Corporations Outline
Fairfax
Spring 2013
I.
INTRODUCTION, CHOICE OF ENTITY
a. SUBJECT IN GENERAL
i. Business=all kinds of profit-making conduct, broad range of activities
ii. Types of business associations:
1. Corporation
2. Unincorporated associations:
a. Sole proprietorship-a business owned by a single person
b. General or limited partnership
c. Other forms: limited liability company, limited liability partnership, and the
limited liability limited partnership
iii. Divided on the basis of whether:
1. Closely held: relatively few owners whose ownership interests are not publicly traded
on an established market
a. Unincorporated firms are usually closely held
b. New business forms developed in 1990s work best when closely (some corps are
closely held though)
2. Publicly held: business that typically has a large number of owners with ownership
interests that are routinely bought and sold on a public market
a. Virtually all are corps, have little in common with closely held firms
3. Developments during the last two decades have greatly increased the attractiveness of
unincorporated forms for closely held firms
a. Forms that grant the advantage of limited liability
b. Unincorporated firms and their owners considerable freedom in electing how
their income is taxed based on IRS code changes
c. Net result: encouraging firms with a few owners to use unincorporated business
forms
b. INTRODUCTION TO BUSINESS FORMS
i. Sole proprietorship: business owned by a single individual that is not operated as a
corporation or other special legal form
1. Advantage: easy to establish, just start conducting business
2. Disadvantage: unlimited personal liability for the obligations of the business
3. Must file an assumed or fictitious name certificate if they used one
4. Relationships with employees and 3d parties governed by agency law
ii. General Partnership: association of 2+ people to carry on, as co-owners, a business for
profit
1. Can be informally created-so long as two+ persons are carrying on as co-owners a
business for profit, a general partnership is created-regardless of whether the co-owners
intended the result
2. Some states view a general partnership as a separate legal entity whose identity is
distinct from that of its owners (partners)
a. Others view it as an aggregate of the individual partners with no legal
differentiation between the business and the partners themselves
3. Either way all the partners have right to participate in the mgmt of the business
4. Advantages: provides for an easy exit for partners, structural flexibility (run the
business as partners see fit), restricted transferability of ownership and pass-through
taxation (no double taxation)
5. Disadvantage: Primary downside is unlimited personal liability, easy exit=unstable
business form
iii. Corporation-most prominent business form
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1. Viewed as a separate legal entity whose identity is distinct from that of its owners
(shareholders)-->acts as a real person
2. Very different from general partnership:
a. Corporation is consciously formed by filing an org doc with state
b. SHs have no right to participate in mgt
c. SH in corp typically has no ability to compel a buyout of his ownership interests
or dissolution for the firm
3. Advantages:
a. Ownership interests in a corporation may be freely and fully transferred without
the consent of other shareholders
b. Corporation provides limited liability for shareholders-personal assets not at risk,
at most just amount of investment
4. Disadvantages:
a. Income is taxed twice-once at corporation level and again at the shareholder
level, generally considered undesirable
b. Also subject to state franchise tax for the privilege of organizing a business in a
state
iv. Hybrid Organizations
1. Limited partnerships: partnership comprised of 2 classes of partners-general and
limited
a. Formed by filing a org doc with state
b. Generals have unlimited personal liability, limited partners have limited liability
c. Limited partners are passive, generals rum the business
d. Same advantages as listed above, except exit rights tend to be more restricted
2. Limited liability partnerships: general partnership that provides partners with limited
liability for the partnership's tort obligations or for tort and K obligations
3. Limited liability limited partnerships: provides LLP like limited liability to some or
all of the partners, have to file org doc with state
4. LLC: Limited Liability Company-preferred business form for many closely held
ventures
a. Business organization formed by a required state filing, that adopts many of the
business features of the corporation and partnership forms
b. Legal entity separate and distinct from its owners (members)
c. Can be structured to provide mgmt rights to members
d. Restricted exit rights for members
e. Characterized by structural flexibility, restricted transferability of ownership
interests, and pass-through taxation
i. Avoid double taxation and franchise taxes
c. TAXATION OF PARTNERSHIPS AND CORPORATIONS
i. Corporate Tax Rates
1. Corporations have historically been treated as separate taxable entities under the IRS
code with their own sets of rules and tables (see table 1 on page 7)
2. Important to distinguish between the marginal and average tax rates in each category
3. Tax structure is mildly progressive, although regressive in some brackets
a. Gradually eliminate the benefit of the lower brackets for corporations that have
incomes over 100k and 15m
4. Corporations subject to tax rates set forth in Table 1 are called C corps, named after
Subsection C of IRS Code
ii. Individual Tax Rates
1. There are four individual tax rate schedules based primarily on marital status, plus
elaborate sets of tax tables based on the rate schedules and used mostly by persons with
relatively small incomes
a. See Table 2 on page 8
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b. Before Reagan, tax rates used to be absurdly high for high income persons, since
lowered but trend towards higher rates
iii. Taxation of Capital Gains and Losses
1. Before 1986, long term capital gains were taxed a 25% (low considering the high tax
rates at the time)
2. Created strong incentives to structure transactions or establish strategies that
transmuted ordinary income into long term capital gains to get that lower tax rate
iv. Capital assets are assets held for profit making or investment purposes
1. Most assets other than inventory and property used in the active trade or business are
capital assets
v. Technical rules with respect to the treatment of capital gains is complex
1. See page 9 for an explanation
vi. Taxation of Proprietorships, Partnerships, and Corporations
1. Proprietorships: consider first the tax treatment of a proprietorship -a business
wholly owned by a single individual
a. A proprietorship is not a separate taxable entity
b. Its income/loss is reported on the proprietor's personal income tax return
c. Manner of reporting reflects that the proprietorship is not a separate entity for its
owner and that its business affairs should not intermixed with personal affairs
d. File your own 1040 taxes + Schedule C for gains/losses from business and add
that number to personal income (similar for state taxes)
e. Also has to pay Medicare and disability tax
2. Unincorporated Business Forms
a. 2+ owners= Subchapter K of IRS as partnership OR can be a corporation
b. "Check the box"-elective tax classification regime, unless a publicly traded
partnership
c. Under Subchapter K, partnership doesn't pay any tax
i. Compute its taxable income and file an informational return (Form 1065)
ii. Passed through to partners who then pay taxes on it
1. Note this is passed on the actual business income, not the income
that is actually distributed to the partners
d. No SECA tax on limited partners unless it’s a guaranteed payments, SECA tax
on earnings of individual members of limited liability companies to the extent
attributable to a trade or business
3. C Corporations
a. Corporate tax rate is in addition to the tax on the ultimate shareholders aka
DOUBLE TAXATIONleads to high tax rates!!
4. S Corporations
a. To give relief to unfair double taxation for C Corporations, S corps created
b. It’s a tax election, not a corporate election (otherwise exactly the same as C
Corps)
c. Less than 100 shareholders, usually smaller than C corps
d. Taxed at a modified pass-through basis
d. DELAWARE CORPORATE LAW
i. “Internal affairs rule" provides that foreign courts should apply the law of the state of
incorporation to issues relating to the internal affairs of a foreign corporation
1. That’s why state of incorporation matters!
ii. Delaware is the dominant state for incorporation, all other states are inferior
1. DE makes a lot of money from corps! That’s why no state personal income tax.
2. Corporations find Delaware incorporation valuable precisely because other
corporations locate there
3. Antitakeover statutes also an important consideration in deciding the state of
incorporation
iii. Major reasons for Delaware's success
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1. Transformation to modern judicial selection system that depoliticized the selection of
judges to attract better talent
2. Reduces regulatory costs through limited network externalities, because of its
regulatory responsiveness, superiority of its Court of Chancery
3. Large developed body of case law in DE
4. Decadence of DE leg on corporate an corporate related campaign corporations-->quick
address of corporate needs
5. Willingness of DE judges to engage in corporate lawmaking
6. Efficiency of DE Courts
iv. Next to SC law, DE law is the most important case law in corp law
v. More that 50% of a US publicly traded corps incorporated there, more than 63% of
Fortune 500
e. CLASS HYPO
i. Two students creating a cupcake business
1. Things to worry about in forming partnership before you start:
a. Tax [all things are important, but tax will overshadow everything else]
i. Tax table in the book is no more because of fiscal cliff, now max rate is
39%
ii. Marginal tax rate in the US, your whole income is not taxed at the same
rate
iii. So now what’s the best organizational form to be in?
1. Partnerships have pass through taxation, the partnership business
itself is not taxed
a. You are taxed at your individual taxation level
2. Corporations: double taxation-as a business, and taxed on
dividends (used to be flat, now it can fluctuate based on your tax
level)
a. Used to be 35% tax rate, so basically no double taxation
and likely your individual tax rate would be lower
3. May shift now since max individual tax rate is higher than the
corporate tax rate
a. Fairfax says she disagrees: the dividend tax rate is crazy
(43%) and then long term capital gains up too!
b. Liability-trying to shield yourself from OTHER people's actions, you will likely
always be liable for your own wrong actions
i. Things to think about-is it delivery? Store? Employees? Nut allergies?
c. Profit
i. Partnership-each partner has equal share in profits
1. Doesn't mean you can't change the default-but if you want a
60/40 you need to change it!
ii. Limited Partnership-default rule is same as above
iii. Corporation-profit split is based on the shares you own
d. Management (employment)
i. Partnership (think law firm)
1. Everyone has equal rights to manage the business
ii. Limited Partnership
1. Different than partnership, you have general and limited partners
2. Limited partners have little to no mgt (like if you didn't want to
manage)
3. Have to have a least one general and one limited partner, so you
can’t be a limited partner and then become a general partner
later
iii. Corporation
1. Shareholders are owners, but usually directors are the mgt
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2. If you're not sure at first, maybe get into corporation and then
later add yourself to the board
e. Exit
i. Limited Partnership-one of the hardest to exit, again since you need 1
general and 1 limited so it’s hard to exit if you’re that one
f. Transfer
i. Corporations-easiest
ii. Partnership-difficult to transfer
iii. Limited Partnership-hybrid of two
g. Ownership structure
i. How to set up?
1. Corporation
a. Even if you are a corp, you still have duties as a director
and can be sued personally for breach of those duties
2. Partnership
a. Usually just referring to general partnership when they
say partnership
3. Limited Partnership
4. S Corp v. C Corp
a. S corp is the same as any other corporation, but it has a
different tax rate similar to a partnership
i. More like a pass through taxation
ii. But S corp has significant drawbacks-limited
number of shareholders, only US citizens, only 1
stock
II. PARTNERSHIPS
a. ESTABLISHING A PARTNERSHIP
i. General Partnership
1. General partnership is thought of as the basic partnership form
2. Governed by the UPA, which most states and adopted and some have tweeked
3. Most states have adopted the RUPA, although UPA has more case law, is the law in
commercially important states like NY and it’s easier to understand RUPA by
understanding UPA
4. The law that applies is the law of the state in which the business takes place.
ii. Formation
1. Does not require a public filing with the state
2. Under UPA it is formed whenever there is an association of 2+ people to carry on as
co-owners a business for profit (UPA 6, RUPA 202)
3. Person who receives a share of the profits of a business is presumed to be a partner in
the business, unless the profits were received in payment of a debt, as wages or for
other listed exceptions
4. General partnership can be created even if the partners do not realize that they
are forming an enterprise
a. Conduct and circs matter, only intent necessary is intent to do those things
which constitute a partnership
i. Don't need subjective intent! Doesn't need to manifest in your head or
writing
b. Important if the appropriate paperwork for another type of entity wasn't filed, or
something went wrong, then you default to partnership
iii. Number of Partners
1. Can be extremely large-doesn’t need to be just two people
2. But if its only one person, or two people and one dies or walks awaysole
proprietorship.
iv. Partnerships are easy to dissolve
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1. Death, withdrawal or bankruptcy of a partner
2. But a lot of times partners go in and out all the time-when does it really matter? For
accounting reasons really.
v. Partnerships and Tax
1. Flow through tax treatmenttax flows through the entity and only the individual
partners get taxed
2. Partnership is still seen as the best route for avoiding taxes
a. Tradeoff for nice tax treatment is poor liability structure
b. THE PARTNERSHIP AGREEMENT
i. Once a partnership has been formed, the partnership operation is governed by the provisions of
the applicable statute
ii. UPA says equal share in profits and losses and each partner has right to participate in mgt
1. Default rules, can be altered by agreement
2. RUPA says agreement doesn't have to be in writing, although that is desirable in
case of future disputes
a. Also may implicate the SOF if >1 yr and not written
iii. There are a lot of partnerships that intentionally don't write anything because if you can't write it
clearly there's no reason to write it at all
c. SHARING OF PROFITS AND LOSSES
i. KESSLER V. ANTINORA
1. Facts: P and D entered into a written agreement for the purpose of building and selling
a single family residence. Kessler was to provide $, Antinora the labor with a
60%K/40%A split in profits. Venture lost money, K sued A to recover 40% of financial
losses. K was repaid all but 78k of the money he advanced and also claimed
interesttotal claim=164k
2. PH: Lower court found for K and found A liable for 40% of losses, A appealed to this
court
3. H: Partnership agreement terms control the issue of the case, but here no mention of
losses so look to statute:
a. The statue says that each partner shall be repaid his contributions and share
equally in profits, and must contribute towards the losses sustained by the
partnership according to his share in the profits.
b. No suggestion that A would ever repay K's losses, nor that K would repay A's
lost labor.
i. No matter what the agreement CONTROLS, agreement says that
the losses will not be borne by the partner---> so agreement is the
CA rule
c. Here K lost some of his money but A lost all of his labor, found for A.
4. California SC Reasoning in Kovacik v. Reed
a. General rule of equally sharing in profits and losses didn't apply when one party
contributed the money and the other the labor
i. In that case neither party is liable to the other for contribution for any
loss sustained
b. How it works:
i. Capital gets repaid, if there’s nothing left over then they both get stuck
with loss
ii. If the worker received compensation though, then they didn’t receive a
loss so they go back to the default rule and they have to pay the loss.
5. This case was a joint venture: a partnership formed to do only one thing, one
venture.
a. Partnership rules still apply even though it’s not an ongoing relationship.
ii. DEFAULT RULE: LOSSES FOLLOW PROFITS
1. You split gains and losses equally, AFTER capital is repaid SO 2-step process
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2. If you have a rule on how to split profits, same can apply to losses if you didn’t
define.
3. Which rule do you apply?
a. Default rule OR CA rule (where applicable) OR their agreement
iii. How to differentiate between a LOAN and a PARTNERSHIP?
1. If you get to put it input, loose agreement, no payback schedule etcLOAN
2. Banks who give loans sometimes want veto power for companies using their money
a. Usually okay to have veto power but affirmative decision making
power=management
iv. CLASS HYPO
1. Default rule: have to repay contribution, and losses get split according to profit
agreement
a. Cupcake Company
i. Best 10k, Toll works and doesn't get paid
ii. Business makes 6000, so Best gets 6000 and that leaves -4000 so loss
gets split according to the agreement or default 50/50
1. So 2k losses, Toll has to pay best 2k
2. California Rule
a. 6000 repaid, 4000 loss what happens?
b. NOTHING so toll doesn’t pay best the 2k in this case (as long as Toll didn't get
compensate, but if he did then you go back to default rule)
3. When do you account for this loss?
a. When it’s a joint venture-its end of the venture
b. But a partner can ask for an accounting at any time, like hey there’s a loss lets
divvy this up
d. MANAGEMENT & AUTHORITY
i. SEE UPA SEC 9 IN STATUTE CHART
ii. CREATION OF THE AGENCY RELATIONSHIP
1. The Second Restatement defines agency as the fiduciary relation which results from
the manifestation of consent by one person to another that the other shall act on
his behalf and subject to his control and consent by the other
2. Agency=consensual relationship in which one person agrees to act for the benefit of,
and subject to the control of, another person
a. As long as the legal definition of agency has been met, an agency relationship
is present regardless of the intent of the parties to create such relationship
i. Must be an agreement but not necessarily K between parties
3. Agent: the person acting for another
4. Principal: person for whom the agent is acting
5. Agency relationship is based on conduct by the principal and the agent
a. Principal manifesting that he is willing to have another act for him
b. Agent manifesting a willingness to act
6. Artificial entity such as corps or partnerships may act as principals or agents
a. An artificial entity itself can only act through agents
7. In a partnership,
a. partnership itself is the PRINCIPAL, each individual partner is an agent
iii. ACTUAL AUTHORITY
1. Also known as express authority or just authority.
2. Arises from the manifestation of a principal to an agent that the agent has power to deal
with others as a rep of the principal
3. If a principal words or conduct would lead a reasonable person in the agent's
position to believe that the agent had authority to act on the P's behalf, the agent
has actual authority to bind the principal
a. May be express (oral or written) or implied (inferred from P's acts)
4. Incidental Authority
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a. Comes along with actual authority, the authority to do things incidental or related
to the authorized transaction
b. Natural to assume they would need to take these steps, unless the P specifies
otherwise
5. SCOPE: includes actual and incidental authority, anything that’s reasonable (think:
ordinary and customary, i.e. hiring partner handing out offers)
6. TERMINATION: requires 2/3 majority vote; if only 2 and they disagree, have to go
with rule already established or dissolve
7. NATIONAL BISCUIT CO. V. STROUD
a. Facts : Stroud and Freeman entered into a general partnership to sell groceries
under the firm name of Stroud's Food Center. There is nothing in the agreed
statement of facts to indicate or suggest that Freeman's power and authority as a
GP were in any way restricted or limited. Stroud told the bread co he would not
be personally responsible for any additional bread sold by P to Stroud; P sold
more bread to Stroud.
b. H: What one partner does with a third party binds the partnership.
i. When both Ps have equal mgt rights, one P cannot restrict the power
and authority of the other to conduct business that was an ordinary
manner connected with the partnership business for the purpose of
the business and within its scope (i.e. buying bread in grocery
business)
ii. When there are 2 partners, 1P cannot be a majority and thus
override the power of another.
c. ***Doesn’t matter that Partner told Nabisco that he didn’t want to be bound by
bread deal, since notice only destroys apparent authority not actual authority.
iv. APPARENT AUTHORITY
1. Arises from the manifestation of a partner to a third party that another person is
authorized to act as an agent for the partnership
a. That person has apparent authority and an act by him within the scope of that
authority binds the P
2. Test: If a P's words or conduct would lead a reasonable person in the TPs position
to believe that the agent has authority to act on the P's behalf, the agent has
apparent authority to bind the P
a. Commonly arises when a P creates the impression that broad authority exists in
an agent when in fact it does not
b. If TP relies on the appearance of authority, the TP can hold the P liable even if
they didn't actually authorize the act
3. Main difference is that the authority flows from P to TP not to agent
a. Sometimes apparent and actual scope will be equal, i.e. P sends identical letters
describing authority to agent and to TP
4. RATIFICATION: Can authorize an action after the fact, authority reverts back to
the day the action was made
a. If the partners who could have authorized the deal, and had notice of it and could
have said something about it and didn’t when they should have, that could count
as acquiescence and therefore ratification
b. But actual authority cannot be taken away after the fact
5. NOTICE: notice destroys apparent authority (i.e. a sign that says we don’t accept
checks)
v. CLASS HYPOS
1. Cupcake business, selling on campus for 1 year
a. Decide to buy a delivery truck, up to max of 50k
b. Best decides to buy a truck for 65k
i. Is there actual authority for this?
ii. 65K>50K scope or no actual authority at all (since it was 50k truck)
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iii. What if you can't find a truck for 50k cuz estimate was two low (maybe
they said something softer, like try to get 50 if you can)
2. Why would a court take a hard line? Because you are personally liable in a partnership!
3. What about roles in the business? Managing partner vs. being uninvolved
a. Does the title matter? Yes! managing partner can make those kind of decisions
b. But if it goes too far may be too much outside of scope
4. What about apparent authority?
a. Is it reasonable for the truck owner to think she has apparent authority to buy
truck for 65k
i. Has to be something that the partnership does to give the impression in
the minds of 3d party
ii. Managing partner title might make that impression
b. But maybe the truck owner doesn't know anything about the business at all, but if
she comes in acting like she’s on it
c. AN AGENT CANNOT MAKE APPARENT AUTHORITY
i. It’s the partnership make impression in the mind of 3d partycan make
authority through agent though, business tells agent is ok agent tells 3d
party
5. What if someone seals the delivery truck, and offers someone a 5k cupcake delivery
deal?
a. The person that makes the deal wants the partnership to honor it!
i. Clearly the thief doesn't have actual authority, can't have a reasonable
belief that they have the authority THEY ARE LYING
ii. But is there apparent authority?
1. Not reasonable to create a catering deal with a delivery truck
driver!
2. But maybe if they see the logo, and the truck, and cards…ASK
YOURSELF: what has the partnership DONE or NOT DONE
a. They left the keys in the instrument of their business on
the street for anyone to steal and make that impression
b. Not going to call it if you did everything to keep that
from happening, but if you were irresponsible and
allowed the reasonable impression to be created you
are liable
e. DUTIES OF PARTNERS TO EACH OTHER
i. SEE UPA SEC 21 IN STATUTE CHART
ii. Fiduciary Duty
1. Partners have a duty to one another that’s higher than honesty
2. Obligation to act on behalf of the entity with your thoughts of self renounced
a. AKA You should be acting for the partnership, not for the interest of yourself
iii. MEINHARD V. SALMON
1. Fairfax: As soon as judge cites Meinhard, the shady partner is about to lose
2. Facts: Gerry leased to Salmon a Hotel in NYC for a term of 20 years, for it to be
changed into shops and offices. Salmon entered into a joint venture with Meinhard for
the necessary funds. M was going to give S half the necessary funds and S was to pay
M 40% of net profits in first 5 years and 50% every year thereafter. S was going to
have sole mgt power.
a. When the lease was near its end, Gerry has become the owner of the reversion.
He wanted to lease out an entire tract of land in the area to destroy the buildings
there and build new ones. He approached Salmon who entered into a lease with
him for 20 years, up to a max 80 years. S never told M about lease, M found out
and sued.
3. H: M and S were co adventures, subject to FD akin to those of partners.
a. Salmon held the original lease as a fiduciary for himself and for M
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f.
b. Since the opportunity for the new lease was incidental to the enterprise, and
S appropriated it to himself in secrecy, he breached the FD he owed to M.
i. Same NEXUS OF OPPORTUNITY.
ii. He did not intend to defraud M, but he should have exercised more
loyalty as a trustee.
c. S must share stocks in his new enterprise to a degree that allowed him an
expected measure of dominion, or 51% essentially.
4. Dissent: This was a joint enterprise, with an expectation that the relationship would
end at the conclusion of the leasethere is nothing unfair in S's conduct.
iv. HYPO ON THIS CASE:
1. If they were losing money, how would it be split?
a. 40/60 at first but then 50/50so 50/50 split of losses
2. If partnership was still ongoing and S entered into this lease, is it within scope?
a. Different kinds of businesses, way bigger deal, lots more land, MUCH longer
time period
b. So probably not actual authority but maybe Gerry though he had apparent
authority
c. Even if you didn't have the authority to make a deal, it doesn't mean you are
off the hook for your fiduciary duty
3. Gerry comes to Salmon the day after-okay? Yes
4. The day before the last day and saying I'm gonna call you tomorrow? No
a. But how far does this extend?
5. Note: At the end of a relationship there may be an even heightened fiduciary duty-that's
when people start stealing the paperclips!
6. What if this was a lease for somewhere else? Court says probably okay, but not
the case here.
v. Johnson v. Peckham
1. One partner bought out another and then resold those oil interests for much higher
2. Evidence came out that the negotiations for resale had begun prior to the time one
partner bought out the other and the buying partner was thus required to share in the
profits from the resale
PARTNERSHIP DISSOLUTION
i. Usually caused by a trigger event:
1. Express will, end of term in K, death of partner, bankruptcy of partnership
ii. During wind up there is still liability, unless there is an agreement to discharge it
1. Even if you leave you are still responsible personally for things that happened when
you were there but not after you leave
iii. Dissolution will end actual authority but apparent authority can continue if TP doesn't have notice
that authority has ceased
iv. Accounting: if you continue a partnership after a dissolution, partner who left is entitled to $
1. Value of money on day of dissolution event (aka 1000 you invested) + either interest or
profits for what you left behind
2. Why choose interests as opposed to profits?
a. When partnership hasn't made any money, if it’s made 16 B you want profits
b. NO SOL
v. CLASS HYPO
1. Facebook: are they in partnership with the twins?
a. Going into business together purpose to make a profit....didn't actually have to
make a profit
b. MZ says he wasn't trying to go into business with them
i. Lost that one, when someone walks away they get those 2 things
2. Why can the twins wait 5 years and then take a bite of MZ's money?
a. You were in a partnership and you left something behind that the partnership is
still using
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b. It’s kind of like a loan you left behind, you want to collect on it now
3. Courts prefer if you account when the dissolution occurs!
a. They don't want you to wait, so they punish you for waiting by having the
lingering second piece
vi. COLLINS V. LEWIS
1. Facts: P and D were co-owners in the partnership LC Cafeteria. Lewis obtained a lease
to construct a cafeteria in the basement of a building, contacted Collins to furnish the $
if he would furnish the lease and mgt. Decided via K and oral communication that all
revenue, minus Lewis salary, would go to Collins until repaid and then all profits
would be divided equally.
a. Lewis guaranteed 30k in first year of ops and then 60k each year after upon
default Lewis would surrender his interest to Collins, also guaranteed loss to
extent of 100k. Estimated 300k to complete the cafeteria, but major delays
opening it and getting started so costs were >600k.
b. Collins was concerned because cafeteria expenses >receipts and demanded it be
run on a profitable basis or he would advance no more funds. Accused Lewis of
mismanagement, Lewis said Collins was interfering with mgt law suit.
2. PH: Jury in trial court found that Lewis was competent to manage business and but for
the conduct of Collins there would be reasonable exp of profit under Lewis
3. H: There is no rule that rants Collins the right to dissolution of the partnership under
this situation
a. A court will not assist the partner breaking his K to procure dissolution of the
partnership w a partner who has not fully and fairly performed the partnership
agreement on his part has no standing in court to enforce any rights under the K.
b. Lewis met his obligation, there wasn't $$ in first year to repay Collins; but
Collins did not
i. Okay for Lewis to take $$ out and put it back in business even though
against agreement because Collin breached K first when he said he
wasn’t going to give any more money
ii. Collins can’t be forced to stay in a business that cannot be profitable, but
Collins was the reason the business failed so he owes Lewis damages
4. Take-aways:
a. You always have the power to dissolve but not the right
i. No right to resolve, you have liability
b. What should Collins have done in the agreement to avoid this? Put a cap in the
agreement! up to the 300k estimate or something
c. For our purposes there are really only 2 rules, but in reality 3 but 2 have
same effect
i. Arizona Rules (older partnership rule)
1. When the LP lose liability protection?
a. When they participate in the control of the business
i. Rule 1: substantially the same as if you were a
GP (no know, no contact)can't avoid liability
if you are basically acting as a GP, and just not
going to the meet and greets
ii. Rule 2: if not substantially the same, then TP
must have actual knowledge coming from direct
contact
ii. Revised Rule
1. Liability is only going to attach if TP reasonably thinks that the
LP is a GP
2. AKA actual knowledge (rule 2 above) DIRECT CONTACT
3. **Later rules started pulling away from old AZ rule because
these other business forms started popping up
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iii. FINAL UPA RULES
1. Removes control piece all together, no liability for LP
2. So why do we have to know these rules at all? Not all
jurisdictions have adopted the final UPA rules
5. CLASS HYPO:
a. Back to cupcake business
i. Best is an LP gives a lot of advice to the GP
ii. Recommends someone to GP as manager of the business, Maggy, and
she is hired
iii. Best moves away and this person comes in, calls back periodically and
asks about maggy and the business etc
1. Maggy has signed a 5 yr contract with school org, but she
overcharged them and pocketed the extra
2. Now the org is suing Toll and Best!
b. Authority? WHEN THERE’S FRAUDULENT ACTIVITY…
i. Actual-no, because outside scope NOT because she stole
1. Long term effects on the business! Outside her scope! Plus she
was stealing $$!! No way that’s reasonable (BUT…)
a. Plus was this reasonable when its Tolls last year at law
school and this is adding another 5 yrs?
2. Courts said it can't work like that because then if you have
fraudulent agents you will never be on the hook!
a. Courts say if its within her scope then it doesn't matter
that she stole money, that doesn't make it outside the
scope (policy reason)
b. But in this case it seems like she might not have had this
ability to engage in this transaction in the first place
ii. Apparent-yes
1. TP would likely think a manager would have this kind of
authority? But for 5 yrs! Another scope issue
2. If the TP knew the history of the business and its plan to be for 3
years of law school it may not be reasonable
iii. If no authority, then just Maggy in trouble, if authority, then entity is
liable
c. Liability?
i. So who in the entity would be liable?
ii. What entity is this? HAS TO BE A GP-they didn't file anything with the
state and there is more than one person
1. OR is this just a sole proprietorship and Best just loaned $$ to
Toll?
a. Are they sharing the profits?? Are they sharing the mgt
role?
i. Advised him about marketing, about a hire-->is
that enough
ii. Can he reject this advice or is it collaborative
decision?
2. Even if they thought they were making an lp or an llp doesn't
matter if they didn't file
iii. What if this was an LLP?
1. Toll would be the supervisor of Maggy the manager
a. But Best recommended her to be hired…
i. What if she were the hiring partner? Seems to
apply more liability, but Toll is clearly day to
day
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b. What if it turns out Maggy embezzles from last job?
i. Best did not do the appropriate diligence when
making the hiring decision
c. LLP supervisor rule left open a lot of questions
i. Applied first to law firms, who supervises the
100s of associates?
2. What if LLC?
a. No one, they all have limited liability
3. What about an LP?
a. Toll=GP liable as supervisor
b. Best=LP, not liable unless she was acting as a GP and
Third Party had actual knowledge (direct contact)
i. Or under AZ rule, was it substantially the same
as GP? Advice enough to rise to the level of GP?
III. OTHER BUSINESS FORMS: SEE CHART
a. LIMITED LIABILITY PARTNERSHIPS (LLP)
i. GP that provides partners with limited liability for the firm's tort or tort and K obligations
ii. It is a GP, not a LP, so all the partners have the right to participate in the mgt of the venture
without risking a loss of their limited liability
1. LLP is really an LLGP (limited liability general partnership)
iii. GP law is applicable when it is not explicitly altered by LLP-specific provisions
iv. Partners have limited liability for firm’s tort and/or contract obligations
1. Are not at risk for negligence or malpractice by another partner
2. Are not responsible for using personal assets to repay liabilities of partnership (except
in minority states)
v. Can convert into LLP (from general partnership)
1. Very easy to do, all provisions of original agreement still apply
2. Exactly the same as general partnership, except filing and liability!
vi. How They Came About:
1. LLPs birth date can be identified as Aug 26, 1991 when the TX House Bill became
effective
a. Provides peace of mind for innocent partners
b. Designed to avoid the fear by a partner that her personal assets may be a risk
because of negligence or malpractice by a partner over whom she has no control
and possibly never met
2. All partners have the benefits, responsibilities, and potential liability as GPs except that
partners have no responsibility for malpractice claims or for liabilities arising from
negligence or misconduct in which they were not personally involved
a. Protection provided known as the shield of limited liability
3. LLP is a direct outgrowth of collapse of real estate and energy prices in late 1980s->led to bank collapses in TX
a. Many law firms found themselves in deep trouble because of their bank and thrift
work at that time
b. One Dallas Law Firm had a partner in a traditional GP who did a lot of bank
work, and left with his clients to start his own firm
c. When everything went down, the FDIC and FSLIC went after his old firm,
including partners that had nothing to do with his work, partners who had retired,
new partners, etc
d. It was eventually settled for amount of firms malpractice insurance, but it lead to
the creation of LLPs
vii. Formation
1. LLP must fall within the state definition of a partnership, association of 2+ people to
carry on as co-owners a business for profit
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2. Also must file with state, including firm name + LLP, address, and statement of
business or purpose
3. Some states require an LLP to provide a specified amount of liability insurance (ie
100k) or a designated pool of funds
4. Without it, it will lose its limited liability protection at least up to amount insurance
would have provided
viii. The Limited Liability Limited Partnership: LP where all the partners have LL
1. "The more Ls the more liability protection"
2. Fairfax says don’t worry about it
b. LIMITED PARTNERSHIPS
i. Formation
1. Need to file a certificate with state, identifying name and GPs and LP
2. Real detail contained in the partnership agreement that the Ps draft and tailor to their
specific needs
ii. MANAGEMENT AND OPERATION
1. As RULPA (1985) 403 a indicates, a GP in a LP has the same rights and powers (and
restrictions) as a GP in a GP
a. Links to GP law
b. Right to mgt, bind partnership through apparent authority, ability to vote
c. All default rules-can be changed
2. RULPA 1985 doesn't explicitly grant or deny mgt rights to LPs
a. Cases say that LPs can't take part in mgt of business (usually in partnership
agreement as well)
b. LPs who participate in the control of the business risk liability for some or all of
the obligations of the venture
3. RULPA 1985 doesn't speak to the issue of whether a LP is an agent of the LPship who
can bind the venture via apparent authority
a. Some case law says LPs have no agency authority merely as a result of their LP
status
4. Under RULPA LPs have no voting rights
5. Some P Agreements grant them, but sometimes only in certain settings, i.e.
removal/election of GP, amendment to agreement, extension of term, sale of assets, etc.
iii. Limited Liability: The Control Rule
1. Central feature of the LP is the LL provided to LPs
2. LPs have no liability for the debts of the venture beyond the loss of their investments
3. LP can lose her LL protection if she participates in the control of business though
a. Language of ULPA unclear as to what constitutes taking part in control of
business
b. Led to uncertainty and later codification of RULPA and ULPA
iv. GATEWAY POTATO SALES V. G.B. INVESTMENT CO.
1. Facts: Creditor suing LP to recover payment for goods supplied. Sunworth Packing as
GP and GB Investment was LP in a LPship. GB agreed to not participate in control of
business and would thus only be liable up to initial contribution and guarantor of loans.
a. Ellsworth, of Sunworth, asked Pribula of Gateway for seed potatoes. Ellsworth
assured him he was good for money because he was in Pship with large fin
institution, which was involved in active op of business.
b. Pribula believes he was doing business with a GP-but only interacted with
Sunworth.
c. Conflicting testimony between GB and Ellsworth
i. Ellsworth said GB was at the office frequently, he reported directly to
them, and daily ops were reviewed by them
2. H: Under the AZ Revised Statutes Annotated, a LP may become liable for the
obligations of the LPship under certain circumstances in which the LP has taken part in
the control of the business
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a. ARS says that possession or exercise of any the powers of a LP constitutes
participation by him in the business of LPship
b. Creditor is not required to have contact with the LP in order to impose liability
on a LP.
c. RULE: If the LPs participation the control of the business is substantially the
same as the exercise of powers of a GP, he is liable to creditors even if they have
no knowledge of his participation and control.
d. Here, genuine issue of fact as to GB’s exercise of control over the business.
c. LIMITED LIABILITY COMPANIES
i. Only need one person to create LLC (used to need 2)
ii. Non-corporate business structure that provides it owners, aka members, with a number of benefits
1. Combines the best of both worlds of partnership (tax) and corporations (mgt and
limited liability)
2. Two Types of Management
a. Member Management (like general partnership)
i. All have managerial control
ii. All have authority to bind LLC
b. Corporate Type Members
i. Managed by a board
ii. Only they have authority to bind
3. Limited liability for the operations of venture, even if partner participates in control
4. Pass through tax treatment
5. Freedom to contractually arrange the internal ops of the venture
iii. LLC emerged as preferred business structure mostly because of tax benefits, many believe it will
replace partnership and closely held corp as dominant form of closely held business entity
1. Fairfax: If you’re not going public, be a LLC not a Corp!
2. Relatively new and less established though, so lots of open questions
3. Since states were so quick to adopt, laws not that uniform
4. DLLCA (DE) and ULLCA (Uniform) sort of the 2 competing statutory models
d. TAXATION OF ENTITIES (ALSO SEE ABOVE):
i. Old Rule: if had certain corporate characteristics then IRS would treat you as corporation for tax
purposes regardless of what you called yourself
ii. New Rule: Check the Box, you can elect to be taxed as Corporation or Partnership
1. Made way for LLC to existCould create entities that have corporate characteristics
but taxed like partnership
iii. All Entities
1. Taxable income = revenue – expenses
2. Marginal tax rate: tax rate on each additional dollar above minimum for that
level
3. Average tax rate: total tax dollars / taxable income
iv. Corporations
1. C Corporations
a. Any business that goes public gets taxed as C Corp
b. Have own progressive tax rates (see pg. 7)
c. Subject to Subchapter C of Internal Revenue Code
d. Gets taxed on earnings and dividends (?)
2. How to avoid double tax
a. Double tax
i. Corporation gets taxed on dividend amount
ii. Shareholder also gets taxed on dividend received
b. If employees and shareholders the same, then pay out “dividends” or profits as
part of salary
3. Capital Gains and Losses
a. Tax on capital assets held for more than 6 months
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i. Capital assets: assets held for profit making or investment purposes
ii. Includes: most assets held by businesses other than inventory and
property
b. Capital Losses
i. Subtracted from gains to determine tax
ii. Excess over gains can be subtracted from next year’s gains
c. Long term (held more than a year)-15% tax
d. Short term-taxed at income tax rate
v. Sole Proprietorships
1. Income or loss is reported on proprietor’s personal income tax return (joint return with
spouse)
a. Income or loss added or subtracted from proprietorship’s other income
2. Must be reported on different forms (or long version) of tax forms
3. Fulfill requirements of Self Employment Contributions Act (SECA)
4. Contribute to Social Security OASI tax
vi. Partnerships (unincorporated business entity)
1. Subchapter K of Internal Revenue Code
2. Can elect to be treated as a corporation
3. If decide to tax as partnership
a. Partnership entity does not pay tax
b. Tax “passed through” to partners in way partnership agreement states
i. Business income still gets taxed, just by partners
ii. Do not necessarily pay based on their income, but on business’s income
4. Must file “informational” form as an entity of their income
5. Each partner must inform partner of their share of partnership’s income and deductions
IV. FORMATION OF A CORPORATION
a. THE PROCESS OF INCORPORATION
i. SEE MBCA SECS 2.02, 2.03, 2.05, 2.06 IN STATUTE CHART
ii. The Formation of Closely Held Corp
1. Where to Incorporate
a. Selection of State of Incorporation Involves 2 factors:
i. Dollars and cents analysis of the relative cost of incorporating or
qualifying as a foreign corp under the statutes of the states
ii. Consideration of the advantages and disadvantages of substantive corp
laws of these states
iii. DE has 50% of all incorporations, can do same day
1. Need an authorized agent if you incorporate where you don’t live
b. As a practical matter, it comes down between state where you do business or DE
i. If business is going to be done mostly in one state, better to incorp there
because there are additional fees and taxes in DE
ii. Might also have to litigate there
iii. DE statute may offer some flexibility not available in other states given
that 342 and 351 of the GCL permit a corp with less than 30 shareholders
to be managed directly by the shareholders
1. Many states have adopted 7.32 of the MBCA though which
permits non-traditional mgt arrangements as well
2. How to Incorporate
a. Now you can do it electronically with state office, or with a company that says
they will do it for you
b. Don't need a lawyer unless agreement will be complex and there is likely to be
disagreement
c. Also need to decide what will be in public articles of incorp, and what will go in
private bylaws or shareholder's agreement
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d. Degree of use of boilerplate language will depend on nature of business,
agreements among the shareholders, and mutual degree of trust and confidence
3. Corporate Documents
a. Articles or Certificate of Incorporation or Charter: required to be in
existence, register it with some state office
i. Used to need three directors, now just one
ii. Usually signed by paralegal, FB signed by MZ
iii. No min amount of capital required to start a corp
iv. Basic requirements are not much, but many go beyond
v. Difference between restated and amended articles of corp
1. If it’s just amended, need original and amended
2. if its restated its got everything all in it together (FBOOK had 11
amendments, made sense to restate it)
b. By Laws: basic operating agreement for corporation
i. Doesn't get filed with state office, but governs the operations of your
corp
c. Charter=public record, bylaws are not
i. But have to file both with SEC if you go public, can find them on the
website
d. Opt in and Opt out provisions
i. Opt in, if you don't put it in your charter it’s not going to apply to you
1. IE Article VII in Facebook
ii. Opt Out, will apply unless you say in your charter it doesn't
b. THE ULTRA VIRES DOCTRINE
i. ULTRA VIRES=LATIN FOR BEYOND THE POWER
ii. ASHBURY RY. CARRIAGE & IRON CO. V. RICHE
1. Facts: Charter of the corp said it was for making and selling railway plant, machinery,
etc. Entered in Ks with Riche to purchase a concession to construct and operate a RR
line. After partial performance, the corp repudiated the K
2. H: The House of Lords found the corp not liable because it owning and operating a RR
line was ultra vires.
a. The K itself was legal, but it was beyond the powers of the company to make it
b. Even if every shareholder agreed, still void because not in articles of incorp.
3. Takeaway: British Law did not permit corps to amend their memoranda in order to
allow for this line of work. Companies could use this doctrine to set aside completed
transactions that they now regret, or as a defense in injured P tort cases.
a. Some courts avoid using it by construing purposes clauses broadly
b. Others use estoppel, unjust enrichment, quasi-K and waiver to avoid as well
especially for completed transactions and tort cases, still applies in executory Ks
though.
c. One superficial justification is that articles of incorporation are public record, and
that people engaging in business with corporation are on notice to check them.
4. Class Notes:
a. Corp has to amend the charter, even shareholders can't have a unanimous vote to
change the purpose of the comp
b. Why is this? State is "chartering" you to do something, tech they can say we
don't want any more fast food restaurants
i. NEED STATE APPROVAL
ii. And a matter of public record
1. Otherwise legal K, corp gets to test the water and pull out
whenever they want
2. Older version of the doctrine says so what! Sounds unfair
iii. 711 KINGS HIGHWAY V. F.I.M.’S MARINE REPAIR SERVICE, INC.
17
1. Facts: D Corp and P entered into a written lease agreement where the P would lease to
the corporation a movie theater, even though the corporation was in the business of
marine activities (as outlined in their articles). P wants the lease to be invalid under
ultra vires doctrine.
2. H: NYS Business law says that no act of corporation and no transfer of property
otherwise lawful shall be invalid under the reason that the corporation was
without capacity or power to do such act unless
a. action brought by shareholder to enjoin corporate act
b. action by or in the right of a corp against an incumbent or former officer or
director of the corp
c. in an action or special proceeding brought by the AG
3. This case doesn't fall into these exceptions, so no substance to P arguments
a. Ultra vires cannot be invoked as a sword in support of a cause of action any
more than it can be utilized as a defense
4. Take Away
a. Court is establishing a new rule
i. ***loophole since a SH that is a director could get out of a bad decision
b. What’s the executory K comment?
i. Full performed 20 year K and now they don't want to pay? Doesn't seem
fair
ii. Once it’s been performed and corp just needs to do something, ie pay,
they can't use thatthere has to be performance left
c. CORPS STARTED WIPING OUT UV WITH GENERAL PURPOSE
CLAUSES
i. SO IF ON EXAM THERE IS A SPECIFIC PURPOSE CLAUSE
THINK UV!!!
iv. SULLIVAN V. HAMMER
1. Facts: D corp mailed its stockholders a Proxy Statement saying that a Special
Committee of Occidental Corp had approved a proposal to provide financial support to
the Museum to be located adjacent to the HQs in LA. Ps filed this complaint asserting
class and derivative claims that the expenditures and commitments to the Museum
constituted a gift and a waste of corporate assets and that Dr. Hammer had breached his
duty of loyalty to make these expenditures for his personal benefit.
a. Ended up in a settlement discussion which needed to be approved by court.
Settlement made minor changes to the original agreement, but ultimately left the
$$ contributions the same (with some additional interest in the profits, etc).
2. H: DE law favors the voluntary settlement of litigation. Court needs to determine the
overall reasonableness of the settlement, in light of the factual and legal circs of
the case:
a. Probable validity of the claims
i. Ultimately Ps have little chance of recovery on the merit because of BJR
b. Apparent difficulties in enforcing claims through courts
c. Collectability of any judgment recovered
d. Delay, expense, and trouble of litigation
e. Amount of compromise compared with amount and collectability of
judgment
i. Views of parties involved
f. Test of whether a corp may make a charitable gift is its reasonableness
i. Museum is a charity, the gift is limited within range of reasonableness
thus reasonably probable P would fail on this claim as well
g. Against the weakness of this claim the proposed settlement is adequate
because
i. Reinforces and assures Occidental's id and meaningful participation
ii. Reinforces and protects charitable nature and consequences of gifts
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iii.
iv.
v.
vi.
vii.
Imposes meaningful controls
Places meaningful restrictions on future donations
Restores equitable portion of any appreciation of properties
Guarantees art stays in LA where it can be enjoyed by US Public
Even if Ps guy says the building really only worth 10m, as opposed to
50m, invested, court skeptical about estimate + good will created by
business
3. Class Take-aways
a. Had a general purpose clause, so what does ultra vires doctrine have to do with
it?
i. Lawful business purpose means a profitable one! Giving money away
doesn't seem to have any profit in it!
ii. To surpass the UV doctrine, need to show that there is something to be
gained from it and reasonable
1. i.e. good will, but how do we quantify this?
a. What if the founders name, not the corps name was on
the building
b. Now in every state every corp can give reasonable gifts to charity
i. Usually charitable gifts are 5% or less of assets (here is much more)
4. Hypo
a. Cupcake case, what if he puts his name on a classroom at his alma matter in CA
i. Ok this won’t fly
b. Buffet corps don't give money to charity, they let their shareholders take their
dividends and give them wherever they want
c. NO SELF DEALING ALLOWED-need stamp of approval from board
d. What about anonymous gifts? Employees still like to be with companies that
donate $
e. Citizens United Case: corps can give $$ to political campaigns in the form of
unlimited ads
c. PREMATURE COMMENCEMENT OF BUSINESS
i. Why is this a problem? They can lose their corporate limited liability!
1. Can happen in three ways
a. Promoters
b. Defective Incorporation
c. Piercing the Corporate Veil
ii. PROMOTERS
1. Term promoter includes a person who acting alone or with others, directly or
indirectly takes initiative in founding or organizing the business or enterprise of
an issuer
2. Also considered, under SEC rule, someone who received 10%+ of class of securities of
corporation
3. AKA founder or organizer
a. Formation of a business enterprise is more about business as opposed to legal
b. In any event, capital must be raised
4. POST V. UNITED STATES
a. Promoters owe a significant fid duty to other participants in the venture
b. Exacting good faith in their intracompany activities and demanding
adherence to a high standard of honesty and frankness
c. Outlaws secret profit making and command the dedication of corporate
funds to corporate purposes
d. In this case, the Ds were convicted of conspiracy and mail fraud stemming from
promotion of a DC country cub
i. Ds stood in a fid relation to both the corp and the members of the
country club, including those anticipated to join
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ii. Required to exercise the utmost good faith in their relations with the
corp and the members, including fully advising the corp and the
members of any interests the D had that would in any way affect corp
and members
iii. Make faithfully known all facts that would influence members to join or
not join
iv. Duty to refrain from misrepresenting any material facts
v. If a promoter used the funds of the corp for own personal use, that would
not only be breach of fid duty but also fraud
5. STANLEY J. HOW & ASSOC., INC. V. BOSS
a. Facts : Action to recover on a K for the performance of architectural services. P
alleged he was due 38k on K and only received 14.5k. Agreement was made
between Boss Hotels and Stanley How, the architect . But it was signed by Edwin
A Boss, agent for a Minn corp to be formed who will be the obligor.
i. Form was the standard form, with blanks filled in. Boss okayed signing
his name like that with how
ii. Checks sent to How, had name of corp on them
iii. Project ultimately abandoned
b. H: No corporate charter, bylaws or resolutions for this corp and no assets in it to
pay what's due on the
i. Case law says that when a promoter assumes to act on behalf of a
projected corp and not for himself, he will be personally liable on his
K unless the other party agreed to look to some other person or fund
for payment
ii. Promoters making an agreement with another on behalf of a corp to be
formed can have 4 intents, see below
iii. Court needs to use usual rules of interpretation of ambiguous Ks
1. How believed Boss Hotel Co was liable to the K
a. This is inconsistent with intending that the new corp was
to be solely liable on the K
b. Oral testimony shows the parties thought the K was ok
as written and that Mr. Boss would be the obligor on K
iv. Only issue is whether the K was a continuing offer to the then
nonexistent corp or was the agreement that Mr Boss was a present
obligor
1. The words "who will be the obligor" are not enough to offset the
rule that the person signing for the nonexistent corp is normally
to be personally liable
2. Just because Boss sent 2 checks which How accepted with name
of new corp doesn't = a waiver of rights
v. Found for P, the promotor Boss is personally liable for the K
6. Class Take Aways
a. How can’t go after corp because it has no assets, because it was never formed
b. Promoters are personally liable for the Ks they sign, unless there is an agreement
to the contrary which are:
i. Revocable offer
1. The other party is making a revocable offer to the nonexistent
corp which will result in a K if the corp is formed and accepts
the offer prior to a withdrawal (normal understanding)
2. Putting ppl in touch with other, no performance is supposed to
start until the corp is form
3. Here there is no promise
ii. Best efforts
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1. Other party is making an irrevocable offer for a limited time.
Consideration to support the promise to keep the offer open can
be found in an express or limited promise by the promoter to org
the corp and use best efforts to cause to accept the offer
2. Promoter is agreeing to use his best efforts to set up corp and to
get the corp to accept the agreement
3. Here there is a promise, but its 2 prong
iii. Novation
1. They may agree to a present K by which the promoter is bound,
but with an agreement that his liability terminates if the corp is
formed and manifests its willingness to become a party. There
can be no ratification of the newly formed corp, since it was not
in existence when the agreement as made.
2. What if there is a director who knows and said nothing
implicitly accepted the K as a corp, cuts off the promotor's
liability
3. Not pleaded in this case
iv. Surety
1. They may agree to a present K on which, even though the corp
becomes a party, the promoter remains liable
2. Court says that the last scenario is the most applicable
c. Why isn't the corp solely liable?
i. Promoter is liable unless facts show us that there was an agreement
to the contrary
1. The way that the K was signed is important to this case
2. Signing as Michelle Murphy, President, Cupcakes Inc
a. If you sign as this it looks like you are signing in your
individual capacity
b. First name that should appear is the corporation
name
7. CLASS HYPO
a. May 1: Promoter signs K with Flour Co
b. May 10: Flour in use
c. May 15: Cupcakes Inc (2off/directors)
i. Other director is upset and doesn't want to pay the invoice
d. April: Invoice
i. Revocable offer? performance started before corp formed so NO corp
liability
ii. Best efforts? no facts to support to this with his best efforts so NO corp
liability
iii. Novation? corp clearly came into existence, but invoice has to be for post
incorp (pre incorp is all promoter liability), other director didn't know
and when she did she said NO (but did she bother to ask? did she see it?
obviously you are using some kind of flour), so LIKELY corp liability
iv. Surety? Doesn’t look like that kind of K in this case
e. ON EXAM- go through all four options, but don't make up facts!
iii. DEFECTIVE INCORPORATION
1. SEE MBCA §§ 2.03, 2.04 IN STATUTE CHART
2. ROBERTSON V. LEVY (DDC)
a. I: Whether the President of an association which filed its articles of
incorporation, which were first rejected then accepted, can be held personally
liable for the K or if the creditor is estopped from denying the existence of the
corp because after the certificate of incorp was issued, he accepted the first
payment on the note.
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b. H: Early common law had three different kinds of corp, which have largely been
eradicated by statute
i. De jure corps
1. Results when there has been conformity with the mandatory
conditions precedent established by statute
2. Not subject to direct or collateral attack
ii. De facto corps
1. One which has been defectively incorporated and thus is not de
jure
2. Requisites
a. Valid law under which a corp can be lawfully organized
b. Attempt to organize
c. Actual user off the corp franchise
d. Good faith
3. Recognized for all purposes except where there is a direct attack
the state in a quo warranto proceeding
iii. Corps by estoppel
1. Not either of the 2 above, by courts were willing to decide on the
equities of the case
2. It is a misnomer-no corp (they haven't fulfilled corp
requirements) and no estoppel (no holding out followed by
reliance)
3. Estoppel problems arose where the certificate of incorporation
had been issued as well as where it had not and under these
conditions
a. Association sues TP and the TP is estopped from
denying P is a corp
b. where a TP sues the assoc as a corp and the assoc is
precluded from denying it was a corp
c. where a TP sues an assoc and the members of that assoc
cannot deny its existence as a corp where they
participated in holding it out as a corp
d. where a TP sues the individuals behind the association
but is estopped from denying the existence of a corp
e. where either a TP or the assoc is estopped fro denying
the corp existence because of prior proceedings
c. Now, before the certificate issues there is no corp de jure, de facto, or by estoppel
i. After the cert, there is a de jure corp
d. If individuals assume to act as a corp before the cert of incorp has been issued,
joint and several liability attaches
i. Doesn't matter who the TP thought they were dealing with, the certificate
is the cut off point for the individualcorp liability
ii. Individuals still liable for actions before certificate even if they later
become a corp, and even if there is subsequent partial payment by
the corp
3. Class Take Away
a. How is this different than the promoter case? Different doctrines apply
i. You think you were dealing with a corporation, even though it was
defective and was not a corp at the time
b. Other states recognize these three kinds of corps, even if this state no longer
does
V. PIERCING THE CORPORATE VEIL
a. Piercing should be an uphill battle-it's not supposed to be easy
b. Doesn't change the corp, it’s still a corp you are just getting behind the veil to find ppl behind it are liable
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i. You can get to particular people, i.e. 1 SH but not all of them
ii. It’s for closely held corps, not public held corps
iii. Going to arise when the corp that you working with doesn’t have $$ to pay, you want to go for
deep pockets
c. Parent/sub context (shareholder is a corp!)
i. Parent mean that’s one corp owns the majority of the stock in another company, they are you
subsidiary
d. Enterprise liability or sibling
i. parent corp owns more than one entity, piercing sidewise to get to siblings (also corps)
e. GENERAL DOCTRINE
i. BARTLE V. HOME OWNERS COOP.
1. Facts: P, as trustee in bankrupcy of Westerlea Builders, has attempted to hold D liable
for the K debts of Westerlea, D's wholly owned subsidiary. D was organized as a co-op
corp composed mostly of veterans and was organized to provide low-cost housing for
its members. When they couldn't get a contractor, they organized Westerlea . Which
later was declared bankrupt. D had contributed 25K original capital + 25K additional.
2. H: D as owner of the stock of Westerlea, controlled its affairs, the outward indicia of
these two separate corporations was at all times maintained during the time the
creditors extended credit, the creditors were in no wise misled, there was no fraud, and
the D performed no act causing injury to creditors of Westerlea by depletion of assets
or otherwise.
a. Also found creditors were estopped by the extension agreement from disputing
the separate corporate identities
b. The law permits the incorporation of a business for the very purpose of escaping
personal liability
1. Doctrine of piercing the corporate veil is invoke to prevent fraud or to
achieve equity, no fraud or misrep nor illegality here
2. Dissent: Westerlea is a wholly owned subsidary and its business was done in such a way
that it could not make a profit. Basically draining money from Westerlea, which could, at
best, break even. Thus Home Owners should be liable.
3. Class Take-Aways:
1. When there’s fraud and misrep they will pierce, these cases are whether or not
they are going to pierce it otherwise
2. “Wholly owned”parent/subsidiary case
3. PCV cases focus on the victim
1. Creditor is not the kind of victim we are trying to protect, they could
have looked at the business and seen they had no assets
2. AND if they pierced here going after a CO OP of veterans-never going
to happen
4. Factors:
1. Stock ownership: necessary but not sufficient, otherwise you could
pierce every wholly owned subsidiary
1. But if you own the whole thing it shows that you are likely using
the subsidiary to do what you want to do with it
2. Overlap of directors and officers, both of the parent and the
subsidiaryraises eyebrows, as director you are supposed to act only in
the best interest of THAT corp
3. Remember: when it doubt, don't pierce! May mean that there is no
remedy, but oh well that's the way that corps are supposed to be!
ii. DEWITT TRUCK BROKERS V. W. RAY FLEMMING FRUIT CO.
1. Facts: P seeks to, by piercing CV, to impose individual liability on the President of the
indebted corp individually. DC found that only stockholders were Flemming, Wife, and
attorney. He owned 90% of shares, and retired 2k of original 5k shares. Other director
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was not involved, didn't attend directors meeting nor received salary, basically a figure
head. Never had a stock holder meeting.
a. Corp sold fruit for growers, remitting the full sales prices minus transportation
cost and sales commission
b. Often didn't return credit the growers were owed on the transportation cost
2. H: Corp is an entity separate and distinct from its officers and stockholders, and its
debts are not the individual indebtedness of its stockholders.
a. This concept is merely a legal theory, and the courts decline to recognize it
whenever the recognition of the corporate form would extend the principle of
incorporation beyond its legitimate purposes and would produce injustices or
inequitable consequences.
b. Courts should be reluctant to pierce corp veil and treat corp and SHs as
identical
i. Proof of plain fraud is not a necessary element in a finding to
disregard the corp entity
ii. Also the fact that all the stock or most of it is owned by an individual
or a few individuals will not be enough
iii. But this combined with other factors-->court will not hesitate to set
aside the corporate shield
1. Whether the entity was grossly undercapitalized
2. Failure to observe corp formalities
3. Non pay of dividends
4. Insolvency of the debtor corp
5. Siphoning of funds of the corp by the dominant SH
6. Non functioning of other directors or officers
7. Lack of corp records
8. Corp is merely a facade for acts of dom stockholder(s)
9. Nature of the victim (from earlier case)
c. When one, who is the sole beneficiary of a corps ops and who dominates it, as in
this case, induces a creditor to extend credit to the corp on such an assurance as
given here, that fact has been considered by many authorities sufficient basis for
piercing the corporate veil
3. Class Take-Aways
a. How do we determine undercap?
i. Not a specific # just what are its debts and obligations?
ii. Do they have reserves? Need a cushion
b. Siphoning implies some type of fraud
c. Salary Establishment-can’t just make it whatever you want
d. Non-payment of dividends is up to the discretion of board, new comps rarely
do it so not a big deal
e. No board means not adhering to corp formalities!
f. Victim: contractor can’t do research and figure out the siphoning stuff
g. “Court says if you're not gonna act like a corporation, then were not going to
give you the benefits of being one”
i. If you are a shareholder and director, you still need to have meetings and
have a record-even if it seems ridicthis is how small companies get in
trouble!
h. AND there was a personal guarantee, not enough on its own because violated
SOF and you are still entering into a k with a corp
iii. CLASS HYPO: PIERCING SIBLINGS
1. Parent is a NY holding company and owns a bunch of subsidiaries, and each of those
owns two cabs as assets
a. Have about 5K in assets/subsidiary
b. Have different director/subsidiary
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c. Observe all corp formalities
d. NYS law says if you are a corp that owns 2 or less cabs, you have to pay less
insurance, more than 2 more, more than ten even more
2. Cab hits 2 ppl and injures them
a. Costs more than 5K, and insurance can't cover it either
b. If the cabs had all been under one corp, there would have been enough insurance
3. Bring suit, want to pierce all the siblings
a. Analysis
i. Stock ownership-not a factor here, they aren't trying to get to parent (has
no assets), they are siblings no one is owning anyone else
ii. Undercap? They seem to be meeting all their requirements, they were
meeting their the creditor obligations
1. But they split it so they didn't have to pay insurance for all the
cabs, they split it because they can't afford??
2. Deliberate effort to split the cabs up into different corp-->this
argument is tough!!!
a. But NYS says it’s ok, this is the amount of insurance
you need for one cab!
iii. No overlap of directors/officers, observing corp formalities
iv. It’s a tort victim! But this isn't enough :(
4. Courts before had always emphasized the importance of ownership, and no ownership
in sibling cases
f.
TORT CASES
i. BAATZ V. ARROW BAR
1. Facts : Baatz's are suing the individual D's Ed, LaVell, and Jacquette who are
stockholders in the corp Arrow Bar. Baatzes were seriously injured when M cross the
center line of a Sioux Falls street with his car and struck them on a motorcycle. Mwas
uninsured and judgment proof, but had been drunk at Arrow Bar prior, where they
continued to serve him drinks.
a. ELJ formed the bar and contributed 50k to the corp pursuant to a stock
subscription agreement
b. They purchased the bar for 155k with a 5k DP, and a promissory note with
personal guarantee for the balance
c. Didn't have dram shop liability at the time of the injuries
2. H: A corp shall be considered a separate legal entity until there is sufficient reason to
the contrary
a. Certain factors will indicate injustices and inequitable consequences-->PCV
i. Fraud rep by directors
ii. Undercap
iii. Fail to observe corp formal.
iv. Lack of corp reords
v. Payment of corp of individual obligations
vi. Use of corp to promote fraud, injustice, or illegalities
b. Just because EL personally guaranteed corporate obligations, they shouldn’t also
be liable to Baatz
i. It’s a K agreement, shouldn't be enlarged to impose tort liability
ii. Evidence that ELJ treated corp separately from their individual affairs
iii. Also, ELJ didn't serve the alch that day to McBrideirrelevant,
bartenders are agents
3. Dissent: they have a history of serving drunk people, and undercapitalized.
ii. RADASZEWSKI V. TELECOM CORP.
1. Facts: action for personal injuries filed on behalf of Konrad Radaszewki, who was
seriously injured in an auto accident when he was hit by a truck driver employee of
Contrux
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2. I: Whether you can PCV and hold the parent of a corp liable
3. H: Generally someone who is injured by the conduct of a corp or one of its employees
can look only to the assets of the employee or of the employer corp
a. But there are exceptions to this general rule where someone can PCV
b. Under MO law there is a triparite test to PCV
i. Control/complete domination of not only the finances but of the policy
and business practice in respect to the transaction attacked so that the
corp had no separate mind, will or existence on its own
ii. Must have been used by the D to commit fraud or wrong, to perpetrate
the violation of a statutory or other + legal duty or dishonest and unjust
act in contravention of P's legal rights
1. Undercap has become a proxy for this part of the test
4. Here, although undercapped, had liability insurance
a. Have to show more than bad business judgment to hold parent comp liable
5. Court says good faith attempt to get insurance is enough
a. ****ignore this three part test-we have the factor test
VI. FINANCIAL MATTERS
a. DEBT & EQUITY CAPITAL
i. Every firm needs financing, aka capital
ii. Debt
1. Borrowing from bank, friends, credit cards
2. Must be repaid at some pt, including interest
3. Not contingent on the success of the business
4. AKA Fixed claims
iii. Equity
1. Capital contributions from owners, outside investors, or retained earnings
2. Synonymous with ownership
3. Value of equity=market value of the property-debts and liens
4. Can describe a bunch of things
a. Money or consideration for issuing stock
b. Amount of a firms legally required capital
c. Capital plant
d. All money and prop firm owns or uses
5. AKA residual claims: after debts are repaid, whatever is left goes to equity holders
b. TYPES OF SECURITIES
i. Securities are equity usually raised from the sale of securities
ii. Securities Act of 1933 imposes substantial disclosure requirements if comp is using mail or
interstate commerce for sale
1. Must be registered or crim and civil penalties
iii. States also have blue sky laws regulating securities whenever a business seeks funds
iv. Shares Generally
1. Shares are units into which the proprietary interests in a corp are divided
2. Corp may create and issue different classes of shares with different preferences,
limitations, and relative rights
3. Each class must have distinguishing designations, and identical rights within one class
a. Must be laid out in the articles of incorporation
v. MCBA 6.01: Two fundamental rights of holders of common shares
1. Entitled to vote for election of directors and other matters before shareholders
2. Entitled to new assets of corp in form of dividends or liquidation
3. One or more classes with attributes must always be authorized
a. At least one share of each class with these basic attributes must always be
outstanding, aka issue to someone
vi. Common v. Preferred Shares
1. Common shares
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2.
3.
4.
5.
a. Class or classes of shares that have the fundamental rights of voting for directors
and receiving net assets of corp
b. May have different classes
c. Non financial rights as well, right to inspect books, right to sue on behalf of corp
to right a wrong committed against it, right to financial info
d. SC says other characteristics are
i. Negotiability (capable of being transferred by delivery or endorsement
when the transferee takes the instruments for value, in good faith, and
without notice of conflicting title claims or defenses
ii. Ability to be pledged or hypothecated (ability to be pledged as security
or collateral for a debt, without delivery of title or possession)
iii. Voting rights in proportion of shares
iv. Capacity to increase in value
e. Tech corp not supposed to start business until shares are issues
f. Financial interests are open-ended, SHs benefit as the business prospers and the
corporate assets increase
Preferred Shares
a. Preferential to common shares in some ways, but also limited
b. Right to receive a distribution more than the common shares, ie $5.00
c. Usually non-voting, unless a dividend payment is missed or corp fails another
financial test
d. Often described by reference to the amount of their dividend preference or by a
percentage of the stocks par or stated value, ie $5 preferred or 5% preferred
e. Details in articles of corp, can't be amended without vote by some % of
shareholders
f. If earnings of a corp are retained by the corp, the value of common shares may
go up but the value of the preferred hares may not
g. Decisions to make a distribution are within business judgment of directors
i. No legal basis for complaint unless its been a long time
h. No min initial contribution is required any more, used to be $1k
Participating Preferred
a. Entitled to special dividend and after the common shares receive a specified
amount, they share with the common in additional distributions on some
predetermined basis
b. Such shares combine some of the features of common and preferred
i. AKA Class A Common
c. Usually have liquidation preferences that are tied in some way to the amounts
receivable by the common shares on liquidation preferences that are tied in some
way to the amounts receivable by the common shares on liquidation
Classes of Preferred
a. Corp may issue different classes of preferred shares
b. Different dividend rates, different rights on dissolution and different priorities
c. Both are senior securities, however, because both have preferential rights over
common shares
Series of Preferred
a. MBCA 6.02 a 2 refers one or more series within one or more classes
b. The concept of a series within a class arose because of problems of raising
substantial amounts of capital through the issuance of preferred shares
i. Often advantageous to tailor the price, dividend, and other terms of the
shares to the market conditions current at the time of issue
c. It was inconvenient and expensive to amend the articles of incorp of a corp with
many shareholders to create a new class of preferred shares
i. Directors can create classes and then carve out series instead
ii. Called blank shares
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iii. Usually no economic difference between a class of preferred shares and
series with in a class
iv. Always have identical preferences, limitations, and relative rights
v. May be set out in charter or by directors later
c. PREEMPTIVE RIGHTS AND DILUTION, MBCA § 6.30
i. CLASS NOTES
1. Only rights that you have to have for shareholders is (for one class of shares):
a. Voting right
b. Liquidation right-right to receive the remaining proceeds in a corp once
dissolved and out of business
2. Optional rights:
a. Dividend-can't pay if paying your dividend will make you unable to meet your
other $ commitments
i. Preference
ii. Cum
iii. Participating
b. Redemption
i. Cash out at some point
ii. Call (corp wants to cash out)
iii. Put (sh wants to cash out)
c. Conversion
d. Anti-dilution
i. Preemptive right
e. Par value-doesn't mean much anymore, just can't issue stock for price less than
that
ii. Special Rights of Publicly Traded Preferred Shares
1. Cumulative Dividend Rights
a. Dividend preference of preferred shares may be cumulative, non cumulative, or
partially cumulative
b. Cum dividend means if preferred dividend is not paid in any year it accumulates
and must be paid before any common dividends are paid
c. Noncum means if dividend isn’t paid out its lost
d. Partially cum is cum to extent there are earnings in the year, and noncum with
respect to any excess dividend preference
i. Unpaid cum dividends are not debts of corp, but right of priority in future
ii. Many states liberally permit payment of cum preferred div from various
capital accts
iii. Usually pub traded preferred have cum rights
2. Redemption Rights
a. May be made redeemable at the option of the corp, usually at the price fixed by
the articles of incorp
b. Corp has power to buy back redeemable shares at any time at fixed price, and
shareholder must accept
i. It’s called being called for redemption, usually takes place after some
specified period of time and price is usually in excess of amount of
shares liquidation preference
3. Conversion rights
a. Preferred shares may be made convertible at the option of the holders into
common shares at a fixed ration specified in the articles of incorporation;
convertible preferred shares are attractive when publicly traded
b. Thus obtain a part of the long term appreciation of the corp's assets if the holders
are willing to give up their preferred rights
c. Common shares must appreciate substantially in price before it is profitable to
convert the preferred shares
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d. Convertible shares are also usually redeemable
i. Described as forced when shares are called for redemption at a time
when the MV of the shares obtainable on conversion exceeds the
redemption price
4. Protective Provisions
a. Preferred shares may also have certain financial protections, such as sinking fund
provisions, which require the corp to set aside a certain amount each year to
redeem a specified portion of the preferred stock issue
b. Convertible preferred shares usually contain elaborate provisions protecting the
conversion privilege from dilution in case of share dividends, etc
c. Importance of these protections cannot be min sine preferred shareholders have
not fared well on arguments based on fid duty
d. Well-settled that corps and their directors owe fid duties to common shareholders
i. ****Preferred shareholders fair poorly in courts because it’s difficult to
side with them when they are competing with common shares
iii. CLASS NOTES AND HYPO
1. Every class of shares has to have the same rights, that’s why you have different classes
since you want to give people different rights
2. Facebook: signed agreement without antidolution agreement
a. Complicated stock classes means they had a lot of rounds of investors who
wanted different things
3. HYPO:
a. $2 Class A (non)
b. $2 Class B (cum)
c. $2 Class C (cum + part)
d. Common
e. Year 1
i. Nothing happens
f. Year 2
i. $1.00 dividend
1. Class A gets $2
2. Class B gets $4 (2 yrs x $2)
3. Class C $4 + $1.00 (if fully participating as if common, so you
give them $4, and you distribute to all commons + this
participating share. If you don't have enough you give pro rata,
not $1-everyone gets pro rata, participating + common)
4. Common $1.00
d. DISTRIBUTIONS
i. GOTTFRIED V. GOTTFRIED
1. Facts: Minority (38%) shareholders in Gottfried are suing majority (62%)
shareholders. Closely held family corporation, they manufacturer and sell bakery
products.
a. Gottfried had two different kinds of stock
i. A stock, without nominal or par value
1. Get $8/share before common stock
2. Participating
ii. Common stock
iii. Preferred stock
b. For 14 years, no dividends had been paid upon the common stock, but dividends
paid on preferred and intermittently on the A stock.
i. Comp was working with a net capital deficit and a loss but a small
surplus before the case
ii. Dividends were paid the year of the case, so now this a case to get what
was owed beforehand
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c. P claims that D is acting with bitter animosity and trying to coerce them into
selling their stock to D at grossly low price
i. Also claim D has been giving themselves salaries, bonuses and corp
loans so they don't care as much about immediate dividends, while P is
off the payroll
ii. Plus D doesn't want to pay high income taxes on dividends
2. H: If an adequate corp surplus is available for the purpose, directors may not
withhold the declaration of dividends IN BAD FAITH. Not present here:
a. Essential test of bad faith is to determine whether the policy of the directors is
dictated by their personal interests rather than the corporate welfare
i. Closely held corps have their own issue
1. Dissension and hostility
2. Large part of your assets involved
3. Major livelihood
4. Hardship suffered by P
5. Plus the fishy D loan stuff, although still outstanding, doesn't
sustain an interference that they were made with a view to the
dividend policy of the corporation
6. Also in this case, the Ps got retirement $$ when they were taken
off payroll
3. Class Takeaways
a. Look and see the different rights for each stock, across the board decisions affect
SHs differently
i. IE cum stocks won’t care if they aren't doing dividends every year
b. What else is a red flag for severe abuse?
i. FAMILY
ii. Also looks like they have track record of not paying out any dividends
1. THEY PAID OUT DIVIDENDS THE YEAR OF THE SUITcourt says doesn't matter
c. Like PCV, its an uphill battle since directors have discretion
d. Avoiding a tax liability is a good case if you can prove it
i. People in different tax brackets, trying to help others at expense of some
ii. DODGE V. FORD MOTOR CO.
1. Facts: Ps are minority shareholders in Ford. Ford owned 58% of capital stock. Corp
was very successful-expected profit of $60M+ huge assets and surpluses in cash. Didn't
declare a dividend during the business year, except once but it was unusually low.
2. H: A refusal to declare and pay further dividends appears to be not an exercise of
discretion on part of the directors, but an arbitrary refusal to do what the circs
required to be done
a. It has been the policy of the corp to annually reduce the price of their cars, and
also wanted to build another plant
i. D says that they were retaining money for these reasons, since they will
likely make less profits with reduced price
ii. Apparent immediate effect will be to diminish the value of the shares and
the returns to shareholders
iii. Mr. Ford convinces us that he has to some extent the attitude towards
shareholders of one who has dispensed and distributed to them large
gains and that they should be content to take what he choose to give
1. Although his sentiments are philanthropic and altruistic, a
business corp is organized and carried on primarily for the profit
of the stockholders
2. Plus the dividend if paid out would be a drop in the bucket-you
could still do all the things you want to do
3. Class Takeaways:
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VII.
a. A lot of people don’t like this case, court telling Ford how much cash he needs in
any given year
b. When a corp starts engaging in activities that aren't profitable there are two
ways of attacking it
i. Failure to disperse adequate dividends (this case)
ii. Ultra vires
FIDUCIARY DUTIES OF OFFICERS AND DIRECTORS
a. Directors
i. Board of directors, don't all meet all the time, usually have committees that they work in as set up
in their bylaws
1. IE nominating committees, financial committee, etc-->can have many others, up to you
ii. Some people are officers/directors AND SH, so you are considered an insider
1. Insider means you are carrying on 2 roles within the corpheightened fid duty
iii. Boards will have a chair, ie chairman of the board
1. Usually the CEO or President but growing movement to separate these positions
b. DUTY OF CARE AND THE BUSINESS JUDGMENT RULE, MBCA § 8.30
i. SHLENSKY V. WRIGLEY
1. Facts: Action of stockholders against the directors for breach of duty of care. P seeking
damages and an order that Ds install lights in Wrigley Field and the scheduling of night
baseball games.
a. D Wrigley is president of corp and owner of 80% of stock
b. Unlike most teams, the Cubs don't have night games
i. P alleges that because of this the team has not been maxing attendance->maxing revenue and income
ii. P says funds for lights are readily available, and their cost would more
than be offset by increased revenue and incomes from increased
attendance
iii. P believes that the D has refused to install lights because of his personal
opinions that baseball is a daytime sport and that the lights will have a
deteriorating effect upon the surrounding neighborhood
iv. P also believes that the other directors have acquiesced to Wrigley's
dominating policies
2. H: All SHs in a corp agrees that he will be bound by the acts and proceedings done or
sanctioned by a majority of the shareholders or by the agents of the corp duly chosen
by such majority, within the scope of the powers conferred by the charter, and courts
will not undertake to control the policy or business methods of a corp, although there
may be a wiser policy seen by the court
a. Court believes that it is not their function to resolve for corporations
questions of policy and business management unless shown tainted with
fraud
i. Here the court is not satisfied that the motives of Wrigley are contrary to
the best interests of the corp and the stockholders, must consider
surrounding neighborhood
ii. Failure to not follow the crowd is not negligence
3. Class Take-Aways:
a. Shareholder derivative suit: stockholders bring a suit against the directors for
breach of fid duty, for the corporation (as opposed to a direct suit, something for
you)
b. Business judgment rule
i. Courts take a conservative approach, don't want to interfere with the
decisions of the directors
ii. Also judges aren't business experts and SHs buy stock for the direction of
the directors, not judges
iii. Have to OVERCOME the BJ rule-uphill battle
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1. If you prove that the board is not entitled to the protection of the
BJ rule, then you can hold the directors liable for breach of fid
duty
iv. You can also make an attack that it was so STUPID, there is so much
evidence that its clearly so irrational
1. This is also the point where it becomes wasteful
v. Otherwise very difficult to attack
ii. SMITH V. VAN GORKOM
1. Facts: Class action of the shareholders against Trans Union Corporation seeking
rescission of a cash-out merger or damages. Trans Union is a railcar leasing business,
had a cash flow of hundreds of millions of dollars annually, but had difficulty in
generating sufficient taxable income to offset increasingly large investment tax credits.
a. Began to look at different alternatives which were proposed in its annual Five
Year Forecast report, a sale of the corp was not one of them
b. CFO Roman did a prelim analysis on a leveraged buyout, but his numbers were
rough (50-60/share)
c. Van Gorkom took the $55/share price and suggested it to Pritzker to buy out
Trans Union, without consulting members of the board
d. Pritzker agreed to the price, so VG went back to the board and disclosed the
offer
i. No one read the proposed merger, nor had expertise in these financial
matters
ii. No one was aware that these calculations were never done correctly
iii. Got competing offers that were higher, but had to take the Pritzker offer
because of the deal
iv. The shareholders voted to approve the merger
2. H: The proper standard for determining whether a business judgment is an informed
one in DE is predicated upon concepts of gross negligence
a. The issue of whether the directors reached an informed decision must be
determined only upon the basis of the info then reasonably available to the
directors and relevant to their decision
i. We must conclude that the board of directors did not reach an informed
business decisions when voting to sell the company for $55/share
1. If they had looked into it, they would've realized the source of its
derivation and would not have relied upon it in good faith
b. The court also rejects the argument that the Board's collective experience and
sophistication was a sufficient basis for finding that it reach an informed
decisions
c. Whether the directors should be treated as one or individually in terms of
invoking the protection of the business judgment rule are questions which were
not originally addressed by the parties
i. Court finds that they all take a unified position, so they are required to
treat them all as one [5 inside and 5 outside]
d. The cash out merger was not the product of an informed business judgment,
thus remanded for determination of a fair price, with the difference between
that and $55 paid to shareholders
3. Dissent: The inside directors wear their badge of expertise in the corp affairs of Trans
Union and the outside directors are all informed business men
a. They are not ordinarily taken in by a fast shuffle
b. Things happen on a fast track now a days
4. Class Notes and Takeaways:
a. Important facts
i. Important board meeting in July, dealing with the nagging tax problem
1. Nothing is mentioned about a potential sale of the corp
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ii. Now its august, Van is meeting with sr mgt, discusses a potential sale
1. Prelim work by CFO of a buyout
iii. September
1. Starts talking with other guy
2. He doesn't want to be stalking horse-essentially the first person
to get everyone excited about the deal, and them someone else
takes it
a. If he becomes that, he wants $$ in shares
3. Gives him 3 days
a. When the directors meet, the lawyer says that they can
be sued if they don't go through with the deal
b. But no one has even read the deal at this point!
4. Active solicitation process doesn't bring anything
iv. Why is it relevant that Van is close to retirement? He’s trying to get a
quick cash out!
v. What was going on with the meetings?
1. Not disclosed, short period of time, etc
2. Meeting is 2 hours-QUICK, ppl wanted to leave, they didn't get
to look at anything
vi. Why didn't anyone wanted to see his study??
1. If someone is making a complex lie, then maybe itll be more
difficult
a. NO ONE KNEW HOW HE CAME UP WITH $55
2. Lawyer is clearly the expert! Even if the CEO isn't
a. But why isn't that reliance??
b. It's not about the decision! Its not about the price! Its about how they went about
making the decision!
i. They don't need to know everything, just what is reasonable for them to
know
c. Why isn't it a cure that a majority of the SHs approved it?
i. SHs are going to go along with the board! They think they have greater
knowledge!!
5. WASTE IS HARD TO PROVE: irrational and unreasonable
iii. DEL. GEN. CORP. LAW § 102(B)(7) [PASSED RIGHT AFTER VANGORKOM]
1. Section 102: Contents of Certification of Incorporation must contain
a. Provision eliminating or limiting personal liability of a director to the corp or its
stockholders for monetary damages for breach of fid duty as director, provided
that such provision shall not eliminate or limit liability of a director for
i. Breach of duty of loyalty to corp or shs
ii. Acts or omissions not in good faith or which involve intentional
misconduct or a knowing violation of the law
iii. Under 174 of this title
iv. Any transaction from which the director derived a personal benefit
b. No such provision shall eliminate or limit the liability of a director for any act or
omissions occurring prior to the date when such provisions becomes effective
2. ***It has to be in your charter for it to cover you, opt in to it
3. What remedies are available?
a. If you are just asking for money damages, case dismissed unless loyalty charges
b. How do get the care case passed dismissal?
i. Link it to loyalty
4. Suit about breaching of fid duty
a. Can't just say 102 b7 won't allow this action to go forward
i. First need to need to know if the co opted in
ii. Then look at the relief the SHs are asking for
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iii. Need to prove its a care claim and not something else
b. What if you have the same scenario as yesterday, but then fairness studies come
out saying the 55 dollars was fair
i. Breach was about the decision making process and lack of care, just
means there is no recovery in the case
ii. But if they have a 102b7 statute you weren't gonna get $$ anyway
iv. BREHM V. EISNER
1. (2000) Case Facts: P alleged that
a. Disney Old Board breach its fid duty in approving an extravagant and wasteful
Employment Agreement for Ovitz as president
b. Disney New Board breached its fid duty in agreeing to a non fault termination of
the OEA
c. The directors were not disinterested and independent
2. The Agreement:
a. In 1995 Disney hired Orvitz as president, agreed to a term of five years with a
base salary of $1M, a discretionary bonus, and 2 sets of stock options-->enable
him to buy 5M shares of Disney stock
b. Termination clause provided that if Orvitz left employment and it was not
his fault, he would receive a compensation package that depended on years left in
K
i. When Orvitz left at no fault after 14 mos, he received $140M in
compensation
3. H: Board is only responsible for considering material facts that are reasonably
available, not every fact that are immaterial or out of reasonable reach
a. Just because no one quantified the potential severance benefits for terminating
early without cause does not create a reasonable inference that the Board failed to
consider the potential cost to Disney in the event that they decided to terminate
Ovitz or that there is a reasonable doubt that the Board did exercise reasonable
care
b. The Old Board is entitled to the presumption under Sec 141 e that it exercised
proper business judgment, including proper reliance on an expert
c. To survive a motion to dismiss, the complaint must allege particularized
facts, not conclusions, that if proved would show for example:
i. Directors did not in fact rely on expert
ii. Their reliance was not in good faith
iii. They did not reasonably believe that the experts advice was within the
expert's professional competence
iv. Expert was not selected with reasonable care which is attributable to the
directors
v. SM that was material and reasonably available to board was so obvious
that the board's failure to consider it was grossly negligent regardless of
expert's advice or lack of advice
vi. Decisions of the Board was so unconscionable as to constitute waste or
fraud
d. Waste test: an exchange that is so one sided that no business person of ordinary,
sound judgment could conclude that the corp has received adequate consideration
[reasonable person standard]
i. Board gets great deference here, consideration was received in exchange
for the OEA
ii. Even if the fact finder would conclude ex post that the transaction was
unreasonably risky
e. Irrationality is the outer limit of the business judgment rule, none of the P's
allegations rise to the level of gross negligence or malfeasance
34
4. 2006 Case Facts: After the case about was remanded, the P's amended their complaint
and resubmitted. Ps allege that the committee members did not properly inform
themselves of material facts and hence, were grossly negligent in approving the NFT of
the OEA.
5. I: Whether the compensation committee members knew, at the time they approved the
OEA, that the value of the option part could reach $92 million order of magnitude
6. Holding:
a. Record shows that the committee members were so informed
b. They got their info from benchmark options previously granted to Eisner and
Wells and the valuations by Watson of the proposed Ovtiz options
c. Also got info from the amount of downside protection Ovitz was demanding
i. Termination without cause compensation would replace his lost CAA
commission
d. There are at least three different categories of fiduciary behavior that are
candidates for the bad faith pejorative label
i. Subjective bad faith: motivated by an intent to do harm
ii. Lack of due care
1. Fiduciary action taken solely by reason of gross negligence and
without malevolent intent
2. Gross negligence without more, cannot constitute bad faith
3. Thus under DE law, a director or officer of a corp can be
indemnified for liability incurred by reason of a violation of the
duty of care, but not for a violation of the duty to act in good
faith
iii. Intentional dereliction of duty or conscious disregard for ones
responsibilities
1. In between the two categories above
2. Such misconduct is properly treated as a non exculpable, non
indemnifiable violation of the fiduciary duty to act in good faith
because
iv. A P who fails to rebut the business judgment rule presumptions is
not entitled to any remedy unless the transaction constitutes a waste
1. Waste only occurs in rare, unconscionable cases where directors
irrationally squander or give away corporate assets, record
doesn't support his
7. Class Takeaway
a. Disney case itself sparked a revolution
b. Shareholders were so upset by the compensation package that they were going to
take steps to remove the directors and CEO who approved the package
i. Couldn't vote against but could withhold their vote, but then realized it
meant nothing because they had a plurality system
1. Now most corps have majority vote systems
c. Court holds no breach of duty of loyalty
i. Court gives the Board a lot of slack when it picks officers
1. But they have to look into a resume!! Call references
2. Hiring deicision
a. How much can someone act unilaterally?
i. Def more discretion and leeway
ii. Different than Vangorkom end of life decisionboard doesn't need to know every detail
ii. How could you say they made an reasonable and rational decision when
they were SHOCKED that he got paid so much (they thought that he
would only get about 30M)
35
1. Remember it’s not about the number! It’s about where it comes
from, how it would be calculated
2. If he was fired with fault, then he wouldn't have gotten anything
a. Why did they do that? reasonable decision to avoid
litigation
d. Wasteful?
i. 140 M for 14 mos, did get extra opinion
ii. Almost impossible to challenge on waste grounds a severance package
1. Company is contractual obligated at this pt to give him the
money!
iii. Also doesn't mean it’s wasteful because they gave him more than the
other people trying to get him-that's what you have to do sometimes to
get someone!
iv. Also with more CEOS getting fired, their lawyers make sure and set up a
fool proof contract
v. Waste is supposed to be so one side and irrational!!
1. Example when citigroup let its CEO go after announcing a huge
loss, and they gave him an absurd deal that wasn't created before
hand
2. Only thing they got was non-compete
3. Court says is this worth it?? NO!
e. How did this survive a motion to dismiss?
i. Not a loyalty case-Eisner owed no duty
ii. They opted into 102b7
iii. All they wanted was money damages-what's going on??
1. They must have framed it into one of the exceptions! Duty of
good faith
2. What is good faith???
a. Court said DE meant to make it a 3d freestanding thing,
not a part of the two
f. VanGorkham Case v. Eisner Case
i. What's the difference? Nature of transaction, use of experts
c. DUTY OF LOYALTY
i. SEE DEL. GEN. CORP. LAW § 144 IN STATUTE CHART
ii. MARCIANO V. NAKASH
1. Facts: 50% of Gasoline Ltd is owned by M and 50% by N. Loans made by Ns to corp
were interested transactions-they both supported and guaranteed the loans. Given the
control deadlock, the decision did not receive majority approval. Ds argue loans are
voidable because of self dealing.
2. H: Fiduciary relationship between directors and corp imposes fundamental limitations
on the extent to which a direct may benefit from dealings with the corp he serves
a. Common law cases were significantly amended by Section 144 of DE General
Corp Law
b. Common law says
i. Where the undisputed evidence tended to show that the transaction
would advance the personal interests of directors , at the expense of SHs,
the SHs can disavow the transaction
ii. Court also examines the motives of the directors and the effect of the
transaction on the corp and SHs
iii. Also look at fairness of a particular transaction and whether it received a
majority, minus interested parties
c. The section 144 validation of interested director transactions is not deemed
exclusive, thus the continued viability of the intrinsic fairness test is mandated
not only by fact situations (ie here were shareholder deadlock prevents
36
ratification) but also where shareholder control by interested directors precludes
independent review
i. Because of the SH deadlock, even if the Ns had attempted to invoke
section 144, it was reasonably unavailable
ii. Ratification process contemplated by 144 presupposes the function of
corporate constituencies capable of providing assents
d. Loans meet the intrinsic fairness test
3. Class Takeaways:
a. Usually bring a case without specifying care or loyalty
i. That way you don't get dismissed if one fails
ii. On exam you are going to need to identify if it’s a care or a loyalty
analysis
1. Everything that's not loyalty tends to be care-so look for loyalty
first
2. If all you have is care, you'll probably lose as a P
b. No presumption of BJR where there’s a conflict of interest
i. Unless it gets cured and comes back....
c. **note if something can't pass muster under the business judgment rule, it can't
possibly pass the loyalty test
i. The loyalty test is a higher test!!
d. Ask yourself: are the directors getting a benefit that the other shareholders
are not getting?
e. In the past, it used to be if a SH challenges a self dealing transaction; it used to be
automatically voidable
i. No longer the case with Del Corp Law 144: Interested Directors
1. Three buckets in statute are either or-just need to get in one!
f. If a person who has an interest doesn't tell the directors that he has an interest?
i. Need disclosure! It's important, unless you think people already know
g. Remember this statute just says that you still need to apply a test to establish a
breach if you get into 1 or 2 bucket
i. Some courts say you get the benefit of the business judgment rule....other
courts say differently
4. CLASS HYPO
a. Back to cupcake company enters into a K with Co P
b. Five directors, 1 and 2 are married to each other, the other 3 are not interested
i. Director 5 says no
ii. Director 1 sits on the board of Co P
c. Duty of care or duty of loyalty?
i. If someone who approves the transaction getting the benefit that other
shs do not
1. Loyalty Breach-YES got this
2. Director 1 is getting benefit, as well as director 2 (we assume
spouses share finances)
d. Look at the DE statue now
i. Bucket one, did the majority of disinterested votes for transaction and
the interest was known
1. Yes, directors 3 and 4
2. If only one of them did or if there was another and it was a
deadlock, then you can't make use of that bucket
3. If it’s only 1 other director, and he says yes, that's a majority
(statute doesn't say quorum)
ii. Ok now you analyze the transaction under the business judgment rule
1. This is good for you if you’re representing corp, don't want a
heightened test
37
a. There’s four steps here…I missed them…
b. One of them is was the interest disclosed- present here
e. Okay lets say this doesn't work, now go on to bucket 2
i. Shareholder's Vote-material facts disclosed [not always a SH vote,
depends on the transaction]
1. Director 1 is also a 70% SH, approved
2. SH 2 has 20%, Y
3. SH 3, 10% N
ii. Here there is no mention of interest or disinterest-just need a majority of
the SHs to vote yes
1. Enough to take away the automatic voidability
f. You have that so now you apply business judgment rule
i. Some courts say you have to knock out the interested party like the
directors vote
1. Then if a majority have rejected the transaction, courts split
2. Some say apply BJR, some say you need to use heightened
intrinsic fairness test
g. Ok no SH approval, no director approval, onto bucket 3
i. If you don't have those things, you apply the intrinsic fairness test
ii. Basically was it fair to the company at the time of the transaction?
iii. In this case....
1. Marcianos were trying to say they couldn't use the statute, cuz no
director or shareholder vote so can't fit into any buckets
2. Court says that 144 is not exclusive, there’s still an IFT test
5. TRY TO GET INTO BUCKET 1 or 2 to get BJR instead of IFT
a. BJR P has burden to overcome
b. IFT board has burden to prove
c. Something might pass BJR but not IFT-huge gap between fair and rational
6. We are left with IFT...how do we determine if this is intrinsicly fair?
a. What's the test-reasonableness?
i. Did they ask around see if they could get the loan from another source?
ii. What about 1% fee for making the loan-is that fair?
iii. Not doing well-maybe couldn't get a bank loan, or it would be more
expensive or more difficult to obtain?
iv. REASONABLE AND RATIONAL
7. If it is invalid, that means it doesn't need to get repaid
a. But if its valid, and gets repaid with interest, and then there might not be
anything left in the corp
d. DUTY OF OVERSIGHT
i. IN RE CAREMARK INTERN. INC. DERIVATIVE LITIGATION
1. Facts: Caremark was a substantial, publicly held corp with shares traded on NYSE.
Many revenues game from 3d party payers, insurers, Medicaid + Medicare.
a. Federal law Anti-Referral Payments Law prohibited remuneration to induce
referral of Medicare and Medicaid patients
b. Caremark entered into Ks with docs, some of which referred patients
i. Fed gov't investigated, indicted Caremark for felonies related to kickbacks
ii. Settled with the gov't, had to pay 250 million to settle the claims + pay
fines and damages; also agree to make reimbursements to certain private
and public parties
c. SHs filed this derivative suit seeing to recover on behalf of the co damages for all
losses suffered by Caremark
d. Proposed settlement was negotiated
i. No monetary payment
38
ii. Caremark had to take steps to assure no future violations of ARPL
iii. Advise patients in writing of any financial relationship between
Caremark and referring docs
iv. Create a Compliance and Ethics Committee of 4 directors, including 2
non-mgt directors to monitor future conduct
2. H: Court addressed this case to approve the proposed settlement as fair and
reasonable, found it was because P was likely to lose on the merits:
a. Directors Duties to Monitor Corporate Operation
i. Complaint charges breach of duty of attn or care in connection with the
ongoing operation of the corp
ii. Claim is that the directors allow a situation to develop and continue
which exposed the corp to enormous legal liability
iii. One of the most difficult theories to win judgment on
b. Director liability for a breach of the duty to exercise appropriate attention may
arise in 2 contexts
i. Board decision that results in a loss because that decision was ill advise
or negligent
1. Subject to review under the director-protective BJR assuming
that the decision was rational + in good faith
2. Can't apply an objective evaluation after the fact, just need to see
if the decision was ration plus IGF at time it was made
3. If so, they have full satisfied the duty of attention
ii. Arise from an unconsidered failure of the board to act in circs in which
due attention would have prevented the loss
1. Loss eventuates not from a decision, but from unconsidered
inaction
2. Most of the decisions of a corp are not subject to director attnonly the most sign ones
a. But ordinary business decisions made by officers and
employees can vitally affect the welfare of the corp
b. Absent grounds to suspect deception, neither corporate
boards nor senior officers can be charged with
wrongdoing simply for assuming the integrity of
employees + the honesty of their dealings
3. It is important that the board exercise a good faith judgment that
the corp's info and reporting system is in concept and design
adequate to assure the board that appropriate info will come to
its attn in a timely manner to satisfy its responsibility
c. TEST: in order to show that the directors breached their duty of care by
failing to adequately control employees, Ps would have to show
i. the director knew or should have known that violations of law were
occurring
ii. that the directors took no steps in a good faith effort to prevent or
remedy the situation
iii. such a failure resulted in the losses complained of (may constitute an
affirmative defense)
d. Liability was huge, but the fact that it results from a violation of crim law alone
does not create a breach of fid duty by directors
3. CLASS TAKEAWAYS
a. Discussing director action or conduct
i. Something's wrong with this decision....
b. Also discussing director INACTION
i. Something was going on in the corp and the directors didn't do anything
about it
39
c. Oversight duty covers everything that goes on in a corps day to day business
i. There is a duty to monitor, and it can be breached if there’s no system in
place to get timely information
d. Majority Rule in Boards
i. Red flags need to be presented to at least a majority of the board
ii. How did we know in this case that the board didn't know about the red
flags?
1. Experts were telling them they were ok
2. They knew about the practices, but didn't know if they were
breaking the law, relied on lawyer who said they were ok
3. But should they have known? Why didn't they know??
a. Should they have known that the system was going to
fail?
4. CLASS HYPO
a. Company in all 50 states
b. Employees bring a suit for sexual harassment --->years and millions in litigation
c. Youtube videos, allegations go back 5 years, reported to own department
d. SHs are saying that the court should have known and taken steps to prevent it and
avoid the libility
e. Are there red flags??? If you are confronted with red flags, then obligated to do
something
i. Did someone tell them? Youtube videos
ii. What if they did see them and the lawyer said don't worry about it
f. If they didn't know, why not??
i. Isn't there training? Isn't there an oversight, someone else looking over?
Is there a number? Is it hidden? Is it read?
ii. Is there system in place reasonably designed to get you the information
you need
iii. Board can't meet every day-but how often do they meet??
5. Post Caremark
a. A lot of confusion about what to do....they said DE SC would do stuff but they
hadn't made any decisions yet
b. Some corps increasing compliance programs, SHs bringing Caremark claims
6. Three kinds of duties:
a. Care-apply BJR
b. Loyalty-144 or IFT
c. Oversight-Caremark, Ridder
ii. STONE V. RITTER (DE SC 2006)
1. Facts: AmSouth Bank and a subsidiary paid 40m in fines and 10m in civil penalties
from the failure of bank employees to file reports required under the Bank Secrecy Act
and anti-money laundering regs. P SHs filed a derivative suit, alleging demand futility
and claiming directors breached their fiduciary duty of oversight.
2. H: Standards for determining demand futility in the absence of a business decision:
a. Court must determine whether or not the facts of the case create a reasonable
doubt that the board could have properly exercised its independent and
disinterested business judgment in responding to a demand
b. Ps assert that the directors face a substantial likelihood of liability that renders
them personally interested in the outcome of the decision on whether to pursue
the claims asserted in the complaint and therefore are not disinterested or
independent
i. Director's personal liability depends on whether they can get out of
102b7 provision
40
ii. Can exculpate directors from monetary liability for a breach of duty of
care, but not for conduct that is not in good faith or a breach of the duty
of loyalty
c. Good faith is necessary condition to liability-it is NOT an independent fid duty
that stands on the same footing as duties of care and loyalty
i. Only the latter 2 duties, when violated, may directly result in liability
1. GF breach can only do so indirectly
d. Also, fid duty of loyalty is not limited to cases involving financial or other
cognizable fiduciary conflict of interest
i. Also encompasses where the fid fails to act in good faith
e. Under Caremark, where directors fail to act in the face of a known duty to
act, thereby demonstrating a conscious disregard for their responsibilities,
they breach their duty of loyalty by failing to discharge that fid obligation in
good faith
i. Lower court failed to find any red flags, or facts that show the board was
ever aware that the Banks internal controls were inadequate, that these
inadequacies would result in illegal activity, and that the board chose to
do nothing about problems it allegedly knew existed
ii. This is a case where info was not reaching the board because of
ineffective internal controls
1. Board actually had a compliance program in place, annual
presentations, and training for directors + written policies and
procedures for compliance approved by Board
2. In the absence of red flags, good faith in the context of oversight
must be measured by the director's actions to assure a reasonable
info and reporting system exists, and not by second guessing
them after the fact
3. CLASS TAKEAWAYS
a. ******ON EXAM: When a SH brings a derivative breach of fid duty claim and
there’s a motion to dismiss on the table it’s going to implicate two things:
i. Demand, whether it will get its day in court
ii. If they are allowed in court, how will we determine substantive merits
analysis on whether they breached
b. This is the DE SC that everyone was waiting on
i. Duty of good faith-left open by Disney case....corps thought they had 3
duties
1. Now it’s clear that there are only 2, but GF is not its own but a
subset of loyalty
c. What about duty of oversight??
i. Caremark was correct about articulating an oversight care....and
Caremark says it’s a loyalty thing....UM NO not that’s not what it says
ii. Oversight is a separate test, its not the 144 test
iii. Why does it matter? 102 b7!
1. If you call if a care breach then you wouldn't be able to sue for
damages under 102 b 7
d. Read cases together, they say:
i. Do you have knowledge of illegal activity?
1. Once you know about this, doesn't matter what system you had
in place
ii. Do you have knowledge of red flags?
1. Same as above, why didn't you do anything about it
iii. Do you have a system in place?
1. Don't need knowledge or red flags, but something going on and
you didn't do anything or know
41
iv. Did you fail to monitor that system?
4. CLASS HYPO
a. What if someone told directors he can't believe that he can work for a corp that
treats employees so crappily, is that a red flag?
i. If its a majority, then implicates whole board
ii. If only one person knows only implicates their responsibility
b. NC offices does really well
i. Turns out the employees were all being paid off the books, gonna cost 2
billion in law suits
ii. Red flags: extreme success + ex who burst in saying the employees hate
manager
c. What violation is this?
i. Oversight
1. Failure to act, illegal activity resulted
d. Ok so test
i. Knowledge-no
ii. Red flags-is the husband a red flag? does this put them on alert?
1. If it was a red flag, then VanGorkom test on reliance on an
expert (Monica)
2. If it wasn't they were free to ignore it without liability
3. Red flag just puts you on notice...doesn't have to be on pt-creates
suspicion in your mind
a. Prob shouldn't haven't relied on Monica
b. What about this relatively small market that has gone
from number 40 to number 3???
i. What about those other bigger states?
ii. In only a couple mos? And other states were
trying to implement it and failed
iii. Did they have an auditer?? Why didn't anyone
discover this??
iii. If not, apply other two prongs
e. DERIVATIVE SUITS AND THE DEMAND SYSTEM
i. When SHs try to bring a derivative suit, the board tries to dismiss
1. Either of the board or the committee (norm)
ii. Question is how do we evaluate the dismissal? BJR or some other test
1. Is the demand excused or required??
iii. If a derivative suit is initiated and corp does nothing to dismiss, don't need to worry about this
iv. Two steps (see chart)
1. First, Aronson and Zapata
a. Usually the corp settles once it gets to Zapata and moves on to next step
2. If it motion to dismiss should not honored, then what kind of breach? etc etc reach
the merits
v. ZAPATA CORP. V. MALDONADO (DE SC 1981)
1. Facts: Zapata's BOD adopted a stock option plan under which certain Zapata's officers
and directors were granted the option to purchase Zapata common stock at 12.15 a
share, ratified by SHs.
a. Zapata was planning a tender offer for 2.3 M of its own shares, expected to raise
price of shares from 18 to 25 dollars
i. Directors and officer exercised their shares, and the next day made their
announcement which raised the price of the shares to the expected 25
b. Maldonado, a SH, instituted a derivative action on behalf of Zapata against 10
officers/directors alleging breach of fid duty
42
i. Did not first demand the board to bring this action, stating demand
futility because all the directors were named Ds and allegedly
participated in the acts
ii. Board then created the Independent Investigation Committee, composed
solely of 2 new directors, to investigate Maldonado's actions, as well as a
similar derivative action then pending in TX, to determine whether the
corp should continue any or all of the litigation
1. Decided to dismiss all litigation in best interests of Co
2. H: Directors of DE corps derive their managerial decision making power, which
includes when to litigate, from 8 Del C 141 a
a. Business judgment rule is a judicial creation that presumes propriety, under
certain circs, in a board’s decision
i. It does not create authority, applies after decision is made as a defense
b. McKee stated as a general rule that a SH cannot be permitted to invade the
discretionary field committed to the judgment of directors and sue in the corp's
behalf when the managing body refused
i. Shouldn't be read so broadly that the board's refusal will be determinative
in every instance
ii. Board members will not be allowed to cause a derivative suit to be
dismissed when it would be a breach of their fid duty
iii. It will be respected, however, if determined by board to be detrimental to
the company, after demand has been made and refused, UNLESS
WRONGFUL
c. SH may also sue in equity in his derivative right to assert a cause of action in
behalf of a corp without prior demand when a demand would be futile, that the
officers are under an influence that sterilizes discretion and could not be proper
persons to conduct the litigation
i. But we see no inherent reason why the two phases of a derivative suit,
the SHs suit to compel the corp to sue and the corp's suit, should
automatically result in the placement in the hands of the litigating SH
sole control of the corporate right through the litigation
d. Independent committee possess the corporate power to seek the termination of a
derivative suit
i. Section 141 c allows a board to delegate all of its authority to a
committee
ii. Can also delegate its power to 2 disinterested directors
e. BALANCING POINT
i. Derivative suits will lose much if Ps can't ever bring them, and corps will
lose much if Ps can always bring them ---> balancing point
ii. BJR doesn't apply here, but instead an inquiry as to independence, good
faith, and reasonable investigation is sufficient to safeguard against
abuse, including subconscious abuse
1. Ethical, commercial, promotional, PR, employee relations, fiscal
and legal factors
2. Court should look at all of these things as if it were a motion for
SJ, with the burden on moving party
f. TWO STEP TEST FOR MOTION TO DISMISS
i. Inquire into the independence and good faith of the committee and
the bases supporting its conclusions
1. Limited discovery may be necessary
2. Corp has burden of proof of independence, not a
presumption
3. If satisfied, moved to next step, if not deny
43
ii. Court should determine, applying its own independent business
judgment, whether the motion should be granted
1. Intended to thwart instances where corporate actions meet
the criteria of step 1, but the result does not appear to satisfy
its spirit, or would prematurely terminate a SH grievance
2. If satisfied, then grant
g. After this case, several courts refused to give decisions by litigation
committees the finality that appeared to be required under pre-Zapata
decisions
3. CLASS TAKEAWAYS
a. **Remember all this stuff only applies to the dismissal decision not to the rest of
the case
b. Demand not required=excused=futile
c. What if the interested directors were there but abstained from voting?
i. In the context of the demand and Aronson we are not concerned with
voting
ii. It’s just are the people who you would have made the demand on
interested in this issue
d. How could those new directors be independent
i. Well they didn't have the same stock options the old directors did...even
though they were selected by them
ii. Don't have to set up a committee, but if there’s no committee how do you
do the analysis-it’s the same
e. Court is making its own decision about whether case should have been dismissed
i. If you make it to Zapata, then you went through Aronson....you already
decided that they aren't disinterested....
vi. ARONSON V. LEWIS
1. Facts: Meyers Parking Systems is a DE corp and its directors ask the court to review
their motion to dismiss for Ps failure to make a demand or demonstrate its futility.
a. Prudential Building Maintenance Corp spun off its share of Meyers to
Prudential's SH
b. This suit challenges certain transactions between Meyers and its directors
i. P claims that these transactions were approved only because a 47%
owner personally selected each director and officer of Meyers
c. Fink had an employment agreement with Prudential that allowed him to become
a consultant when he retired
i. He retired at 75, but was not in poor health
ii. Ended up getting 100k+ in compensation, plus interest free loans
d. Complaint charges that these transactions had no valid business purpose and
were a waste of corp assets because the amounts were grossly excessive and Fink
performs no or little services and can't because he’s old + no consideration for
loans
i. Asked for cancellation of employment K and damages
2. H: After Zapata, the Court left a crucial issue unanswered: when is a stockholder's
demand upon a board of directors, to redress an alleged wrong to the corp, excused as
futile prior to the filing of a derivative suit?
a. Demand can only be excused where facts are alleged with particularity which
create a reasonable doubt that the director's action was entitled to the protections
of the BJR
b. P said that making a demand would be futile because
i. All officers are named Ds
ii. Fink controls and dominates every officer
iii. Would require D-Directors to sue themselves placing the conduct of this
action in hostile hands and preventing its effective protection
44
c. DE law says that directors, not shareholders, manage the business of the corp but
a SH is not powerless
i. SH must first exhaust intracorporate remedies to provide a safeguard
against strike suits
ii. Thus by promoting this form of ADR, rather than litigation, the demand
requirement nods at fact that directors manage business
d. Question of demand futility is inextricably bound to issues of BJ and the
standards of that doctrine's applicability
i. Its protections can only be claimed by disinterested directors whose
conduct otherwise meets the test of BJ
1. Directors can neither appear on both sides of a transaction nor
expect to derive any personal financial benefit in the sense of
self dealing
ii. If such director interest is present, and the transaction is not approved by
the majority of disinterested directors, then the BJR has no application in
determining demand futility
e. Directors also have a duty to inform themselves of all material info reasonably
available to them
i. Then act with requisite care in the discharge of their duties
ii. BJR doesn't apply when directors have either abdicated their functions
or, absent a conscious decision, failed to act
3. To determine demand futility the test is whether with the facts alleged, a
reasonable doubt is created that
a. the directors are disinterested and independent
i. BJR doesn't apply
b. challenged transaction was otherwise the product of a valid exercise of BJ
(substantive analysis)
4. Mere threat of personal liability, standing alone, is insufficient to challenge either the
independence or disinterestedness of directors unless egregious
a. Independence means that a director's decision is based on the corp merits of the
subject before the board rather than extraneous considerations or influences
vii. CLASS NOTES
1. ****Note it’s not about the people who made the original decision, it about the board
making the decision NOW to dismiss the case-even if they are different
2. What’s the difference between interested and independent
a. Interest-financial interest in transaction
b. Independent-captures more, you could have no financial connection to the
transaction and still not independent
3. Who’s interested here? Fink-but that’s not enough
a. Need a majority of combo of independent and/or disinterested
4. What about the substance?
a. Usually employment decisions are OK...but what if he was a stroke victim?
b. What about the loans-seems wasteful??
c. Was there a rational expectation he would fulfill employment duties? to repay
loans?
i. Not proving anything, just raising reasonable doubt at this stage!!!
ii. NOT ABOUT THE UNDERLYING SUIT
iii. Only apply BJR
5. Don't fully analysis the transaction during the Aronson test...that comes later
a. Just has to raise reasonable doubt-no discovery, no witnesses, etc; court just goes
by pleadings
b. you can pass Aronson and Zapata, and get day in court, then eventually lose on
the merits
6. What’s a demand? Ask the corp to sue the directors
45
a. By making a demand, you concede its required
b. Courts thus construe narrowly, want to make sure the letter you sent the corp was
a real demand not just a inquiry letter, etc
f.
viii. CLASS HYPO
1. Dec 1 2008 A (Y) B (Y) C (Y) D (Y) E (N) directors
2. Dec 15 A recommends Monica
3. Dec 16 they hire Monica immediately
4. Jan 1 retreat, where they announced they want to be #1 by 1/1/11
5. 1/1/11-NC #3, made millions in bonuses, etc; ex husband thing
6. March 2011-bombshelll lawsuit for paying employees off the books
7. June-Committee is E and F, investigate lawsuit
8. Motion to dismiss in July
9. Where do we start
a. Aronson, SHs brought a lawsuit without making a demand
i. Excused or required?
b. First look at people on whom you would have made the demand, A-E (NOT F
she comes after the lawsuit)
i. Disinterested/independent?
1. A pushing it through? No
2. E-engaged to Monica, maybe
c. Second prong, transaction valid under BJR
i. What was the process they went through...didn't do much research, no
notice about this decision, didn't seem like they deliberated, just called
her no interview, pay her as much as CEO, waste-making 5x as much
right out of school
ii. But it’s an employment decision, it’s not high level, lot of
discretion...etc
d. To get passed Aronson to Zapata, have to show some likelihood that the case will
stick
i. What about oversight charge??
ii. Try loyalty first, then care, etc
e. Zapata or other side
i. Analyze E and F, should we honor the dismissal decision
DEMAND SYSTEM IN CONTEXT
i. IN RE ORACLE CORP. DERIVATIVE LITIGATION (Court of Chancery of DE, 2003)
1. Facts: P SHs brought a derivative suit alleging insider trading by four members of
Oracle's board of directors .
a. Oracle formed a special litigation committee to investigate the merits of the
claims and to determine whether the company should take any action
i. Directors Hector Garcia-Molina and Joseph Grundfest were appointed to
the SLC
ii. SLC rec'd that no action be taken
b. Ps challenged the independence of the SLC
i. SLC investigation was extensive, they reviewed an enormous amount of
paper and records, and interviewed 70 witnesses
2. H: SLC must persuade me that its members are independent, they acted in good faith,
they had reasonable bases for their recs.
a. Missing from the report were disclosure of several significant ties between
Oracle, the Ds, and Stanford including
i. Boskin being Grundests professor and colleague at a Standford Institute
ii. Lucas being an alum and a major contributor to Stanford4
iii. Ellison making huge donations to Stanford and wanting to co-create a
scholars program
b. SLC says that these facts do not impair that SLCs independence
46
i. None of the Ds would be able to deprive them of their positions at
Stanford nor would Standford be able to punish them because they have
tenure
ii. Also not their job to fundraise for the school
c. According to SLC its members are independent unless they are essentially
subservient to the Trading Defendants, i.e. they are under the domination and
control of the interested parties
i. But there are a lot of things that drive human behavior: greed, avarice,
love, friendship, and collegialitysocial norms, and certain things that
are just not done
d. Found against Ds, SLCs impartiality is in doubt because the facts suggest
that material considerations other than the best interests of Oracle could
have influenced the SLC's inquiry and judgments
3. CLASS NOTES
a. Are some directors getting a benefit that other shs are not??
i. How do we get passed Aronson??
b. SLC
i. Got paid! 250/hr from Oracle....but that’s a low amount for this sort of
job
ii. Professors at Stanford....1700 professors! At different schools!
1. Stronger if all in same field...even if at different schools
iii. Would it have made a difference if the ties had been discussed and
disclosed in the report? Should have likely disclosed it
ii. BEAM V. STEWART
1. Background: SH brought derivative action against corp's founder, officers, and
directors and against corp as a nominal defendant, seeking relief in relation to
accusation of insider trading by founder, private sales of sizeable shares of stock, and
board decisions to provide founder with split dollar life insurance
2. Facts: Beam owns shares of Martha Stewart Living Omnimedia, Inc and filed a
derivative suit alleging that Steward breached her fid duty of loyalty AND care by
illegally selling sock and mishandling the media attention that followed, thereby
jeopardizing the financial future of MSO
a. Lower court found 2/6 members of board to not be disinterested or independent
i. Stewart with 94% of vote, plus face of corp
ii. Patrick who is president and COO
iii. Another director's independence is unrebutted
iv. Martinez: Director of company, also Chairman of Sears Roebuck and
Co, + on board of Pepsi, Liz Claiborne, International Flavors and
Fragrances, and Chairman of Fed of Chicago
1. Also longstanding personal friend of Stewart and Patrick, and
helped his old corps sell Stewart goods
v. Moore: Director, partner of Rainwater, managing Director of
ChaseBank, trustee of Magellan Health
1. Longstanding friend of Stewart, went to wedding for Stewart's
lawyers daughter
vi. Seligman: Director, co-founder of Cassis, contacted publishing house at
Stewart's behest last year to express concerns over a critical biography of
Stewart
3. H: No demand on board had been made, P said it would have been futile since majority
is not independent or disinterested
a. Need to show at least 3 were interested/not independent, since 2 def are, only
need one more
4. Directors entitled to a presumption that they were faithful to their fiduciary duties,
which P must overcome
47
a. Directors are considered unable to act objectively with respect to a presuit
demand if he or she is interested in the outcome of the litigation or is otherwise
not independent
b. Interest must be shown by demonstrating a potential personal benefit or
detriment to the director as a result of the decision
c. Independent is fact specific...creates a reasonable doubt that a director is not so
beholden to an interested director that his or her discretion would be sterilized
i. Flexible determination, but based on more than conclusory info
5. Personal friendships must be of a bias producing nature to influence demand futility
inquiry
a. Structural bias argument presuppose that the professional and social relationships
that naturally develop among members of a board impede independent decision
making
b. No professional colleague can be expected to be as neutral on questions of mgt
behavior no matter if they arose before the professional relationship either
c. Must be financial ties, familial affinity, a particularly close or intimate personal
or business affinity or because of evidence that in the past the relationship caused
the director to act non independently vis a vis an interested director
i. Just because Stewart had 94% of control does not excuse demand
because of presumptions of lack of independence
d. ****Different level of inquiry then in Oracle case where a specific SLC had been
created to determine whether to dismiss the suit
6. Complaint failed to sufficiently allege that relationship between founder and other
directors was such that presuit demand would have been futile
iii. CLASS NOTES
1. Breached her fid duty because of her actions in regards to another company-interesting
set of facts
a. Stock actually does well when she’s in prison for her illegal actions
2. Also brought against other directors for failing to monitor her actions
3. No demand was made so we start at Aronson....
a. Strength of failure to monitor claim
i. Were they supposed to be monitoring her outside activities?
ii. But the company is named after her so everything she does, even private,
is important to them
iii. Duty of loyalty or care claims
4. Court in Beam and Oracle have different opinions about social ties
a. Beam is asking independence in the case of Aronson
i. Saying its going to be difficult, DE SC here
5. Oracle asked independence in Zapata context
a. DE lower court, Beam just limits this to Zapata
i. Presumption on board here to overcome
b. Court says these two cases can be reconciled
iv. CLASS HYPO
1. Cupcake company
a. Amy-y, B (ceo and chair)-y, Carol-n, David (same college, sat on board of her
college comp)-n, Eddie-y
b. Eddie 40%-y, Group A 20%-y, Group B 40%-n
c. Eddie fiance
d. SLC: F (no connect), G (head of bus ethics at Harvard), H (amy=sorority)-->say
that should dismiss
2. Analysis
a. First look at original board
48
i.
VIII.
Amy ok, Bobby being an insider, doesn't matter because person making
decision wasn't above him, Carol, no facts, David, not strong but
possibly an issue
b. Now look at board
i. On day you would've requested demand and see the board
ii. Eddie is a fiance!! No way he can be objective, likely interested
c. Likely you won't get passed Aronson
3. What if de corp and opted into 102b7
a. How would that change your Aronson analysis
i. Have to go for loyalty breach, since under care breach directors wouldn't
have financial liability
b. Zapata determination
i. Look at the slc
1. F ok
2. G harvard and stanford-enemies or both elite? but heading of bus
ethics
3. H-different school, different years???
ii. Also are in Zapata! maybe ties are too much like in oracle
iii. What’s impact of 102b7 in Zapata?
1. Always ask for something else besides money so you can get
both loyalty and care claims through, and force corp to settle and
get money anyway
MANAGEMENT AND CONTROL OF THE CORPORATION
a. HOW THE CORP WORKS
i. Board pics upper level managers, and gives them power
1. IE CEO CFO President + what they are supposed to do
2. Then these guys delegate power to others
3. No one is supposed to be able to act unless they have authority
ii. Board is also supposed to establish a quorum usually majority but board can make it bigger if you
want
1. if 2 factions each have half, them want quorum to be bigger than half so someone
representing other faction will have to be there
b. AUTHORITY OF OFFICERS
i. SEE MBCA §§ 8.40, 8.41IN STATUTE CHART
ii. LEE V. JENKINS BROTHERS
1. Facts : Crane Company agreed to see its Ct plant to NJ corp, Jenkins Brothers. Jenkins
felt it needs to employ competent personnel, and sought to employee Lee
the manager of the Crane Company. Yardley, the President and substantial shareholder
of Jenkins met with him to entice him to join. Lee testified that he promised him a
pension of 1500 a year when he reached 60 years, regardless of what happened in the
mean time.
a. Agreement was never reduced to writing
b. Lee was fired at age 55, at age 60 he wanted his pension and filed suit
2. I: Can it be said as a matter of law that Yardley as pres, chairman, substantial
stockholder, had no power in the presence of the company's most interested VP to
secure for a reasonable length of time badly needed key personnel by promising an
experienced local executive a life pension?
a. One rule widely used is that the president only has authority to bind his company
by acts arising in the usual and regular course of business but not for Ks of the
extraordinary nature
b. However an injustice would result if the managers could do something and then
later turn around and back out of a K saying it was because the board hadn't
okayed it
49
c. President of a corp, as a part of the regular course of business, has authority to
hire and discharge employees and fix their compensation
i. But Ks for life, or in a perm basis, are generally regarded as
extraordinary and beyond the authority of any corp executive if the only
consideration for the promise was the employees promise to work there
1. Said that lifetime employments unduly restrict the SHs and
future boards, they subject the corp to an inordinately substantial
amount of liability, they run for long and indefinite time
2. But pensions are different, except that they run for long
periods of time; considered a fringe benefit to employment
a. Courts go out of their way to uphold them
ii. Apparent authority is essentially a question of fact
1. Depends on the nature of K involved, officer negotiating it,
corp's usual manner of conducting business, size of corp,
number of SHs, circs of K, reasonableness of K, amounts
involved, who the 3d party is, etc
2. In some circs, a K may be so important to welfare of corp
that outsiders would naturally suppose only the board could
handle it
d. CT would probably take the view that reasonable men could differ on the subject
of whether Yardley had apparently authority to make a K
3. CLASS TAKEAWAYS
a. What if Yardley acted on his own, and a day later the rest of Jenkins board said
okay
i. That would be ratification authority relating back to the act and would be
OK
b. Why are we in apparent authority here?
i. Nothing in charter, by law, etc saying that the President has actual
authority to do something like this
ii. Usually you have tasks of managers listed there, also not in minutes or
anything
c. What’s the definition of apparent authority
i. Scope: usually just say they can do whatever is generally within their
duties blah blah
d. What’s the difference between VP and President of a Company? Same
impression of power?? Not really
4. CLASS HYPO
a. Is it reasonable to give Lebron 5x as much a year for 1 year + legal fees?
i. That’s a lot of money but you can't pay Lebron the same as anyone else
b. Have to do something extraordinary to move him-and that’s ordinary for
extraordinary talent!!
c. AUTHORITY OF SHAREHOLDERS
i. SHs and the Board
1. Sometimes shs vote on things when board is too interested
2. Realm of SHs voting
a. Conflict of interest
b. Director election , etc.
3. After Disney “withhold the vote” campaign failure, they started putting in majority
requirements for voting
ii. MCQUADE V. STONEHAM
1. Facts: Action is brought to compel specific performance of an agreement between
parties about running the Giants.
a. D Stoneham became the owner of 1,306 shares (majority); P and D McGraw both
had 70 shares of stock.
50
b. Agreed that they would all be directors, and Stoneham would be Pres, McGraw,
VP, McQuade, Treasurer at certain salaries
i. Also agreed no change in salaries, number of shares, etc etc unless
mutual and unanimous consent of all the parties
c. McQuade became treasurer and then Bondy was elected to succeed him
i. Board consisted of seven men, other four selected by and under control
of Stoneham
ii. McQuade was dropped as treasurer, director, and friend of the Ds, caused
by a falling out of friends, which did not affect the running of the
business
2. H: Although it is true that an agreement among SHs where it is attempted to divest the
directors of their power to discharge an unfaithful employee of the corp is illegal as
against public policy, it is also true that the SHs may not, by agreement among
themselves, control the directors in the exercise of the judgment vested in them by
virtue of their office to elect officers and fix salaries
i. Motives may not be questioned so long as acts are legal
ii. Directors may not by K entered into as SHs abrogate their independent
judgment
b. SH may combine to elect directors, but it is limited to election of directors and
not to Ks that limit their power
c. Here McQuade is not acting on behalf of the corp
i. Impossible to see how the corp has been injured by his substitution
d. It is clear that this happens a lot and McQuade was treated poorly
i. Yet McGraw and McQuade had a duty to SHs and corp and they were
under no legal obligation to deal righteously with McQuade if it was
against public policy to do so
e. Ks are illegal and void when it precludes the board from changing officers,
salaries, policies or retaining ppl except by consent of K parties
iii. GALLER V. GALLER
1. Facts: P, Emma Galler, sued in equity for accounting and for specific performance of
an agreement made between P and her husband, and D and his wife. The bros were
equal partners in Galler Drug Co, each owned half the stock.
a. Bros decided to enter an agreement, on advice of accountant, for the financial
protection of their immediate families and to assure their families, after the death
of either bro, equal control of the corp
b. P's husband got sick and died after signing the agreement; other family had no
intention of honoring it
c. Other family pressured P into selling her stock and would not allow her to
participate in the mgt of the business
d. Agreement alleged
i. 4 Person Board, 3 as necessary quorum
ii. In event of death of either bro, his wife shall have the right to nominate a
director in his place
iii. Annual dividends will be declared by corp at certain rate, as long as there
is enough money
iv. Salary continuation agreement to wife for 5 yrs if bro dies, etc
2. H: Power to invalidate agreements on the grounds of public policy can be abused, so
can only apply where a K is corrupt or dangerous on its face, or created to disguise the
real nature of the transaction.
a. This was a close corp, SHs agreements like this are necessary for the protection
of those financially interested.
b. Some SHs-directors agreements have technically violated the Business Corp
Act and nevertheless been upheld in the light of the existing practical circs
51
i. As the parties to the action are the complete owners of the corp,
there is no reason why the exercise of power and discretion of the
directors cannot be controlled by valid agreement between
themselves
c. Issues with this agreement
i. No specific termination date, but clear that when the wife died (about 30
years later) K would end and that is not enough for invalidation
ii. Clause that provides for the election of certain persons to specified
offices for periods of years likewise does not require invalidation
d. No inherent evil in this K, just trying to provide for families
i. Dividends policy is fair and protects the corps and its creditors
ii. Salary continuation agreement is common, and since no other SHs
besides the parties to this K, the K is not so prejudicial as to invalidate it
3. CLASS TAKEAWAYS
a. Things to think about
i. Harm to public, corp, shs etc
ii. Harm to shs because no minority rejection
1. Those shs who don't sign because they don't care then that’s ok
2. If they OBJECT to it and don't sign court will automatically
apply McQuade
b. Three things you need to look at right off the bat
i. Closely held corp
ii. No objecting minority interested (non signer)
iii. Harm to public, aka creditors
c. Issues in this case
i. Dividends are ALWAYS supposed to be at discretion of the board
1. Thus if you have a provision that relates to dividends it must be
narrowly tailored
2. Usually raised a McQuade red flag because it could hurt
creditors
3. Here there is a limit on dividends dependent on surplus so ok
d. Some states have started creating close corporation statutes
i. If you elect to be treated in that way, then these general business rules
don't apply
d. SHAREHOLDER VOTING AND AGREEMENTS
i. SEE MBCA §§ 7.28, 7.30, 7.31, 7.32 IN STATUTE CHART
ii. If you shift all the duties from the directors to SHs, then there will be an impact on
fiduciary duty
1. Normally SHS have no duty-this creates one!!-which they can breach
iii. Cumulative v. Straight Voting
1. If a corp has 2 shareholders, A with 18 shares and B with 82 shares and 5 directors,
where each SH nominates 5 candidates
2. Directors run at large, whoever gets the most votes gets spots
3. If only straight voting is permitted A may cast 18 votes for each of five candidates and
B may cast 82 votes for each of 5 candidates; thus all 5 of Bs directors will be elected
4. If cumulating voting is allowed each SH is allowed to distribute #ofdirectors x
#ofshares votes
a. A would be entitled to cast 90 or 18x5 votes
b. B would be entitled to cast 410, or 82 x 5 votes
c. If A casts all 90 votes for A1, A1 is ensured of election because B cannot divide
410 votes among 5 directors in such a way to preclude A1s election
5. Increases minority participation in board-considered both good and bad:
a. Democratic, many view points, discourages conflicts of interest
52
b. Introduction of partisan is inconsistent with board repping all interests of corp,
may cause disharmony, may criticize mgt unreasonably leading to less risky
desirable behavior, may leak confidential info, gives an insurgent group a toehold
6. Tends to be tricky, if a SH casts votes in an irrational or inefficient way, he may
not get what he wants-also easy to make mistakes
a. Most likely to occur when one SH votes straight and the other cumulates, so
one SH can steal directors from the other
b. (S/(D+1))+1 is the formula to determine the number of shares needed to elect
one director
i. S is total shares voting, D is the number of directors to be elected
c. To elect n directors: (nS/(D+1))+1
iv. RINGLING BROS.-BARNUM & BAILEY V. RINGLING (DE SC)
1. I: whether an agreement between 2/3 SHs was valid in relation to the exercise of
voting rights of those SHs
2. Facts: Shares: 315 to Ringling, 315 to Haley and 370 to North
a. Meet to elect 7 directors, voted cumulatively
b. Ringling and Haley had an agreement to create a voting trust in which the parties
desired to continue to act jointly on all matters relating to their stock ownership
or interest in
i. Couldn't sell votes without permission of other party
ii. Had to act jointly in voting
iii. If they disagreed on votes, then issue went to an arbitrator who had the
binding decision on the matter
iv. Agreement was binding for 10 yrs
c. Wanted to create an agreement so that they would always be able to get 5/7
directors their way regardless of Mr. North's votes
d. Haley and Ringling disagreed so they entered into arbitration where the lawyer
made a slate of 5 directors
i. Haley did not vote for the arbitrated slate, one director they disagreed on
was elected
e. Ringling brought suit saying the vote was invalid because it went against
agreement
3. H: Statute explains that voting trusts are valid, but not mention of arbitrator.
Here, use of arbitration was valid
a. Had no power unless disagreement
b. Not a party to the agreement
c. No shares were transferred to him
d. Could change the lawyer any time they wanted according to agreement
e. Once he made a decision at least one party had to okay it, can be overruled
f. This agreement did not empower either party to exercise the voting rights of the
other, just to act jointly
4. Neither the cases or statute sustain the rule for which the Ds contend
a. Would impugn well recognized means by which a SH may effectively confer
his voting rights upon others while retaining various rights
b. Statute doesn't apply when agreements between SHs attempt to bind each
other as to how they shall vote their shares
c. These pooling agreements have been held valid and distinguished from
voting trusts
d. This agreement does not violate the law
i. Motive doesn't matter, so long as he violates no duty owed to fellow SHs
5. Clear that this agreement was a deadlock measure, and is a valid K
a. Thus Haley breached the K when she didn't vote the slate
53
b. Found for Ringling, there is one spot that is not filled and must be resolved
by the parties; can raise the issue to the Court of Chancery if they can't
agree
6. CLASS TAKEAWAYS
a. Shares are split: John 370, James 315, Robert 315
b. What is a voting trust?
i. Giving someone the ability to vote on your behalf
1. Usually seen when giving shares to a minor
2. Usually limited to 10 years
c. If this were a voting trust, it doesn't follow the proper procedures to set it up so it
is invalid
i. Argument here is that this is a voting trust and mediator is the one getting
all the voting rights
d. Court says this is a pooling agreement NOT a voting trust so its valid
i. Some pooling agreements are voting trusts in disguise-those are invalid
because they didn't follow the proper setup procedures
e. SHs Agreements v. Pooling Agreements
i. SHs agreements are not automatically valid-have to take it through
checks
1. But once determined valid, it can be specifically enforced
(usually)
ii. Pooling agreements, after Ringling, are automatically valid
1. They are general agreements to pool shares together and vote
together
2. Presumptively valid because shs can vote however they want to
they can make agreements to vote however they want
3. BUT not automatically enforceable
a. Depends on remedies in case of disagreement
b. Not enough that the decision of the arbitrator decision is
binding
c. Have to take an extra step in order to get specific
enforcement
i. Proxy to vote
ii. Damages in case of non compliance
iii. Once valid, if signed, then you cannot violate the pooling agreement
1. So we will not recognize your votes
2. We also won’t recognize anyone’s votes who isn't a SH unless
you have a SH agreement that says we should
a. So don't could James or Loos
b. Only recognize Edith and John
7. CLASS HYPO
a. A= 40%
b. B=30%
c. C= 20%
d. D=10%
e. Decision for Merger:
i. A Yes
ii. B Yes
iii. C Yes
iv. D No
f. Directors:
i. A A 40%
ii. B A 30%, B 30%, C 30%
iii. C A 20%, B 20%, C 20%
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iv. D B 10% C 10% D10%
v. DEADLOCK how would the court solve this if B and C are knocked out
(because there was a pooling agreement and they went against it)
1. Make an agreement between B-D to vote collectively for all
decisions, and then if they were directors, they would vote for D
as CEO
2. This is different than agreeing to vote for each other as directorsthat’s a SH agreement!
a. Would have to see if it was valid first
3. But as it is it’s a pooling agreement
a. Voting collectively part is at least
b. But deciding that D is CEO that is SH agreement
i. Have to run through and see if it harms SHs
ii. A is going to oppose and it’ll be clear that it
would harm the SHs
4. But if they were supposed to follow Ds vote then B and Cs vote
for merger get knocked out
a. A still has 40% out so merger still goes through
vi. SH agreements more like to be enforced by court because they know
what to do!
1. Pooling agreement just say well act collectively-but what does
the court do to enforce it????
g. Deadlock
i. SHs and directors each have 50%
ii. Cum voting may ameliorate this to some degree
1. Sometimes ppl stay on the board for years because there was a
SH deadlock
2. Usually do annual election, but with staggered service
iii. This is why they avoid having an even number of directors
1. Ppl come off the board, someone’s ill, someone abstains
iv. Ways to get around it
1. Arbitration
2. Dissolution-sometimes can't do this if you don't have a
majority!!
a. Statutes says that you need 50%+ to dissolve
b. Unless there is a SH agreement for a lesser number to
dissolve
c. If they dissolve, Directors are in charge of tying up all
the loose ends
3. Petition the court for involuntary dissolution
a. Discretionary remedy of dissolution
i. If you can't agree
ii. If you can't vote for directors more than 2 years
b. VERY RELUCTANT when a corp is solvent and
otherwise profitable
c. Wont award it if they think you are acting improperly
4. Buy off the other person
a. Try to avoid the 50/50 split but no one wants 49
b. You should have a buyout agreement ahead of time for
the other shareholder or the corp to buy you out
i. Come up with a formula AHEAD of time when
ppl are happy so that no issues come up later
ii. Always argue about how much shares are worth
c. Court will prefer a buyout remedy
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i. Usually going to try to buy out the person who
asked for the dissolution
IX. PUBLIC OFFERINGS (SECURITIES ACT OF 1933)
a. PUBLIC OFFERINGS
i. Goal for many closely held corps is to go public to raise a substantial amount of capital by
making a PO of their securities through an underwriter AKA an IPO
ii. Has both significant costs and benefits
1. Benefits
a. Raise a lot of money
b. Pay off pre-existing debt, don't have to rely on bank debt
c. Equity enables a comp to use $$ for long term time horizon
d. Gives current SHS liquidity to sell shares and diversify portfolio
e. Better compete for employees who want stock options
f. Preferred by employees, customers, and suppliers since tend to be more well
known
2. Costs
a. A lot of disclosure has to occur
b. May have engaged in COI transactions
c. Will have to clean up balance sheet, sacrificing long term investments in
order to make short term objectives
d. Substantial legal risk
i. Strictly liable under Section 11 of Securities Act of 1933 for material
misstatements and omission in the Registration Statement
ii. Must file quarterly and annual financial reports and comply with
strict internal acctg control measures and record keepings
iii. Has to deal with analysts and outside shareholders
b. Act came about after the Great Depression because Congress was concerned about securities on market
i. Securities Act of 1933
1. 33 Act, Securities Act
2. Written and passed by a couple of people over a weekend to apply to securities
ii. Securities EXCHANGE Act of 1934
1. Created the SEC
2. Made under ICC so there needs to be an IC hook
3. Not as coherent because it went through Congress
4. Very long compared to 1933 Act
c. DISCLOSURE
i. When it doubt, disclose since the failure to disclose could be a problem
d. State Securities Law
i. Known as blue sky laws
ii. Still need to comply with these, unless preempted by federal laws
1. Often times run parallel
iii. Many states have merit based systems-totally different than federal
e. Registration Statement
i. Prospectus that goes to investors
ii. Additional information on file with SEC but that doesn't have to go to investor
f. Securities
i. Company sells shares to underwriter, who then sells them to public for a fee. Usually a bunch of
firms involved.
ii. They are the ones that have to push the shares! They each get a chunk of shares that they
are responsible for
iii. Accountant: need the financial information on how the corp is making money
g. Three stages of registration:
i. Prefiling period
1. 30 days before securities filing
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2. Can't make offers or share price information
a. Can't condition market for securities
3. Things that don't count as offers
a. Regularly released business information
b. Forward looking information but only if you are a reporting company (ie
already public or well known seasoned issuer or make a whole bunch of
money)
c. Well known seasoned issuers can pretty much issue any information
ii. Waiting period
1. File registration statement with SEC, wait for a comment letter from them
a. Registration statement includes a delay phrase so it doesn't go public in 20
days but instead gets to go post-effective after discussions with the SEC
2. Usually long for IPOs
3. No sales or acceptances
4. Road shows also occur during this time
a. Go on the road and see how much people are willing to pay for comp
5. Can make offers here but can’t accept
iii. Post effective period
1. Copy of final prospective
a. They didn't have price information or back and forth changes from SEC
during prefiling period
h. ***An offer is anything that conditions people to want to invest in your company
i. CLASS HYPO
i. What if you are a company that was preliminary on the east coast and now you are advertising on
the west coast
1. CHECK WITH THE LAWYER FIRST
2. Well it’s kind of what they were doing before, but courts looks at these three things
a. Timing, manner, form
i. Maybe the manner is different here, east v. west
ii. Announcement rules are strict
1. Can announce intentions, but can't mention price and can't editorialize
a. Known as tombstone ads
2. Don't send anything that can be forwarded!! i.e. email
iii. You can't do interviews-even if they can hold it-the interviewer got the information!!!
1. Don't want anyone to have the information ahead of anyone else
iv. If something’s wrong in the offering, the SEC says something’s wrong, then purchasers have
ability to get money back
j. Story about her at the firm
i. If the date in which the registration statement was first filed was 2 days after they were making
offers, that’s a clear violation
1. No one felt comfortable with back dating
ii. If something went wrong...everyone who signed off on it would be liable
1. Liability prob goes to selling efforts ppl, underwriter ppl
iii. Reasonable diligence rule
1. Also usually capped to allotment for underwriters
2. The most shares you pushed the greater your liability is
3. For others its where you gave your advice to, lawyers for legal stuff, accounts for
money etc
k. Other Regulations
i. Reg S off shore offerings
ii. Reg D non public offerings
l. SECURITIES AND EXCHANGE COMMISSION V. RALSTON PURINA CO. (USSC 1953)
i. Facts: Purina manufactures various feed and cereal products. Had a policy of encouraging stock
ownership among employees. Corp resolution authorized the sale of common stock to KEY
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employees who shall inquire of any of the Corp officers or employees as to how to purchase
common stock. Comp classified key employees as those at all levels that are ambitious, involved,
and likely to be promoted
ii. I: Section 4(2) of the Sec Act exempts transactions by an issue not involving any public offering
from the registration requirements of section 5.
1. We must decided whether Ralston Purina offerings of treasury stock to its key
employees are within this exemption
iii. H: Sec Act doesn't define the scope of private offering exemption, also no help from leg history
1. An offering, although not open to everyone who may choose to apply, is nonetheless
public in character for the means used to select the particular individuals to whom the
offering is made bears no sensible relation to the purposes for which the selection is
made
2. The Sec Act is designed to protect investors by promoting full disclosure of info
thought necessary to informed investment decisions
a. Since exempt transactions are those as to which there is no practical need for the
bills application, the applicability should turn on whether the particular class of
persons affect need the protection of the Act
b. An offering to those who are shown to be able to fend for themselves is a
transaction not involving any public offering
3. There is also no warrant for superimposing a quantity limit, like the SEC requests, on
private offerings-doesn't matter whether its a small or large amount of ppl that the
exemption is applied to
a. Even if corp employees fall into exemption, they are not deprived of the
safeguards of the Act
4. The question turns on the knowledge of the offeree’s, not the issuers motives
a. DO THEY NEED PROTECTION from the Act? Yes, they do not have
access to the kind of information which registration would disclosure
b. The obvious opps for pressure and imposition make it advisable that they be
entitled to compliance with section 5
iv. CLASS TAKEAWAYS
1. Two broad kinds of exemptions
a. Certain kinds are exempted from registration
i. Gov't, religious orgs, etc
2. Issue is that they issued a bunch of shares to some of their employees
a. They conceded that if they had issued them to all of their employees then that
would have been a public offering
b. The more people involved in an offering the more likely it will be a public
offering BUT numbers don't matter to the court
3. What if you emailed an offering to someone and they forwarded to another and
said do you want to tag alone
a. Doesn't matter if they said no, it would still be an offer
b. If it’s a public offering and you made an offer or sale before registration
docs were submitted you jumped the gun!
4. Section 4
a. Pretty harsh rule, any misstep, if someone is not sophisticated in the
process...then messes up the whole deal!!
b. What does sophistication mean???
i. If you are wealthy you can buy sophistication
ii. Or you have enough money that it doesn't matter
1. Do you have enough money to risk on this?? Do you
understand it??
c. If you get shares in a private placement, you are going to have to make an
investment and hold it
i. You can't resell it to a large pool
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ii. You need to understand what you are getting into and accept the
risks associated
iii. Look at the three questions of sophistication
X. SECURITIES FRAUD
a. RULE 10B-5 : foundational rule against insider trading is SEC Rule 10b-5 promulgated by the SEC
i. Most famous rule in securities and business law
b. It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of
interstate commerce or of the mails, or of any facility of any national securities exchange—
i. use or employ, in connection with the purchase or sale of any security registered on a
national securities exchange or any security not so registered, or any securities-based swap
agreement any manipulative or deceptive device or contrivance in contravention of such
rules and regulations as the Commission may prescribe as necessary or appropriate in the
public interest or for the protection of investors.
c. Rule 10 b-5: Employment of Manipulative and Deceptive Devices
i. It shall be unlawful for any person, directly or indirectly, by the use of any means or
instrumentality of interstate commerce, or of the mails or of any facility of any national
securities exchange
1. To employ any device, scheme, or artifice to defraud
2. To make any untrue statement of a material fact or to omit to state a material fact
necessary in order to make the statements made, in the light of the circumstances
under which they were made, not misleading, or
3. To engage in any act, practice, or course of business which operates or would
operate as a fraud or deceit upon any person, in connection with the purchase or
sale of any security.
d. Elements of a Claim:
i. Material
1. THC Material Standard – (event already occurred)
a. Substantial likelihood of influencing a reasonable investor
b. Must significantly alter the total mix of information.
c. Doesn’t actually need to have changed someone’s mind on buying or selling
2. Basic Balancing Test (future event that may or may not happen)
a. Probability of Occurrence
i. **Any time a board becomes involved, probability of merger or other
transaction happening is pretty high. They only get involved at the end of
the game.
b. Magnitude of Potential Impact. (e.g. size of company; premium over market)
c. Sliding Scale for requiring disclosure & when must be made.
d. ***This just allows courts to apply the THC test to speculative events.
ii. Reliance You need this to prove a claim when there’s no face-to-face transactions (so not usually
needed for insider trading claims)
1. Fraud on the Market Theory- rebuttable presumption that investors rely on the
integrity of the market in making their investment decision
2. Theory is that stock price is based on totality of public info so when actor inserts lies
into the public info stock, it affects the price of the stock. (proving individual reliance
difficult & class cert)
3. Only applies to shares where there’s an active trading market for company shares. (so
not IPO’s, private companies)
iii. Insider Trading:
1. Material
a. The later a trade is made, the higher the probability of the event actually
occurring so more likely to be insider trading.
2. Non Public
a. Lawful ways to handle non-public knowledge
i. Disclose to sale party or information source
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ii. Abstain from trading until public has digested information
iii. Fact that stock price starts moving is a good indication that the public has
digested the information.
3. Duty
a. Traditional: Insider duty to company’s stock in which trader trades and it’s
existing and potential shareholders. Chiarella
i. Encompasses all levels of employees, and some independent contractors
b. Misappropriation Theory:
i. When an outsider temporarily becomes a fiduciary to a company
and misappropriates confidential info in violation of their fiduciary
duty (to source of the info) for own personal benefit, they are liable.
(O Hagan)
1. Attorneys, accountants, consultants.
4. Breach (trading or passing)
a. Trading without disclosure [no profit from the trade is necessary]
b. Or PASSDerivative liability
i. Tipper: passing for personal benefit (usually $$, but can be other things
that improves reputation or leads to a later financial gain)
ii. Tippee: additional element-must prove that they knew or should have
known that info was passed in breach of a duty
1. I.e. usually overhearing a conversation won’t get you in trouble
UNLESS listen has some duty to the company otherwise
iii. Outsider receiving non-public information will only be derivatively
liable if (1) the insider who provided the info received some benefit
from disclosing the information; and (2) the outside recipient knows
or should know this.
iv. Doesn't matter if the tipper disclosed or not, its the passing for personal
benefit that kicks in the liability and then makes the tippiee liable
5. Reliance (usually super easy to prove)
e. MATERIALITY
i. BASIC INC. V. LEVINSON (SC)
1. Issue: Case requires us to apply the materiality requirement of 10b of the SEC Act of
1934 and Rule 10b-5 in the context of preliminary corporate merger discussions
2. Facts: Basic Inc was a publicly traded comp in chemical refractory for steel industry.
Combustion Engineering, in alumina-based refractories, expressed interested in
acquiring Basic.
a. Met with Basic officers and directors to discuss possibility of merger, during that
time Basic made 3 public statements denying that it was engaged in merger
negotiations
b. Then asked NYSE to suspend trading its shares and issues a release stating that it
had been approached by another comp about a merger
c. Basic then approved the merger and Combustion purchased all outstanding
shares
d. SHs sold their stock after Basic's first public statement but before the suspension
of trading
i. Brought class action asserting they were misled by the 3 false or
misleading public statements and were injured by the artificially
depressed prices caused by these statements
3. H: Act was designed to protect investors against manipulation of stock prices
a. There cannot be honest markets without honest publicity
b. Private cause of action exists and is essential to its enforcement
c. TSC Industries case concluded that an omitted fact is material if there is a
substantial likelihood that a reasonable SH would consider it important in
deciding how to vote in the context of proxy-solicitation
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i. Didn't want to set too low a standard of materiality that would lead to an
avalanche of trivial info on the SHs
d. Application of this standard to preliminary merger discussions is not self evident
i. Where an event like this is contingent or speculative in nature, it is
difficult to ascertain whether the reasonable investor would have
considered the omitted info significant at the time
e. Agree with 2d Circ Test: Materiality will depend at any given time upon a
balancing of both the indicated probability that the event will occur and the
anticipated magnitude of the even in light of the totality of the company
activity (TX Gulf Sulphur)
i. Since mergers can be the life or death of a comp, prelim negotiations
are material at an earlier stage-even if mergers fall through
f. Whether a merger discussion is any particular case is material DEPENDS ON
THE FACTS:
i. Step 1: To figure out the probability event will occur
1. Need to look to indicia of interest in the transaction at highest
corp levels, ie board resolutions, instructions to investment
bankers, and actual negotiations
ii. Step 2: To determine the magnitude of the transaction, need to
consider
1. Size of the 2 corp entitites and of potential premiums over
market value
2. No particular event or factor short of closing the transaction need
be either necessary or sufficient by itself to render merger
discussions material
g. Note that the possibility of a merger may have immediate importance to an
investor even if no merger occurs
i. Also, to be actionable a statement must be misleading-could just say no
comment instead of saying a misleading statement
ii. CLASS TAKEAWAYS
1. 10b5 was growing so large and covering any and all conduct prior to the 1970s/80s that
it got pulled back on scope during those decades
2. Gov't and private citizens can bring cases under the rule
a. DOJ is criminal side, SEC is civil side
b. You have to purchase/sell securities in order to bring suit under 10 b5
i. Holding a security is not enough, even if a company makes pessimistic
comments
3. Used to be left up to state law for SOL on 10b5 cases
a. Now it’s 5 years after violation, 2 years after discovery
4. 10b5 applies to you when you are registered with the SEC or not
5. Basic Case:
a. Merger discussions-WERE THESE MATERIAL?
b. Three different statements made in connection with this case
i. First denying merger conversations
ii. Then deny it again twice, saying they don't know why the stock keeps
going up
c. Are these statements true??
i. No clearly a lie
ii. Is that enough to call it a lie?
1. NO statement needs to be material
2. If reasonable people who in the industry widely know something
is false (e.g. Lakers best season ever) then lying about it isn’t
material!!
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So lies are only problematic when they’re big enough
that they would have influenced a persons decision to
buy or sell, but not big enough that the person would or
should have known them to be lies.
iii. Only actionable if there is a duty to speak
1. But the problem is once you speak you have to speak truthfully
2. They could have just not said anything
Court said they are officially taking on a definition of materiality: TSE industries
definition
i. Reasonable investors would think was important and want to know
ii. Alter total mix of information in a way you think is important
The Test:
i. It’s a balancing test, now known as the Basic standard
1. Balance probability with magnitude
ii. How to apply the test
1. TSE applies when something has already happened
a. Applies to hard facts that happened in the past
2. Basic test when something hasn't happened yet-something
contingent, something speculative
a. YOU have to apply BOTH
i. First use Basic, then ask is this something that a
reasonable investor would care about
3. How to assess probability and magnitude
a. Need to look at how close to the deal they were
i. What’s the probability here
Just say no comment!
i. Court says that’s the same as saying nothing
ii. But what does that say to investors? Makes you look secretive!!
iii. Motive doesn't matter for securities fraud issue
1. But it may matter for breach of fiduciary duty stand point!
iv. But if you are always honest and then you said no comment this one time
that’s a red flag!
1. If nothing’s happening and you say no comment that’s
suspicious!!
***Reasonable investors have to know something about the industry they are
investing in
i. Even if you say something that’s not true but everyone knows that its
false because they are reasonable and know the industry then it’s not
material
Only applies to where there is an active market for the security
i. Rebuttable presumption of fraud on the market...
a.
d.
e.
f.
g.
h.
f.
INSIDER TRADING
i. SEC V. TEXAS GULF SULPHUR CO.
1. Facts: SEC suing TGS to enjoin certain conduct of Ds in violation of Section 10b of
the Act and Rule 10b5 to compel rescission by the individual Ds of securities
transactions. TGS was doing exploratory activities in Canada and they discovered
through drilling an area that was rich in minerals.
a. During the drilling activity, but before announcement of the findings, certain Ds
and persons receiving tips purchased TGS stock and calls. T
b. GS also issued stock options to 26 officers and employees, some of which were
aware of the drilling results.
c. The board nor the stock option committee however knew about drilling activity,
which was supposed to be kept confidential.
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2.
3.
4.
5.
6.
d. Rumors were leaked, and TGS downplayed the activity at first but then later
confirmed the scope of the discovery. Stock prices went from 17 3/8 to 58 ¼
H: Rule 10b5 was promulgated to prevent inequitable and unfair practices and to insure
fairness in securities transactions generally
a. Applies to directors and officers, as well as those not strictly termed an insider
within the meaning of Sec 16b of the Act
b. Thus anyone in possession of material inside info must either disclose it to the
investing public, or if he cannot do so without breaching confidentiality, must
abstain from trading in or recommending the securities concerned while such
inside info remains undisclosed
The info in this case was material-it would have been important to a reasonable
investor and might have affected the price of the stock
a. Major factor in determining materiality is the importance attached to the drilling
results by those who knew about it
b. Clearly they thought it was important since they went out and bought stocks
c. An insider doesn't have to disclose educated guesses or predictions, just have to
disclose basic facts so that outsiders can use their own expertise to reach
investment decisions
Thus all transaction in TGS stock or calls by individuals who knew of the drilling
activity, including tippees, were made in violation of Rule 10b5
a. Darke is also in violation go 10b5-3 and Section 10b for tipping
Before insiders may act upon material info, such info must have been effectively
disclosed in a manner sufficient to insure its availability to the investing public
a. Beating the news by telling your broker to make it effective immediately after the
news is violation
b. Calling your broker immediately after the news breaks, and not waiting for the
news to appear over the media of widest circ, the Dow Jones Broad tape, is also a
violation
Certain insiders accepted options issued to them knowing that the Board nor the Option
committee was unaware of the material drilling information
a. They have since surrendered the options which have been cancelled by the corp,
but the surrender of these options after the SEC commenced the case is not a
satisfaction of the SEC claim
b. Remanded to determine whether an injunction against these Ds is advisable in
order to prevent or deter future violations
ii. CLASS TAKEAWAYS
1. Not only did they number of shares they have increased, they also went from ZERO
CALLS to 12000-they knew for sure that the shares were going to go up! Normally
they are just a probability of success-here they knew for sure!!
2. When does this information become material???
a. Sometimes timing will matter
i. First aerial sighting is years before the stocks were bought-they didn't
even know if they could get the land!
ii. By the time the trading came, the magnitude of the issue has exploded
3. Do they have a duty to disclose or should they abstain
a. If you want to buy stocks from the company, then you have to disclose your
insider information to the public
b. Not just to existing shareholders, you want to tell the whole public so that
everyone’s on equal footing
c. But what if you are under fiduciary duty not to disclose?? No way to get around
it
d. Need to disclose in a public venue where people that invest in this industry would
normally consult
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i. Needs to be effective and efficient enough that it is available to the
investing public
ii. You can disclose the technical information-but you need to make sure
that the public understands it
e. Otherwise you have to abstain from trading
4. You judge the trading by the time the order gets placed NOT AT THE TIME OF
EXECUTION
a. If you call an hour later you’re better off
iii. CHIARELLA V. UNITED STATES
1. I: Whether a person who learns from confidential documents of one corp that is its
planning an attempt to secure control of a second corp violates 10b of Sec Exchange
Act of 1934 if he fails to disclose the impending takeover before trading in the target
company's securities
2. Facts: D is a printer by trade, and he handled five announcements of corp takeover bids
in his work. The names of the corps were blacked out but he deduced them, bought
stock in target companies, and sold immediately after takeover went public making
$30k. SEC indicted him, he was found guilty on all counts after trial.
3. H: To decide if silence in such circs violates 10b, it is necessary to review the language
and legislative history of that statue as well as its interpretation by the Commission and
the federal courts.
a. Statutory language doesn't saying anything about silence, but it was designed to
be a catch all clause to prevent fraudulent practices
b. Obligation to disclose or abstain derives from an affirmative duty to disclose
material information which has been traditionally imposed on corp insiders,
particular officers, directors or controlling SHs
i. Duty arises from existence of a relationship affording access to inside
info intended to be available only for a corp purpose and unfairness of
allowing a corp insider to take advantage of that info by trading without
disclosure
c. One who fails to disclose material info prior to the consummation of a
transaction commits fraud only when his is under a duty to do so
i. And the duty to disclose arises when one party has info that the other
party is entitled to know because of a fiduciary or other similar relation
of trust and confidence between them
d. Accordingly, a purchaser of stock who has no duty to a prospective seller
because he is neither an insider nor a fiduciary has been held to have no
obligation to reveal material facts
i. In this case, the D is not a corp insider nor did he receive confidential
info from the target company
1. Market info upon which he relied did not concern the earning
power or ops of the target, but only the plans of the acquiring
comp
2. Use of that info is not fraud unless he is subject to an affirmative
duty to disclose before trading
a. Here there is no duty since the petitioner was a stranger,
not an agent a fiduciary or someone in whom the corp
has placed its trust
e. Dissent: He stole information from his job and conceded that he was wrong!
4. CLASS TAKEAWAYS
a. How do we determine whether the information he is privy to is material
i. TSC/Basic Test: if the information is definite and not speculative then
you apply the TSC test
1. You are still in Basic here because it is things that are "going" to
happen, its an announcement of a takeover which has to go
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ii.
iii.
iv.
v.
through a range of steps, so this hasn't yet happened which
makes it speculative or contingent so you need Basic Test
So what’s the probability and magnitude:
1. A takeover is akin to a merger it’s a fundamental transaction, for
the company being takeover that’s a major life change in terms
of the corporation which is an even of tremendous magnitude
2. You can tell by how much the stock leaps as a result of this
transaction so even when the probably is relatively low because
the magnitude of this even is so high, the TSC inquiry you get to
this being material at an earlier stag
Here the names were blacked out, can Chiarella say he then did his own
independent research and figured out the probable entities that are going
to be taken over and then when from there
1. He still had this non-public information that others didn't have
access to, he had a place to start
2. The distinction here is what does he know that the public doesn’t
know: he knows there is a definite take over coming and has
information to point him in the right direct to determine the
companies involved
Duty: The gov’t seems to want a rule that just having the
information and trading on it is enough to trigger 10(4) (this clearly
isn't consistent with the Gulf Case, this captures too many people)
1. The court says take a2nd look at Texas Gulf, people don't owe a
duty to the market as a whole, there’s a duty aspect of insider
trading and you’re missing that here
2. Traditionally we impose that duty on corporate insiders
(directors, officers, controlling shareholders)
3. To whom do you OWE the duty?
a. You owe it to the company if you have a relationship to
the company in whose stock you trade
4. Does the duty extend to all employees? YES
a. When they give you information that they EXPECT you
to hold in confidence and corporations generally expect
the employee to hold in confidence any information
because it isn't YOURS it’s the corporations, no matter if
you are a secretary or a low level employee
Breach
1. The breach is the trade w/o disclosure
a. To whom must you disclose?
i. To the people you owe the duty so the rule is
obtain or disclose to once you get there how do
you avoid the breach
ii. You trade with disclosure but the problem is
there is no way to do that because the disclosure
has to be effective to the market and that makes
it public which isn't insider trading so one
defeats the other
2. So does that mean you could hold a meeting of the shareholders
and disclose to them?
a. The corporation defines the company and its
shareholders as its existing AND POTENTIAL
shareholders so you can't just disclose to CURRENT
shareholders, you have to disclose to the public the
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"investing public" because they are potential
shareholders
3. HERE the court says the people were complete strangers to
Chiarella, he has NO relationship to them
vi. The issue the dissent is having is that there is this gap because he
purchases the stock of the target company rather than the company
paying the printer he slips out of liability but that theory doesn’t get
talked about because that theory wasn't brought before the jury
vii. Wall St Journal Case- columnist from Wall St Journal interviewed a
company for an article that ended up recommending that the public get
rid of their stock. But before article was released, columnist told some
brokerage firm who traded on the recommendation before it was
published and made $700,000 profit. The columnist’s info was
technically public bc anyone with the initiative could have pieced
together the same opinion, but the fact that it was going to become the
official position of the Wall St Journal was not publicly
known Columnist couldn’t be held liable bc had no relationship
under Chiarella to the company whose stock was traded.
5. CLASS HYPO
a. You are a cleaning lady working for the company and then you find
something in the trash and you go and trade on that information
i. Even if it’s an independent contractor do you imagine a situation where
there’s an indirect chain
ii. Unfortunately for the cleaning lady she's out of luck, she's gonna get
caught and this is insider trading
iii. This extends to EVERYBODY its is wide sweeping, that’s what the SEC
wants
b. What happens if you have the president of a company who tells her
boyfriend and he trades, does he have a Chiarella duty that gets breached?
i. That kind of indirect relationship isn't enough theres
no employment so for Chiarella purposes the boyfriend is a stranger
so you would need another theory to get the boyfriend
1. The misappriation theory or get the president through some
passive theory so you either meet Driks or O'Hagan,
Chiarella doesnt get you there w/ a boyfriend, the same if this
was a thief who broke into the company and got the info
iv. UNITED STATES V. O’HAGAN
1. Questions Presented
a. Is a person who trades in securities for personal profit, using confidential
information misappropriated in breach of a fiduciary duty t the source of
the information, guilty of violating 10b and Rule 10b5
2. Facts: O Hagan was a partner at a law firm that represented Grand Met regarding a
potential tender offer for the common stock of Pillsbury. While his firm was repping
Grand Met, OH began purchasing call options for Pillsbury stock and other shares and
ended up making a profit of more than 4.3 million. SEC investigated OH and indicted
him on 57 counts, later reversed, and appealed to this court.
3. H: This court finds that criminal liability under 10b may be predicated on the
misappropriation theory
a. Section 10b proscribes using any deceptive device in connection with the
purchase or sale or securities, in contravention of rules prescribed by the
Commission
b. As written, it does not confine its coverage to deception of a purchaser or seller
of securities, rather the statute reaches any deceptive device used in connection
with the purchase or sale of any security
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4. Liability under Rule 10b5 does not extend beyond conduct encompassed by 10bs
prohibition
a. Under the traditional or classical theory of insider trading liability, the 10bs are
violated when a corporate insider trades in the securities of his corporation on the
basis of material, non public information
i. Qualifies as a deceptive device because a relationship of trust and
confidence exists between SHs or a corp and those insiders who have
obtained confidential info by reason of their position
ii. Gives rise to a duty to disclose
iii. Applies to officers, directors, and other perm insiders + attorneys,
accountants, consultants, and others who are temp fiduciaries
5. Misappropriation Theory holds that a person commits fraud in connection with a
securities transaction and thereby violates the 10bs when he misappropriates
confidential info for securities trading purposes, in breach of a duty owed to the
source of the info
a. Defrauds the principal of the exclusive use of that info
b. Premises liability on a fiduciary-turned-trader's deception of those who entrusted
him with access to confidential info
6. The two theories are complimentary
a. Misapprop theory is based on the idea that the breach of a duty owed not to a
trading party, but to the source of the info
b. Protects the integrity of the securities market against abuses by outsiders to a
corp with access to confidential info that will affect the corps security price when
revealed, but who owe no fiduciary or other duty to corps SHs
7. Deception through nondisclosure is central to the theory of liability for which the
Gov't seeks recognition
a. 10b is not an all purpose breach of fiduciary duty ban, rather it trains on
conduct involving manipulation or deception
8. Similarly, full disclosure forecloses liability under the misappropriation theory
a. If the fiduciary disclose to the source that he plans to trade on the nonpublic
info, there is no deceptive device and no 10b violation (although may be
liable under state law breach of duty of loyalty
9. We turn turn next to the 10b requirement that the misappropriator's deceptive use of
information be in connection with the purchase or sale of a security
a. Element is satisfied because the fiduciary's fraud is consummated, not when the
fiduciary gains the confidential information, but when, without disclosure to his
principal, he uses the information to purchase or sell securities
b. He deceives the source of the info and simultaneously harms members of the
investing public
c. If the misappropriation is viewed as sufficiently detached from a subsequent
securities transaction, then 10bs in connection with requirement would not be
met
10. CLASS TAKEAWAYS
a. The problem with the news reports is that this makes it possible that the
information was already public, the court says in a footnote we aren't going to
answer that question however that makes all the difference!
i. If the info was public then you haven't committed insider trading, if there
is info in the public that there is a potential but you know for sure that
there will be one, that is enough for this to be non-public information that
you have access to and are utilizing
b. Of course to the extent its info in the public sphere it has an impact on materiality
i. Because reasonable investors already know about the deal or the
potentiality of the deal then its not material because its already known, so
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its not something a reasonable investor would think of as important in
making their decision
c. But here the certainty changed it, a reasonable investor may care about the
certainty of this deal over the probability
i. Magnitude: it is the case that when a company is being taken over the
magnitude of that transaction is huge (insiders buy in the target because
thats the stock thats going to jump) but the bidder doesn’t have the same
magnitude which means that the probability has to be greater before a
reasonable investor would care
d. The misappropriation theory: if a person misappropriates confidential
information for securities trading purposes
e. O'Hagan: you have to owe a duty before you can be liable for insider trading,
O'Hagan doesnt have classic traditionally Chiarella duty.
i. BUT O'Hagan owes a duty to back to his firm and back to his firms'
client, so even though he doesn’t trade in their stock, if you owe a duty to
the source of the information, you violate that duty when you trade on
that information regardless
ii. The duty is the same whether or not he is trading on someone else's
stock, you can MISAPPROPRIATE information by deceiving people
that you owe a duty to, the source of the information
1. If he got the firm together and says look I'm about to trade peace,
thats ok! because he owes the duty to the firm not potential
shareholders like in Chiarella…
2. But here the duty is two-fold, to the firm and the client company
and because it’s a public company you owe the duty to its
shareholders by extension (including prospective shareholders)
v. DIRKS V. SEC
1. Facts: Dirks worked for a broker-dealer firm who specialized in providing investment
analysis of insurance company securities to institutional investors. Dirks received info
from a form officer of Equity Funding of America, saying that they were committing
fraud and their assets were vastly overstated.
a. Dirks investigated the allegations, and certain employees corroborated the info
b. Dirks openly disclosed his investigations with a number of clients and investors,
some of whom sold their holdings of Equity Funding securities liquidating more
than 16m
c. Dirks attempted to get the WSJ to publish an article, but they denied it until the
SEC filed a complaint against Equity Funding
d. SEC later investigated Dirk's role, and found that he had aided and abetted 10b
violations by repeating the allegations of fraud to members of the investment
community who later sold their Equity Funding stocks
2. H: According to Chiarella, we said that there can be no duty to disclose where the
person who has traded on inside information was not the corporation's agent, was not a
fiduciary, or was not a person in whom the sellers of the securities had placed their
trust and confidence
a. SEC believes that a tippee inherits the Cady, Roberts obligation to a SH
whenever he received inside information from an insider
i. Presumably Dirk's informants were entitled to disclose the Equity
Funding fraud in order to bring it to light
3. The SECs theory of tippee liability appears rooted in the idea that the antifraud
provisions require equal information among all traders
a. This conflicts with Chiarella, and we reaffirm today that a duty to disclose
arise from the relationship between parties and not merely from one's
ability to acquire info because of his position in the market
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4.
5.
6.
7.
b. There is no difference between this case and Chiarella simply because Dirks
got info from direct contact with an insider, where as Chiarella receive info
without direct involvement with an insider
It is common place to ferret and analyze information and this often is done by meeting
with and questioning corporate officers and others who are insiders
That doesn't mean that such tippees are always free to trade on the information
a. Thus some tippees must assume an insiders duty to the SHs not because they
receive inside info, but rather because it has been made available to them
improperly
Thus a tippee assumes a fiduciary duty to the SHs of a corp not to trade on
material nonpublic info only when the insider has breached his fiduciary duty to
the SHs by disclosing the info to the tippee and the tippee knows or should know
that there has been a breach
a. First need to figure out if the tippee was under an obligation to disclose or
abstain, by determining whether the insiders tip constituted a breach of the
insiders fiduciary duty
i. All disclosures of confidential corp information are not inconsistent with
the duty insiders owe to SHs
ii. They may not know that the info is material and non public
iii. Also, absent some personal gain there has been no breach of duty to SHs->thus no derivative breach
b. Scienter is relevant in some cases, but to determine whether the disclosure itself
deceives, manipulates, or defrauds the shs the initial inquiry is to whether there
has been a breach of duty by the insider
i. Courts have to focus on objective criteria like whether the insider
receives a direct or indirect personal benefit from the disclosure such as a
pecuniary gain or a reputational benefit that will translate into future
earnings
Here, there was no actionable violation by Dirks-he was a stranger to Equity Funding,
with no fid duty to SHs, no one who disclosed info gained anything-they were trying to
disclose the fraud thus there could be derivative breach
g. CLASS TAKEAWAYS
i. He is talking to a whole bunch of people while he is doing this… does this make the information
public (people aren't believing him so no one is reporting it or going public with it) but still isn't
HE making this public by telling the gov. and journalists and anyone who would listen?
ii. If Dirks had TRADED on the information (which he DIDNT)
iii. Secrist is EXPECTING him to convey the information so there’s no expectation in the
relationship there so he has no duty so there is no breach because the source of his information
does not expect him to keep the information private (and he has no relationship to Equity
Funding)
1. In order for a tipper to breach their duty there has to be pass for personal benefit
a. That benefit could be to blow the whistle and get fame from that? That’s really
attenuated though the court will probably ignore that
b. We'll come back to this next week but yes, in passing to clients that develops
relationship and his professional reputation
c. Even if you could show that he had a relationship with Secrist and then passed
for personal benefit to clients that enough to hold the clients liable
d. Once you his the pass for benefit the TIPPER is now liable can you get the tippee
as well that’s the derivatives pieces they have to know or should know that they
traded with knowledge of constructive knowledge of the breach
iv. Why can’t we get Secrist? He owes a traditional duty to company, but he didn’t pass the
information for personal benefit NOR did he trade on it so no liability
v. What about Dirks?
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1. If he had a relationship of trust and confidence with Secrist, then you can show a
breach
2. If he gave the information to his clients for a commission, then he clearly got a
personal benefit
a. What if he didn't get a financial benefit...could you still argue it? More attenuated
but it would likely enhance his reputation because his clients would stay with
him
b. BUT any financial benefit counts, even final four tickets
3. Can you get the clients?
a. Tippees are not automatically liable if you prove the breach of Seacrist, he may
be liable in damages to the clients for whatever they sustain
b. You can skip people! For example skip over Dirks and just get to the clients if
they knew or should’ve know that the information was passed to them in
violation of their duties
i. Do they need to know the identity of Seacrest and his duties to the
company?
ii. What if it was just described as hot tip?
1. Reasonable investor would likely know that certain information
would only be available from certain people
h. CLASS HYPO
i. HYPO 1
1. Guy (Switzer) overhears a guy (Platt) telling his wife that his company was in trouble
and it was getting to be liquidated at their children's track meet, mentioned the
company is going to be bought by another company
2. Guy then buys stock in the other company who will buy the failing company, and he
tells a bunch of people about it
a. Some people he said he heard from someone who should know, to others he said
from a reliable source
3. S and P are friends, S was a season ticket holder and sponsored some show with P
4. Suit is brought against S and those who traded under his advice
5. P has a duty to the company to keep their information secure which creates a fiduciary
duty
a. But the overhearing this is not a pass!
b. And there is no personal benefit since he was talking to his wife
6. If he had intentionally passed, is it really true that there’s no personal benefit
a. O they have a reputational relationship
7. But hes talking about this sort of information in a casual setting....is he breaching his
duty? Court leaves this a big question mark
a. Should S known or should have known
8. Let’s say all these things are satisfied, what about the tippees
a. When you hear things like that do you assume it’s coming from an inside source
that breached its duty????
ii. Hypo 2
1. Driver, employed by CEO (NOT THE COMPANY), overhears the CEO say some info
a. Driver says hes gonna act on that info, CEO says I don't pay you enough go for it
b. Not a Chiarella duty because doesn't work for the company, but does he owe an
OHagan duty to the CEO
2. What’s the fiduciary duty there
a. As a general matter any kind of employees like drivers or cleaning ladies, there’s
a fid duty
i. But whats difference here? What destroys the relationship of trust and
confidence?
ii. The driver told the CEO he was gonna act on the information! And the
CEO acknowledges it
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iii. There is no expectation that they aren't going to use that information to
trade on it, thus no relationship of trust and confidence is created
3. Did he pass for a personal benefit
a. He could pay him less
b. He overheard it though! Switzer case said that it had to be an intentional pass!
c. He said it was okay
d. ***A gift is a personal benefit
4. The driver has two duties: trading and passing
a. In this case his duty to trade on it has been extinguished, so he is not liable
b. But his duty not to PASS still remains, so if he tips others he can still be held
liable
i. And those tippees can still be held liable derivatively
5. The reason why disclosure back to your source absolves you of liability is because it’s
all based on deception
a. You can't pretend to be loyal and then go use that information to make money
b. Doesn't mean you aren't going to be liable to someone for another breach
iii. UNITED STATES V. CHESTMAN
1. Facts: Ira Waldbaum was the controlling SH of Waldbaum Inc, the supermarket chain.
Agreed to sell the chain to A and P corp and told his sister, and three of his children
and a nephew about the pending sale, telling them to keep the news quiet until after the
sale, and offered to tender their shares since it would be easier before the sale
a. His sister, told her daughter who told her husband, Keith Loeb
b. Loeb called Chestman, a broker, and told him that Waldbaum was going to be
sold
c. Chestman executed several purchases of Waldbaum for himself, Chestman and
other clients
d. Keith agree to disgorge $25k profits and pay a $25k fine; Chestman was indicted
on 31 counts of violations of SEC Rules
2. H: Chestman's convictions were based on the misappropriation theory, which provides
that one who misappropriates nonpublic info in breach of a fiduciary duty and trades
on that info to his own advantage violates Section 10b and Rule 10b5
a. Chestman was convicted of aiding and abetting Loeb's violation and as a tippee
to his other clients; the alleged misappropriator was Keith Loeb
b. The gov't cannot win unless Loeb breached a duty owned to the Waldbaum
family or his wife based on a fiduciary duty or similar relationship of trust and
confidence AND Chestman knew that Loeb had done so
i. A fiduciary duty cannot be imposed unilaterally by entrusting a person
with confidential information
1. Even if you trust someone not to disclose information, that
person owes no duty not to observe that confidence (Walton v.
Morgan Stanley)
ii. Marriage does not, without more, create a fiduciary relationship
1. The existence of a confidential relationship must be determined
independently of a preexisting family relationship
iii. The relationships in this case were not traditional fiduciary relationships,
but have to see if there was a similar relationship of trust and confidence
1. Reed holding says that the repeated disclosure of business
secrets between family members may substitute for a factual
finding of dependence and influence and thereby sustain a
finding of the functional equivalent of a fiduciary relationship
(where the family members frequently discussed business
affairs)
iv. Here the evidence is insufficient to establish a fiduciary relationship or
its functional equivalent between Loeb and the Waldbaum family
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1. Keith was an extended member of the family and Ira usually
only discussed business with his children
2. Kinship alone doesn't create this kind of relationship, he was not
in the inner circle or an employee
3. The information was gratuitously communicated to him, did not
serve the interests of Ira or anyone, nor was the relationship
characterized by influence or reliance of any sort
4. Being Susan's husband didn't establish fiduciary, nor did the
coda "don’t tell"
a. Her disclosure served no purpose, business or otherwise
and was unprompted
v. Gov't failed to show that Keith owed a fiduciary duty to Susan or the
Waldbaum family, so he did not defraud them nor could Chestman
be derivatively liable
iv. IN 2000, THE SEC PROMULGATED TWO NEW RULES:
1. Rule 10 b 5 1
a. Intended to clarify the definition of insider trading
b. Addressed conflicts among courts over whether a person can be found guilty of
insider trading merely by a showing that the person traded while in knowing
possession of such information or whether a showing that a person actually used
insider information was necessary
i. Standard is closer to knowing possession, with a safe harbor for preplanned trades where they didn't possess the information at the time the
trade was planned
2. Rule 10 b 5 2
a. Designed to provide a more bright-line test for certain enumerated close
family relationships
b. Sets forth a non exclusive list of three situation in which a person has a duty
of trust or confidence for the purpose of the misapprop theory
i. Where a person agrees to maintain info in confidence
ii. When people have a history, pattern, or practice of sharing
confidence such that the recipient of the info knows or reasonably
should know that the person communicating the material nonpublic
info expected that the recipient will maintain its confidentiality
iii. Bright line rule that states that a duty of trust or confidence exists
when a person receives or obtains material non public information
from spouses, parents, children or siblings
1. Doesn't apply to unmarried domestic partners, step parents,
or step children
3. Overrules Chestman in at least 2 ways
a. Announces the three types of relationships that count (see above)
i. The first one confirms Chestman (remember can’t be unilateral)
ii. Overrule Chestman that said you had to discuss business
confidentially, now its broader if you have a confidential relationship
discussing anything
iii. And then the family one, including marital relationship
v. CLASS TAKEAWAYS
1. This is an important event, magnitude is large and Ira has sat everyone down and it
looks highly probable so MATERIAL
2. And Iras only telling his close family so NON PUBLIC
3. Duty
a. Does a SH to a company owe a duty to a company for the purposes of insider
trading? Not a usual one, but a controlling SH like Ira does-he has a lot of power
in the company
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b. Does Ira owe a duty to A and P? No, usually there is an agreement to the contrary
in these types of arms length transactions
c. Does Ira breach his duty when he tells his family?
i. He has to pass for a personal benefit, here he’s just telling them for
admin reasons
d. Does the sister owe a duty to Ira?
i. Iras in the inner circle, so there’s a relationship there, but the mom just
told her because she was worried not for personal benefit
e. As you go down the chain here no one is breaching their duty
i. Ira--Sister--Daughter--Susan--Keith--Chestman
ii. Why start at the beginning? If you can get Ira you can get Chestman
forget everyone else
f. Susan didn't pass for a PB, but Keith did when he told the broker
i. What about the confidentiality between married people? Isn't this usually
one of the greatest confidence relationships in the law
1. Court wanted to see that they regularly discussed business stuff
not just personal stuff
ii. But she told him not to tell anyone, why does the court say thats not good
enough
1. It was unilateral, she said dont tell and he said nothing
2. If he has said okay might have been enough
a. That’s why other judges dissent-this makes no sense to
have such formal conversations
4. What’s the 14 e 3 conviction???
a. There are two insider trading rules: Under 14 e 3 you need to show
information is MATERIAL, NON PUBLIC, RELATES TO A TENDER
OFFER, AND KNOW OR HAVE REASON TO KNOW IT COMES
DIRECTLY OR INDIRECTLY FROM SOMEONE INSIDE THE
COMPANIES
i. No duty requirement
ii. The only way non public information is getting out is if someone
from either company told yo
iii. You can also get it from passing
iv. If you pass material non public related to a tender offer or if you
trade on it and etc etc then you can be liable
v. Courts are flexible on the know or have reason to know
b. Whats a tender offer? It’s a broad offer to SHs to purchase their stocks
c. SEC can bring parallel actions if you are talking about a tender offer
i. Otherwise 14 e 3 doesn't apply!
d. Other provisions of what the target company needs to do
i. needs to send a letter to the shs explaining things
ii. recommend for or against, say they are neutral, or that they are unable to
take a decision
iii. Don't trade on any information from here!!!
vi. SEC V. CUBAN
1. I: Whether SEC had adequately alleged that D undertook a duty of non use of
information required to establish liability under the misapprop theory
2. Facts: Cuban owned 600k stocks in Mamma.com that traded on the NASDAQ.
Mamma decided to raise capital through a PIPE (private investment in public equity)
offering.
a. Decided to tell Cuban, the largest SH at 6.3%, of the offering and invite him to
participate
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b. At the beginning of the call, the CEO told Cuban that he had confidential
information to Convey to him and Cuban agreed to keep it confidential which
CEO relied on
i. Cuban reacted angrily and said he was screwed because he couldn't sell
now, CEO told executive chairman Cuban expected not to sell his shares
ii. Cuban decided to sell all 600k of his shares without telling Mamma.com
and the next day the PIPE offering was public announced
iii. Cuban avoided losses of 750k
3. H: Nature of the duty required by the misapprop theory is at the heart of this case
a. Rule 10 b 5 2 b1 provides that a duty of trust or confidence exists whenever a
person agrees to maintain information in confidence
b. SEC alleges under this rule, Cuban is liable because he agreed to maintain
confidentiality and then breached that duty
c. Court rejects Cuban's theory that they must rely on state law to create a duty
sufficient to support the misapprop theory
d. Central to both the classical and misapprop theories is the idea of deception
i. Further, there is no reason under OHagan that the duty not to use
another's information for personal benefit cannot arise by agreement,
absent a preexisting fiduciary or fiduciary like relationship
ii. Could be seen as conferring stronger footing for imposing liability since
it was your own agreement, rather just a legal trigger because of a
relationship
4. RULE: The agreement, however, must consist of more than an express or implied
promise merely to keep information confidential.
a. Must also impose on the party who receives the information the legal duty to
refrain from trading on or otherwise using the info for personal gain
b. Absent an agreement to refrain from trading on the information, there is no
deception in doing so
c. The expectation is not unilateral, arising merely from the source's subjective
belief that the recipient will not trade on the information - recipient needs to
agree
5. In this case, SEC failed to allege that Cuban agreed to not trade on the
information, even if the CEO expected him too
a. Further, the SEC cannot rely on 10 b 5 2 b1 to impose the required duty because
it lacks the necessary component of an obligation not to trade on or otherwise use
confidential information for personal benefit
vii. CLASS TAKEAWAYS
1. Does it matter than he owns 6.5% of the shares, making him the largest SH?
a. No too small, courts have said if you do own a controlling stake in the
corporation, then you could owe a Chiarella like duty to the corporation
b. CONTROLLING NOT MAJORITY, very few public corps have majority SHs
i. Controlling because you have so many shares that you can elect the vote,
because everyone else is so dispersed and likely won't vote
2. When we are analyzing if the information of the PIPE deal is material, which test do
you use?
a. Basic because its contingent, and then you go into the TSE
b. How likely is it to happen and what’s the magnitude? Could be good or bad
magnitude
3. Does 14 e 3 apply? No, this is not a takeover
a. Remember this is not a broad solicitation, its a private offer so a court would not
likely find this to be a takeover
4. The problem here with looking at state law is that state law defines fiduciary
relationships differently than 10 b 5
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i.
5. But when he said he was screwed, then they sent him more information about this
deal
a. So the 5th circuit things that there was an implicit agreement
b. Also, Cuban is a sophisticated business man and appreciated that he wasn't
supposed to trade
6. If you are in the 5th circuit or in a circuit that follows it
a. If you want a relationship of trust and confidence:
i. Need an agreement of non disclosure and non use
7. Not in the 5th circ, then you have the SEC rule and all you need is an agreement
to not to disclose
a. Agreements can be explicit or implicit
8. Also, usually saying they won't trade usually means that they implicitly won’t tell
anyone
INSIDER TRADING CLASS HYPO
i. Jan 2006 first meeting with Mark (SN CEO), Eddy (unpaid SN intern), Victor (VP Invest Co),
Cameron (unpaid intern at VP invest)
1. Discussing investing money in SN from VP Invest
2. SN only at 3 campuses, a lot of people use it but the Invest Co board is skeptical
ii. Next day, Eddy trade
iii. Feb 2006, Cameron-->Ralph (trade)
1. Asked Ralph not to tell anyone and he responds "of course"
2. Both Cameron and Ralph trade in Investment Co
iv. April 2007 Expansion
v. May 1 2007
1. Mark interview with university paper
2. Said that he’s interested in working with three companies, including Investment Co
a. Stock prices of all three companies rising, including Investment Cos stock rising
to $25
vi. May 2, 2007
1. Investment Co way more on board now, some say they are done with it and they had
made other commitments else where
2. Schedule a bunch of meetings for weekend
vii. Weekend
1. Victor-->Francesca (Victor's fiancé)-->Grace-->Diane-->Bruce and Yvonne
2. Hosting a bridal shower that weekend
a. Victor says he’s not going to be around this weekend and she flips, and says
she’s annoyed that he can't tell her anything about his work
3. Victor then says don't tell anyone but I'll tell you what's going on
a. She says if you don't know by now that you can trust me then maybe I'll call the
whole thing off
4. Family's in town wondering where Victor is, she tells Grace her grandmother
a. Before she tells her grandmother she says I am going to tell you but you can't use
this for anything, Grandma says right, right
5. Diane comes up to Grace and says where is he
a. Grace says I am going to tell you
b. Diane is the family gossip she says of course, but if it’s really hot maybe i can
make a bunch of money off of it
6. Diane tells Bruce who works at the mail room of Investment co
a. Bruce says you finally gave me something i can use
7. Diane tells Yvonne, I am going to give you a hot tip
a. Invest co is a hot property, make an investment it’s a sure deal
viii. Monday, all these people trade
ix. End of the month, they announce their investment stock price jumps to $75
x. SEC brings suit against all these people
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1. Under 14e3 and 10b5
a. To start: 14e3 should be dismissed because this isn't a takeover
xi. Okay now under 10b5 lets look at all the people
1. Eddy
a. He trades without disclosure
b. Nonpublic information, is it material?
i. What standard do we use? Basic because its contingent
1. We don't know if its going to happen, it doesn't look very
probable at this point, but it would have a big magnitude IF SN
took off...
a. Its a year and a half before anything is announced!
2. None of the board members of Investment Co were on board
a. The whole board met to discuss it, but in the meeting it
doesn't sound probable
b. And what does a VP mean? Is he the right guy?
3. People closest to the transaction determine if its material
a. Court may be swayed that it later became really
important
b. But a reasonable investor in invest co would not
consider one meeting for an investment out of all the
things the invest in to be material
ii. Is there a duty?
1. Even though hes an unpaid intern, he is an employee that owes a
fiduciary duty to SN
2. Its an OHagan duty because he invested in an outside company,
not a Chiarella duty because he wasn't an inside
3. What if Mark says to Eddy I don't care what you do with the
information in there
a. Can Mark waive the duty Eddy has to SN?
4. Could she have stepped backwards to find Mark liable?
a. Tipper if he gifted the information to Eddy
b. Then we can get Eddy as a tippee
2. Cameron
a. Same nonpublic and materiality as above
i. Maybe even less material, less probability because there’s been a time
lapse without anything happen
b. Duty
i. Owes duty to Invest co, Chiarella duty
ii. Can't get him as a tipper because he told him in a conversation not for
personal benefit
1. So then you can't get Ralph as a tippee, even if you could argue
that he knew or should have known where the information came
from
3. Ralph
a. Saying of course is a mutual agreement not to tell anyone
b. Under Cuban, promise not to tell isn't going to be enough
i. Ralph also isn't Cuban, not a business agreement etc
c. But outside 5th circuit, then that agreement is enough to establish a relationship
of trust and confidence
d. If they had shared this kind of information and confidence in the past (NOT
JUST BUSINESS BUT ANYTHING CONFIDENCE)
i. Is roommate for four years enough? Some share space some are friends
ii. But he had to ask him not to tell anyone! So maybe they don't have that
kind of relationship
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4. Now on to the other chain of people
a. Non public
i. Followed by the press, mentioned in the newspaper-but its a university
paper
1. And the stock price rose! But then it rose so much more when
the final news came out
2. Also mentioned three companies
b. Material
i. Looks a lot more probable now
ii. Shorter timeline to the announcement at the end of the month
iii. Magnitude, company expanding people have been hearing about it, much
bigger deal now
1. Some people thought it would be amazing, some thought it
would take t hem down-either way lend towards magnitude
c. Victor
i. If Victor traded hes done, he traded without disclosure to the public and
he clearly has a duty to his company
ii. If we try to get him as a tipper because he didn't trade...does that work
1. But he told his fiance not for a personal benefit
2. But if he doesn't tell her and then he doesn't get married, then he
doesn't get income....
iii. Looks like itll be hard to get him, and then hard to get Francesca as a
tippee
1. If you can get him, she prob knew or should have know that the
breach ....
d. Francesca
i. Duty
1. Do they have a history of exchanging confidences?
a. Probably because they are engaged, but the facts show
that they haven't exchanged these kinds of confidences
b. Different than Chestman, its not they have exchange
business confidences, its that they don't normally talk
about these things
2. Not a wife so no automatic
3. But was the agreement mutual? She didn't say yes....
4. Also Cuban/SEC issue, she didn't agree not to trade on it
ii. Tipper
1. Did she pass to her grandmother for a personal benefit? Was it to
impress her
2. Do these people know or should know that this information came
from this kind of source who breached her duty
3. Tippee elements
a. Less likely to know further down the line, like the yoga
instructor
i. They prob don't know who the source even is
ii. But should they still know it came from an
insider
b. What about relative business sophistication
i. But just because they are grandma they knew
enough to tell their broker to pick up shares of
Invest Co
e. Grace
i. She said right right, was that mutual?
ii. History of their relationship? Shes the grandmom
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iii. Is can't use enough? In 5th Circ? Under SEC?
Diane
i. Relationship between Grace-shes her daughter (SEC Rules)
ii. But remember shes a gossip! Did Grace have an expectation that she was
really gonna keep it quiet?
iii. And she said i am gonna make a chunk of change-was that a disclosure?
iv. Does she also owe a duty to Francesca as a member of the family under
Chestman?
g. Bruce
i. Bruce is a lock! Hes a mailman, he owes a Chiarella duty to Invest Co
h. Yvonne
i. The amount of info she got was very narrow, materiality element may be
undermined
ii. She was told she was given a free tip, but did she know where it came
from??
f.
XI. THE TAKEOVER MOVEMENT
a. Key Terms:
i. Takeover: broadly used to describe taking over a company
1. Many different ways to takeover, one of them is through tender offer, proxy, etc
ii. Tender offers: refers to taking over through the process of tender offer or public announcement
to buy shares
b. DEVELOPMENT OF THE WILLIAMS ACT
i. Prior to the 1960s most contests for corporate control took the form of a proxy fight
ii. A more direct way is for a bidder to simply buy up the shares of the target company either on the
open market or by making an offer to the public SHs or both
iii. Prior to the 1960s, most offers would be in the form of exchange offers in which the bidder would
offer its own stock or other securities to the SHs of the target company
1. It’s an offering of securities so subject to 1933 Act
2. But if you offer in cash, you don't need to register it and were thus largely unregulated
during this time
a. Basically a public invitation to Shs to tender their shares to the bidder for
purchase for case, 15-20% in excess of current market prices
b. The bidder sought enough shares to gain control of the target corp, although they
sometimes sought a higher percentage or all of the outstanding shares
c. Usually made an invitation saying they were not obligated to purchase any shares
unless the required amount was tendered
d. If an excess was tendered, they could purchase the excess shares or purchase they
at a pro-rate or first come/first serve basis
3. Usually made by an ad in the financial press, and mailed to SHs as well
a. Brokers received generous commissions
iv. Initially, probability of success of a tender offer appeared to be greater than a proxy because of
the element of surprise
1. Created the term Saturday Night Special-offers came about after close of the market
Friday and expired midnight on Sunday
2. Denied SHs any info as to the reaction of the market and denied management chance to
respond
v. Also, unlike a proxy fight where SHSs had to decide which faction to join, a tender offer was just
a decision to make an investment decision
vi. When a cash tender offer was made, the open market price for the shares usually increased
dramatically
vii. This was all significantly modified in 1968 with Williams Act, which amended sections 13
and 14 of the SEC Act
1. Provides for disclosures by the bidder
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2. Need not be made or filed in advance of the offer so element of surprise is
preserved
3. Anyone who acquires 5%+ of the stock of a registered company must disclosure
the acquisition and notify the issuer within 10 days
4. Provides a set of bidding rules to govern the conduct of tender offers
a. Min period must remain open (20 business day now)
b. Tendering SH has the right to withdraw shares tendered
c. All tendering SHs must receive the highest price paid in the offer
d. That if the offer is over subscribed, all SHs may have their shares purchased
pro rate in proportion to number of shares tendered
5. Technically only apples to companies registered, but includes a catch all anti
fraud rules that apply to all tender offers in IC
6. Purpose was to:
a. Slow down process and give SHs info and target mgt a chance to respond
b. Assure SHs were treated equally and get the highest possible price
viii. Numerous devices were designed to avoid or min impact of Williams Act
1. Launching a front end loaded two tier tender offer, to get the first 51% and then the
other 49%
a. Induced SHs to bid now to get a higher price
2. Or may only launch one tier to get the bare minimum and say nothing about the
minority
3. SEC and states started enacted laws to combat these tactics
c. LEVERAGED BUYOUTS
i. LBO of the 1980s involved an aggressor who purchased all or most of the outstanding stock of
the target for a substantial premium over market price
ii. Financed through loans that might involve short term mezzanine or bridge loans (short term
financing with payment of only interest until the whole balance is due) plus low grade high
interest debt instruments-aka junk bonds
iii. The debt became the obligation of the target corp
1. Proceeds of the debt assumed by the target were used to purchase the shares of the
target
2. Funds to pay the debt assumed by the target were to be obtained by the sale of
components of the targets business or by targets subsequent cash flow
3. Increased by tax savings arising from deductions for interest payment on the debt
iv. Calculation for seeing how much debt a corp could carry was EBIT-earnings before interest and
tax
v. When the debt was paid down sufficiently the target could again become a publicly held
corporation so everyone benefitted
1. Except when the corps couldn't carry the load of the new debt and went into
bankruptcy
2. Issue became whether the LBO transaction itself could be attacked as fraudulent
conveyance
d. BARBARIAN AT THE GATES
i. 25 billion dollar leveraged buyout, biggest in history at the time
1. Since been eclipsed by MCI Worldcom, 29 billion (also largest bankruptcy in history)
ii. Going from a public, stock-exchanged company to a private company
iii. Leveraged buyout
1. In order to purchase to the shares of the company, funds were borrowed
2. Borrowed based on amount of funds in the company and what would be in the
company in the future
a. That's why they were doing all this math-different people had different idea of
how much money was in the company
3. Raised funds by different methods
a. Debt securities: SHs loaned the company money
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b.
c.
i. SHs that get bought out don't really care what happens to the company
post takeover
ii. But if they have debt securities, then they do care what happens because
that will affect chance that debt will be repaid
Consortium of banks loaning money-also did their own calcs to see
Bridge financing: designed to get you over the bridge to get you to long term
financing
i. Between 2yr-1 year short term financing (usually 1 mo)
ii. Then refinanced to longer term structure
56 million golden parachute payments, typical for the 1980's
Billion dollars in legal fees!
d.
e.
iv. Nabisco Story:
1. Went private for a while, but then hit hard times and then went public again
a. Sometimes go private to get out of the eye of the regulators
b. But public means regs back on you but also public $$
c. KKR spent a long time with the company-til 1995
i. Not a quick turn around, partially because it saddled the company with
too much debt and couldn't get out earlier
2. Also had to pay a ton of money to states for tobacco lawsuits
a. Later led to 2 cigarette companies and 2 food companies
b. Very important move given the way tobacco litigation was heading
v. Things to keep in mind
1. Who you chose to finance your transaction can really determine your fate
a. Need to be experienced!!
b. Fire the lawyer if hes the problem!
2. If you have change of control provisions in Ks with original company, then if you
change management then you need to re-negotiate the Ks
a. May even give them the right to terminate, another reason to keep secret!
3. Secrecy important to avoid competitive bidding , especially if you want to end and
close quickly
4. Now you can see the logic of VanGorkom
a. Substantial premium over market doesn't mean that you're getting the best deal!
b. If you allow a bidding war, you will ultimately end up with a better price
vi. MOVIE HYPOS:
1. RJ selling newspapers
a. Throwing in extra things and deals
b. Can the newspaper be held liable for these extra deals
i. Its not in the contract, can there be actual authority?
1. Implied authority, if they know hes doing it and they reward him
for the best sale
a. Something from the principal to the agent to make them
believe that they are authorized to do this
b. Seen it, condoned it or seen it and didn't say anything
when they should have
c. Certainly if they are rewarding him for it, but likely
heard about it
ii. Apparent Authority
1. Representing the newspaper as an agent
2. What's his title? Why would people think that he had the
authority to make these deals
a. Representative, manager etc: its his title from the
principal
3. What if there's no title? Do other newspaper people do it? Didn't
seem super surprised
80
iii. Scope?
1. Picture frame okay
2. What about if you sign up for one year you get five years free?
That seems unreasonable?
c. What if he lies about his authority?
i. Maybe he just sees a bunch of newspapers and tries to sell them but
doesn't actually have affiliation with newspaper
ii. Tries to do a deal if you pay me upfront cash then you can get X months
free
iii. Well did the company do something?
1. Like leaving the keys in the truck, your are supposed to control
your indicas of ownership so people don't get duped
2. Why are employees leaving a stack of today's newspapers by a
dumpster?
2. Lavish spending in the movie
a. While the companys stock was not doing well....
b. Has these motto you got to spend money to make money
i. Convince people that the company is doing well, people get involved
want to be around a prosperous company and invest
ii. Hard to neg this through BJR: even if the company is on the decline,
maybe you want to rebut the declining image
c. What about the board?
i. Are they supposed to have a system of checks on him
ii. Is this a violation of duty of oversight??
1. Is there a rule that dog can't be on plane by itself ??
d. What if the board gives him a blank check and you bring suit against the board
i. Doesn't implicate duty of loyalty
e. What if the board gives him a blank check, but hes on the board, and you bring
suit against them
i. Then duty of loyalty is implicated because he’s doing things that just
benefit him
f. What about demand on the board? Should it be excused or required?
i. Other hypo:
1. Under the de statute it says a transaction will not be voidable so
long as a majority of the SHs approve the transaction it removes
the taint of voidability
3. Insider Trading
a. What about the cigarettes
i. Was he supposed to disclose that???
ii. Wouldn't a reasonable investor care about this ??
iii. Is it Basic, is it still in testing and probable?
1. ut it seems like it kind of at the end at this point, it is what it is
b. Well they did announce it, and it made a blip in the stock prices
i. So probably cigarettes not what people want, people want to get rid of it,
and they just want the crown jewel food company
c. What about when the wife is telling the waxer about the potential take over
i. what if she says thanks for the hot tip, ill also do your eyebrows for free,
and then goes purchases stock in Nabisco
ii. SEC goes after them both
1. extra services were a personal benefit even if she didn't solicit
them she received them by giving the information
2. they had a relationship going on where they discussed this kind
of thing
a. did they expect this to be kept in confidence
81
i. but was thanks for the hot tip enough for
disclosure???
b. What if she said AND i'm going to trade on this
i. ok thats enough
ii. those absolves her of her primary duty
3. Any other way to get the waxer?
a. 10b5 DERIVATIVE LIABILITY: how did she get the
information? From the wife, from the husband
i. the wife owes a duty to her husband
ii. thanks to 10 b 5 2 thats enough
iii. and from the movie they exchange a lot of
business confidences (chestman)
iv. expectation within that relationship that the
information would be kept confidential
b. did she pass for a personal benefit
i. yes she got the free eyebrows
ii. but she didn't solicit it
iii. was the benefit a side benefit....up to the SEC
iv. she could have refused it
v. doesn't matter how big the benefit is, a gift is
still a personal benefit!!
c. Waxer was pretty sophisticated -so she should have
known that it came from someone with duty to company
4. 14 e3
a. relevant because its a tender offer
b. also materiality earlier strong because its a tender offer
c. okay what are the elements
i. its bout a takeover; material-not done yet, its
largest in history though and likely to occur; non
public-newspaper article hadn't come out yet
e. TAKEOVER DEFENSES
i. Assuming that a takeover offer is made, does the incumbent mgt have a duty to oppose, support
or be neutral to it?
ii. If the aggressor has the financial strength to carry out the contemplated offer, SHs of the corp
will almost certainly realize more for their shares if the offer succeeds than if it fails
iii. What should the goal of management be?
1. Remember they are going to lose their positions-so for them its urgent for its not to
succeed!
iv. Entrenchment describes defensive tactics that are designed solely to defeat an offer in order to
preserves managements position
1. It is a breach of the fiduciary duty of loyalty so they must come up with other reasons
why they want to defeat the offer
a. Price is too low
b. Reputation of aggressor for sound fiscal mgt is not good
c. Aggressor is assuming debt obligations that it can't meet with targets assets
d. In the best long run interests of the SHs to remain independent
e. Mgt already has long term plans to improve profits and stock price, protected by
the BJR
f. Would violate antitrust laws
g. Offer is partial one, and is unfair to SHs by coercing them to tender
v. Litigation began to test the validity of these defenses
1. Took form of suits for equitable relief based on violations of the Williams Act or on
breaches of the duty of care or loyalty by mgt, or both
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vi.
vii.
viii.
ix.
2. Where mgt effectively defeated a tender offer without providing an offsetting mgt
buyout or leveraged recapitalization to replace some or all of the lost value to Shs, there
inevitably was a drop in share price and litigation against the mgt began to recover
those losses
a. Usually attacked the BJR
Among the most common and effective and three tier plans that include
1. Classification of the BOD into three groups, with one group being elected each yea
2. Prohibition against removing directors except for cause
3. Provision that prohibited certain designated types of amendments to the articles of
incorp or bylaws unless approved by a supermajority of directors
Cumulative effect of these provisions is to prevent an aggressor that acquired even 100 % of the
shares from replacing an majority of the BOD for 2 years
1. DE statute authorizes the staggering of elections of BOD without regard to the
privilege of voting cumulatively
2. NY state requires 2/3s vote to adopt a supermajority amendment to the articles of
incorp and also requires a conspicuous reference to such a provision on each share
certification
CLASS NOTES
1. Proxy contest: sometimes the proxy doesn't work so they turn to a takeover,
sometimes they are coupled together
a. Usually costs less than a takeover
2. Tender offer: buy all the shares
a. Done by ads, online etc
b. When its hostile, it means management doesn't support it
c. Dont have to ask for 100% of the shares
i. Just need to get control, and they are usually holding some % so they
want 50%+
ii. You're always going to get some shs holding out
1. Maybe they are on vacation, or they are part of the hostile mgt
iii. and if you get 100% its more expensive!
1. Usually why takeovers are structured as mergers
2. Parent creates a subsidiary that does tender offer for some target
company, they get 51% of the shares, then trigger a merger
between subsidiary and target
d. merger happens by majority vote, so if minority rejects they get cashed out at the
merger price
i. they can sue if they think the merger price is unfair but can't do anything
about the merger
e. NO FAIR BIDDER PROVISION in takeovers, can say whatever you want
to one guy and not another
Once a take over is about to happen what can mgt do
1. Get a white knight to rescue mgt (or a stalking horse to drum up interest)
2. Will give them a lock up: a promise to let someone buy something whether or not
the tender offer occurs
3. Scorched earth: enter into a k with some other company that says if this insurgent
group takes over the company you will automatically be able to purchase this division
4. Can also create severance packages that make the takeover more expensive
5. Shark repellants
a. Can put them in the bylaws or articles that make takeovers more difficult, and
say you can't change bylaws if you were hostile; ie staggered boards, can't turn
over the board in 1 year
b. Found different ways to get around it
6. Poison peel---“key to end takeover era”
a. Stock plan in bylaws, charter, shs agreement aka share holder rights plans
83
f.
b. issue to SHs a right that they don't have to pay for, or pay nominal value for
c. trigger event, usually change in control, ie takeover (less than majority of the
votes)
d. dormant, but once triggered you can buy more shares in company
i. you can get 5 shares for a penny a share
ii. dilutes your shares so you can't take over
e. can redeem the right if you negotiate with the board
i. have to deactivate it before something happens
ii. only the existing mgt can deactivate, can't take over first then deactivate
f. no peel has ever been triggered
7. green mail: start buying all the shares in the company, saying they are going to launch
a takeover unless the company buys them out; aka blackmail
JUDICIAL REVIEW OF DEFENSIVE TACTICS
i. UNOCAL CORPORATION V. MESA PETROLEUM CO.
1. Facts: Mesa launched a takeover fight for Unocal, a major oil company. Mesa offer 54
per share for 64,000,000 shares, to bring ownership to 50%.
a. The bulk of the purchase price was to be borrowed in the form of the junk bonds
b. At the same time, Mesa announced that if it were successful in the tender offer, it
would thereafter purchase the balance of the Unocal stock it did not already own
through a second-step merger in which the holders would receive highly
subordinated securities (supposed to be 54/share)
c. Unocal's ultimate defense was a flatly discriminatory proposal: an exchange offer
that provided that if Mesa bought the 6.4 M shares it sought, the remaining SHs
could exchange all of their remaining shares for debt securities worth $72 per
share that would be senior to Mesa's junk bond financing
i. Mesa and persons affiliated with Mesa were not eligible to participate,
which devastated Mesa's financing
d. If it completed its tender offer and obtained control of Unocal, the remaining
Unocal SHs would swap their shares for senior Unocal debt, and Mesa would end
up owning virtually 100% of the corp that was awash in debt
2. H: DE SC evolved a new standard for evaluating such proposals
a. In the board's exercise of corporate power to forestall a takeover bid our analysis
begins with the basic principle that corp directors have a fiduciary duty to act in
the best interests of the corps SHs
b. Duty of care extends to protecting the corp and its owners from perceived harm
whether a threat originates from 3d parties or other SHs
c. A Corp does not have an unbriddled discretion to defeat any perceived threat
i. The restriction placed upon a selective stock repurchase is that the
directors may not have acted solely or primarily out of a desire to
perpetuate themselves in office
ii. Inequitable action may not be taken under the guide of law
d. The standard of proof is designed to ensure that a defensive measure to thwart or
impede a takeover is indeed motivated by a good faith concern that the welfare of
the corp and its SHs must be free of any fraud or other misconduct
i. But this doesn't end the inquiry
e. Further element of balance
i. If a defensive measure is to come within the ambit of the BJR, it must be
reasonable in relation to the threat posed
ii. Entails an analysis by the directors of the nature of the takeover bid and
its effect on the corporate enterprise
1. Concerns include inadequacy of the price offered, nature and
timing of the offer, questions of illegality, the impact on
constituencies other than SHs (ie customers, employees etc), risk
of nonconsummation, and the quality of the securities offered
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f.
Here the threat posed by the Unocal board as a grossly inadequate two tier
coercive tender offer coupled with the treat of greenmail
i. Board stated that its objective was either to defeat the inadequate Mesa
offer or provide the 49% of its SHs who would otherwise be force to
accept junk bonds
ii. We bind that both purposes are valid
g. Such efforts would have been thwarted by Mesas participation in the exchange
offer
i. If Mesa could tender its shares, Unocal would effectively be subsidizing
the former's continuing efforts to buy Unocal stock at $54/share
ii. Mesa could not fit within the class of SHs being protected from its own
coercive and inadequate tender offer
h. Thus we are satisfied that the selective exchange offer is reasonably related to the
threats posed
i. It is consistent with the principle that the minority SH shall receive
substantial equivalent in value of what we had before
i. Thus, the board's decision to offer what it determined to be the fair value of the
corp to the 49% of its shs who would be force to accept junk bonds, is reasonable
and consistent with the director's duty to ensure that the minority SHs receive
equal value for their shares
ii. CLASS TAKEAWAYS
1. Can boards remain passive? If they get a takeover can they just do nothing?
a. A lot of ppl say no...is there evidence to suggest if you inject yourself into the
process can you enhance the overall price that SHs get?
b. A board doesn't need to do anything!
c. The SHs are making the decision to take the deal or not
i. Maybe thats why they should remain passive
ii. But more likely that then can enhance the deal
2. Does fed law impose on directors some duty? Why in the movie are the directors
scrambling to do something?
a. Have to make a statement remember (see above)under 14 e 3
b. What if they didn't make the statement....then can the SHs do something
i. Sue for the difference
3. Remember Caremark?
a. Whats not protected under the BJR? The unconsidered failure to act
i. If you consider something and then decide not to act, thats ok
ii. BUT IF YOU DONT CONSIDER THEN NOT PROTECTED
b. Could prob get a breach under that…Board is obligated to take some action-even
if its just thinking about it and then not acting
4. Back to the Unocal case
a. If Mesa acted, it screwed Mesa over in the long run, but SHs would get money
b. Create a company awash in debt
c. Court develops a two part test to analysis the actions of the board when it takes
an action in result to a tender offer
i. When a board adopts a response it must believe there are reasonably
grounds for threat...
ii. Response must be reasonable in response to whatever the threat is…
d. How does this relate to BJR?
i. SUPPLANTS VAGORKHAM IN TAKEOVERS
ii. Courts call it a heightened fiduciary duty test
1. WHEN YOU ARE DEALING WITH A TAKEOVER, you
apply the UNOCAL/REVLON test NOT BJR
e. Why? because the courts don't trust the directors any more
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iii.
iv.
v.
vi.
i. Their job is on the line, they may be motivated by a desire to perpetuate
themselves in office
ii. We don't want to say its a loyalty breach (too strict), but can't just give
you the BJR
iii. So we need this in between test for a more exacting scrutiny for whether
you breached your fiduciary duty
f. Okay so what if they considered it for 10 mins?
i. Likely not sufficient; if its wouldn’t pass scrutiny under van gorkom, it
wouldn’t pass scrutiny here
5. What was the offer in this case?
a. We are going to pay 70 dollars to the first group, then screw over everyone else
b. It’s basically a threat, rush now and tender your offers or get screwed
i. seems like a legit threat that the board needs to get involved in
ii. potential greenmail
1. buying up the shares to force the company to pay a premium for
them to get them back
2. can a company do that, yes! as long as its not a breach of
fiduciary duty
6. Different scenarios
a. What if the threat is that the company taking over usually lays over 30% of the
employees-case law says that you should consider SHs and other parties
b. Need to be reasonable , Unocal says that you can consider other parties
EMPLOYEES ok
i. What if the shs says you can't elevate their interests over ours
7. BUT WHO CAN THE BOARD PUT FIRST
a. Under unocal it seems ok
b. Fiduciary duty runs to the corporate enterprise, not to the shs
i. thats why it can treat shs differently than others (mesa)
ii. you have a duty to the CORP (as an enterprise), and to its shs
c. other courts say this was not what unocal was saying you have to connect it
back to shs
**States, not DE, started passing statutes that allowed boards to explicitly consider other
constituents
1. Some ppl say this wasn't passed in de so clearly not what they wanted, others say
unocal is putting de in line with other states
People freaked out of the case: if you can say you were concerned about others, especially
without having to tether it to economic interests, then you could really be covering up caring
about yourself
Courts justify no's to takeovers as reasonable if they are no to this takeover, but other better
takeovers ok
1. If the price is the issue, if they up the price, can't argue that any more
2. Can treat shs differently (Unocal), i.e. Mesa was the threat, could treat them differently
even though they were already shs
REVLON, INC. V. MACANDREWS & FORBES HOLDINGS, INC. (DE SC)
1. Facts: Pantry Pride made a hostile tender offer for any and all shares of Revlon Inc for
47.50 per share.
a. Viewing this price as inadequate and finding out that Pantry Pride planned to
break up and sell off Revlon's component businesses, Revlon mgt instituted a
series of defensive tactics, particularly an offer to purchase 10m of its own shares
in part for promissory notes that contained poison pill provisions
b. Pantry Pride then increased its offer in a series of steps , up to 56.25, contingent
on Pantry Pride waiving the poison pill features of the notes
c. Revlon decided to seek a more friendly purchasers, aka white knight
i. One potential was Forstmann Little and Co
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ii. Forstmann and Revlon mgt agreed to a leveraged buyout at 57.25/share
1. Also included lock-up option to purchase some Revlon divisions
d. Pantry Pride then raised its price to $58 per share, Revlon decided to go through
with Forstmann sale
2. H: Upheld Revlon's actions to fight off Pantry Pride's initial inadequate offers but then
enunciated a new legal principle:
a. When Pantry rose its price, it became apparent that the break up was inevitable
i. Discussing with Forstmann was Revlon board's recognition that the
company was for sale
b. Duty of board had changed from the preservation of Revlon as a corporate entity
to the max of the company's value at a sale for the SHs benefit
i. Altered the board's responsibilities under Unocal standards
ii. Revlon could not make the requisite showing of good faith by preffering
the noteholders and ignoring its duty of loyalty to the SHs
1. Revlon argued that it acted in good faith in protecting the
noteholders because Unocal permits consideration of other
corporate constituencies
a. Although such considerations may be permissible there
are fundamental limitations upon that prerogative
b. Such concern for non SHs interest is inappropriate
when auction among active bidders is in progress,
and the object no longer is to protect or maintain the
corp enterprise but to sell to the highest bidder
iii. Margin between the Forstman bid and the Pantry bid was so small
the board ended the auction in return for very little
actual improvement in the final bid (time value of money)
1. Principal benefit went to the directors who avoided personal
liability to a class of creditors to whom the board owned no
further duty under the circs
iv. When a board ends an intense bidding contest on an insubstantial
basis, and where a significant by-product of that action is to protect
the directors from perceived personal liability, the action cannot
withstand the enhanced scrutiny which Unocal requires of director
conduct
v. Concluded that under all the circs the directors allowed
considerations other than the max of SH profit to affect their
judgment, and followed a course that ended the auction for Revlon,
absent court intervention, to the ultimate detriment of its SHs
1. No such defensive measure can be sustained when it represents a
breach of the director's fundamental duty of care
2. Board's action is not entitled to the deference of BJR
c. CLASS TAKEAWAYS
i. When the takeover becomes inevitable, the boards duty changes
from protecting the company from maximizing the shs price
ii. Move out of Unocal to Revlon
1. Threat-really low offer
2. How is this different than unocal
a. You have the obligation to consider other interests
b. But once you hit revlon those drop away
i. Goes from defending corp enterprise to max
price for SH
ii. So if you’re not doing that breach fid duty
(BUT ONLY IF YOURE IN REVLON....if
still in Unocal OK)
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vii. CLASS HYPOS
1. What if they had a white knight but they didn't offer him a lock up
a. Are you still in Revlon?
i. NO need to have both....breakup and sale?
2. Don't care if the takeover firm is taking on debt to pay cash, just as long as the SHs are
paid
3. In the movie didn't it seem that they took a lower over
a. Are they in revlon or unocal?
4. How should we view a courts decision to give someone a lockup?
a. Are they maximizing the shs value???
5. What about in movie when they agree to pay firms expenses of 45 m
a. Can shs bring a suit over this?
i. if they end up accepting his offer, prob ok
ii. but what if they accept another offer? it wouldve been a waste! you didnt
get anything for 45 m
1. BUT THEY DID-they got a bidding war! they got more money
in the end
6. At what point in the movie was the corp in revlon?
a. When the second bid came in? it became inevitable, started discussing selling off
different parts
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