ba outline

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Business Associations: Fall 2012; Renfro, Ashleigh

I.Structure Of Corporate Law

A. BASICS OF CORPORATION LAW

1.Introduction

a. We will discuss the lay out of the course and introduce the concept of the firm. We will also look at the basics of corporate structure and finance as well as at some of the other business forms. Our goal will be to identify the advantages and disadvantages of each form so that you may more intelligently advise clients as to the choice of form. In addi-tion, we will explore the basics of agency law. Corporations, as principals, can only act through agents. We will examine the creation of an agency relationship, the scope of an agent’s authority and the liabilities of principals and agents to third parties.

b. Corporation is an economic institution; most powerful and prominent vehicle to conduct business.

c.The corporation is also a social and political institution; aside from economic issues, impor-tant to think of other implications including: sociology, psychology, political, moral philoso-phy and history

d.DEFINITION OF CORPORATION:

• Corporation (Elements):

o Artificial being, created by a statute allowing its incorporation; an or-ganizations of persons coming together, all of which are necessary

o Independent “person” under the law w/ essentially same rights, liber-ties and protections of an individual; pretty much, in reality a piece of paper in the secretary of state’s office

This piece of paper is important: describes corporate structure

o A way to permit the projects we undertake to continue past human lifetime; enable us to create institutions that carry on our work

Independent liability: Corp is liable for obligations; SHs, directors, etc. have limited liability.

Independent taxation: Corps profits are taxed; then, SHs are taxed person-ally on any distributed dividends.

NOTE: creates a double taxation problem, so Congress reduced the divi-dend tax rate.

o Incorporation: all states have laws regulating incorporation

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o Some basic statistics:

In U.S., there are roughly 32m businesses

Of those, 5-6m are corporations

Roughly 50,000 are big corporations; only a few thousand appear on NYSE

Roughly 26-27m are closely held corporations

• Closely Held Corporations usually have:

o (a) a small number of active SHs, often people who knew each other;

o (b) active participation of many of the SHs in the management and operation of the business;

o (c) a significant amount of SHs’ wealth invested in the corporation; and

o (d) **no ready market for the stock of the incorporation.

o More than half of the shares are held by fewer than five individuals

o Not publicly held

2.Catalog of Business Forms (See Business Forms Chart)

a. ELEMENTS OF CHOICE

• (1) Personal liability: Some business forms offer their equity in-vestors protection against their personal assets being taken to satisfy business liabilities.

o Limited liability puts risk of insufficient business assets on the credi-tor, not the owner, who stands to lose only her investment in the business. (only the assets may be used to satisfy claims)

Close Corp SHs rarely enjoy the complete limited liability protection bc (1) fi-nancial creditors typically require major shareholders to personally guarantee business’s debt; (2) corporations and individuals are responsible for torts (so if shareholder is employee who commits a tort, he is still personally liable); and (3) insurance costs fall on the shareholder.

• (2) Taxation:

o (1) independent entity taxation

• Potential for double taxation when business and investor are taxed separately; after the tax on these entities, any remaining income that

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is distributed by the entity to its owners will be taxed again as income to investors

o (2) “pass through entities.”

• But also problems with pass through forms.(phantom income???)

• Income paid to a taxpayer during the tax year that is not constructively received at the taxpayer's end. Phantom income is not terribly com-mon, but does manifest itself in such investments as limited partner-ships, where the earnings are taxed but not received, and zero-coupon bonds, which are issued at a discount and mature at par. The interest payments for zeros are credited to the taxpayer but no check is actu-ally cut for them. The bondholder effectively receives the payments at maturity, when the bond is redeemed at the higher par value. Books definition of phantom income below

• (3) Level of internal flexibility offered to owners

• (4) Administrative requirements for setting up and maintain-ing the form

• (5) Costs associated with administrative requirements

b.FORMS OF DOING BUSINESS

Form Definition Liability Taxation Formal Docs Req’d

Continuity of life

Agents

Sole Propri-etorship

Business owned by one person in her individual capacity(can have em-ployees)

Personal(all liabilities and all profits go to owner)

Personal No No(can sell as-sets, but not business; can’t transfer liabili-ties)

(1) Can bind princi-pal to obligs. w/in scope of employ-ment; (2) respondeat superior may apply.

(General) Part-nership

Association of two or more per-sons to carry on as co-owners a business for profit; concept of mutual agency

Personal:partners are jointly and severally liable(unless modified by agreement )

Personal:tax liability passed through to the part-ners.*(Risk: phantom in-come)

No (default rules under RUPA; but partners should make agreement!)

No(any change in partnership creates new partnership for liability pur-poses)

Mutual agency; ev-ery partner is an agent and has right to manage. SEE CHECK THE BOX RULES BE-LOW

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Limited Part-nership

Partnership with at least one gen-eral partner and one limited part-ner.

General partner: per-sonal (and right to manage).

Limited partner: lim-ited (entity) liability.

Personal for all (un-less Kitner test shows LP to be more like a corp.)*

Filing is re-quired with lo-cal or state gov-ernment; part-nership agree-ment is a good idea.

Yes General partner: op-erates the business; right to manage.

Limited partner: passive investor.

Limited Liabil-ity Company (LLC)

Amalgamation of business forms, subject to statute, that avoids lim-ited liability/dou-ble tax problem

Limited liability for all members; same LL available for SHs in a corp while being, if it chooses, a pass through organization for tax reasons

Personal for all members* great flex-ibility in the alloca-tion of profits and losses as well as in the allocation of residual assets upon the dissolution of the LLC

Filing require-ment; operating agreement is a good idea.

Yes Managers can be members or out-siders

Corporation See above; As a legal person, unites the organi-zation of people in a way that al-lows it legally and practically to act with one voice

Limited Entity Filing require-ment

Yes Centrally managed; see below for struc-ture.

• Notes on Business Forms

o Limited Liability Partnerships (LLPs) & Limited Liability Limited Part-nerships (LLLPs): other business forms, made mostly obsolete for new businesses by creation of LLCs, but existing partnerships may become these entities. Limits or eliminates the personal responsibility of gen-eral partners for all or some designated part of the business obliga-tions. MUST file certificate with the state. Possibility of use ALWAYS based on state statute.

o Phantom income: undistributed income of a pass-through entity that is nevertheless taxable to the owners.

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“Check the Box” rules permit business organizations other than corpo-rations and sole proprietorships to determine whether to be taxed as a corporation or a pass-through entity.

If business taxpayers are likely to have undistributed income, they would want to be taxed as a corporation to avoid phantom income problem.

If not, they would want to be taxed as a pass-through entity to avoid the problem of double taxation.

o Kitner test: A business is taxed as a corporation if it has more corpo-rate than partnership attributes.

Examines: limited liability, centrality of management, free transfer-ability of interests, and continuity of life.

o Effects of partnership changes:

When one partner leaves, she is owed her share of assets. Other part-ners can buy her out, or partnership can liquidate to pay her off.

Old partner is liable for obligations arising before departure; new part-ner is liable for new obligations only (except new partner’s invested assets may be marshaled to pay a debt arising previously)

o Partners’ Duty of Good faith

Partners are obliged to duty of utmost good faith and fair dealing.

Self-help remedy is resignation and dissolution of partnership. (Pow-erful tool for minority partner.)

3.Corporate Structure

a.Governance

• Shareholders: owners of corporation’s stock; vote for Board of Di-rectors and on some extraordinary matters (“the People”)

• Board of directors: small group (10-12) of persons, mainly out-siders, who set policy, make rules, and oversee the firm’s operations, elected by the shareholders (“the Legislature”)

• Officers : CEO, etc. (“the Executive”)

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• What powers do shareholders have? Why do boards of directors/offi-cers seek to keep share prices high, even in the short term, to please shareholders?

o Shareholders can sell! But hard to coordinate

o Shareholders can get rid of directors! But hard to coordinate

o Derivative suit is unlikely

o **Institutional shareholders may acquire blocks of stock and a lot of power

• Who else are stakeholders?

o Employees

o Local governments

o Suppliers

o Lenders, etc.

b.Financial

• Equity: amount someone puts in to buy shares in a public corporation that the person cannot demand back

o Common stock: voting rights and right of residual earnings (more risk, but possibility of greater returns)

o Preferred stock: right of preferred distribution (less risk, but possibil-ity of lower returns)

• Debt: borrowed money from banks, big institutions, and the public

o Bonds

o Debentures

• Retained earnings: profits reinvested in the company

4.AGENGY

• DEFINITIONS:

o Agent: a person who acts, pursuant to an agreement between the parties, for another person (the principal) and under his or her control.

o Agency: the fiduciary relationship which results from the manifesta-tion of consent by one person to another that the other shall act on

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his behalf and subject to his control and consent by the other so to act.

o Questions: (1) whether the purported agent had authority to act and (2) whether the act that created the purported liability was within the scope of that authority.

o NOTES:

All corporations act through agents (bc corporations are fictional entities)

Assume Corporation is principal and workers, employees, and officers are agents

A 3rd party is injured, who is liable?

• The principal or both the principal and the agent

• For the principal to be liable the authority must (1) exist AND must (2) be in the scope of the agency

a.TYPES OF AUTHORITY —actual, actual implied, apparent, inherent

• (1) Actual authority

o The principal grants authority to the agent to act

Actual Express Authority : “I authorize you to purchase X for me for $50 to-day”

Agent agreed to act under the authority of principle. Principal grants au-thority to agent to act.

Actual Implied / Incidental Authority : Such authority is necessary to complete the act on behalf of principal; principal implicitly authorized the agent to do X by asking him to do Y.

EX. I engage you as an agent to build a building for me (arrange for build-ing). I do not give you money or say anything about money. You go to bank and negotiate a loan on your behalf without being explicitly told to. Whether there is implicit or incidental authority can be a tougher question

• (2) Apparent Authority

o No such authority exists, but principal gives a 3rd party the impression that authority exists; created through an estoppel like equitable de-vice by which the purported P may not deny the existence of the pur-ported A’s authority

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Ex. P gives A a letter to take to bank to obtain a loan. P revokes A’s author-ity, but P does not convey the revocation to the bank. A takes out a loan and absconds w/$. Bank sues P for repayment. P is liable to bank; A is liable to P.

o TEST: Would a reasonable person in the position of the agent have understood such authority to exist if yes, Principal will be bound to the 3rd party

The purported agent cannot create his own authority w/o principal’s acquies-cence:

Principal put in motion the 3rd party’s belief in agent’s authority

Principal has power to notify 3rd party of agent’s lack of authority

Principal is in best position to control agent

• (3) Inherent Authority

o A purported agent is deemed to have the authority he or she reason-ably appears to have—court uses same test for implied authority here Authority is implicit in the position, not the task. ; authority which usually accompanies a P/A relationship; Test restated: what the rea-sonable person would expect is within the authority of an A. ; Often occurs when an undisclosed principal is present

Ex. A president of a corp. is assumed to have the same powers as other pres-idents in similar situations.

Inherent authority stands alone when there is a completely undisclosed prin-cipal.

No apparent authority 3rd party knows nothing about purported principal/agent relationship.

No actual authority if purported agent is explicitly prohibited from engag-ing in the act.

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Watteau v. Fenwick 1 Q.B. 346 (1862)

Facts: Ds purchased a brewery from Humble, but retained Humble as their manager. The brew-ery also retained Humble’s name over the door. Ds expressly forbid Humble from purchasing cigars on credit, but he did so anyway. P sued Ds for the amount owed for the cigarsDs were li-able for the agent’s actions, even if they were done explicitly against Ds wishes, because such actions were within the apparent authority of the agent’s position as manager

Rule: An undisclosed principal can be held liable for the actions of an agent who is acting with an authority that is reasonable for a person in the agent’s position regardless of whether the agent has the actual authority to do so. P is responsible and liable for all of the acts of the A which are within the authority usually confided to an A of that character. Policy concern: not placing the burden on 3rd parties to have to find out who is responsible for acts. Places burden on the P and forces him to closely supervise his agent.

Note: The decision could not be based on apparent authority because the principal is disclosed under that doctrine. The principal is held liable for actions by an agent that are expressly forbid-den, but the case limits a principal to actions of an agent that are reasonable under the circum-stances.

a.SCOPE OF AUTHORITY

• Was the agent was acting within the scope of his/her authority when the act leading to liability occurred?

o If so, the principal will be liable to 3rd parties for the actions of its agent,

o If not, the principal will not be liable to the third party

o Traditional Test: whether the agent was acting in furtherance of the principal’s interest or on a “frolic or banter” of his or her own

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Clover v. Snowbird Ski Resort 808 P.2d 1037 (1991)

Facts: Zulliger worked at the ski resort, as part of his employment, the ski resort gave him a ski pass on the mountain. He was not working at the time of the accident, although he did check in on one restaurant at the request of his supervisor before his shift started. Zulliger was finishing his last run before his shift started when he skied over a crest that was not supposed to be jumped off of and collided with Clover causing her serious injuries

Rule: Scope of employment is a question of fact that must be submitted to a jury whenever rea-sonable minds may differ on this issue, if it is so clear that one is outside the scope of employ-ment. Was it frolic/detour? Also consider spacial and temporal bounds for scope of employment. Ps can be liable not only for A’s exceeding his authority but also for actions which sometimes only have a loose connection to the performance of their authority/job duty

Birkner criteria Employee’s conduct must:

a. Be of the general kind the employee is employed to perform—not a wholly per-sonal endeavor

b. Occur substantially within the hours and ordinary spatial boundaries of the em-ployment

c. Serve as a dual purpose or when the employee takes a personal detour in the course of carrying out his employer’s directions.

Note: Zulliger was definitely an agent, but was he taking a frolic / detour or acting in the scope of his employment—Court says it's a factual question as to whether he was in the scope of his employment

B. THE NATURE OF THE CORPORATION

a.We will examine the process of incorporation and the problems of defective incorporation as well as the role and liability of corporate promoters and look at a corporation’s separate le-gal existence after it is established. Pay particular attention to the Walcovszky case. It deals with the concept of "piercing the corporate veil." What policies support permitting Carlton to structure his business as he did? Are you convinced by Keating’s dissent? If the corporate veil was to be pierced in Walcovszky, who would be liable?

b.The nature of the corporation (cont.): The role and purpose of the corporation: How far from standard business purposes may a corporation go? How does the court ra-tionalize its decision in Dodge? Do corporations have any responsibility to the society? Should they? Who determines how a corporation should meet any responsibility it may have?

c. Sometimes, a corporations is considered a “nexus of contracts”

1.The Process of Incorporating

• Each State has general corporation law governing incorporation proce-dures

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o Each aspiring corporation must file a document called articles of in-corporation, a charter, or a certificate of incorporation.

Requirements:

corporation’s name,

duration (usually perpetual),

a basic outline of its financial structure,

the names of its initial directors, and

the purpose of establishment

a.PROMOTERS, PRE-INCORPORATION AGREEMENTS, AND PROMOTER LIABILITY

• Promoter:

o One who, alone or with others, undertakes to form a corporation and to procure for it the rights, instrumentalities, and capital to enable it to conduct business.

o Promoter is liable (even after Corp is formed) for any and all Contracts entered into unless; 3 exceptions below: Ashley’s Outline: (also re-stated below)

• 1. K’ing party knows the corporation is not in existence but agrees to look solely to corporation for payment

• 2. K expressly states that promoter will be relieved of liability after the corporation is formed

• 3.) Novation

1. Contracts out of liability

the third party will look only to the Corp. for redress

Promoter is relieved of liability once Corporation adopts the Contract

Novation occurs Corporation replaces promoter in NEW Contract w/3rd party.

Default rule: promoter is liable, if there is an agreement relieving promoter of liability, person asserting that argument has the burden of proving it.

o NOTE: Corporation cannot ratify the acts of the promoter because a purported principal cannot ratify an action that was taken before it came into existence.

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Coopers & Lybrand v. Fox (1988)

Facts: When Fox was a promoter he received $10K in tax advice services from C & L for the Corp. he was forming, after the Corp. was formed, both the Corp and Fox refused to pay. Fox was by definition a promoter and so he was held liable under the doctrine of promoter liability

Holding: In the absence of an agreement releasing the promoter from liability, he is liable. Pro-moter has the burden of proving an agreement releasing him from liability exists.

I.Note: Promoter can’t act as an agent for a non-existent principal.

d.CHOOSING THE STATE OF INCORPORATION

• State of incorporation matters re: ability to travel across state lines, cost and admin-istrative burden of filing and organizing and different rules

o Corporations working in other states must register as “foreign corporations”

If Corp doesn’t register, can’t use the state courts

BUT corps can register later and use state corps for claims arising before reg-istration

• Internal Affairs Doctrine : The affairs of a corporation that relate to its internal ac-tivity should be governed by the laws of the state of incorporation—external affairs should be governed by the laws of the foreign state, the federal government, or by traditional conflict of laws rules

• External- governed by the law of the foreign state and the federal governe

• States can require corps to qualify—ie. file a document—to do business in their states. Generally it’s pretty easy for a corporation to conduct business in a foreign state. It is, however, an administrative hurdle and a financial requirement. Small corporations may simply do business without being qualified. Penalties are minimal.

• Many states choose to incorporate in DE to get benefit of internal affairs doctrine (plus favorable tax treatment, lower fees, well-developed courts, etc.

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e.DEFECTIVE INCORPORATION

• Situation where the state has accepted the articles of incirporation for filing and later finds that the papers are defective in some technical way OR situation where the articles have not been filed but the promot-ers believe they have been

• De Jure Corporation (concerning law): One that has completely fulfilled the statutory formalities imposed by state corporation law in order to be granted corporate existence. Corporation under the law, in compliance with statutes, etc; members are protected from liability against all parties.

• De Facto Corporation (concerning fact): Corp made a “good faith” start, but is not de jure bc of a some flaw (failure to file articles of incorporation, etc.); Claim of incorporation is good against the world except the state.

o De Facto TEST :

(1) There must be a state statute allowing incorporation

(2) The D must prove a “good faith” or “colorable” attempt to incorporate un-der that law.

(3) The F must demonstrate actual use of corporate powers (i.e. using a cor-porate name)

• Corporation by Estoppel: A person / entity that deals with a group as if it were a corporation is estopped from attacking individuals within. **opposite of piercing the corporate veil (see below)

o Corporation by Estoppel TEST:

If a 3rd party deals with an entity as a corporation, they are estopped from challenging the corporation’s existence (assuming there is a good faith belief on the part of the entity that it is in fact a corporation.

Cranson v. International Business Machines Corp. (1964) (discusses the doctrine of corporation by estoppel--which is above)

Facts: IBM supplied typewriters to Real Estate Service Bureau for 7 mos before Articles of Incor-poration were filed.

Holding: IBM dealt with w/the Bureay as if it was a corp. and relied its credit (not Cranson’s), so it is estopped from asserting the Bureau was not incorporated when typewriters were purchased. Rule: where one has recognized the corporate existence of an association, he is estopped to as-sert a contrary with respect to a claim arising out of such dealings

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1.DISREGARD OF CORPORATE IDENTITY: “PIERCING THE VEIL”

a.Piercing the Corporate Veil: method for imposing personal liability on corporate insiders; the disregard by the courts of corporate existence (following the insiders’ disregard).

b.When a corporation is a sham, engages in fraud or other wrongful acts or is used solely for the benefit of its director, officers or shareholders, courts may disregard the separate cor-porate existence and impose personal liability on the directors, officers or SHs. The veil(which the court can pierce) creates a separate legally recognized corporate entity and shields the people behind the corporation from personal liability

• Happens very infrequently, applies almost exclusively to closely held corporations

• Possible Incoherence: Once pierced, the corp should hold all SHs liable, but usually only imposes liability on wrongdoers.

c.Vertical Piercing: Plaintiff pierces the veil of the wrongdoing corporate entity to reach the owner: Shell corporations, corporate assets = personal assets.

d.Horizontal Piercing (Enterprise Liability): Plaintiff pierces the veil of the wrongdoing entity to reach the other linked corporations in a common enterprise.

• Common Enterprise Corps functionally same corp: common pool of finances, em-ployees exchanged w/o formality.

e.Agent Piercing (Alter Ego Theory): Plaintiff pierces the veil of the wrongdoing agent / subsidiary (puppet) to reach the parent or controlling entity (puppeteer).

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Walkovsky v. Carlton (1966)

Facts: Carlton divided 20 taxi cab fleet among 10 corps, each w/ only 2 max mortgaged cabs and miminum liability insurance. W. was injured and medical bills exceeded minimum coverage. W. alleged that the Corps were “operated as a single entity, unit, and enterprise” w/r/t financing, supplies, repairs, employees and garaging.

Held. No piercing. Where a corporation is merely a fragment of a larger corporate entity, which actually conducts the business, a court will not pierce the corporate veil to hold individual shareholders liable. This was not a dummy corporation because C was not acting in an individual capacity (personal reasons). He held the minimum requirements for insurance. Should have sued the enterprise (corporation as a whole). Majority says no fraud so no reason to pierce the veil. This case lacks specific intent to defraud

Reasoning: Horizontal Piercing; “Enterprise Liability” (1) The Corp did not share assets. (2) The Corps were not significantly underfunded. (3) If the minimum insurance required by statute is inadequate, the remedy is with the legislature. The corporate form may not be disregarded merely because as-sets of corporation, together with mandatory insurance coverage, are insufficient to assure re-covery.

Reasoning: Vertical Piercing. The claim was not sufficiently alleged. There is no evidence that D was conducting business in an independent capacity. The fact that the fleet has been deliberately split up, only minimum insurance is carried, and capital is minimized, does not mean that the corporate form may be disregarded; if each entity were owned individually and held the same assets and insurance, it is legal.

Dissent: Judges don’t overstep their bounds when they interfere with the plans of those whose corporate or other devices would circumvent legislative policy. The attempt to do corporate business without provid-ing any sufficient basis of financial responsibility to creditors — here, through undercapitalization and minimum insurance liabilities — is an abuse of the corporate entity.

Rule: If Corp is used as a “dummy” for individual SHs actually carrying on business in personal capacity for purely personal reasons rather than corporate ends, Court may treat Corp as Agent and pierce the corporate veil to reach the principal and hold the SHs personally liable. **SH is liable only if conducting business in individual Capacity.

**Look for at least two of the following:

• Tort or Contract claims (though more likely for court to pierce in tort).

• Stockholders engaging in fraud or wrongdoing

• Corporate was inadequately capitalized

• Corporate formalities were not kept (stock certificates, meeting minutes, etc.)

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Kinney Shoe Corp. v. Polan (4th Cir. 1991)

Facts: Polan created 2 Corps: (1) Industrial Corp (I) and (2) Polan Corp (PI). I had no assets, no income, no other bank account, and did NOT observe corporate formalities. I sub-leased from Kinney. PI sub-leased from I, Polan paid first payment w/personal funds and made no other payments. K sued for un-paid rent, won judgment against I and PI, I had no assets, PI declared bankruptcy.

Holding: Polan is personally liable. Dist. Court said, only (1) unity of interest and (2) equitable factors were present, but Kinney should have (3) conducted a reasonable investigation before contracting. App. Ct. reversed and said factor 3 is permissive and NOT mandatory. Grossly inadequate capitalization com-bined with disregard of corporate formalities, causing basic unfairness, are sufficient to pierce the corpo-rate veil. Again, specific intent to defraud/acting in an individual capacity are missing. But this time, the court says other factors are enough to pierce!

TEST/TWO PRONG TEST:

(1) Unity of interest and ownership (Disregarding formalities btwn Corp and Individual); Are the cor-poration and shareholders separate?

(2) Equity: Would injustice result? Would it be equitable to pierce the corporate veil?

a. Relevant Factors (Sea-Land Services, Inc.)

i. (1) Failure to maintain Corp records or to comply Corp Formalities

ii. (2) Commingling of Personal/Corp funds or assets

iii. (3) Undercapitalization: “grossly inadequate” capitalization for reasonable risks of corp. undertaking

iv. (4) One Corp treating the assets of another Corp as its own

(3) Whether it would be reasonable to charge the contracting party with knowledge that a reasonable credit investigation would disclose contracting party assumed the risk (applies to sophisticated 3rd parties)

Notes: **Polan created (I) and (PI) to avoid liability, K should NOT have made this deal w/o extracting a personal guaranty from Mr. Polan? (Maybe Kinney was desperate, or obtained a higher rent!) Why should K get a second bite at the apple?

PIERCING TEST: Most courts adopt a two-part test:

·(1) Unity of interest (disregard of Corp. formalities) The Corp is the alter ego of its sole share-holder.

·(2) Fraud or Injustice Failure of court to pierce would result in injustice

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f.Comments on Piercing:

• Why allow limited liability at all (especially in the context of closely held corpora-tions)?

o Said to encourage business development but it is a relatively new concept, and business developed well prior to its enactment

o Limited liability puts risk on creditors (contracts) and tort claimants, not en-trepreneurs

o Corporations could get insurance!

• Best contemporary justification for limited liability (J. Easterbrook and Prof. Fischel) it allows shares of public cos. to be fungible.

o W/o limited liability, one could only accurately assess risk of investing by investi-gating shareholders and their respective net worths and liabilities

o Even if one could do this, it would be cost prohibitive of investment in multiple cos.

• However, might it not be better to make SHs more vigilant?

o Prof. Gabaldon: limited liability encourages irresponsibility and unaccountability

• Maybe a regime of unlimited liability and insurance would be better.

g.Related Concepts:

• Shareholder Tortfeasor: If a shareholder of corp. commits a tort in the course of the company’s business, he is jointly and severally liable w/the corp. (though other SHs are not); corporate actors are no different from other actors.

• Breach of Contract and Personal Guaranty : In closely held corp., it is very common for those extending credit to the corp. to demand the personal guaranty of the corp.’s principals they become personally liable for corp.’s contract defaults.

• Parent / Subsidiary :

o Parent and subsidiary may be treated as one for some purposes, but are gener-ally treated separately for liability, unless it can be shown that the subsidiary was a mere instrumentality/alter egi (see below)

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o If the subsidiary is the “mere instrumentality” or “alter ego” of the parent corp., then the parent will be liable for the subsidiary (as in piercing).

o Ex. U.S. v. Bestfoods (1998): Parent is liable for subsidiary’s obligations under CERCLA where parent acts as “operator” of subsidiary.

• Reverse Piercing:

o Pass through the wrongdoing corporate insider to pierce another corporation not directly involved in the plaintiff’s injury but which was also merely the insider’s instrumentality;

o i.e., treat the other corporation as if it were the insider himself and not a sepa-rate entity.

o By getting at the insider, Plaintiff can also get to another alter ego corporation.

o Gets around the last-in-line SH problem in Polan.

o *This is what Walkovsky was aiming for via Carlton! (Taxicab Case)

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Sea-Land Services, Inc. v. The Pepper Source (7th Cir. 1991)

Facts: Sea-Land (SL) shipped Jamaican sweet peppers for The Pepper Source (PS). PS didn’t pay its bill. After SL re-ceived a judgment against PS, it “dissolved.” SL went after PS’s owner Marchese’s other corps arguing they were all “alter egos” of each other.

Holding: SL showed that Marchese used his corps as “alter egos” (he didn’t even have his own bank account) but could not show there was an injustice bc debt was not paid.

Rule: The veil of limited corporate liability will be pierced when the plaintiff proves that 1) there is a unity of interest between the individual and the corporation, and 2) to prevent injustice and fraud. Second prong becomes: cir-cumstances must be such that adherence to the fiction of separate corporate existence would sanction a fraud or promote injustice. Piercing the corporate veil is rarely granted and only in CHC’s.

Van Dorn TEST for Piercing the Corporate Veil (& Reverse Piercing)

•Unity of Interest and ownership (Corp & owner have same identity)

o Failure to maintain adequate corporate records or comply w/corp. formalities;

o Commingling of funds or assets;

o Undercapitalization

o One corporation treating the assets of another corporation as its own.

•Adherence to corporate existence would sanction fraud or promote injustice.

o Intent to defraud, OR

o Promote injustice requires something beyond failure to satisfy a judgment

(e.g. unjust enrichment of a party, parent corp. that causes sub’s liabilities and its inability to pay for them would escape those liabilities, an intentional scheme to squirrel assets into a lia-bility free corp. and put liabilities on asset-free corp.)

Castleberry v. Branscum-

-Castleberry filed assumed name certificate after the two other partners started a similar, separate business-Castleberry given a mere $1000 and a $41000 promissory note for the rest of his shares in the corporation-Alter ego is only one of the bases for disregarding the corporate fiction: "where a corporation is organized and operated as a mere tool or business conduit of another corporation.” Alter ego's rationale is: "if the shareholders themselves disre-gard the separation of the corporate enterprise, the law will also disregard it so far as necessary to protect individual and corporate creditors.” Here, it would only apply if against Elite or Custom, not Texan Transfer.-Constructive fraud is the breach of some legal or equitable duty which, irrespective of moral guilt, the law declares fraudulent because of its tendency to deceive others, to violate confidence, or to injure public interests./ “use of a sham to perpetuate a fraud”-advice for clients: if you want to cash out, CASH out. if you MUST take a promissory note, get a personal guaranty on that note.-”In determining if there is an abuse of the corporate privilege, courts must look through the form of complex transactions to the substance.”-- again, look at substance of transaction.-”We disregard the corporate fiction, even though corporate formalities have been observed and corporate and individual property have been kept separately, when the corporate form has been used as part of a basically unfair device to achieve an inequitable result.” ***

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-^^^ This is the basis from which the court is able to find for Castleberry. -The whole purpose of this transaction was to use the transfer in order to perpetuate a fraud against Mr. Castleberry. -Dissent: The above standard (***) is far too broad. It allows judges to abuse the standard by piercing the corporate veil whenever the courts do not like the outcome.-Castleberry pleaded only the alter ego doctrine, and not the above standard, yet the jury considered both in making the decision.-Says could have recovered under trust fund theory or a theory of denuding the corporate assets. (however, this is wrong because Castleberry sold his shares and needs to have shares in order to assert these claims)-danger of allowing judges/jury to make these decisions regarding fairness?

V.T.C.A. Business Organizations Code § 21.223 states that 1) an intent to commit fraud, 2) perpetuation of that fraud, and 3) that the fraud was carried out for the direct benefit of that person must all be shown in order for the veil to be pierced. This is actual fraud, NOT constructive fraud. (Heightened standard) individual’s use of corpo-rate form to enrich himself at the expense of another (INTENT!!)

Piercing the corporate veil is always a question of fact examined on a case-by-case basis.

DeWitt Truck v. Flemming- -Factors looked at by court: undercapitalization, acting in individual capacity, no stockholders meet-ings, etc. -also: need to consider a “fundamental INJUSTICE” which would result from not piercing the corpo-rate veil---> looking for actions that clearly demonstrate inequity-”Proof of plain fraud is not a necessary element in a finding to disregard the corporate entity.” -focuses on assurance from Flemming that he would be responsible for the payments should the cor-poration fail to pay-look at substance of transaction: was it clearly done to avoid later having to pay?

h. What is the Effect of a Judgment?

• If P gets a judgment, it is not a creditor of D (bc D owes P $)

• If D doesn’t have enough $ to pay judgment, then P can pierce or reverse pierce to become a creditor

• If you Pierce D (person) and get his assets in company SH

• If you Pierce D (person) and get his other company Creditor (preference over SHs)

Reasons/Purpose for existence of a corporation: (Detailed ALI explanation. P. 18)1) making money (enhancing corporate profit and shareholder gain)

-how much?-for whom?

2) Philanthropic donations/charity in the interest of the public

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2.The Business Judgment Rule:

a.Business Judgment Rule: Fiduciaries are entitled to use their business judgment in good faith without conflict of interests to make decisions for the corporation; even if the direc-tors are wrong, the SHs will not have action against them unless they have acted in bad faith or there is a conflict of interest

b.Business judgment rule : A legal principle that makes officers, directors, managers, and other agents of a corporation immune from liability to the corporation for loss incurred in corporate transactions that are within their authority and power to make when sufficient evidence demon-strates that the transactions were made in good faith.

*** “The business judgment rule is a presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.” See test on p. 98

Dodge v. Ford Motor Co., 204 Mich. 459 (1919)

Facts: Ford’s business was booming, but Ford “altruistically” decided to reinvest profits in the corp. (and not pay dividends) to lower the price of the cars drastically. Ford claimed even though this would affect short-term profits for the corp, this was the right thing for the corp. and SHs should be happy w/the mas-sive dividends they’ve already received. Stockholder complaining because he is no longer receiving special divi-dends. Ford says he is doing this in the interest of the public, but the court doesn’t accept this.

Holding: Ps were entitled to a larger dividend, but the court’s won’t interfere with business decisions un-less there is fraud or misappropriation, OR an arbitrary decision or an abuse of discretion. Here, Ford mis-understood that the purpose of a Corp. was to make money, not to be a charitable organization.

Rule: Directors and officers (fiduciaries of the corp., high-end execs) are entitled to use their business judgment so long as they do so with due care (and in the best interest of the SHs) and if they make the wrong decision, the SHs will not have any action against the fiduciaries so long as they acted in good faith, and without conflict of interest. -”A business corporation is organized and carried on primarily for the profit of the stockholders. The powers of the directors are to be employed for that end. The discretion of directors is to be exer-cised in the choice of means to attain that end, and does not extend to a change in the end itself, to the reduction of prof-its, or to the non-distribution of profits among stockholders in order to devote them to other purposes.”

-Thus, plaintiff was able to recover.

c.Notes on Business Judgment Rule:

• The business of a corporation is to make money

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• The board of directors has a lot of discretion and the Business Judgment Rule will protect directors from liability for their bad decisions;

• The protection only goes so far corporations must aim to serve the shareholders

• Courts won’t interfere with business decisions w/o fraud, misappropriation, or arbi-trariness, BUT courts will intervene in extreme circumstances.

A.P. Smith Mfg. Co. v. Barlow, 13 N.J. 145 (1953)

Facts: One SH questioned a donation made by A.P. Smith to Princeton University. Stockholder complaining over contributions to Princeton University. Discusses shift from individual donations to cor-porate donations which arose from the growth of corporations. Discusses all positive benefits which arise from such donations Court sustains validity of donation by plaintiff.

Holding: Corps can make contributions so long as they are: (1) reasonable in amount and (3) not a pet charity. Here, the gift was valid.

Rule: Corporate gift-giving is an allowable method of increasing goodwill, but the gift should be less than 1% of capital and surplus and directed to an institution owning no more than 10% of company stock.

d.Notes on Corporate Gift-Giving

• Corps were originally designed to have public and private functions

• Common law developed allowing Corps to make donations that would not directly benefit the corp

• Congress & State Leg have enacted statutes supporting corp’s public giving – bc they have both social and private obligations, this type of giving would be bc of ben-efit to the corp (gain from upholding social obligations).

• NJ enacted a retroactive statute allowing corps to make certain charitable donations

e.The Objective and Conduct of Corporation Analysis and Recommendation (P.18)

• (a) A corp should have as its objective, the conduct of business activities with a view to enhancing corporate profit and SH gain

• (b) Even if corp. profit and SH gain are not thereby enhanced, the corp, in the con-duct of its business:

o Is obliged – like any natural person – to act w/in the confines of the law

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o May take into account ethical considerations reasonably regarded as appropriate to reasonable conduct of business; and

o May devote a reasonable amount of resources to public welfare, humanitarian, educational, and philanthropic purposes

Steinway v. Steinway & Sons (NY 1896)

Facts: Steinway cared about their workers and believed continuity was important for making quality pianos. They bought land in Queens for a new factory and built residences for their work-ers and amenities including a school, church, and public baths. (bc they took great care of their workers, there was little strife or threat of strikes). One Son challenged that the Charter did not permit this land purchase and development, and even if it did, such development for workers’ residence was beyond what the corp and its employees needed (complaints about waste, not fraud or bad faith). Company invests in its own employees by providing them homes, church, school, free li-brary, free bath, etc. Court says it is a question in each case of the logical relation of the act to the corporate purpose expressed in the charter.

Holding: Corp is free to purchase land and develop it for workers’ use bc it is logically related to the corporate purpose, but corp must get rid of land they haven’t used yet (ultra vires – outside the scope of the corp’s business to hold land). Every part of these expenditures was directly related to the le-gitimate objects of the corporation.

Rule: If an act is lawful and not otherwise prohibited, is done for the purpose of serving corpo-rate ends, and is reasonably tributary to the promotion of those ends, in a substantial and not re-mote sense, it may be fairly considered within corporate powers. In looking at these, it considers both the reasonableness of the accommodations as well as the profitability of the company in providing them.

f.Notes

• If there is a nexus between “charitable” and “business purpose BJR applies:

o Fiduciaries, acting in good faith and without conflict reasonably believe moving to Queens and constructing worker community will increase profits

• The fiduciary / corp takes other stakeholders – the labor force – into account

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Simons v. Cogan (Del. 1988)

Issue: whether the directors of the issuing corporation owe a fiduciary duty to the holders of convertible deben-turesFacts: Simons (P), a holder of convertible subordinated debentures in Knoll Corp. filed a class

action suit against Cogan (D), controlling SH, for breach of fiduciary duty to debenture hold-ers. convertible debenture: A type of loan issued by a company that can be converted into stock by the holder and, under certain circumstances, the issuer of the bond. By adding the convertibility option the is-suer pays a lower interest rate on the loan compared to if there was no option to convert. These instru-ments are used by companies to obtain the capital they need to grow or maintain the business. Case law indicates that a convertible debenture is a bond and not an equity security until conversion occurs. A convertible debenture represents a contractual entitlement to the repayment of a debt and does not represent an equitable interest in the issuing corporation necessary for the imposition of a trust relationship with concomitant fiduciary duties.

Holding: Issuing corps do NOT owe a fiduciary duty to debenture holders (creditors). Until the debenture is converted into stock, the debenture holder does not have an equitable interest supporting fiduciary duty. A mere expectancy interest does not create a fiduciary relationship. Before a fiduciary duty arises, an existing property right or equitable interest supporting such a duty must exist. Until the debenture is converted into stock its holder acquires no equi-table interest. Simon cannot recover.

Rule: A mere expectancy does NOT create a fiduciary relationship.

Note: A debenture holder may have a different cause of action against the corporation under State Law (ie Contract Law)

Jedwab v. MGM Grand Hotels, Inc 509 A.2d 584 (Del. Ch. 1986)

Facts: Jedwab (P) objects to a merger claiming that it unfairly favors the corp’s common stock. P claims MGM violated fiduciary duties and that under the common law, preferred SHs are owed same fiduciary rights as other SHs except as modified by K. Plaintiff claims she, as a preferred stock holder, is getting a bad deal upon a merger with Bally Mfg. Co. since after the merger, all stockhold-ers would receive the same treatment.

Holding: P, as a preferred SH, had fiduciary rights including the right to (1) a “fair allocation” of merger proceeds, (2) have the Ds exercise appropriate care in negotiating the merger and (3) to be free of overreaching by Mr. Kerkorian. And such rights should not be evaluated wholly from the contractual terms of the preferred stock designation. -In the absence of an express pro-vision creating preferential rights and special limitations, the rights of the preferred stockholders would de-fault to the same rights of common stockholders. Basically, a fiduciary duty is not owed if it has not been negotiated.Court says that these fiduciary duties cannot be evaluated wholly from the contractual terms of the preferred stock designations. Court holds plaintiff is owed a fiduciary duty.

Rule: Preferred SHs are owed some fiduciary duties which may go beyond those listed in the contract.

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g. Managerialism vs. Shareholder Valuism: The New Business “Ethic”

• Managerialism: The notion that corporations were run by their managers, without significant if any interference by their SHs except for the relatively rare circum-stances. The application of managerial techniques to businesses

o Satisficing: making sufficient profits to enable the corporation to continue to grow and to provide a reasonably return on capital sufficient to allow them to re-main in office

o Empire Building: Creating large Conglomerates

• Shareholder Valuism: Idea that the purpose of the corporation and its manage-ment was to achieve the highest stock price possible for the SHs. Business term which implies that the ultimate measure of a company's success is the extent to which it enriches shareholders.

h.Preferred Stock

• Equity Security – allowed to participate in the profits of the corp by dividends or dis-solution

o Paid before common stock, but after all prior claimants (creditors) have been paid

o Entitled to Preferred dividends (usually a set amount / par value)

o Entitled to liquidation preferences before common SHs

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C. FIDUCIARY OBLIGATIONS

a.What duties does the board, and its members have? What is the duty of care? Who owes it to the corporation? Are the directors/officers trustees of the corporation? What is the role of the executive in managing corporate affairs? What should it be?

2.Duty of Care

a.Duty of Care: Requirement that Corporate Directors use the care that a reasonably pru-dent person would use to make a decision seems like a regular negligence standard until Van Gorkem case (see below); may require fiduciaries to be well-informed in making deci-sions

Kamin v. American Express Company 86 Misc.2d 809 (1st Dept. 1976)

Facts: AmEx issued a dividend from a wholly owned company instead of selling them for a loss. P’s sued bc they thought the loss would have been more beneficial for tax reasons and that the minority of interested directors were acting to protect their corporation.

Holding: There was no self-dealing, derivative decisions are made at the discretion of the board of directors and outside the scrutiny of the court.

Rule: Business Judgment Rule applies bc Board acted in good faith and w/o conflict of interests.

b.Three types of dividends:

• Dividend: Share of profits from previous year, divided pro rata

• Stock Dividend: New stocks given to existing holders in proportion to their holdings

• Property Dividend: Distribute property of corporation (Seagram’s gives out whiskey – property dividend)

c.Why Boards need BJR Protection

• fewer ppl would be willing to serve on boards

• boards would take less risks w/o it

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d.Theories of how boards work:

• Shared trust and acquisition of social capital

• Structural holes: breaks in flow of information

o Outside directors can be a good thing but are more prone to be outside the loop

o Information flow is skewed towards insiders and can be manipulated by them!

• Structural bias: Boards tend to be rich, white males with similar backgrounds and interests; they will seek to avoid conflict, will breed insider loyalty, and will result in less free discourse and challenge

Francis v. United Jersey Bank (NJ 1981)

Facts: Family owned closely held corporation operating as a reinsurance broker that held funds for other insurance companies to diversify their risk. Industry practice required segregation of those funds. Pritchard sons ran the business. They comingled funds and personally bor-rowed from those funds w/o repaying (ie stole). Their mother was the director but was an unin-volved drunk. She was sued by the trustee in bankruptcy for breach of her duty of care.

Holding: Mrs. Pritchard breached her duty of care by nonfeasance – negligently failing to pre-vent this harm. Given Mrs. Pritchard’s total lack of involvement and failure to monitor the mangers, it was easy to find her negligent for nonfeasance.

Directors’ Role:

· some understanding of the business (know the basics)

· be kept informed on activities,

· perform general monitoring (attend and participate meetings)

· have some familiarity w/the financial status of the business (read and understand docs / financial info)

· *IF you see bad behavior – object, resign, seek counsel, threaten suit, blow the whistle – as necessary!

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e.CAUSATION REQUIREMENT:

• Even with a finding of negligence, there may still be a requirement of causation, which links the negligence with the losses.

• Prof. Diamond thinks the Court didn’t have to do this because bankruptcy proceed-ings offer alternative methods for seeking redress.

o Trustee is protecting the creditor.

o One asset the corp. has: a claim against Mrs. P.

o Trustee can bring suit on behalf of the corp. against Mrs. P, rather than on behalf of third-party creditors this wouldn’t implicate the limited liability problem!

f.QUESTION: How does Ms. Pritchard’s personal liability to 3rd parties comport with the con-cept of limited liability?

• **Ordinarily, in the absence of veil-piercing, third party creditors are unable to ob-tain relief from the director or insider of a corporation because they have limited lia-bility.

• **This decision muddies the waters of limited liability and is not really followed but is distinguished on industry basis.

• Reinsurance industry is special: it requires great trust and integrity, and insurance cos. are entitled to rely on their reinsurance brokers.

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Smith v. Van Gorkom (Del. 1985)

Facts: Van Gorkom was Chairman and CEO of Trans Union (TU). He was close to mandatory re-tirement age and wanted to increase the value of his 75,000 shares while he could still sell out. TU’s market price was $38. VG asked CEO how much debt TU’s cash flow could support in a leveraged buy out, CFO said $50, prob not $60. VG contacted Priztker w/o consulting the board of directors and suggested that Pritzker buy the company for $55 / share. Pritzker agreed to the price, which was 40% higher than market price, w/conditions bc he knew TU was worth more than $55/share. VG said nothing to the board or Managers about the deal, he was not authorized to do this.

VG calls a meeting of board of directors, they had no prior notice of Pritzker deal. VG presented the offer to Management who strongly opposed the deal bc timing was wrong and the calculation was off. THEN VG presented to the board (5 inside (employee) directors and 5 outside directors during a 2-hour meeting. The Board voted to approve the deal after hearing VG’s 20 min presen-tation and receiving limited advice from the financial officers. They did NOT hear that the price was fair from an I-Bank that the price was fair. They assumed they could accept a higher price that came along and they did NOT read the merger documents in this initial approval to deter-mine if there was a “market test.”

In Board Meeting # 2: VG presents what he guesses modifications of deal will be w/o seeing them, Board approves w/o reviewing modifications. Lawsuit is filed as closing approaches. In Board Meeting #3: Board votes to Continue with Merger

SHs approve merger based on representation of “management” (really VG’s) approval. VG inter-feres to rebuke two other offers because he wants the deal to close NOW and Pritzker’s is a done deal. TU was priced at $55 bc VG wants it to move quickly, Pritzker knows its worth more.

Holding: The Board breached its duty of care in approving the deal and failing to ameliorate / stop it and was not entitled to deference under the BJR. The directors were grossly negligent in being uninformed on the intrinsic value of the company or VG’s role in forcing the sale and es-tablishing the price and approving the sale after 2 hours without prior notice or reason to act so swiftly.

· (1) The Board’s decision at Meeting #1 to approve the proposed cash-out merger was not the product of an informed business judgment;

· (2) The Board’s subsequent efforts to amend the Merger Agreement and take other cura-tive actions were ineffectual, legally and factually; and

· (3) The Board did not deal with the complete candor with the stockholders by failing to dis-

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close all the material facts, which they knew or should have known, before securing the stockholders’ approval of the merger.

Dissent: This is a business judgment decision and the Board did not act in bad faith or w/con-flict. TU operates on the business fast-track: deals happen fast. Bd. has a good sense of the corp.’s value and can recognize a good deal. Collectively, they have a huge amount of experi-ence and don’t need to see all docs. This is an objectively good deal: getting $55 instead of $38.5! Plus, Directors should have limited liability!

g.Smith v. Van Gorkom

• Do you think the board breached its duty? Which duty?

o **Radical result! Before this time, only Mrs. Pritchard – who knew nothing! – was held liable (see above); here, the Board members knew a lot, but were still found liable.

Board didn’t read documents, asked no questions, and made decisions fast.

Although Board is entitled to rely on VG’s representations, they also know that VG is about to retire and know he might have other motives.

Structural bias issue? Board could have asked more Qs, but they trust VG!

o Ultimately, court decides that there is a bare minimum of what a Board must do to inform itself in order to make a business judgment that will not be impugned.

• Post-Van Gorkom

o Many states passed statutes that allow corporations to include a provision in their charter that eliminates all personal liability of directors, except in case of breach of loyalty or lack of good faith, essentially eliminating the duty of care for directors.

o It is possible that the Board and VG could have been liable for a breach of loyalty they put VG’s interests above the shareholders’ interests.

h.Suits Against Corporations

• Direct Suit

o Individual

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o Class Action

• Derivative Suit

o If corp suffers a loss and SHs suffer as a result, SHs can bring a suit against fidu-ciaries on behalf of the corp.

o SHs rights are derivative of the corp’s rights

o Any recovery goes to the corporation pro rata value of shares may go up

o Problem: Suit cost $ for Corp. if one SH tries to make trouble, it might be better to settle

Strike Suits : SH looks for abnormalities, buys stock, sues, gets paid off.

FRCPs put an end to this but it was a big industry in the 1920s

i.Demise of Duty of Care

• Duty of Care cases are rarely successful

o If claims involves malfeasance BJR limits judicial inquiry into decision-making process

• Demand Required

o Directors can prevent litigation if P’s are required to make a demand on the board and a majority of disinterested directors conclude that the litigation is not in the best interest of the corp.

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In re Caremark International Inc. Derivative Litigation (Del. Ch. 1996)

Facts: Caremark provided healthcare services and was reimbursed by Medicare/Medicaid. Care-mark paid doctors “consulting / research fees” in violation of statute’s anti-kickback regulations. Caremark knew their practices were questionable, but counsel told them they were okay. Care-mark implemented risk management strategies and settled a Federal investigation for $250M. SHs brought a derivative suit claiming Bd breached its duty of care via inaction failure to pre-vent this behavior and loss – and that settlement was unfair.

Holding: Board did NOT breach its duty of care & the settlement agreement is fair. Board acted reasonably and made business judgments. There was no evidence of lack of good faith or a knowing violation of the law. The board has no burden to “ferret out” wrongdoing that it has no reason to believe exists. Settlement is reasonable bc even though P is unlikely to succeed, the burden imposed by the settlement is not onerous (esp. bc corp. has taken most actions already).

Rule: Directors cannot be held liable just because employees have done something wrong. There needs to be a sustained or systematic failure to exercise oversight such as an utter failure to attempt to assure a reasonable information and reporting system exists.

• Even if there is no reason to suspect a lack of compliance, some monitoring system must be in place in order to satisfy the obligation that directors need to be informed for both le-gal compliance and decision-making.

j.What changes does Caremark make to the duty of care? After Caremark, how would you ad-vise a board of a large de-centralized corporation to behave? Is the model workable? If not, can you propose a more effective one?

• Prior to Van Gorkom, theory of corporate duty had declined:

o Standard was “gross negligence”

o It was not a question of judgment: so long as Bd’s decision was made in good faith, and w/o conflict of interest, and using a reasonable process (rea-sonable intent to be informed), the BUSINESS JUDGMENT RULE protected direc-tors.

o Van Gorkom – EXTREME CASE bc Board did nothing – easy to distinguish

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• Cutting back the Duty of Care

o Exculpation statutes: allow corps to exculpate directors for liability (except if there is a conflict)

o Indemnification provisions: Corp. can indemnify directors

o Director and Officer (D & O) Insurance: Can be bought to protect directors

Duty of Care is less Important

Does this mean there is less incentive for directors to behave well

1.The Duty Of Loyalty

a.Duty of Loyalty: This is, perhaps, the most significant of the directorial duties. What, ex-actly, is the duty? How does it differ from the duty of care? Is it a realistic imposition on directors in publicly traded corporations? Should such directors be subject to it? Why?

b. Duty of Loyalty: In any situation where the personal interests of the fiduciary conflict with the interests of the corporation, the fiduciary must put the corporate interests first.

• Three types:

o (1) Self-Dealing: fiduciary deals directly w/corp. (not necessarily wrong, but raises Questions

o (2) Interlocking Directorates: Director of 2 corps that deal with each other

o (3) Corporate Opportunity Doctrine: Fiduciary competes with his corp for an opportunity that would benefit them both.

• If there is a conflict of interest (loyalty), the Business Judgment Rule does NOT apply.

o Business Judgment Rule is based on a presumption of no conflict and due care (or reasonable effort to inform oneself) courts will defer to directors.

o If there is a conflict no presumption, NO deference!

o Then, court applies the TEST:

Was the transaction inherently fair to the corporation at the time it was made?

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Fiduciary has the burden of proof to show fairness.

• FIDUCIARIES MUST ACT IN THE BEST INTEREST OF THE CORPORATION

c.Distinguished from Duty of Care

• Duty of Loyalty Seeks to prevent directors from acting against the best interest of the corporation or self-dealing in such a way as to reap a personal benefit unavail-able to other SHs.

• Duty of Care involves poor decision-making or lack of attention, but NO PERSONAL BENEFIT

2.Self-Dealing Conflict

a.Self-Dealing: Occurs when the fiduciary is on both sides of the transaction and in a position to receive a benefit unavailable to other SHs or the corporation generally. (Raises the specter of corruption and personal profit at the expense of the SHs.)

• Duty of Complete Candor

o If the duty of loyalty in a conflict of interest applies

The burden of proof shifts to the directors

There is greater judicial scrutiny of both the fairness of the process and the substance of the transaction (“entire fairness”).

• When personal benefits are at stake, a director’s incentives and motivations for a transaction changes

o Self-dealers see to avoid disclosure and detection

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Meinhard v. Salmon (NY 1928) (J. Cardozo) [Joint venture, but often cited for corps.]

Facts: L. Gerry leased property on 5th Ave. / 42nd St. in NYC to Salmon (S) (RE developer) and Meinhard (M) (wool developer and factor—lends $ outside of banks) for 20 yrs. M puts up the $, S manages the bldg. Gerry wants to develop nearby land and negotiates a new lease with S: 20 yrs renewable to 80, rent increase, expansion plans for the whole site. S doesn’t tell M, M finds out, wants in, and when S refuses, M sues.

Holding: Salmon breached the duty of loyalty. Secrecy was the problem bc S went behind M’s back and did not provide notice of the new deal. If M knew about the contract, he would have had an opportunity to compete, release property w/Salmon, try to continue business as-is… but S didn’t tell him. S could have waited until after lease expired to contract, then no problem. BUT, because the deal happened before the lease ended, S still owed M the duty of loyalty of a joint adventurer and a managing person.

Rule: Joint-adventurers / partners / directors owe each other a fiduciary duty of loyalty of the ut-most good faith and fair dealing.

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Bayer v. Beran (NY SC 1944)

Facts: Corp contracted for an advertising spot where Pres’s wife and director of the corp would benefit by performing. The court said the decision to advertise was reasonable, but the wife’s participation raised conflict of interest issues that precluded BJR deference and required closer scrutiny.

Holding: The transaction was fair when it was made – no breach of duty of loyalty. Wife con-sulted on program, was paid less than some other singers, not featured, K negotiated by agent. Also, Pres is a 10% - he might be willing to pay something to help his wife’s career by probably not $1M of the company’s funds.

Rule: Conflict itself isn’t impermissible it just changes the test that applies to the transaction.

Note: Board put itself in a bad position – made decisions through individual conferences, not a board meeting. This is how decisions are often made, but it encourages structural bias and may lead to a dominant person overpowering the group bc no one wants to say no one-on-one! Bd could have chosen someone else, they created this bad appearance.

b.Self-Dealing Circumstances

• Officer or director may sell personal property to the corporation or buy corporate property

• Fiduciary’s corp. contracts with another corp. or business entity in which the fidu-ciary has a significant financial interest.

• Interlocking Directorates

c.Entire Fairness: Requirements for Avoiding Self-Dealing

• Full Disclosure & Approval by either disinterested directors or shareholders

• Fair Contract

• Burden of Proof on the fiduciary

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d.If Self-Dealing is Found

• The usual remedy: restitutionary in nature with rescission of the unfair contract or seeking the gains made by the fiduciary.

• Alternative remedy: “Broad, discretionary and equitable remedies”

e.Issues to keep in mind

• (1) What are the legal procedural requirements in terms of voting, quorum, and dis-closure?

• (2) How does compliance with those requirements affect the level of judicial scru-tiny applied to the transaction (business judgment rule, fairness, waste, or some other test) or the burden of proof?

• (3) If there is a failure in the procedure, does that void the contract or have some other effect, such as increasing the level of judicial scrutiny or shifting the burden of proof.

3.The Corporate Opportunity Doctrine

a.The Corporate Opportunity Doctrine: What is the Corporate Opportunity Doctrine? How does it differ from other forms of the duty of loyalty? What factors are considered in de-termining its applicability? Which opportunities may be designated as “corporate” oppor-tunities?

b.Corporate Opportunity Tests

• (1) Interest Test

• (2) Line of Business Test

• (3) The Fairness Test

c.INTEREST TEST

• Interest or expectancy test focuses on circumstances that indicate that the corp. had a special or unique interest in the opportunity.

o EX. If the corp. had been negotiating to acquire the opportunity or the corp. needed the particular investment, but the fiduciary ended up taking the opportu-nity.

• TEST: look at corp’s specific or unique interest in the investment.

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d.LINE OF BUSINESS TEST

• Broader than interest test – also factually sensitive

• TEST applies IF opportunity embraces: “an activity as to which [the corporation] has fundamental knowledge, practical experience and ability to pursue, which, logically and naturally is adaptable to its business having regard for its financial position and is one that is consonant with its reasonable needs and aspirations for expansion.”

• Focus: how closely related the opportunity is to the existing business.

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Broz v. Cellular Information Systems, Inc. (Del. 1996)

Facts: Broz was Pres and Sole SH of RFBC. He was also a board member for CIS which was a competitor of RFBC. CIS had recently emerged from Bankruptcy and was actively divesting it-self of licenses. Broz received an opportunity to purchase a license, CIS was not presented with the opportunity, CIS had no $ and could not make purchases w/o permission from credi-tors. Broz informed CIS’s CEO, Counsel and other officers about his interest in the license; all expressed no interest in the license on CIS’s behalf.

Pricell was also interested in the license. It had no connection to Broz, but was trying to buy CIS. Pricell purchased an option on the license; no one else could buy unless $500K more. Broz outbid Pricell by $500K and acquired MI license. Pricell immediately removed old CIS Board. New CIS Board sued Broz for impermissible usurpation of a corporate opportunity allegedly belonging to CIS.

Holding: Broz did NOT violate the duty of loyalty. Broz had no obligation to consider Pricell’s in-terest in his behavior. Broz did not misappropriate a corporate opportunity (as compared w/CIS) because:

(1) Broz received the opportunity individually not as an officer of corp.;

(2) CIS was not financially capable of taking opportunity at time Broz purchased license;

(3) Opportunity was in CIS’s line of business, however;

(4) CIS had no expectation or interest in license (in fact, demonstrated disinterest!);

(5) Opportunity likely would not benefit CIS

(6) Broz created no conflict of interest by buying license (CIS knew he was competitor);

NOTE: The test would come out differently if Pricell had completed CIS deal before Broz made his purchase and kept Broz on as a director. Broz was not required to formally present the oppor-tunity to the Board. In fact, he was not required to divulge at all b/c it was not a corporate op-portunity! If it had been an opportunity, he would have been required to divulge. Relation-ship btwn. CIS and Pricell was speculative until tender offer closed – 9 days after license. Re-quiring Broz to consider Pricell and its potential plans would be too great a burden on outside directors. We want outside directors to be able to take corp. actions outside their director-ship. Broz did not breach his fiduciary duties to CIS.

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e.CORPORATE OPPORTUNITY DOCTRINE:

• A corporate officer or director may NOT take a business opportunity for his own if:

o (1) he receives opportunity in corporate capacity, rather than in his individ-ual capacity*

o (2) the corporation is financially able to exploit the opportunity;

o (3) the opportunity is within the corporation’s line of business;

o (4) the corporation has an interest or expectancy in the opportunity;

o (5) the opportunity would benefit the corporation; and

o (6) by taking the opportunity for his own, the corp fiduciary will be placed in a conflicting position.

• These are “Totality of the Circumstances” Tests no factor is dispositive

o *Except if Fiduciary received opportunity in his corporate role then automatic corp opportunity

f.Problem of Interlocking Directorates

• If there is a corp. opportunity for both corporations, director must offer the opportu-nity to both boards

o How far does the duty extend? Beyond just disclosure

Meinhard : disclosure and allow to compete

Must subsume personal interest to corporate interest

o Why would a director of one corp. agree to be on board of a competitor?

Builds network and info base

Might help a newer corp. get started

But creates a dilemma that he has no way to escape!

o Can director escape by resigning?

Only if he resigns before taking the opportunity and after disclosure no way out of disclosure!

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Energy Resources Corp., Inc. (ERCO) v. Porter (Mass. App. Ct. 1992)

Facts: Porter and 2 Howard Profs were applying for a fed. DOE grant for minority institutions. Porter brought opportunity to ERCO, Howard U would be lead, ERCO would be subcontractor. Howard U wanted a black-led subcontractor and asked Porter to start his own Co. Porter agreed and they removed ERCO w/o telling them why. When Howard U and Porter’s co was awarded K, Porter quit ERCO (stayed on as advisor). When ERCO discovered why Porter left, they sued.

Holding: Porter breached duty of loyalty. Porter did NOT disclose, used ERCO resources to de-velop project, resigned after signing on to new project w/new co. Porter owed ERCO a chance to compete, a chance to test Howard prof’s resolve to use black corp., and could have cre-ated a subsidiary w/ERCO as minority SH and Porter as a Majority SH

**Echoes Meinhard, Porter should have given ERCO a chance (notice)

Corp. Opportunity Test:

(1)ERCO was financially capable

(2)In the same line of business as project

(3)Had interest and expectancy in the deal

(4)Project would benefit them

(5)Porter’s seizure of opportunity created a conflict

Remedy: Constructive Trust placed on Porter’s interest in new venture – ERCO received benefits of the deal, Porter’s salary, etc.

D. DERIVATIVE LITIGATION

a.Two types of suits by SHs against their corps:

• Direct suits – where the SH has been injured personally and directly by corporate action.

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• Derivative suits – where the injury to the SH is indirect, derived through injury to the corporation and is shared pro rata by all shareholders.

Allows SH to “step into the shoes” of the corp and seek restitution corp can-not demand on its own

If the allegation is that mismanagement or self-dealing resulted in a decline in value of one’s shares, the action is always derivative.

o 2 Actions:

(1) SH sues corp to compel corp to sue on its own behalf (shareholder’s suit)

(2) corp. sues fiduciaries under control of SH and his counsel (corporation’s suit)

o Recovery foes to Corp.

Small SHs have little incentive to sue

Unless corp decides to settle w/ individual SHs lead to strike suits

o History:

Pre-derivative suit, it was very difficult for SHs to sue

Derivative suit developed as an equitable device

Strike Suit: people exploited derivative suit for personal gain

FRCP 23.1 (and state equivalents): required settlement to be approved by court (Caremark)

“Security for cost” legislation: In derivative suit brought by a SH w/less than $50K of stock, SH may be required to provide security (bond) for litigation costs.

Creates large liability for P if P loses makes suits less appealing

b.Demand Required

• SH’s right to bring suit does NOT ripen until he has made a demand on the corp. which has been met with a refusal by the corp to assert its causes of action.

• SH’s right to litigate is secondary to corporate right only for as long as the corp has not decided to refuse to bring suit.

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• Once the corp refuses or impliedly refuses to assert an apparently valid claim, in-volving breach of fiduciary duty by the directors, SH is vested with a primary and independent right to redress the wrong by bringing a derivative suit.

Eisenberg v. The Flying Tiger Line, Inc. (2d Cir. 1971)

Facts: Eisenberg, a minority SH, sued on behalf of himself and all similarly situated SHs to enjoin the effectuation of a plan of reorganization and merger that he alleges dilute or deprive him of his voting rights. Court requires that Eisenberg comply w/NY statute requiring a plaintiff suing derivatively on behalf of a corp. to post security for the corporation’s costs ($35,000). Eisenberg refused; Court dismissed the suit, Eisenberg appealed.

Holding: Eisenberg’s cause of action is personal and not derivative w/in the meaning of the statute. “The reorganization deprived him and other minority SHs of any voice in the affairs of their previously existing operating company.” The injury was direct and not derivative: no bond or other security for costs could be required.

• Gordon v. Elliman – Old Test: whether the object of the lawsuit is to recover upon a chose in action belonging to the SHs directly or whether it is to compel the performance of corporate acts which good faith requires the directors to take in order to perform a duty which they owe to the corp, and through it, to the SHs.

• *Trial Courts have discretion

o If both direct and derivative claims will lie, the choice is the Plaintiff’s.

c.FRCP 23.1

• Can’t buy shares to join a derivative suit (must have been a shareholder at the time of the wrongdoing)

• Typically have to ask the directors to bring the suit on behalf of the corporation

• Must represent interests of the shareholders

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d.Security for Expenses

Baker v. MacFadden Publications, Inc. (N.Y. 1950)

Holding: SHs can aggregate to meet 5% or $50K threshold of stock ownership to exceed secu-rity for expenses requirement. SHs should be able to get the corp.’s stock book so that they can contact other SHs to join their action.

Rule: Small shareholders may aggregate their holdings to avoid paying security for costs

3.Demand Refusal, Demand Excused, and Special Committees in Derivative Litigation

a.Demand Requirements

• (1) Relieve courts from deciding internal matters and gives directors opportunity to correct alleged abuses

• (2) Provide Corporate Boards with reasonable protection from harassment by litiga-tion on matters clearly within the discretion of the directors, and

• (3) Discourage “strike suits” commenced by SHs for personal fain rather than the corp’s benefit

• Standard:

o Whether the board has validly exercised its business judgment must be evalu-ated by determining whether the directors exercised procedural (informal deci-sions) and substantive (terms of the transaction) due care.

b.Demand Refusal

• Board ”rejects” demand after due deliberation, preceded by an investigation of the facts

• May be refused bc the board concluded the law was not violated OR bc pursuing the litigation would not be in the corp’s best interest upon refusal, Bd notifies SH.

• If rejection is wrongful SH can still file a law suit:

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o Procedural decision-making process

If the procedure is defective in rejecting the demand, the Plaintiff can pursue the suit, but Plaintiff MUST show that the procedure with which the board made the second decision was wrongful

BUT there is a presumption of business judgment Bd will move for dis-missal / sum. Judgment

o This applies to a DEMAND REQUIRED CASE

FIRST: the board used reasonable procedures,

SECOND: the board was dominated or did NOT use reasonable procedures.

• DE law under Spiegel makes any future suit by the SH futile by consulting with the board (making demand) the SH has conceded that the board is capable of making this decision (then BJR applies).

Marx v. Akers (N.Y. 1996)Facts: Marx did not make a demand on the board, but brought suit himself claiming the Ds engaged in self-dealing bc 15 outside directors of the 18 member board awarded themselves excessive compensation.

DE Demand Rule: P has to allege facts that create a reasonable doubt that the board was NOT independent and did NOT use due care. (This is too subjective – reasonable doubt is a crim standard – not appropriate for a civil case)

Universal Demand Rule: Everyone needs to make a demand with a few exceptions (statistics are overwhelming that the board will decline to bring suit)

New York Rule: A demand would be futile if a complaint alleges with particularity that· (1) A majority of the directors are interested in the transaction

· (2) The directors failed to inform themselves to a degree reasonably necessary about the transaction

· (3) The directors failed to exercise their business judgment in approving the transaction

Holding: Demand was excused by the Defendant Directors have an interest in their own compensation. However, case was dis-missed for failure to state a claim bc P did not state with particularity what accounting decision or other facts establish excessiveness of compensation.

c.Demand Excused.

• *Always a demand excused case for compensation, but not always a viable claim.

• Self-dealing is not in itself impermissible.

o Burden shifts to fiduciary to prove transaction is okay.

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o Standard shifts from business judgment to entire fairness

o Ps must show enough to shift the burden

Auerback v. Bennett (NY 1979)

Facts: After a corporate audit found that Board was paying bribes to foreign officials, two SHs brought a derivative suit against them. A special committee of disinterested members ap-pointed by the Board refused to support the action. Because of the wrongdoing, demand was EXCUSED.

Holding: Once the special committee was deemed impartial and disinterested, their decision is entitled to BJR deference.

Rule: A party may challenge the independence of a special committee, but once it is deemed in-dependent and disinterested, the committee’s decisions are entitled to deference under the Business Judgment Rule.

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Zapata Corporation v. Malfonado (Del. 1981)

Facts: SH filed derivative action against the officers and directors for a breach of fiduciary duty without making Demand first. Defendant Corp appointed an “independent committee” of two di-rectors not named in the initial suit. The committee moved to dismiss the suit citing that it was not in the corp’s best interest.

Holding: There is an absolute right to initiate the suit in “demand excused” cases, but not to maintain the suit.

Rule: (1) The Defendant Corp has the burden to prove the Committee is (a) independence and (b) exercising good faith and reasonable investigation. (2) The Court should apply their indepen-dent business judgment in determining whether the suit should be taken on.

*Even though there might be independence and reasonable investigation, the court will allow the case to continue if it believe a dismissal will not comport with justice. Because of the problem of structural bias, Courts cannot be sure of board’s complete independence (creates problems of ju-dicial economy).

d.For both “demand excused” and “demand refused” BJR is the standard of deference.

• If there is “taint” Business Judgment Rule does NOT apply

• Special committee only comes in when Demand is EXCUSED.

A. THE CLOSELY HELD CORPORATION

1.Sarbanes-Oxley; We will look briefly at the Sarbanes -Oxley Act

e.The Closely Held Corporation: What is a closely held corporation? How are they differ-ent from publicly traded corporations? Should the same rules apply to each type? If not, what rules and/or devices should be changed to accommodate closely held corporations and their participants? What is the plight of minority shareholders in closely held corpora-tions? How can their rights be protected?

f.Sarbanes-Oxley act of 2002

• Designed to create more stringent requirements and penalties for Execs

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o Makes CEO, CFO, etc. responsible for knowing what’s going on, need to certify reports

• Discussion of making federal law for corporations

o Securities laws have federalized certain aspects of corporate law

g.Closely held corporation characteristics

• Small # of shareholders

• Many SHs knew each other before they created the corporation

• Typical CHC SH has a significant amount of personal wealth tied up in corporation

• NO READY MARKET for shares

1.MINORITY SHAREHOLDERS in a Closely Held Corporation

a.Exit Strategies:

• Minority partners in Partnerships Quit and take assets with

• Minority SHs in a Publicly-Traded Corp Sell Shares

• Minority SHs in a Closely-Held Corp ???

b. Possible forms of Oppression:

• Exclusion from Board (cannot participate in governance)

• Termination of Employment (or failure to employ / loss of salary or benefits)

• Failure of Board to appoint as Officer

• Failure to declare dividends (or disposal of profits in another way that does not ben-efit minority – e.g. to employees when minority SH is not employed by the corp)

c.Possible Remedies:

• Sell Shares difficult because no ready market for shares

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• Invoke fiduciary duties of board but courts give deference to boards and litigation is expensive

• Vote little power as minority

d.Possible Ways to protect minority Shareholders:

• Cumulative Voting and Classified Board

• Proxy Voting

• Voting Trust Arrangement

• Shareholders Agreement

2.Shareholder Voting and Control

a.SHs in CHCs generally play a larger role in operation and management of corporation

• Vote on same matters as Publicly Traded Corp:

o Election of directors

o Extraordinary events in the life of the corporation

Amendments on articles of incorporation

Mergers / Sale of substantially all the assets

Dissolution

• Usually 1 share = 1 vote (might differ)

b.Minority Self-Protection

• Classified Board:

o By dividing shares into classes and apportioning right to elect a certain number of directors to each class, article of incorporation can ensure at least some mi-nority representation on a Board

o Reduce effectiveness of cumulative voting

• Cumulative Voting:

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o SHs to cumulate votes and allocate them among some or all the candidates

Number of Shares is multiplied by the number of directors to be elected in particular election

• Ex. 100 shares x 3 directors to be elected = 300 votes

Created by Statute – some states: prohibit, permit, or require the practice

Only allowed for election of directors

o Formula: How many shares are necessary to elect a certain # of directors?

X = ((S x N) / (D +1)) +1

X = # of shares needed to elect a certain # of directors

S = Total # of shares to be voted at the meeting

N = Number of directors desired to be elected

D = Total # of directors to be elected

• Ex. If S = 100 total shares to be voted; N = 1 director desired to be elected, D = 3 total directors to be elected, then X = 26 shares neces-sary to elect 1 director.

o The larger the number of directors to be elected, the more closely cumulative voting will produce a ratio of majority/minority directors reflecting ratio of major-ity/minority SHs.

c.Agreements Among Shareholders

• (1) PROXY

o Document (form of proxy) whereby SH grants his right to vote on various corpo-rate matters to some agent (also called a Proxy)

Under State Law, proxies are typically revocable at the will of the proxy-giver

Typically expire by statute either after 11 mos or at the annual meeting

Irrevocable if coupled with interest (another legitimate interest or considera-tion in another transaction)

E.g. exchanged with a loan and irrevocable until the loan is expired.

Uses of Proxies:

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Way to gather votes of other SHs and vote more or less as a bloc

Quorum – Minimum number of shares required to be present at a meting

• If too few shares – can’t vote, if too many – difficult to vote

Used to support management initiatives – counters SH’s inertia

• (2) VOTING TRUST (method to pool votes to vote for a particular purpose)

o Device by which a SH may transfer the legal title (incl. voting rights) to his shares to a trustee who holds the shares in trust for the SHs beneficiaries.

Trustee holds title and is recognized by corp.; SHs hold Voting Trust Certifi-cates

Contract is very important! Tells trustee what to do re: dividends, etc.

Established by a written document filed w/state agency

Duration: Up to 10 years renewable (depending on state statute)

Uses:

Give benefits to children or employees w/o giving up control (estate tool)

Loan transaction: lender insists on trust control while corp. in distress

Multiple minority SHs to aggregate and lock in a majority position for 10 yrs

• (3) SHAREHOLDERS AGREEMENT

o Contracts between SHs to pool votes, establish relationships, and most impor-tantly provide an EXIT STRATEGY for minority SH!

o *Attorney MUST advise clients about SH agreements!

o Potential Provisions

Voting for board (each SH agrees to vote for each other or their nominees)

Requirement to confer prior to voting and to vote as minority decides

Methods for resolving disputes between SHs

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Share transfer restriction, usually w/ right of first refusal in corp and /or re-maining SHs

Employment and Compensation

Dividends

**EXIT STRATEGY: Buy-Sell agreements to provide greater liquidity and break deadlocks; allow minority SH to remove himself w/wealth intact!

Put Option – Minority SH can force Majority SH to buy his shares at a cer-tain price if certain circumstances occur

Drag-Along – If Majority SH wants to sell his shares to 3rd party, he must also offer to sell minority shares at same price!

• Suit for Dissolution – If you can show oppression, you might be able to get dissolution (risky)

Ringling Bros.-Barnum & Bailey Combined Shows, Inc. v. Ringling (1947)

Facts: Haley and Ringling (sisters-in-law) agreed to vote together and if they couldn’t agree, agreed to submit to Loos. Haley and Ringling couldn’t agree before meeting and meant to ask for adjournment, Haley didn’t ask for adjournment bc of something Ringling did, Loos tried to adjourn, Haley voted with North to continue the meeting. Loos recommended Haley and Rin-gling to vote 2.5 for themselves and each give a half to Dunn. Haley refuses and votes all his shares for himself and his wife.

Holding: SH agreement was valid buy improperly enforced by lower court. Agreement does NOT call for arbiter to serve as a proxy. If one party failed to vote accordingly, there is a breach of K issue only. Remedy: Breaching party no longer gets to vote. New Board: R wife, R son, Dunn, Wood, Griffin, and North

Note: Remedy does not give Rs benefit of the bargain, does ensure that they are not a minority (H and N could have ganged-up on R). H made a strategic mistake by 1) disobeying agree-ment, and 2) challenging the result. They would have been on the Board and could support Ns – either way, Rs would have been in the minority, even if they had Dunn!

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3.Fiduciary Duties Of Shareholders in Closely Held Corporation

a.What, if any duties do shareholders in CHCs owe each other? Is it possible for the majority to oppress the minority? What are the means by which abuses can be perpetrated?

• Fiduciary Duties

o Serve as aspirational goals and as requirements which may provide legal re-course for breach in both partnerships and corporations

o Legal recourse plays an especially important role in CHCs bc SHs have NO EXIT STRATEGY

o However, fiduciary duties in partnerships are stronger than in corporations

Ramos v. Estrada 8 Cal. App. 4th 1070 (1992)

Facts: Ramos had 50% of Broadcast Corp (BC), Estradas had 10%. BC merged with Ventura 41 (competitor) to create TV, inc. BC and Ventura 41 each had their own internal SH agreements. Estradas breached and voted w/ V41 to oust Ramos (Pres) and another BC member (Sec). BC SH Agreement also had a buy/sell provision to disincentivize any breach. Estrada breaches and chal-lenges agreement.

Holding: Agreement is valid and buy/sell provision is enforceable. This was a Contract, not a re-vocable proxy, with sufficient consideration mutual agreement to limit transfer of stock and ex-ercise control. The Penalty was not unconscionable bc there was NO improper process, Estrada is a sophisticated business woman.

Notes: SHs agreed to buy/sell to disincentivize breach. If there is a defection, others gain. SHs don’t think they will breach. Estrada should have (1) not breached, (2) looked for a potential buyer, (3) played nice, and (4) see if Ventura would elect her to the board anyway.

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Rosiny v. Schmidt (NY. App. Div. 1992)

Facts: McGuire (M), Schmidt (S), and Rosiny (R ) created Ched Corp. (real estate CHC) in 1957. R was M & S’s atty. Ched Ownership = R:20, S:10, M:10. 1957: SH agreement limited transfer of shares. If SH wanted to transfer shares, must first offer to other SHs for book value or $100/share. 1964: R transfers shares to wife, new SH agreement based on market value. 1971: S dies, R transfers his stock to S’s wife, Priddy (P), new SH agreement, back to book value. 1981: R wife gives shares to son, new SH agreement same terms at book value. 1987: Potential buyer wanted to purchase Ched premises for $1.25M. P & M considered sale, but never made a move, then died before cashing out or dissolving. R sons make a claim to buy P & M stock at book value or $200/share (market value is $42K/share). P & M heirs refuse to sell.

Holding: R’s win, SH Agreement is valid and enforceable. SH conduct did not abrogate Agree-ment. SH Conduct did not ignore Agreement bc w/ each transfer, new Agreement was signed. Enforcement is not unconscionable bc Agreement was not procedurally and substantively uncon-scionable when made:

I.M & P had some business experience and understood terms like “book value”

II.M & P signed 4 similar agrs.

III.M & P made meaningful choices, had adequate time to understand/change agr.

IV.No high pressure tactics or misleading behavior by Rs.

V.Rs had no duty to explain terms to other SHs; doesn’t matter that Rs were lawyers.

VI.Low price seems unfair but if no procedural defect, agr. is valid.

Dissent: Enforcing agreement would be unconscionable – It was reasonable for M & P to think they would be allowed to transfer their shares to their children (even if they could not transfer to third-parties) b/c this is what had happened in the past w/o following Agr. M & P were aware of age differential between themselves and R Sons; they never would have agreed to R wife’s transfer to R sons if they knew this could happen!

VII.He who seeks equity must do equity.

VIII.Specific performance will not be ordered where it will produce injustice.

IX.Result of specific performance is undoubtedly inequitable: Rs will get $800K worth of shares for $4K!!!

X.Rs had a duty to M & P as SHs in close corp.

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b.SHAREHOLDERS’ ABILITY TO BIND DIRECTORS

• Corporation is managed by its board of directors

• Directors, not SHs have the responsibility and the authority to make corporate deci-sions

McQuade v. Stoneham (1943)

Facts: Stoneham (S) was owner of NY Giants baseball team; he sold some shares to McQuade (McQ), a City Magistrate, and McGraw (McG), team manager, in 1919. SH Agr.: S, McQ, and McG would use their best efforts to (1) elect each other as directors, (2) make each other officers, and (3) not change corporate policy w/o others’ consent. McQ becomes treasurer for a time (1919-1928). McQ has a disagreement w/S, so S basically kicks McQ off Board, treasurer, and salary. McQ sues for breach of SH Agr.

Holding: SHs can’t enter into an agreement to control the directors in the exercise of the judg-ment vested in them by virtue of their office to elect officers and fix salaries. SH Agrement is in-valid where it precludes the Board of Directors from changing officers, salaries, or policies except by consent of the contracting parties at the risk of incurring legal liability. Stoneham and Mc-Graw’s duty was to the corp. and SHs to be exercised according to their individual lawful judg-ment, not to McQuade himself.

Reasoning: SH power to unite is limited to their ability to elect directors. Once elected, it is up to the directors to manage the corp. Board is supposed to use its independent best judgment to run the corporation; any contract that interferes with that independence is against corporate law (very formalistic). Distinguished from Dodge below on public policy grounds

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Clark v. Dodge (1936)

Facts: Dodge is the money-guy, Clark runs the business and knows the secret formula. In ex-change for sharing the formula with Dodge, Clark gets to stay as a director as long as he’s com-petent and loyal, and he gets 25% of the profit and the promise that the corp won’t pay exces-sive salaries. As soon as the formula is divulged, Dodge reneges and Clark is let go.

Holding: The SH Agreement requiring Dodge to vote for Clark as a director is enforceable.

Rule: If ALL the SHs of a CHC are party to a SHs Agreement, then the agreement (including em-ployment requirements) are valid and enforceable. There is NO Harm, Clark’s salary is paid after creditors, public and SHs are not harmed.

Damage suffered or threatened is a logical and practical test.

(1) Harm to creditors? No (salary to Clark was conditioned only after debt paid)

(2) Harm to minority SHs? No (here, all SHs are involved – unlike in McQuade)

(3) Harm to the public? Unlikely.

Reasoning: Public policy separating SHs and Directors for corp’s good loses its efficacy in CHC where SHs and Directors are same people. Where all SHs are involved, they can agree to bind themselves same people are running corp.

It is efficient to allow people to have freedom of contract. Court recognizes the unique position of CHCs; where there is no harm to anyone (creditors, minority SHs, public) then there is no reason to limit freedom of contract

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Galler v. Galler (1964)

Facts: Two Brothers sign a shareholder agreement for the protection of their respective families. Ben dies, Isadore doesn’t recognize agreement (even though he rushed to get it signed before Ben died). Surviving spouse gets to appoint new director in place of dead spouse. There is also an annual dividend policy ($50,000 so long as there is an earned surplus of $500K).

Holding: There was no complaint by the minority shareholder in this complaint. There was no harm to the creditors bc of the $500K cushion requirement. The compensation provision is not harming anyone. Even when all shareholders are not parties to an agreement, the court will uphold the agreement if there is no harm.

*Court has moved from formalism to contract: if no one is injured and no minority SHs complain, then a SH Agr. is generally OK! State Statutes allow SHs of Privately-held corps to have operat-ing authority instead of Board of directors

4.Majority Shareholders Fiduciary Duties to Minority Shareholders in a CHC

a.Majority Shareholders May Oppress Minority

• Means of Oppression:

o Excluding minority from employment

o Minority isn’t on the board, no say in policy

o No dividend policy – no earnings

• Majority can

o Hire lots of family members and dissipate lots of profits (Clark)

o Sell or lease property you own to the corp at exorbitant price or vice versa

• Minority

o If Partnership – can resign or be bought out (or dissolve corp)

o If Publicly traded co – can sell shares

o If closely held corporation – needs to rely on exit strategy provisions of share-holder agreement (if no shareholder agreement, minority shareholder is in trou-ble)

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Donahue v. Rodd Electrotype Company of New England, Inc. (1975)

Facts: Rodd ran the business, Donahue ran the plant. Rodd has been gifting his shares to his 3 kids over the years. Sons are ready to take over and want Rodd to retire. Rodd wants economic protection for old age. Rodd and other directors enter into a transaction where Rodd is paid $800/share for 45 shares and the rest of his shares go to kids as gift. Donahue (widow) hadn’t heard about the transaction and objects bc she wants the same deal, $800 for her shares, but company refuses.

Holding: Majority SHs breached duty to Minority SH (Donahue). Rodd as majority SH got 2 bene-fits not offered to Donahue as minority SH: (1) Corp. created a market for his shares that wouldn’t otherwise exist; (2) Corp. assets were converted to his personal use (looks like a directed dividend). Remedy: 2 possibilities: (A) Rodd can give back $ plus interest, OR (B) Corp. can buy Donahue’s shares at same price they bought Rodd’s shares.

Rule: **SHs in CHC owe one another substantially the same fiduciary duty in the oper-ation of the enterprise that partners owe to one another (“utmost good faith and loyalty”).

*Donahue is the broadest statement of fiduciary duties in CHCs (limited to CHCs); Court scales back in Wilkes.

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Wilkes v. Springside Nursing Home, Inc. (1976)

Facts: Wilkes had a reputation for doing profitable real estate deals. 3 other people came in in-vesting 25% each, all 4 understood that they would all have a responsibility within the com-pany. The company ran for many years and was pretty profitable. One investor, Quinn, wanted to buy a piece of property from the corporation, Wilkes told the other shareholders to hold out for a higher price, which they got, and Quinn convinced the other shareholders to act against Wilkes. The other shareholders fired Wilkes and removed him as a director. Wilkes was now cut-off as there were never any dividends paid by the company.

Holding: Majority breached duty to minority SH. There was NO legitimate purpose, just trying to “Freeze-out” Wilkes.

Court applied tempered-Donohue.

Classic “freeze-out” case:

1) w/o salary, Wilkes gets no value from business (bc no dividends are declared)

2) w/o board position, Wilkes has no way of influencing corporate policy

3) One of the other SHs offered to buy Wilkes out at a low price.

4) No evidence that the change in staffing was a legitimate business judgment (Wilkes was good at his job)

This is a corporate matter (not personal like Rosiny) bc corp. is involved in salary and services (employment). Court worries Donohue is too restrictive of Majority SHs not letting them run the corp as they see fit. Creates burden-shifting test

Wilkes TEST:

When bringing a suit for breach of good faith fiduciary duty against Majority SHs in a CHC, P must:

1)Minority must make a prima facie case of harm;

2)Majority must demonstrate a legitimate business purpose for the harmful action;

a. If no legit purpose breach

b. If legitimate purpose go to 3)

3)Minority can show that the Majority’s legitimate purpose could have been achieved by a less harmful alternative.

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The court will weigh the legitimate purpose against the practicability of a less harmful alterna-tive.

Rule: SHs in a CHC owe each other a duty of acting in good faith and they are in breach of this duty when they terminate another SH’s salaried position, when the SH was competent in that position to gain leverage against that SH.

b.Distinguishing Wilkes from BJR

• (1) Presumption of Deference

o Business Judgment presumes a legitimate purpose by the Board;

o Wilkes Test has no presumption of deference to the majority, the majority must actually show a legitimate purpose.

• (2) Legitimate Purpose

o Business Judgment Rule ends the inquiry if there is a legitimate purpose;

o Wilkes Test, even if there is a legit purpose, Majority is in trouble if there is a less harmful alternative.

c.Selfish Ownership

• In CHCs, SHs owe significant fiduciary duties to each other

o Selfish ownership must be balanced against fiduciary duties owed to each other

o If self-interested behavior is supported by a legitimate business interest, that’s okay, unless the minority can show there was a less-harmful alternative avail-able.

• Majority can’t gratuitously injure the minority.

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Sugarman v. Sugarman (1986)

Facts: Sugarman Bros. – J, S, and M – were equal partners in a paper corporation. Over time Leonard Sugarman (L), son of M, became 61% owner and effectively controlled corp. Ps = Grandchildren of S, holding 21.78% of stock together, who allege that: L took excessive compensation for himself; L granted his father, M, excessive pension w/o giving any to Ps’ father, S’s son. L refused to hire one P, discharged another P w/ cause. L sought to buy Ps’ stocks at an inadequate price. No dividends ever issued.

Ps bring two suits:

(1) Derivative suit for Self-Dealing: L caused corp. to pay him excessive salary (losses harm corp.)

(2) Direct suit for Freeze-Out: L deprived Ps of desired employment, drained off corp. earnings, refused to pay dividends, and tried to buy out Ps at a low price. (freeze-out harms SHs)

Holding: L’s actions supported Ps’ claims, *Aggregate of activities substantiate “freeze-out” claim. Equitable Remedy – Calculate % of $ wrongfully paid to L and L’s father. All damages given to Ds directly (even derivative damages) bc L is still the controlling SH and Court doesn’t want L to get the benefit of his wrongdoing by giving $ back to the corp.

Take-Aways of Sugarman:

1. Same set of facts can lead to a derivative and direct clam

2. Where the majority remains in control, and there is no exit strategy, the damages might be given to the Ps directly, even on a derivative claim

3. Freeze-out is an extreme breach of fiduciary duty and you must show a pattern of behav-ior which so marginalized the minority that they effectively lose the benefit of their invest-ment in the company

d.FREEZE-OUT

• Minority SHs don’t have a basis to get out of an oppressive situation

o No recourse to escape – minority is most susceptible to being approached by the majority to sell at low price (below FMV)

• Freeze-out extreme result of bad behavior

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o Each act might not be enough for a “Freeze-out” on its own, but in the aggre-gate, if Minority has no other option but to sell at a price below FMV, its probably a Freeze-out.

• PATTERN OF BEHAVIOR IMPLIES BAD INTENTIONS

• Mitigate Risk of “Freeze out” liability:

o Go to highest reasonable amount of salaries – not excessive salaries

Biz Judgment Test—gather data and set salaries at defensible reasonable high end range

o Come up with a Corporate Expansion Policy

Biz Judgment Rule – protects if there is reasonable inquiry and decision to do these things

o DON’T OFFER TO BUY THE SHARES FOR ANY PRICE

After you engage in defensible practices (legitimately protected by Biz Judg-ment Rule) let them approach you…

Zidell v. Zidell (1977)

Facts: Zidell Bros, A & E each own 37 ½% in 4 corps. R owns 25%. A approached R about selling shares to corp. R says he’s willing to sell. A tells E but takes no action. E approaches R and Pur-chases most of R’s shares for E’s son E gains control. A finds out sues Claims E usurped corp. opportunity by buying control.

Holding: E violated no duty by purchasing control w/o first offering opportunity to corp. (not a corporate opportunity). E had no duty to A as a SH to give A the personal opportunity to pur-chase control. Transfer of ownership does NOT affect corporations interest; corporation doesn't care who is in control. This only affects E’s relationship to A.

PRIVATE TRANSACTION NO CORP. OPPORTINTY is BREACHED, NO DUTY OWED TO A.

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Ingle v. Glamore Motor Sales, Inc. (1989)

Facts: Ingle was able to purchase shares after working for the company for a while. He didn’t have an employment contract, but he did have a shareholders’ agreement which stipulated that if Ingle’s employment ended for any reason whatsoever, he was to sell his shares back to glamour at a formulaic price.

Holding: No, Glamore breached no fiduciary duty by firing an at-will employee. Ingle was an at-will employee: he had no employ-ment K and could be terminated at any time. SH Agr. plainly states that Glamore could exercise buy-back provision if Ingle’s employ-ment ceased for any reason. If Glamore had a duty to Ingle as a minority SH vis-à-vis his employment, the parties contracted around that duty in the SG Agr.

Dissent: Ingle was not only an at-will employee, but a minority SH. Ingle’s status as an officer, director, substantial part owner and active participant in the corp. gives him equitable rights and remedies beyond those of an at-will employee.

e.Jordan v. Duff and Phelps, Inc.

• Background:

o Jordan was a shareholder and left his company (and sold his shares). He didn’t know his company was in the middle of discussing a merger that would increase the values of his stocks. He argues that they owed him a fiduciary duty to dis-close the upcoming merger.

• The Court goes the other way:

o Posner, agreeing with the Majoirty in Ingle said it would be fine to give FULL DIS-CLOSURE and tell Jordan that the merger was imminent, and also, that he was fired – full disclosure would limit liability

o Easterbrook disagrees – he says there should be a fiduciary duty to tell – cheaper just to read it into the law than make people negotiate over this term…

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Smith v. Atlantic Properties, Inc. (1981)

Facts: Wolfson and 3 others purchased real estate; each paid 25% of initial payment and incor-porated as Atlantic Corp. to operate property. Wolfson = very wealthy, in highest tax bracket. Wolfson insisted on 80% provision in the articles of incorporation → no important decision by SHs or Board shall be binding unless approved by 80% of SHs. (Each SH had veto power.) Dividend dispute: 3 others want to declare dividends b/c (1) want money and (2) worries about IRS penal-ties for excessive retained earnings (unless you have reason for keeping earnings in business, as in Ford, IRS penalizes using corp. as a tax shelter). Wolfson didn’t want to declare dividends b/c (1) (supposedly) he wanted to reinvest in property and (2) he didn’t want dividends for tax pur-poses. Wolfson had falling out w/others b/c they wouldn’t let him transfer ownership to his chari-table foundation (probably also for tax purposes). IRS assessed tax penalties on corp. in 1962-64, then 1965-68 due to failure to declare dividends. Wolfson paid initial penalties and continued to refuse to declare dividends. Other SHs sued Wolfson for breaching fiduciary duties to other SHs.

Holding: Wolfson breached a fiduciary duty to other SHs by refusing to declare dividends. Don-ahue-Wilkes duty of SHs in CHCs (utmost good faith and loyalty) applies both to ma-jority and minority SHs.

Reasoning: The determining factor for the fiduciary duty owed is whether a party would be con-sidered a controlling party. Bc Wolfson was the controlling party in that he alone prevented the dividend payouts despite no real business justification the court affirms that a fair dividend should be declared. Wolfson was unreasonable and did not demonstrate utmost good faith and loyalty to the business.

E. STATUTORY DISSOLUTION AND OTHER REMEDIES FOR ABUSE

1.Dissolution

a.Exit Strategies for minority partners / SHs:

• Partnership: can exit at any time, need not mean dissolution (although it can mean dissolution if partnership must be dissolved to give partner his shares)

• Publicly Traded Corporation: Sale of Shares at any time.

• Closely Held Corporation: No power to dissolve, no market for shares

o Although SHs in CHCs owe each other the same fiduciary duties as partnerships, absent a buy-back provision they still have NO READY EXIT STRATEGY in re-sponse to majority oppression.

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b.Judicially-Imposed Dissolution Death Sentence of a Corporation

• Statutory Remedy: leads to the liquidation of the corporation, not nec. the liquida-tion of the partnership

• Two Reasons to Order Dissolution:

o Deadlock (decisions can’t be made by Board or SHs)

o Remedy for Oppression

c.Implications of Judicial Order of Dissolution

• Negative Impact

o Forced Sale

o Risk to Creditors

• Contingent Dissolution

o Order to dissolve, but gives the parties a chance to negotiate a buy-sell agree-ment instead

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Matter of Kemp & Beatley, Inc. (NY.2d 1984)

Facts: D & G were SHs and employees of K&B, Inc a CHC with only 8 SHs. D & G held 20% to-gether. After internal turmoil, D resigned and G was fired. Corp stopped paying them dividends and they sued.

NY Law:

Holders of at least 20% of CHC shares may petition for dissolution under “special circumstances”

(1) Mistreatment of complaining SHs (“illegal, fraudulent, or oppressive* conduct”);

(2) Misappropriation of corp. assets by controlling SHs/Board (corp. waste).

Courts shall take into account

(1) Whether liquidation is the only feasible means for SHs to obtain a fair return

(2) Whether liquidation is reasonably necessary to protect rights and interests of any sub-stantial number of SHs or complaining SHs.

Holding: Dissolution was justified. Conduct was OPPRESSIVE Conduct substantially defeated the (1) “reasonable expectations” held by minority SHs that were (2) central to their decision to commit their capital to the enterprise. Here, dissolution was an appropriate remedy.

Reasoning: Min. SHs in CHC may have greater expectations of role in corp. (employment, direc-tion, dividends, salaries, etc.) what is objectively reasonable depends on particular circs. If court finds oppressive conduct, court must consider the totality of circumstances to determine whether some remedy short of dissolution constitutes a feasible means of satisfying minority SHs’ expectations and the rights and interests of any other substantial group of SHs.

Burden-shifting test: If minority SH proves oppressive conduct, burden is on opposing party to demonstrate the existence of an adequate, alternative remedy to dissolution. Every order of dissolution, however, must be conditioned on allowing corp. to buy back min. SH shares at a fair price.

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Alaska Plastics Inc. v. Coppock (1980)

Facts: Crow divorced his wife and she received 1/6 of the Corp in the settlement. Coppick (wife) was excluded from shareholder meetings, there was no dividend policy, and the company of-fered to buy her shares at $15K, she had them appraised at $32-40K. SHs used company funds to take their wives to SH meetings a/o valid purpose. C offered to sell for $40K, Corp offered $20K, S offered $20K individually. C refused and sued for Oppression. The lower court finds that she’s oppressed and orders a forced purchase of her shares for $32 – FMV.

Holding: Mandatory Buyback is not an available remedy here. On Remand P must make an ar-gument for dissolution to receive buyback. Unlike in Donahue, where Maj SH received opportu-nity to sell back shares, Coppock was excluded from “directors’ fees.” P must also argue that these fees were constructive dividends that she was wrongfully excluded from.

RULE: Mandatory Buyback only occurs in 4 circumstances:

(1) When there is a buy-back provision in the articles of incorporation and the contingent event occurs

(2) If Significant Change in Corp Structure occurs (merger, sale, etc.) SH may demand statu-tory right of appraisal

(3) SH may petition for involuntary dissolution, Ct will offer buy-back as an alternative remedy

(4) Potential Equitable remedy upon a finding of breach of fiduciary duty btwn Directors/MAJ SHs and Min SHs where Maj SHs receive a benefit not offered to Min SHs. (Donahue)

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In Re Radom & Neidorff (1954)

Facts: Brother and sister are equal SHs in corp. after sister’s husband’s death. They are un-friendly. NY Corp. Law allows for dissolution of corp. if SHs are so divided that they cannot man-age corp. affairs or elect a Board of Directors on petition of ½ of shares (i.e. deadlock) Brother petitioned for dissolution 5 mos. after brother-in-law died b/c sister won’t sign salary checks; sis-ter also complains of brother’s threats to quit and compete, etc. 3 years passed since original pe-tition due to delays of other litigation; since that time, corp. has been operating at a greater profit than before, but brother still hasn’t received salary.

Holding: Court won’t dissolve (they don’t like dissolution), despite the deadlock, the Corp is do-ing fine. Here, Corp is profitable and judicially-imposed dissolution will be harmful to SHs and the public.

Rule: Dissolution statute allows court to have discretion to grant dissolution in certain circum-stances Courts usually only grant dissolution when competing interests prevent efficient man-agement and achievement of corporate directives.

Dissent: Board is at an impasse and Bro is threatening to quit bc he hasn’t received a salary in 3 yrs. This is WHY the dissolution statute was passed. He shouldn’t have to sue again.

In Re June Wollman v. Marilyn Littman (1970)

Facts: Wollman (Nierenberg) sisters and Littman sisters are equal SHs in artificial fur business. In a separate action, Littmans are su-ing Nierenberg sisters for trying to lure away the corporation’s customers for their competing business. Nierenberg sisters countered w/dissolution petition, claiming that discord made effective mgmt. impossible. Special Term granted dissolution.

Holding: Remand to determine if dissolution was necessary / appropriate. Irreconcilable differences among evenly divided board do not always mandate dissolution. Consider Two Factors Here: (1) Function of two disputing interests are distinct. Dissolution will ren-der relief in the other suit pointless and will effectively accomplish Nierenberg sisters’ alleged purpose of squeezing Littman sisters out of the business!

*Radom and Neidorff show just how hard it is to dissolve a corp!

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2.Shareholder Duties in Contexts other than Closely Held Corporations:

a.What rights do minority shareholders have to cause the termination of the corporate exis-tence? What other remedies do they have for abuse? Do shareholders have duties to each other in a context other than a closely held corporation? If so, what duties?

b.Other Shareholder Cases

• SHs in publicly-traded companies owe very little to each other

o They are permitted to vote their shares in their own self-interest and dispose of them as they please

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c.What obligations does a controlling shareholder have to protect the corporations and minor-ity shareholders in publicly traded corporations? What is the power of control? To whom does control belong? The following cases deal with control of public corporations in vari-ous situations.

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Sinclair Oil Corp. v. Levien (1971)

Facts: Sinclair = parent corp. of nearly wholly-owned subsidiary (97%) Sinven (in Venezuela). Sinclair exercises affirmative control of Sinven admittedly has a fiduciary duty to Sinven. *Fiduciary duty is NOT created by being majority SH alone (b/c not CHC), but rather by exer-cising control of Sinven’s board.

Levien = 2% Min. SH, challenges 3 actions by Sinclair:

(1) Sinclair caused Sinven to give excessive dividends (at a time when Sinclair needed cash)

(2) Sinclair denied Sinven opportunities to expand internationally

(3) Sinclair caused its other subsidiary, Sinclair Int’l, to breach its contract w/Sinven (didn’t pur-chase the amount promised, didn’t pay its debt on time)

Holding: Sinclair breached duty to Sinven by failing to cause its subsidiary to uphold its contract with Sinven; it did not breach its duty as to dividends and other opportunities.

1)Excessive Dividends: Sinven’s minority SHs receive same benefit as parent corp no self-dealing = BJR

2)Denied Opportunities: No example of Sinclair usurping opportunities that came to Sinven no self-dealing = BJR

3)Breach of K: Sinclair controlled and received benefit through Sinclair Int’l and Sinven was harmed self-dealing = Intrinsic Fairness std. applies there must be an accounting for damages on this matter.

Intrinsic Fairness Test: applies when fiduciary is on both sides of a transaction accompanied by self-dealing.

Self-dealing: Parent, by virtue of its domination of subsidiary, causes subsidiary to act in such a way that parent receives a benefit to the exclusion and detriment of the sub-sidiary’s minority SHs.

Business Judgment Rule: applies otherwise.

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Zahn v. TransAmerica Corp. (1947)

Facts: A-F had 2 classes of stock and then added a third class of shares. Class A common has preferences. Class A is convert-ible at the instance of the Class A shareholder in a class B stock on a one-for-one basis. Callable – the board of corp. can require the SH to turn in their shares and exchange them at a fixed price. Class A Attributes: (1) callable and (2) convertible. After A-F called the A shares, they liquidated the company. The price of Tobacco went up – worth $20Million in this market. If A’s participated in the liq-uidation, they would get a much greater payout in the liquidation of Class A. A-F was usurping huge increase in price of tobacco and keeping it from class B shareholders.

Holding: TransAmerica breached its fiduciary duty to A-F’s minority SHs. Under Intrinsic Fairness Test – The Controlling Ma-jority SHs caused corp to act in such a way that would benefit the Maj SHs to the detriment and exclusion of the minority SHs (self-dealing). The Burden of proof is on the Maj to show that they acted fairly, which they cannot do here bc they withheld info from the minority SHs and took the benefit of the corp for themselves. Breach of fiduciary duty.

Rule: “When stockholders votes as a director, he represents all the stockholders in the capacity of a trustee for them and cannot use his office as a director for his personal benefit at the expense of the stockholders.” A Fiduciary CANNOT engage in self-dealing to the detriment and exclusion of minority SHs.

• INTRINSIC FAIRNESS TEST

o Intrinsic Fairness : Applies when fiduciary is on both sides of a transaction and there is self-dealing.

o Self-dealing : Fiduciary (i.e. Parent) by virtue of its domination of subsidiary, causes subsidiary to act in a way that parent receives a benefit to the exclusion and detriment of subsidiary’s minority SHs

• PUPPET-PUPPETEER Theory / Rule

o Where you can’t distinguish between majority SH and the Board, the fiduciary duties that normally would apply to the Board now apply to majority SH.

o Distinguish between public corp. majority SH

ability to elect Board no fiduciary duty

ability to control Board’s decisions or dominate fiduciary duty applies

d.Hierarchy of Fiduciary Duties

• Partners Utmost Good Faith & Loyalty (Meinhard)

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• SHs in CHC Utmost Good Faith & Loyalty w/ a little room for selfish ownership (balancing test) (Donahue-Wilkes)

• Directors & Actively Controlling Maj. SHs in a PTC Good Faith and Loyalty

• SHs in a Publicly-Traded Corp. none

Pearlman v. Feldman (1955) *Not followed by anyone, but interesting

Facts: Wilport wanted the steel, so they were going to buy all of the steel that Newport could produce at the fair market value. But, prior to the sale of his controlling interest in Newport, Feldman, used advanced $$ from clients to make improvements to the business – Feldman plan: use the $$ to modernize Newport and broaden the scope of what Newport can do after the war/shortage ends.

Self-Dealing: Control Block (Feldmann’s) got a premium ($20 for $12 shares), Feldmann took away from Newport, an opportunity he had based on the current conditions and he profited from it at the expense of the corp / shareholders

Holding: Director and Controlling Maj. SH are held to highest level of trust. Although there is no fraud, there is the possibility of corp. gain (expansion in war time), which was a corporate as-set that Feldmann appropriated for himself. Here, the remedy is directed to Minority SHs.

Dissent: Unless Feldmann knew Wilport was a looter (creates a duty not to sell), he didn’t do anything wrong.

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Weinberger v. UOP, Inc. (1983)

Facts: Signal sold part of its subsidiary to UOP, it wanted to sell the rest, couldn’t find another buyer, turned back to UOP. Two board of directors on the Signal board prepared a report that said it would benefit Signal if they received up to $24 per share. A tender offeror is trying to get control of a company (usually one they can’t get in a friendly take over – but this one was friendly) puts out in the market a tender offer (UOP offers to buy any and all Signal shares at $21/share)

Holding: UOP Board breached fiduciary duty to min. SHs by failure to disclose. Standard for evaluating directors’ actions:(1) Business Judgment Rule: Applies unless there is a procedural defect (conflict of interest, lack of due care, self-dealing) if defect, then:(2) Inherent Fairness Test: Burden is on directors to prove the fairness of their actions toward minority SHs, unless an in-formed majority of minority SHs approves of action by vote then burden of proof shifts back to complaining SH.

Here, Signal is on both sides of the transaction and benefits to minority SHs detriment (self-dealing). There was a majority of minor-ity SH approval, but minority was uninformed about Signal’s internal price study.

Burden of Proof is on Signal to show inherent fairness. Signal fails. Judgment for D.

Rule: A Majority SH owes a fiduciary duty to minority SHs to provide all relevant information that would pertain to a proposed cash-out merger. The only way sanitizing (by SH majority vote) applies is after FULL disclosure.

*Highlights problem of interlocking directorates: Inside directors of UOP were between Scylla and Charybdis – if they disclose study it will harm Signal; if they don’t disclose, it will harm UOP minority SHs. Court: “There is no safe harbor for such divided loyalties in Delaware.”

II.Introduction to Federal Securities Law:

a.Here we are introduced to the federal regulatory process in relation to securities. We will define the term “security” for regulatory purposes. We will continue with the definition of a security.

A. REGULATION OF TRANSACTIONS IN SECURITIES

1.SECURITIES REGULATION

a.Securities are regulated by federal and state laws.

• Laws

o Securities Act of 1933 (narrow, focuses only on newly issued securities)

o Exchange Act of 1934 (broader, focuses on mergers, proxies, exchanges, etc., and includes §10(b) and Rule 10(b)(5) re: insider training)

o Blue sky laws = state laws regulating securities

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• Regulation is implemented through required disclosures (so that investors can make informed decisions w/o interference of government). Disclosures are expensive and impose liabilities!

b.Two types of securities:

• Newly issued securities: issuing entity investor

• Previously issued securities: usually between two parties

c. THE MEANING OF “SECURITY”

• Defined in Section 2(a)(1) of the Securities Act as any stock, bond, investment con-tract, (several other devices), or “in general, any interest or instrument commonly known as a ‘security.”

• Aims to distinguish between “investment vehicles” (notes for profits) vs. “commer-cial vehicles” (notes for payment). Securities are investments.

• If it’s not a security, then it doesn’t have to register (expensive!) or abide by the stringent anti-fraud regulations that apply to securities.

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Great Laces Chemical Corp. v. Monsanto Co. (D. Del. 2000)

Facts: Monsanto (producer of Nutrasweet) and its subsidiary, STI, set up another subsidiary, NSC, as an LLC. NSC manufactures the pharmaceutical version of Nutrasweet chemicals. Monsanto/STI want to sell NSC; they create a memo for sale w/ favorable sales projections. Then NSC began having some competition problems (patent infringement, etc.). Great Lakes Chemical (GLC) was a prospective buyer. After some due diligence, GLC convinces Monsanto/STI to drop the price a little bit. GLC buys NSC. NSC’s profits continue to fall. (Monstanto/STI’s estimates were more than double NSC’s actual profits.) GLC sues Monsanto/STI for material misrepresentation and failure to disclose material information re: sale of securities.

Holding: Interest in an LLC ≠ Security per §2(A)(1). Interest is not (1) Stock; (2) Investment Con-tract; or (3) “Any interest or instrument commonly known as a security.” This (1) is NOT a stock doesn’t meet all 5 factors; (2) NOT an Investment Contract No horizontal / Vertical Commonality bc only GLC is buyer and has controlling power; and (3) NOT under “catch all” provision bc Court equates it to an investment Contract.

(1) Stock (United Housing Foundation v. Forman)

a. 5 Common features of stock:

i. Right to receive dividends contingent upon an apportionment of prof-its;

ii. Negotiability ;

iii. Ability to be pledged or hypothecated;

iv. Voting rights in proportion to the number of shares owned;

v. Ability to appreciate in value.

(2) Investment Contract (SEC v. W.J. Howey)

a. An investment contract requires:

i. An investment of $ (almost always met)

ii. In a common enterprise (not only one investor involved)

1. horizontal commonality (pooling among investors)

2. vertical commonality (shared interest between promoters and in-vestors)

iii. With profits to come solely from the efforts of others (passive involve-ment only).

(3) “An [other] Interest commonly known as security” (Landreth Timber Co. v. Landreth)

a. Traditional stock is always a security per §2(A)(1); it is always covered

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d.Relevant precedent re: LLCs:

• Keith : Investment in LLCs is not an “investment” if member retains substantial control.

• Parkersburg Wireless : LLC members had no control “investment contract.”

• Shreveport Wireless : LLC might be “investment contract.”

Kock v. Hankins (9th Cir. 1991)

Facts: Promoters put together 35 partnerships each owning 80 acre parcels in 2700-acre jojoba farm. The parcels could not be successfully managed independently. One care-taker would manage land, would provide supplies, etc. Expected profits were never realized. Investors sued under Securities Act.

Holding: Howey test applies to determine whether these are investment contracts:(1) Partners invested money,

(2) In a common enterprise, but

(3) Did they rely “solely” on the efforts of others to realize profits?Howey was modified by Williamson New question: Whether efforts by others are “undeniably significant” or “essential.”

· Williamson test: Whether…

(1) Formal docs of partnership leave partner w/o power; OR

(2) Partner is so inexperienced in business affairs that they can’t exercise power; OR

(3) Partner is so dependent on a unique characteristic of promoter/manager that they could not operate the busi-ness without them.

· Here:

(1) Agreement gave partners substantial formal legal powers;

(2) Partners were possibly sophisticated in business affairs (they have enough $ to invest in this venture), but the record is underdeveloped here Remanded; and

(3) Partners were probably reliant on promoter/managers’ unique capabilities (unclear whether they could have gotten together to hire a new manager; unable to operate as independent farms) Remanded.

If either factor is found to be present on remand then these interests are securities.

e.Howey/Williamson Investment Contract Test:

• An investment of money

• In a common enterprise

• With profits to come significantly/essentially from the efforts of others, such that:

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o Formal agreement leaves partner w/o power;

o Partner is so inexperienced or unknowledgeable in business affairs that he is in-capable of intelligently exercising meaningfully his partnership powers;

o Partner is so dependent on some unique entrepreneurial or managerial ability of promoter/manager that he cannot replace the promoter/manager or otherwise exercise meaningfully his partnership powers.

f.We will then walk through the registration process and examine the exemptions from the registration requirement. Then we turn to the anti fraud provisions of the Acts. Agassiz is a pre Act case to set the stage.

Goodwin v. Agassiz (1933)

Facts: Agassiz = President and Director in Cliff Mining Co. A geologist had a theory that some land that Cliff hoped to acquire had minerals. Cliff Co. kept the info quiet so that they could buy the land at a low price. In the meantime, Agassiz started buying Cliff stock. Goodwin = minority SH in Cliff Mining Co. who decided to sell stock. Agassiz purchased stock from him. Goodwin later found out about the geologist’s theory and sued.

Holding: Agassiz is not liable because he had no duty to disclose this information to Goodwin. There is no evidence of affirmative fraud No harm to the corporation due to Agassiz’s nondis-closure (in fact, corp. gained from Agassiz keeping geology report quiet b/c they could pur-chase land at lower price). Agassiz breached no duty. He had every right to buy shares over the market.

Rule: Directors have duty to corp., not to individual SHs. (This is probably not true over-all…). *However, strangely, the Court states that Director may have a duty to disclose to seller if the transaction is made face-to-face (but here, Goodwin didn’t seek Agassiz out) Im-practical? Also, here the Court only addresses the fiduciary’s obligations as a buyer, but not as a seller… Pre-Consumer Protection the age of Caveat Emptor!

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2.The Problem of Inside Information:

a.Here, we look at securities already issued, paying attention to the insider trading and anti-fraud provisions of the securities laws. We will also look at the operation of the stock mar-kets. You should understand what is meant by the concept of inside information? Who is protected by the insider trading rules? What harm is sought to be prevented? Texas Gulf Sulphur is the first in a line of cases about insider trading. This case is complicated but sets out many aspects of rule 10b-5. Read it carefully. It has been refined through several more recent cases, some of which received much national attention. How do the cases following TGS affect the interpretation of insider trading?

b.Insider Trading Under the Securities and Exchange Act of 1934

• Section 10(b) of the Securities and Exchange Act aims to prevent fraud.

o It is the primary vehicle for dealing with insider trading.

o It prohibits use of “any manipulative or deceptive device” in a securities transac-tion.

• Rule 10(b)(5) elaborates on §10(b)’s basic rule:

o “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 facil-ity of any national securities exchange,

(a) To employ any device, scheme, or artifice to defraud,

(b) To make any untrue statement of a material fact or to omit to state a ma-terial fact necessary in order to make the statements made, in the light of the circumstances in which they were made, not misleading, or

(c) 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.

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SEC v. Texas Gulf Sulphur (1968)

Facts: TGS was mining for Sulphur in CA. The did exploratory digging and found a promising spot, further tests estimated that it was the largest content of ore ever found. Corp insiders knew and began buying stock, but covered up info from the public by issuing a false state-ment. News got out and people started buying and price went up. TGS directors issued a press release that they were exploring but had not found anything yet, price decreased slightly. A few days later TGS announced an unprecedented find in a press conference and told Canadian Press. Insiders continued to buy.

Holding: Directors violated R. 10(b)(5). Remanded as to whether Corp breached 10(b)(5) also.

Ask:

(1)Who is Liable under R. 10(b)(5)?

a. Statute: “Any person” who engages in manipulation / deceit by active fraud (misstatements) or omission in connection w/securities transac-tion is liable.

b. Active Fraud is punishable even under common law, but for omissions to be punishable, there must be a duty to disclose.

c. In Practice – court requires a person to be a fiduciary or insider to be liable

(2)Is it permissible for TGS to tell its officers not to disclose this info? (YES)

a. Good Corp. reason for prohibiting disclosure want to purchase adja-cent land before price goes up

(3)Can TGS insiders trade on this information before public disclosure? (NO)

a. *Insider can’t take advantage of undisclosed material informa-tion. If insider can’t / won’t disclose, he must ABSTAIN!

(4)What information is covered by 10(b)(5)? (MATERIAL INFORMATION)

a. MATERIAL INFORMATION: Whether a reasonable investor would at-tach importance to the information in deciding whether to sell/buy/hold the security (i.e. whether a reasonable investor would think that this report might affect the price). only facts are material, not opin-ions.

(5)When CAN Fiduciaries / Insiders with Material Information Trade (AFTER EFFECTIVE DIS-CLOSURE)

a. Effective Disclosure Sufficient to ensure its availability to the invest-ing public. (factual question)

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(6)How can TGS Corp. be liable?

a. Initial Press Release may have been misleading and false (determine on remand)

b. BUT Statements were not made in connection with any transaction by Corp.

c. Nevertheless, it is likely that the statement caused people to pur-chase/sell/hold stock it qualifies as “in connection with” transaction for the statute.

Rule: Anyone who, trading for his own account in the securities of a corporation has access, di-rectly or indirectly, to information intended to be available only for a corporate purpose and not for the personal benefit of anyone may not take advantage of such information knowing it is unavailable to those with whom he is dealing. (i.e. the investing public).”

c.Policy Questions re: Prohibition of Insider Trading

• Who is hurt by insider trading?

o *General trust in the market is hurt. If market is viewed as corrupt or inefficient, then the price of capital will go up because people will be less inclined to invest.

o Individual sellers aren’t really hurt (they were going to sell anyway).

• Are rules prohibiting insider trading inefficient?

o Some argue that insider trading is efficient because (1) you can pay execs less because they will have this additional perk, and (2) insider trades serve as an additional source of information (better than reading market reports) and will en-able a more efficient market.

o However, this allows insiders to be compensated first and provides a way for in-siders to further manipulate investing signals.

d.LIMITATIONS ON §10(b) APPLICABILITY

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Santa Fe Industries, Inc. v. Green (1977)

Facts: Santa Fe owns 90% of Kirby stock and wants to merge Kirby into itself. DE has a “short-form merger” statute allowing a parent who owns 90% of a subsidiary to merge w/o getting ap-proval from both boards as long as you give notice to minority SHs w/in 10 days. Statute gives objecting Min. SHs appraisal remedy. Pre-merger, SF investigated to figure out a fair price for Kirby’s stock. SF Provided Min. SHs w/all calculations. SF calculated value of assets/share, found proper price and paid over that. Min. SH claimed valuation was faulty (should have paid value of assets/share) and sued for securities fraud violation in District Court (rather than use appraisal remedy).

Holding: Dismissed, this is not a 10(b)(5) case bc there nothing was withheld or misstated and there was no fraud. P could only go to Court of Chancery for appraisal.

e.The courts have expanded the scope of 10b-5 to include many people who are not insiders. What is the goal of this expansion? Has the expansion gone far enough to achieve the goal? Are there other goals that might have been pursued by the courts or the legisla-ture? How does O’Hagan change the law of insider trading? What are the weaknesses of the holding?

3. Theoretical Expansion of the Concept of “Insider”

a.DUTY TO DISCLOSE

• Some fiduciary-like relationship of trust and confidence must exist

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Chiarella v. United States (1980)

Facts: Chiarella (P) Was a printer at a financial newspaper and deduced the name of a target corp. He purchased stock in the target co and sold right after the merger. He did this many times to make $30K in 14 months. He was convicted on 17 counts of §10(b) violations.

Holding: REVERSED. Chiarella is NOT an insider of Acquiring (A) Corp. and even if he is a tempo-rary insider bc A owns the company he works for, he is NOT an insider of Target Corp and he only traded in target corp. If he hadn’t settled with SEC, he probably could have kept the money.

Rule: “Any person” means “any person with a fiduciary-like obligation” to be liable under §10(b)(5), some relationship of trust and confidence must exist.

b.TIPPEES

• Texas Gulf Sulfur and Chiarella – there MUST be a fiduciary duty to create a duty to disclose or abstain

• Dirks – if there is a breach of duty, for liability to continue, that breach must extend down the chain of tippors/tippees to confer derivative liability. (liability expands from insiders to outsiders)

o TEST: Whether the insider will personally benefit, directly or indirectly, from his disclosure

NO personal gain No breach of duty to SHs

Tippor MUST Breach before Tippee inherits the Fiduciary Duty

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Dirks v. SEC (1983)

Facts: Dirks, an insurance broker, learned about massive, ongoing fraud in EFA from Secrist, a former insider who was trying to reveal the scandal. Dirks went to LA to investigate EFA and found massive fraud. He tried to inform WSJ and SEC to get them to report / investigate. Dirks then told his clients about the fraud, they started selling EFA and the price dropped so quickly, the SEC stopped its trading. Dirks’ clients avoided massive losses. THEN the SEC decided to in-vestigate and Dirks gave them his info, they censure Dirks, he appeals.

Holding: Dirks is NOT liable under 10(b)(5). Duty to disclose arises from a trust relationship, Dirks is NOT a fiduciary of EFA. Dirks is NOT liable under Tippor-Tippee Theory bc (1) Secrist did not breach a duty by disclosing fraud – his duty was to the corp and would have been to fix the fraud – and even if he breached a duty it was NOT for personal gain. (2) Even if Secrist did it for personal gain, Dirks did not know or have reason to know about this.

Tippor-Tippee Theory: Tippee assumes a fiduciary duty to SHs of corp. not to trade on mate-rial non-public information only when:

(1) Tippor/Insider has breached his fiduciary duty of loyalty to SHs by (a) disclosing info (b) for personal gain (direct or indirect – gift, reputation, quid-pro-quo, etc); AND

(2) Tippee knows or should have known about breach.

Note: If Dirks had been liable, his clients probably would not have been liable unless they knew or had reason to know of Dirks’ breach. Chain of liability passes from TipporTippee / Sub-tippor Subtippee.

c.MISAPPROPRIATION THEORY

• Misappropriates confidential information for trading purposes, in breach of duty owed to source of information. Still Requires Fiduciary duty, but to a different party

• WSJ Case

o W wrote WSJ column with positive/negative comments about particular corps. After the column appeared, the stock prices experienced a bump or dip. W de-

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cided to profit from this knowledge by making personal investments and sharing info w/friends.

o WSJ policy: any info that came in was WSJ’s property until published. W knew about policy.

o W got caught and was convicted under §10(b) on misappropriation theory (breach of duty to WSJ). On appeal, the Court split 4-4, so the lower court opin-ion remained intact.

o [Q: What if W had been an independent writer, rather than a WSJ employee? Would he have been liable under some other theory? Perhaps manipulation of the market? (Likely not, especially if he disclosed publicly that he traded on the information.]

U.S. v. O’Hagan (1997)

Facts: O’Hagan was a partner at a law firm that represented Grand Met, who planned a tender offer to Pillsbury. O’Hagan did not work on this project, but during the planning he purchased stock and calls on Pillsbury. He made $4.3M and used this $ to cover up embezzlement. He was convicted of fraud under 10(b) for misappropriating the info. 8th Cir Reversed.

Holding: O’Hagan breached his duty of loyalty, by misappropriating the source’s confidential in-formation for securities trading purposes in violation of §10(b) and R. 10(b)(5). He could have avoided liability by disclosing.

Reasoning: O’Hagan is not a fiduciary of Pillsbury, although he is a fiduciary of his law firm and probably a temporary fiduciary of Grand Met. No traditional liability. O’Hagan breached a duty of trust and loyalty to his firm and their client when he used confidential info about a tender offer for personal gain.

d.Classical Theory of Insider Trading Liability:

• §10(b) and R.10(b)-(5) are violated when a corporate insider trades in the securities of his corporation (or corporation to which he owes a fiduciary duty) on the basis of material, nonpublic information.

o Liability is based on the relationship of trust and confidence between SHs of a corp and insiders who have obtained confidential info bc of their corp. position (Chiarella)

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o Relationship gives rise to a duty to disclose or to abstain from trading to prevent a corp. insider from taking unfair advantage of uninformed SHs

o Classical theory applies not only to officers, directors, and permanent insiders, but also to attorneys, accountants, consultants, and other “temporary fiducia-ries” (Dirks)

e.Misappropriation Theory:

• A person commits fraud “in connection with” a securities transaction, and thereby violates §10(b) and R.10b-5, when he misappropriates confidential information for securities trading purposes, in breach of a duty of loyalty or confidentiality owed to the source of the information.

o Fiduciary’s undisclosed, self-serving use of principal’s info to purchase or sell se-curities, in a breach of duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that information.

o Liability is premised on a fiduciary-turned-trader’s deception of those who en-trusted him w/access to confidential information.

o Complementary to Classical Theory designed to protect the market against abuses by “outsiders” to a corp who have access to confidential info that will af-fect the corp’s security price when revealed, but who DO NOT owe a fiduciary or other duty to that corp’s SHs.

• When you disclose your disloyalty, you absolve yourself of liability (Misappropriation Theory)

o Misappropriation involves “feigning fidelity” to the source of information.

• “In connection with purchase or sale of security”

o Fiduciary’s fraud happens when he uses the information to purchase or sell secu-rities.

• A misappropriator who trades on the basis of material, nonpublic information gains his advantage market position through deception.

f.SUMMARY

• In §10(b) or R. 10(b)-5 cases, there must ALWAYS be a duty:

o (1) Duty to the corporation (TGS, Chiarella)

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o (2) Duty of Tippor to corporation passed to Tippee (Dirks)

o (3) Duty to Source of information (O’Hagan)

A. PROXIES:

a.We will engage in a general discussion of proxies and their regulation. After a general out-line, we will two specific issues: shareholder proposals and the problem of causality in the context of false or misleading proxy materials. Pay close attention to the subtle rule in Mills.

1.Protection of SH Voting Participation

a.PROXIES

• §14(a) of the Securities Exchange Act regulates proxies

• Proxy = document that transfers power from SH to someone else to vote SH’s shares (usually as directed for a limited purpose/time), OR the person who exercises that power.

• Proxy is available for SHs’ votes only, not directors’ votes.

• Benefits of proxy: permits existence of quorum for SH meetings (w/o logistical problems of trying to get people in the room who have insufficient incentive to at-tend); often used to gain support for management proposals

b.The Solicitation Process [CB 596] (SEE TWEN!)

• Corp. files proxy statement w/SEC.

• SEC approves proxy. Corp. sends it to SHs.

• Most SHs don’t take the time to read or vote. If they do vote their shares, they tend to vote for management’s recommendations.

• SHs may make proposals to include in proxy statement at corporation’s cost or at their own cost. If SH wants proposal to be included in management’s proxy, man-agement can refuse if it deals w/day-to-day or personal issues, if it violates state law, or if it is de minimis in effect.

• Proxy contest = fight for control; dissidents use proxies to compete for support.

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c.False or Misleading Proxy Materials [CB 637]

• §14a-9 of SEA: Prohibits false or misleading statements or omissions w/respect to material facts in a proxy solicitation.

• Q1: Who may enforce this requirement?

o J.I. Case v. Borak (1964): A private right of action must be inferred from the Act (though not provided explicitly) because the SEC has too many statements to review and limited ability to discover false and misleading materials. If there were not a private right of action, the law would not be enforced!

• Q2: Whether there is a causal relationship between a false or misleading proxy solicitation and the outcome of a vote. Mills and Virginia Bankshares

Mills v. Electtric Auto Lite Co. (1970)

Facts: Mergenthaler Linotype Corp. owns 54% of Electric Auto-Lite (EAL) and controls Board. Merganthaler wants to merge w/EAL. EAL Board solicited a proxy and recommended merger, but did NOT disclose relationship of Mergenthaler to EAL and control of Board. Mills, a Min SH of EAL, brought suit alleging that the EAL proxy statement contained material misleading omission by failing to reveal Board’s conflict of interest with Mergenthaler. Majority of SHs approved the merger by proxy. Board approved the Merger. Companies Merged.

Holding: This was a misleading omission of a material fact. Mergenthaler’s control was a mate-rial fact (SH would consider this info important in determining whether to invest). But, it’s not clear if there is a causal relationship between omission of the material fact and the vote’s out-come.

Rule: P must show:

(1) That a proxy solicitation contained a material misstatement or omission and

(2) That the proxy solicitation itself was an essential link (causality) in the result or accom-plishment of the transaction

• Causality

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o P does not need to show that material misstatement/omission is the actual cause of outcome or that SHs actually relied on the misstatement omission.

It would be impractical to get this information

o Causality is not foreclosed by proof of the fairness of the terms of the merger .

Just because a merger is fair does not mean that SHs would accept if they had all material information when they made their decision.

Deciding abstract fairness at judicial level takes decision away from SHs.

Undermines SH democracy

• Possible Forms of Relief / Remedies

o Setting the merger aside OR

o Other equitable Relief

o Unscrambling Corporate Transaction is NOT REQUIRED by the Statute

VA Bank Shares, Inc. v. Sandberg (1991)

Facts: FABI (Bank Holding Co.) owns VBI (FABI Subsidiary) and 85% of First American Bank (Bank). FABI wants to merge Bank into VBI. FABI thought $42 was a fair price, proposed merger the Bank, Bank Board Approved. VA law requires that the merger be put to a vote at a SH meet-ing and that info be circulated beforehand. It does NOT require a proxy. Vote was bound to suc-ceed if VBI voted its shares. Bank solicited proxies anyway recommending merger and $42 as a “fair price.” Sandberg is a Min. SH who withheld her proxy and sued for violation of §14a-9. She alleged that this was NOT a high/fair price and (2) that the Board had not believed the price was high or fair but recommended merger to save their jobs (self-dealing)

Holding: False statement re: Board’s belief is NOT sufficient for liability there must also be misstated underlying facts. Here, there was some evidence that the price was not high/fair and that the Board did not believe the price to be high/fair. The Vote here is NOT an essential link.

Rule: P must show evidence that (1) D’s statement of belief was FALSE and (2) the underly-ing facts are FALSE.

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d.Notes on VA Bank Shares v. Sandberg

• Court doesn’t answer the Question of whether S or essential link could be estab-lished even if there was no requirement to obtain proxies.

• Sanitizing Vote

o Sandberg wanted a sanitizing vote by a majority of the minority but Sandberg voted against the merger and lost the right to have fiduciary sanitize the vote.

o VA Statutes require full disclosure and here the high price and conflict of interest were NOT disclosed

If you don’t have full disclosure you don’t have sanitization under the statute.

o TO Sanitize the Vote (under the fairness burden) you need:

(1) Disclosure of conflict

(2) Disclosure of surrounding circumstances AND

(3) a Majority vote of the minority

• The fact that the Court even gets to the merits seems to suggest that it's possible that there could be an essential link if minority SHs were somehow harmed when the solicitation was insulated by misleading proxy vote.

o NOTE: if the misstatement causes someone to vote in favor of the merger, they’ve lost their right to appraisal (which is only available when you voted against the merger or did not vote).

SO one of the SHs who did vote could argue there is causation bc the mis-statement caused them to vote in favor of the merger and thus, they lost their appraisal right (ie. they were harmed).

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III.Mergers, Acquisitions and Takeovers:

A. WHAT IS A MERGER?

a.How may a merger be accomplished? What are the distinctions between mergers, consoli-dations, tender offers, sales of assets etc? What are the rights of shareholders who dis-sent from such transactions

1.Historical Background

a.4 Stages of Corporate Combination (shaped by antitrust laws):

• (1) Pooling arrangements (cartels) – first struck up between RR cos.; unstable “com-munities of interest” that broke apart when no longer convenient.

• (2) Trust – more stable way for competitors to place control in one shared trustee who would run companies in concert.

• (3) Holding company – one corp. in industry formed another corp. to buy competi-tor’s stock (to avoid antitrust law precluding them from buying it outright).

• (4) Merger –one corp. (all assets and liabilities) are absorbed into another corp.

• Principal motivation for business combinations in earlier years: restrain harmful competition.

• Principal motivation for business combination today: finance.

2.How One Corporation Buys another

a.Buy a Controlling Interest From:

• TENDER OFFER: Public solicitation of a certain number of shares at a price (Bypass Corp)

• Controlling SH or block of SHS – quick and cheap (might need less than 505)

• Minority SHs on the Market – slow, drives up the price

• The Corporation (newly issued shares or not) – quickest/easiest if Corp is willing seller

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b.Buy Assets of the Corporation

• Can be a holding company

• Can pay off debts and distribute remaining shares in liquidation

• Can use assets to do other things.

c.Merger vs. Consolidation

• Merger: A + B = A or B

• Consolidation A + B = C

• Asub + B = Asub

o Triangular merger

o Asub is a shell into which B is merged

o All of B’s activities are carried on by Asub

• Asub + B = B

o B might have a strong brand name

o B might have tax losses that can’t be used if the survivor is Asub

• A is shielded from any direct liabilities that B might have

o A only risks its investment value

3.De Facto Mergers

a.What Happens to Target if it Dissolves, looks like a merger

• Target Co is left w/liability after selling all the assets, Target must pay liability be-fore disbursing $ to shareholders.

• Selling corporation can get cash (cash-out merger)

• Selling company can get stock of the acquiring company

b.Mergers require filiing of a certificate of merger in the state of incorporation

• Stock of merged company – evidence of SHs right to receive the consideration promised by the surviving corporation as the price of the merger

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• If the consideration received is stock – the shareholders have a residual claim on as-sets of surviving company

• The surviving corporation MUST assume liabilities of the disappearing corporation as a matter of law.

c.Triangular Mergers

• Surviving corp sets up a shell subsidiary into which the disappearing company merges (forward triangular merger) or which merges into the disappearing company (reverse triangular merger)

• Reverse triangular merger – usually carried out for tax reasons (target corp needs to keep its name to use certain tax credits or carry forward certain tax losses)

d.SH approval

• Mergers must be approved by a req. % of SH (statute usually requires a majority, sometimes bylaws require more)

• SHs of disappearing co. who disapprove are forced to give up their stock and go along w/majority

• They do have appraisal rights and can petition the court for an appraisal of their shares and if the court values them at higher than the merger price, the petitioners can receive a higher price.

• NOTE: appraisal proceedings are not riskless, if the court values the shares at a lower price, the SHs receive a lower price

e.Whether a Merger has occurred.

• Greenacres receive blackacres common stock as consideration for the merger

• Blackacres owns all of the assets and liabilities of itself and greenacres

• Greenacres shareholders are now blackacre shareholders(Merger)

• Greenacres sells all its assets to blackacres, Blackacres pays for assets with com-mon stock

• Then Board of Greenacres dissolves Greenacres and distributes the assets (which consist of blackacres common stock) to Greenacres stockholders

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Farris v. Glen Alden Corp (1958)

Facts: Glen Alden = PA coal corp. It has a lot of tax losses that it can’t use. List Corp. = DE holding co. List and Glen Alden decide to join. Structure of the deal: List (bigger co.) sells all of its assets to Glen Alden in exchange for GA shares. In order to give sufficient shares to List, Glen Alden must issue 3.6M new shares w/o pre-emptive rights (rights that give old SHs chance to buy new shares in proportion to the shares that they currently own). GA assumes all of List’s liabilities and will change its name to List Alden. List will dissolve. Current direc-tors of Glen Alden and List will be directors of List Alden. List’s assets (Glen Alden’s shares) will be distributed to List’s SHs. GA and L structured the deal this way bc state law would not require appraisal if L sells all its assets to GA they would not have had SH approval if they tried to merge.

Holding: This is a De Facto Merger, SHs have appraisal rights. The present “reorganization” agreement so fundamentally changes the corp. character of GA and the interest of their SHs that to refuse dissenting SHs the rights and remedies of a dissenting SH would in reality force him to give up his stock in one corp. and force him to accept stock in another.

Minority Rule: PA merger law was designed to cover this type of transaction. Form will not be held over substance. Min. SH gets appraisal rights.

*Majority Rule: Substance over form – no merger, no liability w/o explicit assumption.*(??)

Glen Alden – PA Corp. List – Del Corp.

Sale of assets Appraisal No Appraisal!

Merger Appraisal Appraisal

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Hariton v. Arco Electronics, Inc., 188 A.2d 123 (Del. 1963) [CB 730]

Facts: Substantially the same as Glen Alden.

Holding: No. This is not a de facto merger, it’s a sale of assets. Min. SH does not have ap-praisal rts.

State created different forms that corps. can choose from. Statutes have different meanings.

**Form prevails over substance – Majority Rule.

• Creative Lawyering

o If lawyer can create model to avoid appraisal rights and create a de facto merger, which should give you appraisal rights, you’re out of luck.

4.Interested Party Transaction

a.Parent Subsidiary Mergers

• The Remedy: Weinberger v. UOP (1983)

o (1) When there’s an interest party transaction, we test the action with entire fairness standard (fair price and fair dealing).

o (2) When Cash-Out deal provides inadequate cash-out price remedy is ap-praisal

o Weinberger says there may be factors trumping appraisal issues

Prior to Weinberger, appraisal had to fit certain formula

After Weinberger, any relevant evidence to show fair value of shares may come in

Appraisal is not only remedy, you can look at fiduciary duty cases and adopt equitable remedies

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Rabkin v. Hunt Chemical Corporation

Facts: Minority SHs wanted to enjoin cash-out merger between Hunt and Maj SH Olin after Olin purposely avoided a one-year commitment to pay $25 per share to Min SHs.

Holding: Appraisal is NOT the only remedy in a wrongful-merger.

No Safe Harbor for “divided loyalties” in DE: When directors of a DE Corp are on both sides of a transaction, they are required to demonstrate their utmost good faith and the most scrupu-lous inherent fairness of the bargain

In Re Siliconix (2001)

Facts: Short form merger to cash-out extra SHs they didn’t get rid of during short-form merger at lowest possible price. V said if it gained 90% it would do a short-form merger. When price went up, V wanted to do a cash exchange for shares for no premium. V also threatened to de-list Siliconix stock (eliminating a market for shares). SH challended offer as inadequate. Min. SHs sued claiming that V dominated board breached its duty by remaining neutral on echange.

Holding: Board did not breach its fiduciary duties, Inherent fairness is not the right standard. Board’s duties in a merger are different than duties in a tender offer. SHs of DE corp are free to accept or reject tender offer on evaluation of their own best interest. Court will intervene to pro-tect SHs right to make a voluntary choice. Board enters into no agreement in a tender offer (un-like in a merger) and has no official statutory role. Board has no duty to ensure inherent fairness.

Here there was no failure to disclose and no coercion. Timing of tender was not coercive bc of market conditions (ie not made at a historic low) and did not result in “capping” effect on price. “Threat” of short-form merger and of de-listing were merely disclosure of possible consequences, not threats.

b.Weinberger’s Reach

• Remember Rosiny: Fiduciary duties of majority SHs extend to corp transactions only, NOT to private transactions.

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o Court views tender as an aggregate of private transactions

• Tender offeror’s duty: (1) Full and Accurate disclosure & (2) No Coercion.

c.Two-tier front-loaded tender offer = very coercive

• Front-end: Offeror offers an inadequate cash price for tender; then

• Back-end: Offeror says it will offer same inadequate amount in junk bonds

• Fear might cause a rush into the front-end deal, even though it is inadequate

Glassman v. Unocal Exploration Corp. (Del. 2001)

I.Facts: Unocal owns 96% of Unocal Exploration (UXP); wants to acquire the rest through S-F merger.

II.DE Short-form merger statute allows a parent corp. that owns at least 90% of subsidiary to merge the subsidiary into the parent corp. by resolution of parent corp. (No min. approval re-quired.) Glassman & other min. SHs filed a class action alleging breach of fiduciary duties of in-herent fairness and full disclosure.

Holding: Absent fraud or illegality, appraisal is the exclusive remedy available to a min. SH who objects to a short-form merger. Determination of FMV must be based on all relevant fac-tors (Weinberger) including damages and elements of future value where appropriate. Although fiduciaries are not required to establish entire fairness in a short-form merger, the duty of full-disclosure remains, in the context of this request for SH action.

In a short-form merger, there is no dealing can only be a fair price issue bc only the acquiring board takes any action.

*Where the only SH option is accept or seek appraisal, SHs must be given all the factual informa-tion material to that decision.

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d.SUMMARY – INTERESTED PARTY TRANSACTIONS

• BJR does NOT apply bc they are interested parties (self-dealing, conflict of interest, etc.)

• Long-form Merger

o Standard: Entire Fairness (1) Fair Price & (2) Fair Dealing

(1) Fair Price

Remedy = Appraisal

(2) Fair Dealing – Uphold Duty of care and Duty of Loyalty

Remedy: “Expanded Appraisal” or rescission/ damages (Weinberger/Rabkin)

(3) *in MA, business purpose is threshold requirement (not Req in DE)

• Short-Form Merger:

o Standard : Business Judgment Rule, NOT entire fairness

S-F Merger statute permits merger w/o fair dealing (or any dealing) w/ Min. SHs (no notice, vote, etc)

Remedy: Appraisal to determine fair price ONLY (Glassman)

• Tender Offer:

o Standard : Voluntary Choice = (1) Full & Accurate Disclosure & (2) absence of co-ercion

NO Fiduciary Duty

NO Obligation to offer fair price (Siliconix)

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B. FREEZE OUT MERGERS & TAKEOVERS

a.What is a freeze out? What standards are violated when one attempts a freeze out? What is the test to determine the validity of a transaction in which a freeze out is alleged

1.Freeze-Out Mergers

Coogins v. New England Patriots Football Club, Inc (1986)

I.Facts: Sullivan was an original 1/10 owner of Patriots voting shares. He gained control but was ousted by other 9 owners of voting shares. There were also publicly-traded non-voting shares. Sullivan then bought out all other voting shares and regained control using huge bank loans. Condition of loans was that Sullivan would use his best efforts to reorganize the Patriots such that corporate income and assets would be used to secure and repay the loans. In order to divert corporate funds to secure his personal loans, Sullivan needed to get rid of the non-voting SHs. Sullivan created a shell corp., the New Patriots. Sullivan donated his 100% of voting shares in Old Patriots to New Patriots. Then Sullivan merged New Patriots w/Old Patriots and cashed out min. non-voting SHs at $15/share. NP approved bc Sullivan = only SH.

II.Both classes of OP stock approved as well. Coggins was proud min. SH who didn’t want to cash out sued for rescission.

III.

IV.Holding: The Cash Freeze-out Merger is invalid. Damages are the appropriate remedy. BC this is an “interested party transaction” Entire Fairness applies: (1) Fair Price & (2) Fair Dealing. The merger is invalid bc even though Sullivan said the purpose was to cash out public ownership, he did this to satisfy personal loans (not a business purpose). The appropriate remedy here is “recissory damages” (amt = to PV of shares including amt of Sullivan’s waste, plus interest) It has been too long since the merger went through and many 3rd parties have relied on it so rescission would not be fair.

V.

Threshold Requirement: Legitimate Business purpose?

MA: is there a legitimate business purpose for the merger?

DE: rejects BP requirement in Weinberger bc believes its encompassed in E.F. Test.

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Leader v., Inc. (1985)

I.Facts: Hycor was a CHC w/5 SHs who were also directors and employees. Hycor made a small public offering (“went public’). 5 majority SHs still owned 85% of corp. This offering falls into small offering exception and need not be registered. Corp. didn’t pay many dividends and stock was very thinly traded. Majority SHs decide to recapitalize, i.e. “go private,” through a reverse stock split: old shares 1 new share (worth 4000 times old share value) Should result in no eco-nomic consequence, no voting proportion change, but: Corp. will not recognize any fractional shares; if SH owns less than 4000 shares (which all min. SHs did) then corp. would buy for $5/old share. (Sold orig. at $4/share) Result = Freeze-Out (only 5 maj. SHs would remain) Min. SHs al-leged breach of fiduciary duty and lack of corporate purpose and requested (1) appraisal, or (2) set aside recap (plus damages).

Holding: Reverse and Remanded for consideration of Price issue. Here, D’s say Entire Fairness Standard Applies bc it's a publicly traded Corp. P’s say D’s owed them duty of “Utmost good faith and Loyaly” under Wilkes bc it's a CHC. Court says it doesn’t matter, both standards get same result bc P’s could not show a less drastic alternative was available.

e.Stock Splits

• Stock split = tool to go public (or to reduce value per share)

o Initially, to go public, a CHC will increase

number of shares to make a public offeringo If stock price has gone too high, it might

hurt liquidity. Corp. might want to allow more people to buy/sell w/o harming corp.

• Reverse stock split = tool to go private (or to increase value per share)

o Recapitalization (as in Hycor)

o Value of stock must be above $1 to stay on

market. If stock price goes to low, corp. can do a reverse split to increase the value of one share (w/o getting delisted!)

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C. TAKEOVERS:

1.What is a takeover?

a.It is important to distinguish between a friendly and a hostile takeover. The process, time and cost of a hostile takeover is quite different from those of a friendly one. What policies underlie the regulatory scheme?

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2.Tender Offers: Hostile Takeovers

a.Tender offers have, certainly from the mid-1980s, played an important role in hostile takeovers. We will examine how they function, the defenses to be interposed against them and the fiduciary duties of the boards of target companies to their corporations and the target’s shareholders.

b.HOSTILE TAKEOVER

• Prospective Acquirer sees a Target Co that it believe is undervalued in the market or would have greater value with better management or additional synergies.

• Acquirer will seek to get the target in one of may ways (see above)

• A Tender Offer is typically the result of a rebuff (or anticipated rebuff) by the target board.

o Usually a Premium will induce Target SHs to sell to Acquirer

Acquirer believes Target is worth more than Market says not supposed to happen in an efficient market

Good for SH if only motive is to make a profit and get out

• Boards inclined to fight off tender offer:

o To protect their jobs

o To save corp and SHs too…

• Williams Act regulates Tender Offers

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Cheff v. Mathes (1964)

I.Facts: Holland Furnace is owned largely by Cheff-Landwehr family group (though it is public co.). Holland Co. sales volume declined $9M from 1948 to 1956, but by 1957 had begun to rise. Holland Co. business model = employ retail salesmen directly to sell furnaces. June 1957: Mr. Maremont of Maremont Auto inquired about merger w/Holland but was rebuffed. Mr. M began buying up Holland Co. shares on mkt. When Mr. M. had 100,000 shares, he demanded to be put on Holland Board. He also expressed opinion that Holland sales methods were obsolete and al-legedly threatened to liquidate Holland or substantially reduce its sales force if he came into con-trol. Worries about takeover fueled employee unrest. Board investigated Mr. M and believed he posed a threat to corp. policies. Mr. M offered to sell his shares to Corp. Mrs. Cheff would buy Mr. M’s shares personally if corp. didn’t buy. Board knew this, but Board authorized purchase of Mr. M’s shares by the corp. Min. SHs filed derivative suit to hold directors liable for improper use of corp. funds to purchase corp. shares for the purpose of ensuring perpetuation of control by current directors. Asked court to rescind purchase and award damages.

II.Holding: No, Board did not breach its fiduciary duties; this defense was permissible. State statute grants corp. power to purchase and sell shares of its own stock. BJ rule (pre-sumption of good faith and reasonable investigation) usually applies to Board decisions. How-ever, when Board authorizes use of corporate funds to purchase corporate shares to remove a threat to control, BoP shifts to Board to prove it acted in good faith.

III.

IV.Rule: Board must prove it had reasonable grounds to believe that Mr. M’s stock ownership posed danger to corporate policy and effectiveness, such that it was justified in purchasing his shares w/corp. funds. Board satisfies its burden by showing good faith and reasonable investiga-tion. Then BJ Rule will apply. (Reasonable Threat BJR to defense).

V.

VI.Result = “Greenmail.” Mr. M made a hostile bid and gets to sell his shares back at a pre-mium. He doesn’t secure control, but he gets a profit!

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Unocal v. Mesa Pertroleum Co. (1985)

Facts: Unocal is not a very efficient oil exploration company. Mesa owns 13% of Unocal and makes a tender offer for 37%. Mesa offered a two-tier “front-loaded” tender offer: (1) Mesa would purchase Unocal’s 37% for $54 cash/share (2) Mesa would purchase outstanding 50% for “junk bonds” worth the same amount. After (1) Mesa will do a long-form merger (he will have enough to vote in a new board who will vote for the merger. After the Merger (2) cashes out Min SHs w/ “Junk Bonds” by another Mesa Co.

Unocal’s Defense: Selective Self-Tender:

•If Mesa acquired 37% through its own offer (tier 1) (Mesa Purchase condition), then Unocal would buy the remaining 49% outstanding for an exchange of debt securities having an aggregate par value of $72/share.

o But Mesa would be excluded form the proposal (Mesa Exclusion) (so Unocal wouldn’t be subsidizing its inadequate offer).

o Would require Unocal to take on $6.5B debt! This would require Uno-cal to limit exploration (which would be good bc they do it too much).

o Board amended trigger: Mesa only had to get 14M shares to meet condition.

•This is a good plan bc if SHs think they can get $72 after the tender, no one will tender. If trigger occurred, remaining SHs would tender for $72 and get out, Mesa would be stuck with $6.5B debt.

Mesa Challenged Unocal’s defense.

Holding: Unocal Board had power and duty to oppose a takeover threat that it reasonably per-ceived to be harmful to the corporate enterprise, and its action is entitled to protection under Business Judgment Rule. Board’s authority to take defensive measures is derived from:

•(1) Its power to manage corp. business and affairs

•(2) Its ability to buy corporate stock (and to do so selectively, so long as its only purpose is not to entrench the current board (Cheff)

•(3) Its duty to protect the corporation and SHs from harm.

Here, Board had reasonable grounds to believe that Mesa’s ownership posed danger to corp. pol-icy and effectiveness:

•Perceived threat: Mesa’s offer was designed to coerce tender by SHs at an inadequate price OR to “greenmail” corp. into buying them out at a premium to prevent takeover. Unocal’s majority-independent Board took reasonable measures to investigate.

•Proportionality: Measure would deter raider, not protect raider against raid, and would en-

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3.Unocal Rule

a.Ordinary standard for evaluating director’s action Business Judgment Rule

• Presumption that directors acted on an informed basis, in good faith, and in the honest belief that their action was taken in the best interests of the company.

• Court will not substitute its judgment for that of the board if the latter’s decision can be attributed to “any rational business purpose”

b.Rule: When a takeover bid is pending, because of the inherent danger of directors’ conflict of interest in a purchase of shares w/corporate funds to remove a threat to corporate pol-icy, when a threat to control is involved, Directors have Burden of Proof to show that they had reasonable grounds to believe that a danger to corporate policy and effec-tiveness existed bc of SH’s ownership.

• Board MUST Show:

o (1) Perception of threat: Good Faith and Reasonable Investigation

o (2) Proportionality: Defensive measures must be proportional to threat per-ceived.

• THEN, if Board meets Burden of Proof BJR applies.

c.Two-tier front-ended merger

• First tier by tender offer; second tier by merger

o If first tier and second tier have same consideration and risk not coercive.

o If first tier is offered at a fair price (or even at an inadequate price), but second tier is offered at a riskier or less adequate price SHs may be coerced to tender into first tier.

• Who will tender first?

o SHs who think the first deal is fair

o Short-term investors (arbitrageurs) who want a quick premium (even if not the best possible value)

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o Risk averse investors who worry that short-term investors will take up the first tier and they will be stuck in the second tier

• There could be an appraisal remedy for the second tier if it is unfair, but most small SHs have no incentive to utilize an appraisal remedy.

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Moran v. Household International, Inc. (Del. 1985)

Facts: Household is a diversified holding company; Moran is a Household board member. House-hold’s Board = 10 outside directors and 6 members of management. Household adopts a Pre-ferred Share Purchase Rights Plan by vote of 14-2 (Moran against) where common SHs are entitled to issuance of 1 right per common share under triggering conditions:

(1) If 30% tender offer is announced rights are issued pro rata and immediately exercisable to purchase 1/100th share of new preferred stock for $100; rights are redeemable by Board for $.50 per right (allows flexibility); or

(2) If 20% purchase is made by any single entity or group Rights are issued and become non-redeemable and are exercisable to purchase 1/100th a share of preferred. (poison pill)

· “Flip Over” Provision: If SH does not exercise the Right and thereafter a merger or con-solidation occurs, the Rights holder can exercise each Right to purchase $200 of the common stock of the tender offeror for $100.

o This is a “Flip Over” Provision bc it adversely affects the acquirer

o This plan will raise no capital (which is why shares are usually offered) b/c NO ONE will buy these shares unless merger occurs.

o Would heavily dilute the value of existing shares of offeror (would make their SHs angry); designed to scare off an acquirer.

· How can Household Board give its SHs rights to another corp.’s stock?

o In an M&A, the acquirer takes on the target’s assets and liabilities. Household is creating an obligation to its SHs that will pass to any acquirer. SHs have a right to buy 1/100th share of preferred stock. If merger occurs…

· Antidestruction Provision: Protects a right that would otherwise be destroyed in a merger. Whenever SH has a conversion right (paid for, or here, given) the acquirer must honor that conversion to an equivalent share of stock – whatever is specified in the antidestruction provision.

· Here, the “flip over” provision is an antidestruction provision AND a takeover defense! Creative lawyering!

Moran, dissenting director, sues b/c he thinks this plan is aimed to deter ALL offers. SEC agreed

I.Holding: the Rights Plan is a legitimate exercise of business judgment. Household argues that it has authority for Rights Plan per: DE law 157: power to issue rights to purchase shares; DE law 151(g): power to issue preferred stock; and DE law 147: power to manage the corporation’s “business and affairs”

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II.

III.Court rejects Moran’s arguments bc (1) Statutory text doesn’t limit purpose to corporate fi-nancing; there is no evidence that legislature intended to limit use and corp. law is evolving; (2) These aren’t sham rights, they have value ($9 dividend);

IV.[Court dodges this issue – of course they are sham rights! No one will use them unless there is a merger!]; (3) These are “anti-destruction” rights, used to ensure that holders of a security will have a right of conversion in the event of a merger (as well as to protect against a coercive two-tier tender offer).

V.

VI.The Rights Plan will not deter all tender offers, just coercive ones – a tender offer might be made on the condition that the Board redeem the Rights, etc. Corp. can “redeem” rights by re-calling them and paying by a cash dividend (here, $0.50 per right in the 30% case) It is impor-tant that rights are redeemable (or that offerors can get around them) so that the directors have a “fiduciary out” (can take a good offer if it comes along).

VII.

VIII.In sum: Court allows Household to use an “antidestruction provision” as a poison pill to deter some – but not all – hostile takeover bids.

d.Moran Notes:

• Where preferred stock is convertible into the common stock of the issuing corpora-tion at a predetermined ratio…

o Anti-dilution Provisions: protect holders of convertible securities against the loss of their proportional interest and against the loss of the value of their securi-ties due to corporate, as opposed to market, action.

o Anti-destruction Provisions: protect the preferred SHs’ right to convert into something if the corporation is merged out of existence (presumably into the common stock of the surviving corporation).

Here, antidestruction provisions are used not to preserve option-holders’ right to convert, but to deter hostile bidders as a poison pill yet the court allows it!

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• Poison Pills: Courts generally allowed pills to remain in existence b/c they enabled the board to negotiate w/other bidders and ultimately increase the takeover price for SHs.

o *BUT* there must be a way to get around the pill, or court will not allow.

• Defenses to Poison Pills:

o Tender for ALL of the shares (no one left to redeem rights);

o Tender for the rights themselves;

o Condition tender offer on redemption of the rights;

o Buy some amount of shares, then run a proxy contest to replace board new board will redeem or remove pill, and takeover would proceed as merger/tender.

o Buy all the assets (only works if Board agrees);

o Tender for 100% or control but don’t merge, just run it as a subsidiary.

o *Court cites Sir James Goldsmith (famous raider) and his takeover of Crown Zellerbach – used many methods and eventually was successful.

• Defenses to the Defense:

o Dead Hand Pill: Permits only the board that adopted rights plan to redeem it.

Courts generally do not allow b/c it distinguishes among voting rights of dif-ferent directors, intentionally interferes w/SH voting rights, and is “dispropor-tionate” as a defensive measure b/c it effectively precludes SHs from receiv-ing takeover bids and participating in proxy contests.

o No Hand Pill: “Deferred redemption provision,” not allowing new board to re-deem rights for 6 months after purchase.

Courts don’t allow b/c it deprives new board power to manage corp. and dis-tinguishes among Boards.

• Q: What test did Moran Court apply?

o Straight BJ rule applies b/c there is no threat yet.

o *If there had been a threat of hostile takeover, then Unocal would apply:

Under Unocal, Board must show:

Perception of threat: Good faith and reasonable investigation.

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Proportionality: Defensive measure must be proportional to threat per-ceived.

THEN, if Board meets BoP BJ rule applies.

(Some states require showing of business purpose, too.)

• Q: What is the difference between protecting the interests of the corporation as an entity and the interests of the SHs?

o Corp. law recognizes only 3 constituent groups: SHs, directors and officers

o Entity theory recognizes that there are many other groups (stakeholders) w/le-gitimate interests in the corporation, including the corporation’s interest in its own independence.

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D. HOSTILE TAKEOVER CASES

1.Revlon v. MacAndrews & Forbes Holdings, Inc. (1986)

FACTS: Pantry Pride (PP) wanted to acquire Revlon.

•Perelman , CEO of PP (new $, crass, used junk bonds), met w/Bergerac (Fr. aristrocrat), CEO of Revlon, to discuss friendly acquisition and suggested price of $40-50. Bergerac re-buffed offer.

•PP Board authorized friendly acquisition of Revlon at $42-43 or tender offer at $45.

•Revlon Board met to consider threat of takeover:

o Investment banker advised that $45 was inadequate price. Corp. would be worth “mid $50” as a whole and $60-70 if sold off in parts. PP’s strategy would be “junk bond” financing and break up of corp.

o Adopted 2 defensive measures:

1. Revlon self-tender for 5M shares at $57/share.

2. Poison Pill:

· Trigger: if any single entity acquires 20% or more of Revlon’s shares at price of less than $65/share

· Note Purchase Rights Plan: Gives each SH right to convert any share of stock into a note for $65 at 12% interest w/one year maturity.

· Revlon Bd. could redeem rights at $.10 each; rights not available to ac-quirer.

•PP made cash tender offer for any/all Revlon shares at $47.50/common share and $26.67/preferred share subject to (1) PP getting financing and (2) note rights redeemed/voided.

•Revlon Board encouraged SHs to reject PP Offer and adopted another defensive measure:

o Revlon self-tender for 10M shares, exchanged for one Senior Subordinated Note of $47.50 at 11/75% interest, due 1995, plus 1/10th of a share of $9 convertible ex-change preferred stock worth $100/share.

o Notes contained covenants which limited Revlon’s ability to incur additional debt, sell assets, or pay dividends unless approved my majority of “independent” (non-management) members of the Board. (Board was not majority real outsiders.)

o Revlon SHs tendered 87% of outstanding shares (approx. 33M); Revlon bought full 10M shares pro rata.

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o *Scorched earth policy: Notes would impose a huge additional cost on any acquirer and would not leave them enough assets to make takeover work.

•Defensive moves stymied PP’s takeover. PP made a second tender offer at $42/common share (lower amount equivalent to first $47.50 offer, given Revlon’s completed exchange SHs had already gotten pro rata premium for shares Revlon bought back).

o Ex. 1000 shares are outstanding at $47.50 worth $47,500.

Corp. buys back 300 shares at $57.50 pays out $17250.

Remaining 700 shares are now worth $30,250 altogether only $43.25/share

WHITE KNIGHT:

•Revlon Board began negotiations w/Forstmann group about being a “White Knight”

•Forstmann’s first offer:

o $56 cash/share;

o Management would “golden parachutes” (compensation package for mgmt. in case of hostile takeover) to buy shares in new corp.;

o Forstmann would assume Revlon’s $475M debt for issuance of notes, and Revlon would redeem Rights and waive the Notes.

•When deal was announced the value of the Notes began to fall steeply; noteholders were irate.

•PP COUNTERED:

o PP countered w/new proposal at $56.25; it would fractionally bid to top Forstmann’s bids.

•NEW FORSTMANN OFFER:

o Revlon Board continued to meet w/Forstmann (with whom it had shared private Revlon data). Forstmann made a new bid at $57.25 subject to conditions:

Lock-up option: if another acquirer got 40% of Revlon’s shares, Forstmann had the right to purchase “jewel” divisions of Revlon at low price;

No-shop provision: target can’t take deal given by offeror and shop it to other acquirers;

$25M cancellation fee if agr. terminated or another acquirer got 20% of Revlon’s shares;

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Revlon would redeem Notes and remove covenants;

Demanded immediate acceptance of offer.

•REVLON BOARD APPROVED FORSTMANN’S OFFER

o UNANIMOUS Decision to accept because

Offer was higher than PP bid;

*It protected Noteholders (Forstmann would issue new Notes);

Forstmann’s financing was firmly in price (not in reality).

•Value of Notes continued to fall:

o Covenants prevented Revlon or acquirer from buying/selling assets or from adding more debt if covenants were removed, Notes became riskier Note value de-creases.

o **Remember: Noteholders are current and former SHs! But, Noteholders only have contractual rights against corp. (no fiduciary duties). Notes could be redeemed by the terms of the contract. Noteholders’ suit against Revlon board would fail.

PP SUES FOR INJUNCTION

•PP sought injunction against Rights Plan and challenged the lock-up, the cancellation fee, and the exercise of the Rights and notes covenants. PP again raised bid to $58/share if it won injunction.

•Court of Chancery enjoined Revlon’s deal w/Forstmann and found Board had breached duty of loyalty by making concessions to Forstmann out of concern of liability to noteholders rather than maximizing the sale price of co. for SHs’ benefit.

HOLDING

•Revlon directors breached their duties of care and loyalty to corp. and SHs.

o In the absence of hostile actions, if Board takes defensive measures BJ rule ap-plies.

o If there is an “impending” hostile action, if Board takes defensive measures Unocal applies.

Unocal Duty: Board has burden of proof to show

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o (1) Reasonable grounds for believing there was a danger to corp. policy and effectiveness (proved by reasonable investigation and good faith) AND

o (2) Response is proportional to the threat posed.

o Here, if there is impending hostile action (Perlman told Bergerac he was authorized to make tender offer) Unocal applies.

•But once corporation’s sale is inevitable, Board’s duty shifts. It must maximize immediate SH value and auction corporation fairly Revlon duty.

•Here, at first, the Board was defending against a hostile offer:

o Defensive measure #1 = Poison Pill Rights Plan Unocal test applies, it passes test.

Board has power to adopt Rights Plan.

Board made reasonable good faith investigation and found tender offer price inadequate.

Rights Plan, like plan in Moran, was proportional to the threat. It quashed an inadequate offer and didn’t stop bidding actually, it spurred higher bidding.

o Defensive measure #2 = Self-tender for 10M shares Unocal test applies, it passes!

Board has power to do it, and self-tender again drove up the price.

•**Once Revlon sought another bidder (“white knight”) and PP continued upping its bids, Revlon put itself up for sale Board’s duty shifted to maximizing benefit for SHs. Board must act as auctioneers, get the highest value for SHs, and treat all bidders equally.

o Board may aim to maximize short-term or long-term benefit, depending on the situ-ation:

Cash out merger: goal is to maximize short-term price

Share swap: goal is to maximize long-term value, Board must weigh long-term benefits against potential short-term gain.

o Board’s priority must be SHs.

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Here, Board prefers “white knight” share swap w/Forstmann b/c (1) dislike Perlman and (2) Forstmann promised to exchange Revlon notes for equiva-lent Forstmann notes (worried about Noteholder value). But PP offer for SH price is higher than Forstmann.

Court: Any worries about Noteholder value is inconsistent w/duties to SHs. Noteholders are owed only contractual duties; they have contractual rights against the Board, but if contract allows board to waive covenants or redeem rights, then the Noteholders have no further rights against the Board. If note is improperly waived, Noteholders can bring a breach of K action against corp., but Board is safe.

o Defensive measure #3 = Lock-up agreement w/Forstmann Fails Revlon test

Lock-ups and related agreements are permitted where their adoption is un-tainted by director interest and breach of duty in order to drive up prices.

Here, there was breach of duty b/c Board acted on other interests (note hold-ers) and ended an active bidding war that would have produced higher price for SHs.

Concern for various corporate constituencies is proper when facing a takeover threat, but there must be some rationally related benefit accruing to SHs, unlike here.

o Defensive measures of no-shop provision and cancellation fee were also impermissi-ble.

a.REVLON Notes

• In a hostile takeover:

o Most of the time, Target Board tries to fight off offers and Unocal applies;

o When there is a share-exchange situation, Revlon kicks in to apply Unocal’s bur-den-shifting framework (to determine if Board maximized SH profit).

• Enhanced scrutiny is the Unocal look:

o When the first part of Unocal does NOT apply bc there are no defensive devices, its not easy to show which option is better for SHs.

o If the Board passes Unocal in the second step (offer comparison after defense are removed) and choose one after good faith and reasonable investigation, BJR should apply after Board meets Unocal burden (this is a burden-shifting device)

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o When there is some qualitative comparison, the Board must make among com-peting offers, if the Board passes Unocal, Court applies BJR.

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2.Paramount Communications, Inc. v. Time, Inc., 571 A.2d 1140 (Del. 1989) [CB 806]

FACTS: Time Corp. looks to expand its operations in the entertainment industry beginning in 1983-84.

•Board (majority outsiders) considered entertainment cos. and began negotiations w/Warner:

o Board thought Warner was best candidate for consolidation b/c of its int’l distribu-tion system, prowess in music industry, compatible cable and publications divisions, etc.

o Board was concerned about maintaining “Time Culture” of journalistic integrity. Time Board insisted it was not for sale and refused to be the target.

o Disagreements over (1) basis for consolidation – Time wanted all-cash, Warner wanted stock-for-stock exchange to preserve SHs equity; (2) corporate governance – Time wanted control of Board and wanted Warner CEO to co-lead then retire in 5 yrs.

o Negotiations broke down, then began again when Warner CEO agreed to leave in 5 yrs.

· 1st Time-Warner Merger Agreement:

o Stock exchange w/premium to Warner SHs for control (so that Warner SHs will own 62% of combined corp.); surviving corp. will be called Time Warner; Board = all 24 members of both Boards, co-CEOs for 5 yrs. but then Time CEO will take over.

o Time undertook additional defensive measures to discourage hostile offers and agreed to a “no shop” clause w/Warner.

o Public reaction was good, proxy for SH vote was sent out, merger looked like a fact…

· Paramount made a surprise all-cash tender offer for any and all Time shares at $175/share (contingent upon Time’s termination of Warner merger and a few other things).

· Time Board viewed Paramount’s offer as inadequate and held steady w/Warner merger.

o Financial advisor said Time’s value at auction was higher.

o Meanwhile, Time’s stock price rose to $182/share.

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o Time didn’t think proxy vote would succeed b/c SHs would mistakenly not recognize long-term potential of Warner merger.

o Time asked NYSE to allow merger to continue w/o a proxy vote but they re-fused. So, Time and Warner changed the deal to avoid a vote.

· 2nd Time-Warner merger agreement:

o Renegotiated as an outright cash and securities acquisition of Warner by Time. Immediate all-cash offer for 51% of Warner; the remaining 49% in mix of cash and securities at same value/share. Time had to make a few other concessions.

o Bottom line: there won’t be a significant Warner SH presence in new Time Warner.

· Paramount upped its offer to $200/share, but Time rejected it again.

PARAMOUNT SUES TO ENJOIN TIME-WARNER MERGER

· Paramount and dissenting Time SHs sued to enjoin Time-Warner merger.

o Two claims:

Revlon breach: Time was up for sale and Board failed to maximize SH benefit;

Unocal breach: Board implemented defenses in its own interests, rather than for corp. or SHs’ interests.

· Court of Chancery allowed merger to go forward; case came on interlocutory ap-peal.

HOLDING: No, Time Board did not breach its fiduciary duties by rejecting Paramount’s tender offer.

· Revlon duties do not apply here.

o Revlon Duty: To maximize immediate SH value and auction the corp. fairly when:

(1) A corp. initiates an active bidding process seeking to sell itself or to effect a business reorganization involving a clear break-up of the com-pany.

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(2) In response to a bidder’s offer, a target abandons its long-term strategy and seeks an alternative transaction also involving the break-up of the company (as in Revlon, where board responded to Pantry Pride’s offer by contemplating a “bust-up” sale to another bidder).

o Revlon does NOT apply where Board’s reaction to hostile offer is a defensive response and not abandonment of the corporation’s continued existence (break-up is not inevitable).

Mere transaction between two corps. is not enough to trigger Revlon just b/c a 3rd party makes a hostile offer. Instead, Uno-cal duties attach.

· Here: Time wasn’t up for sale; its adoption of defensive measures didn’t trigger Revlon.

o 1st Merger Agr. w/Warner BJ Rule applies

Board made its initial merger decision after careful consideration. No offer from another bidder was yet in place. BJ rule applies.

o Unocal applies to 2nd Merger Agr. w/Warner Board meets its Unocal duties

Unocal Duty: When Board takes defensive measure in response to hostile takeover offer, Board has burden to prove:

· (1) perceived threat was reasonable (good faith and reason-able investigation); AND

· (2) Defensive measures adopted were proportional to threats posed.

In the past, Court has recognized that hostile tender offer poses two types of threats:

o Threat of coercion (2-tier offer w/unequal treatment for non-tendering SH);

o Threat of inadequate price.

Paramount argues that an all-cash, all-shares offer (not 2-tier or coercive) falling within a range of values that a SH might reasonably prefer (adequate price) cannot constitute a “threat” to corp./SH interests for the purpose of Unocal analysis.

Here, Court recognizes other threats that target Board might consider (see FN):

o Opportunity Loss – where a hostile offer might deprive target SHs the op-portunity to select an alternative offered;

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o Structural Coercion – SHs tender b/c they fear being left on the back end;

o Substantive Coercion – risk that SHs will mistakenly accept an offer b/c they disbelieve management representation of “intrinsic value” (based on nature and timing of offer, impact on “constituencies” other than SHs, risk of nonconsummation, quality of securities being offered in the exchange, etc.)

Here, Time had reasonable grounds to believe Paramount offer posed a threat: Paramount timed its offer to confuse SHs, Time SHs might tender in ignorance of the strategic benefit that Warner consolidation would produce, loss of Time culture, etc.

o Time made reasonable investigation about Paramount and other co.s prior to beginning its negotiations w/Warner in good faith.

o Time’s restructuring of Warner deal was proportional to Paramount’s threat.

Board has no duty to allow SHs to manage the timeline of corp. goals.

•SHs elected the Board to be their representatives.

2nd Deal meets Unocal standard. Once they meet Unocal duty, BJ Rule applies.

3.Summary: Evaluating Board Decisions

a.Business Judgment Rule

• Presumption that directors acted on informed basis, in good faith, and in the honest belief that their action was taken in the best interests of the company.

• Court will not substitute its judgment for that of the board if the latter’s decision can be attributed to “any rational business purpose”

• Applies unless there is a procedural defect in Board’s decision-making (conflict of in-terest, lack of due care, self-dealing), then…

b.Entire Fairness Rule

• Burden is on directors to prove the fairness of their action towards min. SHs (un-less an informed majority of minority SHs approves of action by vote (sanitizing vote) then burden of proof shifts back to complaining SHs).

• In the long-form merger context, entire fairness requires (1) Fair Price & (2) Fair Dealing

o (1) Fair Price (remedy = appraisal)

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o (2) Fair Dealing: uphold duty of care and loyalty

Remedy: “expanded appraisal” or recission/damages

o (3) *In MA, business purpose is threshold requirements (not required in DE)

c.Enhanced Scrutiny: Unocal Test

• In takeover context, when Board enacts defensive measures there is a possibility that Board is putting its interest in staying in power ahead of SH interest.

• When an acquirer takes action (Unocal) or there is “impending action” (Revlon), the burden of proof shifts to directors to show:

o (1) Board reasonably perceived a threat to corp. policy / effectiveness, shown by:

Reasonable Investigation;

Good Faith; and

o (2) Defensive measures enacted are proportional to the threat.

o Board’s position is enhanced by having a majority of outsiders (less conflict?)

o If Board meets burden Business Judgment Rule applies

d.Value Maximization: Revlon Test

• Once Corp is “up for sale,” Board’s duty shifts must maximize SH value and auc-tion the corp. fairly

• Corporation is “Up for Sale” When:

o (1) A Corp. initiates an active bidding process seeking to sell itself or to effect a business reorganization involving a clear break-up of the company.

o (2) In response to a bidder’s offer, a target abandons its long-term strategy and seeks an alternative transaction also involving the break-up of the company.

• Corp is NOT “up for sale” when Board’s reaction to hostile offer is defensive, and not abandonment of the corp’s continued existence (break-up not inevitable) (Time-Warner)

• Once Revlon duties attach, Board must remove defenses (that do not seek to facili-tate a higher price) and allow a free bidding process (Can’t play favorites)

• Board might put defenses back in place in order to drive up the price when bidding has reasonably reached an endpoint (may seek a new bidder and entice w/a lockup)

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• **”Value Maximization” need not be short-term.

o When bidding is an all-cash buy-out, it is easy to compare bids bc $ is only mea-sure and all SHs will be bought out highest price wins

o It is harder to determine Maximum value when one or both offers is a share-swap or involves securities.

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4.Paramount Communications, Inc. v. QVC Network, Inc. (Del. 1994) [CB 819]

a.FACTS: Paramount Board was interested in a strategic combination with Viacom. Davis = Paramount CEO; Redstone = Viacom CEO and majority SH (85%)/ Paramount = majority owned by unaffiliated public investors.

Redstone and Davis begin negotiations. Viacom will offer a combination of cash and stock worth $61/share; Paramount wants at least $70/share. Negotiations break down. Diller = QVC CEO. Diller asks Davis about buying Paramount. Davis says Par. isn’t for sale.

Viacom stock price starts increasing (allegedly b/c Redstone is buying up stock). Viacom’s purchase of Paramount becomes more realistic b/c it can buy more of Paramount w/less stock.

Paramount and Viacom agree to a deal:

o Cash and share exchange worth roughly $61/share for Paramount stock.

o Paramount amended its poison pill so it wouldn’t harm Viacom.

o Paramount enacted several defensive measures:

No shop provision : Par. would not solicit/discuss any competing trans-action unless:

• 3P made an unsolicited written proposal w/o financing contin-gencies; AND

• Par. Bd. determined that discussions w/3P are necessary for Bd. to comply w/its fiduciary duties

• ** If Bd. thought it was req’d by fid. duties to negotiate w/3P that had not made an unsolicited written proposal w/o contin-gencies, it couldn’t!

Termination fee : Viacom would get $100M if Par. terminated merger b/c of competing transaction, Par. SHs disapproved of merger, or Par. Bd. recommended another transaction.

Stock option: If termination fee triggers occurred, Viacom would have an option to purchase 19.9% of Par. outstanding common stock at $69/share.

Note Feature: Viacom could pay w/senior subordinated note of ques-tionable marketability instead of cash (avoided need to raise $1.6B purchase price);

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**Put Option: Viacom could choose to require Par. to pay Viacom in cash the difference between the purchase price ($69) and the market price of Par. stock. (I.e., could avoid having to buy Par. stock at all and just get the profit. **Not capped, so it could reach unreasonable levels – here, $500M!)

Paramount and Viacom believed the deal was sealed, did everything to discourage others.

QVC announced $80 cash tender offer for 51% of Paramount’s shares; remaining 49% would be converted to QVC stock at same value. QVC also sued.

Paramount and Viacom re-negotiated the deal.

o Viacom knew it would have to raise bid – made $80 cash tender offer for 51% of Par.’s shares; remaining 49% would be converted to Viacom stock at same value.

o Amended agreement did not alter the defensive mechanisms.

Viacom then raised offer again to $85.

QVC upped its bid to $90. Par. Bd. determined QVC bid was not in best interests of SHs b/c excessively conditional and Viacom deal would be better. However, Par. Bd. did not meet w/QVC directors or negotiate b/c it believed the No-Shop Provision of Viacom deal prevented it.

Trial Court issued preliminary injunction in favor of QVC.

HOLDING: Yes, Paramount Board breached its fiduciary duties to SHs.

Standards of Review for Board Action:

o Under normal circumstances, business judgment rule – deference to Board action – applies; neither the courts nor the SHs should interfere w/directors’ managerial decisions.

o Where actual self-interest is present and affects a majority of the directors approving a transaction, a court will apply even more exacting scrutiny – an entire fairness test – to determine whether the transaction is entirely fair to the SHs.

In certain situations, enhanced scrutiny – oversight of directors’ decisions to determine whether they are reasonable – is appropriate. Prior to this case, this Court established two situations where enhanced scrutiny applies:

o (1) The approval of a transaction resulting in the sale of control; and

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o (2) The adoption of defensive measures in response to a threat to cor-porate control.

Significance of a Sale or Change of Control:

Majority SHs have considerable power w/in corp. Acquisition of majority sta-tus comes at a price (control premium) which recognizes value of control and compensates minority SHs for loss of voting power.

Min. SHs’ power is significantly diminished when majority is acquired by a single person, entity, or group, rather than a fluid aggregation of unaffiliated public SHs in the absence of devices protecting min. SHs like supermajority voting provisions, majority of the minority req’ts, etc., min. SHs’ votes are likely to become meaningless.

o [In reality, do min. SHs in big public co. exercise control even when there isn’t a big majority? No – the Board/mgmt. tells them what to do!]

Here, Paramount is majority controlled by public SHs. In Viacom cash and share-exchange deal, Paramount will become majority controlled by a single SH; current SHs will continue on as minority SHs.

Paramount SHs are entitled to receive (a) a control premium and/or (b) protective devices. There being no protective devices in place, Para-mount Bd. had obligation to maximize best value reasonably available for SHs.

Obligations of Directors in a Sale or Change of Control: Enhanced Scru-tiny

Board action in sale of control is subject to enhanced scrutiny because:

the threatened diminution of current SHs’ voting power;

an asset belonging to public SHs – control premium – is being sold and may never be available again;

DE courts traditionally are concerned w/actions that impair/impede voting rights.

“Unocal II” Rule: In a sale or change of control, Board must act rea-sonably to seek the transaction offering the best value reasonably available to SHs.

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In determining which alternative provides the best value for SHs, directors need not consider only the amount of cash involved, but must try to quantify alternatives, adequately inform itself, and analyze the entire situation and evaluate in a disciplined manner the consideration being offered.

Enhanced scrutiny (for determining if Bd made a reasonable deci-sion)

o Court must determine whether Board properly perceived SHs in-terests were enhanced by their actions and that they acted rea-sonably in relation to the advantage to be achieved/threat to be avoided.

o Directors have burden of proving they were (a) adequately in-formed in decision-making process and (b) acted reasonably in light of existing circumstances.

o Directors’ actions must be reasonable, not perfect.

Distinguish Revlon and Time Warner:

Revlon does not require that inevitable dissolution or “break-up” of corp. is necessary before enhanced scrutiny applies rather, in a sale of control the responsibility of the directors is to get the highest value reasonably attain-able for the SHs.

Revlon duties did not apply in Time Warner b/c there was no true change of control pending b/c Time and Warner were both publicly owned, so control would remain in large, fluid market and the dilution effect on existing SHs would be the same as issuance of new stock.

Time Warner stated two circumstances where Revlon duties applied – (1) where corporation initiates an active bidding process to sell itself or to effect a business reorganization involving a breakup of the corp. and (2) where tar-get abandons its long-term strategy and seeks an alternative transaction of the breakup of the company – but explicitly stated that it did not exclude other possibilities!

Here, Paramount deal is w/in first scenario – Paramount accidentally initiated a bidding war – and sought to sell control.

Rule: When a corporation undertakes a transaction which will cause (a) a change in corporate control or (b) a break-up of the corporate entity, the di-rectors obligation is to seek the best value reasonably available to the SHs.

Breach of Duties by Paramount Board:

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Board’s obligations: to evaluate all aspects of the deal critically, considering whether Viacom deal (a) adversely affected Par. SH value; (b) inhibited or en-couraged alternative bids; (c) were enforceable contractual obligations in light of the directors’ fiduciary duties; and (d) in the end would advance or re-tard Par. directors’ obligations to seek best value reasonably available for Par. SHs.

Board’s breaches:

o Didn’t adequately consider the effects of defensive measures, par-ticularly No-Shop Provision and Stock Option;

o Didn’t take advantage of its position post-QVC offer to drive better deal w/Viacom (and remove defenses!);

o Didn’t adequately inform itself about QVC offer or negotiate w/QVC Board or generally about the two deals.

Viacom’s claim of vested contract rights fails b/c the No-Shop provision and the Stock Option were invalid – didn’t allow Board to exercise fiduciary duties properly.

Paramount-Viacom deal is enjoined.

E. HOW DOES UNITRIN IMPACT THE TAKEOVER RULES?

1.Unitrin, Inc. v. American General Corp. (Del. 1995)

FACTS: AmGen = largest home service insurance provider; Unitrin = third largest provider.

• Unitrin Board = 2 employees (CEO & Chairman); 3 SHs (total $450M stock); 2 others

• AmGen made friendly proposal to purchase Unitrin in an all-cash/all-shares (non-structurally coercive) merger at $50/share (30% premium). AmGen would consider offering a higher price if Unitrin could demonstrate additional value and offered to consider tax-free alternatives to an all cash transaction, if desired.

• Unitrin Board met to consider AmGen’s offer. Investment banker (hastily prepared report) & legal counsel advised Board of two possible threats:

o (1) Inadequate price (doesn’t reflect long-term prospects);

o (2) Potential anti-trust problems would prevent merger from being consum-mated.

• Experts advised Unitrin Board to adopt two defenses:

o Poison Pill (SH rights plan);

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o Advanced Notice Provision (if SH makes proposal to change bylaws, must wait).

o *Unitrin already had a “shark repellent” provision in place: required super-majority (75%) approval of any combination with a greater-than-15% stock-holder.

A “shark repellent” is a provision in a company’s by-laws or articles of incorp. that is intended to deter a bidder’s interest in that corp. as a target for takeover.

UNITRIN BOARD REJECTED AMGEN’S OFFER.

• AmGen went public w/offer and rejection.

o Unitrin Board treats AmGen’s public statement as a hostile action intended to co-erce a deal.

o Unitrin adopts the two defensive measures (poison pill/advanced notice) and

o Unitrin begins a Repurchase Program of up to 10M outstanding shares at a price slightly higher than AmGen’s offer. They bought 5M shares before en-joined.

Unitrin Board announced that its members would NOT participate in the pro-gram and that Repurchase Program would make it easier for non-selling SHs (including directors) to defeat a merger w/a greater than 15% SH.

Directors already owned 23% of shares and would not sell. After corp. pur-chased 10M shares, they would own 28% of shares. In combination w/shark repellent provision, after repurchase plan occurred, a merger could not happen w/o Board members’ approval as 28% SHs.

COURT OF CHANCERY ENJOINED REPURCHASE PROGRAM as a breach of Unitrin board’s fiduciary duties.

• Unocal applies to Board’s defenses in response to perceived threats of AmGen’s of-fer.

o (1) Good faith & reasonable investigation of threats? Yes. Board found AmGen’s price to be inadequate and worried about “substantive coercion” (SHs would tender/approve deal in mistaken belief about Unitrin’s long-term value). (Court waived away Unitrin’s antitrust concerns as insignificant.)

o (2) Proportional response? No. AmGen’s offer posed only a “mild” threat – price & structure could be renegotiated, deal was flexible.

Poison pill and advanced notice plan were reasonable.

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Repurchase program was “unnecessary” in light of the two other defenses and the shark repellent. *Court assumed that the Board adopted this Pro-gram to give the majority SHs on the Board control of any merger decision. These directors would be less likely to sell at an inadequate price than other SHs b/c of the prestige/perks they receive as part of Board.

HOLDING: Remanded to determine whether Unitrin Board breached its fiduciary duties by adopting these defenses in accordance w/Court’s modified Unocal standard.

• Court of Chancery Decision was based on 3 continued misunderstandings:

o (1) Court improperly assumed that directors’ will be motivated by the “prestige and perquisites” of Board membership rather than their economic self-interest as substantial SHs.

SHs are presumed to act in their own best economic interests when they vote in a proxy contest. Court was wrong to assume otherwise w/o evidence.

o (2) Court wrongly believed that Repurchase Program was aimed to give SH direc-tors the needed voting power to automatically win a proxy contest under the su-permajority provision 25%.

Generally, 100% of shares are not voted in a proxy contest assume 90% turn-out. With 23% of shares, director SHs already have actual voting power greater than 25% in a proxy contest w/normal SH turnout.

o (3) Court wrongly found that Repurchase Program + Shark Repellent + other de-fenses meant that no hostile acquirer could succeed proxy vote/tender offer at-tempt.

Poison pill is triggered when acquirer gets 15% ownership.

Rational behavior of acquirer = buy 14.9% of shares, then launch and win a proxy contest to elect new directors who are willing to redeem target’s poison pill and remove other defenses.

Court does the math to show that here, even w/the poison pill, superma-jority vote, and repurchase program in place, it would be possible for an acquirer to get sufficient number of votes to elect new Board (45.1%, as-suming 90% turnout) and approve a merger (50.1%, absolute majority re-quired). (If new Board approves of merger, shark repellent won’t come into play only need a majority of votes.)

• Here, it will be easier for acquirer to get enough votes b/c Unitrin is largely owned (42%) by institutional investors. (20 institutions own 33% of stock.)

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o Institutional investors are more likely than other SHs to vote at all, to vote against management, and to vote for proposals by other SHs.

o They are also easier to communicate with! AmGen can convince 20 institutions and win!

o Proxy contest remained a viable option for AmGen to pursue.

COURT OF CHANCERY IMPROPERLY APPLIED UNOCAL TEST:

• Court rightly found that Unitrin reasonably perceived a threat from AmGen’s offer:

o Court has recognized 3 types of threats:

Opportunity loss : hostile offer might deprive target SHs of opportunity to se-lect a superior alternative offered by target mgmt. or another bidder;

Structural coercion : disparate treatment of non-tendering SHs might distort SHs’ tender decisions;

Substantive coercion : SHs might mistakenly accept an underpriced offer b/c they disbelieve mgmt.’s representations of intrinsic value.

o Unitrin believed AmGen’s offer was of “inadequate value” and that it was a form of substantive coercion b/c some SHs seemed willing to exercise short-term gain…

o Board has a duty to respond actively to protect the corp. and its SHs from per-ceived harm; actions show Unitrin was responding to perceived threat of subst. coercion.

Court wrongly found that Unitrin’s defenses were “unnecessary” to meet threat.

• Instead of determining whether the Board’s defenses were “reasonable,” the Court found that Unitrin’s adoption of Repurchasing Plan was unnecessary to meet the “mild threat” posed by AmGen’s flexible offer. They substituted their judgment for the Board’s judgment this is not their job!

• Modified Unocal Proportionality Standard:

o Board does not have unlimited discretion to defeat a perceived threat by any draconian means available. Instead, pursuant to the Unocal proportionality test, Board must act reasonably in relation to the threat.

Court must decide whether Board’s response was reasonable, not perfect (QVC).

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o If Board acts w/in “range of reasonableness,” then it has met its burden and BJ rule applies Court will not substitute its judgment for Board’s.

Court is especially worried about SH disenfranchisement.

• Where boards of directors deliberately employ legal strategies either to frustrate or completely disenfranchise a SH vote conduct violates law. (Blasius)

• When adopting a restrictive stock repurchase, directors may not act solely or pri-marily out of a desire to perpetuate themselves in office (preclusion of SHs’ corpo-rate franchise right to vote) (Unocal)

Modern Unocal Proportionality Standard: Court must ask:

• (1) Whether defense is coercive or preclusive

o If yes (to either), the defense is draconian and impermissible.

o If no, then ask…

• (2) Whether the defense is within the “range of reasonableness.”

o If yes, BJR applies to determine whether permissible.

o If no, entire fairness applies to determine whether permissible.

• [Why does Court change the test? Probably a judicial economy device. If some-thing is coercive/preclusive, don’t waste time weighing reasonableness.]

• Here, it seems like Unitrin’s defenses were not preclusive nor coercive b/c a hostile bidder could yet succeed through a proxy contest… but remanded to the lower court to decide based on this test.

2.Omnicare, Inc. v. NCS Healthcare, Inc. (Del. Supr. 2003)

FACTS: NCS Healthcare faced due to changes in gov’t/3P reimbursements. It was defaulting on approx. $350M of debt (some to banks, some in Notes). Share prices fell from over $20 to $0.50.

• NCS had two classes of shares: Class B = 10 votes/share; Class A = 1 vote/share. Two directors – Outcalt and Shaw – control 65% of voting power of stock. NCS began to seek restructuring alternatives through its financial advisors but was unsuccess-ful. NCS Noteholders formed their own “ad hoc committee” to represent their finan-cial interests. They began to solicit offers to recover their assets (w/o corp. author-ity).

• NCS invited Omnicare – a huge pharmaceutical corp. – to negotiate to acquire NCS. Omnicare proposed an asset sale in bankruptcy for $225M; eventually raised to

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$313M. This acquisition would provide only small recovery for NHs and none for SHs. Omnicare not interested in another type of deal didn’t want to take on more liabilities.

• NCS invited Genesis – a healthcare corp. that had recently returned from bank-ruptcy and had lost a previous bidding war w/Omnicare – to negotiate to acquire NCS. NCS finances began to improve possibility of better deal.

• NCS Board formed an Independent Committee of two independent directors. Finan-cial advisor suggested NCS seek a “stalking horse merger partner.”

GENESIS INITIAL PROPOSAL & EXCLUSIVITY AGREEMENT:

• Genesis proposed merger: (1) full repayment of NCS bank debt; (2) payment of par value for NCS Notes in cash & stock (no interest); (3) payment to NCS SHs of $24M in Genesis stock; (4) assumption of all liabilities.

o Q: How can Genesis pay SHs anything while paying NHs less than full amount? NHs will approve deal b/c it means they will get some value.

o Genesis did not want to be a stalking horse and demanded exclusivity provi-sions.

ENTER OMNICARE

• Omnicare figured out that NCS was negotiating w/someone else and got worried about competition proposed acquisition of NCS

o Omnicare proposed: (1) repayment of NCS bank debt and Notes at par value plus interest, (2) pay NCS SHs $3/share. Deal pays more but is conditioned on due diligence.

o NCS could not respond to the proposal per the exclusivity requirement w/Gene-sis.

o Ad Hoc Committee told Omnicare that the condition of due diligence weakened the deal.

o NCS Board considered proposal, decided that risk of losing Genesis deal if they talked w/Omnicare was too great, but they could use counter-offer to raise Gene-sis’ bid.

GENESIS MERGER AGREEMENT AND VOTING AGREEMENTS:

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• Genesis agreed to raise its bid but it required approval of the deal by midnight the next day or it would withdraw its bid. NCS Board believed this was a real threat.

• NCS Board decided to take Genesis deal, balancing potential risk of a more prof-itable Omnicare deal (if NCS loses Omnicare deal and Genesis walks away, NCS is back to asset sale) vs. certainty of less profitable Genesis deal.

• Board authorized voting agreements w/majority SHs (Outcalt & Shaw), then the merger.

• Merger Agreement w/Defenses: NCS SHs would get 1/10th share Genesis common stock/share & appraisal rights. NCS would redeem NCS’s Notes.

o *NCS would submit merger agr. to NCS SHs regardless of whether NCS Board continued to approve the merger.

o Lock-Up: NCS would not enter into discussions w/3Ps concerning alternative ac-quisition of NCS unless (1) 3P provided unsolicited written proposal, (2) NCS Board believed proposal was likely to result in superior acquisition proposal, and (3) NCS entered a confidentiality agr. w/3P.

o Termination Fee: $6M.

o *NCS Board was aware that combination of voting agreement and merger agreement meant that SH approval of the merger would be as-sured even if NCS Board were to withdraw or change its recommenda-tion and NCS would be prevented from engaging in any alternative or superior transaction in the future.

• Omnicare publicized an alternative offer days after the NCS-Genesis merger was ap-proved made tender offer for all of NCS’s shares at $3.50/share, again conditioned on due diligence.

• Two months later, Omnicare made its offer irrevocable. NCS withdrew support from Genesis deal when Omnicare made an irrevocable offer to acquire NCS.

• However, success of Genesis proposal was pre-determined.

• Omnicare and NCS SHs independently sued to invalidate NCS-Genesis merger.

HOLDING: Yes, NCS Board violated its fiduciary duties by agreeing to these merger defenses.

• Q1: What is the proper standard to evaluate Board’s initial merger deci-sion?

o Usually, BJR applies to merger decision.

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o Revlon duty to max. SH value applies when: (1) Board puts corporation “up for sale” (initiates an active bidding process to sell itself or abandons long-term strategy to seek an alternative transaction that would involve break-up of corp.); or (2) Board undertakes a transaction that will cause a change in corporate con-trol.

o Here: (1) NCS didn’t initiate a bidding war (approached individual corps.) and stopped trying to sell itself once it entered an exclusive deal w/Genesis, and (2) there was no change of control involved (majority SHs already have control in both corps., share exchange will result in same fluid minority). BJ rule applies to merger decision.

• Q2: What is the proper standard to evaluate deal protection devices?

o *Deal protection devices = defenses that require Unocal/Unitrin enhanced scru-tiny b/c Board is protecting its plan against a future competing plan.

Under DE law, merger decisions are made by Boards and SHs. Protection de-vices, like defenses, may take away SHs’ power to reject merger or seek, re-ceive/accept another offer, etc. and create risk of conflict for board.

But no threat? No counter-offer when Board adopts deal-defensive devices…

Here, possibility of enhancement vs. of losing deal and having no comparable alternative = threat. Enhanced scrutiny applies.

• Q3: Do NCS’s deal-protection devices meet Enhanced Scrutiny test? NO.

o Does NCS have a reasonable belief that Genesis’ deal will enhance SH value (such that potential loss would be a threat)? Yes. Genesis can show reason-able investigation of value/risk of deal.

o Are NCS’s deal-protective devices proportionate to the enhancement/threat? No.

Are defenses draconian – preclusive and/or coercive? Yes.

Coercive = aimed at forcing on SHs a management-sponsored alternative to a hostile offer.

Preclusive = deprives SHs of the right to receive all tender offers or pre-cludes a bidder from seeking control by fundamentally restricting proxy contests or otherwise.

Here, deal is coercive b/c if SH vote had been allowed to take place, it would have been robbed of its effectiveness by predetermined outcome of

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the merger w/o regard to merits of deal at time of vote. (But strange b/c no element of forcing here… It’s probably only preclusive, if anything.)

Here, deal is preclusive b/c it foreclosed possibility of another bidder suc-ceeding (fully locked-up deal).

o Merger = draconian and invalid.

[Don’t need to consider whether devices are w/in “range of reasonableness b/c they are draconian.]

• Q4: Was merger agreement otherwise unenforceable b/c it lacked a fidu-ciary out? Yes.

o The omission of a “fiduciary out” in the merger agreement completely pre-vented the Board from discharging its fiduciary duties to the minority SHs when Omnicare presented its superior transaction.

o To the extent that a merger contract purports to require a board to act or not act in such a fashion as to limit the exercise of fiduciary duties, it is invalid and un-enforceable.

• Result = Merger and Voting Agreements are invalid and unenforceable.

DISSENT (C.J. Veasey):

• Unocal should not apply to this case; business judgment rule should apply.

• Here, NCS Board seeks and seeks a deal and can’t get one. They finally get Genesis to make an offer, get Genesis to improve the offer, and are in a very difficult finan-cial place.

• When Genesis demanded NCS agree to the lock-up w/o fiduciary out, they had to agree! Otherwise, the deal would go away.

• It would be a different case if there had been an active bidding war.

• There was no evidence of self-dealing here.

ba outline

Documents

texas gulf

unsolicited

utmost good

active bidding

de facto merger

closely held

reverse triangular

active bidding