas Gulf stock.
The court looked at the conduct of Defendants as evidence that the information was material: they
purchased a great deal of shares in Texas Gulf, they deliberately kept the information from others, and the
timing of their purchases occurred during the period that they exclusively held the information. It did not
matter that there was still an element of uncertainty in the eventual mineral mining, but the key element
was whether a reasonable person would believe that the information would be relevant to the price of the
stock. Further, Defendants should not act upon the information until the information is disseminated to the
point that the public would have had a reasonable opportunity to act on it.

DISCUSSION: The court has moved away from Goodwin v. Agassiz where the emphasis was placed on
whether a plaintiff suffered any damages and was directly wronged by a defendant insider. NOW THE
TEST IS WHETHER DEFENDANTS HAVE AN ADVANTAGE OVER ANYONE WITHOUT THE
INFORMATION. Damages calculated as profits gained since day after press release.
1.
How can a Senior Officer (or any employee) properly invest in company?
a. regular basis – e.g. payroll deductions
b. rule 16 – required reporting of company Officers’ trades
Chiarella v. US
60

ISSUE: Whether a person who learns about a corporation’s plan to takeover a target corporation through
confidential papers discovered while working at a financial printer violates Section:10b if he fails to
disclose the impending takeover before trading in the target company’s securities?

FACTS: Petitioner worked for a financial printing company, Pandick Press, as a markup man. Petitioner
handled documents announcing corporate takeover bids. The names of the acquiring and takeover
corporations were disguised, but Petitioner was able to deduce the companies by other information on
the documents. Petitioner purchased stock in the target companies and sold the shares immediately
after the takeover attempts were announced to the public, making $30,000 in profit over a 14 month
period. In May 1977, Petitioner entered into a consent decree with the Securities Exchange Commission
(SEC) to return his profits to the sellers of the shares. In January 1978, he was indicted and later convicted
on 17 counts of violating Section: 10b and SEC Rule 10b-5. The Court of Appeals for the Second Circuit
affirmed his conviction. The United States Supreme Court granted certiorari. The issues involving Rule
10b-5(b) were dismissed.

RULE: A DUTY TO DISCLOSE ARISES UNDER SECTION 10B UNDER THE SECURITIES EXCHANGE
ACT OF 1934 WHEN THERE IS A RELATIONSHIP OF TRUST AND CONFIDENCE BETWEEN THE
TRANSACTING PARTIES.

HOLDING: No. Silence does not amount to fraud under Section:10(b) if there is not a duty to disclose
based on a confidential relationship between the transacting parties. The Court of Appeals decision is
reversed.

DISSENT: The language of Rule 10b-5 and Section:10b encompasses the principle that a person has an
absolute duty to disclose misappropriated nonpublic information or to refrain from trading if he does not
disclose. Petitioner’s conduct was fraudulent under the meaning of Section:10(b) and Rule 10b-5 because
he wrongfully acquired confidential information and participated in manipulative trading based on it.
MISAPPROPRIATION THEORY: Awkward and unsatisfactory, though. Capital information hampered
and egalitarian principle [Texas Gulf-Sulphur] not effective. RULE 10B5-2 clarifies how the
misappropriation theory applies to certain non-business relationships. THIS RULE PROVIDES THAT A
PERSON RECEIVING CONFIDENTIAL INFORMATION UNDER CIRCUMSTANCES SPECIFIED IN THE
RULE WOULD OWE A DUTY OF TRUST OR CONFIDENCE AND THUS COULD BE LIABLE UNDER
THE MISAPPROPRIATION THEORY.

DISCUSSION: Silence in connection with the purchase or sale of securities is actionable as fraud
under Section:10(b) if there is a duty to disclose such information arising from a relationship of trust
and confidence between parties to a transaction. Here, Petitioner did not have a duty to disclose because
he had no special confidential relationship with the transacting parties.
US v. O’Hagan

ISSUE:
o
The first issue is whether Respondent violated Section:10(b) and Rule 10b-5 when he
misappropriated nonpublic information to personally benefit through the trading of securities.
61
o
The second issue is whether Rule 14e-3(a) exceeds the SEC’s rule-making authority as granted by
the Securities and Exchange Act.

FACTS: Respondent was a partner in a law firm, Dorsey & Whitney, which was representing a
company that was potentially tendering an offer for common stock of the Pillsbury Company. Respondent
was not personally involved in the representation, but he was aware of the transaction enough to
know that if he purchased Pillsbury securities now that they would increase in value once the offer went
through. Respondent was going to use the profits from this transaction to replace money that he
embezzled from the firm and its clients. After the offer went through, he made a $4.3 million profit.
The SEC investigated Respondent’s transactions and claimed he violated Section:10(b) and Section:14(e)
for misappropriating confidential information. A jury convicted Respondent.

RULE: AN OUTSIDER WHO MISAPPROPRIATES CONFIDENTIAL INFORMATION TO PERSONALLY
BENEFIT VIOLATES SECTION:10(B) BECAUSE THERE IS DECEPTION IN CONNECTION WITH THE
PURCHASE OR SALE OF A SECURITY.

HOLDING:
o
Respondent did violate Section:10(b) and Rule 10b-5 because all of the element of the rule were
met. Respondent did use deceit in connection with the purchase of securities. He did not
disclose to the firm or the client that he was using the nonpublic information, and his use of it
was at the expense of the client. He did not necessarily have to deceive the seller in order to
violate the Rule. As a matter of public policy, it would not make sense to limit the scope of the
Act to only prohibit certain kinds of activities that endanger a fair market.
o
Rule 14e-3(a) did not exceed the SEC’s rule-making authority. Again, the purpose of the Act is
to provide safeguards to ensure that the market is operating fairly and that investors can rely on the
market. Rule 14e-3(a) does not require a demonstration of a breach of duty in order to find a party
liable for violations of the Act. There will be instances where justice would deem this appropriate,
such as in this case.

CONCURANCE: The concurring opinions did not agree with the logic of the majority’s test regarding
Section:10(b)’s “in connection with” requirement, i.e. “deception in connection with the purchase or sale
of securities.” The majority held that the deceit occurred just as Respondent intended to misappropriate the
information, while the concurring opinion believed that it would not occur until Respondent actually made
the securities transactions.

DISCUSSION: The case was notable because it resolved a split in the federal circuit courts of appeal on
the issues of whether criminal liability under § 10(b) of the Securities Exchange Act of 1934 might be
predicated on the misappropriation theory of insider trading liability and on the legitimacy of Securities
and Exchange Commission (SEC) Rule 14e- 3(a). The case stated that a person who traded in securities
for personal profit, using confidential information that was misappropriated in breach of a fiduciary
duty to the source of the information, was guilty of violating § 10(b) of the Exchange Act and SEC
Rule 10b-5. The Court has now reversed the decision in Dirks v. Securities & Exchange Commission, or at
least distinguished it, by not requiring a breach of a fiduciary duty as called for in Section:14e-3(a). The
court stresses their concern to uphold the public policy behind the Act, namely to ensure the fairness of the
market. TRADITIONAL THEORY – ONLY CORPORATE INSIDERS WHO USE NONPUBLIC INFO
CHARGED; FIDUCIARY RELATIONSHIP REQUIRED. MODERN MISAPPROPRIATION THEORY –
62
WHEN ANYONE MISAPPROPRIATES CONFIDENTIAL INFORMATION FOR SECURITIES TRADING
PURPOSES, IN BREACH OF A DUTY OWED TO THE SOURCE OF THE INFORMATION. INSIDERS +
OUTSIDERS NOW CAN BE CHARGED.
Dirks v. SEC

ISSUE: Whether Petitioner violated Section:10(b) when he disclosed material nonpublic information to
clients and investors.

FACTS: An insider that worked for Equity Funding of America told Petitioner that the company was
overstating their assets and that Petitioner, who was an officer that provided investment analysis for a
broker-dealer firm, should investigate the fraud. Petitioner interviewed other employees who
corroborated the fraudulent allegations. Petitioner contacted a bureau chief at The Wall Street
Journal and offered his findings for the purpose of exposing the fraud. The bureau chief, fearing a libel
suit, declined to pursue it. During this time, Petitioner told investors and clients about the fraud, and
they reacted by selling their stake in the company. When the stock was being heavily traded and dipped
from $26 to $15, the New York Stock Exchange halted trading and Respondent, The Securities and
Exchange Commission, investigated and found fraud. Respondents then filed suit against Petitioner for
violations of Section:10(b) of the Securities and Exchange Act of 1934 for using the insider information
and perhaps receive commissions from those clients. The trial court and appellate court agreed with
Respondent, reasoning that anytime a tippee knowingly has inside information that they should publicly
disclose it or refrain from acting upon it.

RULE: In determining whether petitioner, as tippee, was under an obligation to disclose or abstain from
telling the properly authorities before dealing in the stock, it was necessary to determine WHETHER THE
INSIDER’S “TIP” CONSTITUTED A BREACH OF THE INSIDER’S FIDUCIARY DUTY. WHETHER THE
DISCLOSURE WAS A BREACH OF DUTY DEPENDED ON THE PURPOSE OR MOTIVATION OF THE
DISCLOSURE. THE TEST WAS WHETHER THE INSIDER WOULD PERSONALLY BENEFIT, DIRECTLY
OR INDIRECTLY, FROM HIS DISCLOSURE. ABSENT SOME PERSONAL GAIN, THERE WAS NO
BREACH. ABSENT A BREACH BY THE INSIDER, THERE WAS NO DERIVATIVE BREACH. A violation
could be found only where thee was an intentional or willful conduct designed to deceive or defraud
investors by controlling or artificially affecting the price of securities.

HOLDING: To determine whether the disclosure itself deceived, manipulated, or defrauded shareholders,
the initial inquiry was whether there had been a breach of duty by the insider. This required courts to
focus on objective criteria, i. e., whether the insider received a direct or indirect personal benefit
from the disclosure, such as a pecuniary gain or a reputational benefit that would translate into
future earnings. Moreover, to constitute a violation of Rule 10b-5, there had to be fraud. There was no
evidence that the former official’s disclosure was intended to or did in face deceive or defraud anyone. The
official intended to convey relevant information that management was unlawfully concealing. Under any
objective standard, the official received no direct or indirect personal benefit from the disclosure. The
Court found little legal significance to the dissent’s argument that the official and petitioner created
new “victims” by disclosing the fraud. They, in fact, prevented the fraud from continuing and
victimizing many more investors. Thus, the Court concluded that petitioner had no duty to abstain
from the use of the inside information he obtained, and it reversed the judgment of the Court of
Appeals.
63

DISCUSSION: The court ruled that mere knowledge of nonpublic information was not sufficient to
find a violation of the securities law. To prove a violation, the Securities and Exchange Commission was
required to establish that a tippee had received the information in violation of the tipper’s fiduciary duty
and, therefore, the tippee had a duty to disclose the nonpublic information before trading shares of stock in
the corporation at issue. In the absence of a fiduciary duty by the tipper, there was no derivative duty on the
tippee.
2.
Dirks was the 1970s Enron of today
a. SEC – wanted mere possession of insider info. to violate
b. Ct. –
information and using for personal gain
i. Here – no personal gain, rather exposing a fraud
3. INSIDER TRADEING
A. TRADING ON THE BASIS OF INFORMATION THAT NO ONE ELSE HAS
I. ACTION BROUGHT UNDER 10B-5
II. TO CONSTITUTE INSIDER TRADING, THE INFORMATION MUST BE MATERIAL
(SUBSTANTIAL EFFECT ON MARKET PRICE OF THE SECURITY) TEXAS GULF
4. MISAPPROPRIATION THEORY: PERSON COMMITS FRAUD “IN CONNECTION WITH” A
SECURITIES TRANSACTION & THEREBY VIOLATES 10B & 10B-5 WHEN HE MISAPPROPRIATES
CONFIDENTIAL INFORMATION FOR SECURITIES TRADING PURPOSES, IN BREACH OF A DUTY
OWED TO THE SOURCE OF THE INFORMATION O’Hagan
a. insider trading violation based on a breach of fiduciary duty by the trader if it involved
manipulation or deception
I. NO LIABILITY UNDER THIS THEORY IF:
1. THERE IS FULL DISCLOSURE
2. THERE IS NO FIDUCIARY RELATIONSHIP OR ITS FUNCTIONAL
EQUIVALENT (I.E. SIMILAR RELATIONSHIP OF TRUST & CONFIDENCE)
CHESTMAN
3. DUTY TO ABSTAIN/DISCLOSE IF INFORMATION “MISAPPROPRIATES”
5. DUTY TO DISCLOSE OR ABSTAIN
a. anyone in possession of material inside information must either disclose it to the investing pubic
or must abstain from trading in or recommending the securities concerned while such inside
information remains undisclosed TGS
b. inside information must be effectively disclosed in a manner sufficient to insure its availability to
the investing public TGS
c. party charged with failing to disclose market information must be under a duty to disclose it
Chiarella
i. STRANGERS: no duty to disclose or abstain simply because he is in possession of
material, nonpublic information if there is no fiduciary relationship Chiarella
II. FIDUCIARIES (INSIDERS & AGENTS)
1. insiders have 10b-5 duty to disclose or abstain while in possession of material,
nonpublic information obtained in a fiduciary relationship O’Hagan
2. Outsiders: outsiders with no relationship to the corporation in whose securities
they trade have an abstain-or-disclose duty while in possession of material,
nonpublic information obtained in a fiduciary relationship O’Hagan
3. Tippers: insider is liable for tipping material, nonpublic information if he
anticipates some direct or indirect personal benefit from the disclosure Dirks
a. also applies to non-insider tippers who know or should know a tip is
confidential & came from an insider who tipper improperly
b. tipper liable he did not trade but tippee or sub-tippee traded
III. TIPPEES (NON-INSIDER TIPPEES & SUB-TIPPEES)
64
1.
tippee assumes fiduciary duty not to trade (abstain/disclose) on material,
nonpublic information if they obtained the inside information improperly Dirks
2. BEFORE TIPPEE CAN BE LIABLE, THE INSIDER’S TIP MUST BE A BREACH
OF A FIDUCIARY DUTY & TIPPEE MUST KNOW OR HAVE REASON TO
KNOW THAT THERE HAS BEEN A BREACH (I.E. THAT THE
INFORMATION IS CONFIDENTIAL) Dirks
3. TEST: WHETHER INSIDERS WILL PERSONALLY BENEFIT
(DIRECTLY/INDIRECTLY) FROM THE DISCLOSURE
4. eavesdropper not liable for trading on inside information because insiders did
not anticipate any personal gain from their indiscretion Switzer
2. SECURITIES FRAUD
A. MATERIALITY
1.
619-623
Fact is material “if there is a substantial likelihood that a reasonable shareholder would consider it
important in deciding how to vote.”
A. MOSAIC THEORY: LOOK AT TOTALITY OF INFORMATION.
b. PREDICTIVE OF FUTURE EVENTS: [Basic v. Levinson (1988) Basic engaged in pre-merger
discussions, denied these discussions however instead of just keeping quiet. Info. was material.
Should have said “no comment.”] So CALCULATE: (PROBABILITY OF FACT BECOMING
TRUE) X (MAGNITUDE OF FACT). Merger is definitely gonna be big. Look at totality of
events.
c. QUANTITATIVE THEORY: By quantitative theory, fact is material if it would have an impact on
the STOCK PRICE OF 10% OR MORE, 10%+ TOTAL ASSETS, 10% ANNUAL INCOME. Less
than 5% probably not..
D. QUALITATIVE THEORY: By qualitative theory, ANY FACT SUCH AS DUTY OF LOYALTY
VIOLATIONS, CRIMINAL ACTIVITY.
e. SEC Fact: Material: Definitely.
f. OPINIONS, MOTIVES, OR REASONS: [V.A. Bankshares (1991): SHAREHOLDER MUST
PROVE THAT SPEAKER DID NOT BELIEVE OPINIONS, HAD NO REASON TO BELIEVE
OPINIONS, AND KNEW SOMETHING CONTRADICTORY]. Tough to do, however, statement
can be both just a misrepresentation and material. Doctrine of Puffery no longer alive. Bespeaks
caution can help.
TSC Indus., Inc. v. Northway, Inc.

ISSUE:
o
Whether petitioner corporations had made a materially misleading omission in the proxy statement
covering the liquidation of the first corporation by failing to accurately describe the extent of the
premium shareholders could expect in acquiring warrants of the second corporation in exchange
for their shares.
o
Whether the failure to disclose substantial purchases of the common stock of the second
corporation by that corporation and a major mutual fund in the period preceding the issuance of
the proxy statement was a materially misleading omission.
65

FACTS: Petitioners issued a joint proxy statement to their shareholders proposing the liquidation of
Petitioner TSC’s assets and their sale to Petitioner National. The proposal was accepted and Petitioner
TSC was dissolved. Respondent, a shareholder of Petitioner TSC, brought suit against Petitioners for
violating Rule 14a-3 of the Act by omitting from the proxy statement that Petitioner National would
gain control of Petitioner TSC by the transfer of Respondent’s shares to Petitioner National.
Respondent also stated that Petitioners violated Rule 14a-9 of the Act by omitting the material facts of
Petitioner National’s control of Petitioner TSC and how favorable the terms of the proposed
dissolution of Petitioner TSC would be to the shareholders. The Court of Appeals for the Seventh
Circuit upheld the denial of summary judgment for the alleged violation of Rule 14a-3 of the Act, but
reversed the denial of summary judgment for the alleged violation of Rule 14a-3 of the Act because the
omissions by Petitioners, as a matter of law, were material

RULE: AN OMITTED FACT WAS MATERIAL FOR PURPOSES OF RULE 14A-9 IF THERE WAS A
SUBSTANTIAL LIKELIHOOD THAT A REASONABLE SHAREHOLDER WOULD CONSIDER IT
IMPORTANT IN DECIDING HOW TO VOTE, AND SUMMARY IS NOT APPROPRIATE IF THE
OMISSION IS NOT MISLEADING AS A MATTER OF LAW.

Π ARGUMENT:


o
Although there was a substantial premium based upon the reduced value for the warrants and the
market prices of the other securities involved in the transaction, the proxy statement misled the
shareholder to calculate a premium substantially in excess of that premium.
o
the first corporation's shareholders should have been informed that the disputed purchases
accounted for one twelfth of all reported transactions in the second corporation's common stock
during a specified period because disclosure of the purchases would have pointed to the
existence or possible existence of conspiratorial manipulation of the price of the stock, which
would have had an effect on the market price of the second corporation's preferred stock and
warrants involved in the proposed transaction
∆ ARGUMENT:
o
a reference to a substantial premium for shareholders required no clarification or
supplementation because there was a substantial premium even if the second corporation's
warrants were assumed to have lost some value before the transaction was consummated
o
district court had properly concluded that there was a genuine issue of fact as to whether there had
been such coordination and that a showing of coordination was essential to the shareholder's
theory
HOLDING:
o
The Court stated that it was unwilling to sustain a grant of summary judgment to the shareholder
on the basis asserted, noting that to do so it would have to conclude as a matter of law that the
proxy statement would have misled shareholders to calculate the premium on the basis of later
market prices of the second corporation's shares and that the difference between that premium and
that which would be apparent from earlier prices and a reduced value for the warrants was
material, questions that the Court thought best left to the trier of fact
66
o

The Court held that if liability was to be imposed in the case upon a theory that it was
misleading to fail to disclose purchases suggestive of market manipulation, there had to be
some showing that there had in fact been market manipulation
DISCUSSION: the Supreme Court, held that an omitted fact was material for purposes of Rule 14a-9 if
there was a substantial likelihood that a reasonable shareholder would consider it important in
deciding how to vote. The decision was notable because the Supreme Court's formulation of the test for
determining materiality, while announced for use in proxy matters such as TSC Indus., would later be
employed in deciding issues of materiality in a much broader range of cases.
B. RELIANCE
1.
2.
3.
4.
915-934
Reliance is an element of 10b-5 COA – causal connection between a defendant's misrepresentation and a
plaintiff's injury.
a. P has BOP
b. Fraud-on-the-Market theory – investors’ information steers stock prices.
i. This is the applicability of the efficient market hypothesis. Market reflects reliance.
Must be impersonal, large national market. Face to face won’t do. Rebuttable by
showing that market was inefficient, plaintiff would have traded anyway.
c. commonly Class Action suits, yet reliance is specific to individuals makes reliance a common
question to the Class as a rebuttable presumption
Speculative events – Balancing likelihood of merger v. magnitude of event
Investors – knowledge of merger talks meets materiality test even before merger takes place
What do you recommend to CEO to say??
a. “No comment”
Basic Inc. v. Levinson

ISSUE: Whether the misleading statements regarding ongoing merger discussions were material enough to
alter the decision of a reasonable investor.

FACTS: Petitioners made chemical refractories for the steel industry. A second business, Combustion
Engineering, Inc., targeted Petitioner as a good acquisition. During merger discussions, the volume of
trading for Petitioner’s stock increased and the price was increasing, seemingly due to rumors of a
potential acquisition. Petitioner publicly refuted the rumors of a merger. Shortly thereafter Petitioner
requested to suspend trading because of merger talks. Respondents sold their shares before the suspension
but after the public denials of merger discussions. Therefore Respondents claimed that Petitioners violated
Section 10(b) of the Securities Exchange Act and of Rule 10b-5.

RULE: MISLEADING STATEMENTS DURING MERGER DISCUSSIONS WILL BE MATERIAL UNDER
RULE 10B-5 IF THE MISSTATEMENTS WOULD HAVE CHANGED THE VIEW OF THE TOTAL
INFORMATION BY A REASONABLE INVESTOR.
o
The Court held that it was not inappropriate to apply a presumption of reliance under the fraud on
the market. In order to invoke the presumption, a plaintiff had to allege and prove: (1) that the
defendant made public misrepresentations; (2) that the misrepresentations were material;
(3) that the shares were traded on an efficient market; (4) that the misrepresentations would
induce a reasonable, relying investor to misjudge the value of the shares; and (5) that the
67
plaintiff traded the shares between the time the misrepresentations were made and the time
the truth was revealed.

HOLDING: The court determined that determining whether misleading statements or omissions were
material under Rule 10b-5 would require a fact-based assessment. The court did not adopt Petitioner’s
“agreement-in-principle” test that would have considered only misstatements after an agreement was made
in principle. The court did not think that the probability of a failed merger outweighed the importance of
providing the information to the investor. The court instead took a fact-based approach, reasoning that
the probability would be weighed against the magnitude of the facts. In this case, a merger has a high
magnitude on investor decisions and therefore the probability of a successful merger does not have to be as
absolute as more trivial topics. The misstatements would still need to be material.

DISCUSSION: The court does not want the investors to be treated as a group that is incapable of
understanding corporate goings-on. However, they still require that the misstatements be material. At one
point, they note in Footnote 17 that a “no comment” may be a safe alternative for corporate officers
who would otherwise feel the need to offer a misleading statement.
C. PURCHASE OR SALE
817-820
1.
Blue Chip Stamps v. Manor Drug Stores –
a. P offered stock but refused purchase; later sued claiming prospectus was misleading.
b. Ct. – Requires standing to bring action private action under 10b-5 limited to actual purchasers
and sellers of securities.
2. BIRNBAUM RULE – LIMITS THE ACTION TO ACTUAL PURCHASERS/SELLERS
a. Holders of puts, calls, options, and other contractual rights or duties to purchase or sell securities
have been recognized as "purchasers" or "sellers" of securities for purposes of Rule 10b-5
b. Justice Rehnquist – discussion of how P can use this to sue if stock goes up after P did NOT
purchase if this decision isn’t applied b/c Businesses opened up to discovery = disruption of
normal business activities
D. SCIENTER
1.
2.
820-824
Ernst & Ernst v. Hochfelder –
a. Brokerage firm customers P suit against audit firm for not catching securities scheme by
President.
i. mail rule at office – letters made out to President only opened by Pres. contrary to good
Acct. practices and D should have discovered this
b. Ct. – No private cause of action for damages under 10b-5 without an allegation of scienter =
intent to deceive, manipulate, or defraud Need actual knowledge
Scienter – a mental state embracing intent to deceive, manipulate or defraud
a. aware of the state of affairs & appreciated propensity of misstatement or omission to mislead
b. some cts. – reckless disregard/gross negligence may be enough to prove scienter
c. Negligence insufficient.
B. SECTION 14 - PROXY REGULATION
1.
589-609; 623-658
Gives someone else the power to cast your vote
a. Sec. 14 & 12
i. 12 – registration with SEC
1. issuer holds $10 million assets and 500+
2.
68
3. if under 12, must comply with 14
ii. 14 – very broad restrictions on proxy solicitation power given to SEC
1. Section 14(a) – worded about as broadly as possible, forbidding any person to
solicit any proxy or consent or authorization in respect of any security therein
specified in contravention of such rules and regulations as the SEC may
prescribe as necessary or appropriate in the public interest or for the
protection of investors.
2. power limit = necessary or public interest or protection of interest
Studebaker Corp. v. Gittlin

ISSUE: Whether Petitioner’s demand for inspection of the stockholders list and his solicitation of
authorizations were part of a continuous plan intended to end in solicitation and to prepare the way for
success.

FACTS: Petitioner began a proceeding to inspect the record of Respondent’s shareholders. He
indicated that he was acting on behalf of himself and on the written authorization from 42 other
shareholders owning shares that constituted over 5% of the company’s stock. Petitioner and his associates
were trying to get management to agree to certain changes in its board of directors and had announced their
intention to solicit proxies for the annual meeting if the request was not met. When these talks had broken
down he had requested access to the stockholders list and been refused. Respondent’s complaint alleges
that Petitioner obtained the authorization from the other stockholders in violation of the Proxy
Rules. Specifically, he had authorization prior to filing proxy material with the SEC. The District
Court enjoined the use of other stockholders’ authorizations to obtain inspection of Respondent’s
shareholders list.

RULE: A LETTER WHICH DOES NOT REQUEST THE GIVING OF ANY AUTHORIZATION WAS
SUBJECT TO THE PROXY RULES IF IT WAS PART OF “A CONTINUOUS PLAN” INTENDED TO END
IN SOLICITATION AND TO PREPARE THE WAY FOR SUCCESS.

HOLDING: Yes. This was Petitioner’s declared purpose.

DISCUSSION: The copy of a stockholders list is a valuable instrument to a person seeking to gain
control and therefore shareholders must have full information before they aid in its procurement.
Presumably the stockholders who gave authorizations were told something and one need only spread
misinformation adequately before beginning to solicit and the Commission would be powerless to protect
shareholders.
In the Matter of Catepillar, Inc.

ISSUE: Whether Caterpillar’s failure to disclose information about the 1989 earnings of its fully owned
subsidiary, CBSA, and uncertainties about its 1990 earnings violate the MD & A Rules.

FACTS: Caterpillar has many divisions and subsidiaries that are viewed and managed on a consolidated
basis. Caterpillar’s subsidiary, Caterpillar Brazil, SA, (CBSA), accounted for 23% of Caterpillar’s
net profits of $497 million. However, its revenues represented only 5% of the Caterpillar’s revenues.
In 1989 CBSA had a greater than usual profit due to currency translation gains, export subsidies,
69
interest income, and Brazilian tax loss carry forwards. CBSA’s financial results were presented on a
consolidated basis with the remainder of Caterpillar’s operations. Thus, the impact of CBSA’s operations
on Caterpillar’s overall results was not apparent from the face of Caterpillar’s financial statements. At a
board meeting in February of 1990, management recognized that Caterpillar’s 1990 forecast depended on
CBSA’s 1990 forecast. Further, CBSA’s 1990 forecast was difficult to predict because Brazil was volatile
and a new administration would be instituting sweeping economic and monetary reforms. Management
began providing projections to the board of directors that separated out the impact of Brazil. In April of
1990, management presented to the board the likely negative effects the economic changes in Brazil
would likely have on CBSA’s sales and profits. The impact was not clear but expected to be negative.
Management noted that the profit in Brazil would be substantially lower than in 1989. Further, these losses
might not be balanced by gains in other parts of the world and consolidated results would be lower than
originally anticipated. Neither Form 10-K nor Form 10-Q indicated the extent to which CBSA had
affected Caterpillar’s bottom line in 1989 nor did they indicate that a decline in CBSA’s future
results could have a material adverse effect on Caterpillar’s bottom line in 1990.

RULE: INFORMATION MUST BE INCLUDED IN THE MD & A IF FAILURE TO INCLUDE IT WOULD
LEAVE INVESTORS WITH AN INCOMPLETE PICTURE OF THE CORPORATION’S FINANCIAL
CONDITION AND RESULTS OF OPERATIONS AND DENY THEM THE OPPORTUNITY TO SEE THE
COMPANY THROUGH THE EYES OF MANAGEMENT.

HOLDING: Yes. Caterpillar failed to include required information about CBSA in the MD & A leaving
investors with an incomplete picture of Caterpillar’s financial condition and results of operations and
denied them the opportunity to see the company through the eyes of management.

DISCUSSION: Caterpillar’s Annual Report on Form 10-k for 1989 should have discussed the impact of
CBSA on Caterpillar’s overall results of operations. Given the magnitude of CBSA’s contribution to
Caterpillar’s overall earnings, disclosure of the extent of that contribution was required under the
MD & A provisions since CBSA’s earnings materially affected Caterpillar’s reported income from
continuing operations. Further, the MD & A should have discussed the currency translation gains, export
subsidies, interest income, and Brazilian tax loss carry forwards since such items were significant
components of CBSA’s revenues that should have been identified in order for a reader to understand
Caterpillar’s results of operations. Both the Annual Report Form 10-K for 1989 and the Quarterly
Report on Form 10-Q should have discussed the future uncertainties regarding CBSA’s operations,
the possible risk of Caterpillar having materially lower earnings as a result of that risk and
quantified the impact of such risk to the extent reasonably practicable. At the February 1990 board
meeting, management told the directors that the impact of Brazil was so significant to reduced 1990
projected results it was necessary to explain it to them in detail. By the end of the first quarter it became
more apparent that management could not conclude that lower earnings form CBSA were not reasonably
likely to occur nor could they conclude that a material effect on Caterpillar’s results of operations was not
reasonably likely to occur due to CBSA’s lower earnings.
Virginia Bankshares, Inc. v. Sandberg

ISSUE:
70
o
A Whether a proxy statement couched in conclusory or qualitative terms, purporting to explain
directors’ reasons for recommending a corporate action, be materially misleading within the
meaning of Rule 14a-9?
o
Whether causation of damages compensable under Section: 14(a) can be shown by a member of a
class of minority shareholders whose votes are not required by law or corporate bylaw to authorize
the corporate action subject to the proxy solicitation.

FACTS: Appellants First American Bankshares, Inc. (”FABI”) began a “freeze-out” merger in which the
First American Bank of Virginia merged into Virginia Bankshares, Inc. (”VBI”) (collectively
“Appellants”). VBI was a wholly owned subsidiary of FABI and owned 85% of the Bank’s shares. The
remaining 15% were owned by the Bank’s minority share holders. The Bank’s executive committee and
board approved the merger at $42.00 per share. Although not required under state law, the directors
solicited proxies for voting on the proposed merger. In this solicitation, the directors explained that
they had approved the merger because of the “high” valuation of the minority holders’ stock.
Although most minority shareholders gave their proxies, Respondent did not. Respondent brought suit
under SEC Rule 14a-9, which prohibits the solicitation of proxies via materially misleading
statements. The trial court instructed the jury that so long as the proxy solicitation involved materially
false statements and that the proxy solicitation was an “essential link” in the merger process, damages
could be awarded to Respondent. The jury awarded respondent $18.00 dollars per share. The appeals court
affirmed.

RULE: IN A SECURITIES FRAUD CASE, A STATEMENT OF OPINION MAY BE A FALSE FACTUAL
STATEMENT IF THE STATEMENT IS FALSE, DISBELIEVED BY ITS MAKER, AND RELATED TO
MATTER OF FACT WHICH CAN BE VERIFIED BY OBJECTIVE EVIDENCE.

HOLDING: Reversed. The knowingly false statements might have been actionable even though
conclusory in form, but respondents failed to demonstrate the equitable basis required to extend the
private action pursuant to 15 U.S.C.S. Section: 78n(a) to them. A proxy statement issued in connection
with a cash merger could not be made the basis of a federal claim under the S.E.C. proxy regulations if the
votes being solicited by the proxy statement could not affect the outcome of the vote. In other words, a
statement couched in terms of opinion may nevertheless be materially misleading, but a false statement in a
proxy solicitation does not meet a test of “causal necessity” if it is addressed solely to shareholders whose
combined votes are not sufficient to prevent the action from being taken.

DISSENT & CONCURRENCE:
o
Justice Scalia concurring in part and concurring in the judgment. Scalia notes that some statements
that contain the word “opinion” represent facts as facts rather than as opinions, and that in this
event, the normal rule of Section: 14(a) liability should apply. Scalia thinks that this is the case
with these facts.
o
Justice Stevens, with whom Justice Marshall joins, concurring in part and dissenting in part.
Stevens asserts that shareholders may bring an action for damages under Section: 14(a) whenever
materially false or misleading statements are made in proxy statements. That the solicitation of
proxies is not required by law or by the bylaws of a corporation does not authorize corporate
officers, once they have decided for whatever reason to solicit proxies, to avoid the constraints of
the statute. Therefore, the Court of Appeals judgment should be affirmed.
71
o

Justice Kennedy, with whom Justice Marshall, Justice Blackmun, and Justice Stevens join,
concurring in part and dissenting in part. Kennedy dissents from the Court’s reasoning as to the
causation required for a Rule 14(a) violation. The real question should be whether an injury was
shown by the effect the nondisclosure had on the entire merger process, including the period
before the votes were cast. Full disclosure, even when the majority shareholder dominates the
voting process, can have the practical effect of the merger transaction not going forward and
avoiding injury to minority shareholders. Nonvoting causation is plausible where the misstatement
of omission is material and the damage sustained by minority shareholders is serious.
DISCUSSION: The Court here ruled that terms like “high value,” in a commercial context, are
reasonably understood to rest on a factual basis. Because of this, these terms could be found
misleading by garden variety evidence. In addition, the Court found that such terms can be
materially misleading even if other information within the statement enables an expert to deduce that
such statements are false. Proxy statements should inform, and not challenge, the reader’s “critical
wits.” Despite these conclusions, however, the Court ruled that because the link between the merger and
the proxy statement was too speculative, there was no private right of action for the minority shareholders.
Minority shareholder’s claim was that the vote was cosmetic, and the minority shareholders’ votes
were not required by state law or corporate bylaw.
1. SEC. 14A-8: S/H PROPOSALS
A. NEED SPECIFIC AMOUNT OF OWNERSHIP AND FOLLOWING GUIDELINES P.778-783
B. CORPORATION CAN EXCLUDE PROPOSALS UNDER CERTAIN CIRCUMSTANCES
(QUESTION 9)
I. IMPROPER UNDER STATE LAW
II. NO PERSONAL GRIEVANCE OR SPECIAL INTEREST (E.G. LABOR UNIONS)
III. RELATES TO “ORDINARY BUSINESS OPERATIONS”
IV. RELATES TO ELECTION…NEXT CASE
Rauchman v. Mobil Corp.

ISSUE: Whether Mobil properly excluded a proposal from its proxy statement that would amend Mobil’s
bylaws to prevent a citizen of an OPEC country from sitting on Mobil’s board of directors. .

FACTS: On October 31, 1980 Respondent appointed a Saudi Arabian citizen, Suliman S. Olayan, to
its Board of Directors. Shortly thereafter Petitioner, who owns 64 voting shares of Mobil stock,
submitted a proposed amendment to Mobil’s bylaws for inclusion in Mobil’s proxy statement for the
1982 annual meeting. The proposed amendment would prevent a citizen of an OPEC country from
sitting on Respondent’s board of directors. Respondent wrote to the SEC staff requesting that they
recommend to the Commission that no action be taken if Respondent were not to include Petitioner’s
proposal in the proxy statement. The SEC staff agreed. The staff noted that in its view, the proposal called
into question the qualifications of Olayan for reelection and thus was an effort to oppose
management’s solicitation on behalf of his reelection. Following the staff’s decision, Petitioner brought
suit to force Respondent to include the proposal in its proxy statement. The District Court granted Mobil’s
motion for summary judgment

RULE: A PROPOSAL THAT CALLS INTO QUESTION THE QUALIFICATION OF A BOARD MEMBER
FOR REELECTION IS AN EFFORT TO OPPOSE MANAGEMENT’S SOLICITATION ON BEHALF OF
72
THE REELECTION PROCESS AND MAY BE EXCLUDED FROM THE CORPORATION’S PROXY
STATEMENT.

HOLDING: Yes. Mobil properly excluded the proposal from its proxy statement because the proposal is an
effort to oppose management’s solicitation on behalf of the reelection process.

DISCUSSION: The election of Olayan to the board would have been forbidden by the proposed
bylaw amendment since the amendment would have made him ineligible to sit on the board. The
proposed comment unmistakably refers to Olayan. A Mobil stockholder could not vote for Petitioner’s
proposal and at the same time ratify the nomination of Mr. Olayan. Therefore the proposal could be viewed
as an effort to oppose management’s solicitation on behalf of Olayan’s reelection.
C. SECTION 16
1.
909-915
Section 16: Directors, Officers and Principal S/H
a. regulates sales/purchases w/in 6 months (only applies to Sec. 12 corporations)
b. purpose: discourage insider knowledge advantages
c. strict liability – showing of information use not required, only timing
i. anyone who owns stock can sue to recover lost profits (even if you don’t own stock at
time they made sale)
ii. Attorney gets a friend to buy some stock  sue on behalf and collect atty. fees from
Corp.!
VII. TAKEOVERS
1.
2.
3.
4.
5.
974-989
Proxy Fights – effort to obtain sufficient proxy votes to elect a majority of BOD
a. who pays costs? – sometimes co. pays if takeover successful: policy personality distinction 
fight about people in mgt. OR policy disagreement
Exchange Offer – public offering of stock (file with SEC/no surprise element)
Cash Tender Offers – buy up shares of target company; offer above market price to S/H to tender their
shares for a price  typically advertised in newspaper
Leveraged Buyouts (LBO) – purchase outstanding market stock for substantial premium over market price
a. financed through loans  new debt obligation of target company if succeeds!
b. big interest payments on debt  sell portions of co., higher income from expanded business, etc.
used to pay
c. works in good economy; bad economy – co. with too much debt went under
Williams Act: §13/14 (companies registered under Sec. 12)
a. 5%+ – Requires disclosures of stock accumulations of more than 5% of a target’s equity securities
so the stock market can react to the possibility of a change in control; [different than §16 10%
rule]
b. Tender offers – By anyone who makes a tender offer for a company’s equity stock so
shareholders can make buy-sell-hold decisions; and
c. Structure of tender offers – Regulates the structure of any tender offer so shareholders are not
stampeded into tendering.
d. Same price - Tender offeror must give same price to all shareholders, and that must be the
highest price ever offered.
A. DEFENSES: BUSINESS JUDGMENT RULE
1.
1026-1053
Panter v. Marshall Field
73
a.
2.
3.
4.
5.
6.
BOD attempted to prevent merger by creating an anti-trust problem – open stores where bidder
has stores purely to create anti-trust problems  S/H argue these where not business
expansions due to increasing profits and stock price dropped
b. Ct. – allowed BOD actions due to BJR
c. dissent – BJR only used by BOD to uphold their personal interests
Unocal v. Mesa Petroleum –
a. Whether defendant BOD had the power and duty to oppose a takeover threat it reasonably
perceived as being harmful to the corporate enterprise, and, if so, whether the action taken was
entitled to protection of business judgment rule.
b. Ct. – Directorial power to oppose plaintiffs' tender offer and to undertake a selective stock
exchange made in good faith and upon a reasonable investigation pursuant to a clear duty to
protect the corporate enterprise. The court further held that the repurchase plan chosen by
defendant was reasonable in relation to the perceived threat and was entitled to be measured
by business judgment rule.
i. A court will not substitute its views for those of a corporation's board if the latter's
decision can be attributed to any rational business purpose.
ii. A corporate board's power to act derives from its fundamental duty and obligation to
protect the corporate enterprise, which includes stockholders, from harm reasonably
perceived, irrespective of its source.
1. Burden by showing good faith and reasonable investigation.
c. Two Prong Test:
i. BOD reasonably perceived threat – “dominant motive” review
ii. Proportionality of action to threat – reasonably related
iii. Fail either prong  BOD violated fiduciary duty
Revlon v. MacAndrews & Forbes –
a. P S/Hs suit against BOD for not maximizing profit in co. auction of assets. D claim BJR protection.
b. Ct. – allow BJR protection because other consideration besides max profit mattered.
i. Revlon BOD used “white knight” Forstmann to submit higher bid than hostile bidder
Pantry Pride.
ii. Ct. – focus not on BOD concerns of threat, rather reasonableness of lockup response.
iii. Takeover inevitable  BOD must auction to get best $ for S/H (case gives NO auction
details)
Unitrin v. American Gen. –
a. Unitrin Mgt. repurchased 10% of shares  increasing Mgt. holdings from 23% to 28%  pill
required a 75% majority S/H approval of any merger = proxy contest untenable.
b. Ct. – repurchase did not preclude a proxy contest = bidders could still win a proxy contest BOD
could protect S/H from their own mistakes: reasonableness test + proportionality test
I. BOD must carry its own initial TWO-PART BURDEN:
1. REASONABLENESS TEST – REASONABLE GROUNDS FOR BELIEVING
THAT A DANGER TO CORPORATE POLICY AND EFFECTIVENESS EXISTED
2. PROPORTIONALITY TEST – DEFENSIVE RESPONSE WAS REASONABLE IN
RELATION TO THE THREAT POSED
Paramount v. Time-Warner –
a. Time targeted Warner for a stock for stock merger; 2 weeks before S/H approve merger,
Paramount attempts hostile bid of Time’s shares  fearing S/H would take P’s bid, Time
restructured Warner deal to buy 51% shares at premium price, using debt to finance while not
giving Time’s S/H a vote.
b. Ct. – allowed Time BOD to restructure: merger not breaking up co. (Revlon) nor was P’s offer
adequate according to BOD (Unocal)
Paramount v. QVC –
74
Paramount keeps looking for targets  Viacom. Agreed merger = P’s S/H get cash + Viacom
stock  after merger announcement, QVC went after P’s stock with better offer and Viacom
volleyed offers higher and higher. P BOD refused QVC bids as “illusory”  QVC sued claimed
BOD breach fiduciary duty (Revlon duty to seek best value for S/H).
b. Ct. – agreed with QVC  opened door to auction which Viacom won (paying $107 instead of
original $69)
Progression of Delaware Ct. decisions:
a. Unocal – Proportionality Test
b. Moran – allows pill that forces bidders to negotiate w/incumbent BOD
c. Revlon – BOD must conduct fair auction when Mgt. bidder plans to bust up Revlon
d. Paramount v. Time-Warner – allows BOD to sidestep unsolicited cash bid
e. Paramount v. QVC – prohibits target BOD from preferring one cash offer w/o considering the
alternative
f. Unitrin – allows defenses to weaken proxy fight/tender offer because S/H might be ignorant
a.
7.
B. DEFENSES: POISON PILLS
1.
1004-1026
Poison Pill (Rights Plan) – Strategy used by corporations to discourage a hostile takeover by another
company. The target company attempts to make its stock less attractive to the acquirer. There are two
types of poison pills:
a. "flip-in" allows existing shareholders (except the acquirer) to buy more shares at a discount.
b. "flip-over" allows stockholders to buy the acquirer's shares at a discounted price after the
merger.
Moran v. Household International, Inc.


ISSUE:
o
Whether the business judgment rule is the standard to be applied to the adoption of the Plan by the
board.
o
Whether Delaware General Corporation Law authorizes the issuance of the Plan.
o
Whether the Board is authorized to usurp stockholder’s rights to receive hostile tender offers.
o
Whether the Board is authorized to fundamentally restrict stockholders’ rights to conduct a proxy
contest.
FACTS: The Board of Directors of Appellees adopted the Preferred Share Purchase Rights Plan,
(Plan), as a preventative measure against future takeover attempts. Subsequently, Appellants brought
suit. The Plan provides that Appellee’s common stockholders are entitled to the issuance of one Right
per common share under two triggering conditions. The triggers are, first, a tender offer for 30% of the
shares and second, the acquisition of 20% of the shares by any single entity or group. Once triggered, the
Right authorizes the holder to purchase $200 of common stock of the offeror or purchaser for $100
thereby causing massive dilution of the value of the aggressor’s shares. Prior to the triggering event, the
right is automatically fixed to the shares and can’t be traded separately form the shares
75

RULE: THE BOARD OF DIRECTORS IS AUTHORIZED TO ADOPT A “POISON PILL.” THE DECISION
TO ADOPT A POISON PILL SHALL BE EVALUATED UNDER THE BUSINESS JUDGMENT RULE.

HOLDING:
o
Yes. The business judgment rule is the standard by which to evaluate the adoption of a
defensive mechanism adopted to ward off possible future advances.
o
Yes. Sufficient authority exists in 8 Del.C. Section: 157 to authorize the issuance of the Plan.
o
Yes. The Plan does not prevent stockholders from receiving tender offers and the change of
Household’s structure was less than that which results form the implementation of other defensive
mechanisms upheld by various courts.
o
Yes. There was sufficient evidence at trial to support the finding that the effect upon proxy
contests will be minimal.

DISCUSSION: This case deals with a defensive mechanism adopted to ward off possible future advances
and not adopted in reaction to a specific threat. The business judgment rule applies here particularly
because the pre-planning reduces the risk that management will fail to exercise reasonable judgment
under the pressure of a takeover bid. Sufficient authority exists in 8 Del.C. Section: 157 to authorize the
issuance of the Plan. Appellants are unable to demonstrate that the legislature meant to limit the
applicability of Section: 157 to only the issuance of Rights for the purposes of corporate financing. The
Plan is distinguishable from sham securities. Lastly, there is insufficient nexus to the state for there to be
state action that may violate the Commerce Clause or Supremacy Clause. Under the Plan a corporation
can still be acquired by a hostile tender offer. Further, the Directors cannot arbitrarily reject the
offer because they would still be held to the business judgment rule. The Plan itself is no different from
any other defense mechanism. While the Plan does deter the formation of proxy efforts of a certain
magnitude, it does not limit the voting power of individual shares. Evidence at trial established that proxy
contests can and have been won with an insurgent ownership of less than 20% and even large holdings do
not guarantee success.
2.
Poison Pill in action:
a. Created – pill right issued with all stock and sits dormant
b. 1st Trigger – acquirer buys at least 20% stock/makes tender offer  triggered right of BOD to
redeem rights
c. 2nd Trigger – exercisable rights to purchase securities at half price
d. Effect – force Bidder to negotiate with BOD beforehand to get an “antidote”
Mentor Graphics Corporation v. Quickturn Design Systems, Inc.

ISSUE:
o
Whether the board had reasonable grounds to believe that the hostile bid constituted a threat to
corporate policy and effectiveness.
o
Whether the defensive measures adopted were proportionate or reasonable in relation to the threat
that the board reasonably perceived.
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
FACTS: Plaintiff sold an emulation product to Defendant. Some time later, Plaintiff acquired Meta
Systems, a French company involved in the emulation business, and began to market its products in the
United States. Defendant reacted by successfully suing for patent infringement. Plaintiff then decided
to acquire Defendant. Plaintiff announced an unsolicited cash tender offer for all outstanding
common shares of Defendant at a price representing a 50% premium over Defendant’s immediate
pre-offer price and a 20% discount from Defendant’s February 1998 stock price levels. Plaintiff also
announced its intent to solicit proxies to replace the board at a special meeting. Defendant concluded
that Plaintiff’s offer was inadequate and recommended that Defendant shareholders reject Plaintiff’s
offer. Then the board amended the by-laws to delay a shareholder called special meeting for at least
three months. The board also amended Defendants shareholder rights plan by eliminating its dead
hand feature and replacing it with a Deferred Redemption Plan, (DRP) under which no newly elected
board member could redeem the rights plan for six months after taking office if the purpose of the
redemption would be to facilitate transaction with an “Interested Person” An Interested Person would be
one who proposed the election of the new directors to the board, in this case, Plaintiff. Plaintiff then filed
this action seeking declaratory judgment that Defendant’s newly adopted takeover defenses are invalid
and an injunction requiring the board to dismantle those defenses.

RULE: WHEN A BOARD OF A CORPORATION TAKES ACTION TO RESIST OR DEFEND AGAINST A
HOSTILE BID FOR CONTROL THE TARGET COMPANY BOARD’S DEFENSIVE ACTIONS WILL BE
ENTITLED TO BUSINESS JUDGMENT RULE PROTECTION ONLY IF IT CAN ESTABLISH THAT 1) IT
HAD REASONABLE GROUNDS TO BELIEVE THAT THE HOSTILE BID CONSTITUTED A THREAT TO
CORPORATE POLICY AND EFFECTIVENESS AND 2) THAT THE DEFENSIVE MEASURES ADOPTED
WERE REASONABLE IN RELATION TO THE THREAT THAT THE BOARD REASONABLY PERCEIVED.

HOLDING:

o
Yes. The board reasonably perceived a cognizable threat.
o
No. The defensive measures adopted were not reasonable in relation to the threat the board
reasonably perceived.
DISCUSSION: The evidence shows that the perceived threat was the concern that Defendant
shareholders might mistakenly accept Plaintiff’s inadequate offer, and elect a new board that would
prematurely sell the company before the new board could adequately inform itself of Defendant’s
fair value. The board reasonably perceived a cognizable threat. The board’s justification for adopting the
DRP was to force any newly elected board to take sufficient time to become familiar with Defendant and
its value and to provide shareholders the opportunity to consider alternatives, before selling. DPR does not
operate to delay a sale to any bidder but only an “Interested Person,” Plaintiff. Defendants have also
failed to carry their burden by failing to explain why a six-month period is reasonable. Further, the
purpose of the DRP is accomplished by the bylaw amendments.
International Brotherhood of Teamster v. Fleming Companies

ISSUE:
o
Whether Oklahoma law restricts the authority to create and implement shareholder rights plans
exclusively to the board of directors.
77
o
Whether shareholders may propose resolutions requiring that shareholder rights plans be
submitted to the shareholders for vote at the succeeding annual meeting.

FACTS: Appellee owns sixty-five shares of Appellant. In 1986 Appellant implemented a shareholder’s
rights plan, commonly referred to as a “poison pill” as an anti-takeover mechanism. Appellee was
critical of this plan seeing it as a means of entrenching the current board of directors in the event Appellant
became the target of a takeover. Appellee passed a non-binding resolution at the shareholders meeting
calling on the board to redeem the existing rights plan. Appellant’s board was hostile to the resolution
and the rights plan remained intact. Appellee then prepared a proxy statement for inclusion in the
proxy materials for the next annual shareholders meeting. The proposed amendment to the bylaws
would require any rights plan implemented by the board of directors to be put to the shareholders for a
majority vote. Appellant refused to include the resolution in its proxy statement. Appellee brought suit
and won. Appellant appealed and moved to suspend the injunction hoping to postpone shareholder vote on
the proxy issue until after the resolution of this case. The motion was denied. Fleming was forced to allow
its shareholders to vote on the proxy. It passed with 60% of the voted shares.

RULE: SHAREHOLDERS MAY, THROUGH PROPER CHANNELS OF CORPORATE GOVERNANCE,
RESTRICT THE BOARD OF DIRECTORS’ AUTHORITY TO IMPLEMENT SHAREHOLDER RIGHTS
PLANS.

HOLDING:

o
No. There is no exclusive authority granted boards of directors to create and implement
shareholder rights plans, where shareholder objection is brought and passed through official
channels of corporate governance.
o
Yes. There is no authority precluding shareholders from proposing resolutions, or bylaw
amendments that restrict board implementation of shareholder rights plans assuming the
certificate of incorporation does not provide otherwise.
DISCUSSION: Appellant argues that the board of directors only may create and issue rights and options.
Appellant relies on 18 O.S.1991 Section: 1038 to claim that “corporation” is synonymous with “board of
directors.” The former Business Corporations Act, 18 Section: 1.2(1) and (23) defines both terms
differently and it is unlikely that the legislature would interchange them as Appellant contends. A
shareholder rights plan is essentially a variety of stock option plan. Other cases reveal that stock option
plans can be subject to shareholder approval. Nothing in existing case law indicates that the shareholder
rights plan is exempt form shareholder adopted bylaws.
C. DEFENSES: STATE LEGISLATION
989-1004
(IL §7.85)
7.85 - VOTE REQUIRED FOR CERTAIN BUSINESS COMBINATIONS – requires supermajority voting for some actions.
CTS Corp. v. Dynamics Corp of America

ISSUE:
78
o
Whether the Williams Act preempts the Indiana Act.
o
Whether the Indiana Act violates the Commerce Clause due to unequal treatment between in-state
and out-of-state entities

FACTS: Appellee owned 9.6% of Appellant, CTS Corporation and announced a tender offer to increase
their ownership to 27.5%. Six days before their announcement, an Indiana law, Indiana’s Control
Share Acquisitions Act, came into effect. The Act allows for disinterested shareholders to hold a
shareholders’ meeting to discuss the merits of a tender offer for controlling shares. Appellee argues
that the Act is preempted by a federal law, the Williams Act. The Williams Act provides guidelines that
offerors need to follow when making a tender offer. Appellee also argues that the Indiana Act violates the
Commerce Clause because it treats in-state entities differently from out-of-state entities.

RULE: STATES, AS THE CREATORS OF CORPORATE ENTITIES, HAVE THE ABILITY TO DEFINE THE
PROTECTIONS AFFORDED TO SHAREHOLDERS PROVIDING THAT IT IS POSSIBLE TO COMPLY
WITH THE STATE LAW AND FEDERAL LAW. ABSENT AN EXPLICIT INDICATION BY CONGRESS OF
AN INTENT TO PRE-EMPT STATE LAW, A STATE STATUTE IS PRE-EMPTED ONLY WHERE
COMPLIANCE WITH BOTH FEDERAL AND STATE REGULATIONS IS A PHYSICAL IMPOSSIBILITY
OR WHERE THE STATE LAW STANDS AS AN OBSTACLE TO THE ACCOMPLISHMENT AND
EXECUTION OF THE FULL PURPOSES AND OBJECTIVES OF CONGRESS.

HOLDING:

o
The Indiana Act is not preempted by the federal law because entities can comply with both
federal and state law without frustrating the federal law. The state law furthers the federal
law’s goal of protecting shareholders from tender offer abuses but does not tip the balance
between management and acquirers. Instead, the rights of shareholders are strengthened in a
situation where many believe shareholders are traditionally at a disadvantage.
o
The Indian Act does not violate the Commerce Clause because corporations by definition are
entities created by state law, and therefore it is only logical that states would define the
rights and characteristics of corporations. The United States Supreme Court noted that there are
several instances where states have laws regulating the powers of acquiring entities, such as
supermajority voting requirements.
DISCUSSION: The decision illustrates that states can offer further protection, in particular for
shareholders, in response to the deluge of questionable tender offers.
VIII. INDEMNIFICATION AND INSURANCE
951-973
(IL § 8.75)
IL 8.75 – Indemnification of officers, directors, employees and agents; insurance- may indemnify – if good faith;
settlement does not presume bad faith; shall indemnify – been successful on the merits or otherwise; who? –
majority BOD vote, independent legal counsel or S/H vote
(MBCA § 8.50)
79
MBCA 8.50 – Indemnification def., permissive, mandatory, pretrial expenses
1.
D&O Insurance – Dir. and Officer Insurance for indemnification paid by corporation.
a. occurrence v. claims made
i. Occurrence – e.g. car insurance cares about when the accident took place, not whether
you’re insured at time of lawsuit
ii. Claims made – coverage in effect needed when claim made against you
1. used mostly in business matters – important because a new insurer will be
responsible for past actions (even if other insurer covered you when acts
occurred)
Merritt – Chapman & Scott Corp. V. Wolfson

ISSUE : Whether a corporate officer is entitled to indemnification in the absence of vindication by a
finding or concession of innocence.

FACTS : Plaintiffs were charged with participation in a conspiracy to violate federal securities laws,
perjury and filing false annual reports with the SEC and New York Stock Exchange. After several trials,
Wolfson entered a plea of no contest to filing false annual reports, was fined $10,000, and the other charges
against him were dropped. Gerbert agreed not to appeal his conviction for perjury, was fined $2,000, and
other charges against him were dropped. The charges against Kosow and Staub were also dropped.
Plaintiffs seek indemnification by Defendant, against expenses incurred in these criminal proceedings.

RULE : CORPORATE OFFICERS ARE ENTITLED TO PARTIAL INDEMNIFICATION IF SUCCESSFUL
ON A COUNT OF AN INDICTMENT, WHICH IS AN INDEPENDENT CRIMINAL CHARGE EVEN IF
UNSUCCESSFUL ON ANOTHER RELATED COUNT.

HOLDING : Yes. A corporate officer is entitled to indemnification to the extent of success in defense of
any claim, issue, or matter.

DISCUSSION : Claimants are entitled to partial indemnification if successful on a count of indictment
even if unsuccessful on another related count. Wolfson and Gerbert were both convicted and sentenced on
charges of perjury and filing a false annual report. These convictions establish that both were judged to be
derelict in the performance of their duty, as director or officer and they are therefore not entitled to
indemnification against expenses incurred in connection with those counts.
McCullough v. Fidelity & Deposit Co.


ISSUE :
o
Whether the policy allows notice in the broader form of any act, error, or omission that may give
rise to a claim for specified wrongful acts.
o
Whether the insureds gave adequate notice of specified wrongful acts.
FACT : Appellee issued four directors’ and officers’ liability policies to four affiliate banks. The policy
covered claims against the insured if the required notice is given to the insurer during the policy
period. The banks furnished Appellee with information about their lending activities that described
80
increasing loan losses and delinquencies and the issuance of a cease and desist order by the Office of
the Comptroller of the Currency. In response to the increasing loan losses Appellee informed the banks
that it would cancel their policies. The banks merged and then became insolvent. Appellant was declared
receiver. Appellant sued the banks’ directors and officers for improperly or illegally making, administering,
or collecting loans. Appellee denied coverage and this suit followed.

RULE : NOTICE OF AN INSTITUTION’S WORSENING FINANCIAL CONDITION IS NOT NOTICE OF
AN OFFICER’S OR DIRECTOR’S ACT, ERROR, OR OMISSION.

HOLDING :

o
No. The policy requires the insured to give the insurer notice of specified wrongful acts to
trigger coverage.
o
No. The insureds did not give adequate notice of specified wrongful acts.
DISCUSSION : Notice in a “claims made policy” serves a different function than prejudicepreventing notice required under an “occurrence policy.” Notice triggers coverage. If the policy
requirement for notice of specified wrongful acts is relaxed, then policy coverage actually expands.
Therefore the policy requires the insured to give the insurer notice of specified wrongful acts to trigger
coverage and cannot be read to allow notice in the broader form of any act, error, or omission which may
give rise to a claim. The insureds failed to give Appellee adequate notice of specific wrongful acts to
trigger coverage. Notice of an institution’s worsening financial condition is not notice of an officer’s or
director’s act, error, or omission. Rising delinquencies and bad loan portfolios, especially in light of falling
real estate prices are insufficient to constitute notice.
81