Corporations
Prof. Gary Chodorow
Beijing Foreign Studies University
2005-06 Semester II
Class 1--Introduction
A.
B.
C.
D.
What is a Corp?
Players
Basic Attributes of a Corp
Theory of the Firm
A. What is a corp?
1. Legal entity
2. Any size
3. Investment vehicle to pool $ &
management.
4. Corp (or any business association) exists
because command & control is cheaper
than bargaining on the market.
B. Players
1.
2.
3.
4.
5.
6.
Shareholders
Managers—directors & officers
Lenders
Customers
Persons injured by the business
Government
C. Basic Attributes of a Corp
Suppose you were asked to invest $1000 in a
company. What questions would you ask
(besides about the product or service)?
1. How long does the investment last?
Separate, perpetual existence.
2. Who manages the investment? Centralized
management.
3. What is the return on investment?
Ownership interests tied to residual
earnings & assets.
4. How can investors get out? Transferability
of ownership’s interests.
5. What are investors’ responsibilities to
others? Limited liability for all
participants.
1. How long does the investment last?
Separate, perpetual existence.
• Perpetual: Persons who contribute $ & labor
may change, but corp doesn’t.
• Separate: Corp not individuals owns the
business’ assets and is liable for the debts.
2. Who manages the investment?
Centralized management.
a. Board of Directors manages the corp. It
often delegates power to officers.
b. Directors & officers have fiduciary duties
to corp.
c. SHs have only limited role in management.
3. What is the return on investment?
Ownership interests tied to residual
earnings & assets.
a. Hierarchy of rights to business earnings:
i.
Creditors (e.g., bank lenders, bond holders,
employees) get return based on k.
ii. Only then do SHs get dividends as declared
by board.
b. Similarly, if business dissolves, creditors’
claims have priority over SHs’.
4. How can investors get out?
Transferability of ownership’s
interests.
• Shares are freely transferable—SHs realize
value of investment thru sale.
5. What are investors’
responsibilities to others? Limited
liability for all participants.
a. Corp liable for own obligations.
b. Corp insiders (dirs, ofcrs, SHs, lenders)
not personally liable to outsiders on corp’s
obligations (unless “veil pierced”).
c. Outsiders (k creditors and tort victims)
bear risk of corp insolvency.
D. Theory of the Firm
SHs & mgrs have conflicting interests which
may prevent corp from maximizing earnings:
• Mgrs:
– Lazy.
– Want huge “perqs.”
– Reluctant to make changes that threaten job security.
• SHs:
– Refuse to reinvest earnings in business.
– Want mngrs to take risks for high returns.
– Want intrusive control powers.
Corp law tries to minimize conflicts. Two views of how…
• Traditionalists--See corp as “control device”:
In public corps, active mgrs may dominate SHs.
Purpose of corp law is to control mgr
opportunism (e.g., increase SH voting power,
require mgrs to disclose info to SHs, strong
fiduciary protection).
• Contractarians--See corp as a “nexus of ks”
(voluntary relations among constituents bound
together by ks, statutes, market constraints).
These factors control mgr opportunism.
Purpose of corp law is to enforce their bargains.
Traditionalists:
Contractarians:
1. Mgrs use “control” to
exploit SHs & other
constituets: (a) SHs
dispersed, so it’s hard for
them to organize; (b) it’s
not cost effective for SH
with diversified
investments to spend a lot
of time of corp’s
concerns.
Mgrs can’t exploit SHs
because market
constraints align their
interests with SHs. (E.g.,
bad managers will be
unsuccessful on the job
market).
Also, SHs can’t be easily
exploited by mgrs
because can sell if mgr
abuses cause share price
to drop.
Traditionalists:
Contractarians:
2. SHs can be exploited
because they are
unsophisticated or
uninformed.
50% of shares owned by
sophisticated institutions.
They become informed
through firms like
Institutional Shareholder
Services and Investors
Responsibility Research
Center. Thus, SHs can’t
be exploited.
Institutional Shareholder Services
&
Investors Responsibility Research
Center
• Provide proxy voting & corporate
governance services.
• Serve institutional investors by analyzing
proxies & issuing informed research &
objective vote recommendations.
• Premise is that good corp governance
ultimately results in increased SH value, so
SHs need to participate in corp governance.
Traditionalists:
Contractarians:
3. Corp law should
Corp law should seek to
mandate rules to promote infer & enforce the
fairness & efficiency.
parties’ bargain, whether
explicit or implicit.
Traditionalists:
Contractarians:
4. Js should actively
enforce mgrs’ fiduciary
duties to SHs.
Js should interfere only
cautiously. Demanding
too much accountability
from mgrs reduces the
discretion they need to
successfully manage the
business.
Hypothetical
A bank (corp) loses money because its directors
approve construction loans in reliance on overly
optimistic projections about the real estate market.
(The borrowers default on the loans, bank
forecloses, getting title to real estate worth less
than the amount of the loans.)
Assume the directors’ mistake was honest & they
took reasonable steps to become informed about
the projected real estate market.
Question: Are the directors liable to the SHs for the
loss? What are the policies behind your answer?
Class 2--Introduction
A.
B.
C.
D.
E.
Sources of Corp Law
Choice of Form
Incorporation & Organization
Choice of Law
Ultra Vires & Corp Social Responsibility
A. Sources of Corp Law
1.
2.
3.
4.
5.
6.
State corp statutes
State common law
Federal statutes
Federal regulations
Stock market rules
American Law Institute Principles of
Corporate Governance
State Corporation Statutes
a.
Regulate how to incorporate; structure of board,
SH rights; governance powers of SHs, dirs,
ofcrs….
b. 38 states have enacted states ABA Model
Business Corporation Act, but some have not
(e.g., DE, NY, CA).
c. Some terms are mandatory (e.g., dirs must be
elected annually), but some terms are default
rules that apply unless the parties choose
different terms (straight v. cumulative voting).
State Common Law
a. Common law interpretations of state
corporation statute.
b. Common law caselaw creating legal
principles (e.g., fiduciary duties,
shareholder derivative suit)
Federal Statutes
a.
Securities Act of 1933: regulates raising capital
in public markets, whether by selling stock or
taking on debt.
b. Securities and Exchange Act of 1934: Corps
whose stock is publicly traded are subject to
periodic reporting requirements, proxy rules,
securities fraud rules, & other rules.
c. Sarbanes-Oxley Act of 2002: rules about board’s
audit committee, hiring audit firms to do
nonaudit work for the company, rules regarding
conduct of corporate/securities lawyers.
Digression: Enron Scandal
• Enron was 7th largest US corp, engaged in energy &
trading.
• Committed financial accounting fraud in order to
increase share value:
– Transactions with supposedly independent entities to
make its financial statements look better—remove
liabilities & increase revenues. In fact, these weren’t
independent entities but companies controlled by
Enron executives.
– Mgrs profited by getting higher salaries, bonuses,
stock options.
• In 2001, upon discovery of fraud, Enron went bankrupt,
wiping out SH investments & employee pensions that
invested in Enron shares.
• Arthur Anderson (independent accountant) criminally
indicted and folded.
Federal Regulations
• Congress established the Securities and
Exchange Commission (SEC) in 1934 to
enforce the newly-passed securities laws, to
promote stability in the markets and, most
importantly, to protect investors.
• SEC rules are codified in title 17 of the
Code of Federal Regulations.
Stock Market Rules
A US stock exchange
(NYSE, NASDAQ,
AMEX) must register
with SEC. SEC
requires exchange have
a body of rules for its
members. E.g., a
majority of the dirs of
each member corp
must be independent.
ALI Principles of Corporate
Governance
• Project to describe and unify the basic rules
for corp governance & structure.
• Not as well received as the ALI
restatements in other areas of law. Courts
mixed on how persuasive this authority is.
B. Choice of Form
Q:
Oliver & Irene plan to open a flower shop.
Matt will run the shop. Ingrid will invest the
money.
What business form should they use?
Basic Information
Sole Proprietorship
A single individual owns business’ assets.
That person is liable for any business debts.
No formal requirements to form or operate this
business.
Business profit or loss shown on personal tax return.
General Partnership:
Partners share mgt & profits. Each is fully liable
for GP’s debts.
GP generally seen as an aggregate of its owners,
not a separate legal entity like a corp.
Partnerships are prevalent in service industries
(e.g., law, accounting, medicine) where trust must
exist among participants and capital needs are not
great.
Law: Revised Uniform Partnership Act 1997
Limited Partnership
Must be at least 1 general partner who runs
business & is fully liable for LP’s debts.
Limited partners provide capital & are liable
only to extent of their investment (provided
they don’t run the business).
Law: Revised Uniform Limited Partnership
Act 1985
Limited Liability Company
Hybrid between corp & partnership. Like
partnership, members of LLC provide capital &
mng the business. Like corp, members are not
personally liable for debts of the LLC.
Law: All states have an LLC act.
Detailed Comparison of Business
Forms
See Handout
Grigg has a sole proprietorship landscaping business. He
has done most work himself & is the sole investor. Now,
he wants to hire employees & purchase equipment. Sister
is willing to invest, but she wants assurance she won’t
have to pay any more than what she invests.
a. Assume Sister invests on the “understanding” that she
will share in profits, will help Brigg run business, & will
not be liable beyond her investment. Is her liability
exposure limited?
b. What forms of business organization might
accommodate Pearl’s multiple wishes? Is this for sure?
c.For Pearl, what is the difference between being a LP
limited partner, LLC member, or corp SH?
C. Incorporation & Organization
“Incorporator” must:
1. Prepare, sign, file articles of incorporation.
2. Hold initial SH/dirs’ meeting.
3. Open a bank account for corp.
4. Issue shares.
Articles of Incorporation
1. Must include (MBCA §2.02):
a. Corp name
b. # of shares corp authorized to issue in each
“class” with description of privileges &
limits on each class.
c. Name & address of agent for service of
process.
d. Name & address of each incorporator.
2. Articles meeting these requirements &
accompanied by incorporation fee must be
accepted by Secretary of State.
D. Choice of Law
•
•
•
•
•
•
“Internal affairs doctrine”:
a. Law of the state of incorp governs most intracorp relationships.
b. Policy: Corp should not subject to conflicting
state laws.
c. In other states, corp may still need to:
1. pay local taxes
2. submit to jurisdiction for lit
3. file as a foreign corp if doing intrastate
business (not interstate business like mailorder company)
50% of Fortune 500; 40% of corps traded on NYSE
choose DE. Why?
Where to file the articles of incorp?
1. Local corp usually chooses state of PPB to avoid
paying extra taxes & fees in another state.
2. Local corp may like to have local corp counsel,
whereas national corp may like DE’s expert
counsel, law, judiciary—more predictable.
3. Incorporators may choose state favoring
management over SHs (e.g., fiduciary duties,
antitakeover statutes).
E. Ultra Vires & Corp Social
Responsibility
1. Ultra Vires = common law doctrine relating to
the effect of corp acts that exceed the powers or
stated purposes of a corp.
2. In the 19th century, corps power was mistrusted
so articles had to state limited purposes. Any
action beyond those purposes was “ultra vires.”
3. Today, corps can be established for any
lawful purpose, so ultra vires doctrine has
diminished in importance.
4. Still, some corporate philanthropy &
provision of benefits to others besides SHs
may be challenged as ultra vires. E.g., A.P.
Smith Mfg. Co. v. Barlow (N.J. 1953).
Class 3
• Chapter 2. Promoters’ Liability & Defective
Incorp
• Chapter 3.Piercing the Corporate Veil—The
Limited Liability Debate
Chapter 2. Promoters’ Liability &
Defective Incorporation
§ 2.02. Promoters’ Liability on Preincorp Ks
§ 2.03. Defective Incorporation
§ 2.02. Promoters’ Liability on
Preincorp Ks
1. Promoter = ?
2. First issue: Is the promoter liable for acts
taken on behalf of the corp to be formed?
What is the parties’ intent?
1. Revocable offer by other party that can be
accepted by corp after formed.
2. Irrevocable offer by other party for a limited
time. Consideration is promoter’s promise to
organize the corp & use best efforts to accept
it to accept offer.
3. Present k by which promoter is bound, but
with an agreement that his liability terminates
if corp is formed & adopts k.
4. Present k on which, even though corp
becomes a party, promoter remains liable
either primarily or as surety.
1. Traditional (strict) rule on promoter’s
liability
a. RKO-Stanley Warner Theaters, Inc. v.
Graziano (Pa. 1976)
b. Goodman v. Darden (Wa. 1983)
2. Cases considering surrounding facts and
circumstances.
a. Sherwood v. Alexander (Or. 1974)
b. Quaker Hill, Inc. v. Parr (Co. 1961).
Second issue: Is the corp liable for promoter’s
ks? Only if “adopts” k …
1. Explicitly
2. Implicitly
3. Acquiescence.
Bascomb plans a business offering carriage rides.
He hasn’t incorporated yet, but he plans to. He signs
k with Antiques-R-Us to buy 10 carriages. He signs
as “agent for ClassicRides, Inc., a corporation to be
formed which will become a party to this contract.”
The k calls for installment payments over 12 months.
a. Before ClassicRides is incorporated, Bascomb
takes delivery of the carriages. When the first
installment comes due, is Bascomb liable on the k?
b. After ClassicRides is incorporated, Bascomb
continues to use the carriages in the business.
When Antiques-R-Us is not paid, is Bascomb liable?
c. After ClassicRides is incorporated & has paid 4
installments, Bascomb sells his shares to Carolyn,
who repudiates the Antiques-R-Us k. Is
ClassicRides liable?
d. After ClassicRides is incorporated, Bascomb
wants to make clear there is a novation. Antiques-RUs’ manager agrees to tear up the original k and sign
a new one with ClassicRides. Bascomb signs as
follows:
/s/
J.S. Bascomb
President, ClassicRides, Inc.
Does this signature accomplish Bascomb’s purpose?
§ 2.03. Defective Incorporation
• The Problem:
– Birth: L forgets to file articles; or SOS returns
articles for failure to pay proper fee.
– Death: Corp fails to file annual reports or pay
annual franchise fee.
– Parties believe valid corp exists.
– Are the parties personally liable?
Common law defenses to personal liability for
defective incorporation:
1. De facto corp: (a) The firm could have
incorp’d; (b) Def made good faith attempt
to incorp; &and (c) Def actually used corp
powers he believed he possessed.
E.g.: Cantor v. Sunshine Greenery, Inc.
(N.J. Super. 1979).
2. Corp by Estoppel Defense: If (a) Insiders
believe they’re incorporated; & (b)
Outsiders dealt w/business as if it were a
corp, then outsiders estopped from later
seeking personal liability on defective
incorp theory.
E.g.: Cranson v. IBM (Md. 1964)
MBCA approach:
• § 2.03: Corp born when SOS issues certificate of
incorp.
• § 2.04: Insiders acting on behalf of corp with
knowledge there was no incorporation are
personally liable.
• Cts split:
– MBCA § 2.03 implies limited liability only if certificate
of incorp actually issued. Robertson v. Levy (D.C. Cir.
1964)
– MBCA § 2.04 implies no personal liability if def didn’t
act (i.e., passive SH) or had no knowledge there was no
incorp, so common law defenses still available.
MBCA § 14.22 on corps that have been
dissolved for failure to file annual report or
franchise tax: If reinstated within 2 years,
no personal liability.
1. Bascomb enters into a contract with Versacci to
purchase uniforms for ClassicRides’ carriage drivers.
He signs the k as president of ClassicRides. When
Versacci delivers the uniforms, ClassicRides does
not pay. Versacci sues Bascomb on the k.
a. Suppose Bascomb mailed articles of incorporation
for ClassicRides to the secretary of state 2 weeks
before signing the k but the articles were lost in the
mail. How might Bascomb argue he is not liable on
the k?
b. Suppose Bascomb asked his lawyer to create the
ClassicRides corp but the lawyer forgot to file the
articles. As Bascomb’s new attorney, how would you
argue that he is not liable on the k?
Chapter 3. Piercing the Corp Veil
• §3.02. The Limited Liability Debate
• §3.02 Grounds for Piercing the Corp Veil
• …
§3.02. The Limited Liability Debate
Advantages of Limited Liability:
Disadvantages of Limited Liability:
Class 4—Piercing the Corp Veil
(cont’d)
• Procedure for Piercing
• Factors Considered in Piercing
• Equitable Subordination
Procedures for Piercing
1. Basis for corp liability.
2. If corp has insufficient assets to satisfy a
prospective judgment, argue for piercing.
3. When veil pierced, all* SHs are personally
liable (not directors or officers of corp.—
although these groups overlap).
* A few cases to contrary (p.59, n.73).
Factors Considered in Piercing
1. How was corp form misused?
a.
b.
c.
d.
Commingle corp & individual assets/affairs.
Corp formalities ignored.
Inadequate capitalization or purposeful insolvency.
Evasion of a K or Statute or Use of a Corp to Work a
Fraud.
2. Who is liable if veil pierced?
a. Another corp in same family?
b. Individual actively involved in bus?
c. Passive SH?
3. Is pl an involuntary creditor?
1. How Was Corp Form Misused?
Evasion of a K or Statute or Use of a Corp to
Work a Fraud
a. Elements:
i.
Purpose of corp was solely to evade a k or
statute; or
ii. Use of s corp solely to work a fraud.
Commingle (aka intermix) corp & individual
assets/affairs.
a. Elements:
i.
ii.
b.
E.g.:
–
–
c.
Mixture of corp & SH’s assets/affairs
(At expense of corp) or (to benefit other)
Loan to SH with no interest or without
documentation.
Using corp bank account to pay personal expenses.
Policy: SH’s interference in corp may reduce its
assets available to creditor.
Corp formalities ignored.
a. E.g.:
–
–
No documentation for loans & other
transactions.
Failure to issue stock certificates, hold
meetings, elect officers.
b. Policy: Ignoring corp informalities is
indirect evidence of commingling of
affairs that harm corp’s creditworthiness.
Inadequate capitalization or purposeful insolvency.
a. Inadequate capitalization. Elements:
i. At time corp formed
ii. Trifling or illusory capital (equity, loans,
insurance)
iii. To pay for foreseeable debts.
b.
Caselaw mixed on whether this single factor
alone is enough to pierce.
c.
Policy: If inadequate capitalization at time of
formation, purpose of incorp may have been to
serve as an instrument of fraud.
Purposeful Insolvency
1. Elements:
i.
SH siphons off corp assets.
2. E.g.: DeWitt Truck Brokers v. W. Ray
Flemming Fruit Co. (4th Cir. 1976) (not in
book)
3. Policy:
2. Who Is Liable if Veil Pierced?
Another Corp in Same Family:
1. Enterprise liability considers following factors:
a. Multiple corps under common ownership.
b. (i) Sub is “mere instrumentality” (exists merely to carry
out parent’s orders), or (ii) there is otherwise
intermixture of assets/affairs, or (iii) similar businesses
are artificially separated to isolate risk of loss.
c. Pl not a voluntary creditor aware of the separate
business entities.
2. Policy: Enterprise’s interference in corp may
reduce its assets available to creditor; also, creditor
may be misled about corp’s creditworthiness (e.g.,
not know profits siphoned off to parent).
Individual SHs:
• Individual SHs of CHC sometimes found
liable.
• No reported case has involved finding
passive SHs of PHC liable because too
many innocent SHs become potentially
liable.
3. Is Pl an Involuntary Creditor?
1. Voluntary creditors can anticipate corp’s
“no recourse” structure & k for personal
guarantees, higher prices, or assurances on
how business will be conducted.
2. Involuntary creditors (tort victims and
retail customers) can’t protect selves as
easily.
EXERCISES
In 2001, Don formed a clock repair business, Timend
Inc. The corp made a 10-year lease with Realty for its
store. For a few years, Timend did pretty well. Don
drew a salary about equal to his net earnings. He kept
careful records of receipts & payments. But he didn’t
observe corp formalities: no SH or dir’s meetings; no
corp resolution authorizing his salary; no dividends.
Last year, Timend began to struggle, & Don’s salary
shrank.
a. Don closes the shop, telling Realty he can no
longer make lease payments. Can Realty pierce the
veil to recover from Don personally?
b. Don had set up a separate corp, Heirloom
Timepieces, to repair clocks valued at more
than $5,000. Don used separate invoice
forms for Heirloom, which subcontracted its
work to Timend. Can Patrick, an Heirloom
customer, look to Timend’s assets for
recovery?
Rupert incorporates Exquisite Timepieces Ltd., a mailorder business that sells watches through TV
commercials. He capitalizes the business enough to buy
TV time and an initial stock of watches. ETL gets off to
a good start. Rupert receives a generous salary equal to
80% of gross receipts. He keeps meticulous records and
observes corp formalities carefully. As new orders come
in, he fills prior orders. After a while, customer orders
go unfilled. Soon there is a large backlog of unfilled
orders.
a. Rupert writes expectant customers, “ETL has
experienced a cash flow crisis and cannot fill your
order.” Can customers pierce the veil?
Example: CERCLA
• Under CERCLA, “owner” & “operator” of
hazardous waste site is made liable for
“response costs” (cleanup).
• Liability will extend to another member of
the corp family under same rules for
piercing the veil.
United States v. Best Foods (U.S. 1998)
• F: Parent sent its own employees to
participate in subsidiary’s ordinary
operating decisions related to toxic waste.
• H: Parent is liable as “operator”.
• R: Parent directly controlling sub. Goes
beyond role of SH (eg, electing directors
and officers, monitoring corp’s
performance).
Equitable Subordination (aka Deep
Rock Doctrine)
1. In a bankruptcy, SHs don’t get distribution until
after creditors—go to “end of line.”
2. If a SH is also a creditor (e.g., loan to corp or
employee of corp drawing salary), should SH
still go to “end of line”? Yes, under same test as
veil piercing.
3. Getting subordinated (losing contribution to
corp) not as bad as piercing corp to find personal
liability (lose personal assets too).
Example from p.53
Facts: Corp goes bankrupt with $100,000 assets and
$500,000 liabilities (debts to SHs of $300,000 and
outside creditors of $200,000).
1. If SHs participate with creditors, they collect
20% of debt ($100,000/$500,000).
2. If SHs subordinated, outside creditors collect
50% of debt ($100,000/$200,000).
3. If veil pierced, outside creditors collect 100% of
debt ($100,000 from corp & $100,000 of SHs
personal assets).
Class 5—Financing the Corp
• Introduction
• Securities: Debt, Common Shares, Preferred
Shares
• Leveraging & Capital Structure
• Legal Capital Rules: Preemptive Rights, Par
Value, Dividends & Repurchases of Shares
• Valuation: Liquidation, Book Value,
Earnings Approach
§ 4.01 Introduction
Methods of Raising Capital:
1. Borrowing—Corp owes debt to creditors. Corp must pay
principal & interest according to loan schedule. Interest
on debt is tax deductible to corp.
2. Investment—SHs hold equity in the corp. Corp needn’t
return investment unless corp dissolves or dirs offer
repurchase shares. Dirs may pay “dividend” out of corp
profits. SHs may be able to sell their shares.
3. Retained Earnings—Profits held by the corp & not paid
out in dividends to the SHs.
SH Rights v. Creditor Rights:
1. Creditors have priority over SHs, so corp
can’t pay dividends unless its debt
payments are up-to-date.
2. If debt payments not up-to-date, creditor
may force corp into bankruptcy. In
bankruptcy, creditors receive their
principal before SHs get anything.
In summary, SHs have greater risk but also
potential for greater return.
§ 4.02 Securities
1. Security = Transferable “instrument”
representing financial value issued by corp to
raise capital.
2. Types of security issued by PHCs: Debt,
common shares, preferred shares.
3. Attributes of security:
a. Risk of loss
b. Power to control the business
c. Return
Debt
1.
Debt security = Obligation to pay specific
sum at future date & usually to pay interest
(% of bond’s face amount) at specified times
in interim.
2. Risk of loss: Generally less risky than equity
because debt has priority. Risk depends on
whether:
– Bonds = secured by specific assets, which
in case of default, must be auctioned off to
pay debt. (less risky)
– Debentures = unsecured debt, so holders
have a general claim to assets with other
unsecured creditors. (more risky)
3. Power to control the business: If debt is
sold to public, k is called “indenture.”
Trustee selected to represent the interests
of the public debt holders. Trustee will
exercise any power to control the business
specified in k.
4. Return: Generally don’t share in profits if
business successful.
Common Shares
1.
Common share = claim to receive share of
residual income & assets of the corp after all other
claims have been satisfied.
2. Risk of loss: Lower priority than other securities.
3. Power to control business: Vote to elect board.
4. Return:
• Value of shares grows if corp profitable.
• May receive dividends.
• So, greater potential for return than other
securities.
Preferred Shares
1. Preferred shares = Shares authorized by
articles with specified rights, usually that they
receive a “preference” over common SHs if (a)
dirs pay a dividend or (b) corp assets
distributed upon liquidation.
2. Risk of loss: Priority in between creditors &
common SHs.
3. Power to control business: Usually no voting
rights.
4. Return: Usually, just paid dividends of a fixed
amount of $ per share each quarter, so don’t
get increased return if corp successful.
Preferred Share
Debt
1. Creation of
Amend articles
new class or
issue
2. Maturity date No
Resolution by
dirs
3. Right to vote
Usually no
Usually no
4. Treatment on Equity
balance sheet
Yes
Debt
5. Interim
payments
Preferred Share
Debt
Dividend
Interest
6.Interim
Fixed (usually)
payment amount
Fixed (usually)
7. Omission of Carries over if
interim payment cumulative
Default
8. Tax effect on
corp of interim
payment
Yes tax
deductible
Not deductible
§ 4.03 Leveraging & Capital Structure
1. Corps usually finance operations w/both
debt & equity.
2. “Leverage” = debt/equity ratio.
3. As leverage increases
–
–
if business successful, SHs’ ROI as a % of
investment increases.
If business poor, risk of bankruptcy increases
Equity Debt
1st-Yr
Pay
ROI
Earnings Creditors
A
$100
$0
$20
(20%)
$0
$20
0
(20%)
B
$40
“
$66
$14
150%
(35%)
C
$100
$60 @
10%
interest
for 1
year
“
$32
(20%)
“
$26
60%
(26%)
Leverage
§ 4.04 Legal Capital Rules
A few terms…
• Authorized shares: Articles must state the
number of shares that the dirs are
authorized to issue in each class.
• Outstanding shares: Shares that have
actually been issued by the dirs.
• Treasury shares: Shares repurchased by
dirs from SHs.
Preemptive Rights
SH’s ownership interest depends on number of shares
actually issued, not those merely authorized to be
issued.
1000 shares
400 shares
X owns 100
authorized
issued
shares = 25%
interest in corp.
If corp then issues the remaining 600 shares to others,
X’s ownership interest has decreased.
1000 shares
1000 shares
X owns 100
authorized
issued
shares = 10%
interest in corp.
1. Preemptive rights = If corp will be issuing
new shares, an existing SH must be
offered the right to purchase a
proportionate # of new shares in order to
maintain his % of ownership and voting
control.
2. Preemptive rights exist only if specifically
authorized in articles. MBCA 6.30(a).
3. PHCs don’t provide for preemptive rights.
Par Value
Traditional rule: Articles must state “par value” =
minimum price at which dirs may sell share. Policy:
– Assure that all SHs bought at same price. (But
today, disclosure laws achieve fairness).
– Protect creditors by requiring that the total par
paid to the corp (“stated capital”) was not paid out
to SHs. (However, this didn’t really protect
creditors cuz corps spent stated capital in business
operations. Also, creditors found other ways of
protection).
2. So, MBCA no longer requires any par value.
1.
Dividends & Stock Repurchases
1.
Dividend = payment authorized by directors in their
discretion to SHs.
2. Stock repurchase = Another way by which SHs may
receive funds from corp.
3. In CHC, potential problems:
• SHs may want to avoid double taxation by
through payment in other way (e.g., salary,
interest on loan).
• Minority SHs may claim majority breaches
fiduciary duty by not authorizing dividend or
stock repurchase.
4. Most PHCs, pay fixed (“regular”) dividend
each yr &, if has done well or has excess
funds, pay “extra” or “special” dividend.
5. Legal requirements for dividend or stock
repurchase: No distribution may be made if,
afterwards:
a. Corp would be unable to pay its debts as
they become due; or
b. Corp’s assets < liabilities + amount
payable to senior preferred shares upon
liquidation.
6. Policy: Avoid adverse impact on creditors &
senior preferred SHs.
§ 4.05 Valuation
• Businesses need to be valuated in many
contexts:
– By creditors who decide how much to lend &
measure risk of loss.
– By investors who decide price for buying or
selling shares.
– By cts in various contexts, such as when SHs
oppose a merger.
Liquidation
1. Liquidation value = (value of assets at
liquidation sale) – (liabilities).
2. Good way to appraise value if buyer wants
to divide up & liquidate assets.
3. Limitation of this method: Not good if
buyer wants to keep assets together to keep
bus going because part of value of such bus
is its “goodwill.” Goodwill can come from
a happy workforce, customer loyalty, a
good location, and so on.
Book Value
1. Book Value = equity (amount paid for
shares + retained earnings) = (assets) –
(liabilities) as shown on the business’
balance sheet.
2. Balance sheet captures book value on one
day, usually last day of corp’s fiscal year.
Limitations of Book Value Approach:
1. Cost-Based Accounting Rules Don’t Show
Appreciation: Under GAAP, appreciation
in value of assets can’t be shown (to
protect creditors & securities buyers from
possible overvaluation by corp).
2. Depreciation May Value Assets Below
True Market Value:
a. “Depreciation” = An expense recorded to
reduce the value of a long-term tangible asset.
b. Each year’s depreciation = (cost - value at end
of useful life of asset)/(# of years in useful
life of asset)
c. E.g. ($90,000 building – 0 value at end of
useful life) / (30 yrs) = $3000 depreciation
each year. So, after 10 years use, the
building’s value has depreciated to $60,000.
3. Intangible Assets Undervalued on Balance
Sheet:
–
–
Intangible assets include trade name,
patents, TMs
Cost of developing them can be included
as an asset but not market value.
Earnings Approach
1. Earnings approach focuses on estimating
the present value of the business’ potential
future earnings.
2. A business’ present value is less than its
total future earnings because of:
a. Inflation
b. Risk of loss
c. Opportunity cost
Formula
PV (Present value) =
(A) Annual return
(R) Rate
R = rate of return you would estimate you would
demand from the investment in an average
year, given inflation, risk of loss, and
opportunity costs.
Assumes annual return continues forever.
Window Washing Business Example
PV = A ($100,000) = $500,000
R (20%)
Note: If you demand a higher rate of return from the
investment (e.g., 25%) in an average year
because you foresee higher inflation, bigger risk,
or bigger opportunity costs, then the PV will be
lower (here, $400,000).
Using Cash Flow to Estimate
A (Annual Return or Earnings)
1. To estimate a corp’s future earnings, you could
simply look at prior years’ income statements,
but that shows depreciation, which is not a real
expense.
2. For greater accuracy, investors look to actual
cash flow reports. E.g., instead of deducting
$3000 for depreciation, cash flow statements
may show that just $1000 was spent to repair the
building, resulting in $2,000 more in earnings.
This is more accurate because the $2000 could
actually be paid out to SHs.
Determining the R (Rate)
1. R = rate of return you would estimate you would
demand from the investment in an average year,
given inflation, risk of loss, and opportunity
costs.
2. U.S. treasury bonds are considered risk-free (i.e.,
U.S. gov’t unlikely to default). So rate of return
for U.S. treasury bonds compensates for
inflation and opportunity costs. Currently, 30year U.S. treasury bonds pay 5% interest.
3. For valuation of a business, the R should always
be higher than risk-free U.S. treasury bonds to
compensate for the risk.
4. To determine the R, look at the rate of
return for similar businesses.
R = A/PV, which is the inverse of the
“price/earnings ratio” published by the
stock markets for each PHC.
P/E for MSFT = 22.41, so
R=1/22.41=4.5% (approximately)
Class 6—The Legal Model of Corp
Governance—SHS Role--§5.05
A.
B.
C.
D.
E.
F.
G.
Right to Vote
Proxy Voting
Proxy Fight
SH Democracy
Vote Buying
Right of Expression
Right to Information
SHs elect
Bd at
annual
meeting &
monitor Bd
SHs
Bd
SHs monitor
Ofcrs
Bd selects
Ofcrs, sets
policies,
monitors
Ofcrs.
Ofcrs run
Corp
A. Right to Vote
What can SHs vote on?
1. Elect & remove officers.
2. Approve bd-initiated transactions:
a.
b.
c.
3.
Fundamental corp changes (merger, sale of
substantially all assets, voluntary dissolution)
Conflicting interest transactions
Amend articles
SH initiated changes:
a.
b.
Amend bylaws
Nonbinding recommendations
When do SHs have a chance to vote?
1. Annual meetings
2. Special meetings—may be called by bd,
president if authorized in articles or byles,
or SHs holding 10% of voting shares.
3. Written consent of SHs instead of
meeting:
1. MBCA 7.04: Consent must be unanimous.
2. DGCL 228: Same % of votes that would be
necessary at a meeting.
Who votes?
• Norm in PHCs is to have once class of
common shares with 1 vote/share.
• Articles may create multiple classes of
shares with different voting rights. E.g:
– Preferred shares may vote for dirs if
fail to receive dividends
– A class of shares held by founders may
have multiple votes/share.
1. To hold a vote, there must be a “quorum.”
2. What % is required to win vote?
a. For bd-initiated transactions, winner is
“simple majority” of votes.
b. For dirs, winner is person with “plurality” of
votes.
c. Corp can set bylaws to require supermajorities for certain actions.
Exercise 1
Graphic Designs is PHC incorporated in an
MBCA jurisdiction. Shirley is the majority
SH. The company president is Buck.
Shirley offers her friend, Jenny, a highly
qualified commercial artist, a job.
a. If Jenny accepts the offer, is the corporation
bound under the agreement?
b. Shirley, as majority shareholder, instructs
the board and Buck to hire Jenny, but they
refuse. How can Shirley force the board or
Buck to follow her instructions?
Exercise 2
Graphic Designs’ 5-person board authorizes Buck to
fire all of the corp’s commercial artists & replace
them with a computer that generates graphic
designs. Shirley is upset about the board’s action.
a. As majority SH, Shirley signs & submits a written
consent that purports to remove all the directors.
Will this work?
b. She calls a special SH meeting to remove the
incumbent dirs & Buck. Will this work?
c. She calls a SH meeting to vote on a SHs resolution
requiring the board to reverse its decision. Will this
work?
Voting for Dirs:
Straight v. Cumulative
•
•
Straight voting: For each slot, each SH votes his
# of shares. E.g.:
• 6 dirs being elected; A owns 80 shares; B
owns 20 shares.
• In the election for each slot, A will win 80
to 20.
Default is straight voting, but articles can
provide for cumulative voting. MBCA 7.28.
Cumulative Voting:
• SH votes (his # of shares) x (# of slots), dividing
votes up as he pleases. All dirs elected at once.
• Policy: Increase minority representation on board.
• E.g.: Same scenario--6 dirs being elected; A owns
80 shares; B owns 20 shares. (So, A gets 480 votes,
B gets 120 votes).
• # of shares needed to elect 1 dir > (total # of shares
voting) / (# of slots +1). Here, need 15 shares
(100/7 = 14.28) or 90 votes (15 shares x 6 slots) to
elect 1 dir.
• To max results, A & B should each vote 90 shares
for as many candidates as they can.
Cumulative Voting:
Maximizing Impact of Votes
(6 slots. A 80 shares. B 20 shares.)
A’s 480 votes
Albert
90
Arthur
90
Alan
90
Amy
90
Adam
90
Ally
30
B’s 120 votes
Beatrice
90
Benjamin 30
Barney
0
Cumulative Voting: X wastes his votes.
6 slots. X has 55 shares. Y has 45 shares.
(Formula still says 90 votes to elect 1 dir).
X’s 360 votes
Albert
Arthur
Alan
Amy
Adam
Ally
91
90
90
89
0
0
Y’s 240 votes
Beatrice 90
Benjamin 90
Barney
60
Ways to undercut cumulative voting:
1. If majority of shares can remove dir w/out
cause.
2. “Stagger” bd so fewer dirs selected at
once. E.g.:
– 3 slots. As before, A 80 shares. B 20 shares.
– To elect 1 dir, need 26 shares [> (100 shares)/
(3 slots +1)]. So B elects no directors.
B. Proxy Voting
• A SH may vote his shares in person or by proxy
(another person appointed by him to vote his
shares).
• To solicit proxies, management or insurgents send
to SHs a package including a proxy card, a proxy
disclosure document, and a return envelope.
(Some corps allow proxy voting on Internet).
• Proxy fights where both management &
opposition solicit proxies on the same issue.
1. Proxy Fight to Change Dirs
1. If corp poorly run, outside group could
initiate a proxy fight to replace the dirs.
2. Proxy Fight to Facilitate an
Acquisition
1. If someone wants to acquire a corp but
incumbent dirs are opposed, there may be
a proxy fight to replace them with dirs in
favor of acquisition.
2. If the matter is not one where SHs have a
right to vote, then the proposal can instead
include a recommendation to the bd.
3. Proxy Fight to Change
Corp Policy
1. If insurgents want to change corp policy,
they may, under SEC Rule 14a-8, include
their proposal with management’s proxy
request (on the same proxy card).
Collective Action Problem
1. Proxy fights often fail due to “collective action
problem.”
2. Why is collective action hard? SHs diverse
investment portfolios so pay little attention to
single corp; SHs dispersed so not easy to
organize.
3. Is this “rational apathy”?
– Cost of bad management may be less than cost of
proxy fight to fix it.
– “Free ride” problem.
– “Wall Street rule.”
1. Collective action is easier for institutional
SHs because benefits of proxy battle may
outweigh costs:
•
•
•
Much larger stake in corp.
Hard to exercise “Wall Street rule” because
selling a large block of shares would depress
share price.
Possible to organize through firms like
Institutional Shareholder Services and
Investors Responsibility Research Center that
research proxy issues & give vote
recommendations.
Interesting Proxy Battles
• Company: Chevron
• When: April 26, 2006
• Why: A binding proposal by Harvard University
law professor Lucian Bebchuk seeks to reimburse
shareholder proponents for the reasonable
expenses of filing proposals that receive majority
support, including expenses related to opposing
the company's attempt to exclude the proposal.
The reimbursement would not exceed the
company's expenses related to seeking to omit that
proposal.
• Company: IBM
• When: April 25, 2006
• Why: IBM & its suppliers’ business practices in
China should respect human and labor rights of
workers by adopting a set of principles defined by
the Int’l Labor Organization (e.g., no products
shall be manufactured in prison camps, must
comply with China’s wage and hour guidelines).
Management opposes this proposal, arguing that
IBM is already a CSR leader.
Class 7—The Legal Model of Corp
Governance
SH Role (cont’d)
D. SH Democracy
E. Vote Buying
F. Right of Expression
G. Right to Information
Board of Directors
Officers
Exam
D. SH Democracy
1. Issue: What if bd tries to thwart SH vote
during a proxy fight or a “hostile tender
offer”? How closely will ct “scrutinize”
bd’s action (i.e., what “standard of
review” is appropriate)?
Schnell (Del. 1971) (p.116)
F: Bd, fearing proxy challenge that had
begun to organize, moved up date of
annual meeting, making challenge more
difficult. Bylaws gave bd power to change
meeting date.
H: Original meeting date reinstated because
purpose of change was to interfere with
SH voting (corp democracy).
Blasius Industries (Del. Ch. 1988) (p.116)
F:
–
–
SH written consent vote to expand bd from 7-15.
Goal was to recapitalize (p.116, n.142).
Incumbent bd responds by expanding bd by 2 more
seats to keep majority. Goal was to defeat
recapitalization.
H: Purpose of bd action was to interfere with SH
voting. In such cases, standard of review is that
bd must have a “compelling justification.”
R: Ct rejected argument that standard should be
“business judgment rule.”
Stroud (Del. 1992) (p.117)
F:
–
–
Bd votes to amend arts to create new
qualifications for dirs. (Purpose was to protect
incumbents).
Fully informed SHs voted to approve this
amendment.
H: Ct held that “compelling justification”
standard inappropriate, even though
amendment would interfere with SH
voting in future, because fully informed
SHs voted in favor of it.
Williams (Del. 1996) (p.117)
F:
–
–
Recapitalization plan includes “tenure
voting”: shares will be super-voting (10
votes/share) but if transferred, only 1
vote/share for first 3 yrs.
Plan approved by SH vote.
H: Business judgment rule will be applied.
E. Vote Buying
1. Vote buying = SH given extra benefit for voting
particular way.
2. Early cts held illegal per se, but today just view
with suspicion.
3. Schreiber v. Carney (Del. 1982) (Pinto p.119,
n.160): Large SH opposed corp reorganization
because of personal tax liabilities. Corp
“bought” SH’s vote by agreeing to loan SH $ to
avoid the tax liability. Here, vote buying was not
illegal because its purpose was to benefit the
SHs by allowing reorganization, not to defraud
SHs.
1. Coercion = SH threatened with harm to
his interest unless votes particular way.
2. Lacos Land Co. v. Arden Group Inc. (Del.
Ch. 1986) (Pinto 254, n.8): CEO/Dir
threatened to block future beneficial corp
transactions unless SHs approved
restructuring giving him super-voting
shares. Held: Restructuring enjoined
because vote coerced.
3. Evaluation: Coercion like vote buying
may be tolerated by ct but only if purpose
is to benefit corp, not to defraud SHs.
F. Right to Expression
1. SHs have right to express views to dirs.
2. Auer v. Dressel (N.Y. 1954) (Pinto 120):
SHs called for special meeting to endorse
former president who had been removed
by dirs. Management refused to hold
special meeting on ground that only dirs
have power to choose officers. Held: SHs
have right to express views to board.
G. Right to Information
1. Annual financial statements (MBCA
16.20): Must include year-end balance
sheet, income statement, statement of
changes in SH equity. Must be audited by
CPA or prepared based on GAAP or
explain deviations from GAAP.
What is an income (aka profit & loss)
statement?
• Shows net income = income – expenses.
• Indicates performance of business over that
period, pinpointing unexpected increases in
expenditures.
• Use income statement to figure business
tax.
Beta Sales Company
Income Statement
For the Year Ended December 31, 200X
Sales
Cost of Goods Sold
Beginning Inventory
Add: Purchases
Total:
Less: Ending Inventory
Cost of Goods Sold
Gross Profit
$462,452
$27,335
235,689
263,024
32,090
230,934
231,518
Expenses
Advertising
Depreciation
Insurance
Payroll taxes
Rent
Repairs & Maintenance
Utilities
Wages
Total Expenses
NET INCOME
1,850
13,250
5,400
8,200
9,600
13,984
17,801
98,852
168,937
$62,581
2. Annual Report for SOS (MBCA 16.22):
Must state agent for service of process, #
of shares authorized & issued, etc.
3. SEC reporting requirements for stocks
registered on national securities exchange
(3300 corps) & to corps traded OTC if 500
SHs & $10 million assets (13,000 corps):
1. Annual 10-K (prepared by independent CPA
firm)
2. Quarterly 10-Q (unaudited financial results)
3. Near real-time 8-K (e.g., change in control,
resignation of director)
4. SH Right to Inspect Books & Records or
List of SHs (MBCA 16.02):
a. SH can on 5 days notice inspect & copy
records like minutes of SH meetings, articles,
bylaws, list of current dirs.
b. SH must have “proper purpose” to inspect &
copy minutes of dir meetings, accounting
records, SH list.
–
E.g., need SH list to communicate w/SHs or
request proxies.
– E.g., need to inspect accounting records to find
wrongdoing, assist SH litigation, appraise shares.
c. What is a proper purpose?
i.
Security First Corp. (Del. 1997) (Pinto p.121,
n.169): To et access to accounting records, SH
must show credible basis of probable wrongdoing.
ii. Pillsbury v. Honeywell (Minn. 1971) (Pinto p.122)
iii. Conservative Caucus v. Chevron (Del. Ch. 1987)
(Pinto p.122, n.175)
iv. Policy: balance SH right to info w/possible
harassment of mgt & misuse of info.
§5.06 Board of Directors
1. Legal model seeks to balance:
–
–
Allow SHs to monitor Bd to limit self-dealing
& mismanagement.
Allow Bd flexibility to mng corp as they see
fit w/out too much SH interference.
2. Dirs are fiduciaries of corp but not agents
of SHs.
Board Structure
1. Unitary board
2. # of dirs set out in articles or bylaws
3. Dirs serve 1-yr term unless staggered bd, in
which case may serve up to 3 yrs.
4. In PHCs, majority of dirs must be independent.
5. Bd may establish committees, which make
recommendations to bd & w/in limits act for bd.
6. PHCs must have some committees made up
entirely of independent dirs: audit,
compensation, nominating.
Meetings
1. Voting:
a. Majority presence at meeting required for
quorum; majority of those present required to
act. (Default rules).
b. As discussed, some bd-initiated actions
require SH vote for approval.
2. Equivalent to meeting:
a. Unanimous written consent of directors
b. Teleconference.
1. Action w/out meeting or equivalent:
a. Baldwin v. Canfield (Minn. 1879) (Pinto
p.125)
b. Modern view looks at substance over form.
2. In Baldwin, what should 3P have done to
ensure bd action transferring land to him
followed proper formalities?
–
Get copy of bd resolution from meeting
“minutes” with corp secretary’s certificate of
authenticity & accuracy.
§5.07 Officers
1. Appointed by dirs to conduct corp’s daily
operations.
2. Officer may be removed by bd at will
w/out cause.
1. Bylaws may specify corp officers & their
duties.
2. Typical officers:
a. President: Overall responsibility for corp mgt.
Directly responsible for carrying out bd’s
orders.
b. VPs: Assist President in specified ways.
c. Treasurer: CFO responsible for controlling &
recording its finances & maintaining
corporate bank accounts.
d. Secretary: Responsible for maintaining the
corporate records.
Officers are Agents of Corp
1. Agent = Person authorized to act for principal.
2. Three types of authority (making principal
responsible for agent’s actions):
a.
Express authority: Principal expressly authorizes agent
to act. E.g., authorization in bylaws, bd resolutions,
employment k. E.g., store owner says to manager, “go
buy some goods.”
b. Implied authority: Principal implicitly authorizes agent
to act. E.g., store manager may purchase goods even if
not expressly told to do so. Authority is implied by store
owner hiring him for position.
c. Apparent authority: Principal’s action manifests to 3P
that agent has authority, 3P relies. E.g., store owner hires
manager but says “don’t buy anything” (so no express or
implied authority. Manager buys anyway. 3P can claim
owner liable under apparent authority—Action
manifesting authority was hiring with title of “manager”;
3P relied by selling goods.
Exam
• Multiple Choice: Choose single best choice.
• Short Answer
• Essay
Sample Multiple Choice
Jackson, a famous and wealthy singer, has patented a
portable recording device, which he wants to
manufacture and sell. If he chooses to do business under
a sole proprietorship structure, which of the following
statements best describes Jackson’s personal liability to
contract creditors of the proprietorship?
(a) Jackson has no personal liability to proprietorship
contract creditors.
(b) Jackson is personally liable to the proprietorship’s
contract creditors.
(c) Jackson is liable to the proprietorship’s contract
creditors, if he had personally guaranteed their
obligations.
(d) None of the above.
MISC
Cumulative Voting: Impact of Staggered Board:
A’s candidates (total 80x3=240 votes)
B’s candidates (total 20x3=60 votes)
Albert
75
Beatrice
60
Arthur
75
Benjamin
0
Alan
90
Barney
0
Statutory Merger
consideration
A Inc.
B Inc.
B’s shares
B merges into A.
A survives. B dissolves.
Consolidation
A Inc.
C Inc.
B Inc.
A&B merge into C, a new corp. A&B dissolve.
Forward Triangular Merger
A Inc.
B Inc.
As Inc.
A creates As (a wholly owned subsidiary),
capitalizing As with A shares.
B merges into As, so As now holds B’s shares.
Result is that A indirectly controls B.
Reverse Triangular Merger
A Inc.
B Inc.
As Inc.
A creates As (a wholly owned subsidiary). A exchanges
100,000 A shares for all of As shares.
As merges into B: All B’s shares exchanged for the 100,000 A
shares held by As.
As disappears--its assets (ie, all of B shares) are transferred
to A. A is now B’s parent corp because it owns all of B’s
shares.
Voting Rights
MBCA
DE
A Inc
B Inc
A Inc
B Inc
Merger
Yes*
Yes
Yes
Yes
Triangular Merger
Yes*
Yes
No
Yes
Sale of Assets
Yes*
Yes
No
Yes
* Pursuant to 20% Rule
Appraisal Rights
MBCA
DE
A Inc
B Inc
A Inc
B Inc
Merger
No
Yes
Yes
Yes
Triangular Merger
No
Yes
No
Yes
Sale of Assets
No
Yes
No
No
Note: No appraisal rights if market exception (discussed below) applies.
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
FORM 8-K
Date of Report: March 30, 2005
STARBUCKS CORPORATION
…
Item 5.02 Departure of Directors or Principal Officers; Election of Directors;
Appointment of Principal Officers.
Effective as of March 31, 2005, Orin C. Smith retired as president and chief executive
officer of the Company and from the Company’s Board of Directors. Effective as of April 1,
2005, James L. Donald, 51, was appointed president and chief executive officer of the
Company and was appointed to the Company’s Board of Directors as a Class 2 director.…
Base Pay
…$840,000…
Bonus
Mr. Donald will continue to be eligible to participate in the Company’s Executive
Management Bonus Plan at an incentive target of 100% of his eligible base salary…. The
objective performance criteria for such incentive targets have been established for him by
the independent members of the Company’s Board of Directors.
Stock Options
…Mr. Donald was granted 100,000 non-qualified stock options at a per share exercise
price equal to the regular trading session closing price of a share of the Company’s common
stock on April 1, 2005. The stock options vest in three equal annual installments and expire
on April 1, 2015, subject to Mr. Donald’s continued employment.
Microsoft (MSFT)
Apr. 4, 2005
Source: Thompson Financial
Due Diligence Defense
Expert
Expertised portion
Nonexpertised portion
Must reasonably
investigate & reasonably
believe info is true
No liability
Nonexpert Must not believe info is
false
Must reasonably
investigate and reasonably
believe info is true
Regulation D Hypothetical
Outdoor Café Inc. plans to open new restaurants throughout
New England. They will need about $3 million, which they
can raise by selling 300,000 new shares at $10 to personal
acquaintances and a group of venture capitalists. Can Outdoor
Café fit within the Regulation D exemption if it has the
following investors?
•10 with net worth over $1 million
•10 with incomes over $200,000
•10 intimately familiar with the restaurant business
•10 relatives of the CEO
SEC Rule 14a-9 (Proxy Fraud)
No proxy solicitation shall be made, written or oral
containing
any false or misleading statement of material fact
or omission of material fact necessary in order to make
the statements therein not false or misleading
in light of the circumstances at the time
Elements of Common Law Fraud: Elements of SEC Rule 14a-9:
Materiality: A reasonable man
would attach importance to the
statement in determining his course
of action.
Substantial likelihood that a
reasonable investor would consider
statement an important factor in
deciding how to vote
Falsity: General rule that omissions
not actionable. Opinions often not
actionable
Omissions and opinions may be
actionable more often.
State of mind: Knowledge or intent
to deceive or at least reckless
disregard of the truth
Negligence
Justifiable reliance
No separate requirement
Loss causation
Proxy solicitation was an essential
link in accomplishing the
transaction OR the
misrepresentation led investors to
forego state law remedies
PROXY STATEMENT FOR ANNUAL MEETING OF
SHAREHOLDERS
TO BE HELD NOVEMBER 9, 2004
This Proxy Statement … is furnished in connection with the
solicitation of proxies by the Board of Directors … to be
voted at the annual meeting of the shareholders … on
November 9, 2004…. The Company will pay the cost of
solicitation of proxies….
ELECTION OF DIRECTORS AND MANAGEMENT
INFORMATION
Nine directors are to be elected at the annual meeting to hold
office until the next annual meeting of shareholders…. The
election of the Company’s directors requires a plurality of the
votes cast….
NOMINEES
William H. Gates III, 48, as a co-founder of the Company, has
served as Chairman since the Company’s incorporation in
1981. Mr. Gates served as the Company’s Chief Executive
Officer from 1981 until January 2000, when he resigned as
Chief Executive Officer and assumed the position of Chief
Software Architect. Mr. Gates is also a director of ICOS
Corporation….
Steven A. Ballmer, 48, has headed several Microsoft divisions
during the past 20 years, including operations, operating
systems development, and sales and support. In July 1998, he
was promoted to president, a role that gave him day-to-day
responsibility for running Microsoft. He was named Chief
Executive Officer in January 2000, assuming full
management responsibility for the Company. Mr. Ballmer is
also a director of Accenture Ltd….
INFORMATION REGARDING BENEFICIAL
OWNERSHIP
The following table sets forth, as of September 10, 2004,
information regarding the beneficial ownership of the
Company’s common shares by all directors…
Names
Amount and Nature of Beneficial
Ownership
of Common Shares as of
9/10/2004(1)
William H. Gates III
1,097,499,336(2)(3)
Steven A. Ballmer
410,967,990
Percent
of
Class
10.09%
3.78%
INFORMATION REGARDING EXECUTIVE
OFFICER COMPENSATION
The following table discloses compensation received for the
three fiscal years ended June 30, 2004 by the Named Executive
Officers.
Annual
Compensation
Long-Term
Compensation Awards
Name
and
Principal
Position
Salary
Bonus
Restricted
Stock
Award(s) ($)
Steven A.
Ballmer
$ 591,
667
$310,000
–
–
$7,865
William H.
Gates III
591,6
67
–
–
1,715
310,000
Securities
Underlying
Options (#)
All Other
Compens
ation
May 11, 2005
Duty of Care & Business Judgment Rule
Duty of Care & Business
Judgment Rule
Topics:
• Introduction
• Policy Issues
• Duty of Care
• Overcoming the Business
Judgment Rule
• Demise of the Duty of Care
Introduction
• Q: What is a fiduciary
duty?
• A: A duty to act
primarily for another’s
benefit in connection
with a particular
undertaking.
Introduction (cont’d)
In what contexts do fiduciary
duties arise in corp law? E.g.:
1. Duty of care of Ds
2. Duty of loyalty of D&Os
3. Executive compensation
4. Fiduciary duties of
controlling SHs
Introduction (cont’d)
Q: How are fiduciary duties
enforced?
A: Through derivative suits
brought by SHs in the name of
the corp.
• Each D who voted for the action
(or, in non-vote situation, failed
to object) is “jointly and severally
liable” for damages.
• Ct can enjoin or rescind Board
action.
Policy Issues
The separation of roles—SH
investment & D management—
creates tension:
Management
Discretion
Management
Accountability
Duty of Care
• Source of Law:
– originally CL, but now some
state statutes. MBCA § 8.30 is
typical.
• Elements:
–
–
–
–
Duty
Breach
Proximate cause
Loss
Duty of Care—Duty
Element
Ds must act:
• In good faith;
• In manner reasonably believed
to be in corp’s best interest; &
• With care that a person in like
position would reasonably
believe appropriate under
similar circumstances.
(MBCA § 8.30)
Duty of Care—Breach
Element—Business
Judgment Rule
• Accusations of breach are
subject to review under the
business judgment rule, under
which Ct will presume there
was no breach.
• This rule limits judicial inquiry
into Board decisions.
Duty of Care—Overcoming
Business Judgment Rule
Business judgment rule not applicable
(or can be overcome) where:
• Lack of good faith (fraud, illegality,
or conflict of interest)
• Waste
• Gross negligence in procedure
• Oversight failure--Inattention
Duty of Care—Overcoming
the Business Judgment Rule
(cont’d)
Lack of good faith--illegality:
Miller v. AT&T (3d Cir. 1974)
Duty of Care—Overcoming
the Business Judgment Rule
(cont’d)
Waste = no rational purpose for the
Board action or inaction. E.g.:
– Issuance of stock without consideration.
– Use of corporate funds to discharge
personal obligations.
Mere bad business decision is not
irrational as long as there is some
justification for it:
– Shlensky v. Wrigley (Ill. App. 1968)
Duty of Care—Overcoming
the Business Judgment Rule
(cont’d)
Gross negligence in procedure
Smith v. Van Gorkom (Del. 1985) (Trans
Union Case) (Presumption that no
breach of duty overcome where Ds did
not obtain an investment banker’s
opinion on the fairness of a merger
offer).
Duty of Care—Overcoming
the Business Judgment Rule
(cont’d)
Gross negligence in procedure (cont’d)
In re The Walt Disney Co. Derivative
Litigation (Del. Ch. 2003) (business
judgment rule N/A where Ds
intentionally avoided their
responsibilities to deliberate).
Duty of Care—Overcoming
the Business Judgment Rule
(cont’d)
Oversight Failure—Inattention
Francis v. United Jersey Bank (N.J.
1981) (D’s complete inattention
to management abuse is breach
of duty of care when D should
have suspected abuse).
Duty of Care—Overcoming
the Business Judgment Rule
(cont’d)
Oversight failure—inattention (cont’d)
• Graham v. Allis-Chalmers Mfg. Co.
(Del. 1963) (no duty to inquire unless
reason to suspect violation)
• In re Caremark Int’l Derivative
Litigation (Del. Ch. 1996) (systematic
or sustained failure to monitor is a
breach of duty)
• SOX 2002 (creates additional
monitoring duties)
Duty of Care—
Causation-in-Fact
Hard to show causation in nonfeasance
cases because there is no certainty
what would have occurred if the Board
had acted differently. Ct must
determine the reasonable steps a D
would have taken and whether that
would have averted the loss. A
business loss can occur for many
reasons.
Demise of the Duty of Care
Del. Gen. Corp. L. §102(b)(7) enacted
as reaction to Smith v. Gorkom: Corps
articles may eliminate damages for
breach of duty of care (but not for duty
of loyalty or acts or omissions not in
good faith).
Most states have enacted similar
legislation.
May 18, 2005
Duty of Loyalty
Topics where Duty of
Loyalty Arises:
1. Interested dir transaction
(self-dealing)
2. Executive compensation
3. Corporate opportunity
4. Parent-subsidiary dealings
5. Tender offer
6. Controlling shareholder
Types of Dir Self-Interest:
Direct interest: corp’s transaction is with dir
herself or she could personally gain from it.
Indirect interest: corp’s transaction is with
another person or entity to which dir has a
strong personal or financial interest, posing a
reasonable threat to dir’s impartiality:




Dir’s close relatives
An entity in which dir has a significant financial
interest
Interlocking boards of directors
Domination by another director (lack of independence)
Policy
1. Assumptions about human nature:


Dir tends to act in self-interested ways.
Group dynamics lead other dirs to identify with their
interested colleague.
2. Duty of loyalty necessary to avoid corruption &
personal profit at SHs’ expense.
3. Good self dealing exists: dir may offer corp
business opportunities not available elsewhere.
4. Markets can’t fully restrain bad self-dealing:


Dir may try to hide evidence
Self-dealing may be “end-game”
Topic 1:
Interested Director
Transactions
Early Common Law
Early CL Voidability Rule: All interested dir
transactions voidable by corp.
Advantage: Easy to administer.
Disadvantage: Corp loses valuable
opportunities to transact with its dirs.
Common Law in Early 1900s
Failure to disclose conflict or to hold
disinterested vote makes transaction
voidable by corp.
Globe Woolen Co. v. Utica Gas & Electric
Co. (N.Y. 1918) (p.225) (Even in case of
procedural compliance—disclosure and
disinterested dir vote—ct will review
substantive fairness).
Interested Director Statutes
Different statutes displace common law to different
extents:
Weak statute:
Regardless of
procedural
compliance, dir
bears burden of
proof of
substantive
fairness
Semi-strong statute: Strong statute:
If procedural
If procedural
compliance,
compliance, no
burden of proof
(or very limited)
shifts to pl to prove
substantive
substantive
fairness inquiry
unfairness
Weak Statutes
(Iowa & Old Cal. Statutes)
Remillard Brick Co. v. Remillard Dandini
Co. (Cal. 1952) (Statute reverses early CL
voidability rule. However, regardless of
procedural compliance, dir bears burden
of proof of substantive fairness).
Semi-Strong Statutes
(New York & New Cal. Statutes)
Where procedural compliance by
disinterested dir vote, pl has burden of
proving unfairness.
Where procedural compliance by
disinterested SH vote, pl has burden of
proving waste. (No fairness inquiry at all in
Cal.).
If no vote held, dir has burden of proof of
fairness.
Strong Statutes (Del. GCL § 144)
Transaction not voidable “solely” because of
interested dir if:
1. Disclosure & disinterested dir vote; or
2. Disclosure & SH vote; or
3. Ct determines transaction is fair.
Statute ambiguous: Two interpretations:
Marciano v. Nakash (Del. 1987) (dicta):
Procedural compliance creates safe harbor, so
no substantive fairness inquiry unless pl
overcomes BJR by showing waste.
Flieger v. Lawrence (Del. 1976): Statute
reverses early CL voidability rule, but ct may
inquire regarding fairness.
Strong Statutes
(MBCA Subchapter F)
Transaction not voidable if either
Approval by disinterested board or
disinterested SHs; or
Substantive fairness.
What disclosure is required?
Outright fraud by interested director is violation of
duty of loyalty.
Various statutory and CL views of what must be
disclosed:
Only the existence of the conflict of interest.
All material info (e.g., disadvantages of
transaction; amount of profit to interested
director).
All material info, except that a dir need not
reveal personal or subjective info that bears
upon his negotiating position (e.g., his urgent
need for cash, or the lowest price he would be
willing to accept). MBCA § 8.60
Topic 2:
Executive Compensation
Policy
1. Corp’s concerns in setting compensation:


Compete in market for services of executives.
Compensation plan should include incentives for
executive to maximize SH value.
2. Reasons for duty of loyalty in executive
compensation:


Dir tends to act in self-interested ways.
Group dynamics lead other dirs to identify with their
interested colleague.
3. Equity concerns about ratio of executive pay to
average employee’s pay (531:1 in U.S.).
Policy (cont’d)
4. Executive compensation is different from
other interested director transactions—
inescapable part of business, cannot be
avoided by entering into arms-length k on
market.
How Executive Compensation Is
Decided in Publicly Traded Corp
Recommendations prepared in compensation
committee, which under national market rules
must consist of all independent directors.
Vote by board, which under national market
rules must have a majority of independent
directors.
Under federal tax law, executive compensation
above $1 million per year is only deductible if SH
approval.
Stock Options:
Definitions
Stock option = option to purchase
specified number of shares of corp’s stock
at an exercise price during a window of
time.
Exercise price = price at which executive
has right to purchase shares.
Premium = (strike price) – (market value at
time of sale by executive)
How Stock Options Are Decided in
a Publicly Traded Corp
Although state law doesn’t require SH
approval of stock option plans, market
rules do.
Once plans authorized, each transaction
requires board approval.
Judicial Review of Executive
Compensation
Under duty of care, BJR prevents review.
Exceptions for lack of good faith, waste, or
gross negligence in procedure.

In re The Walt Disney Co. Derivative Litigation
(Del. Ch. 2003) (BJR N/A where dirs
intentionally avoid their responsibility to
deliberate on compensation).
Judicial Review of Executive
Compensation (cont’d)
Under duty of loyalty:
If majority of dirs are voting compensation
for themselves, then there is self-dealing,
so dirs bear burden of proving fairness.
When there is a disinterested dir or
disinterested SH vote on self-dealing
compensation, cts will generally apply
interested dir statutes.
Judicial Review of Executive
Compensation (cont’d)
Del. Waste Standard for Duty of Loyalty:
Recall Del. G.C.L. § 144: Marciano v. Nakash
(Del. 1987) (dicta): Procedural compliance
creates safe harbor, so no substantive fairness
inquiry unless pl overcomes BJR by showing
waste.
In the case of new stock option plan, procedural
compliance (plan approved by disinterested SH
vote per market rules & full disclosure under
federal proxy rules & fiduciary duty standards),
creates safe harbor, so no substantive fairness
inquiry unless pl overcomes BJR by showing
waste. Lewis v. Vogelstein (Del. Ch. 1997).
Judicial Review of Executive
Compensation (cont’d)
Del. Waste Standard for Duty of Loyalty
(cont’d):
Brehm v. Eisner (Del. 2000) (affirming
dismissal of claim that Ovitz’ termination
package valued at $300 million constituted
waste, even though package was “lavish”
and “exceedingly lucrative”)
May 25, 2005
Duty of Loyalty (cont’d)
& Controlling SHs
Topics

Duty of Loyalty (cont’d)
– Hypotheticals
– Corp opportunity
– Separate Duties
– SH Ratification

Controlling SHs
– Use of Control
Review—Duty of Loyalty
Hypotheticals
Hypothetical 1
The Sluggers baseball team, a publicly held
corp, is incorporated in a jurisdiction that has
adopted MBCA Subchapter F. The team’s
CEO, board chair, and largest SH is Martha
Post (40%). Post hand-picked the other dirs,
including her brother-in-law Abner.
• Question a: REK Services bids to operate the
beer concession for the Sluggers. Abner is a dir
and 25% SH. Any problem for the Hacks in
accepting the bid?
Hypothetical 1 (cont’d)
Question b: Also on the Sluggers’ board is
Duncan, the corp’s outside counsel. Does
she have a conflict of interest in the REK
bid?
Hypothetical 1 (cont’d)
Question c: Assume Post is an interested
director. Nevertheless, she participates in
the board meeting by answering questions
about the transaction with REK and votes
to approve the bid. Does her participation
invalidate the board action?
Hypothetical 1 (cont’d)
Question d: REK contracts to pay
Sluggers $20 million per year for the beer
concession. In the process, Abner
discloses to the Sluggers’ board his REK
directorship and 25% interest but not that
REK’s “bottom line” was to pay as much
as $24 million per year. Does this
invalidate the board’s approval?
Hypothetical 2
MPC, a publicly traded corp established in
Del., owns & operates parking garages.
Morris is the company’s board chair,
president, and 30% SH. No other SH has
more than 5%.
• Question a: Morris’ 3-year executive
compensation k is up for renewal. The MPC
board has 7 dirs: Morris, 2 corp executives, & 4
outside dirs. Advise the board on how to handle
the k approval.
Hypothetical 2
• Question b: Would you recommend the board
seek to have SHs ratify the k?
Corporate Opportunity
Introduction:


Definition
Policy Requires Balance
Remedies
SH may bring derivative action for:
Damages for corp’s lost profits.
Constructive trust to recover D/O’s profits.
Rescission usually not awarded unless 3d
party had notice of D/O’s wrongdoing.
Overview of Issues
1. Is the investment a corp opportunity?
a.
b.
c.
Financial ability?
Would 3d party be willing to deal w/corp?
Is opportunity advantageous to corp?
2. Has the D/O disclosed the opportunity to the
corp?
3. Has the corp rejected the opportunity?
a.
What’s impact of SH ratification?
4. Is the taking of the opportunity by the D/O fair?
5. What remedy?
Legal Tests—Does the Investment
Opportunity Belong to Corp?
Interest Test
Line of Business Test
Fairness Test
ALI Test
Interest Test
Rule
Farber v. Servan Land Co. (5th Cir. 1981)
(p.242-243)
Is this a good rule?
Line of Business Test
Rule from Broz v. Cellular Info Systems
Inc. (Del. Ch. 1996) (p.244)
E.g.: Burg v. Horn (2d Cir. 1967) (pp.246-7)
Is this a good rule?
Fairness Test
Rule from Durfee v. Durfee Canning Inc.
(Mass. 1948)
Is this a good rule?
ALI Test
What is ALI?
Rule: Corp opportunity =
1.
Opportunity dir or officer becomes aware of
a. thru performance of corp functions or under circumstances
that should reasonably lead him to believe that it was
intended for the corp; or
b. thru the use of corp info or property if the dir or officer
should reasonably expect the opportunity would be of
interest to the corp; or
2.
Any business activity of which an officer knows is
closely related to a business in which the corp is
engaged or expects to engage.
Northeast Harbor Golf Club v. Harris (Maine
1905) (p.245)
ALI Test (cont’d)
Procedure:


Is this a corp opportunity?
If so, dir or officer disclose the opportunity & conflict of
interest to the corp.
Failure to make disclosure creates liability per se.


The corp must have an opportunity to take or reject
the opportunity.
The taking of the opportunity by the dir or officer must
be fair:
Rejection by disinterested directors results in a BJR test.
Rejection by disinterested SHs results in a waste test.
If corp rejection doesn’t follow those procedures, def bears
burden of showing rejection “fair.”
Financial Inability
How is financial ability relevant?



If no financial ability, there is no corp opportunity. Broz v. Cellular
Info Systems Inc. (Del. Ch. 1996) (p.244) (line of interest test)
Financial inability is an affirmative defense. Irving Trust Co. v.
Deutsch (2d Cir. 1984)
Financial ability goes to fairness of D&O taking opportunity. (ALI).
How measure financial ability?

Corporate solvency. Irving Trust.
Policy tension:


If corp can’t take opportunity, it’s efficient to let D&O take it.
If law allows D&O to easily prove financial inability, then they
have a strong reason not to do their job in getting financing for
the corp.
Separate Duties
Duties to avoid using corp info, position, or
assets unfairly for personal profit.
Duty not to take undisclosed profits from
transaction on behalf of corp. Hawaiian
International Finances v. Pablo (Haw.
1971) (p.248).
SH Ratification
Situations:
Required voting
Statute allows optional voting
Case law recognizes benefit of optional
voting
Required SH Voting
If statute requires SH vote, it’s “authorization”
not “ratification.”
Where statute doesn’t require disinterested SH
vote, even controlling SH with conflict of interest
can vote.
However, disclosure and disinterested SH vote
may shield controlling SH from claim that used
control of directors to breach duty of loyalty.
(E.g., MBCA Subchapter F: Transaction not
voidable for breach of duty of loyalty if ratified by
vote of disinterested SHs).
Optional SH Voting
Purpose: sanitize a conflict of interest
transaction.
To be effective, there must be full
disclosure of conflict and no coercion.
Statute may explicitly or implicitly require
disinterested SH vote (e.g., MBCA
Subchapter F explicit).
May 31, 2005
Chapter 10: Controlling
Shareholders
Topics
Introduction
 Use of Control
 Freezeouts
 Independent Dirs or Disinterested SH
Ratification
 Sale of Control

Intro
What is a controlling SH?


De jure control = Individual SH or group
(family or investment group) of SHs acting
together owns the majority of shares.
De facto (working) control = In a publicly
traded corp, altho SH or group has no
majority of shares, they may still control
because of wide dispersion of other shares.
Even 20% may be de facto control.
Intro (cont’d)
Usually SH has no fiduciary duty when
voting her shares—SHs invest specifically
to further their economic interests.
But controlling SHs have fiduciary duties
because they have the potential to use
their control and position unfairly for their
own self-interest.
Introduction (cont’d)
How do controlling SHs affect a corp?
They can afford to closely monitor their
investment, benefiting all SHs.
The controlling SH may be interested in
self-dealing, which may provide good
opportunities to corp or may harm corp.
Proxy fight or hostile takeover is less likely.
Truly independent dirs are less likely.
Use of Control
The Basic Rule:
Zahn v. Transamerica (3d Cir. 1947)
(Controlling SH liable for breach of duty of
loyalty where he uses his control of dirs to
gain benefit denied to other SHs).
Use of Control (cont’d)
Transactions Between Parent & Subsidiary:
Parent given room to benefit from self-interested
transactions so long as minority SHs are not hurt:
Sinclair v. Levien (Del. 1971) (Parent corp
breaches its duty of loyalty if uses control of
subsidiary’s dirs in way that both (a) parent
gains benefit not shared with minority SHs & (b)
the minority SHs are harmed)
Use of Control (cont’d)
Sale of Corp to 3d Party:
Review:
Smith v. Van Gorkom (Del. 1985) (Dirs
breach duty of care in sale of corp to 3d
party where grossly negligent in meeting
for only 2 hours & not getting investment
banker’s opinion on the fairness of merger
offer)
Use of Control (cont’d)
Sale of Corp to 3d Party:
McMullin v. Beran (Controlling SH
breaches duty of loyalty in sale of corp to
3d party at his behest if controlled dirs fail
to make informed and good faith decision
that sale is fair to minority SHs).
Freezeouts
Freezeout = Controlling SH forces minority
SHs to surrender their shares in return for
cash or other securities.
Clear conflict of interest for controlling SH.
Mechanics of Freezeout
(Before Freezeout)
A Inc.
B Inc.
A Inc. is controlling SH (parent corp.) of B Inc.
Mechanics of Freezeout
(Step 1)
A Inc.
As
A sets up As, a wholly-owned subsidiary.
B Inc.
Mechanics of Freezeout
(Step 2)
A Inc.
As
B shares
B Inc.
Consideration
A votes its controlling shares in B in favor of a merger
with As. The result is that B’s minority SHs are “frozen
out,” forced to surrender their shares for consideration.
And A now owns 100% of B.
Policy Issues in Freezeouts
Advantages:


B’s minority SHs who are frozen out usually
get from As a premium over current market
price as an inducement to get the B’s board
to vote in favor of the merger.
Eliminating minority SHs saves costs that
must be incurred by public corps (e.g., costs
of compliance with SEC requirements).
Policy Issues in Freezeouts (cont’d)
Disadvantages:

The premium above market price received by
the minority SHs may not reflect the true value
of the corp because:
Controlling SH may be taking advantage of
corporate opportunity or future growth potential not
accurately reflected in market price.
Controlling SH may have taken steps to depress
the market price (e.g., reduce dividends or
increase its compensation).
Note: Note controlling SH always controls timing of
freezeout so can pounce at the moment when SH
price lowest.
State Law on Freezeouts
State statutory scheme for merger applies:


Board & SH votes (except no SH vote
required for short form merger when parent
owns 90% of sub).
Appraisal remedy
State Law on Freezeouts (cont’d)
Duty of loyalty applies:


Freezeout requires “entire fairness” (fair
dealing and price).
Other remedies besides appraisal: enjoin
transaction or award higher damages.
State Law on Freezeouts (cont’d):
Weinberger v. UOP Inc. (Del. 1983):
 What is “fair dealing”? Fairness in disclosure,
timing, initiation, negotiations, and structure of
transaction.
 What is a “fair price”? Court can consider
comparative takeover premiums and
determine value through capitalization of
earnings approach.
 Who has the burden of proof on fair price?
Shifts from controlling SH to pl if “fair dealing”
established.
State Law on Freezeouts (cont’d)
Rabkin v. Philip A. Hunt Chem. Corp. (Del.
1985)
What remedy is appropriate for breach of
duty of loyalty?
State Law on Freezeouts (cont’d)
In Re Pure Resources, Inc. Shareholder
Litigation (Del. Ch. 2002)
Does the duty of loyalty require “entire
fairness” in a controlling SH’s tender offer?
Federal Law
Federal proxy rules apply if SHs vote in
public corp.
SEC Rule 13e-3 requires extensive
disclosure in freezeouts, including board
judgment on fairness and material facts
underlying that judgment.
SEC Rule 10b-5 prohibits fraud in
purchase or sale of securities. Must show
deceit (including failure to disclose).
Independent Directors
or Disinterested SH Ratification
Where controlling SH has a conflict of
interest, corp may seek to lessen judicial
scrutiny of “entire fairness” thru
1. Reliance on independent dirs, or
2. a minority SH vote to ratify the merger.
Relying on Independent Directors
A corp with a 50%+ SH is exempt from
stock market rules’ requirement to have a
majority of independent dirs.
But the corp may still choose to elect
independent dirs in order to attract
investors.
Relying on Independent Dirs (cont’d)
Under Del. Law, if (a) negotiating committee of
independent directors is able to act freely on
behalf of the minority SHs, then (b) ct will shift
the burden of proof to pl, but entire fairness test
still applies.
Example: Kahn v. Lynch Communications (Del.
1994) (issue a):



Controlling SH had enough votes to block sale to
anyone but himself.
Controlling SH threatened that if proposed merger
rejected it would proceed with unfriendly tender offer
at lower price.
Since coercion, ct unwilling to shift burden of proof to
pl.
Relying on Independent Dirs (cont’d)
Example: Kahn v. Lynch Communications
(Del. 1994) (issue b):

Controlling SH did meet its burden of proving
entire fairness of the transaction despite the
coercion because in other respects there was
fair dealing and a fair price.
Compare Marciano v. Nakash (Del. 1987)
(In interested dir transaction, vote of
disinterested dirs or SHs shifts burden of
proof to pl to overcome BJR by showing
waste).
SH Ratification
In Del., there is no statutory requirement
that controlling SH transaction be
approved by majority of minority SHs, but:


If controlling SH meets burden of proving that
such a vote was proper and informed
Then such approval will shift burden of proof
to plaintiff to show entire fairness.
Again, compare to Marciano v. Nakash
(Del. 1987) .
Sale of Control
General rule: Controlling SH who sells just
his shares for a “premium” (not shared with
minority SHs) doesn’t breach duty of loyalty.
Exception: Sale to looter
Gerdes v. Reynolds (N.Y.S.C. 1941):
Facts: Controlling SHs sold their shares in
investment firm for 100%+ premium. Firm’s
assets were public stocks, so buyer could have
easily purchased them on market for without
paying premium. Thus, huge premium gave
controlling SH reason to know buyer intended to
loot the firm (take its assets, leave it with
liabilities), driving the firm bankrupt.
Holding: Controlling SH breaches duty of loyalty
where sells shares to buyer where reason to
know buyer will loot the corp.
Reasoning: Here, premium really did represent
value of corp assets to be shared with minority
SHs.
Exception: Taking Corp Opportunity
Perlman v. Feldman (2d Cir. 1955)
Exception: California Approach
Jones v. H.F. Ahmonson (Cal. 1969):
Facts:




Hi “S&L” share price ($2500) discouraged
trading, deflating value.
Majority SHs created holding company
(United Financial) whose assets were just the
S&L shares. The holding company held
profitable “IPO.”
Minority SHs left out, argued that S&L stock
split would also have encouraged trading.
Minority SHs “directly” sued controlling SHs.
Exception: California Approach
Jones v. H.F. Ahmonson (cont’d):
Holdings:


Controlling SHs took corp opportunity to hold IPO so
violated duty of loyalty. (Possibility for even wider
interpretation: “Fiduciary duty applies whenever
control is material.”)
Controlling SH’s duty of loyalty runs directly to
minority SHs (not just to corp), so direct suit by
minority SHs seeking personal damages is permitted
(not just derivative suit seeking damages for
corporation).
Exception: Sale of Office
If SH buys control of corp, can elect dirs, but to
move quickly & save expense of election, old
dirs instead just resign & appoint buyer’s
nominees as replacements.
If shares sold not enough to transfer control but
seller agrees to resign his directorship and
appoint buyer’s nominee anyway, the seller has
breached a duty of loyalty. Seller has received a
premium for sale of office (a corporate asset).
June 7, 2005
Chapter 11: Special
Problems in the CHC
Topics
Intro: Control Dilemma in CHC
 SH Voting Arrangements
 Management Agreements
 Share Transfer Restrictions and Contractual
Liquidity Rights

Awkward Fit Between CHCs and
Corp Statutes
Statute calls for centralized management
by board and limited role for SHs, but CHC
investors want to control their financial and
human investments.

E.g.: They want to be able to veto transfer of
shares to outsiders.
Statute calls for majority control, but
minority SHs in CHC are easily exploited.
CHC – different from – PHC
Small, tightly knit group
of investors, often family
members.
Investors actively
involved in management.
Large # of investors with
no relationship besides
their share ownership.
Management left to board
and officers, with
exception of proxy voting
at formal meetings.
Investors often are often Investors are diversified,
undiversified, looking to
looking to the corp for
earn a living through their return thru appreciation in
employment by the corp
market price and
or dividends.
dividends.
CHC – different from – PHC (cont’d)
Illiquidity: No ready market for
shares, and perhaps k limits on
transfer. Finding outside buyer hard
since study to value corp is
expensive & buyer would also face
illiquidity.
Public trading
markets (such as
stock exchanges)
make shares
freely
transferable
(liquid).
Potential for exploitation of minority
SHs: Since minority’s shares are not
liquid, majority may seek to exploit
them thru excessive salaries & perqs,
denial of voice in governance, or
denial of dividends.
Less potential
for exploitation
because SHs can
exercise “Wall
Street rule.”
Planning in CHC
Since corp law’s “off-the-rack” provisions don’t
fit CHC participants well, lawyer must make
alterations through:
1.
2.
3.
SH agreements (e.g., “buy-sell agreement”)
Special provisions in the articles & bylaws
Dispute resolution procedures.
In recognition of the special problems of CHCs,
some close corporations have been drafted (e.g.,
Del. And Model Close Corp Supplement). Other
states have woven special provisions for CHCs
into their corp statutes.
In addition, LLC and LLP are available options.
Hypothetical: The Pizzeria
Two family members go into the pizza business:
Bob invests just $5000 but has some pizza
experience, is willing to work, and wants an
annual pay of at least $20,000.
Uncle Rich, who knows nothing about Pizza,
invests $80,000 and hopes for a steady 10%
return on his investment.
What control arrangements would they likely want?
SH Voting Arrangements
1. Vote Pooling Agreement (SH Voting
Agreement)
2. Irrevocable Proxies
3. Voting Trusts
4. Class Voting
5. Cumulative Voting
Vote-Pooling Agreement
Purpose: SHs form a majority coalition to wield effective
control. By sticking together, the coalition can maximize
its interests.
Operation: Under the agreement, in the absence of
unanimity of the parties, all must vote either as majority
decides or as a designated official directs. Vote-pooling
agreements are primarily used in electing dirs.
E.g.:
7 directors
Mrs. Ringling: 315 shares
Mrs. Haley: 315 shares
Mr. North: 370 shares
Vote-Pooling Agreement (cont’d)
Validity: Usually must be in writing, specify the
matters covered, and specify the duration. They
must not be for an illegal purpose.
Enforcement: Specific enforcement allowed if
agreement mentions that remedy. See Ringling
Bros. Combined Shows v. Ringling (Del. 1947)
(denying specific enforcement where not
mentioned in the agreement; instead throwing
out the votes of the SH who breached the
agreement).
Irrevocable Proxies
1. Different than regular proxy: The SH
cannot change her mind and withdraw
the proxy holder’s authority to vote her
shares.
2. Purpose: In irrevocable proxy is a means
for one with an interest in the corp to
protect that interest by ensuring shares
are voted as he wants.
Irrevocable Proxies (cont’d)
Rule: An irrevocable proxy is only valid when it is
“coupled with
an interest”:
1. Interest in the particular shares: The proxy holder
has an interest in the stock for which he is given
the proxy (e.g., an option to buy the stock, or holds
a debt secured by the stock).
2. Interest in the corp (but not the stock itself): E.g.,
the proxy is a condition to agreeing to lend money
to the corp or buy other stock in the corp or
become an employee of the corp.
Irrevocable Proxies (cont’d)
Proxy not coupled with an interest isn’t irrevocable:
If SHs pursuant to a SH voting agreement
designate the proxy holder but he has no other
interest in the corp, he may have little incentive
to vote in the corp’s best interest.
Still, enforcement of such agreements
facilitates corporate contracting, & presumably
the SHs believe the proxy will protect their
financial interests.
Voting Trusts
Differs from SH voting agreement: It’s
self-enforcing because legal title in the
shares is transferred to a “voting trustee”
who has exclusive voting power.
Voting Trust (cont’d)
Creation (MBCA §7.30):





Written trust document.
Shares transferred to trustee, “certificate of
beneficial interest” given to beneficiaries
(giving them back all SH rights except the
right to vote).
Maximum term is 10 years. Renewable.
A list of beneficiaries is delivered to the corp.
Trust irrevocable except by unanimous vote of
the trustees.
Voting Trust (cont’d)
Policy:


Voting trusts are often used by creditors or
venture capitalists to control their investment.
Statutory compliance required to ensure that
the trust is not a secret, uncontrolled attempt
to acquire control of the corp to the detriment
of the non-participating SHs.
Voting Trusts (cont’d)
Illegal voting trusts:
Abercrombie v. Davies (Del. 1957): Majority SHs agreed
that designated agents would vote their shares under
proxies for 10 years. This was a voting trust because (a)
it separated ownership from voting, (b) it transferred
voting power irrevocably for a period of time; and (c) its
principal purpose was to provide for voting control of the
corp. It was an illegal voting trust because it didn’t
comply with the statute.
Ringling Bros. Combined Shows v. Ringling (Del. 1947):
Designated official set to arbitrate disputes in a SH
voting agreement. Not a voting trust because voting
power was not separated from voting—SHs still were
allowed vote their own shares (per arbitrator’s ruling).
Voting Trusts (cont’d)
Illegal voting trusts (cont’d):
Lehrman v. Cohen (Del. 1966): Corp owned by 2
families, each entitled to elect 2 dirs. To avoid
deadlock, an additional share with no financial
rights was issued to corp’s lawyer, who voted
with 1 family and was elected president with a
long-term employment k. Held: Not a voting trust
because families were still allowed to vote their
own shares—mere dilution of their vote did not
create a trust. Thus, a 3d class of shares can be
used as a tie-breaker between 2 evenly divided
factions in a corp.
Voting Trusts (cont’d)
Proper purpose doctrine (applies to not
just trusts but also SH voting agreements
and irrevocable proxies): An agreement
that has as its purpose fraud or illegality is
void. E.g.:


Trust formed to elect directors who will
disregard the environmental laws.
Trust formed to loot the corp.
Class Voting
Purpose: Allocate voting power in corp
disproportionately to investment.

E.g.: SH A invests 80% of start-up $ for
corp and wants proportionate financial
rights but is willing to share control. Corp
can create Class A stock for him that elects
one director and Class B stock for 20%
SHs, who can elect 2 directors (2/3 voting
rights).
Class Voting (cont’d)
Purpose (cont’d): Different classes of
shares can allow disproportionate power in
just particular situations. E.g.:

Board representation:
1. E.g., Lerhman v. Cohen (3rd class of shares elects
1 dir to break tie votes of board).
2. E.g., a way to give minority SHs some
representation (a “window” on the board).


Protection in fundamental changes: e.g., both
classes must approve article amendments.
Modified control structures.
Class Voting (cont’d)
Creation: different classes of shares must
be authorized by articles.
Cumulative Voting
Purpose: Cumulative voting can increase
board representation of minority SHs.
Creation:


Articles must provide for cumulative voting.
To keep majority from removing cumulative
voting, articles can require a supermajority
to do so or can call cumulative voting
majority a “vested SH right.”
Management Agreements
Various types of “management agreements”
may limit the dirs’ discretion in a CHC:
Ks between parties to act in specified ways in
their capacities as dirs.
Ks with the corp that disempower the board (e.g,
employment k granting employee management
discretion over product design or sales).
Agreements that SHs will assume powers of the
dirs.
Management Agreements (cont’d)
All these “management agreements” run up
against the corporate tenet & historic statutory
mandate that the dirs must manage the corp.
MBCA § 8.01(b).
Modern statutes: Some modern statutes
authorize management agreements. E.g.: MBCA
authorizes management agreements where
approved by all SHs, whether in the articles,
bylaws, or another k. Agreement may last up to
10 years and must not be contrary to public
policy. § 7.32(a).
Management Agreements (cont’d)
CL: Where no relevant statutory provision
exists, CL allows management
agreements where: (1) CHC, (2) does not
adversely affect interests of nonparty SHs
or creditors, and (3) deviates only slightly
from the tenet that dirs manage the corp.
Management Agreements (cont’d)
CL (cont’d). E.g.:


McQuade v. Stoneham (N.Y. 1934): Majority SH
and 2 others (but not all) agreed to keep each
other as officers, specifying their positions and
salaries. Court invalidated the agreement as
usurping dirs’ function.
Clark v. Dodge (N.Y. 1936): Corp’s only 2 SHs
agreed that Clark would be the general
manager with pay linked to corp’s net income.
Held: Agreement valid since clause allowing
termination if faithless, inefficient, or
incompetent.
Management Agreements (cont’d)
CL (cont’d). E.g.:


Long Park, Inc. v. Trenton-New Brunswick Theaters Co.
(N.Y. 1948): All SHs agreed to give manager full
authority to run the business. Held—Agreement invalid
because completely sterilized the board for a long
period. No termination if faithless, inefficient, or
incompetent, and no termination on notice without
cause.
Zion v. Kurtz (N.Y. 1980): Unanimous SH agreement
gave minority SH veto power over any business
activities of corp. Held: Valid agreement. (Extreme case
since board completely sterilized).
Management Agreements (cont’d)
CL (cont’d). E.g.:


Galler v. Galler (Ill. 1965) upheld a comprehensive SH
agreement where it did not harm creditors and was not
contrary to public policy.
Somers v. AAA Temporary Service, Inc. (Ill. App. Ct.
1972): SH agreement to amend by-laws to reduce the
number of dirs from 3 to 2. Held: Invalid because
amendment to by-laws requires board vote unless
articles state otherwise. While Galler permitted slight
deviations from the corp. statute, direct contravention is
not.
Effect of Invalidity of Management
Agreement
Sever invalid provisions: What if illegal restraint
on management discretion is part of an
agreement that includes other valid terms?
Court may enforce the valid terms. Triggs v.
Triggs (N.Y. 1978).
Interpret ambiguous terms as valid. Galler v.
Galler (Ill. 1964) (saving an agreement without
an express term of duration by inferring that it
would operate only as long as one of the parties
was living).
Share Transfer Restrictions &
Contractual Liquidity Rights
Transfer restrictions keep CHC ownership closely knit
(exclude outsiders) in order to:
1. Ensure stability in the control & management of the corp.
2. Maintain proportionate ownership interests among SHs
& guard against internal coups.
3. Ensure the corp will satisfy the Subchapter S
requirement of maximum 75 SHs.
4. Ensure compliance with professional corp statutes (e.g.,
only physicians can be SHs of professional medical
corp)
5. Preserve exemptions under securities laws that prohibit
the sale of unregistered restricted securities.
Transfer restrictions are often combined with
contractual liquidity rights, which create a
“private market,” a substitute for the liquidity
available to SHs in PHCs.
Creation of Transfer Restrictions &
Liquidity Rights
1. Usually cover not just share sales but also
trust, gifts, and stock pledges.
2. Agreement may be in the articles, bylaws, SH
agreement, or agreement between corp & SHs.
3. Transfer restriction enforceable against
transferee only if has knowledge of restriction
or the restriction is “conspicuously” noted on
the certificate itself. (Lack of notation is not a
defense in strictly intra-SH agreements).
Creation of Transfer Restrictions &
Liquidity Rights (cont’d)
Drafting issues:
1. What are the restrictions, and who is subject to them?
2. What triggers the “buy-sell” provisions?
3. Who has the option (or obligation) to purchase—corp, SHs,
both?
4. If the corp purchases, who decides?
5. If more than one party is to purchase, in what proportion and
order do the purchases take place?
6. How is the share price determined—book value, outsider
offer, mutual agreement with periodic revisions,
capitalization of earnings, outside appraisal?
7. What if corp cannot repurchase the shares because it’s
insolvent?
8. If funding comes from death or disability insurance policies,
who pays the premiums?
Validity of Transfer Restrictions
Tension between tenet of free transferability and private
corporate structuring to meet participants needs. Rule:
transfer restriction must not be “unreasonable”:
1. Flat prohibition: Prohibition against any transfer to anyone
invalid.
2. Purchase option: SH must 1st offer shares to corp at
specified price. E.g.: Allen v. Biltmore Tissue Co. (N.Y.
1957); Ling & Co. v. Trinity Sav. & Loan (Tex. 1972).
3. Prior approval (consent restraint): E.g.: Rafe v. Hindon (N.Y.
1968).
4. First refusal: SH must 1st offer shares to corp at same price
and on the terms offered by the outsider. OK.
5. Mandatory buy-sell: On death, withdrawal, deadlock, or
other contingency, the SH must sell to the corp at a
specified price.
Legal Capital and Funding for
Corp’s Share Purchase
Corp must not purchase shares if corp
would be insolvent (i.e., bankrupt or
unable to pay debts as they come due).
SH negotiating agreement that corp must
buy his shares at death a requirement that
corp buy life insurance to fund the
purchase after he dies.