AGENCY

Who’s An Agent; When Authority

3 kinds of issues: 1) what’s an agent, looking at the restatement of agency 2) what’s the
affect of an agent on legal relationships of principal 3) agent’s duties to principal

To create an agent/principal relationship, you don’t need to formerly say “I will be your
agent.” The agreement also does not absolutely need to be in writing.

Parties contracting with the agent are liable to the principal.

A principal is also subject to liability on contracts made by the agent on behalf of the
principal.

For a principal to liable for the action’s of the agent: a) the agent must be a
servant/employee of the principal master. b) the tortious action must have been done
within the scope of the agent’s service/employment.

Sect 1 of Rest. defines agency. Agency is the fiduciary relation which results from a) the
manifestation of consent by one person to another that b) the other shall act on his behalf
and c) subject to his control and d) consent by the other so to act.

Sec. 2 of Restatement says the master is a principal who controls or has the right to
control the physical conduct of the agent.

Court stretches to say a jury could find a principal/agent relationship where a teacher
lends a car to a coach to drive students to the game and the coach gets in an accident
(Gordon v. Doty)

Court finds sufficient control by grain dealer to establish that a grain elevator was the
agent of a grain dealer, such that farmers could sue the grain dealer for the grain
elevator’s failure to pay. (Jensen Farms v. Cargill)

Someone will be viewed as a subagent of a principal if the principal’s agent had express,
implied, or apparent authority to hire the subagent.

Apparent authority (sec. 5) deals with whether Sam thought Bill had the authority to
employ him, while implied authority deals with whether Bill had the implied authority to
employ Sam.

Court finds that Bill had implied authority to hire Sam on behalf of the church, because it
was implied that Bill would get help painting the church. Therefore, Sam was a subagent
of the church. (Mill Street Church v. Hogan)

1
Court finds that supervisor had apparent authority to hire the plaintiff on behalf of the
company, because plaintiff reasonably believed that the supervisor was authorized to
make such a sweet deal. (Lind v. Shenly Industries) (check on result)

“the principal is liable for all the acts which are within the authority usually confided to
an agent of that character.” This is similar to, but not quite apparent authority. This
principle the Court put forth is called “inherent authority.” Court finds manager of hotel
had inherent authority to purchase cigars from the plaintiff on the hotel’s behalf.
(Watteau v. Fenwick)

To find apparent authority, we need to find conduct by Arco that truck stop owner could
have interpreted as giving employee authority. Inherent authority would bind Arco if it is
usual for an employee negotiating with the truck stop owner to be able to give discounts.
To show this inherent authority, the normal customs of the trade with respect to the
power of an employee to negotiate discounts would need to be demonstrated. Inherent
authority thus seems to be a looser form of apparent authority. (Nogales SC v. Arco)

Ratification requires intent to ratify with full knowledge of the material circumstances. It
seems unlikely that the wife was aware of the full material circumstances of the lease
with the option to purchase, so therefore she could not have ratified it. (Botticello)

Ratification is usually used as a means of protection of 3rd parties, not the principal.

Woman buys clothes from man in department store who was in fact an impostor. No real
or inherent authority cuz the guy wasn’t an agent. No apparent authority either cuz the
department didn’t really do anything to manifest that the guy had authority. The
alternative theory the court uses is authority by estoppel, under which the Court requires
the woman to show acts or omissions, intentional or careless, by the department store,
which created the appearance of authority in the impostor. There has to be a good faith
reliance on the appearance, and a change in position. (Hoddeson v. Koos Brothers)

Liability in Contract & Tort

Humble and Hoover deal with the level of control necessary to establish tort liability.
Not a bright line rule but one of degree.

Court found lack of control by Holiday Inn over the details of the day to day operations
of the hotel, so that Betsy-Lenn was not a servant-type agent. Therefore, Holiday Inn not
liable for accident. (Murphy v. Holiday Inn)

Actual authority, implied actual authority, apparent authority, inherent authority, or

authority by estoppel can create duties of principal to third person by way of agent.

With respect to creating liability in principal for actions of agent, not any old agent who
does something negligently will make the principal liable. The agent needs to be a
servant type agent, not an independent contractor type agent.

2
Also, you can’t make a master liable for the actions of the servant if the servant is acting
outside the scope of his employment.

Old Restatement guidelines: conduct of servant is within scope of employment if and

only if the action is 1) of kind he is employed to perform 2) takes place within time and
location space limits 3) is motivated in part by a purpose to serve the master 4) not using
force intentionally against someone else.

Even though drunken coast guard sailor does not seem to be motivated by a purpose to
serve the master when turning on the valves at a dock at which his ship is docked, court
employs new foreseeability approach to say, the govt cannot “justly disclaim
responsibility for accidents which may fairly be said to be characteristic of its activities.”
Another way of saying this is that if the actions by the sailor are reasonably foreseeable
by the government, the government should be liable. This conception relies on notions of
fairness. (Bushey)

The Restatement says that certain acts which are intentional torts may be within the scope
of employment but the action “must be of the same general nature as that authorized, or
incidental to that authorized.” Orioles found liable for actions of pitcher who
purposefully pegged a heckling fan. (Manning v. Grimsley)

Gas station employee uses racial epithets against customer following dispute over a credit
card. Court says question of fact whether the employee was acting within the scope of
employment, since the racial epithets were made while at work, while checking credit
cards. And the employee may have been motivated to act in the interests of the
employer. (Arguello v. Conoco)

Govt hires independent contractor to do construction work, and contractor mistakenly

damages a neighboring building, so neighboring building owner sues govt. There are 3
circumstances in which govt might be held responsible for independent contractor’s
action: 1) (didn’t hear) 2) when the government negligently hires a negligent contractor
3) when the activity involved is a nuisance per se or inherently dangerous. Court finds
that knocking down a building in an urban area like this is an inherently dangerous
activity, such that the government can be liable. (Majestic Realty v. Toti)

Fiduciary Obligations of Agents

A few fiduciary duties of agents to their principals include obedience, care, loyalty.

Agents cannot make secret profits from misuse of his position – if he does, he must turn
them over to the principal. Therefore, soldier violated fiduciary duty when used his
position to smuggle goods. (Reading v. Regem)

Employee believes his company cannot do work for a client, so on his own refer the
client to another company, earning himself referral fees. Court says employee violated
his fiduciary duty to the company by not informing the company that the client tried to
place an order with the company. Therefore, employee must give referral fees to his
company. (General Automotive v. Singer)

3
Some employees leave company to start their own competing company and take many of
the original company’s clients with them. Court finds breach of fiduciary duty because
the original company spent a lot of time and money finding and developing these clients,
so the list of clients was a kind of trade secret, and it would be unfair for the employees to
leave and take those clients with them, without doing any of the work necessary to find
and develop these clients. (Town & Country v. Newberry)

There is a duty of loyalty that does not allow secret profits. This is true where there are
conflicts of interest between the agent and principal, or when the agent uses his position
in dealing with others (Reading) or uses property, knowledge or assets of the plaintiffs
(sort of Town & Country). Fiduciary duties also mean that the agent should not usurp
business opportunities of the plaintiff (Singer) or compete with the plaintiff. Also, no
taking of property (broad sense) when the agent leaves the principal’s company (Town &
Country).

Fiduciary duties are not just applied to agents, but lots of other people who have
discretionary powers, eg trustees, partners in partnerships, and directors in corporations.

Degree of fiduciary duty depends on relationship and amount of control a party has.

PARTNERSHIPS

A lot more partnerships and proprietorships than corporations.

Uniform Partnership Act (UPA) is the law in virtually all states, so they are more
authoritative then is the restatement in the agency context.

What’s a partnership? Who’s a partner?

Partnership defined = a partnership is an association of two or more person to carry on as

co-owners a business for profit.

Partnerships are created by agreements or actions that signify agreements (mutual

understandings) – this is in contrast to corporations which require specific formal acts
(filing certain forms, etc.)

So creation of partnerships is much less formal than with formation of corporations –

people do not even have to necessarily know they are forming a partnership to have
formed one.

As a result of a lack of formality, there is a lot of line-drawing. Most rules are only
default rules, and subject to contrary agreement among parties.

Partners themselves pay taxes on the profits they receive; the partnership itself doesn’t
pay income taxes.

4
Default rule is that when people create a partnership, each person has the same voting
power.

As for profit sharing, after each partner is repaid his contribution, the default rule is that
everyone shares equally in annual profits.

If one of the partners acts negligently, the entire partnership is liable for the wrongful act
of the individual partner. Moreover, if the assets of the partnership don’t cover the
expenses of the suit, the individual partners can also be liable for the negligent actions of
another partner. So partnerships have joint and severable liability.

If one of the partners wants to leave the partnership, the default rule is that you can
always dissolve the partnership. Even though it might destroy economic value, he has the
right to just call it quits and get bought out.

Case law helps to distinguish partners from a) employees (Fenwick) b) lenders (Martin v.
Peyton) c) contractors (Southex Exhibitions)

Owner gave receptionist deal in which receptionist would get fixed salary plus 20% of
the profits. Despite the fact that the agreement said they were partners, the court said
they were not partners because she did not have to put up any capital, she would not share
in any losses, and she did not have any control or management rights. Element of co-
ownership is completely lacking. So the element of profit-sharing was present and
relevant, but not enough. (Fenwick)

PPF loans KNK some money. In addition to profit sharing, PPF has some control rights,
unlike the receptionist in Fenwick. The Court says this is what lenders do, so PPF was
not a partner in KNK. (Martin)

Can Cargill case in which party exercising control was found to be principal be
reconciled with Martin, where party exercising control was found not to be partner?

Southex and RIBA run homebuilding show together. Although there was profit sharing,
Southex bore all the risk of loss, Southex seemed to have more of the control of the show,
and the contracts they had were for fixed 5 years terms that could be renewed. Therefore,
court said it seemed more like a service contract than a partnership. Therefore, RIBA had
a right to dissolve the relationship with Southex, so that Southex was not entitled to any
damages for RIBA hiring another company to run the show. (Southex Exhibitions)

UPA 16(1) Partnership by estoppel – if A has represented to C that it is a partner with B

or consented to B representing to C that A and B are partners, and then third party gives
credit to apparent partnership on the faith of such representation – or just gives credit, if
the representation was public, then C may sue A on a theory of partnership by estoppel.
Court finds insufficient evidence of partnership by estoppel between Price Waterhouse
US and Price Waterhouse Bahamas. (Young v. Jones)

Fiduciary Obligations of Partners

5
Salmon, partners with Meinhard in lease of building, goes around Meinhard, toward the
end of the building lease, to lease the entire block where the building is located. Court
says Salmon violated fiduciary duty, because “Joint venturers, like copartners, owe to one
another, while the enterprise continues, the duty of the finest loyalty…Not honestly
alone, but the punctilio of an honor the most sensitive, is then the standard of behavior.”
So what exactly is the standard of conduct required of Salmon? It was not just enough
that he didn’t lie; he had an affirmative duty to disclose to Meinhard of the opportunity
for leasing the block. (Salmon v. Meinhard)

103(b)(3) – a partnership agreement may not eliminate the duty of loyalty under 404(b),
but the agreement may identify specific types or categories of activities that do not
violate the duty of loyalty, as long as those conditions are not manifestly unreasonable.

So yes, you can bargain as to specific requirements of duty of loyalty, but may not do
away with the duty altogether.

Once a partner retires, he is no longer part of the partnership, so that the managers of the
firm had no fiduciary duty of care to him. (Bane)

Violation of duty of care is very hard to prove and win on.

Negligent mismanagement is not sufficient to create a violation of fiduciary duty under

the business-judgment rule. The business-judgment rule under corporations law says that
just making a bad, negligent decision is not enough to make a business manager liable.
The manager must have done something really, really bad or committed intentional
misconduct in order for the manager to be liable for a business decision. (Bane)

Two partners leave law firm and take some associates and clients with them to start new
law firm. They breached their fiduciary duty because 1) they lied months earlier by
saying they were not going to leave the firm 2) bad process of soliciting clients, for
example by delaying informing the other partners of what clients they wanted to take
with them and 3) the prejudicial content of the letter to the clients in contrivance of the
ABA’s ethical guidelines written in footnote 15. (Meehan v. Shaugnessy)

So what’s ok and what’s not ok when leaving a law partnership? They can leave a
partnership, they seem to be able to take associates with them, and may be able to take
clients if the process is right, though they can’t do things like dragging out cases so that
the case is settled after they leave the firm instead of before.

Law partnership expels partner with history of alcohol abuse. Court finds that a firm firm
does have a duty of good faith and fair dealing for expulsion under UPA 31(1)(d), which
cannot be contracted out of, though that duty was not violated here. Very difficult under
Court’s analysis to find a violation of duty of good faith. (Lawlis v. Kightlinger)

Partnership Property; Capital; Management

Woman sells half her interest in company to Shoafs; it is later discovered accountant had
embezzled money so that after recovering money from him, partnership was worth more

6
than previously thought. She claims she should recover all the money, not just half of it.
Court said that Mrs. Putnam did not have an ownership interest in any of the specific
property. The partnership owned the property and she simply had an interest in the
partnership. So the only thing she could and did transfer to Shoaf was her interest in the
partnership. She had no specific interest in the property of the partnership. Therefore,
the Shoafs get the other half of the money from the bookkeeper. (Putnam v. Shoaf)

What does a partner own and whether & how can it be transferred? UPA 24 says
property rights are 3 fold:

1) rights in specific partnership property (sec. 25), which means only possessory
rights for partnership purposes only and those possessory rights are not assignable
by an individual. The possessory rights are only assignable by the partnership.

2) Interest in the partnership. (sec. 26). Interest in the partnership means the
partner’s share of profits & surplus. This interest in the share of profits & surplus
is personal property and is assignable under sec. 27.

3) Management rights: these are equal, unless otherwise agreed (18e). These
management rights are not assignable by an individual partner. (See 18g on how
new partners get in – by consent of other partners)

Management-type rights include various collateral powers. Individual partners can

a) act as agent of partnership
b) bind partnership by admissions, knowledge, wrongful acts, breach of trust
c) the bundle of such rights cannot be sold by the individual partners

Two partners in store. One tells Nabisco the partnership won’t buy from it, but the other
partner then buys from Nabisco. Nabisco demands payment. Court says partnership can
only prevent a partner from taking an action on behalf of the partnership if there is a
majority vote. There is no majority vote here since there are only two disagreeing
partners. Therefore, partner had right to buy from Nabisco and the partnership must pay
Nabisco. (Nabisco v. Stroud)

If there had been a majority vote and the partnership notified Nabisco not to sell, then the
partnership would not have been liable to Nabisco for its sell of bread to Freeman, but
there was no majority here, so the partnership is liable.

1st partner hires an employee even though 2nd partner disagrees. 1st partner pays the
employee and then sues 2nd partner for half the employee’s compensation. Court says
since there was no majority vote on hiring the employee, partnership is not responsible
for one partner hiring the employee. (Summers v. Dooley)

Why the difference between Nabisco and Summers? Perhaps because in Summers, it is
an internal partnership dispute, whereas in Nabisco, if court ruled that the partnership did
not have to pay Nabisco, then Nabisco, a third party that had nothing to do with the
internal partnership dispute, would be left in the lurch.

7
So in short, when 3rd party rights are affected, agency power trumps the deadlock.
(Nabisco). When 3rd party rights are not affected, the deadlock trumps agency power.

Guy rejoins firm as partner and chairman of DC office. Firm then merges with another
firm so that the guy then becomes only co-chairman of DC office. He claims there was a
misrepresentation and fraud by the partnership because they said that no partners will be
worse off due to the merger. He claims he is worse off by becoming co-chairman instead
of just chairman. Court disagrees, saying that the partnership agreement has no special
clause guaranteeing him chairmanship of the DC office, while other lawyers do have
special clauses form themselves. Therefore, he had no contractual right to be chairman.
Firm could have removed him at anytime. Plus, even if this knowledge that he was not
guaranteed the chairmanship would have caused the guy to change his vote on the
merger, it doesn’t matter because his vote would not have affected the outcome of the
merger vote. (Day v. Sidley & Austin)

Mother who is partner brings her child to work and child gets injured. Father of child
sues. Court decides that the mother was acting as partner in the ordinary course of
business when she negligent, so that the partnership is responsible for the mother’s
negligence, and the partnership cannot recover from the mother. (Moren v. JAX)

In real life, a principal can try to collect against an agent, so why can’t a partnership sue a
partner? UPA says otherwise for partnerships, giving individual partner the right to
recover from the partnership for negligent actions they committed while in the ordinary
course of business.

Partnership Dissolution; note on LPs

A partner can dissolve the partnership at any time he likes, though of course he may pay
damages if its in violation of the partnership agreement, but the fact remains he still can
dissolve the partnership. (this is in stark contrast to a shareholder not being able to
dissolve a corporation or his relationship with it).

According to Sec. 38, the rights of partners to partnership property differs depending
upon whether the dissolution is in contrivance of the partnership agreement or consistent
with it.

That is why plaintiff in Owen v. Cohen asked the court to dissolve the partnership based
on the defendant’s action rather than just dissolve the partnership himself before the term
of the partnership was up, in potential contrivance of the partnership agreement.

Main themes:

1) Partner X can dissolve or dissociate from partnership at any time.

2) But consequences depend on wrongful/rightful distinction, and on other factors.

3) If dissolution wrongful, X
a) does have the right to be paid off at her interest, but

8
 b) perhaps paid over time or in future; with offset for damages; & other
partners have right to continue partnership business.
See UPA 38 and RUPA 701, 701.

4) If dissolution rightful, X is bought out at value of his interest. Partnership is

wound up and partners all get payment in cash. Unless… - there are many issues
of implementation, waiver, agreement, and courts may assert equitable powers.

5) Default rule distinction between partnerships at will v. those for a term or specific
undertaking.

-dissolve former -> rightful; dissolve latter-> wrongful (unless term over)

-There are other triggers of dissolution, e.g. death, unlawful business and some
others, e.g. court decrees about impossible partner may lead to wrongful dissolution
remedies (Owen v. Cohen)

5) Default rules about who can dissolve rightfully under what conditions and how
dissolution is carried out can be changed by contract between partners.

Partner wants to get out of 30 year partnership, claiming mismanagement by his partner.
Court disagrees, saying there was no mismanagement, so the partner can dissolve only in
contrivance of the agreement, with all its consequences, eg potential damages. (Collins)

partnership is a partnership at will, so you can dissolve the partnership at any time, BUT
the partners have a fiduciary duty of good faith in the dissolution and winding up of the
partnership. So if the one brother decides to dissolve the partnership, but then opens up
another linen business and has a lot of the same old clients, this would be a dissolution in
bad faith, violating his fiduciary duty to his partner. If he dissolves in bad faith, the Court
will make the dissolving partner compensate the other partner. (Page v. Page)

“A partner may not dissolve a partnership to gain the benefits of the business for himself,
unless he fully compensates his co-partner for his share of the prospective business
opportunity.”

Loss sharing by partners default rule: share losses same way as profits.

Court says default doesn’t apply when one side supplies all the capital and the other
supplies all the labor. In that case, in the absence of agreement, the partner who supplies
all the capital must pay for all the loss, while the partner who supplies the labor/services
does not have to pay for the loss. (Kovacik)

The reason they make this rule is that the services providing partner is in a sense already
losing the cost of his labor, so it’s only fair that the capital providing partner should bear
the capital losses.

Kovacik rule has been rejected by RUPA, which says the partners should split the losses
equally.

9
Partners file a suit to dissolve partnership and buyout a drug-using partner. The drug-
using partner then dies. Question whether filing the suit created dissolution because
estate of drug-using partner will be compensated differently depending upon whether it
has to be a buyout after dissolution or a buyout after death of partner. Court says
dissolution was not caused by the filing of a lawsuit; dissolution only comes with a
judicial decree. (G&S Investments)

Question of how partners leaving law firm should compensate the old firm for taking
clients. If they took the clients ethically, then they compensate based on the partnership
agreement. If they took the clients unethically, then they have to disgorge all profits they
make off these clients to the old firm, such that it would be as if the partners continued to
work for the old firm on these client matters. (Meehan v. Shaugnessy)

NATURE OF THE CORPORATION

Why Corporations

1) Investors have limited liability in corps, whereas partners liable for actions of
partnership and often vice versa.

2) More restrictions on transferability of interest in partnership than interest in

corporation

3) Each partner can kill a partnership. The corporation is perpetual and can only be
dissolved by majority vote

4) Managerial power – partnership model is all for one, one for all. Corporate model
of management is director primacy; power of corporation is mostly in the board

Limits of Limited Liability - Piercing the Vail and Related Doctrines

Cab injures man, but cab is owned by corporation, which is owned by Carlton. The
corporation has minimum liability insurance and minimum capital legally allowed,
Carlton owns 10 of these cab corporations, and when capital accumulated, Carlton would
withdraw assets as dividends as fast as he could. Injured man therefore wants to pierce
the corporate veil and sue Carlton, claiming the corporation is a dummy corporation that
is Carlton’s alter ego. Court doesn’t see much wrong with setting up corporations to
minimize corporate liability, because isn’t that the basic idea of corporations? It
therefore refuses to pierce the corporate veil. So the key seems to be whether Carlton
seems to operate the corporation in his individual, personal capacity, or only as the
director of the corporation. (Walkovsky v. Carlton)

Marchese uses lots of corporations with minimal assets similar to Carlton above to avoid
liability. Plaintiff seeks to pierce the corporate veil. Court expounds piercing the
corporate veil test:

10
 1) such unity of interest and ownership –such control – that separate personalities no
longer exist

The factors we look at here are i) failure to have records or formalities ii) commingling of
funds or assets iii) undercapitalization iv) treating corp assets as shareholder assets, ie a
messy relationship

2) under the circumstances, adherence to the fiction of a separate entity would

sanction fraud or promote injustice

On remand, court allows piercing corporate veil as well as reverse pierce of the other
firms that Marchese owns. (Sealand Services v. Pepper Source)

Fraudulent Conveyance Law - it’s ok to be pay dividends and such, but not when you are
insolvent or when the dividend leaves you with an unreasonably small amount of capital.
Then, it will be looked at as a fraudulent conveyance of money to which creditors have a
right.

Piercing the corporate veil is a somewhat looser form of this fraudulent conveyance law.

Question whether corporate veil of MEC could be pierced to sue its sole shareholder,
Bristol, in breast implant products liability dispute. Court uses totality of the
circumstances test to determine whether Bristol had substantial domination of MEC
which made the wholly owned subsidiary the alter ego of the parent company.

Some of the important factors are that they have common directors and officers, the
companies filed consolidated financial statements and tax returns, the subsidiary operates
with grossly inadequate capital, Bristol represents that the breast implants are its
products, etc. Based on this, corporate veil may be pierced at trial. (Silicone Gel)

Limited partners in a partnership – no liability for partnership but in exchange for no

liability, they must not be involved in management decisions.

Limited partners have gotten around problem of having to choose between no liability
and management power by setting up a corporation to be liable partner of the corporation,
but with them heading the corporation. But they do not technically participate in
management and control of the limited partnership as themselves, but as agents of the
general partner corporation. Therefore, they can run the partnership but not be liable.
Court upholds this scheme, so that limited partners are not personally liable. (Frigidaire)

Shareholder Derivative Actions

On direct v. derivative distinction – Eisenberg v. Flying Tiger Line

On the demand requirement – Grimes v. Donald, and Marx v. Akers

On special litigation committees (SLC’s) – Auerbach v. Bennett, Zapata Corp v.

Maldonado, In re Oracle Derivative Litigation

11
Eisenberg sues in a direct action, not derivative action, because if he files a derivative
suit, he would need to post security for expenses of the corporation This requirement for
posting security is used in order to prevent frivolous strike suits. Court says Eisenberg
correctly filed a direct suit. (Eisenberg)

Direct action – brought by the shareholder in his or her own name. Cause of action
belongs to the shareholder in his individual capacity. Arises from an injury directly to the
shareholder. Monetary recovery of other benefit goes to shareholder.

Derivative action – brought by a shareholder on corporation’s behalf. Cause of action

belongs to the corporations as an entity. Arises out of an injury done to the corporation
as an entity. Monetary recovery goes to corporation.

When shareholder wants to bring a derivative action, the directors are often able to refuse
to take action under the business judgment rule.

In that situation, the shareholder would have to first make a demand on the directors in
the derivative suit. (unless demand can be excused)

Corporation could either agree to the demand and take over the case. Or the corp could
also say no, they won’t sue, after examining it. That would probably be the end of the
case because it would be hard to show wrongful refusal of the demand.

Demand will be excused where the board has a material financial interest and cannot be
trusted to make a fair business judgment. Also demand can be excused where the
plaintiff shows with particularity that the board did not engage in the minimally
informed, adequate process worthy of BJR protection.

In a direct action, no need to make demand on directors nor argue about business
judgment, nor post security for expenses.

In response to a derivative action or not, a board can create a special litigation committee
with the power to investigate the transaction and offer a recommendation.

If one’s voting rights are injured, it is a direct action.

Plaintiff in derivative suit makes demand on board, which refuses. He then claims
demand is futile, but Court says you can’t claim demand would be futile after you make
demand; you can only claim demand futility before you make the demand. (Grimes)

When demand is made and refused, the legal standard for judging the refusal is the BJR.

Delaware Demand Fulility Test:

Plaintiff must allege particularized facts (using ‘tools at hand’ before discovery) creating
‘reasonable doubt’ that board is capable of making a good faith decision on the suit.
Plaintiff could show:

12
 • Majority of board has material financial or familial interest in transaction
complained of
• Majority of board is dominated/controlled by alleged wrongdoer or interested
parties OR
• Underlying transaction not product of valid exercise of business judgment (this
leaves some discretion with the court)

New York test (Marx v. Akers):

(1) Director interest/domination
(2) Good process, esp. info gathering
(3) ‘so egregious’ test

Delaware standard for reviewing special litigation committee recommendation of

dismissal? (Zapata v. Maldonado)
(1) inquiry into independence/good faith of committee; inquire into bases supporting
committee’s recommendations
(2) court may go on to apply its own business judgment as to whether case is to be
dismissed.

Corporation has burden of proving independence, good faith, and reasonable

investigation by the special litigation committee.

Key general issue: who counts as ‘independent’ director for purposes of getting judicial
respect for special litigation committee recommendations? Directors who are university
faculty members when defendant directors and officers have made modest gifts to
university and have considered making very major ones? (Oracle Derivative Litigation)

In sum, shareholders usually can’t just bring a derivative action, they usually must make
a demand first upon the board to take an action. If the board refuses, it is very difficult
for the shareholders, who want to sue, to overcome that refusal. The shareholders have to
allege with particularity some facts that create a reasonable doubt that the directors were
disinterested and independent, or that the board’s decision was way beyond any rational
business judgment.

Derivative suits often have little success, and the success they did have has been modest.
Recently, there has been a shift to class action suits, rather than derivative suits.

Role and Purposes of Corps

Charitable contributions are allowed if the directors judge that they “will contribute to the
protection of corporate interests.” Court therefore says the corporation was allowed to
make the charitable contribution to Princeton. (Barlow)

Other states have different allowances for corporate donations – eg California and New
York corporate code gives corporations the power to make donations, regardless or
irrespective of specific corporate benefit.

13
Power to declare dividends is in the board of directors of alone, and courts will not
interfer UNLESS it clearly appears they are guilty of fraud or misappropriation, or the
refusal to declare dividends amounts to such an abuse of discretion as to constitute fraud
or breach of good faith that the directors are bound to exercise. Court finds Henry Ford
breached this standard by limiting dividends to shareholders and using the money to
benefit employees and consumers of Ford cars (up-front stakeholderism or constituency
approach to corporate purposes). (Dodge v. Ford Motor)

Part owner of Cubs sues, claiming refusal of Wrigley to have Cubs night games is bad for
business and motivated by concern for the neighborhood, not profit maximizing. So like
in Ford case, this is another assertion of primary corporate purpose and an attack on
managerial assertion of stakeholderism. Why does Wrigley win but Ford loses? The
Court here uses a standard of showing of fraud, illegality, or conflict of interest in order
to side with the plaintiff, whereas the standard in the Ford Motor Company case was that
there had to be a breach of good faith by the directors. There are no statements in this
case by Wrigley which are like the statements of Henry Ford that he is looking out for the
interests of workers and consumers. Because there are no statements like this, the Court
is willing to assume that Wrigley is exercising his business judgment that being nice to
the neighborhood is good for business, even if that business judgment is wrong.
(Shlensky v. Wrigley)

Corporate charitable giving is in legal in almost every state.

“matters of conscience” exception allows corporations to cease participating in legal but

seriously unethical business activities (ie involvement in apartheid, genocide, etc.)

FIDUCIARY DUTIES OF OFFICERS ET. AL.

Duty of Care

Three important Delaware opinions: Van Gorkam case (in merger context), Brehm v.
Eisner case (in executive compensation context), Caremark opinion (dealing with
proactively set up systems for dealing with legal violations)

Plaintiffs sue claiming decision to give dividends in subsidiary as opposed to selling

subsidiary a waste of corporate assets that violates the board’s fiduciary duty of care. the
Court holds that it won’t interfere with the director’s discretion just because the decision
appears mistaken. The Court says it will only interfere if there is fraud, illegality, self-
dealing by majority of the board, bad faith, or nonfeasance. This is a strong statement of
the business judgment rule by the Court. (Kamin v. American Express)

Mother shareholder pays no attention as her sons fleece the corporation by having the
corp give loans to themselves. Court find she violated fiduciary duty of care. This case
can be distinguished from Kamin in that here the wife made no business judgment
whatsoever, whereas at least in Kamin a business judgment, though perhaps bad one, was
at least made. (Francis v. United Jersey Bank)

14
So the lesson of the case is that the business judgment rule doesn’t protect a director from
nonfeasance. A director has to take some minimum level of action to undertake her
duties as director.

Affirmatively: director must know rudiments of business, keep informed, attend

meetings, do general monitoring. Must basically go through basic motions of being a
director. If not, can be liable for duty of care violation.

So these two cases taken in conjunction suggest that as long as the directors go through
the basic motions, they will be safe under the business judgment rule.

Board rubber stamps decision of CEO to merger with another company. Court finds
board violated duty of care, saying the process by which the board approved the merger
was wholly inadequate, because the board spent very little time analyzing the merger
agreement, and in fact approved it sight unseen. Also, the board never hired an
investment bank to analyze the fairness of the proposal. (Smith v. Van Gorkom)

Key legal point of Van Gorkom: The directors “breached their fiduciary duty of care to
their stockholders 1) by their failure to inform themselves of all information reasonably
available to them and relevant to their decision to recommend the Pritzker merger.”

Notice here the Court requires the directors to get all information reasonably available,
not just all material information reasonably available.

As a result of this case, Delaware and other states passed statutes saying that corporations
may pass charter amendments which eliminate monetary damage of directors for
violations of duty of care (statute doesn’t apply to violations of duty of loyalty or acts not
in good faith and statute only applies to directors, not officers). Virtually all Delaware
corps have adopted this charter provision shielding directors.

Disney gives large severance package agreement to Ovitz, and then terminates him
without cause, resulting in much larger severance than if they terminated with cause.
Court ruled these board decisions were acceptable under BJR so that there was no
violation of duty of care. (Brehm v. Eisner)

Key legal holding of Eisner: “Substantive due care” concept is foreign to the business
judgment rule in Delaware. “Due care in the decisionmaking context is process due care
only. Irrationality is the outer limit of the business judgment rule.”

Directors can protect themselves by relying on experts.

Ratchet phenomenon – all the children are better than average. So with respect to
executive compensation. Companies want to pay their executives better than average,
which causes a great ratcheting up of executive compensation.

Derivative suit against board for failing to properly monitor actions of company, which
resulted in company breaking law and having to pay major fines. Suit settled for
attorney’s fees and better oversight procedures in the future. Question whether

15
settlement is fair and reasonable, because once settlement is approved, all shareholders
lose right to sue directors on this matter. Court says board of directors have duty of care
to “attempt in good faith to assure…a corporate information and reporting system,” but
the level of detail appropriate for the required info system is a question of business
judgment, though there does need to at least be some legal monitoring system Court
approves settlement as fair and reasonable because under this conception of the duty to
monitor, it would be unlikely for the plaintiffs to succeed, so it makes sense for the
settlement to be modest. (Caremark)

No duty to monitor the personal activities of one of its employees. Therefore, the
directors committed no breach of duty to monitor in failure to monitor Martha Stewart’s
trading activities. (Martha Stewart Litigation)

The Delaware Supreme Court approved the Chancery’s decision, but on different
grounds, saying that the plaintiffs failed to demonstrate demand futility since the majority
of the directors were independent, despite friendships with Martha.

Duty of Loyalty - Interested Director Transactions and Corporate Opportunity Doctrine

Key Legal Principle - The Court, citing a SCOTUS case of Pepper v. Litton from 1939,
said that when an interested-director transaction is challenged, “the burden is on the
director not only to prove the good faith of the transaction but also to show its inherent
fairness to the corporation.” So the duty of loyalty seems a lot stronger than the duty of
care, which is diluted in large part by the business judgment rule.

Directors pass this duty of loyalty test when they are sued for hiring the wife of the CEO
to perform on a radio show sponsored by the company. (Bayer v. Beran)

Shareholder sues, claiming directors are using one corporation for the benefit of another
corporation for which they are directors in violation of their duty of loyalty. Court says
that because this is a conflict of interest situation, the business judgment rule does not
apply. And the burden is on the directors to show that the lease was fair and reasonable
to the corporation. Court find directors fail to satisfy this burden, as they never attempted
to figure out fair rent and acted as if the corporation existed solely for the benefit of the
other corporation. This is a classic example of self-dealing by directors. (Lewis v. SLE)

Corporate opportunity doctrine: If business opportunity is presented to D or O which

1) corp is financially able to take

2) is in corp’s line of business
3) is one in which corp has an interest or a reasonable expectancy
4) taking by the Do or O will bring his self-interest into conflict with corp’s interest

then law will not permit him to take it.

Director of company takes an opportunity to buy something. His company wasn’t

interested in that thing, but the corporation that was trying to buy his company was also
trying to buy that thing. Court found the director did not have to take the interests of this

16
acquiring corporation into account in determining whether to buy the thing. (Broz v.
CIS)

In re Ebay – corporate opportunity doctrine violated

Duty of Loyalty – Dominant Shareholders and Stockholder Ratification

Sinclair has its subsidiary Sinven give out big dividends, which plaintiffs claim is used by
Sinclair to expand its operations abroad, but that Sinven’s profits should have been used
to expand Sinven’s operations. So the claim is that Sinclar took Sinven’s corporate
opportunities.

If self-dealing, intrinsic fairness rule applies with burden on Sinclair, if no self-dealing,

then business judgment rule applies and burden on plaintiffs.

Court finds self-dealing with respect to a contractual claim, but not with respect to
corporate opportunity claim as the plaintiffs have shown no opportunities that came to
Sinven, which Sinven lost to Sinclair. (notice this difference with the later Broz case that
didn’t requires that the opportunities independently come to CIS) (Sinclair Oil)

Dispute over redemption of certain types of stock. Court finds controlling shareholder,
who appointed a majority of the board, had a fiduciary duty to fully inform Class A
shareholders of the value of the firm when it calls Class A shares, so that the Class A
shareholders can decide whether to convert instead. (Zahn v. Transamerica Corp.)

What is important for ratification is not whether a majority of shareholders generally

supported the transaction, but whether a majority of the disinterested shareholders
supported the action. So, since a majority of the disinterred shareholders did not support
the purchase, any issues of self-dealing by the directors had not been cured. Because the
self-dealing nature of the transaction had not been cured, the intrinsic fairness standard
needed to apply and burden was on the directors to show the intrinsic fairness. (Fliegler)

Easier to claim self-dealing decision by directors was not ratified if there was not full
disclosure to the approving stockholders.

3 standards of review, and then the effect of shareholder ratification:

1) for arms’ length transaction? Business judgment rule with burden on plaintiff

2) for interested director transactions? burden on defendant to show inherent fairness of

transaction, unless there is ratification by disinterested directors and shareholders, in
which case the burden is on the plaintiff to show a violation of the BJR.

3) For controlling shareholder-arranged mergers? Intrinsic fairness (stronger than

inherent) needs to be shown and burden on defendant, but if there is ratification, then the
burden is on the plaintiffs to only show that the deal is not fair (doesn’t need to show
violation of BJR). So when there is a controlling shareholder-arranged merger rather

17
than an interested director transaction, it is easier for plaintiffs to win. This was the case
in Wheelabrator.

Disclosure: registration of securities

What’s a security? (Great Lakes)

What’s a public offering? (Doran)

Public offerings of securities must be registered with SEC. The purpose is to mandate
full disclosure and deter fraud; not substantive regulation

Section 5 rules of the road:

a) Don’t offer securities for sale before registration statement filed. What
is an “offer” is broader than you think.

b) Don’t sell securities until registration statement is “effective.” Usually

effective when SEC says so.

c) Deliver statutory prospectus to each buyer before sale.

Great Lakes buys company from Monsanto. Great Lakes sues, alleging that there were
material mistakes and omission (MMOs) in the sale of security to Great Lake.

There was nothing wrong with registration statement, because Monsanto made no
registration statement to the SEC, because this sale doesn’t seem like a public offering
which would require registration with the SEC. Case turns on whether the company was
a security under 33 or 34 of 1934 Securities Act. (Great Lakes)

Security is any note, stock, treasury bond, evidence of indebtedness, and some open
ended categories like investment contract. General partnership interest is not a security.

Five factor test on p. 410 of what are the common features of stock: a) dividend rights b)
negotiability c) right to pledge/hypothecate 4) voting rights 5) ability to appreciate in
value.

Investment contract: 3 elements: a) investment of money b) in a common enterprise c)

with profits to come solely from the effort of others

Horizontal v. Vertical commonality – see p. 413

Doran claims that there was no registration statement, so that the sale of the limited
partnership interest to him violated Sec. 5, so that he says he should be able to rescind
under 12(a)(1). Defendant claims it is exempt from registration as private placement
under 4(2).

18
Consider four factors in determining whether this a private placement – 1) number of
offeeres & relationship to issuer & each other 2) number of units offered 3) size of
offering 4) manner of offering.

Court says this is a private placement under latter 3 factors, but 1st factor is the most
important. To satisfy 1st factor, the defendant must show that all offerees were financially
sophisticated plus had access (either access because of actual disclosure or because of
actual access to the offeror’s information). And not just Doran had to be sophisticated
and have access, but every offeree did. (Doran)

There is now a private placement exemption safe harbor under Regulation D if you are
offering interests that under certain values.

Court found MMOS in registration statement filed by company. Directors then sued. For
expertised parts of the registration statement, the directors just need to show they had no
reasonable belief that the statements were false. For non-expertised parts, they have to
show they had a reasonable belief that the statements were true. Court found defendant
failed to satisfy these due diligence defenses. (Escott)

Later opinions have taken a more understanding approach to reasonable investigations.

If director found guilty of this sec. 11 violation, it doesn’t mean he was negligent, just
that he was unable to prove due diligence, which makes it likely he will be able to be
indemnified by the company and by insurance.

Rule 10b-5

Even though merger negotiations were ongoing, Basic repeatedly denied that negotiations
were taking place. Soon after, merger completed. Shareholder who sold before merger
was announced, saying Basic’s false denials depressed the stock price. Court said that
the existence of negotiations could be material before an agreement in principle had been
reached. (Basic v. Levinson)

The principle of materiality that a misstatement or omission is material if there was “a

substantial likelihood that a reasonable investor would consider it important in deciding”
whether to buy or sell. Very fact dependent standard

Basic should have just said no comment, as court says that omission by silence is ok as
long as there is no duty to disclose, and there is no duty to disclose merger discussions.

Can plaintiffs show reliance on misstatements by invoking the fraud on the market
(FOM) theory? Fraud on the market theory is that in an open and developed securities
market, publicly available (mis)information will affect the market price. This seems to
be a soft version of the efficient capital markets hypothesis.

The Supreme Court accepts this theory, such that there is a rebuttable presumption that
the denial of the mergers affected the market price, so that it is therefore not necessary for

19
the individual plaintiffs to show that they read and relied on the merger denials in selling
the stock. This holding allows plaintiffs to bring class actions based on misinformation.

Under the fraud on the market theory, only publicly available (mis)information will affect
the price. In this case, the misinformation was only privately available, so there will be
NO rebuttable presumption of reliance based on the FOM theory here. (West)

Court concludes two misstatements were material: 1) that company had a patent, whereas
they were only in the process of getting the patent 2) merger agreement was imminent,
whereas the deal was not even close to being completed. (Pommer v. Medtest)

Majority shareholder seeks to buy out rest of shares of company. Some minimum
shareholders sue under Rule 10b-5, claiming price offered was wholly inadequate. But
the statue did offer minority shareholders the opportunity to get a reappraisal in the
Delaware Courts. Court dismisses the case, saying that an action under 10b and Rule
10b-5 requires deception or manipulation., such as a MMO, but none alleged here. Only
allegation is that there was a low-balled appraisal. (Sante Fe Industries)

Key point is 10b and 10b5 only apply to manipulation and deception.

Rule 10b5 covers options, so buyer of option has standing under 10b5 to sue corporation
and officers for MMO. (Deutschmann)

Rule 10b5 MMO Actions: Overview of Elements

Implied private right of action? yes

Jurisdictional prerequisite? Easy to satisfy – use of mails, instruments of interstate

commerce

Must plaintiff be actual buyer or seller of security? Yes, see blue chip stamps case.
(SCOTUS, 1975)

Must plaintiff show bad mental state of defendant? Yes, Ersnt & Ernst. (SCOTUS, 1976)
Scienter (includes recklessness)

Must plaintiff show deception and manipulation? Yes, Santa Fe Ind. (SCOTUS, 1977)

Standard of materiality? Basic Inc. (SCOTUS, 1988) formulation

Proof of reliance? Actual or, if appropriate, FOM

Proof of loss causation? Needed, See Dura (SCOTUS 2005)

Loss Causation – a causal connection between the material misrepresentation and the loss

Dura claims it was going to get FDA approval, but FDA later disapproved. Investors
who bought stock before the FDA disapproval sue. Simply showing that the investor

20
bought at an inflated price is not enough to prove loss causation. To prove loss causation,
you have to prove other facts that nothing else was affecting the price at that time. Also,
members of class who bought after Dura’s statement will also have to have sold after the
FDA disapproval was announced.

How does one prove that the price went down after the FDA disapproval because of the
FDA disapproval? And how does one prove that the price was inflated due to the overly
optimistic statement by Dura? Court didn’t specify exactly how you go about proving
loss. (Dura Pharmaceuticals)

Inside Information

Old case - Director of company buys more company stock based on inside knowledge.
Man who sold stock to him sues the director. The Court said the directors do not have a
fiduciary duty as trustees to the corporation’s shareholders. They only have a duty to the
corporation as an entity. If there was a personal relationship between the buyer and the
seller, then perhaps there would be a duty to disclose the inside information, but this was
an impersonal trade through a broker, so there was no duty to disclose here. (Goodwin)

SEC sues directors for insider trading on info about potentially massive copper discovery.
The Court’s main holding is that, under Rule 10b5, if the insiders had material nonpublic
information, they either had to disclose the information or abstain from trading. This is
the famous “disclose or abstain rule.” So this ruling basically says that Rule 10b5
outlaws insider trading. (Texas Sulpher)

Information is material if the information would affect the decision of a reasonable

investor about whether to buy the stock or not. Two part test: 1) would a reasonable
investor think this is important 2) and this encompasses any fact that in reasonable
contemplation might affect the value/price of the stock. Court says information on
possible copper discovery is material here.

Reasons for disclose or abstain rule: 1) Congressional purpose that all investors on
impersonal exchanges have relatively equal access to material info. 2) insider’s access to
material nonpublic information is for corporate purpose, not for personal benefit – “no
secret profits” reasoning found in fiduciary law generally.

When you are in arm’s length market transactions, there are no fiduciary relationships

Dirks, a broker, finds out about massive fraud at a company, so he tells his clients to sell
and he also tries to get the Wall Street Journal to publish a story about the fraud. SEC
sues Dirks, claiming the tippee inherits an insider’s disclose or abstain obligation
whenever he receives inside information from an insider

Court says the tippee inherits the duty when the insider breaches his fiduciary duty to the
shareholders by tipping and the tippee knows or should know the insider is breaching.
The breach depends on the insider getting a personal benefit. If the insider does not get a
personal benefit from tipping, then he has not violated a fiduciary duty to the

21
shareholders. The insider didn’t breach duty by disclosing, since he got no personal
benefit, so that Dirks inherited no duty himself. (check on this)

Dorsey & Whitney lawyer, working for Grand Met on tender offer it is going to make to
Pillsbury, trades Pillsbury stock based on this secret information which he was supposed
to keep secret. Even though the lawyer was not an insider of Pillsbury or even
Pillsbury’s lawyer, Court used the misappropriation theory to find the lawyer guilty of
violating Rule 10b5 insider trading. (O’Hagan)

Misappropriation theory, p. 503 – “a person commits fraud in connection with a

securities transaction, and thereby violates 10b and Rule 10b5, when he misappropriates
confidential information for securities trading purposes, in breach of a duty owed to the
source of the information.”

So here, the lawyer is misappropriating confidential information from both Dorsey &
Whitney, and Grand Met, in breach of a duty owed to both of them.

Court also relies upon another theory to find liability, called 14b3, which specifically
prevents certain people, such as the lawyer, from trading in a company’s stock in advance
of the company receiving a tender offer. It is clear that the lawyer violated 14b3.

Section 16(b)

Directors or officers or those who own more than 10% of a class of equities are
considered insiders. Under 16b, if these insiders both buy and sell a firm’s stock within a
six-month period (the order is irrelevant), all those profits most go to the corporation.

10b5 applies to trading in bonds and notes, not just stock, so 10b5 is much broader than
16b. 16b applies to only 34 Act filers. Contrast this with Rule 10b5.

If there are multiple sales & purchases within the 6 month period, the sales & purchase
are matched so as to maximize profits, and thereby maximize the amount that has to be
paid over to the corporation. The rule is pretty brightline.

The remedy for violation is by private derivative actions.

A director or officer is caught if he has this status either at the time of purchase or at the
time of sale. He need not be a director or officer at both times. But if you are an insider
by virtue of owning more than 10% of the stock, you must own more than 10% at the
time of both purchase and sale.

Go over p. 523 16(b) questions before exam.

Indemnification & Insurance

Competing policy considerations – want to deter fiduciaries from breach of their duties,
but want not to deter prudent talented people from serving as fiduciaries.

22
Sources of protection:

a) exculpation provisions in charters Cf. 102(b)(7)

b) Indemnification statutes, eg DGCL sec. 145
c) contractual promises to indemnify in bylaws, charters, etc
d) D & O Insurance

Indemnification under DGCL Sec. 145. Overview of subsections:

a) Corp power to indemnify expenses, ie legal fees, and amounts paid in 3rd party
suits if person acted in good faith & with reasonable belief, etc.

b) Corp power to indemnify expenses only (no damages) in derivative actions if

person acted in good faith & with reasonable belief and person not adjudged
liable to corp (except…)

c) Corp obligated to reimburse expenses if defendant is successful on the merits or

otherwise.

To cover situations in which the corporation cannot indemnify directly the employee, the
corporation will often buy D & O insurance, which will indemnify the employee instead.

Chance that director or officer may not be able to be indemnified if he loses, but that he
will be able to be indemnified if he settles, thereby encouraging him to settle lawsuits.

Rules that regulate advance of legal fees by corporation.

Dispute over whether corporation has to indemnify employee who settles lawsuit. Courts
says despite corporate charter requirement to indemnify in absence of finding of good
faith, there is still a good faith indemnity requirement under 145(f) that must be followed.

Also, in suit against both corporation and employee, which settles, the corporation has to
pay a lot of money to the plaintiff but the employee doesn’t have to pay anything. Court
agrees that the employee was therefore technically successful in the suit, and should have
his legal fees paid for accordingly.

Company sues employee for 16(b) violation. Court says company has to advance legal
fees even though the company would not have to pay legal fees if the employee settles or
loses. But he hasn’t settled or lost yet, so until then, he has a right to an advance of the
legal fees. If he does settle or lose, then he would presumably have to pay back the legal
fees. (Citadel Holding)

SOX AND RELATED REFORMS

Major sources of corporate governance changes:

Federal Sarbanes-Oxley Act of 2002 (SOX)
1) NYSE corporate governance rules added to listing requirements in mid-2003
2) Governance rating systems by independent agencies (the GRAs)

23
 3) Stricter tone in state case law (e.g. Oracle, Disney)

SOX-related corporate governance changes – 4 main themes:

1) fix audit process
2) change board of directors
3) improve disclosure
4) empower shareholders?
Audit-related changes (reducing conflict):

1) limit auditors’ non-audit services:

a) prohibit some (info tech consulting, valuations, actuarial services, help

doing internal audit work, etc.)
b) Disclose size of non-audit & audit fees (which can affect governance
ratings)
c) GRA (government rating agencies) campaigns to limit non-audit work.

2) Shift power to hire, fire, pay the auditors (from management or board to audit
committee and audit committee members have to have greater independence)

3) Reduce personal bonding between auditors and the audited (by mandatory
partner rotation and limits on hiring audit firm employees such as with cooling
off period)

Audit related changes (inducing action):

1) Require internal controls, eg making sure the company has documented

procedures to make sure that numbers are input properly and not falsely
(hundreds of little rules in this regard), and Sec. 404 attestations.

Notice that what has happened is that we told accounting firms that they can’t
do all this extraneous non-auditing work, but now they have to do all this
work under Sec. 404 to ensure that the internal controls and processes are
adequate, so there is a question whether the accounting firms have in fact
benefited from SOX despite the limits on what kind of work they can do.

2) Financial literacy and expertise (in audit committee members)

3) New regulator: PCAOB (Public Company Accounting Oversight Board) (the

regulations they pass are supposed to improve the quality of audits)

Board-related Changes (conflict-reducing standards):

1) majority of independent directors (ID’s)
2) stricter definitions of independence
3) ONLY IDs on key committees.
4) Must have key committees: audit, compensation, nominating committees.
5) Supermajority of IDs?
6) Independent chairperson of board

24
 7) Regular executive sessions

Board related changes (action-inducing standards):

1) financial literacy and expertise
2) limits on over-boarding (how many boards certain people can sit on, in order to
make sure people have the time and ability to do an adequate director job)
3) director stock ownership (governance ratings agencies want this in order to align
incentives of directors with that of shareholders)
4) governance guidelines & codes of ethics
5) self-assessments

What do boards do? Management and monitoring. Management depends on collegiality,

but monitoring depends on impartial policeman attitude.

The Big Questions: The SOX-related corporate governance changes all shift the Board’s
role from the management to the monitoring side. How seriously does this hurt the
board’s managerial role?

Transparency enhancements: More and faster public disclosures

Shareholder Empowerment - Some boost from SOX-related changes:

1) shift from staggered boards to annual election of all directors

2) shareholder nomination of directors (proposed SEC rule)
3) movement for “majority vote” requirement in director elections (ongoing)

What’s a majority vote? A majority of the shareholder votes cast, or a majority of the
total possible shareholder votes?

The vast territory of unchanged governance: Areas still under same state and federal laws
that existed before SOX:

1) substantive corp law on self-dealing, executive compensation, private benefits

of control, etc.
2) substantive corp law on mergers, takeovers, other large transactions
3) substantive corp law on basic allocation of power among officers, directors,
shareholders
4) law on private enforcement of the above (derivative suits, etc.)

Post-SOX Corporate Governance Changes

Major legal change depends on a bandwagon effect. BUT, bandwagon-generated

reforms may be very sub-optimal or even perverse. Therefore, what is necessary is
reform as a continuing work in progress.

Big issues today are executive pay, eg pay for performance, and director elections, eg
majority voting, among others.

25
Big issue is that the Federal rules say that a corporation, when faced with a different slate
of directors, can either mail the challenging party’s proxy statement out or give them a
shareholder list. However, the challengers want the list so they know who the owners of
big chunks of stock are and concentrate on them. Knowing this, the corporation rarely
will give out the list under the Federal rules. Many state rules require corporations to
give out the list, though.

PROBLEMS OF CONTROL

Shareholder Voting Control

Court says non-dividend bearing shares representing a negligible investment amount can
be considered shares for voting rights purposes. (Stroh v. Blackhawk Holding)

Illinois allows shares to be considered shares if (1) right to participate in control of a

corporation, (2) in its surplus or profits, OR (3) in the distribution of its assets.

The Illinois constitution (and many states) now allow for different voting shares for
different classes of stock.

Voting rights may be limited within a class of stock as well as between stocks.
(Providence &. Worcester)

Corporation holds open polls during shareholder meeting because its resolution will lose.
It then holds another meeting later, for which it had solicited certain shareholders to come
and vote for its resolution, and at this meeting it wins the resolution and closes the poll.
In order to determine whether there was a breach of duty of loyalty by adjourning the
meeting without closing the polls on proposal, there is a two-part test:

1) Plaintiff must establish that the board acted for the primary purpose of
thwarting the exercise of a shareholder vote/stockholders are not given a full and
fair opportunity to vote. If so –

2) Board then has burden to demonstrate a compelling justification for its actions.

Court found the primary purpose was to thwart the exercise of a shareholder vote and that
it was doubtful there was a compelling justification to do so, but it said the record needed
to be developed further in this regard. (SWIB v. Peerless Systems)

Proxy fights; Private actions re Proxy Rules

Corporations have to have meetings every year for the election of directors and for voting
on other important issues. Some companies have all directors up for election each year,
others have a staggered board. A lot of this depends on state law. Certain notice rules
and quorom requirements have to be met for these annual meetings.

Many people cannot attend these meetings, and it’s not worth them to do so since they
own so little stock. These people can have someone vote for them by proxy. See 14a 7-9

26
Proxy fight over MGM. Directors of MGM pay for the proxy fight expenses for the
directors’ upcoming election. Court says this was ok, because these expenses were
undertaken in an open and obvious manner, and these expenses were reasonable. Plus,
these expenses are undertaken in a fight about key policy decisions of the company. The
result might be different if the proxy fight was a personal dispute between incumbents
and challengers. (Levin v. MGM)

May successful insurgents get their proxy-fight expenses reimbursed by the corporation if
they are successful? Yes, with stockholder approval. Do incumbent directors and officers
need to get stockholder approval for proxy-fight expenses? No, apparently the business
judgment rule applies. Note that the expenses need to be linked to the dispute about
business policies, not just personnel disputes. (Rosenfeld v. Fairchild Engines)

So incumbents can make reasonable expenses, but insurgents on the other hand only get
reimbursed if they win and shareholders approve.

Case makes false proxy statements regarding a merger. 14a says it is unlawful for any
person to solicit proxies in contrivance of rules adopted by the SEC to protect investors,
such as those prohibiting false and misleading proxy statements. Court said under Sec.
14(a) and Rule 14a-9, there is an implied private right of action to enforce this rule.
(Case v. Borak)

Material misstatement in proxy statement regarding a merger. Shareholder sues. In

examination causation, lower courts looks at preponderance of probabilities to see
whether the MMO affected the voting result. In doing that, it considers the fairness of the
merger terms, on the assumption that the shareholders would have voted yes anyway if
the merger was fair.

SCOTUS overrules, saying, if it is found that a) there was a material defect in the proxy
statement and b) the proxy statement was an essential link in the accomplishment of the
transaction, there is sufficient showing of causation of a legally cognizable injury, ie no
need to show the particular defect was an essential link. This is a pretty liberal view of
causation.

SCOTUS said merger could be unscrambled as a remedy, though that’s pretty radical, so
instead damages should be granted to the extent the merger caused injuries. (lower court
found merger fair, so no injuries and no damages. (Mills v. Electric Auto-Lite)

14a7 on mail-or-give-list rule (mainly an issue with proxy fights), 14a8 on shareholder
proposal rule, and 14a9 on antifraud rule. Implied private right of action under 14a9
antifraud rule. Oral and written falsehoods are covered by antifraud rule.

Shareholder Proposals; Inspection Rights

Court says a qualified stockholder may inspect the corporation’s stock register to
ascertain the identity of fellow stockholders for the avowed purpose of informing them
directly of its exchange offer and soliciting tender of stock. Qualified stockholders under

27
NY law have owned more than 5% of stock for over 6 months. The requesting
stockholder must sign an affidavit that the ‘inspection is not desired for a purpose other
than the business of the corporation and that the petitioner has not been involved in the
sale of stock lists within the past 5 years.’” Court says a desire to convince people to sell
their stock does involve the business of the corporation. (Crane v. Anaconda)

Bottom line: in Delaware and in NY, making a tender offer qualifies as a proper purpose
(Del) or in the interest of the business (NY) in order to get access to a shareholder list.

Shareholder wanted shareholder list and corporate records so that he could tell
shareholders that they should stop the company from selling munitions for the war in
Vietnam. Court held that this does not constitute a “proper purpose” germane to his
interest as a shareholder, as a proper purpose means an economic interest. (Pillsbury)

To prove “proper purpose” to see shareholder list, the corporation must show that
shareholder does not have proper purpose.

To prove “proper purpose” to see books and records, the shareholder seeking disclosure
bears the burden of showing “proper purpose.”

Compare this to rules under 14a-8 with proxy statement, in which you can have a non-
economic interest to get something on the proxy statement. Why the difference? The cost
of throwing in one more proposal in the proxy statement is not very much. But the costs
in inspection are much more

Can NY state law and US constitution require an out-of-state corporation doing business
in NY to provide resident shareholders with shareholder record where the requesting
shareholders could not obtain such lists under the laws of the state of incorporation? Yes,
it does not violate the commerce clause, as its an exception to the internal affairs
doctrine. (Sadler)

Several exceptions under 14a8 that allow a company to refuse to send out a proxy
statement of a shareholder proposal. For example, there is a requirement that the
shareholder proposal deal with something more than just ordinary business.

Some shareholder proposals are cast as requests, rather than orders, that can be more
easily passed.

The power of stockholders to change bylaws can’t be taken away.

Shareholder submits resolution for proxy-statement about pate from force-fed geese.
Company seeks to exclude. Law says resolution can be excluded if it involves less than
5% of the companies business or is not otherwise significantly related to the corp’s
business. Court says that although pate makes up less than 5% of company sales, the
issue is otherwise significantly related to the corp’s business due to its ethical and social
significance and the fact that it does implicate significant levels of sales. So Court
defines corp’s business more broadly than just economic matters. (Lovenheim)

28
Shareholders seeks to have resolution on proxy statement regarding examining federal
health reform proposals and their effect on the company. Company seeks exclusion,
claiming it has an insignificant relationship to its business. Court disagrees, saying that
due to spiraling health care costs, health care does have a significant relationship to its
business. Court also disagrees with company claims that the proposal may be excluded
as “beyond the registrant’s power” and by the “ordinary business operations” exception.
(NYCERS v. Dole Food)

Employee shareholders submit resolution proposing that employees be allowed to retire

after 30 years of service regardless of age. Company seeks to exclude the proposal from
the proxy statement. Court says it can be excluded under “ordinary business” exception,
because this is an ordinary business issue that can be worked out in collective bargaining.

Since the proposal can be excluded under the ordinary business exception, the Court
doesn’t get to personal grievance exclusion, which says that a proposal can be excluded
which seeks benefit for proponents that would not be shared by shareholders at large.
(Austin v. Con-Ed)

Control in close corporations

Shareholders make pooling agreement whereby they agree to pool their shareholder
votes. If they disagree, an arbitrator tells them how to pool the votes. Eventually one
shareholder refuses to vote the way arbitrator tells him, claiming the pooling agreement is
against public policy. Court disagrees, saying shareholders are allowed to make pooling
agreements, so that the complaining shareholder breached the agreement.(Ringling Bros.)

Three large shareholders in NY Giants baseball team make agreement to elected

themselves and directors and choose themselves as officers. Against the contract, 2 of
the 3 decline to continue McQuade as director and officer. McQuade sues, but Court
says a shareholder voting contract that precludes directors from changing officers is
illegal and void, as directors have an independent fiduciary duty to do what’s best for the
company, even if that means appoint different officers. (McQuade v. Stoneham)

Only two shareholders of corp, one majority, one minority. They make agreement
whereby majority SH, Dodge, agrees to keep minority SH, Clarke, as direct and manager
in exchange for Clarke giving Dodge a secret formula. Dodge breaks the agreement, and
Clarke sues. Court found the shareholder agreement valid, ordering Dodge to specifically
perform it. Court distinguishes the case from McQuade in that all the shareholder had
signed this agreement, nobody was harmed by the agreement, and there was no attempt to
“sterilize” the board, in that the agreement says Clarke can be removed as officer by the
board for incompetence, inefficiency, etc. (Clarke v. Dodge)

Closed corps are different from regular corps, including because investors are likely to
invest a great deal more of their wealth in the corp and because shares of a closed corp
are more difficult to sell, so a shareholder should have greater flexibility to protect his
rights through a shareholder agreement. As long as all shareholders agree, or minority
SHs do not object, these agreements are ok. Therefore, Court rules shareholder

29
agreement, which gives widow of shareholder certain rights, enforceable. Court notes
there is no harm in the agreement to shareholders, creditors, or the public. (Galler)

Court says, under Cali law, vote pooling agreements on election of directors are not
illegal. So under agreement whereby shareholder must sell his shares at certain price to
the majority if he breaches the pooling agreement, the Court orders breaching shareholder
to sell his shares. Court says voting agreement valid even if corp was not a statutory
close corporation. (Ramos v. Estrada)

Abuse of Control

Close corporation relationships are more akin to partnerships than at will employment
relationships regarding duties of loyalty and good faith to each other. In close
corporations, shareholders do have fiduciary duties to each other. So shareholders in
close corp liable when they leave one of the shareholder employees off the salary list and
don’t reelect him as director, ie freeze him out. (Wilkes v. Springside Nursing Home)

Shareholders in close corporations owe on another substantially the same fiduciary duties
that partners owe one another. That fiduciary duty is of the utmost good faith and
loyalty. (Donahue v. Rodd)

Court in Wilkes applies this Donahue standard with a two step test:

1) when minority SH sues majority SH under this standard, the majority SH

can try to show a legitimate business purpose for their action, eg firing
SH/employee for incompetence. This was not shown in Wilkes.

2) If majority SH does show legitimate business purpose, the minimum SH

can then try to show that the legitimate business purpose could have been
achieved by a less harmful alternative course of action.

Ingle hired as a sales manager of a car company, and then becomes a shareholder in the
business. He is eventually fired, and majority SH exercises right of repossession of
shares at a specified price, per the shareholder agreement. Court finds this action ok, as
the written contract in this case allowed for termination of employee for any reason, so
that Ingle has no right as a minimum SH in a close corporation against an at-will
discharge by the majority SH. Plus, there is not a total freeze out here as Ingle was
compensated at price specified in agreement. (Ingle v. Glamore Motor Sales)

Court seems to see Ingle more like a hire hand than one of the founding partners, so the
Court might think that his reasonable expectations should be less than in Wilkes.

Majority SH refuses to employee minority SHs in a closed corporation, does not pay out
dividends, and gives himself a very large salary. He then offers to buy out minority SHs
shares at a low price. Court found a freeze-out, ruling for the minority SHs. Court
extends strict duty approach to situations involving more subtle freeze-outs from
financial benefits that SHs in close corporations ordinarily expect to receive.
(Sugarman)

30
Lesson is that courts especially like to find a fiduciary duty in a closed corporation where
the majority freezes out the minority shareholders.

Closed corporations has 4 equal shareholders, but bylaws give each a veto power over
company actions. 1 shareholder refuses to give dividends (presumably out of personal
tax consequences to him), resulting in the company paying extra tax to the IRS. Other
SHs sue him to recover this lost extra tax money. Court finds he had a Donahue-type
fiduciary duty when he used his veto power, so that he violated his fiduciary duty here.
(Smith v. Atlantic Properties)

Courts should give deference to shareholder agreements and not interfere to give SHs
rights that were not protected in the shareholder agreements. (Nixon v. Blackwell).

Employee of company, who owns some stock in the company decides to switch jobs. As
part of employee agreement he must sell back his shares to the company. When he
resigns, the company doesn’t tell him that it is in merger negotiations, which would
vastly increase the value of the shares. Employee later sues, claiming he would have
stayed at the company had he known of the merger. Court says his claim survives
summary judgment. (Jordan v. Duff and Phelps)

Control, Duration, and Statutory Dissolution

Two equal shareholders in LLC agreemetn start feuding. The LLC agreement calls for a
buyout at fair market value, but it did not provide for a transfer of the liability on the
mortgage, so one of the guys sues for a dissolution, because he doesn’t want to be bought
out and have to remain liable. Delaware statue says a court may order dissolution of an
LLC “whenever it is not reasonable practicable to carry on the business in conformity
with the LLC agreement.” Basically, if there is a reasonable alternative exit mechanism
besides dissolution, then the court will not grant a dissolution to break the deadlock. The
court rules the buyout provision is not a reasonable alternative exit mechanism, because
the plaintiff would still be liable under the mortgage. Therefore, the court orders
dissolution. (Haley v. Talcott)

Woman as part of divorce gets 1/6 of shares in closed corporation. The other
shareholders pay themselves director salaries, but do not pay out any dividends, so she
gets nothing frm her ownership. She sues. Court views dissolution of company as too
drastic a remedy, so instead it orders that a buyout of her shares at fair market value be
ordered if she can show at trial that the other owners acted in an “illegal, oppressive, or
fraudulent way,” or acted wastefully. (Alaska Plastics)

Dispute between majority and minority SH. Minority SH asks for buyout at fair price.
Court said dissolution or a buy-out could be ordered if the reasonable expectations of the
minority SH, regarding participation in management or employment with the company,
were violated. The reasonable expectations must be based on understandings, express or
implied, among the shareholders. (Meiselman)

31
Three brothers each own 1/3 stock in closed corporation. One brother, Alfred, finds
accounting discrepancy resulting in fight with other brother. The other brothers place
Alfred on mandatory leave of absence, telling employees he had nervous breakdown.
Court found breach of fiduciary duty as the two brothers did not act “openly, honestly,
and fairly.” Court also says Alfred should get lost wages because he had a reasonable
expectation that his employment was not terminable at will, but that there was a lifetime
employment agreement. And because the two brothers did not act in good faith, attorney
fees should be awarded to Alfred. (Pedro v. Pedro)

Disputes arose between majority SH and minority SHs about future of furniture
company. Frustrated that their concerns were not being addressed, the minority SHs
stopped attending meetings, but continued to receive large dividends. Majority SH
refused to buy their shares out, so they sued for dissolution. Court says involuntary
dissolution will be granted where “liquidation is reasonably necessary for the protection
of the rights or interests of the complaining shareholders.” Court found that there was no
bad faith conduct by the majority SH, so that liquidation was not necessary to protect the
rights of the minority SHs. (Stuparich)

Key differences among cases: a) Alaska Plastics – minority SH not told about meetings,
and did not get dividends, so found for plaintiff b) Pedro – minority SH fired from
employment, and lies told to employees as to why minority SH fired, so found for
plaintiff c) Stuparich – minority SHs received large dividends, themselves chose not to
attend meetings, and merely disagreed as to business judgment of majority SH, so found
for defendant.

Transfer of Control

Two possible reasons for paying a premium – 1) to get the private benefits of control by
taking more money from the company as a “salary” for running it 2) because the buyer
believes that it can make the company worth more if it has control.

Conventional case law doctrine is that sale of control block at a premium is not wrong per
se, and seller doesn’t have to share premium with minority SHs, unless sale is 1) to a
looter 2) diverts a corporate opportunity 3) is fraudulent. 4) or involves other misconduct.

Selling a controlling block at a premium is not wrong in and of itself without any
misconduct. (Zeitlin v. Hanson Holdings)

Wilport buys Feldman’s controlling shares of Newport in order to guarantee itself supply
of steel, as this takes place during the Korean War when there is a price control on steel.
Feldman is receiving a premium in essence for guaranteeing supply to Wilport which
might have been guaranteed to Wilport had Wilport agreed to make an advance purchase
of steel from Newport. So this case can sort of be analogized to the corporate
opportunity doctrine, in that Feldman took an opportunity that was available to the
corporation by taking personal advantage of the fact that Wilport was desperate to
guarantee a supply of steel. (Perlman v. Feldman)

32
Essex offers to buy controlling shares from Yates on condition that the board resign after
the purchase so that Essex can immediately appoint new members and take control of the
board, as opposed to having to wait for future shareholder meetings. Yates was taking a
premium basically to give up immediate control of the board. Court says naked sales of
office, independent of control shift, are forbidden. But here we have a sale of office
along with a control shift. The fact that the sale is conditioned on immediate transfer of
board control is therefore okay. (note that only 28% of stock transferred here, so doesn’t
result in automatic control shift cuz it is less than 50% but court believes 28% is enough
to give effective control, so that is why there a control shift here). (Essex Universal)

Plaintiff has right of first refusal in case majority shareholders sell their shares. A
company offers and then withdraws offer to buy the majority bloc, instead proposing a
merger of the two companies. Plaintiff claims the original offer to buy the majority bloc
triggered the right of first refusal, and that even if it did not, the merger proposal did.
Court disagrees, saying the withdrawn offer didn’t trigger the right, and that the right of
first refusal agreement should be narrowly construed, so that the agreement did not cover
mergers. (Frandsen)

Contractual solutions to desires for an equal opportunity rule in sale-of-control situations

include take-me-along provisions, right of first refusals, etc.

If you are a shareholder in a closed corporation, you will have a fiduciary duty of utmost
good faith and loyalty, which requires equal treatment. So in close corporations,
charging a premium might in some circumstances violate this fiduciary duty.

MERGERS, ACQUISITIONS, AND TAKEOVERS

Techniques, in general:

a) sale of assets plus liquidation

The board of each company must decide whether this is expedient or in the best interests
of the company, and a resolution is approved by a majority of the outstanding stock (not
just a majority of the votes) at a shareholding meeting. (check if it’s right that both
boards need to approve)

b) merger or consolidation

They need a merger agreement (DGCL 251) and approval by both board of directors and
a shareholder vote for both companies. There are appraisal rights.
Appraisal right – if you don’t like merger, and vote against merger, and timely file, you
can demand the fair market value of the shares in cash (which could be higher or lower
than the value of the shares you would have received as part of the merger)

Most common form of merger today: acquiring corporation forms new subsidiary, and
Target company merges into it (or vice versa).

Why do such a “reverse subsidiary merger?”

33
 -avoid getting vote of acquiring company shareholders
-but get technical efficiencies of merger
-and keep liabilities of the target company in separate corporate entity from the
acquiring company

c) stock purchases

d) tender offer for all shares, or some percentage of shares.

e) proxy contest – characteristic of hostile acquisitions

De Facto Merger Doctrine

Smaller company absorbs stock of larger company and then liquidates it. The reason
they do this is because based on choice of law considerations, the acquired company
shareholders will not have appraisal rights under a sale, while if the big company
absorbed the small company, then there would be appraisal rights for the acquired
company. So this is done to avoid appraisal rights. Court says, though, that this is a de
facto merger. This is structured as an asset acquisition but you get the net result of a
merger. Therefore, merger, not simple sale rules apply, such that the shareholders of the
big company will get appraisal rights. (Farris v. Glen Alden Corp)

The lesson here is that some courts will try to extend/recharacterize transactions as de
fact mergers because of public policy; other courts will refuse to extend merger rules to
de facto mergers.

Loral attempting to acquire Arco. The way they do it is like a simple sale, except that
Loral, the acquiring company, is paying not with cash, but with stock in itself. Court says
sale of assets statute and merger statute are independent of each other, with equal dignity.
So if you do a sale you don’t get appraisal, and if you do a merger, you do get appraisal.
So no de facto merger doctrine in Delaware. (Hariton v. Arco Electronics)

Freeze-out Mergers

Big corporation seeks to acquire smaller company. The key danger of this merger is that
the parent company owns a significant part of the target company, and some of the
directors of the target company are also officers and directors of the parent company, so
they have a conflict of interest. Because of this conflict, court does not apply BJR to
decision of the target company’s board to accept the merger offer at $21 per share.

Court says plaintiff initially must allege specific acts of fraud,

misrepresentation, or other items of misconduct, indicating unfairness &
demonstrate some basis for invoking entire fairness obligation. If plaintiff
does this, then majority SH then has burden of proof to show entire
fairness, which means showing that there was fair dealing and it was a fair
price. But if the defendant majority SH can show that the merger was
approved by an informed vote of the majority of the minority

34
 shareholders, then the burden will shift back to the plaintiff to show that
merger was not fair. Court finds burden did not shift back to the plaintiffs,
though, because the vote was not informed. (Weinberger v. UOP)

It would have helped to prove fairness had the target company used a
special committee of independent directors to investigate the fairness of
the price.

Approval of independent committee or informed MOM vote shifts burden

of proof to challenging shareholder plaintiff, but entire fairness, not BJR,
remains the standard. Burden of proof shifts only if majority shareholder
does not “dictate” the terms of the merger and the independent committee
has “real bargaining power that it can exercise w/ the majority shareholder
on an arm’s length basis.” (Kahn v. Lynch Communications)

Entire fairness remains the standard even when IC used b/c “the
underlying factors which raise the specter of impropriety can never be
completely eradicated and still require careful judicial scrutiny.” (Kahn v.
Tremont)

COGGINS – don’t understand notes given to me, look up

RABKIN – same thing

GE is acquiring RCA. RCA stocks are to be cashed out at $40 a share, but
RCA charter says RCA preferred stock have a redemption price of $100,
so shareholders sue, claiming the cash-out merger was in substance and
effect a redemption, so that the redemption provision should have been
triggered. Court disagrees, says that a cash-out merger has an independent
legal significance under Delaware law, so that it is different from a
redemption. (Rauch v. RCA Corp.)

Takeovers

Maremont wants to acquire Holland Furnace and change structure of company. He buys
10% of Holland and wants to buy more. Holland, using company funds, offers him
greenmail; in other words, Holland will pay Maremont a premium over market for his
shares in order to prevent him from taking over the company. But if Holland used
company funds to do this, it would reduce the value of other shareholders’ stock. Some
shareholder sue for misuse of corporate funds. (Cheff v. Mathes)

Burden of proof is on the target company directors to show 1) reasonable grounds to

believe that a danger existed to corporate policy and effectiveness, which requires good
faith and reasonable investigation 2) that the directors did not act for the primary purpose
of preserving their own incumbency

Why not use BJR? Because there is a conflict of interest – the board of directors are
fiduciaries but they have a personal interest in whether Maremont takes over.

35
Maremont posed two possible dangers: 1) threat to liquidate 2) threat to change the
business model, which was already causing employee unrest.

Greenmail has dwindled greatly as a defensive tactic. Why? Doesn’t work too well.
Encourages other bidders, plus because of tax implications.

Williams Act provides lots of rules for tender offers

Pickens, a greenmailer, owns some of Unocal’s shares and makes a two-tiered front-end
loaded tender offer for the rest of Unocal shares. On the front end, he offers to buy up to
37% of the stock for $54 per share. On the back end, assuming he gets control, he is
going to do a freeze-out merger with his company to eliminate the minority shareholders,
and pay as consideration for the freeze-out junk bonds ostensibly worth $54, though may
be worth less. In defense, Unocal makes an exclusionary tender offer for its own stock,
but does not let Pickens participate.

In reviewing Unocal’s defensive measures, Court doesn’t want to apply the regular BJR
because of specter of a conflict of interest. Instead, it adopts a conditional business
judgment rule: “an enhanced duty which calls for judicial examination at the threshold
before the protections of the business judgment rule may be conferred.”

Court employs 3 part test to examine Unocal’s defensive tactics. Burden is at first on
defendants to show:

1) the action within the power or authority of the board. Two aspects:
a. the statute authorizes the action and
b. the firm’s charter does not forbid or restrict it

2) the board had reasonable grounds for believing that a danger to corporate policy
and effectiveness existed
a. the directors satisfy this burden by showing good faith and reasonable
investigation (cheff test). Court doesn’t fault them for honest mistakes or
judgments.

3) the defense was reasonable in relation to the threat posed

If the defendants are able to show this, then the burden shifts back to the plaintiff, who
must rebut the BJR. (Unocal v. Mesa)

That the hostile bidder was a greenmailer was relevant to the determination that the
bidder posed a threat.

Court found the discriminatory self-tender was a reasonable or proportionate response.

But you can’t use this defensive tactic nowadays because the SEC adopted a rule (see p.
874) that says that issuer or tender offers need to be offered to all shareholders. You
cannot exclude any of the shareholders, and must include the hostile bidders.

36
This case still important because basic Delaware formula enunciated in this case is still
important – boards don’t have to be passive, but there are tests to determine whether the
defensive actions were reasonable and proportional, and otherwise satisfied the tests.
These tests can be applied to many other defensive tactics that boards may employ.

Take-aways from Unocal – a board of directors and managers of a corporation may

actively resist a tender offer. Some conflict of interest exits, though, so therefore no BJR.
What must the defendant board show? 1) Good faith, reasonable investigation that led to
the conclusion that the hostile tender offer posed a threat to corporate effectiveness, and
2) that the defensive measures taken in response were proportionate and reasonable.

Generalizing- Many roads to apparent dilution:

a) paying greenmail
b) exclusionary self-tender offer
c) shareholder rights (poison pill) plan
d) asset lock-up
e) share lock-up
f) large termination (cancellation) fee

All but the first listed put the main cost on the hostile bidder and so are used as defensive
measures in hostile takeover situations.

Perelman is a hostile bidder for Revlon. White knight named Forstmann comes along to
bid on Revlon. After lots of bidding back and forth, Revlon granted Forstmann an asset
lock-up option. The option gave Forstmann the right to buy two Revlon divisions (two of
Revlon’s more profitable divisions) at a price below their value and was exercisable if
another bidder gets 40% of Revlon shares. Delaware court strikes down the lock-up,
saying that Unocal did not apply; rather the Revlon test applied:

When the board puts the company up for sale, they have a duty to maximize the
company’s value by selling it to the highest bidder – “The directors’ role changed from
defenders of the corporate bastion to auctioneers charged with getting the best price for
the stockholders at a sale of the company.” (though Court says company may consider
other factors as well) This is the basic idea of the Revlon case.

Court says the Revlon board violated its fiduciary duties because the lock-up ended the
bidding prematurely. This meant the board did not act effectively in securing the best
price for its stockholders.

The Court distinguishes between lockups that draw a bidder in and lockups that end an
active auction. “Forstmann had already been drawn in to the contest on a preferred basis,
so the result of the lock-up was not to foster bidding but to destroy it.” (Revlon)

The court also says that no shop clauses are not per se illegal. But this no shop clause is
invalid because it required the board to treat Forstmann more favorably than Pereleman
and because agreement to negotiate only with Forstmann helped end auction prematurely.

37
Professor Gilson advocated the auction model – would permit only those defensive
tactics designed to secure a better offer for the shareholders, such as the release of
information bearing on the adequacy of the offer or seeking an alternative bidder.

Revlon applies only when board has decided to sell. Pre-auction defenses still ok.

Triggering Revlon – bringing in a white knight or management buyout in response to a

hostile takeover would trigger it.

Time and Warner want to merge, but Paramount swoops in and makes a hostile bid for
Time. Time and Warner restructure their deal from a merger to a cash-tender offer
coupled with a freeze-out merger, to avoid having to submit to a vote on the merger
between Time and Warner by Time’s shareholders. (Paramount v. Time)

Revlon duties are triggered under two scenarios: “1) when a corporation inititates an
active bidding process seeking to sell itself or to effect a business reorganization
involving a clear break-up of the company… 2) in response to a bidder’s offer, a target
abandons its long-term strategy and seeks an alternative transaction also involving the
breakup of the company.”

But Court says neither of these scenarios are triggered, so Revlon does not apply.

Court says Unocal does apply, and it will be applied to 1) grant of share-exchange option
and no-shop provision and 2) the decision to recast the merger as a tender offer, so as to
avoid the shareholder vote.

Court finds cognizable threat under Unocal step 1 in that Paramount poses a threat to pre-
existing business strategy/plan and to pre-existing transactions to carry the strategy out.

Courts said response of switching to a cash-tender offer was reasonable and proportional
under step 2, because it was not aimed at cramming down a management alternative to a
hostile bid but at carrying forward a pre-existing transaction in altered form and because
Paramount could still make a tender offer for the combined Time-Warner entity.
Therefore, Time passed the Unocal test and could go ahead and merge with Warner.

Paramount is now a target and agrees to merger with Viacom. QVC comes in and bids
on Paramount. Paramount adopts a bunch of defensive measures against QVC.
(Paramount v. QVC)

Court says Paramount’s defensive measures are subject to enhanced scrutiny a la Revlon.

How does the Court distinguish this situation from the Time-Warner case? Because there
is a change of control if the merger with Viacom went through (from Paramount public
shareholders to Sumner Redstone, CEO of Viacom), while there was no change in control
in Time case, as there would be a fluid aggregation of public shareholders who controlled
the company both before and after the merger.

Paramount v. QBC gives us a restatement of legal principles about what triggers Revlon:

38
When a corporation undertakes a transaction which will cause a) a change in corporate
control or b) a break-up of the corporate entity, the director’s obligation is to seek the
best value reasonably available to the stockholders. (p. 816)

Key features of enhanced scrutiny test: Judicial determinations regarding a) adequacy of

directors’ decision-making process including the information the directors use b)
reasonableness of directors’ action in light of the circumstances then existing (p. 815)

Court says Paramount failed the Revlon test, because when QVC came into the game and
Paramount subsequently modified the original merger agreement, Paramount should have
modified the improper defensive measures.

Hilton is a hostile bidder for ITT. It undertakes a tender offer coupled with a proxy
contest, to take control of the board and prevent a poison pill. ITT responds with a
“comprehensive plan,” which includes a poison pill and a staggered board, so as to
prevent Hilton from getting control of the board and preventing the triggering of the
poison pill. (Hilton Hotels v. ITT Corp)

The Nevada court uses a Unocal test coupled with a Blasius/Stroud test.

ITT fails Unocal test because it fails to show a threat to corporate effectiveness, and the
response wasn’t proportional because installing a staggered board was, in words of
Unitrin case, “preclusive.”

ITT fails Blasius test because adopting the staggered board disenfranchised ITT’s
shareholders without the necessary compelling justification. There is nothing illegal
about classified board, but there is something wrong with just changing to a classified
board to fend off a hostile bidder.

So the main idea of this case is the special concern for the voting rights of shareholders.

In recent years, a dominant defensive tactic has been the combination of a classified
board and a poison pill plan to counter hostile acquirers who launch both proxy contests
and tender offer bids. If a company already has a classified board (doesn’t just create one
in response to a hostile bid) and then adds a poison pill, then almost all hostile bids are
going to be stopped.

Court says no talk clauses are too restrictive and it prevents the board from exercising its
full fiduciary duties. The Court says this is “close to self-disablement by the board.”
Court doesn’t like the board gutting its own powers. (Ace Ltd. v. Capital Re)

Omnicare and Genesis both bidding for NCS. NCS agrees with Genesis to submit the
Genesis’ proposal to a vote, coupled with Genesis locking up the votes of the majority of
voting stock. In sum, Genesis has guaranteed that it will get a vote and that it will win
the vote. Omnicare challenges the deal protections and win. (Omnicare v. NCS)

39
Court said the NCS’s board was required to contract for an effective fiduciary out to
exercise its continuing fiduciary responsibilities to the minority stockholders, but that it
did not do so in the agreement with Genesis.

Is the possibility of losing a deal a threat to corporate integrity, such as to justify deal
protections?

”Deal protection measures must be reasonable in relation to the threat and neither
preclusive nor coercive. The action of the NCS board fails to meet those standards
because, by approving, the voting agreements, the NCS board assured shareholder
approval, and by agreeing to a provision requiring that the merger be presented to the
shareholders, the directors irrevocably locked up this merger.”

State TO legislation; note on corporate debt

Question whether Indiana’s takeover statute, which seeks to protect Indiana-based

companies from takeover and two-tiered tender offers, is constitutional. Key features of
Indiana’s statutes are that it only applies to corporations headquartered in Indiana, and
there is a minimum % of shareholders who are from Indiana. (CTS Corp. v. Dynamics)

SCOTUS purports to use the same preemption standard as in MITE –

1) whether the state law stood as an obstacle to the accomplishment of the

Congressional purpose underlying the Williams Act

2) the basic purpose of the Williams Act was said to be protection of the independent
shareholder from both the offeror and target management.

Powell for majority says there are two parts to the commerce clause analysis: 1) does the
Indiana statute discriminate against interstate commerce? No, because it only deals with
Indiana corporations and doesn’t discriminate based on the state of the bidder. 2) are
there inconsistent regulations that might hinder tender offers? No.

Internal affairs doctrine – rules governing relationships among shareholders, directors,

etc. is governed by state law, and the state law that applies is the law of the state in which
the corporation is incorporated. This mitigates problem of inconsistent regulation.

40