BUSINESS ORGANIZATIONS OUTLINE
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
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
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
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 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
- Even if A acts outside scope, M may still be liable:
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.
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
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
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
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
“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
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
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
– 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
Archaic Servant Contractor Contractor
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
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
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
Sun Oil should be liable because it has a relatively large
interest in the successful operation of the station
Any supplier with a deep pocket and any connection to the
accident should be held liable
Much like deep pocket.
Liability should arise from control or right to control the
Holding oil companies liable causes them to instruct their
service stations to get insurance
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
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
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
No, the principle did not do anything to manifest to the third party
that the agent had that authority.
Yes, “the principal is liable for all the acts . . . which are within the
authority usually confided to an agent of that character”
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
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
Clear intent of all parties that agent be bound
Agent made contract but without authority
Party to the contract?
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
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
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
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
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
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
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
Remedy: Actual damages
No moral condemnation
Need to interpret the contract (e.g. “work 5 and ½ days”)
Breach of fiduciary duty:
X-ref Meinhard v. Salmon: “punctilio of an honor the most
Full Time and Attention Provisions
compensated (such as being a director of another firm)
No provision for board waiver
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
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
Duties that transcend agency
Can you extend
Can you extend
the duty not to
the duty not to
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…”
– 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”
– 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
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…
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
– 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
– 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
(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:
Account for Not to
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”
subj. matter (§ 394)
(§ 393) 9
• 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)
• 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)
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?
• 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?
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
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
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.
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?
• (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
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?
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
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
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.
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?
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
Creditor of firm seeks to attach personal assets of a partner to collect
Yes, but many states require that the creditor first proceed against
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)
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.
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.
Initial capital contribution
A partner may contribute labor.
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
Year 2 Capital $9,000 $0
Year 3 Profit $2,000 $2,000
Year 3 Draw $1,000 $1,000
Year 3 Capital $10,000 $1,000
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
• 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
– 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.
• 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
– 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;
Duration specified in partnership agreement
Specific purpose/object specified in partnership agreement
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
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.
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?
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
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
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
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.
• 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
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
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
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
• 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
– 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?
• 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
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
• Secondary trading markets
5. Flexible 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
• Statutory creation of tax code.
– Usually a “close” corporation
• Principal advantage:
– Combines pass-through taxation with limited liability.
– 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
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
• 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
(MBCA § 2.03)
1. Draft articles of 2. File articles
incorporation with Secretary of
State (not Colin
(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
(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
– 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.
– Camcraft is estopped to deny SGM’s corporate status
– Hence, SGM may sue to enforce the contract
– 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
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
• 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.
• 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
– 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
– 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
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)?
– 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
• “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
• 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.
• 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]
• 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,
– 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 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.
– 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.
• 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
• 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.
• 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:
• Illegal conduct
• 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
(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
• § 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
• (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.
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:
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.
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?
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)
• 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
• 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
– Yes in some ways, you can say I have enough information here
– Court says the board must inform itself of information within its
– Did the Old Board inform itself of all material information reasonably
– No … didn’t calculate the potential expense associated with a non-
– 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
The Business Judgment Rule and the Duty of Care
BJR Applies: Court abstains
? No Conflict No decision
Federal or state
BJR rebutted Yes
Duty of Loyalty
Rebutted: No Decision
Did Egregious decision
No violate Yes decision
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?
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
– 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
– 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
“Modern” DoL Analysis
(DGCL § 144)
Y ES NO
Burden on Defendant
Conflict of Interest? Transaction Voidable
(Direct; Indirect) by Corporation
Burden on Plaintiff
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
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
– 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,
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
• 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
– 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
a "Corporate X1
A YES Does NO No Breach
B Does Corp.
No Breach Regardless
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.”
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?
• 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
• 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
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
(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;
(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
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
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
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
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
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
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
Annual dividend of $1.60
Entitled to liquidation dividend ½ that of Class A
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
Plaintiff claims Class A would have received $240 per share if not called
When the boards duties to class A and class B conflict, what should the
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
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.
• 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”
(YOU DON’T REALLY NEED TO KNOW ALL THE PERMITATIONS OF BURDEN SHIFTING)
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 1. Plaintiff Burden
-Affirmative 2. Defendant
“Intrinsic” vs. “Entire” Fairness
The Wheelabrator case utilizes the notion of “entire fairness”, whereas
other cases focus simply on “fairness”
(sometimes called “intrinsic fairness”)
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
• 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
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
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
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
MBCA § 7.41 limits standing to shareholders
Creditors may not bring derivative suit
MBCA § 7.41(1): Must be a shareholder at the time of the
§ 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
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
To whom does a derivative suit belong?
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
Nuisance suits brought for settlement value
Settled too easily
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
Courts quite liberal in finding such benefit
Settle to go away
Meritorious suits against insider defendants:
Indemnification: Corporation must reimburse director’s expenses if
Settlement in which director doesn’t pay anything deemed a
Plaintiff counsel has incentive to bring
Management has incentive to pay
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)
• 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
– …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?
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
Procedural Challenges to Decision: (“Procedural Duty
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
– Did SLC act independently, in good faith, and with a
reasonable investigation (with the burden of proof on
– Does dismissal pass independent judicial inquiry into
• 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
NEGLIGENCE or RECKLESSNESS in the INVESTIGATIVE
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
• Zapata: (Minority/Del. Rule). In addition to requiring SLC’s
adequate investigation and disinterested members, independent
Under Delaware Law: A Synopsis
YES SH action proceeds in
BoD/SLC name of Corp.
Demand SH action cannot proceed
Made/Pled? unless decision
SH action cannot “wrongful” (Grimes)
Required or Excuse Presumed
Excused? Waived (Grimes)
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
Securities Exchange Act of 1934
Regulates secondary market activity
Created the Securities and Exchange Commission (a.k.a. SEC)
Enforce the securities laws
Promulgate rules and regulations to implement those laws
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
Purposes of Securities Laws
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)
Registration statement filed with SEC
Prospectus distributed to investors
Required in connection with any public sale
Securities Exchange Act (1934)
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
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
In a Common Enterprise
Horizontal Commonality between investors satisfies
common enterprise element, court split whether
vertical commonality between a promoter and an
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
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
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
Virtually no court reads that phrase literally; in
particular, the word “solely” is read as primarily
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
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
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?
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
Public offerings can be useful
Especially the IPO, can bring money into the company
But very expensive:
Costs associated with registration process
Competitors get access to proprietary information
Subject to antifraud regime
On-going regulatory exposure
1934 Act periodic disclosure
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
Private Placement Test
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
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
The Issuer has no defenses.
All other parties have “due-diligence” defenses.
Potential defendants can be thought of as two groups
Registration Statement can be thought of in two parts
The parts prepared by certified experts
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,
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
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
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.
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.
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.
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
Closely related to reliance
But for the fraud, plaintiff would not have invested (or
Akin to proximate cause
Fraud caused the loss
Where reliance is presumed, court will also assume transaction
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
“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?
Nature of the information
Conduct of insiders
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.
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
Fraud on the market theory.
Presumption that investor relied on integrity of
market price—so investor need not have seen
Material Public misrepresentation
How can defendant rebut fraud on the market
Market not deceived (their
misrepresentation did not effect the
Show that specific plaintiffs would have
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.
Were Basic’s statements materially false?
Is this a proper class action, when proof of reliance is an 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?
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
“a highly fact-dependent probability/magnitude
Sometimes materiality shifts depending on who we are
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
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.
Material public misrepresentation
How can defendant rebut fraud on the market
Market not deceived (their
misrepresentation did not effect the
Show that specific plaintiffs would have
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)
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
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
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
Conduct only violates Rule 10b-5 if manipulative or deceptive, not
corporate mismanagement that is a state issue for breach of
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
Shareholder liability Transactional disclosure
Corporate governance Periodic disclosure—
Director/officer fiduciary duties by public companies
Shareholder rights/duties Fraud in conjunction w/
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
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
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.
• 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:
– 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
– 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
• “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
• 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
– Statutory or “Constructive” insiders have duty not to trade while in
possession of non-public information; must “disclose or abstain”
– An insider who trades risks liability if she does so knowingly or (in
most jurisdictions) recklessly
– “Reasonable Investor” test (see below)
• 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
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
• 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
• 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):
• 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?
– Insiders (e.g. Coates) must wait until the information is effectively
disclosed in a manner sufficient to insure its availability to the
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
– Public (SEC) instead of private enforcement
– Legal theory moves from fiduciary duty to securities
The road curves
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).
– 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
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
• 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
– 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
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
Trading Theory via Rule 10b-5
Liability (but see *)
Statutory insider others?
under §16(a) NO
(D/O/Prin. SH)? YES
Liability (but see *)
disclosing? Does Insider Tip
YES (TGS) for Personal
(Dirks, fn. 14)? YES
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
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
– 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
Insider Trading Theory via Rule 10b-5
Liability (but see *)
Does Subject owe a Subject Tip NO
Fiduciary Duty of (recklessly)
confidentiality to others?
info generator? NO
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)?
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 *)
• 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
– 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
“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.
“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
§ 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
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.
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
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
– MBCA § 7.01
– 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
• Shareholder resolutions
– Resolutions are usually proposed by management (e.g. ratify an
– Shareholders may also propose resolutions to request the board to
take specific action (e.g. dismantle a takeover defense, divest from
• 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
– 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
• 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.
– 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”?
• 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
• Detailed rules regarding:
– Process for excluding proposal
– Stock holdings required
– Length of Proposal
– Submission requirements
• 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.”
• What happens if precatory proposal passes and board refuses to act?
– 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
– 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
• 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.
– Investigate alleged corporate mismanagement
– Collecting information relevant to valuing shares
– Communicating with fellow shareholders in connection with
a planned proxy contest
– 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
– 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
• 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
– 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:
“street name” CEDE list
NOBO list (Non-Objecting Beneficial Owners)
Which List? Sadler v. NCR Corp.
– 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
• 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 ....”
– 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
• 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.
Common Stock as a Bundle of Rights
Receive dividends (distribution of profits) when and as declared by
the board of directors
Residual claim on assets in liquidation
Approve some extraordinary matters
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
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
Passes under MBCA
Fails under Delaware (needed 401 to pass)
Special Voting Rules
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.
Minimum price at which shares may be sold
Specified in articles of incorporation
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.
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
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
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
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.
CONTROL IN CLOSED CORPORATIONS
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
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
Close corporations often don’t pay dividends to avoid double
Hypo: 4 friends want to form a close corporation. Decisionmaking issues?
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.
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.
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
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.
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.
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
No possibility of shareholder deadlock, since everybody puts their
shares in the trust and trustee votes
Loss of control.
Duration – most states limit to ten years
Still possible for board to oppress
Vote pooling agreements: Shareholder agreements re board election
Do minority shareholders need protection from exploitation? BoD
has a duty to exercise independent business judgment on behalf of
Note that with the exception of some circumstances involving
controlling shareholders, shareholders do not owe fiduciary duties
to one another.
Director deadlock…how solved?
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
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.
Vote pooling agreements
Shareholder agreements constraining discretion of directors
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
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
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?
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)
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?
Bonus formula? How to define profit? Comparison to other
firms in the same industry…
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
Each family gets 2 board seats
Mandatory death benefits
Unanimity not required if:
The corporation is closely-held
The minority shareholder does not object
The terms are reasonable
Co. was to pay dividends only if sufficient earned
The amount payable was reasonable.
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
Why not deemed a voting trust?
No attempt to separate ownership of stock from voting
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?
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?
CLOSE CORPORATIONS: ABUSE OF CONTROL AND FIDUCIARY DUTIES
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
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?
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
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
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
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
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
Requires shareholder approval of board actions by a supermajority
Because each shareholder owned 25% of the stock, each had an
Dispute arose as to how earnings should be expended
Majority wants to pay dividends
Wolfson wants to reinvest
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.
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.
Why book value not market value?
Book value is the value of the firm’s assets without the value of the
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
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
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
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
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”)
– 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
• 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
• 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.
• 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
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)
• 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.
• Cases like this should be decided on their facts without so much
doctrinal guidance. Summary judgment is improper.
• 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?
Employment agreements to control salaries
Ida and Sally:
Ways of raising additional capital
Buy out agreement
• Is there a problem representing al
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.
Categorizing Deals By Corporate Governance Aspects
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.
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?
Sale of assets
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
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
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
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
E.g., a deed of transfer will have to be properly filed with every
county in which the target owns real estate.
In a merger, the surviving company succeeds to all liabilities of each
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
Both company’s boards
Both company’s shareholders
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
SH vote at A and T: majority of shares entitled to vote thereon
Filing [M.A. or “certificate”]--merger effective at this point
No A.R. if stock of constituent corp is listed--A and T are both
listed; otherwise yes.
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
De Facto Mergers (look at flow chart above)
Two of the most common reasons why people structure transactions that
accomplish the effect of a merger in a non-merger form are
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
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
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.
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 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
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
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
Glen Alden List
(Penn. Corp.) (Del. Corp.)
Sale of Assets Appraisal No appraisal
Merger Appraisal Appraisal
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
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?
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
Sale of all or substantially all of Target’s assets?
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
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
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
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
Must be approved by the board of directors and a majority of
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
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”:
Coggins v. New England Patriots Football Club, Inc. (Mass.)
Sullivan bought the Patriots franchise for $25,000 and contributed it to a
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
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
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
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”
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.
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.
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
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
Plaintiff sued for damages, claiming they were entitled to $100.
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.
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
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
• 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
– 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
• 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
• 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
• §§ 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
2. Public announcement of:
– Bidder’s identity, target’s identity, the amount of securities bidder is
offering to buy, and the price
• 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
• 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
– Pay off the potential acquiror to go away (usually by purchasing
her shares above market value)
– 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.
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 strong self-preservation
decisions and plan
decisions and plan incentives (private
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
– 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
• 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
(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
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
A: : 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 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
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.
DoL -- NO BJR
Threat + Prop.
DoL -- NO BJR
Threat + Prop.
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
• 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
– 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
• 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
• Minimizes risk that a separate secondary trading market
• Rights detached from common stock upon either event
– When detached, the rights were immediately exercisable
– 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
– 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,
• 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
• 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
• Increase debt load
• Poison business covenants limiting borrowing, asset sales,
• 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
• $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
– 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
– The agreement to negotiate only with Forstmann helped end the
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
– “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.”
• 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
• 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-
• 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-
• 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.