I.

INTRODUCTION

This course is intended to provide an overview of corporate governance in the United States with a
focus on the theory of corporate governance, the role the Board of Directors, including applicable legal
obligations and protections as well as best practices, the role of shareholders and third parties,
shareholder activism, executive compensation, and governance related regulation arising from past
market crises.

By the end of the course students will have learned the key concepts of corporate governance and the
role of each of the key constituencies, with emphasis on the allocation of rights and responsibilities
between directors and shareholders. This will include statutes and legal principles under the Delaware
General Corporation Law, Federal securities laws and the rules of the New York Stock Exchange, as
well as “best practices”.

Students will also be familiar with the reasons shareholders engage in activism, the strategies used by
activists and tactics available to Boards to respond to activism. In addition to having a familiarity with
the basic tools necessary to advise a board or a shareholder their respective rights and responsibilities
regarding governance matters, students will be able to make arguments supporting the position of
each.

 John M. O’Hare
 What We Will Cover CLASS I
 Basic governance concepts
 Ongoing hot topic. Advisory function. How do you advise a director and shareholder,
you should know their responsibilities and what each can do. Relationship between owner and
agents, so they may have some control over the people over running the company.
 Sources of Influence
 Board
 Composition
 Operations
 Fiduciary Duties and Accountability
 Protections
 Shareholders: Role and Responsibilities
 Activism
 Tactics
 Defenses
 Executive Compensation
 Focus
 How to advise a Board of Directors
 Or a shareholder interacting with a Board
 What are the Board’s responsibilities
 What are the rights of shareholders
 How to interact with shareholders

Class 1
What we will cover today:
 What is Governance?

1
  Purpose of the Corporation
 Profit maximization
 Other Constituencies
 Philanthropy
 Ken Frazier

 What is a Corporation?
Historically, before corporation was sole proprietorship and partnership.
 Entity separate from its owners
Original partnership, partnership the same as partners. As businesses expanded, there
was greater needs for obtaining financing, when the entity is not separate from owners,
and the indefinite life-that’s not good. Capital raising.

 Indefinite life
 Limited liability
The reason that it facilitates financing, is because you can invest equity without losing
nothing more than investment.
 Transferable ownership interests
Partnership is personal. If you transfer partnership interest, partnership is terminated.
This is not true in corporation.
 Centralized management

 Appointed by shareholders

Key Players (Brown Ch. 2 pp. 9-11)

 Key Players
 Shareholders
 Board of Directors
 Officers/executives
 Other stakeholders
Employees. Community. Common good in society.
 Gatekeepers

Key Players (p. 6-11)

A. Directors
§141 DGCL – Firm’s by-laws must fix the number of directors unless the number is in certificate
of incorporation

§141 (b) DGCL – directors need not be stockholders, although the certificate of incorporation or
by-laws may prescribe the necessary qualification for board directors.
Inside directors- directors employed by company; often own equity in corporation
Outside directors- directors who have no management role or other position of employment
with the corporation

II. Who´s who in Corporate Governance

2
A. Directors

Acting as a board, directors oversee the activities of the corporation.

 Select officer, approve major decisions, provide shareholders with an accounting of the
corporation´s activities.

 Directors are elected annually at the shareholder´s general meeting or by proxy voting.
They are not full time, management is done through executives and officers on a day to
day basis.

 Nominations are made by a nominating committee composed of board members.

(shareholders rarely nominate candidates).

 Directors can also be removed by the election of the majority of shareholder´s entitled to
vote, at any general meeting.

 Possible to stagger director´s terms, so the board does not turn over completely
following every election.

 Directors must be natural persons (never other corporations, partnerships, etc.).

 DGCL – 141(b) directors do not have to be shareholders, unless otherwise established in

the certificate of incorporation.

a) Inside directors: directors employed by the company (e.g. executives)

b) Outside directors: no management role nor any employment relationship. Usually bring
unique perspectives and expertise. They need to obtain information before voting on
proposals made by the board.

B. Officers

 Officers can serve as board members.

 B. Officers
- President or Secretary, CEO, CFO, Treasurer keeps track of the money while CFO
responsible with financial reporting and advise on how to raise money.
Difference between an officer and executive- officer is elected and will have fiduciary
responsibilities and
duties attached as an officer, legal duties attached as officer. The same is not true to
executives.
 Individual employees of the corporation charged with operating the firm and making
day to day business decisions.
 §141 (a) DGCL one individual may hold any number of offices so long as nothing in the
certificate of incorporation or bylaws prohibit such service.

 DGCL – 142(a) – one individual may hold any number of offices so long as nothing in
the certificate of incorporation or bylaws prohibits such service.

3
  DGCL - 142(b) – bylaws can establish the manner in which officers are selected

 DGCL – 142(a) – shareholder´s meeting´s must be recorded in a book kept for that
purpose.

CEO: highest officer; most important decisions, get reports from inferior corporate officers. It is
the public face of the company.

Sometimes, the CEO is also the chairman of the board. However, it is desirable to segregate
functions, in which case, the chairman is going to be an outside director.

(i) CEO and President as different individuals: Where the firm has a president, he will
be the one responsible for daily operations. The CEO will be free to strategize and
engage in forward-looking planning.

(ii) No CEO; only President: Whenever the company has no CEO, the president is the
highest executive.

(iii) CEO as the President

(iv) Presidents with authority limited to single divisions. E.g. marketing or sales

(v) COO and president as the same individuals: COO: Chief Operations Officer.; day-
to-day business of the corporation

(vi) COO and president as different individuals

Senior officer teams also include:

(i) secretary: records the corporation´s business; including formal records of board
meetings and shareholder meetings.

(ii) treasurer; and

(iii) chief financial officer (CFO)

C. Shareholders

 Provide equity capital to the firm. Expectation of profit. Corporation owns the assets,
shareholders own an interest in assets.

 Shareholder´s rights depends on the class of stock they hold and the terms on which the
corporation issued the shares. Common stock- simplest terms of shares. We can have
different classes of common shares, lower voting rights for some. Preferred shares –
voting or non-voting, dividends, redemption rights.

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  Vote on directors elections, amendment of charter, mergers, sales of substantially all
assets, dissolution and other important matters.

 Right to sell the shares, receive the remaining assets in case of liquidation of the
company and to dividends (in case they are declared).

 Institutions can be shareholders – institutional shareholders.

 Activists shareholders: investors who dissatisfied with its firm´s performance,

management or some company policy, attempt to influence a corporate change without
a change in corporate control.

D. Corporate Shareholders

 As stakeholders are subject to the company´s success and losses, stakeholder advocates
have pursued corporate governance reforms directed at compelling directors to consider
broader interests in managing the firm.

 There are arguments for and against stakeholder participation in corporate governance.

E. The Advisors – Gatekeepers and Governance Experts

Lawyers, accountants-responsible for policing the transactions.
Upon the scandals, financial crisis and conflicts of interests of gatekeepers have heightened the
regulations of gatekeepers.

Sarbanes-Oxley (SOX)
 Standards for auditor independence, approval and reporting;
 Public Company Accounting Oversight Board: registers and regulates public accounting
firms and sets procedures for auditing publicly traded companies.
 -creation of public company accounting oversight board
-Section 404; companies are required to report effectiveness of their internal controls
-requires top executives to personally sign that they stand by and understand the financial
accuracy of reporting on company's annual reports

What is Governance? Chapter 1 3-5

Chapter 1 – Introduction to Corporate Governance

 What is Governance?
 Relationship among players
 Government = rules of game
 Why is it needed?

Corporate Governance – refers to the host of legal and non-legal principles and practices
affecting control of publicly-held business corporations. Corporations whose security trade in
liquid investment markets, often on regulated exchanges.

5
An unlisted public company is a public company that is not listed on any stock exchange. Though
the criteria vary somewhat between jurisdictions, a public company is a company that is registered
as such and generally has a minimum share capital and a minimum number of shareholders. Each
stock exchange has its own listing requirements which a company (or other entity) wishing to be
listed must meet. Besides not qualifying to be listed, a public company may choose not to be listed
on a stock exchange for a number of reasons, including because it is too small to qualify for a stock
exchange listing, does not seek public investors,[1] or there are too few shareholders for a listing.
There is a cost to the listed entities, in the listing process and ongoing costs as well as in compliance
costs such as the maintenance of a company register.
Unlisted public companies are more likely to engage in profit-maximising behavior as their share
capital structure makes it very easy to give their members financial returns.
A liquid asset is cash on hand or an asset that can be readily converted to cash. An asset that
can readily be converted into cash is similar to cash itself because the asset can be sold with
little impact on its value. Stocks and marketable securities, which are considered liquid assets
because these assets can be converted to cash in a relatively short period of time in the event
of a financial emergency

Must and should “rules of the game “that govern the two main key players directors and
shareholders. Predictability. If you have a dozen emerging markets, with variance of rules, you
can decide where you can invest where are most consistent to your values.

Promote better decision making.

Corporate Governance primarily prescribes the control rights and related responsibilities of
three principal groups:
(1) The firm’s shareholders, who provide capital and must approve major firm
transactions
(2) The firm’s board of directors, who are elected by shareholders to oversee the
management of the corporation
(3) The firm’s senior executives, who are responsible for the day to day operations of
the corporation

The most fundamental principles of corporate governance are a function of the allocation of
power within a corporation between its stockholders and its board of directors.

Corporate governance guides the behavior of corporate management, encouraging the effective
use of company resources and making management accountable for misuse of those resources.

6
2002 - Many scandals – Enron1, WorldCom2, Tyco3, etc.
Sarbanes-Oxley Act of 2002 – specific corporate governance procedure for public companies,
institutionalizing reform by “converting what were previously voluntary “should have” best
practices into “must have” minimum standards for board structure, composition, and, some
extent, responsibility.
New York Stock Exchange and Nasdaq: revised their listing requirements – listed companies to
implement best boardroom practices.
2008 – financial crisis. Wall Street directors were criticized for approving executive
compensation practices that encouraged excessive risk-taking.
Executive´s greed and directors´ dismal oversight – bankruptcy of Lehman Brothers and other
companies4

1
The Enron scandal, publicized in October 2001, eventually led to the bankruptcy of the Enron Corporation, an American energy company based in Houston, Texas, and
the de facto dissolution of Arthur Andersen, which was one of the five largest audit and accountancy partnerships in the world. In addition to being the largest bankruptcy
reorganization in American history at that time, Enron was cited as the biggest audit failure. [1]

Enron was formed in 1985 by Kenneth Lay after merging Houston Natural Gas and InterNorth. Several years later, when Jeffrey Skilling was hired, he developed a staff of
executives that – by the use of accounting loopholes, special purpose entities, and poor financial reporting – were able to hide billions of dollars in debt from failed deals and
projects. Chief Financial Officer Andrew Fastow and other executives not only misled Enron's Board of Directors and Audit Committee on high-risk accounting practices, but
also pressured Arthur Andersen to ignore the issues.

Enron shareholders filed a $40 billion lawsuit after the company's stock price, which achieved a high of US$90.75 per share in mid-2000, plummeted to less than $1 by the end of
November 2001.[2] The U.S. Securities and Exchange Commission (SEC) began an investigation, and rival Houston competitor Dynegy offered to purchase the company at a
very low price. The deal failed, and on December 2, 2001, Enron filed for bankruptcy under Chapter 11 of the United States Bankruptcy Code. Enron's $63.4 billion in assets
made it the largest corporate bankruptcy in U.S. history until WorldCom's bankruptcy the next year.[3]

Many executives at Enron were indicted for a variety of charges and some were later sentenced to prison. Enron's auditor, Arthur Andersen, was found guilty in a United States
District Court of illegally destroying documents relevant to the SEC investigation which voided its license to audit public companies, effectively closing the business. By the
time the ruling was overturned at the U.S. Supreme Court, the company had lost the majority of its customers and had ceased operating. Enron employees and shareholders
received limited returns in lawsuits, despite losing billions in pensions and stock prices. As a consequence of the scandal, new regulations and legislation were enacted to
expand the accuracy of financial reporting for public companies. [4] One piece of legislation, the Sarbanes–Oxley Act, increased penalties for destroying, altering, or fabricating
records in federal investigations or for attempting to defraud shareholders. [5] The act also increased the accountability of auditing firms to remain unbiased and independent of
their clients.

2
But when the tech boom turned to bust, and companies slashed spending on telecoms services and equipment, WorldCom resorted to accounting tricks to maintain the
appearance of ever-growing profitability. By then many investors had become suspicious of Ebbers’ story — especially after the Enron scandal broke in the summer of 2001.
Shortly after Ebbers was forced to step down as CEO in April 2002, it was revealed that he had, in 2000, borrowed $400 million from Bank of America to cover margin
calls using his WorldCom shares as collateral. As a result, Ebbers lost his fortune.

Cooking the Books

This was not a sophisticated fraud. To hide its falling profitability, WorldCom had simply inflated net income and cashflow by recording expenses as investments.
By capitalizing expenses it exaggerated profits by around $3 billion in 2001 and $797 in Q1 2002, and reported a profit of $1.4 billion instead of a net loss.

3
CEO Kozlowski allegedly took more than $100 million in compensation that wasn't approved by the Tyco Board of Directors. 2002

4
Controversy of executive pay during crisis[edit]

Richard Fuld, head of Lehman Brothers, faced questioning from the U.S. House of Representatives' Committee on Oversight and Government Reform. Rep. Henry Waxman (D-
CA) asked: "Your company is now bankrupt, our economy is in crisis, but you get to keep $480 million (£276 million). I have a very basic question for you, is this fair?" [58] Fuld
said that he had in fact taken about $300 million (£173 million) in pay and bonuses over the past eight years. [58] Despite Fuld's defense on his high pay, Lehman Brothers
executive pay was reported to have increased significantly before filing for bankruptcy. [59] On October 17, 2008, CNBC reported that several Lehman executives, including
Richard Fuld, have been subpoenaed in a case relating to securities fraud. [60]

Accounting manipulation[edit]

In March 2010, the report of Anton R. Valukas, the Bankruptcy Examiner, drew attention to the use of Repo 105 transactions to boost the bank's apparent financial position
around the date of the year-end balance sheet. The New York attorney general Andrew Cuomo later filed charges against the bank's auditors Ernst & Young in December 2010,
alleging that the firm "substantially assisted... a massive accounting fraud" by approving the accounting treatment. [61]

On April 12, 2010, a story in The New York Times revealed that Lehman had used a small company, Hudson Castle, to move a number of transactions and assets off Lehman's
books as a means of manipulating accounting numbers of Lehman's finances and risks. One Lehman executive described Hudson Castle as an "alter ego" of Lehman. According
to the story, Lehman owned one quarter of Hudson; Hudson's board was controlled by Lehman, most Hudson staff members were former Lehman employees. [62]

7
Financial upheaval + economic recession: generated reviewed political support for corporate
governance reform, especially in major banks.
Corporate Governance – refers to the host of legal and non-legal principles and practices
affecting control of publicly-held business corporations. Usually related to public companies.
Corporate governance affects: allocation of risks and returns

Publicly-owned corporations employ diverse governance structures.

Charter and bylaws: determine the allocation of power among the firm´s BoD, executive
managers and shareholders.

Separation of Ownership and Control; Berle and Means (Brown Chapter 1; pp. 11-14)

 Berle/Means: Separation of Ownership and Control

Passive shareholders, growing divide between the owners and executives who are
running the corporation. Board and executives are not shareholders so there is no unity
of interest.
Shareholders interest- profit maximization
Board interest- professional managers, they were no longer family, owners of
shareholders. They do not have incentives through stock ownership. They are in it for
deals, prestige, incentive to make the company big (sometimes, not necessarily not
profitable)
What they were most concerned about is conflicts and fiduciary duties.
Advent of the age of governance. Berle 1930s.

 Who is the owner? Who has the power? Who has the responsibility?
 Interests not aligned – change from past
 Interests of shareholders (owners)
 Maximize profits; distribute income
 Manage risks
 Interests of managers (directors/officers)
 Lack same incentives
 Personal profits /conflicts/prestige
 Interests often opposed
 Rules (governance) required

III. The Enduring Puzzle of Corporate Governance

When then owner of a company was also in control of such a company, he could run the
company in accordance to his own self-interests. Those in control will be able to run the
company in accordance with the owner´s interest on the degree that their interests meet with
the owner´s interests. If their interests do not meet, this will depend on the checks on the use of
power which may be established by political, economic or social conditions.

Agency theory – corporate manager (agents) are economically self-interests and will be not
acting to maximize the interests of shareholders (principals). In order to reduce these agency
costs, some systems of legal and non-legal rules and norms is needed to align the interests of
management with the interests of shareholders and to incentivize management to act in
corporations´ best interest.

8
Berle and Means favored the imposition of judicially-imposed fiduciary duties on
management, revising corporate law to treat corporate managers much like the law of trusts
regards trustees.
In addition, they advocated for an equitable limitation of powers of corporate management.

Historical Development of Governance Brown Ch. 14-27

 Evolution of Governance
 Historically – family/founder controlled
 Shareholder profile
 Post-WWII – CEO centric
Berle and Means shareholders were Small investors and passive and then in the 1950s
there was a significant raise of institutional shareholders after expansion of middle
class. Mutual fund- give me your money and all your friends too and I can buy a
diversified portfolio for you. Blackrock. The impact of this gave rise to Rise of activism.
 Rise of institutional shareholders
 Shareholder value and equity compensation
 Board oriented mgt - independent directors
In the old days, the board were buddies of the CEO.
 Delaware fiduciary standards
 Regulation: FCPA/audit, SOX, Dodd-Frank
 Rise of activism
 What is Governance?
 Who controls the corporation?
 What is the purpose of the corporation?
 Allocation of risks and rewards
 Allocation of rights and responsibilities

IV. The Corporate Governance Revolution

`
Brian R. Cheffins, Did Corporate Governance “Fail” during the 2008 Stock Market
Meltdown? The case of S&P 500

 2008 – financial crisis.5 Changes in the business of investment banks.

 The stock market meltdown as a result of weakness in corporate governance
arrangements.

5
The financial crisis of 2007–2008, also known as the global financial crisis and the 2008 financial crisis, is considered by many economists to have been the worst financial
crisis since the Great Depression of the 1930s.[1][2][3][4]

It began in 2007 with a crisis in the subprime mortgage market in the United States, and developed into a full-blown international banking crisis with the collapse of the
investment bank Lehman Brothers on September 15, 2008.[5] Excessive risk-taking by banks such as Lehman Brothers helped to magnify the financial impact globally.
[6]
 Massive bail-outs of financial institutions and other palliative monetary and fiscal policies were employed to prevent a possible collapse of the world financial system. The
crisis was nonetheless followed by a global economic downturn, the Great Recession. The European debt crisis, a crisis in the banking system of the European countries using
the euro, followed later.

In 2010, the Dodd–Frank Wall Street Reform and Consumer Protection Act was enacted in the US following the crisis to "promote the financial stability of the United States".
[7]
 The Basel III capital and liquidity standards were adopted by countries around the world

9
  Legislative response: Sarbanes-Oxley Act of 2002

In order to assess the responsiveness of Corporate Governance to the stock market turmoil in
2008, it is necessary, to identify the Key corporate governance mechanisms in public companies
and ascertain the role they are expected to play to shareholders

History- reveals corporate governance challenges and fixes.

After war:
US prospering, shareholders profited
Internal governance of companies was not a priority
Stockholders only cared about dividends and prices of the stock
“managerial -oriented model of the corporation”

CEO´s pay was basically composed by salary´s, in accordance with the size of the company. It
incentivized growth through acquisitions, which is not a good deal for stockholders. Numerous
deals failed to live up to expectations and destroyed shareholder value, i.e., Penn Central.

1970´s – International telephone and Telegraph: corruption scandals. Other companies started
to admit their own corruption attitudes.

The corporate governance counter-reaction

Widespread awareness that directors had been passive amidst the Penn Central Collapse and
“questionable payments” scandal fostered a consensus that boards of public companies should
proactively exercise independent oversight so as to enhance managerial accountability 6.

1977 – NYSE, at the request of SEC, has amended their listing requirements: each listed
company to maintain an audit committee composed of independent directors
Public companies were already restructuring their boards even before that towards a more
active and independent board.

1980s -outside directors has won. Increasing vigilant as monitors, mandate to scrutinize
executives.

1993- Congress endorsed the idea that executive pay should be dealt with by independent
directors.

Rise of institutional investors (pension and mutual funds)

6
The financial crisis of 2007–2008, also known as the global financial crisis and the 2008 financial crisis, is considered by many economists to have been the worst financial
crisis since the Great Depression of the 1930s.[1][2][3][4]

It began in 2007 with a crisis in the subprime mortgage market in the United States, and developed into a full-blown international banking crisis with the collapse of the
investment bank Lehman Brothers on September 15, 2008.[5] Excessive risk-taking by banks such as Lehman Brothers helped to magnify the financial impact globally.
[6]
 Massive bail-outs of financial institutions and other palliative monetary and fiscal policies were employed to prevent a possible collapse of the world financial system. The
crisis was nonetheless followed by a global economic downturn, the Great Recession. The European debt crisis, a crisis in the banking system of the European countries using
the euro, followed later.

In 2010, the Dodd–Frank Wall Street Reform and Consumer Protection Act was enacted in the US following the crisis to "promote the financial stability of the United States".
[7]
 The Basel III capital and liquidity standards were adopted by countries around the world

10
strong proponents of shareholder value. Shifted from traditionally, “Wall Street rule” and sell.
Coming from a position of strength since held high number of shares in public companies.

-initially focused on anti-takeover measures. 1980s Deal Decade

- pay for performance instead of pay for size; equity based compensation

Then Came Enron

- Corporate governance scandals.

Sarbanes-Oxley Act of 2002 (SOX)

-new requirements on public companies and executives and directors.
Imperfections addressed by regulatory intervention since US system of market-oriented
capitalism was successful
-part of larger process of strengthening corporate governance rather than departure from past
trends

- Mandated changes in NYSE and NASDAQ National Market listing rules

- Financial reporting oversight. Dark side to option based compensation- more stock
options more fraud, manipulate earnings to maximize pay-outs (Enron)

Private Equity

Most important market-inspired component of the U.S. Corporate governance infrastructure is

the market for corporate control.

While private equity is known for taking companies off the stock market, the surge in private
equity buyouts catalyst for better corporate governance among publicly-traded companies
generally.

Hedge Fund Activism

Purpose of the Corporation

 Purpose of the Enterprise
 Profit “maximization” – historical test
 BUT not always so simple

Profit Maximization (831-832); Klein pp. 252-256 – Shensky

Profit maximization- Boards are legally obligated to act in the best interest of the corporation
and shareholders
-corporations should not be in the business of redistributing wealth; although this view has
been challenged. Some states have adopted statutes that permit charitable contributions.
Some argue that corporations should also consider other non-shareholder interest: suppliers,
employees to the community
Shareholder constituency statutes- allow directors to at least sometimes consider stakeholders
in making decisions. Controversial.
Private ordering- codes of conduct and ethics for employees.

11
Global Company- a set of voluntary standards developed by the United Nations that seeks to
elevate corporate behavior with regard to human rights, labor standards and the environment
and corruption.

Alien Tort Claims Act- statute adopted by the first Congress, actions can be brought in US
courts against corporations that violate internationally accepted standards of human rights.
Antiterrorism Act of 1991

 Deference to Business Judgment

 Dodge v. Ford – supply cars to the masses
 “a business corporation is organized and carried on primarily for the profit of the
stockholders”
Great deference to the judgment of the board
 Shlensky - “day baseball” less profitable
The Court buys into Wrigley’s argument that this is good for business and this is in the
end good for business. Its going to pay off in the long term. For as long not illegal, not
fraudulent.
 BUT: community impact, cost of lights
 No allegation of financial harm
 Directors decide subject to three exceptions
 eBay v. Newmark – Craig’s List no ads
 Courts won’t question non-stockholder interests – making charitable contributions,
paying employees higher salaries or more general norms of corporate culture as long as
they ultimately promote stockholder value

Shlensky v. Wrigley
Illinois Appellate Court
237 N.E.2d 776 (1968)

Rule of Law
As long as a corporation’s directors can show a valid business purpose for their decision, that
decision will be given great deference by the courts.

Facts
The first game of night baseball was played in 1935, and since then, every team except the
Chicago Cubs began playing night games. Most major league games were night games, except
those played on weekends. The Cubs did not play night games. As a result, the Cubs sold fewer
tickets and were less profitable than any other major league team.

Philip Wrigley (defendant), the President of the Chicago National League Ball Club (defendant)
and owners of 80% of shares, which owned the Cubs, was opposed to playing night games,
claiming that night games would be damaging to the neighborhood in which the Cubs played.
The corporation owns and operates Wrigley Field, the Cub’s home park.

Shlensky (plaintiff), a minority shareholder, filed a derivative suit against the directors and
management, claiming that it would be financially practicable for the Cubs’ stadium to install
lights and begin playing night games, and would be very profitable in the long run. He said that

12
the Cubs, in the years 1961-1965 sustained operating losses from direct baseball operations and
the losses are attributable to inadequate attendance at Cubs’ home games.
Shlensky alleged that the only reason the Cubs did not play night games is because Wrigley felt
it was somehow against the spirit of baseball, baseball being a “daytime sport” and that
installation of lights and night baseball games will have affect the neighborhood. The trial court
dismissed the action, and Shlensky appealed.

Issue

Can a single aggrieved shareholder sue a board of directors alleging that the board is not
maximizing profits?

Holding and Reasoning (Sullivan, J.)

No. A corporation’s president and board have authority to determine what course of action is
best for the business. While the president and board must have a valid business purpose behind
their actions, a decision motivated by a valid business purpose will be given great deference.

Plaintiff argues that the directors are acting for reason unrelated to the financial interest and
welfare of the Cubs. In this case, while Shlensky may disagree with the board’s course of
action, Wrigley could have reached the legitimate business conclusion that the Cubs were better
off not playing night games. Wrigley and the board may be concerned about maintaining
goodwill in the community from which the Cubs draw their fans; or they may be concerned
about the costs of operating the lights.

Wrigley and the board may have determined that night games would not have brought in
additional revenue. Indeed, while Shlensky was able to prove correlation between night games
and ticket sales for other teams, he did not prove that night sales would actually be beneficial to
Cubs shareholders. Shlensky did not prove that night games would increase ticket sales, and
did not prove that any potential increases in ticket sales would offset potential increases in
costs. No convincing showing has been made that Wrigley and the board were acting in
anything but the corporation’s best interest. Accordingly, the trial court’s determination that the
complaint should be dismissed is affirmed.

Section 2.01(b) of the ALI

 ALI Corporate Governance Principles

 Objective and conduct of corporation
 Structure – management
 Duties of directors, officers and controlling shareholders
 Control transactions and tender offers
 Remedies – derivative actions

Principles provides that:

13
 (a) A corporation should have as its objective the conduct of business activities with a view
of enhancing corporate profit and shareholder gain. (does not say maximize or long
term)
(b) Even if corporate profit and shareholder gain are not thereby enhanced, the corporation,
in the conduct of its business: (1) Is obliged, to the same extent as a natural person, to act
within the boundaries set by law (Moonves violated the law); (2) May take into account
ethical considerations that are reasonably regarded as appropriate to the responsible
conduct of business; and (3) May devote a reasonable amount of resources to public
welfare, humanitarian, educational and philanthropic purposes.” (just a
recommendation)

Other Constituencies Brown Chapter 11 pp. 856-860

 “Other Constituencies” (tool in a your toolbox, it is not a mandatory requirement;

Delaware same principle applies but not in statutes but in cases in the context of
mergers and acquisitions; consider constituencies in a take over attempt. Unocal
analysis you are maximizing value and you can consider constituencies)
 Directors may consider:
 “Employees, customers, suppliers, creditors, communities”
 Economic and societal goals
 Long-term and short-term interests
 “In considering the best interests of the shareholders….” Most statutes use this phrase
 But Illinois (does not have this requirement of best interest of shareholders)

Committee on Corporate Law, Report on Other Constituencies Statutes: Potential for

Confusion

All of the statute incorporate one or more of the following provisions:

1. The directors may consider the interest of, or the effects of their action on, various non-
stockholder constituencies.

2. These constituencies may include employees, customers, creditors, suppliers, and

communities in which the corporation has facilities.

3. The directors may consider the national and state economies and other community and
societal considerations.

4. The directors may consider the long-term as well as the short-term interests of the
corporation and its shareholders.

5. The directors may consider the possibility that the best interest of the corporation and its
stockholders may be served by remaining independent.

6. The directors may consider other pertinent factors.

7. Officers may also be covered.

14
Better interpretation of statute: directors may take into account the interest of other
constituencies but only to the extent that the directors are acting in the best interests, long as
well as short term, of the shareholders and the corporation.

Corporate Philanthropy
 Philanthropy
Is ok for as long as reasonable.
 Initially not permitted
 Inconsistent with wealth maximization
 Ultra vires

§ Del 122 (9) Delaware has provided that corporations have the authority to “make donations
for the public welfare or for charitable, scientific or educational purposes, and in time of war or
other national emergency in aid thereof.

The statue is silent on whether the contribution must be supported by a business purpose. The
matter has been left to the courts.
 A.P. Smith v. Barlow - permitted if some benefit to business
 Theodora Holding v. Henderson
Logic-it was given to a internal revenue recognized foundation. Its interesting that it
was a grant of a land to set up camp for underprivileged children, the cause was a
contributing factor in the analysis of the court. The Head of Company also lived in the
ranch, although court did not pay attention into this.
 Facts? Test?
 DGCL §122(9) - charitable donations
 May authorize in charter

Theodora Holding Corp. v. Henderson

Delaware Court of Chancery
257 A.2d 398 (Del. Ch. 1969)

Rule of Law
Corporations can make valid donations for charitable purposes.

Facts
Girard Henderson (defendant) had a controlling interest in Alexander Dawson, Inc. (Alexander
Dawson) (defendant) and dominated its corporate affairs. The defendant's ex-wife owned a
large amount of the corporations’ stock through Theodora Holding Corp. (plaintiff).
Over the years, Henderson had caused Alexander Dawson to make charitable contributions to
the fAlexander Dawson Foundation (the Foundation), a legitimate charitable organization
recognized by the Department of Internal Revenue.
In 1967, Alexander Dawson had a total income of $19,144,229.06. In April of the same year,
Henderson asked the board to approve a gift of company stocks valued at $528,000 (Prior to
tract of land in Colorado gift) to the Foundation to finance a camp for under-privileged boys in
Colorado. Although one director objected, Henderson got board approval of the gift by getting

15
rid of five directors. Theodora Holding Corp. brought suit against Alexander Dawson, Inc. and
Henderson in Delaware Court of Chancery, challenging the gift.
Issue
Can corporations make valid donations for charitable purposes?
Holding and Reasoning (Marvel, J.)

Yes.

Under Delaware law, Delaware corporations can make valid donations for charitable purposes.
Del. Code tit. 8, § 122. In A.P. Smith Mfg. Co. v Barlow, 98 A.2d 581 (1953), the Supreme Court of
New Jersey upheld a $1500 corporate gift to a university. The court also held that a charitable
gift made by a corporation must be reasonable both as to amount and purpose to be valid. This
court concludes that test of the validity of a charitable gift by a corporation is that of
reasonableness.

The provisions of the Internal Revenue Code regarding charitable gifts by corporations provide
a helpful guide.

In this case, the Foundation is a legitimate charitable organization recognized by the

Department of Internal Revenue, and thus the gift to the Foundation is a charitable donation.
Further, in 1967, Alexander Dawson, had a total income of $19,144,229.06. The $528,000
corporate gift was well within the federal tax deduction limitation of 5 percent of the total
income. In addition, the gift reduced the Alexander Dawson unrealized capital gains taxes by
$130,000, which increased the balance-sheet net worth of stockholders of the corporation. The
relatively small loss of income otherwise payable to shareholders is "far out-weighed by the
overall benefits" of the gift, which will provide under-privileged young people with
rehabilitation and education. Therefore, the charitable gift is reasonable and thus valid.

M. Todd Henderson & Anup Malani

Essay: Corporate Philanthropy and the Market of Altruism

Philanthropy helps a firms bottom line and can be a source of competitive advantage.
Corporate philanthropy reflects a blend of motives.

In light of the inevitable mixed motives and the inability of courts to distinguish ex post
between “good” and “bad” philanthropic decisions made by firms, the law takes a very
agnostic view. In this way, the law’s perfect permissive attitude toward corporations doing
good (in all forms) is an inevitable result of the business judgment rule: Courts avoid second
guessing business in an attempt to minimize the sum of decision costs and error costs, and the
decision to act charitably, whether it is by donating money or not acting badly, is a
quintessential business decision.

The Delaware General Corporation Law grants every corporation the specific power to “make
donations for the public welfare or for charitable, scientific or educational
purposes…” D.G.C.L. Section 122(9). The giving of contributions is therefore considered under
Delaware corporation law to be within “ordinary business operations.” 

16
 Kenneth Frazier
 Why did he take a stand?
Stand against extremism.
Kenneth Frazier, chief executive of Merck- one of the biggest drugmakers in America
made a public stand against Trump. (offshoot of Trump’s reaction to Charlottesville
clash between white nationalists and counter-protesters, in which a woman was killed)
Mr. Frazier resigned from Mr. Trump American Manufacturing Council, one of several
advisory groups the president formed in an effort to forge alliances with big business.
Only African American who joined the group
(Uber’s Travis Kalanick also quit earlier over Trump’s strict immigration rules)
 What are the risks?
Mr. Trump chastises companies that displease him, i.e., Boeing and Lockheed Martin,
sending share prices tumbling. (but Merck stock went up slightly)

While big companies are increasingly willing to take public stands on many
contentious social issues, they also covet their access to a business-friendly White
House and are being careful not to jeopardize their relationship with the President.
As the day went on, no one supported Mr. Frazier. While other top executives
(Blackstone group, Dell, A.F.L. C.I.O) made statements denouncing racism and bigotry
generally, none criticized Mr. Trump directly or lent their support to Mr. Frazier.
Several hours after Mr. Frazier’s statement, Mr. Trump offered the sharp denunciation
of racism that was lacking over the weekend.

 What should he have done?

 What does the law require?
 What does the law permit?
 What would you have done?

The Moral Voice of Corporate America

Chief executives face pressures, and speaking up can create uncertainty. Customers offended,
colleagues can feel isolated, and relations with lawmakers can suffer. Words can backfire and
public relations disasters. All this as a chief executive is expected to constantly grow sales.

But executives also face pressure from within- employees and board members concerned with
reputational issues.

In short, while companies are naturally designed to be moneymaking enterprises, they are
adapting to meet new social and political expectations in sometimes startling ways. Not every
decision is an economic one.

Indiana came out with watered down version of law (originally did not allow religious service
to gay people) after Mr. Benioff cancelled all salesforce events in the state and threatened to
relocate employees.

Elon Musk of Tesla and Iger of Disney- resigned from presidential advisory councils.

After Charlottesville- business world action went beyond donations to charity and pledges to
plant trees that once defined corporation social responsibility.

17
Those executives who go out on a limb know the risk. We all recognize that with every decision
we make, there is a group of people that are not going to agree with us. But you must define
your core purpose for being. We stand in the interest of something greater than just making
money. Schultz.

 Discussion Questions
 Are directors equipped to oversee?

 Should shareholders have a role in management?

 What “rights” are appropriate?
 How can institutional shareholders exert influence?
 What should be the purpose of a corporation?
 Does governance really matter?
 Who is best to “affect” governance matters?

SOURCES OF INFLUENCE

COVERAGE CLASS 2
 Sources of Governance Principles
There are lot of places to look, legal, quasi-legal, non-legal, market forces. Governance
has evolved, academics have played a part.
 State Law
 Evolutionary and revolutionary
 Federal Law
 Typically revolutionary – reaction to crises
 Exchanges and SRO’s
 Accounting Rules
 Best Practices
 ISS/Glass Lewis
 Academic, Political, Journalistic
 Market Forces – Activism

Trend is for people investing in passive mutual fund and index 7. They simplify the market,
Index fund would buy the stock in the SMP index, they hold the stocks and they hold them
passively forever. They just ride the economy. When it’s a broad economy, the motivation for a
broad investment portfolio is for the economy to be better.

Principle of maximization of profits – a lot of subjectivity involved. Its not as black and white.

7
The main difference between index funds and mutual funds
What really sets index funds apart from actively managed mutual funds is that with index funds, you always know what you're getting. An index fund that tracks the S&P 500
will provide a return equal to that of the S&P 500, less any expenses that the fund incurs. Index funds typically have low costs, with the cheapest choices charging less than 0.1%
per year in expenses.

By contrast, actively managed mutual funds have a broad mandate to invest in stocks that meet certain criteria. You can find out what a fund holds when it releases its portfolio
holdings in its SEC-required reports, but those holdings are out of date by the time they're printed, and funds are not required to update investors on their latest holdings.
Indeed, the semi-secret nature of an actively managed fund's proprietary picks is what gives it a chance to outperform its index-tracking counterparts. However, actively
managed funds are almost always more costly, and annual fees of 1% or more are fairly common.

18
State Law Brown Chapter 2 pp. 29-34
Chapter 2
Corporate Governance, Path Dependency and the Sources of Regulation
Corporate Governance is regulated by several bodies: states, self-regulatory organizations
(such as stock exchanges), federal government (particularly SEC).

SEC
 Created in 1934 to weaken enforcement of securities laws. Independent federal agency
 Sec’s Role in governance process was mostly Limited to ensure adequate disclosure by
listed corporations and to overseeing the proxy solicitation process.
 Currently, SEC has been gaining additional responsibilities and has been involved with
corporate governance.

Stock exchanges
 Originally created as private organizations for trading securities
 After securities laws, they gained regulatory responsibilities
 Subjected to oversight by SEC
 Stock exchange deal with corporate governance through the listing requirements.

States
Internal affairs doctrine:
The rights of directors and shareholders are determined by the state of incorporation.
State of incorporation sets:
(i) the fiduciary standards; and
(ii) the voting rights for shareholders.

The state of incorporation is chosen by the most favorable law.

 State Law
 Existence - creatures of state law
Before, specially chartered corporations initially to promote the development of public works,
i.e., New York corporation to construct of Erie Canal. Required by a state legislature.

Then expansion of commerce from 15 states to 30 states. It did not make sense for a corporation
to be able to do business only in the state where it was incorporated. Standard Oil organization
consisted of many individually chartered corporations and they put them all in a trust.
Standard Oil acted to act in violation of anti-trust. So what they do was to break up Standard
Oil- progeny of those companies consist of 75% of oil and gas in US. As businesses continued to
cross state lines, New Jersey provided that a corporation incorporated in New Jersey can do
business outside New Jersey. Also, no need for a statute.

 Characteristics of modern corporate law

 Basic concepts
 Separate legal entity
 Limited liability
 Transferability
 Delegated management
 Broadly available

19
 Broad purpose and powers
 Ultra vires
 No geographic limitation
 What Law Governs?
 Internal affairs doctrine
Differentiate it with operation. Speeding law does not care about the shareholders but to protect
of the people of Illinois. Corporate governance is about relationship between owners and
managers.
 What is it?
 Alternatives?
 Compare to forum selection?
 California

 Qualification
Mandatory principles

State Law Brown Ch. 2 pp. 29-34

State Regulation
Most significant player in the corporate governance process.

The Internal Affairs Doctrine

Under the internal affairs doctrine, the rights of directors and shareholders are determined
by the state of incorporation. In determining the state of incorporation, companies will pick
the most favorable law.

“The internal affairs doctrine is a conflict of laws principle which recognizes the that only one
State should have the authority to regulate a corporation´s internal affairs – matters peculiar to
the relationships among or between the corporation and its current officers, director and
shareholders – because otherwise, a corporation could be faced with conflicting demands”. 

Internal affairs doctrine (“IAD”): ensures that such issues as (i) voting rights of shareholders,
(ii) distributions of dividends and corporate property, and (iii) the fiduciary obligations of
management are all determined in accordance with the law of the state in which the company
is incorporated.

Faith Stevelman, Regulatory Competition, Choice of Forum, and Delaware´s Stake in

Corporate Law
Corporate Law:
 First, the premise was that “corporations are creatures of state law” (reference to the
charter). However, it ignored the fact that Congress could federalize corporate law for
companies engaged interstate commerce.
 More modern – contractualist approach of corporate law. Corporations = nexus of
private contracts among the factors of production. Respect for choice of law and choice
of forum.

“Lex incorporationis”:
 The rule of corporate law of the incorporating state sticks to the corporate internal affairs
provides a clear, stable rule for resolving conflicts of law questions.

20
  The IAD dictates the law that will apply

IAD is codified in the Restatement (Second) of Conflicts of Law

 Basic premise: the corporate law of the state of incorporation will govern a corporation´s
internal affairs doctrine, regardless of where any dispute is litigated;
 Expansive definition of corporate internal affairs
 Singularity in choice of corporate law – corporation internal affairs should be governed
exclusively by the law of the state of incorporation

MBCA – Revised Model Business Corporation Act8

 Singularity of choice of law
 Section 15.05(c) - States complying with its choice of law dictates should refrain from
“interfering” in other states´ corporation laws, i.e. from amending or supplementing
foreign corporation´s internal affairs provisions.
 Corporate actors can predict which state´s law s will define their rights and obligations.
 Consequences:
a) Parity – in the treatment of shareholders;
b) Predictability – important for commercial arrangements and business.

Internal affairs doctrine is not limited to the “state of incorporation”. The IAD typically applies
to companies incorporated in other countries, which can result in different principles of
corporate governance.

Internal Affairs doctrine Brown pages 37-44

 What Law Governs?
 Internal affairs doctrine
Doctrine of convenience. The consensus, as validated by court cases and restatement (by
advisory group),
 What is it?
 Alternatives?
 Compare to forum selection?
 California
 Qualification
 Mandatory principles
 Comity?

A corporation respecting the law in another state. Willingness of other states to apply the
internal affairs doctrine. Federal law on comity that states should respect the laws of each other.
Consistent with commerce clause.

Many states have sought to adopt additional requirements designed to protect investors and
shareholders by extending to them additional governance rights to foreign corporations
operating in the state. In this sense, California has been very aggressive.

8
The Model Business Corporation Act (MBCA) is a model set of law prepared by the Committee on Corporate Laws of the Section
of Business Law of the American Bar Association and is followed by twenty-four states. It has been influential in shaping standards
for United States corporate law

21
An example of this can be found in Cal. Corp. Code §2100, which states that this chapter only
applies to foreign corporations transacting intrastate business.

Other example is found in Cal. Corp. Code §2115:

Foreign corporations and foreign parent corporations subject to general corporation law;

Formula for determining property, payroll and sales factors; applicable provisions:

“(a) A foreign corporation (other than a foreign association or foreign non-profit

corporation but including a foreign parent corporation even though it does not
itself transact intrastate business) is subject to the requirements of subdivision
(b) commencing on the date in subdivision
(d) and continuing until the date specified in subdivision
(e) if:

(1) The average of the property factor, the payroll factor and the sales factor (as defined
in Sections 25129, 25132 and 25134 of the Revenue and Taxation Code) with respect
to it is more than 50 percent during its latest full income year and
(2) more than one- half of its outstanding voting securities are held of record by persons
having addresses in this state appearing on the books of the corporation on the
record date for the latest meeting of shareholders held during its latest full income
year, or if no meeting was held during that year, on the (…)
(b) except as provided in subdivision (c), the following chapters and sections of this
division shall apply to a foreign corporation as defined in subsection (a) (to the
exclusion of the law of the jurisdiction in which it was incorporated):
Section 303 (removal of directors without cause)
Section 708, subdivisions (a), (b), and (c) (shareholder’s right to cumulate votes at
any election of directors;
Section 710 (supermajority vote requirement) (…)”

Corporation subject to the statute must provide for cumulative voting, right to remove directors
without a cause and is forbidden, in general, to adopt supermajority provisions that require a
percentage above two-thirds.

Wilson v. Louisiana- Pacific resources, Inc.

California Court of Appeals
138 Cal. App. 2d 216 (1982)

Issue: whether the State of California may constitutionally impose its law requiring cumulative
voting by shareholders upon a corporation which is domiciled elsewhere, but whose contacts
with California, as measured by various criteria, are greater than those with any other
jurisdiction.

Palintiff: Ross A. Wilson

Defendant: Pacific resources, Inc., a Utah corporation.

22
Years preceding the action, the average of defendant’s property, payroll, and sales in California
as defined by the Corporations statute exceeded 50 percent (payroll, employees) , and that
more than 50 percent of its shareholders entitled to vote resided in California , so that the
statutory conditions are met. (California eliminated the battle of states by putting in this
limitations.) Except for being domiciled in Utah and having a transfer agent there, defendant
had virtually no business connection with Utah, that its principal place of business has been in
California since 1971, including meetings with shareholders and directors and all employees
and all bank accounts in California.

Courts goes on explaining the full faith and credit clause included in the federal Constitution
(art.IV,§1), which states that full faith and credit… be given in each State to the public acts,
Records, and Judicial Proceedings of other State. The Supreme Court has recognized that there
must not be a rigid and literal enforcement of this clause, without regard to the statute of the
forum. Otherwise in case of conflict, the statute of each state would be enforced in the other
state but not on its own.

Alaska Packers Doctrine- it is presumed that every state is entitled to enforce in its own courts
its own statutes, lawfully enacted. One who challenges that right because of the force given to a
conflicting statute of another and state by the full faith and credit clause, assumes the burden of
proving under a rational basis, that the conflicting interests involved are superior in the foreign
state over the forum’s state.

Test: for the state’s substantive law to be selected, such state must have significant contact or
significant aggregation of contacts, creating state interests, such that the choice of law in
neither arbitrary nor fundamentally unfair.

Court considers that the test is met in this case.

Utah has no interests offended by cumulative voting and the interests of California
overweigh its interests. The majority of the shareholders and business activity is located in
California. So even under the Alaska Packers analysis, there full faith and credit clause provides
no bar to the application of California’s statutes.

Internal affairs doctrine- courts looked to the law of the state of incorporation in resolving
questions regarding the corporation’s internal affairs. It has no application in this case, as it is
inconsistent with the application of the “comparative impairment” approach used by this state
in resolving conflict of law problems.

The court concludes that the mandate is constitutional.

Standard set by the US Supreme Court for determining the validity of the state statutes- where
the statute regulates even-handedly to effectuate a legitimate local public interest, only having
incidental effects on interstate commerce , then it shall be upheld (Pike test). The exception
would be if the burden imposed on such commerce is excessive in relation to the local benefits.

The court establishes that the statute being challenged regulates equally to corporations
domiciled within the state and foreign corporations, applying no distinct burden upon out-of-

23
state interests. As the majority of its business and the shareholders can be resident at one state at
a time, then the requirements of the state are met.

California legislature requires a rational means to allocate the regulation of a corporation to the
state to which it is primarily related, through a narrow exception to the internal affairs doctrine
in situations in which California’s interests are clearly paramount.

Conclusion: the cumulative voting requirement imposed by section 2115 upon pseudo-foreign
corporations is shown to have any effect upon interstate commerce, the effect is incidental and
minimal in relation to the purpose, which that requirement is, designed to achieve.
Note that the internal affairs doctrine has received broad acceptance during the last 20 years.

Race to the Bottom Brown Chapter 2 pp. 51-54

 “Race to the Bottom”

 Professor Carey
 Management friendly legislation
 Federal corporate law?
 Minimum standards
 SOX?
 New Jersey experience
New Jersey was running out of money and wanted to attract incorporation by providing that
corporations incorporated there can engage in business in other states. Franchise Fees. Now
Delaware because laws are more permissive but its not nearly as permissive these days as was
before (Van Gorkon).
 Where “best” to incorporate?
 Delaware currently dominates – why?
 Permissive?
 Efficient?
 Predictable?

Delaware attracts incorporators because they are predictable:

1. they have long opinions. Like law review articles – a lot of dicta in
Delaware Supreme Court decisions.
2. Chancery court is the trial court, heavily business case oriented.

3. Training program in Chancery and then judges are elevated in Supreme

Court.

4. Judges are very frequent speakers in seminars. Chief Justice Leo Strine is
the Chief Justice of Supreme Court of Delaware attends Garrett and you
can get a lot as to where the law is headed.
Case law is very well developed because of the volume of cases
 “Race to the top”?
 Real life??

24
J. ROBERT BROWN Jr., The Irrelevance of State Corporate Law in the Governance of Public
Companies.

Management determines the state of incorporation and has an incentive to incorporate in a

state that most meets its objectives.

Competition for charters among states/race

- State has incentive to implement an approach favored by management, i.e., Delaware
does not impose sales tax, so considerable tax revenues (franchise tax) for companies
incorporating within state. When Delaware amended state law to waive monetary liability
for breach of duty of care, a number of corporations moved to the state; permits liberal
use of poison pills.
- Race to the top- Management has an incentive to incorporate in the jurisdiction that
provides the most efficient corporate law. Maximize profits
- Race to the bottom- Management will choose a jurisdiction that favors its own self-
interest.
50 states to choose from. Future managers will decide what state to choose. Managers will
choose the one to the lenient rules that applied to managers.

Only those areas important to management to result in reincorporation can be explained as a

product of competition among states. Three areas seem likely to be paramount importance to
management:

(1) Maximizing decision making flexibility (particularly for self-dealing transactions)

(2) Minimizing liability (particularly for breach of fiduciary duties) and
(3) Job preservation.

Federal Law Brown Chapter 2 pp. 117-118

 Federal Law
 Governance regulation rare historically
In the past, the most common place where you can find governance based are in securities
regulations. Disclosure requirements.
 Securities regulation disclosure based
Securities Law passed in 1930s which prohibited the short swing transaction of
directors.
 Expansion typically follows a crisis
 Insider Short-Swing Profits Recovery
 Williams Act
1960s dealt with Tender Offer regulations
 Foreign Corrupt Practices Act
1970s. Prohibited bribing foreign officials so books and records requirements.
 Sarbanes-Oxley
After Enron. Substantive governance related law.
 Dodd-Frank
Was in response to the 2008 financial crisis. Contained some things primarily
directed to executive compensation.
 Social and political issues

25
 Included with Securities Laws but did not have anything to financial- reporting
requirement to disclose if products had black diamonds, or oil extractions. Many have
been overruled by courts. This last point is a history point.

 Federal/ State Symbiosis

 Shareholder voting/proxy regulation
Federal Proxy regulations
 Takeover defense/tender offer regulation
 Conflicts/related party disclosure
Duty of loyalty, requirements of derivative action- state law; federal law- disclosure of related
party transactions.
 Director independence
 Freeze-outs/going private rules
 Financial reporting

 STOCK EXCHANGE LISTING STANDARDS

 “Self-Regulatory Organizations”
 Exchange Act: SEC oversight of Exchanges
 Initially focused on quality of issuer
 Reputation; impact on trading volume
 Financial reporting and audits
 Annual stockholders meeting; quorum; voting
 Independent directors
 Why do the exchanges care?
 Enron and Sarbanes-Oxley provided impetus for the adoption by NYSE and Nasdaq of
substantially enhanced governance standards
Came out of early 2000. Suggestions came in the form of stock listing requirements.
Stock Exchange are supervised by SEC under Securities Act of 1934. Since they are self-
regulating organizations, they had listing.

Sarbanes Oxley- 303 A.1-12 Governance related NYSE listing requirements came out of
Sarbanes Oxley.

NYSE- 80% of stock transactions in US. Initial motivation of listing requirements was
to attract business and to make sure that the companies that are traded in our exchange
are of high quality and so that investors will have confidence in exchange.

Regulatory Competition: Delaware vs. The SEC

Tension between Delaware and Federal law

- Delaware’s freedom to act and its limits are not determined solely but its strength vis-à-
vis other states, but by the line demarcating where the federal authorities leave it alone
and where they do not. Within the area that doesn’t provoke federal authorities, Delaware
has autonomy.

In 2002, Congress adopted SOX and gave the SEC a more direct, substantive role in the
governance process by allowing it to use listing standards to regulate audit committee .
During this period, the Delaware courts issued some decisions that hinted at a more rigorous

26
approach toward fiduciary obligations. Some speculated that these decisions were designed to
reduce the pressure for additional federal preemption.

The most recent example of federal intervention occurred in connection with the Dodd-Frank
Wall Street Reform Act adopted in 2010 . The Act gave the Commission the authority to adopt
rules regulating the compensation committee process (limited to exchange traded companies),
much the way that SOX did for the audit committee.

An interesting example of the growing tension between the SEC and Delaware occurred in
litigation challenging Rule 14a-11, the shareholder access rule. For the first time, the State of
Delaware filed an amicus brief in a federal case seeking to invalidate to invalidate an SEC rule
relating to corporate governance.

Shareholders in public corporations are better protected by the amalgam of state and federal
corporation law. Efficient mix of governance rights?

Stock Exchanges Brown Chapter 2 pp. 79-81

Skim NYSE Rule 303 A (on Canvas)

 Stock Exchange Listing Standards

 “Self-Regulatory Organizations”
 Exchange Act: SEC oversight of Exchanges
 Initially focused on quality of issuer
 Reputation; impact on trading volume
 Financial reporting and audits
 Annual stockholders meeting; quorum; voting
 Independent directors

 NYSE RULE 303A!

 .01/.02 – Independent directors
Requirement of independent director in the board. Many companies were doing but
the law formalized it. It required executive sessions.
 .03 – Executive sessions
 .04 – Nominating and Governance Committee
Three committee should be entirely independent directors. Each committee had to
have a charter. The law required the topics that needed to be addressed.
 .05 – Compensation Committee
 .06/.07 – Audit Committee
 .08 – Approval of equity compensation plans
Early attempts
 .09 – Corporate Governance Guidelines
Required
 .10 – Code of Ethics
Required.

Rules only apply to public companies listed in the stock exchange (NYSE) and now only 20%
because trading moved to NASDAQ, techie stock exchange but some of these, in the last 20
years, there was enormous proliferation of other exchanges.

27
A number of IT Companies, Google, Facebook, have voting control. The stock exchanges that
used to be owned by the members and was like a cooperative went public, and so the traders
who used to own NYSE and who were intent to improve quality of shares traded, and earned
from commission. Now that is public, the Stock Exchange gets a commission – there’s a tension
between quality of shares and best interest of owners. It has made NYSE accept high vote, low
vote, dual stock.

The Role of the Stock Exchanges and Self-Regulations

Self-Regulatory Organizations
Much of the corporate governance process for public companies is dictated by stock exchanges
through the use of listing standards. Stock exchanges are self-regulatory organizations.
Traditionally owned by their members (brokers and dealers), stock exchanges have converted
into for-profit companies.

A Bit More History

Robert S. Karmel, The Future of Corporate Governance Listing Requirements

The first NYSE listing standards were not a set of uniform policy by the exchange but instead
were flexible terms (can be changed anytime) inserted in listing agreements negotiated between
each issuer and exchange.

By 1909- listing agreements required companies to distribute annual reports to its stockholders’
annual meeting.

After market crash of 1929- in 1932 independent audits become mandatory for all new listed
companies. Companies agreed to report their earnings quarterly.

Exchange Act: SEC oversight of Exchanges

With the enactment of the Exchange Act, the policies of the NYSE’s regarding listing
requirements was demonstrated by the facts the “Congress closely tracked the NYSE disclosure
requirements when it drafted the Exchange Act.” NYSE existed at the time of the adoption of
the Exchange Act.

Listing standards (required by Exchange Act) has become a central component of the
governance process.

Initially focused on quality of issuer

Prior the enactment of the Exchange Act, listing agreements required issuers annually to
disclose all details about financial condition, such as changes may have been “the NYSE’s focus
during that time on bolstering trading volume.”

Annual stockholders meeting; quorum; voting

28
By 1953, minimum quorum rules were established for shareholder meetings. Beginning 1940,
minimum voting rights were also required for preferred shareholders.

Financial reporting and audits

NYSE’s early statements regarding financial disclosure laid the groundwork for future rules; the
NYSE did not desire to list companies unless their accounting policies were sound and logical
and found complete acceptance among engineers and accountants.

Best Practices
SKIM Commonsense Governance Principles (on Canvas)
The following is a series of corporate government principles for public companies, their board
of directors and their shareholders. These principles are intended to provide a basic framework
doe sound, long-term oriented governance.
 NYSE Rule 303A!
 .01/.02 – Independent directors
 .03 – Executive sessions
 .04 – Nominating and Governance Committee
 .05 – Compensation Committee
 .06/.07 – Audit Committee
 .08 – Approval of equity compensation plans
 .09 – Corporate Governance Guidelines
 .10 – Code of Ethics
 “BEST PRACTICES”
 ALI Governance Principles
 Recommended legal principles
 Commonsense Principles
 Recommended practices
 ISG Governance Principles
 Recommended practices
 GE Governance Principles
 Thought leader’s actual practices
 Responsive to NYSE requirements
 DO “BEST PRACTICES” MOVE THE NEEDLE LEGALLY?
 Good faith
 Reasonable belief in best interests
 Reasonability of actions – MBCA
 Does it matter?
 ALI GOVERNANCE PRINCIPLES
 Objective and conduct of corporation
 Structure – management
 Duties of directors, officers and controlling shareholders
 Control transactions and tender offers
 Remedies – derivative actions
 Commonsense Principles
 Board Composition and Responsibilities
 Shareholder Rights
 Public Reporting
 Board Leadership

29
  Succession Planning
 Management Compensation
 Role of Asset Managers
 ISG Governance Principles
 Boards are accountable to shareholders
 Shareholders are entitled to voting rights in proportion to economic interests
 Boards should be responsive to shareholders and be proactive to understand their
perspectives
 Boards should have strong independent leadership
 Boards should adopt structures that enhance their effectiveness
 Boards should development incentive structures aligned with their long-term strategy
 NYSE GOVERNANCE PRINCIPLES
 Director qualification standards
 Director responsibilities
 Access to management and advisors
 Director compensation
 Orientation and education
 Management succession
 Annual self-evaluation
303A.00 Corporate Governance Standards

303A.00 Introduction

General Application

Companies listed on the Exchange must comply with certain standards regarding corporate governance as codified in this
Section 303A. Consistent with the NYSE's traditional approach, as well as the requirements of the Sarbanes-Oxley Act of 2002,
certain provisions of Section 303A are applicable to some listed companies but not to others.

A company listing in conjunction with its initial public offering is required to comply as follows:

• The company must satisfy the majority independent board requirement of Section 303A.01, if applicable, within one year of
the listing date.

• The company must satisfy the website posting requirements of Sections 303A.04, 303A.05, 303A.07(b), 303A.09 and
303A.10, to the extent such sections are applicable, by the earlier of the date the initial public offering closes or five
business days from the listing date.

• The company must have at least one independent member on its nominating committee and at least one independent
member on its compensation committee as required by Sections 303A.04 and 303A.05, if applicable, by the earlier of the
date the initial public offering closes or five business days from the listing date, at least a majority of independent members
on each committee within 90 days of the listing date and fully independent committees within one year of the listing date.

• The company must have at least one independent member on its audit committee that satisfies the requirements of Rule
10A-3 and, if applicable, Section 303A.02, by the listing date, at least a majority of independent members within 90 days of
the effective date of its registration statement and a fully independent committee within one year of the effective date of
its registration statement.

• With respect to the requirement of Section 303A.07(a) that the audit committee must have at least three members, the
company must have at least one member on its audit committee by the listing date, at least two members within 90 days of
the listing date and at least three members within one year of the listing date.

30
 • The company must comply with the internal audit function requirement of Section 303A.07(c) within one year of the listing
date.

303A.01 Independent Directors

Listed companies must have a majority of independent directors.

Commentary: Effective boards of directors exercise independent judgment in carrying out their responsibilities. Requiring a
majority of independent directors will increase the quality of board oversight and lessen the possibility of damaging conflicts of
interest.

Amended: November 25, 2009 (NYSE-2009-89).

 GE GOVERNANCE PRINCIPLES
 Role of the Board and management (1)
 Independence (4)
 Selection process for directors (5)
 Committees (6)
 Board leadership and agendas (9, 11)
 Executive sessions (8)
 Hot lines (13)
 Executive compensation (16)
 Succession planning (15)

 Why do the exchanges care?

 Enron and Sarbanes-Oxley provided impetus for the adoption by NYSE and Nasdaq of
substantially enhanced governance standards

P. 1000-1001

Sanjai Bhagat, Brian Bolton & Roberta Romano, The Promise and Peril of Corporate Governance
Indices.

 Corporate governance became a topic of intense media and activist institutional investor
interest aftermath of Enron’s collapse and successions of accounting scandals.
 At the same time, corporations were forced to reconsider their governance by federal
legislation and stock exchange listing requirements.
 Mutual funds were pushed to become more involved in governance under regulation
adopted by the US Securities and Exchange Commission, which required funds to adopt
written policies on proxy voting and to disclose their specific votes.
 Shortly before the surge of corporate governance, a team of financial economists: Paul
Gompers, Joy Ishii and Andrew Metrick (GIM) wrote a seminal paper in which they
constructed an index of corporate governance quality for large number of publicly
traded US firms and which will held to improve its future stock performance.
 The relation between governance and performance identified in GIM’s paper offered
intellectual support for commercial governance-ranking services.

31
  GIM did not draw casual connections between good governance and superior
performance, commercial governance service providers.
 However, establishing a relation between governance and performance is technically
difficult – the two variables: governance and performance, are plausibly endogenous,
meaning that their relationship is bidirectional rather than unidirectional;
 Therefore, using existing indices can magnify that problem because their construction is
based in two factually incorrect assumptions:
o Good governance components do not vary across firms;
o Components are always complementary and never substitutes.
 The aim of this article is twofold:
o Analyze the performance of corporate governance indices as predictors of
corporate governance; and
o To consider the public policy implications that follow from that assessment.
 Our core conclusion is that there is no relation between the academic and related
commercial governance indices and corporate performance;
 There is no best measure of corporate governance. The most effective governance
institution depends on context and on firms’ specific circumstances.
 Governance indices are highly imperfect and that investors and policymakers should
exercise utmost caution in attempting to draw inferences regarding a firms’ quality or
future stock market performance from its ranking on any particular governance
measure.
 Corporate governance is an area where a flexible regulatory regime allowing ample
variation across firms is particularly desirable as there is considerable variation in the
relation between different governance indices and different measures of performance.
 Mandatory governance terms are the functional equivalent of a governance index that
has the force of law, because such terms impose on all firms, without allowance for
customization to a firm’s specific circumstances.

Exchange requirements are minimum requirements. Best practice are attempts by different
companies to suggest that they are good companies and responsive to shareholder concerns.
 “BEST PRACTICES”
 American Law Institute (ALI) Governance Principles

Recommended legal principles

2.1- purpose of the corporation. Formulated by legal thinkers and consist of
recommended legal principles. Relatively narrow of 5 categories. What the law
should be.
 Commonsense Principles

 Recommended practices
 ISG Governance Principles
 Recommended practices
 GE Governance Principles

GE’s attempt to comply to NYSE requirements. Similarity in topics. Recall that there is
a requirement in NYSE that companies traded are required to have Governance
Principles.
 Thought leader’s actual practices

32
Responsive to NYSE requirements
Proxy Advisory Services P. 452-456

The Role of Proxy Advisory Firms

Shareholders with diverse holdings must make significant number of complicated voting
decisions. The assistance of this advisors on voting recommendations on particular proposals,
their role in proxy process has, however, generated controversy.

Concept Release on the U.S. Proxy System

Exchange Act Release no. 62495 (July 14, 2010)

Over the last 25 years, institutional investors, including investment advisers, pension plans,
employee benefit plans, bank trust departments and funds have substantially increased their
use of proxy firms.

Every year, at shareholder’s meeting, investors (with fiduciary obligations to vote shares) face
decisions on how to vote their shares on a significant number of matters, election of directors
and approval of stock option plans to shareholder proposals submitted under Exchange Act
Rule 14a-8, which rise policy questions and corporate governance issues.

At special meetings of shareholders, investors also face voting decisions when a merger or
acquisition of a sale of all or substantially all of the assets of the company is presented to then
for approval.

In order to exercise vote rights, said institutional investors may retain proxy advisory firms to
perform a variety of functions:

 Analyzing and making voting recommendations of the matters presented for

shareholder vote and included in the proxy statements;
 Executing votes on the institutional investors’ proxies in accordance with investor’s
instructions, which may include voting shares in accordance with customized proxy
voting policy;
 Assisting with the administrative tasks associated with voting and keeping track of the
large number of vote decisions;
 Providing research and identifying potential risk factors related to corporate
governance; and
 Helping mitigate conflict of interest concerns raised when institutional investors is
casting votes in matter in which its interest may differ from the interest of its clients.

Firms in the business of supplying these services to clients (analysis and recommendations
for voting on matters presented for shareholder vote) are well known as proxy advisory
firms.

Advisory Firms:

33
  Provide consulting services to issuers on corporate governance or executive
compensation matters;
 They are largely unregulated, they remain exempt from proxy rules;
 Also qualitatively rate or score issuers’ corporate governance structures, policies and
practices and provide consulting services to corporate clients seeking to improve their
corporate governance ratings;
 As a result, some advisors provide vote recommendations to institutional investors on
matters for which they also provided consulting services to issuer;
 Some advisors disclose this dual client relationship, other also have adopted to attempt
to address the conflict through the creation of “firewalls” between the investor and
corporate lines of business;
 Two firms rule the industry: Institutional Shareholder Services (ISS) and Glass Lewis;
 Using such advisors seems structural, given the number of proposals that must be
considered by investors in short period;
 The most controversial aspect of these firms concerns the impact of their
recommendation on the voting process. Thus, a negative recommendation will increase
the percentage of negative votes.

The use of such proxy advisory firms by institutional investors raises a number of potential
issues:

A. Conflicts of Interest:

The most frequent raised concern about the proxy advisory industry relates to conflict of
interest.

The Government Accountability Office (GAO) has issued two reports since 2004.

Conflict: Said conflict of interest arises if a proxy advisory firm provides voting
recommendations on matters put to shareholder vote while also offering consulting services to
issuer or proponent of a shareholder proposal on the very same matter. GAO also noted that the
advisors also made the recommendation of voting in favor to keep the client’s business.

Conflict: also arises when proxy advisory firm provides corporate governance ratings on issuers
to institutional clients, while also offering consulting services to corporate clients so that those
issuers can improve their corporate governance ranking.

Potential conflict of interest when owners or executives of the proxy advisory firm have
significant ownership interest in, or serve on the board of directors of, issuers with matters
being put to shareholder vote on which proxy advisory firm is offering vote recommendations.

B. Lack of Accuracy and Transparency in Formulating Voting Recommendations.

Proxy advisors firms may be unwilling to accept any attempted communication from the issuer
or to reconsider recommendations in light of such communications. Even if proxy advisor
entertains comment from issuer and amends its recommendations, votes may have already
been cast based on prior recommendation. Accordingly, some issuers have expressed a desire to
be involved in reviewing a draft of the proxy advisory firm report ensuring that the voting

34
recommendations are based on accurate issuer data. Some advisors have claimed that they are
willing to discuss matters with issuers, bit that some issuers are unwilling to enter into such
discussions. There is also a concern that proxy advisory firms may base their recommendation
on one-size-fits-all governance approach, thus a policy that would benefit issuers, but is less
suitable for other issuers, might not receive a positive recommendation, making it less likely to
be approved by shareholders.

Voting recommendations are treated as solicitation under the proxy rules.

Calls have arisen for greater oversight by the SEC.

Negative recommendations will increase the percentage of negative votes.

 ACADEMICS
Harvard Shareholder campaign
Harvard Law School Form on Corporate Governance and Financial Regulation
- Gives a sense of positions and if a consensus is building.

 What should be the rules?

 Complimentary to:
 ALI, Cadbury, NACD
 “Best Practices”
 Often raise issues before their time
 Lead the way
 Activist – Bebchuk (HLS Program on Corporate Governance)
 Board of Directors

CEO Activism on the increase. Interesting information:

Roadmap for managing brand politics in the Trump era:
Rule 1. Have a firm grasp on which issues are winners and losers.
Rule 2. Don’t overthink doing good
Rule 3. Don’t talk about Trump.
Rule 4. Most Americans would rather you butt out. In the absence of some compelling social
issue that is associated in your brand, just butt out.

3. COMPOSITION OF THE BOARD

(remember to read Commonsense Principle of Corporate Governance)
 BOARD OF DIRECTORS
 If you are not advising an activist, much of Corporate Governance work involves
advising Boards of Directors or advising CEOs how to deal with their Boards of
Directors!
If you are advising an activist, the Target’s Board is the adverse party!
 Board Composition
 Legal Role/ Dynamics
 Qualification
 Nomination
 ELECTION
 Legal Role of Board

35
 Delaware General Corporation Law §141(a):
The business and affairs of every corporation … shall be managed by or under the
direction of a board of directors
The board of directors is responsible for the supervision of management. Managed by is
not the same as operated by, which is done by managers.

 “The Man In the Middle”

Shareholders ----------------------------- Board ---------------------------------Management

 HISTORICAL BOARD DYNAMICS
 CEO influence
Rare that board of directors would object to CEO, people with whom the CEO have
connection. Golfing buddies, neighbors.
 Atmosphere
 Clubby
 Incestuous
Cronyism
 “Breakfast club”
Attitude that the company was supposed to be run by the management.
 Lax oversight
 Rubber stamp
 Process not emphasized

 INDEPENDENCE
 Hallmark of current Board governance
 Incremental development:
 1977 - NYSE Audit Committee
- Started in audit committee
 1978 – SEC
- Lawsuits were brought for bribing foreign officials, SEC required that settlement of
these cases were by independent board.
 1981 - Derivative demand waiver
 1986 - §162(m)
 §16
 1992 – ALI Principles and Cadbury Report
 2002 - Enron – NYSE 303A
 What are the benefits of independence?
It takes the board away from the undue influence of the CEO and the management and
puts them back to their original function- manage the corporation.
Independent directors lack the information on day to day operations of insiders.
Independent directors have to have sufficient general experience and particular skills
to evaluate strategic choices for the company.

 WHAT IS “INDEPENDENCE”?
Independent of management in general. Employees, commercial relationships, social
relationships, family relations.
 Non-employee
 Board or Committee interlocks

36
  Family relationships
 Commercial relationships
 Charitable
 Social relationships
 Other??
 SOURCES OF “INDEPENDENCE”
 Stock exchange rules
 Proxy advisory guidelines
 Best practices
 State law (?)
 Independence and disinterestedness are separate subjects

Brown Chapter 3 pp. 135-142

Qualification
Independence

III. Independent Directors

 Board of directors have the duty to monitor management

 SEC has preferred that directors independent of management perform this oversight
function.
 Mid-1970´s – most experts agreed that boards comprised by majority of independent
directors (persons nor employed by or affiliated to the firm) monitor managers more
effectively. Without conflicts of interests with their relationship to the firm or to its
executives, the independent directors would exercise greater attention and objectivity.

 ALI (American Law Institute´s Principles of Corporate Governance) has soften its
opinion and instead of making it obligatory that the majority of the board was
composed by independent directors, they made it as a “recommendation”.

Independent directorship evolved from being the subject of interesting speculation to an

assumed “best practice for the most successful corporations in the world.”

Jeffrey N. Gordon, The Rise of Independent Directors in the US, 1950-2005: Of Shareholder
Value and Stock Prices

The now conventional understanding of board of directors is that they reduce the agency costs
associated with the separation of ownership and control.

Elected by shareholders, directors are supposed to “monitor” the managers in the best interest
of shareholders.

Independence

Independent director began as a “best practice” and has become a mandatory element for
corporate law:

37
  Delaware courts condition the application of the BJR to board action taken by
independent directors.
 NYSE requires most listed companies to have a majority of independent directors sin the
board.
 NASD requires that conflict transactions be approved by committees consisting solely
by independent directors.
 Post-Enron federal legislation (Sarbanes- Oxley Act of 2002): audit committees
composed solely by independent directors.

Nevertheless, studies have not shown any relation between independent directors and firm´s
performance.

Actually, more than the agency problem, independent directors are useful to increase social
welfare – maximization of shareholder value.

Independent directors solve three (3) problems:

1) Fidelity of managers to shareholder objectives;
2) Reliability of the firm´s public disclosure – makes stock market prices more reliable
3) Binds the responsiveness of firms to stock market signals

Independent directors – “visible hand”:

a) More sensitive to external assessment of their performance as directors
b) Might create significant value in the allocation of resources, not just in their firms, but
also force firms to adapt to best performers.

Mechanisms to increase independence of directors:

1) Tightening standards for disqualifying relationships (e.g., relationship with suppliers,
unaffiliated law firms, etc.);
2) Increase positive and negative sanctions (fiduciary duties; stock-based compensation);
3) Development of intra-board structures (task-specific committees and “lead director”);
4) Reducing CEO influence in selecting directors

Contemporaneous revelations of widespread corporate bribery and illegal campaign

contributions (“questionable payments”) made SEC to insist on independent directors in the
settlement of various enforcement actions.

o Independence standard:

 Proxy Advisory Firm

 1978 Corporate Director´s Guidebook:

First -
a) Management
b) Non-management directors
Then -
a) Affiliated
b) Non-affiliated

38
  1978 – SEC:
a) affiliated; or
b) “independent” – After pressure, SEC withdrew this proposal

 NYSE – 1977:
a) Audit committee composed by “directors independent of management”:
It permitted directors from organizations with “customary commercial, industrial,
banking or underwriting relationships with companies” to be part of the audit
committee, unless the board that it “would interfere with the exercise of independent
judgement as committee member”.

 1996 IRS

 1934 Securities Exchange Act:

a) “non-employee director”

 State courts - derivative suits:

Zapata v. Maldonado – Delaware Supreme Court: “demand-excused derivative action”
– a “special committee” constituted by independent directors could obtain dismissal of
the action, since it was in the best interest of the corporation. Board had the burden of
proven its independence.
Goes into the issue of conflict of interest – state law.

 ALI´s 1992 “Principles of Corporate Governance”:

- Board of public companies: majority of directors free of any significant relationship
with the corporation´s senior executives”

 Enron corporate reform was a sea change:

 NYSE 2002:
- Majority of directors to be independent,
- Stringent independence criteria applied to all directors, not only of board committee
 NYSE 2004 – refined standards:
- Independent directors: “no material relationship with the listed company”.
- Defined exclusions and safe-harbor.
-made the compensation committee of the board independent of management
-states only independent directors could be on it, 
-comp consultant report directly to the committee not the CEO or Board, 
-Required board to issue written philosophy on Executive pay that shareholders could use to
hold up against actual behavior
-LATER: all shares put aside for employee comp had to be approved in ADVANCE by
shareholders
 NYSE RULE 303A
 Majority of Board must be independent
- Way more than majority of independent directors. Usually just one insider (CEO)
 Key Committees must be entirely independent
 Impact of “best practices”

39
  TESTS FOR “INDEPENDENCE”
RULE 303A.02
 Per se
Second category: disqualification. If you fall into any of this, you are disqualified,
whether or not you actually are a good director.
 Employee, relationship with auditor
 Receipt of direct compensation
 Commercial relationships (dollar limit; paid to the company or received from the
company, no judgment needed to be exercised)
 Family relationship, look-back
 Charities, share ownership
Simply owning shares does not disqualify you. Does not matter even if you a big
percentage. NYSE only says who can be in the Board. Does not say how you will
govern. However, Delaware provides safeguards.
Delaware
Countervailing law does not give the director carte blanch to do whatever they
want:
Under Delaware Law, if you are a director and you have been selected by the
controlling shareholder, (representative director) you still have to make a decision
based on the interest of all of the shareholders and not only controlling
shareholder.

When a controlling shareholder, this triggers the Weinburger test, this conflicted
transaction and satisfy the entire fairness test.

Donation does not disqualify a person from being independent.

Even if you pass the per se test, the board takes the step back to look at other
considerations. Relationship with Charities; company makes a donation that is
my favorite charity or where I seat in the board, and board must make a
determination if the same will create a bias.

Social relationship. Not Per Se disqualify. Things that is important for the Board
to identify and think (Van Gorken)
 No “material” relationship
 Board must affirmatively determine” and “consider all factors”
 S-K 407(a)(3) – disclose matters considered

303A.02 Independence Tests

In order to tighten the definition of "independent director" for purposes of these standards:

(a)(i) No director qualifies as "independent" unless the board of directors affirmatively determines that the director has no
material relationship with the listed company (either directly or as a partner, shareholder or officer of an organization that has a
relationship with the company).

(ii) In addition, in affirmatively determining the independence of any director who will serve on the compensation committee of
the listed company's board of directors, the board of directors must consider all factors specifically relevant to determining
whether a director has a relationship to the listed company which is material to that director's ability to be independent from
management in connection with the duties of a compensation committee member, including, but not limited to:

40
(A) the source of compensation of such director, including any consulting, advisory or other compensatory fee paid by
the listed company to such director; and

(B) whether such director is affiliated with the listed company, a subsidiary of the listed company or an affiliate of a
subsidiary of the listed company.

Commentary: Material relationships can include commercial, industrial, banking, consulting, legal, accounting, charitable and
familial relationships, among others. However, as the concern is independence from management, the Exchange does not view
ownership of even a significant amount of stock, by itself, as a bar to an independence finding.

When considering the sources of a director's compensation in determining his independence for purposes of compensation
committee service, the board should consider whether the director receives compensation from any person or entity that
would impair his ability to make independent judgments about the listed company's executive compensation. Similarly, when
considering any affiliate relationship a director has with the company, a subsidiary of the company, or an affiliate of a subsidiary
of the company, in determining his independence for purposes of compensation committee service, the board should consider
whether the affiliate relationship places the director under the direct or indirect control of the listed company or its senior
management, or creates a direct relationship between the director and members of senior management, in each case of a
nature that would impair his ability to make independent judgments about the listed company's executive compensation.

Disclosure Requirement: The listed company must comply with the disclosure requirements set forth in Item 407(a) of
Regulation S-K.

(b) In addition, a director is not independent if:

(i) The director is, or has been within the last three years, an employee of the listed company, or an immediate family
member is, or has been within the last three years, an executive officer, 1of the listed company.

Commentary: Employment as an interim Chairman or CEO or other executive officer shall not disqualify a director from being
considered independent following that employment.

(ii) The director has received, or has an immediate family member who has received, during any twelve-month period
within the last three years, more than $120,000 in direct compensation from the listed company, other than director and
committee fees and pension or other forms of deferred compensation for prior service (provided such compensation is not
contingent in any way on continued service).

Commentary: Compensation received by a director for former service as an interim Chairman or CEO or other executive officer
need not be considered in determining independence under this test. Compensation received by an immediate family member
for service as an employee of the listed company (other than an executive officer) need not be considered in determining
independence under this test.

(iii) (A) The director is a current partner or employee of a firm that is the listed company's internal or external auditor; (B)
the director has an immediate family member who is a current partner of such a firm; (C) the director has an immediate family
member who is a current employee of such a firm and personally works on the listed company's audit; or (D) the director or an
immediate family member was within the last three years a partner or employee of such a firm and personally worked on the
listed company's audit within that time.

(iv) The director or an immediate family member is, or has been with the last three years, employed as an executive
officer of another company where any of the listed company's present executive officers at the same time serves or served on
that company's compensation committee.

(v) The director is a current employee, or an immediate family member is a current executive officer, of a company that
has made payments to, or received payments from, the listed company for property or services in an amount which, in any of
the last three fiscal years, exceeds the greater of $1 million, or 2% of such other company's consolidated gross revenues.

41
  ISS INDEPENDENCE CATEGORIES
 Inside – employee or majority shareholder
 Affiliated Outside
 Former CEO or executive officer
 Immediate family is employee
 Professional services over $10,000 to company, affiliate or officer (disqualified)
 Material transactional relationship, including indirect
 Trustee, director or employee of charity
 Compensation Committee interlocks
 Independent Outside
 No material connection other than Board seat

 DELAWARE

 No requirement for general Board independence

 But relevant to specific conflict situations
 Derivative actions
 Self-dealing

Independence vs. disinterestedness

- Interested transactions, the ones who will approve should be independent.
Independence is independent or no relationship of the person in conflict (Martha Stewart) and
disinterested, not one of the parties in the conflict.

 MARTHA STEWART: INDEPENDENCE

 Analysis is contextual
Bias Producing and Burden of Proof
 Does “friendship” disqualify?
 Relationship must be “bias-producing”
- Have to be in a level of significance that it will bias judgment
 Mere friendship not enough- going to Stewart’s lawyers wedding.
 Business relationship not enough – at least in this case Director of Sears had
business relationship (Martinez) with Martha.
Court said that relationship was not disqualifying
 Result of Board service – “structural bias”
 If you are in the board with somebody long enough, you start to have high regard for
them. This does not disqualify a director for being independent.
 Naturally develop among Board members
Whether a demand was to be made was necessary (no demand, if board is
independence) in Martha Stewart. Burden of proof on plaintiff. In Oracle, the burden
of proof was in Board.
 BUT Oracle…
Professors at Stanford were not independent, because Company made significant
donations in Stanford.
 And InfoGROUP!!!!

152-153

42
 IV. Board Size, Structure and Leadership

Companies with fewer board members outperform their company peers. CEO’s
traditionally have chaired corporation’s board. There is call to separate this two.
Reform advocates call for a leader who is an independent director.

p. 161 – 169
 Proxy Voting Guidelines
 Shareholder proposals
 Takeover defenses
 Social issues
 Management proposals
 Executive compensation
 Equity-based incentive plans
 Board-related governance
 Director qualification and election

 ROLE OF THE CEO

 Historically very significant
 “controlled or decided by”
 CEO’s “team” (or “cronies”?)
Closed system- in theory, under state law, shareholders have the right to
nominate, no influence because CEO to prepare list.
 Nominating Committee response of early governance proponents
-independent to reduce the role of the CEO. Must be fully independent 303-A4
somewhat more disconnected to CEO. Disclosure requirement under the Exchange
Rules.
 SEC 1977 study and response
 Only modest change

 NYSE Rule 303A.04

 Response to Enron and SOX
 Listed companies must have fully independent nominating committee
 Identify and select qualified candidates
 Objective:
 “Enhance independence…quality of nominees”
 [Reduce influence of CEO]

 REGULATION S-K ITEM 407(C)

 Describe Committee
 Process for identifying and evaluating
 Minimum qualifications
 Submission procedures
 Policy re shareholder recommendations
 Who recommended? This is required to be disclosed. Is this the nominee of CEO or
nominee who was recommended by 5% shareholders.

43
  Nominees from 5% shareholders

 DOES ANY OF THIS MAKE A DIFFERENCE?

 Committees independent BUT
 CEOs still involved
 Purpose of Committee: increase shareholder involvement BUT
 Not required to accept S/H recommendations
 “Shareholder recommended candidates rarely seriously considered”
 Tactic to head off proxy access

Selection of Directors.

Although shareholders elect directors neither the Delaware General Corporation Law nor the
Model Business Corporate Act expressly address nomination rights. Critics, then, have long
questioned whether directors selected by boards of incumbent directors will act as effective
monitors and evaluators of CEOs and their executive teams.

Directors essentially hand-picked by the CEO may feel some allegiance, even gratitude, to their
backer and, relatedly, and obligation to support him. On the other hand, a director whose
exercise of “independent” judgment has aggravated the CEO may receive a polite request stand
down for reelection. Simply put, directors may refrain from contradicting or otherwise
alienating the CEO for fear that they will not be reappointed.

In particular, management has strongly opposed proposals to give dissident shareholders

“proxy access”, meaning the right to include in the company’s proxy materials an alternative
slate of director candidates for shareholders’ consideration. In the main, however, unless the
corporation otherwise provides its shareholders with access, dissidents must wage a proxy
contest if they wish to nominate candidates for election to the firm’s board of directors.

The expense and legal risks associated with proxy contests deter most shareholders from
challenging director elections. The most significant impediment to dissidents is the cost –
including the expense of complying with the SEC’s proxy rules and especially printing, mailing
and publicity costs.

Campaign finance rules originally promulgated in the 1950s campaigns from their own pockets,
while management incumbents effectively have unlimited access to the corporate treasury. As a
practical matter, the dissidents will receive reimbursement only if they obtain control of the
board. Challengers also face liability for any false or misleading statements in the proxy
materials.

As of 1992, when ALI published its principles of corporate governance, best practice called for
appointment of nominating committees compromised solely of non-officer directors.

For more than a decade now, the NYSE has required boards of listed public companies to use
nominating committees, staffed entirely by independent directors, for director selection. The
NYSE definition of independence excludes not only officers but also most directors with
affiliations to the company.

44
Rules require disclosure of processes of nominating committee. By learning these procedures
shareholders may become more involved in recommending directors candidates and the CEO
may exercise less influence over the process. In this way, the nominating committee may learn
of other individuals qualified and committed to serve the best interest of the company and its
shareholders. Nominating committees may consult with, and accept nominees from, CEOs. On
the other hand, nominating committees might work to disable CEOs from retaliating against
nonconformists.

Not clear how the nominating committee of outside directors have reduced management
influence over candidate selection. Finally, companies may require directors to tender their
resignations if they receive more “withheld” or “against” votes than “for” votes in uncontested
elections.

Michael E. Murphy, The Nominating Process for Corporate Boards of Directors: a decision-
making analysis.

Late 1970, relatively few companies had any formal procedures for selecting candidates for
boards of directors. In late 1960s, Mace observed “most executives interviewed confirmed that
the selection of new directors was controlled and decided by the president”. The prevailing
theory was that the CEO needed to form an effective team and the choice of directors formed
part of that task. Twenty years later, CEOs referring to corporate board as “my directors”.

The nominating committee emerged as a common feature of corporate governance in the late
1970s largely in response to the SEC investigation of shareholder participation in the corporate
electoral process. In proposing these regulations, the Commission stated that it believed that
“that the institution of nominating committees can represent a significant step in increasing
shareholder participation in the corporate electoral process”.

A corporate director’s guidebook issued in 1976 by the ABA Committee on Corporate Laws
described the nominating committee as “potentially the most significant channel for improved
corporate governance”. Providing a forum for shareholders to submit recommendations for
directors, the nominating committee will offer a more effective and workable method of
affording access to the nominating process to individual shareholders than a direct “right” of
nominating in the corporations’ proxy material.

the SEC saw “the use of nominating committees as vehicle for shareholder participation” in
the nomination of directors. Today the NYSE describe this nominating committee as “central
to the effective functioning board”.

Following passage of the Sarbanes-Oxley Act, both the NYSE and the NASDAQ required
listed companies to appoint independent directors, as defined by the Exchange Rules, to a
majority of positions on their boards. An average of seventy four percent of board members in
companies with over 10 billion in revenues were independent directors in a 2004 survey.

The ALI Principles of Corporate Governance, adopted in 1994, note that “the chief executive
officer, can be expected to be highly active in recommending to and discussing candidates with

45
the committee and in recruiting candidates for the board”, and adds that such participation of
the CEO in the nominating process can be achieved “without making the CEO a member of the
committee”.

For all practical purposes, institutional investors and other shareholders continue to be
excluded from the nominating process.

Nevertheless, SEC adopted still more elaborate disclosure rules in 2003 with the objective of
encouraging nominating committees to consider shareholder recommendations. The revised
rules require, among other things:
 Disclosure of the committee’s policy regarding shareholder recommendations for
directional candidates;
 A description of procedures to be followed by shareholders in submitting such
recommendations;
 Whether the committee has received a recommended candidate from a shareholder or
group of shareholders holding five percent of the stock of the company within 120 days
of the date of the proxy statement;
 Whether the committee chose to nominate such candidate.

At exists today, the original purpose of the nominating committee as an avenue for shareholder
participation in the selection of directors remain unfulfilled, but the committee figures in a set of
“best practices”, enunciated by authoritative voices in US industry. These systems work because
of the adoption of best practices by public companies within a framework of laws and
regulations.

The nominating committee practices advocated by the Conference Board and the Business
Roundtable in two respects:
 They respond to public criticism of corporations by calling on the nominating
committees to follow desirable practices in selecting independent and qualified
members of the board; and
 They advocate a board charter of responsibilities for these committees, which are now
often designated corporate governance committees.

Notwithstanding the previous, CEO still have a voice, perhaps dominating voice, in director
selection. They need not sit as voting members of board nominating committees to do so.

Many arguments favoring CEO involvement in board selection stress the importance of board
collegiality. Harvey Pitt say “Board should strive for collegiality and be constituted to achieve
that result. Ultimately, critical board decisions are vested in the hands of a group, not a single
decision maker. As a result, the system can only work if collegiality is fostered and actually
achieved…”

There is some evidence that reducing CEO influence over the director selection process results
in increased value for shareholders.

❑ DIVERSITY
 Heightened focus in recent proxy seasons

46
 Worldwide issue
 Institutional investors
 State Street and BlackRock – pressure on Nominating Committees
 NY City Controller matrix
 Others – updated voting guidelines
 ISS
 Voting Guidelines
 QualityScore

 Diversity – Why Do We Care?

 Fairness, justice, equal opportunity
 Diverse opinions and viewpoints
 Global competitive advantage
 Improved group deliberations
 Avoid groupthink – independence
 Improved performance?

 DIVERSITY INITIATIVES
 Legal quotas
 Norway, France, Italy, Spain
 Required disclosure
 S-K Item 407(c)(2)(vi) – diversity policy?
 “Diversity” not defined!
 Implementation?
 GENDER DIVERSITY SCORECARD
 Norway – 42%
 France - 40%
 U.K. – 20.3%
 U.S. – 14.2% overall; 20% Fortune 500
 Brazil – 7.7%
 Chile - 6.5%

 Colombia – 13%
 Mexico – 6%
 Philippines – 10.4%
 Peru – 17.3%
 Singapore – 10.7%
 Switzerland – 14/8%
 OVER-BOARDING
Under the SEC rules, if attendance less than 75%, company needs to report. And ISS
would then recommend based on this.
 How many boards are too many?
 ISS has a policy:
 No more than 5 (down from 6)
 CEOs limited to 2 outside boards
 What is ISS’s rationale?

47
  SEC requires disclosure of public boards how many public boards each director serves
on. It is uncommon that director will disclose the school board- even if SEC only
requires disclosure of public boards.

❑ Heightened focus in recent proxy seasons

❑ Worldwide issue

❑ TERM LIMITS

❑ Why is there a concern?

❑ Measures to address

❑ Flat term limits

❑Age limits vs. term limits
Tend to be more prevalent. GE limit is 75 and term limit 15 years.
Commonsense Principles.

❑ Disqualify as “independent”
❑ Rely on self-evaluation and s/h vote
❑ What are the benefits?

❑ What are the drawbacks?

❑ Position of institutions

 DIRECTOR QUALIFICATION BYLAWS

 DGCL §141(b) permits
 Not widely used in the past – but…
 Proxy access …
 Anti-takeover device?
 Only if reasonable – citizenship?
 “Clear day” more defensible
 Conditions to eligibility
 Independence, provide information, agree to policies, skills

DIVERSITY AND TERM LIMITS Brown pgs 183-187

Diversity

The SEC promulgated a new disclosure rule, requiring that publicly- traded companies make
a disclosure in its annual proxy statements, informing how does the nominating committee

48
or board; (1) has a policy with regard to the consideration of diversity in identifying director
nominee; (2) the implementation; and (3) effectiveness of such policy.

The aim of the rule is to provide investors with more meaningful disclosure that will help them
in the voting decisions. However, the rule does not impose a duty of observing diversity.

SEC did not define the term “diversity”, under the argument that the concept might be
expansive and therefore, the companies should be entitled to define diversity in ways that
they consider appropriate. It is said that, due to the lack of definition, the rule is unlikely to
prompt boards to recruit more women and people of color. It is believed that SEC has given a
“moral cover” for companies to comply by taking into account any form of diversity.

SEC’s chairwoman, criticized the relatively low numbers of women in leadership.

Director’s Tenure

Gender diversity accelerates board renewal. Boards with at least one woman director continue
to add more omen to their ranks, while all-male boards have lower refreshment rates (This
indicate that directors become entrenched).

Research also shows aging in US corporate boards. Pros and cons of letting the board have
members for a long time and that are aging:

Pros (benefits):
1.- Mandatory retirement policies and enforcement of term limits may cause corporate boards to
lose high- performing members.

2.- Longer- tenure directors generally have substantial knowledge about the company’s
business, its operations, finances and industry.

3.- They provide historical perspective.

4.- They understand the strengths and weakness of the executive team.

Cons (drawbacks):
1.- Longer tenures compromise director’s independence.

2.- More likely to increase the board compensation, including higher pay to the CEO.

Institutional position:
On 2014, shareholders from Costco submitted a shareholder proposal to request that the board
adopt a bylaw requiring at least two-thirds of directors to have less than 15 years tenure on the
board. The proposal was rejected, but it is expected that similar proposals arise in the short
term.

Establishing and Enforcing Qualifications for Directors of Delaware Corporations- Holly

Gregory

49
The Delaware law permits companies to prescribe qualifications for their directors via charter
amendment or bylaw.

Basic limitations for imposing of qualification-

1) directors must be natural persons;
2) prohibition of enacting any qualification “inconsistent with” the law or corporate
charter. Case law requires that all qualifications be reasonable and equitable and be
related to the objectives and purposes of the corporation.
3) Qualifications that are “unreasonably vague.” are not allowed.

Delaware courts will generally not strike a qualification simply because it has the potential to
disenfranchise shareholders; rather, qualifications will typically fail only where there is some
evidence that the board intended to disenfranchise shareholders in adopting or in enforcing the
qualification.

Milliken Enterprises case- example of highly subjective, yet permissible qualifications. There,
the company amended the corporate charter to require that certain directors possess “substantial
experience in line (as distinct from staff) positions in the management of substantial business enterprises
or substantial private institutions . . . .” The court found that the qualification was valid and that
the term “substantial” was used in many rules and statutes.

Example of rejected qualifications:

1) qualification which would require all directors of a global agricultural company to take
an oath to support the U.S., was rejected by SEC, as it could unreasonably disqualify
competent foreign nationals from the directorships of an international company.
2) ineligibility for election any current or former director who had previously opposed an
amendment to remove the company’s supermajority voting provisions. Delaware found
inconsistent with the law as it affected director’s duties.

Some qualifications:

Compliance with SEC and Stock Exchange rules; background of director; compliance with
company’s policies; criminal history and integrity (between others).

The nominee is entitled to his seat only after he is “elected and qualified. He/she must qualify
within a reasonable time after the election. In spite of this, Delaware law permits a corporation
to apply the qualification standards prior to the election.”

Consequently, it appears that a company remains free to exclude unqualified nominees from
the ballot, notwithstanding that the same nominees must appear on the proxy.

Delaware law specifies only three procedural means by which the term of a sitting director can
be brought to a close:
1) upon the election and qualification of the sitting director’s successor;
2) by resignation; or
3) by removal via shareholder vote.

50
The law does not contemplate the removal of a sitting director for failing to maintain certain
qualifications.

However, an alternative stated in Stroud v. Milliken Enterprises, the Court determined that a
company could amend the corporate charter to provide for the automatic removal of directors
whose qualifications lapse. This is akin to resignation, but the board would encounter the
problem by which the board connot remove their peers. Therefore, shareholder approval must
be obtained.

Another issue is when can the new condition of removal for loss of qualification be applicable to
the director: so long as the director knows before he is seated that he must maintain his
qualifications in order to retain the board seat, the director has full notice of all expectations.

Also, a company can comply with this front-end notice requirement through a private
mechanism whereby directors are required to tender their irrevocable resignation upon being
seated. This will be effective only upon disqualification under the company’s qualification
standards, as is permitted by the DGCL. The safest thing is to obtain stockholder’s authorization
for this.

 PROXY ACCESS
14_A Shareholder proposal- cannot be about election and election process. But you can use it for
shareholder proposal to adopt Proxy Access in the By-laws. SEC passed Proxy Access Rule that
allowed shareholders nominated director, but this was invalidated. Delaware in the meantime
passed Section 112, allowing the insertion of Proxy Access in the By-Laws.
 Right to nominate, but expensive to solicit support for candidates
 What is proxy access?
 SEC’s efforts to grant proxy access
 Delaware §112
 SEC shareholder proposals
 ISS and Glass Lewis support
 NYC campaign
 PROXY ACCESS - FUTURE
 65% of S&P 500 have proxy access
 Trend will continue – significant percentage
This notwithstanding, this has not been used.
 Focus shifting to terms of proposal
 Ownership: 3% for 3 years (threshold; it allows you to nominate somebody and
not conduct your own proxy contest because this access. This requires the
company to put the candidate in the proxy form. More serious activist they want
to do it themselves so they don’t really benefit for proxy access)
14A – 1,000 shares and held for one year, then you can make shareholder
proposal.
 Number of nominees: 20%
 Nominating group size: 20 (to constitute 3%)
 All 2017 fix-it proposals either pulled or failed

PROXY ACCESS, DGLC§ 112 , Sidley Proxy Access Report 2018 (on Canvas)

51
DGCL § 112 Access to proxy solicitation materials.9
By laws may provide: if corporation solicits proxies with respect to an election of directors, it
may be required to include in its proxy solicitation materials, in addition to individuals
nominated by the board of directors: 1 or more individuals nominated by a stockholder.

Strategies for the New Reality of Shareholder Proxy Access

Access to company proxy materials for board candidates nominated by shareholders is now an
imminent reality.

Proxy Access Bylaw (on Canvass)

Proxy Access Reality

Old view - shareholder proxy access impairs the ability of public companies to attract and retain
quality directors

9
The bylaws may provide that if the corporation solicits proxies with respect to an election of directors, it
may be required, to the extent and subject to such procedures or conditions as may be provided in the
bylaws, to include in its proxy solicitation materials (including any form of proxy it distributes), in
addition to individuals nominated by the board of directors, 1 or more individuals nominated by a
stockholder.

Such procedures or conditions may include any of the following:

(1) A provision requiring a minimum record or beneficial ownership, or duration of ownership, of

shares of the corporation's capital stock, by the nominating stockholder, and defining beneficial
ownership to take into account options or other rights in respect of or related to such stock;

(2) A provision requiring the nominating stockholder to submit specified information concerning
the stockholder and the stockholder's nominees, including information concerning ownership by
such persons of shares of the corporation's capital stock, or options or other rights in respect of or
related to such stock;

(3) A provision conditioning eligibility to require inclusion in the corporation's proxy solicitation
materials upon the number or proportion of directors nominated by stockholders or whether the
stockholder previously sought to require such inclusion;

(4) A provision precluding nominations by any person if such person, any nominee of such person,
or any affiliate or associate of such person or nominee, has acquired or publicly proposed to
acquire shares constituting a specified percentage of the voting power of the corporation's
outstanding voting stock within a specified period before the election of directors;

(5) A provision requiring that the nominating stockholder undertake to indemnify the corporation
in respect of any loss arising as a result of any false or misleading information or statement
submitted by the nominating stockholder in connection with a nomination; and

(6) Any other lawful condition.

52
  Present view - SEC Chairman Schapiro has said that the SEC will consider a shareholder
access rule later this month, and Senator Schumer has said that shareholder access will
be an element of his so-called “Shareholder Bill of Rights Act of 2009.”

In an effort to forestall these attempts to further federalize corporate law , Delaware last month
enacted legislation which enables the adoption by Delaware companies of bylaws permitting
shareholder access to company proxy materials.

 such bylaws can be adopted not only by a company’s board of directors, but also by
shareholder action on shareholder initiative.

 Due to the negative impact of shareholder proxy access, companies will resist the
adoption of shareholder access bylaws of any sort.

 Others will favor a wait and-see attitude

 Some companies may consider the preemptive adoption of a reasonable and carefully
tailored bylaw, to deter more extreme versions of shareholder access that may be
proposed by short-term activist or special-interest shareholders.

We have prepared a model shareholder access bylaw (posted in canvass, but the salient points
are here below) for consideration:

 Our model permits shareholders holding at least 5% of a company’s common stock for
at least a year to nominate a limited number of independent director candidates using
the company’s proxy statement and card.
 Our model bylaw also contains features designed to prevent the use of shareholder
access as a “Trojan Horse” for takeover activity.
 For shareholders seeking to effect a takeover via director election, the SEC’s existing
proxy contest process, containing essential disclosure and procedural safeguards,
remains the appropriate mechanism.

If shareholder access is to be a part of our public company landscape, the private-ordering

approach through company specific bylaws contemplated by the Delaware legislation is
preferable to a federally mandated one-size-fits-all proxy access rule.

We expect that significant, long-term shareholders that do not desire the companies in which
they invest to be subject to director election free-for-alls – and the risks likely to result – should
find that the attached model shareholder access bylaw offers a reasonable framework.

 ELECTION – DEFAULT RULE

 DGCL §216(c)(3) – election by plurality
 SEC proxy rules – limited choices:
 “For”
 “Withhold” for all or specific candidates
 No up or down vote
 “Withhold” same effect as abstain
 Unopposed director needs only a single vote

53
  Even though all others vote “withhold”
 “Withhold” vote has only a symbolic effect
 ELECTION – MAJORITY VOTING
 Movement to change system – Disney, 14a-8
Disney’s management was controversial and there was opposition with the way Eisner
running the corporation. The shareholders withheld their votes. There was substantial
shareholder campaign.
14a-8 – Shareholder proposals.
 Companies adopted “policies” preemptively
Companies adopted majority voting policies.
 Legal issues
 Director still legally elected
 §216 permits exceptions only in charter or bylaws
 Must resign if fail to receive majority
 Enforceable?
 Irrevocable?
 Board has discretion to accept

 Shareholders preferred bylaws – legally elected

 But Board has concurrent authority to amend
 §216 amended – Board may not repeal or amend
 Holdover still an issue
 Holdover. You keep your office unless someone has been validly elected.
 SEC rule change now permits a “no” vote

ELECTION DGCL §216(3)

216 Quorum and required vote for stock corporations.

In the absence of such specification in the certificate of incorporation or bylaws of the
corporation:
(3) Directors shall be elected by a plurality of the votes of the shares present in person
or represented by proxy at the meeting and entitled to vote on the election of directors;
and
MAJORITY VOTING Brown Ch. 8 (pp. 456-457)
Brainbridge Majority Voting on Canvass

Majority vs. Plurality Voting

Until the new millennium, directors were almost universally elected through a system of
plurality voting.

Plurality Voting
 Meant that shares were not voted for or against directors. Instead, candidates with the
most votes were elected.
 In unopposed elections, a plurality system ensured that those nominated automatically
won, irrespective of the number of shares voted “against” them.

“Just Vote No” campaign

54
  by Professor Joseph Grundfest of Stanford Law School
 meant to alter the plurality voting; by voting no (actually withhold) against an
unopposed directors, shareholders express their dissatisfaction about the candidate.
 Example- 45% of shareholders of Walt Disney voted against the election of Michael
Eisner, the CEO, to the Board.

Majority Voting
Shareholders began to push for a system of majority voting where votes against the directors
mattered through Shareholder Proposals (Rule 14a-A)
Quickly, large number of companies adopted majority voting.

State law continued to rely on plurality voting to elect directors. As a result, directors not
receiving the majority of votes case were still elected under state law. The practice therefore
arose of requiring directors who did not receive a majority of the votes to resign and leaving
it to the board to decide whether to accept the resignation.

THEREAFTER, majority provisions become common. Victory of shareholder advocacy.

Brainbridge Majority Voting (on Canvas)

ABA Keeps Plurality Voting as the Default for Electing Directors by Prof. Bainbridge

First, some background.

As a general rule:
state corporate law contemplates that shareholder action requires the affirmative votes of a
majority of the shareholders present at a meeting at which there is a quorum.

However, in elections:
State law until recently merely required a plurality shareholder vote.
Delaware General Corporation Law § 216(3): “Directors shall be elected by a plurality of the
votes of the shares present in person or represented by proxy at the meeting and entitled to vote
on the election of directors.”
plurality standard: that the individuals with the largest number of votes are elected as directors
up to the maximum number of directors to be chosen at the election.
The federal proxy rules accommodated state law by providing, in former SEC Rule 14a-4(b),
that the issuer must give shareholders three options on the proxy card with respect to electing
directors.
A shareholder could: (1) vote for all of the nominees for director,
(2) withhold support for all of them, or
(3) withhold support from specified directors by striking out their
names.

In 2006, Delaware responded to considerable pressure from activists and others by amending
the statutory provisions on director election to accommodate various forms of majority
voting.
Pfizer policies—named after the first prominent corporation to adopt one—pursuant to which
directors who receive a majority of withhold “votes” are required to submit their resignation
to the board. Section 141(b) of the Delaware General Corporation Law: A resignation [of a

55
director] is effective when the resignation is delivered unless the resignation specifies a later
effective date or an effective date determined upon the happening of an event or events. A
resignation which is conditioned upon the director failing to receive a specified vote for
reelection as a director may provide that it is irrevocable.

The trouble with these so-called Pfizer or plurality-plus policies:

 the board retains authority to turn down the resignation of a director who fails to get
the requisite majority vote. (In City of Westland Police & Fire Retirement System v.
Axcelis Technologies, Inc., 1 A.3d 281 (Del. 2010))

 it typically was effected by changing board of directors corporate governance policies

rather than by amending the bylaws or articles. As such, continuation of the policy was
subject to the discretion of the directors.

Shareholder activists therefore began using Rule 14a-8 to put forward bylaw amendments
mandating true majority voting.
 A bylaw voluntarily adopted by Intel received wide activist support as a model for
bylaw amendments at other issuers. Under it, a director who fails to receive a majority of
the votes cast is not elected. In the case of an incumbent director who fails to receive a
majority vote in favor of his reelection, there is the complication that, under DGCL §
141(b), a director’s term continues until his successor is elected. The Intel (a.k.a. majority-
plus) model requires resignation of such a director.
 Shareholder activists preferred a bylaw approach to one based on the articles of
incorporation because of the latter’s board approval requirement. In most states,
however, a shareholder-adopted bylaw would be vulnerable to subsequent board
amendment or even repeal. Recall that DGCL § 109(a) provides that the articles of
incorporation may confer the power to amend the bylaws on the board of directors, but
that such a provision does not divest the shareholders of their residual power to amend
the bylaws.
 In response to activist shareholder pressure, however, Delaware amended § 216 by
adding the following sentence: “A bylaw amendment adopted by stockholders which
specifies the votes that shall be necessary for the election of directors shall not be
further amended or repealed by the board of directors.” The Board cant repeal this by-
law provision.
 The ABA Committee on Corporate Laws has amended the Model Business Corporation
Act so as to permit the use of majority voting. MBCA § 7.28.

All of which brings us up to date. Now BNA reports that: The American Bar Association's
Corporate Laws Committee declined a request from Council of Institutional Investors' general
counsel Jeffrey Mahoney to revise the Model Business Corporation Act (MBCA) to make
majority voting the default legal standard for uncontested director elections.

The MBCA is the basis for the corporate laws of most states, except Delaware, according to the
CII. Section 7.28(a) of the MBCA sets plurality voting as the default standard for director
elections unless a company's articles of incorporation call for a different standard.

56
Critics of majority voting schemes correctly contend that failed elections can have a
destabilizing effect on the corporation. Selecting and vetting a director candidate is a long and
expensive process, which has become even more complicated by the new stock exchange listing
standards defining director independence. Suppose, for example, that the shareholders voted
out the only qualified financial expert sitting on the audit committee. The corporation
immediately would be in violation of its obligations under those standards.
Critics also correctly complain that qualified individuals will be deterred from service. The
enhanced liability and increased workload imposed by Sarbanes-Oxley and related regulatory
and legal developments has made it much harder for firms to recruit qualified outside directors.
The campaign for majority voting has created little shareholder value.
There thus is no case for making majority voting the default rule.

 Classified Board
 Directors elected annually
 DGCL §141(d) permits classification
 Up to 3 classes
Class 1- 1 year, Class 2- 2 year and Class 3- 3 years
 Multi-year terms
 Removable only for cause
 Must be in charter or initial bylaws
 Anti-takeover device
 Declassification movement
 But IPOs???

Annual vs. Classified Boards

The Case against Staggered Boards (by Solomon, The New York Times)

Corporate puzzle

Companies that are already public are ditching their staggered boards while companies
undertaking initial public offerings, like Angies’ List and LinkedIn, are increasingly
choosing to go public with staggered boards.

What explains this odd divergence?

Why public companies are choosing to eliminate staggered Boards?

 In the public markets, it appears that pressure from corporate governance activists like
the Harvard project and from proxy advisory firms like Institutional Shareholder
Services is working to coax companies into destaggering.
o The Shareholder Rights Project from Harvard Law School over a period of 5-6
years has succeeded in getting about a third of all the Standard &Poor 500
companies that had a staggered board to eliminate it.
Directors in staggered boards can only be removed for cause.

57
 Academics argue that the staggered board thus serves as a powerful antitakeover device
and “entrenches” the board, unduly protecting it from shareholder influence. Directors
will instead look out for themselves and management instead of shareholders.

o In the public markets, it appears that pressure from corporate governance

activists like the Harvard project and from proxy advisory firms like Institutional
Shareholder Services is working to coax companies into destaggering.

 Academic research also lends some support to the questionable value of a staggered
board. Companies with such boards have been found to have greater likelihood of
making acquisitions that are value-destroying, and a greater propensity to compensate
executives without regard to whether they actually do a good job. (In fairness, there is
also contrary evidence, at least one paper has found that shareholders of companies with
staggered boards receive more consideration in takeovers than companies without such
boards and that a staggered board does not significantly deter bidders.)

Compare this with the market for initial public offerings.

 86.4 percent of the companies going public this year have had a staggered board,
adopted by Tesla, LinkedIn and Dunkin’ Brands.
 Companies going public may believe that the staggered board is important
because it creates value by insulating directors from shareholder pressure so that
they can make long-term decisions. They adopt these provisions because it
prevents shareholders from having undue influence that may affect their ability
to keep their management positions or pay themselves compensation. They want
to be undisturbed for a while.
 In either case, companies are acting to adopt a staggered board before
shareholder pressure comes to bear. In the I.P.O. market, most investors are there
for short-term profits. They buy to almost immediately sell on the first-day “pop”
that often occurs. Corporate governance does not matter to these buyers. They
also include high vote stock-retain a majority vote. As a shareholder activist
wants to change classified board, Zuckerburg can outvote anyone. Google IPO
Propespectus: 2 founders will have controlling vote and very blunt and accurate
that they will decide what you need to do.
 But there may be another explanation here: the lawyers. The corporate legal bar
is not particularly enamored of the staggered board, most likely from its
experience representing companies without such a device. Many of these lawyers
believe the staggered board provides negotiating room to bargain for a higher
premium.
 Annual vs. Classified Board
 The Case against Staggered Boards (by Solomon, The New York Times)

 DGCL §141 (d)

 (d) The directors of any corporation organized under this chapter may, by the
certificate of incorporation or by an initial bylaw, or by a bylaw adopted by a
vote of the stockholders, be divided into 1, 2 or 3 classes;


58
 the term of office of those of the first class to expire at the first annual meeting
held after such classification becomes effective; of the second class 1 year
thereafter; of the third class 2 years thereafter; and at each annual election held
after such classification becomes effective, directors shall be chosen for a full
term, as the case may be, to succeed those whose terms expire.

 The certificate of incorporation or bylaw provision dividing the directors into

classes may authorize the board of directors to assign members of the board
already in office to such classes at the time such classification becomes effective.
 The certificate of incorporation may confer upon holders of any class or series of
stock the right to elect 1 or more directors who shall serve for such term, and
have such voting powers as shall be stated in the certificate of incorporation. The
terms of office and voting powers of the directors elected separately by the
holders of any class or series of stock may be greater than or less than those of
any other director or class of directors. In addition, the certificate of incorporation
may confer upon 1 or more directors, whether or not elected separately by the
holders of any class or series of stock, voting powers greater than or less than
those of other directors. Any such provision conferring greater or lesser voting
power shall apply to voting in any committee, unless otherwise provided in the
certificate of incorporation or bylaws. If the certificate of incorporation provides
that 1 or more directors shall have more or less than 1 vote per director on any
matter, every reference in this chapter to a majority or other proportion of the
directors shall refer to a majority or other proportion of the votes of the directors.

 DGCL 141 (k)(1)

 (k) Any director or the entire board of directors may be removed, with or
without cause, by the holders of a majority of the shares then entitled to vote at
an election of directors, except as follows:
 (1) Unless the certificate of incorporation otherwise provides, in the case of a
corporation whose board is classified as provided in subsection (d) of this
section, stockholders may effect such removal only for cause; or

 DGCL 211 (b)

 (b) Unless directors are elected by written consent in lieu of an annual meeting as
permitted by this subsection, an annual meeting of stockholders shall be held for the
election of directors on a date and at a time designated by or in the manner provided in
the bylaws.

 Stockholders may, unless the certificate of incorporation otherwise provides, act by
written consent to elect directors; provided, however, that, if such consent is less than
unanimous, such action by written consent may be in lieu of holding an annual meeting
only if all of the directorships to which directors could be elected at an annual meeting
held at the effective time of such action are vacant and are filled by such action. Any
other proper business may be transacted at the annual meeting.

59
  Removal – DGCL §141(k)
 Directors may be removed with or without cause – by shareholders
In the absence of a classified board, can corporation limit the removal for cause? No.
 Supermajority vote not permitted
 Frechter v. Zier – 141(k) says “majority”
 May limit to cause if Board classified
 What is “cause”? serious misconduct, beyond well judgment – Rohe v. Reliance
 What if Board not classified?
 Vaalco Energy (2015) – limitation to cause not permitted without classified Board
 No appeal – no Supreme Court ruling

 Role of the Board - Legal

 DGCL §141: “business and affairs … managed by or under the direction of ….”
 Specific statutory responsibilities:
 Prerequisites to shareholder approval
 Sole authority
 Concurrent authority
By-Laws.
 Little additional guidance
 “Manage”?
 “Under the direction”?

 Board vs. Management

 Important to distinguish roles of the Board and Management
 NACD: undue involvement may interfere with objectivity
 Commonsense Principles: minimize time on non-essential matters; focus on
building real value
Strategy and high level advise; focus on long term, operational and financial
plans
 Business Roundtable: Board oversees management and strategy to achieve long-
term value creation

CHAPTER 1. GENERAL CORPORATION LAW

Subchapter IV. Directors and Officers

§ 141 Board of directors; powers; number, qualifications, terms and quorum; committees;
classes of directors; nonstock corporations; reliance upon books; action without meeting;
removal.
(a) The business and affairs of every corporation organized under this chapter shall be
managed by or under the direction of a board of directors, except as may be otherwise
provided in this chapter or in its certificate of incorporation. If any such provision is made in
the certificate of incorporation, the powers and duties conferred or imposed upon the board
of directors by this chapter shall be exercised or performed to such extent and by such
person or persons as shall be provided in the certificate of incorporation.

Board Operations

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Brown, Chapter 3 pp. 119-120

Board of directors are the ultimate decision-making body of the company.

Board approval is a statutory pre-requisite to corporate action on fundamental transactions,

such as whether:

(i) The corporation is amending its charter;

(ii) Buy or sell significant assets;
(iii) Merge with another company;
(iv) Dissolve.

If and when directors recommend a transaction, shareholders have the right to veto it.
However, shareholders cannot initiate transactions, nor can they amend the board´s proposals.

State statutes also grants board of directors the exclusivity authority to:
(i) Issue stock – charter provides how much number authorized to be issued.
(ii) Determine the adequacy of consideration for shares, and
(iii) Declare dividends

Board of directors:
(i) are vested with virtually irrevocable decision-making authority; and
(ii) director´s business judgment are substantially protected from second-guessing by
shareholders and by the courts.

This means that board of directors have substantial autonomy and control over companies´
assets.

Directors do not handle the day-to-day operations of the company; they delegate the work of
running the company to the firm´s officers and other senior executives employed by the
corporation.

Board select the top managers (CEO, CFO and other executives for particular areas of the firm´s
affairs), delegates duties to them, decide their tenure and compensation.

Board also:
(i) advice the executive team, in especially on matters of strategy, long-term
performance targets, vital business policy, etc.;
(ii) assesses the company´s financial and operational performance;
(iii) evaluates management´s leadership;
(iv) supervisory capacity.

General Brown pp. 129-130

Report of Task Force of the ABA Section of Business Law

Corporate Governance Committee on Delineation of

61
Governance Roles and Responsibilities

To the extent that a board delegates functions to management, it must exercise reasonable
oversight and supervision over management.

However, certain board functions cannot be delegated, such as:

 selecting, monitoring, evaluating, compensating and replacing CEO and other senior
executives, when necessary;
 monitoring corporate performance;
 provide strategic guidance to the senior management team; reviewing and approving
financial objectives and major corporate plans;
 developing corporate policy;
 reviewing and approving major changes in auditing and accounting principles and
practices;
 overseeing audit, internal controls, risk management and ethics and compliance;
 In a public company: overseeing financial reporting and disclosures;
 Declaring dividends and approving share repurchase programs;
 Making decisions of major transactions and other material events for submission to the
shareholder´s approval;
 Other functions provided by law, regulation of listing rule, by the certificate of
incorporation or bylaws.

Shareholder Directors
limited powers broad powers
certain directors:
limited for shareholder approval
always limited:
fiduciary duties

Directors own high standards of fiduciary duties, including acting in due care (focusing
appropriate attention and making decisions on an informed basis); in good faith, in the best
interests of the corporation and its shareholders.

Fiduciary duties:

a) duty of care – “all material information reasonably available for them” concerning a
given decision, prior to acting on that decision; and

b) duty of loyalty – the best interests of the corporation and its shareholders takes
precedence over any interest possessed by a director and not shared by the stockholders
generally.

Act in a deliberative and fully informed manner, which requires access to relevant and timely
information

62
Challenges in corporate governance – difference between managers and directors in their access
to information about the corporation and implications of this difference on the ability of part-
time outside directors to hold managers accountable for their responsibilities that have been
delegated to them.

Independent directors – by definition, lack their own sources of information due to their lack of
employment and business ties to the company. This can increase directors´ dependency on
management.

General Electric Governance Principles, Item 2

2. Functions of Board

The board of directors has eight scheduled meetings a year at which it reviews and discusses
the performance of the Company, its plans and prospects, as well as immediate issues facing the
Company. Directors are expected to attend all scheduled board and committee meetings.

In addition to its general oversight of management, the board also performs a number of
specific functions, including:

a. selecting, evaluating and compensating the CEO and overseeing CEO succession planning;
b. providing counsel and oversight on the selection, evaluation, development and
compensation of senior management;
c. reviewing, monitoring and, where appropriate, approving fundamental financial and
business strategies and major corporate actions;
d. assessing major risks facing the Company -- and reviewing options for their mitigation; and
e. ensuring processes are in place for maintaining the integrity of the Company - the integrity of
the financial statements, the integrity of compliance with law and ethics, the integrity of
relationships with customers and suppliers, and the integrity of relationships with other
stakeholders.

Management/Leadership Brown Ch. 3 (pp. 131-134)

 Board vs. Management
 Important to distinguish roles of the Board and Management
 NACD: undue involvement may interfere with objectivity
 Commonsense Principles: minimize time on non-essential matters; focus on
building real value (keep it on a high level)
 Business Roundtable: Board oversees management and strategy to achieve long-
term value creation
 Where to Draw Line?
 Legal
There’s not a lot of guidance. Fiduciary duties. Minimum level of performance
required by law. Specifics in the legal requirement are monitoring and fiduciary duties.

63
  Market expectations
Gives closest guidance as to what Board should be doing.
 Business judgment
Act in good faith, duty of care.

 Board Functions- Routine

From the GE Governance Principles and ABA Principles.
 Selection, monitoring, evaluation, motivation and compensation of CEO and other
senior executives
 Delegation
 Strategic guidance and advice
 Review and approve financial objectives
More supervision and monitoring
 Monitor performance and financial reporting
More supervision and monitoring
 Oversight of audit and internal controls
More supervision and monitoring
 Major transactions
Strategy, business judgement
 Risk management
Increasingly important matter as a governance matter and from Sarbanes Oxley

 Ethics, compliance and governance

 Board Size
 Impact of Board size on Apple?
 DGCL §141(b) set bylaws or charter
 Board may set within a range
 Average size 11-12 members
 Down from 15 in 1988
 What is the appropriate Board size?
 Boards That Lead – Checklist

 Board Administration
 Board Leadership
 U.S. practice/ criticisms
 Shareholder initiatives
 Limited success, BUT
 “Lead Directors” – not a statutory role
 SEC rules – S-K 407(h)
 Executive Session - NYSE 303A.03
 Rationale?
 Non-management vs. independent
 Disclosure – who presides?
 Executive Session – NYSE Section 303A.03 requires non-management directors to meet
at regularly scheduled executive meetings that are not attended by management.

 303A.03 Executive Sessions

64
 To empower non-management directors to serve as a more effective check on management, the
non-management directors of each listed company must meet at regularly scheduled executive sessions
without management.

 Commentary: To promote open discussion among the non-management directors, companies
must schedule regular executive sessions in which those directors meet without management
participation. "Non-management" directors are all those who are not executive officers, and includes
such directors who are not independent by virtue of a material relationship, former status or family
membership, or for any other reason.

 If a listed company chooses to hold regular meetings of all non-management directors, such listed
company should hold an executive session including only independent directors at least once a year
 .

 Disclosure Requirements: If one director is chosen to preside at all of these executive sessions, his
or her name must be disclosed either on or through the listed company's website or in its annual proxy
statement or, if the listed company does not file an annual proxy statement, in its annual report on Form
10-K filed with the SEC. If this disclosure is made on or through the listed company's website, the listed
company must disclose that fact in its annual proxy statement or annual report, as applicable, and
provide the website address. Alternatively, if the same individual is not the presiding director at every
meeting, a listed company must disclose the procedure by which a presiding director is selected for each
executive session. For example, a listed company may wish to rotate the presiding position among the
chairs of board committees.

 In order that all interested parties (not just shareholders) may be able to make their concerns
known to the non-management or independent directors, a listed company must also disclose a method
for such parties to communicate directly with the presiding director or with those directors as a group
either on or through the listed company's website or in its annual proxy statement or, if the listed
company does not file an annual proxy statement, in its annual report on Form 10-K filed with the SEC.
If this disclosure is made on or through the listed company's website, the listed company must disclose
that fact in its annual proxy statement or annual report, as applicable, and provide the website address.
Companies may, if they wish, utilize for this purpose the same procedures they have established to comply
with the requirement of Rule 10A-3 (b)(3) under the Exchange Act regarding complaints to the audit
committee, as applied to listed companies through Section 303A.06.


 Self-Evaluation
 Required by NYSE Rule 303A.09
 Board and key committees
 Governance Committee does Board
 Procedures/Issues
 Who conducts?
 Survey or personal interview
 Individual vs. Board or Committee
 Document retention
Feedback/response Self-evaluation: NYSE Rule 303A.09

65
NYSE Section 303A.09 requires public companies to adopt and disclose corporate governance
guidelines, including several issues for which such reporting is mandatory, and to include such
information on the company’s website (which website should also include the charters of the
audit committee, the nominating committee, and the compensation committee.)

303A.09 Corporate Governance Guidelines

Listed companies must adopt and disclose corporate governance guidelines.

Commentary: No single set of guidelines would be appropriate for every listed company, but certain key
areas of universal importance include director qualifications and responsibilities, responsibilities of key
board committees, and director compensation.

The following subjects must be addressed in the corporate governance guidelines:

• Director qualification standards. These standards should, at minimum, reflect the independence
requirements set forth in Sections 303A.01 and 303A.02. Companies may also address other substantive
qualification requirements, including policies limiting the number of boards on which a director may sit,
and director tenure, retirement and succession.

• Director responsibilities. These responsibilities should clearly articulate what is expected from a
director, including basic duties and responsibilities with respect to attendance at board meetings and
advance review of meeting materials.

• Director access to management and, as necessary and appropriate, independent advisors.

• Director compensation. Director compensation guidelines should include general principles for
determining the form and amount of director compensation (and for reviewing those principles, as
appropriate). The board should be aware that questions as to directors' independence may be raised when
directors' fees and emoluments exceed what is customary. Similar concerns may be raised when the listed
company makes substantial charitable contributions to organizations in which a director is affiliated, or
enters into consulting contracts with (or provides other indirect forms of compensation to) a director. The
board should critically evaluate each of these matters when determining the form and amount of director
compensation, and the independence of a director.

• Director orientation and continuing education.

• Management succession. Succession planning should include policies and principles for CEO selection
and performance review, as well as policies regarding succession in the event of an emergency or the
retirement of the CEO.

• Annual performance evaluation of the board. The board should conduct a self-evaluation at least
annually to determine whether it and its committees are functioning effectively.

Website Posting Requirement: A listed company must make its corporate governance guidelines available
on or through its website.

66
Disclosure Requirements: A listed company must disclose in its annual proxy statement or, if it does not
file an annual proxy statement, in its annual report on Form 10-K filed with the SEC that its corporate
governance guidelines are available on or through its website and provide the website address.

 Board Committees
 Boards may only act in concert
 BUT may delegate to committees - §141(c)(2)
 Standing vs. special
2) The board of directors may designate 1 or more committees, each committee
to consist of 1 or more of the directors of the corporation. The board may
designate 1 or more directors as alternate members of any committee, who may
replace any absent or disqualified member at any meeting of the committee. The
bylaws may provide that in the absence or disqualification of a member of a
committee, the member or members present at any meeting and not disqualified
from voting, whether or not such member or members constitute a quorum, may
unanimously appoint another member of the board of directors to act at the
meeting in the place of any such absent or disqualified member.
Any such committee, to the extent provided in the resolution of the board of
directors, or in the bylaws of the corporation, shall have and may exercise all the
powers and authority of the board of directors in the management of the business
and affairs of the corporation, and may authorize the seal of the corporation to be
affixed to all papers which may require it; but no such committee shall have the
power or authority in reference to the following matter: (i) approving or adopting,
or recommending to the stockholders, any action or matter (other than the
election or removal of directors) expressly required by this chapter to be
submitted to stockholders for approval or (ii) adopting, amending or repealing any
bylaw of the corporation.
 Post-Enron: SEC and NYSE
 Key committees mandatory
 Independence requirements
 Charters – key innovation NYSE 303 A
Puts a lot of substance on what is required from their committees
 Access to advisors and funding
 SEC disclosure – S-K Item 407
 Audit Committee
 Major SOX requirement
 Required for all listed companies
 Rule 10A-3; S-K 407(d); NYSE 303A.07
 Must disclose if no standing committee
 Membership qualifications
 Independence – no other compensation
 Financial literacy - NYSE
 Audit Committee Financial Expert – SEC
 Accting or financial mgt expertise - NYSE
 Specific responsibilities – charter

67
  Compensation Committee
 Mandatory for all listed companies; disclose if none
 NYSE Rule 303A.05
 All members must be independent
 Additional conflicts requirements – 303A.02(a)(ii)
 Review and approve CEO compensation
 Recommend non-CEO executive compensation, incentive comp and equity-based
plans
 Performance targets
 Disclosure – CD&A
 SEC Regulation S-K, Items 407(e)
 Describe deliberative process and authority
 Role of executive officers
 Role of consultants: independence, fees, etc.
 Conflicts and interlocks
 Nominating and Governance
 Mandatory for listed companies
 Must disclose if have none
 Responsibilities – 303A.04
 Nomination – discussed earlier
 Board self-evaluation
 Governance guidelines
 Board leadership
 Committee assignments
 Shareholder proposals

Board Size, structure and leadership.

On average, twelve directors serve on boards of the largest US public companies. After growing
in years following enactment of Sarbanes-Oxley, large public company boards have downsized
over the past few years.

Heidrick & Struggles, an executive search firm, found that the number of board seats in Fortune
500 companies shrunk from 5267 in 2009 to 4637 in 2013, finding that companies with fewer
boards’ members outperform their industry peers.

 A study of corporations with at least $10 billion in market capitalization found that firms
with smaller boards tended to outperform their peer companies with larger boards.

 Governance experts theorize that smaller boards may meet more often, engage in more
robust debates and make more timely decisions.

 They suggest that small board directors must assume more responsibility for the work of the
board.

 Furthermore, boards with fewer members may monitor management more effectively than
larger boards because directors cannot shirk their oversight duties as easily, nor can they
simply free-ride on their colleagues policing efforts.

68
 Small boards not only supervise the performance of executive more closely, but they also
are more likely to assess their own performance regularly.

 On the other hand, since there are fewer members to perform the board’s work, small board
directors necessarily vary larger workloads.

 Therefore, while larger boards have difficulty coordinating and communicating, more
members are available to divide the labor. Larger boards also facilitate diversity,
networking, and information gathering.

Board leadership also has generated debate for at least four decades. Unlike their foreign
counterparts in the UK, Canada, and most European countries, CEOs of American Firms
traditionally have chaired the corporations’ boards.

By revelations that CEOs dominated corporate governance processes at corporations damaged

by fraud and scandal, regulators and academics have called for companies to separate the role
of CEO and board chair since 1970. Finally, research indicates that the cost of compensating one
individual as CEO and chairman is significantly higher than the cost of paying two individuals
to perform those management responsibilities.

Corporate leaders have attacked “one size fits all” prescriptions for good governance, arguing
that firms should adopt whatever leadership structure best suits their organization. According
to companies with dual CEO/chairmen, unified leadership affords clear accountability and
provides benefits of deep operational and industry experience.

As of 2015, CEOs continued to serve as board chairs for nearly two-thirds of the largest US
public companies. Rather than appointing non-executives as their chairmen, these firms have
augmented their boards’ leadership by appointing independent directors to serve as lead
directors.

As with other corporate governance initiatives, the SEC began to address investors’ concerns by
requiring that public companies disclose to shareholders more information about the firms’
board leadership structure.

Lead Directors.

Regulation S-K, Item 407(h):

(h)Board leadership structure and role in risk oversight. Briefly describe the leadership
structure of the registrant's board, such as whether the same person serves as both principal
executive officer and chairman of the board, or whether two individuals serve in those
positions, and, in the case of a registrant that is an investment company, whether the chairman
of the board is an “interested person” of the registrant as defined in section 2(a)(19) of the
Investment Company Act ( 15 U.S.C. 80a-2(a)(19)). If one person serves as both principal
executive officer and chairman of the board, or if the chairman of the board of a registrant that
is an investment company is an “interested person” of the registrant, disclose whether the
registrant has a lead independent director and what specific role the lead independent director

69
plays in the leadership of the board. This disclosure should indicate why the registrant has
determined that its leadership structure is appropriate given the specific characteristics or
circumstances of the registrant. In addition, disclose the extent of the board's role in the risk
oversight of the registrant, such as how the board administers its oversight function, and the
effect that this has on the board's leadership structure.

 Board Functions- Routine

 Selection, monitoring, evaluation, motivation and compensation of CEO and other
senior executives
 Delegation
 Strategic guidance and advice
 Review and approve financial objectives
 Monitor performance and financial reporting
 Oversight of audit and internal controls
 Major transactions
 Risk management
 Ethics, compliance and governance
 Monitoring vs. Advice
 Monitor/Advise (strategy)
 Brown:
 Increased importance of monitoring
 Board selected for reliability
 Board capture?
 Impediments to good advice?
 Strategy less affected
 But doesn’t play a meaningful role!?
 Influenced by management

J. ROBERT BROWN, JR.

THE DEMYTHIFICATION OF THE BOARD OF DIRECTORS

Corporate governance
 Management has a legal obligation to act in the best interest of shareholders but
sometimes does not. Shareholders have an interest in overseeing the actions of
management but often cannot.

Reforms to address this issue take the form of structural changes to the board:
 After Enron, stock exchanges the use of audit, compensation, and nomination
committees, and limited membership to independent directors, excluding management.
 Boards of listed companies were required to have a majority of independent directors.
 Sarbanes -Oxley order in the inclusion of financial expertise on the board and imposed
mandatory standards for audit committee of listed companies.
 Dodd-Frank took a similar approach to compensation committees and tightened
definition of independent director.

This has not generated the anticipated results because the reforms were unaccompanied by
necessary changes in process.

70
Intervention by the board of management action is discretionary but is a matter of structure
and a consequence of legal obligation.
 CEOs must serve in a manner consistent with the express desires of the board of
directors.
 Directors in turn are obligated to act in the best interest of shareholders, and may
dismiss CEO if necessary.

TWO MYTHS

1. Directors are not chosen on basis of substantive qualifications but because of their willingness
to support the policies of management.
 Since directors have inherent authority in corporate affairs, including right to dismiss
top officers, management has incentive to choose directors who favor positions taken by
the chief executive officer (CEO).

2. Boards at public companies do not perform a meaningful advisory function (which is a more
cooperative process), but instead merely reduced to oversight and monitoring (adversarial). In
reality, usually in large public companies, the proposals (for dividends and mergers for
example) usually arrive at the board level after successful negotiation by management and a
thorough vetting by outside experts.

The closest a board comes to a formal advisory rule is participation in the strategic planning
process, i.e., help determine the mission of the company. But still likely influenced by
management’s existing vision.

CONCLUSION:
The boards of the largest public companies do not perform an advisory role, at least in any
systematic and meaningful fashion. Nor does the board manage the corporation. Instead,
directors mostly ensure legal sufficiency and establish outer boundaries for management.
They do not devise the policies or practices implemented by the company but have the
authority and, sometimes, the obligation to intervene when necessary to protect the interest
of shareholders.
 Board Administration
 Board Leadership
 U.S. practice/ criticisms
 Shareholder initiatives
 Limited success, BUT
 “Lead Directors” – not a statutory role
 Boards That Lead
 What would Charan say to Brown?
 What do Charan and Brown agree on?
 Where do they differ?
 Evolution of Board’s role
 Regulation put pressure on monitoring
 Increasingly complex economy
 More intimate involvement

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  Impact on Board focus/leadership
 Inadvertently strengthened leadership
 Charan
 Adversarial relationship?
 Do/should Boards advise?
 Does emphasis on monitoring inhibit advisory role?
 Where do you draw the line?
 What explains the stark difference between Brown and Charan?
 Boards That Lead - Apple
 What went wrong?
 Poor skill set
 Isolation
 Board deference (monitor? advise?)
 What went right?
 Deep understanding of business
 Direct contact with management
 Cooperative relationship with CEO
 No micro-management

FROM CEREMONIAL TO MONITOR TO LEADER

Governing boards should take more active leadership of the enterprise, not just monitor
management.
We also believe that many of the thrusts of government regulators and governance raters have
focused on the wrong issues. They have been concerned with whether the chief executive
should be the same person as the board chair or whether there should have been staggered
terms, etc. The focus instead should be: Board leader can help direct the board in setting
strategy and gauging risk in concert with the CEO, and whether the director’s talent and
collective chemistry make the board a substantive player at the table.
The authors suggest that for the directors it is more important to give them a PRACTICAL
ROAD MAP for knowing WHEN TO LEAD, WHEN TO PARTNER and WHEN TO STAY OUT
OF IT.
 Boards and management have been embracing practices that help define a more
directive, more collaborative leadership of the firm.
 They are taking charge of CEO succession, executive compensation, goal choices, merger
decisions, risk tolerance and other functions that have traditionally been the province of
management.
Shining example of this Board leadership was the Apple Experience, when the Board made
“one of the greatest business decision of all time” by rehiring Steve Jobs thereby acknowledging
their mistake of an irresponsible decision of firing him before in 1985.
In the 12 years after Apple fired Steve jobs, Apple had recruited 3 CEOs, all ineffective, and in
the end left Apple losing financially. Apple was offering itself to be sold (to Dell, to Compaq)
but knowing was willing to buy.
Through the leadership of director Woolard, the Apple Board decided to rehire Steve Jos. Apple
directors still believed that the company might be saved by the right executive.

72
Woolard worked very well with Steve Jobs because he kept himself informed through the CFO
and the key executives and so he and the new board (Steve Jobs asked everyone to resign except
for Woolard and one more) provided substantive guidance and support of Steve Jobs decisions
to:
1. get rid of half of Apple’s engineers
2. put up Apple stores.
3. Hiring Cook of IBM as vice-president

Or strongly advising against some of Jobs decisions: Job’s proposal of employee

profit-sharing that would reward handsomely in the current years but yield so little
in the current year.

Over the years, jurisprudence have developed fiduciary duties of directors: duty of care and
duty of loyalty. Then Sarbanes-Oxley, NYSE listing and independence requirements, Dodd-
Frank Act of 2010 – such regulatory measures have significantly sharpened the board’s role as
monitors of management.
While the duty of care and the duty of leadership have become critical to the director’s
monitoring functions, the additional responsibility, the duty of leadership is becoming
essential as well.
Finding the right balance among board’s leadership components- knowing when to lead,
when to partner and when to stay out of the way- is one of the premier tasks of the board
leader.
The author’s suggest a Director’s Checklist for Leadership Decisions: When to take charge,
when to partner and when to stay out of the way.
Salient points:
When to take charge: selection of CEO, ethics, compensation structure
When to partner: strategy, capital allocation, talent development
When to monitor: Stockholder value
When to stay out of it: execution, delegated authority, operations and non-strategic decisions.
A distinctive feature of this emergent governance model is that one size does not fit all.
Rather than trying to cram square pegs into round holes, directors and executives are crafting
their own way forward.

Day 5 – 12/08/2018

 Fiduciary Duties
 Business Judgment Rule
 Duty of Care
 Oversight Liability
 Duty of Loyalty
 Duty of Good Faith

If you don´t comply with your fiduciary duties, we have the risk of incurring in an monetary
liability.

73
Duty of good-faith went into the duty of loyalty.

 Business Judgment Rule

 Courts will not interfere with business judgment

o The word is DEFERENCE:

 Under the business judgment rule, the courts will defer to the judgment of the
directors.
 Unless there is bad faith, fraud or any improper action, the court will not
second guess the business decisions of the directors.

 Kamin v. Amex (NY) – DLJ special dividend

 Dodge v. Ford – River Rouge
 Schlensky – Wrigley lights – the court made clear that the court did not necessarily
agreed with him, but that he had reasons for establishing his judgment.

o It is a good thing to show that you took something that is against your decision in
consideration. And you have to make sure that you document it – that you have
taken this issue in consideration when making the decision

 Kamin case – NY: NY gives great deference to the business decisions of directors.

 UNLESS:
 Illegal, fraudulent or collusive, bad faith - NY
 Delaware: fully informed, in good faith, honest belief in company’s best
interests – Van Gorkom case
 PRESUMPTION!
 Negligence is not the applicable standard
 Mere errors of judgment not sufficient
 Business reasons will not support a claim

Business Judgment Rule:

1- Great deference to the judgment

2- Negligence is not the standard – the court will not second guess just because
the shareholders allege that they would do it differently.

Kamin v. American Express Co.

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In 1972, American Express Donaldson, Lufken abd Jenrette, Inc. (“DLJ”) . It is alleged that the
BoD of American express has declared a special dividend to all stockholders, pursuant to which
the shares of DLJ would be distributed in kind. According to the plaintiffs, if the American
Express were to sell the DLJ shares on the market, it would sustain a capital loss of $25mi,
which could be offset against taxable capital gains on their investments. This would result in tax
savings of approximately $8mi to the company, which would not be available in the case of the
distribution of DLJ shares to stockholders.

The plaintiffs are challenging the BoD´s business judgment in deciding how to deal with the
DLJ shares, saying the directors are breaching their fiduciary duty of care with regards to the
preservation of the company´s assets.

Ruling:

The question of whether or not a dividend is to be declared or a distribution of some kind

should be made is exclusively a matter of business judgment. Courts will not interfere with
such discretion unless it be first made to appear that the directors have acted or are about to
act in bad faith and for a dishonest purpose. It is for the directors to say... when and to what
extent dividends shall be declared… The statute confers upon the directors this power, and
the minority stockholders are not in a position to question this right, so long as the directors
are acting in good faith

It is not enough to allege that the directors made an imprudent decision, which did not
capitalize on the possibility of using a potential capital loss to offset capital gains. More than
imprudence or mistaken judgement must be shown.

The question of to what extend a dividend shall be declared and the manner in which it shall
be paid is ordinarily subject only to the qualification that the dividend be paid out of
surplus. The Court will not interfere unless a clear case is made out of fraud, oppression,
arbitrary action, or breach of trust.

The minutes of the special meeting indicate that the defendants were fully aware that a sale
rather than a distribution of the DLJ shares might result in the realization of a substantial
income tax saving. Nevertheless, they concluded that there were counter-vailing considerations
primarily with respect to the adverse effect such a sale, realizing a loss of $ 25mi, would have on
the net income of the company, which would result in a decrease of the market value of the
company´s stock.

75
While plaintiffs contend that according to their accounting consultant the loss on the DLJ stock
would still have to be charged against current earnings even if the stock were distributed, the
defendants´ accounting experts assert that the loss would be a charge against earnings only in
the event of a sale, whereas in the event of distribution of the stock as a dividend, the proper
accounting treatment would be to charge the loss only against surplus.

Plaintiffs also made a complaint of self-interest based on the fact that four (4) of the twenty (20)
directors were officers and employees of American Express ad members of its Executive
Incentive Compensation Plan. Standing alone this cannot be an inference of self-dealing.

 Business Judgment Rule Rationale?

 Inappropriate forum for business decisions
 Shareholders voluntarily take risk of bad business decisions
 Quality of management is important
 Litigation imperfect device to evaluate business decisions

 Litigation is an adversarial forum, so everyone is going to the extremes to defend

their positions.

 Decisions require quick judgments

 Unwise to incentivize cautious decisions
 Rewards require risk

 You do not take risks without taking bad decision.

 Risky decisions deal to great rewards to corporations
 If you disincentivize risk taking you will be depriving the company from great
businesses opportunities.

 Business judgment rule applies only if satisfy duty of care

 Van Gorkom Court
Fulfillment of the fiduciary function requires more than the mere absence of bad faith or fraud.
Representation of the financial interests of others imposes on a director an affirmative duty to
protect those interests and to proceed with a critical eye in assessing information of the type
and under the circumstances present here.

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  Van Gorkom Missteps
 Compressed timeline
 Complete deference to Van Gorkom
 Van Gorkom sole negotiator
 Board not informed re Van Gorkom’s role
 Short meeting without notice
 Not an emergency
 No document review or term sheet
 Lack of deliberation
 Senior management not involved
 No support for price
 Van Gorkom - Timeline
 Sunday 9/13 – first meeting
 Thursday 9/17 – second meeting
 Friday 9/18 – call Board meeting
 Saturday 9/19:
 Meet with executive officers
 Board meeting
 Sunday 9/20 – sign agreements
 Why Did Trans Union Think It Did Enough?
 Business judgment rule
 Magnitude of premium
 Market check
 Collective experience of Board
 Prior consideration
 Shareholders made ultimate decision
 Prevailing custom and practice!

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  If Revlon was available at that time, Revlon would have applied. As it is a pre-Revlon
case, so the courts have not had this notion of best price in the sale.
 So we should look to Van Gorkom as a simply duty of care case.

Smith v. Van Gorkom

Delaware Supreme Court
488 A.2d 858 (Del.Sup.Ct. 1985)

Finally, the acquisition was consummated in February of 1981 when almost 70% of the TUC
stock voted in favor of the merger.

Under the business judgment rule, a business determination made by a corporation’s board of
directors is presumed to be fully informed and made in good faith and in the best interests of
the corporation. However, this presumption is rebuttable if the plaintiffs can show that the
directors were grossly negligent in that they did not inform themselves of “all material
information reasonably available to them.”

The court determines that in this case, the Trans Union board of directors did not make an
informed business judgment in voting to approve the merger.
 The directors did not adequately inquire into Van Gorkom’s role and motives behind
bringing about the transaction, including where the price of $55 per share came from;
the directors were uninformed of the intrinsic value of Trans Union; and, lacking this
knowledge, the directors only considered the merger at a two-hour meeting, without
taking the time to fully consider the reasons, alternatives, and consequences.

 The board of directors approved the buyout at the next meeting, based mostly on a 20
minute oral presentation by Van Gorkom. The meeting lasted two hours and the board
of directors did not have an opportunity to review the merger agreement before or
during the meeting. The directors had no documents summarizing the merger, nor did
they have justification for the sale price of $55 per share. No senior managers present.

 That very same evening, Van Gorkom signed the actual merger documents during a
social function marking the opening of the Chicago Lyric Opera season.23 Van Gorkom
would personally benefit from the sale of TUC because he held approximately 75,000
shares of the company.

The adequacy of a premium is indeterminate unless it is assessed in terms of other competent

and sound valuation information that reflects the value of the particular business.

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Defendants cannot rely on stockholders approval of the merger as curing failure of the board to
reach an informed judgment in the approval of the merger. Stockholders were not fully
informed of all facts material to their vote.

Dissent (McNeilly, J.)
The combined experience of the Trans Union board of directors warrants a finding that they
would not have entered into the merger without being fully informed. They were “more than
well qualified” to make an informed business judgment and under the business judgment rule,
they should not be liable.

Almost immediately after this decision, Delaware passed a law (DGCL §102(b)(7)) that allows
corporations to limit the liability of their directors for breaches of the duty of care.

¤ What happened to the business judgment rule? Why did it not apply?
¤ The presumption was successfully rebutted by plaintiffs “We conclude that Trans Union’s
Board was grossly negligent in that it failed to act with informed reasonable deliberation in
agreeing to [the sale]”
¤ What could the board have done differently?
¤ “Go through the motions”
¤ Even if they know this is a great deal. ¤ Create the paper trail – investment-banker
evaluations, lawyer’s opinions, etc. – to prove that the decision was informed
¤ Aftermath and reinterpretations
¤ The court presents this as a “standard” duty of care analysis
¤ But is Van Gorkom actually an early case about heightened standards in the takeover context? [See
M&A chapters]
Explain: why Van Gorkom will not happen agg

VAN GORKOM DISSENT:

o In sum:
 Directors acted in the utmost care in informing themselves of the available facts and figures
before approving the merger:
(i) Business man involved in the management of the company;
(ii) Directors were aware of problems created by accumulated investment tax credits
and accelerated depreciation facing Trans Union
(iii) Were aware of a study prepared by an outside consultant - The Boston Consulting
Group (“BCG”): competitiveness, profitability, cash throw-off, cash consumption,

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 technical competence and future prospects for contribution to Trans Union's
combined net income;
(iv) Board directed that certain changes be made in the merger documents.

 Post-Van Gorkom Duty of Care

 Fully informed basis, which means:
 All available information – basis for the price of the shares
 Active and direct participation – court says “nobady asked this, nobody asked that,
etc.”
 Adequate deliberation – deliberation is short notice, short meeting

 Post-Van Gorkom (cont.)

 Premium alone not enough – when you sell a business, you sell the whole business; the
price of then shares is just a part of it; you have to fund a control premium
 Reputation/experience not enough
 Must go through process!!
 Deal likely valid if good process – the deal would probably be just fine if they
would have gone through the process.
 Shareholder vote not enough
 Directors role important
 Gross negligence is the standard!!!

 Documenting the Deal

 Promote better decision making – better track of what you did
 Van Gorkom is about process not conduct
 Reduce conflicts
 More accurate record - Da
 Reduce exposure to litigation

 Documenting the Deal

 Protocols – putting something in place first.
 Early legal involvement – If you receive a call with a business proposal, the correct
answer is “

 CEO should not go ahead and

 Should not engage advisors to advice the CEO if these advisors are paid by the
company. Then Board should approve it first.
 Have the rules in place, so you know were they are
 Documentation – the minutes can demonstrate that the things that

80
  Process!!
 Practice Take-Aways

 It is another way of seeing that the times have changed. It is not anymore the
time of CEO as the centralized figure in the company and can decide
everything on his own.

Investment banks:

Take care with the engagement letter - they are too pro-investment banks

Valuantion – the studies will change. You have tto document what they are changing and why.

 Fully informed
 Negotiation process - protocols
 Valuation: - basis for your evaluation
 Fairness opinion – opinion from investment bank
 Premium not enough
 Agreements: distribute, sumarize (prepare a summary of the contract that the outside
lawyers will present to the board)
 Diligence and contract issues – presentation on what the due diligence would be
 Senior management input
 Active and direct participation, dont defer to the CEO. The board should act
independently. They can delegate but must exercise oversight. Involvement in entire process –
not just approval – several meetings between CEO of both buyer and target and report back to
their boards. This back and forth is important.

 Don’t defer to CEO
 Be independent, act independently – that doesn´t mean that the board should be in the
front line of the negotiations.
 Can delegate but must exercise oversight
 Involvement in entire process – not just approval – several meetings between CEO of
both buyer and target and report back to their boards. This back and forth is important.
 Decision to explore; NDA; Advisors


 Ask questions – facilitate – Van Gorkom: court stressed that the board did not ask
questions. Whenever there is a presentation and you are the lawyer, you have to raise your
hand and ask, for the benefit of the board, where did they came from the price or the numbers.
The simple thing of being passively watching a presentation is not enough. Multiple meetings
is the norm, even its a good deal. There has to be extended discussion and advance notice with
materials – include materials. Don´t only give them a very long mergers agreement. Prepare a

81
summary in addition to the mergers agreement. The lawyer should be walking the board
through the agreement.
Delaware law encourages you to rely on advisors and consultants reports. Boards are entitled to
rely on investment bankers studies, on lawyer´s advice, etc

 Oversight Liability – what if you are sitting there and not paying attention
 Affirmative decision vs. oversight failure
 Business judgment protects a decision
 Not applicable to “unconsidered inaction”
 Allis-Chalmers no duty unless on notice – allegation was (price fixing problem): the
board should have done something to prevent this. The board have not noticed and so,
the board did not have the duty to do anything to prevent this - 1963
 Caremark went beyond! 1996

Involved kick-backs – which is illegal

 Good faith attempt to implement and adequate information and reporting systems
required – even if they didn´t know that this was happening, they have the general rule of
putting in place the reporting system
 Notice not a prerequisite
 But no liability unless “utter failure” to implement OR sustained or systemic failure of
oversight

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  Stone v. Ritter – Sup Ct.

STONE V. RITTER
Delaware Supreme Court

 Holland Justice:

This is an appeal from a final judgment of the Court of Chancery dismissing a derivative
complaint against fifteen present and former directors of AmSouth Bancorporation (AmSouth),
a Delaware Corporation.

Plaintiff- appellants: William and Sandra Stone, are AmSouth shareholders, and filed their
derivative complaint without making a pre-suit demand on AmSouth’s board of directors (the
“Board”).

Court of Chancery held that plaintiff failed to adequately plead that such a demand would have
been futile, therefore the Court dismissed the derivative complaint.

In this appeal, the plaintiffs acknowledge that the directors neither “knew nor should have
known that violations of law were occurring”, i.e. that there were no “red flags” before the
directors.

Nevertheless, the court of Chancery erred by dismissing the derivative complaint which alleged
that “the defendants had utterly failed to implement any sort of statutorily required monitoring
reporting or information controls that would have enabled them to learn of problems requiring
their attention”.

 Issue.
When specified facts do not create a reasonable doubt that the directors of a corporation acted
in good faith in exercising their oversight responsibilities, will a derivative suit be dismissed for
failure to make demand?

 Discussion.
This case clarifies that Delaware directors do not have a fiduciary duty of good faith that is
separate from other fiduciary duties. Rather, as explained by the court, the duty of good faith

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is a component of the duty of loyalty. The case also teaches that in the context of breach of
oversight claims, a negative (and very costly) outcome does not per se equate to bad faith

 Facts:
o Hamric and Nance were operating a fraudulent 'Ponzi scheme' 10. They did this
with the help of a bank called AmSouth, who provided Hamric and Nance with
accounts and distributed interest payments.
o Had bank employees been paying attention they would have easily uncovered
Hamric and Nance's scheme.
o After the scheme fell apart, AmSouth was forced to pay $50M in fines and
penalties for helping the scam. AmSouth's shareholders instituted a derivative
lawsuit against the directors for wasting corporate money.
o The shareholders argued that AmSouth's compliance program lacked adequate
board and management oversight, and that reporting to management for the
purposes of monitoring and oversight of compliance activities was materially
deficient.
o Basically, since the directors weren't doing their job and investigating what the
employees were doing, the shareholders were out $50M.
o The Trial Court found for AmSouth and the directors. The shareholders
appealed.
o The Trial Court looked to In re Caremark International Inc. Derivative
Litigation (698 A.2d 959 (Del. Ch. 1996)), and found that when shareholders
claim that the directors were ignorant to liabilities, the shareholder can only win
if they show that there was a "sustained or systemic failure of the board to
establish oversight."

 The Delaware Supreme Court affirmed.

o The Delaware Supreme Court found that the standard for determining whether
directors can be liable for failure to exercise oversight of employees who fail to
comply with their duties was a "lack of good faith as evidenced by a sustained
or systematic failure of a director to exercise reasonable oversight."
o That's the same standard that was given in Caremark.
o The Court noted that this was a very high standard to meet.
o See ATR-Kim Eng Financial Corp. v. Araneta (2006 WL 3783520 (Del. Ch. Dec. 21
2006)) for a case that met this standard.
o The Court found that there are two conditions necessary for liability under the
standard set by Caremark:
 The directors utterly failed to implement any reporting or information
system or controls; or
10
The Ponzi scheme is a fraudulent operation of investment that involves paying interest to investors invested their own money or money from
new investors. This system consists of a process in which the profits obtained by the first investors are generated thanks to the money
contributed by them or by other new investors who fall deceived by the promises of obtaining, in some cases, great benefits.

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  Having implemented such a system or controls, consciously failed to
monitor or oversee its operations thus disabling themselves from being
informed of risks or problems requiring their attention.

o In either case, imposition of liability requires a showing that the directors knew
that they were not discharging their fiduciary obligations.
o The Court found that there is no duty of good faith that forms a basis,
independent of the duties of care and loyalty, for director liability.
o The Court found that just because there was a bad outcome in this case, that was
not evidence of bad faith on the part of the directors.
o Basically, this case said that directors are not responsible for ensuring the legality
of every act by the corporation's personnel, even if the illegal conduct would
have been discovered if there hadn't been a failure of the corporate compliance
program.

 Failure to file money laundering reports

 Systems in place, but not filed by employees
 Affirmed Chancery Caremark dicta
 Added scienter condition for liability
 Directors must “know” they are not discharging their fiduciary obligations
 “Draws on failure to act in good faith”
 Good Faith - Disney
 The “absence of bad faith”?
 Defined “bad faith” - very high hurdle
 Actual intent to do harm
 Intentional dereliction of duty or conscious disregard of responsibilities
 Gross negligence with subjective bad intent
 Gross negligence without bad intent not enough
 Intentional failure to act in face of known duty to act
 When on notice of a problem - Allis-Chalmers?
 Caremark – “utter failure to implement or sustained or systemic failure of oversight
 Are Caremark and Disney essentially the same?
 Oversight Overview
 Inaction without notice – Caremark
 Adequate information and reporting
 Good faith attempt
 “Utter failure” to implement or oversee
 Inaction with notice – Allis Chalmers
 Good faith – conscious disregard
 Affirmative action – BJR
 Van Gorkom – gross negligence
 Reaction to Duty to Monitor
 More attention to risk management
 NYSE requires Audit Committee to address
 May delegate

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  Annual risk assessments
 “Red Flags”
 Exception to more lenient standards
 Compensation-related risks – SEC disclosure
 Federal Sentencing Guidelines
 Leniency if effective compliance program
 AND Board oversight
 Yates Memo
 Duty of Loyalty
 Essence of fiduciary relations
 Broadly articulated
 “Undivided loyalty”
 “Relentless and supreme”
 Strine: discretion requires loyalty
 Strictly applied
 Overrides business judgment rule
 No exculpation
 BUT…..
 Variations of Duty of Loyalty
 Conflicts of interest
 Classic Self-Dealing
 Related Party Transactions
 Variations on Self-Dealing
 Corporate Opportunities
 Competition
 Loyalty/ Fair Dealing
 Confidentiality
 Duty of Good Faith
 Duty of Candor/Disclosure
 Self-Dealing
 Originally, void or voidable, even if
 Fair or beneficial to corporation
 Approved by disinterested majority of Board
 Approval by disinterested majority if “fair”
 No relief if majority of Board interested
 Fairness only – Bayer v. Beran

BAYER V. BERAN
Bayer v. Beran (on Canvas)
Supreme Court of New York
49 N.Y.S.2d 2 (1944)

Facts
The directors (defendants) of the Celanese Corporation of America (CCA) started a radio
advertising campaign for the corporation. CCA had advertised before, but never on the radio.

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In making its decision to start advertising on the radio, the directors reviewed studies given to
them by CCA’s advertising department, brought in a radio consultant to help them determine
the station and time to advertise, and hired an advertising agency to produce the ad. In
addition, the advertising commitments were subject to cancellation at any time, and the board
voted to renew the advertising contract after it had been running for a year and a half.

One of the singers on the program on which CCA decided to advertise was the wife of Camille
Dreyfus, one of CCA’s directors. The plaintiff brought suit, claiming that the advertising
campaign was started due to the benefit to Mrs. Dreyfus as it “subsidized” her career and was
“a vehicle for her talents.”

Issue
Does a director necessarily breach his duty of loyalty to a corporation by advertising the
corporation’s product on a program on which the director’s wife is a singer?

Holding and Reasoning (Shientag, J.)

No.

The business judgment rule yields to the rule of undivided loyalty. This rule of law is designed
to avoid the possibility of fraud and to avoid the temptation of self-interest.

Directors have an obligation not to put their own interests before the interests of the
corporation. This duty of loyalty supersedes the business judgment rule so that fraud may be
avoided. The burden of establishing that the duty of loyalty is not violated is on said directors.

However, that burden may be met if after “rigorous scrutiny” it is determined that the
transaction in question was made in good faith and would have been made even in the absence
of the personal interests of the director.

In the present case, the court finds that the directors did not violate their duty of loyalty to
CCA by advertising on Mrs. Dreyfus’s program.

The directors went through an involved process to determine whether to advertise on the
radio, and on what station and channel to advertise. Although the advertising choice may have
enhanced Mrs. Dreyfus’s career, it also greatly benefited CCA and the evidence supports a
conclusion that the same decision on advertising would have been made if Mrs. Dreyfus was
not on the program. Accordingly, the court finds in favor of the CCA directors.

With regard to the issue that the expenditures were illegal because the radio advertising
program was not taken up at any formal meeting of the board of directors and no resolution
approving it was adopted by the board or the executive committee:
Failure to observe the formal requirements is not fatal in this case because the directors (who
are also the executive officers) have a close working relationship with their full time devoted to
the company and all available for daily consultation. Not the same as directors who seldom
meet.

87
 This customary informal procedure has been followed for other projects of equal and greater
magnitude. While a formal procedure would be desirable in the future, this informal procedure
has worked well for the company and has made the company prosper.
The expenditures for radio advertising, although made without resolution at a formal meeting
of the board, were approved and authorized by the members individually, and may not be
considered ultra vires.

 Self-Dealing
 Originally, void or voidable, even if
 Fair or beneficial to corporation
 Approved by disinterested majority of Board
 Approval by disinterested majority if “fair”
 No relief if majority of Board interested
 Fairness only – Bayer v. Beran
 No “formal” Board approval

Self-Dealing Brown Ch. 5 pp. 270-275, Bayer v. Beran (on Canvas)

THE DUTY OF LOYALTY
The Duty of Loyalty requires corporate fiduciaries to manage the business and affairs of the
corporation in the best interest of the firm, placing the corporation’s interest above their own
personal interest or the interests of any third party.
Corporate fiduciaries breach their duty of loyalty if they exercise their power and authority in
bad faith or for improper, non-corporate ends.
Duty of undivided loyalty is not honestly alone, but the “punctilio of an honor the most
sensitive.”

Law deals more harshly the unfaithful (disloyal) manager than with the careless (one who
violated duty of care) manager. Duty of loyalty claims are not protected from judicial review by
the business judgement rule. Duty of loyalty are also specifically excluded from director
exculpation statutes such as Section 102 (b) (7) of the Delaware General Corporation Law.

Self -Dealing Transactions

Classic self -dealing transactions include:
(1) Transactions directly between director or officer of the firm
(2) Transaction between the firm and a person or entity in which the subject director or
officer has an indirect interest, such as a strong personal relationship or a financial stake.

88
Harold Marsh, Jr., Are Director Trustees Conflict of Interest and Corporate Morality
In 1880 the general rule was: any contract between a director and his corporation was voidable
at the instance of the corporation or its shareholders, with regard to the fairness or unfairness of
the transaction.
- Approval does not cure the contract because it was impossible for the interested director
not to influence the other directors.
- 30 years later this principle was dead.
Judicial Review of the Fairness of Transaction
1960- it could be said with some assurance that the general rule was that no transaction of a
corporation with any or all of its directors was automatically voidable at the suit of a
shareholder, whether there was a disinterested majority of the board or not; but that the courts
would review such a contract and subject it to rigid and careful scrutiny and would invalidate
the contract if it was found to be unfair to the corporation.
- The explanation for the change of position from 1880s: a trustee, while forbidden to deal
with himself in connection with the trust property, could deal directly with the case if he
made full disclosure and took no unfair disadvantage. This principle was applied in
analogy to an interested director.

Approval by a Disinterested Majority of the Board

1990 the general rule was: a contract between a director and his corporation was valid if it was
approved by a disinterested majority of his fellow directors and was not found to be unfair or
fraudulent by the court if challenged; that a contract in which a majority of the board was
interested was voidable at the instance of the corporation or its shareholders without regard to
any question of fairness.

Effect of Shareholder Approval

Shareholder ratification will validate the transaction of an interested director, in the absence of
fraud or unfairness. The stock of the interested director or directors may be voted on the
question of ratification, as shareholders they may cast the deciding votes.

Remember BA1:

Transactions between corporation and director or officer are not void (or voidable) solely
(i) for that reason or (ii) because the D/O participated in the meeting approving it Provided
that one of these is satisfied:

Duty of Loyalty

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(1) Full disclosure + good faith authorization of majority of disinterested directors
(2) Full disclosure + good faith authorization of shareholders
(3) Transaction is “fair”

Bayer v. Beran (on Canvas)

Supreme Court of New York
49 N.Y.S.2d 2 (1944)

Facts
The directors (defendants) of the Celanese Corporation of America (CCA) started a radio
advertising campaign for the corporation. CCA had advertised before, but never on the radio.
In making its decision to start advertising on the radio, the directors reviewed studies given to
them by CCA’s advertising department, brought in a radio consultant to help them determine
the station and time to advertise, and hired an advertising agency to produce the ad. In
addition, the advertising commitments were subject to cancellation at any time, and the board
voted to renew the advertising contract after it had been running for a year and a half.

One of the singers on the program on which CCA decided to advertise was the wife of Camille
Dreyfus, one of CCA’s directors. The plaintiff brought suit, claiming that the advertising
campaign was started due to the benefit to Mrs. Dreyfus as it “subsidized” her career and was
“a vehicle for her talents.”

Issue
Does a director necessarily breach his duty of loyalty to a corporation by advertising the
corporation’s product on a program on which the director’s wife is a singer?

Holding and Reasoning (Shientag, J.)

No.

The business judgment rule yields to the rule of undivided loyalty. This rule of law is designed
to avoid the possibility of fraud and to avoid the temptation of self-interest.

Directors have an obligation not to put their own interests before the interests of the
corporation. This duty of loyalty supersedes the business judgment rule so that fraud may be
avoided. The burden of establishing that the duty of loyalty is not violated is on said directors.

90
However, that burden may be met if after “rigorous scrutiny” it is determined that the
transaction in question was made in good faith and would have been made even in the absence
of the personal interests of the director.

In the present case, the court finds that the directors did not violate their duty of loyalty to
CCA by advertising on Mrs. Dreyfus’s program.

The directors went through an involved process to determine whether to advertise on the
radio, and on what station and channel to advertise. Although the advertising choice may have
enhanced Mrs. Dreyfus’s career, it also greatly benefited CCA and the evidence supports a
conclusion that the same decision on advertising would have been made if Mrs. Dreyfus was
not on the program. Accordingly, the court finds in favor of the CCA directors.

With regard to the issue that the expenditures were illegal because the radio advertising
program was not taken up at any formal meeting of the board of directors and no resolution
approving it was adopted by the board or the executive committee:
Failure to observe the formal requirements is not fatal in this case because the directors (who
are also the executive officers) have a close working relationship with their full time devoted to
the company and all available for daily consultation. Not the same as directors who seldom
meet.
This customary informal procedure has been followed for other projects of equal and greater
magnitude. While a formal procedure would be desirable in the future, this informal procedure
has worked well for the company and has made the company prosper.
The expenditures for radio advertising, although made without resolution at a formal meeting
of the board, were approved and authorized by the members individually, and may not be
considered ultra vires.

❑ Duty of Loyalty

❑ Duty of Good Faith

Duty of Loyalty (Brown pgs. 269-275)

Duty of loyalty aims to protect the shareholders of the inherent danger that managers will favor
themselves in expense of the company and shareholders.

Duty of loyalty requires corporate fiduciaries to manage the business in the best interests of the
firm, placing the corporation’s interests above of personal or third-parties´ interests.

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To satisfy the duty of loyalty the directors and officers must:

1) Act in good faith and with a lawful and honest corporate purpose;
2) Avoid engagement in unfair self-dealing;
3) Abstain from wrongly usurping the firm’s business opportunities, unfairly competing
with the corporation; and/or
4) Taking corporate assets or confidential information for their own personal benefit.

Managers cannot engage their self-interest without consent from the corporation having done
full disclosure.

Duty of loyalty also requires acting affirmatively to further the corporation’s best interests and
not limit to abstain of the wrongdoing.

It is dealt harsher with unfaithful managers and the careless ones, which is reflected in the fact
that duty of loyalty claims are not protected from judicial review by business judgment rule.
These claims are also excluded from director exculpation statutes.

Self-Dealing Transactions

Self- dealing transactions include:

1) transactions directly between the corporation and a director or officer of the firm; and
2) transactions between the firm or entity in which the officer has an indirect interest (i.e.
personal relationship or financial stake).

Harold Marsh, Jr., Are Directors Trustees? Conflict of interests and Corporate Morality

Courts’ position in 1880- any contract between a director and his corporation was voidable at
the instance of the corporation or its shareholders, without regard to the fairness or unfairness
of the transaction.

Courts’ position in 1910- any contract between a director and his corporation was valid if
approved by a disinterested majority of directors and was not found to be unfair or fraudulent
by the court if challenged. However, a contract in which the majority of the board was
interested was voidable without regard to any question of fairness.

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Courts’ position in 1960- no transaction of a corporation and its directors were automatically
voidable when challenged, whether there was a majority of disinterested majority of the board
or not. However, the courts would revise such contract under rigid and careful scrutiny and
would invalidate the contract if found to be unfair to the corporation.

Effect of the shareholder’s approval- cases show that shareholders’ ratification will suffice to
validate the transaction with an interested director, at least in the absence of fraud and
unfairness. Furthermore, the stock of interested directors may be voted on the question of
ratification and as shareholders they may cast their vote.

In many courts it is not possible to ratify a fraudulent transaction.

§DGCL144 establishes that a covered transaction is not voidable solely based on the fiduciary’s
conflict of interest under certain circumstances:

§ 144 Interested directors; quorum.

“(a) No contract or transaction between a corporation and 1 or more of its directors or officers, or
between a corporation and any other corporation, partnership, association, or other organization in
which 1 or more of its directors or officers, are directors or officers, or have a financial interest, shall be
void or voidable solely for this reason, or solely because the director or officer is present at or
participates in the meeting of the board or committee which authorizes the contract or transaction, or
solely because any such director's or officer's votes are counted for such purpose, if:
(1) The material facts as to the director's or officer's relationship or interest and as to the contract
or transaction are disclosed or are known to the board of directors or the committee, and the board
or committee in good faith authorizes the contract or transaction by the affirmative votes of a
majority of the disinterested directors, even though the disinterested directors be less than a
quorum; or
(2) The material facts as to the director's or officer's relationship or interest and as to the contract
or transaction are disclosed or are known to the stockholders entitled to vote thereon, and the
contract or transaction is specifically approved in good faith by vote of the stockholders; or
(3) The contract or transaction is fair as to the corporation as of the time it is authorized, approved
or ratified, by the board of directors, a committee or the stockholders.
(b) Common or interested directors may be counted in determining the presence of a quorum
at a meeting of the board of directors or of a committee which authorizes the contract or transaction.”

 DUTY OF LOYALTY

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  Essence of fiduciary relations
 Broadly articulated
 “Undivided loyalty”
 “Relentless and supreme”
 Strine: discretion requires loyalty
 Strictly applied
 Overrides business judgment rule
 No exculpation
 BUT…..
 Variations of Duty of Loyalty

 Conflicts of interest
 Classic Self-Dealing
 Related Party Transactions
 Variations on Self-Dealing - obvious
 Corporate Opportunities
 Competition – compete with the corporation?
 Loyalty/ Fair Dealing – not obvious of self-dealing
 Confidentiality- you cant divulge
 Duty of Good Faith
 Duty of Candor/Disclosure
 Self-Dealing –
business relationship between director/officer with the company
 Originally, void or voidable, even if
 Fair or beneficial to corporation
 Approved by disinterested majority of Board
 Approval by disinterested majority if “fair”
 No relief if majority of Board interested
 Fairness only – Bayer v. Beran
The court evaluated based on “fairness”. It is an interesting case because it had the
notion of self-dealing because of the CEO of the company and the wife who was part of
the advertising campaign.
 No “formal” Board approval
 Shareholder ratification
 Full disclosure
 No fraud

Self-Dealing Brown Ch. 5 pp. 270-275, Bayer v. Beran (on Canvas)

THE DUTY OF LOYALTY

The Duty of Loyalty requires corporate fiduciaries to manage the business and affairs of the
corporation in the best interest of the firm, placing the corporation’s interest above their own
personal interest or the interests of any third party.

Corporate fiduciaries breach their duty of loyalty if they exercise their power and authority in
bad faith or for improper, non-corporate ends.

94
Duty of undivided loyalty is not honestly alone, but the “punctilio of an honor the most
sensitive.”

Law deals more harshly the unfaithful (disloyal) manager than with the careless (one who
violated duty of care) manager. Duly of loyalty claims are not protected from judicial review by
the business judgement rule. Duty of loyalty are also specifically excluded form director
exculpation statutes such as Section 102 (b) (7) of the Delaware General Corporation Law.

Self -Dealing Transactions

Classic self -dealing transactions include:

(1) Transactions directly between director or officer of the firm
(2) Transaction between the firm and a person or entity in which the subject director or
officer has an indirect interest, such as a strong personal relationship or a financial stake.

Harold Marsh, Jr., Are Director Trustees Conflict of Interest and Corporate Morality
In 1880 the general rule was: any contract between a director and his corporation was voidable
at the instance of the corporation or its shareholders, with regard to the fairness or unfairness of
the transaction.
-Approval does not cure the contract because it was impossible for the interested director
not to influence the other directors.
- 30 years later this principle was dead.
Judicial Review of the Fairness of Transaction

1960- it could be said with some assurance that the general rule was that no transaction of a
corporation with any or all of its directors was automatically voidable at the suit of a
shareholder, whether there was a disinterested majority of the board or not; but that the courts
would review such a contract and subject it to rigid and careful scrutiny, and would invalidate
the contract if it was found to be unfair to the corporation.

- The explanation for the change of position from 1880s: a trustee, while forbidden to deal
with himself in connection with the trust property, could deal directly with the case if he
made full disclosure and took no unfair disadvantage. This principle was applied in
analogy to an interested director.

Approval by a Disinterested Majority of the Board

1990 the general was: a contract between a director and his corporation was valid if it was
approved by a disinterested majority of his fellow directors and was not found to be unfair or
fraudulent by the court if challenged; that a contract in which a majority of the board was
interested was voidable at the instance of the corporation or its shareholders without regard to
any question of fairness.

Effect of Shareholder Approval

Shareholder ratification will validate the transaction of an interested director, in the absence of
fraud or unfairness. The stock of the interested director or directors may be voted on the
question of ratification, as shareholders they may cast the deciding votes.
Remember BA1:

95
Transactions between corporation and director or officer are not void (or voidable) solely
(i) for that reason or (ii) because the D/O participated in the meeting approving it Provided
that one of these is satisfied:

Duty of Loyalty

(1) Full disclosure + good faith authorization of majority of disinterested directors

(2) Full disclosure + good faith authorization of shareholders
(3) Transaction is “fair”

Bayer v. Beran (on Canvas)

Supreme Court of New York
49 N.Y.S.2d 2 (1944)

Facts
The directors (defendants) of the Celanese Corporation of America (CCA) started a radio
advertising campaign for the corporation (because they had an entity problem, because FTC
said they were rayon). CCA had advertised before, but never on the radio. In making its
decision to start advertising on the radio, the directors reviewed studies given to them by
CCA’s advertising department, brought in a radio consultant to help them determine the station
and time to advertise, and hired an advertising agency to produce the ad. In addition, the
advertising commitments were subject to cancellation at any time, and the board voted to renew
the advertising contract after it had been running for a year and a half.

One of the singers on the program on which CCA decided to advertise was the wife of Camille
Dreyfus, one of CCA’s directors. The plaintiff brought suit, claiming that the advertising
campaign was started due to the benefit to Mrs. Dreyfus as it “subsidized” her career and was
“a vehicle for her talents.”

Issue

Does a director necessarily breach his duty of loyalty to a corporation by advertising the
corporation’s product on a program on which the director’s wife is a singer?
Holding and Reasoning (Shientag, J.)

No.
The business judgment rule yields to the rule of undivided loyalty. This rule of law is designed
to avoid the possibility of fraud and to avoid the temptation of self-interest.
Directors have an obligation not to put their own interests before the interests of the
corporation. This duty of loyalty supersedes the business judgment rule so that fraud may be
avoided. The burden of establishing that the duty of loyalty is not violated is on said
directors.

However, that burden may be met if after “rigorous scrutiny” it is determined that the
transaction in question was made in good faith and would have been made even in the
absence of the personal interests of the director. (supports their independence; informed Van
Gorkom?-duty of care)

96
 In the present case, the court finds that the directors did not violate their duty of loyalty to
CCA by advertising on Mrs. Dreyfus’s program.
The directors went through an involved process to determine whether to advertise on the
radio, and on what station and channel to advertise. Although the advertising choice may have
enhanced Mrs. Dreyfus’s career, it also greatly benefited CCA and the evidence supports a
conclusion that the same decision on advertising would have been made if Mrs. Dreyfus was
not on the program. Accordingly, the court finds in favor of the CCA directors.
With regard to the issue that the expenditures were illegal because the radio advertising
program was not taken up at any formal meeting of the board of directors and no resolution
approving it was adopted by the board or the executive committee:

Failure to observe the formal requirements is not fatal in this case because the directors (who
are also the executive officers) have a close working relationship with their full time devoted to
the company and all available for daily consultation. Not the same as directors who seldom
meet.

This customary informal procedure has been followed for other projects of equal and greater
magnitude. While a formal procedure would be desirable in the future, this informal procedure
has worked well for the company and has made the company prosper.

The expenditures for radio advertising, although made without resolution at a formal meeting
of the board, were approved and authorized by the members individually, and may not be
considered ultra vires.

 Delaware Section 144

 (a self-dealing transaction between board and corporation is) Not void or voidable IF
any of:
(1) Material facts disclosed to Board and approved by disinterested majority
 Disinterested majority may be less than quorum
(2) Material facts disclosed to shareholders (not necessarily disinterested) and approved
(3) Transaction is fair at time of approval

 Scope of Section 144

 What transactions are covered?
 Does §144 compliance satisfy fiduciary duty?
 Does shareholder approval require approval by “disinterested” shareholders?
If you are a shareholder, you can vote in your own personal self-interest. If you are a
controlling shareholder, you can approve it. Good argument that it should be
disinterested. One prong of 144 does not say disinterested.
 Can a Board enter into an “unfair” deal?
Approval process
 Is one process “better” than another?
 Related Party Transactions

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 SEC Regulation S-K Item 404
 Related Person: disclosure obligations
 Director, officer, immediate family
 5% shareholder
 Direct or indirect interest
 Transactions
 Exceeding $120,000 in a single year
 Approval policies
 NYSE Rule 314 (requires corporations to have polices for evaluating whether
or not it will approve related transactions)

 Corporate Opportunities
This opportunity comes from a third person and if this is an opportunity that can be taken
advantaged of by company, you need to turn over this opportunity.

 “Undivided and unselfish loyalty”

 When can conflicts arise?
 Directors with overlapping interests
 PE firms with multiple companies (two separate boards and director is presented
an opportunity and you are faced with a real conflict as to which corporation to
offer the opportunity)
 Balance competing interests?
 Often messy – fact based
 Traditional Analysis
 Is it a “corporate opportunity”?
 If so, may the director pursue it?
 Corporate opportunity if:
 Within line of business
 Interest or expectancy
 Financially able to exploit
 Inimical to your duties as a director to corporation
 Director May Pursue it independently If:

 Presented to Board and rejected OR

 Corp not in a position to pursue OR (Corporation does not have money or have source
of money)
 (approach from third party with an opportunity is not for corporation but personal)
Received in individual capacity and
 Not essential to corporation and
 No interest or expectancy and
 No wrongful misappropriation
 AngioScore
 Was it an opportunity?
 Was it a corporate opportunity?
 Line of business?
 Interest or expectancy?
 Capable of pursuing?
 Inimical to fiduciary obligations?

98
  Stone v. Ritter – Sup Ct.
 Failure to file money laundering reports
 Systems in place, but not filed by employees
 Affirmed Chancery Caremark dicta
 Added scienter condition for liability
 Directors must “know” they are not discharging their fiduciary obligations
 “Draws on failure to act in good faith”
 Good Faith - Disney
 The “absence of bad faith”?
 Defined “bad faith” - very high hurdle
 Actual intent to do harm
 Intentional dereliction of duty or conscious disregard of responsibilities
 Gross negligence with subjective bad intent
 Gross negligence without bad intent not enough
 Intentional failure to act in face of known duty to act
 When on notice of a problem - Allis-Chalmers?
 Caremark – “utter failure to implement or sustained or systemic failure of oversight
 Are Caremark and Disney essentially the same?
 Oversight Overview
 Inaction without notice – Caremark
 Adequate information and reporting
 Good faith attempt
 “Utter failure” to implement or oversee
 Inaction with notice – Allis Chalmers
 Good faith – conscious disregard
 Affirmative action – BJR
 Van Gorkom – gross negligence
 Reaction to Duty to Monitor
 More attention to risk management
 NYSE requires Audit Committee to address
 May delegate
 Annual risk assessments
 “Red Flags”
 Exception to more lenient standards
 Compensation-related risks – SEC disclosure
 Federal Sentencing Guidelines
 Leniency if effective compliance program
 AND Board oversight
 Yates Memo

Day 6 – 14/08/2018

Good Faith: Stone v. Ritter

Brown, Chapter 5, pp. 236

A failure to act in good faith is not conduct that results, ipso facto, in the direct imposition of
fiduciary duty. The failure to act in good faith may result in liability because the requirements

99
to act in good faith “is a subsidiary element [,]”, i.e. a condition, “of the fundamental duty of
loyalty’”.
It follows that because a showing of bad faith conduct, in the sense described in Disney and
Caremark, is essential to establish director oversight liability, the fiduciary duty violated by that
conduct is the duty of loyalty.
This view results in two additional consequential doctrinal consequences:
(i) the obligation to act in good faith does not establish an independent fiduciary duty
that stands on the same footing as the fiduciary duties of care and loyalty. Only the
later two duties, where violated may directly result in liability, whereas a failure to
act in good faith may do so, but indirectly; and

(ii) The fiduciary duty of loyalty is not limited to cases involving a financial or other
cognizable fiduciary conflict of interest, but also encompasses cases where the
fiduciary fails to act in good faith.

Guttman v. Huang:
“a director cannot act loyally towards the corporation unless she acts in the good faith belief
that her actions are in the corporation´s best interest”.
We hold that Caremark articulates the necessary conditions for director oversight liability:
(a) the directors failed to implement any reporting of information system or controls; or
(b) having implemented such a system or controls, consciously failed to monitor or oversee
its operations thus disabling themselves from being informed of risks or problems
requiring their attention.

In either case, imposition of liability of liability requires a showing that the directors knew that
that they were not discharging their fiduciary obligations. Where directors fail to act in the face
of a known duty to act, thereby demonstrating a conscious disregard that for their
responsibilities, they breach their duty of loyalty by failing to discharge that fiduciary obligation
in good faith.

Brown, Chapter 5, Comments on questions on pp. 238-239

1. Stone v. Ritter:

Delaware Supreme Court – duty of good faith is not a separate duty, but rather an element
of duty of loyalty. Thus, although directors can face liability for monetary damages only if
they violate their duty of loyalty, fiduciaries may be adjudged disloyal by failing to act in
good faith.
o Why do you think that justices focused on duty of loyalty? Recall that in Caremark,
the duty of good faith was connected to the duty of care.
o Insofar as most of Delaware public companies have adopted exculpatory charter
provisions, should corporate directors be concerned about Stone v. Ritter?
o Did the Delaware Supreme Court heighten director´s exposure to liability for money
damages?

2. In re Walt Disney Co. Deriv. Litig. – Delaware Supreme Court warned of the dangers in
defining good faith in such a way that it would collapse into the duty of care:

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 Thus, a corporation can exculpate its directors from monetary liability for a
breach of the duty of care, but not for conduct that is not in good faith.
To adopt a definition of bad faith that would cause a violation of the duty of care
automatically to become an act or mission ‘not in good faith’ would eviscerate
the protections accorded to directors by the General assembly´s adoption of
Section 102(b)(7).

§ 102 Contents of certificate of incorporation

(b) In addition to the matters required to be set forth in the certificate of incorporation by
subsection (a) of this section, the certificate of incorporation may also contain any or all
of the following matters:
(7) A provision eliminating or limiting the personal liability of a director to the
corporation or its stockholders for monetary damages for breach of fiduciary duty as a
director, provided that such provision shall not eliminate or limit the liability of a
director: (i) For any breach of the director's duty of loyalty to the corporation or its
stockholders; (ii) for acts or omissions not in good faith or which involve intentional
misconduct or a knowing violation of law; (iii) under § 174 of this title; or (iv) for any
transaction from which the director derived an improper personal benefit. No such
provision shall eliminate or limit the liability of a director for any act or omission
occurring prior to the date when such provision becomes effective. All references in this
paragraph to a director shall also be deemed to refer to such other person or persons, if
any, who, pursuant to a provision of the certificate of incorporation in accordance with §
141(a) of this title, exercise or perform any of the powers or duties otherwise conferred
or imposed upon the board of directors by this title.

In light of this concern, what are the practical differences between the duty of care and
the duty to act in good faith?

3. In Who´s the Boss? Unmasking Oversight Liability within the Corporate Power Puzzle, Anne
Tucker Nees argued:

Oversight liability – director´s liability for failing to oversee the corporation in

accordance with the fiduciary duty of loyalty, which requires good faith – raises difficult
questions because it engages in analysis close to the forbidden “second-guessing” by
courts that could discourage entrepreneurial risk taking.
On the other hand, the notion that all allegations of failed oversight are beyond the
purview of the shareholders and the courts is equally counterintuitive and potentially
undesirable as it negates the notion of balance, opting instead to allocate total authority
to directors over shareholder´s investments.
Should directors have any liability for failure to monitor management? Why might
factfinders equate poor financial results with bad faith? Is this possibility as concerning
when the court is the factfinder, as in Delaware?

4. To impose liability on directors for breach of their oversight duty, plaintiff must make a
“showing that the directors knew that they were not discharging their fiduciary duty
obligations”.

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 Assuming that directors will not admit such a knowledge, what facts could support such
a showing?
5. Do you think that market forces and reputational concerns provide directors with
sufficient incentives to satisfy their oversight duties? What should corporate law do, if
anything, to motivate directors to be more proactive in fulfilling their monitoring
responsibilities?

ATTACK BASIS OF DECISION

Business Judgment Rule

Specifically, from Aronson v. Lewis (Del. 1984):

BJR is a “presumption that in making a business decision the directors of a corporation

acted on an informed basis, in good faith and in the honest belief that the action taken
was in the best interests of the company.”

BJR does not apply: (a) gross negligence; (b) lack of good faith; and (c) Conflicted
transaction/Interested.

Duty of Case in directorial decision (resulting to loss)

In the case of the duty of care, Stone v. Ritter explains that the first class concerns liability
involving loss from an “action” of the board or "may be said to follow from a board decision
that results in a loss because that decision was ill advised or 'negligent." This is standard duty
of care case, epitomized by Van Gorkom.

Duty of care does not require that the directors the best practices. It only requires that the
directors were informed and there was rationality of the process involved. Good faith doesn’t
matter. The matter of good faith is important only to prove 102 (b) 7 as a defense against gross
negligence liability under duty of care.

Oversight Duty

Caremark
Duty of case in case of Board’s inaction. Caremark raised the standard in Graham v. Allis-
Chalmers, which had limited the board of directors’ compliance oversight obligation to
situations where red flags were waving in the board’s face. Chancellor Allen in Caremark
explains the second kind of duty of care cases involving the Board’s inaction or the “kind of
failure to exercise appropriate attention case "entail[s] circumstances in which a loss eventuates
not from a decision but, from unconsidered inaction." Caremark is such a case.

Chancellor Allen in Caremark elucidates that the corporation must satisfy its obligation to
reasonably informed by assuring “themselves that information and reporting system exists in
the organization that are reasonably designed to provide to senior management and the board
itself timely, accurate information” sufficient to allow the board to make informed judgments.
However, only a sustained or systemic failure of the board to exercise oversight-such as an utter

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failure to assure a reasonable information and reporting system exist-will establish the lack of
good faith that is a necessary condition to liability.

The Supreme Court in Stone v. Ritter clarified that in Caremark, the necessary conditions
predicate for director oversight liability: (a) the directors utterly failed to implement any
reporting or information system or controls; or (b) having implemented such a system or
controls, consciously failed to monitor or oversee its operations thus disabling themselves from
being informed of risks or problems requiring their attention

Courts will only consider directors’ “decision-making process,” not the substance of the
decision.

In re Citigroup Inc. Shareholder Derivative Litigation

In Caremark, damages claim from failure to exercise oversight duty of employee’s misconduct
or violation of the law and not failure to exercise oversight in properly monitoring a business
risk.
Caremark oversight duty does not cover monitory of a business risk because that is part of a
business judgment rule. This is because courts, with the benefit of hindsight, are not in a
position to determine whether a choice was a good business decision. Such action by courts
would also discourage corporate risk taking and would be tantamount to judicial second
guessing.

Good faith
Under DLGC, Section 102(b)(7), Delaware permits Delaware corporations to include a provision
in their certificate of incorporation that immunized directors for even grossly negligent
decisions except “for acts or omissions not in good faith or which involve intentional
misconduct or a knowing violation of law.”

Disney is the leading case for the contours of the duty of care and the meaning of good faith.
Justice Jacobs, In Disney defined good faith as follows:

A failure to act in good faith may be shown, for instance, where the fiduciary
intentionally acts with a purpose other than that of advancing the best interests
of the corporation, where the fiduciary acts with the intent to violate applicable
positive law, or where the fiduciary intentionally fails to act in the face of a
known duty to act, demonstrating a conscious disregard for his duties.

Stone v. Ritter
Delaware Supreme Court
911 A.2d 362 (Del. 2006)

Rule of Law
Directors will be liable for failure to engage in proper corporate oversight where they fail to
implement any reporting or information system, or having implemented such a system,
consciously fail to monitor or oversee its operations.

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Facts

AmSouth Bancorporation (AmSouth) was forced to pay $50 million in fines and penalties on
account of government investigations about AmSouth employees’ failure to file suspicious
activity reports that were required by the Bank Secrecy Act (BSA) and anti-money-laundering
(AML) regulations.

AmSouth’s directors were not penalized.

The Federal Reserve and the Alabama Banking Department issued orders requiring AmSouth to
improve its BSA/AML practices.

The orders also required AmSouth to hire an independent consultant to review AmSouth’s
BSA/AML procedures. AmSouth hired KPMG Forensic Services (KPMG) to conduct the review
and KPMG found that the AmSouth directors had established programs and procedures for
BSA/AML compliance, including a BSA officer, a BSA/AML compliance department, a
corporate security department, and a suspicious banking activity oversight committee.

The plaintiffs nonetheless brought suit against AmSouth directors (defendants) for failure to
engage in proper oversight of AmSouth’s BSA/AML policies and procedures. The Delaware
Court of Chancery dismissed the plaintiffs’ complaint. The plaintiffs appealed.

Issue

Can hindsight be used to determine whether directors exercised their corporate oversight
responsibilities in good faith?

Holding and Reasoning (Holland, J.)

No. Directors will be liable for failure to engage in proper corporate oversight where they fail to
implement any reporting or information system, or having implemented such a system,
consciously fail to monitor or oversee its operations.

The standard for such a determination is whether the directors knew that they were not
fulfilling their oversight duties and thus breached their duty of loyalty to the corporation by
failing to act in good faith.

This is a forward-looking standard and hindsight may not be used to determine whether
directors exercised their corporate oversight responsibilities in good faith.

In the present case, the KPMG report shows that the AmSouth directors had substantial
BSA/AML policies in place, including a BSA officer, a BSA/AML compliance department, a
corporate security department, and a suspicious banking activity oversight committee. The
implementation of this system discharges the directors’ oversight responsibilities because it is
an adequate reporting system and it delegated monitoring responsibilities to AmSouth
employees and departments. Simply because an AmSouth employee failed to follow the
BSA/AML policies and procedures in place does not mean that the directors did not put the

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policies and procedures in place in good faith. As a result of the foregoing, the Delaware Court
of Chancery’s dismissal of the plaintiffs’ complaint is affirmed.

This view of a failure to act in good faith results in two additional doctrinal consequences. First,
although good faith may be described colloquially as part of a "triad" of fiduciary duties (this
does not exist anymore) that includes the duties of care and loyalty, the obligation to act in good
faith does not establish an independent fiduciary duty that stands on the same footing as the
duties of care and loyalty. Only the latter two duties, where violated, may directly result in
liability, whereas a failure to act in good faith may do so, but indirectly. The second doctrinal
consequence is that the fiduciary duty of loyalty is not limited to cases involving a financial or
other cognizable fiduciary conflict of interest. It also encompasses cases where the fiduciary fails
to act in good faith. As the Court of Chancery aptly put it in Guttman, "[a] director cannot act
loyally towards the corporation unless she acts in the good faith belief that her actions are in the
corporation's best interest."

In addition, the Supreme Court then clarified the necessary basis for bringing a Caremark claim
following Disney and Stone:

We hold that Caremark articulates the necessary conditions predicate for director
oversight liability: (a) the directors utterly failed to implement any reporting or
information system or controls; or (b) having implemented such a system or
controls, consciously failed to monitor or oversee its operations thus disabling
themselves from being informed of risks or problems requiring their attention.5
Finally, in Stone, the Supreme Court also laid to rest the doctrinal dispute over
whether the obligation to act in good faith is a separate fiduciary duty under
Delaware law. It is not: “[A]though good faith may be described colloquially as part
of the ‘triad’ of fiduciary duties that includes the duties of care and loyalty, the
obligation to act in good faith does not establish an independent fiduciary duty that
stands on the same footing as the duties of care and loyalty.”6 Instead, the court
held, the obligation to act in good faith, properly understood, is subsumed within
the duty of loyalty.

 Candor/Disclosure
 SEC disclosure obligations
 Delaware: obligation to disclose if seeking shareholder action – Lynch (Van Gorkom)
Under state law, no obligation to disclose unless you are seeking shareholder action. In
Van Gorkon, satisfied the duty of disclosure but not he duty of candor (the duty to tell
the truth).

Part of fair dealing is the duty of candor. One possessing superior knowledge may not
mislead any stockholder by use of corporate information to which the latter is not
privy.

 Malone – Issue/facts?
 Lower Court?
 Supreme Court:
 Candor required (disclose something that was knowingly false, is not
violation), if disclosure made

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  Limited to knowingly disseminating materially false information
 Violates duty of loyalty/good faith
 Dicta: no general duty to disclose

There is a duty to disclose if there is shareholder action. There is also a duty of candor. There is
no general duty to disclose if no shareholder action. However, if you disclose voluntarily then
you will be liable for misstatements (duty of candor) so you will be liable if there is disclosure
voluntary and the misstatement is knowing.

THE DUTY OF DISCLOSURE

Corporate Directors and Officers (CSweet) have affirmative duties of disclosure arising under
federal securities statues.
For the most part, these complex federal laws and regulations establish the scope and substance
of public companies’ disclosure obligations. However, the Delaware courts also have
recognized a fiduciary duty of disclosure owed by corporate directors and officers under state
law.
Recall Smith v. Van Gorkom, the majority found that the directors breached their duty to
disclose to Trans Union shareholders “all material information such as a reasonable stockholder
would consider important” in deciding whether to approve the proposed merger.
Delaware courts first recognized the directors’ disclosure duty in connection with a request for
shareholder action. However, even in the absence of a request for shareholder action, directors
have disclosure duties under state Law, as the Delaware Supreme Court affirmed in the
following case:

Malone v. Brincat.
Delaware Supreme Court.
Holland, Justice:
The complaint alleged that:
 Director defendants intentionally overstated the financial condition of Mercury on
repeated occasions, throughout a 4 year period in disclosures to Mercury’s shareholders;
 Directors “knowingly and intentionally breached their fiduciary duty of disclosure
because the SEC filings made by directors and every communication with shareholders
was materially false” and that “as direct result, the company has lost all or virtually all
of its value ($2 billion);
 All the foregoing inaccurate information was included or referenced in virtually every
filing Mercury made with SEC and every communication Mercury’s directors made to
shareholders during said period of time.

Plaintiffs contend and argue:

 Complaint states a claim upon which relief can be granted for a breach of fiduciary duty
of disclosure;
 Since 1994, the director defendants cause Mercury to disseminate information containing
overstatements of Mercury’s earnings, financial performance and shareholder’s equity.
 As a direct result of the false disclosures, the Company has lost all or virtually of its
value (about $2Billion)
Issue: the individual director defendants filed a motion to dismiss, contending that they owed
no fiduciary duty of disclosure under the circumstances alleged in the complaint.

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Discussion: the Court of Chancery held that directors have no fiduciary duty of disclosure
under Delaware Law in the absence of a request for shareholder action. Delaware Supreme
Court disagrees with the previous. The present appeal requires this Court to decide whether a
director’s fiduciary duty arising out of miss-disclosure is implicated in the absence of a request
for shareholder action.

Held: board of directors is under fiduciary duty to disclose material information when seeking
shareholder action. Directors of Delaware corporation are under a fiduciary duty to disclose
fully and fairly all material information within the board’s control when it seeks shareholder
action. The present appeal requires this Court to decide whether a director’s fiduciary duty
arising out of misdisclosure is implicated in the absence of a request for shareholder action.

Directors who knowingly disseminate false information that results in corporate injury or
damage to a shareholder violate their fiduciary duty and may be held accountable in a manner
appropriate to the circumstances. Even absent a request for shareholder action.
Fiduciary Duty Delaware Directors
An underlying premise for the imposition of fiduciary duties is a separation of legal control
from beneficial ownership.
Directors of Delaware corporations stand in fiduciary relationship not only to shareholders but
to the corporations upon whose boards they serve. Therefore, directors’ fiduciary duty to both
the corporation and its shareholders is triad: due of care, good faith and loyalty.
The tripartite fiduciary duty does not operate intermittently but is the constant compass by
which all director actions for the corporation and interactions with shareholders must be
guided.
The exact course of conduct that must be charted to properly discharge that responsibility will
change in the specific context of the action the director is taking with regard to either the
corporation or its shareholders.
Director Communications Shareholder Reliance Justified.
The shareholder constituents of a Delaware corporation are entitled to rely upon their elected
directors to discharge their fiduciary duties at all times.
Malone v. Brincat
Duty of Candor

Directors of Delaware Corporation are required to disclose fully and fairly all material
information within the board’s control when it seeks shareholder action. In this situation,
they have both the duty of disclosure and the duty of candor. The duty of candor requires not
only the disclosure of information, but that the disclosure is honest and truthful.

However, Delaware directors disseminate information in three contexts where no shareholder

action is not required:
1. Public statements made to the market;
2. Statements informing shareholders about the affairs without request for shareholder
action; and
3. Statements to shareholders in conjunction with a request for shareholder action.

In this case, when the directors disseminate information to stockholders when no

stockholder action is sought, the fiduciary duties of care, loyalty and good faith apply . The

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director’s fiduciary duties include the duty of candor, or the duty to deal with their
stockholders honesty.
Dissemination of false information could violate one or more of those duties. In this way,
shareholders are entitled to rely upon the truthfulness of all information disseminated to them
by the directors they elect to manage the corporate enterprise.

State Fiduciary Disclosure Duty Shareholder Remedy In Action Requested Context.

In the absence of a request for stockholder action, the Delaware General Corporation Law does
not require directors to provide shareholders with information concerning the finances or
affairs of the corporation.
Fraud on Market Regulated by Federal Law.
When corporate directors impart information they must comport with the obligations imposed
by Delaware Law, Federal Law and regulations of Securities and Exchange Commission. This
court has decided not to recognize a state common law cause of action against directors, given
that the claim appears to be made by those who did not sell, and therefore would not implicate
federal securities laws which relate to the purchase or sale of securities.
State Common Law Shareholder Remedy In Nonaction Context
Delaware Law protects shareholders who receive false communications from directors even in
the absence of a request for shareholder action. Therefore, when directors are not seeking
shareholder action, but are deliberately misinforming shareholder about business, either
directly or public statement, there is a violation of a fiduciary duty. The violation may result in
derivative action.
Complaint Properly Dismissed No Shareholder Action Requested.
The plaintiff never expressly asserted a derivative claim on behalf of the corporation or allege
compliance with Court of Chancery Rule 23.1 11, which requires pre-suit demand or cognizable
and particularized allegation that demand is excused.

 Enhanced Scrutiny
(in the middle of business judgment rule and entire fairness- reasonable then you have
deference)
 Unocal - defensive measures permitted if:
 Reasonable belief that danger exists (make that judgment after reasonable
investigation)
 In good faith after reasonable investigation
 Response “reasonable in relation to the threat” (or danger)
 Factors may include price (not high enough), consideration (price-related but
may go into form of consideration), timing (when paid? tomorrow?), other
constituencies (impact on other constituencies, i.e., employees, community,
lender), risk of non-consummation
 May not be coercive (no other choice, forces you to agree) or preclusive (tie their
hands that there is no other real choice) – range of reasonableness

Unocal Corporation v. Mesa Petroleum Co.

Delaware Supreme Court
493 A.2d 946 (Del. 1985)

11
https://h2o.law.harvard.edu/collages/7169

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Rule of Law
A board of directors may repurchase stock from a selected segment of its stockholders in
order to defeat a perceived threat to the corporation’s business so long as the board’s
selection of which stockholders to repurchase from is reasonable in relation to the threat and
not motivated primarily out of a desire to effectuate a perpetuation of control.

Facts

Plaintiff was a corporation led by a well-known corporate raider. Plaintiff offered a two-tier
tender offer wherein the first tier would allow for shareholders to sell at $54 per share and the
second tier would be subsidized by securities that the court equated with “junk bonds”�. The
threat therefore was that shareholders would rush to sell their shares for the first tier because
they did not want to be subject to the reduced value of the back-end value of the junk securities.
Defendant directors met to discuss their options and came up with an alternative that would
have Defendant corporation repurchase their own shares at $72 each. The Directors decided to
exclude Plaintiffs from the tender offer because it was counterintuitive to include the
shareholder who initiated the conflict. The lower court held that Defendant could not exclude a
shareholder from a tender offer.

Mesa Petroleum, who owned 13% of Unocal Corporation’s stock, commenced a two-tier “front-
loaded” cash tender offer for 37% of Unocal’s outstanding stock (64 M shares) at a price of $54
per share in cash. It then issued a supplemental proxy statement to Unocal’s stockholders
disclosing that the securities it offered in the second-step merger would be highly subordinated
(“junk bonds”). (High Yield debt, very risky debt, very subordinated debt)
13 directors met, were given no agenda or written materials, but were given detailed
presentations discussing that Mesa Petroleum’s proposal was wholly inadequate. (your
company is $60 at liquidation: Golman Sachs)
They were also presented various defensive strategies available if the board concluded that
Mesa Petroleum’s two-step tender offer was inadequate, including a self-tender by Unocal
Corporation for its own stock with a reasonable price range of $70 to $75 per share (it would
cost the company $6.5B in debt). They also excluded Mesa Petrolem from the proposal, the
stockholder making a hostile tender offer for the company’s stock. Self -tender is a defensive
strategy because stockholders will sell to Unocal and not to lower bid Mesa Petroleum.

In sum, the Unocal board’s goal was either to win out over Mesa’s $54 per share tender offer, or,
if the Mesa offer was still successful despite the exchange offer, to provide the Unocal
shareholders that remained with an adequate alternative to accepting the junk bonds from Mesa
on the back end. Mesa brought suit, challenging Unocal’s exchange offer and its exclusion of
Mesa. The Delaware Court of Chancery granted a preliminary injunction to Mesa, enjoining
Unocal’s exchange offer. Unocal appealed.

In Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (1985), the Supreme Court of Delaware
addressed the fundamental question of whether the Unocal board had the power and duty to
oppose a takeover threat it reasonably perceived to be harmful to the corporate enterprise, and
if so, is its action here entitled to the protection of the business judgment rule.
At the onset, the Supreme Court notes that boards have the right, and sometimes the obligation,

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to defend the corporation in the face of a takeover. There is basis under the law for the Board to
adopt this defensive measure as provided in DGCL 141(a), respecting management of the
corporation’s business and affairs and DGCL 160(a), conferring board authority upon a
corporation to deal in its own stock, and the board’s fundamental duty and obligation to protect
the corporate enterprise.

The question is under what standards are the directors defense mechanism to a takeover threat
be measured against considering that in responding to a takeover threat, hostile that is, there
directors have an inherent conflict considering that they are likely to be taken out from their
seats.
Prior to Unicol, the standards of review were the “entire fairness” and “business judgment”.
When directors have a sufficient economic interest in a transaction, their approval of the
transaction is deemed to be infected by a conflict of interest. DGCL 144 specifies exactly what
decisions involve prohibited conflicts of interest. If their decision is not approved by
independent decision-makers, the burden is on the directors to prove the entire fairness of the
transaction. Decisions not involving a conflict of interest are subject to the deference of the
business judgment rule.

Delaware courts struggle to locate an appropriate standard of review when dealing with
intermediate sets of decisions—where directors may receive indirect benefits as a result of their
decisions, but do not themselves deal with the corporation. The Delaware Court then
formulated the Unocal analysis.

The Supreme Court pronounced that the board’s response to a takeover threat “should still
be entitled respect they otherwise would be accorded in the realm of business judgment.
However, there should certain caveats to a proper exercise of this function. “Because of the
omnipresent specter that a board may be acting primarily in its own interests, rather than
those of the corporation and its shareholders, Unocal states “that there is an enhanced duty
which calls for judicial examination at the threshold before the protections of the business
judgment rule may be conferred.”

The Unocal Analysis requires the Board decision pass the following two part test, before the
Business Judgment rule is applied:

First, First, the board must show it had reasonable grounds for believing there is a threat
to corporate policies and effectiveness, showing good faith and reasonable investigation.

Second, the board must show the response was reasonable in relation to the threat posed
in light of the circumstances at the time. Unocal refers to this as the “element of
balance”. This entails an analysis by the directors of the nature of the takeover bid and
its effect on the corporate enterprise. Examples of such concerns may include:
inadequacy of the price offered, nature and timing of the offer, questions of illegality, the
impact on "constituencies" other than shareholders (i.e., creditors, customers, employees,
and perhaps even the community generally), the risk of nonconsummation, and the
quality of securities being offered in the exchange

After a defensive measure has met this standard, the court will defer to the business judgment
rule. This means that the court will defer to directors unless there has been some other breach of

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fiduciary duty, for example a breach of the duty of care by being uninformed, or a breach of the
duty of loyalty by acting selfishly to perpetuate themselves in office, or doing something in bad
faith, or committing fraud.

Unocal only applies where boards have acted without shareholder approval.
 Revlon
 Board must seek to obtain the highest price in change-in-control context
“When Pantry Pride increased its offer, it became apparent that a break-up of the
company was inevitable. The duty of the Board changed from preservation of Revlon
to the maximization of the company’s value. This altered the Board’s responsibilities
under Unocal. It no longer faced threats to corporate policy from a grossly inadequate
bid. The whole question of defensive measures was moot. The directors’ role
changed from defenders of the corporate bastion (under Unocal) to auctioneers
charged with getting the best price for the stockholders.”

Revlon: Did the board do the reasonable job of seeking the highest part? The court
does not look if the price is high.

Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc.

Delaware Supreme Court
506 A.2d 173 (Del. 1986)

Rule of Law
When the break-up of a corporation is inevitable, the duty of the corporation’s board of
directors changes from maintaining the company as a viable corporate entity to maximizing
the shareholders’ benefit when the company is eventually and inevitably sold.

Facts

Pantry Pride, Inc. (Pantry Pride) (plaintiff) sought to acquire Revlon, Inc. (Revlon) (defendant)
and offered $45 per share. Revlon determined the price to be inadequate and declined the offer.
Revlon’s investment banker explained that Pantry Pride’s financial strategy for acquiring
Revlon would be through “junk bond” financing followed by a break-up of Revlon and
disposition of assets. With proper timing, according to experts, such transaction could produce
a return to Pantry Pride of $60 to $70 per share, while a sale of the company as whole would be
in the mid 50 dollar range.

Martin Lipton, special counsel for Revlon, recommended two defensive measures:
First, that Revlon repurchase up to 5 M of its nearly 30M outstanding shares.

Second, A Note Purchase rights Plan. Each Revlon shareholder would receive a dividend One
Purchase Note Right for each share of common stock. The Right entitle the holder to exchange
one common share for a $65 principal Revlon Note at 12% interest with a one-year maturity.
The rights would become effective whenever anyone acquired beneficial ownership of 20% or
more of Revlon’s shares, unless the purchaser acquires the company’s stock for cash at $65 or
more per share.

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Pantry Pride $47.5 for common shares. Revlon told shareholders to reject the plan. Revlon
undertook defensive measure, including Despite defensive efforts by Revlon offer to exchange
up to 10 million shares of Revlon stock for an equivalent number of Senior Subordinated Notes
(Notes) of $47.50 principal at 11.75 percent interest. Revlon tendered 87% of shares. Despite this,
Pantry Pride remained committed to the acquisition of Revlon.

Pantry Pride raised its offer to $50 per share and then to $53 per share.

Meanwhile, Realize that they need a white knight—the friendly takeover that company prefers.
Revlon would rather be sold to Forstmann than to Pantry Pride. Revlon was in negotiations
with Forstmann Little & Co. (Forstmann) (defendant) and agreed to a leveraged buyout by
Forstmann, subject to Forstmann obtaining adequate financing.

Under the agreement, Revlon stockholders would receive $56 per share and Forstmann would
assume Revlon’s debts, including what amounted to a waiver of the Notes covenants.

unlike Pantry Pride, who would fire management, Forstmann is willing to work with the
incumbent management of Revlon
management had golden parachute provisions which allowed them to buy shares into new
coapny.

Upon the announcement of that agreement, the market value of the Notes began to drop
dramatically and the Notes holders threatened suit against Revlon. At about the same time,
Pantry Pride raised its offer again, this time to $56.25 per share.

Upon hearing this, Forstmann raised its offer under the proposed agreement to $57.25 per
share, contingent on two pertinent conditions.

First, a lock-up option giving Forstmann the exclusive option to purchase part of Revlon for
$100-$175 million below the purported value if another entity acquired 40 percent of Revlon
shares. Revlon’s Vision CaaCrown-jewel Lockups: the favored bidder can still get our product
line or R&D at a lower price if it does not get the deal

Second, a “no-shop” provision, which constituted a promise by Revlon to deal exclusively with
Forstmann.

In return, Forstmann agreed to support the par value of the Notes even though their market
value had significantly declined.

The Revlon board of directors approved the agreement with Forstmann and Pantry Pride
brought suit, challenging the lock-up option and the no-shop provision. The Delaware Court of
Chancery found that the Revlon directors had breached their duty of loyalty and enjoined the
transfer of any assets, the lock-up option, and the no-shop provision. The defendants appealed.
Issue
When the break-up of a corporation is inevitable, does the corporation’s board of directors
violate its duty of loyalty to the shareholders if its first consideration is not maximizing the
shareholders’ benefit when the company is eventually and inevitably sold?

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Holding and Reasoning (Moore, J.)

Yes. In cases where a board implements “anti-takeover measures,” the burden is on the
directors to prove that their actions were reasonable. However, the business judgment rule
kicks in if they prove a good faith and reasonable investigation resulted in their decision.

In the present case, the Revlon board’s initial defensive measures—its exchange offer for Notes
—was reasonable under the holding in Unocal Corporation v. Mesa Petroleum Co., 493 A.2d
946  (Del. 1985), given the board’s determination that Pantry Pride’s offer was less than
adequate. However, when Pantry Pride continually increased its offer, the court determines that
it became obvious that “the break-up of [Revlon] was inevitable.”

At that point, the Revlon board’s duty was changed from maintaining Revlon as a viable
corporate entity to maximizing the shareholders’ benefit when the company was eventually and
inevitably sold. Revlon moment, defensive measures no longer important but shareholder’s
benefit, get the best price.

By granting the lock-up option to Forstmann that in turn guaranteed par value for the Note
holders who were threatening litigation against Revlon, it is apparent that the Revlon board of
directors had their own legal interests in mind, rather than the maximization of Revlon
shareholders’ benefits. There was essentially an auction ongoing between Forstmann and
Pantry Pride for Revlon’s shares and the granting of the lock-up option effectively ended the
auction rather than letting the auction play out to obtain the highest bid for the Revlon
stockholders. The Revlon board put its own legal interests first to the detriment of the
stockholders. This constitutes a breach of the board’s duty of loyalty and therefore the board is
not entitled to the deference of the business judgment rule. The lock-up option should be
enjoined and the Delaware Court of Chancery is affirmed.

 Weinberger v. UOP
 Obligation of controlling shareholder to minority shareholders in a buyout
merger
 Signal held 50.5%, cash-out remaining %
 “Dominated” Board - no control but they dominated board (directors from
Parent company who are also directors of Target had an internal study that
they did not share with Target)
 Named only 6 of 13 members,
 Process concerns
 Signal “influenced” negotiations
 Lack of disclosure
 Conflicted behavior of Signal directors
 “Entire Fairness”
 When directors on both sides (dominance), utmost good faith and inherent
fairness required
 If no “arm’s length” bargaining, dual capacity directors must be “entirely fair”
with minority

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  Entire fairness is a standard of review composed of (i) fair dealing and (ii) fair
price
 Fair dealing? Mirror real “arm’s length”
 Timing, initiation, structure, negotiation, disclosure
 At both director and shareholder levels
 Fair Price? How should it be determined?

Weinberger v. UOP, Inc.

Delaware Supreme Court
457 A.2d 701 (Del. 1983)

Rule of Law
Minority shareholders voting in favor of a proposed merger must be informed of all material
information regarding the merger for the merger to be considered fair.

Facts

The Signal Companies, Inc. (Signal) acquired 50.5 percent of UOP, Inc.’s (Universal Oil Products
UOP) (defendants) outstanding stock.
Signal elected six members to the new board of UOP (13 members), five of which were either
directors or employees of Signal.
After the acquisition, Signal still had a significant amount of cash on hand due to a sale of one of
its subsidiaries. Signal was unsuccessful in finding other good investment opportunities for this
extra cash so it decided to look into UOP once again.
At the instigation of Walkup and Shamway, Signal Chairman and President, Charles Arledge
and Andrew Chitiea, two Signal officers who were also UOP directors, conducted a “feasibility
study” for Signal and determined that the other 49.5 percent of UOP would be a good
investment for Signal for any price up to $24 per share.
The study found that the return on investment at a purchase price of $21 per share would be
15.7 percent, whereas the return at $24 per share would be 15.5 percent.
Despite this small difference in return, the difference in purchase price per share would mean a
$17 million difference to the UOP minority shareholders.

Shumway and Walkup spoke to Crawford, President, and told him of Signal’s plan to acquire at
a proposed price range of $20-21 before executive meeting. UOP market price US$14.5.
Lehman brothers said that $20-21 price would be fair in their fairness opinion.
This information was never passed along to Arledge and Chitiea’s fellow UOP directors or the
UOP minority shareholders. The UOP board agreed on a $21 per share purchase price. The UOP
minority shareholders subsequently voted in favor of the merger.
Weinberger, et al. (plaintiffs) were UOP minority shareholders and brought suit, challenging
the merger. The Delaware Court of Chancery found in favor of the defendants. The plaintiffs
appealed.
Issue
Is a minority shareholder vote in favor of a proposed merger fair if the shareholders were not
given information on the highest price that the buyer was willing to offer for the shares?
Holding and Reasoning (Moore, J.)

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No.

There is no “safe harbor” for such divided loyalties in Delaware corporation are on both sides of
transactions, they are required to demonstrate their utmost good faith and the most scrupulous
inherent fairness of the bargain. (footnote: fairness could be equated to a wholly independent,
BOD, independent negotiating committee).

The concept of fairness has two basic aspects: fair dealing and fair price.

The former embraces the questions of when the transaction was timed, how it was initiated,
structured, negotiated, disclosed to the directors, and how approvals of the directors and
stockholders were obtained.

Fair price relates to economic and financial consierations, including all relevant factors: assets,
market value, earnings, any other elements that affect the intrinsic value or inherent value of the
shares.

Test for fairness is not a bifurcated one as between fair dealing and price. All aspects of the issue
must be examined as a whole since the question is entire fairness.

Part of fair dealing is the duty of candor. One possessing superior knowledge may not mislead
any stockholder by use of corporate information to which the latter is not privy.

Minority shareholders voting in favor of a proposed merger must be informed of all material
information regarding the merger for the dealing to be fair. Failure to provide the minority
shareholders with all material information is a breach of fiduciary duty.

Here, although Arledge and Chitiea had prepared their study for Signal and were actually
Signal officers, they still owed a duty to UOP because they were also UOP directors. The
feasibility study and, more specifically, the possible sale price of $24 per share and the resulting
$17 million difference in amount paid to the UOP minority shareholders clearly constitute
material information that the shareholders were entitled to know before voting.

Arledge and Chitiea’s failure to disclose that information was a breach of their fiduciary duties
and their actions thus cannot be considered fair dealing.

The basic concept of value under the appraisal statute is that the stockholder is entitled to be
paid for what which has been taken from him; true and intrinsic value of his stock which has
been takin in the merger. In terms of fair price, to determine whether the price of a cash-out
merger was fair, a court is to consider “all relevant factors,” all relevant factors, ie., market
value, asset value, dividends, earnings prospects, nature of the enterprise, facts which throw
into light on future prospects on the merged corporation are not only pertinent to an inquiry as to
value but must be considered by the agency in fixing the value, something that the Delaware
Court of Chancery did not do.

Section 262 now mandates the determination of “fair”value based on all “relevant factors” Only
speculative elements of value excluded, i.e., future value.

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On remand, all relevant factors concerning the value of UOP should be considered in
determining whether the price was fair. As a result of the foregoing, the Delaware Court of
Chancery’s findings that the circumstances of and price paid for the merger were fair are
reversed and the case is remanded.

 Corporate Opportunities
 “Undivided and unselfish loyalty”
 When can conflicts arise?
 Directors with overlapping interests
 PE firms with multiple companies
 Balance competing interests?
 Often messy – fact based
 Traditional Analysis
 Is it a “corporate opportunity”?
 If so, may the director pursue it?
 Corporate opportunity if:
 Within line of business
 Interest or expectancy
 Financially able to exploit
 Inimical to duties to corporation
 Director May Pursue If:
 Presented to Board and rejected OR
 Corp not in a position to pursue OR
 Received in individual capacity and
 Not essential to corporation and
 No interest or expectancy and
 No wrongful misappropriation
 AngioScore
 Was it an opportunity?
 Was it a corporate opportunity?
 Line of business?
 Interests or expectancy?
 Capable of pursuing?
 Inimical to fiduciary obligations?
 Questions from AngioScore
 Inventor, not third party
 Inventorship does not absolve
 Balance “duty” with “innovation”
 Right of first refusal vs. ownership
 What “belongs” to the corporation?
 Deception/misappropriation
 Impact of resignation

 DGCL §122(17)
 Corporation May renounce opportunities

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  In advance or case by case
 Generally or specific
 Application: PE firm or inventor
 Charter or resolution
 Not bylaws!
 Requires full disclosure and no conflicts

DGCL§122(17)

Every corporation created under this chapter shall have power to:

(17) Renounce, in its certificate of incorporation or by action of its board of directors, any

interest or expectancy of the corporation in, or in being offered an opportunity to participate in,
specified business opportunities or specified classes or categories of business opportunities that
are presented to the corporation or 1 or more of its officers, directors or stockholders.

AngioScore, Inc. v. Trireme Medical, Inc. Brown pgs. 316-321

Ruling: a director’s fiduciary duties and his drive to innovate can co-exist, if there is
transparency, loyalty and good faith, subject to the duties to the corporation taking
precedence.

Palintiff claim: AngioScore brings state law claim against its co-founder and former director,
Eitan Konstantino, who invented “AngioSculp”, the company’s signature product for treating
cardiovascular disease (angioplasty balloon catheters). They accuse the defendant Konstantino
for developing a medical device directly competitive with AngioScore’s product and failing to
offer it to the company.

Defendant arguments: no duty was breached because there was no opportunity; and because
AngioScore was not entitled to Konstantino’s intellectual property.

Decision: courts rules for AngioScore and awards remedy.

Additional facts: when Konstantino invented the “AngioSculp”, he sought funding from
investors in exchange of making them part of the board of directors. He himself was member of
the board. Eventually, the board asked him to switch position, which he did. AngioScore
wanted to keep him in the company due to his skills, but Konstantino wanted to work full time
in his new company (TriReme Medical, Inc). He kept being a director until 2010.
Konstantino obtained permission of AngioScore’s board to work on a developing technology
with TriReme, (Stents not competitive with balloon) obtaining a waiver of rights regarding this
product.

On 2009, while Konstantino was director at AngioScore, he developed another product

(Chocolate) that was similar to AngioScore’s product (a balloon), both angioplasty balloon
catheters, applied for provisional patent and requested funding. He and his co-inventor
marketed the product through a third company called Proteus. Both products were similar:
same objective, similar elements, premium pricing, same customers.

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In addition, Konstantino knew that the financial status of AngioScore is relatively strong.
AngioScore was in a prime position to raise further funds.

The court says that Konstantino intended to compete with AngioScore’s AngioSculp and all of
this happened while he was member of AngioScore’s board, having access to confidential
information. For all of this, the court concludes that AngioScore would have exploited
Chocolate’s opportunity.

In addition, Konstantino told AngioScore’s CEO (Trotter) that he was developing a balloon
(different from Chocolate) and made no mention of Chocolate, the real competing product.

Trotter informed Konstantino that he had a conflict of interest and was asked to resign to the
board.

Corporate Opportunity Doctrine

Delaware law states the following elements for misappropriation of corporate opportunity:
1) the opportunity is within the corporation’s line of business;
2) the corporation has an interest or expectancy in the opportunity;
3) the corporation is financially able to exploit the opportunity; and
4) by taking the opportunity for its own, the fiduciary is placed in a contrary position to
his duties in the corporation.

Once the plaintiff has shown that the director’s duty of loyalty has been breached, it is the
fiduciary’s burden to proof that he or she did not seize the opportunity, because the corporation
rejected it or was in no capacity to develop it.

Situations in which the fiduciary can take the opportunity by its own:
1) if the opportunity is presented to the director as an individual and not his corporate
capacity;
2) opportunity is not essential for the corporation;
3) corporation has no interest or expectancy in such opportunity; and
4) the director/officer has not wrongfully employed resources of the corporation for the
development of this opportunity.

General purpose of corporate governance principles: referring specifically to duty of care and
loyalty, is to control for the moral hazards that arise when directors either shirk their
responsibilities or self-serve.

Pp. 322-327

Corporate Opportunity Doctrine Applies to Director who is also an Inventor.

Konstantino is a director of AngioScore. He invents a technology (a medical device known as

Chocolate being used in medical procedures), which is directly competitive with the
corporation he serves. Konstantino resigned as a director. He also offered Chocolate to another
company and not AngioScore.

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Konstantino argues that the corporate opportunity doctrine does not apply to him (prior to his
resignation) considering that Chocolate was intellectual property belonging to Konstantino and
the product of his own imagination. This is not correct.

Directors must exalt the interest of the corporation they serve above their own. The fact of
inventorship does not absolve a director of his fiduciary obligations with respect to inventions
he may develop that compete with the corporation he serves. A director can leave the
corporation thereby dissolving the duties he owes. When he resigned when it was just an idea,
no violation of fiduciary duty.

However, although AngioScore was owed fiduciary duty by Konstantino, those duties do not
entitle AngioScore to outright ownership of the Chocolate opportunity at any point in time.
(like it was coming from third party) Rather, what Konstantino’s fiduciary duty demanded
was that he offer Angioscore the opportunity to acquire the rights to the Chocolate.

Offering the opportunity to AngioScore meet’s Delaware’s demand that directors not undertake
any activity that would harm the corporation they serve and prioritize the interests of these
corporations above their own. And, it remains faithful to the general principle that a director
can establish conclusively no breach of fiduciary duty where, in keeping with the interests of
the corporation he serves first in mind, the corporation is presented the opportunity and rejects
it.

Application of the Corporate Opportunity Doctrine

 Was it an opportunity?

Law requires that certain “opportunities” be offered to the corporation. The definition of an
“opportunity” is a “favorable juncture of circumstances” or “a good chance for advancement or
progress”. Was it mature enough to be an opportunity? In this case, Court found it was mature.
Chocolate was a concrete business opportunity (not a mere idea; preliminary) at the time of
Konstantino’s resignation which should have been offered to AngioScore considering that
Konstantino felt it was sufficiently ready to be offered to other investors.

 Was it a corporate opportunity?

 Line of business?

BUT was it corporate opportunity? An opportunity is within a corporation’s line of business if it

is “an activity as to which the corporation has fundamental knowledge, practical experience and
ability to pursue, which logically and naturally, is adaptable to its business having regard for its
financial position and is one that is consonant with its reasonable needs and aspirations for
expansion.” Chocolate falls within AngioScore’s line of business (medical equipment for
treatment of cardiovascular disease called Angio Sculpt). AngioSculpt and Chocolate are similar
in both purpose and function.

 Interests or expectancy?

For a corporation to have an expectant interest in any specific property, there must be some tie
between the property and the nature of the corporate business. Even if it’s a line of business, but

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you did not intend to pursue it anymore. “Some tie” exists between Chocolate and the nature of
AngioScore’s business. AngioScore also had an actual and expectancy interest in Chocolate by
virtue of its then existing needs and business purposes, and Chocolates potential benefit to
AngioScore.

 Capable of pursuing?

Once plaintiff has made a prima facie showing of financial ability, a fiduciary “faces a
significant burden in establishing that the corporation was financially unable to take advantage
of a corporate opportunity.”

Defendants have not established AngoScore’s inability to capitalize the Chocolate opportunity.
AngioScore had established that it could have capitalized the Chocolate Opportunity had
Konstantino offered the opportunity. Startup companies in Silicon Valley like Angioscore are
always short on cash but it does not mean the company is not profitable or not successful.

 Inimical to fiduciary obligations?

By taking the Chocolate opportunity to himself and the companies he preferred, to the
exclusion of AngioScore, Konstantino placed himself in a position inimical to his duties to the
corporation. He became a competitor of AngiScore.

Old case that says: as long as you do it without bad intent, there is nothing to prevent you to
compete. In theory, it is possible to complete, but be careful, if there is nothing that you did
improper. Practically, cannot be possible.
Remedy

If an officer of director of a corporation, in violation of his duty as such, acquires gain or

advantage for himself, the law charges the interest so acquired with a trust for the benefit of the
corporation at its election, while it denies to the betrayer all benefit and profit.

Defense of Causation

Konstantino’s behavior caused harm to AngioScore because the devices do compete.

Under DGCL§122(17), The corporation can waive its right to pursue a corporate opportunity by
provding its its certificate of incorporation or by action of the board a renouncement of “any
interest or expectancy of the corporation in, or in being offered an opportunity to participate in,
specified business opportunities or specified classes or categories of business opportunities that
are presented to the corporation or 1 or more of its officers, directors or stockholders.

interst of expectancy
of the in

or in being offered an opportunity to participate in, specified business opportunities or specified

classes or categories of business opportunities that are presented to the corporation or 1 or more
of its officers, directors or stockholders.

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DGCL§122(17)

Every corporation created under this chapter shall have power to:

(17) Renounce, in its certificate of incorporation or by action of its board of directors, any

interest or expectancy of the corporation in, or in being offered an opportunity to participate in,
specified business opportunities or specified classes or categories of business opportunities that
are presented to the corporation or 1 or more of its officers, directors or stockholders.

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  SHAREHOLDER ACTIVISM OVERVIEW
 Institutional Investors
 Types of Activists and Motivations
 Activism Strategies
 Evolution of Activist Tactics
 Is Activism Good or Bad?
 Implications of Ownership
 Implications of Board Membership
 Institutional Investors
 Shift from individuals to institutions
 Anonymous shareholder no longer the case
 Fueled by rise of pension funds/mutual funds
 Institutions: 8% of 1950 equities; ~78% in 2017
 Institutional investors own 80+% of S&P 500 ($18Trillion of just those companies)
 Apple = 85.7% (MCST
 “Repeat players” - Nasdaq Ownership Reports
 Index funds
 Better placed to play activist role
 Anonymity and reluctance no longer exists
 Leverage through director election!?!

When Berle and Means wrote about shareholder powerlessness in 1932, most shareholders were
individuals. The situation has changed dramatically with the rise of institutional investors.
Institutional Investors (pension and mutual funds) obtain the individuals’ savings (millions of

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individuals) into enormous portfolios that buy stocks in public companies.By 2002, institutions
owned more than 60% of most large multinational companies’ equity. Institutional investors own 80+% of
S&P 500 ($18Trillion of just those companies)

In this way, they obtain a far better position than individual investors to play an activist role.
Today these institutions have captured two thirds of the market for public equities. This means
that they are the dominant shareholders.
As institutional investors become more and more powerful and influential, they are gaining a
more favorable position in doing an activist role in corporate governance. Moreover, even
though most mutual and pension funds rely on relatively passive stock-picking strategies, a
number of these (i.e. Fidelity, Vanguard and CalPERS) are becoming activists by engaging in
public relations campaigns, litigation and pressuring corporate officers and directors into
following their corporate strategy.
 Institutions and Motivations
 Virtually all institutions are fiduciaries
 But not all institutions are activists!
 Not all activists have the same objectives
 Often depends on goals and structure:
 Investment horizon/holding period
 Investment strategy
 Risk appetite
 Government regulation
 Social goals
 Compensation structure
 Activism types:
 Governance, CSR and financial

Day 9 – 20/08/2018
Brown pgs. 436-437

Iman Anabtawi & Lynn Stout, Fiduciary Duties for Activist Shareholders
Comments:
Berle and Means are credited with having identified the separation of management and
ownership in public companies. The need for some mechanism designed to ensure that
directors act in the best interest of shareholders is generally referred to as “agency costs”.
Influenced by this analysis, Congress in the securities laws have sought to empower
shareholders through the use of disclosure. The legislative history to the proxy provisions
articulated the goal of “fair corporate suffrage”.
Agency costs- mechanism designed to ensure that directors act in the best interests of
shareholders.

Congress established disclosure in order to empower shareholders.

NASDAQ REPORT ON CANVAS

Minow- Pgs 145-146 (Canvas)

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Moreover, these institutions are subject to the highest standard of care and prudence (fiduciary
duty) and as judge Cardozo say they must be “above the morals of the marketplace”. This
appears to be the only thing in common between them.

There are two main problems affecting institutional investors:

i) collective choice- implying the decisions the investors, who has the best information
and conflict of interest;
ii) ii) agency costs- act on behalf of others, the investor manages money from others; i.e.
until 2003, the beneficiary owners of a stock had no idea of how was the proxy card
voted.

Bank trusts- banks are one of the most important trustees of pensions. They are composed of
different beneficiaries with different kinds of interests and are subject to complex legislation
and federal system. In addition, bank trustees are generally irrevocable (unless fraud is
perfected) and therefore, having such a security (fraud is very difficult to detect and prove),
they have a poor investment performance. Banks, especially trust departments, do not
encourage innovation, especially positions that are contrary to corporate’s management’s
recommendation on proxies.

The NASDAQ Instiutitional Ownership Rpeort shows that institutional investors are not only
comprise the majority stockholders, most of them are repeat players.

“Repeat players” - Nasdaq Ownership Reports

 Holdings Summary page provides a single page to  review  all of the
aggregated Institutional andInsider stock holdings.
Types of Institutions and Goals
Pension Funds
Brown Ch. 7 (pp. 438-440)

 Types of Institutional Investors

 Bank Trusts
 Insurance Companies
 Pension Funds
 Mutual Funds
 Hedge Funds

 Bank Trusts and Insurance Companies

 Relationship based
 Close ties with management and/or family
 Long term horizon
 Smaller market share
 Rise of pooled investments
 Insurance companies not subject to Federal regulation
 Heavily weighted to debt investments
 Not big players in the equity market
They are usually holders of debt securities of any company in which they have
an equity investment.

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  Pension Funds
 Longer-term horizon: retirement
 Defined benefit plan – investment risk on plan
 Public (state-sponsored, public employees)
 Leaders in governance and social issues
 Political pressure
 Some very big players – CalPers, NYC
 Private (unions and corporations)
 ERISA – shareholder value, BUT…
 Corporations: sympathetic to management
 Shareholder value and corporate objectives
 May differ if unrelated company
 Unions: shareholder power and employee rights
 At expense of shareholder value?

As equity markets have become more institutional, the types of institutions have also
evolved.
o Insurance companies and banks
 Both with “close ties to management” have given way to mutual funds, pension
plans and hedge funds as the largest institutional investors.

o Different institutional investors have different goals and approaches to corporate

governance, including holding periods, investment strategies, level of government
regulation to which they are subject, interest in the corporate governance of their
portfolio companies, political or social policy factors may influence their decision-
making or voting decisions

K.A.D. Camara, Classifying Institutional Investors

Public pension funds are pool of capital collected by the state and invested on behalf of
state employees. The structure of such funds provides more insulation from political
forces that favor things other than shareholder wealth maximization than does direct
state ownership.

Although public pension funds pursue non-shareholder-wealth-maximization agendas

less often that a state investing directly would, they are among the leaders in corporate-
governance activism.

Such activism includes: effective staggered boards, poison pills, and other devices
related to corporate control.

Public pension funds have often taken the lead in social-responsibility, such as
environmental protection.

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Private pension funds are those associated with private organizations, principally
unions and corporations.

 Union pension funds – pool capital from union members for investment
 Corporate pension funds – pool capital from employees.

Pooled capital is invested either directly or through mutual fund or other engaged
investment adviser.

Voting rights are exercised by the investment adviser, fund officials or management of
the sponsoring organization.

ERISA (Employment Retirement Income Security Act) – requires vote cast and voting
power to be used to benefit plan beneficiaries, rather than the sponsoring organization.

 For example, a corporate pension fund would violate ERISA if it knowingly vote
for an act designed to preserve managerial perquisites at the expense of
shareholder value.

The effect of ERISA is mainly in shaping managerial norms, such as the duty of care.

Union pension funds

 have been among the largest supporters of the recent proposals to increase
shareholder power.
 But they are not concerned only with maximizing shareholder value, but also
with employment contracts and working conditions.
 They tend to be favorably corporate acts such as larger employ benefits package
that decreases shareholder wealth but increases the wealth of employees (an
expropriation of capital for the benefit of labor).

Corporate pension funds:

 Are concerned not only with maximizing shareholder value, but also with things
corporate management is concerned.
 For example, they are expected to prefer managerial insulation form the market
for corporate control, large managerial compensation packages, costly
acquisitions over which managers will then enjoy control, and so forth.

New York City Comptroller Touts Progress in Latest Corporate Governance Push (on
Canvas)
Since 2014, Mr. Stringer has pushed for changes to the way corporate America
oversees itself, arguing that better corporate governance leads to better returns
for investors.
The New York City comptroller, Scott M. Stringer, started pushing company boards to
revamp their corporate governance nearly four years ago.
Mr. Stringer’s efforts are part of a larger movement among major investors to

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get companies to become better citizens. The most notable example to date is
BlackRock, the $6 trillion investment giant that has pushed the companies in
which it has invested to contribute to society or risk running afoul of a major
shareholder.

That mission has broadened:

 from: giving investors more power to nominate directors
 to: including greater disclosures about a board’s diversity

Mr. Stringer’s office oversees five New York City public pension funds
that together manage about $175 billion.

It is and effort to review corporate governance, focusing on mandatory disclosures

about directors’ ethnicity, gender and experience.

Since 2014, Mr. Stringer has pushed for changes to the way corporate America oversees
itself, arguing that better corporate governance leads to better returns for investors.

First part of the campaign focused on proxy access, that lets investors nominate board
candidates. When that campaign began, six companies offered proxy access; now, more
than 520 do.

This effort is part of a larger movement among major investors to get companies to
become better citizens.

Mr. Stringer: “This is about setting the best foundation for future generations and
enshrining the highest standards for our investments.”

Mr. Stringer’s office has held talks with more than 85 of the companies it has set its
sights on, to address improving transparency over the diversity of the boards.
■ Of those, 35 now disclose information on the qualifications of their boards, as well as
racial and gender diversity. They include companies like PepsiCo, Honeywell
International, Duke Energy and Jeffries.

■ Some 49 companies have chosen 59 new directors who are women or

minorities.

Mr. Stringer’s office even went so far as to file with six companies shareholder
proposals that call for mandatory disclosures about board diversity.

From that:

- after agreements with 5 of the companies, the office withdrew such proposals;
and

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 - the 6th company - Exxon Mobil, declined to offer diversity disclosures

Brown Chapter 7 446-447

MUTUAL FUNDS

Jennifer S. Taub, Able but not Willing: The Failure of Mutual Fund Advisers to Advocate for Shareholders’
Rights.

A mutual fund is a legal construct – a business trust or corporation that pools customer money to invest
in a portfolio of securities.

Most funds are invested in stocks, bonds, or money market instruments. Some own a mixture. A mutual
fund that holds corporate stocks is considered to be the shareholder of that corporation. The person (or
institution) who invests money in the mutual fund is considered to be the shareholder of the mutual
fund.

Typically, a mutual fund has no employees. It has a board of trustees or a board of directors. The mutual
fund board hires an investment adviser to manage the investments within the fund. This adviser is a
fiduciary and owes the fund a duty of “utmost good faith, and full and fair disclosure”. The adviser
provides not just advice to the fund, but also discretionary management services – adviser runs the
show.

The adviser is often a wholly owned subsidiary of a financial services firm. Some such adviser firms are
known as “fund families” or “fund complexes” given the numerous mutual funds that each adviser firm
launches and sustains. The adviser may be a private or a public corporation.

The adviser firm that launches the fund initially selects a slate of directors to be elected by the fund
shareholders and the “independent” board members who are unaffiliated with the Adviser firm
continue to nominate directors on a periodic basis.

The directors who are also employees of the firm are considered “interested”.

In addition, mutual funds must file annual report with the SEC. mutual funds must make available free-
of-charge to investors a description of their proxy voting policies and procedures. And, must inform
investors how they may obtain free of charge the policies and procedures and the annual proxy voting
records of the funds.

 Highly regulated
 ’33 Act
 ‘40 Act
 Independent directors
 Related party transactions: fund vs. advisor
Disclosure

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  Mutual Funds (cont.)
 Designed for liquidity – right to redeem
 Mark-to-market

Mutual funds are required to “mark to market” that is to value their portfolios and
price their securities daily, based on market quotations that are readily available at
market value and others at fair value, as determined in good faith by the board of
directors. Mutual funds are required by law to allow shareholders to redeem their
shares at any time. (there are no such rules for hedge fund pricing) Hedge fund
investors may be unable to determine the value of their investments at any given time.
 Driven by short-term economics
 Highly likely to favor a tender offer or other short-term financially
beneficial proposal
They bear little resemblance to other institutional investors because of one important
difference: they are designed for total liquidity. The investors are entitled to take their
money out at any time, at whatever price is that day. The investment manager has no
control over what he will have to pay out or when he will be forced to liquidate a
holding. He therefore views his investments as collateral; they are simply there to make
good on the promise to shareholders to redeem their shares at any time. They are
driven by short-term economics and if there is a tender offer at any premium over the
trading price, mutual fund investment managers have to grab it.

They are not aggressive activists and typically supportive of management sponsored
proposal. They hav been called “enablers of excess”because largest mutual fund
families are complicit in runaway executive compensation because they have not used
their voting power ot constrain pay by tying it closely to individual company
performance.

Federated, Fedelity, Vanguard, Barclays- mutual fund

 Fee structure; compensation structure
 Large portfolios
 Impact of Index Funds
 Dramatic growth of index funds
 Substantial ownership across economy
 Substantial influence
 Rarely engage in activism directly
 But will support activists in contests – RFAs
 Small activist can amass substantial leverage
 Will also support 14a-8 proposals
 Elimination takeover defenses, majority voting, proxy access
 Individual governance policies
 Public statements re governance issues

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  Hedge Funds
 No universal definition – “private funds”
Includes LBO, VC, PE, true hedge, etc.

Hedge funds is one of several categories of investments vehicles that holds a pool of securities, as well
as other assets that do not register its security offerings according to the Security Act and is not
registered as an Investment Company under the Investment Company’s Act.
Carl Icahn and Kirk Kirkorian- hedge funds

 Pooled investments, separate funds

 Lightly regulated (33 Act, 34 Act, Inv. Co. Act)
 Illiquid – investors locked in
 No limits on fees: “2 and 20”
 Varied strategies
 Higher risk strategies; large positions
 Active trading, shorter-term focus
 Often use leverage and short selling
Activism is an attractive investment strategy. Like a classic value approach, it relies on
the fundamental analysis showing that a company’s inherent value is greater than the
trading price of the stock. This adds another component; instead of waiting for the
market to recognize the value, the investors themselves pus for the changes to close the
gap.
 Paradox: investors committed to long-term; but shorter-term investment
strategy
 Hedge Fund Activism
 More open to economic activism – why?
 Investors looking for high returns
 Partly to compensate for high fees
 Rarely driven by social or shareholder rights
 Managers have strong incentive for profits
 “Skin in the game”
Unlike mutual funds, hedge funds typically hold concentrated blocks in a limited
number of companies (focused portfolio) rather than a broadly diversified portfolio
(investing in the market).
More pressure for individual investments to perform
Activist typically own a modest percentage of a target’s outstanding shares, often under 10% sometimes
under 5%. As a result, their success typically depends upon their ability to marshal support among other
institutional shareholders.

Minow- Pgs 220-221 (Canvas)

Hedge funds is one of several categories of investments vehicles that holds a pool of securities, as well
as other assets that do not register its security offerings according to the Security Act and is not
registered as an Investment Company under the Investment Company’s Act.

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Difference with funds that must be registered:
1.- Fees- hedge funds compensate their advisors on a percentage of the funds’ capital gains and capital
appreciation.

Hedge funds were originally designed to invest in equity securities and use leverage and short selling to
“hedge” the portfolio’s exposure to movements of the equity markets, but now include a variety of
investments and strategies. There are no limit to fees.
They use leveraging and higher-risk investment strategies, which increase the challenges. Leverage is
an investment strategy of using borrowed money — specifically, the use of various financial
instruments or borrowed capital — to increase the potential return of an
investment. Leverage can also refer to the amount of debt a firm uses to finance assets.

Mutual funds are required to “mar-to-market”; this is to value their portfolio and price their securities
daily, based on market quotations, and others at fair value, determined under good faith of directors.
Law requires mutual funds to allow shareholders to redeem their shares at any moment. Also, there is
no pricing legislation. Hedge funds may be unable to determine the value of their investment at a given
time.

Minimum investment in hedge funds- normal from 1 to 5 million dollars, are there is a higher risk.

Reasons for the rise of activists hedge funds-

1.- More appealing vehicles for the investments that they already do, collect money from the public and
collect hefty management fees;

2.- Recognition by traditional funds of activism as an attractive strategy, which considers the company’s
inherent value as greater than the trading price of the stock. Under this strategy, the investors push for
the company’s value to increase and don’t wait for the market to acknowledge it.

p. 568-570

 Activism increasing
 Number of campaigns, size of targets
 Historically smaller firms, but Pershing, Trian

Historically, hedge fund activism focused on smaller cap companies because it was too costly to
assemble a sizeable stake in a larger cap company, but this has changed. Few companies today seem
immune from the reach of hedge fund activism. Pershing Square Capital Management L.P joined with a
strategic bidder to make a $60B joint tender for Allergan, Inc., Trina fund Management proxy campaign
that narrowly failed at Dupont.
 But not all hedge funds are activists
 What Attracts Activism?
 Value investing – turnaround situation
 Value investing + activism = profit?

Activism is an attractive investment strategy. Like a classic value approach, it relies on

the fundamental analysis showing that a company’s inherent value is greater than the
trading price of the stock. This adds another component; instead of waiting for the

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market to recognize the value, the investors themselves pus for the changes to close the
gap.

 Excessive compensation
 Excess cash
 Entrenched Board: replace v. short slate
 Business strategy
 M&A or divestiture
 Replace CEO
 Governance – if it facilitates strategy

Traditional institutional investors-basically, pension funds and mutual funds- have long
been essentially “defensive” in their activism (e.g., seeking for example to resist a
management initiative), while hedge funds are “offensive” deliberately seeking out an
underperformed target in which to invest in order to pursue a proactive agenda and
change their target’s business model.

PROXY CONTESTS AND SHAREHOLDER ACTIVISIM

As hostile tender offers become less viable, the focus has shifted to proxy contests. Insurgents opposed
by management often respond through efforts to replace the board. Doing so requires the nomination
of a competing slate of directors and a campaign to capture the votes of unaffiliated shareholders. The
campaign plays out during the proxy solicitation process. The contest can however be expensive.
Insurgents must pay their own expenses while management may rely on the corporate treasury.

Concentrated ownership makes shareholder activism rational from a cost/benefit standpoint.

The types of activist campaigns run by hedge funds range from modest interventions in corporate
governance to more intrusive interventions seeking to sell the company, fire the CEO, or spin off
divisions. The more intrusive intervention, the greater the likely positive stock market response.

Historically, hedge fund activism focused on smaller cap companies because it was too costly to
assemble a sizeable stake in a larger cap company, but this has changed. Few companies today seem
immune from the reach of hedge fund activism. Only a specialized group of hedge unds engage in
activist campaign and proxy fights, but they have recently done very well. Equally important, the assets
managed by activist hedge funds have soared, growing over seven times.

Mutual funds are defensive in their activism, while hedge funds are offensive, deliberately seeking out
an underperforming target in which to invest in order to pursue a proactive agenda and change their
target’s business model.

Activism: Good or Bad

Short-Termism

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 Marty Lipton’s War on Hedge Fund Activists (on Canvas); - Vane
.

 Lipton vs. Bebchuk

 Lipton:
 Wachtell Lipton, experience-driven
 Father of the “poison pill”
 Defender of corporate America
 Supporter of “other constituencies”
 Believes short-term view bad for economy
 Bebchuk:
 HLS professor, empiricist
 Governance activist – staggered boards
 Prices increase after change of control
 Activism:
Good or Bad .
 Maximize value
 Needed efficiencies
 Shareholder focused
 Counter entrenchment
 Restrain exec comp
 Cooperative
 Vigorous debate
 Empowers shareholders
 Outside perspective
 Impressive results

Short-termism
Cost/investment-cutting
Ignore other stakeholders
Disregard managers
Retard incentives
Confrontational
Disruptive to Board
Not representative
Conspiratorial
Destructive results

Marty Lipton's War on Hedge Fund Activists

Michael D. Goldhaber, The American Lawyer
March 30, 2015

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Martin Lipton(corporate law guru who is most revered by managers ) formed Wachtell, Lipton,
Rosen & Katz 50 years ago. His lifelong goal has been to safeguard managers against hostile
takeovers and, increasingly, activist campaigns conducted in the name of shareholders.

 At 83, Lipton is a blue chip stock. He's one of two people to make every list of the 100
Most Influential Lawyers in America since it was launched by the National Law Journal
30 years ago.
 Wachtell Lipton remains The Am Law 100's runaway leader in profits per partner, as it
has been for 15 of the past 16 years.
 Lipton is most famous as the inventor of the "poison pill" defense to corporate
takeovers.
 Identified with the "staggered board," which deters takeovers by spreading the election
of a board's directors over several years.
 pioneer the concept corporate social responsibility. In his seminal 1979 work, "Takeover
Bids in the Target's Boardroom," Lipton argued that directors should protect the
interests of not only shareholders, but all who have a stake in the company: creditors,
community members and most notably employees.

Lucian Bebchuk (corporate law guru who is most feared by managers) a Harvard Law School
professor, champions the "activist" hedge funds that assail CEOs in an intensifying struggle for
control of America's boardrooms.

 His astonishing success has made him the only law professor listed among the 100 Most
Influential People in Finance by Treasury and Risk magazine.
 A lowly student clinic led by Bebchuk—the Shareholder's Rights Project—has
destaggered about 100 corporate boards on the Fortune 500 and the S&P 500 stock index
since 2011.
 As a critic of CEO compensation, Bebchuk paved the way for the Dodd-Frank Act rules
that give shareholders more "say on pay." Shareholder activism has drawn him into
debates with Lipton in 2002, 2003, 2007, and more or less continually since 2012.

Age of the activist investor

we live in the "age of the activist investor." Estimated assets under activist management in 2014
ranged from $120 billion to more than $200 billion. On the low end, that's up 269 percent since
2009, or 4,344 percent since 2001, according to the Alternative Investment Management
Association, a trade group.

Why are activist able to seize effective control of the board?

share ownership has consolidated among a handful of giant asset managers. activists harness
the voting power of the largest investors. Their secret is that giant stock funds outsource their
votes to proxy advisory firms, which routinely side with activists.

What is the request for activism?

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Ihe giant asset managers are rapidly losing market share to low-fee Exchange Traded Funds
(ETFs). (I don’t understand this too! I tried to google it and still cant figure it out) That makes
the institutional investors desperate to show high immediate returns. So instead of activists
going hat in hand to the institutions, the institutions now approach the activists with "requests
for activism." This practice is so common that there is even a name for them in the industry:
RFAs.

Bebchuk : shareholder activism helps companies in both the short and long term.

activists are making managers more focused on maximizing shareholder value than on self-
aggrandizement and lining their own pockets.

Lipton : that activism is awful for companies and the economy over the long run.

1. activists are billionaire hedgies who are out to make a quick buck, while driving great
companies and the economy into a ditch.
- activists typically hold a stock for only nine months before bailing out. In that
short time, they will aim at all costs to hack employment, R&D and capital
expenditures; overload the company with debt; return money to
shareholders through dividends and buybacks; and, as the ultimate goal,
goose the stock through M&A activity.

There's truth to both perspectives. Activist Insight confirms that 49 percent of last year's activist
campaigns made public demands related to M&A outcomes. The Icahn protégé Keith Meister
appears to have created real value for shareholders by throwing out the father-and-son
directors to whom the CEO had given exclusive power to manage the REIT's real estate, and
who were botching the job.

Case of activist failing to acquire Allergan

In the case of Allergan, the activist standard-bearer William Ackman made a failed $53 billion
run at the admired maker of Botox. Allergan typically devoted 17 percent of sales to R&D. It cut
that back to 13 percent during the takeover battle, and the white knight buyer cut it to 7 percent
of combined sales. Ackman's bidder historically held R&D at 3 percent.

"Ackman said this is the most accretive (accretive meaning: an acquisition is considered
accretive if it adds to the item’s value or corporation’s earnings per share) deal he'd ever seen,"
notes Wachtell's Neff, who advised Allergan. "Why? Because they would slash R&D. They took
out the best performer in its sector. Allergan didn't need fixing." For Neff, Allergan is a
cautionary tale of killing innovation. And while Botox isn't exactly a life-saving drug, it is
innovative.

Despite Allergan, the hedge fund account of shareholder activism prevails in the press and the
legal academy.

Search for a middle ground

Some are searching for a middle ground.

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The outspoken Chief Justice Leo Strine Jr. of the Delaware Supreme Court ["Tell Us What You
Really Feel, Leo," March 2012] relates a story that lies somewhere in between the two poles. In
Strine's telling, the little-guy investor needs to be protected from the self-dealing of both
company managers and activist money managers.

"The media and academia are captive to intellectual laziness," Strine says. "It's easier to write a
story about the bad, bad managers against the innocent shareholders, as if it's still 1935. It's
much harder to write about the current complexities of a system of monied interests (money
manager stockholders) versus other monied interests (corporate managers), and how the poor
incentives of that system often give the shaft (means to cheat someone or to deceive someone) to
ordinary Americans, both as investors who have to invest through money manager
intermediaries to save for retirement and college for their kids, and as workers who need
employment from corporations to feed their families."

At 88, Ira Millstein of Weil, Gotshal & Manges is perhaps the only corporate law guru to
outrank Strine and Lipton: "I know activist hedge funds that are in the business of promoting
long-term growth. I know other activists who are only interested in jerking the stock a little bit. I
think there are plenty of both."

Bebchuk study

Bebchuk conclusion in a study that tracked the performance of every activist-targeted company
over five years: When you get these activists involved, the stock price goes up and stays up,
and if anything, the operating metrics improve. Done. End of story."

Critics of Shareholder activism/Negative effects

Critics say data ambiguous and methodologically flawed. Both attribute any gains by
shareholders to a combination of fleeting takeover premiums and wealth transfers from
employees (as the result of layoffs or wage cuts) or bondholders (as the result of downgrades or
bankruptcies). In other words, Ackman and some shareholders are getting rich on the back of
workers and pensioners.

Fishing with Dynamite Analogy

Critics say Bebchuk is trying to prove his own theories. Bebchuk's study says nothing about the
fate of the many activist targets that disappeared from the sample. By Bebchuk's own numbers,
activist intervention increased the chance of corporate death over the study period from 42 to 49
percent.Its like a fisherman fishing with dynamite who will catch more fish than with the use a
fishing rod, but will end up poisoning the river.

There is a shortfall in investment because profits are funneled back to shareholders through buybacks or
dividends. Activism macroeconomically harmful. Destroys Jobs.

Blackrock's Larry Fink: It concerns us that, in the wake of the financial crisis, many companies
have shied away from investing in the future growth of their companies. Too many companies
have cut capital expenditure and increased debt to boost dividends and increase share

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buybacks." As Fink later put it more succinctly, activists "destroy jobs." Fink's opinion matters
more than most, because he speaks for $4 trillion in assets.

Former Treasury Secretary Lawrence Summers is persuaded that hedge fund activism is a
macroeconomic problem. Too much aggressive activism," sometimes at the expense of
employees. Lipton says:"They'll (activist) push to fire more people and cut more R&D and go
too far. They'll want two times too much. It's terribly macroeconomically harmful."

'How do we fix things?'

Lipton speaks of the lifetime contract between a company and its employees, and Neff says that
philosophy carries over to law firm management. Wachtell Lipton resisted pressure from some
partners during the financial crisis of 2008 and 2009, and refused to lay off a single summer
associate or staffer.

Some critics find it a bit rich when Lipton echoes liberal think tanks on distributional inequality.
They note that Lipton never met an executive pay plan he couldn't defend, including the $210
million that The Home Depot Inc. awarded in 2006 to CEO Robert Nardelli despite its flagging
share price. Lipton's consistent loyalties lie not with stakeholders, they suggest, but
management.

Critics say Lipton's loyalty to CEOs should disqualify his law firm from acting for directors
because Marty Lipton is not interested in protecting shareholders; he's interested in protecting
management.

Though his memos chronicle every shot fired across the activists' bow, Lipton knows he's still
losing. Lipton will never win his war until institutional shareholders vote against activists
more. He is the first to say so, and others agree. Chief Justice Strine of Delaware urges
institutional shareholders to tailor their voting policies to their investors' investment horizons—
and to recognize the unique long-term outlook of people relying on index funds for college or
retirement. (I don’t get this too!)
That change in mentality could be promoted through systemic reform. Summers says that
policy changes to give long-term shareholders more voting power or managers more tools to
fend off activists deserve serious consideration. But change could also be achieved through the
exercise of old-fashioned good judgment. "Companies and pension funds are getting smarter,"
says Millstein. "If the real investors think the activists are wrong, then they don't have to go
along."

Brown Ch. 8 (pp. 571-574)

 Activism:
Good or Bad .
 Maximize value
 Needed efficiencies
 Shareholder focused
 Counter entrenchment
 Restrain exec comp
 Cooperative

137
  Vigorous debate
 Empowers shareholders
 Outside perspective
 Impressive results

Short-termism
Cost/investment-cutting
Ignore other stakeholders
Disregard managers
Retard incentives
Confrontational
Disruptive to Board
Not representative
Conspiratorial
Destructive results
A Debate Long Term vs. Short Term Effect of Activist Shareholders
PAGES 571-572
Empirical study that tracks operating performance of activism targets after they are
acquired.
 Basis for such study: manufacturing business, as Census data continues to record
data of public manufacturing businesses even after they stop being public due to
an acquire or otherwise.
 Focus: what changes in operating performance after target stop being public

Plants belonging to targets that eventually drop from the Compustat database perform
better then those plants whose firms are still covered by Compustat.

The study documents that plants belonging to targets that eventually drop from
Compustat database perform better than those plants whose firms are still covered by
Compustat. The evidence provided by the study indicates that focusing on target firms
that remain public should not be expected to result in an overstatement – and indeed
might well generate an understatement – of the pos intervention performance targets.

Stock picking?
Critics of hedge fund activism might argue that improvement in long-term performance
experienced by targets reflects the activists´ “stock picking” ability rather that the
activists´ impact on the company´s operating performance. The storage of something in order
to have it available in the future if the need for it increases
It could merely reflect the activists’ to choose target whose operating performance is
expected to increase.

Nevertheless, the authors stress that interventions are followed by improvements on

operating performance. Therefore, there is no reason to limit the influence of activists
regardless of how much credit they should be getting for such improvements. Stock

138
pickers who successfully bet on future improvements might not deserve a medal, but
they do not warrant opposition and resistance.

There are at least three reasons to believe that the improvements are at least partly due
to activist interventions:

1) Activist engagements involve significant costs, so activists investors would have

strong incentives to avoid bearing them if they believed that the improvements
would come anyways. So, they really believe that their intervention contributes
to such improvements in operating performance;

2) Improvements come even from the measures taken by the company to resist the
activist´s intervention;

Studies show that improvements do not take place after outside blockholders pursuing
a passive strategy announce the purchase of a block of shares, but do occur when
blockholders switch from passive to activist stance.

Identified improvements in performance should be expected to be at least partly due to

the activist intervention. There is no truth that shareholder activism bad for corporation
in the long run.

571-572

A DEBATE: LONG TERM VS. SHORT TERM EFFECT OF ACTIVISTS SHAREHOLDERS.

The increased role of activist shareholders is clear. Some contend that activists have a short-term
horizon that is harmful to companies.

LUCIAN A. BEBCHUK, ALON BRAV & WEI JIANG, THE LONG-TERM EFFECTS OF HEDGE FUND ACTIVISM.

“Myopic-activists” claim that has been playing a central role in debates over shareholder activism and
the legal rules and policies shaping it. According to this claim, activists shareholder with short
investment horizons, especially activist hedge funds, push for actions that are profitable in the short
term but are detrimental to the long term interest of companies and their long-term shareholders.

As a result, activists with a short investment horizon have an incentive to seek actions that would
increase short-term prices at the expense of long-term performance, such as excessively reducing long-
term investments or the funds available for such investments.

1. A Clear Pattern: activists do not generally target well-performing companies.

2. Adverse effect on the post-acquisition performance of acquired firms?

As is the case with peer companies, a significant percentage of targeted firms are no longer
public by the end of the five-year period, having been acquired or otherwise delisted, and are

139
 this no longer part of the Compustat12 dataset of public company date. However, there is no
reason to expect that the operating performance of targets that are acquired will be more likely
to decline rather than improve post-acquisition.

To the extent that this is the case, it can be expected that the performance of assets of activism
targets that are acquired will tend to improve, rather than decline, after the targets are acquired
and stop having their operating performance reported on Compustat.

The study documents that plants belonging to targets that eventually drop from the Compustate
database perform better than those plants whose firms are still covered by Compustat.

BLACK ROCK CEO LETTER.

Larry Fink, the chief executive at BlackRock, the world's biggest investor with $4.6 trillion, just sent a
letter to chief executives at S&P 500 companies and large European corporations.

The letter focuses on short-termism both in corporate America and Europe, but also in politics, and asks
CEOs to better articulate their plans for the future.

Over the past several years, I have written to the CEOs of leading companies urging resistance to the
powerful forces of short-termism afflicting corporate behavior. Reducing these pressures and working
instead to invest in long-term growth remains an issue of paramount importance for BlackRock’s clients,
most of whom are saving for retirement and other long-term goals, as well as for the entire global
economy.

While we’ve heard strong support from corporate leaders for taking such a long-term view, many
companies continue to engage in practices that may undermine their ability to invest for the future. We
certainly support returning excess cash to shareholders, but not at the expense of value-creating
investment.
We also believe that companies have an obligation to be open and transparent about their growth plans
so that shareholders can evaluate them and companies’ progress in executing on those plans.

We are asking that every CEO lay out for shareholders each year a strategic framework for long- term
value creation. Additionally, because boards have a critical role to play in strategic planning, we believe
CEOs should explicitly affirm that their boards have reviewed those plans. BlackRock’s corporate
governance team, in their engagement with companies, will be looking
for this framework and board review.

Annual shareholder letters and other communications to shareholders are too often backwards-
looking and don’t do enough to articulate management’s vision and plans for the future. This
perspective on the future, however, is what investors and all stakeholders truly need. As part of this

12
Compustat is a database of financial, statistical and market information on active and inactive global companies
throughout the world. The service began in 1962.

140
effort, companies should work to develop financial metrics, suitable for each company and industry, that
support a framework for long-term growth. Components of long-term compensation should be linked to
these metrics.

But one reason for investors’ short-term horizons is that companies have not sufficiently educated them
about the ecosystems they are operating in, what their competitive threats are and how technology and
other innovations are impacting their businesses.

Without clearly articulated plans, companies risk losing the faith of long-term investors. Companies
also expose themselves to the pressures of investors focused on maximizing near-term profit at the
expense of long-term value. Indeed, some short-term investors (and analysts) offer more compelling
visions for companies than the companies themselves, allowing these perspectives to fill the void and
build support for potentially destabilizing actions.

Those activists who focus on long-term value creation sometimes do offer better strategies than
management. In those cases, BlackRock’s corporate governance team will support activist plans.

Nonetheless, we believe that companies are usually better served when ideas for value creation are
part of an overall framework developed and driven by the company, rather than forced upon them in a
proxy fight.

To be clear, we do believe companies should still report quarterly results – “long-termism” should not
be a substitute for transparency – but CEOs should be more focused in these reports on demonstrating
progress against their strategic plans than a one-penny deviation from their EPS targets or analyst
consensus estimates.

We also are proposing that companies explicitly affirm to shareholders that their boards have
reviewed their strategic plans. Boards have an obligation to review, understand, discuss and challenge a
company’s strategy.

Generating sustainable returns over time requires a sharper focus not only on governance, but also on
environmental and social factors facing companies today. These issues offer both risks and
opportunities, but for too long, companies have not considered them core to their business – even when
the world’s political leaders are increasingly focused on them, as demonstrated by the Paris Climate
Accord.

At companies where ESG issues are handled well, they are often a signal of operational excellence.
BlackRock has been undertaking a multi-year effort to integrate ESG considerations into our investment
processes, and we expect companies to have strategies to manage these issues. We recognize that the
culture of short-term results is not something that can be solved by CEOs and their boards alone.

Public officials must adopt policies that will support long-term value creation. Companies, for their part,
must recognize that while advocating for more infrastructure or comprehensive tax reform may not
bear fruit in the next quarter or two, the absence of effective long-term policies in these areas

141
undermines the economic ecosystem in which companies function – and with it, their chances for long-
term growth.

We note two areas, in particular, where policymakers taking a longer-term perspective could help
support the growth of companies and the entire economy:

• First, tax policy too often lacks proper incentives for long-term behavior. With capital gains, for
example, one year shouldn’t qualify as a long-term holding period. As I wrote last year, we need a
capital gains regime that rewards long-term investment – with long-term treatment only after three
years, and a decreasing tax rate for each year of ownership beyond that (potentially dropping to zero
after 10 years).

• Second, chronic underinvestment in infrastructure in the U.S. – from roads to sewers to the power
grid – will not only cost businesses and consumers $1.8 trillion over the next five years, but clearly
represents a threat to the ability of companies to grow. Companies and investors must advocate for
action to fill the gaping chasm between our massive infrastructure needs and squeezed government
funding, including strategies for developing private-sector financing mechanisms.

Over the past few years, we’ve seen more and more discussion around how to foster a long-term
mindset. While these discussions are encouraging, we will only achieve our goal by changing practices
and policies, and CEOs of America’s leading companies have a vital role to play in that debate.

Corporate leaders have historically been a source of optimism about the future of our economy. At a
time when there is so much anxiety and uncertainty in the capital markets, in our political discourse and
across our society more broadly, it is critical that investors in particular hear a forward-looking vision
about your own company’s prospects and the public policy you need to achieve consistent, sustainable
growth. The solutions to these challenges are in our hands, and I ask that you join me in helping to
answer them.

Sincerely,
Laurence D. Fink

PART 10
 Activist Tactics - Evolution

Activism requires control or influence over Ownership or the Board

 How do you achieve goals?
 What are the tools?
In business, a corporate raid is the process of buying a large stake in a corporation and then using
shareholder voting rights to require the company to undertake novel measures designed to increase
the share value, generally in opposition to the desires and practices of the corporation's current
management. The measures might include replacing top executives, downsizing operations,
or liquidating the company.

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Corporate raids were particularly common in the 1970s, 1980s, and 1990s in the United States. By
the end of the 1980s, management of many large publicly tradedcorporations had adopted legal
countermeasures designed to thwart potential hostile takeovers and corporate raids,
including poison pills, golden parachutes, and increases in debt levels on the company's balance
sheet.
In later years, some corporate raiding practices have been used by "activist shareholders", who
purchase equity stakes in a corporation to influence its board of directors and put public pressure on
its management.


 Control or Influence
 Total hostility  constructive engagement
Unwanted approach and company would slam the door, this has changed.
 Early “takeover” period – hostile!
 Total ownership – takeover, which may be achieved by a couple of ways, i.e.,
hostile takeover, preemptive bid- so attractive that it forecloses any other bidder
to come by.
 Total Board control
 Recent years
 Short slates- influence to present his or her ideas but does not impose them in an
absolute basis. In board of 10, activist will get 2 or 3. Recent example proxy
contest in P&G; very robust proxy contest and Nelson Peltz of Trian Partners was
trying to just get one seat of 10. Peltz wanted to get on the board to able to
persuade them in a position. He won.
 Influence through engagement
 Increased willingness to engage
 Activist Tactics - Examples
 Total ownership:
 Pershing Square/Allergan
Pershing Square (hedge Fund) and Valeant attempt to acquire Allergan. There
was proxy contest to take over Allergen, tender offer and proxy context but they
lost as Allergan found a white knight.

Valeant and its deal partner Ackman made multiple bids for
Allergan, even pressing a tender offer at one point. However,
Allergan's CEO at the time, David Pyott, was not interested in a
deal with Valeant, which he characterized as a house of cards
fueled by drug price increases and shoddy accounting. He found a
white knight in a foreign drugmaker called Actavis, agreeing to sell
the company in late 2014 for a price that generated a multibillion
profit for Ackman's hedge fund Pershing Square
 Total Board control:
 Icahn/ Yahoo (2008) – no staggered Board
Done by proxy contest, Icahn had an interest and in order to use that tactic and he
needed to persuade 40-50% of the shareholders. They were trying to replace the
entire board and then they compromised.

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The billionaire investor had just under 12 million shares of Yahoo at
the end of 2009, according to the new filing with the Securities and
Exchange Commission. That compares with more 60 million shares he
held last summer.

Two years ago when Microsoft was attempting an acquisition of

Yahoo, Icahn amassed a huge stake in the Internet pioneer. When
Yahoo turned down Microsoft's offer, Icahn started a proxy fight and
sought to oust Yahoo's board in order to influence the deal. In the end,
he reached a settlement that placed him and two others of his
choosing on the board.

In October, the activist investor stepped down from Yahoo's board, in

part citing his belief that CEO Carol Bartz had been "doing a great job"
and noting that Yahoo had signed a search deal with Microsof
 Short slate:
 Trian/P&G
Peltz, an activist investor, took on P&G over the summer, seeking a board seat after
the company rejected his request to be added to the board.
Hedge-fund billionaire Nelson Peltz has won a proxy vote recount for a board seat
at Procter & Gamble.

“Short slate” proxy contests (i.e., contests where a dissident is soliciting proxies in support of nominees
that, if elected, would constitute a minority of the board of directors) are expected to continue to be
popular during the 2013 proxy season (see, for example, the International Game Technology proxy
contest). There are several strategic and practical reasons why a dissident would choose to run a short
slate rather than a control slate, including, among others, the perception among stockholders that
adding a limited number of a dissident’s nominees is often of some benefit to the company and usually
not particularly disruptive, a comparatively greater willingness of proxy advisory firms to support a
dissident’s short slate rather than a control slate, and the fact that dissidents may want to achieve some
influence through a successful campaign but may not want to run the company
 Investment:
Active management (hedging) – Pershing Square (hedge Fund) conducted a 4-5 year
battle against Herbalife, a nutritional supplement company. They were trying to get out
of business, because Bill Ackman of Pershing Square, he did a short sale the stock, he
sold them in advance at a low price. Ackman lost several billion of dollars. He was
using an external approach, he lobbied with FTC, to drive the price down. He lost. is
other major investment, nutrition company Herbalife, was a completely opposite case
but resulted in similar damages.

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From 2012 to 2017, Ackman held a $1 billion short position against the company,
believing that it was a Ponzi scheme with no real product. In the years following
2012, Ackman was accused of orchestrating tactics to undermine Herbalife’s stock
price. Herbalife was sued over Ponzi scheme allegations and went under
an investigation by the Federal Trade Commission (FTC).

The FTC settled the Herbalife case with a $200 million fine on the company in 2016,
but dismissed the Ponzi scheme accusation. An investor lawsuit in California with the
same allegation was also dismissed in 2015

 Passive investment - Warren Buffett

 Engagement - Focus Funds; trying to persuade the company directly, from
management to Board, to get the ideas to get the company higher.

Shark repellant.net

 Control Through Ownership

Control of ownership permits control of Board they can do this by acquiring majority of
shares so they can elect the majority of the board. The advantage is that full ownership
avoids fiduciary duty to minority. Board control permits back-end merger, i.e., a type of
merger that is used to remove minority shareholders of a target or force them to sell
their shares.
How to acquire control through ownership? Activist can purchase from existing
shareholders or directly or through the market. They can make a Tender offer or do
merger or straight M&A (can be hostile or friendly)

The Williams Act is Response to abusive tender offers which characterized Saturday
night Saturday night specials”, those offers made for a short period of time (over the weekend)
on a first-come first-served basis, effectively forcing investors to make rushed and uninformed
decisions.
The early tender offers were largely unregulated affairs, and bidder conduct was often
egregious. The “Saturday Night Special” was a favorite. Disclosure by bidders in these offers
was also cramped: target stockholders oftentimes did not know the bidder´s future intentions
for the corporation, the source or availability of the bidder´s capital, or even the bidder´s true
identity. Stockholders and targets were helpless. Takeover defenses at that time were in their
infancy and virtually non-existent.

In light of the state´s failure to respond, the SEC became the principal governmental actor in
the drive to regulate cash tender offers.
In 1968, the Williams Act amended the Securities Exchange Act of 1934, as amended (the “Exchange
Act”), enacting new provisions and rules related to tender offers.  Specifically, Section 13(d) of the

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Exchange Act (“Section 13(d)”) was “passed . . . in response to the growing use of cash tender offers as a
means for achieving corporate takeovers.”    Prior to the Williams Act, corporate raids through the use of
exchange offers and proxy solicitations were regulated by Section 14(a) of the Exchange Act, as well as
additional rules adopted by the Securities and Exchange Commission (the “SEC”). 

 The Williams Act, and specifically Section 13(d), was enacted to overcome the gap in the securities laws
and require disclosure when holders began “accumulating large blocks of equity securities of publicly
held companies.” 

  Under Section 13(d), persons who, within a short period of time, have acquired large interests of equity
securities, or increased the number of equity securities by a substantial amount, must disclose pertinent
information related to their holdings in a particular company.      Consistent with the general purpose of
the U.S. securities laws, Section 13(d) provides individual investors with greater transparency through
informational disclosure.    In many respects, Section 13(d) acts as an early warning, signaling “every
large, rapid aggregation or accumulation of securities, regardless of technique employed, which might
represent a potential shift in corporate control.”1
 §13(d) – early warning
 §14(d)(1) – tender offer disclosure
 §14(d)(4)-(7) – tender offer process
 §14(e) – anti-fraud

. Section 13(d) and Creeping Tender Offers

Tender offers, although not defined in the Williams Act, traditionally involve an offer to all
shareholders at substantially above the market price.

However, there are other ways to acquire controlling interest in a company. Shares can be
purchased gradually in the open market, an approach sometimes referred to as creeping tender
offer.

The Williams Act substantively and procedurally regulated tender offer with the aim of
responding to the abuses.

New section 14D – attempted to curb coercive practices in tender offers by spelling out
substantive governing rules. More specifically:

Section 14(d)(1) of the Securities Exchange Act of 1934 requires

compliance with certain disclosure and filing requirement in connection
with any tender offer for more than five percent of a class of equity
security registered pursuant to Section 12 of the Securities Exchange Act
of 1934, as well as certain securities of insurance and investment
companies. The principal filing, dissemination and disclosure
requirements with respect to third party tender offers are set forth in
Regulation 14D under the Securities Exchange Act of 1934.

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 Disclosure Section 14(d) (4)– obliged bidders to file on Schedule 14D [now Schedule TO]
publish and circulate a disclosure document in connection with a tender offer
to security holders of the class of securities that is the subject of the offer

section 14(d)(5) required a bidder to provide withdraw rights during the first 7 days of
the offer and thereafter past the sixtieth day, effectively establishing a 7-day minimum
offer period.

 New section 14(d)(6) required a bidder to accept shares tendered during the first 10
days of a partial offer on a pro rata basis; and

 New section 14(d)(7) required a bidder to offer and pay the same consideration to all
tendering stockholders.

 New section 14(e) prohibited misrepresentations, misleading omissions and

“fraudulent, deceptive, or manipulative acts or practices” in connection with a
tender offer.

B. Section 13(d) and Creeping Tender Offers

Tender offers, although not defined in the Williams Act, traditionally involve an offer to all
shareholders at substantially above the market price.

However, there are other ways to acquire controlling interest in a company. Shares can be
purchased gradually in the open market, an approach sometimes referred to as creeping tender
offer.

Telvest Inc. v. Bradshaw

 defining “creeping tender offer”:
- “an acquisition strategy where, by achieving a substantial position in a
company through open market purchases, an acquiring company can
achieve a blocking position which enables them to purchase the remaining
shares by tender or exchange offer at a cost that would be substantially less
than if a formal tender offer had been made earlier”.

Purchases other than tender offers are regulated by Section 13(d), 15 U.S.C. §78m(d):

 Owners with more than 5% of the outstanding voting shares must publicly report their
ownership interest on a Schedule 13D within 10 days.

 Material changes in ownership must be disclosed promptly:

- “Material” = any ownership change of 1% or more.

- The threshold applies to shares owned directly or indirectly and as part of a
“group”.

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 - Shareholders must state the purpose of the acquisition, something ordinarily
reduced to investment or control.

The requirement puts other investors on notice of a possible acquisition attempt, something that
may influence investment decisions

§13(d) Early Warning Reports

Tender offers, although not defined in the Williams Act, traditionally involve an offer to all
shareholders at substantially above the market price.

However, there are other ways to acquire controlling interest in a company. Shares can be
purchased gradually in the open market, an approach sometimes referred to as creeping tender
offer. It is not a “tender offer” and can be done anonymously on exchange. However,
13(d) early warning report shall be required.

Under Section 13(d), any person who indirectly or directly becomes the beneficial owner of more than
5% of an issuer’s equity securities registered under Section 12 of the Exchange Act or any equity security
of an insurance company that is exempt from registration under Section 12(g)(2)(g) of the Exchange Act,
must file with the SEC a Schedule 13D within 10 days after the acquisition

Beneficial ownership has nothing to do with economic interest.

“…a ben
Under Rule 13d-3(a), a beneficial owner of a security incudes any person who, directly
or indirectly, through any contract, arrangement, understanding, relationship, or
otherwise has or shares:
(1) voting power, which includes the power to vote, or to direct the voting of,
such security; and/or
(2) investment power, which includes the power to dispose, or to direct the
disposition of, such security
“SEC intended Rule 13d-3(a) to provide a ‘broad definition’…to ensure disclosure ‘from all
those persons who have the ability to change or influence control” – CSX v. Children’s
Fund

 Group formed when “two or more persons agree to act” – Rule 13d-5(b)(1)
 (b)
 (1) When two or more persons agree to act together for the purpose
of acquiring, holding, voting or disposing of equity securities of an issuer,
the group formed thereby shall be deemed to have acquired beneficial
ownership, for purposes of sections 13(d) and (g) of the Act, as of the date
of such agreement, of all equity securities of that issuer beneficially owned
by any such persons.
In Wellman v. Dickinson, Written agreement not required

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  Conscious parallelism
 CSX v. Childrens’ Investment Fund – circumstances can indicate a group, but
some documented arrangement required

Schedule 13D Content

(A) background, identity, residence and citizenship of beneficial owners;
(B) source and the amount of funds used in making purchases;
(C) if the purpose of purchase or prospective purchases is to acquire control, then must
disclose any plans or proposals which purchaser may have to liquidate, sell the assets
of, or merge the issuer;
(D) number of shares which are beneficially owned (directly or indirectly)
(E) information about any contracts, arrangements or understandings with respect to
any securities of the issuer
 Item 4. Purpose of Transaction
Valeant – Strategic Buyer
-Current intent to propose merger
-No obligation to do so
Pershing Square- Hedge Fund
-Believe stock is undervalued

 Item 6. …Arrangements
Formation of joint entity
Contribution of funds
Governance of joint entity
Termination of arrangement
Standstill for Pershing Square
 Amendment of Schedule 13D
 Rule 13d-3
 Promptly amend if material change
 Purchase or sale of additional 1% -per se material change.
 Qualitative matters may also be material
 Change in plans- purpose for investment, bought it for passive investment and then three months plans to take over.
 Arrangements with others – “wolf pack”

Material changes in ownership must be disclosed promptly. I is “Material”if there is any

ownership change of 1% or more .The threshold applies to shares owned directly or indirectly
and as part of a “group”. Shareholders must state the purpose of the acquisition, something
ordinarily reduced to investment or control.

The requirement puts other investors on notice of a possible acquisition attempt, something that
may influence investment decisions

Schedule 13G

Section 13(g) of the Exchange Act (“Section 13(g)”), requiring certain beneficial holders to file a Schedule
13G with the SEC, was added to the Exchange Act as part of the Domestic and Foreign Investment
Improved Disclosure Act of 1977.2      Section 13(g) aims to mandate disclosure when certain investors
accumulate large amounts of stock in a public company.    Section 13(g) requires “any person owning

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beneficially more than 5 percent of any class of a Section 13(d) security who is not currently required to
report under Section 13(d) . . . to file with the [SEC] a short statement detailing relevant ownership
information and to transmit such . . . statement to the issuer”
Institutional investors acquiring securities in the ordinary course of business (mutual
fund category) and not with purpose of changing or influencing control of the issuer
Qualified Institutional Investors only report their greater than 5% positions held as of the close of the
calendar year either in an initial report or in an amendment in the case of any change in the information
provided. However, if prior to the end of the calendar year the Qualified Institutional Investor owns
more than 10% as of the close of any month, a Schedule 13G must be filed or amended within 10
calendar days reporting the holdings as of the close of the month. After crossing the 10% threshold,
Qualified Institutional Investors must file an amendment to their Schedule 13G within 10 calendar days
following the close of the month to report any ownership change of 5% or more as of the close of the
month.
…
 File 45 days after the end of fiscal year
 Increase over 10% must be filed within 10 days

The term “Passive Investor” means shareholders beneficially owning more than 5% of the class of
registered securities and who can certify that the securities were not acquired or held for purpose of
and do not have the effect of changing or influencing the control of the issuer of such securities and
were not acquired in connection with or as a participant in any transaction having such purpose or
effect.
Persons not seeking to acquire or influence “control” of the issuer and who own less than 20% of the
class of securities are “Passive Investors”. Effective February 17, 1998 the Securities and Exchange
Commission (the “SEC”) added the Passive Investor as a category eligible to file on Schedule 13G. Before
that time, a Passive Investor had to use the long-form Schedule 13D to report accumulations and
changes in stock holdings.
 Passive investors with less than 20%
 File within 10 days
 More limited disclosure

Must file 13D if no longer passive investor or if exceed 20%

 No voting until 10 days after filing 13D
 Proxy Contests
 Alternative to control via ownership (alternative to tender offer, merger and
acquisition or other means to control via ownership)

 Proxy Contests

Proxy contest:
The prevalence of defensive tactics has made hostile tender offer difficult to effectuate. As a
result, acquirers must typically resort to a proxy contest.

 These require the nomination of a compelling slate of directors in an effort to obtain

control of the board.

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 Once elected, the insurgent board will often look more favorably on the acquirers´
efforts to purchase the business.
Proxy contexts are regulated under the federal securities laws - Section 14(a) 15 U.S.C. §78n(a).

 Insurgents must draft and distribute proxy statements to the shareholders they solicit.
 Expenses can be substantial and run into millions of dollars
 Insurgents must pay these amounts from their own pocket while management of the
target company can use the corporate treasury to support its candidates

Boards can adopt a number of tactics and devices to discourage proxy contests, which may
include staggered boards, which:
 break the board into three classes with one elected each year
 insurgents seeking to gain control must wait for at least two consecutive elections.

Poison pills also can affect proxy contests. They are triggered not only by acquisitions but also
by agreements among shareholders. A poison pill with a low trigger can, therefore, interfere
with the ability of insurgents or sharing of expenses associated with the contest.

Given the costs, proxy s are relatively rare, although they are increasing in frequency.
Moreover, hedge funds and other activist shareholders may use the threat of a proxy contest to
induce companies to include their representatives in the slate proposed by management. These
sorts of interactions have been on the increase.

 Alternative to control via ownership – much more common, less hostile, more cooperative, often settled.
 Influence w/o significant ownership
 Need to convince other s/hs to support you
 Increasingly common: 36% success-2004; 77% success in 2014
Proxy rules to contested proxy but also friendly merger.
 Examples:
 Full slate
 Short slate
 Takeover if pill prevents acquisition of X%
 Staggered board
 Also applies to straight M&A merger vote
 Typical Scenario
 Identify target and strategy – activist will look for a good target; undervalued.
 Acquire initial position- acquire a toehold and if its over 5%, file a 13d.
 Discuss operational changes- unless the target completely does not want to engage, it will propose board representation.
 Propose Board representation- can be private or if to put more pressure to the company, they will release publicly.
 Privately or publicly
 Identify candidates – Activist will identity the candidates and candidates can propose very respectable and independent directors in order to give more
credibility to their views.
 Settlement often negotiated at this stage
 Formal nomination
 Solicit proxies- Proxy battle starts, Each side will go out and try to solicit proxies and get them to vote their slate.
 Communications are key – highly regulated

Activists also look for companies with missed guidance or corporate governance issues. A
CEO crisis or a CEO-board conflict can also signal weakness to activists.
Certain characteristics put a company at risk of an activist attack by individual funds or “wolf
packs” of hedge funds that band together to increase their influence. Activists also look for
companies with missed guidance or corporate governance issues and challengeable accounting
practices. Companies in these situations need strategic plans to protect themselves.

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Once activists home in on their targets, they push for the actions they expect will boost the
value of the stock. They accumulate stock to build their influence often in combination with
over-the-counter options that stay under the radar because they are not traded in the open
market.
The best defense is the good offense, and whether or not an activist attack is imminent, all
companies need preemptive strategies for protection. Monitoring trading volumes and
changes to your shareholder base are the first steps in identifying potential activist. Due
diligence to research a real or potential threat and learning about the activist’s track record with
other companies are also basic preparation.
Once a firm is targeted, communications take on a whole new level of importance. The
slightest error, spoken or written, can and will be used to full negative effect. There are no
shortcuts to developing a communication strategy. Regular team meetings will be needed to
gauge progress and address unexpected events.
Activists will reach out to solicit information from directors and establish lines of
communication with dissatisfied investors. They use every channel of communication
available, far beyond the reach of traditional letters, phone calls and meetings.
In addition to its proxy statement and fight letters, activists and targets typically try to sway
shareholder sentiment and win votes by issuing press releases, conducting media interviews
and making presentations to investors. Target companies will ask shareholders to speak out in
favor of their campaign and meet with proxy advisor and large shareholder. The company
should have a general communication plan for proxy fights even before a specific fight begins.
A proxy contest cannot be won if shareholders already feel that management or the board has
a record of being unresponsive. Well-informed shareholders who find management
accessible and open are more likely to support the company in bad times as well as good.

Activist will reach out to other shareholders for support, and begin to recruit director
candidates to serve on their board slate.
Shareholders who cross the five percent ownership threshold are required to file a Schedule
13D and discuss their current intentions with respect to the
company. As the contest progresses, they are required to
amend the 13D filing, providing a play-by-play of their
activities.
Activists will privately or publicly advocate for change at the
company through letters to the board of directors, requests for
meetings with management, distribution of press releases and
interviews with the media. Activists will also reach out to
other shareholders to gain and gauge support, helped by the
wide range of communications channels making interaction
easier than ever.
Next, they begin recruiting director candidates to serve on
their board slate for the target company. The focus today is
more on independent director candidates than employees or
shareholder representatives. Once a proxy solicitation begins,

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almost all investor relations and employee communications will be viewed as solicitation
activities and require appropriate filings with the SEC.
The timeline for typical proxy fight is 45 days, with the steps diligently executed through
guidance from legal counsel and investor advisors. (see box)

 Proxy Regulation
 Solicitation of proxies requires a proxy statement to be furnished
 Rule 14a-3(a)
 Disclose, file (14a-6), do not mislead (14a-9)
 “Solicitation”: any communication calculated to result in procurement, withholding or revocation of a proxy
 Rule 14a-1(l)(1)
 Rule 14a-9: general anti-fraud
PROXY RULES SUMMARY

Key Legal Considerations

The solicitation of proxies is governed by Section 14 of the Securities Exchange Act of 1934, as
amended and Regulations 14A under the Exchange Act.

Solicitation Rules

Rule 14a-1(l)1 The terms “solicit” and “solicitation” include the following:
“Solicitation”: any communication calculated to result in procurement, withholding or
revocation of a proxy
(i) Any request for a proxy whether or not accompanied by or included in a form of
proxy;
(ii) Any request to execute or not to execute, or to revoke, a proxy; or
(iii) The furnishings of a form of proxy or other communication to security holders under
circumstances reasonably calculated to result in the procurement, withholding or
revocation of a proxy.

Includes communications that form part of a continuous plan that culminates in a formal
solicitation and have the purpose or effect of influencing investors will be viewed as proxy
solicitation.

Solicitation does not include “communication by a security holder who does not otherwise
engage in a solicitation. . . stating how the security holder intends to vote and the reasons
therefor.” (Rule 14a-1(l)iv)

The term “written communication” – interpreted broadly to include all communications that are
disseminated to the general public in any form other than orally, includes press releases,
postcards.

Once a solicitation begins, the company should assume that essentially all public or investor
relations and employee communications could be viewed as solicitation activities and make the
appropriate filings.
 Proxy Regulation
 Solicitation of proxies requires a proxy statement to be furnished
 Rule 14a-3(a)
 Disclose, file (14a-6), do not mislead (14a-9)
 “Solicitation”: any communication calculated to result in procurement, withholding or revocation of a proxy (very broadly articulated as trying to encourage
them to vote your way)

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  Rule 14a-1(l)(1)
 Rule 14a-9: general anti-fraud- in your proxy statement and other communications, you have to tell the truth.
Only last proxy counts; proxy statement- big formal statement.

240.14a-3 Solicitation of proxies requires a proxy statement to be furnished

Information to be furnished to security holders. (a) No solicitation subject to this regulation
shall be made unless each person solicited is concurrently furnished or has previously been
furnished with: (1) A publicly-filed preliminary or definitive proxy statement containing the
information specified in Schedule 14A; (2) A preliminary or definitive written proxy
statement included in a registration statement filed; x x

The Proxy Statement and Proxy Card. Rule 14a-6 — Filing requirements.
In a proxy contest, each side must file its proxy statement and form of proxy in preliminary
form with the SEC at least ten calendar days before distributing proxy statement and form of
proxy to investors (Rule 14a-6 (a))

The proxy statement must contain the information specified in Schedule 14a.
Rule 14a-4 specifies requirements for the form of the proxy card.

Rule 14a-9 — False or misleading statements.

Rule promulgated by the Securities and Exchange Commission that forbids proxy statements
that are false or misleading, even by omission, as to any material fact.

The Supreme Court has held that a private right of action exists to remedy violations of Rule
14a-9. A showing of scienter is required.

Standard for materiality under 14a-9: TSC Industries v. Northway

An omitted fact is material if there is a substantial likelihood that a reasonable stockholder
would have considered it important in deciding how to vote.
 Exceptions Permitting Expressing Opinions –
Even If Clause (iii) “Solicitation”
 Not seeking to act as proxy holder – 14a-2(b)(1)
That allows other shareholders, not the company, not the activist, to communicate with other shareholders.
 Not available to mgt., parties w/ interest in contest
 14a-6(g) filing of written materials if over $5mm – make it public.
 Not more than 10 shareholders – 14a-2(b)(2)
- This is available to an activist but not to management.
 Can form a group
 Not available to management
 Bona fide media forums – 14a-3(f)
 Press releases, speeches, advertisements
 Proxy statement on file, no requirement to “furnish”, no form of proxy included
 Internet forums: - 14a-2(b)(6) and 14a-17
Not relevant to activism. When you are involved in the proxy campaign you can get involved in internet forms.
 At least 60 days prior to Annual Meeting

Exceptions Permitting Expressing Opinions – Even If Clause (iii) “Solicitation”

Not seeking to act as proxy holder – 14a-2(b)(1)
Solicitations by Persons not Seeking Proxy authority.
Any solicitation by or on behalf of a person who does not seek power to act as a proxy
and does not furnish or request a proxy is exempt from proxy rules (Rule 14a-2(b))
Categories of persons who cannot rely on this exemption include: Not available to mgt.,
parties w/ interest in contest
 The issuer, its affiliates and their respective officers and directors
 Any nominee for election.
 Any person being compensated by a person unable to rely on the exemption

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  Any person with a substantial interest in the subject matter of the solicitation not shared
pro rate with other holders.
14a-6(g) filing of written materials if over $5mm
Solicitations subject to  § 240.14a-2(b)(1).
(1) Any person who:
(i) Engages in a solicitation  and (ii) At the commencement of that solicitation owns
beneficially securities of the class which is the subject of the solicitation with a market
value of over $5 million,
shall furnish or mail to the Commission, not later than three days after the date the written
solicitation is first sent or given to any security holder, five copies of a statement containing the
information specified in the Notice of Exempt Solicitation ( § 240.14a-103) which statement shall
attach as an exhibit all written soliciting materials.

Exception: Not more than 10 shareholders – 14a-2(b)(2)

 Can form a group
 Not available to management
Rule of Ten
Any solicitation other than on behalf of the company where the total number of persons
solicited is not more than ten is exempt from the proxy rules (other than the anti-fraud
requirements).
 Bona fide media forums – 14a-3(f)
 Press releases, speeches, advertisements
 Proxy statement on file, no requirement to “furnish”, no form of proxy included
 Internet forums: - 14a-2(b)(6) and 14a-17
 At least 60 days prior to Annual Meeting

§ 240.14a-17 Electronic shareholder forums.

(a) A shareholder, registrant, or third party acting on behalf of a shareholder or registrant may
establish, maintain, or operate an electronic shareholder forum to facilitate interaction among
the registrant's shareholders and between the registrant and its shareholders as the shareholder
or registrant deems appropriate. Subject to paragraphs (b) and (c) of this section, the forum
must comply with the federal securities laws, including Section 14(a) of the Act and
its associated regulations, other applicable federal laws, applicable state laws, and
the registrant's governing documents.
(b) No shareholder, registrant, or third party acting on behalf of a shareholder or registrant, by
reason of establishing, maintaining, or operating an electronic shareholder forum, will be liable
under the federal securities laws for any statement or information provided by another person
to the electronic shareholder forum. Nothing in this section prevents or alters the application of
the federal securities laws, including the provisions for liability for fraud, deception, or
manipulation, or other applicable federal and state laws to the person or persons that provide a
statement or information to an electronic shareholder forum.
(c) Reliance on the exemption in § 240.14a-2(b)(6) to participate in an electronic shareholder
forum does not eliminate a person's eligibility to solicit proxies after the date that the exemption

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in § 240.14a-2(b)(6) is no longer available, or is no longer being relied upon, provided that any
such solicitation is conducted in accordance with this regulation.
 E Proxy Regulation In Practice
Rule 14a-12 allows you to make communications and for as long as there is no solicitation. This exception is important: explain to employees how they will be
taken cared of, why this is a good deal. Formal Proxy Statement getting it and filing it with SEC
 Must prepare and file proxy statement
 SEC rules similar to S-1 or Schedule TO
 SEC reviews; no solicitation until definitive
 May then use “other soliciting material”
 Must file anything written – 14a-6(c)
 Personal solicitation materials. If part or all of the solicitation involves personalsolicitation, then eight copies of all written instructions or
other materials that discuss, review or comment on the merits of any matter to be acted on, that are furnished to persons making the
actual solicitation for their use directly or indirectly in connection with the solicitation, must befiled with the Commission no later than the date
the materials are first sent or given to these persons.

 May communicate before filing – 14a-12

 If not a solicitation or no request for proxy
 Must file communication on date of first use
 Why is this exception important?

 Public Relations Campaigns

 “Fight letters”
 Proxy solicitors
 Road shows
 “White papers” (Peltz/P&G)
 Meetings with ISS and Glass Lewis – work for institutional shareholders mutual funds and make recommendations.
 Web site and public forums- do it pursuant to rules.
 Enlist third party supporters (Icahn/Herbalife)- activist will try to enlist other activists.
 File litigation – T.J. Rogers, Cyprus founder

 Coercive Takeovers - Unocal

Little or no regulation
Pre-offer purchases, no advance warning
Terms
 Short period – pressure to accept
 Two tier - discriminatory
 Backend worth less
 First come first served
 No right to change your mind
No disclosure
Plans, identity, source of funds
Saturday Night Special

Although tender offers involve an appeal directly to shareholders, the board of target
companies play a decisive role in the success or failure of the effort. Boards can adopt defensive
tactics that can slow or prevent consummation of an offer (most common = poison pills).
Remember from B.A. II:
 A poison pill is a tactic utilized by companies to prevent or discourage hostile
takeovers. A company targeted for a takeover uses a poison pill strategy to make shares
of the company's stock unfavorable to the acquiring firm. This is accomplished by
making the target company's stock more expensive.
 Shareholder rights plans in which shareholders are given the right to buy shares or
something else like a debt instrument if there is a takeover attempt.
 “Flip in” pills give the shareholder the right to buy really cheap shares of their company
if someone buys a big block of company shares (say 15%) or if someone makes a tender
offer for a big block (say 30%). The rights are not exercisable by the bidder.
 “Flip over” pills give shareholders the right to buy cheap preferred shares of their
company, which then become convertible into bidder stock at a discount from market
price if there is a merger, and the triggers are the same (bidder gets big block of target
shares or makes tender offer for big block of target)
 Generally poison pills can be redeemed by target board which means the board causes
the company to buy back the right (typically at a very low price)

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  Adoption of poison pills in the absence of a specified threat is analyzed with Unocal,
and assuming the board is informed and is at least slightly worried about takeovers,
then the plans are generally proportionate and are fine.
 However, Unocal applies AGAIN when there is an actual takeover attempt and the
board decides whether or not to redeem the pill. A decision not to redeem a poison pill
is considered a defensive measure, and is subject to Unocal analysis.

For poison pills:

a. Def: shareholder rights plans in which shareholders are given the right to buy the shares or
something else when these is a takeover
b. 2 types
a. Flip in pills: give the SH the right to buy really cheap shares of their co. if
someone buys a big block of co.'s shares (15%) or if someone makes a tender offer
for a big block (30%), the rights are not exercisable by the bidder.
b. Flip over pills: give SH the right to buy cheap shares of their co. which then
become convertible into bidder stock at a discount for market price if there is a
merger and the triggers are the same
c. Poison put – forces the target to repurchase shares from shareholders for a large
premium upon some triggering event

c. Features:
a. Can generally be redeemed by the Target board, which means the bd causes the
company to buy back the rights at a low price
b. Can be chewable meaning that SH can revoke them or they may automatically
go away if there is a great bid
c. DE allows poison pills and the IRS doesn’t tax shareholders who receive them at
the time they receive them

Boards responding to a hostile acquisition must meet their fiduciary obligations under state
law.
Unocal Corp. v. Mesa Petroleum Co.:
Recognizing that “(…) a board may be acting primarily on its own interests, rather than those of
the corporation and its shareholders,”, state courts have modified the traditional fiduciary
standards and apply the ‘modified” business judgement rule to defensive tactics. Under that
standard, management of a target company has wide discretion to rely on defensive tactics.
Remember from past classes:
 Enhanced Scrutiny (in the middle of BJR and entire fairness)
 Unocal – In the context of defensive measures permitted if:
 Reasonable belief that danger to the corporation exists
 In good faith after reasonable investigation
 Response “reasonable in relation to the threat”
 Factors may include price, consideration, timing, other constituencies, risk of
non-consummation

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 


 Tender Offer Regulation
 Early Warning - §13(d)
 Tender Offer Process
 §14(d)(4)-(7)
 §14(e)
 Tender Offer Disclosure - §14(d)(1)
 Anti-fraud – Rule 14e-3
The Williams Act substantively and procedurally regulated tender offer with the aim of
responding to the abuses.

New section 14D – attempted to curb coercive practices in tender offers by spelling out
substantive governing rules. More specifically:

Section 14(d)(1) of the Securities Exchange Act of 1934 requires

compliance with certain disclosure and filing requirement in connection
with any tender offer for more than five percent of a class of equity
security registered pursuant to Section 12 of the Securities Exchange Act
of 1934, as well as certain securities of insurance and investment
companies. The principal filing, dissemination and disclosure
requirements with respect to third party tender offers are set forth in
Regulation 14D under the Securities Exchange Act of 1934.

Disclosure Section 14(d) (4)– obliged bidders to file on Schedule 14D [now Schedule TO]
publish and circulate a disclosure document in connection with a tender offer
to security holders of the class of securities that is the subject of the offer

section 14(d)(5) required a bidder to provide withdraw rights during the first 7 days of
the offer and thereafter past the sixtieth day, effectively establishing a 7-day minimum
offer period.

 New section 14(d)(6) required a bidder to accept shares tendered during the first 10
days of a partial offer on a pro rata basis; and

 New section 14(d)(7) required a bidder to offer and pay the same consideration to all
tendering stockholders.

 New section 14(e) prohibited misrepresentations, misleading omissions and

“fraudulent, deceptive, or manipulative acts or practices” in connection with a
tender offer.

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  Tender Offer Definition
 Not defined by statute
 Wellman eight factors
 Widespread solicitation
 Substantial percentage of issuer’s stock
 Premium over market
 Terms firm, not negotiated
 Contingent on certain number of shares
 Limited time offer
 Pressure to accept

 Publicly announced

Wellman Test. In Wellman v. Dickinson, 475 F.Supp. 783,

823-24 (S.D.N.Y. 1979), aff'd on other grounds, 682 F.2d 355
(2d Cir. 1982), cert. denied, 460 U.S. 1069 (1983), the court
set forth and approved the use of eight factors suggested by
the SEC to determine whether a series of purchases
constitutes a "tender offer" (the so-called "Wellman test").
Not all of the following eight factors need be present:

a) Active and widespread solicitation of public shareholders;

b) Solicitation made for a substantial percentage of the

target's stock;

c) Offer is at a premium to the prevailing market price;

d) Terms are fixed rather than negotiable;

e) Offer contingent on the tender of a fixed minimum

number of shares to be purchased;

f) Offer is only open for a limited period of time;

g) Offerees are subjected to pressure to sell their stock;

and

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 h) Public announcements of a purchase program for the
target's securities precede or accompany rapid
accumulation of large amounts of the target's securities.

 §14(d) and §14(e) Rules

 §14(d) tenders for more than 5% of public companies
 §14(e) applies to any tender offer

Section 14(d)(1) of the Securities Exchange Act of 1934 requires compliance with
certain disclosure and filing requirement in connection with any tender offer for
more than five percent of a class of equity security registered pursuant to
Section 12 of the Securities Exchange Act of 1934, as well as certain securities of
insurance and investment companies. The principal filing, dissemination and
disclosure requirements with respect to third party tender offers are set forth in
Regulation 14D under the Securities Exchange Act of 1934.

Issuer Tender Offers. The provisions of Section 14(d) and Regulation 14D do not
apply to a tender offer by an issuer for its own securities. Such tender offers
are instead subject to Rule 13e-4 which, in addition to prescribing filing, disclosure
and dissemination requirements for tender offers by an issuer for its own equity
securities, also duplicates some of the antifraud provisions contained in
Regulation 14E

Regulation 14E under the Securities Exchange Act of 1934 contains procedural
and antifraud provisions applicable to all tender offers - i.e., not just to tender
offers involving registered securities.

 Rule 14e-1: 20 business day minimum offer period

- Rule 14e-1(a). A tender offer is required to remain open at least until midnight
on the 20th business day from the date of commencement. For an offer to be
"open," the bidder must be willing to accept shares for deposit each day during the
20 business-day period.
 Rule 14e-1: prompt payment; notice of extension
 Rule 14e-2: target management must respond within 10 days of
commencement
 Rule 14e-3: general anti-fraud rule

 H. Antifraud Provisions.

 1. Section 14(e). Section 14(e) provides a cause of action
for material misrepresentations and omissions made in connection
with a tender offer. The Supreme Court has held that Section
14(e) is not a basis for regulating the substantive fairness of
tender offer terms beyond issues of misrepresentation and
nondisclosure.


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  a) Rule 14e-3(a) provides that after a bidder takes a
substantial step toward commencing a tender offer, any person
other than the bidder in knowing possession of material, nonpublic
information relating to the tender offer may not purchase or sell
the tender offer securities unless within a reasonable time prior to
any such purchase or sale the information is publicly disclosed.

 b) Rule 14e-3(d) provides that the bidder, the target and
their officers, directors, partners, employees, advisors and persons
acting on their behalf may not communicate material, nonpublic
information relating to the tender offer to any other person where
it is reasonably foreseeable that the communication is likely to
result in a violation of the antifraud provision, unless the
communication is made in good faith.

 Rule 14e-5: no private purchases during offer

 Pre-offer toe-hold permitted

 Rule 14e-5 - Tender offers for the securities of foreign private
issuers that fall within the Tier I Exemption will also be exempt
from Rule 14e-5 (formerly Rule 10b-13) of the Exchange Act, which
prohibits a bidder from purchasing securities except as part of the
tender offer

 Disclosure Obligations
Rules 14d-3, 4 and 5
 Bidder to file Schedule TO as soon as practicable on the date of commencement
- Rule 14d-3
 “Commencement” – publish, send or give security holders the “means to
tender”

Filing and Disclosure - Rule 14d-3. A bidder may not make a

tender offer unless it:

a) Files a Schedule TO with the SEC (amendments must be

filed promptly if material changes occur in the information
set forth in the Schedule TO);

b) Delivers a copy of the Schedule TO to the target and any

other bidders who filed a Schedule TO; and

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c) Gives oral notice of certain information required by Rule 14d-6 and mails a copy
of the Schedule TO to any exchange on which the target's securities are listed (e.g.,
NYSE, AMEX) and the NASD if the securities are traded on NASDAQ
 Disseminate offer to security holders – Rule 14d-4:
 Short form –newspaper ad followed by mailing
 Long form – publish full offer, rarely used today
 Actual mailing produces better results
Cash Tender Offers and Exempt Securities Offers - Rule 14d-4(a). As soon as
practicable on the date of commencement of a tender offer, a bidder must publish,
send, or give the disclosure required by Rule 14d-6
 Target must either provide bidder shareholder list or mail on behalf
of bidder – Rule 14d-5

Obtaining a Shareholder List - Rule 14d-5.

a) Rule 14d-5. A target must respond within two business days of a

bidder's written request for a shareholder list, with notice of the target's
election to either mail the tender offer materials or provide a shareholder
list to the bidder. If the target elects to mail the tender offer materials, it
must do so within three business days of receiving those materials.

b) State. Under the law of many states, a bidder may obtain a

shareholder list upon proper request.

 Schedule TO Content
 Item 1. Summary Term Sheet
 Item 2. Subject Company Information
 Item 3. Identity and Background of Filing Person
 Item 4. Terms of the Transaction
 Item 5. Past Contacts, Transactions, Negotiations and Agreements
 Item 6. Purposes of the Transaction and Plans or Proposals
 Item 7. Source and Amount of Funds or Other Consideration
 Item 8. Interest in Securities of the Subject Company
 Item 9. Persons/Assets, Retained, Employed, Compensated or Used
 Item 10. Financial Statements
 Item 11. Additional Information
 Item 12. Exhibits
 Item 13. Information Required by Schedule 13E-3
 Position of Target – Rule 14e-2

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 Rule 14e-2 requires the target company to state its position on a tender
offer within ten business days of the commencement of the offer.
Specifically, the target must disclose that the target:

a) Recommends acceptance or rejection of the offer;

b) Expresses no opinion and is remaining neutral toward the offer; or

c) Is unable to take a position with respect to the offer.

Target must disclose recommendation, rejection or absence of opinion within ten business days first publication of offer
 If subject to §14(d), must file Schedule 14D-9
 Imposes burden on Board to take a position even though tender is directly to
shareholders
 Time pressure to respond
 Stop, look and listen communication – 14d-9(f)

Rule 14d-9 requires the management of a target company and certain other non-
bidder groups or persons who make recommendations or solicitations with respect
to an offer to file with the SEC and deliver to the bidder and target company
shareholders a Tender Offer Solicitation/Recommendation Statement (Schedule
14D-9). A Schedule 14D-9 includes the following disclosure:

a) The target's identity, address, and telephone number;

b) Information about the target's securities subject to the tender offer including the
title and number outstanding;

c) The filer's identity, address and telephone number;

d) Identify the tender offer and class of securities to which it relates, the name of
the bidder, and the bidder's address;

e) Any material agreements, arrangements or understandings and any actual or

potential conflicts of interest between the filer and the target or bidder;

f) The nature of the recommendation or solicitation, whether the recommendation

is for acceptance or rejection of the tender offer, whether the person expresses no
opinion, or is unable to take a position with respect to the tender offer, and the
reasons for that position;

g) To the extent known by the filer, whether the filer, any executive officers,
directors, affiliates or subsidiaries intend to tender their shares;

h) The identity of any persons employed, retained or to be compensated by the filer

to make solicitations or recommendations;

i) Any transactions in the subject securities within the past 60 days by the filing
person and its executive officers, directors and affiliates;

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j) If the filer is the target, whether any negotiation is being undertaken or is
underway by the target in response to the tender offer which relates to or would
result in an extraordinary transaction, purchase, sale or transfer of a material
amount of assets of target or its subsidiaries or material change in the target's
capitalization or dividend policy; and

k) Exhibits include: disclosure materials, documents regarding conflicts of interest,

and instructions to solicitors.

3. Amendment. Schedule 14D-9 must be amended to promptly disclose any

material change in information previously filed
 Offer Period
 Must remain open for minimum of 20 business days – Rule 14e-1
- Rule 14e-1(a). A tender offer is required to remain open at least until
midnight on the 20th business day from the date of commencement
 Right to withdraw at any time prior to expiration – Rule 14d-7
Withdrawal Rights - Rule 14d-7 and Section 14(d)(5). Withdrawal rights must
be provided to shareholders during the entire period the tender offer is open, but
not during a subsequent offering period
 Subsequent offering period after expiration – Rule 14d-11
 May extend for minimum of three business days
 Must accept and pay for shares already tendered
 Pay for additional shares as tendered
 No withdrawal rights
 Distinguish from mere extension
Subsequent Offering Period - Rule 14d-11. A bidder may elect to provide a
subsequent offering period of 3 to 20 business days during which tender offers will
be accepted if certain requirements are satisfied.
 Amendment of Offer
 Change in consideration extends 10 business days from change
 Rule 14e-1(b)

 Other material change extends five business days from change

 Rule 14d-4(d)(2)
 All Holders Rule/ Pro Ration
 Offer must be available to “all holders” on same terms – Rule 14d-10
 Highest (“best”) price paid to any holder

All Holders Rule - Rule 14d-10. A tender offer must remain open to all
shareholders of the class of securities subject to the tender offer.

Best-Price Rule. Under Rule 14d-10, the consideration paid to any

shareholder must be the highest consideration paid to any other
shareholder during the offer.

 Executive compensation issues – Rule 14d-10(d)

 If not based on number of shares, must be approved by independent
directors
 Pro ration – Rule 14d-8

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  Offer need not be for 100% BUT
 Over-subscriptions must be pro rated in proportion to the number of
shares tendered
Pro-Ration - Rule 14d-8. Where a tender offer is over-subscribed, a bidder who
commences a partial tender offer must accept all securities tendered during the
entire period the tender offer remains open on a pro rata basis according to the
number of shares tendered by each tendering shareholder.
 Tender Offer Insider Trading
 Rule 14e-3
 Response to abuses of MNPI involving tender offers
 Substantial step to commence a tender offer
 MNPI re tender offer
 Acquired from issuer, offering person or officer, director employee, etc.
 No purchase or sale without public disclosure reasonable time prior
 Rule 14e-3 (cont.)
 No need to know there is a tender offer
 No duty required
 Covers both source and tippee
 Does not apply to issuer or “offering person”
a) Rule 14e-3(a) provides that after a bidder takes a substantial step
toward commencing a tender offer, any person other than the bidder in
knowing possession of material, nonpublic information relating to the
tender offer may not purchase or sell the tender offer securities unless
within a reasonable time prior to any such purchase or sale the
information is publicly disclosed.

b) Rule 14e-3(d) provides that the bidder, the target and their officers,
directors, partners, employees, advisors and persons acting on their
behalf may not communicate material, nonpublic information
relating to the tender offer to any other person where it is reasonably
foreseeable that the communication is likely to result in a violation of
the antifraud provision, unless the communication is made in
good faith.

 Pershing Square
 Is there a private right of action? Allergan
 Call of Special Meeting
 S/Hs may propose at annual or special meeting
 Bylaws specify who may call a special meeting
 Typically a director, officer or X% of shareholders
 Many companies limit to directors and officers only
 But shareholders may propose amendment – 14a-8
 ISS will support bylaw amendment IF

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  10% may call a special meeting – low?
 Permitted other than 30 days after or 90 days before
 No limit on matters considered
 Company still gives notice and sends proxy

 Action By Written Consent

 DGCL §228 permits action without a meeting
 Only those shareholders needed to approve
 No advance notice to company or shareholders
 Available at any time
 Activist with votes could remove entire Board

§ 228. Consent of stockholders or members in lieu of meeting.

a./b. Unless otherwise provided in the charter, any action of a meeting of stockholders/member may
be taken, without a meeting and prior notice, by signed written consent, delivered to the corporation,
of stockholders/members having the minimum number of votes that would be necessary to take
such action at a meeting at which all shares/members entitled to vote thereon were present and
voted.[1]
c. To be effective, sufficient written consents must be delivered to the corporation within 60 days of
the delivery of the first written consent to the corporation.[2]

 Unless otherwise provided in charter

 Many companies prohibit action by consent
 Or require unanimity
 If not in initial charter, amendment required
 Frequent subject of shareholder proposals
 ISS addresses on case-by-case basis
 Written Consent vs. Call Meeting
What would be your preference?
 Access to Records – DGCL §220

b) Any stockholder, in person or by attorney or other agent, shall, upon written demand
under oath stating the purpose thereof, have the right during the usual hours for business to
inspect for any proper purpose, and to make copies and extracts from:
(1) The corporation's stock ledger, a list of its stockholders, and its other books and
records; and
(2) A subsidiary's books and records, to the extent that:
a. The corporation has actual possession and control of such records of such
subsidiary; or
b. The corporation could obtain such records through the exercise of control over such
subsidiary, provided that as of the date of the making of the demand:
1. The stockholder inspection of such books and records of the subsidiary would
not constitute a breach of an agreement between the corporation or the subsidiary
and a person or persons not affiliated with the corporation; and
2. The subsidiary would not have the right under the law applicable to it to deny the
corporation access to such books and records upon demand by the corporation.

166
 In every instance where the stockholder is other than a record holder of stock in a stock
corporation, or a member of a nonstock corporation, the demand under oath shall state the
person's status as a stockholder, be accompanied by documentary evidence of beneficial
ownership of the stock, and state that such documentary evidence is a true and correct copy
of what it purports to be. A proper purpose shall mean a purpose reasonably related to such
person's interest as a stockholder. In every instance where an attorney or other agent shall
be the person who seeks the right to inspection, the demand under oath shall be
accompanied by a power of attorney or such other writing which authorizes the attorney or
other agent to so act on behalf of the stockholder. The demand under oath shall be directed
to the corporation at its registered office in this State or at its principal place of business.

 Any record holder or beneficial owner

 Compare to §219
 Must substantiate qualifications
 May inspect and make copies
 Limited to records in possession and control
 No requirement to create materials
 219 List of stockholders entitled to vote; penalty for refusal to produce; stock
ledger.
 (a) The corporation shall prepare, at least 10 days before every meeting of
stockholders, a complete list of the stockholders entitled to vote at the meeting; provided,
however, if the record date for determining the stockholders entitled to vote is less than 10 days
before the meeting date, the list shall reflect the stockholders entitled to vote as of the tenth day
before the meeting date, arranged in alphabetical order, and showing the address of each
stockholder and the number of shares registered in the name of each stockholder. Nothing
contained in this section shall require the corporation to include electronic mail addresses or
other electronic contact information on such list. Such list shall be open to the examination of
any stockholder for any purpose germane to the meeting for a period of at least 10 days prior to
the meeting: (i) on a reasonably accessible electronic network, provided that the information
required to gain access to such list is provided with the notice of the meeting, or (ii) during
ordinary business hours, at the principal place of business of the corporation. In the event that
the corporation determines to make the list available on an electronic network, the corporation
may take reasonable steps to ensure that such information is available only to stockholders of
the corporation.

Day 11 – 22/08/2018

 TOOLS TO DEAL WITH ACTIVISTS

 STRUCTURAL DEFENSES
 SHAREHOLDER ENGAGEMENT
 PREPARATION
 CASE STUDY – ONE BOARD’S RESPONSE
 Structural Defenses
 Poison Pill
 Classified Board
 Controlling shareholder, dual class stock
 Advance notice bylaws

167
 Companies have a number of ways to assure that shareholder meetings are “orderly”.
These include limiting who can attend, monitoring votes at meetings, and vesting
significant power in the BoD Chair, who runs the meeting and is frequently the CEO. A
more cynical view of these and other ways suggests rather than impose order, they seek
to thwart shareholder efforts to influence company affairs, and entrench directors and
executives. Either way, some of these ways matter greatly to an activist investor who
wishes to so influence a company.
Advance notice provisions typically set forth a date by which a shareholder must notify the
company of the intent to propose the matter. These can range from 30-120 days before the
shareholder meeting.

Companies rarely announce the exact date of the annual shareholder meeting in a given
year very far in advance, even two or three months in advance
State corporation law, in particular Delaware, neither specifically allows nor prohibits
advance notice provisions. Section 211(b) of the Delaware General Corporate Law has a
vague sentence how shareholders can propose agenda items (“business”).
 Blank check preferred stock
- That if your charter allows blank check preferred stock, the Board can
decide the features of the preferred stock, specifically the voting right. “We
authorize the Board to issue 1,000 preferred shares and Board can set the
terms.
 Charter and Bylaws restrictions”
Good example, right to call a special meeting, right to a written consent. Tools
for companies to defend themselves if they deprive the shareholders of these
rights.
 Written consent; special meetings
 Change in control covenants
Golden parachutes. Grant employees big severance packages and the idea is
this expense will deter the company to take over the company.
 Changing meeting date
If your meeting is next week and the votes are coming in and you need a little
more time.
 Poison Pills

It is not part of the by-laws or the charter it is a contractual right, based on Delaware 157 that grants the board the right to issue Rights. Rights Agreement. In the middle 1980s,
and the dramatic cases were coming on (Can gorkon, Revlon, unocal), one of the things that was a point of contention, poison pill grants the Rights except the activist and
Moran makes it clear, under certain circumstances this disparate treatment is permitted, the pill dilutes the takeover activist.

 Contractual right (not in charter or bylaws)

 Valid per Moran v. Household
 Limitations: Toll Brothers;

You can have a poison pill and can be redeemed by the board and the reason is not to encroach the board of its fidicuary duty. Toll brothers contained a provision,
“dead hand”- new board cant redeem pill. Delaware cannot do this. Quickturn-6 months. The pill provision has to be a redeem.
 Dividend of one “right” per common share- do it in anticipation of takeover. Attached to the common stock.
 Cannot be traded independently from common
 Triggering event: acquisition of , say, 15% - threshold. What does not trigger the pill is a proxy contest. Bill Ackman of Allergan situation, tender offer, ownership
of shares and then proxy fight.
Poison pill is not preclusive although activist cannot acquire shares but they can do proxy contest.
 Acquisition of additional shares at discount
 Acquirer's rights not exercisable
 MASSIVE DILUTION!!! Of activist. The pill has been triggered only once.
 Fully triggered only once – Selectica
 Unintentional triggers-
 Board may “redeem” prior to trigger
 Poison Pill Approval
 Board creates the contract and issues “Rights” pursuant to resolution
 DGCL §157(a) authorizes Board to issue “rights”

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 Another version of dividend. The document is a Rights Agreement. Rights certificate goes out to shareholders.
§ 157. Rights and options respecting stock.

a. Subject to the provisions of the charter, a corporation may create and issue rights or options to acquire from the corporation shares of its capital stock (“warrants”).
The warrants shall be evidenced by or in such document(s) as determined by the board

 Rights attach to all shares

 Evidenced by:
 Rights agreement with a “rights agent”
 Sets forth the terms of the Rights
 Rights certificate issued to the holders of common
 Poison Pill Mechanics
Before the trigger: you set a purchase price.
 Shareholders have the right to purchase shares
 Purchase Price is deliberately set at a price well above the current or expected market price
 Example: if stock trading at $5/share, “Purchase Price” might be $50 for one share of Common Stock (before the trigger, the $50 is subjectively set, it is high
enough so that nobody is inclined to buy it before the trigger)
 No immediate effect – right is worthless (10x market)
 BUT after rights “triggered” when acquirer ‘s ownership exceeds a threshold, typically 10% - 20%
 THEN…….
 Upon Trigger…
“Each holder of a Right, other than Rights that are or were acquired or beneficially owned by the Acquiring Person (everybody gets it except the activist)(which Rights will
thereafter be void), will thereafter have the right to receive upon exercise that number of shares of Common Stock having a market value of two times the then current
Purchase Price of one Right.”

 Effect of Poison Pill Trigger

 Prior to triggering event, can buy one share $50 (“Purchase Price”)
 After triggering event, can purchase $100 worth of shares for $50 (half price)
 If market price still $5 - 20 shares for $50
 If all shareholders exercise, a 10% acquirer would have its interest diluted to 0.5%
 Poison Pill Math
 1,000 shares trading at $5 each
 Rights issued: 10% trigger; 1 share for $50
 Hedge fund acquires 10% (100 shares) on NYSE
 Other shareholders own 900 shares
 Rights of “other shareholders” when triggered
 Each share can buy new 20 shares for $50
 20 shares = $100 (2x Purchase Price) ÷ $5 (current mkt)
 Price: $2.50 (not $5)
 If all exercise: 18,000 new shares (coming from authorized shares, not from outstanding shares) (900x20)
 Hedge fund will own 100/19,000 instead of 100/1000

 Poison Pills Today

 Not an absolute bar? Yes because you can still do proxy contest.
 Negotiating leverage only
 Board can (must?) redeem if come to agreement (you can convince the Board to redeem the pill. There are new cases “just say no” defense- we have a
pill and we will not pull the pill, now is not a time but will come a time .There must be some point)
 Much less effective in proxy contest
 Proxy contest not covered – rationale for Moran
 10% enough?
 Shareholders and ISS quite hostile
ISS does not like poison pills.
 Insist on shareholder approval to adopt or renew
 Typically expire after 10 years
 Most larger companies don’t have pills
 BUT pills may be kept “on the shelf” In Sotheby, Dan Loeb- board pulled the pill out of the shelf. Generally accepted that this works. No need to put a pill in
place on a clear day, no activist.

Under a typical Shareholder Rights Plan, the company issues a dividend of one “Right” for each
share of its common stock. Each Right represent a conditional right: it is not immediately
exercisable. Board creates the contract and issues “Rights” pursuant to resolution DGCL §157(a) authorizes Board to create and issue “rights”
Another version of dividend. The document is a Rights Agreement. Rights certificate goes out to shareholders.
§ 157. Rights and options respecting stock.

b. Subject to the provisions of the charter, a corporation may create and issue rights or options to acquire from the corporation shares of its capital stock (“warrants”).
The warrants shall be evidenced by or in such document(s) as determined by the board

Moreover, it is attached to and cannot be traded independently of, the corresponding share of
common stock.

The Rights depends upon the occurrence of a triggering event. The key triggering event is the
acquisition of a specified percentage of the company´s shares of common stock.
The threshold ownership level can vary, but it is usually 10% to 20% range.

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Upon the occurrence of the triggering event, the Rights would give the holder the right to
acquire additional securities (or other assets) at a discount.

The key to the poison pill is that any Rights in the hands of the hostile bidder would become
void and nontransferable.

Because all other shareholders would acquire additional securities at a discount, the interest of
the hostile bidder would be diluted severely. This dilution would make the acquisition of the
company prohibitively expensive. The intention is to deter any unwelcome acquisition and the
poison pill has been very effective.

The exact nature of the dilution varies depending on the specific terms of Shareholder Rights
Plan. The main variations fall into three categories:

(i) “Flip over” provisions: entitle shareholders to acquire shares of stock of the hostile
bidder at a significant discount, but only under certain circumstances.

Deficiencies in the “flip over” provisions led to 6he creation of another type:

(ii) “Buy-end” provisions: entitle the shareholders, other than the acquirer, to receive
assets (generally debt securities or cash) from the company.

Also suffer from deficiencies.

“Flip-in provisions”: entitle shareholders, other than the acquirer, to acquire shares
of stock of the target company at a significant discount.
Most pills are flip in
Flip-in provisions don´t suffer such deficiencies and account for the prevalence of the
poison pills.

These provisions, however, would prevent ANY acquisition of the company, for more beneficial
they could be.

Thus, the Shareholder Rights Plan also include provisions that allow the board to “pull the pill”
by redeeming the Rights at a nominal price.

The intention is to encourage potential acquirers to negotiate the acquisition with the board. The
board has the flexibility to redeem the Rights or not, depending on the offer.
However, an unlimited ability to redeem the Rights would also be problematic – it would permit
the acquirer to redeem the rights after gaining control of the company.

Therefore, Shareholder Rights Plan typically provide that the Rights can be redeemed by the
board at any time prior to the triggering event, but not afterwards.

Thus, the flexibility enjoyable by the original board is not freely available to hostile bidder.


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  Classified (Staggered) Board
 DGCL §141(d)
 1, 2 or 3 classes
 Three year terms
 Removable only for cause
 Charter or shareholder approved bylaw
 [Staggered board] The charter, an initial bylaw, or a bylaw adopted by a stockholder vote,
may divide the directors into up to 3 classes, whose terms of office expire in successive years
beginning with class 1 at the first annual meeting after the classification becomes effective. This
charter or bylaw provision, as the case may be, may authorize the board then in office to assign its
members to the newly created classes.
[Classified board] The charter may confer upon holders of any class or series of stock the right to
elect 1 or more directors with such term and voting powers as stated in the charter, which may be
greater or less than those of other directors.
[Differential voting rights] More generally, the charter may confer upon any 1 or more directors
voting powers greater than or less than those of other directors, including in committee votes. In any
such case of unequal director voting rights, every reference in this chapter to a majority or other
proportion of the directors shall refer to a majority or other proportion of the votes of the directors.

 Effect of Staggered Board + Pill

Very strong takeover defense if two is combined.
 Pill forces focus to proxy contest
 No removal of directors without cause
 Must wait for reelection at annual meeting
 Replacement limited to one-third
 Two years required to replace a majority
 Two years is a long time to wait!
 Moore/Wallace; Airgas
 Staggered Boards Today
 Post-SOX pressure to declassify
 Systematic use of 14a-8 proposals
 Bebchuk and Chevedden
 ISS support for proposals, impact on governance scores
 Often preempted by management – slight delay
 Today rare in DJIA and S&P 500
 Still found in IPOs
 Dual Class (High Vote) Stock
 Full voting control – best activism defense
 Disproportionate voting (dual class)
 Founder sells economic interest but retains voting control
 Historically rare, recent use with tech stocks
 Stock exchanges resisted
 Google, Groupon, Facebook, Zynga
 Google IPO prospectus
SNAP – no vote

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  Exclusion from indexes
 Advance Notice Bylaws
Shareholder will have to give advance notice of proposed action at shareholders
meetings.
 Shareholders have right to nominate directors and propose action at
shareholder meetings
 BUT NOBODY LIKES SURPRISES
 Bylaws may condition right to propose on
 90-120 days advance notice
 Identity and background information re proponent (and nominee) (like
13D)
 Ownership, including derivatives
 Nominee’s agreement to abide by policies
 Agreements with others (wolfpack- arrangements or understandings;
conscious parallelism, identify those who invest side by side with you)
 Other Structural Defenses

 Changing Meeting Date

 What if the votes are not coming in?
 Adjournment – after meeting begins
 No new notice required - §222(c)
 Unless bylaws otherwise require
If the annual meeting for election of directors is not held on the date designated therefor or
action by written consent to elect directors in lieu of an annual meeting has not been taken, the
directors shall cause the meeting to be held as soon as is convenient
 But is there bylaw authority for adjournment?
 Who can adjourn? Is a shareholder vote required?
 Requires a strong business rationale – fiduciary issues
 Postponement - before meeting begins
 Board action required
 New meeting? New notice? New record date?
 Proxies still valid?
 Recess – Dynergy
 §231(c) – time of closing polls
The polling hours for each matter shall be announced at the meeting. After the closing of the polls,
no votes or changes thereto shall be accepted, unless the Court of Chancery upon application by a
stockholder determines otherwise
 Engagement – Explanation?
 Decline in defenses
 Companies more willing to listen
 Do they have any choice?
 Activists less set on takeovers
 New willingness to collaborate
 Influenced by Say-on-Pay referenda
 Increased role by large mutual funds

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  Fidelity, Vanguard, State Street -they are coming out issues they feel them
(Larry Fink) and not merely passive.
 Role of ISS? – role is much less in subjective engagement. Oftentimes, big
companies make their own guidelines. It is supportive but not as influential.
 Practice Point: How to Engage
 Make it an ongoing effort
 Anticipate and focus on core issues
 Have an agenda! ( for the company: keep it broad, the advice to client
companies: stick to the high level of the direction and keep on the weeds
on operation data)
 Lead with strategy
 Regulation FD fair disclosure (Regulation of SEC. IT is designed the issue of
selective disclosure. When you meet a huge investor, you still have insider
trading issues, you cannot share material information to BlackRock and one
exception is if the sign a confidentiality agreement but they will not sign. Be
concerned that in these engagements, you cannot disclose nonpublic and
material.)
 Who should participate?
 More than just the IR team
 Directors? Independent? Governance? – Big investors do not want to talk
to the small employees. Director? But who? Independent or chair of
governance committee
 One voice- This is the most important thing! Organize your
communication thing to say one voice. If lead director is communicator,
and if other director gets a query, refer the same to lead director.
 Forum: One-on-one? Blogs? Webcasts?
 Timing and frequency
 Treat with respect! Don’t be defensive!- before companies become
accommodating to engagement, they flatly refused to engage but its not the
same time anymore. Don’t be disrespectful and dismissive.
 How Not to Engage
 Flatly refusing to engage
 Engaging in unstructured discussions
 Avoid surprises
 Being disrespectful or dismissive- because you are sending a message to the
other shareholders that you don’t care about what shareholders say.
 Giving inconsistent messages
 Waiting for a problem before engaging
 Being unprepared!
 Be Prepared!
 Assemble team and contact info
 Officers, banker, legal, proxy solicitor, PR Firm, BOARD, senior executive.
Board representation. Contract information of everyone. Communication
program is very important.

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 You need to be able to call day on one’s day notice. You need when they
are on vacation, unavailable. Leo Strine get the board involved at the very
early time. Processes in place at the beginning- MWF.
Access is very important.
 Develop response protocols (This is Leo Strine)
 To investors, press, employees, analysts
 Speak with 1 voice
 “No comment policy” – this goes into securities regulation. If you are
engaged in preliminary discussion of a transaction, respond with “no
comment”unless there is something you are comfortable going public
with. You avoid making statement that is misleading, lying and
sharing information that is material and nonpublic.
 To activist – early Board involvement
 Prepare Board (do it in advance, briefing on fiduciary duties, strategy)
 Brief re strategy and fiduciary duties
 Discuss protocols for engagement and response
 Review structural defenses, including pill
 Understand shareholder ownership
 Monitor trading volume and public filings
 Be Prepared (cont.)!
 Identify “issues” - understand vulnerabilities
 See through activist eyes
If we have excess cash, what would you do? Get a rational explanation. Get
a real activist in the board meeting, and in the absence of an activist board
member, start thinking like an activist as best as you can.
 Strategy, operations; compensation; financial performance or engineering;
governance; defenses
 Preemptively address
 Special dividend or stock repurchase
 Compensation assessment
 Divestiture
 Develop communication plan
 Goal: early warning
 Proactive and continuing
 Engagement and PR generally

Tools to Deal With Activists

Takeover and Other Structural Defenses

Brown Ch. 8 (pp. 559-560)

A. The Potency of the Poison Pill

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Defensive tactics by the board seek to make the company practically, legally, or economically
unattractive to acquire.

Thus, the board might opt to sell the “crown jewels”, selling the very assets that motivated the
hostile bidder in the first instance.

Employment contracts to top officials (aka “golden parachutes”) might provide for substantial
payments to officers upon a change of control, raising the cost of the acquisition.

Also: use of pac man defense, white knights, white squires and shark repellant amendments
to the articles of incorporation.

The most effective defense is the shareholder rights plan, more known as a poison pill. The
pill ca be implemented by board resolution and immediately renders a hostile acquisition
financially impractical.
Julian Velasco, Just Do It: An Antidote to the Poison Pill

Under a typical Shareholder Rights Plan, the company issues a dividend of one “Right” for each
share of its common stock. Each Right represent a conditional right: it is not immediately
exercisable. Moreover, it is attached to and cannot be traded independently of, the corresponding
share of common stock.

The Rights depends upon the occurrence of a triggering event. The key triggering event is the
acquisition of a specified percentage of the company´s shares of common stock.
The threshold ownership level can vary, but it is usually 10% to 20% range.

Upon the occurrence of the triggering event, the Rights would give the holder the right to
acquire additional securities (or other assets) at a discount.

The key to the poison pill is that any Rights in the hands of the hostile bidder would become
void and nontransferable.

Because all other shareholders would acquire additional securities at a discount, the interest of
the hostile bidder would be diluted severely. This dilution would make the acquisition of the
company prohibitively expensive. The intention is to deter any unwelcome acquisition and the
poison pill has been very effective.

The exact nature of the dilution varies depending on the specific terms of Shareholder Rights
Plan. The main variations fall into three categories:

(iii) “Flip over” provisions: entitle shareholders to acquire shares of stock of the hostile
bidder at a significant discount, but only under certain circumstances.

Deficiencies in the “flip over” provisions led to 6he creation of another type:

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 (iv) “Buy-end” provisions: entitle the shareholders, other than the acquirer, to receive
assets (generally debt securities or cash) from the company.

Also suffer from deficiencies.

“Flip-in provisions”: entitle shareholders, other than the acquirer, to acquire shares
of stock of the target company at a significant discount.
Most pills are flip in
Flip-in provisions don´t suffer such deficiencies and account for the prevalence of the
poison pills.

These provisions, however, would prevent ANY acquisition of the company, for more beneficial
they could be.

Thus, the Shareholder Rights Plan also include provisions that allow the board to “pull the pill”
by redeeming the Rights at a nominal price.

The intention is to encourage potential acquirers to negotiate the acquisition with the board. The
board has the flexibility to redeem the Rights or not, depending on the offer.
However, an unlimited ability to redeem the Rights would also be problematic – it would permit
the acquirer to redeem the rights after gaining control of the company.

Therefore, Shareholder Rights Plan typically provide that the Rights can be redeemed by the
board at any time prior to the triggering event, but not afterwards.

Thus, the flexibility enjoyable by the original board is not freely available to hostile bidder.

 Dual Class (High Vote) Stock

 Full voting control – best activism defense
 Disproportionate voting (dual class)
 Founder sells economic interest but retains voting control
 Historically rare, recent use with tech stocks
 Stock exchanges resisted
 Google, Groupon, Facebook, Zynga
 Google IPO prospectus
SNAP – no vote
 Exclusion from indexes
 Advance Notice Bylaws
 Shareholders have right to nominate directors and propose action at shareholder
meetings
 BUT NOBODY LIKES SURPRISES
 Bylaws may condition right to propose on
 90-120 days advance notice
 Identity and background information re proponent (and nominee)
 Ownership, including derivatives

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  Nominee’s agreement to abide by policies
 Agreements with others (wolfpack)
 Other Structural Defenses

 Changing Meeting Date

 What if the votes are not coming in?
 Adjournment – after meeting begins
 No new notice required - §222(c)
 Unless bylaws otherwise require
 But is there bylaw authority for adjournment?
 Who can adjourn? Is a shareholder vote required?
 Requires a strong business rationale – fiduciary issues
 Postponement - before meeting begins
 Board action required
 New meeting? New notice? New record date?
 Proxies still valid?
 Recess – Dynergy
 §231(c) – time of closing polls

Structural Defenses to Shareholder Activism (on Canvas)

Institutional investors and the influential shareholder advisory services have become
critical of structural defenses that companies may implement to defend against hostile
takeover bids and shareholder activism.

This article, they review the most important structural defensives available to
companies from a legal and business perspective

The surge of shareholder activism in recent years has featured highly experienced and
well-capitalized activists. Activist investors, who acquire a small stake and then
demand change under the threat of a proxy fight, have emerged as the most prevalent
challengers to the incumbency and leadership of corporate directors. The recent
collaboration of an activist hedge fund, Pershing Square, and a strategic bidder, Valeant
Pharmaceuticals, in their unsolicited bid for Allergan has additionally raised the specter
of a new wave of hostile takeover activity utilizing shareholder activism strategies.1
Activism, as an investment strategy, enjoyed remarkable successes in recent years.

Many activist situations emerge, and are resolved, under the public’s radar. In light of
these developments, many observers are speaking of a “golden age” of activist
investing.

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In this new era of shareholder activism, a public company should review not only its
business plan, board composition, and investor relations, but also its structural defenses
to shareholder activist campaigns. Companies pursuing an initial public offering (IPO)
are particularly well advised to ensure that they go public with the best and most
sophisticated defenses available, in order not to jeopardize the IPO.

Powerful defenses against activism can be easily included in the charter of a

company before it goes public, but it may be difficult to obtain the requisite
stockholder approval for adding such defenses to the charter following an IPO.

The proxy advisors (such as ISS and Glass Lewis & Co.) are critical of corporate
policies that could be viewed as interfering with the stockholder franchise.

This article elaborates on the most important structural defenses available to public
companies facing immediate or potential proxy contests or activism campaigns, and the
discussion will focus on Delaware law.

Not every defense will benefit every company when all considerations are weighed.
The following facts must be considered:

- drawbacks of inviting criticism from institutional stockholders and proxy

advisory services;
- the limiting effects;
- potentially costly consequences of running afoul of state law or the federal
securities laws; and
- tax ramifications.

Board is well advised to implement structural defenses before an activist targets the
Company. Defensive measures adopted in response to a proxy contest or other
activist efforts are likely to be subject to enhanced or even strict scrutiny by the
Delaware courts and may receive a negative reaction from the proxy advisory firms,
investors, and the media.

1. MULTI-CLASS CAPITAL STRUCTURES

The best structural defense against shareholder activism is a controlling stockholder or

another management-friendly stockholder with a large stake.

Activists typically stay away from these companies because activists lack the leverage of
a proxy contest to push for change.

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A structure designed to ensure management-friendly control after an IPO is the “multi-
class capital structure” (also known as “dual class capital structure”).

Under this structure, a few specified pre-IPO stockholders (typically the founders)
receive shares of common stock that are entitled to multiple votes per share, while
the public is issued a separate class of common stock that is entitled to only one vote
per share.

Companies with multi-class capital structures are typically safe from shareholder
activism because the holders of the high-vote class of common stock are able to retain
voting control over the company, making a proxy contest a fruitless exercise.

Ideally, the adoption of this structure should be put into place before going public
(before the IPO). The rules of the New York Stock Exchange and NASDAQ allow for the
issuance of super-voting stock at the IPO stage but not after the company goes public.

A company requires stockholder approval to introduce the structure, and institutional

stockholders generally vote against proposals to create a dual class capital structure.
ISS recommends voting against, except in limited circumstances.

2. BLANK CHECK PREFERRED STOCK

Blank check preferred stock means that the board is expressly empowered to
determine the terms and conditions of authorized and unissued preferred stock.

The purpose is to raise capital, but it can also serve as an anti-shareholder activism
device.

First, it facilitates the creation of a poison pill.

Second, a board can use it to create a new series of preferred stock that has special
voting, conversion or control rights, and sell such stock to a management-friendly third
party (a “white squire”).

To create it, a corporation must provide for the blank check preferred stock in its
charter by authorizing a maximum number of shares of preferred stock that the
corporation may issue and by granting to the board of directors the express authority
to determine the voting rights, designations, preferences, rights and qualifications, and
limitations or restrictions of such preferred stock.

Generally, preferred stock is convertible into common stock, its holders vote on an “as
converted” basis, and it becomes redeemable upon a change of control. Once issued, the
specific powers, rights, and preferences of the preferred stock can be set out in a

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certificate of designation and filed with the Delaware Secretary of State as an
amendment to the charter.

A board’s decision to issue stock must be consistent with the directors’ fiduciary
duties. Delaware courts have established a battery of controlling principles and legal
tests to regulate the use of stock in the context of a prospective or pending proxy
context.

Depending on how and when a company issues stock, it will face different levels of
judicial scrutiny.

A company that issues stock with a sound business rationale before the advent of a
contest for control is likely to be protected under the business judgment rule.

Even if a company anticipates a proxy contest, it may still find protection under the
business judgment rule if the court finds that the issuance of stock was designed more
to enhance the company’s business than to foil a would-be dissident at the ballot box.

On the other hand, if the company issues stock in the context of a takeover effort by an
activist, the company could find its issuance reviewed in court under the Unocal or
Revlon standards.

If the company issues stock in a proxy context and appears to have done so for the
“primary purpose” of thwarting the shareholder franchise, the company could face
judicial review under either the Unocal or Blasius standards.

If a court has reason to believe that the issuance of stock occurred in a self-dealing
context, company could find itself being reviewed under the demanding standard of
entire fairness.

The takeaway is that although the analysis will always turn on the specific facts and
circumstances, a company will usually be safer issuing stock before an activist emerges.

Most public companies have blank check preferred stock22 and almost all IPO
companies include this feature. If they don´t, they will need approval from stockholder,
what is difficult.

3. CHARTER AND BYLAW AMENDMENTS

Structural defenses are best secured through charter provisions because stockholders
cannot unilaterally amend the charter of a Delaware Corporation.

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Under the DGCL”), charter provisions can be adopted, amended, or repealed only
through a combination of board and stockholder approval.

It is difficult to add structural defenses to the charter following a company’s IPO

because it can be difficult to get the stockholders´ approval.

Therefore, a company’s board will want at least to be able to adopt bylaws unilaterally
as a next-best means for implementing desirable defenses.

Bylaw Amendments by the Board

Under Delaware law, stockholders possess a “sacrosanct” right to adopt, amend, or

repeal bylaws. Boards, however, can obtain a right to unilaterally adopt, amend, or
repeal the bylaws ONLY if that power is granted in the charter.
The charters of most large public companies and almost all IPO companies include this
feature.

Bylaw Amendments by the Stockholders

Stockholders’ power to unilaterally adopt bylaws is one of the few inalienable powers
stockholders have to directly change the ground rules of a corporation’s governance.

Stockholders are empowered, specifically, to adopt bylaws that shape the “process
and procedures” by which corporate decisions are made.

As such, stockholder-initiated bylaw amendments have become a preferred tool for

activists seeking to advance their agendas for changing corporate leadership. Activists
have proposed bylaw amendments that:

- increase the number of directorships; and

- grant stockholders the power to fill newly created directorships; or
- give stockholders, rather than sitting directors, the power to fill vacancies on the board
created by stockholder-initiated removals.

Such amendments can allow activist stockholders to remove incumbent directors and
appoint their replacements in a single meeting.

A corporation can constrain the ability of activists to affect corporate control by

requiring a higher threshold of stockholder votes for adopting bylaws. Although the
default rule is that stockholders have the ability to propose and adopt a bylaw by at
least a vote of the majority of stockholder voting power,34 the charter or bylaws can
require a supermajority vote for adopting any subsequent bylaw amendment.

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Where the company seeks to impose the supermajority requirement through an
amendment to the bylaws as opposed to the charter, case law is not decisive as to
whether that amendment can only be adopted by a vote of the same supermajority of
stockholders that such amendment would impose on stockholders thereafter seeking to
adopt subsequent bylaw amendments.

Supermajority bylaw adopted unilaterally by a board, in the face of an incipient

challenge to incumbent leadership, could trigger “compelling justification” review and
be struck down in court on the basis of equity.

4. ANNUAL DIRECTOR ELECTIONS VS. CLASSIFIED BOARDS

5. STOCKHOLDER ACTION BY WRITTEN CONSENT

6. STOCKHOLDERS’ RIGHT TO CALL SPECIAL MEETINGS

6. ADVANCE NOTICE REQUIREMENTS

The default rule in Delaware is that stockholders can nominate director candidates
and make other proposals at an annual meeting without prior notice or warning to
the Company.

This a risk for the company. Company will want time to review the nominees and
proposals, to negotiate a compromise or settlement, if possible, and to prepare for a
proxy contest, if necessary.
For these reasons, Delaware courts generally permit a company’s bylaws to require
stockholders to furnish the company with advance notice of their intention to nominate
directors or to present stockholder proposals.

However, the Delaware Court of Chancery warned that it is not averse to striking down
advance notice bylaws that “unduly restrict the stockholder franchise or are applied
inequitably.”70 Furthermore, Delaware courts will construe advance notice bylaws
narrowly, against the company and in favor of the free exercise of stockholders’
electoral rights.

A typical advance notice bylaw requires delivery of a stockholder’s notice to the

company between 90 and 120 days in advance of a meeting. The notice is required to
include disclosure related to the identity of the proxy-soliciting participants and
specifics regarding their nominees and proposals. An advance notice bylaw will
typically also require the proposing stockholder to be a record holder of the company’s
stock.

Generally, advance notice bylaws have become commonplace both for existing public
companies and IPO companies. This feature is among the few defensive measures that

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ISS regards with some measure of approval. By contrast, Glass Lewis unequivocally
recommends that stockholders vote against any proposals that would require advance
notice of stockholder proposals or director nominees.

7. REMOVAL OF DIRECTORS

8. INCREASES IN THE SIZE OF THE BOARD

9. VOTING STANDARDS FOR DIRECTOR ELECTIONS

10. DELAYS OF STOCKHOLDER MEETINGS

Both the company and the insurgent receive daily interim voting results in a proxy
contest from Broadridge.

If an activist were ahead in the vote count, a board might prefer to delay either the
upcoming stockholder meeting or the closing of the polls in a meeting already in
progress, even if a quorum is present.

The purpose in either case would be to solicit additional proxies. The DGCL is sparse
and indirect concerning the conduct of meetings and mechanisms for effecting delays of
meetings and votes.

Controlling law distinguishes between “adjournments” and “postponements.”

Adjournments
An “adjournment” occurs when a stockholder meeting is properly convened, but then
is subsequently, before a vote is taken, rescheduled for a later time and date.122 The
DGCL recognizes that a stockholders meeting may be adjourned but does not provide
the procedures for adjourning a meeting.123 The default rule appears to be that in lieu
of a chairperson-empowering provision in the charter or bylaws, once a meeting is
formally convened and the presence of a quorum acknowledged, the power to adjourn
belongs to the stockholders.124 Delaware courts have accepted that a charter provision
or bylaw can grant to the meeting’s chairperson125 the exclusive power to adjourn the
meeting.

As a practical matter, however, the courts will not allow chairpersons to exercise that
power for just any reason. The Delaware courts have hedged the adjournment power of
the chairperson by reference to the countervailing equitable doctrine of protecting the

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stockholder franchise as well as the full scope of duties subsumed under the heading of
“fiduciary duties.”

The core principle to emerge from a string of pertinent cases is that even where a
company has adopted a chairperson-empowering provision in the charter or bylaws,
the company should formulate as weighty a business rationale as possible for
adjourning the meeting, and should do so “independently, with due care, in good
faith, and in the honest belief” that the adjournment is “in the stockholders’ best
interests.”

The company’s rationale for adjourning a meeting can make the difference between
encountering judicial review under the lenient business judgment standard or
encountering a much more demanding level of scrutiny under some iteration of the
Blasius standard of “compelling justification”.

It is not certain, however, that directors could rely on the mere fear of losing an election
to justify an adjournment, particularly if the board already had ample time under its
own advance notice bylaws to evaluate a dissident slate and to solicit proxies.

Nonetheless, a company is therefore well advised to have a chairperson-empowering

provision in its charter or bylaws.130 After all, it is better for a board to endow itself
with the power and then decide whether to wield it, as opposed to not giving itself the
power at all.

If a company does not have a chairperson-empowering provision, a board is best served

by unilaterally amending the bylaws to that effect. A charter amendment would have a
lower likelihood of success due to the difficulties of obtaining stockholder approval. ISS
recommends generally to vote against proposals to provide management with the
authority to adjourn absent “compelling reasons,” such as for the purpose of
sufficiently informing stockholders in advance of a vote in the event of material
events.132

Postponements

A “postponement” occurs when a scheduled stockholder meeting is never convened

and then a new meeting is scheduled and held, at a later time and date, in place of the
originally scheduled meeting.

Delaware law regards postponed meetings as new meetings. Consequently, postponed

meetings require that a new meeting notice be sent to stockholders. The board could
also be required to set a new record date. The postponement of an annual meeting may

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also result in the re-opening of the advance notice period for director nominations and
stockholder proposals under a company’s bylaws.

The DGCL does not contain any express provisions concerning postponed meetings or
the notice and record date requirements regarding such meetings. For this reason,
Delaware courts have allowed boards to postpone or reschedule stockholder meetings
“as they see fit,” without express authorization in the company’s organizational
documents, “so long as they do not violate the limitations” posed by the DGCL.

In addition, courts look to a board’s actions and statements for indicia of good faith,
independent decision-making, a serious business rationale, directors’ concern for the
best interests of stockholders, and other manifestations of allegiance to fiduciary duties.
A company’s record in this regard could make the difference, as it does in the
adjournment arena, between review under the business judgment rule or review under
an iteration of the Blasius “compelling justification” standard.

An important takeaway from the line of cases on postponements is that fear of losing a
directors’ election, in isolation and without a more substantial business rationale,
may not satisfy the courts as a valid reason for postponing a scheduled meeting.140
An additional consideration could be a potential negative reaction from institutional
investors and stockholder advisory services.

12. FORUM FOR STOCKHOLDER LITIGATION

13. DELAWARE’S ANTI-TAKEOVER STATUTE

14. CHANGE-OF-CONTROL PROVISIONS IN DEBT INSTRUMENTS

15. POISON PILLS

Sample Advance Notice Bylaw (on Canvas)

Boardrooms Rethink Tactics to Defang Activist Investors (on link stated in syllabus)

Until now, the great threat for executives and board members were hostile takeovers. As this has been
diminishing, the new threat is shareholder activism. It is said that shareholder activism today is like
hostile takeovers in the 1980s.

The first approach taken by the boards and executives was to refuse to meet with this shareholders
hoping they would go away. However, with shareholder activism being more established, the approach

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has changed. Many hedge funds are pressing aggressively for changes and this has caused the
companies to adopt measures.

In fact, many companies prepare for activism, even before they are confronted with a real situation.
Chris Young says that the defense before having an activist showing up is to block and tackle, with
dynamic self- assessment and enhanced investor outreach.

In order to prepare for activists, companies exercise to give management and boards a better
understanding of their perceived vulnerabilities. Small teams that include management, a banker, a
lawyer and an outside public relations specialist are often assembled to prepare a response in the event
of an attack. The idea is for the board and management to see the company, the way the activist would
look at it, considering the level of sophistication they are achieving.

“White paper ready”- aspects analyzed are the trading price of the stock, youth of directors and excess
cash.

Another measure done by companies is having a better communication with passive institutional
shareholders. Proactive communication with the shareholder (not waiting for them to do a request) is
important, as the negotiation is more collaborative when it’s out of the public eye.

In the contrary, when a situation goes out in public, companies have to be especially sensitive.

For example, when Starboard Value singled out AOL last year, agitating for it to sell patents and
proposing a new slate of directors, the company was able to withstand the assault. In these cases, the
companies need to understand that other investors are watching and they will see how the company
treats its shareholders.

Another tactic is to simply bring the activists into the company before it goes public (i.e. giving a
board seat).

If none of these works, there are techniques that can be used, such as the poison pill, which has been
tailored to prevent activists from acquiring too large a stake. (I.e. Safeway adopted a novel shareholder
rights plan. It stipulated that no investor filing a 13-D, which designates an activist, could acquire more
than 10 percent of the company. Passive investors, however, filing 13-G forms, could acquire up to 20
percent). However, this tactic is of limited use because most activists don’t want to own the company,
they just want enough stake to get the attention of other investors. This means that structural
defenses, such as poison pills and staggered boards are no longer safe enough.

Managing a Proxy Fight (on Canvas)

Proxy fights, although difficult, are eased when governance rules are known and the correct behavior is
taken.

The following are some guidelines to navigate proxy fight:

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1. Know your company’s weak spot- performing constant self-assessment of vulnerabilities and
adopting measurements give more confidence to shareholders.

2. Identify and reinforce your core message- as shareholders focus on the company’s performance,
it is advisable to obtain proof of success, when an attack is done.

3. Communication with shareholders- will provide an insight of the shareholder’s position, giving
the possibility to the board of communicating with him/her.

4. Engage with dissidents- will provide a good example for other dissidents, showing them that
they and dialogue with management. Additionally, this will give the company a better
understanding of the shareholder’s position, allowing preparing itself in case of an attack.

5. Stay focused on the facts- companies do best when relying on facts.

6. Strengthen independent boards- this is a common requirement by activists in proxy fight. Having
independent board members with independent meetings, show a strong board and
management.

7. Don’t crack messaging- the company has to be very well coordinate of what are they telling to
dissident shareholders. They must observe confidentiality and choose spokes person on the
company’s behalf, in order to avoid any communication issue. This lack of coordination normally
serves for a dissident to claim that management is poorly run.

8. Know when to react to an activist claim and when not to- failing in doing this could bring
negative results giving more credence than necessary. Also, selective responses have a more
positive attention.

9. Think ahead- prepare press statements and legal documents in case of an attack, as activists
move fast. It is important to anticipate to every move.

10. Be flexible- if something comes up that wasn’t anticipated, you need to take smart decisions.

11. Mismanagement of a proxy fight- a proxy fight can be lost, even without merit, but for failure to
communicate and by applying the wrong strategy, such as:

a) taking non-critical commitments: in this case, it is important to adopt new strategies to

improve the business;

b) changing policies to disadvantaging dissidents;

c) replying to personal attacks- make you loose votes in the long term;

d) Refusing to interact with dissidents;

e) Assuming that shareholders and media will not believe on dissidents’ arguments;

f) Allowing management to dominate the board, as this is a potential warning sign to

investors and open invitation to activists. This also occurs when having a divided board.

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 g) Complicated and unclear messages from the company;

h) Changing strategies and course of action away from the long-term objectives of the
company due to a dissident, as this shows a lack of commitment to the company;

i) Being inflexible with dissidents as a sign of strength- openness allows a dissident to

suggest positive change, without threatening the company’s structure;

j) Quickly disregarding proxy advisory firms’ recommendations- they have knowledge and
experience.

Companies are also improving their defenses towards activism attacks, understanding that the best way
to avoid shareholder activism is to be successful in the business and communicate with shareholders, in
addition to prepare for any attack.

Sample Advance Notice Bylaw (on Canvas)

Procedure for Nominations by Stockholders- for this, the shareholder must have given timely written
notice of its intent delivered in the offices of the corporation. Timely notice is considered when given
between 90-120 days in advance of the anniversary of the previous year's annual meeting. If the
meeting is called for a date that is not within 25 days before or after such anniversary date, it will be
considered a timely notice when it was given u to 10 days after the annual meeting notice was received,
whatever occurs first.

If the decision to elect directors will be held in a special meeting, the timely notice set above will be
considered when given no later than 10 days after the notice of such meeting was received or the public
disclosure of the date was made, whatever occurs first. No postponement or adjournment provides a
new period of time for providing such notice.

Proper written form of the notice: (i) person nominated and its information (name, age, occupation,
class and number of shares owned in the company by that person); (ii) if elected, intends to tender,
promptly following such person's failure to receive the required vote for election or reelection at the
next meeting at which such person would face election or reelection, an irrevocable resignation
effective upon acceptance of such resignation by the Board of Directors; (iii) signed questionnaire; (iv)
other information of the nominee that is required to be disclosed in the proxy statement or filing
requests according to section 14 of Exchange Act; (v) as to the Proponent and the beneficial owner, if
any, on whose behalf the nomination is being made: information of such person, including the class and
number of all shares of capital stock of the Corporation that are owned by each such person (beneficially
and of record) and owned by any holder of record of each such person's shares; (vi) a description of any
agreement with respect to such nomination between or among each such person and any of its
affiliates; (vii) a description of any agreement that has been entered into by, or on behalf of, each such
person or any of its affiliates, the effect or intent of which is to mitigate loss to, manage risk or benefit of
share price changes for, or increase or decrease the voting power of each such person or any of its
affiliates or associates with respect to shares of stock of the Corporation, and a representation that the
Proponent will notify the Corporation in writing of any such agreement; (viii) a representation that the
Proponent is a holder of record or beneficial owner of shares of the Corporation entitled to vote; (ix) a

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representation whether the Proponent intends to deliver a proxy statement and/or form of proxy to
holders of at least the percentage of the Corporation's outstanding capital stock required to elect the
nominee and/or otherwise to solicit proxies from stockholders in support of the nomination, and (x) any
other information relating to each such person that would be required to be disclosed in a proxy
statement or other filing required to be made in connection with the solicitation of proxies for election
as directors pursuant to Section 14 of the Exchange Act, and the rules and regulations promulgated
thereunder.

CLASS 11

 Sothby’s Case Study:

Putting the Tools to Work
 What motivated Third Point?
 What was Third Point’s objective?
 What filings did Third Point have to make?
 What role did other investors have?
 What about ISS?
 What were Sotheby’s initial responses?
 When did Sotheby’s adopt its pill?
 Was the pill validly adopted? What standard was applied?

 Sothby’s Case Study

 Stock price up 70%, but revenue lagging
 Third Point/Daniel Loeb
 Expenses too high, missing expansion opportunities
 Creeping purchases (.75%, 3.6%, 5.7%, 9.4%)
 Marcato “white paper” urging cash distribution
 Marcato (6%), Trian (3%)
 Wolfpack – no agreement; no “arrangements”
 Loeb letter
 Expenses, underperformance, CEO compensation
 Sleepy Board
 Sothby’s Case Study (cont.)
 Communication - outreach to Loeb
 $450 million stock buyback
 Offer of Board seat to Loeb - rejected
 Public campaign for 3 Board seats
 Respectable candidates
 Flurry of “fight letters” – see EDGAR file
 Private solicitation
 ISS supported Loeb
 Poison pill adopted

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  Challenged in court
 Pill Litigation - Unocal
 Legally cognizable threat?
 Process
 Board independent
 No evidence of entrenchment
 No staggered Board
 Competent legal advisors
 Reasonable determination of threat
 Creeping control/ wolfpack
 Attempt to gain control without premium
 Reasonable in relation to threat?
 Not preclusive or coercive
 Proportionate, given the threat
 Within “range of reasonableness”
 Two tier trigger?
 Negative control

Brown Ch. 8 (pp. 607-615) A Truce at Sotheby’s After a Costly and Avoidable Battle 13;

Third Point LLC v. Ruprecht

Third Point LLC. is an activist hedge fund and stockholder of the corporation. The other
plaintiffs are institutional stockholders who purport to represent the interests of the
corporation’s stockholders other than the hedge funds.

Defendants are members of the corporation’s board.

Sotheby’s is a global art business and primarily focuses on acting as agent for high-end art sales.
Christie’s is a competitor. When it comes to attracting employees, Christie’s and Sotheby’s are in
“zero sum” game, in which a loss for one translates into a gain for the other.

In 2013, several hedge funds accumulating its stock simultaneously, and at least as to Third
Point, the accumulation was occurring on a relatively rapid basis.

 Hedge funds, including Third Point, begin to purchase Sotheby’s stock. On May 15,
2013, in a Form 13F (quarterly report filed per SEC regulations by institutional
investment managers to the SEC containing all equity assets under management of at
least $100 M in value) filed with the SEC, Third Point disclosed that it had acquired
500,000 shares of Sotheby’s stock.
 Trian Fund Management (“Trian”) another activist hedge fund had acquired 250,000
shares.

13
http://dealbook.nytimes.com/2014/05/05/a-truce-at-sothebys-after-a-costly-and-avoidable-battle/

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  Marcato, another activist fund, filed a 13D (Note: §13(d) Early Warning Reports
required to be filed when on acquire more than 5% Equity security) disclosing the
acquisition of 6.61% of common stock.
 Trian filed a 13D-revealing that as of June 30, 2013- acquired over 2M shares-3% of the
company, then in On August 26, it had acquired a 5.7 stake. According to the filing,
Third Point intended to “engage in a dialogue with members of the Board of
Management” and also might pursue discussions with other stockholders or
“knowledgeable industry or market observers”.
 October 2, 2015- another 13D report from Third Point- shares increased to 9.4%.
Attached to the Schedule 13D was a letter from Leob raising several concerns:
1. Sotheby’s chronically weak operating margins and deteriorating competitive
position relative to Christie’s
2. Ruprecht’s (CEO) generous compensation package
3. Sleepy board and overpaid executive team
4. Lack of expense discipline.

On October 4, the Board unanimously approved the rights plan.

Under the Rights Plan’s definition of “Acquiring Person, those who report their ownership in
the Company pursuant to Schedule 13G may acquire up to a 20% interest in Sotheby’s. A
person is eligible to file a Schedule 13G only if, among other things, they have “not acquired the
securities with any purpose, or with the effect of, changing or influencing the control of the
issuer, or in connection with or as a participant in any transaction having the purpose or effect”
and they own less than 20% of the issuer’s securities. All other stockholders, including those
who report their ownership pursuant to Schedule 13D, such as Third Point and Marcato, are
limited to a 10% stock in the Company before trigging the Rights Plan or “poison pill”.

On March 13- Third point filed 13D- disclosing 9.62% of Sotheby’s stock. It sent a letter to
Sotheby’s requesting that it be granted a waiver from the Rights Plan’s 10% trigger, and allow it
to purchase a 20% stake in the company. The request was denied.

The October 2013 adoption of the rights plan.

Activist investors Third Point et al. file an action for preliminary injunction to enjoin the
enforcement of the rights plan. They do not win.

Analysis

1. The Plaintiffs do not have reasonable probability of success as to the first prong of
Unocal.

Sotheby followed the process: The board is majority independent directors; retained competent
outside financial and legal advisors- prima facie showing of good faith and reasonable
investigation.

There is sufficient support for the Board’s assertion that Third Point posed a legally cognizable
threat, and the treat is objectively reasonable.

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Third Point presented an objectively reasonable and legally cognizable threat to Sotheby’s.
Creeping Control. At the time the Board had adopted the Rights Plan in October 2013, it had
several hedge funds accumulating its stock simultaneously, and at least as to Third Point, the
accumulation was occurring on a relatively rapid basis. Advisors informed board that it was
not uncommon for activist hedge funds to form a group or “wolfpack.”

2. The “primary purpose” of the October 2013 adoption of the Rights Plan was not to
interfere with the stockholder franchise. It was motivated to address a control threat. There is
also no evidence that the Board wanted to entrench themselves. The Board is not staggered,
turns over at an above average rate and dominated by outside independent directors.

3. Plaintiffs have not shown they have a reasonable probability of success as to the second
prong of Unocal.

The reasonableness of the Board’s response is evaluated in the context of the specific threat
identified-the specific nature of the threat sets the parameters for the range of permissible
defensive tactics at any given time. When evaluating whether a defensive measure falls within
the range of reasonableness, the role of the Court is to decide “whether the directors made a
reasonable decision, not a perfect decision.” Courts applying enhanced scrutiny under Unocal
should “not substitute their business judgment for that of directors” and if, on balance, “a board
selected one o several reasonable alternatives, a court should not second-guess that choice.”

Was the adoption of the Rights Plan a reasonable and proportionate response to the threat of creeping
control?

The 10% threshold was reasonable: Third Point was working in connection with one or more
other hedge funds in an attempt to create a control block with the company’s stockholder bases.
A trigger level much higher than 10% could make it easier for a relatively small group of activist
investors to achieve control, without paying a premium, through conscious parallelism.

The provision of the plan that allows passive investors to buy 20% while activist stockholders
cannot purchase more than 10%, while seemingly discriminatory is reasonable considering that
the Rights Plan was adopted to address a threat of creeping control.

b. The refusal to waive the 10% trigger in March 2014

1. Plaintiffs have not shown they have a reasonable probability of success as to the first
prong of Unocal.

A Truce at Sotheby’s After a Costly and Avoidable Battle

Sotheby made a sufficient showing as to at least one objectively reasonable and legally
cognizable threat: negative control. Plaintiffs are correct that the Delaware case law relating to
the concept of negative control addresses the situations in which a person or entity obtains an
explicit veto right through contract or through a level of share ownership or board
representation at a level that does not amount to majority control, but is nevertheless sufficient
to block certain actions that may require, for example, a supermajority. The evidence currently
available indicates that Sotheby’s may have had legitimate real-world concerns that enabling

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individuals or entities such as Loeb and Third Point, to obtain 20% as opposed to 105
ownership interest in the Company could effectively allow those persons to exercise
disproportionate control and influence over major corporate decisions, even if they do
not have an explicit veto power.

The notion of effective, rather than explicit, negative control obviously raises some
significant concerns, chief of which is were does one draw the line to ensure that “effective
negative control” does not become a license for unreasonable defensive measures. In this
case however, there is objective reasonable basis to believe that Third Point could exercise
effective negative control over the company.

3. The refusal to grant Third Point a waiver for 10% trigger falls within the range of
reasonableness.

Ancillary impact of litigation

And in April 2013, Mr. Loeb and Third Point arrived. Third Point eventually took a 9.6 percent
stake, while other hedge funds like Marcato Capital Management entered the picture. Mr.
Loeb’s arguments for change at Sotheby’s varied over time, but they essentially boiled down to the
complaint that Sotheby’s was spending too much and not seizing opportunities to expand its
business.

What happened next was a year of dancing. Sotheby’s did what companies usually do in these
situations: The art house announced some changes to corporate governance and some
shareholderfriendly moves — in its case, a $450 million share buyback.

Mr. Loeb was not satisfied. Although he was twice offered a board seat, he turned it down. It is
here that the competing narratives take place: Sotheby’s says it always wanted to
compromise, but Mr. Loeb stated at the time that one seat was not enough to effect change.

Things became heated when Third Point nominated three directors and Sotheby’s responded by
adopting a poison pill, limiting Mr. Loeb’s stake to less than 10 percent.

What happened next was more wasted money and time as the parties litigated the validity of
the poison pill. Sotheby’s knew that it had the upper hand and Delaware law was on its side.
But for Mr. Loeb, winning the litigation wasn’t as important as deposing the Sotheby’s
directors in the hope that he could find some ammunition for his fight. In other words,
Sotheby’s overreached with the poison pill and gave Mr. Loeb an opening to inflict damage.

Mr. Loeb came up a winner in the litigation tactic that Sotheby’s handed him. Mr. Loeb lost the
case, but in the hearing before a court in Delaware, emails sent among the Sotheby’s directors
came out with some damning stuff. Steven B. Dodge, the lead independent director, stated
that the board “is too comfortable, too chummy and not doing its job” to another director.
Another email stated that at least in part Mr. Loeb was “right on the merits.”

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In truth, these words led to more public-relations problems than anything else and yet another lesson
that people need to be careful about what they write in an email. The emails were perhaps the tipping
point, but didn’t change the truth that Sotheby’s was most likely going to lose the election.

Sotheby’s two largest shareholders (and four of the top 10) were hedge funds, according to Capital IQ.
Institutional Shareholder Services, the proxy advisory firm, came out in support of two of Mr.
Loeb’s nominees. And institutional shareholders have a tendency to support dissidents when there are
identifiable weaknesses in a company (although others would say they are just following the herd).

In these situations, the rule is to compromise and give the hedge funds the seats.

According to FactSet’s corporate governance database, SharkRepellent, there were a record 16

campaigns in the first two months of 2014 in which an activist was granted a board seat. Last year, 80
percent of activists were granted a seat before a proxy campaign was even completed. And 60 percent
of proxy contests that went the distance were won by activists. According to SharkRepellent, even Carl
C. Icahn has stated that he is “surprised” that he is being offered board seats so often to forestall a
campaign.

This not only means that compromise is the preferred route, but it is becoming the case before a proxy
contest gains traction.

So the question is, what happens next at Sotheby’s?

Mr. Loeb has elected his three directors, but two of the independent nominees that Sotheby’s named
during the fight, Jessica Bibliowicz and Kevin C. Conroy, are being kept on as a face-saving move for
Sotheby’s. This makes for an unwieldy 15-person board. Sotheby’s poison pill — which cost millions to
litigate — will also be terminated, but Mr. Loeb is limited to a 15 percent stake in the company.

Sotheby’s will try to move forward, but the issue of credibility will remain with so many directors staying
on.

Sotheby’s statements on Monday were about reconciliation. “We welcome our newest directors to the
board,” said Mr. Ruprecht, the firm’s chief, adding that Sotheby’s “will benefit from five fresh voices and
viewpoints.”

Day 12 – 23/08/2018

 EXECUTIVE COMPENSATION
 Excessive Compensation

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 SEC Compensation Disclosure
SEC regulations tend to focus primarily on disclosure, lets get the facts out there and
let people decide.
 Types of Compensation
 Substantive Regulation
 Compensation Committee
 Legal Standards
 Disney – Duty of Care
 Waste
 The Future
 Excessive Compensation?
Compensation levels are pretty high. Tim Cook, if over a three year period, Apple
outperformed two-thirds of the S&P 500, an index tracking 500 of the biggest public
U.S. companies, get a large chuck of stock (now amounting close to $200M). Apple
outperformed 81% of the stocks in the index.
 Current levels higher than ever
 Median 2017 CEO compensation = $15.7mm
 Compare to foreign counterparts
 Significant impact on income inequality
 Result of performance-based compensation:
 Bonus/equity
 Supplement to fixed salary
 Align with interests of shareholders
 Be careful what you wish for
 Consultant metrics – egos
Board wants to feel they have hired the best CEOs. CEO wants to feel that he is the best.
 Posner – “board capture”?
 Attempts to Restrain?
 Pay for performance
 Tie to results; no performance, no bonus
 IRS Sec 162(m)- executive compensation, we are going to cap it to a million
dollars. Not significant. But there was exception: you could deduct if it was
incentive based, performance based-tied to performance.
Section 162(m)(1) disallows the deduction by any publicly held corporation for applicable
employee remuneration paid to any covered employee to the extent that such
remuneration for the taxable year exceeds $1,000,000. So you can deduct if
compensation, incentive based, performance based.

 Equity compensation
 Incentive increase stock price
 Accounting treatment – no hit to income
 Regulatory initiatives
 Disclosure
 Engagement – “say on pay”
 Shaming – pay ratio disclosure

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In coming months, a new corporate disclosure could add fuel to the debate over executive pay and
inequality. In 2010, as part of the Dodd-Frank Act, Congress passed a rule that requires public
companies to disclose the ratio of the C.E.O.’s pay to the median compensation at the firm. The main
objective was to give shareholders a yardstick for comparing pay practices across companies.

However, productivity can’t come from the person at the top of the pyramid alone, you want a well-
compensated work force to bring productivity and the execution to improve the bottom line.

The ratio has plenty of opponents in corporate America, who argue that it will be expensive to calculate
and won’t provide useful insight into how companies are really paying workers.

Alternative ratio would compare the chief executive’s pay to the federal minimum wage, a number that
would not cost companies anything to calculate. It could also serve another function: another option
would be eliminating any tax deductibility for executive compensation that is more than 100 times the
minimum wage.

 Recoupment – clawback
 Governance and legal
 Legal Landscape
 SEC
 Required Disclosure
 Substantive Regulation

COMPENSATION AND THE SEC

In adopting the Exchange Act, Congress provided SEC with a process, it was assigned the task of ensuring
adequate disclosure of compensation.
Among innovation was the use of “summary compensation table”. Such table included all forms of
compensation including salary, bonuses, stock awards, option awards, non-equity incentive
compensation, deferred compensation and “other compensations”.
The new requirements mandated disclosure of the compensation paid to the CFO, in addition to the
CEO. Director compensation for the first time had to appear in tabular form that included total
compensationThe New Compensation Discussion and Analysis alsocalls for a discussion and analysis of
the material factors underlying compensation policies and decisions reflected in the data presented in
the tables”
In order words, disclosure shifted from amount to process, presumably with the intent to influence the
manner in which compensation was calculated.

COMPENSATION DISCLOSURE
Executive compensation is disclosed in the annual report on Form 10K and in proxy statement. However,
it appears in the proxy statement and is incorporated by reference into the annual report.
The instructions for the disclosure of executive compensation appear in 402 of Regulation S-K.
Item 402 “requires clear, concise and understandable disclosure of all plan and non-plan compensation
awarded to, earned by, or paid to the named executive officers”. The term “earned by” is deliberate.
Total compensation does not reflect an amount actually paid to the relevant officer. It involves the value
of certain benefits, such as perquisites or stock options, as of a specified date.

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One of the areas that has proved difficult to regulate has been the disclosure of perquisites. The
summary of compensation marked in Item 402(c) must include all “other compensations” paid to CEO
and CFO. This includes value of any “perquisites and other personal benefits, or property, unless the
aggregate amount of such compensation is less than $10,000.” i.e. corporate aircraft, country club dues,
installation of security system in officer’s house, etc.
A perk can have a business and personal purpose. Deciding which of these benefits must be treated as
compensation has not always been easy. The SEC amended Item 402 and provided substantial additional
guidance.

 Stock Exchanges – Comp Committee

 Delaware Law
 What fiduciary standard applies?
 SEC Compensation Disclosure
 “Sunlight is the best disinfectant”
 Summary Compensation Table
Layouts the content and composition of compensation and this table applies to
information with respect to CEO and CFO and the next, three highest paid executive
officers.
 CEO
 CFO
 3 highest paid “ executive officers”
 Vice president of principal business unit
 Performs policy-making function
 CD&A

Compensation disclosure analysis it sets out the design, objectives of compensation package
and how this was applied. Why performance metrix is reasonable and how it has been met.
 Types of Compensation
 Salary
 Bonus
 Earned vs. paid
Earned in that year, accrual concept of where regardless when the bonus was
paid.
 Stock Award
Restricted stock- I am going to give you stock but you cannot have it, or it will vest in
three years. Restrictive stock units- same definition. Gives you the incremental
increase, the restricted shares- you get the whole value, not just the increase. You get
stock that you don’t pay for.
 Option Awards

You get the right award to buy stock at a certain price, and you can exercise this right, if
the price of stock has gone up, there is value, you can exercise and pay the exercise price.
 Non-equity Incentive Compensation
What Tim Cook got except that he got the right to get money. Bonus fixed at the
beginning of the three year period. He will get money and not shares.
 Pension

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 Change in pension value
 Deferred Compensation
Sometimes they have a right to receive the compensation deferred for tax purposes.

This was an issue of executive activist, pressure board of directors to prepare a term sheet. In
Disney, Michael Ovitz, the question is whether the board were informed that provision of his
employment package, that accelerated the salary. This drove this type of disclosure.
 Other Compensation - Perqs
 Life Insurance
 Retirement Plan Contributions
 Perquisites
Sensitive to stockholders, prone to abuse, linguistic gymnastics.
 Use of Aircraft, Leased Automobile
 Clubs/Financial and Tax Planning
 Moving/Housing/Security

 Termination Benefits - Ovitz

 Is Disclosure Enough?
 Compensation still increasing!
 Do shareholders care?
 Is disclosure too complex?
 Does shareholder influence in executive compensation conflict with the Directors’
obligation to manage?
 What is the “fair” thing to do?
If the levels of executive compensation were at more moderate levels.
 Substantive Regulation
 IRS Section 162(m)
From Enron, Sarbanes Oxley
 $1mm limit on deductibility of compensation
 Exception for performance-based compensation
 Shareholders must approve every five years
 Unintended consequences
 Eliminated in 2018 tax reform act
 Exchange Act §13(k) – loans to officers
 Prohibits personal loans of any kind
 What is a personal loan?
You cant loan money to executives.
 Applies to directors and executive officers
 Clawbacks
 Sarbanes-Oxley §304
. Congress responded by adopting Section 304 of SOX. The provision made claw backs
mandatory where a restatement occurred as a result of misconduct. While not specifically
expanding the Commission’s authority, the provision provided a potential mechanism for
affecting compensation practices. Despite the previous, the provision sat unused for the first 8
years after adoption of SOX.

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 One formulation that applies to CEO and CFO. If the company is required to restate or
publish its earnings and then discover that the company did not make the same money
or expenses not as stated, the rules required to republish. Required to republish
because of required misconduct.

And if you are CEO and CFO, you need to return everything: performance based
compensation and stock month profits, 12 months prior to original release the one that
was wrong. There is no requirement that misconduct was CEO or CFO. The policy is
that there has to be more personal responsibility. CEO and CFO has to attach a
certification that the statements are accurate. One of those certificates have a criminal
liability consequence.

 CEO and CFO

 Restatement resulting from misconduct
 Performance-based comp and stock profits
 12 month following release of original financials
 No personal wrong-doing required
 Dodd-Frank – proposed – via exchanges
Imposed an obligation to require exchanges, and not just CEO and CFO but the current
and former executive officers. It’s a broader scope of people. This is triggered by an
restatement- there is no need for misconduct. You need to recalculate on the correct on
statements, and give back excess. Also three year look back.
 Current and former executive officers
 Any restatement – no fault
 Excess incentive comp
 Three year look back from restatement
Trump impact uncertain
 Is Disclosure Enough?
 Compensation still increasing!
 Do shareholders care?
 Is disclosure too complex?
 Does shareholder influence in executive compensation conflict with the Directors’
obligation to manage?
 What is the “fair” thing to do?
 Substantive Regulation
 IRS Section 162(m)
 $1mm limit on deductibility of compensation
 Exception for performance-based compensation
 Shareholders must approve every five years
 Unintended consequences
 Eliminated in 2018 tax reform act
 Exchange Act §13(k) – loans to officers
 Prohibits personal loans of any kind
 What is a personal loan?
 Applies to directors and executive officers

34 Act Rule 14a-21

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 § 240.14a-21 Shareholder approval of executive compensation, frequency of votes for
approval of executive compensation and shareholder approval of golden parachute
compensation.

Board are not monitoring. They are backscratching- board composed of former CEOs
Insider lending prohibition under Section 13(k) of the Securities Exchange Act of
1934, as added by Section 402 of the Sarbanes-Oxley Act. This section prohibits
both domestic and foreign issuers from making or arranging for loans to their
directors and executive officers unless the loans fall within the scope of specified
exemptions

Executive Compensation
Excessive Compensation/History

Executive Pay: Invasion of the Supersalaries

http://www.nytimes.com/2014/04/13/business/executive-pay-invasion-of-the-supersalaries.html?_r=0

The proxy statements of the nation’s largest corporations contain information of how to finely calibrate
the pay of top executives with company performance.

The Coca-Cola board: CEO compensation = base salary x base salary factor x business performance
factor. It explains how a failure to achieve certain goals helped limit the bonus to $2 million, but also
describes how Mr. Kent got millions more in stock and options.

This system of compensation has a dark side and incentivize inequality.

The current system of executive compensation, with its emphasis on performance, can theoretically
constrain pay, but in practice it has not stopped companies from paying their top executives more and
more. The median compensation of a chief executive in 2013 was $13.9 million, up 9 percent from 2012.

The pay-for-performance metrics — particularly the idea of paying executives with stock to align their
interests with shareholders — may even have amplified that trend. In some ways, the corporate
meritocrat has become a new class of aristocrat.

High executive pay has contributed to the widening gap between the very rich and everyone else.

Two-thirds of the increase in American income inequality over the last four decades can be attributed to
a steep rise in wages among the highest earners in society. This, of course, means people like the C.E.O.s
in the Equilar survey, but also includes a broader class of highly paid executives. Mr. Piketty calls them
“supermanagers” earning “supersalaries.”

Among C.E.O.s of the 100 largest companies (by revenue) that had filed proxies by April 4, some 26 had
been given a pay cut.

200
The stocks of many companies posted robust performance in 2013, which could also help drive C.E.O.
pay higher.

Rupert Murdoch of 21st Century Fox made $26.1 million for the 2013 fiscal year, during which his
company’s stock rose 46 percent. Disney’s shares didn’t fare quite as well, gaining 23 percent, and its
chief executive, Robert A. Iger, was given a 7 percent pay cut. Still, he made $34.3 million, the second-
highest total in the survey. Zenia Mucha, a Disney spokeswoman, said in an email that 93 percent of
Mr. Iger’s compensation was based on performance.

Wall Street executives are still royally rewarded, but the C.E.O.s of financial firms did not often figure in
the upper echelons of the pay survey. Lloyd C. Blankfein of Goldman Sachs, who made nearly $20
million, was the highest-paid chief executive at a regulated Wall Street firm. But Mr. Blankfein’s
compensation was a mere fraction of some of his peers’ in the so-called shadow-banking sector, where
regulation is much lighter. 

Of the 100 executives on the Equilar list, only nine were women. The highest-paid, Phebe N. Novakovic
of General Dynamics, earned $18.8 million, an amount that placed her behind 20 men in the ranking.

The two lowest-paid executives in the survey were Warren E. Buffett of Berkshire Hathaway and Larry
Page of Google — with Mr. Page earning a symbolic $1. But they aren’t hurting financially: Both are
founders and own stakes in their companies that are worth many billions.

No Perfect Incentives

Executive pay has undergone many changes in recent years to make it more shareholder-friendly. As
well as including a plethora of performance metrics, proxies have become more transparent and easier
to understand. And shareholders have been given ways to express dissatisfaction over compensation in
“say on pay” votes.

But to some skeptics, the new metrics have become an elaborate means to rationalize excessive pay.
“The problem with the pay-for-performance approach is that it is simply impossible to create perfect
incentives,” Lynn Stout, a law professor at Cornell and a critic of the current compensation system. “And
if you try, you may in fact create bad incentives.”

Ms. Stout places much blame on a crucial tax-code change made in the early 1990s. The rule
eliminated tax deductions on compensation above $1 million that wasn’t linked to
performance. The change, she said, helped prompt widespread use of pay-for-performance
metrics. But as that trend grew, pay kept climbing even when shareholder returns suffered.
“I think it’s fair to say that the experiment has failed,” Ms. Stout said.
Stock-based compensation — options and shares combined — has risen as a percentage of overall pay in
recent years. It was 63 percent of the total in 2013, up from 60.2 percent in 2006, according to Equilar.
This is meant to be a good thing: Paying in stock can motivate executives to get the share price higher,
which, of course, will benefit shareholders.

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But as corporate boards place their faith in stock-based plans, they may decide to award even more
stock, and when the market is rising, that can lead to enormous paydays when executives eventually
cash out. The compensation apparatus, despite its checks and balances, ends up pushing pay ever
higher.

Government policy makers can continue to leave the pay machine alone, in the belief that they should
do little to influence the rules of business. But that stance may be harder to maintain if executive pay
continues to be the main cause of income inequality.

One remedy might be to extend potentially attractive stock and options awards deeper into the ranks.
That already happens at some technology companies, but is not as widespread in companies with lower-
paid work forces.

Coca-Cola’s new stock plan, for instance, is available to only 5 percent of its work force. Critic - “You
want people who are motivated and you don’t want people who resent the top people”.

In response, Gloria K. Bowden, a Coca-Cola associate general counsel, said, “This plan covers a
large number of employees — 6,400 employees, currently — and it’s just one method we have to
provide stock ownership to employees.” The company, for instance, encourages stock ownership
through its 401(k) plans.
Some rank-and-file employees aren’t interested in gambling on the upside of stock. They would
just like to be paid more in cash.
“I don’t think there is anyone who’s doing a job that’s worth that amount,” said Mr. Jordan, who favors
more profit-sharing for workers. “The business structures in this country have just got to change so
there is more profit-sharing.”

C.E.O.s vs. Average Joes

In coming months, a new corporate disclosure could add fuel to the debate over executive pay and
inequality. In 2010, as part of the Dodd-Frank Act, Congress passed a rule that requires public
companies to disclose the ratio of the C.E.O.’s pay to the median compensation at the firm. The main
objective was to give shareholders a yardstick for comparing pay practices across companies.

However, productivity can’t come from the person at the top of the pyramid alone, you want a well-
compensated work force to bring productivity and the execution to improve the bottom line.

The ratio has plenty of opponents in corporate America, who argue that it will be expensive to calculate
and won’t provide useful insight into how companies are really paying workers.

Alternative ratio would compare the chief executive’s pay to the federal minimum wage, a number that
would not cost companies anything to calculate. It could also serve another function: another option
would be eliminating any tax deductibility for executive compensation that is more than 100 times the
minimum wage.

Some support a substantially higher tax rate for top earners.

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Congress is highly unlikely to approve a higher tax rate anytime soon. But there are people that are
optimists and think that things can change faster than we think.

Brown Ch. 6, pp. 360-363

A. More on the Structural Issues

CEO compensation is typically determined by the board, which in turn are elected by the shareholders.
As a result, shareholders can oust a board that pays what is perceived to be excessive compensation.
Yet, this straightforward system is not quite as straightforward as it seems.

Richard A. Posner, Essay: Are American CEOs overpaid, and, if so, What if anything should be done
about it?

American CEOs are paid on average about twice as much as their counterparts in other countries. This is
not because Americans earn more than their foreign counterparts.

The proximate cause of American CEOs´ higher incomes is that salaries are a much smaller fraction of
their compensation than of foreign CEO´s incomes – less than half – with the rest consisting partly of
bonuses buy mainly stock options.

The difference is due in part to the fact that foreign firms, inhibited by culture and sometime by law in
their ability to economize on labor costs, have less power to influence the profitability and hence market
capitalization of their firms.

The more effective shareholder monitoring is, the less need there is for incentive-based compensation.

Monitors who are not monitored are imperfect agents of their principal, and so in the absence of
effective monitoring of directors by shareholders, boards have weak incentives to limit CEO
compensation.

The problem is exacerbated by the fact the board is likely to be dominated by highly paid business
executives, including CEOs of their companies. They have a conflict of interest, since they have a
financial stake in high corporate salaries, their salaries being determined in part by the salaries paid to
persons in comparable position in other companies.

They also have the phycological tendency to believe that the salaries of corporate executives accurately
reflect executive´s intrinsic worth. People always believe the are underpaid, never overpaid.

In addition, directors devote only a fraction of their time to the company.

If they are:

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  Inside directors (full time employees of the corporation): they have a conflict of
interest;

 Outside (independent) directors: they have less access to information about the
company and a smaller stake in the corporation´s success.

That´s why there is no persuasive evidence that a corporate performance is positively correlated with
the percentage of independent directors on the board. Many outside directors have no experience in
the business.

CEOs influence the selection of inside and outside directors. Mutual assistance: directors can authorize
generous compensations for the CEO and the CEO supporting generous fees for the directors.

CEOs hire and pay auditors who certify the correctness of the corporations´ financial statements, dangle
consulting contracts in front of auditors who also offer consulting services, and can influence securities
analysts´ reports by steering underwriting fees to investment banks who analysts give their companies
glowing reports.

If directors choose and pay a top dollar executive, they can hide themselves form criticism if the
company performs poorly, by saying that they hired the best candidate. Conversely, if they pick the
second-best candidate, they can be accused of being pound foolish.

The consulting firms that advise directors on how to hire and compensate their CEOs tend to compare
the compensation with equivalent firms and this comparison tend to increase the rages of
compensation. The compensation consultants have a conflict of interest because they also sell other
consulting services.

And almost always the CEO is also a member of the board. The board participates in shaping corporate
strategy. This makes it complicit in the CEO´s decisions and reluctant by firing him or cutting his pay to
acknowledge a mistake for which it may be jointly responsible.

Comments and Questions

1. Judge Posner notes differences in the structure of executive compensation between CEOs in US and
elsewhere. What might be the impact of this difference in structure, particularly the more common
use of stock options as a significant portion of compensation in the US?

2. What does it mean that shareholders monitor the compensation? What are the limits for such
monitoring?

3. Is the problem executive compensation or CEO compensation?

The amount of compensation paid to CEOs relative to other officers has increased.

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 Judge Posner notes that the difference in compensation of CEO and officers under CEO is
pronounced.

4. Isn´t the power to replace the board enough to ensure effective monitoring?

Clawbacks
392-394
COMPENSATION AND THE SEC
In adopting the Exchange Act, Congress provided SEC with a process, it was assigned the task of ensuring
adequate disclosure of compensation. Unsurprisingly, therefore, some regulatory initiatives by the
fledging agency involved executive compensation. These rules were designed to allow “market forces,
rather than legislators or bureaucrats, to shape corporate compensation policies.”
Among innovation was the use of “summary compensation table”. Such table included all forms of
compensation including salary, bonuses, stock awards, option awards, non-equity incentive
compensation, deferred compensation and “other compensations”.
Substantial reforms occurred in 2006, the changes were designed to fill gaps left in place from the earlier
requirements. The new requirements mandated disclosure of the compensation paid to the CFO, in
addition to the CEO. Director compensation for the first time had to appear in tabular form that included
total compensation. However, such reforms went much further than the disclosure of the amounts paid.
As Commission noted:
“The New Compensation Discussion and Analysis calls for a discussion and analysis of the material
factors underlying compensation policies and decisions reflected in the data presented in the tables”
In order words, disclosure shifted from amount to process, presumably with the intent to influence the
manner in which compensation was calculated.

COMPENSATION DISCLOSURE
Executive compensation is disclosed in the annual report on Form 10K and in proxy statement. However,
it appears in the proxy statement and is incorporated by reference into the annual report.
The instructions for the disclosure of executive compensation appear in 402 of Regulation S-K.
Item 402 “requires clear, concise and understandable disclosure of all plan and non-plan compensation
awarded to, earned by, or paid to the named executive officers”. The term “earned by” is deliberate.
Total compensation does not reflect an amount actually paid to the relevant officer. It involves the value
of certain benefits, such as perquisites or stock options, as of a specified date.
One of the areas that has proved difficult to regulate has been the disclosure of prequisites. The
summary of compensation marked in Item 402(c) must include all “other compensations” paid to CEO

205
and CFO. This includes value of any “perquisites and other personal benefits, or property, unless the
aggregate amount of such compensation is less than $10,000.” i.e. corporate aircraft, country club dues,
installation of security system in officer’s house, etc.
A perk can have a business and personal purpose. Deciding which of these benefits must be treated as
compensation has not always been easy. The SEC amended Item 402 and provided substantial additional
guidance.

411
SUBSTANTIVE REGULATION OF COMPENSATION
The SEC’s authority has been expanded and is no longer entirely limited to disclosure. The first modern
attempt to substantively regulate compensation at the federal level probably involved Section 162(m) of
the IRC. The provision disallowed the deduction of amounts paid to the CEO and other top officers in
excess of 1 million. The exceptions, however, swallowed the rule. For one thing, the provision did not
apply to compensation determined based upon “performance goals”. One consequence of the provision
was to encourage greater use of stock and options as part of compensation package.
Sarbanes-Oxley Act dealt with the problem of loans to executive officers. Congress addressed these
problems in an unsubtle fashion and Section 13(k) prohibited personal loans to directors and officers,
given that these created problems.
The other issue addressed by SOX was the problem of performance-based compensation paid based
upon financial statements later found to be incorrect, often because of fraud. Congress responded by
adopting Section 304 of SOX. The provision made claw backs mandatory where a restatement occurred
as a result of misconduct. While not specifically expanding the Commission’s authority, the provision
provided a potential mechanism for affecting compensation practices. Despite the previous, the
provision sat unused for the first 8 years after adoption of SOX.

34 Act Rule 14a-21

§ 240.14a-21 Shareholder approval of executive compensation, frequency of votes for approval of
executive compensation and shareholder approval of golden parachute compensation.
(a) If a solicitation is made by a registrant, other than an emerging growth company as defined in Rule
12b-2 ( § 240.12b-2), and the solicitation relates to an annual or other meeting of shareholders at which
directors will be elected and for which the rules of the Commission require executive
compensation disclosure pursuant to Item 402 of Regulation S-K ( § 229.402 of this chapter),
the registrant shall, for the first annual or other meeting of shareholders on or after January 21, 2011, or
for the first annual or other meeting of shareholders on or after January 21, 2013 if the  registrant is a
smaller reporting company, and thereafter no later than the annual or other meeting of shareholders
held in the third calendar year after the immediately preceding vote under this subsection, include a
separate resolution subject to shareholder advisory vote to approve the compensation of its named
executive officers, as disclosed pursuant to Item 402 of Regulation S-K.
INSTRUCTION TO PARAGRAPH (A):
The registrant's resolution shall indicate that the shareholder advisory vote under this subsection is to
approve the compensation of the registrant's named executive officers as disclosed pursuant to Item
402 of Regulation S-K ( § 229.402 of this chapter). The following is a non-exclusive example of a

206
resolution that would satisfy the requirements of this subsection: “RESOLVED, that the compensation
paid to the company's named executive officers, as disclosed pursuant to Item 402 of Regulation S-K,
including the Compensation Discussion and Analysis, compensation tables and narrative discussion is
hereby APPROVED.”
(b) If a solicitation is made by a registrant, other than an emerging growth company as defined in Rule
12b-2 ( § 240.12b-2), and the solicitation relates to an annual or other meeting of shareholders at which
directors will be elected and for which the rules of the Commission require executive
compensation disclosure pursuant to Item 402 of Regulation S-K ( § 229.402 of this chapter},
the registrant shall, for the first annual or other meeting of shareholders on or after January 21, 2011, or
for the first annual or other meeting of shareholders on or after January 21, 2013 if the  registrant is a
smaller reporting company, and thereafter no later than the annual or other meeting of shareholders
held in the sixth calendar year after the immediately preceding vote under this subsection, include a
separate resolution subject to shareholder advisory vote as to whether the shareholder vote required by
paragraph (a) of this section should occur every 1, 2 or 3 years. Registrants required to provide a
separate shareholder vote pursuant to § 240.14a-20 of this chapter shall include the separate resolution
required by this sectionfor the first annual or other meeting of shareholders after the registrant has
repaid all obligations arising from financial assistance provided under the TARP, as defined
in section 3(8) of the Emergency Economic Stabilization Act of 2008 ( 12 U.S.C. 5202(8)), and thereafter
no later than the annual or other meeting of shareholders held in the sixth calendar year after the
immediately preceding vote under this subsection.
(c) If a solicitation is made by a registrant, other than an emerging growth company as defined in Rule
12b-2 ( § 240.12b-2), for a meeting of shareholders at which shareholders are asked to approve an
acquisition, merger, consolidation or proposed sale or other disposition of all or substantially all the
assets of the registrant, the registrant shall include a separate resolution subject to shareholder advisory
vote to approve any agreements or understandings and compensation disclosed pursuant to Item 402(t)
of Regulation S-K ( § 229.402(t) of this chapter), unless such agreements or understandings have been
subject to a shareholder advisory vote under paragraph (a) of this section. Consistent
with section 14A(b) of the Exchange Act ( 15 U.S.C. 78n-1(b)), any agreements or understandings
between an acquiring company and the named executive officers of the registrant, where the
registrant is not the acquiring company, are not required to be subject to the separate shareholder
advisory vote under this paragraph.

376-380
BREHM V. EISNER
In August 1995, Michael Ovitz (“Ovitz”) and The Walt Disney Company (“Disney” or the “Company”)
entered into an employment agreement under which Ovitz would serve as President of Disney for five
years. In December 1996, only fourteen months after he commenced employment, Ovitz was
terminated without cause, resulting in a severance payout to Ovitz valued at approximately $130
million.
In 1994 Disney lost in a tragic helicopter crash its President and Chief Operating Officer, Frank Wells,
who together with Michael Eisner, Disney’s Chairman and CEO, had enjoyed success. Eisner temporatily
assumed Disney’s presidency, but three months later because heart disease required the board to find a
successor to Eisner.

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Eisner’s primer candidate for the position was Michael Ovitz, leader partner and regarded as one of the
most powerful figures of Hollywood and one of the founders of Creatives Artists Agency, talent
successful agency. Eisner and Ovitz had enjoyed time together for 25years. Therefore, Eisner become
interested in recruiting Ovitz to join Disney, and shared this desire with the board on an individual basis.
Russell, a Disney director and chairman of the compensation committee, assumed the lead in
negotiating the financial terms of Ovitz employment contract. In the course of negotiations, Russell
learned from Ovitz’s attorney that Ovitz owned 55% of CAA and earned approximately $20 to $25
million a year. During the summer of 1995, Ovitz Employment Agreement (“OEA”) was negotiated.
The proposed OEA sought to protect both parties in the event that Ovitz’s employment ended
prematurely, neither party could terminate the agreement without penalty. If Ovitz walked away, for
any reason, he would forfeit any benefits remaining under the OEA and could be enjoined from working
for a competitor. Likewise, if Disney fired Ovitz for any reason other than gross negligence or
malfeasance, Ovitz would be entitled to non-fault payment consisting of $7.5 million a year and $10
million cash out payment for second tranche of options.
Late 1995, Disney compensation committee met to consider the OEA. Committee members discussed
the topics with the information provided by Russell and Watson, which also was determined as
sufficient. The committee voted unanimously to approve the OEA terms, subject to “reasonable further
negotiations within the framework of the terms and conditions” described in the OEA.
Immediately after the meeting, Disney board met in executive session. The board was told about the
reporting structure to which Ovtiz had agreed, but there was an initial negative reaction by some board
members (CFO) to the hiring was not recounted. Eisner led the discussion relation to Ovitz, and Watson
then explained his analysis and both Watson and Russell responded to questions from the board. After
full deliberation, the board voted unanimously to elect Ovitz as president.
Later, the committee approved amendments to the Walt Disney Stock Incentive Plan and also approved
a new plan in order to accommodate Ovitz requirements. Both plans were subject to board approval
and shareholders.
 Ovitz Performance as President of Disney.
Officially began October 1995, date the OEA was executed. The initial reaction was optimistic, and Ovitz
made some positive contributions while serving as president. However, by fall of 1996, it had become
clear that Ovitz was a “poor fit with his fellow executives”. By then directors were discussing that the
disconnect between Ovitz and Disney was likely irreparable and Ovitz would have to be terminated.
 Analysis:
A helpful approach is to compare what actually happened here to what would have occurred had the
committee followed “best practices” scenario, from a process standpoint. In a “best case” scenario, all
committee members would have received, before or at the committee’s first meeting a spreadsheet or
similar document prepared by compensation expert. Making different, alternative assumptions, the
spreadsheet would disclose the amounts that Ovitz could receive under the OEA in each circumstance
that might foreseeably arise.
Another variable in that matrix of possibilities would be the cost to Disney of a non-fault termination for
each of the five years of the initial term of the OEA.
The contents on the spreadsheet would be explained to the committee members, either by experts or
fellow committee member.

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Had the previous suggestions been followed, there would no be dispute over what information was
furnished. Regrettably, the committee’s informational and decisionmaking process used here was not so
tidy.
That is one reason why Chancellor found that although the committee’s process did not fall below the
level required for a proper exercise of due of care, it did fall short of what best practices would have
counseled.
 Analyzing the meetings:
The compensation committee met on September 26, 1995 and October 16, 1995. On the first meeting,
the committee approved the terms of OEA, except for the option grants, which were not approved until
October, after Disney stock had been amended to provide those options. At the September meeting, the
compensation committee considered a “term sheet” summarizing the material terms of OEA, relevantly
disclosed that in the event of a non-default termination, Ovitz would receive:
a. The present value of his salary - $1 million per year for the balance of the contract term;
b. The present value of his annual bonus payments - $7.5 million for the balance of the contract
term;
c. A $10 million termination fee; and
d. The acceleration of his options for 3 million shares, which would become immediately
exercisable at market price.
Therefore, the compensation committee knew that in the event of a no-fault termination (“NFT”),
Ovtiz’s severance package alone could be in a range of $40 million cash, plus the value of the
accelerated options. Because of the actual payout to Ovitz was approx. $130 million, which roughly $3.8
million was cash, the value of the options at the time would have been $91.5 million.
Question: Whether the compensation committee knew (at the time they approved OEA) the value of
the severance package could reach $92 million if they terminated Ovitz without a cause after one
year? Yes they were so informed.
On this question the documentation is far less than best practices. There is no exhibit to the minutes
that discloses the estimated value of accelerated options in the event of NFT termination after one year.
The only evidence was spreadsheets prepared for the compensation committee meetings.
The compensation committee members derived their information about potential magnitude of NFT
from two sources:
1. Value of the “benchmark” options previously granted to Eisner and Wells and the valuations by
Watson of Ovitz proposals, therefore were aware of the value, and a simple mathematical
calculation would have informed them the potential range of Ovitz’s options;
2. The amount of “downside protection” that Ovitz was demanding. He required a financial
protection from the risk of leaving a very lucrative and secure position at CAA, to join a publicly
held corporation to which Ovitz was a stranger and had very different culture and environment
which prevented him from completely controlling his destiny.
It is also on this record that Chancellor found that the compensation committee was informed of the
material facts relating to an NFT payout. If measured in terms of the documentation that would have
been granted if “best practices” had been followed, that record leaves much to be desired.
The Chancellor also found that dispute its imperfections, the evidentiary record was sufficient to support
the conclusion that the compensation committee had adequately informed itself of the potential
magnitude of entire severance package, including options, that Ovitz receive in the event of an early
NFT.

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Accordingly, the Court had sufficient evidentiary basis in the record from which to find that at the time
the OEA was approved the compensation committee were adequately informed of the potential
magnitudes of an early NFT severance payout.

388-390
BREHM V. EISNER
The Waste Claim
The appellant’s final claim is that even if the approval of OEA was protected by the Business Judgment
Rule (“BJR”) presumption, the payment of the severance constituted a waste. A plaintiff who fails to
rebut the BJR presumption is not entitled to any remedy unless the transaction constitutes a waste.
The Court rejected the appellants waste claim.
To recover on a claim of corporate waste, the plaintiff must shoulder the burden of proving that the
exchange was “so one sided that no business person of ordinary, sound judgment could conclude that
the corporation has received adequate consideration. A claim of waste will arise only in the rare
“unconscionable case where directors irrationally squander or give away corporate assets”. This onerous
standard for waste is a corollary of the proposition that where BJR presumptions are applicable, the
board’s decision will be upheld unless it cannot be attributed to any rational business purpose.
The claim that the payment of NFT amount to Ovitz constituted a waste is meritless on its face, because
at the time NFT amounts were paid, Disney was contractually obligated to pay them. The payment of a
contractually obligated amount cannot constitute waste, unless the contractual obligation is itself
wasteful. Accordingly, the proper focus of a waste analysis must be whether the amounts required to be
paid in the event of an NFT were wasteful ex ante.
Appellants claim that NFT provisions were wasteful because:
a. They incentivized Ovitz to perform poorly in order to obtain payment of NFT. The Court found
out that the record did not support that contention – terminating Ovitz and paying NFT did not
constitute waste because he could not be terminated for a cause and because many of
defendants have creditable testimony that the Company would be better off without Ovitz.
b. NFT provisions were wasteful in their very design;
c. Urge that although OEA may have induced Ovitz to join Disney, no contractual safeguards were
in place to retain him in that position- court says, had a rational business purpose to induce
Ovitz to leave CAA and that was the consideration. No evidence was found to support any
notion that OEA irrationally incentivized Ovitz to get himself fired;
d. NFT provisions of OEA created an irrational incentive for Ovitz to get himself fired – court found
that it was “patently unreasonable to assume that Ovitz intended to perform just poorly enough
to be fired quickly, but not so poorly that he could be terminated for a cause.

Board are not monitoring. They are backscratching- board composed of former CEOs
 Is Disclosure Enough?
 Compensation still increasing!
 Do shareholders care?
 Is disclosure too complex?
 Does shareholder influence in executive compensation conflict with the Directors’
obligation to manage?
 What is the “fair” thing to do?
If the levels of executive compensation were at more moderate levels.
 Substantive Regulation

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 IRS Section 162(m)
From Enron, Sarbanes Oxley
 $1mm limit on deductibility of compensation
 Exception for performance-based compensation
 Shareholders must approve every five years
 Unintended consequences
 Eliminated in 2018 tax reform act
 Exchange Act §13(k) – loans to officers
 Prohibits personal loans of any kind
 What is a personal loan?
You cant loan money to executives.
 Applies to directors and executive officers
 Clawbacks
 Sarbanes-Oxley §304
One formulation that applies to CEO and CFO. If the company is required to restate or
publish its earnings and tehn discover that the company did not make the same money
or expenses not as stated, the rules required to republish. Required to republish
because of required misconduct.

And if you are CEO and CFO, you need to return everything: performance based
compensation and stock month profits, 12 months prior to original release the one that
was wrong. There is no requirement that misconduct was CEO or CFO. The policy is
that there has to be more personal responsibility. CEO and CFO has to attach a
certification but that they are accurate. One of those certificates have a criminal liability
consequence.

 CEO and CFO

 Restatement resulting from misconduct
 Performance-based comp and stock profits
 12 month following release of original financials
 No personal wrong-doing required
 Dodd-Frank – proposed – via exchanges
Imposed an obligation to require exchanges, and not just CEO and CFO but the current
and former executive officers. It’s a broader scope of people. This is triggered by an
restatement- there is no need for misconduct. You need to recalculate on the correct on
statements, and give back excess. Also three year look back.
 Current and former executive officers
 Any restatement – no fault
 Excess incentive comp
 Three year look back from restatement
 Trump impact uncertain
 Practical Issues (Dodd Frank)
 Wait or implement?
 Goal: fairness or punishment
Dodd Frank (no fault; setting stage for when regulations are out, and then who are
covered, it can expand) and Sabanes Oxley- both existing.
 Triggering events

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  Fault or no-fault
 Who is covered?
 Compensation covered
 Time period
 Self-executing or discretionary – if all the conditions, then the board will require if
there will be a clawback.

Clawback Pages 811-814 Comments 1-7

Section 304, known as the “clawback provision,” imposes severe financial penalties on CEOs and CFOs—
and only those officers—if the financial statements issued by their company are determined to have
been materially inaccurate.
Section 304 provides that “if an issuer is required to prepare an accounting restatement . . . as a result of
misconduct,” the CEO and the CFO shall reimburse the company by disgorging:
(i) any bonus or other incentive-based or equity-based compensation received, and
(ii) any profits realized from the sale of company stock, during the twelve-month period following the
filing or public issuance of the financial statements that require restatement.
Only the SEC has enforcement power under Section 304; a company cannot enforce the provision
against an executive. However, Section 304 lacks any express requirement that:
(i) the CEO/CFO be shown to have been involved in, or to have had knowledge of, the underlying
misconduct, or
(ii) the compensation to be disgorged have been received based on the financial information that was
restated. Thus, on its face, Section 304 imposes strict liability on CEOs and CFOs for financial
restatements resulting from misconduct that occurs on their watch, regardless of whether they were
involved in, or even knew about, the misconduct.
1. Why did Congress include Section 304 in Sarbanes-Oxley? Other than seeking
indemnification, how might corporate executives avoid potential losses under the statute.
2. Could corporations arrange for or provide insurance protecting executives against the
right that they will forfeit their incentive based compensation?
3. Section 304 provides that “if an issuer is required to prepare an accounting restatement . . . as a result
of misconduct,” the CEO and the CFO shall reimburse the company by disgorging:
(i) any bonus or other incentive-based or equity-based compensation received, and
(ii) any profits realized from the sale of company stock, during the twelve-month period following the
filing or public issuance of the financial statements that require restatement.
What is the argument that Section 304 establishes a standard of strict liability of CFOs and CEOs
whose companies have issue restated financial statements? Does 304 permit the clawback of
bonuses, incentive-based compensation, or stock sale proceeds not alleged to have been tied to,
or affected by, the misstatements?
4. From the Act’s passage in 2002 through 2008, the SEC brought cases sparingly under Section
304. It commenced only 10 enforcement actions seeking disgorgement, and, consistent with traditional
notions of prosecutorial discretion, only did so in instances where the CEO or CFO has already been
convicted of criminal fraud.
Can you think of reasons why the Commission might opt to overlook violations? Is it correct
Section 304 is only a deterred if the SEC uses it? Should Congress instead enact a law granting
shareholders the express private right of action?

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4. Congress had “good policy reasons” for requiring that executive officers reimburse
corporations, even in the absence of allegations of conscious wrongdoing:
Apologist for the extraordinarily high compensation given to corporate officers have
long justified such pay as asserting CEOs take “great risks”, and so deserve great rewards. X x x
In enacting Section 304 of Sarbanes -Oxley, Congress determined to put modest measure of real
risk back into the equation. This is a policy decision, and while its fairness or wisdom can be
debated, its legal effect cannot. Section 304 creates a powerful incentive for CEO’s and CFOs to
take their corporate responsibilities very seriously indeed.
SEC v. Baker, 2012 WL 5499497
6. The Emergency Economic Stabilization Act of 2008, enacted in October 2008, regulated
executive compensation at financial institutions that accepted bailout funds from the federal
government. The statute provided recovery of bonuses and other incentive compensation
awarded on the basis of materially inaccurate financial data.
When it then enacted Dodd-Frank in July 2010, Congress extended the financial crisis legislation
to cover public company executives more broadly. Among other new laws, Section 954 of
Dodd-Frank, the “Recovery of Erroneously Awarded Compensation” provision, added Section
10D to the Securities Exchange Act of 1934. Section 954 requires the SEC to promulgate rules
directing public (exchange-listed) companies “to develop and implement a policy” providing:
“That in the event that the issuer is required to prepare an accounting
restatement due to the material noncompliance of the issuer with any financial
reporting requirement under the securities laws, the issuer will recover from any
current or former executive officer of the issuer who received incentive based
compensation (including stock options awarded as compensation) during the 3-
year period preceding the dame on which the issuer is required to prepare an
accounting statement, based on the erroneous data, in excess of what would have
been paid to the executive officer under the accounting restatement.
7. In July 2015, a full five years after Congress enacted Dodd-Frank, the SEC finally
proposed rules to effect executive compensation clawbacks under Section 945. Rule 10D-1, as
proposed, would prohibit listed companies from indemnifying any executive officer or former
employer against the loss of erroneously awarded compensation. The rule would prohibit the
corporation from paying or reimbursing the executive for premiums for a third-party insurance
policy purchased to fund potential recovery obligations.

Say on Pay 426-428

 Dodd-Frank Say On Pay
 Until 2010, no S/H voice re exec comp!
 Disclosure only
 “Vote with your feet”
Stockholders have a right to express their indignation. This applies to all public
companies, not just listed company, and not imposed through stock exchange
requirements. It is a legislative requirement. IT requires periodic vote on executive
compensation. It’s non-binding.
34 Act Rule 14a-21

213
 § 240.14a-21 Shareholder approval of executive compensation, frequency of votes for
approval of executive compensation and shareholder approval of golden parachute
compensation.

 All public companies, not just listed companies

 Vote on executive compensation
 Essentially a vote on CD&A
 Submit at least every 3 years
Submit say on pay at least every years.
 Also vote on frequency; most submit annually
 Vote on “golden parachutes
When you are engaged in a merger and acquisition transaction, there has to disclosure
to shareholders and opportunity to express themselves, it just advisory.
 In advance of or at time of deal
 Vote is non-binding and advisory only

 Say On Pay: Does It Matter?

 Vote is non-binding and advisory only!
The company cares a lot because of ISS because ISS policy is that if you receive less
than 70% of vote, you don’t get support, it will engage in a withhold campaign, but
more likely focused on the compensation committee.
Less than 50% , it will do a withhold campaign against the whole board. However, this
may depend on engagement of company, like if there is aggressive engagement, ISS
may be softer. Also check problematic pay practices, because this will drive ISS to do
withhold campaign.
 If >70% approval but at least 50%
 ISS action depends on issuer’s response
 May withhold from Compensation Committee
 Below 50%, may withhold from entire Board
 Big impact on shareholder engagement
 ISS Problematic Pay Practices
 Excessive amounts
Comparable analysis with same company, analysis involves looking at same healthcare
company, or big company or executive grant.
 Repricing of options
Hot botton. I granted stock option but executive does not get benefit because stock did
not go up. Some companies adjust in hindsight is not viewed positively by ISS. ISS will
insist that there be a provision in stock option will not be repriced.
 Excessive perqs and tax gross ups
Too many planes, too fancy. When we talk about severance benefit, there is a
provision, in the event of termination without cause – if you grant change of control
severance payment, company pay more so taxes will be covered by company. excise
tax payable by employee.
 Excessive change of control payments
 Option back-dating

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 Options where the paper work granted at September (earlier) and granted option at the
time of market price. Backdating the document in August.
 Pay Ratio Disclosure
 Dodd-Frank mandate – Reg S-K 402(u)
 Disclosure only - shaming purpose
To compare compensation of CEO versus the average employee. 254 to 1. Highly
controversial. Highly debated.

 Required for years beginning January 1, 2017

 First disclosure – 2018 proxy statement
 Equilar survey: median ratio 140:1
 Compare CEO to median for all employees
 Complex and burdensome – foreign employees
 Very controversial
 Meaningful to investors?
 Social vs. investment purpose
 Even some academics disfavor
 Delaware
 Duty of loyalty if CEO or other executive is on the Board
 Compensation must be “fair”
 Independent Committee now makes moot
-eliminated by duty of loyalty issue because independent committee. They can it
all by itself.
 Duty of care if (i) executive not on the Board or (ii) independent committee acts
 Van Gorkom
 BJR applies unless gross negligence (waste?)
 Board Process - Disney
 Full Board approval not required
 Board may delegate authority to Comp Committee
 No loyalty/independence issue at Committee level
 Business judgment rule applied, even though Committee failed “best practices”
Were they aware of accelerated vesting of stock awards?
 No spreadsheet showing potential NFT scenarios
 No detailed minutes
 Imperfect communication
 Remember: gross negligence (waste?) is standard
 Waste
Liability only if there is waste, this is beyond gross negligence.
 “Safety valve,” “outer limit”
 Independent of duties of care and loyalty
 Even if no conflict and improper process
 Plaintiff has burden – heavy burden
 Unconscionable – squander or give away assets
 So one-sided, no person of ordinary sound judgment
 No rational business purpose
 Compare to recklessness
 Sliding scale: loyalty (fairness), care (gross negligence), bad faith, waste
 Why not violation of duty of loyalty?

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  Back-Dating
 What is it?
 Typically at FMV at time of grant
 Setting earlier grant date
 Immediate gain
 Understatement of compensation expense
 Adverse tax consequence
 Why does it matter?
 Tax – conceals in-the-money taxable income
 Financial reporting – overstates income
 Corporate – violates duty of candor
 Spring-Loading
 What is it?
 Grant in anticipation of positive news
 Insider trading??
 Intentional concealment may create liability
 What did Board know?
 What were shareholders told?
 Why does it matter?
 No tax or financial reporting impact
 Insider trading? Who is deceived?
 Tyson case
 Disclosure to shareholders???
 What Can Be Done?
 Have initiatives been effective?
 What might be more effective?
 Who is best positioned to change?

Proxy contest in P&G as $60M

Say on Pay

Practice dubbed “say on pay”- the shareholders’ right to have an advisory vote on executive
compensation.
Dodd-Frank Wall Street Reform Act- Congress made “say on pay” mandatory for all public
companies. The SEC received the regulatory authority to implement the requirement.
Shareholder Approval of Executive Compensation
and Golden Parachute Compensation

The Dodd-Frank Wall Street Reform Act amends the Exchange Act by adding the new Section
14A.
Section 14A (a) (1) requires that “[n]ot less frequently than once every three years, a proxy or
consent or authorization for an annual or other meeting of the shareholders for which the
proxy solicitation rules of the Commission require compensation disclosure shall include a
separate resolution subject to shareholder vote to approve the compensation of executives” as

216
disclosed pursuant to Item 402 of Regulation S-K, or any successor to Item 402 (a “say on
pay”vote).
The shareholder required by Section 14A(a)(1) “shall not be binding on the issuer or the board
of directors of an issuer.”
Section 951 of the Act also adds new Section 14 (a)(2) to the Exchange Act, requiring that: [n]ot
less frequently than once every 6 years, a proxy or consent or authorization for an annual or
other meeting of the shareholders for which the proxy solicitation rules of the Commission
require compensation disclosure shall include a separate resolution to shareholder vote to
determine whether (the say on pay vote) will occur every 1,2 or 3 years. This shareholder vote
“shall not be binding on the issuer or the board of directors of the issuer.”
Section 14A(b)(1)
- In an proxy or consent solicitation material for a meeting of shareholders “at which
shareholders are asked to approve an acquisition, merger or consolidation, or proposed sale or
other disposition of all or substantially all the assets of an issuer, the person making such
solicitation shall disclose in the proxy or consent material:
Any agreements or understandings that such person has with the any named executive
officers of such issuer concerning the type of compensation (golden parachute remember?) that
is based on the merger, consolidation or sale of all or substantially all assets.
The vote on this is not binding on issuer. The vote cannot a overrule the decision of the
board. The votes shall not limit ability of shareholders to make shareholder proposal.

CATEGORIESCONTRIBUTORS HIRING BLOGROLL

The SEC Proposed Clawback Rule

Posted by Joseph E. Bachelder III, McCarter & English, LLP, on Wednesday, October 28, 2015
on The SEC Proposed Clawback Rule Comments Off Print E-Mail Tweet
On July 1, 2015, the Securities and Exchange Commission (SEC) issued Proposed Rule 10D-1 relating to
so-called “clawbacks” pursuant to Section 10D of the Securities and Exchange Act of 1934 (the
Exchange Act). Section 10D of the Exchange Act was added by Section 954 of the Dodd-Frank Wall
Street Reform and Consumer Protection Act of 2010 (DoddFrank).
(On Aug. 5, 2015 the SEC issued its final rule requiring the disclosure of the ratio of the annual pay of
the CEO to the median annual pay of all employees (excluding the CEO). Issuers subject to the rule
must comply with it for the first fiscal year beginning on or after Jan. 1, 2017. The pay ratio rule will be
the subject of a future post.)
Proposed Rule 10D-1, reflecting the statute, directs stock exchanges to require that each listed
company adopt a clawback policy and to delist any company that does not adopt, disclose and
implement such a policy.
Following is a short summary of how the clawback policy under Proposed Rule 10D-1 would work:
1. The clawback would be triggered by an “accounting restatement,” as defined below.
2. The policy would apply to “incentive-based compensation” received by an “executive officer”
during the three fiscal years(including, in some cases, a transition period as noted below)
preceding the date the accounting restatement is triggered (the “look-back period”).
3. The amount clawed back would be the amount received by the executive to the extent it
exceeds what the executivewould have received based on the accounting restatement.
4. The clawback would be “no-fault,” meaning that it would apply irrespective of responsibility of
the executive for theaccounting restatement.

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 5. The clawback would be on the pre-tax amount received by the executive.

Details of Proposed Rule

Following is a more detailed discussion of the proposed rule.
What Is an “Accounting Restatement”?
Proposed Rule 10D-1(c)(1) provides that an “accounting restatement” is a “required” revision of
“previously issued financial statements to reflect the correction of one or more errors that are
material to those financial statements.” A restatement is “required” on the earlier of the date the
listed issuer (meaning its board of directors, a committee of the board or an authorized officer)
“concludes, or reasonably should have concluded, that the issuer’s previously issued financial
statements contain a material error” or “the date a court, regulator or other legally authorized body
directs the issuer to restate its previously issued financial statements to correct a material error.”
What Is “Incentive-Based Compensation”?
“Incentive-based compensation,” as defined by Proposed Rule 10D-1(c)(4), means “any compensation
that is granted, earned or vested based wholly or in part upon the attainment of a financial reporting
measure.” The proposed rule defines a “financial reporting measure” as:
i. a measure “determined and presented in accordance with the accounting principles used in
preparing the issuer’sfinancial statements,”
ii. a measure “derived wholly or in part from” a measure described in clause (i), or
iii. stock price or total shareholder return.
Equity awards, including stock options, that are time-vested and not tied, in whole or in part, to
attainment of financial reporting measures would be excluded as incentive-based compensation under
the proposed rule. Also excluded would be awards based only on attainment of strategic measures
(e.g., a merger) or operational measures (e.g., store openings or increase in market share). The SEC’s
discussion of these exclusions is contained at pages 45-47 of the SEC Release, Listing Standards for
Recovery of Erroneously Awarded Compensation.
What Is the “Excess” Portion of Incentive-Based Compensation That Is
Subject to Clawback?
According to Proposed Rule 10D-1(b)(1)(iii):
The amount of incentive-based compensation subject to the issuer’s recovery policy (the ‘erroneously
awarded compensation’) shall be the amount of incentive-based compensation received that exceeds
the amount of incentive-based compensation that otherwise would have been received had it been
determined based on the accounting restatement, and shall be computed without regard to any taxes
paid.
Three points especially should be noted:
a. The calculation of the “excess” portion of incentive-based compensation that is subject to
clawback often will be acomplicated calculation. First, it will involve calculating the impact of an
accounting error on the financial reporting measure. Second, it will involve calculating the
consequence of that impact upon the amounts received as incentive based compensation by
individual executives.
b. If stock price or total shareholder return is the financial reporting measure for an incentive-
based compensation awardt he issuer would be required to make an estimate as to “the effect
of the accounting restatement on the stock price or total shareholder return upon which the

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 incentive-based compensation was received.” Proposed Rule 10D-1(b)(1)(iii)(A). The issuer
would be required to maintain documentation as to the basis on which it makes the estimate.
Proposed Rule 10D-1(b)(1)(iii)(B). Such an estimate is bound to be complex and likely would give
rise to disputes between not only the issuer and the SEC but also disputes involving
shareholders and the executives subject to the clawbacks.
c. As previously noted, a clawback would be on a pre-tax basis. Tax consequences to an executive
subject to a clawbackare discussed below.
When Must the “Excess” Portion of Incentive-Based Compensation Be
“Received” in Order to Be Subject to Clawback?
The “excess” incentive-based compensation award would have to be “received” during the “look-back
period” in order to be subject to clawback. Such an award is deemed “received,” according to
Proposed Rule 10D-1(c)(6), “in the issuer’s fiscal period during which the financial reporting measure
specified in the incentive-based compensation award is attained, even if the payment or grant of the
incentive-based compensation occurs after the end of that period.”
The “look-back period,” as noted at the beginning of the column, “looks back” from the date an
accounting restatement is required. It applies to the last three completed fiscal years preceding that
date. Also included would be a less-than-nine-month “transition period” that “results from a change in
the issuer’s fiscal year” and occurs during or immediately following the three completed fiscal years.
Who Is an “Executive Officer”?
Proposed Rule 10D-1(c)(3) provides that “executive officer,” for purposes of Section 10D of the
Exchange Act, means “the issuer’s president, principal financial officer, principal accounting officer (or
if there is no such accounting officer, the controller), any vice-president of the issuer in charge of a
principal business unit, division or function (such as sales, administration or finance), any other officer
who performs a policy-making function, or any other person who performs similar policy-making
functions for the issuer. Executive officers of the issuer’s parent(s) or subsidiaries shall be deemed
executive officers of the issuer if they perform such policy making functions for the issuer.”
This is the same definition as the definition given to “officer” by Rule 16a-1(f) under the Exchange Act
(17 CFR 240.16a-1(f)). The proposed rule also notes that “[p]olicy-making function is not intended to
include policy-making functions that are not significant” and that “executive officer” is presumed to
include any person who is designated as an executive officer by an issuer for purposes of Item 401(b)
of Regulation S-K.
As of what point in time is an executive’s status as an “executive officer” determined? Proposed Rule
10D-1(b)(1)(i)(B) provides that “an individual who served as an executive officer of the issuer at any
time during the performance period” of the incentivebased compensation award received by that
individual will be subject to the clawback policy.
Indemnification
Proposed Rule 10D-1(b)(1)(v) prohibits indemnification by the issuer of an executive officer against the
clawback liabilities. The SEC’s discussion of the proposed rule, at page 96 of the SEC Release, notes
that executives could buy their own insurance from a third party.
Limited Board Discretion
Under the proposed rule, an issuer may choose not to pursue a claim to recover “erroneously awarded
compensation” to the extent “it would be impracticable to do so.” The proposed rule provides that

219
“[r]ecovery would be impracticable only if the direct expense paid to a third party to assist in enforcing
the policy would exceed the amount to be recovered, or if recovery would violate home country law.”
Disclosure of Clawback Policy and Application
In addition to disclosure to be required by the stock exchanges (by listing rules still to be adopted), the
SEC proposals set forth disclosure requirements in the issuer’s annual report and in its proxy
statement. Those requirements are contained in a number of proposed amendments, including
amendments to Item 402 and Item 601 of Regulation S-K. The proposed amendment to Item 402
includes a new Item 402(w) which provides that if a listed issuer has a required accounting
restatement that results in clawback requirements, it must disclose certain information regarding that
in its proxy statement.
The proposed amendment to Item 601 includes a requirement that a listed issuer file its clawback
policy as an exhibit to its annual report on Form 10-K.
Effective Dates
Once the Proposed Rule 10D-1 is finalized, the securities exchanges and securities associations must
propose rules implementing it within 90 days after the effective date of final Rule 10D-1. These rules
are to take effect, upon SEC approval, within one year after such effective date. Each listed issuer must
adopt the clawback policy required by Rule 10D-1 within 60 days following the date the applicable
listing rule, as described in the preceding sentence, takes effect. Thus, it is likely to be the latter part of
2016 or even at some point in 2017 before Rule 10D-1 is implemented. Each listed issuer must provide
the required disclosures in the applicable SEC filings that become due on or after the effective date of
the applicable securities exchange or association listing standard.
Tax Consequences to Executives
Under Proposed Rule 10D-1, the clawback is a recovery of the pre-tax “excess” amount. For example, if
an executive was paid an “excess” amount of $100 and paid tax at a 45 percent rate on it the executive
would have $55 left after the tax. The clawback is of the $100. Put another way, in order to pay back
the full $100 to the employer the executive would have to earn another $81.82 (to have $45 after
taxes (at a 45 percent rate).
The executive might try to avoid such a confiscatory rate by claiming a deduction against ordinary
income for the clawed-back amount (under Code Sections 162 and/or 165) or claiming tax recovery
under provisions of Code Section 1341. Unfortunately, the availability to the executive of the
deduction, or, alternatively, the Section 1341 mitigation is uncertain.

Some Observations
1. Once Rule 10D-1 is finalized, many senior level executives of major corporations will, for the
first time, face the risk of“no-fault” clawback of part of their compensation. Approximately
4,800 issuers would be subject to Rule 10D-1, as proposed, according to SEC estimates. If, on
average, the number of senior executives at those issuers subject to the risk of clawback is 15,
that would total 72,000 executives. The risk will vary depending on the quality of financial
management at the company. (A report cited by the SEC in the Release at page 125 indicates
that from 2005 to 2012 there were 4,246 financial restatements reported on Form 8-K under
Item 4.02 by U.S. and foreign filers registered with the SEC. (Such a restatement is generally a
more serious one than a non-Item 4.02 restatement and is one that would more likely be
deemed an “accounting restatement” that would trigger a clawback under the proposed rule.))

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 Only a small fraction of the number of executives noted will ever have any portion of their
compensation clawed back. On the other hand, many will be aware of the risk.
2. The risk just noted may discourage not only careless financial reporting practices (which is what
the law intends) but also business ventures that carry a greater risk of inaccuracies in financial
statements. One example is engagement in a business venture that involves significant pressure
to produce prompt results. Another example would be investment in a foreign jurisdiction in
which there is a greater risk of error (meaning greater risk of error, for example, than in the
United States) in reporting financial results of operations and therefore greater risk of required
financial restatements based on those reports.
3. There will be a tendency to move away from incentives based on financial performance metrics
to incentives that are time-vested. For example, there may be increasing use of time-vested
stock options. There also may be a tendency by issuers to “bifurcate” their equity award
programs. For “executive officers” the awards may be time-vested and for executives below
that level the awards may be performance-based. Generally speaking, these developments
contradict common sense in the design of executive incentive programs.

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