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Class 1 (August 18)
§1 §2 Exam Information Overview of Corporations
Exam will be take-home. Response of about 1,200 words is expected.
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).
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.
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 “himself.”
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 socialsecurity 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.
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.
In Summary The Business Perspective
A corporation is a fiction, but a fiction that can sign contracts, commit torts, and even commit crimes under the right circumstances.
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.
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 exist. 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 business. 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.
Solutions to the Agency Problem
Legal rules, such as the fiduciary duty, try to establish basic rules that management must follow.
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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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.
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 shareholder. 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.
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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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.)
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.
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 budget. 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.
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 dispersedownership 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.
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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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 finance.
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.
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).
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.
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.
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 6%. 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 creditors. 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 circumstances. 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.
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.
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).
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 party. 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.
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 preferredshare 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 up.”
§ 22 § 23
Debt Instruments Options
All debts entail a loan to the corporation with specifications as to when interest should be paid.
A call option is a document giving the holder the right to buy something on a prespecified 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 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.
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.
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.
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 irrationality. 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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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.
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.
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 takeover. 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 care.
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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Summary of Duty of Care
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 problems.
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.”
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.)
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 interest?
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.
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.
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
Updated 04/28/11 10:11:01 PM warehouses. Iowa required a “fair” transaction to feature 1. Disclosure of the deal to disinterested directors 2. Shareholders can ratify the transaction 3. Fair terms
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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 corporation) entire fairness test, but plaintiff has the burden of showing that the transaction is unfair; i.e., shift of burden
disclosure + approval of disinterested directors
business-judgment rule; rationality is the standard; transaction reviewed as if with third party
disclosure + approval of disinterested shareholders nothing
“waste” doctrine; essentially entire fairness test with burden the same as business-judgment shifted to plaintiff rule (“waste = “irrationality”) entire fairness standard (three requirements of fairness); director or officer has burden of showing fairness entire fairness standard; burden of proof is on the controlling owner to show fairness of 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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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.
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 owners.
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.
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).
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 opportunity. 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.)
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 shareholders. Zahn v. Transamerica Corp. Dividend Structure of Axton-Fisher
Class A Dividends Corporate redemption rights (effectively a call option) Conversion rights Distributions of assets upon liquidation Voting rights $32 cumulative $60 + any unpaid cumulative dividends; notice of 60 days before exercising option 1-to-1 switch of Class A shares for Class B shares x2 No Class B $16.00 —
$0.00 x1 Yes
Essentially, Transamerica realized the value of the tobacco stockpiled by AxtonFisher. 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 Liquidate Redeem $40.00 $60.00 100 B $20.00 0
With $30000 of assets
100 A Liquidate Redeem Conversion $200.00 $60.00 $150.00 100 B $100.00 $240.00 $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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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.
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 controlpremium 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 corporation. 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 litigation.
Property Rights versus Liability Rights
Ordinarily, a majority shareholder can force a transaction upon the minority shareholders.
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?)
The Voting System
In a typical corporation with dispersed shareholders, we have the following structure: Shareholders | Board of directors | Management 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 leave.
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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.
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.
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 reason. 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 actions. 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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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 Blasius/Unocal?) 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 later.
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 merger. 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 compensation. 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 shareholders. 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 stock.
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 interests. Think of a share as follows:
Vote Economic Rights
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.
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.
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. Aug. Sep. Oct. Nov. Dec.
$6.75 $8.50 $10.90 $12.50 $12.40 $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.
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 nonefficient 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 unprofitable. 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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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 shareholders. 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 okay.
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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.
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 standpoint.
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.
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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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.
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 rights. 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.
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.” Leverage 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 liability. 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 irrelevant. 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.
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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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 (DCF). 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 $10,000. 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.
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.
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.
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 step.
Structuring Tender Offers
Bidders have structured their tender offers to take advantage of the collectiveaction 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 will. 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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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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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 strongarming 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,” however? 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.
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 flipover 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
Updated 04/28/11 10:11:01 PM existing board, and we will pay you a premium for your shares.” Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc.
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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 sale. 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 duties.
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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 stock? 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.
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 shareholders. 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
Updated 04/28/11 10:11:01 PM place in the proxy-fight context. Hilton Hotels Corp. v. ITT Corp.
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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 started. 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.
Summary of Corporate Law (Minus Securities Regulations)
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) Revlon/102(b)(7) 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 luck.” 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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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 decisions. 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 underpriced. 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 earlier. 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) investors. 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 place. 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.
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 information. Liquidity 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 analysts.
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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.
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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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 01/01/10 (x) 02/01/10 (x) 03/01/10 04/01/10 05/01/10 06/01/10 Action P P S* S+ P+ P* Amount 90 110 70 130 110 90 Price $10.00 $8.00 $50.00 $10.00 $100.00 $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.