Corporations - Coates by SXiMT4


									Section One: Introduction to Enterprise Organization ........................................................................................... 1
  I. Why Do Firms Exist? ...................................................................................................................................... 1
  II. Efficiency and the Social Significance of Corporation Law .......................................................................... 1
  III. Development of the Modern Economics of the Firm ................................................................................... 1
Section Two: The Law of Agency ......................................................................................................................... 2
  I. Introduction to Agency .................................................................................................................................... 2
  II. Formation and Termination of Agency .......................................................................................................... 2
  III. Relationships to Third Parties (Principal Liability) ................................... Error! Bookmark not defined.1
  IV. The Governance of Agency (Agent Duties) .............................................. Error! Bookmark not defined.3
Section Three: The Law of Agency ....................................................................................................................... 6
  I. The Problem of Joint Ownership: The Law of Partnership .......................... Error! Bookmark not defined.4
  II. Partnership Formation ................................................................................. Error! Bookmark not defined.4
  III. Relations with Third Parties ...................................................................... Error! Bookmark not defined.4
  IV. Partnership Governance and Issues of Authority ...................................... Error! Bookmark not defined.6
  V. Termination (Dissolution & Disassociation) .............................................. Error! Bookmark not defined.6
  VI. Limited Liability Modifications of the Partnership Form ......................... Error! Bookmark not defined.8
Section Four: Introduction to the Corporate Form .............................................. Error! Bookmark not defined.8
  I. The Core Characteristics .............................................................................. Error! Bookmark not defined.8
  II. Creation of a Fictional Legal Entity ............................................................ Error! Bookmark not defined.9
  III. Limited Liability ........................................................................................ Error! Bookmark not defined.9
  IV. Transferable Shares ................................................................................... Error! Bookmark not defined.9
  V. Centralized Management .......................................................................... Error! Bookmark not defined.10
Section Five: Debt, Equity, and Economic Value ............................................. Error! Bookmark not defined.11
  I. Capital Structure ............................................................................................................................................ 46
  II. Basic Concepts of Valuation ..................................................................... Error! Bookmark not defined.12
  III. Estimating the Firm’s Cost of Capital ..................................................... Error! Bookmark not defined.13
Section Six: The Protection of Creditors........................................................... Error! Bookmark not defined.13
  I. Introduction ................................................................................................ Error! Bookmark not defined.13
  II. Mandatory Disclosure ............................................................................... Error! Bookmark not defined.14
  III. Capital Regulation ................................................................................... Error! Bookmark not defined.14
  IV. Standard-Based Duties ............................................................................ Error! Bookmark not defined.15
  V. Can Limited Liability in Tort Be Justified? .............................................. Error! Bookmark not defined.16
Section Seven: Normal Governance: The Voting System ................................ Error! Bookmark not defined.16
  I. Introduction ................................................................................................ Error! Bookmark not defined.17
  II. Electing and Removing Directors ............................................................. Error! Bookmark not defined.17
  III. Shareholder Action: The Annual Meeting and Alternatives .................... Error! Bookmark not defined.17
  IV. The Proxy Voting System........................................................................ Error! Bookmark not defined.17
  V. Class Voting .............................................................................................. Error! Bookmark not defined.18
  VI. Shareholder Information Rights .............................................................. Error! Bookmark not defined.18
  VII. Techniques for Separating Control from Cash Flow Rights .................. Error! Bookmark not defined.18
  VIII. The Collective Action Problem............................................................. Error! Bookmark not defined.19
  IX. The Federal Proxy Rules ......................................................................... Error! Bookmark not defined.20
Section Eight: Normal Governance: The Duty of Care .................................... Error! Bookmark not defined.22
  I. Introduction to the Duty of Care................................................................. Error! Bookmark not defined.22
  II. The Evolution of Fiduciary Duties ............................................................ Error! Bookmark not defined.23
  III. The Duty of Care and the Business Judgment Rule................................. Error! Bookmark not defined.23
  IV. The Delaware Variations: Smith v. Van Gorkom and its Legacy ............ Error! Bookmark not defined.24
  V. The Passive or Absent Director ................................................................ Error! Bookmark not defined.25
Section Nine: Conflict Transactions: The Duty of Loyalty .............................. Error! Bookmark not defined.26
  I. Introduction ................................................................................................ Error! Bookmark not defined.26
  II. Duty to Whom? ......................................................................................... Error! Bookmark not defined.27
  III. Self-Dealing Transactions........................................................................ Error! Bookmark not defined.27
  IV. The Safe Harbor Statutes ......................................................................... Error! Bookmark not defined.28

                                                                                                              Spring 2005 Corporations – Coates p. 1
  V. The Effect of Approval by a Disinterested Party ...................................... Error! Bookmark not defined.28
  VI. The Fiduciary Duty of Controlling Shareholders .................................... Error! Bookmark not defined.29
  VII. Director and Management Compensation .............................................. Error! Bookmark not defined.29
  VIII. Corporate Opportunity Doctrine ........................................................... Error! Bookmark not defined.30
  IX. The Duty of Loyalty in Close Corporations ............................................ Error! Bookmark not defined.31
Section Ten: Shareholder Lawsuits ................................................................... Error! Bookmark not defined.31
  I. Introduction ................................................................................................ Error! Bookmark not defined.31
  II. Distinguishing Between Direct and Derivative Claims ............................ Error! Bookmark not defined.32
  III. Solving a Collective Action Problem: Attorney’s Fees and the Incentive to Sue ..... Error! Bookmark not
  IV. Standing Requirements ............................................................................ Error! Bookmark not defined.33
  V. Legal Screens on Derivative Suits: Balancing Rights of Boards to Manage and Shareholders to Judicial
  Review ........................................................................................................... Error! Bookmark not defined.33
  VI. Settlement ................................................................................................ Error! Bookmark not defined.35
  VII. Assessing Derivative Suits: When Are They in the Shareholders’ Interests? .......... Error! Bookmark not
Section Eleven: Fundamental Transactions: Mergers and Acquisitions ........... Error! Bookmark not defined.36
  I. Introduction ................................................................................................ Error! Bookmark not defined.36
  II. Economic Motives for Mergers................................................................. Error! Bookmark not defined.37
  III. Evolution of the U.S. Corporate Law of Mergers .................................... Error! Bookmark not defined.37
  IV. Allocation of Power in Fundamental Transactions.................................. Error! Bookmark not defined.38
  V. Overview of Transaction Form ................................................................. Error! Bookmark not defined.38
  VI. Structuring the M&A Deal ...................................................................... Error! Bookmark not defined.40
  VII. Taxation of Corporate Combinations ..................................................... Error! Bookmark not defined.41
  VIII. The Appraisal Remedy ......................................................................... Error! Bookmark not defined.42
  IX. The DeFacto Merger Doctrine ................................................................ Error! Bookmark not defined.43
  X. The Duty of Loyalty in Controlled Mergers ............................................. Error! Bookmark not defined.43
Section Twelve: Transactions in Control .......................................................... Error! Bookmark not defined.44
  I. Introduction ................................................................................................ Error! Bookmark not defined.44
  II. Sales of Control Blocks: The Seller’s Duties ............................................ Error! Bookmark not defined.44
  III. Sale of Corporate Office .......................................................................... Error! Bookmark not defined.45
  IV. Looting .................................................................................................... Error! Bookmark not defined.45
  V. Tender Offers: The Buyer’s Duties ........................................................... Error! Bookmark not defined.45
  VI. The Hart-Scott-Rodino Act Waiting Period ............................................ Error! Bookmark not defined.46
  VII. The Auction Debate and the Shareholder Collective Action Problem ... Error! Bookmark not defined.46
Section Thirteen: Public Contests for Corporate Control ................................. Error! Bookmark not defined.46
  I. Introduction ................................................................................................ Error! Bookmark not defined.46
  II. Private Law Innovation: The Poison Pill .................................................. Error! Bookmark not defined.47
  III. Proxy Contests for Corporate Control ..................................................... Error! Bookmark not defined.47
  IV. The Takeover Arms Race Continues ....................................................... Error! Bookmark not defined.48
  V. Defending Against Hostile Tender Offers ................................................ Error! Bookmark not defined.48
  VI. Choosing a Merger or Buyout Partner: The Revlon Case........................ Error! Bookmark not defined.49
  VII. Pulling Together Unocal and Revlon ..................................................... Error! Bookmark not defined.49
  VIII. Relevance of Non-Shareholder Constituencies..................................... Error! Bookmark not defined.50
Section Fourteen: Trading in the Corporation’s Securities ............................... Error! Bookmark not defined.50
  I. Two Helpful Perspectives........................................................................... Error! Bookmark not defined.50
  II. Common Law of Directors’ Duties When Trading in the Corporation’s Stock.......... Error! Bookmark not
  III. Corporate Fiduciary law of Disclosure Today ......................................... Error! Bookmark not defined.51
  IV. Exchange Act Section 16(b) and Rule 16 ................................................ Error! Bookmark not defined.51
  V. Exchange Act Section 10(b) and Rule 10b-5 ............................................ Error! Bookmark not defined.52

                                                                                                 Spring 2005 Corporations – Coates p. 2
                                             Coates – Spring 2005
                                             Carol Igoe – x5-4863

Chapter One – Introduction to Enterprise Organization
Why Do Organizations Exist?
   Division of labor – Adam Smith
     An organization still not required since people can still divide labor without formal structure
   Alternative is to have contracts for everything – Oliver Hart
     Not feasible due to necessarily incomplete contracts and labor specialization
     Associated transaction costs would be prohibitively high – reduce efficiency
     Direct command and control (instead of negotiation) reduces uncertainty and complexity
   Politics have major influence
     Historically, major organizations founded and chartered by the government (e.g., IBM)
     Even if judges were efficiency-minded, Congress influenced by orgs that laws intended to regulate
     Distribution of wealth affects policies – contrary to authors’ indications

Three Basic Organizational Forms
   Agency – hierarchical relationships where principal has power to direct agent
   Partnership – joint ownership to reduce transaction costs, form long-term contractual relationships
   Corporations – combination of both types of relationships
     90% of revenues in country but pay only 15% of taxes (demonstrates influence)
     We will focus on major publicly-traded organizations – much more complex laws

Efficiency and the Social Significance of Corporation Law
   Pareto Efficiency – a given distribution of resources is efficient when resources are distributed in such a way
    that no reallocation can make at least one person better off while leaving no person worse off
     Limited application because difficult to find a policy where at least one person is not worse off
   Kaldor-Hicks Efficency – act or rule is efficient if the transaction produces total gains sufficient to provide
    compensation to all those who suffered any loss as a result of the transaction or policy
     Decisive advantage of permitting comparisons of costs/benefits with same metric – wealth maximization
   Both of these principles accept initial distribution of wealth and ignore distributional consequences
   Courts avoid using “efficiency” as standard but rather prefer “fairness”
     Courts generally refer to “fairness to shareholders” so goal of wealth maximization is consistent with aim

Development of the Modern Economics of the Firm
   Coase – transaction costs are substantial and hierarchical organization can eliminate some of those costs
   Agency Cost Theory – view agents as maximizers of their own interests rather than those of the principal
   Agency Costs – any cost associated with the exercise of discretion over the principal’s property by an agent
     Monitoring Costs – costs expended to ensure agent loyalty
     Bonding Costs – costs that agents expend to ensure owners of their reliability
     Residual Costs – costs that arise from differences of interest that remain after above costs incurred

                                                                           Spring 2005 Corporations – Coates p. 1
Chapter Two – The Law of Agency
Introduction to Agency
   Agency – one extends range of own activity by engaging another to act for her and be subject to her control
   Three major aspects of agency law that have the greatest relevance to corporation law
     Formation and termination
     Principal’s relationship to third parties
     Nature of the duties that the agent owes to the principal

2.2.1 – Formation of Agency
   Restatement of Agency § 1 – agency is the fiduciary relation that results from (1) the manifestation of consent
    by one person (the Principal) to another (the Agent) that the other shall act on his behalf and subject to his
    control and (2) consent by the other so to act
     Special Agents – agency is limited to a single act or transaction
     General Agents – the agency contemplates a series of acts or transactions
     Disclosed Principals – third parties understand that agent is acting on behalf of particular principal
     Undisclosed Principals – third parties are unaware of a principle or believe the agent is the principle
     Partially Disclosed Principals – third parties know they’re dealing with agent but not principal’s identity
   Employee or Servant – principal has right to control the details of way in which agent goes about her task
   Independent Contractor – principal’s rights of control are significantly less extensive

2.2.2 – Termination of Agency
   Either party may freely terminate an agency at any time
   If contract fixes set term, P’s decision to revoke or A’s to renounce gives rise to claim for breach of contract

2.2.3 – Parties’ Conception Does Not Control
   Agency relations may be implied even when the parties have not explicitly agree to an agency relationship
   Debtor-creditor relationships – agency relationships implied when creditor assumes “too much” control

Jenson Farms v. Cargill, p. 16, Minnesota, 1981
 Warren Grain operated a grain elevator (middleman) – got $175K in working capital from Cargill
 WG accumulated significant debt and eventually went bankrupt – could not pay off all of its liabilities
    C had served as a lender to WG but maintained significant control over WG’s operations
 P’s brought this action against C to seek recovery of $2 million in debt owed to them by WG
    Irrelevant whether P knew that C was an agent during course of dealing (or that C even existed)
 C asserted that it was just a lender rather than an agent – never consented that WG was its agent
 Court relied upon RS §1 – agency is fiduciary relation that results from manifestation of consent by one
   person to another that other shall act on his behalf and subject to his control and consent by other so to act…
    Operational control over WG established implicit manifestation of consent to agency relationship
    Court is careful to note decision is based on Totality of the Circumstances – only applies to these facts
            Control is not exclusive – more than one person can have “control” over the business
            Lenders’ ability to demand money back gives them some default power
    Court referenced several factors to determine Cargill asserting operational control
            C’s determination that WG needed “strong paternal guidance” is highly influential
            Breadth of information received by C indicative as well (though need some info as lender)
 Mixing Finance with Consulting – banks must decide whether to engage in operational performance of debtor
   to save a potential loan from defaulting, which may make them liable for more than just value of loan
    C decided to engage because it reaped significant profit through sale of grain through WG
    The closer a lender gets to day-to-day decisions the more likely an agency relationship will be found

                                                                             Spring 2005 Corporations – Coates p. 2
2.2.4 – Liability in Contract
   Manifestation of intention to enter an agency relationship need not be explicit – agent must reasonably
    understand from action or speech of principal that she has been authorized to act on the principal’s behalf
     Actual Authority – that which a reasonable person in position of A would infer from conduct of P
     Incidental Authority – authority to do those implementary steps ordinarily done with authorized act
     Apparent Authority – authority that a reasonable third party would infer from actions or statements of P
     Inherent Power (RA §161, 194) – gives a general agent the power to bind a disclosed or undisclosed
       principal to an unauthorized contract, so long as general agent would ordinarily have the power to enter
       into the contract and third party doesn’t know that matters are different – reasonableness standard
             Benefits the principle on most occasions since third party doesn’t have to go to P every time
             Third party still obligated to make inquiries if matter outside reasonable authority of agent

Nogales Service Center v. ARCO, p. 20, Arizona, 1980
 Cafone and Terpenning owned NSC and had an agreement to sell ARCO products
 After NCS fell into financial difficulty, they met with agent Tucker from ARCO to discuss a loan
 Tucker promised them a gas discount and loan upon construction of motel and restaurant at their truck stop
 Key issue is whether Tucker acted within his authority so as to bind ARCO to these promises
 Court held jury should have been instructed on inherent authority (as well as actual and apparent)
    NCS could possibly have believed agent had power to make such a deal based on prior practices
    So as opposed to contract law, we impose liability on the P for promises it had not consented to
            Rule forces P to put 3rd party on notice (as well as agent) that agent not authorized to make deal

 Inherent authority can make principal liable because of conduct which he did not desire or direct, to persons
   who may or may not have known of his existence or who didn’t rely on anything he said or did
 Principal may even be liable on a contract made by a general agent of a kind usually made by such agent,
   even if agent was forbidden to make it and no manifestation of authority to person dealing with agent
 Why put so much potential liability on the principle?
    P can still make claim against agent if he expressly disobeyed a directive
    Allows 3rd parties to rely upon agents – otherwise would vastly reduce the value of agents

2.2.5 – Liability in Tort
   Principals are generally liable for torts committed by servants but not independent contractors
   RS §2 – definitions of master, servant and independent contractor
     Master – principal who employs an agent to perform service and has control over A’s conduct
     Servant – agent employed by a master to perform service whose service is under M’s control
     Independent Contractor – contracts to provide service but physical conduct not subject to control
   RS §220 – several factors for determining if one is a servant or an independent contractor (more on p. 24)
     Extent of control over details of the work, whether person employed is engaged in a distinct occupation,
        whether work is generally done under direction in locality, skill required, who supplies instrumentalities,
        length of employment term, method of payment, belief of parties, etc.
     Lawyer / client relationship is strong example of an independent contractor (vs. employer / employee)

Humble Oil & Refining v. Martin, p. 25, Texas, 1949
 Mrs. Love dropped off her car at a service station, and it rolled out and hit P who sued D (station operator)
 D asserted that it is not liable to P because station was operated by an independent contractor (Schneider)
   No dispute over whether Schneider was also liable since his employee (servant) was at fault
 Court upheld trial court’s ruling that Schneider was a servant (not an independent contractor)
   Humble set the working hours of the station – indicates that H could affect likelihood of torts

                                                                            Spring 2005 Corporations – Coates p. 3
         Humble owns facility and pays majority of expenses (75%) – affects training, safety features, etc.
         General rights of control over Schneider – similarly affects training, operations, etc.
               Control over relationship (could fire S at will and maintain PPE)
               Party that bears financial risk (as H does here) has ability to ask for and receive control
      H’s clause in contract that “S is not our servant” is not dispositive (though can be influential)
      S’s subjective belief that he owns and operates the station is also not dispositive (jury decides)
    If S actually had some assets, H (Principal) could seek compensation from S (Agent) for damages H paid P

Hoover v. Sun Oil, p. 27, Delaware, 1965
 Fire broke out while employee of service station operator (Barone) was filling Hoover’s gas tank
 Sun tried to avoid liability by proving that Barone was an independent contractor (rather than a servant)
 Court used test whether oil company had the right to control the details of operation of the service station
 Held Barone was an independent contractor “as a matter of law” – ruling doesn’t go to jury
    Barone decided on hours of operation, made no reports to H, took profits, bore some risk, 30-day notice
            Sun Oil owns property so power to control and bore some risk – if station closes less oil sold
    Rulings in past few years support corporations’ ability to get out of liability for franchisees
            May be due in part to prevalence of insurance that distributes risk (employees can also pay)
 Coates – no significant distinction between cases so firms seem able to shape relationships to limit liability
 Another rationale – not clear that Sunoco is in best position to monitor the agent’s operations

Policy Considerations
 Without vicarious liability, company will reduce liability in situations where it can pass it off to servants
 Companies’ incentives to focus on safety dramatically reduced if not vicariously liable – hurts consumers
 However, media coverage of poor safety practices (hurts brand) may partly substitute for these incentives

Restatement (Second) of Agency – Limitations on Respondeat Superior
 §219 – Master is subject to liability for torts of servants committed while acting in scope of employment
    Not liable for torts of his servants acting outside scope of employment unless master intended conduct or
       consequences; master was negligent or reckless; conduct violates a non-delegable duty of master

    §228(1) – Conduct of a servant is within the scope of employment, but only if
      Conduct is of the kind servant is employed to perform
      Conduct occurs substantially within the authorized time and space limits;
      Conduct is actuated, at least in part, by a purpose to serve the master; and
      If force is intentionally used by servant against another, use of force is not unexpectable by the master

    §228(2) – Conduct of servant is not within scope of employment if it is different in kind from that authorized,
     far beyond authorized time or space limits, or too little actuated by a purpose to serve the master
      May be within the scope of employment even if forbidden, criminal or tortuous (§230, §231)

                                     AGENTS                                                   NON-AGENTS
                   Servants                         Independent Contractors              Independent Contractors
    Vicarious Liability: Tort and Vicarious        No Tort         Contract             No Tort         Contract
              Liability: Contract                  Liability       Liability            Liability       Liability
              Fiduciary Duties                          Fiduciary Duties                   No Fiduciary Duties

Commitment Between Principal and Agent
 Can’t specifically enforce employment contract on either end (can’t demand job back – just get damages)

                                                                            Spring 2005 Corporations – Coates p. 4
       Employee can ask for part ownership in the firm – even if fired still maintains stake in firm

2.3.1 – The Nature of the Agent’s Fiduciary Relationship
   Fiduciary – legal power over property held by fiduciary is solely held to advance aim of agency relationship
     Duty of Obedience – duty to obey principal’s commands
     Duty of Loyalty – obligation to use fiduciary power in manner best to advance P’s interests (important)
     Duty of Care – duty to act in good faith in exercising power – plays out differently in corporate context
   Several contexts – between partners, trusts and trustees, masters and servants, etc.
   Wrongdoings include misappropriation of principal’s asset or its value and neglect of asset’s management

In-Class Example
 After house on the market for a while, realtor decided to buy house for himself
 Soon thereafter a similar house sold for double the price – did agent violate his fiduciary duty?
    Agent has “a duty to deal fairly with the principal” and thus assumes a risk when dealing with principal
            If principle in a dependent position, payment of less than the reasonable market value for property
              he buys from the principal is evidence that the bargain is unfair – §390 comment (c)
    Court will look at circumstances and may still force agent to pay higher price even absent knowledge

2.3.2 – The Agent’s Duty of Loyalty to the Principal
   § 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
   § 388 – unless otherwise agreed, all profits an agent makes in connection with transactions conducted by him
    on behalf of the principal must be given to the principal
     Comment (c) – an agent who acquires confidential information in the course of his employment or in
         violation of his duties has a duty not to use it to the disadvantage of the principal
   § 389 – unless otherwise agreed, an agent is subject to a duty not to deal with his principal as an adverse party
    in a transaction connected with his agency without the principal’s knowledge
   § 390 – an agent who, to the knowledge of the principal, acts on his own account in a transaction in which he
    is employed has a duty to deal fairly with the principal and to disclose to him all facts which the agent knows
    or should know would reasonably affect the principal’s judgment
     Comment (a) – an agent has a duty not only to make no misstatements of fact, but also to disclose to the
         principal all relevant facts fully and completely. If agent cannot give impartial advice, he must see that
         principal secures third person’s advice. Must disclose what’s reasonable for principal to want to know
     Comment (c) – an agent must not take advantage of his position to persuade the principal into making a
         hard or improvident bargain; if the principal is dependent on the agent payment of less than the
         reasonable market value for property he buys from the principal is evidence that the bargain was unfair

Tarnowski v. Resop, p. 34, Minnesota, 1952
   P wanted to invest in route of jukeboxes and enlisted D to perform due diligence
   D made false representations as to the quality of the route and collected a secret commission
   P rescinded the sale and received $10K of down payment (out of $11K) in a suit
   P sued agent for 1) commission D received and 2) loss P suffered in operating route plus cost of trial
     The principal was able to receive attorney’s fees since dealing with fiduciary duties (not a contract case)
     P was clearly overcompensated – he got money back from sellers, commission and damages (§407)
             Courts will go out of their way to enforce morality on agents – deterrence effect

2.3.3 – The Trustee’s Duty to Trust Beneficiaries
 Private Trust – legal device that allows a “trustee” to hold legal title to trust property, which the trustee is
    under a fiduciary duty to manage for the benefit of another person, the trust beneficiary
     Differs from agency as trustee subject to terms of trust as fixed by creator not to control of beneficiary

                                                                             Spring 2005 Corporations – Coates p. 5
   § 203 – trustee is accountable for any profit made by him through administration of the trust
   § 205 – if trustee commits breach of trust, he is chargeable with resulting loss or depreciation in value of
    estate, profits made through breach or any profit which would have accrued without breach
   § 206 – rule in §205 applies where trustee sells trust property to himself individually or sells his individual
    property to himself as a trustee

In Re Gleeson, p. 36, Illinois, 1954
 Gleeson died and nominated Colbrook as trustee; before her death, Colbrook had held farm as a co-tenant
 Colbrook continued to farm the land after Gleeson’s death and leased property to himself (receiving profits)
     Appeared to be acting in good faith – only 15 days before new season started, increased rent to himself
 Court ruled C breached rule prohibiting trustees from dealing with trust property (penalty = give up profits)
     Guardian of incompetent MUST bring case against trustee (even if no bad faith) or pay profits himself
 C thus required to give all profits from the farming of the estate to the trust
 Why is trust law even tougher than agency law?
     Trustees have complete control of assets (no monitoring) unlike agency relationship where P controls

Sample Case – Food Lion v. ABC
 Two journalists from ABC got jobs at Food Lion as meat distributors and taped everything that went on
 Food Lion lost 10% of its market value on day that videotape aired on 60 Minutes
 Food Lion sued ABC for fraud and breach of fiduciary relationship of employees to principal
    Fraud claim tossed out because must have causation for fraud and press has to have malicious intent
    With duty of loyalty, cannot earn secret profits and must act in best interests of the company

Chapter Three – The Law of Partnership
   Majority of states have now adopted Revised Uniform Partnership Act (RUPA) – binding authority
   General partnership – the earliest and simplest form of jointly owned and managed business
   Joint venture – almost everything from partnership law carries over to this context
   Property held by the partnership is entitled in a special form – tenancy in partnership
     Provides that partnership firm, rather than individual partners, exercises control over property
     In event of bankruptcy or liquidation, this form of title gives creditors of partnership first priority
     Fundamental step toward creation of freestanding legal entity that can contract on its own behalf

Three Fundamental Rules of Partnership Law
 Control (§401) – majority decides ordinary matters (body not share); unanimity required if matters unusual
 Agency (§301) – each partner is an agent to all other partners; all agency obligations carry over (disclosure)
 Liability (§306) – each partner fully liable for debts incurred by partnership if partnership assets insufficient

3.1.1 – Why Have Joint Ownership?
   Capital – after a certain point, selling an ownership stake may simply be cheaper than borrowing more funds

Klein & Coffee – The Need to Assemble At-Risk Capital
 Interest rate on an additional share prohibitively high since much inferior claim on assets in case of default
 Interest also a fixed obligation, payable without regard to success of business (as opposed to profit-sharing)

3.1.2 – The Agency Conflict Among Co-Owners
   Partnership presents last of basic agency problems – conflict between controlling and “minority” co-owners

Meinhard v. Salmon, p. 43, New York, 1928 – Cardozo

                                                                             Spring 2005 Corporations – Coates p. 6
   Joint venture to enter into a 20-year lease of Manhattan hotel – D operated hotel and P provided some funds
   Upon end of lease, D contracted for profitable new lease and construction without telling P; P sued
     Replacement of smelly reservoir with library had made hotel more profitable – D didn’t need P’s funds
     Commercial development in area also made site extremely valuable as high rise office property
   Court held D should have informed P since “joint venturers owe to one another duty of the finest loyalty”
     One partner can’t appropriate to his own use a renewal of lease even if it begins after partnership expires
     Irrelevant that D did not engage in a conscious purpose to defraud P
   D thus kept dominion over lease, but P given a share in the enterprise (he gets one share less than 50%)
     Great deal for P because he can remain in FL and just collect dividends while D operates the site
     Result demonstrates that parties should include duties in contract so no ambiguity as joint venture ends
   Dissent – without actual fraud or unfairness, P can’t appropriate expectancy of renewal

Possible Remedies – how much responsibility should courts have in refining contracts to this level of detail?
 P shares in new opportunities on same terms as in the 20-year joint venture (Cardozo’s remedy)
    Takes away some of the upside for D to seek out these opportunities
 D must inform P, who is free to compete for, or renegotiate over, any new opportunity
    Cardozo suggests this is what S’s fiduciary duty required
 D can keep new opportunities or sell shares to P, as D likes
    May encourage D to operate hotel inefficiently in expectation of future profits after term ends

   Default rule – must share new opportunities to other partners (promotes efficiency/competition)
     Simple rule takes some burden off the courts and forces parties to come up with own remedies
   End-of-Period Problem – always have potential for sudden shifts in incentives near end of agreement
     Want parties to continue to focus on the on-going business as well as new opportunities

Underlying Economics
 Why didn’t D just borrow the money from a bank?
    Moral hazard – risk D may default may cause bank to limit financing or require high interest rate
    Fixed obligations – interest payments must be paid regardless of the profitability of the venture
 Why would parties choose a partnership/joint venture?
    Allows them to limit the agency relationship to a term of 20 years
    Giving D equity in the venture creates much greater incentives to put in more effort

Kraakman’s Rule of Corporate Law #1
 IF you see the words “punctilio of an honor” (from Cardozo’s opinion)…THEN the fiduciary loses

3.2 – Partnership Formation

Vohland v. Sweet, p. 47, Indiana, 1982
 D started working for P’s father in a nursery until he retired; P changed D’s status to give him 20% profits
 D ran physical aspects of nursery, supervised care of stock and customers; P handled finances and sales
 D sued for dissolution of alleged partnership and an accounting; court awarded him $59K; P appealed
 Issue is whether D is entitled to claim on assets (trees) or has already been paid through commission
    D asserted that company used part of his profits to build up inventory from nothing to current level
    P asserted that D put in no capital; both view payment as “sales commission”; no IRS filings
 COA affirmed stating a person in share of profits is prima facie evidence that he is a partner (UPA §7(4))
    Inferred from profit sharing; absence of contribution to capital (nor contract terms) not controlling
    Provides incentive for controlling partner to establish terms of relationship (e.g., define as “wages”)
 Explicit partnership agreement not required; profit-sharing is principle test for establishing partnership

                                                                           Spring 2005 Corporations – Coates p. 7
RUPA Doctrine – p. 134 SM
 202(a) – the association of two or more persons to carry on as co-owners a business for profit forms a
  partnership, whether or not the persons intend to form a partnership
   202(c)1 – joint ownership of property does not itself establish a partnership even if profit-sharing
           Comment indicates passive ownership not dispositive as distinguished from control in business
   202(c)2 – sharing of gross returns does not by itself establish a partnership
   202(c)3 – a person who receives a share of the profits of a business is presumed to be a partner unless
      profits were received in payment for wages, rent, a debt by installments, etc.

3.3 – Relations With Third Parties
   Most common issue of partnership formation arises when creditor goes after potential partner for debts
     Sweet above would have tried to avoid partner status if Vohland sued over outstanding debt (likely win)
   General partnership includes unlimited personal liability for partners so law defined by rights of creditors
     Who is a partner for purposes of personal liability to business creditors?
     When can an exiting or retiring partner escape liability for a partnership obligation?
     Since a partner’s liability on a partnership debt can be satisfied from a partner’s personal property, how
       are such claims to a partner’s personal assets to be balanced against claims of his other creditors?

3.3.1 – Third-Party Claims Against Partners

The Brudney UPA Problems – To Be Updated
 Ars, Gratia and Artis form and operate a business from a warehouse built for $200K
    Ars invests nothing but manages the operations – gets greater of 1/3 of profits or $5K
    Gratia puts in land ($40K) and handles sales – gets 1/3 of profits
    Artis puts in $30K – gets 1/3 of profits
           Artis grants Mayer ½ of his profits (in exchange for $15K) without telling others

Question 1a – If a consumer is injured by equipment that Artis knew was defective, is Ars liable?
 RUPA §306 and UPA §13 say that is doesn’t matter that Artis was acting unlawfully – he can still fully bind
   the partnership by “any wrongful act or omission” – like agency law where agents do illegal things
 So question is whether Ars is a partner under RUPA §202 above
    He didn’t put cash in, he gets a share of the profits (but then again has base salary so less risk), likely has
       at least some control since he runs the place, his name is part of partnership name
    §308 – Partnership by Estoppel – if person purports to be a partner or consents to be represented by
       another as a partner, the purported partner liable to the person to whom representation is made if, relying
       on the representation, he enters into transaction with the actual or purported partnership

Is Mayer Liable?
 He provided capital and gets a share of the profits, however no partnership with Ars and Gratia since his
    existence is not known to them (required)
 Likely liability through a sub-partnership with Artis even though Mayer is not directly entering a partnership
    relationship with others. Can’t call him a full partner because Ars and Gratia not liable for conduct of Mayer

Question 1b – If customer loses foreseeable sales because G fails delivery on-time is Artis liable? Ars? Mayer?
 RUPA §306 – all partners are liable jointly and severally for all obligations of partnership unless agreed
 Artis and Ars are likely partners because they get share of profits rather than wages

Question 2 – Suppose Low loans $50K to the business in exchange for 25% of profits and veto power over large
expenditures. Parties plan to obtain further financing by a bank loan. Gratia tells the bank that Low has an

                                                                             Spring 2005 Corporations – Coates p. 8
interest in the business and the bank makes a loan to the firm and passes the word to suppliers that Low is
interested in the business. Is Low liable to the bank or any supplier who extends credit?
 If Low considered a partner then liable for all actions by other partners under RUPA §306
 If Low not considered a partner, depends on degree of control extended as a creditor – Jenson v. Cargill

What if Low is cashed out before new bank loan?
 Low maintains liability for historical but not future actions by the firm
   Technically every time a partner leaves a firm there is a dissolution of partnership and new formation
   One exception to rule is doctrine in Munn where partnership is modified – old partner is released entirely

Would Low be liable for actions by other partners before entering the picture?
 RUPA §306 – new partners not personally liable for any partnership obligation incurred before admission

Munn v. Scalera, p. 51, Connecticut, 1980
 P’s sued for breach of construction contract; D had recently dissolved partnership with brother
   Other brother had completed project but in doing so ran up outstanding debts with P’s as guarantors
 D filed defense that he was discharged from his obligation since the P’s, upon notification of dissolution of
  partnership, had agreed that the other brother alone would complete performance
   Doesn’t by itself get him off the hook for pre-existing debts since “the rich rats can’t just abandon ship”
   However, may get off the hook if there is a change in the agreement after the partnership is dissolved
   Rule doesn’t hold parties liable for potentially harmful decisions made by ex-partners after dissolution
 UPA §36(3) – where a person agrees to assume the existing obligations of a dissolved partnership, the
  partners whose obligations have been assumed shall be discharged from liability to a creditor who, knowing
  of the agreement, consents to a material alteration in nature or time of payment
   Material alteration – P’s acting as guarantors allowed other brother to accumulate unforeseeable debts
   Court held this alteration fell within literal and understood policy of §36(3) so firm basis to discharge D
 Note – dissolution of partnership does not itself affect partner’s individual liability on partnership debts
   Puts withdrawing partner in tough situation since obligated for debt but has lost control over business

3.3.2 – Third-Party Claims Against Partnership Property
   Fundamental characteristic of all business entities is a segregated pool of assets to secure business debts
   UPA §25(1) recognizes partnership property owned by partners as “tenants in partnership”
     Affords to individual partners no power to dispose of partnership property – de facto business property
     Nevertheless retain transferable rights to net financial returns that assets generate (and management)
   UPA §25(2) – a partner cannot possess or assign rights in partnership property, a partner’s heirs cannot inherit
    it, and partner’s creditors can’t attach or execute upon it

3.3.3 – Claims of Partnership Creditors to Partner’s Individual Property

In Re Comark, p. 55, California, 1985
 Comark and its general partners (Bell and Owens) were sued by Newman for obligations of partnership
 Newman won a judgment against Bell and Owens and tried to levy Owens’ Mercedes
 Trustee in Comark’s bankruptcy tried to enjoin Newman from enforcing judgment against personal assets
 Court held that issuance of a mandatory injunction was necessary to protect Trustee’s interest in property of
    general partners of Comark from being adversely affected by the enforcement of Newman’s claims
     Many creditors beyond just N have claims on assets, so N can’t get around the bankruptcy process
     Theory of bankruptcy is that trustee will maximize value of bankrupt entity – N can’t mess up process
 Bankruptcy Act of 1898 – “jingle rule” – separates partnership/individual creditors and assets
     Partnership creditors get first priority in the pool of partnership assets
     Separate creditors get first priority for individual partners’ personal assets

                                                                            Spring 2005 Corporations – Coates p. 9
   1978 Bankruptcy Code §723 – gives partnership creditors more access to individual assets
     Partnership creditors still have first priority in assets of partnership
     Partnership creditors also placed on parity with creditors of individual partners
     In practice has assisted partnerships in gaining credit but has not hurt individual’s ability to get credit
   State law (UPA or RUPA) determines – UPA follows jingle rule; RUPA follows parity rule

Synthesis of Bankruptcy
 In all cases partnership creditors get first priority in the assets of the partnership
 Claims of partnership creditors are subordinated to those of partner’s creditors (as under the jingle rule) if (1)
   the UPA is controlling state law and (2) §723 does not apply
 Partnership creditors receive parity treatment if either (1) the RUPA is state law or (2) §723 applies

3.4 – Partnership Governance and Issues of Authority

National Biscuit Co. v. Stroud, p. 58, North Carolina, 1959
 Stroud and Freeman entered into a general partnership to sell groceries; agreement didn’t limit F’s power
 S told P that he wouldn’t be responsible for additional bread; P then sold and delivered bread at request of F
 Under UPA, S could not restrict the power and authority of F to buy bread (even if N on notice)
    Stroud was not and could not be a majority of the partners (half of partners is not a majority)
 Freeman’s acts bound the partnership (and Stroud) since ordinary matters connected with business
    Effectively allows one partner (of two) to go out and accrue debt if in ordinary course of business
    Fact that S started dissolution of partnership did not stop him from accruing more debt until official
 Preserves value of ongoing business – opposite rule would allow minority partners to hold up the business

3.5 – Termination (Dissolution and Disassociation)
   Many of most critical aspects of partnership law deal with dissolution and wind-up of partnerships
   In partnerships, bodies count rather than capital contributed – unlimited liability regardless of contribution
     May structure differently if some partners have more assets than others – may demand more control
     However, general partnership may not be best when large amounts of liabilities are present

3.5.1 – Accounting for Partnership’s Financial Status and Performance
   Balance Sheet – evaluation of the financial status of a partnership begins with inspection of balance sheet
     Must bring financials up to date and appreciate that figures representing assets are at historical cost
   Income Statement – second fundamental accounting statement that reflects prior year’s transactions
     Accrual accounting treats amounts paid as expenses in the period to which they relate
   Capital Account – records the effects on the partners’ capital of the operations of business over the year

Basic Lessons on Accounting
 Equity on balance sheet  third party sale value (market capitalization)  going concern value
 Competing objectives of ensuring accounting 1) is correct (verifiable) and 2) reflects current economic reality
    Very strict rules on how we adjust assets and liabilities over time
 Cash Accounting – used by very simple businesses (may not include accounts payable, etc.)
 Accrual Accounting – takes into account legal entitlements (e.g., accounts payable, receivable, etc.)

Dissolution Rules
 Default Rule – every partner has the right to liquidate the partnership and demand a wind-up
     Parties can contract outside of this rule (set a term); partners can still quit but can’t ask for wind-up
 UPA Phases – dissolution, wind-up and termination
 RUPA Phases – disassociation or dissolution, wind-up and termination

                                                                             Spring 2005 Corporations – Coates p. 10
Adams v. Jarvis, p. 62, Wisconsin, 1964
 P withdrew from medical partnership seven years after formation; sought to share in accounts receivable
    Small businesses typically use cash accounting so will not book profits until they are paid
    Partnership agreement gives P rights to % profits in final year, but doesn’t include all outstanding AR
 Issue is whether withdrawal constitutes dissolution of partnership notwithstanding an agreement to contrary
 Court held that parties clearly intended that partnership would continue even though a partner withdrew
    “If partnership agreement provides for continuation, sets forth a method of paying withdrawing partner
      his agreed share and does not jeopardize rights of creditors, then the agreement is enforceable”
            So possible to contract around the default at-will rule that any partner can ask for dissolution
            Decision here rested upon use of word “termination” rather than “dissolution” of partnership
            Under RUPA contract should have said that any “dissolution” shall not lead to a “wind-up”
 Court thus held the partnership was not dissolved so as to require a winding up of its affairs
    P doesn’t get all outstanding AR but D’s have fiduciary duty to collect them in same year

Dreifuerst v. Dreifuerst, p. 66, Wisconsin, 1979
 P’s and D, all brothers, formed a partnership at-will that operated two feed mills; no written agreement
 P’s served D with notice of dissolution and wind-up of partnership; parties unable to agree to terms
 D requested partnership be sold, but trial court denied and divided assets in-kind according to P’s valuations
 Issue is (when partner’s can’t agree) whether business should be split up among partners or sold on market
 COA held UPA §38(1) did not permit in-kind distribution unless all partners agree (or agreement states so)
    Lawful dissolution gives each partner right to have business liquidated and his share of surplus in cash
    Sale is a more accurate means of establishing market value of assets and getting each partner his share
 Creditor protection is likely the reason for standard default rule that assets should be sold (maximize value)
 However, sale of assets likely triggers capital gains taxes that reduce the underlying value to partners
    Alternative would allow remaining partners to buy out departing partner – issue on how to value share
 So many pros/cons between 1) asset distribution 2) asset sale and 3) buying out departing partner

RUPA v. ABA Theories
 RUPA (1994) §§402, 801, 802, and 804 codify Dreifuerst (thus similar to UPA §38)
 ABA recommends allowing a majority of the partners in an at-will partnership to continue the business
  without a winding up, provided that minority’s interest is purchased at fair value

Last Brudney Question
 Artis seeks to leave and wants to add a newcomer. Currently getting 1/3 of profits. Liquidation value (piece-
   by-piece) is $400K. Selling in total (going concern) is $700K. Selling to related business is $500K.
 What approvals are necessary for Artis to bring in a new partner to replace him?
    Unanimity is required since this is an unusual event (outside ordinary course of business)
 On what terms does Artis leave? How does the money exchange hands?
    Artis will argue 1/3 of $700K, indemnification agreement with newcomer to transfer liability
            Newcomers do not pick up previous partnership obligations – default rule in UPA §17
    Other partners will say firm worth less than $700K without Artis
    RUPA §701 – departing partner entitled to share of higher of going concern or liquidation value

Page v. Page, p. 70, California, 1961
 Parties were partners in a laundry business; D ran operations and P served as major creditor
 Enterprise was unprofitable for ten years but when conditions improved P sought to dissolve partnership
 D argued that partnership was for a term – UPA §31 says default rule is dissolution at-will by either partner
    Under D’s theory, P’s decision to dissolve would not give him claim against future earnings
 Trial court agreed a term of time was necessary before dissolution to repay debts – held against default rule
    D referenced Owen v. Cohen to show that courts held partners can impliedly agree to continue business

                                                                          Spring 2005 Corporations – Coates p. 11
   SC held D failed to prove any facts from which agreement to continue partnership for term could be implied
     Hope that partnership earnings would pay for necessary expenses is characteristic to all partnerships
     Hope doesn’t make all partnerships for a term and obligate partners to continue until losses recovered
   P thus had power to dissolve partnership at-will, however fiduciary duty to act in good faith – §31(1)(b)
     Post-dissolution obligation to share profits attributable to pre-dissolution actions – highly unclear
   Fiduciary duties limit the ability of partners to dissolve a partnership at will for own advantage
     At-will partnership not best form when partners have disparate investments or operational involvement

                                          Different Rules Proposed
      No disclosure                 Disclosure                Share known pre-termination opportunity
       No sharing                   No sharing
         At will                      At will                        Implied partnership at term
       No sharing   Share profits from pre-termination events      Until debts are paid – Trial Court

3.6 – Limited Liability Modification of the Partnership Form
   General partnership form has bare minimum features necessary to establish an investor-owned legal entity
     Dedicated pool of business assets
     Class of beneficial owners (the partners)
     Clearly delineated class of agents authorized to act for the entity (again, the partners)
   Limited Liability – creditors cannot proceed against personal assets of some or all of firm’s equity investors
     Can further separate partnership as legal entity and the investors who finance it
   Three Forms – limited partnership LP; limited liability partnership LLP; limited liability company LLC

3.6.1 – The Limited Partnership
   Pre-dates the corporation historically – really is confined to just law and accounting firms
   All limited partnerships must have at least one general partner with unlimited liability
     General partner is treated almost exactly like a member of an ordinary partnership
     In the US, limited partnerships are generally governed by the ULPA or RULPA
   Limited partners may not participate in management or “control” beyond voting on major decisions
     May risk losing their limited liability protection if they do exercise management powers
     Thus no ability to control the organization, determine profit distributions or transfer ownership
     However, still can be very lucrative since limited partners link disbursements to generals with their own
   1975 rule changed above rule – now have to be held out as a general partner to violate (rather than control)
   Traditionally popular because they combine pass-through tax advantages of partnership with limited liability
     Since 1987 any publicly traded equity faces same two-tier tax treatment as a subchapter C corporation

Delaney v. Fidelity Lease Limited, p. 74, Texas, 1975
 P’s alleged that three limited partners “controlled” business of limited partnership through a corporate entity
 Court held that “the personal liability, which attaches to a limited partner when he takes part in the control
   and management of the business, cannot be evaded merely by acting through a corporation”
    Found it undisputed that the corporation was organized to manage and control the limited partnership
    Rejected D’s contention that the limited partner must have held himself out as being a general partner
       having personal liability to an extent that third party relied upon the limited partners’ personal liability
 Limited partners can still contract around this ruling by approaching bank and agreeing not personally liable
    So none of default rules matter if parties think about issues ahead of time and contract around them
    ULPA – most states – even if limited partner exercises control, only liable if held out as general partner
            Demonstrates influence of wealthy in adjusting decisions that hurt them through legislature

                                                                            Spring 2005 Corporations – Coates p. 12
   Note – at this time only corps with less than ten members could elect subchapter S status
     Continuing limitations on use of S corps have been important impetus for recent focus on LLC’s

3.6.2 – Limited Liability Partnerships and Companies
   The search to combine partnership taxation with limited liability has produced two novel business entities
     The registered limited liability partnership
     The limited liability company
   Revenue/expenses treated as though they flow straight through to partners – no subsequent tax on profits
     Theoretically corporations can just inflate salaries to zero out profits and avoid double taxation
     Corps can also elect to be a subchapter “S” corporation – max 75 shareholders and no corp shareholders – The Limited Liability Partnership
   Limited Liability Partnership – general partnership in which ALL partners retain limited liability
     Limited liability provided from the statute varies by state
     Generally only limit liability with respect to liabilities from malpractice, etc. of other partners
             Partners still retain liability for torts arising from their own actions
     A few LLP statutes (NY and MN) extend liability protection to partnership contract debts and torts
   Lawyers prevented from entering into co-ownership deals – can’t sell share to outsiders (ethics concerns)
   Sullivan & Cromwell finally switched to LLP in 2001 after Arthur Andersen – required unanimity of partners – The Limited Liability Company
   LLC is more popular but less easily described than LLP because all 50 states have statutes but none same
   Previous IRS regulations provided the LLC would be taxes like corporation if three of four characteristics
     Limited liability for owners of the business                  – Centralized management
     Freely transferable ownership interests                       – Continuity of life
             LLC drafters relied on failing free transferability of interests and continuity of life tests
   1997 rules scrapped four-factor test in favor of “check the box” approach – LLCs / LLPs choose how taxed
   LLCs can now combine pass-through treatment for federal income tax purposes with limited liability,
    participation in control by members, free transferability of interest and continuity of life (contract for last)
     By contrast, closely held corporations that seek same tax treatment must comply with subchapter S
     LLC can also pass entity-level debt through to members for income tax purposes and adjust the inside
        basis of a firm’s assets upon death of an owner, transfer of ownership interests, or distributions
     Subchapter S corporations (not LLCs, etc.) may participate in tax-free reorganizations with C corps
   Major downside is if company desires to go public (> 35 shareholders) then can’t “check the box”
     One advantage spoken of is ability to expressly contract around fiduciary duties more than corps can

Chapter 4 – Introduction to the Corporate Form
4.1 – Introduction to the Corporate Form

Five Major Attributes of a Corporation
 Legal personality with indefinite life
 Limited liability for investors
 Free transferability of share interests
 Centralized management
 Appointed by equity investors

Primary Objective of Corporate Form

                                                                              Spring 2005 Corporations – Coates p. 13
   To allow entrepreneurs to raise capital – particularly passive equity capital – more easily
     People willing to invest with share of profits but no management control and limited liability

Delaware As the Mecca of Public Corporations
 Over 25% of budget derived from corporate taxes and fees – variable fees based on # of shares outstanding
 60% of Fortune 500 companies incorporated there; only 5% market share for private corporations
    Overall roughly half of public corporations stay in home state; other half incorporate in DE
 NJ started trend of creating attractive incorporation statutes to draw massive influx of incorporations
 Woodrow Wilson passed “7 Sisters Act” that reduced desirability of NJ and led to outflow of corporations
 DE was able to strike a balance between protecting shareholders and not protecting anyone else (consumers)
    WV tried to assume market share but statutes too lenient – made fraud legal so no protection
    MD is now making efforts to steal corporations, but success has largely been limited to mutual funds
 DE court system contributes to dominance – maintains equity (chancery) courts
    Handle requests for equitable relief (injunctions) & disputes over corporate statutes
    Lack of juries ensures quick resolution of issues – also attracts more qualified, interested judges
    Less than half of cases are appealed, and less than half of those are overturned
 Lawyers usually have best knowledge of DE law outside home state law, so recommend incorporating there
 Debate over whether DE has best corporate statutes or bad public policy that everyone incorporates there
 Important to note that companies have ability to move – perceptions of directors, shareholders & lawyers
 Congress also has ability to take up corporate law issues from states and make federal law – e.g., SEA
    Other statutes: SOX (p. 1964); FCPA (p. 1708); NYSE (p. 1250)
 Not all corporate dealings involve DE law; anything with a third party governed by other state’s law
    However, internal affairs (e.g., dispute between BOD) governed by state of incorporation
    CA §2115 (p. 1084) – elaborate body of rules for private/closely held corps in CA and pass certain tests

Major Statutes We Will Cover
 DGCL (p. 529) – Delaware incorporation statutes
 RMBCA (p. 646) – incorporation statutes adopted by over half of states
 ALI PCG (p. 1288) – similar to a restatement; also includes fiduciary duties not included in above statutes
 Charter (p. 1385) – provide for voting stock, BOD and shareholder voting in certain transactions, etc.
 Bylaws (p. 1387) – fix operating rules for governance of corporation – charter supercedes bylaws
    Both charter and bylaws typically override other agreements made by corporation

Analytical Distinctions Among Corporations
 Dispersed Corporation – typical public corporations with multitude of shareholders
 Closely Held Corporation – few shareholders; generally incorporate for tax or liability purposes (not capital)
    Frequently drop features of the corporate form that conflict with status as “incorporated partnerships”
    Whether a closely held business adopts corporate form depends on tax objectives and transaction costs
    Specific rules in DGCL §342 apply to corporations with less than 30 shareholders

   Controlled Corporations – single shareholder or group exercises control through power to appoint board
   Uncontrolled (or “public”) Corporations – no such group in control so control resides in management
     Majority of US corporations fit this model so BOD retains power to elect officers (not shareholders)

   Public Corporations – subject to The Securities Exchange Act – p. 1685
     Contains numerous rules and disclosure requirements for continued business operations
     §12(a) – if securities traded on national securities exchange (NYSE) then “public” so rules apply
     §12(g) – if total assets exceed $1 million and class of equity held by 500+ persons then “public”
            §12(g)1 – SEC raised limit to $10 million in assets AND still requires 500+ shareholders
   Over-the-Counter Companies – qualify as public companies under two rules but not on NYSE or Nasdaq

                                                                          Spring 2005 Corporations – Coates p. 14
4.2 – Creation of a Fictional Legal Entity
   Corporation considered separate person in eyes of the law – extraordinarily important
   Without separate identity creditors would have to investigate all joint-venturers on the loan
     Thus doctrinal fiction of artificial entity vastly reduces costs of contracting for credit
   Entity status allows corporations to have indefinite “life” – enhances stability of corporation form
     Death or departure of a “principal” need not disturb operation of a corporation
   Entity status also supports concepts of transferable shares, centralized management and limited liability

4.2.1 – A Note on the History of Corporate Formation
   Internal Affairs Doctrine – law of state of incorporation governs internal affairs of a corporation
   Special Acts of Incorporation – in earliest years state legislatures created a corporation by passing an act
     Supply restricted by system of special acts and task became heavy burden for legislatures
     Controversial since 1) entities may dominate social landscape 2) possibility for favoritism
   General Incorporation Statutes – corporate form available to all citizens through uniform process
     Equally available and unburdened legislative process – removed a source of corruption

The Erosion of Regulatory Corporate Law
 Dominant story or 20th century was movement from general statutes with mandatory governance terms to
   today’s statues, which are largely free of substantive regulation – corps founded in states with liberal rules
    New statutes allowed corps to have perpetual existence, do business anywhere, organized for any lawful
       purpose, more flexible capital requirements, own stock in other corps, own unlimited land, merge, etc.

4.2.2 – The Process of Incorporating Today
   Process of incorporating is nicely reflect in §2.01 and §2.04 of the Revised Model Business Corporation Act
   Incorporator signs requisite documents and pays fees, then drafts corporation’s “charter”
     Articles of incorporation (charter) state purpose/powers of corporation and define its special features
   Charter then filed with public official – includes corps principal office or agent to be served plus pay fee
     Corp’s legal life begins in DE when charter filed – when issued by secretary of state elsewhere
   First acts of business are electing directors, adopting bylaws, appointing officers and picking a name
   Next step for major corporations is to issue stock for initial capitalization

4.2.3 – The Articles of Incorporation, or “Charter” – p. 1385
   May contain any provision not contrary to law – modern corporation statutes mandate only a few terms
     Must provide for voting stock, board of directors and shareholder voting in certain transactions
     Must provide total amount of stock that may be offered – constrains financial ability of directors
     Must contain the most important “customized” features of the corporation if any
     Must state the original incorporators, company’s name and business and fix its original capital structure
             Thus charter defines how many, classes and nature of shares the firm authorized to issue
     May establish the size of the board or include another other governance terms (e.g., staggered terms)
   Lawyers want to keep charter very flexible because very difficult to change
     Provision generally delegates power to change charter to BOD – otherwise need BOD and shareholders
   Provision generally limits liability of directors of corporation

4.2.4 – The Corporate Bylaws – p. 1387
   Bylaws fix operating rules for governance of the corporation – must conform to statute and charter
     Establish existence and responsibilities of officers, annual meeting date for directors, etc.
   Some statutes grant shareholders inalienable right to amend bylaws – others limit power to the board
     Some courts have reviewed directors’ exercise of power to modify bylaws as abuse of fiduciary duty

                                                                             Spring 2005 Corporations – Coates p. 15
   Generally only need BOD or shareholders to change the corporate bylaws
   Generally minimal rules articulated since the statute fills in most of the gaps

4.2.5 – Shareholders’ Agreements
   Typically address such questions as restriction on disposition of shares, buy/sell agreements, voting
    agreements and agreements with respect to employment of officers or payment of dividends
   Voting trust – arrangement where shareholders publicly agree to place shares with trustee who then legally
    owns them and is to exercise voting power in according to terms of the agreement – statutory restrictions

4.3 – Limited Liability
   Primary reason for LL is to allow corporations to allocate assets and liabilities in an efficient manner
     “Hold” several corps that divide up assets and liabilities – creditors from one can’t sue for assets another
   Corporations have unlimited liability and shareholders have no liability for debts/obligations of corporation
     Limited liability simply means the shareholders can’t lose more than they invest – unlike general partner
     Creditors put on full notice that they can only go after the assets of the corporation – not shareholders
   Several sound reasons why limited liability ultimately emerged as general default rule for corps everywhere
     Vastly simplifies job of evaluating equity investment – ignore rare events, no research on co-investors
     Ability of corps to segregate assets may encourage risk-averse to invest in risky ventures
     Increase incentive for banks or other experts to monitor corporate debtors more closely
   Chief purpose to promote investment in equity securities and thus make capital available for risky ventures
   Only a default rule (creditors can negotiate UL – occurs mainly in small businesses)

Frank Easterbrook & Daniel Fischel – Limited Liability and the Corporation
 Decreases the need to monitor managers – less risk for shareholders so less monitoring costs
 Reduced costs of monitoring other shareholders – makes identity of other shareholders irrelevant
 By promoting free transferability of shares, LL gives manages incentives to act efficiently
    Shares tied to votes so poorly run firms will attract new investors who will install new mgmt. team
 Under LL value of shares equal to DCF, under UL shares not fungible so negotiate each share separately
 Makes it possible for market prices to impound additional info about value of firms – shares fungible
 Allows more efficient diversification as investors can minimize risk by owning diversified portfolio
    Diversification would increase under UL since investor on line for bankruptcy of all firms invested in
 Facilitates optimal investment decisions – managers invest in projects with positive net present value
    Increased availability of funds for projects with positive NPV is read benefit of LL

4.4 – Transferable Shares
   Equity investors own a share interest rather than part of the corporation’s property
   Transferability permits firm to conduct business uninterruptedly as owners change – unlike partnerships
     Absent limited liability, creditworthiness of firm as whole could change when shareholders change
   Encourages development of active stock market, which provides liquidity and option for diversification
   These factors in turn make investing in corps more attractive and so increase firms’ ability to raise capital
   Free transferability also complements mgmt – if market distrusts mgmt, stock will fall and mgmt replaced

4.5 – Centralized Management
   Corporate form provides central coordinating body through board of directors
   Shareholders simply act as owners – formal separation between owners and managers
   Major challenge of corporate law is to set up legal rules so managers will advance shareholders’ interests
     How can law encourage managers to be diligent given shareholders choose managers through votes?
     How can law assist shareholders in acting collectively vis-à-vis manager? What info to shareholders?
     How can law encourage companies to make investment decision that are best for shareholders?

                                                                             Spring 2005 Corporations – Coates p. 16
   Corporate law’s main technique is requiring mgmt be appointed by BOD who is elected by shareholders
     Corps make centralized mgmt of BOD default option and vests more power in BOD than partnerships
   BOD appoints a firm’s officers and is therefore formally distinct from operational mgmt
     Permits distinction between approval of business decisions and their initiation and execution

4.5.1 – Legal Construction of the Board – The Holder of Primary Management Power

Doctrinal Summary
 BOD elected after which it can create officers and subsequently delegate certain powers to them
 DGCL §141(a) – “business & affairs of every corporation shall be managed by or under direction of BOD”
    Board members are not required by duty to follow the wishes of a majority shareholder
    Thus the corporation has a republican form of government but not a direct democracy
    Governance power resides in the BOD not individual directors; need majority and a formal meeting
 Officers and regular employees have general powers of agency to act on the corporation’s behalf
 Shareholders only have ability to alter company operations by voting in a new BOD or suing (unlikely)
 DGCL §271 – sale of all or substantially all of assets must be approved by majority of shareholders
    Majority of shareholders also required for charter amendment (§272) and dissolution (§275)
    Shareholders can amend the bylaws without approval of BOD (§109)
 US law is the extreme in protecting prerogatives of BOD across the board – limited shareholder power

Automatic Self-Cleansing Filter v. Cunninghame, p. 98, England, 1906
 P, who together with friends held 55% of shares, wished to sell company; BOD refused to pass measure
 Court ruled BOD had ultimate authority, and altering directors’ power required extraordinary resolution
    Rejected contention that directors are agents of shareholders – must take minority view into account
 The notion that BOD is not bound by business judgments of shareholders still very alive today

Broad Managerial Powers of Directors
 Appoint, compensate and remove officers
 Delegate authority to subcommittees of the board, to officers and to others
 Declare and pay dividends; amend company’s bylaws
 Exclusive power to approve certain extraordinary corporate actions
    Amendments to articles of incorporation, mergers, sales of all assets, dissolution
 Make major business decisions – products offered, prices charged, wages paid, financing agreements, etc. – The Structure of the Board
   Corporate charter sets forth the structure of the board in very general terms – annual terms is default
     Corp statutes generally permit charters that create staggered boards – one class elected each year
   Board has inherent power to establish standing committees and may delegate aspects of its tasks to them
     Under general practice these include committees on audit, nominations and compensation – Formality in Board Operation
   Corporate directors not legal agents of corp – governance power resides in BOD not individual directors
     Directors only act as a board at formal meetings and by majority vote (unless charter say otherwise)
     Intended to discourage manipulation – also why directors may not give proxies to others – The Standard Critique of Boards

                                                                          Spring 2005 Corporations – Coates p. 17
       Most corporate statutes don’t even mention position of CEO – most important function
       Directors meet 4-8 times a year and receive info through documents and presentations from officers
       Despite limitations, observers place more faith in monitoring abilities of BOD than those of mgmt
         Particularly since percentage of outside directors on boards was increased

4.5.2 – Corporate Officers: Agents of the Corporation
       Corporate charter generally empowers BOD to appoint officers and remove then, with or without cause
       Corporate officers, unlike directors, unquestionably agents of corp and subject to fiduciary duty of agents

Jennings v. Pittsburgh Mercantile Co., p. 103, Pennsylvania, 1964
 D’s VP/CFO and financial consultant met with P; explained D’s desire to raise cash for store modernization
    Concept was the sale and leaseback of major piece of property – frees up cash and gets assets off books
 P brought D’s three offers, and financial consultant told P that executive committee had agreed to third offer
 Within a week, VP told P that offer had been rejected and refused to pay P’s real estate commission
 P sought to recover brokerage commission for alleged sale of leaseback of D’s real property
 Issue is whether D clothed its agent with apparent authority to accept offer for sale and leaseback
    Would bind D to payment of brokerage commission even though agent admits no authority to do so
 Court held agent can’t by own words invest himself with apparent authority – must come from principal
    However, mere granting of VP position does grant some apparent authority to bind D to some deals
 In order for apparent authority to arise from prior dealings, must have 1) similarity and 2) repetitiveness
 Corporate officers of VP and treasurer-comptroller do not provide bases for apparent authority in this case
    Based decision on size of deal and dissimilarity between VP’s prior acts and the offer at hand
    Courts generally look at absolute size, relative size and ordinariness of a deal to judge if BOD required
 Finally, extraordinary nature of transaction placed P on notice to inquire into D’s apparent authority
    Otherwise scope of authority of officers would be extended too greatly to detriment of BOD

Grimes v. Alteon, p. 105, Delaware, 2002
 CEO lacked authority to enter oral contract to sell 10% of any new issue of stock to existing shareholder
 Such a contract constituted a “right” in company’s securities and thus required approval of BOD §152, §157

Menard v. Dage-MTI, Indiana, 2000
 D’s president accepted P’s offer to purchase land from D and signed that he had authority to do so
 D’s board of directors didn’t approve the transaction, so P sought to bind them to the agreement
   After finding out about transaction, BOD sat on the decision for three months before informing P
 Court found that the concept of inherent authority rather than actual or apparent authority controlled issue
   P contracted with president, with whom the law recognizes as one of officers through which corp acts
 Court held D’s president had inherent authority because he satisfied three conditions from RSA §161
   He acted within usual scope of his authority – managed company’s affairs in past with no oversight
   P reasonably believed he was authorized to make transaction – president, prior history, stated in contract
   P had no notice that he was not authorized to sell without board approval – no affirmative act to notify
 Coates – distinctions can be made with Jennings, however cases show authority concepts murky for juries
   Believes the court came out wrong here – deal was unusual and CEO can’t get authority just by saying it
   Secretary of BOD can certify that it has given officer authority to bind company to certain transactions

Chapter 5 – Debt, Equity and Economic Value
5.1 – Capital Structure
        Corporations raise capital to fund operations by selling legal claims to its assets and prospective cash flows

                                                                                Spring 2005 Corporations – Coates p. 18
   Two types of long-terms claims that corporations may sell for this purpose
    Borrow money through the issuance of debt instruments
    Sell ownership claims in the corporate entity by issuing equity securities
  Capital Structure – the mix of long-term debt and equity claims that corps issue to finance their operations

Corporate Debt
  Provides contractual right to receive periodic payment of interest and to be repaid principal at maturity date
  If corporation fails to make payments, creditor has legal remedies to sue or have sheriff seize property
  Typically also gets contractual right to “accelerate” payment of principal amount if debtor defaults
  Debtor generally must pay creditors amount currently due to creditors before can distribute to equity owners
  The debt contract (loan agreement) has great flexibility in design; often creates several classes of creditors
  Maturity Date – most common characteristic of debt; date upon which principal and outstanding interest due
    Zero Coupon Bonds – no obligation to pay interest but must pay higher principal amount at maturity
  Investors choose between investing in debt (as creditor) or lending money to debtor by buying a bond
    Critical advantage of bonds is legal right to periodic interest and priority claim on corp assets
  Tax Treatment – interest paid by borrower is deductible cost of business when calculating taxable income
    By contract no deduction is available for dividends or distributions paid to stockholders

Equity Claims
  Can be customized but generally take the form of common stock
  Holders have no right to any periodic payments nor can they demand return of their investment
  Merely have a right to vote – common stockholders can expect dividends but only when BOD declares
    Equity securities – specifically common stock – generally possess control rights to elect BOD
    Common stockholders also have claim to firm’s assets and income after expenses and interest paid
  Preferred Stock – any equity security on which the firm’s charter confers special right, privilege or limitation
    Just as malleable as bonds but generally state dividend payable when declared by BOD and no voting
    Dividend payment enforced indirectly – stipulate unpaid dividends accumulate and must be paid first
    Ordinarily less risky than common stick since preference in liquidation and dividends

5.2 – Basic Concepts of Valuation
     Four basic finance
      Time value of money
      Risk and return
      Systematic risk and diversification
      Capital market efficiency

5.2.1 – Basic Concepts of Valuation
   Present Value – simply the value today of money to be paid at some future point
   Discount Rate – rate that is earned from renting money out for one year in the market for money
   Net Present Value – PV of profit for an investment [(PV of proceeds) – (PV of costs)]
   Rate of Return – percentage one would earn if he invested in a particular project
    Positive Net Present Value Projects – projects where PV of amount invested < PV of return gained
  Discounted Cash Flows –  (present value of future cash flows) – courts commonly use to value entities
    Discount rate calculated as [risk-free rate] + [risk premium based on market analysis]

5.2.2 – Risk and Return
     Expected Return – weighted average of the value of the investment =  (outcomes x probabilities)
     Risk Neutral – investor is only concerned about the expected return of an investment
     Risk Averse – most investors feel that volatile payments are worth less to them

                                                                           Spring 2005 Corporations – Coates p. 19
   Risk Premium – additional amount risk-averse investors demand for accepting higher-risk investment
    Calculated as percentage difference between expected return and amount investors are willing to pay
    Does not compensate investor for possible out-of-pocket losses associated with probability of failure
    However, intended to include both the known and unknown risks available to investor at given time
  Risk Adjusted Rate – calculation of the PV of risk-expected future cash flows that involves discounting them
    at a rate that reflects both the time discount value of money and the market price of the risk involved
    By contrast the rate at which we discount future cash flows that are certain is the risk-free rate
    More risk in expected future cash flows yields a higher risk premium and a higher risk-adjusted rate
  Agency problem – managers at a bank may act more risk averse since jobs could be on line if default results

5.2.3 – Diversification and Systematic Risk
     Combination of investments may allow risk-free investor to desist from demanding any risk premium
      Packaging of investments to reduce risk is big business on Wall Street – mutual funds, etc.
     Unsystematic risk – can be diversified (e.g., mutual funds)
     Systematic risk – cannot be diversified (e.g., risk of major economic downturn)
     Risk aversion means that investors are averse only to risk that they actually end up bearing
     Thus a risky investment held as part of portfolio that includes other risk investments worth more than alone
      Investor has diversified across a portfolio that has less total risk than its individual components
     Not every risk is diversifiable – in practice most projects involve at least some un-diversifiable risk
     Thus the greater the un-diversifiable risk is, the greater the risk premium and adjusted discount rate

5.2.4 – The Relevance of Prices in the Security Market
     Employing DCF analysis to estimate intrinsic value is a true art – sometimes only rational way to estimate
     For some assets – stocks and oil for example – assets are bought and sold on a well-functioning market
     One of core working hypotheses of modern financial economics is that stock markets aggregate the best
      estimates of the best-informed traders about the underlying present value of corporate assets
     Efficient Capital Market Hypothesis – empirical research indicates stock market rapidly reflects info
      Weak form – info how stock priced in past incorporated but technical analysis unhelpful – most likely
      Semi-strong – all publicly held information is incorporated in a stock price – dubious
      Strong – all information (public or private) is incorporated into a stock price – clearly erroneous
     Accuracy of prices depends on quality of info that informs trading – depends on integrity of top corporate
      management, accounting firms, law firms, investment banks, security analysts, etc.
     The SEC generally relies upon the ECMH – relies upon the market price reflecting prominent information
     Courts can improve on stock prices by using discovery to force out information not publicly held
      Private information and analysis can improve valuation
      Existing market price only reflects what marginal share sells for – price may rise if control sought
      Noise – random valuations generally assigned by non-informed individuals

5.3 – Estimating the Firm’s Cost of Capital

5.3.1 – Estimating the Firm’s Cost of Debt
     Nominal Interest Rate – reflects before-tax costs of debt at moment it is issued (if issued at face value)
      At other times true before-tax cost of debt is IR firm would pay if sought new debt on full principal
     After-tax cost of debt is less than before-tax cost since companies can deduct interest from taxable income
      No tax advantage for companies without revenue or positive income; reason why start-ups provide equity
     Leverage Ratio – debt/(debt + equity) – balances lower cost of debt v. cost of financial duress from too much
     Funding from banks are loans; funding from non-financial organizations are securities
     Capital structure and priorities on firm’s assets in bankruptcy
      Secured loan – held by commercial banks; pay just above risk-free rate; highest priority; force bankruptcy

                                                                            Spring 2005 Corporations – Coates p. 20
        Senior notes – held by mutual funds; pay above risk-free rate; moderate priority; may force bankruptcy
        Subordinated notes – held by insurance companies; pay upwards of 10% since low priority
        Preferred stock – held by VC’s or individuals; no voting but priority in assets and dividends
        Common stock – held by institutions and individuals; voting but lower priority in dividends
        Stock options – held by officers and key employees; low priority on assets
        Warrants to buy CS – held by investment banks or VC’s; low priority on assets

5.3.2 – Estimate the Firm’s Cost of Equity
   Equity plainly has a cost in sense that investors expect a return before will make funds available to firm
    However, no legal obligation to pay equity shareholders – BOD decides if/when dividends distributed
  Three primary methods for estimating this implicit cost of equity
    Discounting Expected Dividends Model – estimates future dividends and then calculates the implicit cost
      reflected in relation between the market price of common stock and expected cash dividend flow
    Capital Asset Pricing Model – measures the historic volatility of company’s stock and, using CAPM,
      estimates the implied cost of equity – links security risk to the volatility of the security prices
            Systematic Risk – system-wide risk that investors cannot get rid of
            Idiosyncratic Risk – company-wide risk that investors can get rid of
    Historical Average Equity Risk Premium Model – equity historically 8% higher than before-tax debt

5.3.3 – The Optimal Balance of Debt and Equity
     Cost of capital important to entrepreneurs and managers because
      Corporations can add value only if accept projects that promise and deliver greater returns than WACC
      Relative costs of capital help determine what is best mix of sources of debt and equity for corp to access

Value of Debt in the Balance Sheet
  Interest payments on debt are tax deductible – cost of debt only about half of stated cost to profitable firms
  Equity can increase potential upside reward if firm able to leverage investment by financing with debt

Risks of Excessive Debt
  As ratio of equity to debt goes down – risk of default up – lenders demand greater interest rates
    At some point in this process debt becomes more expensive than equity
  Managers prefer equity since greater protection against bank monitoring or bankruptcy risk – job security
  Creates risk of bankruptcy, which if it occurs is very expensive and will cost equity as well as debt
    Cost of reorganization in bankruptcy makes less likely that equity shareholders will stay in control of firm

Chapter 6 – The Protection of Creditors
Limited Liability Greatly Exacerbates Traditional Problems of Debtor-Creditor Relationships
  Opens opportunities for both express and tacit misrepresentation in transactions with voluntary creditors
    Managers could simply misrepresent the assets within the corporation and walk away if the business fails
  Makes it possible (and sometime attractive) to shift assets out of corporations after creditors put in funds
  Shareholders can undertake highly risk investments or increase leverage to shift risk to creditors

Corporate Law Pursues Three Basic Strategies to Safeguard Creditors
  Impose a more or less extensive mandatory disclosure duty on corporate debtors
  Promulgate rules regulating amount and disposition of corporate capital
  Impose duties to safeguard creditors on corporate participants such as directors, creditors and shareholders

                                                                           Spring 2005 Corporations – Coates p. 21
 Insolvency Tests – organizations typically treated as insolvent if pass either
  Current Assets < Current Liabilities or
  Assets < Liabilities
    Banks have greater capital requirement to avoid run on banks
    European firms required to have at least 25,000 € to avoid fraud
    US firms don’t have capital requirements but rather distribution constraints – no creditor protection

Creditor Protections
  Guarantees – agreement to be personally liable for debt if corporation defaults
  Security Interests – mortgages, sale/leasebacks, liens, etc.
  Covenants – independently negotiated terms to debt agreements to provide creditors with assurances
    Affirmative – require the company to perform actions (e.g., notify creditors if event occurs)
    Negative – restrict company’s actions (e.g., maintain financial ratios, limit dividends, no new debts)
  Interest – performs an important protection for creditor – provides signal if payment can’t be met

6.1 – Mandatory Disclosure
     Federal securities law imposes extensive mandatory disclosure obligations on public corps
     State law generally makes little use of mandatory disclosure to protect creditors of closely held corps
      Arguably credit bureau reports are more useful than financial statements in evaluating credit risks

6.2 – Capital Regulation
     Regulation of capital committed to corps is very direct means to protect creditors against risks they face

6.2.1 – Financial Statements
     In U.S. generally accepted accounting principles (GAAP) set by Financial Accounting Standards Board
     Principle limitation on balance sheet is that it typically reflects historical costs instead of current values
     Income statements don’t reflect the actual amount of cash that a business throws off in a year

Balance Sheet
  Current liabilities (due within one year) and long-term liabilities (due over a longer period)
  Comparison of current assets to current liabilities (working capital) gives sense of liquidity of assets
  Stockholders Equity – book value of owner’s economic interests – always a “plug figure”
    Stated Capital – product of par value of stock multiplied by number of issued and outstanding shares
           Can’t pay dividends unless equity balance (surplus + retained earnings) at least stated capital
    Capital Surplus – excess between par value of outstanding stock and price the corporation sold it for
           Surplus may be used for business functions such as payment of dividends
    Accumulated Retained Earnings – earnings that have not been distributed to shareholders
  Authorized Capital – limit in charter on capital BOD can authorize (e.g., shares authorized to sell)
    If company re-purchases stock it can 1) put in treasury and reissue later or 2) cancel the stock
  Par Value – historically used to provide baseline value for shares to provide assurances to shareholders
    To show how meaningless this is, all states allow charters to set no par value – whatever BOD decides

6.2.2 – Distribution Constraints
   Weakest of capital regulation measures are restrictions on distributions of capital to shareholders
    New York – bars distributions that would render corporation “insolvent”; dividends only out of surplus
    Delaware – “nimble dividend test” – pay out of capital surplus or net profits in current or preceding year
    California – pay dividends out of retained earnings or assets (as long as assets remain 1.25x greater than
     its liabilities and current assets are at least equal to current liabilities) – modified retained earnings test
  Constraints don’t just apply to dividends but also to repurchases of stock – what occurs in a typical LBO

                                                                                Spring 2005 Corporations – Coates p. 22
Problems on p. 137
  Delaware – $15 billion distribution permitted since BOD can just declare company worth $30
    DE permits companies to revalue assets to true economic value (not stuck to accounting value)
    BOD can rely on experts in their valuation – have to find an I-bank to provide value
           Shows how meaningless these distributional constraints are in real world
    However, if BOD does not go through valuation process, can be on hook themselves for difference
  Without these maneuvers, BOD could authorize $400MM based on “nimble dividend test”

6.2.3 – Minimum Capital and Capital Maintenance Requirements
     Objection to above is they can be avoided by placing trivial sums in trust fund of legal capital for creditors
     Response may be to require shareholders to commit a stated amount of capital to firm
      However, in US statutory minimum capital requirements are either truly minimal or nonexistent
      No matter how high amount set at, can fix level of capitalization only at moment of incorporation
      Within EU capital maintenance rules accelerate point as which failing corps must file for insolvency

6.3 – Standard-Based Duties
     Corp law subjects directors, fellow creditors and shareholders to duties to protect creditors’ interests
     Major instance when BOD shifts fiduciary duty from shareholders to creditors is bankruptcy

6.3.1 – Mandatory Disclosure
   Directors’ duties to protect creditors’ interests is also greater outside the US
   DE Chancery Court has suggested when firm insolvent (no Chapter 11) directors must consider creditors
    Should not consider shareholders’ welfare alone but that of community of interests that constitute firm
    Circumstances may arise when right course to follow may diverge from choice of shareholders
            Example (p. 139) shows focusing on EV to shareholders may create undesirable risk to creditors
            Financial economists term “agency cost of debt” – disparate risk/return strategies for debt/equity
            Fiduciary duty doctrine murky – BOD/CEO can get sued if too risky or too conservative
  Some instances (e.g., LBO’s) when duty found to arise at brink of insolvency rather than full bankruptcy

6.3.2 – Creditor Liability: Fraudulent Transfers
     Fraudulent Conveyance Law – imposes obligation on parties contracting with an insolvent (or near
      insolvent) debtor to give fair value for cash or benefits received or risk being forced to return those benefits
      Most important of creditor protection laws because it actually has some bite – applies even if no intent
      Rationale – companies better off because protecting creditors will provide assurances and thus lower the
         firm’s cost of capital – alternative would be to contract outside rule and increase transaction costs

 UFTA §4 – Fraudulent Conveyance
 A transfer made…by a debtor is fraudulent as to a creditor, whether the creditor’s claim arose before or after the
 transfer was made…if the debtor made the transfer…
  With actual intent to hinder, delay, or defraud any creditor of the debtor
  Without receiving a reasonably equivalent value in exchange for transfer…and the debtor
     Was engaged or about to engage in a business transaction for which the remaining assets of the debtor
        were unreasonably small…or
     Intended to incur…or reasonably should have believed that he would incur debts beyond his ability to pay
        as they came due
  Rule implies some minimal capital requirement – comes into play before insolvency – 2-year SOL
  Currently applied in LBO’s and spin-offs to transfer assets to insulate corps from potential tort liability

                                                                              Spring 2005 Corporations – Coates p. 23
6.3.3 – Shareholder Liability
    Shareholders may be held personally liable to corporate creditors or have loans subordinated to them – Equitable Subordination
   Debt can be subordinated either through contracting or by creditors asking a court to take action
   Courts invoke when equitably compelled to re-characterize debt owed to controlling shareholders as equity
    Usually applied when it appears that fraud is going on but it is difficult to prove
  Means of protecting unaffiliated creditors by giving them rights to corporate assets superior to those of other
    creditors who are also significant shareholders of the firm – rarely used outside of bankruptcy
    Creditor must be an equity holder (and typically an officer) of the company
    Inside-creditor must have behaved unfairly or wrongly toward corporation or its outside creditors

Costello v. Fazio, p. 142, 9th Circuit, 1958
  Three brothers formed a partnership and contributed $52K – one contributed the lion’s share
  Quietly took out investment and reissued as debt, then incorporated with capitalization of just $6K
  Business continued to fail and eventually declared bankruptcy; partners filed claims for promissory notes
    Major creditor protected itself through contracting but suppliers still out payments for inventory
    Thus original partnership loans paid (inventory sold) but corporation then borrowed again from them
  Trustee in bankruptcy asked that these claims be subordinated to those of general unsecured creditors
    Controlling shareholders should be subordinated when corp not adequately or honestly capitalized or
    Firm has been mismanaged to the prejudice of creditors, or where to do otherwise unfair to creditors
  Court held corp not adequately capitalized at creation and partners acted selfishly to detriment of creditors
  Held that undercapitalization is enough to subordinate debt and that actual fraud is not required
    Test to be applied is whether the transaction can be justified “within bounds of reason and fairness”
    If $52K capitalization including partner liability insufficient, $6K with limited liability unbelievable
    Quasi-fraud from omission – brothers didn’t provide notice to creditors about change in capitalization – Piercing the Corporate Veil
   Most frequently invoked form of shareholder liability to protect creditors – set aside entity status
   Two general requirements
    Disregard of corporate formalities – most obvious is moving money around with no paper trail
    Something inequitable – murky standard as above
  Minority jurisdictions may permit veil piercing for thin capitalization, shareholder dominance, etc.
  Unaware of any case where veil has been pierced against a public company – similar for closely-held
  Courts rarely allow veil piercing in tort cases despite fact that one time parties can’t contract beforehand

Sea-Land v. The Pepper Source, p. 148, 7th Circuit, 1991
  P shipped peppers to D, who then stiffed him on substantial freight bill and dissolved with no assets
  P brought action against D and five business entities he owned to recover by piercing the corporate veil
    Received judgment against entity and then tried to recover from D and assets of other entities
    Other creditors have greater priority than D over entities’ assets so P also sued entities to get priority
  Court used two-part test for piercing the corporate veil from Van Dorn
    Such unity of interest and ownership that separate personalities of corp and individual no longer exist
    Circumstances such that adherence to fiction of separate corp existence would sanction fraud / injustice
  Court used four factor-test from Illinois cases to determine that first part of test met
    Failure to maintain adequate records or to comply with corporate formalities – no bylaws, meetings, etc.
    Commingling of funds or assets – corps and D borrowed substantial sums from each other
    Undercapitalization – no assets behind any of the entities
    One corporation treating assets of another corporation as its own – same expense accounts used

                                                                           Spring 2005 Corporations – Coates p. 24
   Court held insufficient information provided to conclude second part of test met
    Concluded that some wrong must result beyond a creditor’s inability to collect (e.g., fraud)
  Case thus remanded to establish whether the kind of additional “wrong” was present
    No evidence presented that D pulled money out of pepper company to avoid paying for shipping
  This case reflects the majority view – most notable factor being failure to treat corporate fiction seriously

Kinney Shoe Corp. v. Polan, p. 152, 4th Circuit, 1991
  D created two corps to re-establish industrial manufacturing business – no meeting held or officers named
  One corporation subleased part of P’s building, which it later subleased to other corporation run by D
    P aware that D had already gone bankrupt once, but was only available party to lease premises to
  D paid first rental payment out of personal funds, but no further payments made by any party
  P filed suit and obtained judgment against first corporation for $166K; then sued D to collect money
  District court held that P had assumed risk of first corp’s undercapitalization so can’t pierce corporate veil
  COA outlined two-prong test to be used in determining whether to pierce corporate veil in contract case
    Is unity of interest and ownership such that separate personalities of corp and individual no longer exist?
    Would an equitable result occur if the acts were treated as those of the corporation alone?
  First test satisfied since D put nothing into corporation and didn’t observe any formalities
    Bought no stock, elected no officers, kept no minutes, made no capital contribution, etc.
  Second test satisfied since D attempted to protect assets by placing them in corp to avoid paying P
  Court further ruled that “assumption of risk” test inapplicable since not required to seek equitable result
  Therefore, court held D personally liable for the debt of the corporation
    Coates says this case was wrong because there was no sanctioning of fraud or injustice
    P could have entered into loan directly with D – likely knew D wouldn’t have agreed to put assets at stake

6.4 – Veil Piercing on Behalf of Involuntary Creditors
   Tort creditors of thinly capitalized corps differ from contract creditors in at least two key respects
    Probably do not rely on the credit-worthiness of the corp in placing themselves in position to suffer loss
    Generally cannot negotiate with a corporate tortfeasor ex ante for contractual protections from risk
  General rule – thin capitalization alone is insufficient ground for piercing the corporate veil

Walkovszky v. Carlton, p. 157, New York, 1966
  P injured four years prior when hit by taxicab negligently operated by D – stockholder in ten similar corps
  P couldn’t collect from corporation since minimum insurance, cabs on credit, medallion non-transferable
  Court said standard to pierce a corporate veil is “whenever necessary to prevent fraud or to achieve equity”
    Such liability extends not only to the corporation’s commercial dealings but to negligent acts as well
  Court held that corporate form can’t be discarded merely since assets of corp and insurance are insufficient
    No assertion that D doing business without regard to formality or to suit immediate convenience
    Not fraudulent for owner-operator to take out only minimum required liability insurance
  Dissent – corps intentionally undercapitalized for purpose of avoiding responsibility for acts bound to arise
  Policy Discussion
    Allowing veil to be pierced and thus holding Carlton liable would reduce number of cabs on streets
    Response is corps with substantial assets should just purchase insurance – why legislature set too low?

Successor Liability
  DGCL §278 – shareholders remain liable to suits for three years after dissolution of corporation – still LL
  Several states require buyers of liquidating firm’s product line to pick up tort liability of seller
  Anticipating the liability, the purchasing firm will reduce offering price by expected liability
  Thus potential liquidator can’t escape liability through sale of damage-causing product line
    Not veil-piercing but rather that the new company assumes liabilities of previous corporation

                                                                           Spring 2005 Corporations – Coates p. 25
6.5 – Can Limited Liability in Tort Be Justified?

Excerpt from Hansmann & Kraakman, Yale L.J., 1991
  Argues, contrary to prevailing view, that limited liability in tort cannot be rationalized
  Empirical evidence that increasing exposure to tort liability has led to widespread reorganization of firms
    Placing hazardous activities in separate subsidiaries, disaggregating firms to avoid liability, etc.
  Closely Held – LL encourages too little precautions and excessive entry/investment in hazardous industries
  Public Corps – LL gives managers incentive to assume too much risk; several reasons for unlimited liability
    Paucity of tort judgments bankrupting such firms may under-represent frequency with which publicly-
       traded firms cause tort damages exceeding net worth since tort victims sue for less than value of firm
    Threat of tort liability exceeding net assets of such firms is unlikely to increase in the future
    Any effort to extend UL to closely-held firms without public firms would encourage all to be public
  Major issue is determining timing rule that determines which shareholders become liable after tort occurs
  Authors suggest modified form of claims-made rule – an “information-based rule” – at earliest of
    Tort claim filed; management became aware of high prop of filing; corp dissolved without successor
  Decisive objection to UL has always been the burden UL might impose on cost of equity for public firms by
    Impairing market’s capacity to diversify risk and to value shares
    Altering identities and investment strategies of shareholders
    Inducing market participants to monitor excessively
  Authors argue this prediction irrational since under current law people exposed to UL every time drive car
  Most often-discussed alternatives to UL are mandating insurance coverage, imposing criminal penalties for
    those who create unreasonable tort risks, and giving tort victims priority over other creditors if bankruptcy

 Rebuttal to Above Argument
  LL allows companies – and entrepreneurs – to take risks that develop products to help society
  Insurance solution does not work in emerging industries where data insufficient to calculate risks
  Overinvestment in insurance inefficient since premiums include costs of fraud, collection, etc.
  Coates would be shocked if LL eliminated for torts – some exceptions such as environmental violations
  Only a select set of industries that can engage in such practices as Carlton was able to do

Chapter 7 – Normal Governance: The Voting System
Important Statutes – DGCL

 §216 – Quorum and Required Vote for Stock Corporations
  Charter or by-laws may specific number of share and/or amount of voting power; also quorum requirements
  In no event shall a quorum consist of less than 1/3 of shares entitled to vote at a meeting – unless class vote
  Defaults
    Majority of shares entitled to vote constitutes quorum in all matters other than election of directors
    Majority of shares present or by proxy and entitled to vote shall be the act of stockholders
    Directors elected by plurality of votes of shares present or by proxy and entitled to vote on such election
    Where separate vote by class required, majority of outstanding shares of such class constitutes a quorum

 §211 – Meetings of Stockholders
  Meetings of stockholders held at place designated by charter or by-laws; otherwise as decided by BOD
    If authorized to do so, BOD may hold meeting solely by means of remote communication
  Unless directors elected by written consent in lieu of annual meeting, such meeting held as stated in by-laws
  Annual meetings must occur within 13 months of each other or Court of Chancery can so order

                                                                           Spring 2005 Corporations – Coates p. 26
    Special meetings and written consent permitted if authorized by charter or by-laws

 §242 – Amendment of Charter After Receipt of Payment for Stock

    Changes to charter permitted if lawful and proper in original charter; can rename firm, change par value, etc.
    Requires BOD to adopt resolution for proposed change and hold a meeting for shareholders to vote thereon
     if amendment would change aggregate number of authorized shares of their class, change par value of shares
     of such class, or hinder the powers, preferences or special rights of the shares of such class

 §109 – By-Laws
  Original or other by-laws may be adopted, amended or repealed by BOD before issuance of stock
  After received payment for stock, the power to adopt, amend or repeal by-laws in voting shareholders
    Corporation can confer power to adopt, amend or repeal by-laws to directors in charter
    Such conferring of power does not divest stockholders to adopt, amend or repeal by-laws

 §223 – Vacancies and Newly Created Directorships
  Unless otherwise provided in charter or by-laws
    Vacancies or newly created directorships may be filled by majority or directors in office or sole remaining
    If filled directorship part of a class, new director stays in office until a vote on that class and qualified
    If chosen by less than full BOD, courts may order election under §211 if >10% shareholders ask for it

 §228 – Consent of Stockholders in Lieu of Meeting
  Unless otherwise provided in charter or by-laws
    Any action taken at annual or special meeting may be taken without a meeting, without prior notice and
       without a vote, if consent in writing signed by holders in same number as would be required at meeting

 §141(d) – Classified Boards
  Directors may be divided into one, two, or three classes by charter, initial by-law, or a new by-law voted on

 §141(k) – Removal of Directors
  Any director or the entire BOD may be removed, with our without cause, by the holders of a majority of the
    shares then entitled to vote at an election of directors – unless charter otherwise provides

 §275 – Dissolution; Procedure
  If board desires dissolution, after adoption of resolution to that effect by majority of board at meeting it shall
    cause notice to be mailed to each stockholder entitled to vote and a meeting to take place to vote on it
  Dissolution also possible without BOD if all stockholders entitled to vote consent in writing and file notice

Doctrinal Overview
   Three Primary Default Powers of Shareholders – right to vote, to sell and to sue
    Power to vote is most important of these rights – voting shares trade at substantial premium to non-voting
  Shareholders have the right to vote on three major issues
    Electing Board of Directors – most important type of voting
    Fundamental Changes in the Organization (e.g., M&A) – typically require BOD approval
    Bylaws and Shareholder Resolutions – binding or precatory (non-binding – recommendation)
  Voting can take place in three situations
    Annual Meetings
    Special Meetings
    Written Consent – petition that circulates; if enough sign and send in then decision binding
           Not permitted in most states unless ALL shareholders sign – intended for small companies

                                                                             Spring 2005 Corporations – Coates p. 27
             DE only requires a majority vote to be binding – thus a more important vehicle in DE
     For every meeting there is a notice and quorum requirement
      DGCL §216 – quorum requirements can be modified in the charter but minimum of 1/3 required
             Of course if greater number required to pass act (e.g., majority for M&A), quorum must meet that
             Courts can order special elections if quorum continually not met and BOD held over without vote
     Voting schemes discussed in this chapter are entirely different for a closely held corporation – unique rules
     Large publicly held companies different as well due to vast number of shareholders – large use of proxies
      Virtually no constraints imposed by states on proxies – generally created by federal and SEC law
     Record holders – only record-owner at most large companies is DTC (a non-profit set up by major banks)
      DTC is a depository trust company that is technically the record holder of all major securities
             DTC sends in one proxy – a director is generally the proxy – to company for voting purposes
      Major bank then coordinates with individual shareholders and DTC in purchase and allocation of shares
      SEC requires DTC and banks to pass along vote to individual shareholder – will vote how you decide
      Note that individuals can’t actually vote by mail – must appoint a proxy to vote in their absence
     Typically only one slate of candidates at meeting so if want to fight need to do so before proxies sent out
      Legitimate proxy fight would require significant expenditures – ads in WSJ, maybe TV or call centers

7.1 – The Role and Limits of Shareholder Voting
   Few public companies restrict BOD’s managerial power in charter – rely on default terms in corp statutes
   Three primary default powers of shareholders – in practice they work together
    Vote on the designation of the board of directors
    Sell their stock if they are disappointed with the company’s performance
    Sue their directors for breach of fiduciary duty in certain circumstances – unclear on value
  Collective Action Problem – passive monitoring by shareholders due to limited influence in voting
  Attempts have been made to create a more active “shareholder democracy”
    1934 Securities and Exchange Act sought to empower shareholders through forced disclosure of info
    SEC has promulgated elaborate proxy rules designed to encourage informed shareholder voting
  New shareholders’ rights movements led by institutional investors have taken increasing role in monitoring

7.2 – Electing and Removing Directors

7.2.1 – Electing Directors
   Every corporation must have a board of directors – even if BOD had only a single director – DGCL §141(a)
    DGCL §211 – requires an annual board meeting (13 months) at which a BOD is elected
  In the absence of any customization in the charter, each share of stock has one vote – DGCL §212(a)
    Voting more valuable to CS holders as security has no maturity date or legal right to periodic payments
  Annual Election of BOD – each year holders of voting stock electing whole BOD or class or directors
    Charter or bylaws fix actual notice period, quorum requirement, record date – within statutory guidelines
    Proposals exist to extend election period – would increase board stability but could make less dynamic
    Changes assume poorly run company, possibility of better returns with new mgmt, better alternatives

7.2.1 – Removing Directors
   At common law shareholders could remove a director only “for cause” – directors have due process rights
   State law generally bars directors from removing fellow directors without express shareholder authorization
    Some statutes do permit shareholders to grant BOD power to remove individual directors for cause
    In all events if BOD uncovers cause for removal, it can petition court to remove director from office
  DGCL §141(k) – Any director or the entire BOD can be removed with or without cause by the holders of a
    majority of the share then entitled to vote at an election of directors, except in the following…

                                                                           Spring 2005 Corporations – Coates p. 28
 Problem on p. 176 – Most Important Practical Problem in this Book
  Successful IPO followed by future plummeting of stock – CEO worried about proxy fight over leadership
  CEO recommends fundamental charter amendments (§242) – only info shareholders receive is from CEO
  Shareholders approve charter amendment to provide BOD with exclusive power to amend the bylaws
    BOD then creates a staggered BOD with 9 directors (3 classes of directors) – gets directors elected
  Shareholder purchases 51% stake in company and desires to install new directors

 How long must she wait and what are her options?
  Can she amend corporate charter? – DGCL §242 requires BOD to propose resolution (shareholders vote)
    She thus can’t force a charter amendment since §141 prohibits her from telling BOD what to do
  Can she amend the bylaws? – recent exclusivity provision grants power to BOD to amend bylaws
    Unenforceable as §109 prohibits divesting stockholders of power to adopt, amend, repeal by-laws
  She could thus use by-laws to expand BOD to 19 and try to stack it in her favor (or eliminate staggering)
    §223 – vacancies typically filled by BOD, however can provide for otherwise in by-laws
    §141(d) – BOD can be classified as staggered only by the certificate of incorporation, an initial by-law or
      by a new by-law adopted by a vote of the stockholders
           In practice shareholders rarely approve staggered boards – must do upon incorporation
  Or she could use her vacancy power to remove the directors that she does not agree with
    §141(k) – most important of voting powers – allows shareholders to remove directors for cause
           “Cause” typically requires a serious crime such as fraud
  Then she could use §228 to amend by-laws by written consent rather than wait for or call meeting
  This is how IBM took over Lotus back in the 1980’s – entire incident took place in less than a week

Hilton Hotels v. ITT, p. 177, Nevada, 1997
  Hilton announced a tender offer for ITT stock and plans for a proxy contest at ITT’s annual meeting
  ITT rejected Hilton’s tender offer and refused to conduct annual meeting as in preceding years
  ITT announced split into 3 entities; largest would have staggered board requiring 80% to remove directors
     Couldn’t just create staggered BOD for ITT – shareholders wouldn’t approve – so had to be creative
     Formed subsidiary with 93% of ITT’s assets – now ITT’s BOD could create staggered board in subsidiary
  Blasius – BOD can’t undertake action if primary purpose to disenfranchise shareholders due to proxy fight
     DE courts adamantly support Blasius since voting one of primary shareholder rights – can’t take it away
  Court used factor analysis to conclude primary purpose of ITT’s plan was to disenfranchise shareholders
     Timing, entrenchment, ITT’s stated purpose, benefits of new plan, effect of classified board
  Shareholders have only two protections against perceived inadequate performance – can’t take away vote

7.3 – Shareholder Meetings and Alternatives
   At annual meeting shareholders may
    Vote to adopt, amend and repeal bylaws
    Adopt shareholder resolutions that may ratify board actions or
    Request the board to take certain actions
  DGCL §211 – should BOD fail to convene annual meeting within 13 months of prior, courts may require it
  Special Meetings – other shareholder meetings that permit them to vote on fundamental transactions
    Generally the only way shareholders can initiate action between annual meetings
    However, meetings expensive, so often define requirements in corporate charter
  Shareholder Consent Solicitations – statutory provision allows shareholders to act by filing written consents
    Can also assist in hostile takeovers where acquirers wish to displace the boards of public companies
    DGCL §228 – any action that may be taken at BOD meeting may also be taken by written concurrence

7.4 – Proxy Voting and Its Costs

                                                                          Spring 2005 Corporations – Coates p. 29
     Proxy voting permits BOD and officers to gather a quorum – no single form mandated for a valid proxy
     State law governs basic duties of proxy holders as agents; fed law governs solicitation/exercise of proxies
     Costs of proxies part of normal governance since essential to operation of annual shareholders’ meetings
      Under current law, insurgent shareholders are only reimbursed for proxies if they are victorious

Problem on p. 183
  Group of dissident shareholders controls 20% of the voting shares of IncumbentAir – poorly run airline
  Have 50% chance of winning proxy fight if spend $2MM for shareholder support – managers spend same
  How should the dissident shareholders think about financial implications of this fight?
    50% win – [reimbursed $2MM in expenses] + [20% of increased firm value] – [20% of $4MM spent]
    50% lose – [out $2MM themselves] – [20% of $2MM that managers spent]
  Result – shareholders must believe management change will increase value of firm by $16 million
  Thus, current rule makes it much harder for proxy fights to occur than would be justified for shareholders
  However, if rule made cost to bring proxy fights lower then more would result – less likely to produce gain
    Proxy fights also result over desire for control rather than just based on financial benefits – not in model
  In reality chance of winning < 50% and shareholder control < 20% – requires very large gain to justify
  Empirical evidence suggests that market price goes up when proxy fights successful – too few proxy fights
    SEC contemplating making changes to allow shareholders to replace just one or two directors

Rosenfeld v. Fairchild Engine, p. 183, New York, 1955
  BOD spent over $100K in defense of their position; very minority shareholder sued for reimbursement
  Test – when directors act in good faith in a contest over policy, they have the right to incur reasonable and
    proper expenses for solicitation of proxies and in defense of their corporate principles or policies
    Stockholders also have right to reimburse successful contestants for reasonable expenses from contest

7.5 – Class Voting
     Most common structure is to have a Class A stock (10 votes/share) and Class B stock (0 or 1 votes/share)
     Rule from 1928 – 1987 forced companies on NYSE to provide voting rights for all common stock
      Development of NASDAQ created competition – new exchange didn’t have this requirement
     SEC passed Rule 19(c)4 – all stock exchanges must have rule that limits capital structure to 1 share / 1 vote
      However, created an exception for newly formed companies – they could establish non-voting classes
     Business Roundtable v. SEC – DC court held SEC overstepped its role as disclosure guardian to impose rule
      SEC maintained rule since major stock exchanges are in New York – 2nd Circuit hasn’t followed DC rule
     Now can only change from single class to dual class structure if go private and then go public again
      No case on point but can company put 98% of assets in new subsidiary with dual shares? Likely not.
     DGCL §242(b)(2) – holders of outstanding shares of a class shall be entitled to vote as a class upon a
      proposed amendment, whether or not entitled to vote theory by the certification of incorporation, if would
      Increase or decrease aggregate number of authorized shares of such class
      Increase or decrease part value of the shares of such class or
      Alter or change powers, preferences or special rights of the shares of such class to affect them adversely
     Voting regimes present risk that majority blocks will advance own interests – minority needs protection
     Transaction subject to class voting means majority of votes of every class that is entitled to a separate class
      must approve the transaction for its authorization
     If proposed charter amendment affects legal rights of class of stock or disadvantages them in some respect,
      then it should be adopted only with the concurrence of majority vote of that class voting separately
      DE statute more limited – requires separate vote if amendment alters legal rights of existing security

Problem on p. 186
  As a general matter, preferred stock does not contain the right to vote for BOD
  However, preferred stock does get to vote as a class if its rights as a class potentially infringed

                                                                             Spring 2005 Corporations – Coates p. 30
      So preferred stock would get to vote if mgmt wanted to create another class of stock with higher rights
     Even just adding preferred stock to same class (with no greater priority) would require class vote
      Company making more of a commitment to other parties so creating greater risk for current shareholders

7.6 – Shareholder Information Rights
   State corporate law in the US leaves function of informing shareholders largely to the market
   By contrast, federal securities law and SEC rules mandate extensive disclosure for publicly traded securities
   DE courts grant two fundamental rights – request “stock list” and inspect “books and records”
   The Stock List – discloses identify, ownership interest and address of each registered owner of stock
    “Proper purpose” defined broadly; courts generally don’t consider if additional “improper” interests
    This right is extremely important because it permits dissident shareholders to run effective proxy fights
    Corps generally produce digitally stored and delivered data; required to produce related identifying info
    Banks obliged under federal securities law to disclose “beneficial owners” to companies (unless object)
  Inspection of Books and Records – shareholder may request broad access to uncover suspect wrongdoing
    Far more expensive than stock list and can jeopardize proprietary or sensitive information
    DE law requires P’s to demonstrate proper purpose – courts carefully screen motives and consequences

General Time v. Talley Industries, p. 189, Delaware, 1968
  Court ruled that stockholders entitled to stock list if primary purpose is reasonably related to that status

7.7 – Techniques for Separating Control from Cash Flow Rights
   Ordinarily good policy to award voting rights to investors who claim corporation’s residual returns
    Managers selected by those with strongest interest in maximizing corporate value
    Statutory prohibition against corporation voting shares owned by the corporation directly or indirectly
  Of course perfectly legal to create non-voting stock (e.g., Martha Stewart) as long as adequate disclosure
  DGCL §160(c) – once stock bought back it’s considered “treasury stock” and loses voting power

7.7.1 – Circular Control Structures
     DGCL §160(c) – shares of its own capital stock belonging to the corporation or to another corporation, if a
      majority of shares entitled to vote in election of directors of such other corporation is held, directly or
      indirectly, by the corporation, shall neither be entitled to vote nor be counted for quorum purposes
      Only applies when a majority is held by corporation – valid if public owns just 51%

Speiser v. Baker, p. 191, Delaware, 1987
  Complex ownership pattern allowed two directors to control a corporation with <35% of its equity
  P asserted that circular ownership of stock among companies violated §160(c) of DE corporate law
    §160(c) prohibits voting of stock that belongs to issuer and voting of issuer’s stock when owned by
        another corp if issuer holds majority of share entitled to vote at election of BOD at second corporation
  Court held that stock held by corporate “subsidiary” may “belong to” issuer and thus be prohibited from
     voting, even if issuer does not hold a majority of shares entitled to vote at election of BOD of subsidiary
  Satisfied here since capital of one corporation has been invested in another corporation and used solely to
     control the votes of the first corporation – principal effect is to muffle voice of public shareholders

7.7.2 – Vote Buying
     Shareholders may not sell their votes unless part of transfer of underlying share; obverse is true as well
     Not a criminal offense but will be easily enjoined by a court if discovered – very likely due to proxy rules
      Separation lessens incentive to improve firm through voting, which is tied to rewards from performance
      Collective choice problem would make value of votes incorrectly small – difficult to value stock as well

                                                                            Spring 2005 Corporations – Coates p. 31
Schreiber v. Carney, p. 199, Delaware, 1982
  In exchange for not opposing a merger, Texas Int’l loaned $3M to Jet Capital – owned 35% of Texas’ CS
  Texas’ BOD unanimously approved the proposal and submitted it to its stockholders for approval
    Also overwhelmingly approved by majority of shares voted by stockholders other than Jet or its officers
  P, a shareholder of Texas, said the loan constituted vote-buying and was therefore void
  Court held vote-buying not per se illegal as against public policy – modern view looks at purpose or object
  Vote-buying here not illegal since object was not to defraud or disenfranchise other stockholders but to
    further interest of all Texas Int’l stockholders – though it was voidable until cured by shareholder approval
    Also, shareholders are perfectly able to vote selfishly and against interests of corporation

7.7.3 – Controlling Minority Structures
      Three more widely accepted structures to separate control rights from cash flow rights than vote-buying or
       circular control rights – dual class share structures, stock pyramids and cross-ownership ties
     Dual Class Share Structure – issue two or more classes of stock with differential voting rights
       Only structure suitable in US since income tax imposed on inter-corporate dividends and ICA
       Still rare in US since NYSE historically would not list such stock and often less valuable in IPO’s
       Often adopted midstream by charter amendment requiring shareholder vote – benefit for loss of vote
     Corporate Pyramid Structure – in a pyramid of two companies, a controlling minority shareholder holds
       controlling staking in holding company that, in turn, holds a controlling stake in an operating company
       3-tier pyramid where controlling minority shareholder holds 50% of shares – 12.5% cash flow rights
     Cross-Ownership Structure – companies linked by horizontal cross-holdings of shares that reinforce and
       entrench the power of central controllers – advantage of making locus of control less transparent
       For example, three companies each own 20% stakes in each other to keep ownership from public
       These structures are very common in France – permits set of boards to control (making public irrelevant)
       Ineffective from tax perspective in U.S. since must pay tax on dividends distributed between companies
               Federal law prohibits banking and insurance companies (huge players) from buying large stakes

7.8 – The Collective Action Problem
      When vote, no one expects his votes to matter – no incentive to monitor firm’s affairs and vote intelligently
      Managers serve information-generating function, so voters delegate to them and endorse their decisions
      Institutional investors can overcome incentives for passivity and engage in monitoring due to large shares
       Given proxy rules and desire not to be sued these institutions don’t start or engage in proxy fights
     Large institutions, because they own stock in many firms, can realize economies of scale in monitoring
     Legal rules as a whole tend to discourage shareholder oversight – some decisions intentional/political
     Collective action problem adds to risk that BOD will do things other than what’s in shareholders interests

7.9 – The Federal Proxy Rules
       Everything in the proxy rules is governed by §14(a) of the Securities Exchange Act
       The SEC has been delegated authority to implement it so we actually look at Regulation 14A
       14a-1(l)(iii) – defines a very broad standard of solicitation to establish large range control to regulate it
         “Furnishing of a form of proxy or other communication to security holders under circumstances
            reasonably likely to result in the procurement, withholding or revocation of a proxy”
         Must give every person to whom communicating with a proxy statement – expensive to produce
         If put ad in mass media then assumed to be directing at all shareholders so must send a proxy to everyone
       14a-2 – exempt when delivering a proxy statement as long as not asking for a proxy card
         Also when number solicited not more than ten or ordinary shareholders and don’t intend to seek proxy
       14a-3(a) – no one may be solicited for a proxy unless they are, or have been, given a proper proxy statement
       14a-4(d) – can’t confer authority to vote at any future meeting or to consent to any unauthorized action
         Proxies can be changed up to the last moment or withdrawn at any point

                                                                              Spring 2005 Corporations – Coates p. 32
         Incumbent BOD knows who’s voting how and when before meeting starts based on proxies
         Opportunities for gamesmanship by BOD to call parties before meeting, change time, etc.
       14a-6 – anything you send to shareholders you must also file with SEC
         Before you mail it and must give SEC an opportunity to tell you they don’t like it
       14a-6(g) – if over $5 million shareholder and interested must at least make a comment
       14a-7 – list-or-mail rule requires company to provide shareholder list or mail dissident’s proxy statement
       14a-8 – town meeting rule – entitles shareholders to include proposals in company’s proxy materials
         To be eligible to submit proposal must have held $2K or 1% for at least one year prior to submission
         Can advance proposal for vote by shareholders without filing with SEC or mailing materials
         Provides number of specific grounds to permit corps to exclude these – e.g., ordinary business
                  Court have interpreted this to only exclude very basic business – not environmental, political, etc.
         Typically fall into two broad categories: (1) corporate governance (2) corporate social responsibility
                  Corporate governance frequently passed if written well – often urge bylaw amendments
                  Coates would like to see more of these proposals arise by lawyers teaming up with hedge funds
         Can also send signals to BOD by voting for non-binding proposals – possibly proxy fight later
                  If BOD does not comply with request, may attract a hostile takeover (e.g., Disney)
                  Nuns bring the most proposals though typically get almost no support (at least at first)
                  Environmental groups get highest level of support (25-40%) though still rarely pass
       14a-9 – False or misleading statements are forbidden on proxy statements
         C/L fraud principles don’t require one to paint the whole picture – just don’t lie
         Courts have held that this rule forces a party who wishes to engage in proxy solicitations to hire a lawyer
            to sit down and draft statements that disclose everything related to issue addressed
         Anyone who has an interest in the company (e.g., BOD, shareholders, etc.) can sue under this rule
       14a-12 – solicitation may be made before furnishing security holders with a proxy statement if description of
        interests, prominent notice to read proxy statement when available, proxy statement sent to shareholders, etc.

Problem on p. 216
 TarPERS is considering a proxy campaign to elect 3 new directors to HLS’s 9-member BOD
    50% public shares owned by mutual funds, pension funds, banks, insurance companies, PE/VC funds
 Wants to test by circulating memo outlining prospective campaign to 15 other institutions with 15% stock
 Advise the TarPERS trustees on the difficulties they may expect to confront
 Not exempt under 14a-2(b)1 since they would like to have a vote at some point
 Under 14a-12 allows solicitation prior to a proxy statement as long as certain formalities are complied with
    Minimal disclosure to recipients, send materials to SEC, and send proxy statement before any cards sent

Chapter 8 – Normal Governance: The Duty of Care
8.1 – Introduction to the Duty of Care
      Shareholders’ right to elect directors and sue are not the law’s only strategies for corporate governance
      Fiduciary standards also play a role in normal governance – goals of a fiduciary are three
       Duty of obedience – must act consistently with legal documents that create authority (e.g., charter)
       Duty of loyalty – must exercise authority in good-faith attempt to advance corporate purposes
              Bars directors/officers from competing with the corporation; appropriating property, information,
                  or business opportunities; and especially from transacting business with it on unfair terms
       Duty of care – must act with “care of an ordinary prudent person in same or similar circumstances”
              Duty of care litigated much less than duty of loyalty since law insulates officers/directors from
                  liability based on negligence in order to avoid inducing risk-averse management of the firm
     Unlike agents, directors have come up with numerous safeguards to protect themselves from liability

                                                                               Spring 2005 Corporations – Coates p. 33
      Coates says it would be tough to find ten successful cases in any one state in the past twenty years
     The formal statement of duty is taken relatively seriously by directors in practice – despite lack of liability

 Four questions to keep in mind as we cover this material
  What is the formal statement of duty?
  What rules have courts created to govern how likely or under what circumstances a director will be liable?
  Who can sue (under what circumstances and using what procedural techniques) – any shareholder
  To what extent can contracting alter the way the duties play out in practice?

8.2 – The Duty of Care and the Need to Mitigate Director Risk Aversion
   ALI’s Principles of Corporate Governance requires director/officer to perform functions
    (1) in good faith
    (2) in manner he reasonably believes to be in best interests of corporation [positive NPV], and
    (3) with care that an ordinary prudent person would reasonably be expected to exercise in circumstances
  General expectations include staying informed, attending meetings, asking questions, requesting analyses

 Ovitz Example
  Disney’s BOD agreed to lucrative golden parachute contract with Ovitz – over $100 million when removed
  Many members admitted that they never realized what they were agreeing to when agreed to terms
  Unlikely that the BOD will be held personally accountable for actions despite failure to inform themselves

 DGCL Statutes About Contracting Around Duty of Care
  §102(B)7 – directors don’t have liability for “duty of care” violations (does not cover officers or injunctions)
    Most public companies do not have this clause – no exculpation – so they turn to the next statute
  §145(A),(B) – may indemnify employees’ expenses in suit arising from good faith actions in firm’s interests
    Not as good at exculpation (where suit just dismissed) since have to worry about collecting fees
  §145(C) – directors/officers shall be indemnified for expenses (and attorneys fees) if defense successful
  §145(F) – authorizes corps to purchase insurance policies for directors and officers
    Still doesn’t cover outrageous acts and having insurance may attract nuisance lawsuits – 15% don’t have
  §145(G) – firm can buy insurance on behalf of directors, officers and employees even if couldn’t indemnify
  §172 – directors and committee members are fully protected in relying on records and data from personnel

 Insulation from Liability Based on Negligence
  Rule provides that where a director acts in an independent, disinterested and informed way, there can be no
     liability for corporate loss, unless behavior outrageous – standard almost entirely procedural (use one or not)
    Directors have small proportionate ownership interest in corp and little to no incentive compensation
    Since enjoy only small fraction of the gains, would be risk-averse if held personally liable for losses
              Would otherwise act very cautiously – only invest where large upside and minimal downside
  Law protects corporate officers and directors from liability for breach of duty of care in many ways
    Statutory law authorizes corps to indemnify expenses incurred when sued by reason of corporate activities
    Statutory law authorizes corps to purchase liability insurance for their directors and officers
    Courts have long evolved the protection of the so-called Business Judgment Rule
    Legislatures authorize companies to waive director (and sometimes officer) liability for acts of negligence

8.3 – Statutory Techniques for Limiting Director and Officer Risk Exposure
     Statutory authorization for corps to indemnify losses and purchase insurance provide reliable protection

8.3.1 – Indemnification
     Most corporate statutes prescribe mandatory indemnification rights for directors and officers – allow more

                                                                              Spring 2005 Corporations – Coates p. 34
     Generally authorize corps to reimburse any agent, employee, officer or director for reasonable expenses for
      losses of any sort arising from any actual or threatened judicial proceeding or investigation
      Must result from good faith actions undertaken on behalf of corporation and no criminal conviction

Waltuch v. Conticommodity Services, p. 243, 2nd Circuit, 1996
  P spent $2.2 million on un-reimbursed legal fees to defend himself against several job-related civil lawsuits
  Court held P not entitled to indemnification under D’s articles of incorporation – even though it does not
    require good faith – since articles inconsistent with §145(a) that requires good faith and in corp’s interests
  However, court held P entitled to indemnification under §145(c) that affirmatively requires corporations to
    indemnify its officers and directors for the “successful” defense of certain claims
    Dismissal of P’s suit without having paid a settlement equals success – not court’s business to ask why

8.3.2 – Directors and Officers Insurance
     Group policies financed by corp pledge to make whole directors who suffer losses from good-faith decisions

8.4 – Judicial Protection: The Business Judgment Rule
     BJR – courts should not second-guess good-faith decisions made by independent and disinterested directors
      Courts won’t decide if board’s business decisions are good as long as good faith and reasonably informed
      Cuts the cases off at pleading stage – P will not even get to discovery if alleged conduct falls under BJR
      Alternative would involve the courts in deciding how corporations should be properly managed
      Exceptions – BOD uninformed, engaged in illegal activities, ignored red flag, made egregious violation

Kamin v. American Express, p. 248, New York, 1976
  AMEX purchased large stake in DLJ in 1972 – peak of stock market – and recession immediately ensued
  Three years later AMEX decided it had to get rid of DLJ – if sold at loss could have gotten tax deduction
    Instead AMEX decided to spin the company off and distribute in dividends – very poor NPV decision
  Shareholder derivative suit by two minority shareholders asked for declaration that dividend wasted assets
    No claim of fraud or self-dealing, and no contention that there was any bad faith or oppressive conduct
  Held that courts will not interfere unless powers have been illegally or unconscientiously executed; or unless
    it be made to appear that the acts were fraudulent or collusive, and destructive of the rights of stockholders
    Mere errors of judgment are not sufficient grounds for equity interference – mgmt powers discretionary
    Courts have more than enough to do – board room is place for thrashing out business questions
  Question whether or not a dividend should be declared is exclusively a matter of business judgment for BOD

8.4.1 – Understanding the Business Judgment Rule

 Three Mysteries of the Business Judgment Rule
  1) What exactly is the rule? – no canonical statement of the rule
    ABA says that a decision constitutes a valid business judgment when it (1) is made by financially
       disinterested directors or officers (2) who have become duly informed before exercising judgment and (3)
       who exercise judgment in a good-faith effort to advance corporate interests
  2) Why is the rule necessary at all? – if passes requirements how could liability result? It probably can’t.
    Procedural – converts what would otherwise be question of fact into question of law – judge not jury
    To change question from whether standard of care breached to whether directors’ conduct meets elements
  3) Why announce a legal duty to behave as a reasonable director but apply rule that no good-faith decision
    gives rise to liability as long as no financial conflict of interest is involved?
    Pedagogic function of informing directors just what “doing the right” thing means under circumstances

                                                                           Spring 2005 Corporations – Coates p. 35
8.4.2 – The Duty of Care in Takeover Cases: a Note on Smith v. Van Gorkom
    Shareholder claimed BOD did not act in informed manner in agreeing to deal even though large premium
    Court held that directors had been grossly negligent in decision making so couldn’t claim protection of BJR
    The very few prior cases imposing liability for breach of duty of care were failed attempts to prevent fraud

8.4.3 – Additional Statutory Protection: Authorization for Charter Provision Waiving Liability
    After Smith v. Van Gorkom, DE passed §102(b)7 – validated charter amendments that provide that directors
     have no liability for losses from transactions in which they did not breach a duty of loyalty or commit acts or
     omissions not in good faith or that involve intentional misconduct or violations of law – >90% corps have

 McMillan v. Intercargo Corp., p. 256, Delaware, 2000
  Stockholders sued directors for breach of fiduciary duty in sale of Intercargo for $12/share
  Certificate of incorporation had provision immunizing directors from liability for due care violations
    Exculpatory provision authorized by DGCL §102(b)7 – court gives sympathetic treatment to statute
  Court thus stated P’s must show directors breached duty of loyalty by engaging in intentional, bad faith or
    self-interested conduct that is not immunized by the exculpatory charter provision
  Court held standard not satisfied – not courts role to determine whether a public approach to selling a
    company or a more discreet approach relying upon targeted marketing by an investment bank is better

8.5 – The Technicolor Case and DE’s Unique Approach to Adjudicating Due Care Claims
    DGCL §102(7) still permits directors to be held personally liable for breaches of due care if bad faith
    Moreover waivers are directed to damage claims – directors duty of care still can be basis for equitable order

 Cede & Co. v. Technicolor, p. 260, Delaware, 1993
  Entrepreneur purchased Technicolor – characterized as arguable breaches of duty of care by BOD
    Shareholders had received full value for stock – earlier appraisal suggested purchase price was premium
  SC held that a breach of either the duty of loyalty or the duty of care rebuts the presumption that the
    directors have acted in the best interests of the shareholders – requires directors to prove transaction fair
  P’s burden of proof met by showing directors failed to inform themselves fully prior to merger agreement
    Court thus held that causation of damages not required to show BOD breached duty of care
    Rather, when fiduciary duty breached BOD must show conduct fair – fiduciaries held to higher standard
  Thus, SC departed from traditional approach – requiring showing of duty, breach, proximate cause and
    injury – to one that if P succeeds in establishing prima facie case of board negligence, then instead of being
    required to also establish causation and damages, the directors must prove either due care or fairness
    Reformulation of proximate cause burden is less protective of directors than traditional approach
  Interestingly found that BOD acted in grossly negligent way but that transaction was in shareholder interest

Emerald Partners v. Berlin, p. 264, Delaware, 2001
  SC held standard of review for transaction where controlling shareholder is interested is “entire fairness”
  Moreover, under the Technicolor rule the directors had the burden to prove fairness, so it was a mistake for
   the court to render judgment in their favor without addressing the issue

8.6 – The Board’s Duty to Monitor: Losses “Caused” by Board Passivity
    Directors’ incentives less likely to be distorted by liability imposed for passive violations of standard of care
    Not surprising that actual liability more likely to arise from failure to supervise or detect fraud than decisions
    However, liability for large losses would financially destroy directors and make board service unappealing
    This section focuses on three cases dealing with directors charged with breaching duty of care by not
     sufficiently monitoring the corporation and thus not preventing a loss that the corporation incurred

                                                                             Spring 2005 Corporations – Coates p. 36
 Francis. v. United Jersey Bank, p. 266, New Jersey, 1981
  Sons took over corporation (3 directors) and drew increasingly large “loans” until the firm went bankrupt
    Borrowed funds from flow of premiums involved in reinsurance business – sons stopped paying back
  Trustees in bankruptcy sued mother’s estate for her negligence in duties as director of corporation
    Not active in business and knew virtually nothing of its corporate affairs – never read financial statements
    However, she would have been outvoted by sons 2-1 and hard for her to sue sons on behalf of corporation
  Court held mother liable since P established mother 1) negligent and 2) negligence proximate cause of harm
    Directors under continuing obligation to keep informed about activities of corporation and go to meetings
    Not required to audit corporate books, but should regularly review financial statements
    Proximate cause since her consultation with an attorney and threat of suit would have stopped loans
  Court thus held that directors have duty to reasonably monitor corporation and actively resist when fraud
    Mother should not be a director if couldn’t understand corporation’s finances – not much asked for here
  Case reflects majority view of a minimum objective standard for directors – can’t abandon their office but
    must make a good-faith attempt to do a proper job
    Fiduciary duties most frequently enforced by creditors in cases of closely held corporations
    Alternatively, often enforced when company sold and purchaser discovers prior improper management

Smith v. Van Gorkom, p. 513, Delaware, 1985
  One of most cited cases in duty of care context – rare decision to hold BOD personally liable for millions
  Van Gorkom – CEO of Trans Union – approaching retirement and decided no capable internal successor
  Turned to respected take-over specialist who agreed to purchase for near 50% premium – 89% SH approved
    No negotiation between CEO and specialist – CEO simply stated a price and specialist quickly agreed
    Deal signed at opera; 20 min pres to BOD; no merger agreement; told BOD he would solicit offers
    BOD meeting to discuss merger lasted just two hours – BOD should have asked detailed questions
    CEO had turned down offer by management to buy out company – no other employees knew of this deal
    Completely cash transaction so all shareholders were bought out – no remaining shareholders
  Shareholders brought class action against Trans Union seeking rescission of cash-out merger
  DE Supreme Court held BOD “grossly negligent” in approving the corporation’s sale – liable for $50MM
    Van Gorkom chose price independent of consultations with investment bankers or lawyers
    Company valuation should be led by BOD not CEO – should involve negotiation or even an auction
    Mental note – don’t sign a major transaction at an opera (appears to be outside normal course of business)

  Major transactions now require two meetings, analysis by I-bankers, BOD questioning, scripted process, etc.
    State statutes require synopsis of minutes from BOD meetings – not verbatim as lawyers will use them
    Not an issue now since once courts require boards to do this (e.g., ask questions) they tend to follow suit
  Insurance premiums went up 800% in a year, many couldn’t get it all, directors started quitting boards, etc.
  Thus Delaware passed §102(b)7 a year later – can remove director’s liability for “duty of care” violations
    Boards still follow processes articulated by Court here – hire I-bankers, hold meetings, ask questions, etc.

Graham v. Allis-Chalmers Manufacturing, p. 271, Delaware, 1963
 Employees at a very large, decentralized manufacturing company pled guilty to anti-trust violations
 P’s charged that directors, even without any knowledge or suspicion of wrongdoing, still should have put into
   effect a system of watchfulness that would have brought such misconduct to their attention in time to fix it
 Court held that absent cause for suspicion there is no duty upon the directors to install and operate a corporate
   system of espionage to ferret out wrongdoing which they have no reason to suspect exists
 Further held that directors not liable for losses since neglect of duty determined by circumstances
    Didn’t recklessly repose confidence in obviously untrustworthy employee, refuse or neglect cavalierly to
       perform duty as director or ignore (willfully or through inattention) obvious danger signs of wrongdoing

                                                                           Spring 2005 Corporations – Coates p. 37
     Current BOD not under an ongoing duty to monitor corporate activity that occurred ten years ago
   Red Flag Doctrine – BOD has no duty absent a red flag; however duty to investigate if a red flag arises
   No use of business judgment rule since no action but rather an omission – BJR only applies to actions

Practical Duty to Monitor
 BOD can’t be expected to micromanage thousands of employees throughout a decentralized organization
 Thus their duty to monitor involves educating management, internal audits, hotline, compliance czar, etc.
 FCPA §13(b)2 of SEA – every public company must have a system of internal controls to ensure that money
   is spent for legitimate purposes – can no longer claim ignorance as an excuse
 SOX §404 – goes further by requiring disclosure controls to ensure SEC disclosures accurate and complete
 CEO Certification – must personally certify that financial statements are accurate/complete and that the
   company’s disclosures set forth any deficiency in its control system the company has uncovered
 Increased funding requirements for large companies justified since public confidence lowers cost of capital

Emergence of Federal Organizational Guidelines
 Set forth uniform sentencing structure for organizations convicted of federal criminal violations
 Create greater monetary penalties and offer powerful incentives for firms to put compliance programs in place
   Much less likely to incur significant monetary penalties if firm can demonstrate compliance programs
   Now less likely that a court will pass over a board’s failure to implement a legal compliance program

In Re Caremark International, p. 276, Delaware, 1996
 Directors notified that employees may be violating Anti-Referral Payments Law
 Subsequently took several steps to assure compliance – internal audit by PWC, new internal charter, etc.
 P’s sued asserting that directors allowed a situation to develop and continue that exposed the corporation to
    enormous legal liability and that is so doing they violated a duty to be active monitors of performance
 Court set lack of good faith standard as sustained or systematic failure of the board to exercise oversight
     Directors have a duty to take reasonable steps to see that the corporation has in place an information and
        control structure designed to offer reasonable assurance that the corporation is in compliance with the law
 Held that P’s offered no evidence that D’s were guilty of sustained failure to exercise their oversight function
     On contrary, corporation’s information systems appear to be good faith attempt to be informed of facts

8.7 – “Knowing” Violations of the Law

Miller v. AT&T, p. 282, 3rd Circuit, 1974
 AT&T failed to collect outstanding debt of some $1.5 million owed by the DNC for communication services
    Corporations are forbidden from contributing to federal election campaigns – Tillman Act
 Stockholders brought a derivative action against AT&T and all but one of its directors
    Alleged firm’s failure to collect involved a breach of directors’ duty to exercise diligence in handling
        affairs of the corporation, leading to a violation of the federal prohibition on corporate campaign spending
 Court held complaint stated claim upon which relief can be granted as it alleged actual damage in form of loss
 Business judgment rule does not cover illegal acts – directors still liable if they violate the law
    Should shareholders be able to sue when BOD acts in their interests via acts that may possibly be illegal?
 Business judgment rule would prohibit alleging just failure to pursue corporate claim – directors’ decision
    The BOD can certainly just sit there and take zero risks – BJR prevents shareholders for suing them

Section 9 – Conflict Transactions: The Duty of Loyalty
   The duty of loyalty is core of fiduciary doctrine – not “weak” like mild controls on BOD to make decisions
     Requires director, officer or controlling shareholder to act in good-faith effort to advance firm’s interests

                                                                            Spring 2005 Corporations – Coates p. 38
     These individuals may not deal with the corporation in any way that benefits themselves at its expense
     Coates says deterrent effect of self-dealing doctrine (possibly even criminal) are only effective standards
   The business judgment rule certainly does not apply when conflicts of interest exist (e.g., self dealing)
   Directors and officers owe their duty to the corporation – legal fiction – rather than solely to shareholders
   Corporate law in every jurisdiction imposes specific controls on two classes of corporate actions
     Those in which a director or controlling shareholders has a personal financial interest
     Those that are considered integral to the continued existence or identity of the company
   This chapter focuses on former – self-dealing transactions, corporate opportunities, compensation, etc.

9.1 – Duty to Whom?
   Corporation has multiple constituencies with conflicting interests – employees, creditors, suppliers, etc.
   Question of whose interests count very important when firm faces insolvency or terminal transaction

9.1.1 – The Shareholder Primacy Norm
   Important theme in US corporate law is that director loyalty to corporation means loyalty to equity investors
   Dodge v. Ford Motor – held that Ford’s directors had wrongfully subordinated shareholder interests to
    consumers by holding back dividends to share success with public – few cases enforce shareholder primacy
   Shareholder primacy notion has not eclipsed norm that directors must act in interests of all constituencies
   Prior to the LBO wave in 80’s, conflict generally arose in context of corporate charitable giving

A.P. Smith Manufacturing v. Barlow, p. 288, New Jersey, 1953
 Court upheld small grant to Princeton since no suggestion that it was made indiscriminately or to pet charity
 Rather it was made to a preeminent institution of higher learning, was modest and within statutory limitations
    Such giving was public policy of state; capped grant at 1% of capital and surplus unless authorized by SH

In-Class Hypothetical – Use Corporate Funds to Support Non-Profit
 CEO gets BOD to agree to construct building for non-profit and support it for 30 years at company’s expense
 How can shareholders attack this transaction?
 Argue BOD violated duty of loyalty by supporting pet charity – though seems to fall under BJR
    Don’t get to “fairness test” since must show BJR doesn’t apply – this doesn’t fall within any exception
 Argue transaction equals corporate waste – exchange of assets for consideration so disproportionately small
   as to lie beyond the range at which any reasonable person might be willing to trade
    Doctrine of waste generally only works where funds flow directly to CEO – not to legitimate non-profit
 Settlement – firm’s name on building rather than CEO’s, charity promotes firm’s name, spots on BOD, etc.
 Thus very hard to sue directors for conduct that can conceivably benefit the corporation in some way

9.1.2 – Constituency Statutes
   Say that directors in carrying out their duties may (not must) consider other groups beyond just shareholders
     Includes creditors, shareholders, managers, workers, suppliers and customers
     DE does not have one of these statutes, however case law adheres to this general principle
   Makes it difficult to sue directors for failure to act in corporation’s interests – acting in some parties’ interests
   Uniquely important in hostile takeovers where directors try to block deal – costs shareholders in short term
     If financial interests the only variable then boards would be compelled to sell company if sold at premium

9.2 – Self-Dealing Transactions
   Directors and officers may not benefit financially at the expense of the corporation in self-dealing transactions
   Early 20th century, court would uphold self-dealing if fair and approved by board of disinterested directors
     An interested director’s presence didn’t count toward a quorum on question in which he was interested
   Good reason to make some binding – knowledgeable directors might offer better terms than anyone else
   Next stage was mid-20th century movement to enact “safe harbor” statutes

                                                                               Spring 2005 Corporations – Coates p. 39
   Bright Line Rule – directors can’t engage in self dealing transactions unless 1) disclosure and 2) fairness
   Students often see more self-dealing than actually exists – test is not just whether person benefited
     Purchase and sale between corporation and fiduciary of assets, stock, etc. raises duty of loyalty concerns
     Purchase of company jet to take CEO to board meeting in Hawaii is not self-dealing
     CEO choosing to hire his nephew to run division not self-dealing – business judgment; no kickback
     CEO decides to stop advertising on violent station is not self-dealing – between corporation and network
   Test – Is there a direct movement of assets or money between a fiduciary and the corporation?

9.2.2 – The Disclosure Requirement
   Valid authorization of self-dealing requires interested director to make full disclosure of material facts at time

Hayes Oyster v. Keypoint Oyster, p. 294, Washington, 1964
 Coast Oyster in financial trouble so CEO got BOD to sell oyster beds to new company – Keypoint
    CEO didn’t disclose to the BOD that he would own 50% of Keypoint (they only knew of other partner)
 Coast’s managers sued CEO for his Keypoint shares and all profits obtained by him as result of transaction
 Court held that CEO was required to divulge his interest so managers entitled to compensation claimed
    Rejected P’s assertion that lack of disclosure immaterial since transaction fundamentally fair
    Not necessary to prove the CEO acted with intent to defraud or that any injury resulted to the corporation
    Fairness requires demonstrating 1) fair price and 2) full disclosure in process – latter lacking here
 Note – directors may not be indemnified by the corporation for violations of a duty of loyalty
    Intentionally and knowingly violating disclosure provisions can lead to criminal prosecution

   Item 404 p. 1652 – disclosure requirements for companies about certain relationships and related transactions
     If self-deal transaction exceeds $60K must include in annual proxy statement sent to shareholders
     Self dealing perfectly legitimate and occurs frequently – just have to satisfy disclosure requirements

9.2.3 – Controlling Shareholders and the Fairness Standard
   Corporate law has long recognized a fiduciary duty on part of controlling shareholders
     Less than 50% of voting power may have duty; over 50% likely will have such a duty
     Controlling shareholders owe a duty of fairness to minority shareholders

Sinclair Oil Corp v. Levien, p. 299, Delaware, 1971
 3% minority shareholders sued majority shareholder (Sinven) asserting that BOD was paying dividends to
    fund its cash flow requirements at the expense of Sinclair – no maintenance of assets so company dilapidated
 Court held that intrinsic fairness standard applied only when fiduciary duty is accompanied by self-dealing
     While parent does indeed owe a fiduciary duty to subsidiary, this alone does not evoke fairness standard
 Paying dividends is not self-dealing because the minority shareholders received a pro rate share of benefits
     Fairness review only required if parent gets something at exclusion of subsidiary’s minority shareholders
 Therefore, BJR is applicable (not fairness) and dividend payments meet this standard – mgmt judgment
     Sinclair’s decision – absent fraud or gross negligence – to pay dividends to finance expansion upheld

Sinclair in Relation to Corporate Opportunity Doctrine
 In general, courts are extremely deferential to dividend payments – otherwise suits would arise all the time
 Court did not find corporate opportunity issue – rather applied the business judgment rule
     Sinclair had subs in other countries; forcing Venezuelan sub to invest elsewhere would create competition
     Alternative would greatly diminish value of creating subs – increase WACC and piss off Sinclair’s SH
 As long as parent company is acting in a reasonable way, subsidiary’s shareholders can’t get around BJR
 Hard for sub’s SH to sue under corporate opportunity doctrine based on how parent manages firm as whole
     Exception when sub being treated in some way that actually involves self-dealing – entire fairness applies

                                                                             Spring 2005 Corporations – Coates p. 40
9.3 – The Effect of Approval By a Disinterested Party
   Principal legal question concerns standard of review after disinterested review and approval

9.3.1 – The Safe Harbor Statutes
   Initially sought to permit boards to authorize transaction in which major of directors had an interest
   DGCL §144 – a director’s self-dealing transaction is not voidable solely because it is interested, so long as it
    is adequately disclosed and approved by a majority of disinterested or shareholders, or it is fair
     Courts have refused reading statutes to mean never voidable if disclosed and either approved or fair

Cookies Food Products v. Lakes Warehouse, p. 303, Iowa, 1988
 Cookies founded in 1975 to produce and distribute BBQ sauce; early sales of the product were dismal
 BOD authorized Herrig to purchase sauce for 20% discount to resell through other businesses
 Sales soared over next several years until founder wanted out; Herrig bought out stock and replaced directors
    Extended term of exclusive distributorship agreement
    Developed recipe for taco sauce – BOD approved royalty fee for more money than BBQ sauce
    BOD twice approved additional compensation for Herrig – special consultant fee in lieu of salary
 Court still evaluates fairness of deal despite BOD approval – BJR inapplicable since controlling shareholder
    Burden on director to show (1) fair price and (2) fairness of bargain to interests of the corporation
 Court held no evidence that Herrig’s services were unfairly priced or inconsistent with corporate interest
 Dissent – Herrig did not show that prices for his services were fair; can’t succeed by showing successful

9.3.2 – Approval by Disinterested Members of the Board
   DGCL §144(a)1 – no self-dealing contract or transaction shall be void solely for this reason if material facts
    disclosed and majority of independent directors in good faith approve transaction even if less than a quorum
   Under established DE law, approval by disinterested directors merely shifts burden of proving fairness in
    controlled transaction to P challenging the deal – it does not transform the standard of review to the BJR
   Two reasons why such a transaction should be subject to some sort of fairness test
     Directors are unlikely to treat one of their number with same degree of wariness as would third party
     Difficult to utilize legal definition of disinterestedness that corresponds with factual disinterestedness
   But an interested transaction between a company and a single director who is neither a top manager nor a
    controlling shareholder does not pose same dangers – courts thus more deferential to independent board

Cooke v. Oolie, p. 311, Delaware, 2000
 P’s alleged D’s failed to act with disinterest and independence and therefore don’t deserve protection of BJR
 Court noted that even assuming this, the transaction was further approved by two disinterested directors
 DGCL §144(a)1 – BJR applies to action of interested director – who is not majority shareholder – if the
   interested director fully discloses his interest and majority of disinterested directors ratify transaction
    Court stated that it will presume that vote of disinterested director signals interested transaction furthers
       the best interests of the corporation despite the interest of one or more directors – granted SJ for D’s
 Note – if terms of deal are sufficiently egregious court will require D to show transaction was fair to company

9.3.3 – Approval by a Special Committee of Independent Directors
   Parent companies have clear obligation to treat subsidiaries fairly and expect scrutiny in shareholder lawsuits
   Techniques that assure appearance and reality of fair deal are useful in supporting such transactions
   Special committee of disinterested independent directors is the most common such technique
   Delaware law requires committee to be property charged by full board, comprised of independent members
    and vested with resources to accomplish its task – almost always will retain I-bankers and lawyers for advice
   Even if process done well, only shifts burden of proving fairness to P in a controlled transaction

                                                                             Spring 2005 Corporations – Coates p. 41
9.3.4 – Shareholder Ratification of Conflict Transactions
   Shareholders may ratify acts of the board, however presents issues not present in agency model
     Law must limit power of interested majority of shareholders to bind minority that may oppose transaction
     Power of shareholders to affirm self-dealing transactions limited by corporate “waste” doctrine

Lewis v. Vogelstein, p. 315, Delaware, 1997
 Shareholder ratification may be held ineffectual because
    Majority of those affirming transaction had conflicting interest with respect to it or
    The transaction that is ratified constituted corporate waste
 Waste entails an exchange of corporate assets for consideration so disproportionately small as to lie beyond
   range at which any reasonable person might be willing to trade – often used when serves no corporate purpose

In Re Wheelabrator Technologies, p. 316, Delaware, 1995
 Ratification decisions that involve duty of loyalty claims are of two kinds
 1) Interested transaction cases between a corporation and its directors
     §144(a)2 – approval by majority of fully informed, disinterested shareholders invokes the BJR and limits
       judicial review to issues of gift or waste with the burden of proof upon the party attacking the transaction
 2) Interested transaction between the corporate and its controlling shareholder
     Involve primarily parent-subsidiary mergers conditioned on receiving majority of minority SH approval
     In parent-subsidiary merger SOR is ordinarily entire fairness – directors have burden to show merger fair
     Where conditioned and approval granted – standard remains fairness but burden shifts to the P

9.4 – Director and Management Compensation
   Technically speaking compensation to directors and officers is “self-dealing” but of course treated differently
   Designing a system that balances productivity gains resulting from high-powered incentives against additional
    monitoring and governance costs that these incentives impose is a task that demands great expertise
   Corporations prefer stock compensation to salary because it creates incentives to increase shareholder value
     Issuance of stock dilutes EPS since more outstanding stock on books; but less salary increases cash flow
     Options tax favored over stock and have an accounting benefit – don’t dilute EPS unless “in the money”
     Options are not treated as an expense when they are issued – FASB is trying to change this
     Lack of certainty of value of options camouflages executive compensation – creates less scrutiny
   Management prefer salary since stock creates risk – can’t control all externalities (e.g., wars, embargoes)
   Call option – right to buy something at a specified price – “strike price”
     “Intrinsic value” of an option equals [market price] – [strike price]
             “At the Money” – strike price = current market price
             “In the Money” – strike price < current market price
             “Out of the Money” – strike price > current market price
     “Actual value” of an option can be much more than intrinsic value
             Black-Scholes model factors in volatility of stock, duration to exercise it, discount rate, etc.
             Stocks with more volatility have greater option value – more likely to greatly exceed strike price
   Stock options thus create incentive for CEO’s to engage in risky behavior – just won’t exercise if price falls
   §141 – BOD has the discretion to determine executive compensation – thus no SH approval to grant options
     However, NYSE requires shareholder approval of all compensation plans that include stock options

Congress Has Influenced Executive Compensation through Two Measures
 Internal Revenue Code §162(m) – corporations may not deduct compensation over $1MM unless
    Compensation is performance-related and the plan is approved by majority of shareholders
 In 1992, SEC dramatically rewrote the disclosure rules for compensation – summary tables of top 5 officers
    Tables must show ALL types of compensation (options valued using Black-Scholes)

                                                                            Spring 2005 Corporations – Coates p. 42
       Must also include charts showing peer compensation and performance – peers chosen by BOD
            May actually increase CEO pay since each company wants to show its CEO is better than peers’

9.4.1 – Perceived Excessive Compensation
   Total compensation grew rapidly from 1994-1999; due to both increases in base and stock options
   Difficult to determine whether any particular CEO received excessive pay – senior officers not fungible
   Decreased job security of CEO’s recently suggests increase in compensation to balance risk / reward tradeoff
   CEO’s don’t own greater percentage of stock now – rather they have options that they exercise and cash out
   Compensation for CEO technically creates issues of duty of loyalty; not for independent directors – BJR
   Possible solutions – (1) link CEO pay to median worker pay; (2) accounting / tax modifications
     Expensing stock options unlikely to affect stock price; may influence BOD since would affect EPS

Anthony Ramirez – Reebok Chief Facing 93% Pay Cut
 Initial 1982 pay pact designed to minimize risk by paying low salary and 10% pretax earnings over $100K
 As Reebok’s earnings exploded so did CEO’s compensation – new deal $1MM base, up to $1MM bonus

9.4.2 – Option Grants and the Law of Director and Officer Compensation
   Compensation agreements not subject to ordinary law of director conflicts – still often ratified by SH or BOD
     Not subject to law since must pay compensation and courts are poorly equipped to determine fair salaries
   Courts at first reluctant with option compensation plans – threat of controllers issuing themselves cheap stock

Lewis v. Vogelstein, p. 322, Delaware, 1997
 Court held shareholder assent is a more rational means to monitor compensation than judicial determinations
   of fairness or sufficiency of consideration – classical waste standard protects against egregious cases of fraud
 Refused to say that no set of facts could be shown to permit it to conclude that granting options constituted an
   exchange to which no reasonable person not acting under compulsion and in good faith could agree

   Today, most compensation committees composed of “outside” directors – NYSE recently made mandatory
   DGCL §143 permits boards to authorize loans or guarantees when “benefits the corporation”
   Federal Sarbanes-Oxley Act of 2002 – prohibits any public corporation, or the subsidiary of such corporation,
    from directly or indirectly extending any credit to any director or officer of the corporation

9.4.3 – Corporate Governance and SEC Regulatory Responses
   In 1993 the SEC took steps to provide compensation info to public through amended disclosure rules
   Guiding principle is all elements of compensation of CEO and four highest paid execs must be fully disclosed
   Table divides into three categories
     Annual compensation – salary, bonus and other annual compensation
     Long term compensation – restricted stock awards, option awards and long term incentive plan
     All other compensation
   Require graph of company’s cumulative shareholder returns for preceding five years versus peers and indices
   Changes to NYSE listing standards in ’02 require companies to seek SH approval for all stock option plans
     Exception to rule for inducement to new employees or in connection with a merger or acquisition

9.5 – Corporate Opportunity Doctrine
   Distinctive branch of duty of loyalty involves when fiduciary may pursue business opportunity on own
    account if this opportunity may arguably “belong” to the corporation – described in standards not rules
   Chief questions that arise concern whether opportunity corporate, the circumstances under which a fiduciary
    may take a corporate opportunity, and the remedies available when fiduciary has taken one illegally

                                                                           Spring 2005 Corporations – Coates p. 43
9.5.1 – Determining Which Opportunities “Belong” to the Corporation
   Three general lines of corporate opportunity doctrine
     Expectancy or Interest Test – the expectancy or interest must grow out of existing legal interest and
       appropriation of the opportunity will in some degree block corporation in effecting purpose of its creation
     Line of Business Test – anything that a corporation could be reasonably expected to do
     Fairness Test – look at factors such as how manager learned of opportunity, use of corporate assets, etc.

9.5.2 – When May a Fiduciary Take a Corporate Opportunity?

 Corporate opportunity doctrine arises when a fiduciary may compete with his company over an opportunity
   Does the company have an interest in the opportunity?
   Has the fiduciary learned about the opportunity?
   Can the company pursue the opportunity?
 Even if a corporate opportunity is found to exist, a fiduciary may often still pursue it if
   Full disclosure to the company AND the company turns it down
 Thus no bright line test – rather courts looks at these factors to determine if duty of loyalty breached
 Most courts accept a disinterested board’s good-faith decision not to pursue an opportunity as a complete
  defense to a suit challenging a fiduciary’s acceptance of a corporate opportunity on her own account
   Critical issue is whether BOD evaluated the question of whether to accept the opportunity in good faith
 Issue arises frequently with VC firms – often involved in several competing companies; want spot on boards

Broz v. Cellular Information Systems, p. 332, Delaware, 1996
 Broz – CEO and sole shareholder of DE corporation – purchased a cellular license in MI for his corporation
    He also sat on BOD of CIS – could not afford license but potential acquirer would have been interested
 Court held that Broz not required to make formal presentation of opportunity to CIS board prior to taking it
    CIS not financially capable of buying license and was actively divesting its cellular licensing holdings
    Broz did tell several board members individually who told him CIS would not take the opportunity
    Broz did not actively compete with CIS for license but rather with an outside entity – PriCellular
 Court further held that Broz was under no duty to consider interests of PriCellular in his analysis
    Acquisition speculative; director must be allowed to make decisions on info that exists at given time
    Tender offer and binding agreement that merger would occur – courts still says deal must be final
 Note – rejection of a corporate opportunity by a CEO is not a valid substitute for consideration by BOD
    Had Broz presented opportunity to BOD at meeting and they declined, case would likely be dismissed

9.6 – The Duty of Loyalty in Close Corporations
   Characteristics of close corporations
     Generally have 2-30 shareholders; often termed “incorporated partnerships”
     Major issues for minority shareholders are (1) lack of a voice and (2) inability to sell shares
   In addition to relying on fiduciary duties, corps contract around these issues through several mechanisms
     Option – corporation can buy the stock of shareholders or sell the stock to other shareholders
     First Option – if a majority shareholder decides to sell shares, minority gets right to sell shares as well
     Right of First Offer/Refusal – if majority shareholder decides to sell shares, minority get first chance
     Buy/Sell Option – similar contract that results when partnership liquidated
   American corporate statutes provide enormous latitude to customize form of a close corporation (and an LLC)
     Explicit provision allows such corps to transfer power from BOD; not possible in regular corps
   Unified Corporations Statute – permits planners to contract around statutory provisions
     Other states provide specialized close corporation statutes in lieu of general corporation law

                                                                           Spring 2005 Corporations – Coates p. 44
Donahue v. Rodd Electrotype, p. 338, Massachusetts, 1975
 Rodd permitted majority shareholder to cash out stock but refused to offer minority shareholders same deal
    P asserted this conduct was self-dealing that breached the duty of loyalty; wanted same deal or rescission
 Court held that Rodd was a close corporation, which is typified by
    Small number of stockholders
    No ready market for corporate stock
    Substantial majority stockholder participation in the mgmt, direction and operations of the corporation
 Court held that majority shareholders in close corporation have more rigorous duty to minority shareholders
    Similar duty that partners and participants in a joint adventure owe one another from Cardozo opinion
 Reacquisition of own stock requires corporation act with utmost good faith and loyalty to other shareholders
 Purchase confers substantial benefits on members of controlling group – same benefits not available to others
 Thus the repurchase of controlling shares – and not minority’s – is breach of duty by controlling stockholders
    Court thus equated rules for stock buybacks with those for dividends – same for all shares
    Court offered two remedies – give D’s same deal on their stock or rescind the prior transaction
 Court in effect defined a new type of company, created a special fiduciary duty for it and then applied rule
    In other jurisdictions D’s could still assert that $800/share is too much – self-dealing that violates duty
 Note – can get $ out of companies via transactions (e.g., loans), dividends, stock buybacks and compensation

   Unsurprisingly, higher standard MA created in Donahue resulted in increase of cases brought
     Even shareholders in closely held corps may act selfishly or harm minority if in pursuit of legitimate
       business objectives and least harmful course of action to further that goal

Easterbrook and Fishel – Close Corporations and Agency Costs
 Fiduciary duties serve as implicit standard terms in contractual agreements that lower cost of contracting
    Should approximate bargain the parties would have reach had they been able to negotiate at low cost
 Should have greater judicial review in closely held corporations than would be consistent with BJR
    Actions have more impact on individual shareholders – firing employee can appropriate share of earnings
 Argues that court in Donahue overlooked what parties would have selected had they contracted in advance

Smith v. Atlantic Properties, p. 344, Massachusetts, 1981
 Wolfson purchased land with three other partners – each contributed equal share and incorporated
    Included provision in charter and by-laws that prohibited many actions without 80% approval
 Parties had a falling out so Wolfson continually refused to declare dividend – annual tax penalties
    IRS forces closely held corps to pay dividends to tax them – otherwise could accumulate and pass to heirs
 Court held that Wolfson recklessly ran serious and unjustified risks that were inconsistent with any reasonable
   interpretation of a duty of “utmost good faith and loyalty” – liable for penalty taxes and related counsel fees

   Delaware does not have “the utmost duty of care” – just has the regular duty of care – above cases from MA
     Majority shareholders only take on fiduciary duty if they dominate the BOD or mgmt of company

 Is there full disclosure to BOD?
 Is there a controlling shareholder or was the BOD dominated in some way?
    If no and BOD independently approves self-dealing – DE will apply the business judgment rule
    If yes and BOD independently approves self-dealing – DE will evaluate for fairness in price and process
 Factors of fair process analysis – full disclosure, who initiated the deal, timing of deal, were any other
   approvals obtained, BOD approval, disinterested shareholder approval – shifts burden
 Courts will scrutinize closely when lack of disclosure, large controlling interest, no independent checks, etc.

                                                                           Spring 2005 Corporations – Coates p. 45
Why Not Just Have a Rule that Prohibits Self-Dealing Altogether?
 Would block many very lucrative deals for the corporation – not in their best interests
 Insiders may also be more excited about providing capital to emerging organizations due to their knowledge
   Perhaps less persuasive after companies become large enough to gain public confidence for capital

Chapter 10 – Shareholder Lawsuits
Types of Suits
   Direct Claim – shareholders suing for wrongs suffered at the hands of the corporation (class actions)
     Likely grievances here would be fraud, taking away right to vote or contract rights, etc.
   Derivative Claim – shareholders suing on behalf of the corporation for harm done to the entity itself
     This is a large exception to BOD having full discretion over if/when corporation should sue; permitted if
             BOD is itself a defendant, or
             BOD agrees to the suit (never happens)
     Once derivative suit is settled, all other claims cannot be brought
     Fletcher Rule – lawyers can be paid fees as long as action brings some substantial benefit to corporation

10.2 – Solving a Collective Action Problem – Attorneys’ Fees and the Incentive to Sue

Quantity of Suits
 Collective action problem indicates that individual shareholders would not want to bring suits – little benefit
 Reality is that too many suits exist because they’re brought by lawyers who get contingency fees
    P’s attorneys are paid – or not – by order of court or as part of settlement at conclusion of litigation
 Key part of law is that first to file derivative action receives full control over action – usually trivial shares
    Lawyers thus have pre-existing lists of shareholders with friends, employees, etc. so can bring suit fast
 Even if claim lacks merit, directors averse to them – harm reputation, likely be deposed, firm pays lawyers
 Directors will thus seek to settle suit if motion to dismiss fails – merit of claim affects amount of settlement

 CEO purchases company stock for 90% of market value; shareholders want to bring suit; what kind?
 Test – what would be the ideal remedy to fix the unfair deal? Here company should get benefit so derivative
    Formally courts look at whether individual or company was harmed – less helpful as stock harmed in both

Fletcher v. A.J. Industries, p. 352, California, 1968
 Another type of agency problem – one group of shareholders taking away rights of other shareholders
 Benefits realized by the corporation must be sufficiently “substantial” to warrant award of attorney’s fees
     Results of action maintain health of corporation and raise standards of fiduciary relationships, or
     Prevents an abuse that would be prejudicial to rights and interests of firm or affect enjoyment or
        protection of an essential right to stockholder’s interest
 Derivative action alleged CEO had dominated BOD and mgmt, damaging corporation is some transactions
 Settlement agreement was reached that replaced four of nine directors and reduced CEO’s power greatly
 Trial court granted application for attorneys’ fees and costs – “substantial benefits conferred on corporation”
 Under the CA rule (1) award of attorney’s fees to a successful P may properly be measured by, and paid from,
    a common fund where his derivative action on behalf of a corporation has recovered or protected a fund in
    fact; but (2) the existence of a fund is not a prerequisite of the award itself
 Derivative suits effective means of policing mgmt – should not be inhibited by limiting compensation of
    successful attorneys to only cases that produce monetary recovery – non-pecuniary benefits very real
 Dissent – variety of shareholders’ action in which “substantial benefit” found is literally boundless

                                                                             Spring 2005 Corporations – Coates p. 46
Notes on Agency Costs in Shareholder Litigation
 Lawyers may initiate strike suits – without merit – to extract settlement by exploiting the nuisance value
    Directors want to settle since bear part of litigation costs (e.g., depositions) but not cost of settling suit
 Legal system itself can generate agency costs by structuring attorneys’ fees in dysfunctional ways
    Awarding percentage of recovery may encourage premature settlement
    Lodestar formula – alternative pays base hourly fee inflated by multiplier to account for difficulty or risk
           Creates opposite incentive to spend too much time litigating relative to settlement outcomes

10.3 – Standing Requirements
   Established both by statute and court rule – aimed at increasing quality of shareholder litigation
   FRCP 23.1 typifies standing rule for derivative actions
     Shareholder must be P for direction of action
     P must have been shareholder at time of alleged wrongful act or omission – can’t “buy a lawsuit”
     P must be able to “fairly and adequately” represent interests of shareholders – no conflicts of interest
     Complaint must specify what action P had taken to obtain satisfaction from BOD or state with
        particularity P’s reason for not doing so

Wall Street Journal Article
 Mr. Greenfield created virtual shareholder-litigation factory – 45 lawyers in 4 offices
 Files suits on behalf of clients with only nominal interest in companies – takes advantage of class-action
  procedures that allow judge to appoint first lawyer to arrive at courthouse to represent holders

10.4 – Rights of Boards to Manage v. Shareholders’ Rights to Obtain Judicial Review
   Demand Requirement – derivative complaint must allege with particularity the efforts, if any, made by the P
    to obtain the action he desires from the directors or comparable authority…or ground for not making effort

Levine v. Smith, p. 364, Delaware, 1991
 Derivate action against GM for transaction allowing Perot to sell back GM holdings worth $740 million
    Perot’s holdings only accounted for 0.8% – serious collective action problem at this company
    Perot got premium for shares in exchange for giving up seat on BOD, not competing and stop criticizing
 Claimed majority of BOD either had financial interest in transaction or lacked independence or due care
 P’s did not seek demand from BOD so in DE must demonstrate that they were excused from making demand
    In prior case DE court dismissed P’s case after seeking demand from BOD – court inferred shareholders
       conceded that BOD neutral by seeking their judgment in the first place (now no demands made in DE)
 Court held when lack of independence charged, P must show that BOD is either dominated by officer or
   director who is proponent of challenged transaction or BOD so under his influence that discretion sterilized
    P’s allegations were unsupported by particularized facts – relate more to issue of director due care/BJR
 To get to discovery P must show majority of BOD misled, not disinterested or swayed by undue influence
 Also held P’s complaint failed to plead particularized facts sufficient to raise reasonable doubt that majority
   of GM Board acted in so uninformed a manger as to fail to exercise due care

Notes on Pre-Suit Demand
 ALI proposes rule of universal demand – P required to make demand but can sue if unhappy with response
 DE SC proposes universal non-demand – infers that whenever P actually does make a pre-suit demand she
   automatically concedes that the board is independent and disinterested with respect to the question
    Practical effects of this inference is to discourage any pre-suit demand at all in Delaware

Rales v. Blasband, p. 368, Delaware, 1993
 Derivative claim alleged Easco invested in junk bonds to help Drexel – under investigation and in trouble
    Charter required company to buy “marketable securities” – questionable whether junk bonds fit these

                                                                            Spring 2005 Corporations – Coates p. 47
   In interim Easco sold, which made the harmed public shareholders owners of a different company – Rales sub
     Court held shareholders could still sue Rales sub in a “double derivative suit” even though Easco gone
   Paradigm from Aronson – and thus BJR – not applicable since BOD didn’t approve challenged transaction
     Would otherwise need to show directors not disinterested/independent or transaction not under BJR
     Where there is no conscious decision by directors to act or refrain from acting, the BJR has no application
   Task of a BOD in responding to a stockholder demand letter is a two-step process
     Determine best method to inform themselves of facts relating to alleged wrongdoing bearing on response
     Weigh alternative available to it, including advisability of internal corrective action and legal proceedings
   Court concluded that respective directors must be considered interested in decision of BOD to given demand
   Now must consider whether current BOD (of new company since Easco gone) independent to pass judgment
     P must show self dealing or in situation where practically impossible for them to act independently
   Held that complaint alleged facts sufficient to create reasonable doubt that majority able to act independently
     Rales brothers can’t sue themselves, other from previous BOD, other can’t sue his boss, last dominated
   Provides incentive to put on independent directors that are able to prevent lawsuits from going forward

Procedural Requirements
 Demand requirement – in order for shareholders to take away right to sue from BOD, they must ask the BOD
   and be refused or they have to explain why asking the BOD would be futile (conflict of interest) – old test

Zapata v. Maldonado, p. 375, Delaware, 1981
 Derivative action alleged breach of fiduciary duty; four years later defendant directors no longer on BOD
    New BOD created an “independent investigation committee” of two new directors to investigate claim
 Issue – after demand requirement can BOD designate new members to evaluate/dismiss claim independently?
    New BOD asserts two new directors independent so court should evaluated their decision by BJR
 Court rejected this theory (and thus §141 allowing BOD to make decisions of the corporation)
    Held it will base decision on matters of law and public policy, in addition to company’s best interests
    Worried that if this goes to BJR then boards can appoint new directors to get rid of fiduciary duty cases
    Court really believes derivate suits good for companies and society – doesn’t want them to all go away
 Public good element in preserving law that interested directors can’t be involved in demand dismissals

Joy v. North, p. 381, 2nd Circuit (Connecticut), 1982
 Court held wide discretion afforded directors under BJR does not apply when special litigation committee
    recommends dismissal of suit – must demonstrate the action is more than likely against company’s interests
 Stated that a court should dismiss a case when it determines that the likely recoverable damages discounted by
    the probability of a finding of liability are less than the costs to the corporate in continuing the action
     Should take into account costs of attorney’s fees and other litigation expenses, indemnification, etc.
     May consider distraction of key personnel and lost profits from publicity – not morale or corporate image
 Dissent – majority opinion unsound since judges not equipped to make business decisions
     Where SLC does not act independently and in good faith, its decision will not survive under Auerbach

 An alternative to Zapata might be more rigorous effort to ensure independence of directors on SLC
    Michigan has created extensive independence requirements for those who sit on an SLC

10.5 – Settlement and Indemnification
   Parties are strongly driven to settle in typical derivative (or class action) suit
     Directors generally have right under company’s bylaws to reasonable indemnification – DGCL §145(b)
     If action goes to trial there is a risk of personal liability that can be indemnified only with court approval
   In practice virtually all public corps purchase D&O insurance – excludes criminal penalties and civil
    recoveries for fraud or fiduciary breach that resulted in personal gain for officers and directors

                                                                             Spring 2005 Corporations – Coates p. 48
 Almost 99% of all derivative suits settle; fiduciaries have no personal liability in virtually all of them
 Therefore must believe that derivative suits provide some form of deterrent effect on fiduciaries
    Derivative actions against Ovitz and Eisner played into shareholders withholding votes for Eisner
 Sometime cases are brought by large shareholders who actually want money from fiduciaries not company
 Duty of care and duty of loyalty cases rarely produce large monetary settlements

10.5.2 – Settlement by Special Committee
   Committees of independent directors might be employed not only to consider whether derivative actions
    ought to be dismissed but also to take control of derivative suits in order to settle them – rare in practice

Carlton Investments v. Beatrice International Holdings, p. 386, Delaware, 1997
 Company paid former CEO Lewis $20 million when terminally ill; he didn’t tell BOD of the compensation
 After more than a year of discovery, BOD added two new directors to form SLC to resolve the issue
    SLC entered into settlement with Estate of Lewis whereby Estate would pay back $15 million
 Court applied two step approach from Zapata (used BJR) and approved settlement
    Noted that settlement falls with range of reasonable solutions – court can’t evaluate merits before trial

 SEA §21D – heightened pleading requirements under federal securities law – though no discovery first
    Presumably get information from newspapers, journalists, insiders, etc.
    §220 permits shareholders to inspect company’s books with good cause – lower threshold than above
 PSLRA – allows largest shareholder to run the claim (as opposed to derivative actions where first to file does)
    In practice rarely take over suits since often corps and fear litigation that they didn’t run claim well
    Congress passes PSLRA to thwart two law firms – San Diego and Philly – that corporations hate
 SLUSA – Securities Litigation Uniform Standards Act
    D of class actions involving securities law can remove action even if no other right to do so
    However, not able to remove to federal court if claim based upon state law of state where incorporated
    So MCI is subject of federal class action, state derivative suits, state fiduciary duty suits (some removed)

Notes from Worksheet
 During the 90’s most cases were in Boxes 1 and 2
 Santa Fe v. Green – Can’t frame a fiduciary duty case
 Along came PSLRA that made box 3 unattractive – increased pleading standards – so box 4 more attractive
 Lampf – shortened SOL for 10(b)5 actions to earlier of 1 year after discovery or 3 years after event
 Central Bank – got rid of private liability for aiding and abetting under 10(b)5 violation

10.6 – Assessing Derivative Suits
   Debatable whether shareholders’ suits do more good than not – clearly impose costs on parties and system
   Derivative suits can increase corporate value in two ways
     Confer something of value on the corporation (e.g., recovers compensation for past harms)
     Deterring wrongdoing that might otherwise happen in the future
   Costs of derivate suits can be resolved into two categories
     Direct costs on the company – price of both defending and prosecuting successful suits (time and dollars)
     Indirect costs – advance payments for some of prospective costs of managerial liability (D&O insurance)
   Empirical evidence offer no support that suits increase market capitalization of firms on whose behalf brought

                                                                              Spring 2005 Corporations – Coates p. 49
Chapter 11 – Transactions in Control
Market Rule
 Market Rule – as held in Zetlin, control shareholder has the right to sell his control for any price he can get
  with no obligation to share benefit with other shareholders or the company
 Four Exceptions:
   Can’t sell to a looter with existing reputation for doing something bad (e.g., Adelphia brothers)
   Williams Act – as part of SEA §13(d), (e) and (f) – tender offers of public company regulated if >5%
   Can’t sell your office – can’t agree to sell directorship for money (without similar stock percentage)
   Corporate opportunity – can’t sell control if what you’re really selling is the opportunity to do something
      that buyer will get benefit of and that you should have given company opportunity first

 Exchanging or aggregating blocks of shares to control company can create self-dealing and opportunity issues
 Investors can acquire control in two ways
     Purchase controlling block of shares from existing control shareholder – likely demand a premium
     Purchasing the shares of numerous smaller shareholders
 Issue is when and how can a controlling shareholder sell his control block? What rules govern such sales?

Justification for Premiums on Controlling Blocks
 Coates Formula – Value = a*V+B = [shares] * [market value] + [bonus value]
 Seat(s) on BOD – opens doors for spots other boards & business opportunities, discretion over other members
 Ability to confer self-dealing transactions (e.g., loans, sellbacks to company, etc.)
 Executive compensation and dividend disbursements decisions
 Enact “freeze-outs” – use corporate funds to buy out minority shareholders
 Insider information to trade effectively (competitors) – studies show board members consistently beat market
     Info about new business opportunities to pursue themselves rather than the company
 Influence over corporate strategy – controlling shareholders more common in journalism, wine, food, etc.

11.1 – Sales of Control Blocks: The Seller’s Duties
   In theory US jurisdictions do not regulate sales of controlling blocks of corporate stock
     Minority shareholders don’t have right to sell stock alongside controlling shareholder or back to company
     MA is an exception that requires same deal to be given to minority shareholders
   However, several exceptions to “market rule” come from handful of cases like Perlman v. Feldmann
   No set definition of a controlled shareholder – dependent on facts of situation – is this person in control?

Zetlin v. Hanson Holdings, p. 395, New York, 1979
 D’s sold 44.4% of corporation – effective control – for a premium of roughly 100%
 Court held transfer legit – absent looting of corporate assets, conversion of corporate opportunity, fraud or
    other bad faith, controlling stockholder is free to sell and purchaser free to buy controlling interest at premium
     Minority shareholders not entitled to share equally in any premium paid for controlling interest
     This would limit transfer of controlling interest to offers to all stockholders (tender offer)

Perlman v. Feldmann, p. 396, 2nd Circuit, 1955
 Controlling shareholder (D) sold shares at 100% premium to steel purchasers so they could guarantee supply
    Steel price set arbitrarily low due to Korean War – created shortage so buying at that price very valuable
 Court held D a fiduciary who – in time of market shortage – can’t appropriate premium to himself
    Market rule is still the rule, but EOR when fiduciary siphoning off corporate opportunity for personal gain
    Implicit in the court’s finding that the sale was bad is that D appropriated corporate opportunity

                                                                             Spring 2005 Corporations – Coates p. 50
   D should have passed offer along to all of shareholders so they could share in premium created by steel price
     Coates says steel purchasers would have benefited from buying whole company so still work under EOR
   P’s entitled to recover share of premium in their own right, not in right of the corporation
   Dissent – majority doesn’t say what fiduciary duties D violated – no evidence received more than stock worth
     Even if a corporate asset – control – was sold, surely the company should recover the compensation

A Defense of the Market Rule in Sales of Control
 Investors’ welfare is maximized by legal rule that permits unequal division of gains from corporate control
   changes, subject to the constraint that no investor is made worse off by the transaction
 Numerous academics have argued for some form of sharing requirements
    Control is a corporate asset requiring that premiums paid for control go into corporate treasury
    Entitle minority shareholders to sell their shares on same terms as controlling shareholder
 Both of these proposed treatments of control premium would stifle transfers of control
    If premium paid into corporate treasury, people may not consent to sale of controlling bloc
    If minority shareholders may sell on same terms, bidders may have to purchase more shares than desired
    Minority shareholders would suffer under both – less likelihood of improvements in mgmt quality

 Modern courts still treat simple sale of controlling lock of shares as free of any duty to minority shareholders
    Such sales rare as controller often requires corporate action of some sort to facilitate sale of control block

11.2 – Sale of Corporate Office
   How deal with sale of small block of stock at premium price for resignation in favor of buyer’s appointees?
   Carter v. Muscat – court upheld new directors appointed as part of transaction to sell 9.7% block of shares
   Brecher v. Gregg – premium for control while purchasing only 4% is contrary to public policy and illegal
   Coates Formula – much more likely to find sale of office illegal when [a] is small (so more effect on others)

11.3 – Looting
   Important qualification of the market rule is the duty to screen against selling control to a looter

Harris v. Carter, p. 408, Delaware, 1990
 Controlling shareholder entered into stock swap with new controller who turned out to be a looter
    Sued by other minority shareholders for letting all of this happen – D hurt double since didn’t cash out
 Court held fiduciary duty comes into play when a majority shareholder sells his interest coupled with
   agreement to resign from board in such a way as to assure buyer’s designees assume corporation office
 When circumstances would alert a reasonably prudent person to a risk that his buyer is dishonest or in some
   material respect not truthful, a duty devolves upon seller to make such inquiry as a reasonably prudent person
   would make and to exercise care so that others who will be affect should not be injured by wrongful conduct
 Coates disagrees with analogy to tort law – duty not to act negligently with respect to other shareholders
 DE SC has rejected tort analogy in other cases – can have fiduciary duty breach when no harm (Technicolor)

11.4 – Tender Offers: The Buyer’s Duties
   Unlike corps in most of world, large public corps in US do not have a controlling shareholder
   Investors who want to purchase a control stake must do so by aggregating shares of many small shareholders
   Can approach largest of small shareholders singly or make general offer – tender offer – open to all of them
   Tender Offer – offer of cash or securities to shareholders of a public company for shares at premium price

Williams Act of 1967 – Equal Opportunity Rule
 Sought to provide sufficient time and info to make informed decision about tender offers and warn market
    Early warning system alerts public and company’s managers whenever one acquires 5% voting stock

                                                                              Spring 2005 Corporations – Coates p. 51
      Mandates disclosure of identify, financing and future plans of tender offeror – includes plans to go private
      Antifraud provision prohibits misrepresentations, nondisclosures, etc. in connection with tender offer
      Regulates substantive terms of tender offers – duration left open, withdrawals, etc.
             14(e)1 – tender offers must be left open for a minimum of 20 business days
             14(d)10 – requires bidders to open tender offers to all shareholders and pay all who tender price
   Curiously the act does not define “tender offer” – absence has led to case law in “de facto tender offers”
     Like amount of control required, Congress declined to define a tender offer to avoid creating loopholes
   Coates – only way to make money off tender offer is in first 5% before required to disclose purpose / info

Contrasting Market Rule with Equal Opportunity Rule
 Forcing offer to extend to everyone will decrease the probability of controlling blocks being purchased
    Can likely make some investments profitable when buying 51% now unprofitable when buying 100%
 Choice between rules hinges upon how often deals will be deterred v. how often new controller hurt company

Brascan v. Edper Equitites, p. 415, New York, 1979
 D acquired large amount of stock in several open market purchases with 30-50 institutional holders
 Court held conduct not a tender offer – bringing such large scale open market and privately negotiated
   purchases within Williams Act would rule no large scale acquisition program legal except tender offer
 Further relied upon Wellman 8-Factor Test created by SEC to assess if acquisitions constituted tender offer
    Active and widespread solicitation of public shareholders
    Solicitation made for substantial percentage of issuer’s stock (valid in this case)
    Premium over prevailing market price
    Terms of offer are firm rather than negotiable
    Offer is contingent on tender of fixed minimum number of shares
    Offer open only for limited period of time
    Offerees subject to pressure to sell their stock
    Public announcements of a purchasing program precede or accompany a rapid accumulation
 Wellman – solicited sale of stock from holders in simultaneous calls with fixed price and one hour window
    Court held solicitation campaign was “de facto” tender offer subject to Williams Act – 7/8 factors present

Chapter 12 – Fundamental Transactions: Mergers and Acquisitions
12.4 – The Allocation of Power in Fundamental Transactions

What Transactions Should Require Shareholder Approval (As Well As Board Approval)?
 Consider first the universal requirement that shareholders must approve amendments to charter
   Shareholders must also approve dissolution (nullifies charter) and merger (can amend charter)
 Principals also rarely trust agents to decide very large decisions – mergers, large asset sales, share exchanges
   Mergers require shareholder vote on part of both target and acquiring company, however the acquiring
      company’s shareholders do not vote when it is much larger than the target – DGCL §251(b)
   Sales of substantially all assets require vote by target’s shareholders (§271) but purchases of assets do not
 The M&A transactions that require shareholder vote are those in which board’s relationship to shareholders
  changes most dramatically, reducing the ability of shareholders to displace their managers after transaction
   Vote in sale of substantially all assets justified since company likely to dissolve after transaction
   Vote to be acquired justified since likely to issue so many new shares that mgmt won’t rely on old votes

                                                                           Spring 2005 Corporations – Coates p. 52
12.5 – Overview of the Transactional Form

READ ABOUT MCI (QUEST & VERIZON) FOR EXAM – Hostile Takeover Bid, Merger, Etc.
 Verizon bought out Slim (13.8% owner) at huge premium – small enough to avoid regulation
   Not a tender offer but under Williams Act had to file 13(d) – 5% purchase or more must file with SEC
   Must let public know of purchase and declare intentions with regard to control over company
   13(f) – money managers who manage over $100MM must file annual list of investments & ownership
   13(g) – allows shorter form filings (annual) for smaller money managers
 Verizon not pursuing tender offer – though it would like to – since offering stock (and cash) in consideration
   Takes just as long to go through other SEC process when non-cash consideration involved
          Process required when non-cash transaction greater than $50MM or 15% ownership bought
   Thus no advantage of doing a tender offer since merger is cheaper and easier
   Timing advantage of tender offers thus only relevant in 30% of cases where only cash is offered

Three Principal Legal Forms of Acquisitions
 Asset Purchase – buy the target company’s assets
 Stock Purchase – buy all of the corporation’s stock
 Merger – merge company or a subsidiary with the target on terms that ensure control of resulting entity

 The consideration that is offered for the transaction is completely independent of the choice of form
    Three basic types of consideration (cash, stock, other) can be matched with each of these three forms
 In terms of deciding which form to utilize, different considerations dominate in public v. private companies
    Private companies often more attuned to transaction costs since smaller asset bases; also no waiting
       period for buying stock, however some delay for buying assets
 Public companies generally prefer two-step mergers
    Stock purchase quick and cheap; merger ensures 100% ownership through “freeze-out”
    Most common stock purchase through tender offer; Williams Act requires offer open for 20 business days
    Merger takes 30-90 days to get through SEC proxy process (filings plus compliance with SEC comments)
    Proxy cards must then be sent to shareholders – through institutions – and returned so total 60 – 180 days

Required Approvals

Stock Purchase
 BOD of Buyer must approve (large transactions at least)
 BOD of Target not required unless pill – ceiling on max stock one can buy (15%) without BOD approval
 Shareholders of Target not required – would interfere with free transferability of shares
 Shareholders of Buyer not required unless issuing >20% of stock in related transactions (NYSE rule)
     NYSE Rule 312 – requires majority of shareholders that vote (not outstanding like DE transactional laws)
     Interesting as BOD can waste cash to construct building but not use 25% of its stock

Asset Purchase
 BOD of Buyer must approve (large transactions at least)
 BOD of Target must approve sale of large assets
 Shareholders of Target not required unless “all or substantially all” of assets
    Test is whether assets are “core assets” of the business; generally 51% satisfies test
    DGCL §271 – requires majority of outstanding shareholders – not majority at quorum
 Shareholders of Buyer not required unless issuing >20% of stock in related transactions (NYSE rule)

                                                                          Spring 2005 Corporations – Coates p. 53
 §251 – requires BOD approval of both Buyer and Target; shareholder approval of both Buyer and Target
    §251(f) – exception when relative size is such that buyer will vastly dominate seller – details below
 §253 – Short-Form Merger Statute – don’t need disappearing corporation’s approval if before the transaction
   the surviving company owned 90+% of disappearing stock

12.5.1 – Assets Acquisition
   Easy and cheap if don’t want all of assets – only have to go to board and transaction costs not prohibitive
     Transaction costs become prohibitive when assets account for 20-30% of acquiring company
   Acquisition of business through asset purchase is slow and has a high transaction cost (low liability cost)
     Must perform due diligence, establish warranties, fix price and payment terms, establish closing, etc.
     Sale of substantially all assets is fundamental transaction so requires shareholder approval – DGCL §271
     However, neither meaning of “all or substantially all” assets nor policy intent behind words clear
     Acquisitions desirable since can just buy select assets – and choose not to buy those with high liabilities

Katz v. Bregman, p. 432, Delaware, 1981
 After selling off significant part of unprofitable assets, company sought to sell lucrative Canadian business
    Canadian profit in 1980 was $5.3MM; corporate loss in the US was $4.5MM
 Court held proposed sale constituted a sale of substantially all of the corporation’s assets
    Constituted over 51% of total assets that generated roughly 45% of net sales in prior year
    Proposal to shift to manufacture of plastic drums is radical departure from history of selling steel drums
    Contrasted with Gimbel v. Signal – only 26% total assets and roughly 15% of revenue and earnings
 Injunction thus issued until transaction approved by majority of outstanding stockholders (>20 days notice)

 Court apparently thought mgmt had agreed to sell too early or something suspect about choosing lower price
 Case likely marks the outer boundary of meaning of the statutes that mandate shareholder votes on asset sales
 Further guidance can be derived from 1996 case Thorpe v. CERBCO where DE SC applies following test:
    Need for shareholder approval measured not by size of sale alone, but on qualitative effect upon company
    Thus relevant to ask if out of ordinary course and substantially affects company’s existence/purpose

Notes on Asset Acquisitions and Potential Liability
 Chief drawback of asset acquisition as method of acquiring company is costly and very time consuming
 Offsetting drawback, it appears that the acquirer accedes only to assets and not liabilities of target
    However, when assets constitute integrated business, courts have identified circumstances where liability
    Examples of “successor liability” include tort claims from defective products, environmental cleanup, etc.
 In response to these types of liabilities, acquisitions are made through separately incorporated subsidiaries

12.5.2 – Stock Acquisition
   Stock purchases even cheaper than mergers but only get the amount of stock you are able to purchase
   Second transactional form of acquiring incorporated business is by purchasing all or majority of its stock
   Corporate law helps eliminate small public minority – 90% owner can cash out minority unilaterally
   Two-Step Merger – boards of target and acquirer negotiate two linked transaction in single package
     First transaction is tender offer for most or all of target’s shares that target board promises to recommend
     Second is merger between target and subsidiary of acquirer – removes those who didn’t tender shares

12.5.3 – Mergers
   Merger legally collapses one corporation into another – resulting corporation termed “surviving corporation”
   Most states require majority vote by outstanding stock of each constituent corporation entitled to vote

                                                                           Spring 2005 Corporations – Coates p. 54
       Default rule is that all classes of stock vote on merger unless charter expressly states otherwise
       DGCL §251 – oddly does not protect preferred stock with right to a class vote unless rights affected
       DGCL §251(f) – exception when relative size is such that buyer will vastly dominate seller
             Surviving corporation’s charter not modified
             Security held by surviving corporation’s shareholders will not be exchanged or modified
             Surviving corporation’s outstanding common stock will not be increased by more than 20%
   Voting common stock of target – or collapsed – corporation always have voting rights
   Common stock of surviving corporation generally required to vote on merger unless
     Their charter not modified, security not exchanged or modified, and total CS not increased by >20%
   Following affirmative shareholder vote, merger effectuated by filing certificate of merger with state office

Advantages of Mergers
 69% of such transactions are done as mergers rather than asset or stock purchases
    20% tender offers followed by mergers; 10% control block sales; 1% asset sales
 Requires board approval, shareholder approval and special filings (merger certificate) so why bother?
    Other two forms do not require shareholder approval or special filings
 Major advantages are low transaction costs and get all of the outstanding shares of stock
    Lower transaction costs than asset purchase – don’t have to register purchase in every county (just DE)
    Stock purchase may require tender offer that creates transaction costs – advertisements, SEC filings, etc.
           Almost 10% of shareholders just not paying attention – don’t collect dividends, stock in safe, etc.
    Merger also highly favored way to take company private – can override dissenters and give whatever
           Minority shareholders can sue if don’t receive fair market value, but BBI gave out free rentals

12.5.4 – Triangular Mergers
   Surviving corporation in a merger assumes liabilities of both constituent corporations by operation of law
   Acquirer has strong incentive to preserve liability shield that the target’s separate incorporation confers
   Easily done by merging target into wholly owned subsidiary of acquirer (or merging subsidiary into target)
     Acquirer A forms subsidiary B; A transfers merger consideration to B in exchange for B’s stock
     Target merges with B (or B merges with T); merger consideration distributed to T’s shareholders
     After T’s stock cancelled, A owns all outstanding stock of B, which owns all of T’s assets and liabilities
   NYSE/NASDAQ have rule requiring shareholder approval if company issues >20% of stock at any one time

12.6 – Structuring the M&A Transaction
   Lawyers, bankers and clients must consider many variables in choosing structure for M&A transaction
   Timing – each side wants deal to occur on present info since neither can predict future market movements
     Speed crucial so ensure costs savings and to maintain deal dynamics (avoid competing bidders)
     Tender offer very fast way to get control – block competition – and still fast to acquire company
     All-cash, multi-step acquisition usually fastest way to lock up target and assure complete transaction
     Merger generally requires shareholder vote of at least target shareholders – months for proxy materials
     If stock is part of deal consideration, two-step structure not much faster since must be registered with SEC
     Thus most deals with all stock consideration are structured as one-step direct or triangular mergers
   Other Factors – regulatory approvals, voting and appraisal rights, due diligence, warranties, termination fees

12.8 – The Appraisal Remedy
   No sensible way to rationalize the existing DE Appraisal Law – but it’s there so deal with it
   Shareholders who vote no on a proposed merger can go to court and ask for fair value of stock in cash
     Fair value is same as fair price – what shareholder should get in self-interested transaction by fiduciary
   Every jurisdiction provides an appraisal right to shareholders who dissent from qualifying mergers
     Often said appraisal right granted as quid pro quo when legislatures allowed non-unanimous mergers

                                                                            Spring 2005 Corporations – Coates p. 55
     DGCL §262(c) permits, but doesn’t require, appraisal remedy when charter is amender or all assets sold
     Most arm’s-length mergers achieve something close to market price so appraisal remedy rarely justified
   Market-Out-Rule – §262 precludes appraisal in stock-for-stock mergers of most public companies
     Shareholders in privately traded firms always have appraisal rights in mergers if required to vote on it
     Rule does not apply to cash mergers – so cash mergers always trigger appraisal rights (makes no sense)
   Rarely used since if clearly getting less than fair market value, also have fiduciary duty claim and better since
    exceptions do not exist (can bring for all corps); must pay own lawyer in appraisal not company
     Only attractive when parent company forces a deal on a subsidiary they control – conflicted BOD
     Courts ambiguous on whether dissenting shareholder can sue on appraisal and fiduciary claim
             Appear to allow both with the exception of an arm’s length merger – no fiduciary claim anyway

The Nature of “Fair Value” – Two Components
 Definition of the shareholder’s claim – what is it specifically that the court is supposed to value
    DE courts clearly define as pro rata claim on value of firm as an ongoing concern
 Technique for determining value
    Measure fair value free of any element of value attributed to merger – DCF methodology most common

In Re Vision Hardware Group, p. 456, Delaware, 1995
 Better Vision born in 1988 in LBO where shareholders invested $500K; failed with debt of over $125MM
 Merger agreement cashed out Vision’s public shareholders for total consideration of $125K
 Minority shareholders sued saying shares worth $15MM – assets less deeply discounted market value of debt
 Court held appropriate valuation of the company’s debt is dollar value of legal claim that the debt represented
 Thus shares held by public shareholders excluding value attributable to merger had no substantial value

12.9 – The De Facto Merger Doctrine
   Some US courts have adopted functionality approach and have accorded shareholder voting and appraisal
    rights to all corporate combinations that resemble mergers in effect – same protection in de facto merger
   DE – self-identified sale of assets that results in exactly same economic consequences as a merger will
    nonetheless be governed by lesser shareholder protections associates with same of assets (not merger)

Hariton v. Arco Electronics, p. 460, Delaware, 1963
 Loral purchased all the assets of Arco in exchange for shares of Loral common stock (3:1 ratio)
 P asserted a transaction constituted a de facto merger; unlawful since DE merger provision not complied with
 Court stated right of corporation to sell all of its assets for stock in another corporation accorded by §271
 P thus aware of this right when purchased stock; also aware that could be forced to accept new investment
 Conclude transaction complained of was not de facto merger – doctrine with legislative domain not courts

12.10 – The Duty of Loyalty in Controlled Mergers
   Some tension between controlling shareholders exercising of voting rights and exercising of control
   Obligation of fairness arises when controlling shareholder does what other shareholders cannot
   Cash Mergers or Freeze-Outs – cashing out minority shareholders through a transaction
     Through merger, asset purchase followed by liquidation, reverse stock split (cash for fractional shares)
     When conflict of interest, controlling shareholders must adhere to duty of loyalty and pay fair value
   Why allow freeze-outs?
     Change of circumstances – corps exist indefinitely so hard to hold them to infinite planning horizon
     Allows tender offers to acquire 100% ownership as second part of transaction

   Prior to Weinberger used doctrine called DE Block – value using market price, book value, EPS & PE ratio
     Accounting numbers undervalued in periods of high inflation
     PE out of whack since they’re based on historical earnings

                                                                             Spring 2005 Corporations – Coates p. 56
     Market price dependent on what the market thinks the court will award in the case at hand
   Weinberger said Delaware Block not mandatory – courts to use accepted methods of financial community
     DCF still dubious since I-bankers choose high discount rate for companies and low for shareholders
   DE Courts have tough time choosing between them so also look at old factors to make sensible valuations

Weinberger v. UOP, p. 465, Delaware, 1983
 Signal acquired 55.5% of UOP at $21/share when UOP shares had traded at $14/share
    Signal only nominated six of board’s thirteen directors; replaced CEO and president when retired
 Feasibility study performed by two Signal officer – also UOP directors – about purchasing rest of UOP
 UOP board adopted proposed merger absent Signal directors – based partly on brief Lehman opinion
 UOP shareholders voted very strongly in favor of merger after recommendation by mgmt and BOD
 P challenged elimination of UOP’s minority shareholders by cash out-out merger
 Court held two Signal officers breached fiduciary duty by not sharing study with UOP BOD or shareholders
    Report showed that $24/share wouldn’t have cost Signal much more than $21 but much to shareholders
    Obvious conflict of interest pose by their creation of feasibility study from UOP info for Signal’s benefit

 Must a controlling shareholder inform minority shareholders of the top price it is willing to pay?
 Would the court have found that Signal officers breached their duty if they didn’t use confidential UOP info?
 Weinberger’s attempt to establish the “new” appraisal as the exclusive remedy for shareholder complaints
   about merger consideration was short lived
 Rabkin v. Hunt Chemical – court permitted non-appraisal attack on a cash-out merger action to proceed
 Following Rabkin (1985) entire fairness actions – rather than appraisals – have been the principal means of
   attacking fairness of price in self-dealing merger

   One of Weinberger’s lasting contributions was to introduce DCF methodology to valuation in DE courts
   Also introduced view that fair value in “new” appraisals includes fair share of synergy gains from merger
     DGCL §262(h) clearly states that such gains are not to be included in the “fair value”

Cede v. Technicolor, p. 474, Delaware, 1996
 Technicolor board negotiated cash price that represented 100% premium over pre-deal market price
 Substantial minority shareholder dissented and brought appraisal action and fiduciary duty suit
 SC ruled controlling shareholder had burden to show price paid to minority shareholders was fair
    This burden could not be satisfied by looking at results of negotiations with Technicolor’s BOD since he
       had begun to implement his new business play by the time of the cash-out merger
 Further ruled that P could simultaneously pursue both appraisal action and claim for breach of fiduciary duty

   Holding makes clear was Rabkin implied:
     Appraisal not exclusive remedy for price concerns when D owes fiduciary duties to public shareholders
     Price complaints in one-step cash or stock merger (arm’s length) can be relegated to appraisal remedy

More Weinberger Notes
 Appraisal appears favored means to challenge merger consideration since provides same measure of recovery
  as entire fairness or fiduciary claim and does not require courts find breach of fiduciary duty – court’s intent
 However, fairness actions still predominate for several reasons
   Appraisal may not be available because of the “market-out” provisions of the statute
   Unlike appraisal suit, action for breach of fiduciary duty can be brought before effectuation of merger
   Suits for breach of fiduciary duty can be brought as class actions – greater incentive for lawyers

                                                                           Spring 2005 Corporations – Coates p. 57
12.10.2 – What Constitutes Control and Exercise of Control
   Self-dealing fiduciaries have two principal devises for easing burden of proving entire fairness
   Shareholder ratification and independent director approval available in controlled mergers – some new issues

Kahn v. Lynch Communication Systems, p. 476, Delaware, 1994
 Alcatel owned 43.3% of Lynch’s stock; designated 5 of 11 directors; and several committee members
 L wanted new technology so proposed merger with Telco – supermajority required so needed A’s consent
 A’s directors proposed merger with Celwave – independent subsidiary of holding company that owned A
 L’s board created Independent Committee to negotiate terms and conditions of combination with C
 With advice from investment bank, IC decided C overvalued so expressed unanimous opposition to deal
 A threatened to proceed with “unfriendly” tender at lower price if $15.50 deal not approved – IC gave in
    If A gets another 7% can force merger and treat minority shareholders poorly (lower price, no dividends)
 Court held initial burden of establishing entire fairness rests on party who stands on both sides of transaction
 Approval by IC of directors or informed majority of minority shareholders shifts burden of proof to objector
 However, mere existence of IC does not itself shift the burden – at least two factors are required
    Majority shareholder must not dictate the terms of the merger
    IC must have real bargaining power that it can exercise with majority shareholder on arm’s length basis
 Court remanded case – threat of tender offer was a threat that prevented arm’s length bargaining
    Here issue is not self-serving directors but domination of a special committee by controlling shareholder
    43% ownership makes formidable since could likely wage successful proxy fight or just buy another 8%
    Members of SC – officers of company – also aware that Alcatel could fire them or reduce compensation

 Court ended up ruling that $15.50 price was fair, however only after extended litigation since used committee
    In future forget about IC – go straight to tender offer since it doesn’t involve any fiduciary duty (Silconix)
    May have to defend value against hold-out shareholders in potential appraisal suit – far fewer in number
 Subramanian conducted study that showed that good firms use tender offers – others use short-form mergers

12.10.3 – Special Committees of Independent Directors in Controlled Mergers
   What effect should courts give to decision of well-functioning committee to approve interested transaction?
   If valid committee approved transaction, two possible responses – review under BJR or entire fairness test
   Kahn seemed to indicate approval of truly independent committee can only shift burden in proving unfairness
   However, DE court held BJR applied in In re Western National since decision made by independent directors
     Held not a controlling shareholder even though 46% stock since limited to 2 of 8 director positions
     Court gave to action of IC the respect it would accord to action approving arm’s length transaction

12.10.4 – Controlling Shareholder Fiduciary Duty on First Step of Two-Step Tender Offer

Tender Offers
 Invented in 50’s when one put ad in newspaper; idea spread like wildfire; corps taken over in 2 days in 60’s
 Brackman’s Law – rich businessmen didn’t like getting fired this way so lobbied for creation of Williams Act
    20 business day minimum to keep offers open (5/10 day extensions for modifications)
    Disclosure requirements – Schedule T-O
    Equal treatment came into effect in the 80’s – must pay all selling shareholders same for their stock
    Withdrawal rights – sellers can change mind up until last moment (can change mind for higher bidders)
    13(d) disclosure rules – have become most important of rules (5% shareholders must disclose)
           After disclosure the market thinks a takeover coming so cost of stock rises dramatically
           Thus after modification in 1972, profit came primarily from first 5% purchased (rest bid up)
           Buyers started making tender offers to get to 50% and treat remaining minority poorly – Unocal

                                                                           Spring 2005 Corporations – Coates p. 58
   Nothing to stop current management from making better tender offer to shareholders if think they’re better
     Fiduciary duties exist – self-dealing transaction – so courts evaluate same as “freeze-out”
     Practically, it is difficult to get enough financing for the management to propose alternative
   Management can also sell to “white knight” – third party to purchase in lieu of hostile takeover party

   Controlling shareholder who sets transaction terms and effectuates it through control of BOD owes fairness
   What if he does not “force” a transaction on BOD but merely “offers” it and independent directors accept it?
   Kahn says controlling shareholder must still pay a fair price, though burden lies with objector to prove unfair
   However, no duty to pay an objectively fair price if offer transaction to public shareholders in tender offer
     No duty to pay fair price or to disclose all material info on the offer as long such an offer is not coercive

Two-Tier Tender Offers
 Purchasers will inform stockholders that they will get better deal if they tender in first tier – large incentive
   Once established control over corporation purchaser would “freeze-out” remaining shareholders
 Businessmen again tried to get Congress to act when many hostile takeover attempts in 1980’s – unsuccessful
 In effect great deal of pressure put on common law to deal with ways lawyers created to stop such takeovers
   DE courts aware that if they imposed fiduciary duties too tightly, companies could incorporate elsewhere
   On other side, decision to tender stock not entirely voluntary if fearing 2nd tier so judges want protection
 So DE courts didn’t take either extreme – no lax BJR or tough entire fairness review – rather Unocal standard

In Re Pure Resources, p. 483, 2nd District, 2002
 Unocal owned 65% of shares of Pure Resources and 5 spots on the 8-member board of directors
 Tension led Unocal to initiate surprise exchange offer for Pure’s minority shares at 27% premium
     Neither tender offer (to get to 90+%) nor §253 merger (last -10%) requires the target’s board to vote
     D asserted this means no fiduciary duty issue so only remedy is an appraisal suit
 Issue at this point is what fiduciary duty target’s board has to resist tender offer – likely by adopting pill
 Pure created Special Committee who didn’t create poison pill but did vigorously seek higher exchange rate
 When Unocal refused to increase its proffered consideration, Committee voted not to recommend offer
 Unocal decided to launch its offer in face of recommendation; Pure minority shareholders sought injunction
     Asserted that offer should be governed by entire fairness standard – offer not voluntary, non-coercive
 Court held controlling shareholder has no duty to permit target BOD to block non-coercive bid through pill
     Only if offer 1) conditioned on majority of public tendering and 2) §253 merger quickly and at same price
 Held Offer in present form is coercive as it includes Unocal directors and officers in definition of minority
     Can be cured if Unocal amends Offer to condition approval on majority of unaffiliated stockholders
 Offer for prompt §253 merger otherwise non-coercive since sufficiently specific and no retributive threats
 Also held stockholders entitled to fair summary of work done by I-bankers behind BOD recommendations

Chapter 13 – Public Contests for Corporate Control
 Threat of a takeover has salutary effect of encouraging managers to work to deliver shareholder value
 Traditional US law opened two avenues for initiating a hostile change in control
     Proxy Contest – simple expedient of running an insurgent slate of candidates for election to BOD
     Tender Offer – even simpler expedient of purchasing enough stock to obtain voting control for oneself
 DE SC first began to grapple with complexities of the board’s duties in contests for corporate control in 1985
     Smith v. Van Gorkom – held entire BOD liable for “gross negligence” when most said met duty of care
     Unocal v. Mesa – standard between lax BJR and rough entire fairness review for board’s defensive tactics
     Revlon – court adopted heightened review short of intrinsic fairness for efforts to resist hostile takeover

                                                                            Spring 2005 Corporations – Coates p. 59
   Private legal innovations – particularly the poison pill – dramatically altered law governing changes in control

Policy Analysis of Takeovers
 Corporate law does not leave takeover analysis entirely up to target’s board because
     Threat of a hostile bid keeps incumbent directors and managers focused and in line
            Worried about slack/laziness, self-dealing, poor investments (empire building, cash), etc.
     Directors have interest in maintaining their position on the BOD – agency cost
 Why not have pure passivity – let the market sort it out?
     Shareholder confusion – may not understand short-term v. long-term value considerations
     Constant worry about takeovers may encourage mgmt to invest poorly to keep control (recapitalizations)
     Costly substitution – incentive to preclude any change in control (e.g., use dual class structures) – Google
     Costly rent-seeking – waste of assets from social perspective through attorneys and bankers fees, etc.

13.2 – Defending Against Hostile Tender Offers

Control Structure
 Since poison pills make proxy fights only realistic way of gaining control, must understand control structure
 Three major categories of control structures – (takeover success rate, remain independent)
    Immediate Removal Possible – special meeting/written consent allowed; can remove quickly (45%, 32%)
    Effective Annual Terms – no special meeting/written consent; wait for annual meetings (40%, 40%)
    Effective Staggered Boards – typically must win two elections so difficult to take over (15%, 65%)
 Stats show that lawyers do in fact have impact both in making companies safe and knowing types to go after

Unocal v. Mesa Petroleum, p. 500, Delaware, 1985
 Pickens – owner of 13% of Unocal’s stock – commenced two-tier cash tender offer for 37% of stock at $54
    Back-end designed to eliminate remaining publicly held shares also at $54 but heavily subordinated
 Unocal’s BOD – 8 outsiders and 6 insiders – met to discuss; Goldman said sale/liquidation value over $60
 Outside directors unanimously agreed to advise BOD to reject offer in favor of self-tender offer
    $72 cash self tender for 30% excluding P; if P gets control, increases to 49% and debt used not cash
    Basically giving away value of corporation to shareholders through bonds to leave Pickens with less value
 Court first held that BOD had ample authority to adopt a defensive measure of this type
    §141 – BOD controls company; §160(a) – corporation can deal its own stock; BOD duty to protect firm
 Held BOD has enhanced duty beyond BJR because of real possibility that it is acting in its own interests
    Directors have fiduciary duty to act in shareholders’ interests; includes protecting from harmful takeovers
    However, may not act solely or primarily out of desire to perpetuate themselves in office
 Board’s stock repurchase plan reasonable to threat posed by inadequate and coercive two-tier tender offer
    Decision to offer fair stock value to other 49% who would otherwise get subordinated bonds reasonable
 Court will not substitute its judgment for the board unless shown by preponderance of evidence that
    Directors’ decisions primarily based on perpetuating themselves in office; or
    Some other breach of fiduciary duty such as fraud, overreaching, lack of good faith, or being uninformed

 Unocal thus announced new standard for reviewing defensive tactics – “enhanced business judgment review”
    Must be some reasonably perceived threat to corporate interests – inadequate and coercive tender offer
    Response to that threat must be proportional to the threat – stock repurchase plan reasonable response
 To earn protection of BJR, the board must show defensive tactic “reasonable in relationship to threat posed”
    Some people claim to this day this was not meant to be a real test – camouflage for simple BJR test
    Coates cited two cases – Interco and Clayton – to show that new standard has been applied
    Though, courts uncomfortable with making board decisions so focus on process – info, deliberations, etc.

                                                                            Spring 2005 Corporations – Coates p. 60
   SEC really disliked excluding Mesa from self-tender, so since 1986 Rule 13(e)4 requires equal treatment
   Unocal permits boards to take into consideration interests outside of just shareholders

13.3 – Private Law Innovation: The Poison Pill
   Front-end loaded, two-tier tender offers can lead shareholders to sell, even if price less than shares worth
   Poison Pill – gives BOD practical power to veto tender offer by effectively requiring approval above 15%
     Typical setup – rights to buy company’s stock at discounted price distributed to all shareholders
     Rights are triggered only if someone buys certain percentage of common stock, who is then excluded
     Result is that buying much stock without BOD approval will dilute shares and be ruinously expensive
   Moran v. Household Int’l – validated the poison pill technique (discussed below)

In-Class Notes
 Poison Pills – place cap on max shares one can acquire without very bad consequences (BOD can waive)
    50-75% of Fortune 500 now have a type of poison pill
    Some companies do not adopt pills since can signal worry about stock or just annoy shareholders
 Structure – want to change structure to channel bids through BOD without changing assets, EPS, taxes, etc.
 Packaged poison pill with several powers conferred to BOD that DON’T require shareholder approval
    §141 – BOD has authority to make corporation’s decisions
    §151 – BOD has authority to issue stock
    §157 – BOD has authority to issue “rights to buy options and stock”
    §170 – BOD has authority to declare and pay dividends
 All pills have two intentional loopholes to ensure ability to takeover company still exists
    Go to court and say the BOD is using the pill in some illegitimate way
    Go to shareholders to elect new BOD who will redeem the pill
 Thus a tender offer is no longer a viable way to take over a company – now must focus on a proxy fight
    Pills have effect of forcing proxy fights to be run by those with less than 15% ownership

Adoption of the Pill
 Board declares a dividend to each shareholder in form of right to buy stock
 Far “out of market” so no one would exercise them at present time – no tax or accounting implications
 If someone buys more than 15% of company, rights become exercisable for half of market price
    Uses phrase “beneficial ownership” to prevent collusion to stay below cap
    Now include “inadvertent triggering” clause – BOD decides if unintentional but must sell down
 However, whoever triggers the rights is excluded from exercising these rights – same as in Unocal
 Thus value of that person’s stock falls since shares diluted – 15% ownership falls to 1.7%
 Board would just put in another pill if individual tried to suck it up and keep purchasing
 Only limit is the number of shares authorized by charter – got around with technique below
    Blank-Check Preferred – most charters have provision to allow BOD to issue preferred shares
    Make preferred shares have ridiculous rights and grant shareholders rights to small fraction of it
 Only way out of pills are charter amendments (need BOD approval) or perhaps bylaws – at issue now
 Adoption of the pill is just the declaration of a dividend – can adopt a pill in a day with a conference call
    Many adopt before takeover challenge – way for lawyers to get in front of high profile directors
    Prevalence of pill throughout corporate America likely helps justify their existence
    Pills not legal outside US – don’t allow discrimination against bidder – where grant preemptive rights

Moran v. Household International, p. 508, Delaware, 1985
 Case made its way to DE SC as a way for Wachtell and Goldman to test the waters – are poison pills legit?
   Not fighting takeover candidate – shareholder – so weak opposing counsel and no premium to deal with
   Real test comes when bidder comes along and challenges board for not redeeming pill when premium

                                                                           Spring 2005 Corporations – Coates p. 61
   Household’s board adopted a shareholders rights plan by a 14-2 vote as a preventative measure
     If merger or consolidation occurs, can exercise rights to purchase $200 of CS of tender offeror for $100
   In meantime one of Household’s directors began discussions of potential LBO as stock undervalued
   Moran sued asserting BOD unauthorized to usurp stockholders’ rights to receive tender offers in such way
     Argued that BOD didn’t have the authority to adopt such a plan and if so then still violated fiduciary duty
   Court first held that Poison Pill authorized by relevant statutes – §141 to make decisions, §157 to issue stock
   Then held board did not violate fiduciary duty – adoption of pill evaluated by Unocal standard
     Rights Plan does not prevent stockholders from receiving tender offers and change in Household’s
        structure less than that which results from implementation of other defensive mechanisms upheld
     Rights Plan doesn’t destroy corporate assets, result in cash outflows, affect EPS or have tax consequences
   Restriction from first acquiring 20% before proxy contests doesn’t restrict stockholders’ right to conduct one
     Evidence established that many proxy contests won with less than 20% and large holdings no guarantee
   Directors thus receive benefit of the BJR in their adoption of the Rights Plan
     Valid since adopted plan in good faith belief that necessary to protect company from coercive acquisitions

 Commentators agree that in hands of loyal managers, pill benefits shareholders by providing managers with
   power to bargain on their behalf and so overcome their chronic collective action problem
 In hands of disloyal managers, pill can be used to entrench managers or increase their private benefits
 Companies that do not have a pill can adopt one in a matter of days (if not hours) if threatened
    All that is required to adopt a shareholders rights plan is a board meeting – not a shareholder vote
 Directors continue to exercise their power subject to fiduciary duty after adoption of shareholders rights plan
    Board might have duty to redeem rights issued under rights plan if efforts no longer reasonable to threat
 DE has forced boards to redeem pills if used to protect company-sponsored alternatives to cash tender offers
 Grand Metropolitan – required BOD to redeem pill after concluding own restructuring proposal unfavorable

13.4 – Choosing a Merger or Buyout Partner: Revlon, Its Sequels, and Its Prequels
   Board’s entrenchment interest can affect not only its takeover defenses but choice of merger or buyout partner
   Mgmt can obtain variety of benefits in “friendly” deals – place on surviving BOD, termination payments, etc.

Smith v. Van Gorkom, p. 513, Delaware, 1985
 Shareholders brought class action for rescission of cash-out merger of Trans Union into Marmon subsidiary
 Trans Union had difficulty generating enough taxable income to take advantage of investment tax credits
    CFO and COO discussed LBO as a solution to the ITC problem – merely ran numbers at $55 and $60
 Van Gorkom – Trans Union CEO – approaching mandatory retirement and didn’t trust a mgmt LBO
 Approached Pritzker – takeover specialist – who made cash offer at $55 absent evidence of fair value
 Van Gorkom presented case to informed BOD for 20 minutes who agreed to terms of terms of agreement
    Trans Union would receive but not solicit competitive offers for period of 90 days
    Trans Union could only provide public – not proprietary – information to potential bidders
 Two press releases indicated strong likelihood of merger with Pritzker but potential for offers – none received
 Court held BOD grossly negligent in that it failed to act with informed reasonable deliberation in agreement
    Adequacy of premium indeterminate unless assessed in terms of other sound valuation info – not market
    Second press release – in combination with first – had clear effect of locking BOD into Pritzer merger
    BOD not fully informed of all facts material to vote; CEO’s representations do not constitute “reports”

Introducing the Revlon Decision
 Revlon gave full cry to court’s desire to modify BJR in transactions that involve a change in control
 Mgmt opposed takeover offer for $47.50 (stock then at $25) from Perelman with two defensive tactics
     1) adopted form of flip-in rights and 2) repurchased 20% of own stock with unsecured note at premium
     Note clouded balance sheet making financing harder and allowed new covenants to restrict asset sale

                                                                           Spring 2005 Corporations – Coates p. 62
   Perelman countered by raising bid price to $56.25 if board agreed to redeem pill – now shareholder pressure
   BOD solicited bid from “white knight” but strategy required removal of covenant – would lower notes value
   BOD finally assured white knight’s victory by giving it no-shop provision, breakup fee and “lock-up option”
    to purchase Revlon’s most valuable assets at bargain price if another bidder gets 40% of outstanding votes
     Lock-up agreement for main assets better than option to sell all assets since no required shareholder vote
   Perelman increased offer to $58 conditional on lock-up being rescinded or declared invalid; sued to enjoin
   Delaware SC firmly rejected what it considered to be Revlon’s attempt to “rig” the bidding

Revlon v. MacAndrews and Forbes Holdings, p. 520, Delaware, 1986
 SC held concern for non-stockholder interests – note holders – inappropriate when an auction among active
   bidders in progress – object no longer to protect or maintain corporate enterprise but to sell to highest bidder
    Lock-ups not per se illegal under DE law – here since ending auction operated to shareholders’ detriment
    Principal benefit was to BOD who avoided personal liability to class of creditors to whom owed no duty
 Favoritism to white knight to exclusion of hostile bidder may be justifiable when latter hurts shareholders
 But when bidders make relatively similar offers or dissolution of the company becomes inevitable, BOD must
   let market forces operate freely to bring target’s shareholders the best price available for their equity

 Court thus announced yet another exception to BJR test – Revlon exception says that in a sale not only can a
   BOD not favor one party over another but the court will play the role of the auctioneer to ensure fair value
 Here court would just create a “fair auction” by getting rid of asset option, no-shop provision and breakup fee
 In general, courts have not found personal liability in cases like this – P just seeking fair auction for company
 From Forstmann’s perspective – white knight – lock-up option, etc. required to justify due diligence costs
    Prospect that companies cannot lock up deal hinders ability to get assurance before more transaction costs
 Ford – only other opinion where BOD violated fiduciary duty by acting for employees instead of shareholders

Barkan v. Amsted Industries, Delaware, 1989 – Clarified Revlon
 Level Playing Field Among Bidders – can’t favor one bidder over another without compelling justification
 Market Check Required – when board considering single offer and has no reliable grounds to judge adequacy
   of offer (Van Gorkom) fairness demands a canvas of the marketplace to determine if higher bids possible
 Limited Exception – when directors possess a body of reliable evidence…to evaluate fairness of a transaction,
   the BOD may approve it without conducting an active survey of the marketplace
 Subsequent cases have upheld that companies can hire I-bankers to secretly solicit informal bids; why do it?
    Very possible that bids received are not desirable so if pubic now have damaged the franchise
    Employees may start jumping ship if think company up for sale, suppliers and creditors worry, etc.

Deal Protection Strategies
 Asset Option – gives acquirer right to buy specified assets of target at specified price – extremely rare in 90’s
 Stock Option – gives acquirer right to buy specified number (%) of shares of target (typically 19.9%) at price
    Stock options appears in 25% of deals in 1999; now typically capped in dollar amount so like breakup fee
 Breakup Fee – gives acquirer cash in event of non-consummation due to target doing deal with third party
    Breakup fees appears in 50% of deals in 1999 ($2.5 billion breakup fee in Exxon/Mobil deal)
 No Shop Provision – target agrees not to actively solicit competing bids (or not negotiate, provide info, etc.)
 DGCL §146 – force a vote – firm may agree to submit a matter to a shareholder vote without BOD approval

Incentive Effects of Revlon
 Recapitalizations preferable to white knight deals – don’t trigger Revlon duties (just Unocal – easier)
 QVC Exception – if transaction creates a controlling shareholder where not one before then considered a sale
     Exception applies even if the transaction is a stock-for-stock merger

                                                                           Spring 2005 Corporations – Coates p. 63
13.5 – Pulling Together Unocal and Revlon
   Paramount addressed whether board has duty to redeem its poison pill and what triggers Revlon duties
   Paramount’s unsuccessful bid for Time also perhaps most famous hostile takeover attempt of the 1980’s

Paramount Communications v. Time, p. 524, Delaware, 1989
 Time initiated friendly merger negotiations with Warner Communications – stock-for-stock merger
 Paramount then announced high $175 cash bid for all of Time’s shares contingent on termination of share
   exchange agreement with Warner, redemption of Time’s poison pill, and resolution of legal difficulties
 Time’s BOD rejected price as grossly inadequate – I-bankers said $250 reasonable for “control market value”
 Dilemma for Time since if shareholders voted would surely reject merger to tender into Paramount offer
 Time tried to thwart Paramount by transforming original merger deal into tender offer for Warner
    Made Time too large (and debt-ridden) to be an attractive target for Paramount
 P increased cash offer to $200 to dissuade Warner merger but to no avail; sued with shareholders to enjoin

Revlon Claims by Time Shareholders
 Shareholders first asserted original stock-for-stock merger put Time up for sale triggering Revlon duties
    Thus BOD should have focused on maximizing short-term shareholder value and treated bidders equally
 Further contended that BOD triggered Revlon duties by structuring merger transaction to be takeover-proof
    Decision to merge imposed fiduciary duty to max immediate value, not erect unreasonable barriers to bids
 Court held, absent limited circumstances under Revlon, the BOD – while always required to acted in informed
   manner – under no duty to max shareholder value in short term even in context of takeover; circumstances are
    Company initiates active bidding process to sell itself or effect a reorganization involving a clear break-up
    Target abandons its long-term strategy and seeks an alternative transaction also involving breakup
 Time’s recasting of merger agreement with Warner from share exchange to share purchase not a basis to
   conclude that Time had either abandoned its strategic plan or made a sale of Time inevitable

Unocal Claims by Paramount
 Court held board’s original decision to expand company through merger sufficiently evaluated so gets BJR
 However, revised agreement was defense-motivated so decision should be evaluated under Unocal standard
 Rejected P’s contention that since offer not two-tier and all all-cash, the only threat was inadequate value
    When evaluating takeover threat, board may consider price, nature and timing, impact on non-
       shareholders, risk of non-consummation and the qualify of securities being offered in the exchange
 Here Time board reasonably determined inadequate value not only threat – shareholders may tender in haste
 Second part of Unocal – court held restructuring of Warner transaction reasonable response to threat posed
    Not aimed at forcing mgmt-sponsored alternative on shareholders, but to bring forth previous transaction

 Case may be read to imply board may maintain a pill defense indefinitely when it fears that shareholders
   might “wrongly” conclude that a hostile offer is fairly priced, despite the board’s contrary view
 Can also infer that the pill may sometimes – but not always – be used to protect new or defensive transactions
 On the Revlon side of Unocal-Revlon dichotomy, court appears to reject change-of-control test as trigger

Paramount v. QVC Network, p. 530, Delaware, 1994
 Court held that sale of control in this case implicates enhanced judicial scrutiny under Unocal and Revlon
 Paramount board unanimously approved merger with Viacom – exempted Viacom from poison pill
 Contained several provisions designed to make it more difficult for potential competing bid to proceed
    No-Shop Provision – wouldn’t solicit, negotiate or endorse competing offer (fiduciary duty exception)
    Termination Fee Provision – Viacom receive $100MM fee if Paramount backs out of transaction
    Stock Option Agreement – Viacom gets option to purchase 19.9% if any of triggering events occur

                                                                          Spring 2005 Corporations – Coates p. 64
   Despite attempt to discourage competing bid, QVC announced $80 cash tender offer for 51% of shares
     Conditioned on, among other things, invalidation of the Stock Option Agreement
   Viacom unilaterally raised tender offer price to $85; QVC followed suit by raising to $90
   Despite better offer, Paramount board determined QVC offer not in best interests of shareholders; QVC sued
     Board did not communicate with QVC since believed No-Shop Provision prevented it
     Valid argument that BOD violated Duty of Care in not acquiring information – like Smith v. Van Gorkom
   Case at bar implicates two circumstances where enhanced scrutiny applied
     Approval of transaction resulting in a sale of control; and
     Adoption of defensive measures in response to a threat to corporate control
   In sale of control, board has fiduciary duty to secure transaction offering best value reasonably available
     Mandated by threatened diminution of current stockholders’ voting power, assets being sold may never be
        available again, and traditional concern of DE courts for actions that impair stockholder voting rights
   Rejected argument that enhanced scrutiny not applicable since no “break-up” of corporation – control change
     Revlon duties not only implicated when clear breakup or target abandons strategy and seeks breakup
     Directors have burden of proving that they were adequately informed and acted reasonably – not perfectly
   Having decided to sell control of the corporation, Paramount board required to evaluate critically whether all
    material aspects of Paramount-Viacom transaction were in best interests of Paramount stockholders
   Board did not satisfy duty since should have been clear that defensive tactics were impeding best value

 DE SC thus adopted a “change-in-control” trigger to distinguish between Revlon and non-Revlon deals
 Drew line at point where public shareholders excluded from meaningful governance in combined company
    Revlon duties likely to be triggered when mergers create shareholdings of 30-35% voting rights
 Second implication of change-in-control test is that cash merger generally triggers Revlon duties unless
   already a majority shareholder of target company – unclear how to evaluate when merger consideration mixed

Problem on p. 541
 X has offered to acquire T in merger for $14, 1/10 of a share of X’s stock, ¼ share preferred, $4.50 (per share)
 Must T’s board treat X’s proposal as a Revlon transaction?
    Cash is only 33 percent of total consideration – but preferred stock is redeemable and nonvoting
    On the other hand X is publicly owned with no controlling shareholder
 Rules underlying Revlon duties seem to turn on assumption that generally boards are better able to value
   companies than shareholders – but in some circumstances, as when shareholders are or might be cashed out of
   post-merger enterprise, boards must maximize short-term value since only value shareholders will receive
 Generally, where merger consideration is cash itself, courts will not defer to board’s judgment – as in Revlon
 However, when consideration is stock of company of equal size, deal protections will receive max deference

Triggering Revlon
 Revlon duties LESS likely if consideration all stock and acquiring shareholders are widely held
 Revlon duties MORE likely if consideration all cash and acquiring shareholder is a controlling shareholder
    Except when target already has a majority shareholder – trigger only if creates controlling shareholder
 Theories to justify
    Institutional Competence – judges more able to assess if cash than more complicated deals
    Coercion – shareholders more likely to be persuaded by cash offerings
    Last Period Agency Costs – company will no longer exist so courts can impart opinion
    Last Chance for Control Premium – minority shareholders unlikely to ever get control premium again

Note on Deal Protection in M&A Transaction Agreements
 Today issue of Revlon duties arises in context of negotiation or enforcing “deal protection” provisions
 Lock-up – any contract, collateral to M&A transaction, designed to increase likelihood parties will close deal

                                                                          Spring 2005 Corporations – Coates p. 65
     Options to Assets – create rights to acquire specific corporate assets exercisable after triggering event
     Options to Stock – options to buy clock of securities of target company’s stock (19.9%) – more common
          Allows jilted acquirer to participate in increased value of target to extent of its % of diluted equity
   Lock-ups have two primary justifications
     May be necessary to compensate friendly buyer when a third party ultimately wins the target
     Boards of target and acquiring companies see unique benefits that shareholder don’t – want to secure deal
   When no change in control involved, board free to choose facially lower value if in best interest of company
   Court should view lock-ups in such situations under BJR – likely use Unocal version since defensive tactic
   A board decision not to recommend a negotiated acquisition is an accepted trigger for a termination payment

Note on “No Shops/No Talks” and “Fiduciary Outs”
 Buyers protect against contingency of target shareholders vote in two ways
    May seek a large lock-up
    May seek certain covenants from seller to protect their deal (e.g., not to shop or supply confidential info)
 Without such protections buyers would invest fewer resources in searching for deals and offer lower prices
 What happens to directors’ fiduciary duties when third party still makes better offer before shareholder vote?
    Target board can’t recommend less attractive original deal without violating duty of loyalty
    However, if the company accepts the better deal it will fact contractual damages from covenants
 Fiduciary Out Clause – if some triggering event occurs, target board can avoid contract without breaching it
    Now they’re heavily negotiated in all friendly merger agreements
    However, if Revlon duties apply, no contract term can protect a negotiated deal from an alternative buyer
       willing to pay more – so contract damages not available in such situations and clauses seem immaterial

13.6 – State Anti-Takeover Statutes
   State legislation – came in waves – an attempt by forces of status quo to limit disruption of hostile takeovers
   First generation of anti-takeover statues addressed disclosure and fairness concerns – firms connected to state
     US Supreme Court struck them down as preempted by federal Williams Act – violated Supremacy Clause
   Next wave tried to avoid preemption by balancing interests of offers/targets with policy of investor protection
     Fair Price Statute – deters two-tier coercive takeovers by requiring same value for those frozen out
              Require high supermajority vote to approve freeze-out merger unless at least same value offered
     Control Share Statute – resists hostile takeovers by requiring disinterested shareholder vote to approve
        purchase of shares by any person crossing certain levels of share ownership in the company (20, 33, 50)
              Offeror can regain voting rights by gaining approval from majority of disinterested shareholders

CTS Corp. v. Dynamics Corp. of America, p. 549, US Supreme Court, 1987
 Dynamics – owned 9.6% of CTS – made tender offer for another million shares to bring interest to 27.5%
 CTS board elected to be governed my provisions of new Indiana anti-takeover statute (incorporated there)
   Conditions acquisition of control on approval of majority of pre-existing disinterested shareholders
 Court first held that the Indiana Act is not preempted by the Williams Act – unlike MITE statute compared
   No communication advantage to board; no indefinite delay on tender offers; state doesn’t get a say
 Court then held that the Indiana Act does not discriminate against interstate commerce
   Part of business landscape for States to create corps, prescribe their powers, define shareholders’ rights

Third Generation Anti-Takeover Statutes – (1987 – 2000)
 In line with CTS decision that state anti-takeover legislation consistent with Williams Act and Commerce
   Clause if it allows bidder to acquire shares, even if it makes such acquisition less attractive in some instances
 DGCL §203 – Business Combinations With Interested Stockholders
    Deters “junk bond”-financed “bust-up” takeovers by preventing acquirers from getting target’s assets

                                                                             Spring 2005 Corporations – Coates p. 66
      “Corporation shall not engage in any business combination with any interested stockholder for period of 3
       years following the date that such stockholder became an interested stockholder unless
             Prior to such date board approved the combination/transaction that made stockholder interested
             Bidder can acquire 85% of outstanding voting stock in a single transaction
             After acquiring more than 15% (and less than 85%) bidder can secure 2/3 vote from remaining
   Disgorgement Statute – mandate disgorgement of profits made by bidders upon sale of target’s stock or assets
     Any bidder who acquires fixed percentage of voting rights – including by proxy – subject to statute
   Redemption Rights Statute – allows shareholders to bring appraisal whenever controlling acquisition (>30%)
   Constituency Statutes – allow target’s board to consider interests of constituencies other than shareholders
     Allow board to use broader range of potential justifications for taking defensive measures

13.7 – Proxy Contests for Corporate Control
   Proxy fights rule since universal adoption of poison pill and judicial rulings that foreclose forced redemption
     Only viable alternative is to negotiate with the incumbent board – may think change in control is good
   Mgmt may expend corporate funds to organize annual meeting and collect proxies to assure a quorum
     Proxy voting substantially lowers cost of voting reduces collective action problem
   Hostile option for displacing mgmt is to run both a proxy contest and tender offer simultaneously
     Closing tender offer conditioned on electing acquirer’s nominees to target’s board and redemption of pill
   Following cases address the legal test for evaluating board actions that affect proxy contests

Schnell v. Chris-Craft Industries, p. 559, Delaware, 1971
 Mgmt sought to amend bylaws to advance date of annual meeting – effort to thwart proxy contest
    Officers argued that it complied strictly with provisions of DE Corporation Law by changing by-law date
 Court granted injunction – advancement to obstruct legitimate efforts of dissident stockholders not permitted
 Also rejected D’s assertion that application for injunctive relief came too late – 4 days after learned of move
    Stockholders not charged with duty of anticipating inequitable action by the mgmt

 Blasius standard (also Chris-Craft) establishes similar fiduciary duty of loyalty in takeover cases – tough test
 If the board is doing something whose primary purpose is to make shareholder voting harder then it must
   come up with a compelling justification and have the burden of establishing case – otherwise will enjoin
    Courts more reluctant to contest board’s decision if capital involved – rather than changing procedures
    If defense to proxy fight made up on spot, courts more likely to intervene – unlike adopting poison pill

Blasius Industries v. Atlas Corp, p. 560, Delaware, 1988
 B – owner of 9% of A stock – proposed restructuring of A’s mgmt that would have resulted in major sale of
   A’s assets, infusion of new debt financing, and disbursement of very large cash dividend to A’s shareholders
 When mgmt rejected proposal, B announced campaign to increase BOD from 7-15 and fill with B’s nominees
 A preempted B’s campaign by immediately amending bylaws to add two new seats and filled with own
 Court held that board acted to impede a majority of shareholders from adopting course proposed by B
    Adoption of two new board members would otherwise be clearly appropriate as independent step
 However, refused to hold board acted out of self-interested motive but rather good faith effort to protect firm
    Board may take certain steps to defeat change in control when taken advisedly, in good faith pursuit of
        corporate interest, and are reasonable in relation to threat of corporate interest posed by change in control
 Since board’s tactics did not involve property – rather corporate governance – left to its business judgment

Notes on Schell-Blasius Cases
 Director actions that interfere with voting process are presumptively inequitable – reverses BJ presumption
 Since changes to voting process often “defensive,” courts may apply Unocal – less demanding than Blasius
    Blasius requires powerful justification to thwart shareholder franchise for extended period

                                                                             Spring 2005 Corporations – Coates p. 67
   One critical difference between review under Unocal and under Blasius
     DE SC’s Time opinion seemed to authorize target board to take defensive action if threatened by coercion
             Simply board’s believe that tender offer inadequate and shareholders don’t understand this fact
     Under Blasius, however, corporate action to defeat proxy contest can’t be justified by parallel belief that
       voters simply don’t understand foolishness of voting for the insurgent slate

Unitrin v. American General Corp, p. 564, Delaware, 1995
 AmGen made hostile tender offer for shares of Unitrin at 30% premium; Unitrin’s board felt inadequate
 Defended with poison pill, advance-notice bylaw, and repurchase of 20% outstanding shares
    Result of buyback is to take the board’s 23% ownership to 28% – didn’t buy more in fear of court
    Increased stock (costlier for bidder); reduced shares outstanding (takeover easier); more BOD control
 Chancery Court held Amgen offer represented threat of “substantial coercion” so applied Unocal analysis
    Court said shareholder confusion – board said don’t know stock undervalued – can constitute coercion
    Board’s requirement to establish a threat thus appears easy – seems less coercive than two-tier in Unocal
 Court next assessed reasonableness of defense tactics – board only loses if coercive or preclusive (draconian)
 Held that the pill was proportional response to threat posed but that the repurchase program not
    At issue was if repurchase program and advance-notice bylaw were also “reasonably related” to threat
 DE SC held that Chancery incorrectly substituted its business judgment for that of Board – Paramount/QVC
    If a board’s defensive response is not draconian (preclusive or coercive) and is within “range of
       reasonableness” then a court must not substitute its judgment for the board’s
 Unitrin board had power/duty to protect shareholders from perceived threat of inadequate tender offer
 Adoption of poison pill and limited repurchase program not coercive and repurchase plan not preclusive
 Since not coercive or preclusive so court must determine if within range of reasonable defensive tactics
    If reasonable to threat, measures entitled to review under BJR – burden back to P to show breach of duty
    P must show decision primarily based on 1) perpetuating themselves or 2) other breach of fiduciary duty

 Unitrin clarifies the Unocal test – makes clear how limited an “enhancement” to BJR Unocal really is
    Target’s directors (not P) bear burden of showing defensive action proportional to threat
    Substantively, action that is “preclusive” or “coercive” will fail to satisfy Unocal’s test
    Assuming defensive measure passes preclusive/coercive test, satisfies Unocal if within reasonable choices
    If reasonable, simply shifts burden back to P to prove defensive action not otherwise breach of duty
 Prior to this case law firms advised that pill adoption in face of takeover would portray board entrenchment
 However, here the court didn’t give late adoption of pill a second thought – can still be legitimate motives

A Note on Hilton v. ITT Corp.
 Hilton initiated $55 cash offer for all ITT shares and proxy context to replace ITT board
 ITT delayed calling annual meeting and in meantime structured a reorganization – three components
    ITT Destinations had 93% current assets and handful of anti-takeover mechanisms (e.g., staggered board)
 Hilton sought injunction as action motivated to protect incumbency and constituted breach of fiduciary duty
 Court concluded installation of classified board is clearly preclusive and coercive under Unitrin

13.8 – The Takeover Arms Race Continues
   Dead-Hand Pill – precludes “hostile” board elected in a proxy fight from redeeming pill for period of time
     Early attempts provided company’s pill could be redeemed only by “continuing directors”
     One invalid as created two classes of directors, unduly conditioned shareholders rights to elect new ones
   Mentor Graphics – different version – no discrimination between old/new directors but 6 months to redeem
     Struck down pill as current board has no authority to restrict power of future boards to exercise judgment

Mandatory Pill Redemption Bylaws

                                                                          Spring 2005 Corporations – Coates p. 68
   Shareholder mandatory pill redemption bylaws unlikely to pass – present two controversial issues
   1) Is a bylaw that mandates the board to exercise its judgment in a particular way a valid bylaw?
     Despite Fleming, most DE firms say mandatory bylaw an invalid shareholder intrusion into §141(a)
     Boards have rights and duties to make independent judgments respect mgmt of the firm
   2) Must managers include in company’s proxy solicitation materials respecting any such proposal?
     SEC Rule 14a(1)(i) specifically states that a board may exclude proposal if illegal/invalid under state law
     Same issues as above to determine if such a bylaw would fall into this category
   Several important policy questions
     When are efficiencies that we gain from delegating authority to centralized managers outweighed by the
         expected agency costs associated with that delegation?
     How much cost is entailed in deciding about wisdom of a stock rights plan?
     How likely is that a pill will deter wanted offers? That management will misuse the pill?

Tactics Within By-Laws
 §211(d) – shareholders can’t call a special meeting unless stated in by-laws
    Shareholders can change by-laws at next annual meeting to allow special meetings
 §141, §142 – directors and officers must have qualifications stated in by-laws
    Shareholders can require share ownership to be on BOD, preclude CEO from serving on BOD, etc.
 §109 – questionable whether supermajority provisions to change by-laws legal when adopted by BOD

MCI Sale
 Friendly deal between MCI and Verizon announced 2/14
 Competing proposal from Qwest announced 2/28
 Verizon subsequently purchased 13% of shares from Carlos Slim
 Analysts are saying that if Qwest can’t buy MCI they are dead – money not an issue
 Is Revlon applicable?
   Focus on the actions of MCI board – has board agreed to transaction that puts the company “in play”?
           Qwest can’t by its own action put the MCI board in play
   Current Verizon offer for 37% cash – paid in “special dividend” so not part of consideration of deal
           Desire to declare as special dividend to avoid implicating Revlon – deal looks like more stock
           Santa Fe Pacific Corp (DE, 1995) says 33% does not trigger Revlon
           In re Lukens (DE, 1999) says 62% cash likely triggers Revlon
   MCI can defend taking lower price through contingencies – Qwest could go bankrupt, no approvals, etc.
 Verizon should be worried about $2.2 billion gap – will require MCI’s shareholders to agree to it
 If Verizon confident that it can get the vote, it can force it to happen through new statute - §146
 Qwest’s possible actions
   Continue friendly overtures by shoring up its bid
   Proxy contest at May 16th annual meeting
   Go hostile through special meeting route
   Go hostile by soliciting written consents
 Qwest has not gone hostile since
   SEC will require full and complete disclosure – need to lay out complete plan (Verizon can then attack it)
   High transaction costs associated with such a fight
 MCI’s board can’t just pass decision off to shareholders – have duty to make recommendation
   Even if contractually obligated to MCI to take vote to shareholders even if don’t recommend the deal
 Now that Qwest’s offer is roughly 50% cash, Revlon almost certainly applies – therefore much harder for
  BOD to go back to shareholders and defend deal with Verizon; under Revlon must focus on short-term value
   Can’t argue that this will create long-term value under Unocal since now will be largely cashed out

                                                                          Spring 2005 Corporations – Coates p. 69
Chapter 14 – Trading in the Corporation’s Securities
 Disclosure obligations that attend corporate securities trading for public companies are primarily federal law
 Securities Act of 1933 – principal statute in public distributions of securities
 Securities Exchange Act of 1934 – primary source of regulatory law for shares traded on “secondary” markets
     §16A – requires insiders to inform the public when trading own securities by filing forms with SEC
     §16B – any short-term profits made by insiders must be returned – private right through derivative action
            If any purchase or sale within 6-month period (regardless of sequence) then calculate profit in
              worst way possible for insider; liability extends for six months after termination of employment
            This relatively mild standard – just keep for 6 months or sell before tanks – reason for 10b-5
     Key Disclosure Items
            S-K: MD&A – standard cross-reference sheet for disclosure forms
            S-X: Financials – specific financial statements required
            12b-20: Catch-All – if make statement in report, must make all others to complete picture
            Management Discussion – lengthy discussion of company’s past and expected performance
 Fiduciary doctrines that play large role elsewhere in corporate law are secondary significance in this field

Example 1
 On the subway and hear city official declaring intent to create new football stadium
 Approach little old lady who owns worthless land near new stadium that will soon be very valuable
 Six weeks after you buy her property city announces deal; she sues and finds out that you knew of info
 Legitimate purchase since no fiduciary duty to this lady and doesn’t satisfy elements of C/L fraud

Example 2
 Same facts, but instead of purchasing land you purchase stock of a company that owns this same land
 No classic insider trading case because a third party leaked news rather than company insider
 There is no duty between strangers on the subway to use information they get from one another

Example 3
 Same facts, but instead of purchasing private stock you make a legitimate tender offer for all of company
 Although the transaction form can matter, here no reason to act differently since still no fiduciary duty
    Forcing tender offeror to disclose all material info to public would make tender offers hard to run
    However, SEC Schedule TO would require tender offeror to disclose specific purpose for company

Example 4
 Suppose CEO purchases stock directly from own corporation – violation of “duty of loyalty” under state law
 However, if CEO purchases stock from 3rd party shareholders then no fiduciary duty involved

14.1 – Common Law of Directors’ Duties When Trading in The Corporation’s Stock
   Common law fraud required proof of five elements: (1) a false statement of (2) material fact (3) made with the
    intention to deceive (4) upon which one reasonably relied and which (5) caused injury
   Given this, fraud remedy generally not available when buyer or seller simply failed to disclose material fact
     Common law fraud was not available to redress losses of persons trading over impersonal markets
   Strong v. Repide – SC held director had special obligation to disclose material facts or refrain from buying
     Director bought stock from shareholder without revealing that company about to enter lucrative contract
   Goodwin v. Agassiz discusses duties of a director or officer as they stood on verge of federal securities laws

Goodwin v. Agassiz, p. 578, Massachusetts, 1933
 D – president and CEO – purchased 700 shares of stock on Boston stock exchange with insider info

                                                                          Spring 2005 Corporations – Coates p. 70
     Experienced geologist had written theory as to possible copper deposits in region where company located
   Court rejected directors occupy position of trustee towards individual stockholders – only property & business
   Directors had no obligation to make possibility of deposits public – could like get sued if proved erroneous

14.2 – The Corporate Law of Fiduciary Disclosure Today
   SEC and federal courts aggressively expanded federal law of disclosure between 1940 and 1970
   Federal courts aggressively expanded federal investor remedies – almost all of this litigation now federal
   State fiduciary law still plays important role in two situations
     Corporation can bring claim for profits made by using info learned in connection with corporate duties
     Shareholders can invoke state fiduciary duty to challenge equality of disclosure that firms makes to them

14.2.1 – Corporate Recovery of Profit from “Insider” Trading
   Under fiduciary – or agency – theory corporation or shareholders should be able to sue insiders derivatively
     It has been only relatively recently that a few state courts have permitted suits of this sort
   Two aspects of this fiduciary duty theory are particularly notable
     Since firm seen as “owning” its nonpublic info, it could allow agent to trade on it if not against law
     Fiduciary duty theory does not attempt to compensate uninformed shareholder with whom insider trades
   Freeman v. Decio – federal court of appeals case that declines to adopt fiduciary duty theory as law of Indiana

Freeman v. Decio, p. 583, 7th Circuit, 1978
 P asserted that D – Skyline’s chairman and largest shareholder – sold stock when knew earnings inflated
    Stock dropped almost 30% after earnings dropped substantially in subsequent quarter
 Court held D did not violate fiduciary duty; insider trading remedies under federal securities law appropriate
    Firm received no injury – most insider info not corporate asset as would violate securities law if dealt in it
    Fiduciary duty doesn’t extend to broad notion that directors can’t receive profit beyond salary
    C/L permits officers/directors to trade in securities free from liability to other traders without disclosure

14.2.2 – Board Disclosure Obligations Under State Law
   Delaware Supreme Court has gradually articulated board’s duty to provide complete disclosure over 20 years
     This state law duty closely parallels the federal disclosure duty under Rule 10b-5
   Directors duty of candor under state law requires exercise honest judgment to assure disclosure of all material
    facts to shareholders; failure to disclose material fact unlikely to give rise to liability unless intent to mislead

14.3 – Exchange Act §16(b) and Rule 16
 Section 16(a) – requires designated persons (directors, officers, 10 %) to file public reports of any transactions
 §403 of Sarbanes-Oxley Act of 2002 – reduced time to file reports to 2 business days from transaction
 Section 16(b) – requires statutory insiders to disgorge to corporation any profits made on short-term turnovers
     Appears to be “bright-line” rule but coverage can require interpretation of presumed intend of legislature
     Gratz v. Claughton – Learned Hand established accepted rule that – in matching sales with purchases for
        §16(b) purposes – court must take into account all purchases and sales from same class of securities
        occurring within 6 months of reportable event (both six months in past and six months into the future)
       Courts have long held that title not dispositive in deciding who is an “insider under §16(b)
            Relevant inquiry is if putative officer had recurring access to non-public info in course of duties
       Toughest issue is what constitutes a “purchase or sale” – voluntariness and ability to use info are factors

14.4 – Exchange Act §10(b) and Rule 10b-5
 1934 Act broadly empowered SEC to promulgate rules regulating trading of securities on national exchanges
     Section 10 of the Exchange Act is the most important such grant of rulemaking power

                                                                               Spring 2005 Corporations – Coates p. 71
Principal Aims of Rule 10b-5
 Policing Disclosure – when companies make any public disclosure it must be accurate and complete
     Applies to ALL statement made in any context to securities – courts have found this to be every statement
     Prevents companies from misleading current or potential shareholders
     So not a crime for a company to “sit” on information forever – except for annual reports, proxies, etc.
 Prohibiting Traditional Acts of Manipulation – e.g., buying/selling large amounts of shares to show volume
 Preventing Insider Trading – much of the focus of the material below

Required Elements of 10b-5 Claim
 (1) Misstatement/Omission, (2) Materiality, (3) Scienter, (4) Reliance, (5) Causation, (6) Damages
 Similar to 14(a)9 claim for proxy solicitations – however 14(a)9 only requires negligence and no sale of stock

14.4.1 – Evolution of Private Right of Action Under §10
 Rule 10b-5 – most important rule promulgated by SEC under §10(b) – makes it unlawful to
     Employ any device, scheme or artifice to defraud
     Make any untrue statement of a material fact or omit to state a material fact necessary in order to make
        the statements made, in light of the circumstances in which they were made, not misleading, or
     Engage in any act, practice, or course of business that operates or would operate as a fraud or deceit upon
        any person, in connection with the purchase or sale of any security

14.4.2 – Elements of a 10b-5 Claim
 Elements of Rule 10b-5 cause of action must resemble those of common law fraud – and real market
       Common law fraud required proof of five elements: (1) a false statement of (2) material fact (3) made
        with the intention to deceive (4) upon which one reasonably relied and which (5) caused injury
   In addition to these elements, the language of Rule 10b-5 seems to mandate
     The requisite reliance must be by a buyer or seller or stock
     The harm must be to a trader in stock
     The misleading statement must be made in connection with a purchase or sale of stock – Elements of a 10b-5 Claim: False or Misleading Statement or Omission
   A false statement (made with intent to deceive) is most basic element of common law deceit – basis of 10b-5
   By contrast, omissions of material facts are more problematic – three different approaches have evolved
     SEC initially said possession of any relevant, material, non-public info = duty to disclose or abstain
     SC in Chiarella said insider must breach a fiduciary duty in trading on inside info to be liable under 10b-5
     SC since adopted intermediate stance of augmenting fiduciary duty with broader misappropriation theory

SEC v. Texas Gulf Sulphur, p. 592, 2nd Circuit, 1969
 D’s purchased stock and/or received stock options when had info of very valuable mineral find in Canada
    One of D’s drafted press release to quell rumors of find – three bought after release before confirmation
 Court held anyone in possession of material inside information must either disclose it to investing public, or if
   he is disable from disclosing it to protect a corporate confidence (or just chooses not to) must abstain from
   trading in or recommending the securities concerned while such inside information remains undisclosed
    Whether facts material within Rule 10b-5 depends on probability event will occur and relative magnitude
    Major factor in determining mine discovery was material fact is importance attached by those who knew
 All transactions in TGS stock or calls by individuals apprised of drilling results in violation of Rule 10b-5
    Can’t take advantage of info knowing it’s unavailable to those with whom dealing – investing public

 This case resulted in eruption of private litigation under Rule 10b-5 in lower courts; SC responded with

                                                                              Spring 2005 Corporations – Coates p. 72
   Blue Chip Stamps – claimants must buy or sell stock – holding in reliance on misstatement not enough
   Ernst & Ernst – scienter required to bring a 10b-5 claim

Santa Fe Industries v. Green, p. 598, US Supreme Court, 1977
 Santa Fe acquired 95% of Kirby’s stock; then used §253 – short-form merger – to acquire the rest
    Company agreed that the value of minority shares $650; market price only $80 per share
    Morgan Stanley appraised the fair market value of minority stock at $125; Santa Fe paid $150
    §253 doesn’t require consent of, or advance notice to, minority stockholders; however, notice of merger
       must be given with 10 days after its effective date and dissatisfied shareholders can demand appraisal
 Minority stockholders objected to terms of merger – $150 value – sued using 10b-5 claim
 Court held transaction neither deceptive nor manipulative so did not violate §10b-5 or the Act or Rule 10b-5
    There was no “omission” or “misstatement” in the information statement accompanying the merger
    Company was open with minority shareholders that it was ripping them off – no manipulation
    Manipulative within statute generally refers to wash sales, matched orders, rigged prices, misleading info

 Supreme Court thus pushed fiduciary duty to pay fair market value to cashed out shareholders back to states
 Singer v. Magnavox – DE then created more elaborate fiduciary duty protection in self-interested transactions
    Weinberger – still later DE affirmed obligation to pay “fair price” and modernized appraisal remedy
 Goldberg v. Meridor – 2nd Circuit held derivative action permitted under Rule 10b-5 on basis that transaction
   between firm and fiduciary or controlling shareholder unfair if involved stock and undisclosed material fact
    P must show (i) a misrepresentation or nondisclosure that (ii) caused loss to shareholders – Elements of a 10b-5 Claim: The Equal Access Theory
   Equal Access Theory – traders owe a duty to market to disclose or refrain from trading on nonpublic info
     Equal Access Theory Never Adopted – essentially just dicta from SEC v. Texas Gulf Sulphur
   Originates from “two principal elements” of applying Rule 10b-5 stated in Cady, Roberts & Co.
     Existence of relationships giving access to info intended only for corporate purpose – not personal benefit
     Inherent unfairness involved where party takes advantage of such info knowing unavailable to other party
   Advantage is that it reaches all conduct that might be popularly understood as insider trading
   Disadvantage is that it’s unclear why “unfairness” of trading on better info defrauds other traders without a
    misrepresentation or a preexisting disclosure duty – investors continually exploit differential access to info – Elements of a 10b-5 Claim: The Fiduciary Duty Theory
   Fiduciary duty theory adopted in two early 80’s SC cases – authority of insider trading law under Rule 10b-5
   Chiarella – Court rejected equal access theory by overturning conviction of financial printer
     Printer did not breach a disclosure duty to other traders by trading on nonpublic info or abusing position
     Lacked relationship-based duty to shareholders of target companies in whose securities he traded
   Dirks – Court held that since employee has not benefited, no tipper violation of Rule 10b-5
     Whether tipping improper turns on whether insider tips to secure personal benefit from the tippee
   Fiduciary duty theory has at least two important attractions
     Supports analogy to common law fraud by isolating preexisting relationship between insiders and traders
     Allows case-by-case review of relationship between putative insiders and other traders – selective targets
   As a liability filter, fiduciary duty theory dramatically under-inclusive by popular standards – leaves much out

Chiarella v. United States, p. 608, US Supreme Court, 1980
 P was a printer who handled five announcements of corporate takeover bids – deduced names from context
 Without disclosing his knowledge, P traded on insider information and realized gain of over $30K
 SC exonerated P since, though silence can be fraud, not under affirmative duty to disclose info before trading

                                                                            Spring 2005 Corporations – Coates p. 73
     Only way duty established is if general duty exists between all stock traders not to trade on nonpublic info
     Formulation of such a broad duty – diverges largely from doctrine – not taken absent congressional intent
   Dissent – read statutes to mean one who has misappropriated nonpublic info has duty to disclose before trades

 SEC passed 14e-3 – can’t use material, nonpublic info about tender offer from target or buyer (or fiduciary)
    It does not impose an obligation on actual bidder in tender offer, but this person must file Schedule TO

Dirks v. SEC, p. 612, US Supreme Court, 1983
 P – officer in NY broker-deal firm – received info that Equity Funding had vastly overstated its assets
 After investigating claim determined it was true; openly discussed findings with clients, investors and WSJ
    Five of these investment advisers liquidated holdings of more than $16 million; WSJ didn’t print article
 Only after stock starts to plummet do SEC and insurance industry regulators seek out and discover the fraud
    Decide to go after Dirks because he disclosed info to his clients and investors who traded in the stock
 SC reaffirmed holding in Chiarella – “no duty to disclose where person who traded on inside information was
   not the corporation’s agent, was not a fiduciary, or was not a person in whom sellers of securities placed trust”
    However, has been unclear how tippee acquires Cady, Roberts duty to refrain from trading on inside info
 Tippee assumes fiduciary duty to shareholders not to trade on material nonpublic info only when insider has
   breached fiduciary duty to shareholders by disclosing info to tippee and tippee knows/should know of breach
    Disclosure is breach of duty if insider personally will benefit, directly or indirectly, from the disclosure
 No derivative breach by P since insiders did not breach duty to shareholders in disclosing nonpublic info to P
    Tippers here received no monetary or personal benefit, but rather motivated by desire to expose fraud

 In 2000 the SEC overturned this result by passing Regulation “Fair Disclosure”
    Prevents insiders from giving material, nonpublic information to security analysts unless also make public
    Prohibits practice of issuers giving material info to favored parties first so they can get trading advantages
 Misappropriation Theory – adopted in O’Hagan; reaches all forms of commonly condemned insider trading
    Wrong not because info disparities in market are suspect, but private appropriation of others’ info rights

United States v. Chestman, p. 619, 2nd Circuit, 1991
 D received nonpublic material info about impending sale of Waldbaum from client; traded heavily on it
    Client received info from wife, whose grandmother was on the Waldbaum BOD and wife of founder
 Court held state must show 1) tipper breached fiduciary duty in disclosing info and 2) D knew he had done so
 Evidence insufficient to establish fiduciary relationship or functional equivalent between client and company
 Theory that client breached fiduciary duty of confidentiality with wife also unsupported by evidence
    Status does not create fiduciary status absent pre-existing fiduciary relation or confidentiality agreement
 Since client owed no fiduciary duty to company or wife, he did not defraud them by disclosing news of sale
 Absent predicate act of fraud by client, D not derivatively liable as client’s tippee – no Rule 10b-5 violation

 In 2000 the SEC adopted Rule 10b5-2 overturning the result; duties of trust or confidence arise whenever
    Person agrees to maintain info in confidence
    History of confidentiality between parties, or
    Person receives any such info from family; recipient can defend by showing that no duty of trust existed
 ReTAC – Relationship of Trust and Confidence – relationships used by the SEC to establish liability

United States v. O’Hagan, p. 624, US Supreme Court, 1997
 D misappropriated confidential info about tender offer in breach of fiduciary duty – law firm working on deal
 Purchased an exorbitant amount of call options and individual shares, making a profit of $4.3 million

                                                                            Spring 2005 Corporations – Coates p. 74
   Upheld SEC’s finding of violation under 10b-5 when P’s firm working for bidder and bought target’s stock
   SC held that criminal liability under §10(b) may be predicated on the misappropriation theory
     Person commits fraud in connection with a securities transaction – violates §10(b) and Rule 10b-5 – when
        misappropriates confidential info for securities trading purposes in breach of duty owed to source of info
     Premises liability on a fiduciary-turned-trader’s deception of those who entrusted him with access to info
     Similar to agency law – not allowed to take advantage of misappropriated info – but here criminal statute
   SC thus upheld D’s conviction because his actions established his guilt under misappropriation theory

 Coates not supportive of this theory – not just liable to give value back but rather person goes to jail
 Info received from any fiduciary relationship that creates “relationship of trust and confidence” cannot be
   traded on – unless principal (or everyone in these relationships) agrees that this info can be traded on (waiver)
    Equal access theory doesn’t entirely justify this – can get up to 5% on nonpublic info to that point
 Example – newspaper employees who receives tip through employment relationship then can’t trade on it
    However, employees can trade if the newspaper waives property right over private info and permits trades
 Example – taxi driver likely can’t trade on passenger’s info (fiduciary duty) but fellow traveler on subway can
 In 1998 Congress passed the Insider Trading and Securities Fraud Enforcement Act (ITSFEA)
    Created private right of action for victim in purchases or sales of security with material, nonpublic info
    Legislative history makes clear that only those who “misappropriate” material, nonpublic info held liable

Summary of Cases
 Cady Roberts – “disclose or abstain” – if material, nonpublic info then must disclose it to public or not trade
 Texas Gulf Sulphur – “equal access” – all market participants should be on equal footing with regard to info
    SEC 14e-3 does impose an “equal access rule” as it related to tender offers but not to mergers, etc.
 O’Hagan – “misappropriation” – can’t trade on misappropriated info if material and nonpublic

 Insider trading made headlines throughout the
 Congress and SEC several times debated whether to codify insider trading laws more specifically
     Declined in fear of people gaming the loopholes – “constructive ambiguity” deters people at margins
 Congress however greatly increased the penalties
     SEA §20A – codifies right not just of the people who traded with insider but anyone in market at time of
        insider trading can sue insider for recovery of any losses associated with position with better information
     SEC §21A(a)(2) – increases the penalties to triple damages – SEC can go after you for 3x what you made
     SEC §21A(a)(a) – control persons can be derivatively liable (e.g., I-banker’s boss if knew of info)
     SEC §21A(e) – bounty hunters can get 10% of the recovery for turning insider traders in
 10b-5, 14e-3, 14a-9 – allow private parties to sue (as well as SEC) for damages flowing from insider trading – Elements of a 10b-5 Liability: Materiality

Basic Inc. v. Levinson, p. 629, US Supreme Court, 1988
 Basic made three public statements denying merger negotiations despite active attempts over two year period
 Shareholders who sold stock between first public denial and announcement of merger sued under Rule 10b-5
 Materiality Standard – “an omitted fact is material if a substantial likelihood that a reasonable shareholder
   would consider it important in deciding how to vote; must be a substantial likelihood that disclosure of
   omitted fact would have been viewed by investor as significantly altered “total mix” of public info”
 Impending merger clearly material, though difficult when event contingent or speculative in nature
 SC rejected “agreement-in-principle” test in favor of totality of circumstances – can be material before AIP
 Case remanded since standard of materiality adopted differs from that used by courts below

                                                                            Spring 2005 Corporations – Coates p. 75 – Elements of a 10b-5 Liability: Scienter
   Common law fraud requires scienter or intention to deceive; two main issues are proof and pleading
     Whether actual intent to deceive must be shown or can be inferred from willful or reckless conduct
     Circuits are split on whether knowledge is required or recklessness is sufficient
     Private Securities Litigation Reform Act of 1995 – requires pleading of facts with particularity
   Rule 10b5-1 – created by SEC in mid-2000 to clarify when “use” or “knowing possession” creates liability
     Liability if aware of non-public material info when made purchase or sale
     Affirmative defenses – proof of plan to purchase before info and (in case of fund) natural person unaware – Elements of a 10b-5 Liability: Standing in Connection with Purchase/Sale of Securities
   P must have been a buyer or seller of stock in order to have standing to bring Rule 10b-5 complaint
   Declining offer to invest based on materially false info not sufficient – too expansive – Blue Chip Stamps – Elements of a 10b-5 Liability: Reliance
   While reliance element of common law fraud, harder as element of Rule 10b-5 claim as faceless transactions
   Fraud-on-the-Market Theory – don’t have to show that shareholder relied on specific statement or omission

Basic Inc. v. Levinson, p. 635, US Supreme Court, 1988
 SC held reliance required for Rule 10b-5 – provides causal connection between misrepresentation and injury
 Upheld “fraud-on-the-market theory” – since most publicly available info reflected in market price, investor’s
   reliance on any public material misrepresentations may be presumed for the purposes of a Rule 10b-5 action
 But any showing that severs links between alleged misrepresentation and either price received (or paid) by the
   P, or his decision to trade at fair market price, will be sufficient to rebut presumption of reliance

 Plurality thus found that reliance on market price was sufficient to meet reliance requirement for Rule 10b-5
 Does not act as binding authority since majority of justices did not join on point – followed by lower courts – Elements of 10b-5 Recovery: Causation
   Private actions under Rule 10b-5 require proof of causation – can be transaction causation and loss causation
     Transaction Causation – must cause a purchase or sale
     Loss Causation – must show that losses incurred are the result of the misstatement
   SC thus now requires P to disprove that other factors caused the loss (e.g., negative industry trends) – Remedies for 10b-5 Violations

Elkind v. Liggett & Myers, p. 640, 2nd Circuit, 1980
 Shareholders brought class action against Liggett for wrongful tipping of inside info about poor earnings
 Court adopted “disgorgement measure” to calculate damages
    Allow any uninformed investor, where a reasonable investor would either have delayed his purchase or
       not purchase at all with benefit of tipped info, to recover any post-purchase decline in market value of his
       shares up to a reasonable time after he learns of the tipped info or after public disclosure
    However, recovery limited to the amount gained by the tippee as a result of his selling at earlier date
       rather than delaying his sale until the parties could trade on an equal informational basis
 In case at hand, all harmed investors get pro rata portion of tippee’s gain – [1,800 shares] x [$9.35/share]

 Disgorgement measure quickly became standard measure of damages in private Rule 10b-5 cases

                                                                            Spring 2005 Corporations – Coates p. 76
14.4.3 – The Academic Debate

Kenneth J. Scott – Insider Trading: Rule 10b-5, Disclosure and Corporate Privacy – 1980
 Three primary conceptions of Rule 10b-5 and its objectives
    Intended to serve ends of fairness and equity – prevent one party from taking advantage of another
    Facilitates flow of info to market, so may better perform security evaluation and capital allocation
    Affords protection to property rights of firm in inside information – intended only for corporate purpose

Daniel Fischel – Insider Trading and Investment Analysts
 If corporate managers are allowed to trade on basis of inside info, shareholders’ wealth might increase since
    Managers might possess increased incentives to create valuable info – immediately compensated
    Insider trading may provide firms with valuable additional mechanism for communicating info to market
 If insider trading inefficient compensation scheme, companies would prohibit it – none have tried to do so

Author’s Views
 Not all informational advantages that insiders gain from fiduciary roles regulated by law – only material ones
 While insider trading can convey info to market, offset by inefficiencies arising from redistribution effects
 Though incentive-based claims have some merit, would reward selection of projects with volatile payouts


 ImClone – publicly traded via NASDAQ 12(g) – had cancer drug awaiting FDA approval
 12/26/01 – Sam (CEO) found out drug was not approved; ImClose disclosed info in press release on 12/28
 12/27 /01 – Sam and daughter sold all shares (millions) through broker (Peter) – Sam put away for 7 years
    Couldn’t just disclose and quickly dump stock; rule says disclose and information must “come to rest”
 12/27/01 – Peter told Faneuil to inform Martha that Sam and daughter are selling – nothing about the FDA
    Martha sold her holdings (4,000 shares); called Sam to see what was going on; avoided $45K in losses
    Created alternative explanation for her sale and claimed lack of knowledge that Peter even knew Sam
 Several charges including making false public statements about her alibi – securities fraud illegal under 10b-5
    Charge dismissed due to high requirements – need motive and facts supporting strong inference of guilt

Insider Trading Case
 Under O’Hagan theory, Peter had a duty to Merrell Lynch not to disclose trading activities of other clients
 Scienter – Martha must have known or acted in reckless disregard that Peter had duty not to disclose info
     Her extensive previous experience as a broker/dealer put her on much greater notice than normal person
 Materiality – info that CEO and daughter dumping shares would affect investors’ mix of info about company
 Benefit – Peter benefited by violating his duty through a better relationship with Stewart

                                                                          Spring 2005 Corporations – Coates p. 77

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