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I.

THREE FORMS OF BUSINESS ORGANZATION

1. Agency: sole proprietorships, the simplest form of business organization, can be terminated at any time
2. Partnership: simplest form of jointly owned business firm, subject to dissolution at the whim of any partner
in the absence of a K. Binding third parties relationships and how relationships evolve where there are
multiple owners.
1. General al liable for partnership debt and share equally in profits.
2. Limited carves out the control portion and the loss portion so that the general partner controls the
business decisions and the limited partners have no controls in the partnerships, so their losses are limited to
their investments.
3. Corporation: most stable, complex, and socially important form of business org
1. Closely held owned by few ppl, often also directors. Like when only your friends and family are
shareholders, almost all shareholders play dual roles as serving the company and as shareholders (akin
to general partnerships)
2. Publicly held owned by vast amounts of ppl, shareholders not all directors

II. BASIC PRINCIPLES OF BUSINESS ORGANIZATION: 3 theories we rely on

1. Efficiency: economists say that they want people to be as happy as possible and need them to be as wealthy
as possible for their happiness to happen! Goal is to achieve maximum output with minimum waste
a. Intuitive Notions: greed is good, efficiency is when things are not wasted, the laws correct role is
to assist people in their greed. Use minimum inputs to get the max output while eliminating waste- $!
b. Formal Notions: corporate law succeeds when increasing individual utility
i. Pareto Efficiency: distribution of resources is efficient if no one could be made better off without
making someone else worse off, such is said to be pareto-optimal. Look to voluntary exchange
to gage efficiency.
1. Look at peoples utility and happiness in the world.
2. Difficulties: (1) uses utils, where are difficult to define because focuses on measuring
someones happiness or usefulness which is subjective and hard to judge (2) ignores the
initial distribution of wealth in society [could make rich richer and poor poorer and still be
efficient] (3) almost impossible to implement b/c very likely someone is going to be worse
off [i.e. rule against fraud wouldnt be Pareto-optimal b/c itd make the fraudster worse off]
ii. Kaldor-Hicks Efficiency: also known as the wealth maximization model. Efficiency is attained
if the people who benefit from the transaction have benefited more than people who were harmed
by the same transaction lost thus this looks to the aggregate and asks did winners win more than
losers lost. Better than Pareto b/c focuses on wealth rather than ungageable utils. Can those
whove gained compensate those whove lost?
1. Difficulties: (1) ignores initial distribution of wealth (2) ignores impact of distributional
consequence, exacerbation (3) some things are not monetary
2. Hypothetical too, trades dont actually have happen
3. Gentile says: This is the best and right standard for evaluating agency, partnership, and
corporate law. Whenever we look at a rule, we will focus on whether or not that rule
maximizes wealth; whether or not the winners win more than the losers lose; whether or not
it assists people in their greed. All of business law is and should be designed to allow
business people to achieve Kador-Hicks efficiency. Business law is and should be about
Kaldor-Hicks efficiency.
c. Macro Theory: Courts use fairness to stand in for economic efficiency in their decision making, by
doing this the courts eventually reach an efficient decision b/c we eliminate waste and facilitate greed,
thus once we get the big pie, we turn to other areas of the law to distribute wealth, However other
areas of law can compensate for the exacerbation, such as labor law and taxes, wealth distribution.

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2. Theories of the Firm: Minimizing Agency and Transaction Costs: goal of business entities is accomplish
this
a. Agency Cost Theory
i. Specialization (Adam Smith): Hiring individuals to work for you creates tremendous gains- said
corporations were good b/c they allowed people to specialize, improve at their tasks, create less
waste.
ii. Smith stated that economies of scale will increase overall production and reduce waste but that
b/c people dont work for themselves they will not work as hard or efficiently.
iii. Principals and Agents (Jensen & Meckling): Agency cost is any cost associated with the exercise
of discretion over Ps property by A. Nature of Agency Relationship: where P and A have
divergent interests, A would like to work for A and P wants A to work for P, A will follow his own
interest. Worker isnt going to work as hard if his interests are divergent
1. Definition of Agency Costs:
a. (1) Monitoring Costs: energies and monies P will spend to ensure that A is doing his
job / is loyal.
b. (2) Bonding Costs: cost A expends to show P his reliability of Ps interests over As
(i.e. entering into a commission agreement or getting paid per page if youre writing
a book for someone) incentive!
c. (3) Residual Loss: this will always be present, costs arising from divergent interests
even after monitoring and bonding costs are incurred. NOTE: BIGGEST LOSSES
come from mgmt laziness, not from perks, but rather from their laziness w/r/t
business decisions (failure to innovate, explore other options/suppliers/distributors,
etc).
b. Transaction Costs Theory: though we have agency costs, there is efficiency
i. Costs of Transacting (Ronald Coase): argument for why companies exist and no-one is running
around alone in the market place, b/c transacting within a company is more efficient than
transacting on the open market.
ii. Transaction Costs: (Oliver Williamson): these costs are more important, transaction costs
outweigh agency costs, the firm is a set of transaction cost-reducing relationships or governance
structures.
1. Source of costs: searching, negotiating, finding the best price
2. Reduction of costs: though governance structures, like partnerships, corporations, agency
relationships to minimize the transaction and agency costs for the end goal of efficiency
3. Three transactions costs: (1) Asset specificity: how specific is the asset? More specific more
vertical integration makes sense (2) Uncertainty: how much is there within the transaction?
(3) Repetition: how often does the transaction take place? More repetition lower the cost.

3. The Role of Lawyers: goal is to effectively effectuate these enterprises


a. Role of Organizational Law:
i. Nature of Law: (1) Doctrinal/Internal Perspective: how is the case before us now like others we
have seen, how does the doctrine develop as transactions become more complex? (2)
Functional/External Perspective: steps back, concerned not only w/ internal consistencies as
doctrine develops but also with its impact on society as a whole. Impact on society?
ii. Role of Law: assist people in maximizing wealth, distributive should be subsequent and not stand
in the way. Achieve KH solution!
b. Role of Lawyers: reduce/limit waste, facilitate organization of transactions in two ways:
i. Regulatory Arbitrage: making sure people comply with the regulations as closely as possible for
the least amount of money (e.g. minimizing taxes, environmental lawyers would seek to conduct
business w/ the least amount of costs buying the rights to pollute).

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ii. Private Ordering: assist parties in organizing their business so that transaction costs are reduced
and trade is facilitated write Ks that help deals go through, write Ks that help businesses order
their affairs. Makes sure people are signing the right forms and getting her transactions done for
her

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III. ELEMENTAL FORMS OF BUSINESS ORGANIZATION: Agency Law

I. AGENCY LAW (p13)


1. Creation of the Agency Relationship
1. Definition: 2d Rest. 1: Agency is a fiduciary relationship which results from (1) manifestation of
consent by one person to another that the other shall act on his behalf and subject to his control, and
(2) consent by the other to so act.
a. RE 1.02: the one for whom action is to be take in the principal
b. RE 1.03: the one who is to act is the agent
2. Definition explained: parties labeling and popular usage is not controlling. For example, you can say
youre not an agent to someone, but if you fulfill the definition of 1.01, then you are (Cargill).
a. Contractual Relationship: Purely voluntary, all that is necessary is consent by P to agree to
have A and A to agree to perform the act and A must be subject to Ps control
b. Fiduciary Relationship: Duties of (1) obedience (2) care (3) loyalty
A. Granted Authority: The principle can dictate the scope of authority the agent can have
Each decision = 1. Agents: undertakes task or endeavor
what to do in- a. Special Agents: those with authority for a single act or transaction
house and what to b. General Agents: those with authority to conduct a series of transactions
do in the market 2. Principles: owner who engages agent to undertake task or endeavor
consider costs, a. Disclosed Ps: Third parties transacting with the agent understand that agent is acting on
amt. of control behalf of the principle
you have and risks
b. Undisclosed Ps: Third parties are unaware of a principle and believe that the agent =
you are bearing
principle.
c. Partially disclosed Ps: Third parties understand theyre dealing with an agent, but do not
know the identity of the principle.
B. Scope of Employment: The employer is not liable if the employee is not within the scope of
employment.
1. NOTE Independent Contractors: those whos details the principle does not control
a. IC = buy services when you need them rts of control are significantly less extensive and
A can exercise independent judgment VS.
b. ee = establish agency relationship P has rt under the K/deal with A to control details
regarding the scope of ee and how A goes about task
2. NOTE: shareholders dont make decisions, officers and directors do they arent Ps, theyre
As we need ground rules to restrain them and to minimize costs/risks of the shareholders
3. Agency relationship vs. ownership relationship not all people involved are Os and the law
draws a distinction b/w Os and non-Os

I. AGENCY TERMINATION
A. Principal OR agent can terminate at any time will NEVER continue over the objection of one of the
parties
1. K can fix set term of agency
a. Principal can revoke K
b. Agent can renounce K
2. Expiration
a. If there is no set term of time terminates within a reasonable time
b. Special agency terminates when specific act is performed or within a reasonable time

2. Liability of Principals for Acts of Agents (p21)


1. Ask First: Is this a Contract or a Tort?

II. AGENCY LIABILITY IN K

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A. Liability in Contract: Ask did A have authority to enter into K on behalf of P. Authority: A must
reasonably understand from the action or speech of P that she has been authorized to act on Ps behalf.
Three methods
B. TEST: Was there authority? RE 7
C. Both Parties must Manifest Consent: necessary for agent to reasonably understand from the action
or speech of principal that she has been authorized to act on the principals behalf
D. Relevant considerations when determining Agency
1. ees position NOTE: intentions dont matter parties can
2. reasonableness of offered terms unintentionally bind themselves
3. ees communications to 3rd party through ee
E. Actual Authority (From As pov) (btwn P and A)
1. (implied or express): authority which a reasonable person in the position of A would infer from
the conduct of P; communication from the P to A saying to do x
1. Incidental Authority: (included within actual authority unless explicitly withheld): authority to
do those implementary steps ordinarily done in connection with facilitating the authorized act
a. *this is an efficiency rationale for why you would want incidental authority we want
the P to be clear and not to have to K for every single tiny thing (i.e. going to California
and implied that a car would be rented while there)
2. Express authority
a. Clear authority b/c actually tell someone to do something
b. 3rd parties can enforce Ks against principle even if P was undisclosed
2. Custom: such limitations can come through custom and whats reasonable within the scope of
employment. Can define limits of actual authority.
3. Termination: at any time by A or P or death of either.
4. Implicit Formation: P is liable for all things the agent needs to do to get x done b/c there is
implied authority to do everything necessary to do x Jensen Farms v. Cargill (18): (undisclosed
Principal case)
i. Facts: Jenson Farms has a contract with Warren and Warren has a revolving line of
credit that Cargill gave them to pay for the grain from the farmers (like Jenson and
other Ps). Cargill also has right of first refusal on grain. Warren defaults and cant
pay the 88 farmers. Farmers sue Cargill (no sense in suing Warren because theyre
bankrupt!). Alleges Cargill is the principal and Warren is the agent and the Farmers
are the third party. Arguing Warren was the agent of Cargill and it bound Cargill.
ii. Holding: An agency is created through a course of conduct where the facts, taken
as a whole show that one party has manifested consent that another party be its
agent, the second party acts on behalf of the first party and the first party
exercise control over the second party.
iii. Rationale: Factors to find C as a principal: (1) constant recommendations for
business, (2) right of first refusal on grain, (3) W requires approval of C to engage in
certain transactions, (4) purchasing stock and paying dividends w/o approval from C,
(5) checks and audits, (6) C had internal correspondence that stated that W needed
strong paternal guidance, (7) stationary purchased with Cs imprint, (8) C financed
purchases of grain and operating expenses
1. (1) It is efficient to ignore the parties stated intentions and imply an agency
relationship b/c where there is control and consent there should be responsibility,
thus people often find themselves in agency relationships without the intention to
be in one
2. Efficiently mitigates harm to farmers if is getting the benefits, they should
bear the costs AND

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3. Discourages funding default hazards putting itself in a position to be
enriched at the risk of other creditors people more likely to engage in mutually
beneficial K exchanges with this rule
4. Crt is incentivizing monitoring by C and to pay attention to companies if
youre going to expend money and exert control, you have to monitor!
5. Its easiest for P to figure out who is its A and what is what A doing. Placing
liability on P that P will be careful about who is acting as A and how broadly the
A may act.
iv. Hanson v. Kynast (handout)
1. Facts: Allen runs down the field in his Lacrosse game in college and he scores
and falls. An opposing player, Kynast, from Ashland University stands over him
and taunts him. Hanson runs over to help Allen and grabs Kynast and K flips H
and H falls on his head. H sues K and Ashland University. H says K is an agent
to Ashland University.
2. Holding: Schools will never be held liable as principals for their students
because there are too many students so how can they monitor and exert
control over all of them
3. Ct says its not P-A or M-S or ER-EE relationship. Ashland not the principal
4. Factors to determine if relationship is agency/principal: individual
performing in course of business? Individual receiving compensation from the
principal? Whether principal supplied tools and place of work in normal course
of relationship? Length of employment? Right to terminate employee at will?
5. Here, a student pays money for an education, so this is a contractual
relationship where the student gets classes, extracurricular activities, etc.
6. Coach control over players insufficient; any benefits Univ. gets is not enough to
convert this from pure provision of services to this special M-S relationship. No
direct control from the coach when hes on the field.
7. Importance of Financial Elements - K not scholarship player, he buys own
equipment, and no fee charged to watch game. This is part of the undergrad
experience. The notion of financial structure, who bears the risk, to indicate
control doesnt work in these special situations where financial aspects
attenuated. No one pays to watch the games and the university doesnt gain any
financial incentives from the sports

F. Apparent Authority: (Look from 3d party pov) (btwn 3d and P) authority that a reasonable third party
would infer from the actions or statements of P
1. Designed to prevent fraud and unfairness to 3rd parties who reasonably rely on Ps actions or
statements in dealing with A
a. Rationale: Burden is on P b/c P is in the position to tell 3rd party not to negotiate with A
P controlled the apparent authority 3rd party shouldnt have to figure out if P meant
what he said
2. Apparent authority applies even if, unbeknownst to 3rd party, P has expressly limited As
authority (Rest. 2d Agency 32)
3. NOTE: only P, NOT A, can give apparent authority
a. A can maybe bind if 3d Party knows about P and knows A, i.e. is Ps assistant
4. Custom: Such a manifestation can come through custom. Janitorial staff says I need to
purchase supplies. Does the janitor have apparent authority to enter those transactions on behalf

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of the bldg? Yes, ordinarily the duty of janitor. What if janitor asks contractor to renovate the
lobby? No, its not customary for J to engage in these transactions.
5. Policy: to provide an equitable remedy for a 3d that if P implied they can deal with A and then
secretly says to A that he cannot deal with 3d, theres a remedy b/c reasonable reliance on the
Ps actions or statements by 3d when dealing with the agent
6. Termination: when it is no longer reasonable for 3d to believe A still acts with actual authority.
a. White v. Thomas (p22):
i. Facts: White (P) has an A, Simpson. W says to S go to this auction, Ill pay
$250K for the farmland, but not the house or acreage surrounding it. S pays
$327K for farmland and exceeds authority. At auctions close, S says I have
POA for White. Here is the check for the land. W gave S a blank check. S seeks
the Thomas, who purchased the house and land around it, and sells them 45
acres of farmland to bring price to $250K.
ii. Holding: in the absence of a principal and any indicia that an agent has
authority to engage in a specific action on the principals behalf, the agent
does not have apparent authority to engage in such action merely because
the agent asserts she has such authority.
1. (1) Mere assertion of authority does not grant such authority.
2. (2) Court holds for P.
3. KH efficient- easier for 3d to monitor A in this situation (only one P)
4. Check here is evidence of the first contract to purchase the land, not the
contract to sell the land, so even if the check was a manifestation of a grant
of authority to act, it surely cant be to sell property.
5. There were not communications b/n P and 3d and they could have
communicated with the P, hes just one guy! The 3d also knew they were
dealing with an agent. As a 3d, you have obligation to contact the P.
G. Inherent Authority/Power: (from cts pov) (Btwn 3d and P)- General Agent can bind P to
unauthorized K as long as A would ordinarily have the power to enter into such K and the third party
doesnt know that matters stand differently
ii. That which a court finds authority as necessary to protect a third party in his dealings
with A where P was not disclosed and thus neither actual nor apparent authority exist.
iii. Gives general A the power to bind P, whether disclosed or undisclosed, to an
unauthorized K as long as A ordinarily would have the power to enter such a K and
3d shouldnt have reasonable disbelief.
iv. Custom: ill-defined b/c doctrine is a mess
1. RST 2: Requirements
Think generally a. The P held the A out to the public as possessing sufficient authority to embrace the
about who particular act in question or knowingly permitted him to act as having such authority
should bear the b. The 3rd person dealing with the agent knew of such conduct by the P and had reason to
burden of believe, did believe, and acted in reliance on the belief that the agent possessed the
clarifying scope necessary authority
of authority
c. Look to reasonable expectations of scope of employment
whats more
efficient? Fair? v. RST 3, 2.01 (comment B): drops inherent authority as a doctrine- says that other
doctrines encompass justifications underpinning inherent authority including
interpretation by the A, apparent authority, estoppel and restitution.
vi. Janitor example. Here this is efficient but it may not always be. This is more of an
equitable solution; it rests on considerations of fairness to 3d parties, which do not
always overlap with considerations of efficiency.
b. Gallant Insurance Company v. Isaac (p26):
i. Facts: Isaac wants to buy a car from a lot and they wont let her buy the car until she
has her new insurance. The insurance agency, Thompson-Harris, says that its not a

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problem and Isaac can come in Monday and pay, but the insurance will be available
ASAP. Over the weekend, she gets into an accident and comes in on Monday and
tells TH she got into an accident. Gallant says- no no no no, we are not paying that
claim because the agent (TH) did not have the authority to bind Isaac with the new
plan.
ii. Holding: an agent has inherent authority to bind its principal where the agent
acts within the usual and ordinary scope of its authority, a third party can
reasonably believe that the agent has authority to conduct the act in question,
and the third party is not on notice that the agent is not so authorized.
1. Authority: prior course of dealing
2. P must give 3d limitations on what agent can do or else this rule will hold
3. Purpose: to avoid sneakiness and dishonesty from the principal.
4. Efficient? usually unless course of practice develops that isnt any good
anymore for whatever reason. Whats fair is sometimes efficient, but not
always.
2. Agency by Estoppel: (1) failure to act when (2) knowledge and opportunity to act arises (3) plus
reasonable change in position on part of third person. (Rest. 2d 8B) P can be bound by As act
3. Agency by Ratification: accepting benefits under unauthorized K will constitute acceptance of its
obligations as well as benefits (Rest. 82, 83) AND/OR learning of unauthorized K and doing
nothing constitutes ratification P can be bound
1. If A purports to be acting for P, only that P or the intended P can ratify

Did P say to A you have Did P say to 3rd Party A has


authority? Authority
Actual Authority YES NO
Apparent Authority NO YES
Inherent Authority NO NO

4. Liability in Tort (p30): RST 3, Section 2.04: P is liable for torts committed by a class of As, where
there is control (employer-employee relationship but not independent K) and scope of action
a. TEST: (1) Was there any employer-employee relationship (2) Was employee acting within
the scope of his/her employment?
i. RST 3, Section 7.07(3): Employee-Employer: P employs A and controls As physical
conduct in performance of service. (respondeat- superior situation)
ii. RST 3, 7.07(2): Scope of employment: (1) performing work assigned by employer or
(2) engaging in course of conduct subject to control by employer
b. No Liability in tort: when there is (1) no master-servant relationship, this usually occurs
within an independent contract situation
c. Gas Station Cases: (1) Where there is significant financial investment look for indicia of
control b/c control is often linked to financial structure. Those who have capital at risk
normally have control and those who normally have control have capital at risk.
i. Humble Oil & Refining Company (p30):
ii. Facts: Humble Oil has as its proprietor Mr. Schneider and Mr. S hires Mr. M to run
the gas station. Ms. L parks her car on the gas station lot, but forgets to set her
parking break. Car rolls down the street and runs over Mr. Martin and his two kids.
Mr. Martin sues Humble Oil company. Mr. M is liable for not setting the break, but
hes not liable because hes judgment proof and poor.
iii. Holding: A party may be liable for a contractors torts if he exercises substantial
control over the contractors operations.
iv. H liable (the attendant is not b/c poor) b/c only H products sold, has hours set for
him, H had title to all goods in store, rent based on amt of products proprietor sold

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v. Hoover v. Sun Oil Company (32):
vi. Facts: Sun Oil has proprietor B and he hires Mr. S to operate the gas station. Mr. S is
smoking a cigarette while filling up Mr. Hoovers car and a fire happens. Hoover
sues.
vii. Holding: A franchise is considered an independent contractor of the franchisor
if the franchise retains control of inventory and operations.
i. Mr. S is independent and not an agent THUS Hoover is not liable b/c proprietor could
sell any products he wanted, set his own hours, had title to all goods in his store
ii. General for both: Why hold these oil cos. liable? They have the incentive b/c they
bear the risks. They will be responsive to incentives like liability. When you place
liability on someone, that entity will pay attention because it will bear the
consequences if theyre not careful. No point in placing the liability on someone who
cant fix the situation.
a. Considerations Factors for S vs. IC in these cases:
1. Extent of Ms control
2. Employed in a distinct occupation or business
3. Kind of occupation industry norms
4. Requisite skill
5. Who supplies instruments or tools
6. Length of time
7. Method of payment
8. Parties intention
G. Whether P is or isnt in business Main considerations for Gas Cases
1. Control ultimate difference in reconciling 2 cases focus on day to day operations and who
has ultimate say
2. Financial Aspects all are in business to make more, more money at stake = greater demand
for control by P; this demand comes with liability for acts by their agents
3. Policy reasons for liability = deep pockets, spread losses, residual interest in business
a. NOTE: main theme for gas station cases is the ct rules based on efficiency reasons
more efficient to put control where liability is
i. If we assign oil co. incentive, theyll exercise more control going forward to
prevent torts
4. Consequences: as liability increases the company will exert more control b/c they have more
risk
a. BUT NOTE Economic repercussions after this case when/if Oil co. pulls back tort
liability in response to case gas prices will go up b/c prices will be raised for gas
station manager
b. Externality Analysis: someone takes an action that imposes costs on others and
those acting dont bear the cost
Humble / WT Schneider Sunoco / Barone

Humble set hours of operation Barone set hours of operation

WTS sold only Humble products Barone could sell non-Sunoco products

Humble held title to goods that WTS sold on consignment Barone took title to goods

Lease terminable at will Lease terminable once annually

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Rent was at least in part based on the amount of Humbles Barone had overall risk of profit and loss though subsidies
products sold and Humble paid a big % of WTS operating costs from Sunoco to ensure competitiveness

Humble could require periodic reports No written reports reqd but rep visited weekly in advisory
capacity

3. Agents Fiduciary Duties: Methods of Governance of Agency (p34):


1. Problem Contract: cannot properly define rights of parties b/c they have to been amazingly expansive
and thus this is impractical to i.d. every situation, thus the transaction costs would be too high. Whole
relationship is not just going to be defined by contract AND
2. Exit Rights: specifying conditions where parties can opt out; this tends to be too general
3. Solution Fiduciary Duties: 3 duties avoids the hassle of negotiating precise K terms, and avoids
relying on exit rts (investment & immediate w/drawal of capital). Basically we have these duties b/c
contract and exit rights are not sufficient

1. Duty of Obedience (8.07): A must adhere to documents that create the relationship and do what
P says. i.e. act in accordance with the express and implied terms of any contract between the
agent and the principle, duty to do your job, not litigated since rare Q whether you satisfied
obligations of your job, almost always followed
2. Duty of Care (8.08): As duty to avoid negligence and to act in good faith, as per the reasonable
person standard while acting on behalf of P
3. Duty of Loyalty (8.01 and 8.02): Duty not to be a thief.
c. Duty to Account for Profits ( 388) unless otherwise agreed, an A who makes profit in
connection with transactions conducted by him on behalf of P, is under duty to give
profit to P
a. A Must account for unexpected and incidental funds whether or not received in
violation of duty
b. Cannot use acquired confidential info to disadvantage of P and must account for
any profits made by use of such confidential info
d. Acting as Adverse Party w/o Ps Consent: unless otherwise agreed, A subject to duty not
to deal with P as an adverse party in transaction connected with agency duty w/o Ps
knowledge (389)
e. Acting as Adverse Party w/ Ps Consent: duty to deal fairly with P and disclose all facts
which the A knows or should know reasonably affect Ps judgment unless P has
manifested that he knows such facts or that he doesnt care to know them (390)
a. Where A secretly profits from relationship with P, those profits rightfully belong to P.
Resop v. Tarnowski (agency) (p36)
i. Facts: Resop (A) hired to investigate jukebox business, Resop doesnt do his due
diligence and lies, R takes $ from both Tarnowski (P) and sellers. P buys
business, finds out that its a bad business and not at all what he was looking for.
P rescinds sale, returns jukeboxes, and wants all $ he paid returned. Sellers
return to him 9k, Resop received a secret commission to push the deal on Mr. T
of 2k. Mr. T sues agent and wants As secret commission and all costs incurred in
the sale. R thinks that once youve been made whole by the seller that should be
enough.
ii. Holding: (1) an agent is liable to a principal for the agents profits made
during the course of the agency. And (2) An agent is liable to a principal for
the damages caused by the agents breach of his duty of loyalty.

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iii. (2) efficient rule: Court forces him to give back his commission-
Overcompensating P gives A strong disincentive to be disloyal
b. The Trustees Duty to Trust Beneficiaries (//s agency relationship)
c. Accountability for Profits in the absence of a breach of trust (203): Trustee
accountable for any profit made by him through or arising out of the administration of
the trust, although the profit doesnt result from breach of trust
d. Liability in case of Breach of Trust (205): if Trustee commits breach of trust,
chargeable with (1) loss or depreciation in value of estate resulting from any breach of
trust (2) any profits made through breach (3) any profit that would have accrued but for
breach
e. Liability for Breach of Loyalty (206): Trustee liable for losses if he sells property to
himself as individual or trustee or otherwise violates duty of trust
i. Trustee, A, cannot deal in the trust property In re Gleeson (trust) (p38)
ii. Facts: Mrs. Gleeson dies, Colbrook is a long time family friend and Mrs. G
makes him the trustee for Gs 3 children. C also farms land and pays Mrs. Gs
rent- it was right before farming season and Mrs. G died, so he calls up the 2
competent children and says hes going to plant the land and raise the rent he
paid by 2/3 and then hell sort it out. C & C leases the farm land and pays more
than previously. The children arent having any of that, but C says there are
special circumstances. (no time to negotiate the lease b/c it was the end of the
season and the land would have sat fallow and the kids would have gotten no
rent)
iii. Holding: A trustee of real property who is also a tenant of the trust property
must account to the trust for profits made as a tenant.
iv. All the profits he made were turned over to the trust to discourage disloyalty
v. Might not be an efficient rule here- would rather have the land farmed and taken
care of, etc BUT in this case theres no one else who would monitor
vi. where there is no P to oversee A, trustee, there must be a strict rule to regulate the
relationship, protects 3d from A overreaching

II. PARTNERSHIP LAW (p41)

1. General: not a legal person, but rather a number of principles acting through agents An association of two
or more persons to carry on as co-owners a business for profit. UPA 6
1. Overview
a. Each partner individually liable for partnership obligations
1. NOTE: possible to K in a way that //s LL of corporations (i.e. voluntary creditors may
agree to indemnify partners and look only to partnership assets to satisfy claims; LL to
involuntary (tort) creditors may be paid through insurance) BUT this all requires custom
tailoring whereas forming a corp. has these features already
b. Typical in service industries (medical, accounting, law) where trust must exist among
participants and capital needs are not great
2. Types of Partnerships:
a. General Partnership (what we discuss below): (1) All PTRs are responsible for all debts in PT
(2) ppl can go after any PTRs personal assets. i.e. all partners are liable for one anothers
mistakes.
b. Limited Partnership: (1) One general PTR responsible for all PT debt and run the PT (2)
Limited PTRs who contribute only capital and can exert no control so they can never lose more
than they put in, thus they are limited to their investment.
c. Limited Liability Partnerships: No general partner with unlimited liability and complete
control all are limited- not personally liable for others mistakes

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1. The level of limited liability applies only to: negligence, malpractice, wrongful act or
misconduct of another PTR or agent of the PT not under the PTRs direct control
2. Lots of law firms flipped to this one the same day and didnt want their clients to get
anxious that they lost faith in one another and now saying to your partners that youll only
be liable if you supervise them.
d. LLC: (1) Hybrid btwn Corp and PT (2) Have members rather than PTRs (3) limited liability for
members (4) pass through taxation (5) can be managed by PT or outside professionals. Only
liable to the extent of your investment but can be run by professional manages if you choose.
1. But disadvantage- membership interests in LLCs arent liquid, so once you become a
member, you cant sell you interest the same way you can if you owned the stock
2. Nature of Joint Ownership
1. Pros: (1) Operational benefits: (a) Specialization, PTs can divvy up responsibilities, which creates (b)
Lower transaction costs (2) Financial Benefits: Increased access to capital by selling shares of
ownership. Whatever the costs of co ownership after a certain point they may be lower than the
agency costs of the debt contract
2. Cons: (1) Conflicts btwn P and A: discussed above in agency relationship (2) Conflicts w 3d: creditors
(3) Conflicts among Ps- controlling v. minority co-owners
a. Fiduciary Duty of Loyalty: Conflict Among Principals: Joint ventures owe one another the
duty of loyalty so as to require disclosure of future business learned during functioning of PT.
Meinhard v Salmon (47)
b. Facts: M & S are joint venturers and have gone into business together. At the end of the lease
term, a developer approaches S for a much larger project that will cover the entire block, and S
will have to redevelop the land for 80-year lease and a much larger hotel. S uses his own
company, MRC, and cuts M out of the deal. M realizes that S undertook the development and
hes not part of it. M sues for piece of the action.
c. Court rules for Meinard.
d. Holding: Joint adventurers owe to one another, while their enterprise continues, the duty of
finest loyalty, a standard of behavior most sensitive
1. P49: Jt venturers, like copartners, owe to one another, while the enterprise continues, the
duty of the finest loyalty. Not honesty alone, but the punctilio of an honor the most
sensitive, is then the standard of behavior.
2. Must disclose opportunities to your co-venturer so they can make the decision to compete
against you or work with you
3. Options on how to handle dispute (1) Continue on same terms: default rule that effectively
imposes a burden on the parties, ensures there is no competition (2) Compete for New
Opportunity: simple disclosure and market competition (3) Grant Right of First Refusal: EXPLAIN 3
(4) Winner Take All: What S is arguing for.
4. KH efficiency: Strict duty of loyalty is KH efficient b/c: it removes complex outcomes that
would have greater transaction costs; removes the need to contract for contingencies;
creates bright line rule that acts as deterrent and reduces litigation; and strengthens
disclosure requirements between partners.
5. Dissent: Looks at whether the deal was fair because there was no harm, shouldnt
recover

3. Benefits of the Partnership Form


1. Factors:
2. (1) Governance Costs
a. monitoring costs are too high in creative fields like advertising, law, et al; in partnerships, the
managers are the owners and thereby reap the benefits / suffer the consequences
3. (2) Tax Consequences
a. Tax code provides that the taxes to the PT flow through just like everything else

12
b. PT are preferred over Corps for Taxes b/c (a) pass-through-status: the income of the PT passes
through the entity to the PTRs thus the PT itself does not pay tax (b) Also, if the PT is losing
money, PTRs can take losses on their taxes
4. Formation of Partnerships: Association of two or more persons to carry on as co-owners a business for
profit.
1. NY = UPA state (UPA = Uniform Partnership Act)
2. UPA Definition 6 association of 2+ persons to carry on as co-owners a business for profit
3. Consequences: Unless PTs contract around the following, a partnership will exist:
a. (1) UPA 7 -share in net profits, not gross returns
b. And
1. All partners liable as principals
2. All partners are liable for the debts of the partnerships
3. All partners are agents of the partnership
4. All partners share equally in control
5. managing partner has a greater fiduciary duty to other PT and business
4. Trick- you can be in a partnership when you dont intend to be in one
5. Def: Gross returns where ppl are getting commissions and profits where ppl are risking loss
6. A partnership can be impliedly created if the ct finds (1) a sig contribution of labor or skills and/or (2)
profit sharing Volhand v Sweet (52):
a. Facts: V is employer and S employee. V says that hell pay S 20% of the net profits and cover
all of his expenses and S does labor. 10yrs later S claims that he wants to dissolve the
partnership so he can get the money that is owed to him. V says no- youre just an employee
and a commissioned salesman- thats why S was getting a portion of the sales. V says thats
nothing like relying on and sharing the net profits.
1. Holding: Parties dont have to explicitly say theyre going to form a partnership under
UPA 7(4), if they share the profits, they are in a partnership (ct found $ paid to was
profits NOT wages)
b. Partnership here.
c. Thus, Partnership formation req: 1) voluntary K of association for purpose of profit and
loss-sharing and 2) intention to form partnership. The intent required is for those things
that constitute a partnership, not to explicitly be partners.
7. Contribution: It doesnt matter whether you contribute capital or labor and skill.
a. Lack of Daily Involvement: This is not per se evidence of the lack of a partnership.
b. This may be an equitable soln from the ct rather than a KH efficient one.
c. One will work harder if given a stake in the company
d. Relevant UPA:
e. 12: Partnership Charged with Knowledge of or Notice to Partner: knowledge to acting
partner, or other partner who reasonably could and should have communicated to acting partner,
operate as notice to or knowledge of partnership except in fraud situations
f. 13: Partnership Bound by Partners Wrongful Act
g. 15: Nature of Partners Liability: all partners liable jointly and severally under 13-14 and
jointly for all other debts and obligations
5. Relations of Partnerships with Third Parties (55)
1. Three questions: (1) who is a Partner for purposes of personal liability to business creditors? (2) when
can an exiting or retiring partner escape liability for a partnership obligation? And (3) since a partners
liability on a partnership debt can be satisfied from a partners non-partnership property, how are such
claims to an individual partners personal assets to be balanced against the claims of other creditors of
that person?
2. Existing Partners:
a. Partner-In-Fact: Two or more persons who agree to carry on for profit a business and they
share in the profits. PTners can bind PT in K, if PTners commit torts in course of business all of

13
PT is liable as knowledge of 1 is of all. You are liable for all debts and whatever happens in the
partnership (can sue another to get $ back)
1. Incoming PTners are liable to all obligations arises before his admittance
2. Under 12 UPA, knowledge of 1 partner is knowledge to all partners, and makes them all
liable
b. Partnership by Estoppel: 16: Partner by estoppel: If someone allows someone else to think
that hes a partner, then if there is (1) reliance (2) he doesnt correct the statement (3) hes liable.
1. Rationale is agency monitoring principles
3. Departing Partners: Dissolution of PT does not itself affect a PTners individual liability on PT debt.
However, two ways exist to release, these balance the policy concerns of (1) making it too easy for
departing Ptners to escape debts (2) making it too difficult would mean that PTner would continue to
be bound despite loss of control
4. (escape liability)
a. Explicit Agreement (section 36(2)): Releases the PTner if the ct can infer an agreement exists
btwn the continuing PTners and the creditor to release the withdrawing PTners.
b. Material Alteration (section 36(3)): Ptners can escape the debts of the PT so long as there has
been some material change in the agreement so that it is clear that all parties know the PT has
been dissolved. TEST: (1) Material change that (2) puts everyone on notice of the partner in
questions withdrawal.
c. UPA Section 36 (1, 2, 3)
1. 36(1) dissolution of partnership does not itself discharge the existing liability of any
partner
2. 36(2,3) if partner withdraws and other partners continue, the withdrawing partner is
released from debt liability if an agreement can be formed between existing partners and
creditor.
3. KH efficiency -- were this to not be the case, there would be a negative impact on the
creditor, which would make loans more expensive
5. 3rd Party Claims Against PT Property: PT property is viewed as being held in a tenancy in PT.
a. Tenants in Partnership (UPA section 25 (1)): PTR is co-owner with his PTRs of specific PT
property holding as a tenant in PT. Such PTRs can use all assets of the PT for PT business but
cannot sell or destroy those assets b/c they belong to the PT.
1. 25(2): A partner cannot possess or assign rights in partnership property. A partners heirs
cannot inherit it and a partners creditors cannot attach or execute upon it.
2. RUPA 501, 502: abandoned the above in favor of entity ownership. A partner is not a co-
owner in partnership property and has no interest in partnership property which can be
transferred either voluntarily or involuntarily. The only transferable interest of a partner in
the partnership is the partners share of the profits and losses of the partnership and the
partners right to receive distributions.
b. Entity Theory (section 26): The PT itself owns property and the PTRs own interest in the
returns from the property and not the property itself.
1. PTRs can only assign the interest in the property and not the property itself, which
balances the policy concerns that we do not want to bind unwilling partners to a random
individual. i.e. whatever benefits that come from property are owned by the partners
themselves
2. This makes sense for creditors b/c Creditors only have access to the returns and not the
property.
3. Full rights cannot be transferred unless other PTRs consent, thus initiating a new PT.
6. Claims of Partnership Creditors Against PT Property (58): Rules determine in what order the PT
creditors and individual creditors are satisfied when a PT and its PTRs go bankrupt simultaneously

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7. Bkry code sasy: A general partner of partnership debtor is liable for any deficiency of the partnership
estate to the extent that the claims of all partnership creditors are not paid in full ( 723 of Bankruptcy
Code)
8. See chart on page 60 for two tests
a. Traditional (Jingle Rule) (p60- UPA h and i): PT Creditors have priority to PT assets and the
individual creditors have priority with respect to the individual partners assets. Thus, ppl get
what they expected based on their prior dealings.
i. TEST: (1) applies only to a UPA state, i.e. New York and (2) 723 doesnt
apply (individual not in bankruptcy OR partnership isnt in Ch. 7)
1. Thus, whatever is left after PTC take will be paid out to individual PTRs who they can
satisfy individual debts and whatever money is left over after that must go to PT debt.
b. New (Parity Rule) (RUPA/1978 Act): PT C have priority to PT assets and are on parity with the
individual C to the individual partners assets.
1. TEST: Followed IF (1) RUPA is controlling state law OR (2) 723 applies (partnership
is in Ch. 7 AND the individual is in bankruptcy)
2. Rationale: (1) Placing PTC and IC on par with each other creates incentive to use PT form,
which is KH efficient (2) IC will have stronger incentive to monitor individual partners if
they know they will have to share the assets with the PTC in bankruptcy.
3. Better protect creditors, allows partnership creditors to go to partnership assets and
individual assets- partnership creditors must be paid first before the individual
creditors
RUPA

PARTNERSHIP

Ch. 7 Liquidation Ch. 11 Reorganization

Partner in Bankruptcy 723/parity 723/parity

Partner Not in 723/parity 723/parity


Bankruptcy

UPA

PARTNERSHIP

Ch. 7 Liquidation Ch. 11 Reorganization

Partner in Bankruptcy 723/parity 723/parity

Partner Not in 723/parity Jingle


Bankruptcy

6. Governance of Partnerships and issues of authority (61): The below two points can be contracted around
a. UPA 18(h): Any difference arising as to ordinary matters may be decided by a majority of the
partners. No act in contravention of any agreement between the partners may be done without
the consent of all.
b. Rationale: (1) Labor and work capital also votes with money capital holders b/c those with labor
and work experience are usually more knowledgeable so no need to freeze them out, incentive to
include them instead (2) this makes PT more stable

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c. Activities within the scope of the TPs ordinary business cannot be restricted unless by a
majority of PTRs National Biscuit v Stroud (p61)
1. Facts: Stroud and Freeman are in partnership and have Stroud food center. S says to
Nabisco that he wont be responsible for any bread delivered after Feb. 6. Nabisco
continues to deliver bread and the bread it delivers has an amount of $100ish. Stroud says
that hes not liable because he said he wouldnt be liable to Nabisco.
2. Holding: The acts of a partner, if performed on behalf of the partnership and within
the scope of its business, are binding upon all co-partners.
3. Partners can change the scope of their agency, BUT if the agreement is not written, the
default rule of UPA 18(h) requires majority of partners to agree to the business decision
4. Rationale: this rule protects companies making agreements with the partnership AND
other partners so one partner doesnt undermine business 50/50 not enough for majority
rule
5. NOTE: Partners are fiduciary agents BUT more specifically, they are agents of the
partnership, NOT each other
7. Termination (Dissolution and Dissociation) of Partnerships (p63)
1. Causes of Dissolution: (1) Expiration of contracted terms (2) any partners express will when no term
is specified (if term is specified, agreement prevails over withdraw- Adams v. Jarvis) (3) death or
bankruptcy of any partner (UPA 31) (4) decree of the ct (section 32) (5) illegality (6) expulsion of any
PTR pursuant to agreement by other PTRs
2. Consequences: (1) Best to terminate once the business of the PT has ceased (2) If PTR personally
wants to retire the PTR has to make sure the Ks are renegotiated so that he no longer has continuing
liability (3) Once terminated PTRs are entitled to distribution of assets (4) Business and affairs wound
up and distributed like bankruptcies
3. Business of Partnership (Wind-Up)
1. Partners go to everyone w/ whom theyve done business, notify them, and wrap up their
affairs.
b. Value of Partnership (Liquidate)
1. divide up value of partnership, according to interests
c. Accounting for Partnerships: Financial Status and Performance Three ways for companies
to keep track of assets
d. Balance Sheet p63: picture of companys financial status at a particular moment in time to be
used in conjunction with income statement using balance sheets for several years will yield a
better picture of what a company looks like
1. Assets = Liabilities + Equity OR Assets Liability = Equity
2. Assets and liabilities: Assets more than liabilities in the black.
a. Equity: provides a link b/w balance statement and capital accounts statement
provides an investor with a crude way to see companys worth
b. Assets: things of value that the company has (i.e. cash, accounts receivable,
inventory)
c. Liabilities: accounts payable to suppliers, notes, ST and LT obligations, line of
credit, etc...
e. Capital Accounts: (Partners Capital): used to make sure that the partners are being treated fairly
and maybe a way to provide how to divide up the business in case of dissolution of partnership
reports income/revenues, etc.. for the year
b. Opening: amt of capital partner invested in co. that year
c. Income for year: their share of the net profits of the business
d. Drawing: the amt that each one of the partners took from the business that year
i. NOTE: partners may decide to take money out of business even if it hasnt made
$

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e. Closing: how much interest each partner has in the business at the end of the yearIf a
PTR has a negative amount in his capital accounts it will be subtracted from the share he
is owed before he is paid out in full
a. Acquisition cost must be fair market value, so when recording acquisition cost of
a building, use value you use from the time of acquisition.
2. Income Statement: Subtracting (1) Revenues into (2) Expenses to show how the business
functions over a period of time, usually a year. (income expenses = net revenue)
a. shows you the revenues and expenses- unlike assets and liabilities, revenues and
expenses are flow concepts (i.e. every month you have revenues and every month
youre buying inventory)
b. balance sheet as of some particular date in time and an income statement is FOR
some period of time
c. gross profit (gross sales minus costs of goods sold) and the you have total
expenses and then you find your net profit.
d. Income minus expenses = net profit
e. Trick: Will not show liquidity b/c doesnt differentiate between cash and debt
3. Statement of Cash Flows: Typically over a year, it will track how much a business took
in and spends, shows the true liquidity of the company.
4. Income= net profit for company divided by co-owners who share in net profits.
Withdrawals are shown.
5. Now, if one partner declares bankruptcy, the total liabilities will be much more than the
assets, so to get the owners equity, you subtract assets liabilities and get negative number
for owners equity.
4. Rights of Partners: Windup: aka liquidation; orderly processing of going out of business; liquidation
of assets to satisfy creditors claims and PTRs assets
a. Opt Out of Wind-Up: PTRs can contract around the statute. Can you opt-out of the
partnership wind-up, b/c you want to carry on the business?
1. PTRs can opt out of wind up so long as they do not infringe on creditors rights. Adams v
Jarvis (65)
Facts: Three physician/partners enter into a medical partnership. Dr. Adams wants to get
out of medical partnership and dissolve /unwind business so that hes paid in
requirements of UPA. A wants the 1/3 of all accts receivable prior to his w/dl pursuant to
liquidation. Partners say UPA 29 doesnt require us to give you 1/3 of all A/R; we only
need to give you a review of all the assets. They say they already have an agreement and
it specifies what you get when somebody leaves. The UPA requires a winding up of the
business and division of all of the assets after liabilities paid and includes accounts
receivable.
ISSUE: Does the partnership agreement or the statute (UPA 29) control the outcome?
Holding: UPA 38(1) has default rule that when dissolution is caused in any way, except
in contravention of partnership agreement, each party unless otherwise agreed would
have rt to apply value of assets against debts (fire sale) BUT in this case parties otherwise
agreed
Even if agreement is poorly drafted, cts will look to intent before looking to UPA
statute.
2. Rationale: (1) Allows for open negotiation (2) if one were unable to K around the statute
each PTR would have big hold up power by threatening to trigger dissolution all the time
(3) monitoring on the right party
3. We rely on parties intent b/c we assume theyre the greediest!
4. All parties are on equal footing- not against public policy in any way here
5. Efficient rule b/c it encourages people to think through their decisions, we dont want to
do a wind-up, distribute the assets, and then reverse engineer the partnership again

17
b. Consequences of Wind-Up: Liquidation is favored over in-kind distribution
1. A statutory wind-up requires a sale of the PT assets and an equal distribution of cash
among PTRs relative to ownership percentages. In-kind division is not favored
Dreifuerst v Dreifurest (p69)
a. Facts: Three brothers had a partnership-at-will with no written agreement. 2
brothers want to give 1 feed mill to 3rd partner, in-kind to wind up the
partnership. says partnership dissolved, and UPA 38(1) provides for payment
in cash after wind-up, not in kind. They dont have enough cash to go ahead and
buy out 3rd brother. One brother requested that they should be able to bid on the
business, b/c presumably they would be able to pay a lower price (business is
distressed, no one else interested).
b. Holding: when there is no agreement and partnership at will, 38(1) fire sale
statute applies cts cant get creative. Partnership can rightfully be
dissolved by the express will of any partner.
c. Rationale: pay in cash, not in kind!
d. Because there has been no wrongful dissolution and the partner that wants out
can leave at will, the partner has a right to wind up the partnership. A whole
sale is better than in kind because (1) the business will likely be worth more
whole than piecemeal [wealth maximization] (2) Statute can be Ked around
e. If remaining PTRs want to retain assets they can purchase them at the sale and
give the withdrawing PTR his fair share.
f. (whole > sum of parts); Latter rule efficient so long as the market works
putting up the business for sale and the highest bidder would effectively
determine the market value. Force the sale!
g. Remember a written agreement controls if there is one
c. Limitations on Power to Wind-Up:
1. Statutory dissolution of PT is constrained by fiduciary duties. If there is a dissolution in
bad faith then breach then damages Page v Page (73)
a. Facts: Page (P) and Page (D) were partners in a linen supply business they had
entered into in 1949 pursuant to an oral agreement. Each contributed about 43k.
in 1958 the business started showing profit. P was the sole owner of the corp.
which was the partnerships major creditor holding a 47k demand note and said it
was a partnership at will and he wanted to terminate it. COURT LETS P OUT
b. Holding: If partners want to create business for a term (i.e. to make a profit)
that will be enforceable over time BUT if there is nothing written, ct is going
to use default UPA rule that when there is no agreement, its a partnership at
will (UPA 31(1)(b)).
c. Must be exercised in good faith. UPA 38(2)(a) damages; rights of partners upon
wrongful dissolution
d. Here, until we make profits is not a specified term. At will and can be
terminated any time
e. Rationale: (1) No one would go into business with anyone if they were stuck in a
PT until profits were being made b/c there is no way to escape (2) Very specific
definition of profitable is necessary.

IV. CORPORATE FORM OF BUSINESS ORGANIZATION: OVERVIEW (P85)

I. Fundamental Legal Aspects of the Corporate Form


1. Nature of the Corporate Form: Entity Status defines the legal bounds of the corp. Has:

18
1. Legal personality with indefinite life
a. Legal personality independent distinct from investors and managers
b. NOTE corp. considered a person for many purposes (i.e. can enter into Ks)
c. Indefinite life = greater stability
2. Limited liability for investors
a. Benefits
i. easy to value shares (doesnt change w/ wealth of SHs)
ii. Easier for SH to invest in risky business encourages investment
iii. Entices creditors to monitor SH will prefer to stay solvent/creditor wants his $ -
efficient structure
iv. Encourages desirable risk taking for managers
v. Permits investment diversification
b. Easterbrook and Fischel Rationale
i. Easy to value shares, diversify and monitor corp.
ii. Reduces costs of monitoring shareholders
iii. Mangers have incentive to act efficiently b/c they can be replaced if prices go down
iv. Market prices can impound additional info about firms value
v. Diversification minimizes risk
vi. Facilitates optimal investment decisions
3. Free transferability of shares
a. Limited liability reduces costs associated with transfer of shares
i. SHs can sell to other investors
ii. Corp. has no obligation to repurchase
b. Allows for management changes to be forced
c. Pressures management to act effectively to avoid takeovers
d. Business uninterrupted by changes in ownership no issues w/ dissolution and
reformation
e. Encourages development of active stock market which facilitates investment provides
liquidity and encourages diversification of equity investments
i. Investments more attractive SO increases ability of firm to raise capital
4. Centralized management (Board of Directors BOD)
a. b/c shareholders are not involved in micro-managing corp. transactions/affairs, there are
lower transaction costs
5. Appointed by equity investors
a. Types of Corporations: Closely v Publicly // Controlled v Diffusely Held
i. (1) Closely Held Corp: Small corps held by a small number of ppl who are also the directors
and officers V. (2) Publicly Held Corp: Big corps held widely by members of the public who
elect directors who hire professional managers to run the business
ii. (1) Controlled: SH or group of SHs that hold more than 50% of the stock and control voting
rights and management V. (2) Diffusely Held: No controlling SH and no ctrl voting and no
ctrl mgmt
2. Benefits of the Corporate Form
a. Ease of Financing: creditor looks at assets of corp and need not concern itself with SH assets. (best
way is to borrow $ and corps can easily do that). They can sell shares to themselves)
b. Ease of Contracting: merchandising, renting, 3d need not be concerned with any other assets than
those in the corp. You know exactly what youre getting when you K with a corporation - you know
youre going to get your assets. In a partnership, its harder because you have to consider the assets
of the partners
c. Ease of Entry and Exit: the market facilitates this shares move about freely and anonymously so
you can go in and out

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d. Ease of Control: Managers are hired by the directors managed by the shareholders. Managers
should be managing effectively and making money so the managers are just thinking about how to
make their shareholder rich. In a partnership, you might have competing interests other than getting
rich but in a public company, you dont MONEY
3. Formation of Corporations:
a. Choice of State of Incorporation: based on two issues Doctrine of Internal Affairs and Taxes
i. Doctrine of Internal Affairs: Governance of the corp is dictated by the State of incorp.
Internal affairs are considered everything that relates to the legal relationships between the
corp participants. Where you incorporate dictates where the law will be adjudicated, but the
headquarter doesnt have to be where you incorporate.
ii. Role of Franchise Taxes: (1) Business Tax: paid to the state where you do significant business
(2) Franchise Tax: paid to the state of incorporation. Calculated based on the number of
corporate shares outstanding.
1. Due when (1) Upon incorp (2) Yearly (3) When issue new shares
b. Process of Incorporation: (1) Old (Ancient) Process: formation required a special statute of incorp
issued by state legislatures (2) Modern Process: fill out form, file with secretary of state and pay
small fee
c. Next: elect D (not named in charter), adopt bylaws and appoint officers.
i. Charter (93): Certificate of Incorp is Articles of Incorp is Charter
a. REQUIRED TERMS: 1) provide for voting stock, 2) board of directors and 3)
shareholder voting for certain transactions the rest governed largely by contractual
freedom
b. MUST CONTAIN 1) original incorporators 2) corporations name and business (very
broad i.e. for general business purposes) (DGCL 102(a)(3)) 3) fix its original
capital structure
c. MAY establish the size of the board or include other governance terms
d. MAY contain any other provisions not in contravention of law
1. Must lay out any special or limited purposes
2. Amendments: difficult to amend the charter and allowed only by shareholder vote.
Under DGCL section 242(b)(1) when the board of directors proposes the amendment
and the shareholders adopt the amendment, the shareholder will vote by majority
vote. If no DO named then incorporators substitute until named
3. charter can never be altered by the shareholders over the objection of the board
because the statute says the process begins with the board (i.e. Bd wont recommend
something to be voted on that they hate) bd proposes SH maj vote amend
ii. THEN By-Laws (94): THESE IS ALL PROCEDURAL - Specific provisions governing
the running of the company.
1. Include: number on BD, titles/functions of officers, check-bank authority, shareholder
voting process etc.
2. also includes an annual meeting date or a formula by which such a meeting date will
be fixed
3. Amendments: statute will control outer limits of amendment rights (i.e. some states
will say SH get to amend so you need to put that directors in the bylaws as the ones
who can amend). Charter can provide for directors right to amend bylaws and can be
amended as long as the charter itself provides that the bylaws can be amended by the
board of directors. Under some statutes, shareholders have the inalienable right to
amend the bylaws (DE) whereas other limits this power to the board (OK). BUT:
141a is a limiting principle that says shareholders can't limit the boards
authority through bylaws.
4. Directors propose amendments - put important things in bylaws b/c Bd controls
bylaws

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iii. Then: elect Ds and appoint officers
d. Theoretical Underpinnings of incororation: Mgmt and SH interest are inversely proportional. See
article- Foundations of Corp Law:
i. Del Law: it is very stable and sophisticated, judges are experts in their fields
ii. Race to the Bottom v Race to the Top (two alternative theories on why to incorporate in one
state v. the other)
1. Race to the Bottom (Cary 1974): giving protection to managers and directors. 2-3
years following Jensen & Mecklings agency cost theory; Carys theory is that DE
pandering to agents of shareholders (owners/principals) and directors (agents) will
pursue their own interests.
a. race to de regulate because the more favorable they can make the laws in
their state, the more money they stand to earn- DE has an incentive to
maintain their legal position, but dont have an incentive to have the best
laws- as the manager of a corporation, youre an agent to the shareholders
and when the interest diverge, theres going to be an agency cost and its
going to get expensive i.e. manager will find a state where its hardest to
fire him, etc.
b. Directors make the incorporation decisions, and DE providing protection to
themselves. Franchise tax will result in states writing statutes that are very
favorable to corporate managers, competition is breed attracting comps. Sees
the mkt is ineffective. Arguments supporting race to the bottom: (1)
Delaware gives weakest protection for SH but remains the highest
incorporation.
2. Race to the Top (Winter): 2d Cir. judge, proponent of the market. Refutes Carys
theory; shareholders arent dumb. Shareholders would see this theory, entrenched
directors, and choose not to buy shares in DE corps. When the corps. need money,
itll harm them theyll have to sell more shares, give up more control, etc. Mgmt
will incorp in states where corp laws best protect shareholders b/c if SH are
unprotected, stock goes down, ripe for takeover, mgmt is at risk. It is easier to raise
capital in corps that incorp in states that protect SH b/c SH will be more likely to
invest. Sees the market as effective and self-regulating. Arguments supporting race to
the top: (1) many commentators favor
3. Commentaries: (1) Romano: (2) Guvertz: (3) Macy: The lawyers drive the outcomes
of where corps incorp b/c they often know DE law and this is cost saving knowledge.
There are a lot more players in this debate than just the states, one group of players
are the interest groups, DE lawyers and judges are going to lean in favor of the
corporations (directors and officers- have choice of where to incorporate and DE
wants the business, AND theyre the ones you can find whereas who knows who all
the shareholder are). (4) Bebchuck: depends on situation whether race to (5) Rowe:
Says the federal government needs to be the final entity to step in when things get out
of control (i.e. Sarbains-Oxley Act) Motivates congress to act and pressure brought
to bare on congresswho will be lobby congress? Directors, managers- can anyone
rep share holder in congress? Pension funds.
iii. Locus of Regulation: (1) Regulation by the States: Those that favor believe race to the top (2)
Regulation by the Federal Government: Those that favor believe race to the bottom

4. Essential Characteristics (p96)


a. Legal Personality with Indefinite Life
b. Limited Liability for Investors: (1) Shareholders are not responsible for the debts of the corp, they
are only liable up to the amount of their investments. (2) Facilitates the transferability of shares b/c of
limited liability (3) Creditors can only reach assets of the corp

21
i. Benefits: (1) Easy to value shares b/c they do not fluctuate with the personal wealth of the SH
(2) decreases risk of investment -more likely for ppl to invest in risky business if not liable
(3) Reduces transaction costs of contracting for credit b/c creditors can do centralized
investigation of corp and not of personal investors. (makes evaluating an equity investment
easier). Increases incentive for banks or other expert creditors to monitor their corporate
debtors more closely. (4) decreases the need to monitor managers and other SH b/c you dont
have to be concerned with losing all your personal money to them, just what youve put in the
corp your liability is only extended as far as your investment
ii. Diff b/w corporate and pship form: Limited liability, which limits assets avail. to creditors to
only those assets in the corporate entity. So shareholders, directors and officers are not
personally liable for the debts of the corporation, unlike the partners. Only rarely do
shareholders have to pay over any more funds.
c. Free Transferability of Shares: Facilitated by limited liability
i. Benefits: (1) Ensures effective monitoring and protects SH (2) Easier to raise capital (3) More
efficient valuation of the corporation: when mgmt does a bad job it is more likely a takeover
will result and b/c of easy valuing this is more efficient (incentives for managers to perform
better b/c all it takes is unhappy SH for the stock price to lower)
ii. Bought and sold in the market all the time.
iii. Transferability and LL very tightly linked. If liability werent limited, the ability to transfer
shares would be impaired, youd have to think several times about investing. If there is
unlimited liability, its better to be in a corporation where the other shareholders have assets;
shares would be harder to trade since youd have to do lots of background digging.
d. Centralized Management: Allocation of Powers
1. Shareholders: 1) elect and approve directors AND 2) approve or disprove non-ordinary or
fundamental changes
2. Board of Directors: manage corporations business (formulate policy, appoint officers to carry
out policy) - See DGCL 141
i. (1)Directors Only BD manages business of the corp. BD has the final say unless SH vote
unseats them Charlestown Boot & Shoe Company(handout)
1. Facts: Mr. D elected a director, as is Mr. W of the Charlestown shoe co. the company
is not doing well and is struggling. Mr. O, a specialist, is invited to help the board
improve business. O says that they should purchase insurance on their only factory
because if the factory burns, it would result in tremendous losses for the corporation.
Later, the factory burns. The shareholders sue.
2. holding: Ct holds legal that BD ignores good advice of outside advisor b/c
ultimate power to make decisions lies within BD- the directors are the ones who
make the business decisions, not an outsider
ii. DIRECTOR DUTIES: (1) direct or manage business of corporation, (2) designates
managers or officers who nominate other officers. (3) appointment power, (4) compensation
power, (5) removal power, (6) declare dividends, (7) amend bylaws, (8) initiate amendments,
(9) mergers, (10) sales of assets,(11) dissolutions, etc.
a. All members elected annually to one year terms charter may provide that theyre
elected by certain classes of stock
b. Can establish committees
c. Formality in Board Operation required for action (can only act as a grp, not individuals)
i. Act as board in formal meetings by majority vote
ii. Hold formal meetings effort to discourage manipulation of board decision
making
Must have proper notice of meetings
Quorum must be present

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d. Automatic Self-Cleansing Filter Syndicate Co., LTD. V. Cunninghame (Eng. CA
NOTE DGCL 271: 1906) (107) (board wont let (shareholder) sell assets when he didnt meet the required
board can refuse to voting percentage under Charter claims board is his agent)
sell assets if SHs i. Holding: there may be a fiduciary duty BUT it is owed to all shareholders, not just
attempt to force sale the majority unless there is a clear majority shareholder vote as required by
charter, board owes duty to ALL shareholders incl. minority. D are agents of
company, therefore all SH constitute the principle, not just majority.
ii. Fogel the mere fact that directors are gathered does not a meeting make (need a
formal call to a meeting)
iii. BD are elected by SH. BD elects Officers.

e. (2) Officers (DGCL Section 142) administer day to day affairs of corp. under supervision of
board. Officers are agents of the corporation and therefore subject to fiduciary duties
i. Substantial officer actions must be sanctioned, explicitly or reasonably impliedly by BD
Jennings v. Pittsburgh Mercantile Company (110)
ii. FACTS: Real estate agent, Jennings, goes on authority of Egmore, the VP, to conduct a sale &
leaseback, who claims he has authority to accept. Jennings performs duties and E tells him
that its not a problem and the Board will be happy with the sale and leaseback. The
transaction makes it to the board and Bd of Directors rejects the transaction, Jennings sues for
his commission.
iii. Holding: A corporations executive officer does not have apparent authority to accept an
offer for a transaction that, for the corporation, is extraordinary
iv. (1) Corp not responsible for CEOs commission where he executed a deal without BDs
permission and against their wishes (2) No authority [actual, apparent b/c not reasonable
action, or inherent] existed b/c CEO had reason to know BD would disprove of the action and
he acted outside scope of role
v. When suing on apparent authority, have to show that P did something to give A reason to
believe they had authority
NO actual authority because board member CANNOT self-authorize power
derives from board as whole
Apparent auth. can be implied by (1) measure of similarity b/w act intended to
bind P and the prior dealings, and, granting similarity (2) degree of
repetitiveness
o Mattered here that this was an extraordinary deal that VPs dont have
authorization to transact alone AND past practice showed he never did
this before
vi. (3) Rationale: Ct is concerned that recognizing inherent authority would disincentive BD
monitoring b/c CEO could engage even w/ monitoring, devaluing the gains of monitoring
entirely.

II. Fundamental Financial Aspects of the Corporate Form


1. Basic Elements of Capital Structure (115): how does this corporation finance its operations?
a. Cash from operations. The only reason ppl invest in corporations is b/c they expect regular dividend
payments, or at a min. that the corp. will increase in value so stock will sell for a higher price than
initially purchased at. MIX OF DEBT AND EQUITY, and the way it uses that capital to finance its
operations. Similar to PT, Corp can borrow money, sell ownership shares, and equity in corp.
b. Debt: Money that is borrowed or leveraged. Long Term: Due in more than 1 year. Holders can force corp
into bry. Debt securities are Ks.
i. Types: 2 categories, different combos generate diff priorities
1. Priority: where creditors come in line to collect corps assets, determined by K (a) Senior:
Debt that must be paid before anyone elses debt is paid, in good times & bad. Gets paid

23
regular interest, and principal at maturity, before anyone else gets their money. Just means
that you come first. All it is, is a contractual claim. You get paid regular interest
payments, and principal at maturity. Doesnt matter what happens to the claim or thing.
(usually lender is a big bank like B of A) (b) Subordinated: second to senior (usually what
corps. issue as bonds). Both determined by K
2. Security: (a) Secured: once an interest is secured those assets are given to the lender only
until the debt is satisfied. Like mortgage debt; attached to assets. If you cant pay it back,
bank will take the property, sell it, pay their interest and principal, then pay other creditors.
(b) Unsecured: everyone else- fixed obligations. Credit card debt, no particular assets
attached to it. paid out of whatever cash one has, recognizing that mortgage debt is both
senior and secure. This is all contractual, everyone knows what debt is out there.
ii. Terms of Debt: irrespective of corps performance, cred receives both:
1. Principal Amount: the amount that is lent, must be repaid on maturity: legal obligation
specifying a date when debtor must repay principle amount in addition to any outstanding
interest not yet paid.
2. Interest Payments: payments paid during specified period (q or yr) at set interest rate.
3. Default: If the principle or the interest is not paid by maturity the bonds are in default and
debtor has defaulted on its debt. Creditors remedy when debtor defaults is to receive an
acceleration of the principle amount from its original maturity date to the present.
Mechanisms creditor will use to sue are usually specified in the loan agreement.
iii. Tax Treatment of Debt: The corporation does not pay income tax on any interest it collects from
debtors, debt is deductible from income tax. (tax shield) Interest is treated as corps operating
expenses before net income for tax is calculated (treated as an expense in accounting but tax
deductible (like giving to charity)). Interest payments on debt are tax deductible
1. In this respect the cost of debt is less than the cost of equity (though there are other factors
that make debt pricier: higher risk of equity investments, costs of financial distress which
increase with a companys debt burden)
a. Corporation will pay interest on its debt every quarter/half-year. That interest is
deductible as an operating expense (salaries, operating costs). But corporations
cannot deduct dividends dbl taxation of dividends. Dividends are taxed twice
once coming into corporation as income, and once when they go out to shareholders
as dividend. Interest on loans taxed only once, when you pay the interest.
c. Equity: Raising capital by selling shares in the corp to institutions, private individuals, and insiders
i. Broad Characteristics: (1) guided by K law but operates by statute (2) holders cannot force corp
into bry (3) Characterized broadly not by the right to payment but by the right to vote (4) one vote
per share default, alterable by the charter
ii. Types: 2 types both of which imply different perks when owned
1. Preferred Stock: Preference with (1) Liquidation during bry: paid out after debt before
common stockholders, usual compensation is $100 per share (2) Dividends: paid before CS,
as dictated by the BD paid at intervals, if dividends are not paid holders cant do anything as
a remedy (3) Voting and BD: sometimes can vote/designate BD seats if dividends have been
skipped for a long period (4) Issued: Usually issued denominations of $100 and 8% interest
rate. Rarely (almost never) votes (only in situ that will alter their rights)
2. Common Stock: (1) Liquidation during bry: residual claimants: are paid out after everyone
else if still money left over (2) Dividends: paid at lower rate than PS, if at all (3) Possess
Voting Rights: want to place votes in hands of those paid last and have highest risk b/c they
will monitor best
3. They vote on directors why? They get the residual after everything thats left, so they dont
want any waste. Allowing common shareholders to vote for directors who then vote for
officers, drives us to the KH efficient solution. They only get paid after everyone combined
gets paid and they dont want waste because then they wont get paid.

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iii. Tax Treatment: Dividends are taxed 2x: once when passing through the corp and then once when
SH receive them

2. Foundational Concepts of Valuation(119): Valuing debt and common stock. 4 basic finance concepts (1)
time value (2) risk and return (3) diversification (4) capital mkts efficiency
a. Valuation Under Certainty (no risk): $1 today worth more than $1 tomorrow and a dollar for sure is
worth more than a risk. a=amount, r=IR earnings, n= number of yrs Discount Rate: cost of waiting to
invest (1+r)n
i. Future Value: FV=A(1+r)n The future value of a present investment
1. Amount you receive today x future value factor (1+interest rate) and n is how many periods
are involved (years)
2. Whats the value of $100 received today if the interest rate is 5% and your money is held for
one year? FV = $100 (1+.05)^1 = $105. It means that if you had the $100 today, it would
grow to $105 in a year. So youd want them to give you either $100 tonight or $105 a year
from now
ii. Present Value: PV=A/(1+r)n The present value of a future return accounting for time value of
money
1. Whats the present value of $100 to be received one year form today if the interest rate is to
be 5%?
2. PV= 100/(1+.05)^1= 95.24
3. So you are not indifferent to getting 100 a year from now because its only worth 95.24
today. A year from now, youd have $100, two years from now, youd have the $105. When
a company buys a machine, it needs to know the companies present value
iii. Net Present Value: - cost + present value of return (or present value benefits- costs)
iv. Difference between PV of amount invested and PV of return on investment.
1. People hold shares only to get periodic dividend payments, or in appreciation of
stock when they sell it at a higher price. So, you have to value a company. Have
to determine if its individual projects are worthwhile. How much are the
brownies likely to bring in, minus the costs (marketing, equipment, supplies), all
at the present value. You spend the money right away, but get the revenue some
time in the future. Permits you (director) to make decisions in your corporation,
without caring about what the shareholders all want, you can ignore their
preferences. Why? you just need to consider profitable projects, and pay them out
to shareholders either through dividends or appreciated share values.
1. (1) Goal: determine whether investment is worthwhile (2) invest only in projects whose
NPVs are positive
v. When interest rate is higher, its more painful for you to wait for the money (lower PV).
When the interest rate is lower, its not as costly for you to wait, which means the PV is higher,
because the PV measures how costly it is for you to wait.
b. Valuation Under Uncertainty: $1 for sure is worth more than $1 with risk
i. Sources of Risk: (1) Risk of no payment at all (2) Risk of payment of another amount (3) risk of
payment at another time
ii. Consequences of Risk: (1) Risk imposes costs on individuals (2) due to risk aversion b/c (a)
individuals have declining marginal utility of wealth [as you become wealthier money begins to
lose value] (b) downside losses are weighted heavier than upside gains, as you slide on curve $
gains value
iii. Types or Risk: Two types 1 affects corp 1 affects market
1. Unsystematic (idiosyncratic): Risk associated with a particular business. Strike at GM plant.
Can be eliminated thru diversification
2. Systematic (market): Risk relating to the entire market. War or inflation. Need premium to
bear the risk. Cannot be eliminated.

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iv. Diversification: Minimizing risk while maximizing gains. 20 <> 100 stocks
1. Technique is to invest in stocks in opposite industries
2. Result is that this eliminates idiosyncratic risk and there no longer exists a risk premium for
holding stocks with unsystematic risks
3. Only unsystematic risk is diversifiable as systematic cannot be eliminated as it is
unavoidable but can be hedged with investments such as gold [which is now inversely
proportional to market].

3. Valuation Techniques Evaluating whether uncertain investments (realistic) are worth it


a. Value of Future Risky Return: Must account for (1) time value of money [interest] (2) Risk. Use PV to
account for time value and risk into discount rate. PV = A/(1+r) n Time value of money is usually US T-
Bill rate since it is risk free and then risk added on (2-5% lets say)
b. Expected Value (weighted average): EV = pixi (p=probability, x=return) SO PROBABILITY X
AMOUNT + PROBABILITY X AMOUNT. Multiply the probability of each outcome by the amount
received in that outcome. Weighted average of the value of the investment, sum of what the returns would
be if an investment succeeded, multiplied by the probability of success, plus what the returns would be if
the investment failed, multiplied by the probability of failure. Ex: coin, if tails $0 if heads $50. Expected
outcome equals .5(0) + .5(50) = 25. BUT theres no chance youd leave with $25, youd leave with 0 or
50. So then $25 is your future value and you can use that for other equations.
c. Variance: variance = risk. Degree of dispersion of actual returns around the expected return. If greater
spread then there exists a greater risk, if a smaller margin smaller risk. Ex: Though EV for toss of 0//20
and 8//12 is both 10, the first is much riskier and many would likely choose the second.
d. Risk(1) Neutral: investor who only is concerned about the returns of the investment and does not
weigh the risk of the project (2) Averse: volatile payouts are worth less to these investors as they compute
the risk into the investments they make.
i. Risk Premium: additional amount that risk-averse investors demand for accepting higher-risk
investments in the capital markets. Theres a risk free rate and there s a required rate of return when
an investor invests. Risk has a price and no one wants to take a risk without being compensated for
it. Risk premium= whatever you pay someone to accept that risk

4. Models for Determining Roles of Prices in Securities Market (p127)


a. Discounted Cash Flow Models: To value a company those evaluating companies must predict the corps
cash flow in the future, thus evaluators must pick the right discount rate to bring the value back to the
present to yield a net present value
b. Rational: benefits to shareholders and accounting conventions if management accepts all net present
value projects, theyll be in good shape
i. Calculating DCF:
1. Estimation of all future cash flows generated by the asset; complicated b/c most assets have
indefinite life where cash flows can only be calculated for a finite number of periods;
terminal value is used: brings all cash flows from a future year, and going into perpetuity,
into that future year
2. Calculation of appropriate discount rate, most simple solution is WACC (weighted-average
cost of capital): the weighted average of the cost of debt and equity, where the weights are
the amts of debt and equity in cap structure. Cost of debt is easier than cost of equity, where
we use the either (a) CAPM capital asset pricing model, which links securities risks to
volatility or (b) historical avrg equity risk premia data: calc of the firms before-tax cost of
debt and adds 8% b/c equity has historically been priced as such
ii. Technique: (1) Predict future cash flows (2) Estimate discount rate, v smart predictions, usually T-
Bill plus premium
iii. Example: Say you buy a stock and the cost is $10 and then the next two years its $12 and then two
years at $15 and then one year at $10. (that is the amount in each period and thats the a) now you

26
need the r to take into account the time value of money and a measure of how it moves w the
systematic risk. Pretend the r is the time value of about 3.5% and the risk is 2.5% so add them for
the r = 6%. Now take -10 + 12/1.06^1 + 12/1.06^2 + 15/1.06^3 + 15/1.06^4 + 10/1.06^5. If this is
a positive number, like 13 or something, what happens now? Your stock is trading in the market at
$10 and you think that the present discounted value of its future cash flows is $13, so then you buy
it!
c. Efficient Capital Markets Hypothesis: Chicago Univ Hypo. Mkt prices always reflect public
information bearing on the EV of stocks and their DCF. Belief ppl can rely on the securities market
without doing their own personal evaluation. Its about stocks reflecting its true price- the present
discounted value and future cash flows are the same
d. Difficulties in Utilizing Models (1) Abstractions in Fundamental Assumptions: The mkt relies on very
strong assumptions that ppl focus on right information relating to valuing a company, not other moods
like the tech bubble, which sometimes effects the market in a good or bad way (2) Difficulties in
collecting, verifying, and analyzing information: Even the most sophis investors have problems with this
as knowing the future is v difficult.

5. Protection of Creditors (131): Must protect creditors so enough debt exists to finance projects
I. OVERVIEW
A. Why Partnerships arent as troublesome for creditors
1. Bc can get at investors personal assets
B. Limited Liability Causes Problems for Creditors of Coporations
1. Opportunities for express and tacit misrepresentation
2. May take assets after getting $ from creditors
3. SHs may undertake risky investments to shift uncompensated risk to creditors
4. SHs can move corp assets to personal accounts
a. Mechanisms for protection:
b. Mandatory Disclosure: Forces corps to regularly disclosure their financial positions allowing creditors to
make informed decisions on lending and specs. Tells you what the debts are, operating income, future
projects. Tells the debt holders, this is whats out there, you should protect yourself as you see fit. If a
C thinks shenanigans are going on, hell just demand a higher interest rate.
i. Federal Securities Law: Predicted on the efficient capital mrks hypo. Requires disclosures to SEC -
when? quarterly, large event, take out large loan
ii. State Law: does not have as stringent disclosure requirements as federal secu law. Do not
necessarily subscribe to efficient cap mkt hypo, utilize capital reg methods discussed below. But
debt is contracted out unlike Fed law
c. Capital Regulation (also protects creditors)

L
A Stated Capital Generally not available for distribution
Capital Surplus
E Surplus
Retained Earnings

i. Balance Sheet Definitions: 3 main components, assets, liabilities, equity


1. Assets: anything that has positive value for the corporation (a) current: maturity less
than 1 year, ex. accounts receivable (b) fixed: maturity longer than 1 year, ex. property,
plant, equipment = assets not intended for sale; the balance sheet fixes the asset value at
historical cost; assets = liability + equity
2. Liabilities: anything that has negative value for the corporation (a) short term: less than one
year, accounts payable (b) long term: more than one year, ex. bank loan

27
3. Comparison of the two (assets and liabilities) gives a sense of liquidity or the capacity of
non-cash assets to be converted into cash
4. Equity: plug number assets liabilities, outstanding shares, can be negative.
a. (1) Stated Capital: Product of the par value of the stock multiplied by the number of
issued and outstanding shares. capital in the corp at its moment of incorp. Money is
there for the protection of the creditors. Franchise Tax uses par value as part of calc
so often par value is penny or less.
b. Surplus Capital surplus + retained earnings: (1) Retained Earnings: profits at end
of yr not yet distributed to SH (net income), likely to be negative in the first years of
operating (2) Capital Surplus: (# shares)(Mkt Price) (# shares)(Par Value)
ii. Dividend Distribution Constraints: Regulations ensure entire surplus is not used to pay SH
dividends which protects creditors by ensure enough funds to pay for immediate loan obligations
1. Capital Surplus Test: NY *can only pay out your surplus. (1) Dividends paid only out of
cap surplus and retained earnings, not stated cap. (2) BD requires SH approval to transfer
funds from stated cap to surplus. Distributions cant render the company insolvent
2. Nimble Divide Test: DGCL 170 (1) Dividends paid either from surplus or from net
profits from current or preceding fiscal year, whichever greater (2) BD may transfer funds
w/out SH approval. Allows transfer for no par stock and allows transfer out of stated capital.
3. Modified Retained Earnings Test: CAL (1) Dividends paid either from surplus or sale of
assets, so long as (1) assets remain 1.25 times greater than liabilities and (2) current assets
are equal to greater than current liabilities (2) More flexible and generous to SH
4. Fair Market Value Test: RMBCA (1) Dividends may be paid from anything so long as (1)
corp is still able to pay its debts and (2) assets remain greater than liabilities combined with
preferential claims of preferred SH. Asset valuation: reasonable mkt measures. (2) Most
modern flexible (3) Insufficient protect for cred esp banks
iii. Other Protections: two other exist, minimum cap reqt and cap maint reqt
1. Minimum Capital Requirements: put up X amt at time of incorp. (1) Pro: provides protection
for cred at initial stage of incorp when there is high risk and lmtd information (2) Con: does
not provide long-term protect b/c corp could take huge loans after meeting reqt (3) US
Criticism: Standard min does not acct for diff btwn comp ; Delaware does not have min
capital requirements; some states do, but the amt necessary is nominal
2. Capital Maintenance Requirements: must maintain X amt of cap at all times and failure to
do so will trigger ability for SH to move for insolvency (1) Pro: provides more long term
protection for cred (2) Con: may permit SH too much ctrl (3) US Criticism: want to avoid
costs of pushing corp into bry when there is a chance of recovery.
d. Duties Owed to Creditors: DO, Cred, and SH all owe duties to creditors
i. Duties Owed by Directors to Creditors: in vicinity of insolvency D has duty to all
1. In the vicinity of insolvency, duty of DO shifts to being owed to corporation as a whole and
not just shareholders Credit Lyonnais Bankv Path Communications Corp
2. Facts: company in swirl towards insolvency has possession of 51 million judgment and is
weighing litigation options to try and get more to satisfy either shareholders or creditors
based on amt and potential of settlement
3. Holding: the company is in the vicinity of insolvency. Once you get in this vicinity, your
duties are owed to the corporation, not just to the shareholders.
4. (2) Rationale: creds impliedly negotiated for additional protection since SHs willingness to
take enormous risks near insolvency is apparent
5. To allow directors to beholden to shareholders is not ok because then shareholders will reject
positive net present value projects because they want more money and they should be
accepting anything thats net present value is positive.
6. (1) Pro: (a) more protection by keeping money in the corp (b) stops DO from swinging for
fences to satisfy SH (c) hard for corps to go bry if they are just having cash flow problems

28
(d) protects DO as viewed as ex-post (2) Con: (a) rule itself looks ex-post at a decision that
was made ex-ante (b) backwards looking at time when only looking at bad decisions,
bondholders protected twice: IR, duty
ii. Duties owed by Other Creditors: (left off here)
1. Fraudulent conveyance law: (a general creditor remedy) imposes an effective obligation on the
parties contracting w/ an insolventor soon to be insolventdebtor to give fair value for the
cash or benefits they receive, or risk being forced to return those benefits to the debtors estate
meant to void transfer by debtors that would be unfair to creditors
a. Fraudulent Transfers (transfers made for purpose of delaying, hindering, or defrauding
creditors) are void
i. Creditors can void transfers if there is (1) Actual fraud: a flat out lie- where
present and future creditors attack transfer by the debtor made with actual intent
to hinder, delay, or defraud other creditors
i. intent is hard to prove
ii. or (2) Constructive: give ambiguous information and allow others to draw
conclusions- if (a) debtors transfer assets w/out receiving fair value (b) debtors
assets left to run business were unreasonably small (3) debtors incur debts
beyond capacity to pay them when due
i. Ex: pay a creditor pittance when in bankruptcy
iii. Rationale: statutes stop ppl from avoiding creditors or engaging in bet the farm
transactions
iv. UFTA 84 Section 4(1) and (2) Uniform Fraudulent Transfers Act (UFTA)-
creditors can attack transfer on two ground 1) when it is made w/ the actual
intent to hinder, delay or defraud 2) or may void transfer made without
receiving a reasonably equivalent value --- the debtor knew that he would incur
debts beyond his ability to pay when they became due
1. Rationale: assets forced back into corp so it can satisfy all liabilities
2. Applications: two examples, leveraged buy outs and retention payments
a. Leveraged buy-outs: def borrowing money against the company assets to purchase
the companys shares at a premium, challenge transfers are made w/out receiving
reasonably equivalent value in return, result successful challenges will set aside the
transaction but only result in bankers losing their fees as it is difficult to trace money
given to stockholders
b. Example: Nabisco has a tobacco business and a cookie business all in one and it also
has a bunch of liabilities of $4billion in debt outstanding. KKR (a private equity
fund/pool of cash) wants to get in. To buy out the shareholders, you have to offer the
share price plus a premium. So for example, instead of $50/share on the market, they
will pay $63/share so they need a billion. KKR says theyll invest $400million and
goes to the bank and says they want $600million. The bank says why? KKR says
theyll pledge assets to the bank when they buy Nabisco. Bank lends $600million to
KKR and now the bank is a big creditor. The billion is paid to the shareholders, so
each is paid $63/share so KKR is the only shareholder. The creditors are upset
because now theres $600million debt outstanding that went to the shareholders and
none to Nabisco. Now the creditors of Nabisco can sue creditors of KKR and say get
rid of $600million loan and get money back from the shareholders (thats what
fraudulent conveyance does- duties owed between one creditor and the other
creditors).
c. Retention payments / severance payments: def paying top officers to stay
throughout bry proceedings challenge transfers are made w/out receiving reasonably
equivalent value in return result transaction will usually be set aside but there is
rarely money left to repay corp

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3. (1) Benefits: tries to stop people from taking money out before bankruptcy, youre making a
loan to your company to keep it going when others wont, stops ppl from engaging in purely
sham transactions (2) Costs: ex-post look at hard decisions, shouldnt all be easily Ked into
everything should be transferred at fair mkt value
4. you the creditors can bring a suit to stop transfer of these assets that are either actually or
constructively fraudulent, and bring those assets back into the co.
iii. Duties Owed by Shareholders: equitable subordination and piercing veil
1. Equitable Subordination: (invoked in bankruptcy context) protects unaffiliated creditors
(creditors not have SH type state in corp)--- debt characterized as equity BY CTS to protect
unaffiliated creditors from getting lesser claim by giving them rts to corp. assets superior to
those of affiliated creditors (an insider creditor) who happen to also be significant SHs of
firm (1) affiliated creditor must be equity holder (2) typically officer of corp. (3) and
committed wrongful behavior
a. Equitable Subordination is the court implemented remedy where PT convert into
Corp and D convert equity into debt. In situations involving undercapitalization,
equity holders cannot convert to debt Costello v. Fazio (145)
i. Facts: director/creditors file voluntary bankruptcy and file claims for $ based
on promissory notes, leaving co. grossly undercapitalized claims
owners/SHs trying to put themselves in same class as unsecured creditors and
their interests should be subordinated to his outside unsecured creditor claim b/c
they used to have a partnership w adequate capitalization, but when became a
corp, withdrew equity and turned it into debt of corp.
ii. Holding: undercapitalization coupled with self-serving transfer warrants
equitable subordination b/c it is not within bounds of reason and fairness
and not within the interest of the corporation as a whole
iii. should be subordinated to the claims of the general unsecured creditors.
iv. (1) D violated duty b/c they acted in their own self interest
v. Ds are personally liable for the debts and creditors must sue b/c their only
claim is one for equitable subordination.
vi. Factual determination b/c reason and fairness
vii. They did all this recapitalization, in order to lob themselves up into the
unsecured creditors. No benefit to the business; they werent making a loan to
the co. to keep it going; they didnt lend $41,000 for the company to keep
operating; instead they tricked the creditors.
b. Could you bring a claim of fraudulent conveyance?
i. Statutes say PRESENT AND FUTURE CREDITORS and say ACTUAL OR
CONSTRUCTIVE FRAUD; cts only let claims for future creditors ONLY
WHEN there is actual fraud.
ii. Here could bring claim for future creditors but not for actual fraud
iii. Constructive fraud? Probably could. Can argue that the original equity cushion
was the right one and taking out the money was fraudulent. Depends if the
business is old or new.
c. Whats the trick with constructive fraud and fraudulent conveyance? Statute
provides for existing and future creditors, but the case law rarely provides protection
under constructive fraud for future creditors.
d. Why? The creditors should be looking at the equity cushion so the future creditors
should be looking at whats going on right now. Existing creditors have the money
leave when they werent expecting it.
2. Piercing the Corporate Veil (151): Setting aside the entity status of the corp so that
individual SH can be held directly liable on contract or tort obligations, thus piercing the
veil

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a. Voluntary Creditors//K Creditors: K victims
i. Different tests to be applied:
1. Van Dorn Test: (1) disrespect to the corp form such that
unity and interest of ownership such that the separate
personalities of the corp and individual are merged
4 factors for the first prong:
a. failure to maintain adequate corporate records or to
comply with corporate formalities
b. commingling of funds or assets
c. undercapitalization
d. one corp treating the assets of another corp as its
own
2. (2) circumstances must be such that adherence to the fiction
of separate corporate existence would sanction fraud or
promote injustice. inability to pay judgment in itself is
insufficient to satisfy this prong.
ii. (1) Van Dorn Tests Sea-Land Services v Pepper Source (152)
iii. Facts: After Sea Land, an ocean carrier, shipped peppers for the Pepper Source,
it couldnt not collect the substantial freight bill because PS had been dissolved.
PS apparently had no assets. Unable to recover on a default judgment against
PS, SL filed another law suit seeking to pierce the corporate veil and hold
Marchese, sole shareholder of PS and other corps, personally liable.
iv. Holding: The corporate veil will be pierced where there is (1) a unity of
interest and ownership between the corporation and an individual and (2)
where adherence to the fiction of a separate corporate existence would
sanction fraud or promote injustice.
v. (1) M commingled his personal and business assets! This is not ok- you cant
use the corporate treasury as your personal bank account! He had other
companies with money in them so the ct reverse veil pierced Os other
companies assets P -> Pepper -> M -> other assets
a. False assurance + tax fraud was sufficient to satisfy
2nd prong.
vi. Laya Test: 3 prongs, 3d permissive
1. (1) Disrespect of the corp form unity and interest of
ownership such that the personalities of the corp and
individual are merged
2. And (2) if the acts were treated as those of the corp alone an
inequitable result would occur [much lower standard than
Van Dorn as undercap can suffice here]
3. And maybe- permissive prong, not mandatory (3)
creditors are charged with knowledge that a reasonable credit
investigation would disclose deemed to have assumed risk
of gross undercapitalization
vii. (2) Laya Test Kinney Shoe v. Polan (157)
viii. Facts: Polan formed IR company and Polan Industries. Although certificates of
incorporation were issued, no organizational meetings were held and no officers
were elected. Company, who had an agreement w. K, defaults on lease and
goes after Polan b/c the company has no assets- sole shareholder who controls
shell corpP made the first rental payment out of personal funds but made no
other payments.
ix. Holding: meets laya test for veil piercing

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x. Polan uses money from his own account, even though he knows the company
should pay and ignored the corporate formalities.
xi. If Polan had kept good books and records, he likely wouldnt be in this mess.
AND gross undercapitalization!
xii. Under the Laya test undercapitalization is enough for 2nd prong
b. (3) LOWENDAHLTest: 5th Circuit 1983 Krivo Industrial Supply v. Natl Distill:
Test: requires SH who (1) completely dominates corp. policy AND (2) uses control
to commit fraud or wrong (3) that proximately causes s injury. The domination
required for this test ordinarily includes a failure to treat the corporation formality
seriously and when it produces injustice or inequitable consequences.
3. Involuntary Creditors//Tort Creditors: tort victims. Differences with K creditors (1)
involuntary creditors do not rely on credit worthiness of corp for risk (2) cannot negotiate
with corp tortfeasors ex-ante for K protections from risk, cannot negotiate risks away.
a. Corp will not be pierced if it respects the corp form in every instance Walkovsky v
Carlton (161)
i. Facts: Walkovszky was run down by a cab owned by Seon Cab Corp. sues ,
SH of 10 corps with 1-2 cabs including corp. at issue, under theory of
respondeat superior when he got hit by cab driven by corp. ee each cab carried
state minimum insurance of $10,000.
ii. Holding: Thin capitalization alone is not enough to pierce corp. veil in
order to be individually liable, would have needed to show that was
furthering his own business purposes rather than those of the corp. (here
there was no divergence of interest)
iii. (1) Ct does not pierce corp form even though C owns 10 individual cab
companies w min insur b/c C respected the corp form
iv. Had legitimate insurance in each company even though theyre small- C didnt
not follow any rules
1. Mangan Case on p162: key factual distinction why the
defendant in M was allowed to be sued- different names of
company was distinguishing factor there.
2. VERY hard for veil piercing to happen in tort. Harder under
standard test because the second prong is satisfied with fraud
and in tort, its usually an accident or negligence and theres
no previous negotiation.
3. Limited liability in tort: cuts transaction costs but incurs
social costs (public safety underinvestment in safety and
overproduction in unsafe products); solutions to the
externalization problem = 1) direct regulation; 2) mandatory
insurance requirements; 3) price tort risks and motivate
safety precautions. 1st priority in corporate bankruptcy is to
tort creditors.
4. Justifications for and against LL in tort
a. inefficient to use LL in tort cases b/c if all costs are internalized, incl. tort liability,
there will be fewer cabs on the road (thats not efficient unless there are less accidents
to offset fewer cabs)
b. if you want to make efficiency argument, have to talk about ways to make person
with control internalize costs/harm; LL creates incentives to take risks
a. Hansmaan and Kraakman

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i. Want creditors to be able to pierce veil every time in public firms can use pro
rata rule to go after all SHs (i.e. creditor owed $200 gets $100 from partner
with $200 and $50 from partner with $50)
1. Tort victims didnt know what they were getting into (unlike voluntary
creditors) and thus should be compensated for their loss
ii. NOTE: NOBODY has accepted this proposal
1. It doesnt solve the problem b/c the injured party wont always be
made whole when there is enough money to achieve that
2. This gets rid of the informational problem of tradable shares BUT
might have situations where tort claimants arent individually
compensated AND the costs of litigation may not be worthwhile b/c
you will be getting pennies from thousands when there are many SHs
2. Possible Reasons Leg. Has not taken part in giving relief to tort claimants
a. Corps have pull with leg b/c they contribute to campaigns (BUT NOTE: bar may
have pull too)
b. Could slow economy down (initial confusion may inhibit investments, cts may use is as
a vehicle for tort reform and hear many cases, etc...)

V. CORPORATE GOVERNANCE (169)

I. SHAREHOLDERS: right to vote b/c they will be paid last and thus have the highest vested interest in making
sure the corp runs as smoothly as possible so they see their return.

1. Rights of Shareholders: 4 rights: (1) Voting (2) Selling (3) Suing (4) Information
a. Voting Rights and BD Elections: regulated by state law, common stock owners vote on (a) BD elections,
(b) charter and articles/certificate of incorporation, (c) mergers/activities other than the normal course of
business, (d) shareholder resolutions.
b. Rationale: why common stock has voting power: (1) place hands in power of those most unsecured from
returns and it will be KH efficient and (2) they lack any other financial guarantees, so theyre most likely
to care about the corporations well being and have an interest in voting
1. Collective Action Problem most important factor affecting shareholder voting

a. Two Extremes
i. Corp is owned by a controlling shareholder and voting is just a formality
ii. Diffuse shares with no controlling shareholder. Any 1 shareholders vote is unlikely to
affect the outcome of the vote.
(a) Economic incentives say to remain passive
b. BUT Feds tried to help increase awareness for SH: Changing Passive Voting System
i. 1934 Securities and Exchange Act (SEA) sought to empower shareholders through
forced disclosure of information and courts have tended to aid this process by implying
private remedies under the Act
ii. SEC, acting under color of s14, has promulgated proxy rules designed to encourage
informed shareholder voting
2. Election of Directors
1. Every corp. MUST HAVE BOD at least one member (DGCL 141(a))

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2. ii. If you want to inc size of Bd, that expansion can be accomplished by resolution of Bd if its
in the bylaws but NOT the Bd if its in the charter. This is b/c the charter is only amended by
the SH whereas the bylaws can be amended by the board if they have reserved that right in the
charter (if not, then SH vote, too like in DGCL)

3. Every corp. MUST HAVE AT LEAST ONE CLASS OF VOTING STOCK


a. default is one vote per share (DGCL 212(a))
b. In publicly financed corps most equity takes form of voting common stock
4. Every corp. MUST ELECT DIRECTORS ANNUALLY (DGCL 211)
a. Occurs at annual SH meeting
5. Procedural Requirements: Actual Notice requirement (DGCL 222(b)); quorum requirement
(DGCL 216) and record date (DGCL 211(c)) established by the charter or in a bylaw
a. NOTE quorum rules (default rule DGCL 216) quorum is over (i.e. 50% +1) of
all shareholders eligible to vote; corp. allowed to reduce quorum requirement to NO
LESS THAN 1/3
b. *note: If theres a vacancy in the Bd, the BD can appoint another member for the BD
but that new appointed member still has to stand for the next election.
1. Types of Votes:
a. (1) Straight: 1 share equals 1 vote in each election for every D, all SH have
equal vote in electing BD. If 3 directors stand for election, you simply vote Y or
N for each director.
i. EX. If you have a co. w/ 100 shares outstanding, Treanor owns 70 and
Diller owns 30. Treanor will vote his 70 shares in favor of his 3 favorite
directors and those directors will win.
b. (2) Cumulative: Number of Shares SH holds multiplied by number of seats
being voted on. Can pile up all of your votes.
i. Ex: Treanor 70 shares, 3 slots outstanding, treanor has a total of 210
votes and can allocate them as he likes. Diller has 30 votes, total of 90
votes. What happens? Diller puts all 90 of his votes on 1 director, who
will get elected b/c Treanor will split his 2 votes, 105 and 105, for his
favorite 2 directors. This permits minority shareholders to weight their
votes for their favorite director, to give them a voice.
ii. Rationale: Ensures minority is represented on BD b/c minority SH can
weigh votes for at least one seat on BD by lumping Hewlett-Packard
Battle: Article stating that while the BD didnt want to nominate
dissident director Walter Hewlett, he could still be elected thru
cumulative voting
2. Types of Boards
A. Types of BDs:
i. (1) Ordinary/Basic BDs: DGCL 211Annual votes for all, the entire
BD is treated as only in 1 class that is voted on each year by SH as a
whole, most fortune-500 companies are basic
ii. (2) Staggered BDs: DGCL 141(d)Annual votes for some, BD divided
into up to 3 classes each up for election at X-year intervals. Rationale:
anti-takeover device, takes at least 2(X) election terms to gain ctrl of BD
thus protecting incumbent BD for at least 2 more terms, protects against
hostile takeovers, especially for minority SH that might not have the
same weight in electing Directors. BD may not adopt staggered BD
where its goal is to make it impossible to change the current BD (the ct
will analyze circumstantial evidence to determine this). Research

34
indicates that staggered boards basically make takeovers through proxy
contest impossible.
B. Removing Directors (173):
i. State law governs. (1) SH can remove BDM only for good cause
unless the charter provides otherwise Campbell v Lowes Inc. stated due
process rights protect BD when they are removed by SH, although the
extent is unclear of what their rights actually are. The definition of good
cause is also uncertain- obviously fraud or unfair self dealing count.
(DGCL 141(k).
ii. (2) BD can remove BDM only if BD has explicit SH approval. Ex: a
BD cannot adopt a bylaw that purports to authorize it to exercise a
removal power. The only bylaw that can grant BD power to remove
BDM is one stating for good cause, only in some states. NYBCL 706 (for
ex:)
ii. SH Meetings and Proxy Voting (176):
Meetings:
1. (1) Annual: required by states corp law, regular business handled, BD elected. If BOD
fail to convene for 13 mos., SH can petition ct to require meeting (DGCL 211
2. (2) Special Meetings: permits SH votes on fundamental transactions (proper purposes) at
meetings other than the annual one this rt depends on state law
A. DGCL 211(d): SH can call only if auth. by corp. charter
B. This is good for efficiency, b/c if SH are calling these meetings, it means theyre
monitoring the corporation closely which will lower agency costs and less waste.
On the other hand, holding more meetings is expensive- its a trade-off.
3. (3) SH consent solicitations: DGCL 228 Definition: SH may take action with any such
action that could be approved at a SH meeting via written consent if there exist
unanimous SH approval. Details: Its a less costly alternative to special meetings for SH,
if the state statute permits, it allows a provision permitting SH to act in lieu of a meeting
by filing a written consent. Rationale: can lessen hostile takeovers
iii. Proxy Voting:
1. To get quorum (50%+), SH may vote by proxy and corp mgmt is allowed to collect
voting authority by collecting proxies instead of showing up the meeting in person.
DGCL 212(b).
2. State law governs basic duties of proxy holders as agents
3. Federal Law governs solicitation and exercise of proxies under 14
4. (1) Proxy cards: sent out by mgmt to SH, SH usually vote in line with CEO, if CEO
doesnt have 51% CEO usually will not call meeting. If CEO doesnt have 51% of the
votes, she will delay/postpone the meeting. Bds of Directors will NEVER lose a
shareholder vote, at these annual meetings. (2) Revocation: SH can revoke by
attending the meeting, SH can always change their proxy at the meeting thus company
hires lawyers to monitor whether large SH show up at meetings which is a cause for
concern (3) Collective Action: b/c proxies costs money, some SH might not approve and
it seems like its in the Bds interest and might be like self dealing. Proxy voting relies on
one or more persons to incur the initial expenses of soliciting proxies which the corp
expends. Since these costs are substantial, SH face a serious impediment to collective
action. CA is not curbed by this process as someone must front substantial expenses.
BUT in 2007, SEC released eproxy which will cut down on costs and potentially lessen
the collective action effect.
5. Paying for Proxies: Diff. treatment for incumbents and insurgents. Costs of soliciting
proxies matter of normal governance b/c annual SH meetings subsidized by corp.
treasury

35
A. NOTE SHs never get reimbursed in a proxy fight (cost is borne by SHs b/c it
reduces future dividends) can avoid this by classifying board and making co.
harder to take over
B. Incumbent BD may incur reasonable expenses related to defense of proxy
contest if (1) dispute related to a policy matter rather than personal matter and (2)
the incumbents act in good faith BUT insurgents will only be reimbursed if (1)
insurgents win and (2) SH ratify it (Froessel Test) Rosenfeld v Fairchild Engine
& Airplane Corp. (179)
i. Facts: Fairchild corp paid monies out of their treasury to reimburse both
sides after a proxy fight. The SH ratified the expenses and stockholder
Rosenfeld argued that they were not legal charges that could be
reimbursed and sued to compel a return all of the funds to the corp.
ii. Holding: Corps may pay reasonable expenses to defend itself and its
corp. policies (objective standard determined by ct look to good
faith)
iii. majority
iv. SH approval = evidence of good faith and ct wont upset their decision.
v. Rationale: (1) Incumbent directors would be unable to defend their
positions and operate corporate policies if this wasnt the case, as well as,
the old boards entitled to reimbursement, too- you want it to be a fair
fight.
vi. Also: encourages only valid proxy contests by reimbursing reasonable
insurgence and discourages frivolous proxy contests by not guaranteeing
insurgents reimbursement. Almost always when insurgents win, both
sides get reimbursed.
iv. ****Insurgents ONLY reimbursed if they win
1. Rationale: this rightly discourages frivolous proxy fights b/c of the high costs, you
only engage if you have a good chance of winning
v. ****Outgoing board can be reimbursed
1. Rationale: theyll use funds to defend corp. policies anyway b/c they want to keep their
jobs SO if there is reimbursement, there will be more incentive to keep SHs informed,
etc...
vi. Class Voting (181):
1. A transaction that is subject to class voting means that a majority (or such higher
proportion that may be fixed) of the votes in every class that is entitled to a separate
class bite must approve the transaction for authorization
2. Default Rule: one class of stock (usu. Common stock)
3. BUT NOTE: DGCL 151(a) allows corp. to create different stock and allocate voting rts
accordingly
A. Preferred Shares: share that has a promised dividend amt. per year pay
preferred dividends before regular SHs
4. NOTE: DGCL 242(b)(2): when you have different classes of stock and you want to
engage in an activity that may hurt a particular class, you have to a have a majority vote
in that particular class
A. this rule CANNOT be Ked around it is a requirement
b. Special Exception: If charter provision provides before issuing shares that SHs
cant vote as a class, that is ENFORCEABLE as long as they are on notice
beforehand, if they buy the shares anyway there is EFFECTIVE CONSENT
5. Nature of SH Classes: (1) Preferred Stock: dividends paid first entitle to liquidation
preference, no voting rights except in the particular circumstances where their own

36
classes interests can be adversely affected (2) Common Stock: subservient to PS but
have voting rights. Go last in payment of dividends
6. To Pass: A majority of the votes in every class that is entitled to a separate class vote must
approve the transaction for its authorization. Rationale: Provides structural protection
for PS (minority) from will of CS (majority) in allowing them to vote. This is a particular
voting right for your class for your class.
7. Effect: Protects legal rights (how much stock outstanding, voting rights, dividend rights,
liquidation rights) but not the economic value itself
A. Application: Comes up most often in mergers when preferred stock does not get
vote in such circumstances b/c a mirror preferred is created (preferred in A now
has preferred in AB and still no voting rights). Rationale: Preferred knew they
had no voting rights when the entered into the company when it was A.

c. Information Rights (183): SHs must be informed in order to vote intelligently. Governed by (1) Fed
Sec Law: 33 Act regulates info given on initial sale of company and IPOs (2) State Law: DL Gen Corp
Law Sec 220(b): SH may inspect (1) company stock ledger (2) SH list (3) other books and records, for
any proper purpose: broadly construed, purpose reasonably related to such persons interests as a SH
i. Stock List: IDs SHs and lists their contact information, it is used by SH to contact SH to give
proposals, instruct on how to vote for certain matters. List discloses the identity, ownership
interest, and address of each registered owner of company stock. Corporation must turn over the
stock list whenever its asked unless the person asking has an improper purpose (never happens).
Doesnt contain proprietary information
1. Access: The list is relatively easy to get b/c judiciary construes proper purpose so broadly
2. Potential secondary motives do not matter when seeking a stock list as long as there exist
proper purpose
3. More info means the mkt will function efficiently
4. Usually digitally stored and delivered and also want identifying information before
releasing it
ii. Inspection of Books and Records: Provides a close look at the corps financial stmts, this is
sensitive and competitive information (costs, trade secrets) and thus cts protect it more
1. Access: Case-by-case Scrutiny of Ct. Ct scrutinize these carefully, likely to deny
requests. Courts almost always reject the shareholder efforts to seek the inspection of
books and records
2. Rationale: Deter sneaky ppl from buying one share of stock and then requesting this
sensitive competitive info.
3. The Ct places the burden of proof directly on SH. Ct analyzes the SHs (1) position
toward the corp (2) SHs stated purpose, it must be strong
4. Why this rationale? (1) Peoples Ulterior motives should be available in annual
report, quarterly report, archives, budgetso why would someone need to look at books
and records with the detailed stuff? (2) People Might be sketchy i.e. plans to launch a
new project in five year projections, new marketing materials, etc that would allow
someone to sneakily respond. The people that were going to want to look would be the
competition- buying a few shares and trying to take a peek at the records to run your
company out of business

2. Separating Essential Rights (Cash Flow Rights and Voting Rights) Vote Buying (184):
a. Vote Buying (192): (1) SH may not sell her vote other than as a part of a transfer of the underlying
share and (2) transferor must give his transferee a proxy to vote the stock unless transferor
specifically retains voting right to protect his legal interest in the stock or the corp is strong enough to
support grant of an irrevocable proxy.
i. Easterbrook & Fischel, Voting in Corporate Law:

37
1. In nearly every case it is legally possible to separate the voting right from the equity
interest BUT its not in a corporations best interest to do that.
2. By not separating a vote from the share, this ensures that an unnecessary agency cost will
not come into being, as separating shares from votes introduces a disproportion btwn
expenditure and reward. Ex: if owner of 20% of stocks acquires all of the votes, his
incentive to take steps to improve the firm is only one-fifth of the value of those decisions,
and the holder of the votes will invest too little, and have an incentive to engage in non-
profit maximizing behavior
3. Believe transactions in votes would be bad b/c (a) hard to value and (b) create costs
without conferring benefits over transactions in votes tied to shares (c) collective action
problem: b/c no voter believes their vote will influence, he would sell vote for any non-
zero price, price may go up but it would not reach equity-dilution
ii. Corporate vote buying is lawful as long as it does not prejudice other SH Schreiber v Carney
(193)
1. Facts: Texas Intl and Texas Air entered merger discussions. Jet Capital was a 35%
shareholder in Texas Intl and had effective veto power over any merger. To merge,
committee of noninterested directors and an independent counsel formulated a loan plan
which the shareholders of Texas International overwhelmingly approved. Schreiber, a
dissenting SH of Texas Air, sued saying vote buying happened and is per se void.
2. Holding: corporate vote buying is permissible if it does not work to the prejudice of
other shareholders.
3. Agreement was a voidable act of vote buying that was cured by SH approval not void
per se b/c object and purpose of agreement was not to defraud or disenfranchise SHs but
rather for purpose of furthering interest of all SHs
4. (1) Ct upholds Jet Caps (SH in Texas Intl) agreement with Texas Intl to withdraw their
opposition to a merger if it received a loan from Texas Intl
5. If such a plan works to the detriment of the nonparticipating SH, then void
6. Crts use standard of intrinsic fairnessif SH majority vote, presume its fair
7. Efficient? Rule itself efficient (buy and sell votes like any other asset) BUT inefficient
because its case by case analysis so you cant inform people of how to act.

3. SEPARATING CONTROL FROM CASH FLOW RIGHTS


a. Objective and Rationale: To maximize efficiency we want to align cash flow rights and voting rights
(which is why we give CS the voting power) and sometimes this goal is frustrated Example: capital
structures with dual-class voting, which misalign control rights and return rights, are not prohibited by
law, although they are discouraged by stock exchange listing requirements. The law does proscribe
some devices that misalign incentives like statutory prohibition against a corporation voting shares
owned by the corporation directly or indirectly.
A. Circular Control Structures Corp may use a subsidiary or joint venture in which the parent corp.
owns a minority interest in order to obtain substantial voting rts in corp.
b. (185)
i. circular control structures try and limit greed and conspiracy where the corporation owns a
subsidiary or a joint venture that could potentially be used in bad faith to control the subsidiary
and has a controlling share within itself which isnt allowed
ii. can separate cash flow rights from voting rights which always makes us nervous because
shareholders are residual claimants and if this changes, theyre not
iii. Statutes (i.e. DGCL 160(c)) proscribe a corp. from voting on shares owned by corp. directly or
indirectly (circular control structures)
i. This statute limits entrenchment disallows director that controls another corp.
from getting that company to buy stock and vote to keep director in

38
iv. no corporation shall vote shares of its own capital stock belonging to the corporation or another
corporation if a majority of the shares of such other corporation entitled to vote is held, directly or
indirectly, by the corporation
v. Speiser v. Baker (186)
1. Facts: Speiser, a 50% owner of the common shares of Health Med Corps and one of its
two directors, contended that the corporation was required to hold an annual stockholders
meeting to elect directors. Baker, the other 50% owner of Health Meds common shares
and its other director, counterclaimed that Health Med could not vote its 42% stock
interest in Health Chem, a publically traded company, at such a stockholders meeting
because to do so would contravene a statutory prohibition on the voting of shares
belonging to a corporation despite the fact that Chem did not hold, even indirectly, a
majority of the stock entitled to vote in Health Meds election of directors
2. Holding: Where a statute prohibits the voting by a corporation of stock belonging to
the corporation, stock held by a corporate subsidiary may belong to the issuer and
thus be prohibited from voting, even if the issuer does not hold a majority of shares
entitled to vote at the election of directors of the subsidiary.
3. Further, where the capital of one corporation has been invested in another and that
investment, in turn, is used solely to control votes of the first corporation, b/c the second
corporation owns voting stock in the first corporation, the statute applies to prohibit
this. This is muffling the voice of public shareholders and only leaves an interested party
to decide the corporations dealings. It would make voters votes null in these situations if
there was no prohibition.
a. DGCL 211(c)- if havent had SH meeting w/in a yr a SH can go to the ct to request a
meeting. Here the capital of one corporation (Chem) was invested in another corp
(Health Med) and that investment was being used to control votes of Chemthis
muffles the voice of the public SHs of Chem in the governance of chem. and thus struck
i. If youre using your own money to entrench yourself its fine BUT you cannot
do so with the SHs money this was protecting the 40% public in Health
chem. Who would have been disenfranchised
c. Controlling Minority Structures (200): The following structures allow a SH to control a firm while
holding only a fraction of its equity:
i. Dual Class Equity Structures: Single firm issuing two or more classes of stock with different
voting rights. Planner can attach all voting rights to the fraction of shares that are assigned to the
controlled, while attaching no voting rights to the remaining shares distributed to the public or
other SH. Essentially, this gives certain people voting rights in the stock and then attaches no
voting rights to the remaining shares that are distributed to the public or other shareholders at that
time. i.e. class A shares get 10 votes/share but other stockholders get 1 vote/share on the market.
This allows a family/concentrated majority to control the company. i.e. Martha Stuart, Ford
family, etc. controlling the company even though its public
ii. Stock Pyramids: Most popular of the three. Two-tier pyramid: controlling minority SH holds a
controlling stake in a holding company that holds a controlling stake in an operating company.
Three-tier pyramid: primary holding company controls a second-tier holding company that in turn
controls the operating company. This structure rapidly separates equity from control.
iii. Cross-ownership Ties: Companies are linked by horizontal cross-holdings of shares that reinforce
and entrench the power of central controllings. Differs from pyramids in that voting rights used to
ctrl the corporate group re distributed over the entire group rather than concentrated in the hands
of a single company or SH. Similar to pyramids because a controller can exercise complete
control over a corporation with an arbitrarily small claim on its cash flow rights
iv. In the US and UK , neither pyramids nor cross-ownership are popular because (1) we impose an
income tax on inter-corporate dividends, thus there is a significant tax penalty on moving
corporate distributions through two or more levels of corporate structure (2) Investment Company

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Act of 1940 imposes regs and reporting requirements on group structures tied together by webs of
minority holdings

4. Collective Action Problem


a. Difficulties in Exercising Rights Definition of the Problem: even a one share, one vote rule cannot
protect SH who habitually approve management proposals. Thus when SH habitually approve mgmt
action, can the SH effectively govern under the voting system?
b. Role of Institutional Investors:
i. Easterbrook & Fischel: (1) all problems can be solved by competitive forces, no need for gov
regulation and intervention and believe there to be a large problem in the market, collective action
(2) SHs are rationally apathetic, individual vote will not change the corp so they defer to mgmt.
1. Huge market supporters, believe that all problems can best be solved by competitive
forces; no need for govt regulation and intervention. They think theres a problem in the
market, with all this information (disclosure laws, quarterly and annual current reports;
state law providing access to stock lists) the shareholders can call up and ask whats going
on. E&F argue thats actually not what will happen. Shareholders no incentive to pay attn.
to this info, and will never get themselves coordinated to do anything about it b/c its
millions of shareholders owning .0001% of a company; takes lots of effort to track enough
ppl to get it up to 10% of the shareholders.
ii. Professor Black: (1) May be true some are apathetic but institutional investors could overcome
collective action problem and govern if gov. restrictions on SH oversight were loosened (2)
Significant SH are less passive b/c they (a) have bigger shares (b) have outside interest due to
fiduciary duties [hold stock for others, pension plans, etc.]
1. Takes the opposite view of E&F. Says its true for everyone, but NOT institutional
investors or p/e or hedge funds. These institutional shareholders (GS, Fidelity, Vanguard,
CS First Boston, JPMorgan) and pools of cash pay attn. It makes sense for them b/c they
have a large stake, and the requisite staff (proprietary trading staff at GS have strong
incentives to pay attn. to whats happening in the company theyre trading its their
bonus and jobs at stake to buy/sell at the right time). SAC Capital, HF in Greenwich,
involved in the market. Argues that E&F have it wrong, the institutions have incentive to
pay attn. b/c of large stakes and staffs.
iii. Pozen: thinks institutional investors will weigh costs and benefits to decide whether to become
active. If it worth their time, money and effort to be active, then they will, but most likely it will
be more costly for them to get heavily involved. A lot of times the involvement depends on their
likelihood of success in an action. Many fees associated with these action set up the assumption
that institutional investors will usually function as passive money manager rather than active
therefore their intervention is generally not expected.
iv. Kahan and Rock: hedge funds will be the most dynamic SH activists. They benefit directly and
substantially from achieving high returns. The incentives for them to monitor is high.
c. Scenarios: Two Scenarios (1) No costs of collective SH action b/c there is only a very small, if more
than one, number of SH thus the voting system is merely a formality. (2) Informed shareholders require
that some investment in information be made by a very large number of SH, which is collectively and
individually costly. Any one SH is quite unlikely to influence the outcome of the vote, thus it may be of
more cost than benefit to a SH to take informed action as her economic incentive is to remain passive,
thus the voting system is merely a formality

5. Governmental Efforts to Coordinate Action (209)


a. Federal Proxy Rules: serving the efficient capital markets hypothesis, disclosure = KH efficiency
i. If theres adequate info in the market, sophisticated players will make the trades necessary to
have the stock prices accurately reflect co. value. So, we need to make sure theres enough info

40
at the market at the right time. SEC will oversee all this making sure cos. making required
disclosures in right format at the right time.
ii. If you send this info to shareholders to vote Y/N, you must provide them w/ the right information.
You want to make sure that all shareholders have the right info in time to make some type of right
decision. A&K march through substantive impact of these fed proxy rules.
iii. Disclosure and SH Communication:
1. Federal Securities Laws: originates with SEC Act of 1934, chiefly 14(a)(c) which regulate
14a-1(l)(iii): virtually every aspect of proxy voting in public companies, 1992 Amend
solicitation is a. Securities Act of 1933: Regulates info comps need to bring forth first time they
any come to the public, ie IPO
communication b. Securities Exchange Act of 1934: Regulates info that public comps must provide to
reasonably their SH on an ongoing basis (reports: annually, quarterly, at votes)
calculated to result i. Section 14A proxy requirements if youre going to send out proxy
solicitations asking shareholders to vote with you, you have to
in procurement of
satisfy all reqs of 14A.
a proxy. c. The fed proxy rules consist of 4 major elements:
i. SEC-Mandated Disclosure: require that anyone soliciting proxies from public
14a-3(a) may not SHs must file with the SEC and disclose relevant info also prohibits
solicit proxy fraudulent or misleading proxy solicitation
unless provide ii. No open-ended proxies: substantive regulation of process of soliciting proxies
proxy statement from SHs - prescribe form of proxy card and the scope of proxy holders power
containing the iii. SH Access: 14a-8 permits SHs to gain access to the corp.s proxy materials
information SHs gain low-cost way to promote certain kinds of SH resolutions
provided in iv. Private Remedies: general anti-fraud provision 14a-9 allows cts to imply a
Schedule 14A private SH remedy for false or misleading proxy materials
(1) Rules:
14a-2(b)(1) (2) Rule 14a-1: 14a-1 defines terms, including the critical terms proxy and solicitation. Proxy
statement is any communication to result in procurement of a proxy. A proxy can be any
solicitation or consent whatsoever
(3) Rule 14a-2: is broadly framed to insure that most proxy solicitations will be subject to regulation
BUT, Exempted proxy solicitations are listed under subsection 2(b).
(4) 14a-2(b)(1): (proxy exemptions in this section added in 1992 amendments) Press release or
letter to someone announcing how you intend to vote your shares in a future mtg and why it is not
a proxy solicitation Announcement exemption. Applies to shareholders and non-shareholders
(a) (a) This allows large financial institutions to announce whether they are going to support a
merger or not
(b) (b) There is no limit on the # of announcements that can be published or broadcast.
(5) 14a-2(b)(2): A communication sent to no more than 10 individuals is not a proxy solicitation
(6) 14a-2(b)(3): Communication that urges a shareholder to vote in a particular manner. One
shareholder can write to another and urge them to vote in a certain way provided the writer
doesnt solicit a proxy or doesnt act in concert with someone who is soliciting proxies (this
exemption does not apply to any person affiliated with the company- i..e CEO cant do this)
(a) Person who own $5mill or less of the cos securities that are the subject of the solicitation
will not be required to submit written soliciting material to the SEC
(b) notice is required to be delivered or mailed to the SEC within 3 days of first use of the
soliciting material
(c) No notice or filing requirement for oral communications
4. 1992 Amendments: created new exemptions (14a2 i.e. role of Institutional Investors: Allows up to 10
institutions to communicate w/ each other without first launching expensive full-scale proxy contest, can take out
ads as well.) and 14a2b- principal registration requirements do not apply to any manager, director, employee, etc
of the company (see slide!)

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iv. SH Proposals (p213) Town Meeting Rule (entitles SH to include certain proposals in the
proxy materials): 14(a)(8) Permits any SH who (1) owns $2000 worth of stock or 1% of company
stock for at least a year (2) submits a proposal less than 500 words (3) and must be submitted 120
days prior to when management releases/mails proxies to file with mgmt your own SH proposal
giving mgmt time to challenge the proposal and time to add it into the proxies
1. The Proposal Itself (1) Reqts of Proposal itself: (a) must state the identity of the SH,
number of proposals and length of the supporting statement and subject matter of
proposal. must be proper subject (b) has to relate to more than 5% of companys business
(c) Cant relate to ordinary conduct of bsn (d) Cant relate to election of D (e) Cant
specifically oppose mgmt proposal
2. (2) Categories: SH proposals fall under either (a) corporate governance or (b) matters of
general social responsibility(in the recent past, this has become more prevalent, most
proposals in the past were corporate governance focused, but people have since become
socially conscious) (3) Rationale: Purpose mgmt run company take suggest not
direction
a. Works like this: shareholder sends proposal to management 120 days before proxy is
released. Management goes through and sees if it can exclude the proposal via the
exclusion grounds (why inclined to exclude? Want to maintain control and if it was
a good idea, think they would of thought of it themselves). Then if it can be
excluded, they will write to the SEC and say they want to exclude it for X reason.
SEC then writes back and says they need to include it and they will OR SEC will
write a no action letter
3. Also lists 13 grounds for exclusion. Rule 14a-8(i) lists grounds that permit firms to
exclude proposals from the co's solicitation materials. If theyre going to exclude one of
these, the company has to get approval from the SEC and must state one of the following
grounds:
a. i. Improper under state law OR a violation of the law (see case below for example of
exempt b/c violation of state law) (14a-8(i)(1), (2))
b. ii. Violation of Proxy Rules (14a-8(i)(3))
c. iii. Personal grievance (14a-8(i)(4))
d. iv. Doesnt relate to substantial part of business (<5%) (14a-8(i)(5))
e. v. Absence of power/authority for co to implement proposal (14a-8(i)(6))
f. vi. Proposal relates to a matter of ordinary business (14a-8(i)(7))
g. vii. Relates to Board elections (14a-8(i)(8)) (2007 amendment broadened the
definitions of election to mean companys can exclude proposals relating to
membership on the board or a procedure for such nomination or election. i.e.
barring on going efforts to allow long time shareholders to nominate someone for
the board)
h. viii. Conflicts with cos proposal (14a-8(i)(9))
i. ix. Co has already substantially implemented the proposal (14a-8(i)(10))
j. x. Proposal substantially duplicates another proposal (14a-8(i)(11))
k. xi. Resubmission of same proposal w/in last 5yrs (14a-8(i)(12))
l. e. Cos that wish to exclude a shareholder proposal generally seek SEC approval
(Rule 14a-8(j))
e. Companys that wish to exclude a shareholder proposal generally seek SEC approval (Rule
14a-8(j))
i. SEC's approval of such a request is called a "no action letter" and states that the SEC's
Division of Corporate Finance will not recommend disciplinary action against the co if
the proposal is omitted. No Action Letter: issued by SEC to permit mgmt to exclude the
SH proposal from the proxy materials w/out being penalized.

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4. Analysis of SH Proposals: (1) Traditional Rule (Current): SH proposals are analyzed on a
case-by-case basis
a. AFSCME Employees (example of 14a8i exemption) (200): The Supreme Courts
decision addressed a proposed stockholder bylaw that would have required the
Board of Directors of CA, Inc. to reimburse the reasonable expenses incurred by
stockholders in conducting successful short-slate proxy contests. (amendment
would make it easier for SH to put forth this short slate and make it easier for
insurgents to challenge directors to allow reimbursements only if you win (existing
law) not if youre successful only
b. The Court held that, while the proposed bylaw related to director elections and,
thus, was a proper subject for stockholder action under Delaware law, the
proposed bylaw mandates reimbursement of election expenses in
circumstances that a proper application of fiduciary principles could preclude
and, thus, if adopted, could cause CA to violate Delaware law.
c. Violation of state law so you cant have this proposal and can reject it
d. Reaffirms the bedrock principle of Delaware corporate law that the directors of a
corporation, not the shareholders, manage the business and affairs of the
e. Bylaws may not mandate how the board should decide specific substantive
business decisions, but may define the process and procedures by which those
decisions are made.
v. Antifraud Rules: 14(a)-9 prohibits use of proxy solicitation materials that contain statements false
or misleading with respect to any material fact, OR which omits any material fact necessary in
order to make the statements therein not false or misleading
vi. private right of action for individuals to bring fraud claims rationale: SEC was concerned they
were not keeping up with claims
1. Elements of a claim P must show: (1) the statement must be material (2) person who gave
statement must met requisite level of culpability: some cts its negligence, others its
scienter (level of intent to commit fraud) (3) proxy statement fraud must cause the damage
(4) damages: money or injunctive or rescission
a. No need to show reliance
b. SEC and SC have accepted that all publicly available information is incorporated in
the stock price, so this makes showing things like reliance or causation REALLY
easy. Just show the fraudulent statement is an essential link in the proxy voting and
thats enough to prove causation
2. Opinions are actionable when they are material to the SH and supported by objective
evidence Virginia Bankshares, Inc. v Sandberg (230)
3. Facts: Freeze out merger required BOD approval and vote of majority SH here, Bank
told min SH theyd receive $42/sh a good and high price- based on info provided by the
Bank. They got vote of majority + majority of minority b/c of material misrepresentation
in proxy b/c price actually not good SH sues on theory of fraud (not really a good deal)
and conflict of interest (director voted in a way to keep his job))
4. Holding: knowingly false statements of reasons for director recommendation are
actionable if they are misleading BUT SH here fails to show causation (must some
injury resulting from fraud) lacked an essential link (vote was not essential to
transaction)
a. b/c majority would have voted in favor w/o the misrepresentation that they were
getting the best deal, they are not liable claims they dont know what minority
would have done and Sct says they dont want to speculate it wasnt required
anyway.
5. (2) It matters that the statement is only an opinion b/c what is material is that it carries
gravitas. Did not matter that the opinion was wrong, what is wrong is if they are

43
misleading about the underlying facts however no damages b/c state remedy is still
preserved
6. Point: if the vote doesnt actually directly cause the material decision to be made, the
proxy fraud rule doesnt apply and there are state rights of action here- so sorry.
b. State Disclosure Law and the Fiduciary Duty of Candor (236): Runs parallel to fed law
i. Fiduciary Duty of Candor: State law recognizes a fiduciary duty of candor that applies to Ds and
Controlling SH; Ds and Ctrling SHs must be honest w/ SHs and provide them w/ all facts
ii. Conflict with Federal Securities Law
1. we dont want the same claims going to two courts so lets make state and Fed law similar
2. if you have a state law and Fed claim, you can consolidate them in federal court
3. state law is trying to make duties as close to federal law when it comes to proxy
disclosures b/c they already have a body of law and making it consistent would make
sense
4. Limitations on Suits
a. Necessity of Shareholder Act: States will only permit a suit to go forward if SH
action is required for transaction to proceed
i. If SH action is necessary state law remedy
ii. If SH action is not necessary no state law remedy
b. Continuing Shareholders: SH who neither purchased nor sold for the duration of the
fraud will have a state law remedy
i. States carve out an anti-fraud niche
ii. Continuing SHs are not protected under Federal Securities Laws, so expect to
see a state action under these circumstances
iii. Claim such as this could be stated on the facts in a state setting (theres a duty whether its state or
federal law and SH will be protected) Malone v Brincat (237): Del Supreme Ct abandoned the
historical limitation on state remedy conflicting with federal securities laws (1) Though ct
dismissed SH action where SH alleged D made false filings with the SEC and distributed false
financial statements to SH, which allegedly caused ruin of the company, the ct held that a claim
could be stated on the facts in the case and gave Ps right to replead as a derivative action or an
individual claim.

II DIRECTORS AND OFFICERS Duties of Directors and Officers and Controlling Shareholders (239)

1. Summary of the 3 principle duties


a. Duty of Obedience: Fiduciary must act consistently with the legal documents that create her authority
(Ex: charter, bylaws, etc.)
b. Duty of Care: duty to not be an idiot // applies in all decisions D and O make must be grossly
negligent, mere negligence does not suffice
i. Definition: D or O has duty to the corp to perform Ds or Os functions: (1) In good faith and (2)
In a manner that he or he reasonably believes to be in the best interest of the corporation and (3)
With the care that an ordinarily prudent person would reasonably be expected to exercise in a like
position under similar circumstances
c. Duty of Loyalty: duty to not be a thief // applies where there is a conflict of interestrequires that
corporate fiduciaries exercise their authority in a good faith attempt to advance corporate purposes
1. Applies where D or O can benefit on both sides of a transaction
2. Bars corporate officers and directors from competing with the corporation

2. Duty of Care/Business Judgment Rule (subject to judicial review) (240):


a. Duty of Care: the standard is gross negligence
i. Definition: D or O has duty to the corp to perform Ds or Os functions: (1) In good faith and (2)
In a manner that he or he reasonably believes to be in the best interest of the corporation and (3)

44
With the care that an ordinarily prudent person would reasonably be expected to exercise in a like
position under similar circumstances
ii. Approach:
1. Q1: Is there a 102(b)(7) provision in the companies charter?
a. If yes unless breach of DoL or good faith then D protected from liability
b. If no go to Q2
2. Q2: Does BRJ Apply?
a. BJR will apply unless (1) D O failed their duty to monitor (2) there is waste (3)
illegality or knowing violating of existing regulation (4) other: fraud or gross
negligence
b. If none of these BJR applies, if any of these no BJR
b. (1) Business Judgment Rule:
i. Definition: Decision constitutes a valid business judgment (and gives rise to no liability for
ensuing loss when it) (1) is made by financially disinterested directors and officers (2) who have
become duly informed before exercising judgment (3) that was exercised in good-faith effort to
advance corp interests.
ii. Assumed to have acted in good faith for the business, so BJR gives good protection in many cases
iii. Approaches to the doctrine: Procedural and Substantive
iv. Procedural Approach (Abstention Doctrine):
1. Theory: a procedural mechanism through which the courts abstain from evaluating the
conduct of the board of directors
2. So they look for the below things and if theyre not there, they abstain
3. (1) In applying BJR cts abstain from reviewing D decisions; as a result cts are less
crowded. (2) Abstention Doctrine: If cts find that D and O have made decisions w/out
fraud, illegality, neg or CoI then the cts will not look further
v. Substantive Approach (Standard of Liability):
1. Theory: it can be seen as a substantive rule that imposes only a gross negligence standard
on the board of directors. Saying why you set the standard of liability so high.
2. (1) Sets the standard for liability very high; if Ds follow the correct approach (which is not
hard) they will have no liability (2) Standard of Liability: if bd has made decisions w/out
fraud, illegality, negligence or CoI then there will be no liability.
3. Rationale for BJR: Role of Risk Aversion: D and O cannot diversify their idiosyncratic
risk, where as SHs can. Thus, D and O are going to be much more risk averse than any SH
b/c of the volatility of the job, so want to insulate D and O a bit from being punished for
making decisions.
4. B/c of agency cost of the potential liability of making risky decisions we want to impose
the BJR to shelter D and O to encourage them.
vi. Justification for BJR:
1. (1) risk taking BJR attempts to bridge gap btwn incentives of BD and SH Gagliardi v.
Trifoods International (241)
a. Facts: Shareholders of TriFoods brought a derivative action against TriFoods for
recovery of losses allegedly sustained by reason of mismanagement unaffected by
directly conflicting interests. The directors moved to dismiss the action.
b. Holding: To sustain a derivative action for the recovery of corporate losses
resulting from mismanagement unaffected by directly conflicting financial
interests a shareholder must plead that a director did not act in good faith
and/or failed to act as an ordinary prudent person would have acted under
similar circumstances
c. The business judgment rule tries to align the incentives facing the directors w/
incentives facing the shareholders. SHs always willing to have BoD make risky
decisions b/c they have limited liability, and they get all the upside gain

45
d. If there were no business judgment rule, then directors would never move beyond a
narrow band of decisions, since they dont want to run the risk greater liability..
2. Avoids judicial meddling and allows competent Ds to serve co. Where there is no
evidence of fraud, illegality, negligence or CoI, the BD is protected as under BJR despite a
foolish decision Kamin v. American Express (250)
Facts: AmEx held stock in Donaldson LJ. The stock declined from $30 mil to $4 mil in
value, $26 mil. loss. Am Ex directors had a meeting to try and decide what to do with
their worthless stock. They declared a special dividend to SHs of the DLJ stock, rather
than cash for business reasons (basically giving them worthless stock). SHs complain,
saying the Bd was dumb, they could have sold the stock, and then would have gotten a
tax write off for selling stock at a loss. They sue because theyre pissed!
3. Holding: Whether or not a dividend is to be declared or a distribution is made is
exclusively a matter of business judgment for the board of directors and the courts
will not interfere as long as the decision is made in good faith.
4. Bd. has the experience and qualification to make these decisions over the courts where
there is no bad faith or self dealing, fraud or illegality
5. Here, considered different viable options and picked one- not grossly negligent
Duty of Care in Takeover Cases (P255-260- read again in hostile takeover section)
a. Smith v. Van Gorkom (DE 1985) CEO, Van, decided to sell co. Approached Pritzer and
offered to sell Trans for $55 a share and Pitzer agreed. Bd approved in 2-3 hr mtg w.o ever seeing
the K or valuations of $55 which CEO decided himself. Shareholders sue
i. Holding: TransUnion directors had been grossly negligent in their decision-making and
therefore could not claim the protection of the BJR.
b. Consequences of Smith: led to an immediate revision in statutory law
i. DGCL s102(b)(7) & MBCA 202(b)(4): A corporation can put a provision in its charter
eliminating personal liability of directors for breach of duties of care (except if their
actions were in bad faith or against the law).
(a) 48 of the states have enacted similar laws.
(b) Directors can defend a claim by pointing to the immunity shield
(c) Shield doesnt extend to knowing violations of crim statutes & self dealing
transaction
A. Overcoming BJR Presumption:
1. Lack of Good Faith: Fraud, illegality or conflict of interest
2. Waste: lack of rational business purpose
3. Gross Negligence: gross negligence in discharging duties to supervise and become informed
a. Smith v. VanGorkum if it is a really stupid business decision, judges may hold you
liable
i. NOTE: this case has been limited to the merger context by some judges
c. (2) DUTY TO MONITOR (261):
i. Definition: BD and O have a general duty to not be inactive in monitoring, being reasonably
informed, attend meetings, review financial statements, etc.
ii. (1) Failure of BD to act must have cost SH loss (2) must be some circumstances that gives red flag
to SHs that someone not doing the right thing
iii. Failing to monitor is not entitled to protection of the BJR
iv. Violation of the Duty to Monitor results from agency cost of passivity; failure to act or respond
may constitute a breach of the DtM
1. Rationale: the tone at the top matters sensible grp to impose liability, BJR d/n apply to
nonfeasance b/c no incentive to protect lazy D O
v. Five cases to illustrate the duty to monitors main principles- p260: United Jersey Bank (what
your duty is), Allis-Chalmers (parameters of duty), In the matter of Michael Marchese (helps
understand where Fed laws come into play and how failure can impact liability), Caremark

46
International (how duty fits in with all actions youre taking) and Citigroup (recent concerns
reflected)
vi. General Application:
1. (1) BJR is not applicable to DtM cases Francis v. United Jersey Bank (260)
a. Facts: Mrs. Pritchard ignored her duties as a director allowing her sons to withdraw
over $12million from client trust account
b. Holding: BJR only protects informed decisions. Liability of a corporations
directors to its clients requires a demonstration that (1) a duty existed (2) the
directors breached that duty (3) the breach was a proximate cause of the
clients losses
c. She does not benefit from the BJR bc she was not informed (she made uninformed
non-decisions) (1) She failed to act in good faith by not being informed at all about
the business and (2) she had a duty to stop illegal activity once she found out about
it (more than a duty to object but to go to the authorities)
d. (2) Rationale: There is no benefit to SHs to protect D&O from own laziness
e. (3) Irrelevant that P relied on her sons to be honest, she has the duty, must enforce
f. (4) She could have confronted them, resigned, and no liability
g. (5) the creditor is monitoring here, as they have a strong stake in corp
h. It would have been SUPER easy for her to just read the financial statements
2. (2) A red flag, sufficient notice, of potential wrongdoing is needed to signal the DtM
Graham. v. Allis-Chalmers Manufacturing Company (268)
a. Facts: Shareholders of Allis Chalmers contended in a derivative action that the
corporations directors were liable as a matter of law for failing to take action to
learn of and prevent antitrust activity of non director employees.
b. Holding: A corporate director who has no knowledge of suspicion of wrong
doing by employees is not liable for such wrongdoing as a matter of law
c. (1) D d/n breach DtM b/c they had no notice actual or constructive knowledge of
wrong doing (2) Determining when sufficient notice exists is difficult and arguable
both ways sometimes
d. NOTE DGCL 141(e): a member of the BOD shall be fully protected in relying in
good faith upon the records of the corp. and such info provided by the officers
e. Although some evidence to the contrary this court though, said that b.c it happened
20 years ago, doesnt mean they should think it would happen now. This was a
very large corporation and it was merely a suspicion back in the day. Its not
efficient to monitor two employes out of thousands.
3. (3) Federal Securities Law: D O have strong duty to monitor affairs of corporation In the
matter of Marchese (272)
a. Facts: The SEC contended that Marchese, an outside director of Chancellor who
served on Chancellors audit committee, violated and caused Chancellor to violate
various provisions of the Exchange Act and Rules because he failed to adequately
monitor the companys financial statements when Marchese signs off on SEC
annual report w/o describing all the drama that had subsequently occurred with the
CEO.
b. Holding: An outside director of a corporation who serves on its audit
committee violates and causes his corporation to violate, the exchange act
there under by recklessly failing to inquire into the corporations financials
when he has knowledge of facts to put him on notice that such inquiry is
warranted.
c. Under Federal Securities Laws

47
d. (1) ct hlds outside D violates Excahge Act by recklessly failing to inquire into
corps financials when he knows of facts to put him on notice that inquiry is
warranted
e. (2) Marchese is no different than D in United Jersey Bank case because he was
aware that funny business had occurred in the past with the corporation
f. (3) Standard imposed is recklessness standard in Federal Law. This guy has all
the info, and lets co. make fraudulent statements. We want these people to be
paying attn.
4. (4) BD has an affirmative duty to attempt in good faith to assure that a corporate
information and reporting systems exist and is adequate In re Caremark (278)
a. Facts: Caremark, a managed health care provider, entered into contractual
arrangements with physicians and hospitals, and worried about kickbacks. To
combat this, Caremark had a compliance programs in place to ensure that ppl
werent taking kickbacks. They even had an 800 number where you could call in
violations. Despite all of this, employees were found breaking the rules.
b. Holding: A board of directors has an affirmative duty to attempt in good faith
to assure that a corporate information and reporting system exists and is
adequate.
c. Controlling Case in Allis-Chalmers ^ (bc in Delaware) BUT is deviated from-
ct says that the law changed. No longer true that simply that mere reliance on
senior officers is sufficient instead the BoD directors need to put some type if
independent in to place to provide BoD reinsurance. Reason for this is that NOW
BoD actions are increasingly scrutinized (movement in Delaware law of greater
burdens on BoD). Here said that the burden satisfied, hand book and independent
auditor, which seems not a big deal anyway.
d. Rule now there is liability for failure to monitor system must take reasonable
steps to put in place an information and control structure designed to offer
Updated good reasonable assurance that corporation is in compliance with the law duty to
faith procedural
monitor was satisfied here with guidebooks and investigation
requirement
e. The level of detail in the monitoring system is subject to BRJ
f. incentive to have good compliance program for corps so they are not held liable
g. Allen said hell treat it like a fed sentencing guidelines case i.e. look at
settlement/damages and mitigate if good compliance program.
5. Note on Federal Overlay
a. US Sentencing Guidelines for Organizations
i. An effective compliance and ethics program can provide the basis for a
download adjustment in the ultimate punishment for corporate wrong doing
ii. If have good monitoring program or tries to implement a monitoring system,
it will lessen their damages (i.e. lessen sentence)
b. DOJ Policy on Charging Organizations
i. Government prosecutors will look at the depth and quality of a companys
compliance program in connection with charging decisions
c. Sarbanes-Oxley Act (section 404)
i. Requires chief executive officer and chief financial officer to certify that
each has evaluated the effectiveness of the companys disclosure controls and
procedures and identified to the outside auditors any material weaknesses in
the company internal controls (happened in light of Enron and WorldCom
disaster situations)
ii. Arthur Anderson (one of big 4 acct firms) implicated in Enron scandal bc
signed off on transactions. Accountants got pushed by very aggressive
clients at each step along the way and the push was very gradual over the line

48
by clients who thought they were doing the best for their shareholders.
Entire accounting firm evaporated over night. What happened when the case
went to trial? Arthur Anderson was acquitted bc he was just on the line.
iii. REMEMBER do not lie to the government
d. Note- in Madoff and SECthe SEC has accepted the efficient capital markets
hypo: which means all information thats in the market place effects the market
YET when Madoff was reporting super normal profits, the SEC wasnt unusually
curious. Theres no good explanation for that. Why werent they suspicious of the
profits? We have no good explanation of that.
6. Stone v. Ritter (2008) affirmed the general test in Caremark for when Ds would be
liable: assuming corp has an exculpation clause, Ds will have liability for failure to
monitor if
a. directors either (1) utterly failed to implement any reporting or information
system or controls Or
b. (2) having implemented such system or controls consciously failed to monitor
or oversee its operations thus disabling themselves from being informed of
risks or problems requiring their attention.
c. And, in either case, imposition of liability requires a showing that the directors
knew that they were not discharging their fiduciary duties.
d. Deference here is almost absolute because it requires conscious decisions and
failures basically Ps will almost never show Ds knew they werent
discharging their duties
7. In re Citigroup (285)- distinguishing b/n BJR and failure to monitor
a. Mortgage crisis
b. Facts: shareholder of Citi brought an action against the D and O of Citi alleging
that they breached their duty to monitor by failing to manage the risks the
Company faced from problems in the subprime lending market and for failing to
property disclose Citis exposure to subprime assets.
c. Holding: deferential status of BJR is applied where there are no blatant red
flags. Court distinguishes between duty to monitor and BJR- cant hold D
directly liable for a bad business decision alone. A risky decision does not
constitute a failure of your duty to monitor
d. So called legacy assets that are worth almost less than zero! Entire company might
be brought down and they OBVIOUSLY breached failure to monitor and knew all
of this but the court doesnt say so
e. There were red flagswhy did the court reject these factors as red flags? Applied
very deferential standard of stone v. ritter and said what is and is not a red flag is a
matter of business judgment. The Board did here what we wanted it to do! Its a
business risk! So here, protected by business judgment rule
vii. Knowing Violations of Law (291):
1. D engaged in illegal activity or a knowing violating of an existing regulation will not
receive the protection of BJR, regardless of whether their actions are intended to benefit
SHs Miller v. AT&T (291)
2. Facts: Shareholders of ATT brought suit when the corporate directors forgave a
$1.5million debt owed it by the Democratic National Convention.
3. Holding: The BJR will not insulate directors from liability where it is alleged that
they have committed illegal or immoral acts.
4. (1) Ct held AT&T liable for waiving 1.5M contribution to DNC (making it an illegal
campaign contribution), and no BRJ b/c AT&T violated statute
5. Here, the act was illegal.

49
(a) When D loses protection of BJR, his conduct will be evaluated under general
duty of care. Director is then likely to lose bc it is not due care to advocate or
permit a violation of crim law
b. Violations of law are not protected by immunity shield provisions DGCL 102(b)(7)
6. (2) Rationale: Cannot give benefit of doubt to BD when they are breaking the law and thus
injuring SHs (3) Sarbanes-Oxley Act of 2002 Section 404: requires that CEO and CFO of
publicly traded corps certify they have disclosed to corps independent auditor all
deficiencies in design/operation, or any material weakness, of firms internal control (P
can sue under that- basically if they dont disclose and something bad happens to corp.)
c. Conflict Does Crime Pay? When there is a knowing violation of a criminal statute, it removes
the protection of the BJR. This doesnt mean co is automatically liable. P has to prove there was a
net loss. If the co benefited as a result and the benefit exceeds loss, there is no recovery for P. If
crime pays, there is no recovery
i. Ex: If co violates environmental laws and is subject to crim fines of $1mill. Directors
may be liable if there was no net benefits. As a result of violation, we got $4mill profit so
there is no net loss and a derivative suit would not be successful.

3. Duty of Loyalty (295)


a. Definition: Duty not to be a thief // D O and ctrling SHs must only deal with the company in terms
that are fair in all respects must be free from Conflict of Interest. Conflict of interest occurs when
Director or Ctrling SH is on both side of transaction, tends to benefit at expense of SH, but transaction
will not be voidable if have approval of disinterested D or SHs, or show it to be a fair transaction w/
disclosure
b. Issue Spotting: Look for Self-Dealing when:
i. (1) Deal is between Corporation & Director
ii. (2) Deal is between Corporation & a Controlling Shareholder
1. Note: Fiduciary duty of loyalty implied through obligation to be fair for controlling
shareholder b/c often the Board is beholden to the controlling shareholder who elects them
c. Approach: Look for self dealing when: Deal is btwn Corp and D or Ctrling SH
i. Q1: Is there an interested party
1. If D go to Q3
2. If Ctrling SH go to Q2
ii. Q2: Was there self-dealing? Apply the Benefit Detriment Test (Ctrling SHs Defensive Measure)
Did the ctrling SH receive a benefit to the exclusion and detriment of the minority SHs?
1. If YES go to Q3
2. If NO claim is dismissed
iii. Q3: Is there an applicable safe harbor statute? (DGCL 144)
1. If YES analyze under 3 approaches
a. Disclosure/Approval + Fairness
b. Disclosure/Approval alone
c. Disclosure + Fairness (likely only in close or smaller corps where disinterested D
approval is impossible and either no SHs or no time to submit to SHs)
2. If NO go to Q4
iv. Q4: Did the interested party to the transaction disclose all material information relevant to their
conflict to relevant parties?
1. If YES go to Q5
2. If NO transaction is voidable b/c non disclosure and unfairness
v. Q5: Was their approval by a disinterested party?
1. If YES go to Q6
2. If NO Corporation must show Entire Fairness (Fair Process and Fair Price) when
challenged (no burden shifting to P b/c no approval)

50
vi. Q6: Which disinterested party approved the transaction?
1. If Disinterested Ds burden shifts to P P must show waste to overcome BJR
2. If Disinterested SHs Got to Q7
vii. Q7: Who are the interested parties in the transaction?
1. If Ctrling SHs burden shifts to P P must show the transaction was not entirely fair
(fair process and fair price)
2. If D burden shifts to P P must show waste to overcome BJR
d. Requirements of the duty: Duty comes into play where D or ctrling SH has an interest in both sides of
a transaction.
i. Elements of the Duty: A transaction is not necessarily void if there is a Conflict of Interest. Under
specified circumstances, the law is willing to allow some conflicted transactions to occur
ii. Statutory Requirements: DGCL 144 safe harbor: Ct wont void transaction per se if Director
stands on both sides of the transaction (ex: if company spiraling downward D may be allowed to
lend to company as they may be the only party willing)
iii. 144 sets outWays to sanitize/cleanse the tx of taint of CoI so BJR can be applied:
1. (1) Disclose Conflict of interest to other D, and have disinterested Ds approve tx by a
majority
2. OR (2) disclose to SHs and have disinterested SHs vote to approve tx
3. Or (3) duty of good faith that applies when Ds act against corporations best interest or
with conscious disregard
a. Remember: Walt Disney held duty of good faith is breached when Ds fail to
consider the financial ramifications of an executives contingent pay package when
Ds fail to establish an oversight system to monitor the corporations legal
compliance or when Ds act as stooges for controlling SHremember Stone v.
Ritter had a super high standard to violate good faith.
iv. Breach duty when: divert corporate assets, take business opportunities, use proprietary info for
personal gain, D set ridic compensation selfishly, etc
e. Application of the Duty: Self-Dealing Transactions:
i. Types of Transactions
1. Transactions with Directors and the Disclosure Requirement: RULE: full disclosure of
all material facts at time of which he is aware at that time + ratification can overcome
voidability
i. Step 1 for Ds: Is transaction b/w corporation and a director?
ii. Step 2: If yes, to sanitize must fully disclose this and all details. Insider must
disclose more than one would normally, recall Meinhard v. Salmon: Some
forms of behavior open to traders in the market are not available to
fiduciaries. Dont have to disclose highest price u would pay though
b. Disclosure is so critical that failure to disclose is equal to unfairness and will render
transaction voidable State ex rel. Hayes Oyster v Keypoint Oyster Co (304)
i. Facts: Coast Oyster Co. claimed that Hayes , its CEO, director and
shareholder, breached his fiduciary duty to Coast by failing to disclose a
secret profit and personal advantage he would gain from the approval of
Coasts sale of oyster beds to Keypoint Oyster Co. SH said breached DoL.
ii. Holding: A corporations director or officer breaches his fiduciary duty
to the corporation by failing to disclose the potential profit or advantage
that would accrue to him if a transaction involving the corporation were
approved.
iii. H breached even though the transaction was financially fair b/c didnt
disclose and was interested in tx
iv. Court rules: Failure to disclose information at the time the other
directors and shareholders approved and the transaction was being put

51
together constitutes a PER SE violation of the duty of loyalty b/c non-
disclosure of self-interest by interested director/officer is in itself unfair
v. Rationale: Disclosure allows the corp to consider all facts when making a
decision; burden placed on the party [the director] best able to bear the facts,
least trans cost
vi. KH efficient rule b/c a base line rule that make people aware- even though
this particular instance was fair, there are many times it could be unfair and
also to determine fairness in the courts in this sense is not efficient
vii. Remedy: Ct makes D give up profit and the shares, this punitive to deter, it
may have made more sense for efficiency just to give back shares.
Reminiscent of agency law in this way
2. Transactions with Controlling SH and the fairness standard (309)
a. Test:
i. Benefit Detriment Test: If majority SHs receive a benefit to exclusion +
detriment of minority SHs then self-dealing implied
ii. If there is self dealing then Intrinsic Fairness Standard: Potential to shift
burden of proof to D to prove its actions were objectively fair.
1. If BDT implies self-dealing D has burden to prove intrinsic
fairness standard
2. If BDT d/n imply self-dealing apply BJR
iii. Establishes benefit detriment test: If minority not harmed then no self-
dealing Sinclair Oil v. Levien (310)
iv. Facts: Sinclair MNC oil co. is the parent company, and Sinven is 97% owned
subsidiary in Venezuela (Sinven). Sinven decides to pay out huge dividends
from capital surplus rather than re-invest and undertake productive
enterprises. Conflict was fully discl b/c all Bd members knew they were
attached to Sinven. 3% shareholders say theyre bleeding Sinven dry, and
violating the duty of loyalty. Apply BJR or intrinsic fairness test?
v. Holding: The intrinsic fairness test should not be applied to business
transactions where fiduciary duty exists but is unaccompanied by self
dealing.
vi. Ct holds Sinclair was not engaged in self-dealing as the minority SHs were
not harmed
vii. Ct lays out the benefit/detriment test, controlling SH can make
decisions, even decisions that appear to benefit it, so long as its not to
the detriment of the minority SHs. Asks: are you the controlling
shareholder taking a benefit to the detriment to the shareholders?
viii. Ct says these dividends are paid out pro rata, this is important to the ct since
it makes the SHs complaints silly. Parent co. ensures subs good books and
records to avoid piercing the corporate veil. So, Ct says SHs knew this was
going to happen. As long as its paid pro rata, its perfectly fine and well let it
stand. Apply BJR!!!!
ix. (2) there is never self-dealing when pro-rata distribution occurs b/c
minority is never excluded at the bereft of the majority SHs
x. One way to prove the fairness element in an interested tx is the application of
the benefit/detriment test
ii. Statutory treatment Recap Safe Harbor Statutes: Approval of Disinterested Parties and Fairness
(314)
1. Definition: Self-dealing transaction is not voidable solely b/c a party is interested, may be
able to preserve the transaction over an objection if it is adequately disclosed and
approved by a majority of disinterested D or SH or it is fair.

52
2. DL Gen. Corp. Law 144: An interested directors participation in a transaction will not
immediately make the transaction void or voidable if:
a. (1) Interest is fully disclosed and a majority of the disinterested Directors ratify the
transaction in good faith or-
b. (2) Interest is disclosed and a majority of the shareholders ratify the transaction in
good faith or-
c. (3) The contract is fair to the corporation at the time of authorization.
3. However, these statutes might also be interpreted to mean that a conflict transaction is
never voidable if it is fully disclosed and authorized or approved by the board and SH in
good faith or if it is fair to the corporation at the time it is authorized (courts have resisted
such a broad reading such as this)
4. Different Permutations with Applying the General Rule- approval by disinterested Ds:
a. (1) Conjunctive: ct requires fairness and disclosure with approval by disinterested
BD / SH (conventional approach)
i. Rationale: (1) it is likely that no one is truly disinterested as all BD members
are probably friends, so having fairness is crucial
ii. Iowa: Cookies Food Products v Lake Warehouse (315)
iii. Facts: Controlling shareholder of BBQ Sauce Co. is profiting from exclusive
distributorships he had, taco royalties and consulting fees, apart from his
salary. He continued to run the business and enhance Cookies food products
profits. SH sue for breach of DoL.
iv. Holding: Directors who engage in self dealing must establish that they
acted in good faith, honesty and fairness.
v. (1) Transaction is OK because he did disclose and he was actually trying to
help the company so the transaction was fair.
vi. SO no breach b/c transactions were substantively fair, fully disclosed AND
approved by disinterested director. Iowas safe harbor statutory requirements
met and hes OK (conjunctive is higher stnd but he meets it here)
vii. Burden of proof: burden of proof is on P to show not fair
viii. Most jurisdictions read the statutes in a conjunctive way
ix. Dissent: should look at mrkt price to show fairness, giving too much credit to
the guy
x. Scholarly Support of conjunctive rule: Melvin Eisenberg
1. Supports requiring fairness plus disinterested approval & disclosure:
a. (1) B/c directors are buddy buddy w/ one another &
none are really disinterested.
b. (2) Distinction between factually & legally
disinterested (difficult to utilize a legal definition of
disinterestedness in corp law that corresponds with
factual disinterestedness).
2. Shifts burden of proof of fairness from D to P and possibly also
stretching the fairness category to include a reasonable belief in
fairness (supports majority above)
3. More likely to rule for the P in these cases (in Cookies they ruled for
D though).
4. Note: if the issue is with a non leading director or not controlling SH,
court is more deferential to the Bd. because there is more
independence of interest and with a mid level director, the
disinterested directors are likely more independent than in a situation
where there is a majority SH and director where you might have
more trouble with interest

53
b. Approval by Disinterested Members of the Board (320)
c. (2) Disjunctive: court requires disclosure with approval by disinterested party
w/out a fairness test (more likely to use w/ lower level mgmt/SH)
i. Rationale: (1) Ratification by disinterested directors is enough to cleanse the
taint of interest and we do not want to give ct so much leverage as the BD is
likely more capable of making business decisions (2) equalizing risk btwn
SH and D (3) rely more on that not all D are inherently interested, they are
capable of disinterest
ii. Deleware: Cooke v Oolie (322)
iii. Facts: Oolie and Salkind were directors as well as creditors of TNN. They
voted to pursue an acquisition proposal that allegedly best protected the
interests of TNN creditors instead of pursuing other proposals that allegedly
offered superior value to TNNs shareholders TNNs two disinterested
directors also voted in favor of the acquisition. TNN shareholder brought
suit against O and S for breach of fiduciary duty of loyalty.
iv. Holding: An interested directors vote to pursue a transaction that would
be beneficial to the director at the expense of the shareholders is
protected by the BJR where disinterested directors ratify the vote.
v. Tx ok here. No fairness standard, just subject to BJR if its approved
d. (3) ct requires fairness and disclosure w/ out approval by disinterested party (more
likely to use when corp is small or closed b/c there is a smaller chance of having
disinterested Ds or SH)
i. Harder to find disinterested Bd in a small company where people might
know each other and all be interested
ii. Where there is disclosure but no disinterested approval, Courts may still
allow the interested transaction to stand if it passes a fairness review. Allows
approval of disinterested directors to satisfy the third prong. Court argues
that approval of disinterested directors is like the approval of any other set of
directors--- and what happens then? Entitled to BJR
iii. Cost is too high to try and ensure disinterested Bd b/c company might be too
small and then would have to hire outside directors which would be a KH
inefficient cost
5. Special Committee of Independent Directors(325)
i. If you hire lots of random outside people to be a special committee and they
come to a decision, its presumptively fair b/c its unlikely theyre interested
its a technique at court by company to show fairness by having a special
committee thats not interested
6. SH Ratification of Transactions (326)
i. Collective Action Problem: SH ratification is more complex than BD
ratification b/c of collective action problems [two extremes in collective
action problem- i..e where SH dont think their vote matters and where
theres a controlling SH so voting is a formality]
ii. Unanimous SH ratification needed to legalizes waste Lewis v Vogelstein
(327)
1. Facts: Mattel gave generous stock options to all employees,
directors, and outside directors. Want to make sure that off and dir
are as focused on share price as SH align interests. SH says waste
share prices diluted!
2. Holding: Unanimous shareholder approval is required to ratify a
conflicted transaction that involves corporate waste

54
3. Look at: If fiduciary makes bad decision and SH ratifies, then it
becomes ok UNLESS SH ratification is (1) made by SHs in which
the majority have a conflict of interest OR (2) ratified transaction
constituted corp. waste
4. Waste: an exchange of corp. assets for consideration so
disproportionately small as to lie beyond the range at which any RP
would be willing to trade
5. Here Mattel giving away generous stock options to all employees =
D and outside D constituted waste b/c it diluted the share price
a. Disinterested shareholder approval will preclude all
judicial review except w/ regard to waste.
6. Rationale: B/c waste constitutes a gift of corporate property, no one
should be forced to gift their own property and thus test should
strongly prejudice waste maker
7. Burden: Once disinterested D approve tx, burden shifts to P to show
waste b/c BJR is applied (waste must be unanimously approved by
SHs to be ok)
a. Must be unanimous because the shareholders are
free to throw their own money away and we assume
that no shareholders is invested in a company where
they expect the directors and officer to engage in
waste
iii. In re Wheelabrator Technologies (328)
iv. Facts: Shareholders of Wheelabrator, whose co. was bought by Waste Mngt
in a merger, brought derivative action claiming that the W directors breached
their duties of loyalty because 4 of 11 W directors were also Waste officers.
The directors contended that approval by Ws non Waste (disinterested)
shareholders extinguished their claim
v. Holding: A fully informed shareholder vote ratifying an interested
director transaction subjects a claim for breach of directors duties of
care and loyalty to BJR rather than extinguishing the duty of care claim
altogether and then BJR.
vi. So this could have been an interested transaction by Bd. BUT the SH ratified
it! (1) SH ratification + full disclosure = ok and crt will use BJR and burden
will shift
vii. Process: If transaction between corporation and director/non maj SH
then approval by disinterested SH shifts burden to s to show waste
1. Approval of disinterested SH gives dir protection of BJR
(presumption of fairness) and only way to overcome protection of
BJR is for P to show waste
viii. If transaction between corp and controlling SH when approved by
disinterested SH burden to to show that transaction wasnt entirely
fair much lower std for (doesnt have to show that it was waste)
(controlling SH has majority for electing Bd.)
ix. If no one approves transaction burden is on corp (D) to show entire
fairness (144c). Corp hasnt done anything to sanitize transaction.
1. Test: If the corp fails to get the approval of the disinterested directors
or SH, then there is nothing left for the corp to do but to show that
the transaction was entirely fair under the safe harbor statute (fair
price and fair process).

55
Approval by Disinterested Directors Approval by Disinterested Shareholders

Claim: Breach of Duty of Loyalty


Claim: Breach of Claim: Breach of Duty
Duty of Care of Loyalty
Effect: Approval by
disinterested director shifts the Effect: Effect: Shareholder
burden to P. Shareholder ratification +
Burden: P must prove waste to ratification + Disclosure shifts the
overcome the Business Disclosure will burden to P to prove
Judgment Rule. extinguish any transaction was
Rationale: Disinterested claim for breach. unfair.
Directors approval sanitizes
the transaction and eliminates
the conflict. Transaction w/ Director
Transaction w/ Controlling
Note: To be in this position Shareholder
there can be NO controlling Burden: P must show
shareholder involved because waste. Burden: P must show the
if the transaction is with the Standard: Approval by transaction was not
controlling shareholder you disinterested entirely fair to the
will never find Disinterested shareholders gave corporation.
Directors!! Directors protection of Entirely Fair: Fair Process
the Business Judgment & Fair Price
Rule waste is the Standard: Much lower
only option to burden.
overcome it.
f. Special Concerns
i. Director and Officer Compensation (330):
1. Types of Compensation
a. Salary: traditional form compensation until the 90s, but agency problems
b. Incentive Compensation/equity: to align incentives of corp and D and O. Based on
performance of individual or performance of the company as a whole [focus on
share price ]
i. Bonuses: initial way to align incentives
ii. Options:
1. Call Option: the right to buy a share of stock at a specified price, at a
specified time. The specified price is the exercise or strike price.
Right to force someone to sell it to you.
2. Put Option: have the right to force someone to buy it from you
a. Ex: exercise price is $100 and current price is $100.
Current price? Zero. Why? Youd pay $100 to get
something thats 100.
b. Ex: stock price in nine months is $120 = $20 worth
c. Ex: stock price goes to $80 = still valuable because
it could go up!
d. Options ALWAYS have value even if the price drops
to $2 a share because its outstanding for a long time

56
iii. (2) Operation: this costs the company nothing on its balance sheet b/c they
are not technically giving anything away and will not dilute the amt of shares
as long as the amount of options is not enormous, difficult to value
iv. Company doesnt have to put this on their balance sheet when theyre not
exercised so this is good for the company
c. Regulatory Responses: Fed govt has attempted to regulate compensation via
disclosure (in line w/ efficient capital markets hypothesis)
i. 1993 Amendments: Feds said there needs to be more disclosure in proxy
statements when SH are electing D at proxy meetings. Required a (1) table
showing the 5 highest paid executives, salary, bonuses, pension funds, (2) a
narrative description [from the compensation committee as to rationale for
compensation] and (3) graphing comparing share price to indexes
1. b/c of this heightened disclosure, salaries shot up! Why? Everyone
wanted to be paid the most
ii. 2006 Amendments: provided for (1) computation of single compensation
number and (2) description of perquisites
iii. Rationale: if there is disclosure institutional investors will police and litigate
where necessary to ensure fairness
iv. Today: Claim to be moving away from efficient capital markets hypo, but not
so sure if thats actually happening
1. Shareholder vote on Executive Compensation Act purpose of act is
that public companies must hold an annual non binding shareholder
vote on executive compensation plans. Non binding bc shareholders
not involved in day to day activity and directors set the compensation
not the SH. Introduced in Congress in March 2007 (intro by
Obama). Still pending in some fashion
I. DIRECTOR AND MANAGEMENT COMPENSATION VIA CASE LAW
1. What happens when pay is provided to someone with a fiduciary loyalty? Its self dealing b/c
theyre paying themselves SO duty of loyalty may be implicated
2. Over time cts realized stock options serve incentive based purpose even though they dilute
interest in corp. SO if youre going to recommend stock option plan for corp., you should
get approval from SHs and THEN BJR applies
d. In determining whether stock options grants constitute actionable waste, ct should
accord substantial effect to SH ratification Lewis v Vogelstein (332)
e. Facts: Mattel case were D freely giving away stock.
f. Look: to determine whether stock options violate duty of loyalty in order to
show waste, must show that exchange was one which no reasonable person not
acting in compulsion and in good faith could agree (basically BJR)
g. Burden to show waste is on P where there has been disinterested ratification.
h. Could look at waste in two ways:
i. (1) Reasonableness v. (2) classic waste standard (no valid bus purpose)
i. Recent cases understand there are collective action problems, but institutional
investors are strong and a SH vote is probably a better way to look at the
reasonableness than for the court to assess waste by reasonableness
j. ct suggests that one-time grant of options is potentially valid, second grant can be
unreasonably risky b/c such a transfer could be absent of true consideration (2)
traditional rule for ct to approve decision to grant options corp must (a) gain
sufficient value in exchange and (b) there must be conditions making it likely that
corp will get such value, but this test was too difficult to apply to the circumstances
ii. HOW DO FIDUCIARY DUTIES DIFFER FROM STANDARDS OF BEST PRACTICE?

57
a. Breach of directorial fiduciary duties will be dismissed where neither intention nor
conscious disregard can be shown In re The Walt Disney Company (341)
b. Facts: Eisner hired Ovitz to work as a high-level exec, and he was a powerful &
talented person at a talent agency, theory that wed marry his talents/skills w/ actors
to the goodies of the Disney Co. Ovitz employed for 14 months, fired w/ a
severance package of $140M because they couldnt fire him with cause and
thought that was the best thing to do b/c he was tanking the stock price. SH sue!
c. Holding: If a breach is alleged with particularity that directors have
intentionally and consciously disregarded their responsibilities regarding
material corporate decision, then there will be liability.
d. (1) no liability here. Ct holds Eisner nor BD liable when both entities were
involved very little in the hiring of Ovitz b/c both satisfied their duty of care as
neither was grossly negligent.
e. Court says that if BJR is going to provide any comfort to these directors, it cant be
just a small step out of bounds. Ct says were not going to engage in hindsight;
these directors are making complex decisions about wildly variable outcomes, and
we dont want them to be concerned about liability b/c every SH is holding a
diversified portfolio, and this risk is simply an idiosyncratic risk.
f. So, there must be MORE than negligence it must be some notion of gross
negligence, which there is a deliberate disregard for the interests of the
corporation. Failing to pay attn. to what all this means for the company. Here,
there is only mere negligence, not gross negligence. Its reasonable to allow the
CEO to chose his replacement.
g. (2) Ps attempt to try BD and Eisner on lack of good faith and courts say we do
not have a good definition of good faith but we know when it isnt there is bad faith
[someone w/ fiduciary obligations acts w/ malevolent intent] What you must do
to act in bad faith is some intention dereliction of duty and a conscious
disregard for ones responsibilities. This is one standard, but not the only one.
h. There is a requirement of the proper state of mind. An actual effort to be a moron.
i. (3) BUT note that later case Stone v Ritter in DEL SC states there is no independent
duty of good faith, its a subset of duty of loyalty
j. No breach of loyalty claim here either b/c no conflict of interest
k. So what is the state of fiduciary duties in this present day?
i. Care, loyalty and good faith: good faith may been seen as simply a higher
level of abstraction of the fiduciary obligation of care and loyalty
ii. 102(b)(7): provides that a corporate charter may waive director liability to
the corp for damages except for, among other things, damages in connection
with a breach of loyalty and for acts or omissions not in good faith this is
very broad protection, but after Disney, the court is inferring that there is
room to find liability.
1. Then why can Ds waive damages for director gross negligence in the
charter but not grosser negligence?
iii. State of law post Disney: (1) mere director negligence does not give rise to
liability. BJR covers circumstances. (2) facts that establish gross negligence
(as in Smith v. Van Gorkum) may be the basis of breach of duty for any
losses that result, but under 102b7 liability can be waived (3) waiver however
may not waive liability that rests in part upon breach of duty of loyalty and
that inability to waive damages is extended to acts or commission not done in
good faith

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DL Gen. Corp. Law 102(b)(7): eliminates personal liability for breaches of the duty of care but maintains
personal liability for breach of loyalty & breach of good faith.
Permits corporations to include a clause in their charter indemnifying D & O from money damages
for a breach of fiduciary duties, so long as it is 1) no breach of duty of loyalty and 2) not an act or
omission that is in bad faith or is a knowing violation of the law.
o DL Legislatures response to TransUnion Directors being held personally liable for gross
negligence in Smith v. Van Gorkum.
Note: Between 102(b)(7) and Business Judgment Rule there is no longer liability for minor breaches
of the duty of care. Shareholders may still recover though for a duty of care violation but judgment
cannot include monetary relief (injunctive okay).
Enactment:
o New companies: may include this provision in their original charter.
o Existing companies: require shareholders approval to amend the charter.

4. CORPORATE OPPORTUNITY DOCTRINE (348): addresses when corporate manager (director or exec)
can pursue business opportunity that may otherwise belong to corp.
i. Litigated when a SH believes a fiduciary breached a duty by usurping an opportunity belonging
to the corporation.
1. P has the burden of proving the existence of corp opportunity.
2. Remedies: must share fruits of opportunity as though the corp had originally taken it.
a. Liability for profits realized by the manager, liability for lost profits and damages
suffered by the corp, and imposition of a constructive trust on the new business or
subject matter of the opportunity
3. Determination of Corporate Opportunity
a. Expectancy of Interest Test: narrow, does the corp have an expectancy of interest
to pursue this particular line of work?
i. Measures corps expansion potential
ii. Manager must seek consent of corp before engaging in venture
iii. managers secrecy in taking an opportunity support finding corporate
expectancy
1. ex: manager misappropriates soft assets of the corp such as
confidential info or goodwill to develop a new business BUT if the
opportunity came to the manager in his individual capacity, crts are
more like to say it wasnt a corp opp (see Broz below)
b. Line of Business Test: is this a line of bsn the company would be likely to engage
in?
i. Compare new business w corps existing operations competitive or synergistic
overlap, i.e. is the project functionally related to what corp does or could do
ii. Need consent
c. Fairness Test: is it fair of the corp to allow individual to pursue the opportunity?
[turns on financial ability of corp]
i. Focuses on fairness of holding the manager accountable for his outside
activities
ii. will look to factors such as how a manager learned of the disputed
opportunity, whether he or she used corp. assets in exploiting the opportunity
and other fact-specific indicia if good faith and loyalty to the corp., in
addition to the cos line of business
d. Broz v. Cellular Info (handout)
e. FACTS: RFBC Inc. owned and run by Broz. Hes also on the BoD of CIS, a
competitor of RFBC. Another company was wondering if Broz wants to buy

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Michigan-2 license. Broz mentions the license to the CEO of the company and a
few other people at CIS and they dont seem interested at all in buying it so Broz
buys the license. Acquirer of CIS sues saying Broz breached his duty of loyalty
because he stole a corporate opportunity from CIS.
i. Hold: TEST: if youre a corp. director/officer, you can take opportunity when
Generally, disclosure to
you disclose + win a vote of disinterested (directors or shareholders, I think).
co that youre taking
opportunity is good Otherwise, the court looks to these factors: (1) show corp. opportunity was
evidence corp wasnt presented to you as individual (2) opportunity is not essential to the corp.
interested (3) corp. holds no interest or expectancy in opportunity AND (4)
director/officer has not wrongly employed resources of corp.
II. No liability for Broz. Here no breach CIS did not have sufficient
expectancy, CIS was not considered a candidate by the 3d party, CIS was not
properly funded, Broz had duties to his own company which CIS was wholly
aware, asked if CIS wanted opp.
III. On the other hand "a corporate officer or director may not take a business
opportunity for his own if: (1) the corporation is financially able to exploit the
opportunity; (2) the opportunity is within the corporation's line of business; (3)
the corporation has an interest or expectancy in the opportunity; and (4) by
taking the opportunity for his own, the corporate fiduciary will thereby be
placed in a position inimicable to his duties to the corporation."
IV. Crt points out that formal disclosure is not required in DE, but helpful
f. In re Ebay (handout) (line of business test)
g. FACTS: Goldman Sachs gave Ebay BD IPO shares from start up companies after
working on their IPO and BD made millions off of it rather than giving such
opportunity to the corporation. SH brought suit saying Ds took corporate opp.
h. Holding: court uses line of business test.
i. (1) Ct held BD liable b/c the corporation regularly and consistently invests in
marketable securities (2) the source of the conflict was that BD was getting IPO
allocations b/c GS wants continued future business from Ebay (3) all three tests
may pass here: (1): has lots of cash what to do w/ (2) invests in securities (3) not
fair b/c of situation
4. Permissibility of Taking Corporate Opportunity- even if crt finds there is an opp, interest is
negated if:
a. Disclosure to BD: if opportunist fully discloses to BD then healthy competition
ensues that heightens social gain [need presentation to BD]
b. Decision of BD: if BD passes on the opportunity in good faith b/c they cannot
financially undertake the opportunity then the opportunist is fully protected
c. DGCL 122(17) added: authorizes waiver in the charter of cop opp constraints of
managers and SH

ii. Close Corporations (351): look for DoL issue when corp is repurchasing shares.
1. Differing definitions, Ex: DGCL 342 says 30 or fewer SH (DGCL 341-56has statutory
criteria for close corps)
2. Typified by (1) a small number of SHs (2) no ready market for the corp. stock and (3)
substantial majority SH participation in the mgmt., directions and operations of the corp.
a. Duty of loyalty more enhanced in context of closely held corps b/c SHs cannot
readily sell shares on open market theres no sources of liquidity even if you
can sell shares it will be at discounted Analogies to PTs and definition
b. Tensions arise b/c (1) SH are D/O and maintain a controlling interest in corp (2)
SHs owe each other a high DoL, similar to PT b/c majority of SH can easily take

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advantage of minority SH (3) It is hard to sell shares b/c (a) there is no mkt for
them (not publicly traded) (b) CHC say cannot sell shares w/out some approval
3. Sets up a central tension in resolving disputes: should we rely on what we expect the
parties would have agreed to had they worked through all the possibilities at hand?
4. Just like most partnerships have partnership agreements that allow them to opt out (esp.
dissolution of partnership), most closely held corps. have partnerships agreements that will
allow them to opt out OR should the court be focused not only on a fiduciary duty, but on
a higher level of fiduciary duty that the courts require in a partnership
5. In general: either explicitly or implicitly, courts rely on an elevated notion of the duties
that are owed. Like all cases involving duty of loyalty breaches, theres a strong element
of case by case analysis and a broad principle is hard to come to
6. Corporate Codes
a. Unified Corporations Statute
b. Specialized Close Corporation Statutes
1. When CHC purchase shares from majority SH: 2 rules
a. Equal Opportunity Rule Pro Rata: CHC must offer each SH an equal
opportunity to sell a pro rata percentage of their shares to the corp at an identical
price
i. Ex: if corp offers to buy 30% of As stock at $1 must offer B same price per
share
1. Rationale: good faith of D&O and fairness, permits all insiders to
monetize their share
2. Con: D&O may elect not to repurchase any shares and compensate
target SH w/ larger compensation, retirement pckg
ii. Doahue v Rodd Electrotype Co. (351)
iii. Facts: Rodd has 80%/Donuahue has 20% - Rodd sells back shares to sons on
the cheap and when Donahue widow asks for same deal she is refused.
iv. Holding: A controlling stockholder in a close corporation who causes the
corporation to purchase his stock breaches his fiduciary duty to the
minority stockholders if he does not cause the corporation to offer each
stockholder an equal opportunity to sell a ratable number of shares to the
corporation at an identical price.
v. The court identifies a very particular standard that is held and the court
unleashes the punctilio of the honor most sensitive standard which
obviously means Rods lost (from Menard v. Soloman)
vi. Giving minority SH a direct cause of action against majority SH instead of
corporation like in larger corps (not subject to usual impediments of derivative
suit)
vii. Rationale: increases ease to raise capital b/c facilitates transferability of shares
viii. Easterbrook and Fischel argue ct missed point by focusing on repurchasing and
should have focused on how close corp. manages retirement of ctrlling SHs
instead as they will be reluctant to go into certain bsns they know they will
have difficult time liquidating and retiring from, this rule d/n provide corp w/
flexibility nor provide much protection to minority SH. Criticism is that
maybe they would not have agreed to this form the outset and could have been
contracted around. Crt is inferring Meinhard duties in a close corp
ix. In support of another view: Some courts refuse to infer partnership type
duties in CHC on the theory that parties could have contracted for, and absent
an agreement, corporate principles apply (i..e Nixon v. Black- in support of
Easterbrook and Fischels approach)

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b. Rule 2: CHC may repurchase shares at their discretion w/ no special duties to
minority SHs DEL rule
1. Rationale: much more flexible for CHC
2. Con: d/n necessarily permit insiders to monetize their shares
ii. Where a provision in the charter protects a minority SH, which makes min SH
an ad hoc ctrling minority SH, he has a fiduciary duty to use the provision as a
majority SH does, which is reasonably Smith v Atlantic (359)
iii. Facts: 4 SH corp. where there was special agreement in charter that required
unanimous vote for all decisions 1 SH (25%) vetoed payment of dividends
that resulted in the majority incurring tax penalties SO they sued.
iv. Holding: duty of loyalty in close corp can extend to minority SH. Where a
Closed corporations articles of incorporation include a provision designed
to protect minority stockholders , the minority stockholders have a
fiduciary duty to use the provision reasonably
v. Court says hes clearly irrational and so hes held liable for that and not
exercising duty of loyalty and good faith.
vi. Close corporation opportunism can be a two way street- a minority SH has
fiduciary duties to exercise his mngt rights in good faith
vii. Remedies: should have sued for statutory dissolution! Should have said the
majority is taking advantage of us and corp should be dissolved. Can wind it
up like a partnership
2. 4 ways that you can take money out of a corporation (1) salary, or: (2) sale of goods and
services (both designed to benefit individuals who receive $ or goods and also provide tax
benefits to the corporation b/c all costs subtracted from revenue before revenue is
computed) or (3) dividends (pro rata) or (4) repurchase shares (permitting all SH who wish
to sell their shares to the company).
iv. Use of Corporate Profits (296): Where corporation takes profits and does not issue dividends
v. Complications w/ Fiduciary Duties: Charitable giving, Exec. compensation, Indemnity &
Insurance
c. Corporate Gift-Giving/Charitable Contributions in corporations:
a. Duty of Loyalty: 2 Competing Norms
i. (1) Shareholder Primacy Norm: directors must act primarily to advance
shareholder interests.
ii. (2) Corporate Constituency Norm: directors must act to advance the interests of
all constituencies in the corporation (employees, shareholders, etc.). This is
also important in LBO context where shareholders get big cash premia &
creditors/employees get screwed.
iii. Rule: Corporations may make charitable gifts as long as there is some
benefit to the corporation and gift is not 1) unreasonable or 2) made to a
directors pet charity.
iv. Rationale:
1. (1) Good for public welfare good for business.
2. (2) Unnecessary to have stricter limitations because market will
regulate. If the gifts are unreasonable shareholders will dump the
stock.
b. Incentives for Charitable Gifts: agency costs, what better way to expand bsn and
promote self then to endow charitable organizations
i. Benefits and Costs of Charitable Gifts: (1) benefits: tax deductions, reputation
value (2) costs: agency costs of finding the organization and doing and
organizing the donating itself, takes time away from corp

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c. In giving to charity corp has a certain level of discretion if such a gift is not (1)
unreasonable or (2) made to a directors pet charity
i. A.P. Smith Manufacturing v Barlow (299)
ii. Facts: Barlow and other SH of AP challenged its authority to make a donation
to Princeton University
iii. Holding: A Corporation should be allowed to make charitable gifts using
corporate funds. State legislation adopted in the public interest can be
constitutionally applied to preexisting corporations under the reserved
power.
iv. (1) ct upholds corp decision to donate money to Princeton University b/c (a) it
upholds the morals of the importance of philanthropy for strength of society (b)
enhances good name of corp, binds it to the community (c) should defer to
capitalistic decisions as ppl will dump the stock if they feel gifts are
unreasonable (2) it is rational to create a (a) reasonable limit (b) that benefits
the corp (c) and furthers corporate ends, not to be exceeded (3) although, what
would truly be KH efficient would be to give dividend to SHs
v. Courts need to balance the competing concerns three approaches
1. (1) judicial review of the actions (most jurisdictions take this role)
2. (2) mandatory disclosure (congress and SEC into this one)
3. (3) substantive rules (least common- caps on amount of money that can
be given to charities- common abroad)
vi. Gift must be in the name of the corporation.

5. Addition Obligations of D&O Insider Information (615)


a. Nature of Inside Info and Insider Trading:
i. Definition: Insiders [employees, D O] making money (or losing money) off of using material non-
public information by executing trades and selling stock in the open market against others who d/n
have info
ii. Potential Costs of Insider Trading
1. Trading Partners: No need to be concerned about trading partners b/c there will likely be a
party w/ more knowledge on one side of any trade, insider or not.
2. Market Integrity: SEC works very hard to root out insider trading over a fear that if you
think you are always interacting w/ insider who knows more than you, thinking the game
is rigged against you, you will never invest in the first place. Also harms efficiency of
ECMH
3. Policy Analysis (case law): Based much more on the unquantifiable feeling that there is
something wrong/unfair with insider trading
4. Delayed disclosure: interferes with the prompt disclosure of important corporate
information that should otherwise be immediately released into the public
iii. Criticisms of Insider Trading Regulation
1. Market price: insider trading arguably causes the company stock price to better reflect
new and unannounced developments. Stocks move smoothly and are closer to their true
value.
2. Communication: the more the mkt has the more efficient the mkt becomes
3. Compensation: perhaps insider trading should be taken into account when setting D O
compensation, no need for huge salaries just balance it out w/ insider trading
4. No Lack of Fairness: truly not unfair, SHs have option of the Wall Street Walk
5. Enforcement Difficulties: it is tremendously difficult to monitor and stop insider trading,
the costs are huge and outweigh the benefits of doing so
6. Economic Analysis (Chicago School & Gentile) not actual law

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a. Efficient Capital Market Hypo is predicated on the dissemination of information,
and the limitations on that are inherently problematic, thus regulations on insider
trading should be limited
b. Rationale: (1) the only person really harmed is the acquirer [Gecko] who has to pay
more and has the potential to make corp more efficient and courts should focus on
protecting acquirer [confidentiality agreements] and trust market will correct itself
as to SHs (2) importance of disclosure in the securities context is different in any
other market b/c non-disclosure costs the entire market (3) if public distrust of the
market reaches a certain threshold then it will be much harder for companies to
raise capital b/c individuals will not invest and the economy will suffer
b. Three bodies of law that govern insider trading:
i. State common law
ii. Federal SEC Rule 10(b)(5)
iii. Short swing profits 16(b) of SEC
c. Common Law Securities Fraud (615): difficult to prove fraud for insider trading under state law.
Absent special facts and circumstances you must bring action for fraud. SH must show:
i. Elements of a claim for fraud (1) a false statement of (2) a material fact (3) made w/ intention to
deceive (4) upon which one reasonably relied and which (5) caused injury
1. Very hard to prove intent b/c there a million reasons why someone might trade at a certain
time. Reliance also almost impossible to show
2. In general, CL does not impose upon a party to transaction any duty to disclose, there is a
duty to disclose where D has some fiduciary duty to P frown out of a special relationship
and majority of CL says insider has fiduciary duty only to the corp not to present of
prospective SH. Therefore, no way for a SH to bring a successful suit if the insider is
silently selling based on inside information
ii. Three approaches to state law insider trading: (1) majority: a duty on insiders not to trade with
corporate SH in face to face tx while in the possession of highly, material non public corporate
information, i.e. special facts rule, (2) minority: a duty on insiders not to trade w corporate
insiders in face to face tx regardless of special facts, (3) NY rule: a duty on insiders to the
corporation not to advance their own pecuniary position using corporate info regardless of harm to
the corp
iii. I.e. Application to Directors- majority rule:
1. Absent fraud, there exists no special duty of disclosure to D O possessing inside info
where the tx occurs on the public stock exchange Goodwin v Agassiz (616)
2. Facts: Mr. A found out that there might be copper underneath land. Mr. G sold his Cliff
Mining Co. shares on the Boston Stock x/c to Mr A b.c there was news reports were
wrong. Mr. A he knew stock would go up b/c he had material information that there
would be copper under the land. Mr. G sues.
3. Holding: Fiduciary obligation of directors are not so onerous as to preclude all
dealing in the corporations stock where there is no evidence of fraud
4. No breach of duty. Directors owe a duty to the corporation. Its unfortunate Mr. G lost
money selling shares to Mr. A, but he owes to duty to you as a SH. His duty is to the
corporation.
5. SH under this court would have to show 5 elements of fraud and tx wasnt face to face,
and fraud c/n be proved
6. Diff b/c here the corp is not harmed at all, whereas SH is harmed b/c if he held on to stock
longer he could have sold for a higher price
7. In special facts doctrine neither affirmative misrepresentations nor actual reliance is
needed to be established. Limited to situations where:
a. Insider purchases from an existing SH
b. Insider in privity w selling SH in face to face tx

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c. Insider knew of material corporate info
d. Secrecy was critically important to the sale
e. *bc of this, often involve concealment of identity and sympathetic Ps
8. Minority: no special facts needed, duty to disclose material nonpublic info in any face to
face tx
9. Plurality Strong v Rebide re-evaluated in 1990 by SC stating Goodwin and Oliver go to
far in each direction, so ct needs to look at special facts and circumstances. Where the
insider buys from the outsider in face to face tx, the majority rule still seems to be
that the insider has no affirmative duty of disclosure and is there not liable if he
simply remains silent. BUT there are some exceptions with face to face: (1) fraud: if
the insider lies or tells a half truth, he will be liable under ordinary fraud principles, (2)
special facts: silence cannot constitute fraud, but if there are special facts that make the
conduct especially unfair, he will be liable even if he remains silent.
10. Corporate Recovery of Profits from Insider Trading (621)
a. May the corporation itself recover? Harken back to agency lawan agent may not
use her principals information for personal profit harm to corporation is rare (no
cases on the subject)
b. Inside info is not a corp asset under agency law; corp is not entitled to the profits of
its agents from insider trading Freeman v Decio (622)
c. Facts: Freeman claims Decio, largest SH, harmed other SHs by trading on material
non-public info. Decio also managed to sell during qtrs where he knew co. would
make negative announcements.
d. Holding: Insider Trading on the basis of material inside information does not
constitute a breach of a fiduciary duty to the corporation.
e. (1) Fed ct rejects per se rule and rejects SH (Freeman) claim of fiduciary breach
DoL] where CEO (Decio) traded on inside info (earnings) b/c info is just info
[relating to the corp and not necessarily a corp asset] it is akin to corporate
opportunity, and making a strict rule is too difficult, thus if the ct upheld Diamond
they think it would be judicial sec reg and they instead defer
f. (2) and state that remedies under fed law cover this so no need to interfere
i. NY opinion rejected old case of Diamond: if insider trades on corp info it
violates fid duty to corporation, b/c such information is a corporate asset, it
belongs to the corp, diamond held that inside information is a corporate asset
and that anyone that profits from trading upon the information has violated
duty and must turn over the profits this court thinks Fed Law has a handle
on this, so were good
ii. No other state court has accepted this rationale and thinks one must show
direct harm or injury from the trading to recover profits
g. Broad disclosure obligations under state law: Fed law is main arbiter of this, but
state has some part, too. DE SC has said theres a broad duty to provide candid and
complete disclosure to SH (parallels 10b5). Expanded scope of disclosure under
fed law with Malone v. Brincat. Ds duty of candor under state law requires
them to exercise honest judgment and assure disclosure of all material facts to SH,
yet if you dont, unlikely to give rise to liability unless failure represented an intent
to mislead. Could maybe get an injunction but likely 102b7 would protect Ds.
d. Duties under Fedl Securites Law (629): alt to state law, better to prove IT, regulate market
i. General Nature of Duty: relating only to the purchase or sale of a security
1. Exchange Act Section 10b: prohibition against fraud in purchase/sale of securities.
10(b)(5):
It shall be unlawful:
a) to employ any device, scheme or artifice to defraud,

65
b) to make any untrue statement of a material fact or omit to state a material fact necessary in order to make
the statements made, in the light of the circumstances in which they were made, not misleading, or
c) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit
upon any person, in connection w/ the purchase or sale of any security.
2. Rule 10(b)(5): we are looking only really at a and c, not b
a. In connection to the sale or purchase of any security it is unlawful to (a) employ
any device, scheme or artifice to defraud (b) make any misstatement or omission of
material fact (c) engage in fraud or deceit on any person
b. Test : (1) evidence of false or misleading statement or ommssion about a
material fact in connection to the sale or purchase of securities (2) made with
intent to deceive (3) and reasonable reliance on misstatement by buyer or seller of
security causing the harm.
i. Statue mandates that the requisite reliance must be a buyer or seller of stock,
the harm must be to a trader in stock and the misleading statement must be
made in connection with a purchase or sale of stock.
c. Approach look for (1) duty to disclose and (2) whether reliance reasonable
d. Note: materially misstatement can typically be proven under A or C, omission is
much harder to prove typically
e. Broad application: (1) rule applies to any form of deceit or fraud including cases
where insider silently buys or sells material non public information. (2) Rule
applies to one who makes a misrepresentation even if the maker never buys or sells
himself and (3) investor who meets several procedural requ may bring a private suit
alleging 10b5 and recover damages BUT SEC will almost always bring suit
ii. Bases for Duty- THREE THEORIES
1. Equal Access Theory (broad) (rationale taken from Cady, Roberts) [court poo poos this
theory and basically doesnt really use it anymore]
i. Theory: Taking advantage of inside information for personal gain, which was
intended to be available only for a corporate purpose, is inherently unfair.
b. Therefore Application: When insider has material, non-public information, he
must either disclose the info before trading or abstain from trading entirely
i. Pro: Easily understandable and applied as blanket rule w strict line in sand, it
reaches all conduct that might be popularly understood as insider trading
(tippees, etc)
ii. Con: (1) Difficult to differentiate btwn those buying/selling based on insider
information and those buying/selling based on good research (2) if every
person who comes into contact w/ insider info will be charged then none of
those ppl will trade and mkt will suffer by so much abstaining
c. Ct utilizes equal access theory: must disclose or abstain SEC v. Texas Gulf Sulfer
(633):
i. FACTS: insiders deny rumors that they struck ore and meanwhile purchase
call options (buy stock at prearranged price at future date buy at todays
price, sell it at tomorrows price = huge profit) SEC sues for violation of
10b-5.
ii. Holding: Anyone in possession of material inside information must
either (1) disclose it to the investing public or, if ordered not to, (2)
abstain from trading in the securities concerned while such inside
information remains undisclosed (equal access theory)
iii. Not duty for directors to tell anyone about material inside info, but they do
have a duty to abstain or disclose!
d. SC does not endorse such strong regulation & limits Fed cause of action under
Rule 10(b)(5). Tries to preserve remedies under State law to protect Fed cts from

66
excessive insider trading claims. Breach of fid duty itself is not enough for 10(b)(5)
need manipulation, misrepresentation, or deception Santa Fee Industries Inc. v
Green (639)
i. Facts: (253 short form merger b/w parent and subsidiary where subsidiary
shares were said by parent to be $640, but the offer was only $150 an amt.
slightly higher than what the parents I-banker valued of $125 SHs claim
10b-5 fraudulent appraisal by the I-banker Morgan Stanley.
ii. Holding: Before a claim of fraud or breach of fiduciary duty may be
maintained under 10(b)5 there must first be a showing of manipulation,
misrepresentation or deception. Rule 10b5 regulates deception, not
unfair corporate tx or breaches of duty.
1. an unfairly low price fraud
iii. SH have no cause of action under 10(b)(5) here b/c there was full disclose
(no manip, misrep, or decep) and the ct wanted to preserve the state remedy
available
iv. Crt thinks b/c theres a state remedy, construe narrowly b/c they have a cause
of action and we want to cut down on litigation
e. Note of disclosure of unfairness- Goldberg v. Merifor (643)
i. Held that a derivative action could be brought under 10b5 on the basis that
the transaction between a corporation and a fiduciary to a controlling SH was
unfair if the transaction involved stock and material facts concerning the tx
had not been disclosed to all SH.
ii. Interpreted as requiring more than mere nondisclosure of impure motive or
culpability. In order to succeed under this principal, P must show (1) a
misrepresentation or nondisclosure that (2) caused a loss to the SH (can be
easily satisfied by SH vote)
2. Fiduciary Duty Theory (647): (narrow) natural outgrowth of Santa Fe theory. Though
manip/decep/misrep may exist, there can be no breach of a duty to disclose insider
information to other traders where no relationship of trust and confidence exists btwn
insider and SHs need to trade on material non public info
3. Need some special relationship (like a breach of confidentiality)
NOTE: in a. Benefits:
Equal Access i. Supports an analogy to CL fraud
theory, the ii. Allows case-by-case review so cts can selectively target insider trading
duty is to the b. Drawbacks
party youre i. Doesnt answer how trading on one of many info disparities defrauds
trading uninformed traders
against BUT ii. Can be underinclusive (i.e. in Chiarella)
with c. A purchaser of stock who is neither insider or fiduciary has no obligation to
Fiduciary disclose material info when trading on such info Chirella v US (649)
Duty Theory
i. Facts: Chiarella, a financial printer, figures out what was the target co. in a
you are liable
to the
merger even though co tried to use code names and traded. SEC begins
narrower investigating once C makes $30K over a matter of months. Sup Ct rejects
class equal access theory:
ii. Holding: A purchaser of stock who has no duty to a prospective seller
because he is neither an insider nor a fiduciary has no obligation to
disclose material information he has acquired and has failure to disclose
such information does not, therefore, constitute a violation of 10(b)5
iii. Chiarella is not an insider w no fiduciary relationship w target co or SHs, so
no breach

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iv. This rule says: if you have a relationship of trust and confidence with the
target SHs then you have a duty to disclose or abstain
v. Merely trading on the basis of nonpublic material info could not trigger a
duty to disclose or abstain
vi. SEC made him disgorge his profits, this case was just abt criminal liable .
This narrows the gamut for those who can be criminally tried for insider
trading
d. Expanding RTAC (you can transfer the RTAC) (tipper/tippee) D/O w/ a
RETAC can pass that RETAC to someone, but only the director/officer can
breach, which includes D/O getting benefit from the tx. No tipper = no tippee
e. Tippee will be held liable for disclosing nonpublic info received from insider, if (1)
tipper has relationship of trust and confidence w/ corp that will transfer to tippee
when (2) tipper breaches by disclosure as tippee knows/should have known that
insider will benefit from such disclosure [violating DoL] and (3) breach occurs
when benefit occurs Dirks v SEC (653)
i. Facts: Dirks was security analyst who got tipped off to fraud by a company
insider he tipped off his clients who dumped the stock before the scandal
went public SEC charged Dirk with being a tippee.
ii. Holding: (above and..)10b5 liability if a tipper is breaching his fiduciary
duty to SHs, then essentially the tippers breach taints tippees liability
all the way down the line there was no breach of fiduciary duty here
b/c the tip was not made by the insider to obtain personal benefit
1. Breach occurs when an insider gains some direct or indirect
personal gain or reputational benefit that can be cashed in later
iii. No benefit here so no violation.
iv. (1) the tip from the insider to D did not benefit the tipper, as he d/n trade
from information and
v. (2) SC said Chirella holding too underinclusive so expanded the gamut
slightly to say that relationship of trust and confidence can be passed on w/
benefit creating temporary insider out of tippee
vi. (3) ct is concerned abt analysts b/c they d/n want to discourage behavior akin
to that in this case (kind of like an analyst safe harbor)
f. No liability when the tippers reasons for revealing the scandal is not to obtain an
advantage to himself and there is no personal gain or benefit
g. *note: ppl working on a transactions (i-bankers, lawyers, accountants) would come
into play under this analysis because they are temporary insiders. They get their
RETAC from the transaction itself, so if youre the lawyer/i-banker/accountant
working on the AOL-TimeWarner merger, you have a RETAC yourself with
TimeWarner, the effective target. You dont have to worry about anothers duty or
their breach. The reason for this distinction, carving OUT the analysts, and
carving IN the people on the deal, it depends on the role they play in the
transactions. Everyone working on the deal, is essentially like the dirs/officers, in
a RETAC to get deal done for benefit of SHs. Analysts are just floating around, and
through their work they come into the information, theyre not just assigned to
work on a particular deal.
4. SEC Reaction
a. Rule 14e-3 (Responding to Chiarella re. Tender Offers): imposes duty on (1) any
person, regardless of a fid obligation, who obtains inside info abt tender offer (2)
that originates either with the offeror or target (3) to disclose or abstain from
trading

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i. NOTE: A buying the shares in preparation for tender offer is exempt from
this rule
ii. equal access theory for TOs
b. Regulation FD (responding to Dirks - Fair disclosure rule): If issuer issues info to
certain people, it also has to issue info to the public so as not to favor particular
parties
5. Misappropriation Theory: (1) the deceitful misappropriation of mkt-sensitive information
is a fraud that may violate rule 10(b)(5) (2) when it occurs in connection with a securities
tx (3) caused by a breach of a fiduciary relationship btwn individual w/ insider info and
the source of that information.
6. Liability arises when a person trades on confidential information in breach of a duty
owed to the source of the information even if the source is a complete stranger to the
traded securities. (OHagan need breach of trust and confidence, yet Qs about
when duty of confidentiality attaches and who has the duty. See below)
a. SEC Response Rule 10b5-2 [overruling Chestman] Note: Rule10b5-2 adopted
to show who owes a duty of trust and confidence:
i. Recipient agreed to keep info confidential
ii. Persons involved in communication have a history, pattern or practice of
sharing confidences and reason to know the communicator expected recipient
to maintain secrecy
iii. Communicator of info was spouse, parent, child or sibling of recipient
unless could show there was no reasonable expectation of confidence
1. Pro: broad scope (reaches lawyers, accountants, etc.)
2. Con: No civil recovery for uninformed traders who dont own info
iv. US v Chestman (662)
v. Facts: Ira selling Waldbaums, tells sister, who tells daughter, who tells
husband, who tells broker even though she told husband not to say
anything broker and husband both trade on confidential info about
upcoming sale.
NOTE: Fiduciary duty under the holding: No 14e-3 liability: 2d Cir. Disagrees that SEC overstepped its
misappropriation theory = some bounds by throwing out CL fraud requirement that there must be fiduciary
sort of relationship of trust NOT duty under 14e-3 it doesnt matter, and that statute is valid
the typical corp. fiduc. duty Holding: No 10b-5 liability: kinship (here marriage) is not enough to create
fiduciary duty under the tippee theory if youre not involved with the mgmt.
of the business there is no automatic expectation and no pre-existing pattern
NOTE: cts trying to balance the tension of protecting markets w/o
creating too many lawsuits
vi. (1) Ct holds Chestman [trader] not guilty of 10(b)(5) b/c alleged
misappropriator Loeb [client/in-law of source] d/n have fiduciary
relationship w/ wife or Waldenburg family and no benefit to tipper [Ira] in
fact Ira was injured by trades (2) additionally, Chestman cannot be liable as
tippee absent tipper [Loebs] fid relationship w/ source
b. US v OHagan (667)
c. Facts: OHagan partner at law firm, repping Grand Met in a tender offer to
Pillsbury. OHagan buys 2500 options of Pillsburys stock in his own name.
OHagan exercises the options, making him the largest SH in Pillsbury, making a
$4.2 mil. profit. SEC charges him with insider trading! OHagan was lecturing at a
law school about insider trading at this time b/c technically he didnt have a
relationship with Pillsbury- his firm was representing Grand Met and at the time of
the shares sales there was no tender offer at the time.

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d. Holding: (1) A person who trades in securities for person profit, using
confidential information misappropriated in breach of a fiduciary duty to the
source of the information, and is guilty of violating 10b-5. AND
e. Liable. Validating misappropriation theory
f. The unauthorized use of confidential info is a deceptive device under 10b5 and in
connection with securities trading
g. SC holds OHagan (law partner) guilty of violating 10(b)(5) under
misappropriation for purchasing options of Pillsbury stock after hearing rumbling
tender offer at firm, breaching duty to law partners, who were the source
h. Under this theory, law firms, investment banks, brokerage firms and accounting
firms have this duty. Associates and partners have a duty. Many times firms
contract with secretaries and janitors so they know they have a duty
i. Violate duty by not disclosing evil intentions and fraud happens when fiduciary
uses the information to purchase or sell stocks
j. Insures the maintenance of fair and honest markets and promotes investor
confidence
e. (Federal) Limitations Short Swing Profits (626): prophylactic rule.
i. Rule 16(b): requires (1) statutory insiders to file public records of any tx in the corps stock, w/in 2
days of the trade (2) statutory insiders disgorge to corp any profits made on short-term turnovers in
the issuers shares (purchases and sales made w/in 6 months)
1. Applies to trading in the equity securities of a corp that has a class of equity stock
registered under 12 of SEC
2. Basic rule: match any transactions that produce a profit
3. Statutory Insiders are: 10% +SH, D and O
4. Rationale: prevent insiders from profiting on insider information
5. Cons: (1) underinclusive: not all insider trading takes place w/in 6 months (2)
overinclusive: short swing tx d/n necessarily involve insider information
6. Automatic strict liability on insiders who make a profit w/in 6 mo period. Recovery is to
the corp and the suit may be brought either by the copr or by SH in derivative suit
7. Gratz v Claughton (627): (1) go 6 months forward or backward from any purchase or sale
and match any tx that produce a profit you will disgorge back to the corp (2) there exists
no offsetting for any loss incurred, but must disgorge profits w/ in 6mo
8. Treatment of mergers or unorthodox transaction: when shares are acquired in a merger or
in an option, courts have been willing to inquire into whether the x should be treated as a
matchable sale or purchases for 16b purposes. Also exemptions where insider abuse is
minimal (i.e. redemptions, conversions, employee benefit plans). Kern County Case
(628): held an unorthodox tx by a hostile bidder (which became a 10% SH) in a takeover
contest is not a matchable sale if there is no evidence of abuse of inside information. No
sale of stock in the merger bc the tx was involuntary and the relationship bn the two
parties was hostile. There was also no evidence of abuse. Thus, merger didnt give rise to
16b.

VI. SHAREHOLDER LAWSUITS: enforcing duties of care, loyalty, obedience

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I Overview Two Types of SH Lawsuits (363): SEC mainly responsible for enforcing insider trading laws but
State law duties of disclosure, obedience, care, loyalty enforced by SHs b/c they are personally harmed

1. Derivative Actions: 2 suits in 1 (suing in equity and to enforce corporate rights); harm to the corporation and
thus derivatively there is harm to SH
a. Step 1: SH bring claim against D&O of the corp, alleging harm to the corp itself (and derivatively to
the SHs) by D&Os failure to sue on an existing corporate claim. The Ps suing for corp, not personal
claim for themselves (i.e. breach of DoL claim)
b. Step 2: If Step 1 is successful then D&O will bring action against the corporation itself
c. Remedy: all recovery is given to corp, SHs d/n receive award.
d. Consequences of successful suit: P gets costs and attnys fees expended (the litigation expenses)
e. Unsuccessful suit: P will be liable to people he sued for costs and attny fees if sued w.out reasonable
cause. If reasonable cause, you prob wont have to reimburse other side, but likely bear own
litigation fees
2. Direct Action: 1 suit; harm to the SH and not the corporation
a. SH brings claim of individual harm against corp, usually filed as class action suits (where all injured)
i. Include: compel payment of dividends declared but not distributed, compel inspection of SH
lists or corporate books, require the holding of a SH meeting, challenge fraud on SH in
connection with voting, sale or purchase of securities, challenge the sale of the corp in a
merger where Ds violated duties to be informed or structure of tx wasnt fair, challenge corp
restrictions on share transferability, challenge denial or dilution of voting rights and compel
dissolution of corp
b. Remedy: is given to the SHs, no recovery for corp b/c corp not harmed here. Damages paid to SH so
attny fees paid from SH recovery or a class action fund
c. Ex: SHs lose voting rights in corp restructuring and they are harmed b/c of it

3. Distinctions Between the Two


a. Ct establishes test to differentiate btwn the two types of actions Tooley (366) (1) Test to decide
whether derivative action or direct action, must ask (a) who suffered from the alleged harm [if corp =
derivative, if SH = direct] (b) who would receive the benefit of any recovery or other remedy [if corp
= derivative, if SH = direct]. Main difference is derivative suits are procedurally more complicated.

II Derivative Actions

1. Nature of Derivative Actions


a. Collective Action Problems (366): Corporation pays the successful (succeeds on merits or settles) s
litigation expenses, including attorneys fees BUT NOTE attny receives nothing when a
derivative suit is dismissed b/c there is no recovery and no benefit
1. Rationale: the (and attny) produced a benefit to the corp. and they should be reimbursed for
their effort
2. This fixes the collective action in the sense that SHs with only a small % of equity will not be
discouraged by the externalized benefits and high attny fees
A. attnies are usually the force driving these suits b/c they want the attny fees they usu. Decide when
and whether to settle
i. Paid contingency fees calculated based on % of recovery based on total recovery for all SHs
a. Theories of payment (1) Common Fund Doctrine: Corp (which IS a common fund) should
pay counsel fees from common fund to those who protect or increase the value of corp.
rule encourages meritorious actions

71
i. All beneficiaries must pay their share of the expense necessary to make benefit available
to them
b. (2) Substantial Benefit Doctrine: (variant of common fund doctrine) award attny fees when
there is substantial benefit to corp. even if action doesnt produce a fund from which they can
be paid
i. Need not be monetary benefits can be for maintaining health of corporation, raising
standards of fiduciary relationships, preventing abuse that would be prejudicial to rts and
interests of corp., affect enjoyment/protection of SH rts
ii. Substantial Benefit Rule: Ps lawyers can recover fees from corp if the corp received a
substantial benefit from the litigation itself, can be $ or governance reforms, and no need for
common funds Fletcher v A.J. Industries, Inc. (367)
1. FACTS: Corp. dominated by Ver Halen, who lets high salaries be paid which
damages the corp. There was a fiduciary breach in allowing excessive compensation
to be paid; corp. harmed by paying too much. The P and D came to a settlement and
there would be changes in corporate governance. The award to the corp doesnt
contain any monetary benefit. Attny want to get paid!
2. Holding: even though the corporation receives no money from a derivative suit,
attny fees are properly awarded if the corp has substantially benefited from the
action
3. (1) Ct adopts substantial benefit rule, stating right of Ps lawyers to recover fees
where benefit not only was monetary but also was governance improvements, thus
negating need to employ common fund
4. (2) Historically cts only allowed common Funds Doctrine but this is rejected here.
Con: hard to measure benefits if only governance changed
2. Requirements for Derivative Actions: Procedural Requirements (373): (1) standing (2) demand [de
facto: futility of] (3) special lit committee // provide screening to suits remedy above problems
a. (1) Standing Requirements FRCP 23.1 (DE follows too) the requirements are not too stringent
i. To have standing P must be (1) a SH for the duration of the action and (2) be holding stock at
What time of wrong conduct [contemporaneous ownership rule] and (3) SH must fairly and
happens in adequately represent the interest of SHs (no obvious CoI) and (4) complaint must specify
merger? what action the P has taken to obtain satisfaction from the companys board or state with
particularity the Ps reason for not doing so (i.e. reasons for not making demand)
ii. Rationale: we d/n want SHs buying into the litigation, want to know SH was injured
b. (2) Demand Requirement of Rule 23.1: many statutes state that the P must express efforts to make a
demand on the board to resolve the dispute or the reasons she did not make demand. Many crts have
interpreted the statute to make demand mandatory unless demand would be futile. The demand
requirement allows the crt to ascertain whether the bd could have acted on demand (Aaronson).
i. Test: P must either (1) ask BD for presuit demand so BD bring suit or (2) bring 2nd suit and
prove futility of demand, why BD was incapable of bringing suit
1. P asks for presuit demand (for the BD to accept the suit and file v corp) When P asks
for approval BD will almost always reject.
a. Ct will then ask was demand properly refused?
i. If yes: Ps rights to initiate actions on behalf of corp are terminated
b/c BD is acting w/in proper scope.
ii. If no: P retains right to initiate action on behalf of corp.
2. P d/n ask for presuit demand, show BD is incapable of OKing demand
a. P must show asking for demand would be futile [futility of demand] since
BD is not disinterested, apply Aranson Test [disjunctive] P must show
either: (1) BD is interested or dominated so they are incapable of evaluating
the suit against corp in any meaningful way or (2) Tx is so unreasonable it

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unlikely to be the product of valid business judgment, thus creating valid
suspicion. Rationale: crt wants to know if Bd could properly evaluate the
demand. If theyre already interested or have made a terrible decision that
could receive BJR, no reason to protect their judgment in this case.
b. Whether demand is futile or not is up to discretion of the courts
3. To withstand dismissal of a derivative action, P SH claiming wrongful demand
refusal or futility of demand must allege particularized facts that overcome the BJR
presumption Levine v Smith (376)
a. FACTS: in 1984, GM bought EDS, one of Perots largest companies, in a
stock transaction, making him one of GMs largest SHs (owned 1% of stock)
and also served on the board. GM is poorly run, Perot discovers this and tells
everyone! BoD of GM embarrassed, and pays him off bigtime. s file their
suit w/o making a demand on the BoD to bring the suit arguing it would be
futile as a SH to bring a suit
a. Holding: failed to make demand to plead the necessary particularized facts that
demand would be futile 2 prong test to overcome demand requirement:
i. (1) specific facts that overcome notion of director independence (i.e. majority of
the board has a material interest in the transaction OR the majority of the board is
dominated by the alleged wrongdoer) (//S DUTY OF LOYALTY) AND IF NOT
NOTE: this prong is NOT met by showing merely that outside directors
Used Aronson test here can were misinformed by inside directors
survive motion to dismiss w/o ii. (2) sufficient facts to present reasonable doubt that transaction was product of valid
making demand if you show exercise of business judgment (//S DUTY OF CARE)
possibility of success in
NOTE: this can be shown by proving bad faith or gross negligence (i.e.
pleading
BOD made no effort to be informed)
b. Ct holds SH d/n satisfy action for futility of demand b/c P d/n satisfy either
prong of Aranson
ii. Universal Non-Demand Rule: In DEL, courts apply a rule that states that if P makes a presuit
demand, then P is impliedly conceding that the BD can properly evaluate whether to bring the
suit, thus BD is entitled to BJR automatically. Thus, P should not bring demand, and instead
will bring the suit and attempt to show futility of demand upon bringing such suit. Then,
parties fight about futility of demand based on disjunctive rule. Cts screen whether demand
is futile.
iii. In the case of double derivative suits, only the 1st prong of Aronson will be analyzed as the 2nd
prong d/n apply b/c of diff BD Rales v Blasbad (381)
1. FACTS: SH owns stock in Easco, 52% of which owned by Rales Bros. Easco via
Rales decides to issue notes (bonds) into the public and issues $100 mil. in securities.
But they ended up investing in junk bonds and Co. collapses. Easco merged into
Danaher Corp. at time of suit, and Rales Bros. only have 44% interest in Danaher,
and they sit on the BoD but dont control it. Mr. Blasbad got share of stock in the
parent company before merger and sues b/c of junk bonds.
2. Holding: in a derivative action where demand excusal is asserted against a Bd
that has not made the decision that is the subject of the action, the standard for
determining demand excusal is whether the Bd was capable of impartially
considering the actions merits without being influenced by improper
considerations
3. Only apply first prong of Aaronson at the time of filing the action. In dbl
derivative suits we look only to whether the BoD is interested or dominated.
Rationale doesnt make any sense to look at underlying decision when boards are
different from the time of decision, to time of demand.

73
4. Here, the BD that made the initial bad decision no longer exists. In applying first
prong and there exists reasonable doubt that the majority of the parent BD could have
acted impartially so demand is excused
5. Note: while court professes to only look at 1st prong, they look at same factors as
under 2nd prong in analyzing the issue
c. After Bd excuses demand (3) Role of Special Litigation Committee (388): formed if court
excuses demand or if BD grants then SH will initiate derivative action, upon such initiation:
i. Now SH brings derivative action:
1. Committee will form, comprised of subset of BD [no interested/dominated or not part
of underlying decision]
2. Who evaluate whether pursuing Ps suit is in the best interest of the corporation [B/c
the ct determines the BD is either interested/dominated or underlying decision isnt
product of valid judgment BD needs to form a special litigation committee]
3. BD will always recommend bringing a motion to dismiss Ps suit and P will always
challenge such a motion, which will be reviewed by the ct
ii. TESTS: 2 of them, one is applied in Del the other is applied in New York
Overview:
1. Zapata Test Del Majority and note DGCL 141(c)
a. (Q1) Procedural: Is SLC truly independent and acting in good faith? [burden
on D] Look at: how SLC members are related to the rest of the board
(Oracle) (Beam)
i. If yes go to Q2
ii. If no ct will dismiss SLCs motion to dismiss
b. (Q2) Substantive: According to Cts independent bsn judgment; was the
SLCs motion to dismiss correct? Look at: best interests of corp by balancing
financial [fees, negative publicity, employee distraction] and policy issues
[deterrence, insurance] (Joy v North)
i. If yes Ct will grant SLC motion to dismiss
ii. If no Ct will dismiss SLCs motion to dismiss
iii. This prong is an exception to the norm of judges refusing to second-
guess D&O business expertise
2. In NY courts analyze SLC not under Zapata but under Auerbach If (1) SLC was
independent (2) acted in good faith and (3) did some reasonable investigation [i.e cts
d/n look to the 2nd prong of Zapata, only first]

3. Establishes test from which to analyze SLC in DE (majority) Zapata Corp v


Maldonado (389)
4. Facts: M files derivative action. 4 years later, BoD appoints 2 new ind. directors to
serve as its SLC which conducts a full investigation, and decides to dismiss the suit.
5. Holding: court should apply two prong test to analyze SLC motion to dismiss:
(1) has the corp proved independence good faith and reasonable investigations
and (2) does the court feel, applying its own independent business judgment,
that the motion should be granted?
6. Burden on Ds to show first prong and then Ct will proceed with the second prong
evaluation
7. courts eval 2nd prong b/c feel particularly capable of evaluating this type of litigation.
iii. Alterations of Zapata Test:
a. The following cases discuss the first prong of Zapata:

74
b. Chancellor Strine expands definition of insider and says to see whether
SLC is independent must be realistic about human nature and look for any
connection possible to the corp and BD In re Oracle Corp (395)
c. Facts: Oracle insiders engaged in improper trades and had to make SLC. On
Bd in general was Ellison is the founder, CEO and largest SH, and donor to
Stanford; Henley is CFO; Lucas, a director, Exec. Committee, Finance &
Audit Comm.; alumnus of Stanford and donor; and Boskin, director,
committee member, professor at Stanford, and taught Grundfest (SLC
member and director, also Law and Business prof at Stanford). Molina, on
the SLC, is Stanfords CS Dept. Chair. Question if independent SLC
d. Holding: SLC does not meet burden of independence where its members
are professors at universities that have ties to the corporation and to the
Ds that are the subject of a derivative action that the SLC is
investigating
e. (1) here, Bd composed of unnamed Bd members and its use of reputable
outside law firm, but still interested b/c SLC members had long standing
professional and academic relationship with principal Ds through Stanford
(2) Chancellor Strine says never to trust SLC and that cts should always
analyze 2nd prong of Zapata test
2. Second Prong Alterations:
a. If litigation has positive net value SLC motion to dismiss denied // If
litigation has negative net value SLC motion to dismiss granted Joy v
North (403)
b. Facts: citytrust SLC recommended the dismissal of an action brought in fed
crt. Fed crt said needed to review committees decision and that committee
would bear the burden of proving that continuing litigation would be more
likely than not be against he corp interests.
c. Holding: SLC recommendation re: termination of suit must be
supported by a demonstration that the derivative action is more likely
going to be against the interests of the corp
d. Crt says pursuing the litigation is no diff. than pursuing any other project; so
we determine the value of the litigation like net present value of a business
decision.
i. Courts think theyre better at evaluating these decisions better than
anyone else (institutional competence)
e. (1) cts will balance financial [fees, negative publicity, employee distraction]
and policy considerations [deterrence, insurance] to determine companys
best interest, in calc NPV only use financial (2) criticism is that such analysis
is underinclusive b/c ct overlooks important policy concerns
f. Considerations Joy v North analysis d/n consider:
i. Ex Ante effects of bringing suit: (1) Benefit: deterrence, if cts decide
that in certain decisions SLC was wrong then future BDs will avoid
that action (2) Costs: insurance premiums will increase b/c riskier
chance for liability
ii. Ex Post effects of bringing suit: (1) Benefit: if successful corp will
get $ or governance change (2) Costs: lit costs expensive will only
hire great lawyers
d. (4) Approval of Settlements (407)
i. Settlements are measured based on the coverage range of D&Os liability insurance, as the
insurance cos analyze whether D&O are indep, industrys likelihood of being sued, Ds

75
qualifications, etc. (bc if go to trial, usually insurance doesnt cover fraud or self dealing,
whereas settlement will allow the proceeds of the insurance policy to be used).
ii. Settlement in everyones interest
1. 100% chance of getting money vs. some probability of loss/costs of trial better for
risk averse ppl (i.e. most attnys)
2. time value of money
3. directors/officers cant be indemnified if they're found guilty
4. litigation disruptive to corp. jobs
5. can be bad press to corp.
iii. Fair and reasonable standard: [default standard for judicial review of settlements] When
analyzing settlements ct must consider whether proposed settlement is fair and reasonable in
light of the factual support for the alleged claims and defenses in the discovery record before
it.
iv. Rationale: SH has interest in quick settlement [double agency problem] so must protect the
plaintiffs somehow, by the fair and reasonable standard
v. Settlement by Sepcial Committee: The parties can contract to use a different standard [Zapata
in this case] Carlton Investments TLC Beatrice International Holdings (409)
i. Facts: Mr. Lewis worked w/ group of i-banks on an LBO; Lewis ends up w/ 45% of the
corp. and a payment of approx. $20M in settlement. Lewis dies, SHs file suit, claiming
that $20M payout was excessive now that hes unavailable to work.
ii. Holding: a proposed settlement negotiated by SLC is to be reviewed under two step
Zapata test.
iii. Should conduct NPV calc to see if settlement is more efficient than trial
iv. Here, 1st step of Zapata was so solidly a yes but ct had trouble practically applying the 2 nd
step. When we talk about SLC decisions, we have 2-prong Zapata. When we look at
settlement decisions, we usually have the fair & reasonable standard! Only here, we
have Zapata standard b/c parties agreed to it so they are analyzing if the decision meets
2nd prong of zapata
e. Value of Derivative Actions
i. Pros: (1) mechanism for enforcing fiduciary duties of D&O (2) have potential to increase
corp value: (a) actual monetary recovery (b) beneficial change in governance structure (c)
deterrent effect
ii. Cons: (1) costs include litigation fees, insurance premiums, and impact of negative publicity
iii. Note: Institutional SHs may have incentive to bring suits as they have large positions and
often have own lawyers

3. Indemnification and Insurance (243)


a. Generally, these statutes authorize corp. to commit to reimburse any agent, ee, officer or director for
reasonable expenses for losses of any sort (attny fees, investigation fees, settlement amts and
sometimes judgments) arising from any actual or threatened judicial proceeding or investigation
i. Limitation: losses must result from actions undertaken on behalf of corp. in good faith
CANNOT arise from criminal conviction (DGCL 145(a)-(c))
b. Del Gen Corp Law S145: Corp may amend charter to indemnify its D&O to (1) protect them for
personal liability or (2) reimburse expenses they incur defending themselves
i. 145(a) applies to direct actions, corp may indemnify if (1) good faith and (2) not in
opposition to corp interests
ii. 145(b) applies to derivative actions, corp may indemnify if (1) good faith and (2) not in
opposition to corp interests
iii. 145(c) corp must indemnify any D that is successful on the merits or otherwise

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1. Any escape form adverse judgment, criminal or civil, is enough to indemnify D&O
under 145(c) Waltuch v ContiCommondity Services (1) ct holds even where sliver
trading VP is found guilty by futures commodities trading commission of mkt
manipulation, and is ineligible for indemnification under 145(a) as he was not acting
in good faith, that he is eligible for indemnification under 145(c) b/c he was
successful relating to private claims.
a. 145(c) says that the company must indemnify its officers and directors if
successful. (145(a) and (b), the company may) So Waltuch is successful
by being dismissed from one suit, and agreed to a deal in another. CCS
settled for a lot of money thats how Waltuch gets his success. The s are
absolutely willing to let Waltuch leave the lawsuit, since they just got a huge
windfall from the Company.
b. So entitled to indemnification if successful and in this case he is b/c he got
the corporation to pay $35m to make this whole thing go away. CCS pay s
the money and *poof* its gone.
2. (2) rationale: this rule is likely due to the intense lobbying by D&O of congress
iv. 145(f) (249) states that indemnification is not the exclusive benefit D&O are entitled to,
D&O are entitled to the corp taking out insurance.
1. D&O insurance provides way for the company to pay these legal fees. Of course,
every company has D&O insurance, and provides an upper bound on these settlement
amounts. SHs pay for the D&O insurance, effectively, out of the companys coffers.
v. Del Gen Corp Law S102(b)(7): Exculpation Clause: Permits corps to include a clause in their
charter eliminating personal liability for monetary damages [not injunctive damages] for
breaches of DoC but not for (1) breach of loyalty and (2) acts or omissions not in good faith
or (3) involved in knowing violations of the law
1. Passed by Del Congress in reaction to Smith v Van Gorkum where ct found D&O
were grossly negligent and thus personally liable for their carelessness in a mortgage
approval.
2. Enacting the Provision: New companies: include in original charter. Existing
companies: require SH approval to amend charter
3. Waiver for damages claims only, can still get an injunction in some cases
4. Rationale: protect D&O where no insurance exists, to limit monetary liability thereby
giving D&O greater freedom to take riskier bets, same rationale for protecting BJR.
D/n want to include DoL b/c do not want to make it OK for D&O to steal and not be
liable for personal damages against them.
5. Ps cannot shoehorn a DoC breach into a DoL breach McMillan v Intercargo (1) Ct
hold no breach of DoL where ct has exculpation clause and SHs cant sue under DoC
so they sue under DoL claim as a result of protracted auction period leading to lower
price for acquisition of comp BJR b/c 102(b)(7) in charter
vi. Prior to 102b(7) helping to define the meaning of good faith Cede & Co. v. Technicolor (259)
v. Facts: like Van Gorkum. Technicolor BoD quickly elected to sell itself to Ron Perelman
at a 100% premium. The CEO cheerleader for the deal; some argument that hes
interested in the tx, and BoD goes along w/ it. SHs sue for a breach of the duty of care.
vi. Del SC under Horsey says where SHs sue for breach of DoC where Tech BD exercised
gross negligence by very quickly elected to sell itself to Ron Perelman at a 100%
premium per stock that D must show entire fairness to afford itself protection under BJR
(3) rationale: if there were no liability ever D&O would have no incentive to satisfy their
DoC, need some level of deterrent effect here
vii. (4) the ultimate conclusion is it is impossible to satisfy DoC and DoL w/out having good
faith

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viii. So bottom line: showing gross negligence is enough, dont need to show injury or
causation like the DC said. D has burden to show

3 levels of behavior in DoL land for Director and Officer


1. Negligence: wont have any liability b/c you are entitled to BJR and to extent you must defend yourself the
BD can approve exculpation 102(b)(7) and will fall outside of liability
2. Gross Negligence: you will have liability b/c you will have breached DoC and you wont be entitled to BJR
but can show entire fairness to negate liability, to extent you must defend yourself the BD can approve
exculpation 102(b)(7) and you will fall outside of monetary liability but not injunctive (worst that will happen
is an injunction)
3. Bad Faith: an extreme form of gross negligence, not in DoL land as there is no conflict present, this means
you have abandoned your office and doing no good for anyone and causing lots of trouble to extend you must
defend yourself BDs approval of exculpation 102(b)(7) will do nothing and you are personally liable for
monetary and injunctive liability

VII. SIGNIFICANT TRANSACTIONS: STRUCTURAL CHANGES TO CORPS

I Transactions in Control (p413)

1. Overview of Control Transactions:


a. Two ways for SH to gain control: (1) purchasing a controlling block of shares from an existing
control SH (will pay premium over price for control) and (2) purchase numerous shares of smaller SH
b. Whenever control changes hands it will always do so at a premium, why? 2 explanations depending
on how one views the efficiency of markets.
1. Efficient Txs: If you believe mkt is efficient then one argues these txs increase the wealth
of entire society maximizing wealth and minimizing costs and raising SH prices.
1. Those who believe in this theory want to encourage such txs
2. Consequences of Agency Costs: If you believe mkt is not efficient, the buyer can take
advantage of the corp for himself which encourages waste and inefficient markets
1. Those who believe in this theory want to restrict such txs

2. Duties of Sellers: Sales of Control Blocks (416)


a. Regulation of Control Premia: Control blocks command a higher market price [control premia] than
non-controlling shares. Premium = additional value above the financial value of a share that comes
with controlling corporate business.
1. i.e. K has 10mil shares at $20. M wants to have majority and needs Ks shares so M might
pay $50+ (lets say)- the difference in price ($30) for control is the premium.
2. Control over corp is the ability to directly influence corporate decision making
3. Premia b/c (1) private benefits of control, salary, perks, prestige and (2) actually believe
you can run the corp more profitably and regain investment in future sale
4. Control blocks need not be 51% of a corps shares, ct interpret ctrl as practical matter so
total shares controlled may be very low if acquiring large stake is hard
a. Regulation of control premia Market Rule: Minority SHs are not entitled to share in the
premia of a control sale (w. three exceptions). Holder of control block may sell his shares at the

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highest price possible w/out including the minority b/c the sale of control is market trx that only
creates rights a duties btwn the parties privy to that tx.
1. Exceptions
a. Selling a corp. opportunity for personal benefit that belonged to corp. as
a whole
b. selling corp. office
c. Selling to a looter
2. Rationale: minority shares d/n have same attributes as ctrling shares [no private
benefits of control] so they d/n command the same share price. The premium
belongs to the controlling SH b/c its inherent in the control and not the stock
itself. i.e. sell for whatever you like.
5. Absent any of the three exceptions, market rule applies Zetlin v Hanson Holdings (416)
6. FACTS: HH and Sylvestri family own 44% of Gable Industries. HH sells to Flintkote Co.
at $15/share when trading price is $7.38/share to get control. wants to impose duty on
buyer to pay control premium to all SHs
7. Holding: a majority SH need not share the premium their control block commands
with minority SH.
8. rationale: ct is concerned that w/out the market rule that such txs would be severely limited
to tender offers.
9. We permit this rule b/c it rewards the majority for collecting a controlling block of the
shares; we must believe that in order to enforce a market rule, in the efficiency of the
market. The controlling SH will do better for the co. than any of the other SHs, if not then
we wouldnt allow the SH to take the company. Controlling purchaser wouldnt pay a
premium if he didnt think he would improve the company.
1. Alternative to mkt rule: is the Equal Opportunity Rule stating that minority SHs are
entitled to sell their shares to a buyer of ctrl on the same terms as seller of ctrl block.
Argue control should be viewed as a corporate asset in which SH should share. The
rationale for such a rule is simply fairness, nothing about mkt in play. (most reject
this rule)
a. Criticisms of Equal Opportunity: (Easterbrook and Fischel): Ppl d/n buy ctrl
blocks for private benefits of control as they are too limited but b/c they want
to (1) improve corp or (2) loot corp and limiting sales such as these hurt
minority, looting is easily hindered by regulations so we should not be
limiting such txs b/c they limit ways efficient mgmt can take over corp.
could also leave inefficient management intrenched in companies, dilute
value of control held, efficient management is likely preferred by SH.
b. Exceptions to the Market Rule: where cts will step in and say ctrlling SH cant just sell stock to
highest bidder w/out paying attention to minority to protect minority
ii. Controlling SH cannot sell their control block when any of three exceptions:
iii. (1) youre selling some type of collective or corporate opportunity for your benefit or
iv. (2) sales of corporate offices (i.e. your position as CEO in the company) or
v. (3) looting selling to ppl who effectively destroy value
1. Sale of Collective Opportunity
1. Cts will not permit a controlling SH to exclusively enjoy ctrl premia where there is
collective corporate opportunity associated w/ the sale of the ctrl block, under such
circumstances minority must be included under equal opportunity rule Perelman v
Feldmann (417)
2. FACTS: Feldman, who controlled 37% of Newport Steel, sold his shares for
$20/share, a two thirds premium over the market price of $12. A minority SH
brought a derivative suit claiming F had sold a corporate asset, namely Newport steel
supplies during the Korean Wars steel shortage, when steel prices were controlled

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and access to steel commanded a premium. F had invented a way to skirt the price
controls by having buyers make interest free advances to obtain supply commitments
(Feldman Plan). The buyer wanted Newports steel supplies free of Fs plan.
i. Holding: premium reflects took corporate asset (opportunity) for personal
gain rather than for the good of the corp. SO he breached his fiduciary duties
and must account to minority SHs for the premium he gained
BUT corp. wasnt really hurt value of shares went up after the sale
BUT this isnt what the ct looks at
3. Liable. Court says F took a corporate opportunity that belonged to corp
4. Rationale: Violates fiduciary relationship [punctilio of honor] of ctrlling SH to
minority SHs [Easterbrook and Fischel do not agree- let the market drive these tx]
2. Sale of Office (428): occurs where mgmt sells small amt of stock and premium and agrees
to resign in favor of the buyers BD appointees at the conclusion of the sale, thus paying
premium for ctrl of office
1. Cts treat board succession promises as prohibited sale of office (seems like bribery) if
the challenger shows either:
a. The buyer did not acquire working control and therefore could not have
elected his own slate
i. If its a controlling block they can put in who they want as BOD
b. OR the sales price exceeds the premium the control block alone commands,
suggesting the price included a prohibited sale of office
2. Rationale: Against public policy, when new officers come in, you hope theyre there
to improve the corp, but if there for own selfish reasons, not going that
3. Note: where sale is in gray area of being corporate office and a change in mgmt
follows court will not always reject the transaction.
4. Examples: Carter v. Muscat and Brecher v. Gregg
a. Carter: Bd appointed a new slate of Ds as part of a tx in which the corps
management sold a 9.7 block of its stock to a new controlling person at a
price slightly above market. Despite a SH challenge, the crt upheld the
reelection of the new directors at the annual SH meeting. Crt holds: OK
here- sold for only a slightly above market premium and SH consented.
b. Brecher: CEO of a public company received a 35% control premium on the
sale of his 4% block of stock in exchange for his promise to secure the
appointment of the buyers candidates the corps new CEO and the election of
two of the buyers candidates to the Bd. CEO temporarily delivered his
promise but the corp board son reveled and fired the buyers CEO. Here,
Stockholder of corp successfully sued CEO and forced him to disgorge the
premium to the corporation. Crt said: paying a premium for control while
purchasing on 4% of stock is contrary to public policy and illegal b/c clear
that position was being sold selfishly and not for benefit of corp
3. Sales to Looters (429): looter = someone who will extract thru control position private
benefits or ctrl sufficient block to control entire corp and effectively will destroy value of
corp. A controlling SH may not sell control if the seller has reason to suspect the buyer will
use control to loot the corp and the SH left behind. If the control seller has reason to
suspect the buyer will steal corporate assets or engage unfair self dealing tx, the seller
becomes liable for any damages caused by the buyer including any damage to the corps
earnings power. Corporate recovery is not limited the control premium the seller received.
1. If circumstances would alert the reasonably prudent seller of a ctrol block to be
suspicious of buyers honesty there is a duty on such a seller to make (1) a reasonable
investigation and (2) exercise reasonable care Harris v Carter (429)

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2. FACTS: s claim that selling control to looters gives CSH duty to those who are
harmed as a result there is evidence Carter didnt know looting was going to
happen BUT there were things that should have tipped him off.
3. Holding: a majority SH may be liable if he negligently sells control and such sale
damages the corp
4. (1) Ct holds Carter liable and states he had duty to properly screen where Carter sells
his 52% stake in Atlas to Mascolos who give Carter worthless shares, thus the tx
loots the company and ct holds (2) Enough red flags existed that Carter should have
known to investigate, financial statements, shady character
5. Rationale: Fiduciary duty of care and tx costs majority SHs are in better position to
investigate than minority SHs. ( i.e. Caremark- red flats) such regulation is
efficient b/c only occurs when there are sufficient red flags and (2) they prohibit tx
that should not occur
6. Note: D/n place liability on looters b/c (1) no reasonable expectation of finding such
looters or if you do find them hard to recover from them (2) prophylactic, want to
create preventative rule

3. Duty of the Buyers: Buying Control Blocks (433)


a. Ways of purchasing control blocks
1. Negotiated Transaction: Rare, negotiate ctrlling SH to purchase controlling block
2. Tender Offer: Common, Offer of cash or securities to SHs of public corporation in
exchange for their shares at a premium over market price the function of which is to gain a
ctrl block of a publicly held company that lacks a controlling SH. Open to all SHs.
Premium is analogized to the control premium paid to a controlling SH
b. Williams Act of 1967: Intended to curb abuse of tender offers, where SHs were under high pressure
to accept immediately, by equalizing positions of the offeror and SHs involved in tx. Sought to
provide SHs sufficient time and information to make an informed decision about tendering their
shares and to warn the market about an impending offer. Also gives equal opportunities to SH
Regulation of Tender Offers:
1. Early Warning System S13(d): any person or group that acquires beneficial ownership
of more than 5% of a public corporations equity securities must file a disclosure
document with the SEC. The disclosure alerts the stock market and management of a
possible change in control. Must be filed within 10 days after 5% threshold is passed.
Institutional investors have 45 days of years end and a shorted report under 13g. 13d and
13g reports annually or upon acquiring 10+% of an issuers shares.
1. Must disclose: acquirers identity/background, source and amount of funds for
making purchases, number of the targets shares held by the acquirer, any
arrangement that the acquirer has with others concerning shares of the target and the
acquirers purposes for the acquisition and his intentions w. respect to the target.
2. Implication: SHs may sue for injunction if acquirer fails to make 13(d) filing
3. Rationale: (1) signals mgmt and other possible purchasers to think that maybe the
corp is ripe for takeover attempt (2) reallocates money from acquirer to target SHs
by notifying SHs of possible tender, so they dont sell prematurely
2. Disclosure Requirements S14(d)(1): Upon launch of the tender offer, to purchaser corp
purchaser must disclose identity, plans, and financing for the corp.
1. Rule 14d-3: must keep reports current
2. Rule 14e-2 requires targets board to comment on tender offer
3. Rule 13e-4 companies must make similar disclosure as 3rd parties do
4. Rule 13e-3 mandates disclosure when insiders plan on going private
5. Implication: Upon disclosure the target BD must recommend to SHs whether SHs
should accept or reject the tx, or state they cant reach conclusion

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6. Rationale: goal of having as informed SHs as possible when deciding to sell
3. Anti-Fraud Provisions S14(e): Prohibits misrepresentation, nondisclosures, or any
fraudulent, deceptive, or misrepresentative practices in connection w tender offer. Bars
trading on inside information in connection with a tender offer.
1. Implication: (1) SHs have a private right of action to enforce this section (2) this rule
reaches beyond 10(b)(5) b/c under that you need to be SH during entire duration here
you need to only have held during period of tender or have proven you would have
purchased in tender but d/n b/c of fraud
2. Rationale: unproductive and inefficient to allow trades based on fraud
4. Substantive Regulation S14(d): a dozen rules that regulate the substantive terms of tender
offers including matters such as how long offers must be open, how bidders treat SH, etc.
Bidder must file document the day it commences the TO. (includes same info as 13D plus
extra)
1. (14e-1) Offer must be held open for 20 days (was originally 7 days but SEC extended
it)
2. (14d-10a2) Best Price Rule: have to pay same best price for all SHs that tender into
offer. If consideration alternatives are provided, each SH can choose.
3. (14d-6) Pro-Rata Requirement: when the bidder seeks only a portion of all the shares,
and SH tender more than the bidder seeks, the bidder must purchase the tendered
shares on a pro rata basis. Ex: bidders seeks 50% of targets stock and 75% is
tendered, bidder must purchase 2/3 of each SH tendered shares then return
unpurchased stock b/c (50/75) is 2/3.
4. (14d-10a1) all holders: tender offer must be open to all SH of the same class and not
exclude any from tendering.
5. (14d-7) withdrawal rights: SH can withdraw their shares at any time while the offer is
still open.
6. Implications: (1) allows time for mgmt to respond under disclosure requirements (2)
encourages auctions by allowing time for other potential acquirers to place
competitive bids above current tender offer, thus this windows result is only the
potential of hurting the offeror
i. Auctions: Pro: (a) make sure assets go to highest valuing user (b) target SH
receives highest possible returns on their share (c) dont want there to be too
many tender offers they are costs Con (a) bid up the price (b) if 1st wins he
will pay more (c) if loses wasted costs

II. Mergers and Acquisitions (443)

1. Essential Elements of Merger and Acquisition Transactions


a. Rationale for M&A
i. Increase Efficiency: increase efficiency by creating synergies that meets demands at a lower
costs. (1) Economies of scale: spreading fixed costs over a wider group of assets (2)
Economies of scope: being able to spread costs across a broader range of related bsns. Ex:
busn might merge with another company that manf a product and the other one has a very
efficient marketing dept = talent of companys management could be a source of economies
of scope if a merger could extend its talents to a larger base. (3) Vertical integration of corps
increases efficiency. Ex: cheaper to merge with a supplier than to by the product
1. Redistribute Gains (Wealth): (1) We support efficiency enhancing txs but if taxes redistribute
wealth we are indifferent as tx is not our concern, we are concerned w/ greed. Tax Benefits: Tax
benefits for carrying net operating loss (NOL) corp that lacks sufficient income to overcome
NOL, SO if they merge with high income co, they can match NOL and realize benefits

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2. Lower Agency Costs: get rid of mgmt that is not performing well realize benefits of this b/c 3rd
parties more willing to pay premium for majority of voting power
a. This is a motivation for hostile takeovers
b. Friendly mergers use compensation to get s to leave
ii. Diversification: can diversify companys business portfolio and projects to increase
corporate earnings.
b. Value Destroying Reasons for Merger
i. Opportunistic M&A transactions i.e. Squeeze-out merger: controlling SH acquires all of a
cos assets at a low price, at the expense of minority SHs
ii. Mistaken Mergers: occur when planners misjudge the difficulties of realizing merger
economies (i.e. underestimating costs of overcoming disparate firm cultures, neglecting
intangible costs, etc)
iii. Wanting to expand empire: cos almost always perform a little worse after merger (target
does better) this may be a bad reason to merge mergers generally dont justify the
premium paid over the market price for the assets acquired
c. Modern era: (1) corp statues permit mergers if recommended by the Bd and approved by a majority of
SH. If BoD refuses to approve merger, there can be no friendly deal, result is a hostile tender offer to
the SHs which effectively turns the sale into a vote. Only need 51% majority. (2) SH right to dissent
from a merger and demand an appraisal right. (3) new forms of consideration arose beyond securities,
most notably cash.
d. Allocation of Power in fundamental tx- when SH vote:
i. SH given power to approve any changes in the charter (dissolution, amendments)
ii. SH given vote in a sale of all or substantially all corporations assets even though no
change in charter occurs
iii. SH vote on merger
iv. Policy rationale: (1) who has the best information: depends, sometimes managers but
managers have incentive issues so SH will usually wish to decide most only very large issues
and will decide only issues that they can expect to decide with competence (investment like
decisions rather than bus judgment decisions). Operational decisions are not usually for SH
b/c of this. and (2) who has the best incentives.
1. Differs from state to state: mergers, for ex, require SH vote on target and acquiring
companys part except the acquiring companys SH do not vote when the acquiring
company is much larger (DGCL 251(b)).
2. Sales of substantially all assets require a vote by targets SH (DCGL 271) but
purchases of assets do not require them to do so.

2. 3 WAYS TO MERGE (Asset Acquisition, Stock Acquisition, statutory merger) (452)


a. Asset Acquisition: A could buy all of Bs assets
i. Structure
A= 1. A would issue stock/cash in exchange for Ts assets
acquiring 2. T becomes shell holding co. usu. Dissolve after paying liabilities and Ts assets
corp. (stock or cash paid by A) will be distributed pro rata to SHs
T = Target 3. can be very expensive and time consuming
corp ii. Statutory Protections
1. SHs of A DO NOT have to vote on this considered a business decision
2. Majority SH approval necessary for T if there is de facto merger (T is selling all or
substantially all of its property/assets (DGCL 271))
3. What is substantially all?
a. When deciding what substantially all means cts may interpret this for
fairness purposes and if suspicious, ct may apply much lower standard Katz v
Bregman

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b. Facts: (CEO) wants to sell subsidiary (worth 51% of assets and 45% of
income) to a co. at a lower price than another co. is offering SHs want to
enjoin sale b/c substantially all assets are being sold w/o SH approval and the
assets are a very profitable part of the co.
c. Holding: SH vote necessary when selling all or substantially all assets
d. (1) Ct classifies 51% of all corps assets at 45% of all corps revenues
substantially all of Targets assets thus issuing an injunction for merger b/c
of fairness, as CEO was inherently suspect where he accepted lower bidder
for the sale of such assets.
e. Test from Thorpe v. CERBCO: the need for SH approval is to be measured
not by the size of the sale alone, but also on the qualitative effect upon the
corporation. Thus, it is relevant to ask whether a tx is out of the ordinary
course and substantially affects the existence and purpose of the corporation.
b. Stock Acquisition: A could (1) buy controlling block of T assets (from itself, some, or all of T SHs)
OR (2) Do tender offer to acquire controlling interest
i. Structure
1. Buying Controlling Blocks
a. A would pay stock/cash in exchange for shares
b. T would become subsidiary of A, though T would be unaffected by
transaction
c. Tax treatment of a TO w.out one
2. Tender Offer(with subsequent freeze-out (TRANSACTION IN WHICH THOSE IN CONTROL
OF CORP. ELIMINATE THE EQUITY OWNERSHIP OF NON-CONTROLLING SHS) of remaining
T SHs)
a. Structure: A makes cash tender offer once it has control, it can freeze out
NOTE: when residuals get remaining SHs for cash old owners of T have cash, A and its SHs own T
cashed out at a higher i. regulated by Williams Act
price, the time value of ii. 2 step acquisition first step is conditioned on getting majority of
money may motivate an
shares and then you want to eliminate the remaining minority SH so
earlier sale regardless of
the larger payout 2nd step is cash out merger for residuals or it can sometimes be
accomplished through a triangular merger
iii. No SH vote required
iv. Not a lot of price regulation (i.e. Hanson Holdings)
b. Problem: if you merge with tender offer, there is possibly going to be a
residual minority of publicly traded shares
i. Fiduciary duty then owed to public SHs more likely to sue b/c
controlling SHs always negotiating with themselves in a way, which
is self-dealing
ii. Publicly traded shares subject to federal regulation, whereas
privately owned companies are not
c. NOTE: Under Williams Act it has to be open for 20 days at least
NOTE: tender offers usu. i. May put in merger agreement that going beyond a certain tender
Conditional on getting the
period requires consent of BOD if they are not getting the
required % of shares
Williams Act allows required amt. of tenders it may be evidence that the deal is bad for
minimum requirement SHs SO BOD would want tender offer to close OR if market
BUT NOT maximum circumstances change it is good to have a time limit
requirement of shares ii. Also, may require BOD consent so if the merger isnt gonna happen,
the BOD can get back to their jobs
d. Williams Act does not allow different prices depending on when they tender
AND does not allow a maximum % - tender offer must be open to all

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c. Statutory Merger: a legal event that unites two existing corporations with a public filing of a
certificate of merger, usually with SH approval 2 entities become 1
i. Traditional Structure
1. A absorbs T A called a surviving corporation
2. A would pay shares or cash to T SHs
3. After merger, both A and T SHs own surviving company
ii. Statutory Protection
1. DCGL 251(c): requires a majority vote by the outstanding stock of each constituent
corp. entitled to vote (absolute majority)
a. Default Rule DGCL 212(a): all classes of stock vote on a merger unless
the certificate of incorporation expressly states otherwise
b. NOTE DGCL 251 does NOT protect preferred stock with the right to class
vote in most circumstances UNLESS their formal (NOT economic) rts are
adversely affected by charter (DGCL 242(b)(2))
2. Voting common stock of T always has voting rts common stock of the surviving
corp. (A) as well as that of the collapsed corp. (T) is generally required to vote on a
merger
a. Exception when 3 conditions are met
DGCL 251(f); i. The surviving corp.s charter is not modified
RMBCA 12.03 ii. The security held be the surviving corp.s SHs will not be exchanged
or modified
iii. AND the surviving corp.s outstanding common stock will not be
increased by more than 20%
b. Rationale: mergers satisfying these requirements have too little impact on the
surviving corp.s SHs to justify the delay and expense of SH vote
3. Generally: merger always requires approval of the Bd
4. After Bd initializes, SH meeting called
5. Following a SH vote, merger is effectuated by filing a certificate of a merger w a
state office. Surviving corp may be restructured through adoption of an amended
charter and bylaws which have approved by SH majority vote. Dissenters have
appraisal rights if they have voting rights on a merger.
6. Tort liability, hard to find particular actors if there is a merger. Also, losing ownership
in the target company, but you end up w/ cash or owning stock in the acquirer you
suddenly dont have ownership in the company if you wish to bring a derivative suit.
iii. Triangular Mergers: a good way to preserve liability (tort and debt) shield in merger
Parent corp.
1. Structure
Acquiring a. Merge T into wholly owned subsidiary of the A (Forward triangular Merger
Target
Corp. (new A survives) OR merge subsidiary into target (reverse triangular merger T
Corp
subsidiary)
survives)
2. In this structure, creditors CAN go after Target BUT NOT Parent corp.
3. Ex: Acquirer (A) forms wholly owned subsidiary(S). A transfers the merger
consideration to S in exchange for all of Ss stock. Then Target (T) will merge into S
the merger consideration will be distributed to T SH and their T stock will be
canceled. Stock of A in T will also be canceled. Thus, after the merger, A will own
all outstanding stock of S which will in turn own all of Ts assets and liabilities. If S
is surviving, the merger is called forward triangular and if T is surviving, reverse
triangular merger.
d. Different Structures of Mergers At the effective time when lawyer files merger certificate with
Secretary of State the Target is merged into the acquiring company [or Acquirer Sub is merged into
Target] and Target SHs stock automatically converts into right to receive consideration stipulated to
by the merger (cash or securities). This occurs by operation at law, magically at the effective date.

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Target or Subsid disappears, only leaving Surviving Corp. Tax liabilities govern how you combine the
businesses.
i. Forward Subsidiary Merger [T merges into Acquisition Subsidiary]
1. Transaction: at the effective time Target is merged into an Acquisition Subsidiary
[a shell company] and the SHs stock in Target automatically converts into right to
receive consideration stipulated to by the merger
2. Result: Target completely disappears into Acquisition Subsidiary, which is Surviving
Corp, becoming subsidiary of Acquirer.
ii. Backward Subsidiary Merger [Acquisition Subsidiary merges into Target]
1. Transaction: at the effective time Acquisition Subsidiary [shell company] is
merged into Target whose SHs stock automatically converts into the right to receive
consideration sipulated by the merger, either cash or securities
2. Result: Acquisition Subsidiary completely disappears into Target, which is Surviving
Corp, becoming subsidiary of Acquirer
iii. Liability: (1) If after merger Target defaults on loan that was taken out pre-merger, Cs can
only go after Target and not Acquirer (2) In a forward subsidiary merger, when SHs lose
ownership in Target they d/n have standing reqt to bring derivative suit
iv. Short Form Merger (DGCL 253): if corp. owns 90% of subsidiary it can do a cash out
merger parent will decide how much to pay minority SHs of Target
1. Advantage
a. You dont need vote of T SHs
2. Disadvantage
a. 10% minority gets appraisal rights (DGCL 262) ct will say whether
parent has given fair consideration and if they have not, corp. must give SHs
more
e. SH Voting: (1) BD approves [if d/n approve possible tender] (2) SHs approve by >51%
i. Procedure of SH Voting:
1. Del Gen Corp Law S251: Majority, at least 51% must approve all mergers
2. Del Gen Corp Law S271: SHs are reqd to vote to approve sale of assets if such a sale
is of all or substantially all of the corps assets [~80% but no set #]
ii. Rationale for SH Voting
1. Transformation of Investment and Relationship: During this process, such control txs
fundamentally change the relationship btwn Ss and BD: (1) The nature of the
investment can change as bsns may change product (2) Relationships w/ mgmt
changes as they have new incentives that no longer align with SHs as mgmt are now
concerned will the future of their jobs and security
2. Common Skills: These txs arent that hard to evaluate, we are asking SHs to make
investment decisions not bsns decisions.
3. Severe Agency Problems: D&O know they will be replaced and they want to protect
their jobs, which may impact their decisions throughout the tx, and tend to choose
those mergers where they will likely keep their jobs
f. Regulating Mergers and Acquisitions
i. If you think M&A are efficient: want no regulation as possible in statute or judicial review.
ii. If you think M&A are inefficient: want regulation if you see such txs as centering around
mgmt protecting their inherent interests [trying to keep their jobs]
3. STRUCTURING THE M&A TRANSACTION
a. Timing
i. Speed almost always desirable time value is real
ii. Some delays are imposed as a matter of law (i.e. Williams Act)
iii. In order to get things done quickly, try to limit SH votes
1. All cash multi-step acquisition usu. Fastest

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2. Using stock requires getting SEC involved
3. All cash tender offer triggers Williams Act
b. Regulatory Approvals, Consents, and Title transfers
i. Often sell specific assets to avoid anti-trust problems when 2 competitors merge antitrust
problems can halt the merger
ii. Reverse triangular mergers are the cheapest and easiest method of transfer b/c they leave both
preexisting operating corporations in tact
iii. Those merging will try to minimize cost of obtaining regulatory approvals or consents in K
needed to close transactions
c. Planning Around Voting and Appraisal Rights will try to minimize voting requirements and
appraisal rights
i. Particularly wary of structures that trigger class votes for preferred SHs b/c they can extract
holdup payment in exchange for allowing the deal to proceed
d. Due Diligence, Representations and Warranties, Covenants and Indemnification tools for
controlling risk
i. Representations of warranties that the Target reports = less important and harder to enforce
1. Problem = for breach of K you should be able to go after T (old SHs) BUT if its a
stock for stock merger you would be suing your own SHs this is bad for publicity,
value of co, etc
2. SO once T goes away, usu. Stuck with whats left
ii. Covenants not to destroy value of corp. during merger
iii. Fiduciary Duties arise with control premiums
e. Deal protections and termination fees (i.e. Van Gorkum, Unocal, Revlon, Moran)
f. Accounting Treatment
i. Taxation: gains or losses affect tax treatment of a merger, tax also reorganizes ownership
interest without fundamentally changing the identity of the owner, IRC has safe harbors for
tax free reorganization (there is no recognition of gain by sellers except to the extent they
receive permissible consideration other than stock of A)

4. THE APPRAISAL REMEDY: Challenges to Mergers and Acquisitions (474):


a. Appraisal Rights Del Gen Corp Law S262 right for SH who dissent from a merger. exercise such
rights when as a SH you know BD has not done anything wrong but believe that the stock is very
undervalued in deal. [note: DE mandates appraisal only in connection with corporate mergers, i.e.
DGCL 262]
a. Only goes to those that didnt vote on the merger
b. Market out rule: if shares can be traded publically, one cannot get appraisal
claiming an unfair price b/c could have sold shares on the market
c. NOTE: the appraisal rts only come into play if youre being cashed out and
your stock isnt liquid i.e. when your investment is taken away from you
ii. Pre-Requisites for Appraisal Rights, must:
1. a Continuously Hold shares from announcement to completion of merger and
2. a Vote against the merger and
3. d File written request w/in 20 days prior to effective merger date and
4. e Exercise appraisal rights w/in 120 days of merger
iii. Process for Appraisal Rights
1. Do above things
2. Must show that price was unfair
3. Court determines fair value of shares with interest
4. Dissenting SHs who claiming appraisal rights bear all costs for proceeding
5. Proceeding only reimburses individual SH who brings action
iv. General:

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1. Rarely invoked in arms length tx (remedy is costly and if arms length, likely to
achieve something close to mrkt price likely not worth it in arms length tx where
consideration is cash or pub. traded securities)
b. Transactions that Trigger Appraisal Rights
i. Merger, Consolidation or Compulsory Share Exchange
1. Generally SHs of T have appraisal rts but SHs of A do not
2. Short Form Merger SHs squeezed out have appraisal rts even if they dont vote
(DGCL 262(b))
ii. Sale of Assets
1. DGCL 262(c): SHs have no appraisal rts in sale of assets unless provided in the
corp. charter
iii. Charter Amendment
1. DGCL 262(c): Permits but does not require an appraisal remedy when the corp.s
charter is amended or when substantially all assets are sold
iv. Limitation of Appraisal Rights: Market Out Rule Del Gen Corp Law S262(b)
1. No appraisal rights if have a market out
2. Target restores appraisal remedy if SH receive consideration anything other than:
a. Receive stock in surviving corp as consideration for merger [eliminating
appraisal right in stock deals] or
b. Have 2000+ SH or
c. Hold stock in any other comp traded on public exchange or
d. Cash in lieu of fractional shares or
e. A combo of those
3. Ex: SH in privately traded firm w fewer than 2000 SH will always have appraisal
rights in a merger if theyre required to vote on it
4. Rationale: limit appraisal rights to such SHs b/c such SHs can sell shares and obtain
fair market value for them, thus they need not appraisal rights remedy
v. Different Valuation of Shares: 262 entitled to fair value of shares on day of vote w/out taking
into account benefits from merger, though some cts are taking into acct
1. Majority: Discounted Cash Flow: Relies on discounting future cash flows back to net
present value. (DE employed this after Weinberger)
a. Pro: relevant to financial markets
b. Con: b/c expert testimony is needed there are disagreements about
underlying factors that lead to different valuations for what the NPV is for
the appraisal
2. Traditional Delaware Block Method: Court takes weighted average of (1) Assets
from balance sheet (approx 10% value- give low weight because assets rise during
years and the balance sheet can be outdated) (2) Earnings Value from income
statement (apprx 45%- easier and more accurate to calculate, but not 100%
accountable) and (3) Market Value from the market (approx 45% or sometimes more)
a. Pro: Easy to use and set numbers, information contained in all merger docs
b. Con: No correlation to financial markets
3. Del ct rejects the Block Method and adopts Discounted cash flow method but many
jurisdictions still employ it
c. De Facto Mergers: (form v. substance debate) (479)
i. De Facto Merger Doctrine: (substance) if tx is substantively and effectively a merger then the
rights associated with a merger are triggered
ii. Role of Equal Dignity Rule: (form) A merger and an acquisition tx each has its own
formalities and rights and courts give each equal dignity [DE i.e. no appraisal rts if not an
actual merger]

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1. Effect: (1) If tx is structured and identified as merger cts will treat as such (2) if tx is
structured and identified as an asset deal then cts will treat as such
2. Rationale: Formalistic reqs exist so that individuals can predict the legal
consequences of their actions. If ppl chose to structure a tx a certain way and comply
with its formal req then ct will not surprise them with liability
3. Delaware adopts the equal dignity rule (govern merger or asset sale as what it is!)
Hariton v Arco Electronics
4. FACTS: Arco sells all assets to Loral. Loral buys all the assets and liabilities, for
283,000 shares. Loral transfers to Arco a bunch of stock at 3:1 ratio. Arco dissolves
itself, and distributes the Loral shares to its SHs. This looks like a merger! If Arco
had merged into Loral, the same result would happen.
5. Holding: a corporation may sell its assets to another corporation even if the
result is the same as a merger without following the statutory merger
requirements
6. (1) Court rejects former Arco SH de facto merger argument by applying equal dignity
rule saying that tx is an asset deal b/c it lacks all formalities of a merger and thus no
appraisal rights implied where all this is true even though looks like merger b/c Arco
gives all assets to Loral who gives stock in exchange and Arco dissolves itself
distributing Loral shares to its SHs
7. Why do SH want appraisal rights: lose standing to file derivative suit and allege a
breach of duty without them
8. Crt thinks theres a reason why statutes are laid out a certain way and we should
respect them. Also, appraisal proceedings are expensive, delay a tx, devalue assets
b/c of litigation expenses, etc
9. If want to avoid appraisal: make sure consideration is liquid or asset transfer
d. Unfair Treatment of Minority Shareholders: Cash-Out Mergers or Freeze-Outs
i. General: controlling SH owe fiduciary duty of loyalty to corporation and minority SH, yet all
SH have the right to vote their shares in their own best interest- creates a conflict
ii. Freeze-out or Cash-out Merger - Co decides to get rid of its minority shareholders.
1. Ex: Parent-subsidiary merger: Every time the parent company wants to take action, it
has to have a shareholder vote even though it controls the majority stake and will
always win. Eventually, maj will get rid of shareholders and purchase shares for cash
to avoid the pointless expenses of proxy votes.
2. Minority shareholders can challenge this on the basis that the whole transaction is
unfair.
3. Freeze outs are almost always done in cash, so shareholders wont get any
appreciation.
4. A.A. Sommer: concerned minority is just getting squeezed out by majority so then
they wont reinvest in the market because theyre scared theyll be the subject of one
of these freeze outs
iii. 2. Short-Form Merger - Under DE law, if the parent owns 90% of the subsidiary, all it has
to do is say, Were buying you out at $x per share.
1. If the parent owns less than 90% but more than 50%, it has to hold a vote even
though itll clearly win.
3. Reasons for Permitting Freeze-Outs and Short-Form Mergers
a. Pros: Lowers costs, allows the co to get into new markets more quickly, eliminate future
expenses related to shareholders, keeps information private (no disclosure).
b. Cons: Squeezes out minority for less than they deserve. Raises duty of loyalty concerns.
c. As long as minority gets a fair price and appraisal rights, theres no reason not to allow them.
They could increase the corps value.

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d. Disclosure rules SEC adopted rule 13e-3 of the Williams Act specifically to require uniquely
extensive disclosure in going-private transactions.
4. Entire Fairness is standard for Freeze-Outs Weinberger v. UOP (DE 1983) (486)
Facts: Signal owned 51% of subsidiary, UOP. Signal decides to cash out remaining shareholders
by freeze-out. Report says up to $24 a share is good investment for Signal. Signal offers $21 a
share. CEO of UOP doesnt negotiate, just passes info along bc Signal controls his job. Lehman
says price is fair but bases its conclusion on Signals studies. Majority shareholders approve. Ps
claim breach duty b/c they werent told of price Signal was willing to pay in cash tx and files a
class action.
3. Holding:
a. (1) Elements of future value known or susceptible of proof as of the date of the merger
and not the product of speculation may be considered in the appraisal valuation
i. ct expands appraisal right before not allowed to look at value created by merger
and NOTE they say you must look at value created by merger
NOTE: if there was no ii. This rejected the old DE Bloc Method now use discounted cash flow method
breach of duty of Discounted Cash Flow (used by investment community): looks at value of
loyalty there would companies using anticipated future cash stream and then after making
still be an appraisal assumption about risk-free interest rates and corp. risk figures out how
right SO ct creates
much present cash would produce that future stream
expanded right here
get shares + any explicit incorporation of projection data (earning trends, future
speculative value prospects, etc
today this is the most common technique employed
NOTE: this appraisal remedy is understood as a protection against self-
dealing this in a sense refashions DGCL 262(h) from the idea of
appraisals reflecting value of corp before merger
b. (2) Need informed majority vote OR a special committee that can bargain at arms length
in order to comply with fiduciary duty of loyalty
i. directors were on both sides of merger SO they owed entire fairness (fair
dealing and fair price)
(1) fair process- which imposes a duty on the corporations to completely
disclose to the SHs all information germane to the merger and (2) fair
price- which requires that the price being offered for the outstanding
stock be equivalent to a price determined by an appraisal where all
relevant non-speculative factors were considered.
ii. when fiduciary duty is breached, you have to give up value created and give it
back to minority SHs (here there were recissory damages)
v. FN7: mandates use of special negotiating committees to create a sense of independent
in negotiating
b. What Subsidiary Boards Should Do in Approving Freeze-Out (UOP):
i. Bargaining: Forming special committee of indep directors (not EEs of either Signal or
UOP) and have them negotiate
ii. Advice: Indep committee has meaningful advice (I-bankers, lawyers)
iii. Showing the above shifts Burden to Ps to show transaction was not fair
c. Consequences of Weinberger
i. Now there is always an indep committee with indep advisors in a merger
ii. Courts now say you can bring class action for breach of fiduciary duty AND an
appraisal proceeding at the same time
(a) In case you cant show breach, you have appraisal proceeding.
Notes On Weinberger, Rabkin, and Technicolor: On The Blurring Of Analytical Categories
a. Weinbergers attempt to establish the new appraisal as the exclusive remedy for shareholder
complaints about merger consideration was short lived:

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B. i. Rabkin v. Phillip A. Hunt Chemical Corp. here, majority SH told minority hed pay them X price and
then waited more than the allotted time and paid them less. He said under Weinberger they can only
seek appraisal remedy for duty of loyalty claim If there is a breach of duty of loyalty, SHs are still
permitted to seek appraisal rt appraisal rt does NOT replace duty of loyalty
1. NOTE: in self-dealing mergers, entire fairness actions rather than appraisals have been the
principal means of attacking the fairness of price
i. Cede v. Technicolor (Del 1996) arose out of a 2-step, arms length cash merger.
Technicolor board negotiated a cash price that represented about a 100% premium. The
1st step tender offer was fully subscribed. The 2nd step merger was accomplished a few
mos after the tender offer closed. A substantial minority shareholder dissented from the
merger and brought an appraisal action. As the action progressed, the shareholder
uncovered evidence of board misbehavior and brought a 2 nd suit charging multiple
breaches of fiduciary duties by Technicolor directors and Mr. Perelman.
(a) Issue: whether Mr. Perelman owed a fiduciary duty to pay a fair price to the
minority shareholders in the 2nd step merger.
(b) Holding: DE SC held that Perelman, as a controlling shareholder, had a
burden to establish that the price paid to minority shareholders was fair.
(c) Result: P could simultaneously pursue both his appraisal action and his claim
for breach of fiduciary duty and need not choose at any point prior to judgment
which remedy he would elect.
2. In general: SO when there is a claim that owed fiduciary duty to SHs (as in parent-
subsidiary merger OR 2 step merger) appraisal is NOT the exclusive remedy for complaints
concerning price
a. NOTE: if youre alleging breach you can try to block merger beforehand with
preliminary injunction
3. BUT where there is NO fiduciary duty owed (one-step cash/stock merger b/w firms with no
shared ownership interest a.k.a arms length transaction) complaints about price alone may be
relegated to appraisal remedy
4. NOTE: Breach claims brought more often than appraisal
a. Making out claim of breach = turbo statutory rt get appraisal + speculative value
b. Breach claim can be brought on behalf of all whereas appraisal can only be brought by
those who didnt vote in favor this affords counsel a means to get larger payout than
mere appraisal
c. Appraisal may not be available due to market-out provision (DGCL 262(b)(1), (2))
d. Breach claim and injunction request can be brought before merger which increases
settlement leverage (as opposed to appraisals where s bear their own litigation expense)

Control and Exercise of Control (497)


(ii) Kahn v. Lynch Communication (497)
NOTE: ct here is 1. Facts: Alcatel, a subsidiary, acquired 43% of Lynch stock in a SH vote. A later
recognizing implicit opposed Lynchs intention to acquire Telco and proposed that Lynch acquire
coercion minority Celawave instead, an indirect subsidiary of Alcatels parent co. after an independent
SHs fear retribution committee opposed that proposal, A offered to acquire the entire equity interest of L.
if they go against A offers were rejected by L as insufficient and A said they would proceed with
majority SH thats
unfriendly tender if not approved. Then it was approved. K, a minority SH, brought
why ind. Fairness. Is
appropriate
class action suit.
HERE. Committee (2) Holding: judicial standard of review in interested cash-out merger transaction by controlling or
didnt have real dominating SH is entire fairness (i.e. fair procedures, price, adequate disclosure, etc)
bargaining power ( A) If NO special committee was formed BURDEN IS ON THE TO SHOW ENTIRE FAIRNESS
b/c controlling SH (B) If special committee formed BURDEN ON CHALLENGING SH- TO SHOW LACK OF ENTIRE
had final say about FAIRNESS
tender offer

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(I) 2 factors required in order for independent committee to prove entire fairness
1. majority SH must not dictate terms of merger
2. special committee must have real bargaining power that it can exercise with the
majority SH at arms length basis
(II) Where independence of special committee is questionable THE CO. () HAS THE
BURDEN OF PROVING THE PRICE OFFERED IN THE FREEZE-OUT WAS FAIR
(3) NOTE: If this was NOT a transaction with controlling SH LEGAL BURDEN WOULD BE ON
COMPLAINING SH- AND WOULD CHANGE TO THE BJR STANDARD IF THERE WAS MAJORITY OF
MINORITY RATIFICATION OR ARMS LENGTH TRANSACTION WITH INDEPENDENT COMMITTEE OF
DIRECTORS
ii) Controlling SH fiduciary duty on first step of a two step tender offer (504)
(a) No federal law duty to pay fair price if skips board and TOs
(b) In TO, company already has control and is just purchasing more control by going straight to
SH
(c) In re Pure Resources Inc SH litigation (504)
(I) Facts: Unocal corps owned 65.4% of Pure Resources and wanted to take it private via an
exchange offer by which Unocal hoped to acquire the balance of Pures share in exchange
for its own stock. Minority SH believed the offer was inadequate and coercive and
therefore, subject to entire fairness review. They also contended that Unocal and Pures
Bds had not made an adequate and non misleading disclosure of material facts relating to
the Offer.
(ii) Holding: for a parent tender-offer to not be coercive, the offer must be (1) subject to
a majority of minority tender condition (2) include a promise to engage in a prompt
253 back-end merger at the same price as the tender offer if he obtains 90% of the
shares and (3) not involve retributive threats (4) give time to board to review the
price
1. Preliminary injunction was granted BUT could have been cured by disclosure of
committees statements
(III)NOTE: Ct is respecting form over function here ct recognizes heightened entire
fairness standard for mergers BUT there wasnt heightened protection for tender offers
here the ct provides that realizing that these 253 tender offers by controlling SHs are
structurally coercive when they can offer less money on the back end

III. Contests for Control


1. Overview of Control Contests (511)
A. Hostile Takeovers
1. Methods of Hostile Change of Control
(a) Proxy Contest running an insurgent slate of candidates for election to the board. Also
techniques to pursue a partial slate of Ds who will promote change through constructive
engagement
(b) Tender Offer purchasing enough stock to obtain voting control, costly technique
(c) Hybrid - proxy contest and tender offer merged into a single form of hostile takeover b/c
defensive tactics have made it difficult to pursue either avenue alone
(2) Threat of takeover encourages all mgrs to work to deliver shareholder value and maintain high
stock prices
(a) If you believe markets are efficient and that current market prices represent discounted value
of cos future cash flows and that cos strive to get Kaldor Hicks efficiency, then youd
support hostile takeovers
ii. Henry Manne advocates letting hostile takeovers happen, he relies on the market to
guide us. Sometimes a hostile takeover will unseat bad managers and increase efficiency
i. What does the BoD do when it is faced w/ an unwanted acquisition? Two extremes:

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1. Cts have said so long as there is no breach of fiduciary duty (duty of care &
loyalty), no fraud or illegality, the cts wont second-guess the BoD and officers;
they have protection of the BJR.
2. Txs involving some type of Q of loyalty, those transactions arent void/voidable,
they have to be sanitized (approval of ind. directors, SHs, or show entire fairness
of TX both by process and price).
ii. If theres a hostile bid, the BoD might have a strong interest in pressing back to protect
the SHs. This might benefit the SHs b/c hostile bidder can offer SHs more than the
current price, but well off the historic high. Under what standard should the courts
evaluate what is happening?
B. Defending Against Hostile Takeover Offers
(1) Duties of Sellers (Targets):
(2) Defensive measures must be reasonable in relation to the threat posed Unocal v. Mesa Petroleum
(Del. 1985)(515)
(a) Facts: Unocal stock trades at $33. Mesa (via Pickens a corp raider) purchases 13% of
Unocal. Makes all filings under 13d. Launches tender offer for remaining 37% for $54 a
share in cash. It will do a freeze out merger for the remaining shares for $54 a share, but that
will be mix of cash and bonds, particularly junk bonds - actual value of the junk bonds is $45
a share. Unocal gets an I-bank to value their stocks and they say $60 so dont want to accept
$54. And defensively responds with self-tender of $72 a share offer if Mesa hits 50%. No one
will tender into Mesa now. Then Unocal offers to buy 33% at $72 no matter what but
excludes Mesa. Mesa wants in
(i) Tender to pickens: If they tender into Pickens offer and he wins, it will be $54 (Williams
act- best price rule, i.e. all get best price and goes pro rata to all SH). If Pickens loses,
$33 pre bid price
(ii) Dont tender to pickens: If dont tender and pickens wins, youll get $45 which was the
assumed value of the junk bonds/cash situation. If pickens loses, $33 pre bid level goes
back
1. Holding: Board can engage in defensive measures to prevent takeover if they comply with
proportionality test requires that
a. (1) the BOD reasonably perceive the bidders action as a threat to corp. policy (threshold
dominant purpose inquiry into boards investigation)
i. this is met as long as the defensive measures are not coercive or preclusive from
the back end of the 2-step merger (i.e. not draconian)
b. (2) any defensive measure that BOD adopts must be reasonable in relation to threat posed
(proportionality test)
i. NOTE: business purpose broader than simply maximizing SH wealth (i.e.
constituency concerns for ees etc..)
2. NOTE: this is NOT a BJR case b/c there is a risk of entrenchment
(b) Court sees this as a situation where theyll take the $54 over the $33 at market price, BUT the
bankers estimated the value was actually $60, so its coercive bc youre still getting less than
you should.
(c) Rationale: Unocals response is reasonable in relation to the threat posed by Mesa.
Enhanced BJR
ii. Note: SEC thought a discriminatory self-tender was same as greenmail and
promulgated Rule 13e-4 which bars discriminatory self-tenders.
(a) Unocal standard is an intermediary b/n the two extremes the court previously adopted (almost
BJR standard)

C. The Poison Pill- shareholder rights plans (never triggered)

93
i) Poison Pill defensive maneuver to a hostile takeover. Bd can adopt poison pills without shareholder
approval. Takes the form of capital instruments: right to buy a capital asset, such as a bond, common
share, or preferred share. Only real function is to alter the allocation of power b/n SH and boards.
How it works:
(1) Rights to buy the cos stock at a discounted price are distributed to all shareholders.
(2) These rights are triggered only if someone acquires more than a certain %age of the cos stock
(say 15%) without first receiving the target boards blessing
(3) The person whose stock acquisition triggers the exercise of the rights is herself (or in the case of a
corp, itself) excluded from buying discounted stock
(4) Result: buying a substantial block of stock without the prior consent of the targets board will be
ruinously expensive, shares will be diluted and buyer will end up losing most of investment
2. Types of Poison Pills
* = might be illegal in CA; ** = illegal in DE but legal in MD and GA
a. Flip Over Pill gives target shareholders other than the bidder the right to buy shares of the
bidder at a substantially discounted price (50%)
i. Less effective than flip-in
b. Flip In Pills* - gives target shareholders other than the bidder the right to buy shares of the
target at a substantially discounted price (50%).
(1) Supposed to work b/c targets Bd can put terms in any merger agreement w/ acquirer that will
force the acquirer to recognize flip over rights
(2) Pill can be adopted in a matter of days or even hours
(3) Validating the Poison Pill Moran v. Household Intl, Inc (Del. 1985)(525)
a. Facts: HH Bd adopts poison pill which is triggered after announcement of a tender offer for
30% of HHs shares OR the acquisition of 20% of HH by a single entity. Also there is a flip-over
provision: right to purchase $200 of the common stock of the tender offerror for $100. Moran,
HHs largest shareholder, sues
(a) Holding: As long as it is related to a perceived threat, the defensive measures to a hostile
takeover are ok benefit of BJR extended to adoption of rights plan under corp. financing
structure
(b) Poison pill defenses are permitted under a literal reading of DGCL 157 and 151.
(a) s151g board is permitted to issue stock of its own accord as long as there
are sufficient authorized shares and as long as board is authorized to issue blank
check preferred stock (crt reads this super narrowly)
(b) s157 board is authorized to issue rights over its stock
ii. Court says when and if threat of takeover arises, then it will evaluate whether leaving
shareholder rights plan in place is reasonable in relation to the threat posed under
Unocal
1. After bidder bids, Bd will condition their bid on getting 51% of shares PLUS
redemption of the poison pill. Hostile bidder will sue if not removed. Bidder can
also try to start a proxy contest and try to get new Bd members that will retract the
pill
2. Bd has an ongoing fiduciary obligation to redeem the pill if it is no longer reasonable
in relation to the acquisition offer (i.e. when get into Revlon land)
b. Pros and Cons of Poison Pill
i. Pro: Need to protect mgts long-term plans
ii. Con: Mgts method to stay in power; share price goes down when you adopt the poison
pill bc it means someone is trying to take over co bc it is poorly managed.
II. CHOOSING A MERGER OR BUYOUT PARTNER
A. How does BOD pick Merger partner?
1. Mgmt. thinks merger will be good/improve business

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2. Mgmt. wants to secure jobs/retirement plans ct fears mgmt will pick someone who is friendly
to them at SH expense (i.e. white knight)
a. Smith v. Van Gorkom (Del 1985)(533) DGCL adoption of 102(b)(7) direct response to
this case.
1. Facts: Trans Union publicly held company that leased RR cars. Not successful,
and TU generated lots of losses (NOLs) that could be used to offset future gains,
and reduce total tax burden and they had no income to use the NOLs. Van
Gorkom, CEO, wanted to retire comfortably, and he had the ppl in the treasury
dept. figure out at what cost the co. could do an LBO. They figure out its
$55/share to generate enough income to keep going. Van Gorkom gets his friend
Pritzker to buy the company at $55/share quickly. Van Gorkom calls emergency
meeting of BoD, gives no notice about his plan, BoD meets < 2 hrs, no written
docs, no accountants or bankers to advise them. BoD approves merger. SHs
allege breach of fiduciary duty.
2. Holding: The business judgment rule shields directors or officers of a
corporation from liability only if, in reaching a business decision, the D or
Os acted on an informed basis, availing themselves of all material
information reasonably available.
3. Trans board was grossly negligent in failing to act with informed reasonable
deliberation in agreeing to the Pritzker merger
4. Significance: before Smith, such bd decisions were protected by BJR. Smith is the
first of several in which the court struggles to construct a new std of judicial
review for change in control transactions such as mergers.
ii. Auctions: Crt also says auctions give a sense of a real price and work if theyre realcrt
doesnt think the auction was meaningful here b/c not enough time or information and
restrictions on SH
b. Once Bd Decides to sell Co, it must act as auctioneer and sell for highest price for SH-
Revlon v. MacAndrews (Del 1986)
i. Facts: Ron Perelman makes hostile offer for Revlon and raises it as Revlon attempts to
get rid of him. Revlon grants lock-up option to white knight, Forstmann, to purchase
Revlons most valuable assets (crown jewels) at bargain price if another bidder
(Perelman) were to acquire more than 40%. (i.e. give white knight: asset lock-up = opp to
buy Revlons best assets at discount price; no-shop provision where Revlon promises to
not seek other buyers and keep info from prospective buyers; and a break-up fee if the
deal falls through; and Forstmann retains notes which trade at par value) Forstmann
offers $57.25/share but Perelman increases to $58 (100% inc) contingent on the lock up
being rescinded or declared invalid and redemption of the pill. Perelman sues.
ii. Holding: Once youve given up the corporate enterprise and made decision to sell
the company (or it becomes inevitable that co will be sold) the role of BoD becomes
an auctioneer. Cant treat favored bidders; must share info w/ all bidders; must play
them against each other; MUST take down all defensive measures.
iii. Lock ups can only be there when they encourage the bidding process. Important to keep
the auction process moving.
iv. Revlon-land when youre clearly for sale. Once youre in Revlon mode, all you
can do is sell company to the highest bidder. Once in Revlon land, all lock-ups taken
down voluntarily or stricken by the courts. BoD will have its own counsel, b/c their
big role is to say youre still subject to Unocal OR you are in Revlon land, you must
auction company to the highest bidder.
v. NOTE: you know youre in Revlon-land when:
1. You decide to sell the company
2. Breakup of the company is inevitable

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vi. Ds have duty to sell to the highest price for shareholders (but hard to tell if breached an
actual fiduciary duty).
vii. When you are not clearly for sale, defensive measures are more likely to bc upheld bc std
for evaluating measures is reasonable in relation to threat posed.
viii. However, distinction bw transactions where the co is sold and where board merely
defends against a hostile takeover bid is not always clear.
ix. Duties: when a sale or break up of the company becomes inevitable, the Ds role is
changed from defenders of the corporate bastion to auctioneers charged w getting the best
price for the SH at the sale of the company, the Ds role remains an active one charge with
the duty of selling the company at the highest price attainable for the SH Say you get a
white knight friendly bidder. The moment you give up the white knight, or restructure
the business, then everything changes. You need to hire a new bank to serve at the
auctioneer.
x. What must Ds do: (1) level the playing field and treat all bidder equally (2) market
check required and must look for other bidders if theres just one (2b) exemption allowed
in very limited circumstances to avoid market check if you believe that one bid is the
right bid. When the Ds possess a body of reliable evidence with which to evaluate the
fairness of tx they may approve the tx without conducting an active survey of the
marketplace.
D. Pulling Together Unocal and Revlon
1. Continuum:
a. Moran: You can put in/ adopt a takeover defense (poison pill) even if theres no threat. BOD
can adopt preclusive defense measures at any time.
b. Unocal: Once there is a threat, the BODs defense strategy must be reasonable in relation to
the threat posed.
c. Revlon: Once youve decided the company will be broken up, you must be an auctioneer and
get as much value as possible.
a) Threat to Business Plan can be long-term OR short-term (Threat is easy to show) Paramount v. Time,
Inc (Del 1989)
i) Facts: Paramount launched its bid after Time initiated friendly merger with Warner. Time thwarted
Paramount by transforming deal into a tender offer by Time for Warner, making itself too large and
debt-ridden for Paramount. Prior to Times tender offer, Paramount and several Time shareholders
sought to enjoin the tender offer to give Times shareholders choice bw Paramounts bid. Ps assert a
Revlon claim bc the merger agreement effectively put Time up for sale, which required Times board
to enhance short-term shareholder value and treat all acquirers equally.
ii) Holding: A boards efforts to prevent a takeover via tender offer will not be invalid merely
because the takeover offer constituted fair market value
iii) Times decision to expand by merging with Warner was analyzed under Unocal and essentially
entitled to the protection of the BJR. Time boards decision that Paramounts offer posed a threat to
corp policy was made in good faith (essentially ANYTHING is a threat according to this court).
Times response was reasonably related to the threat.
b. Court says this was not a sale of the co, therefore, Revlon duties did not attach:
i. A defensive reaction to a hostile tender offer is not an abandonment of the corps
continued existenceno Revlon duties, only Unocal duties
c. Gentiles View Very Easy to Show Threat to Business Plans
i. Revlon collapses Unocal analysis into the BJR bc it seems like any fool idea you have
can satisfy the standard
ii. Threat to corp is that shareholders will take Paramount offer ($200) rather than waiting
for the $250 value over time.
(a) Why does Time get away with this: say they have a long term business strategy with Warner
that might be more valuable than the price upfront and SH that would have voted would not

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have understood that and might have made the wrong decision. Court comfortable with
effective BJR here so now Unocal Stnd in this case doesnt look so much like its in the
middle anymore
(b) Why debt? When youre the target of a hostile bid, its helpful to take on debt b/c co. that
wants to buy you will pull up and reconsider. The debt makes you less attractive to the
acquirer b/c youre less flexible.
(c) What if Time wanted to go solo? Most commentators have said that taking themselves off
the market would be permissible. Not in Revlon land b/c they were effectively being merged
for a long term plan and if they cant do it with Warner, they can say they have a long term
plan thats just for them so then they can drop the whole deal altogether.
(d) But If Time BoD determined to take the Paramount offer, in the best interest of the SHs, then
its abandoned the longterm plan for corporate enterprise, so its now in Revlon land.
3. Sale of Corp OR Change in Control triggers Revlon duties to sell for highest price
(a) Paramount v. QVC Network, Inc (Del 1994) (554)
(i) Facts: Paramount bd approved merging P into Viacom and made public announcement. K
contained 3 provisions that made it difficult for competing offer to succeed: (1) No Shop
provision P wouldnt solicit another offer unless a 3rd party made an offer in writing w/o
financing contingencies; (2) Termination Fee V gets $100 mill if P accepts competing
offer or if maj of stockholders dont vote for V merger; and (3) Stock Option V can buy
19.9% of Ps stock if any triggering events in (2) happen [for cos listed on NYSE, you
need shareholder approval to grant over 20% of shares]. CEO of QVC sends P
competing bid for $80 a share w/financing. QVC filed this suit and publicly announced
its tender offer for 51% of Ps stock, conditioned on invalidation of stock option
agreement bw P and V. V enhanced its agreement but still left 3 encumbrances the same.
QVC offered $90 a share but P rejected QVCs bid bc it was too conditional.
(ii) Holding: A change of corporate control or a break-up of the corporation subject Ds
to enhanced scrutiny and requires them to pursue a tx that will produce the best
value for SH AND A bd breaches its fiduciary duty if it contractually restricts its
right to consider competing merger bids
(iii) Vs defensive measures were improperly designed to deter potential bidders and they do
not meet the reasonableness test.
ii. RULE: When a corp undertakes a transaction which will cause: (a) a change in corp
control; OR (b) a break-up of the corp entity, the directors obligation is to seek the best
value reasonably available to the stockholders.
(a) Paramount Ds were wrong in asserting that both a change of control and a
break up are required for higher scrutiny
iii. RULE: If a co with diffusely-held shares is acquired by co with controlling
shareholder, that necessarily is a Revlon transaction and Board is required to
auction off the co.
(a) When you unwittingly find yourself in Revlon bc youre getting acquired by
controlling shareholder, you have to auction off co.
(b) here, 51% controlling SH would have acquired the company, so then would
have triggered Revlon bc there would have been a change of control. Contrast
to last case where it was a merger of equals- maybe no change of control.
(c) Thus, Paramount BoD must tell Viacom we are in Revlon land and
dismantle the defensive measures, and we have to conduct a full-fledged
auction.
(1) If youre in Revlon, must strip away all defensive measure, provide all information that youre
providing to the favored bidder, must treat hostile bidder fairly to conduct an auction b/c only
through bidding do you get highest price for SH
(2) Trick is: cash or something as good as cash!!!

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(3) Deal Protection Devices in QVC: signed deal w. Viacom and P never though about making the
break up, no shop, etc lessened or revised and the court isnt very keen on them. Basically means
P was willing to make a deal w. P at any cost.
4. Triggering Revlon Duties (CHART) * = except when target has a maj shareholder
a. When will you unwittingly find yourself in Revlon land?

Revlon duties less likely Revlon duties more likely


All stock consideration All cash
Merger of equal size of T Whale/minnow
Widely held sale of control Controlling SH

*heavily fact intensive analysis! Not one factor is determinative. i.e. if only merger of equals = Paramount
v. Time, i.e. if controlling SH = Revlon Land, i.e. if merger of equals AND controlling SH = harder to see!
Its analyzed on a case by case basis.

Revlon Duties Less Likely to be Triggered when:


i. all stock consideration
ii. merger of equals (size of target v. acquirer)
iii. widely held (acquirer shareholders)
b. Revlon Duties More Likely to be Triggered when:*
i. All cash consideration
(a) Nabisco agrees to buy my small cookie co at $20 a share and thats it. If stock
goes to $90 after merger, you dont get it
(b) What if its 40% cash and 60% stock?
ii. Whale/minnow (size of target v. acquirer)
iii. controlling shareholder (acquirer shareholders)
(a) There is a range bw widely held and controlling shareholder.
c. ai&ii and bi&ii = Institutional competence theory (Revlon)
i. Shareholders have institutional competence based on dollar comparisons
d. aiii and biii = Sale of Control Theory (QVC)
5. A Response to Threat that is Preclusive or Coercive is Never Reasonable Omnicare Inc v. NCS
Healthcare (Del 2003) (578)
(a) Facts: 2 men, 20% shareholders, control board of NCS bc they hold B shares 10 votes per
share (controlled 65% voting power). Co is $350 in debt. Genesis will buy NCS only in a
lock-up bc it doesnt want Omnicare to steal deal again. Lock up granted irrevocable proxy
to bidder to vote their shares for the merger and committed the NCS board to not shop the
company and to put the merger to a SH vote even if the Bd no longer recommended it. Thus,
the Bds hands were tied even if another bidder came along. Also, NCS agrees to no fiduciary
out, with a $6mill termination fee, $5mill expenses. Omnicare bids higher, but controllers still
must vote for Genesis
(b) Holding: lock-up deal protection devices that when operating in concert are coercive
and preclusive are invalid and unenforceable in the absence of a fiduciary out clause
(c) Genesiss defensive measures are unreasonable and invalid. The merger agreement and voting
agreements are preclusive and coercive
(a) Note: This deal was smelly bc 65% controllers only had 20% economic
interest interests didnt align w/shareholders
b. Today these deals have to have a fiduciary out, otherwise you are in Omnicare
i. Ct will scrutinize the deal for provisions that are preclusive or coercive
ii. this did not allow SH to effectively vote in the merger

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iii. reviewing court must determine the deal protection are not preclusive or coercive
before determining reasonableness (Blasius type voting comes first and Unocal
proportionality analysis comes second)
E. Deal Protections in M&A Transactions
1. Fiduciary Outs says Bd will not negotiate/shop w/other bidders unless not doing so would be a
breach of the boards fiduciary duties.
a. If Bd signs covenant to recommend and a better deal arrives before shareholders vote, target bd
CANNOT continue to recommend less attractive deal bc it would violate their duty of loyalty.
Thus, the board is well advised to breach the K.
i. However, the co then faces contractual damages which is no good either
ii. Fiduciary Out Clause cuts through this catch-22
iii. If some triggering event occurs (such as a better offer), then the target board can avoid
the K without breaching it.
2. Lockups increase the likelihood that the parties will be able to close the deal
a. Asset Lock-Up (Crown Jewel) favored bidder gets your most valued business if it doesnt get
to acquire company at a lessened price
b. Stock Lock up 19.9% goes to favored bidder at a discount price (note not 20% bc after 20%
you have to let the SH vote)
c. Time of Lock-up: If bd grants lock-up after negotiating, lock-up may survive Revlon/QVC
scrutiny, while a similar option granted very early is more susceptible to ex-post attack
d. When no change in control is involved, ct should apply BJR if Bd chooses a lower-value
merger; However, DE courts will use the Unocal version of BJR since the lock-up serves an
obvious defensive function.
3. Break up fees - permissible so long as they defray bidders costs
a. DE cts have agreed that bw 2.5-3.5% of total purchase price is acceptable breakup fee
4. No Shop/No Talk Provisions
a. Limits Communications with other bidders
5. Submission to shareholders
a. no matter what happens, your bid will be submitted to the shareholders
b. s251(c) of DGCL was amended in 1998 to validate Ks that require the board to submit a
merger proposal to shareholders for a vote even if there is a better offer now on the table
6. Recommendation to shareholders
a. No matter what happens, your bid will also be recommended to shareholders
7. Deal Protection Provisions are valuable when they entice 1 st bidder to come in
a. You stimulate auction when you get white knight, so it is ok to promise him lock-up, break up
fee, etc
b. Once defensive measures stop stimulating auction and auction is going, its difficult to justify
why it is you have these defensive measures
c. Rationale: bringing in first (friendly) bidder is costly bc he has to figure out the value to figure
out what the premium price should be
i) Justification for 2nd generation of deal protections, is to protect long term value of transaction
by going w/ friendly bidder, and we best determine whats in the long term interests; got the
first bidder here; unique benefits
ii) All of the above provisions will be written into the merger agreement of asset sale agreement b/c
protected measures target company gives to favored bidder to protect the tx from other bidders and
make the target less attractive to other bidders.
iii) Justifications: gives costs to the friendly bidder, combining two favorable businesses can be great, so
just helping it along
b) State Anti-Takeover Statutes
2. Second Generation Anti-Takeover Statutes

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A. Control Block Statute resists hostile takeovers by requiring a disinterred shareholder vote to
approve the purchase of shares by any person crossing certain levels of share ownership in the co
that are deemed to constitute acquisition control (usually 20%, 33.3% and 50% of shares) 27
states have this
i. Ohio enacted such a statute in 1982 that became the model for other states
ii. Indianas control share statute varied by allowing the bidder to cross the relevant
ownership thresholds without obtaining shareholder approval but with an automatic loss
of voting rights. The offeror could regain voting rights only upon gaining approval from a
maj of disinterested shareholders
(a) Indianas statute was upheld in CTS
c. CTS Corp v. Dynamics Corp of America (US SC 1987)
iii. Facts: Dynamics owned 9.6% of CTS and announced a tender offer to get it 27.5%. CTS
was protected by an Indiana anti takeover statute which was in the form of a control form
statute (if hostile bidder acquired shares and independent SH did not approve the
acquisition of shares, the shares would not vote). So now hostile bidder gets X% of
shares and cant vote them. Dynamics brings suit challenging antitakeover statute as
preempted by Williams Act.
iv. Holding: a law permitting in state corporations to require SH approval prior to
significant shifts in corporate control is constitutional
v. Indiana act is valid doesnt conflict w/Williams Act
1. (a) Rationale: Offeror can make tender offer to accept shares on condition that
shares receive voting rights within a certain period of time. Williams Act permits
tender offers to be conditioned on offerors subsequently obtaining regulatory
approval.
2. What is relationship b/n the statute and the Williams Act? (Malone v. Brincat-
duty of disclosure and proxy rules. DE crt says: well interpret our duty of
candor such that it runs alongside of or is supplemental to the federal proxy rules
so that disclosure requ of fed securities act are not undermined or contravened)
same is true of antitakeover statutes. Indiana statute is OK here b/c doesnt alter
or interfere or contravene any substantive provisions of Williams Act. Allows
hostile bid to be completed in 20 days specified in Williams Act.
3. crt thinks SH here can still make their own decisions
4. effect of statutes: makes initial bid lower and fewer hostile TO
b. (2) Other provisions include Other Constituency Statutes which allows BoD to consider others,
like EEs who rely on job security. Statute can provide for different things.
c. (3) Pill Validation Statutes permit poison pills against hostile bidder. After pill put in place, SH
vote on pill in next meeting and pill put in place unless its flipped into something like Revlon
land where the bidder will want the pill to be redeemed.
d. Back End Statutes:
e. Fair Price Statute 27 states - deters coercive 2-tier takeovers by requiring minority shareholders
who are frozen out in the 2nd step of such a takeover receive no less for their shares than the
shareholders who tendered in the first step of the takeover
i. This result is achieved by requiring a very high super-majority vote to approve a freeze-
out merger unless the merger provides shareholders with a statutory Fair price that
equals or exceeds the original tender offer
f. Business combination statutes (discussed below)

3. Third Generation Anti-Takeover Statutes (1987-2000)


a. After the US SCs approval of the Indiana statute, numerous states adopted 3 rd generation
antitakeover statutes
i. You can have more than one type of statute per state

100
b. Business Combination Statute (Moratorium statute) 33 states prohibits a corp from engaging
in a business combination within a set period of time after a shareholder acquires more than a
threshold level of share ownership
i. In some statutes, an exception allows a merger to proceed in that time period of a
statutory fair price is paid in the merger
ii. NY adopted the first moratorium statute in 1985 and DE followed in 1988
DGCL s203. Business Combinations with Interests Stockholders
(a) Prohibits business combinations bw acquirer and target for a period of 3 yrs
after the acquirer passes 15% threshold unless:
(i) s203(a)(1): takeover is approved by target board before the bid
occurs; or
(ii) s203(a)(2): acquirer gains more than 85% of shares in a single offer
(i.e. moves from below 15% to above 85%), excluding insider directors
shares; or
[to get 85% of shares, you know 15% are still out there. Mgt
usually owns 5-6-7% of co. and typically 10% dont vote, so
getting 85% if mgt opposes transaction is a significant task]
(iii) s203(a)(3): acquirer gets board approval and 2/3 vote of approval
from disinterested shareholders (i.e. minority who remain after the
takeover).
(b) NOTE ON DGCL S203
(i) If acquirer passes 15% threshold without complying with s203, it is
the end for 3 years.
(ii) 203 applies to hostile and friendly takeovers
(iii) If you are making a hostile bid under s203, you can condition it on
anything you want (i.e. getting 51% shares and board approval)
(A) Alternatively the bidder could protect itself by specifying an
85% min tender condition to its obligation to close its tender
offer
c. Extreme Statutes
Staggered Board: employ classified Bd making it harder for takeover (not that effective)
Disgorgement Statute adopted by PA and OH. They mandate the disgorgement of profits made
by bidders upon the sale of either stock in the target or assets of the target
i. Any bidder who acquires a fixed %age of voting rights, including voting rights acquired
by proxy solicitations, is subject to this statute
ii. Under the PA statute, any profit realized by a controlling person from the sale of any
equity security of the target within 18mos of becoming a controlling person belongs to
the target
(a) A controlling person is any person or group who has acquired, offered to
acquire, or publicly disclosed the intent to acquire over 20% of the total voting
rights
(b) Since the emphasis is on voting rights, a solicitation of proxies triggers the
disgorgement provision
iii. OH statute is more circumscribed, providing safe harbors to mgt proxy solicitations
and to insurgent solicitations made in accordance with the fed proxy rules where the
solicitation of the voting right is limited to the matteres described in the proxy statement
and constrained by the instructions of the proxy giver.
(a) The constitutionality of these statutes remains untested.
G. Proxy Contests for Corporate Control
1. Those seeking a change of mgt have 2 alternatives:
a. Negotiate with the incumbent board

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b. Hostile option of running both a proxy contest and a tender offer simultaneously
i. Proxy contest - only good for a yr bc then ousted board will try to get back
(a) Staggered boards are biggest prob bc it takes 2 yrs to gain control
(b) Many cos have been forced by their institutional investors to withdraw their
staggered boards
ii. Tender Offer - Closing the tender offer is conditioned on electing the acquirers
nominees to the board and the bds redemption of the targets poison pill
iii. Under the hostile option, there are a variety of further defensive steps:
(a) Target board may issue stock into friendly hands
(b) It may move the meeting date
(c) It may sell assets that the raider presumably treasures and it may sell them
to a friendly party for a high-vote stock
(d) It may put covenants in new loan agreements that impede the takeover.
1) Overview:
2) Before pill existed: board control is inevitable consequence of buying majority of shares. You would make a
straight tender offer conditioned on getting 51% and existing Bd would resign bc theyd know that theyd be
voted out of office the next time there was an election b/c the TO has 51% but if staggered, bd it would take 2
years but theyll probably still resign
3) After poison pill: in a hostile bid, you have to have the control first, bc you need board to redeem pill. Only
other option would be to flip company is Revlon land b.c court will say its time to take off defensive
measures. If not in Revlon land, stuck in Unocal/Unotrin land and usually target wins and poison pill will
stay in place.
a) So you need to launch proxy contest: then you can get new Ds out of office and then the Ds will just
take pill off for you.
VOTING IS SPECIAL Cant Infringe on Shareholders Voting Rights Schnell v. Chris-Craft
Industries (Del 1971)
(1) Facts: Incumbent board at Chris Craft strung along dissidents, kept negotiating so they were
lulled into thinking they were making progress. Then, incumbent directors, a couple of mos
before shareholder mtg, amend bylaws to advance mtg 1 month and moved the mtg to an obscure
location. Now dissidents dont have enough time to file schedule 14, so they sue
(2) Holding: A board is entitled to amend the bylaws only for a proper purpose. Perpetuating oneself
in office is an inequitable purpose. Bds action had the effect of infringing on the shareholders
voting rights
(3) Just because something is legally possible, doesnt mean they can do it
(4) Weird: usually courts just look at the statute and defer BJRcourts have strong affinity to SH
democracy for a reason we cannot pinpoint, i.e. vote buying is Ok
ii) Blasius Industries Inc v. Atlas Corp (Del Ch 1988)
(1) Facts: Blasius owned 9% of Atlas. Blasius intends to increase board from 7 to 15. Its going to fill
new board seats with its own nominees. Atlas amends bylaws to add 2 new board seats and fills
them with 2 of its own candidates. Atlas now has maj of 9.
(2) Holding: This is a defensive tactic that limits the ability of shareholders to vote. Therefore,
its invalid bc voting is special.
(3) A Bd cannot enlarge the size of the Bd for the purpose of preventing maj SH from voting and
giving control to own Bd
(4) Analyzed under Unocal but special.this will be thrown out but a poison pill, for ex, will stay

c. Blasius v. Unocal:
i. When you are in Blasius-land, you are prohibited from taking any measures that are
defensive aimed at shareholder vote

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ii. When you are in Unocal-land, you can take any defensive measures essentially
Unocal is less demanding
4) Takeover Devices that the Court wont allow
Slow Hand Pill** pill that may not be redeemed for a speicifed period of time after a change in
board composition
i. even if hostile bidder successfully launches proxy contest and gets 51% vote, this new
board cannot redeem the pill for some period of time (typically 1 yr, sometimes 2)
ii. These pills are illegal in DE
a. Rationale: Fiduciary outs are need to withstand scrutiny of no talk clauses.
Undertaking this pill binds yourself to be in a position to breach your fiduciary
duty
e. Dead Hand Pill** Pill that may only be redeemed by the continuing directors - directors in
office at the time of adoption of the pill or nominated to office thereafter by continuing directors.
i. In most jurisdictions, courts have not ruled on the validity of dead hand pills and some
corps continue to adopt them.
f. No Hand Pill** - Pill that may not be redeemed by current or future boards for the life of the
pill (usually 10yrs)
a) Reminds us of Omnicare- will be invalid if preclude D if cant satisfy fiduciary duties
b) Duties might require them to redeem the pill i.e. Revlon Land or when lost Unocal analysis

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