"Corporations Bullard MS"
Morgan Stephens CORPORATIONS OUTLINE FALL 2010 BULLARD I. BUSINESS ASSOCIATIONS II. AGENCY AND PARTNERSHIPS III. CORPORATIONS – FORMATION AND FINANCES IV. LIMITED LIABILITY AND ULTRA VIRES V. BOARD OF DIRECTORS VI. CORPORATE DEMOCRACY VII. DERIVATIVE ACTIONS AND INDEMNIFICATION VIII. DUTY OF CARE IX. DUTY OF LOYALTY X. DUTIES OF CONTROLLING SHAREHOLDERS XI. CLOSELY HELD CORPORATIONS XII. SEC REGULATION I. BUSINESS ASSOCIATIONS A. Sole Proprietorship 1. Advantages a. Direct control b. Simplicity c. Lower expenses d. No double taxation 2. Disadvantages a. Unlimited liability b. Dependent on the management of the owner (death business lost) c. Not easily transferred B. Partnership 1. Advantages a. No separation of ownership and control (agreement) b. Flexible and simple c. Lower expenses d. No double taxation 2. Disadvantages a. Unlimited liability b. Partner cannot sell his interest; if a partner dies then the partnership is disolved C. Limited Partnership - general partner + one or more limited partners 1. Advantages a. Limited liability (not for general partner) b. Separation of ownership and control 1 c. Lower expenses 2. Disadvantages a. Unlimited liability (for general partner) b. Transferability D. Limited Liability Company (LLC) 1. Advantages a. Limited liability b. Separation of ownership and control c. Lower expenses d. No double taxation 2. Disadvantages a. Transferability restricted by agreement and laws E. Limited Liability Partnership (LLP) 1. Advantages a. Limited liability b. Lower expenses c. No double taxation 2. Disadvantages a. Not easily transferred F. Corporations 1. Advantages a. Limited liability b. Separation of management and control c. Interest easily transferred (securities) d. Perpetual life 2. Disadvantages a. Double taxation – profits and dividends taxed (not in S-corp.) b. Management – may manage for their own interests (e.g. higher salaries and perquisites) c. Expensive reporting and registration II. AGENCY AND PARTNERSHIPS A. Agency Definition 1. Fiduciary relation which results from the manifestation of consent by one person [the principal] to another [the agent] where the agent will act on the principal’s behalf and will be subject to the principal’s control and consent by the agent B. 3 Elements of Agency Relationship: 1. Consent to act on principal’s behalf (implied or express) 2. Subject to control of principal and 3. Acts on behalf of principal (i.e. consents) C. Fiduciary Obligations 1. Duty to act solely for the benefit of the principal 2. Cannot deal with the principal as an adverse party (i.e. conflict of interest) 3. Duty to give profits to principal if working for principal 4. Any third party bound to the principal even where the agency relationship or identity of the principal is not disclosed (unless agent makes misrepresentation) 2 D. Actual Authority (express or implied) 1. Ask: what went on between the parties? 2. Gay Jenson Farms v. Cargill a. Facts: Cargill, Inc. financed Warren Seed, Inc. to sell grain to farmers. Warren Seed defaulted on K’s and the farmers sued Cargill, claiming that Cargill and Warren had surpassed the basic debtor/creditor relationship and that Warren Seed had become Cargill’s agent. Look for dramatic increases in lines of credit b. Held: agency requirements were met based on parties’ conduct (implied agency relationship) c. Analysis: Agency Factors as applied i. Consent of principal Directing “agent” to implement recommendations ii. Control of agent by principal - note: all of these factors cannot be considered in isolation, but must be considered against the backdrop of Cargill’s aggressive financing of Warren Seed Determination that Warren Seed needs “strong paternal guidance” Day to day interference – checks and audits, constant recommendations and criticisms regarding finances, salaries, and inventory Veto power over mortgage entry, stock purchases, dividend payments Financing of all operations Power to discontinue financing Warren Seed’s use of Cargill’s letterhead iii. Agent’s consent – Warren Seed’s consent to above E. Apparent Authority 1. Perception of principal and agent relationship even though the parties were not 2. Can exist in the absence of actual authority where the principal gives a third party reason to believe that actual authority exists (RPP standard?) 3. Policy a. Allows third parties to rely on “reasonable perceptions of agency” w/out having to investigate the validity of the agency before every transaction 4. Butler v. McDonald’s a. Facts: a child cut his hand when a glass door shattered at a McDonald’s leased under a franchise agreement. The parents sued McDonald’s claiming that the franchisee 1) held himself out as McDonald’s agent and 2) P believed and relied on this. b. Apparent authority applies when: i. The franchisor’s “image of uniformity” led a reasonable person to think that he or his employees were employees or agents of the principal (McDonald’s) ii. P actually believe employees were agents iii. P relied to his detriment on agents’ care and skill 3 III. PRE-INCORPORATION A. Exam Tip 1. Bullard combines pre-incorporation; defective or de facto corporation; and piercing the corporation into one factual scenario B. Forming the Corporation 1. Promoter’s Liability (pre-incorporation liability) a. If the corporation has not been formed, then no agency relationship can exist. b. As a result, those acting on behalf of the pre-incorporation business will be held personally liable for their acts. c. Also, such person(s) has no power to bind the non-existent principle d. Issue when a K says the corporation “will be formed” i. If corp. is never formed nor deemed to have adopted it: promoter is liable e. O’Rorke v. Geary i. Facts: D, acting on behalf of a corporation that had not yet been formed, entered a contract with the P to have a bridge built; D then did not pay and claims that the corporation is now liable, not him ii. Held: when a party is acting for a proposed corporation, he may take the following actions to hopefully avoid liability: Take the risk and bind himself and after formation of the corporation he would seek indemnity Bind himself with the stipulation/understanding that once the company is formed, it will step into his shoes Offer made to non-existing corporation which results in a K if the corporation is formed while the offer is still open f. Old Dominion v. Lewisohn i. Facts: A syndicate was formed to buy land and mining rights from another company. Profit was to be divided based on how much pro rata individuals invested in the syndicate. After the purchase the syndicate created a corporation and increased shares of stock to 150k at $25 par. Two directors then sold 100k shares and sold the property for 30k shares, thus leaving 20k shares to be sold to the public. The two directors essentially sold land and property worth $1,005k for $2500k. Thereby devaluing the 20k shares sold to the public. ii. Held: no wrong was done to either side b/c each side had a say in the plan, except for the public (who had yet to own shares). g. A corporation has a personality separate and apart from its shareholders. Thus ratification by a corporation upon full disclosure will preclude corporate complaints when the shares change hands. 2. Defective Incorporation – thought corp. was formed a. De facto corporation i. A promoter will not be personally liable if… A law exists that authorizes incorporation; A good faith effort to incorporate under the existing law Actual use or exercise of corporate powers 4 ii. Five classes of cases where issue of de facto corp. will arise: Honestly and reasonably believes the certificate of incorporation has been filed but was not Articles mailed to the Sec. of State but delayed or returned b/c of an error A 3rd party agrees to enter into a contract with a company in its corporate name even though 3rd party knows the company has not yet filed its charter with the Sec. of State A party enters into a contract on behalf of a company even though its charter has not yet been filed, and the other party dealt with the defective corporation and not the individual A passive investor provides funds w/ the instruction not to engage in business until the articles of incorporation are filed but the business commenced anyway before the incorporation iii. Pocahontas Fuel v. Tarboro Cotton Attempt at compliance was enough to meet de facto corporation, although the mere fact that a creditor has dealt with the D as a corporation is not alone sufficient b. Estoppel theory – generally employed where the person seeking to hold the officer personally liable has contracted or otherwise dealt with the association in such a manner as to recognize and in effect admit its existence as a corporate body i. Cranson v. IBM Facts: D is advised by his lawyer that his business is incorporated. He orders typewriters from IBM in the company name and IBM relies on the company credit when shipping the typewriters. Unknown to him, incorporation does not take place until after the order. Held: no personal liability. In relying on the company credit, IBM dealt with the D as a corporation and was estopped from denying its existence. C. Capital Formation (focus on relative positions of lenders and stockholders regarding corporate risk) 1. Financing a. Bondholders – a corporation may seek to borrow funds from the public by selling bonds. A bond is a certificate that contains a promise from the corporation to repay the lender the principal (plus interest) at a future date. i. Advantages over stockholders Ahead of stockholders in bankruptcy, hence lower risk and accompanying lower rate of return b. Stockholders – stocks are certificates that represent ownership interest in the corporation i. Preferred Stock - Preference over common stockholders in the receipt of dividends and in liquidation (bankruptcy). Voting rights - Generally not entitled to vote unless dividends are missed for some specified period of time. In such an event, 5 preferred stockholders may be authorized to elect a specified number of directors. Two Forms: - Cumulative preferred stock – when a dividend is declared, the common stockholder cannot get the dividend until any dividends in arrears are paid to the preferred stockholders (e.g. - Non-cumulative preferred stock – loses the right to any dividends if the board does not declare them in any given year (i.e. no right to dividends missed in prior years) ii. Common Stock Usually entitled to vote to elect the board of directors and on other issues submitted to the shareholders for approval Right to a proportional amount of any dividends declared by the BoD The corporate charter may allow for different classes of common stock 2. Balance Sheet a. Identifies corporate assets and the source of those assets (debt and/or equity) b. Stated capital – “par value” is the stated value of a security as it appears on its certificate. A bond’s par value is the dollar amount on which interest is calculated and the amount paid to holders at maturity. c. Capital surplus (APIC) – stockholder contributions in excess of par value 3. Order in bankruptcy a. Debtors preferred stockholderscommon stockholders b. This corresponds with risk incurred by the debtor/stockholder IV. LIMITED LIABILITY AND ULTRA VIRES A. Piercing the Corporate Veil 1. Theoretical Doctrines to Pierce a. Instrumentality doctrine b. Alter Ego doctrine c. Identity Doctrine (basically the same) 2. Inadequate capitalization a. Must have enough capital for reasonably foreseeable business needs b. Sufficient amount decided on a case by case basis c. Amount of insurance is considered 3. Elements - majority rule is inadequate capitalization + something else a. Alter ego doctrine i. Such unity of interest an ownership that the separate personalities of the corporation and the individual no longer exist (individual controls) ii. If the acts are treated as those of the corporation alone, and inequitable result will follow 6 iii. Must be a nexus to connect the actions of the defendant to the harm that was incurred Commingling funds/using as personal money Hold out as responsible for debt causes people to invest that otherwise would not have 4. Factors a court will look for a. Whether shareholders treat the assets of the corporation as their own (co- mingle) and add or withdraw capital from the corporation at will b. Whether shareholders hold themselves out as being personally liable for debts of corporation c. Whether they provide inadequate capitalization for the reasonable risks of the corporation i. An adequate amount of insurance can cover this d. Actively participated in the conduct of corporate affairs i. Shows that D controlled the corporation and that is was his fault e. Failure to maintain the corporate formalities necessary for the issue of or subscription to the corporation’s stock f. Use of a corporation as a mere shell or conduit to operate a single venture or some particular aspect of the business of an individual or another corporation g. Formation of the corporation to assume the existing liabilities of another person/entity 5. Minton v. Cavaney a. Facts: a lawyer and two friends started a corporation which owned a pool. That corporation never had any assets or money and was not allowed to trade stocks. A girl drowned at the pool but that corporation could not pay the judgment. Family tried to go after the partner with money and make him pay based on “alter ego” that the guy had unity of interest. b. Held: no unity of interest because he did not… i. Treat the assets as his own and withdraw or add capital from the corporation as if it were his own ii. Hold himself out as personally liable iii. Provide inadequate capitalization iv. Actively participate in the day to day affairs 6. Walovsky v Carlton a. Facts: taxi cab service set it up so that many corporations existed, each owning one taxi cab and then one central corporation dispatched them all thereby limiting the need for liability insurance required by law for fleets. Guy had ten corporations, each with two cabs, one that hit a bystander. i. Court said generally that you can pierce the veil to prevent fraud or inequity. People using the corporate structure to further their own business, rather than the corporations, will be liable for the corporation’s acts. b. Held: no piercing b/c complied with all laws and requirements even though he deliberately split them up to avoid paying more insurance that was as an issue for the legislature to deal with not the courts. 7 7. Costello v. Fazio a. Facts: a partnership was created by 3 investors. Once the partnership was formed, two of the three partners withdrew all their money leaving each partner having invested 2K. The business suffered losses and owed money so they incorporated it thus trying to shield themselves from the debts. To run the company basically the court held they needed $50k had but they only had $66. b. Held: inadequately capitalized and thus the banks could pierce the veil. Moreover, when the two partners withdrew the money they did it for their own benefit and to the detriment of the corporation. i. Minority rule: a finding of under capitalization by itself is sufficient to pierce the veil. The higher your merchandise turnover rate the lower the capital you need, however here it was too low c. This is really an equitable subordination case where the capital structure and not the veil, was pierced d. Promissory notes (advantages over holding stock for corporation owners in formation) i. Tax benefits - principal and interest on the note are expenses and thus can be deducted for tax purposes. Dividends are not deductible ii. Priority in bankruptcy - debt holder has higher priority iii. Restrictions on dividends - owners would rather have debt to make sure they can get paid by the corporation e. If capital is removed and converted into debt for the personal benefit of the shareholders (trying to get priority), leaving the corporation undercapitalized to the detriment of the corporation, the doctrine of equitable subordination applies i. Would then treat debt as equity 8. Luckenbach v. W.R. Grace & Co. a. Facts: A parent company cannot start a child company and then under capitalize it. Here a big company started a subsidiary steamship company and then put 10k into it when it needed 800K b. Held: Pierce the veil of the subsidiary to the parent company because the identity is one and the same B. Ultra Vires 1. Actions outside the corporation’s authority (per corporate charter) 2. Modern courts largely abolished the doctrine a. Statutes mostly allow a corporation to engage in “any lawful business” unless the charter says differently b. Most states also abolished 3rd party claims of ultra vires to rescind a K c. Policy - today, shareholders invest more in the managers than in the company specific projects V. BOARD OF DIRECTORS A. Generally 1. Corporation operates for the benefit of its shareholders, but they do not manage the corporation board does 8 B. Charlestown Boot & Shoe v. Dunsmore 1. Held: Absent a shareholder agreement, the only recourse for shareholders dissatisfied with the managers and directors would seemed to be to elect directors to appoint managers that will carry out the shareholder’s wishes C. However, Courts are deferential to shareholder power to remove directors for cause 1. Auer v. Dressel a. Facts: shareholders used by-laws to call a special meeting to endorse the old president and vote for the removal of 4 directors. President refused to call the meeting, saying the charter gave removal power to the officers. b. Held: just b/c the charter gave the directors the power to remove directors does not mean the shareholders do not have that power 2. Campbell v. Loew’s Inc. a. Facts: two factions were fighting for control of Loew’s. There were 13 directors; a quorum was seen. After several resignations, 5 of one faction and 4 of another were left on the board. The other faction refused to come to the meeting so there could be no quorum. Therefore, the president called stockholder’s meeting to remove two directors for cause, increase the size of the board and quorum to 19 and 10 respectively, and fill the vacancies. He sent out solicitations and a call for proxy votes. The other faction claimed this was control policy b/c if the majority could increase the size of the board it could defeat the minority influence crated by cumulative voting. b. Held: shareholders implied power to remove directors for cause outweighs cumulative voting policies where… i. There has been service of specific charges ii. Adequate notice, and iii. Full opportunity of meeting the accusation. iv. Court held SH’s can remove directors for cause D. Board Elections 1. Number of directors is set by the by-laws or certificate of incorporation 2. Directors are usually elected each year at the annual shareholder meeting, however, some elect a staggered board where only a portion of the board members are elected each year a. Staggered board i. Ensures board continuity ii. Some states now provide for removal of directors by shareholders for cause unless articles of incorporation or by-law say otherwise E. Board Functions 1. Monitor/oversee management a. Select, evaluate and (when appropriate) replace the CEO b. Determine management compensation c. Review planning for the future 2. Review and approve financial objectives, strategies, and plans a. Provide advice to shareholders on votes concerning strategic issues facing the corporation such as a merger with another corporation 9 3. Provide advice and counsel to top management 4. Select and recommend to shareholders for election the slate of directors a. This permits self-perpetuation unless there is an actively supported competing slate 5. Review adequacy of internal controls a. Also consider other systems to assure compliance with applicable laws b. Internal controls are useful for monitoring management and the use of assets F. Directors’ Meetings 1. Generally a. State statutes require that board action be taken at a duly convened meeting i. Therefore, directors cannot vote by proxy ii. But they can be present by telephone or electronic communication b. State statues usually allow corporate action to be taken without a meeting where there is unanimous approval by all members of the board (pg 152) 2. Notice a. Unless the by-laws or articles of incorporation provide otherwise, two days’ notice to board members of special board meetings are required b. Otherwise, regular board meetings may be held without notice 3. Quorum and voting requirements a. Minimum necessary to hold a meeting and take valid action - 1/3 is typical b. A super-majority provision can be established by the articles or bylaws. c. If a quorum is present, the affirmative vote of the majority of directors present will constitute an act of the board 4. Proxy solicitation a. Request to vote someone else’s shares b. Used only for shareholder votes G. Board Committees - state statutes authorize the board to divide into committees that have powers of the full board with respect to certain types of director action 1. Executive committee - often empowered to act for the board in reviewing and approving much of the business of the corporation. It will usually bring only the most important matters to the board for further approval 2. Compensation committee - is assigned the task of passing on salaries and bonuses of officers 3. Audit committee - responsible for assuring that the company’s books and records are accurate. It seeks to assure that the accounting controls and procedures are function properly and are adequate 4. Special litigation committee - used to review issues related to derivative suits sought by shareholders. It may also be asked to investigate internal corporate misconduct. 5. Nominating committee - used to select candidates for the board H. Inside and Outside Directors 1. An “inside” directors is a director who is also holding a management position that may function as an agent when wearing that hat, but not when acting as a director 10 2. An “outside” director is one who is not employee or otherwise affiliated with the corporation a. This is supposed to bring independence, broadened experience and perspective to the corporate decision making process b. NYSE requires a majority of board to be outside directors c. SOx requires audit committees to be composed of outside directors who are neither employees nor consultants to the corporation I. Officers and the Sources of Power 1. As agents of the corporation, officers’ authority derives from agency law 2. An officer’s authority to act may be found in the corporation’s bylaws, a resolution of the board, or a job description approved by the board (pg. 164-65) VI. CORPORATE DEMOCRACY A. Cumulative Voting (see also slides on TWEN) 1. Allows minority to have representation a. Staggered voting may undo cumulative voting (effectively get 1 per year which is same as straight line) b. Reverse cumulative voting - someone in minority must change vote i. Instead of employing straight line voting, to prevent removal, the director must have the number of votes against removal that was required to elect him 2. In straight voting, each shareholder gets to vote his shares once per each shareholder 3. In cumulative voting, each shareholder gets votes = # nominees x # shares - if 5 directors up, top 5 vote getters are elected. a. Formula that can be used X=((n-1)(d+1))/s i. n=# shares minority has to vote ii. d=# directors to be elected iii. s=total # shares to be voted by all shareholders b. Example: Assume A has 60 shares and B has 40 shares and 5 directors up for election: A’s nominees B’s Nominees A B C D E F G H I J Straight 60 60 60 60 60 40 40 40 40 40 Cumulative 60 60 60 60 60 40 40 40 40 40 Cumulative 100 100 100 0 0 100 100 0 0 0 Cumulative 60 60 60 60 60 100 100 0 0 0 Cumulative 60 60 60 60 60 68 67 65 0 0 Cumulative 77 76 74 73 0 68 67 65 0 0 Cumulative 77 76 74 73 0 100 100 0 0 0 Cumulative 77 76 74 73 0 75 75 50 0 0 4. Diffuse Ownership vs. Cumulative Voting a. When there are millions of shares and thousands of shareholders, ownership is diffused and cumulative voting is not as important 11 b. Closely held companies, it is very important because large blocks are owned and those blocks can makes a big difference in voting c. Expense is conditional on size 5. Staggered Voting vs. Cumulative Voting a. If all the directors are being elected at one as opposed to only a few directors per year, the cumulative voter (minority shareholder) can get more directors on the board if all the directors are up for election at once b. With staggered voting, the minority shareholder will not be able to get as many directors on the board i. See slides and above example c. If you are doing a staggered cumulative vote every year for only one director, it is the same as straight line voting because the minority cannot overcome their numbers B. Varying Shareholder rights 1. Some variations a. Weighted voting - one class of shares may be given a multiple number for each share held. This allows that class to cast a disproportionate number of votes and allows acquisition of control with fewer shares than would otherwise be required. b. Class voting - articles of incorporation may create different classes of shares or subclasses with varying voting rights i. One class may be allowed to vote as a class on matters before the shareholders such as election of directors, while another class is denied that right ii. Class voting can be used to guarantee representation on the board by dividing directors into classes with certain positions to be elected by specified groups of shareholders c. Contingent voting - on class might have contingent voting rights in the event that the directors do not declare dividends. d. Disparate voting - example would be to grant one class of shares several votes for each share held while another class only has one vote 2. Varying voting rights can become an issue when voting power is concentrated in one class of stock even though there are multiple classes a. Recapitalization is a great defense mechanism to merger attacks b. This is done when a closely held firm decides to go public, but still wants control c. Rule - if you are already public, you cannot create a dual system of stock and get listed i. Dual before going public, you can be listed. 3. Ways to attack recapitalization a. Misleading proxies to shareholders - test for consent is whether a person/shareholder is informed. b. Also cannot threaten other shareholders to adopted dual class of shares because of your CEO position 4. Lacos Land v. Arden Group 12 a. Problem arises when CEO says, “if we don’t get this dual stock, I won’t vote for a merger even if it is in the shareholder’s best interest i. OK for a shareholder to make such a threat (huge mistake) However, he was shareholder and CEO, therefore had conflicting roles ii. If CEO believes this but did not tell anyone, the recapitalization would have been valid, but as it was here, the shareholder really did not have a choice. The statement invalidated it C. Formalities for Shareholder Meetings 1. Corporate statutes generally require an annual meeting of shareholders a. Held at time and place as fixed in bylaws b. Notice is required for annual meetings i. Given to shareholders of record (i.e as of the “record date”) 2. Can also be special meetings of shareholders a. Called by board or persons so authorized in articles of incorporation or the bylaws b. Many states allow a stated percentage of voting shares to mandate a special meeting c. Require more specialized notice 3. Quorum requirements a. Varies for state to state b. General rule is a shareholder meeting cannot be destroyed by a shareholder leaving the meeting once quorum is established i. Different for board of director meeting c. Once there is a quorum, action is taken when a plurality of those voting approve VII. DERIVATIVE ACTIONS AND INDEMNIFICATION A. Background 1. Arises out of principle that the one who is harmed should bring the claim a. Not a claim you typically want to leave to shareholders and thus better left to directors i. Better access to info ii. Easier to manage B. Derivative vs. Personal Actions - if injury is not incidental to an injury to the corporation, an individual cause of action exists 1. If harm is specific to individual, then not a derivative claim (pgs. 761-62) 2. If shareholder is harmed because corporation is harmed, it is derivative (pg. 762) C. Standing Requirements - i.e. requirements to bring derivative suit 1. P was shareholder at time of the transaction (harm) a. Unless stock acquired by operation of law 2. Not collusive to confer improper jurisdiction 3. P fairly and adequately represents the interests of the shareholders similarly situated a. Look out for personal vendettas/motivated by personal litigation 4. Other rules 13 a. Merger destroys shareholder standing b. Creditors do not have standing D. Demand requirement (1st step) 1. Must be a valid claim on which the corporation could have sued, and a. Corporation refused to proceed after suitable demand or b. Type of claim which the board is not in a position to make a decision (e.g. conflict of interest) 2. Corporation should go to great lengths to ensure directors charged should not be involved in deciding whether to bring suit a. Special litigation committee to investigate suit i. Evaluation by court - certain level of deference ii. Approaches Majority - extend the business judgment rule to special litigation committee which precludes review of merits…look for good faith, independence, and sufficiency of investigation. If self- dealing, the presumption does not apply Directors charged w/ misconduct are prohibited from participating in the selection of the special litigation committee Court makes substantive review on merits whether actions should be dismissed iii. Court is more likely to scrutinize the decision of the SLC if there was self-dealing by director E. Miller v. AT&T 1. Facts: AT&T directors refused to recover 1.5 million debt from DNC for 4 yrs. Directors say BJR shields them. Shareholders claimed this equated to campaign spending (outlawed by statute), and the breach of the statue avoids the BJR problem. 2. Issue: Is this claim subject to a derivative suit? 3. Held: normally, not collecting a debt would be covered by the BJR, but where not collecting a debt is itself alleged to be an illegal act, and the statute was enacted in part to protect stockholders from corporate funding of campaigns without their approval, 1) stockholders have standing and 2) can bring a derivative claim based on the illegality of the act VIII. DUTY OF CARE A. Standard of Care - discharge duties in good faith with the care of a person in the same circumstances as the director and with a reasonable belief that the actions are in the best interest of the corporation 1. Procedures a. Board should monitor and have procedures in place for risks of the corporation b. Directors should be concerned that the corporation has programs looking toward compliance w/ applicable laws and regulations, both foreign and domestic, that it circulates policy statements to this effect to its employees, AND c. That it maintains procedures for monitoring such compliance 14 2. Red Flags a. If board is alerted to previously unknown risk, it should take appropriate action b. Many cases can turn on this 3. Causation a. Must show that breach of duty by director caused a loss to the corporation 4. Bates v. Dresser a. Facts: Charge against president and directors with loss of lots of money through the thefts of an employee i. Red flags - this was a novel way to steal money, the employee who was stealing from the bank was living beyond his means b. Issue: whether board of directors and president neglected duty by accepting cashier’s statement of liabilities and not inspecting ledger c. Held: The board of directors cannot be held liable because their confidence in him was reinforced by the government examiner saying nothing was wrong. However, the Dresser (president) should have been put on notice and is liable for the losses he let happen - even though the precise form of fraud could not have been foreseen d. Class Notes: i. It appears that directors are entitled to rely on the honesty and integrity of their subordinates until something occurs to put them on suspicion that something is wrong. If such occurs and goes unheeded, then liability of the directors might well follow, but absent cause for suspicion there is no duty on the directors to install and operate a corporate system of espionage to ferret out wrongdoing which they have no reason to suspect exists ii. Here, obvious risk, lots of red flags, few employees, board had duty to monitor president; President liable but directors properly relied on president, new scam, not paid salary iii. The president/CEO will be held to a higher standard of liability because he is responsible for the day to day operations of the company and should see the red flags and fix them iv. You need to read the case law on how people have handled these red flags and on what has happened in general in cases like yours and advise your client on how to proceed in this situation v. You are going to get a great deal of protection if you do a hired out examination of the situation to get an outside opinion on the potential of fraud B. Business Judgment Rule 1. Generally a. Presumption that, absent self-dealing or other breach of the duty of loyalty, directors acted in good faith, on an informed basis, in the honest belief that the action taken is in the best interests of the corporation (only need to get past 1 of these) b. Higher than a negligence standard 15 c. The determination of whether a business judgment is an informed one turns on whether the directors have informed themselves prior to making a business decision, of all material information reasonably available to them 2. Overcoming presumption of the BJR: a. Plaintiff must overcome the presumption that the decision was an informed one b. Breach of fiduciary duties of good faith, loyalty or due care: i. Situation of illegality or fraud (violating corporation by- law/procedure) ii. Not being informed or acting in gross negligence iii. Director Acted in self-interest or iv. Conflict of interest c. After the BJR is pierced, they always settle, otherwise, you would have to go the merits of the decision to determine damage 3. Shlensky v. Wrigley (1968) a. Facts: plaintiff is a minority stockholder of the Chicago Cubs and sues to have lights installed on Wrigley Field so the team can play night games. Alleged that the president of the Cubs refused to install lights not for business purposes but because baseball is a “day-time game” b. Rule: Business Judgment Rule is the presumption that, absent self-dealing or other breach of the duty of loyalty, directors acted in good faith, on an informed basis, in the honest belief that the action taken is in the best interest of the corporation i. Presumption: plaintiff must overcome the presumption for the court to review substantive merits of decision ii. Higher than negligence standard (because negligence isn’t going to cut it!) c. Held: directors not liable because decision was clearly within their scope of decision making and no fraud, illegality, or conflict of interest was involved d. Class Notes: i. The response which courts make is that it is not their function to resolve for corps questions of policy and business management ii. Directors are elected for their business capabilities and judgment and the courts cannot require them to forego their judgment because of the decisions of directors of other companies iii. BJR is process oriented and informed by a deep respect for all good faith board decisions iv. If you pass the process test then you are free and clear. If you fail, you have to go on to substantive test v. You want to keep your eye out for the process gatekeepers (elements you have to show before you will be able to attack the substance of the decision) 4. Smith v. Van Gorkom a. Facts: Retiring CEO wants to sell company for $55/share and merge with another company. The board drives the deal through biased proxies. The 16 stock was trading at $38/share but shareholders sued claiming CEO and directors should have gotten more for company because calculating the stock sale price back from the amount needed to pay interest on huge LBO debt was not a good way to valuate b. Definitions: i. Cash-out merger - Pritzker pays for all the corporation’s stock, then the stock is held by another corporation (better than buying in market b/c assured of getting it all) Every shareholder has to sell if majority goes with the board, but they can get an appraisal ordered by a court ii. Stalking horse - when one person goes out and finds a good deal and then other investors try to get in on it Protect through a lock-up provision where disallow to solicit other offers etc. iii. Control premium - amount you are willing to pay over the current market price to control the firm iv. Treasury stock - stock authorized but not issued or stock the corporation has repurchased v. Not smart to hire same attorney to represent in litigation that gave advice in/to board - this effectively removes an advice of counsel argument c. Issue: was stock priced reached/valuated by reasonable process? d. Held: the board was found to have violated duty of care (not being informed) i. Did not ask for outside evaluation to determine company’s value e. Rule: i. Board must make reasonable effort to be informed of all information about the subject matter (information that is material and reasonably available) ii. A board may cure by becoming informed while still time to back out of deal iii. Proxy solicitation - cannot relieve board of liability but can validate the merger if shareholders are informed IX. DUTY OF LOYALTY A. Self-Dealing Transactions - when a director serves his own interest to the detriment of the firm 1. Globe Woolen v. Utica Gas & Elec. a. Facts: electric company sued for rescinding losing K with yarn maker. Electric company argued that the K was voidable b/c the key player breached his fiduciary duty to them during formation by failing to fully disclose conflict/transaction b. Held: abstaining from voting was not enough of a disclosure when he remained silent at the board meeting. You have to proactively bring it to the attention of the board and if it was bad for the company you had to say so. 17 i. Active duty to renounce if inequity in knowledge ii. Director should inform of all material facts he knows that affect a transaction c. Note: this was the old common law rule that all self-dealing transactions are voidable 2. Current Law - How would you insulate a board from a Globe Woolen situation? a. 3 typical means to preclude K from being voidable: i. Ratification by an independent majority of the board Via independent committee Board must be informed of all material info ii. Approval or ratification by the shareholders (this takes a long time) Need full disclosure like above Costs Subject to requirement of good faith - Requires impartiality iii. Showing that the K is just and reasonable as to the corporation BOP on interested director or officer Fairness typically requires the transaction reflect terms one would expect in an arm’s length transaction b. 2 options for voting i. Majority of directors must agree, discounting interested director ii. Majority of independent directors binds (even if only 3 independent) B. Conflicts of Interest 1. Gilder v. PGA Tour a. Facts: amending the bylaws contemporaneously with the adoption of a rule involving a conflict of interest may violate fiduciary duties. If found to be a violation of duty, a court may intervene to prevent or annul conduct of the board b. Held: changing the by-laws is ordinarily fine, but in this case, the timing of the vote and the amendment was too close and found to be a conflict/self- dealing i. The change was directly related to a specific issue/problem/transaction, so by making the change to get around the inherent problem, it was self-dealing C. Corporate Opportunities 1. Generally a. Means that a board member or someone else important takes an opportunity for themselves that in reality belonged to the corporation 2. Guth v. Loft a. Facts: Loft was a corporation that sold candy. Guth became Loft’s President. Loft sued Guth because he did not sale the syrup formula to Loft that he used to flavor Pepsi. Loft went out of business. Loft argued that Guth breached his duty of loyalty by using company assets to build up 18 another company. Guth argued that the opportunity to him personally and was out of Loft’s business sector. b. Rule: when a business opportunity comes to a corporate officer or director in his individual capacity rather than his official capacity, and the opportunity is one which, because of the nature of the enterprise, is not essential to his corporation and is one which it has no interest or expectancy, the officer or director is entitled to treat the opportunity as his own, and the corporation has no interest in it if the officer or director has not wrongfully embarked the corporation’s resources therein 3. Analysis of Corporate Opportunity a. Capacity - did it come to you individually or in official capacity i. If the opportunity came b/c of your position, a court will likely view the interest/expectancy test (infra) broader b. Essential to corporation/business i. Pepsi syrup is not essential but candy syrup is c. Interest or expectancy - did the corporation/business have an interest or expectancy in the business (broader) - outside the core business i. Does the business have the fundamental knowledge, practical experience, and ability to pursue an opportunity, which is adaptable to the business with regards to the corporation’s financial position and consistent with future goals? If so, then corporate opportunity 4. Other factors to consider a. Nature of officer’s relationship with management and control of the corporation b. Prior disclosure to the board of the opportunity and subsequent rejection by the board i. Full disclosure c. Use of corporate facilities, assets, or personnel in acquiring opportunity d. Whether acquisition of opportunity harmed or benefited corporation e. Officer’s good faith f. Fairness to the corporation which a RPP would recognize in like positions g. Corporations ability to have taken the opportunity h. Whether the director knew the corporation was looking for opportunity 5. ALI approach to corporate opportunity a. May not take advantage of corporate opportunity unless i. First offer to corporation and disclose conflicts of interest and corporate opportunity; and ii. Either Rejection of opportunity is fair to corporation Opportunity is rejected in advance following disclosure by disinterested directors, or Rejection is authorized in advance or ratified following such disclosure by disinterested shareholders and rejection is not equivalent to waste of corporate assets b. A corporate opportunity is: 19 i. Any opportunity to engage in business activity of which a director or senior executive becomes aware, either In his official capacity or circumstances that should lead that director or senior executive to believe the offeror expects it to be offered to corporation, or Through use of corporate information or property, the opportunity is one that should reasonably be expected to believe would be of interest to the corporation, or ii. Any opportunity to engage in a business activity he knows is closely related to a business which the corporation is engaged or expects to engage 6. To take advantage of corporate opportunity, a director must a. Fully disclose the conflict and the opportunity to corporation, and b. Corporation rejects the opportunity X. DUTIES OF CONTROLLING SHAREHOLDERS A. Fiduciary Duties 1. Intrinsic Fairness test a. Generally: i. When the situation involves a parent and a subsidiary, with the parent controlling the transaction and fixing the terms, the test is one of intrinsic fairness - shifting of burden of proof b. Basic situation i. When the parent has received a benefit to the exclusion and at the expense of the subsidiary c. A parent owes a fiduciary duty to its subsidiary when there is parent-sub dealing. However, this alone will not evoke the intrinsic fairness standard i. Standard will be applied only when the fiduciary duty is accompanied by self-dealing: parent is on both sides of a transaction with its subsidiary Self-dealing occurs when the parent, by virtue of its domination of the subsidiary, causes the subsidiary to act in such a way that the parent receives something from the subsidiary to act in such a way that the parent receives something from the subsidiary to the exclusion of, and detriment to, the minority stockholders of the subsidiary If no self-dealing, apply business judgment rule 2. Getty Oil v. Skelly Oil a. Facts: Getty Oil received the oil import quota while Skelly Oil did not; Getty Oil owned 71% of Skelly Oil and the minority shareholders owed the rest; is the parent receiving something to the detriment of the subsidiary? Skelly Oil wants the quota it would have received had it been an independent business b. Note: This case doesn’t really help us understand because Getty Oil would benefit if Skelly Oil received the quota 3. ADT v. Grinnell Corp. 20 a. Facts: minority shareholder plaintiffs alleged that Grinnell, realizing it would soon have to sell its ADT stock b/c of a pending anti-trust action, caused ADT to pay excessive dividends. b. Held: dividend payments conformed w/ applicable statutory law, and P’s could not prove an abuse of discretion, the court ruled that the complaint did not state a cause of action 4. Sinclair Oil v. Levien a. Facts: parent formed subsidiary (Sinven) to run its Venezuelan oil production. Parent (owned 97%) forced Sinven to pay out more dividends than they made in profit. P in this case owned 3% of the Sinven stock. Also, International (another Sinclair sub), was allowed to breach a K with the subsidiary i. Dividends - in determining whether the dividends were self-dealing, the court noted that the minority shareholders received a proportionate share of the money. Thus, Sinclair received nothing from Sinven to the exclusion of its minority stockholders. As such, no self-dealing b. Held: trial court should not have applied intrinsic fairness, but should have applied the business judgment rule c. Corporate opportunity i. Sinclair did not give new oil exploration opportunities to Sinven, but gave them to other subsidiaries ii. Parent may do this b/c the other subsidiaries might be 100% owned vs. the 97% ownership of Sinven Could potentially trigger intrinsic fairness test iii. Parent said that opportunity was allocated by country iv. Also, opportunities went to the parent originally. Therefore, no opportunities originally went to Sinven, and thus no opportunities that were owed to Sinven If originally offered to Sinven, then parent gave opportunity to another, it may be within the interest and expectancy of Sinven - i.e. the offeror thought it was w/in sub’s interest v. Getty Oil - sub had to share in the parent’s oil quota and they could not have their own quota. If the parent’s quota was based on parent’s use--which included all their subs--could be self-dealing d. Contract claim - court did apply intrinsic fairness test i. Parent forced Sinven to contract with International, but the parent allowed International to breach the K w/out letting Sinven sue Here, the controlling shareholders did receive a benefit to the expense of Sinven Sinven cannot get the benefit of the K (International will not buy quota) 5. Zahn v. Transamerica Corp. a. Facts: Axton Fisher had 3 classes of outstanding stock i. Preferred Par $100 21 Cumulative dividends at $6 Liquidation value of $105 plus accrued dividends - No matter what happens to the tobacco owed by the company 1 share/1 vote (if 4 quarters of no dividends) ii. Class A common If the value of the tobacco goes up, they get more - goes down, they get less Cumulative dividends at $3.20 If further funds available via action of board, Class A and B were entitled to share equally Upon liquidation and after payment of obligations to preferred shareholders, Class A entitled to share with Class B in distribution of remaining assets but A stock gets twice as much per share as B stock Each share convertible to 1 share of B stock - BUT wouldn’t convert because you like the preference and you like the liquidation Callable at $60/share, 60 days Voting stock b/c of provision regarding 4 successive defaults on dividends iii. Class B common Voting stock: 1 share/1 vote Far more than A shares - calling the shots at the board level b. Facts Cont’d: i. Through a series of purchases, Transamerica owned virtually all of outstanding B stock of AF after converting it’s A stock, and thus had control of and dominated the company ii. AF’s principal asset was tobacco that was carried on its books at $6.4M, but Transamerica knew its market value was approximately $20M. Transamerica, majority owner and controller of voting stock, called A stock and then liquidated the corporation to take advantage of the higher asset value of the tobacco. iii. B shares getting a benefit to the detriment of the A shares; the current B shares saw the liquidation coming and converted to get more money c. Court’s Analysis: i. Court applied the intrinsic fairness test because violation of fiduciary duty by not disclosing full information to A shareholders (minority) ii. B shareholders received benefit at expense of A shareholders by not providing full information No need to tell them what to do, but must provide information Corp still had right to call, but should have given full information to allow opportunity to convert to B stock iii. Here, the right to call the A stock was confided in the directors and not the stockholders 22 When one votes as a director he represents all the stockholders in the capacity of a trustee for them and cannot use his office as a director for his personal benefit at the expense of the stockholders When voting as a stockholder, he has right to vote with his own benefits in mind and to represent only himself d. Rules: i. One in control of a majority of the stock and of the board of directors of a corporation occupies a fiduciary relation towards the minority stockholders, and is charged with the duty of exercising a high degree of good faith, care, and diligence for the protection of such minority interests. Every act in its own interest to the detriment of the holders of minority stock becomes a breach of duty and of trust, and entitles to plenary relief from a court of equity ii. Majority shareowners have the right to control, but when they do so, they have a fiduciary relation toward the minority shareholders, as much so as the corporation itself or its officers and directors iii. A director is a fiduciary. So is a dominant or controlling stockholder or group of stockholders. Their powers are powers in trust. Their dealings with the corporation are subjected to rigorous scrutiny and where any of their contracts or engagements with the corporation is challenged, the burden is on the director or stockholder not only to prove the good faith of the transaction but also to show its inherent fairness from the view point of the corporation and those interested therein e. Other definitions i. Convertible securities - right to convert into another type or class of security Ex: bondholder entitled to convert into a specified number of common shares Conversion price usually computed at a price above the existing market price so that conversion will occur only if there is a substantial increase in share price into which conversion is made Makes convertible securities more popular and those more valuable A bondholder will usually agree to receive lower interest rate for convertible bond b/c he could later take advantage of capital appreciation - Reduces borrowing costs and when conversion occurs, the company can simply print the necessary shares into which conversion is made - This will dilute the ownership of other shareholders 23 ii. Warrants - option of a specified time duration that entitles holder to purchase a security at a specified price, which is usually above the existing market price Detached - may be traded separately from security with which the warrants were issued - Warrant may have a market value that will be based on price of the shares subject to the warrant, the prospects of the company and the remaining time left before the warrant expires iii. Redemption or call rights A callable security means the corporation may purchase or redeem the security from the holder at the corporation’s option for specified price A redeemable security may limit the owners’ future prospects - Ex: holder of cumulative preferred stock that is paying dividends of 7% of liquidation value of $100. The corporation will call the security because the corporation can refinance by issuing new preferred stocks or bonds that pay a lower rate and thereby reducing the corporation’s financing costs - Usually, the call price is above the principle or original issue price of the security being redeemed. This provides the owner with some protection against being called since interest rates will have to fluctuate somewhat to make it worthwhile for the corporation to call. 6. Jones v. Ahmanson (11/4/10) a. Facts: i. Control Group’s Decision to Leave Minority Shareholders Controlling shareholders (control group) of United Savings and Loan Association (Association) decided profit from the rise in the market value of savings and loan companies - control group owned 85% of Association Association was essentially a closely held corporation - Its shares were not actively traded - No public market for either the control group or minority It could have gone public and sold its shares to outside investors BUT the control group created a parent holding company (United) and opted to transfer their shares (85% of Association) to it - Control group gave their stock (85%) in Association to United in exchange for shares in United (250 United for 1 Association) - Why divide 250 to 1? Because people are a much more likely to buy shares that are split up into $1 shares than say shares worth $100 - just an idiosyncrasy of the market because people are irrational 24 Minority shareholders in Association were not given the same opportunity to transfer their shares to United and share in the increased value from those public sales - However, their stocks are essentially worthless because the minority has no say so in governing the Association and the only people that will buy their shares will do so only for a huge discount - United’s stock just looks so much better to potential investors The control group now controlled United (which controlled Association) and had two public offerings of United, netting $7.2M ($6.2M went to control group) - Initial Public Offering (IPO) a. $10 per share but only sold 8% of company (conditioning the market and allowing it to value your stock) b. Issued 60,000 $100 bonds = $6M c. Other $1.2M is the market value of the remaining shares = $10 per share of United d. 1.4M shares outstanding - Secondary Offering a. $25 shares now; so it allows them to sell close to half of the company at $15 more than the IPO b. Control group sold about 47% of shares to public, but retained 53% of United c. 1.57M shares i. Public = 738k shares (47%) ii. Control group = 832K shares (53%) ii. Dividend Policy with respect to the $300k for bond interest In 1959 - Control group, through its control in United, forced Association to pay $75 per share in dividends - Minority shareholders are happy In 1960 - $57 per share in dividends In 1961 - United forced Association to reduce its payment of dividends to less than $4 per share - If the minority were to get the same deal as control group made for themselves - their shares would be worth $6k and for their Association shares to only get $4 dividend is not good - Essentially tells the minority shareholders that the control group is turning off their supply - squeezing them out by reducing dividends and then trying to buy them out Minority owned about 1000 shares and the control group offered to buy about 350 shares at $1,100 per share even though the book value of each share was worth $1,411 25 b. Issue: whether controlling shareholders who use control of a business for their advantage, including its sale, have a direct fiduciary obligation to minority shareholders? c. Rule: majority shareholders may not use their power to control corporate activities to benefit themselves alone OR in a manner detrimental to the minority. Any use to which they put the corporation or their power to control the corporation must benefit all the shareholders proportionately and must not conflict with the proper conduct of the corporation’s business. i. Majority shareholders cannot have exclusive benefit of transactions - if this is the rule, then this case is easily decided. The real question is whether this is the appropriate standard d. Held: because the control group took actions using their control to obtain an advantage unavailable to the minority and without any business purpose, they violated their fiduciary duty to the shareholders e. Notes: i. Fiduciary responsibility is simply a policy opinion ii. Why did control group not simply have stock split with Association and go public? If they did a 250 to 1 split with Association, the minority shareholders get benefit of IPO - Control group would only get 85% of the original $6.2 M disbursed - Also, after both public offerings, control group owns 53%, but if the other 15% was in the corporation, this shareholder block could influence votes iii. Stepped Ownership Structure iv. Did the minority’s position really change though? They still own 15% of company that still doesn’t have a market for its shares B. EXAM TIP 1. Ahmanson, Lacos, and Donahue deal with the same types of problems: who controls the entity and how do you allocate economic interest in the business XI. CLOSELY HELD CORPORATIONS - courts will focus on substantive fairness A. Definition 1. Small number of shareholders 2. No ready market for stock 3. Substantial majority of shareholder participation in management/operation of the firm B. Heightened Fiduciary Duties 1. Majority directors in a closely held corporation have a duty of “strict good faith” to all shareholders 2. Functional reasons for heightened standard - justified because the corporation functions much differently than a public corporation a. Watch out for high salaries b. Similar to partnership 26 i. Shareholders more likely to be employees, have large investments, undiversified ii. A court is more likely to step in and use equitable principles than it would for a widely-held corporation c. In a close corporation, people trust each other enough to go into business together, thus there is often no contracting for employment cars, insurance etc. There is an reasonable expectations of these things (no real market) i. Reasonable expectations must be known to all participants…look for Course of dealings between the parties, Original expectations, Changes in these expectations d. No ready market for shares, so if a disgruntled/unsatisfied stockholder wants to sell, it is difficult if not impossible because no ready market. He may be forced to sell to majority at a lower price that the stock is actually worth e. Solutions - Minority entitled to his percentage i. By the corporation buying all if his stock or ii. By dissolving the corporation and paying as a percentage of liquidation This is sort of the “nuclear option” which gives the minority shareholder serious power in the even the his reasonable expectations have been upset 3. Donahue v. Rodd Electrotype Co. a. Facts: a corporation bought shares of its founder, the father gave the rest to the children and now the sons are in charge. The corporation (children) refused to offer Donahue the same price that the corporation bought the father’s shares for previously i. There could have been an alternative Donahue hypothetical where the majority shareholders simply fired him and he could bring the same claim b. Held: any case in which the controlling stockholders have exercised their power over the corporation to deny the minority such equal, the minority shall be entitled to appropriate relief Before father After sale Shares before sale After sold and gifted divided his shares for $36k Father 200 81 36 0 Son 1 0 39 39 51 Son 2 0 39 39 51 Daughter 0 39 39 51 Donahue 50 50 50 50 Outstanding 250 248 203 203 Shares c. Why give d. The court set out two forms of relief in this case: 27 i. Remit money with interest which is equivalent to specific relief requested by P ii. May also require Corporation to purchase all of P’s shares for the price the corporation bought the majority’s shares e. How can you fix the Donahue problem? i. Compensate the father and gift all the stock - hire as that father as a consultant and pay him $36k You should insulate this from IRS and minority by having the father actually come in and consult periodically - Tax: better b/c you can deduct salary and not dividends ii. Buy the father’s shares for a lower price, then offer that price to Donahue iii. Dividends - pay out a $36k dividend and the children take their part of the dividend and independently buy the father’s stock - no equal opportunity required and the children have all the shares iv. Voting trusts - infra f. NOTE: because a case could be made that this deal was done to get the father out (who was old and not at his best with regard to the corporation), a modern court could potentially utilize the business judgment rule and thus get a different result XII. SEC Regulation A. Introduction 1. Going to impose certain requirements when the interests in the business is in securities 2. Imposes a new set of rules if you have a public relation to the sale of securities B. What is a security? 1. A particular kind of interest in a business enterprise 2. Securities imply some handing off of management of the enterprise 3. Aspects of Securities a. Formality i. Has no intrinsic right to management b. Functional C. Types of Securities 1. Stocks 2. Bonds 3. Investment Contracts a. Investment of money in a common enterprise with a reasonably expectation of profits to be derived primarily from the efforts of others D. Registered Offerings 1. Refers to registration of securities to be sold through the filing of a registration statement 2. Not applicable to: a. Private Offerings b. Exempt Securities c. Exempt Transactions 28 E. Public Companies 1. Refers to companies that are subject to regular reporting requirements 2. Triggers federal regulation of: a. Tender Offers b. Insider Trading c. Proxy Solicitations d. Misc. Corporate Matters F. Legislation Overview 1. Securities Act of 1933 - regulates public offerings of securities and prohibits offers and sales of securities which are not registered with the SEC a. Primary statute regulating securities b. The statute and the SEC regulate the contents of the registration statement and prospectus c. Required a 20 day waiting period between the filing of the registration statement with the SEC and the offer of the stock to the public i. This allowed investors time to assess the information being disclosed and to make an informed, unhurried investment decision 2. Securities Exchange Act of 1934 - extended federal regulation to trading in securities, which are already issued to the public a. On-going reporting requirements for publicly-traded companies b. Substantive proxy regulations; disclosure obligations; authority is limited to disclosure c. Regulations of exchanges/brokers/dealers i. Currently regulated by the Financial Industry Regulatory Authority 3. Public Utility Holding Company Act of 1935 a. Designed to correct abuses in the financing and operation of electric and gas public utility holding systems b. Repealed in 2005 4. Trust Indenture Act of 1939 a. Regulates indentures and the trustees, which are typically banks who care- take the issuance of bonds b. A law that requires all corporate bonds and other debt securities to be issued subject to indenture agreements and comply with certain indenture provisions approved by the SEC 5. Investment Company Act of 1940 - regulates mutual funds a. For most companies, it exists to be avoided; companies which have a lot of money and wanting to invest may be subject to this act’s regulations 6. Investment Advisors Act of 1940 a. Battle between brokers and investment advisors G. Securities and Exchange Commission (SEC) 1. Independent federal agency that is charged with responsibility for the enforcement and administration of federal securities laws 2. Composed of five members appointed by President for 5 years and not more than 3 can be members of the same political party 3. Four “Divisions” and a number of separate “offices” a. Division of Corporate Finance 29 b. Division of Enforcement c. Division of Market Regulation d. Division of Investment Management e. Office of General Counsel f. Office of Chief Accountant H. Goal of Federal Securities Law 1. Basically externalized what society expected of corporations and boards at their infancy (Ex: not to pollute, not to fire employees because of their race, etc.) 2. Monitoring: a. Reporting requirements of Securities Act and disclosure requirements of Exchange Act I. Registration 1. Initial public offering of securities; must file registration statement 2. Hasn’t made public offering, but has triggered a minimum number of assets and shareholders by the end of the year: a. $10 million in assets and 500 shareholders b. If not, not required to register under the Exchange Act J. Turf Wars 1. Between financial advisors and brokers 2. Between investment banks and insurance companies a. Regulated by mix of state and federal exchange laws b. Banks are to allowed “opt-in” meaning they can choose what to be regulated by K. Financial Reporting by Public Companies 1. §12(g) of the 1934 Act requires registration with the SEC of any company with total assets exceeding $1M (raised to $10M by SEC rule) and a class of equity securities with at least 500 shareholders 2. §13 of the 1934 Act imposes periodic disclosure and other requirements on companies required to register under §12 a. 10-K, 10-Q, 8-K L. SEC Proxy Regulations 1. Under §14, there must be a. Full and fair disclosure of all material facts with regard to any management submitted proposals that will be subject to a shareholder vote b. Material misstatements, omissions, and fraud in connection with the solicitation of proxies is prohibited c. Facilitate shareholder solicitation of proxies as management is not only required to submit relevant shareholder proposals, but also to allow the proponents to explain their position in the face of any management opposition d. Mandate full disclosure in non-management proxy materials i. Thus are significant in corporate control struggles and contested takeover attempts etc. 2. §14(c) - even if a company does not solicit proxies from its shareholders in connection with a meeting, it must furnish them with information substantially equivalent to that which would be required if it did solicit proxies 30 3. §14(f) - a corporation must also make disclosures to shareholders when a majority of its board is replaced by action of the directors (without a shareholder meeting) in connection with the transfer of a controlling stock interest 4. Schedule 14A - prior to every meeting of its security holders, a registered company must furnish each shareholder with a proxy statement with a form on which the security holder can indicate his approval or disapproval of each proposal expected to be presented at the meeting. Copies of the proxy statement must be filed with the SEC at the time when are mailed a. Preliminary Proxy b. Definitive Proxy M. Shareholder Proxy Proposals 1. SEC Rule 14a-8: a shareholder has the right to include proposals in proxies; Requirements: a. Timely notice to management (45 days before the annual meeting) b. Maximum 500 words, which includes the proposal, everything c. Investor’s holdings must be worth at least $2K or constitute 1% of the securities entitled to vote at the meeting for a total of a year before the proxy proposal d. Have to be given shareholder list, so they can be contacted 2. Shareholders of a publicly held company are entitled to disclosure of the following: a. The direct and indirect compensation paid to the top executives b. A comparison chart comparing the company’s executive compensation stock price performance with that of comparable companies over the past five years and c. The compensation committee’s report of policies and criteria used in fixing executive compensation 3. Dodd-Frank Act a. “Say on pay” provision i. Creates a new section in the exchange act that requires companies to have a mandatory non-binding approval vote on executive compensation every three years ii. You have to let the shareholders decide whether to have the say on pay vote every 1, every other year, or every three years b. Golden Parachutes i. Compensation that is paid to executives in connection with a merger or acquisition ii. Requirement c. 3% shareholder for 3 years to put a nominee on the proxy i. Still have to get 51% of the votes to get the nominee on the board 31