CORPORATIONS OUTLINE Ryan Holt

1. GENERAL CORPORATIONS INTRO

(1) General Rules of Ownership, Control, and Liability
Profit is the residual interest in a businesswho gets whats left after everyone else gets paid? The person who gets the residual is what we think of as the owner of the business. o Ex: Simple ownership w/ employee. Thomas owns a bunch of rental property. He hires X to manage the properties. X has certain control rights that have been delegated to X by Thomas, but Thomas (the owner) has the residual interest after paying Xs salary. X has delegated authority subject to right of control and ultimate residual interest. o Ex: A creditor gets involved. Thomas has to take out a loan to buy the properties. The lender, a bank, requires a mortgage on the property (it is a condition for lending the money). Thomas has to pay the mortgage payments, now, as well as the manager. The creditor gets paid before Thomas gets paid, o/w creditor forecloses on the mortgage. A typical mortgage includes control rights for the creditorusually, negative control rights, which prevent the owner from doing certain things. The owner has positive control rights, the rights to initiate actions (but subject to veto of lender). The manager, also, has certain positive control rights subject to the owners ultimate right of control. General rule: the law attaches liability to control, because the controlling person is responsible for the actions of the controlled entity if the actions result in liability of the controlled party. o Conversely, if one does not have control, then one does not have liability for what another does (thus, if a manager is an independent contractor, then maybe the owner can get around liability by showing managers actions were not controlled by owner). o Three interests: Owner has right of positive control and residual interest; Manager has rights of limited control; and Creditor has negative control rights.

(2) Five Types of Organizations Covered in Course

(1) PARTNERSHIPS. o Partners are the owners. (1) Partners have the residual intereststhey get paid after everyone else gets paid. (2) Partners also have the right of control. o Associates are employees of the firm. They get paid a salary and benefits, but they do not have residual interest in the firm. However, associates do have certain control rights (partners have delegated some control w/in particular sphere). o The liability created by the associates is borne by the partners, because the partners are the ones with ultimate control. This incentivizes the partners to create a good system. o Non-equity partners are senior members of the organization who get paid income but do not have a residual interest. They are not owners, however, because they lack residual

interest. They are just another form of employee. o Executive committees are delegated more control rights by the partners. o Managing partner takes care of daily operations of business. o Creditors may have certain negative control rights. (2) LIMITED PARTNERSHIPS. o General Partners have control of the firms, and also receive a residual interest. They therefore have unlimited liability. o Limited Partners contribute something (generally cash) to the business in exchange for a percentage of the profits (residual interest). However, these are passive investors; they have no control rights. B/c they have no right of control, limited partners are not liable for the other agents of the firm. Because we want to encourage capital formation and we are afraid that if we attach liability to everyone who invests in the business no matter what degree of control they have, we do not attach liability w/o control. This rule creates the risk, though, that no one will be held responsible if all the money is w/ the limited partners. o Creditors (3) CORPORATIONS. o Shareholders (SHs): Contribute cash/property to the business, for which they get a piece of paper called stock, which entitles them to percentage of profits if directors say so. Get a right to vote on the directors, who run the organization. Have the residual interest. o Directors: Have the control rights for the organization. Liable for the actions of the managers as a general rule. o Managers: Have most of the authority, which has been delegated to them by the directors. The CEO is usually the manager with the most authority. o Creditors: Include banks (who hold mortgages/secured credit), and bond holders (who may have secured credit or may not). Once creditors go from having negative control rights to positive control rights, then the law holds them liable. (4) LIMITED LIABILITY COMPANIES (LLCs) o Members: Are the owners who contribute cash and get rights to residual payments. Statutes limit the liability of the members for the managers. Hence, they can have the residual interest and control rights but no liability. o Managers can be either member managed or professionally managed. Basically, the

LLC can select either the partnership rules for liability or the corporate rules for liability. (5) LIMITED LIABILITY PARTNERSHIP (LLP) o Just like a partnership, but by statute the law allows the partners to limit their liability for the actions of others. This also decouples control from liability. o The states decided to disconnect control and liability in order to encourage capital formation. o For smaller businesses, LLCs and LLPs are enormously popular because of the limited liability.

2. AGENTS AND EMPLOYEES

(1) Creation of the Relationship
Agency Relationships. PRINCIPAL-AGENT RELATIONSHIP o Agency is the fiduciary relation that results from the manifestation of consent by one person (principal) to another (agent) that the other shall act on his behalf and subject to his control, and consent by the other so to act. RSA 1(1). The law creates CONTRACTUAL LIABILITY for principal for actions of agent. Requirements: The principal must tell the agent to work for him, The agent must agree to do so, and The principal must retain the right of control. MASTER-SERVANT RELATIONSHIP o The Master is a principal who employs an agent to perform service in his affairs and who controls or has the right to control the physical conduct of the other in the performance of the service. RSA 2(1). This is a subset of the principal-agent relationship; it requires the right to control the physical conduct of the agent. The most common such relationship is the employee-employer relationship. o The law creates BOTH TORT AND CONTRACT LIABILITY for the master for the actions of the servant. The addition of tort liability is due to the increased control of the principal/master. A. Gay Jenson Farms. Co. v. Cargill, Inc.; Minn 1981; pg 7. Cargill entered into an agreement to provide credit to Warren, a local grain elevator, that could be used for working capital. Cargill also sought to buy grain from Warren. That K gave Cargill access to Warrens books and gave Cargill the right of first refusal. Later, Warren acted as an agent for Cargill to buy new grain and sunflower seeds. Cargill extended the credit line after taking more control of operations, but Warren eventually collapsed financially. The farmers who were owed by Warren sued Warren and also named Cargill as a jointly liable party under a theory that Cargill was Warrens principal. Ps won at trial by jury; affirmed here, as court held that Cargill was a principal. A CREDITOR MAY BE LIABLE for debts of another when it becomes a principal by: 3

o (1) Consenting to such a relationship, o (2) Having the agent act on its behalf, and o (3) Exercising control over the agent. Because Cargill assumed de facto control over its debtors businessby making many recommendations, by having right of first refusal, by preventing Warren from encumbering its assets, by having right of entry, and by financing its operating expensesit became a principal for that debtor. Some sort of agreement is necessary in order to create an agency, but it need not be a contract and that need not be the intent of the parties. The relationship here is different from that of a supplier and a buyer because the supplier cannot be said to have had an independent businessWarren sold almost all of its grain to Cargill, and all portions of its operations were financed by Cargill. The policy argument that such a decision will discourage loans to grain elevators is unfounded, b/c most banks are not so actively involved in their debtors grain businesses; here, Cargill was first and foremost looking for grain. The issue in this case is negative vs. positive control rights, in order to determine whether a principal-agent relationship was established. The reason for this is because Cargill wore multiple hatsit was a creditor, but it was also a buyer of grain, and it was arguably a principal. PLANNING. o How could a creditor in such a situation refrain from becoming a principal? By not stepping in and running the operation, by not designating their own person to make decisions, and by not assuring the creditors of payment. o How could Cargill avoid a situation like this in the future? If there were multiple creditors, and the problem w/ the grain elevator was financial distress (in other words, a business problem as opposed to corruption/fraud, as happened in Warrens case), then Cargill could go to other creditors and try to negotiate a decrease on the debt load from all of them in order to keep Warren solvent.

(2) Liability of Principal to Third Parties in Contract

When does the agent have authority to bind the principal when agent interacts w/ 3d parties? P = principal; A = agent; T = 3rd party. (A) ACTUAL EXPRESS AUTHORITY o P tells A to go forward and enter into a K with T. o P is liable for the K with T. o What is interesting here is the limit of As authority (i.e. could A reject or finalize a deal). (B) ACTUAL IMPLIED AUTHORITY o Like above, but A had to travel to negotiate the K with T. P did not expressly tell A to incur travel expenses, but it was necessary to incur those expenses to negotiate the K. o A thus has implied authority to incur those expenses. o This is a filling in of the things behind the actual authority so that A can complete the task in a way agents ordinarily/customarily do that. 4

o To determine the scope of actual implied authority, we have to know what the actual express authority was. Mill Street Church of Christ v. Hogan; Ky. 1990; pg 14. o Church hires Bill Hogan to paint its building. When Bill gets to a tough to reach spot, he has discussions with Dr. Waggoner, an Elder, about hiring a helper. He then hires his brother Sam. He had hired Sam to help in the past, but the Elders did not know of it this time until after Sam fell and was injured. o Sam Hogan sought WC from the church for his injuries. The New Board found Hogan was an employee and awarded WC; affirmed here. o An agent has implied authority when the principal actually intended the agent to possess authority such as necessary to carry out the duties of the job. Here, Hogan had implied authority to hire his brother, b/c he had been able to hire help in the past, the church knew the other potential helper would be difficult to reach, and the job could not be completed by one person. Furthermore, it would be unfair for Sam Hogan not to be considered an employee, b/c he believed that his brother Bill had the authority to hire him and he relied on that representation (seems like apparent authority). o o o (C) APPARENT AUTHORITY We are focused on the relationship b/w P and T. P tells T that A acts on his behalf and has authority to act on his behalf. T reasonably and actually believes that A has authority. T executes the K that A provides. P is bound. Requires: (1) MANIFESTATION FROM P to T that A has authority to deal; (2) T HAS OBJECTIVE, REASONABLE BELIEF that A has authority to deal; AND (3) T SUBJECTIVELY BELIEVED that A had authority to deal. Ex: P sends T a fax telling T that A has authority. P tells A that he cannot finalize the deal. A does not have actual authority to finalize the deal. However, A does has apparent authority, because T has no notice of the limitation on As authority.

Lind v. Schenley Industries; 3d Cir. 1960 (en banc); pg. 16. Lind was employed by Parks & Tilford, and he was offered a job as assistant to Kaufman, sales manager for NY. The VP told Lind that Kaufman had the authority to set his salary. Lind was informed by Kaufman that he would be paid 1% commission of gross sales of men under him. The raise never occurred, though, and Lind sued for expectation damages. The jury made several specific findings, and also found generally for Lind. The trial judge, though, entered a JNWV and an order for a new trial in event of reversal. The majority here reversed both holdings in favor of the jury verdict for Lind. The dissent, though, thought a new trial was appropriate. Agency can be created by: o Apparent authority, by which a principal acts in such a manner as to convey the impression to a 3d party that an agent has certain powers; or Apparent authority was created because: (1) the VP told Lind that he would need

to go to Kaufman to get his salary (this is the manifestation of consent by P to 3d party); (2) Lind had an objective, reasonable belief that Kaufman had authority b/c other managers also had the 1% commission as part of their deals; (3) Lind apparently had a subjective belief that Kaufman had authority. o Inherent authority, which arises from an agent being designated by the principal as the kind of agent who normally possesses certain powers. See post. Here, Kaufman had the inherent authority to offer Lind this particular comp package, because he was his direct supervisor and the person who would naturally transfer communications from the upper executives to the lower ones. Whether the alleged agent actually had salary-setting power is irrelevant in the analysis of apparent authority. So long as it appear so, liability is created. Three-Seventy Leasing Corp. v. Ampex Corp.; 5th Cir. 1976; pg 22. Joyce (370) was working to close a deal with Ampex, through Kays, and his superior Mueller. He was then to lease that equipment to EDS. Ampex sent a document to Joyce without its own signature, which Joyce executed. He then heard back from Kays that the computer parts would be delivered. Ampex never delivered to EDS, and 370 sued Ampex for damages. The district court found there was an enforceable K. Here, the court affirms on theory that Kays, the agent, accepted a contract. Here, it was reasonable for a third party to presume that Kays, a salesperson, had authority to accept the deal on a sale. Also, there was nothing in the document suggesting o/w. o Moreover, Joyce explained that he wanted all communications to go through Kays, and Mueller agreed (he also told all his staff the same). Joyce could therefore expect that Kays was speaking for the company. (D) INHERENT AUTHORITY - An undisclosed P who trusts A with management of business is liable to Ts with whom the agent enters into transactions usual in such businesses and on the principals account, although contrary to the directions of the principal. RSA 195. A similar rule applies for general agents, who are As who do work for the P on an ongoing basis: undisclosed P is liable to T when T conducted transactions with A on a continuing basis. RSA 194. Watteau v. Fenwick; QB 1892; pg 25. An undisclosed principal inherent authority case. P sold cigars, bovril, and other articles to a bar which was operated by Humble, but which he had transferred to Ds (Watteau, brewers). P had never heard of Ds. Humble failed on his credit to P, so P sued Ds for the value of the cigars. Trial court found for Ps (that Humble was an agent); affirmed here. Inherent authority. P IS LIABLE for all the acts of A that are WITHIN THE AUTHORITY USUALLY CONFIDED to A of that character, notwithstanding limitations put on that authority b/w the principal and agent alone. o The principal need not hold out that the agent has the authority to do particular things in order for such inherent agency to exist.

o Here, there is no apparent authority b/c the 3d party had never heard of the principal, so there could be no manifestation of authority from P to 3d party. o If P authorizes A to do business, and A does business in its ordinary course, then P should be held liable for As actions. o One cost of such a rule is that it discourages passive investing, b/c Ps are liable to 3d parties for things that were outside of the control that they wished to exert. (Hence the rise of limited liability companies/partnerships.) Kidd v. Thomas A. Edison, Inc.; SDNY 1917; pg 28. A disclosed P inherent authority case. Edison (D) hired Fuller to negotiated deals with singers to participate in tone test recitals to promote a sound recording invention. Fuller entered into deals with singer Kidd (P) which were in excess of the actual, unusual limitations on Fullers authority (unlike prior custom, Edison would not guarantee a singing tour). P sued D in contract. The jury found for P, and the court here denied a motion to set aside that verdict b/c Fuller had apparent authority to deal for D. If P does not want A to be able to act in a customary fashion, then P should make sure that T knows of limited authority. o A general agent [one who engages in repeat transactions for P] for a disclosed or partially disclosed P subjects P to liability for acts done on his account which usually accompany or are incidental to transactions which the agent is authorized to conduct if, although they are forbidden by the principal, the other party reasonably believes that the agent is authorized to do them and has no notice that he is not authorized. RSA 161, o The key to understanding this case is custom. This is the part of inherent authority that applies in the disclosed principal setting. This is analogous to the reasoning in 370 Leasing, where the court explained that a salesman would customarily be able to make sales. o Rationale for inherent authority. The case explains that estoppel is not the best rationale for holding a principal liable for the dealings of an agent who exceeds his actual authority, b/c estoppel is not appropriate in that P has never communicated with T. Instead, the court explains that P has vouched for As reliability, and T must be able to believe P will be bound to As minor deviations in order to deal effectively. o Because P was disclosed here (Kidd knew that she was going to work for Edison), 194 and 195 do not apply. There was also no actual authority. There was also no manifestation from P to 3d party that A had authority, so apparent authority is flawed, as well. (E) RATIFICATION o A shows up at Ts door and says that P wants to enter into a K with T. However, P had never heard of A. T agrees to contract with P, then A takes the deal to P, who likes what he sees and ratifies it. o Here, P is now bound, b/c even though A did not have authority at the time, the deal was ratified by P later. o Callback Offer Hypo:

You are at a callback, and the managing partner gives you an offer. Does he have authority? Who is the principal? It is the partnership combined. The managing partner is the agent, and you are the 3d party. To determine if the MP had actual authority, one must examine the communication b/w the partnership as a whole and the MP. Suppose you leave the firm, go home, and wait by the mailbox for an offer. A letter arrives on firm letterhead signed by the MP stating that you have an offer. Is there apparent authority? Has there been a manifestation by the principle to 3d party? It may be created by a combination of the letterhead and the title of the MP. Next, you ask for 6 months off to travel before you start. The MP says it is okay. It is unlikely the MP has the actual express authority. He may, though, have actual implied authority. Change of facts: at the interview, an associate tells you that theyd like to have you join the firm. Doubtful there is actual authority, unlikely apparent authority. However, the firm can ratify the unauthorized offer and is then bound.

(3) Liability of Principal to Third Parties in Tort

(A) Servant versus Independent Contractor FRANCHISING Generally Popularity of franchises. o Perspective of franchisee: Most franchisees are not typically very experienced businessmen. Such person can learn the system and yet be independent. There is also reduced risk of failure. Advertising is a major benefit, too. o Perspective of company: The alternative is to do it themselves. However, one limitation is money, and having franchisees put up their own money allows franchisors to open up new markets lets them ride on backs of franchisees. It diffuses the risk of failure. Additionally, they get highly motivated/incentivized people running their businesses (they get paid only if they sell products). Because franchisors have much more significant bargaining positions, they are able to draw up contracts such that they will not be liable for the workings of the franchisees, thereby causing externalized costs to third parties (when the franchisee is undercapitalized). It is important to distinguish master-servant from independent contractor (franchisee). o Agent-type independent contractors agree to act on behalf of P, but not subject to Ps control on how the result is accomplished. o Non-agent independent contractors operate independently and enter into arms length transactions with others. Two major TYPES OF FRANCHISES: (1) PRODUCT AND TRADE NAME franchise. 8

o The franchisor licenses a wholesaler/retailer to sell its product. o Franchisor exercises some control over the franchisee (ex: making sure franchisee cleans the bathrooms). o General examples: automobile dealership; gasoline service stations. (2) BUSINESS FORMAT franchise. o The franchisor provides the franchisee with an entire business concept, including marketing/advertising strategy, operational manuals, and ongoing assistance in making sure the standards are met. o The relationship b/w the franchisor and franchisee is a contract. That K embodies the entire relationship b/w the franchisor and franchisee. o Typically, the former provides the latter w/ training, advertising, assistance, supplies, and the right to use the franchisors trademark. o The franchisee agrees to pay an initial fee and a royalty payment, and to follow the requirements of the franchisors system. o The K also includes termination clauses. o The franchisee cares much about territorial exclusivity (they want other franchises to be further away). Humble Oil v. Martin; Tex. 1949; pg 48. Servant case. Mrs. Love left her car at a filling station operated by Schneider. It rolled into the street, injuring 3 Martins. The station was owned by Humble Oil, who financed all the operations, set Schneiders hours, and had other control. Martins sued Humble for Ss negligence; Ps were successful. Affirmed here (S was a servant of Humble). An operator of a gas station is a servant of the oil company when the oil company has control rights in the contract, finances much of the operation, and controls the day-today operations of the gas station (i.e. the hours of operation). o There was little difference b/w Ss situation and that of a store clerk who worked for commission; his only authority was to hire and fire his workers. o Schneiders only real power was to hire and fire workers, and there was language in the K that S had to do everything that Humble told him. The complication here is that the harm was caused not by the gas-selling aspect of the filling station, which Humble cared about, but rather by the car repair division which Humble had no interest in. However, the court here viewed these two aspects of the business as integrated, perhaps b/c that was the custom at the time (gas stations and mechanics went hand-in-hand). Due to respondeat superior, a master is liable for his servant in tort. Hoover v. Sun Oil Co.; Del. 1965; pg 50. Independent Contractor case. Ps were injured as result of a fire at filling station operated by Barone. Sun Oil owned the station and all of its equipment and leased it to Barone. Sun had some control of the operations (Barone was required to maintain certain equipment and use it only for Sun products) but not all control (Barone made no written reports to Sun, assumed all financial risk, and set his own hours). Ps sued Sun for the negligence of Barone in the fire. Sun won at SJ (Barone was an independent contractor, not a servant); affirmed here. 9

For an operator of a filling station to be a servant of the oil company, the oil company must retain the right to control the details of the daily operation of the station; control or influence over results alone is not enough. o While Sun did have some areas of negative control and it maintained close contact with Barone through a sales rep who came by weekly, this is merely because they shared an interest in the stations financial success. How to explain the different results in Sun Oil and Humble Oil? o Better drafting. The K in Sun Oil did not give the franchisor control. However, in that case, the franchisor came and made a wide variety of suggestions (thus, while the indicia of control was removed, its substance may not have been). o Who bears the risk and gets the returns? Whoever has the risk and return (i.e. who pays the utilities, how rent is calculated, etc) is really the owner, and that entity is the party that has the incentives and ability to control. The question, then, is who has the residual interest (who will take any profits), and who will suffer any liability. In Humble Oil, the oil company would suffer all the loss. In Sun Oil, Barone bears the risk of loss and has the residual interest. Going back to Cargill, the creditor had the residual interest in the business b/c the debtor was approaching the vicinity of insolvency, so any future profits would go towards paying back the debt. Looking at risk/return is helpful when things like contractual language can be so manipulable.

Murphy v. Holiday Inns, Inc.; Va. 1975; pg 53. Holiday Inns gives a complete system of marketing and operating their franchise in exchange for a fee from the franchisor (this is a business format franchise). Betsy-Len is the franchisee. P slipped and fell, and then sued Holiday Inns, and the trial court entered SJ for D. Affirmed here (there was no master-servant relationship). Because the franchisor did not retain POSITIVE CONTROL RIGHTS over the sort of day-to-day operations that would affect the maintenance of the facility and whether people would slip and fall, there is no master-servant relationship. o While the contractual provisions may have given HI control over the architectural style and type of furnishing, it did not give HI control of daily maintenance, which led to this particular injury. o Franchisee holds the residual interest HIs position is more like that of a creditor. It gets a fixed payment and small royalties, but it does not have a residual interest that would incentivize it to control daily operations. Two separate reasons for creation of master-servant relationship: (1) control; (2) residual interest (who has the risk of loss and return). PLANNING: Franchisors options when franchisee is not running a solid operation: o (1) Positive incentives (carrots); 10

o (2) Financial penalties (sticks); o (3) Cancel the franchise; o (4) Arbitration agreement. (B) Tort Liability and Apparent Agency Miller v. McDonalds Corp.; Ore. 1997; pg 58. P, a McDonalds regular, injures herself by biting into a sapphire in a Big Mac from a franchised McDonalds store. McDonalds had a right to control the way food was prepared, and this was what led to the harm. P sued McDonalds. The trial court granted SJ for D (no control). The court here reversed, finding issues of fact as to actual master-servant relationship as well as apparent agency. For a master to be liable in tort through APPARENT AGENCY, the putative principal must have held out the 3d party as an agent, and plaintiff must have relied on the holding out. o Apparent agency v. apparent agency Apparent agency creates an agency relationship where no agency relationship existed before. Apparent authority creates authority for an authorized agent when no authority existed before. o Apparent agency is built on the reasonable belief of the 3d party that the franchisor is controlling the store. Here, that belief is based on all the things that McDonalds does to make people believe that all McDonalds are the same. (This is not about the relationship b/w the franchisor and franchisee.) o There was an issue of fact here as to whether the 3d party had a reasonable belief that McDonalds owned the storea sign in the store that stated that that particular store was independently owned. PLANNING: How could the franchisor protect itself in situations like this? o (1) Advertising that particular McDonalds are not owned by the company (however, this takes away from the value of the trademark); o (2) Require insurance/indemnification clauses, as well as minimum net worth of franchisees (however, it is expensive to monitor this anywhere other than up front).

(4) Fiduciary Duties of Agents

Generally Fiduciary duties of agents focuses on As duties to P, rather than the relationship b/w A, P, and T. How does A have to behave wrt P? The AGENT HAS A DUTY TO ACT CAREFULLY AND LOYALLY. o Duty of Care (Negligent vs. Intentionally Bad Decisions): If a manager has decision-making authority and makes a very stupid, negligent business decision, he does not face liability for that b/c it would stifle his discretion to do his delegated tasks. If the manager intentionally does something stupid, then the act was taken disloyally and the manager has breached a fiduciary duty. This issue of where we draw the line b/w negligence, gross negligence, intl 11

actions permeates this area of the law. o Duty of Loyalty: The agent has the duty to act in the best interests of the principal (as if the assets were As own assets). Duty of loyalty is a broad, overarching prohibition, but when it is put in practice it is actually a series of sub-doctrines to deal with common, recurring fact situations (we have to think about it at a very particularized level). Why Create Such Duties? o The law gives agents power (the principal can be bound by their actions); thus, we impose duties on agents to ensure they take care of the assets they have control over. Derivative Actions. o If a manager negligently burns down the employers office, the employer can sue the manager (agent) for negligent injury of the principals property.

General Auto. Manu. Co. v. Singer; WI 1963; pg 83. Singer, skilled manager of auto manu operations, directed a large volume of business attracted by him to other shops that had the equipment to do the work properly. He profited the difference b/w what GA would have charged and what the other shop charged, and he did not disclose to GA that he was serving as a broker. GA sued Singer for the lost profits by his breaching his fiduciary duty. Here, the court found a breach of Ds duty of loyalty. An employee breaches his duty of loyalty to his employer by directing business away and profiting from it, unless he obtains consent from the employer to do so. o We are trying to protect the companys assets from being ripped off from its employees. The assets are the potential business that GA could have invested in the machinery so that it could perform itself, or that it could have served as a broker for itself. o Even if the employee truly believes that the firm cannot do the work and simply turns the business away (thereby not profiting from it), the employee must make a disclosure to the firm and let the firm decide how it wants to react to the possibility of business. o The remedy here is profit disgorgement. However, the court here allows Singer to keep his share of gross revenues that he would have had had he acknowledged the business to the firm. Agent forced to perform work he does believe he can do Hypo. o Singer makes a disclosure, GA wants Singer to do the work, but Singer believes he cannot do it (and that his reputation would be damaged). o Singer would have to do the work, and he also cannot warn the potential client that he might want to take the business elsewhere. o If the firm insists, Singers only option is to quit. Suing on the K versus fiduciary duty. o Singers employment K states that Singer must devote his entire time and skill to the business. Why not just sue on the contract? o Under the K, it is not entirely clear that he couldnt work for other businesses on his day off. 12

o Also, the remedy for breach of fiduciary duty, profit disgorgement, would be easier to prove than expectation damages. PLANNING: How could Singer deal with this problem effectively beforehand? o (1) Singer could bargain for more money such that it would offset the potential loss to his reputation. o (2) Can Singer bargain around the rule of duty of loyalty? YES. The law permits contracting around the duty of loyalty in small firms settings, but it does not allow contracting around it in public company settings. Duty of loyalty should be mandatory rule when there are either: (A) Large asymmetries of information. At small firms, it is more likely that all the parties are active and share the relevant information. At large firms, though, passive investors are less likely to receive all information. (B) Ks of adhesion. At small firms, parties are more likely to negotiate the terms of their relationship with each other. If duty of loyalty were a mandatory rule, this might decrease the value of some small firms where they would o/w want to contract around it. So long as the two characteristics above are not likely present, the law should allow that deal. Town & Country House & Home v. Newbery; NY 1958; pg 87. The employees of a cleaning service quit, started their own cleaning service, and solicited some of the customers of their old employer for their new cleaning service. The old employer sued on the theory of unfair competition for drawing away those customers. This is a duty of loyalty issue, and the court held that the new company should be enjoined from taking away more customers and should give up some of its profits. The duty of loyalty is breached when a (former) employee of X uses Xs customer list (a trade secret) to benefit its own new company. o This is another example of how the duty of loyalty stops people from ripping off assets of the firm. Here, the asset is the customer list of the firm, a trade secret. How far can separated employees go? o They put up signs in all the old neighborhoods where they used to work, saying they are former of employees of the old firm and that they would give them their desired service. This would breach their duty of loyalty, b/c identifying those neighborhoods was part of the work in the first place. o The law, though, would allow an entirely separate business to follow that business around and pick off its customers, b/c in that instance there is no prior connection to the firm; there is no reason for the competitors here to be loyal to that firm. Also, because our economy is driven by competition, we do not want to stifle it by preventing this sort of competition b/w competitors with no prior employee-employer relationship.

3. PARTNERSHIPS
The role of taxes in partnership o In a partnership, we pass through income tax to the partners. o Therefore, there is no income tax at the entity level (instead, the individual partners pay tax as a part of their income). o Now, any form of unincorporated entity can elect partnership tax treatment w/o 13

partnership form organization.

(1) Formation of Partnerships

UNIFORM PARTNERSHIP ACT (UPA) A partnership is an association of two or more persons to carry on as co-owners a business for profit. UPA 6(1). A share of the profits is prima facie evidence of partnership, UPA 7(4), unless they are for wages, Fenwick, or interest on a loan, Martin v. Peyton. Fenwick v. Unemployment Compensation Commission; NJ 1945; pg 91. Fenwick owns a beauty shop where Cheshire is the receptionist. Cheshire wants a raise, but Fenwick instead wants to make her a partner, who would get a share of 20% of profits (if any arose). They execute the deal, which does not change Cheshires relationship to the firm in any other way. Unemployment agency claims that the firm has 8 employees (minimum amount in order to pay unemployment tax), but Fenwick claims that she is a partner, hence there are only 7 employees. The court here finds that Cheshire is not a partner, so tax must be paid. Factors that indicate the EXISTENCE OF A PARTNERSHIP: o (1) Parties intention; o (2) SHARING OF PROFITS/LOSSES; o (3) Ownership/control of the businesss property; o (4) ALLOCATION OF THE CONTROL of the business; o (5) Language of the agreement (when the dispute is b/w the parties, not for 3d party claims); and o (6) Conduct towards 3d parties. o Here, Cheshire does have a small share of the profits, but she has absolutely no control rights. Those profits appear to serve as wages to an employee, which implies that a mere share of profits is not enough to create partnership. 7(4)(b). This finding of wages to an employee is likely in part b/c Cheshire does not have any control rights; she appears to be an employee. PLANNING: o How to make this deal appear as a partnership despite lack of control rights? The UPA allows partnerships to contract around the default rule of equal control rights. 18(e). Thus, an attorney could state that each partner has a voting right for control equal to its share of profits. Because she had a 20% share of profits, and he had a 80% share, he would have total control; thus, as to practical effect this changes nothing, but it could turn the decision of the court. o How to deal with future dissolution. DISSOLUTION is the change in the relation of the partners caused by any partner ceasing to be associated in the carrying on . . . of the business. UPA 29. Partnership at will: No specified term how long it will last. 14

Whenever a partner says I dissolve, that is an event of dissolution. The agreement must specify what happens to the partnership property in the event of dissolution. Here, an attorney would want to specify that Fenwick contributed all of the property, and that in the event of dissolution he would get all the property back. That would then make the agreement look more like a partnership. Most rules are default rules for partnerships. Why would the law allow this in such context? o We like the ideas of parties structuring their relationships in the way they like best b/c we think it will make the deals more efficient and help them properly structure their transactions. o We are less concerned of the problem of it being contracted around b/c most of the owners are active managers in the company. Martin v. Peyton; NY 1927; pg 96. KNK was having capital problems, so Hall, its managing partner, went to PPF (individuals) to receive a large loan of negotiable securities. In compensation for the loan, PPF (called trustee by the agreement) were to receive 40% of KNKs profit; an option (a right that they do not have to exercise) to buy 50% of the firm; the right to inspect the books; the right to veto speculative transactions; consulted on important decisions; Hall is made managing partner; every partner gave them a signed resignation which PPF would only use if it felt need to do so). KNK takes the loan and loses all the money by engaging in contractually forbidden foreign currency speculation. Other lenders find KNK insolvent, so those other lenders go after PPF, arguing that they are partners and therefore liable. Because they have ONLY PASSIVE CONTROL and limited residual interests, the LENDERS DO NOT RISE TO THE LEVEL OF PARTNERS. o Who has the control rights? The loan agreement provides that Hall will be the managing partner. Was Hall an agent of PPF? While PPF does have a lot of leverage on Hall (b/c they have all the signed resignation letters), they do not have the legal right to control him (they only have negative control rights). o Who has the residual interest? While PPF does receive a large share of profits, they can argue under UPA 7(4) (d), which states that a share of profits is prima facie evidence of partnership, unless it serves as interest on a loan (though the amount of the payment may vary). Additionally, PPF has an option to buy 50% of the firm (to the extent there are profits, they can benefit from them), but they do not share in the risk of loss. Analogy to Cargill. o Like the lenders in Cargill, PPF here had the negative control rights of checking the books and veto rights. o This decision can be reconciled with Cargill b/c it takes place in NY, the financial center of the country, where we care more about encouraging investment than we care about protecting individuals like farmers.

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(2) Fiduciary Obligations of Partners

Meinhard v. Salmon; NY 1928; pg 109. Gerry leased a hotel to Salmon for 20 yrs. Salmon was required to renovate it using $200K. Salmon went to Meinhard to arrange for receiving half the renovation money from him in exchange for: Ms getting a share of profits, Ms sharing any losses equally, but S has all the control rights. At the end of the lease term, Gerry offers Salmon an opportunity to get involved in a skyscraper project on the same property. Meinhard learns later of this new lease, and he sues Salmon for breach of fiduciary duty of loyalty. Cardozo holds that Salmon did breach his duty to his partner; the remedy is either half the lease in trust, or the shares minus one in the project (so that Salmon would retain control, as before). PARTNERS OWE EACH OTHER A DUTY OF LOYALTY to share all information about opportunities that come to the partnership during its duration. o The law must protect partners like M, who are not held out to those who come in with development opportunities. Otherwise, the managing partner could reap all the benefits. o It does not matter that we are unable to know whether M would have actually agreed to be a part of the new deal. Even though Ss failure to disclose the information was not purposively to deprive M of the opportunity, it is still a breach of fiduciary duty. Types of partnerships (duration): o (1) Partnership at will. Any partner can terminate at any time. o (2) Term partnership. Ends at the end of a proscribed term (a number of years, or the length of a single project). What is the term of the partnership? o Salmons position is that the partnership is for the term of the 20 yr lease on the building. o Meinhard argues that the partnership is also for a term, but the term is anything that is related to the property. Under this view, the opportunity brought in by Gerry belongs to the partnership, and there is a fiduciary duty to Meinhard wrt this opportunity. o The court may determine the term by looking at the intention of the partners when they entered into business together. Business Phases here. o Old businessDissolution(winding up)TerminationNew business. BUSINESS OPPORTUNITY DOCTRINE. When does a fiduciary have an obligation to offer an opportunity that comes to them to their firm? Two important question to ask: o (1) What types of businesses are w/in the FIRMS LINE OF BUSINESS? What is the relationship b/w the opportunity and the firms current business practices and possibilities (i.e. is this an area where the firm could expand into in the future)? Does the firm have the financial capability to do this (or could it obtain that capability through loans)? Does the firm have experience or knowledge about this business? Here, was this partnership in business to develop and benefit from this particular piece of property indefinitely, or was its scope merely the single project? o (2) If it did fall in the line of business, DID THE PARTIES CONTEMPLATE that 16

officer/manager would offer it to the firm? Who is the person who received it? If partner, then it is likely it was contemplated it would be offered to the firm. Did the opportunity come to them in an official or an individual capacity? Did the manager use the firms facilities (meetings in the office, calls on firm phone)? Comparing Singer. o In Singer, the opportunity was held to be within the scope of the business, so the employee had to disclose it to the employer. o The decision in Meinhard is harder b/c the corporation in Singer had an indefinite duration, but the partnership here is limited by some, unclear, term. Lawlis v. Kightlinger & Gray; Ind. 1990; pg 125. Lawlis was a partner at a law firm in Indianapolis. He became an alcoholic but hid his illness from the partnership for a year. When he tells them about it, they entered into an agreement providing that he would have time off for treatment but there would be no second chances. He later had a relapse, but the firm gave him another chance. He goes sober, then he demands his full status back. He is then expelled from the firm. Lawlis sues that he was wrongfully expelled. The court disagrees. The PARTNERSHIP MAY EXPEL one of its partners per the authority conferred to it in its agreement so long as that expulsion is in good faith. o Here, the partners actually allowed L multiple opportunities and were understanding of his situation while he was suffering from alcoholism. See also UPA 31(1)(d) (explaining how dissolution may be caused by bona fide explusion). A no cause (guillotine) provision in a partnership agreement should be enforceable; this allows partnerships to contract out of fiduciary duties. o Allowing partnerships to contract around fiduciary duties is likely efficient b/c there are not large asymmetries of information and there will not be contracts of adhesion. The parties are bargaining b/w themselves ex ante, and they are bargaining with the advantage of (near) full information.

(3) Rights of Partners in Management

National Biscuit Co. v. Stroud; NC 1959; pg 140. Stroud and Freeman owned a grocery store as a partnership. They bought bread from NBC. Stroud told NBC that they should stop shipping bread and that he would no longer be responsible for paying for such bread. Freeman requested the bread still to be delivered. The bread was delivered despite Strouds request. NBC sued Stroud b/c the partnership agreement stated that Stroud would hold all liability on dissolution. The court here found Stroud incapable of preventing the shipment and therefore liable. When there is EVEN NUMBER OF PARTNERS, one partner cannot place restrictions on the other for matters of ordinary business. o Generally, any difference b/w partners as to ordinary matters of the business may be decided b/w a majority of the partners. o When there is an even split, there is no majority, so an even split cannot limit the other 17

half from acting w/in the expectations of ordinary business. PLANNING: How could Stroud have gotten around this problem? o The partnership agreement could have required unanimous consent for daily business decisions, and this would eliminate actual authority for the one partner. o But, in order to prevent partnership apparent authority, see UPA 9(1), there would also have to be some way to promote the fact to all 3d parties that both partners must consent to any business decision. Summers v. Dooley; ID 1971; pg 142. Summers and Dooley have equal stakes in a trash collection partnership. Dooley couldnt work, so he hired his own replacement. S decides they need to hire a 3d person (D disagrees). S pays the 3d person. S then sues D to force him to pay for part of 3ds salary. The trial court found that S should get partial payment, but not entire payment for 3d party. Affirmed here. Because S does not have the actual authority to unilaterally change the terms of the K (there is no majority), he cannot bind the partnership and D is not liabile. Actual vs. Apparent Authority. o Because this is a case b/w partners but no 3d party, all that matters is actual authority. o Because S did not have a majority, he did not have actual authority, so D is not liable for Ss decision. Firing of Grocery Store Employee Hypo. o A, B, and C own grocery as partnership. C hires his son D. A and B want to fire D. o What can they do? (1) Dissolve the business. If they have the cash, they could buy out Cs share. (2) Fire D using their majority power under UPA 18(h). o What if C negotiated for complete control in the meat department? In that situation, they would need all the partners consent to go against the partnership agreement. 18(h) Day v. Sidley & Austin; DC 1975; pg 146. Day was a senior partner at Sidley. Sidley wants to merge with another new firm, Liebman. Negotiations are carried on exclusively at executive committee level, and when the information reaches the partners, there is some fallout. Day had chaired the DC office of Sidley, but after the merger he became co-chair of the office. Day sued claiming that he had a contractual right to be the sole chair of the DC office and that Sidley had breached contract stating that no partner would be worse off. His claims were dismissed here. Because Days managerial authority had already been delegated to the executive committee, he was not made any worse off by the merger, so his claims fail. o Executive committee has the real power. At Sidley, many of the important policy decisions were delegated by the agreement to the executive committee (e.g., partners participation (share of profits); required balances of partners; admission and severance of partners). The partners who together have a majority of all voting shares can then only ratify or decline those decisions by the executive committee. The power at large partnership is delegated to a small group of partners. 18

There are good efficiency reasons for doing that, but such contracting around eliminates many of the default rules for partnership. o Here, there was no breach of fiduciary duty, b/c the remaining partners did not acquire any more power within the firm as a result of withholding the information about the potential merger. The BASIC FIDUCIARY DUTIES OF PARTNERSHIPS are partners: o (1) Must account for any profit acquired in a manner injurious to the interest of the partnership; o (2) Cannot acquire for himself a partnership asset w/o consent; o (3) Cannot compete w/ partnership w/in scope of business. Note how far this narrow understanding of fiduciary duties for partners has come from Cardozos utmost loyalty in Meinhart. What really protects you as a partner in private practice is having clients. Because, your share of profits will not be lowered more than it should be when you could walk away with clients.

(4) Partnership Dissolution

The CAUSES OF DISSOLUTION are listed in UPA 31. Dissolution is caused: o RIGHTFULLY (w/o violation of the parties agreement), by: End of the definite term or undertaking in the agreement; Express will of any partner when partnership-at-will; OR Good faith expulsion of any partner in accordance with the powers conferred by the partnership agreement. o WRONGFULLY (in contravention of agreement), By the express will of any partner at any time. This leads to breach of K and right to damages under UPA 38. o AUTOMATICALLY, by Death of any partner; Bankruptcy of any partner or the partnership; OR Decree of court under 32. Continuation agreement states that when the partnership automatically dissolves for whatever reason (b/c one partner leaves or another comes in), the partnership continues on as before. Owen v. Cohen; Cal. 1941; pg 152. Owen and Cohen go into business together running a bowling alley. Owen puts forward the capital to start it up. Cohen belittles and mistreats Owen, and Owen wants to get out of the business. Owen files a suit seeking dissolution and share of partnership assets. Trial court holds that dissolution is proper, and that company assets should pay off Owens loan and then be split b/w the two. A partner can apply to a court for dissolution when the other partner has engaged in such conduct that tends to affect prejudicially the carrying on of the business. A COURT SHALL DECREE A DISSOLUTION whenever: 32(1) o (1) Partner has been declared a lunatic;

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o (2) Partner has carried on conduct that tends to affect prejudicially the carrying on of the business; o (3) Partner willfully or persistently breaches the partnership agreement (or conducts himself in such a way that it is not reasonably practicable to carry on the business with him); o (4) The business of the partnership can only be carried on at a loss; OR o (5) Other equitable circumstances. o Here, Cohen repeatedly breached and undermined Owen, so there are several subsections which merit dissolution. o The court here overrides the part of the agreement that the loan should only paid out of profits, b/c Cohen appeared to have willfully and persistently breached the partnership agreement. Thus, the court finds that the loan should be paid off in full out of the dissolved assets. Proper use of automatic dissolution. o Going to court and seeking judicial dissolution was a smart move here, b/c o/w the dissolution likely would have been a wrongful one, see UPA 31, b/c the court would have likely read in the duration of the partnership as the amount of time necessary to pay off the loan. Using this approach, though, the dissolution was automatic, and avoided potential negative effects for Owen. Collins v. Lewis; TX 1955; pg 155. C and L are partners in building a cafeteria. Term of 30 yrs. Lewis is to manage the caf; Collins is to put up the money. Collins is to be repaid for his loan at a rate of $30K the first year and $60K thereafter. There were building delays, so Collins put up over $600K. Upon opening, there were operational problems. Collin sues for dissolution and seeks foreclosure on the debt owed by Lewis. Lewis wins at jury trial; Collins must continue to make money available. Affirmed here. Bad performance and inability to make a profit is not sufficient alone to dissolve a term partnership. o Collins does not have the right to a dissolution by a decree of the court, but he does have the option of wrongful dissolution, see UPA 31(2). If Collins were to go that route, he would receive his share of the value of the property, minus any damages proven by Lewis, minus the value of any intangible assets (good will), see UPA 38. Clearly, wrongful termination would not likely be a good option for Collins. PLANNING: What protection should Collins have put in the partnership agreement? o (1) Shorter term. However, this would likely still require being locked in during the startup, which is the most risky period. o (2) A cap on funds to be contributed (e.g. Collins would put in $300K but not a penny more). However, Lewis in return would probably want some kind of compensation during the period, b/c he could potentially not get any pay for his work. Page v. Page; Cal. 1961; pg 160. Brothers invested equal amounts at outset of linen supply business. It was not profitable at first, but then a military base opened nearby, which provided business. HB, a corporation

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wholly owned by P, wanted to foreclose on a demand note of $47K in order to dissolve the partnership. Lower court held that partnership was for term of period to repay the note; reversed here b/c no way to find implied term in the agreement. Thus, HB has the right to dissolve the partnership. When a partnership merely hopes that it will pay off its expenses, it is not necessarily a partnership for the term of the debt, but rather is a partnership at will (so long as no implied term in the agreement). o Thus, HB can dissolve the company, b/c there was no way to find an implied term within the agreement. Thus, one of the partners has the right to dissolve the business and take control of the business as soon as it becomes profitable. o However, any sort of dissolution must satisfy the requirement of being done in good faith, otherwise it would be a violation of the fiduciary duty of the partner. This would be a violation of the business opportunity doctrine (the difference here, though, is that the business opportunity is a prospective one). Cf. Singer, supra (holding that mechanic could not appropriate business to himself by serving as a broker at his employers business). PLANNING: How could HB take over the business legally? o He could buy out his brothers share. He would need to come up with a reasonable valuation of his brothers interest. (A) Hire a professional appraiser. (B) HB could pick a price and then tell his brother either that he could by him out for it, or HB could buy George out for it (however, a problem could arise if George doesnt have any money). (C) Put it on the market and see what the market values it. o Take his brother to court for dissolution. o Buy-sell agreement. Put in the contract what happens in the event of dissolution. A buysell agreement decides beforehand what method to use to value the company in the event of a situation like this. Prentiss v. Sheffel; Ariz. 1973; pg 163. Two partners, S and I, own majority of partnership. P owns a minority share. S and I believe that P is not contributing his share operationally, and P is unable to contribute his share of the next capital payment. S and I sought dissolution in court. The lower court found a partnership at will and that it was dissolved by the freeze-out of P of the management and affairs of the business. The trial court ordered liquidation by sale, and S and I bought the company. P was upset that his former partners could purchase the business, so he appealed. The court here found no bad faith by S and I and no injury to P, so affirmed. When a partnership at will is dissolved in good faith, the partners should be allowed to bid on the business at the judicial sale auction. o The majority partners were not trying to steal a partnership asset from P. This was a partnership at will, so they can dissolve for any reason or no reason so long as they are not operating in bad faith. Here, they were not operating in bad faith, because they merely did not get along with the minority partner. o The minority partner actually benefited from the majority partners being able to bid up

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the price of the business, b/c it increased the value of his 15% share that was being paid off. However, minority partner argues that b/c the majority have a bigger equity interest it is easier for them to be able to buy the business. The court says tough luck. The best way to prevent being frozen out as a minority partner is to contract for a term partnership. However, this would lock a minority partner into a longer-term commitment (which might not be desirable if the minority partner wants to be able to cash out). o Cf. closely-held corporate section, where minority shareholders sometime want to be able to be bought out. Another way that the majority partners could have dealt with this would have been to allow the minority to participate but recognize that such participation does not give the minority a right of control. (So long as the minority is not excluded from operational discussions, he will not have been frozen out.)

(5) Limited Partnerships

LPs Generally o Formation. To form a limited partnership, one must file a certificate of limited partnership with the Secretary of State. When it has been accepted, you have formed a limited partnership. If you think you have formed a limited partnership and have not b/c of failure of acceptance, you have actually formed a general partnership. o Management. Limited partnership agreement, a K b/w the parties, is usually quite detailed in allocating management responsibilities to the general partners. Limited partners put in cash or other consideration, but have very limited or no control rights. o Liability. General partners have liability. Limited partners have limited liability (b/c they do not have control); all they have at stake is what they put into the firm, not their personal assets. A claim would be first against the entity, and second against the general partners. It has become common to create a corporation as the general partner (injecting the corporate form b/w the shareholders and liability; this insulates the shareholders from potential liability to creditors of the LP). This creates incentives to undercapitalize the corporate general partner. If lenders choose to do business with entities with little or no assets in them, there is a risk that the sophisticated creditor is assuming (a risk being assumed for a price, likely b/c of an increased interest rate). The law is therefore not too sympathetic to sophisticated creditors, who choose to do business with the firm. However, the law is sympathetic to people who are injured by this kind of LP by no choice of their own and have claims in tort. o Fiduciary Duty. The general partner has a fiduciary duty to the firm and to the LPs, b/c the LPs 22

have entrusted their assets to the management of the LPs. This includes the duty of care and the duty of loyalty. The law allows contracting out, just as in the partnership setting (b/c we are not concerned w/ asymmetric info or Ks of adhesion); however, this perhaps should not be the case with private equity firms, which are very sophisticated LPs. Limited partners do not have a fiduciary obligation, b/c they are not managing other peoples money. o Dissolution. LP agreements specify what constitutes an event of dissolution (it is required in order to be approved by the Sec. of State). There will also, though, likely be a continuation provision (specifying what happens in event of bankruptcy, etc., and how the entity will continue on). There are default rulesthe Revised Uniform Limited Partnership Act (RULPA, a model code, which many states have adopted). RULPA incorporates by reference UPA. It also incorporates the RS of Agency. Many states, though, have adopted different versions of RULPA. Holzman v. De Escamilla The general partner is DE; the limited partnership entity is Hacienda farms; the LPs are R&A. The farm grows crops, and while DE is the GP, it turned out that R&A were actually in charge. They could draw on the firm bank accounts w/o consent of DE, could veto DEs use of account, and even forced DE to resign. Trustee brought suit against R&A claiming that they should be liable as general partners b/c they were in control of the business. Court found R&A GPs; affirmed here. A nominally limited partner who exercises control becomes liable as a general partner for the activities of the limited partnership. o Because R&A could withdraw all of the assets of the firm w/o even the knowledge of the GP. LPs not attractive for active investors. o Limited partnerships are not an attractive alternative for investors who wanted to be able to control the management of their investment. o State legislatures noticed this, so many have enacted RULPA 303(a), which expands the amount of control that LPs can exercise w/o becoming general partners: A limited partner is liable only to persons who: (1) Transact business with the limited partnership; and (2) Reasonably believe, based upon the LPs conduct, that the limited partner is a general partner. Id. PLANNING. How could R&A have gained control w/o liability here? o They could have placed a corporation as the GP, and could have appointed themselves as the board of directors and the officers. o Who suffers from such a structure? Third parties plaintiffs/creditors.

4. THE NATURE OF CORPORATIONS

(1) Corporations Generally
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Formation. o File articles of incorporation (or certificate of incorporation, or the corporate charter) with the Secretary of State. The formation document in which we put the basic terms of the K b/w the corporate entity and the shareholders Can be fairly limited at first: Location, Number of shares, Who initial board is, Who initial officers are. Can only be amended by: A recommendation by the board of directors, Followed by the approval of shareholders (SHs). o A second document, the corporate by-laws, must be drafted (though these need not always be filed. Mostly housekeeping rules (time and place of meetings). May be amended either by a majority vote of the shareholders or the board of directors. Liability. o There is limited liability for the SHs (only liable for the amount of their investment). Control. o SHs have limited control rights. They delegate their control rights to the body that manages the corporation, the board of directors. The board in turn delegates most day-to-day control rights to the management, called the officers. Fiduciary Duties. o Officers and directors have fiduciary duties to both the entity and the SHs b/c they manage other peoples money. o SHs do not have fiduciary duties (with limited exceptions to be elaborated on later), b/c they do not manage others money. Shareholders may act in their own self-interest. Dissolution. o A corporation is dissolved only when: Board makes a recommendation to the shareholders that they do so, and SHs approve it. o Otherwise, the corporation lasts forever (it is not for a term or at will).

(2) Promoters and the Corporate Entity

Promoters engage in transactions before the corporation is formed that prepare for the formation of the corporation. What happens when a 3d party sues on Ks that promoter has entered into on behalf of the not-yet-formed corporation? o (1) Can the corporations become a party to the K? Yes, if ratification by board. A corporation acting through its board may ratify the K and become liable to the 3d party. 24

o (2) May the agent still be liable after the board ratifies? The promoters name is on the K, so the promoter will still be liable to the 3d party, even though the corp. has ratified, unless the K specifically provides that, once the corporation (principal) ratifies it the promoter (agent) is no longer liable. o (3) What if the corporation is never formed (i.e. there is no de jure corporation)? The investors who decided not to form the corporation would be a general partnership. If any of their names were on the K, then the GPs would be liable on the K. Note that this does not always seem fair. When does the law permit these wannabe SHs to use the protections of the corporate form? (A) CORPORATION. When the shareholders: o (1) Tried in good faith to file and create a corporation; o (2) Had a legal right to create a corporation; AND o (3) Acted as if they formed a corporation. o De facto corporations is a common law defense, so it is available in some situations, so long as it has not been eliminated by statute. o Ex.: The lawyer forgets to file the corporate documents and then the de facto shareholders go into debt. (B) CORPORATION BY ESTOPPEL: o (1) 3d party thought it was dealing w/ a corp.; AND o (2) 3d party would receive a windfall gain (would be able to collect when usually not) if permitted to deny it. o Also a CL doctrine that may be eliminated by statute. These two doctrines can overlap, but they do not have to: o Estoppel will not apply in a tort claim where the driver of an attempted corporation vehicle injured a 3d party, b/c 3d party did not think it was dealing w/ a corporation.

Southern-Gulf Marine Co. v. Camcraft, Inc.; La. 1982; pg 202. Camcraft is the 3d party that signs a K w/ Barrett, the promoter, who was acting on behalf of a yet-to-be-formed corporation called Southern-Gulf. SG was supposed to be incorporated in TX, but it was actually incorporated in Caymans, but then Camcraft accepted that incorporation. Camcraft defaulted on the ship. SG sues SG was a TX corporation by estoppel, because Camcraft believed that it was dealing with a corporation, and it would receive a windfall of being able to sell the boat to someone else for a gain.

(3) The Corporate Entity and Limited Liability

Walkovszky v. Carlton; NY 1966; pg 207. Carlton is stockholder of 10 corporations, each of which has 2 cabs registered in its name, and each of which has the minimum auto liability insurance required by law on any one cab. Walkovszky was injured by one of the cabs. 25

P sues the corporation, but it is undercapitalized, so he seeks to pierce the corporate veil and go after Carltons personal assets. Dismissed by trial court; affirmed here (though the court acknowledges that a claim could be stated so long as it states w/ specificity how Carlton was doing business in his individual capacity). The courts may PIERCE THE CORPORATE VEIL based upon the following factors: o (1) The SH co-mingling his assets with those of the corp; o (2) The corporation is undercapitalized; and o (3) The corporate formalities are not followed. Appointing a board; Filing articles of incorporation; Creating by-laws; Having director meetings, and Having shareholder meetings/votes. In order to receive corporate form benefits, SH must respect separateness & formalities. o The law grants special protection to personal assets through the corporate form. In order to benefit from that protection, SH must respect the separateness of the corporation. o SH cannot co-mingle corporate and personal assets; SH cannot ignore the formalities. o If SH does not respect that separateness, then the law sees through the corporate form and to the personal assets. Enterprise liability. P could also pierce through the single corporation by alleging that it was operated as part of a larger single enterprise. o P could have potentially gone after the collective assets of the entire enterprise by alleging that C1-C10 were all effectively part of a single large entity. o Under this theory, he could not have gone after Carltons personal assets. o He would need to show that this business was not operated as 10 separate, small businesses, but as one larger business. To prove this, he should show things like one garage, all the maintenance done at that garage, the employees move throughout each cab company, etc. What are the alternatives for preventing this problem? o (1) Legislatively require a greater minimum capitalization level for each individual corporation; o (2) Legislatively require a greater minimum level of liability insurance; o (3) Pierce the corporate veil. The problem w/ piercing the corporate veil is that it would discourage investment. The law could, however, hold investors liable on a pro rata basis (shareholders are only liable for their proportion ownership in the company), but then this would cause collection problems. There is definitely a trend towards limiting liability. Sea-Land Services v. Pepper Source; 7th Cir. 1991; pg 212. SL shipped items for PS, which is owned entirely by Marchese. M has several other companies that he wholly owns, and he jointly owns Tienet w/ Andre. PS stiffs SL on the bill. SL tries to pierce the corporate veil to M, and reverse-pierce the corporate veil to the other corporations. Trial court granted SL SJ. Reversed here, but then injustice found on remand,

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and affirmed. The CORPORATE VEIL WILL BE PIERCED when: (Van Dorn test) o (1) There is unity of interest and ownership; AND Lack of corporate formalities; Co-mingling of assets; Use by one corp. of another corp.s assets; Inadequate capitalization. Here, the first prong of the test is easily satisfied: there have been no meetings, he charges his own personal expenses to the corporation, bylaws were never passed, they were all run out of the same office. o (2) Doing o/w would sanction fraud or promote injustice. Injustice requires showing some wrong beyond the creditors inability to collect. This prong is more problematic here. Fraud cannot be proven at SJ stage (b/c it is an issue of fact); SL therefore must prove substantial injustice. Why would P desire to reverse-pierce the corporate veil? o SL could only get to insurance policies against those companies if it had a claim against those corporations (SL could access everything else with a claim against Marchese b/c SL would then own all the stock in those corporations). Harm to passive investors, too. o One problem with piercing the corporate veil is that passive investors in companies like Tienet will also have their veil pierced, even if they were not the ones who were abusing the corporate form. PLANNING. o It is important as a corporate lawyer to remind clients who are owners of small corporations that the formalities must be followed in order to benefit from the limited liability of the corporate form. o Failure to do this may result in malpractice against a corporate attorney.

(4) Shareholder Derivative Actions

(A) Direct and Derivative Suits Generally Principal-agent model of corporation. This is a conceptual model that does not imply agency liability. SHs are the principals, and the directors and managers who run the company are agents. For publicly traded companies, the SHs will be diffuse. o For this reason, SHs have ownership, but they do not have real controlthey do not tell the directors/managers what to do. o SHs have a vote over directors, but usually managers control who are nominated, so SHs do not have that much control there.

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Principal-agent problem. o SHs want management to maximize profits. o Managers want to maximize their own utility, though (which involves labor/leisure choice; own salary; sharking from firm; etc.). o This creates a potential divergence of interests. Good corporate governance means that management incentives are aligned with SH incentives. o (1) The board can act as a management alignment tool by hiring non-management directors (to sit on salary committee, audit committee, etc.). o (2) SHs can act to keep divergence of interests to a minimumthey may monitor corporate management by staying informed and (i) Voting when the opportunity arises, (ii) Selling shares, or (iii) Suing on behalf of the corporation.

Shareholder derivative suits. o The suits in (iii) are called derivative suits, b/c they are derivative of the corporations right these are suits by a SH on behalf of the corporation to recover for the corporation. o Direct vs. derivative suits. o Direct suits arise from the individual SHs right to sue. o Derivative suits are by a SH on behalf of the corporations rights. What type of protections should be put up around derivative suits in order to allow the corporation to determine whether or not to sue? o A corporation (acting through its board) might not choose to sue itself for two reasons: (1) Poor business decision (the lawsuit might be overly expensive compared to the likelihood of recovery, or it might detract from PR and goodwill); OR The corporation should not sue and needs ways to discourage these suits. Ways of discouraging these SH suits: o Bond posting requirement (for corporate legal fees if loss, see Cohen, post. o Contemporaneous ownership requirement to make sure the SHs are real parties in interest. (SH must have owned shares at the time of the alleged illegality as well as when the suit was filed.) o Demand requirement and special litigation committees. (2) Personal self-interest (e.g. the culprit was related to a board member). SHs should be able to sue. Cohen v. Beneficial Ind. Loan Corp.; S. Ct. 1949; pg 232. BILC was DE corp. doing business in NJ. Shareholder Cohen alleged that managers and directors of BILC were engaged in continuing and successful conspiracy to enrich themselves at expense of the company. Cohen owns about 0.01% of outstanding stock. SH sues derivatively in federal court (diversity) for fraud, mismanagement, and waste (i.e. when the corporation gives assets away unreasonably). NJ statute required SH derivative Ps holding < 5% of stock or < $50K to post a bond that would pay for Ds reasonable fees. BILC moved to require a bond to be posted by Cohen. Court here requires federal diversity

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courts to apply NJ statute. State statutes requiring shareholders to post bonds for Ds defenses must be applied in federal diversity courts. The purpose of requiring a bond is to discourage strike suits. These are suits brought by shareholders for their nuisance value or so they could attempt to force corporations to settle frivolous claims. These bond-posting statutes must be considered substantive rather than procedural b/c it creates new liability where one did not exist before. Also, if the federal courts did not apply those statutes, it would encourage forum shopping for Ps who did not want to file a bond to seek out federal court. Delaware does not have a bond-posting statute. o DE has chosen no bond-posting requirement to spur derivative litigation. o DE is home to about 2/3 of the corporations in the US. o There is a tremendous amount of derivative litigation that is funneled into DE trial courts. o DE has developed the Court of Chancery to handle its expertise. o For this reason, DE law is disproportionately important in corporate law, b/c it is highly persuasive and influences the law of other states. Eisenberg v. Flying Tiger Line, Inc.; 2d Cir. 1971; pg 236. Eisenberg is a former SH of Flying Tiger (FT). FT adjusted the capital structure of the company (it retired some securities and debt claims and replaced them with new securities and debt claims): (1) FT 100% FTC 100% FTL. (2) FT + FTL = FTL. (3) FTC 100% FTL. After the merger, the public SHs own shares of FTC, but the operating assets are with FTL. FTC is now a holding companyit holds stock of other companies and provides management services. Now, FTL, which has the operating assets, is regulated as an airline, and FTC, the holding company, can participate in other, unregulated business ventures. Finally, FTL changes name to FT, which has brand value. P brings claim against company for having his stock and voting rights changed as a result of the merger. Instead of having the right to vote in electing the board of directors for the entity that controlled both the management and operating assets, he only has control rights over an entity that has management services, but not operating assets. In essence, he alleges his control rights are diminished. He argues that his claim is direct, not derivative. The court agrees it was direct, so it should not have been dismissed for failure to post a bond. A lawsuit is DERIVATIVE when it challenges acts of the management on behalf of the corporation. o A derivative claim is that the corporation is harmed (recovery goes to the corporation). It is DIRECT when it challenges the right of the present management to exclude SHs from proper participation. o A direct claim is that the SH personally was harmed (e.g. voting rights have been decreased, so shareholder is personally hurt). o Eisenberg had lost voice in any potential future merger. Suppose US Airways wanted to merge with FT. The board and SHs of US Air would have to approve the merger. Also, the board and SHs of FT would have to approve, but the board would be appointed by the FTC board and its shareholders are the FTC board. TOOLEY TEST: To determine whether SHs claim is derivative or direct, consider:

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o Who suffered the alleged harm, the corporation of the suing stockers, individually; and o Who would receive the benefit of any recovery or other remedy, the corporation or SHs, individually? Tooley v. Davidson (Del. 2004). Where SH only seeks declaratory judgment and no monetary recovery will go to the corporation, the claim may be direct. Bennett. Subsidiary/Parent Corporations. o A subsidiary corporation is a company whose voting stock is at least 50% owned by another corporation. Thus, the subsidiary (sub) is clearly controlled by the parent company. o A wholly owned subsidiary is one in which the parent owns 100% of stock. Merger defined. A merger is when one corporation is absorbed into another, and when that corporation assumes all the assets and liabilities of the latter. Who pays when the corporation is sued? o Direct suits: the corporation usually indemnifies officers and directors. o Derivative suits: there is no indemnification of officers and directors (they pay personally). The corporation is essentially suing itself, and it would not make sense for the corporation to pay itself. o Incentive to settle in derivative actions. Ds are not reimbursed by corporation. Ps do not have the assets to finances protracted litigation. Judges have busy dockets. There is still value in derivative suits, though: (1) Deterrence. Such suits discourage officers from abusing their positions. (2) Compensation for harm done to Ps. (3) Public good is created when courts decide the law in derivative cases (they make up a large portion of corporate law cases). (4) It gives judges an opportunity to shape the norms of corporate conduct, and that message gets echoed from lawyers to clients. Alternatives to lawsuits: Markets punish corporate misconduct. Board of directors can punish corporate misconduct by ousting people who dont do a good job or engage in misconduct. Regulators, such as the SEC, can control corporate wrongdoing. Who receives the recovery in derivative suits? o Usually recoveries in derivative suits go to the corporation. o Where corporation would be likely to abuse that recovery again, P will receive his or her pro rata share. See Lynch v. Patterson (P, 1 of 3 shareholders in corporation, recovered monies that other two had been overpaying themselves, even though it was a derivative action, b/c o/w those two would have had control of that money). (B) The Demand Requirement Because a derivative suit is one in the corporations name, shouldnt the board get to decide whether derivative litigation is brought? In general yes, unless we are suspicious the board is

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not doing the right thing. See Sch. A (Demand Requirement Flow Chart). Grimes v. Donald; Del. 1996; pg 241. DCS approves an employment agreement with its CEO, Donald. The agreement gives him extensive benefits and control of the company. It also allows him unilaterally to decide that the Board has interfered w/ his management capabilities, in which case he gets an incredibly generous severance package. SH Grimes sues to invalidate this agreement as well as any ongoing compensation as a result of it. He alleges: (1) abdication by the board of its duty to run the company; (2) that the board breached its duty of care; (3) the board committed waste. The court here find there was no abdication, and that the demand was not wrongfully refused. ABDICATION only exists when the Board gives up its ultimate freedom to direct the strategy and affairs of the company. o For abdication to occur, the board must enter into agreement that formally excludes it from exercising its statutory powers. This is a mandatory rule. The board cannot give up its responsibility to manage and direct the business and affairs of the company in the SHs best interests. o Though the employment agreement seemed to give significant power to Donald as well as a gigantic severance package, this is really a business judgment of the board. The board still retains the ability to fire Donald, even though it will cause financial consequences. Lots of board actions have financial consequences (that alone does not create abdication), and the board should have the discretion to decide what sort of agreement was necessary in the CEO labor market. o Because the recovery sought here is a non-monetary one, the court allows Grimes to go forward on a direct rather than derivative basis. DEMAND EXCUSAL: a SH proceeding with a derivative suit must have had made a demand that the board bring the lawsuit, unless demand would be futile b/c: o (1) Majority of the board has a material financial or familial interest; o (2) Majority of the board is incapable of acting independently because it is controlled by a dominant director or shareholder; OR o (3) The underlying transaction was not the product of a valid exercise of business judgment. WRONGFUL DEMAND REFUSAL: After a demand of the board is refused, SH may still proceed if the refusal was wrongful b/c the board breached its fiduciary duty by: o (1) Failing to act independently or with due care; or o (2) Acting beyond valid business judgment. WAIVER: Once SH makes a demand, SH: o (1) Cannot argue that the demand was excused; and o (2) Cannot proceed to discovery w/in the confines of a derivative suit. o The latter point is problematic, b/c it works against being able to prove wrongful refusal. However, the court here explains that SH may use the tools at handPs may use 220 as an information-gathering tool (this is a backdoor way into discovery). o Here, a demand was made by the board, so the argument that demand was excused was 31

not available. Applying the business judgment rule to the Boards refusal, that refusal was not wrongful. Scope of the Demand Requirement. o DE: Grimes shows that in DE demand is not required in every instance b/c it may be excused where it would be futile. (In those instances, P need not demand but must prove futility.) o Model Business Corporation Act (MBCA) and some states require universal demand. Purpose for Demand Requirement. o (1) Relieve courts from deciding matters of internal corporate governance; o (2) Provide boards with reasonable protection from harassment; o (3) Discourage strike suits brought for personal gain. Marx v. Akers; NY 1996; pg 250. SH brought suit against IBM for approving unreasonably high compensation for executive officers as well as for directors themselves. IBM moved to dismiss based on (1) failure to make a demand, and (2) failure to state a claim. The court held that the demand was not excused as to the compensation of the officers (so that claim was dismissed), but that the demand was excused for the claim against the directors compensation. However, that claim failed to state a cause of action. Demand is excused when: o (1) Majority of board is interested in challenged transaction; o (2) Directors did not fully inform themselves of transaction; or o (3) Transaction so egregious that it could not have been product of sound business judgment. o Claim for high compensation for officers. Only 3 of the 18 directors were also officers (inside-directors), so a majority of the board was not interested. Thus, demand is not excuse wrt this claim. o Claim that directors set high compensation for themselves. Demand was excused b/c a majority of the Board was interested. However, the claim failed. For EXCESSIVE COMPENSATION claim, P must allege: o (1) Compensation rates excessive on their face, or o (2) Directors acted with bad judgment or bad faith. (C) Special Litigation Committees (SLCs) Composed of members of the board. Only job is to consider whether a corporation should pursue a lawsuit. Delegated with full responsibility to determine whether a suit should go forward. Auerbach v. Bennett; NY 1979; pg 256. GTE found though an internal investigation that bribery and kickbacks had occurred. SH files a derivative suit against directors; demand excused. Board responds by setting up a SLC, which is composed of new directors who were not on board at time of alleged bribery. The SLC decided not to sue the board. The court determines that, b/c there was no issue of fact as to the independence of the SLC members and thoroughness of the investigation, the final business judgment of the SLC that 32

the suit should not proceed cannot be questioned. NY: SLC DETERMINATION that a suit should not proceed IS DETERMINATIVE: o SLC members are INDEPENDENT; AND Here, the suit was against 4 of 14 directors. The members of the SLC were new directors; they were not on the board when the alleged briberies occurred. There is therefore no triable issue of fact as to their disinterested status. o SLC conducted a GOOD FAITH, REASONABLE INVESTIGATION of the allegations of the complaint. For the investigation to be adequate, it must have done things like: Review the work of auditors and legal investigative counsel, Conduct interviews, Study documents. Concern is that board appointed SLC so as not to be sued. o Another way of dealing with this problem w/o changing the standard would be for the court to appoint the members of the SLC. Zapata Corp. v. Maldonado; Del. 1981; pg 261. SH brings derivative suit against several officers and directors of Zapata. He claims that demand is excused. There are 4 years of litigation, then Zapata appoints an SLC made up of 2 new board members appointed just so that they could be on this SLC. The SLC does a thorough investigation and concludes the suit ought to be dismissed. The court determines that the courts should determine whether a SLC recommendation may dismiss a suit using a three part test, and it remands here. DE: SLC DETERMINATION that a suit should not proceed is DETERMINATIVE: o The SLC members ARE INDEPENDENT; o The SLC conducted GOOD FAITH and REASONABLE INVESTIGATION that satisfied procedural requirements; and This may require hiring special counsel and independent auditors, as well as a massive discovery process. o The COURT DETERMINES, using its own business judgment, that a motion to dismiss should be granted. Here, we are using the court to decide whether structural bias is a problem. If the court concludes that the suit should not go forward even if the SLC was apparently independent and investigated in good faith, then it must believe the SLC was biased. A major problem here is that the SLC will control what the record is composed of, and if it is biased then it will assert that bias that way to minimize the courts capability to detect it. But see Alford (allowing the SH plaintiff to supplement the record in situations like this).

In Re Oracle Corp. Derivative Action; Del. Ch. 2003; pg 269. Ds brought derivative claims of (1) insider trading, and (2) a bad faith failure of the board to 33

monitor. On the basis of these claims, demand is excused, and an SLC is established. Two new board members were named to the SLC: Stanford computer science professor and Stanford law professor. SLC conducts extensive investigation and determines that suits should be dismissed. The court here determines that SLC has not met its burden to show the absence of a material factual question about its independence. SLCs have the burden of showing their impartiality and objectivity, showing: o (1) Freedom from domination and control; AND o (2) Freedom from the pressures of institutional and social norms. o The court was particularly upset that all of the contacts that the SLC members had with Stanford, and all of the contacts that Oracle had with Stanford and the Silicon Valley community, had not been disclosed by the SLC. Those contacts were not uncovered until discovery. o The personal contacts b/w Oracle, the SLC members, and Stanford were striking. Also, one of the SLC members was a professor who had published many articles that generally disagreed with derivative litigation in general. Burden Shifting Scheme. Beam v. Stewart (Del. 2004). o In determining whether demand should be excused in the first place, the board is presumed to be independent (the burden to prove interestedness is on P). Additionally, only financial interests will be considered (the social norms of Oracle will not be). o Once an SLC has been created, the burden of proving independence is on the SLC. Once demand futility has been established, there should be a more searching approach to Ds independence. Subjective independence test. o The court is moving away from a bright-line conflict of interest test and towards one of subjective independence. o This new test is much more subjective and judicially oriented, and its goal is to weigh against the structural bias of the SLC. (D) New York Stock Exchange Overview When companies list their shares in the NYSE, they are required to have independent directors on their compensation and audit committees (among other things). The NYSE must therefore clearly define disinterested directors. No director qualifies as independent unless the board determines that the director has no material relationship with the listed company. NYSE Listed Co. Manual 303A.02. o Material relationship: May include being outside counsel to the company, b/c that could create a conflict of interest where the director wants more legal work. Does not necessary include owning shares, however, b/c shareholders have an incentive for the company to do well. A director is not independent per se if: o (1) The director is an employee of the listed company, or an immediate family member is an executive officer of the listed company; o (2) The director has received more than $100K in direct compensation from the listed 34

company during any 12 month period in the last 3 years (this is designed to pick up on director with consulting K with company); o (3) The director or immediate family member is partner of firm that is companys internal or external auditor; o (4) The director or family member has been on compensation committee of another company where any of listed companys present executive officers serves; o (5) The director is a current employee of a company that has made large payments to or received large payments from the listed company, unless that other company is a charitable organization.

(5) The Role and Purposes of Corporations

Questions about the proper role of corporations: o When may a corporation contribute to charities? o When must corporation pay out dividends to its SHs? o To what extent can a controlling SH use the corporation to execute his own personal preferences? BUSINESS JUDGMENT RULE (BJR) underlies all these questions. o Courts will respect and defer to the judgment of the board, UNLESS the board: Has a CONFLICT OF INTEREST (duty of loyalty); Fails to exercise DUE CARE (duty of care); Engages in WASTE; Engages in FRAUD; Engages in ILLEGAL action; Acts in BAD FAITH. Corporations are to be run for the benefit of the SHs o Certificate of incorporation (aka charter) is the fundamental K that lays out the relationship b/w the corporation and its shareholders. In general, there is freedom of K here, subject to some mandatory rules (e.g. no abdication of authority). o In former eras, though, the corporate charter was granted to give a company a monopoly in a particular industry (e.g. the East India Trading Co.) where there was a strong public interest. The goal of the firm extended beyond profit maximization to include running the firm as a public trust. o This was a very different conception of corporate charters, and it changed dramatically with the liberalization of the granting of corporate charters. o We created a requirement that corporations be run to benefit the SHs. States in return grant limited liability to corporations. A.P. Smith v. Barlow; NJ 1953; pg 282. AP Smith decides to give a charitable contribution of $1500 to Princeton U. NJ has a statute allowing for corporations to make charitable contributions, but the statute did not exist at time of incorporation of AP Smith. SH sues for declaratory judgment to prevent the donation. The trial court found that the gift was intra vires. b/c NJ had passed a statute that expressly authorized such donations.

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The RESERVED POWER OF THE STATE to alter the charters of corporations after they had been formed is limited to alterations that advance the public interest. Thus, the NJ law applies to corporation here even though it was formed pre-statute. o Justifications for the corporations donations: Good for society to have private educational institutions that educate the leaders of that society. Long-term benefits to SHs. Creates a stream of good employees (future workers from Princeton). Creates a reputation of that company as responsible citizen. Short-term benefits to SHs. Donations allow for tax write-offs and Perhaps for increased sales in the short run. Corporations cannot donate unreasonable amounts to charity. What is unreasonable? o Look to state statute for express definition. Determining what amount is reasonable is easy when the statute expressly defines it, as here. o Look to the tax code for providing reasonableness (maximum amount deductible as charitable contribution would seem reasonable). No donation to directors pet charities are reasonable. When corporate funds are donated to charities that are simply the personal interest of board members, but are not arguably within the interest of the corporation, no donation would be reasonable. Court is carving out a small area where the corporation does not need to maximize SH value. PLANNING. How should corporations determined whether charities it should donate to? o (1) Smaller corporations may determine by K (in the charter). o (2) The law could completely ban charitable giving by corporations (the amount that would have been donated to that charity would therefore go to SHs, who could then give it to the charities of their choice). However, this might decrease charitable giving overall). Dodge v. Ford Motor Co.; Mich. 1919; pg 288. Henry Ford founded Ford Motor, which produced the first mass-produced automobile in USA. He owned 58% of Ford Motor; the Dodge brothers owned 10%.. (They were also founders of Dodge Motor, competitor of Ford). Company was highly successful and had a policy of issuing special dividends. In 1916, Henry Ford announces that corp will end special dividends and instead invest everything into River Rogue plant, which will lower cost of cars, allow it to produce parts, etc. Dodge brothers sue on the grounds that refusing to pay dividends is inimical to the best interests of the corporation and is arbitrary. They seek that the court require Ford Motor to issue special dividends and enjoin construction of the plant. Court here holds that the corporation must issues dividends, but it refuses to enjoin construction of plant. Because corporations are ORGANIZED FOR THE BENEFIT OF SHs, the powers of the directors must be employed to that end. Corporations cannot be conducted with the primary humanitarian purpose of benefiting others. o Henry Ford clearly desired to spread the benefits of capitalism to all of his employees. However, the decision not to pay dividends will decrease the values of the shares and will harm the SHs in the short run. Hence, the court must intervene to protect the SHs. 36

o However, because the court is unable to determine what the ultimate result of expanding the business by building another plant would be (there may be long term financial benefits to the SHs of such expansion), it refuses to enjoin the building of the new plant. It refuses to second-guess the business expertise of a successful company like Ford Motor. General rule is that dividend payments are discretion of board. o Ninety-nine percent of the time, dividends are considered a business judgment. o The court is, in a sense, treating the corporation as a closed corporation, explaining that H. Ford refused to issue dividend and refused to purchase Dodge bros. stock, thereby preventing them from receiving any return on investment. o A company needs sufficient surplus to be able to pay dividend without violating debt covenants and other obligations. States determine the minimum level of cash that company must have by statute. Fords Background Motivations (Tax and Goodwill). o Dodge brothers were using dividends as capital to run their business (they needed them). o Ford got goodwill by being seen as a good guy relative to the other corporate leaders of his time. o Ford got 58% of the special dividend. Therefore, he would want to pay out dividends, except for the fact that it would be taxable income. By reinvesting into the plant, he could hopefully increase the value of the company and receive that income through selling his appreciated shares for capital gains (taxed at a lower rate). Shlenksy v. Wrigley; Ill. 1968; pg 293. Mr. Wrigley refused to install lights at Wrigley Field because he believed that they would hurt the neighborhood. He also didnt like night baseball. The Cubs had been suffering operating losses, and all of the other major league teams had night games. The White Sox, also in Chicago, had highly attended night games. Schlensky sued derivatively to compel the Cubs to play night baseball, claiming: (1) directors are acting contrary and wholly unrelated to business interests of corporations and that their arbitrary and capricious acts constitute waste; and (2) directors breached duty of care failing to exercise reasonable care and prudence in management of corporate affairs. The court here upholds the trial courts dismissal of both claims. Courts will not question the business judgment of directors in operational matters unless there is a showing of fraud, illegality, or conflict of interest. o Here, Shlenksys complaint did not allege any of those requirements. Here merely theorized that having night games would make the business more profitable. However, the court does not believe it is in a position to determine the best profit route for a corporation (e.g. installing lights might have had an adverse effect on the neighborhood, decreasing property values and deteriorating the neighborhood of the ballpark to the long term financial disadvantage of the SHs). o Additionally, on the duty of care claim, the SH failed to allege damages to the corporation. On the profitability issue, the mere showing that attendance was higher at night games did not necessarily imply that that was the cause of higher profits (other factors specific to Wrigley Field could have been causing the losses). What if Wrigley also had a controlling interest in the Cubs?

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o Assume Mr. Wrigley also controlled 80% of the White Sox and 51% of the Cubs. o Now, there is a concrete fact that supports a potential duty of loyalty violation o P can allege that the reason there are no Cubs night games is that Wrigley does not want competition with White Sox, where he stands to benefit more, given his higher financial stake. This potential conflict of interest would allow the plaintiff to overcome the presumption that the decision is protected by the BJR. Should corporations have an obligation to support society generally? o (1) They have the resources; they are a quasi-public institution. o (2) Society gives a lot to corporations (tax benefits, limited liability, etc.); corporations should give back. o (3) Civic responsibility. Like citizens, corporations might feel a duty to the country. o (4) Good business practices/profits. It is actually in the long-term best interests of the corporation to make these contributions.

5. THE DUTIES OF OFFICERS, DIRECTORS, AND OTHER INSIDERS

(1) The Duty of Care
(A) Duty of Care of Board in Major Transactions Kamin v. American Express Co.; NY 1976; pg 328. AmEx decides to distribute shares of stock of another company that has lost value to shareholders. If AmEx sold the stock itself, it would sustain a large capital loss that would be offset against some of its own capital gains. By distributing them in the dividend, though, there are alleged tax losses of $8m. o SHs file derivative suit alleging waste. The court here holds that the directors decision to distribute dividends is protected by the BJR, so complaint dismissed. o SHs must allege more than just imprudence or mistaken judgmentthey must allege fraud, self-dealing, or bad faithwhen challenging the decision of the directors to distribute certain assets through dividends. o The question of whether a dividend should be paid, and how much, is exclusively a matter of business judgment for the directors. Thus, a claim that some other course of action would have been more advantageous for SHs, so long as it does not allege improper conduct, is no actionable. o Additionally, the board was aware of the exact issues raised the SHs in the complaint, and they made the reasoned decision not to sell the stock but rather issue it in dividend form. This is likely b/c selling the stock for a large loss could have had an even larger negative affect on the market value of their own stock. Smith v. Van Gorkom; Del. 1985; pg 332. o VG is the CEO of a profitable company, TU, which is having trouble b/c it generates a large amount of investment tax credits with a limited life that are going to waste b/c it cannot generate enough taxable income to use them. The senior management of TU considered a leveraged buy-out (LBO). The share price was $31 on the market, and the price discussed for an LBO was $55. Later on, VG met w/ Pritzker, but P did not want to be a stalking horse (i.e. he didnt want to bid unless there was some guarantee he would win). Thus, P requests that he get an option to buy 1M shares at just above market price. Due diligence is 38

done over the next two days alone (usually this takes months), and P bids at $55. VG tells him to draft the merger agreement (very unusual to allow one side complete control). The next day, VG brings in outside counsel, but does not consult with TUs regular counsel or any investment bankers. VG explains the deal to the senior management, who are very upset (1) because they do not get the benefits they would have from a LBO; and (2) because they know a strategic bidder like P will replace them. Soon after, the private equity firm comes back in and offers $60/share; VG prevents that deal, though, b/c he wants his own deal to go through. The board meets the next week. The board is made up of very experienced, qualified business people, who know TU very well. However, there is only a 20-minute presentation by VG, and no documents. The board agrees to the P deal, but then decides later that they need amendments to the deal. They approve amendments w/o even seeing them (they make conducting a market check harder b/c the only other bid that can be considered is a fullyfinanced alternative bid). The proxy statement of the merger was sent out to the SHs. The directors included all of the negative info about the deal (including that they never read the agreement) in the proxy statements. SHs brought class-action claim against TU and its board for breach of duty of care. The court here held that the board breached its procedural duty of care in selling TU to Pritzker for $55/share and that damages should be awarded to the extent that the fair value of TU exceeded that amount. A board BREACHES ITS procedural DUTY OF CARE by not adequately informing itself of the material aspects of a deal. o The court is not second-guessing the substance of the boards decisions, but rather that they were not informed in making that decision. o What the board did well and wrong here: Board did well: Showed up to the meetings. Understood the business; Smart and knowledgeable about the firm. Board did wrong: Uninformed about the value of the company. Relied too much on Romans, who was only asked to value the company based on taking on debt for an LBO. Failed to read the merger agreement. Board has an affirmative duty to look beyond what is given to it. o The board has a duty to inquire and to look beyond what is given to it to all material information that is reasonably available to make an informed decision. o It is thus reasonable to ask the board to bring in an investment banker. o The board also has a duty to check up on the CEO if there are any red flags. Here, VG did not tell the board that there was a possible deal through KK&R, the private equity firm, but the board was still held responsible for the failure to get a better price. Proper Valuation of the Company. o The market price only indicates the value of one share. This does not indicate the value of control of the company. When one owns enough of the company to have control, one has the benefit of 39

redeploying the assets to increase the value of the company, one can also make the company benefit himself. o The real way to value control of the company is to put the entire company up for sale. However, the market test here was not a real valuation, b/c limitations: (1) Company could not solicit bids; (2) Company could not disclose any non-public information to prospective buyers. o Financial bidders vs. Strategic bidders. o Financial bidder (e.g. a private equity firm) wants to execute an LBO. In an LBO, the bidder puts forward some of its own cash as equity and pays for the balance using borrowed cash secured by the assets of the company. An LBO (or MBO, involving managements equity) will make bidders a lot of money b/c they are leveraging their equity (they will pocket any increase in value). Here, the $55/share amount that the LBO bid does not reflect the intrinsic value of the company; rather, it reflects what the LBO can afford to pay its mezzanine creditors. o Strategic bidder has its own management team. It can likely pay more for the company because it will not be using borrowed money. o Direct claim against the directors. o This lawsuit is a direct claim (it is a class action), b/c the SHs are individually, directly harmed for getting less money for their shares than they believe is just. o Thus, there is no discussion of demand. o There are many more direct, class action SH lawsuits than there are derivative suits. o Pritzker is not a defendant, b/c he does not have a fiduciary duty to the TU SHs. However, he possibly could have been named as D on an aiding and abetting claim: if Ps could show that he knowingly sought to induce the directors of TU to breach their fiduciary duty. o Legislative Response: Allow Boards to Opt Out of Duty of Care Liability. Del. 102(b)(7). o State legislatures passed amendments to their corporate codes that allowed boards to opt out of their fiduciary duties (they exculpated the directors from their liability from the duty of care). o Rare situation where the law allows contracting out of a duty in the corporate setting. o This eliminates monetary damages for directors for breach of duty of care. o Reasons for legislation: Encourage talented people to serve on boards by quashing fear of personal liability. Boards might act too conservatively in ways that do not maximize profits. Decrease the incentive for corporate attorneys to bring suits (b/c they limit availability of damages. o SHs still have protections and remedies: SHs can sell their shares; SHs can sue officers (either derivatively or via class action);

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Alternative theory that officer VG breached his duty of care to the corporation, and these statutes do not limit the liability of officers. SHs can vote (vote down proposed transactions and vote directors out of office). o Proxy Statements and Ratification. o The proxy statement is a document sent out to SHs that has all the information about the deal (the prices, values, and everything else that led up to the deal). o SHs then send in a proxy card telling members of management how to vote for them. o Here, the directors included all of the negative info about the deal (including that they never read the agreement) in the proxy statements; this was perhaps b/c the directors were trying to fully inform the SHs of their wrongdoings so that the SHs would ratify the bad deal if they agreed to it. SHs do overwhelmingly approve the deal, likely b/c they still got a lot of money. o How a corporation can use excess cash: A ss et s In iti al Di vi de nd St oc k R ep ur ch as e $2 00 $1 00 $1 00 # of sh ar es 10 0 10 0 50 St oc k Pr ic e $2 $1 Ca sh pa id ou t 0 $1 00

$1 00 fo r 50 sh ar es pu rc ha se d o Note the equivalence to SH of paying dividend and repurchasing stock. Thus, corp can shift assets of company around w/o affecting value. Cinerama Inc. v. Technicolor Inc.; pg 342. o When the duty of care is breached, the court must determine whether the transaction price 41

$2

was fair. If the price was not fair, the court awards damages. If the price was fair, then there are no damages. Brehm v. Eisner; Del. Sup. Ct. 2000; pg 345. o In 1995, Disney Old Board (OB) hired Ovitz as its President. Ovitz was a close friend of Chairman and CEO Eisner. The OB brings in a compensation consultant, Crystal, to advise on employment agreement w/ Ovitz. The K had a base salary of $1M, a discretionary bonus, and two kinds of stock options. The K allows the board to terminate Ovitz for cause for gross negligence or malfeasance, but it grants giant termination payment for non-fault termination. In his year there, Ovitz did nothing of any value to the company. In 1996, the New Board (NB) fires Ovitz, and Ovitz walks away with $140 in severance pay that was paid to him as the result of a non-fault termination. No one figured out exactly how much the termination payment was valued at ex ante. o P SHs bring derivative suit against OB for breach of fiduciary duty for entering into wasteful employment agreement, and suit against NB for breaching fiduciary duty in agreeing to nonfault termination of Ovitz. The court affirms the dismissal of Ps complaint. o PROCEDURAL DUE CARE: In making business decisions, the board is: o (1) Responsible for considering ONLY MATERIAL FACTS REASONABLY AVAILABLE, and o (2) Entitled to RELY IN GOOD FAITH UPON EXPERTS brought in to advise the corporation. o Here, the payout scenarios of the Ovitz K were certainly materially, due to their large size, and the dollar exposure numbers were also available. However, Ps must rebut the assumption that the board relied in good faith upon the consultant Crystal. o Because the complaint did not allege bad faith reliance, lack of reliance, that the expert was not selected with reasonable care, or that the decision of the board was so unconscionable as to constitute fraud or waste, the OBs reliance on the expert prevents a procedural due care claim. o Decisions of EXECUTIVE COMPENSATION are protected by the BJR except in unconscionable cases where directors intentionally squander corporate assets. o Because the employment K here is not so one-sided as to constitute waste (i.e. it was not an exchange so one sided that no business person of ordinary sound judgment could conclude that the corporation received adequate consideration), this substantive due care, or waste, claim fails. o As to the NBs decision not to litigate whether Ovitz could be fired for cause, he may have breached the K, but those breaches are only alleged, and proving these could have resulted in expensive litigation for the company. That decision of whether to let Ovitz walk with the large termination payout or to litigate the K was discretionary to the NB. o So long as no particularized allegations showing clear waste (e.g. there was no substantial consideration for what the board did) then the BJR protects the boards decisions. o What downward pressures may be exerted on executive pay? o SHs can challenge: (1) Procedures the board used to set pay; and (2) The outer limits of the envelope of executive pay.

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However, so long as the board follows the appropriate procedures, the board has tremendous discretion in setting executive pay. o SHs could sell (but this does not help if executive pay is too high everywhere). o Press releases and disclosures may also affect pay. (B) Affirmative Duties of Directors Francis v. United Jersey Bank; NJ 1981; pg 356. P&B was in the reinsurance broker business. It took deposits from clients who entrusted it to pay those funds over to reinsurers. Mrs. P inherited a 48% interest in the company from her husband; she was the largest SH and also one of three directors. The other directors, her two sons, misappropriated company monies from the trusts held for clients to themselves in the form of loans. The business went bankrupt, and Mrs. P died. A trustee in bankruptcy brought suit against Mrs. Ps estate to recover the amounts stolen. The court held her estate was liable to 3d parties b/c of nature of reinsurance business. DIRECTORS HAVE A RESPONSIBILITY to learn about the business and to be familiar with its financial statements, as well as to object to illegal courses of action. For banks and reinsurance companies, this creates a duty to protect 3d party clients. o Directors have a duty to exercise reasonable care, and the nature and extent of such care depends upon the type of the corporation and its size and financial resources. Here, the character of the reinsurance business allowed the company to hold clients monies that were supposed to be transferred to appropriate parties. This creates a heightened duty to make sure those funds are properly being transferred instead of stolen. o When a director discovers an illegal course of action, that director has a duty to object and to resign if the action is not corrected. The duty to take reasonable means to prevent illegal conduct by co-directors may also include the threat of suit. o The financial statements here disclosed on their face the misappropriation of trust funds. Had Mrs. P looked at all, she would have realized that her sons were siphoning off the money. Similarly, if she would have asked them to stop, they must have done so b/c the violation was so clearly egregious. o Negligence of a director does not result in liability unless it proximately causes the loss. However, it is clear that Mrs. Ps negligence resulted in the loss to the trustees, b/c she did not resign until after the bankruptcy, and b/c she had a duty to prevent the misappropriation of funds. This is an unusual case where a director owes a fiduciary duty to a creditor. Directors have a duty to: o (1) Be familiar with the fundamentals of the business. o (2) Be informed about the companys activities. o (3) Must review the financial statements, in order to catch obvious discrepancies. When there is a red flag, directors have duty to inquire. Gambling with Creditors Money to Save Corporation Problem. CB at 362. o Corporation is going broke and hopes to use final $5K on an advertising campaign that has only a 5% chance of turning around the business. The corporation owes money to creditors and wages to employees. The board is asked to decide whether to spend on the risky advertising campaign.

o o

o o

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o Directors have the incentive to gamble with the creditors money. o Directors have a fiduciary duty to their SHs, but not to their creditors in a spa business such as the one in the problem. o As the corporation approaches insolvency, the SHs stake in the company approaches zero. Thus, whatever is left becomes other peoples money, and the incentive is to take bets (even bad bets) to save the ship; the money would have o/w gone to the creditors. o Corporate law does not have a good answer to this problem. This problem has to be solved by bankruptcy law and law enforcing debt covenants (K law). In Re Caremark Intl Inc. Derivative Litigation; DE 1996; pg 362. o Caremark provided patient care and managed health care services. CM had a practice of entering into Ks w/ hospitals and MDs in exchange for providing products that CM provided to Medicare recipients. In 91/92, there was an investigation into this referral process, and CM then changed its policy to prohibit such quid pro quo. An outside auditor was brought in and found no material weaknesses. In 94, though, CM was indicted in MN for bribing Dr. Brown to distribute a drug sold by CM to Medicare recipients. The board met and was informed but denied wrongdoing. o Five SH derivative actions were filed and consolidated. They alleged CMs directors breached their duty of care by failing to adequately supervise the conduct of CM employees, thereby exposing CM to liability. CM entered a plea on the indictment. It also reached a proposed settlement w/ the SHs. The court approved the settlement here b/c it believed the SHs would have lost in court, but the proposed changes are minor. o DIRECTOR LIABILITY EXISTS: o (1) When a negligent, affirmative decision of the board results in a loss unless the board made a good faith effort to inform itself and exercise appropriate judgment; OR The court will not second-guess directors for making decisions that appear in hindsight to be substantively wrong. It will only intervene when there was not a good faith effort to be informed or act properly. Negligence here cannot mean the same thing as in other areas of the law. If directors were required to make decisions based on a RPS, then they could not take risks that reasonable people might not take but which might be expected of certain investments in the market. o (2) DUTY TO MONITOR: When the boards unconsidered inaction results in liability, unless the board had attempted in good faith to assure the existence of a corporate information and reporting system. The level of detail in such an information system is a question of business judgment, but it is important that some system for ensuring that important information is reaching the board in a timely manner exists, o/w the board could not satisfy its responsibility to stay informed. Monitoring systems are more necessary than they were in the sixties, when Graham was decided, b/c there are other federal laws (i.e. the sentencing guidelines allowing for more favorable sentencing for corporate leaders when internal monitoring exists) that incentivize such monitoring.

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Here, there was no sustained or systematic failure of the board to exercise oversight, so no liability would have existed. o Requirement of INTERNAL MONITORING SYSTEMS. o Directors of companies must make sure those companies have internal monitoring systems. o Boards have a duty to monitor (or to make a business judgment that such monitoring is not necessary). o Liability to directors for failure to monitor exists if there is an utter failure to ensure that a reasonable reporting system exists. o Section 404 of the Sarbanes-Oxley Act requires the existence of such a monitoring system, and it also requires that the companys public accounting firm to assess the monitoring system. o Why place boards in charge of monitoring over management? o Management is more likely to engage in opportunism; creating this duty in the board is an effort to reduce the agency costs of separating ownership and control. o Asymmetric information. Management has a significant informational advantage, and they can use that either to: (1) Conceal from the board; or (2) Show the board what it wants to see. By creating an independent informational channel, it reduces the information asymmetry and places a check on the information management provides. o Trucking Penal Fines and Harm to the Corporation Problems. CB at 372. Corporation ships through PA using trucks. The trucks weigh so much, though, that they must pay a penal fine when caught. There is the possibility to bribe the officers. If these fines are not paid (i.e. if the corporation elects not to truck through PA), the corporation will go out of business. What should the board choose to do? In a derivative lawsuit, the SHs claim against directors for knowingly engaging in criminal conduct must be that there was harm to the corporation. The board is not entitled to the presumption of the BJR if any of the six things (breach of care, breach of loyalty, waste, illegality, bad faith). SHs in problem one would allege that directors had knowingly violated the law, so they would not be covered by the BJR. The only other thing SHs would have to plead is harm to the corporation. In first problem, b/c violating the law maximizes profits, the derivative claim fails. Derivative suits exist in order to compensate injured SHs for harm; they are not focused on deterring types of conduct. Perhaps the law should attempt to fine managers or directors who make decisions that will likely harm SHs.

o o o

(2) The Duty of Loyalty

(A) Directors and Managers Bayer v. Beran; NY 1944; pg 374. o Company decided to engage in radio advertising campaign in order to get new information out about its product. The CEOs wife was a well-known singer, and she advised them as to how best to create a classical music presentation. She was also hired to perform for the ad, 45

o o

though the board did not act collectively when it decided initially to begin this campaign. The corporation was not closely held. SHs bring suit that advertising campaign was wasteful and that the CEO had breached his fiduciary duty b/c of a conflict of interest in employing his wife in the ads. The court held here that the duty was not breached. ENTIRE FAIRNESS TEST: When the board is disabled due to an apparent conflict of interest, breach of loyalty unless board can establish entire fairness of the transaction. o When directors are placed in a position where selfish, personal interests might be in conflict with the duty owed to the corporation, the courts subject the directors to the most rigorous scrutiny. o The corporation clearly needed an advertising campaign to differentiate its product due to the recent regulation, so all that must be shown is that it was fair to hire the wife instead of a different singer. o There are all the indicia of an arms length transaction. She was treated the same as any other singer would have been. She was paid less than the other singers, and she was not treated better than them; it was clearly not about promoting her career. The transaction did not harm the company; it got what it would have gotten had someone else run the company. Boards Must Typically Act as Whole. o Typically, the only way for a board to act is as a whole. o This case is unusual in that the court does not seem to mind that the board acted so informally. o The court likely goes with the ratification theory b/c so many of the directors were inside directors and there was clearly no harm. Why Duty of Loyalty analysis even though only one conflict? o There is only one director who appears to have a conflict of interest: either the CEO dominates and controls the rest of the board, or the opinion is simply wrong.

Lewis v. SL&E; 2d Cir. 1980; pg 379. o LGT is an operating company that leases land from SLE, whose only asset is the land. There is a ten-year lease, and LGT gives SLE cash. The LGT SHs are the two sons, Richard and Leon Jr. SLE is owned by the sons as well as siblings Carol, Donald, Margaret (CDM). Richard, Allen, Leon Jr. and Henry H. are directors of both LGT and SLE. Contract provides that CDM must sell shares of SLE if they have not bought share of LGT by particular date. That date passed, triggering sale. o Donald brings suit that directors had breached their duty of loyalty b/c they operated SLE in a manner that benefited LGT, which resulted in a lower-than-reasonable share price for Donalds SLE shares. The court held the duty of loyalty was breached. o INTERLOCKING BOARDS place burden of proving entire fairness of transaction on the defendant directors. o Interlocking board is where the directors are making decisions for two companies that have adverse interests. o Here, there are directors sitting on both boards, as well as directors who have substantial financial interests in both companies. Because there is a conflict the BJR

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does not shield the directors decisions. o Here, the directors had the burden (by statute, b/c there was no way that the transaction could be ratified by disinterested directors or SHs) of proving that the rent amount was fair and reasonable. Because Ds did not make an effort to determine fair rent, and the property taxes paid by SLE clearly went up, the lease did not seem fair. o SANITATION STATUTES provide three ways conflicted transactions may still proceed: o (1) Full disclosure of all facts and conflicts followed by ratification by the disinterested directors on the board [this would not work here, b/c all directors are interested b/c all sit on both boards]; o (2) Full disclosure followed by ratification by SHs [note that this should only be disinterested SHs, and courts often provide those terms]; OR o (3) Prove the entire fairness of the transaction. o Efficiently allowing some interested transactions. o The rule in this statute increases the number of interested transactions, but it should only increase the number of such transactions that are fair to the company. o This seems like an efficient result (some transactions should go forward even though they are interested). o Pyrrhic Win Because Illiquid Asset. o This is Pyrrhic victory for Donald. The decision requires LGT to pay more money into SLE, but Donald now has an illiquid asset and shares ownership with people who hate him (and will refuse to buy out his share). o The buyout agreement was badly drafted, b/c it did not give him the option to sell his shares for a fair price. (B) Corporate Opportunities Broz v. Cellular Information Systems, Inc.; DE 196; pg 384. o Broz is president of RFBC and is on the board of CIS, two cellular telephone companies. Mackinac wants to sell a MI cell license but did not offer it to CIS. Broz wanted to purchase it for RFBC, and he explained this to officers and directors of CIS, who told him CIS did not want the license. At the same time, CIS is in the process of being bought by PriCellular (PC), but that is delayed due to financing problems. PC purchases an option to buy the license, but then Broz makes a greater offer and purchases it. Soon after, PC closes its tender offer for CIS. o CIS and PC sued Broz for usurping the corporate opportunity of purchasing the license. The court here held that there was no such breach of fiduciary duty, b/c even though he didnt formally present it to the board the opportunity did not satisfy the test. o CORPORATE OPPORTUNITY DOCTRINE: An officer/director who seizes a business opportunity for himself breaches his fiduciary duty when: o (1) The OPPORTUNITY WAS AN ASSET OF THE FIRM; (i) The corporation is financially able to undertake the opportunity; Here, CIS was not financially capable of exploiting this opportunity. It was in a bad financial position at the time the license was presented to Broz. The part of the test is manipulable (i.e., ex post, it can be easy to make it seem like corporation was not able to buy it), so we do not make it

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outcome-determinative. (ii) The opportunity is in the corporations line of business; An opportunity is within a corporations line of business when it involves an activity as to which the corporation has fundamental knowledge, practical experience and ability to pursue. Beam. (iii) The corporation has an interest or reasonable expectancy in it; and An interest is something that a corporation has a contractual right to do (e.g. an option to buy land). An expectancy is something that in the ordinary course of business we would expect the corporation to receive. Cf. Meinhart v. Salmon (reasoning that business people would expect discussions about the renewal of the lease). Here, CIS had no expectancy in the license b/c it was in the process of divesting its cellular license holdings and its business plan did not involve any new acquisitions. o (2) The LAW SHOULD NOT ALLOW THE OFFICER/DIRECTOR TO COMPETE for the asset; AND The self-interest of the director or officer is brought into conflict with that of the corporation such that taking the opportunity constitutes a breach. (i) Nature of the officer/directors relationship to management and control of the corporation. (ii) Whether the opportunity was presented in personal/individual capacity. (iii) If officer/director used corporate facilities, assets, or personnel. o (3) The misappropriation resulted in HARM TO THE CORPORATION. o Broz had only an attenuated relationship w/ CIS. He learned of the opportunity while he was outside of CIS, and he did not utilize corporate resources in pursuing it. There was no harm to the firm. o Must director/officer consider potential future acquirers? o The interesting issue here is whether Broz needed to consider the business plans of CISs suitor, PriCellular. o The court here held that Broz was not under a duty to consider PCs plans b/c it was not clear that PC was going to acquire CIS. o It would be disabling for business people to have to consider offering opportunities to all potential suitors of corporations on whose boards they sit. o Safe harbor by offering to board. o If officer/director believes ex ante that the corporation is not entitled to the opportunity based on the factors above, he is not required to present it to the board. o However, by formally offering it he creates safe harbor from future litigation. o Additional Problems. CB at 388 o Problem 1: it is irrelevant that PC had no financial problems and could have invested in MI-2, b/c Broz did not owe a fiduciary duty to PC before it purchased CIS. o Problem 2: Broz now has an obligation to offer it both to CIS and to RFBC (b/c there are other SHs). o Problem 3: Now, Broz is an officer, and the deal came to him in his capacity as an officer. This suggests that taking it would more likely constitute a breach. 48

o See also Singer and Meinhart. This doctrine applies really to any kind of entity: a similar analysis applies to partnerships and general agency relationships. In Re eBay, Inc. Shareholders Litigation; DE 2004; pg 389. o eBay used Goldman Sachs (GS) to underwrite an IPO. eBay continued to use GS for $8M in business. GS allocated over 40 lucrative IPOs to eBay CEO, which he was able to sell for millions in profit. o P shareholders filed derivative suit (demand excused) against eBay claiming that CEO and others usurped a corporate opportunity, and against GS claiming aiding and abetting of breach of fiduciary duty. Court held opportunity was usurped and that GS aided and abetted the breach here. o Because eBay was financially able to exploit the IPOs, it had enough security investments to make it w/in its line of business, and receiving the IPOs placed CEO in conflict with eBay, breach for usurping business opportunity occurred. o The IPOs were given by GS essentially to reward eBay for bringing it past business and to encourage it to keep bringing business. These benefits went directly to the individuals, though, instead of to the corporation, which held a large portion of its assets in securities and could have benefited. o Even if the corporate opportunity doctrine were not invoked, the CEO breached his duty of loyalty by failing to account for profits obtained personally in connection with transactions related to the company. o To be liable for AIDING AND ABETTING A BREACH OF FIDUCIARY DUTY: o (1) A fiduciary relationship must exist; o (2) Individual D must have breached its fiduciary duty; o (3) Ps must have been damaged; AND o (4) The abetting entity must have knowingly participated in the breach. Here, the only issue was whether GS knowingly participated in the breach. However, it is clear that GS knew that CEO owed fiduciary duty to eBay not to profit personally at eBays expense, and GS had reason to know of eBays investment of excess cash in securities. Hence it aided in the breach. o Going Public and Spinning IPOs. o When a company goes public, it issues shares of stock to members of the public. o It must first prepare a registration statement. o The investment banker is the party that markets the security for the company. It takes about 7% of the gross proceeds that the company would have gotten from the stock. o Because this is so lucrative, there is a lot of competition b/w investment banks to be the lead underwriter of these offerings. o Hence, investment banks spin IPOs by giving lucrative IPOs to executives of companies that it wants to come back to them for business in the future (this is a form of bribery). o Purpose of the Corporate Opportunity Doctrine. o We want to keep corporations from being ripped off by their officers and directors. o The law rejects a bright-line rule requiring all opportunities to be given to corporations b/c that would discourage members of the business community from serving on boards. 49

o The law also does not allow public corporations to opt out contractually from their duty of loyalty b/c of concerns about asymmetries of information (is allowed in close corporations). (C) Dominant Shareholders o Fiduciary Duties are not typically imposed on SHs. o This would be administratively complex. o More importantly, SHs are not in control of managing other peoples money, which is why we impose fiduciary obligations. o However, when a SH has a controlling interest, the SH runs the show, b/c that SH can appoint the board. o Different scope of duty imposed on control SH. o The duty imposed on control SH is different in scope from the duty imposed on manager/directors, b/c that control SH has a huge stake in the firm (bears the pain). o We are not concerned about control SHs acting to destroy value; we are instead concerned that they do things that disproportionately benefit themselves at the expense of other SHs. Sinclair Oil Corp. v. Levien; DE 1971; pg 394. o Sinclair is an oil company that produces oil in Venezuela through its subsidiary (97% owned; 3% public) Sinven. Sinclair also owns 100% of shipping subsidiary Sinclair International (full vertical integration). o P SH of Sinven alleges (1) that Sinclair caused Sinven to pay excessive amount of dividends, (2) Sinclair caused Sinven to breach its K w/ Sinclair; and (3) Sinclair diverted a corporate opportunity from Sinven. The court holds that there was no breach of fiduciary duty or diversion of corporate opportunity, but there was a breach of K. o When a PARENT COMPANY ENGAGES IN SELF-DEALING WITH A SUBSIDIARY, the intrinsic fairness testwhich requires the parent to prove the transactions were objectively fairis applied. Otherwise, apply BJR. o Control SHs owe a fiduciary duty to the corporation such that they do not give themselves disproportionate benefits at the expense of minority SHs. o Self-dealing occurs 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 to the exclusion and detriment of the minority SHs. o The dividends here resulted in large sums of money being transferred from Sinven to Sinclair. However, a proportionate share of the money was received by minority SHs of Sinven, so there was no self-dealing. Hence, the BJR applies, and the dividends were lawful b/c there were no allegations of improper motives or waste. o Why is there no business opportunity divestment claim here? Sinclair creates new subsidiaries whenever a new international oil opportunity arises. An opportunity arises in Brazil, and Sinclair creates a subsidiary for that opportunity instead of granting the opportunity to Sinven. If that opportunity was stuck in Sinven, Sinclair would only get 97%, while if it is stuck in a new subsidiary, Sinclair gets 100% of the proceeds. There is no business opportunity doctrine claim b/c Sinclairs business strategy is to have separate subsidiaries to develop opportunities in separate countries,

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and the court does not want to second guess that strategy. o The breach of K claim succeeds, b/c Sinclair cannot meet the intrinsic fairness test: late payments occurred and Sinclair did not buy the full quantity contracted for, and both of these were unremedied breaches. o How should a parent deal with multiple subs that do business w/ each other? o The subs here are not wholly owned, but they deal w/ each other. o How should the parent price transactions b/w the subs? o (1) Perform a squeeze-out merger to cash out the minority SHs. o (2) Set up an independent committee that ensures disinterested board approval to the extent possible. This committee does not receive SLC deference, though, b/c control shareholder entirely selects this committee. Zahn v. Transamerica Corp.; 3d Cir. 1947; pg 399. o AFT has three kinds of stock. Preferred stock (see below); Class A stock w/ 2 to 1 liquidation preference to Class B SHs, is redeemable by corporation with 60 days notice at $60, and is convertible into Class B stock at option of SHs. Class B stock. TA has control of Class B stock of AFT, and AFT is sitting on large inventory of tobacco. The value of the tobacco skyrockets, but most SHs do not know this b/c it is not on the books. TA would like to divert the increased value from Class A SHs to Class B SHs. The board redeems the Class A shares for $60 (those SHs do not choose to convert to Class B), and then liquidates, such that Class B SHs receive increased value of stock. o P, Class A SH, sues TA directly on behalf of himself and other Class A SHs, alleging that TA breached its fiduciary duty as a control SH to AFT. o DUTY OF CANDOR: A control SH may breach its duty to the minority by requiring minority SHs to take financial action w/o all material information about the corporation. o See chart on pg 404 of casebook for breakdown of how liquidation affects Class A and Class B SHs under different rights and (as)symmetric information. o On remand, the court explained that the case was really about the boards failure to inform the SHs about the value of the tobacco (a duty of candor case). There is a duty of candor to make full disclosure to SHs before they are asked to vote. The court on remand focuses on that b/c we are asking the SHs to make a decision. Either they allow their shares to be redeemed, or they convert them to Class B stock. o Why isnt the boards decision to redeem Class A shares a self-interested one? o Class B SHs have residual interest in corporation (b/c they get paid after everyone else; indeed, KY has an opinion holding that Class A stock like this is a kind of junior preferred stock). o Where one class of stock must be favored, the board has a duty to exercise the redemption provision to take out A in order to maximize the gain to B. Regardless of whether TA controlled the board, the board had a duty to maximize the value of the Class B stock. o This was therefore not a self-dealing transaction by TA; instead, it was a violation of the duty of candor to allow Class A SHs to have full information in making their decision.

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o Categories of stock: o Preferred stock. Typically non-voting stock unless dividend has not been paid for several quarters; Issues a cumulative dividend (i.e., skipped dividend payments continue to be obligations from company to the SHs). These are therefore a cross b/w equity and debt. Are desirable for investors desiring guaranteed income instead of capital gains. (Conversion clauses are valuable here b/c they allows investors to convert their debt instrument into an equity instrument.) o Common stock. Owners of residual interest in company; Have voting rights in company; SHs are owed fiduciary duty by officers and directors of corporation. o Mechanics of Dissolving a Corporation. o (1) Board resolution. o (2) SH approval. o (3) Sell all assets and use proceeds to pay off debt holders. o (4) Remainder goes to the residual owners of the company. (D) Ratification Fligler v. Lawrence; DE 1976; pg 405. Lawrence is president of Agua, a mining company. He acquires antimony properties in personal life and offers them to Agua, which rejects the opportunity. Lawrence forms a new company (USAC) and transfers property to it in exchange for stock. Lawrence then grants Agua an option to buy USACs stock in exchange for its stock. Agua exercises the option, board and SHs approve. P SHs sue derivatively, alleging that Ds usurped a corporate opportunity. Court holds that the transaction was intrinsically fair. DISINTERESTED BOARD OR SH RATIFICATION (or a showing of entire fairness) removes the taint of conflict in an interested director transaction, such that the TRANSACTION WILL BE SCRUTINIZED UNDER THE BJR. o Three ways in which DE statute 144 allows for interested transactions: (1) Full disclosure to the disinterested board of directors and disinterested board approval (even if there is not a quorum). (2) Full disclosure to the SHs and (insert: disinterested) SH approval. (Ratification only makes sense when the law asks the disinterested parties to vote, not when the interested parties can ratify the transaction for their own benefit.) (3) Entire fairness of the transaction. Effect of RATIFICATION ON DUTY OF CARE. o Ratification only removes the taint wrt the duty of loyalty claim, but it does not remove the taint wrt the duty of care waste claim. But see Wheelabrator, post. o That is b/c waste is a void, rather than a voidable, transaction. o The law requires UNANIMOUS CONSENT to ratify such a reordering of the assets 52

o o

of the company. In Re Wheelabrator Techs., Inc. Shareholders Litigation; DE 1995; pg 408. o Waste owns 22% of WTI. The two negotiated a transaction that they call a merger, but which is really a share exchange. Some Waste SHs exchange their shares for a mix of Waste and WTI shares. At the end of the day, Waste owns 55% of WTI. Waste has a minority of directors who sat on the WTI board. To get the deal approved, the interested directors are excused and the disinterested directors listen to I-bankers and lawyers, and then those disinterested directors approve the transaction. The interested directors return, and the full board approves. Then, a majority of the disinterested SHs vote to approve the transaction as well. o P SHs bring claim that the proxy statement was misleading (did not tell SHs that board approved after only one three-hour meeting). If the disclosure was inadequate, the SH ratification would be inadequate. The court rejects that claim, though, b/c board was already familiar with both companies and went through thorough process. o DISINTERESTED SH RATIFICATION causes: o DUTY OF CARE claim to be extinguished; If informed SHs approve a merger, then the claim that the board did not exercise procedural due care must fail. o DUTY OF LOYALTY claim (INTERESTED DIRECTORS/officers) to be extinguished except for possible waste claims; This is a result of the sanitation statute. o DUTY OF LOYALTY claim (transaction w/ CONTROL SH) to have the burden shifted on P to show the entire fairness of the transaction. The law requires entire fairness here b/c there is a greater possibility of selfdealing when a control SH is engaging in a transaction w/ the corporation. There is a reason to be more suspicious of control SHs than directorsa final period problem, when the control SH is trying to squeeze out the minority SHs. o Here, the court states that there is no controlling SH transaction, b/c there is no control SH (even though Waste owned 22% of shares in public company). Hence, there is no conflict of interest transaction and the BJR applies.

(3) Disclosure and Fairness RULE 10b-5

RULE 10B-5 o The overarching rule for policing fraud in the sale of any security. o What is a security? o Stocks = almost always considered securities. o Bonds = sometimes considered securities. 53

o Applies to any company issuing stock (not limited to companies registered w/ the SEC). o The basis of most class action lawsuits that are brought under securities laws. Those lawsuits are often coupled with other types of securities claims. o The real battlefield is whether D can win the motion to dismiss. P gets no discovery at initial phases. (25% are dismissed; most that proceed are settled; virtually no cases that proceed go to trial.) o Private rights of action. o Some commentators believe that the SEC should be responsible for all such fraud enforcement instead of private rights of action. o Others believe that these private actions are a necessary supplement b/c the SEC is understaffed and incapable of enforcing corporate fraud. o Review: COMMON LAW FRAUD: o (1) SCIENTER is when a seller intentionally lies about something related to the sale (e.g. Thomas sells a car by intentionally lying about the condition of the car). It is more challenging when the seller is severely reckless in closing eyes to the info. o (2) Lie must be MATERIAL to purchase decision. Problems: (i) Subjective/objective materiality (e.g. does it matter that the buyer would have cared about something others would not have?). The law requires objective materiality. (ii) Proof. The buyer must be aggrieved in order to bring the suit, so he has incentive to say lie was material. o (3) PROXIMATE CAUSE (the buyer would not have bought it anyways). o (4) DAMAGES (was there actual harm?). o (5) RELIANCE (buyer has to have relied on the lie). JUDICIAL LIMITATIONS on 10b-5 actions. o Standing. The protections of Rule 10b-5 extend ONLY TO PURCHASERS AND SELLERS of a corporations securities. Blue Chip Stamps (holding Ps who had option to buy shares of stock did not have standing b/c they did not actually buy). o SCIENTER. Liability for a false or misleading statement requires proof of mind of scienter that the person made the statement w/ an intent to deceive, manipulate, or defraud (recklessness is sufficient, too). Ernst & Ernst. It is unclear what the current pleading requirement is for scienter. o Secondary liability. There is no private right of action against those who aid and abet violation of Rule 10b-5 unless that person made a misleading statement himself (a primary violator). Central Bank of Denver. However, accountants and attorneys sometimes conspire to conceal fraud. o There is currently a split in the circuits about whether the person must have spoken or only must have been a substantial participant. STATUTORY LIMITATIONS on 10b-5 actions. o Stay on discovery. P does not get discovery until the court decides whether to dismiss the case. This cuts down on Ps bargaining power in settlement until it is clear whether it is a frivolous case. o Lead plaintiff provision. 54

o Suppose we believe class actions are all about plaintiffs lawyers making money, b/c there is no one watching over the lawyer to check against them enriching themselves. o To combat this, the investor with the largest financial interest in the claim will be appointed by the court to be the class representative (the lead plaintiff); that investor cares the most about what happens in the case and hence will monitor the lawyers conduct. o Those people are usually institutional investors. Basic Inc. v. Levinson; S. Ct. 1988; pg 450. o CEI sought to merge w/ Basic. While internal merger discussions were ongoing, the officers of Basic made persistent statements to the market that no such discussions were occurring. The merger went through, and the price of the stock went up. Ps were sellers (10B-5 allows purchasers or sellers to bring action), and they claimed that if Basic had told the truth they would have been able to sell their stocks for more money. o Court remanded wrt whether the misleading information was material based upon the balancing test. It also held that class actions may presume reliance for fraud. o I. Info about MERGER NEGOTIATIONS IS MATERIAL based upon BALANCING: o (1) PROBABILITY that the merger will succeed; AND In assessing probability, the court should look to board resolutions, instructions to investment bankers, and actual negotiations b/w principals and/or their intermediaries. Time Line of a Merger: (1) Opening contact b/w the parties. (2) The target board is informed, usually by bringing in investment bankers and legal advisors. (3) Management of target goes to talk to the other side. (4) A letter of intent is signed. o Issues to negotiate: (1) Price. (2) Employment/severance of officers of target company. (5) Agreement in principal (the preliminary merger agreement). o The business people step out of the equation and the lawyers step in. The key issues have been decided, and the fine print must be negotiated. (6) Board approval. (7) Proxy statement sent to SHs. (8) SH approval. (9) Filing of certification of merger. o (2) ANTICIPATED MAGNITUDE of the merger on SH value. In assessing magnitude, the fact finder should consider the size of the corporate entities and the potential premiums over the market value. o To be actionable, a statement must be misleading. Silence, absent a duty to disclose, is not misleading under rule 10b-5. No comment is the functional equivalent of silence when it is used persistently. o SEC requirements make the duty to speak complicated. The form 10K is their annual report, and the form 10Q is filed quarterly for 55

the other three quarters. Those forms have tons of mandatory disclosure. Thus, there is a duty to speak every 90 days. Even immaterial information often must be disclosed. Form 8K requires virtually continuous disclosure about certain topics that the SEC is quite interested in (e.g. if corporation adopts a poison pill). o The previous standard was TSC v. Northway. In the proxy-solicitation context, an omitted fact is material if there is a substantial likelihood that a reasonable SH would consider it important in deciding how to vote. Thus, 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. The court explained that this standard is unworkable for merger negotiations b/c it is unclear how a reasonable investor would consider an uncertain, future event. o II. An INVESTORS RELIANCE on any public, material misrepresentation MAY BE PRESUMED for the purposes of a rule 10B-5 action in info-efficient markets. o The fraud-on-the-market theory states that misleading statements will defraud purchasers of stock even if they do not directly rely on those statements b/c the price of the stock they buy or sell will have incorporated that information. In effect, the statement defrauds the market, which relies on the misrepresentation, and the market price in turns defrauds the investor, who relies on that price. o Reliance is a required element of a cause of action for fraud (stems from common law), but proving individual reliance is too burdensome in class action security cases. o The modern securities market is information efficient; that information is incorporated into the market price, and investors rely on that price to make their investment decisions. This has been reinforced by empirical studies. o While reliance is presumed, Ds MAY REBUT THAT PRESUMPTION: Ds may rebut by a showing that severs the link b/w the misrepresentation and either the price P received/paid or Ps decision to trade at the fair market price. For example: The market believed the merger was going through despite statements; P sold for unrelated concerns. However, practically speaking, D is not going to be able to rebut presumptions in a class action case. o In cases where markets are not informationally efficient (e.g. IPO market, thinly traded companies), this rebuttable presumption does not apply. o The fraud-on-the-market theory should not be adopted by federal courts, so reliance cannot be presumed. White. o Courts should not make decisions based upon trends in economic theory in which they are not experts. Any such change should come from Congress. o The Court assumes that investors rely on the integrity of the market price in making investment decisions. In actuality, many investors make decisions to buy or sell b/c they believe the price inaccurately indicates the companys worth. 56

Here, the application of the rule will allow investors who were betting that Basic was not telling the truth and then sold their shares to recover more even though they were not relying at all upon the statements. The people who will pay for such recoveries are innocent investors. o Informational vs. Allocative Efficiency. o Informational efficiency: When a company discloses material news to the market, the market prices that information into the stock quickly based on various investors expectations of how that news will change value. o Allocative efficiency: The market reacts to price the security accurately. This has an underlying concept of the right value, which is hard to nail down. The dissent discusses allocative efficiency. Santa Fe Industries, Inc. v. Green; S. Ct. 1977; pg 468. o SFI acquired control of 95% of stock of Kirby Lumber. It wanted to cash out the minority SHs, so it effected a short-form merger under 253 of Delaware statute. It merged with subsidiary (after parent director approval) and offered payments in cash to minority SHs. SFI found that liquidation value of Kirby was $640/share; Morgan Stanley valued Kirby at $125/share. SFI offered minorities $130/share. o Minority SHs, instead of using state-law appraisal remedy, sued in federal court. Court here held that 10b-5 does not allow for CoA for breach of fiduciary dutyit requires manipulation, and there was none here, so dismissed Ps claim. o Federal law does not support a cause of action for breach of a fiduciary duty of control SHs; 10b-5 only prohibits transactions that are either manipulative or deceptive. o The language of the statute gives no indication that Congress intended to prohibit any conduct that did not involve manipulation or deception. o Manipulation is a term of art referring to practices that mislead investors by artificially affecting market activity. The potentially low offer to minority SHs here is not manipulative in that sense. Here, Ps had all the information they needed to make their decision to accept the offer or seek judicial appraisal. o Because the purpose of the statute is to encourage full disclosure, Ps claim of unfairness should not be brought under the statute. o There already exists a state law remedy; further, if federal securities law were extended to overlap with state corporate law, it would confuse investors and potentially cause conflicting standards.

6. CLOSELY HELD CORPORATIONS

o Common law and statutory doctrines from close corporations (CCs).

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o Some states have developed common law doctrines and statutory doctrines that apply exclusively for CCs. o In some states, the company must elect to be treated as a CC in order for those statutes/doctrines to apply.

(1) Control in Close Corporations

(A) Separating Economic Interest & Control Divergence b/w economic interests and control rights o Usually, when a party has an economic interest, it also has control rights. o In CCs, parties often want to have econ interest but not be involved in daily operations. o Scenarios where economic interest but little control: o (1) X has a start-up company idea but does not have managerial talent, so X pursues executives who are already accomplished at larger firms. To lure that executive away, X must give him a disproportionate amount of control in the firm. o (2) X has a start-up and goes to a bank for a loan. X has little assets, so to encourage the bank to loan he offers them a high degree of control in the business. How to SEPARATE ECONOMIC INTEREST FROM VOTING CONTROL. o Suppose small business (production of hockey masks). Participant Jason Freddie Chucky Investment ($) 10m 6m 5m Voting Interest 20% 30% 50% Profit Share 47% 29% 24%

o Based upon the above scenario of the corresponding investments, how can a corporation effectuate giving those participants the corresponding voting interests and profit shares? o (1) DUAL CLASS STOCK. Class A = ordinary; Class B = no dividend payments but super-voting. Sell the common stock to the parties in proportion to their investments. o (2) Use common stock and some OTHER KIND OF SECURITY. Sell 5m shares of common to Chucky, 3m shares of common to Freddie, and 2m shares of common to Jason. Place the remaining investments in non-voting securities: Payout priority Paid w/ common stock (last) Ahead of common, but after debt Bankr. Pref. Last Cash Demand Low Corp. Taxes Not deductibl e Depends

Nonvotin g common Preferred Stock

After debt

Cumulati ve dividend (like debt

58

Debt

Paid first

First

obligation ) Puts big demand on cash (bad for firm)

Deductibl e

Small businesses do not want to be too tied up to debt, b/c that restricts cash flow and inhibits the ability to expand the company. o (3) Create 3 CLASSES OF STOCK. Class C gives right to elect 5 directors on board; Class F has right to elect 3 directors; Class J has right to elect 2 directors. Then, apportion the numbers of shares according to economic share. o (4) Create a VOTING TRUST. Issue common stock to each based on economic interest. Then, take 5.9m of Js votes and distribute them into a trust (0.3m votes to F; 5.6m votes to C. Legal mechanics. Each party allocates legal title to shares to the trustees of the trust. However, each retains the equitable interest in the stock. The trustees determine how to vote the trust according to the trust instrument. The person who put the trust in gives up the right to vote but retains the right to receive payments. Have a limited life (this is provided by statute b/c of a fear of separating ownership and control). Must be publicly disclosed. o (5) Create a VOTE POOLING AGREEMENT. The SHs enter into a K to accomplish what they want to accomplish with a voting trust but w/o locking votes up in a trust (this is more flexible, but it also is subject to attack in certain circumstances). Big questions: How long does it last? What do you do if the parties stop liking each other? Role of an arbitrator and ability to vote. Usually, the agreements appoint someone to be an arbitrator who will vote the shares in accordance w/ the K in case of disagreement. For arbitrator to be able to vote, the K has to give the arbitrator the power to vote the stock. This requires an irrevocable proxy. o A revocable proxy (a proxy is simply an agency relationship; X appoints someone else to vote his shares). o An irrevocable proxy cannot be prevented from voting the shares. This can be done by coupling the proxy with an interest

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o o

(e.g. the SH agrees that in return for having a proxy he will agree to work for the firm; a bank has an interest to create an irrevocable proxy b/c the bank lends money to the firm). There must be some kind of consideration given to the company that grants the proxy. This must be explicit; courts do not imply irrevocable proxies. Vote pooling agreements only affect what SHs can do but have no effect on what parties can do as directors. Thus, over time a new kind of agreement developed: SH agreements. (B) Vote Pooling Agreements Ringling Bros. v. Ringling; DE 1947; pg 599. Three SHs owned corporations: Ringling, Haley, and North. R and H entered into an agreement that they would vote their shares for directors together (so that they could select 5 of 7); if they failed to agree on how to vote, Loos would arbitrate. Before 1946 meeting, they failed to agree beforehand, and they agreed to adjourn. At the meeting, though, Mr. H voted against adjournment, so voting proceeded. At the end, it was unclear which directors had been elected. P (R) brought suit to review the election. Court held that the vote pooling agreement was valid, that H breached it, and that the six people elected by R and N were the directors (Hs votes rejected). When a SH breaches a vote pooling agreement, the votes by that SH at an election should be rejected. o The agreement sought to take advantage of the fact that, by concerted action, R and H could select 5 of the 7 directors. In case of deadlock, it provided for arbitration. However, the arbitrator himself had no authority to vote the shares, and neither SH had the authority to vote the others shares. The agreement did create an obligation for a SH to follow the arbitrators direction so long as the other agreed w/ the arbitrator. o A DE statute that allowed for voting trustees in certain circumstances is inapposite here. SHs are allowed to create means for effectively conferring their voting rights to others (e.g. when dividends are not paid to a certain class of SH for a period of time). In this agreement, the SHs attempted to bind each other, not to delegate their voting rights to others in a way that might violate that statute. o The remedy here is that the six individuals voted on by R and N are directors. This leaves one vacancy, but it will be filled at the next yearly election. Cumulative voting vs. straight voting. o Straight voting. Each SH can cast one vote for each share held and the election for each director is separate. Thus, if control SH has 80 shares, minority has 20 shares, and there are 10 directors, the control SH will win 80-20 for each director and will nominate the whole slate. o Cumulative voting. Each SH can cast one vote for each position on the board for every share. Thus, if control SH has 80 shares, minority has 20 shares, and there are 10 directors, the minority will get 200 votes and will vote 100 each on two directors. This is a way of ensuring that minority SHs have representation on the board of directors.

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o The K is valid, but there is no mechanism for the arbitrator to vote the stock. o Hence, the court cannot enforce that part of the K. o However, H breached the agreement, so the court nullified her votes. o When a vote pooling agreement is created, there must be an irrevocable proxy that would allow the arbitrator to vote the shares. Ramos v. Estrada; CA 1992; pg 623. o Ramos and his wife, along with Estrada and her husband formed the BG. Another group, V41, and the BG sought control of a license from the FCC. They agreed to come together to form TI. Initially, BG and V41 each had 5000 shares of TI, and each got to appoint 4 directors. After some time, BG received a tiebreaker in each. BG came to a SH agreement that voted all shares as however majority of BG desired. If anyone failed to do so, the agreement provided they must sell their shares based upon buy/sell provision. Estrada defected to V41 in a vote to remove Ramos as president, and BG then voted Estrada out with a majority of their shares. o Ramos sued Estrada for breach of K. The court held that the K was valid and was breached; therefore, Estrada must sell shares based upon buy/sell provision. o Even though the corporation here is not a CC, POOLING AGREEMENTS ARE VALID KS that are specifically enforceable when there is no market for the shares. o Moreover, the K was not unconscionable b/c Estrada was a sophisticated businesswoman, and she freely signed the agreements. o VOTE POOLING AGREEMENTS VS. SH AGREEMENTS. o SH agreements Only allowed in close corporations where there is no objecting minority. Create the authority for SHs to bind directors. Galler. o Vote pooling agreements Are allowed even when there is an objective minority interest or the corporation is not a close corporation. Do not create the capacity for SHs to bind directors directly. o The agreement here was a vote pooling agreement. A SH agreement could not be entered into here b/c there would be an objective minority (V41). o Pooling agreement used here to punish a director and exert control. Estrada went against the desires of BG in her capacity as a director. BG then used the vote pooling agreement to punish Estrada for what she did as a director. Estradas vote as a director did not violate the agreement. It was not until she refused to follow the desire of the majority in voting against herself as a director that she breached. o PLANNING. Buyout (BUY-SELL) AGREEMENTS. CB at pg 182. o TRIGGER EVENTS. Events that trigger the obligation of the firm to buy a partner/SH ownership interest. Typical trigger events include: Death and disability (b/c the SH or his heirs will likely not still want to be involved with the firm but would prefer to cash out); and 61

The will of any partner (b/c they want the flexibility to be able to cash out at any time). o OBLIGATION VS. OPTION to buy. Does the firm have the obligation to buy or merely an option to buy? Obligation Bad for the firm if they did not have good cash availability at the time; Good for SH b/c SH knows he can get out. Option Bad for the SH b/c he might not be able to get paid. Good for firm b/c no worries about cash. o PRICE. How should price be determined? Set a price each year; Formula (e.g. five time earnings); and Appraisal. o The most important thing is to have the parties consider all these things beforehand. (C) Shareholder Agreements McQuade v. Stoneham; NY 1934; pg 606. M (manager of baseball team), Q (city magistrate), and S (majority SH) entered into agreement that they would use their best efforts to keep themselves on as directors and officers of the corporation. The agreement also stated that there would be no changes in policies that could interfere w/ rights of minority SHs. S and Q had a falling out, and Q was voted out of his office and director position. Q sued for specific performance of the agreement. The court held that the K was void b/c it restricted the board, so Q loses. SH AGREEMENTS ARE VOID for violating public policy (of unlimited discretion of boards) when they PRECLUDE BOARD from changing officers, salaries, or policies. o Directors have a duty to the corporation, and that may not be abrogated by preconceived agreements of SHs. SHs may not control the directors in the exercise of the judgment vested in them to elect officers and fix salaries. o Here, the other minorities do not seem to mind that Q has been voted out. There does not appear to be any injury to the corporation due to Qs absence. o Leaving the determination of the validity of such an agreement up to a courts determination of public policy is dangerous; that would allow courts to pass on the motives of directors. A bright-line rule prohibiting such Ks is preferable. An agreement that merely provides for the election of fit officers and adhesion to particular policy is legal so long as it is designed not to harm minority SHs or outside 3d parties. o The K was valid itself b/c it did not harm anyone. Whatever a single control SH would have the power to do, a group of SHs has the power to contract together to do. Because a single, control SH could control the policies of a corporation through elected directors, a group of SHs should be able to contract to do the same. Should the power of the board be a mandatory rule? o The majority holds that the SH agreement prevents the board from determining who 62

o o

the managers will be, as well as their compensation, and is therefore void. There is a mandatory rule of corporate law that you cannot contract around the boards power. o The dissent, though, argues that free contracting allows for efficient allocation of resources. Thus, contracting out should be allowed so long as there are no negative externalities to minority shareholders or outside parties (e.g. creditors, the public). o Clark v. Dodge; NY 1936; pg 611. Clark owned 25% of the stock in two corporations that manufactured medicine. He knew the secret formula and managed the daily business affairs. Dodge owned the remaining 75% and took no active part in the business, though he was a director. The two entered into an agreement that Clark would stay on as a manager so long as he was competent (Dodge would vote him in using his shares) and that Clark would receive of profit as compensation. Clark lost his position, and he sought reinstatement, accounting for his lost compensation, and he also sued for waste. The court held that the K was legal and there was a cause of action, here. Where the directors are the sole SHs, unanimous agreements that those SHs must vote for certain people as officers are enforceable. o While the business of a corporation shall be managed by its board of directors, the doctrine that any agreement that limits the powers of the directorate is only appealing b/c of its administrative simplicity. In actually, where the public is not affected, the parties in interest should be able to limit their respective rights. o Here, there was no attempt to sterilize the board of directors. The agreement did not set a particular policy path for the company; rather, it only stated that Clark should stay on as manager, that he should be compensated fairly, and that no excessive salaries should be paid to others. This is only a negligible invasion on the powers of the directorate. No Third Party SH. o This case is distinguishable from McQuade b/c there is no 3d party SH here (in that case, M was also a SH). o This rule makes tons of sense. If two people are going to go into business together, they should be able to structure their business in whatever way they like. PLANNING. EMPLOYMENT CONTRACTS. o Duration appears important, but it likely isnt b/c employer could always fire him. o Termination for cause is a narrowly defined item, and it matters a lot to the employee how it is defined (b/c if employee is terminated for cause he wont get anything). o Termination w/o cause: The extent of severance is very important (the length of the severance package is the true duration of the employment K). The only value of the agreement, then, is to protect that interest of the minority SH. o Job description is important b/c it prevents employee from being marginalized (employee should be allowed to quit for a good reason while still having access to the severance package, such as responsibilities being changed in a significant way or being transferred to an undesirable location).

o o

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o An employment K for a minority SH in a CC is a necessity in addition to a SHs agreement. Galler v. Galler; IL 1964; pg 618. o B and I, brothers, were equal owners of drug company, with both owning 110 shares of stock. Both sold 6 shares to employee, R, for $10K each, but then Is wife bought those shares. B and I entered into agreement to assure an equal share of control in both families. B then executed a trust naming his wife as a trustee. When B died, his wife demanded the additional shares from I so as to make each ownership share equal, but I refused. o P sued for specific performance of transfer of 6 shares for half the price that R paid. The court held that Is family had to account for all the monies they received that should have gone to Bs family under the K. o SHS IN CLOSE CORPORATIONS CAN CREATE SH AGREEMENTS to protect potential minorities from majority tyranny so long as: o (1) NO COMPLAINING MINORITY interest appears; o (2) No fraud or injury to the PUBLIC OR CREDITORS is present; AND o (3) No clearly prohibitory STATUTORY LANGUAGE is violated. o Such SH agreements are necessary to insure a large minority SH some amount of control so that the minority is not subject to oppression from the majority. o In close corporations, tyranny is more likely when no such agreement exists b/c there are not liquid markets for shares. o In CCs, the SHs agreement is typically the result of careful deliberation and bargaining among all initial investors, unlike publicly traded companies. o Here, the duration, election of directors, mandatory declaration of dividends, and salary continuation provisions of the agreement were all valid. Thus, Is family is required to make Bs family whole. o The SH agreement here is reasonable. o The requirement that the board must pay dividends is limited by a provision that ensures that the corporation will only pay dividends when there is enough of an earned surplus: this protects outside creditors, who will be harmed if there were not enough cash in the company. o The agreement does not last forever, b/c it will end when all of them die. o The salary continuation agreement (paying out funds to the widow) is valid: Waste can be ratified by unanimous consent. o This was not a gift, b/c the employee gave as consideration in the form of his labor when the K was executed. o PLANNING. BUY-SELL AGREEMENT preferable. o In the end here, neither side has control of the company. o The better result would have been to have placed a buy/sell provision into the SH agreement so that the widow could have gotten out the value of the investment.

(2) Abuse of Control in Close Corporations

Wilkes v. Springside Nursing Home, Inc.; MA 1976; pg 630. o W, R, Q, and P formed a corporation to operate a nursing home (b/c they wanted limited liability). They each owned 25% of stock, worked for the corporation and received salaries. 64

o o

o o

The corporation paid no dividends. The other SHs froze out W, cut off his salary, and offered to buy his shares at a value below what they would have accepted. W sued for breach of fiduciary duty owed to him by others. The court held that the other SHs did breach the duty of good faith and loyalty here. LEGITIMATE BUSINESS PURPOSE TEST: SHs in close corporations breach their fiduciary duty of good faith when they FREEZE OUT another SH unless: o Majority has a legitimate business purpose that is more practicable than a less harmful alternative. o SHs in close corporations usually wear two hats: they are both capital investors and employees of the firm. They therefore depend primarily on salary as the principal return on their investment. When frozen out of salary, they lose the value of their investment FREEZE-OUT defined. o A managing SH who has been receiving some sort of compensation for services (e.g. salary) gets fired by the other SHs. o SH usually then finds that he receives no dividend for his investment, no salary, and cannot sell their illiquid investment in the company. Compared to partnerships. o If this were a partnership, freeze outs are a dissolution event, such that the minority partner must be paid off if the rest of the firm is to continue on. Compared to public companies. o For public companies, only control SHs owe fiduciary duties to other SHs. For CCs, all SHs owe each other a fiduciary duty. o Public corporations law does not help W here. W is getting no return on his labor or capital. When everyone works for the firm, the incentive is to pay all salaries and no dividends (b/c salaries are deductible operational expenses for the corporation, while dividends are not deductible). Once W leaves, he is not getting a return on his labor, and he is not getting a return on his capital. It is therefore crucial that he get some sort of dividend payout. Suit to force board to pay dividends is a loser. W would lose if he sued the board for refusing to pay dividends (that is within their wide discretion). Suit for self-dealing under entire fairness is a loser. W would lose if he sued the board for self-dealing under the entire fairness test What is the proper remedy for a freeze out? o W gets treated the same as any other SH. Under Wilkes, W gets a return for both his labor (he gets a salary so long as he willing to work) and his investment (so long as other SHs get dividends). o However, W really wants to get out of the company (have his minority stake sold), and the court does not award that here. W really needed a buy-sell agreement to be in place in the K. o CC law is a hybrid of partnership and pubic company law. W would have been satisfied under partnership law (b/c there would have been a dissolution), but he would have had no remedy at all under typical public company law. 65

o DELAWARE LAW DOES NOT RECOGNIZE WILKES CLAIM. o Instead, all parties are expected to plan ahead and bargain for buy-sell agreements such that minority SHs do not get stuck with illiquid assets in a freeze-out. Nixon v. Blackwell. o DE is a relatively minor player in the CC world; most CCs are incorporated in the state of the SHs residence. o Ingle v. Glamore Motor Sales, Inc.; NY 1989; pg 637. G owns an automobile dealership and brings in I to manage it. G sells I 40% of stock at fair price. They enter into agreement that, if I should cease to be an employee of the corporation for any reason, G could buy Is shares. Several years later, G brought his two sons in and fires I. I sues for breach of fiduciary duty and breach of K. He loses. When a CC has the option to buy the shares of an employee who serves at the employers will, the employee has no protection from termination and buyout. A control SH in a CC owes a fiduciary duty to minority SH employees such that the control SH cannot fire and buy out that employee at will. PLANNING. o Minority SHs also need an employment K. Buy-sell agreements only protect a capital but not a labor investment. If a minority SH really wants to have secured employment and there is a buysell agreement at the option of the corp, minority needs to negotiate an employment K. o Low price in buyout clauses create incentive for majority to use threat of discharge. When a buyout price is too low, the majority has an incentive to hold the threat of discharge over the minority. SQUEEZE OUT defined. o In a squeeze out, the minority SH does get bought out such that his investment is returned. o Here, the SH is not locked into an illiquid investment (w/ no return on either labor or capital), but rather is bought out at an appropriate price.

o o o o

Sugarman v. Sugarman; 1st Cir. 1986; pg 642. o Brothers J, S, and M jointly own Sugarman Bros., a corporation that sells paper products. Those brothers also organized LTC, which then changed its name to Statler Tissue, and which was then merged into SB to form Statler Corp. Ms son L is the control SH, and Ss grandchildren wanted to work for the firm but either were not given a job or had been fired. The corporation did not pay dividends. L offered to buy the grandchildrens shares for an unfairly low price. o P grandchildren brought two claims against L. The first claim was a derivative action for excessive salary paid to L as a result of prohibited self-dealing. The second claim was a directly claim that L breached his fiduciary duty by freezing out Ps. The court here held that a freeze-out occurred and that pro rata payments for Ls excessive compensation must be paid to Ps. o TO PREVAIL IN A FREEZE-OUT claim, P must allege that majority SH:

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o (1) Took some ACTIONS THAT WERE DESIGNED TO FREEZE Ps out of the financial benefits they would ordinarily have received; and Actions indicating freeze out include: Overcompensation of majority SH; Never paying dividends to SHs; Refusing employment to minority as director or manager; Allegations of wrongful discharge. o (2) OFFERED TO BUY out Ps shares at an INADEQUATE PRICE. The offer to buy out the minoritys shares is the capstone of the majority plan. This alone is not enough to breach fiduciary duty, but it may serve to create a breach when the actions indicating freeze out occurred first. o Another claim: excessive compensation w/ duty of loyalty breach. o L was setting Ls own salary, so there is some evidence of duty of loyalty breach. o L would then have to establish the entire fairness of the transaction. (This could be done by bringing in a consultant who would find a very large range of acceptable salaries.) o This would be a derivative claim, though, and any award would therefore go to the corporation (and L, who is in control, might be able to misappropriate it again). o However, Ps could try to show that individual recovery was necessary and get the recovery themselves. See Lynch v. Patterson, supra. o Smith v. Atlantic Props. Inc.; MA 1981; pg 646. W and 3 other investors each owned 25% of Atlantic. W was afraid that the other SHs would gang up on him, so he had a provision included that all decisions required an 80% vote; this gave him effective veto power. W was taxed at a marginal tax rate of 90% for ordinary income, so he wanted to retain earnings in the company that could be attained by him as CGs when the company is sold. The other SHs wanted to pay out dividends. Because of this deadlock, earnings piled up in cash. The IRS began penalizing Atlantic for failing to do anything with its cash. Other SHs brought fiduciary duty claim against W for his exercising his veto power to prevent the firm from paying out dividends and causing the IRS earnings penalty. The court here held that W breached his duty of utmost good faith and loyalty, so he was charged with paying back the other SHs for the penalty taxes and legal costs. A minority SH who has veto power and thereby exercises a de facto controlling interest owes a fiduciary duty to the other SHs not to recklessly run risks to corporation. o Here, W desired the earnings to be reinvested in the corporation instead of paid out in dividends for his own personal tax reasons. However, he did not provide a convincing program of appropriate improvements that could have persuaded the others SHs. Alternative argument that corp should pay fees. o All of the SHs acted in bad faith by acting as if their interests were the only ones that mattered. They should have been able to reach a compromise by investing some of the earnings in maintenance and paying out some dividends. Bad faith case. The SHs acted in their own best interest instead of in the best interests of the corporations. Hence, a typical director fiduciary duty case (not CC) would work here. Mechanism for breaking a deadlock needed. 67

o o

o This is not really a Wilkes case dealing with a freeze-out. The problem is that there is a deadlock here that cannot be broken, and there needs to be a mechanism to break it. o The proper was of dealing with this would be to force dissolution of the company. o If the three SHs had filed for dissolution, W would likely try to buy them out (b/c he knows how to run the business, he has the money and they do not, and he does not want the assets to be broken up and sold piecemeal).

(3) Control, Duration, and Statutory Dissolution in Close Corporations

o Alaska Plastics, Inc. v. Coppock; AK 1980; pg 664. C, G, and S jointly owned AP corp and were officers and directors. As part of divorce settlement, C transferred half of his stock to his ex-wife M. They then proceeded to freeze out M as they pay themselves salaries. Because AP never paid dividends, M never received any money from the corporation. P brought claims that she had been frozen out and that the Ds had breached their duty of care to the corporation (a derivative claim). The court held that the involuntary dissolution statute allowed the courts to fashion a less drastic remedy, such that the majority was forced to buy out Ps shares on remand. The court dismissed the derivative duty of care claim b/c of the BJR. The ways that a MINORITY SH CAN FORCE THE MAJORITY TO BUY HER OUT: o (1) A buy/sell provision in the charter, bylaws, or contract; o (2) Involuntary dissolution by statute; This sort of liquidation is a drastic solution, but courts have the inherent equitable power to fashion alternative remedies. o (3) Demanding a statutory appraisal after significant change in corporate structure (e.g. merger or sale of substantially all assets of company); This is not applicable here b/c no significant structural change. o (4) Equitable remedy for breach of fiduciary duty to minority SH. The equitable remedy, requiring the minority to be put in the same position as the majority SHs, is what is proper here. Because the majority SHs received substantial directors fees, salaries, and other expenses, P here must be paid constructive dividends such that she is put in the same position. Involuntary dissolution statutes o Protect minorities who did not obtain buy-sell. These are backstop provision to protect SHs when they did not plan ahead with a buy-sell provision. o Require showing of oppressive conduct. These typically require the minority to show some kind of oppressive conduct by the majority. Some courts are lenient on oppressive conduct. It is often in the best interest of the company to allow the corporation to break up. See Smith v. Atlantic Props. Some courts are strict in requiring oppressive conduct. Dissolution is an extreme solution (it gives minority SHs lots of bargaining power). o Not all states have involuntary dissolution statutes, and very few attorneys are aware of them. However, when you have one, it is a very powerful weapon. Wilkes only leads to a buyout when majority SHs had their shares bought out. o Under Wilkes, the minority gets equal treatment (here, P would only be able to 68

o o o

receive her pro rata share for payments made that she deserved, e.g. payments of other wives expenses and directors fees). Meiselman v. Meiselman; NC 1983; pg 671. o I and M brothers owned corporation that managed theaters and real estate. I was the majority SH who ran the business. M was excluded from management and decision-making but had drawn a salary. I and M did not get along. I fired M. M lost salary and benefits, but M continued to receive some dividends. o P (M) sued to require the corporation to buy his shares at a fair price. The court remanded for a determination of whether P was entitled to a statutory buy-out of his shares. o When a minority SHs REASONABLE EXPECTATIONS in his rights and interests are frustrated, then a statutory-forced buy-out of his shares is appropriate. o Such reasonable expectations might include expectations that the minority will participate in management or be employed. If those expectations are frustrated, then the court has the power (via a statute) to order a buyout. o The minority need not show fraudulent or oppressive conduct. Pedro v. Pedro; MN 1992; pg 681. o Three brothers jointly owned TPC corp, and they all worked there for most of their adult lives. P was fired after working there for 45 years. P had discovered accounting discrepancies that revealed a large amount of money had been lost, had brought in outside accounts to try to figure it out, and was discouraged from doing so. The SHs had an SRA (a form of buyout agreement) that provided that the value of each share was valued at 75% of net book value each year. o P brought claims of breach of fiduciary duty and breach of lifetime employment K with TPC. The court awarded large damages to P on both claims, as well as attorneys fees b/c Ds had acted in bad faith. o When a valuation agreement sets the value of shares at less than the FMV, P who has FD breached may receive the difference as damages for being forced to sell his shares. o The MN involuntary dissolution statute provides that a court may order a buyout of the shares at fair value for a CC when: (1) deadlock among directors; (2) waste; (3) oppressive conduct by majority. o The majority SHs clearly breached their fiduciary duty to P here: They did not make payments as required by the SRA. They interfered with Ps responsibilities. They hired a private investigator to follow him. They told him that he would be fired if he informed others of the financial discrepancies. o The majority need not cause the value of the company to decline in order to have breached their FD. Here, the company was still as valuable, but there was a clear breach. o P received damages in return for his 1/3 share of the company. However, he received both the amount from the buyout agreement (the SRA) as well as the difference b/w the SRA and the FMV as compensation for being forced to sell his shares. The court does not want to rule that the buyout agreement price is unfair, so it makes P whole by awarding the difference as damages in lieu of liquidation. o When P has a reasonable EXPECTATION OF LIFETIME EMPLOYMENT, a salary, 69

and a significant place in management, he is not terminable at will, and P may recover damages for lost wages if terminated. o Here, the MN statute instructs the court to take into consideration when fashioning equitable relief both the duty the SHs owe to the minority as well as that minoritys reasonable expectations. P had worked for the firm for 45 years and had planned to work there for his life like his father had, so P had a reasonable expectation of lifetime employment. Because he was fired w/o cause, he must be awarded lost wages. o Courts can formulate creative remedies for wrongs using involuntary dissolution statutes. o The court makes P whole both by awarding him damages up to the FMV of the shares as well as by awarding him damages through an implied lifetime employment K. o PLANNING: There should have been a buyout agreement that did not price the shares too low, and there should have been an employment K for P.

7. MERGERS, ACQUISITIONS, AND TAKEOVERS

o Corporate control is really the conflict that arises b/w directors and SHs.

(1) Mergers and Acquisitions

o o o (A) De Facto Merger Doctrine The times when SHs can vote appear to be arbitrarily created (they are based more on historical developments than modern finance). These deals are structured as other than a straightforward merger b/c a party does not want to allow SHs to dissent for the fair values of their shares. Statutory Merger. o Procedure prescribed in the state corporation laws for this combination. o Merger agreement prescribes the treatment of the SHs of each corporation. o Board and SH approval. Approval by votes of the boards of directors and the SHs of each of the two corporations is required. o Filing of merger agreement. Upon the filing of the merger agreement w/ the appropriate state official, the target company ceases to exist and all its interests, rights and obligations pass to the acquiring company. o Appraisal rights. SHs of each corporation who vote against the merger have appraisal rights such that they can demand cash for the FMV of their shares. Practical Mergers. o Share offer merger A offers its shares to the SHs of T in return for their T shares. A seeks to acquire enough T shares to gain control of T. No votes of SHs by T would be required, and no appraisal rights would accrue. o Assets acquisition merger 70

A buys all of Ts assets for stock or cash. A does not have to deal with Ts SHs (only w/ Ts directors). A does not assume all of the unforeseen liabilities of T as it would under a statutory merger. o Glen Alden merger T acquires all the assets of A. T pays for As assets by issuing new shares to A, which A in turns distributes to its SHs. T issues enough shares such that A owns the vast majority of Ts shares and hence has control. This method might avoid appraisal rights. o Farris v. Glen Alden Corp.; PA 1958; pg 715. A acquires T by having T buy all of As assets in exchange for T stock: GA was a PA corporation involved in mining coal. Lind was a DE holding company with a variety of interests. The two corporations entered into a reorganization agreement whereby GA acquired all of Ls assets in exchange for issuing large new amounts of stock to L, which L then distributed to its SHs. GA then assumed all of Ls liabilities, and it changed its name to Lind Alden. L was then dissolved and business was carried on through LA. The SHs of GA approved. P was a GA SH who objected, claiming that no notice given to the GA SHs that the true intent and effect of the reorganization was to effect a merger and that the SH approval was therefore void. The court agreed that the reorganization was a merger and that the approval was void, here. DE FACTO MERGER: A combination that has the practical effect of a merger, notwithstanding its form or name, should be treated as a merger such that SHs must be notified accordingly and be given statutory rights of dissent and appraisal. o Mergers and sales of assets, which used to be clearly distinct, have taken on hybrid forms. Instead of looking at names, it is therefore important to refer to the consequences of the transaction. o Purpose of the PA statute. When a corporation loses its essential nature, the SH should be able to demand cash for his shares. Here, GA is transformed fundamentally (it goes from being a mining company with little LT debt to a holding company with many assets and greater LT debt). Moreover, List effectively has control b/c it has 11 or 17 directors. Importantly, GA SHs suffered a serious financial loss b/c the value of their shares would decrease after the transaction. The transaction should therefore be considered a merger. Legislative developments. o In response, the PA legislature passed a law stating that the court should not apply the de facto merger doctrine. The court, though, refused to recognize that law (more specifically, it holds that it was not the legislatures intent). o The court is concerned here that the price the GA SHs are receiving for their stock is much too low. GA was essentially controlled by L even before the transaction, so the GA board was more concerned with L SHs than GA SHs.

Hariton v. Arco Elecs.; DE 1963; pg 722.

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o A and L entered into the same sort of reorganization agreement as in Glen Alden (i.e., A sold all its assets to L, which paid for the assets by issuing new shares, and A distributed the shares to its SHs). A SHs approved the plan. o P was an A SH who did not vote, and he sued alleging that the transaction was an illegal de facto merger. The court held the merger to be valid here. o DELAWARE ALLOWS FOR GLEN ALDEN MERGERS without appraisal rights to dissenting SHs. o Form of the transaction will be respected in DE even if it hurts minority SHs. o Is this approach a good one? The race to the top argument says yes, because companies will move there so they can take advantage of the increased value to the corporation of that law. The race to the bottom argument says no. o The DE courts focus on predictability. This is good for DE business. DE is dominant jurisdiction for public companies in US b/c those corporations know they can trust DE judges to respect form over substance. Twenty percent of DE budget is franchise fees for DE corporations. This creates jobs for lawyers there, as well. o Why should there be different rules for asset sales than mergers? o The reason is a historical one; lawyers just recently discovered how to create a merger through an asset sale o Internal Affairs Doctrine. o Choice of law principal: when a court decides a matter b/w managers and SHs of a firm (e.g. a fiduciary duty), it must apply the law of the state of incorporation. o Virtually everything in corporate law is a dispute b/w SHs and managers, so this is critical. o Parties can predict the law that will be applied based upon state of incorporation. (B) Freeze-Out Mergers Weinberger v. UOP, Inc.; DE 1983; pg 724. o Signal performed cash-out merger of UOP minority SHs: Signal, a publicly traded company, sold one of its subsidiaries and had excess cash. It acquired a majority interest in UOP, another public company, through a combined share issue by UOP and a tender offer at $21/share. Signal controlled 7 of the 13 directors of UOP (interlocking boards), and the new UOP CEO, Crawford, was a former Signal employee. Signal began investigating a complete purchase of UOP. Two Signal employees, A&C, conducted a feasibility study and decided that UOP would be a good investment at any price up to $24/share. Signals executive committee then met and decided to make an offer. The UOP CEO agreed that $21/share was fair; he did not negotiated price but did negotiate employment packages for UOP senior management. The UOP CEO got a hurried fairness opinion from investment bank (IB) that also concluded the $21 price to be fair. The Signal board agreed to the merger. UOP then made disclosures to its board about the proposal. The UOP minority SHs approved the deal, so the merger went through, thereby cashing out each minority SH for $21/share. o Ps, former minority SHs of UOP, filed class action lawsuit against Signal and UOP, claiming the merger was unfair to them. The court held here that neither the dealing nor the price of

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the merger were fair. For a CASH-OUT MERGER TO BE FAIR to minority SHs, there must have been both FAIR DEALING and FAIR PRICE. o Burden Shifting. Ps first have the burden to demonstrate some basis for invoking the fairness obligation. After that burden has been met, the control SHs have the burden to show that the transaction was entirely fair, unless the merger was approved by an informed majority of the minority SHs, in which case the Ps have the burden to show the transaction was unfair. o The feasibility study conducted by A&C of Signal was not shared with the UOP SHs, even though it was material information to UOP. It showed that Signal would have still bought shares at $24/share, and that that price did not decrease return on investment much from the $21 price. o Fair dealing involves both the duty of candor and issues of how the transaction was timed, initiated, structured, negotiated, disclosed, and voted upon. Here, there was no candor wrt to the feasibility study. The UOP CEO did not negotiate strongly for his company to get a higher price. Because of all these factors, the dealing in this transaction was not fair to the minorities. Two parts to the deal. o The first part of the deal was an arms length transaction b/w two equally strong adversaries. Signal acquired 50.5% of UOPs stock. 40% of the stock was to be acquired via a tender offer at $21/share (FMV at that time was $14/share). This portion was oversubscribed: almost 70% of SHs wanted to sell at that price, but Signal only had to buy the 40%. The other portion was 10.5% authorized, unissued shares from UOP. o In the second part of the deal, no one represents the minoritys interest. The UOP board was controlled by Signal, and it negotiated for itself. Is there a 10B-5 claim here? o Suppose SHs sold their shares to buyers while UOP and Signal were negotiating. Those buyers would have 10b-5 standing b/c they were buyers of securities. o Was the statement that the two corporations were negotiating a material misrepresentation? Perhaps, b/c it gave the impression that the price would be even higher than $21/share (b/c that was the initial price, and it only should have gone up if UOP was actually negotiating). o Was there scienter? Yes, b/c UOP knew it was not seriously negotiating. STEPS OF WEINBERGER ANALYSIS. o (1) Did the interlocking directors BREACH A FIDUCIARY DUTY? Here, the UOP directors breached their duty of candor to both the outside UOP directors and their SHs by not sharing the feasibility study. o (2) Was the TRANSACTION FAIR? (A) Was there a FAIR PRICE? Would the price have been arrived at in an arms length transaction? In determining this, courts must use new methods of valuing companies (i.e. discounted cash flow). 73

(B) Was there FAIR DEALING? Was the transaction structured in a way to bring about a fair result? Factors to consider: o (i) Who initiated the deal? o (ii) Was this a hurried, fast deal? o (iii) Were there real negotiations? o (iv) Was there adequate disclosure (to both directors and SHs)? o (v) Was there a hurried investment bank opinion? Independent negotiating committee (INC) made up of independent directors of UOP who would bargain for them would help. o Before an INC will be deferred to: (1) INC must be truly independent; (2) INC must have fully informed itself of the deal; (3) Court must determine in its own judgment that they negotiated at arms length. Cf. Zapata. o Which is more important, dealing or price? o Price is what SHs really care about in the end, but it is much more indeterminate than fair dealing (there is usually a range of fair prices). o Courts are better at judging procedures than conducting valuation. We have a lot more confidence that the result was fair if the process resembles an arms-length transaction. o A control SH need not enunciate a business purpose in a squeeze out merger. Weinberger o The deal must be fair to the minorities, but there need be no LBP. o What price do minority SHs get when company value goes up during transaction? o Generally in appraisal, SHs in appraisal get the value of their minority interest in the company before anything happened (i.e. before the merger changed things around). o Suppose a two-step transaction (where T was initially worth $10/share) causes the value of the company to go up to $14/share after the merger b/c of new plans to the company. o Do the minority SHs get $10 or $14? It depends on how long between step one and step two. If the control SH was able to begin effectuating its new plans for the company during the time period b/w those two steps, then the minorities will only get $10; if plans had gone into effect, minorities will get $14. Cede & Co. v. Technicolor. Coggins v. New England Patriots; MA 1986; pg 736. o Control SH squeezed out minorities to repay personal debt: Sullivan owned Patriots corporations originally w/ 9 other voting SHs and nonvoting public SHs. He was ousted, but he then personally borrowed money from a bank in order to buy back all of the voting shares. He then wanted to cash out the nonvoting SHs so that he could restructure the corporation in order to help pay back his personal debts to the bank. He did so by forming a new corporation and merging the old corporation into the new one and paying off the old nonvoting SHs. This was approved by a majority of the nonvoting SHs. o Ps were former owners of nonvoting shares who brought class action alleging that the transaction was unfair and requesting the voiding of the merger. The court here held the merger was illegal but could not be undone b/c it had taken place so far in the past, so 74

damages were awarded to P. o When a control SH and directors execute a freeze-out merger that eliminates public ownership, those Ds have the burden of proving: o (1) There was a legitimate business purpose (LBP) for the merger; AND Here, the transaction lacked a legitimate business purpose. The ostensible purpose was to fulfill NFL policy against public ownership, but that was not a real reason b/c Sullivan already owned 100% of the voting shares before the transaction, so there would not be internal management disputes that would be relevant to the NFL. Because there was no LBP, no fairness analysis needed. Generally easy to satisfy LBP. These are LBPs for squeezing out minorities: Saving money that would have been paid to list public stock on NYSE. Eliminating public ownership of subsidiaries in order not to have to set up expensive procedures that protect against self-dealing. SH ratification does not affect this prong, b/c this is a void transaction. o (2) The merger was fair to the minority, considering totality of circumstances. SH ratification shifts the burden onto Ps to prove not entirely fair. o Rescissory damages as remedy. o Too much time has passed for rescission of merger. o Thus, Ps get rescissory damages: Ps are put back into the position where they would have been had the transaction not occurred. Here, this is a generous remedy that they are entitled to present value of their share of Patriots assets on the theory that the merger had never occurred. o The alternative would have been to seek appraisal, which would have given them the value of the benefit of the company before the merger occurred (much less). Rabkin v. Philip A. Hunt Corp.; DE 1985; pg 742. o Olin purchased 63.4% of Hunt shares from control SHs T&N at a price of $25/share. The agreement also required Olin to pay $25/share if it bought the remaining Hunt shares within the next year. Olin waited past the year, then it sought to buy the minority shares at $20/share. It had always intended to do so but made public statements to the contrary. (Query 10b-5 claim.) Olin did its due diligence, and Hunt appointed an INC that hired an IB and did the same. The INC balked at first at the price, b/c its IB said it was at the bottom end of the fairness range. However, when Olin would not budge, it accepted the $20/share price. A proxy statement was issued with a thorough disclosure of the facts. o Ps were minority SHs of Hunt who challenged the price of their cashed-out shares as grossly inadequate, b/c they believed Olin manipulated the timing of the deal such that it would not have to pay the $25/share price. The court here held that a Weinberger claim like this is not limited to appraisal as a remedy and remanded. The trial court found for Ds on remand. o Appraisal is not the only remedy available for a Weinberger claim. o P minority SHs may have remedies other than appraisal (they desire the $25 price that the control SHs got) when the control SH acted in bad faith in a freeze-out merger. o Olin, the majority SH of Hunt, had a conscious intent to deprive the minority SHs of Hunt of the same bargain that Olin had made with Hunts former majority SH. Counter: Isnt that fair, b/c those shares had a control premium? Also, Olin did not breach the K by waiting until after the one year commitment period 75

had passed. o Control SH must show both fair dealing and fair price. o Fair dealing appears to be shown (INC; hired IB; full disclosure to SHs), but the INC did not push back hard to negotiate a higher price. o No complaints about unfair price, so Ps lose on remand.

(2) Takeovers
(A) Unocal Analysis o Two main issues in every transaction: o Price (usually in hostile takeovers, though, price is well above market); o Incumbent management compensation (real fight: management doesnt want to go). o Friendly vs. Hostile acquisitions. o Friendly acquisitions: management does well. o Hostile acquisitions: management is usually terminated w/ prejudice (they may have a severance package already in place, but they will likely get nothing else). o Underlying motivation for balancing tests: fear of management entrenchment. Cheff v. Mathes; DE 1964; pg 758. o Directors of company under siege borrow money to buy back stock at large premium from acquirer. Holland (furnace company that had undergone a reorganization of its sales force after recent profitability issues) had a unique practice of employing large numbers of salespersons (they sold furnaces by committing fraud). Maremont inquired about a merger b/w Holland and his company, Motor Products, but Holland did not agree to it. Maremont apparently had a reputation of liquidating companies for a quick profit. It arose soon that Maremont was buying shares of Holland. Maremont met w/ Cheff, CEO of Holland, and indicated that he was interested in control and wanted to change to business practices of Holland. There was some evidence that there was unrest among employees b/c they were wary of Maremont gaining control. Maremont bought up more stock, and then he made an offer to sell that stock to a subsidiary of Holland at a substantial premium. Holland needed to borrow money to buy the stock back, and the board decided to do so in order to prevent Maremont from being able to take control. Some directors were employed and had pecuniary stake; others did not. o Ps, owners of Holland stock, brought derivative claim against directors of Holland and Holland itself for improperly repurchasing the stock at an unfairly high price in order to perpetuate their own control. The court held for Ds here; it was reasonable for the directors to use corporate funds to buy back stock b/c of threat of Maremont. o Board may engage in defensive techniques (e.g. stock repurchase) to solidify its position over a hostile acquirer so long as it acts in good faith upon reasonable investigation. o Directors with pecuniary interest have the burden; they must prove their business judgment. o Directors w/o pecuniary interest must have the same burden overcame by Ps. There is not the same risk of self-dealing here as there is with employed directors. They are protected by BJR. o Once board shows it has identified a threat to the corp, it may take any defensive action. o Board must show it identified a threat to the corporation. Board must:

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 Conduct reasonable investigation into the nature of the threat; and Act in good faith. (Essentially a duty of care analysis.) o After doing this, board can take any defensive action and is protected by BJR. o No review of how drastic the boards response is to the potential threat. Does not get to underlying question of entrenchment b/c not sufficiently graduated. This test worked for a long time b/c tactics used in acquisitions were fairly unsophisticated. The invention of the tender offer, which allowed the acquirer to get the deal in front of the SHs w/o management approval, changed the focus of the law. o Control Premiums and Greenmail. o Maremonts block had a control premium. The price paid by the board was not too high, because Maremonts block had a deserved control premium, which would exist with that share block if sold to any purchaser. o Greenmail. When potential acquirer sells back share block to corp at high premium. Bad for SHs. Suppose XYZ has value of $100. It has 100 shares, so price is $1/share. R has 20 shares and asks for $2/share (b/c of control premium). The board agrees to this greenmail. Now, the value of XYZ is $60, and there are only 80 shares. The price per share is $0.75. Thus, the remaining SHs subsidized the defense of the target managements jobs.

Unocal Corp. v. Mesa Petroleum Co.; DE 1985; pg 770. o Mesa (Pickens) began a two-tiered front loaded cash tender offer to take over Unocal (vertically integrated oil company), whereby it offered a front end tender offer for $54/share and a back end of higher-risk debt securities purportedly also worth $54 each. The independent Unocal board got advice from an IB, which concluded the offer was inadequate, and which proposed a self-tender as a defensive strategy. The Unocal board rejected the Mesa tender offer as inadequate and approved a self-tender offer in which it would buy shares at $72 each and also would buy remaining 49% if Mesa prevailed in acquiring 51%. Importantly, Mesa was singularly excluded from this offer. o Mesa challenged its exclusion from the self-tender as a violation of the boards fiduciary duty to Mesa. The court held that the boards decision was protected by the BJR. o UNOCAL: BOARD HAS POWER TO PUT UP DEFENSIVE MEASURES so long as: o (1) IDENTIFY THREAT: There was a threat such that the board had a clear duty to protect the corporate enterprise; o (2) DUTY OF CARE: The board performed a reasonable investigation in good faith in order to identify this threat; AND Was the process in identifying the threat complete? Was a majority of the board independent? Was an investment banker brought in? 77

(2) PROPORTIONALITY: Plan is reasonable in relation to the threat posed. There does not appear to be in any substance to this prong, yet. The court does not reveal what, if anything, the board could do that would breach its fiduciary duty at this point. This test gives the board tremendous discretion in defending itself against the threat. o Here, the board determined the two-tiered offer was inadequate and coercive. It was designed to pressure SHs into tendering in the first tier even if the price was inadequate so they could avoid the second tier. If Mesa were allowed to participate in the self-tender, it would thwart its purpose and subsidize Mesas acquisition. o The structure of a TWO-TIERED TENDER OFFER and why it is COERCIVE. o Front end: Pickens wants to acquire the 37% he needs to get control. For this, he offers cash. o Back end: Pickens then offers to buy remaining 49% w/ securities w/ face value = $54. These securities are highly subordinated debt (junk bonds), and their face value > their FMV. o Creates a strong incentive for the SHs to tender immediately to get the cash. This is coercive. o Stock Repurchase and Scorched Earth Defensive Techniques. o STOCK REPURCHASE on band end only. Unocal offered securities with a face value of $72 on the back end of transaction only. This motivates people to wait so they could take the $72, and when everyone does this, the front end of the offer will not go through (and the board will not even have to pay out anything). o SCORCHED EARTH Technique. Even after SHs successfully demand that the board remove the condition that they will only buy stock if Pickens is successful on his front end, the selftender with the Pickens exclusion still makes the deal undesirable to Pickens. This is b/c the amount of money paid out by the corporation to SHs will deplete the value of the company such that he will spend more to get control of it than its value at the end of the day. This is known as the scorched-Earth defense. o Shares Initial Picken s (10%) Picken s (step 1000 100 400 Price Paid --$35 $55 Total Value $55K $3.5K $22K

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2) Compa 500 $70 ny o The value of control = (55K 35K) (22K + 3.5K) = -5.5K old value minus debt Pickens costs

$35K

o Regulatory Aftermath. Unocal could no longer discriminate against Mesa. o After this case, SEC prohibited this type of discriminatory self-tender performed by Unocal and required self-tenders to by made to all SHs. Rule 13e-4(f)(8). Omnicare Inc. v. NCS Healthcare; DE 2003; pg 819. o NCS was having financial difficulties and was seeking restructuring alternatives, and it was the object of competing acquisition bids by Genesis and Omnicare. Holders of Notes (NCS debt) formed a committee, the AHC, to represent their interests. NCS had two SHs who had control combined, but if they sold their class B shares with super-voting power those shares would lose their extra votes and no longer create a controlling interest. Omnicare came in and offered to buy NCSs assets at a bankruptcy sale, but then it began secret discussions with the AHC. AHC then contacted Genesis about a possible deal for NCS. NCSs operational position improved somewhat, and Genesis made an offer to fully pay back NCS debt and give value to SHs, as well. That offer required NCS to enter into an exclusivity agreement. Omnicare then made a slightly better offer, but an independent committee (IC) of the NCS board determined that NCS should not break the exclusivity agreement to go for that deal, b/c it was subject to too much risk (it was expressly conditioned on due diligence, and previous Omnicare offer was so low). Genesis then improved its offer, the IC and NCS board approved the deal, and a merger agreement was executed. As part of that NCS/Genesis deal, protective devices: (1) SH voting agreement (required 2 majority NCS SHs to vote their shares in favor of Genesis deal); (2) merger agreement would go to SH vote despite change of board recommendation ( 251(c) provision); (3) there was no fiduciary out clause for NCS board; (4) termination fee; (5) no-shop provision. Hours after that deal b/w Genesis and NCS was executed, Omnicare offered a better, but still conditional, deal and began a tender offer. Genesis granted NCS a waiver to talk to Omnicare. Then, Omnicare made its deal a full commitment (removed conditions), and the NCS board withdrew its recommendation of the Genesis deal. o Omnicare sued in an attempt to enjoin the NCS/Genesis merger b/c the effective of the defensive devices breached the boards fiduciary duty. The lower court held in favor of the NCS board on the basis of the BJR. The court here reverses in favor of enjoining the merger b/c the protective devices breached the boards fiduciary duty under Unocal (the SVA and vote-despite-recommendation clauses were preclusive, coercive, and not reasonable in relation to the threat). o Defensive devices adopted by a board to protect a merger transaction must meet the enhanced scrutiny test of Unocal. The board must demonstrate: o (1) Reasonable grounds for believing that a danger to corporate policy and effectiveness existed; AND This step required the board to show that they acted in good faith after conducting a reasonable investigation. Here, the threat was the risk of the Genesis deal going away if NCS moved 79

towards the conditional Omnicare deal. o (2) The defensive response was reasonable in relation to the threat posed. (A) Merger deal protective devices were neither coercive nor preclusive; COERCIVE if it is aimed at forcing upon SHs a managementsponsored alternative to the hostile offer. PRECLUSIVE if it deprives SHs of a right to receive all tender offers or precludes a bidder from seeking control by fundamentally restricting proxy contests or otherwise. Here, b/c the SVA and 251(c) provision interacted to make any other competing transaction impossible, they were both preclusive and coercive. (B) The response was within a range of reasonable responses to the threat perceived. By not negotiating for a fiduciary duty out clause, the board contracted away its fiduciary duty. Because the defensive measures circumscribed the boards fiduciary duties and served as an absolute lock-up on the deal, they were not reasonable in relation to the threat. o Under Unocal, the defensive measures here were reasonable in relation to the threat, and they were neither preclusive nor coercive. o Hindsight should not be part of the analysis. Hindsight allows the court to realize that a better deal was going to be offered by Omnicare, but the board did not know that at the time. It believed that the Omnicare deal was excessively conditional and risky. o Situations exist where lock-ups are necessary. NCS had been swaying on the edge of bankruptcy, and Genesis required a lock-up in order to put forward an offer that not only would repay all NCS debt but also would get some value for SHs. Genesis was the only game in town, so the defensive actions were reasonable to the threat of Genesis walking. o Bright-line rule requiring target boards to negotiate fiduciary out clauses will discourage potential bidders who would only bid if they had certainty that their deal would go through o Moreover, there was no coercion b/c the SVA decided the SH vote by pulling together the two control SHs; it did not force minority SHs to vote otherwise. o Decision-makers at NCS are Control SHs, who have incentive to get best deal. o By the interaction of the 251(c) provision, the no-shop, and the SVA, there is no way that this deal is not going to go through. o However, minority SHs are riding along with the control SHs, who are also trying to get the highest possible value for their shares. o UNOCAL VS. REVLON DUTIES: Entrenchment and Sale. See Sch. B. o Is this a Revlon case? There was not a change of control, b/c NCS was already controlled by control SH before transaction began. NCS was up for sale but came out of sale before deal. NCS was essentially put up for sale when it was looking for bankruptcy restructuring alternatives. 80

 However, NCS was no longer for sale when the Genesis bid came in. Thus, there are no Revlon duties. o Unocal definitely applies b/c defensive devices create specter of entrenchment. Note that this transaction is not an entrenchment transaction: the board had complete control before, and it is volunteering to lose control in the Genesis deal. (B) POISON PILLS o Purposes o Stop two-tiered offers (especially the flip-over component), but this was so effective that two-tiered offers essentially no longer exist. o Stop a creeping acquisition, in which a bidder purchases a small stake in the company (5-10%) and then through a series of negotiated or open-market purchases accumulates something approaching control. o Means by which boards can conduct an auction. Boards want to have control over the process (fair rules); the pill gives the board a way of enforcing whatever rules are set. Pills are therefore the gavel that lets the board run the auction. o Used as a board entrenchment technique to prevent sale at any price. From a target SH perspective, this is not an ideal outcome. The difficultly from the courts perspective is how to sort out how the pill is being used. o Mechanics o Does not require a SH vote and can be implemented very quickly (can be drafted and approved by board in a number of hours). o STEP ONE: The plan creates securities known as rights (or options or warrants), in which the holder has the option to purchase new shares of stock of the issuing corporation. Done by passing a resolution to authorize blank check stock, which is a special new kind of preferred share. The rights initially: Have no value, Trade as part of the common shares, and Can be redeemed by the board at any time for any reason for $0.01. This is like a warning shot. o STEP TWO: First trigger is the announcement of a bid to buy over a certain percentage of stock or the actual acquisition of that stock. Also known as a distribution event (when raider announces intent to acquire a certain amount of stock, say 20%). The right becomes freely tradable (it detaches from common stock). People can buy up these rights for cheap. Rights are discriminatory against acquirer: they have no value in his hands. o STEP THREE: Second trigger gives the rights real value.

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FLIP-OVER element (older) Triggered if the target is merged into the acquirer. Entitles the holder of each right to purchase common stock of the acquiring company at half-price. Didnt effectively deter acquisitions, though, b/c the acquirer could wait until the rights expired and then merge. FLIP-IN element: (newer) Triggered when the raider actually acquires that percentage ownership of the stock. Entitles the holder of each right to buy two shares of the target issuers common stock at half-price. Dilutes the value of the targets stock such as to make it less desirable to the acquirer. Board also has the discretion to lower the percentage ownership necessary to trigger this part of the pill (e.g., down to say, 10%). This is to prevent acquirer from having leverage in a proxy fight (o/w the acquirer might buy up 19.9% ownership and then use those votes and others to try to oust the board and remove the pill). Redemption provision Allow the board to stop the effects of the pill (by redeeming the rights being traded for a nominal price) up until the second trigger is pulled. Give the board leverage in negotiating w/ the acquirer and allow it to get the best possible deal for SHs. o Pills usually only implemented when management has small ownership stake. o Where management has large stakes in the target firm, their incentive is to sell their shares at a large premium offered by the acquirer. o DEAD HAND POISON PILL. o Only the incumbent directors have the power to redeem the pill. o Prevent acquirer from buying company even if it won proxy contest. o Are these valid? Georgia and some others have held these valid. Delaware and others have held these invalid. They constitute an unlawful abdication of the boards power to manage the business and affairs of the company. They are both coercive and preclusive under Unocal. Toll Brothers. o Coercive b/c it forced SHs to reelect incumbent directors b/c they were the only ones who could redeem the pill. o Preclusive b/c it makes takeover effectively impossible b/c the pill could not be redeemed (an acquirer would have to buy its way through the pill); it would therefore prevent the SHs from receiving a control premium for their share of the company. o NO HAND POISON PILL. o Prevents new directors from redeeming the pill for six months. Eventually expires, but has same effect as dead-hand pill over that period.

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o Struck down in DE. Quickturn Design Sys (1998). DE Supreme Court: The pill prevented the board from discharging its fundamental duties of managing the company (an abdication case). Under this theory, it would be possible to contract around the law by inserting something in the articles of incorporation limiting the management responsibilities of the board (this is allowed under 141 of DE law). Lower appellate court. The pill was somewhat preclusive and was not reasonable under a Unocal analysis. This theory would prevent the company from being able to contract around the law wrt the no hand pill. (C) Revlon and its Progeny Revlon v. MacAndrews & Forbes; DE 1985; pg 781. o Pantry Pride (PP) sought to acquire Revlon. Revlon board declined initial overtures at price of $45/share b/c IB told them the price was too low. They instituted defensive measures: (1) they tendered an offer for 10m shares of own stock in exchange for highinterest notes that contained covenants restricting asset sale or the incurring of debt, the covenants could be waived by the board; and (2) adopted a primitive poison pill with triggering event of 20% ownership (each SH except for acquirer got a right to acquire a $65 note in exchange for one share of common stock). The management goes back and forth with PP for a while, and then the board goes out to find a white knight. Forstmann (F) enters into the bidding process, and Revlon board agreed to an LBO by F and Revlon management, and F required that note covenants be waived and pill redeemed. The value of the notes fell, and there was the prospect of suit against the board from the note holders. PP then announced it would top any F offer, even though F had access to inside financial information. F offered $57.25/share, and Revlon board stopped the bidding by entering into a deal w/ a crown-jewel lock-up option allowing F to purchase the best divisions of Revlon for less than theyre worth; a no-shop provision; and a $25m cancellation fee if Revlon walked. PP had offered $56/share, and it later offered $58/share. o PP filed suit asking for the deal provisions to be enjoined. They were successful at trial court, and the court here affirmed b/c Revlon board stopped the bidding in a way that did not benefit the SHs. o REVLON: When the ACQUISITION OF A TARGET COMPANY BECOMES INEVITABLE and the bidding prices are all fair, the BOARD HAS A RESPONSIBILITY TO GET THE BEST POSSIBLE DEAL FOR THE SHS. o Initial takeover defenses fulfilled boards fiduciary duties. PPs initial bids were too low. The poison pill and the companys own exchange offer were both reasonable in order to drive up the bidding price for the SHs. o When the price went up, the role of the board shifted. The board was initially a defender of SH interests. The increased price and fact that the company was for sale turned them into auctioneers whose role was solely to get the best price.

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o o

o Rationale of ending auction to protect note-holders is improper. A target cannot stop the auction for the reason of prioritizing constituents other than SHs. The board needed the security that F would provide them by ensuring the note holders would not sue the board. The board has a duty to enhance the value of SHs, not the note holders whose rights were fixed by contract. When ending bidding early helps the board but does harm to SH value, the board breaches its duty of loyalty. o Lock-up agreement can be valuable, but not when bidders already present. Lock-ups can draw new bidders into the mix. However, F had already been bidding here, so there was no value to ending the auction. Once the board determined to redeem the pill, the company is up for sale. o The Revlon board decided to redeem the pill at a certain value. o Once the pill is redeemed, the board acknowledges that the company is up for sale. o At this point, Revlon duties (sell the company for the highest possible price) kick in. There were two sets of defenses in Revlon: o Initial defenses. The Notes Rights Plan and stock buyback. These must be analyzed under Unocal. (1) Did the board acted reasonably in determining that there was a threat (was there thorough process; was the price to SHs inadequate)? (2) Were the boards defenses reasonable in relation to the threat? o Secondary defenses. The lock-up, no shop provision, and cancellation fee. Once board has decided to sell, it must use defenses to get the best price reasonably available. NO SHOP PROVISIONS are impermissible in active auctions, b/c they intervene in the bidding process w/o adding value to SHs. CANCELLATION FEES are impermissible in active auction b/c those fees are to encourage parties to bid in the first place (b/c financing is expensive), but in active auctions there are already bidders. LOCK-UP PROVISIONS might make sense in certain circumstances (e.g. when the target gets great value out of the bid), but here Forstmanns bid was only slightly higher. Once there are two competing bidders, the board cannot play favorites unless there is a good reason involving SH value. How can we know when a company is up for sale? o When the Revlon board told management to negotiate an MBO, it was inevitable that the firm would no longer continue in the form it was before. (This is like the board putting up a for sale sign.) o When a board proposes a fundamental split of the company that is not voted on by SHs, this is objectively a break-up of the companys assets, so Revlon applies and any

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other bidder would have a right to bid on a level playing field. o o Paramount Comm., Inc. v. Time Inc.; DE 1989; pg 792. Time wants to merge with Warner. Then, Paramount makes a tender offer for Time. Finally, Time recasts its merger with Warner as a tender offer. Time considers mergers with Warner and Paramount and decides that Warner is preferable b/c it would allow it to retain its journalistic integrity. Also, Warners CEO had a reputation of retaining management after a merger, while Paramounts CEO had a reputation of terminating management after a merger. Time suggests a tender offer but Warner prefers a stock-for-stock offer so they can retain some control of the board. The deal breaks down, but word of an impending Paramount offer causes Time to agree to the merger. The deal allows each Warner SH to trade its $40 share for a $51 Time share. The merger has three main defenses: (1) A share exchange agreement that allowed either party to acquire around 10% of the others stock. This makes a competing bid more expensive and it gives value to either Time or Warner who would be able to tender it into an acquiring bid. (2) Dry up letters from banks (but these dont work b/c Paramount goes to Japan). (3) A no shop provision. Paramount comes in and makes a tender offer for Time at $200/share. Time SHs clearly want to tender into the offer; however, Times board calls the bid smoke and mirrors because of the three conditions attached: (1) termination of the Time-Warner merger agreement; (2) waiver or satisfaction that change of control conditions of local cable stations will be satisfied; and (3) certification by management to waive the protection of Delaware Code 203. However, all of these factors are controlled by Time. Time cannot argue that this is not good value, so it changes its offer for Warner to a tender offer (which does not require SH approval) in which Warner SHs can exchange their $40 shares for cash and stock worth $70 (the economics here are clearly terrible from Time SH perspective but great from Warner SH perspective). The Time board wants to preserve its LT plan. Times board is a majority of outside, disinterested directors. It is also a staggered (classified) board. Paramount brings injunction to prevent Times tender offer for Warner. When the POSSIBILITY OF A CHANGE OF CONTROL TRANSACTION exists both before and after a transaction, there is no sale of control and REVLON DUTIES DO NOT APPLY. o CONTROL WAS IN THE MARKET both before and after the deal. Here, the possibility of a change of control transaction existed both before and after Time merged with Warner. Both companies were majority owned by diffuse public SHs. Thus, control was in the market the whole time. Paramount could feasibly buy control of the combined entity. Change of facts: If Paramount wanted to acquire Warner before the deal, but afterwards Warner SHs are cashed out and Warner is controlled by Time, then Revlon would apply b/c there would be no SHs of the target company existed after the cash-out transaction.

o o

o Unocal Analysis Applied to the Time Defenses:

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o (1) Was there a threat to the corporation? The court will defer to the boards definition of what the threat is. Board determined the following threats: (1) Conditions attached to the Paramount offer (the requirement involving local cable stations). (2) Timing of Paramounts sudden cash offer right before the merger. o The LT objective was to merge Time and Warner, and the SHs will be confused in voting for the wrong transaction. o Counter: This argument seems overly paternalistic. (3) SHs will choose to do something the board doesnt agree with. o Board is in charge of managing the affairs of the company. o (2) Did board have a reasonable basis in determining those threats were real? Reasonable investigation includes history. Time had considered several mergers over years and determined that Warner was preferable to Paramount. o (3) Was the defensive action reasonable?? It is reasonable for boards to determine the future of the company, especially where they have a LT strategy for accomplishing that. The response was also reasonable b/c it did not block a future transaction. The deal did not block control premium in future transaction. Not w/in reasonableness range if preclusive. First time the court has stated there is some outer limit to defensive tactics under the Unocal test. o Major defenses in place already at Time: o (1) Classified board. Directors are elected in blocks each year, seriatim (like the US Senate). Prevents quick redemption of a poison pill b/c it takes at least two years to gain control of the board. This is a very effective means of preventing takeover. o (2) Revoking of SH actions by written consent. Actions by written consent by SHs allow SHs to take action at any time they want for any reason. Bulletproofs the classified board. Eliminates the ability of SHs to take out the classified board. o Should boards be the ones who decide whether a takeover bid goes through? o Pro board: Boards manage corporations for stakeholders (e.g. employees, managers, creditors, suppliers, buyers). This is a persuasive argument until the board puts the firm up for sale. SHs are myopic, and the boards duty is to maximize LT value. SHs are looking for a quick gain that might not even be in their best interest. o For board to be able to decide, SHs must not be precluded from ousting the board.

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Paramount Comm. Inc. v. QVC Network Inc.; DE 1994; pg 802. o Paramount (disinterested board; controlled by public SHs) discussed a combination w/ Viacom (owned and controlled almost entirely by Redstone). The stock price of Viacom started going up b/c Redstone was buying up the few public shares. After some dispute over price, a deal is reached, and the Paramount board approved the merger. This original merger agreement had three defensive tactics: (1) no shop provision (preventing Paramount board from discussing deals w/ other firms unless they had solid financing and to do o/w would violate boards fiduciary duties); (2) termination fee of $100 million; and (3) stock option agreement (allowed Viacom to purchase 20% of Paramounts outstanding common stock at $70/share with junk bonds and elect to take the difference b/w market value and that price if deal fell through) (this option agreement is a huge deterrent to other acquirers). Then, QVC proposed a merger w/ Paramount and had financing in place. Paramount board authorized management to meet w/ QVC. QVC made a two-tiered tender offer conditioned on removal of stock option agreement. Viacom raised its bid, and Paramount negotiated a fiduciary out but did not take advantage of its leverage at this point to raise the price much or remove the defenses in place. Thus, the companies were not negotiating on level playing fields. Viacoms final offer was $85/share; QVCs offer was $90/share. Paramount board recommended the Viacom offer. o QVC filed injunction to prevent the Paramount defenses. The court here held that the Paramount boards actions were not reasonable and violated their duties. o When target BOARD AUTHORIZES A SALE OF SHS CONTROL INTEREST, the board has a DUTY TO GET THE BEST VALUE for the SHs. o ENHANCED SCRUTINY (Revlon applied): Was the boards decision-making process adequate? Considerations include: o Price, o Conditions attached to the bid, o Experts brought in for advice. This step will almost always be satisfied. Were the boards actions reasonable in light of the circumstances? What did the board do to get the best possible deal for SH? o No shop provisions are impermissible. Here, the board did not try to renegotiate the uncapped stock option agreement such that QVC could make the best possible bid. This was a huge deterrent for SHs getting the best price. o Once company is for sale, board must apply reasonable process and act reasonably. o In Revlon cases, there is usually more than one bidder. o This test is designed to determine how far the board can go in favoring bidder A over bidder B. o This looks similar to Unocal analysis. o Change of control test revisited. o The Paramount-Viacom transaction would cause a change of control, b/c there was no control SH in Paramount but Redstone would control a Paramount-Viacom entity. SHs of Paramount would never have the chance to get a control premium for 87

the stock b/c they would be subordinated to Redstones concentrated ownership. o Compare Time-Warner, where control was in the market before and was in the market after. (D) SH Disenfranchisement and Blasius Duties Hilton Hotels Corp. v. ITT Corp.; NV 1997; pg 837. Hilton announced a tender offer of $55/share and plans to initiate proxy contest to acquire ITT. ITT rejected the tender offer, postponed its annual meeting to push back a proxy contest, and announced a new plan to divide up its assets. The plan created a classified board (which would prevent the SHs from being able to vote out more than one third of the board in any given year), required 80% SH vote to remove directors w/o cause, required 80% to remove the classified board (bulletproofed board) (and to remove the 80% restriction), and contained a poison tax pill. ITT sought to implement the plan w/o SH approval b/c this is merely asset restructuring which also created corporation with new rules. Hilton raised its tender offer and brought suit. Hilton sued to enjoin ITT from implementing its plan b/c it violated the boards fiduciary duty under Unocal. The court agrees here that the defenses in the plan were unreasonable and enjoined the plan. BLASIUS TEST: When target boards DEFENSIVE MEASURES touch on issues of control such that their PRIMARY PURPOSE IS TO DISENFRANCHISE THE SHs, those measures will not be allowed unless compelling justification exists. o Justification. The law gives boards tremendous discretion in how to run the company, but it reserves the right of SHs to remove the board as their way of checking managements power. o Primary purpose is disenfranchisement here. While classified boards are usually permissible, the timing of the change (the fact that it was instituted two months before the already-delayed annual meeting) indicates a purpose of disenfranchisement. Contradiction of earlier representation to judge. Additionally, ITT represented to the judge that an extension was needed b/c it wanted to inform the SHs how to vote, then it created a classified board that took away that right to vote. o Strength of boards showing: Unocal < Blasius < Revlon. Because ITT did not attempt to present a compelling justification at all, it is unclear how strong Blasius is here. From other cases, we can tell that Blasius requires a presentation then of more than Unocal and not quite as much as Revlon. The court additionally went through Unocal analysis. o (1) Did the board have reasonable grounds to believe a threat existed? Here, there was no such threat, b/c the Hilton would not have pursued a different corporate policy, ITT board did not conduct a good faith, reasonable investigation w/ Hilton, and the price alone did not appear inadequate. This NV judge is not as deferential as a DE judge would likely be. o (2) Was the response proportional to threat? Here, the classified board was preclusive b/c it prevented the current ITT SHs from determining the membership of the board.

o o

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Because the threat was very mild, even slight preclusion from classified board is not proportional to threat.

o Why rule on Unocal rather than Revlon? o There was clearly a Revlon claim here, b/c ITT broke up its assets, thereby triggering Revlon duties. o NV has an other constituencies statute, which allows the board to consider other, non-SH constituencies. Because Revlon requires maximizing SH value when selling an asset such statutes make a Revlon inquiry essentially indeterminate. o Such statutes are not a problem in Unocal analysis, though, b/c Unocal already expressly allows for other constituencies to be considered in the analysis. o Nevada is a copycat state. o Because of the internal affairs doctrine, the NV court must apply NV law (b/c both corporations are incorporated in NV). o However, NV adopts DE law in order to encourage corporate development there. Thus, NV court must analyze DE law. (E) State and Federal Legislation CTS Corp. v. Dynamics Corp.; S. Ct. 1987; pg 849. Dynamics owned 9.6% of common stock of CTS, an IN corporation. Six months after a new IN law went into effect, Dynamics announced a tender offer for another million shares of CTS (which would bring ownership to 27.5%). CTS board elected to be governed early by the IN law. IN law applies to any corporation (that does not opt out) located in IN over a certain minimum size, and it conditions acquisition of control of such a corporation on the approval of a majority of the pre-existing disinterested SHs. (Purchases that would bring ownership over three thresholds, 20%, 33%, and 50%, does not acquire the voting rights along with those shares unless there is a majority vote of disinterested SHs. The acquirer, and the officers and directors of the target company are interested and not allowed to vote.) Dynamics sued after its tender offer, arguing that the IN law was preempted by federal law (the Williams Act, which regulates tender offers by requiring degrees of disclosure and by providing procedural rules) and by the Dormant Commerce Clause. The district and circuit courts found preemption. The Court here found neither preemption nor DCC violations. Because the purpose of the IN statute is to place investors on an equal footing with takeover bidders and it neither gives management or the offeror an advantage and does not impose any indefinite delay on tender offers, it is not PREEMPTED by the Williams Act. o The IN statute allows SHs to vote as a group, so it prevents them from being coerced into a takeover by a front-loaded two-tiered tender offer. o An interpretation of the Williams Act that preempted the IN statute would also preempt longstanding corporate takeover defenses allowed by law such as staggered board and cumulative voting. The IN statute does not violate the Dormant Commerce Clause. o The IN statute does not discriminatory against interstate commerce and does not subject activities to inconsistent regulations.

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o Constitutionalization of internal affairs doctrine. The IN statute is constitutional b/c it only applies to IN corporations. o Corporations are entities created by state law, and it is therefore acceptable for states to prescribe their powers, define the rights that are acquired by purchasing their shares, and protect SHs of those companies. o Opt-out vs. Opt-in Statutes. (IN statute is an opt-out statute.) o Opt-out. Board (which prefers to have statute apply to protect its jobs) will simply choose to have the statute apply instead of putting a charter amendment to a vote. Prevents the SHs from getting to vote on whether they like the statute. Makes the statute apply to a large number of corporations. o Opt-in. A charter amendment is necessary in order to opt into the statute. This requires a SH vote. Thus, the board will put the charter amendment to a vote, and the SHs will get to make the decision. o Almost every state has some kind of anti-takeover statute. o Political reality. Most of the parties concerned are concentrated voting blocks that are aligned against hostile takeovers (e.g. labor, communities, etc.). o PA anti-takeover statute. Much more draconian and allows more entrenchment than others. Has the following provisions: Control shares acquisition. Buyer of shares over a certain limit loses voting rights unless it obtains approval from majority of disinterested shares. Other constituencies provision. Even in a sales situation, the board can point to other constituencies, making Revlon analysis indeterminate. Profit disgorgement. Allows any SH to sue to recover greenmail. Tin parachutes. o Gives small severance packages to longtime employees. o Very expensive for prospective acquirer of large companies. Labor Ks remain in place. After it was enacted, the share prices of PA corporations dropped (b/c there was no chance of anyone ever getting a control premium). o DE anti-takeover statute. (Moratorium statute.) Once the bidder has acquired over 15% of the shares, it cannot enter into a business combination w/in 3 years. Exceptions: (1) Bidder acquires 85% of the stock on the front end; (2) Management approves (a friendly deal); and (3) Target board approves a merger after the bidder acquires the 15% threshold and 2/3 of the shares (not held by the bidder) approve the merger.

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o The IN statute is likely better for the bidder, but this is not entirely clear. The statute: o Takes both management and the bidder out of the picture for the purpose of voting on whether the deal should go through. o Is troublesome for the bidder b/c it creates uncertainty. If the bidder loses the SH vote, then the corporation has the call option to buy the all those shares back at FMV. o Is helpful for the bidder b/c it effectively creates a referendum to the SHs on the defense of the company. If the SHs overwhelmingly vote in favor of the bidder, then management will not be able to argue that any takeover defenses were for the benefit of the SHs.

8. PROBLEMS OF CONTROL
(1) Proxy Fights
o (A) Strategic Use of Proxies Levin v. Metro-Goldyn-Mayer, Inc.; SDNY 1967; pg 535. A proxy fight occurred b/w longtime management and potential new managers over fundamental questions regarding the policy of MGM. The old management used corporate funds and facilities to prepare its proxy solicitation materials: they used company employees, the top four proxy soliciting firms, and outside counsel. P SH of MGM (and the potential new manager) sued MGM for its management using corporate funds to further itself in the proxy fight. The court held here that the MGM management used a reasonable amount of corporate funds in proxy solicitation. When corporate management is engaged in a proxy fight with new management over policies fundamental to the company, MANAGEMENT MAY USE A REASONABLE AMOUNT OF CORPORATE RESOURCES IN PROXY SOLICITATION. o The law allows for this sort of expense when the purpose of the expense is to inform voters. This is a legitimate corporate purpose. o The burden is placed on P to determine whether the amounts spent were reasonable. The court applies something akin to the BJR as to managements decisions of what to spend. It does not want to intervene there. o Here, the amounts paid by MGM management to prepare its proxy solicitation were reasonable, so it could pay for them out of corporate funds. MECHANICS OF A PROXY FIGHT. o Usually, SHs vote for only option via a proxy card. SHs vote for directors by executing a card delegating their votes to someone who will attend the annual meeting. Typically, managements slate is the only one offered. o When a dissident wants to gain control of the board, it solicits its own votes by sending out a competing card to the managements card. o Dissident assembles a team of experts. Proxy solicitors. Conduct strategy of contacting all SHs.

o o

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 Get out the vote campaign. (Incumbent management may hire all top firms to preempt dissidents.) Public relations people. Create a narrative of where the company is going and why the proffered slate of directors can take them there. Lawyers. Sculpt the transactional side (by drafting proxy statements, and conducting due diligence and regulatory compliance). Handle litigation arising out of the proxy fight (litigation usually arises out of misuse of corporate funds and accuracy of the proxy disclosures). Forensic accountants. Seek to prove fraud or mismanagement of the company. Company employees. Help lawyers prepare documents; Help proxy solicitors in finding whom to contact. o Dissident prepares a proxy statement. o Dissident determines who are the beneficial owners of shares There is little public info about who has beneficial ownership. The corporation has a stocklist of who has legal title. About 5% of shares are held in record name (they have actual certificates of stock with their name on it). Other 95% is held in the name of CEDE (for NYSE corps). An electronic clearinghouse that keeps tabs of who is buying/selling/holding the companys stock in real-time Acts on behalf of two principal organizations: banks and brokers. (E.g., CEDE might have the information that SunTrust owns 5m shares.) Banks and brokers in turn hold some shares for themselves and some for other investors (e.g. smaller banks, trusts, and individuals). Whoever is at the end of the line is the person who votes, who must be persuaded to cast a ballot on one sides behalf. See Sch. C for diagram of stock ownership structure. (B) Reimbursement of Costs o The use of corporate funds for directors to retain their positions is not waste when it is a corporate rather than a personal expense. Because directors must be able to get across their message of the which direction the corporation should follow, the expenses relate to the corporations future and are proper business expenses. Rosenfield v. Fairchild Engine & Airplane Corp; NY 1955; pg 537. o An old board spent $106K in corporate funds for proxy solicitations. They were ousted by the SHs by the vote (SHs were upset that a large K had been given to director Ward), and the new board requested payment of its $127K in expenses in proxy solicitation by the corporation. The SHs ratified that request.

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o SH filed derivative suit claiming that the corporation should be reimbursed for the proxy fight costs by both sides. The court here held that the use of corporate funds to fund the proxy fight was permissible. o INCUMBENT BOARD: In a contest over policy (as opposed to a purely personal power contest), corporate directors may make reasonable expenditures from corporate funds for the purpose of soliciting SH support for those positions that they believe in good faith are in the best interests of the corporation. o When there is no proxy contest, if directors could not incur reasonable and proper expenses in soliciting proxies for giant corporations, the corporate business might be interfered with b/c of SH indifference and the difficulty of procuring a quorum. o When there is a proxy contest, if the directors were not financed by the corporation for defending their actions in proxy fights, such corporations would be at the mercy of wealthy entities seeking to wrest control away from them. o Almost anything goes in terms of reasonableness, so long as it is somehow connected to the proxy solicitation. Unless the expenditure constitutes waste and P affirmatively proves that to be the case, courts will not overturn the business judgment of incumbent management. o INCOMING BOARD: An incoming board may be reimbursed by the corporation for their proxy fight expenditures: o (1) By an affirmative vote of the SHs; or o (2) If the incumbent board agrees as part of a settlement to pay their expenses. o Only the expenses of the incumbent board reasonably related to informing the SHs fully and fairly concerning corporate affairs should be allowed. Van Voorhis. o The distinction b/w expenses for maintaining control and contest over policy questions is unworkable. Van Voorhis. o It is impossible to sever policy from persons, and it is rarely clear which is the predominant factor. Here, for example, the facts indicate that the SHs simply wanted to get rid of the board for paying themselves too much. This seems like it was less about policy and more about the people. o The majoritys test, which only allows for the incumbent board to spend corporate funds on a proxy fight when the fight is over policy (but not entrenchment/control), is unworkable. o Rules under-incentivize insurgents from searching for poorly-managed firms. o Insurgents only get reimbursed when they win, and it is expensive both to search for poorly managed firms and to wager a proxy fight. o However, there do not seem to be any preferable alternatives. Giving a dissident a multiple of expenditures both is unfair to the SHs of the corporation and may over-incentivize dissidents from challenging management. Only compensating incumbent boards when they win will not sufficiently encourage them to wage proxy fights b/c their own money will be on the line if they lose. o This issue is very important these days b/c hedge funds frequently wage proxy fights.

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(C) Private Actions for Proxy Rule Violations o SEC Rules: Regulation of Proxy Fights o Section 14(a) of the 1934 Securities Exchange Act prohibits people from soliciting proxies in violation of the SEC rules, which require filing statements with the SEC. o Solicitation is a broad concept; Anything that may lead to requesting a proxy card may be deemed a solicitation. Gittlin (requiring SH to file statement w/ SEC when it was asking other SHs to join in petition to get SH list from corp so it could wage proxy fight). Only applies when a SH is soliciting proxies for itself (e.g., they do not apply when a pension fund campaigns for a proposal that does not ask for proxies). o SECTION 14(a)(9) PROHIBITS FALSE AND MISLEADING STATEMENTS made in the context of proxy statements. (This is comparable to Rule 10b-5.) o Require corporation to provide proxies for every SH meeting. o Require disclosures from all who solicit proxies in the form of proxy statements. For management, this includes annual report. For insurgents, this includes CoIs and major issues to be discussed. o Management may mail out the insurgents proxy materials to its SHs directly and charge the costs to the insurgent, instead of disclosing its SH list. JI Case Co. v. Borak; S. Ct. 1964; pg 544. o P owned 2000 shares of common stock of Case. Case sought merge w/ ATC. The merger was approved by a small margin of the vote. o P brought suit to enjoin the merger (i.e. make it void) by arguing that Case delivered false and misleading proxy solicitation materials such as to violate 14(a) of the SEA. The Court here held that 27 does create a private right of action for violations of 14(a) of the SEA. o An implied private right of action is created by the SEA for P SHs alleging that false and misleading proxy solicitation materials were distributed to them. o The purpose of 14(a) is to prevent management or others from obtaining authorization for corporate action by means of deceptive or inadequate disclosure in proxy solicitation. The language the protection of investors implies judicial relief. o The private right of action is for both direct and derivative claims. The injury the SH suffers here is derivative, b/c it flows from damage that is done to the corporation (due to deceit practiced on SHs as a group). o Private enforcement of proxy rules is a necessary supplement to regulatory enforcement. SEC does not have the time to hold all corporations accountable. Mills v. Electric Auto-Lite; S. Ct. 1970; pg 547. o Auto-Lite was 54% owned by Mergenthaler (which was in turn 33% owned by AMC). Mergenthaler sought to merge Auto-Lite into itself, and it needed a 66% vote from A-L SHs in order to do so. It solicited proxies from A-L SHs and did not include the fact that all 11 of A-Ls board members were nominated and controlled by Mergenthaler. The merger was consummated. o P SH of A-L brought direct and derivative action against A-L for material misrepresentation in proxy solicitation in violation of 14(a) of the SEA. P sought the voiding of the merger.

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CA7 held that the omission was material but that it did not cause the merger b/c the deal was o/w fair. The Court here held that the fact that the omission was material was itself sufficient to establish that it caused the merger, so a violation occurred (and it remanded to determine the appropriate remedy). o In a 14(a) SEA claim of MISLEADING INFORMATION IN A PROXY STATEMENT, a finding of MATERIALITY IS SUFFICIENT to make a SHOWING OF A CAUSAL RELATIONSHIP b/w the violation and the injury where the proxy solicitation was an essential link in the accomplishment of the transaction. o Here, causation occurred b/c the solicitation was an essential link in the approval of the merger (this is b/c the public SHs approval were necessary b/c 2/3 approval of the merger was required). o If the misstatement or omission is material, then it is by definition to be of such character that it might have been considered important by a reasonable SH who was trying to decide how to vote. o CA7s test would insulate from redress all proxy violations that were unrelated to the terms of the merger itself. This would substitute judicial judgment for SH vote, and it would undermine the congressional purpose of full and fair disclosure to SHs. o Proper form of relief will vary from case to case. The merger should only set aside if it is equitable at that later time. Monetary damages may sometimes be appropriate (an accounting may be ordered where the SHs were deceived as to the value coming to them). Looking at the fairness of the merger is also appropriate. o Ps should have their attorneys fees reimbursed by the corporation when they establish such a SEA violation. Though the general rule is that each party bears its own fees, exceptions have been made (as here) where a P brings a suit on behalf of a class. Additionally, this will impose fees on the corporate entity, which will then spread those cost out over all the SHs in exchange for the benefit of P bringing a suit to benefit them. o Components of a 14(a)(9) claim: o Reliance is presumed by the law. o Mental state required is only negligence (not scienter, as with 10B-5 claims). o Causation, the most interesting issue, is controlled by Mills. Causation is assumed if the misleading info is material, so long as the proxy solicitation is an essential link. o Argument that causation is established for 14(a)(9) claim even when no essential link. o If a SH approves a transaction, that SH gives up the right to seek appraisal. o Thus, a SH whose vote is unnecessary (b/c majority SH has 90% of the vote and only 60% needed to approve deal) might gives something up as result of misleading proxy. o The proxy could therefore cause that SH to vote in favor of a transaction that the SH would not have o/w, and the SH would lose appraisal rights. o Cf. Virginia Bankshares, in which the public SHs vote was not needed (the control SH had 85% of the vote), but misleading proxies were distributed anyways. The court held that causation could not be established. o However, by losing the state law remedy of appraisal, the misleading proxy does cause harm to SHs who approve a transaction. 95

o Overlap of 10B-5 and 14(a)(9) claims. o It is worthwhile to sit down and compare 10b-5 and 14(a)(9) actions. o Because someone might buy or sell a security as a result of information in a proxy statement, an overlap of the two laws might occur.

(D) Shareholder Proposals SH Proposals Generally o General Rule. Rule 14a-8 REQUIRES SECURITIES ISSUERS TO INCLUDE SH PROPOSALS in proxy materials UNLESS a Rule 14a-8(i) exception: o (1) Improper under state law. The proposal is not a proper subject for action by the SHs under state law. o (2) Violation of law. The proposal, if implemented, would cause the company to violate a state, federal, or foreign law. o (3) Violation of proxy rules. The proposal would violate a proxy rule, including 14a-9, which prohibits false or misleading proxy soliciting materials. o (4) Personal grievance. The proposal relates to a personal claim against the company or is meant to benefit a SH not shared by the SHs as a whole. o (5) Relevance. The proposal relates to operations accounting for less than 5% of total assets, and less than 5% of net earnings and gross sales, and is not o/w significantly related to the companys business. o (6) Absence of authority. Company does not have authority to implement proposal. o (7) Management functions. Proposal relates to ordinary business operations. o (8) Relates to election. Proposal relates to election for membership on board. o (9) Conflicts w/ company proposal that is being submitted for same SH meeting. o (10) Substantially implemented by company already o (11) Duplication of another proposal already included in same proxy. o (12) Resubmission of something that has been included in previous 5 years. o These exceptions exist b/c there are specific situations where it does not make sense to tax SHs over things that do not matter to SHs generally or which are not possible topics of SH discussion. o FOR 14A-8 TO APPLY, SHs must: o (1) Have held securities of company for at least one year; o (2) Own either 1% of the companys stock or $2000 of stock. o (3) Actually attend (or send a representative to attend) the SH meeting. o (4) Timeliness. Proposal must be submitted at least 120 days prior to the time that the company sent out its proxy materials in the prior year. This gives the company 96

o o

time to seek a no-action letter. o (5) Length. No SH can submit more than one proposal per year per company. The maximum length for each proposal is 500 words. Process of SH proposal submission, company exclusion, and no-action letters. o SH submits a proposal. o Corporation seeks a no-action letter from the SEC. o Entry-level attorneys at the SEC do preliminary research on proposal and the corporation and briefly state either that the SEC would not take action if not included, or that they would seek enforcement if the proposal was not included. Nonbinding. SHs are only allowed to submit precatory (nonbinding) proposals to the corporation to be included on the proxy statements. If these proposals were mandatory, they would infringe on the boards right to run the corporation. Popular SH proposals are mostly corporate governance proposals, including: o Eliminate or require a SH vote on a poison pill; o Eliminate or require a SH vote on a classified board; o Require directors to hold a certain percentage of shares; This seeks to align director incentives with SH incentives. o Adopt mandatory cumulative voting; This is sought out by institutional investors b/c it protects the interests of institutional investors by increasing the odds of their voting an investor representative onto the board. o Prohibit greenmail; This protects SHs from having their value drained. o Separate CEO and chairman of the board. This creates two centers of power, such that there are checks and balances and the CEOs power is checked by the chairman of the board. Why have corporation pay the cost of putting the proposals in proxy materials? While this taxes all SHs for the opportunity to hear and vote upon proposals that are put on the ballot by other SHs, it is an attempted solution to the collective-action problem involving SHs. Mostly symbolic value. Only a small fraction of the time when these proposal are passed by SHs at meetings are they actually implemented by the board. However, their approval does put some pressure on the board to adopt them officially. This is especially true when the proposal relates to corporate governance.

Lovenheim v. Iroquois Brands, Ltd.; DDC 1985; pg 559. o P, SH of D company, sent materials to D that he wanted to be included in the proxy materials that were being sent out in preparation for the annual SH meeting. The materials informed that he sought to propose a resolution at the meeting that D form a committee to determine whether its French food suppliers force-fed their foie gras geese. D refused to include the information. o P filed an injunction suit in district court seeking D to be required to include the materials in the proxy materials. The court here held that Ps information must be concluded b/c it involved ethical and social issues that were important to the business. o When a SH proposal implicates ethically and socially significant issues and has a 97

meaningful relationship to the business, the corporation must include those materials at the request of the SH in its proxy materials. o The exception to the rule invoked here is Rule 14a-8(i)(5). While foie gras did not consume more than 5% of the corporations business, the otherwise language (read in the context of the history of the rule) did not require a significant economic relationship. o Thus, b/c the force-feeding proposal related to significant social and ethical issues that in turn related to the business, the exception does not apply. o SEC belief in what is significant issue changes over time. There is a degree of subjectivity to what the SEC believes is a significant issue. For this reason, something like napalm used in Vietnam may not be a significant social issue in one era, but forcefeeding of geese for foie gras is socially significant in another era.

NYCERS v. Dole Food Co.; SDNY 1992; pg 563. o NYCERS, a public pension fund in NYC and SH of Dole, requested that Dole include a proposal in its SH proxy materials. The proposal requested a formal committee to be appointed to consider how different health plan plans being considered by national policymakers would affect Dole. Dole sent a letter to the SEC asking for a no-action letter b/c the proposal concerned an ordinary business operation. The SEC issued the noaction letter on an alternate basis (it requested the company to get involved w/ the political/legislative process). Dole refused to include the proposal. o Pension brings an action in district court requesting that the proposal be included in the proxy materials. The court here held that the proposal must be included b/c none of the Rule 14a-8(i) exceptions apply. o A corporation need not include a SH proposal in its proxy materials when it: o (1) Deals with a matter relating to the ordinary business operations; Here, the proposal does not related merely to ordinary business operations b/c the question of which plan Dole should support could have large financial consequences for Dole. o (2) Related to operations accounting for < 5% of assets/profits and is not o/w significantly related to the business; This exception does not apply here b/c health care clearly affects more than five percent of Doles income. o (3) Deals with a matter beyond the businesss power to effectuate. Though a corporation does not have the power to effectuate changes in national policymaking, this proposal only dealt with forming an internal committee, and that can clearly be done by Dole. Austin v Consolidated Edison; SDNY 1992; pg 568. o P SHs sought to force ConEd to include in its proxy materials a nonbinding resolution that would lower the retirement age of ConEd employees. ConEd sought and received a no-action letter from the SEC, and they refused to include the resolution. o Ps sought to compel ConEd to include the resolution in its materials. The court here

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dismissed the complaint b/c these involved ordinary business operations. o A corporation need not include a SH proposal in its proxy materials when the proposal is designed to further a personal interest which is not shared with the other SHs at large. o The employee/SHs here were merely trying to use the proxy materials as a way to try to improve their own personal situations. o Additionally, decisions relating to pensions clearly fall within ordinary business operations. Moreover, SHs could use the unions for leverage. o If SH has mixed-motives but proposal is interesting to SHs, it must be included. o Suppose the SH was a labor union immediately involved in collective bargaining with the company and sought to include a proposal removing a poison pill. o SH labor union has two interests: (1) They are investors who would like to increase the value of their investment by a takeover prospect. (2) They are workers who might be using the threat of removal of the poison pill as a bargaining chip to buoy their own self-interest. o What factors matter in determining which is the predominant interest? Whether other SHs would approve the proposal (e.g., if 80% of SHs approve the proposal), b/c that could indicate that the investor interest was ubiquitous. Whether there is any prospect of a takeover bid for the company. o Generally, so long as the proposal would be interesting to most SHs, it must be included even if part of the reason for its submission by a particular SH is selfinterest. (E) Shareholder Inspection Rights o SHs seek to receive from corporation: (1) stocklists; (2) books and records. o Obtaining STOCKLISTS and BOOKS & RECORDS: Relevant laws o FEDERAL LAW wrt stocklist. o Rule 14a-7 gives management of the companies an option either to (1) Provide the dissident the stocklist, or (2) Mail the dissidents materials on its behalf and charge them. o Applies only to companies that are registered and subject to federal securities laws. o Not a satisfactory option for the dissident, which would rather target the SHs itself. Thus, dissidents usually resort to state law. o STATE LAW wrt stocklists and books & records. o Company must give dissident the stocklist so long as dissident: (1) Owns a certain percentage of companys stock or has held the stock for more than certain period of time. DE is exception here. (2) States a proper purpose that relates to the financial interests in the company (e.g., wanting stocklist to get names of wealthy individuals to solicit would not be a proper purpose). (3) Gives some sort of affidavit that it will not abuse or resell copies of this stocklist. 99

 Dissident must usually pay for production of stocklist. o Obtaining BOOKS & RECORDS: Generally, the law gives access to info to SHs who will maintain its confidentiality so that they can decide whether to buy or sell stock. Heightened scrutiny for proper purpose in books & records. Because this may been used as a subterfuge for competitors to try to obtain access to confidential internal documents, courts scrutinize the proper purpose requirement much more closely. Tools at Hand: Alternative to Discovery: May be an alternative to discovery: this is the tools at hand that SHs may use to access the information they need before discovery so that they can survive a motion to dismiss. Crane Co. v. Anaconda Co.; NY 1976; pg 572. o Crane was seeking to take control of Anaconda by means of a tender offer. It requested and then demanded a copy of Anacondas SH list for its inspection so that it could send its tender offer materials to those SHs. Anaconda refused to give up the list. o Crane sued to require Anaconda to deliver its SH list. It included an affidavit that it did not desire the list for the purposes of any business other than Anaconda and that it had not sold a SH list w/in five years. The court here held that Anaconda must deliver its SH list to Crane. o A SH desiring to discuss relevant aspects of a tender offer should be granted access to the SH list unless it is sought for an improper purpose; desiring to contact SHs about a tender offer is not an improper purpose. o A SH has a right to protect his investment in the corporation. A tender offer has a substantial effect on that investment, and SHs therefore have a right to learn from another SH about the specifics of a tender offer. o Foreign corporations statutes: Exception to internal affairs rule for stocklist requests. o NY has a foreign corporations statute that allows it to apply its law to corporations incorporated in other states when: (1) SH is a resident of NY; (2) Corporation does business in NY; (3) SH has owns over 5% of shares or has owned shares for over six months; and (4) SH is requesting stocklist. Pillsbury v. Honeywell; MN 1971; pg 575. o P bought 100 shares of Honeywell simply so he could give himself a voice in Honeywells corporate affairs and attempt to persuade it to cease producing munitions that were being used in Vietnam. P demanded that Honeywell produce its SH list and all corporate records dealing w/ weapons manufacturing. Honeywell refused to comply. o P sued to require Honeywell to disclose its SH list and other records. The court here held that Honeywell need not open its materials to the SH b/c that SH had no interest in the information other than his own social and political views. o When SH only bought a stake in a company such as to impose his own political and

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social views (not because of interest in its economic well-being), the company has the right to deny that SH access to its stocklist and records. o SH had no interest in economic value of shares. The SH had absolutely no interest in Honeywell until he heard that it produced weapons being used in Vietnam. He admitted that his purpose for buying shares was simply to try to influence the company in this respect. o Power to inspect books & records may be the power to destroy wrt a large firm. Allowing SHs to roam through these records would make it impossible for a large firm to keep its records efficiently and carry about its business. o PLANNING. SH could potentially access stocklist by phrasing the request for the stocklist as something that related to the long-term economic interests of the company (because of possibility of poor publicity and loss of goodwill). o Different burden of proof on proper purpose. o For stocklist, company has burden to proof improper purpose. o For books & records, SH has burden of proving proper purpose.

Sadler v. NCR Corp.; 2d Cir. 1991; pg 578. o AT&T (NY corporation) purchased a small number of shares of NCR, a large computer company (incorporated in MD w/ PPoB in OH), with a plan to begin a hostile takeover of NCR. NCR had a poison pill in place, so AT&T had to attempt to replace the board to redeem the pill along with its tender offer plans. MD law allowed for a special meeting for this purpose to be called upon 25% of SH vote, and NCRs charter required 80% vote of all shares to replace the board. AT&T sought NCRs SH list, a CEDE list, and a NOBO list. NCR refused, so AT&T entered into an agreement by which the Sadlers (NY residents who also were large SHs of NCR) demanded the lists under NY law. o The NY foreign corporation statute 1315 required a foreign corporation who did business in NY to turn over its SH list to any NY SH who had more than 5% of shares and has been a SH for more than 6 months. (AT&T had not held NCR shares for long enough under this law.) Sadler requested the SH lists under this law. The court held that the law was valid, that the Sadlers could act as agents, and that NCR must turn over all the SH lists requested (including the NOBO list). o Under the NY stocklist demand statute: o Agency. A prospective acquiring corporation may enter into an agreement with an eligible SH to make the demand on its behalf. While it appears that AT&T has made the Sadlers its agent, the NY statute is supposed to be liberally construed in favor of SHs, and it does not necessarily incorporate into it the technical aspects of the law of agency. Thus, AT&T may make the demand through these SHs. o Corporation must obtain a NOBO list for the SH even if it did not already have one in its possession. A corporation may obtain a NOBO list (which contains a list of those owning beneficial interests in shares in a corporation who have given consent to the disclosure of their identities) within ten days. This is a

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simple, mechanical task, and the NOBO list has the same function as other SH lists. Additionally, in this case the NOBO list was practically necessary b/c NCRs charter required approval of 80% of SHs to replace the board at a special meeting. DE does not require incumbents to give NOBO list to dissident when it does not already have it. However, that leaves the playing field biased in favor of incumbents. o NOBOs vs. COBOs. o COBO lists are consenting beneficial owners (opt in; not important anymore). o NOBO list contains the names of all the beneficial owners of the companys stock who have not objected to the disclosure of that information.

(2) Shareholder Voting Control

SH Voting Generally o SHs may act through MEETINGS OR LETTERS OF WRITTEN CONSENT: o (1) Required annual meetings. Directors are elected and other business is taken care of. SH notification of meetings is required by state law, and federal law requires lengthy disclosure in proxy statements, as well. o (2) Special meetings. When a substantial number of SHs so elect (varies according to state law), special meetings must be called. These can conduct any business that can be conducted at annual meetings. o (3) Letters of written consent. If enough SHs write in a vote on a particular matter, then it will be achieved immediately, as soon as the votes are revealed. In DE, any action can be taken by written consent when they have 50% + 1 votes. These can be stealthily obtained w/o informing the board. These are typically not used except at CCs where they are not used as a takeover device but rather a facilitator for corporate actions (when SHs are scattered around the world). o Anyone who held stock at the RECORD DATE gets to vote. The corporation establishes a record date, and anyone who owned stock on that date gets to vote. o Types of voting. o Straight voting (1 share one vote on each matter). o Cumulative voting (1 vote times number of directors, and SH can vote all votes for one or more directors).

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o Class voting (suppose different classes of stock that elect different directors). o Contingent voting (e.g., preferred stock has contingent voting; it has no right unless event occurs, such as no dividend for specific number of quarters). Stroh v. Blackhawk Holding Corp.; Ill. 1971; pg 585. o Blackhawk raised capital by issuing two classes of stock: Class A stock was sold at $4/share; class B stock was sold at $0.0025/share. The articles of incorporation stated that class B shares had no rights to dividends. Both classes had equal voting rights of one vote per share. The purpose was to ensure management would maintain control even after company went public. o Ps claimed that the class B shares were not really stock as defined by IL law. The court here held that the class B shares were stock despite the fact that they only had control rights but no economic rights. o A corporation may issue stock that may not share in the earnings or assets of the corporation, but it may not issue stock that has no voting rights. o Elements of proprietary ownership. The IL statute explains that shares are the units into which the proprietary interests in the corporation are divided. Proprietary rights were defined as the right to: (1) Participate in the control of a corporation, (2) Share in its profits, or (3) Share in the distribution of its assets. So long as a share has some of those elements, it is stock. The stock here had voting rights, so there was an element of proprietary ownership to make it stock. o Voting rights may now be limited. The same IL statue indicated that articles of incorporation could not limit or deny voting rights to any shares of stock. That has now been changed in IL to allow for limiting of voting rights. o Different voting power is even allowed w/in a single class of stock. Not only are different voting powers allowed b/w different classes, but a corporation may even have shares of same class have different voting rights. Providence and Worcester (DE 1977). o SHs are not taken advantage of when they know no control premium beforehand. o Public SHs buy stock here with the knowledge that they will never get a control premium for their shares. The price is therefore slightly discounted. o Management does this b/c it wants to maintain control. There are many reasons to separate ownership from control, and the law does not worry about this when the SHs know about this before they purchase the stock. o Exchange Listing Rules against midstream recapitalization. The NYSE and NASDAQ have listing requirements that prohibit midstream recapitalization of companies. This attempts to prevent a fragmentation of control and ownership in midstream that would deprive SHs of the chance of a control premium. SWIB v. Peerless; DE 2000; pg 590. o SWIB was an institutional investor that owned 8% of Peerless common stock. The Peerless board, which received much of its compensation through stock options, proposed an increase in the number of option shares available for issuance in a proxy statement to SHs. SWIB opposed the measure and wrote a letter to other SHs, but it did not attend the special meeting to vote on it. The meeting was held but was adjourned b/c proposal was losing. In the interim, Peerless did not inform all SHs of the adjournment, but it did drum up more support for the proposal, which passed at a later meeting. 103

o SWIB brought a Blasius claim to invalidate the passage of the proposal on the theory that the adjournment was for the purpose of interfering with the SHs ability to vote. The court denied SJ for both parties, but it suggested that Ps would probably win at trial. o BLASIUS TEST: A board breaches its duty of loyalty: o (1) By taking action for the primary purpose of thwarting the exercise of a SH vote; Here, if Peerless has really adjourned to increase SH participation, it would have informed all of its SHs that it had adjourned. That would have been the best way to determine the true will of the SHs. o (2) When the board fails its burden to demonstrate a compelling justification for its actions. Peerless argues that this is not a typical Blasius case b/c the board action is not motivated by entrenchment. However, there is a possible conflict here in that they get some of their compensation through options. However, it is unclear if the causal link b/w allowing the issuance of more options and the directors receiving them is so attenuated such that this is a compelling justification. Ratification theory fails. Peerless argues that the adjournment allowed for more SHs to participate, and that this essentially ratified the defect in the process. However, b/c it is unclear whether the ratification was obtained fairly, this is not dispositive. o SH need not attend SH meeting to have standing. o The court rejected Peerlesss argument that SWIB did not have standing b/c it did not exercise its rights to show up to the meeting and object. o The court reasoned that the proxy system works exactly b/c SHs do not have to show up to SH meetings to protect their rights (SHs are diffuse and it is too costly for them to attend all meetings personally). o ONLY BENEFICIAL OWNERS CAN VOTE unless routine matter. o Agents (e.g. brokers) of beneficial owners may vote for them on routine matters at SH meetings w/o beneficial owner direction. o Agents are not allowed to vote for the beneficial owners w/o direction on nonroutine matters. o Because the proposal to increase the issuance was not routine, the initial vote was lower, b/c the beneficial owners themselves must vote. o Ratification as to void vs. voidable acts. o Void acts May not be cured by majority vote, only by unanimous consent. Include fraudulent acts, gifts, waste, ultra vires actions (where the companys charter limits the companys business to a specific venture and the board does not abide by that.) o Voidable acts May be cured by SH majority ratification Include those that are performed in the interest of the company but beyond the authority of management.

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9. LIMITED LIABILITY CORPORATIONS

o A new form of organization. o Most popular form for non-public companies. o Desirable features: o (1) Limited liability for investors; o (2) Pass-through partnership-style tax treatment (i.e. dividends are not taxed at the entity level); o (3) Completely flexible in terms of management (b/c LLC rules are all default rules alterable by K unless they affect 3d parties).

(1) Formation
Westec v. Lanham; CO 1998; pg 300. o Clark hired Westec to do work for his LLC, PII. Clark gave Westec a business card with the name of another LLC member, Lanham, and the initials PII on it, but he does not disclose that he was representing an LLC. Westec did the work but did not get paid by the LLC. o P sought to recover for its unpaid bill against PII as well as both Clark and Lanham individually. The court held that the principles of agency law applied such that both Lanham was individually liable despite an LLC notice statute in CO that provided that the filing of LLC articles of organization give third parties constructive notice that a company is an LLC. o When 3d party sues a manager or member of an LLC under an agency theory, the principles of agency law apply notwithstanding statutory notice rules applying to LLCs. o Statutory interpretation requires LLC in name for constructive notice. It cannot be that the legislature intended create constructive notice for 3d parties whenever they deal with agents of LLCs, even if they do not know the name of the company. Instead, a reasonable interpretation of the LLC notice statute is that 3d parties have constructive notice that a company is an LLC and that the members and managers cannot be held individually liable once they know the name of the company. o Policy justification. If 3d parties were always considered to have constructive notice that they were dealing w/ LLCs when they dealt w/ agents even if they did not know the company name, agents could commit legally condoned fraud by misleading 3d parties into believing the agent would be bound by the K (when really only the LLC would be bound). o Failure to form LLC properly creates a LP. If parties try to create an LLC but fail, what is formed in a limited partnership.

(2) The LLC Operating Agreement

Elf v. Jaffari; DE 1999; pg 303. o Elf and Jaffari formed an LLC such that Elf could distribute Jaffaris environmentallyfriendly metal product. They filed the certificate of formation and had a comprehensive agreement that had both mandatory arbitration and forum selection clauses. The relationship fell apart. o Elf sued Jaffari, both directly and derivatively (on behalf of their LLC) in DE state court. The trial court dismissed b/c it found the arbitration clause enforceable. The court here agreed that the case must be dismissed b/c of arbitration agreement. 105

o Because LLC law favors freedom of contract b/w parties, a MANDATORY ARBITRATION CLAUSE IS ENFORCEABLE such that DE courts must dismiss suits. o LLC law strongly favors freedom of K. Much of the statutory landscape is default rules, and there are very few mandatory rules that parties cannot contract around. o The fact that the LLC did not sign the agreement itself is irrelevant.

(3) Piercing the LLC Veil

Kaycee Land v. Flahive; WY 2002; pg. 312. o Flahive Oil & Gas was an LLC with Roger Flahive as its managing member. Kaycee entered into a K w/ Flahive LLC to do work on its property. o Kaycee sued Flahive LLC for damages to its property, and it sought to pierce the LLC veil to access Flahives personal assets. The court here held the piercing the veil is appropriate for LLCs as it is for corporations. o The LLC VEIL MAY BE PIERCED to allow awards to 3d parties from individual assets when members or officers of an LLC fail to treat it as a separate entity as contemplated by statute and some other substantial injustice. o While the WY LLC statute does not expressly allow for piercing the LLC veil, this is b/c the WY statute was one of the first, and it was done before the legislature had considered the possibility of piercing. o Piercing the veil in corporate law is a common-law, equitable doctrine, and it may be carried over into LLC law despite the lack of express statutory authorization. o The considerations for when an LLC veil should be pierced are somewhat different than those for corporate veils, b/c the LLC formalities are not the same. o LLC formalities which must be followed to void piercing: Filing articles of organization; filing operating agreement; separating funds. o LLC can select to have very limited formalities by contract, though.

(4) Fiduciary Obligations

o McConnell v. Hunt Sports Enterprises; OH 1999; pg 317. Wealthy individuals in OH came together to try to attract an NHL franchise to Columbus. They formed an LLC. McConnell and Hunt were the two leading factions. When the city was unable to raise money for an arena through raising taxes, an insurance company made an offer to build the arena. Hunt refused the offer, but McConnell accepted it. McConnell formed a competing entity, made the deal w/ the insurance company, and was awarded the franchise by the NHL. Hunt sued McConnell for breaching his fiduciary duty by competing with the business of their LLC. The court held here that there was no such breach b/c the LLC agreement included a clause that expressly allowed members of the LLC to compete against the LLC. While LLCs usually create fiduciary relationships precluding direct competition b/w members, MEMBERS CAN CONTRACT AWAY DUTY NOT TO COMPETE. o The LLC agreement here contained plain, unambiguous language that the members could compete against the LLC. McConnell did just that by going out, negotiating with the insurance company to get the arena, and forming a competing entity. The court enforced the terms of the agreement, allowing the member to compete w/ LLC. Contracting out of duties of loyalty and care.

o o

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o Some states have mandatory rules preventing avoiding duty of loyalty. o LLCs can also contract out of their duty of care by requiring willful misconduct rather than negligence.

(5) Dissolution
o New Horizons Supply Coop. v. Haack; WI 1999; pg 323. Haack was a member of an LLC freight company with her brother. She owed around $1000 of fuel bills on a card service and failed to pay. When the creditor contacted her, she told them her brother had left the company and that she was reorganizing it. Later, she refused to pay again. P brought small claim to collect on debt against D in individual capacity. The trial court held that there was not sufficient evidence to show that this really was an LLC and that it was being operated as such, so D was personally liable. The court here held for D on alternative theory that the LLC had been dissolved and D had not followed the proper statutory procedures to insulate assets from creditors. When a dissolution event occurs, LLC creditors have first priority to the assets unless member: o (1) Files articles of dissolution listing its known debts; and o (2) Provides written notice to its known creditors containing info regarding the filing of claims. o The filing of articles of dissolution are optional under this statute. However, if these steps have not been fulfilled, then claims may be enforced individually against the members of the LLC. o The members individually liability for those claims are limited by the amount of the total value of assets distributed to that member in liquidation. Most LLCs select the corporate (and default) rule: they have permanent life unless dissolved.

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