Corporations Outline:

Introduction to Corporate Law:

Participants in the Corporate Structure:...............................................1Foundations for Corporate Law:............................................................2Management of Corporations................................................................4Fiduciary Duties....................................................................................5Corporate Finance (could spend some additional time here).............13Disregarding the Corporate Entity (Piercing the Corporate Veil)......15Civil Liability – Rule 10(b)-5 Claims....................................................19Insider Trading....................................................................................23Shareholder Voting:.............................................................................27Corporate Acquisitions, Takeovers, and Control Transactions...........35The Williams Act:.................................................................................44Mergers:..............................................................................................45Partnerships, Limited Partnerships, LLCs...........................................47

Participants in the Corporate Structure: Managers:

o Appointed by the Board of Directors to run the company (can also be removed by the board)

o Encompasses the CEO, CFO, COO, etco CEO tenure has decreased in recent years as a product of

investor activism, global competition… This is one reason for the increased pay-rate

demanded by CEOs Directors:

o Independent Director Director that has no direct or indirect relationship

with the companyo Outside Director

Directors that have no employment or consulting role with the company outside of the director relationship

An outside director may, however, have an interest in the wellbeing of the company through another relationship

o Audit Committee: Boards of Directors typically act through committees

– one being the audit committee Maintains oversight over the company’s accounting

and financial reporting processeso Board of Directors:

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Members of the board, individually, can do nothing – the only power that exists is vested in the board as a whole.

The board only has the power to act when it is in a meeting:

The meeting must be duly called (according to the rules outlined in the bylaws, charter, etc.)

Action by Consent – If there is a resolution that is signed by all the directors, it can have the authority of the board.

o Not used in all situations because there is no deliberation and consensus after a thorough discussion (can pose a problem in a lawsuit)

o Post-Enron: Revised listing standards from NYSE and Nasdaq Majority independent boards are required Listed companies must have a nominating

committee (for hiring) and a compensation committee comprised entirely of independent directors

Tighter definition of an independent director (pg 12) Shareholders:

o Two basic features characterize ownership in public companies:

Ownership is dispersed among participants in the market

A significant percentage of the ownership lies with institutional investors (pension funds and mutual funds)

o Shareholder activism Different shareholders have different goals

Pension funds are typically “buy and hold” investors and therefore have more incentive to engage in proxy battles and litigation

Mutual funds are active traders and will simply sell their investment in a stock and move the money elsewhere

Foundations for Corporate Law: The fundamental place to start is State corporation law:

o Model Business Corporation Act Most states follow this act (some more closely than

others)

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o Delaware: Not a model state, but the majority of corporations

and the value of those corporations dwarfs the rest of the country combined

Why is DE so popular? Race to the Bottom Theory:

o Delaware’s statute is designed to give management leverage and flexibility in designing corporate charters

o “Pro-management”o Even though DE has a franchise fee,

corporations are willing to locate there because of the benefits

Race to the Top Theory:o If a state made a rule that was too lax,

investors would not want to put their money in a corporation located there

o Investors like investing in Delaware corporations – therefore the rules must be advantageous

Other reasons:o Delaware is very efficient in dealing with

all things corporate (filings, paperwork, etc.)

o The court system has evolved to benefit corporations and shareholders alike (access to the courtroom, jurisprudence, a court that is devoted to corporate law)

Federal Laws: Basically deal with disclosure Securities Exchange Act of 1933 (302):

o Regulates transactions in securitieso Basic strategy:

Create a mandatory system of disclosure – limited to the initial distribution of securities

If investors were provided with all the material information about a security there would be no unfair informational advantages

o SEE BELOW FOR MORE DETAIL Securities Exchange Act of 1934 (303):

o Created a continuous disclosure systemo A corporation is subject to the ’34 Act if:

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It lists its securities on a national securities exchange, or

Any class of its equity securities is held of record by at least 500 personsand the corporation has gross assets over a specified level, or

The corporation files a ’33 Act registration statement that becomes effective

o SEE BELOW FOR MORE DETAIL Sarbanes-Oxley Act of 2002

o Serves as an amendment to the Exchange Acts

o A public company cannot loan money to its executives or directors

o Created the Public Company Accounting Oversight Board

Oversees the audit of public companies that are subject to the securities laws

The board has rulemaking authority with respect to auditing, attestation, quality control and ethics

Section 201 – prohibits accounting firms from providing a variety of non-audit services to an audit client (controversial)

Requires securities exchanges to adopt listing standards under which a corporation’s audit committee must be composed entirely of independent board members

Stock Exchange Rules Self-regulatory organizations – hybrid public

private enterprises If you are listed on an exchange, you pay for

the privilege and the exchange actively markets itself

Stock Exchanges are strictly regulated by the SEC – therefore they have to enforce their own rules

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o Prevents the inevitable conflict of interest when an organization has to regulate its own customers

Charters: Certificate of Incorporation / Articles of

Incorporation Amendment requires both board and

shareholders Bylaws:

Laws that the Board or Managers have enacted and must abide by

Either the shareholders or the directors can amend the bylaws

Bylaws cannot contradict the law above – cannot contract out of the law by passing a bylaw

Management of Corporations Management of the regular business affairs is vested in the

Board of Directors, who have been elected by the shareholders Officers of the corporation are normally appointed by the Board Fundamental corporate changes require approval by the

shareholders, usually on recommendation by the Board Officers of the Corporation:

o Authority: Menard (59):

Actual Authority – Has the board given the agent (officer) the authority to engage in a particular act?

Apparent Authority – Has the board implied (to the third party) that the agent has the authority to act?

o The board’s direct or indirect manifestations to the third party and not from representations of the agent himself

Inherent Authority – The power of an agent that is not derived from authority or apparent authority, but solely from the agency relation and exists for the protection of persons harmed by or dealing with a servant or agent

Authority is based on an individual’s office or station within a company

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General Rule – The court is going to find in favor of the party that acted the most reasonably

Treasurer’s Authority Goth v. Anaconda (63):

o Kraft, treasurer, signed a guarantee for a friend

o Court found no actual or apparent authority

o Cannot be inherent authority – this line of dealing has nothing to do with the business

o Bank should have acted more reasonably and looked for confirmation from the board or the CEO

Ultra Vires Doctrine: Originally – A corporation could only act to

accomplish the specific goals it was established to accomplish

o i.e. Coca Cola could not go into the real estate business because it was specifically formed to sell beverages

To prevent overarching monopolies, corporate charters included language stating the specific line of business that the corporation intended to engage in – and the corporation was limited to this line of business

Delaware eventually moved to broaden a corporation’s abilities

Ultra vires can still be raised in some contexts:o Corporate guarantees of third party

debts that do not benefit the corporationo Non-profits – excessive charitable

contributions may be viewed as wasteful and ultra vires

Fiduciary Duties Fiduciary Duty:

o Generally defined as one who is given power that carries a duty to use that power to benefit another

o The primary problems faced by shareholders are mismanagement of the business or unfair self-dealing by those in control of the corporation

o Sliding Scale:

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There is a tension between the different analyses that a court will use in a breach of fiduciary duty case (ranging from the Business Judgment Rule to a Fairness Analysis)

Plaintiffs and Defendants want different levels of scrutiny from the court (the ones that benefit each party the most)

The court “slides” along the scale of options to provide the most amicable result based on the facts presented in the case

Duty of Care:o Requires directors to perform their duties with the

diligence of a reasonable person in a similar circumstanceo Duty of Care issues typically come up in two contexts:

There is a decision made in a negligent manner There is a failure to act or monitor where a loss

could have been prevented o Business Judgment Rule:

The Golden Rule of corporate law The Business Judgment Rule is a rebuttable

presumption that directors in performing their functions are honest and well-meaning, and that their decisions are informed and rationally undertaken

Justifications: Encourages corporate risk-taking – without

the business judgment rule directors may not take the risks necessary to maximize profits

Avoids judicial meddling – judges don’t want to make business decisions

Encourages directors to serve – w/o the Rule, directors may not have the incentive to join boards in the first place

o Overcoming the Business Judgment Rule: As a plaintiff, you must overcome the business

judgment burden in court Must show:

The action by the board was not in good faitho Fraud, conscious disregard, the act was

illegal, director had a conflict of interest The action lacked a rational business purpose Gross negligence on the part of the board Inattention – directors are not exercising their

oversight duties

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o Director cannot sit by if he knows that the CFO is embezzling money

o Cases: Wrigley:

Shareholders want Cubs to play night-ball, but the majority shareholder doesn’t believe baseball should be played at night

Court dismisses the plaintiffs argument because Wrigley claimed the reason for not playing baseball at night was the potential degradation to the surrounding neighborhood and loss of real estate value

o Even though this reasoning is relatively ludicrous, the court didn’t want to take it any further – the board had a reason, it wasn’t entirely irrational, so it passes muster

Miller v. AT&T AT&T did not collect on a phone bill to the

DNC While the board may have been able to come

up with a reason for this, there is a law in place (campaign finance) that forbids such actions

Because there was a financial DAMAGE to AT&T because of the board’s actions, the shareholders were allowed to bring suit – otherwise fiduciary cases cannot be used as a vehicle to get you into court

Smith v. Van Gorkom (Trans Union) When are directors not informed? The court used the Gross Negligence standard

here The directors claimed they weren’t grossly

negligent:o They got a substantial premium on the

company’s stocks over the current market value

o The merger contract allowed for a market test

o The board was knowledgeable about the business

o The board had relied on counsel’s advice that failure to accept the bid would result in litigation

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The court did not agree:o Even though they got a substantial

premium, it was useless without valuation information from elsewhere to validate the offer price

o Market test was not useful – Trans Union was not allowed to ask for other bids, only accept them

o The directors had only discussed the events of the offer briefly and never got a financial consulting firm to validate the deal

Lessons:o The court does not want to look at the

result of a decision, but the process Therefore, even if you get a good

result, the process leading up to it needs to be good

o Any time a board is making an important decision, they have to sit down and genuinely deliberate

All that matters if a decision goes to court is whether the board deliberated properly

DGCL 102(b)(7)o Enacted after Van Gorkomo Eliminates monetary damages for breach

of duty of care cases Still liable for acts not in good

faith or breaches of the duty of loyalty

o Essentially takes the teeth out of the duty of care

In re Walt Disney: Post-DGCL 102(b)(7) The actions taken by the board weren’t great,

but they did not rise to the level of recklessness

After 102(b)(7), negligence is not enough to recover, the board must hit recklessness

Stone v. Ritter: Director Oversight is subject to review under

the duty of good faith – which is a subset of the duty of loyalty

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o This was unclear before this case Duty of faith issues arise when there:

o Is an intentional act in not advancing the corporation’s best interest

o Is an intent to violate positive lawo Intentionally failing to act in the face of

a duty to act There are two categories:

o If the board fails to consider an option that could be a threat or problem – this could be a breach (ie forgets to follow the law

o If the board considers the option, but fails to implement anything to mitigate the problem

Duty of Loyalty (110):o Requires the fiduciary to act for the best interests of their

corporation and in good faith Can involve intentional dereliction of duty, or actual

intent to cause harm to the corporation, or a conflict of interest where an individual’s interests will be elevated above that of the corporation

o Common law rule: A corporate contract with one or more of its

directors – or with another corporation or business enterprise in which one or more of the directors was associated as a manager, shareholder, or partner – was voidable irrespective of fairness

Became more liberalized over timeo Modern Rule:

The general rule is that no transaction of a corporation with any or all of its directors was automatically voidable at the suit of a shareholder, whether there was a disinterested majority of the board or not; but that the courts would review such a contract if it was found to be unfair to the corporation

o Burden of Proof: Once a challenger shows the existence of a conflict

of interest, it is up to the challenged director to prove the conflicted transaction’s validity (see below – depends on state)

Under a duty of loyalty analysis – the defendants are not afforded the protections of the business judgment presumption (bolster this)

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o Judicial Fairness Tests: Substantive Fairness:

Did the director’s interest win out over the corporation’s interest?

o Objective test – is the price paid reasonable?

o Value to corporation – was the transaction valuable to the corporation?

Procedural Fairness: Whether the directors who approved the

transaction lacked independence and acceded to their interested colleague? Elements to consider include:

o Was everything disclosed to the board?o What was the composition of the board?o What role did the interested director

play in the transaction’s initiation, negotiation and approval

o Statutes dealing with interested directors: Weak Form Approach:

Follows the common law approach to an extent

Contracts must be fair – the burden of proof always falls to the fiduciary

Cookies Food – Burden of proof belonged to Herrig through the entire case to prove that he had not breached the duty of loyalty

o The majority felt he carried that burdeno The dissent felt that he did not meet the

burden even though the court had interpreted the law correctly

o This is arguably the hardest test to pass – see below – and yet the court has determined that Herrig passed it

Iowa Statute:o The contract or agreement shall not be

voidable if: the interest is disclosed and the interested director does not vote; the interest is disclosed and the shareholders authorize the agreement; the contract or transaction is fair and reasonable to the corporation.

Semi-Strong Approach: Statutory compliance with disinterested

director approval shifts the burden of proof

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from the defendant to the plaintiff but retains a fairness test

New York Statute – 119 California Statute – 120

Strong Form Approach: Approval by the disinterested board would

generally limit judicial inquiry. Disinterested board approval shifts the burden to the plaintiff and removes the fairness inquiry

o Special Case – Parent Subsidiary Dealings Dealings between a controlling shareholder (the

parent) and the corporation (the subsidiary) raise many of the same conflict-of-interest concerns as do dealings between a director and the corporation.

Wholly owned subsidiaries: Few problems here – virtually unfettered

discretion to do whatever you want with the subsidiary

Partially owned subsidiaries: This is where the problems can occur – if the

parent (as the majority stockholder) forces the subsidiary to do something against its interest, there may be grounds for a suit

o Unfavorable contract termso Dividend policy

Judicial Review: Dichotomy:

o If the plaintiff can show clear parental preference for a transaction (burden starts with the plaintiff to show preference) – the court should apply the Intrinsic Fairness Test:

Under this test, the burden then shifts to the defendant to prove that its transactions with the subsidiary are objectively fair

o If the plaintiff cannot show that the transaction is clearly preferential to the parent, the court will apply the Business Judgment Rule

Sinclair Oil v. Levien (131): The court applied the business judgment rule

to the allocation of dividends because all shareholders got their fair apportionment.

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It does not matter that the minority shareholders were claiming that this aided the parent – the minority did not effectively prove that the transaction was clearly preferential to the parent

o Special Case – Compensation of Managers Forms of Compensation:

Salaries and bonuses – direct compensation Stock plans – incentive compensation Pension plans – deferred compensation

Judicial Review of Compensation: Executive compensation plans have to be

authorized by the board – if this approval comes after work by a disinterested, independent compensation committee and it is approved by informed, independent, disinterested directors, it should avoid a fairness review in court

Courts often defer to the decisions of directors when dealing with compensation – especially independent directors

Lack of good faith (which violates the duty of loyalty) could provide a platform for plaintiffs if it can be proven

o Backdating stock options is one example Waste Doctrine:

o If compensation is approved by a board of independent, disinterested directors, the plaintiffs may attempt to show that there is no relation between the compensation level and the executive’s services only then will the court consider interfering with the director’s approved compensation level

o Rogers v. Hill – tobacco case (140)o Walt Disney –

“plaintiffs must shoulder the burden to prove that the exchange was so one-sided that no business person of ordinary sound judgment could conclude that the corporation has received adequate consideration

Corporate Opportunities Doctrine

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Subset of the Duty of Loyalty – balances the corporation’s expansion potential and the manager’s entrepreneurial interests

Corporate managers have a duty to loyally put corporate interests ahead of their own

o This includes taking a profitable business opportunity away from the corporation

Irving Trust Co. v. Deutsch (161)o Company wanted to purchase stock of

affiliate to gain access to patents. Company didn’t have the funds necessary to purchase the stock – a group of directors and employees came forward and offered to purchase the stock and provide the benefits of access to the patents to Company. Company agreed.

o Individuals later sold their stocks for a significant profit, although Company was not effected because it already had access to the patents

o Issue: whether the prohibition against corporate officers acting on their own behalf is removed if the corporation itself is financially unable to enter into the transaction?

o Holding: No. Directors of a solvent corporation are forbidden from taking for their own profit a corporate contract on the plea of the corporation’s financial inability to perform.

Policy: without this rule, directors might not try very hard to get funding before simply opting to fund ventures themselves – and capitalize.

This rule does not apply to employees who don’t have fiduciary duties

Rapistan Corp. v. Michaels (167):o Guth Rule: If there is presented to a

corporate officer a business opportunity which the corporation is financially

able to undertake,

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which is, from its nature, in the line of the corporation’s business and is of practical advantage to it,

is one in which the corporation has an interest or a reasonable expectancy, and

by embracing the opportunity, the self-interest of the officer or director will be brought into conflict with that corporation,

the law will not permit him to seize the opportunity

o Guth Corollary: When a business opportunity

comes to a corporate officer in his individual capacity rather than in his official capacity, and the opportunity is one which, because of the nature of the enterprise, is not essential to his corporation, and is one in which it has no interest or expectancy, the officer is entitled to treat the opportunity as his own, and the corporation has no interest in it

Burg v. Horn (170):o Court does not apply the line of business

test – here, one party had already been investing in real estate when the corporation was formed and that party was also not a full-time or a fully-invested member of the corporation. Therefore, the corporation did not have the expectancy that these opportunities would belong to the corporation.

Tests for whether Corporate Opportunities exist: Interest / Expectancy Test

o Corp has an interest in an opportunity if it has some contract right regarding the opportunity

o Corp has an expectancy concerning an opportunity if existing business arrangements lead it to reasonably anticipate being able to take advantage of the opportunity.

Line of Business Test

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o Corporate opportunity exists if: closely related to the corp’s existing or prospective activities

Fairness Test o Court measures the overall unfairness

which would result if Dir. Took Opp for himself.

Corporate Finance (could spend some additional time here)

Time Value of Money:Present Value = Future Value / 1+r

This is present value for a future value of one year in the futureIf you want to do multiple years in the future you take it to the power of that number (see example on 181.

Present value is used to determine the feasibility of a projectIf the net present value is a positive number, the project will likely be a good one for the firm to undertake

Net Present ValueTakes account of the cost of money and produces an answer to the question whether a project is worthwhile or not.It will also indicate which of two or more projects of equal size is the most profitable.

Expected ValueThe return for an uncertain investment is called the expected value, which is the average of all possible returns weighted by

Stock Options:o Calls:

Gives the holder the right to purchase from the writer of the option a specific asset at a specified price (strike price) at a specified time.

If the value of the asset is greater than the exercise price at maturity, it is in the money and will be exercised

Common stock in a corporation that has also issued debt has the characteristics of a call option – if the debt comes due and the corporation cannot repay it, the corporation goes into re-org and there is a chance that the stockholders get eliminated

o Puts:

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A put option giver the holder the right to sell to the writer of the option a specified asset at the exercise price.

If the value of the underlying asset is less than the exercise price it is in the money and will be exercised

o The Determinants of Option Value (Black Scholes(sp) formula) (equations on 212-216):

The current value of the underlying asset The exercise price The time value of money (see above) The variability of the underlying asset (this is

probably the most important element) Bond holders are much less accepting of

volatility Stockholders, on the other hand, are more

accepting of volatility (based on the potential upside)

The time to expiration Stock:

o Common Stock Can actually be a form of option

If debt is issued it will come due at a certain point

At this time, the company will either be worth more than the outstanding debt or less

o If the company is worth more than the debt issued, the stockholders will pay back the debt and take the remaining upside and keep the business

o If the company is worth less than the outstanding debt, the stockholders will not exercise the option to repay the debt and will instead hand the company over to the bold holders

Preferred Stock:o Midway on the continuum between common stock and

debto Like stock in that its claim to income and assets is

subordinate to that of debto Like debt in that its claim to income and assets is superior

to stock Dividends:

o Payments to shareholders that represent a current return on investment – paid at the discretion of the directors

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o Legal requirements for payment of dividends differs among states

o Basic Principle – don’t permit payment of dividends in cases where the payment will adversely affect investors or creditors

If dividend payments deplete a company’s capital creditors and stockholders could be harmed in the future

Efficient Capital Market Hypothesis:o The share price set by the market can be a benchmark for

the performance of the business and its management In order for this to work, the shares must be traded

in an efficient marketo The Efficient Capital Market Hypothesis claims that the

numerous active traders in the stock market react quickly and efficiently to information whenever new information is available about a company, it is immediately reflected in the stock price.

o Three levels of market efficiency: Weak form efficient – prices reflect all information

about past stock prices (the idea that the price is only indicative of historical information)

Semi-strong form efficient – prices also reflect all publicly available information such as financial statements and earnings reports

Strong form efficient – prices reflect not only public information but private information as well

There are significant arguments for the idea that markets are not rational at all and therefore, do not encompass information from sources

Kamin v. American Express:o AMEX made a bad business investment and purchased a

company whose stock later plummetedo AMEX decided to issue a special dividend to shareholders

and give the company away to themo Stockholders filed suit saying that AMEX should have sold

the stock at a loss and then written the loss off on their books

o AMEX says it does not want the bad press from selling the stock (will impact stock prices poorly)

o Court says that is fineo This is a duty of care question – similar to Wrigley

The court does not want to look into the reasons behind a decision, as long as there are reasons

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Disregarding the Corporate Entity (Piercing the Corporate Veil) Party attempts to hold the shareholders, directors and officers

of a company personally liable for some actiono Normally, the individuals behind a corporation are

protected by limited liability for the actions of the corporation

In these cases, the corporation has been legally formed – there are no issues with incorporation

A frequent example occurs where a party wants to hold an individual, who is also the sole shareholder for a company, liable for actions of that company

o Often the individual is another corporation – a wholly owned subsidiary

How to Pierce (Plaintiff bears the burden to prove these):o Shareholder must control and dominate the corporationo There must be fraud, injustice or unfairnesso The Plaintiff must show harm

Factors in Piercing:o Inadequate Capitalization – was the corporation purposely

structured so that there were few or no assetso Corporate formalities observed – its easy to tell if the

corporation observed formalitieso Fraud or injustice – Was there a misrepresentation?

Would the adherence to the fiction of a separate legal entity sanction a fraud or injustice?

o Was the entity simply the alter-ego of the shareholder?o Are you piercing to reach an individual or a corporation?

Easier to reach another corporation because it doesn’t defeat the idea of limited liability (as much)

Easier to pierce to reach fewer shareholders rather than more

Perpetual Real Estate v. Michaelson Properties:o Contract claim against individualo Alter Ego Test

The corporate entity was the alter ego of the individuals sought to be personally charged

Easily proven in this case The corporation was a device or sham used to

disguise wrongs, obscure fraud, or conceal crime Hard to prove here

o Piercing not allowed Kinney Shoe Corp. v. Polan

o Contract claim against individualo Suit to recover on sublease

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o Test: Is the unity of interest and ownership such that the

separate personalities of the corp and the individual shareholder no longer exist?

Would an equitable result occur if the acts were treated as those of the corp alone?

Court assumes that the creditor has conducted an investigation prior to entering into a contract – otherwise it is on the creditor and piercing is not allowed

o Piercing is allowed because of the failure to observe corporate formalities

Its important to observe formalities!! Sub-Topic – Parent Subsidiary Relationships

o Is it possible for a claimant to make a claim against a subsidiary’s parent if the sub doesn’t have the assets to fulfill a claim?

o Fletcher v. Atex Tort claim trying to reach the parent corporation Test: Plaintiff must show

The parent and the subsidiary operated as a single economic entity

That an overall element of injustice or unfairness is present

Factors for whether parent and sub act as a single economic entity:

Whether the corporation was adequately capitalized for the corporate undertaking

Whether the corporation was solvent Whether the dividends were paid, records

kept, officers and directors functioned properly, and other formalities were observed

Whether dominant shareholder siphoned corporate funds

Corporate Disclosure and Securities Fraud Why do we need securities fraud laws?

o Without them there would be very little trust in the marketplace and theoretically, the volume of trading that takes place would be significantly diminished

o Required disclosure allows the market to accurately assess information

Securities markets are different than other markets in that you cannot touch the product, you don’t want

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the current product (the stock), you want the promise of future returns

o There are general anti-fraud laws, but they don’t cover the range of needs presented by securities

o Most individuals agree that some level of securities regulation is necessary the debate occurs when discussing how much regulation is necessary

Securities Act of 1933:o Basic strategy of the act was to create a system of

mandatory disclosure to supplement the preexisting law of fraud

If investors were provided with all material information about the security to be offered there would be no unfair informational advantages and the security would not be overpriced.

o INITIAL OFFERING REQUIREMENTSo Expansion on common law fraud:

Holds the issuing corporation strictly liable for material misrepresentation or omission in its offering documents

Makes those who participated in the offering liable for the issuer’s failure to disclose unless they could satisfy the burden of proving that any such material error or omission could not have been reasonably detected by them

o Elements: Registration Filed with the SEC Prospectus

Describes Business Risk Factors Financial Information

o What is not subject to the ’33 Act? Registration process is not applicable if the offering

is only available to funds or other corporations Registration process does not apply if the operation

and the transaction are small Starting a business in your garage and selling

stock to neighbors Ordinary market transactions – day-to-day stock

trading Securities Exchange Act of 1934:

o Continuous disclosure system Regulates the secondary market (trading among

investors)o A corporation is subject to the ’34 Act if:

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It lists its securities on a national securities exchange;

The corporation has gross profits over a certain level (currently 10,000,000); or

The corporation files a ’33 Act registration statement that becomes effective

o Reporting Requirements: Annual Reporting (Form 10-k)

Audited financial statements Percentage breakdowns of the lines of

business Quarterly Reports (Form 10-Q)

Unaudited financials for each of the first three quarters of the fiscal year

Form 8-K Released when major contracts are signed Significant management changes take place

Proxy Statement Sent out before annual meetings Explains the matters that will be up for vote

during the meetingo Rule 10b-5

SEE BELOW Blue Sky Laws:

o State regulatory laws Exchange Rules:

o Govern the members that list with an exchange (NYSE / Nasdaq)

o Have rules that govern when a significant event must be disclosed to the public

o Both major exchanges have relatively similar rules

When does a disclosure obligation arise?o Timing:

Financial Industrial Fund v. McDonnell Douglas A corporation is entitled to withhold disclosure

until information ripens Plaintiff has the burden to prove that it

exercised due care in purchasing stock, that the defendant failed to issue appropriate information when sufficient information was available for an accurate release, and there existed a duty between the plaintiff and the defendant to release the information

o Merger Discussions

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Basic v. Levinson Whether merger discussions in any particular

care are material depends on the facts. Board resolutions, instructions to investment

bankers, actual negotiations between principals or their intermediaries may serve as indicia of interest

Materiality depends on the significance the reasonable investor would place on the withheld or misrepresented information

o Duty to Update: Backman v. Polaroid Corp.

Is there a duty to update projections after the initial information is provided?

o There can be, but the information must be material to the reasonable investor (and probably information that cannot readily be inferred through the other information already released)

There is no duty to update periodic SEC filings – they “speak” only as of the day of publication

Civil Liability – Rule 10(b)-5 Claims A plaintiff potentially has a wide array of remedies available to

him if a corporation issues a material misstatement or omission in connection with the purchase or sale of a particular security

o Bring action at common law or equityo Assert a private cause of action under state “blue sky”

lawso Assert a private cause of action under federal law – 10(b)-

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Rule 10(b)-5o Implied Civil Liabilities (basically judge-made rule)o Applies to both a purchaser and a seller in securities

transactionso Based on Sec. 10 of the 1934 Securities Exchange Act

The Rule does not explicitly provide for a private cause of action, however, courts easily implied one, first in 1946 and then explicitly in 1964

Without the implication that the rule applies to private actions, it would be left solely for the SEC to utilize

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o Elements of a Cause of Action under 10b-5 Elements:

Standing Materiality Causation Scienter Damages

Standing: (if time, read more from this section – 353-368)

Birnbaum Doctrine – Purchasers and Sellerso Only actual purchasers and sellers may

recover damages in a private 10b-5 action

o Therefore, if a false or misleading statement leads a person not to buy or sell, there is no 10b-5 liability

o Blue Chip Stamps v. Manor Drug Stores: The rule does not cover offers to

sell, but only actual sales or purchases

Mergers:o Traditionally mergers have been

recognized as sales for purposes of Rule 10b-5, even when the shareholder does not make or vote on any investment decision – Forced Seller

This theory is in dispute now Materiality:

Defendant affirmatively misrepresented a fact, or omitted a material fact that made his statement misleading, or remained silent in the face of a fiduciary duty to disclose a material fact

Materiality = % chance of issue occurring (P) x the magnitude of the event (M)

o This must also be compared against the size of the company – what is material for a little company may not be for a larger one

Bespeaks Causation Doctrine:o The inclusion of sufficient cautionary

statements in a disclosure document renders misrepresentations and omissions unactionable

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o It is incumbent on investors to read all information available to them and make a deliberate decision based on that information (not just the information that works in their favor)

o “Total Mix”o Private Securities Litigation Reform

Act of 1995: Amends the ’33 and ’34 Acts Fortifies the Bespeaks Causation

Doctrine Apparently, under the Act, even if

a knowingly false statement is not actionable if it is accompanied by appropriate cautionary statements

SEC v. Texas Gulf Sulfur:o Executives purchased stock based on the

information they received from an exploratory search

o If the materiality of the event is such that other investors would likely want to pursue the same strategy, then it is material enough that it should be disclosed.

Virginia Bankshares v. Sandberg:o Holding company wants to buy out its

minority shareholderso Board comes up with a price and

represents it as a “good” priceo Shareholders sue under 10b-5 on the

premise that the board does not believe this statement to be true

o Court: Statements of the board, even

conclusory ones are actionable under 10b-5

Must allege facts that make this believable

Here there were numerous facts disclosed to the board that were not shared with shareholders

Causation (reliance):

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There must be a link between the plaintiffs decision to buy or sell and the defendant’s actions (this is the reliance piece)

There must also be a link between the misrepresentation and the plaintiff’s loss (this is the causation piece)

Affiliated Ute Citizens v. United States:o In a case where the defendant fails in a

duty to speak, courts will dispense with proof of reliance if the undisclosed facts were material

Basic v. Levinson:o In the case of false or misleading

statements in an open and developed securities market, courts have created a rebuttable presumption of reliance

o If material misinformation artificially distorts the market price of a security, courts will infer that investors have relied on the misinformation

Dura Pharmaceuticals v. Broudao The plaintiff must prove that the fraud

produced the claimed losses to the plaintiff

o Plaintiffs cannot simply allege losses caused by an artificially inflated price due to “fraud on the market” but must allege and prove actual economic loss proximately caused by the alleged misrepresentations

Scienter: The mental state requirement – plaintiff must

show that the defendant’s mental state embraced the intent to deceive, manipulate, or defraud

Ernst & Ernst v. Hochfelder:o Accounting firm was negligent when it

failed to audit company’s books and uncover a corrupt CEO’s actions this is not enough for a 10b-5 action

o There must be an intent to deceive on the part of the defendant

o The court did not address whether recklessness would trigger 10b-5

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(however, CoAs have since found recklessness sufficient to trigger 10b-5)

Pleading scienter:o Tellabs v. Makor

You have to plead with particularity the facts that give rise to a strong inference of fraud

In order to survive a motion to dismiss, your claim must have a cognizant change of success in light of all the surrounding facts

Damages: According to class, there are three types of

damages:o Rescission:

Allows the defrauded plaintiff to cancel the transaction

Pg 419 – court allowed for damages beyond loss where the defendant’s profits from the transaction exceeded the plaintiff’s loss (under the idea that the defendant shouldn’t profit at all from fraudulent actions

o Cover Damages: Only applies when the plaintiff, in

an attempt to mitigate losses, sells the stock

The difference between the price at which the plaintiff transacted and the price at which the plaintiff could have transacted once the fraud was revealed

o Out-of-Pocket Damages: Most common Plaintiff recovers the difference

between the purchase price and the true value of the stock at the time of purchase

o Defenses to a 10b-5 claim: Statute of Limitations:

Two-year statute of limitations for private 10b-5 actions

o After discovering facts that constitute a violation

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Implemented under Sarbanes-Oxley Contribution:

Defendant can seek contribution from others at fault

Based on percentage of responsibility

Transactions not covered by Rule 10b-5o Corporate Mismanagement

Santa Fe Industries v. Green Santa Fe short-formed a minority shareholder

out of its shares Hired a financial firm to propose a good price

– firm came back with $150 Minority shareholders were told of their

appraisal rights Minority instead tried to file a claim under

10b-5 Court:

o There was no lack of disclosure in this case and therefore, no fraud

o Causes of action based on breach of fiduciary duty without a disclosure claim belong in state court

However – Superintendent of Insurance v. Bankers Life

Here a corporate mismanagement claim also included elements of fraud – if that is the case, then a 10b-5 claim may be formulated

o Aiding and Abetting fraud in the sale of securities Central Bank of Denver v. First Interstate Bank of

Denver Secured bonds require that the “secured”

property be worth 160% of the outstanding principal plus interest

Bank got an appraisal that said the land may have declined in value but the bank did not check into the situation and the bondholder defaulted on the loan

Court:o The scope of §10b is broad, and can

reach all who are involved directly or indirectly with deceptive practices

o However, the defendant must engage in actual fraudulent behavior and not merely provide collateral assistance

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The Private Securities Litigation Reform Act of 1995 (423-429)o In relation to Rule 10b-5o Passed partially in response to the belief that plaintiff’s

attorneys were taking advantage of the current rule structure and were benefitting more from the litigation than the plaintiffs

o The Act seeks to make conditions more favorable for plaintiffs than plaintiff’s attorneys, and rid the courtrooms of frivolous lawsuits

o The volume of post-Act litigation has been close to the same as pre-act litigation, however, the parameters that plaintiffs use to get into court are slightly different (428-429)

Insider Trading There are multiple sources of law that deal with insider trading:

o Rule 10b-5: the federal “abstain or disclose” ruleso §16(b) of the exchange act: intended to chill short-term

speculative trading by insiderso State lawso Sarbanes-Oxley: new rules on insider trading

What is insider trading?o Utilization of non-public, material information to purchase

stocks by insiders Does it apply to outsiders?

Why is insider trading inappropriate? (theories for regulating)o Fairness

It is not fair for those who trade without access to material, non-public information

Not generally accepted by state corporate lawo Market Integrity

Outsiders will be more leery of acting because they are unsure of what the insiders know

Only somewhat acceptable (ECMH posits that more information is better for everyone)

o Cost of Capital Insider trading leads investors to discount the stock

price of companies when insider trading is permitted making it harder to raise capital

o Property

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Those who trade on confidential information reap profits without paying for the information (through research/risk-taking/other admirable traits in the market)

Federal Law:o Rule 10b-5

In re Cady Roberts & Co. First case that suggests insider trading might

violate Rule 10b-5 Chiarella v. United States:

Individual was prosecuted for using information obtained in a copy room to trade on.

Supreme Court reversed – Rule 10b-5’s obligation to disclose or abstain arises only when there was a fiduciary duty owed to the corporation or its shareholders (in this case, the copy-boy had no fiduciary duty to anyone)

Rule 14e-3:o Modified post-chiarellao Discussed at length in US v. O’Hagano Any person in possession of material

non-public information about a tender offer is prohibited from sharing or trading on such information

Dirks v. SEC A breach occurs when an insider gains some

direct or indirect personal gain or a reputational benefit that can be cashed in later

o In this case, Secrist was not divulging the information to gain from it – but to warn of fraud taking place in his company

A tippee (someone that has received information from an insider) assumes a fiduciary duty to the shareholders of a corporation only when the insider has breached his fiduciary duty to the shareholders

Post-Dirks:o Insiders:

Traditional – directors, officers, employees, controlling shareholders

Temporary – accountants, lawyers

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o Outsiders (with a duty to the source) Outsiders with no relationship to

the company have a duty to abstain or disclose when they are aware of material, non-public information obtained in a relationship of trust or confidence

Is this 10b-5(2)?o What must a tippee know to be liable?

Those without an inherent confidentiality duty inherit one when they knowingly receive improper tips from an individual who breached a confidentiality duty

o Tippers: Insiders and outsiders with a

confidentiality duty who knowingly make improper tips are liable as participants in insider trading

HOWEVER, the tipper must expect some reciprocal benefits for the tip (Dirks)

(this is different from the liability under 14e-3)

Regulation FD: This is the Post-Dirks rule Fair Disclosure Purpose - Forbids companies from selectively

disclosing material non-public information to important members of the investment community

Reasoning – Selective discussions with securities analysts (etc) is essentially systematic tipping of valuable insider information

There is no private cause of action under FD Bars disclosure only to market professionals

and shareholders likely to trade If disclosure is intentional – it must be done

simultaneously with the entire market If disclosure is unintentional – the company

must promptly disclose information to the rest of the market (within 24 hrs)

Exclusions from the Rule:o Does not apply to IPOs

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o Normal course of businesso Disclosure to media or government

officials – under normal circumstanceso “road shows” or other SEC permissible

venueso Misappropriation Theory:

Under misappropriation theory, Rule 10b-5 liability arises when a person trades on confidential information in breach of a duty owed to the source of the information, even if the source is a complete stranger to the traded securities.

United States v. O’Hagan: Partner in a law firm purchased stock in

company that used the law firm to make a tender offer

Lower court convicted him of misappropriating information

Supreme Court:o Confirmed misappropriation theory:

The unauthorized use of a deceptive device under §10

In connection with securities trading

Is a violation Rule 14e-3

One violates the rule if he trades on the basis of material non-public information concerning a pending tender offer that he knows or has reason to know has been acquired directly or indirectly from an insider of the offerer or issuer

o Without regard as to whether the trader owes a pre-existing fiduciary duty to the information’s source

There is no need to prove that the tipper breached a fiduciary duty for a benefit under 14e-3

o Family and Business Relationships – Rule 10b-5(2) (497) Prevents family members from trading on material,

non-public information acquired from a family member that was an insider

Can’t claim information was inadvertently leaked

Also, prevents persons who have a history or practice of sharing confidences (both business and

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personal) so the recipient had reason to know the communicator expected the recipient to maintain the information’s confidentiality

Doesn’t cover people that are just living togethero Use / Possession Distinction– Rule 10b-5(1) (486)

Prevents people who are “aware” of material nonpublic information from buying stocks on that basis

Forecloses potential problems when individuals “know” of information, but don’t necessarily “use” the information in their decision

Auto-trades would get around this even awareness is trumped because the transaction is occurring outside of the individual’s capacity

o Damages in a Tipping Case: Elkind v. Liggett:

Disgorgement:o The trader, tipper, or tippee’s liability is

capped at the amount of profit made or loss avoided

o Section 16(b) (Short-Swing Transactions): Requires specified traders to report their trading in

their company’s securities, and authorizes the corporation to recover from these insiders any profits made on stock purchases and sales in a 6-month window

Basically, individual can’t make a “matching trade” within 6 months that creates a profit for the individual

o Must invest for longer than 6 months or buy-sell at different volumes of stock

Applies to trading in equity securities Imposes automatic, strict liability on qualifying

officers, directors, and 10-percent shareholders who make a profit in short-swing transactions within a 6-month period

A 16(b) violation is not a “crime”, it just creates liability to the corporation

Loss avoided is the same thing as profit earned

The offending director or 10-percent shareholder has to disgorge profits to the corporation

The 10-percent shareholder:

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o The application of the rule requires that the shareholder be a 10%+ shareholder on every leg of the transaction

If you have a sub-10% shareholder that has “deputized” an individual on the board, you may be held liable for 16b disgorgement

Mechanical Application: You can actually go “into the whole” if you

make multiple transactions and accrue a loss (example from E&E book)

Always go “lowest in, highest out” Always “zero out” as many of the shares as

possible

Shareholder Voting: Overview:

o Purpose of Shareholder Voting (when is a vote typically required?):

Elect directors to the board Plurality has been the standard in the past

(majority of the shareholders that participate in the vote)

The majority standard is becoming more prevalent because it gives shareholders a greater voice (need an actual majority of the shareholders, not just the majority of those who choose to vote)

o Plays a big role when only the incumbent is on the ballot – under plurality standard, a single vote would be sufficient to get the director back on the board

SEE BELOW – Straight v. Cumulative Voting Pass fundamental corporate changes

Usually limited to ratifying or vetoing the board’s recommendation

Generally, stockholders have no power of initiative

Some statutes authorize corporation to require a supermajority vote to enact a change

Initiate limited changes to the corporate governance structure

Amendments to bylaws

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Amendment of Articles of Incorporation (limited number of statutes)

Shareholder Proposals: Rule 14a-8 Allows the shareholder to attach a proposal to

the corporation’s own proxy statemento A good avenue to trigger negotiations

with the companyo Shareholders can only recommend

actions by the board – cannot try to dictate

There are several exclusions to the rule that allow a corporation to deny a stockholder addition to the proxy statement:

o If the proposal is political in nature or has a social agenda

o If the proposal is overly broado If the proposal effects less than 5% of

the corporation’s business The board cannot deny proposals that are

primarily related to corporate success however:

o Cracker Barrel – not hiring homosexuals is bad for public relations and bad for business. This is such a significant issue in society that the shareholders should have the right to say something about it

o Medical Committee – selling napalm is bad for business. Committee was able to overcome Dow’s contention that this was a political proposal. Court also disallowed subsequent denial of a proposal as too broad, saying that Dow was effectively trying to have it both ways

o Veto Powero Voting belongs to the shareholders:

(DE allows bondholders to vote as well – if the corporation adds it to the bylaws)

Shareholders have paid for the privilege to vote – not employees or officers

Ultimately, no one can take over control of a corporation without first acquiring the right to elect a majority of the board of directors

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Critics have long claimed that shareholder voting fails to properly hold individuals accountable in corporations

Low participation rates Normally, ownership is so varied that working

control of a corporation can be maintained by a small minority of the shareholders

o Why isn’t shareholder voting like a democracy? Proxies:

Corporation solicits proxies at corporation’s expense

Individuals must fund their own efforts Individuals may feel that they aren’t informed

enough and therefore opt to side with management – regardless of the circumstances

Rational Apathy Problem It’s too much work for a single shareholder or

group of shareholders to act against management

Free Rider Problem Shareholder assuming that another

shareholder will effect the change needed at a corporation

Potentially allows a shareholder to take on no additional effort and expense to get the desired result while another expends time and money

Will freeze action by all parties everyone is assuming someone else will do the work

Institutional Investor Problem: Not retail investors These investors hold significant stakes in a

company However, they hold large stakes in a

significant number of companies – creates a problem for the institutional investor to be present at all corporate functions and speak on issues effectively

Pension Funds – more active, more likely to stick around and wage a fight

Mutual Funds – more willing to sell and reinvest elsewhere

o Mechanics of Shareholder Meetings: Types of Meetings:

Annual

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o Corporations are required to have an annual meeting

o Hilton v. ITT Corp. Meeting does not have to be

exactly every 12 months Statutes can determine the

window of time a corporation has to have its annual meeting

“Annual” meeting really means “regular” meeting

Special Meetings:o Directors can call special meetingso Usually called to vote on an important

issue that cannot wait until the annual meeting

o When can shareholders call a meeting? Delaware:

Look to the charter and bylaws

Default state, the corporation does not have to permit for a shareholder-called meeting

Colorado: 10% of the shareholders can

always call a meeting Notice:

Stockholders must receive appropriate noticeo Must be timely (more than 10 days, less

than 60)o Must contain enough information to

make a decisiono Record Date – must be the owner of the

stock as of the record date to vote on the matter provided in the notice

Quorum: Must be quorum to be a valid meeting

Appearance in person or by proxy: If you can’t be there in person, you must sign a

valid proxy statement giving another entity the right to cast your vote in a specific manner

Types of Voting: Majority Vote:

o Many statutes require a majority vote of all the outstanding shares (not just the

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shares that are present) to pass board initiated transactions (mergers, sale of assets, dissolution)

Simple Majority Vote:o If the statute does not require an

absolute majority, it likely requires a simple majority – a majority of the votes that are present

Plurality Vote:o Used in director electionso The director gets elected if he gets more

votes than the next guy If there is only one candidate, one

vote gets him on the board Action by Consent:

Under most statutes, shareholders can act without a meeting by giving their written consent for an action

The appropriate majority must still be obtained (what about a simple majority vote?)

Datapoint Corp v. Plaza Securities Co (DE)o Board enacted bylaws that limited the

effect of a shareholder consent initiative in the faece of a hostile consent proposal by a shareholder

o Court struck down bylawo However, DE § 228 does not necessarily

prevent a corporation from adopting bylaws that would provide some structure around consent initiatives

o Judicial Oversight: Schnell v. Chris-Craft Industries:

The fact that the charter, bylaws, and statute allow the board of directors to change the date of the election does not mean that the board can do it simply to increase their chances of winning a contested election

o This violates the fiduciary duties of the board

Under normal circumstances, a judge will not interject and determine the proper time for a shareholder meeting or director election during an annual or special meeting

Hilton Hotels v. ITT

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ITT restructured itself into three different corporations

Stroud v. Grace

Individual family owns the majority of the shares in a company and desires to change the corporate charter and bylaws

o The changes would essentially give the family permanent control over the company

Minority shareholders protested the change At the time of the proposal, there is no threat

to management Court finds that the decision only needs to

pass the business judgment test and easily accomplishes this

o This is not a situation where the board needs to meet the compelling justification standard (Blausius) – since there is no threat

o If the court required the compelling justification standard here, basically any decision made by a board in the future could be seen as judiciable

MM Companies v. Liquid Audio (NEED TO DO WORK HERE)

Blausius Standard:o Unless the board can articulate a

compelling justification for its action, courts intervene to protect established principles of democracy

o Applies when the primary purpose of the board’s action is to impede shareholder’s opportunity to vote

Reconciling Blausius with Unocal:o Assess Blausius first – is there a

compelling justification for the board’s actions

o If there is a compelling justification for the board’s actions – Apply Unocal / Unitrin

There must be a threat The reaction to the threat must be

reasonable

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It cannot be coercive or preclusive

o Director Elections: State statutes don’t require that directors own

shares, but only that they be individuals and meet qualifications outlined by the corporation’s bylaws and charter

Voting Methods: Straight Voting:

o The top vote-getters are elected to the board for the open vacancies

o Shareholders vote their shares for each open directorship

Therefore, a shareholder holding a majority of the shares can elect the entire board of directors

If you have 100 shares and there are 3 open positions, you cast 3 votes of 100 shares

Cumulative Voting (598):o Allows shareholders to accumulate all of

their votes and allocate them to the director they choose (or directors)

Increases the chance that a minority shareholder will get a director on the board over a majority shareholder’s vote

o Shareholders must be careful to allocate votes such that they don’t accidently provide other shareholders an edge

Applies to both majority and minority shareholders

o Calculations: Number of shares required =

Number of shares voting / Number of Directors to be elected + 1

o Director Removal and Vacancies: Common law:

Directors could only be removed for cause Commentators criticized this notion – why

should a director have some sort of vested interest in their directorship?

Modern:

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Slowly adopted by more jurisdictions:o Directors may be removed without cause

if the certificate or bylaw adopted by the shareholders provides.

o DE, CA, and Revised Model Business Corporation Act go further and allow for removal even if the cert. and the bylaws are silent

o DE allows corporations to remove directors through written consent

However there must be unanimous consent in this instance

o DE caveats: If the board is staggered, the

director can only be removed for cause

However, shareholders can amend the organization of the corporation, eliminate the staggered board, and then immediately remove directors without cause

If the corporation has cumulative voting a director can only be removed for cause unless the entire board is going to be removed

Directors have no inherent ability to remove another director from the board

Vacancies: Common law:

o Shareholders were required to fill director vacancies

Statutory:o Vacancies can be filled by the board

Unless the vacancy was caused by a removal without cause

o Staggered Boards: The board is classified into groups of directors –

each with multiple year terms that expire at different times

This can serve as a protective measure – an activist shareholder cannot replace the entire board in one year

o One Share / One Vote:

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Do you have to have “one share, one vote”? No, as long as the certificate of incorporation

provides for the different classes of shares It is more restrictive if the corporation

attempts to institute new classes of shares after incorporation

Corporate boards cannot enact stock classifications after incorporation

o Unless the plan is enacted after a shareholder vote w/ full disclosure

o However, a shareholder vote approving the measure is invalid if it was only approved through coercion

Dual classification can be easily obtained at incorporation – there is no coercion or “sneaky dealings” on the part of the board at that point

State Regulations: Lacos Land v. Arden Group (DE)

o Implied threats that unless the proposed amendments were authorized, a controlling shareholder would oppose transactions which could be determined by the board of directors to be in the best interest of the shareholders – are impermissible

When is coercion permissible?o If a controlling group of shareholders

asks for something specific, but does not threaten retribution if they don’t get their way – the court will likely find this to be permissible

o Street Name Ownership: Individuals don’t own a “paper” stock certificate

anymore – brokerage firms possess the stock certificates and the shareholders own shares underneath the brokerage firm

In the early 70’s the Depository Trust Company was formed and the DTC holds global certificates for all publically traded companies

Brokerage firms have equitable interests in these global certificates and they, in turn, pass owner ship of that portion down to the individual consumer (shareholder)

The DTC knows which brokerages own how many shares of a particular company, but the

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DTC does not know who personally owns the stocks

o This prevents the DTC from being able to produce a list of stockholders for a particular company (for things like a proxy contest)

o It can be difficult for the corporation as well as individuals that wish to commence with a contest

What is the process for individuals to get ahold of a stockholder list?

o Vote Buying: Historically vote buying was per-se illegal Over time, courts have cautiously started to accept

the premise of vote-buying Courts will still look closely for fraud or

disenfranchisement (anything that disparately impacts other shareholders)

Schreiber v. Carney: Company loaned money to an individual to pay

off debt so that the company could merge with another and the individual would not face adverse tax consequences

Court:o Transfers of voting rights, without the

underlying economic interest (basically, selling the vote) is not necessarily illegal,

Unless the object or purpose is to defraud or in some way disenfranchise the other stockholders

o Since this action was done in the open and fully disclosed to shareholders, there is no fraud

o Vote buying is so subject to disenfranchisement and fraud, however, that it will always be subject to the intrinsic fairness test

o Proxy Contests: Requirements:

A disclosure must accompany every proxy solicitation (contents regulated by fed.)

The format of the proxy card is outlined in federal regulations

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The disclosure and the proxy card must be pre-filed with the SEC for review

False and misleading proxy solicitations are prohibited

Proxy statements will either be sent out by management, a group of shareholders, or an outside group

Proxy Contest Expenses: Management traditionally charges the

expenses of a proxy statement and contest to the corporation, while non-management groups must fund the effort themselves

Why don’t challengers get reimbursed?o If management had to reimburse any

challenger, there would be the opportunity for a minority shareholder who has minimal chance of success to charge the corporation with significant costs

o Forcing challengers to pay their own way ensures that only valid challenges will be brought

Rosenfeld v. Fairchild Engine:o The expenses of a proxy contest can be

reimbursedo The incumbent management can

reimburse themselves when they win a proxy contest

o Challengers: Can be reimbursed if they win a

proxy contest If they do not win the contest,

there will not be any reimbursement – the corporation is under no obligation to reimburse a challenger

Election Inspectors: Individual shareholders can sign multiple

proxy cards during a proxy solicitation – it is permissible to flip-flop sides during the solicitation process

However, only the last card signed should count as the “shareholder’s vote”

State statutes authorize corporations to assign an “election inspector” to cut off potential controversies. Duties include:

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o Ascertaining the number of shares outstanding

o Determining the shares represented at the meting and the validity of all proxies and ballots

o Counting all votes and ballotso Producing and retaining a record of the

determinations and challengeso Certifying the determinations and their

count of all votes and ballots

Corporate Acquisitions, Takeovers, and Control Transactions Policy Considerations:

o Governance of Corporations poses a fundamental agency problem

Shareholders delegate decisionmaking for certain transactions to management because managers have greater expertise; however, giving managers the discretion to deploy that expertise on behalf of shareholders also gives managers discretion to favor their own interests at the expense of the shareholders

o Takeovers and acquisitions illustrate this agency problem: Shareholders are charged with making the final

decision of whether to merge or purchase a large asset, but this requires expertise that usually resides with the managers of the corporation

There is a constant threat of conflict of interest for management because what is “best for management” may not be best for the shareholder – how can the shareholder be sure that management will bring the best options forward?

Takeover Strategy:o There are several options for initiating a takeover of a

corporation: Merger Sale of Assets (the company can sell itself off) Tender offer Proxy Contest

o Some options are considered “friendly” in that they are done with management’s approval (mergers and sales of assets will typically be the result of a friendly takeover transaction)

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o Others are more conducive to a hostile takeover, where management opposes the proposed transaction (tender offers and proxy contests are normally used in hostile takeovers)

o There are federal regulations that can come into play with each of these strategies

Defensive Tactics of Targets:o Many tactics are implemented prior to the arrival of a

hostile bidder (these all require shareholder approval w/o evidence of coercion or fraud):

Staggered Boards: Requires a shareholder vote Draws out the length of time required to

initiate a takeover through proxy elections In DE removal on a staggered board is only for

cause Majority voting (or super majority voting )

provisions: Requires the hostile bidder to truly get a

majority of shareholders on board Article Provisions:

Fair price in a freeze-out merger Recapitalization:

Providing two classes of shares where one class is given significant voting rights in lieu of good dividends

o Tactics that can be implemented during a takeover bid: Restructure of the target to make it less desirable Granting of an option to sell off a crown jewel Selling a block of shares to a “white knight” that will

side with management Increasing debt through various means – makes the

target less desirable, and may prevent the hostile bidder from using the target as collateral once a takeover is achieved

Take the corporation private – usually through a self-leveraged buyout

o Poison Pills: The most significant of the defensive tactics Has the ability to thwart an unfriendly takeover and

give control to the target directors Do not require a shareholder vote! Basic Structure:

Corporation issues to shareholders a class of convertible preferred stock that is originally

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priced well outside market levels so that they are effectively useless

Upon a triggering activity:o A hostile bidder acquires a certain

percentage of the corporation, oro A hostile bidder makes a tender offer for

a certain percentage of the corporation The board then has a specific amount of time

to redeem (nullify) the convertible shares (which essentially would let the offer go through)

If the board does not redeem, the convertible shares become “poison” and if the hostile offeror makes further moves for the company, the rights become exercisable and permit shareholders to purchase large amounts of shares at a discounted price (in a flip-in scenario, shareholders buy the target’s stock, in a flip-over scenario, shareholders buy the acquirer’s stock)

o This significantly increases the costs for the acquirer

The reasoning behind the pill’s issuance is to get the acquirer to talk to the board before commencing with an offer

Types of Poison Pills: Flip-in:

o Entitles the holder to buy discounted target securities and excludes the acquirer from participating

Flip-over:o Entitles the holder to buy discounted

acquirer securities Dead-hand:

o Response to a combined tender offer/proxy contest

o Seeks to block the redemption of the poison pill by directors who were not in office at the time of its adoption

o Invalidated in DEo Can only be redeemed by directors in

office at the time of its adoption – or their nominees

o Following successful proxy fight, the pill cannot be redeemed, but must expire

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Slow-hand:o Like the Dead-hand pill, but just slows

the redemption by a new director by a certain period of time (normally 6 months)

o Invalidated in DE Shareholder Response:

Shareholders – particularly institutional shareholders – have come to dislike poison pills

Amendment of bylaws to prevent poison pill from being adopted without shareholder approval

Amendment of bylaws to do away with implemented poison pill, immediately, not at expiration date

State Law:o All DE unless otherwise specifiedo When a target company’s management and directors

institute actions to defend the corporation from a hostile takeover, what should the standard of review be when shareholders take them to court?

Business Judgement Standard – doesn’t work because it would almost certainly require the court to stand by the director’s decision 100% of the time

Intrinsic Fairness – isn’t called for because theoretically, management is applying its skills to the situation and should be given some deference

Thus the Unocal test (below)o Cheff v. Mathes

Board of directors made a “greenmail” offer to a stockholder (offering premium over the current stock value) in order to keep the stockholder from making a hostile tender offer

Minority shareholders brought suit saying the board did not have the right to take on the substantial debt necessary to buyback the shares

Court opted not to apply the business judgment rule or the duty of loyalty standard:

Court shifted the burden to the defendant directors to show whether there were reasonable grounds to believe a danger to corporate policy or effectiveness existed

Directors were able to satisfy this burden the potential hostile bidder had a bad record of previous business decisions

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o Unocal Corp. v. Mesa Petroleum Mesa owned a 13% portion of Unocal and

commenced with a two-tier takeover (first acquiring 51% of the company and then engaging in a freeze-out merger)

Unocal commenced with a stock buy-back in an effort to prevent Mesa from taking over control of the company – in order to do this, Unocal issued a significant amount of debt and ended up being heavily leveraged (which worked against Mesa as Mesa would need to use Unocal’s assets to cover its debt after a takeover)

Mesa challenged Unocal’s self-tender as beyond the power of the board and a breach of fiduciary duty

Court: When directors implement a defensive tactic

there arises an omnipresent specter that a board may be acting primarily in its own interests, rather than in those of the corporation or its shareholders

If a defensive measure is to fall under the business judgment rule, it must be reasonable in relation to the threat posed

The directors must analyze the nature of the takeover bid and its effect on the corporation and determine that harm will take place

Test: The defensive board must prove:

o That it had reasonable grounds for believing that a danger to corporate policy and effectiveness existed (the threat), and

o The defensive tactic was reasonable to the threat posed (the response)

Only then will the court apply the business judgment rule to the board’s decision

o Revlon v. MacAndrews A company made a hostile attempt for Revlon and

Revlon took defensive steps to rebut the hostile takeover, eventually Revlon found a white knight to buy the corporation (instead of the hostile)

Friendly merger Lock-ups:

“no-shop” provisions crown jewel sale cancellation fee

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In the court’s view, lock-ups are permitted under DE law when their adoption is untainted by director interest

Court: Revlon mode:

o A company enters into Revlon mode when it has announced that it is for sale

Here the target found a white knight, and therefore has effectively announced that it is for sale

While Unocal suggests that directors can be concerned with other corporate interests during a takeover, once a company enters into Revlon mode, those concerns are only valid if they are rationally related to getting shareholders the best price

Exception: When the bidder is a “strategic buyer” the

board does not have to make as thorough an “attempt” to canvas the market for the best price

o Strategic buyers may be better for the stockholder in the long run

o Paramount v. Time Time negotiated a friendly merger with Warner to

pursue a plan of strategic expansion Paramount entered and offered Time up to $200 per

share in a takeover bid, and Time directors feared that shareholders would reject the merger with Warner in favor of Paramount

Time then switched its agreement around and purchased 51% of Warner (which did not require shareholder approval) and then effected the merger with Warner

Paramount brought both Revlon and Unocal arguments against Time

Under Time – there does not appear to be a general obligationto sell a corporation simply because there happened to be a substantial premium in cash offered to shareholders in a tender offer when such a sale would upset a business plan

Unlike Revlon, there was no planned breakup of Time, just the merger

Revlon:

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Time’s negotiations with Warner did not put the company up for sale (a dissolution or breakup of the company was not inevitable) such that it entered Revlon mode – and in the end, Time did the purchasing

If Time was being “purchased” by Warner, it would be a different scenario

Unocal: Using the two-part test:

o The court found that there was a “threat” in that Paramount’s offer was designed to confuse shareholders and prevent them from adequately considering the Warner merger plan

o The directors were therefore allowed to react with a proportionate response – which was to protect the pre-existing plan

The court decided that determining which was the better deal for the shareholders was a question for the directors in this case – and therefore, the directors did not violate their duty

o Paramount v. QVC Paramount agreed to be acquired by Viacom in a

friendly acquisition with a no-shop provision If Paramount terminated the agreement, or

stockholders did not approve the transaction, or Paramount’s directors recommended a competing transaction – Viacom would receive $100 million termination fee and the option to buy 24 million Paramount shares

Paramount shareholders would own shares of the new merged company, but the controlling shareholder would still be Sumner Redstone (70%)

QVC made an offer for Paramount but Paramount viewed the merger with Viacom as a better long-term fit for the company and shareholders

Basically structured the same as the Time deal QVC sued to enjoin Viacom’s offer and Paramount’s

use of defensive tactics Court:

The Time decision did not apply and Revlon was triggered in this case because there would be a change of control when the merger took effect

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In the Time case, both companies were public companies with widely dispersed shareholder bases

In this case, after the merger, there would be a controlling shareholder and the Paramount shareholders would effectively be minority shareholders

Rule:o If the transaction will involve the target

shareholders turning into minority shareholders, then the court should use enhanced scrutiny to determine whether the target board adequately examined all proposals and sought the best price for shareholders

Essentially, in QVC the court has said that Paramount put itself up for sale because the effect was going to be a significant change for shareholders – not unlike a cash sale

Therefore, the board had the obligation to look for the best deal possible for shareholders

o Unitrin v. American General Corp. American General instigated a two-step unsolicited

bid to replace the incumbent Unitrin board and then make a tender offer

Unitrin, in response, implemented a repurchase program whereby the corporation repurchased shares on the open market, but directors did not take advantage of the offer – the result was that the directors ended up with a larger percentage of the outstanding votes and were able to withstand a merger proposal which needed a supermajority of the outstanding shares

AmGen argued that the buy-back plan, in addition to Unitrin’s poison pill and the supermajority requirement made any tender offer basically impossible

Court: Reviewed the repurchase program under the

Unocal Test:o Is there a threat to corporate policy?o Was the reaction to the threat

proportionate? The court determined that the buy-back

program did not conclusively prevent AmGen from winning a proxy contest or eventually

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winning support for a merger – the price would simply have to be right

Therefore, the reaction of the target board was not disproportionate (and the court said that the bid was a low-ball bid)

o The buy-out plan probably helped Unitrin buy out short-term speculators (arbitragers) who just wanted to get in on the merger profits

o OmniCare v. NCS Healthcare NCS is insolvent and looking for a buyer Omnicare approaches first and offers a fire sale for

the company – shareholders will get very little if anything

NCS continues to look around and Genesis agrees to purchase for a reasonable share price – but only in a lock-up agreement

Agreement required that the merger agreement be brought before the shareholders

Agreement also required that the two major shareholders sign irrevocable proxy agreements to vote for the merger

Omnicare comes back around and makes a better deal than Genesis and the board may want to side with Omnicare now

However, the effect of a change in sides is null, the merger with Genesis is essentially locked down

Court: Unocal Analysis:

o Is there a threat to corporate policy?o Are the actions taken by the board

proportionate in the face of that threat? New element (Unitrin) – Are the

actions coercive or preclusive? Here, the board’s actions were entirely

preclusive because there was no option for Omnicare to present a better offer once the agreement with Genesis was signed – the terms of the agreement took any option away from the shareholders to make a decision, or to receive the best offer

o Perlman v. Feldmann Newport Steel case Fiduciary obligations of controlling shareholders

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Feldmann owned 37% of Newport Steel and sold his shares for a premium

This was during the Korean War and there were price controls on steel

Feldmann had created a way around the price controls (the Feldmann Plan)

The purchaser of the stocks wanted to get ahold of Newport’s steel without the Feldmann Plan process, which made the steel more expensive to the purchaser

Court: Feldmann violated a fiduciary duty to the

company by selling the ability to charge profits through the Feldmann plan

The court held that Feldmann, in this case, had to share the premium received for his shares

Premium sharing (controlling block of shareholders) Generally, a controlling shareholder is under

no obligation to share the premium his controlling block of shares commands

o Mendel v. Carroll Carroll family owns a controlling share in Katy

corporation and makes a move to take the company private by making a tender offer to shareholders

Outsider makes a higher offer for shares of the company and wants the Katy board to exercise an approved option to issue new shares that would be purchased by the outsider (and would take the Carroll family out of control of the company)

Mendel and other minority shareholders brought suit to force the board to issue the shares giving the shareholders a better offer

Court: The plaintiffs are comparing apples to oranges In the first case, the Carroll family already

owns controlling stock of the company and is simply trying to gain the rest of the shares of the company

In the second case, the Outsider is attempting to gain controlling stock in the company

The Outsider’s offer should be worth more because he is purchasing controlling stock in the company

o A controlling block is worth more than a non-controlling block

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Takeaways: If there is a control group that owns more than

50% then the fact that an outsider responds to the freezeout by offering to buy the corporation for a higher price does not mean that the control group has to sell or give up the freezeout

o In Re Digex Shareholders Litigation Intermedia owns 60% of Digex and the public owns

40% Worldcom wants control of Digex

Two options:o Purchase Digexo Purchase Intermedia (and gain the 60%

contol of Digex) Worldcom decides to purchase Intermedia

Intermedia and Worldcom asked the Digex board to take affirmative action to facilitate the sale of Intermedia to Worldcom

If Worldcom was purchasing Digex, it would be up to the board to throw up some road-blocks and insure the best price for shareholders

That obligation does not go away just because Worldcom is purchasing Intermedia

o Digex directors should have critically assessed the proposed deal to make sure it was the best possible option for Digex shareholders – and if not, then the board should have refused to recommend

The Williams Act: Overview:

o Amends the 1934 Securities Exchange Acto Designed to regulate stock purchases that effect corporate

controlo Mandates disclosure for stock accumulations of more than

5% of a target’s equity securitieso Mandates disclosure by anyone who makes a tender offero Provides for enforcement of these

Schedule 13d Disclosure:o Disclosures must include:

The acquirer’s identity and background The source and amount of funds for making the

purchases

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# of target’s shares held by the acquirer the acquirer’s purposes for the acquisition and his

intentions with respect to the targeto Beneficial ownership means that you have share voting or

investment control of a stocko Beneficial ownership also relates to group ownership – if

you agree to act together with another shareholder with respect to your shares – you are deemed to be a group and must disclose any 5%+ ownership in a corporation

o Disclosure rules are designed to prevent a “secret” accumulation and takeover attempt

Section 14d and 14e:o Applies to tender offerso The acquirer has to hold the tender offer open for at least

20 business days If the acquirer changes the terms of the tender offer,

a new 20 day window is triggeredo The acquirer has to treat all target shareholders the same

– must deal equally with everyoneo The acquirer has to maintain the same price for all target

shareholderso Target shareholders have the right to withdraw during the

20-day window Considerations:

o Acquirers typically want to get the largest share of stock possible before word leaks about an acquisition attempt – once word leaks, the stock price is likely to rise significantly

Will likely attempt to get the largest share possible before the 10-day reporting requirement arrives

o Hedge funds often work in similar manners (Wolfpack situation):

Purchase a measurable portion of stock in a company, agitate so that the stock price rises, and sell at a profit

If hedge funds pursue the same company with the same motive, but are not acting in conjunction, there is no duty to disclose (unless one of the funds reaches disclosure levels on its own)

However, if the funds formally agree to work together for the common goal of spiking a stock price, then there is a duty to disclose if the group reaches the appropriate levels

o Acquirers will try to avoid the statutory disclosure requirements and the statutory tender requirements:

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Wellman v. Dickinson: Acquirer made 39 simultaneous telephone

calls to large holders and offered to buy their stock at a substantial premium, but left the window for consideration open for a short period of time

The court concluded that there had been a public solicitation in this case

Wellman Factors for a Tender Offer:o An active widespread solicitation of

public shareholderso Solicitation of a substantial percentage

of the target’s stocko The offer of a premium priceo Non-negotiable termso Conditioning the offer on the acquisition

of a specified number of shareso The offer being open for a limited period

of timeo Pressure on the shareholder to tendero Substantial publicity concerning the

offer

Mergers: Freeze-out Mergers:

o Controlling shareholder and the board of directors (this is often a parent subsidiary relationship) agree to a merger where minority shareholders will get cash for their shares and the majority shareholder will retain its shares, making it the sole shareholder

This is different than a short-form mergero Court Review:

The court will ask whether the majority shareholder offered both: Fair Dealing and a Fair Price (This is the ENTIRE FAIRNESS STANDARD)

o Purchasers typically don’t like the increased rigor of the entire fairness standard – one way to avoid this test is to utilize a tender offer rather than a freeze-out merger

If the purchaser can acquire more than 90% of the shares, then it can commence with a short-form merger, which will only be subject to the appraisal standard on review (see below)

Long Form and Short Form Mergers:o Long Form:

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Must be approved by the board and then the shareholders

This is a traditional mergero Short Form:

There is a majority shareholder that possesses 90%+ of the corporation

There is no vote required to effect a merger – the majority shareholder can simply buy out the remaining shareholders

Court: In determining validity of a short-form merger,

the court will:o Evaluate the corporation and determine

whether the offer to the remaining shareholders is legitimate (This is the APPRASIAL METHOD)

To get to a short-form merger application, it is typically necessary to make a freeze-out tender offer first.

Under Pure Resources, that tender offer must meet the test for a fair price:

In re Pure Resources Inc.o The essential duty of the court is to

ensure that majority shareholders don’t bully around minority shareholders

o Test for tender offer: The tender offer must be subject to

non-waivable majority of the minority tender condition

The controlling stockholder must promise to consummate a prompt short-form merger at the same price if it gets 90%+ of the outstanding shares through the tender offer

The controlling stockholder cannot make any threats to the minority stockholders

Weinberger v. UOP, Inc. (fair dealing case)

o Company is a significant shareholder in UOP and decides to engage in a tender offer and eventually a merger

o Company has some individuals on UOP’s board (this makes them conflicted when dealing with the transaction)

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UOP also did not set up an independent committee to review the proposal from Company

o Court: Utilized entire fairness standard:

Was there both fair dealing and a fair price? Court says no to both: There could not be fair dealing because of the

conflict of interest and the haste with which the deal was put together

Therefore, there is a good chance that this is not a fair price

Kahn v. Lynch Communications (fair dealing case)o Kahn made a merger offer to Lyncho Kahn owns 43% of the companyo Kahn threatens the board that if the merger offer

proposed to the board is not accepted, Kahn will issue a tender offer to shareholders

o Court: Looks to entire fairness:

To review a deal proposal, there must be an independent committee or at least a majority of the minority to approve the deal

However, the independent committee must be effective and cannot be beholden to the purchaser

Court find’s Kahn’s offer to coercive Court did not look to business judgment review, b/c

the controlling shareholder has inherent potential to coerce the shareholder vote for the merger

Kahn II (fair price case)o Fair value can be based on opinions of the parent’s

investment banker, even though the subsidiary’s committee has received opinions of higher value from other investment bankers

o Court: When parent bears the burden of showing entire

fairness, the parent must come forward with credible, persuasive evidence of fair price under recognized valuation standards

Partnerships, Limited Partnerships, LLCs

General Partnership

Limited Partnership

LLC

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Nature ? Entity EntityFormation Unintentionally File w/ State File w/ State

Liability Joint & Several GP - Unlimited; LP - Limited

Limited

Fiduciary DutiesOwed to all partners, can be varied

SameSame

Partnershipso Two or more individuals carry on a business together as

co-ownerso A partnership is not a tax-paying entity

Income and losses from the partnership are treated as income or losses of the partners individually

o Fairway Development v. Title Ins. Co of Minnesota FD had two partners and entered into a contract

with Title Ins. FD added another partner FD later had an issue and filed for an insurance

claim which Title Ins. denied because the addition of a new partner created a new entity – which Title was not under contract with

Court: Agreed with Title

This decision created a lot of uncertainty and was later overturned statutorily in the RUPA (I think it still stands under the UPA)

o Voland v. Sweet Sweet worked for Vohland Over the course of time became a valued employee

and moved into a different compensation structure At points, Sweet’s 20% commission was partially

invested back into the business before Sweet received his take-home pay

Sweet brought action that he was a partner to the business

Court agreed Takeaway:

A partnership can be formed unintentionally Even if both partners are intent on not

creating a partnership, it can exist based solely on circumstances

o Fiduciary Duties: Meinhard v. Salmon

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Salmon managed a property leased from Gerry Meinhard was an investor with Salmon on the

project Salmon re-signed a lease with Gerry but did

not included Meinhard Meinhard sued Takeaway:

o Fiduciary duties are owed to all partners Limited Partnerships

o Entirely a creation of statuteo Serves two aims:

Limited liability for investors Avoidance of double taxation for partners

o General Partner: Same as a partnership – unlimited liability

o Limited Partner: Not personally liable directly or indirectly by way of

contribution for an obligation of the limited partnership – even if the limited partner participates in management and control of the partnership

o Formation: Can only be formed by filing a certificate of limited

partnership in the office of the secretary of state Under RULPA – a partner that erroneously, but in

good faith, files paperwork for a limited partnership, will be treated as a limited partner

o Liability: RULPA:

Limited partner is liable only to persons who transact business with the limited partnership reasonably believing based upon the limited partner’s conduct, that the limited partner is the general partner

ULPA: Limited partner will not be liable as a general

partner unless he takes part in the control of the business

o Gotham Partners v. Hallwood Realty Partners The Partnership has essentially adopted the entire

fairness test through bylaws – even though the entire fairness test is not necessarily applicable to the situation

Based on this case:

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DE has said that it is ok to not only restrict fiduciary duties, but a limited partnership can also eliminate fiduciary duties

However, the implied covenant of good faith and fair dealing still exists and will be followed

LLC Member-Managed - looks more like a partnership Manager-Managed - looks more like a corporate form In all cases - There will be an operating agreement, and you can

come up with any kind of operating structure you want The LLC is more a "creature of contract" than the other types of

partnerships - the general partnership is more a creation of common law

Westec v. Lanham and Preferred Income Investorso

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