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Class 1 (August 18)

§1 Exam Information
Exam will be take-home. Response of about 1,200 words is expected.
§2 Overview of Corporations
When we talk about “corporations,” we generally mean publicly traded
corporations. Publicly traded corporations are distinguished from other types of
corporations, such as limited liability corporations (LLCs).
§3 What is a corporation?
Prof. Goshen: “A corporation is a make-believe game for adults.” A corporation is
a legal person whose existence is specified in a paper document. A manager is
then appointed to make the corporation “do” things.
§4 The First Corporations Case
In Solomon v. Solomon Inc., Adam Solomon owned a business in which produced
letter products. Adam wanted to organize his business as a corporation. At that
time, the law required that at least seven people participate in the formation of a
corporation. The corporation had 1,000 shares, of which 994 were owned by
Adam. The remaining six shares were owned by his wife and children. Adam then
sold the letter-making business to his corporation. Of course, the seller was Adam
in his personal capacity whereas the buyer was the corporation. Because Adam
asked for a price that was higher than what the corporation’s assets allowed, Adam
decided to give a loan to his corporation. The sale created a situation in which the
corporation owed Adam some amount (let’s say £1,000). Adam thereby became a
secured creditor.
As it turned out, the business ultimately failed. Adam claimed that he, as a
secured creditor, meant that he had first dibs to the corporation’s remaining
assets. Adam prevailed on appeal, where the court said that the corporation was
not an “alter-ego” of Adam. Rather, it was to be treated as an entirely separate
legal entity. The court said that the other creditors should have realized that
corporation was a distinct entity even though Adam had made the loan to
§5 A Second Corporations Case
In Lee v. Lee’s, Lee created a corporation that owned one small aircraft used for
agricultural purposes. Lee owned the vast majority of the shares and piloted the
airplane. One day, the aircraft crashed, with Lee dying in the accident. The
corporation, however, continued to “live.” The shares that formerly belonged to
Lee passed via inheritance to his wife. His wife proceeded to sue the corporation
for compensation for Lee’s death. Because the wife was acting as a manager of
the corporation, she was effectively on the receiving end of the suit. The point of
the exercise was to extract compensation from the British social-security system,
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which provided compensation for deaths in workplace accidents. The social-

security system made the argument that Lee was not an employee of the
corporation. The court said nothing prevents a person from being an employee of
a corporation while also serving in other capacities (such as a manager). Pointing
to the fact that Lee had signed an employment contract with the corporation, the
court found that Lee was indeed an employee of the corporation. Note that one
party to the contract was Lee in his individual capacity and the other was Lee in his
capacity as an agent of the corporation.
§6 A Hypothetical
Suppose that Lee planned to smuggle drugs using his airplane and that the police
had enough probable cause to arrest Lee. Could Lee be convicted of conspiring
with his corporation to smuggle drugs? (From the standpoint of criminal law, this
theory does not fly because there is no actus reus.) Courts have declined to
impose liability for this sort of “self-conspiracy.”
Alternatively, suppose that there were two managers of the corporation who
conspired to smuggle drugs. In this case, criminal liability could attach because
there are three parties: the two managers and the corporation.
§7 In Summary
A corporation is a fiction, but a fiction that can sign contracts, commit torts, and
even commit crimes under the right circumstances.
§8 The Business Perspective
Consider the individuals and entities with which a corporation has relationships:
shareholders, managers, creditors, suppliers, employees, consumers, other
corporations, the government, and so forth. Each type of contact falls under some
legal regime. Employees, for example, fall under the protection of employment
regulations. Consumers fall under the law of products liability and contracts.
Suppliers are likely to have security interests in certain goods. The general public
is likely to fall under the protection of environmental laws. The government is
likely to impose taxes and regulations. Other corporations fall under the protection
of antitrust laws.
When we speak of “corporate law,” we usually refer to the laws that govern a
corporation’s relationships with shareholders, managers, and creditors. With
regard to creditors, corporate law addresses only those obligations that
corporations have when they are “alive.” (If a corporation is going bankrupt, its
obligations are governed by bankruptcy law.)
This view of corporations essentially holds that corporate law addresses the nexus
of contracts that sustains its relationships to other parties.
§9 A Story
Mrs. Fields got a cookie recipe from her grandmother, which is well-received by
friends. Mrs. Fields decided to open a store to sell her cookies, which becomes a
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success. Eventually, Mrs. Fields decides to open a second store and hires John to
run it. At this point, she faces the problem of how to make sure that John does an
acceptable job of running the store.
This is the classic agency problem. The agency problem has two elements: (1) an
information gap and (2) a conflict of interest. Here, the information gap consists of
Mrs. Fields’s not knowing what John is up to at the second store. The conflict of
interest is that John wants to shirk whereas Mrs. Fields would prefer that he work as
hard as possible. Both ingredients must be present for the agency problem to
Mrs. Fields might try to solve the agency problem by entering into a contract with
John for the purpose of imposing certain minimum requirements on his
performance. Alternatively, she might install a camera in the second store in order
to monitor John. She might ask for regular accounting reports. She might share
some of the profits with John, so that he has an incentive to do well.
In practice, the solution is likely involve a mix of these approaches. Of course,
implementing these measures will impose costs, known as “agency costs,” on the
Still, this does not solve the problem entirely. Suppose that John is intent on
leaving the store at 5pm to play tennis with this girlfriend and that he values
tennis-playing at $50. On the other hand, the store stands to make $200 if it stays
open for the rest of the evening. If John’s share of the profits amounts to less than
$50, he will close the store and leave. Of course, Mrs. Fields would prefer to walk
in and offer him a $100 share of the profits, but this is impractical in most
circumstances. These kinds of losses are known as “residual losses.”
Of course, it makes sense to hire an agent only if the profits from the second store
exceed the agency costs. A business owner, such as Mrs. Fields, therefore wants
to minimize agency costs. Many businesses have solved this problem on a large
scale. (Consider that McDonald’s manages thousands of stores worldwide.)
Suppose that Mrs. Fields has solved the agency problem for the second store and
wants to turn her two-store operations into a chain. Mrs. Fields approaches Diane
expressing a desire for a $2M investment. In exchange, Mrs. Fields offers Diane a
40% share in the profits.
Now Diane is starting to worry. Perhaps Mrs. Fields will underreport profits. Mrs.
Fields might start paying herself a much higher salary, which would reduce
reportable profits and thereby lower the amount to be paid to Diane.
Suppose that Mrs. Fields decides to start a chocolate factory to manufacture
chocolate chips for her cookie factories. As long as Mrs. Fields has 100%
ownership of both the chocolate factory and the cookie factory, it doesn’t matter
what price at which the chocolate is sold to the cookie factory. The only party that
cares is the IRS, which collects taxes on such transactions.
This, however, creates a problem for Diane. Because Diane’s interest comes solely
from the profit from the cookie factory, Mrs. Fields has an incentive to lower the
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cookie factory’s profits by raising the price of the chocolate. This issue known as
the conflicted-transactions problem.
Diane might respond by demanding veto rights over potentially conflicted
transactions. Alternatively, Diane could establish a benchmark price above which
the sale of chocolate would be suspect.
Note that Diane is now the principal and Mrs. Fields is the agent. As with the
Fields/John relationship, Diane will invest only if the gains exceed the agency costs.
Now suppose that Mrs. Fields wants to get a $2M loan from a bank. The loan
officer is now worried. Perhaps Mrs. Fields will take the money and flee. Perhaps
she will take on additional creditors who might take precedence in claims to the
business’s assets.
Suppose Mrs. Fields wants to upgrade the ovens in the store. Option 1 is a
standalone oven, which takes up store space and isn’t very efficient. Option 2 is
an oven built into the wall, which takes up no store space and is quite efficient.
Mrs. Fields would obviously prefer the built-in oven. The bank, however, would
prefer the standalone oven since it could be sold in the case of bankruptcy. The
bank might respond by writing restrictions into how the business might operate.
We now have three agency relationships: Diane/Fields, Creditors/Fields, and
Fields/Jones. Corporate law is all about these relationships. In a typical business,

Diane ↔ Shareholders
Minority Shareholders ↔ Mrs. Fields
Management ↔ John

The point of corporate law is to provide solutions to these agency problems.

Rather than having Mrs. Fields enter into tailor-made contracts for each agency
relationship, corporate law provides “default” solutions to these problems.
§ 10 Solutions to the Agency Problem
A Legal Solutions
Legal rules, such as the fiduciary duty, try to establish basic rules that
management must follow.

B Structural Solutions
Structural solutions include devices such as the board of directors, which
supervises the management. The board of directors supervises the managers on
behalf of shareholders. (Of course, this raises the question of who monitors the
board of directors.)
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C Market Solutions
If management runs a corporation too poorly, share values might become low
enough to allow for a takeover. This in itself provides an incentive for the
management not to abuse the agency relationship. In addition, securities
regulations ensure that corporations disclose enough information for the market to
function effectively.
§ 11 Creating a Corporation
The charter, certificate of incorporation, or articles of incorporation is the
document that creates the legal fiction known as a corporation. Corporate law is
state law; each state sets forth its own technical requirements for incorporations as
well as default solutions to the agency problems. By far, Delaware is the most
popular state for incorporation. As a practical matter, this class will be concerned
mainly with Delaware law, though the differences between Delaware corporate law
and analogous laws in other states are not great.
The charter must contain certain provisions. First, the charter must state the name
of the corporation. Usually, the name cannot be something that could create
confusion as to the identity of the business. Second, the charter must specify the
number of shares that can be issued by the corporation. The number of shares
controls the amount of discretion to be exercised by the board of directors.
Suppose that Fields Inc. issues 100 shares to Diane and 200 shares to John. This
initial allocation would make John the controlling shareholder. If the board issues
500 shares to Mrs. Fields, however, Mrs. Fields then becomes the controlling
The charter may additionally designated different classes of shares or delegate
that responsibility to the board. This is also a large source of control, and it lays
the foundation for the “poison pill defense” to hostile takeovers.
In sum, the board of directors may exercise control through (1) allocation of the
numbers of shares and (2) setting the rights associated with each class of shares.
Additionally, the charter must specify agents to receive service in the event of a
lawsuit as well as the personal liability of the directors.
The charter may contain additional provisions to govern the corporation.
§ 12 Treaties
A corporate charter may be changed after filing, but the board of directors must
recommend the change. Shareholders may not recommend any changes. Once a
change has been recommended, however, shareholders must approve the change.
Changes must be filed with the Secretary of State.
The particular requirements for passing an alteration to the charter depend on the
jurisdictions. In particular, DGCL § 242(b)(1) says that abstentions count for the
quorum but not as “yes” votes.
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§ 13 Adopting Bylaws
Bylaws specify rules regarding the internal operations of the corporation. The
bylaws are not a public document. The charter can be considered the
“constitution” of the corporation, and the bylaws can be considered subsidiary
statutes. In practice, this means that bylaws cannot contradict the charter.
According to DGCL § 109(a), shareholders can always change the bylaws; the
board of directors may also do so if they are permitted to do so in the charter.
Jurisdictions operating under MBCA § 10.20(b) say the same with regard to
shareholders but say that the board is allowed to change the bylaws by default,
unless expressly restricted from doing so.
Suppose that the charter itself empowers the board to change the bylaws. (This is
true for most corporations.) Suppose that the board makes some change that
doesn’t sit well with the shareholders. The shareholders change the bylaws back.
Can the board then reinstate their change? The MBCA says that shareholders have
the “last word” in such cases of competing modifications. The DGCL does not give
shareholders this power, but it authorizes courts to adjudicate such disputes.
There is a division of view between the U.S. and the rest of world as to where the
“center” of the corporation lies. In non-U.S. countries, shareholders are the center;
as such, shareholders may dictate the bylaws. The U.S. view is that the center is
the board of directors. Just as the board may take out loans or hire employees, it is
the board of directors that “hires” shareholders. (The notion of “hiring”
shareholders is admittedly a bit odd.)
§ 14 Sources of Regulation
Corporations must comply with regulations from state and federal regulations.
Usually, federal regulations set forth only disclosure requirements, but Congress
may impose requirements beyond mere disclosure.
A third source of regulation is the stock exchange. Each stock exchange has its
own rules, some of which might affect the operation of the corporation.
Fourth, private arrangements might modify the “default” rules supplied by
corporate law.
§ 15 Why Delaware?
Initially, the leading state for incorporation was New Jersey. In the early 20th
century, New Jersey had a versatile corporate law as well as good courts with a
great deal of experience in administering that law. In 1909, governor Woodrow
Wilson of New Jersey introduced seven changes to the law (known as the “seven
sisters”), which were unacceptable to the business community. Delaware, which
had the same advantages of the old New Jersey laws, announced that it would
recognize all New Jersey precedent. As a result, all the corporations moved to
Delaware. Currently, fees from incorporation make up about 20% of the Delaware
At least one professor has argued that Delaware is leading a “race to the bottom”
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in the sense of allowing directors to exploit shareholders. Another professor,

however, has argued that shareholders can simply respond by selling shares in
Delaware corporations and buy shares in some other corporations. Empirically,
one study has found that shareholders of Delaware corporations tend to make
more money than those for other corporations.

Class 2 (August 19)

Recall that corporate law is intended to solve the agency problems that arise in
various contexts. In the shareholders/management problem, the shareholders
would like the management to work as hard as possible while the management
would prefer otherwise. The information gap makes it difficult for shareholders to
maintain control over the management. Another agency problem may arise
between a controlling shareholder and minority (public) shareholders. Typically,
the controlling shareholder has access to more information about the corporation
than the minority shareholders and may have the incentive to take certain actions
at the expense of minority shareholders. Creditors may also have interests that
are at odds with those of shareholders.
§ 16 Dispersed Ownership versus Controlling Owner
The difference between dispersed ownership and a controlling owner reflects the
choice of where to place the most serious agency problem. In a dispersed-
ownership model, most of the discretion is vested in the management. Therefore,
there is a serious agency problem between the shareholders and the management.
If there is a controlling owner, the controlling owner will minimize any agency
problem between shareholders (including himself) and the management. On the
other hand, there will be a greater agency between himself and the minority
shareholders. Neither model is necessarily “better”; which to choose depends on
the circumstances.
The board of directors, which sits between the shareholders and the management,
is one way to minimize the shareholers/management agency problem.
§ 17 Limited Liability and Separate Legal Entity
Recall that the corporation is considered a separate legal entity. If a corporation is
confronted with a judgment against it, the individual shareholders are liable for the
corporation’s acts only to the extent that they own shares. Even if the corporation
does not have enough assets to satisfy the judgment, the shareholders cannot be
made to add more of their own money. Contrast corporations with partnerships, in
which the partners are not so insulated from liability.
The “separate entity” status of corporations means that personal creditors of a
shareholder cannot go after the corporation’s assets. In general, the corporation’s
creditors must be paid back first; only then can personal creditors of shareholders
be paid.
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§ 18 Limited Liability as an Invention

Limited liability is an invention, albeit one as important as electricity (according to
Prof. Goshen). To understand why, we need to take a detour into corporate

A Expected Return
In real-world situations, the probabilities and returns that determine the expected
return on any investment is not known with great certainty. As a result, each
person will have a different estimate of what the expected return will be.

B Risk
When we speak of “risk” in everyday life, we usually mean the chance that
something bad will happen. In finance, “risk” is a completely neutral term that
refers only to the degree of variation among possible outcomes. In general, risk is
measured in terms of the variance. In corporate finance, the expected return and
the standard deviation are sufficient to characterize any investment. (This only
works for returns that have a normal distribution.) In finance, there is a general
assumption that people will prefer “sure bets” to riskier investments (i.e., that
people are risk-averse).

C Decreasing Marginal Utility

There is a difference between the money outcome of a game and the utility
outcome of a game. In particular terms, the pain of losing $5 is greater than the
pleasure of making an additional $5. (This is a direct result of decreasing marginal
utility of money.) If there is a 50/50 chance of winning $5 and losing $5, a rational
person would not play the game. In order to balance the two utility outcomes, it is
necessary to make the “good” outcome more than $5—the additional amount is
known as the “risk premium.”
In practice, investments are “black box” games whose internal workings cannot be
changed. Investors can express their preferences only by changing their
willingness to pay for the shares. When investors are risk-averse, they will demand
larger risk premiums and ask for lower share prices.

D What do investors do?

Typically, an investor will diversify his investments, so as to avoid “putting all the
eggs in one basket.” Fundamentally, there are two kinds of risks: (1) systematic
risks, which affect large chunks of the market, and (2) specific risks, which affect
only specific corporations. The idea is that a diversified portfolio will make the
specific risk go away. The question is how many different investments one should
make so as to lower the specific risk to the level of the systematic risk. The
general assumption is that the requisite number of investments will no be so high
as to impose prohibitive logistical burdens.
Apartment for diversification, there is a linear relationship between risk and the
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expected return demanded by investors. (The slope is obviously positive.)

Typically, investors will demand a positive expected return even when the risk is
zero; this minimal return reflects the time value of money.
Suppose that we have a corporation (which, for our purposes, is a black box)
whose expected return per share is $20 a year. The lower the price per share, the
greater the expected return. Investors try to figure out which investments are
overpriced or underpriced with respect to the risk.
§ 19 Back to Limited Liability . . .
Suppose that Zohar needs to borrow $2M in order to build a hotel. The bank, of
course, asks what happens if the business goes under. Perhaps Zohar then says,
“You can collect from my other assets.” The bank agrees to set the interest rate at
Now suppose that Zohar says, “I want a no-recourse loan,” so that the bank can
collect the assets of the failed hotel but no more. The bank, seeing the increased
risk, sets interest at 10%.
The point of creating a corporation is the equivalent of announcing to the world
that one would rather do business under the latter set of circumstances. Without a
corporation, one would have to include a no-recourse clause in every contract
having to do with the business. By contrast, all these declarations can be
consolidated into a designation like “Inc.” or “Ltd.” If an investor insists on being
able to collect directly from the shareholders, the investor can ask those
shareholders for a personal guarantee. In effect, the corporation is a device for
shifting the risk of failure from shareholders to creditors.
Over 90% of the world’s business activities is done through corporations, where
there is limited liability. Why is it that the world finds it more efficient to have no
recourse against individual shareholders? First, consider what would happen in a
world with unlimited liability. Suppose that Zohar buys a share of some
corporation for $100 and goes about teaching corporate law. The management
does something stupid and creditors come knocking. Zohar is then informed that
he has to sell his house to satisfy the corporation’s debts. While it’s possible to fix
this problem by having shareholders constantly monitor the CEO, this fix is not
financially feasible for someone who owns only $100 of stock.
Consider a creditor who has just obtained a $10M judgment against the
corporation. The creditor looks at the list of shareholders and realizes that Bill
Gates is on the list. The creditor realizes that it makes sense to go after Bill Gates
first since he is the most likely to have the money to pay the judgment. Of course,
this imposes a burden on the shareholders themselves to monitor each others’ net
worth and to make sure that the other shareholders don’t try to avoid paying.
Limited liability solves both these problems. Shareholders don’t have to worry
about being collected against, and creditors don’t have to chase after individual
Most importantly, however, a corporation makes sure that the shares are
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“homogeneous” vis-a-vis each other. Under unlimited liability, the value of a

share depends not only the expected return but also on the net worth of the
shareholder. Under an unlimited-liability regime, rich persons have greater risk
exposure by virture of having greater net worth. A homeless person on the street
would, by contrast, enjoys a sort of natural limited liability by virtue of being
judgment-proof. These differences make it very difficult to trade shares since two
individuals might value a share very differently owing to their financial
Ultimately, corporations are a device for dispersing risk. Each corporation invites
each shareholder to take a small slice of the total risk. Each individual investor
protects himself by investing in multiple corporations. This is all possible because
of limited liability.
§ 20 Involuntary Creditors
Suppose that a corporation is constructing a building. A load of bricks lands on an
unfortunate pedestrian, who sues for $2M in damages. The corporation has only
$50K in assets to satisfy the judgment. How is limited liability justifiable in this
situation? Here, there is a tradeoff between the individual’s buying insurance and
the corporation’s buying insurance. In limited circumstances, courts will allow
“piercing of the corporate veil” to place liability directly on shareholders.
Alternatively, courts have said that particular managers who can be identified as
tortfeasors can be made personally liable for the tort. If you personally commit a
tort, even in your capacity as a CEO or other manager, you are nonetheless
personally liable.
§ 21 Capital Structure of Corporations
When a business wants to raise money, it generally does so by issuing debt or
equity. Debt consists of a very specific contract stating the amount of money to be
loaned and the amounts and times at which interest has to be paid. Equity, on the
other hand, gives the shareholder a residual claim to the assets of the corporation.
Importantly, fixed claims (such as debts) must be paid before residual claims can
be paid. Equity, however, also gives shareholders the power to control who is on
the board of directors.
Equity affords shareholders three rights: (1) voting rights, (2) dividends, and (3)
the residual claim to assets after liquidation. The residual claim is very important
because it gives shareholders a proportional claim to the profits of the corporation.
Suppose that a corporation initially has two shares at $100 each (for a total value
of $200). Suppose that the corporation makes $40. The share price would
subsequently go up to $120 ($20 profit for each share).

A Types of Shares
If a corporation has only one type of share, then each share has exactly the same
rights under a “one right, one vote” system.
Of course, a corporation doesn’t have to have only one kind of share. It might opt
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to create Class A shares, which grant only voting rights, and Class B shares, which
grant only economic rights.
Even more elaborately, a corporation can customize the types even further. Class
A shares might be given 10 times the voting rights of Class B shares with all other
rights identical among all shares. Even more elaborately, a corporation can create
a Golden share whose only associated right is the right to veto a sale to the third
Note that a share without economic rights has value for the shareholder only
insofar as the shareholder can “steal without breaking the law” by exploiting
various aspects of the corporation.

B Preferred Shares
Preferred shares go below fixed claims but above common shares when it comes to
precedence of claims. In a going concern, dividends are paid first to the preferred-
share holders before common shareholders are paid.

Cumulative Preferred Shares

A cumulative preferred share allows unpaid dividends to “stack up” in favor of
preferred shareholders, so that all accumulated dividends must be paid before any
common shareholders can receive dividends.

Non-Cumulative Preferred Shares

For a non-cumulative preferred share, dividend payments deferred at the board’s
discretion (but not dividends missed due to lack of profits) may generally “stack
§ 22 Debt Instruments
All debts entail a loan to the corporation with specifications as to when interest
should be paid.
§ 23 Options
A call option is a document giving the holder the right to buy something on a pre-
specified date at a pre-specified price. A put option is a document giving the
holder the right to sell something on a pre-specified date at a pre-specified price.
Furthermore, a European option gives you the right only on the specified day. An
American option gives you the right at any time up to the specified day.
Suppose the price of a stock is $100 currently and that Zohar wants a European
call option with a strike (option to buy) price of $120 on December 31, 2011. If,
when that day comes, the price is $118, there is no point in exercising the option.
On the other hand, if the price on that day is $140, then exercising the option
would allow Zohar to buy a $140 stock at only $120 (yay!). Basically, price goes
up = make money.
Notice that an option is ordinarily a bet between two third parties as to the
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performance of the corporation. Options have no effect on the corporation itself.

A warrant, on the other hand, is a call option issued by the corporation itself. A
right is a warrant that is already “in the money” when it is issued.

A Convertible Bonds
A convertible bond is a bond that comes with a call option. The call option gives
the holder the right to exchange the bond for some shares.

Class 3 (August 20)

Recall that corporations raise money by issuing securities, which fundamentally
consists of debt and equity. In the real world, securities can become very complex
through the creation of derivatives and other financial instruments.
§ 24 Some Basic Accounting
A corporation has assets and liabilities. Entitlement to assets is divided among
shareholders and creditors. Recall, however, that the shareholder’s ownership of
residual claims means that shareholders are the “last in line” to profit from any
gains and the first to suffer losses since fixed claims must be satisfied first.
Recall the risk-versus-expected-return line. Various securities fall at various points
on the line. When a corporation is created, the incorporator decides the classes of
securities to issue and where each class falls on the line.
§ 25 Fiduciary Duties
There are two fiduciary duties: (1) the duty of care and (2) the duty of loyalty. But
first things first. A crucial is question is what it means to be a fiduciary.

Dodge v. Ford Motor Co.

At the time, Ford Motor Company was making money hand over fist. At the time,
demand was so high that it seemed Ford could sell as many cars as it wanted
without lowering the price. The Dodge court said that the fiduciary duty consists of
immediate maximization of profits. The court is saying that the corporation is not
an instrument of charity; the court would not allow Ford to burden the other
shareholders with his own altruistic goals. Ford, however, would have been free to
write rebate checks drawing on his personal accounts. This doctrine serves as a
protection for minority shareholders.
At the time, the Dodge brothers were building their competing car company, and
many of the actions questioned in the case were directed at stifling competition
from Dodge. Ford had to spin an altruistic tale to avoid getting sued under
antitrust laws.

A.P. Smith Mfg. Co. v. Barlow

First, we should make clear the distinction between “pure” donations and
donations that are promotional in nature (e.g., “50% of proceeds go to some
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charity”). Here, we are dealing with an apparently “pure” donation. Here, Smith
Manufacturing was probably trying to take advantage of a tax break. That said,
why not allow the shareholders to make individual donations? The Smith court
realized that corporations made up most of the entities capable of making sizable
donations and that it is much more efficient to solicit the CEO of a corporation for a
donation than to solicit thousands of shareholders individually.

Credit Lyonnais and North American v. Gheewalla

In Gheewalla, the Delaware Supreme Court made it clear that fiduciary duties are
owed only to shareholders. From a practical standpoint, it is necessary to specify
an unchanging group of individuals to which the fiduciary duty runs. Otherwise, it
becomes impossible to enforce the duty since a CEO could always point to some
group that benefits from some decision.

A Duty of Care
Francis v. United Jersey Bank (The Reinsurance Case)
Consider where the interests lie. Insurance companies entrusted money to
Pritchard & Baird. The money was then stolen by the two younger Pritchard
brothes. Now creditors are suing to recover the stolen money. But didn’t we say
that fiduciary duties run only to shareholders, not creditors?
Here, the court is treating Pritchard & Baird as a bank, which owes a fiduciary duty
not only to shareholders but also to depositors (here, the client insurance
companies). Given the resemblance of Pritchard & Baird to a bank, it would not
have been enough for Mrs. Pritchard to resign in the face of persistent malfeasance
by the directors.

In re Emerging Communications
Consider the problems of relying on “expert” opinions in running a corporation. On
the one hand, we want directors to be informed. On the other hand, increasing
liability for knowledgeable individuals could create an incentive to be ignorant.

Kamin v. American Express Co.

Basically, American Express had paid $30M for an asset. Subsequently, business
went wrong and the asset ended up being worth only $4M. American Express
therefore suffered a loss of $26M. Even though it was possible for Amex to arrange
its accounts in such a way as to make it seem the asset was still worth $30M, the
market already knew that the value had decreased to $4M.
One way to deal with the problem would be to sell the asset to a third party for
$4M. The sale, of course, would result in a loss of $26M, but the $26M loss could
be used as a tax deduction. As it turned out, the IRS gave a tax deduction of $8M.
So in effect, the sale resulted in a gain to Amex of $12M ($4M from the sale and
$8M in tax breaks).
The second way to deal with the problem is to distribute shares of the asset
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directly to shareholders. The problem, however, is that the IRS gives no tax
deduction for this transaction.
In Kamin, the board of directors foolishly chose the direct distribution of dividends
and missed out on the tax break.
How does Kamin differ from Francis? In Kamin, the board used a valid process
even though the ultimate decision was “stupid.” Francis, by contrast, involved a
complete lack of process.

What is the business-judgment rule?

The business-judgment rule requires two things: (1) that a decision was made; (2)
that it was made with information and in good faith; and (3) that there was no
conflict of interest. Under the business-judgment rule, the standard of liability is
If the requirements of the business-judgment rule are not met, then the standard
of review is reasonable care (i.e., the same standard as in negligence liability).
Furthermore, if there is a conflict of interest, then the business-judgment rule is
replaced by the “entire fairness” standard.

Smith v. Van Gorkom

A key point here is that a director can rely on a report only if that report was
generated by an individual who is competent to produce that document. Suppose
that a company receives an offer to be purchased for $38 per share. The Smith
court says that merely obtaining a premium over such a price does not support
applying the business-judgment rule. The Smith court found that Van Gorkom
should have taken some effort to determine the amount at which Pritzker actually
valued the company.
In Smith, the $55 per share purchase price came from estimates of what would
happen in a leveraged buyout (LBO).

How a LBO works

In a LBO, the management of an existing corporation forms a new corporation.
The new corporation takes on a lot of debt in order to buy out the existing
corporation from its shareholders. Immediately after the LBO, the management
controls the new corporation, which owns the old corporation.
In Smith, the LBO scenario was essentially irrelevant to the Pritzker negotiations
because the LBO calculations reflected nothing about what a third party would be
willing to pay for the corporation.
Pritzker also demanded a “lock-up” option, which gave him the right to buy 1M
shares of the corporation at $38 per share, to be exercisable upon the attempt of
any other party to buy Trans Union. So why would the board of Trans Union give
Pritzker such an option? Pritzker is afraid that other buyers will free-ride on the
due diligence he performed in estimating the value of Trans Union. The lock-up
option would compensate Pritzker for his research costs in the event he failed to
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acquire the company.

The problem in the Smith case is that Pritzker left Trans Union with no ability to
seek an alternative buyer.
Prof. Goshen: Note that the level of research needed to reach a decision as to
whether to sell the company is subject to the business-judgment rule.

B Effect of Smith v. Van Gorkom

Following Smith, Delaware inserted § 102(b)(7) of its General Corporation Law,
which exempted directors from liability for breaching the duty of care as long as
they do not act in bad faith. (Delaware was afraid that Smith would cause
corporations to reincorporate in other states.) Soon thereafter, corporations
started inserting § 102(b)(7) into their charters. Why should shareholders vote for
such an addition? Wouldn’t directors tend to be negligent?
The answer is that directors already have an incentive to avoid being negligent.

C Gantler v. Stephens
There was a conflict of interest between the directors of First Niles and the
shareholders. In particular, the directors had business relationships with First Niles
that might be damaged in the event of a sale. The Chancery Court (the lower
court) correctly concluded that standing to lose one’s position as a director does
not usually amount to a conflict of interest by virtue of being inevitable. In this
case, however, there were additional business interests beyond merely remaining
on the board.
Here, the board sought to implement a “reclassification” that would remove the
voting rights for small shareholders. (As it turned out, the board fixed the standard
at 300 shares.) Shareholders who held fewer than 300 would have their shares
converted to preferred shares. The effect was to cancel the voting rights
associated with the vast majority of shares, thereby preventing the possibility of a
Here, the question was the effect of shareholder ratification. The court said that
ratification allows a decision to be subject to the business-judgment rule, even if
that decsions would not ordinarily be reviewed under a standard of reasonable

D Lyondell Chemical Co. v. Ryan

How is this case different from Van Gorkom? The main difference is that Lyondell
took place after the enactment of DGCL § 102(b)(7). The plaintiffs claimed bad
faith because bad faith is the only “hook” by which liability could attach. The lower
court characterized the board’s “wait and see” decision as bad faith, but the
Delaware Supreme Court disagreed on the ground that Lyondell had no obligation
to act at the time the “wait and see” decision was taken.
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§ 26 Summary of Duty of Care

A If the Board Has Taken an Action
First, as whether the action was informed. If the action was not informed, then the
standard of review is gross negligence. If the action was informed, then we ask if
the action was conflicted.

Class 4 (August 23)

Recall that even though the duty of care imposes a standard of reasonable care, it
is fairly easy to fulfill the requirements of this duty. Absent irrationality or gross
negligence, liabilty will not attach. Furthermore, DGCL § 102(b)(7) provides
additional protection against claims alleging breach of the duty of care.
By and large, courts try to avoid dealing with claims that management is running a
corporation incompetently. Courts generally leave the market to deal with such
§ 27 The Duty of Loyalty
Unlike the duty of care, the duty of loyalty entails considerably more judicial
enforcement. The duty of loyalty often involves conflicts of interest interfere with
the proper operation of market forces. The main issue of the duty of loyalty is
“conflict of interest.”

A Direct Conflicts of Interest

Suppose that the sale of an asset is taking place between a corporation and an
officer of the corporation. Here, the officer might have an incentive to overcharge
the corporation for something he is selling. Similarly, the officers might underpay
for an asset he is buying from the corporation.
A typical real-world example is the compensation package. Unlike a normal
transaction, the corporation has no choice but to negotiate compensation
packages with its directors. (This lack of choice results in a specialized standard
for reviewing compensation decisions.)

B Indirect Conflicts of Interest

Suppose suppose that Corporation A is entering into a transaction with Corporation
B. As it happens, someone is simultaneously a director, officer, or controlling
owner of both corporations. The possibility of self-dealing thus arises; the
individual on both sides of the transaction might try to negotiate terms that are not
fair to one of the parties.
This situation commonly arises in parent-subsidiary dealings. In such dealings, the
parent company may try to profit at the expense of the subsidiary’s shareholders.
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C What is an “interest” for the purposes of conflict of

Aside from obvious financial interests, there is the problem of favoritism toward
certain individuals (e.g., friends). People choose their friends to choose on the
boards of corporations in the hopes that the friends will support their views.

D Mixed Motives
Suppose we have a public corporation C whose shares are trading for $100.
Suppose that acquirer A wants to buy C. A can buy up to 5% of the shares of C
without any notification. Once A has exceeded the 5% threshold, A must disclose
within ten days whether it intends (1) to hold its shares as a passive investor or (2)
to initiate a takeover. Suppose that A increases its holdings to 10% and makes a
tender offer for the rest of the shares at $150. When C’s directors learn of the
takeover attempt, they approach A and offer to buy out A’s 10% holding for $160
per share, subject to the condition that A promise not to abandon the takeover
attempt. (This is known as “greenmail.”) Note that at his point the shareholders
have missed out on (1) the money they would have made upon accepting the
tender offer. The shareholders are also forced (2) to share the cost of paying A to
go away.
Now, the motives of the board for participating in such greenmail are not always
clear. First, the board may genuinely believe that A is bad for the corporation’s
future. Alternatively, the board may be afraid that A might fire them upon a
successful takeover. When courts review decisions of boards in this context, they
apply a special standard to account for the mixed-motive nature of the question.

Lewis v. S.L. & E., Inc.

The directors of SLE owned only 35% of the corporation whereas the directors of
LGT (the same people) owned 100% of LGT. Therefore, the directors had an
incentive to have SLE lease ladn to LGT at a discounted rate. (The directors would
suffer only 35% of the loss to SLE but enjoy 100% of the gain to LGT.) In this case,
there were no “independent” directors to approve the transaction. The only
alternative was to have the transaction approved through a shareholder vote. But
what do we do when the shareholders in SLE might also have a conflict of interest
with LGT?
The court found that the rent charged by SLE was not fair.

E Three requirements for a fair transaction

(1) Fair price, (2) fair dealing, (3) transaction is in the interest of the corporation

Cookies Food Products

Mr. Herrig had four transactions with Cookies Food Products: (1) an exclusive
distribution agreement, (2) royalties for the taco sauce, (3) compensation for doing
“consulting” work for the company, and (4) the arrangement to use his
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Iowa required a “fair” transaction to feature
1. Disclosure of the deal to disinterested directors
2. Shareholders can ratify the transaction
3. Fair terms
Although the relevant statute said that any of the three features would sustain a
finding of a fair transaction, the court found that (3) fair terms had to be present in
any fair transaction.
In this case, the board of directors approved the transactions. Why did the court
find the transactions to be fair? The court essentially held that Herrig was a
manager of better “quality” than the corporation might have found on the open
market. Considerations of “quality,” however, raise complex issues for review by
the courts. Basically, being a successful tends to bolster one’s chances of
prevailing in this kind of case.

According to DGCL § 144,

director or officer controlling owner (who may not

have an official position in the
disclosure + approval of business-judgment rule; entire fairness test, but plaintiff
disinterested directors rationality is the standard; has the burden of showing that
transaction reviewed as if with the transaction is unfair; i.e.,
third party shift of burden
disclosure + approval of “waste” doctrine; essentially entire fairness test with burden
disinterested shareholders the same as business-judgment shifted to plaintiff
rule (“waste = “irrationality”)
nothing entire fairness standard (three entire fairness standard; burden
requirements of fairness); of proof is on the controlling
director or officer has burden of owner to show fairness of
showing fairness transaction

In practice, the allocation of the burden of proof has a major practical impact on
who is likely to win; usually, the party with the burden is less likely to win. For
controlling-owner transactions, the fairness test + shifted burden creates
something similar to the business-judgment rule, but with the court reserving the
ability to inspect the transaction in detail.
Note that any defect in obtaining the approval of directors or shareholders causes
that approval to become to equivalent to “nothing,” whereupon the entire-fairness
standard applies.
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§ 28 Distinctions between directors, shareholders,

and controlling parties
Do we trust directors more than shareholders or vice versa? On the one hand,
directors have more knowledge of the operation of a corporation. But directors
tend to be less objective than shareholders. By contrast, shareholders are more
objective, but they have much less ability to weigh the merits of a transaction.

A Distinction between directors and controlling owners

Note that the controlling owner has more power than a director. The controlling
owner dictates who can serve on the board, so the directors are likely to defer to
the judgment of the controlling owner. In particular, it is difficult for directors
appointed by the controlling owner to act with “disinterest.” Furthermore, a
controlling owner may threaten future retaliation against minority shareholders
who fail to vote for its propositions. This is why courts have declined to apply the
business-judgment rule outright in conflicted transactions involving controlling
§ 29 Waste
How is the “waste” standard different from the fairness standard? “Waste” usually
refers to a transaction in which the price paid for an asset is outrageously
disproportionate to the price. Query, however, what happens when shareholders
approve of the wasteful transaction.
When a court states that a particularly transaction was wasteful, it is expressing
the view that the particular decision is outside the decision-making competence of
the shareholders. Waste doctrine is an ongoing attempt to figure out what sorts of
decisions are simply outside the scope of the corporate function.

Tyson II
Under the Tyson Stock Incentive Plan, the directors could receive options with
strike prices equal to whatever the market prices were at the time the options were
issued (i.e., the Plan authorized the granting of “at the money” options). The
whole point of “spring-loaded” stock options is to grant options immediately before
the disclosure of favorable inside information. That way, the probable price
increase following disclosure of the information will put the options “in the money.”
A related practice is backdating, in which options are granted with a strike price
equal to some earlier, lower market price.
The court ruled against Tyson because the directors were “hiding behind
formalities” when making the disclosures regarding the spring-loaded options. In
effect, the court is imposing a duty of complete disclosure upon the corporation.

A Approving a Transaction
The Walt Disney case, which took place a few years ago, had to do with a CEO who
received a $140M severance package after doing a bad job for a year. The issue
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there was whether there was a breach of the duty of care by the directors. The
plaintiffs pleaded bad faith in order to overcome DGCL § 102(b)(7). The court
rejected the plaintiffs’ theory, saying that there is a difference between failing to
do one’s job (bad faith) and doing one’s job poorly (lack of care).
§ 30 Corporate Opportunity
Hawaiian International Finances
Note that Pablo Realty, Inc. is being sued alongside Pastor Pablo and Rufina Pablo.
Why would Pablo Realty be getting sued? The reason is that individuals who knew
of a breach of fiduciary duty are obligated to return any gains resulting from that
breach. Pablo Realty “knew” about the breach of fiduciary duty since Pablo, its
director, violated his duty to Hawaiian International.

Broz v. Cellular Information Systems

See p. 669 in casebook for four-factor test for whether something is a corporate
The Delaware Supreme Court is listing four elements to consider when evaluating
when a corporate opportunity has been improperly taken.
Suppose that CIS could and wanted to buy the Michigan-2 license. If such were the
case, what should Broz do?

Northeast Golf Club

Suppose that Zohar is on a business trip when he finds $100 on the sidewalk.
Does that $100 belong to the corporation or to Zohar personally? Alternatively,
suppose that Zohar buys a lottery ticket and wins. Neither of these cases would
result in an obligation to disclose to the corporation. See the ALI’s procedure for
presenting an opportunity for corporate consideration.
Now suppose that the corporate board has considered and rejected the offer. Note
that a business opportunity entails risks. Corporate opportunities differ from
outright gifts in this important respect.

eBay Litigation
The court held that the taking of IPO shares was basically like allowing
management to take bribes. Goldman Sachs was essentially bribing the eBay
executives to choose Goldman Sachs for future business. This created a conflict of
interest and therefore the incentive to breach the fiduciary duty.

Class 5 (August 24)

Last time, we addressed the issue of conflicted transactions and the fairness
standard. Recall the matrix from Class 4. Approval by disinterested shareholders
or disinterested directors lowers the standard of review from the fairness standard.
(Who has the burden of proving the validity of the transaction depends on whether
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the conflicted party is a controlling shareholder or a conflicted director.)

§ 31 Controlling Owners
A What is “control”?
There are two ways to achieve control of a corporation. First, becoming a majority
shareholder automatically means that one is a controlling owner. Alternatively, a
minority shareholder can be a de facto controller of the corporation by
substantially dictating the operations of the corporation. From the perspective of
corporate law, the question is whether a particular shareholder owns enough stock
in a corporation so as to influence decisions that may impact the other

Zahn v. Transamerica Corp.

Dividend Structure of Axton-Fisher
Class A Class B
Dividends $32 cumulative $16.00
Corporate redemption rights $60 + any unpaid cumulative —
(effectively a call option) dividends; notice of 60 days
before exercising option
Conversion rights 1-to-1 switch of Class A shares $0.00
for Class B shares
Distributions of assets upon x2 x1
Voting rights No Yes

Essentially, Transamerica realized the value of the tobacco stockpiled by Axton-

Fisher. Transamerica didn’t want to pay the dividends to the Class A shareholders.
Note that the exercise of the call option technically fell within the bounds of the
corporate charter.
The breach of fiduciary duty did not consist of the mere exercise of the option. The
breach occurred because Transamerica did not disclose information (the rise in
tobacco prices) that would have allowed Class A shareholders to decide whether
the convert their shares to Class B shares.
Here, the fiduciary duty runs to Class B shareholders because they own the
residual interest in the corporation.
Why did the price of tobacco spike in this case? The government had imposed
regulations, but the regulations divided tobacco into two classes: “high-quality”
tobacco (which had a high price) and “low-quality” tobacco (which had a lower
price). Axton-Fisher had low-quality tobacco, but Transamerica realized that it
could sell the low-quality tobacco to Philip-Morris for use as high-quality tobacco.
The Class A shares were designed to protect shareholders from the downside.
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Assume we have 100 shares of A and 100 shares of B. Assume that the
corporation issuing the shares is worth $6,000. Now imagine that we have a
choice between liquidating the corporation and redeeming the Class A stock.
With $6000 of assets
100 A 100 B
Liquidate $40.00 $20.00
Redeem $60.00 0

With $30000 of assets

100 A 100 B
Liquidate $200.00 $100.00
Redeem $60.00 $240.00
Conversion $150.00 $150.00

The point of Zahn is that there were two otherwise legitimate options: one
favoring Class A shareholders and one favoring Class B shareholders. Assuming
both choices are legal in themselves, the controlling shareholder had an obligation
to honor its fiduciary to Class B shareholders.

Calculating Damages
We would take the difference between what the Class A shareholders actually
received ($80.80) and what they would have received had they converted their
holdings to B shares.

Trados Shareholder Litigation

Shareholders own residual claims. The point of the fiduciary duty is that if you
maximize the value of the residual claims, then you must be maximizing the
chances of satisfying fixed claims as well.
Suppose that a corporation has assets of $100. Suppose we have a preferred
share with a claim to $50 of the assets. Then we have a common share with a
residual claim, i.e., $50. Now suppose that something bad happens, so that there
is only $50 left in assets. Now, the common share is worth nothing; the entire $50
will go to the preferred share. However, if we keep running the business, there is
no downside for the common shareholders; because the common shareholders
have nothing more to lose, they have no place to go but up. This, however, means
that the common stock is acting as a call option.
The claim in Trados was that the directors failed to take into account the option-like
interest that common shareholders had in their shares.
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Sinclair Oil Corp. v. Levien

Levien made three claims: (1) dividends that were too high, (2) taking of a
corporate opportunity, and (3) breach of contract.
On point (1), the rule is that as long as everyone is getting pro rata dividends,
those dividends will be evaluated under the business-judgment rule.
Notice that the distribution of dividends by Sinven did benefit Sinclair since Sinclair
could then use that money to go exploring for oil elsewhere.
The point of Sinclair is that as long as dividend distributions are pro rata, the
business-judgment rule applies. Even if the distribution of dividends leads to the
loss of a business opportunity, that does not mean that any heightened standard
will apply.
On point (3), the court found that the breach of contract benefited Sinclair at the
expense of Sinven.

B Fiduciary Duty of Controlling Owners

Levco Alternative Fund v. Reader’s Digest Ass’n, Inc.
Existing structure of Reader’s Digest:
Class A shares (no voting)
Class B shares (voting)
Proposed recapitalization:
1. Create new Class C shares
2. Allow B → 1.24 C conversion
3. Allow A → 1 B conversion
In this case, several transactions were combined in an attempt to hide
maneuverings that benefited Reader’s Digest at others’ expense.
Suppose that a controlling shareholder owns 60% of a company and the public
owns 40%. Suppose that Zohar owns exactly 1 share of the company. What is the
value of his voting right? Effectively nothing. Suppose that the company is 100%
owned by the public. In this case, the vote has value because it can become part
of a controlling block of shares. However, in the 60/40 controlling/public
relationship, the value of the vote is nothing because there is no way for the shares
in the 40% publicy held block to become part of the controlling majority. So
clearly, the voting value of the share depends on the structure of the corporation.
Suppose now that we have Class A shares with no voting rights and Class B shares
with voting rights. Would it be sensible to allocate the corporation’s assets 50% to
Class A and 50% to Class A? The answer is no since the value of B’s voting rights
should be reflected in the value of B shares. So the B shares should get some
additional slice of the assets. Suppose now that we gave voting rights to Class A.
What we have effectively done is to take away B’s control premium and impose a
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50/50 split of assets; B shareholders will demand to be compensated for the

reduction in their ability to control the company. The corporation can compensate
B for giving up a portion of its voting control by issuing B more shares. Note,
however, that the size of the control premium depends on whether it’s possible for
non-majority shares to become part of the controlling block.
So there are two questions here: Is $100M indeed the value of the control-
premium slice? Is the B → 1.24 C conversion a fair way compensate B
shareholders for their loss of control?
There are two issues: (1) the value of the voting right of a single share. This
answer depends on whether someone already owns a majority of shares. If so,
then the voting right of the remaining shares will be low since there will be no way
of taking control of the corporation simply by buying those shares. By contrast, if
the ownership of the corporation is dispersed, then every vote carries with it some
control premium. Reader’s Digest Inc. started with 50% ownership in the hands of
a controlling owner. In other words, the owner had guaranteed control of the
The first step in the transaction was to pay the controlling owner $100M to reduce
his holdings from 50% to 40% of the corporation. (Was $100M the right sum?)
Once that was done, the second step was to pay B shareholderes to give up their
voting rights. Note that when a corporation owns its own shares, those shares
become meaningless because a corporation does not need claims against itself. In
effect, the effect of a corporation’s purchase of its own shares is to decrease the
number of shares circulating on the marketplace.
The two ways that A shareholders can be hurt is (1) if the controlling shareholder is
paid too much to give up his control premium and (2) if B shareholders are
compensated too much for giving up a portion of their voting control.

Calculating Damages in Reader’s Digest

If the B shareholders received too many shares of C at the B → 1.24 C rate, then
the corporation could issue more C shares to A shareholders at a number that
would bring the A:B ownership ratio to the appropriate value.

Kahn v. Lynch Communication Systems, Inc.

Alcatel was trying to merge with Lynch. A merger requires approval from (1) the
shareholders of both corporations and (2) the directors of both corporations.
However, notice that Alcatel already controls 43% of Lynch’s shares, so it would
automatically be able to account for that fraction of the shareholder votes.
In an ordinary merger, the transaction is “consensual” in the sense that the
directors and shareholders of both corporations agree to the transaction. A second
way to go about the merger is for the acquiring corporation is to make a tender
offer to individual shareholders for their shares.
Alcatel is provoking a collective-action problem. Let’s say that the unfriendly
tender offer is for $14, which represents some premium over the market price of
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the stock. Although the shareholders know that they could collectively hold out for
$15.50, each individual shareholder has an incentive to immediately cash out at
the $14 price.
Now, what is the effect of the fact that Alcatel threatened Lynch? Nothing.
Suppose that Alcatel had simply walked away from the negotiations and made the
unfriendly tender offer the next day. It seems that there’s nothing legally wrong
with doing this.
A key point in this case is that the process of fair dealing is a proxy for determining
whether the purchase price was fair. Fair dealing allows the parties to avoid
§ 32 Property Rights versus Liability Rights
Ordinarily, a majority shareholder can force a transaction upon the minority

Class 6 (August 25)

The legal aspects of corporate law are generally quite simple. The real task is to
figure out what “trick” a corporation is trying to pull off in a questionable
transaction? (For example, is the corporation trying somehow to benefit itself at
the expense of someone else?)
§ 33 The Voting System
In a typical corporation with dispersed shareholders, we have the following

Board of directors

Dispersed shareholders have no incentive to monitor the board of directors. The

investment of the typical shareholder is too small to make it worthwhile to keep
track of what the corporation is doing. Even is a single shareholder went to the
trouble of keeping an eye on the corporation, other shareholders could free-ride on
his efforts. In most matters, shareholders will agree with the managers’ course of
action. (This has been empirically demonstrated.)
Although the shareholders are technically supposed to appoint the board of
directors, in practice it is often the management that chooses the directors. Of
course, this creates a fox-guarding-chicken-coop scenario. Delaware law is making
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a push toward having independent directors on corporate boards. Additionally,

federal regulations and the rules of stock exchanges are also pushing in this
direction. In other words, we should really treat the board of directors and the
management as having the same agency relationship (and agency problems) in
relation to the shareholders.
Consider the potential conflicts of interest between management and directors.
First, the board meets infrequently—typically once a month. Furthermore, the
board relies on information provided by the management in making decisions, so
the management has an obvious incentive to avoid disclosing unfavorable facts to
the board. Finally, managerial control of the board means that directors have an
incentive to avoid conflicts with the management. (However, this difficulty is not
considered a “conflict” for the purposes of corporate law.) Prof. Goshen: The
hardest part of functioning as an effective monitor is that the shareholders (whom
the directors are supposed to be watching vigilantly) is the social environment in
which directors operate. Managers often have very chummy relationships with
directors (with lots of expensive dinners and such). This tends to create
friendships between managers and directors, and directors have a hard time
evaluating management’s performance impartially. Note that even “independent”
directors, who are not appointed by the management, are susceptible to the same
sort of chummy relationships.
For shareholders, the board-management ties mean that the chances of using the
board to overthrow ineffective management are effectively zero.
But what about institutional investors, which may own large blocks of the
corporation’s stock? Can they be trusted to correct ineffective management?
We’ve now established that (1) boards of directors don’t rein in the management,
that (2) independent directors don’t help either. So what about (3) hostile
takeovers as a device for overthrowing ineffective management? The fundamental
problem with a hostile takeover is that it is very expensive (owing to the need to
pay shareholders a premium in a tender offer.) This means that ineffective
management can drive down share prices by quite a bit (often by 50% relative to a
“competently managed” level) without facing any danger that a hostile takeover
will become a real possibility. The prevalence of such situations was the basis for
the “Wall Street rule,” which held that dissatisfied shareholders should just sell
their shares rather than trying to overthrow the management.
So what about (4) institutional investors as a check on management? Note that
institutional investors do not represent all shareholders of a corporation. Rather,
they are looking out for the interests of their own investors. Sometimes, a decision
that is good for the institutional investor is not good for the corporation.
One might imagine that (5) the market for products might check bad management.
The problem is that large corporations can withstand huge losses from bad
products before facing any danger of bankruptcy. For example, between 1986 and
1990, GM lost $20B but had accumulated so much equity that the loss didn’t even
affect its bond ratings. In fact, the CEO was paid a severance package $50M to
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Currently, the focus has shifted to (6) “gatekeepers,” such as accountants,

lawyers, and somesuch. But as with the previous five iterations, there is an agency
problem. For example, accountants are hired and paid by the management; it is
not good for accountants to “rock the boat” with the management.
As of now, millions of people are entrusting corporate managers with their money
by buying shares of corporations, and they are making money. Why is this, given
that so many agency problems exist? The first view is that the regulations, taken
together, are effective in reining in agency-relationships abuses. Alternatively, it
could be the case that most people are honest, so that management is not as
prone to abuse agency relationships as one might expect. Within managerial
circles, managers know each others’ reputations, good or bad. These sorts of
social relationships might check abuses.

A Private Corporations or Public Corporations?

Suppose there is corporation held by three shareholders, who simultaneously serve
as managers. Here, there is no agency problem since shareholders and
management are the same people. Does this mean that private corporations are
preferable to public ones in terms of avoiding agency problems?
Note that no one is forcing corporations to be public or private. Investors have
incentives to take private companies public (or vice versa) if they think that doing
so will improve the efficiency of those corporations. The fact that both types of
corporations exist suggests that neither type of corporation is inherently “better.”

Charlestown Boot & Shoe Co. v. Dunsmore

The court is articulating the principle that shareholders cannot directly interfere
with the business decisions of directors. The directors are independent. If
shareholders don’t like what the directors have been doing, they can fire the
directors. Independence of the board protects the minority shareholders from the
majority. The board of directors have a fiduciary duty to serve all shareholders
alike, not just those who are in the minority.

B Firing a Director
The corporate laws of many states allow shareholders to remove directors for good
reason. Furthermore, Delaware law allows shareholders to fire directors for no

Classified Boards
Suppose there is a board with 15 members. In a normal board, a majority
shareholder can fire all 15 directors for no reason. In a classified board, the
directors are divided into three groups, such that only one group comes up for
reelection each year. Someone who takes over such a corporation can only
appoint 5 directors upon takeover; it will take two additional years to replace the
remaining 10 directors. (The sole exception is if the buyer has good reason to fire
one of the remaining 10 directors.) The point of classified boards is to serve as a
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defense against takeovers; most owners are hesitant to deal with such a delay
since the non-removable directors can cause trouble with their business decisions.
Because classified boards strongly disincentivize takeovers, Delaware law forbids
corporations from arranging their boards in such a way to require more than three
years to obtain a majority of the board.

Directors are not agents of shareholders

Directors are not legally recognizable agents of shareholders. This is the central
basis for the independence of the board; shareholders are not allowed to give
instructions to the board. Contrast this with the relationship between directors and
management, which is an agency relationship. [So what exactly is the point of
having shareholders appoint the board?]
In some other countries (e.g., Israel), the shareholders can take authority away
from the board of directors and directly make decisions for the company. Which
rule is implemented depends on whether one thinks that the board or the
shareholders should be the center of the corporation.

Schnell v. Chris-Craft Industries, Inc.

Here, the directors disingenuously changed the date of the shareholder meeting to
make it harder for shareholders to reach a consensus on removing the directors.
Here, we are again confronted with an action that is ordinarily permitted but which
has been prohibited because of disingenuous underlying motives. The directors
are interfering with shareholders’ rights. The law does not allow directors to
frustrate the division of power between themselves and shareholders.

Blasius Industries, Inc. v. Atlas Corp.

Atlas basically implemented a “board-packing” plan in order to entrench its
majority on the board. The court held that a board must have a “compelling”
reason for such an action before that action could be validated.
Let’s accept the court’s conclusion that the primary interest of the maneuver was
to make sure the directors remained in power. But let’s also say that the
underlying motivation was to prevent an unfavorable transaction.
The court says that directors generally have a duty to fend off purchasers who
might want to hurt the corporation. At the same time, the court is also saying that
the directors cannot serve that duty by messing with the separation of power
between directors and shareholders. The court is imposing a higher level of
scrutiny on “protective” manipulation of the board than on other protective
Delaware observes the Unocal rule, which says that manipulations designed
principally to interfere with the effectiveness of a vote involves a conflict between
the board and a shareholder majority. The rule says that directors must respond
“proportionally” to a threat; they are not to take “draconian” measures. The
Unocal rule falls between the entire-fairness standard and the business-judgment
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rule in terms of strictness.

In practice, it is difficult to tell when the Unocal rule should apply and when the
Blasius analysis should apply. In fact, it’s hard to tell if there is any appreciable
difference between the two cases. As a result, courts often apply both standards
to cases.
Suppose that a board of directors in a proxy fight realizes that the vote is likely to
be close. The board approaches a shareholder and offers to buy his block of shares
for some (presumably elevated) price. As a result, the board solidifies its own
position. Which standard should apply? (Business-judgment rule or
Prof. Goshen: We need to decide whether Blasius or Unocal applies only if there is
some material distinction between the standards. This question will be discussed

C Proxy Voting
The Borak Case
The Borak case established that private parties may sue for violations of proxy
rules. To the extent that allowing private enforcement increases the number of
parties that could potentially enforce the rules, why doesn’t the government just
ask for more manpower?

Mills v. Electric Auto-Lite Co.

There are two views in this case. First: In order to obtain damages, you need to
show that shareholders would not have approved the merger but for the
misleading statement. Second: The plaintiff need only show that controlling the
vote itself (i.e., the proxy process) was necessary for prevailing on the decision.
The court took the second view.
As to damages, the court says that fairness determines damages (fairness = no
damages). [So there will be damages if the defendant cannot prove the
transaction was fair?]

“Materiality” of information disclosed within proxy statement

The test for materiality is based on “substantial likelihood” of reliance on the part
of the shareholders. See TSC Industries v. Northway, Inc.

Virginia Bankshares, Inc. v. Sandberg

There were several factors pointing toward a materially misleading statement by
the directors: (1) the $42 per share price was recommended despite valuation as
high as $60, (2) the valuation of real estate based on historical rather than present
values, and (3) directors who wanted to keep their positions by approving the
Note, however, that Virginia Bankshares had 85% of the shares. In other words, it
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did not need to go through the proxy process in order to prevail on the decision.
Virginia Bankshares solicited proxies because it needed to preserve its reputation
within the community.
The court said that one need not show reliance on the part of any shareholders
because that would be practically intractable. The court also imposed liability on
the basis of negligence, though courts disagreed as to the exact standard.

Rosenfeld v. Fairchild Engine and Airplane Corp.

The court limited reimbursement of proxy costs to disputes as to “policy.” The
incumbent can be compensated whether it loses or wins. Insurgents, however, can
be compensated only if they win and if they receive shareholder approval for the
Now suppose that the insurgents admitted that the contest were purely personal.
Note that such a claim would seem to eliminate the incumbents’ ability to be
reimbursed for the costs spent defending against such a contest. One way around
the problem is to frame the personal issue as a policy issue. The incumbents can
claim, for example, that the insurgents are actually lying and that the insurgents
actually intend to overthrow the management.

Class 7 (August 26)

The new SEC rules mark the first step in shifting power from directors to

Short Selling
Suppose that an investor knows that a stock’s price will rise from $200 to $400. In
that case, he should take a “long” position by buying shares and waiting for the
price to rise. Now suppose that the investor knows that the price will drop from
$200 from $100. Suppose also that he does own any of the stock. In this case, he
will borrow the shares from someone who has no intention of selling. He will sell
the borrowed shares at $200, wait for the price to drop to $100, and repurchase
the shares at $100. Then he returns the shares to the lender and walks away with
$100 per share. This is known as a “short” position. One takes this position when
he believes that the price of a stock will go down.
Consider, however, the risk of short selling. If the investor initiates a short sale at
$200 but then the price goes up to $1,000, he will lose $800 per share. Notice that
there is no limit to the losses that can result from short selling. By contrast, the
maximum that one can lose from a “long” position is the purchase price of the
§ 34 Shareholder Voting
Ordinarily, there is an alignment of interest between shareholders’ voting and
shareholders’ economic interests. Suppose that a shareholder owns 10% of the
votes but none of the economic interest. In this case, the shareholder cannot be
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trusted to vote in a manner that will maximize the corporation’s economic

Think of a share as follows:

Economic Rights

A Vote Buying
The problem of vote-buying results from the fact that individual shareholders tend
not to value their votes very much. Since the average shareholder owns only a
tiny fraction of the voting stock, he is unlikely to believe that exercising those
votes will have any impact on the outcome of any corporate decisions. At this
point, an interested party can approach the investor and offer $2 in exchange for
the votes. Buy accumulating a large number of votes, the interested party can
then influence the decisions of the corporation. Because the interested party has
no economic interest in the corporation, he cannot be trusted to vote in the best
interests of the corporation. For this reason, Delaware law prohibits vote-buying.

B Eliminating Economic Rights Through Short-Selling

Suppose that an investor first purchases 10% of a corporation’s stock (i.e., obtains
a long position in those shares) and thereby obtains 10% of the vote. Suppose that
the investor then enters into a short-sell with an additional 10% of the stock. As
long as the investor holds on to the borrowed shares, the gains and losses from the
long and short positions will cancel each other. In effect, the investor no longer
has any economic interest in the stock; all that remains is the voting rights
associated with the shares. The investor may then have an incentive to vote in
such a way as to benefit third parties (perhaps another corporation in which he has
an interest) regardless of whether the particular decision is good for the
corporation. This is known as “empty voting.”
As it stands, the SEC has no rules regarding disclosure by investors who take
empty-voting positions.

C Sale of Control
The whole point of the control premium is to reflect the fact that control of a
corporation can allow a controlling owner to take advantage of private benefits of
control while staying within the bounds of his fiduciary duty. The extent of these
private benefits depends on various factors, including government regulations,
market conditions, and so forth. Empirical studies indicate that the control
premium is 10%. By contrast, these studies indicate that the control premium in
Italy is 70%.
The minority shareholders will earn money if the purchaser of the control is a
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better manager than the seller of control. On the other hand, they will lose money
if the purchaser is a worse manager than the seller. But this is a risk that occurs in
any transfer of control.
For the seller, the crucial point is the moment of sale. Before that moment, the
seller can be held liable for violations of the fiduciary duty. After the shares have
passed in the hands of the buyer, the seller no longer cares what the buyer does
with the corporation.
From the perspective of the minority shareholders, the important question is
whether the new controlling shareholder is a better thief than the previous one.

Zetlin v. Hanson Holdings, Inc.

The plaintiffs are complaining that the former controlling owners of Hanson
Holdings should have allowed the plaintiffs to share in the control premium
resulting from the sale of their controlling shares. The court is saying that the
control premium is the private property of the controlling owner.

Gerdes v. Reynolds
Note that the shares were valued at 6¢ but sold at $2. This is a typical example of
selling a corporation to a looter. The idea is that the sellers are receiving a
premium in exchange for allowing the buyer to do whatever he likes. The plaintiffs
claimed that the sellers should have known that the buyer was a looter.
The rule is that the controlling owner can keep the control premium, but he has a
duty to perform due diligence. He cannot close his eyes when he sees that the
buyer is paying a huge premium for the shares in question. In general, the
majority shareholders have a duty to ensure that the buyers are not looters.
The law is essentially forcing the sellers of control to police buyers to make sure
that the buyers are not corporate looters.

Perlman v. Feldmann
The central issue is the impact of the transaction on the Feldmann Plan. There was
a shortage of steel, so Newport Steel should have raised prices. However, this was
not politically feasible because it would make the company look unpatriotic. The
Feldmann Plan got around this problem by allowing interest-free loans from
consumers. This is effectively raising the price of the steel. The sale of Newport
Steel upset the apple cart with regard to the Plan. The “business opportunity”
missed was the opportunity to make customers pay a bribe to get the scarce steel.
The buyers (who were consumers of steel) wanted to avoid paying the bribe by
buying Newport Steel.
The court is not making a rule that the control premium always has to be shared
with the minority. The court is saying that if the sale of a controlling block entails
the sale of some asset belonging to the corporation, then the seller cannot keep
the premium all to himself.
Here are actual share prices for Newport Steel around the sale:
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Jul. $6.75
Aug. $8.50
Sep. $10.90
Oct. $12.50
Nov. $12.40
Dec. $12.00

Notice that share prices went up after the sale. However, we don’t know two key
facts: (1) what were the overall market conditions and (2) the value of the
company’s inventory.

D Possible Rules on Control Premiums

The U.S. rule: Seller gets to keep all of premium unless there is evidence that the
buyer is a corporate looter (i.e., transactions are subject to the fiduciary duty)
Equal premium: Premium must be shared with all shareholders on a pro rata basis
The goal of rules on control premiums is to make sure that all efficient transactions
(i.e., which enhance the performance of the corporation) are allowed and all non-
efficient transactions (i.e., those involving corporate looters and so forth) are
prohibited. Which of these rules is better?
The U.S. rule allows all efficient transactions to go through. Suppose that a buyer
pays $17 per share for a company whose stock is trading at $15. If the buyer is
indeed a good manager, then the minority should be very happy; the buyer is
essentially betting that he can increase the value of the company to more than
$18 per share. The problem is filtering out bad transactions. On the other hand, it
is also possible that the buyer is a looter who seeks to recover his $2 premium by
selling off assets of the corporation. The U.S. rule doesn’t have any way to
distinguish between these two scenarios.
In the same scenario, the equal-premium rule would require the buyer to buy out
the minority’s shares at $17 as well. In effect, the buyer would be required to
purchase 100% of the corporation. Consequently, there is no incentive to loot the
corporation. So the equal-premium rule filters out all looting transactions. The
problem, however, is that some “good” transactions will also be prohibited.
Basically, the requirement that the premium be paid to minority shareholders
increases the expenses of the buyer, making some otherwise-efficient transactions
Which rule is better depends largely on how good the courts are at using the
fiduciary duty to rein in abuses that might take place under the U.S. rule. Perhaps
the U.S. rule would be better when corporations are being governed by Delaware
courts (which are very good at evaluating transactions for efficiency). By contrast,
the equal-premium rule would be better with English courts, which are not as
skilled with corporate law.
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Brecher v. Gregg
Importantly, the court is saying that there is a threshold size below which a block
of shares will, as a matter of law, not be considered a controlling block. When an
extremely small block of shares is allowed to control a corporation, that
shareholder has no incentive to observe the fiduciary duty. Instead, the
shareholder would be tempted to benefit himself at the expense of the other
But—the existing 4% owner can exploit the corporation just as much as the new
one. So why are we afraid of new owner? The answer is that the new owner will
have even more incentive to steal from the corporation in order to compensate for
the control premium he paid to the original owner.

Essex v. Yates
Here, Yates received a control premium for a 28.3 percent block of shares. The
court said that the burden was on the plaintiff to show that 28.3 percent was too
small to be a controlling block and that the payment of the control premium was
therefore inappropriate.
Note that the agreement concerning the appointment of new directors was
necessary because the buyers were not sure that they would be able to gain
control of the board through the normal voting mechanisms. Judge Friendly and
the majority disagree as to whether these sorts of arrangements are a valid way to
circumvent an uncertain vote.

Inhibiting Changes to the Board

Delaware law prohibits corporate charters from saying outright that shareholders
may not fire directors. Suppose, however, that we structure the shares in such a
way that the directors are guaranteed to have a majority of the voting shares. This
approach technically complies with the limitations of Delaware law. In fact, the
combination of a “poison pill” and a staggered board effectively prevents attempts
to fire the board, and this approach also falls within the limitations of Delaware law.
Suppose that a corporation initially has only A shares. It would be plainly illegal to
let the directors exchange their A shares for a new class of B shares, which as ten
times the voting rights of A shares. Now suppose that we try to avoid this
problem. We redefine A shares to have ten times the voting rights of before.
However, we write into the charter a condition saying that a buyer of an A share
will get only one vote with that share unless the buyer holds that share for at least
three years. Because shares on the open market are traded frequently, it is
basically impossible for any buyer to get the ten votes. Delaware law says that
this kind of scheme is not a conflicted transaction. Delaware law says that as long
as a change to the corporate charter formally affects all shareholders equally, it is
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Class 8 (August 27)

§ 35 Mergers and Acquisitions
Corporations can grow (1) internally, by building more factories, etc., or (2)
externally, by acquiring other corporations. Reasons for purchasing other
corporations include economies of scale, economies of scope, “synergies,” risk
diversification, gaining market presence, and so forth. Regardless of the motives
behind the mergers, the key here is that the mergers discussed here are friendly
mergers. From the standpoint of corporate law, the fear is that friendly mergers
may be designed to benefit the management of both corporations to the detriment
of the shareholders.
There are three ways to acquire a corporation: (1) asset acquisition, (2) stock
acquisition, and (3) merger. The choice as to which method to use is influence by
many factors. Some of these considerations include tax issue and regulatory
issues. For our purposes, however, the important factors are shareholders’ rights,
the speed of the merger, and several similar factors.

A Asset Acquisition
Suppose we have acquiring corporation A and target corporation T. Initially, both A
and T have their own assets. In an asset acquisition, A purchases T’s assets,
paying in cash or by issuing shares of itself. This method, however, entails huge
transaction costs. A must spend time and money identifying T’s assets and
performing due diligence on them. Then there is the technicalities of transferring
title of the assets. Furthermore, T may hold some assets that are not transferrable.
At any rate, when the transaction is finished, all of T’s starting assets will belong to
A, and T’s “assets” will consist only of A stock.
The advantage of this method is that A can pick and choose the assets it wants to
purchase. A, for example, might buy only T’s factories without taking on the
employees working in those factories. In other words, A can avoid unfavorable
liabilities that might arise against T. Suppose that T polluted a river some years
before the merger. An asset purchase would insulate A from any judgment
rendered against T. In terms of shareholders, an asset purchase generally will not
trigger shareholder-approval requirements for either A or T. That said, the NYSE
has added its own requirement saying that some kinds of asset-for-stock purchases
must be carried out with shareholder approval. In particular, if A pays out 20% or
more of its total shares in exchange for T’s assets, then A must have that
transaction approved by a simple majority of its shareholders.
Now, after T’s assets have been acquired, the next step is to liquidate T and
distribute the proceeds to T’s shareholders. If T was paid in cash, then T’s
shareholders take that money and go home. If T was paid in A stock, T’s
shareholders become A shareholders.
Normally, no liability against T will run to A. However, some courts will treat this
sort of asset acquisition as a de facto merger and extend T’s liability to A.
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Usually, asset acquisitions are rare because they are so complex from a practical

B Stock Acquisition
Here, our goal is to reach a situation where T is a subsidiary of A. One way to do
this is to buy shares of T from T’s shareholders. This is typically done through a
tender offer. The problem with this, of course, is that the shareholders may not be
willing to give up their shares. This is a particular problem when a few holdouts
prevent A from getting 100% ownership of T. But assuming that the purchase of
stock is successful, we again have a situation where A is insulated from T’s
liabilities. Again, the main exception is when someone convinces a court to pierce
the corporate veil. Because T’s shareholders are offered money for their shares
individually, there is again no triggering of T’s shareholders’ rights.
A second way to do a stock acquisition is for T to issue enough new shares to A so
that A has control of T. In this case, T shareholders will have to approve the
transaction, but only under the simple-majority rule imposed by the NYSE. There is
no appraisal on either side.

C Merger
In a merger agreement, the shareholders and directors of both corporations must
approve. Furthermore, shareholders on both sides get appraisal rights. Normally,
the articles of merger must be filed with the relevant government offices. Once
this is done, all the assets and liabilities of T will move to A. T’s shareholders will
then get whatever price was negotiated for the transaction (either cash or A stock).
The merging parties have a choice as to the name of the corporation that emerges
from the merger. Notice, however, that liabilities against T can now be held
against A after the merger.
There are several exceptions to the requirements of board/shareholder approval
and shareholder appraisal.

Small-Scale Mergers
If A is much bigger than T, then the transaction can qualify as a small-scale
merger. The question turns on whether T’s shareholders are getting less than 20%
of A’s shares as payment. Of course, T’s shareholders don’t care that T is “small”
in comparison to A; T’s shareholders will still get to approve the transaction by a
vote as well as appraisal rights. For A, however, there is neither a vote nor
appraisal rights for shareholders.

A Twist
Suppose that A issues new shares to third parties to raise cash. A then uses the
cash to buy T. In this case, there will be no shareholder approval by T since the
transaction is technically an outright purchase rather than a merger.
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Short-Form Merger
Suppose that A already owns 90% or more of T. In this case, A can “cash out” the
public owners of T following a unilateral decision by the board of A. A’s board
simply offers a price to T’s public shareholders and tells them to go home. T
shareholders’ only right is the appraisal right, in case they feel the offered price is
too low.

D Triangular Mergers
Suppose that, as before, corporation A and corporation T want to merge. Let’s say
that under the agreement, T shareholders should get one million shares of A. In a
normal merger, approval by shareholders and directors on both sides will
consummate the transaction.
In a triangular merger, A creates a new corporation N, which has no assets. A then
transfers to N one million A shares (which would be paid to T shareholders in a
regular merger). Now, a merger agreement is signed between T and N. Again, T’s
shareholders will get one million shares of A. The difference, however, is that A is
the sole shareholder of N. Furthermore, the board of N will be employees who do
A’s bidding. When the T-N merger is complete, subsidiary N will hold all of T’s
assets and liabilities. The last step is to determine whether the subsidiary should
be called T (“backward triangular merger”) or N (“forward triangular merger”).
Here, A is again insulated from liabilities originally against T. Furthermore,
shareholders of A neither get to vote on the merger, nor do they get appraisal
It should come as no surprise that the most common form of merger is the reverse
triangular merger.

Difference between Triangular Merger and Stock Acquisition

In a stock acquisition, the problem is that not all of T’s stockholders may be willing
to sell their stock. If there are some holdouts, then A will have to go through an
additional rigmarole of forcing out the holdouts. By contrast, a triangular merger
automatically forces all of T’s shareholders to go along with the transaction as long
as a majority of T’s shareholders approve.

E Leveraged Buyouts Revisited

Suppose that someone wants to buy T corporation. The buyer creates a new
corporation A and has A borrow a lot of money (for the eventual purpose of buying
T). At this point, A has no assets to secure the loan. Now, the lack of assets
means that bonds issued by A will have very low ratings. In general, bonds rated
BBB or above are known as “investment-grade bonds.” Lower classes are known
as “junk bonds.”

Suppose that corporation A and corporation B are similar in every respective and
both have $1,000 in assets. Corporation A is financed 90% by equity and 10% by
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debt. Corporation B is the other way around: 10% by equity and 90% by debt.
Now suppose that something bad happens to the economy and both corporations
lose $200 of their assets. In corporation A, the $200 loss will be borne by the
shareholders. In corporation B, the first $100 of the loss will exhaust what can be
borne by the shareholders; the remaining $100 will fall on the creditors. B is
known as a “highly leveraged” corporation since it has a lot of debt compared with
its asset value.
In the A/T leveraged buyout, the huge debts incurred by A will fall on T’s assets.
Bonds issued by T will have their ratings reduced because of the sudden increase
in debts. Result: T’s bondholders will be angry.
Now, a very smart investor figured out that a diversified portfolio of junk bonds
could give a higher-than-normal return/risk ratio. (In short, the bonds issued by A
were underpriced.)

Hollinger, Inc. v. Hollinger International, Inc.

The entire point of this case is that the Gimble test isn’t really a test. There is no
simple way to know whether some transaction involves “substantially all” of a
corporation’s assets.
Note that the chain of subsidiaries owned by Hollinger International do not act
independently. Rather, each subsidiary does the bidding of the parent and acts in
the parent’s interest. This is a reason for tracing the chain of subsidiaries back to
the parent.
The court, however, was careful to avoid saying that one could trace the chain of
subsidiaries back to the parent since this is a drastic doctrinal move. Rather, the
court said that International signed the contract, so that should be the basis for

Hariton v. Arco Electronics, Inc.

The court here seems to favor form over substance; as long as the acquiring
company complies with the technical requirements of an asset purchase, the
transaction is characterized as such a purchase rather than as a merger.

Ferris v. Glen Alden Corp.

Why did the two corporations opt for the “upside-down” merger format? The
purpose was to take advantage of favorable state laws. See p. 1071. Glen Alden
was a Pennsylvania corporation. List was a Delaware corporation. By making Glen
Alden the purchaser, it was possible for the parties to avoid triggering certain
shareholder rights.
Note that the “book values” of shares are irrelevant in this context. The book
values are calculated only for accounting purposes and do not reflect actual
market values of stocks. Basically, book values are calculated from “snapshots” of
a corporation’s status as of some arbitrary date.
For practical purposes, the accounting profession has chosen to valuate assets
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using methods that are easily verifiable. For example, a building is always listed at
its purchase price. Of course, the problem is that accountants then have to adjust
for the appreciation or depreciation of assets.
The judges were wrong to rely on book value in making their decisions. (Note that
this was the Supreme Court of Pennsylvania, not Delaware.) They decided whether
the plaintiffs had been harmed on the basis of values that were completely
Aside: In recent years, there has emerged an accounting system called
International Financial Reporting System (IFRS). This system requires that assets
be recorded based on their current values, not based on purchase cost or some
other arbitrary snapshots. IFRS has not yet been adopted completely in the U.S.,
but American accounting firms are increasingly using methods that are in line with
the intent of IFRS. Of course, the downside is that some subjective judgment is
necessary to appraise certain assets, so there is some room for manipulation of
asset values.

Terry v. Penn Central Corp.

Here, there is again a form-over-substance ruling, but this time the voting rights as
well as the appraisal rights are gone. So now we have to ask ourselves, “Why is
shareholder voting necessary?” It is one thing to say, “I don’t like the change that
has been taken place.” It is a different thing to say, “I feel the transaction has
been done in a way that is unfair to me.”

Class 9 (August 30)

§ 36 Mergers and Acquisitions: Freezeouts and
Appraisal Rights
Why allow shareholders to vote on actions by the corporation? The first answer is
that shareholder voting can safeguard the corporation against wrong decisions.
The second answer is that shareholders need to be in a position to “punish”
directors for making bad decisions.
The settled law, however, doesn’t fit this logic in that a purchasing corporation is
not required to seek the consent of its shareholders before buying another
corporation. The same is true of triangular mergers. In a cash transaction, there is
usually no stockholder vote required since no shares are being diluted.
§ 37 What is an appraisal?
Suppose that Zohar owns a machine that produces shoes. Suppose also that the
machine is the corporation’s only asset and that the corporation has only one
share. So what should be the price of the share?
Suppose that the machine can produce, every year, an expected return of $1,000
per year.
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A Discounting to Present Value

Because of the time value of money, money in the future is worth less than money
today. Suppoe that the machine can produce $1,000 per year forever, we make
the calculation
PV = $1000 / 10% = $10,000 (where PV = present value)
This value ($10,000 in the above example) is called the discounted cash flow
Of course, this model is a bit simplistic in the sense that it assumes the same
expected return throughout the lifetime of the machine. In real life, the expected
returns from the machine may change from year to year; these changes need to
be taken into account. Likewise, expected returns may also be adjusted based on
the company’s projected growth.
Since we have only one share in our example, the value of the share should be
Note that calculating things like future cash flows is far from a precise exercise.
It’s very hard to know what the expected return on any particular asset. In fact,
small changes in the initial estimates can lead to very different final results.

B The Block Method of Valuation

Under the “block method” of valuation formerly used by the Delaware courts, asset
values, stock prices, and discounted cash flows would be assigned different
weights and then averaged to come up with the value of the corporation. Now, the
prevailing method of valuation is DCF. Some other states, however, still use the
block method.

C Appraisal Rights
Why do appraisal rights exist? Originally, corporations were not traded on open
markets. The lack of liquidity meant that appraisal was the only way to get any
meaningful estimate of the value of a corporation. Now that many corporations
are publicly traded, consider what purposes appraisal may serve.
Originally, there was the fiduciary duty, which required directors to engage in fair
dealings and to provide a fair price in a merger. Now, the appraisal right
supplements the fiduciary duty.

Practical Dimensions of the Appraisal Right

Note that most appraisal-right claims are brought by individuals. Furthermore, a
plaintiff demanding his appraisal rights need not point to any particular
wrongdoing on the part of the directors. The plaintiff need only argue that “the
price was not right.” Appraisal also carries its own risk: if the appraised value is
less than the value offered in the merger, the plaintiff gets the appraised value. By
contrast, a fiduciary-duty action has a “floor” in that the worst that could happen is
that the plaintiffs will settle for the originally offered price. Finally, there are
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exceptions to the appraisal right, which do not hold when a breach of fiduciary
duty is claimed.
It should therefore not be surprising that most shareholder actions are brought as
fiduciary-duty claims rather than appraisal-right claims.

Exceptions to the Appraisal Right

Appraisal rights are not available (1) on the purchasing side of a short-form
merger, (2) in a sale of assets, and (3) in a triangular merger. Furthermore, there
is the “market out” exception. If the payment made to the minority shareholders is
in the form of shares of the purchasing corporation. Prof. Goshen: This makes no
sense, since it is just as easy to underpay the minority in shares as in cash.
Consider corporation C, with minority shareholders owning 40% of the stock. Let’s
say that the total value of the assets of C are $1,000. We know that on the open
market, the minority’s shares will be worth less than $400 (and the majority’s more
than $600) because of the control premium. Suppose that the control premium
here is $100, so that the minority’s shares are really worth only $300. When a
court refuses to apply the “minority discount,” the court is in effect saying that the
minority is entitled to a portion of the control premium. Why should the court do
this? The reasons vary. (See casebook.)
Now suppose that the controlling owners of C want to buy out C in order to merge
it with some other corporation. The resulting synergies will increase the value of
C’s holdings from $1,000 (the original value of C) to $1,500. The minority
shareholders are not entitled to share in this surplus. See DGCL § 262(h). Is this
fair? Consider the view that any surplus derivable from potential mergers may
already be reflected in the price of the stock. In other words, part of the value of
the synergy can be viewed as already being locked up in the assets of the
unmerged corporation.
§ 38 Mergers: Friendly versus Hostile
Suppose that a corporation has a stock price of $100. Suppose that a buyer is
willing to pay $150 per share for 50% of the shares (thereby gaining effective
control). Note that $150 is a 50% premium for the shares. However, note that the
buyer would not be offering $150 per share unless he were reasonably sure that he
could make significantly more than $150 per share after the purchase. So let’s
suppose the buyer thinks that he can increase the value of the corporation to $200
per share. In this scenario, there is an incentive for potentially minority sellers to
hold out because they know the buyer is making a bet that share prices will go up
after the merger. In this case, there is a pressure not to tender. If that pressure
holds, then the transaction will not take place, and everyone will suffer because a
beneficial transaction will have been frustrated.
So—if you want mergers to take place, there has to be a way to prevent the
holdouts from sharing fully in the value increase resulting from the merger.
Suppose that the bidder is allowed to force holdouts to accept the second tender
offer, whatever the price might be. This creates a pressure to tender. Suppose,
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however, that the bidder then says that he will only buy 50% of the shares at
$150. At this point, the average seller will sell half his shares at $150. The second
half will then be sold at the forced price (let’s say $100). The average selling price
of the shares will ultimately be $125.
The only scenario in which sellers can express their true opinion as to the value of
their stock is when the price in the second step is the same as the price in the first

A Structuring Tender Offers

Bidders have structured their tender offers to take advantage of the collective-
action problem that shareholders face. In fact, there are a great number of
techniques for making the second stage look the same as the first while concealing
some material differences. Courts are aware of the ways in which bidders can do
“damage” to holdouts.

Weinberger v. UOP, Inc.

Consider that we are trying to replicate an arm’s-length transaction between the
buyer and the seller. Why does Signal have any duty to disclose to UOP’s
shareholders information concerning Signal’s intended bids? The answer is that
the estimate of $24 per share came from a conflicted director of the target
corporation. See footnote 7, which states that UOP should have established an
independent committee to review the merger. Had UOP done that, Weinberger
would have had to carry the burden of proof as to the fairness of the transaction.
The Weinberger court, however, said that a business purpose was not necessary to
support the merger. Again, the rationale for abrogating the business-purpose
requirement is to allow the corporation to end its relationship with shareholders at
Suppose that acquiring corporation A wants to buy target corporation T. A states
that it will carry out the transaction in a two-step format, with both steps featuring
a price of $150 per share. Initially, A has no fiduciary duties to T’s shareholders
since it is not a controlling shareholder. Once A acquires more than 50% of T’s
stock, however, it becomes a fiduciary.

The Solomon Rule

The Solomon rule says that there is no fiduciary duty in a cash-out merger.
Suppose that A already owns 90% of T. In this case, A owes no fiduciary to T’s
shareholders in effecting a cashout merger for the remaining 10%.
Suppose now that A undertakes an ordinary merger with T. Here, we can have (a)
the independent directors approve the merger or (b) a majority of the minority
approve the merger. In either case, the fairness standard (with burden on plaintiff)
will apply.
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Pure Resources, Inc. Shareholder Litigation

In this case, the court is starting to close the gap between a regular merger and a
cash-out merger. Here, the court says that A should not initiate a tender offer
unless a majority of the minority of T approve of the transaction. Furthermore, the
court says that the second step of the merger must give any remaining
shareholders the same price and at a reasonable price after the initial offer.
Empirical studies have shown that the premiums paid on tender offers is lower
than the premiums paid during mergers.

The CNX Gas Group Case (May 2010)

In this case, the Delaware Court of Chancery made a decision that overruled a
decision of the Supreme Court of Delaware. The court said that doing (a) and (b)
above throws a merger onto the business judgment rule. If (a) or (b) alone is done,
then the fairness test with shifted burden applies. The court also held that an
independent committee of independent directors must approve any tender offer; it
is no longer enough to have a majority of the minority to approve the offer. Failure
to meet this requirement will trigger the fiduciary duty. This case introduces a
certain amount of uncertainty into settled doctrine concerning mergers.

Berger v. Pubco (July 2010)

In the second step of a cash-out, shareholders have only an appraisal right.
Suppose that a shareholder tendered on the basis of defective information. What
rights does the shareholder have? The Supreme Court of Delaware said that in
such a case, shareholders have a collective, as opposed to individual, right to
appraisal. The holding imposed a very high cost on defective information.

Class 10 (August 31)

Shareholders face two problems in a merger: (1) the collective-action problem and
(2) the information problem. The Williams Act imposed some limitations on the
ways in which shareholders could be manipulated. Before the Williams Act,
strategies such as the “Saturday night special” severely limited shareholders’
ability to exercise their discretion as to mergers.
The Williams Act provided, among other things, an early warning system. Once a
buyer has purchased 5% of a target company, the buyer must disclose its
intentions as to a possible takeover. Of course, the Williams Act mitigates, but
does not eliminate, pressure on shareholders.
The alternative is to have directors negotiate the terms of a sale. The problem
here, however, is that directors might be conflicted. One way to mitigate this
problem is to say that directors must go through with the sale. This would
eliminate any conflicted gains resulting from frustrating a sale.
A third line of reasoning states that directors should do nothing. If managers knew
that it were very easy to take over their corporation, then managers would do a
better job of managing to avoid putting themselves in a position to be taken over.
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Prof. Goshen favors this rule. The reasoning is as follow:

The value of a share is based on two things: (1) the assets of the corporation and
(2) the size of the control premium. The control premium is in turn determined by
(a) the probability that the company will be taken over and (b) the amount that
any buyer would be willing to pay for control. The probability of a takeover tends
to be inversely related to the size of the control premium: the more expensive it is
to take over the corporation, the less palatable it will be to potential buyers.
Consider whether the search costs (for discovering a takeover target) are really
“sunk.” Suppose that a bidder buys 5% of the target’s stock. If the bidder
ultimately loses the bid for the company, is any gain resulting from the initial 5%
enough to offset search costs? Empirical studies suggest that the answer is yes.

Unocal Corp. v. Mesa Petroleum Co.

Prior to this case, “greenmailers” had already acquired a bad reputation for strong-
arming companies into making them payments. Mesa’s tender offer for Unocal
had a two-tiered structure. The first tier used cash. The second tier used bonds,
but the bonds had a value that was lower than what was printed on the bonds
themselves. Consider two checks: the first one is for $100M from Bill Gates; the
second one is for $100M from Prof. Goshen. The second check will clearly be worth
less than $100M; in fact, they will be valued at whatever people think Prof. Goshen
will be able to pay. This was the case with the second-tier bonds. The bonds were
“highly subordinated,”—in other words, they were ahead only of shareholders in
claims to assets upon liquidation. In practice, this meant that the bonds traded at
a significant discount to account for the risk of default. So the bonds, which had a
face value of $54, were worth closer to $45.
The claim here was that the tender offer was coercive since shareholders who did
not give up their shares in the first tier would end up with the less-valuable bonds
in the second tier.
Unocal’s response to the tender offer was to say that if Mesa was successful in
acquiring at least 51% of Unocal, then Unocal would acquire its remaining
outstanding shares through a debt-for-stock exchange at $72 per share. In effect,
Unocal was counteracting Mesa’s pressure to tender with a pressure not to tender.
At this point, no sane shareholder would have been willing to offer $54 in the first
tier when it was possible to get $72 at the second tier.
But why would this maneuver affect Mesa’s willingness to keep pursuing the
merger? Consider the following example. Corporation C has assets of $120 and
two shares: share A and share B. If the two shares are identical, both will be worth
$60. In this scenario, Mesa was willing to buy share A for $54 since it knew the
share was worth $60. Unocal’s response was to increase the value of share B to
$80 by giving the B shareholder priority in claims as to the corporation’s assets.
As a result, the value of share A decreases to $40. Now, it is no longer worth
Mesa’s while to buy share A at $54. In the actual Unocal case, Unocal’s maneuver
caused the value of first-tier shares to drop to $48.40 from the estimated value of
$60 (according to Goldman Sachs).
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But Unocal went one step further by committing to buy 29% of the shares for $72
per share regardless of whether Mesa’s tender offer succeeded. This was a huge
financial commitment and required huge amounts of debt. As a result, Unocal
would have to change its business plans to account for these new obligations.
Unocal was very clear, however, that this 29% commitment would not include any
shares held by Mesa. What is the effect of this decision?
Suppose that a corporation has assets of $60 and three owners (A, B, and C), who
each own two shares at $10 each. Now suppose that the corporation offers only B
and C to sell back to the corporation one share each at the price of $20. Consider
what happens when B and C accept this offer:
A – 2 shares
B – 1 share + $20
C – 1 share + $20
Now we are left with 4 shares and $20 in the corporation. This means that each
share is worth only $5. In other words, the two shares of A are worth only $10, as
opposed to the $20 before. The holdings of the shareholder who doesn’t
participate in the buyback are diluted. This rearrangement is a zero-sum game
because the company is simply reassigning claims among various shareholders.
Unocal justified this maneuver as a way to protect itself against the takeover.
Note, however, that Unocal’s action was actually more coercive than Mesa’s offer.
The 29% commitment by Unocal would drastically raise the value of those shares
at the expense of the remaining 71%. In effect, the first 29% of the shares would
be worth $72 whereas the remainder would be worth only $35. Compare this
spread with the $54/$45 spread of Mesa’s offer. (The 29% offer went out pro rata
to all non-Mesa shareholders who wished to tender their shares.) Believe it or not,
some shareholders nonetheless tendered to Mesa.
Here, the court found that Unocal’s actions were legitimately defensive conduct
because Mesa had started a coercive tender offer. Is this response “proportional,”
In any case, the Unocal rule states that a company taking a defensive action must
show (1) a threat and (2) that the defensive action is proportional to the threat in
order to avail itself of the business-judgment rule.
§ 39 Poison Pills
The “poison pill” is possible only because the Unocal court said that a corporation
may discriminate against a threatening bidder in a hostile-takeover effort. There
are two types of poison pills: “flip-in” and “flip-over.” The board of directors
adopts the pill by incorporating the relevant provisions into the corporate bylaws.
The operation of a pill begins with the distribution rights (i.e., call options) that are
way, way out of the money. (This is mainly to notify bidders of the existence of a
poison pill.) The second step is to define a triggering condition (e.g., a bidder
obtains a certain percentage of the stock), which changes the terms of the initial
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options. The triggering condition usually changes the terms allow existing
shareholders to purchase additional shares of the target (or the bidder) at a
significant discount.
Suppose that a corporation has $300 in assets and three shareholders (A, B, and
C). So initially, we have
Total assets: $300
A – $100
B – $100
C – $100
Suppose that the hostile bidder buys A’s share and thereby fulfills the triggering
condition (by owning 33% of the shares). The triggering condition states that B
and C will allow to buy one additional share at half price. So now the total assets
of the corporation are $400, but there are five shares. So now each share is worth
only $80.
Bidder – $80 (1 share; lost $20 because paid $100 for share)
B – $160 (2 shares; gained $10 because paid only $50 for second share)
C – $160 (2 shares; gained $10 because paid only $50 for second share)
The poison pill thus dilutes the bidder’s holdings. In real-world scenarios, a pill
may take away a much larger fraction of the bidder’s value.

Flip-Over Pills
How is this even possible from the legal standpoint? The answer is that the flip-
over pill activates only after the purchase is completed. In practice, the flip-over
pill is part of the conditions of sale of the target corporation.

Redeeming the Poison Pill

Usually, the target corporation allows its board to “redeem” the poison pill by
buying back the associated rights from the shareholders. In fact, this is part of the
reason that proxy fights have become prominent; the acquiring corporation tries to
change the board of the target, so that the new board can cancel the poison pill.

Standard of Review for Poison Pill

Poison pills are reviewed using the Unocal standard. (This is the case both when
implementing the pill and using the pill.) Now if we say that a board can
unconditionally decline to redeem the pill, we are essentially saying that literally
anything can count as a “threat” for the purposes of the Unocal rule. This also kills
the proportionality standard of the Unocal rule; what is there to say about the
“proportionality” of saying “no” to redeeming a pill?

Proxy Fights and Poison Pills

Now, a bidder will approach shareholders of the target and say, “Help us oust the
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existing board, and we will pay you a premium for your shares.”

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

Here, Revlon issued “poison debt” to prevent Pantry Pride from getting the
financing necessary to take over Revlon. The court is saying that the initial $45
offer and the later $42 offer were essentially equal offers. This is because the
initial purchase of 20% of Revlon stock diluted the remaining stock.
Revlon essentially put itself up for sale during the course of negotiations with
Pantry Pride. The court, however, found that Revlon improperly placed the
interests of the noteholders above those of the stockholders. This was because
the Revlon directors were afraid that the noteholders would sue them for the drop
in value of the bonds. (Note that this is not a realistic danger; the court called out
the directors for having this fear.) Revlon, in attempting to guarantee the bonds,
were redirecting money from the stockholders to the noteholders.
Note that the bidder doesn’t care at all how Revlon allocates the proceeds from the
Under the Revlon rule, once there is a sale of control, the directors of the target
corporation must conduct an auction or take whatever steps necessary to
maximize shareholder value.

Class 11 (September 1)
Paramount Communications, Inc. v. Time Inc.
The deal started out as a stock-for-stock merger between the two companies, but it
became a two-tier merger in which the first tier was paid in cash and the second
tier in stock. The Time-Warner merger was structured as a triangular merger at
first, but it became a two-tier tender offer.
How do the Revlon duties apply to this case? Note that Warner seems to be selling
control to Time. In the end, Time’s board was able to force Warner’s shareholders
to give up the $200 price and accept the $110 price. The court gave deference to
directors as to the intrinsic value of shares.

Paramount Communications Inc. v. QVC Network

Paramount granted to Viacom a “lockup option” that would compensate Viacom in
the event that Viacom lost its bid for Paramount. The key idea here is that the
Paramount shareholders would end up in the minority once the merger was
complete. The court here said that no contract could abbreviate the fiduciary duty
of directors.
Suppose we have corporation A and corporation B. The two corporations engage
in a stock-for-stock merger in which A exchanges shares of itself for B’s assets. In
the end, the original B shareholders become shareholders of A. If A and B both
have dispersed ownership, there is no transfer of control and therefore no Revlon
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Suppose instead that A gives B’s shareholders cash. After the merger, the former
B shareholders simply go home. Here, all the shareholders left after the merger
will be A mergers. Here, there is a sale of control and therefore Revlon duties. But
now, why should the form of payment dictate whether the Revlon duties are
triggered? After all, can’t the former B shareholders use their cash to buy shares in
the post-merger corporation? Why is there one rule for cash and one rule for
Here, the court is deferring to the discretion of the board as long as the payment is
in the form of shares. The adequacy of cash payments, on the other hand, is very
easy for courts to evaluate.
Consider the scenario in which Paramount shareholders became minority
shareholders upon completion of the merger.
§ 40 Special Lecturer
The Delaware General Corporations Law does not contain the words “fiduciary
duty” anywhere. Rather, the fiduciary duty is a common-law creation of Delaware
courts. Before the takeover boom in the ’80s, cases turned on concepts like
“purpose.” The main obstacle, however, is that determining a person’s purpose
was difficult when judges were unable to see that individual in person. Therefore,
tests like Unocal were developed to allow judges to make decisions without having
to determine issues like directors’ intent.
Formerly, mergers could not go through unless the shareholders unanimously
approved. This meant a single holdout could spoil the prospects for a merger.
Lawyers circumvented this rule by arranging for long-term “leases” of corporations
that operated essentially like mergers.
In general, directors have huge power to change a company without approval by
Directors’ duties in the takeover context arose in the ’80s.

The Unocal case

Unocal was the most aggressively defensive move by a corporation on record. The
court’s standard of “reasonableness” for defensive conduct gave courts great
discretion in deciding what sorts of conduct were allowable. (Note that
“reasonable” does not mean the same as “rational” in this context.) The Unocal
court said that courts may consider the interests of the “community” in deciding
whether some defensive action was appropriate. (Lots of things could fall under
“community” interests.)

The Interco (?) case

This was the first case in which the court ordered a board to redeem a poison pill.
Suggestion: Read side-by-side the chancellor’s opinion and the Delaware Supreme
Court’s opinion in Time-Warner.
The consequences of Unocal and Moran are that most transfers of ownership take
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place in the proxy-fight context.

Hilton Hotels Corp. v. ITT Corp.

Here, ITT postponed the meeting and explained that postponement as giving the
shareholders an opportunity to consider Hilton’s tender offer. Now, if ITT did not
have a staggered board, Hilton would simply initiate a proxy fight in order to install
a new board that would redeemed ITT’s poison pill. So why did ITT decline to add a
staggered board to counter Hilton’s advances? The problem is that reconfiguration
of the board would require a vote. The only “safe” place to put the rearrangement
was in the corporate charter, but by that time the proxy fight would already have
So ITT created a new corporation (with the staggered board and other defensive
features it wanted) and passed its assets to the new corporation. What’s wrong
with this approach? Recall that the value of a share consists of (1) the value of the
assets and (2) the control premium.
§ 41 Summary of Corporate Law (Minus Securities
The challenge of corporate law is to detect from the fact pattern which standard of
review to apply. So here are the standards of review:
Entire fairness (strictest)
Entire fairness + shift of burden to plaintiff
Intermediate test (Unocal/Blasius)
Gross negligence (implies standard of reasonableness)
Business-judgment rule / waste (standard of rationality only)

Class 12 (September 2)
§ 42 Securities Regulation
The purpose of securities regulations is to ensure the efficient operation of capital
markets. Where there are repeat players in a market, prices will tend to match the
quality of the product since it’s possible to cheat people only once.
Now suppose that a buyer and seller are negotiating over the price of a black box.
As long as neither party has more information than the other as to the contents of
the box, the game is “fair” in the sense that neither party can use his informational
advantage to manipulate the other party. Corporations are like black boxes, and
thousands of investors constantly try to guess the value of the contents of those
boxes. However, investors invariably have differential access to knowledge about
the contents of the box. The important thing is that not every investor needs to
know the key information in order for price to reflect value. Emprical studies show
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that as long as at least 25% of investors know the relevant information, the market
will behave as if every investor knew that information.
Suppose corporation A and corporation B are both trying to raise money. These
companies might sell stock (or bonds) directly to investors. This is known as the
primary market since the corporations are directly receiving money for the
securities. After the securities have been issued, investors will trade the securities
amongst each other. This is known as the secondary market. Note that trading on
the secondary market does not bring any money to the corporation. The
secondary market performs important functions, such as allowing for takeovers
when the stock price is too low. Furthermore, prices in the stock market serve as a
benchmark for transactions outside the stock market.
An efficient market is a market in which prices reflect value. The problem is that
testing the efficiency of markets is very difficult because there is no objective
measure of value. There are three test for efficiency:

Weak Efficiency
Weak efficiency is based solely on past prices. If there is some information that
can be gleaned from past prices, an efficient market will incorporate that
information into present prices. The result is that the price will fluctuate randomly
from day to day. This result has been borne out by empirical studies.

Semistrong Efficiency
A market is semistrongly efficient if prices immediately and accurately all publicly
known information. If some piece of information becomes known which alters the
price, prices should respond immediately. In practical terms, this means that
prices should respond within 7–14 minutes. From an ex post perspective, however,
it is hard to tell whether prices actually hit the “magic point” within 7–14 minutes
or whether the actual price reached represents undershooting or overshooting.
This has implications for people who might want to make delayed use of the
relevant information. If there is reason to believe that the market has overshot,
then an investor should take a short position on the security. If there is reason to
believe that the market has undershot, then an investor should take a long
position. If there are some expert investors who can “beat” the average investor
by making quicker and better use of the information, then the market can be said
to be inefficient. (Mutual funds like to claim this about themselves.)
Unfortunately, empirical studies of mutual funds have found that they don’t beat
the market when their results are adjusted for risk.
“There is something in life which is even more important than wisdom. It’s called
So what about investors who seem to have some kind of “magic touch”? It is
entirely possible that those few people out of the many thousands (if not millions)
of investors are simply statistical outliers.
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Strong Efficiency
A market is strongly efficient when it immediately and accurately reflects all
information (not just publicly known information, as in a semistrongly efficient
market). Suppose that some information starts out private, so that perhaps only
the CEOs of two merging companies initially knows the information. When the
information is release publicly, one of two things will happen:
(2) Nothing. The information may leak to a sufficient number of persons to cause
the market to respond. If this is the case, then insiders should not be able to beat
the market. Empirical studies have shown that inside traders in the U.S. routinely
beat the market despite the prohibition on insider trading. (Whether insider
trading should be allowed will be discussed later.)

Securities Regulation Tries to Promote Semistrong Efficiency

Who are the players in the market?
• Insiders – People who work in the corporation. They are privy to all sorts of
information not otherwise available, and they may influence corporate
• Information traders – Professionals. They analyze corporations. They often
work for institutional investors. Some may work indepedently and sell their
analyses to others in the market. In general, all these people invest based
on information. In short, they are looking for underpriced assets to buy and
overpriced assets to sell.
• Liquidity traders – They don’t care whether assets are overpriced or
underpriced. Their decision to buy or sell is driven primarily by their desire
to invest or consume. If they want to invest, they will do so by buying into
index funds or something similar. The key is that their buy/sell decisions are
driven by personal needs, not whether they think some asset is overpriced or
• Noise traders – Some invest based on clearly ridiculous criteria (tarot card
readings and so forth). Others try to be information traders but aren’t
professional enough to actually profit from information. They can exhibit
herd behavior and therefore can significantly influence prices.
The movement of the market is the sum of the influences from all four groups.
Noise and liquidity traders cause prices to fluctuate about the “true” value.
Information traders try to take advantage of these deviations by taking short
positions when the prices are too high and long position when prices are too low.
In other words, information traders tend to counter the fluctuations produced by
noise and liquidity traders.

Information Trading
Now, information traders must make enough of a return in order to cover their
costs and make a profit. The insight here is that the size of the price deviations is
only one factor influencing the behavior of informational traders. The other factor
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is the cost of running an information-trading operation. The higher the costs of

information trading, the larger the fluctuations. The fewer the information traders
in the market, the larger the fluctuations.

Enter Securities Regulation

Securities regulations affect search costs for getting information. Disclosure laws
force corporations to disclose certain types of information to everyone for free.
This reduces search costs. The same is true of verification costs. Laws force
corporations to make honest statements about the state of their operations.
Securities regulations therefore lower the likelihood of getting deceptive
information (i.e., fraud). Securities regulations therefore allow information traders
to focus of analyzing corporations. This, however, does not mean that the
regulations place no limitations on analyses. In particular, securities regulations
are particularly concerned with analysts with conflicts of interest. Finally,
regulations govern the actual trading of securities. Trading rules are intended to
rein in insider trading; otherwise, the information traders will have no chance to
profit from their analyses because insiders will always have the same information

Two “Chunks” of Securities Regulations

The first part of securities regulations generally comprises rules concerning search,
verification, and analysis. These rules are similar throughout the world. This set of
information, however, has nothing to do with “small” (i.e., non-professional)
Alongside these regulations exist a set of rules designed to protect small investors.
They govern how mutual funds and institutional investors can deal with their
clients. (This part of the regulations is not relevant to this class.)
Suppose we had a world with only insider or information traders. In such a world,
the market price would always reflect exactly the “true” value of the security. At
the other extreme, a world with only noise traders would exhibit completely
random fluctuations of prices. There is an ongoing battle between these two
extreme scenarios. Sometimes, informational traders may believe it’s profitable to
join the herd in the short term. (During the dot-com boom, even funds specializing
in short positions were long on the NASDAQ.)

Prohibitions on Fraud
Normally, when we say “fraud,” we are referring to misleading pieces of
information. This is in contrast to “manipulations,” in which an unscrupulous
investor might try to buy and sell from multiple accounts owned by himself, etc.

Basic Inc. v. Levinson

“Hard” information consists of objectifiably verifiable facts. “Soft” information,
however, involve hard-to-verify claims, such as projections concerning future
conditions. In terms of legal doctrine, this means that it’s much easier to
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determine whether hard information is material. The Basic court considers three
tests for the materiality of information concerning mergers:
1. The “agreement in principle” rule. This rule has the advantage of being a
bright-line rule. Furthermore, this rule has the advantage of not forcing the
corporations to disclose the planned merger too early. Under the “too early”
justifiation, the court pointed out problems concerning
1. When the possibility of a merger becomes a material fact
2. When the obligation to disclose arises
2. The Basic court rejected the agreement-in-principle test and accepted
instead the magnitude-of-probability test. The court recognized that
agreement-in-principle was a purely doctrinal rule that had no regard for
economic realities. The magnitude-of-probability test, however, focuses on
economic realities.
3. Lying. The court rejects this test works backward. Even if a lie is found, no
liability will attach if that lie was found to be “not material.” But this
completely negates the purpose of calling the statement a “lie” in the first
The court, however, wanted to have a legal test that would fit economic reality.
Note, however, that the court does not specify how great the probability of a
merger (or the expected returns) can be before the possible merger becomes a
material fact.
The Basis court held that the possible merger became a material fact before
agreement in principle occurred (and disclosure rule took effect). The main
objective of this holding was to rein in insider trading. By holding that the possible
merger was a material fact before its disclosure to the public, the court was
hanging a sword over the heads of would-be insider traders who knew about the
merger before everyone else.

Fraud-on-the-Market Theory
This theory assumes that (1) the market is efficient and (2) the integrity of the
market price. Now, “efficiency” in this sense cannot refer to strong efficiency; if
that were the case, then there would be no such thing as “insider” trading anyway.
In an omitted footnote, the court is saying that it is providing protection to
information traders. Second, there is the question of what the “market price” is.
The court is saying that “antitrust or political pressure” is a way to rebut the
integrity of the market price.

Class 13 (September 3)
A major goal of securities regulation is to minimize the costs associated with the
pricing of securities. This is accomplished through disclosure requirements and so
forth. The lower costs allow more competition.
Section 10(b) and Rule 10(b)-5 give rise to an implied right of action. This right of
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action is available only to parties that actually sold or purchased securities on the
basis of information.
§ 43 Insider Trading
Recall that the only two types of traders that can align price with value are (1)
information traders and (2) insiders. When we say that an insider has traded,
intuition tells us that it is the party opposite the insider that has been cheated in
some way. But consider what happens upon closer investigation.
Consider a piece of favorable inside information, which drives the corporation’s
stock price from $100 to $200. In a world without insider trading, disclosure of the
information would cause the price to jump instantaneously from $100 to $200.
Due to insider trading, however, the price gradually rises from $100 to $200 in
anticipation of the information’s release. What happens to a liquidity trader
playing alongside the insiders? When the liquidity trader is buying alongside the
insider, the liquidity trader “loses” because the insiders have driven up the prices.
The same is true when a liquidity trader sells alongside insiders. By contrast,
liquidity traders “win” when taking positions opposite those of the insiders. On
balance, however, liquidity traders have diversified portfolios, so they’ll be on the
same side and opposite sides with respect to insiders with about equal frequency.
Consequently, liquidity traders can diversify away the effects of insider trading.
Compare the situation of the liquidity traders with that of information traders.
When the price of a stock is rising due to insider trading, an information trader
(who has no idea that positive information is about to be divulged) will conclude
that the stock is overpriced and therefore take a short position. Because the
positive information will ultimately cause the stock to keep rising, information
traders will lose on their short positions. An analogous scenario unfolds for price
drops. In other words, information traders will always trade on the “same side” as
insiders and constantly losing.
In fact, insiders have an incentive to “milk” inside information by delaying
disclosure of information. This maneuver is not available to information traders
since they have no influence over when the corporation decides to release inside

Normally, liquidity is provided by “market makers,” who are people who constantly
trade shares with others. Market makers make money by implementing a bid-ask
spread, so they always buy at a slightly lower price than they sell. The difference
between the bid price and the ask price is known as the spread. The higher the
bid-ask spread, the lower the liquidity; a higher spread means a higher price of
trading. Market makers know that they will “lose” when trading with insiders, so
they try compensate by increasing the spread; this reduces liquidity.
Empirical studies have shown that the bid-ask spread is indeed lower in countries
that strictly enforce anti-insider-trading laws. Such markets also have more
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§ 44 Reasons for Restricting Insider Trading

One argument against insider trading is that it is “unfair.” The problem, however,
is the notion of fairness to be applied. For example, consider that gamblers in a
casino know that the odds are always stacked in the casino’s favor. This is similar
to what happens when the average investor trades with insiders. Since the
investor knows beforehand that some people will have an informational advantage,
does it mean anything to call this state of affairs “unfair”? Similar problems exist
with arguments as to the integrity of markets and the level playing field. Another
argument is that insiders improperly take advantage of information that “belongs”
to their corporations.

SEC v. Texas Gulf Sulphur Co.

This case presents the “classic” theory against insider trading. In the classic
scenario, an insider uses insider information to trade in the shares of his own
corporation. The court here established the “disclose or abstain” rule; if one is not
sure whether a fact is material, then one should avoid trading in the stock of that
corporation. Here, the court said that information was material if it “might affect”
the decisions of the average investor. (This bar was later raised to “substantially
affect.”) Now, the court’s reliance on the trading of the insiders is a bit circular;
the very fact of the trades tends to make those trades suspect. Still, the trading
pattern of insiders can provide insight into the nature of trades, especially if the
pattern of trades differs drastically from how the insiders normally trade.
This case is based on the “equal access theory.” This theory says that anyone who
gains access to non-public information has a duty either to disclose that
information or to avoid trading on that information. Of course, the “equal access”
nature of the theory means that the duty must run to the market as a whole. The
courts have created this duty to rein in insider trading. The fact that the duty runs
to the market in general means that an insider cannot “opt out” of this duty.

Chiarella v. United States

The argument of the prosecution was that Chiarella owed a fiduciary to the market
in general. An alternative theory was that Chiarella owed a duty to the source of
the information (in this case the acquiring corporation), but the court did not reach
this issue. Nonetheless, Chiarella marked the beginning of the misappropriation
theory of insider trading.
Now, does a person who happens to come across inside information automatically
owe a duty to disclose that information? Suppose that a corporate lawyer tells his
wife of some transaction, and his wife then makes some trades based on that
information. Who has breached a duty? Or suppose that a waiter overhears some
private information between two CEOs who happen to be dining at the restaurant.
He then makes some trades. Is he liable for insider trading? One answer would be
that the spouse is liable but the waiter is not. This is because the spouse has a
relationship of confidence with her husband, so that her husband has some
reasonable expectation that she will not divulge information carelessly. By
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contrast, no such relationship exists between the waiter and the dining CEOs.
What about people like lawyers, accountants, investment bankers, and other
people who might come into contact with insider information? Here, the argument
is based on access.

Dirks v. SEC
Normally, the rule is that the recipient of inside information passed without any
breach of fiduciary becomes a temporary insider. The recipient then faces
essentially the same restrictions as a regular insider. However, if the insider did
breach the fiduciary duty in releasing inside information to a “tippee,” then the
tippee faces liability for using the information to trade.
Here, the twist is that the releasor of information was doing so with the intent of
exposing fraud. If we say that the releasor of information did not breach his
fiduciary duty, Dirks should be considered a temporary insider. But the court did
not take this approach; rather, the court held that Dirks could nonetheless have
traded using the information.

The Meaning of “Personal Gain”

“Personal gain” includes not only immediate monetary benefit but also reputation
and other “intangible” factors. Dirks basically opened the door to giving inside
information to analysts legally. Of course, the result is that analysts who get inside
information will have a significant advantage over ones who don’t. As a result,
corporations invited the “closed conference call,” which are calls that are
invitation-only. These calls disclosed enough information to give the invitees
enough private information to have a material advantage. Analysts who wrote bad
reports about the corporation, however, found themselves shut out of such calls.
In other words, these calls became a way for corporations to pressure analysts to
produce biased reports. In 2000, the SEC put an end to this practice.

Liability of Tippees
Suppose that the initial tippee disseminates information to other tippees, who in
turn disseminate the information even further. How far should liability run? The
rule is that anyone in the chain who knew the information came from a breaching
insider faces liability.
§ 45 What the SEC Restricts
Currently, the SEC no longer allows closed conference calls (see supra). If an
insider makes an unintentional disclosure of insider information to someone who is
likely trade on that information, that insider has the immediate duty to correct that
problem by disclosing that information to the general public.
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United States v. O’Hagan

Had O’Hagan purchased the shares of the client corporation (i.e., the acquiror), he
would undoubtedly be liable for insider trading. Here, however, O’Hagan
performed “front-running” by purchasing shares of the target corporation.
Rule 10b-5 says that deception is a necessary ingredient of fraud.
Consider the practice of “warehousing.” Warehousing occurs when an insider tells
particularly investors to hoard shares in anticipation of a tender offer. Rule 14e-3
disallowed this practice.
There are two competing considerations. First, we need to facilitate takeovers.
Thus, bidders need to be able to buy initial blocks, so that they will be
compensated in the event of a failed bid. On the other hand, this allowance is
harmful to information traders because the initial purchases are based on inside
information. Because warehousing is a way to circumvent the 5% limit imposed by
the Williams Act, Rule 14e-3 makes sure this loophole does not open.

The Martha Stewart Story

The CEO of a corporation got word that the FDA had rejected the application of one
of its medical devices. The CEO told his broker to sell the CEO’s shares. As it so
happens, the broker also worked for Martha Stewart. The broker informed Martha
Stewart that the CEO was selling his shares and asked whether she would like to do
likewise. Stewart answered yes.
Now, what did Stewart actually know? Only that the CEO was selling his stock.
She had no explicit information as to the motives behind the sale. In order to find
liability, we must say that the CEO’s decision to sell was itself a material fact.
In actuality, Stewart was convicted for trying to hamper the investigation, not for
any investment-related actions themselves.
Section 16 of the Securities Exchange Act imposes duties on certain insiders to
disclose their holdings and whether they are selling or buying additional shares of
those holdings. Currently, the Sarbanes-Oxley Act requires these insiders to
disclose relevant trades within two days. The second part of section 16 creates a
non-rebuttable presumption that “short-swing” transactions are based on insider
trading. Regardless of the actual motives for such trades, the insider must return
any money made from those transactions to the corporations.

Date Action Amount Price

01/01/10 (x) P 90 $10.00
02/01/10 (x) P 110 $8.00
03/01/10 S* 70 $50.00
04/01/10 S+ 130 $10.00
05/01/10 P+ 110 $100.00
06/01/10 P* 90 $8.00
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Now, consider the 10% benchmark of section 16. Section 16 assumes that holding
10% or more of the stock is what converts an ordinary investor into an insider.
Therefore, any transaction involving less than 10% of the stock and the initial
transaction that puts the investor over the 10% limit don’t count toward the limit.
Having eliminated the irrelevant transactions, we look for buy-sell combinations
that maximize the total profit. So we match 70 shares from S* and P* for a profit of
2940. The remaining 20 shares from P* are matched with S+ to give an additional
40 in profit. That gives a total liability of $2980.