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success. Eventually, Mrs. Fields decides to open a second store and hires John to
run it. At this point, she faces the problem of how to make sure that John does an
acceptable job of running the store.
This is the classic agency problem. The agency problem has two elements: (1) an
information gap and (2) a conflict of interest. Here, the information gap consists of
Mrs. Fields’s not knowing what John is up to at the second store. The conflict of
interest is that John wants to shirk whereas Mrs. Fields would prefer that he work as
hard as possible. Both ingredients must be present for the agency problem to
exist.
Mrs. Fields might try to solve the agency problem by entering into a contract with
John for the purpose of imposing certain minimum requirements on his
performance. Alternatively, she might install a camera in the second store in order
to monitor John. She might ask for regular accounting reports. She might share
some of the profits with John, so that he has an incentive to do well.
In practice, the solution is likely involve a mix of these approaches. Of course,
implementing these measures will impose costs, known as “agency costs,” on the
business.
Still, this does not solve the problem entirely. Suppose that John is intent on
leaving the store at 5pm to play tennis with this girlfriend and that he values
tennis-playing at $50. On the other hand, the store stands to make $200 if it stays
open for the rest of the evening. If John’s share of the profits amounts to less than
$50, he will close the store and leave. Of course, Mrs. Fields would prefer to walk
in and offer him a $100 share of the profits, but this is impractical in most
circumstances. These kinds of losses are known as “residual losses.”
Of course, it makes sense to hire an agent only if the profits from the second store
exceed the agency costs. A business owner, such as Mrs. Fields, therefore wants
to minimize agency costs. Many businesses have solved this problem on a large
scale. (Consider that McDonald’s manages thousands of stores worldwide.)
Suppose that Mrs. Fields has solved the agency problem for the second store and
wants to turn her two-store operations into a chain. Mrs. Fields approaches Diane
expressing a desire for a $2M investment. In exchange, Mrs. Fields offers Diane a
40% share in the profits.
Now Diane is starting to worry. Perhaps Mrs. Fields will underreport profits. Mrs.
Fields might start paying herself a much higher salary, which would reduce
reportable profits and thereby lower the amount to be paid to Diane.
Suppose that Mrs. Fields decides to start a chocolate factory to manufacture
chocolate chips for her cookie factories. As long as Mrs. Fields has 100%
ownership of both the chocolate factory and the cookie factory, it doesn’t matter
what price at which the chocolate is sold to the cookie factory. The only party that
cares is the IRS, which collects taxes on such transactions.
This, however, creates a problem for Diane. Because Diane’s interest comes solely
from the profit from the cookie factory, Mrs. Fields has an incentive to lower the
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cookie factory’s profits by raising the price of the chocolate. This issue known as
the conflicted-transactions problem.
Diane might respond by demanding veto rights over potentially conflicted
transactions. Alternatively, Diane could establish a benchmark price above which
the sale of chocolate would be suspect.
Note that Diane is now the principal and Mrs. Fields is the agent. As with the
Fields/John relationship, Diane will invest only if the gains exceed the agency costs.
Now suppose that Mrs. Fields wants to get a $2M loan from a bank. The loan
officer is now worried. Perhaps Mrs. Fields will take the money and flee. Perhaps
she will take on additional creditors who might take precedence in claims to the
business’s assets.
Suppose Mrs. Fields wants to upgrade the ovens in the store. Option 1 is a
standalone oven, which takes up store space and isn’t very efficient. Option 2 is
an oven built into the wall, which takes up no store space and is quite efficient.
Mrs. Fields would obviously prefer the built-in oven. The bank, however, would
prefer the standalone oven since it could be sold in the case of bankruptcy. The
bank might respond by writing restrictions into how the business might operate.
We now have three agency relationships: Diane/Fields, Creditors/Fields, and
Fields/Jones. Corporate law is all about these relationships. In a typical business,
Diane ↔ Shareholders
Minority Shareholders ↔ Mrs. Fields
Management ↔ John
B Structural Solutions
Structural solutions include devices such as the board of directors, which
supervises the management. The board of directors supervises the managers on
behalf of shareholders. (Of course, this raises the question of who monitors the
board of directors.)
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C Market Solutions
If management runs a corporation too poorly, share values might become low
enough to allow for a takeover. This in itself provides an incentive for the
management not to abuse the agency relationship. In addition, securities
regulations ensure that corporations disclose enough information for the market to
function effectively.
§ 11 Creating a Corporation
The charter, certificate of incorporation, or articles of incorporation is the
document that creates the legal fiction known as a corporation. Corporate law is
state law; each state sets forth its own technical requirements for incorporations as
well as default solutions to the agency problems. By far, Delaware is the most
popular state for incorporation. As a practical matter, this class will be concerned
mainly with Delaware law, though the differences between Delaware corporate law
and analogous laws in other states are not great.
The charter must contain certain provisions. First, the charter must state the name
of the corporation. Usually, the name cannot be something that could create
confusion as to the identity of the business. Second, the charter must specify the
number of shares that can be issued by the corporation. The number of shares
controls the amount of discretion to be exercised by the board of directors.
Suppose that Fields Inc. issues 100 shares to Diane and 200 shares to John. This
initial allocation would make John the controlling shareholder. If the board issues
500 shares to Mrs. Fields, however, Mrs. Fields then becomes the controlling
shareholder.
The charter may additionally designated different classes of shares or delegate
that responsibility to the board. This is also a large source of control, and it lays
the foundation for the “poison pill defense” to hostile takeovers.
In sum, the board of directors may exercise control through (1) allocation of the
numbers of shares and (2) setting the rights associated with each class of shares.
Additionally, the charter must specify agents to receive service in the event of a
lawsuit as well as the personal liability of the directors.
The charter may contain additional provisions to govern the corporation.
§ 12 Treaties
A corporate charter may be changed after filing, but the board of directors must
recommend the change. Shareholders may not recommend any changes. Once a
change has been recommended, however, shareholders must approve the change.
Changes must be filed with the Secretary of State.
The particular requirements for passing an alteration to the charter depend on the
jurisdictions. In particular, DGCL § 242(b)(1) says that abstentions count for the
quorum but not as “yes” votes.
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§ 13 Adopting Bylaws
Bylaws specify rules regarding the internal operations of the corporation. The
bylaws are not a public document. The charter can be considered the
“constitution” of the corporation, and the bylaws can be considered subsidiary
statutes. In practice, this means that bylaws cannot contradict the charter.
According to DGCL § 109(a), shareholders can always change the bylaws; the
board of directors may also do so if they are permitted to do so in the charter.
Jurisdictions operating under MBCA § 10.20(b) say the same with regard to
shareholders but say that the board is allowed to change the bylaws by default,
unless expressly restricted from doing so.
Suppose that the charter itself empowers the board to change the bylaws. (This is
true for most corporations.) Suppose that the board makes some change that
doesn’t sit well with the shareholders. The shareholders change the bylaws back.
Can the board then reinstate their change? The MBCA says that shareholders have
the “last word” in such cases of competing modifications. The DGCL does not give
shareholders this power, but it authorizes courts to adjudicate such disputes.
There is a division of view between the U.S. and the rest of world as to where the
“center” of the corporation lies. In non-U.S. countries, shareholders are the center;
as such, shareholders may dictate the bylaws. The U.S. view is that the center is
the board of directors. Just as the board may take out loans or hire employees, it is
the board of directors that “hires” shareholders. (The notion of “hiring”
shareholders is admittedly a bit odd.)
§ 14 Sources of Regulation
Corporations must comply with regulations from state and federal regulations.
Usually, federal regulations set forth only disclosure requirements, but Congress
may impose requirements beyond mere disclosure.
A third source of regulation is the stock exchange. Each stock exchange has its
own rules, some of which might affect the operation of the corporation.
Fourth, private arrangements might modify the “default” rules supplied by
corporate law.
§ 15 Why Delaware?
Initially, the leading state for incorporation was New Jersey. In the early 20th
century, New Jersey had a versatile corporate law as well as good courts with a
great deal of experience in administering that law. In 1909, governor Woodrow
Wilson of New Jersey introduced seven changes to the law (known as the “seven
sisters”), which were unacceptable to the business community. Delaware, which
had the same advantages of the old New Jersey laws, announced that it would
recognize all New Jersey precedent. As a result, all the corporations moved to
Delaware. Currently, fees from incorporation make up about 20% of the Delaware
budget.
At least one professor has argued that Delaware is leading a “race to the bottom”
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A Expected Return
In real-world situations, the probabilities and returns that determine the expected
return on any investment is not known with great certainty. As a result, each
person will have a different estimate of what the expected return will be.
B Risk
When we speak of “risk” in everyday life, we usually mean the chance that
something bad will happen. In finance, “risk” is a completely neutral term that
refers only to the degree of variation among possible outcomes. In general, risk is
measured in terms of the variance. In corporate finance, the expected return and
the standard deviation are sufficient to characterize any investment. (This only
works for returns that have a normal distribution.) In finance, there is a general
assumption that people will prefer “sure bets” to riskier investments (i.e., that
people are risk-averse).
A Types of Shares
If a corporation has only one type of share, then each share has exactly the same
rights under a “one right, one vote” system.
Of course, a corporation doesn’t have to have only one kind of share. It might opt
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to create Class A shares, which grant only voting rights, and Class B shares, which
grant only economic rights.
Even more elaborately, a corporation can customize the types even further. Class
A shares might be given 10 times the voting rights of Class B shares with all other
rights identical among all shares. Even more elaborately, a corporation can create
a Golden share whose only associated right is the right to veto a sale to the third
party.
Note that a share without economic rights has value for the shareholder only
insofar as the shareholder can “steal without breaking the law” by exploiting
various aspects of the corporation.
B Preferred Shares
Preferred shares go below fixed claims but above common shares when it comes to
precedence of claims. In a going concern, dividends are paid first to the preferred-
share holders before common shareholders are paid.
A Convertible Bonds
A convertible bond is a bond that comes with a call option. The call option gives
the holder the right to exchange the bond for some shares.
charity”). Here, we are dealing with an apparently “pure” donation. Here, Smith
Manufacturing was probably trying to take advantage of a tax break. That said,
why not allow the shareholders to make individual donations? The Smith court
realized that corporations made up most of the entities capable of making sizable
donations and that it is much more efficient to solicit the CEO of a corporation for a
donation than to solicit thousands of shareholders individually.
A Duty of Care
Francis v. United Jersey Bank (The Reinsurance Case)
Consider where the interests lie. Insurance companies entrusted money to
Pritchard & Baird. The money was then stolen by the two younger Pritchard
brothes. Now creditors are suing to recover the stolen money. But didn’t we say
that fiduciary duties run only to shareholders, not creditors?
Here, the court is treating Pritchard & Baird as a bank, which owes a fiduciary duty
not only to shareholders but also to depositors (here, the client insurance
companies). Given the resemblance of Pritchard & Baird to a bank, it would not
have been enough for Mrs. Pritchard to resign in the face of persistent malfeasance
by the directors.
In re Emerging Communications
Consider the problems of relying on “expert” opinions in running a corporation. On
the one hand, we want directors to be informed. On the other hand, increasing
liability for knowledgeable individuals could create an incentive to be ignorant.
directly to shareholders. The problem, however, is that the IRS gives no tax
deduction for this transaction.
In Kamin, the board of directors foolishly chose the direct distribution of dividends
and missed out on the tax break.
How does Kamin differ from Francis? In Kamin, the board used a valid process
even though the ultimate decision was “stupid.” Francis, by contrast, involved a
complete lack of process.
C Gantler v. Stephens
There was a conflict of interest between the directors of First Niles and the
shareholders. In particular, the directors had business relationships with First Niles
that might be damaged in the event of a sale. The Chancery Court (the lower
court) correctly concluded that standing to lose one’s position as a director does
not usually amount to a conflict of interest by virtue of being inevitable. In this
case, however, there were additional business interests beyond merely remaining
on the board.
Here, the board sought to implement a “reclassification” that would remove the
voting rights for small shareholders. (As it turned out, the board fixed the standard
at 300 shares.) Shareholders who held fewer than 300 would have their shares
converted to preferred shares. The effect was to cancel the voting rights
associated with the vast majority of shares, thereby preventing the possibility of a
takeover.
Here, the question was the effect of shareholder ratification. The court said that
ratification allows a decision to be subject to the business-judgment rule, even if
that decsions would not ordinarily be reviewed under a standard of reasonable
care.
D Mixed Motives
Suppose we have a public corporation C whose shares are trading for $100.
Suppose that acquirer A wants to buy C. A can buy up to 5% of the shares of C
without any notification. Once A has exceeded the 5% threshold, A must disclose
within ten days whether it intends (1) to hold its shares as a passive investor or (2)
to initiate a takeover. Suppose that A increases its holdings to 10% and makes a
tender offer for the rest of the shares at $150. When C’s directors learn of the
takeover attempt, they approach A and offer to buy out A’s 10% holding for $160
per share, subject to the condition that A promise not to abandon the takeover
attempt. (This is known as “greenmail.”) Note that at his point the shareholders
have missed out on (1) the money they would have made upon accepting the
tender offer. The shareholders are also forced (2) to share the cost of paying A to
go away.
Now, the motives of the board for participating in such greenmail are not always
clear. First, the board may genuinely believe that A is bad for the corporation’s
future. Alternatively, the board may be afraid that A might fire them upon a
successful takeover. When courts review decisions of boards in this context, they
apply a special standard to account for the mixed-motive nature of the question.
warehouses.
Iowa required a “fair” transaction to feature
1. Disclosure of the deal to disinterested directors
2. Shareholders can ratify the transaction
3. Fair terms
Although the relevant statute said that any of the three features would sustain a
finding of a fair transaction, the court found that (3) fair terms had to be present in
any fair transaction.
In this case, the board of directors approved the transactions. Why did the court
find the transactions to be fair? The court essentially held that Herrig was a
manager of better “quality” than the corporation might have found on the open
market. Considerations of “quality,” however, raise complex issues for review by
the courts. Basically, being a successful tends to bolster one’s chances of
prevailing in this kind of case.
In practice, the allocation of the burden of proof has a major practical impact on
who is likely to win; usually, the party with the burden is less likely to win. For
controlling-owner transactions, the fairness test + shifted burden creates
something similar to the business-judgment rule, but with the court reserving the
ability to inspect the transaction in detail.
Note that any defect in obtaining the approval of directors or shareholders causes
that approval to become to equivalent to “nothing,” whereupon the entire-fairness
standard applies.
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Tyson II
Under the Tyson Stock Incentive Plan, the directors could receive options with
strike prices equal to whatever the market prices were at the time the options were
issued (i.e., the Plan authorized the granting of “at the money” options). The
whole point of “spring-loaded” stock options is to grant options immediately before
the disclosure of favorable inside information. That way, the probable price
increase following disclosure of the information will put the options “in the money.”
A related practice is backdating, in which options are granted with a strike price
equal to some earlier, lower market price.
The court ruled against Tyson because the directors were “hiding behind
formalities” when making the disclosures regarding the spring-loaded options. In
effect, the court is imposing a duty of complete disclosure upon the corporation.
A Approving a Transaction
The Walt Disney case, which took place a few years ago, had to do with a CEO who
received a $140M severance package after doing a bad job for a year. The issue
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there was whether there was a breach of the duty of care by the directors. The
plaintiffs pleaded bad faith in order to overcome DGCL § 102(b)(7). The court
rejected the plaintiffs’ theory, saying that there is a difference between failing to
do one’s job (bad faith) and doing one’s job poorly (lack of care).
§ 30 Corporate Opportunity
Hawaiian International Finances
Note that Pablo Realty, Inc. is being sued alongside Pastor Pablo and Rufina Pablo.
Why would Pablo Realty be getting sued? The reason is that individuals who knew
of a breach of fiduciary duty are obligated to return any gains resulting from that
breach. Pablo Realty “knew” about the breach of fiduciary duty since Pablo, its
director, violated his duty to Hawaiian International.
eBay Litigation
The court held that the taking of IPO shares was basically like allowing
management to take bribes. Goldman Sachs was essentially bribing the eBay
executives to choose Goldman Sachs for future business. This created a conflict of
interest and therefore the incentive to breach the fiduciary duty.
Hypothetical
Assume we have 100 shares of A and 100 shares of B. Assume that the
corporation issuing the shares is worth $6,000. Now imagine that we have a
choice between liquidating the corporation and redeeming the Class A stock.
With $6000 of assets
100 A 100 B
Liquidate $40.00 $20.00
Redeem $60.00 0
The point of Zahn is that there were two otherwise legitimate options: one
favoring Class A shareholders and one favoring Class B shareholders. Assuming
both choices are legal in themselves, the controlling shareholder had an obligation
to honor its fiduciary to Class B shareholders.
Calculating Damages
We would take the difference between what the Class A shareholders actually
received ($80.80) and what they would have received had they converted their
holdings to B shares.
the stock. Although the shareholders know that they could collectively hold out for
$15.50, each individual shareholder has an incentive to immediately cash out at
the $14 price.
Now, what is the effect of the fact that Alcatel threatened Lynch? Nothing.
Suppose that Alcatel had simply walked away from the negotiations and made the
unfriendly tender offer the next day. It seems that there’s nothing legally wrong
with doing this.
A key point in this case is that the process of fair dealing is a proxy for determining
whether the purchase price was fair. Fair dealing allows the parties to avoid
litigation.
§ 32 Property Rights versus Liability Rights
Ordinarily, a majority shareholder can force a transaction upon the minority
shareholders.
Shareholders
|
Board of directors
|
Management
B Firing a Director
The corporate laws of many states allow shareholders to remove directors for good
reason. Furthermore, Delaware law allows shareholders to fire directors for no
reason.
Classified Boards
Suppose there is a board with 15 members. In a normal board, a majority
shareholder can fire all 15 directors for no reason. In a classified board, the
directors are divided into three groups, such that only one group comes up for
reelection each year. Someone who takes over such a corporation can only
appoint 5 directors upon takeover; it will take two additional years to replace the
remaining 10 directors. (The sole exception is if the buyer has good reason to fire
one of the remaining 10 directors.) The point of classified boards is to serve as a
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defense against takeovers; most owners are hesitant to deal with such a delay
since the non-removable directors can cause trouble with their business decisions.
Because classified boards strongly disincentivize takeovers, Delaware law forbids
corporations from arranging their boards in such a way to require more than three
years to obtain a majority of the board.
C Proxy Voting
The Borak Case
The Borak case established that private parties may sue for violations of proxy
rules. To the extent that allowing private enforcement increases the number of
parties that could potentially enforce the rules, why doesn’t the government just
ask for more manpower?
did not need to go through the proxy process in order to prevail on the decision.
Virginia Bankshares solicited proxies because it needed to preserve its reputation
within the community.
The court said that one need not show reliance on the part of any shareholders
because that would be practically intractable. The court also imposed liability on
the basis of negligence, though courts disagreed as to the exact standard.
Short Selling
Suppose that an investor knows that a stock’s price will rise from $200 to $400. In
that case, he should take a “long” position by buying shares and waiting for the
price to rise. Now suppose that the investor knows that the price will drop from
$200 from $100. Suppose also that he does own any of the stock. In this case, he
will borrow the shares from someone who has no intention of selling. He will sell
the borrowed shares at $200, wait for the price to drop to $100, and repurchase
the shares at $100. Then he returns the shares to the lender and walks away with
$100 per share. This is known as a “short” position. One takes this position when
he believes that the price of a stock will go down.
Consider, however, the risk of short selling. If the investor initiates a short sale at
$200 but then the price goes up to $1,000, he will lose $800 per share. Notice that
there is no limit to the losses that can result from short selling. By contrast, the
maximum that one can lose from a “long” position is the purchase price of the
stock.
§ 34 Shareholder Voting
Ordinarily, there is an alignment of interest between shareholders’ voting and
shareholders’ economic interests. Suppose that a shareholder owns 10% of the
votes but none of the economic interest. In this case, the shareholder cannot be
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Vote
Economic Rights
A Vote Buying
The problem of vote-buying results from the fact that individual shareholders tend
not to value their votes very much. Since the average shareholder owns only a
tiny fraction of the voting stock, he is unlikely to believe that exercising those
votes will have any impact on the outcome of any corporate decisions. At this
point, an interested party can approach the investor and offer $2 in exchange for
the votes. Buy accumulating a large number of votes, the interested party can
then influence the decisions of the corporation. Because the interested party has
no economic interest in the corporation, he cannot be trusted to vote in the best
interests of the corporation. For this reason, Delaware law prohibits vote-buying.
C Sale of Control
The whole point of the control premium is to reflect the fact that control of a
corporation can allow a controlling owner to take advantage of private benefits of
control while staying within the bounds of his fiduciary duty. The extent of these
private benefits depends on various factors, including government regulations,
market conditions, and so forth. Empirical studies indicate that the control
premium is 10%. By contrast, these studies indicate that the control premium in
Italy is 70%.
The minority shareholders will earn money if the purchaser of the control is a
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better manager than the seller of control. On the other hand, they will lose money
if the purchaser is a worse manager than the seller. But this is a risk that occurs in
any transfer of control.
For the seller, the crucial point is the moment of sale. Before that moment, the
seller can be held liable for violations of the fiduciary duty. After the shares have
passed in the hands of the buyer, the seller no longer cares what the buyer does
with the corporation.
From the perspective of the minority shareholders, the important question is
whether the new controlling shareholder is a better thief than the previous one.
Gerdes v. Reynolds
Note that the shares were valued at 6¢ but sold at $2. This is a typical example of
selling a corporation to a looter. The idea is that the sellers are receiving a
premium in exchange for allowing the buyer to do whatever he likes. The plaintiffs
claimed that the sellers should have known that the buyer was a looter.
The rule is that the controlling owner can keep the control premium, but he has a
duty to perform due diligence. He cannot close his eyes when he sees that the
buyer is paying a huge premium for the shares in question. In general, the
majority shareholders have a duty to ensure that the buyers are not looters.
The law is essentially forcing the sellers of control to police buyers to make sure
that the buyers are not corporate looters.
Perlman v. Feldmann
The central issue is the impact of the transaction on the Feldmann Plan. There was
a shortage of steel, so Newport Steel should have raised prices. However, this was
not politically feasible because it would make the company look unpatriotic. The
Feldmann Plan got around this problem by allowing interest-free loans from
consumers. This is effectively raising the price of the steel. The sale of Newport
Steel upset the apple cart with regard to the Plan. The “business opportunity”
missed was the opportunity to make customers pay a bribe to get the scarce steel.
The buyers (who were consumers of steel) wanted to avoid paying the bribe by
buying Newport Steel.
The court is not making a rule that the control premium always has to be shared
with the minority. The court is saying that if the sale of a controlling block entails
the sale of some asset belonging to the corporation, then the seller cannot keep
the premium all to himself.
Here are actual share prices for Newport Steel around the sale:
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Jul. $6.75
Aug. $8.50
Sep. $10.90
Oct. $12.50
Nov. $12.40
Dec. $12.00
Notice that share prices went up after the sale. However, we don’t know two key
facts: (1) what were the overall market conditions and (2) the value of the
company’s inventory.
Brecher v. Gregg
Importantly, the court is saying that there is a threshold size below which a block
of shares will, as a matter of law, not be considered a controlling block. When an
extremely small block of shares is allowed to control a corporation, that
shareholder has no incentive to observe the fiduciary duty. Instead, the
shareholder would be tempted to benefit himself at the expense of the other
shareholders.
But—the existing 4% owner can exploit the corporation just as much as the new
one. So why are we afraid of new owner? The answer is that the new owner will
have even more incentive to steal from the corporation in order to compensate for
the control premium he paid to the original owner.
Essex v. Yates
Here, Yates received a control premium for a 28.3 percent block of shares. The
court said that the burden was on the plaintiff to show that 28.3 percent was too
small to be a controlling block and that the payment of the control premium was
therefore inappropriate.
Note that the agreement concerning the appointment of new directors was
necessary because the buyers were not sure that they would be able to gain
control of the board through the normal voting mechanisms. Judge Friendly and
the majority disagree as to whether these sorts of arrangements are a valid way to
circumvent an uncertain vote.
A Asset Acquisition
Suppose we have acquiring corporation A and target corporation T. Initially, both A
and T have their own assets. In an asset acquisition, A purchases T’s assets,
paying in cash or by issuing shares of itself. This method, however, entails huge
transaction costs. A must spend time and money identifying T’s assets and
performing due diligence on them. Then there is the technicalities of transferring
title of the assets. Furthermore, T may hold some assets that are not transferrable.
At any rate, when the transaction is finished, all of T’s starting assets will belong to
A, and T’s “assets” will consist only of A stock.
The advantage of this method is that A can pick and choose the assets it wants to
purchase. A, for example, might buy only T’s factories without taking on the
employees working in those factories. In other words, A can avoid unfavorable
liabilities that might arise against T. Suppose that T polluted a river some years
before the merger. An asset purchase would insulate A from any judgment
rendered against T. In terms of shareholders, an asset purchase generally will not
trigger shareholder-approval requirements for either A or T. That said, the NYSE
has added its own requirement saying that some kinds of asset-for-stock purchases
must be carried out with shareholder approval. In particular, if A pays out 20% or
more of its total shares in exchange for T’s assets, then A must have that
transaction approved by a simple majority of its shareholders.
Now, after T’s assets have been acquired, the next step is to liquidate T and
distribute the proceeds to T’s shareholders. If T was paid in cash, then T’s
shareholders take that money and go home. If T was paid in A stock, T’s
shareholders become A shareholders.
Normally, no liability against T will run to A. However, some courts will treat this
sort of asset acquisition as a de facto merger and extend T’s liability to A.
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Usually, asset acquisitions are rare because they are so complex from a practical
standpoint.
B Stock Acquisition
Here, our goal is to reach a situation where T is a subsidiary of A. One way to do
this is to buy shares of T from T’s shareholders. This is typically done through a
tender offer. The problem with this, of course, is that the shareholders may not be
willing to give up their shares. This is a particular problem when a few holdouts
prevent A from getting 100% ownership of T. But assuming that the purchase of
stock is successful, we again have a situation where A is insulated from T’s
liabilities. Again, the main exception is when someone convinces a court to pierce
the corporate veil. Because T’s shareholders are offered money for their shares
individually, there is again no triggering of T’s shareholders’ rights.
A second way to do a stock acquisition is for T to issue enough new shares to A so
that A has control of T. In this case, T shareholders will have to approve the
transaction, but only under the simple-majority rule imposed by the NYSE. There is
no appraisal on either side.
C Merger
In a merger agreement, the shareholders and directors of both corporations must
approve. Furthermore, shareholders on both sides get appraisal rights. Normally,
the articles of merger must be filed with the relevant government offices. Once
this is done, all the assets and liabilities of T will move to A. T’s shareholders will
then get whatever price was negotiated for the transaction (either cash or A stock).
The merging parties have a choice as to the name of the corporation that emerges
from the merger. Notice, however, that liabilities against T can now be held
against A after the merger.
There are several exceptions to the requirements of board/shareholder approval
and shareholder appraisal.
Small-Scale Mergers
If A is much bigger than T, then the transaction can qualify as a small-scale
merger. The question turns on whether T’s shareholders are getting less than 20%
of A’s shares as payment. Of course, T’s shareholders don’t care that T is “small”
in comparison to A; T’s shareholders will still get to approve the transaction by a
vote as well as appraisal rights. For A, however, there is neither a vote nor
appraisal rights for shareholders.
A Twist
Suppose that A issues new shares to third parties to raise cash. A then uses the
cash to buy T. In this case, there will be no shareholder approval by T since the
transaction is technically an outright purchase rather than a merger.
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Short-Form Merger
Suppose that A already owns 90% or more of T. In this case, A can “cash out” the
public owners of T following a unilateral decision by the board of A. A’s board
simply offers a price to T’s public shareholders and tells them to go home. T
shareholders’ only right is the appraisal right, in case they feel the offered price is
too low.
D Triangular Mergers
Suppose that, as before, corporation A and corporation T want to merge. Let’s say
that under the agreement, T shareholders should get one million shares of A. In a
normal merger, approval by shareholders and directors on both sides will
consummate the transaction.
In a triangular merger, A creates a new corporation N, which has no assets. A then
transfers to N one million A shares (which would be paid to T shareholders in a
regular merger). Now, a merger agreement is signed between T and N. Again, T’s
shareholders will get one million shares of A. The difference, however, is that A is
the sole shareholder of N. Furthermore, the board of N will be employees who do
A’s bidding. When the T-N merger is complete, subsidiary N will hold all of T’s
assets and liabilities. The last step is to determine whether the subsidiary should
be called T (“backward triangular merger”) or N (“forward triangular merger”).
Here, A is again insulated from liabilities originally against T. Furthermore,
shareholders of A neither get to vote on the merger, nor do they get appraisal
rights.
It should come as no surprise that the most common form of merger is the reverse
triangular merger.
Leverage
Suppose that corporation A and corporation B are similar in every respective and
both have $1,000 in assets. Corporation A is financed 90% by equity and 10% by
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debt. Corporation B is the other way around: 10% by equity and 90% by debt.
Now suppose that something bad happens to the economy and both corporations
lose $200 of their assets. In corporation A, the $200 loss will be borne by the
shareholders. In corporation B, the first $100 of the loss will exhaust what can be
borne by the shareholders; the remaining $100 will fall on the creditors. B is
known as a “highly leveraged” corporation since it has a lot of debt compared with
its asset value.
In the A/T leveraged buyout, the huge debts incurred by A will fall on T’s assets.
Bonds issued by T will have their ratings reduced because of the sudden increase
in debts. Result: T’s bondholders will be angry.
Now, a very smart investor figured out that a diversified portfolio of junk bonds
could give a higher-than-normal return/risk ratio. (In short, the bonds issued by A
were underpriced.)
using methods that are easily verifiable. For example, a building is always listed at
its purchase price. Of course, the problem is that accountants then have to adjust
for the appreciation or depreciation of assets.
The judges were wrong to rely on book value in making their decisions. (Note that
this was the Supreme Court of Pennsylvania, not Delaware.) They decided whether
the plaintiffs had been harmed on the basis of values that were completely
irrelevant.
Aside: In recent years, there has emerged an accounting system called
International Financial Reporting System (IFRS). This system requires that assets
be recorded based on their current values, not based on purchase cost or some
other arbitrary snapshots. IFRS has not yet been adopted completely in the U.S.,
but American accounting firms are increasingly using methods that are in line with
the intent of IFRS. Of course, the downside is that some subjective judgment is
necessary to appraise certain assets, so there is some room for manipulation of
asset values.
C Appraisal Rights
Why do appraisal rights exist? Originally, corporations were not traded on open
markets. The lack of liquidity meant that appraisal was the only way to get any
meaningful estimate of the value of a corporation. Now that many corporations
are publicly traded, consider what purposes appraisal may serve.
Originally, there was the fiduciary duty, which required directors to engage in fair
dealings and to provide a fair price in a merger. Now, the appraisal right
supplements the fiduciary duty.
exceptions to the appraisal right, which do not hold when a breach of fiduciary
duty is claimed.
It should therefore not be surprising that most shareholder actions are brought as
fiduciary-duty claims rather than appraisal-right claims.
however, that the bidder then says that he will only buy 50% of the shares at
$150. At this point, the average seller will sell half his shares at $150. The second
half will then be sold at the forced price (let’s say $100). The average selling price
of the shares will ultimately be $125.
The only scenario in which sellers can express their true opinion as to the value of
their stock is when the price in the second step is the same as the price in the first
step.
But Unocal went one step further by committing to buy 29% of the shares for $72
per share regardless of whether Mesa’s tender offer succeeded. This was a huge
financial commitment and required huge amounts of debt. As a result, Unocal
would have to change its business plans to account for these new obligations.
Unocal was very clear, however, that this 29% commitment would not include any
shares held by Mesa. What is the effect of this decision?
Suppose that a corporation has assets of $60 and three owners (A, B, and C), who
each own two shares at $10 each. Now suppose that the corporation offers only B
and C to sell back to the corporation one share each at the price of $20. Consider
what happens when B and C accept this offer:
A – 2 shares
B – 1 share + $20
C – 1 share + $20
Now we are left with 4 shares and $20 in the corporation. This means that each
share is worth only $5. In other words, the two shares of A are worth only $10, as
opposed to the $20 before. The holdings of the shareholder who doesn’t
participate in the buyback are diluted. This rearrangement is a zero-sum game
because the company is simply reassigning claims among various shareholders.
Unocal justified this maneuver as a way to protect itself against the takeover.
Note, however, that Unocal’s action was actually more coercive than Mesa’s offer.
The 29% commitment by Unocal would drastically raise the value of those shares
at the expense of the remaining 71%. In effect, the first 29% of the shares would
be worth $72 whereas the remainder would be worth only $35. Compare this
spread with the $54/$45 spread of Mesa’s offer. (The 29% offer went out pro rata
to all non-Mesa shareholders who wished to tender their shares.) Believe it or not,
some shareholders nonetheless tendered to Mesa.
Here, the court found that Unocal’s actions were legitimately defensive conduct
because Mesa had started a coercive tender offer. Is this response “proportional,”
however?
In any case, the Unocal rule states that a company taking a defensive action must
show (1) a threat and (2) that the defensive action is proportional to the threat in
order to avail itself of the business-judgment rule.
§ 39 Poison Pills
The “poison pill” is possible only because the Unocal court said that a corporation
may discriminate against a threatening bidder in a hostile-takeover effort. There
are two types of poison pills: “flip-in” and “flip-over.” The board of directors
adopts the pill by incorporating the relevant provisions into the corporate bylaws.
The operation of a pill begins with the distribution rights (i.e., call options) that are
way, way out of the money. (This is mainly to notify bidders of the existence of a
poison pill.) The second step is to define a triggering condition (e.g., a bidder
obtains a certain percentage of the stock), which changes the terms of the initial
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options. The triggering condition usually changes the terms allow existing
shareholders to purchase additional shares of the target (or the bidder) at a
significant discount.
Suppose that a corporation has $300 in assets and three shareholders (A, B, and
C). So initially, we have
Total assets: $300
A – $100
B – $100
C – $100
Suppose that the hostile bidder buys A’s share and thereby fulfills the triggering
condition (by owning 33% of the shares). The triggering condition states that B
and C will allow to buy one additional share at half price. So now the total assets
of the corporation are $400, but there are five shares. So now each share is worth
only $80.
Bidder – $80 (1 share; lost $20 because paid $100 for share)
B – $160 (2 shares; gained $10 because paid only $50 for second share)
C – $160 (2 shares; gained $10 because paid only $50 for second share)
The poison pill thus dilutes the bidder’s holdings. In real-world scenarios, a pill
may take away a much larger fraction of the bidder’s value.
Flip-Over Pills
How is this even possible from the legal standpoint? The answer is that the flip-
over pill activates only after the purchase is completed. In practice, the flip-over
pill is part of the conditions of sale of the target corporation.
existing board, and we will pay you a premium for your shares.”
Class 11 (September 1)
Paramount Communications, Inc. v. Time Inc.
The deal started out as a stock-for-stock merger between the two companies, but it
became a two-tier merger in which the first tier was paid in cash and the second
tier in stock. The Time-Warner merger was structured as a triangular merger at
first, but it became a two-tier tender offer.
How do the Revlon duties apply to this case? Note that Warner seems to be selling
control to Time. In the end, Time’s board was able to force Warner’s shareholders
to give up the $200 price and accept the $110 price. The court gave deference to
directors as to the intrinsic value of shares.
Suppose instead that A gives B’s shareholders cash. After the merger, the former
B shareholders simply go home. Here, all the shareholders left after the merger
will be A mergers. Here, there is a sale of control and therefore Revlon duties. But
now, why should the form of payment dictate whether the Revlon duties are
triggered? After all, can’t the former B shareholders use their cash to buy shares in
the post-merger corporation? Why is there one rule for cash and one rule for
stock?
Here, the court is deferring to the discretion of the board as long as the payment is
in the form of shares. The adequacy of cash payments, on the other hand, is very
easy for courts to evaluate.
Consider the scenario in which Paramount shareholders became minority
shareholders upon completion of the merger.
§ 40 Special Lecturer
The Delaware General Corporations Law does not contain the words “fiduciary
duty” anywhere. Rather, the fiduciary duty is a common-law creation of Delaware
courts. Before the takeover boom in the ’80s, cases turned on concepts like
“purpose.” The main obstacle, however, is that determining a person’s purpose
was difficult when judges were unable to see that individual in person. Therefore,
tests like Unocal were developed to allow judges to make decisions without having
to determine issues like directors’ intent.
Formerly, mergers could not go through unless the shareholders unanimously
approved. This meant a single holdout could spoil the prospects for a merger.
Lawyers circumvented this rule by arranging for long-term “leases” of corporations
that operated essentially like mergers.
In general, directors have huge power to change a company without approval by
shareholders.
Directors’ duties in the takeover context arose in the ’80s.
Class 12 (September 2)
§ 42 Securities Regulation
The purpose of securities regulations is to ensure the efficient operation of capital
markets. Where there are repeat players in a market, prices will tend to match the
quality of the product since it’s possible to cheat people only once.
Now suppose that a buyer and seller are negotiating over the price of a black box.
As long as neither party has more information than the other as to the contents of
the box, the game is “fair” in the sense that neither party can use his informational
advantage to manipulate the other party. Corporations are like black boxes, and
thousands of investors constantly try to guess the value of the contents of those
boxes. However, investors invariably have differential access to knowledge about
the contents of the box. The important thing is that not every investor needs to
know the key information in order for price to reflect value. Emprical studies show
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that as long as at least 25% of investors know the relevant information, the market
will behave as if every investor knew that information.
Suppose corporation A and corporation B are both trying to raise money. These
companies might sell stock (or bonds) directly to investors. This is known as the
primary market since the corporations are directly receiving money for the
securities. After the securities have been issued, investors will trade the securities
amongst each other. This is known as the secondary market. Note that trading on
the secondary market does not bring any money to the corporation. The
secondary market performs important functions, such as allowing for takeovers
when the stock price is too low. Furthermore, prices in the stock market serve as a
benchmark for transactions outside the stock market.
An efficient market is a market in which prices reflect value. The problem is that
testing the efficiency of markets is very difficult because there is no objective
measure of value. There are three test for efficiency:
Weak Efficiency
Weak efficiency is based solely on past prices. If there is some information that
can be gleaned from past prices, an efficient market will incorporate that
information into present prices. The result is that the price will fluctuate randomly
from day to day. This result has been borne out by empirical studies.
Semistrong Efficiency
A market is semistrongly efficient if prices immediately and accurately all publicly
known information. If some piece of information becomes known which alters the
price, prices should respond immediately. In practical terms, this means that
prices should respond within 7–14 minutes. From an ex post perspective, however,
it is hard to tell whether prices actually hit the “magic point” within 7–14 minutes
or whether the actual price reached represents undershooting or overshooting.
This has implications for people who might want to make delayed use of the
relevant information. If there is reason to believe that the market has overshot,
then an investor should take a short position on the security. If there is reason to
believe that the market has undershot, then an investor should take a long
position. If there are some expert investors who can “beat” the average investor
by making quicker and better use of the information, then the market can be said
to be inefficient. (Mutual funds like to claim this about themselves.)
Unfortunately, empirical studies of mutual funds have found that they don’t beat
the market when their results are adjusted for risk.
“There is something in life which is even more important than wisdom. It’s called
luck.”
So what about investors who seem to have some kind of “magic touch”? It is
entirely possible that those few people out of the many thousands (if not millions)
of investors are simply statistical outliers.
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Strong Efficiency
A market is strongly efficient when it immediately and accurately reflects all
information (not just publicly known information, as in a semistrongly efficient
market). Suppose that some information starts out private, so that perhaps only
the CEOs of two merging companies initially knows the information. When the
information is release publicly, one of two things will happen:
(2) Nothing. The information may leak to a sufficient number of persons to cause
the market to respond. If this is the case, then insiders should not be able to beat
the market. Empirical studies have shown that inside traders in the U.S. routinely
beat the market despite the prohibition on insider trading. (Whether insider
trading should be allowed will be discussed later.)
Information Trading
Now, information traders must make enough of a return in order to cover their
costs and make a profit. The insight here is that the size of the price deviations is
only one factor influencing the behavior of informational traders. The other factor
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Prohibitions on Fraud
Normally, when we say “fraud,” we are referring to misleading pieces of
information. This is in contrast to “manipulations,” in which an unscrupulous
investor might try to buy and sell from multiple accounts owned by himself, etc.
determine whether hard information is material. The Basic court considers three
tests for the materiality of information concerning mergers:
1. The “agreement in principle” rule. This rule has the advantage of being a
bright-line rule. Furthermore, this rule has the advantage of not forcing the
corporations to disclose the planned merger too early. Under the “too early”
justifiation, the court pointed out problems concerning
1. When the possibility of a merger becomes a material fact
2. When the obligation to disclose arises
2. The Basic court rejected the agreement-in-principle test and accepted
instead the magnitude-of-probability test. The court recognized that
agreement-in-principle was a purely doctrinal rule that had no regard for
economic realities. The magnitude-of-probability test, however, focuses on
economic realities.
3. Lying. The court rejects this test works backward. Even if a lie is found, no
liability will attach if that lie was found to be “not material.” But this
completely negates the purpose of calling the statement a “lie” in the first
place.
The court, however, wanted to have a legal test that would fit economic reality.
Note, however, that the court does not specify how great the probability of a
merger (or the expected returns) can be before the possible merger becomes a
material fact.
The Basis court held that the possible merger became a material fact before
agreement in principle occurred (and disclosure rule took effect). The main
objective of this holding was to rein in insider trading. By holding that the possible
merger was a material fact before its disclosure to the public, the court was
hanging a sword over the heads of would-be insider traders who knew about the
merger before everyone else.
Fraud-on-the-Market Theory
This theory assumes that (1) the market is efficient and (2) the integrity of the
market price. Now, “efficiency” in this sense cannot refer to strong efficiency; if
that were the case, then there would be no such thing as “insider” trading anyway.
In an omitted footnote, the court is saying that it is providing protection to
information traders. Second, there is the question of what the “market price” is.
The court is saying that “antitrust or political pressure” is a way to rebut the
integrity of the market price.
Class 13 (September 3)
A major goal of securities regulation is to minimize the costs associated with the
pricing of securities. This is accomplished through disclosure requirements and so
forth. The lower costs allow more competition.
Section 10(b) and Rule 10(b)-5 give rise to an implied right of action. This right of
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action is available only to parties that actually sold or purchased securities on the
basis of information.
§ 43 Insider Trading
Recall that the only two types of traders that can align price with value are (1)
information traders and (2) insiders. When we say that an insider has traded,
intuition tells us that it is the party opposite the insider that has been cheated in
some way. But consider what happens upon closer investigation.
Consider a piece of favorable inside information, which drives the corporation’s
stock price from $100 to $200. In a world without insider trading, disclosure of the
information would cause the price to jump instantaneously from $100 to $200.
Due to insider trading, however, the price gradually rises from $100 to $200 in
anticipation of the information’s release. What happens to a liquidity trader
playing alongside the insiders? When the liquidity trader is buying alongside the
insider, the liquidity trader “loses” because the insiders have driven up the prices.
The same is true when a liquidity trader sells alongside insiders. By contrast,
liquidity traders “win” when taking positions opposite those of the insiders. On
balance, however, liquidity traders have diversified portfolios, so they’ll be on the
same side and opposite sides with respect to insiders with about equal frequency.
Consequently, liquidity traders can diversify away the effects of insider trading.
Compare the situation of the liquidity traders with that of information traders.
When the price of a stock is rising due to insider trading, an information trader
(who has no idea that positive information is about to be divulged) will conclude
that the stock is overpriced and therefore take a short position. Because the
positive information will ultimately cause the stock to keep rising, information
traders will lose on their short positions. An analogous scenario unfolds for price
drops. In other words, information traders will always trade on the “same side” as
insiders and constantly losing.
In fact, insiders have an incentive to “milk” inside information by delaying
disclosure of information. This maneuver is not available to information traders
since they have no influence over when the corporation decides to release inside
information.
Liquidity
Normally, liquidity is provided by “market makers,” who are people who constantly
trade shares with others. Market makers make money by implementing a bid-ask
spread, so they always buy at a slightly lower price than they sell. The difference
between the bid price and the ask price is known as the spread. The higher the
bid-ask spread, the lower the liquidity; a higher spread means a higher price of
trading. Market makers know that they will “lose” when trading with insiders, so
they try compensate by increasing the spread; this reduces liquidity.
Empirical studies have shown that the bid-ask spread is indeed lower in countries
that strictly enforce anti-insider-trading laws. Such markets also have more
analysts.
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contrast, no such relationship exists between the waiter and the dining CEOs.
What about people like lawyers, accountants, investment bankers, and other
people who might come into contact with insider information? Here, the argument
is based on access.
Dirks v. SEC
Normally, the rule is that the recipient of inside information passed without any
breach of fiduciary becomes a temporary insider. The recipient then faces
essentially the same restrictions as a regular insider. However, if the insider did
breach the fiduciary duty in releasing inside information to a “tippee,” then the
tippee faces liability for using the information to trade.
Here, the twist is that the releasor of information was doing so with the intent of
exposing fraud. If we say that the releasor of information did not breach his
fiduciary duty, Dirks should be considered a temporary insider. But the court did
not take this approach; rather, the court held that Dirks could nonetheless have
traded using the information.
Liability of Tippees
Suppose that the initial tippee disseminates information to other tippees, who in
turn disseminate the information even further. How far should liability run? The
rule is that anyone in the chain who knew the information came from a breaching
insider faces liability.
§ 45 What the SEC Restricts
Currently, the SEC no longer allows closed conference calls (see supra). If an
insider makes an unintentional disclosure of insider information to someone who is
likely trade on that information, that insider has the immediate duty to correct that
problem by disclosing that information to the general public.
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Now, consider the 10% benchmark of section 16. Section 16 assumes that holding
10% or more of the stock is what converts an ordinary investor into an insider.
Therefore, any transaction involving less than 10% of the stock and the initial
transaction that puts the investor over the 10% limit don’t count toward the limit.
Having eliminated the irrelevant transactions, we look for buy-sell combinations
that maximize the total profit. So we match 70 shares from S* and P* for a profit of
2940. The remaining 20 shares from P* are matched with S+ to give an additional
40 in profit. That gives a total liability of $2980.