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Business Associations Outline- Prof.

Rose
Table of Contents
Agency……………………………………………………………………… Capital
………. 1 Regulation………………………………………………………….
8
Mandatory
Terms…………………………………………………………………………
Disclosure……………………………………………………. 8
… 1
Standard-based
Duties………………………………………………….. 8
Authority…………………………………………………………………… Substantive
… 2 Consolidation…………………………………………….. 9
Agency by Successor
Estoppel……………………………………………………….. 2 Liability………………………………………………………… 9
Agency by Limited
Ratification…………………………………………………… 2 Liability…………………………………………………………….
Liability in 9
Tort……………………………………………………………… 2 Governance: Voting
System………………………………………………. 9
Shareholders’ Voting
Governance…………………………………………………………………
Rights…………………………………………… 9
… 3
Electing
Partnership………………………………………………………………
Directors…………………………………………………………. 10
……….. 3
Costs of Proxy
In
Voting……………………………………………………. 10
General………………………………………………………………………
Information
3
Rights……………………………………………………….. 10
Circular Control
Formation……………………………………………………………………. Structures……………………………………………. 10
.. 4 Vote
Relations with 3d Buying……………………………………………………………………
Parties………………………………………………. 4 11
Controlling Minority
Governance………………………………………………………………… Shareholders…………………………………. 11
… 5 Collective
Action……………………………………………………………. 11
Proxy
Termination…………………………………………………………………. Rules……………………………………………………………………
5 11
Business and Limited Liability State Disclosure
Forms…………………………….. 5 Laws……………………………………………………. 12
Corporate Governance: Duty of
Form………………………………………………………………… Care………………………………………………….. 12
6 Fiduciary Duties of
In Directors…………………………………………. 12
General…………………………………………………………………….. Duty of
6 Care…………………………………………………………………..
13
Corporation………………………………………………………………….
. 6 Indemnification…………………………………………………………….
Capital 13
Structure……………………………………………………………….
7
Insurance……………………………………………………………………
… 13
Equity………………………………………………………………………… Business Judgment
… 7 Rule………………………………………………… 13
Exculpation
Debt…………………………………………………………………………… Statutes……………………………………………………… 13
… 7 Rebutting the Business Judgment Rule Presumption……….
Time Value of 13
Money…………………………………………………….. 7 Federal Rules and
Risk and Regulations……………………………………….. 14
Return…………………………………………………………….. Duty of
7 Loyalty…………………………………………………………………..
Diversification and Systemic 15
Risk…………………………………… 7 In
Valuation: Efficient Capital Market General……………………………………………………………………..
Hypothesis………………. 7 15
Creditor Self-Dealing
Protection…………………………………………………………… Transactions………………………………………………. 15
8 Safe Harbor
In Statutes……………………………………………………… 15
General……………………………………………………………………. Disinterested Director
8 Approval……………………………………. 16

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Shareholder Triangular
Ratification………………………………………………… 16 Mergers………………………………………………………. 21
Executive Nuts and
Compensation………………………………………………... 17 Bolts……………………………………………………………… 22
Corporate
Opportunity…………………………………………………... 17
Tax……………………………………………………………………………
Close
….. 22
Corporations…………………………………………………………
Appraisal
17
Remedy…………………………………………………………. 22
Shareholder
De Facto Merger
Lawsuits…………………………………………………………17
Doctrine……………………………………………… 23
Direct v. Derivative
Duty of Loyalty in Controlled
Claims…………………………………………….. 17
Mergers……………………………. 23
Standing
Controlling Shareholder Duties in Tender Offers…………….
Requirements…………………………………………………. 18
23
Screening Procedures: Demand
Public Contests for Corporate
Requirement………………… 18
Control………………………………. 24
Screening Procedures: Special Litigation Committees……..
In
18
General………………………………………………………………………
24
Settlement………………………………………………………………… Defending Against Hostile Tender
…. 19 Offers………………………… 24
Sales of Poison
Control…………………………………………………………………. Pills…………………………………………………………………….
19 24
In Selecting Merger/Buyout
General……………………………………………………………………… Partners………………………………… 25
19 Protecting the
Control Deal………………………………………………………… 26
Premia……………………………………………………………… State Antitakeover
19 Statutes…………………………………………… 26
Sale of Corporate Proxy Contests for Corporate
Office…………………………………………………. 20 Control…………………………….. 26
Insider
Trading………………………………………………………………….
Looting………………………………………………………………………
27
…. 20
In
Tender Offers: Williams
General………………………………………………………………………
Act…………………………………………… 20
27
Hard-Scott-Rodino
False or Misleading Statement or
Act………………………………………………….. 20
Omission…………………….. 27
Mergers and
Theories of Insider
Acquisitions…………………………………………………. 21
Trading……………………………………………. 28
Fiduciary Duty
Mergers………………………………………………………………………. Theory…………………………………………………… 28
. 21 Tipper/Tippee
Asset Liability…………………………………………………. 28
Acquisition…………………………………………………………… Theories of 10b-
21 5………………………………………………………….. 28
Stock
Acquisitions………………………………………………………….
Misappropriation…………………………………………………………..
21
29

Agency
Terms (RA3d §1.01)
• General agent- authorized to do a series of acts or transactions; ex. general employee; has
much broader scope of authority than a special agent; principal is bound by general scope of
agency
• Special agent- helps with a particular transaction or a particular series of transactions; ex. real
estate agent, stock broker, consultant, lawyer, investment banker, etc.
• Termination- RA3d §§3.10 and 3.11; can revoke (by principal) or renounce (by agent); actual
authority ends right away, but apparent authority doesn’t end until it is no longer reasonable for a
third party to believe the agent still has authority to perform transactions for the principal
• Conceptions Don’t Control- RA3d §1.02; whether the agreement is called an agency or not doesn’t
matter; all that matters is whether the elements in 1.01 are present; if they are, there is an agency
relationship (see Jenson Farms)
o Jenson Farms Co. v. Cargill, Inc. (Minn. 1981)

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 Cargill made Warren its agent for new wheat, and Warren made contracts with
farmers. Warren defaulted on the contracts. Should Cargill be liable as principal of
Warren? Yes.
 To have agency, need agreement, but not k or intentions. Agency could be found
here (C consent; W action; C control over W). C was making economic decisions. C
financed W to get grain, not merely to finance.
 Control and liability are linked. If you have control, you have liability too.
 Conceptions do not necessarily control. What is said is irrelevant; what is
done determines the relationship.
Authority (mutually exclusive)
• Actual- something the principal says or does makes the agent believe he has authority to do
something; this can be express or implied
o Need objective manifestation by the principal, the agent’s reasonable interpretation of that
manifestation, which leads the agent to believe that he is authorized to act on behalf of the
principal
• Apparent- the principal’s words or conduct leads a reasonable person in a third party’s
position to believe that the agent was authorized to act
o Need manifestation attributable to the apparent principal, manifestation reaches 3d party,
manifestation caused the 3d party to believe that the apparent agent was authorized, 3d
party’s belief was reasonable
• White v. Thomas (Ark. App. 1991)
o White employed Simpson to make purchases up to a certain amount while White was away.
Simpson made a purchase beyond authority (over amount), so then contracted to sell part of
the property to Thomas. Should White be bound by the sale contract? No.
o Simpson had actual authority to buy, but neither actual nor apparent authority to sell. Since
selling was not needed to perform the assigned task of buying, selling was not within
Simpson’s authority in any way. Simpson’s statements cannot show agency or scope of
authority.
o Although there is an agency relationship and actual authority for certain actions,
there can be no apparent authority for other actions that are not closely related.
The least cost avoider was Thomas, who could have avoided the issue from the
beginning.
• Inherent- exists if a 3d party has an actual or reasonable belief that the agent possesses
authority to act in a specified manner, even if not based on particular manifestations of the
principal
o Principal will be liable for agent actions that usually accompany or are incidental to
transactions which the agent is authorized to conduct
o Gallant Ins. Co. v. Isaac (Ind. App. 2000)
 Gallant’s agent was authorized to make new insurance policies and changes to
existing policies. The policies became binding on Gallant when the information was
faxed and the policy paid for. Isaac’s insurance expired on the 2nd, she applied for a
new policy with the agent on the 2nd, which she was told went into effect on the 3rd.
She wrecked on the 4th, and Gallant said the policy was not in effect until the 6th
because Isaac paid on the 5th. Is Gallant bound by the policy? Yes.
 Inherent power is derived from the agency relation itself. It exists to protect 3d
parties who are harmed through dealing with a principal’s agent. Renewal is
incidental to authorized conduct and the agent had common practice of binding
without payment., so agent acted within scope of authority. Isaac reasonably
believed that agent had authority and did not have notice of lack of authority. Agent
had inherent authority.
 Inherent authority can be used to give an equitable remedy when the court
thinks a certain party ought to be responsible. If an action is incidental and
similar to authorized actions, it could be found to be within the scope of
authority of the agent even if it is technically a violation of the agency
relationship. Gallant was the least cost avoider because it could have easily
controlled the agent.
Agency by Estoppel
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• One person (a principal) cannot take advantage of another person (a 3d party) who has changed
his or her position to his or her detriment in reliance on a representation from the first person
(because of belief about an agent who maybe really isn’t an agent).
Agency by Ratification
• A principal will be bound by an agent’s actions if, even though the agent didn’t have actual or
apparent authority, the principal ratifies the actions of agent after the fact. The principal can’t back
out after that.
Liability in Tort
• Respondeat Superior- principal will be held liable for tort damages done by a servant/employee
within the scope of authority/employment
• Employee v. Independent Contractor:
o Employee’s manner and means of performance of work is controlled by the principal;
gratuitous work does not relieve principal from liability (RA3d§7.07)
o Many factors go into determining whether the principal has control (RA3d§7.07 Comment f)
• Humble Oil & Refining Co. v. Martin (Tex. 1949)
o Humble sold its gas at Schneider’s station. Is Schneider an independent contractor or an
agent?
o Schneider is an agent because Humble controlled certain details of the station indicating a
master-servant relationship (reports, commission, financing, supervision, equipment,
products, termination at-will by Humble, etc.).
o If a person is a servant, and therefore an agent, the principal is liable for torts.
• Hoover v. Sun Oil Co. (Del. 1965)
o Sun Oil had lease and dealer agreements with Barone at his station. Barone lights up a
cigarette, everything explodes, and Hoover sues. Is Sun Oil liable for Barone’s tort? No.
o Barone was an independent contractor rather than an agent because Sun Oil did not control
details of day-to-day operation.
o If a person is an independent contractor, he is not an agent, and the higher
company is not liable for torts.
Governance
• Costs: Principals spend money to make sure that agents care about their jobs and do them
correctly.
o Monitoring- monitor agent’s behavior
o Bonding- align agent’s interests with principal’s interest; funds forfeited if agent acts
contrary to principal’s interests; ex. covenant not-to-compete
o Residual Loss- occurs when agent does not perform in best interests of the principal
• Fiduciary Duties: Duty of agent to principal – reduce agency costs
o Duty of Care- agent must act with standard care within the scope of the agency (RA3d
§8.08)
o Duty of Loyalty- agent must act selflessly and in best interests of principal (RA3d §§8.02-
8.06)
o Elements of the exception under 8.06
• Tarnowski v. Resop (Minn. 1952)
o Tarnowski employed Resop as agent for purchase of property. Respo didn’t do a good job,
and Tarnowski wanted to rescind the deal, but the sellers wouldn’t. Tarnowski recovered
down payment from the sellers. Can he now recover Resop’s profit as agent and also
damages? Yes.
o All profits made by an agent belong to the principal, whether made through performance or
violation of the agency relationship, regardless of damages/profits or rescission/recovery
(RA3d §407(2)). In addition to profits, the principal can recover damages (RA3d §407(1) –
comment a: P is entitled to indemnification for any loss caused by A by violation of duty).
o The harmed person (principal or 3d party) can be compensated not only for losses
in the transaction, but also for related damages. Harmed person can be over-
compensated (policy to avoid duty of loyalty/care violations).
• In Re Gleeson (Ill. App. 1954)

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o Gleeson died and made petitioner trustee for property. Petitioner wanted to continue leasing
the land, so he did. He made a profit from doing so through farming. Does he have to pay
that profit to the trust as its trustee? Yes.
o Trustee can’t deal in his individual capacity with the trust property. Petitioner did not try to
find a new tenant, which is what he should have done as trustee. Trustee can’t be tenant at
the same time; since petitioner was trustee, he owes the profit to the trust from tenancy.
That he acted in good faith, honesty, and there was no loss to the trust are not justifications.
o Trustee must act in the best interest of the trust. Trustees cannot deal in their
individual capacities with trust property. Any profits made by the trustee from the
trust property must go to the trust.

Partnership
In General
• An alternative to debt is to give investors a residual claim, which means that profits, losses, and
likely control will be shared.
• Paradigm partnership: An unincorporated business, intended to make a profit, which has two or
more participants, each of whom brings something to the partnership, each of whom co-owns the
business, each of whom has a right to co-manage the business, each of whom shares in the profits
of the business, and each of whom are jointly and severally liable for the debts of the business.
• Partnerships lessen monitoring costs by giving incentive to do a good job and aligning interests.
• Meinhard v. Salmon (N.Y. 1928)
o Salmon and Meinhard had a joint venture to pay for a lease. Salmon agreed to a new lease
without telling Meinhard, and Meinhard wanted the lease held in trust for the joint venture.
Should Meinhard have any rights to the new lease? Yes, approximately half.
o Joint venturers owe a duty of loyalty to each other. Salmon should have told Meinhard about
the opportunity. Since he didn’t, it must be held in trust. A partner cannot take a renewal for
himself without telling the other partner.
o Duties in Partnership: one partner has a duty to disclose any opportunities
related to the current venture with the other. One cannot hide opportunities while
original deal is still operating. Opportunities presented after the venture is over
are not required to be disclosed.
Formation
• No state required filing. No explicit agreement needed. A partnership can exist even if the partners
have agreed not to make a partnership (UPA).
• Types:
o Partnership at will- each partner can cause the partnership to end at any time
o Partnership for a term- the partnership lasts only for a specified time
o Partnership for a particular undertaking- lasts until the completion of a particular project
• Factors to determine whether a partnership exists:
o Control, loss sharing, contributions of property (cash or other assets), profit sharing (is this
the sole remuneration?), the parties’ characterization of the relationship (focus on what they
did rather than what they said)
• Vohland v. Sweet (Ind. App. 1982)
o Sweet worked for Vohland and was paid through a share of net profits. Inventory was paid
for out of earnings, which were part of Sweet’s money (since he received part of net profits).
Is Sweet a partner or employee? Partner.
o UPA §7(4) states that receipt of share of profits is prima facie evidence of partnership.
Contribution to partnership does not have to be monetary; it can be physical (i.e.,
labor/skill).
o Must have: voluntary k (sharing of profits/losses), intent to do things which create
partnership (doesn’t matter whether parties intended to make partnership or explicitly said
they weren’t partners).
o You can form a partnership even though you don’t intend to. Partnership depends
on what actually happens, not what is said.
Relations with Third Parties

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• Partners have unlimited personal liability. There is joint and several liability under UPA §15 for
partnership torts and wrongful acts, and joint liability for partnership contracts.
• Retiring Partners:
o UPA §36(2)- a partner is discharged from any existing liability upon dissolution
o UPA §36(3)- partners whose obligations have been fulfilled are discharged from any further
liability
• Partners’ Rights in Partnership Property:
o UPA and RUPA create “entity” form- the partnership owns the property; the partners have an
interest in the property; UPA §25
• Creditors’ Rights:
o Partnership property- partnership creditors are first in line for partnership assets
o Individual property of partners- Under RUPA & US bankruptcy laws, individual and
partnership creditors have equal footing; Under UPA, partnership creditor claims are
subordinated to an individual partner’s creditors’ claims
Jingle Rule vs. 723/807
UPA § 40(h) & (i) ‘78 Act (§ 723(c)),
(a.k.a. “Jingle Rule”) RUPA § 807(a)

Partnership Individual Partnership Individual


Assets Assets Assets Assets First Priority

Second Priority

Partnership Individual Partnership Individual


Creditors Creditors Creditors Creditors

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Governance
• National Biscuit Co. v. Stroud (N.C. 1959)
o Stroud and Freeman had a general partnership. Stroud did not want to purchase bread from
National Biscuit, and he told them that. Freeman continued to buy bread from National
Biscuit. Did Freeman’s actions bind the partnership? Yes.
o What a partner does with a 3d party binds the general partnership. UPA §18(h) says that an
unrestricted partner’s actions cannot be restricted if they are an ordinary matter connected
with the business. A restriction can be instituted only by majority.
o One partner’s actions bind the partnership and can make the partnership liable.
The only way to restrict is through a majority of the partners agreeing to restrict.
In a partnership of 2 partners, one partner cannot restrict the other.
Termination
• UPA:
o Dissolution §29- any change of partnership relations, e.g. the exit of a partner
o Winding up §37- orderly liquidation and settlement of partnership affairs
o Termination §30- partnership ceases entirely at the end of winding up
• RUPA:
o Disassociation §601- a partner leaves but the partnership continues, e.g., pursuant to
agreement
o Dissolution §801- the onset of liquidating of partnership assets and winding up its affairs
• Difference: A partner leaving doesn’t necessarily result in dissolution under the RUPA; UPA was
“unless otherwise agreed.” If you don’t agree otherwise, things aren’t ruined under RUPA.
• Adams v. Jarvis (Wis. 1964)
o Adams withdrew from a partnership and then wanted a portion of the accounts receivable.
Should he get it? No.
o UPA §38(1) applies only unless otherwise agreed. It contemplates discontinuance upon
withdrawal, but does not forbid other options. Since the agreement provides for continuation
and a method of paying the dissolving partner, it is enforceable. Only the leaving partner
dissolves; the others remain in the partnership. The remaining partners owe a fiduciary duty
of good faith to the withdrawing partner to collect accounts receivable for the rest of the
year; after the year is out, accounts receivable remain in possession of the partnership.
o Partners may opt out of statutory wind-up under UPA in a partnership at will. If
they otherwise agree, only the partner leaving goes through dissolution, and the
partnership continues with the remaining partners.
• Dreifuerst v. Dreifuerst (Wis. 1979)
o P wanted out of the partnership, but did not allege contravention. D wanted his equity share
in cash, but the trial court ordered in-kind distribution. Should the court have ordered that?
No.
o UPA §38(1) says that when dissolution occurs for any other reason than contravention, each
partner may have the assets applied to discharge the partnership’s liabilities, and the
surplus paid in cash to the respective owners based on the net amount owed, unless
otherwise agreed. If partners haven’t agreed to in-kind distribution, the statute does not
permit it. Lawful dissolution gives each partner the right to have the business liquidated and
his share of the surplus paid in cash.
o The mode of liquidation in a statutory wind-up is cash, unless otherwise agreed.
• Page v. Page (Cal. 1961)
o P and D had an oral partnership agreement. One business picked up, P wanted to dissolve.
Was the partnership for a term or at will? At will.
o There was no implied term. Just because there may be a common hope of the partnership
does not establish by implication a definite term or particular undertaking under UPA §31(1)
(b). If P is terminating in bad faith, and D discovers that later, he may sue for a breach of
fiduciary duty.
o A partner in a partnership at-will can leave at any time, subject to fiduciary duty
restraints (good faith). Opportunities offered during the partnership must be
presented to all partners.
Business and Limited Liability Forms

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• Sole Proprietorships
o Formation: no formalities; no organizational costs
o Characteristics: pass-through taxation; informal decision-making (no collective); no
qualification requirements for other states; ALL LIABILITY
• Partnerships
o Formation: no special formalities
o Characteristics: shared profits, control, and liability; duties (fiduciary)
• Limited Liability Forms
o Formation: state filing required; liability limitations vary with level of state regulation
o Limited Partnership (LP):
 General Partner- has control; has partnership liability; one tax (pass-through, only
individual taxed)
 Limited Partner- no control; liability limited to investment; one tax (pass-through,
only individual taxed)
o Limited Liability Partnership (LLP):
 General Partners- have control; one tax (pass-through, only individual taxed); NO
LIABILITY (at least with respect to torts), except investment
 Creditors are protected through insurance and minimum capitalization requirements
o Limited Liability Company (LLC):
 Member-managed LLC- all members are equal in control rights; all have control; one
tax (pass-through, only individual taxed); NO LIABILITY
 Manager-managed LLC- Managing member has more control, but members still have
control too; one tax; NO LIABILITY
o LLLP:
 General Partner- control; one tax; NO LIABILITY
 Limited Partners- no control; one tax; liability limited to investment
 Functions like a LP for purposes of control and LP liability, but like an LLP for purposes
of GP liability

Corporate Form
In General
• Choosing a business form- Consider what the client does and state rules that would apply
o Assess costs: creation costs (filing fees); operation costs (taxes, annual fees)
o Assess risks: advantages/disadvantages of different forms (case law, lender willingness)
o Assess management options: requirements for appropriate operation (formalities to
maintain limited liability)
o Assess flexibility: possibility of change to entity type (how easy/difficult)
Corporation
• Directors and Management- control; possible liability, but mostly falls on corporation
• Shareholders- very limited control rights; two tax levels (corp and individual), NO LIABILITY (but
sometimes there is liability for directors, officers, and controlling shareholders)
• Benefits: eliminates personal liability: creditors rely only on business assets; investors enter and
exit easily; minority investors can’t dissolve; 3d parties know who is an agent
• Aspects: investor ownership; legal personality: company can sue and can be sued like a person;
limited liability: limit to investment; transferable shares; centralized management under elected
board
• Formation: State’s corporate code; state laws; federal securities laws; exchange listing standards.
Internally, corporations are shaped by their own articles, bylaws, etc.
o Need articles of incorporation and bylaws. Bylaws may be amended by the shareholders
without board approval sometimes.
• Transferability: Investors like liquidity. Shareholders can come and go without disruption.
• Centralized Management:
o Shareholder Primacy: Shareholders are principals who hire corporate officers and directors
as agents. The point is to maximize the wealth of the shareholders.

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o Director Primacy: Directors are mediating hierarchs who actually possess authority in the
corporation and are the best people to have such power.
o Automatic Self-Cleansing Filter Syndicate Co., LTD. v. Cunninghame (Eng. C.A. 1906)
 Automatic wanted to sell assets, but board didn’t approve. The articles said an
extraordinary resolution (3/4 vote of shareholders) could override board
management, but the resolution failed 55%-45%. Should the sale proceed anyway?
No.
 Directors are expressly given full powers with the only limit on general authority
being an extraordinary resolution. A mere majority cannot alter the articles.
 Directors are hybrid agents. Managers are clearly agents to the
corporation, but only indirectly agents to directors and shareholders.
Shareholders are more like passive investors than principals. Directors are
agents in that they are elected by others to represent the corporation, but
do not take instructions. They also seem like principals to managers as
managers answer to directors.
o Jennings v. Pittsburgh Mercantile Co. (Pa. 1964)
 Jennings talked with 2 executive committee members of Pittsburgh Mercantile about
an offer for sale and leaseback. One told Jennings that any offers would be accepted
or rejected by the executive committee and subsequent board approval would be
automatic. After an offer, one told Jennings it was accepted, the other said it was
rejected, and Pittsburgh Mercantile would not pay commission on the sale. Should it?
No.
 Accepting and rejecting offers for sale is extraordinary to the business of Pittsburgh
Mercantile. An agent cannot give himself apparent authority through his words. That
the people Jennings spoke with were on the executive committee was not a
reasonable basis upon which to infer apparent authority to accept sale offers.
 There must be limitations on management agent powers to avoid
corruption. Need to give some power to reduce transaction costs, but
limited.

Capital Structure
Equity
• Sell shares of the company
• Common stock- money in exchange for votes
o Residual claimants (last in line); no guaranteed dividends; no contractual protections
o Voting rights to elect board and vote on fundamental transactions
• Preferred stock- money in return for supervision and priority in getting returns (no votes)
o Contractual: rights outlined in stock purchase agreement and company charter
o Preference in liquidation; dividend preference; limited voting rights
Debt
• Get loans through securities; federal regulation
• Bonds:
o Long-term secure instruments (secured by corporation assets/property)
o Zero-coupon: buy a bond for a certain amount, then cash it end at the end of the period for
more
o Usually, bonds pay a coupon rate each period as interest for buying the bond
o Bond indenture- the agreement between the company and bond trustee (banker) on behalf
of the purchasers (people with money in the bank)
• Debentures:
o Long-term unsecured promissory note
o Debenture indenture
• Notes:
o Shorter-term, secured or unsecured
o Note agreements set out rights between note-holders and company (no trustee needed)
• Convertibles: start as debt; end as stock
Time Value of Money

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• Willing to pay interest to compensate the lender for not using his or her money in another way.
• Think of the interest rate as a discount rate: calculate the value today of future payments.
Risk and Return
• Expected Value: A risk neutral person would pay anything less than but up to the expected value of
an investment to invest. Most people aren’t risk neutral, they are risk averse, and so will tend to
pay less than the expected value. This is a form of discounting. The difference between the
expected value and the price a person is willing to pay is the risk premium.
Diversification and Systemic Risk
• Put money into diversified portfolios to reduce the risk of one investment not paying off. This way,
investment portfolios usually balance out, and the investor will do as well as the market.
• There are some risks (systemic or systematic) that cannot be diversified away, such as things that
affect the market as a whole, and investors will expect to be compensated for taking these risks.
Valuation: Efficient Capital Market Hypothesis (ECMH)
• Weak form: historical information is fully reflected in current price; prices change only in response
to new information
• Semi-strong form: not only is all historical information put into the price, but all current public
information is put in also; this is the version with the most traction/best describes what actually
happens in the market
• Strong form: prices incorporate all information, whether public or not

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Creditor Protection
In General
• US law is debtor-friendly. There isn’t a lot of protection for creditors. The most helpful is contractual
protection.
Capital Regulation
• Minimum capital requirements- companies don’t have to keep very large amounts of money, so it
doesn’t offer much protection
• Distribution restriction- restrictions on how much money residual claimants (shareholders) can take
out of the company through dividends
• Financial Statements- par value doesn’t really mean anything anymore; it doesn’t provide
protection for creditors
• NY law, DE law, CA law, RMBCA (doesn’t require boards to use financial statements in valuation;
can use “a fair valuation or other method that is reasonable”)
• These constraints put up roadblocks and hurdles, but they don’t provide that much protection for
creditors. They just make shareholders and companies think twice.
Mandatory Disclosure
• Most state statutes, including Delaware, don’t require periodic disclosures, even to shareholders
Standard-based Duties
• Fiduciary duties shape director behavior.
• This duty protects creditors when the company enters the “zone of insolvency”: when in the
“zone,” duty shifts from shareholders to the corporation as a whole, including its creditors
• Fraudulent Transfers: happens when the owners of a company realize that it is about to tank and
then move the company’s assets out of it and leave only debt. There is nothing left for creditors.
o Two kinds: Actual or intentional and Constructive
• Costello v. Fazio (9th Cir. 1958)
o Fazio and Ambrose had capital investment in company. When it changed to a corporation,
they took most of it out in exchange for promissory notes, knowing the company wasn’t
doing well. Should their creditors’ claims be subordinated to general unsecured creditors?
Yes.
o They took the capital out in exchange for debt purely for personal gain: they wanted to be
equal with other general creditors. They violated their fiduciary duty to the corporation by
withdrawing capital in the face of undercapitalization and adverse finances. Such action
cannot be justified within bounds of reason and fairness.
o Equitable subordination is used when something unfair has been done to punish
the unfair actors (in this case, shareholders; form of shareholder liability).
• Piercing the Corporate Veil: limited liability protects shareholders/investors from personal liability
for corporate issues; but, if the liability shield is used in a way that harms other economic actors, it
can be pierced.
o Basis for Piercing:
 P must first establish an independent basis to hold the corporation liable
 Usually require corporate form to be used to commit fraud or perpetrate some other
dishonest act
 Courts look at attendant facts and equities. Regularly-considered factors: Small firms
(less that 10 shareholders), undercapitalization, failure to observe corporate
formalities, intermingling of assets of corporation and shareholder, individual use of
corporate assets, siphoning of corporate funds, non-functioning officers/directors,
misrepresentations.
o Sea-Land Services, Inc. v. The Pepper Source (7th Cir. 1991)
 Sea-Land shipped peppers for the Pepper Source, but it never paid the bill. Its owner,
Marchese, owned lots of other companies. Should Sea-Land be able to pierce the
corporate veil of Pepper Source to get to Marchese and reverse-pierce to get to his
other companies? Yes, if test met.
 Test: 1. Unity of interest and ownership so there are no separate personalities; 2.
Cause fraud or promote injustice. Factors for identities: records, mixed funds,

11
undercapitalization, asset sharing. Mere unsatisfied judgment is not enough to
promote injustice; need unfairness, fraud, deception, or compelling public interest.
 Creating separate subsidiaries to avoid reverse-piercing is legal if
formalities are observed. Veil piercing is an equitable remedy, so flexibly
used by courts. Two-prong test: 1. Does corporation have a separate
existence or it is a mere instrumentality or alter ego of a person? 2. Is the
corporate “fiction” used as a tool of fraud? Does it promote injustice?
o Kinney Shoe Corp. v. Polan (4th Cir. 1991)
 Kinney subleased to one of Polan’s companies, which had no assets, no income
except from another one of Polan’s companies, and no money. Kinney won a
judgment against the company for unpaid rent, but it didn’t pay. Kinney wants to
pierce the veil of the company to hold Polan personally liable. Can it? Yes.
 Even if a corporation is separate from its owner, that separation may be set aside
when it would work inequity. Totality of circumstances test: 1. unity of interest and
ownership; 2. inequitable result. Possible 3d prong: if investigation was possible and
would have warned the person of issues, the person assumes the risks of the
company and veil will not be pierced. This prong may, but not necessarily must, be
applied by courts.
 In some instances it is appropriate to require claimants to investigate
companies. But, the corporate form must be protected by punishing bad
actions that use the corporation as a shield.
o Walkovszky v. Carlton (N.Y. 1966)
 Walkovsky was hit by a cab owned by a company owned by Carlton. Carlton owns
stock in 10 cab companies. Can Walkovsky pierce the veil of the company to get to
Carlton? No.
 Courts can pierce corporate veil to prevent fraud or achieve equity. Can get to a
larger corporation through smaller, connected one, or can get to stockholder if
corporation is a “dummy” for protection. But, need allegations of individual capacity
to pierce to stockholder.
 Must allege fraud to pierce the veil of one corporation and go after others
or the owners.
Substantive Consolidation
• When, for equitable reasons, all assets are consolidated within a conglomerate to satisfy the
creditors of one of the individual businesses of the conglomerate. This is an equitable remedy given
by courts in many situations when one business of a conglomerate goes bankrupt and cannot fulfill
the debts it owes to its creditors.
Successor Liability
• DGCL § 278 & § 282: shareholders remain liable pro rata on their liquidating dividend for three
years
• RMBCA § 14.07: same as Delaware, provided that corporation publishes notice of its dissolution
• Successor Corporation Liability: Product line test in some jurisdictions may hold acquiror liable if it
buys the dissolved corporation’s business intact, and continues to manufacture the same line of
products
o Any sophisticated buyer who buys the business as a going concern will contract for
indemnification for tort liability, or pay less. So only way for shareholder to escape long-term
liability through dissolution is to sacrifice the going-concern value of the business and keep
only the piecemeal liquidation value.
Limited Liability
• Benefits: Reduces need to monitor agents (managers); Reduces need to monitor other
shareholders; Makes shares fungible (which also facilitates takeovers); Facilitates diversification
(without LL, minimize exposure by holding only one company); Enlists creditors in monitoring
managers
• Benefits of Transferable Shares: Permits takeovers; disciplines management; Allows shareholders to
exit without disrupting business; Shares are fungible; facilitates active stock markets, increasing
liquidity

Governance: Voting System


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Shareholders’ Voting Rights
• Electing directors at annual or special meetings
• Fundamental changes to the corporation: mergers, sale of all assets, dissolutions, charter
amendments
• Shareholder resolutions: typically at annual meetings and proposed by management (but
sometimes by shareholders under certain conditions)
• Special meetings:
o RMBCA- vote of 10% of shareholders needed to call a special meeting
o Delaware- shareholders can’t call a special meeting unless the charter permits
• Process:
o At the beginning of the year, in-house counsel and outside lawyers prepare two disclosures:
annual report and proxy statement
o Proxy statement tells about matters shareholders will be voting on at the annual meeting
 Called a proxy statement because most shareholders don’t actually go to the
meeting; they fill out a card and proxy votes that way for them
o A professional firm then counts the proxies.
 Most shareholders don’t care about voting because they really don’t have that much
voting power (small share of company with limited voting rights because the board
puts forth the proposals for voting)
 Also, securities are typically held in the name of a brokerage as a part of a pool of
stock, and investors tend to think the brokerage knows the better way to vote, so
does not give direction.
o NYSE Rule 452: Brokers/investment advisors are allowed to vote proxies for which they
receive no direction as long as nothing big is going on at the meeting (merger, proxy
contest).
• Who cares about proxy voting?
o Mutual fund managers: required to care by SEC through fiduciary duties and requirements of
disclosure of proxy voting policies and actual proxy votes
o They meet their fiduciary duties by hiring an advisory firm to look into the issues and tell
them how to vote
Electing Directors
• Voting for directors is a fundamental right of shareholders because they are residual claimants; we
want them to control who is elected as director, because those people will maximize the value for
shareholders, not just worry about creditors.
• Other interested parties (creditors, preferred stockholders, etc.) are protected through contract.
Shareholder franchise is protected through statutory rights and enforcement of fiduciary duties.
• One share, one vote.
• Why stagger or classify boards? Protection against raiders; can’t get rid of entire board in one year.
Raiders are forced to negotiate with the board, which will try to maximize value for shareholders in
a takeover.
• Standard Voting Procedure: shareholders can apply all their shares to each seat
• Cumulative Voting Procedure: shareholders get a total number of votes to “spend.” The total is the
number of seats up for election times the shares you own. This helps to protect minority
shareholders.
Costs of Proxy Voting
• Mailing costs, legal fees, payments to proxy management firms; contested matters and
disagreements can cost a lot too.
• Rosenfeld v. Fairchild Engine & Airplane Corp. (N.Y. 1955)
o In a proxy contest, the losing side was reimbursed. The winners were also reimbursed by
majority vote of shareholders. Rosenfeld, a shareholder, wants the money paid returned to
the corporation. Should the money be returned? No.
o Rule: In good faith contest over policy, directors defending can make reasonable and proper
expenditures from corporate $. Stockholders also have right to reimburse winners.
o The board is authorized to incur good faith, reasonable proxy expenses in defense
of company policies. Incumbents (whether they win or lose) get reimbursed, and

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successful insurgents can also be reimbursed (if voted). This is because both
sides are protecting policies, not people.
Information Rights
• Information rights can be very important if you are thinking about taking over a company.
• Stockholders: generally get stock list and access to books and records (sometimes)
• DGCL §220: To get access to books and records, prove that you are a stockholder, properly demand
the access, and show that you have a proper purpose. If the stockholder complies with this, the
burden is on the corporation to show that the stockholder has an improper purpose.
• MBCA §16.02: Need a good faith demand, particular reason for demand described, and records
directly connect with the purpose.
• Thomas & Betts Corp. v. Leviton
o T&B needed to see records to investigate waste and management, facilitate use of equity
accounting method for its investment, and assist in valuation. The court decided that T&B
was just being a bully, and so did not allow the access. Can’t use the business’s records
to bully it into selling itself.
Circular Control Structures
• Corporation sets up ownership in such away that it can maintain management power over its
subsidiaries, and a lot of control over itself.
o DGCL §160: If the corporation directly or indirectly holds a majority of the voting stock of
itself or another corporation, and that corporation owns a majority of the voting stock of
such other corporation, the shares owned in the original corporation cannot be voted. Want
to avoid management entrenchment; keep management from completely controlling all
decisions made by the companies.
• Speiser v. Baker (Del. Ch. 1987)
o Speiser set up a circular control structure where Chem was owned by HM, a subsidiary,
Speiser, Baker, and the public. 95% of HM’s equity was owned by Chem, but Chem owned
preferred stock, which, unconverted, was only 9% of vote. Speiser was the president of HM,
so he controlled the way it voted its shares. HM’s shares, together with Speiser’s and Bakers
were controlling. Can HM vote its Chem shares? No.
o §160 doesn’t allow subsidiary to vote its shares in its parent if the parent controls the
subsidiary by a majority. A literal reading of 160 doesn’t lead to Chem “controlling” HM
because it only has 9% voting power. But, 160 can be extended. Policy: Don’t want directors
to control votes of the parent by sneaky ownership of subsidiary. Stock owned by a
subsidiary may be prohibited from voting even if parent doesn’t own majority of voting
shares of subsidiary.
o Judge reads §160 more broadly than the actual words to get to the purpose of the
law: avoid management entrenchment. If a director is using his management
position to control all decisions of his company, it goes against the spirit of §160.
Vote Buying
• Schreiber v. Carney (Del. Ch. 1982)
o Jet was a Texas Int’l shareholder and had veto power over big transactions. Jet didn’t want
Texas Int’l to merge with Texas Air, and wanted a loan to exercise its warrants (stock
options) in Texas Int’l. Texas Int’l offered the loan in exchange for Jet giving up veto power,
and then went through with the merger, approved by shareholders with full disclosure. Is
vote-buying illegal per se? No.
o Rule: Vote-buying is illegal per se if done to defraud or disenfranchise the shareholders. If
done for some other purpose, there is a presumption of illegality that can be cured by an
intrinsic fairness test. The loan was vote buying to remove Jet’s veto power, but it was done
to further interests of shareholders. So, it was voidable, but cured by shareholder approval
with full disclosure.
o Vote-buying is bad because it separates control from cash flows. People with
control only may not act in the best interests of the company. Vote-buying is
illegal per se only if used to defraud or disenfranchise stockholders. If done for
some other reason, vote-buying is viewed as voidable subject to an intrinsic
fairness test.
• Separating Control from Cash Flows

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o Greenmail- an investor buys a bunch of shares of a company and threatens a proxy fight;
then, the company agrees to pay off the investor at a premium to avoid the proxy fight that
it thinks it will lose. Sort of like blackmail, but called greenmail because you use money to do
it.
o Empty voting- decouple economic interest from voting; depends on short-selling to work;
the people who short sell shares do so to keep the voting rights but get rid of the economic
connection
 Short-selling: you borrow shares from someone who owns them to get the voting
power, then you immediately sell those shares for the same price you paid for them;
the economic value cancels out to equal because if the price goes down, the short
position goes up and the long position goes down, and vice versa; people do this
because they don’t care about economic value of the shares, but the voting power
for the time being
o Hidden ownership- uses total return swaps to separate control from cash flows; you hide
your position to not tip off regulators, then you reveal yourself to the company to show that
you have a huge voting interest, but no economic interest; economic interest must be
disclosed to SEC, but not voting interest
 Total return swaps- a bank buys the stock, but has no economic interest, just voting
interest, and a hedge fund buys the economic interest from the bank; the bank
agrees to pay the appreciation of the stock to the hedge fund for letting the bank
keep the voting power; the hedge fund is also able to hide its economic ownership of
the company since it is in several different chunks, which saves money while
acquiring lots of shares
Controlling Minority Shareholders
• People who own small amounts of the economic interest in a company can control the companies
because of the way they own the voting rights. The voting rights can add up to a majority,
controlling share. Pyramid structure. Dual-class structures.
Collective Action
• Institutional investors only care about voting rights, and so aren’t large activists. The SEC decided
to impose fiduciary duties on institutional investors to get companies to care about how they are
voting. They are required to care about voting, actually read the info and become informed before
voting, and engage in more activism.
Proxy Rules
• Proxy rules are federal rules. They govern, mostly, disclosure within public companies.
• 4 Aspects:
o Disclosure requirements: stockholders must disclose if they are asking for votes
 Rules 14a-1(l)(iii), 14a-3(a), 14a-2(b)(1), 14a-2(b)(2), 14a-6(g)
o Regulation of proxy solicitation
o 14a-8: about access to matters up for vote on corporate ballot
o Antifraud rules
• Shareholder Proposals
o Not necessarily the views of the corporation or its board; shareholders remind the board of
some externalities that may result from its actions; try to get the corporation to be more
politically correct
o Not normally political in nature; often involve corporate governance; shareholders want the
corporation to be run properly
o SEC tries to balance concerns of shareholder power and directing the corporation while
maintaining enough separation so that the company can run smoothly and avoid
micromanagement by shareholders
 Rules 14a-8(b), 14a-8(c), 14a-8(d), 14a-8(e), 14a-8(h), 14a-8(m)
o Rule 14a-8 is about excluding shareholder proposals for several reasons
 Exclude if improper under state law
 Exclude if a violation of (any) law
 Exclude if a violation of proxy rule
 Exclude if about a personal grievance or special interest
 Exclude if irrelevant (<5% of total assets and <5% of net earnings and gross sales)
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 Exclude if there is absence of power or authority for company to implement the
proposal
 Exclude if related to management functions
 Exclude if related to elections
 Exclude if directly conflicting with a proposal which will be submitted by the company
to the shareholders at the same meeting
 Exclude if the proposal has already been substantially implemented by the company
 Exclude if related to specific amount of dividends
 Exclude if it failed in prior years (by a certain percentage, e.g. 90%)
o There are exceptions to these exclusions. Ex. if immaterial, but about a significant social
issue, may continue.
o CA, Inc. v. AFSCME (Del. 2008)
 AFSCME, a CA stockholder, proposed a bylaw, which CA wanted to exclude. The SEC
certified 2 questions to the court: 1. Is a stockholder reimbursement bylaw properly
proposed under Delaware law? Yes. 2. If adopted, would the bylaw cause CA to
violate any Delaware laws? Yes.
 The bylaw is a proper proposal under 109(a) because it is procedural and not
substantive. 141(a) precludes shareholders from encroaching upon the board’s
managerial authority. The bylaw may cause directors to breach fiduciary duties
because it does not have a “fiduciary out,” and any restraint on the ability of the
board to manage is not allowed under 141.
• Antifraud
o Rule 14a-9: solicitations made by means of proxy statement or other communication
containing any statement that is false or misleading as to any material fact at the time it is
made, or if it only gives a half-truth, in connection with any proxy are illegal
o Elements of Cause of Action
 1. Materiality- a reasonable, rational shareholder would find that information
important in deciding how to vote; something a normal shareholder would care about
 2. State of Mind- state of mind threshold in SEC fraud is a lot lower than in common
law fraud; 2d and 3d Cir: (gross) negligence standard; 6th Cir: intentionality or
extreme recklessness standard
 3. Causation- no need to prove actual reliance; no need to prove that you read the
misstatement; causation is presumed if there is a material misstatement and it was
an essential link in the accomplishment of the transaction
o Remedies: prospective (injunction) and remedial relief ($$$)
o Virginia Bankshares, Inc. v. Sandberg (1990)
 In soliciting proxies for a merger, directors stated that a share price would be “high
and fair.” Can a conclusory statement be materially misleading under 14a-9? Yes.
Can minority shareholders whose votes are not required sue? No.
 Any recommendation or explanation by the directors can be important if a
reasonable shareholder would think so. But, mere disbelief or undisclosed belief as to
the statement is not enough for liability under 14a-9. If a minority shareholder is
induced to forfeit a state-law right, there can be liability, but if the state laws protect
against votes given under misleading information, no such loss occurs.
 If you lie about something objectively verifiable, there is liability. If your lie
is not objectively verifiable (belief and opinion), there may not be liability.
This goes to materiality.
State Disclosure Laws
 Malone v. Brincat: Can still have state law claims for lying in proxy statement even though it is
largely a matter taken over by federal law.

Governance: Duty of Care


Fiduciary Duties of Directors
• Fiduciary duties help manage the principal-agent problem. Important at state level.
• Owed to whom?
o Shareholders, generally (or shareholders and corporation)
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o In “zone of insolvency”, duties shift to corporation and its creditors. In certain situations,
duties can shift to being owed to different people.
• What duties?
o Duty of Obedience- directors must be obedient to the laws; not much litigation
o Duty of Care- Delaware law; more litigation
o Duty of Loyalty- good faith fits under this duty in Delaware; more litigation
o MBCA- good faith duty; duty of care; duty of loyalty
Duty of Care
• Directors must base decisions on a reasonable belief. Looking for a rational basis for the decision.
This is a low threshold- can be satisfied with almost any reason.
• Directors must make decision with reasonable care. There must be some process to the decision-
making.
• Protecting Directors
o Indemnification: §145 (statutory)
o Insurance: §145(f) (statutory)
o Elimination of monetary damages for breach of duty of care: §102(b)(7) (statutory)
o Case law: business judgment rule- good faith business judgments will not lead to liability
• Gagliardi v. TriFoods (Del. Ch. 1996)
o What must a shareholder plead to state a claim to recover corporate losses allegedly due to
mismanagement unaffected by directly conflicting financial interests? Must have a conflict of
interest, improper motive, or high egregiousness.
o If a director makes a decision in good faith and there is no self-dealing or
improper motive, the director is not legally responsible. Exception: the decision is so
egregious that liability follows regardless of absence of conflict of interest or improper
motive. Court won’t second-guess a good faith decision when there is no conflicting
interest. Protections through business judgment rule, indemnification, and insurance.
Indemnification
• Waltuch v. Conticommodity Services (2d Cir. 1996)
o When do the provisions of §145 allow indemnification?
o 145(a) and (f) require good faith for indemnification. 145(c) does not require good faith; only
require success of the merits of the suit. 145(g) allows for circumvention of the good faith
requirement through the purchase of insurance.
o Delaware law is flexible in setting up protections for directors and officers.
Insurance
• D&O Insurance protects the officers and takes away a lot of the risk of wrongdoing. Yet, insurers
don’t have incentive to monitor director and officer behavior. Instead, if insurer sees a pattern of
bad behavior, it raises the prices.
Business Judgment Rule
• If directors are acting in good faith, making rational decisions or employing a rational process, and
are not conflicted in some way, then they are not going to be second-guessed by the courts. Rule
provided in Brehm v. Eisner.
• Justifications: Judges aren’t directors; Discourages vexatious suits by setting a high bar for proving
director liability; Want directors to make decisions without fear of litigation; Protect corporations
from having to disclose sensitive information to defend director decisions.
• Procedural Aspect: Presumption that director acted on informed basis, in good faith, and in best
interest of company. Plaintiff must rebut this presumption. High burden.
• Substantive Aspect: Merits of the decision are generally not subject to review.
• Kamin v. American Express Co. (N.Y. 1976)
o American Express directors made a stupid decision about dividends in-kind. Kamin wants the
decision stopped. Should the court second-guess the business judgment of the directors?
No.
o Mere errors of judgment are not sufficient grounds for equity interference. More
than imprudence must be shown. If there is no fraud, self-dealing, or bad faith,
just a stupid decision, there will be no imposition of judicial judgment. Good faith
is what matters.
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• Smith v. Van Gorkom (Del. 1985)
o Directors have to inform themselves about the decision and its implications before making
it; have to be at least not grossly negligent. Need some process of decision-making.
o This case is sort of an outlier; shows that the business judgment rule may be overcome by
gross negligence.
Exculpation Statutes
• Eliminate or limit personal liability of a director for breach of a fiduciary duty.
• DGCL §102(b)(7); MBCA §2.02(b)(4)
• Liability can be limited, but not in certain situations (see laws, on slide).
Rebutting the Business Judgment Rule Presumption
• Plaintiffs can try to rebut the presumption by alleging facts sufficient to support a finding that the
directors violated the fiduciary duty of care. However, most corporate charters have a 102(b)(7)
provision, which protects against this breach. In order to avoid dismissal, the claim must contain
both a duty of care claim AND a duty of loyalty/good faith claim.
• If plaintiffs rebut the presumption, then the burden shifts to the defendants to show that the
challenged transaction was entirely fair. Entire fairness review to determine which duties have been
breached. Any breaches of the duty of care will be covered by a 102(b)(7) provision. Loyalty
breaches, however, are not covered by 102(b)(7).
• Francis v. United Jersey Bank (N.J. 1981)
o One director did not pay attention to the actions of the other directors. Is inattention enough
to be liable for corporate losses? Yes.
o A director should understand and be familiar with the business. Lack of knowledge is not a
defense to breach of duty claims. There is a continuing obligation to stay informed and
object to illegal actions. If failing to act reasonably leads to a certain result, and the result is
realized, causation can be inferred.
o Directors must act in good faith. They must also act as an ordinarily prudent
person under like circumstances (due care): understand the business, understand
duties, keep informed.
o Basic Rule of Law for Liability for Passivity:
 If you fail to act when a similarly-situated director or officer would have acted, you
are liable for the consequences (to shareholders, maybe to creditors);
 If and only if it is your failure that was the proximate cause of the loss.
 If you should and could have stopped the loss, you will be held liable.
• Graham v. Allis-Chalmers Manufacturing Co. (Del. 1963)
o 1959 directors noticed possible antitrust violations and acted right away. Should they have
been on notice of possible antitrust violations due to consent decrees entered in 1939? No.
o Directors are entitled to rely on the honesty and integrity of their subordinates until
something occurs to put them on suspicion. If there is notice of wrongdoing, and then
nothing is done, liability follows. But, absent cause for suspicion, there is no duty on
directors to install and operate a corporate system of espionage.
o Red-flag Doctrine: Board isn’t expected to actively seek out wrongdoing. Wait for
red flags to appear; until then, rely on the integrity of the employees.
o Justification: Very difficult if not impossible for the board to actively monitor all the
happenings; don’t want directors to be completely risk averse and paralyzed with the duties
of excessive monitoring.
• In the Matter of Michael Marchese (Admin. Proceeding 2003)
o Marchese went along with everything Adley wanted to do. Was he reckless? Yes.
o Directors should inquire into details when there is reason to believe something
wrong is happening. Read documents you sign, pay attention to approvals, object
if something is fishy.
• In Re Caremark International Inc. Derivative Litigation (Del. Ch. 1996)
o What sort of monitoring must directors do to ensure that the corporation functions within the
law?
o Directors need to create a system for monitoring and reporting legal compliance.
Investigate red flags if they are raised. Use good faith effort. Only a sustained

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systematic failure of the board to exercise oversight will establish lack of good
faith, which is a necessary condition to liability for a breach of the duty of care.
• In Re Citigroup Inc. Shareholder Derivative Litigation (Del. Ch. 2009)
o Citigroup was exposed to the subprime lending market, where it lost a lot of money. How
should the duty of care under the business judgment rule be evaluated?
o The decision-making process is what matters, rather than substantive evaluation of the
decision. If the decision was made in good faith and on an informed basis, then need to
allege interest or disloyalty. Cannot require monitoring of “excessive” risk.
o Court won’t second-guess when there has been some monitoring. Excessive risk
doesn’t fall under Caremark, as it requires monitoring of legal compliance.
Federal Rules and Regulations
• Exchange Act §13(b)(2) says that accurate books and records must be kept. It also requires there
be some system of internal accounting controls.
o Make sure information systems are secure. Make sure only the correct people are accessing
accounts.
o Internal auditing
o Segregate duties
o Policies and procedures to make sure things are done in the correct ways.
o Training programs to make sure you have good people working for you.
o Ethics policy can help stop bad behavior.
• §404 of Sarbanes-Oxley: Requires management to go on record about the internal controls system.
Must say that there is one, that they reviewed it, and that it is working.
• §302 requires CEO and CFO to certify that the internal controls system works and that it is doing
everything it is supposed to accurately.
• §906 imposes criminal liability if violated knowingly, with large possible monetary penalties and
jailtime. Even higher penalties if violated willfully.
• Miller v. AT&T (3d Cir. 1974)
o AT&T shareholders sued directors for breach of duty for failure to collect a debt in violation
of corporate campaign finance laws. Does the business judgment rule protect the directors?
No.
o If the allegation of a breach of duty entails a violation of law, then the business judgment
rule can’t insulate the directors’ decision to do such a thing, even if not influenced by
personal interest or bad faith.
o Business judgment rule will not protect directors from a decision that violates a
federal or state law when directors knew that the law was being violated,
regardless of sound business judgment.

Duty of Loyalty
In General
• Owed to whom?
o “The corporation and its shareholders.”
• Norms:
o Shareholder wealth maximization norm- enhance value for shareholders; directors are
ultimate locus of power
o Shareholder primacy norm- act as agents of the shareholders
• Dodge v. Ford
o NOT GOOD LAW; just good for idea of shareholder primacy- constituency of shareholders
should be placed in front of other constituencies in importance when making business
decisions.
o NOW, courts defer to decisions even if other constituencies were considered because of the
“long-term” interest of the company justification
• A.P. Smith Manufacturing Co. v. Barlow (N.J. 1953)
o If corporations give money away, it must benefit the company. This common law principal is
construed broadly so that any indirect benefits justify the contribution. As long as there is no
personal interest involved, it is allowed.

19
o As long as the directors are acting in the long-term interest of the corporation,
courts will likely find that the decision is ok and is good for the shareholders.
• Director Primacy: directors retain the power to balance interests of different constituencies; general
rule after Dodge
• Constituency Statutes: Law moved toward allowing directors to balance non-shareholder interests
with shareholder interests.
Self-Dealing Transactions
• Basic idea: deal has to be fair and approved by directors or shareholders, or be fully disclosed and
approved by disinterested directors or shareholders. Forms of non-voidable director self-dealing
transactions are seen in Ohio, Delaware, and the RMBCA.
• State Ex Rel. Hayes Oyster Co. v. Keypoint Oyster Co. (Wash. 1964)
o A director/shareholder used his power to influence the company to sell assets. He then
bought the assets through another company and sold his shares in the first. Was the deal
fair? No.
o Even if all aspects of the deal itself are fair, nondisclosure by the director of his interest in
the transaction is inherently unfair. So, the harmed company can choose to rescind the deal
or affirm it. If it affirms, it is entitled to the profits received by the interested director.
o Directors can’t directly or indirectly acquire a profit or any other personal
advantage in dealings with others on behalf of the corporation. Transaction is not
voidable if fair, but nondisclosure of interest is inherently unfair. §144 of DGCL
looks to fairness in the face of nondisclosure.
• Sinclair Oil Corp. v. Levien (Del. 1971)
o A parent company completely controlled its subsidiary and forced it to pay dividends to all
shareholders. Was this self-dealing? No.
o The intrinsic fairness test is applied when a parent with a fiduciary duty controls transactions
of a subsidiary and has received benefits to the exclusion and at the expense of the
subsidiary. Here, dividends were received by all shareholders, not just the parent, so there
was no self-dealing. Business judgment rule applies.
o Intrinsic fairness standard is applied only when self-dealing is involved. The
interested party must receive something more than others. If not, business
judgment rule applies.
Safe Harbor Statutes
• Cookies Food Products v. Lakes Warehouse (Iowa 1988)
o A majority shareholder entered into agreements with the company which increased his
compensation. The other shareholders thought this a breach of fiduciary duty. Is it? No.
o Iowa safe harbor statute says that a self-dealing transaction is not void or voidable because
of self-interest if either the board knows about the interest and approves the transaction,
the shareholders know about the interest and approve the transaction, or if the transaction
is in itself fair and reasonable. Since the board knew and approved and since the transaction
was fair, not voidable. Not void because the shareholder also acted in good faith, honesty,
and fairness.
• Delaware and Iowa have weak safe harbors (the clause that says “not voidable if”): provide
protection against self-dealers, but not against fairness review. Even if approved, could be subject
to more than BJR.
• RMBCA has a stronger safe harbor in that if the transaction is approved by at least 2 disinterested
directors, after full disclosure, it is only subject to BJR.
Disinterested Director Approval
• Cooke v. Oolie (Del Ch. 2000)
o 2 interested directors and 2 disinterested directors approved a deal. The shareholders
alleged breach of fiduciary duty on the interested directors. Did they breach? No.
o Business judgment rule applies because the action was not irrational or egregious and a
majority of the disinterested directors approved the deal. Disinterested approval removes
the taint of self-interest. DGCL §144 says BJR applies to actions of an interested director so
long as the director is not the majority shareholder, he fully discloses his interest, and a
majority of disinterested directors ratify. Disinterested approval creates a presumption of
good faith and loyalty, so BJR applies.

20
o §144 says apply BJR unless something is obviously fishy. Possibly some
connection between disinterested directors and interested ones. Another idea is
that disinterestedness is impossible (Eisenberg) because of social ties between
friends and directors, so some fairness review should apply.
• Special Committees of the Board
o Create a committee of legitimately disinterested directors
o Watch out for social ties, as they usually cause interests, even if not direct interests in the
transaction
o Hire separate outside counsel, consultants, and bankers to keep separation from conflicts
with the business
o Keep up an impeccable process of dealing with transactions
Shareholder Ratification
• Lewis v. Vogelstein (Del. Ch. 1997)
o Shareholder ratification may be ineffectual in certain circumstances:
 Conflicts of interest: majority of those affirming had a conflicting interest
 Corporate Waste: exchange of corporate assets for consideration so
disproportionately small as to lie beyond the range at which any reasonable person
might be willing to trade
o But, if shareholder ratification is informed, uncoerced, and disinterested for a
transaction in which corporate directors have a material conflict of interest, it will
have the effect of protecting the transaction from judicial review except on the
basis of waste.
• In re Wheelabrator (Del. Ch. 1995)
o Shareholder ratification does not extinguish duty of loyalty claims (but it does extinguish
claims that the action exceeded the board’s authority and breaches of duty of care).
o Shareholder ratification changes the standard of review. If the transaction is
director-interested and shareholders approve it with full information, the standard of
review on a breach of loyalty claim becomes BJR with burden on plaintiff to prove waste
or gift (was entire fairness with burden on defendant to prove fairness). If the transaction is
majority shareholder-interested and minority shareholders approve it with full
information, the standard of review on a breach of loyalty claim becomes entire fairness
with burden on plaintiff to prove unfairness (was entire fairness with burden on

Standard of review DGCL §144 RMBCA §8.61 ALI §5.02


(burden of proof)

Neither board nor EF (D): But see Siliconix (non- EF (D) EF (D)
shareholders approve coercive tender offers)

Disinterested BJR (P) (fairness reserved): BJR (P): §8.61(b)(1) & Reasonable belief in
directors authorize Cooke. But see Cookies, Kahn Comment 2 fairness (P): §5.02(a)(2)
(EF if controller, burden shifts (B)
to P)

Disinterested BJR (P) (fairness reserved): BJR (P): §8.62(a) & Comment EF (D): §5.02(c), §5.02(a)
directors ratify same as above 1 (2)(A), §5.02(b).

Shareholders ratify BJR/Waste (P). But see Waste (P) [like BJR] Waste (P) [like BJR]
Wheelabrator (EF, if
controller)
defendant to prove fairness). If approved by a flat majority, burden remains on
defendant to prove fairness.

21
Executive Compensation
• Call options- options to buy shares at a specified price, called the strike price
• Give executives incentive to raise the stock price of the company’s shares. When call options are in
the money, executives will exercise them to earn a profit.
• Harvey Pitt: Tie compensation to performance; reward executives for producing objectively
measured sustainable development; Tie compensation to company goals; Make sure compensation
committee is independent; Regularly revisit and revise compensation methodologies; Give good
descriptions of compensation decisions in company filings
• Lewis v. Vogelstein, Part II (Del. Ch. 1997)
o Waste should be reviewed traditionally. A decision constitutes waste if there is no
consideration and no person of ordinary prudence could possibly agree to it. To
validate an officer or director stock option, court must find that a reasonable
board could conclude that the corporation may reasonably expect to receive some
benefit/consideration (regardless of reasonableness or proportionality). A good
faith determination by a disinterested board, at least when ratified by a
disinterested shareholder vote, entitles the decisions to BJR.
• Disney (Del. Ch. 2005)
o Balance the competing interests of protecting directors’ decisions with providing incentives
for directors to act. 102(b)(7) protects duty of care violations. Breaches of good faith are
breaches of the duty of loyalty, and so are not covered by 102(b)(7). If there is a 102(b)(7)
clause, must allege breach of loyalty or good faith.
Corporate Opportunity
• Can a fiduciary take corporate opportunities?
o Yes:
• If the corporation is declining the opportunity
• If the corporation is unable to take the opportunity
o If there is a question as to appropriateness, the fiduciary bears the burden of proving that he
took the opportunity in good faith.
• DGCL §122(17) gives a way for a corporation to say that it will allow certain directors or officers to
take opportunities from the corporation without possibility of litigation.
o Why? If the business is really reliant on human capital, there will be more 122(17) clauses.
People won’t stick with your company. If the business is more bricks and mortar, you don’t
depend on particular people with particular capabilities, so no incentive to have a 122(17)
clause.
Close Corporations
• Characteristics: Non-publicly held; no market for shares; often family businesses; few shareholders;
often restrictions on share transfer; buyback agreements; shareholder managed
• Illiquidity: no ready market in which to trade shares; difficult to get out investment; restrictions on
transfer make it harder to sell shares
• Exploitation: since owners know you are stuck, they can exploit you
• Donahue v. Rodd Electrotype Co. (Mass.1975)
o Close corporations should be subject to the same fiduciary duties as between partners:
utmost good faith and loyalty, a punctilio of an honor the most sensitive.
o In a stock repurchase, if the stockholder whose shares were purchased was a member of the
controlling group, the controlling stockholders must cause the corporation to offer each
stockholder an equal opportunity to sell a ratable number of his shares to the corporation at
an identical price.
o Rule of equal treatment in stock purchases; treat minority the same. Concurrence
says that equal treatment isn’t required in all aspects, such as different
salaries/dividends due to possible unequal contributions.
• Smith v. Atlantic Properties, Inc. (Mass. App. 1981)
o A veto provision can turn minority shares into ad hoc controlling interests, which triggers the
heightened close corporation duty of majority shareholders to minority shareholders.
o MINORITY VIEW: the heightened standard of duty in close corporations doesn’t
apply to every sphere of the business (as was said in Donahue concurrence).
22
Shareholder Lawsuits
Direct v. Derivative Claims
• Direct Claims: shareholders seek to enforce obligations owed to shareholders (rights to dividends,
merger challenge, right to meeting, challenge to proxy vote, right to transfer shares, etc.)
• Derivative Claims: shareholder seek to enforce obligations owed to the corporation and
shareholders collectively (duty of loyalty, duty of care)
• Tooley (Del.): direct v. derivative depends on who suffered the harm (corporation or shareholders?)
and who receives the benefit of recovery (corporation or shareholders?)
• Plaintiffs’ attorney’s fees tend to drive shareholder lawsuits because shareholders face a collective
action problem (one shareholder doesn’t want to bear the risk for a small recovery) and recovery
usually goes to the corporation. Regardless, attorney’s get a portion of the recovery if they win, so
they take the risks.
• Plaintiff and attorney interests diverge sometimes. The net return to attorney’s and plaintiffs vary
widely in certain instances of settlement.
• Fletcher v. A.J. Industries, Inc. (Cal. Ct. App. 1968)
o Shareholders brought a derivative action, which was settled. They wanted the corporation to
pay the attorney’s fees. Should it? Yes.
o Generally, recovery of attorney’s fees must be expressly permitted by statute. An exception
is the common fund doctrine, which allows for recovery of fees if a fund exists for a group
who pursued litigation to protect it. The “substantial benefit” rule says that if derivative
plaintiffs are successful, fees may be awarded against the corporation if the corporation
received “substantial benefits” regardless of if they are pecuniary and there is no fund.
o A common fund is not required for an award of attorney’s fees in derivative
actions. Regardless of how achieved (settlement v. judgment), if the corporation
realizes substantial, even if nonpecuniary, benefits, fees are proper. Benefits are
substantial if they maintain the health of the corporation, raise the standards of fiduciary
relationship, or prevent an abuse.
Standing Requirements
• P must be beneficial owner- owns shares
• P must adequately represent interests of shareholders generally
• P must own shares at time of alleged wrong
• P must fulfill demand requirement
Screening Procedures: Demand Requirement
• P must approach the board and tell it about the problem. Ask the board to repair the problem;
explain in complaint.
• OR, explain why demand would be futile or excused, and explain in derivative complaint.
• Levine v. Smith (Del. 1991)
o If you don’t do a demand, then you must show futility or wrongful refusal.
o Aronson Test of Demand Futility (used when challenged decision is one made by
the board being sued): P must
 Overcome presumptions of director disinterest or independence by
rebutting through well-pleaded facts; OR
 Plead particularized facts sufficient to create a reasonable doubt that the
challenged transaction was the product of a valid exercise of business
judgment (due care).
o If a shareholder makes a demand, the first option is waived.
• Rales v. Blasband (Del. 1993)
o Rales Modified Demand Futility Test (use when the challenged decision is not a
business decision made by the board that is considering demand):
 P must create a reasonable doubt that, as of the time the complaint is filed,
the board could have properly exercised its independent and disinterested
business judgment in responding to a demand.
o This situation arises when the directors who made the decision have been replaced, the
subject of the suit is not a business decision, or the decision challenged was made by the
board of a different corporation.
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Screening Procedures: Special Litigation Committees
• Zapata Corp. v. Maldonado (Del. 1981)
o If the board delegates its decision-making authority to a special litigation committee, the
Zapata test applies to assess the committee’s decisions to dismiss or end a derivative suit.
o Two-Step Zapata Test (for SLCs):
 1. SLC must persuade the court that it is independent, acted in good faith,
and had reasonable bases for its recommendation. Burden is on corporation
to prove these things. If court is not persuaded, it denies the corporation’s
motion to dismiss. If it is persuaded, it may go on to the next step (or grant
the motion to dismiss).
 2. Court applies its own “business judgment.” Even if step one is fulfilled,
the court may decide to deny the motion to dismiss based on its own
judgment.
• In re Oracle Corp. (Del. Ch. 2003)
o Social interactions should be considered when determining SLC independence.
More than only economic interests should be considered. It is irrelevant which
way impartiality pushes a person; if there is any impartiality, the SLC is not
independent.
• Joy v. North (2d Cir. 1982)
o During business judgment prong of Zapata test, court must make a comparison of the direct
costs imposed upon the corporation by the litigation with the potential benefits.
o Action should be dismissed when the probability of liability times recoverable
damages are less than expected costs. Expected costs include attorney’s fees,
out-of-pocket costs, time spend in preparation and participation, and mandatory
indemnification. Insurance should not be considered.
o Also, if there is an insubstantial likely net return, the court may also look to distraction costs
and potential lost profits. Overall, the court should be deferential to the corporation’s
decision.
Settlement
• Why settle? Distraction to directors and management; Costs; Avoid judgment on the merits so that
if there is D&O insurance and other policies, they aren’t precluded from using them
• Carlton Investments v. TLC Beatrice International Holdings, Inc. (Del. Ch. 1997)
o If an SLC decides to settle the derivative litigation, the court should apply the
Zapata test to that decision. Use the test to determine if the settlement is fair.
o If satisfied that SLC is independent, acted in good faith, and has reasonable bases for
decision to settle and terms of settlement agreement, court should only apply its business
judgment to deny settlement if the decision is egregious or irrational.

Sales of Control
In General
• Seller’s duties:
o Case law mechanisms that may regulate the sale of control
o Control premia associated with sales of control
o Sale of corporate office and looting
• Buyer’s duties:
o Tender offers
o Hart-Scott-Rodino
• What is control?
o SEC definition (very opaque):
• Power, direct or indirect, to direct or cause the direction of management and policies
of a person (entity). To control in some determinative way. (Basically anything.)
o FASB definition:
• Some sort of mathematical majority.
o IASB:
• Control strategic financing and operating policies to increase private benefits.

24
o CFIUS:
• Majority or dominant minority power to direct or decide matters affecting an entity.
o State Laws
• Functional, not mechanical, test: It’s not about what you own, but rather what you
can do.
Control Premia
• Zetlin v. Hanson Holdings, Inc. (N.Y. 1979)
o Although minority stockholders deserve protection when control blocks are sold, that
protection does not include inhibitions of legitimate interests of other stockholders.
Controlling interests often command a premium, and requiring the buyer to offer that
premium to all stockholders would essentially require tender offers all the time.
o The controller can sell its shares at a premium to others (absent bad faith).
“Market Rule”: controlling shareholders can sell shares for whatever the market
will give them and not share. Minority shareholders are irrelevant in that
situation. As long as corporate machinery is not being used in the sale, the
Market Rule applies. Using corporate machinery (203 waiver; board help) opens
the sale up to higher scrutiny (entire fairness).
• Perlman v. Feldmann, (2d Cir. 1955)
o MINORITY VIEW: When the sale of a control block results in a sacrifice of corporate good will
and an unusual profit to the fiduciary who caused the sacrifice, he should account for his
gains and share them with the other shareholders. This is called an equal opportunity rule.
The Market Rule creates more value-creating deals.
• In re Digex
o Intermedia wanted to sell its Digex stock, and it was using a corporate mechanism to help it
do so.
o DGCL §203 says that a stricter standard is applied when a corporate mechanism is used to
sell the control. But, buyers of control blocks can try to get a 203 waiver.
Sale of Corporate Office
• General rule of thumb: when the percentage of shares sold is 10% or less, courts may be inclined to
think there was no functional control, and so are more inclined to find the bare sale of a corporate
office. That means the seller can’t keep the premium, and must give it back to the corporation.
Looting
• Warning signs:
o Excessive or inflated purchase price offered, incommensurate with inherent value of control
stock
o Intention to finance the purchase with the acquired corporation’s assets
o Insistence on conversion to cash
o Reputation and previous fraudulent behavior
o Lack of any source of adequate funds to pay for the purchase
• Harris v. Carter (Del. Ch. 1990)
o Rule: When transferring control of a corporation to another, a controlling
shareholder may, in some circumstances, have a duty to investigate the bona
fides of the buyer, i.e., to take such steps as a reasonable person would take to
ascertain that the buyer does not intend or is unlikely to plan any depredations of
the corporation. This circumstance arises when there is existence of facts that
would give rise to suspicion by a reasonably prudent person. Analogy to reckless
drivers in tort.
o This is neither duty of care nor duty of loyalty. More like duty of care, though, but 102(b)(7)
would not cover.
Tender Offers: Williams Act
• §13(d) “early warning” provision:
o Must disclose certain things
o If you are just trying to gain equity and not control blocks, then you don’t have to disclose so
much
o If you are trying to get control, you have to give time and notification
• Disclosure 14(d)

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• Antifraud 14(e)
• Tender offer process- Exchange Act Section 14/ SEC rules (see chart on slide) (oct. 27)
• Brascan Ltd. v. Edper Equities Ltd. (S.D.N.Y. 1979)
o 8-factor test to determine if offer was a de facto tender offer:
 1. Active and widespread solicitation of public shareholders
 2. Solicitation for substantial percentage of issuer’s stock
 3. Premium over the prevailing market price
 4. Terms of offer are firm rather than negotiable (fixed rather than flexible)
 5. Offer is contingent on the tender of a fixed minimum number of shares
 6. Offer is open only for a limited period of time
 7. Offerees are subjected to pressure to sell their stock
 8. Public announcements of a purchasing program precede or accompany
rapid accumulation
o Don’t need all 8 for acquisition program to be a tender offer. This is the most commonly
used test.
o BUT, Hanson Trust (2d Cir. 1985) says the relevant determination is whether the sellers
need the protections of tender offer rules.
Hard-Scott-Rodino Act
• Triggers
o Size of Transaction Test: Notification is required if the acquiring person will acquire and hold
certain assets, voting securities, and/or interests in non-corporate entities valued at more
than $65.2 million.
o Size of Person Test (all transactions valued at more than $260.7 million are not subject to
the Size of Person Test but are automatically reportable): Generally one "person" to the
transaction must have at least $130.3 million in total assets or annual net sales, and the
other must have at least $13 million in total assets or annual net sales.
• Minimum Waiting Period §18a(b)(1)(B):
o 30 days for open market transactions, mergers and negotiated deals;
o 15 days for cash tender offers (remember that for companies registered with the SEC (public
companies), the tender offer period under SEC rules extends to four weeks);
o May be extended for another 30 days (10 days for cash tender offers) if DOJ or FTC makes a
Second Request (§18a(e)(2))
• Tender offers often conditioned on 2 things:
o Expiration of the HSR waiting period- typical time frame is extended up to 30 days
o Tender of a majority of shares

26
Mergers and Acquisitions
Mergers
• Merger- a combination; one company will be absorbed by another; one company remains. Can be
hostile or friendly.
• Asset acquisitions- acquiring all of the assets of a firm, but not the company itself through
purchasing shares
• Compulsory share exchange- acquisition of stock; stock for stock deal; one company pays in stock
to shareholders of another company to acquire it
• Good Motives: Economies of scale, Economies of scope, Vertical integration, Tax benefits, Agency
costs, Diversification
• Evil Motives: Squeeze-out, Looting, Monopoly power, Hubris
• Shareholder power
o Whale-minnow mergers: need approval by minnow, but not whale
o Asset purchases do not require approval when substantially all assets of another company
are purchased
o Asset sales do require approval when substantially all assets are sold
Asset Acquisition
• Cash-for-asset acquisitions
o Cannot separate assets from their liabilities if they are connected. Liabilities directly related
to the purchased assets will be assumed by the acquirer.
o Target company’s stockholders must approve sale of all or substantially all of the assets
(DGCL §271)
o Target may dissolve (DGCL §275)
• Stock-for-asset acquisitions
o Acquirer uses its own stock to purchase all of target’s assets (DGCL 271). Acquirer’s
stockholders don’t vote (under DGCL), and don’t get appraisal rights.
o Target dissolves (DGCL 275) and former target stockholders receive stock in acquirer
o Tax-free transaction under §338(a)(1)(C) of IRC
• Katz v. Bregman (Del. Ch. 1981)
o “All or substantially all”- look to percentages such as assets, sales revenues, and
operating income. Look at whether the line of business would change.
o “All or substantially all” requires board and majority shareholder approval in
target.
o Here, percentages around 50% were enough with the changing of the line of business.
o Thorpe v. CERBCO
 Qualitative effect: out of the ordinary course and substantially affects the existence
and purpose of the corporation; need for shareholder approval is based not only on
the size of the sale, but also on the qualitative effect upon the corporation.
o Hollinger Inc. v. Hollinger Int’l
 All means all, the entire amount or quantity of, the whole extent, the whole, etc.
 A sale cannot substantially affect the existence and purpose of a corporation if it is
not quantitatively vital (so, to be qualitatively important, it must also be
quantitatively important)
 “Substantially all” does not mean “approximately half.” “Substantially all” means
“essentially everything.”- from V.C. Strine
Stock Acquisitions
• Cash-for-stock acquisitions
o Acquirer purchases stock for cash from target shareholders
o Target becomes subsidiary
o Two steps (typically)
 1. Cash tender offer
 2. Cash-out statutory merger under DGCL 251 (acquirer owns <90% of target’s
shares) or DGCL 253 (acquirer owns 90% or more of target’s shares)
o In Delaware, no vote required by acquirer or target shareholders (target votes by tendering)
27
• Stock-for-stock acquisitions
o Acquirer uses its stock as consideration for target’s stock
o Target stockholders become acquirer stockholders
o Target becomes subsidiary
o Target’s assets and liabilities remain within the subsidiary target
o In Delaware, no vote required by acquirer or target stockholders (although target
shareholders essentially vote by exchanging)
• Stock-swap mergers
o Target and acquirer merge with acquirer surviving merger
Triangular Mergers
• Avoid acquirer stockholder votes by creating a subsidiary, and merging the subsidiary with the
target
• Reverse triangular
o Acquirer owns all of its subsidiary’s shares
o Subsidiary merges into target; target shareholders get money or assets of the sub
o Acquirer, as owner of sub, gets target stocks as consideration for the merger, and then
target is owned by acquirer
• Forward triangular
o Acquirer owns all of its subsidiary’s shares
o Target merges into subsidiary; target shareholders get assets of acquirer subsidiary
o Target is extinguished by merging into acquirer subsidiary
Nuts and Bolts
• Kind of Deal: Purchase of assets, Purchase of stock, Merger
• Kind of Consideration: Cash, Stock, Combination
• Accounting: How will the merger affect the financial statements of the surviving company?
• Deal Protection: Adjustments for good/bad performance (of purchase price), Escrow agreement,
Other contractual protections
• Filings: HSR filings, SEC filings, State filings
• Diligence: Financial review, Business operations (contracts), Assets, Liabilities, Legal, Personnel,
Transaction
Tax
• If you take cash, you are immediately taxed on the transaction
• If you take stock, you are taxed when you sell the stock
• Try to make it tax free
o §368 of IRC permits tax free corporate combinations, without recognition of gain, under
certain general conditions:
 Issuance of some voting stock by acquiring corporation
 Continuity of ownership interest: continuing interest from old to new business (no
cash outs)
 Continuity of business enterprise: surviving enterprise must continue a significant
portion of the target corporation’s business after the reorganization
 Valid business purpose: some reason for reorganization other than tax savings
 Step transaction doctrine: cannot be part of a larger plan that if taken in its entirety
would be a taxable transaction
• “A” Reorganization: a “statutory merger or consolidation.”
o No restrictions placed on type of consideration used, even permitting money to be
exchanged (typically up to 50% can be non-stock; non-stock consideration is called “boot”),
as long as the continuity-of-interest requirement is satisfied.
• “B” Reorganization: like an acquisition; transfer of voting shares of acquirer for control in target; no
boot, stock only
• “C” Reorganization: substantially all asset acquisition solely in exchange for voting stock of acquirer
Appraisal Remedy

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• Generally, shareholders get a vote on the merger deal. Exceptions: Whale/minnow mergers,
Triangular mergers, Short form mergers, Asset deals. Appraisal rights, dissenters’ rights, are
typically available when shareholders get a vote.
• How does appraisal work?
o 20-day window before the shareholder vote for dissenting shareholders to file notice of
dissent
o Dissenters must not vote on the merger
o Dissenters must file a petition for appraisal within 120 after the merger (if it goes through)
o Court conducts an appraisal hearing
• DGCL v. RMBCA
o RMBCA: more favorable to dissenters; requires corp to immediately pay a “fair price,” which
the dissenters can contest the fairness of, but they have money from the beginning to use in
pursuing the appraisal action
o DGCL: requires shareholders to win their case (or force settlement) before they are paid, so
they have to put a lot of money up front for legal fees to pursue the appraisal action
• Market-out Rule
o DGCL 262(b)(1): gives situations in which appraisal rights are not available
o DGCL 262(b)(2): carves out exceptions to (1) when the sellers or targets must accept
anything other than other stocks for their shares
• Calculating Fair Value
o Old Way: Delaware Block Method
 Market value, net asset value, earnings value
 Judge assigns a percentage weight to each of these values to determine value;
largely based on historical information
o New Way: Discounted Cash Flow Analysis
 More volatility in valuations, but focuses on forward-looking information
De Facto Merger Doctrine
• Hariton v. Arco Electronics, Inc. (Del. Ch. 1962)
o Loral wanted to buy Arco’s assets in exchange for shares. The agreement reached was 1
Loral share for 3 shares of Arco, and Arco was to dissolve. Is this a de facto merger with
appraisal rights? No.
o Appraisal rights are available only under merger statutes. Since Arco continued to exist after
the exchange, even if only to wrap-up, and since dissolution wasn’t formally required, it
wasn’t a merger. A complete sale of assets is allowed under §271, and shareholders knew
that. Even if not every part of 271 was followed, the transaction is still a sale of assets, with
not appraisal rights.
o Sales of assets that accomplish, in effect, a merger, are not de facto mergers, and
do not get the rights associated with mergers, such as appraisal rights. Just
because of sale of assets doesn’t comply completely with 271 doesn’t make it a
merger.
Duty of Loyalty in Controlled Mergers
• “Controlled” transactions
o Freeze-outs through mergers – Timberjack
• Step 1: tender offer
• Step 2: Freeze-out under 253 of DGCL
o Other squeeze-out/freeze-out techniques:
• Asset sales
• Reverse stock splits
• “Going-private” transaction (regulated under Exchange Act Rule 13-e3)
o Reverse Stock Splits
• Reduces the number of shares and increases the share price proportionately. Ex. own
10,000 shares, it declares a one-for-ten reverse split; now you own 1,000 shares,
worth the same total amount of money; no effect on value
• Companies do this to increase price of shares and attract institutional investors or
avoid being kicked off an exchange for too low a price

29
• Weinberger v. UOP, Inc. (Del. 1983)
o Majority owner of UOP had officers do a feasibility report for an acquisition. The report was
used only for Signal’s benefit. Minority shareholders approved. Is this fair to the minority
shareholders of UOP? No.
o When directors are on both sides of a transaction, they are required to demonstrate their
utmost good faith and inherent fairness.
o Entire fairness test in controlled mergers (2 parts):
• 1. Fair Dealing- cannot use corporate information to mislead when the
stockholder doesn’t know the info (share info, no rushing, etc.)
• 2. Fair Price- use any techniques generally considered acceptable in
financial community and admissible in court
o Remedy: will not void completed transaction; disagreeing shareholders can get appraisal;
uniformed agreeing shareholders can get evaluation of value, which must be given to all
minority stockholders
o If freeze-out is done through short-form merger, no entire fairness required, only appraisal
rights.
o Rabkin allows class action litigation of breaches of fiduciary duty in mergers.
o Rabkin and Cede say that appraisal is the exclusive remedy when only fair price is at issue.
If fair dealing is at issue, there are other possible remedies. Weinberger has lost much of its
force.
• Kahn v. Lynch Communication Systems, Inc. (Del. 1994)
o Lynch wanted to buy Telco, but Alcatel, 43.3% shareholder, wanted it to buy Celwave. Lynch
eventually gives in through its independent committee. Is Alcatel a controlling shareholder?
What standard?
o If there is a controlling shareholder, entire fairness is applied (burden on D to
prove fairness). If an independent committee is used, entire fairness is applied
but with the burden on the P to prove unfairness. If the independent committee
isn’t actually independent because there is no bargaining power and terms are
dictated by the controlling shareholder, entire fairness is applied with burden on
D.
• Don’t need >50% to be controlling. If power is demonstrated over decisions, that is
control.
o If there is no controlling shareholder, but there are “interested parties” involved,
the review of the committee’s decision is BJR.
Controlling Shareholder Duties in Tender Offers
• Disclosure under SEC rules
• No general duty to pay a fair price, so long as the offer is not coercive
• Business judgment review (Siliconix) – BUT SEE IN RE PURE
• In Re Pure Resources, Inc., Shareholders Litigation (Del. 2002)
o What standard of fiduciary conduct applies when a controlling shareholder seeks to acquire
the rest of the company’s shares?
o If acquisition occurs through tender offer followed by short-form merger (Solomon
approach), encourage the free flow of capital between willing buyers and sellers so
long as seller consent is not mislead or coerced. Possibility of inherent coercion.
Acquisition through tender offer is non-coercive if:
 1. subject to a non-waivable majority of the minority tender condition
 2. controlling stockholder promises to consummate a prompt §253 merger
at the same price if it obtains more than 90% of the shares, AND
 3. controlling stockholder has made no retributive threats
o Then determine if independent directors of target have a role in the decision –
given free rein and time; directors must operate in good faith and diligence.
Details of fairness opinion must be disclosed to ensure an informed shareholder
decision.

Public Contests for Corporate Control


In General

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• Proxy contests and tender offers, or a hybrid form.
• Basic problem: no one is truly independent; Even if they have no financial connection, directors and
managers have a desire to keep their jobs. They may fight to stay in for the wrong reasons. Are the
incumbents doing the right thing for the company, and not just for themselves? How much
deference should we give such boards?
Defending Against Hostile Tender Offers
• Unocal Corp. v. Mesa Petroleum Co. (Del. 1985)
o Mesa owned stock in Unocal, and wanted all publicly owned shares. It set up a 2-tiered
tender offer. The independent directors of Unocal met and decided to reject the offer and
pursue a self-tender which would offer substantially more cash to remaining shares if the
first-tier of the tender offer was successful. This plan excluded Mesa from selling some of its
shares back to Unocal. Can the board do this? Yes.
o Before BJR is applied to a director decision to defend against a tender offer,
directors must show that they had reasonable grounds for believing that a danger
to corporate policy and effectiveness existed. Directors cannot act merely to keep
themselves in office. Balancing Test: Defensive measure must be reasonable in
relation to the threat posed in order to get BJR.
• Unitrin v. American General
o Added to Unocal; Target directors bear burden of showing that defensive action was
proportionate to a threat. If the defensive action is preclusive or coercive, it will fail Unocal
test. If not coercive or preclusive, Unocal is satisfied as long as the defense is within the
range of reasonable action (similar to BJR; doesn’t have to be most reasonable action). This
is a form of “enhanced” BJR.
Poison Pills
• Two Types
o “Flip-in”: allows existing shareholders (except the acquirer) to buy more shares at a discount
o “Flip-over”: allows stockholders to buy the acquirer’s shares at a discounted price after the
merger
• Flip-In Pill
o Step 1: Rights plan adopted by a board vote. Shareholder vote not necessary as long as the
board has the requisite provision in the charter allowing it to issue blank check preferred
stock.
o Step 2: Rights are distributed by dividend and remain “embedded” in the shares.
o Step 3: Triggering event occurs (it never does) when prospective acquirer buys >10% (or
whatever the % trigger is) of outstanding shares. Rights are no longer redeemable by the
company and soon become exercisable.
o Step 4: Rights are exercised. All rights holders are entitled to buy stock at half price – except
the acquirer, whose right is canceled.
o The goal is to use this land mine to make sure that all transactions go through the board of
directors, and not around the board. The board wants to approve takeovers, not have hostile
ones, so they want the offerors to come to them, not go around them through hostile tender
offers and other acquisition strategies.
• Moran v. Household International, Inc. (Del. 1985)
o If the defensive mechanism is within the authority of the board, the BJR from
Unocal is applied. Directors must then prove good faith, reasonable investigation,
and a defense proportional to the threat posed (as stated in Unocal).

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Selecting Merger/Buyout Partners
• Smith v. Van Gorkom (Del. 1985)
o Requires boards to be well-informed when making decisions. Need a proper
fairness determination, an auction or “market test” that actually works, and to
examine the documents before accepting them. These are duty of care issues,
which are now mostly irrelevant due to 102(b)(7).
• Revlon, Inc. v. MacAndrews and Forbes Holdings, Inc. (Del. 1986)
o Break-up became inevitable for Revlon, but it didn’t like Pantry Pride, so it tried to use a
poison pill and a stock repurchase. When sale became inevitable, Revlon entered a lock-up
agreement with Forstmann.
o Once sale or break-up is inevitable, the board’s responsibility shifts to the
stockholders/equity owners, and creditors’ interests take a backseat. The board
cannot properly enter an auction-ending lock-up agreement to avoid a hostile
buyer if that buyer is making a better offer. This is a breach of good faith and the
duty of loyalty.
 Can only consider other constituencies if there are rationally related benefits flowing
to stockholders. Can’t interfere with contractual obligations to other constituencies,
but continuing with an auction is not improper since noteholders’ rights were fixed.
o Lock-ups are not per se illegal; if they end an active auction and operate to
shareholders’ detriment, they are illegal.
o When a board ends an auction for no good reason, and does so in order to protect
itself from liability due to earlier defensive measures, the action cannot withstand
Unocal scrutiny of director conduct. When the board’s duty is to be an auctioneer and
sell to the highest bidder, a no-shop or lock-up provision cannot withstand Unocal.
Can’t play favorites when break up is inevitable. Must allow market forces to operate
freely. Breach of duty of care (so no BJR).
• Market check required: when there are no grounds for judging adequacy of an
offer, directors must canvas the marketplace to see if higher bids could be elicited;
exception (very limited): if there is enough info to evaluate fairness, no market check
needed for director approval
o Duties can be triggered when the company initiates a bidding process, break-up is
inevitable, or corporate control passes to a third party. (SEE QVC)
• Paramount Communications, Inc. v. Time, Inc. (Del. 1989)
o Time had merger agreement with Warner, but Paramount made a cash offer for all of Time’s
shares. The board rejected it, but since the stockholders knew about the offer, Time’s board
knew they wouldn’t approve the merger. Time then made a cash tender offer to Warner
which would result in a merger. Paramount and Time shareholders sued to enjoin the offer,
awaiting regulatory approval for Paramount to buy Time.
o Did Time put itself up for sale by entering a merger agreement with Warner? No.
o If there is no imminent sale or break-up, no change of control, and no active
bidding process started by the company, Revlon does not apply, but Unocal does
(to the defensive measure). A tender offer as a defensive response is evaluated
under Unocal.
 1. Is there a threat, reasonably perceived? Look for inadequate offer value,
ignorance of shareholders, conditions attached to offer, timing of offer
 2. Is the defensive measure reasonable in proportion to the threat? Look for
a reason to want to continue with other deals, obligation to abandon a plan to
maximize shareholder profit
• Paramount Communications, Inc. v. QVC Network, Inc. (Del. 1994)
o Paramount entered a merger agreement with Viacom. The agreement included deterrents to
competing bids such as:
 No-Shop provision: can’t solicit, encourage, discuss, negotiate, or endorse any
competing transaction, unless the third party proposal was unsolicited AND
discussions are necessary to comply with fiduciary duties.

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 Termination Fee: Buyer will receive $$$$ if seller terminates because of a competing
transaction, failure of shareholders to approve, OR seller board recommended a
competing transaction.
 Stock Option Agreement: If any triggering event in Termination Fee occurs, buyer has
option to purchase big percentage of seller’s outstanding common stock at set price.
o In analysis under Revlon, look at adequacy of decision-making process, info used
by directors, reasonableness of action in light of circumstances. Directors have
burden.
o If there is no trigger for enhanced scrutiny in takeover negotiation, use BJR.
Triggers for enhanced scrutiny:
 1. Board approval of a transaction triggering a break-up or bidding process
(Revlon)
• Can be triggered by company initiated bidding process, inevitable
break-up, OR corporate control passing to a 3d party. Includes a sale or
merger for cash or debt securities and a merger for securities that passes
control to a private company or a public company with a majority shareholder.
 2. Adoption of defensive measure in response to threat to corporate control
(Unocal)
o A reasonable decision will suffice; the board does not have to make a perfect decision.
• Lyondell Chemical Co. v. Ryan (Del. 2009)
o In considering a deal with Basell, the Lyondell directors only considered it for a few days.
They did do negotiation, prepared a fairness opinion, and discussed the deal at a meeting.
The deal protections (no-shop and break-up fee) had fiduciary outs and were not
unreasonable. The board approved. Are there duty of care and loyalty issues? No.
o There was an issue of fact as to a breach of the duty of care because the directors
considered the deal quickly. But, there was no evidence of knowing ignorance of
responsibilities, bad faith, or other loyalty issues. Since there was a 102(b)(7) clause, there
are no issues left for trial.
Protecting the Deal
• Deal protection provisions get people to bid. But if they are too onerous, they may scare bidders off
and leave shareholders unprotected.
• Lock-up Provisions
o Stock or asset lock-ups
o Termination fees
• Usually around 3% of deal amount, but courts resist a set number in evaluating
reasonableness of the protection under Unocal or Revlon
o Common triggers for termination fees
• Shareholders reject
• Board fails to authorize or approve the deal (maybe because of another deal)
• Board recommends another deal
• Omnicare, Inc. v. NCS Healthcare, Inc. (Del. 2003)
o If a lock-up provision does not have a fiduciary out, the deal is unavoidable to
shareholder. This is preclusive and coercive, and so fails Unitrin and therefore
Unocal.
o THIS MAJORITY DOESN’T EXIST ANYMORE – ERODED – “PERFECT STORM” CASE
o Very particularized facts with lots of provisions that come together to create a really bad
lock-up. Force the vote provisions and voting agreements aren’t always illegal. Provisions
with no fiduciary out are not always per se illegal (according to dissent).
o Provisions that prevent the fulfillment of fiduciary duties are invalid and
unenforceable.
State Antitakeover Statutes
• Designed like poison pills and other defensive mechanisms to try to get buyers to come through a
certain gate (the directors or the shareholders) when giving offers, rather than going around and
attacking the company.
• There are statutes that are directed towards buyers who acquire control blocks. There are also
statutes that are aimed at protecting shareholders in second-step freeze-outs.
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o Acquiring Control Blocks: control share acquisition statutes, other constituency statutes, pill
validation statutes
o Second-Step Freeze-Outs: business combination statutes, fair price statutes
• CTS Corp. v. Dynamics Corp. of America (1987)
o If the state statute and the Williams act can both be followed at the same time,
the statute doesn’t violate the Commerce Clause, and there are no delays or
unfairness between shareholders and directors, the statute is not preempted by
the Williams Act.
o If the primary purpose of the statute is to protect shareholders and states’ interests, it
probably doesn’t conflict with the Williams Act.
• DGCL § 203
o 203 is a freeze-out statute which bars business combinations between acquirer and target
for a period of 3 years after the acquirer passes the 15% threshold unless:
• (a)(1)- takeover is approved by target board before the bid occurs; OR
• (a)(2)- acquirer gains more than 85% of shares in a single offer (i.e., moves from
below 15% to above 85%), excluding inside directors’ shares; OR
• (a)(3)- acquirer gets board approval and 2/3 vote of approval from disinterested
shareholders (i.e., minority who remain after the takeover)
Proxy Contests for Corporate Control
• After pills, buying a majority of shares did not necessarily lead to board control. Instead, board
control is needed to be able to buy a majority of shares because the board must redeem the pill
before the purchase in order for the pill not to take effect.
• Schnell v. Chris-Craft Industries, Inc. (Del. 1971)
o The board moved a meeting date up so that the proxy contest wouldn’t be ready. Is that
allowed? No.
o A board cannot use corporate machinery to perpetuate itself and obstruct the
rights of stockholders to vote in a proxy contest. When bylaws designate the date
for a meeting, any campaigns are expected to be geared toward that date, not an
advanced date. Just because the change was legally possible under Delaware law
does not mean that inequitable action becomes permissible.
• Blasius Industries, Inc. v. Atlas Corp. (Del. Ch. 1988)
o Even if the board is acting in good faith in response to a threat, it cannot prevent
shareholders from electing a majority of new directors. Unocal does not apply; a
higher standard of compelling justification applies when action is taken primarily
to interfere with effectiveness of stockholder vote.
o If only indirectly affecting voting rights through a defensive mechanism that is meant to
benefit shareholders, Unocal will probably be applied. If directly affecting in order to
entrench, probably get Blasius standard.

Insider Trading
In General
• § 16 of Securities Exchange Act
o Covers trading in ANY equity securities of a public company
o Applies to officers, directors, and 10% shareholders
 To qualify as a 10% shareholder, must have held 10% or more of the company’s
stock immediately before both the purchase and sale to be matched. Any purchases
or sales made after a person reaches the 10% threshold will be subject to §16.
o 16(a)- Requires lots of disclosure
o 16(b)- Short-swing profits rule
 If you have a purchase and subsequent sale match within 6 months, or vice versa (a
sale and subsequent purchase match within 6 months), and if you make any profit,
you have to disgorge it to the company (if you are a covered party).
 Works mechanically; no scienter requirement
 SEC will match any sales/purchases that produce a profit.
 Basically discourages any trading within a 6 month period by the covered parties.
o 16(c)- prohibits short sales by insiders subject to §16
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o §16 is a blunt-force instrument and is both under-inclusive and over-inclusive. It punishes
perhaps innocent behavior when insiders do trading within 6-month periods that wasn’t
actually meant to be bad, but is seen that way just because it makes a profit. It fails to
punish perhaps bad behavior because people can avoid §16 by just waiting longer than 6
months to do the trading. But, the SEC isn’t worried about over-inclusiveness, only under-
inclusiveness.
• §10-b
o Unlawful for any person to use any device to manipulate or deceive people in any way that it
may be necessary or appropriate for the SEC to protect investors.
o Rule 10b-5
 Can’t defraud or deceive in the purchase or sale of any security, or make untrue
statements or omit a material fact necessary to make statements made not
misleading, etc.
 Elements (similar to common law fraud): Material misstatement, Scienter, Reliance,
Loss causation, Damages, Jurisdictional nexus- use of an instrumentality of interstate
commerce, Transactional nexus- in connection with the purchase or sale of any
security
o Issues with 10b-5
 Is there a private right of action? Is the SEC going to police everything itself? Kardon
and TGS provide private rights of action
 What does 10b-5 actually prohibit with its very broad language? Case law.
• Affirmative Defenses for 10b5-1(c)
o The purchase/sale is not “on the basis of” material, nonpublic information if the person
making the purchase or sale demonstrates that before becoming aware of the information,
the person had
 Entered into a binding contract to purchase or sell;
 Instructed another person to purchase or sell for the instructing person’s account; OR
 Adopted a written plan for trading securities.
False or Misleading Statement or Omission
• SEC v. Texas Gulf Sulphur Co. (2d Cir. 1968)
o TGS did surveys of land, found some good stuff, but didn’t disclose it. Some insiders traded
on the info.
o Under 10b-5, insiders can’t trade on information that is to be used only for
corporate purposes. If a person has material, nonpublic information, they must
either disclose it or abstain from trading or recommending the securities. Can’t
lie, mislead, or give half-truths.
o Materiality- balance the indicated probability that the event will occur with the anticipated
magnitude of the event in light of the totality of the company activity.
o Extension beyond insiders- anyone possessing information who may not be strictly
termed an “insider” under 16(b) is still subject to the “disclose or abstain” rule; constructive
or temporary insiders covered too.
• Santa Fe Industries Inc. v. Green (1977)
o Santa Fe did a short-form merger under §253 and followed all provisions and gave all
relevant information. This is not a violation of 10b-5 just because it might be unfair.
o If no fraud, deception, or manipulation is involved, the action does not fall under
10b-5, but rather under the states’ corporate governance laws. If action involves
fraud and purchase or sale of securities, then it falls under federal law.
o Generally, fairness falls under state law and full and fair disclosure falls under federal law.
Theories of Insider Trading
• Equal Access: inherent unfairness is involved where a party takes advantage of such information
knowing it is unavailable to those with whom he is dealing
o Pros: psychologically appealing (seems fairer); includes “outsider trading;” easy to link to
damages
o Cons: potentially removes the incentive to conduct research, reducing pricing and allocative
efficiency

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• Fiduciary Duties: insider trading can only occur when there has been a breach of a fiduciary duty
(except 14e-3)
o Pros: focuses on the relationship between parties, thereby analogizing to the
misrepresentation/reliance rubric of common law fraud; more selective than equal access
theory
o Cons: does not catch some objectionable activity (an informational advantage – however
gained – may be exploited so long as no duty is owed)
Fiduciary Duty Theory
• Chiarella v. United States (1980)
o Chiarella was a printer, and he learned about tender offers from buyer information and
traded in the target’s stock on that info.
o Chiarella did not violate 10b-5 because he had no duty to the target or its shareholders. He
did not trade in the securities of the buyer, so he did not breach any duty there. No duty to
disclose or abstain, so no fraud.
o Response to Chiarella: Rule 14e-3
 It is illegal to trade in securities of a company that is going to be the target
of a tender offer based on information obtained from:
• The bidder
• The target
• Anyone connected to the bidder or the target
 No breach of fiduciary duty to anyone is required to show a violation of
14e-3
 Possession of material, nonpublic information re: tender offer leads to duty
to disclose or abstain
Tipper/Tippee Liability
• Dirks v. SEC (1983)
o A tippee has a fiduciary duty to disclose or abstain from trading on material,
nonpublic information only if the insider providing the tip violated a fiduciary duty
to the shareholders by disclosing the information to the tippee and the tippee
knows or should know that there has been such a breach.
o A tip violates an insider’s fiduciary duty if the insider will personally benefit,
directly or indirectly, from the disclosure. Absent some personal gain, there has
been no breach of duty to stockholders, and absent a breach by the insider, there
is no derivative breach.
o Benefit includes any pecuniary gain or reputational benefit that will translate into
future earnings. A breach also occurs if the insider gives information as a gift to a
trading relative or friend.
o Without a fiduciary duty, there can be no violation of 10b-5. There is no fiduciary
duty requirement under 14e-3.
• A careless disclosure is not a breach.
• If the tippee has a duty of trust and confidence to the source of the information, the outsider must
disclose or abstain.
• Tippees without a duty of confidentiality inherit a disclose-or-abstain duty from the tipper if they
knowingly trade on a tip. Subtippees also inherit the disclose-or-abstain duty if they know (or should
know) the information came from a breach of duty.
• Strangers: a stranger who has no relationship to the source of the material, nonpublic information
has no disclose-or-abstain duty (find papers floating around on the street).
Theories of 10b-5
• Classical Theory: a corporation’s insiders (or tippees) trade on information
• Misappropriation Theory: information subject to a fiduciary duty of trust or confidentiality is used for
trading in securities without disclosing to the owner of the information that the information is being
used for trading
o The person misappropriates information from a person to whom you owe a fiduciary duty,
and you trade on that information.
 Classical theory wouldn’t get them because they aren’t an insider and they don’t owe
a fiduciary duty to the company’s investors.
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 BUT, the person does owe a fiduciary duty to the person from whom they got the
info. There is deception because the misppropriator fails to disclose to the source of
the info that he or she is using the info for trading. The “in connection with” element
is satisfied because nondisclosure coincides with trading for the misappropriator.
o 10b5-2 gives a non-exclusive list of when there is a duty of trust or confidence.
Misappropriation
• United States v. O’Hagan (1997)
o O’Hagan got info through his law firm about a tender offer. He traded in the securities of the
target. He is a misappropriator under 10b-5 because he owed a duty to the source.
o A person is a misappropriator when he gets material, nonpublic information from
an insider or someone who knows the info, regardless of fiduciary duty to
shareholders, and trades on it knowing that the info was given in trust and
confidence and without telling the source that the person is trading on it.
 No duty owed to shareholders by source or misappropriator, necessarily,
but misappropriator owed duty to source to abstain from trading or
disclose that he is going to do so.
• SEC v. Dorozhko (2d Cir. very recent)
o Hacker gets into company information and trades in the stock.
o Holding: A fiduciary duty to disclose is not required to find insider trading. This is completely
out of step with case law since O’Hagan – some breach of a duty to disclose is required.
Dorozhko may sound good as a policy matter, but it is wrong on the law.
o To believe that the hacker was a misappropriator, you’d have to believe that he owed a duty
to disclose to the computer server that he intended to trade on the information. This is
ridiculous. This isn’t insider trading.

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