Business Associations – Klein, 3rd Edition

PART I: AGENCY & PARTNERSHIP: BASIC FORMS OF ENTERPRISE ORGANIZATION- AGENCY, PARTNERSHIP, & LLC

I. Introduction and Agency LawA. Law of enterprise organization:

I. Agency = simplest=> can be terminated at any time by either the principle/agent.II. Partnership => jointly owned business firms.

III. Corporation law => deals w/ the creation and governance of the private legal entities that are the principle economic actors in the modern world.

B. Forms:i. Sole proprietorship .

ii. Partnership - can be done through Ks or filing w/ secretary of state.iii. LLC - Only way to do is file w/ secretary of state.iv. Corporation - Filing w/ secretary of state.

1. DE has 65% of all corporations formed.C. Goal= facilitation of voluntary business orgs. to make wealth grown-> use other people’s labor and money!D. How capital markets work: Shareholders-> Corporations<- Creditors

i. Shareholders get upside (equity), but no guarantee=> much riskier, higher return.ii. Creditors get a fixed payment=> less risk, less upside (less returns).

iii. Corporation run by Board of Directors-> (hires) CEO.1. Relationship b/w Board & shareholders governed by state corporate law.

a. Shareholders vote for Board.II. Objective of Corporate Law – Efficiency

a. Pareto Efficiency - Distribution of resources is efficient when resources are distributed in such a way that no reallocation of resources can make at least one person better off w/o making at least one person worse off – “Pareto optimal”; “Pareto efficient” – only when all parties have a net utility gain; Problems:

i. Uses a fixed point for the original distribution of resources ii. Everything makes at least one person worse off – not possible for courts to make everyone happy.

b. Kaldor-Hicks Efficiency - Deals w/externalities – uncompensated costs imposed on parties w/o their consent-> leads to an overall improvement in social welfare – if at least one party would gain from it after all those who suffered a loss as a result of the transaction or policy were fully compensated.

i. Limits – doesn’t say anything about initial distribution of wealth.c. Coase – 1937 – Nature of the Firm; Costs assoc. w/transactions b/t market participants were substantial; Firms exist b/c

sometimes it is more efficient to organize complex tasks within a hierarchical organization than on a market; Could do complex tasks on markets but where many steps are involved market transacting is costly b/c might require extensive negotiation or wasted effort to discover the best prices.

d. Transactions Cost Theory – Owners of various resources commit to some “contractual” governance arrangement, such as the firm in order to reduce their transactions costs and share the resulting efficiency gains.

e. Agency Cost Theory – Actors affect the interests of other actors in a transaction; sometimes act in their own self-interest rather than that of the company as a whole.

i. Basic insight – to the extent the incentive of the agent (the person or interest that possesses discretionary power over some aspect of the principal’s investment in the relationship) differ from the incentives of the principal herself, a potential cost will arise – “agency cost”

ii. Agency cost – any cost (explicit or implicit) associated w/the exercise of discretion over the principal’s property by an agent.

iii. Principal aim of corporation law is to reduce agency costs. *Note – courts rarely use efficiency when justifying their decisions – apply the law, don’t create their own, and when they do create their own they don’t justify it on extrinsic concepts like efficiency. f. Life Cycle of the Firm

i. Venture Capital Financing: form LLC/LLPii. Go public: IPO (get traded), but have to be reviewed by Chancery.

iii. M&A Activityiv. Bankruptcy/privatize

III. Agency a. Shareholders= agency & Board= principleb. Principal has 3 powers: 1) power to direct, 2) expect, and 3) select.C. 3 general sources of agency costs:

i. Monitoring costs – costs that owners expend to ensure agent loyaltyii. Bonding costs – costs that agents expend to ensure owners of their reliability

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iii. Residual Costs – costs that arise from differences of interest that remain after monitoring and bonding costs are incurred

d. Definition = Rs3d Agency 1.01– Agency is the fiduciary relationship that arises when one person (a “principal”) manifest assent to another person (an “agent”) that the agent shall act on the principal’s behalf and subject to the principal’s control, and the agent manifests assent or otherwise consent so to act. Broken down:

i. Consensual relationshipii. Principal – grants authority to another to bind her in certain respects

iii. Agent – accepts that responsibility1. Subject to the agent’s consent, the principal can define or delimit the granted authority in any way she

pleases. e. Parties’ Conception Does not Control: Agency relations may be implied even when the parties have not explicitly agreed

to an agency relationship.i. Gay Jensen Farms v. Cargill (1981) –Case about ACTUAL authority. Ps sued when company defaulted on Ks for

sale of grain. D (Warrant) was in a security agreement with the defaulting company (Cargill), provided funds over the years and had a variety of agency Ks. Ps sue both D and defaulting company.

ii. Rule: To create an agency there must be an agreement, but not necessarily a K b/t the parties – agreement may result in the creation of an agency relationship even if the parties did not call it an agency and did not intend the legal consequences of the relation to follow. Control can be inferred though not expressed!

1. Existence of an agency may be proved by circumstantial evidence which shows a course of dealing b/t the two parties.

iii. All 3 elements of agency exist here – D directed Warren to implement its recommendations, and W acted on D’s behalf in procuring grain for D as part of its normal operations that were financed by D.

iv. 9 Factors that indicated D’s control – constant recommendations, right of first refusal on grain, inability to act w/o D’s approval, right of entry onto premises, correspondence and criticism, financing purchases and power to discontinue financing.

1. Cargill exercised more than nominal control over Warren and was an active participant in Warren’s operations rather than simply a financier.

v. §14K – one who contracts to acquire property from a 3rd person and convey it to another is the agent of the other only if it is agreed that he is to act primarily for the benefit of the other and not for himself.

1. Factors indicating a supplier v. an agent are: (1) that he is to receive a fixed price for the property irrespective of the price paid by him, this is most important (2) that he acts in his own name and received the title to the property which he thereafter is to transfer (3) that he has an independent business in buying and selling similar property.

vi. Restatement §8 –(inherent) power to affect the legal relations of another person (P) by transactions with 3rd persons, professedly as agent for the other, arising from and in accordance with the other’s (P) manifestations to such third persons

f. Authority i. Agents acting with authority may bind principals (authority is the starting point for analysis of contract actions).

Authority is also an element in vicarious liability based tort actions against the principal; no need for written/verbal confirmation, as long as intention of both parties is manifested.

ii. Actual Authority - RS3 §2.01 – An agent acts with actual authority when the agent reasonably believes, in accordance with the principal’s manifestations to the agent, that the principal wishes the agent to act.

iii. Apparent Authority – RS3 §2.03 – When a 3rd party reasonably believes the actor has the authority to act on behalf of the principal and that belief is traceable to the principal’s manifestations

g. Liability in Contracti. RS2d Agency §140 – The liability of a principal to a 3 rd person upon a transaction conducted by an agent may be

based upon the fact that:1. The agent was authorized2. The agent was apparently authorized3. The agent had a power arising from the agency relationship and not dependent upon authority or apparent

authorityii. RS3d Agency 6.01 & 6.02 – When an agent, acting with actual or apparent authority, makes a contract on behalf of

a principal, the principal and the third parties are parties to contracth. White v. Thomas –White employs Simpson and gives her Power of Attorney to attend a land auction and bid up to $250K for

a 220-acre farm. Simpson wins the auction for the remaining 217 acres with a bid of $327,500. When Simpson realizes that she had exceeded White’s authority, she agrees to sell 45 acres to other ppl. White “has a heart attack” when he finds out, but closes on the 217 acres, then refuses to sell the 45 acres. They sue White for specific performance on the 45 acres.

i. Court held that in the absence of a principal and any indicia that an agent has authority to engage in a specific action on the principal’s behalf, the agent does not have apparent authority to engage in such action merely because the agent asserts she has such authority.

1. Reasonable from the general manifestations of the principal – the court says this was not a reasonable reliance – big difference between buying and selling; Also, this is real estate=different!

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i. Inherent Authority - R2d §161 – a general agent for a disclosed or partially disclosed principal subjects his principal to liability for acts done on his account which usually accompany or are incidental to transactions which the agent is authorized to conduct if, although they are forbidden by the principal, the other party reasonably believes that the agent is authorized to do them and has no notice that he is not so authorized.

j. Estoppel to Deny Existence of Agency Relationship - R3d. §2.05 – A person who has not made a manifestation that an actor has authority as an agent and how is not otherwise liable as a party to a transaction purportedly done by the actor on that person’s account is subject to liability to a 3 rd party who justifiably is induced to make a detrimental change in position because the transaction is believed to be on the person’s account, if

i. (1) the person intentionally or carelessly caused such believe, or ii. (2) having notice of such belief and that It might induce others to change their positions, the person did not take

reasonable steps to notify them of the factsiii. similar to inherent agency in the restatement 2d, just under another name

k. Gallant Insurance v. Isaac – Gallant (Pr) sells car insurance to Isaac (3rd) through its agent Thompson-Harris (A). Policy states that any changes would have to be authorized by Pr. 3rd buys new car, which A agrees to insure effective immediately. A and 3rd agree that 3rd would come in to fill out paperwork. 3rd gets into a car accident & goes to A’s office to fill out the paper work as planned and also reports her accident. P denies coverage b/c A was not authorized to renew 3rd policy w/o authorization from P.

i. Court found that the insured could have reasonably believed that the agent had the authority to bind the policy; An agent has inherent authority to find its principal where the agent acts within the usual and ordinary scope of its authority, a third party can reasonably believe that the agent has authority to conduct the act in question and the third party is not on notice that the agent is not so authorized.

ii. The agent had a common practice of binding policies orally in violation of the agreement with principal and principal accepted so the court finds it to be reasonable

1. Implied authority – the 3rd party can reasonably believe that this is ok b/c they keep doing it even though it’s against the agreement – Gallant never stopped them in the past

2. Apparent authority – 3rd party had no reason to doubt the agreement/propriety of Thompson-Harris’ actions given that they were her only contact with Ins. Co. – Gallant had never objected to any of the prior interactions similar to the one in question

iii. Two-part test: 1) Does A’s power derive from the agency relationship? 2) Could the third party reasonably believe the A had that authority?

iv. DIFFERENCE btw Gallant and White - Availability of information – buyer had much more ability to collect information in White than in Gallant. Least cost monitoring – burden on Isaac to monitor insurance agent and company is too much v. the burden of Thomas checking Simpson’s relationship w/White. Lowering the monitor costs. Burden on the party who can monitor cheapest.

l. Agency by Estoppel or Ratification i. Elements of estoppel are customary – Failure to act when knowledge and an opportunity to act arise plus reasonable

change in position on the part of the third person. (Best Buy hypo)ii. Ratification – accepting benefits under an unauthorized K will constitute acceptance of its obligations as well as its

benefitsm. Liability in Tort: P generally liable if and only if master/servant relationship (not independent contractor) and within scope

of employmenti. RS3 §2.04 – An employer is subject to liability for torts committed by employees while acting within the scope of

their employmentii. RS3 §7.07(3)(a) – an employee is an agent whose principal controls or has the right to control the manner and

means of the agent’s performance of workiii. Independent contractor – person who contracts with another to something for him but who is not controlled by the

other or subject to the other’s right to control with respect to his physical conduct in the performance of the undertaking.

iv. Factors in Rs2d Agency §220(2)(a)-(j) to determine servant v. independent contractor 1. Extent of control the employer exercises over details2. Whether or not the agent is engaged in a distinct business3. Type of occupation, whether it is normally done without supervision in locality. 4. Skill required in particular occupation5. Whether the employer supplies the tools necessary6. Length of employment (longer the length of the employment, the more likely it is a servant relationship)7. Method of payment (wage v. per job)8. Whether the work is regular business for the employer9. Intention of parties10. Whether employer is in business

v. Rs2d Agency on Principal Liability:1. Rs2d Agency §215 – Conduct Authorized but Unintended by Principal – where injury ensues as a result of

servant’s act, principal is liable for tort damages

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2. Rs2d Agency §216 – Unauthorized Tortious Conduct: Principal may be liable for tortious conduct of agent, despite the fact that he does not personally violate a duty

3. Rs2d Agency §219 – When Master Is Liable for Torts of His Servants – if servant acts in scope of employment

4. Rs2d Agency §228 – Scope of Employment: a. Kind of employment to perform; b. Substantially within the time and space limits; c. Purpose, in part at least, is to serve master; and d. Intentional by servant and not unexpectable by master

5. Rs2d Agency §230 – Forbidden Acts: may be within scope of employment6. Rs2d Agency §231 – Criminal or Tortious Acts: may be within scope of employment7. Rs2d Agency §232 – Failure to Act: by servant, may be within scope of employment

vi. Humble Oil v. Martin(1949) – P and his two children were injured when they were struck by a vehicle that rolled out of a service station owned by D (principal). and operated by S (agent). Evidence showed D exercised control over S’s operations, but D said it couldn’t be held liable for S’s torts.

1. Rule: A party may be liable for a contractor’s torts if he exercises substantial control over the contractor’s operations.

2. Rationale – Evidence showed that D mandated much of the day-to-day operations of the station, enough to justify the trial court’s finding of a master/servant relationship rather than a contractor relationship.

vii. Hoover v. Sun Oil Co. (Del. Sup. Ct. 1965)– Hoover sought to hold franchisor Sun Oil responsible after Hoover was injured in a fire at a service station franchise operated by Barone.

1. A franchisee is considered an independent contractor of the franchisor if the franchise retains control of inventory and operations.

2. Test: whether the franchisor retains the right to control the details of the day-to-day operations of the franchisee. Franchisor influence insufficient.

3. Why the different results?Humble/Schneider Sunoco/BaroneHumble set hours of operation Barone set hours of operationSchneider sold only Humble Products Barone could sell non-Sunoco productsHumble held title to goods that Schneider sold on consignment

Barone took title to goods

Lease was terminable at will Lease was terminable once annuallyRent was “at least in part, based on the amount of Humble’s products sold” and Humble paid a big % of Shcneider’s operating costs (e.g., 75% of utility bills)

Barone had “overall risk of profit and loss” though subsidies from Sunoco to ensure competitiveness

Humble could require periodic reports No written reports required, but representative Peterson visited weekly in an advisory capacity

a. Day-to-day evidence of control is less important than the legal rights of the parties to control – R3d 7.07

n. Governance of Agency- 3 methods:i. Contract

ii. Exit rightsiii. Fiduciary duties

1. Duty of obedience – to what the explicit instructions of the principal are (doesn’t cover a lot, can only instruct so much)

2. Duty of care : (anti-negligence) acting in good faith as a reasonable person would, being informed and not negligent.

3. Duty of loyalty (anti-cheating) – can’t cheat on the principal; acting in good faith to advance the P’s interest.

iv. Duties of the Agent to the Principal1. §8.01 General Fiduciary Principle – an agent has a fiduciary duty to act loyally for the principal’s benefit

in all matters connected with the agency relationship2. §8.02 – Material Benefit Arising out of Position – An agent has a duty not to acquire a material benefit

from a 3rd party in connection with transactions conducted or other actions taken on behalf of the principal or otherwise through the agent’s use of the agent’s position

3. §8.03 – Acting as or on Behalf of an Adverse Party – an agent has a duty not to deal with the principal as or on behalf of an adverse party in a transaction connected with the agency relationship.

4. §8.06 – Principal’s Consent – a. Conduct by an agent that would otherwise constitute a breach of duty as stated in §§8.01-8.05

does not constitute a breach of duty if the principal consents to the conduct, provided that:

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i. In obtaining the principal’s consent, the agent:1. acts in good faith, 2. discloses all material facts that the agent knows, has reason to know, or should

know would reasonably affect the principal’s judgment unless the principal has manifested that such facts are already known by the principal or that the principal does not wish to know them, and

3. otherwise deals fairly with the principal; and ii. the principal’s consent concerns either a specific act or transaction or acts or

transactions of a specified type that could reasonably be expected to occur in the ordinary course of the agency relationship.

v. Duty of Loyalty – 1. §8.01 – an agent has a fiduciary duty to act loyally for the principal’s benefit in all matters connected with

the agency relationship2. §8.06 - In certain circumstances, the agent can act as an adverse party as long as there is full disclosure and

fair dealing – real estate is an example of this type of a beneficial relationship with an agent as adverse party

a. Hypothetical §§8.01-8.06 (pg. 35) – Client just sold his house and the buyer was his own real estate agent. But the client discovers that the house down the street sold for 50% more through another agent the next week.

i. Probably could void – not full disclosure under §8.06vi. Tarnowski v. Resop (1952) – A (Resop) takes $2K “secret commission” from third party (T) on “coin operated

music machine” deal on behalf of P (Tarnowski). 1. Rule – An agent is liable to a principal for the agent’s profits made during the course of the agency;

it is not material that no actual injury to the principal results, or that the principal made a profit on the transaction.

a. It is also irrelevant that the principal, upon discovering a fraud, rescinded the K and recovered from that with which he has partied. P’s remedy from agent – secret commission; all costs of collecting form sellers as damages.

2. Rs2d Agency 407 – If an agent has received a benefit as a result of violating his duty of loyalty, the principal is entitled to recover from his what he has so received, its value, or its proceeds, and also the amount of damage thereby caused.

a. If the agent’s wrongdoing requires the principal to sue to recover, the principal is also entitled to attorneys’ fees from the agent, since the attorney’s fees are directly attributable to the agent’s breach.

3. Doesn’t he seem to be overcompensated – he gets back more than he suffered?a. Deterrence rationale – deter agents from engaging in this type of behavior – Signifies the

seriousness of fiduciary duties (duty of loyalty)vii. In Re Gleeson(1954) – Mary Gleeson dies; Con Colbrook, a close friend and tenant on her land, is the executor and

trustee under her will, which benefits her 3 children. Barely back from the funeral when the lease is up; Con talks the whole thing over with the 2 competent beneficiaries, leases the land for another year, increases payments by 67%, and finds another tenant the next year. Con files his first semi-annual report; beneficiaries collectively object; lower court approves report; appeals court reverses.

1. Colbrook discussed the arrangement with the beneficiaries but – §203 - the trustee is accountable for any profit made by him through or arising out of the administration of the trust, although the profit does not arise from a breach of trust -> Trustee can’t profit.

a. No (good faith) exceptions – duty of loyalty is stronger for trusts.2. Guardian of incompetent beneficiary probably brought the action – his fiduciary duty to challenge this

IV. Partnershipa. Partnership Defined - 2 or more parties entitled to the business and its returns

i. All owners are liable as principals and are all agentsii. All are jointly and severally liable for debts (creditor can pick w/e P1 and go after them, and then P1 can go after P2

to get share)iii. All are equally responsible for control, unless there is some other agreementiv. Creditor of partnership, once assets have been exhausted, creditors of p-ship stand on equal footing as individual

creditorsb. Governing Laws (see chart on UPA v. RUPA)

i. Revised Uniform Partnership Act (RUPA) (1997)– used in about 2/3 of states.ii. Uniform Partnership Act (UPA) (1914)– used in 1/3 states, being displaced by RUPA.

iii. Definition of Partnership (UPA §6(1); RUPA §101(6)):“an association of 2 or more persons to carry on as co-owners a business for profit”

iv. ‘Co-owners’ means:1. shared control of the business; shared profits of the business

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2. No formal creation requirements. Doing business as co-owners results in creation of partnership by operation of law

c. Meinhard v. Salmon – Meinhard and Salmon are hotel joint venturers. Salmon gets 60% of profits for first five years, then 50-50 for the remaining 15. Losses are split equally. When the first lease is about to run out, Salmon is presented with a new opportunity: lease the whole block for 80 years. Salmon accepts for his own corporation (Midpoint), without consulting or informing Meinhard; Meinhard now wants a piece of the action.

i. “Joint adventurers owe to one another, while their enterprise continues, the duty of finest loyalty, a standard of behavior most sensitive. …A trustee is held to something stricter than the morals of the market place. NOT HONESTY ALONE, BUT THE PUNCTILIO OF AN HONOR THE MOST SENSITIVE, IS THEN THE STANDARD OF BEHAVIOR.” – JCARDOZO

1. Cardozo seems to be suggesting a pretty broad spectrum of duty – the offer of the new venture came during the joint venture where he owed at least a duty to fully disclose to his partner the new venture/opportunity

2. Black-letter law points: motives do not matter in duty of loyalty.ii. Should have disclosed all related activities – Cardozo leaves open what the rule is, just that lack of disclosure breaks

the duty – is disclosure enough? We don’t know-> about deterrence.iii. 2 truths from this case

1. If a court cites Meinhard’s language, the D is going to lose2. If a court cites Meinhard’s “punctilio of honor” language, the D is going to lose badly

d. General Partnership – General partnerships can be organized w/no formalities and no filing – partnership status depends on the factual characteristics of a relationship between two or more persons, not on whether the persons think of themselves as having entered into a partnership.

i. Uniform Partnership Act is still the standard as Revised UPA is being adopted1. UPA §6 – a partnership is an association of 2 or more persons to carry on as co-owners of a business for

profit2. UPA §7(3) – share of gross returns (revenues) does not indicate partnership b/c that is where wages come

from3. UPA §7(4) – receiving net profits is prima facie evidence of partnership, unless net returns are interest

payments, wages, rent, etc.ii. In general, look at 3 things to determine partnership status:

1. control over the enterprise (agency law);2. profit sharing (UPA §7(4));3. and intent of the parties

a. UPA §6, alsob. UPA §18(g) – no person can be a member of a partnership w/o the consent of all the partners

iii. UPA §7(1) –Partnership by estoppel- persons who are not partners to each other are not partners as to 3rd parties, except for p-ship by estoppel (UPA §16)

1. If a person represents itself as being a partner in an enterprise (or consents to others making the representation) AND a third party reasonably relies on the representation (actual reliance required) and does business with the enterprise

2. THEN the person who was represented as a partner is personally liable on the transaction, even though that person is not in fact a partner – somewhat analogous to apparent authority doctrine.

a. UPA§16(1) refers only to those who “give credit,” b. RUPA §308 expands this to all transactions and case law has made this clear even in the UPA

contexte. Vohland v. Sweet – Sweet does apprenticeship with Vohland the Elder; Elder dies, Vohland Junior takes over and renames it

“Vohland’s Nursery.” Beginning in 1963, Sweet was paid 20% of net profits of nursery. No explicit agreement. Sweet’s 20% share is (erroneously) called “commission.” In 1979, Sweet sues to dissolve partnership – i.e., wind-up, sell assets, and distribute proceeds. (284,860 x 20% = $65,972)

i. Sweet contributed labor and expertise into a nursery business, from which he took 20% of the profits-> Had been reinvesting profits in the company for years to build up inventory stock – Sweet wants his 20% of the stock out

1. Vohland is arguing Sweet was on commission, never meant to make him a partner and he never contributed capital

ii. For purposes of creating a partnership, one partner’s contribution may consist of labor and expertise. A partnership may be defined as 2 or more persons carrying on as co-owners of a business for profit. No one element or test exists for identifying a partnership, but, generally speaking, a partnership relation involves mutual contribution and mutual share of the profits-> the intention to do the acts creating the p-ship that count, not actually intending a p-ship!

1. Court seems to think that Vohland was creating ownership incentives in Sweet and then not actually give him ownership

f. Continuing liability of an existing partner i. Default Rule -> Exiting partner is liable for debts created before leaving

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ii. Common law and UPA are sensitive to the exiting partner’s liabilities, but you have to be careful not to allow partners to go running for the hills when a partnership fails

iii. If you can show that the lender knew the partner was withdrawing and agreed to release that partner, then they will not hold them liable for those debts

iv. UPA §36.4 – if the retired partner dies, their estate is still liable for all debts prior to departure, but estate can pay off personal debts first

g. Management and Control- Unless otherwise provided in the partnership agreement:i. Every partner has a right to participate in the management of the partnership business.

ii. Any difference arising as to ordinary matter connected with the partnership business may be decided by a majority of the partners, with each partner having one vote regardless of the relative amount of his capital contribution.

iii. Extraordinary matters require approval by all the partners.h. Authority – every partner is an agent of the partnership for the purpose of its business.

i. UPA- UPA §18(h) – Any difference arising as to ordinary matters connected with the partnership business may be decided by a majority of the partners; but no act in contravention of any agreement between the partners may be done rightfully without the consent of all partners

ii. UPA §9(2) – An act of a partner which is not apparently for the carrying on of the business of the partnership in the usual way does not bind the partnership unless authorized by the other partners

1. Required to object in a timely manner2. Could do so if the partner had real or apparent authority3. Construction

iii. Partner has apparent authority for carrying on in the usual way the business of the partnership – unless the partner in fact has no authority to act for the partnership on a particular matter and the person with whom he is dealing “has knowledge” that the partner has no authority.

iv. RUPA- Even if a partner’s actual authority is restricted by the terms of the partnership agreement, she has apparent authority to bind the partnership in either:

1. the ordinary court of the partnership’s actual business2. business of the kind carried on by the partnership, unless the third party knew or had received notification

that the partner lacked authority. v. RUPA §303(a)(2) – provides for the filing of a “Statement of Partnership Authority”

1. Grant of authority is conclusive as to third parties even w/o actual knowledge, unless have actual knowledge that the partner does not have such authority.

2. Limitation not effective unless the third party knows of the limitation or the statement has been delivered to him.

vi. RUPA §401(j) – An act outside of the ordinary course of business of a partnership and an amendment to the partnership agreement may be undertaken only with the consent of all parties

i. National Biscuit v. Stroud (1959)– Stroud and Freeman formed a partnership to run a grocery store. Stroud told National Biscuit that he would not be personally liable for any more bread it sold to the store. Freeman ordered more bread, National Biscuit delivered it and National Biscuit sued Stroud for payment.

i. Why didn’t Stroud’s letter alert Nabisco that Freeman had no authority?1. UPA§9(1) Rules of Authority - “Every partner is an agent of the partnership for the purpose of its

business, and the act of every partner, including the execution in the partnership name of any instrument, for apparently carrying on in the usual way the business of the partnership of which he is a member binds the partnership, unless the partner so acting has in fact no authority to act for the partnership in the particular matter and the person with whom he is dealing has knowledge of the fact that he has no such authority.”

ii. Rule – The acts of a partner, if performed on behalf of a partnership and within the scope of the business, are binding upon all partners.

j. Assets=liability + equity (capital) i. Value inventory at cost.

ii. Accounting value does not = market value.iii. Accrual- taking adjustment in period it is incurred.

1. Amortization= depreciation accrued as well.k. Capacity to sue and be sued

i. UPA – suit on a partnership obligation must be brought by or against individual partners, it cannot sue or be sued in its own name.

1. Partners are jointly and severally liable for wrongful acts and omissions of the partnerships and breaches of trust.

2. Only jointly liable for all other debts and obligations of the partnership – means creditors have to join all the individual partners in a lawsuit.

ii. RUPA – partnership may both sue and be sued in its own name and partners are jointly and severally liable for all obligations of the partnership.

1. But adds a new barrier to collecting against an individual partner on such liability.

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2. Must exhaust all other remedies before resorting to collecting against an individual partner. l. Partnership Relations With Third Parties

i. UPA and RUPA Provisions1. UPA §9 (1) – Act of every partner binds partnership (apparent authority)2. UPA §12 – notice to any partner on partnership affairs counts as notice to the partnership3. UPA §13 – where, by any wrongful act/omission of partner acting in ordinary course of business or with

authority of his co-partners, loss/injury is caused or penalty is incurred, p-ship is just as liable as the acting partner

4. UPA §14 – the partnership is bound to make good the loss where received money is misapplied in scope of partner’s apparent authority or while in the custody of the partnership

5. UPA §15 – partners are liable jointly and severally for everything chargeable under §13 and §14, and jointly for all other partnership debts and liabilities

6. UPA §18:a. B – Partnership must indemnify every partner for payments made and liabilities incurred in the

ordinary and proper conduct of the business. Each partner is an agent of the partnership and all the other partners.

b. F – No partner is entitled to remuneration for acting in the partnership business.c. G – No partner can become a member of the partnership without the consent of all the partners.

7. UPA §36: Dissolutiona. Dissolution of the partnership does not of itself discharge existing liability of any partner.b. Releases the departing partner of partnership debts IF the court can infer an agreement between

the remaining partners and the creditor to release the withdrawing partner.c. Releases the departing partner of personal liability where the creditor and the remaining partners

renegotiate8. RUPA §306 Partners are jointly and severally liable on partnership torts and contracts.9. RUPA §307(d) – Partnership assets must be exhausted before pursuing personal assets.

m. The Rights of Partnership Creditorsi. UPA §15 – Partners jointly and severally liable on partnership torts; jointly liable on p-ship contacts

ii. RUPA §306 – Partners jointly and severally liable on partnership torts and contracts, BUT:iii. RUPA §307(d) – Must exhaust business assets before pursuing personal assetsiv. Tax advantages – no double taxation like corporation where profits are taxed as corporate profits and then taxed

again as dividend profits – partnerships only get taxed once1. Businesses are more easily able to claim deductions for business loss rather than personal

n. Personal Liability – every partner is subject to unlimited personal liability for the debts and obligations of the partnership. i. UPA §15 – partners are individually liable for wrongful acts and omissions of the partnership (such as torts),

breaches of trusts, and for all other debts and obligations of the partnership ii. RUPA § 306 – partners are liable for all obligations of the partnership.

1. But adds a barrier to collecting against an individual partner:2. Judgment for a claim against a partner cannot be satisfied until:

a. a judgment on the same claim had been rendered against the partnershipb. a writ of execution on the judgment has been returned unsatisfied.

3. Exhaustion rule – partnership assets must be exhausted before a partner’s individual assets can be reached. 4. Exception – rule does not apply if the partnership is in bankruptcy.

o. Transferability of Interests – parent cannot transfer his partnership interest to make the transferee a member of the partnership, except w/the consent of all remaining partners.

p. Third Party Claims Against Partnership Propertyi. Segregated pool of assets to secure business debts – characteristic of partnerships

1. If didn’t have this, all of the business and personal assets of investors would be available to both business and personal creditors.

2. Would create a severe problem as the number of co-owners increasedii. Property Ownership - affords to individual partners virtually no power to dispose of partnership property, thus

transforming this property into de facto business property1. UPA 25

a. Partnership can hold and convey title to property in its own name.b. But the property is said to be “owned” by the partners in a “tenancy in partnership.” – partners

cannot dispose of the property individually. c. Strips away from partners all the usual incidents of ownership, including the right to assign and

the right to bequeath.2. RUPA §203 – Property acquired by a partnership is property of the partnership and not of the partners

individually. 3. RUPA 501 & 502 – Partnership actually owns property. Partner does retain transferable interest in the

profits arising from the use of partnership property and the right to receive partnership distributions

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a. If a partner does not own her partnerships assets in a general sense, she retains a transferable interest in the profits arising from the use of partnership property and the right to receive partnership distributions.

b. Two-level ownership structure – Contributors of equity capital do not “own” the assets themselves but rather own the rights to the net financial returns that these assets generate, as well as certain governance or management rights.

iii. Partner’s interest can be transferred in most circumstances – get a “charging order” which is a lien on the partner’s transferable interest that is subject to foreclosure unless it is redeemed by repayment of a debt.

q. When both Partners and Partnership are in Bankruptcyi. UPA §40(h) & (i)/Jingle Rule – gives the partnership creditors priority over all partnership assets and assigned first

priority to the separate creditors of the individual partners in the individual assets of those partnersii. 1978 Act/ (§723 (c)) RUPA §807 (a) - the RUPA follows the parity treatment rule codified in §723 of the

Bankruptcy Act of 1978. First administers the estate of the partnership and then the assets of the general partners to the extent of any deficiency

iii. Jingle Rule (left) v. 1978 Act (right)

iv. The revised rule against jingle rule cuts against the incentives to individualize assets to prevent creditors from reaching partnership assets.

r. Applicability i. In ALL cases, partnership creditors get first priority in the assets of the partnership.

ii. For Individual Assets1. Jingle Rule Distribution applies where:

a. UPA is controlling state law, ANDb. §723 does not apply (ie: partnership is NOT in chapter 7 or the individual partner is NOT in

bankruptcy).2. Parity Treatment Distribution where EITHER:

a. RUPA is the state law, ORb. § 723 Applies (ie: partnership is in chapter 7 or individual partner is in bankruptcy).

s. Dissolution and Disassociationi. UPA

1. Dissolution §29 – any change of partnership relations, e.g., the exit of a partner:a. Rightful dissolution- normally death, incapacity, withdrawalb. Wrongful dissolution- by express will of any partener (ex. misconduct, breach of K…)

2. Winding up §37 – unless otherwise agreed, last surviving partner may have an orderly liquidation and settlement of partnership affairs It may also be allowed upon a showing of cause by the court

3. Termination §30 – partnership ceases entirely at the end of winding up ii. RUPA

1. Disassociation §601 – uses the three terms in UPA, but adds a third term, dissociation, to describe the termination of a person’s status as a partner.

2. Dissolution §801 – the onset of liquidating of partnership assets and winding up its affairsa. Winding up: only happens on the occurrence of certain events.b. Buyouts: mandatory if want to continue the interest.

iii. UPA (1914):

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iv. RUPA (1997):

v. Dissolution – 3 issues1. Ability of partners to opt out of statutory wind-up in a partnership at will (Adams v. Jarvis)2. How to liquidate assets in a statutory wind-up (Dreifuerst v. Dreifuerst)3. Limitation of the power to force statutory dissolution and wind-up (Page v. Page)

t. Adams v. Jarvis: Adams, Jarvis, and a third doctor entered into a partnership for the practice of medicine. Agreement provided that the firm would continue to operate even if one doctor withdrew and that the withdrawing partner would be entitled to share in the profits for any partial year that he remained a partner, but all accounts receivable were to remain the property of continuing partners. Adams later withdrew and claimed a right to share in the partnership’s existing accounts receivable.

i. Court held that a partnership agreement which provides for the continuation of the firm’s business despite the withdrawal of one partner and which specifies the formula according to which partnership assets are to be distributed to the retiring partner is valid and enforceable. Adams doesn’t get 1/3rd of accounts rec., but only his share of profits til end of year.

ii. UPA §38(a) – when dissolution is caused in any way...unless otherwise agreed, may have the partnership property applied to discharge its liabilities, and the surplus applied to pay in cash the net amount owing to the respective partners.”

iii. Reasonable that remaining doctors would want to keep control over accounts receivable, but P is entitled to profits from accounts receivable that were collecting during the year of Ps withdrawal (remanded to determine amounts).

u. Dreifuerst v. Dreifuerst– Ps brought suit against their brother (D) to dissolve a partnership in which they were all partners. D contended that under Wisconsin law he had a right to force a sale of partnership assets in order to obtain his fair share of the assets in case upon dissolution.

i. Court held that a partnership at will is a partnership that has no definite term or particular undertaking and can rightfully be dissolved by the express will of any partner.

1. Lawful dissolution gives each partner the right to have the business liquidated and his share of the surplus paid in cash.

ii. UPA §38(1) – “when dissolution is caused in any way, except in contravention of the partnership agreement, each partner, as against his co-partners...unless otherwise agreed, may have the partnership property applied to discharge its liabilities and the surplus applied to pay in cash the net amount owing to the respective partners.” -> So they had to sell off the property and split the money less any debts.

v. Page v. Page– P sought a declaratory judgment that the partnership he had w/D was a partnership at will which he could dissolve.

i. A partnership may be dissolved by the express will of any partner when no definite term or particular undertaking is specified. However, the dissolution of an at will partnership must still be acted upon with good-faith in accordance with the fiduciary duties owed by each partner.

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ii. Appellate court found that the dissolution was in good faith (no evidence to the contrary – no proof that the new found profits were anything more than temporary) and found that Big Page could dissolve without owing anything to Little Page.

D. Alterations of the Partnership Form1. Limited Partnership (UPA §1001)- cannot go after individual assets, only partnership assets. Like general partnerships, no distinction between general and limited partners, just has a liability shield. Mostly used by service firms -> law firms, accounting, etc.

a. Partners are divided into two classes – general partners and limited partnersi. General partners – essentially have the rights and obligations of partners in an ordinary partnership

1. Must have one or more2. Have unlimited liability for partnership obligations.

ii. Limited partners – normally do not participate in the management of the partnership’s business and are subject to only limited liability.

1. Liability of a limited partner for partnership debts is limited to the capital she contributes to the partnership. 2. If limited partners do exercise management powers they risk losing their limited liability protection as de facto general partners

b. Control test – if limited partners exercise control they can be held liable as a general partner. i. Rationale – those who can actively shift assets out of the firm, or make risky decisions, should be held personally liable to prevent opportunism against partnership creditors. Opportunism concern does not apply to passive investors so we do not hold them liable. ii. Revised Uniform Limited Partnership Act (1985) – adopts control test but adds the qualification that a limited partner who participates in the control of the business is liable only to persons who transact business w/the limited partnership reasonably believing based on the limited partner’s conduct that the limited partner is a general partner. iii. Revised Uniform Partnership Act (2001) – no liability for limited partner even if the partner participates in the management or control of the limited partnership.

c. Two-tier tax treatment for any enterprise with publicly traded equity – Enterprise is taxed on its entity income, and its investors are taxed again at individual rates.

2. Limited Liability Partnership (LLP)a. Need to be registered with the state, different states have different requirements.b. All partners are limited in liability and can exercise control.c. The partnership itself is limitless, but individual partners cannot be liable after entity is exhausted.

i. Creditors can only rely upon business assets for liquidation. ii. Limited partners share in profits without incurring personal liability for business debts; iii. Limits liability only for partnership liabilities arising from DLLPA §1515(b)

1. Negligence, malpractice, wrongful act, or misconduct of another partner.2. Or an agent of the partnership not under the partners’ direct control.

3. Limited Liability Companies (LLC): best of both worlds-a. This is the entity of choice today b/c the owners enjoy control and limited liability and the LLC can elect not to be taxed as a corporation but to have income attributed to its owners to be treated as a partnership.

i. “Check the box” taxation - Allows all unincorporated businesses to choose whether to be taxed as partnerships or corporationii . Disadvantages : complex to form (operating agreement), easier to “pierce the veil,” and state taxes might be applicable, like a corporation, but unlike a partnership.

b. Formation – formed by filing Articles of Organization in state i. Operating Agreements then set out additional details.

c. Management i. Member managed – managed by their members, apparent authority is comparable to the apparent authority of a partner.

1. Each member has the power to bind the LLC for any act that is for apparently carrying on the business of the LLC in the usual or ordinary way. 2. Even if an action is not in the usual or ordinary way, the remaining members may confer on a given member actual authority to bind the LLC to an action or type of action.3. The remaining members may also withdraw the actual authority of a member to take a certain kind of action that is in the regular or ordinary way. 4. In this case, the LLC will still be bound, but the member may have to indemnify the company for any losses

ii. Manager managed – managed by managers who may/ may not be members.

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1. Rules concerning authority are comparable to those in corporations – i.e. typically the managers only have apparent authority to bind the firm.2. Members have no apparent authority to bind the LLC, just as shareholders cannot bind a corporation.

iii. Default rule – LLC is to be managed by its members – this prevails unless the members agree otherwise-> some states modify the default rule.

*Big difference b/w LLC/LLP is the default governance structures for the two entities.->More about protection from each partner.

PART II: THE CORPORATE FORM: THE BASIC CLAIMS ON CASH FLOWS UNDER THE CORPORATE FORM, INCLUDES VALUATION AND CREDITORS’ RIGHTS

a. Core Characteristics of the Corporate formCore Characteristics General

PartnershipLLP LLC Corporation

Investor Ownership X X X XLegal Personality X X X XLimited Liability X X XTransferable Shares X X XCentralized management under an elected board

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iii. These features complement each other and help to raise capital from passive investors for large perhaps risky ventures.

IV. The Corporate Form A. Why use the corporate form?

a. Eliminates problem of personal liability for obligations of entities.b. Entrance/exit becomes a lot easier for ppl.

i. Shares become more fungible->more easily traded-> get a new source of information about the company w/o having to

c. Prevent minority investors from threatening to dissolve firm.d. Default provisions in corporate code.e. More stable and predictable source of law and definition of fiduciary duties.f. Corporations are publicly traded (for the most part).

B. 5 core characteristics:a. 1) Legal personality with an indefinite life.b. 2) Limited liability for investors.c. 3) Free transferability of share interests.d. 4) Centralized management.e. 5) Appointed by investors.

C. Characteristics – make the corporation an efficient form of enterprise organization. 1. Legal personality with indefinite life

a. Corporation is considered a separate person in the eyes of the lawb. Advantages:

i. Makes it easier to sign contracts, closes sales, and take title in its own name.ii. Enables corporations to own assets, delimits the pool of assets upon which corporate creditors can rely for repayment.iii. Reduces the cost of contacting for credit.

c. Indefinite life – enhances the stability of the corporate form – death/departure of a “principal” doesn’t matter, corporate form remains.

2. Limited liability for investorsa. Implications

i. Shareholders cannot lose more than the amount they invest.

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ii. Shareholders unlike the general partner, who is legally a party to all partnership agreements and is thus liable under them

b. Reasons for having limited liabilityi. Simplifies the job of evaluating an equity investment – if not liable on the debts, more likely to invest.ii. Encourage risk adverse shareholders to invest in risky venturesiii. Increase the incentive for banks or other expert creditors to monitor their corporate debtors more closely

. c. Easterbrook and Fischel – 6 reasons why limited liability reduces the cost of separation and specialization

i. Decreases the need to monitor managers – managers find ways to offer assurances w/o a need for director monitoringii. Limited liability reduces the costs of monitoring other shareholders – don’t need to know who other shareholders are, don’t need to monitor their assets to pay debtsiii. Gives managers incentives to act efficiently

1. Shares are tied to votes – poorly run firms will attract new investors who can assemble blocs at a discount and assemble new managerial teams2. Threat of displacement gives existing managers incentives to operate efficiently in order to keep prices high. 3. Limited liability reduces the cost of purchasing shares

iv. Makes it possible for market prices to impound additional information about the value of firms1. W/unlimited liability shares would not be homogenous commodities, wouldn’t have one market price

v. More efficient diversification – w/unlimited liability would limit the number of shares1. Limited liability facilitates optimal investment decisions2. Managers can invest in risky projects w/o exposing the investors to ruin. 3. Increased availability of funds for projects w/positive net values

3. Free transferability of share interestsa. Equity investors in the corporate entity own something distinct from any part of the corporation’s property – share interest

i. May be transferred together w/all rights that it confersii. Allows the firm to conduct business uninterruptedly iii. Avoids complications of dissolution and reformation

b. This is immediately tied to limited liability – w/o limited liability the creditworthiness of the firm as a whole could change as the identities of its shareholders changed.

i. Value of shares would be difficult for potential purchasers to judgeii. Ability of investors to freely trade stock encourages the development of an active stock market.

c. Free transferability is a default provision – can agree to restrict transferability. d. Serves as a potential constraint on self-serving behavior of the managers of widely held companies

i. If stock market distrusts, share price will fall and it will be more likely that managers will be replaced. ii. Anti-takeover defenses that limit the ability of shareholders to sell their stock to would-be acquirers are controversial b/c they restrict the power of the market to discipline managers.

4. Centralized Management Appointed by Equity Investors a. Centralized management can achieve economies of scale in knowledge of the firm, its technologies and markets.

i. Shareholder-designated Board of Directors, not investors, are accorded the power to initiate corporate transactions and manage the day to day affairs of the corporation. ii. This causes a problem – investors become rationally apathetic – need to develop rules to ensure managers will advance financial interests of investors w/o impinging on management’s ability to manage the firm productively.

b. Formal distinction b/t board and managementi. Initiation and execution – managementii. Monitoring and approval – board iii. Distinction serves as a check on the quality of the delegated decision making.

B. Formation1. Two Basic Types of Corporations

a. Close Corporation – basically an incorporated partnership. i. Small, so shareholders are likely the officers and directors.ii. May have features that restrict the transfers of shares or other provisions that conflict with general corporate status.iii. Reason for incorporation is tax status rather than raising capital, so usually

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do in their own state instead of DE, for ex.iv. Absence of secondary market for shares.*Are often controlled corps.

b. Publically-held corporations*Can be controlled corps, but usually are not.i. When a single shareholder or group of shareholders exercises control through its power to appoint the board. ii. Where there is no such group, control is said to be “in the market,” where anyone can purchase control by buying enough stock, but until they do, practical control resides with the existing management of the firm.iii. Problems occur in self-dealing transactions and protection of minority shareholders’ rights.1.large company ->main trait is a public secondary market in which the corp’s shares are listed and traded2.primary market-> transactions to which the corporation is party

a. eg. issuing or repurchasing shares3.Secondary market-> transactions to which corp is not a party

a. Eg. A sells to B shares in X corp4.Public Secondary Market – eg. Stock exchange

2. Choosing Where to Incorporate a. U.S. Firms not constrained by headquarters, place of business or other operational factors in choosing where to incorporate.b. State of incorporation dictates which corporate law rules apply under “internal affairs” doctrine.

i. DE has 50% of incorporations because of favorable laws & almost 25% of DE state budget comes from corporation fees.ii. State charges annual franchise taxes ranging from $10 flat fees to $10,000+ based on income, assets, etc.

c. Mechanics of reincorporation are straightforward: creation of a new firm in the destination state, followed by tax-free merger of the existing corporation into the new one, requires shareholder approval. Typical reincorp. Costs are $70,000 in 2000.

3. Incorporation a. Process of Incorporating

i. Individual called an incorporator signs the requisite documents and pays the necessary fees . DGCL§107ii. Incorporator drafts and signs a document called the Articles of Incorporation or the Certificate of Incorporation. = “charter”

1. DGCL have requirements that have to be in charter.-> To change, board has to approve w/ majority of shareholders.-> By-laws can be changed unilaterally.-> Shareholders can amend w/ majority vote too.

2. State the purpose and powers of the corporation and define all of its special features. o Be as broad as possible.o The provision that shareholders get to vote equally.o Initial directors typically named. o Other provision that will affect shares.o Terms of directors.

-> Typically three year terms.3. Identifies office within the state or an agent in the state upon whom process can be served.

iii. Charter is filed w/a public official-> Secretary1. Have to pay a fee when file charter – fee varies by state – DE calculated by how many shares the corporation is authorized to issue.

iv. First acts of business in a newly formed corporation – take place at an organizational meeting DGCL §108

1. Electing directors2. Adopting bylaws3. Appointing officers

b. DGCL §102: Contents of Articles of Incorporation-i. (a)Requirements –

1. Must provide for voting stock 2. A board of directors – size and terms, procedures for removal3. Shareholder voting for certain transactions. 4. Name the original incorporators

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5. State the corporations name and business, address6. Fix its original capital structure…

ii. Beyond the essentials can have any provision that is not contrary to lawex. cannot opt out of duty of loyalty. DGCL §102(b)(7)

c. DGCL §109: Corporate Bylawsi. Must conform to the corporation statute and the corporation’s charterii. Fix the operating rules of the governance of the corporation.iii. Can cause tension if shareholders can amend.iv. Should include:

o What officers will corp. have: CEO, CFOo Size of the board.o Establish date of annual meeting.o Can include features of how board will operate, but default will be majority of directors.o Shareholder agreements.

d. Shareholder’s agreements DGCL §218(c)i. Formal agreements among shareholders – typically address questions such as restrictions on the disposition of shares, buy/sell agreements, voting agreements, and agreements w/respect to employment of officers of the payment of dividends.ii. Voting trust – an arrangement in which shareholders publicly agree to place their shares with a trustee who then legally owns them and is to exercise voting power according to the terms of their agreement. DGCL 218(a)

§111- Jurisdiction by Court of Chancery.o Issues of internal affairs.

§112- Bylaws may provide shareholder access to the proxy. §113- Proxy expense reimbursement.

o If shareholders win, reimbursement. §121- General powers of corporation. §122- Specific powers.

o Things you can definitely do.o (9)- power to make charitable donations.o (17)- corporate opportunity opt out.

§123- Corp. power to hold shares in other companies.

C. Role of Board of Directors 1. *DGCL 141(a)(most important provision in Code) – a)”The business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors, except as may be otherwise provided in this chapter or in its certificate of incorporation.”

*Not enough for Chancery Court that a board has officers-want to make sure equity is fulfilled and fiduciary duty upheld to shareholders.* Directors have no special duty to follow wishes of a majority shareholder, this is not direct democracy.

Other sections: §142: Officers not necessary, officers honorary

o Third time there is a mention of officers and authority. o Majority of officers have to be independent- cannot work for company or have worked for company.o Law holds board accountable, even though they may not have as much power as CEO.o Role of officers change, especially in times of crisis.

§144: Interested directors.o When board can ratify conflicting transactions.o How to get protection from _____.

§145: Indemnification and insurance. *Important section.o Protecting directors from personal liability.o 3 lines of defenses:

1) DNO insurance. Cover losses and attorneys fees. Will not cover for criminal conduct. Deductibles, max payout provisions.

2) Indemnification. Statute has limitations- cannot indemnify for bad faith violations. Can only protect good faith violations.

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To be personal liable a lot of things would first have to happen: DNO would have to max out payout, company would have to be insolvent so that it could not indemnify you, and then you would be “on the hook.”

Only happened twice: Enron, WorldCom. Personal liability very rare.

3) Court of chancery can: Enjoin things before they happen.

§151: Classes and series of stock.o Default rule: Each class is able to vote for what affects their class rights.

§193: Dividends. o Company doesn’t even have to declare dividends, and when it declares dividends, it doesn’t even have to

pay them. §203: Anti-takeover statute.

o If you acquire more than 15% in a DE corporation’s securities, you will not be permitted to merge with that company, unless you get 85% of board’s approval.

Prevents hostile takeovers. §212: Proxy

o Shareholders may vote by proxy. §213: Securing a vote by buying stuff…

o Have to have date and time to fix who is shareholder and who is not.o Have to buy 60 days before meeting or whatever fixed date.

§216: Quorum for shareholder action.o Majority entitled to vote.o Presents sets of defaults in ___.

(In contested elections) directors elected by plurality in default. §220: Ability to inspect books and records (by shareholders)

o Usually a preview to a lawsuit- get information to survive summary judgment. §228: Shareholders acting in lieu of a meeting.

o Very few boards permit. §252/253: Merger statutes

o 253- Freeze-out merger. If you acquire 90% of company, you get to tell 10% what their share is worth or the Chancery tells

them what it is worth and you buy them out. §262: Appraisal action/ review

b. Automatic Self-Cleansing Filter Syndicate Co. v. Cunninghame (Eng. C.A. 1906): A 55% majority group of the shareholders of the company contended that the company’s board of directors could not override the groups’ vote, made at an ordinary shareholders meeting, to sell the company’s assets, notwithstanding that the company’s charter required a 75% vote to limit the board’s decision making power.

ii. Rule – Where a company’s charter requires a 75% vote of the shareholders, made as an “extraordinary resolution” to override a board of director’s decision, a mere majority resolution made at an ordinary shareholders meeting may not override the board’s decision that is contrary to the majority’s wishes. iii. Rationale

1. The governing statute gives precedence to the directors’ decision in this situation, and gives to the directors the absolute power to do all things other than those expressly reserved to the shareholders.2. The director’s power is subject to extraordinary resolutions, so that if the shareholders desire to alter the directors’ powers, they must do so not by a resolution made by a majority vote at an ordinary meeting, but by an extraordinary resolution – this is the only mechanism that may be used to override the minority. 3. There would be no point to require a “special resolution” for removal of directors in the company’s charter if the company could be sold by majority vote at a general shareholders meeting over the objection of the board.4. This rule protects the interests of the minority shareholders.5. Anyone unhappy with the decision can make a resolution to remove directors, create a staggered board, or vote in a new board at the next vote.iv. Note DGCL §271: Sale, lease or exchange of assets; consideration; procedure

1. BASICALLY - you can’t do this. Board of directors must propose the sale of all assets and then you need a majority of shareholders to vote on it. Shareholders

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cannot sell the assets of a company without approval of the board. You would have to get rid of the directors – mandatory term

2. Structure of the Board a. Charter sets terms for general structure

i. Default – all member of the board are elected annually to one year terms.ii. Can classify different types of stock to elect directorsiii. All directors have one vote on matters before the board

b. Board has inherent power to establish standing committees for the effective organization of its own worki. Committees are usually filled by “independent” directorsii. Matters that by statutes require board action cannot be delegated to committee

c. Corporation statues generally allow charters to create staggered boards – directors are divided into classes that stand for election in consecutive years. DGCL §141(d)

i. Shareholders generally oppose staggered boards b/c they enhance management’s ability to resist hostile takeovers.ii. Staggered boards are usually not offered for shareholder approval anymore, but they are standard features of new companies now.

d. Formality in Board Operation i. Governance power resides in the board of directors, not in the individual directors that constitute the board. ii. Legally speaking, only act as a board at a duly constituted board meeting and by majority vote (unless a supermajority is required on the issue)iii. Need proper notice of meetings and a quorum (majority of board present & signed resolution)– bylaws usually specify, state law provides minimum

*Minimum set by statute- DGCL §141(b)iv. Law’s requirement of a formal meeting is an effort to discourage the manipulation of board decision making. v. Directors may not give proxies for others, they must vote personally

D. Corporate Officers 1. Introduction

a. Corporate charter empowers the board to appoint officers and remove them, w/or w/o cause; Board generally has power to delegate to corporate officers as it sees fit c. Corporate officers are unquestionably agents of the corporation and are subject to the fiduciary duty of agents-> VP, CEO, treasurer…

2. Jennings v. Pittsburgh Mercantile Co. (Pa. 1964): D contended that Egmore, D’s VP and Treasurer-Comptroller, did not have apparent authority to accept an offer for a sale an leaseback, and that therefore P, a real estate broker, was not entitled to commissions for a sale and leaseback transaction that Egmore seemed to accept but that D’s board of directors did not.

b. Rule – A corporation’s executive officer does not have apparent authority to accept an offer for a transaction that for the corporation is extraordinary.

Generally, corporate officers, unlike directors, are unquestionable agents of the corporation and are therefore subject to the fiduciary duty of agents. Moreover, the board of directors generally may delegate its powers to the officers as it sees fit. It seems, therefore, that if this case had involved an ordinary company transaction, rather than an extraordinary one Egmore should have been deemed to have apparent authority to enter into it. Thus, it seems this case places the burden on third parties of determining whether a corporate transaction is ordinary or extraordinary.

c. Rationale i. Apparent authority is defined as that authority which, although not actually granted, the principal:

1. Knowingly permits the agent to exercise or2. Holds him out as possessing.

ii. Agent cannot by his own words invest himself w/apparent authority. iii. For a reasonable inference of the existence of apparent authority to be drawn from prior dealings, these dealings must have:

a. A measure of similarity to the act for which the principal is sought to be bound, and granting this similarity, b. A degree of repetitiveness

v. The extraordinary nature of this transaction placed P on notice to inquire as to E’s actual authority, particularly since he was an experienced real estate broker.

1. Had P done so, he would have discovered that the board never considered any of the proposals and did not delegate actual authority to accept officers.

E. Financial Structure1. Capital Structure – Business corporation raises capital to fund its operations

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a. Two types of long term claims for this purposei. Borrow money through the issuance of debt instruments (loans)

1. Those who buy corporate debt have a contractual right to receive a periodic payment of interest and to be repaid the money they initially loaned at a stated maturity date. 2. If corporation fails to make these payments, creditor has a legal remedy3. Creditor can also accelerate payment in case of a default.

ii. Equity claims – selling ownership claims in the corporate entity1. Common stock – type of claim – fragile legal protections

-> No right to periodic payment, cannot demand return on investment, cannot tell managers what to do->Only have a right to vote, can receive dividends when the board of directors declares so.

2. Legal Character of Debt a. The loan agreement has great flexibility in design – Can construct to whatever the parties desire as long as it is within the lawb. Maturity date – issuer of debt will have an obligation to repay at a stated future date.

i. Repayment obligation – principal amount plus any outstanding interest not yet paid by the maturity date.ii. If any interest/principal is not paid when due=> bonds in default.

c. Investing as a creditor has a few advantages:i. Have a legal right to a periodic paymentii. Priority claim over shareholders on corporate assets if the corporation defaults, and can sue on the K if not paid on time.

d. Tax treatmenti. Interest paid by the borrower is a deductible; cost of business when the firm calculates its taxable incomeii. No deduction is available for dividends or distributions paid to the corporations’ shareholders.iii. Cost of debt is less than equity to a corporation.

3. Legal Character of Equity a. Common stock – contractual in nature but the law fixes clear default rules on the K.

i. Most important rules – owners of stock can vote to elect directors and that stock carries one vote per shareii. Possess control rights in the form of the power to elect the board of directors.iii. Any deviation from the one-vote per share rule must appear in the charter.

b. Residual claims and residual controli. After elect the board, common stock owners have residual claim on the corporations’ assets and incomeii. Board pays the expenses and interest to creditors, whatever is left over can belong to the stockholders in that it is available for the payment of dividends

c. Preferred Stock – an equity security on which the corporate character confers a special right, privilege, or limitation

i. Get paid before general stockholders for dividends and liquidation. ii. Ordinarily does not vote as long as its dividend is current, on certain fundamental matters get a class vote (meaning they can veto the venture)iii. DGCL – right must be created specifically in the document creating and defining the preferred stock

4. Basic Concepts of Valuationa. Time Value of Money

i. risk x time x skill= wealthii. Depends on the use you have for it or on the value you can get by finding someone who needs that dollar now for something valuableiii. Present value – the value today of money to be paid at some future pointiv. Discount rate – tells us how to calculate present values

1. Rate that is earned from renting money out for one year in the market for money; 2. I.e. discount rate of 10 % means you earn 10 cents for lending $1 for one year. 3. Equations: PV (1+r)=FV

a. FV = PV + r(PV)b. PV = FV/ [(1+r)^t]c. PV-expenses (cash flows)= NPV-> On this one project, what is the value to me today? Present value of all streams of cash in future minus expenses.

v. Rate of return – the percentage that you would earn if you invested in a particular project

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vi. Interest – the money you are promised when you lend out money or the amount you have to pay if you borrow money.

b. Risk and Return i. Assessing the uncertainty in investments – probability of success or failureii. Expected return – what investor calculates to determine probability of success or failure.

1.= Weighted average of the investment2. Sum of what the returns would be if an investment succeeded, multiplied by the probability of success, plus what the returns would be if the investment failed, multiplied by the probability of failure.

iii. Financial risk – calculating the present expected value of this opportunityiv. Risk neutral – if all investor cares about it the expected return of the investmentv. Risk averse – volatile payouts are worth less to these investors

1. Most investors are this; demand extra compensation for bearing riskvi. Risk premium – the additional amount that risk adverse investors demand for accepting higher risk investments in the capital markets

1. Does not compensate the investor for possible out of pocket losses – even risk neutral request this b/c failure lowers the ER of the investment.2. Instead is compensation for the intrinsic unpleasantness of volatile returns to the risk adverse investors who dominate market prices.

vii. To calculate present values of risky expected future cash flows, we need to discount those cash flows at a rate that reflects both the time discount value of money and the market price of the risk involved – this is a risk adjusted rate.

b. Diversification and Systematic Riski. Unsystematic risk= risk you can diversify; particular to a company.

1. Ex. Risk that this company will get hit by a computer virus.ii. Systematic risk= not diversifiable; in the system; risk that will affect every bet in the

portfolio in the same way.1. Ex. Risk that interest rates will go up/ down.

i. Packaging investments to reduce risk – construction of mutual funds, a diversified portfolio ii. Risk aversion means that investors are averse only to risks that they actually end up bearing. iii. So a risky investment held as part of a portfolio that includes other equally risky investments is likely to be worth more to its owner than if it would be if it were held alone-> Odds are that even if a few of the investments go bad, most of them will succeed.v. Diversified across a portfolio that has less total risk than its individual components vi. Means that risky investments should be priced to reflect the fact that investors need not bear all the risk associate w/holding a single investment

d. Valuing Assets NPV calculations for all the year periods-> calculate NPV of a terminal value based on current growth. Assets – Liability = $ + NPV future cash flows + NPV terminal value = VALUE OF BUSINESS

i. Discount Cash Flow (DCF) Approach: Requires a prediction of all future cash flows, and a discount rate to bring those cash flows back to the present to yield a “net present value” (NPV)

2. Steps in the process:a. Estimation of all future cash flows generated by the assetb. Calculation of an appropriate discount rate

ii. Weighted average cost of capital – weighted average of the cost of debt and the cost of equity where the weights are the relative amounts of debt and equity in the capital structure

1. Calculating debt is easier, calculating equity is harder.iii. Capital asset pricing model – built on insight that well-functioning markets will link risk and return-> Links securities risk to the volatility of the security prices.

e. Relevance of Prices in the Securities Marketi. Socially valuable if the prices of securities reflected well informed estimates based on all available information of the discounted value of the expected future payments – stock market does this. ii. Depends on the quality of information that informs trading, which depends on the integrity of all the major actors in the market

f. In Re Emerging Communications, Inc., Shareholder Litigation (Del. Ch. 2004): The business valuation efforts for the plaintiff minority shareholders and the defendant majority shareholder disagreed on the appropriate inputs for determining ECM’s cost of capital as well as the relevance of market price for determining ECM’s fair value.

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ii. Issue #1 – Is it appropriate to apply a small stock premium in determining the cost of capital where doing so is shown to be appropriate in a particular case – yes

1. There is finance literature supporting the position that stocks of smaller companies are riskier than stocks of large ones, and therefore command a higher expected rate of return in the market.2. Caselaw also recognizes the propriety of a small firm/small stock premium in appropriate circumstances.3. The issue is not whether a small firm/small stock premium is permissible theoretically, but whether defendants have shown that a premium of 1.7% is appropriate in this particular case – Ds have here.

iii. Issue #2 – Is it appropriate to apply a supersmall size premium in determining the cost of capital where although the company is very small it is also insulted from risk through several advantages – No

1. D justified the supersmall size premium on the basis that ECM is much smaller than the average companies used for generating accepted data for determining the size premium – D offers no rationale for using this premium. 2. Although very small, ECM was unusually protected from the hazards of the marketplace – it was well established, it had no competition, it was able to borrow at below market rates, and it was cushioned by regulators from extraordinary hazards. 3. D implicitly argued that these advantages were not enough to offset the risk, but D never argued that explicitly – needed to support this.

iv. Issue #3 – Is it appropriate to apply a weather related premium in determining the cost of capital where such a premium is unsupported by valuation literature or empirical evidence – No

1. There was no evidence that there would be no insurance coverage for hurricane losses, and D did not provide enough factual support to show that this should increase the cost of equity.

v. Issue #4 – Does the market price of a publicly traded stock corroborate fair value where there are factors that indicate the market price is below fair value – No.

1. Even if traded in an efficient market, market price does not always = fair value. 2. Record shows that ECM’s stock was not traded in an efficient market – b/c the market price didn’t represent the company’s true value Ds decided to abandon the merger which caused Ps to bring suit. 3. B/c the majority interest was owned by one individual, the market price of ECM stock always reflected a minority discount.4. Market was inefficient b/c material information was withheld from it5. Therefore the market price did not corroborate the fair intrinsic value.

V. Protection of CreditorsA. Problems & General Safeguards

Limited liability exacerbates the traditional problems of debtor-creditor relationships:a. Opens opportunities for both express and tacit misrepresentation in transactions with voluntary creditors – misrepresent assets, walk away if business fails. b. Limited liability makes it possible and sometimes attractive to shirt assets out of the corporation after a creditor has extended credit to the corporation – shareholders distribute assets to themselves and leave the debts w/the corporation. c. Creditors can minimize the costs of such shareholder opportunism by taking security interests in particular corporate assets or negotiating specific covenants that give them early warning of credit problems

1. Fraudulent Transfer Act- limitation= only an ex post remedy; fairly loose standard.2. Mandatory Disclosure

a. Federal securities law imposes extensive mandatory disclosure obligations on public corporations, but no US state requires disclosure of financial records for creditors.b. Public issues of debt are themselves occasions for extensive disclosurec. Credit bureau reports are more useful than financial statements for evaluating credit risks associated with close corporations

3. Capital Regulation2. E.g. requiring investors to contribute a minimum amount of capital to the corporation and restricting the

removal of capital from the firm; SE=>minimal capital= legal capital= par value x shares outstanding.3. Very direct means by which the legal system can attempt to protect against some of the risks that creditors

face.4. How do you know what is surplus so that you can make distributions to shareholders?

a. Par Stock = if the stock has par value then the stated capital is equal to the number of shares outstanding times the par value of each share.

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Ex. – Corp. issues 1,000 shares with a $10 par value. The stock has a $30 selling price per share. Corp.’s stated capital will be $10K, and the remaining $20K paid in by shareholders as part of their orginal investment is the “capital surplus.”

b. No Par Stock = Stated capital is an arbitrary amount that directors decide to assign to the sated capital account. Ex. – Corp. issues 1,000 shares at $30 per share issue price, but because the stock is “no par,” the corp.’s stated capital will be whatever the board decides it should be. If they decide stated capital should be $5K, then in addition to this $5K the corp. will have $25K of “capital surplus.”

4. Financial Statementsa. Accounting is a standardized methodology for describing a firm’s past financial performance; A= L + SE

i. Income statement – presents the results of the operation of the business over a specified period. 1. Limitations – account of profit/loss does not reflect the actual amount of cash that a business throws off (or makes available to its owners) per year.2. Net profit may differ from the cash available for distribution for a number of reasons

a. Depreciation is a non-cash charge reflected in the income statement; it reduces net profit but it does not affect the amount of cash that can be made available that year b. Does not reflect the amount of case available to the owners.

ii. Balance sheet – represents the financial picture of a business organization as it stands on one particular day.

1. Limitation - typically reflect historical costs not current market valuesa. Book value (the value found on the balance sheet) may therefore differ quire a bit from the current economic value of an assetb. A balance sheet might show a value for shareholder equity that is much more than shareholders could achieve upon the sale of the firm or, more likely in an inflationary period, a value that is much less than the firm’s market value

2. Divided up into two columns – assets and liabilities a. Assets

i. Current assets (working assets) – constantly cycling through the firm’s production process – cash, marketable securities, accounts receivable, inventories, and prepaid expensesii. Fixed assets (capital assets) – property, plant and equipment, buildings, machinery, equipment, furniture and vehicles

b. Liabilities – divided into current liabilities (due within the year) and long-term liabilities

3. Every element of the corporation’s value must be accounted for by an equivalent debt or equity claim on the liability column

a. This is done in the stockholders’ equity column. b. For both legal and accounting reasons, the stockholders’ equity is divided into 3 accounts:

i. Stated capital (capital stock) – represents all or a portion of the value that shareholders transferred to the corporation at the time of the original sale of the company’s stock to its original shareholders. ii. Capital surplus – if the stock is sold for more than its par value.

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iii. Earned surplus (retained earnings) – the amounts that a profitable corporation earns but has not distributed to its shareholders.

4. A comparison of current assets with current liabilities gives a sense of the liquidity (or the capacity of non-cash assets to be converted into cash)

a. Both current assets and current liabilities are listed in current dollars. b. Long-term liabilities also tend to be stated in units that approximate real economic dollars

b. Distribution Constraintsi. NYBC 510 – bars distributions that would render the corporation “insolvent” –

1. “Insolvent”=unable to pay its immediate obligations as they come due2. Dividends may be paid only out of surplus; they may not be paid out of stated capital

ii. DGCL 170 – nimble dividend exception – directors of a business corporation may pay dividends either out of:

1. Capital surplus, OR2. if there is no capital surplus, out of net profits in the current or preceding fiscal year.3. This is done to permit boards to reward the shareholders of firms that, although not conspicuously healthy, may be on an upward trajectoryAND: DGCL § 244(a)(4) allows board to transfer out of stated capital into surplus for no par stock. Also, dividends can be paid from a Reevaluation Surplus, which allows the firm to adjust its books to reflect that an asset is worth more (in economic value) than the amount at which they are carried on the books.

iii. California’s two-part distribution test – Corporation may pay dividends either out of its retained earnings or out of its assets, as long as those assets (on the balance sheet) remain at least 1.25 times greater than its liabilities and the current assets at least equal current liabilities

c. Minimum Capital and Capital Maintenance Requirementsi. An obvious objection to distribution constraints based on accounting categories such as capital surplus is that they are easily avoided through the expedient of placing trivial sums in the “trust fund” of legal capital reserved for creditorsii. But within the United States, statutory minimum capital requirements are either truly minimal ($1,000) or entirely nonexistentiii. One reason that minimum capital requirements cannot be an effective creditor protection is that this check, whether it exists, is fixed at the date of organization of the corporation iv. Even if companies cannot dip into minimum capital to pay shareholders, normal business activity can easily dissipate a company’s capital, leaving nothing on the books for its creditors

B. Director Liability to Creditors 1. Directors owe an obligation to creditors not to render the firm unable to meet its obligations to creditors by making distributions to shareholders or to others without receiving fair value in return

a. Delaware Chancery Court has suggested that when a firm is insolvent (but no one has yet invoked the federal bankruptcy protections), its directors owe a duty to consider the interests of corporate creditors

i. When a corporation is “in the vicinity of insolvency,” its directors in making business decisions should not consider shareholders’ welfare alone but should consider the welfare of the community of interests that constitute the corporation.ii. But that result will not be reached by a director who thinks he owes duties directly to shareholders only, needs to see the bigger picture.

2. Fraudulent TransfersFraudulent Conveyance & UFTA §4 – Under this provision (txt below) and §5 a dividend paid either by an insolvent corp. or under circumstances that leave the corporation with “an unreasonably small capital” would be fraudulent, and could thus be reclaimed by the creditor on behalf of the corporation. (a) a transfer made…by a debtor is fraudulent as to a creditor, whether the creditor’s claim arose before or after the transfer was made…if the debtor made the transfer…

(1) with actual intent to hinder, delay or defraud any creditor of the debtor; or(2) without receiving a reasonably equivalent value in exchange for the transfer…AND the debtor:

(i) was engaged or about to engage in a business transaction for which the remaining assets of the debtor were unreasonably small…or(ii) intended to incur…or reasonably should have believed that he [or she] would incur debts beyond his [or her] ability to pay as they came due…

a. Fraudulent conveyance law imposes an effective obligation on parties contracting with an insolvent – or soon to be insolvent – debtor to give fair value for the cash or benefits they receive, or risk being forced to return those benefits to the debtor’s estateb. The statute provides a means to void any transfer made for the purpose of delaying, hindering, or defrauding creditors.

i. Can void transfers by establishing that they were either actual or constructive frauds on creditors

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ii. Future creditors who knew or could easily have found out about otherwise vulnerable transfers cannot void them.

c. Creditors may attack a transfer on two grounds: TEST:i. Present or future creditors may void transfers made with an “ actual intent to hinder, delay or defraud any creditor of the debtor”ii. Creditors may void transfers made without receiving a reasonably equivalent value if the debtor is left with remaining assets unreasonably small in relation to its business or he would incur debts beyond his ability to pay as they became due or the debtor is insolvent after the transfer

C. Shareholder Liability to Creditors1. Equitable Subordination – subordination of shareholders debts

a. =Means that the shareholders debt claims against the corporation will not be paid unless and until all other corporate creditors are paid

i. *The doctrine is rarely invoked outside the bankruptcy contextii. Effect – loans from the shareholders to the corporation are treated as if they were not loans but rather invested capital (stock), at least compared to the claims of creditors who are not shareholders.

1. Usually means that the shareholders’ “loans” to the corporation will not be repaid, because if the corporation has gone into bankruptcy, typically there will not even be enough money to pay off the outside creditor’s claims. 2. Dist. piercing corporate veil

a. When corporate veil is pierced, shareholder has to pay the corporation’s debts.b. Here, the shareholder’s claims merely get placed behind the claims of non-shareholder debtors – may lose loans but not liable for corporate debts.

b. Two main requirements for ES:i. The creditor be an equity holder and typically an officer of the companyii. The insider-creditor must have, in some fashion, behaved unfairly or wrongly toward the corporation and its outside creditors

c. Costello v. Fazio (9th Cir. 1958): The trustee in bankruptcy for the bankruptcy estate of Leonard Plumbing and Heating Supply, Inc., contended that claims against the estate of the company’s creditors, Ambrose and Fazio, who were also its controlling shareholders, should be subordinated to those of general unsecured creditors because Ambrose and Fazio had converted the bulk of their capital contributions into loans and left the company grossly undercapitalized, to the detriment of the company and its creditors.

ii. Rule – Where in connection w/the incorporation of a partnership, and for their own personal and private benefit, partners who are to become officers, directors and controlling stockholders of the corporation, convert the bulk of their capital contributions into loans, taking promissory notes, thereby leaving the partnership and succeeding corporation grossly undercapitalized, to the detriment of the corporation and its creditors, their claims against the estate of the subsequently bankrupted corporation should be subordinated to the claims of the general unsecured creditors. iii. Rationale

1. The corporation was grossly undercapitalized – A&F only left $6,000 in the business, 1/65th of net sales. 2. Clear that the depletion of the capital account in favor of a debt account was for the purpose of equalizing the capital investments of the partners and to reduce tax liability when there were profits to distribute

a. F&A acted for their own personal benefit to the detriment of the corporation. b. Inequitable to permit those shareholder-creditors to share in the assets of the bankrupt company, in the same parity with general unsecured creditors.

3. Mismanagement and fraud are not required in order for subordination to occur. The true test is whether the transaction was within the bounds of reason and fairness – A&F’s actions were not here.

2. Piercing the Corporate Veil a. Corporation is a legal entity distinct from its shareholders

i. Normally the obligations of the corporation are separate from the shareholders. ii. Shareholder normally has no liability for corporate debts or other obligations – liability is limited to loss of her investment. iii. Under certain circumstances, shareholders can be found liable to corporate creditors – this is “piercing the corporate veil.”

->But never used against publicly traded co. or on passive shareholders.-> fairly rarely used in DE corps.

b. Tests for piercing the corporate veil are vaguei. Was the corporate the “alter ego” or instrumentality of its shareholders – two components

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1. Evidence of “lack of separateness” e.g. shareholder domination, thin capitalization, no formalities/co-mingling of assets (“Tinkerbell test” – to be protected, shareholder must believe in the separation)2. Unfair or inequitable conduct – this is the wildcard

ii. Lowendahl test (NY): veil-piercing requires 1. Complete shareholder domination of the corporation – failure to treat the corporation formality seriously: failure to hold meetings, no articles of incorporation, comingling of funds!2. Corporate wrongdoing that proximately causes creditor injury.

iii. Another formulation of the test calls on courts to disregard the corporate form whenever recognition of it would extend the principle of incorporation “beyond its legitimate purposes and would produce injustices or inequitable consequences”iv. Cases focus on four factors to determine whether a corporation is so controlled by another to justify disregarding their separate identities:

1. The commingling of funds or assets2. Failure to maintain adequate corporate records or comply w/corporate formalities3. Undercapitalization4. Domination and control.

c. Veil Piercing on K Creditors i. Sea-Land Services, Inc. v. Pepper Source (7th Cir. 1991): When P could not collect a shipping bill b/c D had been dissolved, P sought to pierce the corporate veil to hold Ds sole shareholder personally liable.

2. Van Dorn Test – the corporate veil will be pierced where:a. There is a unity of interest and ownership b/t the corporation and an individual and b. Where adherence to the fiction of a separate corporate existence would sanction fraud or promote injustice.

3. Application a. There can be no doubt that the unity of interest and ownership part of the test is met here.

i. Corporate records and formalities have not been maintained, ii. Funds and assets have been commingled with abandon, iii. D was undercapitalized, and iv. Corporate assets have been moved and tapped and borrowed without regard to their source.

b. Second part of the test is more problematici. An unsatisfied judgment, by itself, is not enough to show that injustice would be promoted – every person trying to pierce the corporate veil has this. ii. Promoting injustice means something less than an affirmative showing of fraud.iii. Remanded so P could show some form of wrongdoing.

ii. Kinney Shoe Corp. v. Polan (4th Cir. 1991): After a corporation owned by D defaulted on a building sublease t/P, P sought to hold D personally liable since his corporation was inadequately formalized and D had not observed any corporate formalities.

2. Rule –Laya test: In a breach of K, the corporate veil will be pierced where a 1) unity of interest and ownership blends the two personalities of the corporation and the individual shareholder, and 2) where treating the acts as those of the corporation alone would produce an inequitable result; 3) (May be applied) Party assumed the risk.3. Rationale

a. In this case, it is undisputed that the corporation had no paid-in capital and that D did not observe any corporate formalities. b. A third prong of the test may apply where a complaining party may be deemed to have assumed the risk of the gross undercapitalization where it would be reasonable for such party to protect itself by making a credit investigation c. Third prong does not apply here, b/c D failed to follow simple formalities of maintaining a corporation, he cannot now extricate himself by asserting that Kinney should have known better.

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d. Veil Piercing on Behalf of Tort Creditorsi. Tort creditors of thinly capitalized corporations differ from contract creditors in at least two key respects.

1. They probably do not rely on the creditworthiness of the corporation in placing themselves in a position to suffer a loss.2. They generally cannot negotiate with a corporate tortfeasor ex ante for contractual protections from risk

ii. Walkowszky v. Carlton (NY Ct. App. 1966): P was run down by a taxi owned by D, sued stockholder of D who was a stockholder in ten corporations, including the cab company, each of which had only two cabs registered in its name.

2. Rule – Whenever anyone uses control of the corporation to further his own rather than the corporation’s business, he will be liable for the corporation’s acts. Cannot use corporate form to hide from personal liability.

a. Upon the principle of respondeat superior, the liability extends to negligent acts as well as commercial dealings.b. However, where a corporation is a fragment of a larger corporate combine which actually conducts the business, a court will not “pierce the corporate veil” to hold individual shareholders liable.

3. Rationale – stockholder here was not shown to be conducting business in his own capacity.

a. Corporate form may not be disregarded simply because the assets of the corporation, together with liability insurance, are insufficient to assure recoveryb. Not fraudulent for the owner of a single cab corporation to take out no more than minimum insurancec. Fraud goes to whether D was “shuttling his funds in and out of the corporations without regard to formality and to suit his own convenience”

4. Note - Thin capitalization alone is insufficient ground for piercing the corporate veilii. Carter-Jones Lumber Co. v. LTV Steel (6th Cir. 2001): Denune, the sole shareholder of Dixie, a corporation, which had been found to illegally polluted under CERCLA, contended that his complete control of corporation and its illegal polluting activities was insufficient, as a matter of law, to trigger veil piercing and impose personal liability on him.

2. Rule – Mere control of a corporation, no matter how complete, is not insufficient, as a matter of law, to trigger veil piercing. 3. Veil piercing is an equitable doctrine that is not susceptible to satisfaction by a single list of factors.

a. Otherwise, courts would not be able to act where equity demanded piercing to avoid injustice.b. The Federal Court 3 pronged test:

i. Control over the corporation by those to be held liable was so complete that the corporation had no separate mind, will or existence of its ownii. Control over the corporation by those to be held liable was exercised in such a manner as to commit fraud or an illegal act against the person seeking to disregard the corporate entityiii. Injury or unjust lost resulted to P from such control or wrong.

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District Court Circuit CourtSea Land Service Pierce – van dorn test satisfied Don’t pierce – remanded for

factual inquiry on second prong – On remand it was Pierced due to D’s fraud

Kinney Shoe Don’t Pierce – assumption of Risk under 3rd prong of Laya Test

Pierce – third prong not applicable here

c. Even though a corporation could satisfy all the factors in D’s list, it would be inequitable to shield the corporation’s controlling shareholder where the shareholding caused the corporation to commit an illegal act, especially if the shareholder’s degree of control was great and if the harm to third parties was great.

e. Alternative Remedies i. Substantive Consolidation (Horizontal veil piercing) – equitable remedy in bankruptcy that consolidates assets among corporate subsidiaries for the benefit of creditors of the various corporate subsidiaries

1. The corporate holding company structure is ignored for the purpose of distributing assets in bankruptcy2. Because bankruptcy law is federal law, substantive consolidation represents yet another area where federal law undermines well-established state corporate law doctrine on veil piercing.3. If bankruptcy courts regularly collapse entities in an exercise of their equitable powers, the corporate form will lose its utility as a device for “asset partitioning” and risk allocation.4. Substantive consolidation hinders the development of “internal capital markets” that efficiently allocate capital within firms

ii. Dissolution and Successor Liability1. Although shareholders can eventually escape all liability through the simple act of dissolving the corporation and abandoning its assets, it may be more difficult to escape tort costs by selling the corporation’s assets2. Doctrine of Successor Corporation Liability

a. The buyer of the liquidating firm’s product line picks up the tort liability of the seller, at least as the liability relates to the purchased product lineb. Purchasing firm will reduce the offering price by the amount of the expected liability. c. Potential liquidator cannot escape liability through sale of the damage-causing product line and distribution of the proceeds

3. To avoid imposition of successor corporation liability, the purchasing firm must have no operation identifiable as continuous with the selling firm’s product line.4. DGCL 278 & 282 – shareholders remain liable pro rata on liquidating dividend for three years

3. Limited Liability in Tort? - Hansmann & Kraakman, Toward Unlimited Shareholder Liability for Corporate Tortsa. Limited liability in K gives a default term, which does not exist in tort liability. b. Limited liability in tort can be justified because without it:

i. There would be administrative problems.ii. Stocks wouldn’t be equivalent prices on the market. (Don’t know if jointly severable how much other shareholders have)iii. Research costs would be increased.iv. Managers, not shareholders make decisions. v. Wouldn’t be able to diversify because of risk aversion.

c. Limited liability in tort cannot be justified because: i. It creates incentives to mis-invest by externalizing the marginal increase in tort damages caused by expansion of the firm and creates incentive for excessive investment and gives managers in publicly traded corporations incentives to assume too much risk.ii. Too little prevention.iii. Encourages overinvestment in hazardous activities. (But might give more for the firm to pay!)iv. Firms are getting very smart about exploiting the limited liability form to shield themselves.

d. Suggested rule is pro rata liability for investors in excess tort damages the firm’s estate fails to satisfy. i. Timing issue (occurrence or judgment rule? He says claims made rule)ii. Between two parties, it seems like firms are benefiting at cost of individuals.

VI. Shareholder Voting A. Role and Limits of Shareholder Voting

1. Shareholders vote on three kinds of matters:a. Election of directorsb. Organic or fundamental changes – mergers, sales of all assets, corporate dissolutions, charter amendments. c. Shareholder resolutions – recommendation desired by a shareholder or group of shareholders, specifying a change in corporate policy or disclosure. Minimum requirement is $2,000 market value of stock, held for at least one year.

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2. Shareholder Meetings and Alternatives a. DGCL 211 – Normal meeting.

i. If board fails to call a meeting within 13 months of the last, courts will entertain a shareholder’s petition and require a meeting be held.ii. Shareholders may also vote to adopt, amend, and repeal bylaws; to remove directors; and to adopt shareholder resolutions that may rectify board actions or request the board to take certain actions

b. Special Meetings – DGCL §211(d) allows board to call a special meeting – harder because no shareholder option.

i. Some statutes allow the holders of at least 10% of all votes entitled to be cast demand such a meeting in writing

c. Action by written consent – DGCL §228 provides that any action that may be taken at a meeting of shareholders may also be taken through written consent of number of shareholders required to approve the transaction at the meeting. d. Proxy system – if you can’t attend annual shareholder meeting (ASM) you can still vote by finding a representative (proxy) who goes to the meeting and votes on your behalf

Shareholders have three basic rights: 1) vote, 2) sell shares, and 3) sue. Retail shareholders rights a lot more narrow than institutional shareholders. Primary players (shareholders

who would vote):o 1) Mutualo 2) Pension, private, public, uniono 3) Insurance companies- very passive.o 4) Hedge funds- unregulated.

3. Electing Directorsa. This is the foundational – and mandatory – voting right.

i. Every corporation must have a board of directors, even if the “board” has only a single member DGCL 141(a)

b. W/o customization in the charter, each share of stock has one vote – DGCL 212c. Cumulative Voting

i. Each shareholder may cast a total number of votes equal to the number of directors for whom she is entitled to vote, multiplied by the number of voting shares that she owns. ii. E.g. Own 10 shares, and there are 5 directors to be elected, get 10 votes for each director for a total of 50 votes. iii. Shareholder can then “cumulate” the votes – use all on one person, use some for one person and some for another, etc.

4. Removing Directors a. Common Law – Shareholders could remove a director only “for cause”b. Campbell v. Loew’s Inc. (Del Ch. 1957) – establishes that a director is entitled to certain due process rights when he or she is removed for cause, although just what these rights include, and who decides when they are violated remains unclear.

i. Fraud or unfair self-dealing is cause to remove a director, but what about abysmal business judgment

c. DGCL 141(k) – confers broad removal power on shareholdersi. Provides that when the board is classified directors can be removed only “for cause,” unless the charter provides otherwiseii. A board cannot adopt a bylaw that purports to authorize it to exercise a removal power over other directors

d. Unitary v. Staggered Boards i. Unitary board – all directors are elected annually, shareholders have a clean shot at electing a full board once a year.

1. Might be able to “pack” the board with new directors, or remove directors without cause and replace them with new directors

ii. Staggered board – shareholder must win two elections, which can be as long as 13 to 15 months apart, in order to gain majority control

1. Entrench boards and managers in ways that deter value-increasing hostile takeover bids.

5. Class Voting a. Different from classification of the board, which is staggering the board and directors are elected in different years.b. Each shareholder class (common shareholders, preferred shareholders, etc.) has to vote as a class. Why would this make a difference?

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i. There are different risk profiles for different classes of shareholders, standing in line in different places on the corporation’s cash flow. A single project can have different returns for the different classes.

c. DGCL 242(b)(2) – Class is entitled to a vote on an amendment if:i. It would increase the number of authorized shares of such class.ii. Increase or decrease the par value of the shares.iii. Alter or change the special rights, powers, or preferences of such class adversely. iv. Note – This is more limited because it is dependent on a change of legal rights.

5. Cumulative voting: (rare)a. In typical case (w/o cumulative voting) 50+1% wins=> bare majority.b. W/ cumulative voting, the objective is to give shareholders the ability to have proportional

representation on the board.i. Ex. 10 board members, 100 shares= 1,000 votes & can divide however you wanted.

ii. Virtually guarantees minority representation in voting.iii. *Extremely rare for DE corps-> in DE default is 1 share, 1 vote.

B. Proxy Voting 1. Introduction

a. Given the widely dispersed share ownership of most publicly financed corporations, public shareholders are unlikely to actually attend shareholder meetingsb. As a result, in order to gather a quorum, the board and its officers are permitted to collect voting authority from shareholders in the form of proxies.c. General provisions

i. Proxies must record the designation of the proxy holder by the shareholder and authenticate the grant of the proxyii. In most cases, proxy holders may exercise independent judgment on issues arising at the shareholder meeting for which they have not received specific instruction.iii. Proxies, like all agency relationships, are revocable unless the holder has contracted for the proxy as a means to protect a legal interest or property, such as an interest in the shares themselvesj. Registration pursuant to §12 of SEC Act: a proxy solicitation is covered by the SEC rules if the proxy is solicited concerning stock register under §12 – stock must be registered as per §12 if: (1) the stock is traded on a national securities exchange; or (2) the company has at least five million dollars of assets and the class of stock in question is held by at least 500 record owners. So, the company must file 10-Ks and other regular reports as per the SEC, along with following the solicitation rules. k. Proxy information – once a company decides to solicit proxies it must comply with filing and disclosure requirements. All docs to be sent to stock holders must first be filed with the SEC, and if they deem it insufficient or inaccurate, the SEC will order revisions. Proxy solicitations must contain a “proxy statement,” which discloses: (1) conflicts of interest; (2) details of any compensation plan to be voted on; (3) compensation paid to the five most highly paid officers; and (4) details of any major corporate change being voted on. If the solicitation is by management and related to an annual meeting to select directors, then an annual report must be included. There is also the anti-fraud rule (SEC Rule 14a-9(a)) and if there is any fraud in the proxy statement then a shareholder has the implied right to bring a private action. l. Proxy Transactions - §14 of SEC Act:i. Solicitation by Management – if the solicitation is by management, the solicitation of even one person falls within the SEC rules.ii. Solicitation by Non-Management – but if the solicitation is by non-management (e.g, it is by an insurgent faction trying to get its own slate of directors elected to the board), the solicitation is not covered so long as the number of persons solicited is ten or fewer.1. Solicitation of 11 or more – But if non-management solicits eleven or more people, the solicitation falls within the SEC rules even if none of the people solicited actually grants a proxy to the solicitor. Solicitation = (a) on oral request for a proxy, even if no proxy card is sent to the person being solicited; (b) a request (written or oral) not to execute, or to revoke, a proxy solicited by someone else; and (c) an advertisement (furnishing of a form of proxy or other communication to security holders under circumstances reasonably calculated to result in the procurement, withholding, or revocation of a proxy – a newspaper ad urging to give or deny a proxy would be included). Proxy Contest Costs:2. Management expenses – corporation may pay for the “bare bones” compliance by management with federal proxy rules. Thus, costs of drafting and printing proxy cards and of mailing them to shareholders.

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- So long as the contest involves a conflict over “policy” and is not merely a “personal power contest” the corporation may pay for management’s reasonable expenses. (advertising , retention of proxy-specialist firms, telephone and private meetings with large holders around the country, etc.).3. Expenses of successful Insurgents – if they succeed and control the majority of the board of directors, they will then likely approve reimbursement of the insurgent’s proxy costs.- Reimbursement to successful insurgents is allowed if: (1) the contest involved “policy” and not wasn’t a power struggle; and (2) the stockholders approve reimbursement (Rosenfield). (Former management before leaving will also likely have themselves paid back.)4. Unsuccessful Insurgents – They have virtually no chance of having the corporation reimburse.

2. Proxy Solicitation Expenses – Rosenfeld v. Fairchild Engine & Airplane Corp. (N.Y. Ct. App. 1955): P brought a derivative suit to have the $261,522 that had been paid to both sides of a proxy contest returned to the corporation.

b. Rule – Directors may make reasonable and proper expenditures from the corporate treasury to persuade stockholders of the correctness of the directors’ policy positions and to solicit shareholder support for policies that the directors believe, in good faith, are in the corporations’ best interest. c. Rationale –

i. If not, incumbent directors would be unable to defend their positions and corporate policies. As such, the old board was reimbursed for reasonable and proper expenditures in defending their positions.ii. Stockholders also have the right to reimburse successful contestants for their reasonable expenses. As such, the new board was also reimbursed for its expenditures by the stockholders.

d. Dissent – personal expenses were wrongly included in the reimbursements. 3. Federal Proxy Rules

a. Four major elements i. Disclosure requirements and a mandatory vetting regime that permit the SEC to assure the disclosure of relevant information and to protect shareholders from misleading communicationsii. Substantive regulation of the process of soliciting proxies from shareholdersiii. A specialized “town meeting” provision (Rule 14a-8) that permits shareholders to gain access to the corporation’s proxy materials and to thus gain a low-cost way to promote certain kinds of shareholder resolutions; and iv. A general antifraud provision (Rule 14a-9) that allows courts to imply a private shareholder remedy for false or misleading proxy materials

b. Specific Provisions:i. Generally

1. Securities Exchange Act of 1934 establishes (among other things) disclosure requirements for corporations after they have gone public. 2. All public companies are subject to proxy regulation under §14(a) 3. Schedule 14A what you need to disclose in a “full dress” registration statement. 4. Bad Old Days (Pre-1992) if a dozen shareholders want to talk to one another about the company they must file a proxy statement with the SEC, forcing stockholders to act in public, costly, potentially embarrassing ways. Publicity instills silence.ii. Disclosure & Shareholder Communication – Rules 14-a-1 – 14-a-7 1. Rule 14a-1 – A proxy can be any solicitation or consent whatsoever; solicitation is any communication reasonably calculated to result in the procurement of a proxy2. Rule 14a-2(b)(1) – solicitation that does not seek directly or indirectly to act as a proxy is exempt from filing requirements3. Rule 14a(2)(b)(2) – non-management solicitation to 10 or fewer shareholders is exempt4. Rule 14a-3 – No one may be solicited for a proxy unless they are, or have been, furnished with a proxy statement containing certain information in Schedule 14A5. Rules 14a-4 and 14a-5 – Regulate the form of the proxy and the proxy statement, form of the vote (see short slate problem)6. Rules 14a-6, 14a-12 – Formal filing requirements for proxy and solicitation materials (sent to SEC before shareholders)7. Rule 14a-6(g) – even if exempt, if shareholder owns more than $5 million worth of stock, must file communication and Notice of Exempt Solicitation after sending out8. Rule 14a-7 – sets forth the list-or-mail rule under which, upon request by a dissident, a company must either provide a shareholders list or undertake to mail the dissident’s proxy statement and solicitation materials to record holdersiii. Town Meeting Rule (Shareholder Resolutions) – Rule 14(a)(8) 1. Requirements –

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a. Shareholder must hold $2,000 or 1% of the corporation’s stock for a year ((b)(1)); b. Must file with management 120 days before management plans to release its proxy statement ((e)(2)); c. Proposal may not exceed 500 words (d); and d. Proposal must not run afoul of subject matter restrictions.

2. Grounds for excluding proposals from the company’s solicitation materials (14a-8(i)) – burden on company to demonstrate grounds for exclusion.

a. Not a proper subject for shareholder actionb. One that would require the registrant to violate any lawc. False or misleadingd. Related to redress of a personal claim not shared w/shareholders in general.e. Related to operations that involve less than 5% of assets, earnings and sales and is otherwise not significantly related to the corporation’s business.f. Related to issues over which the registrant has no power to control.g. Related to conduct of the registrants ordinary business operations not involving important political or social issuesh. Related to election to the registrant’s boardi. Counter to a proposal to be submitted by the registrantj. Moot b/c the corporation has already substantially implemented the proposalk. Substantially duplicative of an earlier proposall. Related to the amount of a dividendm. Substantially the same as a proposal previously rejected by shareholders at a previous meeting.

iv. The Anti-fraud Rule - Rule 14a-91. Materiality – a misrepresentation or omission in a proxy solicitation can trigger liability only if it is material – there is substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote2. Culpability – the SC has not yet determined a standard of culpability3. Causation and reliance – a plaintiff need not prove actual reliance on a misrepresentation to complete a Rule 14a-9 cause of action

a. Showing of materiality normally satisfies the causation requirement.b. Exception – Virginia Bankshares, Inc. v. Sandberg (1991) – if management or parent owns or controls a majority of the stock, so that it can cause shareholder approval of the relevant transaction w/o any votes from the minority, false or misleading statements in a proxy statement will not normally give rise to liability in a private action by minority shareholders b/c the transaction would have been approved even w/o their votes.

4. Remedies – the Mills Court contemplated that courts might award injunctive relief, rescission or monetary damages

4. State Disclosure Law: Fiduciary Duty of Candora. State law has done little to regulate proxy solicitation by management

i. Traditionally, state law did not go beyond the duty of loyalty (the obligation not to lie to one to whom the duty extends)ii. Today – Substantive regulation has disappeared, and the courts have inserted themselves ex-post to judge the fiduciary duties.

b. Malone v. Brincat (Del. 1998): Involved a long-term fraud in which the directors made (or permitted the corporation to make) false filings with the SEC and distributed false financial statements to shareholders.

ii. In affirming its dismissal, whenever directors communicate publicly or directly with shareholders about the corporation’s affairs with or without request for shareholder actions directors have a fiduciary duty to exercise case, good faith and loyalty…the sine qua non of director’s fiduciary duty is honesty. iii. Any cause of action under Malone requires shareholders to hold onto their shares to limit federalism conflict because then they are not protected under SEC Rule 10b-5

C. Shareholder Information Rights1. Shareholders must be informed in order to vote intelligently

a. State law mandates neither an annual report not any other financial statement. b. By contrast, federal securities law and the rules promulgated by the SEC mandate extensive disclosure for publicly traded securitiesc. Shareholders were recognized to have a right to inspect the company’s books and records for proper purpose

2. Delaware courts recognize two fundamentally different types of requests

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a. The Stock List – discloses the identity, ownership interest, and address of each registered owner of company stock

i. Proper Purpose for acquiring the stock list is broadly construed, and once it is shown, the court will not consider whether the shareholder has additional, “improper” purposesii. Burden is on the corporation to produce related identifying information – need to keep the list updated and produce a second list of stock brokerage firms whose stock is registered in the name of the Depository Trust Co. and to furnish daily trading information

b. Inspection of Books and Recordsi. Here a plaintiff may allege the need for very broad access to the company’s records in order to uncover suspected wrongdoing.ii. Such a request, however, places the legitimate interests of the corporation at risk – may jeopardize proprietary or competitively sensitive informationiii. Under Delaware law, this is reflected formally by requiring plaintiffs to carry the burden of showing a proper purpose and, informally, by carefully screening plaintiff’s motives and the likely consequences of granting her request.

3. General Time Corp. v. Talley Industries (Del Ch. 1968): General Time refused to provide a list of its stockholders to Talley, a GT stockholder, contending that Talley had an improper secondary purpose for obtaining the list.

b. Rule – Where a shareholders desires a list of a corporation’s stockholders to solicit proxies for a slate of directors opposed to current management, that purposes is proper and sufficient to require the corporation to provide the list, regardless of the shareholders’ possible secondary motives for obtaining the list. DGCL §220c. Rationale

i. It is undisputed that, as a matter of law, the desire to solicit proxies for a slate of directors in opposition to management is a purpose reasonably related to the stockholder’s interest as a stockholder, and that therefore, such a purpose is proper when making an inspection request. ii. Thus, when a stockholder’s status qua stockholder is established, and the stockholder seeks production of a stockholders’ list for a purpose that is germane to that status, he is entitled to its production

d. Note – proper purpose is decided on a case by case D. Circular Control Structures Problem

1. DGCL §160(c) – shares of its own capital stock belonging to the corporation or to another corporation (parent or otherwise related), if a majority of the shares entitled to vote in the election of directors of such other corporation is held, directly or indirectly, by the corporation, shall neither be entitled to vote nor be counted for quorum purposes.

a. Prohibits management from voting stock owned by the corporationb. Rationale - managers are selected by the corporate constituency (investors) w/the strongest interest in maximizing corporate value

2. Speiser v. Baker (Del. Ch. 1987): P, a 50% owner of common shares of Health Med Corp. and one of its two directors, contended that the corporation was required to hold an annual stockholders meeting to elect directors. D, the other 50% owner of Health Med’s common shares and its other director, counterclaimed that Health Med could not vote its 42% interest in Health Chem, a publicly traded company, at such a stockholders meeting b/c to do so would contravene a statutory prohibition on the voting of shares “belonging to” a corporation – despite the fact that Chem. did not hold, even indirectly, a majority of the stock “entitled to vote” in Health Med’s election of directors.

b. Issue #1 - Where a corporation has failed to hold an annual stockholders meeting for the election of directors, in contravention of statutory law, must such a meeting be held even if it means that one of two directors will be removed – yes.

i. D’s affirmative defenses allege no wrong to Health Med or its shareholders that will occur by reason of the holding of Health Med’s annual meeting.ii. The essence of his defense is that he will likely be voted out of office as a Health Med director and the company will fall under P’s complete domination – legally, there would be nothing wrong with that result.

c. Issue #2 - Where a statute prohibits the voting by a corporation of stock “belonging to the corporation,” may stock held by a corporate subsidiary “belong to” the issuer and thus be prohibited from voting, even if the issuer does not hold a majority of shares entitled to vote at the election of directors of the subsidiary – Yes.

i. Counterclaim cites DGCL 160(c) - literal reading of this language does not prohibit the voting of Health Med’s stock in Chem since Chem through its subsidiary does not hold, even indirectly, a majority of the stock “entitled to vote” in Health Med’s election of directorsii. Specifically, the phrase “belonging to the corporation,” when interpreted in light of the statute’s history and underlying policy, can reach the facts of this case. iii. The statute is applicable here, where the capital of one corporation has been invested in another corporation and the investment, in turn, is used solely to control votes of the first corporation. The

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only effect of this structure is to muffle the voice of the public shareholders of Chem in the governance of Chem

E. Vote Buying 1. General rule – shareholder cannot normally sell her vote unless she is selling the stock that goes along with it.

a. Rationale – vote buying violated public policy as a breach of the duty shareholders owed to each other. This principle maintained that each shareholder voting his own interests was essential to preserving the interest of the stockholders collectively.b. In today’s corporate environment this concept has been largely abandoned.

2. Schreiber v. Carney (Del Ch. 1982): Jet Capital, a shareholder of Texas International Airlines, agreed to withdraw opposition to a merge if it received a loan from Texas International.

Court held that corporate vote-buying is permissible if it does not work to the prejudice of the shareholders. Shareholder approval precludes voiding this transaction. Vote-Buying is illegal if its purpose is to defraud or disenfranchise other stockholders. It is also illegal on Public Policy grounds, because each stockholder should be able to rely on the independent judgment of his fellow stockholders –like fraud, but as viewed from a sense of duty owed by all stockholders to one another.c. Rationale

i. No per se prohibition on vote buying in established opinions, though it appears to be uniformly rejected b/c occurred to the detriment of the non-participating shareholders. ii. Today, the law is much more lenient towards these types of transactions; iii. Holding – vote-buying is not void, but rather voidable only. In this instance, shareholder approval precludes voiding the transaction.

F. Controlling Minority Structures 1. Dual class equity structures – A. single firm that issues two or more classes of stock with differential voting rights (high vote and low vote stock).

a. This is most popular in the US, other two not used as much. 2. Corporate Pyramid Structure – A controlling minority shareholder holds a controlling stake in a holding company that, in turn, holds a controlling stake in an operating company. 3. Cross-ownership structures – Linked by horizontal cross-holdings of share that reinforce and entrench the power of central controllers, voting rights distributed over the entire group. Oceanic Exploration Co. (p.197)• Voting trusts= voting trusts are ok. Here, the stockholder gave up his right to vote on all corporate matters over a period of years in return for “valuable benefits including indemnity for large liabilities.”

iv. CA v. AFSCME – SEC certifies questions to the Delaware Supreme Court b/c they’re not certain – not qualified in Delaware law. AFSCME proposed for inclusion on CA’s proxy statement a bylaw that would require the CA board of directors to reimburse the reasonable fees of any stockholder that sought to elect less than 50% of the board (i.e. a short slate) and succeeded in electing at least one director. SEC certified whether this was a proper subject for action by stockholders and whether, if enacted, it would violate any DE law to which it is subject.

1. The Court held that the bylaw was a proper subject for stockholder action. Answering the second in the negative, the Court held that if adopted the bylaw would violate state law. The net result is that the bylaw can be excluded from CA’s proxy statement under SEC Rule 14a-8(i)(2).

2. DGCL §141(a): The business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors, except as may be otherwise provided in this chapter or in its certificate of incorporation.

VII. Fiduciary Standards A. Introduction – Fiduciary standards play a role in normal governance of a corporation

1. Duty of obedience – fiduciary must act consistently with the legal documents that create her authority. 2. Duty of care – reaches every aspect of an officer or directors conduct:

a. Requires these parties to act with “the care of an ordinarily prudent person in the same or similar circumstances”b. Law insulates from liability based on negligence – do this to avoid risk adverse management

3. Duty of loyalty – requires that corporate fiduciaries exercise their authority in a good faith attempt to advance corporate purposes.

a. Cannot compete w/the corporation, appropriate its property, information or business opportunities and transacting under unfair terms

B. Normal Governance – Duty of Care1. General Standards

a. ALI §4.01(a) – A director or officer has a duty to the corporation to perform the director’s or officer’s functions:

i. In good faithii. In a manner that he or she reasonably believes to be in the best interests of the corporation and

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ii. With the care than an ordinarily prudent person would reasonably be expected to exercise in a like position and under similar circumstance

b. Gagliardi v. Trifoods International (Del. Ch. 1996): Shareholders of Trifoods International, Inc. brought a derivative action against TriFoods Directors for recovery of losses allegedly sustained by reason of mismanagement unaffected by directly conflicting interests, the Ds moved to dismiss.

ii. Issue – what did shareholders have to plead to sustain their action? iii. Rule – to sustain a derivative action for the recovery of corporate losses resulting from mismanagement unaffected by directly conflicting financial interests, as shareholder must plead that a director/officer did not act in food faith and/or failed to act as an ordinarily prudent person would under the circumstances.

c. Not another negligence rule – more adverse to holding directors liable – why? i. Bear the full costs but receive only a small fraction of the gainsii. Would discourage officers from undertaking valuable but risky projects

d. Why we have statutory safeguards (indemnification) and judicial safeguards (business judgment rule) 2. Statutory Protections

a. Indemnification – i. Statutes authorize corporations to commit to reimburse any agent, employee, officer or director for reasonable expenses for losses of any sort arising from any actual or threatened judicial proceeding or investigation.

1. DGCL §145(a) - may indemnify for D&O actions in good faith2. DGCL §145(f) – may indemnify for actions beyond those provided by statute but still in good faith3. DGCL §145(c) – success in a legal action requires indemnification for legal expenses, even if not in good faith.

ii. Limits – losses must result from:1. Actions undertaken on behalf of the corporation2. In good faith3. And cannot arise from a criminal conviction

iii. Waltuch v. Conticommodity Services, Inc. (2nd Cir. 1996): D refused to indemnify P for legal fees resulting from litigation that arose out of his former employment w/D, P brought suit for indemnification.

2. Issue #1 – Does a provision of a corporation’s articles of incorporation that provides for indemnification w/o including a good faith limitation violate DGCL 145 – yes.

a. DGCL145(a) limits a corporation’s indemnification powers to situations where the officer or director to be indemnified acted in good faithb. DGCL 145(f) does not free the corporation from this good faith requirement.

3. Issue #2 –If the director is successful in his lawsuit should he be indemnified against expenses (including attorneys’ fees) actually and reasonably incurred by him in connection therewith – Yes

a. Escape from an adverse judgment or other detriment, for whatever reason, is determinative.b. Once P achieved his settlement gratis, he achieve success “on the merits or otherwise”c. Accordingly, D must indemnify P under DGCL 145(c) for the $1.2 million in legal fees he spent defending the private lawsuits

b. Directors’ & Officers’ Insurance i. DGCL §145(g) - corporation may buy insurance whether or not the corporation would have the power to indemnify such person against such liabilityii. Why general corp. insurance instead of raising salaries & board fees and letting the directors buy their own accounts?

1. D&O insurance may be cheaper if the company acts as a central bargaining agent for all its officers & directors2. Uniformity may have value in that it standardizes directors’ individual risk profiles in decision-making, and avoid potentially negative signaling that would arise from directors having different levels of coverage.3. Tax law may favor firm wide insurance coverage4. Corporate purchase of D&O helps disguise the total amount of management compensation.

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3. Framework for Director and Officer Liabilitya. Business judgment Rule – presumes that the duty of care standard has been metb. Waiver of Liability (DGCL §102(b)(7)) – 90% of DE companies eliminate D&O liability for

duty of care violations (“Self insurance” for gross negligence)c. Indemnification – may indemnify for D&O actions in good faith (DGCL §145(a)) and for those

beyond those provided by statute but still in good faith (§145(g)). d. D&O insurance – corporation may buy D&O insurance “whether or not the corporation would

have the power to indemnify such person against such liability” (DGCL §145(g)). e. Reimbursement of Legal Expenses – even if not in good faith, success in a legal action requires

indemnification for legal expenses (DGCL §145(c)). 3. The Business Judgment Rule- (ONLY applies to duty of care)

a. ALI §4.01(c) – A director or officer who makes a business judgment in good faith fulfills the duty under this section if he:

i. Disinterested - Is not interested in the subject of the business judgmentii. Is informed with respect to the subject of the business judgment to the extent that the director or officer reasonably believes is appropriate under the circumstances ANDiii. Rationally believes that the business judgment is in the best interests of the corporation

b. Chancellor Allen: “The business judgment rule in effect provides that where a director is independent and disinterested, there can be no liability for corporate loss, unless the facts are such that no person could possibly authorize such a transaction if he or she were attempting in good faith to meet their dutyc. Business Judgment Rule may be rebutted by showing:

i. Fraud.ii. Conflict of interest – lack of objectivity or independence.iii. Illegality of action.iv. Waste – lack of rational business purpose.v. Gross negligence.vi. Inattention to mismanagement, management abuse, or monitoring illegality. vii. Lack of information.viii. Receipt of improper benefit.

d. Rationale for the BJR i. Judges should not second guess good-faith decisions made by independent and disinterested directors. ii. Procedural reason – when courts invoke the business judgment rule, they are converting what would otherwise be a question of fact into a question of law for the court to decide – Insulates disinterested directors from jury trialsiii. Substantive reason - Converts the question “was the standard of care breached” into related but different questions of whether the directors were truly disinterested and independent and whether their actions were in good faith.

e. Kamin v. American Express Co. (NY 1976): P brought a shareholders’ derivative suit claiming D had engaged in waste of corporate assets by declaring a certain dividend in kind.

ii. Issue – should the courts interfere w/a board of directors’ good faith business judgment as to whether or not to declare a dividend to make a distribution – No. iii. Rationale –

1. Whether or not to declare a dividend or make a distribution is exclusively a matter of business judgment for the board of directors, and courts will not interfere w/their decision if made in good faith.2. It is not enough to charge, as P has, that the directors made an imprudent decision or that some other course of action would have been more advantageous – insufficient and cause of action must be dismissed.

f. Miller v. AT&T (3rd Cir. 1974): Shareholders of AT&T brought suit when the corporate directors forgave a $1.5 million debt owed it by the Democratic National Convention

ii. Rule – The business judgment rule will not insulate directors from liability where it is alleged they have committed illegal or immoral acts. iii. Rationale

1. Business judgment rule only applies where there was good faith. 2. Business judgment has no place in the decision to commit illegal acts.3. Here Ds were charged w/violating campaign contributions laws – prima facie case has been stated by the complaint.

4. Delaware’s approach to Duty of Care a. Smith v. Van Gorkom (Del. 1985): Shareholder of a company sued alleging that the board of directors did not act in an informed manner when agreeing to a merger deal and thus breached their duty of care

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ii. Holding – the directors were grossly negligence in their decision making and could not claim the protections of the business judgment rule; announces gross negligence standard- BJR does not apply in violation of duty of care.iii. Unique b/c it holds financially disinterested directors personally liable for the consequence of their business decision – First Delaware case to do soiv. Note – may be better seen as a takeover case than a duty of care case.

b. DGCL 102(b)(7) – reaction to Van Gorkomi. Validated charter amendments that provide that a corporate director has no liability for losses caused by transactions in which the director had no conflicting financial interest or otherwise was alleged to violate a duty of loyaltyii. Only waives damage claims, can still be the basis for an equitable order (such as an injunction)

c. Cede & Co. v. Technicolor (Del. 1993): Takeover entrepreneur acquired Technicolor in a transaction characterized by arguable breaches of the duty of care by Technicolor’s board of directors.

ii. The Delaware Chancery Court held that Technicolor’s shareholders failed to prove any injury b/c they had apparently received full value for their stock. iii. Delaware SupCt reversed –

1. Breach of the duty of care, w/o any requirement of proof of injury, is sufficient to rebut the business judgment rule.2. A breach of either the duty of loyalty or the duty of care rebuts the presumption that the directors have acted in the best interests of the shareholders, and requires the directors to prove that the transaction was entirely fair.

d. Application at pleadings stage i. Malpiede v. Townson (Del. 2001) – a complaint must allege a breach of the duty of loyalty in order to survive a motion to dismissii. McMillan v. Inter Cargo Corp. (Del Ch. 2000): Ps alleged that the target’s CEO agreed to a

low acquisition price so that he could keep his job following the merger2. Chancery court dismissed the complaint b/c such generic allegations are too easy to make3. Unless particularized facts supporting duty of loyalty claims are alleged, the principal purpose of 102(b)(7) would be denied by allowing such claims to proceed to trial.

e. Emerald Partners v. Berlin (Del. 2001): Arose from a “roll up” transaction – a corporation w/a controlling shareholder entered into transactions in which it acquired through merger 13 corporations owned or dominated by this controlling shareholder. Minority shareholder in the corporation sued the corporation’s directors

ii. Eventually only Ds left were the “disinterested” directors, trial court dismissed iii. Delaware SupCt reversed

1. Holding – the correct standard of review for a transaction in which a controlling shareholder is interested is objective fairness (aka “entire fairness”)2. Ds had the burden to prove entire fairness, so it was a mistake for the court to render judgment in their factor w/o addressing this issue.

iv. Once the Ps have overcome the presumptions of the business judgment rule, DGCL 102(b)(7) offers less protection to defendant directors.-> If P allegation of gross negligence so that BJR cannot apply, and place burden of proving entire fairness to Ds (shifts), required to show: 1) fair process and a requirement to prove 2) fair price.

4. Duty to Monitor a. Business judgment rule protects boards that have made decisions – now looking at when directors simply fail to do anything.

i. Director’s incentives are far less likely to be distorted by liability imposed for passive violations.ii. Actual liability is more likely to arise from a failure to supervise or detect fraud than from an erroneous business decision.iii. Issues arise when loss would financially destroy directors and make board service unappealing to others.

b. Francis v. United Jersey Bank (N.J. 1981): D ignored her duties as a director allowing her sons to withdraw over $12 million from client trust accounts. Trustees sue for negligence.

ii. Rule - Individual liability for a corporation’s directors to its clients requires a demonstration that:

1. A duty existed2. The directors breached that duty3. The breach was a proximate cause of the client’s losses

iii. Rationale – this is a departure from the business judgment rule

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1. The director of a corporation stands in a fiduciary relationship to both the corporation and its stockholders. 2. Inherent in this role is a duty to acquire a basis understanding of the corporation’s business and a continuing duty to keep informed of its activities.3. This entails an overall monitoring of the corporation’s affairs, and a regular review of its financial statements which may present a duty of further inquiry

iv. Note – directors do not ordinarily owe a duty of care to third parties unless the corporation is insolvent.

c. Graham v. Allis-Chalmers Manufacturing Co. (Del. 1963): Shareholders of D contended in a derivative action that the corporation’s directors were liable as a matter of law for failing to take action to learn of and prevent antitrust activity of non-director employees. => Does not imply BJR!

ii. Rule – A corporate director who has no knowledge of suspicion of wrongdoing by employees is not liable for such wrongdoing as a matter of law. iii. Rationale

1. Board may rely on the honesty and trustworthiness of its employees until something puts the board on suspicion that something is wrong2. “Absent cause for suspicion there is no duty upon the directors to install and operate a corporate system of espionage to ferret out wrongdoing which they have no reason to suspect exists.”3. Here, it was impossible for the board to know every employee, once board found out about the improper actions it took sufficient action.

d. Beam v. Martha Stewart (Del. Ch. Ct 2003): P claimed that Martha Stewart’s directors and officers breached their fiduciary duty by not monitoring her affairs to ensure that they would not harm the company.

ii. Rule – Directors and officers of a corporation do not have a fiduciary duty to monitor the personal, financial, and legal affairs of other directors and officers to ensure that their conduct does not harm the company. iii. Rationale

1. Only have duty to monitor when have reason to suspect wrongdoing.2. Nothing preceding her stock scandal that would have given the board reason to suspect wrongdoing.3. The duty to monitor arises when there is suspicion of wrongdoing by the corporation, and, regardless of how closely Stewart is identified with MSO, she is not MSO. 4. Unreasonable to impose such a duty because monitoring a director’s personal affairs is neither legitimate nor feasible, and could engender liability for the corporation – Martha could sue corp. in tort.

e. In the Matter of Michael Marchese (SEC Enforcement Action, 2003): The SEC contended that D, an outside director of Chancellor who served on Chancellor’s audit committee violated, and caused Chancellor to violate, various provisions of the Exchange Act and Rules thereunder b/c he failed to adequately monitor the company’s financial statements.

ii. Rule – an outside director a corporation who serves on its audit committee violates and causes his corporation to violate, the Exchange Act and Rules thereunder by recklessly failing to inquire into the corporation’s financials when he has knowledge of facts to put him on notice that such inquiry is warranted. iii. Rationale – D recklessly failed to investigate into matters that he knew could be potential issues and certified the SEC filings anyway. iv. Note – directors need to be concerned with their duty to monitor and duty of care not only because of the potential of shareholder derivative actions brought under state law, but also because of the potential of SEC enforcement actions

f. In re Caremark International Inc. Derivative Litigation (Del Ch. 1996): Caremark, a managed health-care provider, entered into K arrangements w/physicians and hospitals, often for consultation or research w/o first clarifying the unsettled law surrounding prohibitions against referral fee payments.

ii. Rule – board of directors has an affirmative duty to attempt in good faith to assure that a corporate information and reporting system exists and is adequate. iii. Rationale

1. Directors do not have to monitor the day to day operations of the company, but they do need to determine whether they are receiving accurate information.2. Directors need to make a good faith effort to monitor compliance, be aware of major activities and related issues that could pose a threat to the company

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4. Duty of Care After Caremark -> need to show one of the following:a. Director failed to acquaint themselves with the basics of the business and should have known of a

red flag (Francis, Van Gorkham);b. Director had notice of a red flag and failed to investigate (Allis Chalmers);c. Director failed to monitor/institute compliance program regarding important aspects of the firm’s

activity (e.g., compliance with laws that the company is at high risk of violating). Chancellor Allen says that the duty of oversight includes an affirmative director duty to “assure that appropriate information and reporting systems are in place.” (Caremark)

C. Conflict Transactions – Duty of Loyalty 1. Introduction

a. Duty of loyalty – requires a corporate director, officer, or controlling shareholder to exercise her institutional power over corporate processes or property (including information) in a good faith effort to advance the interests of the company

i. Officers, directors and controlling shareholders may not deal w/the corporation in any way that benefits themselves at its expense

b. Specific corporate actions over which it may be sensible to limit board discretion:i. Self-dealing transactions b/t the company and its directorsii. Appropriations of “corporate opportunities”iii. Compensation of officers & directorsiv. Relations b/t controlling shareholders and minority shareholders

c. Duty to Whom?i. Shareholder Primacy Norm - director loyalty is ultimately loyalty to equity investors b/c shareholders elect the board. 1. Dodge v. Ford Motor Co. (Mich. 1919): Henry Ford rejected shareholder dividends, said he had an obligation to share his success w/the consumer by lowering prices. Dodge sued claiming the directors wrongfully subordinated shareholders interests to those of the consumer.

b. Court agreed – affirmed the primacy of the shareholders interests2. Note – this is one of the few decisions to enforce shareholder primacy as a rule of law.

a. Today the decision would probably be justified on grounds that it would increase long term corporate dividendsb. Situation would only arise if company announced that it was acting in interests of non-shareholders over shareholders like here

ii. Alternative model – directors must act to advance the interests of all constituencies in the corporation, not just the shareholders

1. Rationale – State bestows the status of legal entity, including limited liability on the corporation in order to advance the public interest by enabling the board to protect all corporate constituencies, not just shareholders2. A.P. Smith Manufacturing Co. v. Barlow (N.J. 1953): Barlow and other shareholders of AP challenged its authority to make a donation to Princeton University.

b. Rule – state legislation adopted in the public interest can be constitutionally applied to preexisting corporations under the reserved power. c. Rationale

i. Fifty years before the incorporation of P, the NJ legislature provided that every corporate charter thereafter granted would be subject to alteration and modification at the discretion of the legislatureii. Statute expressly authorizing reasonable charitable contributions is applicable to P and must be upheld as a lawful exercise of Ps implied and incidental powers under common law principles

2. Self-Dealing Transactionsa. Black Letter Law – Crunchtime

i. Definition – Self Dealing transaction is one in which 3 conditions are met:1. Key player and the corporation are on opposite sides of a transaction2. The Key Player has helped influence the corporation’s decision to enter the transaction AND3. the Key Player’s personal financial interests are at least potentially in conflict w/the financial interests of the corporation.

ii. Modern Rule – courts will frequently intervene in a self-dealing transaction1. Fairness – if the transaction if found to be fair to the corporation, the court will uphold it, regardless of whether it was approved by disinterested directors/shareholders.

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2. Waste/fraud – if the transaction is unfair that it amounts to “waste” or fraud” against the corporation, the court will usually void it at the request of a shareholder, even if it was approved by disinterested directors/shareholders

a. Def. of waste is very restrictiveb. DE – transaction will not be invalidated as constituting waste unless it is an exchange that is so one sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration.

3. Middle ground – if transaction is not clearly fair or waste, then the presence/absence of approval by disinterested directors/shareholders will be the deciding factors.

a. If transaction was approved, court prob. will toob. If not, court prob. will invalidate the transaction.

iii. How to avoid invalidation: 1. Disclosure + Board approval

a. Disclosure: two kinds of info:1. the material facts about the conflict2. the material facts about the transaction

ii. When disclosure must be made – courts split1. Some courts say must be disclosed before2. Some courts allow ratification after the fact.

b. Board approval – by a majority of the disinterested directors .i. Director is interested if either:

1. he or an immediate member of his family has a financial interest in the transaction. 2. He or a family member has a relationship w/the other party to the transaction that would reasonably be expected to affect his judgment about the transaction. 3. Also can be interested if an indirect party to the transaction – i.e. he owns an equity position in the other transaction.

ii. Quorum – majority of the disinterested directors, not a majority of the total directors. iii. Approval doesn’t necessarily immunize the transaction from attack, esp. if it is very unfair – but shifts the burden of proof to the person attacking the transaction.

2. Disclosure + Shareholder Approval a. Self-dealing transaction will be validated if it is fully disclosed to the shareholders and then ratified by a majority of them.b. Disinterest shareholders – courts split about whether the ratification must be by a majority of disinterested shareholders or merely by a majority of all shareholders (which could potentially include the Key Player)

3. Fairness – transaction can be validated by showing that it is fair to the corporation. a. This is dispositive – will suffice even if the transaction was never disclosed. b. Determined by the facts as they were known at the time of the transaction.

b. State Ex. Rel Hayes Oyster Co v. Keypoint Oyster Co. (Wash. 1964): Coast Oyster Co claimed that Hayes, its CEO director and shareholder, breached his fiduciary duty to the corporation by failing to disclose a secret profit and advantage he would fain from the approval of Coast’s sale of oyster beds to Keypoint Oyster Co. Coast sought disgorgement of such secret profit from Hayes or his company.

ii. Rule – A corporation’s director or officer breaches his fiduciary duty to the corporation by failing to disclose the potential profit or advantage that would accrue to him if a transaction involving the corporation were approved. iii. Rationale

1. Although not every transaction involving corporate property in which a director has an interest is voidable at the option of the corporation, since such a K cannot be voided if the director/officer can show that the transaction was fair to the corporation, nondisclosure by an interested director/officer is per se unfair2. Hayes needed to disclose at the point where he was voting on the transaction so that the Coast shareholders and directors could make an informed determination as to the advisability of retaining Hayes as CEO under the circumstances and to determine whether or not it was wise to enter into the K.

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3. Irrelevant that Coast may not have suffered any direct harm or that Hayes had no intent to defraud Coast - What matters is that Hayes was not loyal to Coast

c. Controlling Shareholders and the Fairness Standard i. Corporation law has long recognized a fiduciary duty on the part of controlling shareholders to the company and its minority shareholders

1. Dominant value (Delaware law) – controlling shareholder’s power over the corporation and the resulting power to affect other shareholders gives rise to a duty to consider their interest fairly whenever the corporation enters into a K with the controller or its affiliate2. Clearly governs when a controlling shareholder engages in a conflicted transaction w/the corporation

ii. Control here is determined by a practical test rather than a formalistic one1. Safe harbors may be created by getting disinterested approval2. When there is a controlling shareholder, must look at fairness of price and fairness of process

iii. Sinclair Oil Corp v. Levien (Del. 1971): Sinclair contended that although it controlled its subsidiary Sinven and owed it a fiduciary duty, its business transactions with Sinven should be governed by the business judgment rule, and not by intrinsic fairness test.

2. Rule – the intrinsic fairness test should not be applied to business transactions where a fiduciary duty exists but is unaccompanied by self dealing. 3. Rationale

a. Self dealing - Where the parent company receives some benefit to the detriment or exclusion of the minority shareholders of the subsidiary; The business judgment rule applied to transactions where Sinclair did not engage in self dealing.c. Sinclair did engage in self-dealing when it forced Sinven to contract with Sinclair’s wholly owned subsidiary – this was self-dealing and will be subject to the intrinsic fairness test.

d. Approval by a Disinterested Party i. Safe Harbor Statutes – DGCL §144(a)(1) – Alternative Interpretations

Deal has to be: 1) approved by disinterested directors; OR 2) approved by shareholders; AND 3) fair.1. Literal reading - transaction not voidable solely because it is interested if disinterested board approval or shareholder approval, but court still needs to do a fairness inquiry.2. Broader reading - not voidable if disinterested board approval or shareholder approval, i.e., court avoids a fairness inquiry

ii. General Principles – Cookies Food Prod. v. Lakes Warehouse (Iowa 1988)1. Facts – After Herrig, a majority shareholder in P, turned the company around by promoting and selling its products through his own distributing company, other shareholders alleged that he had skimmed off profits through self dealing transactions. 2. Rule – Directors who engage in self-dealing must establish that they acted in good faith, honesty, and fairness.3. Rationale

a. Rule is in addition to the requirement that any such transactions must be fully disclosed and consented to by the board of directors or shareholders, or at least be fair and reasonable to the corporationb. Given his hard work on Cookies’ behalf, Herrig’s services were neither unfairly priced nor inconsistent with Cookies’ corporate interest; Herrig also provided sufficient information to Cookies’ board to enable it to make appropriate decisions.

iii. Director Approval – Cooke v. Oolie (Del. Ch. 2000): Shareholders of The Nostalgia Network (TNN) contended that two TNN directors, Oolie and Salkind (Ds) breached their duty of loyalty by electing to pursue a particular acquisition proposal that allegedly best protected their personal interests as TNN creditors rather than other proposals that allegedly offered superior value to shareholders. Ds maintained that b/c the board’s disinterested directors also voted to approve the acquisition, their conduct was protected by the business judgment rule’s safe harbor.

2. Rule – an interested director’s vote to pursue a transaction that would be beneficial to the director at the expense of the shareholders is protected by the business judgment rule where disinterested directors ratify the vote. 3. Rationale – Any taint of disloyalty is removed by the vote of the disinterested directors supporting the same deal b/c no incentive to act disloyally and should be only concerned with advancing the corporation’s best interests

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iv. Shareholder Approval - Lewis v. Vogelstein (Del. Ch. 1997)1. Rule – Unanimous shareholder approval is required to ratify a conflicted transaction that involves corporate waste. 2. Rationale –

a. Transaction that satisfies the high standard of waste constitutes a gift of corporate property and no one should be forced against their will to make a gift of their propertyb. Corporate waste entails an exchange of corporate assets for consideration so disproportionately small as to lie beyond the range at which any reasonable person might be willing to trade

v. Shareholder Ratification – In re Wheelabrator Tech., Inc. (Del Ch. 1995)1. Facts – Shareholders of WTI, whose company was bought by Waste Management, Inc., in a merger transaction brought a derivative action claiming that the WTI directors breached their duties of care and loyalty b/c 4 of 11 WTI directors were also Waste officers. The directors contended that approval by WTI’s non-Waste shareholders extinguished the claims. 2. Rule – A fully informed shareholder vote ratifying an interested director transaction subjects a claim for breach of directors’ duties of care and loyalty to business judgment review, rather than extinguishing the claim altogether.3. Rationale

a. Shareholder ratification shifts the burden of proof to the Ps, whether the standard is business judgment or entire fairnessb. Where, as here, the conflict of interest involves the directors (rather than the controlling shareholder), the business judgment standard is applied.

3. Director and Management Compensation Two avenues to regulate pay:

o 1. Tax policy- Section 182 of IRC. Congress limited the deductibility of e-pay to $1million. Problem: everyone wants to get paid $1 to meet deductibility.

Can only expense performance-based pay up to $1 million!o Restrict salaries so that people get payment in restricted stock and can only decrease in value.o Options are difficult to use as compensation- so companies use packages: part salary part options-> Track

options to stock price.o Compensation committee negotiates compensation with advice of compensation consultant.

a. Three-part compensation, generally: base salary, annual bonus, stock optionsi. Difficult to determine what fair compensation for CEOs – hard to find market price for the talents. ii. Compensation is fair and reasonable when the following are taken into account:

1. Relation of compensation to executive’s qualifications, ability, responsibility, and time devoted.2. Corporation’s complexity, revenues, earnings, profits, and prospects. (Remember: risk can’t be diversified so we need to address this in compensation structure).3. Likelihood incentive compensation will achieve its objectives.4. Compensation paid to similar executives in comparable companies.

iii. Shareholders or other disinterested directors often ratify the compensation of the CEO and other board members to provide an extra measure of legal insulation. Two reasons for doing so:

a. Corporations must pay compensation – don’t attract volunteersb. Courts are poorly equipped to determine fair salaries b/c of the unique character of particular managers and the wide range of return managers command on the market.

b. Option Grants – Lewis v. Vogelstein (Del. Ch. 1997)i. Rule – when determining whether stock option grants constitute actionable waste, courts should accord substantial effect to shareholder ratification. ii. Rationale – the one time option grants to the directors were sufficiently unusual as to require further inquiry into whether they constituted waste – court is saying that these potentially could be valid. iii. Note - By assuming that shareholder ratification was informed, the court ruled that transactions where officers or directors were paid protected that transaction from judicial scrutiny except on the basis of waste, and that the exchange was best evaluated in light of a proportionality review at another time

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c. Corporate Loans to Officers and Directorsi. DGCL §143 – board may authorize such loans when it finds that the loan or guarantee benefits the corporation.ii. Sarbanes-Oxley §402 of 2002 – Prohibits any indirect or direct loans to corporate officers in publicly traded companies. These prohibitions had disappeared 70 years earlier.

d. Corporate Governance and SEC Regulatory Responsesi. 1993 – SEC enhanced disclosure rules – Three noteworthy elements:

1. Companies had to disclose, in a standardized summary compensation table, the annual compensation, long term compensation, and other compensation for the top five employees 2. Required a narrative description of all employment Ks w/top executives and disclosure of a compensation committee report explaining the committee’s compensation decisions 3. Required a graph showing the company’s cumulative shareholder returns for the previous five years, along w/a broad based market index and a peer group index for the same period

ii. Effect of these reforms – increased transparency, wanted to shame corporations into reasonable compensation for top executives – but the latter didn’t work.iii. 2006 SEC reforms – requires a single number that captures all compensation for each of the top executives, as well as improved disclosures on other payouts

e. Disney decisions – erosion of business judgment rule for executive compensation. 1. Disney CEO Michael Eisner needed a President, asked Orvitz who insisted in “downside protection” to give up his 55% interest in the Creative Artists Agency, took job; Soon realized that Orvitz was not a good fit for Disney, fired him w/o cause and Orvitz ended up w/$140 million in compensation total for 15 months of service as President of Disney. 3. Shareholder P’s brought suit on behalf of the corporation, claiming that the Disney directors breached their duty of care in approving Orvitz’s agreement and that the severance payment was waste.

a. Ps had to assert that the board had not acted in good faith under DGCL 102(b)(7) waiver contained in the Disney charter.

4. In October 1998 – Delaware Chancery Court dismissed the complaint as board was made of independent directors who had no interests in the transaction. 5. Delaware SupCt reversed in part on appeal, directed that P be given the opportunity to replead.ii. In Re The Walt Disney Company Derivative Litigation (Del Ch. 2003)

1. Rule – A claimed breach of directorial fiduciary duties will survive dismissal where it is alleged with particularity that directors have intentionally and consciously disregarded their responsibilities 2. Rationale – claims survive dismissal.

a. Facts alleged by the shareholders suggest that the directors consciously and intentionally disregarded their responsibilities, adopting a “we don’t care about the risks” attitude concerning a material corporate decision. b. Where a director consciously ignores his or her duties to the corporation, thereby causing economic injury to its stockholders, the director’s actions are either “not in good faith” or “involve intentional misconduct.”

iii. In Re The Walt Disney Company Derivative Litigation (Del Ch. 2005)1. Rule – Intentional dereliction of duty – a conscious disregard for one’s responsibilities – is an appropriate standard for determining whether fiduciaries have acted in good faith.2. Rationale

a. A failure to act in good faith may be shown, for instance, where the fiduciary intentionally acts w/a purpose other than that of advancing the best interests of the corporation, where the fiduciary acts w/the intent to violate applicable positive law or where the fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties.b. Applying these principles here, the shareholders must prove by a preponderance of the evidence that the presumption of the business judgment rule does not apply either b/c the directors breached their fiduciary duties, acted in bad faith, or that the directors made an unintelligent or unadvised judgment by failing to inform themselves of all material information reasonably available to them before making a business decision. c. With regard to the Old Board’s hiring of Ovitz, and the Compensation Committee’s approval of the OEA, the directors did not act in bad faith, and at

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most acted with ordinary negligence – which is insufficient to constitute a violation of the fiduciary duty of care.d. Eisner did not act in bad faith – believed his actions were in the best interests of Disney when he hired Ovitz.

i. He was responsible for termination, not new board, so the new board can’t be held liable for that. ii. Eisner was exercising business judgment in firing Ovitz when he did not meet expectations – taken w/company’s best interest again.

3. Analysis – Court repeatedly notes that Eisner did not exemplify best practices of corporate governance, what seemed to save him from a breach of duty was his subjective belief that he was acting in the company’s best interest.

iv. Ps again appealed to the Delaware SupCt, who affirmed 1. Dicta on good faith in Delaware SupCt – Defined a spectrum of behavior for identifying “bad faith” conduct

a. One end – fiduciary conduct that is motivated by an actual intent to do harm – classic, quintessential bad faithb. Other end – grossly negligent conduct w/o any malevolent intent – cannot constitute bad faith.c. In between – conduct that involves intentional dereliction of duty, a conscious disregard of ones responsibilities. Such misconduct is properly treated as a non-exculpable, non-indemnifiable violation of the fiduciary duty to act in good faith.

2. But they didn’t reach a conclusion on whether the fiduciary duty to act in good faith is a duty that can serve as an independent basis for imposing liability upon corporate officers and directors.

v. DGCL 102(b)(7) – provides that a corporate charter may waive director liability to the corporation for damages except for, among other things, damages in connection with a breach of loyalty and for acts or omissions “not in good faith” HOLDING: (Black letter law) Good faith is a subjective, rather than objective determination.

o *Mere negligence does not give rise to liability.o *Gross negligence escapes the BJR, but falls under 102(b)(7).o *Bad faith does not get BJR OR 102(b)(7).

4. Corporate Opportunity Doctrine a. Black Letter Law : True fairness test!

i. Issue - when a fiduciary may pursue a business opportunity on her own account if this opportunity might arguably belong to the corporation - whether a given transaction is interested in the first instance. Whether opp.=interest.

1. Dist. self dealing cases – issue there is whether the transaction violates duty of loyalty, not whether it is interested from the start. 2. Rule – A director or senior executive may not compete w/the corporation, where this competition is likely to harm the corporation.

a. Usually find this even where Key Player prepares to compete while still employed by the corporation. b. If compete after he leaves the corporation, not a violation of duty of loyalty, unless insider is barred by valid non-competition clause. Cannot use trade secrets. c. Use of corporate assets (tangible goods, info) – not allowed where:

i. Use harms the corporationii. KP gets some financial benefits

3. Approval/ratification – conduct that would otherwise be prohibited as disloyal competition may be validation by being approved by disinterested directors or being ratified by the shareholders. Key Player must fully disclose the conflict and competition he proposes to engage in.

ii. Director/executive may not do so when a business opportunity is found to “belong” to the corporation – three tests to determine:

1. Interest or expectancy – narrowest protectiona. Corporation has an interest in an opportunity if it already has some K right regarding the opportunity. b. Corporation has an expectance if its existing business arrangements have led it to reasonably anticipate being able to take advantage of that opportunity.

2. “Line of Business” test – broadest protection

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a. Opportunity is corporate if it is closely related to the corporation’s existing or prospective activities. b. Factors affecting determination:

i. How this matter came to the attention of the director, officer, or employeeii. How far removed from the “core economic activities” of the corporation the opportunity liesiii. Whether corporate information is used in recognizing or exploiting the opportunity

3. Fairness test – a. Court measures the overall unfairness that would result if the insider took the opportunity for himself. b. Factors to consider

i. How a manager learned of the disputed opportunityii. Whether he or she used corporate assets in exploiting the opportunity, and iii. Other fact-specific indicia of good faith and loyalty to the corporation

4. Factors to consider regardless of the test (in addition to above)a. Whether the opportunity was afforded to the insider as an individual or corporate managerb. Whether the opportunity was essential to the corporation’s well beingc. Whether the parties had a reasonable expectation that such opportunities would be regarded as corporate. d. Whether the corporation is closely or publicly held – case for opportunity stronger if publicly held.e. Whether the person is an outside director or full-time executive – more likely to find opportunity w/full time executive.

iii. When May a Fiduciary Take a Corporate Opportunity1. A fiduciary may take an opportunity if the corporation is not in a financial position to do so – implies that the corporation has determined not to accept the opportunity 2. Issue – whether the board has evaluated the question of whether to accept the opportunity in good faith3. Most courts accept a board’s good-faith decision not to pursue an opportunity as a complete defense to a suit challenging a fiduciary’s acceptance of a corporate opportunity on her own account

b. In re eBay, Inc. Shareholders Litigation (Del. Ch. 2004): Shareholders of eBay brought derivative actions against certain eBay officers and directors for usurping corporate opportunities by accepting from eBay’s investment banker thousands of IPO shares at the initial offering price.

ii. Rule – Where a corporation regularly and consistently invests in marketable securities, a claim for usurpation of corporate opportunity is stated where it is alleged that the corporation’s officers and directors accepted IPO share allocations at the initial offering price instead of having those allocations offered to the corporation.iii. Rationale

1. Factual considerationsa. eBay financially was able to exploit the opportunities in questionb. eBay was in the business of investing in securities, as it had hundred of millions of dollars invested in such investmentsc. eBay was never given an opportunity to turn down the IPO allocations as too risky or to accept them

2. This conduct placed the insiders in a position of conflict with their duties to the corporation – commercial discount from the bank as a reward for their positions in the corporation. 3. Reasonable inference that the insiders accepted a commission or gratuity that rightfully belonged to eBay but that was improperly diverted to them

iv. DGCL §122(17) explicitly allows waiver to corporate opportunity constraints. Many companies had begun to have “interlocking” boards (i.e. Silicon Valley)

5. Duty of Loyalty in Close Corporations a. Close corporations typified by small number of stockholders, no ready market for corporate stock, and substantial majority stockholders participation in the management, direction and operations of the corporation

i. Minority shareholders are at a disadvantage

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1. Majority stockholders to oppress or disadvantage minority stockholders through “freezeouts”2. The minority shareholders are not readily able to sell their interests, since there is not a ready market for such interests, as there is with publicly traded companies.

ii. Easterbrook & Fischel – Strict Standards of Fiduciary Duty1. Minority shareholders who believe those in control have acted wrongfully may bring an action for breach of fiduciary duty2. Fiduciary duties should approximate the bargain the parties themselves would have reached had they been able to negotiate at low cost3. Because of the problems with liability rules as a means for assuring contractual performance, the parties have incentives to adopt governance mechanisms to resolve problems that cannot be anticipated

b. For Majority Shareholders – Donahue v. Rodd Electrotype Co. (Mass. 1975)i. Facts – P, a minority shareholder in a close corporation, sought to rescind a corporate purchase of shares of the controlling stockholder. ii. Rule - A controlling stockholder (or group) in a close corporation who causes the corporation to purchase his stock breaches his fiduciary duty to the minority stockholders if he does not cause the corporation to offer each stockholder an equal opportunity to sell a ratable number of shares to the corporation at an identical price. iii. Rationale

1. Purchase by the corporation confers substantial benefits on the members of the controlling group whose shares were purchased, since it turns corporate assets into their personal assets2. These benefits are not available to the minority stockholders if the corporation does not also offer them an opportunity to sell their shares3. The controlling group may not, consistent with its strict duty to the minority, utilize its control of the corporation to obtain special advantages and disproportionate benefit from its share ownership

c. For Minority Shareholders – Smith v. Atlantic Properties, Inc. (Mass. 1981) i. Facts – Wolfson, a minority stockholder acting pursuant to a provision in the articles of incorporation, was able to prevent the distribution of dividends, which made the corporation have to pay a penalty tax for accumulated earnings. ii. Rule – Where a closed corporation’s articles of incorporation include a provision designed to protect minority stockholders, the minority stockholders have a fiduciary duty to use the provision reasonably. iii. Rationale

1. Wolfson unreasonable used a provision to protect minority shareholders2. He was warned of the penalty tax that could result from a failure to declare dividends but refused to vote for an amount of dividends that would minimize the possibility of penalty tax3. The trial judge was correct in protecting the majority stockholders by ordering Wolfson to reimburse Atlantic for the penalty taxes

VIII. Shareholder Lawsuits A. Direct v. Derivative Claims

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STANDARD OF REVIEW Delaware (DGCL §144) RMBCA §8.61 ALI §5.02Conflict: NO Board or Shareholder Approval

Entire Fairness Review (burden on D)

EF (D) EF (D)

Disinterested Board Approves

BJR (Cooke) unless Controller, then Entire Fairness (EF) (See Cookies) (Burden on P)

BJR (P): §8.61(b)(1) & Comment 2

Reasonable belief in fairness (P): §5.02(a)(2)(b)

Disinterested Board Ratifies BJR (P) Same as above BJRP: §8.62(a) & Comment 1

EF(D): §5.02(c), §5.02(a)(2)(A), §5.02(b).

Shareholders Ratify BJR/Waste (P). Unless Controller, then EF (P) (Wheelabrator)

Waste (P) Waste (P)

1. Derivative suit – an assertion of a corporate claim against an officer or director which charges them with a wrong to the corporation.

a. This only indirectly affects shareholders – basically two suits in onei. First suit is against the directors, charging them w/improperly failing to sue on the existing corporate claim.ii. Second suit is the underlying claim of the corporation itself.

b. Injury alleged to the corporate interest – implies that any recovery that results should go directly to the corporation itself.c. Has many special procedural hurdles designed to protect the board of director’s role as the primary guardian of corporate interests.d. Examples – most cases brought against insiders for breaches of fiduciary duties

i. Suits against board members for failing to use due careii. Suits against an officer for self-dealingiii. Suits to recover excessive compensation paid to an officeriv. Suits to reacquire a corporate opportunity usurped by an officer.

e. Costs/benefitsi. Benefits – May confer value on the corporation (i.e. firing bad manager) and add value by deterring future wrongdoing ii. Costs – Direct costs of defense and possibly prosecution, indirect costs of insurance, lost profits, loss of efficiency because officers are preoccupied, bad publicity, etc.

2. Direct actions – normally brought as class actions= gathering together of many individual or direct claims that share some important common aspects.

b. Injury alleged is to the personal interest. c. Examples:

i. An action to enforce the holder’s voting rights.ii. An action to compel payment of dividendsiii. An action to prevent management from improperly entrenching itself (e.g. to enjoin the enactment of a “poison pill” as an anti-takeover device)iv. A suit to prevent oppression of minority shareholdersv. A suit to compel inspection of the company’s books and records.

d. Company plays no role, shareholders/attns get paid; take money out of the co…3. Commonalities b/t the suits:

a. Require Ps to give notice to the absent interested partiesb. Permit other parties to petition to join in the suitc. Provide for settlement and release only after notice, opportunity to be heard, and judicial determination of fairness of the settlementd. Successful Ps are customarily compensated from the fund that their efforts produce.

4. Tooley v. Donaldson, Lufkin & Jenrette (Del. 2004): Suit was brought by minority shareholders as a direct (class) action alleging that the board had breached a fiduciary duty to them by agreeing to a twenty two day delay in closing a proposed cash merger.

b. Chancery court dismissed – said the potential claim only belonged to the corporation. c. Del. Supreme Court affirmed the dismissal, but re-stated the test for derivative v. direct

i. TEST – the issue must turn solely on the following questions:1. Who suffered the alleged harm (the corporation or the suing shareholders) AND2. Who would receive the benefit of any recovery or other remedy (the corporation or the stockholders individually)?

ii. Holding – no claim was stated by the complaint b/c the shareholders had no individual right to have the merger occur at all.

5. Gentile v. Rossette (Del. 2006) – illustrates the malleability of the direct/derivative distinction; CEO and director of SinglePoint came up w/a scheme to increase their debt ratio, completed this w/o notifying the minority shareholders of the primary purpose. Minority shareholders brought suit against CEO & director.

b. Chancery Court granted summary judgment for D, Ps claim was solely derivative and Ps lost standing when company merged.c. Delaware SupCt reversed – held that the Ps claim was both direct and derivative

i. Found a direct claim from an extraction from the public shareholders, and a redistribution to the controlling shareholder, a portion of the economic value and voting power in the minority interest.ii. Public shareholders harmed in the same way that Ds directly benefited.

B. Attorney’s Fees & Incentives to Sue1. When all investors hold small stakes no one investor has a strong incentive to invest time and money in monitoring management2. Change the incentives if award attorney’s fees

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a. “Common fund” theory – courts usually award the Ps attorneys a reasonable fee for bringing a successful derivative action.

i. Under this theory the fee is paid out of the amount recovered on behalf of the corporation. b. Ps attorney gets nothing when a derivative suit is dismissed b/c there is no recovery and no benefitc. When it succeeds on the merits or settles the corporation is said to benefit from any monetary recovery or governance change, but company also pays the feesd. Differing modes of compensation

i. DE awards percent of total award ii. Federal Courts use lodestar method to include costs expensed and risk (this prevents premature settlement problem)

3. Fletcher v. A.J. Industries (Cal. App. 1968): P requested attorneys’ fees for successfully settling a derivative suit.

b. Rule – Even though the corporation receives no money from a derivative suit, attorneys’ fees are properly awarded if the corporation has substantially benefited from the action. c. Rationale – extension of the common fund theory – “substantial benefit” rule

i. If the corporation received a substantial benefit from a derivative action, even though non-monetary, recovery of attorney fees should be allowed.ii. Here there was a restructuring of corporate management, a restriction on the authority and voting rights of the majority shareholders, possible future monetary awards, and the saving of excessive salary paid to the former Treasurer – these were substantial corporate benefits

C. Standing for Derivative Suits 1. Underlying assumption – screening for qualified litigants increases the quality of shareholder litigation. 2. FRCP 23.1 – Delaware also follows – standing rules for derivative actions

a. P must be a shareholder for the duration for the actionb. Contemporaneous ownership rule – P must have been a shareholder at the time of the alleged wrongful act or omissionc. P must be able to fairly and adequately represent the interests of shareholders, meaning in practice there are no obvious conflicts of interest. d. Complaint must specify what action the P has taken to obtain satisfaction from the company’s board or state w/particularity the Ps reason for not doing so.

3. Demand Requirement of Rule 23: Black Letter Rulesi. Demand on the board is excused where it would be “futile,” which exists if the board is accused of having participated in the wrongdoing.ii. Delaware – Demand futility test

1. Demand will not be excused unless P carries the burden of showing a reasonable doubt about whether the board:

a. Was disinterested and independent or b. Was entitled to the protections of the business judgment rule (i.e. acted rationally after reasonable investigation and w/o self-dealing)

2. This is difficult to get – must plead facts showing either part with great specificity, plead duty of loyalty instead of due care. iii. Demand Required and Refused – result depends on who D is:1. Unaffiliated third party – P will almost never be able to pursue his suit after the board has rejected it.2. Suit against insider – P has a better chance of having board refusal overridden, but must show either that:

a. The board somehow participated in the alleged wrongb. Directors who voted to reject the suit were dominated or controlled by the primary wrongdoer.

b. Levine v. Smith (Del. 1991): GM shareholders filed shareholder derivative suits against GM’s directors, challenging the buy-back of GM stock from Ross Perot, its largest shareholder, and others, on the grounds that Perot and the others were wrongfully paid a premium to stop criticizing GM and that the GM directors approving the buy back could not have acted independently. The Chancery Court dismissed, rejecting the shareholders’ claims of demand futility and that the GM directors lacked independence.

ii. Rule – To withstand dismissal of a derivative action, a P shareholder claiming demand futility or wrongful demand refusal must allege particularized facts that overcome the business judgment rule presumption. iii. Rationale

1. Where demand futility is asserted, two related but distinct questions must be answered:

a. Whether threshold presumptions of director disinterest or independence are rebutted by well pleaded facts

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b. Whether the complaint pleads particularized facts sufficient to create a reasonable doubt that the challenged transaction was the product of a valid exercise of business judgment

2. Chancery court properly applied the test here – a. Shareholders did not plead sufficiently particularized facts to show that GM’s outside directors were so manipulated, misinformed and misled that they were subject to management’s control and unable to exercise independent judgmentb. Shareholders’ allegations more appropriately related to the issue of director due care and the business judgment rule’s application to the challenged transaction

c. Pre-suit Demand: Is the traditional equity rule of pre-suit demand the best way to adjudicate the board’s colorable disability to claim sole right to control the adjudication of corporate claims?

ii. ALI – said no – rule of universal demand1. P would be required to always make a demand and if she was not satisfied w/the board’s response to her demand she should institute suit. 2. If Ds sought dismissal of the suit, then the court would review the board’s exercise of business judgment in making its response.

iii. Delaware SupCt – rule of universal non-demand1. Infers that whenever a P does make a pre-suit demand, she automatically concedes that the board is independent and disinterested w/respect to the question to be litigation2. If independence is conceded by making demand, then the only prong of the Levine test that the P is left is the second prong, which asks whether bad faith or gross negligence may be inferred from the decision itself.3. Practical effect of this rule is to discourage pre-suit demand

d. Rales v. Blasband (Del. 1993): Blasband, first a shareholder in Easco Hand Tools, and then a shareholder in Danaher Corp., which acquired Easco as a wholly owned subsidiary, contended that demand was excused in a double derivative action he brought b/c the Danaher board could not impartially consider the merits of his derivative action (relating to improper use by the Easco board of the proceeds from sales of its senior subordinated notes) w/o being influenced by improper considerations.

ii. Rule – In a derivative action where demand excusal is asserted against a board that has not made the decision that is the subject of the action, the standard for determining demand excusal is whether the board was capable of impartially considering the action’s merits w/o being influenced by improper considerations.iii. Rationale

1. Levine test is inapplicable here b/c inapplicable the Danaher board did not make the decision that is being challenged2. Court must determine whether or not the particularized factual allegations of a derivative stockholder complaint create a reasonable doubt that, as of the time the complaint is filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand3. Here board was interested b/c federal court had ruled that Blasband had pleaded facts raising at least a reasonable doubt that the Easco’s board’s use of proceeds from the note offering was a valid exercise of business judgment

iv. Note - two other situations where this test would apply and Levine would not1. Where a business decision was made by the board of a company, but a majority of the directors making the decision have been replaced, AND 2. Where the subject of the derivative suit is not a business decision of the board

v. Note – Board of directors must respond to demand in 2 steps:1. Directors must determine the best method to inform themselves of the facts relating to the wrongdoing and weigh legal and financial considerations in responding. It must also investigate reasonably if necessary.2. Board must weigh alternatives. Including internal action and commencing legal proceedings.

D. Special Litigation Committees : of independent directors to investigate question of whether to dismiss suit a. Varies by jurisdiction

i. Divide b/t those that follow Delaware – Zapata case below – give a role to the court itself to judge the appropriateness of a special litigation committee’s decision to dismiss a derivative suit. ii. Those that follow NY – Auerbach v. Bennett – if the committee is independent and informed, its action is entitled to business judgment deference w/o any further judicial second guessing.

2. Zapata Corp. v. Maldonado (Del. 1981): Maldonado has initiated a derivative suit charging officers and directors of Zapata w/breaches of fiduciary duty, but 4 years later an independent investigation committee of two disinterested directors recommended dismissing the action.

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b. Rule - Where the making of a prior demand upon the directors of a corporation to sue is excused and a stockholder initiates a derivative suit as detrimental to the corporation’s best interests, the court should apply a two-step test to the motion:

i. Has the corporation proved independence, good faith, and a reasonable investigation 1. If no, then court will deny corporation’s motion and allow case to proceed. 2. If yes, go on to next step.

ii. Does the court feel, applying its own independent business judgment, that the motion should be granted – may but don’t have to apply this step.

1. Court can strike a balance between legitimate corporate claims, as expressed in a derivative stockholder suit, and a corporation’s best interests, as expressed by an independent investigating committee2. Look at whether there would be a just result in letting suit proceed despite step 1, how compelling corporate interest is in dismissal of a non-frivolous lawsuit, interests of law/public policy. 3. If the court’s independent business judgment is satisfied, then it may grant the corporations motion subject to any terms/conditions it sees fit.

3. In re Oracle Corp. Derivative Litigation (Del. Ch. 2003): Oracle Corp’s SLC moved to terminate a derivative action brought on Oracle’s behalf, claiming it was independent.

b. Rule – SLC does not meet its burden of demonstrating the absence of a material dispute of fact about its independence where its members are professors at a university that has ties to the corporation and to the Ds that are the subject of a derivative action that the committee is investigating. c. Rationale

i. Independence turns on whether a director is for any substantial reason incapable of making a decision with only the best interests of the corporation in mind – focus on impartiality and objectivity. ii. SLC has not shown it is independent here – ties are so substantial that they cause reasonable doubt about the SLC’s ability to impartially consider whether the trading defendants should face suit iii. Burden of establishing independence lies w/the corporation.

4. Joy v. North (2nd Cir. 1982)- Citytrust’s SLC recommended the dismissal of a derivation action brought in federal court under diversity jurisdiction. The federal court determined that under state law it was required to review the committee’s decision.

b. Rule – a SLC’s recommendation regarding the termination of derivative litigation must be supported by a demonstration that the derivative action is more likely than not to be against the interests of the corporation. c. Rationale

i. Court’s function is to weigh the probability of future benefit to the corporation, not to decide the underlying litigation on its meritsii. Factors the court should weigh include attorney’s fees, out-of-pocket expenses, time spent by corporate personnel on the litigation, and non-discretionary indemnification, but not insurance that has already been paid foriii. If after the court weighs these factors it finds a likely net return to the corporation that is insubstantial relative to shareholder equity, it may take into account two other items as costs

1. Impact of distraction of key personnel by continued litigation2. Potential lost profits which may result from the publicity of a trial

d. Dissent – majority goes beyond the Zapata standard, judges shouldn’t make business judgments. 5. Settlement by Special Litigation Committee – Carlton Investments v. TLC Beatrice International Holdings, Inc. (Del. Ch. 1997): The Chancery Court review a SLC’s proposed settlement of a derivative action on behalf of TLC.

b. Rule – A proposed settlement negotiated by a SLC is to be reviewed under the two-step approach set forth in Zapata, involving, first, a review of the SLC’s independence, good faith, and reasonableness of its decision, and, second, a discretionary business judgment review of the settlement’s meritsc. Rationale

i. Court cannot decide the merits of the particular claims, only looking at merits of the settlement. ii. Here, applying the first step of the Zapata test, the SLC and its counsel proceeded in good faith throughout the investigation and negotiation of the proposed settlement; the conclusions reached by the SLC, which formed the basis for the amount of the proposed settlement, were well informed by the existing record; and the proposed settlement falls within a range of reasonable solutions to the problem presented

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iii. This should be enough to support the settlement, but if undertaking the second Zapata step is necessary, with the court exercising its own court’s conclusion is that this settlement represents a reasonable compromise of the claims asserted

d. Note – court uncomfortable w/exercising business judgment here – courts ordinarily should not exercise such business judgment except where doing so will protect shareholder welfare.

Class: Transactions in Control (p. ?-441) Controlling blocks of stock:

o Selling at a premium. If control is sold, minority shareholder does not have control. Don’t have a minimum control %.

o Cases where 30-40% is the threshold; lowest seen is 10% in sale of corporate office. Subject to fiduciary duties.

o Market” Rule Absent looting of corporate assets, conversion of a corporate opportunity, fraud or other acts of bad faith, a

controlling stockholder is free to sell, and a purchaser is free to buy, that controlling interest at a premium price

o 3 main exceptions: Collective Opportunity (Perlman case) Selling a corporate office Looting (Harris)

Pearlman Rare cases where sale of control resulted in a loss of opportunity to the company. Harris v. Carter Controlling shareholder has a duty to investigate the buyer in some circumstances, but not an affirmative duty.Williams Act- Attempts to make takeovers fairer to the target’s shareholders, by reducing the pressure upon them to make a quick decision and by ensuring that all shareholders will be treated equally. In response to where buyer “lightening ray” offers. To control tender offers. 4 characteristics:

o 1) Filing requirements.o 2) Substantive regulations for offers themselves.

20 days that offer must remain open. Early Warning System (§13(d)) – Act requires anyone who purchases more than 5% of the stock of a publically held company

to disclose that fact promptly to the SEC. Tender offer= an offer of cash or securities to the shareholders of public corps. in exchange for their shares at a premium over

market price.o SEC did not define tender offer, but has an 8-factor test: (Brascan Ltd.)

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Solicitation – An active and widespread solicitation is made o the target’s public shareholders; Percentage – The solicitation is for a substantial percentage of the stock; Premium – The offer to purchase is made at a premium over the prevailing market price; Firm Terms – The terms of the offer is contingent on the tender of a fixed number of shares (and is perhaps, though

not necessarily, subject to a fixe maximum number that will be purchased); Limited Time – The offer is open only for a limited period of time; Pressure – The offerees are subjected to pressure to sell their stock; and Public Announcements – The buyer publically announces an acquisition program, preceding or accompanying his

accumulation of stock. If there is a Tender Offer – The Act requires comprehensively regulates tender offers. It does this in 3 ways:

o General Disclosure (§14(d)(1)) – The Act requires comprehensive disclosure by any bidder of the bidder’s identity, financing, and plans for the company is the bid is successful.

o Anti-Fraud Provision (§14(e)) – prohibits “any fraudulent deceptive, or manipulative” practices in connection with a tender offer.

o Terms of the offer (§14(d)(4)-(7)) – governs the substantive terms of the tender offer, e.g., duration, equal treatment

IX. Mergers and Acquisitions A. Introduction

1. Among the most important transactions in corporate law are those that pool the assets of separate companies into either a single entity or a parent company and a wholly owned subsidiary.

a. Law of M&A transactions provides (relatively) quick and inexpensive ways to reform the portioning and management of corporate assets

2. Sources of Value in these transactionsa. Economic Sources of Value – economies of “scale,” “scope,” and “vertical integration”

i. Economies of Scale – result when a fixed cost of production – such as the investment in a factory – is spread over a larger output, thereby reducing the average fixed cost per unit of outputii. Economies of Scope – mergers reduce costs not by spreading costs across a broader range of related business activitiesiii. Vertical Integration – arises by merging a company backward, toward its suppliers, or forward, toward its customers

b. Other sources of value – tax, agency costs, and diversificationi. Tax Benefits – Corporations w/tax losses may prefer to find a wealthy merger partner instead of setting off its own losses. ii. Agency Costs – can replace an underperforming management team when buy control. iii. Diversifying a company’s business projects – also increases corporate value, maintains year-round gain.

3. Opportunistic motives for Transactionsa. Squeeze out merger – controlling shareholder acquires all of a company’s assets at a low price, at the expense of its minority shareholdersb. Merger that creates market power in a particular product market and thus allows the post-merger entity to charge monopoly prices for its outputc. “Mistaken” mergers – occur because their planners misjudge the costs involved.

4. Evolution of Merger Law a. Almost non-existent until 1890, at first needed unanimous shareholder approval.b. Then corporate statutes were amended to allow majority shareholder approval, providing they were recommended by the board. c. Now – Mergers require shareholder and board approval.

i. DGCL §251(b) – Mergers require vote on part of both the target and the acquiring company except when the acquiring company is much larger. (whale-minnow) Rationale: May result in dilution of acquirer’s stock.ii. DGCL §271 – Sales of substantially all assets require shareholder vote of target, but not acquirer (regardless of size). Rationales: There is no change in management of the acquirer or dilution of shareholder vote. Target is likely to be dissolved upon the sale.iii. Dist. two statutes – agency problem is more severe in the former – shareholder approval is required in transactions that change the board’s relationship to its shareholders most dramatically.

B. Transactional Forms1. Introduction

a. Three principle legal forms of acquisitions i. Acquirer can buy the target company’s assetsii. Acquirer can buy all of the target company’s stock

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iii. Acquirer can merger itself for a subsidiary corporation w/the target on terms that ensure its control of the surviving entity.

b. In each of the three transactional forms, the acquirer can use cash, its own stock, or any other agreed-upon form of consideration

2. Statutory Merger – DGCL §251 – follow procedures set up in the state corporation statutea. Explanation

i. One corporation merges into another w/the former (“disappearing” corporation) ceasing to have any legal identity, and the latter (“surviving” corporation) continuing in existence. ii. After the merger, the surviving corp. owns all of the disappearing corp.’s assets and is responsible for all of the disappearing corp.’s liabilities. iii. Ks b/t the disappearing corp. and third parties are now b/t the surviving corp. and the third party. iv. Shareholders in the disappearing corp. are now shareholders of the surviving corp.

b. Process under DGCL 251i. Acquiror & Target boards negotiate the merger. Board gets initiation and approval. ii. Proxy materials are distributed to shareholders as needed (see below)iii. T shareholders always vote (§251 (c))iv. A’s shareholder vote unless outstanding increases by <20% surviving corporation’s charter is not amended, and security held by surviving corporation’s shareholders will not be exchanged or modified. (too insignificant) (§251(f)),

1. DGCL §251 does not protect preferred stock with right to a class vote unless there is a charter amendment (§242(b)(2))2. This is only when amendment alters the format rights of preferred stock, not when it reduces economic value.

v. If majority of shares outstanding approves, T assets merge into A, T shareholders get back A stock. A gets T liabilities. vi. Certificate of merger is filed with the secretary of state. vii. Dissenting shareholders who had a right to vote have appraisal rights

3. Asset Acquisitiona. Process – DGCL §271

i. Once again, the boards of the two firms – A and T – negotiate the deal. ii. But now, only T’s shareholders get voting and appraisal rights if substantially all are sold (because only T is being bought)iii. Transaction costs are generally higher because title to the actual physical assets of the target must be transferred to the acquirer. But acquiror may do this if they feel shareholders won’t approve. iv. After transfer, selling corporation usually liquidates the consideration received (e.g. cash) to its stockholders. v. Liabilities are not necessarily assumed

b. Katz v. Bregman (Del. Ch. 1981): In Ps action against D, the CEO of Plant Industries, to enjoin the proposed sale of the Canadian assets of Plant, P contended that a sale of substantially all the assets of the corporation required the unanimous vote of the stockholders.

ii. Rule – Under Delaware law the decision of a corporation to sell all or substantially all of its property and assets requires not only the approval of the corporation’s board of directors, but also a resolution adopted by a majority of the outstanding shareholders of the corporation entitled to a vote. iii. Rationale

1. Here, the proposed sale of Plant’s Canadian operations would constitute a sale of substantially all of the assets of Plant as presently constituted2. Under Delaware law, an injunction should issue preventing the consummation of such sale at least until it has been approved by a majority of the outstanding stockholders of Plant, entitled to vote at a meeting duly called on at least 20 days’ notice

iv. Note – represents a court taking up the tools at hand to reach a result that it thought fairness to shareholders required

c. Thorpe v. CERBCO (Del. 1996): CERBCO stock in Instituform constitutes 68% of CERBCO’s assets. Public shareholders want CERBCO to sell its controlling interest in Instituform, controlling shareholder wants to sell its controlling interest in CERBCO and block the deal.

ii. Delaware Supreme Court holds that sale of CERBCO’s stock in Instituform would constitute a sale of substantially all of CERBCO’s assets – requires a shareholder vote – controlling shareholder can veto the transaction. iii. Test – The need for shareholder approval is to be measured not by the size of the sale alone, but also on the qualitative effect upon the corporation. Thus it is relevant to ask

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whether a transaction is out of the ordinary course and substantially affects the existence and purpose of the corporation

3. Stock Acquisitiona. The purchase of control by an acquirer is merely a shareholder transaction that does not alter the legal identity of the corporationb. To acquire a corporation in the full sense of obtaining complete dominion over its assets, an acquirer must purchase 100% of its target’s stock, not merely a control blockc. Compulsory Share Exchange – RMBCA §11.03/Stock-for-Stock Acquisition

i. T shareholders give up T shares and get back A sharesii. Difference between the statutory merger and the compulsory share exchange is that T corp. keeps it separate existenceiii. In a regulated industry, where corporation cannot legally own assets outside of industry, corporation can do it indirectly through this, and this is a liability shield. iv. RMBCA 11.03 – Share Exchange Transactions

1. This is a tender offer negotiated with target board that becomes compulsory after approval by shareholders.2. At time 1, A Corp exchanges shares of A for T shareholders’ shares. 3. At time 2, A shareholders and T shareholders own A.4. A completely owns T.

a. Must be for ALL shares to be a full-fledged acquisition, otherwise it is just a shareholder transaction. b. Benefits because eliminates SEC regulations. c. Some states have short form merger statutes which allow a 90% shareholder to cash out minorities unilaterally. DGCL §253

d. Can’t be done in Delaware. But they have provision for a “two step merger”i. Boards of Target and Acquiror negotiate 2 linked transactions in a single package.ii. Tender offer for most or all of the target’s shares at an agreed price which T’s board recommends to shareholdersiii. Merger between target and a subsidiary of the acquiror which is to follow the tender offer and remove minority shareholders who failed to tender. (Usually at the same price as tender offer). If for cash, this is “cash out.”

4. Merger Generallya. A merger legally collapses one corporation into anotherb. In most states, a valid merger requires a majority vote by the outstanding stock of each constituent corporation that is entitled to vote.c. The voting stock of the surviving corporation is generally afforded statutory voting rights on a merger except when 3 conditions are met:

i. The surviving corporation’s charter is not modifiedii. The security held by the surviving corporation’s shareholders will not be exchanged or modifiediii. The surviving corporation’s outstanding common stock will not be increased by more than 20 percent

d. The rationale for this exemption is that mergers satisfying these conditions have too little impact on the surviving corporation’s shareholder to justify the delay and expense of a shareholder vote

5. Triangular Mergersa. Used to shield A from the liabilities of T – do this by merging into a wholly owned subsidiary of A. b. Forward Triangular merger –

i. A creates a subsidiary for the purpose of the transaction, S had no assets except shares of stock in the A. ii. T is then merged into S, and T shareholders get the shares of stock in A. iii. S is the surviving corporation

c. Reverse Triangular Mergeri. Same facts as above, except that S merges into T, so that T is the surviving corporation that is a subsidiary of A. ii. Cheapest and easiest method of transfer because both preexisting operating corporations are left intact. Stock purchases have costs but are much simpler.iii. DGCL §11.03(g)(3) – only if it is keeping T shareholders in place will there be a 20% vote exemption.

d. Two Step Mergeri. e.g. tender for $35, and once acquirer gets 51%, rest cashed out for $25 – two-tiered front loaded offerii. Could attack in State Court as self-dealing and unfair, though probably unsuccessful because

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1. Majority of stockholders (51%) tendered and approved the transaction2. No requirement that both steps offer equal price

iii. Could attack in Federal Court as manipulative under 10b-5 (or by 14(e) of Exchange Act, which forbids manipulation in connection with tender offers) iv. What is the benefit of the two-step reverse triangular over one-step?

1. Speed, as soon as tender offer is complete, you own company.2. With one-step, must file proxy materials, shareholder vote

6. De-Facto Mergera. Some US court have accorded shareholder voting and appraisal rights to all corporate combinations that resemble mergers in effect.

i. This is a functionalist approach ii. Counterargument to this approach - corporations exist as entities because certain formal steps are taken

b. NO De-Factor Merger in Delaware – Hariton v. Arco Electronics, Inc. (Del. 1963)i. Facts – D sold all of its assets to Loral Corp. in exchange for Loral common stock. P, a shareholder in D challenged the transaction as a de-facto merger. ii. Rule - A corporation may sell its assets to another corporation even if the result is the same as a merger without following the statutory merger requirementsiii. Rationale

1. No interaction b/t assets and merger statute, as long as one or the other is followed correctly, doesn’t matter if action is illegal under the other. 2. The theory of de facto merger can only be introduced by the legislature, not the courts3. Cannot distinguish this transaction b/t one where no dissolution of the selling corp. is required b/c Arco continued in existence. 4. Rationale of de-facto merger doesn’t apply in DE – no right to appraisal, P knew that D could sell at any time.

iv. Note – this approach is the minority rule v. Criticism of this approach – Since the merger procedure is authorized to achieve the result sought by Arco, it seems unfair to allow the use of another device to obtain the same result indirectly in order to deny the protections given to minority shareholders under the more direct approach

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Statutory Merger (DGCL §251, RMBCA

§11.02)

Asset Acquisition (DGCL §271, RMBCA

§12.01-.02)

Share Exchange (RMBCA §11.03)

T Voting Rights

Yes – need majority of shares outstanding (DGCL §251(c)), or majority of shares

voted (RMBCA §11.04(e))

Yes, if “all or substantially all” assets are being sold

(DGCL §271(a)) or no “significant continuing

business activity” (RMBCA §12.02(a))

Yes – need majority of shares voted

(RMBCA §11.04(e))

A Voting Rights

Yes, unless <20% shares being issued

(DGCL §251(f), RMBCA §11.04(g))

No (though stock exchange rules might

require vote to issue new shares)

Yes, unless <20% shares being issued (RMBCA §11.04(g))

Appraisal Rights

Yes if T shareholders vote, unless stock market exception

(DGCL §262, RMBCA §13.02)

Yes under RMBCA if T shareholders vote,

unless stock market exception (RMBCA §13.02(a)(3)); No in Delaware, unless provided in charter

(DGCL §262(c))

Yes, unless stock market exception

(RMBCA §13.02(a))

C. Structuring the Transaction – many different factors to consider1. Timing

a. Speed is almost always desirable in acquisition transactionsb. Different types of transactions

i. All cash, multi-step acquisition is usually the fastest way to lock up a target and assure its complete acquisitionii. All case tender offer may be consummated 20 days after commencement under the Williams Act.iii. If stock constitutes any part of the deal, the two-step structure generally does not provide a significant timing advantage because the stock to be issued generally must be registered with the SEC pursuant to Rule 145 of the Securities Act. iv. Most deals using 100% stock are structured as one step direct or triangular mergers

c. Title Transfers i. Title transfers not a matter of concern in a merger since all assets owned by either corp. vest as a matter of law.ii. In sale of assets may result in substantial cost and delay.iii. Thus reverse triangular mergers are the cheapest and easiest methods of transfer iv. Stock purchases entail stock transfers and the corresponding costs of documentation but are simpler than asset purchases.

d. Regulatory Approval –varies w/type of transaction – Try to choose a structure that minimizes the cost of obtaining regulatory approvals or consents needed to close the K. e. Voting and Appraisal Rights

i. Sometimes condition transactions on shareholder approval or provide appraisal rights ii. Weary of these transactions because they can slow down the process.

2. Lawyer’s Role in Deal Structuring a. Barrier – Different expectations about the value of the company

i. Lawyer Response: Build in contingent payments: “Earn-out” or “Clawback”b. Different time preferences

i. Negotiate timing of paymentsc. Asymmetric information: the “Lemons” problem

i. Representations and warranties will facilitate the due diligence process by forcing the disclosure of all the target’s assets and liabilities. ii. Covenants – tool for controlling risk, i.e. Pledge by target to use its best efforts to cause merger agreement to close, Board will recommend approval of the mergeriii. Parties will typically indemnify each other for any damages arising from any misrepresentation or breach of warranty – Allocates burden of undiscovered noncompliance to the party making the representation

d. Imperfect informationi. Negotiate “to the seller’s knowledge” versus “to the best of seller’s knowledge” versus “to the best of seller’s knowledge and after diligent investigation.”ii. Due Diligence – acquiring reliable information about the target through SEC filings, financial statements.

D. Taxation of Corporate Combinations1. Basic Concepts

a. Taxes levied on income in the US, which includes gains in value of investmentsb. Gain – calculated as the excess of the new amount realized on sale over the taxpayer’s adjusted cost basis.

i. Adjusted cost basis – cost after reduction for the depreciation or amortization charges made against the asset’s cost in calculating annual income taxes. ii. Realization of gain – generally occurs when an investment is soldiii. Recognition – refers to the legal rules that determine whether taxes will be due at the time the gain is realized.

2. Tax Free Corporate Reorganizationsa. Subsection 368(a)(1)(A) – excepts statutory mergers in which a sufficient proportion of the consideration is stock

i. Must meet 3 additional requirements in addition to being a merger under state law:1. Business purpose, not merely a tax avoidance purpose for the transaction2. Satisfies a community of interests test3. Satisfies the continuity of business enterprise requirements

ii. Can be accomplished in triangular form

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b. Subsection(a)(1)(B) – exempts transactions where at least 80% of all shares of voting stock (and 80% of each class of nonvoting stock) of Target are acquired in exchange solely for voting stock of the acquirer. Includes boot to the extent of 20% of the total.c. Subsection 368(a)(1)(C) – exempts reorganizations in which A acquires assets solely in exchange for voting stock of A – 3 common forms:

i. A acquires substantially all of Ts assets in exchange for its voting stock - 90% of the fair value of Ts net assets and at least 70% of Ts gross assets constitutes the acquisition of substantially all Ts assets.ii. Forward triangular merger form. – A’s subsidiary acquires substantially all of Ts assets in exchange solely for voting stock of A. iii. Forward triangular merger in which T merges into S and Ts shareholders receive only A voting stock.

d. Qualification under 368 means that there is no recognition of gain by sellers except to the extent they receive “boot” (any non-voting stock consideration)

E. Appraisal Remedy 1. Appraisal Process

a. Every U.S. jurisdiction provides an appraisal right to shareholders who dissent from qualifying corporate mergers.

i. Most states provide appraisal for shareholders who dissent from a sale of substantially all of the corporation’s assets. ii. Half states, an amendment to the corporate charter gives rise to an appraisal.

b. Quid pro quo for getting rid of unanimous shareholder approval requirement, but now markets are very liquid so mainly this remedy is used in non-publicly traded firms or transactions which shareholders have structural reasons to believe consideration may not be “fair value.” (i.e. there is a controlling shareholder) (GS feels this is never justified in an arms length transaction.) c. DGCL §262 mandates appraisal only in connection with corporate mergers and only in certain circumstances.

i. Shareholders get notice of appraisal right at least 20 days before shareholder meeting §262(d)(1) ii. Shareholder submits written demand for appraisal before shareholder vote, and then votes against (or at least refrains from voting for) the merger §262(d)(1) iii. If merger is approved, shareholder files a petition in Chancery Court within 120 days after merger becomes effective demanding appraisal §262(e)iv. Court holds valuation proceeding to determine the shares’ fair value exclusive of any element of value arising from the accomplishment or expectation of the merger §262(h)v. No class action device available, but Chancery Court can apportion fees among plaintiffs as equity may require §262(j)

2. Market-Out Rule – DGCL §262(b)a. Always get appraisal rights – §262(b)

i. statutory merger, less than 2,00 shareholders (privately traded) b. No appraisal right – §262(b)(1) don’t get appraisal rights if your

i. Shares are market-traded, or ii. Company has 2,000 shareholders; or iii. Shareholders not required to vote on the merger

c. Appraisal rights apply if – §262(b)(2) i. merger consideration is anything other than shares in surviving corporation or shares in third company that is exchange-traded or has 2,000 shareholders (with de minimis exception for cash in lieu of fractional shares)

3. The Nature of “Fair Value”a. The appraisal right is a put option – an opportunity to sell shares back to the firm at a price equal to their “fair value” immediately prior to the transaction triggering the right.b. 2 dimensions of appraisals

i. The definition of the shareholder’s claim (i.e. what it is specifically that the court is supposed to value) AND ii. the technique for determining value

c. Different ways to determine value – i. Value as minority shares, that is, apply a minority discount – least desirable for dissenting shareholdersii. Value as pro rata claim on going concern value, that is, no minority discount but no claim on the benefits of the deal. iii. Value as pro rata claim on going concern value, including the benefits from the deal – most desirable for dissenting shareholders

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d. In Re Vision Hardware Group, Inc. (Del. Ch. 1995): Minority shareholders pursuing their appraisal remedy contended that the debt of Better Vision should have been valued at its face value rather than at the deep discount at which it was purchased by Trust Company of the West, the acquirer in the merger that cashed out Vision’s public shareholders.

ii. Rule - The debt of an imminently bankrupt corporation should be valued at face value rather than at discounted value paid by an acquirer as part of a transaction that will keep the company from declaring bankruptcyiii. Rationale –

1. In an appraisal proceeding, shareholders are entitled to the fair value of their shares, without accounting for any element of value arising from the accomplishment or expectation of the merger, on a going-concern basis, free of any minority discounts2. However, in this case, it is more appropriate to view Vision on a liquidation basis b/c w/o the TCW proposal and its effectuation, Vision was a going concern heading immediately into bankruptcy and, unless new credit was made available, liquidation3. Therefore, under the particular circumstances of this case, the appropriate valuation of the company’s debt is the dollar value of the legal claim that that debt represented4. Shares value was no greater than the amount paid in fact.

X. Transactions In Control A. Introduction

1. Exchanging or aggregating blocks of shares large enough to control corporations.2. Buyers are willing to pay a premium for this – why?

a. Premium is a payment for “private benefits of control”b. Buyers believe they have a superior business plan that will increase the value of the stock in their hands – attempt to drive up the price of their stock, pay premium for it.

3. Investors can acquire control in two ways – both raise issues a. Purchase of a Control Block – Can purchase a controlling block of shares from an existing control shareholder

i. Incumbent controller will demand a premium over market price. ii. Can get premium through larger private benefits or by putting the company’s assets to more profitable uses. iii. Makes regulatory measures have two effectsiv. Mitigates the risk of opportunistic transfers of control to bad inquirersv. But also could hinder the efficient transfer of control to acquirers who will use company assets in more profitable ways.

b. Purchase of Public Shares – purchase the shares of numerous smaller shareholders – tender offer i. Similar tradeoff b/t preventing bad transfers and hindering good ones

B. Purchasing a Controlling Block of Shares 1. Seller’s Duties – three issues: 1) extent to which the law should regulate premia from the sale of control; 2) Law’s response to sales of managerial power that occur w/o transferring a controlling block of stock; 3) seller’s duty of care to screen out potential looters. 2. Regulation of Control Premia

a. Different Tests i. Common law rule – “market rule” – sale of control is a market transaction that creates rights and duties between the parties, but does not confer rights on other shareholders.ii. Alternative – “equal opportunity rule” – minority shareholders would be entitled to sell their shares to a buyer of control on the same terms as the seller of control.

b. Zetlin v. Hanson Holdings, Inc. (N.Y. 1979)i. Facts – When D and the Syvestri family sold their controlling interest in Gable Industries for a premium price, P, a minority shareholder, brought suit contending that minority shareholders were entitled to an opportunity to share equally in any premium paid for a controlling interest. ii. Rule – Absent looting of corporate assets, conversion of corporate opportunity, fraud or other acts of bad faith, a controlling stockholder is free to buy that controlling interest at a premium price. iii. Rationale

1. Minority shareholders are entitled to protection against abuse by controlling shareholders, but not to inhibit the legitimate interests of other stockholders. 2. For this reason that control shares usually command a premium price – added amount an investor is willing to pay for the privilege of directly influencing the corporation’s affairs.3. P basically arguing that cannot get control unless offer to all shareholders – this is contrary to current law.

c. Perlman v. Feldmann (2nd Cir. 1955)

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i. Facts – After D sold his controlling interest in the Newport Steel Corp., P and other minority stockholders brought a derivative action to compel accounting for, and restitution of, allegedly illegal gains accruing to D as a result of the sale. ii. Rule – Directors and dominant stockholders stand in a fiduciary relationship to the corporation and to the minority stockholders and beneficiaries thereof. iii. Rationale

1. When the sale of a control block necessarily results in a sacrifice of an element of corporate good will and consequent unusual profit to the fiduciary who has caused the sacrifice, he should account for his gains.2. Need not be absolute certainty that a corporate opportunity is involved, only a possibility of corporate gain is necessary to trigger the fiduciary duty and recovery for breach of that duty

iv. Dissent 1. As a dominant shareholder, D did not have a duty to refrain from selling the stock he controlled – majority fails to specify the fiduciary duty that is being violated. 2. Record shows that D did not receive excess value for his stock, b/c a controlling block is worth more than ordinary stock.

v. Note – this case dealt w/steel transactions during wartime – violated fiduciary duty b/c premium was based on belief that steel shortage was an attempt to divert a corporate opportunity

d. Easterbrook & Fischel – Defense of Market Rule in Sales of Controli. Sales of controlling blocs of shares – good example of transactions where the movement of control is beneficial.

1. Premium price – unequal distribution of the gains2. But this unequal dist. reduces the costs to purchasers of control, and increases incentives for inefficient controllers to relinquish their positions.

ii. Some commentators say there should be a sharing requirement 1. “equal opportunity” rule – entitle minority shareholders to sell their shares on the same terms as the controlling shareholder2. These proposals would stifle transfers of control - people may not consent to the sale of a controlling block, bidders may have to buy more than necessary, causing transaction to be unprofitable. 3. Minority shareholders would suffer w/the decrease in management improvements.

iii. Perlman v. Feldmann – suggests that the gains may have to be shared in some circumstances – had special circumstances here

1. Problems w/this treatment:a. Court’s proposition that an corporate opportunity was extracted – unless the price of the shares plummeted, it could not be extracting enough to profit. b. Source of the premium is the same source of gains for the shares after the buyer installed new managers and furnished a more stable market for the products.

2. Not always as fortunate as shareholders in Perlman – have “looters” – take the $ and run, one time transaction.

a. Hard to detect them in advance.b. System should deter looters through heavy fines/imprisonment, not through preventative remedy.

e. Delaware rule - Simple sale of a controlling block of stock, unconnected to any corporate activity, is free of any duty to minority shareholders.

i. But these are rare – often need corporate action to facilitate the sale of a control block, and whenever corporate board takes action, should do so when it believes that it is beneficial to the corporation. ii. In Re Digex Inc. Shareholders Litigation (Del. Ch. 2000)

1. Facts – Acquirer first approached the board of the partly held subsidiary of the controller w/a lucrative offer. Controller arranged to sell itself to the inquirer in lieu of selling the subsidiary, thereby excluding the subsidiary’s minority shareholders from a premium, obtained a waiver of DGCL 203. 2. Rationale – failure to extract something in exchange for the waiver might violate the board’s burden to show entire fairness because it is of value. Waiver must be for the benefit of the corporation and all its shareholders, not just its controlling shareholder. This shows that market rule doesn’t necessarily always work in practice.

3. Sale of a Corporate Office a. Issue – sale of relatively small block of stock in a widely held firm at a premium by the CEO or managing directors who simultaneously promise to resign.

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i. Problematic b/c giving control w/o making them buy the appropriate amount of stock. b. Carter v. Muscat (N.Y. 1964) – board of the Republic Corp. appointed a new slate of directors as part of a transaction in which the company’s management sold a 9.7% block of its stock to a new “controlling” person at a price slightly above market.

i. Despite a shareholder challenge, the court upheld the re-election of new directors at the annual shareholders meeting.

c. Brecher v. Greg (NY 1975) – court found that paying a premium for control while only purchasing 4% of a company’s outstanding shares is “contrary to public policy and illegal”

4. Looting – controlling shareholder may not sell his control block if he knows or suspects that the buyer intended to “loot” the corporation by unlawfully dividing its assets.

a. Harris v. Carter (Del Ch. 1990)i. Facts – Harris and other minority shareholders of Atlas Energy Corp. and his associates committed a breach of fiduciary duty by negligently selling control of the corporation to a group who looted it. ii. Rule – A majority shareholder may be liable if he negligently sells control and such sales damages the corporation. iii. Rationale – When a corporate fiduciary’s action may foreseeably harm the corporation his negligent acts causing such harm are compensable – applies negligence standard to corporate context.

b. Note – Harris is the majority view – negligence is sufficient for looting.i. Minority view – Levy v. American Beverage – in that case actual knowledge of the buyer’s wrongful intentions was required for liabilityii. Excessive price alone is not ordinarily enough to put seller on notice that the buyer is a looter – factor to be considered, but not determinative.

C. Tender Offers - an offer of cash or securities to the shareholders of a public corporation in exchange for their shares at a premium over market price

1. Williams Act regulates tender offers a. Purposes

i. Sought to provide shareholders sufficient time and information to make an informed decision about tendering their shares and to warn the market about an impending offer. ii. Also intended to assure shareholders of an equal opportunity to participate in offer premia & to discourage hostile tender offers on the margin

b. Four Principle Elements i. “Early warning system” – section 13(d) – alerts the public and the company’s managers whenever anyone acquires more than a 5 percent of the company’s voting stock.

1. Basic Rule (Rule 13d-1(a)) – investor must file a 13D report within 10 days of acquiring 5%+ beneficial ownership. 2. Rule 13d-1-(b) gives Partial exemptions for qualified institutional investors and passive investors who only need to file within 45 days of year end. 3. Updating requirement (Rule 13d-2) – must amend 13D promptly on acquiring material change (~ +/- 1%)4. Key Definitions – “beneficial owner” means power to vote or dispose of stock (13d-3(a)); group is anyone acts together to buy, vote, or sell stock (13d-5(b)(1))Each group member deemed to beneficially own each member’s stock.5. §13e-3 – Mandates strict disclosure when insiders plan to go private and force public shareholders out of the company.6. §13e-4 – Requires companies to make disclosures when tendering for their own shares.

ii. General Disclosure – Section 14(d)(1) – mandates disclosure of the identity, financing, and future plans of a tender offeror, including any plans for any subsequent going-private transaction. iii. Anti-Fraud Provision – Section 14(e) – anti-fraud provision that prohibits misrepresentations, nondisclosures, and “any fraudulent, deceptive, or misrepresentative” practices in connection w/a tender offer.iv. Rules that regulate the substantive terms of tender offers

1. §14d-7 – Shareholders who tender can withdraw while tender offer open2. §14d-10 – Tender offers must be made to all holders; all purchases must be made at the best price3. §14e-1 – Tender offers must be open for 20 business days4. §14e-2 – Requires target’s board to comment on the tender offer.5. §14e-5 – Bidder cannot buy “outside” tender offer

2. Wellman v. Dickinson (S.D.N.Y. 1979) – Court offered Eight factor Test to determine if it was a tender offer:

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a. Active and widespread solicitationb. The solicitation is made for a substantial percentage of the issuer’s stockc. A premium over the prevailing market priced. The terms of the offer are firm rather than negotiablee. Whether the offer is contingent on the tender of a fixed minimum number of sharesf. Whether the offer is open only for a limited period of timeg. Whether the offerees are subjected to pressure to sell their stockh. Whether public announcements of a purchasing program … precede or accompany a rapid accumulation.

3. Brascan v. Edper Equities Ltd. (S.D.N.Y 1979): Brascan, a Candadian company traded on the American Stock Exchange, contended that Edper violated section 14e of the Williams Act when Edper acquired 24% of Brascan’s stock over two days. Brascan claimed that this acquisition constituted a de facto tender offer and that Edper therefore violated provisions requiring the announcements of further purchases.

b. Rule – The mere acquisition of a large portion of a company’s stock by itself does not constitute a tender offer for purposes of section 14e of the Williams c. Rationale – Conduct Edper engaged in is not what is commonly understood as a tender offer, all Edper did was acquire a large amount of stock in open market purchases.

i. Edper’s conduct meets only one of 8 criteria for a tender offer:1. Calling for active and widespread solicitation of public shareholders – this is clearly not met2. Calling for a larger accumulation of stock – is met3. Calling for a premium over the prevailing market price is met, but only to a slight degree.4. Calling for firm offer terms, rather than negotiable terms, is not met.5. Calling for the offer to be contingent on the tender of a fixed minimum number of shares – met only to a slight degree6. Calling for the offer to be open only for a limited period of time – not met.7. Calling for the offerees to be subjected to pressure to sell their stock was not met. 8. Calling for public announcements of a purchasing program preceding or accompanying a rapid accumulation – not met.

ii. Edper did not violate section 14e of the Williams Act4. The Hart-Scott-Rodino (HSR) Act Waiting Period

a. Gives FTC & DOJ the proactive ability to block deals that violate the antitrust laws.b. Minimum waiting period before closing a transaction §18a(b)(1)(B) – vary by transaction

i. Cash tender offers – acquirers must wait 15 calendar days after filing before closingii. Regulated open market purchases – acquirers must wait 30 days after filingiii. Mergers, asset deals, and other negotiated acquisitions – both parties must wait 30 days after filingiv. may be extended for another 30 days (10 days for cash tender offers) if DOJ or FTC makes a Second Request (§18a(e)(2))

c. Who must file – §18a(a)(2)i. The acquirer in all deals > $212 millionii. An acquirer with assets or sales > $106 million and a target with assets or sales > $11 million (or vice versa), if the deal involves assets or securities > $53 million.

d. Corporate law importance – waiting periods it imposes before a bidder can commence her offeri. Must be disclosed immediately to target companies, and bidders may not close a deal until the relevant waiting period has elapsed.

D. Freeze-outs 1. Black Letter Rules

a. Freeze-out – transaction in which those in control of a corporation eliminate the equity ownership of the non-controlling shareholders through legal compulsion. b. Context in which a freezeout is likely to occur:

i. Second step of a two step acquisition transaction – A buys 51% of T’s stock then eliminates the remaining 49% of shareholders through a merger. ii. Where two long term affiliates merge – the controlling parent eliminates the publicly held minority interest in the subsidiaryiii. Where the company goes private – insiders cause the corporation or its underlying business to no longer be registered w/the SEC, listed on a stock exchange or actively traded over the counter.

c. General rule – in evaluating a freezeout courts will usually:i. Try to verify that the transaction is basically fair ANDii. Scrutinize the transaction especially closely in view of the fact that the minority holders are being cashed out (as opposed to being given stock in a different entity)

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d. Techniques for carrying out a freeze-out i. Cash out merger – insider causes the corporation to merge into a well funded shell, and the minority holders are paid cash in exchange for their shares, in an amount determined by the insiders. ii. Short Form Merger – If A owns 90% or more of T, then T can be merged into A w/all of Ts holders paid off in cash.iii. Reverse Stock split – outsiders end up w/fractional shares and the corporation can compel the owners to exchange them for cash.

e. Federal Law on Freezeouts i. SEC Rule 10b-5

1. If there has been full disclosure, then P is unlikely to convince the court that the rule has been violated, no matter how “unfair” it may seem.2. But if the insiders concealed or misrepresented material facts about the transaction then the court may find a violation

ii. SEC Rule 13e-3 – requires extensive disclosure by the insiders in the case of any going-private transaction, can be liable for damages or an injunction

f. State Law on Freezeouts i. General test – in most states must meet at least the first prong and possibly the second:

1. The transaction must be basically fair, taken in its entirety, to the outsider/minority shareholders. 2. The transaction must have been undertaken for some fair business purpose.

ii. Basic fairness – most courts require:1. A fair price2. Fair procedures by which the board decided to approve the transaction 3. Adequate disclosure to the outside shareholders about the transaction.

iii. Business purpose – sometimes cannot put through a transaction even if pay a fair price b/c sole purpose cannot be to eliminate the minority stockholders.

1. Esp. likely to be applied when transaction is a going private one.2. DE has abandoned this requirement.

2. Cash out Merger Cases a. Weinberger v. UOP, Inc. (Del. 1983): Claiming that a cash-out merger b/t UOP and Signal was unfair, P a former minority shareholder of UPO brought a class action to have the merger rescinded. Directors of UOP were also directors of Signal, and study said $24 should be offered for shares, but Signal only offered $21 w/o informing shareholders of the study.

ii. Rule – When seeking to secure minority shareholder approval for a proposed cash-out merger, the corporations involved must comply w/the fairness test:

1. Fair dealings – imposes a duty on the corporations to completely disclose to the shareholders all information germane to the merger and2. Fair price – requires that the price being offered for the outstanding stock be equivalent to a price determined by an appraisal where “all relevant non-speculative factors” were considered.

iii. Rationale – This acquisition was not fair b/c no fair price, was lower than was study by directors admitted was fair, dealings were not fair b/c was no negotiations and no disclosure about the study w/the higher price.

b. Rabkin v. Phillip A. Hunt (Del. 1985): buyer of control block had K w/the seller that if the buyer completed a cash-out merger within 12 months of purchasing control, it would pay the minority shareholders no less per share than it had paid to acquire its control stake. Buyer waited a little more than 12 months and cashed out the minority at a lower price. Minority shareholders claimed a breach of fiduciary duty instead of getting an appraisal b/c waited longer on purpose.

ii. Court permitted the non-apprasial attack to proceed. c. Cede v. Technicolor, Inc. (Del. 1996): Merger arose out of a two-step, arm’s length cash merger between a corporation controlled by Ronald Perlman and Technicolor, a public company w/no controlling shareholder

ii. Court of Chancery found that Perlman did not owe a fiduciary duty to pay a fair price to the minority shareholders in the second step mergeriii. Del SupCt – reversed

1. Perlman had a burden to establish that the price paid to minority shareholders was fair and that the burden could not be satisfied by looking at the results of a negotiation with the Technicolor board.2. Appraisal remedy – P could simultaneously pursue an appraisal action and his claim for breach of fiduciary duty.

iv. Note – Holding makes clear what Rabkin implied:

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1. When there is a claim that the D owes fiduciary duties to public shareholders (i.e. parent-subsidiary merger, two tier cash out merger) – appraisal is not the exclusive remedy2. But where there is a straight cash or stock merger between firms w/no shared ownership interest, complains about price alone must be relegated to appraisal.

d. Fairness remedy still predominates – why?i. Appraisal may not be available because of the “market out” provisions ii. Action claiming breach of fiduciary duty can be brought before the merger, which provides the P the opportunity to request a preliminary injunction.iii. Suits for breach of fiduciary duty can be brought as class actions – leverage

3. What Constitutes Control – Kahn v. Lynch Communication Systems, Inc. (Del. 1994)a. Facts – After Lynch’s board approved a controlling shareholder’s per share tender offer for its minority shares, P sought to enjoin the cash-out merger and recover monetary damages. b. Rule – A shareholder owes a fiduciary duty if it owns a majority interest in or exercises control over the business affairs of the corporation.c. Rationale

i. Despite is 43.3% minority shareholder interest, Alcatel exercised control over Lynch by dominating its corporate affairsii. A controlling or dominating shareholder standing on both sides of a transaction bears the burden of proving its entire fairness, which can be established by showing that negotiations were conducted at arm’s length and that there was no compulsion to reach such an agreement.iii. Chancery Court should not have shifted this burden to P.

4. Special Committees on Independent Directors in Controlled Mergersa. Assuming a properly constituted, diligent and well advices special committee of independent directors approved a transaction – courts treat it in two ways:

i. Treat the special committees as that of a disinterested and independent board, which merits review under the deferential business judgment rule. ii. Continue to apply the entire fairness test, even if the committee appears to have acted w/integrity, since a court cannot easily evaluate whether subtle pressure or feelings of solidarity have unduly affected the outcome of the committee’s deliberation.

b. In Re Western National Corp. Sharholders Litigation (Del. Ch. 2000)i. Facts – shareholder Ps attacked the fairness of a merger between Western National and American General. Value was $29.75 per share, preannouncement market price was $28.19. Shareholders attacked the deal as unfair. ii. Court granted SJ for Ds, held that since business judgment rules applied to judicial review of the case, since in the court’s view, American General was not a controlling shareholder.

5. Controlling Shareholder Fiduciary Duty on the First Step of a Two-Step Tender Offer a. A controlling shareholder who sets the terms of a transaction and effectuates it through his control of the board has two duties:

i. A duty of fairness to pay a fair price. ii. A duty under both corporate law and federal securities law to disclose all material information respecting the offer.

b. In Re Pure Resources Inc Shareholders Litigation (Del. 2002)i. Facts – Unocal Corp. owned 65.4% of Pure Resources, Inc., and wanted to take it private via an exchange offer by which Unocal hoped to acquire the balance of Pure’s shares in exchange for its own stock. Minority shareholders believed the offer was inadequate and coercive, and therefore subject to entire fairness review. They also contended that Unocal and Pure’s board of directors had not made adequate and non-misleading disclosure of material facts relating to the offer. ii. Rule – a tender offer made by a controlling stockholder (to be followed by a short-form merger) is coercive to the extent it includes in its definition of a “majority of the minority” shareholders affiliated with the controlling stockholder as well as management which has incentives that are different from those of other minority shareholders, but is not subject to entire fairness review where the other aspects of the tender offer are non-coercive and full disclosure has been made. iii. TEST - To accomplish this, the law should consider an acquisition tender offer by a controlling shareholders non-coercive only when:

1. It contains a non-waivable majority of the minority provision2. A short form merger will take place immediately after the controlling shareholder obtains more than 90% of the shares and3. The controlling shareholder has made no retributive threats.

c. The Tender Offer Roadmap

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i. Offer cannot be coercive: Our law should consider an acquisition tender offer by a controlling stockholder non-coercive only when

1. It is subject to a non-waivable majority of the minority tender condition2. The controlling shareholder promises to consummate a prompt §253 merger at the same price if it obtains more than 90% of the shares; and 3. Controlling shareholder has made no retributive threats

ii. Target board independent directors must have role: the majority shareholder owes a duty to permit the independent directors on the target board free rein and adequate time to react to the tender offer, by (at the very least):

1. Hiring their own advisors, providing the minority with a recommendation as to the advisability of the offer, and 2. Disclosing adequate information for the minority to make an informed judgment

iii. Details of fairness opinion must be disclosed “Stockholders are entitled to a fair summary of the substantive work performed by the investment bankers”

Summary of DE law on Freeze-Outs: In light of Weinberger and later cases decided under it:A. Entire Fairness Rule: A freeze-out transaction, as well as any other transaction in which insiders are on both sides of the transaction, will be sustained only if it is “entirely fair,” as measured by fair procedures, fair price, and adequate disclosure (Weinberger). B. Burden of Proof: Under some circumstances, the burden of proof can shift to the plaintiff to show that the terms of the transaction were unfair. For this burden-shifting to occur, however, all of the three following things must happen:

1. Approval by a majority of minority – A majority of the minority shareholders must vote to approve the transaction (Weinberger).2. Disclosure – The D’s (insiders trying to sustain the transaction) must carry the burden of showing that they made adequate disclosure of the transaction (Weinberger).3. Arm’s Length Process – There must be a simulation of an arm’s length process, in which representatives of the minority and the majority negotiates. Usually, this will be by a committee of independent directors, who negotiate with the majority-holder (Kahn).

C. Damages: Plaintiff/shareholders attacking the fairness of a freeze-out or other merger transaction, even if they win, will normally have to be content with a monetary recovery equal to what they would have gotten under appraisal (Weinberger). This means that the Ps will usually not be able to get an injunction, and will not be able to recover in a class action for all the frozen out shareholders (including those who didn’t request appraisal). Therefore, a P will normally have to comply with the appraisal statute (e.g., by giving notice, prior to the merge, that he dissents) before he will even be allowed to attack the transaction on grounds of unfairness.

1. Fraud or Overreaching – On the other hand, an injunction and class action damages will apparently still be available if the Ps prove fraud, misrepresentation, or gross and palpable overreaching (Rabkin injunction against freeze-out allowed if P can show “overreaching” by the majority).

F. Hostile Takeovers 1. Introduction

a. Works as a powerful market mechanism for displacing bad managers i. If a corporation is badly managed, its share price will decline relative to others in the industry, making it profitable for a new group to make a tender offer and bring it into more efficient leadership. ii. Control contests are profoundly unpleasant for incumbent managers

b. Law opened 2 avenues for initiating a hostile change in controli. Proxy contest – the simple expedient of running an insurgent slate of candidates for election to the boardii. Tender offer – the even simpler expedient of purchasing enough stock oneself to obtain voting control rather than soliciting the proxies of others

c. Black Letter Law i. State regulation of hostile takeovers – DGCL 203

1. Prohibits any business combination b/w the corporation and an interested stockholder for three years after the stockholder buys his shares.2. Anyone who buys more than 15% of a company’s stock is covered.3. Net effect – anyone who buys less than 85% of a Delaware corp. cannot for three years conduct a back end merger b/t the shell he uses to carry out the acquisition and the target therefore:

a. Cannot use the target’s assets as security for a loan to finance the share acquisitionb. Cannot use the target’s earnings and cash flow to pay off the acquisition debt.

ii. Defensive Maneuvers

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1. Pre-offer techniques – shark repellants – generally must be approved by a majority of the target’s shareholders. Examples:

a. Super majority provision – may amend articles of incorporation to require that more than a simple majority of the target’s shareholders approve any merger or major sale of assetsb. Staggered board c. Anti-greenmail amendment – prohibit the paying of greenmail to discourage any hostile bidder bent on receiving greenmail. d. New class of stock – second class of common stock and require that any merger or asset sale be approved by each class then the new class can be placed w/persons friendly to management.e. Poison pill – try to make bad things happen to the bidder if it obtains control of the target, making the target less attractive

i. Call plan – gives stockholders the right to buy cheap stock in certain circumstances. Contain “flipover” provision that is triggered when an outsider buys a certain amount of the target’s stock. Holder of the right can then acquire shares of the bidder at a cheap price.ii. “Put” plans – if a bidder buys some but not all of the target’s shares, the put gives each target shareholder the right to sell back his remaining shares in the target at a predetermined fair price. iii. Shareholder approval is not generally required.iv. Can be implemented after a hostile bid has emerged. v. Most have been upheld, only where it has the effect for foreclosing virtually all hostile takeovers it is shut down.

2. Post-offer techniques a. Defensive lawsuitsb. White Knight – target finds itself a white knight who will acquire the target instead of letting the hostile bidder do so.

i. Often given a lockup – some special inducement to enter into bidding processii. Crown jewel option – e.g. of special inducement – option to buy one of the target’s best businesses at a below market price. iii. Lockups are the type of anti-takeover device that is most likely to be invalidated, esp. if used to end, rather than create an action.

c. Defensive acquisition – target takes on a lot of debt to make itself less attractive. d. Corporate restructuring – restructure to raise short term stockholder value.e. Greenmail – buys the bidder’s stake back at an above-market price, usually in return for some agreement where the bidder agrees not to attempt to re-acquire the target for a number of years

i. Most courts seem to allow thisf. Sale to friendly party – may sell less than controlling block to friendly party who won’t tender to a hostile bidder.g. Share repurchase – buy back shares from the public if insiders hold a substantial but not controlling stakeh. Pac Man – target may tender for the bidder

iii. Delaware response to defensive maneuvers 1. Business judgment rule – target and its management will get the protection of the business judgment rule under the following circumstances:

a. Reasonable groundsi. Board and management must show that they had reasonable grounds for believing that there was a danger to the corporation’s welfare from the takeover attempt.ii. May not use anti-takeover measure to entrench themselves in power – must be protecting shareholder’s interests, not their own.

b. Proportional response – must show that the defensive measures they actually used were reasonable in relation to the threat posed.

i. Cannot be preclusive – have the effect of foreclosing virtually all takeovers.ii. Cannot be coercive – forces management solution on the shareholders.

c. Reasonable investigation – must reasonably investigate the hostile bid.

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2. Decision to sell the company – once target’s management decides that it is willing to sell the company, courts give enhances scrutiny to the steps the target board and managers take.

a. Management and the board must make every effort to obtain the highest price for the shareholdersb. All would be bidders must be treated equally. c. If management is interested, have to be careful not to favor them.

3. Sale of Control – enhanced scrutiny given to transactions in which the board sells control of the company to a single individual.

a. Only where the target is merging into a friendly controlled acquirer that enhanced scrutiny will be triggered. b. If target is merged into a friendly acquirer that is already held by the public at large w/no single controlling shareholder or group, there will be no enhanced scrutiny.

4. Board may just say no – If board has not previously decided to put the company up for sale or dramatically restructure it, then the board basically has a right to reject unwanted takeover offers.

2. Defending against Hostile Takeovers – Cases a. Unocal Corp. v. Mesa Petroleum Co. (Del. 1985): Mesa was a stockholder in Unocal attempting a takeover that Unocal’s directors tried to fight by making an exchange offer from which Mesa was excluded.

ii. Rule – A court will not substitute its own judgment for that of the board of directors of a corporation that has decided to fight a takeover attempt by one of the shareholders in the absence of showing that the decision was primarily based on some breach of the directors’ duty. iii. Rationale

1. No duty owed to a stockholder in a corporation that would preclude the directors from fighting a takeover bid by the stockholder if the board determines that the takeover is not in the best interests of the corporation2. Selective exchange offer was reasonably related to the threats posed (inadequate and coercive two-tier tender offer) and fit within the directors’ duty to ensure that the minority stockholders receive equal value for their shares

b. Unitrin v. American General Corp. (Del. 1995): American makes a hostile takeover bid, Unitrin’s board resists by installing a “morning after” pill and repurchasing 20% of its shares. Share repurchase increases Unitrin directors’ stake from 23% to 28% and gives the board a solid veto power over a freeze-out transaction (due to 75% vote requirement for transactions with a >15% shareholder.)

ii. Chancery Court finds a threat of “substantive coercion” and upholds the pill as proportionate to the threat, but strikes down the repurchase as disproportionate under Unocal.iii. Delaware Supreme Court reverses “if the directors’ defensive response is not draconian (preclusive or coercive) and is within a ‘range of reasonableness,’ a court must not substitute its judgment for the board’s.”iv. Re-articulation of Unocal Proportionality requirement

1. Second step of Unocal is a two-part inquiry: a. Was defensive tactic “coercive” or “preclusive” and if not, b. Does it fall within a range of reasonableness.

2. Defendant directors have burden of showing proportionality. a. If D succeeds, then burden shifts to P to show breach of fiduciary duty (i.e. entrenchment, lack of good faith, or being uninformed)b. If D fails, it gets final opportunity to show entire fairness of the transaction

c. Moran v. Household International, Inc. (Del. 1985): Household International adopted a poison pill as a general anti-takeover device, as opposed to a response to a particular threat.

ii. Rule – a corporation may adopt a poison pill as a general anti-takeover device as opposed to a response to a particular threat. iii. Rationale

1. When corporate directors prove that they had reasonable grounds for believing that a danger to corporate policy and effectiveness existed, and that a defensive mechanism adopted was reasonable in relation to the threat posed, the deferential business judgment rule will be applied as the level of scrutiny to the directors’ decision2. Whether the response is to a particular threat or a general threat is of no great relevance3. Here, the Chancery Court found that the majority of Household’s board was concerned about a two-tier tender offer takeover and that the defensive measures taken were reasonable

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d. Smith v. Van Gorkom (Del. 1985): The board of directors of Trans Union Corp. voted to approve a merger agreement based solely on the representations of D, one of its directors.

ii. Rule – The business judgment rule shields directors or officers of a corporation from liability only if, in reaching a business decision, the directors and officers acted on an informed basis, availing themselves of all material information reasonably available. iii. Rationale –

1. The director has a duty to the corporation’s shareholders to make an informed business decision regarding a proposed merger before it is subjected to shareholder approval2. Subsequent shareholder ratification does not relieve the director from this duty, unless their approval is also based on an informed decision.3. In this case, the directors breached their duty of care by failing to conduct further investigation as to the proposed merger, and by submitting the proposal for shareholder approval without providing them with the relevant facts necessary to make an educated decision

e. Revlon, Inc. v. MacAndrews and Forbes Holdings, Inc. (Del. 1986): Solely to prevent a hostile takeover, the board of Revlon granted Fortsmann certain lock up options

ii. Rule – A board of directors cannot grant lock up options solely to prevent competitive bidding for a corporation iii. Rationale

1. When it appears that an active bidding contest for a corporation is underway, the board of directors, whose duty is to the shareholders, is under an obligation to do what it can to maximize the sale price for the benefit of the stockholders2. A lock-up is not necessarily illegal, and when it is done to prevent a takeover which would be detrimental to shareholders, it may be employed3. Where, however, the lock-up has no effect other than to prevent competitive bidding, thus depressing the stock’s price, the lock-up works not to benefit the shareholders, but rather it burdens them4. Here, it has not been shown that the lock-ups were designed to do anything other than stifle competitions, and this was improper

iv. Note – initial tender offer for Revlon was low, and the court did not argue w/the board’s early defensive measures b/c they drove up the price of the stock.

f. Paramount Communications v. Time, Inc. (Del. 1989): Paramount contended that anti-takeover measures enacted by Time’s directors in response to its tender offer were invalid b/c Paramount’s per-share offer amount was fair market value.

ii. Rule – A board of directors’ efforts to prevent a takeover via a tender offer will not be invalid merely b/c the takeover offer constituted fair market value. iii. Rationale –

2. Under Revlon, a directorate is under a duty to maximize shareholder prices only when it is clear that the corporation is “on the block,” meaning when a sale is a foregone conclusion.3. Time was not the object of a bidding war, and was not effectively up for sale, which would have triggered a duty under Revlon on the p arty of Time’s directors to maximize per-share-value. 4. This being so, for the business judgment rule to attach, the rule under Unocal is that a directorate may oppose a takeover if:

a. There are reasonable grounds for believing that a danger to corporate effectiveness and policy exist andb. The defensive measures adopted are reasonable.

5. A court should not, under Unocal, substitute its judgment for that of the corporation’s as to what is a “better” deal is.

a. First prong – Time’s board had decided, after long deliberation, that the Warner deal was in the best long term interest of the corporation. Had reason to worry about Paramountb. Second prong – Time’s response to the threat was reasonable – carried forward the pre-existing transaction in modified form.

g. Paramount Communications v. QVC Network, Inc. (Del. 1993)i. Facts – The Paramount board approved unusually restrictive contractual provisions to prevent unsolicited tender offers from interfering w/their intention to transfer control of Paramount to Viacom. ii. Rules

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1. A change of corporate control or breakup of the corporation subjects directors to enhanced scrutiny and requires them to pursue a transaction that will produce the best value for stockholders2. A board of directors breaches its fiduciary duty if it contractually restricts its right to consider competing merger bids.

iii. Rationale 1. A judicial determination must be made as to whether the board’s decision-making process was reasonable, and whether the board’s actions were reasonable given the existing circumstances.

a. By selling the controlling interest in Paramount to Viacom, the majority shareholders in Paramount would lose the ability to guide the corporation through the selection of directorsb. Therefore, the fiduciary duties of the directors require that they endeavor to assure that the shareholders receive the greatest possible value for their interests

2. Solicitation of competing bids for the corporation is a reasonable method to ensure that shareholder interests are properly valued

a. The board was under a duty to inform itself of all realistic options that might maximize the position of the shareholdersb. In this case, the Paramount board entered into highly restrictive contracts which prevented it from considering other offers – preventing it from fully informing itself.

3. Poison Pills a. Types of Poison Pills

i. “Flip Over” Pill –1. Gives target shareholders other than the bidder the right to buy shares of the bidder at a substantially discounted price. (after freezeout) 2. Allegedly derived from DGCL §157“Every corporation may create and issue … rights or options entitling the holders thereof to purchase from the corporation any shares of its capital stock.” Emphasis added.

ii. “Flip In” Pill 1. Might be illegal in California2. Gives target shareholders other than the bidder the right to buy shares of the target at a substantially discounted price.

iii. “Chewable” Pill – Pill disappears if fair price criteria are met (e.g. fully-financed, 100% offer for a 50% or more premium over current market price). iv. “Slow Hand” Pill

1. Illegal in Delaware but legal in Maryland, Virginia, Pennsylvania, and Georgia2. Pill that may not be redeemed for a specified period of time after a change in board composition.

v. “Dead Hand” Pill 1. Illegal in Delaware but legal in Maryland, Virginia, Pennsylvania, and Georgia2. Pill that may only be redeemed by the “continuing directors” so hostile board that is elected in a proxy fight cannot redeem the pill for a stated period of time. Another case ruled that current directors cannot restrict power of future boards.3. Delaware said it was illegal because it created 2 classes of directors without necessary charter authorization and unduly conditions rights of shareholders to elect new directors.

vi. “No Hand” Pill 1. Illegal in Delaware but legal in Maryland, Virginia, Pennsylvania, and Georgia2. Pill that may not be redeemed by current or future boards for the life of the pill (usually ten years).

b. Implementing a “Flip In” Poison Pill i. The flip-in is a provision in the target company's corporate charter or bylaws.

1. The provision gives current shareholders of a targeted company, other than the hostile acquiror, rights to purchase additional stocks in the targeted company at a discount rate. 2, These rights to purchase occur only before a potential takeover, and when the acquirer surpasses the "kick-in" or threshold point of obtaining outstanding shares (usually 20 - 50%).

ii. No potential acquiror or other shareholder will risk triggering a poison pill by accumulating more than the threshold level of shares because of the threat of massive discriminatory dilution, making it prohibitively expensive to obtain control through purchase. The threshold level therefore effectively sets a ceiling on the amount of stock that any shareholder can accumulate before launching a proxy contest.

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iii. Four steps:1. Rights plan adopted by board vote. Shareholder vote not necessary as long as the board has the requisite provision in the charter allowing it to issue blank check preferred stock.2. Rights are distributed by dividend and remain “embedded” in the shares.3. Triggering event occurs (it never does) when prospective acquirer buys >10% of outstanding shares. Rights are no longer redeemable by the company and soon become exercisable.4. Rights are exercised. All rights holders are entitled to buy stock at half price – except the acquirer whose right cancelled.

iv. In friendly deal, target wants to ensure that rights are not triggered, so it redeems the pillv. Poison pill can be good in that they allow company to defend against hostile bidder (can veto tender offer); can be bad because they deter potential bidders from value-creating transactions

c. “Dead Hand” Pillsi. Core idea – a pill cannot be redeemed by the “hostile” board that is elected in a proxy fight for a stated period of time.

1. Can take a variety of forms2. Radical idea – permit a board to limit the ability of shareholders to designate those with board power

ii. Carmody v. Dell Brothers (Del Ch. 1998)1. Delaware’s first case dealing w/dead hand pills2. Held that such a device was invalid because:

a. it created two classes of directors without the necessary authorization in the company’s charter andb. it unduly conditioned the rights of shareholders to elect new directors.

iii. Mentor Graphics Corp. v. Quickturn Design Systems (Del Ch. 1998)1. Facts – No discrimination b/t old and new directors. Delayed redemption provision - provided that, while generally the board had a redemption power, it had no such power for 6 months following the election of a new board (or a majority of new directors)2. Chancery Court - Struck down the pill based on a Unitrin/Unocal analysis. No abstract threat to the corporate made reasonable the imposition on the shareholders’ right to have fully functioning directors in place. 3. Del supCt – affirmed but did not invoke the Unocal/Unitrin principle

a. Was based on the statutory interpretation of directors’ powerb. Present board did not have the authority to restrict the power of future boards to exercise their managerial judgment. c. Rationale raises interesting questions – other things such as standard contracts restrict the power of future boards

d. Mandatory Pill Redemption Bylawsi. Requires the board of directors to redeem an existing pill and to refrain from adopting a pill without submitting it to shareholder approval.ii. Present two controversial issues

1. Is a bylaw that mandates the board to exercise its judgment in a particular way a valid bylaw?

a. Most leading Delaware firms have opined that a mandatory bylaw would constitute an invalid intrusion by the shareholders into the relam protected by section 141(a) of the DGCLb. Delaware courts haven’t reached a conclusion on this issue

2. Whether managers must include in the company’s proxy solicitation, materials respecting any such proposal.

a. Questions are related, if it is invalid, SEC is not going to require certification.iii. Unisuper v. News Corp. (Del Ch. 2005)

1. Facts – The News Corp. board of directors contended that an alleged agreement it had made w/shareholders to permit a shareholder vote on poison pills was unenforceable as a matter of law b/c it was inconsistent w/the grant of managerial authority to the board and b/c it would require the board to refrain from acting when the board’s fiduciary duties required action. 2. Rule – A K b/t a corporation’s shareholders and its board of directors to permit a shareholder vote on defensive measure is not invalid as a matter of law3. Rationale

a. The agreement here gives power to the shareholders, and not a third party, so it is saved from invalidation under the statute – shareholders are ultimate holders of power in the corporation, and exercise right to vote to exercise control.

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b. Board doesn’t disable its fiduciary powers by granting power to the shareholders – shareholders should be able to fill a particular gap in the corporate K if they want. c. When the shareholders, as principals, make explicit the corporate K on a given issue, the directors, as agents, must act in accordance with the amended corporate K, there is no longer the need for the gap filling role performed by the fiduciary duty analysis.

4. Closing the Deal a. Lock-up – any contract, collateral to an M&A transaction, that is designed to increase the likelihood that the parties will be able to close the deal

i. Two major categories1. Asset lock-ups – create rights to acquire specific corporate assets that become exercisable after a triggering event, such as a target shareholder vote disapproving a merger or a target board’s decision to sign an alternative merger agreement2. Stock lock-ups – options to buy a block of securities of the target company’s stock at a stated price

ii. Termination fees are often justified as necessary to compensate a friendly buyer for spending the time, money, and reputation to negotiate a deal with a target when a third party ultimately wins the target

1. Courts approve reasonable payments2. Boards of the target and acquiring companies see unique benefits from the favored transaction that the target’s shareholders may not recognize, and that these boards therefore wish to minimize the possibility that a third party might break up the deal

iii. In determining whether a lock-up is consistent with the board’s duties in a Revlon transaction, courts will weigh such considerations as how early in the process the lock-up was given and the value-enhancing nature of its specific termsiv. Buyers rights under “deal protective” provisions are commonly triggered by:

1. Failure of the board to recommend a negotiated deal to shareholders in light of the emergence of a higher offer (thus employing a “fiduciary out,” which is discussed in the next section)2. A rejection of the negotiated deal by a vote of the target’s shareholders3. Later sale of assets to another firm

b. “No Shops/No Talks” and “Fiduciary Outs”i. For acquirers in corporate mergers, the legal requirement that the target’s shareholders vote approval introduces an irreducible contingency into merger contracts – a second bidder might offer a price before the shareholders vote and the deal closesii. Buyers protect against this risk in two ways

1. Seek a large lock-up, as described above2. Seek certain covenants from the seller that will protect their deal

a. Ex: not to shop for alternative transactions or supply confidential information to alternative buyersb. To submit the merger agreement and no other agreement to the shareholders for approvalc. To recommend that shareholders approve this agreement

iii. When a better deal arrives before the shareholder vote, can the target’s board continue to recommend the less attractive original deal without violating their duty of loyalty? Or face contractual damages?

1. “fiduciary out” clause – if some triggering event occurs, then the target’s board can avoid the contract without breaching it

5. Shareholder Lock-ups – a. Omnicare, Inc. v. NCS Healthcare, Inc. (Del. 2003)

i. Facts – Omincare sought to acquire NCS Healthcare. Genesis Health Ventures had made a competing bid for NCS that the NCS board had originally recommended, but then withdrew the recommendation and instead recommended that the shareholders accept the Omnicare offer, which was worth more than twice the Genesis offer. However, the agreement b/t Genesis and NCS contained a provision that the agreement be placed before the NCS shareholders for a vote, even if the board no longer recommended it. There was also no fiduciary out clause in the agreement. Pursuant to voting agreements, two NCS shareholders who held a majority of the voting power agreed unconditionally to vote all their shares in favor of the Genesis merger, assuring it would prevail. Omnicare challenged the defensive measures that were part of the Genesis transaction.ii. Rule - Lock-up deal protection devices, that when operating in concert are coercive and preclusive, are invalid and unenforceable in the absence of a fiduciary out clause

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iii. Rationale 1. Apply Unocal, not Revlon b/c no sale of control or break up. 2. First prong – the Genesis defensive measures were unreasonable and not proportionate to the threat – left NCS w/no alternative transaction3. Second prong – defensive measures were both preclusive and coercive, and, therefore, draconian and impermissible - completely prevented the board from discharging its fiduciary responsibilities to the minority stockholders when Omnicare presented its superior transaction4. Defensive measures – the voting agreements and the provision requiring a shareholder vote regardless of board recommendation – when combined to operate in concert in the absence of an effective fiduciary out clause are invalid and unenforceable

iv. Dissent 1. NCS board’s actions should have been evaluated based on the circumstances present at the time the Genesis merger agreement was entered into – before the emergence of a subsequent transaction offering greater value to the stockholders2. The lock-ups were reached at the conclusion of a lengthy search and intense negotiation process in the context of insolvency, at a time when Genesis was the only viable bidder3. Under these facts, the NCS board’s action before the emergence of the Omnicare offer, reflected the actions of “a quintessential, disinterested, and informed board” made in good faith, and was within the bounds of its fiduciary duties and should be upheld4. Any bright-line rule prohibiting lock-ups, such as the one put forth by the majority, could, in circumstances such as those faced by the NCS board, chill otherwise permissible conduct

b. Orman v. Cullman, (Del Ch. 2004) i. Facts – Through dual class structure Cullman family owns controlling interest in General Cigar since IPO in February 1997. January 2000 Swedish Match agrees to buy out minority shareholders of General Cigar at $15.25 per share cash, such that Swedish Match would own 64% and the Cullman family would own 36% of General Cigar (with Cullmans still retaining control).

1. Merger agreement contained:a. No breakup feeb. A fiduciary out that allowed General Cigar to consider an unsolicited superior proposalc. A class vote of the A and B shares separatelyd. A majority of the minority approval (effectively) from the Class A shareholders

2. Cullman family agreed to vote their controlling interest for the Swedish Match transaction and against any alternative acquisition proposal for 18 months after any termination of the merger.

ii. Chancery court upholds shareholder lockup: “In Omnicare the challenged action was the directors’ entering into a contract in their capacity as directors. The Cullmans entered into the voting agreement as shareholders… Unlike Omnicare, the public shareholders were free to reject the proposed deal, even though permissibly their vote may have been influenced by the existence of the deal protection measures.”

6. State Anti-takeover Statutes a. First Generation of anti-takeover statutes

i. Addressed both disclosure and fairness concernsii. Was generally limited to attempted takeovers of companies w/a connection of the enacting statuteiii. E.g. Illinois Business Takeover Act of 1979

1. Required any offer for the shares of qualifying target companies to be registered w/the secretary of state, after which the offer entered a 20 day waiting period and then become registered unless during that period the secretary called a hearing to adjudicate the fairness of the offer.2. Secretary had discretionary power to call hearing, but was required to do so if requested by the target’s outside directors 3. Would deny if offer failed to provide full disclosure or was inequitable and would impart fraud and deceit 4. In 1982 – Supreme Court struck down this Act as preempted by the federal Williams Act & in violation of the Supremacy clause

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b. Second generation of statutes then attempted to avoid preemption by the Williams Act by maintaining an appropriate balance between the interests of the offerors and the targets within the overarching policy of investor protection.

i. E.g. “Fair price statute” – deters coercive two tier takeovers by requiring that minority shareholders who are frozen out in the second step of such a takeover receive no less for their shares than the shareholders who tendered in the first step of the takeover.

1. Typically achieved by requiring a high supermajority vote to approve a freeze out merger unless it provides a “fair price”

ii. E.g. “control share statute” – resists hostile takeovers by requiring a disinterested shareholder vote to approve the purchase of shares by any person crossing certain levels of share ownership in the company that are deemed to constitute “acquisition of control”

1. Ohio enacted a statute in 1982 that became a model for other states2. Indiana enacted a statute that varied the model by allowing the bidder to cross the relevant ownership thresholds without obtaining shareholder approval but w/an automatic loss of voting rights.

a. The offeror could regain voting control upon gaining approval from a majority of disinterested shareholders.b. Statute was upheld in case below

iii. CTS Corp. v. Dynamics Corp. of America (1987)1. Facts – Indiana enacted a statutory scheme requiring shareholder approval prior to significant shifts in corporate control. 2. Rule – A law permitting in state corporations to require shareholder approval prior to significant shifts in corporate control is constitutional.3. Rationale – Corporations are creatures of state law, and states are free to formulate policy regarding the internal operations of corporations, provided they do so in a non-discriminatory manner, which is the case here.

c. Third Generation Anti-takeover statutes (1987-2000)i. Followed logically from the SupCt holding in CTS that state antitakeover legislation is consistent w/both the Williams Act and the Commerce Clause if it allows a bidder to acquire shares, even if it makes such acquisition less attractive in some circumstances. ii. “Business combination statute” – aka moratorium statute

1. Prohibits a corporation from engaging in a “business combination” within a set time period after a shareholder acquires more than a threshold level of share ownership2. Some statutes allow merger to proceed if a statutory fair price is paid3. DGCL 203 – its moratorium statute

a. Meant to deter “junk bond” financed “bust up” takeovers by preventing acquirers from getting their hands on the assets of target firmsb. Two “outs” that may affect the planning of an acquisition

i. Statute’s restriction does not apply if the bidder can acquire 85% of the outstanding voting stock in a single transaction. ii. Its restrictions do not apply if after acquiring more than 15% but less than 85%, a bidder can secure a 2/3 vote from the remaining shareholders (other than itself) as well as board approval.

c. Defines the term “business combination” narrowly so as only to cover transactions between the target and the bidder or its affiliates.

iii. Disgorgement statute – PA and Ohio1. Mandate the disgorgement of profits made by bidders upon the sale of either stock in the target or assets of the target.2. Any bidder who acquires a fixed percentage of voting rights, including (in some acts) voting rights acquired by proxy solicitation, is subject to this statute. 3. Under PA statute – any profit realized by a controlling person from the sale of any equity security of the target within 18 months of becoming a controlling person belongs to the target.4. Ohio statute – more circumscribed – provides safe harbors to management proxy solicitations.

iv. Redemption Rights Statute – Allows shareholders to bring an appraisal action not merely for freeze out mergers but also whenever a person makes a “controlling share acquisition,” defined as acquisition of 30% of a corporation’s stock.v. Constituency statutes

1. Allow (or in some states require) the board of a target corporation to consider the interests of constituencies other than the shareholders when determining what response to take to a hostile takeover offer.

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2. Deter takeovers by releasing directors from some of the fiduciary constraints imposed by caselaw, allows the board to use broader justifications. 3. Example of Indiana’s statute

a. Alters the content and judicial scrutiny applied to director’s duties.b. Rejects Delaware’s imposition of enhanced scrutiny and instead referred solely to “good faith exercise of business judgment after reasonable investigation” as the measure of a directors duty.

7. Proxy Contests for Corporate Controla. Schnell v. Chris-Craft Industries (Del. 1971)

i. Facts – Ds managing directors amended the bylaws in accordance w/the new DGCL, advancing the date of the annual stockholders meeting. ii. Rule – Inequitable action does not become permissible simply b/c it is legally permissible.iii. Rationale

1. There is no indication of any prior warning of management’s intent to amend the bylaws to change the annual stockholders’ meeting date.2. Rather it appears that management attempted to conceal this action as long as possible.3. Stockholders may not be charged with the duty of anticipating inequitable action by management and of seeking anticipatory injunctive relief to foreclose such action. 4. Until management changed the date of the meeting, the stockholders had no need of judicial assistance.

iv. Dissent – in view of the length of time leading up to the immediate events that caused the filing of this action, the lower court was correct that the application for injunctive relief came too late.

b. Blasius Industries, v. Atlas Corp. (Del. Ch. 1988)i. Facts – The Board of Directors of D sought to prevent P from obtaining shareholder approval of its plan to enlarge the board by voting to expand the board to give control to an insurgent group. ii. Rule – A board of directors may not enlarge the size of the board for the purpose of preventing a majority of shareholders from voting to expand the board to give control to an insurgent group. iii. Rationale

1. Shareholder franchise is the ideological basis for directorial power.2. The only legitimate reason why a select group of persons can control assets not belonging to them is a mandate from those who do control the assets.3. Consequently, any effort made by the directors to frustrate the will of the majority, even if taken for the most unselfish of reasons, must fail.4. Any attempt to frustrate shareholder voting cannot stand up to a challenge

c. Notes on Schnell and Blasiusi. Judicial review under these cases is perhaps the most exacting under corporate law – unequivocally reverses the business judgment presumption – director action that interferes with the voting process is presumptively inequitable. ii. But these two cases do not always apply – since manipulations of the voting process can be characterized as “defensive” courts may apply the Unocal test to them (less demanding)iii. In both instances directors have the burden to establish compliance w/a relative standard iv. Differences b/t Unocal and Blasius review

1. Blasius requires a very powerful justification to thwart shareholder franchise for an extended period – But a week or two may allow a less compelling justification2. Time Warner opinion seems to authorize a target board to take defensive action of the company is threatened by “substantive coercion” (which basically means the company knows best) – this excuse cannot be used under Blasisus review

d. Hilton v. ITT Corp. (D. Nev. 1997)i. Issue – whether certain defensive actions by the ITT board in response to a Hilton takeover attempt constituted a violation of fiduciary duty. ii. Facts – ITT board tried to reorganize w/o shareholder vote to prevent takeover by Hilton. Hilton said action was to protect the incumbency of the board and constituted a breach of fiduciary duty.iii. Court first determined that the ITT board could reasonably conclude that Hilton’s offer was inadequate. Then considered whether the defensive action was preclusive or coercive – said it was both – the new provision would preclude current shareholders from exercising a right they currently possess – to determine the membership of the ITT board.

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