Business associations 3: Iinternal governance

F15

Business associations

Chapter 3:

Internal governance

(corporate governance)

Prof. Amitai Aviram

Aviram@illinois.edu

University of Illinois College of Law

Copyright © Amitai Aviram. All Rights Reserved

© Amitai Aviram. All rights reserved.

Internal governance

Overview of Chapter 3

a. Litigation solutions

1. Private paternalism

2. Classification

3. Application

b. Exit solutions c. Customizing the firm

2


Private paternalism

Chapter 3: The big picture

• Corporate law = acting through others

• Two main legal issues:

– Corporate compliance (external governance): B’s liability to T for A’s actions

• The shielding problem

– Corporate governance (internal governance): A’s liability to B for A’s actions

• The agency problem

• The agency problem: when someone works for another, they do not work as efficiently as if they worked for themselves, because they do not gain the full value of their work, so they might:

– Shirk (put in less effort or care than if they worked for themselves)

– Steal (act in ways that benefit them at the expense of the beneficiary)

3


Private paternalism

Two types of agency problems

• Vertical (managerial) agency problem (management vs. shareholders)

– B owns Acme corp.; A is Acme’s CEO (Chief Executive Officer)

– A flies on business trip; buys 1 st class ticket

– This adds to Acme’s expenses compared to flying coach, reducing B’s wealth

– A claims this is in B’s interest, since comfortable flying conditions allow A to be well-rested, therefore negotiating better deals for Acme (increasing profits more than the extra cost of flying 1 st class)

– But maybe A just wants to be comfortable & would function just as well flying coach

4

• Horizontal (majoritarian) agency problem (controlling SH vs. minority SHs)

– Carol owns 60% of Acme corp.; Maya owns 40%; Acme rents office from Carol

– Acme used to make an annual profit of $100K, that was distributed as dividends to the SHs ($60K to Carol, $40K to Maya)

– When rent contract is renegotiated, Carol raises rent by $90K. Now profits are only $10K, so Carol gets $6K & Maya $4K (the $100K now divided $96K/$4K)

– This is unfair to Maya if the rent raise was unjustified, but maybe the fair cost of rent really did increase by $90K (in which case not giving it is unfair to Carol)


Private paternalism

Solutions to minimizing the agency problem

Bonding: A’s welfare is aligned with B’s welfare

Voice: B has unilateral powers that may affect A’s behavior

Exit: B has unilateral power to end association with firm & take her share of the value the firm created

Litigation: Independent party (judge) enforces appropriate behavior by A

Morality/identity

Joint ownership/performance-based compensation

Appointment

Authority / Approval

Protest

Termination (dissolution)

Dissociation

Alienation

Fiduciary duty

Limitations:

• Not every job is conducive to appeal to morality/identity

• Joint ownership less effective than 100% ownership & works poorly when there are many As

• Performance-based compensation requires ability to identify relevant benchmarks, observe performance & punish sufficiently to deter

5


Private paternalism


Bonding: A’s welfare is aligned with B’s welfare

Voice: B has unilateral powers that may affect A’s behavior

Exit: B has unilateral power to end association with B & take her share of the value the association created


Morality/identity

Joint ownership/performance-based compensation

Appointment

Authority / Approval

Protest


Dissociation

Alienation

Fiduciary duty

Limitations:

• SH rivalry: Voice can make the horizontal (majoritarian) agency problem worse by facilitating the majority’s tyranny of the minority

(or, if minority has veto power, the reverse)

• SH apathy: Voice is not effective when beneficiaries cannot effectively govern collectively, yet this is precisely when the vertical agency problem is at its worst

• When Bs are rationally apathetic, either no voice, or voice taken over by activists (who advance their own interests, which tend to be short-term)

6


Private paternalism




Exit: B has unilateral power to end association with B & take her share of the value the association created

Morality/identity


Appointment


Protest

Termination (dissolution)

Dissociation

Alienation


Fiduciary duty

Limitations:

• If exit requires the firm (or the other Bs) to buy the exiting B’s interest, this can create financial difficulties and be exploited by an opportunistic B

• Alienation solves this at price of being stuck with B’s you don’t like

• Success is highly dependent on figuring out the “correct” value of B’s share

• If shares are not actively traded, this is difficult

• Even if shares are traded, firm/controller may be able to manipulate market

• Traded shares usually don’t include value of controlling the firm

• Very effective exit may cause excessive managerial focus on the short-term

7


Private paternalism




Exit: B has unilateral power to end association with B & take her share of the value the association created

Litigation: Independent party (judge) enforces appropriate behavior by A

Morality/identity


Appointment


Protest


Dissociation

Alienation

Fiduciary duty

Limitations:

• More uncertainty of outcomes (B can select good As, but can’t control quality of the judge; A can’t consult with judge to avoid violating the law)

• Expensive to litigate, so when Bs are rationally apathetic, either no litigation, or litigation taken over by lawyers, who advance their own incentives (attorney fees)

8


Private paternalism

Challenging an actor’s behavior

• B gets two distinct challenges vs. A’s behavior (acts & omissions)

– Authority: A did not have the right to do the particular act on B’s behalf

– Fiduciary duty: A’s behavior had an improper purpose (wasn’t in B’s interest)

9

• Conduct authority analysis as we’ve learned in Section 1c4 [R3A §3.01]

1.

Manifestations by B that are perceived by A (this includes agreements between A&B, bylaws, charter & law)

2.

These manifestation cause A to reasonably believe that A is authorized to act in a certain way on behalf of B

– R3A §2.02(1): A has authority for acts that are “necessary or incidental” to achieving the principal’s objectives

• We will learn how to conduct FD analysis in sections 3a2/3a3

– In the remainder of the class we will discuss the idea behind FD – private paternalism


Private paternalism

The norm-generating rule

• Litigation involves an independent party (judge) enforcing appropriate behavior by A

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• How do we decide what’s the appropriate behavior (the normgenerating rule)?

– Private ordering : appropriate behavior is what the parties contractually agreed it would be (courts enforce the contract)

– Public paternalism : judges, regulators or legislators set the norms they believe are best for B (or for society)

– Private paternalism : A tasked with deciding what’s good for B, but is required to act in the interest of B (when legally enforceable, court can punish A if A acted for a purpose other than the benefit of B)


Private paternalism

Norm-generating rule: private ordering

11

• Under private ordering, government enforces voluntary agreements the stakeholders reached

• Strengths

– Least effort to enforce (agreements reflect balance of power between stakeholders)

– Usually easy to morally justify (these are the terms the parties agreed to)

– Stakeholders likely know best what terms are most suitable for them

• Weaknesses

– When stakeholder can’t exclude others from their contribution (e.g., providing security, clean environment, educated population), others have no need to bargain with that stakeholder

– Societies discourage some voluntary agreements; e.g., when:

• Bargaining power varies widely;

• Society is more sympathetic to one party than the other;

• Society wants to avoid commodification of sacred values, such as life/liberty

– When it is difficult to anticipate future contingencies or to describe in objective terms all desirable/undesirable behavior: this is a particular problem for equityholders (SHs), who can’t specify their right to the firm’s profits


Private paternalism

Norm-generating rule: public paternalism

12

• Public paternalism allocates to the government the task of setting the norms it believes are best for B (or for society)

– The political process determines what government’s preferences are, so stakeholders & the firm use the political process to protect their interests

• Strengths

– Protects stakeholders w/weak bargaining power but significant political power

• E.g., the community (which can’t exclude the firm from its contributions & wants to enforce on the firm certain social values)

• Weaknesses

– Polity that elects government’s officers is not identical to the group of stakeholders in a firm – so outcome of political process represents balance of political power (votes & lobbying power), which might be so unfavorable to some stakeholders that they would not participate

– One size fits all: government can’t create special terms for each firm, so the balance that is struck is a compromise that isn’t optimal for some firms


Private paternalism

Norm-generating rule: private paternalism

13

• Private paternalism requires one who acts on B’s behalf to pursue B’s interests

– When legally enforceable, A has a fiduciary duty to B, so a judge can punish A if she acted against B’s interest

– If Bs’ interests are diverse, A can do whatever she wants, find an interest of some stakeholders that fits with that action & claim that’s the interest she is pursuing

– So, private paternalism works better the more narrowly defined the interests A must pursue (ideally, Bs should have a homogenous, narrowly-defined shared interest)

• Strength

– Good for equityholders (SHs), who are poorly protected by private ordering & public paternalism

• Weakness

– For legal enforcement to be effective, A must pursue a homogenous, narrowly defined interest. Requires prioritizing one group of stakeholders over all others.

• Benefit corporations sacrifice this effectiveness to allow more inclusiveness of non-SH stakeholders


Private paternalism

Three modes of private paternalism

14

• Board-supremacists

– The agency problem in SH voting & SH litigation is severe

• SH rights get hijacked by plaintiff lawyers & short-term SH activists, so voice solutions should be constrained & accountability maintained mostly through an efficient fiduciary duty & market oversight

– Firm’s interests = SH interests

• SHs are least able to rely on private ordering & public paternalism, so the firm’s interests should be limited to SH (long-term) interests; other stakeholders can protect themselves through regulation or contract

• Limiting the firm’s interests to SH interests makes FD & market oversight more efficient

– Board autonomy is important

• Boards are necessary because SH apathy and SH rivalry make SHs unable to govern


Private paternalism


15

• SH-supremacists

– The agency problem in corporations is severe

• Boards are necessary for day-to-day management, but require significant oversight to reduce the agency problem

• Boards are less accountable to SHs than plaintiff lawyers & SH activists, so boards should be mostly constrained by voice solutions (making it easier for SHs to oversee directors)

– Firm’s interests = SH interests

• Agree with board-supremacists (though less hostile to short-term SH interests)

– Board autonomy is undesirable

• Boards use their autonomy to enrich themselves and their supporters at SHs’ expense


Private paternalism


• “Team production” school

[less agency solutions, more stakeholder inclusiveness]

– The agency problem is not as harmful to society as the prioritizing of SHs over other stakeholders of the firm

• Focus on SH interests causes firms to externalize costs on other stakeholders, who can’t sufficiently protect themselves through regulation & contract

• Voice & litigation solutions should be weakened or expanded to non-SH constituencies, since SHs tend to excessively focus on the short-term and on profits

– Firm’s interests = Mix of all stakeholders’ interests

– Board autonomy is important

• Boards exist to mediate the interests of all stakeholders. They must be allowed to use their discretion, even at the cost of a slightly greater agency problem

16


Private paternalism

SH wealth maximization norm

• The shareholder wealth maximization norm states that the purpose of corporate acts should be to maximize SH’s financial interests (i.e., value of residual claim on the firm

17

• The norm & its limits: ALI’s Principles of Corporate Governance §2.01

(reflects most U.S. jurisdictions)

– “A corporation should have as its objective the conduct of business activities with a view to enhancing corporate profit and shareholder gain.”

– “Even if corporate profit and shareholder gain are not thereby enhanced-”

• Corp must act within the boundaries of the law

• Corp “may take into account ethical considerations that are reasonably regarded as appropriate to the responsible conduct of business”

• Corp may give to charity “reasonable amount of resources”

• Benefit corporations explicitly reject the SH wealth maximization norm


Internal governance




2. Classification

3. Application


18


Classification

What is a fiduciary duty?

19

• FD is a duty that requires an actor to act in the interest of the beneficiary, beyond what is required of A by contract

• FD analysis framework

1.

Duty : is A required to act in B’s interest?

2.

Flaws : identify potential flaws in A’s behavior Classification

3.

Standard of review (“SoR”): who decides if A’s act was in B’s interest?

4.

Application (of SoR to the potential flaws)

– Ratification/prior approval (if behavior by/attributable to B waived FD breach)

• Regarding prior approval, consider exculpation: Under DGCL §102(b)(7), a firm can have a clause in its charter that eliminates or limits directors’ personal liability for monetary damages for breach of FD, except:

– Self-dealing & bad faith (acts/omissions not in good faith, involving intentional misconduct or knowing violation of the law, and acts/omissions where director derived improper personal benefit)

– Unlawful dividend payment/stock repurchase

• So, if a firm has an exculpation clause, a challenge based on unintentional negligence of a director , that requests a remedy of damages (as opposed to an injunction) will fail


Classification

Duty

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• Agents

– Agents owe a FD to the principal (so, duty test is whether A is B’s agent)

– Officers: conflicting authorities as to whether officer FD follows rules for agents or autonomous fiduciaries; for this course, treat officers as agents

• Autonomous fiduciaries

– Directors: each director owes a FD to the firm (and to its SHs)

– Incorporators: an incorporator owes a FD to the firm she is forming

• SHs

– SHs do not owe a FD to the firm or to other SHs

– Exception: SH may owe FD in exercising control of the corporation

• This exception is discussed in M&A; for BA, treat SHs as never owing a FD


Classification

Flaws in an actor’s behavior

Negligence

Types of legal flaws

Self-dealing Bad faith

Negligent act

Negligent inaction

CoI

Unauthorized benefit

Corporate waste

Illegality

Disregard of duty

Failure to disclose

• Negligence (breach of A’s duty of care (“DoC”))

– Action/inaction in which A doesn’t employ sufficient effort/care

• Self-dealing (breach of A’s duty of loyalty (“DoL”))

– Conflict of (self-)interest & duty (“CoI”)

– Unauthorized benefit from fiduciary position

• Bad faith (breach of A’s DoL)

– A acts disloyally/fails to act loyally (i.e., behavior against B’s interest) without evidence of self-dealing

• This is a category designed to give judges extra discretion to condemn A’s behavior even when there is no evidence of self-dealing

• Bad faith category doesn’t exist in agency SoR (FD breached only by selfdealing or negligence)

21


Classification

Self-dealing

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• Conflict of interest occurs when A faces a conflict between his selfinterest & his duty to act in B’s interests, in matters connected with the fiduciary relationship

– Did A have personal interest in A’s behavior that conflicts with B’s interest?

– Did the CoI occur in a matter connected with the agency relationship?

• Unauthorized benefit from fiduciary position: A obtains an unauthorized benefit by use or by reason of his fiduciary position or of opportunity, knowledge or access to property that results from the fiduciary position

– Did A receive a benefit?

– Was the benefit unauthorized?

– Was the benefit derived in connection with the agent’s position or actions on behalf of the principal?


Classification

Self-dealing: overlap between the two prongs

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CoI without proof of benefit

Benefit without proof of CoI

(conflicted actor transaction)

Conflict of interest

E.g., Usurping business opportunities

Unauthorized benefit from fiduciary position

Conflicted actor transaction: Agent Ann hires her brother Tom to work for B (Tom is the most qualified candidate & charges B below market prices)

Usurping business opportunity: A is an employee of B’s auto repair business; T asks A to repair her car; A does this on his own (not for B)


Classification

Flaws: bad faith ( actions / inactions )

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• Corporate waste

– Act is so one-sided (against the firm) that no business person of ordinary, sound judgment could conclude that the firm has received adequate consideration

– Corporate waste is occasionally referred to as:

• “Irrational” acts

• Act motivated by an improper purpose (a purpose other than B’s welfare or

A’s self-interest)

• Illegality

– Actor intentionally violates the law (including fraud)

• Conscious disregard of duty

– A intentionally fails to respond to a known FD or exhibits a conscious disregard of a known FD

• Failure to disclose

– Under some circumstances A has a duty to disclose information to other actors

– When failure to disclose is entirely merged in another flaw (i.e., only impact of failure to disclose is facilitating the other flaw), analyze only the other flaw

• E.g., A hires A’s spouse to work for B, without disclosing the CoI to B: analyze this only as self-dealing, not a second time as failure to disclose


Classification

SoR

• SoR: Who decides if A’s act was in B’s interest?

– Beneficiary?

– Actor?

– Judge?

B’s discretion

(Agency SoR)

25

A’s discretion

(BJR)

Between A & judicial

(Enhanced scrutiny)

Judicial discretion

(Entire fairness)


Classification

SoR

26

• Agency SoR: emphasis on beneficiary’s discretion

– Applies to all agent behavior (acts/inactions)

– Court must find a FD breach if A is negligent or self-deals, unless B approved A’s behavior (limits both judicial discretion & deference to A)

– Drawbacks of relying on B’s discretion

• Doesn’t protect against horizontal agency problem (SH rivalry: C oppressing MSHs)

• Doesn’t work when Bs cannot effectively govern collectively (SH apathy)

• BJR SoR: emphasis on actor’s discretion

– BJR is the default SoR for behavior (acts/inactions) of autonomous fiduciaries

– FD breach only if A fails to use discretion (no decision/arbitrary decision) or behaves in bad faith (i.e., A is knowingly unfair to B)

– Drawback of relying on A’s discretion: A can often hide shirking/stealing

• Entire fairness SoR: emphasis on judicial discretion

– Applies when autonomous fiduciary is self-dealing (also applies when controller is self-dealing, but this isn’t part of course material)

– Breach if court thinks action was unfair to B

– Drawbacks of relying on judicial discretion

• Uncertainty for A & B on how judge would rule (B can choose A, but can’t choose the judge; A can consult with B, but can’t consult in advance with the judge)

• FD decisions are heavily fact dependent, so precedents are less useful than other areas of law

• Enhanced scrutiny SoR: compromise between A & judicial discretion

– Applies for certain board actions in which there is an increased risk that board has CoI with SHs


Classification

SoR selection flowchart

27

Stewards don’t owe FD; end of analysis

Steward What type of actor is A?

Autonomous fiduciary

Was A self-dealing?

No

Did A deploy power against B or act to facilitate a change of control in the firm?

No

BJR applies

Agent Agency SoR applies

Yes

Yes

Entire fairness applies

Enhanced scrutiny applies


Classification

SoR: when does entire fairness apply?

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• Entire fairness SoR applies if A was self-dealing

– I.e., A is conflicted with respect to the challenged behavior or received an unauthorized benefit from the fiduciary position (latter is typically an inaction anyway)

• A (an actor or member of a collective actor) is conflicted if:

– A has a personal interest in A’s behavior that conflicted with B’s interest, and the conflict occurs in a matter connected with the fiduciary relationship

– Another member of the collective actor who is conflicted fails to disclose their interest to A despite a duty to do so (the duty exists if the interest is material; i.e., a reasonable A would regard the undisclosed interest as significant to deciding on the act)

– Someone with a CoI controls or dominates A

• Test for control/domination (Beam v. Stewart): is the non-interested director would be more willing to risk his or her reputation than risk the relationship with the conflicted director ?

• A collective actor (e.g., board, board committee) has CoI if 50% or more of its members have CoI

– Example: board composed of 4 directors votes 4-0 to hire Ann

• If 1 director has CoI & 3 don’t, decision benefits from BJR

• If 2 directors have CoI & 2 don’t, BJR is rebutted


Classification

SoR: when does enhanced scrutiny apply?

• Enhanced scrutiny applies when:

– A deploys corporate power against SHs to achieve greater good for firm

• Board interferes with SH voting rights (Blasius)

• Board implements actions that make it impossible or economically unfeasible for SHs to sell their shares to someone (Unocal)

– A embarks on a transaction that will result in a change of control (Revlon)

29


Internal governance




2. Classification

3. Application

• Agency SoR

• BJR

• Entire fairness

• Enhanced scrutiny


30


Agency SoR

Negligence

• R3A §8.08: Test for A’s negligent behavior (act or inaction)

– Did A act with care, competence & diligence normally exercised by agents in similar circumstances?

– Special skills/knowledge A has/claims to have are considered in analysis

31

• In Agency SoR, both the process and the substance of the behavior is evaluated for negligence

– Process: did A possess sufficient expertise & information to act?

– Substance: would a reasonable actor behave in this way?

• Goes beyond the process of reaching the decision how to behave, to the competence of executing that decision

• Can apply to inactions as well as actions


Agency SoR

Self-dealing: Conflict of interest

32

• Rash [CA10, 2007]

– Rash hired to manage the Tulsa, OK division of JVIC’s oil refinery & power plant maintenance business

– Rash owned TIPS (a scaffolding business); JVIC had its own scaffolding business

– Rash often selected TIPS as subcontractor for JVIC-Tulsa’s contracts (paying over $1M between 2001-04)

– Does Rash have a CoI?

• Personal interest in his behavior that conflicts with JVIC’s interest?

• Conflict occurred in a matter connected with the agency relationship?


Agency SoR

Self-dealing: fairness (is not a defense)

33

• Self-dealing is not always bad

– Hypo: Ann is the CEO of Orange & Blue Taxi Corp, a taxi company. One of O&B’s cabs breaks down. Ann’s brother Tom is a car mechanic. Is there an advantage to the firm in having Tom fix the cab (rather than go to another mechanic)?

• Fairness

– Fairness is not a defense to self-dealing in agency law. Even if the Rash court found that TIPS was the best & cheapest firm to do scaffolding jobs for JVIC-

Tulsa, Rash would have breached his FD

– The rule is different for autonomous fiduciaries. When directors self-deal, but the deal is fair to the firm, they do not breach their FD.

– Why does the agency SoR not allow a fairness defense?

• Agency SoR emphasizes beneficiary discretion: if B did not approve the deal, it is held to be bad for B, even if it looks good to the judge

• This rule supports B’s power to control A: to avoid liability in conflicted situations, an agent must ask B for approval (can’t rely on deal being fair)

• In contrast, with autonomous fiduciaries, Bs are seen as unable to effectively control A, so relying on B’s discretion & control is less effective


Agency SoR

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Self-dealing: Unauthorized benefit (from fid. position)

• Hypo: Angie worked at Patty’s restaurant. Patty told Angie she would be paid an hourly wage. Nothing was mentioned about tips.

• After serving a large & demanding group, she gave the bill to Tom, who paid for the group.

• Tom then handed Angie a $50 bill and said “This is for you, not your boss. We were a fussy group and you had the patience of a saint.”

• Does Angie breach her FD if she doesn’t give the $50 to Patty?

• Did A receive a benefit?

• Was the benefit unauthorized?

• Was the benefit derived in connection with A’s position/actions on behalf of P?


Agency SoR

Approval

35

• Breach of FD (as well as exceeding authority) can be cured by the beneficiary’s approval (ratification/prior consent)

– When relevant, approval analysis should be done as a separate step from the

FD analysis, following the rules we learned in section 1c

• In Rash, JVIC’s president Joe Vardell told Rash that he had no problem with Rash forming a business which might contract with JVIC, but court did not view this as valid approval

– Vardell’s statement was a response to Rash asking for permission to use his own “tool rental company”, not a scaffolding business

– This creates ambiguity, at least, whether Vardell’s consent applied to the scaffolding business

– Also issue with scope of approval: approval is limited to a specific transaction or specific type of transactions; Vardell could not absolve Rash from all breaches of FD. His statement seems to approve self-dealing in on type of transactions: with Rash’s tool rental company


Agency SoR

Summary

36

• Negligence: FD breached if reasonable actor would have exercised more care/effort under the same circumstances (R3A §8.08)

• Self-dealing: FD breached if A has CoI (R3A §§8.01, 8.03-8.04) or if A received an unauthorized benefit from the fiduciary position (R3A

§8.02, 8.04-8.05)


Internal governance




2. Classification

3. Application

• Agency

• BJR

• Entire fairness



37


BJR

Overview of the BJR SoR

• BJR is a rebuttable presumption that A’s behavior was in B’s interest; when BJR doesn’t apply, it is said that “BJR was rebutted”

– Rebutting the presumption doesn’t always mean FD was breached

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• Step 1 (BJR rebutted?): Court defers to A (no FD breach), unless –

– A didn’t make a business judgment (inaction or negligent act)

– A didn’t act in good faith pursuit of a legitimate corporate interest

• Step 2 (FD breached?): Once BJR is rebutted, FD is breached –

– If legal flaw was negligence, FD is breached if act was grossly negligent

– If legal flaw was a bad faith action, FD is automatically breached

– If legal flaw was a bad faith inaction, certain tests for whether FD was breached


BJR

Negligence

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• Negligent act

– Step 1: is BJR rebutted? Procedural evaluation of negligence

• Identify necessary expertise & information, taking into account time constraints & importance of the challenged decision to B

• Did actor acquire necessary expertise & information?

– Step 2: is FD breached?

• If BJR rebutted, DoC is breached if actor was grossly negligent

• McPadden v. Sidhu (Del.Ch. 2008):“gross negligence is conduct that constitutes reckless indifference or actions that are without the bounds of reason”

• This is similar to negligence test + subjective “red flag” warning to A (usually, a negligent act that rebuts BJR will breach FD)

• Negligent inaction

– Step 1: is BJR rebutted? Yes, because it is an inaction

– Step 2: is FD breached? Only if inaction was grossly negligent


BJR

Bad faith actions

• BJR rebutted & actor breached FD if:

– Corporate waste: transaction is so one-sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration

• Alternative test: A knowingly pursues a purpose other than SH welfare or A’s self-interest

– Illegality: actor knowingly violates the law (including fraud)

40


BJR

Bad faith: Disregard of duty

41

• BJR always rebutted, because disregard of duty is an inaction

• FD breached (under Stone v. Ritter test) if one of the following is established:

– Directors utterly failed to implement any reporting or information system or controls

– Having implemented such a system or controls, consciously failed to monitor or oversee its operations, thus disabling themselves from being informed of risks or problems requiring their attention

• Evidence of non-compliance doesn’t prove lack of a system or insufficient monitoring


BJR

Bad faith: Failure to disclose

• BJR always rebutted, because failure to disclose is an inaction

• FD is breached when actor fails to disclose to other actors (e.g., board, board committee, SHs) all material info reasonably required for them to act on behalf of the firm

– E.g.: since SHs elect the directors, board would act in bad faith if it failed to provide SHs all material info it has relevant to deciding whether to elect the proposed candidates

– MBCA duty of disclosure (MBCA 8.30(c); use this for Delaware law as well): duty to disclose info that is material to the discharge of another actor’s decision-making or oversight functions , unless disclosure violates a superior duty (imposed by law, confidentiality agreement, ethics rule, etc.)

– When info isn’t related to facilitating another actors’ acts, failure to disclose may still breach FD if it qualifies as a bad faith disregard of duty

42


BJR

Summary

43

Step 1:

BJR rebutted?

Step 2:

FD breached?

Application: BJR

Negligent act Negligent inaction

Process only negligence test

(expertise & info)

Automatic

(inaction)

Corporate waste

Corporate waste test

Gross negligence

(negligence + subjective “red flag”)

Gross negligence

Illegality Disregard

Knowingly acting illegally of duty

Automatic

(inaction)

Automatic breach if BJR rebutted

Automatic breach if BJR rebutted

Test for disregard of FD (Stone)

Failure to disclose

Automatic

(inaction)

Test for failure to disclose


Internal governance




2. Classification

3. Application

• Agency

• BJR

• Entire fairness



44


Entire fairness

The fairness test

45

• General test: was the challenged behavior in B’s interest (i.e., wealthmaximizing for the SHs)?

– Side test (for actions): Does the firm benefit from an act of this type, or was it motivated by the benefit of the actor?

• Detailed test (typically used to evaluate transactions)

– Were the terms similar to those likely achieved in a non-conflicted (arm’s length) transaction?

• Fair process (for determining price/other terms)

• Fair price (valuation/comparison)

– In re Nine Systems Corp. (Del.Ch. 2014): if process is grossly unfair, decision is unfair even if the price is fair (possible remedy: shifting attorney’s fees & costs)

• Detailed fairness test for usurpation of business opportunities

(Guth v. Loft test: no single factor is dispositive; court balances all factors)

• Was B financially able to take the opportunity?

• Was the opportunity is in B’s line of business?

• Did B have an interest or expectancy in the opportunity?

• By embracing the opportunity, would A create a conflict between his/her selfinterest and that of B?


Internal governance




2. Classification

3. Application

• Agency

• BJR

• Entire fairness



46


Enhanced scrutiny

Why enhanced scrutiny?

47

– Some actions often pose significant benefit to SHs, yet are tainted by a mild degree of CoI. Without enhanced scrutiny, we would be forced to either treat these actions as self-dealing (applying entire fairness, which may deter these actions) or as not self-dealing

(applying BJR, which would immunize the action from most challenges)

– Enhanced scrutiny allows the court to look into the substance of the decision (unlike the purely procedural evaluation of the BJR), without taking discretion entirely away from A

– Rather than asking “how would I have acted?”, the judge asks whether A’s actions are reasonable in relation to the alleged

(legitimate) purpose of the action


Enhanced scrutiny

Applying enhanced scrutiny

1. Quasi-BJR : did the board find, in good faith & after a reasonable investigation, a legitimate purpose that warranted the board’s act?

• Legitimate purpose: No bad faith (i.e., no corporate waste or illegality)

• Good faith: No self-dealing

• Reasonable investigation: No negligence

48

2. Was the act a reasonable response proportionate to the purpose?

• Usually act is seen as unreasonable if it is:

– Coercive (forces B to vote in favor of A’s desired act); or

– Preclusive (prevents B from ever successfully exercising their right)

• But an act might be unreasonable even if it is not coercive or preclusive


Enhanced scrutiny

Applying enhanced scrutiny: example

49

• Meeting of Target’s SHs called to approve sale of Target to Acquirer

– Rumors are that the board was originally in favor of the deal, but now want to thwart it because they discovered that they would be replaced after the merger

• An hour before the meeting the board receives a non-binding offer from Spoiler Corp. to buy Target for a price that is 5% higher

– The board decides to postpone the SH meeting by one month to make time for

Spoiler to make a binding offer and have SHs consider it as an alternative

• A Target SH sues, asking to enjoin the board and force it to hold the

SH meeting immediately.

• Which SoR applies?

– If court determines board motivation was to keep their jobs, this is self-dealing, so entire fairness applies

– If court determines board motivation was to consider a potentially better offer for SHs then this is not self-dealing. However, board’s use of power to postpone the meeting still frustrated SHs’ right to vote at the meeting, so enhanced scrutiny applies.


Enhanced scrutiny

Applying enhanced scrutiny: example

• Application of enhanced scrutiny to the example

1.

Quasi-BJR: did the board find, in good faith & after a reasonable investigation, that firm faced a threat that warranted the board’s act?

• Legitimate purpose: allowing a better offer to materialize & allowing SHs time to consider it (so no corporate waste or illegality)

• Good faith: court investigates evidence of self-dealing; none likely here

(otherwise, court would have applied entire fairness)

• Reasonable investigation: court will consider whether the board had adequate information, expertise & time to make a decision on the postponement

2.

Was the act a reasonable response proportionate to the threat posed?

• Act is not c oercive (SHs are not forced to vote against Acquirer’s deal)

• Act is not preclusive (postponement merely delays deal by a month; if a month was enough to certainly kill the deal, it may be preclusive)

• Is it unreasonable anyway? Is one month too long (considering whether less time would reasonably suffice)

50


Internal governance

Overview of Chapter 3 a. Litigation solutions

b. Exit solutions

1. Alienability

2. Dissociation

3. Termination (dissolution)

c. Customizing the firm

51


Exit solutions

Types of exit solutions

52

• Exit solutions allow B unilaterally to leave the firm & receive her share of the firm’s value

– Alienability: allow B unilaterally (without requiring consent of firm/other Bs) to sell interest in the firm to third parties

• Allows for the firm’s longevity & maintains firm’s goodwill, but no guarantee business ownership remains in acceptable hands

– Dissociation: allow B to unilaterally sell interest in the firm back to the firm/other Bs (at the interest’s fair price)

• Allows for the firm’s longevity, maintains firm’s goodwill & keeps business ownership in acceptable hands, but requires that: (1) parties agree on the fair price; (2) firm/remaining Bs are able to pay; (3) firm is viable to the remaining Bs without the dissociating B

– Termination (dissolution): allow a SH to unilaterally cause the firm to terminate, liquidate its assets & divide the proceeds

• but allows restrictions on alienability, but sacrifices firm’s longevity & may lose firm’s goodwill (value of the “live” business - value of the “dead” business)

• Public firms favor alienability over dissolution/dissociation

• Private firms favor dissolution/dissociation over alienability

– Why? (Compare to marriage)


Alienability

Rules on alienability in corporate law

53

• Transferable shares

– By default, SH can sell shares without restriction

– Restrictions on alienating SH rights separately from shares (e.g., selling right to vote without selling shares)

• Perpetual existence

– By default, a corporation exists indefinitely

• Restrictive dissolution

– Individual SH has no right/power to dissolve

– Dissolution if majority of both board & SHs vote in favor, or (in rare cases) by judicial or administrative order

• Capital lock-in (SH can’t withdraw equity capital, giving corporation financial stability, but at expense of lost accountability)

• When corp issues new shares, SH pays corp (say, $10) for shares

• When SH wants to cash out, she can’t force corp to buy back her shares; instead, SH can sell shares to T (corp keeps the $10)

– Exception 1: if shares were specifically made redeemable

– Exception 2: corp may choose to repurchase the shares


Alienability

Rules on alienability in partnership law

• April, a partner in a three-partner law firm, wants to cash out

• Can she (unilaterally) sell a 1/3 share of the partnership assets (e.g.,

1/3 of the furniture) to Brian?

– RUPA §501

• Can she (unilaterally) sell her control rights in the partnership to

Brian? Her economic rights?

– RUPA §401(i), 502, 503(a)(3)

54


Internal governance


b. Exit solutions

1. Alienability

2. Dissociation

• Dissociation

• Buyout agreements

• Relationship between dissociation & buyout agreements

– Termination (dissolution)


55


Dissociation

Dissociation in corporations & partnerships

• Dissociation allows B to unilaterally sell interest in the firm back to the firm/other Bs (at the interest’s fair price)

• By default, corporations have “capital lock-in” (no dissociation)

– But a corporation can issue shares that are redeemable at the SH’s option

– Also, SHs can create a buyout agreement in which they agree on situations in which one party may force other parties to buy her shares

• In RUPA partnerships, each partner has a power to dissociate (this is mandatory, not just default rule)

– RUPA §602(a): “A partner has the power to dissociate at any time, rightfully or wrongfully, by express will…”

– Departing partner generally remains liable on pre-dissociation partnership obligations unless released by creditors [RUPA §703]

– If the partnership agreement prohibits or limits dissociation (e.g., requires partner to remain a partner for X years, or give X days advance notice), a dissociation contrary to the agreement is called “wrongful dissociation” – it creates a dissociation, but former partner is liable for breach of contract

56


Dissociation

Implied terms may limit dissociation

57

• Ann & Becky are partners in building & operating a cafeteria

• Ann supervises construction & operates the cafeteria (“service partner”); Becky puts up the money

– Partnership agreement states Becky is to be repaid $30K in 1 st year of operation

& $60K/yr. thereafter, until her investment is fully repaid

• Original estimate of building costs: $300K

– When building costs reach $600K, Becky refuses to put up more money; sues for dissociation

• Can Becky dissociate?

– Can Ann make an argument that Becky wrongfully dissociated?


Dissociation

Statutory dissociation under RUPA

•

By act of a dissociating partner [RUPA §601(1)]

– By right: if the partnership is at will

– Wrongful dissociation [RUPA §602(b)]

•

By terms of partnership agreement [RUPA §601(2)-(3)]

•

By unanimous vote of all other partners [RUPA §601(4)]

– Limited to specified circumstances

•

By court order [RUPA §601(5)]

•

By operation of law [RUPA §601(6)-(10)]

– E.g., due to death, bankruptcy, unlawfulness

58


Buyout agreements

Some key considerations

59

1.

Who buys the equity interest?

– Third parties

• No buyout agreement; just avoid share transfer restrictions

• Limited value if market is very thin (few buyers/sellers)

• Undesirable business partners

• Difficult when firm must have share transfer restrictions (e.g., Del. statutory close corp.)

– Remaining SHs

• Raises problems with liquidity of SHs

• Can be used opportunistically to extract benefits

– Or else SH will cash out, forcing the other SHs into insolvency

– The firm

• Raises problems with firm’s liquidity (can be used opportunistically)

– Life insurance

• One of the most commonly implemented exit arrangements in close corporations is triggered upon a SH’s death. Why?

• Life insurance both helps with financing the buyout, and avoids arguments over valuation (since it’s clear the deceased SH’s estate would sell the shares, it would push for high valuation)


Buyout agreements

Some key considerations

2.

Triggering event: what has to happen to allow a SH (or the firm) to force a buy-out?

– Check relevant statutes for mandatory/default right to dissociate, and make sure to cover all situations that allow dissolution/dissociation under the applicable statute

3. Price for which equity interest is bought-out

– Parties may determine value periodically by agreement

• Parties often neglect to do so

• As interests diverge, parties may disagree

– Parties may hire an appraiser

• May be difficult to agree ex-post on the identity of appraiser

• Appraiser may over time develop a closer connection to one party

60


Buyout agreements

Some key considerations (price)

61

• Parties may set a formula

– Often a multiplier of annual cash flow or earnings

– Example

• Acme is a close corporation that owns a shopping mall; annual profit: $500K

• A similarly-situated company is publicly held, with 2M shares outstanding, trading at $5 a share (market cap: $10M) & an annual profit of $1M (so price/earnings ratio: 10)

– If Acme has the same P/E ratio, it should be worth $5M ($500K x 10)

– Acme’s buyout agreement can either specify the multiplier, or require checking the multiplier at time of buy-out

• Parties may use book value

– Book value is the price of the assets when purchased, reduced over the years for wear & tear (depreciation)

– Depreciation may not reflect real value (e.g., antique that appreciated in value; car that lost much value in 1 st year)


Buyout agreements

Some key considerations (price)

62

• Strategic process

– E.g., “You cut, I choose”: One party names a price, the other decides whether it will buy from the other, or sell to the other, at that price

– Works well if both parties have sufficient cash & info

– Example: Banks A & B jointly own Acme, a home financing joint venture

• Bank A (much larger than Bank B) owns 75% of the shares; Bank B owns 25%

– As a result of antitrust enforcement, banks required to break up the joint venture; charter had a buyout clause that implements “you cut, I choose”

• Bank A decides on a price per share (any price it wants)

• Bank B then chooses whether to sell its interest to Bank A at that price, or buy Bank A’s shares at that price

– Assume that both banks have no financial constraints

• Would Bank A decide on price that’s higher or lower than Acme’s perceived value?

– Now assume Bank A expects Bank B to have liquidity problems

• Bank B has less money & has to pay for 3 times the # of shares

• Does A expect that B will buy or sell?

• Would A decide on price that’s higher or lower than the perceived value of Acme?


63

Relationship between dissociation & buyout

Haley v. Talcott

[Del. 2004]

Employment

Agreement

Redfin Seafood

Grill

Owns 100%

Matt

Haley

Personal

Guarantee

Bank

Loan/

Mortgage

50% 50%

Matt & Greg

Real Estate, LLC

Personal

Guarantee Greg

Talcott


64


Haley v. Talcott

• Talcott owns Delaware Seafood (aka Redfin Seafood Grill), a restaurant operated by Haley

• Haley’s employment contract gives him a “bonus” of 50% of the restaurant’s profits, after the loan from Talcott was repaid

– Why pay Talcott’s loan first?

• Is this a partnership?

– What do the parties do to avoid framing this as a partnership?

• How is Haley vulnerable to misappropriation?

– Firing Haley

• What does Haley do to protect himself?

– Siphoning the profits out of the company

• How can Talcott siphon money out of the Redfin Grill?

• What does Haley do to protect himself?


65


Haley v. Talcott

• Haley exercises the option; owns 50% of Matt & Greg Real Estate, LLC

– LLC purchases the property, financing it through a mortgage from County Bank

• Both Haley & Talcott sign personal guarantees for the mortgage

– Redfin Grill leases the property from the LLC for $6,000/month – enough to pay the mortgage but probably below market rent

• Relationship deteriorates

– Haley expects to receive equity interest in the Redfin Grill

– Talcott refuses, and eventually sends Haley a letter purporting to accept Haley’s resignation & forbidding Haley from entering the premises of the Redfin Grill

– What right does Talcott have if Haley resigns?


66


Haley v. Talcott

• LLC Agreement has an exit mechanism

– If a member elects to “quit” the LLC, the other member may elect to purchase the departing member’s interest for fair market value.

– If other member does not elect to purchase, LLC is dissolved

• Why does Haley want to dissolve rather than exercise the contractual exit mechanism?

– How does Haley respond to Talcott’s letter?

• What’s Delaware law’s general attitude regarding judicial dissolution when a contractual exit mechanism exists?

– How does it rule in this case?


Internal governance


b. Exit solutions

1. Alienability

2. Dissociation

3. Termination (dissolution)

• Termination in agency

• Forced dissolution

• Statutory dissolution

• Process of dissolution


67


Termination in agency

Terminating agent’s actual authority

[R3A §3.06]

68

• Agreement between P & A

• Law (“the occurrence of circumstances specified by statute”)

• Changed circumstances (“the occurrence of circumstances on the basis of which [A] should reasonably conclude that [P] no longer would assent to [A’s] taking action on [P’s] behalf.”)

• A’s or P’s death/cessation of existence/suspension of powers

• P’s loss of capacity

• P’s and A’s power to terminate



Death

[R3A §3.07]

69

• A’s death/cessation of existence/suspension of powers → Terminates actual authority

• P’s death/cessation of existence/suspension of powers → Terminates actual authority:

– Immediately (except as provided by law) – if P is not an individual

– Only when A has notice of P’s death – if P is an individual

– Termination effective vs. T if T has notice of P’s death (even if A doesn’t know)



P’s loss of capacity

[R3A §3.08]

• P’s loss of capacity terminates actual authority:

– Immediately – if P is not an individual

– Only when A has notice of P’s permanent/adjudicated loss of capacity – if P is an individual

– Termination effective vs. T if T has notice of P’s permanent/adjudicated loss of capacity (even if A doesn’t know)

• P can agree in writing that actual authority will become effective upon P’s loss of capacity, or not be revoked by loss of capacity

– Why allow this exception with loss of capacity?

70



Power to terminate

[R3A §3.10]

• Regardless of any agreement between P&A, actual authority is terminated if:

– A renounces authority by manifestation to P; or

– P revokes authority by manifestation to A

• Authority is terminated when the other party has notice

• If an agreement between P&A does not allow termination of the agency (or specifies a term beyond the time the agency was terminated), the agency is still terminated, but the terminating party might be liable for breach of contract

71



Terminating agent’s apparent authority

[R3A §3.11]

72

• Termination of actual authority does not end any apparent authority held by the agent

– Why is there a separate rule for terminating apparent authority?

• Apparent authority ends when it is no longer reasonable for T to believe that the agent continues to act with actual authority

• Hypo 1: Supermarket tells one of its cashiers that she’s fired

– Is actual authority terminated?

– How can it terminate the cashier’s apparent authority?

• Hypo 2: Now, supermarket fires a manager responsible for purchases of produce

– If the manager now orders another shipment of produce on the supermarket’s behalf, must the supermarket pay?

– How can it terminate the manager’s apparent authority?


Termination in firms

Types of dissolution

• Voluntary dissolution: firm acts to dissolve itself

– Corporation: board & SH vote (DGCL §275; MBCA §14.02)

– Partnership: by unanimous vote of partners

• Forced dissolution: dissolution by unilateral action of any SH

– Corporation: individual SH has no right/power to dissolve

– Partnership: yes, by default (RUPA); yes, mandatory (UPA)

• Statutory dissolution: court/gov’t forces firm to dissolve

– Administrative (DGCL §284; MBCA §14.20)

– Judicial: Individual SH/partner can petition court to dissolve in some cases

(MBCA §14.30; RUPA 801(5),(6))

73



Delaware corporations

74

• Voluntary: Board vote + SH vote + Filing [DGCL §275]

• Forced: no unilateral right for SH to dissolve

• Statutory

– Administrative: Delaware AG may sue to revoke a corporate charter “for abuse, misuse or nonuse of its corporate powers, privileges or franchises” [DGCL §284]

– Judicial: No right of dissolution for “oppression”

• Nixon v. Blackwell (Del. 1993): Court-imposed buy-outs are inappropriate because contractual protection is available to MSHs

• What’s the disadvantage of this approach?

– I.e., if parties can contract for dissolution, why should a court dissolve the corporation in situations not covered by an agreement?



Tradeoff between liberal & restrictive dissolution

75

• Forced dissolution can be made easier or harder

Liberal

– Forced dissolution allowed

(mandatory in UPA partnerships; default in RUPA partnerships)

– Judicial dissolution if MSHs’ interests are frustrated

(Stuparich)

– Judicial dissolution if MSHs are oppressed

(MBCA §14.30(2)(ii))

– Judicial dissolution only due to fraud/abuse

(DGCL §284)

– Only voluntary dissolution allowed (majority vote)

Restrictive

• Liberal dissolution sacrifices longevity and gives MSHs some leverage

• On the other hand, it prevents/mitigates oppression


Forced dissolution

UPA

76

•

Three triggers for dissolution:

– By act of one or more partners [UPA §31(1)-(2)]; e.g.:

• At the termination of the partnership’s term or particular undertaking, or, if it has none, at the will of any partner

• Wrongful dissolution: In contravention of the agreement between the partners, by the express will of any partner at any time

– By operation of law [UPA §31(3)-(5)]

• Due to death or bankruptcy of a partner, or due to bankruptcy or unlawfulness of the partnership

– By court order [UPA §31(6); §32]


Forced dissolution

Continuing operations (UPA)

•

Archie, Beatrice & Chris are partners

– Partnership agreement states that partnership will last for 10 years & that no partner may dissolve it before that time

•

Nonetheless, after only two years Archie announces that he is dissolving the partnership

– Can he do this?

•

Beatrice & Chris now cease to be partners of each other, even though they desire to remain partners

– Can they do anything to continue the partnership?

• Note UPA § 38(2)(b)

77


Forced dissolution

RUPA

78

• By voluntary dissociation of a partner, if the partnership is a partnership at will [§801(1)]

• By dissociation of a partner through operation of law, if within 90 days at least half of the remaining partners want to dissolve the partnership [§801(2)(i)]

• By the unanimous vote of all the partners [§801(2)(ii)]

• By the terms of the partnership agreement [§801(2)(iii)-(3)]

• By operation of law due to unlawfulness, but there are 90 days to cure the illegality [§801(4)]

• By court order [§801(5)-(6)]

– Partner’s suit: Economic purpose frustrated; not reasonably practicable to carry on the partnership business

– Transferee’s suit: if equitable and possible under the terms of the partnership agreement


Forced dissolution

RUPA vs. UPA

• Hypo: Anita is a partner in a law firm

– Partnership agreement silent regarding partnership’s duration & right to dissociate or dissolve

– Anita informs the other partners she is dissociating from the law firm

• What happens to the partnership?

– Note RUPA §601(1), 801(1)

• Can the partnership agreement opt out of this outcome?

– Note RUPA §103(b)(6)-(8)

• Conclusion: Is a partner’s ability to dissolve different in RUPA than

UPA?

79


Statutory dissolution

MBCA

•

MBCA §14.30(2) – Dissolution may be ordered when:

– Corporation is deadlocked

• Board is deadlocked;

• SH are unable to break deadlock; and

• Irreparable injury or paralysis of the corporation will result from the deadlock.

– Shareholders are deadlocked

• SH are evenly divided

• SH fail to elect successor directors in (at least) two consecutive annual meetings

– Board or controller acts illegally, oppressively or fraudulently

– Corporate assets are being misapplied or wasted

80



Meiselman v. Meiselman

[NC 1983]

81

• North Carolina allows dissolution when it is “reasonably necessary for the protection of the rights and interests of the complaining [SH]”

• Meiselman: To dissolve a close corporation, sufficient to show that

MSHs’ reasonable expectations are frustrated

– MSH doesn’t need to demonstrate oppressive/fraudulent conduct by controller

• To be ‘reasonable’, expectations must -

– be reasonable under the circumstances

– be/reasonably should be known to controller

– be central to MSH’s decision to join the venture

• Meiselman: In a close corporation it is a reasonable expectation to participate in the management of the business or be employed by it

– But this is limited to expectations embodied in understandings, express or implied, among the participants



Stuparich

[Cal. App. 2000]

• Siblings Malcolm Jr., Candi & Ann owned equal amounts of HFM’s non-voting shares, but Malcolm owned majority of the voting shares

– HFM had a profitable mobile home park & an unprofitable furniture business

– Malcolm, his wife & son worked in HFM (no claim of excessive salaries); Candi

& Ann didn’t

– Candi & Ann wanted to separate the two parts of the business; Malcolm didn’t

• After their mother’s shares are distributed, C&A expect to gain control of the corporation, and call for a SH meeting to vote

– They discover that their father (Malcolm Sr.) “clandestinely” sold his shares to

Malcolm Jr. for a low price (Malcolm Jr. now has 51.56% of voting shares)

– C&A ask Malcolm to buy them out; Malcolm refuses

• At a family event at the home of the Malcolm Sr., Malcolm & Candi had an altercation that resulted in physical injuries to Candi

– Fight may have been over the sisters’ unsuccessful attempt to impose an involuntary conservatorship on their father

82



Stuparich v. Harbor Furniture Mfg.

83

• The sisters sue for dissolution

– CA statute states that in close corporations (<35 SH) dissolution may be granted if it is “reasonably necessary for the protection of the rights or interests of the complaining [SH]” (similar to NC statute in Meiselman)

• What are the sisters’ frustrated expectations?

– Working for the company

• Under Meiselman, is fact that sisters didn’t work at HFM grounds for dissolution?

– Disagreement about HFM’s strategy

• What principle can Jr. cite to justify his decision not to sell the furniture business?

• Would the sisters’ argument be stronger if they wanted to keep the furniture business & Malcolm Jr. wanted to sell it?

– Expectation to control the company

• Does court recognize a reasonable expectation of the sisters to control the firm?

– Acrimony & violence between SHs

• Does court allow dissolution of the corporation due to the violent incident between

Malcolm Jr. & Cindi?


Process of dissolution

Hypo

84

•

Archie, Beatrice and Chris are partners in a grocery store

– On January 1, they vote unanimously to dissolve the partnership

– On January 2, Archie sells bread that is in the grocery store to customers

& Beatrice orders more bread from a bakery

•

Chris claims that these transactions do not bind the partnership, because it has dissolved and so it no longer exists as a legal entity

• Is he right?

– Note RUPA § 802(a), 804

• What effect does dissolution have? Why?



Terminology

• Winding-up

– Liquidating the partnership’s assets/business

– Settling the partnership’s debts/obligations

– Dividing between the partners the remaining assets/money

• Termination: The partnership ceases to exist

• Dissolution: The process that begins with winding-up & ends in the termination of the partnership

85



Division of profits & losses

•

RUPA provides default rules on division of profits/loss

•

Division of profits

– Default rule: Profits divided equally between partners [ RUPA §401(b) ]

– What if one partner contributed 90% of capital? Equal distribution

– What if one partner contributed 90% of work? Equal distribution

•

Division of losses

– Default rule: Losses divided the same way as profits. [RUPA §401(b)]

•

Partnership agreement can change this default

– E.g., there need not be symmetry between division of profits and losses

86



Capital account

87

• Capital account: A running balance reflecting each partner’s ownership equity (see RUPA §401(a))

• Begins with the initial contribution

– Not limited to money (also labor, assets & anything else partners agree on)

• Share of the profits is added

• Share of losses & “draws” (distributions) is subtracted

• Example

– April contributed $5,000 to ABC law firm in return for a 1/3 interest in the partnership

– Firm ended 1 st year with a $3,000 loss (so April’s share of the loss was $1,000)

– In 2 nd year firm made a $9,000 profit (April’s share of that was $3,000)

– At end of 2 nd year, the partners made a draw of $4,500 (April received $1,500)

– April’s capital account at end of 2 nd year is: 5,000 - 1,000 + 3,000 – 1,500 = $5,500



Dissolution as an incentive

• Most firms are worth more “alive” (as an operating business) than

“dead” (assets sold separately)

– For that reason, even in dissolution the business is often sold in one piece

– Even if sold in one piece, some of firm’s value will be lost because -

• Dissolution forces to sell now, which weakens the seller’s bargaining position

• Outsiders aren’t sure if firm has “skeletons in its closet”, so they discount the price to account for risk of negative surprises

– What is the likely outcome if a court orders dissolution due to frustrated expectations/oppression?

• Judicial dissolution serves as an alternative to buy-out agreements, but also as an incentive to form buyout agreements

– Analogy: parent threatens to take away a toy if siblings can’t agree how to share it

88


Internal governance

Overview of Chapter 3 a. Litigation solutions b. Exit solutions


1. Customizing via SH agreements

2. Customizing via constitutional documents

89


Customizing the firm

Customizing in public & private firms

•

Rules governing a firm can be derived from the law or from contracts created by the stakeholders

•

Public firms derive more rules from laws and fewer from contracts compared to private firms

– More mandatory laws (that contracts cannot modify)

– Opting out of defaults is done by manipulating the firm’s institutions (e.g., rights attached to shares, or to firm offices) rather than manipulating individual SHs’ rights

• Example: X wants double the voting rights of other SHs

• Private firm (e.g., partnership): partnership agreement provides that X has double voting rights

• Public firm: charter creates Class B shares with double voting rights as

Class A shares; X receives Class B shares

90


Customizing via SH agreements

Why is agreement enforcement a major issue?

91

•

SHs in a close corporation sign a SH agreement obligating them to vote in favor of a specified slate of directors

– Directors favor expanding into the widget market

•

Some SHs renege on the agreement; vote for directors who refuse to expand into widgets

– As a result, Acme does not expand into widgets

•

Other SHs sue for breach of the agreement

– What are the damages? How easy is it to prove them?

– How can you make the agreement easier to enforce?



1. Voting trust

92

• Title of shares transferred to a trust

• Agreement forming the trust gives trustee power to vote the shares

• Disadvantages?

• Statutory restrictions

– Publicity: some states require the voting trust to be made public (e.g., DGCL

§218), or to submit to the firm information on participating SHs (e.g., MBCA

§7.30), which makes this info accessible to MSHs through SH inspection rights

– Duration: some states limit the duration of voting trusts (MBCA used to have a

10-year limit, but no longer does)



2. Contractual enforcement

93 a) Specific performance

– DGCL §218(c) allows voting agreements, implicitly allows a remedy of specific performance

– MBCA §7.31(b) states that voting agreements are specifically enforceable

– Court may refuse to enforce due to oppression / violation of other SHs’ rights b) Irrevocable Proxies

– Proxies usually revocable; can be made irrevocable if attached to an interest

[MBCA §7.22(d)]

– Being a party to a voting agreement is considered an interest

[MBCA §7.22(d)(5)]

– So, the proxy tends to be an enforcement mechanism that is ancillary to a voting agreement c) Is the SH agreement valid?

– If it constrains discretion that isn’t subject to FDs

(e.g., appointing directors)

• Voting agreements generally permissible [DGCL §218(c); MBCA §7.31]

– If it constrains discretion that is subject to FDs

(e.g., appointing officers)

• Does it impermissibly constrain the board’s discretion?

[McQuade/Clark]



McQuade v. Stoneham

[NY 1934]

94

• Stoneham owned a majority of the stock of the NY Giants

• McGraw (the Giants’ manager) & McQuade (a city magistrate) bought a small amount of stock from Stoneham

• The three signed a SH agreement

– Agreed to do their best to elect each other as directors

& appoint each other officers at specified salaries

• McQuade lost Stoneham’s favor & was fired

– McQuade sues for specific performance

• Court:

– Board must exercise independent business judgment on behalf of all SHs

– If directors agree in advance to constrain board’s judgment, SH will not receive the benefits of their independence

– Therefore, agreement is void as against public policy

• Protection in the SH agreement didn’t save McQuade

– How can he protect himself from being fired?



McQuade v. Stoneham

•

McQuade seems to offer a bright line rule

Valid

Constrain

SH judgment

Void

Constrain director/officer judgment

•

But the rule is not so bright

95



Clark v. Dodge

[NY 1936]

•

Clark knows a valuable secret formula. Dodge contributes money. They form two drug companies.

•

Clark and Dodge sign an agreement:

– Clark agrees to disclose his secret formula

– Dodge agrees to invest the required money

– Clark receives 25% of profits (salary & dividends)

– Dodge would vote, both as SH & director, to assure that Clark would be a director & General Manager as long as his performance was faithful, efficient and competent

– Why does Clark need the agreement? Why does Dodge?

•

Clark discloses secret formula. Dodge eventually fires Clark.

– Clark sues. Dodge claims SH agreement is void.

– Apply the reasoning in McQuade to this case

96



Clark v. Dodge

97

• Clark court: MSHs aren’t harmed by a commitment to keep someone as an officer “as long as he is faithful, efficient and competent”

– I.e., SH agreements are valid if SH merely agree to do as directors what they could do validly anyway

• This contradicts the holding in McQuade

– Also, SHs may be harmed by an obligation not to fire without cause (e.g., downsizing; better/cheaper candidate)

• Clark court: McQuade was designed to protect MSHs who were not parties to the agreement

– In Clark, all SHs are parties to the SH agreement

• Clark creates an exception to McQuade when all SHs are parties to the SH agreement

• How can Dodge avoid the SH agreement (reach McQuade outcome)?



“Homemade McQuade”

The homemade McQuade

Turning Clark …

98

… into McQuade



“Homemade McQuade”

• Preempting the “Homemade McQuade”

– The company can prevent a “Homemade McQuade” by creating constructive knowledge of the agreement – including the agreement in the charter or printing a reference to the agreement on all stock certificates

• Another obstacle for Homemade McQuades – Galler v. Galler

– In Galler, the court held that a SH agreement is valid even if not all SHs are parties to it, if:

• The corporation is closely-held

• The terms are reasonable (i.e., MSH should not object)

• The MSH does not object

99



Caselaw summary

100

• McQuade: SH can commit to how they vote as SH, but cannot constrain their judgment (or others on their behalf) as directors

• Clark: SHs can constrain their judgment as directors, if all SH are parties to the SH agreement

• Galler: SHs can constrain their judgment as directors even when some SHs aren’t parties to SH agreement, if terms of agreement are reasonable and fair to those SHs (& those SHs don’t complain)


Customizing via constitutional docs

Limits on bylaws

101

• Boilermakers Local 154 Retirement Fund v. Chevron Corp. [Del.Ch. 2013]

– Chevron & FedEx boards amend bylaws to add a “forum selection bylaw”, which requires that derivative suits, fiduciary duty suits, DGCL suits and internal affairs suits involving the company will be adjudicated in Delaware courts.

– The bylaw addresses venue (which court) not applicable law. What law would apply to fiduciary duty suits, internal affairs suits, etc. & why?

• Plaintiff SHs sue to invalidate the bylaws, claiming:

– Bylaw does not have valid subject matter

– Bylaw is not binding on SHs because board, not SHs, amended the bylaw

– Bylaw should be invalidated because there are many circumstances in which it can be abused



Limits on bylaws

102

• Valid subject matter

– DGCL 109(a): bylaws may address any subject “ not inconsistent with law or with the certificate of incorporation , relating to the business of the corporation, the conduct of its affairs, and its rights or powers or the rights or powers of its stockholders, directors, officers or employees .”

1.

Bylaws are subordinate to the law & charter

• So, anything that the law says should be in the charter (e.g., number of authorized shares, rights of shares) is not valid bylaw subject matter

2.

Valid subject matter includes

• Business/affairs of firm

• Rights/powers of firm, SHs, directors, officers & employees

3.

Bylaws dictate process, not substantive decisions

• Court: “[B]ylaws typically do not contain substantive mandates, but direct how the corporation, the board, and its stockholders may take certain actions.”



Limits on bylaws

103

• Effect of board-adopted bylaws

– By law, SHs have the right to amend bylaws; board may amend bylaws only if the firm’s charter allows it

– The charters of Chevron and FedEx allowed the board to amend bylaws

– Court: Delaware law does not follow the “vested rights doctrine”, which prohibits a board from modifying bylaws in a way that diminishes SH rights without SH consent

– Any SH who bought shares in the company knew of the authority the board had to amend bylaws, had consented to being governed by the bylaws as may be amended by the board

– SHs can always repeal a board-amended bylaw they don’t like

• Potential for abuse

– In an earlier case (CA, Inc. v. AFSCME Emps. Pension Plan [Del.2008]), the court said a bylaw is not valid because there are many potential situations in which it would mandate actions that would violate directors’ FD

– Chevron court clarifies that CA was a unique case & doesn’t represent Del. law

– Bylaw is not invalidated because it can be abused; if a particular act abuses the bylaw, that act can be challenged



Stock specifications

104

• Delaware

– DGCL §102(a)(4) allows corporations not to issue any stock (charter needs to state this & either specify conditions of membership or that these conditions are in the bylaws)

– DGCL §151(a): “Every corporation may issue 1 or more classes of stock or 1 or more series of stock within any class thereof, any and all of which classes… may have such voting powers, full or limited, or no voting powers, and such

[economic rights]… as shall be stated… in the certificate of incorporation… or in

[a board resolution] pursuant to authority expressly vested in it by its [charter].”

– DGCL §151(b) allows the issuance of redeemable shares as long as after redemption there are still shares with full voting powers

– DGCL §151(e) allows the issuance of convertible shares

• MBCA

– MBCA §6.01(b) – “Minimum requirements”:

• At least one class of shares with unlimited voting rights

• At least one class of shares with a residual claim (i.e., the right to receive the net assets of the corporation upon dissolution) – doesn’t have to be the class with unlimited voting rights

– MBCA §6.01(c) – Authorizes non-voting stock, convertible stock, and other characteristics of stock



Stock specifications

105

• Authorized shares: Maximum # of shares corporation can have

– Board has authority to issue shares, up to the authorized number (DGCL §161)

– What purpose do authorized shares serve? (Note: number of authorized shares must be specified in charter; changes to charter require both board & SH vote)

• Outstanding shares: # of shares corp issued (& not repurchased)

• Authorized but unissued shares: Shares that are authorized but have not been issued by the firm (or were issued & repurchased)

– Example: Acme’s charter says it has 1,000 authorized shares. Acme’s board issues 200 shares to investors. Acme now has 1,000 authorized shares, 200 outstanding shares, 800 authorized but unissued shares

• Treasury shares (DGCL): shares that have been issued in the past, but later repurchased by the issuing corporation

– Example: Acme Corp. now repurchases 50 of its 200 outstanding shares. After purchase, it has 1,000 authorized shares, 150 outstanding shares, 50 treasury shares, 800 authorized but unissued shares

– MBCA classifies treasury shares as authorized but unissued shares

(MBCA §6.31(a))

• I.e., Acme has 1,000 authorized shares, 150 outstanding shares, 850 authorized but unissued shares



Policy on customizing control rights

106

• Hypo 1: Acme Corp. has only one class of stock. SHs are entitled to dividends (if board authorizes dividend distribution) & to Acme’s net assets upon dissolution, but not entitled to vote

– Is this permitted by MBCA §6.01?

– Are there any risks to this capital structure?

• Hypo 2: Acme has instead two classes of stock

– Class A shares are the same as in the above hypo (entitled to dividends & net assets upon dissolution, but not entitled to vote)

– Class B shareholders have the same rights as Class A, except that each Class B share also has one vote

– Is this permitted by MBCA §6.01?

– Are there any risks to this capital structure?




107

• Can the market protect itself?

– Abe is offered Acme non-voting shares; economic value of 1 Acme share is $10

– Abe thinks Acme’s directors are a bunch of thieves

• Abe estimates that they will “steal” $10M ($1/share)

• Abe agrees to buy a share for $9 ($10-$1 stolen)

– If SH can assess the decrease in share value caused by the inability to keep board accountable, then there’s no harm from non-voting shares

• SH pay a price proportionate to their (limited) rights

• Companies who want to raise capital more cheaply can give voting rights to SH

& receive a higher price per share

– Can SH assess the harm from an unaccountable board?

• Does FD suffice?

– Suppose that there is no way to assess the discount for lacking the ability to keep the board accountable. Nonetheless, a board action that is not in SHs’ interest violates directors’ FD.

– Isn’t it enough to give SHs right to sue the board for breach of FD?




108

• If we can’t trust the market to protect itself & we can’t trust FD to protect nonvoting SHs, why not prohibit nonvoting shares?

– Can still bypass with “supervoting” shares

• E.g., 1 class A share has 1 vote; 1 class B share has 1M votes

– So why not require each share to have equal voting power (“1 share, 1 vote”)?

• Equal voting power: SEC’s attempt

– In 1988, the SEC adopted Rule 19c-4, prohibiting any stock exchange or mutual securities association from listing any stock of a corporation that takes any action to the effect of nullifying, restricting or disparately reducing the per share voting rights of existing common SH.

– The Business Roundtable v. SEC (D.C. Cir., 1990): Court vacates the rule on the ground that it exceeds SEC’s authority

• SEC instead informally pressures stock exchanges to adopt similar requirements in their listing rules

• But does an equal voting power rule solve the problem?




109

• Hypo based on Stroh v. Blackhawk Holding Corp. [Ill. 1971]: Chris forms Blackhawk Corp., with two classes of shares:

– Class A – “Normal shares”

• Chris buys 50,000 shares for $2/share (firm receives $100K)

– Class B – Voting rights, but no econ rights (no rights to dividends or assets in dissolution)

• Chris buys 500K such shares for 0.1¢/share (firm receives $500)

• Blackhawk sells to public 500K Class A shares at $4/share

(firm receives $2M)

Buyer Shares Acquired Cost Votes Economic Rights

Chris 50K Class A

Chris 500K Class B

Public 500K Class A

$100K (~4.8%) 50K (~4.8%)

$500 (~0%) 500K (~47.6%)

$2M (~95.2%) 500K (~47.6%)

50K (~9%)

0 (0%)

500K (~91%)

Total $2,100,500 1,050,000 550,000

• Do Blackhawk’s shares offer equal voting power? Yes (was required by the Illinois constitution at the time)

• Does this prevent a split between control & economic rights? No



Addressing SH right misappropriation

110

• Problem of “watered stocks”: Acme worth $100, has 10 shares outstanding

– How much is each share of Acme worth?

– Acme’s board issues 10 new shares to Jill for $2/share ($20 total)

– What is Acme worth now?

– How many shares does Acme have now?

– How much is one Acme share worth now?

– Value of Jill’s shares? Value of other SHs shares?

• Legal solutions to the misappropriation

1.

Limit the number of shares that the board is allowed to issue without authorization from the existing shareholders

• Authorized shares: maximum number of shares that the firm can have

• Charter must specify the number of shares the corporation is authorized to issue (their number can only be changed by changing the charter)

• Both MBCA [§1.40(2)] & DGCL [§161] use this concept

2.

Set a minimum price for the shares

• Par value is the minimum price for which a share can be issued (doesn’t affect the price share is sold by the SH to a new SH)

• E.g., Acme has 1M common shares, with a par value of $1. If Acme issues a new share to Sarah, it must receive consideration of no less than $1. Sarah, however, is free to sell the share at any price (or give it as a gift).

• DGCL uses this concept [DGCL §153(a)]; MBCA does not



Addressing creditor right misappropriation

111

• Problem of siphoning assets to SHs: Acme has 10 shares outstanding,

$100 in assets, no debt

– Acme issues $50 of one-year bonds, bearing 10% interest

• Acme’s net assets are now $150; it will need to pay $55 in 1 year

• A year later, Acme lost $70; it has $80 in assets ($150-70)

• How much are the bondholders entitled to?

– Before bonds mature, Acme declares $8/share dividend

• SHs receive 100% of Acme’s assets ($80); bondholders receive nothing

– Instead of dividend, Acme repurchases 8 of its shares at $10 each

• 80% of SHs receive 100% of Acme’s assets; bondholders & 20% of SHs receive nothing

• Legal solutions to the misappropriation

1.

Contractual approach: bond agreement can create limits on dividends/repurchases or state that if certain financial ratios indicate firm approaches insolvency, firm must pay debt immediately

2.

DGCL approach: specify a minimum amount of assets that dividends cannot compromise (“legal capital”)

3.

MBCA approach: prohibit a dividend that causes insolvency



Review

• Controller Cass is creating a firm, and wants to own 60% of the control rights & 20% of the economic rights

• Methods 1-2 are suitable for private firms

– Customizing via arrangements between SHs

– Assume only other SH is minority SH Mary

• Methods 3-5 are suitable for public firms

– Customizing via constitutional documents (share specifications)

– Assume other SHs constantly change (“the public”)

112



Review: Method 1 (voting trust)

113

• 1 class of shares, 100 shares outstanding: Cass buys 20; Mary buys 80

• Mary forms a trust with Cass as the trustee, and transfers to the trust legal title to 40 shares

– Mary is the beneficial owner of the fruits of this trust (e.g., dividends), but Cass

(as trustee) gets to vote them at his discretion

Dividends:

80% (40+40)

Mary – 40

Trust – 40

Cass – 20

Control: 60%

(20+40)



Review: Method 2 (voting agreement)

114

• 1 class of shares, 100 shares outstanding: Cass buys 20; Mary buys 80

• Cass & Mary sign a voting agreement (AKA vote pooling agreement) in which Mary promises to vote 40 of her shares as Cass instructs

– Some voting agreements have a designated arbitrator would decide how to vote if parties disagree

– To ensure that the agreement is specifically enforceable, Mary may give Cass an irrevocable proxy to vote a 40 of Mary’s shares

• Why does Cass need an irrevocable proxy?

• MBCA §7.22: Proxies are ordinarily revocable at the will of the SH, but a SH can give an irrevocable proxy. Usually, the proxy must be coupled with an interest. Acceptable interests include:

– Proxy holder is a pledgee

– Proxy holder has purchased/agreed to purchase the shares

– Proxy holder is a creditor of the corporation who required the irrevocable proxy in order to extend it credit

– Proxy holder is an employee of the corporation who required the irrevocable proxy in his employment contract

– Proxy holder is a party to a voting agreement

• Proxy irrevocable only as long as proxy holder has an interest in firm



Review: Method 3 (dual-class; 1 share, 1 vote)

115

•

As in Stroh

– Class A shares have one vote per share, full economic rights

– Class B shares have one vote per share, no economic rights

•

Assuming firm plans to issue 2M A-shares to raise money

– C buys, for a symbolic price (0.1¢) 2M B-shares

– C also buys 20% of A-shares (400K shares)

– Public buys remaining 80% of A-shares (1.6M shares)

– Result: C has 60% of control rights (2.4M out of 4M votes) & 20% of economic rights (400K out of 2M A shares)



116

Review: Method 4 (dual-class; voting/non-voting)

•

If non-voting common shares are permissible:

– Class A shares are non-voting, full economic rights

– Class B are voting, no economic rights

• C buys 20% of A-shares

– Remaining A-shares sold to the public

– Result: C has 20% of the economic rights

• C buys 60% of B-shares

– Remaining B-shares sold to other investors who want to buy control rights and who are acceptable to the controller (typically, such investor would also buy A-shares to get economic rights, and will insist on sharing control rights via SH agreement with C)

– Result: C has 60% of control rights



Review: Method 5 (class-specific rights)

•

Design share classes as follows:

– Class A shareholders (as a group) appoint 2 of the 5 directors & receive 80% of the economic rights

– Class B shareholders appoint 3 directors & receive 20% of the economic rights

•

Controller buys only Class B shares & issues to the public only Class A shares

– Results: Controller has 60% of control rights (appoints 3 of the 5 directors), and receives 20% of the economic rights

•

Example: “Golden shares”

117