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Corporations Outline AGENCY

I. Who is an agent?
A. Agency indicates the relationship which exists when one person acts for, and under the direction of another person. 3 principal forms of agency at CL: 1. Principal and agent 2. Master and servant 3. Employer or proprietor and independent contractor. B. Where this relationship exists, the acts of the agent bind the principal, and the property or benefit of the agents actions must be given to the principal. C. Restatement Second Agency (R2A) 1 Legal standard for agency 1. Manifestation of consent by P to A that A shall act: a) on Ps behalf b) subject to Ps control 2. As consent to so act. D. Gorton v. Doty (1937) Schoolteacher loaned her car to the schools coach to transport the football team to a game. The car got into an accident and the parents of one of the injured players sued the owner of the car. Held: Coach was teachers agent. 1. Borderline case: No real manifestation be Ps behalf. Far more resembles a gratuitous bailee than a principal. Even the control was pretty limited, more like a restriction on a very limited matter and did not control most aspects of the coachs driving. Agency Relationships Arising Out of Close Business Dealings A. R2A 14O: Creditor becoming a principal. 1. Creditor becomes a principal at that point at which it assumes de facto control over the conduct of the debt 2. 9 factors re control B. R2A 14K: Supplier relationships 1. One who contracts to acquire property from a 3rd person and convey it to another is the agent of the other only if it is agreed that he is to act primarily for the benefit of the other and not for himself. (High std.) C. Where a creditor or purchaser company exerts too much control over the operations of the supplier/debtor company, it can give rise to an agency relationship and the principal may be held liable for the debts of the agent company. (Cargill grain elevator case) Forms of an agents authority to enter into contracts A. Actual Authority Actual authority can be express, implied, or incidental. (Mill Street Church hired brother in the past) B. Apparent authority Authority for agents unauthorized actions derived from overt actions by principal to 3P. Principal acts in such a manner to give the impression to a third party that an agent has certain powers which he may or may not actually possess. Key is a reasonable belief of authority by T. (Lind Alcohol salesman compensation package); (3-70 Leasing expensive computers on credit) C. Inherent authority Agents authority arises impliedly from the designation or position the agent is granted by the principal. Authority for such decisions is necessary to the fulfillment of the duties of the position. Evolved in response to the anomaly of a 3P who knew little about market and therefore would not know enough to give rise to the belief that the authority was conferred. Generally found in 2 circumstances: undisclosed principals & agents exceeding their authority. 1. R2A 8A Indicates the power of an agent which is derived not from authority, apparent authority or estoppel, but solely from the agency relation and exists for the protection of persons harmed by or dealing with a servant or other agent. a) P may have forbidden A to make such a dealing. b) P have made no overt manifestations to 3P to give him the impression that A had such authority. c) All that is necessary is that A is Ps agent, and the dealing was one commonly done by persons in As position. See comment b to R2A 181. 2. Undisclosed principal. a) Agent who negotiates a contract w/ third party can be sued for any breach of the contract unless the agent discloses: (1) that he is acting on behalf of a principal, AND (2) the identity of that principal. b) Watteau v. Fenwick Pub manager ordered cigars and other items not within his authority. 3. Disclosed principal with agent exceeding his authority in a field where the agents generally do have the authority to enter into the disputed transactions. a) Kidd v. Thomas Edison Edisons A to set up performances of singers to demonstrate the new phonograph.



b) Nogales Truck stop out west entered into a financing agreement with an oil company to expand and improve the facility and to make it competitive. D. Ratification 1. R2A 82 An affirmance by a person of a prior act which did not bind him but which was done or professedly done on his account. Requires 2 elements to be satisfied: a) Acceptance of the results with an intent to ratify, and b) with full knowledge of all material consequences. 2. Must demonstrate an intent to ratify, not just passive acceptance of the results. (Botticello Husband and wife owned farmland as tenants in common.) 3. A key concept in determining whether permitting or denying are ratification is preventing the principal from having an option to accept or disavow the contract to the principals benefit and 3Ps detriment. (See examples in book and slides). E. Agency by Estoppel 1. R2A 8B P can be liable for transaction purported to be on his account to 3Ps who have changed their position in reliance on transaction where: a) P intentionally or carelessly caused such belief b) knowing of mistaken belief and that 3Ps may change position, did not take reasonable steps to notify them of the real facts. 2. A principal can be estopped from claiming that a person acting as its agent was not really its agent if the principal was negligent in supervising and ensuring that such imposters or abuses of agency/authority do not occur and the injured party is not at fault. (Hoddeson Woman scammed by a man posing as a furniture salesman.) F. Agents Liability on the Contract 1. Disclosed principal Generally none. 2 exceptions: a) Clear intent by all parties that agent be bound b) Agent made K, but w/o authority (1) Party to contract? (2) Fraud? (3) Implied warranty of authority 2. Undisclosed principals OR partially disclosed (meaning the other party to a K knows there is a principal behind the agent but does not know the principals identity R2A 4(2)) then the agent is also a party to the K and can be held liable. a) A treated as party to the K b) 3P must elect who to sue 3. Atlantic Salmon v. Curran Sleazeball businessman hid behind fictitious corporations and racked up almost $300K in debt for salmon purchases from Norwegian companies. Liability of Principal to 3rd Parties in Tort for Actions of Agent A. Master - Servant (ER-EE) Relationship 1. R2A 219(1): Master is liable for servants torts committed in the scope of their employment. 2. ER exerts near complete control over how the EE goes about acting on behalf of the ER. Or at least is subject to the control of ER. 3. Liability supported by theory of inherent agency or respondeat superior. B. Independent Contractor 1. Independent contractors (2 types) A person who contracts to do something for another who is not controlled by the other as to means and methods of completing the task. a) Agent-type IC has agreed to act on behalf of the P. Is subject to limited control by P as to the chosen result. But is not subject to total control by Ps as to how that objective is accomplished. (1) Ordinarily not liable for actions of agent-type IC, but some exceptions? b) Non-agent type IC operates independently through arms-length transactions. Perhaps less control on Ps part, but more importantly, this type of IC has no power to act on Ps behalf. P is not liable at all for the actions of non-agent ICs.


Archaic Modern

Servant Employee

Independent Contractor (agenttype) Non-servant agent Subject to limited control by P with respect to the chosen result Has power to act on Ps behalf

Independent Contractor (nonagent) Non-agent independent contractor Perhaps less control on Ps part but NO power to act on Ps behalf

Res 3rd Level of Liability

Employee P liable if A within scope of employment

Non-employee agent P NOT liable except in special circumstances

Non-agent service provider P is NOT liable in agency law

C. Differentiating between servants, agent-type IC, and non-agent type IC. 1. R2A 220 Definition of Servant a) A servant is a person employed to perform services in the affairs of another and who with respect to the physical conduct in the performance of the services is subject to the others control or right to control. (Humble Oil servent, vs. Sun Oil IC). b) In determining whether someone is a servant or an independent contractor, the following factors are considered: (1) Ps control over details of work (2) A is engaged in a distinct occupation or business (3) Is work usually done under direction of employer (4) The skill required in the particular occupation (a) High skill= contractor (b) Low skill= employee (5) Who supplies the instrumentalities, tools, and place of work (6) Length of time for which A is employed (7) Method of payment (by time/by job) (a) Time= employee (b) Job = Contractor (8) Is the work part of the regular business of the employer? (9) Do parties believe they are master/servant? (10) Is P in same business? D. Tort Liability for Apparent Agency 1. Elements for apparent agency a) Principal must hold out the franchisee or IC as its agent, and b) 3rd party must reasonably rely on that apparent agency. 2. R2A 267 One who represents that another is his servant or other agent and thereby causes a third person justifiably to rely upon the care or skill of such apparent agent is subject to liability to the third person for harm caused be the lack of care for skill of the one appearing to be a servant or other agent as if he were such. (Miller v. McDonalds (1997) Woman injured herself by biting into a heart-shaped sapphire in her Big Mac.) E. Scope of Employment 1. Types of tests for scope of employment a) Purpose test b) Economic approach best cost avoider (like Carroll Towing) c) Foreseeability test (see Bushey) 2. R2A 228 Scope of Employment. A servants conduct is not within the scope of employment if it is... too little actuated by a purpose to serve the master. As conduct is within the scope of employment if: a) It is of the kind A is employed to perform. b) It occurs substantially within the authorized time and space limits (if not it is a frolic and detour. c) It is actuated, at least in part, by a purpose to serve P. d) If force is intentionally used by A against another, the use of force is not unexpectable by P. (see below). E.g., bouncers, bodyguards.

3. R2A 230 An act, although forbidden, or done in a forbidden manner, may be within the scope of
employment. 4. R2A 231 Servants acts may be within the scope of employment even if consciously criminal or tortious, but serious crimes are outside the scope. (Manning Orioles pitcher heckled). 5. Liability for agents actions even when outside the scope of employment. R2A 219(2) A master is not subject to liability for the torts of his servants acting outside the scope of their employment, unless: a) The master intended the conduct or consequences; or b) The master was negligent or reckless, or c) The conduct violated a non-delegable duty of the master d) The servant purported to act or to speak on behalf of the principal and there was reliance upon apparently authority, or he was aided in accomplishing the tort by the existence of the agency relation. F. Liability for Torts of an Independent Contractor 1. General Rule: Principal not liable for torts of IC 2. Exceptions: a) Principal retains control over the aspect of the activity in which the tort occurs (in that case, P is a master) b) Principal employs incompetent independent contractor ( 213, 219(2)(b)) (1) Is a financially irresponsible contractor an incompetent one? (Most say NO) c) Performance of the contractors task is inherently dangerous. (Majestic Realty) d) Duty is non-delegable (Same rationale as 219(2)(c)) A duty so important to the community that the principal may not delegate (usually applies to certain statutory duties) Fiduciary Obligation of Agents A. R2A 13 An agent is a fiduciary with respect to matters within the scope of his agency. Fiduciary duties include: 1. Duty of care [ 379] 2. Duty of loyalty a) Payment from a 3rd party (kickbacks, bribes, tips) b) Secret profits (Reading) c) Usurping business opportunities from principle (Singer) d) Grabbing and Leaving (Town & Country) 3. Gratuitous agents (R2A 379(2)) Only need to act with the std of care that gratuitious agents performing similar actions must take. B. R2A 387 Unless otherwise agreed, an agent is subject to a duty to his principal to act solely for the benefit of the principal in all matters connection with his agency. PARTNERSHIPS


I. Choice of Business Associations

A. What are the options in forming a new business (if alone you do not have sufficient funds to do everything on your own?) 1. Obtain a loan from a friend or a bank (possible agency relationship). 2. Go into the business jointly with a partner (partnership). 3. Create a corporation and attract investors with sale of stock interests (corporation). B. As one goes from simple (agency) to more complex (corporations) the roles of individual actors within a business become more specialized Definition of Partnerships A. Governed by statutory state law. 1. Uniform Partnership Act (1914) UPA most focus will be on UPA since there is more case law under UPA than reformed version. Plus, many states still use the old one. 2. Uniform Partnership Act (1997) RUPA B. UPA 6(1) - Association of two or more persons to carry on as co-owners a business for profit forms a partnership, whether or not the persons intend to form a partnership. 1. Co-owners means: a) Shared control of the business b) Shared profits of the business 2. No formal creation requirements can arise organically (and unexpectedly!) C. UPA 7 In determining whether a partnership is formed, the following rules apply: 1. Co-ownership of property is not sufficient to establish a partnership, even if the profits are shared. 2. The sharing of gross returns does not alone establish a partnership.


3. A person who receives a share of the profits of a business is presumed to be a partner in the business, unless the
profits were received in payment: a) of a debt by installments b) for services as an IC or wages or other compensation to an employee c) of rent d) of an annuity or retirement plan or health benefit e) of interest charged on a loan f) for the sale of goodwill to the business or other property by installments or otherwise. D. Factors to look for: 1. Intent of the parties (more important inter se than in dealing with 3P) 2. Share in the profits and losses (most important) 3. Contribution of property, capital contributions 4. Control and management Close Calls: Determining When a Partnership Exists A. Potential difference btw partners and employees (Fenwick) 1. Intent to enter into partnership vs. intent to hire a subordinate employee 2. Sharing of profit and loss vs. payment of wages regardless of financial status 3. Shared control of management vs. subordinate 4. Investment with capital and ownership of equity (sometimes) vs. labor contribution 5. Holding organization out to be a partnership vs. one owner a) Profit-sharing generally sets up a presumption that a partnership exists. But that presumption is negated if the shared profits are only meant as payment of salary. B. Partners as compared with Lenders and the Debtor-Creditor Relationship 1. Lenders can enter into loan agreements to be paid back interest and principal though a share in profits. UPA 7(4)(a), (d). 2. And lenders may impose some constraints on a debtor business. Creditors often requires some measure of control in order to protect their investment, and courts have held this to be acceptable. But must be careful not to assume too much control. (Martin v. Peyton) 3. What if you are a creditor who becomes a partner? Double whammy a) You are losing your priority spot for getting your money back b) AND you are liable for all the debts of your partners c) You become subordinated to the debt of non-partner creditors and to debt of partners C. Profit-sharing between two businesses as prima facie evidence of a partnership 1. The existence of a profit-sharing arrangement between two businesses is considered prima facie evidence of a partnership. But there are circumstances that can rebut this presumption with a finding of meeting the factors set out in 7(4), or totality of circumstances (Southex Exhibitions). 2. For this reason, two businesses entering into a project where they will split the profits will often form a separate corporate entity to engage in the joint activity and prevent partnership liability form arising. D. Partnership-by-estoppel 1. UPA 16 A person who represents himself, or permits another to represent to him, to anyone as a partner in an existing partnership or with other not actual partners, is liable to any such person to whom the representation is made who had, on the faith of the representation, given credit to the actual or apparent partnership. (Young v. Jones Price Waterhouse) Liability of Partners A. UPA 15 All partners are liable for liabilities of the partnership 1. Jointly and severally for everything chargeable to the partnership under 13 & 14 [e.g., torts and breaches of fiduciary duties.] 2. Jointly for all other debts and obligations of the partnership. [contracts]. Fiduciary Obligation of Partners A. RUPA: 404 General Standards of Partners Conduct 1. (b) Duty of loyalty is limited to the following: a) 1) Appropriation of a business opportunity b) 2) Refrain from dealing with the partnership on behalf of a party having an interest adverse to the partnership c) 3) Refrain from competing with the partnership in the conduct of the partnership business 2. (c) Duty of Care a) Refrain from engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of the law




3. (e) A partner does NOT violate a duty or obligation under this act or under the pship agreement merely because
the partners conduct furthers the partners own interest B. Loyalty to the partnership and disclosure of business opportunities. Cannot eliminate the duty of loyalty. But it can be limited if not unreasonable. C. Types of obligations of partner to partnership. (Meinhard v. Salmon) 1. Offer business opportunity to partner(s)? 2. Only inform them of the opportunity and then compete? D. Duties after dissolution. No duty to former partners with whom accounts have been settled with the partnership. (Bane v. Ferguson) E. Grabbing and leaving. Partners may plan to compete with the entity to which they owe allegiance, provided that in the course of such arrangements they do not otherwise act in violation of their fiduciary duties. (Meehan) F. Expulsion from partnership. RUPA 601. 1. Permitted pursuant to the partnership agreement (Lawlis) 2. Or by unanimous vote of the other partners where: a) it is unlawful to carry on the business w/ that partner b) partner has transferred all or substantially all of his interest in the partnership c) corporate or partnership partner is dissolved, wound up etc. Partnership Property A. UPA 24: The property rights of a partner are 1. his rights in specific partnership property, 2. his interest in the partnership, and 3. his right to participate on the management. B. UPA 25(1): A partner is a co-owner with his partners of specific partnership property holding as a tenant in partnership. C. UPA 25(2): What does tenant in partnership mean? 1. Equal right as other partners to possess partnership property for partnership purposes; but, no right to possess partnership property for any other purpose (unless the other partners consent) 2. Rights in specific partnership property are not assignable except in connection with the assignment of rights of all the partners in the same property. D. UPA 26: A partners interest in the partnership is his share of the profits and surplus. Can be assigned to another w/o permission of the other partners. E. Asymmetry in liability to creditors 1. Personal debt can attach only to that partners partnership interest. Creditors cannot go after the partnership property, just as an individual partner cannot sell his interest in the partner. 2. However, the individual partners in a general partnership ARE personally liable (jointly and severally) for any torts or other liability of the partnership. F. Conveying partnership interest to another 1. Once interest in partnership is conveyed to another, retired partner no longer has interest in the partnership property, even if that partnership property arose during tenure of retired partner. (Putnam). G. Capital Accounts 1. Capital accounts are a way for a partnership to track the amount each partner has paid into the partnership. As a default rule, this does not make any difference as to how much of the profits are paid out to each, but each partner has a right to return of that capital at some time, subject to the liabilities and obligations of the partnership. 2. Raising a particular partners balance in the capital accounts: a) Payments of capital into the partnership b) Profits accruing to the partnership (divided across the partnership accounts) 3. Lowering a particular partners balance in the capital accounts: a) Draws (taking money home) b) Losses attributable to the partnership H. Allocating profits among partners 1. Traditionally the profits are divided equally, no matter how much each partner works or contributes to the partnership capital. Default rule. 2. Partners free to enter into contractual arrangements that allocate profits in another way. I. Losses 1. General rule: Losses apportioned in the same way as the profits. 2. Loss apportionment can also be modified by the terms of the partnership agreement. J. Raising additional capital (for a partnership project gone bad) 1. Interest-free loan



a) Ask the partners to make interest-free loans to provide enough cash, interest-free, to the partnership to finish the project and save everyones investment. b) Temptation to hope that the other partners will pick up the slack to save their shares (free-riding) w/o making any contribution oneself. 2. Pro rata dilution a) Offers more shares at the same rate as the original offering. b) Works well if the venture is profitable, but needs some extra cash. But who would want to buy shares at the same price as originally offered when the enterprise is losing money and the shares are worth less? Encourages free-riding even more than the loans. 3. Penalty dilution a) Sell points or shares at a rate significantly lower than the original one. This provides incentive to purchase the maximum allowed by the managing partner to preserve original investment. b) Can be abused by a managing partner if that person wants to gain a much greater share in the partnership Partners Rights in Management A. UPA 18(e) Absence agreement to the contrary, all partners have equal rights in the management and conduct of the partnership business. 1. At minimum this means that they must have access to information and must be consulted and allow to vote. 2. When a majority deprives a partner of participation in control, it violated the partnership rights. If pervasive, disgruntled partner can sue for dissolution. B. UPA 18(f) No entitlement to remuneration for acting in the partnership business, except for reasonable compensation in winding up the partnership business. C. UPA 18(h) - Consent required among partners 1. Ordinary business decision majority a) Compare UPA 9(1) and RUPA 301(1). Under Revised consider community standards in determining what is ordinary for a particular venture in the community rather than just what is ordinary for the particular partnership. 2. Extraordinary decision unanimous a) Adding new partner b) Acting in contravention with the partnership agreement c) Highly unusual or not related to the partnerships business D. Partners authority to bind the partnership to contracts with 3rd parties in face of opposition by other partner(s). Partner is an AGENT and can bind partnership for any transaction w/in scope of partnership business. (Stroud). E. Partners right to participate in the management. Cannot deprive one partner of his right to participate in management. (Summers). F. Partners right to indemnity from partnership for liability arising out of course of business. (Moren v. JAX Restaurant). 1. Compare for employee incurring loss, there would NOT be a duty of indemnity by the partnership. While a person could sue the partnership on a theory of respondeat superior, theoretically the partnership could seek indemnity or contribution from the employee (unlikely that employee would be able to pay though!) G. Partnership rights pursuant to express agreement. Limiting right to equal management and other default rules of partnership. Significant freedom to contract around the default UPA rules on partnership. Can vest great authority in an executive committee. (Day v. Sidley Austin). 1. Partnership agreements can get around the deadlock problems present in Stroud & Summers. AUTHORITY Central decision-making body Needed when constituents have: Differing business interests Unequal access to information High costs of acting collectively Corporation optimized for these characteristics

CONSENSUS Collective decision making Requires constituents with: Similar business interests Comparable access to info Minimal costs of acting collectively Partnership optimized for these characteristics


Terminating the Partnership A. The right and power to dissolve the partnership 1. Partners always have the power to dissolve the partnership, but not necessarily the right to dissolve. 2. Three types of dissolution a) By act of one or more partners [UPA 31(1)-(2)]

(1) At the termination of the partnerships term or particular undertaking, or, if it has none, at the will of any partner (2) Wrongful dissolution: In contravention of the agreement between the partners by the express will of any partner at any time. Damages for breach. (Collins). b) By operation of law [UPA 31(3)-(5)] (1) Death or bankruptcy of partner c) By court order. [UPA 31(6); 32] 3. RUPA 801(5): A partnership is dissolved by a decree that: a) the economic purpose of the partnership is likely to be rxbly frustrated b) another partner as engaged in conduct relating to the partnership business that makes it not reasonably practicable to carry on the business with him c) is not otherwise reasonably practicable to carry on the partnership business in conformity with the partnership agreement. 4. UPA 32 - Dissolution by Decree of Court Permits dissolution by the court whenever any number of factors are present: When a partner (a) is declared unsound mind, (b) becomes incapable of performing his part, (c) guilty of conduct that prejudicial to business, (d) willfully or persistently commits a breach of the partnership agreement, or otherwise conducts himself in matters relating to the partnership business that it is not reasonably practicable to carry on the business, (e) business can only be carried on at a loss, or (f) other equitable circumstances. (Owen v. Cohen). 5. Term of partnership can be difficult at times to determine, but a court will not imply a term until all debts are paid back. Otherwise, the exception would swallow the rule for all non-profitable partnerships. (Page v. Page). 6. General rules for terms of partnerships a) In absence of a term, it is a partnership-at-will and dissolution is not considered wrongful. b) Partnerships can be explicitly set for a term of years or tied to some other temporal marker or goal. (For the period of a lease. Until something is sold.) (Collins). B. Consequences of dissolution UPA 37, 38 1. Dissolution is not the same as the final termination. Begins the process of winding up that eventually results in final termination after all debts are paid, assets disposed of, and accounts settled with all partners. 2. Comparison of dissolution under UPA and RUPA. [SEE SLIDES] 3. 4 routes following a dissolution: a) Continuation per agreement b) Continuations following wrongful dissolution c) Acquisition of assets/business by some partners d) Completed wind up period and termination 4. Continuation per agreement: Traditionally the departure of death of any partner caused dissolution, however today partnerships can avoid this result with a continuation agreement. a) Effect on partnership: Creditors of old automatically become creditors of new b) Effect on departing partners (1) Entitled to an accounting FMV of partnership share + interest from dissolution (2) Remains liable for all firm obligations during tenure until novation. c) Effect on a new partner (1) Liable for old debts, but liability can be satisfied only out of partnership assets (i.e. no personal liability). (2) Personally liable as other partners under 15 for all new obligations. 5. Acquisition of assets/business by some partners a) During wind up period, the assets/business of the partnership will likely be put up for sale (liquidation). Because outside bidders fear adverse selection (lemons), often these assets will be purchased by some of the former partners. b) Using dissolution to freeze out one of the partners. Former partners allowed to bid on the company during the liquidation sale and buy out anothers share. (Prentiss v. Sheffel). (1) Only if dissolution was purposefully done to take advantage of another partners liquidation problem to purchase the partnership assets/going concern at an unfairly low price. In that case, it is bad faith and breach of fiduciary duty. In effect, then, when a partner dissolves and bids for the assets must pay fair price. (2) Since outside bidders fear adverse selection (lemons) in the businesses that are up for sale, they tend to discount that uncertainty from the price they will bid. Whereas the partners know how strong (or weak) the company is. Thus, current partners often value the remaining percentage of the property greater than outsiders. The real action at many such auctions is between former partners.


c) Always liquidation in a court-ordered dissolution? Or can the court grant one partner an exclusive buyout opportunity at a court-ordered bidder? (Disotell v. Stiltner). 6. Continuation following wrongful termination of the partnership a) Wrongful dissolver must pay damages and has limited rights to participate in the winding up of business. Remaining partners have a right to continue on with the partnership business w/o the wrongful dissolver. (Pav-Saver Corp). (1) UPA 38 Value of the partnerships good-will is not included. (2) RUPA 701 Entitled to payout of value of goodwill. C. Division of remaining profits/losses 1. UPA 18 Sharing of partnership losses. Partners must contribute towards the losses, whether of capital or otherwise sustained by the partnership according to his share in the profits. a) Exception for service partners? Applies only if the service partner does not receive a salary or any other compensation and did not make any capital contributions. Kovacik v. Reed (1957). b) RUPA 401(b) Explicitly rejects holding in Kovacik. Still leaves a little wiggle room. Its possible for partners to agree to treat capital and operating losses differently. Thus leaving the door open to courts to find an implied agreement to treat differently. 2. Order of Partnership Liability Payments at Dissolution. UPA 40(b) a) Those owing to creditors other than partners, b) Those owing to partners other than for capital & profits, c) Those owing to partners in respect of capital, d) Those owing to partners in respect of profits. D. Exit Mechanism: Buyout Agreements 1. For outline of issues and alternatives for a buyout agreement, see pg. 182. 2. Determining the buyout price a) Annual assessment of partnership share price and agreement b) Hiring an appraiser c) Formula d) Book value e) I pick, you choose, Texas shootout. Becoming more and more popular. Some say that it is even malpractice to not include in agreement. Self-assessment mechanism. (1) One partner sets the price, the other decides if he wants to leave or buyout the partner setting the price at his price. Works well when partners want to go their own ways. (2) Somewhat more difficult when uneven interests or multiple partners. 3. Buyout agreements need not be as economically advantageous for severing partners as would dissolution as sale of assets. (Belman). E. Law partnership dissolution No express agreement. Attorneys fees received on cases in progress upon dissolution of a law partnership must be shared by the former partners according to rights in former partnership. (Jewel v. Boxer). F. Law partnership dissolution Express agreement. (Meehan II). Limited Partnerships A. There are general partners AND limited partners. General partners are liable for debts like a normal partner. Limited partners are liable only to the extent of their contributions. B. Death of limited partner does not cause dissolution of partnerships, and limited partnership shares are often transterable C. BUT limited partners are liable as general partners if they take over more management and control than that accorded to a limited partner and others reasonable believe, based on LPs conduct, that the LP is a GP. (Holzman). D. RUPA provides greater protection from liability for LPs, even where they exert some managerial control over the partnership. (See RULPA 303(a)-(b)). E. LLLP vs. LLP 1. Limited Liability Limited Partnership a) Usually results from a conversion from LLP. b) Similar to a limited partnership, but grants GP limited liability as well (somewhat similar to making a corporation the general partner). c) Wasnt always permissible. Now more widespread. 2. Limited Liability Partnership RUPA F. Limited Liability Partnerships 1. Must file with state to change general partnership to LLP. 2. Limits the liability of partners only for negligence and misconduct of others, not contractual obligations. 3. Created to protect law firms from the devastating effect of malpractice liability.


I. Types of Corporations
A. Publicly-held Many of the most famous corporations are publicly traded corporations with their stock listed on the stock market. The vast majority of stockholders play no role in management. B. Closed corporations A small group of major shareholders control the company and the stock in the corporation is not offered to the public at large. C. Critical attributes 1. Legal personality 2. Limited liability 3. Separation of ownership and control 4. Liquidity 5. Flexible capital structure II. Comparing Partnerships and Corporations (See Slide # 7 Chapter 3) III. Rights of Corporations A. Right of recognition. States cannot discriminate against foreign corporations. B. Delawares dominance 1. More than 300K companies are incorporated in Delaware including: a) 60% of the Fortune 500 b) 50% of the companies listed on the NYSE 2. Why does DE dominate? a) Race to the bottom DE is willing to stoop the lowest. Give managers everything they want at the expense of the shareholders. b) Race to the top DE is the best. It cant be that the shareholders lose out, because the shareholders ultimately decide in which state to incorporate. 3. Benefits a) No minimum capital requirements b) One corporate can incorporate another c) Franchise tax low, same w/ corporate tax d) Dont actually have to move to DE e) *** Because so many corporations today, have very educated judges in corporate law and an extremely detailed corporate code. IV. Liability for Pre-Incorporation Activity (Promoters) A. Promoter a person who identifies a business opportunity and puts together a deal, forming a corporation as the vehicle for investment by other people. B. Promoter has a fiduciary obligation to: 1. The corporation 2. To third persons for pre-incorporation commitments C. Secret Profit rule for promotors 1. Applies where P deals w/ corporation itself 2. P cannot make SECRET PROFIT in the dealings w/ the corporation 3. If property is acquired by P BEFORE became promoter: a) Equation: Price of property sold to corp FMV (1) Note: It is not price paid by P at an earlier time 4. If property is acquired by P AFTER became promoter: a) Equation: Price paid by corp price paid by P 5. If profit is made, then must determine whether corporation KNOWS about the profit. Only in trouble if it is secret. D. Liability for Pre-Incorporation Activity The fact that a promoter has not yet formed a corporation at the time of contracting is no defense if later that corporation seeks enforce K. (Southern-Gulf Marine). 1. De-facto corporation court can treat unincorporated corporation existed it the parties: a) acted in good faith b) had a legal right to create a corporation c) acted as if the corporation existed 2. Corporation by Estoppel: A court will also treat a firm improperly incorporated as a corporation if 3Ps: a) Thought the business was a corporation; and


b) Would earn a windfall if it were now allowed to deny that the business was a corporation.

3. Promoter Liability Pre-Incorporation Activities

a) Once articles are filed, corporation becomes party to the contract if it adopts (expressly or implied) b) Once the articles are filed, the promoter remains on the hook if the corporation breaches until a novation (agreement by all parties, 3P, corp and promoter) to release liability. Corporate Limited Liability and Corporate Veil-Piercing A. Limited liability in a corporation The general rule is that the corporate entity limits liability for business activities to the assets of the corporation itself. This means that the maximum liability for a shareholder of a corporation is the value of the shares themselves. The shareholders personal assets generally cannot be reached by corporation shareholders. B. What are the justifications of limited liability? 1. Encourages entrepreneurial activities and investment. Predictability of risk in engaging in investment (especially for small investments by persons who are risk-adverse) 2. Alternative means of protecting potential plaintiffs minimum required insurance/capital 3. Transferability of investment assets C. Corporate veil-piercing The exception to the general rule is where several corporations are used by one business owner interchangeably and without regard to the supposed individual entity status each carries for the purpose of defrauding or causing injustice (unfairly limiting liability?). Courts are very reluctant to do this and will do so only where there is a clear showing. D. Three situations where veil-piercing can arise: 1. Alter ego (Pepper Source) 2. Undercapitalization (Walkovszky v. Carlton). 3. Parent-subsidiary (Silicon Gel Breast Implant) E. Requirements for veil-piercing for alter-ego theory. Corporate entity will be disregarded and the veil of limited liability pierced when two requirements are met: 1. Such unity of interest and ownership that the separate personalities of the corporation and the individual [or other corporation] no longer exist. a) Factors to consider: (1) Commingling of funds and other assets of the entities (2) The holding out of one entity that it is liable for the debts of the other (3) Identical equitable ownership in both (4) Use of same offices and employees (5) Use of one as a shell for the conduit for the affairs of the other 2. Circumstances must be such that adherence to the fiction of separate corporate existence would sanction a fraud or promote injustice. F. Veil-piercing where there is an actual parent corporation/subsidiary corporation relationship. Corporations can be the sole shareholder of other corporations, and enjoy limited liability for the subsidiarys actions. However, must be careful not to engage in too much control and domination and must respect the individual corporate form of the sub. corp. (Silicon Gel Breast Implant). 1. Factors to review in analyzing whether a parent corporation is an alter ego of a subsidiary. a) P & S have common directors or officers b) P & S have common business departments c) P finances S d) P & S file consolidated financial statements and tax returns e) P causes incorporation of S f) S operates with grossly inadequate capital g) P pays salaries and expense of S h) S receives no business except through P i) P uses Ss property as its own j) Daily operations of two corporations not kept separate k) S does no observe basic corporate formalities, such as keeping separate books and records and holding shareholder and board meetings. G. The alter ego makes a dominating, controlling parent organization liable for the subsidiary, but does not create liability between subsidiaries. (Roman Catholic Archbishop of SanFran). That would be enterprise liability. Shareholder Derivative Actions (see Derivative Action Flowchart, slide 33, chapt. 3) A. Strange concept that arose in equity courts: Gives shareholders standing to sue in the corporations name to enforce the corporations rights against abuse by its own board of directors (and by extension) the corporation itself! Suing the corporation for its own good. B. POLICY: This mechanism gave shareholders a method to combat self-serving and inappropriate behavior on the part of the directors or managers of a publicly held company.




1. Agency costs Costs associated with the fact that managers may not be operating in the best interest of the
owners. For corporations, may be concerned that the agents of the corporation (executives and directors) may be acting in their own interest. Arises from the division of owners and management. a) Bonding costs tying incentives of agents with that of the enterprise (commissions). b) Monitoring costs attempting to monitor the agents is incurs costs and can reduce morale. c) Residual loss regardless of efforts, incentives of owners and managers will diverge and some losses will be incurred as a result. 2. Require some outside method to police the management. Strong incentive to settle on both sides in 1. Strike suits a) Lawsuits brought that have little chance of prevailing but can recover harassment costs from the corporation through settlement. b) P: obviously have a strong incentive to settle, since they have no real case. D: also has an incentive to settle for any amount less than the legal costs it would incur getting the suit dismissed. 2. Meritorious claims a) SH derivative suits that have a decent chance of prevailing at trial. b) P: Still quite a lot of uncertainty at trial and such suits do not have a high victory rate (lose 90% of the time at trial), so strong incentive to settle even when claim has merit. D: directors insurance covers liability only if the suit comes to a favorable resolution, which essentially means settlement. 3. Too much litigation vs. too little deterrence Criticism of the derivative suit actions 1. Romano (1991) Famous article claiming that derivative suits are detrimental. a) Very few derivative suits actually go to trial. Of those that go to trial, P loses 90% of the time. Suggests that the general universe of derivative suits are mostly not meritorious. b) Only half of the settlements resulted in the corporation receiving any real money. Average recovery < $6 million, and 90% go to litigation costs. c) Little evidence of deterrence. (Most controversial point.) Distinguishing direct shareholder suits from derivative suits. 1. DE test for whether an action brought by a shareholder against the directors of a corporation is a derivative suit or direct action (2-prong): a) Who suffered? (1) Corporation (derivative) (2) Shareholder (direct) (Eisenburg v. Flying Tiger Line) b) Who would receive the benefit? (1) Corporation accounts (derivative) (2) Private individuals (direct) Limitations on such suits (not stringent): 1. Must be shareholder, but not necessarily a large one. 2. Must make a demand on BoD to bring suit. a) Unless it would be futile b/c suit against an interested BoD and they would be Ds. 3. (Some j/ds) Must post a bond for the corporations Requirement of demand on the directors 1. Universal Demand Rule MBCA 7.42. Mandatory demand in writing and 90 day wait (unless irreparable harm would result). This is the general rule. Following consideration the BoD can decide to: a) Commence the suit requested b) Permit the SH to continue w/ the suit c) Reject the demand as not being in the best interests of the corporation. (Need only meet BJR) (1) Thus P must disprove either: (1) Independence of the decisionmaker, or (2) Lack of good faith basis or reasonable inquiry. Difficult if BoD delegates decision to independent Ds or committee. (2) If the rejection of the demands is determined wrongful then the derivative suit can be maintained. If not wrongful, then the suit is dismissed. 2. Non-universal demand rule Before a derivative action can be maintained, the stockholder purporting to be acting on behalf of the corporation must make a demand to the board of directors that they right the alleged wrong or allege with particularity why the stockholder is justified in forgoing the demand. This rule is followed in DE and NY. It is also codified in FRCP 23.1 Demand or excuse why no demand. a) Aronson Rule (DE): The demand requirement is excused if plaintiff shows reasonable doubt that either: (1) majority of the board has a material financial or familial interest, OR







(2) majority of the board is incapable of acting independently for some other reason such as
domination or control, OR (3) the underlying transaction is not the product of a valid exercise of business judgment. b) In DE, it is foolish for a plaintiff to make a demand. If court determines that a demand was necessary, can always make one later. If court finds no demand was necessary, it removes the chance of the corporation to can review the basis of the derivative action w/in the BoD and (presumably) reject it as not in the best interest of the corporation. (Grimes) c) NY Law - Grounds for claiming excusal of the demand requirement. Must show one of three things with particularity (no reasonable doubt standard). Higher hurdle. 3-prong test: (1) Majority of the board has a material financial or familial interest (2) Whether directors failed to inform themselves (duty of care) (3) Challenged transaction is not the product of a valid exercise of business judgment H. The role of special litigation committees (SLC) 1. SLCs are used to avoid the potential conflict with the DoL in situations where a SH derivative action implicates some, but not all, of the directors on the board. If the decision to dismiss the action is made by conflicted directors, then the burden will be on the corporation to prove good faith and rxble inquiry. SLCs restore the deferential BJR. 2. How to review the demand a) If the independent Ds make up a QUORUM of the BoD, then the independent Ds can review demand itself. If demand rejected by a majority of the independent Ds, BJR applies. b) If there are at least SOME independent Ds, a majority vote of those Ds can appoint a subsection of the board (at least 2 independent Ds) to a SLC to review the demand. If rejected by SLC, BJR applies. c) If there are NO independent Ds, the BoD can ask a court to appoint an independent panel. 3. If the special committee (or quorum or court-appointed committee) determines that a dismissal would be in the best interests of the corporation, then the case is dismissed. This gives some control back to the corporation (from the plaintiffs attorneys). 4. Reviewing a special committee for independence. a) Deferential review (NY) If disinterested and independent (burden on P to disprove), apply BJR to decision of SLC. (Auerbach). b) More intrusive review (DE) If disinterested and independent (burden on corporation/SLC to prove), court will review SLCs decision to terminate a derivative lawsuit with a std not so deferential as the BJR, will apply its own independent business judgment to the merits! (Zapata). (1) Right to bring a suit The requirement of a demand (or an excuse for not bringing one) must be met before a SH can file the complaint. SH can bring the suit after a denial or by showing that a demand would be futile. (2) Right to maintain However, once the action is initiated, if the corporation has a quorum of disinterested board members or sets up a SLC and conducts a proper investigation, then the corporation has the right to terminate the derivative suit. SH has no individual right, in the face of resistance by disinterested, independent board members of the corporation itself, continue to press the lawsuit. (3) These are DIFFERENT! c) Disputes over control of the suit in DE (Zapata standard, intrusive and aggressive) (1) Two situations where a boards decision to not to sue will not be respected: (a) Where the determination of the board was wrongful, such as where refusal/dismissal where such action violates the board members fiduciary duties to the corporation. See not valid exercise of business judgment or failure to inform themselves. (b) Where the demand would be futile. See not impartial. (2) But even after a wrongful rejection or a successful excuse of demand, a board tainted with self-interest of a majority of members CAN appoint a special committee of independent, impartial board members to determine whether the derivative litigation is in the best interests of the corporation, so long as a two-step test is satisfied: (a) Inquiry into the committees: (i) independence (ii) good faith (iii) reasonable investigation (a) Burden on corporation in proving these factors (b) In the courts discretion, it may apply its own independent business judgment to the merits of the case in making its decision whether the motion should be granted. Separation of Ownership and Control




A. Capital structure - Set of claims to its assets and future earnings. Can be divided into two groups of securities: 1. Stocks/equity a) Rights (1) Dividends (if dividends are declared) (a) Preferred SHs have first right. (2) Residual assets of the firm (after all creditors are paid) (3) Vote on some issues (but not all) (a) election of directors (b) changes to the charter (c) mergers and other fundamental corporate changes b) Authorized shares the maximum amount of shares permitted by the corporations bylaws. c) Outstanding shares shares issued by the corporation and held by public SHs (insiders & gen public). 2. Bonds/debt a) Rights (1) Repayment of interest + principal (2) Collateral (3) Control (limited) b) Convertible bond can be converted into stock. Gives the owner some of the preferences of the bond while combining the advantages of owning stock. c) Warrant A security issued by the corporation that gives the SH a right to purchase stock at a later time at a designated price. SH pays a small amount for the warrant, and must pay the balance before a certain time to own the stock. (Sort of like an option.) B. Centralized Management 1. Although SHs own the corporation, DGCL 141(a) gives managerial authority to the BoD. 2. Hierarchy: Applicable federal/state law, AoI, By-laws, BoD decisions, decisions of officers. The Role and Purpose of a Corporation A. Focus on profit vs. societal good & charitable giving 1. Originally, the corporate form was directed at the public benefit of managing and ordering the trade as well as the private purpose of profit for the members. 2. However, as time passed and the corporate entity was applied to more and more trades, the purpose of making profit came to predominate. Common law came to require that all expenditures of corporate funds (monetarily) benefit the corporation. (Dodge v. Ford). 3. That was changed when corporations came to control the majority of the wealth in the country, and the CL rule has been abolished in some states by statute. (Barlow). B. Dividend payments and other business decisions Courts will not second guess a boards judgment (such as to pay or not pay dividends or make a certain investment) unless there is clear evidence of fraud, misappropriation, or breach of good faith to SHs. C. Business Judgment Rule Deferential standard applied to the discretional decisions made in the course of running a business. Recognizes that courts are ill equipped and infrequently called on to evaluate what are and must be essentially business judgments. So, the court defers to the BoDs decisions, unless: 1. Directors breach their Duty of Loyalty, because their decision is tainted by fraud, illegality, or conflict of interest. 2. Directors breach their Duty of Care, because they do not conduct sufficient investigation or deliberation to make a business judgment. D. Elements of BJR 1. a business decision 2. made with due care 3. by disinterested and independent directors 4. in the good faith belief it is in the best interests of the corporation and its SHs 5. with no abuse of the directors discretion E. Shlensky v. Wrigley (1968) Dispute over whether it was necessary to invest in lighting for the Cubs ballpark. Brought derivative action against Wrigley (80% interest) for mismanagement. Claimed the lack of night baseball was hurting the profitability of the team. 1. HELD: Defers to the decision of the Board. Courts ought not interfere with business decisions in the absence of fraud or breach of good faith. 2. Wrigley based his decision on a puritist view that baseball was a daytime game. Not really based on profit, but aesthetics. Gave a couple of other minor reasons such as the threat of increased crime in the neighborhood from night games. Court did not scrutinize the reasons.


3. Wrigley stands for the general rule that courts will nearly always defer to the business judgment of the board of
directors, even where more profit could be had by choosing another path. Ford is an exception! F. ALI Principles of Corporate Governance 2.01 a) A corporation should have as its objective the conduct of business activities with a view to enhancing corporate profit and shareholder gain. b) Even if corporate profit and shareholder gain are not thereby enhanced, the corporation, in the conduct of its business: (1) Must obey the law (2) May take into account ethical considerations that are appropriate for the responsible conduct of business (3) May devote a reasonable amount of resources to public welfare, humanitarian, educational, and philanthropic purposes. FIDUCIARY DUTIES IN CORPORATIONS

I. Duty of Care
A. Directors have a duty not to neglect, or fail to perform, or otherwise violate the duties in management and disposition of the corporate assets. This is NOT a negligence standard, but a duty not to abdicate judgment entirely. Very differential standard. B. Legal presumption that boards conduct is a proper exercise of business judgment. Application of BJR will shield even quite egregious director mistakes from court review. (Kamin). C. Imposing more care on the BoD Decision that is not adequately informed will not be granted the protection of the Business Judgment Rule. Must gather all reasonably available information before making a major decision (DE). (Van Gorkom). 1. Very (in)famous case. Some thought it would ruin DE as a corporate haven! Demonstrates a set of circumstances that might show a breach of the duty of care. 2. Also, duty of Van Gorkom to provide all material information concerning a merger or sale of company. 3. What could the company have done better? (How to avoid being Van Gorkom) a) Boards today are extremely careful to show all the motions of careful deliberation. b) Hire outside experts to estimate not only the worth of the company to the stockholders and the management, but to the potential outside purchasers. Factor in a control premium. c) Fairness opinion from a investment banker. (Some doubt about the validity of such opinions, where the investment banker knows that the board wants the deal to be determined fair. d) Set forth the methodology for coming up with the fairness opinion/intrinsic value. e) More skeptical questioning of the CEO by the board. 4. ALI standard is a little lower, directors must inform themselves where it is reasonable necessary. D. Even where the duty of care is violated, the transaction can pass muster if overall it is very fair. Court must engage in the Entire Fairness Test. (Cinerama v. Technicolor). 1. Factors for determining entire fairness of the deal: a) Timing, negotiation, ... of the transaction b) Disclosure to and approval of directors c) Disclosure to and approval of the shareholders d) Price obtained vs. ideal price E. Directors may rely on reports or other information from (1) corporate officers or employees, (2) legal counsel, accountants, or other experts/professionals, or (3) a committee of the board on which a particular director is not a member. (Brehm v. Eisner) 1. Reliance on expert is not always a total defense under 141(e) where: a) BoD did not rely on the expert b) Reliance was not in good faith c) Advice not in the experts competence d) Expert not selected with reasonable care (N by BoD) e) So obvious that grossly negligent f) Decision so unconscionable that no reasonable board could agree (Waste) F. Corporate Waste A decision so one-sided that no business person of ordinary sound judgment could conclude that the corporation could receive adequate consideration. Way, way over the top. High standard. (Brehm v. Eisner); (Kamin). G. Total abdication of responsibilities of director - Director must have a least a rudimentary knowledge of the business, enough to be able to scrutinize the books. BJR does not apply where no decision was made. (Francis).


1. Sarbanes-Oxley Major point: Bar no longer as low as in the Francis case (total abdication), especially as
pertains to accounting. Now directors must take a more active role in the management. Some of the mechanisms required are procedural. (see slides for more info) H. Directors are not expected to know about or discover all misdeeds of the corporations employees. Required only to ensure that a reasonable information and reporting system exists. (In Re Caremark International). Duty of Loyalty A. The duty of loyalty requires directors to give their full efforts and loyalty towards advancing the best interests of the company. Cannot use the company to advance personal interests to the detriment of the corporation. B. Courts may be more willing to closely scrutinize alleged violations of the duty of loyalty as it may not involve as much business judgment that the courts feel incompetent to second guess. BJR presupposes that the directors have no conflict of interest, thus directors with a conflict of interest cannot escape review of the fairness of the transaction. (Bayer). C. Conflicting director/officer transactions 1. A director has a conflicting interest with respect to a transaction or proposed transaction if the director knows that he or a related person (spouse, parent, child etc.) a) Is a party to the transaction b) Has a beneficial financial interest c) Is a director, general partner, agent, or employee of another entity with whom the corporation is transacting business that is so important that it would be brought before the board. (Lewis v. SLE). 2. An entire board will be found to be conflicted where: a) A majority of the individual directors are interested; or b) Where one of the directors is interested and dominates. (Bayer). 3. Corporations may avoid contracts entered into by directors with a conflict of interest where (1) the conflict of interest was not disclosed to the board (or SHs) before voting on the contracts, AND (2) the contract is unfair to the corporation. (Lewis v. SLE). a) Once it gets to the duty of loyalty analysis, the burden shifts to the s (the interested directors) to prove that the transaction was fair. b) Thus, Ps do not have to establish waste (the high level of wrongdoing). Waste is necessary where the BJR applies to overcome the BJR. 4. Strategy to avoid the problem of a conflicted board. See ratification below. a) Get a majority of disinterested directors to agree/ratify the transaction. (Not possible in Lewis since there were no disinterested directors.) b) Get the SHs to ratify the transaction. If material facts are known, may operate to shield the transaction from a claim of a violation of duty of loyalty. D. Corporate opportunities directors are obligated to offer the corporation a business opportunity and not to take it for their personal use. For a business opportunity to qualify for this treatment, it must be shown that: 1. DE test for finding usurpation of a corporate business opportunity: An officer/director violates DoL by embracing a business opportunity if: a) The corporation was financially able to take advantage of the opportunity (Broz) b) In the line of the corporations business and of practical advantage to it c) Corporation has an interest in it or a reasonable expectancy d) Officer or director by embracing the opportunity is brought into conflict with corporation 2. ALI Rule for Corporate Opportunities. Broader definition of corporate opportunity and more concerned with senior executives taking advantage than directors. Definition of a corporate opportunity: a) For all insiders: (1) In connection with the performance of functions as a director/senior executive; or (2) Under circumstances that should lead to believe that person offering opportunity expects it to be offered to the corporation; or (3) Acquired through the use of corporation information or property, if reasonably expected that this opportunity would be of interest to the corporation. b) For senior executives only, any opportunity that is closely related to a business in which the corporation is engaged or expects to engage. 3. Permitting an insider may take advantage of a corporation opportunity: a) The insider first offered the opportunity to the corporation, and disclosed the conflict of interest; b) The corporation rejected the opportunity; and either (1) The rejection of the opportunity is fair to the corporation; or (2) The opportunity is rejected in advance, by disinterested directors or [in case of a senior executive] by a disinterested superior, in a manner satisfying the BJR; or (3) The rejection is authorized or ratified by disinterested SH, and the rejection is not a waste of corporate resources.



4. Corporate opportunities in non-traditional areas, claims purchase and selling of stocks as usurping a beneficial
opportunity. a) IPO stocks w/in line of business and rxble expectancy. (In re eBay). b) Possible new issuance of stock to raise $$ not w/in rxble expectancy. (Martha Stewart Omnimedia). E. Fiduciary duties of dominant shareholders 1. Generally, courts are far less concerned about conflicts of interest among SHs than among board members or executives because: a) Unrealistic to police due to the large number of SH of a public corporation; b) Not as involved in the day-to-day operations and usually individual SHs have very little influence over the management opportunities; c) Institutional SH hold stocks in such a wide variety of companies that it would be unrealistic to expect that they would hold no conflicting stocks. 2. Where one shareholder (another corporation) completely dominates a subsidiary corporation and there is evidence of self-dealing, the courts will scrutinize dealings for intrinsic fairness. (aka no BJR protection). Burden of proof of the fairness of the business transactions shifts to dominant shareholder. Dominant shareholder owes a fiduciary duty to the subsidiary to deal on mutually beneficial terms. 3. Basic situation for application of this rule is the one in which the parent has received a benefit to the exclusion and at the expense of the subsidiary. a) Using subsidiary for benefit of parent company. (Sinclair Oil). b) Parent causing a freeze out of minority SH w/o disclosure of windfall. (Zahn). Ratification sterilizing the conflicted transaction. A. DGBL 144(a). No contract or transaction between a corporation and 1 or more directors or officers... shall be voidable solely for this reason, or solely because the director or officer is present at or participates in the meeting of the board or committee which authorizes the contract or transaction, or solely because any such directors or officers votes are counted for such purpose if: 1. (a)(1): with disclosure of material facts, it is approved by a majority of the disinterested directors 2. (a)(2): with disclosure of material facts, it is approved by a majority of the shareholders (***interpreted to not necessarily sterilize an interested decisions if the interested parties have a majority of the shares) 3. (a)(3): contract is fair to corporation at time it is authorized, approved, or ratified B. 141(b). Quorum. A majority of the total number of directors. How many votes needed given a quorum to make a decision. Interested directors or SH count towards a quorum. 1. 141(b) Making a decision majority of the directors present. 2. 144(a)(1) Ratification Affirmative vote of the majority of all the disinterested directors. C. In DE, ratification of the decision of an interested board by a majority of SH can shield the decision from liability. Shifts burden of proof to the objecting SH and basically reinstates the BJR. Requires: (1) majority of (2) independent and (3) fully informed SHs. (Fliegler). 1. Compare DGBL 141 with N.Y. Bus. Corp. Law 713 in Lewis. Does not require good faith on the part of the board. Seems to make validation of a directors interested contract easier than DE. D. Burden-shifting effect of ratification in cases of dominant SH (parent-subsidiary relationship) 1. Where there is a merger (or other transaction) taken between a parent and subsidiary, if the transaction is approved by the majority of the minority, the burden of demonstrating the merger was unfair shifts to plaintiff. But standard still that of intrinsic fairness (not BJR). (Wheelabrator). E. Summary: Effect of fully informed SH ratification 1. Duty of care claims a) Extinguished by informed vote. 2. Duty of loyalty claim against director a) BJR applies b) Burden shifts to P must show waste 3. Duty of loyalty claim against dominant SH a) Std remains intrinsic fairness b) Burdon shifts to P must show unfairness PUBLIC CORPORATIONS


I. Securities: Disclosure and Fairness

A. Capital Markets Markets for trading corporate securities 1. Primary market Issuer of securities (corporation) sells them to investors. (IPO). a) Purpose: To raise capital b) Regulation: Securities Act of 1933. (aka 33 Act, Securities Act)


(1) Rejected merit-based assessment. Understood that some people may want to invest in risky or unusual ventures. (2) 2 Primary Goals: (a) Disclosure (b) Prevention of fraud 2. Secondary market Investors trade securities among themselves w/o any significant participation of the issuer (NYSE, NASDAQ etc.) a) Purposes: 1) Liquidity. More attractive to purchase something on the primary market if it is easy to cash out at any time. 2) Pricing. Also the open market gives a more realistic barometer of the perceived value of the company, aggregates information into value. 3) Diversification. Allows for many potential investors, not just very well connected/wealthy ones. b) Regulation: Securities Exchange Act of 1934. (aka 34 Act, Exchange Act) B. Difficulties in assessing the value of a company. 1. Market capitalization: # of shares * price of share. 2. Asset-based valuation: Look to what the tangible assets the corporation owns. a) A: Can be easy to assess. (Brick & mortar operation). b) D: Doesnt take into account what is done with those assets, good will. (Law firm). 3. Multiple of current sales and earnings: Look at price of similar companies that have been sold in the past and compare sales/earnings figures and extrapolate how. a) A: Based on past sales of similar company so good will is included. b) D: No two companies are exactly the same. Not clear how well the previous companies sold relate. 4. Discounted cash flow method: Look into the future and prognosticate the cash flows into the future and then discount that value to present value. a) A: Allows take into account every possible thing that can affect the firm. b) D: Very speculative. How does the assessor know what to expect in the future? C. Efficient Capital Markets Hypothesis 1. Potential investors engage in all these methods of valuation. Combine all the individual analyses and bits of information possessed by each and the aggregate represents the true value of the firm. 2. Three versions a) Weak form: Future movements in values of a stock do not depend on past values. The random walk. Cannot look to the history of a specific stock and know which way it is moving. Everyone believes. b) Strong form: Market price incorporates all information, including private information. Theory is that is even if one person has valuable information concerning the price of the company, he would trade on it and it would be incorporated into the price. Due to fraud and anti-insider trading laws, no one really believes this theory. c) Semi-strong form: Market price incorporates all public information. 3. Old view: Up until recently, most believe the reality is between semi-strong and strong forms. Believed that all public information was incorporated along with some private information that is incorporated through insider tips. 4. New view: Due to irrational investors, the reality is more between the weak form and the semi-strong form. Even if the well-informed investors take advantage of the foolish investors that create a bubble, there is no way to predict when that bubble will burst. II. Basic Framework of Securities Regulation A. Securities Act of 1933 B. Exchange Act of 1934 C. Comparing disclosure mandated by each Act: Securities Act Exchange Act Transactional Periodic Disclosure by issuers in connection with a primary From 10 (once per security class) market transaction Form 10-K (annual) o File registration w/ SEC Form 10-Q (quarterly) o Provide prospectus to investors Form 8-K (episodic w/in 15 days of major event) Applies to any public sale of securities Applies to registered companies only

III. Securities Act of 1933

A. Definition of a Security 1. Two sets of definitions 2(1) of Securities Act a) List of specific instruments: note, stock, treasury stock, bond, debenture b) Catch-all phrase: Evidence of indebtness, investment contracts, and any instrument commonly known as a security.


c) PLUS context clause escape hatch unless the context otherwise requires. (1) Creates at once a detailed list and a very vague standard for a security. 2. Requirements to find that something is a stock. First of all, it must be called stock. Also must look to the other characteristics associated with common stock: a) The right to receive dividends contingent upon an apportionment of the profits b) Negotiability c) The ability to be pledged or hypothecated d) The conferring of voting rights in proportion to the number of shares owned e) The capacity to appreciate in value 3. Investment contract is one where a person invests money in a common enterprise and is led to expect profits solely from the efforts of a promoter or a 3rd party. a) Howey four-part test. (1) An investment of $ or other valuable property, and (2) In a Common enterprise (a) Horizontal commonality Pooling of interests between the investors and the promoter. (Standard). (b) Vertical commonality Some sort of relationship between the investors and the promoter. (9th Cir.) (3) With an expectation of profits (4) Coming solely (primarily) from the efforts of others. b) Solely from the efforts: Securities holders can have some minor control over the affairs of a company, so solely is not strictly interpreted. Rather, the key question is whether investor is left w/o meaningful control over his investment. Must be impediments to meaningful control, and cannot be a case of lazy or disinterested investors not utilizing the control they have. (Robinson). 4. Sometimes difficult to tell when a particular type of instrument or investment is a security. Failing to properly identify such an instrument as a security is dangerous for 2 reasons: a) Registration requirements: SEC regulations require that securities be registered. Where a lawsuit is filed against a person who issued an unregistered investment, the lawyer must prove (1) it is not a security, or (2) it falls within one of the exceptions to registration, or (3) settle the lawsuit on the best terms possible! b) Where there is an interest in a partnership, the 5th Circuit has held that there is a rebuttable presumption that it is not a security. 5. Securities fraud liability: It is much easier to prove securities fraud than regular fraud under state common law rules. Elements are less demanding and there are procedural advantages such as liberal venue and service of process. Plaintiffs in fraud cases will often attempt to tie them to some security to reap these advantages. So knowing when securities are present is necessary to assessing potential liability. 6. Most common basis of malpractice claims against lawyers is security regulation issues!! B. Registration Process 1. The Securities Act prohibits the sale of securities unless the company issuing the securities has registered with the SEC. 2. Securities Act 5.Three basic rules for registration. Prima facie case for registration: a) Cannot be offered through mail or in interstate commerce unless registration statement has been filed with SEC (jurisdictional requirement). b) Registration: Securities may not be sold until after the registration statement has become effective. c) Prospectus: The prospectus (disclosure document) must be delivered to the purchaser before a sale. 3. Timeline for registration and communications restrictions a) Prior to filing (1) No offering of securities for sale through mails or interstate commerce. 5(c) b) From time of filing until the statement becomes effective (1) SEC reviews submitted registration documents (2) Offers permitted, but no sales (3) Usually takes 20 days. Practically, no offers for sale are feasible b/c company usually does not know the price it will sell the securities 20 days in advance. c) From time registration statement becomes effective ( 5 of the Act) (1) Selling allowed. (2) Prospectus must be delivered to people offered the securities before the sale.


4. Registration requires the company to give extensive information about finances and business to the SEC. This
can involved a large amount of lawyers fees, accounting services, and investment banking services, and can cost a lot of money. For that reason, companies often seek to avoid this expense. 5. Exceptions to the registration requirement. a) Exempt securities Rare and specialized. These never need to be registered no matter how often traded. b) Exempt transactions More common. The exemption from registration works only on the first transaction and does not mean a subsequent transaction involving that same security will also be exempt. 6. Exempt transactions. (Doran) a) Transactions other than with issuer, underwriter, etc. 4(1)d b) Private offering exemption Securities Act 4(2). (1) Four factors relevant in finding a private offering (CA) (a) Number of offerees, relationship to each other and to issuer (i) Knowledge & sophistication of investor (ii) Sufficient information disclosure, basically the equivalent to the type of information a registration document would have provided. Can be accomplished through: (a) Disclosure to the offerees (b) Effective access to relevant information (b) Number of units offered (c) Size of the offering (d) Manner of the offering 7. Regulation D Promulgated to clarify the requirements for finding a private offering. Provides for a safe harbor for private offerings. a) Rule 504: Not more than $1M (1) Direct the offer to unlimited # of persons. b) Rule 505: Not more than $5M (1) Direct the offer to no more than 35 buyers c) Rule 506: Greater than $5M (1) No more than 35 buyers (2) All the buyers must pass a series of tests of their financial sophistication. d) All these rules apply only where the security is not advertised widely and generally not available to the public! e) Still must report the sale to the SEC afterwards. 8. Regulation D exempts only the initial sale, so buyers can resell only if they find another exemption. Plus resales can count towards the number of buyers in the original sale, and thus take the issuer out of the protection of the safe harbor! a) Issuers should make reasonable inquiry into the buyers plans. b) Rule 144 provides a partial safe harbor if stock held >2 years and re-sold sparingly. C. Civil liabilities for fraud and failure to follow registration procedures. 1. Express private rights of action a) Securities Act 11. Misrepresentation in registration statement. (Escott v. BarChris). (1) Elements for a successful cause of action: (a) False statements or omissions (b) Materiality (average prudent investor standard) (c) Defendants (all who sign or take part in the creation of the registration statement + BoD) do not establish affirmative defenses (2) Due Diligence defense (see below and Escott v. BarChris). b) Securities Act 12(a)(1). SL for offers & sales in violation of 5 (gun-jumping enforcer) c) Securities Act 12(a)(2). Misrepresentations in prospectus/oral sales. 2. Implied private rights of action a) Exchange Act 10(b) & SEC rule 10b-5 (other securities fraud & insider trading) b) Exchange Act 14(a) and proxy rules (misleading proxy statements). Exchange Act of 1934 A. Integrated disclosure system 1. Many of the disclosures required under the Securities Act involve a substantial amount of overlap with the disclosures required for registered companies under the Exchange Act. a) Securities Act = transactional disclosures b) Exchange Act = periodic disclosures



2. To increase efficiency, the SEC has adopted the integrated disclosure system. Centers on the disclosures
required by the Exchange Act. 3. Exchange Act reporting forms and their functions a) Form 10 Initial registration. Needs to be filed only once for a particular issuer and class of stock. Extensive disclosures. b) Form 10-K Annual disclosure. Includes audited financial reports and managements report of the previous years activities. c) Form 10-Q Quarterly disclosure. Filed the first three quarters of the year. Unaudited financial statements and managements report to shareholders. d) Form 8-K Episodic disclosures. Filed within 15 days of important events affecting the corporations operations or financial condition. 4. Regulation S-K: Adopted uniform disclosure standards for both Acts, so virtually all filings are now prepared under identical instructions, thus reducing the transaction costs associated with various disclosure obligations. Resembles form 10. 5. Integrated Securities Act forms a) S-1 Basic registration statement form, requires detailed disclosure of both information about the issuer and about the transaction. (No savings). b) S-3 Integrated form. Permits company to integrate information about the issuer from the most recent 10-K form filed. Thus only the disclosure information about the current transaction must be added. (1) Prerequisites to use of S-3 form (a) Large substantial number of shares outstanding (b) Seasoned has been a reporting company for several years B. Securities fraud 1. Exchange Act 10(b) a) It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality. b) Not self-executing. Simply states that Congress is concerned about such fraud. But delegates the power to set forth specific rules to the SEC. 2. Rule 10b-5 (must know these NUMBERS!) a) Most famous, and arguably most important, SEC regulation. Most broadly applicable anti-fraud rule in the federal securities law and undoubtedly the provision utilized most often. b) Breadth: No requirement the security be registered w/ the SEC. If a security is sold, 10b-5 applies. c) It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, (1) To employ any device, scheme, or artifice to defraud, (2) To make any untrue statement of a material fact OR TO OMIT to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (3) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, d) ... in connection with the purchase or sale of any security. 3. Rule 10b-5 has been subject to significant judicial interpretation and gloss. Has in effect accumulated a body of federal common law surrounding it. Clearly makes securities fraud criminal. A private civil action has been implied. 4. Elements of Rule 10b-5 claim a) Jurisdictional nexus b) Transactional nexus (purchase OR sale, excludes a person who refrains from action) c) Materiality d) Reliance e) Causation f) Scienter (knowing or reckless intent to deceive) 5. Two key questions: a) Whether a misrepresentation of preliminary merger discussions are material within the rule, and what standard should apply to determine materiality. b) What standard should apply in determining causation of harm to SHs for material misrepresentations? 6. Materiality: Substantial likelihood that the disclosure of the omitted fact, for which there is a duty to disclose, viewed by a reasonable investor as having significantly altered the total mix of information made available. (Texas Gulf Sulphur). a) For materiality of events of speculative or contingent nature, adopted the 2d Cir. formula: [probability of transaction] x [magnitude of the event] [totality of company activity]


7. Reliance: Fraud-on-the-market theory (Basic Inc. v. Levinson). Promotes reliance and belief on the work and
analysis of others that have determined the price of the stock. Thus, a plaintiff should not have to demonstrate actual reliance on the misstatement, because it is reasonable to rely on the price as an amalgamate of all the information presented to the market. Very important to law because: a) Proving reliance would be extremely difficult, especially for casual investors. Would make it possible really only for the most sophisticated investors. b) Only applies to publicly traded companies. c) This is a rebuttable presumption. Corporation can rebut by showing: (1) the market did not believe the misstatement (2) a corrective statement was made prior to transaction (3) specific plaintiff would have entered into transaction regardless (as a practical matter, impossible especially in a class action) d) Even if the statement was true at the time it was made, if the facts change such that the statement can lead to misperception, the corporation must retract or correct. e) If one of the managers, who was in the dark about the matter, makes a statement that is untrue, those managers who are aware of the truth are obliged to correct the misperception. 8. Causation: Two types of causation must be demonstrated, transactional and loss. a) Transaction causation also presumed where material + fraud-on-the-market. b) Loss causation, must show you have lost $$ due to misrep. (more difficult = battle of experts). 9. Judicial limitations on actions under Rule 10b-5 a) Standing: Persons who have not bought or sold securities cannot bring claim. b) Scienter: Definition: Intent to deceive, manipulate, or defraud. Recklessness counts. c) Secondary liability and Scope of Interpretation: No implied action for aiding and abetting violations under rule 10b-5. Scope of interpretation is controlled by the text of the statute 10(b). Look to express causes of action for guidance. Act regulating fraud Persons potentially liable Std. of liability What fraud is covered Rule 10b-5 Anyone making fraudulent Several elements, most Any fraud or material statements in connection w/ the important is scienter misstatement in connection w/ purchase or sale of security. (recklessness or intent to a purchase or sale of a commit fraud.) security. Exchange Act 11 Listed persons in the act, Presumption of liability unless False or misleading statements essentially the issuer, all signers defense of due diligence can be in the registration documents of registration statement & all established by s. NO defense at the time they become experts involved (certifying). for company (strict liability). effective. Exchange Act 12(a)(2) Issuer or person acting on its Presumption of liability unless Fraud or material misstatement behalf to sell the security. can show unaware and in in the prospectus or oral exercise of rxble care could not statements relating to have known about falsity. prospectus in offer OR sale.

Due Diligence Defense Experts


Expertised portions 1. Reasonable investigation (at expert level), and had reasonable belief the statements were true. 2. Expertised portions were taken out of context or otherwise do not reflect actual experts assessment. No reason to believe, and did not believe, that the expert statements were misleading. No investigation requirement. INSIDER TRADING

Nonexpertised portions No liability.

After reasonable investigation, had reasonable belief that the statements were true.

I. History & Background

A. Rule 10b-5s greatest impact is to prohibit most instances of trading securities on the basis of inside information. According to this view, insider trading may be considered an omission of a material fact (the inside information) in connection with a purchase or sale of a security. B. At common law background, there were two basic rules for insider trading: 1. Can trade anytime (majority). Directors have fiduciary duty to corporation, not SH.





2. Disclose or abstain (minority adopted today) C. Theories for when trading on non-public information results in a violation. 1. Fiduciary duty (traditional theory) The trade must have resulted in a violation of a fiduciary duty. Generally outsiders cannot be held liable for trading on the information. Narrow scope. 2. Misappropriation theory If information given in confidence and not for the use of private gain, one cannot use it to trade to ones advantage. Can reach some outsiders who trade on information they should not have received or intended for another use. More expansive. 3. Level playing field theory Law should protect against unfair use of insider information by anyone to ensure a level playing field for investors. Use of this privy information for private gain is not permitted by anyone. Very expansive. D. Current rule per 10b-5: A person violates rule 10b-5 if he breaches a duty of trust and confidence owed to any of the following: 1. the issuer; 2. shareholders of the issuer; or 3. in the case of misappropriation of confidential information, the person from whom it was misappropriated. E. Penalty for violation 1. Exchange Act 21(d) SEC civil penalty for insider trading: 3x the insiders profits. 2. Damages to shareholders or others in private action 3. Criminal penalties Definition of material inside information. A. What is material inside information? 1. Applies to situations that are extraordinary in nature and which are reasonably certain to have substantial effect on the market price of the security. 2. Encompasses not only disclosure of earnings and distributions of a company, but also those facts which affect the probable future of the company and those which may affect the desire of investors to buy, sell, or hold the companys securities. 3. Materiality is often assumed when the insiders are actively trading based on a particular bit of information. A kind of behavioral finding. (See Texas Gulf). 4. Does not apply to an insiders: a) General familiarity with the company b) Superior financial or other expert analysis resulting in educated guesses or predictions B. Where the information does not arise inherently from the position w/in the company, it is not insider information. (Goodwin). C. Anyone who, trading for his own account in securities of a corporation, has access, directly or indirectly, to information intended to be available only for a corporate purpose and not for the personal benefit of anyone, may not take advantage of such information knowing it is unavailable to the investing public. (Texas Gulf Sulphur). D. Insiders such as directors or executives of publicly traded companies have no obligation to provide specific SHs with information regarding the company. The law does not require equal knowledge between insiders and outside SH, only that the insider not abuse his position of greater information. Liability of Insiders A. Usually insider trading involves insiders in the company who stock was traded, but not always. The prohibition also reaches outsiders who trade on such material, non-pubic information that was intended for internal use only. B. Traditional theory: Must have a fiduciary duty TO THE ISSUER before insider trading can be found. (Chiarella). C. Temporary insiders 1. Lawyers, investment bankers etc. have increased access to the much of the same information that corporate insiders have. Even under the traditional approach, a court will find a fiduciary duty among such professionals who are temporarily privy to inside information. 2. But this only applies where the lawyer/investment banker uses information gained from client to purchase the clients stock. (Compare to OHagan.) D. Information provided to another business in arms-length transaction does not make the employees of that business temporary insiders. Under traditional theory, they will be able to trade on that information. Liability of tippers and tippees A. Often such persons will be brokers or market analysts who receive and disseminate or act on insider information. Under the traditional theory required derivative liability. (Dirks) 1. Dirks test: Improper acquisition of insider information and derivative liability for tippee. a) Insider has to breach fiduciary duty (duty of loyalty) to the shareholders by disclosing the information to the tippee, usually where the tip was made for an improper purpose (e.g. money, kickbacks, gifts, reputational benefit etc.), AND


b) Tippee knows or should know that there has been a breach

2. We have a duty problem

a) Difficulty in applying duty to disclose material non-public information to outsiders due to the lack of any special relations (like the fiduciary relationship officers of a corporation have) on which to base a duty. b) Duty on tippee contingent upon insiders duty. So if the disclosure was not to the personal benefit of the insider, then there is no derivative breach for the tippee. B. SEC strikes back: The SEC determined in 2000 that the Dirks tipping regime was an inadequate constraint on insider trading. Issued Regulation FD (Fair Disclosure): 1. If someone acting on behalf of a public corporation discloses material nonpublic information to securities market professionals or holders of the issuers securities who may well trade on the basis of the information, the issuer must also disclose that information to the public. a) If intentional must disclose identical information simultaneously. b) If unintentional (a slipup) must disclose promptly thereafter. c) Encourages use of modern telecommunications (internet, webcasting) d) Basically once you tell some people, you have to tell the others. V. Liability for Misappropriators A. Misappropriation theory: Person commits fraud in connection with a securities transaction, and thereby violates 10b 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. (Chestman). 1. Here duty need not be owed to the issuer or SHs of issuer. B. Rule 10b5-2 (SEC response to Chestman). Non-exhaustive list of 3 situations in which a person has a duty of trust or confidence for purposes of the misappropriation theory. 1. Agreement to maintain information in confidence. 2. Between two people who have a pattern or practice of sharing confidences such that the recipient of the information knows or reasonably should how that the speaker expects the recipient to maintain the informations confidentiality. (Vaguest.) 3. Obtains material nonpublic information from a spouse, parent, child, or sibling, unless recipient can prove that he had no reason to know that the information was confidential. VI. Enhanced liability for Insider Trading During Tender Offers A. Exchange Act 14(e) & Rule 14e-3(a) Prohibits trading on undisclosed information in the tender offer setting, even on the absence of a duty to disclose. Increases insider trading liability within the context of tender offers. Some of the most notorious violations have happened w/in this context. (OHagan). B. Rule 14e-3(a) Liability for person trading on material non-public information who knows or had reason to know the info came (directly or indirectly) from: offeror, target, anyone working for either. C. Rule 14e-3(b) A Chinese wall defense for business associations (institutional traders?), allowing exemption where someone didnt know and there is some procedure for preventing the person from obtaining the information or from trading on it. D. Rule 14e-3(c) Offering person can purchase based on such knowledge (DUH!). E. Rule 14e-3(d) Liability for communication of material private information if rxbly FOS that will be misused. VII. Flowcharts & Analysis (see slides) VIII. Policy: Should insider trading be prohibited? A. Arguments for criminalizing 1. Fairness argument: Level the playing field. Doesnt seem right that some people have access to crucial information just because they work in securities, have connections, or work for the issuer (insider). 2. Undermining confidence argument: Outsiders are less willing to participate if they feel that they are competing with insiders who know better then them. This Bid/ask spread: Increases because there is always the threat that what you think is a fair price may not be so due to inside information, so you will increase your margins 3. Property right theory: Inside corporate information is not your property; it is the property of the corporation. Using it for insider trading is stealing. 4. Prevent incentives for bad management: Dont want management to take low positions on own companys stock and act accordingly. B. Arguments for permitting 1. Volume argument: If one already knows that he wants to buy or sell, it is better to have more transactions in general. (?) But a person may not be so certain that he will want to buy if he knows 2. Market efficiency argument (Accuracy): The incorporate of insider information into the market price results in a far more accurate price of the company stock. More closely approaches the true price of stock because there is less secret information held w/in the company. Approaches strong position of capital markets efficiency. 3. Executive compensation: Level as to insiders and it is a perk of employment at the company.



I. Intro & Background

A. SH do not manage the corporation. The BoD does. SH keep the BoD accountable. B. Voting rights of SH 1. The election of directors a) Slate voting: Each share gets one vote per slot to be voted for a candidate for that particular slot, and candidates with largest number of votes wins. b) Cumulative voting: Each share gets one vote per board position, but can use all votes obtained to cumulatively vote for one candidate. Allows minority SH to assure themselves of some representation. 2. Amendments to AoI and bylaws 3. Fundamental transactions a) Mergers b) Major asset sales C. SH meetings 1. Annual mandatory 2. Special MBCA called by BoD or by SH owning 10% interest. DE law no right for SHs. D. Proxies 1. As a practical matter, in large publicly traded corporations, very few of the SHs own enough stock to have any real influence over corporate affairs, so most do not attend these meetings. (For smaller corporations this may not be true, and a greater proportion of the SHs may show up.) 2. Absent SHs may vote by proxy. Often incumbents will directly solicit these proxy votes from minor SHs, often unchallenged. E. What can a disgruntled SH do? 1. Tender offer try to take over the corporation. Most dramatic. 2. Proxy solicitation Dont want to buy the company. Just want the company to do what you want. Ask SH to designate you as their proxy to vote on who will be on the board. 3. Shareholder proposal F. Proxy fights 1. Proxy fights are where an insurgent group seeks to oust incumbent managers and replace them with others faithful to that group. 2. They do this by soliciting proxy cards to gain sufficient votes to defeat the management. 3. For those that like war! 4. But to turn over the board completely, it can take quite a while G. History of use of proxy fights 1. In the 1950s, proxy battles were relatively common. 2. However, from the 1960s through the 1980s the proxy fight fell out of favor as aggressive investors found that tender offers were a more cost-efficient way to take control. 3. Regulation in 1980s and 1990s increased the difficulty of tender offers, and now proxy battles are returning as a viable method of takeover, or used to increase pressure on management while engaging in a tender offer. Strategic Aspects of Proxy Fights A. In a personal power contest, management cannot seek compensation from the corporation for the expenses incurred during a proxy battle. B. BUT, management can spend a reasonable amount of corporate funds in soliciting proxies, even when the use of such corporate resources may have the result in prejudicing an insurgent group of SHs who are also soliciting proxies, where the dispute involves a bona fide policy dispute. (Levin). 1. Not so much a concern about waste. Usually the amount of money is not so great. The concern is that the management gets an upper hand and it distorts the voting process. 2. Courts do not give much weight to the fundamental conflict of interest the incumbent directors all share: the interest in keeping their jobs. To consider that conflict an issue implicating the duty of loyalty would require BoD to always pay for proxy fights. C. Prevailing insurgent group may ask for reimbursement for costs incurred during the proxy battle if approved by the SHs. (Rosenfeld). D. Regulating proxy solicitation 1. Exchange Act 14(a): Like 10(b), 14(a) is not self-enforcing, but relies on SEC rules to provide it with content. Section applies only to registered securities. a) Rule 14a-3(a): Anyone soliciting a proxy must first provide a written proxy statement filed with SEC.





b) Rule 14a-3(b): Incumbent directors must provide an annual report before soliciting proxies for the annual meeting. 2. What encompasses a solicitation? See Rule 14a-1(i)(1). a) Exemptions 14a-1(i)(2) & 14a-2. b) Examples: Long Island Lighting Co. planned to build a nuclear plant. Certain types of advertising on radio could be considered a proxy. 3. Why regulate proxy voting? a) Make sure SHs are not mislead when voting as to who should be a director of a public corporation. Restrictions on Fraudulent Proxy Solicitations Under Exchange Act A. Rule 14a-9 There is an implied private action for proxy rule violation. While Congress did not explicitly provide for a private right of action, there is a good policy reason to provide for this: helps to enforce the broad remedial purpose of the statute. (Borak). B. Elements of a fraudulent proxy 1. Violation 2. Materiality 3. Causation (not difficult to satisfy if material defect) 4. Remedy C. Requirements for finding a material misrepresentation in a proxy - Must show that an omission or misrepresentation (defect) was material, must show a significant propensity to affect the voting process. (Electric Auto-Lite). 1. In regard to remedies, once merger has gone through, courts will generally not unravel a merger. As a practical matter it would not be easy to do and may cause much harm to the company. Compensation in the form of money damages was more appropriate. D. Proxy statements need only provide sufficient information for SH to understand the relevant information, not to lay out the end analysis. Sophisticated investors can draw their own conclusions. (Seinfeld) Shareholder Proposals A. Another mechanism, besides annual voting, for SH to have a voice in how the corporation operates. However, SH cannot demand or usurp the power of the BoD to make the ultimate business decisions. Not within the power of the SH to order the board around. B. Rule 14a-8. Allows eligible SH to put a proposal before their fellow SHs, and have proxies solicited for them on the companys proxy statement (i.e. expense of soliciting proxies is borne by the company.) C. Eligibility 1. Continuously, for over a year, hold at least $2000 in market value or 1% interest. [Easy] 2. Proposing SH must appear at meeting. [Easy]. 3. Corporations bases for exclusion. Rule 14a-8(i) [Difficult to overcome] a) (4) Personal benefit b) (5) Insignificant relationship Matter is < 5% of business and not otherwise significant. c) (6) Beyond power to effectuate d) (7) Ordinary business matters D. Corporations regularly try to prevent SH from getting proposals on the proxy. Usually where a SH proposal is such that at least possibly it could overcome an exclusion, the corporation asks the SEC for ruling. These rulings can be challenged in the DC Circuit, but are rarely challenged (but see Lovenheim) E. Exclusion for relevance - Ethical and social issues are included, but must be important and there must be some relationship to the corporation. (Lovenheim). 1. Rarely do SH proposals on noneconomic issues garner enough votes to be successful anyway, so corporations are loath to spend much money supporting such initiatives. F. Shareholder proposals cannot involve ordinary business matters that are usually decided as a matter of course by the management. Must be something extraordinary and a major policy proposal. a) Pension plan reform as extraordinary (Dole Food) and ordinary (Austin). SHAREHOLDER INSPECTION RIGHTS

I. Methods to Gain Access to List of Shareholders

A. Rule 14a-7 In response to a meritorious demand for a proxy solicitation, the corporation has the choice to disclose the SH list OR mail solicitation material itself to the SH and bill the insurgents for the cost. B. Most incumbents choose to mail the materials themselves rather than disclose the list. C. If the insurgents want the list (a very good idea), they will have to look to state law for permitting the disclosure of SH lists. Nothing in the federal proxy rules grants a right to obtain SH lists (nor do they prohibit the disclosure. Qualifying shareholder





A. Courts are concerned with the effect a deluge of inspection requests would have on very large publicly traded corporations. 1. Thus, today there are certain requirements that must be met before a SH has the right to demand a SH list or other information. 2. Often this involves meeting a minimum % of ownership (like 5%). Proper purpose A. Must identify the purpose of the request for inspection and determine whether that purpose is not improper. 1. A qualified SH may inspect the SH list of a corporation for the purpose of informing them of a tender offer. Such matters that deal with the potential price/value of a corporations stock is within the purposes of the issuers business, so long as the issuer is a publicly traded company. (Crane v. Anaconda). 2. Purchasing stock for the sole purpose of advancing a social cause is an improper purpose, and such a SH demand for inspection should be denied. Purpose must be germane to ones interest as a stockholder and contemplates concern with investment return. (Pillsbury v. Honeywell). How much info can a SH request? A. Under NY law, where a SH is entitled to a SH list, the issuer corporation is required not only to permit inspection, but to gather easily accessible compilations. (Sadler v. NCR Corp. 2d Cir. 1991) 1. Departs from DE law which requires a corporation to permit inspection by qualifying SH only of lists and information that are available at the time. MERGERS & ACQUISITIONS

I. M & A Transaction Alternatives

A. Proxy contest B. Tender offer C. Stock purchases D. Sale of assets E. Merger/consolidation Steps for Merger Under DE Law A. Approval of BoD (both companies) 1. May modify the articles of incorporation. B. SH must approve (as it is an extraordinary transaction ) 1. Approval must be by a majority of the shares that are entitled to vote. 2. Acquisition of assets (even all) does NOT require a SH vote under DE law, only approval by the BoD. C. Filing D. Appraisal rights (if any) 1. Very limited in DE. Does not apply to: a) Publicly traded companies. b) Or corporations that have stock held by 2000 SHs or more. c) Thus generally applies only to closely held corporations. 2. Must perfect the appraisal rights by: a) Sending notice to corporation b) Vote against the merger Methods for Corporate Mergers A. Statutory merger 1. Combination accomplished by using a procedure outlined in the state corporation laws. (Most are the same.) 2. Terms of merger spelled out in merger agreement, drafted by the parties, which controls the rights of SHs. Considerable flexibility. 3. Requires approval of the votes of both BoDs and SHs. a) No need of SH approval if acquisition does not substantially diminish (new rights less than 20% of total) their control of new entity. 4. Appraisal right SH who vote against merger can demand FMV in cash. B. Practical mergers 1. Acquiring company offer its shares to target SHs in exchange for those shares. Since dealing directly w/ target company SHs, no need for vote and no appraisal rights. 2. Purchasing target companys shares for cash by subsidiary. 3. Asset acquisition: Purchasing all target companies assets in exchange for acquiring companys stock or cash. a) May prevent future liabilities of target company from passing on to acquirer. b) State law varies as concerns SH vote and appraisal rights




c) Target company is left with nothing but shares of acquiring company. Distributes these shares to its SH and liquidates itself. IV. De facto merger doctrine: Asset acquisition and avoidance of appraisal rights. GOAL: Avoid appraisal rights Glen Alden (PA law) List (DE law) Merger SH vote SH vote Appraisal rights Appraisal rights Asset sale (List buying) SH vote No SH vote Appraisal rights No appraisal Asset sale (Glen Alden buying) No SH vote? (did one anyway b/c SH vote (selling all assets!) Transactional form: No appraisal rights for so many extra shares were issued) No appraisal rights SH in either firm, which was the goal of No appraisal rights the corporations. De facto merger bumps the analysis up from this box to the merger box. A. Why try to avoid appraisal rights? 1. Cash drain a) Can raise funds by issuing debt or securing loans. b) More expensive, must hire lawyers, bankers, and pay interest. 2. Uncertainty of what the price will be after appraisal. a) Want to know in advance how much such a major transaction will cost. B. Classic tension between form and substance 1. Form: Viewed strictly as an asset purchase, to which the merger requirements do not apply. 2. Substance: Effected a merger in substance, despite the use of a form that gets around the substantive right. Court found that the substance of the deal was more important. Downside: less predictable, makes it more difficult for corporations to plan. C. After Glen Alden, PA legislature again revised the business code to more clearly state that it intended to dispense with the de facto merger doctrine. Reaffirmed the validity of FORM. 1. Tested in Terry vs. Penn Central (3d Cir. 1981). Subsidiary corporation acquired target. SH sued parent company for denying SH voting and appraisal rights. Court stated that there was no de facto merger doctrine. Dismissed. D. Independent legal significance of merger and asset purchase rules under DE code DE rejection of the de facto merger doctrine. (Arco Electronics). Freeze-out Mergers A. Definition: bids by controlling shareholders seeking to acquire the remaining minority equity stake in a firm deals commonly referred to as minority freeze-out bids. Minority shareholders receive lower premiums and realize lower announcement period returns in freeze-out bids relative to comparable arms-length transactions. B. Why would someone wish to freeze-out other SH? 1. Minority SH may be more pain than they are worth, especially if the dominant SH does a lot of business with the target company. (Like in Unocal case) 2. Capture all the value that the majority SH (allegedly) contributes to the corporation. C. Triangular mergers (see slides) 1. Forms of triangular mergers a) Forward triangular merger Subsidiary is the surviving entity. b) Reverse triangular merger Target is the surviving entity. 2. Steps in a triangular merger a) Acquirer forms subsidiary (a corporation 100% owned by the buyer) b) Subsidiary is capitalized with the consideration to be paid to the targets SH. c) Subsidiary merges with target, paying the targets SH. D. Abrogation of the business purpose rule in DE. Entire Fairness Standard: Majority SH in effecting a freeze-out merger must demonstrate utmost good faith and the most scrupulous inherent fairness to the bargain. (Weinberger). 1. Two basic aspects: fair dealing and fair price. a) Fair dealing: Like procedural due process. Looks to how the deal was structured, the time table, research and analysis of the benefits/drawbacks of the merger, and the withholding or disclosure procedures of relevant information. b) Fair price: Substantive fairness of the bargain to the minority SH who are being involuntarily bought out. 2. Procedural fair dealing embraces questions of when the transaction was timed, how it was initiated, structured, negotiated, disclosed to the directors, and how the approvals of the directors and SH were obtained. (Rabkin).



3. Strategic reasons a minority SH resisting freeze-out may want to enjoin merger rather than get appraisal.
a) Judicial bias in appraisal proceedings (?) b) Holdout Price majority SH increases as control approaches 100%. Good to be HO! c) Tax If near death, less tax if assets stay in stock form than if cashed out. d) Controlling SH may bring assets into corp, freeride on that value e) Real option theory Allows SH to gamble on stock price per appraisal price. E. DGBL 262. Appraisal rights. 1. 262(h) provides that shareholders who dissent from a merger and seek appraisal are entitled to receive cash payment equal to the fair value of the shares exclusive of any element of value arising from the accomplishment or expectation of the merger. 2. Difficulty in ascertaining what the fair value is in a two-step merger with the acquiring company first buying out a controlling SH, then the minority SH: a) One transaction: The premium paid to the controlling shareholder does not affect the appraisal price of the remaining shares purchased in the two-step cash-out merger. Minority SH still only get the pre-merger price! Premium price paid to previous controlling shareholder and subsequent rise in stock price on the market in the interim is irrelevant to the merger price the freeze-out acquirer is required to pay. (Ohio) (1) Prevents dissenting shareholders from sharing in the control premium paid to the controlling shareholder. Makes mergers more attractive. (2) Strongly encourages minority SH to take the tender price, which while not as high as the price offered for the stock of the controlling SH, is still usually above market value. b) Two transactions: After purchase of the controlling SH, the price of the shares rises and a new corporate reality is formed. Once new dominant SH installs management and board and uses these tools to freeze out the remaining minority, must pay the fair value of the shares at the moment of the second stage of the two-step cash-out merger. Value added by acquiring corporation subsequent to purchase part of going concern. (Del.) (1) Permits dissenting shareholders to benefit, at least somewhat, from the price paid to the controlling SH. (2) Prevents inefficient mergers (?) (3) Discourages the two-step merger process, makes it more expensive. 3. Only feasible to seek appraisal (considering large legal fees), where the SH has a very large interest in the company. So even under DE approach, most SH will simply take the tender price. 4. Possible discounts in calculating the value of minority shares in DE a) No marketability discount Doesnt matter that shares have low/no liquidity. b) No minority discount Take entire price of corporation, and give pro rata value. c) Discounts any benefit caused by the merger itself (synergy values 262(h)). F. Business purpose rule: Under Mass. law, controlling SH violate their fiduciary duties when they cause a merger to be made for the sole purpose of eliminating a minority on a cash-out basis. There must be a valid corporate reason for the freezeout merger. (Coggins v. New England Patriots) 1. Two-part test in j/d with business purpose rule a) bears burden of proving that the merger was for a legitimate business purpose. (1) If not, then does not matter how fair the deal was. (2) If for a legitimate purpose, then move onto 2nd test. b) bears the burden of proving that, considering the totality of the circumstances, it was fair to the minority. 2. If a majority SH knows in advance that a valid business reason is required, it may be pretty easy to find some argument for going private and met the business purpose rule. Doctrine of Independent Legal Significance A. In DE, action taken under one section of the DBGL is legally independent, and its validity not dependent upon, not to be tested by the requirements of other unrelated sections under which the same final result might be attained by different means. B. Rationale for doctrine: The various provisions of DBGL are of equal dignity, and the corporation may resort to one section thereof w/o having to answer for the consequences that would have arisen from invocation of a different section. (Predictability and flexibility in structuring transactions!) C. Delaware courts will look to form over substance in this case too, and rejects the de facto non-merger doctrine. (Rauch). D. In Rauch, court used DILS to reject the implication by P that the transaction was a de facto non-merger. That it was not really a merger, but a corporate redemption of his preferred shares w/o payment of the agreed price. 1. GE gone the asset acquisition route, the asset purchase would have been followed by a redemption and dissolution of the company. No corresponding section to 251 permitting approval of a different price for a class of shares. DILS would not apply no equal dignity.



2. In that case, to buy out the preferred SHs at $40 in that case, RCA would have to put an amendment of the
articles of incorporation lowering the redemption price to $40/share to the preferred SH in advance of the redemption. Risky proposition. 3. Same concept permits re-structurings (de facto mergers) under asset acquisition provisions w/o invoking the statutory merger requirements of another section of the law (see above). Equitable Considerations in Review of Merger Fairness? A. Where controlling owner in LLC had practical veto power over 3-person board of managers (could appoint & remove 2 of 3 managers), appointed manager and minority owner could not conspire in secrecy to effect a merger that deprived majority owner of control. Must disclose merger plan and allow him to take measures to protect interest in company. (Castiel). 1. Usually, under the Uniform Limited Liability Company Act, a unanimous vote of members (like owners or shareholders) is required before a merger. However, it permits the LLC agreement contract around it. In Castiel the LLC agreement was unusual in that it permitted a merger based upon a majority vote of managers. 2. Reminiscent of Zahn (tobacco case) in that managers must share the information w/ SH and permit them to act on that information. 3. Here the Delaware court actually elevated substance over form. The substance of the agreement clearly contemplated that Castiel would have a veto power over a proposed freeze-out merger, even if in form that was not actually granted to him. 4. Some serious questions concerning this opinion. a) Does the appointed manager have any independence at all? Must he act only in the best interests of Castiel, or the best interests of the company? b) LLC agreement provided for specific veto power to the venture capitalist in the case of proposed merger or sale of assets. No such protection afforded to Castiel. Does this suggest the court should extend such protection to him as well? Or does the lack of such a provision give rise to a negative inference that Castiel could rely solely on his appointment and removal powers? c) Violation of a duty of loyalty argument is somewhat disingenuous. B. Williams Act 1. Enacted in 1968 in response to a large number of uninformed mergers and acquisitions. Now comprises SEC Exchange Act Rules 13d and 14d. 2. The Williams Act was created in order to protect investors from these occurrences. The bidders must include all details of their tender offer in their filing to the SEC and the target company. Their file must include the terms, cash source, their plans for the company after takeover, etc. There are also time constraints that stipulate the minimum period of time the offer may be open and the number of days after the offering in which shareholders have the right to change their minds. TENDER OFFERS & HOSTILE TAKEOVERS


I. Why would Board of Directors resist a hostile takeover that offers a premium on the stock price?
A. BoD may think that the corporation may be better under their wise guidance. BoD claims it has long-term plans that reduce the profitability of the corporation in the short term. 1. But some say the market adjusts to incorporate the prospects in the long term. Markets recognize the potential for long term growth and increase or decrease the stock price accordingly 2. Others say the market does not prognosticate the long-term future benefits very well. B. Concern about job security eventually all the old directors will be ousted. 1. Can offer golden parachutes to the directors to placate them. Reduces resistance and promotes cooperation. 2. But they look pretty bad. Usually the corporation is underperforming (thus it is a target for a takeover), and these lousy directors are profiting from their incompetence. Similar to bribes. C. Hold out for more money 1. May think that an even greater premium could be attained. 2. Difficult to determine when the max price has been reached, or distinguish hard bargaining from entrenchment. Why would a Board of Directors not resist a hostile takeover? A. Golden parachute B. Knowledge of something really bad about the condition of the company C. Long-term reputational interest 1. If a coveted director, then there will be no problem in receiving another offer. 2. Leaving with a deal that gives SH added value improves reputation and chances of receiving another directorship. Introduction to hostile takeovers in practice - Greenmail






A. A corporation can purchase or redeem its own stock as a method of warding off a hostile takeover subject to some conditions (Del. Bus. Law 160), but the decision of the BoD to effect such corporate purchases may not be centered on perpetuation of control. B. Directors acting in such situations are necessarily confronted with a conflict of interest. But not all have the same pecuniary interests in their position. C. Thus, the burden of proof is on the directors with substantial pecuniary interests to justify the purchase as one primarily of corporate interest (in other words, meeting the BJR), and that they had reasonable grounds for belief that the raider posed a threat. (Cheff). D. Greenmail In the 1980s, the term used to refer to a purchase by corporation of a potential acquirers stock at a premium over the market price. 1. Suppressing greenmail: Congress enacted a tax penalty of 50% on proceeds gained via greenmail defined as gain from the sale of stock that was held for less than two years and sold to the issuer on an offer not made on the same terms to all SHs. Seems unethical, may act as an expensive deterrent to takeovers, which may be a better 2. Defense of greenmail: Acts as a wakeup call to corporations that are poorly managed or organized. Even if the corporation needs to buy the person off, his attack may have provided valuable information to the corporation as to its weaknesses and areas that need reform. Rewards the greenmailer for his extensive research that basically is disclosed to the market through his actions. New takeover mechanisms, defenses, and regulation A. Two-tiered front loaded cash tender offer Offering a substantially higher price in a tender offer for the first 51% of the stock in a company (front-end), and announcing plans to merge the remaining shares into another firm at a lower price (cashout). 1. Some court thought such offers were coercive. SH were faced with the proposition of losing out on the higher price (at least for 51% of their stock) if they didnt act fast. 2. Such a tender offer may force them to forego a potentially more lucrative corporate raider offer that they believe may come later. 3. But, on the other side, in a straight up tender offer, may SH may have the incentive to freeride and not tender their shares, assuming that the purchaser has a plan to increase the value of the stock beyond the offer price. Thus the two-tiered front loaded cash tender offer is simply and ingenious way to combat freeloaders. B. Williams Act (codified at 13d, 14d-e under the Securities Act of 1934). 1. Apply only to securities registered under the Exchange Act. Regulates TENDER OFFERS 2. 13d Notification requirements for purchasers of greater that 5% of a certain class of a companys stock. Must file Schedule 13D disclosure statement (and update if anything changes): a) Identity of the acquirer b) Source of funding for purchase. c) Intentions for influencing control or effecting a takeover or liquidation of the company. d) Total # of shares owned, beneficially owned, has a right to purchase or are controlled by associates or affiliated groups with a common plan. e) Other contracts related to acquisition, control, or economic interest in the securities. 3. 14d Makes it unlawful (via the mail/interstate commerce/national securities exchange) to make a tender offer for at least 5% of a class of securities w/o filing the documents required by 13d. a) If tender is over-subscribed, acquirer must accept stock on a pro-rata basis. b) If the price is subsequently raised during the period of the tender offer, then acquirer must pay the higher price to all SH who tendered, even early ones who tendered at the lower price. c) Tender offer must be kept open for at least 20 days. Acquirer can revoke w/in first 5. 4. 14e Criminalizes untrue statements or ... omit to state any material fact ... or to engage in any fraudulent, deceptive, or manipulative acts ... in connection with any tender offer or request or invitation for tenders. a) This creates heightened scrutiny for insider trading during tender offers. 5. Target company has to file a disclosure as well: support, take no position, or oppose and state reasons for opp. 6. 10-day window before filing gives some leeway in making acquisitions before disclosure. But would not likely permit the acquirer to secretly acquire more than 5%, because the purchase of such large volumes of shares w/in such a short space of time. C. Defensive measures 1. Self-tender for shares (excluding or including hostile acquirer). 2. Poison pills 3. Supervoting rights 4. Management Buy-Out (MBO) White knight corporation teams up with management to provide some equity (the rest is leveraged by lenders) to a subsidiary corporation that will purchase the target company, thus preventing the takeover by a hostile acquirer. Management saves their job. White knight gets favorable terms. Unocal standard for review BoD action in face of a hostile tender offer. (Intermediate review, or enhanced BJR).


A. Burdon on the BoD to show: B. Good faith and reasonable investigation of the situation (usually duty of care). C. Proportional response to the threat (modified aspect enhanced review). 1. What is a threat or danger to the corporate policy or effectiveness? a) Coercive offers (especially 2-tiered front-loaded tender offers) (Unocal) b) Inadequate price c) Timing of the deal, may be done to confuse SH or scuttle a competing deal (Paramount I) d) Insufficient information provide = SH tendering in ignorance e) Takeover that will not allow SH the option of remaining (Paramount II) f) Threats to corporate culture (Paramount I) D. The Unocal doctrine can apply to defensive measures that are adopted to ward off possible future advances too. E. The Unocal doctrine applies to unilateral BoD action. Ratification by SH re-imposes deferential BJR. F. What is a proportionate response to the threat posed by the tender offer? Unitrin v. Am. Gen. Corp. (Del. 1995) 1. Not draconian (not overkill) 2. Not coercive (has the effect of compelling SH to side w/ management) 3. Preclusive actions (dead hand & no-hand poison pills) G. Revlon duties: Where the company is up for sale and change of control OR break-up is imminent, BoD must auction company off at the highest possible price and maximize shareholder value. 1. Once it becomes clear that the company is up for sale, BoD has a duty to auction the company off to the highest bidder and maximize SH profit from the transaction. a) Triggering Revlon Company up for sale (1) Corporation initiates an active bidding process seeking to sell itself or to effect a business reorganization involving a clear break-up of company. (Revlon) (2) In response to a bidders offer, a target abandons its long-term strategy and seeks an alternative transaction involving the break-up of the company. (Revlon) (3) A publicly traded corporation with no dominant SH negotiates a merger with an acquiring company that would become the dominant SH change of control. (Paramount II) 2. To satisfy Revlon duties, the BoD of the corporation in play must: a) Become informed of the alternatives b) Maximize current SH value 3. BoD CAN favor one contender over another, but only if such favoritism enhances SH value. Cannot erect unreasonable barriers to the sale (especially discriminatory ones) that act to reduce the profit SH will receive from the sale. 4. If the board satisfies its Revlon duties BJR applies. If not must prove entire fairness. H. Can take consideration of other contingencies other than the SH, but only if the concern over them rationally relates to benefits accruing to the SH (compare with Cheff). I. SEC RESPONSE: After Unocal, SEC prohibited issuer tender offers other than those made to all SH. Rule 13e-4(f)(8). VI. ALI Proposed Rule: 6.02. Action of Directors That Has the Foreseeable Effect of Blocking Unsolicited Tender Offers A. The board of directors may take action that has the FOS effect of blocking an unsolicited tender offer, if the action is a reasonable response to the offer. B. In considering whether its action is a reasonable response to the offer: 1. The board may take into account all factors relevant to the best interests of the corporation and SH, including, among other things, questions of legality and whether the offer, if successful would threaten the corporations essential economic prospects; and 2. The board may, in addition to the analysis under (b)(1), have regard for interest of groups (other than SH) with respect to which the corporation has a legitimate concern if to do so would no significantly disfavor the long-term interests of the SH (more favorable to non-SH interests than DE law) C. A person who challenges an action of the board on the ground that it fails to satisfy the standards of (a) has the burden of proof that the boards action is an unreasonable response to the offer. (BoP on P, not on D BoD more difficult to est. violation) D. An action that does not meet the standards of (a) may be enjoined or set aside, but directors who authorize such an action are not subject to liability for damages if their conduct meets the standard of BJR. (virtually no BoD liability for violation). VII. Poison pills A. Highly complex plans designed to provide a degree of protection against hostile takeovers. Evolved in response to the SECs ban on discriminatory self-tender offers. B. Example of a poison pill -- Shareholder Rights Plans. Typically adopted by BoD w/o SH action. Flip-in/Flip out Plan: 1. Based on a warrant, a separate form of security which grants the holder an option to purchase new shares of stock of the issuing corporation, may provide for discounted purchase price.


2. Three additional elements to this security:

a) Flip-in element Once 20% trigger actually reached, option permits holders other than the acquirer and its associates to buy 2 shares a price. Thus dilutes the value of the stock acquired by the unwanted raider. b) Flip-over element Triggered after 20% is reached and where raider attempts to merge the target into the itself or an affiliate. Permits holders to purchase common stock of the acquiring company at price. Thus dilutes the value held by the acquiring companys SH. c) Redemption provision Permits the BoD of target company to redeem the poison pill warrant rights for a nominal sum. Thus the acquirer is forced to negotiate with the BoD to ensure redemption! 3. Rights attach to outstanding common stock, cannot be traded separately, and are priced so that exercise would be economically inefficient. 4. Distribution event - The right to trade in these rights (warrants) is triggered when someone announces an intention to acquire a certain amount of the companys stock (usually 20%). So they become detached from the stock itself and can circulate on the market. Diffusion results in danger of the flip-in and flip-over effects even where the vast majority of SH in target company agree with the deal! 5. No corporation has ever swallowed a fully implemented poison pill plan with both flip-in and flip-out provisions. C. Back-end share plans 1. Weaker poison pill. Basically sets the minimum price. Permits the back-end SH, following a trigger event, to transform their shares into another valuable package, such as a package of bonds worth a certain sum. (Ex. $65 in bonds (debt) would be granted to the back-end SH to set a minimum price for a tender offer at that amount.) 2. If you want to acquire the corporation through a partial tender offer, must pay the amount. D. Poison debt 1. Can issue poison debt following triggering event that includes highly restrictive covenants such as not permitting the corporation to use the assets of the corporation as collateral for a loan. Gives these debt holders 2. Protects against leveraged buyouts in which the acquirer racks up a lot of debt and needs to sell or use acquired assets as collateral following takeover. E. Lock-up provisions and cancellation fee 1. Locks up the crown jewels of the corporation by giving a White Knight the option to buy them at bargain basement prices. 2. Often combined with a cancellation fee that the target corporation would have to pay if successful in taking over the company. The loss of this money to another corporation makes the target less attractive, but it can also lower SH value from the transaction! (See chart). F. Defensive mechanisms impermissibly infringing on the right of directors to control company. 1. Dead hand poison pill developed to meet the challenge of combined hostile bid w/ proxy contest. Permits the retraction of poison pills only by the dead hand of deposed directors! 2. No hand poison pill Lite version of dead hand poison pill. Permits new directors to retract poison pills only after serving 6 months. Courts rejected the rationale that it gives the new directors a cooling off period, time to adapt and analyze the takeover offer. a) Essentially the courts say that the board has all the power to run the company, but not the power to reduce its own power. G. Many shareholder groups OPPOSE such poison pill plans, as it reduces the chance that a value building merger or takeover can take place. Calcifies the stock to some extent. H. But can increase price in some cases; how lock-up provisions can be good for a target company Starting values W/o lock-up fee W/lock-up fee to Bob for $1M W/ lock-up fee to Bob for $50M Acme Market Cap. $ 70M If Bob knows that Ann Bob will feel secure in Bob would bid no higher than values it greater, he will engaging in the bidding. If he $45M, b/c above that amount Anns value $ 100M not participate because misread Anns max bid, he Bob would make less $$ on the Bobs value $ 95M he knows he will lose wins but above $71M. If hes purchase ($50M). So Ann Cost of bidding $ 1M $1M in the end. right, bids Ann up to $96M would win at $71M (minus Ann bids: $71M (minus 1M) = $95M. $50M) = $21M. a) Lock-up fee in Revlon was not one to encourage higher bidding, but to restrict it. Thus it was unreasonable to the court (like the $50M cancellation fee above). I. Directors are not obliged to abandon a deliberately conceived corporate plan for a short-term SH profit unless there is no basis to sustain the corporate strategy. (At least where the transaction does not involve bartering away the SHs one chance to sell controlling share per Paramount II.) (Paramount I). 1. Case has been criticized simply due to the huge differential between the prices. Paramount was clearly the company that valued Time more. Prices offered werent even close.




Unanimity Norm in Delaware Supreme Court A. Although DE Supreme Court has differing views, they generally try to avoid fractured opinions to avoid ambiguity. However, this does not necessarily make the law any more predicable, it just hides the dispute. Results in fine (unsupportable) distinctions. B. Tensions in Delaware merger law 1. Moral implications a) Popular perception is that hostile acquisitions are immoral or wrong. b) Economically most hostile takeovers are beneficial. 2. Corporate governance tensions a) Good effect: Hostile acquisitions are useful b/c they reduce agency costs (force directors and executives to act MORE for the benefit of the SH, align their interests. (1) Transactional accountability Where takeover is successful, the new management improves the target company. (2) Systemic accountability the specter of hostile takeover forces management in general to manage better and fortifies resolve for necessary, but unpleasant, actions (such as firing employees), as a preventative measure against future hostile takeovers. b) Bad effect: Threat of hostile takeover may cause directors (who want to remain) and SHs (who want value maximized) interests to diverge and increase agency costs. 3. Debate over proper role of management when faced with hostile bid. a) Total management passivity (Easterbrook & Fischel). Controversial approach, b/c general view with sale of property is fighting for the best price. b) Auction (Gilson). Management should seek to play one potential purchaser off the other to obtain the best possible deal for SH. Accords w/ case law. Consequences of a Merger on Employees A. Often mergers will result in downsizing or streamlining. This will often result in massive firings to improve profitability and reduce redundancy. But this is not a problem, because under U.S. law corporations have NO fiduciary duty to the employees, only to SH. B. Worrying about TWO constituencies complicates matters. Especially because these two groups (SH & employees) are often at odds as to what is beneficial. Courts would have a difficult time balancing these interests. C. Implicit Contract Business will ultimately fail if it treats employees too poorly (especially high-value employees). Thus it may be in the best interest of the corporation to take into consideration the concerns of the employees, even though it owes them no duty comparable to the duties to SH. 1. But where there is a very valuable opportunity, the corporation may take it even where it violates the implicit contract with the employees. SHAREHOLDER VOTING CONTROL

I. Public Corporations vs. Closed Corporations

A. Most of the issues involving SH voting and SH agreements are important only to closed corporations. Thus the cases in the section deal almost exclusively with closed corporations. B. How do SH in closed corporations have different interests than publicly traded corporation? 1. Often SH in closed corporations have a bigger share of ownership. Close corporation in DE must have not more than 30 SH. (DGCL 342(1)) 2. If not happy, SH in publicly held corporation can easily exit (liquidity). In close corporation it can be very difficult to divest interest. 3. SH in closed corporations are often employed by the corporation. Much of the earnings of the corporation are distributed as earnings in capacity as employees due to the tax advantage. Brings up conflicts of interest. 4. More important to have methods of resolving disputes btw SH in closed corporation. Essential rights of SHs A. Different j/d require different minimum rights in the ownership of stock. Some require that all stock have voting rights, others, like DE, permit the rights of stock to be manipulated in any way the corporation sees fit. B. Separating voting rights from economic benefits of stock 1. Arguments for: a) Happy to be passive investors, if results in greater dividends. b) Others want to have more control than payment. (Talented CEO who wants to be sure that he will have control, but does not have the $$ to purchase sufficient stock to assure control. 2. Argument against: a) SH with disproportionate control compared to investment and economic rights may not be so interested in increasing the value of the stock (to the benefit of other normal SHs)





C. Limitation on alienation of the voting power of stock in Illinois. (Blackhawk Holding) D. DE General Corporation Law 151(a) does not limit the power of the articles of incorporation to create stock with voting powers, full or limited, or no voting powers. E. Even within classes of stock, voting power can be allocated by the articles of incorporation (P & W v. Baker Del. 1977). Interfering with shareholder voting rights A. Two starkly different tests for analyzing director action in SH voting 1. Blasius standard Consists of two-part test: a) First, P must establish that the board acted for the primary purpose of thwarting the exercise of a SH vote. (See Peerless Systems) b) Then, Board has the burden to demonstrate a compelling justification for its action. 2. BJR In absence of a finding that the primary purpose of boards action was to interfere with or impede exercise of the SH franchise, apply BJR. Very deferential. Usually means the corporate action challenge will not incur liability. B. Blasius standard is considerably more rigorous than either Unocal or Revlon! Compelling justification needed! Like opposite of BJR, finding that Blasius applies is virtually a death knell for the BoD action. C. Usually such interference claims arise out of contests for the control of the company, such as where management faced imminent loss of a proxy contest. D. DGCL 211 Permits electronic SH meetings held at website. If management wanted low SH voter turn-out, would it be okay to hold a traditional meeting? Control in Closely Held Corporations A. SH agreements or pooling agreements SH may band together and contract to vote in concert to obtain benefits for themselves. Where a tie is possible, reasonable measures of tie-breaking to ensure voting trust continues to act jointly is not objectionable. (Ringling Bros). 1. Such agreements can prevent the shifting of alliances over time, if properly enforced. a) Prevents empty core bargaining game. Cycling of results in which at each stage a coalition of voters seek to victimize the newly formed minority, but then that minority approaches one of the two oppressors and offers a better deal, and so on forever. B. SH agreements to perpetuate certain directors and their salaries. 1. View that SH agreements cannot impinge upon the independent judgment of directors. Power to unite is limited to the election of directors and not extended to contracts whereby the power of directors to manage the business is restricted. (McQuade). 2. Limiting McQuade: In a close corporation where incoming minority SH cannot be harmed and all SH are party to the contract, SH agreement to vote shares for a particular person and not decrease salary is valid. (Clark). a) If apply McQuade, the result would be straightforward: SH agreement would be void. Restriction on the director to act on circumstances at a later time. b) Limits McQuade to its facts. There some of the SH entered into agreements that deprived third-party SHs the independent judgment of the directors on the board. c) But easy to defeat the holding in Dodge. If the shares are transferable. Than Dodge could create third party SHs by selling a few shares to outside persons. Then the director constrained by the SH agreement will suddenly have a duty to the third party SH to exercise his independent business judgment. (Homemade McQuade.) d) How to make the SH agreement stick. Prevent home-made McQuade = Make sure anyone purchasing the shares take NOTICE of the existing SH agreement. Print the notice on the shares themselves. 3. DGCL 141(a) The business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors, EXCEPT as may be otherwise provided for... in the certificate of incorporation. [Then the BoD will exercise in accordance with those powers listed.] 4. DGCL 142(b) Officer shall be chosen in such manner and shall hold their offices for such terms as are prescribed by the by-laws or determined by the board of directors or other governing body. C. Agreements by which the SH commit to electing themselves, or their representatives, as directors are generally considered unobjectionable. The problem may arise where the agreements purport to set the executives as well. That involves the discretion of the BoD, not SHs. D. Voting Trusts (DGCL 218) SH turn over share to a trustee to vote for them. Trustee votes in their stead and according to the rules in the document establishing the trust. Maintains control in some family or group. 1. Potential advantages: Avoid potential of deadlock, guards against danger of oppression, enhances voting power of the group. 2. Potential disadvantages: Must really trust the trustee, some states limit the duration (MBCA renewable 10year terms). E. Irrevocable proxies



I. Characteristics of a LLC
A. LLC combines features of a corporation with features of a partnership. 1. Limited liability for its members 2. More flexibility in developing rule for management and control a) By all its members like partnership b) By managers who may not be members like corporation 3. Advantageous tax implications a) Taxed only once on the profits, like partners in partnership. Members can take individual tax deductions for any losses losses pass through. b) Corporations are taxed on their profits, and the SHs are taxed again on the profits distributed to them. No deductions for SH if stock goes down. 4. Some fees at formation for LLC, but modest that are not imposed on partnerships. 5. Right to participate in control (default) like partnerships: majority on mundane, unanimous on extraoridinary. B. Terminology of an LLC vs. Corporations 1. Managers = Directors 2. Members = Shareholders 3. Articles of Organization = Articles of Incorporation (but more cursory?) 4. LLC Operating agreement = Bylaws (also some aspects of Articles of Incorporation) C. Introduced in WY in 1977. 1. Used to be specialized to exploitation of real estate and mineral rights. 2. In 1988, IRS loosened the rules on tax pass-through. Suddenly all states passed them and LLCs became very popular. D. Why would anyone stay with corporations? 1. Network effects easier to communicate/work with others when you have the same form as anyone else. (Like use of PCs vs. Macs). a) Some claim network effects are not that big of an advantage for corporations. Look to the growing popularity of LLCs. 2. Greater legal certainty, long precedent, less litigation costs. Comparing LLCs to Corporations (SEE SLIDES!!) Requirement of notice A. To claim the benefits of limited liability and avoid personal liability on a contract, agents of an LLC must disclose that he is acting on behalf of an LLC. (Westec). 1. In agency law, member of LLC was acting for the benefit of a partially disclosed principal, and therefore was personally liable on the K. 2. Agency law often circumvents the limited liability protection of LLC and corporate law. MUST know the principles of agency! The LLC Operating Agreement A. Steps to create an LLC 1. Certificate of Formation (Articles of Organization?) relatively brief and formal document. Does not provide much information and contemplates a later filing of the LLC agreement. a) Must specify whether will be partnership-style, or manager controlled. 2. Pay filing fees and franchise tax 3. Choose a name (often must list a designation that it is an LLC! See above.) 4. LLC Agreement Analogous to Articles of Incorporation in the corporate context. a) Operating agreement can trump the articles of organization as between members. b) But 3rd parties can rely on the Articles of Organization, so if the new rule has something to do with outsiders, better to amend. B. Conversion of Partnerships to LLCs 902 1. Can be done relatively easily if the partnership was formed after the advent of LLCs and recognizes the possibility of transfer. 2. No retrospective limited liability for general partners for liabilities incurred before the conversion to LLC. C. LLC Act 18-1101 It is the policy of the Act to give the maximum effect to the principle of freedom of contract and to the enforceability of LLC agreements. Grants broad discretion to structure the business relationship. 1. But cannot contract around the following provisions (103(b)): a) unreasonably restrict a right to information to access to records b) eliminate the duty of loyalty, but the agreement may:




(1) identify specific types or categories of activities that do not violate the duty of loyalty, if not manifestly unreasonable; and (2) specify the number or percentage of members or disinterested managers that may authorize or ratify, after full disclosure of all material fact, a specific act or transaction that would otherwise violate DoL c) unreasonably reduce the duty of care D. Only when the LLC agreement is inconsistent with mandatory terms of the states LLC Act will the terms of the agreement be invalidated. Agreements in derogation of the LLC act are not narrowly construed. (Elf v. Jafferi). E. Derivative actions by members against LLC is permitted by DE law (another ex. of hybrid). (Elf v. Jafferi). V. Piercing the LLC Veil A. Even in absence of specific statutory language, court found that the equitable doctrine of piecing the corporate veil could be applied to LLCs. (Kaycee Land & Livestock). B. Some state statutes authorizing the creation of LLCs specifically state that veil-piercing applies to LLCs under similar conditions as to corporations. C. But what formalities and procedures must LLCs follow? Much more relaxed business structure, so it seems difficult to imagine what action would trigger veil-piercing. (But see Haack). 1. Can be organized like a partnership, in which case no formalities would be necessary. 2. Even if organized more as like a corporation, members often act as managers and may confuse roles. VI. Duty of Loyalty in LLC A. LLC Agreement can provide for direct competition by members with the LLC itself and other actions that in the corporate context would be clear breaches of loyalty. (Hunt Sports Enterprises). B. Operating agreement of a LLC may, in essence, limit or define the scope of fiduciary duties imposed upon its members. Permits members to even contract around the duty of loyalty! (See restrictions above) C. But in the absence of such a limitation, members of an LLC owe each other the duty of utmost trust and loyalty, just like in other contexts. VII. Dissolution A. Steps for dissolution 1. File articles of dissolution at the appropriate state agency (the one under which it was formed). May be optional. 2. Notify creditors of dissolution and claim filing procedure or deadline. 3. Distribute company assets to creditors in order of priority. 4. Members may be liable to remaining creditors up to the amount of assets they received from the liquidation. B. Members must effect an appropriate dissolution of an LLC to maintain limited liability shield from the LLCs debts. Must distribute remaining LLC assets in the order of priority. Failure to do so can result in personal liability. (Haack). CORPORATE DEBT

I. Terminology
A. Types of corporate debt 1. Debentures long-term unsecured debt obligations 2. Bonds long-term debt obligations secured by property of the debtor 3. Notes shorter term (less than 1 year) debt obligations. B. Indenture Document containing the contractual terms of the debt, including any covenants the corporation assumes in exchange for the funds. 1. Highly standardized language. Not usually negotiated by either party to the contract, but included as a matter of course by the underwriters. Rights of Bondholders A. The rights of bondholders are governed by private contract. Corporate officers and directors owe no fiduciary duty to these holders of debt. Thus, if they want to protect themselves from action taken by a particular debtor BoD, they must seek assurances in the contract rights (covenants) in the indenture. B. Primary interest of bondholders 1. Interest rate to be paid. 2. Creditworthiness of the corporation issuing the bonds. C. Corporate indenture trustee 1. Representative of the bondholders charged w/ enforcing the rights in the indenture. 2. Conflicts of interest a) Trustee likely part of a bank, and that bank may have loaned money to the same corporation. b) Trustees need to attract new business c) Appointed by the issuer




D. Highly standardized language of bond indentures leaves no room for ambiguity. Meaning of the terms is a question of law, not of fact. Rejected textualist approach, but a functional approach balancing the rights of the party and implied intent. 1. Term permitting the merger or consolidation of the all or substantially all of the company precluded finding that a party could sell off assets one by one until only enough remained to cover debt and then sell the remains to another acquirer. 2. Term protects the bondholders from having the underlying assets stripped away and holding debt vastly more risky that initially planned, while permitting the debtor flexibility to merge or consolidate the whole company if it chooses to do so. (Sharon Steel Corp, - accelerating payment of bonds for P). E. No implied rights not based on clear rights in the indenture. To do so would re-write the contract entered into by parties. 1. If bondholders want to prevent the corporation from taking on massive new debt in a LBO, covenants against such behavior must be bargained for. 2. Representations to lenders of the high credit rating and low debt-asset ratio do not amount to an implied right or estoppel against the company acting to degrade credit rating. (RJR Nabisco denying recover to P, but still won?) Dangers to Bondholders A. Besides contractual guarantees, very little control over the corporations and no fiduciary duties owed. B. Corporation can take actions such as assuming a large amount of debt that drops its investment grade rating and therefore depreciates the value of the long-term bonds by increasing the risk of bankruptcy. Drops the probability of payment.