TABLE OF CONTENTS 1. INTRODUCTION TO THE LAW OF ENTERPRISE ORGANIZATION .............................................................................................. 7 1.1. EFFICIENCY AND THE SOCIAL SIGNIFICANCE OF ENTERPRISE ORGANIZATION ................

..................................................................... 7 1.1.1. Wealth Creation and the Corporate Form of Organization ....................................................................................... 7 1.1.2. What Do We Mean by Efficiency?...................................................................................................................................... 7 1.1.2.1. Pareto Efficiency .............................................................................................................................................................................. 7 1.1.2.2. Kaldor-Hicks Efficiency (The Rule of Wealth Maximization) ........................................................................................ 7 1.2. LAW FROM INSIDE AND OUT: SHARED MEANINGS AND SKEPTICISM ................................................................................................... 7 1.2.1. The Outside and the Inside................................................................................................................................................. 7 1.2.2. Fairness and Efficiency ........................................................................................................................................................ 7 1.3. DEVELOPMENT OF THE MODERN THEORY OF THE FIRM ..................................................................................................................... 7 1.3.1. Ronald Coase s 1937 Insight .............................................................................................................................................. 7 1.3.2. Transaction Cost Theory ..................................................................................................................................................... 7 1.3.3. Agency Cost Theory .............................................................................................................................................................. 7 ACTING THROUGH OTHERS: THE LAW OF AGENCY...................................................................................................................... 8 2.1. INTRODUCTION TO AGENCY ................................................................................................................................................................ 8 2.2. AGENCY FORMATION, AGENCY TERMINATION, AND PRINCIPAL S LIABILITY ...................................................................................... 8 2.2.1. Formation................................................................................................................................................................................ 8 2.2.2. Termination ........................................................................................................................................................................... 9 2.2.3. Parties Conception Does Not Control ............................................................................................................................. 9  Jensen Farms Co. v. Cargill Inc. (p. 18) .............................................................................................................................................. 9 2.2.4. Liability in Contract .............................................................................................................................................................. 9 2.2.4.1. Actual and Apparent Authority ................................................................................................................................................. 9  White v. Thomas (p. 22) ......................................................................................................................................................................... 9 2.2.4.2. Inherent Authority .......................................................................................................................................................................... 9  Gallant Ins. Co. v. Isaac (p. 26).............................................................................................................................................................. 9 2.2.5. Liability in Tort .................................................................................................................................................................... 10 2.3. THE GOVERNANCE OF AGENCY (THE AGENT S DUTIES) ................................................................................................................... 10 2.3.1. The Nature of the Agent s Fiduciary Relationship ..................................................................................................... 10 2.3.2. The Agent s Duty of Loyalty to the Principal ............................................................................................................... 10  Tarnowski v. Resop (p. 36) .................................................................................................................................................................11 2.3.3. The Trustee s Duty to Trust Beneficiaries ................................................................................................................... 11  In re Gleeson (p. 38) ..............................................................................................................................................................................11 THE PROBLEM OF JOINT OWNERSHIP: THE LAW OF PARTNERSHIP .................................................................................... 11 3.1. INTRODUCTION TO PARTNERSHIP ..................................................................................................................................................... 11 3.1.1. Why Have Joint Ownership?............................................................................................................................................. 11 3.1.2. Agency Conflicts Among Co-Owners .............................................................................................................................. 11  Meinhard v. Salmon (p. 47) .................................................................................................................................................................11 3.2. PARTNERSHIP FORMATION ............................................................................................................................................................... 12  Vohland v. Sweet (p. 52) ......................................................................................................................................................................12 3.3. RELATIONS WITH THIRD PARTIES .................................................................................................................................................... 12 3.3.1. Who Is a Partner? ................................................................................................................................................................ 12 3.3.2. Third-Party Claims Against Departing Partners ........................................................................................................ 13 3.3.3. Third-Party Claims Against Partnership Property .................................................................................................... 13 3.3.4. Claims of Partnership Creditors to Partner s Individual Property ....................................................................... 13 3.4. PARTNERSHIP GOVERNANCE AND ISSUES OF AUTHORITY ................................................................................................................. 13  NABISCO v. Stroud (p. 61) ...................................................................................................................................................................13 3.5. TERMINATION ................................................................................................................................................................................... 13 3.5.1. Accounting for Partnership s Financial Status and Performance ......................................................................... 13  Adams v. Jarvis (p. 65) ..........................................................................................................................................................................13  Dreifuerst v. Dreifuerst (p. 69) ..........................................................................................................................................................14  Page v. Page (p. 73) ................................................................................................................................................................................14 3.6. LIMITED LIABILITY MODIFICATIONS OF THE PARTNERSHIP FORM ................................................................................................... 14 3.6.1. The Limited Partnership ................................................................................................................................................... 14 3.6.2. Limited Liability Partnerships and Companies .......................................................................................................... 14 3.6.2.1. The Limited Liability Partnership ......................................................................................................................................... 14 3.6.2.2. The Limited Liability Company............................................................................................................................................... 14 THE CORPORATE FORM ..................................................................................................................................................................... 14

2.

3.

4.

4.1. INTRODUCTION TO THE CORPORATE FORM ...................................................................................................................................... 14 4.2. CREATION OF A FICTIONAL LEGAL ENTITY ........................................................................................................................................ 15 4.2.1. A Note on the History of Corporate Formation ........................................................................................................... 15 4.2.2. The Process of Incorporating Today ............................................................................................................................. 16 4.2.3. The Articles of Incorporation, or Charter ................................................................................................................. 16 4.2.4. The Corporate Bylaws ....................................................................................................................................................... 16 4.2.5. Shareholders Agreements ............................................................................................................................................... 16 4.3. LIMITED LIABILITY ........................................................................................................................................................................... 16 4.4. TRANSFERABLE SHARES .................................................................................................................................................................... 17 4.5. CENTRALIZED MANAGEMENT ............................................................................................................................................................ 17 4.5.1. Legal Construction of the Board ..................................................................................................................................... 18 4.5.1.1. The Holder of Primary Management Power ..................................................................................................................... 18  Automatic Self-Cleansing Filter v. Cunninghame (p. 103)........................................................................................................18 4.5.1.2. Structure of the Board ................................................................................................................................................................ 18 4.5.1.3. Formality in Board Operation................................................................................................................................................. 18  Fogel v. U.S. Energy Systems, Inc. (p. 107) .....................................................................................................................................18 4.5.1.4. A Critique of Boards ..................................................................................................................................................................... 18 4.5.2. Corporate Officers: Agents of the Corporation ........................................................................................................... 19  Jennings v. Pittsburg Mercantile Co. (p. 110)................................................................................................................................19  Grimes v. Alteon (p. 112) .....................................................................................................................................................................19 5. DEBT, EQUITY, AND ECONOMIC VALUE ......................................................................................................................................... 19 5.1. CAPITAL STRUCTURE ........................................................................................................................................................................ 19 5.1.1. Legal Character of Debt ..................................................................................................................................................... 19 5.1.1.1. Maturity Date: A critical advantage of bonds, from the perspective of investors, is that the investor generally faces less risk as a creditor than as an equity older because creditors have a legal right to periodic payment of a return (interest) and a priority claim over the company s shareholders on corporate assets in the event that the corporation defaults. If creditors are not paid on time, they can sue on their contract. ..................... 20 5.1.1.2. Tax Treatment: Interest paid by the borrower is a deductible cost of business when the firm calculates its taxable income. ............................................................................................................................................................................................ 20 5.1.1.3. Subordinated Debt ....................................................................................................................................................................... 20 5.1.1.4. Bonds ................................................................................................................................................................................................. 20 5.1.2. Legal Character of Equity .................................................................................................................................................. 20 5.1.2.1. Common Stock: Equity has not the right to payment but (usually) the right to vote on certain important matters. Equity securities generally possess control rights in the form of the power to elect the board of directors. The charter contains the specifics of the firm s equity securities. .......................................................................... 20 5.1.2.2. Residual Claims and Residual Control: Common stock holds the residual claim on the corporation s assets and income. After the company has paid its expenses and paid interest to creditors, whatever is left is available for the payment of dividends. .................................................................................................................................................. 20 5.2. BASIC CONCEPTS OF VALUATION ...................................................................................................................................................... 20 5.2.1. The Time Value of Money ................................................................................................................................................. 20 5.2.2. Risk and Return ................................................................................................................................................................... 20 5.2.3. Diversification and Systematic Risk .............................................................................................................................. 21 5.3. VALUING ASSETS ............................................................................................................................................................................... 21 5.3.1. The Discount Cash Flow (DCF) Approach ..................................................................................................................... 21 5.3.2. The Relevance of Prices in the Securities Market ...................................................................................................... 21 THE PROTECTION OF CREDITORS ................................................................................................................................................... 21 6.1. MANDATORY DISCLOSURE ................................................................................................................................................................ 21 6.2. CAPITAL REGULATION ....................................................................................................................................................................... 21 6.2.1. Financial Statements .......................................................................................................................................................... 22 6.2.2. Distribution Constraints ................................................................................................................................................... 22 6.2.3. Minimum Capital and Capital Maintenance Requirements .................................................................................... 22 6.3. STANDARD-BASED DUTIES ............................................................................................................................................................... 22 6.3.1. Director Liability ................................................................................................................................................................. 22  Credit Lyonnais Bank Nederlands (p. 141) ...................................................................................................................................22  North American Catholic Educational Programming Foundation, Inc. v. Gheewalla (p. 143) .....................................23 6.3.2. Creditor Protection: Fraudulent Transfers ................................................................................................................. 23 6.3.3. Shareholder Liability ......................................................................................................................................................... 23 6.3.3.1. Equitable Subordination ........................................................................................................................................................... 23  Costello v. Fazio (p. 145)......................................................................................................................................................................23 6.3.3.2. Piercing the Corporate Veil ...................................................................................................................................................... 23

6.

6.4. 7.

Sea-land Services, Inc. v. The Pepper Source (p. 152) ...............................................................................................................24 Kinney Shoe Corp. v. Polan (p. 157) .................................................................................................................................................24 VEIL PIERCING ON BEHALF OF INVOLUNTARY CREDITORS ................................................................................................................ 24  Walkovszky v. Carlton (p. 161) ..........................................................................................................................................................24  

NORMAL GOVERNANCE: THE VOTING SYSTEM............................................................................................................................ 25 7.1. THE ROLE AND LIMITS OF SHAREHOLDER VOTING ........................................................................................................................... 25 7.2. ELECTING AND REMOVING DIRECTORS ............................................................................................................................................. 25 7.2.1. Electing Directors ............................................................................................................................................................... 25 7.2.2. Removing Directors............................................................................................................................................................ 25  Campbell v. Loews Inc. (p. 173).........................................................................................................................................................25 7.3. SHAREHOLDER MEETINGS AND ALTERNATIVES ................................................................................................................................ 26 7.4. PROXY VOTING AND ITS COSTS ......................................................................................................................................................... 27  Rosenfeld v. Fairchild Engine & Airplane Corp. (p. 179) ..........................................................................................................27 7.5. CLASS VOTING ................................................................................................................................................................................... 27 7.6. SHAREHOLDER INFORMATION RIGHTS .............................................................................................................................................. 27 7.7. TECHNIQUES FOR SEPARATING CONTROL FROM CASH FLOW RIGHTS .............................................................................................. 28 7.7.1. Circular Control Structures .............................................................................................................................................. 28  Speiser v. Baker (p. 186) ......................................................................................................................................................................28 7.7.2. Vote Buying........................................................................................................................................................................... 28  Schreiber v. Carney (p. 193) ...............................................................................................................................................................28 7.7.3. Controlling Minority Structures...................................................................................................................................... 28 7.8. THE COLLECTIVE ACTION PROBLEM ................................................................................................................................................. 29 7.9. THE FEDERAL PROXY RULES ............................................................................................................................................................. 30 7.9.1. Rules 14a-1 Through 14a-7: Disclosure and Shareholder Communication ....................................................... 30 7.9.2. Rule 14a-8: Shareholder Proposals ............................................................................................................................... 30  Carpenters Pension Fund Proposal and Supporting Statement (p. 214) ...........................................................................31  CA v. AFSCME (p. 220) ..........................................................................................................................................................................31 7.9.3. Rule 14a-9: The Antifraud Rule ...................................................................................................................................... 32  Virginia Bankshares, Inc. v Sandberg (p. 230)..............................................................................................................................32 7.10. STATE DISCLOSURE LAW: FIDUCIARY DUTY OF CANDOR ............................................................................................................... 32 NORMAL GOVERNANCE: THE DUTY OF CARE ............................................................................................................................... 33 8.1. INTRODUCTION TO THE DUTY OF CARE ............................................................................................................................................. 33 8.2. THE DUTY OF CARE AND THE NEED TO MITIGATE DIRECTOR RISK AVERSION ................................................................................. 33  Gagliardi v. Trifoods International, Inc. (p. 241) .........................................................................................................................33 8.3. STATUTORY TECHNIQUES FOR LIMITING DIRECTORS AND OFFICER RISK EXPOSURE ....................................................................... 33 8.3.1. Indemnification ................................................................................................................................................................... 33  Waltuch v. Conticommodity Services, Inc. (p. 243) ....................................................................................................................33 8.3.2. Directors and Officers Insurance.................................................................................................................................... 34 8.4. JUDICIAL PROTECTION: THE BUSINESS JUDGMENT RULE .................................................................................................................. 34  Kamin v. American Express Co. (p. 250).........................................................................................................................................34 8.4.1. Understanding the Business Judgment Rule ............................................................................................................... 34 8.4.2. The Duty of Care in Takeover Cases: A Note on Smith v. Van Gorkom .................................................................. 35  Smith v. Van Gorkom (p. 255) ............................................................................................................................................................35 8.4.3. Additional Statutory Protection: Authorization for Charter Provisions Waiving Liability for Due Care Violations.............................................................................................................................................................................................. 35 8.5. DELAWARE S UNIQUE APPROACH TO ADJUDICATING DUE CARE CLAIMS AGAINST CORPORATE DIRECTORS FROM TECHNICOLOR TO EMERALD PARTNERS ...................................................................................................................................................................................... 35  Cede & Co. v. Technicolor (p. 259)....................................................................................................................................................35  Emerald Partners v. Berlin (p. 260) .................................................................................................................................................35 8.6. THE BOARD S DUTY TO MONITOR: LOSSES CAUSED BY BOARD PASSIVITY ................................................................................... 36  Francis v. United Jersey Bank (p. 262): ...........................................................................................................................................36  Graham v. Allis-Chalmers Manufacturing Co. (p. 268)...............................................................................................................36  In re Michael Marchese (p. 272)........................................................................................................................................................36  In Re Caremark (p. 278).......................................................................................................................................................................37  Stone v. Ritter (p. 285)..........................................................................................................................................................................37  In Re Citigroup (p. 285)........................................................................................................................................................................37 8.7. KNOWING VIOLATION OF LAW ....................................................................................................................................................... 37  Miller v. AT&T (p. 291) .........................................................................................................................................................................37 CONFLICT TRANSACTIONS: THE DUTY OF LOYALTY ................................................................................................................. 38

8.

9.

9.1. DUTY TO WHOM? ............................................................................................................................................................................. 38 9.1.1. The Shareholder Primacy Norm ..................................................................................................................................... 38  A.P. Smith Manufacturing Co. v. Barlow (p. 299) .........................................................................................................................39 9.1.2. Constituency Statutes ........................................................................................................................................................ 39 9.2. SELF-DEALING TRANSACTIONS ......................................................................................................................................................... 39 9.2.1. Early Regulation of Fiduciary Self-Dealing .................................................................................................................. 39 9.2.2. The Disclosure Requirement ........................................................................................................................................... 39  Hayes Oyster Co. V. Keypoint Oyster Co. (p. 304)........................................................................................................................39 9.2.3. Controlling Shareholders and the Fairness Standard............................................................................................... 40  Sinclair Oil Corp. v. Levien (p. 310) ..................................................................................................................................................40 9.3. THE EFFECT OF APPROVAL BY A DISINTERESTED PARTY ................................................................................................................. 40 9.3.1. The Safe Harbor Statutes .................................................................................................................................................. 40  Cookies Food Products v. Lakes Warehouse (p. 315) ................................................................................................................40 9.3.2. Approval by Disinterested Members of the Board .................................................................................................... 41  Cooke v. Oolie (p. 322) ..........................................................................................................................................................................41 9.3.3. Approval by a Special Committee of Independent Directors .................................................................................. 42 9.3.4. Shareholder Ratification of Conflict Transactions .................................................................................................... 42  Lewis v. Vogelstein (p. 327) ................................................................................................................................................................42  In Re Wheelabrator Technologies, Inc. (p. 328)...........................................................................................................................42 9.4. DIRECTOR AND MANAGEMENT COMPENSATION ............................................................................................................................... 43 9.4.1. Perceived Excessive Compensation ............................................................................................................................... 43 9.4.2. Option Grants and the Law of Director and Officer Compensation ....................................................................... 43  Lewis v. Vogelstein (p. 332) ................................................................................................................................................................43 9.4.3. Regulatory Responses to Executive Compensation ................................................................................................... 44 9.4.4. The Disney Decision ........................................................................................................................................................... 44  In re Walt Disney Co. (p. 341) ............................................................................................................................................................44 9.5. CORPORATE OPPORTUNITY DOCTRINE ............................................................................................................................................. 44 9.5.1. Determining Which Opportunities Belong to the Corporation........................................................................... 44 9.5.2. When May a Fiduciary Take a Corporate Opportunity? ........................................................................................... 45 9.6. THE DUTY OF LOYALTY IN CLOSELY-HELD CORPORATIONS ............................................................................................................. 45  Donahue v. Rodd Electrotype Co. (p. 351) .....................................................................................................................................45  Smith v. Atlantic Properties Inc. (p. 359) .......................................................................................................................................45 10. SHAREHOLDER LAWSUITS.............................................................................................................................................................. 46 10.1. DISTINGUISHING BETWEEN DIRECT AND DERIVATIVE CLAIMS ...................................................................................................... 46 10.2. SOLVING A COLLECTIVE ACTION PROBLEM: ATTORNEYS FEES AND THE I NCENTIVE TO SUE ......................................................... 46  Fletcher v. A.J. Industries, Inc. (p. 367) ...........................................................................................................................................46 10.3. STANDING REQUIREMENTS ............................................................................................................................................................. 47 10.4. BALANCING THE RIGHTS OF BOARDS TO MANAGE THE CORPORATION AND SHAREHOLDERS RIGHTS TO OBTAIN JUDICIAL REVIEW 47 10.4.1. The Demand Requirement of Rule 23 ........................................................................................................................ 47  Levine v. Smith (p. 376) .......................................................................................................................................................................47  Rales v. Blasband (p. 381) ...................................................................................................................................................................48 10.4.2. Special Litigation Committees ...................................................................................................................................... 48  Zapata Corporation. v. Maldonado (p. 389)...................................................................................................................................48  In Re Oracle Corp. (p. 395) ..................................................................................................................................................................49  Joy v. North (p. 403) ..............................................................................................................................................................................50 10.5. SETTLEMENT AND INDEMNIFICATION ............................................................................................................................................. 50 10.5.1. Settlement by Class Representatives .......................................................................................................................... 50 10.5.2. Settlement by Special Committee ................................................................................................................................ 50  Carlton Investments v. TLC Beatrice international Holdings, Inc. (p. 409) ........................................................................50 10.6. WHEN ARE DERIVATIVE SUITS IN SHAREHOLDERS INTERESTS? .................................................................................................... 51 11. TRANSACTIONS IN CONTROL ......................................................................................................................................................... 51 11.1. SALES OF CONTROL BLOCKS: THE SELLER S DUTIES ...................................................................................................................... 51 11.1.1. The Regulation of Control Premia ............................................................................................................................... 51  Zetlin v. Hanson Holdings (p. 416) ...................................................................................................................................................51  Perlman v. Feldmann (p. 417)............................................................................................................................................................51 11.1.2. A Defense of the Market Rule in Sales of Control..................................................................................................... 52  In re Digex (p. 428) ................................................................................................................................................................................52 11.2. SALE OF CORPORATE OFFICE .......................................................................................................................................................... 53 11.3. LOOTING ......................................................................................................................................................................................... 53

............ 521) .............57  Thorpe v.............................. CHOOSING A MERGER OR BUYOUT PARTNER: REVLON....................................2............. ECONOMIC MOTIVES FOR MERGERS ..... 59 12..... Inc..................................... Timing..... 497) ............................. 56 12...................53 TENDER OFFERS: THE BUYER S DUTIES .....................5............ PUBLIC CONTESTS FOR CORPORATE CONTROL ................................... Other Sources of Value in Acquisitions: Tax...........................2.. 481)...................................................................... 61  In re Transkaryotic Therapies (not in CB) ................................9..... 513) ...................................... 63  Weinberger v......................... DEFENDING AGAINST HOSTILE TENDER OFFERS .....................................................................5............... 58 12..................................................................................................................................................................................... (p..........1........ Mergers . 504) ........................................................................................... v...... 439) ............................64 12.......... FUNDAMENTAL TRANSACTIONS: MERGERS AND ACQUISITIONS .....................5...10...64 12..................................................10......................................................... 55 12........................... History and Theory ................................................... Integration as a Source of Value .......................... TAXATION OF CORPORATE COMBINATIONS ...................2............. 56 12............................................................ 55 12................ The Appraisal Alternative in Interested Mergers ..6...... What Constitutes Control and Exercise of Control.66 13....................................................................... Suspect Motives for Mergers .............................................................. 11..........2. THE APPRAISAL REMEDY .............................................................61 12.............................................................................. 55 12..... Arco Electronics........... 60 12...................................................................................................................................... PRIVATE LAW INNOVATION: THE POISON PILL ......................................2..........................................................................2....................... 60 12............................................................................................................... Carter (p................................................................................................................................ 60 12......................... 59 12......5..................2..........................................................1...................................................................................... Representations and Warranties......................... UOP....... 55 12..............................8.................................. Consents............................................................... 60 12......................................................................................................................... Tax-Free Corporate Reorganizations....................... 456) ..................................................................................... 515) ....................1............... and Diversification .........................................................................................................................6................................6........................................................................ THE DUTY OF LOYALTY IN CONTROLLED MERGERS .............................................1.... THE DE FACTO MERGER DOCTRINE .......... 525):............................................ 66  Smith v. (p.................. Selectica (p..................................... Accounting Treatment ...........68  Versata Enterprises v.....................................................1................7......................................................................................................3.........8............................................................................. 62  Hariton v................................................................. 62 12......................................................... (p......... The Nature of Fair Value ......................................... STRUCTURING THE M&A TRANSACTION .......................................... Inc..... 62 12......................................8.................68 13.................................. 504) ........7................... 64  Kahn v..................54 THE HART-SCOTT-RODINO ACT WAITING PERIOD ............................................................................................. (p..................................... 65 12..........................5............6....... THE ALLOCATION OF POWER IN FUNDAMENTAL TRANSACTIONS ................................................ Special Committees of Independent Directors in Controlled Mergers...... CORPORATE LAW OF MERGERS ..........................................6.............. 58 12...... Agency Costs................... Mesa Petroleum Co..................................................................66  Unitrin v....................... (p................................................ Bregman (p................................65 13......1....... 55 12.........3..................... CERBCO (p.... Inc................................................................3.............. 56 12.............................3................ 429) ............................................................ 67  Moran v........................................................................................................................................... American General Corp....6...........6................................................... 59 12..4....................................................... Triangular Mergers ............ OVERVIEW OF TRANSACTIONAL FORM .........1..54  Brascan Ltd........................................................................................................................................3..... and Title Transfers .............. ITS SEQUELS..................................................  Harris v.................... When Mergers Were Rare .................................... 59 12................................................................................................................................... 65  In re Siliconix Shareholder Litigation (p......... 66 13........................................................................ Inc......3.................................................................................................... 56 12......................................... THE EVOLUTION OF THE U......................10..............................................................6......................... 60 12........... Controlling Shareholder Fiduciary Duty on the First Step of a Two-Step Tender Offer ........................ 486) .................................................... INTRODUCTION ..................................................................................................... 453) .... Regulatory Approvals.................11........................................................................... Edper Equities Ltd........................................................ (p............58 12.8......... 53  Wellman v....................................... 59 12.......S........................... 57 12.......................................5........1........................................4............... v.............................................................1..5..2..................................................................................2..................................................2..4................. (p..............................................................3.................................... 57  Katz v............65  In re Pure Resources.......... 60 12.......... Cash Mergers or Freeze-Outs ..................................................... 59 12............... 66  Unocal Corp............................................... 68 .....4.......................................................................................................................... Covenants.....................................4.......................................... and Indemnification ..................................................................................................................3................................................................................................ Dickinson (p. 60 12...................... Asset Acquisition .....................4................................................ Deal Protections and Termination Fees ..................... 55 12............8......................................................3...........................................................................................................................................................................7................................... Household International (p.............2..................................................................................... Van Gorkom (p......2.......................10.....2.... Due Diligence................. Stock Acquisition ...... Basic Concepts .... 435) .......................... 56 12...............................................................63 12........................................67 13............................ 55 12.... AND ITS PREQUELS .................................................................................. Planning Around Voting and Appraisal Rights.................. 532) ......................................... The Market-Out Rule .............. Lynch Communication Systems.. The Modern Era ................................................................................................. Do Mergers Create Value? ..................4......... INTRODUCTION ......................................... 63 12.......10..............................................4.........................................................

..............................79  Goldberg v.................................... 86 14................................................ 78 14.........................................................................................1........................................................................................................... (p.7................................................................................... 80 14.. 73  CTS Corp............ Elements of 10b-5 Liability: Causation ................................... 610).................... PROTECTING THE DEAL ...........................................68 13......... 589).............................................................................................................................................................................................. Agassiz (p.................... 84 14............................................................................................................................................................................ Elements of 10b-5 Liability: Fiduciary Duty Theory .............................................. News Corp....... 667) ...................... Atlas Corp.............. Inc....6....................................6............................................................................................................. Elements of 10b-5 Liability: Standing......... v........................................................................ NCS HealthCare (p.... 579) .............................. 85 14...................... Elements of 10b-5 Liability: Materiality ...7................................. 83 14........................... 633) .....1............. Van Gorkom (p.......82 14......................4......................................................................................................... Smith v..................................8................... 83  Basic Inc........ Texas Gulf Sulphur Co.... 547) .......................................................................................................................... 639) ................................ 653) .................................. 622).................... Elements of a 10b-5 Claim. 86  Are Deal Makers on Wall Street Leaking Secrets? (p...................................................................................................................... Elements of 10b-5 Liability: Equal Access Theory.... Elements of 10b-5 Liability: Scienter ....... 77 14........................................... SEC (p....................................................2.........71 13................................ No Shops/No Talks and Fiduciary Outs ......................... MacAndrews & Forbes (p............................................................................................................................... Third-Generation Antitakeover Statutes (1987-2000) ...................2.......................................... 76 14.........................2...................................................... v........1.and Second-Generation Antitakeover Statutes (1968-1987) ..... Dynamics Corp..... Chris-Craft Industries (p........ 75 13...............................6..........................................................1. 86 14... United States (p.................................................................................86 ........................... Inter-Tel (p........................................ Elements of 10b-5 Liability: Reliance .....................................3..................................... Mandatory Pill Redemption Bylaws .............4......................................... 71 13...........78  Santa Fe Industries v........79 14........................................ in Connection with the Purchase or Sale of Securities................................................4............................................................... Liggett & Myers...........................................80  Dirks v.........................................................................7......................................8...................................................................................73 13........................................ 73  Schnell v.......................... 77 14................... 78 14.................. Time (p.................................................. Board Disclosure Obligations Under State Law ...................74  Mercier v.........................................................................................70  Lyondell Chemical Co............................... 541).......................... 72  Omnicare v....................................................................................................................... Insider Trading and Informed Prices .................................................76 14....... The Academic Debate ................................ 76 14..................................................................................................................................................... 599) ............................ 604):...................................................... 643) ....4....................................................................... Elements of a 10b-5 Claim: False or Misleading Statement or Omission ....................................1............................................................................................................1.... 604) ...........2................................................................4.................................................................................................................. 77  Freeman v................. Remedies for 10b-5 Violations .............. Dead Hand Pills............................................................... 80  Chiarella v.................. Meridor (p........................................................ ITT (p..... Insider Trading as a Compensation Device .......................3........... Decio (p.................. (p.................................................................................................4..........................................................................7............................................ v.... 75 13......................4........ 78 14...................... 587 n....................................... 85  Elkind v.4...............................83 14..................4................................................................... 76  Goodwin v......77 14....................... Shareholder Lock-Ups ............................ 662) ..........2...................................................... 78  SEC v.............................. EXCHANGE ACT §16(B) AND RULE 16 ..................... Evolution of Private Right of Action Under §10 ....9.........................................2.............. 73 13... First..4................................................................. QVC (p. 686) ..............9.4...............................2.............69  Paramount v................................................. EXCHANGE ACT §10(B) AND RULE 10B-5 ..........2......... 672).................................... 616)..............74  Blasius Industries v............................... 7): .................. (p......................................2........................................... THE CORPORATE LAW OF FIDUCIARY DISCLOSURE TODAY .....................................................1........................ 533) .2................................................................4...............................................................4.......................................... 84  Basic Inc....... (p...........2...................................................................4....................5............................... 71 13......4... Green (p.............................. 679)................................................................. 695) ......................................... Corporate Recovery of Profit from Insider Trading ..............................................................1.............................................. 73 13....................................68  Revlon v............................................. COMMON LAW OF DIRECTORS DUTIES WHEN TRADING IN THE CORPORATION S STOCK ............................................................................................2..................6....................................2.................. 598) ......................................................................................4................................85 14..........84 14...........................................................72  Orman v............................. Levinson (p.......................................74  Hilton v....................................4..................................3...............................2.................................................................................................................................................. PROXY CONTESTS FOR CORPORATE CONTROL ............ O Hagan (p..........................................................4.................. 69  Paramount v....................................9....................2.. 75  Unisuper v..82  United States v.........................2..............5...... Ryan (p.......................... STATE ANTITAKEOVER STATUTES ......................................... Levinson (p...... 80 Elements of 10b-5 Liability: Misappropriation Theory ............................................................................................75 13................................................................ Chestman (p..2......................... Cullman (p...................... v.. 649) ............... TRADING IN THE CORPORATIONS SECURITIES .......................................4............................................................................... THE TAKEOVER ARMS RACE CONTINUES ...............................2. 568) ............. of America (p........................80  United States v................................................................................ 554)..................... PULLING TOGETHER UNOCAL AND REVLON ..........72 13...........76 14..................................................................................................................

while those practicing law have an interior perspective.  A transaction is efficient if the aggregate monetary gains to the winners exceed the aggregate monetary losses to the losers-that is. but courts rarely do so.1. Agency Cost Theory  Agency theory addresses how the actions of one actor (the agent ) affect the interest of another (the principal ).2.2.3.1.  It addresses such important issues as how corporate enterprises are created and capitalized. . 1. and only when.2.  It is virtually impossible for courts or legislatures to make important decisions that do not make someone worse off. DEVELOPMENT OF THE MODERN THEORY OF THE FIRM 1. Wealth Creation and the Corporate Form of Organization  Corporation law deals with the creation and governance of the private legal entities that are the principal economic actors in the modern world. strategic behavior. and what mechanisms exist to improve their performance. 1.  Even voluntary agreements among private parties sometimes fail the Pareto efficiency test because they impose uncompensated costs on third parties.1. What Do We Mean by Efficiency?  Corporation law succeeds to the extent that it enables individuals to increase their utility. Kaldor-Hicks Efficiency (The Rule of Wealth Maximization)  An act (or a rule) is efficient if at least one party would gain from it after all those who suffered a loss were fully compensated.2.3.  The corporate form dominates in all instances where technology creates economies of scale. 1. The Outside and the Inside  When empiricists study law. how their economic performance is monitored.  Firms exist because. Ronald Coase s 1937 Insight  The assumption that informed markets costlessly bring together buyers and sellers at an equilibrium price simply ignores many of the problems that real economic activity must solve. is has serious drawbacks:  It is agnostic about the legitimacy of the original distribution of assets within a society. they do so from an external vantage point.1. 1. 1. to be accomplished more cheaply than they could be effected on markets.2. Because shareholders are the residual claimants to the corporation s income and assets. resources are distributed in such a way that no reallocation of resources can make at least one person better off without making at least one other person worse off.  Agents in the economic sense typically act with respect to property that principals own. 1. how power over their internal affairs is distributed. as well as academic commentators. LAW FROM INSIDE AND OUT: SHARED MEANINGS AND SKEPTICISM 1. Transaction Cost Theory  The firm is a set of transactions cost-reducing relationships or governance structures. Fairness and Efficiency  Judges and lawyers.  When traditional corporation law addresses fairness.  Efficiency is a controversial judicial standard.  While Pareto efficiency is important. Pareto Efficiency  Pareto reasoned that a given distribution of resources is efficient when. ought to use efficiency in the production of wealth as the principal standard for evaluating current law. and informational asymmetry inevitably involves guesswork.  General partnership is a somewhat more stable form of relationship and the simplest form of jointly owned business firm. 1. it generally refers to fairness to shareholders. the total wealth of the affected parties increases.1. EFFICIENCY AND THE SOCIAL SIGNIFICANCE OF ENTERPRISE ORGANIZATION  The modern law of organizational forms is premised on the idea that facilitating individuals efforts to create wealth is wise public policy.1. protection of their interests through a fairness norm is generally consistent with increasing total corporate wealth and with moving toward a Kaldor-Hicks efficient state.3. especially complex and reiterated transactions.2.3.1. in a world of positive transaction costs.2.3.  Courts have used the language of moral reasoning when they are forced to make decisions. 1. it is sometimes more efficient to organize complex tasks within a hierarchical organization with its established authority and compensation structures than on a market.1. in part because determining what counts as a cost and benefit in a world of incomplete markets.2.  The agency relationship can be thought of as the simplest form of business organization. 1. INTRODUCTION TO THE LAW OF ENTERPRISE ORGANIZATION  The study of corporate law is about the relationship between those who finance and those who manage. 1.1.1.  Firms permit transactions.2.

 Conflict between managers and investor/owners  Ability of majority owners to control returns in a way that discriminates against minority owners. AGENCY TERMINATION. contract with independent contractor  Non-profit organizations problematize ownership because.1.  This is one of the ways in which corporate law is like property law. limitations on liability run both ways a shareholder s creditors cannot reach the corporation s assets and vice-versa.  This is important because a firm s value is greater than the sum of its parts (a point seen when we discuss stock selling at multiples of the combined value of its assets)  Corporations exist. debtors can seize stock.2.  The corporation gives rise to agency problems. but so are firms like GE. 2. one who is a residual claimant (this is what distinguishes an owner/residual claimant from a lender or contract holder.  There are three primary types of agency costs: monitoring costs (costs owners expend to ensure agent loyalty). which are owned by their customers. which have millions of shareholders. in part. a potential cost will arise that is termed an agency cost.g. but also all third-parties who do business with them. The most effective way to minimize transaction costs is to allocate ownership to those with the highest transaction costs. INTRODUCTION TO AGENCY  The simplest form of joint economic undertaking occurs when one person extends the range of her own activity by engaging another to act for her and be subject to her control. by definition. who has a fixed claim)  One who has control (rather than relying on a contract)  E. Such a relationship is called an agency. they do not distribution and do not have residual claimants. but it does so at the risk of creating agency problems that must be constrained if it is to succeed.2. control over employee vs. AND PRINCIPAL S LIABILITY 2. Management is seen as offering to investors a share of the utility that can arise from centralizing information and expertise in a single enterprise.  Model problem: Contract manufacturing  Why doesn t Harris Teeter manufacture its own crackers?  Economies of scale (quantity) and scope (variety)  Why don t Harris Teeter and Trader Joe s own a manufacturer together?  Anticipated conflicts between owners  What other reasons to contract manufacture exist?  Exit rights  Lack of experience and expertise in an industry  Personal and social motivations  Eliminate element of risk associated with status as residual claimant  Minimizing risk-bearing.  Firms are not always owned by entrepreneurs non-profits are one example. corporate law alone can accomplish this. to serve an interest of a controlling agent rather than the interest of her principal. and residual costs (costs that arise from the differences of interest that remain after monitoring and bonding costs are incurred). but cannot force the company to liquidate assets.  Also like property.  What is ownership?  One who has an equity stake. and co-ops.  To the extent the incentives of the agent differ from the incentives of the principal herself.1. that is.  Agency can create legal relationships between strangers principals and the third parties with whom their agents interact.  Third-parties who are likely to confront imperfections in contracting that expose them to the prospect of a firm s behaving opportunistically toward them.According to agency theorists.  The firm could be understood as a complex of contracts between owners of the various factors of production of the firm. a transaction may be motivated.  The corporation reduces the transaction costs of complex economic contracting. This is seen in limiting the reach of a shareholder s debtors.  A foundational theory is that firms are always owned by those who contract with the firm. for this reason contract alone cannot bar creditors of an owner from seizing assets. bonding costs (costs that agents expend to assure owners of their reliability). 2. contracting parties will demand higher returns to contract with the firm. Formation  . Unless the law or the parties craft protections from these risks. in particular.  The risks and rewards of managers may be out of alignment with the interest of shareholders. AGENCY FORMATION.. ACTING THROUGH OTHERS: THE LAW OF AGENCY 2. in part at least. it is not just the rights of the corporation and its shareholders that are affected by the relationship. is important.

 Apparent authority: what a third-party should have inferred about the agent s authority. Isaac (p. which in turn sells 90% of grain to Cargill.  In apparent authority cases..  Gallant Ins. or pay dividends).4. White declines to make the transfer.2.2. Actual and Apparent Authority  An agency is an arrangement that confers legal power on the agent and gives rise to duties by both the principal and the agent. correspondence and criticism regarding management. Simpson bids much more than this and wins. Termination  Either the principal or the agent can terminate an agency at any time. the farmers sue Cargill.  White v. 2. purchase stock. The policy actually benefits principals because it makes it more likely that third-parties will deal with agents. the principal s decision to revoke or the agent s decision to renounce gives rise to a claim for damages for breach of contract. but argue the agent lacks authority to bind the principal in a certain matter:  Actual authority: what the agent should have inferred about the extent of his authority. who grants authority to another to bind her in certain respects.2. the agent represents or implies that his is acting on his own behalf. Cargill not only loaned Warren money. 22)  Facts: White gives Simpson authority to purchase property for up to $250.  Agent s Ability to Bind  Sometimes a party will acknowledge an agency relationship exists. (p. undisclosed.  This has to be the holding. Simpson clearly lacks actual or inherent authority and the appellate court holds she also lacked apparent authority. asserting the extent of an agent s authority cannot be show solely by his own declarations or actions in absence of the principle. for example.  Characteristics of Agency Relationships  Voluntary  Fixed or indefinite  Specific (agency limited to a single act or transaction) or general  Disclosed. and the agent manifests assent or otherwise consents so to act. requirement that Warren obtain Cargill s approval to enter into mortgages. When she realizes this. Parties Conception Does Not Control  Agency relations may be implied even when the parties have not explicitly agreed to an agency relationship Jensen Farms Co. or partially disclosed  Agent acts on behalf  Agent subject to control  Employment (when a principal has a right under his deal with the agent to control the details of the way in which the agent goes about her task)  Independent contractor  NB: a single individual can simultaneously hold more than one agency relationship as to the same interaction (firm associate as to firm and to client) 2.Restatement 3d Agency: Agency is a fiduciary relationship that arises when one person (a principal ) manifests assent to another person (an agent ) that the agent shall act on the principal s behalf and subject to the principal s control. Thomas (p. but also exerted significant control over Warren (right of entry for audit. 18)  Facts: Farmers sell grain to Warren Seed & Grain Co.3. arguing that Warren was Cargill s agent. It includes incidental authority (power to do what is necessary & proper) by default. Liability in Contract 2.2. v.  Inherent authority gives agents a bare minimum authority. Inherent Authority  Inherent Authority: gives a general agent the power to bind a principal to an unauthorized contract as long as a general agent would ordinarily have the power to so contract and the third party does not know that matter stand differently in this case.  If the contract between them fixes a set term of agency.4. Cargill Inc. v. 2.  An agency is a consensual relationship between the principal.2. who accepts that responsibility.  Holding: An agency relationship may exist whether or not the principal or agent defines it as such or even desires it to be such if the relationship is functionally a principal-agent one. and the agent.2.  Holding: White is not bound by Simpson s agreement with Thomas. When Warren goes bankrupt.1. 2. Co. otherwise anyone could make himself another s agent.4. she agrees to sell of some of the land to Thomas. 26)  .  This is important when. Both parties must manifest their intention to enter an agency relationship.2.000. what is accepted as evidence is tremendously important.  Reasoning: The Cargill-Warren relationship was so visible that it seems equitable to vindicate the farmers reliance.

3. Operator set hours of operation Operator sold only Humble products. the stations are franchises. THE GOVERNANCE OF AGENCY (THE AGENT S DUTIES) 2. sells car insurance through its agent Thompson-Harris.02 An agent has a duty not to acquire a material benefit from a third party in connection with transactions conducted or other actions taken on behalf of the principal or otherwise through the agent s use of the agent s position. Liability in Tort  Only a particular kind of agency relationship. If the concern is that the plaintiffs be compensated for injuries. while in Gallant.  Coasian theory posits that if transaction costs between franchisor and franchisee are low. the principals should also be liable.1. the purposes established at the time of creation of the relationship. (p.  Agency by ratification: if the principal accepts the benefit of a transaction.  Reasoning: Least-cost monitoring.Facts: The principal. as a reasonable person would act. the third-party had no reason to be suspicious. 32) The station operator negligently allowed a car to An employee was fueling a car and lit a cigarette roll away. The franchisee is a part-owner and is responsible for day-to-day operation (unity of residual claims and control). 2. because they ll contract around it. but representative from Humble could require periodic reports. it is the insurer. Martin (p. which started a fire Humble set hours of operation. The Nature of the Agent s Fiduciary Relationship  In common law. (3rd) Agency) §7. Thompson-Harris agreed to insure plaintiff s car effective immediately. it doesn t matter how we allocate liability.  . competitiveness. ordinarily triggers vicarious liability for all torts committed within the agent s scope of employment. No written reports required. the third-party was clearly dubious as to the agent s authority. in Gallant.  Held: Gallant is bound because Thompson-Harris and Gallant had a course of dealing in this manner.3. Sunoco visited weekly in advisory capacity.  There s circular reasoning at play: we assign liability because we want people to exert control and people exert control because they are liable.2.  If the holdings were based on least-cost monitoring the station owners/operators should be liable.  The fiduciary is bound to exercise her good-faith judgment in an effort to pursue.  In both cases.  Inherent authority focuses on the reasonableness of the third-party. The principal denied coverage when the plaintiff had an accident because its agent lacked authority to issue modified policies without the principal s approval. Humble Oil v. striking pedestrians. while in White it was the third-party.2. an agent is a fiduciary of her principal. Lease was terminable annually. which the plaintiff reasonable relied on (even though there is no evidence that the plaintiff so relied or was even aware of the practice). Operator could sell non-Sunoco Products Humble held title to goods operator sold on Operator took title to goods.  Whether an agent is an employee or independent contractor thus becomes critical.3. the agent had authority. Rent was partly based on amount of Humble s Operator had overall risk of profit and loss.07: An employer is subject to vicarious liability for a tort committed by its employee acting within the scope of employment.  Rest. under future circumstances. 30) Hoover v.  The fiduciary s duties fall into three general categories:  Duty of obedience to the documents creating the relationship  Duty of loyalty to exercise power in good faith to best advance purposes of the principle and not for personal benefit  Duty of care to act in good faith.  Agency by estoppel: failure to act when knowledge and opportunity to act arise plus reasonable reliance by a third-party. Lease was terminable at will. Held: Sun not liable. even though the paperwork had not been processed. The Agent s Duty of Loyalty to the Principal  Restatement (3d) Agency Duty of Loyalty  § 8. Gallant.5. Held: Humble liable. Sun Oil Co. in becoming informed and exercising power 2. consignment. while agency by estoppel looks to the reasonableness of the principal s behavior. though products sold and Humble paid large percentage of received subsidies from Sunoco to ensure operator s costs.  An employee is an agent whose principal controls or has the right to control the manner and means of the agent s performance of work. 2. the employer-employee relationship. In White. All franchisees benefit if franchises are well-run.

 If the people who are the inferior claimants also have control. less recovery costs. . which provides that ownership rights over partnership property. 36)  Facts: Agent/defendant took secret commission from seller for a deal on behalf of principal/plaintiff.2. 2. This gives creditors more confidence in transacting with the firm. 3.  If the settlor is deceased.  Held: It is acceptable for the plaintiff to recover over and above damages because we want a strong deterrent effect on agents acting this way.  Held: Despite absolutely no bad faith.  §8. which Salmon accepts without telling Meinhard.§ 8. (ii) discloses all material facts that the agent should know would reasonably affect the principal s judgment .  .1.  With respect to the relations among partners. although the profit does not result from a breach of trust. in the event of partnership bankruptcy or liquidation. . (Thus. THE PROBLEM OF JOINT OWNERSHIP: THE LAW OF PARTNERSHIP 3. the agent (i) acts in good faith. the trustee may be locked into place. INTRODUCTION TO PARTNERSHIP  The general partnership is the earliest and simplest form of a jointly owned and managed business.3. 3.000 down payment back from seller.  Asset partitioning: assets are owned by the firm. Tarnowski v. lack of clarity regarding fairness and high associated enforcement costs.1. not by the owners. lenders and contractors who deal with the firm have priority as compared to the owners creditors.  With respect to third parties. the law of partnership closely follows agency law. the primary agency problem is not the conflict between the agent or manager and the owner the paradigmatic problem in the law of agency but potential conflict among the joint owners. prior claimant are more likely to receive satisfaction on money lent (since owners are residual claimants). Agency Conflicts Among Co-Owners Meinhard v. making the trustee s fiduciary obligations the only check on the trustee s behavior.  The trustee is subject to the terms of the trust.06 (1) Conduct by an agent that would otherwise constitute a breach of duty does not constitute a breach if the principal consents to the conduct. this form of title gives creditors of the partnership first priority over the claims of the creditors of individual partners.  In partnership. selling an ownership stake may be a cheaper way to raise capital than attempting to borrow additional funds.  Reasoning: The tenant/trustee is dealt with so harshly because of evidentiary concerns. At the end of the lease. plaintiff comes out ahead). Salmon (p.  § 8.  The remedy given (same proportional shares in second lease as in first) may diminish Salmon s incentive to seek new opportunities. not to Salmon alone. Resop (p.  Held: Meinhard is entitled to ½ interest in the deal. . a new lease is offered to Salmon. numerous common law rules deal with the internal problems of these small. as these have been fixed by the trust s settlor. This relationship would not be possible through contracting alone. 47)  Facts: Meinhard supplies ½ capital.  Facts: Gleeson appoints her tenant trustee of a trust which includes the property he leases from her. jointly managed firms. Gleeson s trust comes into force two weeks before the tenant/trustee s lease was up for renewal. In re Gleeson (p.1. As a result. 38)  Restatement (2d) Trusts § 203: The trustee is accountable for any profit made by him through or arising out of the administration of the trust. This seems to benefit the lessor at Salmon s expense. for a total of $5.03 An agent has a duty not to deal with the principal as or on behalf of an adverse party in a transaction connected with the agency relationship. provided that (a) in obtaining the principal s consent.200. 3. The Trustee s Duty to Trust Beneficiaries  The private trust is a legal device that allows a trustee to hold title to trust property which the trustee is under a fiduciary duty to manage for the benefit of another person.  Reasoning: Salmon took advantage of a benefit (the opportunity to take a new lease) that belonged to the joint venture. The tenant/trustee discussed the matter with the beneficiaries and got their approval to renew the lease at a higher rate of rent and find a new tenant the next year. the trust beneficiary.02 is treated as a default provision of the principal-agent contract.  Rules give distinct legal treatment to partnership property: tenancy in partnership. Why Have Joint Ownership?  At a certain point.500 of $11. Plaintiff receives $9.1. Salmon supplies the rest and manages the property they ve leased.  Salmon should have given Meinhard notice as to the opportunity so that Meinhard could compete for it if one or both did not want to continue as joint venturers. Plaintiff also receives agent s secret commission and all costs associated with recovering from the seller. the tenant/trustee must return to the trust any profit from his lease.3. and in practice.

the duty of the finest loyalty. 3. Not honesty alone.  In order for a partnership to exist. even though that person is not in fact a partner. 3. but the punctilio of an honor the most sensitive.  Somewhat analogous to apparent authority doctrine.1. A party who receives a share of profits is presumptively a partner. the partners need to consent to the structural elements of a partnership. Only thus has the level of conduct for fiduciaries been kept at a level higher than that trodden by the crowd.  Reasoning: Though the parties conceived of the arrangement as resulting in Sweet being paid a commission. Salmon s option: Salmon can keep the new opportunity or offer a piece to Meinhard.If Salmon has the option to retain the opportunity and compensate Meinhard in some other way. but courts sometimes impute general partnerships)  UPIA § 7: Partnership Formation: (3) The sharing of gross returns does not of itself establish a partnership (4) The receipt by a person of a share of the profits of a business is prima facie evidence that he is a partner in the business.3. . how are such claims to an individual partner s personal assets to be balanced against the claims of other (nonpartnership) creditors of that person? 3.) 2. Sweet (p. He seeks this because much of the profits to which he is entitled have been reinvested and can t be liquidated short of dissolution. (This is close to Cardozo s remedy: Meinhard got a 50% participation in the new deal. A trustee is held to something stricter than the morals of the market place. (b) As wages of an employee or rent to a landlord. while the enterprise continues. like copartners. is then the standard of behavior. Competition/Renegotiation: Salmon must inform Meinhard. 52)  Facts: Sweet was paid 20% of profits. 55)  The whole partnership is charged with the business-related torts of any partner under §13. (Cardozo suggests this is what Salmon s fiduciary duty required. §7 contains codification of exceptions. Salmon might heavily invest in ways that make the opportunity even more attractive. Sweet wants it considered a partnership so he can sue to dissolve. Same Term Option: Meinhard participates in any new opportunity on the same terms as in the 20-year joint venture. the parties conception of the relationship doesn t control.3. It will not consciously be lowered by any judgment of this court.2.) 3. RELATIONS WITH THIRD PARTIES  Three principal issues rise under the topic of creditor rights:  Who is a partner for purposes of personal liability to business creditors?  When can an exiting or retiring partner escape liability for a partnership obligation?  Since a partner s liability on a partnership debt can be satisfied from a partner s nonpartnership property.  Held: No error in finding the existence of a partnership. any new opportunity. or renegotiate over. As to this there has developed a tradition that is unbending and inveterate. are forbidden to those bound by fiduciary ties. PARTNERSHIP FORMATION  Key Features of General Partnership  All partners are liable as principals  All partners are general agents of the partnership*  All partners are jointly and severally liable for debts of the business  All partners share equally in control* * Can be altered by contract  NB: No one actively organizes this way anymore. . Cargill. just like the old deal. owe to one another. then the person who was represented as a partner is personally liable on the transaction. but need not agree to be called a partnership. Many forms of conduct permissible in a workaday world for those acting at arm s length. Uncompromising rigidity has been the attitude of courts of equity when petitioned to undermine the rule of undivided loyalty by the disintegrating erosion of particular exceptions . (d) As interest on a loan (e) As the consideration for the sale of a good-will of a business or other property Vohland v. Who Is a Partner?  Ars Gratia Artis Problem (p.  Notable for: Cardozo s punctilio admonition: Joint venturers. but no such inference shall be drawn if such profits were received in payment: (a) as a debt by installments or otherwise.  .  Possible Terms for Allocating New Opportunities (from better to worse from Meinhard s perspective) 1. as in Jensen v.  Slide 19# 23#  Partnership by estoppel: If a person represents himself as being a partner in an enterprise (or consents to others making the representation) and a third party reasonably relies on the representation (actual reliance required) and does business with the enterprise. Whether a party is a partner is defined under §7. as he likes. who is free to compete for.

thus transforming the property into de facto business property. 3. which gave creditors of individual partners priority over creditors of the partnership with respect to individual partners personal property. which is the equity that the partners have in the firm. even though this is contrary to the partnership agreement.3. . Stroud tells Nabisco he personally would not be responsible for any bread delivered after February 6. Stroud (p. Partnership creditors receive parity treatment if either (1) RUPA is controlling state law or (2) §723 applies (the partnership is in Chapter 7 or the individual partner is in bankruptcy) 3.  With respect to partners property if the partnership is insolvent.  The capital account will have a report that records the effects on the partners capital of the operations of the business over the year. Adams v.  Held: Stroud could not restrict Freeman s power and authority to engage in ordinary business matters. Nabisco nevertheless delivers after February 6. TERMINATION 3. partnership creditors are on equal footing with personal creditors under Federal Bankruptcy law (§723 of the Bankruptcy Code the parity rule).  Under UPA:  Dissolution (§29): any change of partnership relations. and the surplus applied to pay in cash the net amount owing to the respective partners.1. the partnership is not in Chapter 7 or the individual partner is not in bankruptcy).  The contributors of equity capital do not own the assets themselves but rather own the right to the net financial returns that these assets generate. each partner. .  This is different from the old (jingle) rule. partnership creditors are subordinated to the claims of a partner s creditors if (1) UPA is controlling state law and (2) §723 does not apply (that is. may have the partnership property applied to discharge its liabilities.3. Stroud is liable for debts owed to Nabisco.. the retiring partner is released from liability to creditors who. e. as to claims against the individual assets of partners. Adams withdraws from the three-doctor Tomahawk Clinic partnership.3. unless otherwise agreed. Third-Party Claims Against Departing Partners  Liability of Retiring Party (§36)  A would-be former partner is only released from liability when the remaining partner(s) and creditor(s) so agree (agreement can be inferred).  Where a party assumes the debts of a dissolved partnership. 3.  Termination (§30): partnership ceases entirely at the end of winding up.  UPA § 38(1): When dissolution is caused in any way. 65)  Facts: Dr.  If a partner does not own her partnership s assets in any ordinary sense. Accounting for Partnership s Financial Status and Performance  A firm s balance sheet is a simple statement of the assets that it holds. . as against his co-partners .5. Third-Party Claims Against Partnership Property  A fundamental characteristic of all business entities is a segregated pool of assets available to secure business debts. Jarvis (p. contends that his withdrawal constitutes a dissolution that requires a winding-up under UPA. except in contravention of the partnership agreement.2. NABISCO v.  The income statement reflects the results of transactions in which the firm has engaged over a set period. agree to material alteration in the nature or time of payment of such obligations. which may follow RUPA and give partnership and individual creditors equal footing (parity rule) or may follow UPA and give personal creditors priority (jingle rule). the partnerships creditors are always first in line. the exit of a partner. but no act in contravention of any agreement between the partners may be done rightfully without the consent of all the partners.3. . knowing the new situation. even though Stroud warned Nabisco he would not be responsible for the debt.5. The partnership dissolves on February 25. PARTNERSHIP GOVERNANCE AND ISSUES OF AUTHORITY  Any decision related to ordinary matters may be decided by a majority of partners (but one of two is not a majority) under §18(h). the liabilities that it owes. often a year. it depends on state law. as well as certain governance or management rights. 3. Claims of Partnership Creditors to Partner s Individual Property  With respect to partnership property.4. and the difference between the two.  Winding up (§37): orderly liquidation and settlement of partnership affairs.g.  Partnership property owned by the partners as tenants in partnership affords to individual partners virtually no power to dispose of partnership property.  With respect to partners property if the individual is insolvent. she nevertheless retains a transferable interest in the profits arising from the use of partnership property and the right to receive partnership distributions.  Thus. 61)  Facts: Stroud and Freeman are partners.4.3.

 LLC statutes generally offer more flexibility than corporate statutes in the form of near-complete freedom to opt out of default rules.g. The Limited Partnership  Limited partners share in profits without incurring personal liability for partnership debts.1.  UPA §38(1): When dissolution is caused in any way. each partner. (ii) centralized management. The Limited Liability Company  LLC: offers a broader range of liability protection than LLPs.Under RUPA:  Disassociation (§ 601): a partner leaves but the partnership continues.  Held: Unless otherwise agreed to by the partners. Limited Liability Partnerships and Companies 3. malpractice.1. THE CORPORATE FORM 4. and Dr. They are often restricted to use by professionals. Today. but S corps may participate in tax-free reorganizations with C corporations. Because corporate earnings are doubly-taxed. 3. winding-up of the business and sale in cash is required. Dreifuerst (p. LLCs were taxed like a corporation if they possessed three or more of the following four corporate characteristics: (i) limited liability for the owners of the business.2. which means that business creditors cannot proceed against the personal assets of some or all of a firm s equity investors. 3. instead. The partnership agreement is valid.  Until 1997.  Dissolution: (§ 801): the onset of liquidating of partnership assets and winding up its affairs. . as against his co-partners .  The tax incentives for organizing in these variations on partnership changed in 1997 when the IRS switched to check the box rules which allowed unincorporated businesses to choose whether to be taxed as partnerships or corporations. any firm that is publicly-held is forbidden from electing partnership treatment.2. INTRODUCTION TO THE CORPORATE FORM Core Characteristics GP LP LLC Corp  . 3. e. or else in-kind valuation and separation would be satisfactory to all. may have the partnership property applied to discharge its liabilities. wrongful act.  Policy rationale: limited partners don t have control.  Why don t all businesses elect partnership taxation?  If corporation income tax rates are lower than individual income tax rates. The brothers disagree about valuation. LIMITED LIABILITY MODIFICATIONS OF THE PARTNERSHIP FORM  The general partnership form has the bare minimum of features necessary to establish an investor-owned legal entity: (1) a dedicated pool of business assets.  The decision as to what entity form is chosen is frequently a function of tax liability. No partnership agreement.  NB: The court warns Big Page that he has a fiduciary duty not to withdraw in bad faith. Little Page claims Big Page is forcing him out. Page v. .  Why use limited partnership rather than a corporation when both limit liability? To remove control from the parties who would otherwise be shareholders with control rights.2.2. there are advantages to entity forms that incur only pass-through taxation. Cloud) to the defendant brother and other mill (Elkhart Lake) to the two plaintiff brothers.6. 73)  Facts: Both parties contribute equity capital. gives one mill (St. (2) a class of beneficial owners (the partners). The Limited Liability Partnership  LLP: general partnership with certain kinds and degrees of limited liability. and the surplus applied to pay in cash the net amount owing to the respective partners. they are functionally very similar to corporations. pursuant to agreement. Dreifuerst v. 4.. they risk losing their limited liability protection. unless otherwise agreed. but Big Page also contributes debt.6. 3. 69)  Facts: Winding-up of at-will partnership among three brothers to run two feed mills. or misconduct of another partner or an agent of the partnership not under the partners direct control. Just when the partnership turns a corner. any partner can dissolve the partnership at any time (partnership at will unless otherwise specified).  Held: The provisions in UPA that govern relationships between partners can be modified by the partners. Limited partners may not participate in management or control.6. Page (p. and (3) a clearly delineated class of agents authorized to act for the entity (the partners). so they shouldn t share in liability.  Limit liability only as to partnership liabilities arising from the negligence.6. except in contravention of the partnership agreement. (iii) freely transferable ownership interest. Trial court declines one brother s request for a sale of the assets. Adams withdrawal does not constitute a dissolution of the partnership as to the remaining partners. .  The separation between the partnership as a legal entity and the investors can be further increased by adding limited liability. Big Page seeks to dissolve the partnership.6.  Held: The trial court s approach is rejected.1. retaining corporate earnings may be preferable. if they do. and (iv) continuity of life. small corporations ( S corporations) have some of the same tax advantages of partnerships.

 Thus. but problematically. and how often. or other operational factors in choosing where to incorporate. including such matters as who votes. in a scenario similar to the situation between beneficiaries of spendthrift trusts and their creditors.S. competing states externalize costs to the remaining 49 states. practical control resides with the existing management of the firm. all they have to do is buy or sell shares  Prevents minority investors from holding up the firm by threatening to dissolve it  Makes it easy for third parties who contract with the firm to know whom they deal with is an authorized agent. is highly responsive to lobbying groups (like affected professionals) who want to keep incorporating in Delaware an attractive option.Investor ownership X X X X Legal personality X X X X Limited liability X X X Transferable shares X X X Centralized management under an elected board * X Indefinite existence * X X X * If so chosen  Benefits of the corporate form:  The corporation emerged as a response to the limitations of the partnership for financing.  The corporate form also:  Eliminates problems of personal liability creditors rely only on business assets  Allows investors to enter and exit firm.  Arguably.  The desire to attract corporations can lead to a race to the bottom to attract managers or a race to the top to attract shareholders.1. CREATION OF A FICTIONAL LEGAL ENTITY  The corporation is considered a separate person in the eyes of the law. as a smaller state. .  Because its principal investors need not execute the transaction or even agree to it. 4.  Corporations are attracted to states of incorporation based on whether the state offers:  Favorable terms. the doctrinal fiction of an artificial entity vastly reduces the costs of contracting for credit.  Enabling corporations to own assets delimits the pool of assets upon which corporate creditors can rely for repayment.  U. a state will come to optimal compromises to attract both mangers and shareholders.2. Where there is no such person or group. whether there s a race to the bottom or top in respect to managers and shareholders. control is said to be in the market. 4. firms are not constrained by HQs.  These characteristics combine to make the corporation a highly efficient legal form for enterprise organization. who in turn pay income tax to the state. place of business. Losers include tort victims. the information and coordination costs of closing the transaction are minimal. on what.  Close Corporations: Closely held corporations (so named because they have few shareholders) are often businesses that incorporate for tax or liability purposes rather than for capital-raising purposes. including fiduciary duties  Judiciary experience and position  Creditor s rights  Franchise fees  Speed & ease of incorporation  States attempt to attract incorporating entities because the states collect incorporation fees and franchise taxes and attract business for professionals who assist corporations. depending on the critic. franchise fees make up a larger portion of Delaware s revenues.  The state of incorporation dictates which corporate law rules apply under the internal affairs doctrine.  Delaware.  Controlled Corporations: Corporation in which a single shareholder or group of shareholders exercises control through its power to appoint the board. which enhances the stability of the corporate form. especially where large aggregations of capital are required and complex operations demand specialized management. All they need is a board resolution.2.  NB: You must maintain an agent in the state of incorporation upon whom process can be served. Further.  Limited liability makes free transferability more valuable by reducing the costs associated with transfers of interest (the value of shares is independent of the assets of their owners)  Free transferability permits the development of large capital (equity or stock) markets.  As long as control is in the market.  The status of the corporation as a fictive legal entity allows it to have an indefinite life. which are also advanced by the presence of centralized management. A Note on the History of Corporate Formation  The law of the state of incorporation governs the internal affairs of a corporation. there s clearly a race to the bottom regarding tort creditors.

and shareholder voting for certain transactions. board of directors. Shareholders Agreements  Shareholders agreements typically address such questions as restrictions on the disposition of shares.  The charter must provide for voting stock. and miscellaneous topics. its address. this is particularly useful in small businesses where owners will be unable to secure credit without so waiving. a board of directors. rights of preferred shareholders. stock.There was a race between states to deregulate: authorizing corporations to own the stock of other corporations (permitting the holding company structure.2. voting agreements. should there be any.3.  Limited liability can be waived through contract between owners and creditors. committees.  The bylaws might have other provisions relating to stockholders. The Corporate Bylaws  The bylaws must conform to both the corporation statue and the corporation s charter. number of common shares. officers. the size of the board of directors or the manner in which the size of the board is to be established.  The chief purpose of limited liability is to encourage investment in equity securities and thus to make capital more available for risky ventures. suppliers.2. purpose (usually any lawful act ).  Limited liability vastly simplifies the job of evaluating an equity investment. 4. if any). permitting organization for any lawful purpose. made possible corporate joint ventures and networks of corporations related by ownership).  NB: Reincorporation requires shareholder approval. have no liability for the debts of the corporation.  The typical corporation statue of today is a nonregulatory enabling statue with few mandatory features.  Limited liability may increase the incentive for banks or other expert creditors to monitor their corporate debtors more closely. and as shareholders of public companies grew more numerous and disaggregated. adopting bylaws. The Articles of Incorporation.2. indemnification. 4. intermediate claim holders (such as. and agreements with respect to the employment of officers or the payment of dividends.  The charter may establish the size of the board or include other governance terms.  The bylaws should establish the existence and responsibilities of corporate offices.  After it is duly executed. the secretary of state issues the corporation s charter. original capital structure (classes.  After the articles are filed and the fee is paid.  If it is to have some governance oddity.  The charter must name the original incorporators. the name of company. and shareholders. own and vote stock of other corporations. the charter is filed with a designated public official. LIMITED LIABILITY  Corporations have unlimited liability.  The ability of the corporate form to segregate assets may encourage risk-averse shareholders to invest in risky ventures. or Charter  The articles of incorporation may contain any provision not contrary to law. Shareholders cannot lose more than the amount they invest. perhaps. shareholders have the inalienable right to amend the bylaws. 4. an annual meeting date or a formula by which such a meeting date will be fixed. venture capitalists. relaxing capital requirements.  Under DGCL §109.5.  The incorporator drafts and signs a document called the articles of incorporation (under RMBCA) or the certificate of incorporation (under the DGCL) (also known as the corporation s charter).  Upon filing. tort victims. 4. a fee will be due. in turn. buy/sell agreements. which. and utility suppliers.3.  Bylaws fix the operating rules of the governance of the corporation. and the federal government began to regulate public companies through securities law. 4.2. and allowing corporations to amend their certificates of incorporation.  As corporate management s freedom to act grew under the enabling approach of modern statutes. and other miscellaneous provisions. by reason of their shareholder status alone. this condition must be spelled out in the charter. who may straddle the line between debt and equity holders).4. courts came to give greater weight to judicially-created fiduciary duty of corporate directors and officers. The Process of Incorporating Today  An incorporator signs the requisite documents and pays the necessary fees.  .  The company charter will contain any customized features of the enterprise.  The AOI state the purpose and powers of the corporation and define all of its special features. employees. trade creditors (such as plumbers and electricians).  A firm s creditors can include banks & bond holders.  The corporate charter will contain the most important customized features of the corporation. allowing corporations to have indefinite/perpetual existence. and merge with other corporations. and appointing officers.2.  The first acts of business in a newly formed corporation are electing directors (if initial directors are not named in the charter). own land without limit. landlords.

as the identities of its shareholders changed. limited liability in contract can lead to: 1. as a default rule. By using limited liability. which is exacerbated by contractual debt. transaction costs make it likely that only the wealthiest shareholders will be pursued by tort victims which means shares will have less value to these wealthy owners. Limited Liability in Contract (p. not investors. are accorded the power to initiate corporate transactions and manage the day-to-day affairs of the corporation.  The free transferability of stock complements centralized management in the corporate form by serving as a potential constraint on the self-serving behavior of the managers of widely held companies. perhaps fundamentally.   . Limited liability reduces the costs of this separation and specialization.  Transferability permits the firm to conduct business uninterruptedly as the identities of its owners change. The creditors most likely to insist on a personal guarantee of debt are banks and large landlords. This leads to taking fewer precautions than appropriate to the risk and externalizing this cost to tort victims. you can pick and choose priority of creditors in respect to personal assets. TRANSFERABLE SHARES  Equity investors in the corporate entity legally own something distinct from any part of the corporation s property: they own a share interest. rather than proportional. the creditworthiness of the firm as a whole could change. CENTRALIZED MANAGEMENT  Centralized management can achieve economies of scale in knowledge of the firm.5. Allows market prices to impound information about the value of firms 5.  Among the foundational problems for modern corporate law is the determination of the set of legal rules and remedies most likely to ensure that these managers will strive to advance the financial interests of investors without unduly impinging on management s ability to manage the firm productively. given that shareholders choose the directors who designate managers?  How can the law assist shareholders in acting collectively vis-à-vis managers.  Shareholder designated boards of directors.  Is unlimited liability in tort on a pro rata basis feasible? Hansmann and Kraakman argue yes. in turn. its technologies and markets.  Limited liability and transferability are complementary features of the corporate form. investors who are active bear all the costs of activity. because many companies are now owned by wealthy individuals and institutions and the pro rata share of unlimited liability is unlikely to bankrupt them  However.  The ability of investors to freely trade stock encourages the development of an active stock market.  If investors see value in agreeing to restrictions on transfer. because this debt can be prioritized.  How can the law encourage companies to make investment decisions that are best for shareholders?  Corporate law attempts to mitigate the agency problem by requiring.  The are at least three aspects of this problem:  What can the law do to encourage managers to be diligent. Decreased need for shareholders to monitor each other 3.  Absent limited liability. all jurisdictions provide mechanisms for permitting agreements to that effect. 97)  The costs generated by agency relations are outweighed by the gains from separation and specialization of function. increases interest rate 2. that management be appointed by a board of directors that is elected by the holders of common stock in the company. Facilitates optimal investment decisions  Rather than mere avoidance of risk and monitoring costs  Real benefit: the increased availability of funds for projects with positive net values  Limited Liability in Tort (course materials)  Encourages mis-investment and over-involvement in hazardous activity.  The formal distinction between a corporation s board and its management permits a distinction between the approval of business decisions and their initiation and execution. but receive only part of the benefits. 4. thus distorting share value. which avoids the complications of dissolution and reformation. facilitates investment by providing liquidity and by facilitating the inexpensive diversification of the risk of any equity investment. Allows diversification 6. 4.  Such a share may be transferred together with all rights that it confers. Promotes free transferability of shares  The value of a share does not change depending on whose hands it is in 4.  If we assume that owner s personal liability must be joint and several.4. especially in the case of widely held companies with many small shareholders?  Rational apathy: in large corporations with dispersed ownership. Decreased need for shareholders to monitor managers  Shifts monitoring to lenders. An active market.

S. (p. as its board of directors or governing body deems expedient . or to others. . . Empowering boards to act in opposition to the will of shareholder majorities can provide a check on opportunistic behavior by controlling shareholders. . shareholders may not take matters into their own hands. The Holder of Primary Management Power  Automatic Self-Cleansing Filter v. Energy Systems. Proper notice of these meetings must be given and a quorum must be present. . U. the prices it will charge.  Held: The board is the agent of shareholders acting as one. and dissolutions. the exclusive power to initiate and approve certain extraordinary corporate actions. Structure of the Board  In default of any special provisions in the charter.5.  Directors act as a board only at a duly constituted board meeting and by majority vote (unless the corporate charter requires a supermajority vote on an issue) that is formally recorded in the minutes of the meeting.  Corporation statutes generally permit corporate charters to create staggered boards. to officers.  Reasoning: The court upholds the article s effort to protect minority shareholders. the three outside directors convened and decided to fire the CEO.1. mergers. the board makes decisions. the board of directors or governing body may abandon such proposed sale . McDiarmid then asks the court to order the board to sell the assets. Inc. who then left the building. subject to the rights. the power to delegate authority to subcommittees of the board. not in the individual directors who constitute the board.4. Just before a scheduled board meeting.1. . that is.5. including deciding the products the company will offer. but that is not the case here. 4. 4. the CEO called a special meeting of shareholders for the purpose of removing the other directors from office and electing replacements. Formality in Board Operation  Corporate directors are not legal agents of the corporation. not of 55% of shareholders. Two days later. . all members of the board are elected annually to one-year terms. institutional shareholders have generally opposed staggered boards because they plainly enhance management s ability to resist hostile takeovers. .1. McDiarmid and friends bring such a resolution to sell the company s assets.  Typically. A Critique of Boards .  The board has inherent power to establish standing committees for the effective organization of its own work.5. which consisted of the CEO and three outside directors. and more generally. when and as authorized by a resolution adopted by the holders of a majority of the outstanding stock of the corporation entitled to vote thereon. if any. which helps to ensure that the board will act in the interest of the company s owners. Governance power resides in the board of directors.5. some of which must be ratified by shareholders. The charter may provide that board seats are to be elected by certain classes of stock. 103)  Facts: McDiarmid and friends own 55% of Automatic Self-Cleaning Filter (ASCF). compensate. its residual claimants.  Held: The Delaware Chancery Court held that the three outside directors had not held a valid board meeting to fire the CEO and the CEO thus retained the authority to call the shareholder meeting.2. . by the stockholders . such as amendments to the articles of incorporation.1. Legal Construction of the Board 4. and it may delegate certain aspects of its task to these committees or to ad hoc committees. The outside directors then went to the boardroom and announced their decision to the CEO. resolution fails 55% to 45%.  Fogel v. the power to amend the company s bylaws.  The board of directors has the primary power to direct or manage the business and affairs of the corporate.1.S.  (b) Notwithstanding authorization or consent to a proposed sale . the power to declare and pay dividends. The managerial powers of the board include the powers to appoint. so the board must follow the articles of incorporation (a work of the whole) over 55% when the articles do not consider 55% sufficient. except by voting out directors. Cunninghame (p. . Energy had a four-member board of directors. and remove officers.5.  Usually a board s duty to the corporation and to the shareholders perfectly cohere. but usually designates managers to do so. . the wages it will pay.3. of third parties under any contract relating thereto. all or substantially all of its property and assets . .  Since the early 1990s. 4. 107)  Facts: U.   The additional distinction between a corporation s board and its shareholders is principally a device for reducing the costs of corporate decision making. . ASCF charter vests control in the board.1. subject to regulations by extraordinary resolution of 75% of shareholders. the financing agreements it will enter. . 4. sales of all assets. The articles of incorporation always control. the power to make major business decisions. and the like. DGCL §271 reaches the same result:  (a) Every corporation may at any meeting of its board of directors or governing body sell . The board is usually elected by the firm s shareholders.

 If a corporation fails to make any of these payments. covenants.  Its holders have no right to any periodic payment.  These practical limitations make the role of the outside. no tax deductibility  Control is enforced by collective action in the form of voting  Debt p fixed claims (interest + principal). Jennings v. the creditor has legal remedies. 112)  Facts: A CEO attempted to enter an oral contract to sell 10% of any new issue of stock to an existing shareholder who wished to maintain his proportional shareholdings. they merely have a right to vote.2. unlike directors.  This construction was required by the fundamental social policies of protecting the board s power to regulate corporate capital structure and ensuring the certainty of property rights in corporate sales. and a three-member executive committee of directors. directors of a large corporation meet only between four and eight times a year. the most important single organizational role in the large majority of corporations. and director). are unquestionably agents of the corporation and are therefore subject to the fiduciary duty of agents. Egmore (Mercantile s VP and Treasurer-Controller.  Most equity claims on corporations take the form of common stock. CAPITAL STRUCTURE  A business corporation raises capital to fund its operations by selling legal claims to its assets and prospective cash flows by:  Borrowing money through the issuance of debt instruments.  Common stockholders can expect to receive dividends. not principals.  Selling ownership claims in the corporate entity by issuing equity securities. director on the boards of major U. Legal Character of Debt  . as a board. nor can they typically tell the firm s managers what to do.  Restatement 3d Agency §2.1. Debt  Equity p residual claims.  Executive officers are agents.  Held: The agent s words or acts on their own are not sufficient to establish apparent authority. Jennings argues that Mercantile is bound through apparent authority of Egmore. 110)  Facts: Mercantile is a publicly-held corporation with 400 shareholders. Egmore tells Jennings that the executive committee has the power to accept an offer. who are intimately versed in the company s business affairs. tax deductibility  Covenants enforced by suit 5. corporations one of the last great amateur roles in American life. Pittsburg Mercantile Co. Further.1. but they get those dividends only when the corporation s board of directors so declares. 4. and therefore Mercantile is not bound. control rights. along with Stern ( financial consultant ). nine directors. and Jennings sues for his commission.Most corporate statutes do not mention the position of CEO. Grimes v. such a contract constituted a right in the company s securities and thus required board approval. most directors cannot in the time available consider the merits of any significant number of complex corporate decisions or second-guess the judgments of the corporation s full-time officers.1.  Equity vs. nor can they demand the return of their investment from the corporation. a sale and leaseback of all assets is not an ordinary transaction in the course of business it is an extraordinary transaction.S.03: Apparent authority is the power held by an agent or other actor to affect a principal s legal relations with third parties when a third party reasonably believes the actor has authority to act on behalf of the principal and that belief is traceable to the principal s manifestations.  Debt is more secured than equity and senior claims more secured than junior ones. those who buy corporate debt have a contractual right to receive a periodic payment of interest and to be repaid their principal at a stated maturity date.  Usually.  Moreover.  The creditor typically also gets a contractual right to accelerate payment of the principal amount if the debtor defaults.5. is the principal. 5. and eventually does so through Stern.  Held: The CEO lacked authority. The board. instructs Jennings to solicit offers for a sale and leaseback of its real property in order to raise money for modernization. acceleration. EQUITY. Corporate Officers: Agents of the Corporation  The corporate officers. AND ECONOMIC VALUE 5. (p. or independent. directors customarily receive their information about the corporation through the filter of documents and presentations put together by the corporation s officers.  In most instances. Mercantile argues that Egmore did not have authority to do the deal. DEBT.  Unlike the CEO.  The debtor generally must pay its creditors the amounts currently due before the debtor can distribute funds or other things of value to equity owners. Alteon (p. corporate officer. But the board rejects.

Bonds  A form of debt in which the loan is taken from a large number of loans  The instrument that creates the bond is called an indenture.2. so that the costs are automatically spread out. they are sensitive to what the risk is.1. the payments are fixed. does not carry voting rights (control) in ordinary circumstances. The Time Value of Money  Present value is the value today of money to be paid at some future point. to a large extent we are talking about general patterns of contract terms.1. when we speak of the legal characteristics of debt. the debt contract the loan agreement has great flexibility in design.  Maturity Date: A critical advantage of bonds. 5. if extensive enough and flexible enough. While people are generally risk averse. from the perspective of investors. in more complex companies.  Any lawsuits for enforcement will be paid from collective bond payments.  Like debt because they carry a stated dividend (like interest rate obligation. among each of several classes of creditors.  Bonds have collective action problems. who must enforce the terms of the bond if any of the bondholders petitions for them to be upheld.2. typically has preference over common stock in liquidation and dividends. covenants. privilege.  Like equity because there is no fixed claim. Subordinated Debt  Like debt because the claim is senior to equity claims. begin to look like control. FV = PV (1 + r)n PV = FV / (1 + r)n r = (FV / PV)1/n 1 where FV = future value. The charter contains the specifics of the firm s equity securities.1. PV = present value. Thus. uncertainty as to two strong outcomes is preferable to certainty as to weak outcomes.  Like equity because the claim is junior to other types of debt.   . 5.  Expected return does not measure risk or uncertainty. if they play out as expected.1. Residual Claims and Residual Control: Common stock holds the residual claim on the corporation s assets and income. weighted by the probability of each outcome occurring.2. Their rate of return is higher than the market rate of return. or limitation. it is junior in security to traditional debt. but payable only when declared by board).  The legal characteristics of debt are largely general patterns of contract terms. Risk and Return  The expected return is the sum of possible outcomes.  Preferred Stock: An equity security on which the corporate charter confers a special right. The loan agreement allocates risk and responsibilities between the debtor and creditor and. so they often have an indenture trustee. Legal Character of Equity Common Stock: Equity has not the right to payment but (usually) the right to vote on certain important matters. The discount rate tells us how to calculate present values. r = annual interest rate (or discount factor).  Interest is the money you are promised when you lend out money or the amount you have to pay if you borrow money. n = number of years  Projects for which the present value of the amount invested is less than the present value of the amount received are positive net present value projects. BASIC CONCEPTS OF VALUATION  The four basic finance concepts that are important for understanding value are:  Time value of money  Risk and return  Systematic risk and diversification  Capital market efficiency 5. The discount rate is the rate that is earned from renting money out for one year in the market for money. 5. If creditors are not paid on time. they will pay out more than is needed to compensate for the time value of money. 5. Equity securities generally possess control rights in the form of the power to elect the board of directors. After the company has paid its expenses and paid interest to creditors.2.2.  Tax Treatment: Interest paid by the borrower is a deductible cost of business when the firm calculates its taxable income.1. whatever is left is available for the payment of dividends. covenants are used.1.2.Debt securities are contracts.1. Investing in such projects is a good idea for investors. they can sue on their contract. carries conditional voting rights. is that the investor generally faces less risk as a creditor than as an equity holder because creditors have a legal right to periodic payment of a return (interest) and a priority claim over the company s shareholders on corporate assets in the event that the corporation defaults. 5.

 Most projects involve a combination of diversifiable and undiversifiable risk. VALUING ASSETS 5. market prices aggregate the best estimates of the best-informed traders about the underlying present value of corporate assets. When expected payoffs differ.3. of the discounted value of the expected future payouts of corporate stocks and bonds. people s risk-aversion is highly idiosyncratic. based on all available information. 5. even though it does not attempt to protect other classes of corporate stakeholders. people will prefer the less-risky options. the risk premium is compensation for the intrinsic unpleasantness of volatile returns to the risk-averse investors who dominate market prices.  Risk can be valued by increasing the discount rate (r) by the risk premium. the problems of corporate creditors are no different from those of any other creditors.  The risk premium does not compensate the investor for the possible out-of-pocket losses associated with the probability than an investment might fail.1.  Prices in an informed market should thus be regarded as prima facie evidence of the true value of traded shares. but these protections are costly and some forms of debtor opportunism are so blatant that no amount of contracting can offer protection from them.  However. instead. Limited liability can have this effect in two ways:  It opens opportunities for both express and tacit misrepresentation in transactions with voluntary creditors.2.  Creditors can minimize the costs of such forms of opportunism by exercising vigilance and negotiating for contractual protections. Whether the market price of a company s shares also reflects the value of the entire company is a more complicated question.3.2. 5. lawmakers believe that the core corporate feature of limited liability greatly exacerbates the traditional problems of debtor-creditor relationships.  Federal securities law imposes extensive mandatory disclosure obligations on public corporations. and for which the risk-averse investor demands a premium. 6. it provides creditors with additional protections.If the expected payoffs are the same.3.  It makes it possible and sometimes attractive to shift assets out of the corporation after a creditor has extended credit to the corporation. The Relevance of Prices in the Securities Market  The efficient market hypothesis posits that the prices of securities reflect well-informed estimates. Capital Regulation  Distribution constraints  Minimum capital requirements*  Capital maintenance requirements* *More common in the EU 3. then calculate an appropriate discount rate usually the weighted average cost of capital (WACC).  Apparently. not every risk is diversifiable there is always some level of market (systematic) risk that even the most diversified investor must bear. but corporate law does not leave creditor protection solely to general law.2.  The additional amount that risk-averse investors demand for accepting higher-risk investments in the capital markets is termed the risk premium.1. that is. The Discount Cash Flow (DCF) Approach  Estimate all future cash flows generated by the asset. THE PROTECTION OF CREDITORS  Fundamentally. a risky investment held as part of a portfolio that includes other equally risky investments is likely to be worth more to its owner than it would be if it were held alone. mandatory disclosure offers some promise of controlling it. the appropriate risk premium and risk-adjusted discount rate depend only on the undiversifiable portion of the risk.  Investors are averse only to risks that they bear. Mandatory Disclosure Duty  SEC requirements 2. 5. Fiduciary Duty Constraints  Director liability  Creditor liability: fraudulent conveyance  Shareholder liability: Equitable subordination and piercing the corporate veil 6.  Since investors can hold diversified portfolios. MANDATORY DISCLOSURE  Insofar as debtor opportunism turns on misrepresentation. Diversification and Systematic Risk  Investments can be combined to reduce risk.  These opportunistic moves would lose much of their appeal if shareholders did not have the shield of limited liability.  Corporate law generally pursues three basic strategies in its limited efforts to protect creditors: 1. 6. CAPITAL REGULATION  Terminology:  . thus.3. risky investments should be priced to reflect the fact that investors need not bear all the risk associated with holding a single investment.

normal business activity can easily dissipate a company s capital. . or net profits in current or preceding fiscal year (whichever is greater). or assets would be less than liabilities plus the preferential claims of preferred shareholders (§ 6. by a debtor is fraudulent as to a creditor. .  These obligations are chiefly established by the Uniform Fraudulent Transfers Act §4: (a) A transfer made . STANDARD-BASED DUTIES 6.2. or defraud any creditor of the debtor.40(c): may not pay dividends if you can t pay debts as they come due (§ 6. whether the creditor s claim arose before or after the transfer was made . 6. Director Liability  Under certain circumstances. directors owe an obligation to creditors not to render the firm unable to meet its obligations to creditors by making distributions to shareholders (failure here can lead to personal liability for directors). in contrast to the income statement. . . . 6. . This is the amount of equity or the ownership stake that shareholders have in the business (the book value of the owners economic interests).  The balance sheet represents the financial picture of a business organization as it stands on one particular day.2.  RMBCA § 6.1.2. and retained earnings. .S.  The principal limitation of the entries on the balance sheet is that they typically reflect historical costs instead of current economic values. The capital maintenance rules accelerate the point at which failing corporations must file for insolvency. jurisdictions in the EU have traditionally adopted capital maintenance rules in conjunction with minimum capital rules. . goodwill.  For this reason. NYBCL § 516(a)(4) allows board to transfer out of stated capital into surplus if authorized by shareholders.  Shareholders equity represents the difference between the asset values and the liability values.3.  The income statement suffers limitations as well its account of profit or loss does not reflect the actual amount of cash that a business throws off in the year. delay. .1. . 6.Stated capital: a reserve for creditors and others who have claims against the firm that is generally not available for distribution.  Retained earnings: shareholder equity less stated capital and capital surplus.40(c)(2)).  Minimum capital requirements cannot be an effective creditor protection because the requirement is fixed at the date of organization of the corporation. statutory minimum capital requirements are either truly minimal or entirely nonexistent (neither the DCGL nor the RMBCA requires a minimum capital amount as a condition of incorporation). as long as ratio of assets to liabilities remains at least 1. . DGCL § 244(a)(4) allows board to transfer out of stated capital into surplus for no par stock. but board may meet the asset test using a fair valuation or other method that is reasonable in the circumstances (§ 6.3.  California Corporate Code § 500 ( modified retained earnings test ): may pay dividends either out of its retained earnings (§ 500(a)) or out of its assets (§500(b)(1)). and outstanding legal claims against third parties.40(d)).  Liabilities include all debts of the business payable to others. corporate law). which presents the results of the operation of the business over a specified period.. Distribution Constraints  New York Bus Corp.2. if the debtor made the transfer .  Capital surplus: the difference between the initial sale price of the stock and the par value of the stock. Credit Lyonnais Bank Nederlands (p. 141)  .25.  It is comprised of stated capital. and distributions cannot render the company insolvent.  Assets include all of a business s tangible property. Minimum Capital and Capital Maintenance Requirements  Within the U. Even if companies cannot dip into minimum capital to pay shareholders. or (ii) intended to incur. .  Regulation of the capital committed to the corporation is a very direct means by which the legal system can attempt to protect against some of the risks that creditors face (but it dose not provide a strong protection under U. . or (2) without receiving a reasonably equivalent value in exchange for the transfer.3. 6.S. intellectual property. Financial Statements  Accounting is a standardized method for describing a firm s past financial performance. Book value may differ quite a bit from the current economic value of an asset. Law § 510 (capital surplus test): may only pay distributions out of surplus (§510(b)). or reasonably should have believed that he [or she] would incur debts beyond his [or her] ability to pay as they came due. and capital assets capital liabilities (§500(b)(2)). (1) with actual intent to hinder.  Par value: amount of stated capital that corresponds to each share of stock outstanding. capital surplus. and the debtor: (i) was engaged or about to engage in a business transaction for which the remaining assets of the debtor were unreasonably small.40(c)(1)). .  DGCL § 170(a) ( nimble dividend test): may pay dividends out of capital surplus + retained earnings.

or have any loans they have made to the company subordinated to other creditors under the doctrines of equitable subordination and corporate veil piercing. if all formalities are observed and nothing funny with the accounts. hindering. Fazio (p.3. Gheewalla (p. believed .  The statue provides a means to void any transfer made for the purpose of delaying.  The requirements are that (1) the creditor be an equity holder and typically an officer of the company and (2) the insider-creditor must have. 145)  Facts: The partnership began to encounter difficulties. Two partners converted capital (nominally) into notes during corporation formation. . and (2) corporate wrongdoing that proximately causes creditor injury. Piercing the Corporate Veil  Veil piercing refers to the equitable power of the court to set aside the entity status of the corporation to hold its shareholders liable directly on contract or tort obligations. or defrauding creditors.3. 143)  Held: Creditors could not assert a direct claim but did have standing to assert a derivative claim against an insolvent corporation. alter ego of the individual.1. to recharacterize debt owed by the company to its controlling shareholders as equity. . . circumstances may arise when the right (both the efficient and the fair) course to follow for the corporation may diverge from the choice that the shareholders (or the creditors. They nevertheless retained control. weak rules exist because efficient and effective creditors contract around them and weak creditors don t lobby.  Tests go under various names: agency test. etc.g. 6.  Held: The notes held by former partners will be treated as the least senior debt. minority shareholders.  Reasoning: Recognizing that directors of an insolvent corporation owe direct fiduciary duties to creditors would create uncertainty for directors. Inc. delay. or defraud any creditor of the debtor.  Creditors may attack a transfer on two grounds:  Present or future creditors may void transfers made with the actual intent to hinder. unreasonably small in relation to its business or the debtor intended . shareholder must believe in the separation)  Unfair or inequitable conduct this is the wildcard in veil-piercing cases. 6. in some fashion.3. Creditor Protection: Fraudulent Transfers  Fraudulent conveyance law imposes an effective obligation on parties contracting with an insolvent or soon to be insolvent debtor to give fair value for the cash or benefits they receive.2.3.In managing the business affairs of a solvent corporation in the vicinity of insolvency. or risk being forced to return those benefits to the debtor s estate. or has been managed to the prejudice of creditors. good faith negotiations with individual creditors for the benefit of the corporation. . v. or any single group interested in the corporation) would make if given the opportunity to act. shareholder domination. or where to do otherwise would be unfair to creditors. or the employees. no formalities/comingling of assets ( Tinkerbell test to be protected.  Formulations of the doctrine:  Lowendahl test (NY): veil-piercing requires (1) complete shareholder domination of the corporation. behaved unfairly or wrongly toward the corporation and its outside creditors.  Most creditor rights that really matter are contractual ones.3. or reasonably should have believed he would incur debts beyond his ability to pay as they became due or the debtor is insolvent after the transfer. Directors of insolvent corporations must retain the freedom to engage in vigorous. North American Catholic Educational Programming Foundation.  Probably no piercing: against public corporation. instrumentality of the individual .  Fraudulent transfer doctrine permits creditors to void transfers by establishing that they were either actual or constructive frauds on creditors. against passive shareholders.3. e. The notes earned no interest and were recallable on demand. 6.  .  Equitable subordination is a means of protecting unaffiliated creditors by giving them rights to corporate assets superior to those of other creditors who happen to also be significant shareholders of the firm.  Creditors may void transfers made without receiving a reasonably equivalent value if the debtor is left with remaining assets .  Generally consist of two components:  Evidence of lack of separateness.. Shareholder Liability  Shareholders may either find themselves liable to corporate creditors. by considerations of equity. Equitable Subordination  Courts of equity invoke the equitable subordination doctrine when they feel compelled.3.  Reasoning: [C]laims of controlling shareholders will be deferred or subordinated to outside creditors where a corporation in bankruptcy has not been adequately or honestly capitalized. 6. Costello v. .2. . thin capitalization.

 Held: Court of Appeals dismisses the complaint with regard to Carlton for failure to state a claim. Carlton (p. the corporate form will lose its utility as a device for asset partitioning and risk allocation. Walkovszky wants Carlton held personally liable because the cars are heavily mortgaged and the insurance policies are car-specific. VEIL PIERCING ON BEHALF OF INVOLUNTARY CREDITORS Walkovszky v.  Countervailing considerations of ex post fairness run strong and deep in bankruptcy proceedings. there is still a potential third prong defendant might still prevail by showing assumption of risk. Polan (p. Sea-land Services. no assets.4.  Substantive Consolidation  Substantive consolidation is an equitable remedy in bankruptcy that consolidates assets among corporate subsidiaries for the benefit of creditors of the various corporate subsidiaries.  Held: Reverse grant of summary judgment by district court in favor of Sea-Land.  Reasoning: Marchese utterly failed to adhere to corporate formalities.  Dissolution and Successor Liability  . you should discuss possible corporate veil piercing openly. and (2) an inequitable result would occur if the acts were treated as those of the corporation alone. The Pepper Source (p.  Summary of Veil Piercing Cases: District Court Circuit Court Sea-Land Services Pierce Van Dorn test satisfied Don t Pierce Remanded for factual inquiry on second prong Kinney Shoe Don t Pierce Assumption of risk under Pierce Third prong not applicable third prong of Laya here 6. Walkovszky was struck by a cab owned by Seon Corp (driven by Marchese). Industrial (which has no assets) signs lease with Kinney. with leave to serve an amended complaint.  Reasoning:  Fundamental problem for involuntary creditors there is no lobby on their behalf. BUT: if both prongs satisfied.Van Dorn test (7th Circuit applied in Sea Land): (1) such unity of interest and ownership that the separate personalities of the corporation and the individual [or other corporation] no longer exist.  Held: The court rejects the district court s application of a third prong regarding whether Kinney assumed the risk of Industrial defaulting. 157)  Facts: Polan owns Industrial and Polan Industries.  The vagueness of promote injustice seems to reflect our ambivalence regarding limited liability itself. v.  If engaging with a large corporate creditor.  Why reverse pierce rather than take share ownership? Sea-Land wants to be on level footing with other corporate creditors and superior to Marchese s personal creditors (debt claim rather than equity claim). Kinney Shoe Corp. as well as several other corporations. Sea-Land seeks to pierce the veil of Pepper Source and reverse pierce other corporations dominated by Marchese. 161)  Facts: Each corporation has two cabs.  Laya test (applied in Kinney Shoe): (1) unity of interest and ownership such that the separate personalities of the corporation and the individual shareholder no longer exist. the court looks to whether failure to pierce would sanction a fraud or (lower standard) promote injustice. 152)  Facts: The Pepper Source contracted with Sea-Land to ship products and then failed to pay its freight bill. He ran them all out of the same office. then subleases to Polan Industrial. but this standard is more than simply a creditor s inability to collect. and seeks to hold Carlton (stockholder of ten of these cab corporations) personally liable. Marchese is the sole shareholder of PS. v. the corporate holding company structure is ignored for the purpose of distributing assets in bankruptcy. using the same expense accounts. and (2) circumstances must be such that adherence to the fiction of separate corporate existence would sanction a fraud or promote injustice.  Veil piercing unfairness usually is found when assets are shifted in ways that seem designed to defeat liability but may be less than fraud. Inc.  Reasoning: The court looks to whether (1) separate personalities of corporation and shareholder no longer exist and (2) an inequitable result would occur if the acts were treated as those of the corporation alone. and minimum insurance. sophisticated creditors will require personal guarantees of small business owners.  This can be problematic because if bankruptcy courts regularly collapse entities in an exercise of their equitable powers. borrowing from them and lending to them interest-free.

which facilitates getting in touch with the ultimate beneficial holder (unlike bearer system in France & Germany).  Many jurisdictions have the product line test if the buyer continues to manufacture the same line of products.Many small firms undertaking dangerous activities are not only thinly capitalized but also likely to dissolve and liquidate before the full extent of their potential tort liability becomes known. but it is unclear what constitutes good cause.07 establishes the same rule as Delaware. it may be more difficult to escape tort costs by selling the corporation s assets due to the doctrine of successor liability. 173)  Establishes that a director is entitled to certain due process rights when he or she is removed for cause. without regard to whether she invests in becoming informed and voting intelligently. NORMAL GOVERNANCE: THE VOTING SYSTEM 7.  Another mandatory feature of the voting system is the annual election of directors. (p. but a corporation s actual notice period.  RMBCA §14. cheaper costs of communication between institutions.  The power to sell their stock if they are disappointed with their company s performance.1. Removing Directors  At common law. and (3) shareholder resolutions.  Upon dissolution.  Although shareholders can escape all liability through the simple act of dissolving the corporation and abandoning its assets.1.  Liability will follow if assets continue to look and be arranged as they were when they were in the original organization. quorum requirement. we allow liability to follow the corporation.2. the less she suffers from this problem of rational apathy.2. sales of all assets.  . and  The right to sue their directors for breach of fiduciary duty in certain circumstance.  Thus. quorum requirements.  State law mandatory rules: all state statutes except one require an annual meeting for election of directors. the rule in Delaware is that shareholders remain liable pro rata on their liquidating dividend for three years (§§ 278 & 282). 7. Instead. corporate dissolutions. a shareholder is likely to get the same proportionate share of any benefit.  Proxy system: if you can t attend the annual shareholder meeting (ASM). Thus.  Growing institutional portfolios. 7. charter amendments).  Common stock carries voting rights because common shareholders have a greater need for the default protection of voting rights than other investors in the enterprise. Campbell v.  Basic Features of the Voting System:  Registered shares: each share has a holder of record. provided the corporate publishes notice of its dissolution. equity investors in public corporations rely largely on the default terms built into corporation law to control the agency costs of management. Loews Inc. 7. and the evolution of new agents of shareholder organization have created ownership and coordination structures that fall between the extreme cases where collective action costs are nonexistent (because the corporate has a controlling shareholder) or preclusive (because stockholding is highly diffuse).  The only way for shareholders to escape long-term liability through dissolution is to sacrifice the goingconcern value of the business and keep only the piecemeal liquidation value. (2) certain fundamental corporate transactions (mergers. ELECTING AND REMOVING DIRECTORS 7.  When assets have shifted to a new entity. the regulation of shareholder voting and proxy solicitation really does matter for the typical public corporation today. and record date will be established by the charter or in a bylaw. and any one shareholder s vote is quite unlikely to affect the outcome of the vote. though default varies.  State law default rules: all state statutes permit special meetings and action by written consent.2. it will be held liable. THE ROLE AND LIMITS OF SHAREHOLDER VOTING  Very few public companies restrict the board s managerial power in their charters. but the corporation remains intact.  The default powers of shareholders are:  The right to vote on (1) the designation of the board. shareholders could remove a directors only for cause. you can still vote by finding a representative (proxy) who goes to the meeting and votes on your behalf.  The greater a shareholder s stake is.2. Electing Directors  Every corporation must have a board of directors and every corporation must have at least one class of voting stock.  Collective action problem: any one shareholder s prospective share of the potential benefit that informed action might produce would probably not justify her personal costs. any sophisticated buyer will contract for tort indemnification or pay less if it purchases the business as a going concern.

 . however. it will take the TA 3 years to gain control of the board. if less than the entire board is to be removed. The invention of the poison pill made control of the board a prerequisite for acquiring a company s shares.  Cumulative Voting: B casts 303 shares all for one candidate => guaranteed to get one seat on the board. amend. and to adopt shareholder resolutions that may ratify board actions or request the board to take certain actions.  She should pack the board of directors and eliminate the staggered board. has a three-person board elected to annual terms. or directing that the amendment proposed be considered at the next annual meeting of the stockholders. 174): The CEO. but disadvantageous in that they distort capital and acquirors often overpay.  A shareholder may have ways to disassemble a staggered board by packing the board with new directors or remove directors without cause and replace them with new directors  The difference between unitary and staggered boards becomes most relevant in the context of a hostile takeover bid. The directors then amend the bylaws to provide that the number of directors shall be fixed at nine and divided into three equal classes. or (2) In the case of a corporation having cumulative voting. . declaring its advisability. the TA would be hamstringed.3.  The TA will be able to amend the bylaws under DGCL §109(a). no director may be removed without cause if the votes cast against such director s removal would be sufficient to elect such director if then cumulatively voted at an election of the entire board of directors . .  Cumulative voting is only a problem if she wants to retain some board members in the case of a corporation having cumulative voting. and repeal bylaws. . . shareholders always have power to amend the bylaws. any corporation may. .  By simply voting out directors. . . and either calling a special meeting of the stockholders entitled to vote .  Example: Family Corp. A owns 199 shares and B owns 101 shares.  Straight Voting: A would win each seat 199 to 101. In the interim.  Example (p. . The directors with the most votes get the seats. . . a 25% shareholder. if less than the entire board is to be removed. Family Corp. shareholders may effect such removal only for cause. .  DGCL §242(b)(1): (b) Every amendment [to the certificate of incorporation} shall be made and effected in the following manner: (1) If the corporation has capital stock.DGCL §141(k): Any director or the entire board of directors may be removed. except as follows: (1) Unless the certificate of incorporation otherwise provides. If she s willing to fire everyone. provided. . because A s 597 votes cannot be divided three ways so that all three are greater than 303. has the board recommend and shareholders approve an amendment to the articles of incorporation vesting the power to amend the bylaws solely in the board and to provide for cumulative voting.  Implication: Cumulative voting system improves likelihood of minority representation on the board. . . amend or repeal bylaws. . the power to adopt. in its certificate of incorporation. with or without cause. amend or repeal bylaws shall be in the stockholders entitled to vote .  The TA will not be able to simply fire board members without cause in Delaware. a staggered board makes board control more difficult. amend or repeal bylaws upon the directors .  DGCL §109(a): After a corporation has received any payment for any of its stock. The fact that such power has been so conferred upon the directors . by the holders of a majority of the shares . she can do so. 7.  Staggered Boards  A staggered makes it more difficult for a shareholder to gain control of the board of directors. .  Cumulative Voting: each shareholder gets votes equal to number of shares owned times number of seats to be filled. . its board of directors shall adopt a resolution setting forth the amendment proposed. nor limit their power to adopt.  Takeover: a shareholder attempts to gain voting control of the board so he can replace the board who will then appoint new management. . . a takeover artists accumulates 51% of the shares. Later.  DGCL §223(a): Unless otherwise provided in the certificate of incorporation or bylaws: (1) Vacancies and newly created directorships resulting from any increase in the authorized number of directors elected by all of the stockholders having the right to vote as a single class may be filled by a majority of the directors then in office .  Takeovers are advantageous because of high acquiror valuation and their usefulness in disciplining managers. no director may be removed without cause if the votes cast against such director s removal would be sufficient to elect such director if then cumulatively voted at an election of the entire board of directors. . has 300 shares outstanding. the TA risks enormous conflicts with management. in the case of a corporation whose board is classified . shall not divest the stockholders or members of the power. confer the power to adopt.  The TA will not be able to amend the articles of incorporation because she needs the board to propose the amendment. to remove directors.  If the classification requirement was put in the articles of incorporation. SHAREHOLDER MEETINGS AND ALTERNATIVES  Shareholders may vote to adopt.

part.6. a 3% shareholder (or shareholder group) can place nominees on the company s proxy statement.  Reimbursement rules can differ on at least three dimensions:  Amount: reimburse all. attempting to force both sides in proxy contest to reimburse corporation for their proxy expenses.  Conferring class votes gives each class a veto right.  Shareholder proxy access makes contested director elections more likely: Under an SEC rule adopted last August. the minority needs structural protection against exploitation by the majority. Insurgents generously reimburse incumbents for the additional $28K. Insurgents spent $127K.4. RMBCA § 7. even if the candidate doesn t get a majority  Majority voting: candidate must receive a majority of votes to be seated. To gather a quorum. On the other hand. such rights can themselves be used opportunistically. for which they reimbursed themselves after shareholder resolution authorizing reimbursement. we don t always reimburse incumbents because it might encourage frivolous suits. reimbursements to successful dissidents might be attacked as self-dealing. Under current law. so a candidate in an uncontested election can still lose  The moral authority is what matters most in a Just Say No campaign. 7.  . for which they reimbursed themselves from the corporate treasury. Incumbents spent $106K. or nothing?  Conditionality: do you need to win to be reimbursed?  Bias: favor incumbents. incumbents always get reimbursed for reasonable expenses attributable to issues of principle or policy and insurgents may be reimbursed if they get a shareholder resolution authorizing the reimbursement. such expenses are not reimbursed unless the insurgents are successful. RMBCA § 7.  This raises the question whether the law ought to encourage insurgent shareholders to solicit proxies by reimbursing their reasonable expenses as well. the board and its officers are permitted to collect voting authority from shareholders in the form of proxies.  When dissidents triumph. authorizing the board to expend corporate funds on its own re-election seems to permit a kind of self-dealing.  Reasoning: We always reimburse incumbents because we don t want them to be too timid. and another $28K for which they were never able to reimburse themselves.  New rule on broker voting gives activists more influence in director elections: July 2009 SEC rule prevents brokers from voting discretionary shares in uncontested director elections. insurgents.  Action by written consent: DGCL § 228 provides that any action that may be taken at a meeting of shareholders may also be taken through written consent of holders of the number of voting shares required to approve that action at a meeting attended by all shareholders.  On one hand. substantially reducing proxy solicitation costs. CLASS VOTING  To the extent the interests of classes of shareholders diverge. which gives more power to institutional investors. SHAREHOLDER INFORMATION RIGHTS  State corporate law in the United States leaves the function of informing shareholders largely to the market.  A transaction that is subject to class voting simply means that a majority (or such higher proportion as may be fixed) of the votes in every class that is entitled to a separate class vote must approve the transaction for its authorization.  While proxy voting allows public shareholders to meet. (Shareholders apparently never asked to ratify insurgent generosity to the old board.02 allows board or 10% of shareholders to call a special meeting. federal securities law and the rules promulgated by the SEC mandate extensive disclosure for publicly traded securities. but without shareholder ratification.  Developments in Proxy Solicitation in Delaware:  Plurality voting: candidate with the most votes wins. PROXY VOTING AND ITS COSTS  Shareholder meetings require a quorum to act. (p.)  Holding: Full reimbursement permissible. shareholders have decided that their expenses were made in a good-faith effort to advance a corporate interest. Proxy voting relies on one or more persons to incur the initial (and substantial) expenses of soliciting proxies. the costs of soliciting proxies are a matter of normal governance because subsidizing these costs from the corporate treasury is essential for the operation of annual shareholder meetings.5. 7.  Usually classes are used to separate cash flow rights from control. it does not remedy their collective action problem. this protection is offered by the class voting requirement. Fairchild Engine & Airplane Corp.Special Meetings: DGCL § 211(d) allows board to call a special meeting. By contrast. 179)  Facts: Classic derivative suit brought by attorney who owns 25 shares. 7. or neither?  Recent Developments:  New eProxy Rules (Rule 14a-16): Incumbents and insurgents can file proxy materials on a website.  Two ways to vote in elections in Delaware corporations: #### Rosenfeld v.04(a) requires unanimous written consent.

holds the remaining 9% of Health Med.  Approaches to shareholder access:  Delaware approach: for books & records. but was in the interest of shareholders and was ratified by the shareholders. and address of each registered owner of company stock.7. 186)  Facts: Health Chem has 4 shareholders public.02. Baker. and shareholder meeting minutes if proper purpose (§ 624(a)-(e)). stock list.  Circular ownership creates issues regarding deceptive or misleading structures and agency conflicts.7.  Specifically enumerated documents (RMBCA): shareholder list. Separation of shares from votes introduces a disproportion between expenditure and reward. The merger would result in negative tax consequences for JCC. shareholders were recognized to have a right to inspect the company s books and records for a proper purpose. Cross-ownership permits a controller to exercise complete control over a corporation with an  . vote buying was impermissible.1. managers are selected by the corporate constituency with the strongest interest in maximizing corporate value.  Holding: While this was vote-buying.  The most straightforward CMS form is a single firm that has issued two or more classes of stock with differential voting rights. Baker (p. ownership interest. Health Med is controlled by Speiser and Baker. 7.  Modern rule: You can use dual-class structures if. by the corporation.2. even though it doesn t legally hold a majority of voting rights or functionally control Health Med.  The stock list discloses the identity. 7. votes and share ownership must go hand-in-hand.  Nevertheless. holds a controlling stake in an operating company. Vote Buying  At common law. and catch-all under § 624(f) for books & records. buying shares at Y price and committing to sell them at a later date at Y price. and only if. it is not void because the purpose of the vote-buying was not fraud or disenfranchisement.7.  The most popular structure for erecting CMS structures worldwide is the corporate pyramid structure.  Attaching the vote firmly to the residual equity interest ensures that an unnecessary agency cost will not come into being. 193)  Facts: Jet Capital Corp. 7. if a majority of the shares entitled to vote in the election of directors of such other corporation is held. the structure is introduced at the IPO. had effective veto power of Texas International.  Cross-holding structures differ from pyramids chiefly in that the voting rights used to control the corporate group are distributed over the entire group rather than concentrated in the hands of a single company or shareholder.7. the law s policy of aligning control with residual returns is sometimes frustrated. in turn. TECHNIQUES FOR SEPARATING CONTROL FROM CASH FLOW RIGHTS  It is ordinarily good policy to award voting rights to the investors who claim the corporation s residual returns. Carney (p. and accounting records if shareholder shows proper purpose (RMBCA § 16. In this way. JCC demands a loan to enable it to exercise warrants (which are similar to stock options) in exchange for not vetoing the merger. but its stock can be converted to hold 95% of the vote.At common law. 7. which can lead to inefficiencies and improper incentives. Independent directors and counsel for Texas International determine that the loan makes sense and Texas International s shareholders voted to ratify the loan decision. through Medallion. shareholder meeting minutes. stock pyramids. Speiser v. Health Chem. Speiser. The controlling minority structure (CMS) form can be used in principle to separate cash flow rights from control rights. in which a controlling minority shareholder holds a controlling stake in an operating company that.  An inspection of books and record may jeopardize proprietary or competitively sensitive information.01(e))  Hybrid approach (New York): statutory right to inspect key financial statements. directly or indirectly  Shares of its own capital stock belonging to the corporation or to another corporation.  Holding: Health Chem does not have a majority of shares entitled to vote. Controlling Minority Structures  Dual class share structures. Schreiber v. and cross-ownership ties permit a shareholder to control a firm while holding only a fraction of its equity. for shareholder list.  This can be hugely problematic p competitors or those who have insurance on the company s debt (fire insurance) have incentive to destroy the company and can lead the company to ruin through empty voting.  Each of the three basic controlling minority structure forms firmly entrench minority control. shall neither be entitled to vote nor be counted for quorum purposes. directly or indirectly. § 16. excerpts from board minutes. but has no financial stake in the share  Examples: Buying X # of shares and shorting X # of shares. at least under these circumstances. Circular Control Structures  DGCL §160(c): a corporation may not vote its own shares. but a majority of voting shares do belong to Health Chem. burden is on shareholder to show proper purpose. which would like to merge with Texas Air. and Health Med.  Empty voting: when someone holds voting rights.3. burden is on corporation to show improper purpose (DGCL § 220(c)).

Short of aggregating. the managers serve this function. current proxy rules are not ideal because professional investors don t need information dumbed down and smaller investors won t use the information they are given. and making sure that merger and control transactions make sense for shareholders. This generates the possibility that hedge funds will help overcome the classic agency problem of publicly held corporations by dislodging underperforming managers. financial intermediaries could monitor the actions of corporate managers. pension trusts.  Take-home: Money managers get paid a portion of assets under management. the portion is not large enough to incentivize activism. Nonetheless. no shareholder.  Take-home: We don t have large shareholders because we have constructed barriers to large shareholding. The fee structure gives hedge fund managers a very significant stake in the financial success of the fund s investments.  Easterbrook & Fischel. on the whole. The fees do not cover heavy intervention on the part of the money manger.  In a different legal environment. outside venture capital funds. the percentage stakes held by the largest institutions would likely grow. Institutional Investors: The Reluctant Activists:  For most institutions. so hedge funds benefit directly and substantially from achieving high absolute returns.  Take-home: The solution to the collective action problem is to allow larger investors. challenging ineffective strategies. has the right incentives at the margin unless that stake is 100 percent.  Kahan & Rock.  When many are entitled to vote.  Twenty years ago. the approach to shareholder activism is straightforward: to decide whether and when to become active. one-vote rule cannot protect shareholders who habitually approve management proposals. dumbed down or not. but legal rules keep financial institutions smaller than they would otherwise be. such as investment companies.  Black. some sort of collective information-generating agency is necessary.  Most fees for money managers are set on the assumption that institutional investors will usually function as passive money managers rather than as activists. it is unlikely that voters would think themselves able to decide issues for themselves with greater insight than the managers do.arbitrarily small claim on its cash flow rights.  Morley is skeptical:  Mutual funds have never been active  We have these restrictions because there were very serious conflicts of interest  We don t want Wall Street controlling America  Banks need very low-risk investments  Pozen. While. No wonder voters delegate extensively to managers and almost always endorse their decisions.  Take-home: Is this good? Conflict of interest and empty voting are concerns. because the U. If legal restrictions were loosened. the participants in the venture will arrange to conserve on its use.  Neither pyramids nor cross-ownership are popular in the U. none of the voters expects his votes to decide the contest. no matter how large his stake.  Shareholder passivity aggravates agency problems between shareholder and managers.  We expect voting to serve its principal role in permitting those who have aggregated equity claims to exercise control. however. In contrast. and some insiders. . they have hardly proven to be a silver bullet. Hedge Funds in Corporate Governance and Corporate Control:  Hedge funds are emerging as the most dynamic and most prominent shareholder activists. and monitoring incentives would be correspondingly stronger.8. based on the assumption that venture fund managers will be actively involved with most of their portfolio companies.  Those who have more shares.  Rules that encourage shareholder oversight of corporate managers are few and weak. Cross-holdings have the advantage of making the locus of control over a company group less transparent.S.S.  The incentives for hedge funds to monitor portfolio companies differ in several important respects from those of traditional institutional investors. similar stories were told about institutional investors mutual funds. the rise of these traditional institutional investors has probably been beneficial. pension funds. Next Steps in Proxy Reform:  A shareholder who owns a large percentage stake in a company will do more monitoring than a shareholder who owns a small stake. In a firm. advisory fees for a venture capital fund are typically much higher. and insurance companies. and this has negative consequences for shareholder monitoring. and consequently. Voting in Corporate Law:  Because voting is expensive. THE COLLECTIVE ACTION PROBLEM  Even a one-share. rather than returns relative to a benchmark. imposes a significant tax penalty on moving corporate distributions through two or more levels of corporate structure. an institutional investor compares the expected costs of a course of action with the expected benefits. 7.  Hedge fund managers are highly incentivized to maximize the returns to fund investors.  Many hedge funds strive to achieve high absolute returns. Consequently none of the voters has the appropriate incentive at the margin to study the firm s affairs and vote intelligently. do not face the collective action problem to the same extent.

 Whether the proxy rules or other legal barriers impede collective action by shareholders depend not only on the rules themselves but the identify of the shareholders.1.  Less than 10 persons are solicited.  14a-12: Allows solicitations prior to the furnishing of a proxy statement if the solicitor later provides a full proxy statement to each person solicited. Disclosure requirements and a mandatory vetting regime that permit the SEC to assure the disclosure of relevant information and to protect shareholders from misleading communications. but it served a political need.  In order to be eligible to submit a proposal. and 4.9.  If the solicitor is the company itself (i.  14a-3: Contains the central requirements about the kinds of information that must be furnished to shareholders by anyone soliciting a proxy. incredibly complicated.  Newspaper ads which do no more than state the issue and describe how a full proxy statement may be obtained. Rules 14a-1 Through 14a-7: Disclosure and Shareholder Communication  14a-1: Defines solicitation and other key terms.  Securities laws online: http://taft. a shareholder must have held at least $2. more regulation makes it less likely that people will solicit proxies because of the associated expense.000 in market value or 1% of a corporation s securities for one year. However. large. and other activist shareholders are not. Says companies must register with the SEC.7. subject to elaborate restrictions that allow a board to exclude proposals. Substantive regulation of the process of soliciting proxies from shareholders. 2.  Attempts to form a group for purposes of a majority election proposal under the new 14a-11. Companies may exclude the proposals on the following grounds: 1) The proposal is not a proper subject for action by shareholders under state law 2) The proposal would cause the company to violate any law 3) The proposal violates the proxy rules 4) The proposal relates to a personal grievance or other interest not shared by the shareholders at large 5) The proposal relates to operations which account for less than 5% of the company s total assets and gross sales 6) The company lacks the power or authority to implement the proposal . THE FEDERAL PROXY RULES  The federal proxy rules consist of four major elements: 1.html 7.  Sarbanes-Oxley is a disaster.9.  The goal of proxy rules is to provide clear information so shareholders can make informed decision. hedge funds.2. All public companies are subject to proxy regulation under § 14(a) of the 34 Act.9.  Solicitation includes any request for a proxy (this has been very broadly interpreted by the SEC).  The rules are mandatory. it s more difficult for corporations to vote with their feet. Because there is no competition (unlike with state laws).law.  Securities Exchange Act of 1934 ( 34 Act ): establishes (among other things) disclosure requirements for corporations after they have sold securities on the public markets for the first time. passive institutions might well be deterred by the prospect of a lawsuit when scrappy value investors. The following are wholly or partially exempted:  Solicitations in which the solicitor does not seek proxy authority. 3.  Securities Act of 1933 ( 33 Act ): deals with disclosure procedures that companies must follow when they sell securities on the public markets for the first time..  Solicitation does not include statements by a shareholder that simply indicate how the shareholder will vote. purposes and other matters.  14a-13 to 14a-18: Various technical requirements 7.edu/CCL/xyz/sldtoc. A general antifraud provision (Rule 14a-9) that allows courts to imply a private shareholder remedy for false or misleading proxy materials.  Regulation 14A (Rules 14a-1 through 14a-12): substantive regulation of the process of soliciting proxies and communication among shareholders. and detailed.e. securities holdings. the registrant )  Recent balance sheets and income statements  Description of the registrant s business  Names and biographical information about members of the board of directors  14a-4 to 14a-7: Technical requirements for drafting and mailing of proxy statements. Shareholders may only submit one proposal per annual meeting and it may not exceed 500 words. Rule 14a-8: Shareholder Proposals  14a-8: Authorizes shareholders to place their own proposals on a registrant s proxy.  Lobbying is also a problem p managers are far better organized than shareholders.  14a-2: Defines which solicitations trigger the proxy rules. A specialized town meeting provision (Rule 14a-8) that permits shareholders to gain access to the corporation s proxy materials and to thus gain a low-cost way to promote certain kinds of shareholder resolutions.uc. including:  A proxy statement conforming to Schedule 14A and disclosing information about the solicitor s identity.

 Most Rule 14a-8 shareholder proposals fall into one of two categories: corporate governance or corporate social responsibility. which is how it must act no CEO action here) by adopting a new policy requiring a director who was elected with less than a majority of the vote to tender his resignation to the board. officers. HP seeks a no-action letter from the SEC authorizing HP to exclude the Carpenters proposal from the proxy. whichever is greater. which are often brought by labor unions or institutional investors. .  These proposals. 8) The nominating shareholder or group is not holding any of the registrant s securities with the purpose or effect of changing control of the registrant (d) Registrants only have to include a total of one nominee or a number of nominees equal to 25% of the board. not inconsistent with law or with the certificate of incorporation. the conduct of its affairs. 7) The nominating shareholder or group files a statement regarding their intent with respect to continued ownership of the registrant s securities after the election. except as may be otherwise provided in this chapter or in its certificate of incorporation. the company does not have to include any nominees in the present election. relating to the business of the corporation. If one director or 25% of the board has already been elected under this rule and has terms that will extend past the upcoming election.  An important governance question today is the extent of the shareholders ability to enact bylaws that limit the range of options open to the board in managing the firm.  The SEC will not mandate access to the company s proxy statement if the matter on which shareholder action is sought is not a proper subject of shareholder action under state law. 220)  Facts: CA submits a 14a-8 proposal to amend the bylaws to reimburse shareholder for reasonable expenses incurred in the successful election of its candidates to less than 50% of the board. the Carpenters Union Pension Fund asks HP to include in its proxy statement for its upcoming annual meeting a proposal to require nominees for the board of directors to receive a majority of the vote cast in order to be elected or re-elected to the board.  DGCL §141(a): The business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors. CA v. this is at best a costly annoyance and at worst an infringement on management s autonomy.  Held: The SEC denied HP s request for a no-action letter  Reasoning: What the Carpenters proposed and what HP adopted were fundamentally different things.  Issues: (1) Is the AFSCME proposal a proper subject for action by shareholders under Delaware law? (2) Would the proposal.7) The proposal deals with a matter relating to the company s ordinary business operations 8) The proposal seeks to oppose or nominate individual candidates for a particular director election or otherwise to influence the outcome of a particular director election 9) The proposal conflicts with the company s own proposals 10) The proposal has already been substantially implemented by the company 13) The proposal relates to a specific amount of a dividend  From the perspective of a shareholder. Carpenters Pension Fund Proposal and Supporting Statement (p. On November 2. cause CA to violate any Delaware law?  Held: (1) Yes (2) Yes its fiduciary duty  DGCL §109(b): The bylaws may contain any provision.  Rule 14a-11. CA seeks a no-action letter from the SEC to exclude the proposal. 2005. 214)  Facts: On October 7. AFSCME (p.  Corporate Social Responsibility Proposals (p. The Shareholder Proxy Access Rule  14a-11: Allows shareholders to include director nominees on the registrant s proxy statement.  (b) A shareholder nominee shall be included in a registrant s proxy statement if the following conditions are satisfied: 1) The nominating shareholder individually or with a group of other shareholders holds at least 3% of the total voting power of the corporation. 2005.  Corporate governance matters address issues ranging from executive compensation to internal corporate governance proposals such as the separation of the chairman and CEO roles to external corporate governance proposals such as dismantling poison pill or staggered board takeover defenses. 2) The nominating shareholder or group has held 3% for at least three years and will hold 3% through the date of the election. 225)  Under Rule 14-8a. from the perspective of corporate management. directors. and its right or powers of its stockholders. this has the advantage of low costs. companies may exclude shareholders proposals that deal with matters relating to a company s ordinary business operations. or employees. if adopted. HP counters (through its board. are now common and frequently win significant shareholder votes.

Public shareholders get $42 per share cash. opines.3.  This means that most proposals that survive 14a-8(7) are going to touch on significant policy issues. STATE DISCLOSURE LAW: FIDUCIARY DUTY OF CANDOR  State law has traditionally done little to regulate proxy solicitation by management. 4th Circuit affirms. . not with disclosures to the market (which is the subject of the federal securities laws).9. the court held the plaintiff couldn t show damages. because the corporation wasn t required to solicit proxies and had sufficient votes without the minority shareholders.  Court s response: (1) too speculative (2) state claim does not necessarily appear to be barred. causation is presumed if a misrepresentation is material and the proxy solicitation was an essential link in the accomplishment of the transaction. shall be made by means of any proxy statement . relied upon. VBI solicited proxies from shareholders. . Inc. However. jury awards $18 more per share. the SEC agreed that Cracker Barrel could omit a proposal to prohibit employment discrimination on the basis of sexual orientation. which allegedly caused the complete ruin of the company. appears to be trying to substitute some federal standard of fairness. which is false or misleading or omits any material fact necessary in order to make the statements therein not false or misleading . almost none will minutely define requirements). if there is information that shows that what the director reasons.10. Rule 14a-9: The Antifraud Rule  14a-9: Gives shareholders the right to sue a person soliciting a proxy for false or misleading statements. A plaintiff could always charge the common law tort of fraud if she could prove all of its difficult elements a knowingly false statement of a material fact. or monetary damages.  Private suits by investors alleging injury as a result of a violation of the federal securities laws have emerged as an important device for enforcing these laws. their votes are so small they have no hope of preventing the merger). on recommendation of outside banker. there have been two major themes in this area: (1) the gradual disappearance of substantive regulation and (2) the growing importance of fiduciary duties. v Sandberg (p. . with the effect of causing injury. . the Sixth Circuit has required proof of intentionality or extreme recklessness. the SEC reversed its holding in Cracker Barrel and its bright line rule against employment-related proposals and moved to a case-by-case analysis.  In 1997.  Malone v. rescission. the most powerful lobbyists are managers. The solicitation included statements that the board believes $42 is high and fair price.  Causation and Reliance: a plaintiff need not prove actual reliance on a misrepresentation. 237)  Facts: The directors made false filing with the SEC and distributed false financial statements to shareholders. 7. but they must not attempt to micromanage the corporation (but because the proposals are limited to 500 words.  The plaintiff argues that (1) the majority shareholders might not have been willing to vote for an openly unfair plan.  .  Remedies: Courts might award injunctive relief. States are accountable through competition with other states in a way that the SEC is not. 230)  Facts: Freeze-out merger of Bank into VBI (the buying company gained a majority of shares and minority shareholders were forced to accept cash for their shares.  Culpability: Second & Third Circuits (Delaware) have adopted a negligence standards. . or believes is false (and the director knows or suspects this).  Justice Kennedy.  In the twentieth century. Virginia Bankshares.  The state law was concerned with the governance of the corporation. . Even though it didn t need to under Virginia law.  Lessons learned: Don t make evaluative statements ( high or fair) and don t solicit unneeded proxies. . 7.  Until recently. Brincat (p.  Generally speaking.  No solicitation subject to this regulation . containing any statement . In corporate matters. The elements include:  Materiality: a misrepresentation or omission can trigger liability only if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote. even if it advantaged them and (2) the misleading statement may have barred them from a state remedy. Delaware now imposes a fiduciary duty when directors communicate with shareholders even if proxy solicitations are not allowed. Dissenting shareholder brings suit claiming violation of 14a-9. . in dissent. . it s better to give minority shareholders no information rather than potentially misleading information. most of the Delaware cases minimized potential conflict between state corporate law and the massive body of federal regulatory and judicial law governing corporate disclosure by crafting the state law duty of candor to look like the federal law and by limiting the fiduciary duty of candor to circumstances in which a corporation asked shareholders to take action of some sort.  The federal courts have implied private rights of action under the securities acts. federal law (SEC) is influenced by lobbyists.In 1991. opinions or belief may be material.  However.  Held: Statements of reasons.

The sine qua non of director s fiduciary duty is honesty. but only a fraction of the upside benefits. officer. The only limits are that the losses must result from actions undertaken on behalf of the corporation in good faith and that they cannot arise from a criminal conviction. granted pursuant to the other subsections of this section shall not be deemed exclusive of any other rights to which those seeking indemnification . to exercise care.  Corporate directors and officers invest other people s money. . director or officer . . Waltuch v. primarily because the law insulates officers and directors from liability based on negligence in order to avoid inducing risk-averse management. . vote of stockholders or disinterested directors. because investors can diversify away idiosyncratic risk. (2) in a manner that he or she reasonably believes to be in the best interests of the corporation. it does not automatically void the decision or warrant damages.1. against expenses (including attorneys fees). employee. . but stated a view of the merits that permitted the plaintiffs to replead. Generally. pending or completed suit.  Statutory law authorizes corporations to indemnify the expenses incurred by officers or directors who are sued by reason of their corporate activities. and loyalty . Indemnification  Most corporate statutes prescribe mandatory indemnification rights for directors and officers.Holding: The Delaware Supreme Court affirmed dismissal of the complain in deference to SEC. . proof of failure to satisfy the duty of care merely removes the presumption against liability. criminal. . THE DUTY OF CARE AND THE NEED TO MITIGATE DIRECTOR RISK AVERSION  ALI §4. . and.  The statutory law also authorizes corporations to purchase liability insurance for their directors and officers. or director for reasonable expenses for losses of any sort arising from any actual or threatened judicial proceeding or investigation. but little or no downside risk. fines and amounts paid in settlement actually and reasonably incurred by the person . Inc. there can be no liability for corporate loss. (p. bankers have upside incentives. 8. . . They bear the full costs of any personal liability. administrative or investigative. Inc. and (3) with the care that an ordinarily prudent person would reasonably be expected to exercise in a like position and under similar circumstances. officer. the Delaware court stated they would not be protected by SEC Rule 10b-5. . judgments.  The law protects corporate officers and directors from liability for breach of the duty of care in many ways. . . . INTRODUCTION TO THE DUTY OF CARE  The duty of care reaches every aspect of an officer s or director s conduct. since it requires these parties to act with the care of an ordinarily prudent person in the same or similar circumstances  Despite its sweeping scope. unless the facts are such that no reasonable person could possibly authorize such a transaction if he or she were attempting in good faith to meet their duty. Although the business judgment rule eliminated the downside risk of liability. 8. has been successful on the merits or otherwise . NORMAL GOVERNANCE: THE DUTY OF CARE 8.3. with respect to any criminal action or proceeding. employee or agent of the corporation . these statutes authorize corporations to commit to reimburse any agent. The Delaware Supreme Court stated: Whenever directors communicate publicly or directly with shareholders about the corporation s affairs. Liability under a negligence standard therefore would predictably discourage officers and directors from undertaking valuable but risky projects. . Without the business judgment rule. 241)  Held: The business judgment rule in effect provides that where a director is independent and disinterested.  DGCL §145: (a) A corporation shall have power to indemnify any person who was a party to any threatened. .  Reasoning: Since these shareholders did not sell their shares. (c) To the extent that a . whether civil. Conticommodity Services.3. . agreement. if the person acted in good faith and in a manner the person reasonably believed to be in or not opposed to the best interests of the corporation.  Reasoning: We don t want managers to be overly risk adverse. managers bear other downside risks. 8. but they receive only a small fraction of the gains from a risky decision. good faith. . . the manager would bear all the downside risks of loss. 243)  . . . Trifoods International. STATUTORY TECHNIQUES FOR LIMITING DIRECTORS AND OFFICER RISK EXPOSURE 8. Gagliardi v. may be entitled under any bylaw. had not reasonable cause to believe the person s conduct was unlawful. (p.2. by reason of the fact that the person was a director. (f) The indemnification . . the duty of care is litigated much less than the duty of loyalty. such person shall be indemnified against expenses . with or without request for shareholder actions directors have a fiduciary duty .  The business judgment rule is a common law rule and creates a presumption that the duty of care has been satisfied.  One problem with our banking system is that liability is flipped.01(a): A director or officer has a duty to the corporation to perform the director s or officer s functions: (1) in good faith.1. like being removed from office. .

claiming waste of corporate assets because Amex could sell the DLJ shares and use the capital loss to offset capital gains. with the following limitations:  The corporation may only indemnify expenses and attorneys fees and not an actual judgment or amounts paid in settlement. stating that every board decision can affect the financial statements and holding for plaintiffs here would mean all board decisions are conflicted if salary is based on earnings.0 million.  Reasoning: While there is an element of self-interest (declaring a special dividend makes the company look better and gives directors a better salary.  Directors who risk liability for making unreasonable decisions or even for failing to become reasonably informed or engaging in appropriate deliberation before acting are likely to behave in a risk-averse manner that harms shareholders. or inexplicable as not to be an exercise of good-faith judgment.  Reasoning: Waltuch was successful on the merits or otherwise when the suit was dismissed without Waltuch having paid a settlement.  Holding: Summary judgment in favor of defendant. (p.  Even expenses and attorneys fees can t be reimbursed unless a court determines that the defendant is fairly and reasonably entitled to indemnity despite the adjudication of liability.  . unconsidered. he becomes the target of lawsuits by angry silver speculators and an enforcement proceeding brought by the Commodity Futures Trading Commission (CFTC). American Express Co.2 million. Waltuch brings suits against Conti for indemnification of his $2. Defendant directors claim that this possibility was considered but rejected due to negative impact on accounting profits.  DGCL §145(b): If the plaintiff brings an action as a derivative suit on behalf of the corporation. JUDICIAL PROTECTION: THE BUSINESS JUDGMENT RULE  The business judgment rule means that courts will not decide whether the decisions of corporate boards are either substantively reasonable by the reasonable prudent person test or sufficiently well informed by the same test.  Thus. 8.0 million shares of DLJ common stock for $29.2.4. (2) is informed with respect to the subject of the business judgment to the extent that the director or officer reasonably believes is appropriate under the circumstances.3. In the private actions. rather than on the plaintiff s own behalf. under Conti s charter and under §145(c). place the financial muscle of an insurance company behind the company s pledge to make whole those directors who suffer losses as a result of their good faith decisions.  Disinterested directors who act deliberately and in good faith should never be liable for a resulting loss. 250)  Facts: In 1972 Amex acquired 2. Two shareholders file suit to enjoin the distribution. or for monetary damages. but incurs $1. Waltuch is dismissed with no settlement contribution. corporate law announces a legal duty to behave as a reasonable director would behave but applies a rule that no good-faith decision gives rise to liability as long as no financial conflict of interest is involved. move for summary judgment.9 million. which allegedly would have resulted in a net tax savings of $8 million.Facts: Waltuch is Vice President and Chief Metals Trader for Conticommodity Services ( Conti ). Understanding the Business Judgment Rule  A decision constitutions a valid business judgment (and gives rise to no liability for ensuing loss) when it (1) is made by financially disinterested directors or officers (2) who have become duly informed before exercising judgment and (3) who exercise judgment in a good-faith effort to advance corporate interests. Conti settles for >$35 million.01(c): A director or officer who makes a business judgment in good faith fulfills the duty under this section if the director or officer: (1) is not interested in the subject of the business judgment. no matter how stupid their decisions may seem ex post. In the CFTC action. and names an officer. When silver prices crash.  The business judgment rule also allows courts to convert the question Was the standard of care breached? into the related. 8.  ALI §4.2 million in unreimbursed legal fees. by 1976 the stake was worth approximately $4.  The business judgment rule allows courts to convert what would otherwise be a question of fact whether the financially disinterested directors who authorized this money-losing transaction exercised the same care as would a reasonable person in similar circumstances into a question of law.  Holding: Waltuch is entitled to indemnification under §145(c) for his expenses pertaining to private lawsuits. 8. the court rejects this argument. and (3) rationally believes that the business judgment is in the best interests of the corporation. and spends another $1 million in unreimbursed legal fees. for fraud and market manipulation. but different questions of whether the directors were truly disinterested and independent and whether their actions were not so extreme. Directors and Officers Insurance  Group policies. Amex declares a special dividend to all shareholders distributing the DLJ shares in kind. employee or agent. while selling at a loss is a better choice as a practical matter).4. Kamin v. director. Waltuch agrees to a penalty that includes a $100. financed by the corporation. then the corporation may indemnify.000 fine and a six-month ban on buying or selling futures contracts from any exchange floor.1.

. 2. For acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law 4. The court took issue with the process of the directors decision. and 52% owner of May s common stock.  [W]hen entire fairness is the applicable standard of judicial review. . . However. .  . Emerald Partners v. Emerald Partners. No allegation of conflict of interest. provided that such provision shall not eliminate or limit the liability of a director: 1. which May had waived under §102(b)(7). finding that the directors had been grossly negligent.  Holding: The Chancery Court noted lapses of care. Hall proposes a roll-up transaction in which May would acquire thirteen corporations controlled by Hall. The Delaware Supreme Court reversed.3. not only on their risk of personal liability. Acting mainly on his own. For any transaction from which the director derived an improper personal benefit. because shareholders received a premium on their stock. Trans Union shareholder sues. Cede & Co. gross negligence doesn t necessarily mean that the substance was unfair there may be gross negligence in a transaction that is completely fair. Van Gorkom and before Delaware adopted § 102(b)(7). holding that the business judgment rule does not apply in cases of gross negligence. The directors duty of care still can be the basis for an equitable order.  Take-home: When there is a defect in process.5.  Holding: Chancery Court dismisses the complaint against the remaining directors without conducting an entire fairness analysis because all that is left are duty of care claims.2. is a publicly held company with unused NOL s (net operating losses) and a CEO (Jerome Van Gorkom) looking to retire. On remand. the business judgment rule may not apply and directors must show fairness. CEO. 8. For any breach of the director s duty of loyalty. . most board members will decide how to act based on several considerations. and deal protection features. v. . The Duty of Care in Takeover Cases: A Note on Smith v. 3-2. brings suit alleging that the transactions were unfair to May. Gross negligence with respect to process is sufficient to put burden on directors to show entire fairness. Additional Statutory Protection: Authorization for Charter Provisions Waiving Liability for Due Care Violations  The Delaware legislature responded to Smith v. Hall later declares bankruptcy and is out of the picture. Supreme Court reverses. injury or damages becomes a proper focus only after a transaction is determined not to be entirely fair [citing Cede II] . Disinterested board is incredibly casual (à la Van Gorkom) in approving the transaction: gets no credible valuation.4. not the substance of it. etc.Why? There is social value to announcing a standard that is not enforced with a liability rule. 255)  Facts: Trans Union Corp. Dissenting shareholders bring suit against the Technicolor directors claiming breach of the duty of care. but claim that the board did not act in an informed manner in agreeing to the deal. claiming breach of the duty of care. . Van Gorkom (p. . DELAWARE S UNIQUE APPROACH TO ADJUDICATING DUE CARE CLAIMS AGAINST CORPORATE DIRECTORS FROM TECHNICOLOR TO EMERALD PARTNERS  Section 102(b)(7) waivers are directed to damage claims. but found no evidence that the board s action caused injury. Van Gorkom arranges a sale to Jay Pritzker s company for $55 per share cash. Van Gorkom by passing DGCL §102(b)(7): The certificate of incorporation may contain . A provision eliminating or limiting the personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty . Berlin (p. finding that board approval fell within protection of the business judgment rule. Van Gorkom Smith v. 259)  Facts: Technicolor CEO Kamerman negotiates with takeover artist Perelman to sell Technicolor to Perelman for $23 per share. . 8. Stock is selling for $35 per share. 8. . such as an injunction. §102(b)(7) only becomes a proper focus of judicial scrutiny after the directors potential personal liability for the payment of monetary damages has been established. the transaction was successfully defend as fair. Delaware Supreme Court reverses. board approves the merger.  Reasoning: Duty of care does not require plaintiff to show injury.  This was a major outlier in duty of care jurisprudence. company is not shopped to other potential buyers. a minority shareholder in May. Technicolor (p. 260)  Facts: Hall is Chairman.  Reasoning: The decision hinged on the fact that the directors didn t adequately inform themselves.4.  Holding: Chancery Court approves the transaction. representing a 100% premium over pre-bid share price. after two hour meeting. despite breach of duty of care. Transaction is negotiated and approved by May s independent directors. Van Gorkom calls a special meeting of the board but does not give them an agenda beforehand.  This took place before Smith v.

vitally affect the welfare of the corporation. no liability.  Holding: The directors are not liable.  Directors incentives are far less likely to be distorted by liability imposed for passive violations of the standard of care than for liability imposed for erroneous decisions.  . continue the practice of shareholder loans. and two sons Charles Jr. In late 1950s. after he dies.  The failure of appropriate controls can result in extraordinary losses following monitoring failures. and its succession planning. decentralized public corporation that makes electrical equipment. Shareholder brings derivative suit against directors and top officers to recover on behalf of the corporation for the violations of law in the late 1950s. damages awarded. 272)  Facts: Chancellor Corp. and finally whether damages have been waived. trustees in bankruptcy bring suit against Mrs. If it was a breach of duty of loyalty. primary insurer takes the first $X in liability. its management compensation. and then the reinsurer takes the rest. (3) If it was a breach of duty of care and the company has a §102(b)(7) waiver. the integrity of its financial reporting. Pritchard. so it is not surprising that actual liability is more likely to arise from a failure to supervise or detect fraud than from an erroneous business decision.  The board authorizes only the most significant corporate acts or transactions. Allis-Chalmers and four mid-level managers plead guilty to price-fixing charges. starts the practice of co-mingling accounts and making shareholder loans which he pays back. Reinsurance brokers like P&B move premium payments and loss payments from primary insurers to reinsurers and back. (p. Marchese certifies 1998 10-KSB. boards of public companies have a particular obligation to monitor their firm s financial performance.  Holding: Mrs.  Holding: Marchese agreed to undisclosed settlement for recklessly ignor[ing] signs pointing to improper accounting treatment. and William. United Jersey Bank (p.. so the theory is the directors breached their duty of care by failing to institute a system of watchfulness to prevent those violations. but don t pay the money back. It is clear that the defendant directors had no knowledge of anti-trust violations. she breached that duty and caused plaintiffs to sustain damages for which her estate must be held liable. 8. Graham v. it entered into a consent degree with the FTC to stop fixing prices on condensers and turbine generators.6. Mrs. Pritchard (and eventually her estate) for negligence in the conduct of her duties as a director of the corporation. its compliance with the law.  Reasoning: The directors were not grossly inattentive to their duty to actively supervise and manage the corporate affairs. 262):  Facts: Pritchard & Baird is a closely-held reinsurance firms with four directors: Charles Pritchard Sr. Firm goes bankrupt. and William run the business. or ignore either willfully or through inattention obvious danger signs of employee wrongdoing. (founder). however. acquired MRB in 1999 but CEO and other officers forged documents showing the transaction taking place in August 1998 in order to consolidate MRB earnings a year earlier. Allis-Chalmers Manufacturing Co. directors are entitled to rely on the honesty and integrity of their subordinates until something occurs to put them on suspicion that something is wrong. Primary insurer writes the policy to the insured.  In general.  In Re Caremark (below) puts in place a duty to implement a compliance system even before misconduct is suspected In re Michael Marchese (p. Pritchard had a duty not to merely object and resign but to make reasonable attempt to prevent the misappropriation of the trust funds.  Directors here did not recklessly repose confidence in an obviously untrustworthy employee. but resigns from the board in 1999 and expresses concerns to the SEC. refuse or neglect cavalierly to perform their duties as directors. 268)  Facts: Allis-Chalmers is a very large.g. In 1937. Charles Jr. New auditors sign-off on 1998 acquisition date. the lesser decisions that are made by officers and employees can.  The board must monitor largely through reports from others.  Reasoning: There is a minimum objective standard of care for directors. e. then whether damages would be appropriate.Reasoning: We first must decide whether duty of care or loyalty was breached. Charles Sr. Francis v. Audit committee members Marchese and Peselman received a report from outside auditor challenging 1998 acquisition date but did not follow up. and then gets reinsurer to take on some portion of the risk. The inquiry is: (1) Was there a breach of duty of care or loyalty? If yes: (2) Was the transaction entirely fair? If not. pay big fines. We only waive damages if directors have not violated the duty of loyalty. directors cannot abandon their office but must make a good-faith attempt to do a proper job. THE BOARD S DUTY TO MONITOR: LOSSES CAUSED BY BOARD PASSIVITY  The relatively few cases that actually impose liability on directors for breach of the duty of care are not cases in which a decision proved disastrously wrong but cases in which directors simply failed to do anything under circumstances in which it is later determined that a reasonably alert person would have taken action.

 Reasoning: The mens rea standard applied is recklessness. Since 1990, SEC enforcement actions have been a powerful and frequently used weapon to secure compliance with the federal securities laws.  SEC enforcement director: We intend to continue following closely in our investigations on whether outside directors have lived up to their role as guardians of the shareholders they serve . . . . We will exercise particular scrutiny in considering the role of directors in approving or acquiescing in transactions by company management.  Federal Organizational Sentencing Guidelines  The United States has begun to sometimes treat lapses from statutory or administratively mandated standards of business conduct as criminal matters. Federal statutory law has been a powerful engine of this movement.  Sarbanes-Oxley (2002) requires CEOs and CFOs to certify that they have developed internal control and compliance systems and to disclose any weakness to outside auditors.  The Federal Organizational Sentencing Guidelines are so draconian that corporations are rarely charged, much less convicted, of crime because it is a death sentence.  The threat of conviction is almost always enough to ensure a corporation s complete compliance. In Re Caremark (p. 278)  Facts: Caremark is a publicly traded health care provider and is subject to the complex provisions of Anti-Referral Payments Law: basically, you re not supposed to pay MDs to refer patients whose treatment is paid for by Medicare or Medicaid. Caremark had always had an ethics guidebook, an internal audit plan, and a toll-free confidential ethics hotline. Price Waterhouse gave control system a clean bill of health. But despite it all, lowerlevel officers apparently engaged in enough misconduct to cost $250 million. Shareholders file derivative suit seeking recovery from the board of directors, claiming breach of the duty of care. Case is before Chancellor Allen because the judge has an obligation to review for fairness a settlement in a derivative suit. Chancellor Allen is asked to approve a settlement in which the Caremark directors promised only to implement relatively insignificant additional safeguards to increase Caremark s ability to comply with the ARPL in the future.  Holding: The settlement is fair and reasonable.  Reasoning: In the event that a firm s internal controls fail to prevent a loss and the CEO did not identify any weakness in the control system to the auditors, there is little risk of directorial liability unless the board s failure to prevent a loss resulted from a systematic failure to attempt to control potential liabilities.  When a board makes a decision, content is off-limits and only process will be examined for violation of good faith or rationality. As to failure to act, we look to whether the board makes a good faith judgment that the corporation s information and reporting system is in concept and design adequate to assure the board receives timely, appropriate info. No failure here because there is not sustained and systemic failure of the board to exercise oversight.  This case imposes a duty to put a compliance system in place even before misconduct is suspected (differs from Graham v. Allis-Chalmers, above). Stone v. Ritter (p. 285)  Facts: AmSouth shareholders brought suit against their directors for failing to detect a scheme among certain employees which led to a $40 million fine against the company.  Holding (endorsing Caremark): Absent any red flags, in order for directors to be held liable for lack of oversight of officers and employees there must be a finding that directors either: (1) utterly failed to implement any reporting or information system or controls, or (2) having implemented such system or controls, consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention. and: imposition of liability requires a showing that the directors knew that they were not discharging their fiduciary obligations. In Re Citigroup (p. 285)  Facts: Citigroup is deep into so-called toxic assets, which leads to massive losses by late 2007. Plaintiffs allege that board should be liable under Caremark for failing to make a good faith attempt to follow the procedures put in place or fail[ing] to assure that adequate and proper corporate information and reporting systems existed that would enable them to be fully informed regarding Citigroup s risk to the subprime mortgage market. Plaintiffs argue that public reports on deterioration of subprime mortgage market should have served as red flags. Citigroup has a 102(b)(7) waiver in its charter.  Holding: Duty to monitor for fraud or other criminal activity is not the same thing as duty to monitor for business risk. Caremark is limited to the first duty; if plaintiffs allege bad judgment, they win only if they can show bad faith or failure of procedure regarding acts of misconduct or criminal activity. 8.7. KNOWING VIOLATION OF LAW Miller v. AT&T (p. 291)  Facts: Shareholder suit against AT&T s board, alleging that AT&T is refusing to collect on a $1.5 million loan made to the Democratic National Committee during the 1968 election. Shareholders bring a derivative action claiming 

that this is an illegal campaign contribution, in violation of federal law. District Court dismisses the suit for failure to state a claim.  Holding: Shareholders are entitled to recover when directors knowingly commit unlawful acts the business judgment rule will not insulate directors from knowing violations of the law.  Reasoning: We let shareholders sue in these circumstances because they help detect and enforce violations of the law.  Clean Air Hypo: Decision is whether to use a lower grade of fuel in operating a large plant. Lower grade will create an 85% chance of violating the Clean Air Standards Act at least once a month; best estimate is 3.5 times per month. Fine per violation, if detected, is $10,000 per violation. Using the lower grade of fuel would save more than $80,000 per month.  Distinguished because (1) conduct is actually beneficial to shareholders and (2) Act is intended to benefit public, not designed with the purpose of protecting shareholder interests.  Under §145(a) & 102(b)(7), corporations can t indemnify against knowing violations. 9. CONFLICT TRANSACTIONS: THE DUTY OF LOYALTY  The core of fiduciary doctrine is the duty of loyalty.  Corporate law imposes specific controls on two classes of corporate actions: (1) those in which a director or controlling shareholder has a personal financial interest and (2) those that are considered integral to the continued existence or identity of the company.  Interested corporate actions include self-dealing transactions between the company and its directors, but they also extend to other transactions, such as appropriations of corporate opportunities, compensation of officers and directors, and even relations between controlling shareholders and minority shareholders.  The duty of loyalty requires a corporate director, officer, or controlling shareholder to exercise her institutional power over corporate processes or property (including information) in a good-faith effort to advance the interest of the company.  A corporate director, officer, or controlling shareholder may not deal with the corporation in any way the benefits themselves at its expense. 9.1. DUTY TO WHOM?  Directors owe their duty to the corporation as a legal entity, yet the corporation has multiple constituencies with conflicting interests, including stockholders, creditors, employees, suppliers, and customers.  When a solvent corporation pursues its regular business activities, the interests of its management, creditors, employees, and stockholders are largely congruent with the interests of its equity investors.  The question of whose interests ultimately count is of principal importance when the corporation faces insolvency or when it contemplates a terminal transaction for equity investors.  As a firm approaches insolvency, the rationale in favor of shareholder primacy loses force, because shareholders have little downside risk and great incentive to gamble. 9.1.1. The Shareholder Primacy Norm  That director loyalty to the corporation is, ultimately, loyalty to equity investors is an important theme of U.S. corporate law. There is widespread sentiment that a corporation should be managed for the benefit of its shareholders.  In response to the growth of hostile takeovers, which frequently increase the value of the firm through externalizing costs, some legislatures passed other constituency statutes that allowed directors to consider interests other than shareholders , such as employers, suppliers, customers, and even communities affected by their decision.  Under these statutes, directors are entitled to consider short- and long-term interest of the corporation; the resources, intent, and conduct of any person seeking to acquire control of the corporation; and any other pertinent factors.  PCBL 1715(a) is one example; like most, it is an enabling, no mandatory or default, rule.  Though these statutes seemed earth-shattering at the time, they really do much that the business judgment rule doesn t.  Lynn Stout, Five Theories Competing with Shareholder Primacy Norm 1. Market inefficiency 2. Capital lock in 3. Team production theory  Non-shareholders often make firm-specific investments and we need directors intervention to prevent shareholders from exploiting these people. 4. Universal shareholder 5. Prosocial shareholder  Shareholders generally don t want the company to engage in antisocial behavior, even if it is profitable  Rights of shareholders: vote, sell, and Sue  Voting is a weak right because of collective action problems, dual class share structures, lack of direct voting on a number of important decisions, use of takeover defenses and other issues.

A.P. Smith Manufacturing Co. v. Barlow (p. 299)  Facts: A.P. Smith Manufacturing Company made a grant to Princeton University. The certificate of incorporation did not expressly authorize the contribution. Stockholders objected to the gift.  Holding: Contribution permitted.  Reasoning: The rationale in support of corporate gift-giving offered in the case isn t terribly compelling, but the business judgment rule will almost always protect directors because some kind of rationale can be crafted (i.e., reference to long-term corporate benefits) 9.1.2. Constituency Statutes  The question To whom do directors owe loyalty? had much more economic import in the LBO transactions of the 1980s. In these transactions, buyers would typically offer shareholders a high premium price for their shares and then, when they had control, sell off significant assets, lay off workers, increase debt on the company s balance sheet, and replace senior management.  In most cases, these changes increased the value of target companies, partly at the cost of imposing uncompensated losses on nonshareholder constituencies.  Managers often resisted being taken over, but in justifying their resistance to high-premium cash offers, they could not persuasively resort to a vision of maximizing long-term economic value of shareholders. Thus, managerial advocates turned to the rationale that directors owe loyalty to something apart from the shareholders alone: the corporation, understood as a combination of all its stakeholders.  State legislatures enacted statues that provided that directors have the power (but not the obligation) to balance the interests of nonshareholder constituencies against the interests of shareholders in setting corporate policy. 9.2. SELF-DEALING TRANSACTIONS  Directors and officers may not benefit financially at the expense of the corporation in self-dealing transactions.  The law might simply prohibit all (direct or indirect) transactions between directors or officers and the corporation. An alternative approach would be to permit interested transactions that are fair but to proscribe those that are not.  Ideally, the legal regime should be simple (like the preclusion alternative0 but discriminating (like the screening alternative), and it should operate without requiring (or inviting) litigation in every such transaction. 9.2.1. Early Regulation of Fiduciary Self-Dealing  Beginning in the early twentieth century, courts would uphold a contract between a director and the corporation if it was (1) fair and (2) approved by a board comprised of a majority of disinterested directors. A contract that did not meet both tests was voidable.  Under early twentieth-century law, an interested director s attendance at a board meeting could not be counted toward a quorum on a question in which he was interested. This rule meant that a corporation could not act to authorize a contract in which a majority of the board was personally interested.  There was, however, good reason to make some of these contracts binding. One response to this dilemma was for shareholders to put into the corporation s charter a provision allowing an interested director to be counted toward a quorum.  Courts continued to require directors to prove that such transactions were fair that is, these transactions remained voidable following interested approval but only if they were unfair or inadequately disclosed. 9.2.2. The Disclosure Requirement Hayes Oyster Co. V. Keypoint Oyster Co. (p. 304)  Facts: Verne Hayes is director, 23% shareholder, and CEO of Coast Oyster, a public corporation. Coast faces cash flow problems and Verne convinces the board to sell two oyster beds. Verne then suggests to Engman, a Coast employee, that Engman form a new corporation (Keypoint) to buy the oyster beds. Verne arranges for his own family corporation, Hayes Oyster, to help Keypoint with financing, in exchange for which Hayes Oyster receives 50% of the equity in Keypoint. The agreement whereby Hayes Oyster gets 50% equity in Keypoint happens after Coast board votes to sell, but before Coast shareholders approve sale. Coast s new management discovers what Verne has done and brings suit to recover Verne s and Hayes Oyster s secret profits. Trial court rules for Verne.  Holding: Trial court reversed; Verne is made to disgorge profits.  Reasoning: Nondisclosure alone is problematic, even though the deal was fair  Self-dealing transactions invoke requirements of (1) disclosure, (2) fairness, and (3) disinterested approval.  Requiring a corporate fiduciary to disclose his or her interest in a proposed transaction with the corporation is only the first step. The difficult question is just what must be disclosed beyond the simple fact of self-interest.  Recall Meinhard v. Salmon: some forms of behavior open to traders in the market are not available to fiduciaries. Among these forms is a range of disingenuous actions that fall short of fraud.  The holding in Hayes Oyster isn t a perfect reflection of current law; the Delaware standard is that a director must disclose all material information far more, on its face, than would be disclosed in an arm s-length transaction (such as reservation price but this is not enforced)

Federal securities law requires disclosure not only to board, but also to shareholders, even if they will not vote on the matter, if the transaction is over $120,000. 9.2.3. Controlling Shareholders and the Fairness Standard  Corporation law has long recognized a fiduciary duty on the part of controlling shareholders to the company and its minority shareholders.  A shareholder with less than 50% of the outstanding voting power of the firm may have a fiduciary obligation by reason of the exercise of corporate control. A shareholder with 50% or more of the vote will probably owe such a duty, despite evidence that it did not in fact exercise control.  The dominant value is that a controlling shareholder s power over the corporation, and the resulting power to affect other shareholders, gives rise to a duty to consider their interests fairly whenever the corporation enters into a contract.  The subsidiary value is the entitlement of all shareholders even controlling shareholders to vote in their own interests. Sinclair Oil Corp. v. Levien (p. 310)  Facts: Sinclair Oil Company owns 97% of Sinven s stock and dominates Sinven s board. Sinven is involved in oil exploration and production in Venezuela. Sinven minority shareholders bring suit against Sinclair Oil for paying excessive dividends that prevented Sinven s industrial development. Sinclair responds that dividends and other decisions should be judged under business judgment rule. Chancellor finds that Sinclair owed Sinven a fiduciary duty and applies the intrinsic fairness test; finds that Sinclair did not sustain its burden of proving that the dividends were intrinsically fair to the minority shareholders. Sinclair Oil appeals.  Holding: The Chancellor erred in applying the intrinsic fairness test; the business judgment rule should have been applied. Sinclair meets its burden under the business judgment rule.  Reasoning: The entire fairness rule comes into play when the parent, by virtue of its domination of the subsidiary, causes the subsidiary to act in such a way that the parent receives something from the subsidiary to the exclusion of, and detriment to, the minority shareholders. There was no such self-dealing here, so the business judgment rule protects the parent. No business opportunities came to Sinven, so Sinclair didn t take any business opportunities from it.  The trend in Delaware is to extend the entire fairness rule to every act of the controlling shareholder. This is concerning to controlling shareholders because litigating entire fairness claims is expensive and outcomes are uncertain.  Corporate opportunity doctrine: an opportunity only belongs to a corporation if it came to a controlling shareholder or agent by virtue of his relationship to that corporation.  If this is not the case, depending on the jurisdiction, the corporation to whom the opportunity belongs may have right of first refusal or at least right to disclosure. 9.3. THE EFFECT OF APPROVAL BY A DISINTERESTED PARTY 9.3.1. The Safe Harbor Statutes  Safe harbor statutes initially sought to permit boards to authorize transactions in which a majority of directors had an interest.  They provide that a director s self-dealing transaction is not voidable solely because it is interested, so long as it is adequately disclosed and approved by a majority of disinterested directors or shareholders, or it is fair.  DGCL §144: Interested Directors and Officers (a) No contract or transaction between a corporation and . . . its directors or officers or any other corporation in which its directors or officers have a financial interest . . . shall be void or voidable solely for this reason . . . , if: 1) The material facts as to the director s or officer s relationship . . . and as to the transaction are disclosed . . . and the board or committee in good faith authorizes the contract or transaction by the affirmative vote of a majority of the disinterested directors; OR 2) The material facts . . . are disclosed . . . to the shareholders entitled to vote thereon . . . and the . . . transaction is specifically approved in good faith by vote of the shareholders; OR 3) The . . . transaction is fair as to the corporation as of the time it is authorized, approved or ratified, by the board of directors, a committee or the shareholders. (b) Common or interested directors may be counted in determining the presence of a quorum . . . .  In sum, a transaction won t be voided solely on the basis of interestedness if one of the three conditions are met:  Disclosure of material facts + disinterested director approval  Disclosure of material facts + shareholder approval  Transaction is fair (+ approved) Cookies Food Products v. Lakes Warehouse (p. 315)  Facts: L.D. Cook forms Cookies, Inc. to produce and distribute his original barbecue sauce. Cookies enters into a distributorship agreement with one of its minority shareholders, Duane Speed Herrig. Distributorship proves so successful that in a matter of years, Herrig has bought out Cook, become the controlling shareholder (with 53%), becomes a director, takes control of the board, and entered into several more self

 Finally. claiming that Oolie and Salkind breached their fiduciary duty by electing to pursue a particular acquisition proposal that . offered superior value to TNN s shareholders. however. best protected their personal interests as TNN creditors.  Take-away: Allows judicial review for fairness once the statute s conditions have been satisfied (this is the most common approach).  But an interested transaction between the company and a single director who is neither a top manager nor a controlling shareholder does not pose the same dangers. Thus. or will be accorded the protection of the business judgment rule. This is a duty of loyalty. courts can be expected to be more deferential to the decision of an independent board. Here full disclosure and approval by disinterested directors can arguable protect shareholder interest. directors are unlikely to treat one of their number with the degree of wariness with which they would approach a transaction with a third party.  But in an interested transaction.  Melvin Eisenberg. what effect should reasonably disinterested procedure have on a derivative suit claiming that he transaction constituted a breach of loyalty if the interested actor was not an employee or a controlling shareholder?  One possibility would be to dismiss the derivative suit for failing to state a claim in light of the board s approval. the approval of an interested transaction by a fully informed board has the effect only of authorizing the transaction.  In re Siliconix Shareholders Litigation: The Court of Chancery held that a controlling shareholder has no obligation to pay a fair price in a noncoercive tender offer to minority shareholders.  Casebook commentary: if there is clear evidence of unfairness. case.  Second. who personally face the daunting task of valuation. . Herrig did not breach his duty  Reasoning: The compensation Herrig received was fair and reasonable. Lynch Communications Corp. Trial court finds no breach of fiduciary duty and rules for Herrig. 9. including Oolie and Salkind. since there are grounds to suppose that even disinterested directors are not fully independent from a controlling shareholder.dealing contracts with Cookies. is not exposed to the same institutional pressures because it can simply remand cases for valuation. all of which are successful. IN this context.  There are two reasons why such a transaction should be subject to some sort of fairness test.  If a self-interested transaction that ahs been approved by disinterested directors is substantively unfair. summary judgment for defendants  Reasoning: Because disinterested directors approved the transaction. (p.  Holding: Business judgment rule applies. the Chancery cases have invoked business judgment-like review where it seems fair. Self-Interested Transactions in Corporate Law  The real question is whether a self-interested transaction that has been approved by disinterested directors after full disclosure wills till be subject to a test of fairness. so the business judgment rule applies.2. 322)  Facts: The Nostalgia Network ( TNN ) has a board with four directors.  Kahn v. and Cookies board knew that he was interested.  First. unless the shareholder could plead fraud.  Holding: Affirmed. Board votes unanimously to pursue the USA acquisition proposal. rather than pursue other proposals that . but which take out about half the company s cash flows.3. . The Delaware Supreme Court. the transaction is not actionable so long as it is not irrational or egregious. then the Chancery Court might review and decide to void (fairness review will be applied and plaintiff will have burden) Cooke v. 324): The Supreme Court cabined the tendency to invoke business judgment review by Chancery judges in cases involving controlled mergers (where one individual is the controlling shareholder in two corporations that she wishes to merge). The Delaware Supreme Court may be more receptive to judicial valuation because it is less exposed to the weaknesses of the process. not duty of care. . Oolie (p. a court might apply the business judgment rule to the substance of the transaction that is.  This narrow judicial interpretation is plausible when a conflicted transaction is between the controlling shareholder and the corporation. not of foreclosing judicial review for fairness. it can normally be inferred that either the approving directors were not truly disinterested or that they were not as wary as they should have been because they were dealing with a colleague. Minority shareholders bring suit. seem institutionally inclined to avoid it wherever they can do so responsibly. it is difficult if not impossible to utilize a legal definition of disinterestedness in corporate law that corresponds with factual disinterestedness. Minority shareholders bring suit alleging that self-dealing contracts grossly exceeded the value of services rendered and that Herrig did not fully disclose the benefit he would gain.  Second.  Chancery judges. a court could give the approval a more modest effect by simply shifting the burden of proving fairness from the defendant to the plaintiff. . Approval by Disinterested Members of the Board  Under traditional interpretation of safe harbor statutes. .

Almost universally. and vested with the resources to accomplish its task.  Applies to conflicted transactions. The plaintiffs claim is extinguished entirely  Applies when the only issue is some minor duty of care problem (like Smith v.3.  A committee must just say no when a controlling shareholder refuses to consider advantageous alternatives unless the controller proposes terms that are their financial equivalent. (p. Inc.  If the terms of a deal are sufficiently egregious to raise strong suspicions in their own right.  To be effective. on their face.  Shareholder ratification may be held ineffectual (1) because a majority of those affirming the transaction had a conflicting interest with respect to it or (2) because the transaction that is ratified constituted a corporate waste. which holds that even a majority vote cannot protect wildly unbalanced transactions that. a special committee must be properly charged by the full board. the agent must full disclose all relevant circumstances with respect to the transaction to the principal prior to the ratification.  Regarding an interested transaction between an company and one or two of its directors who are not affiliated with a controlling shareholder.  Applies to an ordinary conflicted transaction. after investigating in detail the independence of the target s board and its special committee of independent directors.  . In Re Wheelabrator Technologies.3. Shareholder Ratification of Conflict Transactions  Generally speaking. it only shifts the burden of proving fairness from the defendant to the plaintiff in a controlled transaction. 327)  Ratification contemplates the ex post conferring upon or confirming of the legal authority of an agent in circumstances in which the agent had no authority or arguable had no authority. but:  The law must limit the power of an interested majority of shareholders to bind a minority that is disinclined to ratify a submitted transaction. but the shareholder plaintiff who attacks the transaction will bear a substantial evidentiary burden if the process is well executed.  Informed.  Every aspect of the operation of the special committee is important in assuring that its recommendation receives judicial respect.  Committee members must understand that their mission is not only to negotiate a fair deal but also to obtain the best available deal. duty of loyalty cases when person is the majority shareholder. and finding that its minority shareholders had approved the merger on full information. duty of care cases only. both controlled by the same shareholder. 3. An attempt to coerce the principal s consent improperly will invalidate the effectiveness of the ratification.  The agent must act not only with candor. The conflicted transaction is reviewed under the business judgment rule.  The special committee of disinterested independent directors is the most common such technique. but with loyalty. Techniques that assure the appearance as well as the reality of a fair deal are useful. and when there is some lack of corporate authority 2.  The power of shareholders to affirm self-dealing transactions is limited by the corporate waste doctrine. Vogelstein (p.  To be given effect under Delaware law. dominated.4.  Even if the committee process is done well. Lewis v.In re Western National Corporation Shareholders Litigation: the Court of Chancery applied business judgment review to a merger between two corns. The plaintiffs claim is reviewed under the entire fairness standard. irrationally dissipate corporate assets. 9. comprised of independent members. duty of loyalty cases when the person is not a majority shareholder. disinterested shareholder ratification of a transaction in which corporate directors have a material conflict of interest has the effect of protecting the transaction from judicial review except on the basis of waste. the Court of Chancery can be expected to require the defendant explain the transaction as one that represents a fair deal to the company. uncoerced.  The more worried we are about the transaction. the committee will retain outside investments bankers and lawyers to advise it. or manipulated in some fashion. the more we want the court to seriously review the transaction. shareholders may ratify acts of the board. 328)  Delaware Court of Chancery articulated a different formulation of the possible consequences of shareholder ratification: 1. Van Gorkom) and the court is not terribly concerned about risks of transaction. 9.3. the Court of Chancery is likely to employ business judgment review as long as the remaining disinterested directors who approve the transaction cannot be shown to be misinformed. Approval by a Special Committee of Independent Directors  Parent companies have a clear obligation to treat their subsidiaries fairly.

02 Neither board nor EF (D): but see Siliconix EF (D) EF (D) shareholders approve Disinterested BJR (P): Cooke.  Because option terms aren t always standardized. currently trading at $100. including its overall level (for being too high). Incentive compensation based on the performance of individual managers or. If board members approve option grants for themselves. and thus reduce the agency costs of management. managers are more likely to game incentive pay schemes at the monetary stakes increase. If XYZ stock price goes to $120.  Compensation structures must respond to this by providing a substantial part of manager compensation in the form of fixed. Perceived Excessive Compensation  Shareholder advocates attack many common features of top executive compensation. where this cannot be monitored. directors ratify Comment 1 5. option grants are generally reviewed under the business judgment rule (old doctrine said otherwise). realizing profit of $20. Effect of Approval by a Disinterested Party (Burden of Proof in Parenthesis) DGCL §144 RMBCA §8. so incentive compensation increases agency costs. Option Grants and the Law of Director and Officer Compensation Lewis v.61(b)(1) & Reasonable belief in directors authorize Cookies (EF.62(a) & EF (D): §5. the value of shareholder approval gets lower.  Stock Options as Compensation for Executives  Strike price is usually current market price.  However. that reward executives for standing aside gracefully in the sale of their companies.02(b) Shareholders ratify BJR/Waste (P): but see Waste (P) Waste (P) Wheelabrator (EF. the market isn t deep enough in some cases to provide a value estimate. if controller?) 9. option holder can exercise the option. but see BJR (P): §8. and the common sweeteners in compensation contracts. cannot easily diversify their investment in the firm.  Awarding stock options rather than stock takes away the downside risk to the exec. 5. this gives executives incentive to act in ways that will increase the market price of the firm. frequently the option is not currently exercisable and/or is exercisable over a period of time. 332)  Nowadays. However. with strike price of $100. a fixed salary is unlikely to do enough to induce a manager to accept risky projects that nevertheless are valuable from a long-term shareholder perspective.2.  At the Money call option: strike price = current market price  In the Money call option: strike price < current market price  Out of the Money call option: strike price > current market price  Valuing options  Valuation is difficult because of timing.02(c). if controller?) Comment 2 fairness (P): §5.4.02(a)(2)(A). the procedures used for setting compensation (for being insufficiently disinterested). As the transaction gets sketchier. Vogelstein (p.61 ALI §5. 9. But managers. rather than a reasonableness or fairness standard.4.  The most valuable asset of a senior manager is his skill and specialized knowledge of his firm.4. buy a share at $100. such as golden parachutes. on the performance of the company as a whole. shareholders may ratify. and sell it for $120.  . The effect of shareholder ratification is to cause the option grant to be reviewed under a waste standard. DIRECTOR AND MANAGEMENT COMPENSATION  Compensation is a necessary form of self-interested transaction. Compensation plans that are wisely structured and closely monitored can better align the interest of managers and shareholders.. which will reduce the amount that a manager has at risk. This fact will tend to make managers risk averse. short-term claims (salary). executives might not hold control over increasers of stock price.  However. but awarding stock gives the recipient the market value of the stock instantly.  A call option is never less than worthless (no risk of negative payoff. can be an antidote to management slack.02(a)(2)(B) Disinterested BJR (P): same as above BJR (P): §8. its form (for not sufficiently punishing failure). 9.  Option Terminology:  Call Option: right to buy a share at a specified price (the strike price ) (Compare: a Put Option is the right to sell a share at a specified price). as would be the case for someone holding the stock if prices declined)  Example: Call option on XYZ Corp.1. like other employees.

under the statutory language. Disney s general counsel investigates the possibility of termination for cause by does not keep any notes or seek outside legal advice.4. 341)  Facts: Eisner.  The most basic duty of every fiduciary may be said to be the duty to exercise good faith in an effort to understand and to satisfy the obligations of the office. loans to directors or senior officers are illegal for public corporations.5. such waivers however may not waive liability that rests in part upon breach of the duty of loyalty and. quintessential bad faith.  This drove up compensation. Corporate Loans  Under the Sarbanes-Oxley Act. 9. neither the business judgment rule nor the waiver authorized by §102(b)(7) will protect the defendant from liability. Determining Which Opportunities Belong to the Corporation  There are three general lines of corporate opportunity doctrine:  . no one wanted to have executives who were worth less than average. The Disney Decision In re Walt Disney Co. non-indemnifiable violation of the fiduciary duty to act in good faith.4. no violation of fiduciary duty. We prefer options so directors are not overly risk-averse.  The corporate opportunity doctrine is a special application of the duty of loyalty.  The Disney court provided a spectrum of behavior for identifying bad faith conduct. The chief questions that arise in the corporate opportunity context concern whether an opportunity context concern whether an opportunity is corporate. cannot constitute bad faith. that inability to waive damages is extended to acts (or omissions) not done in good faith. Little over a year later.  Disney establishes that there can be a level of director neglect or inattention that might lead a court to find that the directors were not seriously trying to meet their duty. in which event the protection of the charger amendment authorized by §102(b)(7) may not offer protection. a conscious disregard for one s responsibilities . convinces Ovitz and Disney s Board to have Ovitz come on as second-incommand. Disney s board votes to terminate Ovitz without cause due to Ovitz s poor performance.4.3. not duty of care 9. under §102(b)(7) such liability for gross negligence alone can be waived. unless part of incentive compensation plan (to encourage the use of incentive plans). Disney s CEO.  NB: Defendants motion to dismiss had to be denied because the facts alleged suggested that the directors consciously and intentionally disregarded their responsibilities. grossly negligent conduct. Under the terms of his employment agreement. CORPORATE OPPORTUNITY DOCTRINE  Corporate opportunity cases focus on when an opportunity is corporate rather than personal and hence off-limits to the corporation s managers. (p. In the event of this extreme level of inattention. The board was not under a duty to act in exiting the agreement. The government doesn t want compensation masked as debt that will never be repaid.5. 9. deliberate disregard of the duty of care also gets around the business judgment rule.  SOX requires that companies have directors and executives repay bonuses if financials must be restated. a §102(b)(7) waiver cannot waive liability for acts in bad faith (which includes deliberate disregard of the duty of care). the SEC implemented regulations that required public disclosures regarding top executive pay.1. On the other end of the spectrum. On one end of the spectrum.  Tax deductability of executive salaries is limited to the first $1 million. and the remedies that are available when a fiduciary has taken a corporate opportunity illegitimately. Van Gorkom) be the basis for a breach of duty finding and result in liability for any losses that result However. such misconduct is properly treated as a nonexculpable. the circumstances under which a fiduciary may take a corporate opportunity. without any malevolent intent. mere director negligence lacking that degree of attention that a reasonable person in the same or similar situation would be expected to pay to a decision does not give rise to liability. Eisner then made a reasonable business judgment in exiting the agreement (so no violation of fiduciary duty).  NB: Self-dealing violated duty of loyalty. fiduciary conduct that is motivated by an actual intent to do harm constitutes classic.  Reasoning: Amounts of executive compensation are reviewed under business judgment rule unless there is a conflict of interest. Delaware law apparently reflected the following formal structure of director liability for inattention:  First.  Incidentally. facts that establish gross negligence may (as in Smith v.  Third. Regulatory Responses to Executive Compensation  In 1993 and 2006. Ovitz receives a $140 million severance package  Holding: Eisner did not breach fiduciary duty in entering the employment agreement with Ovitz because he honestly believed Ovitz would be a positive influence on the corporation. The board made only a cursory review of Ovitz as candidate for Disney President.  Post-Disney. so again. 9. In between lies conduct that involves intentional dereliction of duty.  Second.

9. Atlantic Properties does well. and other fact-specific indicia of good faith and loyalty to the corporation. effectively giving each of the four shareholders veto power.500.6. classifies any opportunity falling within a company s line of business as its corporate opportunity Factors affecting this determination include (1) how this matter came to the attention of the director. but the company refuses. This test considers factors such as how a manager learned of the disputed opportunity.5.  . Euphemia brings suits against the directors and the company to rescind the purchase of Harry s shares. with equal shares for Smith. which reflects book and liquidating value. THE DUTY OF LOYALTY IN CLOSELY-HELD CORPORATIONS Donahue v. in addition to a company s line of business. Trial court finds that transaction had been carried out in good faith and with inherent fairness. we encounter problems because we don t know what the parties would have wanted. Smith. Euphemia Donahue (wife) offers to sell her family s shares on the same terms. IRS assesses penalty taxes totaling approximately $40. but Wolfson continually vetoes the payment of any dividends. Inc.  This defense is effective only if a court is persuaded that the decision to reject a valuable opportunity on financial grounds is the genuine business judgment of a disinterested decision maker. used in Meinhart & Sinclair Oil)  Finally. whether he or she used corporate assets in exploiting the opportunity. limited exit opportunities and no requirement to produce audited financial statements  However. even in public companies. (2) No ready market for shares  This is a problem because there are liquidity concerns. 351)  Facts: Rodd Electrotype has three directors: Charles Rodd. officer. Trial court finds that Wolfson breached his fiduciary duty and holds him liable for the penalty taxes. Rodd Electrotype Co. and an unnamed lawyer. 359)  Facts: Dr. When May a Fiduciary Take a Corporate Opportunity?  Incapacity is related to disinterest and implies that a corporation s board has determined not to accept the opportunity. a fiduciary should be free to take the opportunity. (p.. it is reasoned. (p. and Burke who each contribute $12.  But in applying this vision to the Donahue (or any other) case.000.2. wife and son of the other co-founder.  The fiduciary who takes the opportunity bears the burden of establishing this defense. Atlantic Properties Inc. acting through Charles. then sets up Atlantic Properties. buys half of Harry s stake for $800 per share. Smith v. and 20% by the two Donahues.The first includes those cases that end to give the narrowest protection to the corporation by applying an expectancy or interest test  The second test. which had been rejected. it s more likely that there is a majority shareholder.  Court defines a close corporation as having: (1) A small number of shareholders  This is a problem because with a low number of shareholders. Zimble. The company. 9.  Holding: Shareholders in closely-held corporations owe one another substantially the same fiduciary duty in the operation of the enterprise that partners owe one another. Wolfson puts in a charter provision requiring an 80% shareholder vote to approve any action. Wolfson testifies that he included the provision to prevent the others from ganging up on him. 16% each among Charles. Frederick Rodd. not market) and other ways managers can extract benefits  Easterbrook & Fischel. Close Corporations and Agency Costs  Fiduciary duties are a substitute for what the parties would have chosen if they had bargained for it in advance. Wolfson purchases land for $50. The company had previously offered to buy the Donahue shares for amounts between $4 and $400 per share. you can take assets out of bad managers hands. In either event.000 for unreasonable accumulation of corporate earnings and profits. and Burke bring suit to remove Wolfson as a director and to have him reimburse Atlantic for the penalty taxes and related expenses. partially for personal tax reasons and partially due to personal animosity towards the other shareholders.  This is the most common approach. known as the line of business test. some courts employ a more diffuse test that relies on multiple factors a fairness test to identify corporate opportunities. It is owned 33% by Harry Rodd (co-founder and father of Charles and Frederick). which means you have to sell at a low price (3) Majority shareholders that are also managers  This is a problem because of freeze-outs (valuation by managers. Stock repurchases have to be available to all shareholders on the same terms. and their sister. and (3) whether corporate information is used in recognizing or exploiting the opportunity. (2) how far removed from the core economic activities of the corporation the opportunity lies. we treat what they would have done ex ante as the desirable state because we believe their envisioned arrangement maximized value. or employee. Zimble.  Most courts accept a board s good-faith decision not to pursue an opportunity as a complete defense to a suit challenging a fiduciary s acceptance of a corporate opportunity on his own account. Frederick.

 The class action and the derivative suit share important commonalities: both require plaintiffs to give notice to the absent interested parties. A. SOLVING A COLLECTIVE ACTION PROBLEM: ATTORNEYS FEES AND THE I NCENTIVE TO SUE  If the shareholder suit is to be plausible for enforcing fiduciary duties in widely held corporations.  . Wolfson s behavior was unreasonable and he should be liable for the penalty taxes.. if successful. and in both actions. successful plaintiffs are customarily compensated from the fund that their efforts produce. so there are opportunities for extortion-like behavior regarding non-meritorious claims. The claim in such a suit is to recover damages suffered by individuals directly because they are shareholders. but if we insist on enforcing terms that lead to absurd results.2.  Holding: Pursue a direct suit.  Reasoning: The corporation received substantial benefits as a result of the action and its settlement. so claims may be settled too easily and too early.1. Such a system has evolved out of the court of equity s practice of awarding attorneys fees to plaintiffs whose litigation created a common fund that benefited others as well as the plaintiff herself. the stockholder should be compensated for pursuing this action.  A derivative suit (and the remedy of vote cancellation) is not appropriate for internal conflict. the plaintiff s lawyer can be paid out of the resultant fund. charging them with improperly failing to sue on the existing corporate claim.  A class action is simply a gathering together of many individual or direct claims that share some important common aspects. A suit that is correctly characterized as a derivative suit may be dismissed if it does not satisfy the provisions of Rule 23. Such an injury only indirectly harms shareholders.1 of the Federal Rules of Civil Procedure.  These suits typically allege that the corporation s directors have failed to vindicate its claims because they themselves are the wrong-doers and so would be the defendants in the resulting suit. 10. which agrees to vote the stock favorably to the board. Inc. a derivative suit. The stock was issued at a 10% discount to the prevailing market price.  Agency Costs in Shareholder Litigation  Legally.  Positives: This arrangement addresses collective action problems in using suits to enforce fiduciary duties  Drawbacks: Companies and managers are risk averse and costs of litigation are high.J.Holding: Trial court ruling affirmed. opportunity to be heard. both permit other parties to petition to join in the suit. Ultimately. Inc. which are customarily brought as class actions. instead. Example (p. provide for settlement and release only after notice. but whether the corporation was entitled to monetary recovery was to be determined in the future (though corporate reorganization was to be performed immediately). here the parties did contract ex ante for the situation in question. ultimately. a settlement was negotiated. DISTINGUISHING BETWEEN DIRECT AND DERIVATIVE CLAIMS  The derivative suit advances a corporate claim. we will force parties to expend enormous sums on specifying extremely precise terms. 365)  Facts: The board of Friendlier. the court sees the parties agreement as made against the background of good faith. 10. The second suit is the underlying claim of the corporation itself. settlement is common and safe.  Fiduciary duties can deter misconduct only if the shareholders can bring claims of fiduciary breach to court. the plaintiffs lawyers are agents of shareholders. and judicial determination of fairness of the settlement. the stock price would include the value of potential favorable judgment.  The derivative suit is an assertion of a corporate claim against an officer or director which charges them with a wrong to the corporation. Inc. Industries. retaining the right to share in favorable judgment. or by the corporation directly if there is no fund.  The derivative suit is said to represent two suits in one: the first suit is against the directors. if damages are monetary. Fletcher v.  Reasoning: We want to give effect to contracted terms. SHAREHOLDER LAWSUITS  There are two principal forms of shareholder suits: derivative suits and direct actions.  Derivative suits have a number of special procedural hurdles designed to protect the board of directors role as the primary guardian of corporate interest. the law must construct an incentive system to reward small shareholders for prosecuting meritorious claims. 10. but the court ignores their agreement. just as the corporate defendants are fiduciaries charged with acting for the corporation and. if we sold right to recover along with the stock. (p.  Held: If pursuit of a shareholder claim is successful. for its shareholders. defeats a coalition of insurgents at the annual shareholders meeting by issuing a 15% block of common stock to the Friendship Investment Company. which implies that any recovery that results should go directly to the corporation itself. would give Friendship 15% of the recovery. But both sides have important financial interests at stake: fees for the lawyers and potential liability for corporate officers and directors.  Friendlier. 367)  Facts: Shareholders pursued a derivative action alleging that the corporation had been damaged due to mismanagement by one of its directors.  Compare to Donahue.  Membership in the class is restricted to shareholders who held at time of injury (these shareholders can/will sell at a depressed price.

 The law of presuit demand and the law of dismissal by independent board committees can be understood as judicially created measures intended to fine-tune the power and incentives of plaintiffs lawyers to prosecute shareholder suits. against the will of management. and especially in the rare case in which a derivative case is settled over the objection of a derivative plaintiff. on the ground that the board could not exercise disinterested business judgment. GM pays Perot $742 million in exchange for: his GM stock.  Aronson Demand Futility Test:  Our view is that in determining demand futility the Court of Chancery in the proper exercise of its discretion must decide whether. Chancery Court rejects the demand futility claim  . now. 10. Hence. and an agreement not to wage a proxy contest or to publicly criticize GM s management. with 0.  When the board seeks to terminate a derivative suit at a later point in the litigation. STANDING REQUIREMENTS  Standing requirements. argue that demand is excused because it would have been futile.1. GM buys EDS from Ross Perot in a stock transaction that makes Perot GM s largest shareholder. which is borne by the corporation or its insurer. 10. under the particularized facts alleged.  Corporate defendants may be too eager to settle because they bear at least some of the costs of litigation personally. which screen who may bring a derivative suit. . The Demand Requirement of Rule 23  A derivative complaint must allege with particularity the efforts.  Here. or suits without merit. a reasonable doubt is created that: (1) the directors are disinterested and independent.4. but under §135(b). In this case. BALANCING THE RIGHTS OF BOARDS TO MANAGE THE CORPORATION AND SHAREHOLDERS RIGHTS TO OBTAIN JUDICIAL REVIEW  When a shareholder-plaintiff should be empowered to take a corporate claim out of the hands of the board.  Parties will almost certainly be indemnified under Officers and Directors Insurance if they settle. 10. is an issue that can arise in several contexts:  When a company moves to dismiss a derivative suit on the ground that the shareholder-plaintiff has made a presuit demand on the board.  A director who settles will be deemed to have prevailed otherwise. but the board has refused to bring the suit. Shareholders bring derivative action claiming breach of fiduciary duty. the corporation cannot indemnify them if they are found to have acted in bad faith. . simply to extract a settlement by exploiting the nuisance value of litigation and the personal fears of liability even if unfounded of officers and directors.Plaintiffs lawyers may initiate strike suits. and (2) the challenged transaction was otherwise the product of a valid exercise of business judgment. and then by the full (22-person) board minus Perot. As Perot discovers how GM is run. 376)  Facts: In 1984. but they do not bear the cost of settling. plaintiffs attorneys and corporate defendants if these defendants remain in control of the corporations have an incentive to settle on terms that are mutually advantageous but that allow the defendants to fully escape personal liability for their conduct.3. because only the class plaintiff's lawyer gets paid. the court must decide whether or not to defer to the board s business judgment in electing not to prosecute the action  When the shareholder-plaintiff does not make demand on the board. after the suit has already survived the company s initial motion to dismiss. or the grounds for not making the effort. the Court of Chancery must make two inquiries. Smith (p.4. notes. are established both by statute and by court rule.  In connection with settlement of shareholder suits.  Here the court must pass on the validity of the plaintiff's excuse for not making presuit demand.  The plaintiff must be a shareholder for the duration of the action  The plaintiff must have been a shareholder at the time of the alleged wrongful act or omission  The plaintiff must be able to fairly and adequately represent the interests of shareholders (there are no obvious conflicts of interest)  The complaint must specify what action the plaintiff has taken to obtain satisfaction from the company s board or state with particularity the plaintiff's reason for not doing so  It used to be a race to the courthouse. Levine v. one into the independence and disinterestedness of the directors and the other into the substantive nature of the challenged transaction and the board s approval thereof. most jurisdictions give standing to plaintiff with largest unconflicted interest (most adequate plaintiff) on the grounds that this plaintiff will best supervise litigation. They are premised on the assumption that screening for qualified litigants increases the quality of shareholder litigation. made by the plaintiff to obtain the action he desires from the directors or comparable authority . if any. triggering mandatory §135(c) indemnification of officers who prevail on the merits or otherwise  Agency problems also arise when shareholder litigation is meritorious and corporate managers face a serious prospect of liability. Deal is approved by a three-person subcommittee of the board. and puts Perot on GM s board.8% of its stock. he goes bananas starts criticizing GM publicly for making second rate cars.

 Holding: Demand is excused. The factors are:  The directors are disinterested and independent  The challenged transaction was otherwise the product of a valid exercise of business judgment.  Speigel v. with particularized facts. it recommends that the court dismiss the suit. the merits of the suit. except no dismissal if plaintiff alleges undisclosed self-dealing (§7. Buntrock presumption. that the challenged transaction is protected by the business judgment rule. Shortly after the deal but before the shareholder suit. if a shareholder asks the board to pursue the suit.  RMBCA: must make demand and wait 90 days unless irreparable injury (§7.44(a)). individual right to continue a derivative suit for breaches of fiduciary duty. he concedes that the board is independent and disinterested with respect to the question to be litigated. demand rarely made due to Speigel v. The Chancery Court rules that shareholders have an independent.42).10(a)(2)). 10. and if demand is refused and shareholder continues. Thus. in part. So at the time the suit is brought. demand is excused. and (b) did not rebut the presumption that the decision was an exercise of valid business judgment.  With universal demand or universal nondemand. all suit is pursued on demand futility.because (a) plaintiffs did not plead particularized facts sufficient to create a reasonable doubt as to the independence of the GM board. in helping them finance their earlier takeovers with junk bonds. we omit the second prong of the Aronson/Levine test. This rule has the effect of foreclosing demand. but entails more time and cost by the board. Here.2. along with six others. Buntrock (p. However. we only apply the first prong of the Aronson/Levine test. and if demand is refused shareholder may continue by alleging with particularity that board is not disinterested (§7. neither factor was met here. 381)  Facts: Shareholder/plaintiff Blasband owns stock in Easco Handtools. but they instead invest the proceeds in Drexel junk bonds at a time when Drexel is on its last legs and the DOJ is hot on Milkin s trail. A universal demand rule allows the court to do so with more information. Since this board is not the one that engaged in this dubious transaction. the plaintiff must:  Establish that the directors are interested or dominated and hence incapable of passing on a demand. the court imposes the requirement that the plaintiff show there is a substantial likelihood that the director is going to be liable. officially to finance debt repayments and operations expansion.44(d)) or did not act in good faith (§7.  Holding: Either factor will be sufficient to demonstrate demand futility: The premise of a shareholders claim of futility of demand is that a majority of the board of directors either has a financial interest in the challenged transaction or lacks independence or otherwise failed to exercise due care.  The court identifies the tactic of naming the board as defendants so the plaintiff can show demand futility as a potential problem. .10(a)(1)) and reasonable belief in fairness for alleged duty of loyalty violations (§7. Whether the board is independent or not turns on. 389)  Facts: Plaintiff files a derivative suit in Delaware. court will review board motions to dismiss derivative suits using a graduated standard: business judgment rule for alleged duty of care violations (§7. The question from Aronson is whether the plaintiff has to create reasonable doubt as to one of the factors or both of them. Rales Brothers do a public debt offering of $100 million in notes. the Zapata board appoints two new independent directors who serve as a special litigation committee (SLC). but all they do now is sit on the board. and court screens based on two-part Aronson/Levine test: P must establish either that directors are interested/dominated or must allege facts that creat[e] a reasonable doubt of the soundness of the challenged transaction.  Reasoning: If the board at the time suit is filed is different from the board at the time the challenged transaction are different (which often happens in mergers or changes of ownership). and four years into the litigation. the court will ultimately have to pass on the board s ability to fairly deal with the issue the litigation presents.10(b)).03). The Rales brothers own 44% of Danaher. Rales v.  Under the Aronson/Levine Test in Delaware for demand futility in derivative suit.  Comparison of Demand Futility Approaches  Delaware: in practice. the Rails brothers and Caplin are interested because they might be held liable in the suit. the Rales brothers merge Easco into a subsidiary of Danaher. Special Litigation Committees Zapata Corporation. The SLC investigates the action and like virtually all SLCs.4. which they also control.  ALI: must make demand unless irreparable injury (§7. a company that is controlled and managed by the Rales brothers (well-known takeover artists). the shareholder/plaintiff is no longer a shareholder of Easco but is instead a shareholder of Danaher. The suit alleges breach of the duty of loyalty the investment is the quid pro quo for Drexel s past favors for the Rales brothers personally. v. Maldonado (p. or  Create a reasonable doubt. even if the corporation does not want to. 380): In Delaware. Blasband (p.

 The second prong is astonishing. the application of that prong would be subject to appellate review. and a reasonable investigation. and Stanford was and stood to continue to be a beneficiary of major donations by the members of the Oracle board.110-page report concluding that Oracle should not pursue the plaintiffs claims against the defendant directors.  If the court had to apply prong 2. Holding: Zapata two-step: (1) the court should inquire into the independence and good faith of the committee and the bases supporting its conclusion. we don t bother to apply prong 2.  Reasoning: The problem with SLCs is that they can always be set up to recommend against pursuing litigation.  If the committee meets the first prong.  If the committee fails in the first prong. applying its own independent business judgment. . were held to be interested because they were both professors at Stanford. give special consideration to matters of law and public policy in addition to the corporation s best interest.  NB: It is somewhat odd that a court may second-guess the board s evaluation of a derivative action when demand is excused. the committee is held to lack independence (though good faith and reasonable investigation are not a concern). Grundfest and Garcia-Molina from Stanford to the board as a two-person SLC with complete authority to respond to the litigation. (2) The court should determine. The corporation should have the burden of proving independence. when appropriate. Speigel) Corporation brings suit Suit proceeds Suit dismissed SLC No SLC SLC recommends dismissal or settles SLC recommends suit Case continues Zapata two-step (Carlton) Case continues In Re Oracle Corp. and serving out of personal interest and a sense of public duty. insider trading occurs when a person has information about a company that is both material and non-public and uses this information in buying/selling in the market.  Holding: The court finds that the special litigation committee fails the first prong of the Zapata two-step. whether the motion should be granted. but not when demand was required but the board rejected suit.  Reasoning: The directors were newly appointed to the board for the specific purpose of serving on the special litigation committee and all the decisions of the special litigation committee were made in private meetings. whether to apply prong 2 is the court s discretion. Delaware Derivative Suit Decision Tree Plaintiff doesn't make demand Plaintiff makes (Aronson/Levine two demand prong test)  Board does not refuse Demand excused (Rales) Demand required Board refuses Relaxed BJR (Levine. however. One of the two members of the special litigation committee was a corporate law expert. Plaintiffs challenge independence of the SLC in Delaware Chancery Court. Oracle appoints Profs. (p.  Zapata states that the court should. Lucas (Stanford alum and major donor to Stanford) & Boskin (a Stanford economics professor).  Roughly speaking. Courts don t have business judgment. 395)  Facts: Derivative complaint alleges insider trading by four Oracle directors: Ellison (major donor to Stanford). SLC produces 1. good faith. The members. What the Zapata court was faced with was the end of derivative litigation forever. The committee had its own counsel and conducted extensive investigation. former commissioner of the SEC. This is very illegal. Henley.

5. and lost profits from negative publicity. 409)  Facts: Reginald Lewis does an LBO of Beatrice Foods with the help of some banks.  The dissent is concerned that the majority is making the second prong mandatory (but it s not clear the majority really imposes this requirement).  Thus.  Further. which eventually negotiates a settlement for Lewis s estate to pay Beatrice $14. North)  The plaintiff's claim of breach of fiduciary duty succeeds only if director has a direct financial interest in the issue (here. so he places enormous weight on the first prong. however. (2) of the settling suits. in exercise of the second Zapato prong. Settlement by Class Representatives  The parties are strongly driven to settle in the typical derivative (or class action) suit. (Loosely follows Joy v.1. few ever do in public companies. directors. While shareholders are formally invited to participate in considering the settlement s merits. Inc.  Directors will generally have a right to indemnification of reasonable defense costs if the action settles. However. North (p. A director s directors and officers insurance coverage will typically exclude losses that arise from fraud or self-dealing. Plaintiff objects to the settlement and brings suit in the Delaware Chancery Court. 10.9 million plus interest in installment payments over seven years. there is a risk of personal liability that can be indemnified only with court approval. (1) most suits settle and lead to an award of attorneys fees. the issue is whether the director is interested. while settlement allows the proceeds of the D&O insurance policy to be used. ordinarily special litigation committees are permitted to serve their function (especially if they learn from Oracle). an alternative to the Zapata rule might be a more rigorous effort to ensure the independence of the directors who sit on the special litigation committee. The company appoints an SLC. but also doesn t want to see derivative litigation foreclosed. compensation of the CEO). Lewis ends up with 45% of Beatrice and banks get 20%. (p. 403)  Majority: The court s function is thus not unlike a lawyer s determining what a case is worth for purposes of settlement. It then exercises its business judgment and finds the settlement reasonable. and the prospect of a trial imposes the further risk that all suit costs will be lost in the end. about half result in monetary recovery. should weigh the amount and probability of liability.5.5 million in compensation payment just before he dies.The case is designed to illustrate that the definition of independence for a special litigation committee can be fairly broad general social ties and sense of institutional loyalty.  If an action goes to trial. We can expect special litigation committees to offer settlement on terms more favorable to directors (their colleagues) than plaintiffs would. it can purchase liability insurance for its officers. TLC Beatrice international Holdings. Van Gorkom  .  Holding: Defendants did not breach their fiduciary duties in connection with the board s approval of the compensation package.5. indemnification costs.  NB: The corporation has the burden of satisfying the Zapata test.  For board skeptics and reformers. 10. It finds the special litigation committee s procedure was reasonable and the special litigation committee independent. the corporation cannot indemnify officers that are adjudged to be liable to it.  The majority says courts. the court approves the form of the notice of settlement that is conveyed to the shareholders.  This opinion is fairly extraordinary. rather than the plaintiff of proving it isn t met.  The Chancellor doesn t want to exercise business judgment as a judge.  The breach of duty of care claim succeeds if plaintiff can get past the business judgment rule by showing (i) bad faith deliberate disregard of duties or that directors are interested or (ii) a Smith v.2. whether or not the corporation would have the power to indemnify them against such liability.  Dissent: the Zapata two-step asks more questions than it answers. Carlton Investments v. Settlement by Special Committee  Plaintiffs resist because they might wish other terms of settlement. Joy v. distraction of key personnel. (3) D&O insurance pays for most or all of the settlement fund in most cases and (4) officers and directors never face out-of-pocket costs. Beatrice pays Lewis $19. SETTLEMENT AND INDEMNIFICATION 10. there are so many considerations that the court lacks the knowledge and expertise to properly weigh. Litigation becomes increasingly costly as a suit progresses through discovery.  After the lawyers negotiate a settlement. One of the big bank shareholders brings derivative suit alleging self-dealing and waste. The members of the special litigation committee here seem no more or less independent than managers are from their board. and agents. attorney s expenses.  Reasoning: The court evaluates the special litigation committee s decision using the Zapato two-step.  Joy differs from Zapata in that there does not appear to be consideration for matters of law and pubic policy under the rule in Joy.

and a purchaser is free to buy. and sell their controlling block to Flintkote Co. who pay recoveries to the corporation itself.1.  The incumbent controller will demand a premium. jurisdictions have statutes that require any acquirer of a control block to offer to acquire all shares at the same price paid in the control transaction. or by doing both.  The common law rule. a looter could exploit the collective action problem of disaggregated shareholders by buying 51% of a target corporation at a high price and later appropriating a large part of the value of the remaining 49% as a private benefits.1. but does not confer rights on other shareholders. but can also use that power to block efficient transfers for selfish reasons.  Take-home: It is extremely hard to challenge the substance of executive compensation. that controlling interest at a premium price. 11. litigation imposes direct costs on a company (litigations costs and insurance costs).S. The Regulation of Control Premia  While some non-U. corporate law has come to recognize that share transactions on the market cannot be wholly isolated from the core agency problems of corporate law. SALES OF CONTROL BLOCKS: THE SELLER S DUTIES  Issues regarding the sale of the control block once it is obtained: (1) the extent to which the law should regulate premia from the sale of control (2) the law s response to sales of managerial power over the corporation that appear to occur without transferring a controlling block of stock (3) the seller s duty of care to screen out buyers who are potential looters 11. as well as to plaintiffs and defendants attorneys.  By purchasing the shares of numerous smaller shareholders.  A waste claim does not work because the corporation did not give away something for absolutely nothing.6. 416)  Facts: Hanson Holdings and Sylvestri family together own 44. 417) .S. TRANSACTIONS IN CONTROL  Transactions in shares have traditionally escaped regulation by corporate law.  Holding: New York Court rejects equal opportunity rule  Reasoning: Absent looting of corporate assets. a controlling stockholder is free to sell. fraud or other acts of bad faith. or ex post derivative litigation.  Under the equal opportunity rule. WHEN ARE DERIVATIVE SUITS IN SHAREHOLDERS INTERESTS?  Corporations pay premiums to insurers. The acquirer may expect to finance the control premium by extracting larger private benefits that the incumbent controller already does.4% of Gable Industries. The claim has to be shoe-horned into the above procedural-type claims. by putting the company s assets to more profitable uses.  Articulates the baseline rule Perlman v. 10. but the corporation has the right to insure itself of risk.38 per share. Hanson Holdings (p. Over the past 50 years. U. claiming that minority shareholders should have an equal opportunity to share in any premium paid for a controlling interest. conversion of a corporate opportunity. for $15 per share at a time when the Gable stock is selling for $7. Zetlin v. shareholders would be entitled to sell their shares to a buyer of control on the same terms as the seller of control.  It seems the corporation is paying itself and paying insurers and attorneys for the privilege of doing so.  In the absence of ex ante regulation. Feldmann (p.  Benefits and Costs of Shareholder Derivative Suits:  The suit may confer something of value on the corporation and the prospect of a suit can deter wrongdoing that might otherwise happen in the future. however. jurisdiction do not afford such a right. but do so only at the price of also reducing the number of efficient control transfers. Minority shareholder Zetlin brings suit challenging the transaction. 11.  However.  Investors can acquire control over corporations in two ways:  By purchasing a controlling bloc of shares from an existing control shareholder. is that sale of control is a market transaction that creates rights and duties between the parties. antitakeover defenses.1.  A critical tradition attacks both the fairness and efficiency of the market rule and proposes instead premiasharing alternatives.situation gross negligence/utter failure to follow reasonable procedure (NB: (ii) is not enough to get past a §102(b)(7) waiver. What shareholders do with their own property has been seen as their own business. or market rule.  Managers who control preclusive defensive tactics have a great deal of leverage to bargain on behalf of their shareholders.  A variety of regulatory measures directed at acquirors from minimum tender offer periods to mandatory cashout rights for minority shareholders mitigate the collective action problem of target shareholders and thereby reduce the risk of inefficient takeovers.

If a §203 waiver must be justified on the basis of a corporate benefit.  Reasoning: You can t sell to someone who you reasonably should know will exercise control to the detriment of the firm (market rule is thus qualified)  Gives legal support for according minority shareholders a claim on control premia. it will stifle transfers of control. Feldmann resigns with his directors to allow Wilport to take control of the board.000 $900 Private Benefit $100 $500 Net Firm Value $900 $400 Minority Share Price $10/share $4.  The premium price received by the seller of a control bloc amounts to an unequal distribution of gains. a decision to cooperate arguably requires a benefit for the corporation itself or the minority shareholders. thereby increasing the number of beneficial control transfers. The controller arranged to sell itself to the acquirer in lieu of selling the subsidiary. thereby excluding the subsidiary s minority shareholders from a premium deal. Inefficient Sales of Control  Inefficient Sale: 90 shares total: 45 trade in the market. CEO.  How Much Do Delaware Courts Really Believe in the Controller s Right to a Control Premium? In re Digex (p. Plaintiffs are entitled to recovery in their own right. Trial court finds that $20 per share was a reasonable value for a controlling block and rules for Feldmann.  Thus.Facts: Korean War triggers a steel shortage. 45 are held by the controller. If vigorously construed.g. and controller of 37% of Newport Steel shares. or adopt the equal opportunity rule. boards are frequently asked to cooperate with potential buyers of control. 428)  Facts: An acquirer first approached the board of the partly held subsidiary of the controller with a lucrative offer.. which the company could have used for its advantage (e. A Defense of the Market Rule in Sales of Control  Easterbrook & Fischel. The costs of deterrence are probably much lower than the costs of dealing with looting through a system of prior scrutiny that would scotch many valuable control shifts as a byproduct.56/share. or $12. Corporate Control Transactions  Investors welfare is maximized by a legal rule that permits unequal division of gains from corporate control changes. here.  §203 prevents a party who purchases control of Delaware corporation from pursuing a cash-out merger to eliminate minority shareholders for a period of three years unless the company s board approves ex ante or certain other technical requirements are met.2. which would entitle minority shareholders to sell their shares on the same terms as the controlling shareholder. but the controller violated a duty of fairness to minority shareholders when it pressured the subsidiary s board to waive the applicability of DGCL §203 in order to facilitate its sale.  Efficient Sale:  . this unequal distribution reduces the costs to purchasers of control (because the purchaser need only buy the control bloc and not all shares at the higher price). as the likelihood of improvements in the quality of management declined. but a semi-official price freeze and rationing of steel supply prevent steel suppliers from directly extracting gains.44/share Analysis: Old Controller values the stake at $450 + $100 = $550. However.22/share. too. in violation of his fiduciary duty to the corporation. Some steel sources gain nevertheless by obtaining interest-free loans in exchange for commitments to sell steel later. the board must either conclude that the transfer itself is good for the corporation or must extract some benefit from the controller to justify cooperation. or $15. The old controller is asked to sell to a new controller: Looter Old Controller Total Firm Value $1.  Holding: The controller was entitled to use its voting power as a shareholder to block a deal between the subsidiary and the acquirer. he is accountable to the minority stockholders. Looter values the stake at $700. instead of in right of the corporation. and increasing the incentive for inefficient controllers to relinquish their positions. for $20 per share when the stock is trading at $10-$12.  Holding: To the extent that Feldmann s price included a bonus. subject to the constraint that no investor be made worse off by the transaction. 11. Feldmann is director. The shareholders of Newport bring suit alleging that Feldmann sold a corporate opportunity (control over steel supply) for personal gain.  Reasoning: The board may waive the §203 constraint only for the benefit of the corporation and all of its shareholders not just its controlling shareholder.  If we treat control as a corporate asset. this norm seriously weakens a controlling shareholder s entitlement to the whole of a control premium.1.  Even when §203 is not at issue. an end-user of steel.  Efficient vs. minority shareholders would suffer. which would require that premiums paid for control go into the corporate treasury. Feldmann sells his stake to Wilport Syndicate.  The best remedies for looting are based on deterrence rather than prior scrutiny. through the Feldmann Plan ).

Gregg Size of Control Block Premium Received by Seller 9. if it looks like sale of corporate office. Muscat (p. Carter (p. a duty devolves upon the seller of a control stake to make such inquiry as a reasonably prudent person would make and generally exercise such care so that others who would be affected by his actions should not be injured by wrongful conduct. 11. 45 are held by the controller. and that Carter should have been alerted by the suspicious financial statements that Mascolo offered for ISA.438) Directors re-elected by shareholders 4% 35% Fate of CEO fired by board Newcomer(s) Holding Upheld Disgorgement of control premium  It is better to: have significant control block (keeps ownership united with control). Minority shareholders bring suit against the Carter directors alleging that ISA is a totally bogus firm.250 Minority Share Price $4. LOOTING Harris v.  Holding: A stockholder of the company successfully sued Gregg derivatively and forced him to disgorge his control premium to the company. low likelihood of looting) 11. which is insufficient.  The law tracks functional reality. 11.350 $100 Private Benefit $500 Net Firm Value $400 $1. it would also stifle efficient ones.  Holding: Where circumstances would alert a reasonably prudent person to a risk that the buyer is dishonest or in some material respect not truthful. Carter directors resign from the Atlas board and Mascolo takes over.350/90 or $15.2. Gregg (p. Muscat Brecher v. The seller must act reasonably. Minority shareholders bring suit against the Mascolo directors alleging that they looted all of Atlas assets: diluting minority interest in Atlas by issuing Atlas stock for worthless ISA stock.00/share. not purchase of corporate office). even though you can sell shares that will give someone the right to appoint nominees to corporate office. We impose penalties on Carter rather than solely on looters because they are likely to be judgment proof. the deal goes through. Carter seems to be the least-cost-avoider. Under EOR. Efficient Buyer can offer up to $1.  Comparison: Carter v.89/share Analysis: Looter values the stake at $15. buying a worthless chemical company owned by Mascolo. TENDER OFFERS: THE BUYER S DUTIES .  Carter v. While a strict liability standard would better discourage inefficient transfers. but the company s board soon rebelled and fired the buyer s handpicked CEO. Pursuant to agreement. in exchange for his promise to secure the appointment of the buyer s candidate as the company s new CEO and the election of two of the buyer s candidates to the board of directors.7% slightly above market (AKS p.  Holding: The court upheld the re-election of the new directors at the annual shareholders meeting  Brecher v. Gregg temporarily delivered. which Looter values at $700. the CEO of a public company. because Efficient Buyer can bid up to $725 for Looter s stake. Looter Efficient Buyer Total Firm Value $900 $1. 428)  Facts: The board of the Republic Corporation appointed a new slate of directors as part of a transaction in which the company s management sold a 9. In this case.56 per share (see previous). Comes before the Chancery Court on a motion to dismiss. with a negligence standard.4. at least in comparison to minority shareholders.  Reasoning: Paying a premium for control while purchasing only 45 of a company s outstanding shares is contrary to public policy and illegal. received a 35% control premium on the sale of his 4% block of stock.7% block of its stock to a new controlling person at a price slightly above market. because we want to unite ownership and control. 429)  Facts: Carter Group exchanges its 52% in Atlas for the Mascolo Group s stake in ISA. keep control premium low (premium is for control. be reelected (a sign that shareholders approve.90 shares total: 45 trade in the market. and engaging in various other self-dealing transactions.3. Under market rule.44/share $13. it probably is.  Reasoning: This standard is similar to tort law liability. SALE OF CORPORATE OFFICE  Basic rule: You can t sell corporate office. 429)  Facts: Gregg.

In the face of a hostile target. e. 439)  Facts: Sun Company buys 34% of Becton Dickinson in a brilliantly designed lighting strike : simultaneous phone calls to 30 large institutional shareholders and 9 wealthy individuals. A premium over the prevailing market price 4. at a fixed price substantially above market but left open only for one hour. so an investor who wishes to purchase a control stake in a widely held company must do so by aggregating the shares of many small shareholders. . (2) a conventional tender offer.Large public companies in the United States generally do not have a controlling shareholder. Edper buys another 14% the next day. and (3) private purchases. Whether the offer is open only for a limited period of time 7.  Updating requirement (Rule 13d-2): must amend 13D promptly on acquiring material change (~ +/. Connacher contacts 30-50 institutional investors and 10-15 individual investors and buys 10%. vote. precede or accompany a rapid accumulation Brascan Ltd.  Basic Rule (Rule 13d-1(a)): investor must file a 13D report within 10 days of acquiring 5%+ beneficial ownership. group is anyone who acts together to buy. v. Gottlieb felt this required that those solicited be limited in number. all purchases must be made at the best price  14d-7: Shareholders who tender can withdraw while tender offer open  14e-5: Bidder cannot buy outside tender offer  These provisions work together to protect shareholders from high pressure sales tactics. Whether the offer is contingent on the tender of a fixed minimum number of shares 6. including any subsequent going-private transactions. but within those limits the lawyers felt there would be no problem. Edper Equities Ltd. The solicitation is made for a substantial percentage of the issuer s stock 3. give management time to respond.  The Williams Act sought to provide shareholders sufficient time and information to make an informed decision about tendering their shares and to warn the market about an impending offer. deceptive. Lipton] and Charles Nathan of Cleary. Each group member deemed to beneficially own each member s stock. The lawyers wanted to structure a privately negotiated transaction. without further announcement. and give competitors the opportunity to engage in a bidding war.1%)  Key Definitions: beneficial owner means person with the power to vote or dispose of stock (13d-3(a)). .  General Disclosure: (§14(d)(1)): requires tender offeror to disclose identity and future plans.  . Whether public announcements of a purchasing program . The terms of the offer are firm rather than negotiable 5. or manipulative practices in connection with a tender offer. The regulatory structure of the Williams Act has four principal elements:  Early Warning System (§13(d)): requires disclosure whenever anyone acquires more than 5% of the stock. give shareholders and news media the opportunity to investigate a would-be purchaser. 435)  Facts: Edper owns 5% of Brascan (Canadian company) and is turned down when it proposes a friendly acquisition.g. In response to a demand from Canadian officials Edper announces that it has no plans to buy any more shares at that time. considering (1) open market purchases. Brascan brings suit claiming violation of 34 Act §14(e) and Rule 10b-5 (general antifraud provision). Whether the offerees are subjected to pressure to sell their stock 8.  The buyer might approach the largest of the small shareholders singly. Partial exemptions for Qualified Institutional Investors and passive investors. the other argued for an upper limit of 40. equal treatment.  Holding: The court develops an 8 factor test to determine whether a solicitation is a de facto tender offer subject to the requirements of the Williams Act. on April 30th. a conventional tender offer was not considered attractive. and any fraudulent. Fogelson [of Wachtell. bringing total stake to 29%. 13D reports tell you who you can buy from.  Eight factor test: 1. or the buyer might make a general offer a tender offer that is open to all shareholders.  Anti-Fraud Provision (§14(e)): prohibits misrepresentations. Dickinson (p. Wellman v. Edper engages Connacher to buy shares. (p. There was an extended discussion of strategy . It was felt that it would lead to competitive bidding which would make the desired acquisition more expensive.  Investors might want to keep their investment secret to avoid driving up the purchase price or triggering takeover defense mechanisms. One felt that up to 60 solicitees was safe.. Active and widespread solicitation 2.  14e-1: Tender offers must be open for 20 business days (helps lessen the pressure to rush into the decision without adequate information)  14d-10: Tender offers must be made to all holders. . nondisclosures. and each of the eight factors was present except widespread solicitation. mostly from them. Nevertheless. duration.  If you want to acquire a control stake. . or sell stock (13d-5(b)(1)). The lawyers indicated that the law regarding tender offers was still murky and that the concept of a tender offer had not been precisely defined.  Terms of the Offer (§14(d)(4)-(7)): governs the substantive terms of the tender offer.

 One example is a squeeze-out merger. The surviving corporation subsequently owns all of the property and assumes all of the obligations of both parties to the merger. Following an acquisition. at the expense of its minority shareholders.1.  Another form of opportunistic merger is one that creates market power in a particular product market and thus allows the postmerger entity to charge monopoly prices for its output. usually with shareholder approval.  An RMBCA share exchange closely resembles certain kinds of mergers in its legal effects.  Acquisitions comprise a generic class of nonmerger techniques for combining companies. Suspect Motives for Mergers  There are also opportunistic motives to enter mergers that increase shareholder value or management compensation at the expense of another corporate constituency. The law of M&A transactions provides quick and inexpensive ways to reform the partitioning and management of corporate assets.2.2. in which a controlling shareholder acquires all of a company s assets at a low price. because investors can diversify on their own) 12.5. thus reducing the average fixed cost per unit of output. There are three legal forms for such transactions: the merger.  An acquirer with assets or sales > $106 million and a target with assets or sales > $11 million (or vice versa). and Diversification  M&A transactions are often said to generate value for three other reasons:  Tax: Corporations with tax losses may set those losses off against income in subsequent years. A corporation that lacks sufficient income might prefer to find a wealthy merger partner rather than waste its NOL. or forward. the acquiring corporation may or may not assume liability for the obligations of the acquired company.  From a corporate law point of view. INTRODUCTION  Among the most important transactions in corporate law are those that pool the assets of separate companies. Integration as a Source of Value  Gains from integrating corporate assets arise from what economists term economies of scale. it is important because of the waiting period the HSR imposes before a bidder can commence her offer (similar to a stricter §13(d) requirement). Agency Costs.2. a special form of economies of scope. This ability to carry an NOL is valuable only if its owner has sufficient taxable income to absorb it. 12.  Economies of scope spread costs across a broader range of related business activities. it becomes more likely that an outsider buyer can profit by purchasing a controlling block of stock and replacing the incumbent managers. if the deal involves assets or securities > $53 million.3.1.  May be extended for another 30 days (10 days for cash tender offers) if DOJ or FTC makes a Second Request (§18a(e)(2))  Who must file ((§18a(a)(2)):  The acquirer in all deals > $212 million. which generally involve the purchase of the assets or shares of one firm by another. This source of efficiency often explains horizontal mergers between firms in the same industry.2. the purchase (or sale) of all assets. 12.  Minimum waiting period before closing a transaction (§18a(b)(1)(B)):  30 days for open market transactions. Contracting through the market can be expensive.  15 days for cash tender offers. 12. toward its customers.  Diversification: M&A transactions are sometimes said to increase corporate value by diversifying a company s business projects.  Agency Costs: As a company s stock price declines because the market anticipates that its incumbent managers will mismanage in the future.2. ECONOMIC MOTIVES FOR MERGERS  The corporate form partitions business assets into discrete pools under the management of particular management teams. THE HART-SCOTT-RODINO ACT WAITING PERIOD  Designed to give the FTC and DOJ the opportunity to block deals that violate anti-trust laws.Holding: Not a de facto tender offer Reasoning: It only clearly met one Wellman factor solicitation made for large % of the target s stock (but arguments in the opposite direction are quite plausible) 11. Other Sources of Value in Acquisitions: Tax.   . mergers and negotiated deals. and vertical integration. thus smoothing corporate earnings over the business cycle (but this shouldn t add value. toward its suppliers.  A merger is a legal event that unites two existing corporations with a public filing of a certificate of merger. 12.  Realizing maximum returns from replacing managers will generally require that the target company merge with a subsidiary of the acquiring company. may arise by merging a company backward. scope.  Vertical integration.  Economies of scale result when a fixed cost of production is spread over a larger output. FUNDAMENTAL TRANSACTIONS: MERGERS AND ACQUISITIONS 12. and (in RMBCA jurisdictions) the compulsory share exchange.

but managers may have incentive problems.  Beginning around 1840. then the law must preclude unilateral amendment of the charter by the board. Delaware and many other states allow mergers to proceed with the approval of only a bare majority of the outstanding shares.  Today.  . it has been possible under state law to construct a cash-out merger. while acquirers break even.  Thus. When Mergers Were Rare  Mergers were rare until roughly 1890 because legislatures created business corporations by special acts of incorporation and shareholders naturally lacked the power to amend these legislative charters. 12. however. neglecting intangible costs. but purchases of assets do not require them to do so. shareholder must approve both corporate dissolution.3. but until around 1890. CORPORATE LAW OF MERGERS  The history of U. in which shareholders can be forced to exchange their shares for cash as long as the procedural requirements for a valid merger are met. the basic charter of the corporation. and corporate mergers. or lose on average.S.  Rationally.  Originally shareholders of a merging company could receive only equity in the surviving company in exchange for their old shares.Finally.  Sales of substantially all assets require a vote by the target s shareholder.  If it is useful for investors to be able to rely on any constraint in the charter. Under the mid-century statutes. principals will reserve power to veto those matters that are most economically significant and in which they have some capacity to exercise informed judgment. the range of possible forms of consideration moved beyond securities in the surviving corporation to include all forms of property most notably cash.2.4. in which the surviving corporation s charter may be amended. merged enterprise.  Targets generally win. states greatly liberalized the permissible forms of merger consideration. which nullifies the corporate charter. these criteria suggest that dispersed shareholders will wish to decide at most only very large issues (those that affect their entire investment) and will wish to decide only issues that they can be expected to decide with some competence ( Investment-like decisions rather than business decisions).  In the corporate context. providing that they were recommended by the board and approved by a majority of a company s shareholders. stat incorporation law barred shareholders from amending their charters (which a merger would require) without unanimous consent. states established the shareholders right to dissent from a proposed merger and demand an appraisal or judicial determination of the cash value of her shares as an alternative to continuing as a shareholder in the new. measured by immediate stock market price reaction to the merger s announcement. mergers do create value. Common errors include underestimating the costs of overcoming disparate firm cultures.3. The general contours of corporate law follow this logic.4. 12.  To protect investors reasonable expectations. such as the labor difficulties that might follow wholesale layoffs.2. mistaken mergers destroy value because their planners misjudge the difficulties of realizing merger economies. and who has the best incentives  Managers will generally have much better information regarding a company s business and all of its proposed transactions. on average. except where fiduciaries duties were triggered. 12.  It is a universal requirement that shareholder approve material amendments of the articles of incorporation. Do Mergers Create Value?  The general weight of the evidence indicates that. Toward the end the nineteenth century.3. 12. merger law is one of constantly loosening constraints.1. The Modern Era  Technological change in the last decades of the nineteenth century increased the efficiency scale of many injuries. from at least mid-century onward. except the acquiring company s shareholders do not vote when the acquiring company is much larger than the target (DGCL §251(b)).  In the mid-twentieth century. corporation statutes were amended to permit mergers and charter amendments that received less than unanimous shareholder approval. The fundamental move in this evolution occurred when the law became willing to treat equity investors as a class of interests that could. and failing to anticipate the added coordination costs that result merely from increasing the size of a business organization. the law must provide a shareholder veto over all transactions that might effectively amend the charter.  Mergers require a shareholder vote on the part of both the target and the acquiring company. Thus. 12. the enactment of general incorporation statutes permitted shareholders to incorporate on their own initiative.  In exchange for removing the unanimous shareholder consent requirement.S. be adequately protected by majority vote and a right to a statutory appraisal of fair value. THE ALLOCATION OF POWER IN FUNDAMENTAL TRANSACTIONS  The merger is the most prominent among a handful of corporate decisions that require shareholder approval.  Two major considerations ought to determine the allocation of decision-making power within organizations: who has the best information. THE EVOLUTION OF THE U.

4.5.. A may be liable for cleanup expenses. which requires shareholder approval Katz v. alleging that shareholder vote is required because the deal sells all or substantially all of its property and assets.The M&A transactions that require shareholder approval are those that change the board s relationship to its shareholders most dramatically. We allow A s shareholders to vote in some circumstances because their holding may be diluted if > 20% shares are issued. and 52% of its operating income.  A sale of substantially all assets is a fundamental transaction for the selling company. T assets merge into A. a. Plant Industries decides to sell its Canadian operations (Plant National). If A pays T s shareholder with cash in acquisition of assets. A(cquiror) & T(arget) boards negotiate the merger 2. paying cash avoids triggering the vote requirement. Certificate of merger is filed with the secretary of state. Idea is to take the proceeds and shift to a different line of business (making plastic drums instead of steel drums). 45% of its revenues. A gets a carryover basis  In each of these transactional forms.5. Dissenting shareholders who had a right to vote have appraisal rights. A shareholder vote if A stock outstanding increases by > 20% (§251(f)). negotiate covenants.  Some caveats. if T s assets constitute hazardous environmental conditions. If we didn t have these caveats. even though Universal offered a higher bid. 2.1. fix price and terms of payment.A and T -. a. or (3) the acquirer can merge itself or a subsidiary corporation with the target on terms that ensure its control of the surviving entity. T shareholders always vote (§251(c)). Plaintiff shareholders seek an injunction against the deal. OVERVIEW OF TRANSACTIONAL FORM  There are three principal legal forms of acquisitions: (1) the acquirer can buy the target company s assets.  The purchase of assets presents a standard set of contracting problems.  In an asset acquisition. 453)  Facts: As part of a broader divestment strategy. it doesn t need the shareholders of A to vote in favor of the merger. much more than ½ is required to mean  . Transaction costs are generally higher because title to the actual physical assets of the target must be transferred to the acquirer. reducing the ability of shareholders to displace their managers after the transaction is completed.  Statutory Merger (DGCL §251): 1. Bregman (p.g. it would be easy to avoid liability in these circumstances. Plant CEO Bregman agrees to sell Plant National to Vulcan.  Mergers vs.  Each form has particular implications for the acquisition s transactions costs (including its speed). Once again. aggregate acquisitions can be quite large. and in the case of purchasing a large firm.  Holding: ½ means all  Reasoning: Court appears concerned that CEO was selling the subsidiary to the second-highest bidder and used ½ means all to require a shareholder vote. selling corporation usually liquidates the consideration received (e. however: if T s assets constitute an integrated business. conduct due diligence. (2) the acquirer can buy all of the target corporation s stock. 3. A may be hit with successor liability under tort claims if T has dissolved and paid out a liquidating distribution to its shareholders. Asset Acquisitions:  While a merger unites assets and liabilities. potential liability costs. In most cases. while in a merger. T shareholders (traditionally) receive A stock. the boards of the two firms -. rather than size or shareholder competence. the acquirer can use cash. only T s shareholders get voting and appraisal rights (because only T is being bought ). asset acquisition allows A to accede only to T s assets but not T s liabilities. and tax consequences. which constitutes 51% of its assets. 12. Asset Acquisition  The acquisition of a business through the purchase of its assets has a relatively high transaction cost (but a low liability cost). or any other agreed-upon form of consideration. Even if it s is on the NYSE. establish representations and warranties. its own stock. are the binding functional determinants of when the law requires a shareholder vote. 3. which usually requires shareholder vote whenever new stock is issued. cash) to its stockholders.  Asset Acquisition (DGCL §271) 1. A gets a stepped up basis. Likewise. 5. After transfer. 4. Proxy materials are distributed to shareholders as needed (see below).negotiate the deal. transfer titles) is costly. But now. 12.  It seems possible that concerns relating to shareholder future control over managers. If majority of shares outstanding approves.  Each individual step (identify assets.

The acquiring company s stock (or other tender offer consideration) is then distributed to the target s shareholders pro rata. Moreover. acquirers typically do not want a small minority of public shares outstanding (there are costs to being a public company).  Mergers satisfying these conditions have too little impact on the surviving corporation s shareholders to justify the delay and expense of a shareholder vote. Mergers  A merger legally collapses one corporation into another. the company s stock.03 provides for a compulsory share exchange. or a majority of. Stock Acquisition  A second transactional form for acquiring an incorporated business is through the purchase of all. under compulsory share exchanges there are two survivors (this is functionally similar to a triangular merger).  NB: RMBCA does not require vote on the sale of assets unless the business does not continue to exist after the transaction (quite permissive to sellers over shareholders).  The first transaction is a tender offer for most or all of the target s shares at an agreed-upon price.  The stock exchanges and NASDAQ require a listed corporation to hold a shareholder vote on any transaction or series of related transactions that result in the issuance of common stock (or convertible preferred stock) sufficient to increase outstanding shares by 20%. CERBCO s public shareholders wanted CERBCO to sell Insituform. where there is one surviving corporations. where an asset accounting for 56% of the corporation s value was not substantially all because that means essentially everything ) Thorpe v. in effect. after approval by the requisite majority of shareholders. in which the boards of the target and the acquirer negotiate two linked transactions in a single package. an acquirer must purchase 100% of its target s stock. wanted to sell their controlling interest in CERBCO instead. however.  The voting stock of the surviving corporation is generally afforded statutory voting rights on a merger except when three conditions are med: (1) the surviving corporation s charter is not modified. 456)  Facts: CERBCO was a holding company with three subsidiaries. which is to follow the tender offer and remove minority shareholders who failed to tender their shares. but also on the qualitative effect upon the corporation. Intl.  Reasoning: The need for shareholder approval is to be measured not by the size of the sale alone. the board will in most instances call a shareholders meeting to obtain shareholder approval of the merger. not merely a control block. The management teams of the corporations.substantially all (see Hollinger.  Unlike a merger. After the board formally authorizes the execution of this agreement. comprising 68% of CERBCO s assets. prepare a merger agreement for board approval.2. while the acquirer becomes the sole owner of all of the stock of the target. v Hollinger. Inc. 457). 12.  The result is a form of acquisition that receives the tax treatment of a tender offer without the attendant holdup problems of a true tender offer or the awkward residue of a minority of public shareholders.3. a tender offer negotiated with the target board of directors that.  Corporate law recognizes the legitimacy of the desire to eliminate a small public minority through easy-toexecute short form merger statutes. which allow a 90% shareholder to simply cash out a minority unilaterally. aided by lawyers and often by investment bankers. a valid merger requires a majority vote by the outstanding stock of each constituent corporation that is entitled to vote. would have been subject to a shareholder vote under DGCL §271. the stock exchange rules require approval of 50% of shares voting on the matter as opposed to 50% of outstanding shares. CERBCO s stock in Insituform comprised 68% of its assets and was CERBCO s primary income-generating asset. but Delaware does not.  The second transaction is a merger between the target and a subsidiary of the acquirer. CERBCO (p.  RMBCA §11.  Some states offer acquirers and willing targets the statutory device of a compulsory share exchange transaction.  When the parent owns >90% of each class of stock in a subsidiary.5. (p.5. .  In most states.  Holding: A sale of Insituform shares. 12. as a practical matter. the two-step merger. (2) the security held by the surviving corporation s shareholders will not be exchanged or modified: and (3) the surviving corporation s outstanding common stock will not be increased by more than 20%. becomes compulsory for all shareholders.  The voting common stock of the target or collapsed corporation always have voting rights. Unlike corporate statutes.  Two-Step Merger  Delaware instead has a hybrid acquisition form that produces almost the same result. it can merge the subsidiary into another company without a shareholder vote all the parent must do is have the subsidiary s board adopt a resolution setting forth the consideration to be paid to the subsidiary s minority shareholders and approving the merger. The controlling shareholders of CERBCO. It is relevant to ask whether a transaction is out of the ordinary course and substantially affects the existence and purpose of the corporation. including Insituform. This is.  To acquire a corporation in the full sense of obtaining complete dominion over its assets.

STRUCTURING THE M&A TRANSACTION  To choose the right structure for an M&A transaction. a merger is effectuated by filing a certificate of merger with the appropriate state office.  The acquirer has a strong incentive to preserve the liability shield that the target s separate incorporation confers. which are designed to protect friendly deals from hostile interlopers.6. 12. Due Diligence.  By contrast. Covenants.Following an affirmative shareholder vote.4. as well as confidentiality provisions. Preserving the liability protection that separate incorporation provides to the acquirer is almost always a highly desirable business goal. and (2) fiduciary out provisions. 12. An all-cash tender offer may be consummated 20 business days after commencement under the Williams Act. which. a merger will generally require a shareholder vote of at least the target shareholders. shareholder votes and appraisal rights are costly and potentially risky. Consents. reverse triangular mergers are the cheapest and easiest methods of transfer because they leave both preexisting corporations intact.5. the acquirer (A) creates a subsidiary (S). the two-step structure generally does not provide a significant timing advantage because the stock to be issued generally must be registered with the SEC.  . including costs. which will have been approved by the shareholders as part of the merger vote.  Planners will attempt to choose a structure that minimizes the cost of obtaining regulatory approvals or consents under contracts needed to close the transaction.  If stock constitutes any part of the deal consideration. This can easily be done by merging the target into a wholly owned subsidiary of the acquirer (or by merging the subsidiary into the target). Ordinarily. 12. Planning Around Voting and Appraisal Rights  From the planner s perspective.  No matter which company (S or T) is the survivor. Representations and Warranties. Regulatory Approvals. In practice.6.  In negotiated transactions. Triangular Mergers  The surviving corporation in a merger assumes the liabilities of both constituent corporations by operation of law. 12. Timing  An all-cash. and Title Transfers  In a sale of assets.  In this structure. 12. and threats from alternative acquirers. and client must consider the interaction of many variables.4. since these votes may enable the holders of such securities to extract a holdup payment in exchange for allowing the deal to proceed. information known and unknown. its charter can be restated at the merger to include the governance terms and capital structure that parties deem desirable. 12. will involve several months for clearance of the proxy materials with the SEC and solicitation of proxies under the proxy rules.3.  Shareholders who disapprove of the terms of the merger must dissent from it in order to seek. as an alternative. title transfers may impose substantial cost and delay. Thus. The merger agreement will be entered into by all three parties. planners will choose a structure that voids or minimizes such requirements. accounting treatment. Stock purchases are much simpler to conclude than asset purchases.6.  The maintenance of the liability shield is the premise for the triangular merger form.  There may also be standstill agreements.6. Planners will wish to make the transfer of corporate assets as cheap as possible. The governance structure of the surviving corporation may be restructured in the merger through the adoption of an amended certificate of incorporation and bylaws. which bar hostile activity before the agreement is closed.2. in turn. the merger consideration will not be transferred first to the S but will be distributed at the closing of the transaction directly from A to the holders of T s shares in consideration of the cancellation of those shares.  Merger agreements may contain specialized provisions not found elsewhere: (1) lock-up provisions. a judicial appraisal of the fair value of their shares. which will own all of T s assets and liabilities. Thus. and Indemnification  Hostile takeovers will rarely provide much opportunity for due diligence. multistep acquisition is usually the fastest way to lock up a target and assure its complete acquisition.  A will own all the stock of S. A transfers merger consideration into S in exchange for all S s stock. the lawyer.  T then merges into S (forward triangular merger) or S merges into T (reverse triangular merger).  At the time of merger. regulatory hurdles. liabilities. which takes several months to complete.  Planners are particularly wary of structures that trigger class votes for holders of preferred stock. most deals using 100% stock consideration are structured as one-step director or triangular mergers. merge consideration is distributed to T s shareholders and T s stock will be cancelled. Risk and uncertainty will accordingly be greater. the representations and warranties contained in a merger agreement will facilitate the due diligence process by forcing the disclosure of all the target s assets and liabilities. speed. banker.1.6.

Up to 20% boot allowable.  A typical covenant offered by a target in a merger agreement will provide that the business will be operated only in the normal course from the date of the signing of the agreement to the closing. stock acquisition): A acquires solely in exchange for its voting stock (or the voting stock of its parent) at least 80% of T s stock. Compliance with these provisions makes these transactions nonrecognition events.6. in economic substance. which is not amortized but rather subject to a periodic assessment for impairment.  Qualifying a transaction as a tax-free reorganization under one of these provisions generally means that there is no recognition of gain by sellers except to the extent they receive boot.  Another typical covenant will require the target to notify the buyer if it learns of any event or condition that constitutes a breach of any representation or warranty. No boot allowed.  In addition.Target warranties and representations are particularly useful when there is a solvent corporation or individual to stand behind them. TAXATION OF CORPORATE COMBINATIONS 12. Accounting Treatment  In a direct merger. asset acquisition): A acquires substantially all of T s assets in exchange for A s stock. Deal Protections and Termination Fees  Among the most important terms of a friendly merger agreement are those terms that are designed to assure a prospective buyer that its investment in negotiating in good faith with a target will result in a closeable transaction.  The reorganization must satisfy the continuity of business enterprise requirements.6. An A reorganization must meet three principal requires in addition to being a merger or consolidation under state law:  There must be a business purpose. 12. merely reorganize ownership interests without fundamentally changing the identity of the owners.6.  The reorganization must satisfy a continuity of interests test. the consideration that A uses to acquire control must be solely or predominantly stock:  IRC §368(a)(1)(A) ( A Reorg . the surviving corporation will typically record the assets acquired at their fair market value. statutory merger): mergers & consolidations executed pursuant to state law.S. provided that A s stock must constitute a substantial and meaningful portion of the total consideration.7.  The shareholders of the target corporation will generally realize a gain or loss upon the sale or exchange of their stock in either an individual transaction or a corporate transaction. 12.8. 12.7. Tender offers last 20 days. To the extent that the merger consideration exceeds this amount. the survivor will record the excess as an intangible asset. not merely a tax avoidance purpose for the test.  Section 368 delineates three ways of obtaining control over a business. The agreement will effectively allocate the burden of undiscovered noncompliance to the party making the representation.5.  Sellers will take a carryover cost basis in the stock they receive and buyers assume the carryover basis of the transferors in the target stock or assets they acquire.1. which includes gains in the value of investments as they are realized and recognized.  Every U. Basic Concepts  Federal taxes are levied on income. History and Theory  The shareholder vote is the shareholders principal protection against unwise or disadvantageous mergers or other fundamental transactions. An important aspect of tax planning for M&A transactions is to attempt to defer the recognition and realization of any realized shareholder gain. a standard covenant is a pledge by the target to use its best efforts to cause the merger to close (usually subject to a fiduciary out).7.8.  An A reorganization offers great flexibility to the corporate planner. goodwill. the parties will customarily indemnify each other for any damages arising from any misrepresentation or breach of warranty.  The federal income tax code contains specific provisions defining the characteristics of tax-free reorganizations. Because the concept that drives the §368 safe harbor is continuity of ownership. 12. 12. while M&As take at least 3 months. where control is acquired through any method from a single entity or small group. Tax-Free Corporate Reorganizations  The Code does not recognize taxable gain for transactions that.  IRC §368(a)(1)(C) ( C Reorg . jurisdiction provides an appraisal right the right to a judicial appraisal of the fair value of one s shares to shareholders who dissent from qualifying corporate mergers.1.  Warranties and representations have their greatest use in private deals that is.  IRC §368(a)(1)(B) ( B Reorg .  Additionally. the target is a sitting duck).  Acquirers tender before merging to keep out hostile bidders (between the time the merger agreement is signed until the shareholder vote. Up to 50% boot allowable. The acquirer uses a tender offer to prevent others from purchasing control of T. THE APPRAISAL REMEDY 12.2.  .

you must forego merger consideration and wait for settlement of the claim. who previously could have prevented the alteration of her investment simply by vetoing a proposed merger.0 million shares. Cede & Co. and if he fails. Hedge funds and arbitrageurs owned 2. however.  In most aspects. The Appraisal Alternative in Interested Mergers  Today the appraisal remedy tends to be invoked either in nonpublicly traded firms or in transactions in which shareholders have structural reasons to think that the merger consideration may not be fair value.  M&A Deal Commentary (May 2007): A likely effect of this decision will be to encourage aggressive investors (for example. the possible remedies are very broad.  In a fiduciary fairness action. arguably because without conflicts of interest.  With increased liquidity of equity markets.  It is often said that the appraisal remedy was granted as a quid pro quo when legislatures first permitted the authorization of mergers to be effectuated with less than unanimous shareholder approval. 4. UOP. an appraisal action is easer for shareholders to bring. TKT sought summary judgment on the grounds that the hedge funds must prove that each share that they seek appraisal for was voted against the merger. then bought 8.  In some aspects. 12.  The appraisal remedy is rarely invoked in arm s-length mergers. If merger is approved. Court holds appraisal hearing.  The law has also provided an equitable remedy in the form of fairness review when minority shareholders challenge the self-interested transaction.  Traditional law dealt with the overlap between an appraisal and a suit for breach of fiduciary duty by making appraisal the exclusive remedy of shareholders who complained that the merger consideration was inadequate or unfair. hedge funds and arbitragers) to examine every cash merger in Delaware for suitability for appraisal claims with the goal of either negotiating a settlement of the claims after the merger or convincing an appraisal court that the value of the shares was higher than the merger price.9 million in favor of the merger and voted against or abstained with 16. On the record date (June 10. most arm s-length mergers achieve something close to market price.0 million shares. some judicial remedy to assure fairness is necessary. and then votes against (or at least refrains from voting for) the merger (§262(d)(1)). In re Transkaryotic Therapies (not in CB)  Facts: Slim majority of Transkaryotic (TKT) shareholders approve the sale of their company to Shire Pharmaceuticals for $37 per share cash. the question is whether there are other justifications for this remedy that give it continuing utility for publicly-traded firms.8.8 million shares.  Setting Up an Appraisal Claim (DGCL §262): 1.9 million shares through Cede and voted against the merger.  Any merger involving a self-interested controlling shareholder continues to provide a compelling justification for the appraisal remedy or something like it.  Plaintiffs can bring a fairness action as a class action on behalf of all affected shares and not just the small minority who will typically dissent from the merger and seek appraisal. and voted 12.  Importantly.7 million shares.1 million shares through Cede before the close of the deal and sought appraisal for all 11.  A judicial appraisal was a way to provide a liquidity even for such a shareholder. 3. Unocal Exploration (p.  Where there is a controlling shareholder or some other reason to doubt that the shareholder vote fairly reflects the independent business judgment of a majority of disinterested public shareholders.  Weinberger v. shareholder files a petition in Chancery Court within 120 days after merger becomes effective demanding appraisal (§262(e)). an action alleging breach of entire fairness seems more favorable to plaintiffs.The Delaware corporate law statute mandates appraisal only in connection with corporate mergers and then only in certain circumstances (DGCL §262). Shareholders get notice of appraisal right at least 20 days before shareholder meeting (§262(d)(1)). Inc. (p. 477): Delaware Supreme Court modernized the appraisal remedy as to longform mergers by approving of the use of modern valuation techniques and by attempting to unite the appraisal remedy and the equitable action against a fiduciary.  A plaintiff in an appraisal proceeding is entitled to claim only a pro rata share of the fair value of the company without regard to any gain caused by the merger or its expectation. 477): Delaware Supreme Court held that appraisal is the exclusive remedy of minority shareholders cashed out in a §253 short-form merger. 2. Shareholder submits written demand for appraisal before shareholder vote. was holder of record for 29.  Glassman v. 2005).2.  The plaintiff need only establish her bona fides as a dissenting shareholder to seek appraisal and need not show that the board or a controlling shareholder breached a fiduciary duty.  Holding: Chancellor Chandler denies summary judgment and allows the shareholders to seek appraisal on all 11.  Shareholder Voting & Appraisal Summary  . the defendant must prove that a self-dealing transaction was fair in all respect.

02(a)) RMBCA §13. unless stock market Rights unless stock market exception (RMBCA exception (DGCL §262. with a projection of future cash flows and an estimate of the appropriate cost of capital for discounting those expected cash flows to present value.  After Weinberger.  The counterargument is that corporate law contains a large element of formalism. RMBCA §11. courts have accorded shareholder voting and appraisal rights to all corporate combinations that resemble mergers in effect. unless <20% shares Yes.  There is a de minimis exception for cash in lieu of fractional shares. if shares are traded.  Delaware courts and most U. but rather a source of utility that permits people to accurate predict the legal consequences of their activities. valued at liquidation value.02(a)(3)).S. courts take the formalist side of the argument. THE DE FACTO MERGER DOCTRINE  Some U. No in Delaware. 262(b)(3)) 12.  Thus. capitalized using a price-to-earnings ratio. Each side presents through an expert a detailed evaluation of the firm.02) Yes. or (iv) a combination of those items.03) Yes need majority of shares voted (RMBCA §11.  However. including the benefits from the deal.000 registered holders.  Asset Value: net assets. The Market-Out Rule  Section 262 of the DGCL grants the right of judicial appraisal to all qualifying shares of any class in a merger effectuated under the general merger statute (DGCL §251). Delaware law determined fair value for appraisal purposes by a technique known as the Delaware block method. this is not mere formality. this remedy is denied under the Delaware appraisal statute (and others see RMBCA §13.04(g)) Appraisal Yes if T shareholders vote.S.  Notwithstanding the above.02) Yes need majority of shares outstanding (DGCL §251(c)). appraisal is restored if target shareholders receive as consideration anything other than (i) stock in the surviving corporation. apply a minority discount. or majority of shares voted (RMBCA §11.  Additionally.  Delaware law clearly defines the dissenting shareholder s claim as a pro rata claim on the value of the firm as a going concern.01-. These courts have reasoned that when a de facto merger has the same economic effect as a de jure merger. the discounted cash flow (DCF) method became the most common valuation technique in appraisal cases.T Voting Rights Statutory Merger (DGCL §251.02(a)) No (though stock exchange rules might require vote to issue new shares) Yes under RMBCA if T shareholders vote. 12.000 shareholders have no appraisal rights in a stock-for-stock merger. §13. unless provided in charter (DGCL §262(c)) Share Exchange (RMBCA §11.  This is equivalent to the market-out rule (2) value as pro rata claim on going concern value. if all or substantially all assets are being sold (DGCL §271(a)) or no significant continuing business activity (RMBCA §12. that is. that is. shareholders should have the same protection.8.  It is difficult to justify withholding appraisal in stock-for-stock mergers when shares are publicly traded but granting appraisal rights in cash-out mergers. 12. Yes.04(e)) Yes. Also get appraisal rights in shortform mergers (DGCL §§ 253(d).9. Traditionally. This technique examined a number of factors relating to a firm s value including:  Market Value of Shares: share price.8. or (3) value as pro rata claim on going concern value. A Voting Rights . (iii) cash in lieu of fractional shares. being issued (RMBCA RMBCA §11.02).04(g)) §11. unless stock market exception (RMBCA §13.  Approaches to Valuation (in order of increasing desirability for dissenting shareholders) (1) value as minority shares. but shareholders in a public company with more than 2.02(b)) when shares of target corporations are traded on a national security exchange or held of record by 2. no minority discount but no claim on the benefits of the deal.3.04(e)) Asset Acquisition (DGCL §271. appraisal is denied if the shareholder were not required to vote on the merger.  Earnings Value: last three years of earnings. RMBCA §12. shareholders in a privately traded firm will always have appraisal rights. The Nature of Fair Value  The appraisal right is a put option an opportunity to sell shares back to the firm at a price equal to their fair value immediately prior to the transaction triggering the right.4. (ii) any other shares traded on a national security exchange. unless <20% shares being issued (DGCL §251(f).

e. Arco Electronics. and her exercise of control over the corporation or its property. All shareholders.  . 12. The shareholder knew this could happen.  Forms of Freeze-outs:  Merger  Tender offer  Reverse stock split  Asset acquisition  Most are statutory mergers. Such transactions often occurred when the pro rata value of the assets held by these companies far exceeded the market value of their minority shares. there are drawbacks. (p.  Cash-out mergers (or freeze-outs) reemerged as a controversial topic during the 1960s and 1970s when a period of low stock market prices followed after a boom in public offerings of stock. in addition to appraisal proceedings.  The SEC adopted Rule 13e-3 under the Williams Act specifically to require uniquely extensive disclosure in goingprivate transactions.  Controlled mergers expose minority shareholders to an acute risk of exploitation.1. Arco dissolves and distributes the Loral stock to its shareholders (i. classic asset acquisition for stock). Arco transfers all of its assets to Loral. have the right to vote their shares in their own best interest. but asset sales and reverse stock splits can also be freeze-out techniques.  The exercise of control gives rise to an obligation of fairness when the control does what other shareholders cannot (such as access non-public corporate information). which can arguably reflect her own selfish self-interest.A self-identified sale of assets that results in exactly the same economic consequences as a merger will nonetheless be governed by the (lesser) shareholder protections associated with a sale of assets and not the full panoply of merger protections.  Take-home: Functional rationales for appraisal rights are totally incoherent.10. Arco shareholder brings suit claiming right to appraisal because the deal was a de facto merger.  Why Permit Freeze-outs?  Efficiency firms that go private don t have to meet the reporting requirements that apply to public companies  Remove collective action problem  Eliminate majority-minority conflicts  Financing (a parent may want to own a subsidiary completely to use it as collateral in financing)  Eliminate the risk/threat of shareholder litigation  Enable more robust protection of (legitimate) private corporate data  While freeze-outs have value..10. Hariton v.  Reasoning: The Delaware legislature has decided to give appraisal rights to mergers but not asset acquisitions. challenging freezeout mergers on the grounds that the controlling shareholder breached its fiduciary duty of entire fairness to minority shareholders. the controlling shareholder sets up a dummy corporation that merges with the target firm and minority shareholders are cashed out (DGCL §251). and/or receiving a low price. The low stock value allowed many controlling shareholders to cash out public shareholders at prices substantially below the prices these investors had paid for the same shares a short time before. it will be a short-form merger.  In freeze-out mergers. Loral transfers its stock to Arco. which cannot. Treating this as a de facto merger with attendant appraisal rights is a slipper slope.  Singer v. THE DUTY OF LOYALTY IN CONTROLLED MERGERS  Controlling shareholders owe to the corporation and its minority shareholders a fiduciary duty of loyalty whenever the exercise any aspect of their control over corporate actions and decisions.  Appraisal isn t a perfect remedy here (why?) which helps to explain heightened judicial scrutiny in this area. Magnavox (not in casebook): Permitted shareholders to bring class actions. Minority shareholders are at risk of experiencing negative tax consequences. having their long-term interests frustrated. Cash Mergers or Freeze-Outs  Freeze outs are the ultimate conflicted transactions. if majority shareholder holds more than 90% of shares. Shareholders approve the transaction. 481)  Facts: Loral buys all of Arco in an arms-length asset acquisition after months of negotiating and two rejected offers. Thus. however. there is some tension between a controlling shareholders exercise of voting rights.  Established a per se rule: a freezeout without a colorable business purpose did breach entire fairness duty (and getting rid of minority shareholders doesn t count as a business purpose). primarily in the form of equity issues for minority shareholders and inefficient abuses of freeze-outs by a controller to extract value from minority shareholders. A cash-out even at a premium price allowed the controlling shareholders to capture a disproportionate share of the company s value. while courts wrestled with the task of protecting minority shareholders without banning freeze-outs altogether. 12. Inc.  Holding: The shareholder does not have a right to appraisal.

95 exchange ratio to the Lynch independent committee (IC). but DGCL §262(h) clearly say no). drop in value. brought as class action. Lynch board appoints a committee of independent directors to negotiate with Celwave. this is an attempt to make appraisal as valuable as entire fairness (because the court wants appraisal to be the only remedy. 486)  Facts: Signal owns 50. however. We require a higher standard of proof as to conflicted transactions involving a controlling shareholder than we do conflicted transactions involving senior officers because we think a single director probably can t sway the board.  Holding: The board did not meet its duty of entire fairness. If this was done. Plaintiff UOP shareholders bring a class action challenging the transaction as a breach of the UOP board s fiduciary duty. Signal directors Walkup and Crawford withdraw from the UOP board meeting approving the transaction. (p.  To protect a freeze-out. UOP CEO Crawford makes no effort to negotiate with Signal.  The court s attempt to make appraisal the exclusive remedy (outside of fraud. undoing Singer). Signal board decides to buy the remainder of UOP.  Suits for breach of fiduciary duty can be. Thomson McKinnon (IC s banker) concludes that 0. Arledge and Chitiea (UOP and Signal directors) write report that any price up to $24 per share would be a good investment for Signal.95 would overvalue Celwave.5% of UOP and holds six board UOP seats out of thirteen.2.  Appraisal Suit vs.  Unlike an appraisal suit. As a functional matter. which provides the plaintiff an opportunity to request a preliminary injunction. Lynch Communication Systems. but were involved in the negotiations up to that point (and persuade Crawford to sell the deal). (p. and lost opportunities. Lynch wants to buy Telco but supermajority provision gives Alcatel veto power and Alcatel proposes that Lynch acquire Celwave (owned by Alcatel) instead. misrepresentation. Signal board offers $21 per share. What Constitutes Control and Exercise of Control Kahn v. The following are helpful:  A vote of majority of minority of the shares  Independent negotiating committee it should make demands to demonstrate a real back-and-forth  Serious fairness opinion  Evidence of real deliberation and negotiation  New approach to valuation established. p. but allows it to continue to serve as a favor in determining entire fairness. They can t be bifurcated. Based on this advice. Breach of Fiduciary Duty Claim  Appraisal may not be available because of the market-out provision.  Ordinarily. Dillon Read (Alcatel s banker) recommends as 0. there is no such thing as a truly disinterested director. Inc. Inc. 494)  The court also rejects business purpose as a per se rule (again undoing Singer). ratification by disinterested directors triggers business judgment rule.  Plaintiffs claiming breach of fiduciary duty receive the benefits of the deal at closing even as they pursue the suit. and UOP board approves the offer with a hastily-drafted fairness opinion from Lehman Bros. Damages caused by the merger are included. in a controlled transaction. the freezor must show arm s-length bargaining.  Plaintiffs can bring a fairness action as a class action on behalf of all affected shares and not just the small minority who will typically dissent from the merger and seek appraisal.k. which affords counsel a means to get paid from the class settlement. a 55% premium over pre-bid market price. the standard Delaware block method is rejected in favor of proof of value by any generally-accepted techniques or methods of valuation. 52% of total outstanding minority shares approve the merger. UOP.  Reasoning: UOP should have appointed an independent negotiating committee of its outside directors to deal with Signal at arm s-length. Alcatel withdraws the Celwave proposal but makes an offer to  . Weinberger v. you can still bring a class action to challenge the entire fairness of a freeze-out merger (see Rabkin. 12. 497)  Facts: Alcatel owns 43. and self-dealing) is ineffective. The size of the group represented has a great impact on negotiating leverage and the fee expected by the lawyer.  Whether valuation includes a fair share of synergy gains available in the merger is unclear (The court seems to say yes. There are two components of entire fairness: fair dealing (procedural) and fair price (substantive). conditioned on approval by majority of the minority UOP shareholders. whereas a controlling shareholder would have the power to vote his wishes through (and/or fire directors who stand against him).a. the IC unanimously opposes a Celwave/Lynch combination. and most often are. the burden would shift to the plaintiff to show unfairness. the monetary equivalent of rescission.3% of Lynch Communications.Established that minority shareholders remedy was so-called "recissory damages" a.  The appraisal remedy is now recissory damages (making shareholders totally whole). Chancery Court rules for defendant directors. an action claiming breach of fiduciary duty can be brought before the effectuation of the merger. study is shared with Signal board but not with UOP. including tax consequences.10.

which then acts to accept the offer through its independent directors.  If a target s special committee is slow or negotiations break down. which merits review under the deferential business judgment rule or (2) continue to apply the entire fairness test. IC is reconstituted to negotiate with Alcatel.10. courts may (1) treat the special committee s decision as that of a disinterested and independent board. they can remain shareholder and force the controller to cash them out. Controlling Shareholder Fiduciary Duty on the First Step of a Two-Step Tender Offer  A controlling shareholder who sets the terms of a transaction and effectuates it through his control of the board has a duty of fairness to pay a fair price. Pure board has eight members: 5 Unocal designees. but finally recommends a $15. and finally recommends against the exchange offer to Pure s minority shareholders. and well-advised special committee of independent directors.4% stake in Siliconix. consisting of two Pure directors who are plausibly independent of Unocal. Vishay announces a tender offer at $28. a burden that is not met here. Lynch Communication Systems. as long as such an offer is not coercive. the controlling shareholder must still pay a fair price. Chancery Court rules for defendants because the IC had appropriately simulated a third-party transaction. contingent on getting to 90% ownership of Pure. 504)  Facts: Unocal Corp. The controlling shareholder does have a fiduciary duty to make adequate disclosures. Shareholders Litigation. In May 2001. as long as the tender offer is pursued properly. 12. the free choice of the minority shareholders to reject the tender offer provides sufficient protection.50 per share offer on threat of a hostile bid from Alcatel. and Pure minority shareholders bring suit seeking an injunction to block the offer. 504)  Facts: Vishay owns an 80. a controlling shareholder can go around the special committee by launching a tender offer. Lynch disinterested directors then approve the freezeout merger. . Vishay launches an exchange offer of 1.10. (p.acquire the remaining 56. In re Pure Resources. In short. in which event they will have the protection of an appraisal right.  If the controlling shareholder does not force a transaction on the board through the actions of his board appointees but merely offers the transaction to the board. where negotiations are conducted at arms-length and there is no compulsion to reach an agreement.5 shares of Vishay for each Siliconix share. Special Committees of Independent Directors in Controlled Mergers  Assuming a properly constituted.7% of Lynch at $14 per share cash. and (3) the controlling stockholder has made no retributive threats. . and 1 joint designee. the court seemed to suggest that even a truly independent committee decision could only shift the burden of proving the unfairness of the transaction to the plaintiffs.  An acquisition tender offer by a controlling stockholder is non-coercive only when: (1) it is subject to a nonwaivable majority of the minority tender condition. .  Reasoning: Entering such a transaction is voluntary on the part of minority shareholders. if they don t like the price. 12. however.  In Kahn v. Minority shareholder challenges the offer as an inadequate and unfair price. Unocal nevertheless goes ahead.  Holding: Attempting to meet the formalities required in Weinberger shifts the burden of proof to plaintiffs only if the independent committee is sufficiently independent. rejects $15. nonmanagement Siliconix directors who are unaffiliated with Vishay. Pure forms a Special Committee.82 cash (a 10% premium) for the remaining Siliconix stock. and Pure managers hold another 11%. although the burden lies with an objecting shareholder to prove its price unfair. Minority shareholders bring suit against the Alcatel directors alleging breach of fiduciary duty as controlling shareholder. Special Committee negotiates with Unocal. (2) the controlling stockholder promises to consummate a prompt § 253 merger at the same price if it obtains more than 90% of the shares. In February 2001.  Reasoning: This committee was not independent because the controlling shareholder was holding a gun to their head.  Holding: A shareholder who skips the board altogether and offers a transaction directly to the public shareholders in the form of a tender offer has no duty to pay a fair price. In re Siliconix Shareholder Litigation (p. wants to acquire the remaining 19.6%. diligent.4. the court gave to the action of the independent board committee the respect it would accord an action approving an arm s-length transaction. and requests the opportunity to discuss its tender offer with a special committee of independent. Chancery Court refuses to apply entire fairness scrutiny: Vishay was under no duty to offer any particular price. . Pure CEO Hightower holds 6%. however.00 as inadequate. Inc. Siliconix sets up a Special Committee consisting of two directors and negotiations begin. since a court cannot easily evaluate whether subtle pressure or feelings of solidarity have unduly affected the outcome of a committee s deliberation. even if the committee appears to have acted with integrity. 2 Hightower designees. or a fair price.3.  In In re Western National Corp. Unocal makes a surprise exchange offer at a 27% premium to market price. to the minority shareholders of Siliconix unless actual coercion or disclosure violations are shown. holds 65% of Pure Resources. fails to adopt a poison pill (that would give it veto power).

but claim that the board did not act in an informed manner in agreeing to the deal. by (at the very least) hiring their own advisors. and (3) the controlling stockholder has made no retributive threats. there were two avenues for initiating a hostile change in control: (1) the proxy contest the simple expedient of running an insurgent slate of candidates for election to the board and (2) the ender offer the even simpler expedient of purchasing enough stock oneself to obtain voting control rather than soliciting the proxies of others. PUBLIC CONTESTS FOR CORPORATE CONTROL 13. Unocal board meets to review the offer. (2) Directors response has to be reasonable in relation to the threat.1. as the law s acceptance of increasingly potent defensive tactics has made it difficult to pursue either avenue alone. This case is a duty of care outlier because it is an M&A transaction. The standard consists of two steps: (1) Directors had to have reasonable grounds for believing there was a threat to the corporation. finding that the directors had been grossly negligent. Van Gorkom (p. and corporate control transactions are subject to higher standard than the business judgment rule. (Directors can consider the impact of the takeover on corporate constituencies other than shareholders in deciding whether there was a threat to the corporation). is a publicly held company with unused NOL s (net operating losses) and a CEO (Jerome Van Gorkom) looking to retire. 513)  Facts: Trans Union Corp.  Holding: Intermediate standard of review (between lax business judgment review and tough entire fairness review) for defensive measures in hostile takeover settings.  Holding: Delaware Supreme Court reverses. Stock is selling for $35 per share. 13. the proxy contest and the tender offer have often merged into a single hybrid form of hostile takeover. Trans Union shareholder sues. which would then allow the hostile tender offer proceed. Mesa Petroleum Co. DEFENDING AGAINST HOSTILE TENDER OFFERS Unocal Corp. if successful in the first-stage tender offer. if Mesa gains 50% (and Mesa excluded from the offer). and then offers a lower price to those who get cashed out at the back  . 515)  Facts: Unocal stock trading at ~$33 per share.2. Mesa discloses its plan to freeze out the remaining 50% for junk bonds worth ~$45. Goldman reports to the board that the minimum cash value in a liquidation would be $60 per share cash.  Reasoning:  Practitioners have essentially stopped making two-tiered tender offers (where offeror offers to buy one set of shares in a tender offer at one price. Van Gorkom calls a special meeting of the board but does not give them an agenda beforehand. board approves the merger. providing the minority with a recommendation as to the advisability of the offer. (2) the controlling stockholder promises to consummate a prompt §253 merger at the same price if it obtains more than 90% of the shares. Mesa Petroleum (Pickens) quietly buys 13% of Unocal s stock and then makes a tender offer for another 37% at $54 per share in cash.Holding: Even a tender offer can be coercive. and they give target shareholders the opportunity to share in this new value. after two hour meeting. Smith v. Van Gorkom arranges a sale to Jay Pritzker s company for $55 per share cash. (p.  Reasoning: An acquisition tender offer by a controlling stockholder is non-coercive when: (1) it is subject to a non-waivable majority of the minority tender condition. and disclosing adequate information for the minority to make an informed judgment. Mesa brings suit to enjoin the defensive measures. making control contests an important potential constraint on manager-shareholder agency costs. The threat of a takeover has the salutary effect of encouraging all managers to deliver shareholder value. INTRODUCTION  Control contests give acquiring managers the opportunity to capitalize on the new value created by different plans or better skills. Chancery Court approves the transaction. Acting mainly on his own.  In recent years. 3-2. claiming breach of the duty of care. and tender for remaining 20%. v.  Details of fairness opinion methodology must be disclosed: Stockholders are entitled to a fair summary of the substantive work performed by the investment bankers  NB: These conditions apply only when the person launching the offer was a controlling shareholder at the outset of the offer.  Historically. finding that board approval fell within protection of the business judgment rule. 13. No allegation of conflict of interest.  Target board independent directors must have role: [T]he majority shareholder owes a duty to permit the independent directors on the target board free rein and adequate time to react to the tender offer.  Casebook Authors Interpretation: This is the first installment in a series of attempts by the Delaware Supreme Court to impose an intermediate standard of review on anti-takeover measures. and deal protection features. Board decides on a defensive recapitalization : self-tender for 30% of the shares at $72 per share in debt securities. and this offer was because its majority of the minority vote requirement included within the definition of the minority Pure stockholders who were affiliated with Unocal as directors and officers. also at $72 per share in debt securities.

 Poison pills are legal/fair because everyone gets the rights. the defendant gets a final opportunity to show entire fairness of the transaction.  Implementing a Flip In Poison Pill  Step 1: Shareholder approval is not necessary as long as the board has the requisite provision in the charter allowing it to issue blank check preferred stock. All rights holders are entitled to buy at the discounted (usually half) price.3. there s no breach of contract on the part of the corporation. except the acquirer. if he doesn t the flip over pill isn t effective. Unitrin appeals to the Delaware Supreme Court.  Sometimes the rights might not be distributed at all unless some event occurs  Alternative strategy  A pill with a higher triggering threshold is actually scarier to potential acquirers because it means you will lose even more when the pill is activated. then he has to suffer the consequences. almost every company has an implicit poison pill. or other securities in place of common shares if there aren t enough common shares available (because this number is limited by the articles of incorporation) Pyrrhic strategy. if not. then it is will satisfy Unocal so long as it is within a range of reasonable action (= business judgment rule).  Reasoning: Rearticulation of Unocal s Reasonable in Relation to Threat Requirement: 1. but strikes down the repurchase as disproportionate under Unocal. entrenchment. bear the burden of going forward with evidence to show that the defensive action was proportionate to a threat.  Step 2: Rights are distributed by dividend and remain embedded in the shares  Step 3: Triggering event occurs (it never does) when prospective acquirer buys > set percentage (frequently 10 to 15%) of outstanding shares.end) because if they make a coercive tender offer. 13. not the plaintiff. Unitrin s board resists by repurchasing 20% of its shares.  Assuming that a defensive measure passes the preclusive/coercive test (= not draconian).  Some corporations include provisions permitting distribution of cash. The Chancery court finds a threat of substantive coercion and upholds the pill as proportionate to the threat.  Not clear that this is legal.  NB: Boards no longer have discriminatory self-tenders as a take-over defense. e. and. (p.  Thus. Second step of Unocal is a two-part inquiry: was the defensive tactic coercive or preclusive. or being uninformed. assets.. American General Corp. If the defendant fails to show proportionality. whose right was cancelled.  Thus. Share repurchase increases the Unitrin directors stake from 23% to 28%.  Other Types of Pills  Flip over pill allows shareholders of the target other than the bidder the right to buy stock in the acquirer at a substantially discounted price. 3. 4. under Unical/Unitrin:  The target s directors. a court must not substitute its judgment for the board s. lack of good faith.  Step 4: Rights are exercised. Unitrin v. if the acquirer does something that disqualifies him from exercising his rights.  While commentators and institutional investors generally believe that hostile tender offers are a useful device for disciplining corporate management. managers themselves believe that vulnerability to hostile bids is a profound weakness in the corporate governance structure because it exposes disaggregated and disorganized shareholders to abusive tender offers. 2.  Action that is preclusive or coercive will fail to satisfy Unocal s test. In order to be effective. the acquirer must complete a merger. Rights are no longer redeemable by the company and soon become exercisable. it gives the target board license to take extraordinary defensive measures. does it fall within a range of reasonableness. If the defendant shows proportionality. 521)  Facts: American General makes a hostile takeover bid. but it remains highly controversial. burden shifts to plaintiff to show breach of fiduciary duty.  Chewable pill: pill disappears if fair price criteria are met  Slow hand pill: pill that may not be redeemed for a specified period of time after a change in board composition  Illegal in Delaware  Dead hand pill: pill that may only be redeemed by the continuing directors .g. Defendant directors have burden of showing proportionality. the following year the SEC banned discriminatory tender offers by both companies and outsiders.  Holding: Justice Holland reverses: [I]f the directors defensive response is not draconian (preclusive or coercive) and is within a range of reasonableness. PRIVATE LAW INNOVATION: THE POISON PILL  The invention of the poison pill was tremendously effective in preventing takeovers. and gives the board a solid veto power over a freeze-out transaction (due to 75% vote requirement for transactions with a >15% shareholder).

Selectica (p. Illegal in Delaware No hand pill: pill that may not be redeemed by current or future boards for the life of the pill (usually ten years).  Holding: The combination of poison pills and staggered boards is not preclusive of a change in control under the Unitrin standard. the corporation has a new owner. largest shareholder and potential acquiror. but reduced the trigger to 5% after Versata began threatening to take control. Moran. 533)  It s not about takeover defenses (Unocal). (emphasis added)  City Capital Associates Ltd. The recapitalization permits Revlon to subject itself to specialized debt covenants that restrict the sale of assets. Household International (p. Buyer can combine steps 2 and 3 by having the corporation assume the loan. on the advice of Wachtell. Revlon board adopts a poison pill and tenders for 20% of its own shares with notes.  Holding: There is no categorical rule that all poison pills are valid or invalid. but each takeover attempt/response is judged individually and there is continuous review. .  Illegal in Delaware Moran v. The ultimate response to an actual takeover bid must be judged by the Directors actions at that time.  (1) Did the board respond to a threat? (2) Was the response reasonable? If so. all-cash.4. Moran appeals.  Alternately. 532)  Facts: Selectica adopts a poison pill that gives every stockholder except the acquiror a new share of stock if the pill is triggered.  Apparently not very important in this context. they will not be able to arbitrarily reject the offer. CHOOSING A MERGER OR BUYOUT PARTNER: REVLON. who owns all or substantially all of the corporation s shares. Selectica had adopted a 15% trigger at the time of its IPO. each must be analyzed under the Unical test. 1988): Chancery Court requires target board to redeem a stock rights plan that the company used to protect its recapitalization alternative to a hostile. Ch. impossible to defeat. v. brings suit to enjoin the pill as outside the board s authority and an invalid exercise of business judgment. 525):  Facts: In August 1984.  Leveraged Buyout  Step 1: Buyer borrows large amounts of cash and uses it to acquire all or almost all of the target s stock. ITS SEQUELS. pills are.. Versata argued that the NOLs would never be used. but selecting a merger partner (Revlon). the Delaware Supreme Court examined the board s fiduciary duty in arranging for the sale of a company. Morley doesn t seem to believe it stands for what the CB editors think it stands for. . When the Household Board of Directors is faced with a tender offer and a request to redeem the Rights. and the corporation has a great deal of debt. Sachs) vote against. MacAndrews & Forbes (p. all-shares tender offer. AND ITS PREQUELS  The board s entrenchment interest can affect not only its takeover defenses but also its choice of a merger or buyout partner. Revlon v.  Step 2: Buyer uses its control of the corporation to cause the corporation to raise large amounts of cash: (a) Buyer causes the corporation to take out a huge loan (b) Buyer sells off many of the corporation s assets. on a clear day. which  . Lipton and Goldman Sachs.50 per share when the stock is trading at $25 (a 90% premium). Ch. Chancery Court upholds the poison pill as a legitimate exercise of business judgment. but in the 1980s. 13. 1988): Chancery Court required Pillsbury to redeem its poison pill after concluding that Pillsbury s own restructuring proposal was not as good as a hostile all-cash offer from Grand Met. Versata Enterprises v. Directors Moran and Whitehead (co-Chairman of Goldman. in practice. even though in fact this combination makes a takeover impossible. Van Gorkom (p. Partnership v.  Step 3: Buyer pays itself the cash as a dividend and uses the cash to pay off Buyer s original loan. Pillsbury (Del.  Grand Metropolitan Pub. because Selectica was a perpetually money-losing company and would never have income against which the NOLs could be used. poison pill] is not absolute. Household Intl (Del. and acquisition of 20% of the shares.e. because management can obtain a variety of benefits in friendly deals. but combined with staggered boards.  When all is said and done. The Selectica board argued that the pill was necessary to protect tax net operating losses (NOLs) which had accumulated in the corporation and which would be lost if control of the company changed hands. and nothing we say here relieves them of their fundamental duties to the corporation and its stockholders.  Traditionally corporate law treated decisions to initiate merger proposals as business judgments as long as management did not have a conflicting ownership interest. . Two triggers: announcement of a 30% tender offer. 541)  Facts: Perelman makes a hostile all-cash tender offer for Revlon at $47. Interco (Del.  Forced Pill Redemption  The best way to pull a pill is through a proxy battle. Smith v. Co.  Moran v. Household International board adopts a poison pill by a 14-2 vote. 1985): The Rights Plan [I. Ltd. business judgment rule applies  Reasoning: Boards have authority to adopt poison pills.

the directors role [is] changed from defenders of the corporate bastion to auctioneers charged with getting the best price for the stockholders at a sale of the company. noshop provision. . gets an asset lockup. then Warner s CEO (Ross) retires and Time CEO (Nicholas) takes over. so the merger with Warner is not a sale of the company. the directors possess a body of reliable evidence with which to evaluate the fairness of a transaction. . Time s board rejects the offer based on (revised) fairness opinion from Wasserstein Perella which values the Time shares for as much as $250. and they can t totally shackle the directors and prevent them from accepting a superior bid. Time gets nervous about its shareholder vote. . . Perelman increases his offer to $58.  Holding: When a sale or breakup of the company becomes inevitable.  Exemption Allowed in (Very) Limited Circumstances: When . and breakup fee. they may approve the transaction without conducting an active survey of the marketplace. the court says you can care about non-shareholder interests.  Directors are opposed to Perelman s offer because they will lose their jobs and because they don t want to be affiliated with Perelman.  Market Check Required: When the board is considering a single offer and has no reliable grounds upon which to judge its adequacy.  Revlon Duties Clarified:  Level Playing Field Among Bidders: [W]hen several suitors are actively bidding for control of a corporation. The directors also worry that they ll have personal liability for the notes they issued as part of the takeover defense. and Time is not abandoning its long-term strategy (the company is not up for sale)  Revlon Triggers: (1) When a corporation initiates an active bidding process seeking to sell itself or to effect a business reorganization involving a clear break-up of the company . including cross-options to deter third-party bidders. .  Lock-up options are not per se illegal. . but only so far as they help to maximize shareholder value. . a no-shop provision.  Three Kinds of Possible Threats:  Structural coercion: the risk that disparate treatment of non-tendering shareholders might distort shareholders tender decisions (Moran problem)  Opportunity loss: a hostile offer might deprive target shareholders of the opportunity to select a superior alternative offered by management  Substantive coercion: the risk that shareholders will mistakenly accept an underpriced offer because they disbelieve management s representations of intrinsic value. Time shareholders join suit and also assert a Revlon claim.in turn makes an LBO more difficult.25.  Holding: Revlon is not triggered. so the deal with Warner is restructured so that Time borrows $10 billion and uses it to make a cash tender offer for Warner (the tender offer avoids the shareholder vote under the merger. . . . in response to a bidder s offer. changed only in the respect that they are charged with the duty of selling the company at the highest price attainable for the stockholders benefit. Chancery Court rules for Perelman and enjoins the asset lockup. But Perelman is undeterred he raises his offer to $50. . and a breakup fee. fairness demands a canvas of the marketplace to determine if higher bids may be elicited. Paramount makes an all-cash hostile bid for 100% of Time shares. and finally to $56.25 per share. The directors role remains an active one. and $600 million total for Warner s management team. When multiple bidders are competing for control . Forstmann Little enters as a white knight and eventually agrees to pay $57. Time (p. Directors are not obliged to abandon a deliberately conceived corporate plan for short-term shareholder profit unless there is clearly no basis to sustain the corporate strategy. . 547)  Facts: Time and Warner agree to a stock-for-stock merger-of-equals in which Warner shareholders get 62% of the surviving company. PULLING TOGETHER UNOCAL AND REVLON Paramount v. Paramount brings suit to enjoin Time s defensive tactics under Unocal. the directors may not use defensive tactics that destroy the auction process. Ross gets $200 million in cash and options by the time he retires. CoCEO s for five years. The noteholders are not pleased by Revlon s solicitation of Forstmann as a white knight because Revlon is giving Forstmann the opportunity to make its debt more senior to the noteholders claims. . 13.  In Revlon. Various deal protection devices.  Reasoning: Revlon is not triggered because both before and after the merger control of Time is in the market. a target abandons its long-term strategy and seeks an alternative transaction involving the break-up of the company. (2) where. . Deal protection mechanisms are supposed to be designed to get actors who would not otherwise bid to bid. Time was to offer new shares greater than 20% of its outstanding shares).5. fairness forbids directors from using defensive mechanisms to thwart an auction or to favor one bidder over another. with the promise of even more if Revlon redeems (i. then upped to $200.e. gets rid of) its pill. $53. in exchange for supporting the par value of the Notes which had faltered in the market. and brings suit to enjoin the defensive tactics and deal protection devices that Revlon used to preserve its deal with Forstmann. first at $175..

no control premium would be owed to the minority shareholders (they didn t have control before.  Revlon mode is more likely (unless target has a majority shareholder) where (1) consideration is in cash rather than stock. opportunity loss (see Time). The deal gives substantial deal protection measures to Viacom. In the middle range. even if it s a poor one. courts will not defer. while 3 relates to the Sale of Control Theory under QVC. claiming Paramount was in Revlon-mode. so they can t demand a control premium now. Time. target board must maximize immediate shareholder value (board can implement deal protections to increase price but can not use anti-takeover mechanisms to discriminate among What is a sale of the firm sufficient to trigger the Revlon duty. (Time) Valid threats are: structural coercion (see Unocal). it doesn t have to abandon it for short-term shareholder profit. but Paramount rejects the offer as excessively conditional while making no effort to explore the conditions or negotiate with QVC. as when shareholders are or might be cashed out of the postmerger enterprise. in stock-for-stock mergers of equals.  1 & 2 relate to the Institutional Competence Theory under Revlon. In cash deals. QVC re-raises.  Revlon duties are likely to be triggered when mergers create shareholdings with between 30 and 35% of the voting rights in widely held companies. substantive requirements are level playing field and market Act II: Unocal Defensive tactics (how and how long a board can resist a hostile takeover) will be judged using intermediate scrutiny: (1) must be a perceived threat. courts will inevitably assess deal-protective terms by evaluating the good faith of the corporate directors who approve these terms. and substantive coercion (cf.  When control of the corporation is vested in the fluid aggregation of unaffiliated shareholders. QVC files for an injunction. Sale or breakup of the company (Time) or sale of control (QVC) triggers Revlon duties. see Unitrin). 554)  Facts: Paramount agrees to be acquired by Viacom. so Unocal means nothing. (2) the merger is a whale/minnow transaction rather than a merger of equals.  But if Paramount already had a controlling shareholder. boards of directors are better able to value companies than are shareholders but in some circumstances.  Reasoning: The standard for application of Revlon is that Revlon applies if a change in control is occurring.  Case Act I: Moran Holding Installing a pill is authorized by Delaware statute and survives intermediate scrutiny under Unocal Open Questions When will a court force a target board to redeem its pill because it has arbitrarily reject[ed] the offer ? Some Answers Rarely (in practice. never. Paramount v.  The more the value of merger consideration depends on synergies between the target and the acquiring company.  In most circumstances. but leaves the deal protection unchanged. boards must maximize short-term value. boards really very rarely have to pull poison pills. Time. all impediments to the QVC offer are struck down. Unocal analysis: The court finds a threat (shareholders are too stupid to know that Paramount s offer is too low) and finds Time s response reasonable (Time had a long-term business strategy and changing the deal structure with Warner was necessary to protect that strategy). this was the case in Paramount v. and (3) the acquiror has a controlling shareholder rather than being widely held.  Holding: Paramount was in Revlon-mode. so we re back to the business judgment rule. and just what does this duty consist of? . the more courts will defer to the judgment of the target s directors. What constitutes a threat to the corporation justifying defensive action? Act III: Revlon When Revlon duties are triggered. where the merger represents mixed consideration or the target is vastly smaller than the survivor. and (2) tactics must be reasonable in relation to the threat posed. QVC (p. postTime): Board is not required to give up a long-term strategic plan unless there is clearly no basis to sustain the corporate strategy.  As long as the board has a plan. but QVC nevertheless jumps the deal. they will defer a great deal. you can always say the price is too low. BUT after Time. since this is the only value shareholder are likely to receive. transactions that result in shifting their role to a minority equity voting position in the surviving company require payment of a control premium to the unaffiliated shareholders. Time).  Under the framework set up in Paramount v. Viacom matches and then raises QVC s offer. This case seems to invoke the second and third types of threats. the board can always survive the Unocal analysis.

Delaware Supreme Court accepts interlocutory appeal. not of duty of care.6. prospective buyers would invest fewer resources in searching for deals and might offer less generous prices. Asset lock-ups create rights to acquire specific corporate assets that become exercisable after a triggering event. the target corporation will lose some of its more attractive assets through the exercise of the lock-up rights. Lyondell board agrees to the deal after extremely expedited process and no market canvass for a higher bid. Lump-sum payments no larger than 3 to 4% of the deal price are easily rationalized.6.buyers) check (Barkan). A target board might be asked to covenant (a) not to shop for alternative transactions or supply confidential information to alternative buyers. No Shops/No Talks and Fiduciary Outs  For acquirers in corporate mergers. On November 20th 2007. Lyondell Chemical Co. but doesn t waive option of injunction). but buyers resist them. The two major categories of lock-ups are options to a target s assets and its stock.  Since the Delaware Supreme Court has seemed to declare contracts unenforceable that violate a fiduciary duty. so question is whether the Lyondell board acted in good faith.  Holding: The directors did not beach their duty of loyalty by failing to act in good faith. Lyondell had a §102(b)(7) waiver (which merely waives directors personal liability for damages for breach of duty of care. or fraud examples of bad faith that will trigger personal liability for directors 13. Delaware Chancery Court allows claim to proceed on duty of loyalty claims against the board. Corporations can t waive liability for bad faith under §102(b)(7). the directors met their duty of care. PROTECTING THE DEAL  Deal Structuring Lockup Agreements  A lock-up is a contract collateral to an M&A transaction that is designed to increase the likelihood that the parties will be able to close the deal.  Asset lockup: Gives the acquirer the right to buy specified assets of the target at a specified price after a triggering event. it was not deliberate disregard of duty of care for them to do nothing in the two preceding months because they were not in a Revlon situation. money. They are justified as necessary to compensate a friendly buyer for spending the time. there is only one Revlon duty. Shareholder plaintiff nevertheless allege that price was inadequate and directors breached their Revlon duties.  Counsel for targets have devised the fiduciary out clause.  Acts taken in bad faith are said to be breaches of duty of loyalty.  Breakup fee: Gives the acquirer a cash payment in the event of non-consummation. Lyondell didn t breach a duty by not reacting to the threat of a hostile offer because it was merely a specter of possible future action. target counsel typically admonish that the legal risk of failing to have a fiduciary-out clause is unacceptable. and that is to get the best price for the shareholders. v.  Personal Liability for Directors  Negligence no personal liability for directors under business judgment rule  Gross Negligence no personal liability for directors if effective §102(b)(7) waiver  Deliberate disregard. 568)  Facts: On July 9th 2007. Buyers protect against this risk in two ways:  They may seek a large lock-up  They may seek certain covenants from the seller that will protect their deal. Ryan (p.  In determining whether a lock-up is consistent with the board s duties in a Revlon transaction.  Reasoning: Revlon applies only when a company has embarked on a transaction on its own initiative or in response to an unsolicited offer that will result in a change in control (Paramount v. Should a third party disturb the pending transaction. courts will weigh such considerations as how early in the process the lock-up was given and the value-enhancing nature of its specific terms. 13. Lyondell shareholders approve the sale by more than 99% of voted shares. Bassell CEO Blavatnik negotiates with Lyondell CEO Smith and eventually offers to pay $48 per share in cash to acquire Lyondell.9%) at a specified price (typically the deal price in the protected transaction ). but requires tight deal protections.  Such terms can serve the interests of target shareholders as well as those of acquirers. Court finds that once Revlon applied (the active bidding process began). and (c) to recommend that shareholders approve this agreement. (b) to submit the merger agreement to the shareholders for approval. self-dealing. without them. . contract damage may not ever be available against a corporation that abandons a transaction subject to Revlon duties on the grounds that a better deal is available. however. QVC holding). Where a transaction triggers Revlon duties. Extremely rare in the 1990s. the legal requirement that the target s shareholders vote introduces an irreducible contingency into merger contracts.  Stock option lockup: Gives the acquirer the right to buy a specified number of shares of the target (typically 19. the lock-up provides that the jilted acquirer can participate in the increased value of the target to the extent of its proportionate share in the company s diluted equity. and reputation to negotiate a deal with a target.1. Should a third party disrupt the parties favored transaction.

Cullman (p. Genesis is the only one (seemingly) interested in NCS.  According to the majority. In January 2000 Swedish Match agrees to buy out the minority shareholders of General Cigar at $15. 579)  Facts: Omnicare makes offer for NCS but negotiations break down. Omnicare comes back with a better offer & NCS recommends the Omnicare offer. The Cullmans entered into the voting agreement as shareholders. Part of the deal requires NCS Chairman & President to commit their votes (they hold voting control. that deference may indeed be the business judgment rule. the case extends this holding to Unical situations. Omnicare brings suit to invalidate the stockholder lockup agreement. . what it means is whether the minority ought to expect to receive a control premium (which is the case in a public corporate where shareholders hold a control stake in diffuse fashion). .13. but they commit their votes not as directors but as controlling shareholders) and allows Genesis to force a vote. and (4) a majority-of-the-minority approval (effectively) from the Class A shareholders. but the controlling shareholders also sit on the board. [Unlike Omnicare.  Holding: The fact that the contract forces the directors to neglect their fiduciary duties invalidates the contract.25 per share cash. permissibly.6. the law must let the board make business decisions without fear of being second-guessed. their vote may have been influenced by the existence of the deal protection measures.  Unical applies when the board is resisting sale. even if the parties don t negotiate them into the agreement. 7):  Facts: Through a dual class structure the Cullman family owns a controlling interest in General Cigar. the board no longer gets the deferential business judgment review. Delaware Chancery Court upholds the agreement under Unocal analysis.  Orman can be distinguished from Omnicare on two bases: (1) since the controlling shareholders in Omnicare were directors. but Genesis forces the vote and wins (because controlling voters are committed already). and against any alternative acquisition proposal for 18 months after any termination of the merger.  When the transaction does constitute a change in control that deference will be expressed in some form of heightened scrutiny. Shareholder Lock-Ups  Whether or not a transaction constitutes a change in control.2. Unical applies whenever deal protections are employed to prevent a hostile takeover.) upholds the shareholder lockup: In [Omnicare] the challenged action was the directors entering into a contract in their capacity as directors. Orman v.  This was clearly true in Revlon scenarios before this case. The merger agreement contained: (1) no breakup fee.  Unical and Unitrin seem to apply when the majority is trying to entrench itself.  According to the dissent.] the public shareholders were free to reject the proposed deal. but will only make an offer if it can get a fully locked up deal. when the transaction is not a Revlon transaction. they couldn t sign the agreement (2) unlike the force-the-vote provision entered into by the . such that Swedish Match would own 64% and the Cullman family would own 36% of General Cigar (with Cullmans still retaining control). QVC says what s important is whether there s a sale in control. even though they own less than 20% of the company.  This side agreement (which is really what makes the agreement preclusive) is a consequence of shareholder action. (2) a fiduciary out that allowed General Cigar to consider an unsolicited superior proposal.  Holding: Chancery Court (Chandler.  Revlon does not apply here because control was not diffusely distributed before the deal. 587 n.  But another way to handle the conflict would be to have directors obliged to fulfill their fiduciary duties but the firm nevertheless liable for breaching the contract. . even though. Omnicare v. But the Cullman family agreed to vote their controlling interest for the Swedish Match transaction.  Fiduciary outs are now a mandatory term. C. these controlling shareholders sat on the board. if the board s process is deliberate and informed and the board is truly independent. Unical only applies when the board is using its position to maintain its employment status.  Unical test: (1) Did the board respond to a threat? (2) Was the response reasonable? If so.  Majority applies Unical and Unitrin here. NCS HealthCare (p.  Reasoning:  When Paramount v. business judgment rule applies  Unitrin test: (1) that the deal protections weren t coercive or preclusive and (2) the response fell within a range of reasonableness (more permissive than merely being reasonable)  Dissent  Unitrin doesn t apply because there was no meaningful minority stockholder voting decision to coerce. (3) a class vote of the A and B shares separately.

 In Revlon mode. or  § 203 (a)(3): acquiror gets board approval and 2/3 vote of approval from disinterested shareholders (i.. 13.  Fair price statutes (27 states): set procedural criteria to determine a fair price in freeze-outs. the board cannot consider other constituencies or can only consider them to the extent that considering them benefits the shareholders.7.  A prominent example is the business combination statute. brings suit challenging the Indiana antitakeover statute as preempted by the Williams Act and a violation of the (dormant) Commerce Clause. those seeing opportunity in a change of management have only two alternative: (1) negotiate with the incumbent board or (2) run both a proxy contest and tender offer simultaneously. minority who remain after the takeover). excluding inside directors shares.2.e. Third-Generation Antitakeover Statutes (1987-2000)  After the Supreme Court held in CTS that state antitakeover legislation is consistent with both the Williams Act and the Commerce Clause if it allows a bidder to acquire shares. Dynamics Corp. The Indiana control share acquisition statute prohibits a bidder from voting its shares beyond 20% ownership unless approved by disinterested shareholders (i. the agreements entered into by the board in Orman did not compel the merger. also referred to as the moratorium statute.e.  Holding: U.7. STATE ANTITAKEOVER STATUTES 13. even if it makes such acquisition less attractive in some circumstances.1.  Reasoning: The Williams Act doesn t preempt any state statute that may limit or delay the free exercise of power after a successful tender offer.8.7. shareholders other than bidder and insiders).  In 1982.  Other constituency statutes (31 states): allow the board to consider non-shareholder constituencies. of America (p.  Importance of the Proxy Contest Safety Valve  Before the pill (pre-1985): board control is an inevitable consequence of buying a majority of the shares: . 13.  After the first generation of antitakeover statutes was invalidated.  Pill validation statutes (25 states): endorse the use of a poison pill against a hostile bidder. Supreme Court struck down this approach as preempted by the Williams Act and thus in violation of the Supremacy Clause. This type of statute prohibits a corporation form engaging in a business combination within a set time period after a shareholder acquires more than a threshold level of share ownership. PROXY CONTESTS FOR CORPORATE CONTROL  In a world in which a board may unilaterally adopt a poison pill.  It is meant to deter junk bond -financed bust-up takeovers by preventing acquirers from getting their hands on the assets of target firms.  DGCL §203:  DGCL § 203 bars business combinations between acquiror and target for a period of three years after the acquiror passes the 15% threshold unless:  § 203 (a)(1): takeover is approved by target board before the bid occurs. numerous states adopted similar statutes. MITE five years earlier. Supreme Court upholds the Indiana statute. Court of Appeals strikes down the statute as preempted by the Williams Act. or  § 203 (a)(2): acquiror gains more than 85% of shares in a single offer (i.S.S.  §203(a)(3): if you can manage to get the shares in a proxy contest.  Related to Second-Step Freeze Out:  Business combination (freeze-out) statutes (33 states): prevent a bidder from merging with the target for either three or five years after gaining a controlling stake unless approved by the target s board. 13.and Second-Generation Antitakeover Statutes (1968-1987)  The first generation of antitakeover statutes addressed both disclosure and fairness concerns and was generally limited to attempted takeovers of companies with a connection to the enacting state. 589)  Facts: Dynamics makes a hostile tender offer for CTS Corp.  Other State Regulation of Hostile Takeovers:  Related to acquiring a control block:  Control share acquisition statutes (27 states): prevent a bidder from voting its shares beyond a specific threshold (20-50%) unless a majority of disinterested shareholders vote to approve the stake. The statute in question does not conflict with the provisions or purposes of the Williams Act and to the limited extent that it affects interstate commerce. a second generation of statutes attempted to avoid preemption by the Williams Act by maintaining an appropriate balance between the interests of the offers and the targets within the overarching policy of investor protection. v.. CTS Corp.. with closing the tender offer conditional on electing the acquirer s nominees to the board and the board s redemption of the target s poison pill. you just vote out the board and get a new board. the U. distinguishes the Illinois antitakeover statute struck down in Edgar v.board in Omnicare (when combined with the director/shareholder vote commitment). moves from below 15% to above 85%). this is justified by the state s interest in protecting shareholders. First.e.

corporate action to defeat a proxy contest cannot be justified by a parallel belief that the voters simply do not understand the foolishness of voting for the insurgent slate.1. the Chancery Court recognized this as a sleazy.  Under Blasius. the incumbent board amends the by-laws to advance the meeting date by one month to mid-December (and.  Reasoning: The central importance of the franchise to the scheme of corporate governance requires closer scrutiny when you interfere with a shareholder vote. Incumbent board strings the dissidents along in negotiations and then. when there are only a couple of months left before the annual meeting. Blasius Industries v. even though it can do other things. that is not allowed. Objective is to execute a restructuring plan for Atlas. 602): c is most likely to invoke Blasius review. Atlas preempts the campaign by immediately amending its bylaws to add two new board seats. in the end. is simply the board s belief that the tender offer is inadequate and that the shareholders do not understand that fact. Bidder makes a tender offer and gains a majority of the shares 2. however. and fills the board seats with its own candidates. courts may apply the Unocal test to them: Review under Unocal is less demanding than review under Blasius. is the same. Dissidents bring suit seeking an injunction to postpone the meeting. the new directors redeem the pill.  Under Blasius.  In Unocal. the action must be reasonable in light of something else (a threat that he act is directed against). clearing the way for the hostile bidder to proceed with its bid. Once in office. This.  Since manipulations of the voting process can often be characterized as defensive.  The board bears the heavy burden of demonstrating a compelling justification after the plaintiff has established that he board has acted for the primary purpose of thwarting the exercise of a shareholder vote. 2. Blasius brings suit to enjoin the board packing tactic. The excuse that the board gave was that it wanted to avoid the Christmas mail crush in sending out the solicitation materials and getting back the proxy cards. 598)  Facts: Dissidents are negotiating with management up to the last possible moment. (p. Almost every hostile takeover defense interferes with the shareholder vote in some way.  Questions (p. but refuses to grant the injunction. but we can construct an argument for almost anything to trigger Blasius review. the justification for the act must be deemed compelling in light of something else (the threat that the act is directed against).  NB: If the board is staggered. All of this has the effect of leaving too little time for dissidents to organize and solicit proxies. announces its intention to solicit shareholder consents to increase the size of the board from 7 to 15 members.  The substantive difference is one of emphasis. directors have the burden to establish compliance with a standard. you need a compelling justification (higher standard than Unocal). a 7% shareholder of Atlas. Chris-Craft Industries (p. Board will almost certainly resign because independence is doomed. Blasius requires a very powerful justification to thwart a shareholder franchise for an extended period. if the directors act solely with the purpose of entrenching themselves and with no other purpose. Mercier v. and in both instances. however.  Legal power held by a fiduciary may not be deployed in a way that is intended to treat a beneficiary of the duty unfairly. Atlas Corp. The structure of analysis under either review standard.  In both instances. Bidder launches a proxy context to replace the target s board over one (no staggered board) or two (SB) annual elections. Schnell v.  Holding: Unical does not apply when the primary purpose of the board action is to interfere with the shareholder vote. 604) . moves the meeting to an obscure town in upstate New York). hard-ball tactic. in these circumstances. 599)  Facts: Blasius Industries. the standard is a relative one. 3.  The Delaware Supreme Court s Time-Warner opinion seems to authorize a target board to take defensive action if the company is threatened by what the court terms substantive coercion.  After the pill (post-1985): board control is a prerequisite to buying a majority of the shares: 1. If directors stay they will be voted out over one (no staggered board) or two (SB) annual elections.  Reasoning: There is a higher standard of duty when messing with the shareholder vote.  Morley s interpretation: The board can t take specific actions to interfere with specific votes. Inter-Tel (p. and to fill the new board seats with Blasius nominees. in hopes of avoiding a fullfledged proxy contest.  Holding: Injunction granted. for good measure. directors cannot be removed without cause.

 Holding: The board met its two-part burden under Blasius of proving that their action (1) served. Courts struck these down because they created two classes of directors and unduly conditioned the rights of shareholders to elect new directors. Quickturn Design Systems.. 606)  Slow Hand Pills  Later versions of the dead hand pill. the gains are great and the cost modest in comparison. 606) 13. 604):  A spin-off is when a parent puts assets in a subsidiary and then distributes shares in its subsidiary to its shareholders. for example.Facts: The Inter-Tel board delayed a merger vote by twenty-five days in order to provide more information to shareholders and because it became clear that shareholders were not going to approve the merger on the original meeting date. and was motivated by.  The Delaware Supreme Court affirmed on the basis that a present board did not have the authority to restrict the power of future boards. to exercise their managerial judgment (but they really do this all the time). except as may be otherwise provided in this chapter or in its certificate of incorporation. Inc.  The technique developed involves a shareholder bvlaw that requires the board of directors to redeem an existing pill and to refrain from adopting a pill without submitting it to shareholder approval. or employees.  Whether the law should recognize shareholder power to amend the bylaws to eliminate or alter pills raises an optimal delegation problem : When are the efficiencies that we gain from delegating authority to centralized managers outweighed by the expected agency costs associated with that delegation?  Where does the poison pill fit in the continuum of efficient delegation?  Staggered boards cannot be adopted by board vote.9. not inconsistent with law or with the certificate of incorporation.9. relating to the business of the corporation.  Early versions provided that the company s pill could be redeemed only by the company s continuing directors. known as slow hand pills. The spin-off strategy here was designed to avoid a shareholder vote.. a company that encompasses 93% of ITT s assets and 87% of its revenues. 13. it has no such power for the six months following the election of a new board. even though they may appear in either the certificate of incorporation or the bylaws *but only in the bylaws if that particular bylaw is approved by the shareholders. The classified board provision for ITT Destinations will preclude current ITT shareholders from exercising a right they currently possess to determine the membership of the board of ITT. is clearly preclusive and coercive under Unitrin. v. the conduct of its affairs. p. officers.*  . Under Moran. a term defined to mean directors in office at the time of adoption of the pill or nominated to office thereafter by continuing directors.  §109(b): The bylaws may contain any provision.  The Hilton court concluded that the installation of a classified board for ITT Destinations.2.  Reasoning: You can t justify interfering with the shareholder vote by alleging substantive coercion (merely arguing the shareholders were too stupid to realize the price was too low we won t tolerate the same rationale that we did in Paramount v. Toll Brothers. provided that while generally the board had a redemption power. ITT (p. through the adoption of stock rights plans. (Mentor Graphics Corporate.  The idea is that boards have rights and duties to make independent judgments respecting the management of the firm.1. we denied shareholders the power to appoint directors or approve fundamental transactions.  §141(a): The business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors. a legitimate corporate objective. the legal infrastructure of corps reflects the belief that agency costs would be too high if. (Carmody v. directors. Inc.  In the case of everyday business decisions. THE TAKEOVER ARMS RACE CONTINUES 13. but equally plainly. Mandatory Pill Redemption Bylaws  Some opponents of the pill have sought a technique to gain control of the decision of whether or not to implement a poison pill. Time) Hilton v. the decision to install a stock rights plan falls within this authority.  The Chancery Court struck down the pill by a Unitrin/Unocal analysis. and its right or powers of its stockholders. Dead Hand Pills  A dead hand pill cannot be redeemed by the hostile board that is elected in a proxy fight for a state period of time. and (2) was reasonable in relation to the legitimate objective and not preclusive or coercive.9. p.  Shareholder mandatory pill redemption bylaws present two controversial issues:  Is a bylaw that mandates the board to exercise its judgment in a particular way a valid bylaw?  Must managers include materials respecting any such proposal in the company s proxy solicitation?  Most of the leading Delaware firms have opined that a mandatory bylaw would constitute an invalid intrusion by the shareholders into the realm protected by §141(a) of the DGCL. Shareholders who may in all events elect a different board if they are displeased with the current one are not given the power to co-manage the firm.

and issuing corporations when dealing in the corporation s own securities is primarily an area of federal law. as part of its reincorporation from Australia to Delaware. Agassiz (p. 14. on the Boston Stock Exchange. One month later. directors. 1926.  The board has more freedom to limit its authority through contracts than through the bylaws. Based on surveys done by the other company. but the court doesn t explore that issue. boards can t stagger themselves. fiduciary disclosure law atrophied. and announced that. or employees.  Fiduciary duties are designed to fill gaps in the contractual relationship between shareholders and directors. or employee for trading profits made by using information learned in connection with his corporate duties. In March 1926. the News Corp. The SEC and federal courts aggressively expanded the federal law of disclosure between 1940 and 1975. Goodwin v.  State fiduciary duty law continues to play an important role in two situations:  First.  Whether it is pro-shareholder (is being able to adopt a poison pill good for shareholders?). the conduct of its affairs. and its right or powers of its stockholders. 610)  Facts: In October 2004. 14. Unisuper v.1. it might or might not hold to its board policy. since these investors could not be said to have traded in reliance on statements made by unknown counterparties. There were several reasons shareholders opted for federal court relief rather than pressing in state court for change in fiduciary law:  First. In November 2005. not inconsistent with law or with the certificate of incorporation.  §109(b): The bylaws may contain any provision. a newspaper discloses that Cliff Mining has stopped exploration on its property. federal courts created remedies for shareholders and investors through the process of implication.  The federal courts aggressively expanded federal investor remedies by implying private rights of action under the federal securities laws. going forward. or (3) cause the corporation to sign a contract with third party for pill redemption. relating to the business of the corporation. board agreed with certain institutional investors to a board policy that any poison pill adopted by the News board would expire after one year. director.  Holding: No duty to disclose  Reasoning: Agents of the corporation usually don t have a duty to disclose information in market transactions unless special facts are present. even if they opt out. the News board extended its pill in contravention of its earlier stated board policy.  Reasoning: This was acceptable even though the general provision is that mandatory pill redemption bylaws are unacceptable because this was not a bylaw (it was a contract).  Third. 616)  Facts: Agassiz and MacNaughton are directors and officers of Cliff Mining Company and officers of another mining company. the director deliberately created a misleading impression. However. they can t be used to silence shareholders and prevent them from specifying what the corporate contract is to say.§109(a) gives a default rule giving shareholders the right to amend bylaws and not giving that right to board members. (p. (2) get the shareholders to adopt a mandatory redemption bylaw (but it can t be very powerful). News Corp. TRADING IN THE CORPORATIONS SECURITIES  The obligations of directors. Liberty Media appeared as a potential hostile bidder.  Second. the amendment of the Federal Rules of Civil Procedure made federal courts an attractive place for classbased litigation. officers. Cliff Mining starts exploring on its property in 1925 but ends without results in May 1926.  Holding: The contract not to extend the pill is enforceable.  If you want to implement a pill redemption. THE CORPORATE LAW OF FIDUCIARY DISCLOSURE TODAY  After the enactment of the federal scheme of securities regulation in 1933 and 1934. based on favorable non-public information contained in the geologist s report. the News board promptly installed a pill. a corporation can bring a claim against an officer. the 1934 Act provided for national service of process for federal courts. you can (1) put it in the certificate of incorporation. On May 14th. COMMON LAW OF DIRECTORS DUTIES WHEN TRADING IN THE CORPORATION S STOCK  The common law fraud remedy was generally not available when the buyer or seller simply failed to disclose a material fact without overt deception and it was unavailable to redress the losses of persons trading over impersonal markets. officers. although many corporations opt out. 14. a geologist had written a report identifying the possibility of copper deposits in Cliff Mining s property. Agassiz and MacNaughton anonymously buy shares from Goodwin.  . In May 1926. unless shareholders approved an extension.2.  Special facts: evidence that the director sought out a specific buyer or seller.

1972.  § 16(b): statutory insiders must disgorge any profits on short-term turnovers in the issuer s shares (purchases and sales within any six month period). increases management shareholding. officers. by using a corporate asset to one s own advantage. and president of Skyline Corp. The Delaware Supreme Court has gradually articulated a board s duty to provide candid and complete disclosure to shareholders that closely parallels the federal disclosure duty under Rule 10b-5. Decio (p. EXCHANGE ACT §16(B) AND RULE 16  Gratz v.  Two notable aspects of the fiduciary duty theory are: (1) if the nonpublic information is owned by the corporation.  § 16(a): Statutory insiders (directors. Oreamuno. that is payable to the corporation. however. couldn t we expect corporations to regulate insider trading themselves? The mere fact that we think (and we don t all think) that insider trading is bad doesn t justify our current regulatory system.  In calculating the profit realized from a sale (or purchase).  Holding: No corporate recovery is allowed for gains made by insider trading if there is no corporate harm.  However. 1972.  Federal law creates a remedy for individuals. Board Disclosure Obligations Under State Law  Although federal law is the principal arbiter of disclosure obligations.  Reasoning: In duty of loyalty cases. the 10b-5 class action has made substantial advances toward becoming the kind of effective remedy for insider trading that the court of appeals hoped that it might become. Otherwise the common charter waiver of liability for damages under §102(b)(7) will protect directors from good faith (when negligent) failure to adequately disclose. One then deducts the lower total purchase price from the amount realized on the reportable sale to determine the profit. in Nov.  Diamond v.  The director s duty of candor under state law requires them to exercise honest judgment to assure the disclosure of all material facts to shareholders.g. 14. absent a federal prohibition. if any. Resigns in Sept. e.  If insider trading is generally bad and inefficient.2.  Officer status defined as access to non-public information in the course of employment. Skyline announces an unexpected 17% drop in earnings.Second. The same process is repeated looking forward six months.  Exemption for unorthodox transactions.  The fiduciary theory allows corporations to recover damages based on insider information. so any profits made from its misappropriation by fiduciary must be disgorged to corporation. it is customary to consider whether..2.1. chairman of the board. and moves stock prices in the right direction.  Theory says that the information is a corporate asset. a court must take into account all purchases and sales of the same class of securities occurring within six months of the reportable event (both six months in the past and six months into the future). not simply individuals who own stock in the corporation. a covered person must first look back six months and match the number of shares sold (or purchased) with the same number of shares purchased (or sold). was decided in part because of a lack of other adequate means for preventing insider trading. there is an important common law duty of disclosure. 622)  Facts: Arthur Decio is the largest shareholder. if no evidence of insider information  .3. shareholders can invoke state fiduciary duty to challenge the quality of the disclosure that their corporation makes to them. Claughton (p. short-swing profits in takeovers. 627): In matching sales with purchases (or purchases with sales) for §16(b) purposes. Freeman v. The SEC prevented the corporation from profiting from the insider information. and 10% shareholders) must file public reports of any transactions in the corporation s securities. 1972. 14. insider trading gives management bad incentives and can be unfair and we don t need to incentivize information discovery. but not for corporations. is unlikely to give rise to liability unless this failure represents intent to mislead. Corporate Recovery of Profit from Insider Trading  Insider trading:  Insider trading allows companies to maintain confidential information.2. which is not controlling precedent here. and that Decio and others sold Skyline stock knowing that the earnings had been overstated. Freeman brings a shareholder derivative suit alleging that Skyline deliberately overstated its earnings for the previous two quarters before Nov. but in the decade since it was decided. one with a fiduciary duty denied the corporate of some opportunity. District Court grants summary judgment for Decio. Failure to disclose a material fact. 14. so the corporation didn t lose an opportunity to make money. Freeman appeals to 7th Circuit. even if the corporation suffered no damages. a corporation could allow its agents to trade on it (2) the fiduciary duty theory does not attempt to compensate the uninformed stockholder with whom the insider trades.

(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made.  Section 10: It shall be unlawful to use or employ. directly or indirectly.  Liability is primarily in two areas:  Misrepresentations and omissions in required and voluntary disclosures  Insider trading 14. . whenever he changes his ownership of securities. (a) To employ any device.  The SEC and the Second Circuit Court of Appeals initially took the aggressive position that any possession of relevant.4. EXCHANGE ACT §10(B) AND RULE 10B-5  The 1934 Act left open an indirect route for revisiting insider trading. and overinclusive because short-swing transactions need not involve insider information. It broadly empowered the SEC to promulgate rules regulating the trading of securities on national exchanges or through the means of interstate commerce. (6) and that reliance causes harm. 629:  Raj is not an insider until he is made treasurer. the Supreme Court has adopted the intermediate stance of augmenting the fiduciary duty theory with the more far-reaching misappropriation theory.  Example from slides: 10% shareholder makes the following trades in a six month window:  Purchases . and the misleading statement must be made in connection with a purchase or sale of stock. From then on.4. 10 @ $40  Sales 10 @ $40.and overinclusive.  Example from p. Texas Gulf Sulphur geologists make a valuable discovery of an extremely rich zinc/copper deposit.  He is liable for damages in the amount of $2. material.  Recent SEC rules bring all derivative combinations that track the financial characteristics of an issuer s securities under §16(b). there is a strong correlation between being an insider and engaging in short-term trades and having inside information).  The rule is both under. 14. by the use of any means or instrumentality of interstate commerce. the language of Rule 10b-5 seems to mandate that the requisite reliance must be by a buyer or seller of stock.2. (p. but it does apply to transactions entered into up to 6 months after the person ceases to be an insider. or artifice to defraud. Elements of a 10b-5 Claim  The elements of common law fraud are: a (1) false or misleading statement (2) of material fact that is (3) made with intent to deceive another (4) upon which that person (5) reasonably realized. Texas Gulf Sulphur Co. 633)  Facts: In October 1963.4. finding it necessary that the insider breach a fiduciary duty in trading on inside information in order to find 10b-5 liability. When that happens. therefore. or (c) To engage in any act. in connection with the purchase or sale of any security. the federal courts required a theory on which to predicate a duty to disclose.1. there is a concern that it goes further than authorized by the language of §10(b) 14.  Suits may be brought on behalf of a corporation or by the SEC.  In addition to these elements. in the light of the circumstances under which they were made.1. including other TGS  . scheme. In order to stretch 10b-5 liability beyond active misstatements.  Then language of the Rule addresses omissions. with no offset for loss on other matched pair.  Rule for calculating short-term profits is extremely harsh. 10 @ $30  Result: Match purchase of 10 at $30 with sale of 10 at $40 to find § 16(b) liability of 10 shares @ $10 per share = $100 recoverable to the corporate. he has to file requisite forms within 10 days of becoming an insider. he has to file again within 2 days (§16(a)(2)(C)). equity imposed an affirmative duty to disclose only when a fiduciary was a party to the transaction. TGS President Stephens instructs them to not tell anybody. Evolution of Private Right of Action Under §10  It shall be unlawful for any person.2. 14. practice. .000)  We exclude transactions entered into before a person becomes an insider. or course of business which operates or would operate as a fraud or deceit upon any person. in connection with the purchase or sale of any security . it is underinclusive because insider trading can occur over a period longer than six month. or of the mails or of any facility of any national securities exchange. the harm must be to a trader in stock. any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may proscribe as necessary or appropriate in the public interest or for the protection of investors. Elements of a 10b-5 Claim: False or Misleading Statement or Omission  At common law.200 (40¢ x 3. not misleading.000 + 20¢ x 5.10 @ $30. you match any transactions that produce a profit.  Courts have interpreted this rule to create a private cause of action.4.This section applies whether or not the insider has access to inside information (bright line rule easier to enforce. If this language reaches everyone possessing material nonpublic information.  The Supreme Court took a more traditionalist approach in Chiarella. nonpublic information gives rise to a duty to disclose or abstain from trading. SEC v.  More recently.

Court of Appeals reverses. fully disclosed acts are not covered if they are merely unfair (the plaintiffs were merely claiming the report was misleading because it didn t say the price was unfair). Green: attempted to preserve state law regulation of internal corporate affairs. and Coates liable but dismisses the suit against twelve other TGS insiders. Santa Fe offers $150 per share in the short-form merger. a director of Corporate C.  Similarly. District Court finds Crawford. Manor Drug Stores: Claimants must be buyers or sellers of stock.  If all # (9:15 April 28). Morgan Stanley appraises the fair market value of Kirby s assets at $640 per share. 643)  If D.  People can be liable under 10b-5 even if the transaction about which the disclosures are made or not made even if the transaction is fair. if C s board does not sue D. a shareholder could sue D under Rule 10b-5 in a derivative action (if she can demonstrate that the board s judgment not to sue D is not deserving of business judgment deference). persuades C s board.  The failure to disclose unfairness is not a material omission. TGS issues a misleading press release to quiet speculation. usually companies only have to disclose at certain intervals. of its minority shareholders) when the corporation is influenced by its controlling shareholder to engage in a transaction adverse to the corporation s interest 9in effect. including the fiduciary duties that directors and officers owe to the corporation. And as information inevitably trickles through the organization. all of whom know at least something about the new discovery. the plaintiff attempts to meet this require by arguing that if full disclosure had been made. everybody starts trading. Minority shareholders forego their appraisal remedy but bring suit alleging a 10b-5 violation by Santa Fe for obtaining a fraudulent appraisal. and] then state corporate law would cease to matter and all litigation would occur under 10b-5. Meridor (p.  Holding: Insiders found liable.  To find a violation of Rule 10b-5. Hochfelder: scienter required to bring a 10b-5 claim  Santa Fe v. [Rule 10b-5 were extended here to encompass this fact pattern as fraud. to sell him stock. Clayton.  Holding: Affirmed.  Take-home: (1) Everyone has a duty not to trade on inside information. Santa Fe Industries v.  Most commonly. TGS issues stock options (= calls ) to its top executives. if they elect to disclose. there must be (1) deception (2) that caused loss to shareholders (3) that is more than mere nondisclosure of impure motive or culpability. Supreme Court grants cert. Goldberg v. by fraud. the minority shareholders interests) and there is nondisclosure or misleading disclosures as to the material facts of the transaction.  Omissions . holding stock in reliance on misstatement is not enough  Ernst & Ernst v. no violation of 10b-5  Reasoning: There is no omission or misstatement when a statement merely neglects to address the fairness of a proposal or action. District Court dismisses the claim because there was no omission or misstatement in the proxy information. U.  There is deception of the corporation (in effect. C can sue D under Rule 10b-5 even though it can also sue D for breach of fiduciary duty. (2) materiality depends on the expected value of future events (probability x magnitude)  The Supreme Court s Effort to Constrain 10b-5 Liability (p. Green (p. In February 1964. 639)  Blue Chip Stamps v.  Goldberg held that a derivative action could be brought under Rule 10b-5 on the basis that the transaction between a corporation and a fiduciary or a controlling shareholder was unfair if the transaction involved stock and material facts concerning the transaction had not been disclosed to all shareholders. we untether 10b-5 liability from fairness. SEC brings a 10(b) action against everybody.  Take-home: Rule 10b-5 applies only if defendant has engaged in some deceptive or manipulative act. there has to be some verifiable fact. 639)  Facts: Santa Fe Industries gradually increases its stake in Kirby Lumber from 60% to 95% and then decides to do a short-form merger under DGCL § 253. appropriating value from the minority shareholders.employees and directors. the disclosure has to be accurate. even when the company has no obligation to disclose. regardless of their relationship with the company (later altered).S. the shareholders could have sought injunctive relief against the proposed transaction under state law. However. any one in possession of material non-public information must disclose  Reasoning: Ordinarily there is no free-floating duty to disclose. it could not easily be contained. In April. and offering $25 above the Morgan Stanley stock valuation to lull minority shareholders into tendering. so that they can buy up the rest of the land needed. and values Kirby s stock at $125 per share.

Roberts Disclose or Abstain Rule  Analytically the obligation rests on two principal elements: first.  The theory allows case-by-case review of the relationship between putative insiders and other traders. Elements of 10b-5 Liability: Misappropriation Theory  A person who has misappropriated nonpublic information has an absolute duty to disclose that information or refrain from trading.  Three Theories for the Subset of People who are Liable for Trading on Inside Knowledge: 14. SEC censures Dirks for aiding and abetting in violations of 10b-5 by informing his clients of the alleged fraud at Equity Funding. The victims of insider trading are easily identified: they are all uninformed traders to whom the insider should have disclosed. Second Circuit affirms. ruling that a financial printer who had traded on confidential foreknowledge of pending takeover bids he gained through his employment did not breach a disclosure duty to other traders by doing so.2. the inherent unfairness involved where a party takes advantage of such information. Dirks)  By isolating a preexisting relationship between insiders and other traders.  Cady. Investors continuously exploit differential access to information. a doctor may not trade on information revealed by a patient who stumbles across the information on the street.  However. NYSE halts trading in the stock.  Holding: No violation. including interviewing employees. As a liability filter. United States (p. and discusses this information with his clients. which is how trading on one of many kinds of informational disparities defrauds uninformed traders. 649)  Facts: Chiarella is employed in a financial print shop (Pandick Press) and is able to figure out the identity of the target from code names in merger documents.S. indeed. The basis for this duty is said to be the inherent unfairness of exploiting an unerodable information advantage.3. knowing it is unavailable to those with whom he is dealing. over 14 months he realizes a gain of $30.  Under this theory. reaches all conduct that might be popularly understood as insider trading. Supreme Court grants cert. Elements of 10b-5 Liability: Equal Access Theory  All traders owe a duty to the market to disclose or refrain from trading on non-public corporate information. 653)  Facts: Dirks is an investment advisor who receives information from Secrist.The SEC has taken the view that the simple possession of inside nonpublic information no matter the circumstance that led to that knowledge gives rise to a duty to disclose or abstain but most courts have tended to emphasize the need for an act of fraud or manipulation. and the U.2.4. Chiarella v. Chiarella buys the target s stock before the deal is announced and sells immediately afterwards. the effort to profit from such disparities is precisely what keeps securities prices informed. since it cannot reach such seemingly clear-cut wrongdoing as the printer s trading in Chiarella. . the Supreme Court rejected the equal access theory. 14.2.000. the fiduciary duty theory supports an analogy to common law fraud that eases the assimilation of insider trading into the statutory prohibition against securities fraud. Dirks v. in its unqualified form.  In order to establish that an insider violates 10b-5 by breaching a duty to disclose or abstain to an uninformed trader. many of whom then sell stock holdings in Equity Funding. moreover.  Reasoning: The trader had no relationship with the target company s shareholders.  However. and second. and thus permits courts to selectively target insider trading.  Holding: No liability  . Jury finds Chiarella guilty of violating §10(b) of the 34 Act and 10b-5. the existence of a relationship giving access . Price of Equity Funding begins falling. pre-existing legal relationship of trust and confidence between the insider and the counterparty. because he gained his knowledge through the relationship to the bidding company and bought shares in the target company. you have to show there was a specific. (Chiarella. it is not obvious why the unfairness arising from trading on access to superior information defrauds other traders in the absence of misrepresentation or a preexisting disclosure duty. SEC begins investigating his activities and Chiarella eventually enters into a consent decree agreeing to return his profits to the sellers of the shares. the fiduciary duty theory fails to answer the question originally raised by the equal access theory.4. that Equity Funding has vastly overstated its assets. Elements of 10b-5 Liability: Fiduciary Duty Theory  In Chiarella. . (Burger dissent in Chiarella)  Even if the source of the information and the person who trades on the information have no fiduciary duty to the people with whom the trader is trading. and California insurance authorities discover evidence of fraud. a former officer of Equity Funding. the fiduciary duty theory is dramatically underinclusive.  Equal access. to information intended to be available only for a corporate purpose and not for the personal benefit of anyone. SEC (p. Dirks does research on Equity Funding.

Absent some personal gain. directly or indirectly. that he will give her important information if she pays him.  Congressional legislation extends a private action to market trades on the basis of a fiduciary breach to an employer. Jack is an employee of General Industries Inc. The release of information was for a corporate purpose and those getting the information could use it.  We think yes. the SEC moved to reassert its equal access conception with respect to trading on tender offer information by invoking its independent power to regulate tender offenses under §14(e).  §243. Same as (1) except that Jill is Jack s girlfriend and offers Jack no payment in return for the information. probably no liability under a fiduciary theory of tipping 4. Same as (5) except that Jack tells Jill not to trade on the information.  But by requiring companies to give information to everyone if they give it to anyone. Jill pays Jack. yet the favored few could clearly derive a trading benefit from early access.  This practice not only offended a sense of fairness but also threatened to corrupt the integrity of analysts.  Liability (listen to recording at 9:50 on April 26) # 2. Whenever an issuer or any person act on its behalf ii.  Thus.  Elements of Tipper/Tippee Liability (i) A Tipper knowingly gives MNPI to a Tippee in breach of a fiduciary duty to the corporation (ii) The tipper derives some personal benefit from the disclosure of the information (iii) The tippee trades on the information  Hypotheticals: 1. an associate at a hedge fund. No liability for Jill under fiduciary duty theory Notes on Dirk & Rule 14e-3 and Regulation FD  The SEC appears to have no problem in finding a benefit to meet the Dirks requirement in most tipper tippee cases. brokers. the relationship that triggers Rule 10b-5 and the resulting unfairness both refer to the insider s source of information. selective disclosure to favored analysts] shall be deemed to be a violation of Rule 10b-5. Simultaneously in the case of an intentional disclosure b.  Now. absent a breach by the insider. Jack is not knowingly deriving any benefit. Reasoning: The test for liability is whether the insider personally will benefit. or else he could lose his job. Discloses any material nonpublic information regarding that issuer or its securities iii. this would be a violation tipper/tippee is always irrelevant under equal access) 5. The issuer shall make public disclosure of that information a. if not. [To a broker.102: No failure to make a public disclosure required solely by Reg FD [that is.  No liability.  Congressional and Judiciary Response to Dirks  Lower federal courts responded to Chiarella and Dirks by extending the misappropriation theory to reach outsiders who trade illicitly on confidential information.  The deceitful misappropriation of market-sensitive information is itself a fraud that may violate Rule 10b-5 when it occurs in connection with a securities transaction. SEC Rule 14e-3 imposes a duty on any person who obtains inside information about a tender offer that originates with either the offeror or the target to disclose or abstain from trading. or journalists. from his disclosure. investment analyst or shareholder who is likely to sell] iv.  This means there is no criminal liability for violation of Reg FD alone. # 6. no duty of confidence owed by Jack to fellow passengers (even under misappropriation theory. Jack tells Jill. there has been no breach of duty to stockholders.  Depends whether the CEO is getting some benefit from Jack.  No liability. GI about to be charged with criminal violations of the Clean Water Act.  Regulation Fair Disclosure i. (GI). Jack gives Jill the info and Jill sells GI stock. Reg FD may stifle the release of information entirely.  After Chiarella. dealer. Cheatham and Howe LLP and learns the information in the course of representing GI in preparations for the criminal proceeding.  . Same as (1) except that Jack is a doctor who treats the CEO of GI and Jack learns the information from the CEO during a check-up. but under equal access theory. Same as (1) except that Jack is a lawyer at Dewey.  # 3. Promptly in the case of an unintentional disclosure  This was a response to the practice of officers and directors disclosing material information to preferred analysts. there is no derivative breach. investment advisor. Same as (1) except that Jack learns the information when he overhears two GI employees talking on the subway.

while the fact that Susan instructed her husband not to disclose is irrelevant to his status as a tipper." The  .  Holding: No liability under Rule 10b-5. who tells her husband Keith Loeb.  Insider trading is wrong not because informational disparities in the market are suspect but because it involves the private appropriation of information rights that belong to someone else. Plan is that Ira will sell his control block for $50 per share. pattern. or  a person receives or obtains material non-public information from a spouse. a supermarket chain. or sibling. United States v.  Holding: A security-trader violates the 34 Act by trading securities on the basis of misappropriate information pertaining to a company other than his own and the SEC had authority to make Rule 14e-3(a). mail fraud. guilty of fraud for profiting from stock options in Pillsbury Company based on nonpublic information he misappropriated for his personal benefit. was considering placing a tender offer to acquire a majority share in Pillsbury Company. this applies to virtually all information related to tender offers. decides to sell out to A&P in a friendly deal. Chestman appeals.  This is an equal access theory. It locates a real duty and a fraud by focusing on the putative insider s illicit conversion of valuable information rather than on a fictional relationship between the insider and uniformed traders. in connection with the purchase of a security. 662)  Facts: Ira Waldbaum. Chestman (p. or has reason to know.  (d) It is a violation of 34 Act § 14(e) for a possessor to communicate the information described in (a) under circumstances in which the tippee is reasonably likely to trade of that information. Loeb buys for himself.  Reasoning: A security-trader who fails to disclose personal profits gained from reliance on exclusive information is guilty of employing "a deceptive device . president and controlling shareholder of Waldbaum s. And despite warnings at each step in the chain to not tell anybody.  Rule 14e-3  (a) It is a violation of the 34 Act § 14(e) to purchase or sell securities on the basis of information that the possessor knows.  Take-home: The court begins to adopt a misappropriations theory of insider trading. Loeb pays a fine and agrees to cooperate. in addition to other circumstances. O Hagan (p. The Rule 14e-3a conviction stands however. The U. Second Circuit agrees to re-hear in banc. no duty of trust or confidence existed. unless the recipient can demonstrate that. is non-public and originates with the tender offeror or the target or their officers. parent. and his other clients.The misappropriation theory can reach almost all forms of insider trading that are commonly condemned. United States v. . Loeb calls his stockbroker. whenever:  a person agrees to maintain information in confidence. under the facts and circumstances of that family relationship.3 million profit. which forbids security trading on nonpublic foreknowledge of a tender offer.S.  NB: The SEC has undone what the Supreme Court said about familial relationships not creating fiduciary duties through Rule 10b5-2:  A duty of trust or confidence arises. and there will be a simultaneous tender offer for public shares in Waldbaum Ira tells his sister Shirley about the deal. and 10b-5 violations.  However. Grand Metropolitan PLC. Loeb. Chestman buys for himself. or practice of sharing confidences such that the recipient of material non-public information knows or reasonably should know that the person communicating the information expects that the recipient will maintain its confidentiality.  But because all information originates from these sources and the mens rea standard is so low. 667)  Facts: The SEC found James O'Hagan. who tells her daughter Susan. Court of Appeals for the Eighth Circuit reversed O'Hagan's convictions under the 34 Act. a partner at Dorsey law firm. it does protect her from liability.  A fiduciary relationship does not arise simply by entrusting a person with confidential information (when they don t agree in advance to maintain confidentiality). NASD begins an investigation. regardless of whether they involve traditional insiders.  Relates solely to tender information from offeror or target which the possessor knows or has reason to know is non-public. nor does marriage or familial relationship automatically create a fiduciary relationship. child. O'Hagan knew that Dorsey's client.  two people have a history. Jury finds Chestman guilty on all counts. The Circuit Court applied the Act only to security-traders who wrongfully use confidential information pertaining to their own companies and ruled that the SEC had exceeded the rule-making authority granted to it by the Act by making it a fraudulent action to trade securities on exclusive non-public foreknowledge of a tender offer. and Second Circuit panel reverses on all counts. and Chestman is indicted on 14e-3.  Reasoning: No liability under Rule 10b-5 because there existed no fiduciary or equivalent relationship of trust or confidence between Keith and the Waldbaum family or his wife to make him liable as a misappropriator. O'Hagan bought a large number of stock options without telling his firm and later sold his options for a $4. . to say that he has accurate information that Waldbaum is about to be sold. Chestman.

acts . it is permissible because the prohibition is reasonably designed to prevent . a fact finder will need to consider such facts as the size of the two corporate entities and of the potential premiums over market value.2. deceptive.4.  § 21A(e): bounty hunter provision. if you do disclose. by rules and regulations define. However. . there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the total mix of information made available. (Afterwards. and thereby violates §10(b) and Rule 10b-5 when he misappropriates confidential information for securities trading purposes. in connection with any tender offer.  Take-home: The case adopted in Rule 10b-5 context the standard of materiality that had been adopted in other securities regulation contexts (#9:42 on April 28) under TSC Industries: an omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote . District court grants summary judgment to the defendant directors because the negotiations were not destined to lead to a merger with reasonable certainty. The Commission shall .  Take-home: Rule 14b-3 is applied in a manner that shows it is an equal access theory and the misappropriations theory is applied by the court (# 9:37 on April 28) §78t-1: Liability to Contemporaneous Traders for Insider Trading (insider Trading and Securities Fraud Enforcement Act ITSFEA)  # 9:39 on April 28  § 20A: creates a private right of action for any trader opposite an insider trader. . Basic says that it didn t want to drive its suitor away by inviting competition. . . ." Rule 14e-3(a) of the Exchange Act. 14. which allows SEC to provide 10% of recovery to those who inform on insider traders. . The SEC has authority to "define and prescribe means reasonably designed to prevent fraudulent . with damages limited to profit gained or losses avoided. v. In order to assess the magnitude of the transaction.  It s hard to imagine under this standard that any live and plausible merger negotiates would be anything but material.2. you only must disclose if you trade on the information.4. if the controlling person knew or recklessly disregarded the likelihood of insider trading and failed to take preventive steps. or to engage in any fraudulent.  Holding: Whether merger discussions in any particular case are material depends on the facts a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity (rejection of the agreement-in-principle test). acts and practices [that] are fraudulent.  This case directly reverses Chiarella. . in breach of a duty owed to the source of the information. Sixth Circuit reverses.  Any contemporaneous trader (doesn t have to be actual counterparty)  Damages are limited to the trader s actual profits  § 21A(a)(2): allows civil penalties up to three times the profit gained or loss avoided. or manipulative. finding that otherwise immaterial merger discussions become material when Basic denied their existence.5. Elements of 10b-5 Liability: Scienter . security-trader knowingly abuses the duty owed toward the source of information. forbids security-traders from trading on the basis of information they know should be kept private unless they publicly disclose their trades.) Basic shareholders who sold after first public denial of the merger negotiations file suit claiming 10b-5 violations by the Basic directors. illustrating the shift from the fiduciary theory to the misappropriation theory. . a fact finder will need to look to indicia of interest in the transaction at the highest corporate levels.  Reasoning: In order to assess the probability that the event will occur. . which Basic flatly denies (three times).  § 21A(a)(1)(B): controlling person may be liable too. . . 672)  Facts: Basic Industries engages in merger negotiations with Combustion Engineering for almost two years about the possibility of being acquired at a premium price. 14. Elements of 10b-5 Liability: Materiality Basic Inc.  Although Rule 14e-3 prohibits acts that are not themselves fraudulent under the common law or §10(b). Meanwhile. Levinson (p. the disclosure must be accurate. there are rumors of a pending deal. or manipulative acts or practices. such acts and practices as are fraudulent. adopted under this fraud-prevention authority.  Reminder: There s no free-floating duty to disclose. whether the source is the company he works for or not.4.  Securities Exchange Act §14(e): It shall be unlawful for any person to make any untrue statement of a material fact or omit to state any material fact necessary in order to make the statements made not misleading.  The misappropriation theory holds that a person commits fraud in connection with a securities transaction. and prescribe means reasonably designed to prevent. in connection with any tender offer . deceptive.

(Afterwards.2. 679)  Facts: Basic Industries engages in merger negotiations with Combustion Engineering for almost two years about the possibility of being acquired at a premium price. unless the person can demonstrate that: (1) before becoming aware of the information. 14. two issues respecting this mental state requirement persist:  The first issue regards proof: whether actual intent to deceive must be shown in order to establish liability or whether scienter may be inferred from conduct that is simply willfully or recklessly negligent. held that a plaintiff must have been a buyer or seller of stock in order to have standing to bring a complaint about an alleged violation of Rule 10b-5. or (c) did not permit the person to exercise any subsequent influence over how. Meanwhile.  That is. manipulate. 14.4. Elements of 10b-5 Liability: Reliance  Reasonable reliance is an element of common law fraud. and whether to trade. and (3) the trade was pursuant to the contract.) Basic shareholders who sold after first public denial of the  .  Congress adopted the Private Securities Litigation Reform Act (PSLRA). Reliance as an element of a Rule 10b-5 claim is more complex. which Basic flatly denies (three times). v. The Supreme Court confirmed this in Blue Chip Stamps et al. or plan either (a) specified the amount of securities to be traded and the price. instruction.  On the assumption that markets are affected by all public information. we might conclude in such a situation that the price a person gets or pays in transacting in the stock is affected by the false statement. The Supreme Court has confirmed that liability under Rule 10b-5 requires specific intent to deceive. Elements of 10b-5 Liability: Standing.  The plaintiff is permitted to plead facts about which she has a reason to believe may be true (even if she is not certain). However. deciding not to buy or not to sell in detrimental reliance on a materially false statement is not protected under Rule 10b-5.  These defenses are widely used by senior executives.7.  Rule 10b-5: Trading Pursuant to a Preexisting Plan:  Rule 10b-5 defines illicit trading as trading on the basis of material nonpublic information if the person trading was aware of the information at the time of the trade.  Other circuits have concluded that Congress merely intended to adopt the Second Circuit pleading standard.6. or plan. or defraud.  Reliance issues are particularly implicated when a false statement is made by an insider that affects the market price of the stock. Newport Steel Corp. and (2) the contract. and in this case.4. Manor Drugs. a Rule 10b-5 disclosure insulates them from liability. or (c) adopted a written plan to trade. Basic says that it didn t want to drive its suitor away by inviting competition. if the circumstances pleaded together so constituted the required strong inference.  The Ninth Circuit adopted the most permissive standard by holding that the plaintiff needed to state in her pleading only that the defendant had acted with scienter. she (a) entered into a binding contract to purchase or sell.  The Second Circuit applied the strictest test: it required the plaintiff to plead facts that give rise to a strong inference of fraudulent intent.2.  Some courts have held that the appropriate mental state may be inferred from reckless or grossly negligent behavior.Common law fraud requires scienter or intention to deceive. instruction. in Connection with the Purchase or Sale of Securities  Birnbaum v. but a shareholder never hears the false statement. The Rule requires insiders to pre-commit to a plan before they are in possession of material non-public information if they want to trade without being liable for insider information. or (b) included a written formula or algorithm for determining the amount and price. which provided that the complaint must state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind. This pleading burden could be satisfied by alleging facts that specified a motive to defraud and an opportunity to do so. v. not merely adopt it.  Some circuits take the demanding view that Congress wanted to strengthen the Second Circuit pleading requirement. Levinson (p. there are rumors of a pending deal.  The second issue is one of pleading. (b) gave instructions for the trade. Basic Inc.  However. and therefore hold that a plaintiff must minimally plead deliberate recklessness or conscious recklessness as an element of her claim under Rule 10b-5. when.  There is also a provision for investing entities in which the natural person making the investment on behalf of the entity was unaware of the inside information and the entity itself had implemented reasonable measures to protect against insider trading. there s gamesmanship insiders often have fairly good ideas of how material questions are likely to be answered.

$40) * 10.  Holding: Damages should be calculated via the disgorgement method. the bad news is later made public stock falls to $40 (assumed to be true value ). Plaintiff buys 10. amount. Here. v. Where materially misleading statement have been disseminated into an impersonal. 14.e.000 shares = $80. Defendants appeal to Second Circuit.  In Dura Pharmaceuticals Inc. well-developed market for securities. 686)  Facts: On July 17. the misrepresentation must be relied on. in an open and developed securities market.  Calculating 10b-5 Damages under different rationales:  Example: The company discovers bad news internally and tippee sells 5. and hence. Sixth Circuit reverses.  Reasoning: To the extent that the disgorgement method makes the tipper and tippee liable up to the amount gained by their misconduct. the measure bars windfall recoveries of exorbitant amounts bearing no relation to the seriousness of the misconduct. District Court finds 10b-5 liability and calculates damages using the out-of-pocket method. It also avoids the difficulties faced in trying to prove traditional out-of-pocket damages based on the true value of the shares purchased or damages caused by reason of market erosion attributable to tippee trading. when negative earnings announcement is disclosed on July 18th. without more. the price of a company s stock is determined by the available material information regarding the company and its business. Broudo. (2) that a reasonable investor would not have paid as high a price or made the purchase at all if he had had the information in the tippee s possession.  For liability to attach. 14. the difference between the price that plaintiffs paid for the stock (~ $52-$55) and the actual true value of the stock when bought. District court grants summary judgment to the defendant directors because the negotiations were not destined to lead to a merger with reasonable certainty.4. had the material matter been disclosed. by limiting the total recovery to the tippee s gain.merger negotiations file suit claiming 10b-5 violations by the Basic directors. More facts are necessary to show that the loss resulted from the disclosure. up to the limits of the tippee s gain. and (3) the price to which the security had declined by the time he learned of the tipped information or at a reasonable time after it became public.  You can try to show that the plaintiff paid no attention to market prices or you can try to show that the market price reflected the true price (free from the influence of a misrepresentation). Private actions under Rule 10b-5 also require proof of causation. On the other hand. it should deter tipping. Liggett & Myers (L&M) tells certain analysts about a negative earnings announcement to be disclosed publicly the next day.  The market price of shares traded on well-developed markets reflects all publicly available information. (p. He then has a claim and. P can recover ($48 . will be sufficient to rebut the presumption of reliance. Elements of 10b-5 Liability: Causation  In common law fraud.000. finding that otherwise immaterial merger discussions become material when Basic denied their existence.  Reasoning: The fraud on the market theory is based on the hypotheses that.8..2. or his decision to trade at a fair market price. Remedies for 10b-5 Violations Elkind v. Misleading statements will therefore defraud purchasers of stock even if the purchasers do not directly rely on the misstatements.  Measure used when company has made a misstatement about itself. can recover the decline in market value of his shares before the information became public or known to him. and that reliance must cause a loss.  Determining loss causation in this context closely resembles proof of damages.  NB: Any showing that severs the link between the alleged misrepresentation and either the price received (or paid) by the plaintiff. The causal connection between the defendants fraud and the plaintiffs purchase of stock in such a case is no less significant than in a case of direct reliance on misrepresentations. Liggett & Myers. i. the reliance of individual plaintiffs on the integrity of the market price may be presumed (presumption is appropriate for reasons of equity and efficiency).3.  If the plaintiff can satisfy the trier of the fact that she would not have entered into the transaction.800 L&M shares at ~$55 per share. Inc. Analysts clients sell 1. 1972.000 shares at $50 stock falls to $48 as a result. a misstatement or omission must both cause the plaintiff to enter the transaction (transaction causation) and cause the plaintiff s loss (loss causation). the Supreme Court held that the fact that a price was inflated by false statement at the time of purchase was logically insufficient.000 shares at $48. the L&M stock price drops to ~$46. under which the plaintiff is required to prove (1) the time. and price per share of his purchase. . well-developed securities market is appropriate (fraud on the market theory of reliance).  Out-of-pocket measure: Price paid minus true value when bought.4. to establish that a loss on sale after truthful disclosure was caused by the misdisclosure.  Holding: A presumption of reliance when misleading statements are disseminated into an impersonal. the omission will be said to cause the transaction (transaction loss). any material misrepresentations.

14. obviously market-sensitive facts and cannot reach insiders informed decisions to refrain from trading. O Hagan  Materiality: what a reasonable shareholder would consider important. P can recover ($50 .  Measure used when tippee trades on information.4. The Academic Debate  While case law has explored the boarders of impermissible trading.$48) * 10. 690)  Elements of Rule 10b-5 Action:  False or misleading statement or omission: Chiarella. Existing law merely bars trading on material information that is. 695)  Suspicious stock-rice movements were found prior to 29% of the merger announcements the SEC studies between 2000 and 2004. same as out-of-pocket measure by assumption ($80.4.  .  Deregulating insider trading would invite managers and similar insiders to extract large rents at shareholder expense without any real check by the corporation or the market. Dirks.  Scienter: specific intent to deceive.  Injury/Damages: disgorgement rule (Liggett). Insider Trading as a Compensation Device  There is no reason to believe that managers negotiated contracts would correctly anticipate levels of insider trading or that other market controls would operate to check excessive insider trading.  Thus.000).  Not all informational advantages that insiders gain from their fiduciary roles are regulated by law. Here.000.000) = $50.000. much commentary has toyed with the question of whether even core insider trading is necessarily harmful. manipulate. Insider Trading and Informed Prices  Critics of regulation argue that insider trading leads to more informed prices that may actually increase investor confidence.4. Are Deal Makers on Wall Street Leaking Secrets? (p. Essentially equivalent to plaintiff s losses.  Disgorgement measure: Post-purchase decline due to disclosure.  Insider trading invites an uncompensated redistribution of returns from uninformed traders to insiders. or months anyway.2. or defraud (Ernst & Ernst).  Damages for fraud-on-the-market are calculated differently from damages for insider trading action? (p.4. capped at gain by tippee ($50.  Standing: must be a purchase or sale of securities (Blue Chip Stamp). insiders trading returns would exceed those of outsiders even if existing laws were perfectly enforced.1.  Insider trading is an appropriation of information rights that permits informed insiders to earn systematically higher trading returns than can uniformed outsiders. but investors prefer to maintain their information monopolies as long as possible. Here.4.000 shares = $20. 14. and inside information is likely to be publicly disclosed in a matter of days.4. Causation-in-fact measure: Price decline caused by D s wrongful trading (though not the later disclosure of information).  Reliance/Causation: presumption of reliance on the integrity of market price (Basic). weeks. 14. which could exceed defendant s gains. Basic probability x magnitude test. though may be inferred from reckless or grossly negligent behavior. capped at gain by tippee.

and (3) under-capitalization. common law of contracts. and Actual Authority. inherent authority is important to those dealing with the agent (since they can t claim actual authority if they didn t know there was a separate principal) Partnership  Ownership is defined as (1) right to claim residual earnings and (2) right to exercise control. but where the application of rules is based on standards. which would otherwise par a weaker motion under Rule 14a-8(8).  The source can be anyone. Blasius applies whenever the measure the board has taken interferes with a specific vote (outcome or timing). you can discuss that. last question will assume facts of the second  2 or 3 issue spotters  1 long spotter broken into four different parts organize response by parts  No discussion of policy. but really the right in question is the right to sue. and Blasius  Unocal duties apply whenever a board resists takeover. Agency by Estoppel and Agency by Ratification  Inherent authority: if principal is undisclosed. partnerships are small and the partners themselves are the agents. It probably applies to partnerships. but not why we use those standards instead of others)  Anything discussed in class or in the book is fair game  Don t ignore the first portion of the class (agency or partnership)  There will be a lot of issues to allow people to differentiate themselves. Don t get into lengthy discussions of law that you re not applying to the facts. so long as they know the tipper had a relationship of trust or confidence to the source that was violated. but presumption is rebutable.  Clearly-wrong answers will hurt you. not keeping separate books. following precedents. Three Factors for Veil Piercing: (1) lack of observance of corporate formalities (co-mingling assets. Uniform Partnership Act or RUPA (extra points for explaining both if they differ)  DGCL §216 states that the general rule is that a majority is a majority of the votes represented at the meeting (needed for most votes)  Only exception is director elections in which the default rule in Delaware is plurality. parent treating subsidiary as though there is no distinction at all). Apparent. so the duty to monitor isn t relevant. Economize on your words. but useless or irrelevant discussion won t  Understand the big picture and be able to recall things quickly  Jurisdiction has DGCL. (2) refusing to pierce would serve an injustice.  You can t have a tippee unless there is a tipper someone who intends to disclose with hope of gain. not just shareholders. §202 or RUPA and §7 of UPA create presumption of partnership wherever a person shares in net profits. # look up these provisions. Exam  Three hours long  3 questions. It s not as important in partnerships because usually as a practical matter. understand and apply those standards. Equitable subordination: An equity holder who doubles as a debt holder will have his debt claims treated as equity claims under certain circumstances.  Because we don t want people to behave opportunistically as the corporation approaches insolvency The duty to monitor is part of the duty of care (not loyalty because it doesn t involve self-interest). Board duties are chiefly important when the board faces a takeover attempt and are only relevant when the board has a say in a transaction (so not relevant when one controlling shareholder sells to another). Rule 14a-11 provides more stringent standards for shareholders to meet for placing a director nominee on corporate proxies that Rule 14a-8. because they sit on both sides of the transaction  Weinberger roadmap: simulate arm s length bargaining Practice Exam on Remedies: If shareholders have the right to vote something down.  Ex: veil piercing (talk about the factors. Duties for controlling shareholders  Do not sell to looter (Harris)  Higher duties in freeze outs. Revlon applies whenever the board agrees to facilitate a deal in which the minority shareholders give up control.  We care about board duties because it has the authority to force people to sell their shares or to prevent them from doing so in the context of a merger  Governed primarily by Unocal. Revlon. Inherent. just as most of the duties that we discuss in relation to corporations do.  Rights/claims: A breach of fiduciary duty (duty of care or duty of loyalty) claim or an appraisal right in a merger context  Remedies: Injunctions or damages Duty of care (applies only to directors or officers): hierarchy of misconduct            . (# 3:46) Tippees can be liable even if they have no relationship of trust or confidence to anyone.

    Negligence no personal liability for directors under business judgment rule Gross Negligence no personal liability for directors if effective §102(b)(7) waiver (but you can pursue an injunction) Deliberate disregard personal liability for directors Self-dealing (duty of loyalty) or fraud examples of bad faith that will trigger personal liability for directors .