I. Economic and Legal Aspects of the FirmA. Themes

i. Purposes of corporations1. Profit-seeking2. Driving economic growth3. Limited Liability 4. Minimize contracting costs5. Minimize agency costs

ii. Sources of corporate law1. Mostly state legislatures 2. Some common law3. Federal government—disclosure obligations4. Stock exchange rules

iii. Purpose of corporate law 1. Structure of corporation

a. Legal view. Shareholders elect Board, who delegate to managers, who keep shareholders informed.

b. Real world View. Managers call the shots and keep shareholders out of the loop.

i. “Wall Street Rule.” Dissatisfied shareholders can sell.

2. Responsibilities of board to shareholders3. Corporate governance

a. Incentive structuresi. Johnson and Mecklin, Theory of the Firm. Agents

will act in interests of corporation only up to ownership stake. Anything less than full ownership produces waste.

b. Fiduciary Dutyc. Pricing

i. Easterbook and Fischel, The Corporate Contract. The price of a corporation’s stock reflects its governance structure. Corporate law should be default rules to contract around.

d. Institutional investors have become majority of shareholders. i. Leads to more agency problems, but also more

sophisticated oversight e. Sarbanes-Oxley

i. § 301. A publicly held company must have independent directors sitting on the auditing committee.

ii. § 302. The CEO and CFO must sign off on reports.iii. § 304. CEO and CFO forfeit compensation if the

signed-off reports are wrong. iv. § 307. SEC issues rules of professional responsibility

for lawyers.v. § 404. Accounting firm has to audit financial

reporting.B. Agency Law

i. Possible structures of organization1. Market relationship2. Operation by contract3. “State Supplied Forms”

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a. Sole proprietorshipb. General partnershipc. Limited partnershipd. LLCe. Corporation

4. Organized as a spectrum, determined by:a. Specialization of product and human capitalb. Asset specificity. The next best use of the asset declines

dramatically in value. ii. COMMUNITY COUNSELING SERVICE, INC. V. REILLY (Fourth

Circuit, 1963)1. Holding During his period of employment, an agent must place the

interests of his principal above his own. 2. Fiduciary duty. Elements:

a. Substitute principal’s interest for agent’sb. Turn over anything that comes to agent that belongs to

principal c. Honesty and full disclosure

3. To extend the company’s protection, could have had him sign a non-compete clause.

a. Robbins v. Finlay. Non-compete clause must come with compensation, such as through specialized training.

iii. Restatement of Agency Law1. § 387. General Principle. Unless otherwise agreed, an agent is

subject to a duty to his principal to act solely for the benefit of the principal in all matters connected with his agency.

2. § 385. Duty to Obey. 3. § 388. Duty to Account for Profits Arising out of Employment. 4. § 393. Duty not to compete with the principal as to subject matter of

agency. 5. § 394. Duty not to act for one with conflicting interests. 6. § 395. Duty not to use or disclose confidential information to compete

with or injure the principal. 7. Alternative conception of fiduciary duty (Easterbrook): the bargain the

parties would have struck. More room for contractual opt-out. iv. At will employment

1. HAMBURGER V. HAMBURGER (Massachusetts Superior Court, 1995)

a. Holding An at-will employee has no obligation not to set up financing for and plan his next job while still employed.

2. Combination of fiduciary duty and at-will employment favors the employer

a. Imbalance exists because the principal is a residual claimant 3. FOLEY V. INTERACTIVE DATA CORP. (California Supreme

Court, 1988) a. Holding An employer, through course of dealings and the

presence of mandatory company policy, can transform at will employment into a relationship that can only be terminated for cause.

v. BLACKBURN V. WITTER (California District Court of Appeal, 1962)1. Holding The principal is bound by the acts of its agent in a relationship

with a third party.

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2. Apparent Authority. If principal gives signals to the world that its agent has authority, and a third party reasonably interprets these signals, the principal is bound.

II. Partnerships and Other Non-Corporate EnterprisesA. General Partnership has been eroded somewhat by the development of LLPs and LLCs

i. Norms best suited for a trusting, small group of participants with similar ideas as to how to run the firm

B. Uniform Partnership Acti. Profit/Loss

1. § 401(b). “Each partner is entitled to an equal share of the partnership profits and chargeable with a share of the of the partnership losses in proportion to the partner’s share of the profits.”

2. HYNANSKY V. VIETRI (Delaware Court of Chancery, 2003)a. Holding Determination of whether a partnership exists

requires an inquiry into the intent of the parties to share profits.

b. Intent to form a partnership or a partnership agreement is not dispositive.

3. New York law: must ask whether the parties are intended to share losses

4. When only one party contributes money and the other human capital, courts generally will not force an equal sharing of financial losses.

a. Other partner has already lost his time and invested human capital.

ii. Management1. § 401(f). “Each partner has equal rights in the management and

conduct of the partnership business.” 2. COVALT V. HIGH (New Mexico Court of Appeals, 1983)

a. Holding When a partnership is equally divided, the status quo governs.

iii. Dispute Resolution1. § 401(j). A difference arising as to a matter in the ordinary course of

business… may be decided by a majority of the partners. An act outside the ordinary course… may be undertaken only with the consent of all of the partners.”

iv. Partner Admission1. § 401(i). “A person may become a partner only with the consent of all

the parties.” v. Relationship

1. Fiduciary relationship a. MEINHARD V. SALMON (New York Court of Appeals,

1928)i. Holding The fiduciary duty between partners

requires one partner to inform the other of an investment opportunity made possible by the partnership.

ii. “Not honesty alone, but the punctilio of an honor the most sensitive….”

iii. UPA tries to bound the decision. 2. § 404(a). “The only fiduciary duties a partner owes to the partnership

and the other partners are the duty of loyalty and the duty of care…”a. Both duties also framed in the negative

i. § 404(b). Duty of loyalty: accounting and competition

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ii. § 404(c). Duty of care: negligence, recklessness, misconduct, or illegal conduct

3. § 301(1). “Each partner is an agent of the partnership for the purpose of its business. An act of a partner… carrying on in the ordinary course of the partnership business… binds the partnership….”

vi. Liability1. § 306. “[A]ll partners are liable jointly and severally for all obligations

of the partnership….” a. § 305(a). “A partnership is liable for loss or injury… as a

result of wrongful act or omission… of a partner acting in the ordinary course of business of the partnership or with authority….”

b. Includes malpractice or criminal behavior2. P.A. PROPERTIES, INC. V. B.S. MOSS’ CRITERION CENTER

CORP. (S.D.N.Y. 2004)a. Holding When one partner has inherent authority ad is trying

to further the interests of the partnership, any agreements are binding.

3. HAYMOND V. LUNDY (E.D. Pa. 2002)a. Holding A partner acting contrary to the Partnership

Agreement is exceeding his authority and the partnership is not bound.

b. Anomalous case and difficult to square with P.A.P. vii. Exit

1. § 601. “A partner is dissociated from a partnership upon the occurrence of any of the following events: (1) the partnership’s having notice of the partner’s express will to withdraw….”

a. Also expulsion, (3) and (4), or a judicial finding of wrongful conduct (5), bankruptcy (6), or death (7)

b. For bankruptcy or death, the partnership does not have to be wound up; can buy out the partner’s share

i. All other times, must be wound up. 2. MCCORMICK V. BREVIG (Montana Supreme Court, 2004)

a. Holding Dissolution requires liquidation of the partnership’s assets into cash before distribution.

III. The Corporate Form A. Choice of the corporate form

i. Important variables: liability, taxes, and governanceii. S-Corp and C-Corp are tax distinctions.

1. Limited liability, but entity/double taxation2. Partnerships: flow through taxes, but no limited liability 3. Limited partnerships: flow-through taxes; limited partners only have

limited liability a. LLCs can choose taxes, but members have limited liability

iii. Limited Liability. Liability is limited to the amount of the initial investment. 1. Partnerships can use insurance to limit liability 2. In publicly held corporations, transaction costs would go way up; have

to investigate the wealth characteristics of other shareholders iv. Tax treatment. Corporation itself is a taxed entity; so are shareholders. Leads to

double taxation problems. 1. Partnerships, etc., are flow-through entities. Individual partners are

taxed, but the entity is not. B. Basic characteristics

i. Internal Affairs Doctrine. The law of the state of incorporation governs the relationships between shareholders, directors, and officers.

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1. 35 states have adopted the MCA, and compete with Delaware for the franchise tax.

2. Delaware has the advantage of experienced judges and legislators and extensive case law

a. Two-layered court system, Chancery and Supreme:i. Chancery Court is a corporate law court; explicitly a

court of equityb. Corporate law amendments are proposed by the Corporate

Law Section of the Bar, adopted by the General Assembly ii. Norms.

1. Separation of functiona. Assumes a hierarchy between passive investors and active

managers. Directors are generally independent or executives b. Same person can hold multiple roles, especially in closed

corporationsc. Leads to agency and monitoring costs

2. Adaptability a. Free transferability of shares

i. But, DCL § 202 allows restrictions on transferability b. Corporation lasts indefinitely c. Common stock. Comes with residual claimant status and

voting rights, for election of directors. d. Preferred stock. Comes with liquidation rights, and a right to

receive dividends before common stock3. Judicial Deference, via the business judgment rule4. Limited liability

iii. Shareholder/Director/Manager relations1. Effecting change

a. DGCL § 242(b). Amendments to the certificate of incorporation are to be proposed by the board of directors and submitted to shareholders for majority vote

b. DGCL § 109. Shareholders have the right to amend the bylaws; can be delegated but not divested.

2. DCGL § 141(a). “The business and affairs of every corporation… shall be managed by or under the direction of a board of directors, except as may be otherwise provided….”

3. DCGL § 211. Directors must be elected at an annual meeting or by written consent. Can get a court order to force it.

a. § 211(d). Shareholders can’t call a special meeting. b. MBCA § 7.02(a)(2). If 10% of voting power submit demands

for a meeting, a special hearing will be called. 4. Voting.

a. Straight voting. Vote for all board members, winner takes all. Default under MBCA § 7.28(e).

b. Cumulative Voting. Multiply number of shares by board members.

i. Formula: SX/(D+1)+1=necessary number of shares c. Directors usually nominated by high-level officers,

shareholders vote up, down, or withhold. d. HOSCHETT V. TSI INTERNATIONAL SOFTWARE,

LTD. (Delaware Court of Chancery, 1996)i. Holding The ability to elect directors by written

consent does not substitute for the mandatory annual shareholders’ meeting.

ii. Since overruled by § 211. 5. Removal

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a. Default rule is that directors may be removed by simple majority of shareholders, with or without cause. § 141(k), § 8.08(a).

i. For cumulative voting, can’t be removed if enough votes to elect him oppose his removal. §8.08(a), with or without cause, § 141(k), without cause, with cause still majority.

ii. MBCA § 8.09. Can get a judicial override to remove a director for fraud or other grounds.

b. Campbell v. Loew’s, Inc. Intent to take over not a cause, but harassment is.

i. Director to be removed must be allowed to present his case to stockholders

c. Classified boards; removal only for cause. § 141(k). d. Removal by written consent

i. DCGL § 228. As many votes as would be necessary at a meeting

ii. MBCA § 7.04. Unanimity. e. MURRAY V. CONSECO (Indiana Supreme Court, 2003)

i. Holding A director may be removed by the board, under Indiana law, unless shareholders are divided into classes and he was elected by one of these classes.

ii. No other MBCA jurisdiction allows for removal by the board.

f. ADLERSTEIN V. WERTHEIMER (Delaware Court of Chancery, 2002)

i. Holding A director must be given adequate notice of intentions to remove him so that he may invoke his lawful defenses.

g. CENTAUR PARTNERS, IV V. NATIONAL INTERGROUP, INC. (Delaware Supreme Court, 1990)

i. Holding A shareholder may not change a provision requiring 80% vote to enlarge a board without 80% of the votes.

C. Public Companiesi. Distinctive features

1. A market for their shares2. The makeup of the shareholder population3. Proxy voting

ii. Background of public corporations law1. Federal securities laws assume passive shareholders 2. Many laws reflect the takeover boom of the 1980s3. Hedge fund. Lightly regulated pool of private capital.

a. Mutual funds are regulated by the 1940 Act; hedge funds are much more active shareholders

4. Equity-based compensation came into vogue in the 1990s and was regulated beginning in 2003

iii. Benefits1. For company

a. Get capitalb. Cash out holdings, at least partiallyc. Public awareness/status

2. For investorsa. Liquidation. The “Wall Street Rule”b. Valuation

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i. Efficient Markets Hypothesis.1. Weak form: Can’t predict future movement

on the basis of past prices. Generally accepted.

2. Semi-strong form: Stock prices reflect all relevant publicly available information

3. Strong form: Stock prices reflect all relevant information, including inside information. Controversial; we regulate insider trading.

ii. Crashes/Bubbles, despite EMH, can be traced to:1. Traders’ interest in hyping irrational

propositions 2. Noise traders. Cancel each other out mostly,

but sometimes cloud the market.3. Professional arbitrageurs, who ride the wave

created by noise tradersiii. Alternative explanation for efficient markets: Stock

market does a good job of evaluating projects and allocating capital.

iv. Cross-listing1. Alternative Deposit Receipts allow foreign companies to list their

shares in the U.S. a. Different levels of regulation and disclosure

v. Independent directors1. From 20% in 1950 to 80% today2. Reasons:

a. Institutional ownershipb. Market premium, post-Enronc. Increased legal rules, legal incentives, and exchange

regulationd. Shareholder wealth-maximization more accepted as a measure

of value3. Tradeoffs arising from directors not being involved: objectivity vs.

informationvi. Proxy voting.

1. Federal laws supplement state lawa. 1934 Act, § 14. Registered security must comply with proxy

regulations. May not solicit proxies. 2. Governed closely by SEC Rules

a. Rule 14a-2(b)(2). Allowed to solicit less than ten shareholdersi. Rule 14a-1(l)(2)(iv). A statement of how one intends

to vote is not a solicitationb. Rule 14a-9. Anti-fraud rule.

D. Shareholder Proposals and Access to Corporate Recordsi. Company must either give you a shareholder list upon request or put your

proposal in their own communications. Usually the latter. ii. Rule 14a-8.

1. 14a-8(b). To submit a proposal, must have held $2000 or 1% worth of stock for at least a year.

2. Proposals can be excluded for the following reasons: a. 14a-8(i)(1). Improper under state law

i. For example, must be phrased as suggestions; under DCL § 141(a), board is responsible for operations.

b. 14-18(i)(3). False or misleading statements. c. 14-18(i)(5). Less than 5% of assets and earnings, if “not

otherwise significantly related to the company’s business”

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d. 14-18(i)(7). Ordinary business operations.e. 14-18(i)(8). Election processf. 14-18(i)(13). Raising the dividend.

iii. Social issues1. LOVENHEIM V. IROQUOIS BRANDS, LTD. (D.D.C. 1985)

a. Holding The “significantly related” exception to Rule 14a-8(i)(7) permits shareholder proposals on social issues to be included for a shareholder vote.

2. Cracker barrel discriminated against gay employees; SEC declined to take enforcement action on exclusion of shareholder proposal, as employment is within the realm of management

3. Tide has turned recently from social issues to corporate governancea. Often, objections to anti-takeover provisions or the

nominating process iv. Access to books and records

1. CONSERVATIVE CAUCUS V. CHEVRON CORP. (Delaware Court of Chancery, 1987)

a. Holding Shareholder communications related to business risks of doing business in unstable nations is a proper purpose for acquiring a shareholder list.

b. If seeking common documents, burden is on company to show purpose is improper, if unusual documents, like board minutes, the burden is on the shareholder

2. Delaware Code is more permissive as to what documents can be acquired.

a. § 220(b). Allows shareholders the right “to inspect for any proper purpose, the corporation’s stock ledger, a list of its stockholders, and its other books and records….”

b. § 16.02(b). Shareholder only entitled to an exclusive list of records: minutes, accounting records, and shareholder list.

IV. Fiduciary duties and Shareholder SuitsA. Fiduciary Duty of Loyalty

i. Types 1. Duty of Loyalty

a. Corporate opportunities b. Conflict of Interest Transactions

2. Duty of Carea. “Waste” doctrine: a combination of the duties of loyalty and

care3. Duty of good faith4. The business judgment rule interfaces with these duties5. “Intrinsic fairness” standard. If directors haven’t met their duties, this

standard is the backstop defense. ii. Standard of conduct.

1. MBCA doesn’t use the word “fiduciary conduct.”2. § 8.30(a): “Each member of the board of directors… shall act: (1) in

good faith, and (2) in a manner the director reasonably believes to be in the best interests of the corporation.”

a. § 8.30(b): “The members of the board of directors… shall discharge their duties with the care of a person in a like position would reasonably believe appropriate under similar circumstances.”

3. § 8.31 defines the standard of liability, which is higher and separate. 4. Independent directors are obligated to ask tough questions when they

discover something suspicious. B. Business Judgment Rule

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i. A judicial presumption that directors have acted properly. 1. If applicable, courts won’t reach the duties. 2. Institutional competence is the oft-cited reason

ii. Gries Sports Enter., Inc. v. Cleveland Browns Football Co., Inc. “The rule is a rebuttable presumption that directors are better equipped than the courts to make business judgments and that the directors acted without self-dealing or personal interest and exercised reasonable diligence and acted with good faith.”

1. If directors aren’t entitled to the business judgment rule, intrinsic fairness. Basically a shift in presumption.

iii. SHLENSKY V. WRIGLEY (Illinois Appellate Court, 1968)1. Holding The court will not judge the controlling shareholder for an

idiosyncratic decision without a concrete showing it cost shareholders money.

2. Unanimity principle: ordinarily, shareholders are unanimous in desire to maximize shareholder price

3. Minority shareholders bought into the Cubs knowing they were subject to Wrigley’s whims.

C. Other constituenciesi. DODGE V. FORD MOTOR CO. (Michigan Supreme Court, 1919)

1. Holding A court will not disturb a decision that seems to not maximize shareholder wealth if it has the potential to maximize long-term wealth.

ii. Maine BCA § 756. “[T]he directors and officers may… consider the effects of any action upon employees, suppliers, and customers of the corporation, communities… and all other pertinent factors.”

iii. Pennsylvania BCC § 1715. Directors may consider “shareholders, employers, suppliers, customers, and creditors of the corporation, and… communities.”

1. (b). No factor necessarily controlling. iv. Fiduciary duties usually run to shareholders because they are residual claimants

D. Corporate Opportunity Doctrinei. ALI Guidelines

1. Corporate opportunity: made aware because of status as director, through the use of corporate information or property, or is closely related to the company’s line of business

2. May take it only after full disclosure and rejection3. NORTHEAST HARBOR GOLF CLUB, INC. V. HARRIS (Maine

Supreme Court, 1995)a. Holding Under the ALI guidelines, a director must formally

disclose any corporate opportunity to escape liability. ii. Delaware standard

1. Guth v. Loft. If a business opportunity “which the corporation is financially able to undertake, is, from its nature, in the line of a corporation’s business and is of practical advantage to it, is one in which the corporation has an interest or a reasonable expectancy, and [the director’s interest] will be brought into conflict with that of the corporation, the law will not permit him to seize the opportunity for himself.”

2. BROZ V. CELLULAR INFORMATION SYSTEMS, INC. (Delaware Supreme Court, 1996)

a. Holding A director has no obligation to disclose an opportunity the corporation had no financial ability to take on the basis of a speculative potential purchase by another company.

b. Presentation to the Board is a safe harbor only, not a necessity. 3. Guth standard leaves an unwieldy eight-factor test:

a. Director may not take opportunity if: (1) corporation is financially capable of exploiting it, (2) it is within the line of

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business, (3) the corporation has an interest or expectancy in the opportunity, and (4) the fiduciary will be placed in a position inimical to the corporation

b. Director may take opportunity if: (1) it is presented to him in his individual, not directorial capacity, (2) it is not essential to the corporation, (3) the corporation has no interest or expectancy, and (4) the director didn’t employ the corporation’s resources to pursue the opportunity.

E. Conflicting Interest Transactionsi. This is one way to rebut the business judgment rule.

ii. Common law rule: the contract was voidable at the defendant’s option, if any conflict was present.

1. GLOBE WOOLEN CO. V. UTICA GAS & ELECTRIC CO. (New York Court of Appeals, 1918)

a. Holding A director on both sides of a transaction is not protected merely by refraining to vote, but must protest a transaction he knows to be unfair.

iii. DCL § 144(a). 1. No conflicted transaction will be voidable solely on the basis of the

conflict if:a. The director makes it known and disinterested directors vote

in good faith, orb. The director makes it known and shareholders vote in good

faith, ori. Courts read “disinterested” there too

c. Contract is fair to the corporation. i. Two elements: fair dealing and fair price

d. “Good faith”: the vote is for the benefit of the corporation, not to do a friend a favor.

2. SHAPIRO V. GREENFIELD (Maryland Court of Special Appeals, 2000)

a. Holding The standard to be applied to conflict of interest transactions is intrinsic fairness.

b. Maryland statute was modeled after Delaware, among other states

c. Difference between corporate opportunity and conflicts of interest is that the corporation is taking the opportunity in the latter.

iv. MBCA § 8.61. Deals with an elaborate set of provisions, defining applicable terms with specificity. No states have adopted it.

v. Shareholder ratification1. A disinterested shareholder ratification doesn’t make transaction

automatically valid, only shifts burden of proof. Plaintiff can still prove that it is not in corporation’s best interests. This is judicial gloss.

2. Plaintiff can argue “waste”: that the transaction was so fundamentally bad that the directors are giving away corporate property for trivial consideration.

a. Only unanimous shareholder ratification can validate a wasteful transaction.

vi. Parent-Subsidiary Conflicts1. SINCLAIR OIL CORP. V. LEVIEN (Delaware Supreme Court,

1971)a. Holding In a parent-subsidiary relationship, there must be

self-dealing to overcome the intrinsic fairness test. b. Self-dealing. Receiving a benefit to the exclusion of minority

shareholders, or imposing a burden not shared by a majority.

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c. An excessive dividend payment is not self-dealing; minority shareholders receive it too

d. Because parent dominates subsidiary, the shareholder owes a fiduciary duty to the corporation.

vii. Executive Compensation 1. BYRNE V. LORD (Delaware Court of Chancery, 1995)

a. Holding Stock option compensation is unfair if the directors have no obligation to remain with the corporation to exercise them.

b. Establishes a two-prong test:i. Must provide a tangible benefit to the corporation

ii. Value of the options have to bear a reasonable relationship to the value of the benefit

1. § 157(b): the consideration set by directors is conclusive—which guts the value prong.

F. Fiduciary Duty of Care and Good Faith i. JOY V. NORTH (Second Circuit, 1982)

1. Holding The business judgment rule benefits shareholders, who can diversify, by rewarding risk.

ii. Directors’ Duties1. SMITH V. VAN GORKUM (Delaware Supreme Court, 1985)

a. Holding Directors’ duty of care includes a duty to inform themselves about major transactions.

b. The standard under the business judgment rule is gross negligence.

c. This case breathed life into the duty of care.d. Delaware legislature responded by adding § 102(b)(7),

allowing certificate of incorporation to immunize directors for the duty of care

i. Not good faith or loyalty; MBCA allows you to immunize breach of duty of loyalty.

2. IN RE CAREMARK INTERNATIONAL, INC. DERIVATIVE LITIGATION (Delaware Court of Chancery, 1996)

a. Holding Directors’ duty of care includes a duty to set up a system of monitoring and compliance.

b. Graham v. Allis-Chambers. 1963 case saying there was no duty to implement “corporate espionage” to catch wrongdoing they had no reason to suspect.

c. Only a systematic failure to exercise oversight will establish the necessary lack of good faith

3. IN RE ABBOTT LABS (Seventh Circuit, 2001)a. Holding Failure to take action despite six years of FDA

warnings is sufficient to establish a breach of the duty of good care.

iii. Officers’ Duties1. MILLER V. U.S. FOODSERVICE, INC. (D. Md. 2005)

a. Holding Failure to address compliance failures, and misrepresenting the protections in place, is a breach of the duty of care.

b. Business judgment rule widely assumed to apply to officers. iv. Good faith

1. Disney Casesa. BREHM V. EISNER (Delaware Supreme Court, 2000)

i. Holding Boards have wide discretion to determine executive compensation.

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ii. Difficult to call a compensation contract waste, which requires no consideration going to the corporation.

b. IN RE THE WALT DISNEY COMPANY DERIVATIVE LITIGATION (Delaware Court of Chancery, 2003)

i. Holding If a board fails to evaluate an executive compensation contract, they are not protected by the business judgment rule.

ii. Chancellor Chandler has recharacterized a Van Gorkum-style failure of oversight from duty of care to duty of good faith.

1. Shrinking duty of carec. IN RE THE WALT DISNEY COMPANY DERIVATIVE

LITIGATION (Delaware Court of Chancery, 2005)i. Holding The directors of Disney did not commit

waste, malfeasance, or negligence in approving the compensation contract of Michael Ovitz.

1. This is after case has been tried, under fairness standard.

ii. Bad faith can be proven by “intentional dereliction of duty, a conscious disregard for one’s responsibilities.”

iii. Distinguished from Van Gorkum; executive compensation not as important as a merger.

d. After Disney cases, bad faith includes (1) intentional wrongdoing and (2) dereliction of duty, but not gross negligence.

2. STONE V. RITTER (Delaware Supreme Court, 2006)a. Holding The duty of faith is not a separate duty but part of the

duty of loyalty. b. Also officially endorses the Caremark standard. c. Affirms that a Van Gorkum-style standard is not due care and

cannot be insulated by a § 102(b)(7) provisionv. Executive Compensation

1. United States leads the world in absolute standards and in proportion of variable pay (63%).

a. Variable pay had arisen out of attempt to align incentives. i. Problems with stock options:

1. Incentives for “earnings management”2. No indexing; overstates managers’

contributions3. Incentives to use insider information4. No expensing, but they dilute the common

stock pool when exerciseda. This has changed; now they are

expensed. ii. Also, has led to stock-option backdating

1. Not illegal, but companies do it fraudulently—lying to shareholders

2. Debatable whether it is a problem. 3. Sarbanes-Oxley

a. CEO and CFO must certify that all financial statements are accurate

i. If there is a restatement of earnings, they must return their compensation for that period

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b. Attorneys must report information about fiduciary duties to general counsel or CEO—then must follow up.

G. Derivative Litigationi. Mechanics

1. Brought by a shareholder on behalf of and in the name of the corporation

a. A two-part suit, technically:i. Compel the corporation to take action against

someone who has wronged itii. The suit itself.

b. The recovery goes to the corporation, not to shareholders directly.

2. § 141(a). The decision to sue is a decision of the directorsa. In a securities fraud case, shareholders can sue directlyb. Must first make a written demand the directors take action. If

refused, can sue for wrongful refusali. In most jurisdictions, this is a requirement. MBCA §

7.42ii. In Delaware, it can be excused if demand would be

futileii. ARONSON V. LEWIS (Delaware Supreme Court, 1984)

1. Holding To excuse demand as futile, a shareholder plaintiff must prove improper influence on the board.

2. Two part test to excuse demand. Must establish a reasonable doubt:a. That the directors were disinterested and independent, orb. That the challenged transaction was otherwise the product of

valid exercise of business judgment. 3. Essentially sets up a litigation-within-a-litigation

iii. Brehm v. Eisner. Pleadings in derivative suits must be pled with particularized facts.

1. Difficult to do that before discovery, but shareholders have access to § 220 records.

2. Also added wrinkles to both prongs:a. Were the judgments of the directors clouded?b. Was the informational component defective?

iv. Grimes v. Donald. If demand is refused, the refusal gets the business judgment rule unless the shareholder can prove a reasonable doubt that the board acting interestedly or without due care.

1. Provides an incentive not to make demand. v. IN RE THE LIMITED, INC. SHAREHOLDERS LITIGATION (Delaware

Chancery Court, 2002)1. Holding A board of which half the directors, not a majority, are

interested and not independent, excuses demand in a derivative suit. 2. Interestedness: a conflicted financial interest3. Independence: not beholden to a controlling shareholder/CEO

a. Independence turns on whether salaries are material, that they owe their primary job to the CEO, and a donation solicited by a college president.

vi. Rales v. Blasband. Where the board considering the demand did not make the challenged decision, the Aronson test is inappropriate. Instead, examine whether there is a reasonable doubt that the board considering the demand could have exercised its independent and disinterested business judgment.

vii. Special Litigation Committees1. ZAPATA CORP. V. MALDANADO (Delaware Supreme Court,

1981)

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a. Holding Where the board appoints a special committee to evaluate a demand request, the committee will be evaluated for interestedness and good faith.

b. Two-part testi. Was the Special Litigation Committee disinterested

and act in good faith, and were there reasonable bases for the decision?

ii. If plaintiff meets that requirement, court can use a “smell test”. Anything goes.

2. New York, in a related litigation to Zapata, had simply applied the business judgment rule

3. Iowa gives no deference to the SLC determination. 4. SLC disinterestedness turns on whether the director is, for any

substantial reason, incapable of making a decision in the best interests of the corporation.

viii. Directors can limit their liability through:1. Exculpation

a. § 102(b)(7). Corporation, subject to certain limitations, can simply eliminate personal liability in the certificate of incorporation

2. Insurance. a. Permitted to purchase “D&O” insurance under the DCL

3. Indemnification.a. § 145. A corporation can indemnify expenses, damages, or

settlement amounts paid by directors if the director acted in good faith and reasonably believed the action to be in the best interests in the corporation.

i. § 145(b). Shareholder derivative suits do not allow judgments and settlements to be indemnified. Corporation paying itself.

b. § 145(c). If the defense is successful, mandatory indemnification.

c. § 145(f). Can contract for more. i. OWENS CORNING V. NATIONAL UNION

FIRE INSURANCE CO. (Sixth Circuit, 2001)1. Holding A corporation cannot contract

around the good faith requirement of indemnification in by-laws.

V. Close Corporations and LLCsA. Basics

i. Close corporations are analogous to partnerships, but perpetually existing1. Majority rule presents problems in a close corporation context2. Voting agreements are permitted

ii. Major problem is lack of liquidity for shares. iii. Why, in light of problems for minority shareholders?

1. Limited liability, and limits transaction costs2. Rational preference for corporate norms

B. Ex Ante Contracting i. § 141(a) can be contracted around.

1. § 350. “A written agreement among the stockholders of a close corporation holding a majority of the outstanding stock entitled to vote… is not invalid… on the ground that it so relates to the conduct of the business and affairs of the corporation as to restrict or interfere with the discretion or powers of the board of directors….”

ii. § 343 and § 342. Form a close corporation by putting it in the certificate 1. Can’t have more than 30 shareholders

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2. No public offering and subject to share transfer restrictions.3. MBCA § 7.32. A shareholder agreement stripping the board of

discretion must be unanimous. Otherwise the same. iii. RAMOS V. ESTRADA (California Court of Appeal, 1992)

1. Holding An agreement to vote is valid and enforceable. 2. § 7.22(d)(5). Could be prevented by issuing an irrevocable proxy to

each party to the agreement. Self-enforcing. C. Ex Post Judicial Review

i. ZIDELL V. ZIDELL (Oregon Supreme Court, 1977)1. Holding A conservative dividend policy will only be overturned if not

in good faith and for a legitimate business purpose. a. Courts will often look for large cash reserve in cases to

compel dividends.2. Minority shareholders have a large burden to overcome in the business

judgment rule. ii. DONAHUE V. RODD ELECTROTYPE CO. (Massachusetts Supreme

Court, 1975)1. Holding If a close corporation buys back the shares of the controlling

shareholder, it also must make an equal offer to all minority shareholders.

2. Imposes on majority shareholders a strict duty of good faith to minority shareholders.

iii. WILKES V. SPRINGSIDE NURSING HOME, INC. (Massachusetts Supreme Court, 1976)

1. Holding When minority stockholders allege a breach of strict good faith duties, the business decision itself must be analyzed.

2. Two-part test:a. Was there a legitimate business purpose?b. If so, plaintiff can show a less harmful alternative

3. Cuts back on Donahue. iv. NIXON V. BLACKWELL (Delaware Supreme Court, 1993)

1. Holding Fiduciary duties to minority shareholders do not imply equal treatment.

D. Involuntary Dissolutioni. IN RE KEMP & BEATLEY, INC. (New York Court of Appeals, 1984)

1. Holding If a close corporation violates the reasonable expectations of minority shareholders, the conduct is oppressive enough to justify dissolution of the corporation.

2. New York law allows dissolution actions to be brought for illegal, fraudulent, or oppressive actions.

ii. GIMPEL V. BOLSTEIN (New York Supreme Court, 1984)1. Holding The “reasonable expectations” test should not be applied

where the shareholders of a close corporation are not the initial investors.

2. Instead, conduct must be inherently oppressive; burdensome, harsh, and wrongful.

iii. Often, courts will look to a less harsh remedy E. Share repurchase Agreements

i. CONCORD AUTO AUCTION, INC. V. RUSTIN (D. Mass, 1986)1. Holding A mandatory buyback of shares at a set price is valid in the

absence of fraud and bad faith. ii. GALLAGHER V. LAMBERT (New York Court of Appeals, 1989)

1. Holding An at-will employee does not obtain fiduciary duty rights by virtue of receiving shares as a condition of employment.

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iii. Pedro v. Pedro. Where a minority shareholder is wrongfully forced out, he is entitled to fair value of his shares rather than the price in the buyback agreement.

1. An outlier case, but bad faith was key. F. Limited Liability Companies.

i. Uniform Limited Liability Company Act1. § 301(a). Members’ actions bind the company.

a. § 301(b); if managers aren’t members, members don’t bind the company.

b. § 302. LLC is liable for damages by a member or manager in the ordinary course.

2. § 303. Debts incurred are only debts of the company, even if not abiding by the by-laws.

3. § 404. Member-managed companies, have partnership-style management rights. Manager-managed companies have corporation-style rights.

4. Broad contracting authority a. Elf Autochem North America, Inc. v. Jaffari. An LLC

agreement to submit to arbitration will be upheld. ii. GOTTSACKER V. MONNIER (Wisconsin Supreme Court, 2005)

1. Holding Members of an LLC have to meet a standard of fairness when making a conflicted transaction.

2. Also held: If two people hold stock in an LLC collectively, they each hold half of the stock in question.

iii. Fiduciary Duty1. HARBISON V. STRICKLAND (Alabama Supreme Court, 2004)

a. Holding Members of an LLC cannot contract out of their fiduciary duty.

2. VGS, INC. V. CASTIEL (Delaware Chancery Court, 2000)a. Holding It is a violation of fiduciary duty for minority

shareholders in an LLC to act against the interests of the majority without notice.

iv. Exit1. Legislatures have passed tighter exit rules since the IRS liberalized its

tax rules. a. McGee v. Best. The LLC agreement will be enforced, even if

contrary to expectations of the founder as to exit. VI. Creditors

A. Dividends and Distributions i. Creditors are fixed claimants—their obligations are fixed by contract. Risk of

asset dissipation. 1. Law has protections in place

a. Equity cushion. Shareholders are residual claimants.b. Par value. Shares were once a measure of capital the firm had

—measured by par value. No longer recognized in every jurisdiction

ii. Directors determine the amount of capital of the firm1. Must equal at least the par value of the shares

a. All else goes to surplus. b. DCL § 153. “Shares of stock with par value may be issued

for such consideration… as determined from time to time by the board of directors.”

i. § 152. Can’t be an IOU. ii. MBCA § 6.21(b). Any consideration, including

promissory notes. iii. Dividends.

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1. Delawarea. § 170. Can only pay out of surplus, or a “nimble dividend”

out of net profits from the fiscal year. b. § 174. Directors personally liable for paying improper

dividends. 2. Model Act

a. § 5.40. Can distribute dividends unless equitably or bankruptcy insolvent.

b. Also provides for personal liability. c. § 6.40(e). The insolvency tests have to be satisfied on the date

that the debt is incurred, not when they are paid. B. Piercing the Corporate Veil

i. A way for debtors to attack limited liabilityii. Contract Context

1. Factors: a. Observance of corporate formalitiesb. Fraud or injusticec. Undercapitalization

i. A controversial factor. Must be grossly inadequateii. Judge it as of the time the firm is formed.

2. CONSUMER CO-OP V. OLSEN (Wisconsin Supreme Court, 1988)

a. Holding When a creditor knows of it’s debtor’s financial situation but continues to loan, it waives its right to pierce the corporate veil.

3. KC ROOFING CENTER V. ON TOP ROOFING, INC. (Missouri Court of Appeals, 1991)

a. Holding Where an individual uses a succession of corporations to contract and avoid debts, the corporate veil will be pierced.

4. Equitable Subordinationa. When a shareholder transforms himself into a creditor, court

can push him back to the end of the linei. Less drastic remedy than veil piercing.

iii. Tort Context1. Stronger case for piercing, because tort victims are not voluntary

claimantsa. Same three prong test.

2. WESTERN ROCK CO. V. DAVIS (Texas Court of Civil Appeals, 1968)

a. Holding A director will be held liable for tort claims incurred when the director is in control, and the corporation is a shell with no assets.

b. Factors:i. Reasonable foreseeability

ii. Proximate causation (by the fraudulent use of the corporation)

iii. Lack of insuranceiv. Undercapitalization

1. Weighs heavier in tort cases; they can’t investigate

3. BAATZ V. ARROW BAR (South Dakota Supreme Court, 1990)a. Holding No veil piercing will be found where the company

observed corporate formalities and was not undercapitalized.

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4. Walkovsky v. Carlton. Where taxicab companies had the legal minimum insurance, the veil is not pierced. This true even though the cab company was comprised of six different corporations.

a. Enterprise Liability. Treating assets as a group that have been put into separate corporate boxes. Goes to the fraud or injustice prong.

i. A solution where shareholders don’t observe formal borders

iv. Incorporated Shareholders1. Theoretically, should be easier to pierce against corporate shareholders,

but empirically litigation is less successful a. Moral hazard problem: corporations absorb upside but box in

the risk; leads to riskier behavior b. Some of the positive justifications for individual shareholders

don’t hold for corporations 2. CRAIG V. LAKE ASBESTOS (Third Circuit, 1988)

a. Holding The power to control a subsidiary does not allow for corporate piercing if that control is not exercised to a substantial extent.

3. UNITED STATES V. BESTFOODS (U.S. Supreme Court, 1998)a. Holding Control of a subsidiary’s facility by a parent

corporation under CERCLA does not track corporate veil-piercing law.

b. Court rules that CERCLA did not alter veil-piercing law. Veil piercing leads only to indirect liability, not direct liability.

i. For direct liability, the parent must be in control of the facility, not just the subsidiary

v. LLCs1. KAYCEE LAND AND LIVESTOCK V. FLAHIVE (Wyoming

Supreme Court, 2002(a. Holding The corporate veil piercing doctrine applies to LLCs. b. Most courts have found the same.

C. Risk Allocation Devices i. Securitization

1. Pools of securitized assets transferred to a BRV, which is then marketed to private investors

ii. Promoter’s Liability 1. RKO-STANLEY WARNER THEATRES, INC. V. GRAZIANO

(Pennsylvania Supreme Court, 1976)a. Holding Promoters of a company are liable for the agreements

they enter into before a corporation has formed, unless an express provision releases them.

iii. Investors’ Liability 1. TIMBERLINE EQUIPMENT CO. V. DAVENPORT (Oregon

Supreme Court, 1973)a. Holding Investors are strictly liable if they represent

themselves as a corporation before it exists. 2. The strict liability rule is specific to Oregon

a. Possible defenses:i. De facto corporation.

1. Operates against all creditors 2. Where the investor generally acts as a

corporation, and a creditor reasonably would have believed that they were transacting with a corporation, not a person.

ii. Corporation by estoppel.

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1. Operates against a particular creditor2. Creditor thought they were dealing with a

corporation. It would be inequitable to find the investor liability.

b. MBCA § 2.04. “All persons purporting to act as or on behalf of a corporation, knowing there was no incorporation under this Act, are jointly and severally liable for all liabilities created while so acting.

i. No strict liability; knowledge required iv. Ultra vires

1. Outdated doctrine; a corporation had no authority to act outside of its strict charter

2. Delaware law allows chartered powers to be to engage in any lawful activity.

3. MBCA § 3.04 mostly disposes of it as well; limited opportunities under 3.04(b).

VII. Mergers A. Friendly Mergers

i. Shareholders given more rights in merger context1. Voting

a. Condoret’s Jury Theorem: when facing a binary decision, if people are more than 50% likely to get the right answer, the more people voting, the more likely the group is to get it right.

b. § 251 governs both mergers (where one is absorbed) and consolidations (where they are combined into a new corporation)

i. § 251(c). Shareholders of both corporations get voting rights in a merger of equals

ii. § 251(f). De minimus exception for acquirer where the acquired firm is less than 20% of the acquirer.

c. § 253. No vote necessary for a short-form merger, where either corporation owns 95% of the other.

d. Delaware doesn’t contemplate a “compulsory share exchange,” a share for share transaction that makes one company a subsidiary of the other.

i. MBCA § 11.03 gives shareholders voting rights. 2. Appraisal. The right of a shareholder to have his or her shares valued

and bought back by the corporation at “fair value” if he or she dissents from the merger.

a. § 262. Only dissenters receive these rights b. If no voting rights, no appraisal rights.

i. Except non-parent owned shares in a short-form merger.

c. § 262(b)(1). Market exception—no appraisal rights if held by at least 2000 holders or on a stock exchange.

i. § 262(b)(2). But, if receive anything but stock in exchange, get appraisal rights. Can receive cash for fractional shares.

d. § 13.02(a). Appraisal rights for compulsory share exchanges. e. Triangular Merger

i. Acquirer creates a subsidiary, which acquires the acquired corporation. The ultimate acquirer’s shareholders do not get voting rights.

ii. HEWLETT V. HEWLETT-PACKARD CO. (Delaware Chancery Court, 2002)

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1. Holding Hewlett-Packard did not issue misleading information to shareholders or buy votes so as to render its merger with Compaq invalid.

2. A merger of equals. Shareholders of both constituent corporations must approve the merger agreement.

3. DCL § 225 allows shareholders to challenge the vote in an expedited procedure

iii. Sale of assets1. § 271. Only selling company gets voting rights and only if selling “all

or substantially all” of assetsa. No appraisal rights. b. HOLLINGER, INC. V. HOLLINGER

INTERNATIONAL, INC. (Delaware Chancery Court, 2004)

i. Holding If the remaining assets are viable or profitable, a corporation has not sold substantially all of its assets.

iv. De facto merger1. Acquired sells assets for shares, dissolves, and distributes the shares to

its own shareholders. 2. Ends up as a statutory merger, but have stripped away voting and

appraisal rights, at least in Delaware.a. HARITON V. ARCO ELECTRONICS, INC. (Delaware

Supreme Court, 1963)i. Holding Giving “equal dignity” to different statutes

requires a finding that de facto mergers are distinct from statutory mergers.

b. APPLESTEIN V. UNITED BOARD & CARTON CORP. (New Jersey Superior Court, 1960)

i. Holding A de facto merger will be treated as statutory merger.

ii. Most states follow this lead. v. Merger Accounting

1. Old systema. Purchase Accounting. Treats the companies as two separate

corporations who have come together. Account for premium as a separate asset, goodwill.

i. Goodwill, as an asset, must be depreciated. Reduces income when it amortizes.

b. Pooling. Account for them as if they had always been together. Improved earnings.

i. Eliminated in 2001.2. Now, not necessary to amortize good will; evaluate it periodically until

it becomes “impaired”; then depreciate. vi. Minority Squeeze outs

1. COGGINS V. NEW ENGLAND PATRIOTS FOOTBALL CLUB, INC. (Massachusetts Supreme Court, 1986)

a. Holding A minority shareholder is entitled to rescissory damages when a merger is consummated by a conflicted controlling shareholder, for no legitimate business purpose.

2. WEINBERGER V. UOP, INC. (Delaware Supreme Court, 1983)a. Holding In appraisal actions, stocks must be valued according

to modern financial measures. b. Reaffirms duties of loyalty and burden rulesc. Says that the fairness test is not bifurcated between fair

dealing and fair price. It’s holistic.

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d. Ordinarily, appraisal is the favored remedy, with equitable exceptions for certain unsavory situations.

e. Did away with “Delaware Block” valuation method. f. Overrules the business purpose protection.

vii. Sale of control 1. Control premiums can be used for legitimate reasons (value of the

ability to vote) and illegitimate ones (squeeze out minority shareholders, loot the company). Role of law is to sort out the good motives from the bad.

2. Generally, controlling block is allowed to be sold at a premiuma. TRYON V. SMITH (Oregon Supreme Court, 1951)

i. Holding There is no fiduciary duty to inform minority shareholders of a controlling block sale as long as the sale is in good faith.

b. “Best price” rule of the Williams Act regulates this somewhat. 3. Three exceptions

a. ESSEX UNIVERSAL CORP. V. YATES (Second Circuit, 1962)

i. Holding Mass, seriatim resignation of the board is acceptable as part of a sale of a control block of stock.

ii. Naked sale of office is prohibited, but this is OK—it allows control

b. HARRIS V. CARTER (Delaware Chancery Court, 1990)i. Holding Controlling shareholders have a fiduciary

duty to investigate whether the purchaser will loot the company.

ii. Duty to investigate is triggered by circumstances that would “awaken suspicion and put a reasonably prudent man on his guard.”

iii. New York: knowledge; Delaware: lower—perhaps gross negligence.

c. PERLMAN V. FELDMANN (Second Circuit, 1955)i. Holding A control premium that reflects a sale of

corporate opportunity must be distributed to shareholders.

4. IN RE DIGEX SHAREHOLDERS LITIGATION (Delaware Chancery Court, 2000)

a. Holding A subsidiary must negotiate at arm’s length with its parent before surrendering control in a merger.

b. Will lead to due diligence on subsidiaries as well as the targets B. Hostile Takeovers

i. Target refuses to negotiate with the bidder. Tactics:1. Bidder

a. Makes a tender offer to shareholders i. Regulated by Williams Act—can’t play groups of

shareholders against each other.ii. Obtains 51% and replaces board

b. Proxy fight—put in place your own slate of directors to control

i. Regulated by proxy regulationsii. Own far less than half the shares

2. Target has legitimate and illegitimate reasons to resist takeoverii. Enhanced Scrutiny

1. CHEFF V. MATHES (Delaware Supreme Court, 1964)

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a. Holding When resisting a hostile takeover, a board must establish a danger to corporate effectiveness and policy by good faith and reasonable investigation.

2. UNOCAL CORP. V. MESA PETROLEUM CO. (Delaware Supreme Court, 1985)

a. Holding When resisting a hostile takeover, directors must prove their response is in good faith.

b. Unocal enhanced scrutiny test:i. The burden is on the directors to show reasonable

grounds of belief of danger to corporate policy or effective

1. Requires good faith and reasonable investigation

2. Materially enhanced by an independent majority of directors

ii. Response to the danger must be appropriate. 1. Must not be “draconian”; that is, not

preclusive or coercive iii. Once these are established, action must fall within a

“range of reasonableness”; essentially business judgment rule

3. Unitrin, Inc. v. American General Corp. defines the draconian test. Has to be either preclusive or coercive to fail.

a. Preclusive when it makes it mathematically impossible or reasonably unlikely that the insurgent can control a majority of the board.

b. Coercive: Designed to force your own shareholders to vote for incumbent management or vote against the bid for reasons unrelated to the merits.

iii. Poison Pills 1. Created in response to the outlawing of discriminatory share buybacks

a. Trigger is usually the purchase of a threshold block of stock, often 20%

b. “Flip-in”: Entitles the target shareholders to buy additional stock for half price. Discriminatory against bidder.

c. “Flip-over”: Reserved for situations in which the target doesn’t survive, or if shares are exchanged.

i. Shareholders have the right of purchase shares in the bidder for half price.

2. MORAN V. HOUSEHOLD INTERNATIONAL, INC. (Delaware Supreme Court, 1985)

a. Holding A pre-emptive poison pill defense can be a proportional response to a threat based on the firm’s overall vulnerability.

b. Evaluated under Unocal. c. When a specific threat arises, must apply Unocal again to the

invocation of the poison pill iv. Auction Context

1. REVLON, INC. V. MACANDREWS & FORBES HOLDINGS, INC. (Delaware Supreme Court, 1986)

a. Holding Once a Board has committed to sale of the company, it must maximize shareholder price without regard to corporate policy.

b. How to satisfy Revlon obligations?i. A closed auction

ii. A market check, pre- or post-agreement

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c. Deal protection devices? Court says that no-shop provision is not per se illegal

i. FN 16. Board is to be active, which includes enticements to land an initial bid.

2. PARAMOUNT COMMUNICATIONS, INC. V. TIME, INC. (Delaware Supreme Court, 1990)

a. Holding Revlon duties are not triggered when the shareholders of both corporations are the market, and therefore, there will be no change in control.

b. Also a factor in not triggering Revlon was that the long-term planning was not abandoned, as it was in Revlon

c. With Revlon not triggered, apply Unocal test. 3. PARAMOUNT COMMUNICATIONS, INC. V. QVC NETWORK,

INC. (Delaware Supreme Court, 1994)a. Holding Revlon duties are triggered when defensive measures

will result in a new controlling shareholder taking control. b. Market shareholders controlled Paramount, but the acquirer,

had a controlling shareholderi. Market shareholders too are entitled to a control

premium for their stockii. Will be subject in the new company to the

disadvantages of being minority shareholders c. Once the board has committed to a sale of control, they forfeit

their right to say their long-term plan is better than the high bidder’s.

d. Once Revlon is triggered, must look at substance of the deal. Process must be structured to maximize the deal.

i. Cannot discriminate between favored and non-favored bidders.

ii. Standard is a range of reasonableness 4. Ultimately, Revlon triggered when:

a. Board initiates a bidding processb. Board abandons long-term strategy in response to a third party

bid c. Change of control.

v. Shareholder franchise 1. Blasius line

a. Schnell v. Chris-Craft Industries, Inc. Even legally permissible interferences with the shareholder franchise can be declared inequitable.

b. Blasius Indus., Inc. v. Atlas Corp. The board must come up with a compelling justification for an action if the primary purpose is to interfere with or impede the shareholders’ right to vote for their directors.

i. No one has ever survived the compelling justification test

2. MM COMPANIES, INC. V. LIQUID AUDIO, INC. (Delaware Supreme Court, 2003)

a. Holding When the voting rights of shareholders are interfered with in the context of a battle for control, the Blasius test must be incorporated into Unocal.

b. First, Unocal. When satisfied the measures aren’t draconian, have to ask if the primary purpose is to impede the franchise.

i. If so, apply the compelling justification testii. Do not get the benefit of the range of reasonableness.

vi. Pre-planned defenses

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1. CARMODY V. TOLL BROTHERS, INC. (Delaware Court of Chancery, 1998)

a. Holding A “dead-hand” poison pill is an invalid defense.b. Dead-hand Poison Pill. Only the directors who implemented

the poison pill or their designees can redeem it. c. Violates § 141(d) by discriminating between directors. d. No compelling justification under Blasius.

2. Shareholder approval of defenses. a. Quickturn Design Systems v. Mentor Graphics suggests that

when shareholders approve the defense, move to business judgment rule.

i. Divided case with strong dissents—perhaps you have to check to make sure the shareholders were reasonably informed.

vii. Deal protection Devices 1. Deal Protection Device. A defensive measure designed to protect a

deal that was negotiated between two companies.a. Examples:

i. Termination feeii. Stock option lock-ups

iii. No-shop closesiv. Matching rightsv. Force-a-vote condition.

b. Will encourage a higher initial bid—less fear that the bidder’s deal will be jumped.

2. OMNICARE, INC. V. NCS HEALTHCARE, INC. (Delaware Supreme Court, 2003)

a. Holding Where a deal is protected by an agreement that controlling shareholders will vote for the deal and an agreement to force a vote, and there is no fiduciary out, the devices are draconian.

b. Preclusive because the minority shareholders cannot change the outcome.

c. Disingenuous and limited to its facts. 3. IN RE TOYS ‘R’ US, INC. SHAREHOLDER LITIGATION

(Delaware Chancery Court, 2005)a. Holding There is no obligation under Revlon to negotiate a

less restrictive deal protection device when doing so could jeopardize the highest bid.

b. When the process looks good, the defendants will usually win. c. Don’t want to promote endless incremental bidding; deal

protection devices do not deter substantially higher bids VIII. Federal Law

A. Proxy Regulationsi. Disclosure regulations are broad and getting broader.

1. Regulation S-K is almost 100 pages long. ii. Generally, state law governs substantive law, and federal law governs procedure

and disclosure 1. SROs have their own regulations, but 1934 Act gives SEC authority

over SROs2. State law governs the allocation of power with the corporation, the

corporate governance 3. BUSINESS ROUNDTABLE V. SECURITIES AND EXCHANGE

COMMISSION (D.C. Circuit, 1990)a. Holding The SEC is beyond its authority when it regulates the

voting power of stock.

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b. The number of votes per share is a matter of state law. 4. Sarbanes-Oxley establishes substantive laws in areas in which states

generally have not interfered—board structure, independent directors, executive compensation, etc.

a. Attorney requirementsi. Rule 205.3(b). Must report up the ladder to superior

if you find a material violation of the securities laws. ii. Then must monitor the corporation’s response or go

all the way to general counsel or CEO, or legal compliance committee

iii. Can divulge confidential information to SEC, which conflicts with state law.

iii. § 14(a)1. “It shall be unlawful for any person, by use of the mails or by any

means… of interstate commerce… in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors, to solicit or to permit the use of his name to solicit any proxy or consent or authorization in respect of any security… registered pursuant to section 12 of this title.

2. Rule 14a-9. “(a) No solicitation… shall be made by means of any proxy statement… or other communication, written or oral, containing any statement, which.. is false or misleading with respect to any material fact, or which omits to state any material fact necessary in order to make the statements therein not false or misleading or necessary to correct any statement in any earlier communication with respect to the solicitation of a proxy for the same meeting or subject matter….”

a. Covers both affirmative misstatements and omissions or half-truths

b. Creates an obligation to correct public statements to ensure they remain accurate.

3. Elements for a private right of action a. Standing

i. J.I. CASE CO. V. BORAK (U.S. Supreme Court, 1964)

1. Holding A private right of action exists under § 14(a) of the Securities and Exchange Act.

b. Statement or omission of a material facti. TSC INDUSTRIES, INC. V. NORHTWAY, INC.

(U.S. Supreme Court, 1976)1. Holding A statement or omission is material

if there is a substantial likelihood that a reasonable shareholder will find it important.

a. Would significantly alter the “total mix” of available information.

2. Mixed question of law and fact. 3. Definition applies throughout the securities

laws. ii. VIRGINIA BANKSHARES, INC. V. SANDBERG

(U.S. Supreme Court, 1991)1. Holding A statement of reasons, opinions,

or beliefs are actionable only if they are

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materially misleading as to the underlying subject matter.

2. Have to look at the underlying value of the stock; doesn’t matter if the directors thought it was different or the subjective motivation for giving the price

c. Causation/Reliance i. MILLS V. ELECTRIC AUTO-LITE CO. (U.S.

Supreme Court, 1970)1. Holding If the proxy statement was an

essential link in the transaction, causation is established.

2. “Essential link”—the votes of the shareholders whose proxies were solicited were necessary to the transaction.

a. “Voting causation.” Don’t need to prove they even read the prospectus.

ii. VIRGINIA BANKSHARES, con’t1. If votes aren’t necessary to approve the deal,

the proxy statement is not an essential link.a. If the proxy statement is not an

essential link, causation cannot be established.

d. Mental statei. Not decided in Virginia Bankshares (FN 5).

ii. Gerstle v. Gamble-Skogmo, Inc. Second Circuit: negligence is enough.

1. Other circuits require recklessness at least. e. Damages

i. Intertwined with causation. ii. Transaction Causation. Misstatement caused

shareholders to vote affirmatively for a transaction and therefore to forfeit appraisal rights.

iii. Wilson v. Great American Industries, Inc. “Loss causation.” Would have gotten more value in appraisal than in the merger.

iv. Supreme Court has not spoken. B. Rule 10b-5.

i. “It shall be unlawful for any person… (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 material fact… not misleading, or (c) to engage in any act, practice, or course of business which would operate as a fraud or deceit upon any person.”

1. Applies to all securities, registered or unregistered. 2. Sweeping scope—any device, scheme, or artifice to defraud; applies to

any type of communications ii. Elements

1. Materiality. TSC definition.a. BASIC INC. V. LEVINSON (U.S. Supreme Court, 1988)

i. Holding To determine materiality of a statement or omission in a merger context, a court must weigh the probability of the merger against its magnitude.

1. Probability: Have to look at “indicia of interest” at highest corporate levels

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2. Magnitude: Size of both corporate entities, size of premium, etc.

ii. TSC test is not self-defining in the merger context because mergers are inherently speculative.

iii. FN 17. Silence or “no comments,” absent a duty to disclose, are not misleading under 10b-5.

2. Required mental statea. Ernst & Ernst v. Hochfelder. Requires scienter, but doesn’t

say what scienter. b. Private Securities Litigation Reform Act

i. Enacted to combat “fraud by hindsight.” Plaintiffs sued everyone whose stock price declined, and would extract settlements by getting past motion to dismiss.

ii. Contours1. Imposes a lead plaintiff requirement; the

plaintiff with the largest financial stake chooses the attorney.

2. Sanctions on attorneys for frivolous litigation

3. Stays discovery until motion to dismiss4. Proportional liability on defendants5. Plaintiffs must “plead with particularity

facts giving rise to a strong inference that the defendant acted with the required state of mind.

a. Required state of mind is punted to courts.

iii. TELLABS, INC. V. MAKOR ISSUES & RIGHTS, LTD. (U.S. Supreme Court, 2007)

1. Holding A strong inference must be at least as strong as any other inference possible from the pleadings.

3. Plaintiff must be a purchaser/seller. a. BIRNBAUM V. NEWPORT STEEL CORP. (Second

Circuit, 1952)i. Holding An action under Rule 10b-5 can only be

brought by purchasers or sellers of stock. ii. Primarily covers the type of fraud associated with the

purchase or sale of securities1. That is, fraud as to the value of the

securities; not fiduciary duty, etc. b. SUPERINTENDENT OF INSURANCE V. BANKERS

LIFE & CASUALTY CO. (U.S. Supreme Court, 1971)i. Holding As long as fraud touches on the sale of

securities, there is a right of action.ii. Overturns Birnbaum on:

1. Does not only cover the type of fraud associated with the purchase/sale of securities

2. Does cover corporate mismanagement. iii. FN 9. Confirms that there is a private cause of

action. c. BLUE CHIP STAMPS V. MANOR DRUG STORES (U.S.

Supreme Court, 1975)i. Holding An action under Rule 10b-5 can only be

brought by purchasers or sellers of stock.

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ii. Adopts Birnbaum on that point. iii. Shareholders who do not choose to sell have no claim

d. SANTA FE INDUSTRIES, INC. V. GREEN (U.S. Supreme Court, 1977)

i. Holding In an action under Rule 10b-5, it is required to prove manipulative or deceptive conduct.

ii. Manipulative. Called a term of art: creating an artificial market for securities

iii. Deceptive. Goes beyond a breach of fiduciary dutyiv. Williams Act later required that a controlling

shareholder state that a transaction is fair—providing the element of deception if it is not in fact fair.

4. Reliance/Causation.a. Affiliated Ute Citizens v. United States. Materiality implies

reliance and causation. b. BASIC, INC., con’t.

i. Holding Fraud on the market can be used to establish reliance in a 10b-5 action.

ii. Fraud-on-the-Market. People who purchase securities do so in reliance on price as a measure of the stock’s value.

iii. Presumption that can be rebutted1. Show that accurate information actually

made it to the market 2. Show that plaintiffs sold or would have their

stock for unconnected reasons iv. Only a four-justice majority.

5. Damages a. DURA PHARMACEUTICALS, INC. V. BROUDO (U.S.

Supreme Court, 2005)i. Holding To establish damages from a fraudulent

misstatement, plaintiffs must plead and prove that when the truth came out, the inflated stock price dropped.

ii. The inflated price itself is not enough. 1. Can’t sell at an inflated price and recover.

iii. Damages will be the difference between the inflated price paid by the plaintiff, and the price to which it declined at the time the news came out.

C. Williams Acti. Construed as an attempt to protect shareholders during tender offers, while not

affecting the relationship between the bidder and the targetii. Key facets

1. Disclosure elementa. § 13(d). If an investor owns more than 5% of a public

company, must disclose percentage, identity, purposes, source of money

i. 13D form—try to make it bland but truthfulb. § 14(d). Must make a statement of § 13(d) information plus

an additional set from the SEC when you make a tender offer for 5%

2. § 14(e). General anti-fraud provisiona. Usually injunctive relief

3. Traffic rulesa. 14e-1. Offer must remain open 20 daysb. 14d-6. Shares must be bought pro rata

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c. 14d-5 and 14d-7. Shareholders can withdraw tendered securities

d. 14d-9. Must offer same price to everyone. No premiums in a tender offer

i. Trumps state lawe. 14e-2. Target management must send statement

recommending a course of action for shareholders, either in favor, against, or neutral. Is subject to anti-fraud provision.

iii. FIELD V. TRUMP (Second Circuit, 1988)1. Holding One cannot escape the best price rule by temporarily

withdrawing a tender offer to give some shareholders a premium, then reinstating the offer.

iv. What is a tender offer? 1. Teased out by case law.2. Large number of shareholders in impersonal transactions is generally a

tender offera. Many factors can be taken into account

v. State laws 1. CTS CORP. V. DYNAMICS CORP. OF AMERICA (U.S.

Supreme Court, 1987)a. Holding A state law that limits the voting powers of acquiring

companies, and is limited to corporations incorporated in and having a substantial connection to the state, is valid.

b. Not preempted by the Williams Act, which is neutral as between bidder and target

c. No commerce clause problem if limited to the state. States still allowed to regulate corporations.

2. AMANDA ACQUISITION CORP. V. UNIVERSAL FOODS CORP. (Seventh Circuit, 1989)

a. Holding A state law freezing control after a hostile takeover is valid under the Williams Act and the commerce clause.

D. Insider Tradingi. Classical Theory

1. In re Cady, Roberts & Co. SEC case first linked 10b-5 to insider trading.

2. SECURITIES AND EXCHANGE COMMISSION V. TEXAS GULF SULPHUR CO. (Second Circuit, 1968)

a. Holding A person with access to inside information has a duty to disclose it to the public or abstain from trading in the shares of the corporation.

b. TSC definition of materiality not helpful; use a probability-magnitude test

i. Materiality is rarely an issue in insider trading cases3. CHIARELLA V. UNITED STATES (U.S. Supreme Court, 1980)

a. Holding A person is not prevented from trading on inside information unless he or she has a fiduciary duty to the shareholders of the corporation, or a similar relationship of trust and confidence.

b. SEC follows this case with Rule 14e-3. In a tender offer, no one can trade on the information before it becomes public.

4. DIRKS V. SECURITIES AND EXCHANGE COMMISSION (U.S. Supreme Court, 1983)

a. Holding A tippee will be found guilty of insider trading only when the disclosure by the tipper is a breach of fiduciary duty, and the tippee knew or should have known that it constituted such a breach.

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b. Since the tipper had an altruistic motive—exposing fraud—no breach here, and no liability for Dirks.

c. FN 14. Temporary/Constructive insiders. Outsiders, such as lawyers or accountants, can become fiduciaries if they are agents of the corporation.

d. FN 22. In the context of a deal, a constructive insider does not have a duty to the other company.

5. Prevention for insidersa. Must wait until information reaches the market b. Set up a buying program in advance, with a set trading

window; usually after the quarterly and annual reports have been released

i. A 10b-5-1 plan is a contract that sets up that window ii. Regulation FD

1. Classical insider trading theory left a large loophole for analysts and market professionals; as long as disclosure was made for a valid corporate purpose, they could trade on it.

2. Regulation FD bans selective disclosure, specifically to Wall Streeta. If an issuer discloses material information to someone on Wall

Street, he or she must disclose it:i. Immediately if intentional

ii. Promptly if inadvertent b. Companies complied with this by simultaneously streaming all

press conferencesc. Rule 102—no private right of action for an FD violation,

including under Rule 10b-5. 3. SECURITIES AND EXCHANGE COMMISSION V. SIEBEL

SYSTEMS, INC. (S.D.N.Y. 2005)a. Holding General statements should not be parsed for

borderline inconsistencies with public statements in order to find liability under Regulation FD.

iii. Misappropriation Theory 1. Carpenter v. United States. Wall Street Journal reporter had no

fiduciary duty to the shareholders of the corporations. His tipping couldn’t be reached under Chiarella and Dirks. Court forced to affirm, 4-4 without opinion.

2. S.E.C. v. Cherif. Seventh Circuit upholds a theory of misappropriation in trading on stock information.

3. UNITED STATES V. O’HAGAN (U.S. Supreme Court, 1997)a. Holding A trader will be found guilty under Rule 10b-5 for

misappropriating financial information for securities trading purposes if the trader owes a fiduciary duty to the source of the information.

4. S.E.C. v. Chestman. Pre-O’Hagan Second Circuit case. Misappropriation theory can apply to family members based on discretionary authority and dependence.

a. SEC promulgated 10b5-2, which created a rebuttable presumption of a duty of trust or confidence when a family member receives confidential information.

5. Unclear after O’Hagan if personal benefit to the tipper is still required when a misappropriating party tips another.

a. If the tipper knows it’s misappropriated, that more likely to be found a violation.

b. McDermott. Investment banker liable for misappropriation and for tipping mistress.

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c. United States v. Falcone. Attenuated circumstances still can provide tippee liability if the parties should have known that something was wrong.

iv. Securities Exchange Act § 161. An officer or director must report their holdings in their own

corporation to the SEC. a. Sets up derivative liability in a short period of time; “short

swing” liability. 2. No scienter necessary. A very blunt instrument.

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