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I. Introduction
        1. Sole Proprietorship
              a. You cannot be a Sole proprietorship and share ownership
                  or else you are a proprietorship, or more often called a
              b. Any type of business can have employees, including a
                  sole proprietorship
              c. The sole proprietor is compensated for his labor, his role
                  as an investor, his ideas and his management.
                       i. In general the law tends to allocate control along
                          with risk
                      ii. An employee in the context of working for his
                          employer is his agent.
                     iii. A bank may loan the employer money but the
                          employer still controls the company because he
                          has the risk, although they may place restrictions
                          on the loan, like requiring it to be used for the
                          kind of business specified.
                             1. borrowing money from the bank is debt,
                                  money owed that must be paid back
                             2. money invested in a business is equity, it
                                  does not need to be paid back, does not
                                  have an interest rate, and usually it entitles
                                  one to participate in the upside
                             3. The people who are shareholders are also
                                  the owners of the business and residual
                                  claimants, they get profits.
                                      a. Creditors are someone to whom you
                                         owe money.
                                      b. Partnerships are not usually used in
                                         business anymore because they do
                                         not protect people from liability
                                      c. sometimes the manager does not
                                         have complete control, the people
                                         who put in the most money have
                                         most of the risk and therefore most
                                         of the control
2. The difference between public and private companies.
    a. Public Companies
           i. The public can buy and sell stock in it.
    b. Private Company

i. It can be very difficult to sell your stock, making the issue of
   control so important, the shareholders that do not have
   control can find themselves stuck with worthless stock and
   no control, a minority stake you cannot do anything with or
   get rid of. There are many things that can protect someone
   like a buy sell agreement which can let someone out of
   ownership at a latter date.

                                  AGENCY LAW

       Agency is a relationship that results from the manifestation of consent by
       P to A that A shall act on P’s behalf and subject to P’s control, and A’s
       consent to so act. Restatement of Agency (Second) §1

       When the agent is acting outside the scope of the agency you cannot
       sue the principal.
                  Was the conduct of the same general nature as, or incident
                     to, that which the servant was employed to perform
                          See Restatement of Agency § 229
                  Was the conduct substantially removed from the authorized
                     time and space limits of the employment
                          “Frolic and detour”
                  Whether the conduct was motivated at least in part by a
                     purpose to serve the master
                  Most courts now require a “total abandonment” of the
                     employment to constitute a frolic and detour
      Some Exceptions:
              - Even if A acts outside scope, M may still be liable:
                      M’s intent,
                      M’s negligence
                      Reliance by 3rd parties on “apparent” scope.
                      Principal retains control over the aspect of the work in
                         which the tort occurs
                      Principal engages an incompetent contractor (Majestic
                         analysis questions 1-2)
                      Activity contracted for is inherently dangerous, a
                         nuisance per se (An activity that creates a “peculiar risk
                         of harm to others unless special precautions are taken”)
                      Nondelegable duty (usually statutory like a building code,
                         but can be broader) - A duty so important to the
                         community that the principal should not be allowed to
                         farm it out to another.

       The third party can also be held liable to the principal

       A principal is liable on contracts made by an agent on the principal’s

       Control can be established by a condition precedent. Gorton v. Doty
       (you don’t need compensation)

You can form an agency relationship without knowing. The Cargill
court says “there must be an agreement, but not necessarily a contract
between the parties.”

Control can be established in more than one way, if you have a situation
where you have the option of not following a suggestion, but if the
advisor is financing you and they can stop at anytime it may still
be control even if you don’t follow all the suggestions. Gay Jenson
Farms v. Cargill

The principal needs to effectuate control but the control does not have
to be completely effective, and the control does not have to be
completely related to the wrong.

Marital relationship not enough to make one spouse the agent of
another. Botticello v. Stefanovicz

In order for an agent to avoid liability, he must reveal not only
that he is acting on behalf of a principal, but the identity of the
principal. The 3rd party has no obligation to ask. Atlantic Salmon A/S

A creditor becomes a principal at the point at which it assumes de facto
control over the conduct of the debtor. Restatement 14 O

Supplier: One who contracts to acquire property from a third person and
convey it to another is the agent of the other only if it is agreed that he is
to act primarily for the benefit of the other and not for himself.
Restatement § 14K
       Comment: Factors indicating that one is a supplier, rather than an
       agent, are: (1) That he is to receive a fixed price for the property
       irrespective of price paid by him. This is the most important. (2)
       That he acts in his own name and receives the title to the property
       which he there after is to transfer. (3) That he has an independent
       business in buying and selling similar property.

       General Notes:
           i. The law of agency in Torts is Respondiot Superior/Vicarious
          ii. It is the ability to exercise control that is relevant not the
              actual exercise of control, but it doesn’t help to actually
              exercise control.

               iii. Agency law reaches a little farther then your sense of
                    fairness, it is a very far reaching doctrine, partly because the
                    principal will probably have more money.

5 Distinct Ways to Form an Agency Relationship
            – Actual Express Contractual Duties: Principal & Agent explicitly
              agree that A has power to act on P’s behalf and subject to P’s
                  • Actual Express Authority (AEA)
            – Actual Implied Contractual Duties: Relationship between P &
              A is such that court can reasonably infer parties intended to
              delegate A power to act on P’s behalf and subject to P’s control
              We have this category because sometimes we don’t tell our
              agent everything we want the agent to do, but it is still within
              the relationship of agent and principle.
              There is an incentive with implied authority for the principle’s
              instructions to be clear or else there will be more implied
              authority than you wish.
              Under apparent authority the third party can still enforce a
              contract against the principle even if he did not now that agent
              was acting as an agent for the principle.
              Implied authority often depends on industry customs.
                  • Actual Implied Authority (AIA)
            - Apparent:          “Apparent authority is the power to affect the
              legal relations of another person by transactions with third
              persons, professedly as an agent for the other, arising from and
              in accordance with the other’s manifestations to such third
              persons.” Restatement § 8
              Apparent authority depends on communications between
              the principle and the third party the principle somehow
              gives appearance that the agent has authority, a manifestation
              of authority, and the actual authority is not there.
              There is a requirement of reasonableness it usually turns
              on what is customary and reasonable in the community.
              Apparent authority exists only where there is some connection
              between the third party and the principal.
              You must always look at how the third party learned of
              the agent’s alleged authority and ask whether the
              principal reasonably can be said to have been the source
              of that knowledge.
              When you have a case of apparent authority when the agent
              goes beyond their actual authority they are liable to the
              principle for violating their fiduciary duty.

    If there is apparent authority not only can the third party
    enforce the contract against the principle, but also the principle
    can enforce the contract against the third party even though it
    is apparent not actual authority.
-   Ratification: If the principle decides to adopt a contract
    negotiated by an unauthorized person. It can be ratified to the
    agent or to the third party.
         “A” acts without authority (of any kind) and there is no
           grounds for estoppel.
         “P” will only be bound if “P” ratifies the contract
         Ratification requires
                A valid affirmation by “P”
                To which the law will give effect
     What types of acts constitute an affirmation by the principal?
            Affirmation can be express or implied
            Principal must know or have reason to know all
               material facts
            Will be denied legal effect where necessary to
               protect the rights of an innocent third party
    Also includes estoppel. (Note that estoppel is not truly a form of
    authority. It is a bar to raising defenses to the authority claim.)
-   Inherent: Arises solely from the designation by the principal of
    a kind of agent that ordinarily possesses certain powers.
    Usually comes up in situations with an undisclosed principle, or
    where an agent exceeds their authority. A catch all. Inherent
    agency extends the principal’s liability to acts that the principle
    has prohibited to the agent but that are within the scope of
    authority that agents engaged in similar activities usually
    possess. (this is similar to the liability of partners even if the
    partner committing the act has concealed his membership in the
        In undisclosed principal cases, what is the scope of the
        agent’s authority?
                “the principal is liable for all the acts . . . which are
               within the authority usually confided to an agent of
               that character” Watteau
               Restatement § 195 “agent enters into transactions
               usual in such business and on the principal's account”

The legal consequences of an agent’s acts DO NOT depend on the
type of authority the agent possessed.

To prove agency you must prove (1) that an agency relationship
existed and then (2) what kind (or kinds) of authority the agent
Usually you can have more than one type of authority.
The reason you bother saying not to do something even if there is
a custom is that: most agents will listen, then you have a claim
against the agent, and maybe you take steps to let people know.
Often when there is either apparent or inherent there is the other,
however, note the difference between the two in a situation like
Watteau where the third party did not even know there was a
principal. In that situation there is no manifestation by the
principal to the third party, but there can still be inherent authority,
as in Watteau where ordinarily the goods would be supplied to that
type of establishment (such a transaction would be normal in the

Authority v. Power
    An agent may bind the principal even when the agent lacks
      any form of actual authority
           “A power is an ability on the part of a person to
              produce a change in a given legal relation by doing or
              not doing a given act.” Restatement § 6
           An agent’s power to bind the principal is broader than
              an agent’s authority to bind the principal
                  E.g., estoppel

Gorton v. Doty
Facts: parent loaning car to coach if he drives
She could not have really protected herself with a contract,
because it is not binding on a third party, although she could then
go recover from the alleged agent.
Doty really should disclaim any control over the use of her car or if
she had rented them the car then she would just be operating a
business and not acting as a principal.

Gay Jenson Farms v. Cargill
Facts: Warren grain elevator, Cargill big seed company finances
       them with loans
   1. Cargill's constant recommendations to Warren by telephone;
   2. Cargill's right of first refusal on grain;
   3. Warren's inability to enter into mortgages, to purchase stock
       or to pay dividends without Cargill's approval;

                 4. Cargill's right of entry onto Warren's premises to carry on
                      periodic checks and audits;
                 5. Cargill's correspondence and criticism regarding Warren's
                      finances, officers salaries and inventory;
                 6. Cargill's determination that Warren needed "strong paternal
                 7. Provision of drafts and forms to Warren upon which Cargill's
                      name was imprinted;
                 8. Financing of all Warren's purchases of grain and operating
                      expenses; and
                 9. Cargill's power to discontinue the financing of Warren's
              Cargill found to be principal.
              The difference between banks and companies acting like Cargill is
              that banks do not tinker with day to day operations.

              Cargill Situation Planning Solutions
              It may be that there was a loan officer in the company that did not
              want to mess up their loan record.
              Reduce Cargill’s control by setting strong standards in advance,
              avoid the biggest mistakes lenders make like: veto power, putting a
              person in control over the company, or providing assurances of
              payment to the other creditors.
              Take on additional control, since you are already the principal make
              sure it is done right. Like McDonalds, one of the benefits of that is
              that you can go to any McDonalds in the world and know what to
              expect. But even if one of McDonalds’ restaurants does not do
              something they are required to do McDonalds is still liable because
              with control comes the power to police.
              It might have been okay to say we are going to have you talk to an
              outside consultant instead of coming in yourself.

Servants and independent contractors
Principle and Agent are big categories within that context there is a subcategory
of master servant or independent contractor, you can have an agency
relationship that doesn’t fall under master servant.
    • Why does the distinction matter?
           – Vicarious liability depends not only on whether an agency
              relationship existes, but also on the kind of agency relationship that
              is involved.
           – Master is liable for servant’s torts.

          –  Principal generally not liable for the torts of an independent
   •   What is the distinction?
         – A servant’s physical conduct of the task is controlled or is subject to
             the right of control by the master
                 • Note that the master does not have to actually exercise
                    control over what the agent does; he or she merely needs to
                    have the right to control the agent's physical performance of
                    the assigned task
         – An independent contractor’s performance of the task is not subject
             to the principal's control.

Independent Contract Types
   • Nonservant agent (a.k.a. agent-type independent contractor)
         – Subject to limited control by P with respect to the chosen result
         – Has power to act on A’s behalf
   • Nonagent independent contractor (a.k.a. nonagent service provider)
         – Perhaps less control on P’s part
         – No power to act on A’s behalf

           P liable if A w/in  P not liable except             P not liable in
           Scope of employment     in special cases            agency law

                                    Independent       Independent
Archaic             Servant         Contractor        Contractor
                                    (agent-type)      (nonagent)

Modern PC           Employee                          independent

Restatement                         Nonemployee       Nonagent service
3d                                  agent             provider

Liability in Tort

   “A master is subject to liability for the torts of his servants committed while
   acting in the scope of their employment.” Restatement (Second) § 219(1)

Sequential analysis of tort liability

   Is there an agency relationship between P and A?
   Is A P’s servant or independent contractor?
   If servant, was conduct within scope of employment?

Agent Tort Liability:
      Agent basically is always liable for torts she commits
              Though the principal may be as well

             Humble Oil & Refining Co. v. Martin
             Facts: Car at gas station rolls away hits somebody, oil company
             sued, operator of the gas station required to follow orders
             Humble found liable for the acts of the operator’s employee
             Key factor: Whether Humble has a legal right to control Schneider’s
             “physical conduct” on job. (that is the manner in which the job is
             performed rather than the result) See Restatement of Agency
             (Second) § 2.

             Is there an argument that Humble might have made but didn’t that
             could have absolved it of liability despite the court’s finding that a
             M-S relationship existed?
             Yes, that it is outside of the scope of the M-S relationship

             Hoover v. Sun Oil
             Facts: employee drops cigarette, recommendations not orders, sun
             oil logos

             Bushey & Sons v. United States
             Facts: drunk sailor coming back to boat loosens wheels
             US defends on scope of employment grounds
                    Was conduct of same nature as that authorized?
                    Was Lane on a frolic and detour?
                    Did Lane have a purpose to serve US?
             Discards purpose test, not all courts agree.
             Friendly goes with a fairness not a cheaper cost avoider theory,
             and comes up with a broad understanding of foreseeablity, that it is
             not foreseeable that he will turn the wheels but it is foreseeable
             that sailors will go out and drink and in coming back something
             might happen.
             Three issues:
                    1. If some harm is foreseeable: Liability, even if the
                        particular type of harm was unforeseeable
                    2. Conduct by the servant which does not create risks
                        different from those attendant on the activities of the
                        community in general will not give rise to liability

        3. The conduct must relate to the employment
Not all courts accept (see, e.g., Clover v. Snowbird Ski Resort),
most courts now require a total abandonment of the employment
to constitute a frolic.

Majestic Realty Associates, Inc. v. Toti Contracting Co.
Facts: employee of independent contractor goofed in demolishing
This case is an exception in that the principle is being held liable for
the acts of an independent contractor.
They are liable because it was an inherently dangerous activity,
Negligence per se.
The policy behind the decision is to get your contractor to get
insurance when doing inherently dangerous activities.
The court signals that hiring an independent contractor without
enough insurance could be like hiring one that is incompetent.
The court distinguishes “inherently dangerous” activity from “ultra-
hazardous” (serious risk which cannot be eliminated) which is strict

Policy: When to apply vicarious liability?
       Sun Oil should be liable because if creates the appearance of
Residual interest
       Sun Oil should be liable because it has a relatively large
       interest in the successful operation of the station
Deep pocket
       Any supplier with a deep pocket and any connection to the
       accident should be held liable
Risk spreading
       Much like deep pocket.
Risk prevention
       Liability should arise from control or right to control the
       harmful activity
       Holding oil companies liable causes them to instruct their
       service stations to get insurance
Economic analysis
       Cheaper cost avoider

                    Compensation for losses
                    Retribution for morally blameworthy conduct

Principal’s Liability in Contract

   Restatement § 144: a principal “is subject to liability upon contracts made by
   an agent acting within his authority if made in proper form and with the
   understanding that the principal is a party”

             Mill Street Church of Christ v. Hogan
             Facts: handyman hires brother to help him as he had done in the
             Sam sues for workers comp from church, has to be an employee,
             Bill had to have authority to hire Sam
             Sam is a subagent of the church because Bill had actual implied
             and apparent authority to hire Sam.
             Actual Implied Authority
                   Why?
                         Implied authority “includes such powers as are
                           reasonably necessary to carry out the duties”
                         Did agent believe based on present or past conduct
                           that he had authority?
                         Job needed two men and the church had let him hire
                           Sam in the past
                                No clear instructions to the contrary expressed
                                    to agent, even if in principal’s “mind”
                         Sam’s belief relevant?
                                Sam’s belief is relevant to apparent authority,
                                    but not implied authority
                   Planning implications?
                         The church should tell Bill he does not have the
                           authority to hire someone, and let people know that
                           all hiring has to be done by the church

             Lind v. Schenley Industries, Inc.
             Fact: Told by president that he would be assistant to Kaufman but
             that he had to talk to Kaufman, Kaufman told him about a 1%
             commission he would get, company says Kaufman never had this
             authority to give him this salary
             Court said Kaufman had apparent authority, no actual authority
             Analysis: The court confuses actual implied authority with both
             apparent authority and inherent authority, and the court opines
             wrongly that proof of a specific form of authority is not required.

Restatement § 8 requires a “manifestation” by the principal to the
third party to support apparent authority. What was Park & Tilford’s
manifestation to Lind?
            Installing Herrfeldt as sales manager and clothing him
               with authority to make representations re
               employment on PT’s behalf.
Apparent authority is a question of fact and often turns on what is
customary in the field.
     Planning: What should Park & Tilford have done?
           o You could have a department like human resources
               and everyone gets an employee manual and everyone
               knows that they can’t get a raise or promotion
               without the human resources department’s consent.
               An employee manual is usually used to disclaim
               liability for these types of things. You can make a
               belief in the authority unreasonable by notice (actual
               or constructive through an employee manual or
               something). Train Herrfeldt and Kaufman not to
               make these sorts of offers. Insist on written
               employment contracts with managerial employees.

370 Leasing Corporation v. Ampex Corporation
Facts: Joyce signs contract with signing block for Ampex and never
sends it back, he also has a letter from Kays at Ampex confirming
shipping, and an internal memo from Kay’s boss says we made this
big deal and Kays is in charge of all communications with Joyce
On what type of authority is Joyce relying?
        Apparent authority, not actual authority, Kays did not have
        authority to sign this letter. Nor did his boss.
The internal memorandum has significance in proving apparent
authority if you assume Joyce new about the memorandum, and it
supports the argument that there was silence and Ampex wasn’t
denying the contract.
 Broad category of implied authority is “a kind of authority
    arising solely from the designation by the principal of a kind of
    agent who ordinarily possesses certain powers” (Lind)
         Actual implied authority: act of putting agent in such a
           position leads agent to reasonably believe he has
         Apparent (“implied”) authority: act of putting agent in
           such a position leads third party to reasonably believe
           agent has authority.
 All authority that is not express is implied.
 Implied Authority is NOT a separate category.

               What should Ampex have done to protect itself?
                   Again, train its agents and give notice to potential third
                   Form contract requiring approval by contract manager.

              Watteau v. Fenwick
              Facts: Beerhouse manager, Humble, owned beerhouse and then
              sold it but stayed as the manager. Beerhouse manager only
              allowed to purchase certain things, he buys other things, manager’s
              name is still on the door.
              Humble didn’t have actual authority because he as the agent could
              not have reasonably believed the scope of his authority to include
              that ability,
              Apparent authority?
              No, the principle did not do anything to manifest to the third party
              that the agent had that authority.
              Inherent authority?
              Yes, “the principal is liable for all the acts . . . which are within the
              authority usually confided to an agent of that character”

Former Authority
Sometimes you have to take steps to let people know that they no longer have

Ratification, Estoppel, Agent’s Liability

Botticello v. Stefanovicz
Facts: Couple each owns undivided half interest in the property, tenants in
       common. Walter leases with an option to purchase without consulting
       Mary. Plaintiff moves in pays rent and makes improvements, Mary cashes
       checks. Plaintiff tries to exercise the option, Mary says no
Court says that the martial relationship is not enough to make one spouse the
agent of the other
A marriage is not the same as a partnership.
The only real question here is did she ratify it by accepting rent
Court said no just being married doesn’t imply consent

Planning: Botticello could have shown her the contract, or explained it to her and
then if she still accepted the rent the ratification argument would work

The agency rules relating to undisclosed principals apply to partnerships.

Distinguish Ratification from Actual Authority Created by Acquiescence

        “(1) Acquiescence by the principal in conduct of an agent whose
previously conferred authorization reasonably might include it, indicates that the
conduct was authorized; if clearly not included in the authorization, acquiescence
in it indicates affirmance.
        (2) Acquiescence by the principal in a series of acts by the agent indicates
authorization to perform similar acts in the future.”
                Restatement § 43

Hoddeson v. Koos Bros.
Facts: Fake furniture salesman takes plaintiff’s money
Why isn’t this a case of the apparent authority of an apparent agent?
        No holding out by Koos that tall man was its agent.
Why doesn’t Koos’ failure to police its sales floor constitute the requisite
            “A manifestation is conduct by a person, observable by others, that
            expresses meaning.” Restatement (Third) § 1.03 cmt. b.
            Although omission can be a manifestation here it is not.
Court holds that if you don’t watch your store well enough in some situations you
are estopped from disclaiming responsibility, court calls it agency by estoppel,
court says new trial so you have the opportunity to argue estoppel.
Apparent authority and estoppel are similar, but in estoppel the third party has to
alter their position in order to win, and estoppel only binds the principal not the
third party.
     On remand, what will Hoddeson have to prove to make out a case of
             Acts or omissions by the principal, either intentional or negligent,
                which create an appearance of authority in the purported agent
             The third party reasonably and in good faith acts in reliance on
                such appearance of authority
             The third party changed her position in reliance upon the
                appearance of authority
     Where agent had authority (of any kind) contract is binding on both P and
             Estoppel only binds P

Agent Liability on the Contract
  Disclosed Principal
      Two exceptions:
           Clear intent of all parties that agent be bound
           Agent made contract but without authority
                   Party to the contract?
                   Fraud/deceit?

                     Implied warranty of authority (bulk of jurisdictions)
                      (Restatement section 329)
                             Agent is not a party to the contract, but 3rd party is
                             entitled to: “the amount by which he would have
                             benefited had the authority existed.”
  Partially disclosed or undisclosed principal
      Agent treated as though a party to the contract
      Third party must elect who to sue

Fiduciary Obligations: What duties do P and A owe to each other?
Agent’s Fiduciary Duties
    Care (i.e. duty not to “shirk” on the job)
    Loyalty (i.e. Don’t Steal from the firm!)
           Kickbacks, bribes or gratuities (Restatement § 388) Even gratuities
              given after the fact
           Secret profits
                   From transactions with principal (Restatement § 389)
                   Use of position (Reading)
           Usurping business opportunities from principal (Singer)
           “Grabbing and Leaving” (Town & Country)
Most of the stuff gets fixed by disclosure, or else it is not up to the agent to
decide whether the amount is too small to report or whether it is wrong or not

   Particular Duties
  of Loyalty


Under §388 of the Restatement of Agency (Second): “Unless otherwise agreed,
an agent who makes a profit in connection with transactions conducted by him
on behalf of the principal is under a duty to give such profit to the principal.”

Atlantic Salmon A/S v. Curran
Defendant selling salmon representing himself as a corporation when in fact he
wasn’t, at some point had a company called Marketing Designs, Inc.
Because there was no principal he became the de facto principal.
Black Letter Law: If an agent wants to avoid liability, he must reveal not only
that he is acting on behalf of a principal, but the identity of the principal. The 3rd
party has no obligation to ask.
Planning: What should the plaintiff’s have done to protect themselves? A credit
check, or they could have checked with the secretary of state.

Reading v. Regem
Facts: British sergeant while on duty goes on ride on trucks of smugglers to help
       them get through without being inspected and gets paid for it.
Crown wants money he earned
Court awards Crown money because the only reason he got the money was
because he was acting as their agent.
Court says if his position as an agent more than affords him the opportunity for
getting the money, but rather plays a predominant part in his getting the money
then he is accountable for it to his master.
“The Agent has a duty to act solely for the benefit of the principal in all matters
connected with his agency.” Restatement 2 section 387
Remedy? Constructive trust, meaning you are in reality holding the money for
the principal.
Why should we give the Principal a property right in the secret profits of its
Agent if the Principal is not damaged?
We want to discourage it, not give any incentive to engage in behavior we
consider wrong.
 Note that the holding is not dependent on a measurable loss of value to the

General Automotive Manufacturing Co. v. Singer
Court says he was Automotive’s agent and owed them the profits he made on
the side
He argues that he is allowed to do it because they were beyond the capacity of
But he is the manager of Automotive so he has to work for the sole benefit of
the Principal
Court says he should have disclosed, and it would have been in Automotive’s
discretion to reject the work, and to take any profits from assigning the work, by
failing to disclose he violated his duty to act solely for the benefit of his principal.

What if GA wanted the job, but Singer thought GA would do a bad job, could he
warn the customer?
No, but he could quit, it is not his right to warn the customer
Why wasn’t Singer decided as a breach of contract case?
Automotive would only get compensatory damages Automotive’s lost profits from
not doing the work, not disgorgement of Singer’s profits.

Breach of Contract v. Fiduciary Duty
     Contract:
           Remedy: Actual damages
           No moral condemnation
           Need to interpret the contract (e.g. “work 5 and ½ days”)
     Breach of fiduciary duty:
           Remedy: Disgorgement
           Moral condemnation
                  X-ref Meinhard v. Salmon: “punctilio of an honor the most
Full Time and Attention Provisions
     Issues?
           Outside activities
                  uncompensated
                  compensated (such as being a director of another firm)
           No provision for board waiver
           Moonlighting?
           Writing the Great American Novel?

Town & Country House & Home Service, Inc. v. Newbery
Facts: Special quick and assembly line type house keeping, employees steal
client list which was difficult to cultivate for this special type of house cleaning,
employees contact only people on the list but after their employment has ended.
Court says the client list was a trade secret
Was it possible to allege that defendants breached their duty not to compete?
Yes, because they advertised specifically to her customers, the problem is not
that they left and started their own competing business
You are not allowed to compete when you are still the agent of the principal
Suppose Alice a 3rd party competitor spies on the T&C trucks to get the client
She would not be liable because she is not an agent so she can compete with
the principal.
If you have an independent basis for gathering the information you are okay,
even if you are a past agent, you can’t compete while you are still an agent

If they could have got the list from hiring a private detective but they decided to
just avoid the trouble and use it because they already had it in their minds what
is the difference?
Because we want to impose that hassle, that barrier, before they can use the
principal’s information.

 Duties that transcend agency

                                                        Can you extend
                                                       Can you extend

                                                         the duty not to

                                                        the duty not to
                                                       compete beyond
                                                      compete beyond
                                                            the terminal
                                                           the terminal
                                                        date of agency?
                                                       date of agency?
         DUTY NOT TO COMPETE                                        Time
         DUTY OF CONFIDENTIALITY (including T.S.)


The duty not to compete ends when the agency relationship ends, but the duty
of confidentiality extends beyond the termination of agency.
They are different duties, you cannot do much about the duty not the compete
at least in CA, but with the duty of confidentiality you can and some people use
it to extend the duty not to compete.

Non-Compete Clauses in CA
   • By statute, CA law prohibits non-compete agreements “of any kind…”
   • Caveats:
        – Breadth of CA statute is narrower than § 393:
               • Post-employment covenants against recruitment of
                   customers/clients or coworkers are not proscribed.
        – Other “close by” fiduciary duties unaffected:
               • Post-employment covenants not to disclose/use trade
        – Express statutory exceptions
               • Sale of assets & goodwill of a business
               • Non-compete agreements among partners
               • Non-compete agreements among members of LLC

List of “factors”
To determine whether Information = “Trade Secret”
      Information not widely known outside the firm.
      Information is not widely known within the firm.
      Firm tries to guard the information.
      Information valuable both inside and outside firm.
      Large costs incurred to develop information.
      Information could not cheaply be duplicated.

Uniform Trade Secrets Act
(Cal. Civ. Code § 3426 (1999))
   • Trade secret = information (including a formula, pattern, compilation,
       program, device, method, technique, or process) that:
           – (1) Derives independent economic value, actual or potential, from
              not being generally known to the public or to other persons who
              can obtain economic value from its disclosure or use; and
           – (2) Is the subject of efforts that are reasonable under the
              circumstances to maintain its secrecy.

Consequences of Trade Secret Liability:
   • Injunctive Relief
         – Actual or threatened.
         – Term: Life of T.S. “plus”
   • Damages
         – Actual Damages
         – Unjust Enrichment of Misappropriator
         – Reasonable Royalty (retrospective/prospective)
         – PUNITIVE DAMAGES (up to 2X)
   • Attorneys’ Fees for bad-faith litigation
         – (Either party)


A partnership is an association of two or more persons to carry on as co-owners
a business for profit” UPA Section 6(1)

All partners are agents of the partnership. UPA §9 … and thus each partner owes
the same fiduciary obligations that any agent owes a principal;

An agreement is necessary to form a partnership.

   •   No formalities are required to form partnership...
          – …so long as enterprise “walks & talks” like one...
          – …which includes a number of factors, including:
                 • Intent (express or implied); Risk sharing (i.e. profit and
                     loss); Elements of sharing of control; Rights on Dissolution

Partnerships are the only type of entity (a sole proprietorship is not really an
entity) that you don’t have to file anything with the state, it is very cheap to set
up a partnership, with a corporation you need an attorney.

No body ever uses a partnership in the real world.

Sources of Partnership Law
   • Statutory Body of Law:
          – Uniform Partnership Act (1914):
                • Adopted by every state except La.
          – Revised Uniform Partnership Act (1997);
                • Adopted in about half the states, including CA
          – (These are called the “Default Rules”, used to fill in gaps. Even if
             you want the default rule to govern you should still put it in the
   • Common Law Cases

Defining Characteristics:
  1. For-profit, unincorporated business
  2. Two or more “owners”(A & B)
  3. Partners each make contribution to business (capital, labor, land, etc)
  4. Partners share profit/loss;
  5. Partners jointly enjoy rights of control/management;
  1. P-ships can vary by K many rules
  2. P-ships hire external capital/labor without adding new partners, one of the
      determining factors to determine if the new employees or the lenders are
      partners is control, and sharing profits and losses

What’s at Stake?
  • Liabilities: All partners are agents of partnership and can therefore
      obligate the partnership...
          – …and thus all partners are personally liable on such obligations
                 • Joint liability for partnership debts
                 • Joint & Several liability for “wrongful” act of a partner
  • Control Rights: Also shared among the partners;
  • Return: Profits shared equally among the partners;
          – Shared pro rata on dissolution of partnership
          – “Forced Sale” rights upon dissolution
  • “Regulatory posture”:
          – Tax treatment; regulatory classification, flow through taxation
             means the partnership does not pay taxes on profits, the individual
             partners do, with corporations there is double taxation

Default rule votes based on one vote per person, not pro rata on shares

UPA §18 provides that: “The rights and duties of the partners in relation to the
partnership shall be determined, subject to any agreement between them, by the
following rules: … (e) All partners have equal rights in the management and
conduct of the partnership business.”

UPA §31 provides that: “Dissolution is caused: (!) Without violation of the
agreement between the partners, … (b) By the express will of any partners when
no definite term of particular undertaking is specified.”
That leaves the problem of what happens to the partnership property upon
dissolution. UPA § 18 provides in part, (a) Each partner shall be repaid his
contributions … and shall share equally in the profits and surplus.”

Fenwick’s Caution: Even though P-ship agreements can alter most rights/duties
between partners, bending the default rules too far is risky: It risks a legal
finding that no partnership existed in the first place

Lack of formality => Principal Tension:
       – Though “fit” with default rules helps to determine status...
       – …once a partnership, no need to follow default rules!
       – The “trick” for organizations worried about partnership status, but who
          dislike the UPA default rules:
          • Either live with more default rules, or take care to contract around
              them in fashion that formally resembles them.

Fenwick v. Unemployment Compensation Commission

Beauty store with receptionist, agreement says partnership, receptionist gets
20% of profits if there are any, but no control, did not bear losses, or other
Professor thinks there was a partnership
Factors: Return, Risk, Control, Duties, and Duration(can either sever)
UPA § 7(4)
       “In determining whether a partnership exists: … (4) The receipt by a
       person of a share of the profits of a business is prima facie evidence that
       he is a partner in the business…
       But …
       The Act further provides that sharing of profits is prima facie evidence of
       partnership but “no such inference shall be drawn if such profits were
       received in payment … as wages of an employee,” and it seems that is the
       legal inference to be drawn from the factual situation here.
This case is saying that if you are too successful as a transactional attorney in
giving your client all of the control then there is not a partnership

Partners vs. Owner/Employee
   • Type of Claim on Firm:
            – Employees: Usu. no capital contribution; fixed salary (+ bonus)
            – Owner: Initial contribution; residual claim of firm value
   • Control
            – Owner usually has significant control; Ee: Little/none
   • Duration: Limited or for the life of the business
            – Owner: usually entitled to stay in business indefinitely
            – Ee: fixed term employment contract or “at will”
   • Liability to Third Parties
            – Owner yes;
            – Ee: none
   • Contributions/Rights on Dissolution
            – Ee: can’t force dissolution, and only gets wages due
            – Owner: can force dissolution and gets residual surplus
But is it so simple?
Implications of the UPA as a default, “form contract”
   •   Risks (Upside and Downside)
          – PAs often allow for partner w/o capital contribution
                  • Usu. when partner has already contributed labor/expertise
   •   Control
          – Partnership Agreements (PAs) frequently designate one person to
              have managerial power;
   •   Rights on Dissolution
          – In such partnerships, the partner contributing capital would have a
              right to her capital

Partnership Fiduciary Duties

All partners are agents of the partnership. UPA §9 … and thus each partner owes
the same fiduciary obligations that any agent owes a principal;

RUPA §404 General Standards of Partner’s Conduct
     (a) The only fiduciary duties a partner owes to the partnership and the
         other partners are the duty of loyalty and the duty of care set forth in
         subsections (b) and (c).
     (b) A partner’s duty of loyalty to the partnership and the other partners is
         limited to the following:
                            (1) to account to the partnership and hold as trustee
                                for it any property, profit, or benefit derived by
                                the partner in the conduct and winding up of the
                                partnership business or derived from a use by the
                                partner of partnership property, including the
                                appropriation of a partnership opportunity;
                            (2) to refrain form dealing with the partnership in the
                                conduct or winding up of the partnership business
                                as or on behalf of a party having an interest
                                adverse to the partnership; and
                            (3) to refrain from competing with the partnership in
                                the conduct of the partnership business before the
                                dissolution of the partnership.
     (c) A partner’s duty of care to the partnership and the other partners in
         the conducting and winding up of the partnership business is limited to
         refraining from engaging in grossly negligent or reckless conduct,
         intentional misconduct, or a knowing violation of the law.
     (d) A partner shall discharge the duties to the partnership and the other
         partners under this [Act] or under the partnership agreement and
         exercise any rights consistently with the obligation of good faith and
         fair dealing.
     (e) A partner does not violate a duty or obligation under this [Act] or
         under the partnership agreement merely because the partner’s
         conduct furthers the partner’s own interest.
     (f) A partner may lend money to and transact other business with the
         partnership, and as to each loan or transaction, the rights and
         obligations of the partners are the same as those of a person who is
         not a partner, subject to other applicable law.

Young v. Jones
Partnership by estoppel
Investors relied on audit done by PW Bahamas, try to sue PW-US under
partnership by estoppel

    No evidence of actual partnership
    Plaintiffs did not show that they relied on any holding out by PW-US
    Reliance is an element of estoppel

    Under what theory could Plaintiffs have proceeded against PW-
         Apparent Agency, which has the added advantage of no
           requirement of a showing of reliance.
         But, remember the Holiday Inn case.

                       Duties of Loyalty:
                         Agency Law

      Account for                                                  Not to
         profits                                                use/disclose
      arising out                                               confidential
       of empl’t                                                information
        (§ 388)                                                  (§§ 395-6)

                     Not to act                     Not to
                     as adverse                    act with
                                     Not to      “conflicting
                                  compete in      interests”
                    (§§ 389-92)
                                  subj. matter     (§ 394)
                                   of agency
                                    (§ 393)                               9

Some Examples...
  • UPA § 20:
       – Obligation to render true and full information on all things affecting
  • UPA § 21:
       – Partners must account for profits from any transaction connected
          with formation/conduct/business of P-ship
  • UPA § 22:
       – Each partner has a right to a formal accounting of her

A Caveat within Partnerships
   • Many cases hold that partners owe fiduciary duties not only to the
     partnership as an enterprise, but also to each other as individuals

          –   Not at issue with agency law (where the principal is only one
          –   Generally not so in corporations law (where SHs usually don’t owe
              fiduciary duties to each other)

Partnership Opportunities
   • A Partner must disclose the partnership opportunity
   • Then the managing partner(s) must decide whether to act on that
   • BUT, that decision must be made in good faith.
Doctrine of Organizational Opportunities
    To what extent do business opportunities of which a fiduciary learns
       belong to the firm rather than the individual?
           Agency Restatement § 387: “Unless otherwise agreed, an agent is
             subject to a duty to his principal to act solely for the benefit of the
             principal in all matters connected with his agency.”
           Corporate opportunities doctrine
Boundaries of the standard; or “there are distinctions of degree”
    Joint enterprise/venture v. general partners
           Andrews v. Cardozo
    During the partnership v. at its end
           UPA (1997) § 404(b)(1)
    Geographic?
           No liability if a “location far removed”
    Status of partner (Managing v. silent)
    Cardozo is ambiguous both as to the standard and its boundaries

Meinhard v. Salmon
Facts: One partner goes behind the back of the other partner and negotiates to
develop a new building after the partnership is to end.
   •    Why did Cardozo side with Meinhard?
          – In particular, where did Salmon go wrong?
             The trouble about his conduct is that he excluded his coadventurer
             from any chance to compete, from any chance to enjoy the
             opportunity for benefit that had come to him alone by virtue of his
   • What should Salmon have done?
          – DISCLOSE!
   • Would disclosure alone suffice?
          – “The punctilio of an honor most sensitive”
          – “The thought of self was to be renounced”
   • Cardozo seems to suggest that more might be required… Does Salmon
       have to give Meinhard the opportunity to be a partner in the new

Policy: Is Meinhard the right default?
     Hypothetical bargain
            If partners can withhold new information—such as the discovery of
              a new business opportunity—from each other, then each has an
              incentive to drive the other out so as to take full advantage of the
            As each incurs costs to exclude the other, or to take precautions
              against being excluded, the value of the firm declines
            A legal rule vesting the firm with a property right to the information
              and requiring disclosure is more efficient
     Suppose Meinhard and Salmon want a different rule. Maybe that neither
       partner owes fiduciary duties to the other. Is that valid?
            Compare UPA (1997) § 404(b)(1) and § 103(b)(3)
            Partnership agreement “may not . . . (3) eliminate the duty of
              loyalty under Section 404(b) . . . but: (i) the partnership agreement
              may identify specific types or categories of activities that do not
              violate the duty of loyalty, if not manifestly unreasonable”
            Note the difference between a prospective waiver and a
              “ratification” after the fact RUPA §103(b)(3) (ii)

Bane v. Ferguson
Facts: Bane retired from Isham, Lincoln & Beale and became entitled to a
       pension that would end if the firm dissolved. Later ILB merged with
       Rueben & Proctor. The merger turned out to be a disaster and the
       merged firm dissolved. Bane sues, claiming mismanagement in arranging
       the merger.
Held: “Nor can Bane obtain legal relief on the theory that the defendants
       violated a fiduciary duty to him; they had none.”
    At the time of the alleged violation, was Bane a partner in ILB?
            No, he had a contractual relationship with the firm. Although some
                might argue Bane continued to have “partner-like” status, at least
                with regard to the firms viability and profit.
    The Court says ILB had no duty to Bane and even if there is a duty the
       defendants are protected by the business judgment rule (or something
       like it).
            Harming the partnership would normally be thought of as a
                violation of the duty of care, but maybe such conduct can also be
                thought to be disloyal – at least if egregious enough.

Grabbing and Leaving:
Meehan v. Shaughnessy
Facts: Partners want to leave firm,
       1. Approached Cohen, another partner, and asked her to join them in the
         new firm of Meehan Boyle & Cohen (MBC). She agreed.

       2. They asked three associates to follow them to MBC. They agreed.
       3. Two of the departing lawyers met with one of the clients to convince it
          to route its business to MBC. It agreed.
       4. After notifying the firm on November 30, 1984, that they would form
          MBC January 1, 1985, they wrote letters to their clients inviting them to
          move their business to MBC.
       The partnership agreement varied from usual fiduciary duties, with regard
       to taking work with you.
       PC alleged:
            1. Boyle told one of the other lawyers who was leaving (Schafer) to
                 manage his cases in a way that would defer payment to 1985.
            2. When a PC partner left (in an unrelated affair), Boyle reassigned
                 most of his cases to Schafer and himself.
    The PC partnership agreement required that departing partners give the
       firm 3-months’ notice. For reasons not explained, PC waived this
    The agreement also provided that partners could take with them pending
       cases, so long as they paid the firm an appropriate fee.
   MBC breached their duties to the partnership, but how?
       1. They contacted their clients in December in a way that did not fairly
            give the clients a choice to stay with PC, they gained an unfair
            advantage over PC(their former partners) in breach of their fiduciary
       2. Until December, they lied to their partners about their plans to leave.
            A partner has an obligation to render on demand true and full
            information of all things affecting the partnership to any partner. UPA
   Fiduciaries may plan to compete with the entity to which they owe allegiance,
   “provided that in the course of such arrangements they do not otherwise act
   in violation of their fiduciary duties.”
       • (1) Does the holding imply that M & B have an affirmative duty to
            inform the other partners of their plans to leave?
                 – No
       • (2) Suppose that the defendants had never lied about their intentions,
            and had made an announcement on private letterhead,
                 – the morning after they leave the firm;
                 – making clear that clients could stay with firm;
        Meehan is not the last word on client contact.
        Context (i.e., motivations, actors, and partnership agreement) is

Grabbing and Leaving: Permissible v. Impermissible
Locate office   Negotiate        Negotiate with   Negotiate with
space           merger with      fellow partners  associates (can’t
                another firm                      steal associates, but
                                                                    can make plans known)

Contact clients        Contact clients        Remind clients of     Not inform
before announce        before leaving         right to have         clients of right to
departure (probably    firm                   counsel of own        have counsel of
can’t say come with                           choice                own choice
me, but can relay

                       Keep plans             Deny plans when
                       confidential           asked

                       Take client files      Take desk files

    Many firms explicitly ban such behavior in partnership agreements, thus altering
    the fiduciary duties.

         ABA Standards: Guidelines for Notice to Clients

   Notice is mailed                              Sent promptly after change

     Sent to clients with whom                  Does not urge client to sever
  lawyer had an active attorney-               her relationship with former
        client relationship                   firm and does not recommend
                                              hiring the lawyer’s (though it
                                                 can say lawyer willing to
    Related to open and pending
                                               continue her responsibilities)
   matters for which lawyer had
   direct personal responsibility
     to the client immediately                  Makes clear client can decide
         before the change.                          whether to stay

                                Is brief, dignified, and not
                               disparaging of former firm

Lawlis v. Kightlinger & Gray
Facts: partner becomes an alcoholic, other partners outline a series of steps for
        him to take, they sign agreement that specifically says no second chances,
        starts drinking again, partners outline a series of steps for him again and
        this time he recovers, demands his full partnership position back,
        Wampler notifies him that they are going to recommend his severance,
        and they remove all files from his office, then they vote to fire him.
     Wrongful dissolution claim
             Rejected by court; Wampler simply announced what the other
                partners intended to do he did not dissolve the partnership without
                the vote called for in the agreement.
     Breach of fiduciary duty – claiming they violated the implied duty of good
        faith and fair dealing firing him for the predatory purpose of increasing the
        partner to associate ratio
             Partners had right to do as they did by contract (“guillotine”
                clause(no cause expulsion)) and breached no fiduciary duty
Self interest alone does not make for a breach of fiduciary duty, it is true they
will make more money by kicking him out, but that does not mean they are
kicking him out for that purpose

How do we square the court’s approval of the guillotine provision with Cardozo’s
famous proclamation in Meinhard that partners should be selfless?
They can be selfless with regard to themselves, but that doesn’t mean they have
to be selfless with regard to the other partner’s interest, but any way any
selflessness is trumped by the contract
     Assume no expulsion provision in partnership agreement. May firm expel
        Lawlis or otherwise disassociate itself from him?
            Consider:
                    UPA (1914) § 32(1)(b) or (d) incapable of performing his
                      part of partnership contract, or willfully or persistently
                      commits a breach of the partnership agreement, or
                      otherwise so conducts himself in matters relating to the
                      partnership business that it is not reasonably practicable to
                      carry on the business in partnership with him
                    RUPA §601

Disassociation – when a partner leaves a law firm, instead of having the
partnership dissolved and then reformed without the partner who left
Under the RUPA 601 there are three instances when a partner can be

Effect of Assigning Partnership Interest
Putnam v. Shoaf
         The Shoaf’s are actually being paid to take over Mrs. Putnam’s interest in
         the partnership
         They discover that the bookkeeper has been embezzling from the firm.
         They sue and recover 68k.
         Mrs. Putnam claims she was entitled to this recovery.
           Putnam loses
              She had no specific interest in the unknown damages to separately
              convey or retain, and she conveyed her partnership interest to the
     Is the court treating the partnership as an entity or an aggregate?
          An entity
           UPA (1997) § 201(a): “a partnership is an entity distinct from its
           UPA (1997) § 203: “Property acquired by a partnership is property
              of the partnership and not of the partners individually.”
The point is when you buy an interest in a partnership you are buying the whole

Creditors’ Access to Firm and Personal Assets

A partnership is a separate entity UPA 201, 203
You don’t own a third of everything the partnership owns, but you own a third of
the partnership
    Creditor of firm seeks to attach personal assets of a partner to collect
       debt. Allowed?
           Yes, but many states require that the creditor first proceed against
              the partnership
           Hint: UPA (1997) § 306
          (a) “Except as otherwise provided in subsections (b) and (c), all
              partners are liable jointly and severally for all obligations of the
              partnership unless otherwise agreed by the claimant or provided by
          (b) A person admitted as a partner into an existing partnership is not
              personally liable for any partnership obligation incurred before the
              person’s admission as a partner.
          (c) An obligation of a partnership incurred while the partnership is a
              limited liability partnership, whether arising in contract, tort, or
              otherwise, is solely the obligation of the partnership. A partner is
              not personally liable, directly or indirectly, by way of contribution or
              otherwise, for such an obligation solely by reason of being or so
              acting as a partner. This subsection applies notwithstanding
              anything inconsistent in the partnership agreement that existed
              immediately before the vote required to become a limited liability
              partnership under Section 1001(b).
    Personal creditor seeks to attach firm assets. Can the creditor seize
       partnership property to satisfy the debt?
           No, because the partner can’t touch partnership property and the
              creditor can’t touch more than the partner, the creditor can get in
              front of money coming out of the partnership in proportion to the
              ownership interest of the partner in the partnership
           Hint: UPA (1997) § 501 and 504(e)
              § 501
              A partner is not a co-owner of partnership property and has no
              interest in partnership property which can be transmitted, either
              voluntarily or involuntarily.
              § 504(e)
              This section provides the exclusive remedy by which a judgment
              creditor of a partner or partner’s transferee may satisfy a judgment
              out of the judgment debtor’s transferable interest in the
    Is the creditor out of luck?
           No they can get in between some of the money coming out of the
           Hint: UPA (1997) § 504(a)-(b)

                 (a) On application by a judgment creditor of a partner or of a
                     partner’s transferee, a court having jurisdiction may charge
                     the transferable interest of the judgment debtor to satisfy
                     the judgment. The court may appoint a receiver of the
                     share of the distributions due or to become due to the
                     judgment debtor in respect of the partnership and make all
                     other orders, directors, accounts, and inquiries the judgment
                     debtor might have made or which the circumstances of the
                     case may require.
                 (b) A charging order constitutes a lien on the judgment debtor’s
                     transferable interest in the partnership. The court may
                     order a foreclosure of the interest subject to the charging
                     order at any time. The purchaser at the foreclosure sale has
                     the rights of a transferee.

Partnership Capital
    Initial capital contribution
          A partner may contribute labor.
    Capital Account:
          The way you keep track of what you have put into the partnership
             is the capital account.
          A running balance reflecting each partner’s ownership equity
                  UPA (1997) § 401(a)
                     Each partner is deemed to have an account that is:
                        (1) credited with an amount equal to the money plus the
                            value of any other property, net of the amount of any
                            liabilities, the partner contributes to the partnership
                            and the partner’s share of the partnership profits; and
                        (2) charged with an amount equal to the money plus the
                            value of any other property, net of the amount of any
                            liabilities, distributed by the partnership to the partner
                            and the partner’s share of the partnership losses.
          Allocation of profits increases capital account
          Allocation of losses decreases capital account
          Taking a “draw” (distribution) decreases capital account

                                   Alice                   Bob

   Year 2 Capital                $9,000                     $0
   Account Balance
   Year 3 Profit                 $2,000                   $2,000

   Year 3 Draw                   $1,000                   $1,000

   Year 3 Capital                $10,000                  $1,000
   Account Balance

Partnership Profits
    Profits divided equally per capita(person) not pro rata. UPA (1914) §
     18(a); UPA (1997) § 401(b)
    Partnership agreement provides for profits to be divided: 90% to Alice;
     10% to Bob. Agreement silent on losses. How are losses allocated?
         Losses follow profits, absent contrary agreement. UPA (1914) §
             18(a); UPA (1997) § 401(b)

Raising Additional Capital
The Free Rider Problem

Agreement can state that the managing partner can issue a call for additional
funds and provides that if any partner does not provide the funds called for, his
share is reduced, according to the existing formula. This is sometimes referred
to as pro rata dilution.

Another approach is called penalty dilution, where the partnership agreement
might provide that if the managing partner determines that additional funds are
needed, new points will be offered to the partners at a price of $250 each. (This
would be called 4 to 1 dilution, since the original points were sold for $1,000)

Another approach requires partners to make loans to the partnership, pro rata,
when called upon by the managing partner to do so. The loans might for
example bear interest at three percent above the prime rate, with no
distributions to be made to the partners until the full amounts of the loan and
interest are paid. The tough problem is to specify the consequences of a failure
of a partner to comply with a request for loan money. One possibility is to allow
the non-defaulting partners to make the loan and compensate them for doing so
by providing for repayment of, say, 110 percent of the amount loaned, plus

The right to buy new shares in a company are called pro rata rights your right to
participate in any new investment at the same percentage of your interest in the
business, you want that to prevent dilution (other people buying more of the
company or you selling more pieces of the company your share of the company
decreases), and punishes those who don’t reinvest, and it increases your returns
the right to invest at the same price can be incredibly useful if the shares are
becoming more valuable

Another approach is to provide in the partnership agreement that the managing
partner can sell new partnership shares to anyone at whatever price can be
obtained. This is comparable to a corporation selling new shares of its common
stock in order to raise new equity funds.

Resolving Disagreements among Partners
  • The UPA grants all partners the (default) “all partners have equal rights in
     the management and conduct of the partnership business,”
        – UPA § 18(e)
  • But if the partners disagree, whose viewpoint wins out?
        – Hint: UPA § 18
        § 18(h) “any difference arising as to ordinary matters connected with
        the partnership business may be decided by a majority of the

National Biscuit Company v. Stroud (decided under UPA (1914) not (1997))
Facts: Stroud and Freeman formed a partnership to run a grocery store. Stroud
       told National Biscuit that he would not be personally liable for any more
       bread it sold to the store. Freeman ordered more bread and National
       Biscuit sued Stroud for payment.
            Remember: full personal liability for debts of the partnership. If the
              partnership is liable on the contract, then so is Stroud.
UPA § 9(1) (1914):
       Every partner is an agent for the partnership for purposes of its business,
       and act of every partner … for apparently carrying on in the usual way the
       business of the p-ship … binds the p-ship, unless
           – the partner so acting has in fact no authority to act for the
              partnership in the particular matter, and
           – the person with whom he is dealing has knowledge of the fact that
              he has no such authority.
UPA 1997 changes it to: UPA (1997) § 301(1): “Each partner is an agent of the
       partnership for the purpose of its business. An act of a partner, including
       the execution of an instrument in the partnership name, for apparently
       carrying on in the ordinary course the partnership business or
       business of the kind carried on by the partnership binds the

      partnership, unless the partner had no authority to act for the
      partnership in the particular matter and the person with whom the
      partner was dealing knew or had received a notification that the
      partner lacked authority.”
    • Since a majority of the partners did NOT vote to end Freeman’s authority
       to buy bread on credit from Nabisco, the partnership was not bound by
       Stroud’s objections.
    • The partnership is bound by Freeman’s orders since he is an agent of the
    • If the Partnership is bound, then so is Stroud
    • The only way for Stroud to end his potential liability was to dissolve the
       partnership and notify the suppliers.
If he had gone out and bought diamonds then the question would be is this in
the ordinary course of business.
You could argue you are changing the nature of the partnership so you need
     Planning: What terms could be inserted into a partnership agreement to
       avoid these problems in the future?
            Allocate controlling interests;
            Appoint a “tie-breaker”;
            Require unanimous partner consent before doing business with a
              supplier (and notify creditors).

Day v. Sidley & Austin
(Illustrates extent to which courts allow partnership agreement to derogate from
Facts: firms merge, Washington office becomes run by co-chairmen, partner
        claims he was promised to be the chair of the Washington office when he
        joined the firm and that the decision to appoint co-chairmen was made
        prior to the merger and defendant’s concealment of that decision was a
        material omission and without that prior information his vote of approval
        for the merger would not have been given.
Day’s Three Main Claims:
      Misrepresentation: S&A’s executive committee engaged in material
        misrepresentations that induced his assent, and thus agreement is
      Breach of K: He had a contractual right to remain the sole chair of the DC
      Breach of Fiduciary Duty: Secrecy of EC about merger
Defendants claim that any possible taint of plaintiff’s vote in favor of the merger
is of no consequence because only a majority was required.

Court says plaintiff was not deprived of any legal right as a result of his reliance
on the statements. The partnership agreement sets forth in detail the
relationship between the partners and no mention is made of plaintiff’s status in
the Washington office, and the partnership agreement seemed to embody the
complete intentions of the parties as to the management of the firm.
Breach of Contract
Under the partnership agreement partners could be admitted and severed from
the firm and the partnership agreement could be amended by majority approval.
The merger could be considered either as the admission of new partners or the
making of a new or amended agreement, and thus majority approval was all that
was required, and a post facto change in plaintiff’s vote would be of no effect.
Plaintiff claims that the merger was such a fundamental change in the nature of
the partnership as to require unanimous approval, but common law and
statutory standards can be overridden by agreement.
Breach of Fiduciary Duty
The basic fiduciary duties are: 1) a partner must account for any profit acquired
in a manner injurious to the interests of the partnership, such as commissions or
purchases on the sale of partnership property; 2) a partner cannot without the
consent of the other partners; acquire for himself a partnership asset, nor may
he divert to his own use a partnership opportunity; and 3) he must not compete
with the partnership within the scope of its business.
What plaintiff is alleging concerns failure to reveal information regarding changes
in the internal structure of the firm. No court has recognized a fiduciary duty to
disclose this type of information.

Rights to Manage the Partnership
   • Recall that under UPA § 18e
          – Each partner has equal rights to manage ==> right to a voice; to
             be consulted

Background Knowledge
         – Under UPA 1914, when even one partner leaves the partnership it
            is dissolved, the agreement may however contain a provision
            specifying that the remaining partners will continue as partners
            under the existing agreement in a continuation agreement.
         – Under UPA 1997, if a partner retires pursuant to an appropriate
            provision in the partnership agreement there is a dissociation rather
            than a dissolution. When there has been a dissociation, the
            partnership continues as to the remaining partners and the
            dissociated partner is entitled, in the absence of an agreement to
            the contrary, to be paid an amount determined as if “on the date of
            dissociation, the assets of the partnership were sold as a price
            equal to the greater of the liquidation value or the value based on a

               sale of the entire business as a going concern without the
               dissociated partner.” §701(a) and (b)

Default rule is that losses follow profits
Dissolution must be carried out in good faith.

Expulsion provisions (review)
   • Allow the partners, on a specified majority vote, to remove a partner.
          – Recall:
                 • In UPA jurisdictions, expulsion is in reality a “dissolution” of
                     the partnership, followed immediately by a reconstitution
                     with all non-expelled partners.
   • Fiduciary duties constrain exercise of such provisions, but only as regards
       certain motives:
          – Self-interest, freeze-outs, bad faith, etc.
          – Otherwise, partnership law gives a fairly wide berth

Dissolution v. Going out of Business
    Dissolution is not the same as going out of business:
           A dissolution is simply the “change in relationship of the partners
              caused by any partner ceasing to be associated in the carrying on”
              of the firm’s business. UPA (1914) § 29.

3 Phases of Demise for a Partnership under the U.P.A.
            1                                 2                             3

      Dissolution                  Winding Up                  Termination

The Right to Dissolve
    “there always exists the power, as opposed to the right, of dissolution”—
       Collins v. Lewis
           Dissolution by will of one or more partners. E.g., UPA (1914) §
           Dissolution by operation of law. E.g. death, UPA (1914) § 31(4)
           Dissolution by court order. E.g. lunatic, UPA (1914) § 32(1)(a)

Causes of dissolution (UPA § 31)
   • “Extraneous” Causes:
          – Death, bankruptcy, impossibility, and/or special equitable decree
             (see § 32).
UPA § 32(1)

   •   Commands dissolution decree in the event that:
           (a & b) A partner becomes incapacitated from performing;
           (c) A partner’s misconduct prejudicially affects business;
           (d) A partner willfully/persistently breaches PA or otherwise
           conducts him/herself in a way that makes the ongoing relationship
           impractical to carry on;
           (e) The business can only be operated at a loss;
           (f) Other circumstances render dissolution equitable;

Term Partnerships
    Explicit term
          Duration specified in partnership agreement
          Specific purpose/object specified in partnership agreement
    Implicit term
          Term implied by the nature of the partnership purpose/objectives.
             (e.g. the partnership plans to build and sell new condos at the

            Disassociation and Dissolution: UPA (1997)

   Disassociation                  Business continued per Article 7
       § 601                   •    Purchase of disassociated partner’s
                                    interest (§ 701)
                               •    Disassociated partner not
                                    automatically released for
                                    obligations before disassociation(§ 703)

                               Business dissolved per Article 8
                               •    Events of dissolution (§ 801; x-ref §
                               •    Business must be “wound up”

Dissolution: Effect on Partnership
    After dissolution, the partnership must be wound up, absent agreement
       among the partners to carry on the business.
           Assuming that the business will not be continued, the winding up
              process generally contemplates that the firm’s assets will be
              distributed to the partners.
    Authority of partners to act on behalf of partnership terminated except in
       connection with winding up of partnership business. UPA (1914) § 33;
       UPA (1997) § 804.

Continuation per Agreement: Effect on Partnership
    Technically creates a new partnership
           Recall confusing treatment of this issue in Putnam v. Shoaf
    Creditors of former partnership automatically become creditors of new
      partnership. UPA (1914) § 41.

Continuation per Agreement: Effect on Departing Partner
    Departing partner entitled to accounting
           Fair value of partnership
           Interest from date of dissolution in event of unreasonable failure to
    Departing partner remains liable on all firm obligations unless released by
      creditors. UPA (1914) § 36; UPA (1997) § 703.

Continuation per Agreement: Effect on New Partners
    If a new partner joins the firm when it continues after a dissolution, the
      new partner is also liable for the firm’s old debts, but such liability can
      only be satisfied out of partnership property. UPA (1914) § 41(1); UPA
      (1997) § 306(B).
           The new partner can not be held personally liable for the old debts,
             unless he or she expressly agrees to be so held.

UPA (1914) § 18
   “The rights and duties of the partners in relation to the partnership shall
      be determined, subject to any agreement between them, by the following
   “(a) Each partner shall be repaid his contributions, whether by way of
      capital or advances to the partnership property and share equally in the
      profits and surplus remaining after all liabilities, including those to
      partners, are satisfied; and must contribute towards the losses, whether
      of capital or otherwise sustained by the partnership according to his share
      in the profits.”
UPA (1914) § 40
   § 40(b): subject to contrary agreement, upon dissolution partnership
      assets should be distributed as follows: “(I) Those owed to creditors other
      than partners, (II) Those owed to partners other than for capital and
      profits, (III) Those owed to partners in respect of capital, and (IV) Those
      owed to partners in respect of profits.”
   § 40(d): "partners shall contribute, as provided by [§18(a)] the amount
      necessary to satisfy the liabilities [set forth in § 40(b)]. . . ."
What is the Default Rule?
   Losses should follow profits

Buyout Agreements
   What are the major concerns:
         Restricting the right to sell “stock” to whomever I please.
         Providing the right to force the company or other owners to buy
            back my “stock”.
   What provisions might be included in our buy-sell Agreement?
         Right of First Refusal
         Right to require purchase of my stock
                Right of First Refusal and right of company to purchase on
                  dissociation are not the same, right of first refusal is the
                  right to preempt the sale you want to carry out, not the
                  company forcing you to sell.
         Stock Transfer restrictions
         Right of Company to purchase on death, disability, dissociation.
         Traditional buy-sell
                One person gets to decide if they want out. I want to
                  activate buy-sell. The other person gets to set the price.
                  Other person gets to decide whether they want to buy or sell
                  at that price.
   What devices can be used to establish price?
      Appraisal
      Formula
      Book Value - add up the value, subtract the liabilities, sometimes this
        is more than the value sometimes it is less
      Buy sell arrangement that sets the price
      Fixed amount

G&S Investments v. Belman
Facts: Partner Nordale becomes a crack head, causes a lot of problems
       G&S want to kick him out of the partnership they sue for dissolution,
       Nordale objects, he dies, then G&S try to exercise the buy out clause in
       the agreement
       Even though this was a limited partnership we are using the general
       partnership rules because Nordale was a general partner.
       The partners argue that his conduct, in contravention of the partnership
       agreement, gave the court the power to dissolve the partnership and
       allow them to carry on the business by themselves.
       §32 (1914) authorizes a court to dissolve a partnership when:
           2. A partner becomes in any other way incapable of performing his
           part of the partnership contract.
           3. A partner has been guilty of such conduct as tends to affect
           prejudicially the carrying on of the business.

           4. A partner willfully or persistently commits a breach of the
           partnership agreement, or otherwise so conducts himself in matters
           relating to the partnership business that it is not reasonably practicable
           to carry on the business in partnership with him
        Court says filling the complaint did not constitute a dissolution of the
        partnership requiring the liquidation of the assets and distribution of the
        net proceeds of the partners.
        If filling the complaint was a dissolution then he would get the current
        market value of the real estate which had gone up.

Funding the Buyout Clause
    Buyout triggered by death
           “Key man” life insurance funds buyout
    Buyout triggered by retirement
           Use pension fund?
    Buyout by partners or by partnership?
           Lump sum or installment?

      (1) Under UPA (1914) dissociation of a partner automatically
      triggered dissolution.
      Regardless of whether disassociation breached Partnership Agreement.
      (2) Under RUPA §§ 701 and 801, dissolution may or may not be
      (3) But the “wrongfulness” of the dissolution (or the dissociation)
      does affect the options of the parties after dissolution or
      E.g., forced sale; continuation option; suit under wrongful dissolution
      E.g. buyout price less damages and potential delay until end of term
      (4) Term of p-ship may be implied from other evidence
      (5) Watch out for implied duties! Dissociation may constitute
      breach of Partnership Agreement if in bad faith or if the purpose
      is to freeze out -- breach of fiduciary duty.

Wrongful Dissolution
  • Critical question revolves around characterizing whether the dissolution
        that occurred breached any express/implied terms in the Pship Agrmnt. or
        occurred before the end of the Pship Term
           – If “yes” => Wrongful; If “no” => Legitimate
   •    Two frequent situations:
          – X dissolves partnership, asserting that it is a partnership at will. Y
              objects, claiming that the partnership is for a term, or for
              completion of a specific uncompleted task;

          –   X dissolves partnership, using authority given in P.A. Y still objects,
              claiming that X’s decision is in bad faith, constituting a breach of
              fiduciary duty.
                            The Stakes (UPA § 38)
     “Non-Wrongful” Partners                         “Wrongful” Partners

   Right to force liquidation and                    No liquidation right
   pro-rata distribution of P-ship

    Option to continue P-ship at              No option to continue. If others
  termination with other partners            do, wrongful partner may have to
            who remain                                wait for share

 Right to bring legal action against              No legal cause of action.
   “wrongful” party (if any) for
           breaching PA

Wrongful Dissociation Under RUPA
  • Under RUPA a partner who wrongfully dissociates will be entitled to the
     greater of liquidation value of going concern value (its value as an
     operating business, Amazon example), Minus damages. RUPA section
     701(b and c)
  • A partner who wrongfully dissociates will have to wait for payment until
     the end of the term or undertaking, unless she can show a court that
     there will be no “undue hardship” to the business of the partnership.
     RUPA §701(h) It is calculated at the time the dissolution occurred, then
     plus interest.

Dividing Profits / Losses
Jewel v. Boxer
Facts: law firm breaks up, no written partnership agreement
Held: In the absence of a partnership agreement, the UPA requires that
        attorney’s fees received on cases in progress upon dissolution of a law
        partnership are to be shared by the former partners according to their
        right to fees in the former partnership, regardless of which former partner
        provides legal services in the case after the dissolution.
It is unclear whether RUPA 401(h) gets us out of Jewel or not

Last Comments on Jewell
   • Champion v. Superior Court (CA, 1988):
        – Chose not to follow Jewel in case of withdrawal of partner (but PA
           agreement provided for survival of p-ship).
               • If a partner withdraws, but...
               • her share is not large portion of firm’s work...
               • then there is no pro-rata sharing imposed during winding up
   • RUPA § 401(h):
        – A partner is not entitled to remuneration for services performed for
           the partnership, except for reasonable compensation for services
           rendered in the winding up of the business of the partnership.

   Policy: What effect might the court’s ruling in Jewel have on future law firm
          – Incentive to dump cases right before dissolution

Meehan v. Shaughnessy
   • The Parker Coulter Partnership Agreement provides that PC is entitled to a
       “fair charge” for cases removed by a departing partner.
   • PC takes all other unfinished business that is not removed and is NOT
       required to pay any charge, fair or otherwise.
   • This is different from the Jewel rule which was the default rule
   • For cases improperly removed, MB must pay damages (less overhead)
       (i.e. disgorge profits)
           – Winds up being 89.2% which is what their percentage would have
               been had they stayed at PC.
           – Money treated as constructive trust like with breach of agent’s duty
               of loyalty cases.

   •   What would you have asked PC to include in the Partnership Agreement to
       improve MB’s result?
       A fair share cost for PC

Unlimited Liability in General Partnership UPA v. RUPA
   • UPA (1914) § 15 “All partners are liable: (a) Jointly and severally for
       everything chargeable to the partnership under sections 13 and 14 [i.e.,
       mainly torts]; (b) Jointly for all other debts and obligations of the
   • UPA (1997) § 306(a): “... all partners are liable jointly and severally for all
       obligations of the partnership unless otherwise agreed by the claimant or
       provided by law”

   • MBCA § 6.22(b): “... a shareholder of a corporation is not personally liable
     for the acts or debts of the corporation except that he may become
     personally liable by reason of his own acts or conduct”

Rise of unincorporated limited liability entities
   • Limited partnerships
              Defined: A partnership formed by two or more persons and having
                     one or more general partners and one or more limited
              Formation: The limited partnership is formed by filing documents
                     required by statute.
                 • Typically filed with Secretary of State
              Tax aspects:
                 • Pre-Tax Reform Act of 1986, significant tax shelter
                 • Post-TRA, those advantages eroded but still widely used to
                     generate passive losses
              General Partner Liability in Limited Partnerships
                 • Full personal liability
                 • BUT!
                         – Corporation may serve as general partner
   • Limited liability companies (LLCs)
   • Limited liability partnerships (LLPs)
   • Limited liability limited partnerships (LLLPs)
          • Limited Partner Liability in Limited Partnerships
                 • ULPA (1976): “A limited partner shall not become liable as a
                     general partner, unless, in addition to the exercise of his
                     rights and powers as a limited partner, he takes part in the
                     control of the business.”
                         – What constitutes control?
                                • Holzman
                                        • 2 Limited liability partners 1 general
                                            partner, limited partners decided
                                            themselves what crops to plant, to fire
                                            the general partner, and the agreement
                                            allowed two of the three partners to
                                            draw checks from partnership bank
                 • RULPA (1985) § 303(a)
                         – Only limited partners who participate in control can
                             be held liable

       – They can be held liable only to those who reasonably
         believe based on the limited partner’s conduct that
         they are a general partner.
             • But cf. Mount Vernon: A limited partner who
                disregards the limited partnership form to such
                an extent that he becomes substantially the
                same as a general partner has unlimited
                liability regardless of a plaintiff’s knowledge of
                his role. At the same time, a limited partner
                may have unlimited liability for exercising less
                than a general partner’s power if the fact that
                he acted as more than a limited partner was
                actually known to the plaintiff.
      • The Final Word: If a limited partner is known by the
         creditors to be a limited partner then it does not
         matter if they participate in control, it has to be really
         egregious control and then the Mount Vernon kicks in
         and they are liable.
•   RULPA (1985) § 303(b)
      – provides “ a limited partner does not participate in
         control solely by consulting with and advising a
         general partner with respect to the business of the
         limited partnership.



                  P-Ship & Corporate Status Compared
                      General Partnership                Corporation
  Lim. Liab.          No (but PA can have           Yes (but creditors may
                     indemnity provisions)            seek guarantees)

  Free transf     No (default)                    Yes (default)
  Continuity      At will (default)               Indefinite (default)
  Fid. Duties     Care/loyalty (def/imm)          Care/loyalty (def/imm)
    Mgmt.         Decentralized (default)         Centralized (default)
  Flexibility     Excellent                       Sometimes Awkward
  Formation       Informal                        Formalities Req’d
     Tax          “Pass-through”                  Double on earnings; Corp
  Treatment                                       only on losses.

In a corporation only the board of directors have a duty of care and duty of
loyalty not the shareholders because they are not a part of the management.

Corporation shareholders don’t pay taxes unless there is a dividend.

Critical corporate attributes
   1. Legal personality
   2. Limited liability
             See, e.g., MBCA § 6.22(b):
             “Unless otherwise provided in the articles of incorporation, a
             shareholder of a corporation is not personally liable for the acts or
             debts of the corporation except that he may become personally
             liable by reason of his own acts or conduct.”
   3. Separation of ownership and control
           MBCA § 8.01(b): “All corporate powers shall be exercised by or
             under the authority of, and the business and affairs of the
             corporation managed by or under the direction of, its board of
           Shareholders entitled to vote on:

                     Election of directors (MBCA §§ 8.03-.04)
                     Any amendments to the articles of incorporation and,
                      generally speaking, by-laws (MBCA §§ 10.03, 10.20)
                     Fundamental transactions (e.g., mergers; MBCA § 11.04)
                     Odds and ends, such as approval of independent auditors
   4. Liquidity
                 • Secondary trading markets
   5. Flexible capital structure
          Capital structure:
                  The permanent and long-term contingent claims on the
                     corporation’s assets and future earnings issued pursuant to
                     formal contractual instruments called securities
                  Many ways to package such claims; e.g., stocks and bonds
   6. The corporation is an entity with separate legal existence from its owners
         1. Legal fiction, but a useful one
         2. Possesses (some) constitutional rights
         3. Separate taxpayer

S Corporation
    • Statutory creation of tax code.
           – Usually a “close” corporation
    • Principal advantage:
           – Combines pass-through taxation with limited liability.
    • Disadvantages:
           – Constraints on # of shareholders, types of shareholders (other
                companies can’t hold stock), capital structure you can only have
                one type of stock capital structure, limits on how you can deduct
                pass-through losses.
A simpler structure, usually a small closed corporation
Advantages: pass through taxation, and limited liability
Up till LLC’s it was the best thing to use for pass through taxation and limited
A c corporation is the normal corporation

Debt and equity securities
  • Bonds and other debt securities typically consist of two distinct rights:
         – The bondholder is entitled to receive a stream of payments in the
             form of interest over a period of years
         – At the end of the bond’s prescribed term (i.e., at maturity), the
             bondholder is entitled to the return of the principal
  • Creditors; not owners
  • Equity securities (a.k.a. shares) represent “the units into which the
      proprietary interests in the corporation are divided”

          –   Residual claimants: equal right to participate in distributions of the
              firm’s earnings and, in the event of liquidation, to share equally in
              the firm’s assets remaining after all prior claims have been satisfied
          –   A limited right to participate in corporate decision making by
              electing directors and voting on major corporate decisions

Capital structure terminology
  • Authorized shares: The articles must specify the number of shares the
      corporation is authorized to issue.
  • Outstanding shares: The number of shares the corporation has sold and
      not repurchased.
  • Authorized but unissued shares: shares that are authorized by the charter
      but which have not been sold by the firm.
  • Treasury shares: shares which were once issued and outstanding, but
      which have been repurchased by the corporation
         – The MBCA has eliminated the concept of treasury shares, so that
             reacquired shares under the RMBCA are simply classified as
             authorized but unissued shares.

Issuance of stock
   • Board of directors prerogative.
        – Shareholders involved only if:
                 • Board wants to sell more shares than are presently
                    authorized in its charter
                 • Board of directors wants to issue a new class of shares not
                    authorized in the charter
        – So long as the charter authorizes the class of shares in question
            and there are sufficient authorized but unissued shares, the board
            is free to sell shares for “any valid purpose” as long as the
            corporation receives adequate consideration for the shares.

Corporations: Sources of Law
  • Statutory and Case Law within each state
  • Because of specificity of codes, the relative incentive to contract around
     corporate code may be smaller

The incorporation process
Choosing a state of incorporation
Paul v. Virginia (US 1869) A state may not exclude a foreign corporation engaged
in interstate commerce
Foreign = another state
Alien = another country

                         The Incorporation Process

                                                          = Inc.
                                                            (MBCA § 2.03)
 1. Draft articles of              2. File articles
    incorporation                 with Secretary of
                                  State (not Colin
               The                     Powell)
           (MBCA § 2.01)                         Mandatory terms (MBCA § 2.02(a))
                                                 Optional terms (MBCA § 2.02(b))

    • Draft bylaws (MBCA § 2.06)
    • Organizational meeting (MBCA § 2.05)
          – Name directors, if necessary
          – Adopt bylaws
          – Appoint officers
    • Issue stock
Final Steps:
(1) Adopt By-Laws
(2) Issue Stock (SEC Filings)
(3) Appoint Officers

   • Promoter: Someone who purports to act as an agent of the business prior
     to its incorporation. A “promoter” is a person who identifies a business
     opportunity and puts together a deal, forming a corporation as the vehicle
     for investment by other people.
Principal Problem w/ Promoters:
Enter agreements and contracts with 3d parties on behalf of an as-yet fictional
1. Once the articles are filed, does the corporation become a party to the
          – Yes, but not automatically. The corporation must “adopt” the
          – Adoption can be effected:
                 • Expressly (typically by a novation); or

                   • Implicitly (e.g., ratification by acceptance of benefits)
            – The corporation might even acquire rights under the contract as a
               third party beneficiary.
2. Once the articles are filed, is the promoter liable if the corporation breaches
the contract?
            – MBCA § 2.04
                   – All persons purporting to act as or on behalf of a
                       corporation, knowing there was no incorporation under this
                       Act, are jointly and severally liable for all liabilities created
                       while so acting.
            – What if corporation adopts the contract?
            – Promoter needs to be released from liability by other party to the
3. If the articles are not filed, is the promoter liable on the contract?
            – Yes. Absent an agreement to the contrary, the promoter remains
               liable on the contract if the corporation never comes into existence.
               MBCA § 2.04.
            – It is possible that the would-be investors in the never formed
               corporation are liable under partnership law, especially if they are
               sharing profits and control.
4. If the articles are not filed or are defectively filed, can the defectively formed
entity (or individuals) enforce the contract?

Promoters and fiduciary duties
   • Promoter owes fiduciary obligation to corporation she promotes.
        – Duty of Loyalty
               • (render information; not to compete; not to act as adverse
                  party w/o consent)
        – Duty of Care and Skill
   • Creates a potential problem with circularity:
        – Who benefits from the promoters’ fiduciary duties before corp. is
           formed & shares sold?

Southern-Gulf Marine Co. No.9, Inc. v. Camcraft, Inc.
   •   Wrinkle # 1:
          – Here the corporation seeks to enforce a contract made on its behalf
              before it was incorporated
   •   Wrinkle # 2:
          – A defective incorporation:
                 • Contract called for a Texas corporation, but firm
                     incorporated in Cayman Islands.
   •   Result
          – Camcraft is estopped to deny SGM’s corporate status
          – Hence, SGM may sue to enforce the contract

   •   Rule?
          – A third party who dealt with the firm as though it were a
              corporation and relied on the firm, not the individual defendant, for
              performance is estopped
   •   Fine distinction to be drawn between de facto corporation and corporation
       by estoppel

Distinction between de facto corporation and a corporation by estoppel
De facto – you thought you were a corporation and did everything right but
          somebody else messed up, means the court might give you limited
          liability because the third party thought they were dealing with a
Corporation by estoppel - you hold yourself out as a corporation and the other
                         side believes you are a corporation and they would get a
                         wind fall by saying you are not a corporation. Tort
                         victims don’t fall under corporation by estoppel because
                         they did not contract with the false corporation.

Related Doctrines Addressing “Defective” Corporations
   • De Facto Incorporation: Treat improperly-incorporated entity as
      corporation if organizers:
         1. tried to incorporate in good faith,
         2. had a legal right to do so, and
         3. acted as if a corporation.
   • Incorporation by Estoppel: Treat as proper corporation if person
      dealing with the firm
         1. thought firm was a corporation all along;
         2. would earn a windfall if now allowed to argue that the firm was not
             a corporation.

Generic Questions
  • Is it improper to incorporate your business for the express purpose of
     avoiding personal liability?
        – No its okay.
  • Is it improper to split a single business enterprise into multiple
     corporations so as to limit the liability exposure of each part of the
     business? [recall Southern-Gulf Marine]
        – No its okay.

Limited Liability
   • MBCA § 6.22(b): “… a shareholder of a corporation is not personally
      liable for the acts or debts of the corporation except that he may become
      personally liable by reason of his own acts or conduct”

      Policy: Is L.L. a good idea?
             (a) SHs’ incentive to monitor management?
             (b) SHs’ incentive to monitor each other?
             (c) Creation of a developed trading market for shares?
             (d) Outsiders’ incentive/ ability to monitor management?
             (e) SHs’ ability to diversify portfolio?
             (f) Incentive to impose negative externalities on third parties?
             Creates a much greater incentive to invest
          • Externalities
                 – Allows Carltons of the world to avoid some of the social cost
                    of their activities
          • Encourages excessive risk-taking

“Piercing the Corporate Veil”

Policy: “Externalities” and the (In)Voluntary Creditor
    • Voluntary Creditors (e.g., Lenders, Employees)
           – Ex ante negotiations with firm...
           – …easy to find out whether firm is incorporated.
           – Thus: Can demand more attractive Prices/Interest Rates to adjust
              for increased risk
    • Involuntary Creditors (e.g., Tort victims)
           – No ex ante negotiations...
           – Thus: Cannot demand higher “price”
                  • Must depend on existence of insurance, changing their
                      activity levels, etc.

Walkovszky v. Carlton
Facts: fragmented taxi corporation
Plaintiff Offered Two Theories:
    1. All 10 corporations were part of a single enterprise
        • Court’s Reaction?
               – Not wrongful
               – Drew distinction between veil piercing, gets to shareholders,
                  and enterprise liability, gets to larger corporation
        • What would plaintiff have to show in order to recover under the
            enterprise theory?
               – That Carlton did not respect the separate identities of the
                      • Assignment of drivers

                     • Use of bank accounts
                     • Ordering of supplies, etc
                     Then he could get to the assets of the other corporations
   2. Multiple corporate structure was an unlawful fraud on the public
      • Court’s Reaction?
              – Plaintiff’s injury unchanged by ownership structure
      • By what standard will the Walkovsky court decide whether to pierce
          the veil and hold Carlton liable?
              – Where a shareholder uses control of the corporation to
                 further his or her own, rather than the corporation’s,
                 business, he or she will be held liable for the corporation’s
                 acts and debts on a principal-agent theory.

There are three separate legal doctrines that the plaintiff might invoke in a case
like Walkovsky: (a) enterprise liability; (b) respondeat superior (agency); and (c)
disregard of the corporate entity (“piercing the corporate veil”)

              Policy: What incentives are created by the court’s refusal to PCV?
                     • The insurance will stay at the minimum, and the capital
                        will remain low

Avoidance of personal liability is easy: respect the corporate formalities and take
       out the minimum insurance
Avoiding enterprise liability is more difficult. Need separate books and bank
       accounts for each corporation, plus careful accounting for supplies, for
       borrowing of drivers, etc…

Alternative Approaches to reach beyond corporate assets
Agency Law: Was corp. an agent of defendant (Rest. §1)?
“Vertical” Piercing (Conventional)
Allows one to reach the SH’s assets
Basic Q: Did SH transgress SH-Corp boundaries plus injustice
“Enterprise Liability
Allows one to reach the sister Corp.’s assets
Basic Q: Did sister corps transgress Corp-Corp boundaries (integrated resources
for a common business purpose)?

Agency Law
        – The court makes no distinction between PCV and agency theory.
        – However, issues of fraud, adequate capitalization, etc., ought to be
          irrelevant to liability under this Master/Servant agency theory.
        – Agency theory does not work well to impose liability on individual
          shareholders like Carlton, since they are likely to have authority to

              act as corporate offices or employees so their acts of control will
              not be in their role as shareholders.
          –   Agency is more useful in some parent-subsidiary situations where
              e.g. executives of the parent who have no official role in the
              subsidiary take control of the subsidiary.

Should we distinguish between tort victims and contract creditors?
         – Note that most courts do not make this distinction (but see Silicone

Sea-Land v. Pepper Source
Facts: Defendant owns a bunch of corporations himself, and half of another one,
        no corporate meetings, or articles of incorporation, etc.
Plaintiff claims they were alter egos of the defendant that he used for his
personal gain
    • “Black Letter” Illinois Law
                TWO conjunctive elements for a PCV claim:
                (a) Unity of interest and ownership, and
                (b) Refusing to allow PCV would either
                           – (i) sanction fraud or
                           – (ii) promote injustice.
        As for part (a) of the test the Illinois cases focus on four factors: “(1) the
        failure to maintain adequate corporate records or to comply with
        corporate formalities, (2) the commingling of funds or assets, (3)
        undercapitalization, and (4) one corporation treating the assets of another
        corporation as its own.”
        As for part (b) the Illinois test does not require proof of intent to defraud
        creditors, either the sanctioning of a fraud (intentional wrongdoing) or the
        promotion of injustice, will satisfy the second element.
    Sea-land has failed to prove the second element, it would be shown if it could
    establish that Marchese used these corporate facades to avoid its
    responsibilities to creditors; or that one of the other corporations will be
    “unjustly enriched” unless liability is shared by all.
    • Even if it was necessary, is the case for piercing the company he only
        owns half of equally strong?
        if you don’t allow it then it creates a big incentive to put you money in
        jointly owned corporations, but you are saying that because he was
        stealing from Andre Andre should be able to lose everything in the
        corporation, but he was mingling assets and things with Tie-Net.
    • While other states are similar, they are more “muddied” than that stated

Factors Relevant to Control/Unity of Interest Prong

   •   Commingling of funds
   •   Undercapitalization
   •   Disregard for corporate formalities:
           – Failure to hold shareholder meetings
           – Failure to hold board meetings
           – Failure to keep minutes of said meetings
           – Failure to keep separate books
           – Failure to issue stock
           – Failure to appoint a board
           – Failure to adopt charter or by-laws
One factor in California is the formation and use of a corporation to transfer to it
the existing liability of another person or entity.

Second Prong
   • Is it enough that the creditor will be unable to collect the full amount
     owed unless the court pierces the veil?
         – No. Sea-land is especially explicit on that point. There must be
             something more: e.g., fraud or unjust enrichment.
   • Is a shareholder who avoids personal liability by definition unjustly
         – More likely with torts, because you could argue with contracts
             people take that into account when contracting with the

With reverse piercing you get out of the place of the shareholder, and instead
get in with the creditors of the corporation.

What reverse piercing allows you to do is to get to the assets of the company
were the defendant is a shareholder along with the creditors.
The alter ego doctrine is part of piercing it is a synonym for a unity of purpose, a
blurring of the lines between the barriers of the firms, can also refer to a new
company created that is essentially a part of an older one.

  • Piercing the corporate viel (per Sea-land)
        – The corporation was the controlling shareholder’s alter ego; and
        – Adherence to limited liability would “sanction a fraud or promote
  • Enterprise liability
        – Such a high degree of unity of interest between the two entities
           that their separate existence had de facto ceased
        – Corporations not operated as separate entities, resources are
           integrated to achieve a common business purpose.

In re Silicone Gel Breast Implants Products Liability Litigation (They misapplied
the law, but it is good for plaintiffs.)
Facts: Bristol owed all the stock and ran the show in breast implant company
First claim: (Vertical Piercing)
    • Legal requirements for such a claim:
           – “Best of” compilation of factors [225-26] ex.:
                   • grossly inadequate capital
                   • subsidiary receives no business except that given to it by the
           – “Extra” element – fraud, misrepresentation
    • How does the court treat this omission of the second element?
           – Distinguishes tort from contract claims
                   • Says in tort cases there is a presumption for the second
                   • But it is questionable whether this is a tort case there are
                      contract aspects in products liability.
Second claim: (Direct Liability)
    • Restatement 2d of Torts § 324A:
           – Liability of one who gratuitously but negligently provides services
               that are necessary for protection of 3rd party.
    • Aggressive marketing by Bristol may make them directly liable.

   •   Are there any other theories plaintiffs might use to attach liability to
           – Apparent Agency/Authority
                 (1) Manifestation from P to third party of Principal/Agent, or
                 (1) Reasonable Belief
                 (2) [Detrimental Reliance]
Corporate shareholders:
   • One interpretation of case:
          – Courts are less rigorous with requirements for proof when the
             “piercee” shareholder is a corporation;
             Policy: In fact, some have argued that such a rule makes sense as
             a normative matter.

Review: “Piercing the Veil”
  • Nearly every jurisdiction employs a 2-part test:
        1. Unity of ownership/interest
        2. Disallowing would be “inequitable”
             *Conjunctive (but has some “sliding scale” properties)
   •   Neither part of test is clean:
          – Unity: multiple factors (e.g., formalities, domination, commingling,
             “thin” capitalization)

          –   Inequitable conduct: (Illegality, torts, fraud, other “unfair” business
              practices, usually need more than inability to compensate Plaintiff)
   •   Test applies to either vertical or reverse PCV.

When you pierce the corporate veil the shareholder has unlimited liability
There have been no cases involving piercing for publicly owned corporations

Review: Avoiding “Piercing”
  • Respect corporate formalities
        – Governance structure, minutes
        – No commingling of assets, – not taking out dividends when money
            is owed to creditors
  • If not respected, things are murky
        – Inadequate Capitalization
        – Torts: Inadequate Capitalization
        – Contracts: Fraud/Misrepresentation
        – Individual vs. Corporate SH.

AP Smith Mfg. v. Barlow
Facts: Corporation makes gift to university, president says it was in the long term
interest of the corporation
    • SH Claims:
           – (1) Decision to make a $1,500 donation to Princeton University was
              ultra vires;
   •   Ultra Vires Doctrine:
          –  Action by officers or board of directors contrary to corporate
             purpose (usually as stated in charter)
         – Considerably less important than it used to be:
                 • Most corporations have broad charter provisions
                 • DGCL §§ 101(b); 121(a); 124
                 • Today, such claims are usually couched in terms of
                    “wasting” corporate assets
Held: Court says they that a corporation can give a gift.

Planning: It is possible for corporations to adopt charter provisions expressly
limiting or prohibiting charitable contributions. Such provisions are unheard of.

Dodge v. Ford Motor Co.
Facts: Ford declares he is not going to ever give out any more special dividends,
       starts raising wages, and says he will continue to do so even if it is not in
       the corporation’s best interest
   • What relief were the Dodge boys seeking?
           – To require FMC to issue special dividends
           – To enjoin the construction of the River Rouge plant

           – FMC must issue the special dividends
           – FMC can continue with its construction plans
                 • Why did the court decline to enjoin the expansion of the
                        • “The judges are not business experts”
                                • Implicates the business judgment rule
   • What standard of review does court announce re dividend decisions?
          – Courts will generally leave dividends to the discretion of the
          – But will intervene if refusal to pay amounts to “such an abuse of
             discretion as would constitute a fraud, or breach of … good faith”
          – Under BJR, courts won’t scrutinize decisions about how to maximize
             profits; but they will scrutinize decisions about whether to do so.
          – Why doesn’t Ford meet this standard?
             • Ford ran the company as an “eleemosynary” institution
                     – “A business corporation is organized and carried on
                        primarily for the profit of the stockholders. The powers of
                        the directors are to be employed for that end.”
             • Latent Antitrust Concerns
                     – Promoting competition among manufacturers
             • Minority Oppression/Close Corporation
                     – Dodges can’t easily dump their shares.
Bottom Line:
                     – While BJR gives discretion to managers in deciding how
                        to pursue the corporation’s objective (e.g., maximize SH
                        profits), the “waste” limitation withholds such discretion
                        for decisions about whether to do so.
                     – Thus, in spite of BJR’s protection, management must be
                        able to offer a rational basis for decision.

Publicaly Traded Companies
       If this was a publicly traded company then you don’t have as much of a
       right to force the company to issue dividends. Because it is a publicly held
       company you can easily sell your share.
       Usually in these cases a minority shareholder is trying to stop the majority
       holder from giving a dividend.
       You can’t give out dividends that would render the company insolvent.
       There are limits on dividends but they are usually how much money the
       company has, etc.

Shlensky v. Wrigley
Facts: Shlensky was a minority shareholder in corporation that owned the
       Chicago Cubs and operated Wrigley Field. P.K. Wrigley owned 80% of the

       stock, refused to install lights. Cubs consistently lost money, probably
       attributable to poor home attendance which was probably attributable to
       lack of night baseball. Wrigley refused to institute night baseball because
       he believed that baseball was a day-time sport and that night baseball
       might have a negative impact on the neighborhood, and he says he is not
       motivated by profits.
   • Wrigley wins
Rule of law:
           – In the absence of a showing of fraud, illegality or self-dealing by
              the directors, their decision is final and not subject to review by the
                  • This is the Business Judgment Rule
           – Since the courts won’t review such decisions, plaintiff has no
              standing to sue
           – Court assumes decision benefited Cubs, sights plausible reasons.

There are fiduciary duties of the board, and they cannot be waived in the
abstract. So if you want to tailor you business for the well being of society and
you have specific provisions designed to that effect then you can enforce those
provisions. But you can’t ask minority shareholders to waive their rights in the

When you want to use your business for your moral, political, or charitable
agenda and there are other shareholders then the BJR will not protect you.

Fiduciary Duties
   • Duty of Care
         • Regulates thoroughness and diligence in performing tasks.
         • Limited by BJR.
         • MBCA § 8.30(a): “Each member of the board of directors, when
            discharging the duties of a director, shall act: (1) in good faith, and
            (2) in a manner the director reasonably believes to be in the best
            interests of the corporation.
         • This is a negligence standard
         • Almost all duty of care issues are resolved by the business
            judgment rule.
   • Duty of Loyalty
         • Regulates self-dealing transactions by management.
         • No BJR shield

Two Ways of Thinking about the Business Judgment Rule
  • As an abstention doctrine
        – Court will not review BoD decision, there is a presumption of good
            faith and against judicial review of duty of care claims, the court

              will abstain from reviewing the substantive merits of the director’s
              conduct unless the plaintiff can rebut the bjr’s presumption of good
              faith by carrying the burden and showing the directors, in reaching
              their decision, breached one of the fiduciary duties – good faith,
              loyalty, or due care. If the rule is rebutted it the burden shifts to
              the directors so show the “entire fairness” of the transaction.
          – Preconditions:
                  • No fraud
                  • No illegality
                  • No self-dealing
                  • Decision not egregious
   • As a standard of liability
          – No liability for negligence, has to be gross negligence or
          – Instead liability based on:
                  • Fraud
                  • Illegal conduct
                  • Self-dealing
                  • Egregious misconduct
Overcoming the BJR
      Aronson v. Lewis (Del. 1984):
          • BJR does not protect corporate fiduciaries if their actions:
                      (1) are not in the honest belief that action is in best interests
                      of corporation…or
                      (2) are not based on an informed investigation…or
                      (3) involve a conflict of interest.
      • How plaintiff go around BJR?
              – Illegality or fraud;
              – Conflict of interest alleged (DoL)
      • How plaintiff go through BJR?
              – Poor/hasty investigation of choices available and
              – Was there a “rational basis” for decision?
Reconciling the DoC and the BJR
   • The duty of care tells directors don’t be negligent
          – Standard of conduct is aspirational
   • Business judgment rule insulates directors from liability for simple
MBCA Provisions
   • § 8.30 Standard of Conduct
          – “Each member of the board of directors, when discharging the
              duties of a director, shall act: (1) in good faith, and (2) in a manner
              the director reasonably believes to be in the best interests of the

   •   § 8.31 Standard of Liability
          – (a) A director shall not be liable to the corporation or its
              shareholders for any decision to take or not to take action, or any
              failure to take any action, as a director, unless the party asserting
              liability in a proceeding establishes that:
                  • (1) any provision in the articles of incorporation authorized
                       by section 2.02(b)(4) or the protection afforded by section
                       8.61 for action taken in compliance with section 8.62 or
                       8.63, if interposed as a bar to the proceeding by the
                       director, does not preclude liability; and
                  • (2) the challenged conduct consisted or was the result of:
                           • (i) action not in good faith; or
                           • (ii) a decision
                                   • (A) which the director did not reasonably
                                      believe to be in the best interests of the
                                      corporation, or
                                   • (B) as to which the director was not informed
                                      to an extent the director reasonably believed
                                      appropriate in the circumstances; or
                           • (iii) a lack of objectivity due to the director’s familial,
                               financial or business relationship with, or a lack of
                               independence due to the director’s domination or
                               control by, another person having a material interest
                               in the challenged conduct ...
                           • (v) receipt of a financial benefit to which the director
                               was not entitled or any other breach of the director’s
                               duties to deal fairly with the corporation and its
                               shareholders that is actionable under applicable law.

Kamin v. American Express
Facts: American Express gives stockholders stock
       They say by giving us the stock in kind you lost a huge tax benefit, and
       the failure to do so was a violation of their duty of care.
       BJR, no bad faith or dishonest purpose and no neglect of their duties
       because they did make a choice.
       The conflict of interest with the 4 directors doesn’t matter because the
       other 16 directors didn’t have a conflict of interest and they approved it
       to, so loyalty was not a problem.

BJR and the Requirement of an Informed Decision
Smith v. Van Gorkom
Facts: Trans Union is unable to get tax benefits, chairman Van Gorkom decides
       to sell company to get the benefits, negotiations with financier Pritzker for

        Trans Union Corporation to be bought through a leveraged buy out at $55
        – Romans(financial analyst) doesn’t say this is how much our company is
        worth, he says how much the company could borrow.
                   The merger
                          Former TU shareholders get cash as part of the
                          In this case for each share worth $38 they get an iou
                            for $55 in the short future.
                          Prtizker says he wants a million shares at $38. This is
                            a lock up.
                                o Lock up – why would Pritzker want this? He is
                                   guaranteed at least $17. Plus he may deter
                                   the bidding. It may also take value out of the
                                   deal, and somebody who was competing would
                                   have to pay more than he was willing to pay.
                   Van Gorkom tells senior management about the deal, and
                     they hated the deal.
                   TU BOD approves the merger after 2 hour meeting, no
                     written studies or other documentation.
                   BOD approves revised deal. Shareholders approved the deal.
                   This is a class action because the wrong was done to the
                     shareholders. In a derivative action by shareholders, the
                     wrong is done against the company.
                   Trial court ruled in favor of the board because of the bjr.
                   Business Judgment Rule does not protect:
                          Fraud
                          Illegal conduct
                          Self-dealing
                          Egregious misconduct, and
                          No protection for an uninformed decision
                           RULE - Says that we are not reviewing your
                            substantive decision. But we can review procedural
                           The legal test for procedural challenges to BJR:
                               o Not enough procedure, no subsequent
                                   correction, no SH cleansing of breach
                               o If not did SH approval of deal “cleanse” breach
                                       Rule = Normally this does. But the
                                          approval must be informed. There is
                                          cleansing when there is an
                                          uninformed decision by

                              o Factors for “entire fairness” Cinerama v.
                                          The timing
                                          Initiation
                                          Structure of the transaction
                                          Disclosure to and approval by the
                                        Aggressive bargaining by fiduciary;
                                        Fiduciary’s knowledge of business;
                                        Whether outside valuation advice
                                        Magnitude of premium over market
                                        Surmountability of “lock-ups” by 3rd
                                o Damages – board has to pay the difference
                                   between $55 and the market value . That
                                   difference may be 0 because that was a fair
                                   price. This is an affirmative defense that was
   The Board’s Reliance on Chairman
   - DGCL § 141(e) provides a defense for directors who rely on reports from
      officers. Why didn’t § 141(e) apply here?
          o Van Gorkom was uninformed
          o BoD had a duty to make inquiry into the basis of Van Gorkom’s
              opinion … can’t rely blindly, good faith not blind reliance
                  No protection for an uninformed decision
                  The determination of whether a business judgment is an
                     informed one turns on whether the directors have informed
                     themselves “prior to making a business decision, of all
                     material information reasonably available to them.”
                  Gross negligence is the standard for determining whether a
                     business judgment reached by a board was an informed
                  Who has burden of proof?
                          Party attacking boards decision

Evaluating the Standard
   - The “reasonably available” standard requires an in-depth study:
          o Valuation study
          o Discussion of course of the negotiations
          o Review of actual contract
   - Policy: Is this an appropriate standard?

          o Information is costly
          o Where is point of diminishing returns?
          o What “Costs” Result from Judicial Review
                Hindsight bias may discourage risk-taking
                Interference with internal governance
                Judicial decisionmaking not subject to market discipline:
                In theory Firms whose managers make bad decisions are
                  weeded out in Darwinian selection

Business Judgment Rule post-Van Gorkom
    A standard of liability
           Directors may be held liable for gross negligence in failing to make
             an informed decision
    A rule of abstention
           Will court review substance of BoD decision?
                 No
                 Court will examine decisionmaking process
                        The extent to which BoD made an informed decision

Planning: What do   we do now to make a proposed merger safe (or safer) from
                    Get an outside expert. Get a fairness opinion.
                    Get Lawyers to review the contracts
                    Board members should now insist on insurance

DGCL § 102(b)(7)
         – Duty of Care (still) a default rule, but permits “indemnity”
               • Effectively allows charter to limit/eliminate personal liability
                   for directors’ breach of DoC.
         – Duty of Loyalty; fraud doctrines still immutable
               • But see DGCL § 122(17)

Practice Points
   • After Van Gorkom (as before), s always assert BJR in DoC actions;
   • Anticipating this, s tend to plead faulty procedure rather than substantive
          – Or, by arguing fraud/illegality/DoL
          – Note: Plaintiffs must show existence of duty, breach (BJR),
              causation, and damages
   • Actions often easier for s under federal law if company is publicly traded.
   • Remember: BJR only protects people who don’t have a conflict of interest.

Challenging Process: Lessons from Van Gorkom & progeny

       1. While BJR creates a presumption that the board’s decision was
              …plaintiff can rebut presumption by showing that prior to making
              decision, board was grossly negligent (or reckless) in informing
              themselves about material information reasonably available to
       2. Defendants found to have breached their DoC procedurally can still
              defend on other grounds (e.g., causation):
               Transaction was “entirely fair” to corporation (Cinerama)
               Fully-informed SHs voted to approve board’s action (Van

Business Judgment Rule and “Good” Corporate Governance, WASTE
Brehm v. Eisner
Facts: Disney board gives Ovitz a contract with incentives to induce a non-fault
Plaintiff’s Allegations:
    • Old Board violated its duty of care and committed waste in 1995 when it
        approved the compensation package
    • New Board violated its duty of care and committed corporate waste in
        1996 when it approved non-fault termination
What is corporate waste?
            – A transaction “that is so one sided that no business person of
                ordinary, sound judgment could conclude that the corporation has
                received adequate consideration” (a pretty extreme standard)
    – What did plaintiff need to prove to show process due care violation?
            – Board was grossly negligent in failing to inform itself of all material
                information reasonably available to it
    – Can the board consciously make a decision to take the risk that it lacks
        key information?
            – Yes in some ways, you can say I have enough information here
            – Court says the board must inform itself of information within its
                “reasonable reach”
    – Did the Old Board inform itself of all material information reasonably
            – No … didn’t calculate the potential expense associated with a non-
                fault termination
    – Was Old Board therefore liable?
            – No, because they brought in an executive compensation
                expert. § 141 (e) defense (Delaware law)
            – Court adds some pre-conditions to § 141(e) defense:
                    – the expert defense only applies if you have asked
                        them about their qualifications and it is within their

Why did Eisner come out this way and Van Gorkom come out the other way?
          – Van Gorkom involved a final period problem
          – Brehm involved much smaller amount in relative terms
          – Van Gorkom Board wholly abdicated its role
                  • Van Gorkom rests on the absence of a sufficient record of
                     any deliberative process
                  • In Brehm board at least hired an expert
What is the relationship between the bjr and the duty of care in this case?
      Here we are not even getting to the BJR rule because of the
      expert defense.

  The Business Judgment Rule and the Duty of Care
                         BJR Applies: Court abstains

     Fraud                                                      Illegality
       ?            No         Conflict                        No decision
                                   of                           Egregious
                                               N?                decision
    Yes                                                        Uninformed
  BJR rebutted
                                       Yes                        Waste
 Federal or state
  Fraud claims
                                    BJR rebutted                      Yes
                                   Duty of Loyalty

                       BJR                                      Illegality
                    Rebutted:                                  No Decision
                       Did                                  Egregious decision
                    defendant                                  Uninformed
          No         violate          Yes                        decision
                      DoC?                                        Waste
                                                               No Decision

      Defendants                   Calculate
         Win                       damages
                                   see Van

Francis v. United Jersey Bank
Facts: Widow is director, but inactive, Pritchard boys: Charles Jr. & William other
       directors, father had said Charles would “take the shirt off my back,”
       embezzled large sums in form of “loans.”
Why do creditors have standing to sue for fiduciary duty breach?
    Because insurance companies are similar to a bank in that they are
       holding people’s money in trust they owe fiduciary duties to their
   - Plaintiff alleged a breach of duty of care by Pritchard
           o Role of business judgment rule?
                    None:
                            Rule has no application where directors have failed to
                             exercise business judgment — i.e., failed to make a
                            Note that the rule DOES protect a Decision not to act.
   - Is Pritchard automatically liable, because BJR doesn’t apply?
           o No. Plaintiff still has to show that Pritchard breached her duty of
   - Did Pritchard breach her duty of care?
           o Yes – inattentive – facts that she was old, depressed, drunk, and
               ignorant of business were no defense, she is liable for losses
               caused by acts of insiders, like officers, directors and shareholders.
   • Even if she breached her duty of care, was it the proximate cause of
       injury to plaintiffs?
           – i.e., could Mrs. Pritchard have done anything about it?
   • Duty to be informed:
           – “Obligation of basic knowledge and supervision”
           – Read and understand financial statements
           – Object to misconduct and, if necessary, resign
           – Sue the wrongdoers?
           – Upon discovery of an illegal course of action, a director has a duty
               to object and, if the corporation does not correct the conduct to
           – Usually a director can absolve himself from liability by informing the
               other directors of the impropriety and voting for a proper course of
               action. A director who is present at a board meeting is presumed
               to concur unless his dissent is entered into the minutes of the
               meeting or filed promptly after the meeting.
   • Could Prichard have invoked right to rely on other
       director’s/subordinates’ reports/opinions?
           – Yes, but a director may not rely on subordinates when they notice
               subordinates acting inappropriately.

In re Caremark Int’l Inc.
What do you do when your company is doing something illegal? (this is not a bjr
Facts: Caremark is a managed care health company subject to the Anti-Referral
       Payments Law, which prohibits managed care organizations that receive
       Medicare/Medicaid funds from paying doctors to refer patients to firm.
   • Feds prosecute and civilly sue Caremark
   • Caremark settles; pays $250 million
   • Shareholder sues Caremark board “derivatively”
           • Caremark settles shareholder suit
           • Agrees to pay plaintiff attorney fees of $1 million
   • Settlement requires court approval
Rules of Law:
   • Does business judgment rule apply?
           • No – this was a lack of oversight case; no board decision
   • Did board violate its duty of care?
           • Not decided due to procedural posture
           • Probably not – no evidence of “sustained failure to exercise …
       Director liability for breach of the duty of care may arise in two distinct
       contexts, from a board decision that results in a loss because that decision
       was ill advised or negligent, and from an unconsidered failure of the board
       to act in circumstances in which due attention would, arguably have
       prevented the loss.
       The first case will typically be subject to review under the bjr assuming
       the decision was the product of a process that was either deliberately
       considered in good faith or was otherwise rational.
   • Does the board have a duty to adopt a law compliance program?
           – Although court says absent grounds to suspect deception, neither
               corporate boards nor senior officers can be charged with
               wrongdoing simply for assuming the integrity of employees and the
               honesty of their dealings on the company’s behalf.
           – Allen says yes: must “attempt in good faith to assure … a corporate
               information and reporting system” to ensure compliance with the
           Where a claim of directorial liability for corporate loss is predicated
           upon ignorance of liability creating activities within the corporation,
           only a sustained or systematic failure of the board to exercise
           oversight such as an utter failure to attempt to assure a reasonable
           information and reporting system exists will establish the lack of good
           faith that is a necessary condition to liability.
What would an “adequate” law compliance program include?

   •   Policy manual
   •   Training of employees
   •   Compliance audits
   •   Sanctions for violation
   •   Provisions for self-reporting of violations to regulators

A decision to cause the corporation to violate the law is not protected by the BJR
       – If the BJR were a standard of liability, then directors are liable
       – But if the BJR is an abstention doctrine, then directors are not
          automatically liable. Instead, the court goes on to ask whether the
          decision was a reasonable one.

Egregious board decisions
   • In Caremark, court limits liability for egregious decisions. When can
     directors be held liable for egregious decisions?
         – Only where directors acted in bad faith or followed an irrational
            decisionmaking process
         – No “objective” review of substance of decision

          – Makes it easier to prosecute securities fraud, particularly financial
          – Imposes greater responsibility on senior management and
             directors, particularly independent directors and audit committee
             members, by requiring them to take a substantially more proactive
             role in overseeing and monitoring the financial reporting process,
             including disclosure and reporting systems and internal controls
          – Does not purport to change the common law duty of care, but
             increases civil and criminal enforcement authority over the conduct
             of corporate officers and directors,
                 • No question that potential civil liability for directors will be
                     greater after Sarbanes-Oxley
The goals of Sarbanes-Oxley
             Is to have some accountability for what goes into financial
             statements, that more goes into financial statements, less is
             hidden, and that the average investor can understand more from
             looking at those financial statements.
Sarbanes-Oxley Audit Committee Requirements
   • Section 301 of Sarbanes-Oxley orders SEC to adopt rules mandating that:
          • The audit committee shall receive reports from the independent
             auditors regarding critical accounting polices and practices,
             discussions that have taken place with management regarding
             alternative treatments of financial information under GAAP, and any

                     accounting disagreements and other material written
                     communications between the auditors and management
              •      The audit committee must establish procedures to receive and
                     address complaints regarding accounting, internal control and audit
                     issues, and to provide company employees an opportunity to make
                     confidential, anonymous submissions regarding accounting and
                     auditing matters

“Modern” DoL Analysis
                                                                                              Transaction Valid

                                                                                      Y ES

                                                    Has transaction
                                                   been "cleansed"?
                                                    (DGCL § 144)
                                        Y ES                                          NO

                                                                Burden on Defendant
    Conflict of Interest?                                                                    Transaction Voidable
     (Direct; Indirect)                                                                         by Corporation


                  Burden on Plaintiff
                                               Transaction Valid

  DGCL § 144:
  (a) Informed, Disinterested
  BoD approves; “or”
  (b) Informed SHs ratify; “or”
  (c) Transaction is Substantively
  Fair to corp.

The duty of loyalty goes around the business judgment rule.
The duty of loyalty used to mean if you breached it and engaged in a transaction
then any contract into which you entered was void or voidable at the
shareholder’s request.
      The old way was to ask:
              Is there a conflict of interest?
                            Transaction b/t corporation and fiduciary
                            Transaction b/t corp and another corp in which
                            fiduciary has [substantial?] financial interest (Lewis)

                           Family transactions (Bayer)
                    If “yes”, transaction is voidable by corporation
              These kind of questions really depend on what the specific statute

Bayer v. Beran
This case is under the old regime
Facts: big radio advertising spending, CEO/Director’s wife gets hired.
       Plaintiffs claim the radio advertising chosen for the benefit of the wife.
       BJR does not apply because of duty of loyalty is the question here
       Burden of proof with regard to breach of fiduciary duties is not clear, but
               assume that once the plaintiff has shown there is a conflict of
               interest it is up to the defendant to show that it was okay even
               though there was a conflict of interest, to show not only the good
               faith of the transaction but also to show its inherent fairness.
Held: That her participation in the program may have enhanced her prestige as a
       singer is no ground for subjecting the directors to liability, as long as the
       advertising served a legitimate and a useful corporate purpose and the
       company received the full benefit thereof.
       Why do they win?
           – Tennyson did not get unreasonable pay
           – The program was not designed to further her career
           – The company obtained its money’s worth from the radio campaign
   – Non-fiduciary duty issue
           – Transaction was ultra vires (illegal as beyond corporation’s power)
               because no formal board action
           – Holding?
                   – Very fact oriented analysis
                   – Formal procedure desirable
                   – But informality ok here, the directors were executives in the
                       company that constantly communicated and they discussed
                       the radio plan, and they took a later vote that ratified the

Lewis v. S.L. & E., Inc.
Facts: two private corporations same board different shareholders, boards allow
       one corporation to use the land of the other corporation at very low rent,
       shareholders sue
Court says that since the directors were serving on both boards they have the
       burden of showing that the transaction was fair and reasonable, and if
       they show that it will not be voided.
   • How to cleanse: NY BCL § 713
          Note first: financial indirect conflict ONLY if substantial

            Three Alternative ways to cleanse:
                • Disclosure to BoD & approval
                      – Quorum requirements
                • Disclosure to SH & approval
                      – No apparent Quorum req’t
                • Defendant can show transaction fair & reasonable at time of
   •   Compare: DGCL § 144
         Merely a financial interest for a conflict of interest.
            Three Alternative ways to cleanse:
                • Disclosure to BoD & approval
                      – No quorum req’t; but majority of disinterested req’t
                • Disclosure to SH & approval
                      – No apparent Quorum req’t
                • Transaction fair at time of approval
                      – Burden of Proof?

The Doctrine of Corporate Opportunities
  • Usurpation by an officer or director for personal gain of some prospective
     business venture or development in which the firm has a property right
  • Flip-side of interested director transactions
        – Note potential for overlap if opportunity also involves a contract
            with firm
  • Part of Fiduciary Duty of Loyalty
        – Limits corp. fiduciary’s ability to pursue new business prospects
            individually without first offering them to corp.
        – It does not apply to employees, just senior management and board
            of directors.
        – Usually the cause of action for this belongs to the corporation, not
            the shareholders, so it usually comes up as a derivative action
        – There is no obligation to disclose corporate opportunities, there is
            an obligation not to take corporate opportunities.

                                                                                                 No Breach Regardless
      Basic Roadmap                                                                              of Fiduciary's Actions

                                  NO                                                                  No Breach
                                       NO                                          YES                  Breach
   Is Prospect
  a "Corporate                                                                             X1

 A        YES                Does                                                   NO                No Breach
                           Fiduciary                                Does
                           Disclose?                              Fiduciary
                       B                        Does Corp.
                                                 Properly                                   X2
                                                                                                 No Breach Regardless
                                            C                         YES
                                                                                                 of Fiduciary's Actions
                                        Interest / Expectancy /

                                                                                Line of Business

                                                                                         “Fairness” & Hybrid Tests
                  “Incapacity” Based Defenses

                  “Source” Based Defenses

  Guth v. Loft , 5 A.2d 503, 514 (Del. 1939): “Where a corporation is engaged in a certain
  business, and an opportunity is presented to it embracing an activity as to which it has
  fundamental knowledge, practical experience and ability to pursue, which, logically and
  naturally, is adaptable to its business having regard for its financial position, and is one that is
  consonant with its reasonable needs and aspirations for expansion, it may be properly said
  that the opportunity is in the line of the corporation’s business.”

Corporate Opportunity?
     The question is does the corporation have an interest, an expectancy, or a
             An interest is a contractual right, an expectancy is not a contractual
             right, but something they should be offered like a renewal right,
             and a necessity is something the corporation needs to continue its
     Also is it within the company’s line of business, not just today but in the
     future, Guth v. Loft

      Some states also do a fairness test, was it fair or equitable to the
      corporation, hard to predict.
      Some states combine the interest expectancy with the line of business test
Source Based Defenses – the source of the opportunity came to the individual in
      his individual capacity, for his skills or something.
Incapacity Based Defenses – the corporation could not have taken the
      opportunity even if they wanted to, these types of defenses tend to work
      better when they can be objectively verified by some outside measure,
      like look the company did not have the money, rather than they did not
      want to deal with them

“Cleansing” a Conflict
   Cal. Corp. Code § 310; DGCL § 144:
   • Full Disclosure to SH & approval
          – Interested director should not vote shares
   • Full Disc. to BoD/committee. & app./auth./rat.
          – Note: § 310 – “just & reasonable” caveat, in California you not just
              have to get approval it has to be just and reasonable approval.
   • Director bears burden of proving transaction just & reasonable/entirely
      fair at time of approval
          – Extremely difficult in corporate opportunity contexts
      The Delaware corporate law was recently amended giving corporations
      the power to . . . (17) Renounce, in its certificate of incorporation or by
      action of its board of directors, any interest or expectancy of the
      corporation in, or in being offered an opportunity to participate in,
      specified business opportunities or specified classes or categories of
      business opportunities that are presented to the corporation or one or
      more of its officers, directors or stockholders.

Consequences of Corporate Opportunity status
  1. The D/O must disclose the existence of the Corp. Opp. (and her conflict of
     interest) to the board/SHs.
  2. Corp. has right of first refusal on project
         – But can choose to give it to fiduciary…
         – Difficult issues:
                • Does disclosure/rejection have to be “formal”?
                • Is it subject to same three “cleansing” criteria as for D.o.L.?
  3. Remedy: Gains-based (constructive trust)
         – Injunctive relief & punitive damages also.

Broz v. PriCellular
Facts: Defendant sole shareholder in RFBC and on the board of another cell
       phone company CIS
          – Broker named Rhodes offers Mich-2 to Broz in Broz’s RFBC capacity

         – Wearing his RFBC hat, Broz buys Mich-2
         – CIS board did not formally clear purchase, although informal ok by
            CEO and some other directors
         – PriCellular had also bid on Mich-2, but Broz out-bid it
         – PriCellular acquires CIS
         – PriCellular sues Broz for taking corporate opportunity
Delaware Law: What is the Test?
   • A corporate opportunity exists where:
         – Corporation is financially able to take the opportunity
         – Opportunity is in the corporation's line of business
         – Corporation has an interest or expectancy in the opportunity
               • Interest: Something to which the firm has a better right
                       • If officer bought land to which the corporation had a
                          contractual right, the officer took an “interest”
               • Expectancy: takes something which, in the ordinary course
                   of things, would come to the corporation
                       • If the officer took the renewal rights to a lease the
                          corporation had, the officer took an “expectancy”
   • Factors or elements?
         – Unclear
   • Relevance of corporation’s capacity?
         – Not dispositive
         – Lessens defendant’s burden by showing good faith
   • Relevance of board approval or lack thereof?
         – Not required
         – Board approval creates a safe harbor
         – Broz did not usurp a corporate opportunity
         – Why?
               • He learned about it in his personal capacity
               • CIS was not financially capable taking the opportunity
               • It was in CIS’s line of business but it had no cognizable
                   interest or expectancy
                       • They were getting out of that business
                       • They had sold off several similar franchises
                       • Key players told Broz it was ok to go ahead
               • He was under no duty to consider the future uncertain plans
                   of PriCellular.

Conflicts Under the American Law Institute Principles of Corporate
  • ALI § 5.05
  • Bifurcates inquiry:

                •  Was the opportunity in question a “corporate opportunity” as
                   defined by § 5.05(b)?
                           (1) Any opportunity to engage in a business activity of which
                           a director or senior executive becomes aware, either:
                                  (A) [i] In connection with the performance of
                                  functions as a director or senior executive, or [ii]
                                  under circumstances that should reasonably lead the
                                  director or senior executive to believe that the person
Subsection 5.05(b)(1) applies offering the opportunity expects it to be offered to
to both officers and directors    the corporation; or
                                  (B) Through the use of corporation information or
                                  property, if the resulting opportunity is one that the
                                  director or senior executive should reasonably be
                                  expected to believe would be of interest to the
                                  corporation; or
                           (2) Any opportunity to engage in a business activity of which
                           a senior executive becomes aware and knows is closely
                           related to a business in which the corporation is engaged or
                           expects to engage.
                 • If so, was the corporate opportunity properly rejected by the
                   appropriate corporate actor per § 5.05(a)?
                           (1) The director or senior executive first offers the corporate
                           opportunity to the corporation and makes disclosure
                           concerning the conflict of interest and the corporate
                           (2) The corporate opportunity is rejected by the corporation;
                           (3) Either:
                                  (A) The rejection of the opportunity is fair to the
                                  (B) The opportunity is rejected in advance, following
                                  such disclosure, by disinterested directors, or, in the
                                  case of a senior executive who is not an executive, by
                                  a disinterested superior, in a manner that satisfies the
                                  standards of the business judgment rule; or
                                  (C) The rejection is authorized in advance or ratified,
                                  following such disclosure, by disinterested
                                  shareholders, and the rejection is not equivalent to a
                                  waste of corporate assets.
                       • What effect does rejection have under § 5.05(a)?
                               • How rejected determines standard of review
                               • Judicial review not foreclosed
                       • Plaintiff has burden of proving that rejection did not satisfy

   •   The so-called “refusal to deal” defense; see also
          • Financial incapacity (Broz)
          • Technical capacity (Singer)
          • Functional capacity (Broz)
   •   None recognized by ALI § 5.05

Basic principles
    Shareholders acting as shareholders owe one another no fiduciary duties
    Controlling shareholders can owe fiduciary duties to the minority
            controlling shareholders can control the board
            Where a shareholder vote is required a court may scrutinize
               whether that shareholder used the vote in an unfair manner.
    In general, transactions between a controlling S/H and the corp. are
       subject to an intrinsic fairness test.
            The controlling S/H will have the burden of proving the transaction
               was fair to the corporation.
            BUT only when a potential for self-dealing is present in the
               arrangement. (i.e. when the controlling S/H can receive something
               at the expense of the corp. (or the minority S/H.))
    Courts usually presume dominance at 25%.
    Virtually all successful suits against dominant SHs are for duty-of-loyalty:
       I.e., causing board to effect a non-pro-rata distribution of corporate
    As with interested directors, once plaintiff makes this showing, burden
       shifts to the defendant SH to “cleanse”…

Transactions Between Parent and Subsidiary Corporations
Sinclair Oil v. Levien
Facts: liquidating Sinclair Venezuela
    Minority objected to three aspects of Sinclair-Sinven relationship – which
           1. Sinven’s large dividends
           2. Sinven prevented from expanding
           3. Contract between Sinven and another Sinclair subsidiary was
               breached, and Sinclair did not cause Sinven to enforce.
Court Identifies 2 Standards of Review
    Business judgment rule
            BoP on plaintiff to rebut
    Intrinsic fairness
            BoP on defendants to show transaction was fair to Sinven
    How does court select standard of review?

             Intrinsic fairness used when dominant shareholder has
                received a benefit to the exclusion and expense of the
                minority shareholders of the subsidiary.
Issue   1: Dividend Policy
        Standard of review?
             Business Judgment Rule
             Why?
                    Minority got pro rata share of dividends so although self-
                       dealing it was not to the detriment of the minority
Issue   2: Expansion Policy
          Sinclair used Sinven exclusively to develop Venezuela properties
          Business judgment rule
                 Plaintiff could identify no opportunity Sinclair usurped from
                   Sinven so although self-dealing not detriment to the minority
                 This is an important point, the source of the opportunity
                   matters, if you get squeezed out of an opportunity that came to
                   you then intrinsic fairness, if the opportunity comes to Sinclair
                   they don’t have to give it to Venezuela, they haven’t taken an
                   opportunity that was Venezuela’s.
Issue   3: Breach of Contract
          Sinven sold its oil to International (another Sinclair subsidiary)
                 International breached contract
                 Sinven did nothing
          Standard?
                 Intrinsic fairness
                 Sinclair got the oil without having to comply with contract duties
          Suppose nonenforcement of contract had been approved by a majority
            of the disinterested directors and then also by a majority of the
            disinterested shareholders (a.k.a. a “majority of the minority”)?
                 Shifts BoP to plaintiff to show transaction was unfair –
                ??? Back to BJR
                Might turn on how disinterested the directors were.
                If the action is ratified instead of approved, then standard is
                 unclear under DGCL

Decomposing Ownership
Debt is not an ownership interest, and debt holders are not owed fiduciary
First you pay off debt and then you pay off equity.

Zahn v. Transamerica
(this case is about insider information, not conflict of interest)

Facts: Transamerica was the controlling shareholder of Axton-Fisher
             Preferred stock: Not relevant
             Class A stock: 2/3 owned by Transamerica
             Class B stock: Almost all owned by Transamerica
             Transamerica had elected majority of the board
     Class A
             Annual dividend of $3.20
             Entitled to liquidation dividend 2x that of Class B
             Convertible into Class B at option of holder
             Callable by corporation at $60/share plus accrued but unpaid
     Class B
             Annual dividend of $1.60
             Entitled to liquidation dividend ½ that of Class A
             Not convertible
             Not callable
Plaintiff’s allege
     Transamerica caused Axton-Fisher’s board to call the Class A shares for
        redemption at $80
             $60 call price plus $20 in unpaid dividends
     After the Class A was redeemed, the Firm was then liquidated
             Allegedly to appropriate for Transamerica the increased value of
                tobacco inventory
     Plaintiff claims Class A would have received $240 per share if not called
        before liquidation
     When the boards duties to class A and class B conflict, what should the
        board do?
             The board has a duty to its lowest class of shareholders, to the
                shares that are most common.

Fliegler v. Lawrence
Facts: Lawrence along with the other Agau directors decide the corporation
       can’t purchase land, so they form the US Antimony Co. and transfer the
       land to it, and give Agau an option to purchase the land in the future.
       Agau eventually exercises that option with shareholder ratification and the
       shareholders sue.
 Why didn’t shareholder ratification under DGCL §144(a)(2) protect the
        The vast majority of voting shareholders weren’t disinterested and the
       Court holds for the defendant because it was intrinsically fair.
Bottom Line:
   • Unlike conflicted transactions involving directors/senior execs

            –  In which informed SH ratification virtually disposes of the claim
               (absent waste, fraud, illegality)
   •     ...When the conflict of interest involves a controlling SH
             – The only method for cleansing is intrinsic/entire “fairness”, with the
               initial burden on the dominant SH
             – Disinterested SH ratification shifts burden
                    • Note: This is INCONSISTENT with wording of § 144
             – Plaintiff can still win by showing intrinsic/entire unfairness

                                Summary of “Cleansing”

           DoC Suit                      DoL Suit                     DoL Suit
       (Director/Officer)            (Director/Officer)             (Dominant SH)

§ 144 Not Binding               § 144 Binding                   § 144 Not Binding
(a) Infm’d BoD Vote             (a) Infm’d BoD Vote             (a) Infm’d BoD Vote
                                        - Disinterested: BJR
          -Generally BJR                - Interested: go to (c)
                                                                       -  Generally no
                                                                        help, unless min
          -BJR doesn’t apply    (b) Infm’d SH Vote
        go to DoC and/or                - Disinterested: BJR
                                                                (b) Infm’d SH Vote
        (c)                             - Int’d: go to (c)
                                                                        - Disint’d: go to
(b) Infm’d SH Vote              (c) Fairness
                                        - Defendant Burden
          - Absolute Defense                                            - Int’d: go to (c2)
                                                                (c) Fairness
(c) Fairness                                                            1. Plaintiff Burden
        -Affirmative                                                    2. Defendant
        Defense                                                         Burden
        (Cinerama)                                                      (Merger:

“Intrinsic” vs. “Entire” Fairness
     The Wheelabrator case utilizes the notion of “entire fairness”, whereas
       other cases focus simply on “fairness”
         (sometimes called “intrinsic fairness”)
    Difference:
          Substantive/Intrinsic Fairness: Solely a substantive consideration
            (terms of deal = arm’s length K)
                 Requires that the transaction reflect terms one would expect
                  in an arm’s length transaction.
                       Basic inquiry– consideration paid for the value
                 Applies to generic DoL disputes
          Entire Fairness: Fair substance plus fair dealing

                  Applies to DoL disputes involving a dominant SH when the
                   complained of transaction is a merger, or anything else
                   (e.g., charter amendment) that requires a SH vote
                  Entire fairness involves the process by which the transaction
                   was done. Involving, e.g., timing, structure, negotiating
                   process for the deal (even if the price was fair). It makes
                   the fairness consideration especially difficult in the Dominant
                   SH situation.

   • A derivative action is a suit in equity against a corporation to compel it to
       sue a third party.
   • Definition: simultaneous suits in equity by...
          – (1) a SH against corp. to compel it to sue another;
          – (2) the actual suit by corp. against that other party
   • B/c the SH is suing “in right” of corporation…
          – Any remedy from principal suit goes to corporation;
          – The corporation is required to pay for the SH attorney’s fees if suit
              is successful (or often if it settles).
   • Why do we have this? Because you don’t have a cause of action against
       the third party.
Direct and Derivative Suits
    Direct
           Brought by the shareholder in his or her own name
           Cause of action belonging to the shareholder in his or her individual
           Arises from an injury directly to the shareholder
    Derivative
           Brought by a shareholder on corporation’s behalf
           Cause of action belongs to the corporation as an entity
           Arises out of an injury done to the corporation as an entity
Derivative versus Direct actions
       Direct: a suit is direct if it alleges a direct loss to the shareholder.
          • Force payment of promised dividend;
          • Enjoin activities that are ultra vires;
          • Claims of securities fraud/blue sky laws;
          • Protecting participatory rights for SHs
       Derivative: a suit is derivative if it alleges a loss to the shareholder that
              derives from a loss to the corporation. (quintessential case is suit to
              force corporation to sue manager for fraud)
          • Breach of duty of care
          • Breach of duty of loyalty
          • Enjoin “management-retrenching” practices
   • It can get hard to say which category it falls under, direct or derivative.

Principal legal distinction: Is the plaintiff arguing that there was an injury
done to the corporation or was it something personal?
What’s at stake? Well, as noted, there are all these procedural differences
and attorney fee differences between the two. So the determination is often
Unfortunately, the “legal test” for determining whether a complaint is
derivative or direct is pretty vague and difficult to apply.
The basic rule is this: A suit is derivative if the wrong complained of
primarily constituted an injury to the corporation, but direct if the
wrong complained of primarily constituted an injury to individual
shareholders as such.
Nevertheless, courts will often conduct an inquiry into whether the
“gravaman” of the action tends toward corporate injury or individual
shareholder inquiry. But the analysis necessarily implicates casuistry. Some
         • A SH is also an employee, and she was fired and forced to sell her
            shares under an ESOP. This would be a direct action. The harm
            emanates from her employee status.
         • A SH is denied her right to inspect the books of a corporation.
            Also direct: This is a right that she can partake in individually.
         • SH is denied right to exercise redemption/exchange/voting rights.
            Once again, these are rights that she can individually exercise as a
            SH independent of other SHs
         • SH complains that directors recklessly investigated corporate
            expansion, and turned the firm into a money loser. This one’s
            derivative: the SHs only injury is a general loss of profit -- a right
            that she can only partake in pro rata with other SHs.
         • Same for suits for corporate opportunities, executive compensation
            or other DoL actions.
         • Try this one: SH alleges that corporation recklessly investigated
            merger possibilities, and thereby agreed to a low-ball bid,
            representing to the SHs that it was a good deal in order to get their
            approval for the deal. Could be either (Van Gorkom brought as
         • Preferred SH sues to get a dividend paid which corporation has
            decided to reinvest in firm (Dodge v. Ford). Seems derivative, but
            courts often treat as direct, possibly b/c remedy goes to SH rather
            than corp. But goes both ways potentially.
         • SH claims that board has “abdicated” its directorial authority by
            entering into a contract that prevents it from managing the firm
            (Grimes). Potentially either direct or derivative (though note that in
            Grimes the claim of abdication simply wasn’t sufficient on its own

Eisenberg tests
   These tests help you decide if it is direct or derivative
    Who suffered the most direct injury?
           If corporation, suit is derivative
    To whom did defendant’s duty run?
           If corporation, suit is derivative
           Called into question by Eisenberg

Plaintiff Qualifications:

       Shareholder Status
              MBCA § 7.41 limits standing to shareholders
                     Creditors may not bring derivative suit

       Contemporaneous Ownership
              MBCA § 7.41(1): Must be a shareholder at the time of the
               alleged wrongdoing
                    Continuing wrongs?
              § 7.42: Must be a shareholder when suit commenced
              Many states say also must remain a shareholder through final

       Fair and Adequate Representative
               MBCA § 7.41(2): Named plaintiff must be a fair and adequate
                 representative of the corporation’s interests
               On what grounds might one challenge a plaintiff’s fairness or
                     Conflicted interests, such as bringing suit for unrelated
                       strategic purposes
                     Unclean hands

Security for Expenses Statutes
    NJ provides that a shareholder who brings a derivative suit and who owns
       less than 5% of the stock or stock worth $50,000 is liable for the
       corporation’s reasonable expenses if suit fails
    Corporation can ask court to require such a plaintiff to post a bond to
       secure such expenses before suit goes forward

Policy Concerns
     To whom does a derivative suit belong?
           Corporation
     Why didn’t corporation sue?
           Maybe good business reason not to sue

         But maybe directors or senior managers would be defendants, so
            possible conflicts of interest
    Derivative suits allow shareholders to hold directors accountable
         Supreme Court called it a “remedy born of stockholder
    Potential abuses:
         Strike suits:
                 Nuisance suits brought for settlement value
         Meritorious suits:
                 Settled too easily

Plaintiff-side Incentives
     Any recovery goes to corporate treasury, whether by settlement or trial
             Lawyer is real party in interest
     Lawyer can get contingent fee out of any recovery
     BUT corporation also must pay plaintiff’s legal fees if there is a substantial
        nonmonetary benefit
             Courts quite liberal in finding such benefit
                    E.g., Caremark

Defendant-side Incentives
    Strike suits:
          Settle to go away
    Meritorious suits against insider defendants:
          Indemnification: Corporation must reimburse director’s expenses if
             successful defense
          Settlement in which director doesn’t pay anything deemed a

Combined Effect
   Strike suits
         Plaintiff counsel has incentive to bring
         Management has incentive to pay
   Meritorious suits
         Management has incentive to settle in ways that ensure
         Plaintiff lawyer has incentive to settle so as to get on to next case
         Hence, settled too lightly

3 “Procedural” Hurdles to the derivative action
      1. Bonding Requirements – put up money in case you lose
      2. Demand Requirement - you have to ask the board to do what you want

3. Special Litigation Committees

First Hurdle: Security Requirement
    • In some states (though not Del), a derivative claimant with “low
       stakes” must post security for corporation’s legal expenses.
    • Eisenberg v. FTL Inc.
       Facts: Eisenberg, a former shareholder of Flying Tiger, brought a
              class action suit to enjoin (i.e., overturn) a reorganization
              that allegedly had the intent and effect of moving the
              operations of Flying Tiger into a wholly owned subsidiary,
              with parent holding company being inherited by the former
              SHs of Flying Tiger. The specifics:
                      FTC’s Board did all the voting for FTL, but not SHs of
                      Thus, if FTL wanted to merge or sell all/substantially
                             all assets to another, it no longer needed
                             approval of public shareholders.
           • Eisenberg’s Complaint:
                  – Deprivation of voting rights to former Flying Tiger SHs
                      with respect to operating company.
           • FTL’s Counter-argument:
                  – Eisenberg’s claim is derivative. Must post security
                      under NY law.
           • Trial court:
                  – Held that Eisenberg was required to post security (as
                      per NY’s law)
       Held: Reversed
           • NY law (§ 627) on posting security applies...
                  – only to derivative actions -- not to direct actions.
           • Because harm to voting rights constitutes harm to a
              shareholder rather than harm to the corporation, Eisenberg's
              claim is direct.
           • Test for whether action is direct or derivative?
              Court applies the “Lazar” test, a suigenerous test that states
              that if a corporation impairs SH’s right to participate in
              governance of corporation, that’s a direct right (granted in
              the stock certificate), and not one that is merely incidental to
              ownership interest at firm.

   •   In some states, there is another avenue to escape security-posting

      •   Cohen v. Beneficial teaches that such statutes are presumptively
          substantive parts of state law, and thus apply to diversity SH
      •   BUT: If state law itself says that its own bonding statute is
          procedural, then the question of posting security is once again a
          federal one…
               – …and under federal law, no security-for-expenses statute

Second Hurdle: Demand Requirement
   • Most states require SHs in derivative suits first to approach Board
      of Directors and demand that they pursue legal action…
             • … unless the SH can claim a valid excuse.
   • Related issues:
             • When is demand requirement excused?
                     • If the demand would be futile
             • If not excused, what recourse does SH have if Board
                 decides not to pursue?
             • Does making the demand affect one’s subsequent rights
                 to bring a derivative action?
   – The basic Test
      2-Part test from Aronson v. Lewis (1984):
         • Demand requirement excused only if such a demand would
             be “futile.” I.e., whether there is a reasonable doubt that
                 – (a) Directors are disinterested & independent, AND
                 – (b) Challenged transaction was product of valid
                     exercise of business judgment.
         • Is this test conjunctive or alternative?
                 • Alternative

      The First (and trickier) Part of Test: Deals with CURRENT decision-
              making capabilities of the board rather than the board’s
              capabilities at the time of the alleged wrong. First prong
              asks whether the BoD has the ability to reach a disinterested
              decision about whether it’s in the corporation’s best interests
              to pursue litigation.
      This is a relatively unclear area of law. But what the first test
              seems to require is that a majority of the board is either
              DIRECTLY implicated in the wrongdoing or are DOMINATED
              by those who are.
      A substantial turnover of the board between the transaction
              complained of and the filing of the suit would make it more
              difficult to get by this prong you would have to prove that

       the new guys are dominated by the implicated old guys that
       are still on the BoD.

The second (much easier) part of the test: Deals with whether the
      action(s) that motivate the complaint itself are likely to be
      protected by the BJR in litigation.
In what circumstances is something NOT protected by the BJR?
              Duty of Loyalty
       Blasting Through:
              Procedural Challenges to Decision: (“Procedural Duty
                     of Care”)
              Substantive Challenges: (“Substantive DoC”; or

•   If you make a demand and then a disinterested majority of the
    board says no then usually the BJR protects them.
•   If demand excused, Board cannot dismiss
        – Caveat 1: Can still move for dismissal, often on advice of
           Special Litigation Committee
        – Caveat 2: If demand excused but still made, SH waives
           any possible excuse claim

Summary So Far:
  • SH does not always get her day in court.
        – Either board must yield to her demand, or she must
           show that demand is futile
  • Ostensible Purpose of Demand Requirement
        – To stem the “hold-up/strike-suit” problem, one
           shareholder should not be allowed to waste the
           assets of other shareholders.
  • In Delaware, if demand is made, SH is usually deemed to
    have conceded its necessity
        – And SH would then have to demonstrate “wrongful
                  – Under Delaware law, where demand is
                      made the plaintiff is deemed to have
                      conceded that it was required, which in
                      turn makes the decision of the board on
                      whether to dismiss a matter of business
                      judgment, which in turn means that the
                      plaintiff invariably loses.

                               And where demand is required, or made,
                               the plaintiff is not entitled to discovery.
                 –   Thus, well-advised SHs rarely make demand, and
                     instead routinely allege futility (per Aronson rule)

Third Hurdle: Special Litigation Committees
   • 2-part test for demand-excused cases in which an SLC has
       recommended dismissal:
             – Did SLC act independently, in good faith, and with a
                  reasonable investigation (with the burden of proof on
                  defendants), and
             – Does dismissal pass independent judicial inquiry into
                  business judgment?
          • Vested with decision-making power of board about whether
             to pursue litigation.
          • If the SLC decided against, it would cause the corporation to
             make a motion to dismiss the action.
          • Once the committee has found out its information, the court
             gives a lot of deference for what the committee thinks is in
             the best interest of the corporation.
          • But the court will scrutinize the procedures used to
             investigate the underlying facts and determine the existence
             of possible legal liability.
          • As such, it’s likely going to take a finding of GROSS
             process to overturn the process of an independent SLC;
          • And a finding of WASTE to overturn the SUBSTANTIVE
             content of its decision.
   • Competing Approaches
       • Auerbach: (Majority rule) No substantive scrutiny of SLC
             – Showing that SLC was disinterested and conducted an
                  adequate investigation, ends inquiry.
             – SH must show wrongfulness/lack of info.
       • Miller: SLC not valid if structurally biased:
             – Interested directors can’t participate in board selection of
                  the SLC.
       • Zapata: (Minority/Del. Rule). In addition to requiring SLC’s
          adequate investigation and disinterested members, independent
          judicial scrutiny.

     Demand Requirements
 Under Delaware Law: A Synopsis
                                                                      YES        SH action proceeds in
                                                    BoD/SLC                         name of Corp.
                                     YES                              NO

                      Demand                                                     SH action cannot proceed
                     Made/Pled?                                                      unless decision
                                                  SH action cannot                 “wrongful” (Grimes)
          REQUIRED                                    proceed
    Required or                                   Excuse Presumed
     Excused?                                     Waived (Grimes)
               EXCUSED      Demand
                                                                                   SH action proceeds
                                                            SLC            YES      in name of Corp.
Excused if  pleads with particularity                  recommends
facts that create reasonable doubt about                  pursuing?
 (1) Directors' disinterestedness &
 independence (at litigation);                                        NO         SH action proceeds
  (2) The exercise of sound business                                             unless defendant can
judgment (at time of alleged wrong);                                             pass 2-pt Zapata test
Aronson v. Lewis; Brehm v. Eisner.


 Sources of Law
     Securities Act of 1933
            Regulates the offering and sale of new securities (primary markets)
            The 1933 is primarily a disclosure (transactional disclosure) statute,
              what do you have to do and tell people if you want to take your
              company public.
     Securities Exchange Act of 1934
            Regulates secondary market activity
            Periodic disclosures
            Created the Securities and Exchange Commission (a.k.a. SEC)
                  Independent agency
                  Enforce the securities laws
                  Promulgate rules and regulations to implement those laws
                    more effectively
                  The SEC looks at the adequacy of the disclosure, not the
     What are “Blue Sky” Laws
            State laws that regulate securities

           You have to check the states where the security is being offered or
           There are state and federal laws and you have to comply with both
            of them.

Purposes of Securities Laws
    Full disclosure
          Make sure that investors have all the information they need to
             make informed decisions
    Prevention of fraud
          Agency cost problem re disclosure – how to make a credible bond?

    Securities Act (1933)
            Transactional
                 Registration statement filed with SEC
                 Prospectus distributed to investors
            Required in connection with any public sale
    Securities Exchange Act (1934)
            Periodic
                 Form 10 (once)
                 Fork 10-K (annual)
                 Form 10-Q (quarterly)
                 Form 8-K (episodic)
            Only required of registered companies

   Selling Securities under the Securities Act of 1933

      Registration              Registration
    Statement Filed              Statement
       with SEC                   Effective

      No        Offers permitted          Sales
    selling       but no sales           allowed
    activity      SEC review:          Prospectus
                  adequacy of           must be
                 disclosure, not        delivered

      When a company goes public they issue new stock for the public markets,
      and usually they have the buyers already lined up, the investment banks
      kind of market the stocks and they have some power over who gets to
      buy the stock, they tend to price the stock at just below they think it is
      worth, so that it will go up, after the lined up buyers buy the stock it goes
      to a secondary market after it has been registered through its IPO. Since
      the investment banks had control over who gets to buy the stock they
      would use it as a currency giving it to people to hold on to for a short
      amount of time and then sell it once it goes up to its real price or give it
      to their friends. It is not clear that this is illegal.
      The idea is not that the public will read the disclosures, but that analysts
      will do so, and there will be enough public sense about the company.

What is a Security?
   §2(1) of the Securities Act of 1933
             “The term ‘security’ means any note, stock, treasury stock, security
             future, bond, debenture, evidence of indebtedness, certificate of
             interest or participation in any profit-sharing agreement, collateral-
             trust certificate, reorganization certificate or subscription,
             transferable share, investment contract, voting-trust certificate,
             certificate of deposit for a security, fractional undivided interest in
             oil, gas, or other mineral rights, any put, call, straddle, option, or
             privilege on any security, certificate of deposit, or group or index of
             securities (including any interest therein or based on the value
             thereof), or any put, call, straddle, option, or privilege entered into
             on a national securities exchange relating to foreign currency, or, in
             general, any interest or instrument commonly known as a
             "security", or any certificate of interest or participation in,
             temporary or interim certificate for, receipt for, guarantee of, or
             warrant or right to subscribe to or purchase, any of the foregoing.”
   Implications of whether it is a security:
           Whether the registration requirements apply to the transaction?
           Plaintiff’s have a much easier time bringing a fraud claim.
Great Lakes v. Monsanto
    Monsanto and STI formed NSC as a Del. LLC and put their Nutrasweet
       business in it. In 1999 they sold NSC to Great Lakes.
    Great Lakes claims Monsanto & STI didn’t adequately disclose a
       competitor’s, Daesang’s, activities, resulting in overly optimistic
       projections, which inter alia, violated Rule 10b-5.
    Great Lakes claims it was either stock, an investment contract, or “any
       interest or instrumentality commonly known as a ‘security.’”
    What is the test for determining if it was a security?

 (Landreth) It is unnecessary to apply the Howey test to
  transactions involving traditional stock. Insofar as the
  transaction involves the sale of an instrument called stock,
  and the stock bears the five common attributes of stock
  enumerated in Forman the transaction is governed by the
  securities laws. (Great Lakes) As well as having the five
  characteristics to be traditional stock the transaction must
  be an investment transaction and not a commercial
  transaction. This is determined by applying the Howey
 Howey test for determining if something is an “investment
      A contract, transaction or scheme whereby a person invests
             Anything constituting legal consideration for purposes
               of contract law should satisfy the first prong of the
               Howey test
      In a Common Enterprise
             Horizontal Commonality between investors satisfies
               common enterprise element, court split whether
               vertical commonality between a promoter and an
               investor satisfies.
                    Horizontal Commonality requires a pooling of
                      investors’ contributions and distribution of
                      profits and losses on a pro-rata basis among
                    Vertical Commonality is less stringent, and
                      requires that an investor and promoter be
                      engaged in a common enterprise, with the
                      “fortunes of the investor linked with those of
                      the promoters.”
                           Ninth Circuit rule?
                                   Vertical commonality suffices but
                                    the Ninth Circuit uses a restrictive
                                    definition of vertical commonality
                                    that requires there to be a direct
                                    correlation between the
                                    promoter’s returns and the
                                    investor’s returns.
                                         E.g., vertical commonality
                                            would not exist if the
                                            promoter got a fixed fee
                                            irrespective of whether the

                                                      investor made or lost
                                    Notice that you will often have vertical
                                       commonality where you have horizontal
                                       commonality. The pool of investors as a
                                       group typically will be in vertical
                                       commonality with the promoter of the
             Is led to expect profits
             Solely from the efforts of the promoter or a third
               party (control)
                    Virtually no court reads that phrase literally; in
                        particular, the word “solely” is read as primarily
                    The test?
                               How much effort must the promoter put into
                                       the project, as opposed to the investor’s
                                       efforts, in order for the expectation of
                                       profits test to be met?
                               The critical inquiry is “whether the efforts
                                       made by those other than the investor
                                       are the undeniably significant ones,
                                       those essential managerial efforts which
                                       affect the failure of success of the
             It is immaterial whether the shares in the enterprise are
               evidenced by formal certificates or by nominal interests in
               the physical assets employed by the enterprise
             Note that it is the investment scheme that is the security,
               not the enterprise—not the land or the citrus trees.
      Five most common feature of stock (Forman):
             The right to receive dividends contingent upon an
               apportionment of profits
             Negotiability
             The ability to be pledged or hypothecated
             Voting rights in proportion to the number of shares owned
             The ability to appreciate in value
      Nothing falls under “any interest or instrument commonly known as
        a ‘security’” that does not fall under an investment contract.
 Was Great Lakes investment in NSC a security and, therefore, subject to
      No.
             It was not traditional stock because although they meet the
               five Forman factors, but it was not an investment transaction
               but a commercial transaction under the Howey test because

                there was no common enterprise, and did not involve profits
                solely form the efforts of others because Great Lakes could
                remove managers, and it was not an investment contract for
                the same reasons.
   Why would Monsanto and STI owe a duty to Great Lakes?
       There is a fiduciary duty of sorts that is owed to potential or
         acquiring shareholders created by the securities act.

   Does 10b-5 apply to close corporations?
        Yes, per Landreth
   Does 10b-5 apply to general partnerships?
        Circuit split:
               Goodwin v. Elkins (3d Cir.): A bright line standard that says
                 that because partners have a legal right to control the firm a
                 general partnership interest is never a security
               Williamson v. Tucker (5th Cir.): Look beyond the bare scope
                 of partnership law and consider the economic realities. A
                 security might be present if (1) the partnership agreement
                 deprives one or more partner of his legal control rights,
                 essentially leaving him in the position of a limited partner;
                 (2) the investor is so inexperienced or unknowledgeable in
                 business affairs as to be incapable of exercising his or her
                 legal rights; or (3) the investor is so dependent on some
                 unique entrepreneurial or managerial ability of the promoter
                 that the investor cannot exercise meaningful partnership
                      The 10th Circuit adopted only the first prong of
                         Williamson. Hence only a contractual deprivation of
                         control rights would result in finding that a general
                         partnership interest is a security.
   Does 10b-5 apply to limited partners?
        Limited partners have limited control rights
               RULPA gives greater rights
        Some courts therefore adopt per se rule that limited partnership
          interests are securities
               But limited partners can exercise considerable de facto
                 control. E.g., Holzman v. de Escamilla.
        The general rule is a limited partnership interest is a security.

Limited liability, no double taxation, flexible.
Two kinds one managed by the members, one managed by a manager

Primary Markets

    Public offerings can be useful
         Especially the IPO, can bring money into the company
    But very expensive:
         Costs associated with registration process
                 Lawyers
                 Accountants
                 Printers
                 Delay
         Disclosure costs
                 Competitors get access to proprietary information
                 Subject to antifraud regime
         On-going regulatory exposure
                 1934 Act periodic disclosure
                 Proxies, etc…

Public Offerings v. Private Placements
    Private Placements are exempt from the Securities Act and therefore
           Securities Act § 4(2)
                   “Section 4. The provisions of section 5 shall not apply to…
                          (2) transactions by an issuer not involving any
                             public offering….”

Private Placement Test
     Four factors:
            Number of offerees and relationship to issuer
                  Offerees’ knowledge and sophistication
                  Offerees’ access to information
                  Required of all investors or all offerees?
                         Depends on the offeree
                  How much information required?
                         “the information a registration statement would have
                  How may information be provided?
                         Private placement memorandum
                         Access to files and records
            Number of units offered
            Size of the offering
            Manner of offering
                  No general advertising or solicitation

Important Civil Liabilities
    1933 Act § 11
          Fraud in the registration statement

         Due diligence defense
    1933 Act § 12(a)(1)
         Strict liability for illegal offers and sales in violation of §5
         Rescission remedy
    1933 Act § 12(a)(2)
         Fraud in a prospectus or oral sales communication in interstate
         Defendants who conduct a reasonable investigation cannot be held
    Implied private rights of action
         1934 Act § 10(b) and SEC Rule 10b-5
                1934 Act § 14(a) and proxy rules

Civil Liability under Section 11
     §11 is the principal express cause of action directed at fraud committed in
        connection with the sale of securities through the use of a registration
     does not apply to exempt offerings
     Under §11 the following parties are liable if the registration statement
        contains an untrue material fact or omits a material fact that causes the
        statement to be misleading:
              Those who sign the registration statement, which is most of the
                important people.
              Directors
              Experts
              underwriters
     The Issuer has no defenses.
     All other parties have “due-diligence” defenses.
     Potential defendants can be thought of as two groups
              Experts
              Everyone else
     Registration Statement can be thought of in two parts
              The parts prepared by certified experts
              Everything else
     Under §(a)(4) experts are not liable for misstatements in the “non-
        expertised part of the document.
     Under §(b)(3)(A) w/respect to “non-expertised” portions, the non-experts
        must show that after reasonable investigation, they had reasonable
        grounds to believe, and did believe, that the statements were true.
     Under §(b)(3)(B) roughly the same test applies to the liability of the
        experts with respect to the expertised portion.
     Under §(b)(3)(C) w/respect to expertised portions, the non-experts must
        show that, they had no reason to believe, and did not believe, that the
        statements were misleading.

    Under §11(c) test for reasonable investigation and reasonable belief:
         The level of care that a prudent person would exercise if his or her
           own money were at stake.
         Note a defendant may reduce the damages she owes by showing
           that part of the damages resulted, not from the misstatements in
           the document, but rather from other causes.
         Defendant has the burden of showing that its misconduct did not
           cause the plaintiff’s damages.
         Defendants, other than the issuer, have the burden of showing that
           they were not negligent in the preparation of the registration

Escott v. BarChris Construction Corp.
    BarChris constructed bowling alleys, but collapsed in the Great Bowling
       Craze Bust of the early 1960’s.
    Shortly before going under, it issued some debentures
    In the registration for those debentures it misstated its financial condition.
    The debenture holders brought a class action under §11 of the 1933 Act.
    The sued: BarChris who signed the registration statement, the
       underwriters (Drexel), the directors and the accountants (Peat Marwick)
    Were there misstatements?
           Yes, easy call.
    What is the difference between a material misstatement and a plain old
           Material means information an average prudent investor ought
              reasonably to be informed before purchasing the security, matters
              such an investor needs to know before he can make an intelligent,
              informed decision.
    Were there material misstatements?
           Yes. They were prevalent in the 1961 figures. These figures were
    Were there material misstatements in the 1960 figures (the expertised
           Yes, some
Due-diligence Defense
    Bar-Chris
           No due-diligence defense because they are the issuer
           Only the parts of the registration statement audited by PM were
    Vitolo (President) & Pugliese (VP) – directors
           Little education and didn’t understand.

            Court calls that irrelevant, directors have a standard of care and
              V&P should have hired lawyers to review registration statement for
      Kircher (Treasurer-director)
            Court doesn’t believe him and suggests he purposely fed false info
              to Peat Marwick.
      Brinbaum – director
            Recently out of law school and did not investigate the accuracy of
              the registration statement.
      Grant (outside counsel) – director
            Sued only as director not as counsel. Drafted registration
              statement and did not investigate whether the answers he received
              from the Company were true. No liability as an attorney, but as a
              director, he has to investigate the accuracy.
      Peat Marwick – Outside auditors
            PM assigned young Berardi to audit, and Berardi took the BarChris
              officers at their word. He inadequately checked statements, so PM
              can not claim it exercised due diligence.

Who must file disclosures?
All publicly traded companies and some large close corporations.

RULE 10b-5
Exchange Act §10b-5 and Rule 10b-5
Section 10b provides:
      It shall be unlawful for any person, directly or indirectly, by the use of
      any means or instrumentality of interstate commerce or of the
      mails, or of any facility of any national securities exchange.—
               (b) To use or employ, in connection with the purchase or sale of
               any security registered on a national securities exchange or any
               security not so registered, any manipulative or deceptive
               device or contrivance in contravention of such rules and
               regulations as the Commission may prescribe as necessary or
               appropriate in the public interest or for the protection of investors.
    Notice that §10b applies to any security, including securities of closely
      held corporations that generally are not subject to the Exchange Act.
Rule 10b-5
      It shall be unlawful for any person, directly or indirectly, by the use of any
      means or instrumentality of interstate commerce, or of the mails or of any
      facility of any national securities exchange,
               (a) To employ any device, scheme, or artifice to defraud,
               (b) To make any untrue statement of a material fact or to omit to
               state a material fact necessary in order to make the statements

             made, in the light of the circumstances under which they were
             made, not misleading, or
             (c) To engage in any act, practice, or course of business which
             operates or would operate as a fraud or deceit upon any person,
      in connection with the purchase or sale of any security.
           Justice Dep’t: Willful violations are a felony (see Securities
             Exchange Act § 32(a).
           SEC: Brings civil actions.
           Private parties?
                  No express cause of action.
                  Supreme Court implied private right of action in
                    Superintendent of Insurance v. Bankers Life & Casualty Co.
                 “The existence of this implied remedy is simply beyond
                   peradventure.” Herman & MacLean v. Huddleston (1983).
           “in connection with the purchase or sale of any security” Only
            purchasers or sellers have standing to sue – Blue Chip
            Stamps v. Manor Drug Stores
           Blue Chip plaintiffs decided NOT to buy due to fraud but had no
                 Plaintiffs said you had to sell your stock by law and you
                    didn’t want to so you made it look worse than it was so we
                    wouldn’t buy, and if we would have bought we would have
                    made a lot of money.

           If you sue under 10b-5 you end up in federal court as opposed with
            breach of a fiduciary duty which is a state law issue.
           If a low level person comes out and says something incorrect the
            company has a duty to come out and correct the statement

Rule 10b-5 Elements
  Traditionally, a plaintiff suing under Rule 10b-5 needed to show four things:
   Scienter: defendant acted with an intent to deceive, manipulate or
          State of mind:
                  Intent to deceive, manipulate or defraud (Sup. Ct.)
                  Reckless disregard of falsity of statement (all circuits but Sup
                    Ct. has reserved the issue.)
                  The 1995 Private Securities Litigation Reform Act (PSLRA)
                    altered the standard of pleading recklessness in some
                    circuits. Some circuits now require pleading detailed facts
                    showing evidence of deliberate recklessness which raises the
                    standard back closer to fraud.

       Required in private party litigation – Ernst & Ernst v. Hochfelder
       Required in SEC actions – Aaron v. SEC (1980)
 Proximate cause (the misstatement caused the damage)
       Two Types of Causation
             Transaction causation
                     Closely related to reliance
                     But for the fraud, plaintiff would not have invested (or
                       sold, etc….)
             Loss causation
                     Akin to proximate cause
                     Fraud caused the loss
       Where reliance is presumed, court will also assume transaction
             Omissions
             Fraud on the market
       Loss causation not presumed
             Usually turns into a battle of experts.
 Material misrepresentation or omission
       “whether there is a substantial likelihood that a reasonable
         shareholder [or investor] would consider the fact important” – TSC
         Indus., Inc. v. Northway Inc. (1976)
       Whether there is a substantial likelihood that a reasonable investor
         would consider the omitted fact important in deciding whether to
         buy or sell securities
                     Effects of this standard?
                     Under this materiality standard, insiders will seldom
                       be able to defend their trades by arguing that
                       information is immaterial.
             But how do we apply when faced with uncertain and
                contingent facts?
                     “a highly fact-dependent probability/magnitude
                       balancing approach” (Basic)
             Doesn’t the fact that an insider traded on a piece of
                information, itself demonstrates materiality?
       Materiality Factors
             Nature of the information
             Company response
             Market response
             Conduct of insiders
 Reliance
       To establish fraud at common law, a plaintiff must affirmatively
         prove reasonable reliance on deception.
       Not so under 10b-5 doesn’t have to be reasonable.

           Traditionally, under 10b-5 if the case involved an affirmative
             misrepresentation, courts required the plaintiff show that he or she
             relied on the misrepresentation.
           Material Omissions…
                  If the case involved a failure to disclose, courts adopted a
                    rebuttable presumption of reliance – Affiliated Ute Citizens of
                    Utah v. US (1972)
                  But Basic is a misrepresentation case…so what could the
                    Court do?
                         Fraud on the market theory.
                               Presumption that investor relied on integrity of
                                  market price—so investor need not have seen
                               Invoked when?
                                       Material Public misrepresentation
                                       Efficient market
                               How can defendant rebut fraud on the market
                                       Market not deceived (their
                                         misrepresentation did not effect the
                                         market price.)
                                       Corrective statements
                                       Show that specific plaintiffs would have
                                         sold anyway
                         Note that any requirement of showing actual reliance
                           has class certification implications
   with some of these things there is going to be some overlap, especially with
   reliance and causation
   • Rule: Fraud only needs to “touch and concern” a purchase or sale

Basic Inc. v. Levinson
Facts: Plaintiff are people who sold their stock, after the company said there
      was no merger, but before the merger, claiming they would have got a
      higher price but for the untrue denial.
    Issues:
          Were Basic’s statements materially false?
          Is this a proper class action, when proof of reliance is an issue?
    Side-issue
          Where 10b-5 liability is premised on an omission of material fact,
             liability can only arise where the defendant had a duty to disclose
          Did Basic may not have had a duty to disclose the merger
              No they did not have a duty to disclose
                   If not, what should Basic have done?

                        They should have just not commented, court does not
                          decide if that would have been enough.
    Why is company liable for something President said?
          Agency law
    General standard of materiality?
          “whether there is a substantial likelihood that a reasonable
            shareholder [or investor] would consider the fact important” – TSC
            Indus., Inc. v. Northway Inc. (1976)
                But how do we apply when faced with uncertain and
                   contingent facts?
                        “a highly fact-dependent probability/magnitude
                          balancing approach”
                Sometimes materiality shifts depending on who we are
                   talking about.
    Reliance
          Material Omissions…
                If the case involved a failure to disclose, courts adopted a
                   rebuttable presumption of reliance – Affiliated Ute Citizens of
                   Utah v. US (1972)
                But Basic is a misrepresentation case…so what could the
                   Court do?
                        Fraud on the market theory.
                               Presumption that investor relied on integrity of
                                 market price—so investor need not have seen
                                 misrepresentation, sophisticated analysts rely
                                 on the information and they control large
                                 financial resources and set the market price.
                               Invoked when?
                                      Material public misrepresentation
                                      Efficient market
                               How can defendant rebut fraud on the market
                                      Market not deceived (their
                                         misrepresentation did not effect the
                                         market price.)
                                      Corrective statements
                                      Show that specific plaintiffs would have
                                         sold anyway
                        Note that any requirement of showing actual reliance
                          has class certification implications, that you could
                          never bring a class action under 10b-5.

West v. Prudential Securities, Inc.
Facts: Broker lied to clients saying Jefferson was going to be acquired.

    Plaintiffs are the class of investors who bought Jefferson stock during the
     time Hofman was lying. (not Hofman’s client’s)
    Held:
          No case. Plaintiffs cannot show that Hofman injured them.
                  Fraud on the market theory depends on dissemination of the
                     information and Hofman only lied privately. He could not
                     affect the price of Jefferson stock.
                  Easterbrook argues that even if professional investors had
                     heard the lie, they would have discounted it once events
                     made it clear that no one was planning to buy Jefferson. If
                     they discounted the lie, the price of Jefferson stock would
                     have returned to earlier, lower levels.
                  Judge says it is a horizontal demand curve, there is no
                     demand for Jefferson stock per se such that increasing the
                     demand would increase the price, as the price goes up it
                     doesn’t matter, major investors are not going to chose to
                     buy less of the stock they are going to chose to buy none of
                     the stock, they are choosing a stock to diversify their
                     portfolio, they want a specific combination of risk and return,
                     so they will just not buy that stock when it does not fit and
                     will buy another stock that fits that balance, the price of
                     stock will only change when investors who control enough
                     funds acquire new information about the stock about the
                     return they can expect.

Pommer v. Medtest Corporation
    Medtest had a technology.
    Manning sells stock to the Pommers .
    At the time of the sale, West (another Medtest shareholder) told the
       Pommers that:
           Medtest had a patent on the technology (incorrect at the time)
           A sale of Medtest to Abbott Labs for a price between $50 million
             and $100 million was imminent. (deal falls through)
    The Pommers sue under Rule 10b-5
Held: The Pommers win on the patent issue.
    Why didn’t Judge Easterbrook believe that the Pommers were misled by
       the imminent sale talk?
           Sale price of $50-100 million reveals a lot of uncertainty so reliance
           A sale at $50 million would have been worth $1.5 million to the
             Pommers, but Manning sold them the stock for only $200k.
    Why doesn’t the fact that a patent was eventually issued matter?

         “Good fortune may affect damages, but it does not make the
           falsehood any the less material.”
         The Pommers would have paid less if they had known that Medtest
           had not obtained the patent yet
    Under what circumstances should West and/or Medtest be held liable?
         West is not liable if he didn’t know the Pommers were negotiating
           to buy from Manning. (Sceinter)
         Medtest is liable only if West was acting as its agent.
    What are the Pommers damages?
         The difference between $200,000 and the amount an investor
           would have had to pay who was fully apprised of the pending
           patent whether or not the patent actually issues.
         The measure is what would the plaintiffs have received but for the
           false denials, but the company is going to say the false denial kept
           the merger going and without it the price would have gone down,
           so no damages.

Santa Fe Indus. v. Green
    Santa Fe Industries held 95 percent of the stock of Kirby Lumber Corp.
          Santa Fe merged Kirby Lumber into itself (at $150/share) using the
             Delaware short-form merger statute
                  No shareholder vote required
                  Shareholders have the right to have a court appointed
                    appraisal determine what they should get for their stock
                  Shareholders claim fair price = $772 physical assets valued
                    at: $640/share
    Plaintiffs (minority shareholders) claim merger violated Rule 10b-5
          Merger was effected without prior notice to the minority
             shareholders and was done without any legitimate business
             purpose, but to eliminate the minority shareholders from the
          Their shares had been unfairly undervalued
    Plaintiffs are not claiming that they were lied to; rather, they are claiming
     a breach of duty because the transaction was unfair
    Holding:
          Conduct only violates Rule 10b-5 if manipulative or deceptive, not
             corporate mismanagement that is a state issue for breach of
             fiduciary duty.
                  Under 10b-5 manipulation has a very specific meaning,
                    practices that artificially affect market activity for the
                    purpose of misleading investors.

         The Federal-State Balance

                States                                     Federal

                                       Santa Fe
         Shareholder liability                    Transactional disclosure
       Corporate governance                         Periodic disclosure—
   Director/officer fiduciary duties                by public companies
      Shareholder rights/duties                     Fraud in conjunction w/
                                                   securities transactions


Wash Sales
   Manipulator enters a purchase order and a sale order at the same time
     through the same stockbroker
          Ownership of the stock does not change but creates the
           appearance of activity in a security

Matched Sales
    Manipulator enters a purchase order with one stockbroker and a sale
      order, at the same time and at the same price, with a different broker
          Sometimes involves multiple manipulators acting together (so-
             called “cross sales”)
          Matched purchase and sale transactions create the false
             appearance of active trading

Evading Santa Fe
    Acme makes a very popular product
    Acme’s annual report makes a great many glowing references to the
          Acme routinely ascribes Company X’s stock market success to the
             success of the product
    Unbeknownst to the shareholders, however, Acme’s scientists have
      established that the product is dangerous and defective
          Acme’s management continues to manufacture the product

 The defects are eventually discovered, massive liability suits ensue, the
  company goes bankrupt
 Shareholders sue management
 State law claim?
      Duty of Care
 Who wins?
      Probably the BJR protects them
 Rule 10b-5 claim?
      Allege that during the relevant time period (i.e., before public
         awareness of the risks posed by the product), management knew
         or recklessly disregarded the fact that the product was defective
         and failed to disclose those facts
      It is possible they could win under these facts, more an issue of
         disclosure than Santa Fe.

                             INSIDER TRADING

   • Why is insider trading illegal?
         – Does economic analysis suggest a theory that has both justificatory
             and explanatory power?
         – Or should we just repeal the whole thing?
   • Deregulatory arguments:
         – Market efficiency
         – Executive Compensation, and if shareholders don’t like it they won’t
             invest in such a firm, or if they don’t mind they won’t invest and
             then why should the SEC care,
         – Most of it goes undetected, conveying to the public that stock
             market trading is an unrigged game anyone can play and that
             might be misleading
   • Regulatory arguments:
         – Fairness
         – Property rights
   • Question: Who gets harmed?
      • Shareholders who Sold? Well maybe they would have sold anyway
      • Shareholders who kept shares? Not unless the price is dropping
      • Other Arbitrageurs? Definitely harmed, but maybe it is a risk of the
      • Acquired firm? Probably not unless you have more and more people
                          buying up stock on behalf of the acquirer
      • The acquirer? They might have to pay more for the firm they are
      • Society
             – Efficient “pricing” of shares?
             – Opportunity cost of Corporations’ efforts
   • There is an argument you don’t need 10b-5 to deal with this because they
      can require that the investment bankers not disclose and if they do then
      there are contract damages there.
   • If we have to strict of a rule then we can’t have stock analysts that meet
      with management and try to evaluate the company

Distinguish Between
   • “Generic” 10b-5 violations (which do not involve inside trades) and
      “Insider Trading” 10b-5 violations (which do.)
   • Government (SEC) enforcement actions against violators and private
      rights of action by contemporaneous traders
          – Damages vs. fines and/or imprisonment
          – Necessity of showing Reliance and Transaction/Loss causation

The word insider does not appear anywhere in 10b-5, this is important to
remember because 10b-5 was created to address fraud, so the expansion of
10b-5 to encompass insider trading really only happens when the insider had
some duty.
   • Insider trading liability is premised on an omission of material fact
          – Problem: Liability for omission can only be imposed where
             defendant had a duty to disclose
                • Silence is not fraudulent absent a duty to speak
          – Whence comes the insider’s duty to speak?

As pertains to Insider Trading
   • Duty:
         – Statutory or “Constructive” insiders have duty not to trade while in
            possession of non-public information; must “disclose or abstain”
   • Scienter:
         – An insider who trades risks liability if she does so knowingly or (in
            most jurisdictions) recklessly
   • Materiality:
         – “Reasonable Investor” test (see below)
   • Reliance
   • Proximate Cause

Under the traditional theory of insider trading Rule 10b-5 is violated when a
corporate insider trades in the securities of his corporation on the basis of
material, nonpublic information. Trading on such information qualifies as a
“deceptive device” under § 10(b), we have affirmed, because “a relationship of
trust and confidence [exists] between the shareholders of a corporation and
those insiders who have obtained confidential information by reason of their
position with that corporation.

Why is Martha Stewart not guilty of insider trading?
She did not get information the FDA was not going to approve the drug, but that
the company executive was selling his stocks

Texas Gulf Sulphur
      Facts: Exploring mine, president demands secrecy because land prices
             will go up before they can purchase the land (so there was a good
             corporate justification for nondisclosure, until the land acquisitions
             had been completed), insiders trade, corporation at first denies
             media claims.
      Posture and Holding:
         • SEC action against both individual defendants and corporation
         The Corporate Defendant

             •   Why was TGS charged with violating 10b-5?
                   – TGS was not a purchaser or seller
                           • Status as such is only relevant to private party
                              plaintiff standing to sue
                   – “In connection with”
                           • Satisfied if the press release “would cause
                              reasonable investors to rely thereon” and “cause
                              [such investors] to purchase or sell a corporation’s
         Insider Defendants
             • Legal rule re insider trading?
                   – Where an insider has material nonpublic information the
                       insider must either disclose such information before
                       trading or abstain from trading until the information has
                       been disclosed THIS IS NOT THE LAW TODAY
                   – “Disclose or Abstain” Cady-Roberts THIS IS NOT THE
                       LAW TODAY
             • Policy: Rationale for rule?
                   – The federal insider trading prohibition was intended to
                       assure that “all investors trading on impersonal
                       exchanges have relatively equal access to material
      Held: CA2 reverses some of the individual dismissals, and reverses TGS
                 – Note: Coates waits till just after the press release is
                   released, court says not okay
                        Ct holds that insiders must wait until info. has had a
                           “chance” to percolate through the market.
                        Would it be different today?
                        Probably, because of the internet

Who is an Insider?
  • Exchange Act § 16(b): Officers, directors, and 10% shareholders
        – § 16(b) also requires such insiders to report changes in their
           ownership stake, and to disgorge “short-swing” profits from quick
           purchase or sale.
        – But in addition, cases can involve what are known as TEMPORARY
           Insiders (Harder Cases):
               • Dirks.
               • This will usually mean any agent who, because of their
                  position, is given access to trade-secret like knowledge that
                  is reasonably expected to be confidential. Thus, this can
                  include various contractual privies, former executives,

                                                    families of insiders, etc. This is why the trading of the firm’s
                                                    geologist (not a statutory insider) is also proscribed.)

When May Insiders Trade?
  • Rule?
       – Insiders (e.g. Coates) must wait until the information is effectively
          disclosed in a manner sufficient to insure its availability to the
          investing public

So at this point there are two paths to go down:
One is more limited related to property rights, one is the securities fraud path
which brings a lot more things into the securities realm.

                           Going down the securities fraud path

          Cady Roberts                                Texas Gulf Sulphur
             1961                                           1968

                          • Effects:
                            – Federalization
                            – Public (SEC) instead of private enforcement
                            – Legal theory moves from fiduciary duty to securities


                                       The road curves

                              Cady Roberts
     Scope of Liability

                              Chiarella and Dirks

Chiarella v. US: Limits of “Traditional” I-T Liability

Facts: Printer correctly identifies identity of tender offer. He did not buy stock in
       the corporation doing the printing he bought stock in a corporation he had
       no relationship with, (and therefore he had no duty to their shareholders).
   • Majority:
           – Throws out the “level playing field” theory for prohibiting insider
           – Violation of 10b-5 occurs only if informed trader owed a duty to the
              corp/SHs. Did he? No, no relationship of trust with the
              shareholders of the corporations whose shares he traded.
                  • He had a duty to his principal as an employee, but it was not
                     to the shareholders.
   • Dissent (Burger)
           – First articulation of the “misappropriation” theory of Insider Trading
           – Reads the relevant sections to mean "that a person who has
              misappropriated nonpublic information (regardless of the duty
              owed) has an absolute duty to disclose that information or to
              refrain from trading."
           – But not adopted by court…..(yet)
A case that places a distinct limit on the traditional I.T. theory.
Articulates the premise that under a "traditional" insider trading
       approach, the use of inside information is only a violation if the
       possessor has a "duty" to the shareholders.
Throws out the argument that antifraud provisions are present to ensure Parity
       of information.

Dirks v. SEC
Facts: Dirks tells his clients what he has learned from a former officer that
       company is cooking books, his clients sell the stock, he doesn’t trade.
       Brought up as a tipping tippee.
Held: Secrist owed a duty of some kind, but he did not breach that duty
   • Secrist’s duty to corp/SHs:
           – Was he a “statutory” insider?/Did Secrist Actually Owe a Duty to
              the EFA and its SHs?
                   • No. Secrist DID have a duty to SHs, but it was NOT a
                       statutory duty. He was not a director/officer/large SH under
                       §12. Rather he was a former Officer.
                   • But, recall in TGS, the statutory label is only sufficient (not
                            Definition of a “temporary” insider: Fn 14.
                                 • The basis for recognizing this fiduciary duty is
                                     not simply that such persons acquired
                                     nonpublic corporate information, but rather
                                     that they have entered into a special
                                     confidential relationship in the conduct of the

                                    business of the enterprise and are given access
                                    to information solely for corporate purposes.
          – If so, does Dirks “inherit” Secrist’s “Cady/Roberts” duty (disclose or
                 • Not unless the insider breaches(and personal benefit test) a
                     fiduciary duty in disclosing, and tippee has constructive
          – Does Dirks “pass it on” to his tippees?
                 • Court: NO. For tippee to inherit duty: Tipper must be tipping
                     for personal benefit. Obviously, Dirks’ tippees have nothing
                     to inherit, since Dirks did not inherit a “Cady-Roberts” duty
                     from Secrist.
   •   Holding re tipping?
          – In general, the tippee’s liability is derivative of the tipper’s, “arising
             from his role as a participant after the fact in the insider’s breach of
             a fiduciary duty.”
          – A tippee therefore can be held liable only when:
                 • The tipper breached a fiduciary duty(and personal
                     benefit test) by disclosing information to the tippee,
                 • The tippee knows or has reason to know of the
                     breach of duty

Tipper Liability
   • Tippers...
         – May Be Liable for their tippee’s trades.
                 • Even if tippees themselves not liable under Dirks,
                   tipper can still be liable under the first half of Dirks
         – Who give bad tips can be sued by their tippees!
         – Tippers who trade: liable as insiders if Dirks test satisfied

SEC v. Switzer
Facts: Barry Switzer overheard CEO telling his wife something at a track meet.
       Switzer and his pals traded on the info.
Held: Given the facts, Switzer is not liable. He is neither an insider nor a
       constructive insider. Platt is not liable since a tipper violates a fiduciary
       duty in giving the tip only if he profits from the breach and Platt did not
       profit here. Plus even if telling the wife was a breach of a fiduciary duty
       Switzer would have had to have known or have had reason to know it was
       a breach

Disclose or Abstain

   •     The disclose or abstain regime still is present. However, the question is
         “Who must disclose or abstain?” When does the rule apply.
   •     Note also, that given the frequently existing confidentiality restrictions,
         this becomes more of an abstain rule.

                                                                                   Liability under a “Traditional” Insider
               Is subject in
              possession of
                                                                                      Trading Theory via Rule 10b-5
                                                             No Liability
              material, non-
               public, info?

                                                                                                                No Tipper/Tippee
                                                                                                               Liability (but see *)

                                                                            Does Insider
                                                                                Tip                       NO
              Statutory insider                                               others?
                under §16(a)                                      NO
               (D/O/Prin. SH)?                                                                YES
                                                                                                                No Tipper/Tippee
                                                                                                               Liability (but see *)
                                                       Does insider
                                                       disclosing?                     Does Insider Tip
                                         YES              (TGS)                         for Personal
                                                                                       Benefit (Dirks)?

             Temporary insider
               (Dirks, fn. 14)?                                                      YES
                                                                                                                 Tipper Liability
                                                                                                                ONLY (but see *)

                                                                                    Does Tippee                   NO
                                                    *Subject Liable for              have reas.
                                                   Personal Trades under           knowledge of                         YES
                                                          10b-5                   Tipper’s Breach
       No Liability under Traditional
         Theory (but there may be                                                     (Dirks)?
        liability via msapp., 14e-3;
           mail/wire fraud, etc.)                                                                               Tipper & Tippee
                                                                                                                Both Liable (but
21                                                                                                                   see *)

U.S. v. O’Hagan
     O'Hagan was a partner in the law firm representing Grand Met in a
     potential tender offer for the common stock of a company. O'Hagan did
     no work on the Grand Met representation, but knew about it and
     purchased stocks.
The Misappropriation Theory of Insider Trading
     The "misappropriation theory" holds that a person commits fraud "in
     connection with" a securities transaction, and thereby violates § 10(b) and
     Rule 10b-5, when he
            (1) uses confidential information in breach of a duty owed to the
                   source of the information (fulfilling the “breach of duty”

               (2) doesn’t disclose this information to trading partners
               (3) and proceeds to trade on that information. (“transaction”)
       The two theories are complementary. The classical theory targets a
       corporate insider’s breach of duty; the misappropriation theory outlaws
       trading on the basis of nonpublic information by a corporate “outsider” in
       breach of a duty owed not to a trading party, but to the source of the
       Full disclosure to the source of the information of plans to trade on the
       information forecloses liability under the misappropriation theory because
       then there is no deception, but there still might be a state law breach of
       duty of loyalty.
       Even when the duty doesn’t cross over, if you take information in breach
       of a duty then you are still liable.
       Under this theory Chirella would have been liable
       Under this theory fiduciaries of the acquiring company are also liable even
       though they have no fiduciary duty to the soon to be acquired company.
       The fraud is not the trading but how you acquired the information.
       According to the court there were duties to the law firm and to the client
       and they were both breached
Held: 10b-5 convictions reinstated
   • A fiduciary’s undisclosed use of information belonging to his principal,
       without disclosure of such use to the principal, for personal gain
       constitutes fraud(deception) in connection with the purchase or sale of a
       security and, thus, violates 10b-5.
           – Duty of Trust & Confidence owed in misappropriation case (under
               new SEC guidelines (Rule 10b5-2) when:
                   • Person agrees to maintain information in confidence
                   • There is a history of sharing confidences so recipient of the
                      info knows or should know that the person communicating
                      the info expects the recipient to maintain confidentiality
                   • Person receives the information from a spouse, child, parent,
                      or sibling (unless the recipient can prove that he had no
                      reason to know that the information was confidential).
           – Note that this is a “non-exhaustive” list.
   • “Misappropriation” theory consistent with § 10(b) and Rule 10b-5
           – Statute/Rule proscribe “deception” by trader “in connection with
               purchase/sale” of securities.
           – In this case, deception works through undisclosed use of the
               principal’s info; and purchase/sale requirement clearly met.
           – Santa Fe Industries does not contradict this outcome.
               Misappropriation can’t be about just any breach of fiduciary duty,
               deception is required.
                   • To escape 10b-5, O’Hagan need only disclose (to whom?)

                        •  Probably Hagan should disclose to the law firm and
                           the Grand Met
                 •   Which must give him permission?
                       • If you literally read the case you don’t need
                           permission from anyone, they just say you have to

Traditional I-T, clarifications
   • Gift means a gift from the tipper. It is viewed as the equivalent of trading
       in the info and giving the tippee the money.
   • Under the traditional theory, there should be tipper liability for an insider
       only, but there are a few (I think incorrect) cases which have transferred
       the violation of the insider tipper to a subsequent outside tippee turned
   • Policy: The reason for the personal benefit requirement is that the Insider
       tipper doesn’t just have a duty of confidentiality, they have a duty of
       loyalty. It is almost as though the court has created a duty to refrain from
       self dealing in non-public information.

U.S. v. Chestman (Non-traditional cases)
Facts: Waldbaum is about to be acquired by A&P; Ira Waldbaum, president tells
       sister Shirley; Shirley tells daughter Susan who tells husband Keith; Keith
       tells his broker, Chestman who buys stock for his own account and his
       clients. SEC argues Keith misappropriated info from his wife Susan which
       he then tipped to Chestman
           – The requisite relationship will be found where one party acts on the
               other’s behalf and “great trust and confidence” exist between
               the parties.
           – Unilaterally entrusting someone w/confidential information does not
               by itself create a fiduciary relationship.
                   • Even if the disclosure is accompanied by an admonition such
                      as “don’t tell.”
           – Familial relationships in the absence of evidence that Keith
               regularly participated in confidential business discussions
               are not fiduciary in nature w/out some additional element. (So
               SEC passed Rule 10b5-2)
           – But the SEC has promulgated rules that say that family
               relationships are relationships of trust and confidence, the
               rule has not been tested yet.

US v. Willis
   •   But in U.S. v. Willis, a psychiatrist traded on inside information learned
       from a patient in the course of therapy.

              –     Relevant part of the Hippocratic Oath: Whatsoever things I see or
                    hear concerning the life of men, in my attendance on the sick or
                    even apart therefrom, which ought not to be noised abroad, I will
                    keep silence thereon, counting such things to be as sacred
              –     Court determined that, based on the Hippocratic Oath, the requisite
                    breach of fiduciary duty had occurred.
              –     Problem w/identifying relationships which are “inherently fiduciary”
                    in nature. Note that issues relating to the nature of the fiduciary
                    duty are routinely swept under the rug.
              –     The real test involves a fiduciary duty that relates to the
                    information and relates to not using the information for
                    insider trading, so not just any fiduciary duty will qualify.

                                                                                Liability under a “Misappropriation”
              Is subject in
             possession of
                                                                                Insider Trading Theory via Rule 10b-5
                                                             No Liability
             material, non-
              public, info?

                                                                                                                    No Tipper/Tippee
                                                                                                                   Liability (but see *)
           Does Subject owe a                                               Subject Tip                       NO
            Fiduciary Duty of                                               (recklessly)
            confidentiality to                                                others?
             info generator?                                      NO
                                                                                                                    No Tipper/Tippee
                                                                                                                   Liability (but see *)
                    YES                                Does subject
                                       YES             disclosing?                          Does Subject
         Is Info. w/in the scope                           (TGS)                           Tip for Personal
           of Fiduciary Duty?                                                              Benefit (Dirks)?

                                                                                                                     Tipper Liability
                                                                                                                    ONLY (but see *)

                                                                                    Does Tippee                       NO
                                                    *Subject Liable for              have reas.
                                                   Personal Trades under           knowledge of                             YES
                                                          10b-5                   Tipper’s Breach
           No Liability under
        Misappropriation Theory                                                       (Dirks)?
     (perhaps there may be liability
      under mail/wire fraud, stats.)                                                                                Tipper & Tippee
                                                                                                                    Both Liable (but
31                                                                                                                       see *)

14e-3 Liability
  • In O’Hagan the Court also held that: the SEC has authority to adopt rule
     14e-3 as a prophylactic measure against insider trading specifically in
     connection with a tender offer.

   •   Section 14e-3: Governs Insider Trading w/respect to Tender
       Offers. Prohibits insiders of the bidder and target from divulging
       confidential information about a tender offer to persons that are likely to
       violate the rule by trading on the basis of that information.
           – Does not prohibit bidder from buying target shares or from telling
               its legal and financial advisors about its plans.
           – Targeted at practice of “warehousing”.
   •   14e-3 provides that in the process of a tender offer (or preliminary steps
       thereof), it is a violation of §14(e) for any other person with material
       information relating to such an offer that he knows or has reason to know
       is non-public, and which has been acquired directly or indirectly from, the
       offering person; the issuer of the securities sought by the offerer; or any
       subordinate officer, directer, partner, executive, or "temporary insider" to
       buy any securities, options, convertibles at any time prior to the tender
       offer, unless he first makes that information publicly known along with its
   •   Elements of a typical 14e-3 action:
           – Possession of inside info. regarding tender off.
           – Materiality of information
           – Knows or has reason to know the info came from an insider,
               director or ind.
           – Purchase, sell, (or cause to be purchased/sold) security/derivative
               of offeror or target without first disclosing info to trading partner, if
               the bidder has commenced or has taken substantial steps toward
               commencement of the bid (e.g. formulation of a plan, arrangement
               of financing, preparing tender offer materials).
   •   Strict Liability:
           – No breach of duty required
   •   Only applies to tender offers.

  • Administrative hearings against defendants under the SEC’s direct
      regulation (brokers, dealers, etc.)
  • Equitable relief in civil case brought by the SEC:
         – Injunctions; e.g., forbidding violator from being employed in the
             securities industry
         – Disgorgement of profits
         – Treble money sanction under ITSA
  • Criminal indictment: 20 years jail and up to $5 million fine for individuals
      and $25.5 million for corporate defendants per count
         – Exchange Act § 32 makes it a felony
  • Private suits—rare

                           SHORT-SWING PROFITS

Section 16(a)
    “Every person who is directly or indirectly the beneficial owner of more
       than 10 per centum of any class of any equity security . . . or who is a
       director or an officer of the issuer of such security . . . within ten days
       after the close of each calendar month . . . shall file with the Commission .
       . . a statement indicating his ownership at the close of the calendar month
       and such changes in his ownership as have occurred during such calendar
                                                    Note that this time frame has
                                                    been reduced to two business
                                                      days following the trade.
Section 16(b)
    “any profit realized by [such beneficial owner, director, or officer] from
       any purchase and sale, or any sale and purchase, of any equity security of
       such issuer . . . within any period of less than six months . . . shall inure
       to and be recoverable by the issuer”
    Insiders: § 16(b) applies only to officers, directors, or shareholders with
       more than 10% of the stock
    § 16(b) applies only to companies that must register under the 1934 Act
            Compare Rule 10b-5, which applies to all issuers
    Equity securities
            § 16 applies only to stocks and convertible debt (you have the right
              to convert it to equity, stocks)
            Compare Rule 10b-5, which applies to all securities
    Sale and purchase
            § 16(b) applies whether the sale follows the purchase or the
              purchase follows the sale.
                   Shorting the stock – betting the stock will go down, you sell
                      the stock you own and then buy it at a price you pick in
    Recovery
            Any recovery goes to the company
            Shareholders can sue derivatively, and a shareholder's lawyer can
              get a contingent fee out of any recovery or settlement
            Courts interpret the statute to maximize the gains the company

/Key statutory language
    “This subsection shall not be construed to cover any transaction where
       such beneficial owner was not such both at the time of the purchase and
       sale, or the sale and purchase, of the security involved”

Reliance Elec. v. Emerson Elec.
    June 16: Emerson buys 13.2% of Dodge in a takeover attempt. Dodge
       then merged into Reliance (a “white knight”)
    Aug 28: Emerson sells some shares (3.24%); for the purpose of reducing
       his holdings to 9.96%
    Sep 11: Emerson sells remaining 9.96%
            Was the June 16 purchase a “matchable” purchase?
                   Sup Ct declines to answer
            Assuming the June 16 purchase is matchable, can it be matched
              with the Sep 11 sale?
                   No. Emerson was not a 10% owner on 9/11

Foremost-McKesson v. Provident Securities
    In order to liquidate, Provident agreed to sell 2/3 of its assets to
    In exchange on Oct 20, Provident received cash and Foremost debentures
       convertible into > 10% of Foremost stock.
    Oct 24: Provident distributes some debentures to shareholders
    Oct 28: Provident sells remaining debentures and distributes cash to its
    Provident sues for a declaratory judgment that it had no §16(b) liability.
Issue: Can we match Oct 20 acquisition with Oct 24 disposition?
            Note: This is the issue that was left open in Reliance
    Statutory issue: “This subsection shall not be construed to cover any
       transaction where such beneficial owner was not such both at the time of
       the purchase and sale, or the sale and purchase, of the security involved”
            In a purchase-sale sequence, the transaction by which the
              shareholder crosses the 10% threshold is not a matchable
            Only purchases effected after one becomes a 10% shareholder are

Kern County Land Co. v. Occidental Petroleum Corp.
    Occidental acquired over 20% of Old Kern’s stock in steps (so some stock
       was acquired after it already owned 10%) through a tender offer.
    Old Kern mgt. negotiated a merger w/Tenneco.

    Rather than become a minority SH in Tenneco, Occidental gave Tenneco
      an option to purchase its stock which could not be exercised until 6
      months after the tender offer commenced.
    Tenneco sues to recover Occidental’s “short-swing” profits.
Two issues:
           Did the signing of the merger agreement which gave Occidental the
             “irrevocable” right to exchange its shares constitute a “sale”?
           Was entering into the option agreement with Tenneco a “sale”?
Held: Sale not covered by 16(b). Since Occidental did not have access
      to inside information, the situation did not present an
      opportunity for abuse.
    The exchange did not involve a “sale” within the meaning of §16(b).

Planning: What should Occidental’s attorney’s have clarified in the terms??
           Occidental shall have no 16(b) liability and if it does Tenneco will
            indemnify Occidental.
           The reduction of the purchase price will be at $10/share for each
            share acquired up to a maximum of $8,886,230, rather than a
            blanket credit of $8,886,230

                                PROXY FIGHTS

Shareholder Meetings
   • Annual
         – MBCA § 7.01
   • Special
         – MBCA § 7.02
         – Different states have variations on who can call a special mtg.
             (various officers, directors and shareholders)
   • For all SH meetings a quorum (of 50%) is required
   • Only SHs who hold stock on the record date can vote.
   • Election of directors
   • Fundamental changes to the corporation
         – Mergers, sales of all assets, corporate dissolutions, charter
             amendments, etc.
   • Shareholder resolutions
         – Resolutions are usually proposed by management (e.g. ratify an
             option plan)
         – Shareholders may also propose resolutions to request the board to
             take specific action (e.g. dismantle a takeover defense, divest from

Proxy Voting
   • A Shareholder (as principal) may appoint a proxy (a.k.a. proxy agent) to
      vote his/her shares at the meeting
   • Appointment effected by means of a proxy (a.k.a. proxy card)
          – Can specify how shares to be voted or give agent discretion
          – Revocable
          – Without the routinized proxy process, the firm would often find
             itself w/out a quorum.

   • Rival groups may nominate rival slates of directors, the group w/the
       greatest number of votes will find its entire slate elected. So 51% gets
       you complete control.
          – Note a voting system called cumulative voting exists under which
             major shareholders can elect the percentage of the board members
             equal (roughly) to the percentage of stock they control.
          – E.g. Alan owns 300 shares and nine directors are being elected,
             Alan will have 2,700 votes to allocate as he chooses.

Securities Exchange Act § 14(a)
   • It shall be unlawful for any person, by use of the mails or by any
       means or instrumentality of interstate commerce or of any facility of a

      national securities exchange or otherwise, in contravention of such rules
      and regulations as the Commission may prescribe as necessary or
      appropriate in the public interest or for the protection of investors, to
      solicit … any proxy … in respect of any security … registered pursuant
      to Section 12 of this title

SEC Proxy Rules
   • 14a-3: Incumbent directors must provide annual report before soliciting
      proxies for annual meeting
   • Anyone who “solicits” a proxy must provide a written proxy statement
      BEFORE soliciting the proxy.
         – Free writing generally permitted thereafter.

What is a Solicitation?
  • “Solicit” includes not only “direct requests to furnish, revoke or withhold
      proxies, but also ... communications which may indirectly accomplish such
      a result or constitute a step in a chain of communications designed
      ultimately to accomplish such a result.”— Long Island Lighting Co. v.
      Barbash, 779 F.2d 793, 796 (2d Cir.1985).
          – An environmentalist group ran newspaper and radio ads critical of
              the defendant electrical utility's management. Incumbent managers
              sued the environmentalists, alleging that their ads constituted a
              proxy solicitation.
  • Rule 14a-1(l)(2)(iv) exempts public statements of how the shareholder
      intends to vote and its reasons for doing so.
  • Rule 14a-2(b)(1), subject to numerous exceptions, exempts persons who
      do not seek "the power to act as proxy for a security holder" and do not
      furnish or solicit "a form of revocation, abstention, consent or
          – Consequently, for example, a newspaper editorial advising a vote
              against incumbent managers is now definitively exempted.
  • Rule 14a-2(b)(2) exempts solicitations of 10 or fewer persons.
  • Rule 14a-2(b)(3) exempts the furnishing of proxy voting advice by
      someone with whom the shareholder has a business relationship.

Levin v. Metro-Goldwyn-Mayer, Inc.
   • Levin and his friends owned about 11% of MGM stock worth about $20
   • Levin was on the MGM board, but didn’t like the way the incumbents (the
       O’Brien group) had run the firm.
   • Levin organized a proxy fight to outs the incumbents.
   • The O’Brien group hired a PR firm and incurred other costs at corporate

   • Levin and pals contested the use of corporate funds by the O’Brien group.
Held: Judgment for MGM. The expenses were not excessive or illegal.

Rosenfeld v. Fairchild Engine & Airplane Corp.
   • Insurgents won control of Fairchild through a proxy fight.
   • Incumbents had charged $106K for their won proxy expenses while in
       office and insurgents paid them another $26K upon taking control.
   • Insurgents reimbursed themselves $127,000 for their own expenses and
       arranged for SHs to ratify that reimbursement.
   • Plainfiff SH brings a derivative lawsuit to challenge these payments.
Held: Judgment for defendants
   • The proxy fight concerned questions of corporate policy rather than simply
       personal control and the expenses were reasonable.

     Basic rules:
         – Can management use corporate funds to pay for expenses they
            incur in conducting their proxy solicitation?
                • Yes, as long as the amounts are “reasonable” and the
                    contest involves “policy” questions rather than just a “purely
                    personal power struggle”—Rosenfeld
         • The firm may reimburse incumbents whether they win or lose.
         • The firm may reimburse insurgents only if they win and only if SHs
            ratify the payment.
         • Majority rule (called Fairchild rule): incumbents always get
            reimbursed insurgents get reimbursed if they win
   • Reimbursement rules can differ on at least three dimensions:
         • Amount: reimburse all, part, or nothing?
         • Conditionality: must you win to be reimbursed?
         • Bias: favor incumbents, insurgents or neither (neutral)?
   • How do we know it is a policy contest?
   • What would be a “reasonable” expense?
         – Disclosure statements to shareholders
         – Telephone solicitations
         – In person visits to major shareholders
                • Wining and dining said shareholders
                • Private jet to bring major shareholders to company HQ
                • Giving corporate contract to major shareholder (conflict of

Policy: Should insurgents be reimbursed for their expenses they incur in
conducting their proxy solicitation?
          – If they win?

          –   If they lose?
                      That gives an incentive to spend as much as possible, but
                             there is already the incentive so spend enough to
                             make sure you win or else you won’t get reimbursed.
          –   If insurgent groups are reimbursed only when they win, should
              incumbents be reimbursed when they lose?
                      It would degrade the quality of the people on the board, or
                             they would all demand proxy insurance.

Lovenheim v. Iroquis Brands, Ltd.
Facts: shareholder wants to include information about a resolution he is going to
       offer at the shareholders meeting in the proxy materials
   • Pâte operations economically “significant”?
           – No
   • Why included?
           – “Otherwise significantly related” includes ethical and/or social
   • Not otherwise significant
           – Rule 14a-8(i)(5) allows exclusion of proposal that relates to
              operations which account for less than 5 percent of the firm’s
              assets, earnings or sales, and is not otherwise significantly
              related to the firm’s business
Basis for holding?
   • The rule itself is ambiguous
   • The SEC before the 1983 amendments required inclusion of important
       policy questions even where less than one percent of the firm’s assets or
       earnings were implicated by the question
   • In adopting the five percent test, SEC said proposals that don’t satisfy the
       five percent tests can still be included
   • Medical Committee decision implied that proposals involving general
       political and social concerns were acceptable

Rule 14a-8: Shareholder Proposals
   • Allows qualifying shareholders to put a proposal before their fellow
          – And have proxies solicited in favor of them in the company’s proxy
          – Expense thus borne by the company
   • What should a shareholder be allowed to include in a Proposal to other
   • What should be excluded?
Substantive grounds for exclusion

   •  The proposal does not concern a proper subject for action by shareholders
      (like you guys should fix Outlook, that is not really a shareholder issue, it
      for the board) (this element seems to overlap with number five)
   • The proposal is illegal
   • The proposal violates the proxy rules (e.g. misleading material)
   • The proposal concerns a matter beyond the power of the firm to
   • The proposal relates to a company’s ordinary business operations
   • The proposal has been submitted in the past and has not obtained much
          – Issue with most SH proposals is not whether they will win, but
              whether they will get enough support to resubmit the proposal the
              next year.
Procedural aspects
   • Detailed rules regarding:
          – Process for excluding proposal
          – Timing
          – Stock holdings required
          – Length of Proposal
          – Submission requirements
                 • Number
                 • Prior submissions
                 • Showing up
Substantive grounds for exclusion
   • Precatory (i.e., nonbinding) phrasing
          – E.g., Dole:
                 • “shareholders request the Board of Directors to establish a
                     committee . . . for the purpose of evaluating the impact of a
                     representative cross section of the various health care
                     reform proposals being considered by national policy makers
                     . . . Further, the aforementioned committee should be
                     directed to prepare a report of its findings.”
   • Why?
   • What happens if precatory proposal passes and board refuses to act?
          – BJR
          – Rule 14a-8(i)(1):
                 • A shareholder proposal must be a proper subject of action
                     for security holders
                 • It must be an action which it is proper for shareholders to
                 • Look to state law to decide that question
                          – E.g., DGCL 141(a)
                 • If shareholders not allowed to initiate, still ok if phrased as

Ordinary Business or Not?
   • Disinvestment in South Africa? Include
   • Get out of tobacco business? Include
   • Get out of nuclear power business? Include
   • End affirmative action? Include
   • Start affirmative action? Include
   • Non-discrimination on basis of sexual orientation? Include
   • Non-discrimination on basis of veteran status? Include
   • Executive compensation? Include
   • Employee compensation? NO

Shareholder inspection rights
   • Although §14 of the 1934 Act requires incumbents to either mail
      insurgents’ material to SHs or give insurgents a copy of the SH list,
      incumbents almost always choose to mail the material themselves. BUT,
      SHs also have rights under state law to inspect the books of a corporation.
   • Policy concerns:
         – Shareholders have a legitimate interest in using the proxy system
             to hold the board accountable
         – Insurgents may want to communicate directly with some major SHs
             and/or may need access to corporate records other than
             shareholder lists.
         – Nobody wants a junk mail distributor to get access to the
             shareholder list or a competitor to get access to the corporation’s
             trade secrets and other proprietary information

Delaware statute
   • Section 220(b):
         – Shareholder must make a written demand setting forth a “proper
         – A “proper purpose” is one “reasonably related to such person’s
             interest as a stockholder”
   • Section 220(c)
         – If shareholder only seeks access to the shareholder list, BoP on the
             corporation to show that shareholder doing so for an improper
         – If shareholder seeks access to other corporate records, BoP on
             shareholder to prove requisite proper purpose.
         • Proper
                 – Investigate alleged corporate mismanagement
                 – Collecting information relevant to valuing shares

                 –  Communicating with fellow shareholders in connection with
                    a planned proxy contest
          •   Improper
                 – Attempting to discover proprietary business information for
                    the benefit of a competitor
                 – Secure prospects for personal business
                 – Institute strike suits

Crane Co. v. Anaconda Co.
Facts: Crane announced a tender offer for Anaconda stock
          – Crane asked for the shareholder list
                 • SEC rule would require Anaconda to mail the offer directly
          – Anaconda refused, arguing that Crane wanted the list in an effort
             to gain control and that is not a proper purpose. Is it?
                 • The fact that it is related to their stock ownership makes it a
                    proper purpose, and it is good for the shareholders to know
                    what is happening.
          – Note that Crane is an Illinois corp.; Anaconda is a Montana Corp.
             Why is suit brought in NY?
                 • They were forum shopping and they were doing business
          – Communicating with other shareholders about offer was a proper
          – Statutory interpretation
          – Foreign corporations
                 • NY law applies because access to stockholder lists is a
                    departure from the general rule that the laws of the state of
                    incorporation control corporate governance law issues.

Noneconomic purposes: Pillsbury v. Honeywell, Inc.
         – Plaintiff belonged to an antiwar group trying to stop Honeywell
           from producing anti-personnel fragmentation bombs for the military
         – Pillsbury (not the dough boy company) bought some Honeywell
           stock, and requested access to Honeywell’s shareholder list and to
           corporate records relating to production of such bombs. Pillsbury
           explicitly stated that he cared only about the morality of
           Honeywell’s work.
         – Pillsbury lacks a proper purpose germane to his interest as a
           shareholder for requesting the shareholder list or corporate records

          –   Purpose based solely on Pillsbury’s pre-existing social and political
              views rather than any economic interest (Remember the Ford
              Motor case?)
   •   Limitation: “suit might be appropriate when a shareholder has a bona fide
       concern about the adverse effects of abstention from profitable war
       contracts on his investment in Honeywell.”
   •   Why is this case different from Lovenheim (the force fed goose to make
       patè case)?
          – State law vs. Fed. Law (§14a)
          – Stated non-economic reason.
          – This is about getting access to the list, not about getting something
              on the ballot, and here you need to have a proper purpose and
              here it needs to be a little more economic. (This would be
              absolutely something that could get on the ballot.)

There are three types of shareholder lists:
                    Record List
                    “street name” CEDE list
                    NOBO list (Non-Objecting Beneficial Owners)

Which List? Sadler v. NCR Corp.
  • Facts
          – AT&T launched a tender offer for NCR
                 • NCR was a Maryland corporation that did business in New
                 • AT&T had no right under either NY or Maryland law to a
                     shareholders’ list
                 • Under NY but not under Maryland law, its ally Sadler had
                     such a right
          – In Sadler’s name, AT&T asked for both a CEDE and a NOBO list
  • Holding on choice of law: MD or NY?
          – New York
          – “Access to stockholder lists is a recognized exception to the internal
             affairs doctrine ....”
  • Review:
          – What is internal affairs doctrine?
                 • Corporate governance issues controlled by law of state of
  • Holding on list entitlement?
          – AT&T entitled to both lists
          – NCR must prepare NOBO list even if not pre-existing
                 • Delaware law to the contrary
                        • Delaware only requires preparation of CEDE list
          – Why?

       •   Liberal interpretation of statute – “to facilitate shareholder
–   Note that shareholders are on the NOBO list unless they ask to be
    taken off and they never ask to be taken off.

                          SHAREHOLDER VOTING

Common Stock as a Bundle of Rights
    Economic rights
           Receive dividends (distribution of profits) when and as declared by
              the board of directors
           Residual claim on assets in liquidation
    Voting/Management rights
           Elect directors
           Approve some extraordinary matters
Packaging Rights
    MBCA § 6.01(b)
           Requires at least one class with unlimited voting rights
           Requires at least one class with residual claim
    MBCA is very liberal – some states are more restrictive
    MBCA § 6.01(c)
           Authorizes nonvoting stock and other variants on one share-one
Voting Rights
    Meetings:
           Annual
           Special
                  Who can call?
                        Compare MBCA § 7.02(a)(2) [BoD, 10% SHs, plus
                           others authorized in articles] with DGCL § 211(d)
                           [BoD, plus others authorized in articles]
    Action without meeting (a.k.a. written consents):
           Must be unanimous under MBCA.
                  Compare DGCL § 228(a)—action by consents okay if same
                     number of shares consent as would be needed at a meeting.
    In order for shareholders to take action, there must be a quorum at the
       meeting. What is the default rule for a quorum? See MBCA § 7.25(a).
           A majority of the shares entitled to vote.
    Under MBCA § 7.25(c)?
           A matter is approved if votes cast in favor are greater than the
              votes cast against.
    Under DGCL § 216?
           Decisions must be approved by the vote of a majority of the shares

    If there are 800 total votes:

         In Favor    399
         Opposed 398
         Abstain     3
    Result?
         Passes under MBCA
         Fails under Delaware (needed 401 to pass)

Special Voting Rules
    Cumulative voting
           Optional system for electing directors
    Voting by groups
           Potentially applicable when corporation has multiple classes of
           (e.g. Preferred Class B may have approval/veto rights over certain
              types of transactions.)

Stroh v. Blackhawk Holding Corp.
     Par value:
             Minimum price at which shares may be sold
             Specified in articles of incorporation
     Stock split:
             Effected by changing par value through amendment to articles
                    Here the number of shares was doubled and the par value
                      was cut from $1 to 50¢
             Used to get more shares into the hands of investors or lowering the
               price at which stock’s trade, you can have a reverse split
     Illinois constitution prohibited nonvoting common stock
     Two classes of Blackhawk stock
             Class A – standard common stock with both economic and voting
             Class B – common stock with no economic rights (no right to
               ordinary or liquidating dividends) but with one vote per share
     Structure means Management is unaccountable to shareholders
     If management would have just issued more class A stock to gain control
        they would have made more money, but it seems they just were control
        freaks and they assumed the all class A plan would be overreaching.
     Note that after the subsequent split of A shares and the sale of new A
        shares, the promoters still wind up with less than 50% of the total votes.
Plaintiff argument
     What did plaintiffs argue with regard to the validity of the Class B shares?
             That the Class B shares were invalid because they lacked economic

            Plaintiffs said that real shares represent the “proprietary” interests
             in the corporation
            Further, “proprietary” necessarily assumes an economic interest
    The Court rejected plaintiffs' argument, holding that the Class B shares
      were valid. Why?
    A “proprietary” right is not just a right to profits or distributions; a right to
      participate in control is also a proprietary right. Because Class B stock
      had that right, it is a valid form of stock.
           The proprietary rights conferred by the ownership of stock may
               consist of one of more of the rights to participate “in the control of
               the corporation, in its surplus or profits, or in the distribution of its
           Only the right to management incident to ownership may not be
    Note: There is no duty of loyalty issue here because future shareholders
      are not owed a duty and they disclosed and the shareholders chose to buy
      into it.

    Incentive to mismanage
         As the value of A shares falls the value of B shares could rise.
                 The greater the opportunity for gain, the greater the value
                    of control.
                 The greater the mismanagement, (up to a point) the greater
                    the opportunity for gain.
         The combination of these two propositions creates an incentive for
            those with control, but little or no investment, to mismanage and
            increase the value of their stock.
    How else could the original Blackhawk investors have accomplished the
     same thing?
         Issue themselves the right to elect six directors and then sell
            identical shares to the public except the public shares could elect
            only 3 directors.
         Class voting on other issues, so that they would have to be
            approved by both classes.
         If there were no state law prohibition, sell nonvoting shares to the
         If Blackhawk were a smaller close corporation we might use a
            voting trust, a vote pooling arrangement or irrevocable proxies.


    Galler v. Galler:
         “a close corporation is one in which the stock is held in a few
            hands, or in a few families, and wherein it is not at all, or only
            rarely, dealt in by buying or selling”
         i.e., no secondary market for shares

Some  Major Deal points
     How decisions will be made
     Who will be directors
     Who will be officers
           Who will do what work
    Salaries and dividends
    Termination
    Bringing in new shareholders
    What do you do when you can’t agree?
    What do you do about a situation where one party is always being
      dominated by others?
Investor Passivity Often Not an Option
    No market exit
    Compensation
           Close corporations often don’t pay dividends to avoid double

Hypo: 4 friends want to form a close corporation. Decisionmaking issues?
           Deadlock (2-2)
           Oppression (3-1)
   1. Voting trust
   2. Shareholder agreements
          a) Agreements relating to election of the board of directors (a.k.a.
             vote pooling agreements)
          b) Agreements relating to limitation on the board’s discretion

     Example: J, F and A are starting a
     hockey mask production center
  Participants   Investments   Voting Interest

  Jason          $10 mil.      20%

  Freddie        $6 mil.       30%

  Alice          $5 mil.       50%


The control is not following the money.
Potential Solutions:
            Stroh stock:
                   Two classes of stock: A and B; A has the usual incidents in
                      ownership and B would have nothing but a vote (it would be
                      bought for a trivial price) and would be sufficient to give
                      Alice and Freddie the vote the want.
    Common Stock:
            First allocate this stock to the three in proportion to the voting
              interests they want. Since Alice wants the greatest interest, she
              would pay $5 mil. For her 50% interest. But this means, Freddie
              should pay $3 mil. for 30% and Jason should pay $2 mil. for 20%.
            The problem is this leaves $8 mil. more for Jason to invest and $3
              mil. more for Freddie to invest.
                   So you could have them receive nonvoting common but they
                      may insist on preferred stock or debt instead (but remember
                      if you put money in as debt that money is not shareholder
                          You still have the issues of taxes, dividend preference,
                             liquidation preference, priority in bankruptcy, cash
                             availability for regular interest payments, cash
                             available to repay principal, etc.
    Class specific board members:
            Three classes of stock: A, F and J.
            A picks 5 board members
            F picks 3 board members
            J picks 2 board members
    Voting Trust:
            Jason would place some of his stock in trust and give Freddie and
              Alice the right to direct its vote.
            Statutes generally limit the duration of voting trusts (e.g. 10 yrs).
    Vote pooling arrangements
            Two or more SHs could make an agreement to pool votes
              (sometimes used to avoid legal limitations on voting trusts)

          Be wary of means to enforce the pooling arrangement.
    Irrevocable proxies:
          Although proxies are ordinarily revocable at the instance of the
            shareholder, SHs (subject to certain conditions) may grant
            irrevocable proxies. Generally such proxies must be “coupled with
            an interest” which means that the proxy holder must have some
            other interest in the firm.
                 The irrevocability lasts only as long as the interest.

Voting trust
    An agreement among shareholders under which all of the shares owned
       by the parties are transferred to a trustee, who becomes the nominal,
       record owner of the shares
           The trustee votes the shares in accordance with the provisions of
              the trust agreement, if any, and is responsible for distributing any
              dividends to the beneficial owners of the shares
    Advantages?
           No possibility of shareholder deadlock, since everybody puts their
              shares in the trust and trustee votes
    Disadvantages?
           Loss of control.
           Duration – most states limit to ten years
           Still possible for board to oppress

Vote pooling agreements: Shareholder agreements re board election
    Valid?
           Do minority shareholders need protection from exploitation? BoD
             has a duty to exercise independent business judgment on behalf of
             all shareholders.
           Note that with the exception of some circumstances involving
             controlling shareholders, shareholders do not owe fiduciary duties
             to one another.
    Practical problems?
           Director deadlock…how solved?
           Director oppression
    Enforceability?
           Specific performance?

Vote pooling agreements: Enforcement mechanisms
Ringling Bros. v. Ringling
    Corporation used cumulative voting to elect directors
         A mechanism by which the minority gets to elect some directors
                Directors are elected all at once.

                  Cumulative Voting: each shareholder gets number of votes
                     = (number of board vacancies) times (number of shares
                  May cast all votes for one (or more) member of the BOD.
           Ringling and Haley family factions had a written agreement under
             which they were to vote together
                  Effect of agreement:
                        Ringling and Haley by combining votes were able to
                            elect 5
                        North was able to elect only two directors
           In the event of deadlock, the disagreement was to be determined
             by an arbitrator, Mr. Loos, who was also their lawyer
           When called upon to arbitrate the dispute, Loos decided that the
             Ringlings and Haleys should vote for two Ringlings, two Haleys, and
             a Mr. Dunn
           The Ringlings did so
           But the Haleys defected, casting all of their votes for the two
Held: The agreement was valid, but the Haley votes should not be counted, you
      cannot force them to vote but if they violate the agreement their votes
      don’t count so they are not elected to the board so we only have six
      directors, three to three.
    If you were Loos, their lawyer, how would you have drafted the
      An enforcement mechanism for if they can’t agree, like if they can’t agree
      one party gets to vote all the shares one year and the other party gets to
      vote all of them the next year.

Shareholder agreements
    Voting trusts
    Vote pooling agreements
          (E.g., Ringling)
    Shareholder agreements constraining discretion of directors
            Very common
                 Require certain persons as officers
                 Specify compensation and/or dividend policy
                 Require shareholder approval of board actions

McQuade v. Stoneham
    Stoneham, McGraw, and McQuade own stock in the NY Giants
         Shareholders agreement by which all agreed that they will each do
           their best to elect each other directors and appoint each other
           officers at specified salaries

    McQuade fell out of favor w/Stoneham and was fired … sued, seeking
      specific performance
           Stockholders may combine to elect directors, the power to unite is,
              however, limited to the election of directors and is not extended to
              contracts whereby limitations are placed on the power of directors
              to manage the business of the corporation by the selection of
              agents at defined salaries.
           Directors must exercise their independent business judgment on
              behalf of all shareholders
           If directors agree in advance to limit that judgment, then
              shareholders do not receive the benefit of their independence.
           Agreement is therefore void as a restriction on board independence
              which is against public policy
Rationale sensible?
           Most corporate law rules are just default provisions -- off the rack
              rules which the parties are free to alter to meet their particular
           When one is dealing with a close corporation, in which the SHs
              naturally would want a greater voice than they would get in the
              case of a public corporation, parties should have even greater
              flexibility in modifying the off the rack rules provided by the statute
              than normally accorded to public firms.
                   But how far should this go?
    Easily evaded?
           Get agreement that he will be elected a director. Have by-laws
              state that officers may be removed only for cause or by the
              unanimous vote of the directors.
                   Need to make sure that amending the by-laws requires
                       unanimous director and/or shareholder action.
           Alternatively, employment contract coupled with stock buy-out
                   If they fire him, he can get damages and require them to
                       buy back his stock (so he’s not stuck with his investment).

    If you represented McQuade, what terms would you put in an
       employment contract? (See p. 622)
          Duration?
                What happens at the end of the employment term?
                Define termination for cause.
                        You want to put in termination for cause because if you
                          don’t put it in it is going to be implied in so if you put
                          it in you can narrow it.
                  What happens in the case of illness/disability?

            Compensation?
                Bonus formula? How to define profit? Comparison to other
                     firms in the same industry…
            Job description?
                 Clarify areas of responsibility, title, other permitted activities
                     (e.g. City Magistrate)
            Termination and liquidated damages and duty to mitigate?
                 Include buyout agreement for the stock.
                 Having no duty to mitigate could be very valuable.

Clark v. Dodge
    Clark and Dodge together owned two drug companies
    Clark owned 25%; Dodge owned 75%
    In return for Clark revealing a valuable secret formula, Dodge agreed to
       vote his shares and vote as a director to assure that Clark would be a
       director and general mgr. as long as his performance was faithful, efficient
       and competent and would get ¼ of the profits by salary or dividend.
    Clark kept his part of the bargain and got fired by Dodge.
            Dodge reneged on his promise and should pay.
            McQuade designed to protect minority shareholders who were not
              party to the agreement
            Where the corporation has no minority shareholders, the rule is
                   But note limiting language in contract (“as long as his
                      performance was faithful, efficient and competent”); maybe
                      invalid if goes beyond those limited items
            Note that the corporation could have used cumulative voting to
              elect the board and then no agreement for board election would
              have been necessary.

Galler v. Galler
      Shareholder agreement:
            Each family gets 2 board seats
            Mandated dividends
            Mandatory death benefits
          Agreement Valid
          Unanimity not required if:
                The corporation is closely-held
                The minority shareholder does not object
                The terms are reasonable

                       Reasonable time
                       Co. was to pay dividends only if sufficient earned
                       The amount payable was reasonable.
    Application?
         Agreement did not have an unreasonable duration
         Company was to pay dividends only if it had sufficient earned
         Death benefit was reasonable
    Agreement had a vote pooling component
         Valid.
         Why not deemed a voting trust?
                 No attempt to separate ownership of stock from voting
    Remedy?
         Corporation had been unable to pay mandated $50,000 annual
            dividends because Aaron’s and Isadore’s salaries exceeded those to
            which Emma had agreed
                 Isadore and Rose must account
                 Presumably back dividends must be paid
         Emma and her appointee on board?
                 Presumably
    They could have allowed the surviving brother to buy out the other
     brother’s shares instead of forcing the surviving families to work together.

Ramos v. Estrada
    The Broadcast Group had a 50% interest (later raised to just over 50%) in
       Television, Inc. The Ventura Group owned the other 50%.
    The Ramoses had 50% of the BG stock and wound up with 25% of TV
    The Estradas and each of the other couples each had 5% of TV
    The BG SHs agreed to vote their stock together to elect directors to TV
    If anyone violated the agreement, the others could purchase their TV
       shares at cost plus 8% per yr.
           This was probably well below market value since the FCC granted
              the TV license after the investment was made and the license must
              have been valuable.
    At a directors’ meeting of TV, Estrada sided w/the Ventura group ousting
       Ramos as president of TV
    At the next BG meeting the group nominated a slate of directors that
       excluded the Estradas
    The Estrada’s refused to abide by that vote and the other BG members
       contend they had a right to buy the Estradas’ TV stock.

            Jmt. against the Estradas.
            Vote pooling agreements like this are valid even if the firm is not a
              statutory close corporation. It is not a “failed irrevocable proxy.”
                   You cannot have a vote pooling agreement that says that we
                      will vote these directors who are us and we will vote this
                      business decision once we are elected.
                   You can though vote out directors who don’t make the
                      decision you want them to make. So this is kind of a way to
                      get around it.
                   So Ramos used an otherwise valid VPA to circumvent the
                      McQuade-Clark ban on non-unanimous agreements about
                      what directors will do.
      What did the Estradas do to breach the Agreement?
            Refusal to vote for the slate of BG directors which excluded her; it
              was not her voting to oust Ramos
            The breach is not voting to outs Ramos, because as a director you
              are allowed to exercise independent judgment and the reason the
              vote pooling agreement is valid is it is an agreement as to who to
              vote for as directors not an agreement as to what the directors are
              going to do.
      Perhaps the Black-letter rule is:
            (a) you can agree about how you’ll vote as shareholders, but
            (b) you can’t agree about how you’ll vote as directors
                   Unless we have a closely held corp and the agreement is
                      signed by all the SHs (and perhaps, when the nonsigning
                      minority shareholders cannot or do not object.)
      Could the members of BG explicitly agree about how they would vote as
            No, BG was only half of the TV SHs.
      Why would Estrada defect?
            Because she has leverage even as a minority shareholder because
              she can tip the balance.

Statutory closed corporations are not the same as just closed corporations.

   Agreement says: Abel will be President, Baker will be V-P, Charlie will be
     Secretary, and Delta will be Treasurer
         Spells out specific requirements vis-a-vis salary, dividends,
            pensions, tenure in office and the like
   Is it Enforceable? (Should it be?)
   What if Ed is a part of the group and Ed is a 3% SH with no office?


     At early common law, shareholders qua shareholders had no fiduciary
       obligations to firm or fellow shareholders
            Some erosion vis-à-vis controlling shareholders of public
              corporations (E.g., Sinclair Oil v. Levien)
     More erosion in close corporation

The “Freeze Out”
    This sections involves one of the most important fiduciary duty problems
      in a close corporation is the freeze-out
    In a freeze-out, a controlling SH block earns a return at the expense of
      the others.
    Still another reason to draft a buy-sell agreement at the outset.
           Review the buyout material in chapter 2

Note: The earnings of closed corporations are usually distributed in major part in
salaries, bonuses and retirement benefits.

The partnership analogy
Wilkes v. Springside Nursing Home
           Prior Mass. decision – Donahue v. Rodd Electrotype – had
            analogized close corporations to partnerships
           Applied partnership-like fiduciary duties to shareholders of close
            corporations, utmost good faith and loyalty
                 Explicitly invoked Cardozo’s decision in Meinhard v. Salmon
           Does partnership analogy survive Wilkes?
                 Partly
    Plaintiff: One of four equal shareholders in a close corporation (Wilkes,
       Riche, Quinn and Pipkin [replaced by Connor])
           Each had been a director and officer, worked for the company,
              receiving a regular salary
           Firm paid no dividends
    Relations between Wilkes and the other shareholders deteriorated
           Wilkes gave notice of intent to sell his shares
           He was then stripped of his salary and offices
           He sued, alleging breach of fiduciary duty
           Wilkes was improperly frozen out no legitimate business reason for
              firing him and not re-electing him
           Rule of law:

                  In a close corporation a majority must have some legitimate
                   business purpose
                  If so, burden shifts to minority to show there is a less
                   harmful alternative to the minority’s interest
                  If so, court must balance the legitimate business purpose
                   against the practicability of proposed alternative
Bottom line:
    This leave us with a new standard of fiduciary duty that is less strict than
      that which partners owe each other, but stricter than the BJR at least in
      Massachusetts, but see Nixon v. Blackwell for Delaware law.

    What is the court’s policy rationale?
           The majority presumably invested more in the corporation to
              purchase voting control, they should have a degree of control
              reflecting their investment.
           The minority shareholder presumably knew of the existence of a
              controlling block of shareholders when he or she bought into the
                    The minority shareholder therefore assumed the risk that
                      some decisions would be adverse to his or her interests.
    What might have been a legitimate business purpose in this case?
           If Wilkes had been negligent in failing to perform his duties or in
              failing to perform them with due care.
                    But Wilkes was competent and remained willing to perform
                      his tasks.
    Once Wilkes was fired, dividends became critically important.
           Note the distinction between public and closely held corporations.
    How could the parties have arranged things ex ante to avoid this
           Shareholder agreement to maintain each other in office.
                    Query re enforceability.
                           Not telling the directors what to do just electing
                             them, the officers part is okay because they all
           Employment agreement between corporation and Wilkes.
                    Would the parties have agreed to employment agreements
                      that did not allow for termination for cause?
                           Note how this allows one to bypass McQuade.
           Requirement of dividend payments?
           Buy-out agreement under which the parties are required to buy out
              a disgruntled investor.
    What is an argument against expansion of the fiduciary duties among
           Investors are heterogeneous.

                 Some investors may prefer more flexibility and less stringent
                   fiduciary standards, while others prefer stricter standards
                   and less flexibility.
                       Under pre-Wilkes law, the former could incorporate,
                           while the latter could form partnerships.
           Courts maximize investor welfare by letting investors choose the
            form best suited to their business, which requires different legal
            rules for shareholders and partners.
           Could Wilkes have been decided using other principals we have
            already covered?
                 Directors breach of duty of loyalty (self-dealing) for payment
                   of excessive salaries so BJR would not apply (note court
                   would probably not order dividends or hiring of Wilkes)
                 You could argue that if you are a group acting together just
                   like a controlling shareholder would so you have fiduciary
                   duties. Controlling SH group engaged in self dealing must
                   show inherent fairness.

Smith v. Atlantic Properties (Prof. thinks case is ridiculous but it’s out there)
    Shareholder agreement constraining director discretion (to avoid potential
       for freeze-outs)
            Requires shareholder approval of board actions by a supermajority
              (80%) vote
            Because each shareholder owned 25% of the stock, each had an
              effective veto
    Dispute arose as to how earnings should be expended
            Majority wants to pay dividends
            Wolfson wants to reinvest
Tax implications
    Maximum marginal tax rate on ordinary income:
            Dividends tax as ordinary income
    Maximum capital gains tax rate:
    Accumulated earnings tax (unreasonable accumulation of corporate
       earnings and profits).
            A minority shareholder, at least where he has a veto power over
              corporate action, has fiduciary duties to the majority
            Wolfson’s use of his veto power was inconsistent with that duty
              because it subjected the corporation to an unnecessary assessment
              of penalty taxes
                   It is just that Wolfson let his bad feelings show too much
                      and failed to produce a plan for improvements.

Sinclair Analysis
    Under Sinclair, if a SH is not controlling, they are not liable.
    Since when does a 25% block control a 75% block.
    Even if Wolfson is treated as a controlling SH, he gained no benefit at the
        expense of the others so no liabiltiy.
    To the extent the Wilkes line of cases makes sense, it makes sense in the
        context of freeze-outs, NOT SH deadlocks. In a freeze-out the SH block
        earns a return at the expense of the others.

Delaware: Nixon v. Blackwell
    Rejects special close corporation fiduciary duties
    Controlling shareholders subject to Sinclair Oil standard
          ESOP life insurance policies normal compensation; so no violation

Jordan v. Duff and Phelps, Inc.
    Jordan worked for Duff & Phelps, Inc. in Chicago as a securities analyst.
    He held his job under an at-will K so the firm could fire him when it
    Jordan bought (or was buying) 240 shares of D&P stock which under the
       terms of the purchase agreement, he had to resell to the firm at book
       value if his employment terminated for any reason.
    When Jordan told his boss Hansen about his plan to move to Texas,
       Hansen did not tell Jordan about the old failed merger talks with Security
       Pacific. He also didn’t tell Jordan about a 2nd round of Sec. Pac. talks
       that began later that yr. (A $50 mill. valuation for D&P was being
    Hansen let Jordan work through the end of the year so Jordan could get
       the higher book value that would then apply to the sale of his stock.
    Jordan worked through December and tendered his stock.
    Two years later D&P was eventually acquired in an LBO by an employee
    Jordan sued for rescission
    Jordan has a cause of action under Rule 10b-5 (for failure to disclose
       material information) and state law fiduciary duties. If proven, he would
       only be allowed a damages remedy, not rescission.
    Posner dissents

    Why book value not market value?
        Book value is the value of the firm’s assets without the value of the
          firm’s reputation.
        He gets book value because it is easier to calculate.

        When the value of stock goes up it is more likely that the market
          value will go up faster than the book value. So when you can fire
          someone and then they have to sell you your stock you have to an
          incentive to fire them if they get the book value.
 Materiality: Why doesn’t the court care about the fact the original merger
  fell through?
        Because we don’t judge these things on what ends up happening,
          but what the state of knowledge was at the time when they should
          have disclosed.
        Ultimately Jordan must show had he known, he would not have
          quit. Even when the second merger failed, he would have stayed
          with the firm because based on the failed proposals, he would have
          believed that more were coming.

 Posner versus Easterbrook (This fight is primarily about materiality)
      Under 10b-5 if someone associated with the corporation is trading,
        the corporation must disclose.
      But Posner says the reasons for disclose or abstain rule don’t apply
        here since Jordan does not have the usual choices. Employees
        who quit can not hold stock and the firm could have fired him at
        any time.
      Easterbrook says D&P could not have fired Jordan just to prevent
        his earning money on the merger.
      Posner says yes they could. But maybe not in a close corp. under
        Wilkes. Because the people doing the firing on the board are also
        the people who are going to benefit. But we also have the
        shareholder’s agreement that says that owning stock doesn’t add
        any rights as far as employment.

                             TRANSFER OF CONTROL

Control Premium
      Why would you want control?
             Two main reasons:
                o You think you can add value to the company, maybe by
                  putting in the right people.
                o Put yourself in as an officer and give yourself a nice salary,
                  in a public company with a lot of shareholder’s this is not
                  going to be scrutinized as strictly. (but can’t be self-dealing)

   •     The control premium problems arise when a buyer purchases a large
         block of stock in a corporation. If the other shares are widely dispersed,
         the block will often bring in a per-share price above the stock’s market
         price (i.e. the “control premium”)
   •     Why?
             – If B wants a large block of stock and does not buy dominant
                 shareholder S’s block of shares he will need either to;
                     • Launch a tender offer
                            – B will pay considerably more than the market price for
                               the shares
                     • Collect shares on the open market
                            – Initial purchases on the open market will often drive
                               up the market price.
             – If S is willing to sell, both she and B can gain by agreeing to
                 transfer the stock for a price between the market price and the
                 tender offer (or driven-up open market) price.
             – Control means almost everything: You can run the company as
                 you see fit; appoint your candidates as officers; and even freeze
                 out minority SHs.

   • The purchase and sale of control is subject to special regulation b/c these
       purchases are no ordinary purchases of stock.
   • Two main issues:
          – The payment of a control premium
                • Should a controlling shareholder be free to sell at that
                    premium? Fairness to the other shareholders?
          – The sale of corporate offices
                • Courts are often suspicious when a buyer finds a corporate
                    office attractive enough to pay money for it.

Frandsen v. Jensen-Sundquist

   •     The Jensen family owned 52% of JSA and JSA owned a majority of the
         shares of the First Bank of Grantsburg.
   •     Frandsen owned 8% of J-S.
   •     The Jensen family had a right of first refusal agreement with the minority
   •     JSA announces a merger w/1st Wisconsin Bank at $62 per share.
   •     Frandsen claims he has a right of first refusal.
   • RFR does not apply.
        • If the transaction had originally been structured as a sale of the
           FBG asset, then there would be no issue he would have had no
        • Even the original structure is ok, since a merger is not the same as
           a sale of stock.

Zetlin v. Hanson Holdings
    • Zetlin owned 2% of Gable Industries; Defendants owned 44%
    • Defendants sold their stock at a premium.
    • That’s fine! “Absent looting of corporate assets, conversion of a corporate
        opportunity, fraud or other acts of bad faith, a controlling stockholder is
        free to sell, and a purchaser is free to buy, that controlling interest at a
        premium price.”
    • Note that this is the American rule; British law and the EU both require an
        acquirer of control blocks of more than 30% to offer to purchase ALL
        outstanding minority shares, presumptively at the same price.
This is the general rule: control premiums are allowed as long as you are selling
is really the control.

Control Premiums
   • Why would someone pay a control premium?
          – They believe that control shares may carry special benefits in the
             form of generous salaries, perks, etc.
                • Is the noncontrolling SH harmed by this?
          – Shares may be worth more in the hands of a new owner b/c the
             incumbent is doing a poor or avg. job of managing the business.
                • If so, why wouldn’t the buyer, want to buy all the
                   outstanding shares?
                       • Risk

Perlman v. Feldmann

   •   Feldmann, family and friends owned 37% of common stock of Newport, a
       steel maker, and controlled the corp.
   •   There was a steel shortage due to the Korean war, but
       ethical/reputational restraints kept Newport from raising its prices.
   •   Newport did force buyers to pay interest-free advances (the “Feldmann
   •   The Feldman group sells their shares to Wilport, an end-user of steel for
       $20/share (market price was $12/share)
    •  Plaintiffs sue to force the Feldmann group to share the control premium.
    • Judgment for the plaintiffs.
    • What breach of fiduciary duty did the court have in mind?
          • The court thinks that Feldmann has cashed out a corporate
               opportunity, namely, the Feldmann Plan.
          • Once Wilport has control, it will be able to buy steel from Newport
               at posted prices, w/out giving low interest loans.
          • So there will be no more loans to modernize Newport facilities.
    • If this is correct, then perhaps the suit should be against Wilport;
       Feldmann just hands over control. Newport is taking the corporate
          • Dissent finds the majority position confusing; I agree.
          • Any suggestion in this case that there may be something wrong
               w/premiums for control standing alone has not been reflected in
               subsequent decisions of other courts. View the case as a unique
               set of facts.
What you should take from this case is that control premiums are okay but there
is an opportunity to argue that the premium not just for control but something
impermissible and therefore that portion of the premium is inappropriate.

Essex Universal v. Yates
   • Yates owned 28% of Republic Pictures and agreed to sell that interest to
   • As part of the deal, Yates promised to deliver a board loaded w/Essex
   • Yates had board members resign one at a time while the other board
       members replaced them w/ Essex nominees.
   • When the Republic stock rose, Yates tried to renege on the deal, claiming
       that delivery of an Essex dominated board was legally impermissible.
   • District Court awards summary judgment to Yates
Held: Reversed (with three different positions taken by the three member panel)
   • Lumbard:
          • The sale of a control block of stock at a premium is permissible, but
              sale of an office is not.

          •   It is okay to received payment for the immediate transfer of
              management control to one who has achieved majority share
              control but would not otherwise be able to convert that share
              control into operating control for some time.
          •   Were Essex buying a majority interest in the firm, the arrangement
              would be unobjectionable, since Essex would eventually obtain
              control of the board, but one must bear in mind the prohibition of a
              “naked office sale.”
          •   Essex is buying less than a majority, but b/c Republic is publicly
              held, Essex’s 28% gives it control of the board anyway. If so the
              arrangement is permissible. Unless Yates can prove that 28%
              would not let Essex gain control of the board.
   •   Clark:
           • Cases like this should be decided on their facts without so much
               doctrinal guidance. Summary judgment is improper.
   •   Friendly:
           • Directors owe a fiduciary duty to all SHs, not just to the controlling
               SH. When directors replace resigning directors, they must elect the
               nominee whom they believe would best serve the interests of the
               corp. Directors who automatically elect the purchaser’s nominee
               violate that fiduciary duty. BUT, this conclusion is unexpected and
               should not be applied retroactively so reversal is proper.
   •   If Yates held only 3% of the stock would the result have been different?
   •   It would not have been okay because it is clear he is not selling control,
       but the directors positions.
   •   If a 51% SH can demand a control premium, why can’t a 4% SH?
           • Is a 4% SH more likely to exploit and less likely to add value?
                   • Yes, it is a lot more effort to raise the value of the company
                      and therefore the value of your stock rather than just exploit
                      for your own gain.
   •   Under NY and Delaware law there are restrictions (or potential
       restrictions) against removing directors without cause.


Planning Problem p. 702-703
   • Ida, Sally and Maria are forming a business to mfctr. and sell computer
         – Ida will supervise production
         – Sally will be in charge of sales and production
         – Maria will put up the money for the start-up phase but will not play
            an active role in the business.
   • What advice would you give them?

          –    RFR agreement, tag along provisions, employment agreements,
               buyout provisions, mandatory dividends?
           For Maria:
               Mandatory dividends
               Employment agreements to control salaries
           Ida and Sally:
               Ways of raising additional capital
           All parties:
               Buy out agreement
   •   Is there a problem representing al
           – Yes

Problems p. 714
   1. none whatsoever
   2. you have to ask about the possibility of a freeze out

                            MERGERS AND ACQUISITIONS

         Merger v. Consolidation

          Constituent Corporations           Surviving Corporation


       Acme Inc.                                     Acme Inc.


                                 Ajax                  New
       Acme Inc.
                              Corporation            Company


Categorizing Deals By Corporate Governance Aspects
    Negotiated acquisitions
           Target is willing to be bought; key issues:
                  Mechanics by which the acquisition takes place
                  Duties of management in selecting and negotiating with a
                  Risk that competing bidders will try to buy the target out
                    from under the initial bidder.
    Hostile acquisitions
           Key issues:
                  How can the target defend itself against the raider?
                  What can the raider do to defeat those defenses?
                  Often lead to corporate control auctions
                        Key issue: What can target do to influence the
                           outcome of the auction?
Available Techniques
    Merger
           also Consolidation
    Sale of assets
    Proxy contest
    Tender offer
    Stock purchases
Tender Offers
    What is a tender offer?

            A tender offer is simply a public offer usually made to all
               shareholders of the target corporation in which the buyer offers to
               purchase target company shares
            You simply offer to buy any and all shares tendered
Principal Distinguishing Characteristics
     Mergers and sales of assets require approval by the target’s board of
     In contrast, none of the other techniques require target board’s approval:
            A proxy contest does not require board approval, although a
               shareholder vote is still required.
            A tender offer doesn’t require either board approval or a
               shareholder vote — if 50.1% of the shares are tendered to the
               buyer, the buyer wins.
            A stock purchase will have the same effect as a tender offer.
When To Bypass The Board?
     The board refuses to sell at any price
     The board is holding out for a price higher than the bidder is willing to pay
     The board is holding out for side-payments
Mergers v. Asset Sales
     Merger takes effect when the articles of merger are filed with the requisite
       state official
            Key events thereupon take place by operation of law
     Statutory sale of assets is much more complicated
            As a result, the mechanics of transferring control and consideration
               are more complex

           Sale of Assets                                       Acquirer

                    Target                              Acquirer
             2               Target liquidates

                                   Both corporations survive, but target is
                                   typically then liquidated
    If the payment to the Target was stock, the Target SHs become
                     shareholders in the Acquirer.                            14
                                                                                   More choice

Merger/Asset Sale Tax Consequences
    There are significant tax consequences which frequently dictate the
      structure of a merger, combination, reorganization, asset sale, etc.
    For example, if merger structured as tax-free reorganization, no tax
      consequences to shareholders.
    The tax issues involved are beyond the scope of this class, BUT you need
      to be aware of their existence.
Ease of transferring control
    When a merger becomes effective, the separate existence of all corporate
      parties, with the exception of the surviving corporation, comes to an end
    In an asset sale, the target company remains in existence at least for a
      little while after the asset sale has been completed
            Only title to the assets change hands, both corporations remain
Ease of transferring assets
    In a merger, title to all property owned by each corporate party is
      automatically vested in the surviving corporation
    In an asset sale, documents of transfer must be prepared with respect to
      every asset being sold and those documents must be filed with every
      applicable agency
            E.g., a deed of transfer will have to be properly filed with every
              county in which the target owns real estate.
Successor liability
    In a merger, the surviving company succeeds to all liabilities of each
      corporate party
    In an asset sale, subject to some emerging tort doctrines, the company
      purchasing the assets does not take the liabilities of the selling company
      unless there has been a written assumption of liabilities
Ease of passing consideration
    In a merger, the consideration passes to nondissenting shareholders
    In an asset sale, the process of distributing the consideration to the
      target’s shareholders is more complicated
            Since the target is still in existence one option is to distribute the
              consideration as a dividend
            More often the target is formally dissolved and its remaining assets
              (including the consideration paid in the acquisition) are distributed
              to its shareholders in a final liquidating dividend
Shareholder Voting and Appraisal
    Avoid voting whenever possible.
            Cumbersome and expensive
            Might vote No

     Appraisal rights (sometimes called “dissenters’ rights”) give dissenting
      shareholders the right to demand that the corporation buy their shares at
      a judicially determined “fair market value”
           The prospect that any significant number of shareholders exercise
              them will threaten the acquisition
Shareholder Voting and Appraisal in Standard Merger
     Approval
           Both company’s boards
           Both company’s shareholders
     Appraisal
           Available to shareholders of both corporations in some states.
           Some states (like Delaware) eliminate dissenters’ rights (i.e.
              appraisal rights) for public corporations.
Shareholder Voting and Appraisal in Asset Sale
     Delaware § 271 requires approval of a sale of substantially all the
      corporation’s assets by the board and shareholders of the selling
           Shareholder approval must be by a majority of the outstanding
     Delaware does not require that the shareholders of the purchasing
      corporation approve the transaction. Only the board of the purchasing
      corporation need approve the transaction
     Nobody gets appraisal rights under Delaware law in an asset sale
Mergers: Summing Up
     Step 1 (Ex. under Del. law)
           T and A boards adopt Merger Agreement
           A’s charter can be amended at this point
           Allows cash and securities other than Acquirer common as
     Step 2
           SH vote at A and T: majority of shares entitled to vote thereon
     Step 3
           Filing [M.A. or “certificate”]--merger effective at this point
     Appraisal rights
           No A.R. if stock of constituent corp is listed--A and T are both
              listed; otherwise yes.
Triangular Transactions
     Provides the transaction cost-minimizing advantages of an asset sale,
      while also providing the advantages of a merger
           Buyer sets up a shell subsidiary—call it NewCo
           NewCo will be capitalized with the consideration to be paid to
              target shareholders in the acquisition — cash, debt or equity
              securities of the buyer

    NewCo then merges with the target
        In a forward triangular merger, NewCo will be the surviving entity
        In a reverse triangular merger, the target will be the surviving

         Acquirer Corp and Target Corp Plan a
         Reverse Triangular Merger

      Acquirer Inc.                           Acquirer Inc.

      NewCo Inc.                              Target Corp.


Effect of a Triangular Transaction: Target Perspective
     The target company ends up as a wholly owned subsidiary of the acquirer
            The former target shareholders either become shareholders of the
               acquirer or are bought out for cash
            Target shareholders still get to vote and still get appraisal rights
Effect of a Triangular Transaction: Acquirer’s Perspective
     From the buyer’s perspective, the parent company itself would be the only
       shareholder of NewCo
            As a result, the parent’s board of directors will decide how to vote
               the NewCo shares
            The parent company’s shareholders have no corporate law right to
               vote, nor to appraisal
Effect of a Triangular Transaction on Successor Liability
     After a triangular merger, the target in effect remains in being as a wholly
       owned subsidiary of the true acquirer
            As such, the target is solely responsible for its obligations, unless
               the plaintiff is able to pierce the corporate veil and hold the parent
               company liable

De Facto Mergers (look at flow chart above)
Dissenters’ Rights
    Two of the most common reasons why people structure transactions that
      accomplish the effect of a merger in a non-merger form are
           Tax benefits

           Dissenters’ rights
Acquirer Corp and Target Corp Plan a Reverse Triangular Merger
    Will Acquirer Corp’s Shareholders Get Voting Rights?
           No ... In a merger, only the shareholders’ of the constituent
             corporations are entitled to vote
                  Here the shareholders who are entitled to vote are the
                    shareholders of Target and the shareholders of NewCo
                  The sole shareholder of NewCo is Acquirer
                        Acquirer’s board will decide how to vote NewCo’s
           Ditto as to appraisal rights
De Facto Merger Doctrine
    Substance-over-form argument
    Court says: “even though you structured your transaction as a triangular
      merger or asset sale, we are going to treat it as a regular two-party
    Result: Buyer’s shareholders get the right to vote and the right to dissent
Delaware Law
    Is de facto merger good law in Delaware?
           No, per Hariton v. Arco Electronics
    Why did Delaware reject de facto merger doctrine?
           Doctrine offends the equal dignity of the merger and asset sale
             provisions of the statute
Regulatory Arbitrage OK in Delaware
    Court says there is no reason why the statute couldn’t provide different
      routes to the same result, with different levels of shareholder protection.
      But why?
           The statute provides various ways of accomplishing an acquisition
           No one acquisition technique is always appropriate
           De facto merger increases uncertainty and eliminates the
             advantages of multiple acquisition formats
Pennsylvania Law
    Pennsylvania courts latched onto de facto merger at an early date
           Many of the classic cases are Pennsylvania cases
           Filled with platitudes like: Form should not be elevated over
    The Pennsylvania legislature kept adopting statutes designed to limit it
           Pennsylvania courts eventually got the message and pretty much
             stopped using the doctrine

Farris v. Glen Alden Corp
A reverse triangular merger
Remember Pen has changed this by statute but it is still floating around out

    List owned 38.5 % of GA
            L wanted to merge the two companies
    L sold its assets to GA for GA stock
    L then liquidated and distributed the GA stock to its shareholders
            L shareholders wound up owning 76.5 percent of the GA shares
            Plaintiff, a GA shareholder, claimed that he was entitled to
              dissenter’s rights
    GA is losing money—selling assets could mean loss of tax loss carry
    GA owns coal mines
            To transfer to List in an asset deal means many deeds and real
              estate transfer taxes
    Why structure transaction that way?
            List sold its assets to Glen Alden for Glen Alden stock
            List board and shareholders approved the sale
            Glen Alden shareholders get no appraisal rights
            List SHs wind up owning 76.5% of GA shares
    Why did GA shareholders get to vote?
            GA apparently had insufficient authorized but unissued shares of
              stock to distribute to L
                   Accordingly, needed to amend the articles of incorporation
    Under Delaware law, shareholders in a merging corporation had
       dissenters’ rights; shareholders in a corporation selling its assets did not
    Under Pennsylvania law, both shareholders in merging corporations and
       shareholders in corporations selling their assets had dissenters’ rights
    If merged in a statutory merger, the boards of both and the shareholders
       of both would have voted on the merger
    If GA sold its assets to L, GA shareholders would have gotten appraisal
    Holding? When is a de facto merger is present?
            When a transaction so fundamentally changes the nature of the
              business as in effect to cause the shareholder to give up his shares
              in one company and against her will accept shares in a different
            On these facts, the court found that there had been the requisite
              fundamental change

    Relevant factors for fundamental change in nature of business include:
     change in board composition; change in shareholder composition;
     significant changes in shareholder values; and significant changes in the
     company’s lines of business

         Avoiding Appraisal
                        Glen Alden           List
                        (Penn. Corp.)        (Del. Corp.)

  Sale of Assets        Appraisal            No appraisal

  Merger                Appraisal            Appraisal


Freeze-out Mergers

    In theory, quite straightforward
           Give shareholders who dissent from the merger the right to have
               the fair value of their shares determined and paid to them in cash
       All appraisal statutes give you appraisal rights in long-form mergers of
          closely-held corporations
       Impossible to generalize beyond that
                Whether appraisal rights are available for any other type of
                   transaction depends on which state’s law governs
   Availability of Appraisal: Delaware Law
       Standard two-party merger?
                Yes
       Standard merger; Target's stock is listed on a national securities
          exchange and the consideration is stock in the acquiring company?
                No (See §262(b)(1))
       Standard merger, Target’s stock is listed on a national securities
          exchange, Consideration paid is cash
                Yes, but complicated
   DGCL § 262(b)

       Section 262(b)(1) provides that appraisal rights shall not be available
        for targets whose stock is listed on an exchange or where the target
        has more than 2,000 record shareholders
       But section 262(b)(2) then gives those target shareholders back
        appraisal rights if the consideration paid in the merger is anything
        other stock
                Sale of all or substantially all of Target’s assets?
                       No

The Merger as Private Eminent Domain
    Hold-out shareholders have no remedy where they simply want to keep
     their target shares
          Majority shareholders may effect a freeze-out merger to eliminate
             the minority
    Statute does give disgruntled shareholders a right to complain about the
     fairness of the price being paid for their shares; namely, the appraisal

Exercising Appraisal Rights
    DGCL § 262(a) requires that dissenting shareholders:
          1. Hold onto their shares continuously through the effective date of
             the merger
          2. Perfect their appraisal rights per § 262(d) by sending written notice
             to the corporation, prior to the shareholder vote, that she intends
             to exercise her appraisal rights (it is not sufficient to merely vote
             against the merger at the meeting)
          3. Neither vote in favor of nor consent in writing to the merger

Exclusivity of appraisal
    Weinberger held?
            Relief for unfair mergers usually is limited to the appraisal remedy
            In cases of fraud, misrepresentation, self-dealing, deliberate waste
               of corporate assets or gross and palpable over-reaching, relief may
               be available outside appraisal

Eliminating the Minority
     Getting rid of the minority is fairly straight-forward
           The transaction is usually structured as a back-end, “freeze-out”
              merger, typically one of the triangular transactions
     Critical points
           Must be approved by the board of directors and a majority of
              outstanding shares
                   Controlling shareholder will have leg up on getting approval

          Once approved, shares of stock of the non-surviving corporation
            are transformed by operation of law into IOUs collectible for
            consideration promised in the merger agreement
                 E.g., in Weinberger the merger agreement provided that
                    each share of old UOP would be converted into an IOU for
    Eliminate costs associated with being publicly held
    More flexibility in moving assets around within the firm
          Get unencumbered access to target assets
    Eliminate issues of fiduciary duty to the minority
          Recall Sinclair Oil v. Levien

Class Actions: The Burden of Proof
    Who has the burden of proof that the transaction was fair?
            Depends ... Can shift
            Note that this seems to apply only to class actions, not to appraisal
    What determines allocation of BoP?
            Whether the merger has been approved by a majority of the
              minority shareholders
Shifting Burden of Proof
    BoP allocation when a majority of the minority shareholders approved the
            Defendant must show that they completely disclosed all material
              facts relevant to the transaction
            If defendant makes such a showing, the burden is on the plaintiff
              to show that the transaction was unfair to the minority; but
            If defendant is unable to make that showing, the burden remains
              on the defendant to show that the transaction was fair
    BoP absent shareholder approval
            Plaintiff must come forward with some evidence of fraud,
              misrepresentation or misconduct relating to the merger
            Once plaintiff does so, the burden is on the defendant majority
              shareholder to show that the merger was fair

The Entire Fairness Standard
    How do we define fairness?
           Compare the challenged transaction to the hypothetical terms that
             might be reached between two parties dealing at arms-length
                  In Weinberger the court equated fairness to the conduct
                    that would be expected of a disinterested independent board
    Components of “entire fairness”:
           Fair dealing
           Fair price

Coggins v. New England Patriots Football Club, Inc. (Mass.)
    Sullivan bought the Patriots franchise for $25,000 and contributed it to a
       new corp.
    Nine other investors bought equal interests (10,000 shares ea.) for $25K
    The Patriots Corp. sold 120, shares of nonvoting stock at $5 per share
    Sullivan is ousted from mgt. and regains control by buying all the voting
       shares that he did not own at a cost of $102/share (approx. $7.8 mil.)
       paid for with a loan and the banks want him to use the corporate income
       to repay the loan.
    Since Sullivan knows that having the corp. assume his personal loan and
       repay it is a violation of his fiduciary duty, he tries to buy out the
       nonvoting SHs.
    He creates a new corp. which he wholly owns and merges the old Patriot
       firm into the new firm, the nonvoting SHs get $15/share
    Each class approved the merger, but Coggins sues to void the merger
            The merger was impermissible. Since voiding the merger is
              impracticable, Coggins gets damages.
    Note that the court cites Singer, a Delaware case, but under Delaware law
       the requisite business purpose, need not be a corporate business purpose.
    Second if Sullivan had known he needed to show a business purpose, he
       probably could have built the appropriate record (e.g. minority SHs reduce
       corporate flexibility, public corps. incur significant auditing and filing
    By the time of Coggins, Singer had been rejected in Delaware;
       Weinberger abandoned the business-purpose requirement for cash-out
            If a merger is fair to the cashed-out minority, that now ends the

Rabkin v. Olin
    Further development of appraisal regime
    Key issue: Exclusivity of the appraisal remedy
    March 1, 1983: Olin bought 63 percent of the outstanding stock of Hunt
       from Turner & Newall for $25 per share
           Olin agreed that if Olin bought the rest of Hunt stock within a year,
             it would pay $25 for that stock as well
           Olin stated it had “no present intention” to buy the rest
                  Court observed, however, that “it is clear that Olin always
                    anticipated owing 100 percent of Hunt.”

    March 23, 1984 (just after the one year period ends): Olin met with its
      investment banking firm to plan its purchase of the remaining stock at $20
      per share
          Engineered a cash-out merger at $20/share
          Plaintiffs rejected an appraisal and challenged the merger as unfair
          The defendant moved to dismiss
    Judgment for the plaintiffs. Why?
          Under Weinberger, appraisal “is not necessarily the stockholder’s
            sole remedy”
          Here, the plaintiffs “seek to enforce a contractual right to receive
            $25 per share”
                 The Court of Chancery must “closely focus upon
                   Weinberger’s mandate of entire fairness, based on a
                   careful analysis of both the fair price and fair dealing
                   aspects of a transaction”

Appraisal Remedy
    Under what circumstances is appraisal plaintiff’s exclusive remedy post-
           Rabkin seems to limit appraisal to cases in which plaintiff’s only
             complaint is that the price paid is unfairly low.

What did Olin do Wrong?
   Suppose that at the time Olin bought the initial block from Hunt, it
      anticipated buying the minority interest at $20 per share as soon as
      possible, and said so. Is there anything wrong with that?
          The law seems to be clear that a premium for control is
          If $20 is not enough for the minority shares, it is difficult to see
             why appraisal is not the appropriate remedy
   Turner & Newall insisted that Olin wait at least a year before cashing out
      the minority. But so what?
          Is it just that Olin and Turner & Newall were not candid?
                  The court seems to interpret the one year rule as some sort
                    of effort by Turner & Newall to encourage Olin to pay $25
                    per share to the minority shareholders, and some sort of
                    agreement by Olin to do so
                         But then why talk about mergers, fair procedure, fair
                           price, etc. why not just talk about breach of K.
                         Remember that this is an appeal from a grant of a
                           motion to dismiss on the pleadings.

Planning Issue

    Why did Turner & Newall insist on the one year commitment?
        The one year commitment is a routine item requested by sellers of
           control blocks of stock to protect them from liability for
           expropriating an acquisition premium
        Perhaps, Turner & Newall thought taking a control premium was
           unseemly and might result in bad P.R.

Equitable Remedies
    Assuming SHs receive “fair value” through the appraisal process, why
      might a SH prefer other remedies?
           If dissenting SH, X, can enforce equitable remedies, the court may
             award her the amount she would have earned had she been able
             to invest in the firm. Since it usually takes several yrs to get to
             trial, X may have a be able to get a risk-free investment with the
             appraisal price being the downside.
                  Note that majority SHs often freeze out minority
                     investors b/c they plan to invest their own resources
                     in improving the Co. Equitable remedies effectively
                     give dissenting SHs a chance to free-ride on this
           If dissenting SH, X, has the right to enjoin or rescind the merger,
             she can “hold up” the majority SH for far more than the fair value
             of the minority’s shares.
           Also, attorney fees and advantage of class action over individual
             appraisal actions

Rauch v. RCA Corporation
    GE wanted to buy RCA’s assets for cash
    RCA had both common and preferred SHs
    RCA’s articles provided that RCA could redeem the preferred stock for
    If GE had bought RCA assets for cash, and RCA had then wanted to
       liquidate and distribute the cash to its SHs, it would have been required to
       redeem the preferred.
    Instead, RCA merged into a GE subsidiary
    Pursuant to the merger, Preferred SHs got $40/share and common SHs
       got $66
    Plaintiff sued for damages, claiming they were entitled to $100.
            Complaint dismissed
    The court refused to recharacterize the merger as a “de facto
       redemption”, adopting essentially the same equal dignity approach it used
       to dismiss a de facto merger claim in Hariton.


Hypo 1
   Target is in the business of making wooden baseball bats In light of the
     increasing cost of the source woods, Target sells all of its wooden bat
     manufacturing assets to Acquirer in return for cash It uses the cash to go
     into a new line of business: making aluminum baseball bats Is this a de
     facto merger?
   Does the transaction so fundamentally change the nature of the business
     as in effect to cause the shareholder to give up his shares in one company
     and against his will accept shares in a different business?
          Relevant factors include: change in board composition; change in
             shareholder composition; significant changes in shareholder values;
             and significant changes in the company’s lines of business
   Only the latter is even arguably present, and the company’s business has
     in fact changed only in a very minor way

Eligibility of Appraisal
    Hypo: Sue Shareholder walks into your office
            She just got a proxy statement in the mail from Target Co.
                  Announces that Target’s board of directors has agreed to
                    merge with Acquirer Co. and solicits proxies in favor of the
                  Pursuant to Delaware § 262(d), also states that appraisal
                    rights will be available in connection with the merger
    Sue thinks this merger is a lousy idea
            Given the facts we have so far, does Sue have any legal basis for
              preventing the merger from taking place?
                  No. If approved by a majority of the shareholders, it will


Two principal ways for Firm A to acquire Firm B:
    • Negotiate with a deal with mgmt (“friendly” acquisition)
          – Statutory Merger
          – Sale of assets
    • Purchase shares from the firm’s SHs (“hostile” acquisition)
          – Using a “creeping” acquisition or a tender offer
                 • Might have to pay a “Control Premium”
          – Then replace members of the board and engineer a statutory
              merger under § 251 or § 253.
                 • Perhaps squeezing out any remaining shareholders
Tender Offers
    • In its basic form, a tender offer is simply a public offer usually made to all
       shareholders of the target corporation in which the buyer offers to
       purchase target company shares
Most potent weapon in the hostile corporate raider’s arsenal
    • Advantages over major alternatives, such as asset sales or mergers:
          – Approval by the target’s board of directors is a necessary
              prerequisite to statutory transactions
                 • Tender offer permits the bidder to bypass the target’s board
                     and to purchase a controlling share block directly from the
Most potent weapon in the hostile corporate raider’s arsenal
    • Advantages over major alternatives, such as asset sales or mergers:
          – Until the late 1960s, almost total lack of legal rules applicable to
              cash tender offers
                 • Mergers and proxy contests were subject to a complex web
                     of federal and state laws
                 • Imposed substantial disclosure obligations on acquirers
                     utilizing those techniques
                 • Typically also imposed delay
Williams Act (1968)
    • Federal regulation of tender offers
          – Disclosure
          – Procedural requirements, albeit mainly to make the disclosure
              requirements more effective
    • Two principal components:
          – § 13(d) requires disclosure of preliminary stock acquisitions that
              may lead to a tender offer or other type of acquisition effort
          – §§ 14(d) and 14(e) regulate the actual tender offer itself
Beachhead Acquisitions
    • Keeping one’s interest in the target and one’s takeover plans secret for as
       long as possible is crucial for the acquirer.

   •  § 13(d) of the 1934 Act and the SEC rules thereunder form, in effect, an
      early warning system for the target company
Key Required Disclosures
   • Identity
   • Plans and intentions
          – Including whether you intend to seek or are considering seeking
             control of the issuer.
   • Any contracts, arrangements, understandings or relationships with respect
      to the securities of the issuer
Tender Offers
   • §§ 14(d) and 14(e) triggered when any person commences a tender offer
      for more than five percent of a class of a target’s equity securities
Commencement of a Tender Offer: Rule 14d-2
   1. Transmission of an offer to the shareholders in one of the ways specified
      in 14d-2(a).
   2. Public announcement of:
          – Bidder’s identity, target’s identity, the amount of securities bidder is
             offering to buy, and the price
Required Disclosure
   • On date offer commences, bidder must file a disclosure document on
      Schedule 14D-1 with the SEC
   • Most of the information contained in the Schedule 14D-1 also must be
      disseminated to the target’s shareholders either by:
          1. Long-form newspaper publication of the offer
          2. Summary publication and mailing of disclosure statement
                 • Incumbent management must either mail for bidder or
                     provide NOBO and CEDE lists
Incumbent’s Response
   • Schedule 14D-9 must be filed by target
          – Management must state whether they support the offer, oppose it,
             or that they are unable to take a position
          – Management must also summarize the reasons for its position
Some Defensive Tactics
   • “Greenmail”
          – Pay off the potential acquiror to go away (usually by purchasing
             her shares above market value)
   • Competition
          – Find a friendly “white knight” to take over firm
          – Allocate “lockup” rights to first/preferred bidder
   • Scorched Earth Policy
          – Poison Pills
          – Share Repurchases at a premium
   • Turn the Tables

          – The “Pac-Man” Defense. The original takeover target attempts to
            swallow (takeover) the original bidder.

            Judicial Ambivalence
          toward defensive tactics
       Reasons for Deference
       Reasons for Deference        Reasons for Scrutiny
                                    Reasons for Scrutiny

      •Mgrs are supposed to
       •Mgrs are supposed to       •Managers may have
                                    •Managers may have
      make day-to-day
       make day-to-day             strong self-preservation
                                    strong self-preservation
      decisions and plan
       decisions and plan          incentives (private
                                    incentives (private
      long-term strategy.
       long-term strategy.         benefits of control)
                                    benefits of control)
      •Implicit decision: Not
       •Implicit decision: Not     •If a takeover attempt
                                    •If a takeover attempt
      to sell out/bust up firm.
       to sell out/bust up firm.   is “worth it”, odds are
                                    is “worth it”, odds are
      •Or if sell, get highest
       •Or if sell, get highest    that it’s because mgmt
                                    that it’s because mgmt
      price possible for SHs
       price possible for SHs      is doing a poor job
                                    is doing a poor job

Cheff v. Mathes
   • Holland Furnace sold furnaces through the fraudulent tactics.
   • Because of the investigation into these practices, the firm was doing
   • Maremont became interested and contacted Holland’s president, Cheff,
       about a merger, but Cheff rejected Maremont’s overtures.
   • Maremont began buying Holland stock, announced his purchase publicly
       and demanded a place on the board.
   • Cheff refused.
   • Holland investigated and found that Maremont often bought corp.s to
       liquidate them at a profit
           – Holland employees, aware of Maremont’s interest began showing
              discontent. (Note this risk is minimized by trial ct.’s findings.
   • Having met resistance, Maremont offers to sell his stock to the firm at a
       premium over:
           – his purchase price and over the market price
   • Directors discuss whether to buy Maremont’s stock through Hazelbank, a
       Cheff family investment firm. But instead decide to pay greenmail – to
       buy the stock w/ corp. funds
   • Other SHs challenge

   •   Trial court finds that the purpose behind the purchase was to perpetuate
   •   Looking at the substance of the greenmail transaction, what type of
       fiduciary duty does it implicate?
           – Duty of Loyalty; Duty of Care; Waste
Basic Test
   •    Inside Directors (Cheff & Trenkamp)
            – Direct Conflict of Interest in their desire to perpetuate themselves
               in office. ==> DoL analysis.
                   • Directors must either show cleansing of the transaction after
                       full disclosure or “fairness” to corporation.
    • Outside Directors (the conflict is less)
            – Lower standard, need to show good faith and reasonable
            – Note there is NO presumption of duty of care (BJR)
            – Directors must affirmatively demonstrate:
                   • Reasonable investigation gave grounds to perceive danger to
                       corporate policy and effectiveness; and
                   • Good faith of their actions.
            – Professor is going to treat this test like a mini duty of loyalty
               analysis we are going to ask did they show good faith and do
               reasonable investigation.
(1) Insiders: If a defensive maneuver is executed by insiders, or their votes are
necessary to approve it, or insiders dominate an approving board, then such
transactions will apparently receive a standard DoL analysis.
Intrinsic vs. Entire? Probably intrinsic, given that they only own a small fraction
of shares, and that the transaction is not a merger.
(2) Outsiders: The court does not jump wholly to the BJR presumption. Indeed,
even the non-interested directors are "called upon to justify their actions” and
thus bear the burden of showing:
...that after a “good faith and reasonable investigation,” they had “reasonable
grounds to believe that a danger existed to corporate policy and effectiveness”
[NOTE: When we look at Unocal in a few minutes, this will be amended
In this case, the court finds, the outside directors met this test. They apparently
took steps to investigate Maremort’s true aims, and then reasonably honestly
concluded that "there was a reasonable threat to the continued existence of
Q: What principal threat was involved? Was it a threat to shareholder value?
A: No -- it was a threat to employee morale and composition.
Employees were worried about either a liquidation or a substantial change in
sales practices and possible reduction in force should Maremort take over:
                            • M’s reputation as a buy-n-burn acquiror

                        •      His articulated views that door-to-door sales aren’t
                              the way to go;
                           • His lack of forthrightness about his intention to
                              acquire company
Thus, even though the trial court found that Maremont was not the cause of
employee unrest, the Ct. finds, that conclusion is not supported by the evidence.
It’s significant that the court finds the “threat” need not be to SH value, but can
be to something else. We’ll see when and where this comes up again later.
Interesting Note: The fact that outside directors have to make the above
demonstration suggests that Cheff/Trenkamp can’t simply defend their DoL
claims by showing a “cleansing” under § 144(a) (outside director vote). Indeed,
the whole action of the board still has to be justified under the
“investigation/threat” analysis above.

Open questions after Cheff: As to “uninterested” directors...
  • How is the Cheff test distinct from a BJR approach?
         – (Is it just the same test with burden switched to defendants?)
         – On its face, Cheff seems distinct from BJR, on at least two grounds.
             First (and more speculatively), “reasonable investigation” seems
             more like a negligence standard than a recklessness standard.
             Second (more importantly) the burden of proof is shifted. Unlike
             the usual BJR case, now the DIRECTOR has to show good faith and
             reasonable investigation rather than having it presumed.
  • What constitutes a “threat to corp. policy/effectiveness”?
         – i.e., what constituencies matter in determining threat?
                 • SH (which classes?/in what proportions?).
                 • Others (BHs? Employees? Customers? Community?)
             While the court doesn’t answer this question, directly, it does signal
             that at least employee welfare counts in some respect. Now this
             could be b/c that’s a long run interest of SHs, or it could be b/c the
             court’s taking a broader view of which constituencies have primacy
             in such situations.
             One thing is clear, however: After Cheff, mgmt’s own job security
             doesn’t count as a bona fide threat.
             You should also note that corporate constituency statutes (that we
             studied after Dodge v. Ford) are highly relevant here.
             Pennsylvania’s, for example, would certainly suggest that
             reasonable fear for employee/creditor/community welfare ALONE
             (even if contrary to SH interests) can justify a defensive tactic by a
  • Is bona fide threat sufficient defense for any defensive action?
         – i.e., Can BoD “break a birdhouse with a sledgehammer?”
      Also the court never really discusses the “proportionality” of the defensive
      move by the Holland board -- whether the action was tailored to the

       threat. In other words, it cost a lot of $$ to send greenmail to Maremont.
       If the monetary threat to the firm is smaller than the cost of eliminating
       the threat, what result?

Unocal v. Mesa
   • T. Boone Pickens's firm, Mesa Petroleum, owned 13 percent of Unocal,
       and wanted to take it over.
   • Q: Any idea why?
   • A: The notes just before the case suggest that Unocal’s breakup value
       was higher than its trading value.
   • Anyway, Mesa made a "two-tiered front-end loaded tender offer" for the
       rest. It would buy 37+ percent of the stock (64 million shares) for $54 per
       share (the front-end). It would then cash out the remainder with junk
       bonds (ostensibly) worth $54 (the back-end).
   • It’s probably safe to assume (as the court did) that the bonds were worth
       less than $54. Because the tender offer would not have been "coercive" if
       the bonds were worth the front-end price, we too assume for purposes of
       class discussion that the bonds were worth less than $54.
   • To stop the Mesa takeover, Unocal made a competing tender offer for its
       own stock at $72/share. Its offer was a bit different.
           o (1) It was selective, -- Mesa couldn’t participate. (“Mesa Exclusion”)
           o (2) It kicked in ONLY if Mesa acquired a controlling interest (i.e., 64
               million shares of Unocal stock), Unocal would purchase notes from
               all tenderers with notes (IOUs) valued $72. (“Mesa Purchase
   • Idea: Unocal’s board hoped it would either make it impossible for Pickens
       to get enough takers, or if he did, the defense would leave Unocal so that
       there is no value left for him because the firm is committing to paying out
       huge sums of money to current shareholders who don’t sell to Pickens.
   • When the shareholders complained about this aspect of the defense,
       Goldman Sachs and Dillon Read advised Unocal to alter the deal. Unocal
       agreed to buy 50 million of the shares tendered regardless of whether
       Mesa acquired 50+ percent.
           o Now, Unocal's strategy becomes considerably more dangerous and
           o SHs WILL now tender, and thus Unocal has to finance the
           o To do it, Unocal in fact had to borrow, thereby creating some
               bankruptcy risk, the financial risk associated with high leverage.
           o This was sort of like scortching the earth before the invasion! Thus,
               it still made the acquisition unattractive to Mesa.
   • Mesa sued, arguing that the Unocal directors owed it (Mesa) the same
       fiduciary duties they owed all other shareholders. If the Board arranged

     for Unocal to repurchase the other shareholders' stock at advantageous
     prices, they owed Mesa same treatment.
  • Trial court granted a preliminary injunction on Unocal’s offer (finding that
     the Mesa exclusion was impermissible), and the defendants appeal.
The Unocal 2-prong Test
     (1) “Threat” Prong
      Board acted in Good Faith: After reas. investigation, concludes that a
      danger exists to corp. policy & effectiveness.
      (2) “Proportionality” Prong
      Action must be reasonable in relation to threat posed. (Explicitly new
Court notes that ordinarily, there is a presumption of the duty of care from BJR
But b/c takeover defenses here in this strange netherland between DoC and DoL,
the BJR isn’t quite as permissive here.
But the court goes a bit beyond where Cheff went: Directors subject to a two-
part test (now known as the unocal test). “Threat Prong” “Proportionality Prong”.

Q: What constituencies matter in determining proportionality?
       SHs, creditors, customers, employees, community, short-term speculators
       (but not BoD or officers).
Q: Does this list of contingencies seem consistent with similar lists of relevant
contingencies we’ve seen earlier (Ford; Pillsbury v. Honeywell)?
       A: No -- It seems to go far afield from these earlier cases. Only in the
       Pennsylvania constituency statute do we see such a wide set of
Q: Given this broad-based set of constituencies, what sorts of things can be
considered “threats”?
       A: [753]: Adequacy of price for the SHs, nature/timing of offer, risk of
       nonconsummation, quality of instruments exchanged, questions of

Q: In this case, then what was the threat that the Board was attempting to fight
       A1: Mesa's offer was coercive and inadequate to SHs (especially the back
       end). The danger here would be to the unlucky SHs who don’t tender, or,
       if the front end is oversubscribed, to the tendered shares that get elbowed
       out. (Btw, Does the incentive to tender early always mean coercion? NO --
      See example before case).
      A2: Pickens had been a greenmailer in the past. (May not actually be
      true, but if it is, it means that it’s he (and not existing SHs) who benefits
      from “irrationally” depressed stock). (Note of course, that this leaves open
      WHY the stock is depressed -- greenmailer may have disciplined
      management. Moreover, b/c firm doesn’t have to pay greenmail, it seems
      like the probability of success would be relevant).

Q: But at any rate, according to the court, was their measure taken by Unocal
reasonable relative to the threat posed? If so, what constituencies was it
protecting? Was it justified in excluding one of the shareholders (Mesa)?
       A: Yes. Unocal designed its self-tender to stop the Mesa offer, or at least
       protecting back- end SHs. (Here, you may want to tease out the fact that
      if everyone tendered, they would get pro-rata participation, and thus
      would all be a small-part back end and other part front end SH -- MM
      theorem may hold).
      As to excluding Mesa, this was essential to making the defense work, the
      directors could validly do so. Allowing Mesa in would both fail to stop
      them, and subsidize their offer.

Unocal Postscript
   • Unocal and Mesa eventually negotiated and agreement that let Mesa
      participate in Unocal’s self-tender.
   • At that point, a Unocal SH sued Mesa under what statute?
         – §16(b) Why?
         – Mesa argues that self-tender qualifies as an unorthodox transaction
              (e.g. Kern County) and is not subject to §16(b)
         – The court held Mesa liable under §16(b), stating that the Kern
              County exception applies to involuntary transactions, and this one
              was voluntary.

How different is Unocal from the BJR?
  • Threat Prong:
        – Like Cheff looks very similar (broad constituencies and time
        – Formally, burden is now on directors, but such broad justifications
           seem pretty easy to come up with;
  • Proportionality Prong:
        – Not well developed in Unocal.
               • Many subsequent cases seem not to focus on it at all.
        – Unitrin v American Gen. (1995): Del. Supreme Court holds that
           proportionality prong has some “teeth”
               • Even if bona fide threat exists, protective measure cannot be
                  “preclusive” or “coercive”
               • Court never has defined what those terms mean

            Importance of Unocal:
           Mushrooming of the BJR
     Carves out a special test for “defensive
      measures” and tender offers.

 Deferential                                            Strict
  Scrutiny                                             Scrutiny
         Gross Negligence

                                                      DoL -- NO BJR
                            Threat + Prop.

                                                      DoL -- NO BJR
           (Van Gorkom)
           Non-Def. Acts

                            Threat + Prop.
          (Van Gorkom)
          Non-Def. Acts

                              Def. Meas.

                             Def. Meas.



Post- Unocal standards of review
   • Traditional BJR, exemplified by cases like Van Gorkom
   • Traditional duty of loyalty, exemplified by cases like Weinberger
   • The new conditional BJR set out by Unocal
   • Unocal left two critical questions:
          • Which decisions get reviewed under which standard?
          • What content should we give the applicable standard in a given
Poison Pills
   • First Generation Preferred Stock Pills:
          – Lenox: 1983
          – Based on “blank check preferred stock”
   • How would you get the preferred stock out to the shareholders?
          – Lenox issued a special dividend consisting of nonvoting, convertible
              preferred stock, the dividend issuing at the ratio of one preferred
              share for every forty shares of common stock
   • Antitakeover effect?
          – Based on conversion feature of the preferred stock
                  • Adaptation of standard anti-destruction clause of convertible
          – If Lenox was acquired, the preferred stock became convertible into
              common stock of the acquiring corporation at well-below market
              prices (i.e., a flip-over pill)
                  • Discriminatory: “interested person” could not exercise
Beating the First Generation

         – Crown Zellerbach pill only kicked in if the bidder tried to effect a
             freeze-out merger
         – Goldsmith acquired a controlling interest in Crown Zellerbach but
             did not effect freeze-out
                 • Goldsmith suffers no poisonous effects
                 • On the other hand, since the rights were now exercisable in
                    the event of a merger, Goldsmith precluded anyone from
                    merging with Crown Zellerbach
Second Generation Pills
   • Based on rights issued as a pro rata dividend on the common stock to the
     shareholders of the target corporation
         – Rights are corporate securities that give the holder of the right the
             option of purchasing shares
         – The rights become exercisable upon some triggering event, such
                 • Acquisition of a specified percentage of target shares
                 • Announcement of a tender offer for some specified
                    percentage of the shares
   • Flip-over feature retained
   • Flip-in feature added
         – Enables shareholders of the target to purchase target stock or debt
             at a discount
                 • Resembles a standard warrant
                 • Discriminatory: “interested person” not eligible
         – Causes dilution in the target shares held by the acquirer
                 • Grand Met v. Pillsbury: Would have reduced Grand Met’s
                    interest in Pillsbury from 85% to 56%. Value of Grand Met’s
                    holdings would have declined by more than $700 million
Redemption Features
   • Give the board the option of redeeming the rights at a nominal cost in
     order to allow desirable acquisitions to go forward
         – Window redemption: board retains the ability to redeem the rights
             for a specified time period following the issuance of the rights
         – White knight redemption: rights redeemed for a transaction
             approved by a majority of the “continuing directors”

Example: Household International Pill
   • Two triggering events:
         – Making of a tender offer for 30% or more of Household’s shares
         – Acquisition of 20% or more of Household’s outstanding shares by
            any person or group
   • Rights initially “stapled” to common stock

           – i.e., not issued in physical form and not able to be sold separately
              from the common stock
           – Why?
                  • Minimizes risk that a separate secondary trading market
                     would develop
   •   Rights detached from common stock upon either event
           – When detached, the rights were immediately exercisable
   •   Flip-over
           – Once detached and exercisable, if the offeror subsequently effected
              a back-end merger, the holder of the right can use the right to
              purchase $200 worth of the offeror’s common shares for $100
   •   Redemption
           – If triggered by the making of a tender offer for 30% or more of the
              stock, the board would be permitted to redeem the rights at a price
              of 50¢ per right at any time prior to their being exercised
           – If triggered by the acquisition of 20% or more of the stock,
                  • Why?

Poison Debt
   • Target issues bonds or notes with terms that make target less attractive
         – Forbid an acquirer from burdening the target with further debt
         – Forbid an acquirer from selling target assets
         – Make a change of control an event of default
   • Very effective defense against leveraged takeovers

   •   No bidder has ever gone forward with a bid in the face of a fully
       implemented second generation pill
          – In the face of such a pill, the only successful bids have been:
                 • Where target’s BoD agreed to deal and redeemed pill
                 • Where bidder successfully conducted a proxy contest to
                    elect a new board that then redeemed pill
                 • Where court invalidated pill

   •   Moran case validated pills but held that the board cannot defeat a bid by
       any “draconian” means
   •   Presaged the pill cases holding that one could not just say no
   •   A non-coercive offer cannot be permanently blocked by a poison pill. City
       Capital Assoc. v. Interco, Inc.
   •   “When the Household Board of Directors is faced with a tender offer and a
       request to redeem the Rights, they will not be able to arbitrarily reject the
       offer. They will be under the same fiduciary standards any other board of
       directors would be held to in deciding to adopt a defensive mechanism,

       the same standard as they were held to in originally approving the Rights

Shareholder Self-help: Anti-pill Bylaws
   • Can shareholders unilaterally adopt a bylaw prohibiting poison pills?
         – Bylaw amendments are one of the very few corporate actions
             shareholders allowed to initiate under state law
         – Federal shareholder proposal rule (Rule 14a-8) gives shareholders a
             mechanism to put a proposed bylaw on the ballot
         – Does DGCL § 141(a) imply substantive limits on the appropriate
             subject matter of by laws?
                 • E.g., could shareholders adopt a bylaw providing that
                    shareholders must ratify the business model?
                        • Probably not
                        • Bylaws historically are about process and rights
                            respecting the shares themselves, not corporate
                            governance or business policy
   • Bylaw from Teamsters v. Fleming Companies, 975 P.2d 907 (Okla.1999):
         – “The Corporation shall not adopt or maintain a poison pill,
             shareholder rights plan, rights agreement or any other form of
             'poison pill' which is designed to or has the effect of making
             acquisition of large holdings of the Corporation's shares of stock
             more difficult or expensive ... unless such plan is first approved by
             a majority shareholder vote. The Company shall redeem any such
             rights now in effect.”

Revlon v. MacAndrews & Forbes Holdings
   •   Pantry Pride made a hostile tender offer for Revlon
   •   Revlon found a white knight in leveraged buyout specialist firm Forstmann
   •   Resulting control auction set new standard (or did it?)
   •   Perelman meets with Bergerac (Revlon CEO)—threatens Take over at
   •   Board adopts defenses:
           • Poison pill—per share $65 note at 12% with one year maturity
              triggered by purchase of 20%, unless there is an all shares offer for
           • Redeemable
           • Held: OK per Unocal
   •   Perelman’s First Offer
           • $47.50 all shares all cash; redeem rights plan
   •   Revlon Bd.:
           • Exchange Offer

          •    Swap 10M shares for 10 year senior subordinated notes at 11.75%
               + 1/10 share $9 Cumulative Convertible Exchangeable preferred at
                   • Package value: $57.50
                   • 87% of shareholders grab it
           • Purpose:
                   • Increase debt load
                   • Poison business covenants limiting borrowing, asset sales,
                       and dividends.
                          • Once the Shareholders hold the Notes with protective
                              covenants, will they oppose the offer?
                   • Suppose management wants to do an LBO?
                          • “Independent directors” can waive the covenants
           • Held: OK per Unocal
   • Several rounds of bidding, with Pantry Pride topping every Forstmann
   • Revlon accepted Forstmann's last bid. To end auction, granted Forstmann
       an asset lock-up option
           • The option gave Forstmann the right to buy two Revlon divisions at
               below market price; exercisable if another bidder gets 40% of
               Revlon shares
   • Also:
           • $25 million cancellation fee
           • No shop clause
   • The Delaware Supreme Court struck down the lock-up (also the
       cancellation fee and the no-shop clause)
   • Treated the lock-up as a type of takeover defense
           • Hence, the lock-up implicated not traditional business judgment
               rule analysis but rather Unocal
What is the rule of law that emerges from Revlon?
   • When the board puts the company up for sale, they have a duty to
       maximize the company's value by selling it to the highest bidder:
           – "The directors' role changed from defenders of the corporate
               bastion to auctioneers charged with getting the best price for the
               stockholders at a sale of the company."
Invalidity of the Lock-up
   • Violated the board of directors' fiduciary duties. Why?
           – Because the lock-up ended the bidding prematurely: “In reality, the
               Revlon board ended the auction for very little improvement in the
               final bid”
           – Distinguish between lockups that draw a bidder in and lockups that
               end an active auction

                          – “FL had already been drawn in to the contest on a
                             preferred basis, so the result of the lock-up was not
                             to foster bidding but to destroy it”
Invalidity of the No Shop
   • No shops are NOT per se illegal
   • But this no shop required the BOD to treat Forstmann more favorably than
       Pantry Pride
           – The agreement to negotiate only with Forstmann helped end the
               auction prematurely
So what triggers Revlon?
   • The “Imminent Break-up” of the target firm
   • Cases since Revlon:
           – Imminent “Change in Control” of the firm…
                  • …even if no break-up is to follow
           – …from a “fluid aggregation” of dispersed shareholders to a unified
               entity or group.
                  • Paramount v. Time: Did not trigger Revlon
                  • Paramount v. QVC: Triggered Revlon
   • Unifying concept (best guess):
           – Were target’s SHs on verge of losing their future ability to extract a
               “control premium” for shares?
   • Bringing in a white knight or a management buyout in response to a
       hostile takeover triggered Revlon. But what else did?
           – Revlon was triggered only if the transaction would result in a
               change of control
                  • If control would not change hands, the transaction was
                      subject only to Unocal

Paramount Communications v. Time: Change of Control?
   •   Delaware supreme court indicated Allen’s change of control analysis was
       correct “as a matter of law,” but it rejected plaintiffs’ Revlon claims on
       “broader grounds”:
          – “Under Delaware law there are, generally speaking and without
              excluding other possibilities, two circumstances which may
              implicate Revlon duties. The first, and clearer one, is when a
              corporation initiates an active bidding process seeking to sell itself
              or to effect a business reorganization involving a clear break-up of
              the company. However, Revlon duties may also be triggered
              where, in response to a bidder’s offer, a target abandons
              its long-term strategy and seeks an alternative transaction
              also involving the breakup of the company.”

Defensive Recapitalizations

   •   Target company typically issues a dividend consisting of cash (often
       borrowed) and debt securities, reducing the post-dividend value of the
       target's stock to the extent of the distribution
   •   Target managers and/or the target's employee stock ownership plan
       effectively receive the dividend in the form of stock, rather than cash or
       debt, at an exchange rate based on the stock's post-dividend value
           – Alternatively, the target may conduct a tender offer in which public
               shareholders exchange their stock for cash and debt
   •   In either case, management's equity interest increases substantially vis-à-
       vis public shareholders

Do Defensive Recapitalizations Trigger Revlon?
   • Where a recapitalization transfers effective voting control to target
      management, the courts treated the transaction as a "change in control"
      of the corporation requiring adherence to Revlon's auction rule.
   • To what extent can management use a poison pill to protect recap?
          – Led to the poison pill cases
          – Allowed management to delay the hostile bid long enough to give
             the board time to arrange an alternative transaction

Nonshareholder Constituencies
   • Unocal: Target directors may consider the impact of their decisions on
     non-shareholder constituencies—i.e., employees, customers, creditors,
     communities, and the like
   • Revlon? Once their auctioneering role has triggered can the BoD still
     consider non-shareholder interests in making decisions about the auction?
         • No. Once an auction begins the board may no longer consider non-
            shareholder interests.
   • Revlon: Even outside the auction setting, cut back on Unocal:
         • “A board may have regard for various constituencies in discharging
            its responsibilities, provided there are rationally related benefits
              accruing to the shareholders.”
          •   Implication for the threat prong of Unocal: Courts were reluctant to
              say that threats to non-shareholder interests justified takeover

   – The board may evaluate offers on such non-price grounds as the
     proposed form of consideration, tax consequences, firmness of financing,
     antitrust or other regulatory obstacles, and timing.
   – The board may only consider factors relevant to the shareholders' best
   – No favoritism
         – Any effort to make sure that one side or the other prevailed, such
            as giving one side a lock-up, was highly disfavored

   – The board must be adequately informed of the material facts and engage
     in a thorough review of available options
         – Shopping the corporation—i.e., a fair competition between multiple
            bidders—had two functions:
               – Gathering information about value of firm
               – Constraint on conflicts of interest
   – Bottom line?
         – Fair competition
   – Target directors are given considerable discretion in conducting a Revlon
     auction. They need not be passive observers of market competition.

Relationship between Van Gorkom and Revlon
   • Van Gorkom requires that decision to merge be an informed one
          – Case implicitly approved shopping the company as a means of
              gathering information, but did not require the directors to do so
   • Delaware addressed in Barkan
          – Holding: Revlon does not require that every control transaction be
              preceded by a bidding contest
          – When the board is considering a single offer and has no reliable
              grounds for judging its adequacy, a concern for fairness demands
              that the market be canvassed
                 • But when directors possess a body of reliable evidence with
                     which to evaluate the fairness of a transaction, they may
                     approve it without an active survey of the market

Summary of these Cases
  • Intermediate Scrutiny in T-O defense context.
        – One of two levels
  • “Mere” resistance of a takeover
        – Unocal duty (threat/proportionality prongs)
        – Num. constituencies and time horizons OK.
  • Change of Control, Break-up or other event that causes shareholders to
    lose the future ability to extract a “control premium”:
        – Revlon duty (modified threat/prop. test)
        – Duty to maximize short term SH welfare.
  • Consequences of flunking applicable test
        – Unenforceability of defensive lock-ups.
        – No liability for directors (absent more)

Delaware’s Motive-Based Balance
   • Motive analysis figures prominently in Delaware decisions
         – In other words, under the Unocal/Revlon regime, the board retains
            full decisionmaking authority — including the authority to foreclose
            shareholder choice — unless it acted from improper motives

  • The conflict of interest present when the board responds to an unsolicited
     tender offers differs only in degree, not kind, from any other corporate
  • A conflict of interest does not necessarily equate to blameworthiness
         – Rather, it is simply a state of affairs inherently created by the
             necessity of conferring authority in the board of directors to act on
             behalf of the shareholders
  • We therefore would expect the courts to develop standards of review for
     takeover defenses that are designed to detect, punish, and deter self-
     interested behavior


    • Suppose that:
          – Mesa’s offer had been a one-tier offer at $54 cash per share (and
              therefore not coercive to SHs);
          – And Pickens had no reputation as a greenmailer;
    • Under Unocal, which of the following would still be considered bona fide
          – Pickens wanted to liquidate the firm in 5 years
          – Pickens wanted to exploit a loophole in Unocal’s debentures to
              cheat the bondholders
          – Pickens wanted to “downsize the firm”
Given the broad constituencies cited in Unocal, all of these are bona fide threats
to someone who counts.

The difference b/t Unocal and BJR may be very small indeed, other than the
burden shifting to the directors: It may be very easy to overcome it.


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