Business Associations Outline

Sole Proprietorship
A business that is carried
on by a single owner.
The business is the
owner.

Partnership
An association of two or
more persons to carry on
as co-owners of a
business for profit.

None

None

Control

The One Owner =

Management

Liability

Unlimited

All partners are both

managers and owners,
each share in the profit
and loss.
Unlimited, plus

Taxation

Direct (1 time)

Profits divided among

partners and reported in
each tax return

Lifespan

Coextensive with Owner,

life of the ownerdebts
from Sole Proprietorship
live on.
Nonesell assets

At the will of the

partners, for the life of
the partners.

Definition

Formalities

Exit

Power to exit at any

time, but not necessarily
the right to exit at any
time

Corporations
A separate legal entity
created by authority of
lawdoesnt exit until
you go through
formalities.
Certificate of
Incorporation; Bylaws;
Issue shares of common
stock; Shareholders =
owners; directors elected
@ board meetings;
appoint officers regular
meetings of various
groups.
Shareholders = Owners
Directors/Officers =
Management
Limited to the amount of
investment
Double taxation;
corporate tax on earners
and personal tax on
dividend income
Indefinite: not at all tied
to owners
Sell shares.

Part One: Agency & Partnership

I.
II.

Introduction
Business Concepts
a. Business any endeavor with a profit motive
b. Accrual Method a method of accounting that records revenue when earned and
expenses when incurred, rather than when they are paid in cash.
c. Risk uncertainty, possibility that future returns will deviate from expected
returns
1

III.

IV.

i. Leverage use of debt in the business

1. Leverage creates risk
a. potential for gain, but also the potential for loss
b. Security Interest An interest in an asset which secures
payment of an obligation; allow the asset to be sold upon
default to satisfy the specified obligation.
ii. Covenants Contractual obligation or prohibition
a. in loan contract, binds the borrower and gives the lender an
element of control
2. Indirect control to creditors
a. Use of funds
b. Maintenance of business
c. Restrictions
i. Limitations on taking of further loans
ii. Limitations on withdrawals
d. Control upon default
3. Reduce Risk
Sole Proprietorships and Agency
a. Characteristics of Sole Proprietorships business carried on by a single owner:
i. No Formalities
ii. Management = owners; has total control
iii. Unlimited liability
iv. Direct taxation
v. Life of sole proprietorship is life of owner
vi. Owner can exit by selling their assets.
b. 3 Elements of Agency Relationship under Restatement of Agency 1
i. Mutual Consent
1. express or implied manifestation of consent
ii. Action on behalf of another
iii. Control
1. Restatement of Agency 14O veto power is not enough; there
needs to be defacto control to be considered control.
c. Agency Cases
i. Gorton v. Doty
1. Doty lent automobile to coach to take football players to a game.
2. Shows application of the restatement.
ii. A. Gay Jenson Famrs Co. v. Cargrill, Inc.
1. Very rare case where a lender will be held liable for the companies
they lend to.
Authority
a. Actual Authority Restatement 7
i. Authority
1. 3 requirements:
a. Mutual Consent
b. On behalf of another
c. Control

b.

c.

d.

e.

2. Power to affect legal relations of the principal

a. Agent can bind the principal in contract
b. Limited by scope of authority
3. Based on the principals desires Restatement 33
ii. Creation of Actual Authority
1. Principals manifestation of consent to agent Restatement 26
iii. Incidental Authority
1. incidental; usually accompany; reasonably necessary
iv. Mill Street Church of Christ v. Hogan Implied Actual Authority Case
1. church painting case
Apparent Authority Restatement 8
i. Apparent Authority
1. Power to affect legal relations of the principal
2. Person is not actual an agent
ii. Creation of Apparent Authority
1. Principals manifestation of consent to third party
a. Accidents, lies, uncorrected statements
iii. Lind v. Schenley Industries, Inc.
1. Case where Lind sues for 1% commission in sales, which he never
received.
a. Company could have protected itself by putting the contract
in writing.
Agency by Estoppel
i. Elements Restatement 8B
1. Belief in agency relation by third party
2. Reliance by third party
a. Had to change position
3. Fault of the principal
ii. Hodesson v. Koos Bros.
1. Plaintiff buys furniture from salesman who turns out to be not a
salesman.
Inherent Agency Power Restatement 8A
i. Inherent authority is created simply by the act or contract entered into by
the agent even if expressly forbidden by the principal.
1. Best to think about inherent authority as a last resort.
2. Cant have inherent agency power without an agency relationship
ii. Watteau v. Fenwick
1. Bar owner was liable for agents purchasers even thou be expressly
forbid them
iii. Kidd v. Thomas A. Edison, Inc.
1. Company liable for agent overstepping his authorization to enter
into contracts because of customary powers of similar agents.
Ratification Restatement 82
i. The Principal acts in a manner which expresses or implies that she
authorizes the contract after the fact, the principal will then be bound by
ratification

V.

1. Used if no actual, apparent or inherent authority is found to exist at

the time of the agents action.
ii. Botticello v. Stefanovicz
Liability in Agency
a. Master/Servant Relationship
i. Employment
1. Master = employer (principal)
Servant = employee (agent)
2. Key is the control over the physical conduct of the agent in the
performance of the service
b. Independent Contractors 2 of the Restatement
i. Key is there is no control over the physical conduct of the agent in
performance of the service.
ii. ICs can be agents (if principal has control) or non-agents (if the principal
does not have control)
c. Servants v. Independent Contractors
i. Restatement of Agency 220(2) list factors to consider whether someone
is working as a servant or independent contractor:
1. Extent of control
2. Whether it is a distinct occupation
3. Who supplies location and equipment
4. Length of time and relationship
5. Method of payment
6. Parties belief
ii. Relevance of different between Servant & IC is the extent of vicarious
liability
1. Independent Contractors
a. Principle is liable for the actions of an Independent
Contractor when the principle authorized the conduct (i.e.,
had a contract)
2. Servants
a. Principle is liable for authorized conduct AND
unauthorized conduct that is within the scope of
employment.
i. Restatement 228 list things that are in the scope of
employment
ii. Liability is limited to scope of employment because
it is fair and foreseeable.
3. Vicarious Liability
a. Encourages Responsibility
b. Cost Spreading puts the burden on the company and
they will spread the cost to all the customers.
iii. Humble Oil & Refining Co. v. Martin Servant v. IC
iv. Hoover v. Sun Oil Company Servant v. IC
v. Murphy v. Holiday Inns, Inc. Servant v. IC
vi. Billops v. Magness Construction Co. Tort Liability/Apparent Authority
vii. Ira S. Bushey & Sons, Inc. v. United States Scope of Employment

VI.

viii. Arguello v. Conoco, Inc. Statutory Claims

Fiduciary Duties in Agency
a. Fiduciary Duty Restatement 13
i. More than a moral relationship, legal relationship with enforceable duties
ii. 13 agent is a fiduciary with respect to the scope of the agency only.
b. Agent to Principal
i. Contractual Duties
ii. Duty of Care
1. Extent of Duty of care depends on the status of the agent
a. Paid Agent = standard care + special skill
b. Gratuitous Agent = lower standard (what the person relied
on you for.)
iii. Duty of Loyalty
1. Accounting for profits 388
a. Agent that makes profits in connection with his duties must
give the profit to the principal.
b. Reading v. Regem
i. Solider uses his authority to smuggle goods and gets
money
c. General Automotive Manufacturing Co. v. Singer
i. Signer was the general manager of an automotive
shop but sent jobs he couldnt handle to another
place.
2. Non-competition
a. As to the subject matter of the agency, you are not allowed
to compete.
b. Town & Country House & Home Serve, Inc. v. Newbery
i. You are allowed to compete with your former
employer.
ii. You are not allowed to use confidential information
in competing
c. Bancroft-Whitney Company v. Glenn
i. Manager violated fiduciary duty because he took
employees with him when he left (used confidential
information.)
ii. Law says there are fiduciary duties to both the new
and old employer
1. Must avoid situations where one conflicts
with the other.
3. Conflicting interests
a. Have to avoid all conflicts of interest
4. Confidentiality 395
a. Even after termination
c. Principal to Agent
i. Contractual Duties
ii. Indemnification 438

VII.

1. All loses or expenses must be reimbursed as to the agreement or

what is appropriate
Introduction to Partnerships
a. Characteristics of Partnership Law: Uniform Partnership Act (UPA)
i. No Formalities
ii. Joint ownership and management
iii. Unlimited liability, plus
iv. Pass-Through (i.e., 1x)
v. Lifespan is the life of the partners
vi. Power to exit at any time, but not necessarily the right to exit at any time.
b. Formation of Partnership
i. Elements UPA 6(1)
1. Consensual Association
a. Consent to elements of partnership
b. Not necessarily consent to partnership
2. Carry on as co-owners
a. Most issues arise here
3. Business for profit
ii. Interpretive Rules UPA 7
1. Not joint interests in property
a. Just because you have a joint interest in property, doesnt
automatically make you partners
2. Not sharing of revenues alone (e.g., sales commission)
a. Sharing of profits is prima facie evidence
i. Unless its payment of debt, salary,
c. Partnership Rights UPA 18
i. Equal share in profits and losses
1. Fenwick v. Unemployment Compensation Commission
2. Southex Exhibition, Inc. v. Rhode Island Builders Association, Inc.
a. Profit Sharing ins only prima facie evidence
ii. Equal management
iii. Consent to adding partners
1. Each partner
iv. No right to salary
v. Agreement can vary partners rights
1. Not necessarily to the outside world though, only among partners
a. Also not necessarily powers and obligations
2. Day v. Sidley & Austin
a. Had an executive committee that made decisions over
many matters.
d. Agency Law
i. Every partner is an agent of the partnership
1. Acts for apparently carrying on the business in the usual ways are
binding on the partnership
a. unlessthird party knows partner had no authority

i. if they read the partnership agreement and realized

that he has no authority
2. Acts not for apparently carrying on the business in the usual way
are not binding
a. unlessact is authorized
3. You only worry about apparent authority if the act is not authorized
ii. Partnership is charged with wrongful acts of any partner
1. Acting in ordinary course or business or
2. Acting with authority
e. Partnership by Estoppel UPA 16
i. Elements
1. Manifestation (false part saying non-part is part)
2. Reliance on direct manifestation
a. orpublic manifestation w/o reliance
3. *Extension of credit*
a. seems to exclude tort situations
b. extension of credit by third party to the apparent partner
ii. Liability
1. For actual partnership, if authorized
a. consent (of manifestation) of all partners is required to
impose liability
b. partners who didnt know arent liable, therefore
partnership isnt liable.
2. For apparent partner: (creates virtual partnership)
a. as partner, if partnership is liable
b. otherwise, with consenting apparent partners
i. Only those partners who knew are liable, not the
partnership as a whole.
iii. Young v. Jones
f. Property Rights of Partners UPA 24
i. Right in specific partnership property UPA 5
1. An equal right to possess partnership property for part purposes.
ii. Interest in the partnership UPA 26 (share of profit & losses)
iii. Right to manage the partnership
iv. Assignment of partners interest: UPA 27
a. you can not sell your managerial or power in the profits
because the partnership is a voluntary organization that
takes the agreement of all partners to change it.
2. Conveys only interest in the partnership
3. Does not affect partnership
v. Putnam v. Shaof
g. Rights of Partners in Management UPA 18
i. Default rules:
1. Equal right to management
2. Disagreement on ordinary matters settled by majority vote
18(h)

3. Contravention of agreement requires unanimity

ii. Can be changed by agreement.
iii. National Biscuit Company v. Stroud
1. Absent a majority vote to settle disagreement, revert to the status
quo, which is normally that partner can act & bind the partnership
iv. Summers v. Dooley
1. different outcome from the national biscuit case
VIII. Fiduciary Duties of Partners
a. Introduction
i. UPA is not very clear on fiduciary duties
ii. Revised UPA gives an exhaustive list of duties
iii. Meinhard v. Salmon
1. Best statement of Duty of Loyalty:
a. owe to one anotherthe duty of the finest loyalty
b. After Dissolution
i. Bane v. Ferguson
1. No duty of care is owed to former employees of a firm
a. A partner is a fiduciary of his partners, but not of his former
partners, for the withdrawal of a partner terminates the
partnership as to him.
c. Grabbing and Leaving
i. Meehan v. Shaughnessy
1. Duty of loyalty stands up until the point that you are not working
at the firm.
d. Expulsion
i. Lawlis v. Kightlinger & Gray
1. Duty of loyalty is not violated for being fired if you can be fired
for any purpose.
IX.
Partnership Dissolution
a. Ending a Partnership under UPA 30
i. Three Stages
1. Dissolution in UPA, the change in the relation of the partners
caused by any partner ceasing to be associated with the
partnership; in RUPA, the commencement of the winding up
process.
2. Winding Up the process of settling partnership affairs after
dissolution
3. Termination the end of a partnership
b. Causes of Dissolution under UPA 31
i. Power to dissolve
1. Always have the power, but not always the right.
ii. Right to dissolve
1. You have the right to dissolve in:
a. At will partnerships &
b. As specified in agreement
2. Page v. Page

c.

d.

e.

f.

a. Partner may only dissolve an at will partnership if they do

so in good faith.
iii. Automatic dissolution
1. Term expires
2. Partnership becomes unlawful
3. Death or bankruptcy of a partner
4. Court decree
Judicial Dissolution
i. Insanity
ii. Inability
iii. Serious misconduct
iv. Unpredictability
v. Other equitable circumstances
vi. Owen v. Cohen
1. If the court is convinced there is serious misconduct, the court will
order dissolution.
vii. Collins v. Lewis
1. Collins wanted a dissolution but did not have the right to dissolve.
He wanted a dissolution form the court because Lewis did a really
bad job running the business. The jury rejected this.
Effect of Dissolution
i. Authority is terminated
1. Except as to winding up.
ii. Existing liabilities remain UPA 36
iii. Future liabilities only with respect to:
1. Winding up
2. Certain innocent parties
Winding Up
i. Distribution of Assets:
1. Creditors other than partners
2. Partners as creditors
3. Partners return of investment
4. Partners profits, if any
ii. Monin v. Monin
1. Partners fiduciary duties continue until the business is completely
wound up.
Continuing the Partnership
i. Partners who have not wrongfully dissolved UPA38 can continue the
partnership
1. by agreement
2. Pav-Saver Corporation v. Vasso Corporation
ii. Effect on creditors UPA17 & 41
1. Continuing partnership remains fully liable
2. Continuing partners remain fully liable
3. Former partners remain liable for old obligations
a. Including winding up obligations

X.

4. New partners liable for:

a. New obligations
b. Old obligations, but only out of partnership assets
iii. Jewel v. Boxer
1. Any profits gained during wrap-up of partnership is divided
between partners according to their share of the business.
g. Ending a Partnership under RUPA 601
i. Dissociation in RUPA, the change in a partnership caused by a
partners ceasing to be associated in the carrying on of the business.
ii. Default Rule: partnership continues RUPA 801
1. Exception includes partnerships at will
iii. In ever dissociation, either:
1. Dissociating partners interest must be purchased
2. Or partnership is dissolved and wound up
iv. G & S Investments v. Belman
1. Partnership Buyout an agreement that allows a partner or
shareholder to end her relationship with the other partners or
shareholders and receive a cash payment in return for her interest
in the business.
a. i.e., capital account value = book value, not fair market
value.
2. Advantages of having a buyout agreement:
a. Avoid litigation
b. Allows the business to keep going
c. Avoid unpredictability of judicial decision
3. Disadvantages of having a buyout agreement:
a. Price may not be set correctly
b. Undermines the entire relationship
Limited Liability
a. Problems so far with Business Associations:
i. Sole Proprietorships Problems
1. Limited Funding
2. Unlimited Liability
ii. Partnership Problems
1. Too many managers
2. Better, but still limited, funding
3. Unlimited liability plus
b. Limited Partnerships
i. Limited Partnerships partnerships with two types of partners, general &
limited
1. General Partner a partner with the right to manage the business
and with unlimited liability
i. Uniform Limited Partnership Act 403
2. Limited Partner a partner with no right to manage the business
but with limited liability
i. 402

10

ii. Advantages of Limited Partnerships:

1. Greater access to funding
2. Efficient management
iii. Holzman v. De Escamilla
1. A limited partner that takes control of the business becomes a
general partner
c. Forming a Limited Partnership
i. Select Name 102
1. must contain the words limited partnership
ii. File Certificate of Limited Partnership 101
1. Contains minimal information
2. Provides notice of existence
3. Generates filing fees for the state
iii. Optional: written LP agreement
1. If you dont, default rules will apply
iv. CANNOT be formed accidentally!
1. Filing creates a LP, without the filling, there is not limited
partnership.
d. Limited Liability
i. Based on the passive investor status
1. Passive investor status required to get limited liability 303
ii. History of increasing availability
1. Originally only available for specific purposes
a. Law used to give limited liability on a case by case basis
2. Expanded for industrialization
3. Eventually available for all
iii. Increasing diversity
1. Originally only had LPs and corporations
2. Now there are LLCs, LLPs. LLLPs. Etc.

11

Part Two: General Corporate Law

I.

Introduction to Corporations
a. Limited Liability
i. Is Limited Liability a good thing?
1. Encourages investment
2. Fairness to passive investors
3. Limits the cost to society of litigation
ii. Is Limited Liability a bad thing?
1. Increase stakes for creditors
2. Encourages investors to engage in risky activities because the risk
is externalized
b. Corporations
i. Two types of Corporations
1. Public Corporations
2. Closed Corporations
3. Can be in between a public corporation that has control in a few
investors hands.
ii. Formalities: many required
1. Filings and other documentary requirements
2. Regular meetings of various groups
iii. Control: separation of ownership and management
1. Officers are true managers
2. When you have separation of ownership and management you
have conflicts of interest
iv. Liability: limited to investment
1. You cant lose anything more than you have put into the business
v. Taxation: double taxation
a. major drop of corporation form
2. Corporate tax on corporate earnings
3. Personal tax on dividend income
vi. Lifespan: indefinite
1. Not at all tied to owners
vii. Exit: sell shares
1. Free transferability of shares
2. It is harder for corporations that are not on open market exchange
(i.e., closed corporations)
c. Contractarian Theory a theory that views the corporation as a web of
contractual relationships among various stakeholders rather than as a separate
legal entity owned by the shareholders
1. Just a web of contracts
ii. Employees
1. Input:
labor

12

2. Rights:
fixed compensation first; very little control
3. Risk:
low
iii. Trade Creditors
1. Input:
property
2. Rights:
fixed payment first; very little control
3. Risk:
low
iv. Debt Holders
1. Input:
cash
2. Rights:
fixed principal + interest; some indirect control
3. Risk:
moderate
v. Equity Holders
1. Input:
cash, property and/or labor
2. Rights:
residual profits; control
3. Risk:
high
d. Forming a Corporation, i.e. incorporation
i. Select a name
1. Must contain Inc. or similar title (corp., depends on state law)
2. Cannot contain certain words, e.g., bank (depends on state law)
ii. Select a state
a. need not be the state you do business in
2. Internal affairs doctrine a choice of law rule under which courts
look to the corporate law of the state of incorporation to determine
the internal rights and duties applicable to a corporation
3. For each state you look at the laws of that state
iii. File certificate of incorporation document establishing and governing
the internal affairs of the corporation: charter
1. Contains minimal information
2. Provides notice of existence
3. Generates filing fees for the state
iv. Various other formalities
v. Cannot be formed accidentally!
e. Conflicts of Interests
i. Key players: Management and shareholders
ii. Interests of management and shareholders are usually aligned
1. e.g., profit
iii. Sometimes interests diverge
1. e.g., management rights, responsibilities and benefits
a. agency costs
2. Shareholders may want to replace management
a. proxy contest
b. hostile takeover
3. Management wants to insulate itself

13

a. defense tactics
b. state of incorporation
f. State of Incorporation
i. Benefits to state
1. Fees
2. Related services industries
ii. Competition among states
a. Big debate over whether this is a good thing or bad thing
2. Flexibility / innovation
a. state corporate law should be able to change to the ever
changing corporate environment
3. Clarity / consistency
a. clear statutes and consistent judicial decisions
4. Responsiveness / service
a. with state legislature and officers respond to your needs
5. Substantive content
a. the actual law itself are they good for you?
iii. Race to the bottom theory that competition among states leads states to
pass increasingly lenient corporate laws
a. burdens of bad laws are shared by all states, while benefits
go to the one state who gets the fees
2. Favors corporations over others
3. Favors management over shareholders
g. Delaware winning of race to bottom
i. State of Preference for incorporation
1. Originally: more favorable laws
a. less regulation
2. Now: legitimate benefits
a. flexibility / innovation
b. clarity / consistency
c. responsiveness / service
3. Why does Delaware act moderately? Risks federal intervention
a. They push as much as then can, without getting the federal
government involved.
b. states like PA do not have to worry about this and blatantly
act in favor of management
h. Main Issues
i. Public Corporations
a. many shareholders, none with a controlling interest
2. Control issues
a. individual shareholders have little control
14

II.

b. small minority interests can have large influence

3. Conflicts of interests
4. Securities laws: continuous disclosure
a. require that public corporations continuous disclosure
various information about themselves
b. under the microscope
ii. Close Corporations
a. small group of owners, who have a real say in the business
2. Control issues
a. large minority interests can have no influence
i. You can have 49% and still have no say (if the other
half has 51%)
b. deadlock
3. Freeze-out action taken by the majority shareholders in a close
corporation to frustrate the expectations of the minority
shareholders
Corporate Formalities
a. Overview starting a corporation
1. Select name
2. Select state of incorporation
3. File certificate of incorporation
ii. Hold organizational meeting
1. Adopt bylaws
a. document, subordinate to the charter, that governs the
internal affairs of a corporation
2. Issues shares
a. before issuing shares, all we have is the
incorporator/promoter
iii. Hold shareholder meeting
1. Elect directors
iv. Hold board of directors meeting
1. Appoint officers
b. Incorporation
i. Who can incorporate?
1. Anyone, including another corporation DGCL 101(a)
a. parent corporation one corporation that owns another
(subsidiary)
i. subsidiaries can own other subsidiaries
2. affiliates anyone who controls, is controlled by, or is under
common control with, another; e.g., parent and subsidiary, or cosubsidiaries
ii. How do you incorporate?

15

1. First step Certificate of incorporation/Charter

a. DGCL 102; form on p.1404
2. Contents
a. name
b. address
c. nature of business dangerous, because can limit your
actions
i. anything else will be ultra vires
1. unauthorized; beyond the scope of power
allowed by the corporate law and/or charter
d. authorized stock number of shares that the company can
issue and classes and series of stocks and their rights
(normally want to authorize more than you plan to
originally issue planning for future)
i. common stock security representing a basic
ownership interest in the company (general voting
rights [one share/one vote], and entitled to residual
profits & dividends)
ii. preferred stock preference on dividends (issued
prior to common stock dividends) limited voting
rights
1. for example, $1 preferred stock will get $1
dividend before common stock gets
anything, but wont get more than the $1 per
share.
e. par value a dollar value, specified in a corporations
charter, that establishes the minimum price for which a
share of stock may be issued and which is set aside for the
protection of creditors
i. par value is irrelevant now dont have to have it
1. lawyer have put it at a penny
2. some state laws have done away with par
value
f. names and addresses of promoter
i. lawyer and law firm
ii. initial directors (if they are selected at the time of
incorporation)
g. optional items
i. put in any rule you want to govern the corporation
ii. common ones:
1. preemptive rights the right of a
shareholder to purchase enough newlyissued shares to maintain her percentage
ownership in the corporation

16

a. used to be the default rule, now you

put them in the charter
i. makes sense in closed
corporation, but not really for
public corporations
2. special voting rights (i.e., may require a
supermajority of shareholders to
successfully vote on an issue)
3. limits on directors liable for breach of
fiduciary duty
iii. Southern-Gulf Marine Co. No. 9, Inc. v. Camcraft, Inc.
1. De facto Corporation Doctrine a legal doctrine under which
courts may treat a business that was not properly incorporated as a
corporation if the promoters made a good faith effort to incorporate
and treated the business as a corporation.
a. Generally in corporate law form matters
b. Doesnt make much sense, as how does someone make a
good faith effort to file a certificate of incorporation yet not
file it?
2. Corporation by Estoppel a legal doctrine under which court may
prevent third parties from denying corporate existence if they
acknowledged the corporate entity and would earn a windfall by
subsequently denying corporate existence.
c. Organizational Meeting
i. DGCL 108; form on p. 1416
1. Adopt bylaws
a. Minutes: what happened
b. Resolutions: what was decided
2. Adopt stock certificate and corporate seal
a. you dont have to have a stock certificate
b. book entry security a security represented by an entry in
a register; a.k.a., uncertificated securities
c. corporate seal
i. unnecessary and archaic
3. Elect directors / appoint officers
4. Issue shares
a. Fully Paid and Non-Assessable Share share which has
been purchased from the issuing company and paid for in
full, and with respect to which the issuing company cannot
demand more money from the shareholder
5. Authorization to do business in other states
a. Have to file in each state to do business there
6. Select fiscal year

17

7. Set annual meeting of shareholders

8. Approval of past acts
a. relieve the incorporator of potential liability by official
authorization or approval of his past acts.
9. Any other business
d. Bylaws
i. Form on p. 1406
1. Stockholders
i. Voting Rules HAVE to be in the charter, but can be
contained in the Bylaws
b. meetings
i. written consent in lieu of a meeting
c. notice (for meetings)
i. cant be too early, or too late
d. quorum (default is majority)
e. record date the date on which ownership is established
for purposes of shareholder voting
i. whoever owns shares 15 days before the vote
2. Directors
i. Default rule is that each director is elected
individually
b. number
c. term
i. generally one year, but can be removed for no cause
ii. could have a staggered board (like the US Senate)
with a % elected each year)
iii. Bylaws may provide otherwise (can set any number
or standard)
iv. Classified Board a board of directors structured
so that only a fraction of its members is elected each
year for multi-year terms; a.k.a., staggered board
d. meetings
e. quorum
f. telephonic meeting/video conferencing
3. Board committees
4. Officers
i. Delaware is open for officers
ii. NY requires certain officers
b. main offices
5. Stock
a. certificate
b. lost certificates
6. Indemnification of officers and directors
18

III.

a. take care of indemnification that is optional

7. Miscellaneous
a. fiscal year
b. seal
c. amendment of bylaws (generally speaking, shareholders
can, and directors may or may not be able to (but usually
can))
Piercing the Corporate Veil
a. Limited Liability the limitation of an investors liability to her investment in
business, such that business creditors cannot go after personal assets
i. General rule: shareholders are not liable for corporate obligations
1. Exceptions are very rare
ii. Piercing the corporate veil holding shareholders personally liable for
the obligations of the corporation
1. Two Part Test
a. Failure to respect the corporate form
b. Some injustice
b. Failure to Respect Corporate Form
i. Failure to respect corporate formalities
a. If you are not respecting the corporate form, the courts
wont either
2. Failure to incorporate
3. Failure to issue shares
4. Failure to hold meetings
5. Failure to maintain records
ii. Failure to maintain separate identity
1. Unity of interest and ownership
2. Commingling of assets
3. Domination by shareholder
4. alter ego or dummy
iii. Walkovszky v. Carlton
1. Veil was not pierced because inadequate capitalization alone will
not lead to liability absent a finding that the corporation abused the
arrangement by failing to follow corporate formalities;
iv. Frigidaire Sales Corporation v. Union Properties, Inc.
1. Court respect form over justice. (Velasco likes this case.)
v. Issues:
1. The question is: how much is enough? Always a factual
determination. Missing one or two meetings probably not enough,
but never holding them is almost certainly enough.
c. Some Injustice
1. Mere fact that the injured plaintiff goes uncompensated is not
enough, you need more.
19

ii. Fraud
iii. Other injustice
1. Undercapitalization failure to provide adequate capital for the
business when incorporating
a. Judged ex ante, not ex post
i. In other words, it had to be clearly too little from
the beginning, not just turning out that there wasn't
enough.
b. Cover foreseeable and natural expenses
2. Siphoning of funds excessive withdrawal of corporate resources
for shareholder benefit
a. Also viewed ex ante
3. Intentional scheme to evade responsibility
a. Something more than just the general forming of a
corporation
b. Big elaborate scheme, that although legal, seems fishy
4. Unjust enrichment
iv. Kinney Shoe Corporation v. Polan
1. If there is truly is no money, available, it is undercapitalization and
the corporate veil can be pierced
2. You have to have enough assets at start up to account for slowness
in selling your product.
3. Third Prong introduced by the court:
a. If an investigation would disclose that the corporation is
grossly undercapitalized, based upon the nature and the
magnitude of the corporate undertaking, such party will be
deemed to have assumed the risk of the gross
undercapitalization and will not be permitted to pierce the
corporate veil.
d. Related Theories
i. Enterprise liability a legal doctrine under which a court may hold an
entire business enterprise (i.e., all affiliates) liable for the obligations of a
constituent corporation
1. Lack of separate identity
a. As between corporations (if its b/t corp & owner, its
piercing corp veil)
2. Some injustice
3. Sea-Land Services, Inc. v. Pepper Source
a. Reverse Piercing going the other way with piercing the
corporate veil
i. Another word for enterprise liability

20

IV.

4. This is not piercing the corporate veil; the owner of the entire
corporate enterprise may still escape liability even if the entire
enterprise is liable.
ii. Direct liability
1. In theory, owner can be liable for the owners own action in respect
to the business.
a. Holding persons liable for what they do.
2. In re Silicone Gel Breast Implants Products Liability Litigation
a. Velasco HATES THIS CASE.
b. By the Courts logic, enterprise liability would be the rule
and not the exception.
The Purpose of Corporations
a. What is the purpose of Corporations?
1. Profits for shareholders
2. Provide goods or services to public
3. Self-perpetuation
4. Society allows corporation Purpose thus is to benefit society.
ii. Dodge v. Ford Motor Co.
1. Henry Ford could not run his corporation for social good, but
rather for profit to shareholders. Must put interest of the
shareholders before monetary interests.
2. A court will not uphold irrational decisions about dividends that it
determines to be an abuse of the directors discretion.
iii. Shlensky v. Wrigley
1. The court will not enter a contested situation based only on poor
business judgment; there must be fraud, illegality, or a conflict or
interest. Business decisions are in the hands of the Board.
a. Here it didnt matter that the directors didnt want to put in
lights because it was in the neighborhoods best interest,
not in the best interest of the corporation because the
property would become more valuable if it could offer
night games.
iv. NOTICE THE DIFFERENCE BETWEEN THE FORD CASE AND
WRIGLEY CASE.
1. In Wrigley the court says that corporations can take into
consideration socially beneficial or injurious factors (i.e., dont
have to just consider profit or shareholder maximum value
v. A.P. Smith Mfg. Co. v. Barlow
1. Court is more accepting of charity that it was in the Dodge case.
2. Modern corporations should have duties to society beyond wealth
maximization
3. Difference
a. Socially responsible behavior is necessary (i.e., moral duty
to act well when forced to act at all)
21

b. Charitable donations are not necessary; they are a choice.

4. Similarities
a. In both cases it is a decision to divert resources from profitmaximizing uses to
5. Should corporations be allowed to be charitable?
a. Yes corps have extensive resources
i. Corps better at giving b/c its more convenient to
solicit $1 million from a corp than $1 mil from
100,000 individuals.
ii. Corps can monitor their resources better
iii. Donations are tax deductible if it goes to charity,
no taxes. If it goes to shareholders, its taxed.
b. No
i. Do we really want this amount of resources directed
by those in the upper classes?
ii. Why should they get to spend shareholders money
iii. Tax counter-argument you can just pay the tax
and allow the govt to apportion it
vi. Statutes
1. Constituencies Rules:
a. Del GCL 122(9):
No mention of corporate
benefit
b. Cal CC 207(e):
Regardless of specific
corporate benefit
(general)
c. NY BCL 202(a)(12):
Irrespective of corporate
benefit (doesnt
matter)
2. Recent laws allow directors to consider any factors when making
business decisions basically they can do as they please for the
benefit of shareholders, employees, suppliers, political lobbying
groups, etc. (29 states have general laws like this)
b. Whose interest should be predominant?
i. Shareholder have the most incentive to take the best route for the company
1. They look at all the risk positive and negative. Willing to risk
losing the corporation if they stand to make tons o money.
a. Shareholders dont bear all the loss, only the initial loss of
stock value. (employees can lose jobs, etc). shareholders
are willing to gamble with the jobs/livelihoods of others.
2. Other groups (employees, directors, creditors) all they want to do
is avoid risk.
ii. Credit Lyonnais Bank v. Pathe Communications Corporation

22

V.

1. When corp is near insolvency, the directors are not just agents of
the shareholders, but owe a duty to the corporate enterprise.
a. Shareholders will be looking at equity (Assets Liab)
while the corp may only be looking at assets.
2. Near Insolvency:
a. Creditors bear risk of loss, AND
b. Interests of shareholders and Directors/Corporation are not
aligned.
Business Judgment Rule
a. Business Judgment Rule a legal doctrine that protects business decisions from
judicial review; a presumption that, in making a business decision, the directors
of a corporation acted on an informed basis, in good faith, and in the honest belief
that the action taken was in the best interests of the company
1. An informed business decision, carefully made in good faith and
w/o conflict of interest, they will be held without fault so long as
the decision was rational. (note: rational, not reasonable)
ii. If the courts decide that the BJR applies, directors normally win.
iii. In most cases, the courts wont look at the substance of the decision:
1. waste, totally irrational, no win situation are the only ways to
challenge the substance of a business decision.
iv. You dont win your case, by challenging the substance of the decision
1. You challenge the decision making process.
a. Standard is gross negligence
v. Kamin v. American Express Company (New York)
1. Facts: The Board declared a special dividend to the shareholders
(causing a large tax liability) instead of liquidating a bad
investment. The shareholders brought a derivative suit claiming a
waste of the corporate assets.
2. Held: Declaring the dividend is a board decision that is protected
by the Business Judgment Rule. The court will only interfere if
there was a lack of good faith. The fact that a decision was poor or
less advantageous than an alternative is irrelevant.
vi. Joy v. North
1. VELASCO THINKS THIS CASE IS WRONG
2. Limits of Business Judgment Rule
a. Cases in which the corporate decision lacks a business
purpose
b. Situation is tainted by a conflict of interest
c. Situation is so egregious as to amount to a no-win decision
d. Results from an obvious and prolonged failure to exercise
oversight or supervision.
3. Extreme rare to find a case is a no-win situation (in this case it was
the loan as a no-win situation.)
23

a. The bank had all the risk of loss, but none of the potential
profit/gain.
4. Courts are far better at making procedural decisions than they are
at making ex post facto, substantive business decisions.
VI.

Duty of Care
a. Gross Negligence is the standard!
i. Francis v. United Jersey Bank (New Jersey)
1. Directorial management does not require a detailed inspection of
day-to-day activities, but rather a general monitoring of corporate
affairs and policies.
2. Director has to object when they see the management engaging in
illegal activity
a. Bring it to the attention of the board
b. Must resign rather than being a part of it
3. You have to take steps to try to prevent illegal activity:
a. Voting against it
b. Talking to accountants
4. Director of bank in this case did nothing, thus it was clear that she
reached her duty of care.
5. Director owes fiduciary duties to shareholders.
a. This was a special case where the director owed fiduciary
duties to creditors.
b. Why can clients sue in this case? It is an insurance
company ins cos and banks are different
ii. In re Caremark International Inc. Derivative Litigation
1. Sustain and systemic failure is the standard of review.
a. Standard of review is much lower than standard of conduct.
2. Directors needs only make the most important decisions, the rest
can be done by officers.
a. Dont have a duty to enact a system of corporate
espionage to determine if theres anything wrong.
b. Absent grounds for suspicion, board members cannot be
held liable for assuming that employees were trustworthy
c. Director is responsible for enacting some time of
compliance/auditing/information system is in effect a
duty to remain informed or provide a process by which he
could remain informed.
i. Breach would be a sustained and systemic failure
gross negligence
3. Directors didnt have to pay anything for their misconduct;
attorneys received almost $1 million.
4. Two types of duty of care claims:

24

a. Bad decision protected by the BJR courts do not look at

substance unless it is irrational more concerned with
decision making process
b. Failure to act
iii. Martha Stewart Living
1. Corp didnt have to monitor MSs personal life/affairs.
2. Why not, though? If the corp is all about her?
iv. Smith v. Van Gorkom (Delaware)
1. Directors have an obligation to be informed.
2. Facts: The CEO went to a friend to initiate a merger. He offered
this friend a low price--$55/share. No negotiations occurred at any
point. Many of the terms of the deal were disadvantageous to the
corporation. Senior management was vocal about their
disagreement with the deal. The deal was kept very quiet, even the
lawyers were uniformed. The CEO told the board about the deal
but they never saw it in writing. The corporation had 90 days to
accept other offer, but no solicitations to potential purchasers were
made. The board signed the merger agreement without reading it
even though they had almost no information as to whether it was a
good price or deal.
3. Directors violated their duty of care in this transaction.
a. Didnt determine the intrinsic value (whats it worth)
b. Didnt get the best price (what can you get for it)
4. But did they really? They could have made a decision in two
hours, considering they were experienced directors
5. More Efficient Market Hypothesis
a. Is there an intrinsic value that is more than market value?
What does it matter if you think the company is worth
$60/share but no one will pay more than $50/share?
b. Theoretically it might be worth $60, and someone might
give you that higher price someday, but someone is offering
you $50 now (market value is $35)
6. Leveraged Buyout (LBO)
a. Borrowing money to buy a company and use the
companys profits to pay off the debt.
i. If it works, you end up owning the company for
free (you dont put much capital in)
ii. If it doesnt, the business goes belly-up and youre
stuck with the debt
b. Banks may not want to make that risky loan, so the person
can sell junk bonds
i. Bonds are rated based on risk, higher risk requires
more interests

25

ii. If you have too much risk, the bonds are not
considered investment grade and are of lower
quality (many banks cant buy) junk bonds
iii. High risk, high return. Very speculative

VII.

7. Fallout:
a. This was a very sophisticated set of directors, selling for a
very high price, with an inconclusive market test.
b. Most people didnt even see this as negligence, but the
court found it to be gross negligence.
i. Less people wanted to be directors
ii. Insurance companies didnt want to insure directors
iii. Many states passed laws allowing corporations to
eliminate the duty of care
1. In other words, corporations can put a
provision into the charter a phrase that says
directors cannot be liable for breach of duty
of care
v. Cinerama v. Technincolor, Inc.
1. There was a breach of duty of care so directors had to defend their
decision under the strict entire fairness test.
a. Fair Price
b. Fair Dealings
2. Court decided it was fair, even thou they breached their fiduciary
duty.
a. There is a duty of care, but the directors will not be
personally liable for a breach of the duty of care.
b. There is still the possibility of injunctive relief or voiding
the deal, just not liquidated damages from directors
3. Vcry similar situation; court upholds VanGorkum (say they dont
get the protection of the BJR) and the entire fairness test applies
a. BJR rational basis test
b. Entire Fairness Test strict scrutiny
Duty of Loyalty
a. Interested Transaction Law
i. Director Interest
1. Default
a. Entire fairness test; burden on the defendant
2. Independent Director Approval Unclear
a. Some states suggest Entire fairness test; burden on the
defendant
b. Most often (Delaware) business judgment rule; burden
on plaintiff
3. Independent Shareholder Approval
26

a. Business judgment rule; burden on plaintiff

ii. Controlling Shareholder Interest
1. Default
a. Entire fairness test; burden on defendant
2. Independent Director Approval
i. If this is even possible
b. Entire fairness test; burden on plaintiff
3. Independent Shareholder Approval
a. Entire fairness test; burden on plaintiff
iii. Bayer v. Beran (New York)
1. Standard of care in duty of loyalty cases most rigorous scrutiny
2. It is not improper to appoint relatives to responsible position in a
company as long as it is done within the duty of care and does not
violate the business judgment rule. A director must use the kind of
judgment that one would expect and give in similar situation to the
conduct of his own affairs.
a. Business Judgment Rule requires undivided loyalty and the
avoidance of the temptation of self interest.
b. Courts have to limit what counts as a conflict of interest
i. If BJR is default, than entire fairness has to be kind
of rare
ii.
iv. Zahm v. Transamerica (Federal Case)
1. Facts: Transamerica owned nearly all of a particular class of stock
in the Axton-Fisher Tobacco Company. It exercised its control
over the Board to redeem all of its class A stocka class that had
no voting rights. After the shares were redeemed, the corporation
liquidated and only Transamericathe controlling shareholder
benefited from the liquidation. Another class A shareholder sued
claiming that he should have been allowed to benefit from the
liquidation.
2. Held: Transamerica unfairly used its controlling share of the
corporation to profit at the expense of the minority shareholders
thereby violating its fiduciary duty as a controlling shareholder.
3. Basically
a. The company could either liquidate or redeem they chose
to redeem first, then liquidate second. This caused the
minority shareholders to get less than had they just
liquidated first.
i. In other words, the majority shareholder secretly
chose the option that would benefit them at the
expense of minority shareholders, b/c the minority
shareholders could have traded in their stock for the

27

class B stock had they known what was going to

happen.
4. The real problem wasn't that the minority shareholders didnt know
the company was going to liquidate, it was that the shareholders
didnt know what the company was worth before the liquidation.
5. Basically the court finds that this was a conflict of interest situation
the company/majority shareholder didnt disclose the value or
the intent to liquidate, thus screwing the minority shareholders b/c
they didnt have the opportunity to convert, giving the company a
windfall.
a. Conflict of interest self dealing apply entire fairness
test.
b. Basically the class A shareholders (minority) cant
complain about the redemption. Class B was controlling,
therefore could make decisions on their own. The duty of
loyalty problem was that the Company didnt give them the
valuation information which would have allowed them to
convert.
v. Lewis v. S.L. & E., Inc.
1. Tolerant of conflicts of interest as long as the transaction is fair.
2. There was no interest in charging the best rent b/c they were
charging it to another company it owned.
3. The BJR does not apply
a. Must be a business judgment this wasnt, as there was no
consideration given for the lease
b. Duty of loyalty issue not all the siblings owned both
companies, yet they secured a below-market value rent for
the renting company.
4. What did shareholders win?
a. Shareholders get upward adjustment of book value
i. Add in the rent you did not get over time
5. Should we allow conflicted transactions?
a. A conflict of interest doesnt mean something is wrong
its just the potential to be wrong
b. Having to prove everything is fair will require the courts to
look at the substance, which is not consistent with the
policies behind the BJR (courts not qualified to make these
decisions)
c. There are sometimes when a conflict of interest is
unavoidable courts will need to make a decision
d.
vi. Shareholder Conflict on Interest
1. Individual shareholders can act in their own interests

28

a. You have no fiduciary duty to other shareholders

b. This is in public corporations
i. Not as much so in private corporations.
2. There are no conflicts of interest w/ shareholders.
vii. Sinclair Oil Corp. v. Levien (Delaware)
1. Facts: Sinclair Oil owned 97% of a subsidiary. Sinven paid out
very large dividends both to Sinclair oil and its minority
shareholders. The dividends were in excess of Sinvens net
earnings. A minority shareholder of Sinven sued Sinclair claiming
that the dividends were excessive and that Sinclair breached its
duty as a controlling shareholder in paying them out since it
received the majority of the benefit. The minority shareholder also
claimed that Sinclair usurped corporate opportunity by stealing
business from Sinven through its control as the majority
shareholder. It also claimed that Sinclair forced Sinven to enter
into contracts with a wholly owned subsidiary. Such contracts
required fixed high quantity purchases and full payment on receipt.
a. Fiduciary duty apply BJR
b. Conflict of interest? apply entire fairness test
2. Held: This is not a breach of the duty of loyalty because the
minority received their appropriate sharethe controlling
shareholder did not benefit at the minoritys expense. Thus, no
preference or additional benefit was given to the controlling
shareholder to the exclusion of the minority shareholder.
3. Plaintiff has to prove his transaction was intrinsically fair.
a. Selfishness is ok as long as it doesnt rise to the level of
self dealing.
4. Notes
a. Sinclair owes levien a fiduciary duty as the majority
shareholder in Sinven (with levien being the minority)
i. When theres control, theres a fiduciary duty.
When theres a fiduciary duty, you apply the BJR.
Youd have to show a conflict of interest to apply
the entire fairness test to look at the substance
ii. Conflict of interest: need self dealing, i.e., when
the fiduciary gets something to the exclusion of the
minority owner. (like being on both ends of the
transaction..selling & buying)
iii. Sinclair needed money and caused Sinven to pay
out to cover it, but theres no conflict of interest
when all the shareholders get their fair share.
b. Sinclair was directing opportunities to other subsidiaries
instead of Sinven. Thats under the BJR so long as Sinclair

29

wasnt actively taking away opportunities that Sinven

already had.
c. Breach:
i. Court applies entire fairness test b/c Sinclair is on
both ends (contract between Sinclair and Sinven,
which is controlled by Sinclair)
viii. Fliegler v. Lawrence
1. Burden of proof shifts to plaintiff if the transaction was approved
by fully informed disinterested shareholders.
2. Ratification: Delaware law allows conflicted transactions to be
made by non-conflicted parties. Shareholder ratification
automatically invokes the BJR and the burden is on the plaintiff to
show the transaction essentially amounted to waste.
a. Note this is shareholder approval, not necessarily
disintrested shareholder approval.
b. Theoretically, if the conflicted shareholders hold a majority,
they can ratify a transaction that benefits them.
c. Statute also allows the conflicted parties to prove fairness
w/o ratification to allow the transaction.
3. Court says that the entire fairness test applies even if the
transaction is ratified.
a. So why bother with the ratification?
i. Vote counts as evidence of fairness, no dispositive,
but good evidence
ii. Burden of proof shifts instead of the defendant
having to prove that its fair, the plaintiff will have
to prove that its unfair. Plaintiff bears burden if the
shareholders ratified the decision.
ix. In re Wheelabrator Technologies, Inc. Shareholders Litigation
1. If fully informed disinterested shareholders give approval it voids
the duty of care claim.
a. If you ask for a shareholder vote, you have a duty to fully
and fairly disclose all relevant information.
b. Van Gorkum why didn't shareholder approval extinguish
duty of care claim there?
i. Shareholders werent fully informed
c. Burden of proof:
i. Controlling stockholder + fully informed
disinterested shareholder approval = entire fairness
test, but shifts burden to plaintiffs to prove
transaction was not fair
ii. Directors normally have burden to prove in duty
cases that the decision was fair
iii. Why are the tests different?
30

1. Potential for greater influence by controlling

shareholder
iv. This was a director transaction, not controlling
shareholder court says there was no evidence that
22% was controlling. 51% would be presumed.
b. Qucik Summery of interested transaction law
i. Director:
1. default rule is EFT w/ burden on defendant
2. If we have independent, fully informed, disinterested director
approval: (other directors are aware of conflict)
a. sometimes its EFT w/ burden on plaintiff
b. more often its BJR w/ burden on plaintiff
3. Independent shareholder approval
a. BJR; burden is on plaintiff
ii. Controlling shareholder interest
1. Default
a. EFT; burden on defendant
2. Independent director approval (assuming controlling shareholder
didnt appoint all directors)
a. EFT, burden on plaintiff
3. Independent shareholder approval
a. EFT; burden on plaintiff
iii. EFT:
1. Transaction must be fair for the corporation and its shareholders
2. Have to prove that it is entirely fair (not perfect, but fair)
3. When does the transaction have to be fair?
a. Some states say at the time of the transaction (ratified later
provided the transaction was fair)
b. Delaware says the transaction must be fair at the time it is
approved. (no later ratification)
iv. Main Conflict situations
1. Salaries & benefits management gets to set its own salaries, but
its an everyday occurrence b/c every company has to set salaries.
a. use fully informed, independent director approval form a
salary committee
2. Business dealings w/ the director director wants to engage in
some business dealing with the company
3. Derivative litigation when shareholder wants to sue corporation
4. Hostile takeovers or proxy contests
VIII. Corporate Opportunities
a. As a general rule a fiduciary should not take an opportunity that belongs to the
corporation for their personal benefit.

31

i. Real question is whether it is a corporate opportunity or personal

opportunity.
1. Theres no clear test, but consider these factors:
a. The line of business buying a direct competitor is more
in the line of business than buying a secondary
competitor.
i. Maybe shouldnt matter conglomeration is a
corporation combined of different businesses (like
potato chips and microchips)
b. Interest or expectancy like an extension of a lease;
expected to be able to extend lease and didnt get it.
i. CEO buying land with oil under it
c. Source of opportunity used corporate assets and time to
develop or discover the opportunity; its more likely to be a
corporate opportunity.
d. Party involved in order of most problematic: officers,
directors, employees, shareholders. (assuming its not a
controlling shareholder)
e. Fairness consider all the circumstances
ii. Directors have a greater duty to the business than a mere agent
1. Barber shop example: agent (barber) hears of other shop for sale
can quit and buy w/o informing.
2. Director of barber shop is in a different boat; had to inform other
directors and they had to decide as a group if the shop should buy
the other shop.
3. NOTE: director votes the interested directors vote doesnt
really count (disinterested approval)
b. Factors to be considered on whether something is a corporate opportunity
i. Line of business
1. Closer it is to the line of business the more likely it is a corporate
opportunity
2. Some people say it has to be in the same line of business to be a
corporate opportunity
ii. Interest or expectancy
iii. Source of opportunity
iv. Party involved
1. Closer you are to an officer the more likely it is to be a corporate
opportunity
a. Officer Director Employee Shareholder
v. Fairness
c. Test:
i. Broz v. Cellular Information Systems, Inc.
1. PRO DIRECTOR
32

IX.

2. Where the director believes that the corporation is not entitled to

an opportunity, there is no reason to present the opportunity to the
board.
3. Presenting to the board is just a safe harbor.
ii. Energy Resources Corp v. Porter
1. LESS PRO DIRECTOR
2. Before a person may take advantage of an opportunity he must
present it to the board.
3. Argued that Howard had refused to deal with the company; only
wanted to deal with the scientist / director
a. Failed to satisfy other elements, though
i. Did not disclose to corporation
ii. Did not give reasons Howard wouldnt deal so the
corp could possibly make adjustments.
Shareholder Actions
a. Direct vs. Derivative Litigation
i. Direct action a lawsuit initiated by an injured person on her
own behalf
1. Typical litigation: injured party sues
ii. Derivative action a lawsuit initiated by a shareholder on the
corporations behalf against third parties (often management)
because of managements failure to take action against the third
parties
1. Atypical: on behalf of injured party
2. Reasons for allowing it:
a. Person is unable to sue
3. Problems with Derivative Litigation:
a. Corporation should be able to say whether or not they want
to sue, not shareholders
i. Management would have to make this call
ii. Shareholders are not supposed to run the business
b. Cant allow each and every shareholder to make decision
c. Shareholders may not understand all the issues
d. Shareholders may have vendettas and have personal
interests
iii. Cohen v. Beneficial Industrial Loan Corp.
1. Reason for derivative suit management apathy
iv. Eisenberg v. Flying Tiger Line, Inc.
1. VELASCO THINKS THIS IS A BAD CASE, SHOULD HAVE
BEEN A DERIVATIVE ACTION AND WAS FOUND NOT TO
BE.

33

2. Injury to the corporation it is a derivative action; injury to the

individual is a direct action.
b. Incentives
i. Shareholders have very little incentive to sue
1. If they do sue, they would have to incur expenses of the litigation
and then the corporation would get the benefit
a. this is a problem for people who like derivative action
ii. Attorneys do have incentives
iii. Elements
1. Litigation expense
a. unpredictability
2. Contingent fee a fee charged for a lawyers services only if the
lawsuit is successful or favorably settled out of court, usually
representing a percentage of the award
a. Contingent fees make shareholders more willing to sue
because it limits the incentive not to sue.
3. Award of attorneys fees
a. normally attorney will be awarded fee if he is successful
b. normally he will get the full fee regardless of recovery
4. Indemnification provisions
a. If directors dont have to pay the judgment but are going to
be indemnified by the corporation you have problems.
iv. Strike suits a lawsuit initiated not with the intention of winning on the
merits, but with the intention of obtaining a profitable settlement
1. Weak case, but the potential for a jury to give you a lot of money
2. Entrepreneurial attorney an attorney acting as a businessman
with respect to lawsuits, making investment decisions with her
time and taking the risk of profit and loss
3. Courts and the Corporate World think that derivative actions are
strike suits
a. Reasons for thinking this:
i. Shareholders rarely win in court (Business
Judgment Rule)
ii. Settlements there is a very small dollar recover
1. Counter to this is structural relief is often
granted, small dollar amount is relative,
some changes in management
c. Statutory Solutions
i. Expenses
1. Awarded if successful
a. litigation costs (including attorney fees) will be awarded if
successful
i. sometimes this is optional (may language)
34

X.

ii. Security
1. Some states require that the shareholder post security for the
corporations expenses
a. it is rare that the shareholder will be liable if the
corporation wins, but it is there incase
2. NY says you need to post but not if you own 5% of stock/$50,000
iii. Standing
1. Contemporaneous ownership rule the rule of standing providing
that, in order to initiate a derivative action, a plaintiff must have
been a shareholder at the time of the action complained of
a. Argument that this does not make sense:
i. All shareholders can have a real interest
b. Some states (like NY) require that you are a shareholder at
the time of action and at the time of the lawsuit.
iv. Demand
The Demand Requirement
a. Demand Requirement
i. Before a shareholder can bring a derivative action he has to bring it up
before the board of directors.
1. They can decide whether it makes sense to sue
a. If they say no, there will be a record of their reasons and
the court can say whether they make sense or not.
2. Exceptions:
a. Irreparable Harm
i. If there will be irreparable harm from making the
demand, they dont have to make it
1. If time is a critical factor
b. Demand Futility
i. If there is a conflict of interest, it would be futile to
ask the board to sue itself.
1. NOT ALL STATES ALLOW DEMAND TO
BE EXCUSED FOR FUTILITY
a. Mostly to avoid extra litigation costs
ii. When would it be futile?
1. Conflict of interest (majority of board is
interested in the transaction)
ii. Grimes v. Donald (DEMAND FUTILITY IN DELAWARE)
1. You cant just argue that demand was futile, you have to present a
case
a. not enough that they all participated in action
b. not enough that they all approved the action
c. not enough that they failed to take corrective action

35

2.

3.

4.

5.

d. not enough to allege that they are all controlled or

dominated by a shareholder
Particularized allegations have to be made in the pleadings
BEFORE you get to discovery
a. Note that this is more than a notice pleading requirement;
you must allege details before discovery
b. Use tools at hand available to shareholders
i. Public information
ii. Inspection rights
Grimes Test
a. Reasonable doubt needs to be created that directors are
disinterested and independent or the challenged transaction
was a product of a valid business judgment
i. 1st prong sounds like duty of loyalty
ii. 2nd prong sounds like duty of care
b. Does demand futility sound like a loyalty issues?
c. If demand futility cannot be shown, the court has the right
to dismiss the action.
d. Reasonable doubt means that the board has a reasonable
belief
Once you make a demand, you waive demand futility
a. the ball is in the directors court
b. you can still argue wrongful refusal of demand
i. standard for this is the Business Judgment Rule
1. Once the directors make a decision it is
protected by the Business Judgment Rule.
Class Notes
a. Basically, if demand is rejected (which will likely be the
case)
i. You can no longer plead demand futility (that
demand is excused)
ii. You can then make a claim for wrongful refusal,
which is essentially challenging the BJR
b. Plan:
i. Make demand, its probably rejected
1. You can try to argue wrongful refusal, but
youll likely lose under the BJR
ii. Argue demand futility
1. Have to deal in particularized allegations,
which is very difficult.
2. This is the best route despite the difficulty,
b/c the other route is more than likely a dead
end

36

iii. Marx v. Akers (DEMAND FUTILITY IN NEW YORK)

1. This is a derivative action so you need demand futility
2. Demand Futility in New York is established by:
i. takes out the reasonable doubt standard of Delaware
Test
st
b. 1 prong a majority of the directors are interested in the
transaction or
c. 2nd prong the directors failed to inform themselves to a
degree reasonably necessary about the transaction or
d. 3rd prong the directors failed to exercise their business
judgment in approving the transaction
3. Majority of board was disinterested so we respect to most of the
board demand would not have been futile.
4. Difference b/t Delaware & New York tests
a. New York does not require reasonable doubt
i. Delaware does the plaintiff have a reason to
doubt?
ii. New York the plaintiff must have a reasonable
belief that the board lacks independence
1. Harder to meet the New York test
5. When the board is conflicted, they have to prove it was valid under
the entire fairness test
a. But the court puts the burden on the plaintiff to allege
particular facts, where normally it would be the corp having
to show it was not conflicted
b. Why dont they apply that here?
i. The court realizes that in cases like this, where the
issue is director compensation, applying the EFT
would subject nearly all similar transactions to
judicial review.
b. Special Committees
i. Notes:
1. These situations are generally used when demand futility is
established as a way for the corporation to avoid litigation.
ii. Auerbach v. Bennett (NEW YORK SPECIAL LITIGATION
COMMITTEE)
1. Ford created a special litigation committee whose decision was not
questioned by the court
a. The board placed the final authority to decide whether to
pursue litigation into the hands of this committee, which
was comprised only of disinterested directors appointed
after the alleged incident giving rise to the litigation.
b. the process can be inquired into, but NOT the substance

37

i. will look at procedures chosen

ii. how they engaged counsel
iii. basically the court will show great deference
2. Rule in New York
a. If you have a special litigation committee, properly
appointed and after a good faith investigation concludes
that it is in the best interest of the corporation to dismiss the
derivative suit the Business Judgment Rule will apply.
i. Basically, if there is not a conflict of interest, the
BJR applies.
3. Class notes
a. Structural bias: directors will naturally be predisposed to
be biased towards one another. Court responds that if we
don't trust the directors, we wont have the BJR and the
courts will have to make all the decisions.
b. Two ways to establish demand futility: reasonable doubt as
to independence of directors, or decision not product of
valid business judgment.
4. New York is extremely deferential toward corporations
iii. Zapata Corp. v. Maldonado (DELAWARE SPECIAL LITIGATION
COMMITTEE)
1. Delaware that there are risks in the situation
a. Is the new committee really disinterested?
i. Structural Bias independent directors may be
biased
1. They will have to make decisions about
colleagues on the board, often times those
same colleagues who got them their board
position.
b. Balancing the interest of all the parties
i. Not truly to dismiss cases after years of litigation
2. Courts are applying their own business judgment
a. Two Part Test:
i. Essentially Auerbach
ii. Courts then apply their own BJR
1. But that was the whole point of the BJR
2. Deleware doesnt apply the BJR very often
anymore.
b. Delaware Supreme Court creates a test where courts are
applying their own Business Judgment
i. Odd development that is unique in corporate law
c. Who could justify this?
i. Need for some kind of balancing
1. Counteracts structural bias
38

XI.

3. They really dont apply their own business judgment, but they can.
iv. DELAWARE court if the far extreme for not trusting directors, NEW
YORK court is far extreme for trusting directors.
c. Derivative Litigation
i. The board is the one who decides whether or not to sue, so
ii. We allow shareholders to sue on companys behalf
iii. Problems:
1. Disincentives for shareholders to sue
a. Costs
i. We allow an award of expenses, but only if they win
2. There is incentives for attorneys to bring derivative suits
a. Law focuses on disincentives to sue to counter this
i. Demand requirement
1. Particularized allegation
2. Special Litigation Committee
b. Hard for a shareholder to win in derivative action
i. Courts are not sympathetic because it is not a
shareholder right but a corporation right
Executive Compensation
a. Executive Compensation
i. Growing problem
1. Top executives get too much money
a. disclosure of compensation packages is poor
b. Courts dont know what to do.
2. Compensation levels is clearly Business Judgment
a. Concern with structural bias directors are conflicted in a
collegial sort of way (top officers are directors) and in a
mutual interest way (directors are often directors for other
companies)
i. Is there really arms-length negotiation here? If the
directors are disinterested, maybe, but even then,
theyre officers in other corporations.
ii. Argument for: we have to set our salaries above
average to get above average employees.
1. But everyone paying above average causes
salaries to increase exponentially.
3. Gap between Executives and average workers is growing:
a. In 1970s average gap was 40 times, by 1991 average gap
was 140 times
b. estimates in 2003 is 500 times
ii. Flexibility in Setting Pay
1. Paying executives based on performance

39

XII.

a. If you set the wrong incentives you are in trouble

2. Compensation is based on the short term performance
iii. Brehm v. Eisner
1. Executive compensation is under the business judgment rule.
2. Duty of Care question basically, the CEO was fired and he got
$140 million in compensation; argue that anyone putting the corp
in this situation breached their duty. Derivative suit
a. Argument was that it was waste; so irrational that it didnt
deserve the protection of the BJR
i. Court said this decision had to be unconscionable;
meaning it was highly unlikely that they could win.
3. Extreme deference to the corporation; you basically have to make
your case with specific evidence in the pleadings.
Indemnification & Insurance; Inspection Rights
a. Indemnification & Insurance
i. Indemnification reimbursement of a loss or expense incurred by
another.
1. Particularly in this case, reimbursement of cost of litigation
expenses incurred by director, officer or employee (attorneys fees,
court fees, etc)
ii. Special Rules of Corporate Law that either require/permit/forbid
indemnification
1. DGCL 145
a. (a) allows indemnification in direct actions (suing CEO
directly)
i. some requirements:
1. have to be acting in the good faith of
company
2. criminal action had to have believed that
their actions were lawful
b. (b) allows indemnification in derivative actions (suing CEO
on behalf of corp)
i. similar requirements to (a)
ii. If defendant is liable to the corporation the court has
to approve the indemnification as fair and
reasonable
c. (c) requires indemnification if defendant is successful on
the merits or otherwise
d. (d) requires specific authorization for any indemnification
payment under (a) or (b)
i. basically, if youre guilty, the board has to decide
whether or not to reimburse them.
e. (e) allows advancement of expenses

40

f. (f) allows additional rights

g. (g) allows liability insurance (even when indemnification is
not allowed
i. allows directors/officers insurance when
indemnification is not allowed.
iii. Waltuch v. Conticommodity Services, Inc.
1. Law only allows corporation to indemnify when they are acting in
good faith
2. Power to indemnify is limited to good faith
3. Success is vindication as far as the court is concerned
iv. Citadel Holding Corporation v. Roven
1. Limit on advancement of funds is it has to be reasonable.
2. Basically; the purpose is to protect you in advance for things you
will be indemnified for. So theres a presumption that youll be
indemnified.
b. Inspection Rights
i. Generally, shareholders can demand to see basic corporate records
1. Charter, bylaws, minutes of board meetings, list of shareholders
ii. Reasons for allowing inspection rights
1. Why should only one slate of candidates have access to voters
iii. Standard for allowing shareholder access
1. Request has to be for a proper purpose
a. Economic Interest
b. Valuation Issues
c. Takeovers
d. Proxy Contest
2. Requests that would not be considered proper
a. Possibly goodwill concerns
b. Political Activism
iv. Derivative Litigation
1. In theory is positively related to the corporation and the inspection
rights would be a proper purpose
v. State ex rel. Pillsbury v. Honeywell, Inc.
1. Moral arguments are not good enough for inspection rights.

41

Part Three: Federal Securities Law

I.

Introduction to Federal Securities Laws

a. History
i. Security an instrument that evidences the holders ownership rights in
an organization (e.g., stock), the holders creditor relationship with an
organization (e.g., bonds), or the holders other financial rights (e.g.,
options)
ii. State securities regulation
1. Common law fraud didnt provide enough protection for the
sale of securities; hard to prove fraud.
2. Blue sky laws state security laws
a. merit regulation
i. state laws looked at investment and decided
whether it was a good investment, too speculative
or not
iii. Stock Market Crash of 1929
1. Great Depression
a. Brought federal law to the table.
iv. Federal securities regulation
a. helps investors make own (good) investor decision
2. Mandated disclosure
a. in selling securities companies have to give adequate and
accurate information to investors
b. done by filing detailed reports to government which are
distributed to investors
3. Antifraud rules
a. company is liable if the disclosure is inaccurate or
incomplete
4. No merit regulation
a. You can sell any security you want to so long as investors
are properly informed.
b. Federal Securities Laws
i. Securities Act of 1933
1. Primary markets the market for securities sold by issuers to
investors (when the company is selling you a security, like an
initial public offering (IPO))
a. must register securities and deliver prospectus before
selling securities to the public (public offerings covered,
private offerings are outside the scope of this law)
1. registration requirement have to file
detailed report (registration statement) to
Securities & Exchange Commission
a. SEC reviews registration statement
for the adequacy and not the
accuracy

42

b. When it is complete, SEC declares

the registration statement effect
2. After this is completed, the prospectus is
delivered
a. Prospectus information about the
offering; have to deliver it as a sales
document.
b. Always contains the registration
statement
ii. unlessexemption is available
b. liability for false or misleading statements or omissions of
material fact (deception)
i. much tougher than common law fraud
ii. standard prohibits false statement of material fact
(no lies)
iii. also prohibits misleading statements of material fact
(no half truths)
iv. also prohibits misleading omissions of material fact
(nothing left out)
ii. Securities Exchange Act of 1934
1. Secondary Markets the market for securities traded by investors
among themselves (e.g., NYSE, NASDAQ)
i. Same structure, but implemented very differently
b. Main focus is not on selling investor but issuing company
i. must file periodic reports on company performance
ii. must file additional reports under certain
circumstances
iii. liability for manipulation or deception
1. not only in reports but any communication
from the company (press releases,
interviews, etc)
iv. Individual Liability if you lie or misrepresent,
youre liable. (but you have no mandated
disclosure)
2. Securities industry generally
a. Brokers, analysts, etc are regulated.
iii. Securities and Exchange Commission the agency established to oversee
the enforcement of federal securities laws
iv. State law is concerned with form over substance, while federal law is
more concerned with substance
1. Theres no race to the bottom competition like states competing
for corporations b/c theres only one fed gov and it has preempted
the field.
c. Valuation
i. Commodities products that are abundant and fungible; e.g., produce
1. Easier to price, because of many buyers and sellers

43

2. Pricing is through supply and demand

ii. Special Goods rare or unique items
1. Difficult to price how much is x painting worth?
iii. Corporation as a whole is a special good, but the share of stock is a
commodity
iv. Strong Market
1. Strong Liquidity have to be able to buy & sell quickly
2. Availability of information so you can analyze before the fact
3. Efficiency ability to buy and sell cheaply
v. There are strong markets for public corporations
1. Confident traders and strong market
vi. Closed corporations do not have strong markets
1. Not much info available, not publicly traded so not very liquid,
d. Efficient Market Hypothesis the theory that, in a strong market, such as U.S.
capital markets, prices quickly reflect all available information
i. Price may not be accurate, just that it reflects all available information
ii. Why?
1. Combined efforts of all investors analyzing information creates an
equilibrium price
iii. Weak Form of Efficient Market Hypothesis
1. Current prices reflex all past price information
2. You cant beat the market by looking at trends
a. Falling or rising price isnt a good reason to buy or sell
the current price already reflects that.
b. You cant do better than youre supposed to
3. General accepted as true
iv. Semi Strong Form of Efficient Market Hypothesis
1. Current prices reflex all publicly available information
2. Cant beat the market through analysis
a. You cant read financial statements, trends, industry, etc
and decide which stock is better all this information is
already reflected in the stock price.
b. This never claims that the prices are accurate, only that
they reflect all the public information
3. Widely accepted as more or less true
a. Very few mutual funds can consistently beat the market.
v. Strong Form of Efficient Market Hypothesis
1. Current prices reflect all available information, public & private
a. Basically, if I have secret information, should I buy? The
strong form says no, as current prices reflect all public and
private information. So you cant beat the market with
private information
b. This theory assumes that insider trading has already
happened by the time you get the information, so the price
already reflects it.

44

vi.

vii.

viii.
ix.

II.

2. Insider Trading the use of material, nonpublic information in

trading the shares of a company by a corporate insider or other
person who owes a fiduciary duty with respect to such information
3. Not accepted as true
a. If it was true, public announcements wouldnt make a
different, but they do.
b. If this were true, it would suggest people couldnt make
money on insider trading, but they do.
c. Looking at the stock price over time, it doesnt just jump at
the moment of announcement, it starts to rise around the
time of the announcement, leading to the belief that there
were some leaks & insider trading going on.
Equilibrium level of disequilibrium
1. Analysts must analyze in order for the market to be efficient, but
once they do so, they are useless b/c they cant beat the market.
Basically, analysts can only really hope to make enough $ to
analyze.
Ramifications for Security Law
1. If strong form is true, omissions are not so important because the
price already reflects what is really happening
2. If weak form is true, public disclosure is most important thing
because information is necessary
3. If semi strong form is true, getting information into the hands of
the public is not so important
Diversification the process of reducing risk by investing in multiple
opportunities
1. If you diversify you are not gambling as much
Lessons from Efficient Market Hypothesis
1. Dont try to beat the market
a. Even if someone can beat the market, you cant
b. Invest in index funds
i. Basically a buy & hold strategy; buy stocks on
the NASDAQ or S&P 500 and hold on to them.
ii. Actively managed funds (typical mutual funds)
have higher trading/management fees.

Rule 10b-5
a. Rule 10b-5
i. SEC rule under Exchange Act 10(b)
a. broad antifraud rule
b. single most fundamental provision of federal security laws
2. Congressionally delegated authority
ii. Forbids, in connection with purchase or sale of securities:
a. similar to, but broader, than security act
2. Devices, schemes and artifices to defraud
3. Practices which operate as a fraud or deceit

45

4. False or misleading statements or omissions of material fact.

iii. Enforcement
1. SEC intended to be enforced by
2. Private investors courts have found an implied cause of action
a. Not clear that Congress or SEC intended this.
iv. Elements of a cause of action under 10b-5
1. Scienter intent to deceive (or recklessness; lower courts say yes,
SCOTUS hasnt ruled)
a. fraud
2. Materiality relevance/significance
a. not little details are enough
b. Basically, anything important enough to effect a decision
3. Purchase or sale
4. Causation
a. deception must be the cause of the harm
5. Reliance
a. plaintiff must have actually been deceived
v. Basic Inc. v. Levinson
1. How should materiality be defined?
a. Anything that would affect a decision
i. Reasonable person?
ii. Reasonable investor?
2. What court says about materiality:
a. An omitted fact is material if there is a substantial
likelihood that a reasonable shareholder would considered
it important in deciding how to vote.
i. To fulfill the materiality requirement there must
be a substantial likelihood that the disclosure of the
omitted fact would have been viewed by the
reasonable investor as having significantly altered
the total mix of information made available.
3. Probability Magnitude Test (2nd Circuit)
a. Look at the probability and magnitude of the event to
determine if it is material:
1. Gives an expected value.
2. Basically P x M = Expected Value
ii. Consider facts such as the size of the corporation,
effect on the value of the corporation, etc.
4. Security Laws are about disclosure not protection, so you only
need to disclosure material facts
a. protection of corporate secrets
5. Supreme Court is not talking about timing of disclosure, they are
talking about the accuracy of disclosure
a. In this case, they didnt have to say anything.
i. Silence absent a duty to disclose is not misleading
under rule 10b-5. (i.e., No Comment)

46

ii. If you want to have secrets you have to have a no

comment policy if you deny some claims and say
no comment to others, the no comment operates
as a yes.so you always have to say no
comment
b. But the courts say once you say something, it has to be
materially true.
6. Fraud-on-the-market theory:
i. Based on the hypothesis that, in an open and
developed securities market, the price of a
companys stock is determined by the available
material information regarding the company and its
business.
1. Basically the efficient market hypothesis;
its a clear adoption of the EMH
b. Misleading statements will therefore defraud purchasers of
stock even if the purchasers do not directly rely on the
misstatements
c. The casual connection between the defendants fraud and
the plaintiffs purchase of stock in such a case is no less
significant than in a case of direct reliance on
misrepresentations
d. This is derivative reliance; were relying on the market, and
the market was defrauded. But its a rebuttable
presumption.
i. How to rebut?
7. Fraud must be in connection with sale or securities
a. Problematic in this case b/c the misrepresentation wasnt
connected with the purchase or sale of securities. It was
made to maintain the status quo during merger
negotiations. Court ignores this; seems to be a very broad
interpretation that anything could lead to a purchase or sale.
vi. Santa Fe Industries, Inc. v. Green
1. Claims:
a. low valuation was fraudulent
b. Freezing out minority shareholders
i. Breach of fiduciary duty issue
2. Does Federal Law protect against unfair behavior, i.e., breach of
fiduciary duty?
a. Court of Appeals says yes, Rule 10b-5
b. Supreme Court says:
i. There is no cause of action for breach of fiduciary
duty (or any substantive fairness) under Federal
Security Laws.
ii. Bascially, no unfair claims under federal securities
laws.only deception claims.

47

III.

Insider Trading
a. Insider Trading the use of material, nonpublic information in trading the shares
of a company by a corporate insider or other person who owes a fiduciary duty
with respect to such information
i. Goodwin v. Agassiz
1. How would this court decide the problems?
a. CEO duty to the company and not random shareholder
2. Is there any harm to the corporation from Insider Trading?
a. None of the money from the stock market goes to company
b. Indirect harm is company losses goodwill
i. Harder for the company to do another primary
offering
3. This is where the law stood before security law.
a. Included for historical purpose
b. There was no protection for insider trading
ii. Securities and Exchange Commission v. Texas Gulf Sulphur Co.
1. Court ultimate rule on insider trading:
a. Disclose or Abstain Rule
i. Anyone in possession of material insider
information must either disclose it, or if he cannot
in order to protect a corporate confidence, or he
chooses not to do so, must abstain from trading in
or recommending the securities concerned while
such information remains undisclosed.
2. Probability Magnitude Test
a. Whether facts are material will depend on any given time
on a balancing of the probability that the event will occur
and the magnitude of the impact.
3. Misleading Statements
a. Needs to be in connected with the trading
b. Rule doesnt require trading by speaker, just that the fraud
needs to be connected with the purchase or sale
i. It is connected with the purchase or sale if it causes
people to purchase or sale\
ii. Basically, a false or misleading statement by the
company, and subsequent trading by the purchaser
is enough for the plaintiff to sue.
1. But any trading is enough for SEC
4. Business Judgment rule does not apply state matter vs. fed sec
laws
5. This case is not the law anymore
iii. Chiarella v. United States
1. Mere possession does not mean that there is deception involved,
there must be fiduciary duty

48

2. If a breach of fiduciary duty is deceptive it is actionable under

federal security laws, not because it is a breach of fiduciary duty
but because it is deceptive
a. Deception or fraud is the only thing that is covered by rule
10(b)(5); if a breach of fid duty gives rise to an obligation
to disclose, and no disclosure is made, it may be considered
deceptive
3. Non-fiduciaries do not violate Rule 10b-5 by engaging in insider
trading
iv. Dirks v. Securities & Exchange Commission
1. SEC didnt see Dirks as a bad guy and only censored him
a. They did this to create a rule of law for the future
2. SEC theory is that once you received insider information you
become an insider
3. Supreme Court rejects SECs theory as trying to get rid of
Chiarella
a. Two Part Test:
i. Says you can inherit fiduciary duty but only when
1. the insider has breached his fiduciary duty to
the shareholder and
2. the tippee knows or should have known of
this breach
4. Breach of Fiduciary Duty needs to be a Personal Benefit
(money or its equivalent)
a. Direct to you
b. Indirect to your friends or family
c. Note that this personal benefit requirement is unique to
federal securities law; state breach of fid duty doesnt
require a benefit.
5. Only way strangers will have fiduciary duty is if they inherit the
duty
a. There must be an unbroken change and you ask from each
person to the next go through the two part test.
v. United States v. OHagan
1. Tender Offer a public offer to buy a minimum number of shares
directly from shareholders at a fixed price, usually at a substantial
premium and usually part of a takeover attempt
2. Court discuss classic theory: Chiarella
a. there is a deception only if there is a breach of fiduciary
duty
i. applies not only to personal insiders of the
company, but also to accountants, attorneys, and
others who may temporarily have access to that
information.

49

IV.

ii. Classical theory would say that OHagan had a fid

duty to the buyer (GM), but OH bought shares of P
stock, to whom OH owed no duty.
3. SEC tries to expand scope under 10b-5
a. Misappropriation Theory
i. A person commits fraud in connection with a
securities transaction, and thereby violates 10(b)
and Rule 10b-5 when he misappropriates
confidential information for securities trading
purposes, in breach of a duty owed to the source of
the information.
ii. Basically, you can violate 10(b)(5) by breaching a
duty to the source of the information. While he had
no duty to P, he did have one to GM, and breaching
his duty to GM falls under this theory.
iii. Distinctions between classical theory and
misappropriation theory are slight. See pg 503 for
good description
iv. Loophole: if you tell the party you got the
information from that youre going to use it for your
own purposes, its no longer deception and youre
off the hook. This loophole doesnt work with
classical theory.
4. SEC has gotten what it wants in terms of tender offers
vi. Rule 14(e)(3)
1. No trading w/any material nonpublic information regardless of
fiduciary duty
2. Court says delegation of authority under 14(e)(3) gives the SEC
authority to proscribe rules to prevent deception. Authority under
10(b)(5) was limited strictly to illegality and punishment of
deception; this authority is a little broader.
3. Rule 14(e)(3) is limited to tender offers
Proxy Solicitations
a. Shareholder Meetings
i. Due to shareholder apathy, shareholders have no reason to go to
shareholder meetings
1. You can authorize people to vote on your behalf thou.
2. Management always seeks authorization to vote your shares
a. They need a quorum to conduct business
3. If someone else asks you, they are opposing management
ii. Proxy
1. (1) one who is authorized to act as a substitute for another, esp in
corp law, a person who is authorized to vote anothers shares;
2. (2) the grant of authority by which a person is so authorized;
3. (3) the documents granting the authority; i.e., the agent, the
authorization or the instrument

50

iii. Proxy Contest competition to obtain the right to vote shareholders

shares, often as a part of a hostile takeover
iv. Proxy Solicitation an attempt to obtain the right to vote shareholders
shares, most often conducted by management
v. Proxy Statement a document required by federal law to be delivered in
connection with a proxy solicitation
b. Coverage of Proxy Rules
i. Exchange Act 14(a)
1. Delegation of authority to SEC
ii. Regulation 14A
1. Every solicitation of a proxy with respect to registered securities
iii. Solicitation
1. Very broad definition
a. includes any request for a proxy
2. Exceptions:
a. Rule 14d-2(b): shareholder conversation
i. Conversation among fewer than 10 people, it wont
count for proxy solicitation
b. Rule 14a-1(l)(2)(iv): institutional investors
i. If you just say that here is what I am going to do.
c. Proxy Materials
i. Proxy Statement
1. Serves the Federal Security law of Mandated disclosure
2. Schedule 14A sets out all the requirements
ii. Proxy Card
1. Description of solicitor
a. because shareholders may presume it is management
2. Blank space for date
a. It is illegal to solicit a undated or postdated proxy
i. Reason for this is because proxies are revocable
3. Separate identification of matters to be voted on
a. discretion is an option
d. Delivery of Proxy Materials
i. Delivery to shareholders
1. Prior to any solicitation
i. First thing you do has to give someone a proxy
statement
1. You cant first talk to them and then give
them a proxy statement
b. exception: Rule 14a-12
i. Allows a solicitation without a proxy statement.
1. You can have discussions, before you
actually prepare a proxy statement
ii. But before you give them a proxy card or ask you
have to give them a proxy statement

51

e.

f.

g.

h.

2. Management solicitation for annual meeting must include annual

report
ii. SEC filings
1. Preliminary proxy statement
a. 10 days in advance
2. Final proxy statement
3. Other written materials
Other Matters
i. Opposing solicitations
1. Shareholder proposals
a. may have to be included in managements proxy
2. Proxy contest
i. Have to spend their own money to do that.
ii. Sometimes allow reimbursement for success proxy
contest
b. either mail materials at insurgents expense
c. or provide shareholder list
3. State law always give the right to get the shareholder list
a. This is not a conflict with the federal standard
i. Federal law gives the option, State law doesnt
ii. Antifraud provisions
1. Information must be clearly presented
2. Civil liability for false or misleading statements or omissions of
material fact
J.I Case Co. v. Borak
i. First case to recognize private cause of action under Rule 14(a)(9)
ii. Argument that it doesnt make sense:
1. Not necessarily the case that every group always need more help
with the enforcement of the laws
Mills v. Electric Auto-Lite Co.
i. Has to prove three elements of proxy solicitation:
1. Materiality
2. Reliance
3. Causation of injury
a. Proxy solicitation must have been an essential link to the
transaction
i. Votes were necessary to determine the outcome
Virginia Bankshares, Inc. v. Sandberg
i. If the directors actually believed that the price was fair, they didnt lie.
ii. To prove someone didnt believe their opinion:
1. The statement must be objectively false or misleading, not just that
they believed it to be unfair.
iii. Freezeout merger in glossary look up its forced upon minority
shareholders b/c majorities have control to do it.
iv. What is required to prove causation in proxy solicitations is Loss
Causation, not just transaction causation.

52

1. Electing director? Must prove that electing the director caused the
loss.
2. Bad merger? Must prove that the merger alone caused the loss.
V.

v.
Shareholder Proposals (DIDNT COVER THIS SECTION)
a. Shareholder Proposals
i. How much access should shareholders have to the Proxy System?
1. Rule 14a-8
2. Shareholder can get proposals in, subject to criteria of exclusive.
a. Supposing that we have a good standard, only the good
ones will get through
3. Who gets to apply the standard is a real problem?
a. If it is management, often the shareholders who want to put
in ideas are the ones that have problems with management
b. Court, we really dont want courts making this type of
business judgment
4. What we have is a system where the company gets the first stab of
it.
a. Company has to notify SEC either that they are going to
include it or exclude it
b. If SEC disagrees they can take a stab at it
c. Either side can appeal SEC decision to court.
i. This really doesnt happen
ii. Company doesnt want to upset SEC
iii. Shareholders dont have money
ii. Criteria under Rule 14a-8:
1. Shareholder must have $2,000 or 1% worth of stock
2. Proposal must be 500 words or less
3. Company can exclude the proposal if they can meet one of
different standards:
a. violation of law
b. personal grievances
c. company would lack power or authority to implement
d. company has already done the suggestion
e. idea already brought up
f. specific dividends
i. you cant demand it or request it
g. Improper under State Law
i. Which state?
ii. We are going to have SEC decide what is proper
under state law?
iii. What is proper for shareholders to decide under
state law?
1. Most Proposals according to Rule 14a
2. BUT state law gives shareholders VERY
limited powers

53

a. so the two are in conflict

3. Shareholders can amend the by-laws and
almost anything can be in the by-laws
h. Relevance
i. If it counts for 5% of company business it is
relevant
ii. Who should decide whether issue x is relevant?
i. Election
i. If proposal relates to the election of directors, it can
be excluded
1. Electing directors is the one thing that is
most proper for shareholders to do under
state law.
iii. Institutional Investors
1. Care about shareholder proposals
iv. Shareholder getting greater access to proxy materials:
1. Triggering Events
a. At least one director gets 35% or more
b. Shareholder proposal to get access gets majority approval
c. If the board fails to implement any shareholder proposal
that gets shareholder approval

54

Part Four: Control Transactions

I.

Shareholder Control
a. Shareholder Voting
i. Directors manage the business, not shareholders
ii. Shareholder voting rights are limited:
1. To elect directors
2. To amend charter or bylaws (approval from shareholders & Dir)
3. To approve certain major transactions
a. i.e. mergers
4. Other matters submitted for shareholder vote
5. No right to manage business generally
iii. Voting standard
1. General rule: majority of shares present
a. present includes by proxy
2. Special rule: majority of all shares (not just shares present)
a. i.e. for mergers
b. absent shares count as no
3. Charter can provide different rules
a. election of directors plurality
i. most votes wins; cant vote no on someone
4. Default rule for quorum is half, but can go down as low as a 1/3
5. Legal requirement: cant go beneath; sets a minimum
a. Default rule: can go down.
iv. State of Wisconsin Investment Board v. Peerless Systems Corp.
(DELAWARE)
1. Facts:
a. By-laws allowed for adjournment
2. Blasius Test
a. another exception to Business Judgment Rule
b. 2 Part Test:
i. 1) conditions: plaintiff must establish that the board
acted for the primary purpose of thwarting the
exercise of a shareholder vote (difficult test)
ii. 2) then the board has the burden to show a
compelling reason for their actions
3. Management tried to increase the vote of the people that they
thought would vote in their favor.
4. What could a compelling justification be for thwarting the
shareholder vote?
a. combat other interference with voting
b. fraud on the part of shareholders or proxies
5. Courts are very hesitant to invoke Blasius because it is such a
demanding standard
6. Duty to disclose

55

a. no general duty to disclose under state law, but under

Delaware law a board of directors, is under a fiduciary duty
to disclose fully and fairly all material information within
the boards control when seeking shareholder action
7.
b. Control
i. (true) control = 50% + 1 vote
1. you always win
ii. Effective control 50%
1. Shares present and voting usually less than 100%
a. So you just need majority of present shares
2. Influence ~ control
a. Opposing significant minority may be difficult
c. Electing Directors
i. Default Rule
1. Each director is elected separately
2. Each share is entitled to one vote per director
3. Majority shareholder (50% +1) can elect all directors
ii. Supermajority voting
1. Cumulative voting
2. All directors are elected together
a. So you might have 15 candidates and 12 get elected
3. Each share is entitled to multiple votes
a. i.e., 10 spots open, each share gets 10 votes
4. Minority shareholders get proportional representation
5. Ex.: If you have 12 shares, you have 12 votes and you can give all
your votes to one person or split them.
d. Cumulative Voting
i. Number of shares needed to elect directors:
ii. Number of directors that can be elected:
e. Class Voting each class of stock can vote separately on some or all matters
1. Can apply to all votes
ii. Each class of stock has different voting rights
1. E.g. class A stock gets 2 votes per share, B gets 1
2. E.g., each class entitled to vote separately on some or all matters
a. action requires approval of each class
i. e.g., mergers require approval of each class.
3. E.g., only certain classes entitled to vote on some or all matters
a. e.g., only common stock may vote for directors
i. preferred often cant
b. e.g., common stock elects half of the directors, preferred
stock elects half of the directors
f. Power Arrangements
i. Classified shares different voting rights, different dividend rights
1. Setting up different power arrangement
2. Loose certain tax benefits

56

a. In order to be taxed as a partnership and avoid the double

taxation you can only have one class of stock.
3. Could set it up where experts get class A stock with more control
(i.e. votes for directors) while the class B stock goes to financiers
who get more profits per share
ii. Proxy
1. Normally revocable at will
2. Irrevocable only if coupled with an interest
a. Not necessarily clear what an interest is but we know that
employment contracts count. (i.e., promise an employee a
proxy)
3. S Corporation
iii. Voting trust a plan in which shareholders transfer their shares to a
trustee for the purpose of creating a voting block
1. Actual transfer of shares,
a. usually original shareholders still get dividends
2. Control by agreement or in one party
3. Problem: limited to 10 years
a. Court dont like, thought it was a sneaky way to get control
i. So they imposed the 10 year limitation
iv. Pooling agreement a plan in which shareholders agree to vote their
shares together; a.k.a., shareholder agreement and voting agreement
a. Similar to voting trust
2. Retention of shares by shareholders
3. Control by agreement
4. Problem: enforcement
a. Courts are more excepting
g. Management Entrenchment
i. Ownership tend to have significant amount of shares, enough for control
1. Stock options for execs can often lead to this situation
ii. Control over proxy mechanism
1. Management has power to solicit your proxies; expensive for
others to oppose, management wins on plurality of votes
2. Rational apathy shareholders dont really care.
iii. Class voting
1. Exchange offer for new shares with high voting rights but low
dividends
2. Gives general shareholders higher dividends at the expense of their
voting rights so management gets stock w/ voting rights
iv. Capped voting
1. Holdings beyond a certain point carry reduced voting rights
a. e.g., 100 shares 100 votes; 1,000 shares 150 votes
2. This prevents hostile takeovers; even if you have 90% of the
company, your votes are capped at a certain amount. (could even
hold 90% of stock, but only 200 of 200,000 votes.)
3. Downside is management reduces its voting power

57

II.

v. Shareholder Activism
1. Officers appointed by directors, directors elected by shareholders.
In theory, shareholders have the ultimate control
2. Burle-Means thesis (glossary) says that officers ultimately have
the final say, as they run the day-to-day business, set the agenda,
and have little responsibility to directors.
a. You could say the officers choose the directors they set
the meeting, choose who is on the ballot, and the
shareholders essentially endorse their choices.
vi. Activist companies
1. Institutional investors are rising; they tend to have more shares and
tend to pay more attention. This could thwart this theory, as these
big shareholders can exercise more control.
a. But corporations can choose not to deal with these
companies, so they wont be as quick to opposed
management.
Close Corporations
a. Closed Corporations
i. Harder to sell than public.
ii. Freeze-Out action taken by the majority shareholders in a close
corporation to frustrate the expectations of the minority shareholders
1. withhold dividends
2. deny employment in a closed corporation
iii. Increasing trend among courts to treat closed corporations as special.
1. Sometimes they will waive rules (Clark v. Dodge)
2. Sometimes they will impose fiduciary duties on majority
shareholder to minority shareholder
iv. State legislatures:
1. Building more flexibility into general corporation law.
2. Special Closed Corporation laws
a. Special laws address two problems
i. Parties that are not aware of technical requirements
of corporation law.
1. Lets them run business they way they want
to contract to.
ii. Risk of piercing the corporate veil
b. Delaware Closed Corporation Statute (most of the time we
are not talking about a closed corporation statute)
i. To get into the statute:
1. You have to have no more than 30
shareholders
2. You have to have no registered public
offering
3. You have to have transfer restrictions

58

a. Transfer restrictions a charter

provision or agreement that restricts
a shareholders ability to sell her
shares
4. Affirmative selection:
a. You have to want to be governed by
the closed corporation statute
ii. Most closed corporations dont fall under this
statute because they are not aware of this option
iii. If the statute applies:
1. Basically allows for management of
corporation by shareholder, makes it a lot
like a partnership but with the laws of
limited liability.
3. Ringling Bros. Barnum & Bailey Combined Shows v. Ringling
a. Facts: State statutes permitted voting trust, but party did
not comply with the standards.
i. Parties did their own thing
b. They did their own voting agreement
c. Difference between a pooling agreement and a voting trust:
i. pooling agreement give up the right to vote, but not
the power to vote
ii. voting trust you lose the power to vote
4. McQuade v. Stoneham
a. Corporations should me managed by management and not
by shareholders
i. If shareholders try to run the business, they are
usurping the role of directors
ii. Basically, shareholders cannot agree to force
directors to do something.
b. Are pooling agreements illegal in New York under this
case?
i. You cannot have a pooling agreement among
directors telling them what to do.
ii. Power to vote in realty telling the directors what to
do.
c. An agreement to try to control the actions of directors is
invalid
d. Seems the problem is that some shareholders and creditors
can get hurt in the deal see next case
5. Clark v. Dodge
a. Same court as McQuade, just two years apart, similar
situation of shareholders telling directors what to do
b. Clark distinguishes from McQuade:
i. there is no real harm to have a special agreement
controlling what the directors of the corporation do
59

1. we are going to look the other way when all

the shareholders are a party to the agreement
and no one else is being harmed (i.e.,
creditors)
6. Galler v. Galler
a. Where no complaining minority interest appears, no fraud
or apparent injury to the public or creditors is present, and
no clearly prohibiting statutory language is violated, we can
see no valid reason for precluding the parties from reaching
any arrangements concerning the management of the
corporation which are agreeable to all.
b. Follows clark v. dodge
c. Freeze out actions taken by the majority shareholders to
frustrate the expectations of the minority shareholders
i. Denying employment you think generally that in a
closed corp the minority shareholders would expect
employment.
ii. Denying dividends majority decides when the
stock pays dividends; could decide instead to give
himself higher salary.
d. When no one else is injured in a closed corporation, the
shareholders can tell the directors what to do.
i. State corporate law is becoming more flexible
allowing for more customized arrangements to fit
the variety of corporate structures, particularly with
respect to closed corporations.
e. Pooling agreement statutes Delaware closed corporations
protect against
i. the risk of disruption of the parties agreements
agreed to arrangement they didnt know was illegal
ii. risk of piercing the corporate veil for noncompliance with rules they didnt realize existed.
1. For example, what are the odds that a mom
& pop corporation have an annual meeting
with 60 days notice?
v. Delaware closed corp statute see other outline for details
vi. Federal Law
1. Closed corporations can avoid double taxation by becoming a S
Corporation a close corporation that has elected to be taxed as a
partnership rather than as a corporation
2. Requirements for S Corporation Status
a. Unanimous consent of shareholders
i. In order to terminate S Corporation status you only
need a majority
b. No more than 100 shareholders

60

III.

c. All shareholders must be individuals, estates, or certain

trusts
i. Not another corporation cant be a subsidiary
d. No shareholders can be non-resident aliens
e. You can only have one class of stock
i. You can only have common stock
3. This is something that corporations often do.
a. Why subject yourself to double taxation when you dont
have to.
b. Most corporations that can elect S-corp status do so
i. Theoretically the problem is that you get taxed on
everything the corporation makes, whether or not
you take out anything. Any reinvestment is done
after-tax as well.
Abuse of Control
a. Abuse of Control
i. Wilkes v. Springside Nursing Home, Inc.
1. General Rule:
a. Stockholders in closed corporation owe one another
substantially the same fiduciary duty in the operation of the
enterprise that partners owe one another substantially the
same fiduciary duty in the operation of the enterprise that
partners owe to one another.
i. Rule sounds like all shareholders, and not just
majority shareholders, but it seems to allow ad hoc
majority groups.
2. Court announces 2 part Test for analyzing a breach of the strict
goof faith duty owed:
a. Controlling group must be able to announce a legitimate
business purpose for their action.
b. The action must be the least restrictive means to
accomplish the goal.
i. This makes it more than just the BJR, but still less
than the entire fairness test. (Velasco now thinks
that this may be more restrictive than the entire
fairness test in some respects)
ii. Ingle v. Glamore Motor Sales, Inc.
1. Limiting principle that this court adopts for fiduciary duty owed by
majority shareholders.
a. we only want to impose the fiduciary duty when they are
shareholders that are essentially like partners
i. In this case, Ingle was essentially like an employee
rather than a partner
2. Many courts (especially MA in Wilkes) are less willing to protect
shareholders when they planned ahead and it just didnt work out
they way they wanted.

61

IV.

a. Courts are more likely to help you if you dont have an

agreement (i.e., failed to plan ahead)
3. Nixon v. Blackwell (pg. 659)
a. Delaware is not likely to help shareholders that didnt plan
ahead.
i. It would be inappropriate judicial legislation for
this Court to fashion a special judicially created rule
for minority investors when there are no negotiated
special provisions in the certificate of incorporation,
by-laws, or stockholder agreements.
iii. Smith v. Atlantic Properties, Inc.
1. Court generally dont want to interfere when shareholders have
made an arrangement
a. Interfere may be appropriate when parties are truly stuck
i. They could have gotten out of the corporation, by
dissolving it.
iv. Jordan v. Duff and Phelps, Inc.
Corporate Dissolution
a. Corporate Dissolution
i. Shareholder vote
1. Often requires super-majority vote
ii. Charter amendment
a. Can limit the life of a corporate, therefore dissolving it.
2. Requires board and shareholder approval
iii. Judicial dissolution
1. Courts are hesitant to dissolve corporations
a. profitable business
b. opportunistic behavior
2. Would help minority shareholders in freeze-out situation
a. if too easy, the minority could take control of the majority
3. Mitigating factors that should give comfort to courts to allow
dissolution
a. Dissolution does not mean the end of the business
i. salvage value/liquidation value v. going concern
value
1. Salvage value the value of a business
if its assets are sold individually;
usually less than going concern value
2. Going Concern value the value of a
business if sold as a business; usually
higher than salvage value
b. Sale as a going concern
c. Alternative forms of relief
iv. Alaska Plastics, Inc. v. Coppock

62

1. Facts: Plaintiff (minority shareholder) was being frozen out of the

corporation
2. Court doesnt think they are authorized to dissolve in this case:
a. They feel that they are authorize to dissolve when there is
serious misconduct
b. She was just a shareholder and not a partner (thus probably
shouldnt be entitled to fiduciary duties.)
v. Pedro v. Pedro
1. Facts: By firing him, they are forcing him to sell at 75% of book
value instead of intrinsic value AND he will not be employed with
the company
2. Courts give him his reasonable expectations of full salary till 75
and fair market value of his shares
a. What about the duty to mitigate?
vi. Stuparich v. Harbor Furniture Mfg., Inc.
1. Self dealing
a. they are either on both sides of the transaction or because
they are getting something at the exclusion of others
b. invokes the entire fairness test
i. plaintiff has to prove the transaction is entirely fair
b. Judicial Dissolution
i. Who can seek a dissolution shareholders
1. You dont not need a majority to seek a dissolution
a. most states have some kind of ownership requirement in
terms of the amount of shares
ii. When can you seek dissolution?
1. Waste of corporate assets
2.
a. Corporation can not be run properly
3. Oppressive conduct by majority shareholders
i. What oppressive conduct is varies from state to
states.
b. Some courts have a high standard:
i. Burdensome, harsh or wrongful conduct
ii. Violation of specific rights of minority
c. Middle standard:
i. Breach of fiduciary duty of good faith and fair
dealing
ii. Subtle forms of misconduct
d. Frustration of reasonable expectations
i. In cases of closed corporations, the complaining
shareholder need not establish oppressive or
fraudulent conduct by the controlling shareholder or
shareholders.
1. Reasonable expectations include
expectations that the minority shareholders

63

will participate in the management of the

business or be employed by the company
but limited to expectations embodied in
understandings, express or implied, among
the participants.

V.

4. Deadlock
a. Among directors or shareholders
b. Super-majority voting provisions
Transfer of Control
a. General Rule with respect to buying and selling shares
1. Zetlin v. Hanson Holdings, Inc.
ii. It has long been settled law that, absent looting of corporate assets,
conversion of a corporate opportunity, fraud or other acts of bad faith, a
controlling stockholder is free to sell, and a purchaser is free to buy, that
controlling interest at a premium price.
iii. You are allowed to sell at a premium for the most part.
1. Unless you know the purpose is a known looter or a suspected
looter.
a. For the rule to be meaningful you have to go beyond
known looter because nothing is truly known
b. Who says whether the suspected person is a looter?
i. Reasonable person?
ii. Reasonable business person?
b. Sale of Directorship
i. Shareholders can vote however they want for a directorship
1. Selfish reasons etc.
ii. Whoever you elect thouwill have fiduciary duties to all the shareholders
(including minority shareholders)
1. But, to the extent the business judgment rule applies, it only
protects waste and self-dealing.
iii. Should you be able to buy a directorship by buying shareholders votes?
1. Egalitarian concerns
2. Rational Apathetic, people should be able to only keep the rights
they want.
c. Transfer of Control
i. Perlman v. Feldman
1. Facts: Buyers had to pay for steel now, even thou they would not
get it till a year from now.
a. Interest free loan is gained
b. Court rules against Feldman
2. Feldman breach his fiduciary duty by getting a corporate
opportunity
3. NOT A GOOD DESCRIPTION OF THE LAW, USED FOR
HISTORICAL PURPOSES

64

ii. Adolf Burley It has been argued that a controlling shareholder can not
sell his shares at a premium unless all can share in the premium and not
for your own personal benefit.
1. One share is supposed to be one vote, but once you have someone
with 51%, the rest of the shares have no realistic vote.
iii. Essex Universal Corporation v. Yates
1. If you are transferring controlling interest, you can replace the
directors right away.
2. Effective control can be less than 50% + 1.
a. How do we know when we have enough control to apply
the rule?
1. You can only sell control if you have a
controlling interest.
ii. You know you have control, by how you exercise it.
b. How many directors has he put in, do they listen to him.
c. If he can deliver then he has effective control.
3. Replaced directors by one by one they resigned and then they filled
the vacancies.
4. If director didnt want to resign, it probably wouldnt be
enforceable by contract because of fiduciary duty.
a. As between buyer and seller we can enforce it.
b. Cant sell control, but we will allow it if you are selling a
controlling interest.
iv. Frandsen v. Jensen-Sundquist Agency, Inc.
1. Right of first refusal an agreement providing that, before a
shareholder can sell her shares to a third party, other shareholders
would have the right to buy such shares at the price at which they
would have been sold to the third party
a. Reasons for having this:
i. You dont want to be stuck with someone you dont
want in a closed corporation
ii. If they are selling at a good price you might want it.
2. Take along right an agreement providing that, before a
shareholder can sell her shares to a third party, other shareholders
have the right to sell their shares to such shareholder at the price at
which the shares would have been sold to the third party
a. Reasons for having this:
i. Approval of who the person is selling to
ii. Minority shareholders can take advantage of the
premium
3. Why have both a right of first refusal and take along right?
a. New market for your shares (especially in closed
corporation)
i. If it is a good price, you can buy it for yourselfIf
it is a bad price, you can sell your own shares.

65

VI.

4. Both of these agreements only cover sale of shares, not sale of

assets
5. This case dealt with a sale of assets.
a. Is formalism appropriate in this case?
i. This was not really a corporate law issue, but a
contract interpretation issue.
ii. In contracts we dont go with form over substance,
we go with the meaning of the parties.
Acquisition of Control
a. Acquiring Another Company
i. Acquisition a general term that refers to a business combination of any
type(e.g., merger, stock purchase or asset purchase)
ii. Takeover an attempt by an acquiror to gain control of a target
iii. 3 Ways to acquire another company
1. Stock purchase an acquisition in which an acquiror buys the
stock of the target from the shareholders
a. A + B = A + B (two separate corps b4 & after)
i. Target becomes a subsidiary
b. Shares purchased directly from shareholders
i. Target company is not involved
1. Each shareholder makes up his or her own
mind
c. No approvals
2. Asset purchase an acquisition in which the acquiror buys the
assets (and maybe liabilities) of the target (just about all assets)
a. A = A + B (one new co takes on the assets of both old)
b. Approval of targets directors and shareholders needed
i. Target company is involved
ii. Shareholders get say whether their assets are sold,
but s/h of other company dont get say over whether
their company buys assets
3. Merger an acquisition in which an acquiror and a target
combine into one surviving company
a. A + B = AB
i. Like a marriage
ii. Can be the original company or a totally new
company
b. Approval of both companies directors and shareholders
i. Because both companies are effected.
c. 3 Possible outcomes
i. Constituent Corporation a corporation party to a
merger
ii. Surviving Corporation the constituent
corporation that survives a merger
iii. Resulting Corporation a new corporation formed
as a result of a merger

66

b. Merger Procedures
i. Del. 251
1. Prepare merger agreement
2. Approval of directors of each company
3. Approval of shareholders of each company
a. True Majority (50% + 1)
i. Abstentions count as no
4. File with Secretary of State
5. Dissenting shareholders have appraisal rights
a. Appraisal Rights the right to forego the contractual
consideration in a merger (or similar transaction) and to
receive instead the fair value of the shares
i. Shares sold to company
ii. What if merging corporations are incorporated in different states? Follow
both, especially the one that is more strict for each part.
c. Consideration in a Merger
i. Standard merger:
1. Consideration is shares in surviving corporation
2. Number of shares depends on value of constituent corporations
a. EX: if A is worth $100 mil and B worth $50 mil, the ratio
will be 2 to 1. (so every share from A is worth twice a B
share in new company.) this is a very simplified example,
also have to take in to account premiums paid, amount of
shares outstanding, etc
ii. Legal possibilities:
1. Law provides that a merger agreement can have any consideration
a. Securities, cash, property, vodka!
b. Shareholders from each corp dont have to get the same
thing.
2. Different consideration
a. Cash-out merger a merger in which one companys
shareholders receive cash instead of shares in the surviving
corporation
i. Very similar to a stock purchase
1. Differences between the two:
a. Cash-out requires approval of board
b. Stock purchase gives shareholders
choice
ii. Shareholders being cashed out are usually from the
target corporation.
b. Merger of Equals both companies simply combine no
real acquiror or target.
d. Appraisal Rights
i. Appraisal rights
1. Most states allow the option
2. Delaware

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a. Allows for mergers, but not for other type of transactions

i. Not for all mergers
b. Not for public corporations if you receive shares
i. You can sell your shares easily, where as in a closed
corporation you wouldnt be able to sell your shares
easily
1. You are still going to get stuck with the bad
deal because the stock price will reflect the
ratio
3. Other states
a. Merger, asset purchase, certain charter amendments
i. Each States laws have to be followed
ii. Delaware procedure 262
1. Company gives notice of appraisal rights
2. Demand appraisal before vote (s/h must demand)
a. Not after the fact.
3. Cannot vote in favor of merger
a. Either has to vote against merger or not to vote
4. Petition for appraisal
5. Court determines fair value of shares
a. Fair value of shares may be less than merger consideration
b. Reasons why it may be lower:
i. 262(h) Fair value of your shares is your shares
standing alone.
1. You can not take into account synergistic
gains
2. Synergy the advantage that results when
a combination is greater than the sum of its
parts
3. (i.e., worth more than the sum of its parts)
ii. Acquirer often pays a premium to get the target
shares.
1. Premium used to persuade shareholders
2. Premium an amount above the market
price paid by an acquiror to target
shareholders in order to purchase the shares
iii. Even if the fair value = merger consideration, you
then have to deduct the cost of the appraisal.
c. When should one seek an appraisal?
i. NOT when you are quivering over value
ii. Wise person only seeks an appraisal when you are
really getting taken advantage of (like stock worth
$50/share and the merger is going at $25/share)
e. Form over substance
i. Cash-out merger
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ii. Triangular merger merger between one company and a subsidiary of

another
1. Acquiror mergers its own subsidiary with a target. Often the
subsidiary is a shell corporation, created only to merge with the
target.
2. Advantages you can avoid a shareholder vote of the acquiror.
a. The rules are target and subsidiary must approve. Target
shareholders must approve, but not acquiror. Need
approval of only subsidiary, whose votes are made by board
of directors.
b. Often used when acquiror knows it doesnt have the
support of its shareholders b/c paying a premium, etc.
iii. Short-form merger a procedure under some states laws where a parent
corp can merge with a subsidiary w/o a shareholder vote.
1. For example, do a triangular merger and then a short form merger.
This would put the corporations in exactly the same place as if they
just merged normally, but this was without a shareholder vote.
f. Loopholes ways to structure transactions to get around limitations
1. Form over law.
ii. Cash-out merger
1. Want to merge, but you dont want each corporations shareholders
to be shareholders of the new company
iii. Triangular merger a merger between one company and a subsidiary of
the other
1. Merger between one company and the subsidiary of another
a. Subsidiary is usually a shell corporation
2. Subsidiary tries to merger with a target corporation
a. This avoids the shareholder vote of one of the companies
because the subsidiary does not have its own shareholders.
iv. Short-form merger a procedure under some states laws under which a
corporation may merge with a subsidiary without a shareholder vote
1. As long as it is a simple merger of a parent and subsidiary, you
dont need a shareholder vote.
v. TM followed by SFM
1. You can do the exact same thing that would happen in a merger,
without having to get shareholder approval
vi. M = Merger, TM = Triangular merger, SP = Stock purchase, AP = Asset
purchase
g. Practical Considerations
i. Key: M=merger, SP=stock purchase, AP=asset purchase, TM=triangular
merger, SFM=short form merger
ii. Liability
1. M: joins two companies liabilities
2. SP & TM: keeps liabilities separate
3. AP: parties can (generally) decide
a. Can buy half liabilities, can buy known liabilities, etc.

69

b. Why would you want to buy liabilities?

i. Maintain business relationships, ex. PR reasons
ii. MAIN REASON you pay less for the company.
1. Net cost compared to gross cost

VII.

iii. Structure
1. M & AP: one surviving company
2. SP & TM: two surviving companies
iv. Ownership
1. M, TM & AP: acquirer gets 100% ownership
2. SP: acquirer may get less than 100%
a. Everyone may not agree
i. There will be minority shareholders
ii. Even if everyone agrees, there are always people
that dont know/arent informed and dont sell.
b. To get around this:
i. Stock purchase to get 51%, Create a subsidiary and
then do a triangular merger and cash-out the
minority shareholders
v. Approval
1. M: both sets of directors and shareholders. Hard to get.
2. TM & AP: both sets of directors; only targets shareholders
3. SP: consenting shareholders; not directors. Target company is not
involved.
vi. Appraisal Rights:
1. Delaware: only for M
2. Some states: M, TM & AP
vii. Consequences
1. Renegotiation of contracts
a. Not really a problem with TM or SP.
b. With M or AP contracts will have to be renegotiated, etc.
2. Nontransferable rights
a. Merger some rights transfer (as operation of law), but
there may be non-transferable rights under Federal Law.
b. Asset purchase important to take into consideration.
3. Tax and accounting consequences
De Facto Mergers and Freeze-Out Mergers
a. De Facto Mergers Cases
i. Farris v. Glen Alden Corporation (PA)
1. De Facto Merger Doctrine a rule that transactions which are not
styled as mergers but which essentially are mergers may be treated
as mergers for purposes of shareholder vote and/or appraisal rights
2. Statutory language does not get rid of the de facto doctrine
a. Court would not let the form prevail over the substance,
stuck with the de facto merger doctrine
b. Completely ignored the statutory mandate; said that they
will not blind themselves to the reality of the transaction.

70

c. Legislatures here and in other states are trying to get rid of

the statutory merger doctrine
3. Even thou the legislature said they got rid of the de facto merger
doctrine the court wasnt sure they wanted to go with that.
4. Appraisal rights: when corp combines w/ another so as to lose its
essential nature & alter fundamental relationships of shareholders
among themselves & corp, a shareholder who doesnt wish to
continue may treat his membership as terminated and get cash for
shares.
ii. Hariton v. Arco Electronics, Inc. (Delaware)
1. This is the majority rule
2. Most states (almost all states) have moved away from the De Facto
Merger Doctrine
a. PA/NJ are outliers
3. FORM PREVAILS OVER SUBSTANCE (de facto merger
would be substance over form)
b. Freeze-Out Mergers
i. Cash-Out Mergers
1. Should they be permitted?
a. Some shareholders do not agree and are forced to give up
their shares.
i. The appraisal remedy just gives them cash, even
thou this is what they are trying to avoid in the first
place.
ii. This may be the only real solution (appraisal)
2. Freeze-out Merger a merger in which minority shareholders are
forced to receive cash for their shares and to lose their status as
shareholders
a. involuntary cash-out merger
b. Forced buy-out is the problem not the solution.
c. Note difference from freeze out, where minority
shareholders expectations are frozen out due to lack of
dividends, employment, etc. there the shareholders WANT
to sell, but cant. Here they dont want to sell, but have to.
c. Freeze-Out Mergers Cases
i. Weinberger v. UOP, Inc. (Del.)
1. Facts: We have self-dealing, they have to prove under the entirefairness test unless there was fully informed disinterested
shareholder approval.
a. There was disinterested shareholder approval, but they
were not fully informed
2. Directors of UOP had the duty to tell the company what it new.
a. There were also directors of the other company and had a
fiduciary duty to the other company
b. They have to disclose to UOP, but they cant disclose to
Signal

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c. How do you reconcile this problem?

i. Courts say if you create the problem, you have to
deal with it. You have to keep fiduciary duties to
both.
3. BEST EXPLANATION OF ENTIRE FAIRNESS TEST (pg. 734735)
4. Entire Fairness Test
a. To see if there is entire fairness, you look to 1) fair dealing
and 2) fair price.
b. Basically when theres self dealing, you apply this test.
i. If there is fully informed, disinterested shareholder
ratification, the burden shifts to plaintiffs to show it
was unfair.\
ii. Court says here the approval wasnt fully informed!
iii. Shareholder vote is not necessarily the same as fully
informed, disinterested shareholder approval.
1. In the case where the majority of shares are
held by the conflicted party, you would need
a majority of the minority to vote for
approval.
c. Court may ignore fair price if it was obviously fair dealing,
or may ignore fair dealing prong if the price is obviously
right.
5. Court liberalized the appraisal proceedings.
a. You can use any tools to figure out what a fair value is.
i. We will here the experts
ii. 262(h) the appraisal value can not include any
benefits of the merger
6. Rejected the business purpose test.
ii. Coggins v. New England Patriots Football Club, Inc. (Mass.)
1. Facts: Person wants his share, not cash, because he wants to be an
owner in the Patriots
2. Legal Test Court Employs:
a. 2 Part Test
i. Defendant bears the burden of showing a business
purpose
1. Business Purpose Test
ii. Entire Fairness test
b. Is there ever a valid business purpose to a freeze-out
merger?
i. To say there is a business purpose test is doomed to
failure.
1. Test of lawyers creativity
ii. This Case

72

1. The defendant alleges the business purpose

is an eternal variable (NFL wants single
owners.)
a. This is the ONLY example of where
there is an external variable with a
plausible reason.
2. Court doesnt buy this and has a strict
reading of what is a legitimate business
purpose.
a. If this reason is rejected, when are
we EVER going to allow freeze-out
mergers
3. The rule must be that we are never going to
allow Freeze-out mergers, because we are
never going to have a business purpose that
the court will accept.
3. In the end, all the person gets is money, not their shares.
a. Courts seem to be unable to recognize anything but the
economic interest.
iii. Rabkin v. Philip A. Hunt Chemical Corporation
1. Have to prove entire fairness
a. Fair Dealing
i. Court says that there was not fair dealing:
1. Any sort of misconduct results in lack of fair
dealing
2. Here they played with the timing of the
transaction
3. Factors:
a. Negotiations
b. Disclosure
b. Fair Price
i. Everyone agrees in this case that the price was fair.
2. Things that are normally ok, may not be ok for people with
fiduciary duties.
a. Basically, under the contract only it was ok to wait and pay
when the shares would be cheaper. But these directors also
had a fiduciary duty to the target company, and they
screwed that company by waiting until the contract expired
and they could buy the shares for less.
VIII. Hostile Takeovers
a. Takeovers
i. Hostile Takeover takeover that does not have the support of the
directors of the target
a. not exactly hostile to shareholders
b. normally done by a stock purchase
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i. tender offer
1. once you have 10% (via open market
purchase) you make a tender offer for 51%
of the company
2. Freeze-out merger to get 100% of the
company
ii. Shareholders like takeover (get premium), management dislike (lose
control/job)
b. Reasons for Takeover
i. Undervaluation
1. Market value of the shares, is less than the fair value of the shares
2. Efficient Market Hypothesis says that this is doubtful, not that it is
untrue.
ii. Synergy the advantage that results when a combination is greater than
the sum of its parts
a. if true, this would result in a net gain to society
2. Economies of scale the reduction in unit costs generated by
buying or producing in volume; often results from the fact that
fixed costs are divided over a large number of units
3. Economies of scope the reduction in unit costs generated by
producing similar or related items; often results from the fact that
assets or skills may be transferable
a. ex. computer parts co can acquire a computer factory.
4. Financial synergy the advantage that larger companies have
over smaller companies in raising money
a. Internally large company can earn a lot of money and
support itself
i. using retained earnings to support new products
b. Externally cheaper to borrow or sell securities on a larger
scale than for a smaller scale.
c. Financial Synergy led to the rise of Conglomeration the
process of internal diversification
i. Expansion into unrelated lines of business
ii. Negative of this is that it leads to a lack of focus
iii. Diversification can be a bad thing in that some
companies can be doing poorly/some well and the
poor performance can be hidden and there would be
no pressure for improvment
iii. Agency costs the costs associated with an agency relation; i.e., the risk
that the agent may pursue her own interests instead of those of the
principal
a. stems from separation of owners and management
b. hard for shareholders to remove management
c. Takeover can help reduce agency costs.
2. Inefficient management
3. Excessive compensation
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4. Self-aggrandizement management is tempted to improve size

over profits.
a. Management likes bigger size because it gives them power
and prestige
b. Shareholders obviously would rather have profits.
iv. Wealth transfers a shift in wealth from one group to another, often
without a net benefit to society
a. BAD REASON for takeovers
2. Wealth taken from employees (taken by acquiror)
a. cut salaries, benefits or jobs
3. Wealth taken from creditors (taken by acquiror LBO)
a. After takeover business can be more risky
b. We are not worried about new creditors (knew what they
were getting into and charged appropriate interest rate.)
i. Old creditors lent money when it was a lot less risky
1. Leads to shareholders stealing from
bondholders
2. Basically old creditors get screwed low
interest rates,
4. Government
a. Save on taxes
b. Shareholders wealth is at the detriment of the
government/society
5. There is some evidence that some of the value that is created
comes from wealth transfers.
a. Do account for some of the value created for shareholders
6. There is NO evidence that all or most of the value comes from
wealth transfers.
c. Reasons for Defense (opposing takeovers)
i. problems with most of these reasons is that they are easy to claim but hard
to prove or disprove.
1. Who gets to decide whether management gets to resist business?
a. Management runs business
b. Shareholders:
i. 2 main powers:
1. voting rights to remove management
2. sell shares (supposed to be unlimited power)
a. If management can resist a hostile
takeover, it is limiting your rights to
sell your shares.
ii. Coercive offers
1. If hostile offer is coercive and shareholders really dont have a
choice it is appropriate for management to step in.
2. Best example is a two-tiered front loaded tender offer

75

a. a tender offer at a premium, seeking control but not full

ownership, with the explicit or implicit promise of a
subsequent freeze-out merger offering inferior
consideration to remaining shareholders
b. even if shareholders want to say no, they have to say yes,
for fear of a worse deal
3. Originally coercive offers were pretty blatant
a. but as courts became wise, they became more subtle
i. ex. $50 in cash, or $50 in bonds on the backend
4. Shareholders want protection from coercive offers.
5. Fact is they dont much exist anymore
a. Precisely because it is allowed to be resisted.
6. All-cash, All-shares offer an offer to buy any and all shares for
cash, with the promise to follow up promptly with a cash-out
merger at the same price in cash
a. no coercion in this offer
b. Management tries to claim coercion but it doesnt work.
iii. Undervaluation
1. (pay less than shares are worth, but EMH makes this implausible)
2. Good deal for acquire, but not for target shareholders
3. Courts protect this for a reason because management has a better
idea of what the company is worth.
iv. Opportunity loss
1. Management, acting in shareholders interest, can claim this is a
good deal, but we can get a better deal
2. Way to get around this..auction
v. Incompatibility
1. i.e., management argues that its not a good business decision for a
potato chip company to purchase a microchip company.
vi. Other constituencies
1. Unfair to employees, creditors, government, community, society,
environment
vii. Entrenchment efforts by management to resist ouster, as by a hostile
takeover
1. Of course management can not give this as a reason.
d. Takeover Defenses (the HOW)
i. Previously considered:
1. Other constituency statues
2. Staggered boards a board of directors structured so that only a
fraction of its members is elected each year for multi-year terms;
a.k.a., classified board
a. Dont actually do much because once a takeover is
accomplished, they really dont want to be on a board
where they have to resist the owner of the company
3. Voting rights

76

a. Ways that make it difficult or impossible for someone to

take over the company.
ii. Additional mechanisms:
1. Greenmail the repurchase by a target of its own shares from an
acquiror at a premium (hostile buys 10% and threatens to buy all;
company has to pay premium to stay them off)
a. shareholders hate thisinstead of getting the premium they
are paying the premium
b. Management is forced to pay greenmail to get you to go
away.
c. Paying greenmail makes you vulnerable to more greenmail
threats (they know youll pay)
2. Crown jewel defense a takeover defense in which the target
sells its most valuable assets in order to become less attractive to
the acquirer
a. Similar to shooting yourself in the foot.
3. Share repurchase the reacquisition by a company of its own
shares from the public
a. Do this to drive the price up and make it more expensive
for the acquiror to acquire
b. Reduce the supply of willing sellers in the market.
c. Increase the managements relative position.
4. White knight defense a takeover defense in which the target
convinces a friendly third party to make a superior offer
i. Not a better deal for shareholders, if White Knight
gets advantages
b. Termination fee a fee to be paid to a friendly would-be
acquiror should the proposed transaction not be
consummated
i. Only if the White Knight loses so the bad acquiror
would have to pay.
ii. Justified because it would cost the White Knight
money to win the fight
c. Lock-up option a provision in an acquisition agreement
designed either to preclude a competing bidder from
acquiring a company or to provide compensation to the
original bidder in case it loses in a bidding contest
i. Ex. of Stock Lock-Up
1. White knight would get extra shares if the
hostile bidder wins.
d. No-shop provision a provision in an acquisition
agreement that limits the targets ability to deal with other
potential bidders
i. Acquiror agrees not to deal with anyone else.
5. Golden parachute a large severance pay contract for top
management that is triggered by a change in control

77

a. Management is giving itself an exit payment by directors

i. Considered part of there compensation package
6. Poison pill (PREMIER DEFENSE) - a takeover defense in
which shareholders of the target (other than the acquiror) are
granted the right to acquire securities (or other assets) at a
significant discount. With this, you CANNOT complete a hostile
takeover.
a. considered to be the ultimate defense
i. gives everyone (all other shareholders) all of the
money/assets and leaves hostile acquiror with
nothing but the name.
b. 3 ways around the poison pill
1. all of which involve elimination of poison
pill
ii. negotiate a better deal with management
1. not hostile, no poison pill
iii. get a court to order the redemption of poison pill
rights
1. Order management to do this as part of
fiduciary duty.
iv. Launch a proxy contest to replace board, who will
then remove the poison pill
e. Hostile Takeover Cases
i. Introduction
1. Cheff v. Mathes (Delaware)
a. Redemptions can not be used by directors to prevent a
corporate raid if the sole purpose is to keep the directors in
office.
i. This rule does not apply if the corporate raid is a
threat to the corporations interest as opposed to the
directors interest.
b. Standard is satisfied by:
i. Good faith
ii. Reasonable investigation
c. Class Notes:
i. Directors have to have reasonable grounds to
believe there is a threat to company they can
argue that theyre not acting in their own self
interest
ii. Development
1. Unocal Corporation v. Mesa Petroleum Co. (Delaware)
a. Statistics of the takeover:
i. A front loaded, hostile, two tiered tender offer for
37% of UNOCAL

78

b.
c.

d.

e.

f.

g.

ii. There was junk bond financing in second tier (back

end)thus the offer was very coercive to
shareholders
iii. A known corporate destroyer (frequent green
mailer) financed the tender offer.
Basis of suit: The bidder sued to enjoin the self tender
claiming it was a breach of the directors fiduciary duty.
Director Defenses:
i. Consulting with lawyers and outside investment
bankers
ii. Self tender offer by the Board at a premium price
that was not available for the shares owned by the
bidder (Mesa)
Held: There was no breach of the directors fiduciary duty.
The board acted in the shareholders best interest. Only a
majority of outside independent directors acted, and they
did not stop the tender offer, they merely attempted to
remove the coerciveness.
Rule of law
i. All Board defense actions are subject to enhanced
scrutiny because of the omnipresent specter that
the Board is acting in its own best interest. This
enhanced scrutiny requires that directors show they
had reasonable grounds for believing a danger to
the corporate policy and effectiveness existed.
ii. Note: Directors cant act solely to perpetuate
themselves in office.
iii. Defensive mechanisms may only be used as a
method to thwart off a takeover attempt if motivated
by a good faith concern for the corporations
welfare free from fraud or misconduct.
Courts have defined the Unocal Enhanced Scrutiny
Intermediate Test Proportionality:
i. The Board must perceive the bidders action as a
threat to corporate policy.
ii. Must show that the Boards action is proportional to
that threat.
2 part test:
i. Cheff v. Mathes
1. Good faith
2. Reasonable investigation
a. Reasonable grounds to believe there
is a threat
ii. Response must be reasonable in relation to the
threat posed.
iii. In other words
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1. Reasonableness to believe there was a threat

2. Response was proportional to threat
h. What constitutes a threat?
i. Coercive offers (e.g., forced to accept front end of
two tier offer b/c afraid of back end)
ii. Inadequate offers
iii. Risk of non-consummation
iv. Quality of securities being offered
i. Now in response to this caseFederal Securities law
requires that a tender offer must be offered to all
shareholders
i. Discriminatory offers are illegal under Federal law
offers must be open to all shareholders
j. Unocal is the basic test for defensive measures:
i. Reasonable grounds for threats
ii. Reasonable measure to deal with threat
1. Poison pill is considered reasonable.
k. Directors dont always win and defensive measure are not
always upheld, but there is a lot of discretion is still given
to directors so there is not as much pressure as you would
think there would be.
2. Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc. (Delaware)
a. Facts: Pantry Pride Corporation attempted a hostile
takeover of Revlon. Revlons Board took action to thwart
the tender offer. The defenses include bidding with
Forstmann, a white knight, and eventually giving
Forstmann a lock-up on key assets a no-shop provision (it
appeared that the Board was making these defenses to
protect Revlons note holders). However, despite all of
these efforts, the tender offer became inevitable.
MacAndrews, the controlling stockholder of Pantry Pride
was granted an injunction to prevent Revlons board from
continuing the defensive measures. Revlon appealed the
injunction.
b. Held: The injunction was upheld. Directors are allowed to
take defensive measures when they feel a takeover bid is
not in the corporations best interest without violating their
fiduciary duties. Thus, the defensive measures taken were
in and of themselves legal. However, as soon as the
dissolution or sale of the corporation becomes inevitable,
their duties shift and they must try to get the shareholders
the best possible price. They can no longer try to protect
the corporation or other constituencies. Thus, Revlon
defines the Unocal standardit changes when the sale
becomes inevitable.

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c. Rule: As soon as a sale or dissolution of the corporation is

inevitable, things change. No more defensive mechanisms
The Board becomes an auctioneer and attempts to get the
highest shareholder price.
i. Tilted Playing Field The Board owed no duty to
the potential suitors and, therefore, does not need to
deal with them on equal footing as long as it is
achieving the best results for the shareholder.
However, the Board can no longer favor other
constituents over shareholders.
ii. In Revlon, that sale was inevitable because it
became apparent that the corporation was going to
be sold either to the bidder or the white knight.
d. Defensives are not per se illegal
1. It is ok to use the poison pill in response to a
threat
ii. Real question is whether you have to get rid of the
poison pill at some time?
e. How do you know when a sale is inevitable?
i. When there is definitely an auction out therewhen
there is a white knight
ii. Otherwise, Sales are relatively found to be
inevitable
f. Best way to get the best price is normally an auction
i. Auctions are not required thou by the court
ii. You can also try to get the best price by using
defensive measures
g. Here defensives were used improperly
i. Defensive measures were used to end the auction
1. To insure that the white knight won.
ii. Favored the white knight too much.
h. Revlon standard is pretty tough.
i. Companies try to avoid the application of Revlon
ii. Want to stay in the realm of UNOCAL.
1. Under Revlon you have to sell for the best
price
2. Under unocal you have the ability to say no.

81

Epilogue
I.

Ethical Responsibilities of Corporate Attorneys

a. Ethical Responsibilities of Corporate Attorneys
i. ABA Model Rules of Professional Conduct
1. 1.13 most important identify your client
a. Corporate Attorney
i. Your client is not the CEO
ii. Your client is not a human being, it is the
corporation
1. Perhaps you can think of that as the Board
of Directors and not the CEO
2. But ultimately it is the shareholders
3. Law says it is the corporation so you have to
behave accordingly
iii. Responsibility is to report things that hurt the
corporation
1. You have to report up the ladder
2. If the company does not care, you may have
to resign
iv. Confidence is not violated by going up the ladder
1. Some argue that you can go outside the
company and it still will not violate
confidence
ii. Is there a special role for corporate attorneys?
1. Are they advocates or players?
a. Players that actively participate and not just advise.
i. Are you not just representing your client and then
do you have a duty to society.
ii. SEC clearly wants this to be the case.
1. Security attorneys have responsibilities to
society and not just their clients.
iii. SEC enforcement
1. For protection of investors, SEC wants everyone involved in
securities to behave responsibly
2. National Student Market Corporation Case
a. SEC greatest success in this regard (ethical responsibility of
attorneys)
b. Attorney was found guilty of aiding and abetting a security
laws violation
c. Historically SEC has not been very active in enforcing
against attorneys
3. State Bars have not been very active really
iv. Sar-bans Oxoly may change all this:
1. 307 clearly authorizes SEC to define and enforce ethical
standards for attorneys

82

II.

a. How are they going to use this?

b. Argument that they dont have the authority doesnt exist
c. Contemplates a codification of reporting up the ladder
requirements
i. Now you have to do this.
2. Proposed rule would have required a nosy withdrawal
a. If going up the ladder does not work, you have to quit and
then tell the SEC that you are quitting for a reason
b. SEC hasnt passed this but hasnt taken it off the table
3. Another possibility
a. Is that the attorney withdraws but then the company has to
tell the SEC.
v. SEC is more serious then it has ever been.
1. Rules makes securities law more risky
vi. Independent Directors Article
1. Some think that there is no such thing as independence because
they will always judge the other directors as they would judge
themselves.
Limited Liability Companies and Limited Liability Partnerships
a. Limited Liability Companies an unincorporated legal entity created by
authority of law
1. Simple a mixture of corporate law and partnership law.
ii. Certificate of formation an official document establishing and
governing the internal affairs of a limited liability company; a.k.a., charter
iii. Operating agreement an agreement among the members of a limited
liability company that sets forth the structure and terms of the company
1. Can make it as much like a corporation or as much like a
partnership as you want.
2. You know nothing about a company when you see LLC.
iv. Members an owner of a limited liability company
v. Managers a designated manager of a limited liability company (if any)
vi. Why arent all businesses LLC?
1. Increasingly they are.
2. Problems:
a. Few statutory default rules
b. Little case law
c. People unsure what they are dealing with
d. Public businesses are taxed regardless, but smaller
businesses are increasingly become LLC
3. Law firms in some states cant be LLC, have to be some form of
partnership.
vii. LLCs are the culmination of the flexibility in BA law.
b. Limited Liability Partnerships a partnership with limited liability among the
partners
i. Has to be a partnership, but it is a limited liability partnership

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ii. Partners are responsible for your own actions, but limited liability for what
your partner has done
1. That is limited liability, but not limited liability +
2. Some people limited the shield to torts, but not contracts
iii. More and more law firms are becoming LLPs
c. Formation
i. Water, Waste & Land (Westec) v. Lanham (Colo. 1998) p. 288
1. Third party brought suit against agents for LLC, and LLC for
amount due on contract for engineering services.
2. The statutory notice provision applies only where a third party
seeks to impose liability on an LLC's members or managers
simply due to their status as members or managers of the LLC.
When a third party sues a manager or member of an LLC under an
agency theory, the principles of agency law apply notwithstanding
the LLC Act's statutory notice rules.
3. Under the common law of agency, an agent is liable on a contract
entered on behalf of a principal if the principal is not fully
disclosed.
4. An agent who negotiates contract is not liable when he has given
notice to the third party that there is a principal for whom he acts
and also notice of the name or identity of the principal. Thus, an
agent is liable on contracts negotiated on behalf of a partially
disclosed principal; that is, a principal whose existence, but not
identity, is known to the other party.
d. The Operating Agreement
i. Elf Atochem North America v. Jaffari (Del. Sup. Ct. 1999) p. 293
1. Section 18-101(7) of Del.s LLC Act defines the limited liability
company agreement as any agreement, written or oral, of the
member or members as to the affairs of a limited liability company
and the conduct of its business.
2. The Act is designed to permit members maximum flexibility in
entering into an agreement to govern their relationship. It is the
members who are the real parties in interest. The LLC is simply
their joint business vehicle.
3. Members can alter the default jurisdictional provisions of the
statute and contract away their right to file suit in Del.
a. Policy of the Act is to give maximum effect to the principle
of freedom of contract
e. Piercing the LLC Veil
i. Kaycee Land and Livestock v. Flahive (Wy. 2002) p. 300
1. Whether, in the absence of fraud, the remedy of piercing the
corporate veil was available against a company formed under the
Wyoming LLC Act (Act).
2. *It is not to be presumed that the legislature intended to abrogate
or modify a rule of the common law by the enactment of a statute
upon the same subject; it is rather to be presumed that no change in

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the common law was intended unless the language employed

clearly indicates such an intention. The rules of common law are
not to be changed by doubtful implication, nor overturned except
by clear and unambiguous language.
f. Fiduciary Obligation similar to that imposed in a partnership
i. McConnell v. Hunt Sports Enterprises (Ohio 1999) p. 305
1. After breaking away from original LLC, appellees obtained an
NHL franchise. Appellees sought declaratory judgment that LLC
operating agreement permitted members to compete for NHL
franchise as well as judicial dissolution of LLC. Appellants'
counterclaim alleged interference with prospective business
relationships and breach of contract and fiduciary duty.
2. *An operating agreement of a limited liability company may, in
essence, limit or define the scope of the fiduciary duties imposed
upon its members.
3. In general terms, members of limited liability companies owe one
another the duty of utmost trust and loyalty. However, such general
duty in this case must be considered in the context of members'
ability, pursuant to operating agreement, to compete with the
company.
4. Except as otherwise provided in the operating agreement, the
members of a dissolved limited liability company who have not
wrongfully dissolved the company may wind up the affairs of the
company.
g. Dissolution
i. New Horizons Supply Coop v. Haack (Wis. App. 1999) p. 311
1. When the company dissolved, D failed to take the appropriate
steps that were required by the statute to shield herself from any
personal liability for the company's debts. Also, P's claim did not
appear to exceed the value of any liquidation distribution D might
have received from dissolution of the company.
2. *Wis. Stat. ch. 183 expressly permits the importation of concepts
such as "piercing the veil" from business corporation law into
limited liability company law.
3. A dissolved limited liability company may dispose of known
claims against it by filing articles of dissolution, and then
providing written notice to its known creditors containing
information regarding the filing of claims.
h. LLC Mergers
i. VGS, Inc. v. Castiel (Del. Ch. 2000) p. 756
1. *The court found that had D manager knew of the proposed
merger, he would have taken steps to protect his majority interest.
Since the minority managers were aware of this, they breached
their duty of loyalty to D manager by failing to act in good faith.
2. Reading the Act in light of the equitable maxim that equity looks to
the intent rather than to the form, the statute must be construed to

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allow action without notice only by a constant or fixed majority. It

can not apply to an illusory, will-of-the wisp majority which would
implode should notice be given. Nothing in the statute suggests
that a court of equity should blind its eyes to a shallow, too clever
by half, manipulative attempt to restructure an enterprise through
an action taken by a "majority" that existed only so long as it could
act in secrecy.

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