Business Associations Notes - Fall 1999 Professor Hillman Book: Cary & Eisenberg (7th ed. 1999). 8/24/99 I. Forms of Business Associations A. Corporation 1. the "one-size-fits-everything" form of business association a) from multi-nationals to the single owner. B. Most other legal systems recognize two types of corporations 1. Small corporations (small # of owners) 2. Large corporations 3. This formal distinction is not formally recognized in American Law. C. However, in the U.S. laws are being adapted to recognize the distinction between the two forms. 1. Close Corporation (or closely-held corporation) a) handful of owners b) typically most, if not all, stockholders are actively involved in managing the business c) No existing market for the stock (1) Owner may be able to sell the stock, but it will not be on the market. Instead it may take years for a stockowner to arrange a sale. (2) This affects how we will view the corporation. 2. Public Corporation (publicly held) a) ownership widely disbursed b) separation of ownership from control (1) Usually there is no single person with enough ownership to exercise control over the corporation. (2) Because public corporations operate in the markets (thus providing an easy exit) this affects how we conceptually treat corporations. OUR MODEL of a SMALL CORPORATION: DAVIS HARDWARE A. Sole stockholders are two persons. 1. It's not 50/50. 2. Hillman owns 60%, and I have 40% 3. Hillman thus controls the corporation 4. Hillman thus can make decisions about who can be employed. a) And, he can decide that I am not. b) The law is arranged to deal with these sorts of problems in close corporations. Corporation as a form of organization A. The corporation is a LEGAL ENTITY 1. It is a person separate from those who act for or on behalf of the corporation B. FORMATION requires FORMAL ACTION 1. In order to create a corporation, a filing must be made with the state. 2. There is NO SUCH THING as an "inadvertent corporation." C. OWNERSHIP INTEREST is evidenced by SHARES II. III. D. MANAGEMENT is CENTRALIZED 1. At the "base" of the organization is the STOCKHOLDERS 2. Stockholder elect a BOARD of DIRECTORS 3. the Board of Directors then elects the OFFICERS a) President, Vice-president, Secretary, etc. b) I. 8/25/99 Legal Characteristics of Corporations (continued) A. LEGAL ENTITY (Legal Person) 1. Separate from people who own or act on behalf of corp. B. Can only be formed by FORMALITITES C. OWNERSHIP INTEREST is TRANSFERRABLE (shares) D. MANAGMENT is CENRALIZED 1. ORGANIZATION a) Shareholders elect BoD b) BoD elects Officers 2. Close corporations - often the same people play many roles. E. PERPETUAL EXISTENCE 1. When the existing shareholders pass away, the corporation continues. F. LIMITED LIABILITY 1. Shareholders of the corporation are not personally liable for the obligations of the corporation. 2. The corporation is responsible for its own debts. 3. Thus if the corporation has tort or contract liability the can only collect to the extent of the corporation's assets. 4. Why do we call it "limited liability"? a) Because the shareholders can loose the money and the labor that they have invested in the corporation. b) "CAPITALIZING" the corporation occurs when people invest their money in the corporation. G. DOUBLE TAXATION 1. Corporate income is potentially taxed twice. 2. There are two Taxpayers a) The Corporation: when corp has taxable income, it pays tax on that income at the corporate tax rate. b) The Shareholders: when dividends or salaries are paid, taxes are further paid on the personal income. 3. One way to get around this under the TAX LAW on this point is to form an S-corp. a) Under the S Corp, the corporation does not exist as a separate taxable entity. b) Basically all gross income of the corporation is directly attributed to the SHAREHOLDER. (1) The benefit is that the first tier of taxation (corporate tax) is eliminated. c) But, only a very limited number of corporations can qualify for S corp status (1) Must be closely held. (2) Additional restrictions apply as well. d) S corporation is relevant ONLY FOR TAX PURPOSES. II. Another way to reduce double taxation is to increase the salary of shareholder/employees. a) In this case, the net taxable income of the corporation is reduced (NET INCOME = REVENUES - EXPENSES). b) In many close corporations, the shareholders work to eliminate net income by distributing income to themselves in the forms of salaries. 5. NO PASS THROUGH of TAX LOSSES a) Here we are NOT passing through ECONOMIC LOSS (because there is limited liability). b) PASS THROUGH of TAX LOSS, can be valuable, because the shareholders can then use the tax loss of one corporation to offset income from other sources. c) EXAMPLE: (1) Davis hardware buys a "machine" with projected life of 10 years at a cost of $10. (a) From a tax analysis point of view this purchase is recognized as a 10 year cost, and 10% of the cost should be applied over each year for the next 10 years. (b) Thus, for each year there is an expense of $1 for each of the next 10 years. (2) Now, lets say that in all of Davis hardware's other business, NET TAXABLE INCOME has been reduced to ZERO. (a) IN this case, what the corporation would show is a taxable income of $-1 for the year. (b) Here, the corporation wants to pass through the loss to the shareholders so they can take advantage of the loss. (3) BUT, the laws of corporations PROHIBIT this type of pass through. d) However, partnerships or LLCs can pass through these types of losses. (1) This is one advantage of the alternate forms of association. H. NO UNIFORM LAW OF ORGANIZATION 1. Corporate law is STATE law, and state statutes VARY. 2. There is a UNIFORM ACT, but only the "lesser" states have adopted the uniform act. I. CORPORATE LAW is a "JEALOUS" LAW 1. Historically there has been little room for variation in structuring corporations. 2. There is not much option to individually contract to change the forms of incorporation mandated by law. a) This rule has broken down some recently. PARTNERSHIP 4. III. DEFINITION 1. An association of two or more owners to carry on a business for profit. B. FORMS of PARTNERSHIP 1. General Partnership 2. Limited Partnership a) contains two "classes" of partners (1) two or more general partners who are active in the business (2) one or more limited partners who only contribute investment (but do not participate in running the partnership.) C. Characteristics of Partnerships 1. Is very unsettled at this time 2. Several years ago, partnership law was well settled under the UPA (49 states). 3. BUT, now, several states (20 some odd) have passed RUPA. a) BUT, when many states passed RUPA, they have added substantial variations, leaving much less settled law than there was several years ago. CORE LEGAL CHARACTERISTICS of PARTNERSHIPS A. PARTNERSHIP is NOT a LEGAL ENTITY B. POTENTIALLY UNLIMITED LIABILITY for PARTNERS 1. Each partner is jointly and severally liable for the liabilities of the partnership. C. REQUIRES NO FORMALITIES for FORMATION 1. Unlike incorporation which requires formal filing of documents. 2. BUT, to form a partnership, all that is required is the INTENT of TWO OR MORE PERSONS to form a partnership. a) This can lead to the INADVERTENT PARTNERSHIP D. OWNERSHIP is NOT FREELY TRANSFERRABLE 1. IF one owner wants to transfer their interest, the other partners must agree. a) This is because of the high risk of potentially unlimited liability. E. NO DOUBLE TAXATION 1. The partnership is NOT a separate taxpayer F. PASS THROUGH of TAX LOSSES 1. Any tax losses of partnership can be used to offset other income. 2. A. 8/26/99 I. Partnerships (continued) A. Two types 1. General Partnership 2. Limited Partnership B. Characteristics of General Partnership 1. Breakdown in uniformity of law since early '90's 2. Not a legal entity a) But, for some purposes a partnership is treated as an entity (1) EXAMPLE: partnership can hold property in its own name b) However, the general rule is that there is no separate entity. Rather you have only created a relationship between two or more persons 3. Each partner is liable for the obligations of the partnership 4. No formal action required to form partnership a) Only requires "requisite intent" (1) May be formed on the basis of CONDUCT from which we can INFER the existence. 5. Ownership not freely transferrable 6. No double taxation a) Because partnership is not a legal entity 7. Pass through of tax losses to individual partners a) Often this is the deciding factor in whether a partnership or corporation is formed 8. Does not have an unlimited life a) Corp has potentially perpetual existence b) Partnership, as a relationship, only exists as long as the relationship c) What happens when somebody leaves a partnership (1) UPA rule: any time somebody leaves a partnership, the original partnership is dissolved. (2) However, the owners may use their power of freedom of contract to alter this model. (a) Note how this differs from corp. law, which LIMITS the owners ability to make contractual exceptions. (3) Under Partnerships, the law only acts as a set of DEFAULT RULES which come into play only if there are not existing contractual agreements. 9. No centralization of management a) In a "pure" partnership, each partner has FULL RIGHT AND AUTHORITY to run the business. (1) Thus there is a complete merger of ownership and management. (2) Obviously, the larger the partnership, the more cumbersome management becomes (imagine a 300 partner firm!) (3) But, once again, the partners can contract around these arrangements. Thus the partners can agree to designate an "executive" to run the partnership. And, this arrangement supersedes the default rule. II. III. LIMITED PARTNERSHIP A. Revised Uniform Limited Partnership Act (RULPA) 1. Creates very specific rules (but they are not comprehensive) 2. To the extent the rules are deficient, you go back to RUPA or UPA for a default rule. B. Characteristics 1. Two types of partnerships a) General partners b) Limited partners 2. Can only be formed by formal action (filing document with state) 3. Management is centralized. a) General partners manage the business b) Limited partners' role is passive (1) Typically limited partners provide investment, and general partners bring management. 4. Limited Liability for LIMITED PARTNERS ONLY! a) General partners are still jointly and severally liable for for all of the partnerships liabilities. b) BUT, limited partners liability is limited to the extent of their investment. 5. TREND is toward allowing limited partners to become more active in the partnership. a) In the most recent revision limited partners have been allowed to act as an officer of a general corporate partner, or as an employee of the limited partnership. b) EXAMPLE: The "business" is Davis Hardware is set up to have two limited partners as human beings. Then these two humans set up a corporation, with one of them as the president. Now, the corporation becomes the general partner of Davis Hardware. Note that it is important to make sure that business is transacted on behalf of the corporation. LIMITED LIABILITY COMPANY A. Hybrid form of association incorporating aspects of both partnerships and corpoations. B. Persons involved in the LLC are "members." C. Characteristics of LLC 1. No double taxation 2. Memebers are have great freedom to form structure by K 3. Potentially unlimited life 4. Limited liability for the members D. Potential problems/challenges 1. 2. it is a relatively new form of association, and so the case law is not well developed yet. in LLC, if the members are trying to maximize $$ in the business, this results in having to take enough money out of the LLC to pay for the indivdual member's tax burden. I. II. III. IV. V. 8/27/99 CLARIFICATION regarding taxable income. A. Dividend payments are not considered "expenses" for purposes of taxes, but salaries are. In other words, paying dividends results in double taxation. But, paying salaries equal to profits means that the corporation pays no taxes because it is deducted as an expense. Why isn't the LLC a good form of business for large, public corps? A. Difficulties with contracting (but this can be worked out in the membership contract itself) B. BIG REASON: Taxes. For large companies that are constantly reinvesting in the business, shareholders would be liable for taxes but receive no dividends. Troubles for PROFESSIONAL organizations A. LLC lawfirms -- the idea behind this structure is that one "member" will not be liable for the malpractice of another. 1. Consequence is the elimination of vicarious liability. 2. HILLMAN: Suggests that the courts will void such attempts as against public policy. B. But, today, nobody worries about this because of an even newer form of association... LIMITED LIABILITY PARTNERSHIP A. Puts into partnership statutes that partners are not liable for the malpractice of other partners. 1. Requires registration of the agreement with the state. B. Basically this is exactly a general partnership with only ONE DIFFERENCE: limited liability for the partners 1. NOTE that this is NOT THE SAME as a "limited partnership" because the limits on liability apply to GENERAL PARTNERS C. Now all states have LLP's but they tend to have slight variations 1. Some limit the types of business that can be LLPs 2. Some limit the "limited liability" to professional misconduct only 3. But, most states have "full shield" limited liability a) Shields individual partners from all vicarious liability for other partners' acts (regardless of type). JURISDICTION of the CORPORATION A. An artificial legal person that can only be created with consent of the sovereign. 1. In the US, the "sovereign" was replaced by the "legislature." 2. Early American law required charters granted by the states for very specific activities. 3. Then, early in the twentieth century, there was a big push for general incorporation statutes a) Only required the formal filing of documents. b) No "consent" is required. B. However, the corporation can only be formed in ONE Jx (e.g., California, Delaware, Nevada, etc.) C. The law allows corporations to incorporate wherever the owners would like to incorporate. 2. In making this choice, the shareholders are choosing what corporate law will govern the corporation. SCOPE of CORPORATE LAW 1. Corporate law generally governs the relationships between the shareholders, directors and officers of the corporation. 2. DELAWARE, for years, has tried to make its state the state of chioice. a) Filing fees, infrastructure, Delaware Bar etc are all set up to encourage incorporation in Delaware. b) 1. 8/31/99 I. Jx of Corporations A. When we talk about Jx of the corporation, we are not talking about where the corp will do business B. We are talking about which state's laws will govern the internal relationships of the corporations DELAWARE has become the Jx of CHOICE A. Sophistication 1. Strong body of corporate law 2. Strong corporate bar 3. Smart judges B. Right kinds of biasis 1. Types of "fights" that might occur in corporate setting a) Management (referring to both Board of Directors and the Officers) v. Shareholders (typically public company) (1) What are the biasis that managers have here? (2) They want to KEEP THEIR JOBS (a) Thus state law which makes it more difficult for shareholders to organize, communicate, and adjust management composition is more attractive (3) AND, they want to MAXIMIZE THEIR SHARE of the corporation's wealth. (a) Thus state laws which allow management the greatest leeway to distribute corporate wealth to themselves will be more attractive b) Majority Shareholders v. Minority Shareholders (typically close corp). (1) Here there are questions of what does the law do to protect each interest. (a) A state which favors majority shareholders will be more attractive to those with the "power" over the corporation. c) Shareholders v. Creditors (1) Shareholders are the people who have a "residual claim" on the assets of the corp. (2) Creditors have "prior claims" over the assets of the corporation. (3) STATED SIMPLY: Creditors get paid first (a) Dividends cannot go to shareholders until the creditors have been paid. (4) The question here is how these responsibilities will be allocated. As long as creditors are not put at "undue risk" the corp can pay dividends. II. III. IV. V. VI. VII. A state which favors shareholders will be more attractive to shareholder investment in the corporation. Can a single lawyer represent both parties in a majority/minority formation of a corp? A. This is not a MAJOR CONFLICT (like representing both sides in a tort conflict) B. BUT, it does require a change in the lawyer's type of advice 1. Rather than say where the BEST place for incorporation is, the ATT'Y should advise on the EXISTENCE OF CONFLICTS and make it clear what the advantages and disadvantages 2. CAL CORP CODE § 2115 A. Provides that no matter where a corporation is incorporated SOME of the cal corp code will apply 1. Mostly applies to close corporations 2. However, some of the Cal. Corp. Code's most important protections (e.g., for minority shareholders) are NOT INCLUDED Statement at p. 125 regarding close corporations incorporating in the state where it does business: A. ERRONEOUS ASSUMPTION: that close corporations are typically small. Close corps may have SUBSTANTIAL ASSETS. B. HILLMAN: IF a corporation is of sufficient size to be consulting a lawyer on incorporation, Delaware is probably a good choice. LLC's and § 1001 A. The law of the state where the LLC is organized governs its operation. B. Once again, Delaware has made a push to have a strong LLC statute (no surprise). PREINCORPORATION TRANSACTIONS A. Problems arise here where people act on "behalf" of a corporation before it is formed. B. "PROMOTER" is a person who acts on behalf of a not yet formed corporations. C. Core problem here is a theoretical one 1. If we form a corp and then incur liabilities on behalf of the corp we are acting in our corporate roles. We as agents are not personally liable. 2. BUT, as "promoters" we have no PRINCIPAL of whom we are the AGENTS. This is conceptually impossible. a) One way to deal with this, is to say that once the corporation is formed, it can ACCEPT what the promoters did. b) BUT, note here that after making a promise as promoters, we may not have the corporation accept the debt after formation. 3. RULE: (from case in supp) Says that promoters are personally liable for any preincorporation liabilities EXCEPT if the contract with the creditor CLEARLY and EXPLICITLY states that the liability only runs to the not yet existing corporation. 4. (a) I. II. 9/1/99 PREINCORPORATION TRANSACTIONS A. Supp. Case. 1. There is a real risk for promotors who act on behalf of not-yet-formed corporations. 2. In order to avoid liability there needs to be an express provision in any K's with creditors that the promotors are not personally liable. PROCESS of FORMING the CORPORATION. A. Both corps and LLC are formed by filing an official document. 1. The document is filed by the "incorporators" 2. The document may go by various names. B. Meeting of the Board of Directors 1. Board may be named in the document 2. Board will meet and adopt bylaws a) So, now there are two documents: (1) Certificate of Incorporation (2) Bylaws (a) Bylaws are essentially the "statutes" that govern the corporation (sample is in the supp). (i) (ii) Elections of Officers, & descriptions of their positions. Meetings of Shareholders III. IV. 3. Board will appoint officers 4. Board issues shares of stock in exchange for consideration TROUBLES with FORMING CORPS A. Often boilerplate bylaws are adopted, which typically favor the majority shareholders and existing board of directors. 1. Here, minority share holders need to use there leverage to fix the bylaws. Otherwise the chance may never arise again. a) What about a guaranteed seat on the board? b) What about guaranteed employment? c) What about the right to veto certain major actions? (1) For instance, the bylaws can provide that certain actions require unanimous consent. DEVELOPING a CAPITAL STRUCTURE for the CORP A. All corporations have at the core of their capital structure one type of ownership: 1. STOCK a) Stock is generally given in exchange for money (capital) necessary to run the business. 2. But, what is "stock"? B. COMMON STOCK: 1. The document filed with the state (articles of incorporation) will DESCRIBE the corporation's stock. E.g., a) "The corporation is authorized to issue up to X amount of stock." 2. Common stockholders are referred to as RESIDUAL CLAIMANTS of the assets of the corporation. C. D. There will be many claimants against the corp's assets. Once EVERYBODY ELSE is paid off, everything left belongs to the common stock holders. b) This is okay (according to Hillman) because every other claim is going to be DEFINED. OTHER CLASSES of STOCK SENIOR TO common stock 1. PREFERRED STOCK a) Here, this stock has a "preference" vis-a-vis the common stock. The "preference" is that DIVIDENDS must be paid to the preferred stock holders before common stock holders get paid. (1) HOW MUCH of a preference? This depends on how the preferred stock is described in the AoI. AOI will specifically describe the amount of the preference. (2) e.g., the AOI may state $1 per share on preferred stock. Thus, if the corp declares dividends it must pay the full dollar to preferred stock holders before paying other dividents. (3) THIS IS NOT A RIGHT to $1 per year per share. The decision to issue a dividend REMAINS WITH THE BOARD OF DIRECTORS. (4) The PREFERENCE EVAPORATES at the end of the year (there is no accumulation over years if no dividend is paid). UNLESS the AOI creates the preferred stock as CUMULATIVE PREFERRED STOCK (5) CUMULATIVE PREFERRED STOCK has the preference rolled over from year to year. In this case, all nonpayments or short payments must be paid before common stockholders receive a dividend. b) Preferred stock MUST BE AUTHORIZED by the articles of incorporation. c) WHO WANTS PREFERRED STOCK? (1) Preferred stock has a slight advantage in lower risk, and would be wanted by people who want a $$ return on investment. (2) BUT, there is no real upside, because payments of dividends would result in tax to the preferred stock holder. (3) ALSO, preferred stock will have a limited payment on liquidation. (e.g., preferred shares sold at $20 and limited to a preferred liquidation value of $20). (4) Preferred stockholders also do not get to VOTE on officers of the corporation. CREDITORS 1. TRADE CREDITORS a) e.g., PG&E 2. BOND/DEBENTURE a) V. VI. Investment of money with a date certain for repayment and an agreement for annual or semi-annual payments of interest to the bondholder. b) This is NOT subject to the BOD's approval. c) Bondholders are SENIOR CLAIMANTS to all stockholders in the corporation. They are SENIOR TO ALL CLAIMANTS d) BONDHOLDERS have no voting control in the corporation. e) BONDS are described in the AOI. CLOSELY HELD CORPORATIONS A. There are some special rules for close corps which relax some of the rigid formalities. B. BUT, the rules generally only apply to STATUTORY CLOSED CORPORATIONS 1. This is a closed corpoation that ELECTS "statutory closed corporation" status in its AOI. 2. HILLMAN: There is no reason not to elect this status. ULTRA VIRES DOCTRINE A. IT used to be that formation of corporation required consent of the sovereign. And this authorization was very limited to very specific activities. B. TODAY corporations can be formed to engage in ANY LAWFUL ACTIVITY. Look at paragraph 3, pg. 1007 of the statutory supp. 1. Thus -- we can engage in ANY activity. 2. Thus the doctrine of Ultra Vires is largely dead now. 3. a) 9/2/99 I. ULTRA VIRES A. Now, largely dead b/c of language which allows corps to form "for any lawful purpose." B. ULTRA VIRES doctrine ran largely to the benefit of the shareholders 1. Allowed shareholders to prevent corporation from engaging in certain activities. C. Three areas where ULTRA VIRES may apply 1. Can a corp be a partner in a partnership? a) Yes. This issue has been resolved. 2. Can a corp. guarantee others debts? a) Once again, largely a dead issue now. b) BUT, we talk about Ford's arrangements with their dealers here. Dealers need to take out loans to pay for cars from Ford motor company. But banks won't loan w/o security on the loan. So, Ford motor company guarantees the loan. 3. Corporate gifts a) Somewhat resolved. Corporations can give gifts. (these aren't gifts, they are corporate good will). (1) Gifts to recognized charitable organizations are okay. (2) BUT there are still ongoing litigation issues regarding gifts to non-recognized charities or directly to individuals. b) i.e., Masterpiece theater by Mobil Corp. RECOGNITION and DISREGARD of "CORPORATENESS" Piercing the Corporate Veil A. Here we are piercing the corporate veil for purposes of holding shareholders personally liable for the actions of the corporation. B. Normal corporate law says "limited liability" C. BUT, this is inconsistent with agency law, which says that the PRINCIPAL (e.g., shareholder) is liable for the actions of the AGENT (e.g., corporation). D. NY § 630 - says that the ten largest shareholders are personally liable for employees paychecks. 1. NY also provides that its laws apply regardless of the state of incorporation. But, this law is not included. 2. Once again, this is contradictory to Eisenberg's statement that close corps should incorporate in the state of operation., TWO BROAD GROUPINGS of CASES A. Tort claimaints 1. "Involuntary creditors" B. Contract cases Walkovski v. Carlton (p.165) A. Carlton is sole stockholder in several corporations. Each corporation has two taxicabs. Each corporation carried minimum statutorily required insurance. was injured by one of the cabs. sues the driver and the corporation owning the cab. The problem here is that the neither the driver, nor the cab company has II. III. IV. V. B. C. sufficient assets to pay. But the shareholder (CARLTON) has plenty of $ to cover because of all of his various corporations. 's theory is that the multiple corporations is really one entity just creatively organized to defraud the public. WHAT DOES HAVE TO PLEAD TO GET PAST MOTION TO DISMISS BY ? 1. must plead that is operating this fragmented corporate structure "in an individual capacity." WHAT IS THE TEST TO DETERMINE WHETHER OWNER IS OPERATING THE CORP. IN INDIVIDUAL CAPACITY 1. MAJORITY: Looks to commingling of funds as the test. In other words, as long as FORMALITIES of payments to owner (i.e., issuing paychecks, having payroll, dividends, etc.) are handled properly then the corp is not being operated in INDIVIDUAL CAPACITY. 2. MINORITY: Looks to practice of undercapitalizing the corporation as the test of shareholder liability. a) PROBLEMS with this position: Where do we test "sufficient capitalization." Some say only at the beginning (this appears to be the position of the Keating dissent). Others say that it should be an ongoing test (very minority view). b) OTHER PROBLEM: What is "sufficient" capitalization. 3. MOST JX in the wold require some minimal amount of capitalization on the formation of a corp. THERE IS NO SUCH REQUIREMENT IN THE UNITED STATES. 4. The only discipline on this in the US is that some courts are willing to pierce the veil on failure to sufficiently capitalize (but not the majority). RULE in NY still stands that undercapitalization is not sufficient. I. II. III. 9/7/99 PIERCING the CORPORATE VEIL (cont'd) A. SEE WRITTEN NOTES FROM FRIDAY B. Piercing the veil goes to the heart of the concept of "corporateness" 1. i.e., holding shareholders personally responsible for the corporation's liabilities Kinney Shoe v. Polan A. Here Kinney leases to Industrial Realty (owned by Polan), Industrial Realty then leases PART of the property to Polan Industries (also owned by Polan). B. Why did Mr. Polan structure things this way? 1. Because he didn't want to rent the entire property for Polan Ind. 2. Here, Polan uses I.R. as a "shell" corporation. 3. Thus, Polan Ind. only pays (and is liable for) the portion of the rent that represents the property it actually uses. And, if Industrial Realty defaults, then Polan is insulated. C. In this case Polan Indutries also went bankrupt however, and so there is a total disaster. D. TWO PART TEST for PIERCING THE VEIL: 1. Unity of interest and ownership 2. Does an equitable result occur if acts are treated as those of the corp. alone. E. QUESTION: Did Lincoln Polan really put "nothing" into industrial realty? 1. Here, the first payment of the lease between Industrial and Kinney was made by Lincoln Polan directly. 2. THIS WAS NOT SMART: What Polan should have done was to CAPITALIZE Industrial, and then let Industrial make the payment. a) But, even if Polan did this, there would still be th question of formalities. IN other words, whether capitalized or not, there were no minutes, no directors meetings, no election of officers. POLAN missed all of the formalitites. b) Note that the result here is PUNITIVE. Whether the formalities were observed does not itself injure Kinney or any third party. Here, the court is willing to SPANK POLAN just for the fact of failing to meet the state's requirements. c) AND, even if Polan had met the formalities, there would still be problems, BUT, the investment fact is important. Even so (bottom of 181) the court still implies that failure to observe formalities alone might have been enough (?) to avoid piercing the veil. F. EQUITY ISSUE 1. This is a K case (willing assumption of risk by Kinney) rather than a Tort case (unwilling assumption of risk). 2. Lower court says K assumed the risk. BUT, App. Ct. says this is plainly erroneous (without adeqate explanation. NOTES at pp. 185-91 IV. Limited liability protects shareholders from having to monitor the corporations activities. 1. Good for encouraging diversifying and maximizing investments. B. Limited Liability also eliminates the need for owners to monitor wealth of coowners 1. e.g., in a partnership, each onwer will want to be sure that other partners are not "judgment-proof." C. Limited Liability makes shares "fungible" BUT it may also result in moral hazard." D. Note that many of these arguments apply more strongly to close corps than public corps. 1. Owners in small corps will want to make sure corp is being handled well, and are typically involved in management. Parent-Subsidiary Relationship A. Under this relationship, a Parent Corporation is a 100% shareholder & owner of the subsidary company. B. CERCLA CASE (from Supp???) 1. Here a facility that has deposited a hazardous waste is a subsidiary of the parent corp. 2. Under CERCLA the question that arises is DOES A PARENT CORRP "OWN" or "OPERATE" a SUBSIDARIES FACILITY? a) In this case there was a "SUBSTANTIAL IDENTITY" officers and directors between the two corps. The district court finds that "this is enough" to pierce the veil. b) Supreme Court says NO this is not enough. Mere identity of officers and directors is not enough alone, AS LONG AS the people acting in these roles KEEP THEIR ROLES STRAIGHT. c) SOMETIMES inappropriate action by officers of a subsidairy may result in liability for a parent. But this opinion is useless in setting solid standards. 3. POINT THAT CAN BE TAKEN FROM CASE: If officer of subsidiary takes action that fails to benefit the subsidary because it benefits the parent. 4. OR, trouble can also result where the offcers completely disregard their relative roles in each company. C. DID the court worry about adequate capitalization here? 1. NO, because CERCLA doesn't look for capitalization, it only looks for "eccentric" action by the officers in terms of "owernship or operation." A. I. II. III. IV. 9/7/99 Noon Make-Up Session PULLING THINGS TOGETHER ON PIERCING THE VEIL A. Piercing the veil cases typically involve either 1. CLOSE CORPS 2. OR PARENT-SUBSIDARY PROBLEMS FACTORS TO LOOK AT IN CLOSE CORP SETTING A. UNDERCAPITALIZATION 1. No STATUTORY requirement to capitalize corps. 2. The veil may be pierced if undercapitalization occurs, but usually other "bad acts" must be included. B. CONDUCTING BUSINESS on a PERSONAL RATHER THAN CORP BASIS 1. Not using the right "name" when transacting business 2. Failing to observe formalities (electing directors, officers, etc.) C. TREND IN THE COURTS: 1. Del § 354: Allows SHAREHOLDERS to dispense with many corporate formalities. FACTORS TO LOOK AT IN PARENT SUBSIDIARY RELATION A. Well if the subsidiary is 100% owned by the Parent Corp, then essentially we have a "close corp" setting. B. BUT, this is different, because often we have identity in officers and directors. 1. Thus what we are looking for, in a sense, is two separate "persons." PROBLEM, IIB A. Here we have two balance sheets. B. ABOUT BALANCE SHEETS: 1. There are two sides, and they must balance. a) On the left side are the ASSETS of the corp b) On the right side, are the CLAIMS against those assets which are divided into two broad categories: (1) LIABILITIES (CREDITOR claims against the corp) (2) EQUITY or CAPITAL (SHAREHOLDERS, the residual claimants). C. Thus a balance sheet tells us what a corporation has, and what claims there are against the corp. 1. As a future creditor, what you DON'T want to see is ASSETS that are EQUAL TO LIABILITIES (you want to see plenty of assets to cover the creditors). D. What a balance sheet doesn't tell us: 1. PERFORMANCE of the CORPORATION. a) Here there is an INCOME STATEMENT that tells us how the company is doing over time. E. INCOME STATEMENT 1. Income - Expenses = Net Income (PROFITS) F. WHEN ANSWERING THE PIERCING THE VEIL ISSUES, we look to the BALANCE SHEET. G. H. I. J. K. L. M. EXAMPLE: Corp is formed and $100 is put into corp. What does balance sheet look like now? 1. ASSETS = $100 cash 2. L & E = $100 a) LIABILITIES = $0 b) EQUITY = $100 (called PAID IN CAPITAL, or PIC) NOW we engage in some business. WE are going to buy $900 from the bank to buy some machines. 1. ASSETS = $1000 a) $100 cash b) $900 machines 2. L & E = $1000 a) LIABILITIES = $900 (loan) b) EQUITY = $100 (p.i.c.) Note, that if this is a balance sheet, and this corp comes to you asking for credit, it may not be very wise to loan the corp money. (high liability, low equity). NOW at the end of the first year we have a profit of $500 cash. 1. ASSETS = $1500 a) $600 cash b) $900 machines 2. L & E = $1500 a) LIABILITIES = $900 b) EQUITY = $600 (1) $100 p.i.c. (2) $500 of RETAINED EARNINGS or R.E. Note that this now improves credit worthiness. The ratio of DEBT (liabilities) to EQUITY has been reduced. Thus, a potential creditor might feel better about loaning to the corp. NOW, say that a $100 payment is made on the machines... 1. ASSETS = $1400 a) $500 cash ($600 - $100 payment) b) $900 machines 2. L & E = $1400 a) LIABILITIES = $800 ($900 - $100 payment) b) EQUITY = $600 (1) $100 pic (2) $500 re NOW, the next year is a disaster, and we have a $500 loss... 1. ASSETS = $900 a) $0 cash ($500 - $500 loss) b) $900 machines 2. L & E = $900 a) LIABILITIES = $800 b) EQUITY = $100 (1) $100 pic V. (2) $0 re ($500 - $500 loss) N. NOW in year three, we LOSE another $200 (e.g., we owe employees $200 that we don't have). 1. If the company has borrowed $$ to pay, what does the balance sheet now look like? Now there is NEGATIVE NET WORTH (R.E.) a) ASSETS = $900 (1) $0 cash (2) $900 machine b) L & E = $900 (1) LIABILITIES = $1,000 (a) ($800 owed on machine - $200 loan to pay wages) (2) EQUITY = $-100 (a) $100 pic (b) -$200 re ($0 - $200). NOW, moving on to PROBLEM IIB A. Here the ratio of debt to equity in the SUBSIDARY is 50:1, while the parent company's ration is 5:1. B. FIRST QUESTION: Was the SUBSIDARY "UNDERCAPITALIZED"? 1. Here we discussed the fact that even though there was $100,000 put in (a lot of $$), the business of the subsidiary was multimillion, and very risky. 2. HILLMAN suggests that we should compare the DEBT RATIOS of parent to subsidiary as one way of measuring (although not conclusively) undercapitalization. a) 9/8/99 I. Back to Problem II B A. Questions of Capitalization 1. 5:1 debt ration for parent, 50:1 debt ratio for subsidiary. 2. Combine this with the fact that the subsidiary is engaged in more dangerous activity than the parent. 3. These facts at least suggest we may have an undercapitalization issues. a) Certainly not conclusive, but is an indicatior. B. Did the owner properly respect the "personhood" of the subsidiary 1. SIMILARITY OF NAMES a) Here 's might be able to argue that the similar names might lead people to believe that they are dealing with the parent. b) In the CARLTON CASE (cab case) the court said that the fragmented structure was a "common arrangement" in cab industry. 's could use this to defend. 2. IDENTITY OF OFFICERS a) BEST FOODS CASE, had similar officers. There is nothing wrong with having same officers. BUT did JONES keep his hats straight when he was doing deals for each Corp.? b) QUESTIONS: Were there BOARD MEETINGS of world ships? Board of Directors are supposed to meet for BIG deals by the corporation. Did BOD meet to approve $12 mil ship building K? Did BOD meet to approve $5 mil loan to buy the Neptune. c) Here we discussed what happens if the atty is approached with the fact that the board "kind of got together" and decided but there was no formal meeting. Atty MUST avoid any encouragement of falsifying documents. At most, what the client might be able to do is prepare a CURRENT DOCUMENT memorializing the past decision. 3. WERE THERE SEPARATE OFFICES? a) Are there different phone lines? b) Here, if there is only one office and phone line, an argument can be made that there is a "commingling" of assets because of the shared offices and phone lines. c) Corporation must be careful to make sure that expenses are properly split. d) And, once again we have the question of misleading third persons doing business with the orgs. C. Piercing the veil is a very PLAINTIFF SPECIFIC issue. 1. In other words, we may find that actions pierce the veil with regard to one claim, but not with regard to others. a) WELLS FARGO's CLAIM: In this case, the BANK originally decided to loan money to WORLD SHIPS at its formation. It knew, or arguably should have known, about the liabilities and equity of WORLD SHIPS. Thus we are less sympathetic. b) c) HOWEVER, in Wells Fargo's favor, the POST LOAN activity of WORLD SHIPS does raise questions, because we have questions of whether formalities were followed. HILLMAN: thinks that this is the weakest claim against WORLD SHIPPING. TEXACO'S CLAIM: In this case, Jones failed to get the "customary insurance." Here, IF world ships is undercapitalized, did Texaco "assume the risk"? Less likely here, because Texaco is not loaning money, it is making basic assumptions about World Ships' behavior. AND, Texaco has arguments of confusion as raised above. KOREAN SHIPYARD CLAIM: Here, there are problems for the Shipyard, because it has decided to extend $12 million credit to a corporation with total assest of $5.1 mil. Here there are mitigating factors for the Shipyard because of cultural, distance, and informational gap issues. But, this cuts both ways, lack of info could also be viewed as a warning sign to the foreign shipyard. HILLMAN: Suggests that this claim probably falls between the other two. d) I. II. III. 9/9/99 Back to Problem IIB (World Shipping/World Ships) A. Continuing with discussion of claim of Korean Shipyard. 1. In the past, claims for foreign claimants would have been significantly discounted because of the difficulties of the Shipyard in litigating the claim in the US. BUT, now, such problems are less likely to occur (big firms in SF will take on foreign client). 2. Ultimately, Hillman suggests that the shipyard's claim falls between the other two. Stronger claim that the bank. But significance of the transaction suggests that Shipyard should be assigned a greater duty of diligence than Texaco. B. Hillman says that in evaluating this claim, since World Ship's other ship is sunk, Word Shipping may very well want to AFFIRM the debt in order to get the ship so they can continue in business. C. Hillman says, realize that we need to go beyond the simple answer to look for what a settlement might really look like. SUBORDINATION OF SHAREHOLDER CLAIMS A. BLACK LETTER LAW: If a corporation does not have enough money to pay its debts (ie claims by creditors) then the shareholders of the corp should get nothing out of the corporation. B. BUT, what happens when a shareholder is ALSO a creditor of the corporation? 1. DOCTRINE OF EQUITABLE SUBORDINATION: When equity requires, the creditor claim of an individual who is also a shareholder will be equitably subordinated to claims by creditors who are NOT shareholders of the corporation. C. EXAMPLE: Davis Hardware 60/40 split. Corp is having hard times. Nobody outside will loan $$. So shareholders give $$. 1. IN this case, suppose corp has $50 in assets, and $200 in liability. But now shareholders give "loan" Hillman give $60K, and I give $40K. 2. In analyzing claims after corp goes under, we will look to: a) ADEQUATE CAPITALIZATION (1) Would a reasonable person have loaned money based on existing financial statement? If not, the shareholder loans may be reclaissified as equity. b) WAS THE "LOAN" IN PROPORTIONS EQUAL TO SHAREHOLDER'S OWNERSHIP? (1) IF so, this looks a lot more like stock. D. IS it "morally wrong" to do this? 1. No, it gives advantages, but there are no downsides. At most owners "lose" their loan as equity. But they stand to recover at least something (if not the full value of the loan) in settlement. LIMITED LIABILITY IN THE LLC SETTING A. These questions in the LLC are not well settled. IV. § 303 of the ULLCA sets up the principle of limited liability for LLC's but it also says that failure to observe formalities IS NOT A GROUNDS for piercing the veil and holding LLC's liable. 1. So, does this make it "harder" to pierce the veil for an LLC? It certainly repudiates many cases relying on this factor. 2. Notice that undercapitalization is NOT mentioned here. 3. HILLMAN says that this rule still makes piercing the veil possible, but it can make it more difficult. HILLMAN SUGGESTS that a good lawyer would make the case for undercapitalization, and still bring in "formalities" as an "added factor" in piercing the veil (thus not the "grounds" but just an extra consideration). CONTROL & MANAGEMENT of the CORPORATION: ACTIONS BY DIRECTORS & OFFICERS A. Where do the rules affecting such actions come from? 1. State statute 2. Common Law 3. ALI's - Principles of Corporate Governance a) The way corporate law "should be" 4. Bylaws of the Corporation 5. Contracts between shareholders B. A "less formalistic" view of corporate structure 1. MODERN VIEW: The "NEXUS of CONTACTS VIEW": viewing shareholders as "owners" of the corporation is wrong. Instead we should view the corp as an "economic unit" with may varied interest holders. a) Calling "shareholders" owners is not accurate. Shareholders do not have all of the powers of owners. They cannot demand to speak with the officers or direct their actions. b) Relationship b/t majority & minority shareholders: The direction of law does not give minority shareholders absolute rights against majority. Majority only has to treat minority "fairly" when it does crappy things to them. c) B. I. II. III. IV. 9/10/99 What does it mean when we call shareholders "owners" of the corporation. A. In this case we are talking about a kind of economic ownership. B. But, shareholders are not full "owners" as the term is normally used. Board of Directors A. Inside & Outside Directors 1. Inside Directors a) Directors who are also officers of the corporation 2. Outside Directors a) Directors who are not officers of the corporation B. Corporation is "Managed by or Under the Direction of" the Board of Directors (see § 141(a) Delaware Corp. Code.) 1. But there are problems with taking this literally a) Typically members of the board do not have the time to act as full time overseers and managers of the corporation. b) As a practical matter, the officers of the corporation run the day-today operations. c) Requiring full time "management" by BOD would effectively prevent participation by outside directors. 2. ALI Principles (§ 301) Activities of corp are overseen by the "senior officers" appointed by the BOD, with the BOD given the duty of supervising the senior officers' activities. Shareholders power over BOD A. Very limited 1. Shareholders elect BOD, typically on annual basis a) Shareholders may remove members of BOD between elections, but usually this process is so difficult that it rarely happens. 2. Shareholder must approve amendments of Articles of Incorporation. a) It used to be that shareholders also voted on the bylaws, but modern statutes typically say this is left to BOD. 3. Shareholders must approve "certain extraordinary actions" by the corporation. a) Note that this must be something more than a "major action." (1) e.g., merger with another corporation (2) or sale by the corporation of "substantially all"of its assets b) Shareholder voting rights are triggered by what the statute or some other source (AoI or Bylaws) specifically enumerated list). To what extent do shareholders initiate action A. Alex v. Russel (p. 257) 1. Corp has two classes of common stock: class A & class B. This creates the ability to structure power between shareholders. a) For example, in Davis Hardware, we could form two classes of stock, and then say that class A stock elects two directors, and class B elects one. This way we insure that class B (me) gets at least one spot on BOD. V. In this case, the class A stock has a right to call a meeting of ALL shareholders in the corp. The stockholders generally vote to call a BOD meeting. President refuses to call the meeting. (Here, President refuses to call the meeting b/c he is afraid that he will be tossed out). In this case the President stated as his ground that it was improper to have shareholders call a BOD meeting in order to appoint or remove officers. 3. Ct. HOLDS that the meeting should go forward. The court finds that here since the shareholders are not directly replacing the officers, the BOD meeting should go forward. The court interprets the shareholders resolution as a referendum and request to the Board to replace the president. Teamsters case (p.46) A. Here, the teamsters hold shares in the Fleming Companies. Teamsters are protesting the corps plan to implement a "stock rights plan" as being at the expense of existing shareholders for purposes of "entrenching" the BOD. 1. HILLMAN: notes that the law places significant obstacles in the path of shareholders who want to effect changes in mgm't. 2. TENDER OFFER: suppose an outside corporation realizes that shares are poorly performing ($20/share), but that they could throw out mgm't & make stock worth $60/share. So the outside corp. makes a TENDER OFFER to existing shareholders to buy existing $30. 3. To prevent this, a BOD may adopt a "POISON PILL" stockholder "rights" plan. In other words, the BOD could say that for each share of stock that is owned a shareholder can buy $10 of corporate assets for $1. In this situation the BOD can make the TRIGGER for this "liquidation" is an outside TENDER OFFER. Essentially this creates a "self-destruct button" for the corporation, resulting in the practical fact that the outside tender offer will never happen. 4. RATIONALE for allowing this type of activity: That there is a lack of bargaining power b/t individual shareholders and the outside corporation. 5. BACK TO CASE: in this case, the State statute said that BOD was able to adopt the "poison pill" policy on its own as a "shareholder rights" plan. Shareholders wanted the right to ratify this policy. Court eventually rules in favor of shareholders and require the BOD to allow shareholder ratification. 6. 2. I. II. III. 9/14/99 Stockowner Rights Plans & Poison Pills A. We discussed this last time. Actions by the Board of Directors (starting @ p. 292) A. Usually the BYLAWS set forth the time & place of the annual meeting of the Board of Directors 1. Thus no notice for this meeting is generally required. 2. But for any other special meetings requires notice. B. Actions at Board Meetings are Formal 1. Action is taken by VOTING on RESOLUTIONS before the Board. C. Sometimes Boards may act informally 1. The Board may meet through a conference call 2. TheBoard may not meet at all, and each director may simply sign off on the resolution. a) In some states, this type of action requires UNANIMOUS CONSENT by the directors. 3. Boards may allow for action by SUBCOMMITTEES a) The lawfulness of committee action is questionable in some states, because many state's laws only say that actions can be undertaken by the Board of Directors. b) Delaware allows certain actions by committees c) ALI's Model Rules take this even a step further and REQUIRE certain actions to be taken by committees. (1) For instance TIER I corporations MUST have an audit committee which is completely composed of outside directors. (a) This committee basically is used as an outside check on the officer's potential ability to distort financial information. (2) ALI also recommends two more committees of outside directors for TIER I corporations. (a) COMPENSATION COMMITTEE: Sets the compensation of the corporate officers (b) NOMINATING COMMITTEE: Charged with nominating people to sit on the board. (3) For TIER I corps ALI also recommends that the majority of the BOARD itself should be oustide directors. d) For TIER II Corps (smaller publicly held corps) (1) ALI still recommend that there be at least 3 outside directors (but not necessarily a majority). OFFICERS (see p. 299) A. President (mandatory) 1. Top officer of corp. IV. General rule: President has authority to act on behalf of the corporation in ordinary business of corp. BUT, EXTRAORDINARY actions require approval of the board. a) There is not a bright line here, HILLMAN recommends that wherever there is a question, the president should go to the BOD. B. Secretary (mandatory) 1. Keeper of the "corporate truth" 2. Maintains minutes 3. Certifies accuracy of resolutions C. Chief Executive Officer (not required, but most corps have one) 1. May be the same as the President, but not necessarily so. a) For example, President may serve as COO. 2. HILLMAN: For all practical purposes, if a corp has a CEO this will normally be the true "top" positions. 3. Why have "two" positions? Often it is the result of deal making. One corp absorbed by another, and the president of the absorbed corp becoming COO and the president of the absorbing corp becoming CEO. 4. HILLMAN: The "title" of president has essentially been "trumped" by CEO and COO D. Chief Operating Officer (not required, most corps have on) E. Chief Financial Officer 1. Used to be known as "corporate treasurer" 2. In reality is expected to act with a degree of independence from the CEO and COO 3. Has the responsiblity of making sure the company's financial information is ACCURATE, regardless of the directions of the CEO and COO 4. CFO has significant, independent responsibility (and liability) to ensure that financial information & reporting is properly maintained. F. Chief Information Officer LLC's & MODELS of MANAGEMENT A. Under most state statutes, there are two types of LLC's 1. Member managed a) Equivalent of shareholder or owner managment. b) In this case, each "member" has the authority to act on behalf of the LLC and bind it for business purposes. c) This essentially parallels the partnership model. d) By AGREEMENT, the members can restrict the authority of members to bind the corporation under a MEMBERSHIP OPERATING AGREEMENT e) BUT, often third parties do not know about these internal documents and restrictions, and if this is the case, 3rd parties can reasonably rely on member actions which supersede the operating agreement. 2. 2. In these cases, the AGREEMENT really gives other members rights against the member who violates the agreement, NOT a defense against 3rd party reliance. Manager managed a) Only managers have authority to act on behalf of the LLC. And, even then, they can only take actions in the ordinary course of business. b) If the act is extraordinary one, a majority vote of managers is required. c) Original managers are listed in the Articles of Organization filed with secretary of state when forming the LLC. (1) After this, new managers are ELECTED by the members on an annual basis. (2) This essentially eliminates one tier of management as compared to corps. (traditional corp is SH-DIR-OFF; member managed LLC (3) (1) I. II. 9/15/99 How do you verify that a person is "authorized" to transact business on behalf of an LLC or Corp. A. Get a legal opinion from the Corp. or LLC's in-house or "out-house" lawyer that the person transacting business has the authority to transact this business. Public Corps & Shareholders (Part IV of syllabus) A. In a modern public corporation CONTROL has been DIVORCED FROM OWNERSHIP. 1. This is the practical effect of very small ownership interests disbursed over a wide number of shareholders. 2. BUT, shareholders COULD exercise this power. 3. HILLMAN: Points out that today, many public corporations are under INSTITUTIONAL control, and thus the chances for shareholders to organize and exercise control. E.g., mutual funds, insurance companies, pension funds, etc. a) SEE CHART in Supp. (1) Mutual funds have gone from 5% ownership to 14% (2) Pension plans have grown from 15% to 26% (a) This means that 1 of every 4 shares of stock is owned by pension plans. b) Thus any given INSTITUTION may well have a significant number of shares in a corp. (1) e.g., maybe Wells Fargo, Citibank and BofA hold enough shares to "call the shots" at Intel. (2) This hasn't really been happening. (a) INSTITUTIONS tend to hold stock in a "representative" capacity. Thus the institution does not have a direct economic stake in the corp. (b) PROFILE of typical INSTITUTIONAL HOLDER is that these are short term investments. Thus, if there are any concerns about the management of the corp., exit is the preferred choice over attempts to exercise shareholder control. B. Other things that can undermine the picture of shareholder ownership divorced from control: 1. CalPERS has become an extremely active INSTITUTIONAL INVESTOR. a) It has made clear that it will be holding stock for the long term. b) CalPERS (California Public Employee Retirement System) has, in fact issued its own Principles of Corporate Governance (1) TRULY INDEPENDENT outside directors (a) No customers, no suppliers, no direct interest in income of corp. (b) And, non-independent directors should be large in number III. IV. V. VI. And, the president should have to meet with independent directors alone several times during the year. (2) Compensation to Directors: (a) Give stock or stock options, rather than actually paying cash. (thus aligning directors interests with shareholder interests). (3) Compensation to President (a) Should be tied to performance of corp. (4) TWO OTHER RECOMMENDATIONS that CalPERS backed off on: (a) Independent directors no longer considered "independent" after being on board for more than 10 years. (b) No directors over 70 years old. C. Increased day trading activity further solidifies divorce of ownership from control. 1. How much "control" will be exercised by a 10 minute shareholder? D. Bottom line of most of this (with major exception of CalPERS) approach is that incentive is to LIQUIDATE INTEREST when shareholder dissatisfaction arises rather than engage in the efforts necessary to exercise control over corp. DIVISIONS of MANAGEMENT and OWNERSHIP A. Shareholders have "ownership" B. BOD and Officers are "managers" and "control" the corp. ONE THEORY A. There is a broader theory which suggests that there is a broader "constituency" which extends beyond just shareholders. B. Here we are talking about SOCIAL RESPONSIBILITY 1. The "traditional model" is that Managers only responsibility is to increase shareholder wealth. C. BUT, there are others who say that there are other "major reasons" for the existence of Corps. 1. E.g., improving worker conditions, environmental quality, etc. Ford Motor Co, Case (p. 220) A. In this case, the court harangues Henry Ford for plowing money back into the corporation to build more cars and provide more jobs instead of maximizing profits. But, they ultimately allow Ford's actions. PROBLEMS with SOCIAL RESPONSIBILITY of ORG. AS A GOAL A. If there is a single, objective, economic goal (gain). This is easier to manage. But, if there are "fuzzy goals" (e.g., mgm't should be "good"), how can this be evaluated? Might it not lead to managers who do lousy at managing assets to justify their existence? B. (c) I. II. III. IV. V. VI. VII. 9/15/99 Second Session Social Responsibility of Corporations A. How responsible do we want corporations to be? B. Do we want the economic interests of shareholders to be "subordinated" to other interests. 1. But this leads to problems of evaluation of management TRANSLATING POLICY QUESTIONS INTO LAW A. § 2.01 (ALI) 1. IT is the obligation of MANAGEMENT to increase shareholder profit and corporate gain. BUT, Management "may take into account" social responsibility concerns and divert "reasonable resources" to such causes. 2. Thus the core mission is to advane welfare of the shareholders. Smith Case (p. 223) A. Donation by corp. to Princeton University is challenged as not being in economic interest of the corporation. 1. President says it is good business directly for the corporation as an INVESTMENT for the corporation. 2. Kind of the diametric opposite of the Ford case 3. Here, the business is not saying "we're investing in quality of life and jobs, and people's opportunity to build better lives" 4. But here the President of Smith Co. is saying this is NOT social responsibility. It is a direct investment in the future. 5. Court upholds donation. Constitutency Statutes A. Many states have laws which allow the Managers "to consider" employees, the community, etc. B. Ultimately, of course, these statutes only protect Managers against LIABILITY for their actions. But, nothing protects managers from being thrown out at the next election. C. DELAWARE: says that responsibility is to SHAREHOLDERS period. 1. But, of course, "reasonable" dedication of resources to other purposes is okay. SHAREHOLDER VOTING A. Is ONLY applicable to the ELECTION of DIRECTORS 1. Cumulative voting IS PERMITTED in MOST STATES if you opt for it in your articles of incorporation. 2. The purpose of cumulative voting is to give minority shareholding SOME REPRESENTATION on the BOD. WHAT is CUMULATIVE VOTING? A. Each shareholder has the right to cast the number of votes that is equal to the shares they own TIMES the number of directors. B. AND, the SHARHOLDER may CUMULATE THEIR VOTES and cast them ALL TO ONE CANDIDATE. PROBLEM IVB-2 A. under part a, B gets to elect no directors. VIII. under part b. (go to equation on p. 308) 1. D = ((x-1)(n+1))/S a) Where D = the number of Directors B can elext b) x = number of shares that B holds c) n = number of directors d) S = total number of shares 2. So, under this problem: a) D = ((499-1)(9+1))/1000 b) D = ((488)(10))/1000 c) D = 4.98 3. Thus B can elect 4 directors. 4. HOW does this mechanically work? a) B cumulates their votes, and then only divides them between their 4 choices. This will guarantee B four spots. C. under part c, what we see is that as we reduce the number of directors being elected at any one time, then we dilute the effect of cumulative voting. D. And if somebody falls below the threshold of reaching D=1 then they get no directors. WHY BOTHER securing a minority position on the Board? A. Because the ability to place members can be COMBINED with supermajority voting for certain actions (thus giving minority the power to veto certain actions). B. B. I. II. III. 9/16/99 Once again, WHY BOTHER securing the minority position on the Board? A. May help with super-majority voting B. AND, helps with getting information about what the Board is doing. 1. And if something truly bad is about to happen, there might be the ability to pursue legal remedies. Rights of Shareholder's to access shareholder lists & books & records of corp. A. ACCESS to SHAREHOLDER LIST 1. Why would shareholder want the list? a) To potentially take action against board. b) Possibly take coalition action, or contact other shareholders to buy them out. B. BOOKS & RECORDS of CORP. 1. Why would shareholders want access to this info? a) To check-up on management. b) Evaluate beyond management whether shareholder wants to stay a shareholder c) Espionage! (1) Person buys shares with the intent of obtaining private information to use in competition (bad) (2) Or, person may be whistleblower (good). C. STANDARDS for SHAREHOLDER ACCESS TO INFORMATION 1. GENERAL LEVEL: Shareholder gets the information if they have a PROPER PURPOSE for requesting the information. a) SHAREHOLDER LIST: Normally ASSUMED to be an appropriate request by the shareholder, and burden is placed on the BOD to show improper purpose. b) BOOKS & RECORDS: Here, burden of proof is shifted. NO ACCESS unless SHAREHOLDER can show that purpose is proper. D. SO, what is a PROPER PURPOSE 1. Many sates have statutory rule: DeMinimis shareholders are not allowed access to Books & Records. a) Typically "DeMinimis" is set at 5%. Anything below this will get no access. b) And, even over this amount, shareholder still bears burden. SECURITY FIRST CORP. v. US DIE CASTING (p. 58) A. Merger designed by BOD's to discourage "better offer." In this case the BOD's agreed that if any outside offer came along for Security First, then Security First would have to pay $2.25 as a "Termination fee." OF course, this is much like a poison pill strategy. Anybody who might want to make a better offer will think twice b/c of immediate loss of $2.25 mil. B. Then, after a while, the two companies decide the merger will not go ahead due to "differences in mgmt philosophy. C. BUT, Security First agrees to pay $275K in Mid Am's costs. D. E. F. G. H. AND, Security First agrees to pay $2 million to Mid Am in the next 1.5 years if another merger deal comes along. 1. HILLMAN: Notes that this is even more severe than a poison pill, because, in this case even if a FRIENDLY OFFER comes along, the "bomb" goes off. HILLMAN: Note here, that shareholder brings suit to demand to inspect books & records, instead of just suing for BOD's breach of fiduciary duty. Why? 1. HILLMAN suggests that inspecting the books & records might give BROADER ACCESS than discovery in a litigation. a) Discovery will be contested document by document by the corp., whereas once shareholder meet burden of showing PROPER PURPOSE then all books & records should be available. IN this case, managed to show PROPER PURPOSE because 1. More was paid than agreed for the cancellation of the merger 2. Why was $2 million fee agreement extended for 18 months 3. Security never "broke" merger agreement, so why pay at all. HOLDING in this case: The court finds that has met their burden to get the books & records, BUT that the access will be specifically limited to very specific documents related to the transactions that have been specified. SHAREHOLDER LIST: Here the court denies the shareholder list because of failure of a proper argument. ] 1. HILLMAN: could have easily gotten list simply by saying that he wanted it to coordinate future litigation with regard to the questionable transaction. 2. I. II. III. 9/17/99 Item 4d: MANDATED DISCLOSURES & FED SECURITIES A. Corps are primarily governed by STATE LAW B. But, FEDS get into the Act under Federal Securities Act 1. Here, feds are interested in controlling the flow of knowledge and capital. SECURITIES involve TWO TYPES of TRANSACTIONS A. PRIMARY TRANSACTION 1. ISSUER: The person who "issues" a security (such as stock) which is issued by the corporation. 2. The PRIMARY TRANSACTION is where the INVESTOR gives the CORP. $$ in exchange for STOCK. a) Sale of stock is called an EPISODIC EVENT. Only at limited intervals will the CORPORATION itself ISSUE the stock. b) The day-to-day trading of stock is NOT a "primary transaction" because the ISSUER is not involved. B. SECONDARY TRANSACTION 1. IS the day-to-day, minute-to-minute trading of stock between investors. 2. HILLMAN: This is the most IMPORTANT aspect of securities 3. YET, in these transactions, the corporation itself is not involved. SIX MAJOR PIECESof SECURITIES REGULATION (see p.324) A. '33 Act & '34 Act were the first federal laws 1. Prior to this time, securities were only regulated by state law (called "Blue Sky" laws). 2. DEBATE on federal acts: a) BRANDEIS VIEW: The correct way to regulate investment transactions is to require full disclosure, so that people can make rational, informed decision. b) DOUGLAS VIEW: That investors cannot take care of themselves, even with full disclosure, and thus gov't should take a role in assuring a fair deal. 3. BRANDEIS VIEW WON: Disclosure is all that is required, gov't is not in business to prevent people from making foolish, albeit informed, investments. B. '33 Act is primarily involved with PRIMARY TRANSACTIONS and PUBLIC OFFERINGS of securities by corporations 1. Requires extensive disclosures about the corps business, officers, potential conflicts, etc. 2. REGISTRATION STATEMENT: Before a corp can offer to sell a security, a registration statement must be file with the SEC which discloses the required information. C. '34 Act also is concerned about FRAUD in PRIMARY TRANSACTIONS, but it also addresses SECONDARY TRANSACTIONS 1. '34 Act regulates markets, brokers & dealers, has some powerful anti-fraud provisions, prohibits insider trading by corporate officers, requires ONGOING disclosures by ISSUERS. IV. V. VI. VII. VIII. CONTINUING REPORTING PROVISIONS of '34 Act: Even after PUBLIC OFFERING & REGISTRATION STATEMENT under '33 Act, the '34 Act requires a CONTINUING STREAM of INFORMATION to the markets. 3. 3 important aspects of Continuing Reporting Provisions a) 10K Report: An annual report that every publicly held company must file. (1) Must explain what has happened and what is expected to happen to the company AND independently audited financial information about the company. b) 10Q Report:Quarterly reports that must be completed every three months, and which also contain UNAUDITED financial information. c) PROXY SOLICITATION SYSTEM: also requires extensive reporting requirements by the corporation. EFFICIENT CAPITAL MARKET HYPOTHESIS A. SIMPLE LEVEL: Our securities markets are very efficient in that they quickly respond to information, and reflect that information in the pricing of securties. GOALS of SECURITY REGULATION A. To provide information so that prices reflect that information B. To prevent "corrupt" information from distorting the market PROXIES (p. 330) A. § 14 of the '34 Act is the only section that deals with proxies. 1. "It is unlawful for any person to solicit proxies in violation of rules promulgated by SEC." B. SEC: 1. An independent commission of 5 commissioners who each serve 5 years, staggered terms. 2. No more than 3 of the commisioners are to be from same political party 3. Charged with enforcement of Securities Acts. PROXY SOLICITATION in CONTEXT A. Every corp is supposed to have an annual meeting of shareholders. B. BUT, practical realities prevent the actual assembly of all the shareholders. 1. Typically actual attendance is less than 1% of actual shareholders. C. PROXY is how shareholders get represented. This is an AGENCY arrangement where shareholders select a person to represent them and vote their shares. 1. Typically, the MANAGERS of the corporation will solicit shareholder proxies. 2. AND, in some cases, SHAREHOLDERS may want to solicit other sharholders proxies. a) Elect new board b) Put resolutions to shareholders PURPOSES of SEC's PROXY RULES A. Prevent Fraud B. Ensure that corporation puts full info about itself before the shareholders 2. C. IX. X. Provide mechanism by which non-management shareholders can solicit proxies 1. e.g., managers get to use corporate funds to solicit. STRUCTURE of SEC's §14 RULES A. § 14(a)(1) 1. Definitional section. Defines "proxies" and "solicitations." 2. SOLCITATION: "A communication to security holders reasonably designed to result in the procurement, withholding or revocation of a proxy." B. § 14(a)(3) - Timing 1. You cannot solicit a proxy unless you have first filed a proxy statement. 2. A PROXY STATEMENT is an extensive disclosure document that should provide all the information shareholders would want to know before deciding where to assign their vote. C. § 14(a)(6) 1. PROXY STATEMENT must be filed with the SEC before it is distributed to the public. a) Typically SEC just collects the documents b) BUT, it CAN review the document at its discretion and require more disclosure. D. § 14(a)(7) & (8) 1. Deal with shareholder solicitations E. § 14(a)(9) 1. Requires TRUTH in proxy solicitations The "SO WHAT" Rule: A. What happens in a failure to follow § 14 1. SEC ACTION a) SEC can take action to ENJOIN the matter that is the subject of the solicitation b) SEC can seek disciplinary actions against ATTORNEYS, etc. c) SEC can also refer to JUSTICE DEPARTMENT for CRIMINAL PROSECUTION 2. PRIVATE ACTION under the Securities Acts a) In many cases the provision of the '33 and '34 acts are silent as to whether private causes of action are authorized. b) First case that came up involved § 14 c) LORAC CASE: Mgmt makes material misrepresentations in solociting proxies for corporate merger. (1) S. Ct. HOLDS: That shareholders do have right to sue under § 14. (2) BUT, MORE RECENTLY, the S. Ct. has been holding back on granting new rights of action, BUT, it has held that PAST IMPLIED private rights of action remain enforceable (including § 14). (3) 9/21/99 I. PROXIES A. Management solicits proxies of shareholder for annual meeting B. Solicitation MUST be accompanied by PROXY STATEMENT 1. This STATEMENT is very detailed, and itself is a major form of disclosure about the corporation. SHAREHOLDER SOLICITATION of PROXIES A. Shareholders may also solicit proxies of fellow shareholders. 1. Disagreements with management over policy 2. Desire to throw out existing management B. MANAGEMENT WILL TRY TO BLOCK these ATTEMPTS 1. May deny the shareholder access to shareholder lists (without legal action) SEC RULE 14(a)(7) A. IF management is going to solicit proxies, management MUST provide to any shareholder that requests it, the number of shares in the company and the approximate costs of mailing. B. IF the shareholder wishes to pursue solicitation, then EITHER management can simply provide the list to the shareholder, OR it can provide "space" in its own mailing and then have the shareholder pay the proportional cost of the corporation's solicitation. SEC RULE 14(a)(8) A. FREE RIDE PROVISION: 1. IF this provision is applicable, management MUST include the shareholder proposal and statement in its own mailing AT NO COST to the shareholder. 2. LIMITS on APPLICABILITY of 14(a)(8) a) Not available to de minimis shareholders (at least 1 year of ownership & value of stock must be worth more than $1,000). b) Not available if shareholder is proposing something that is "not a proper subject" for shareholder action. c) Not available if the proposal violates law. d) Not available if statement contains untrue or misleading statement. e) Not available if the proposal is a "personal grievance" against the corporation or its officers. f) Not available if the proposal is beyond the powers of the corp. g) Not available if proposal affects the ordinary day-to-day business of the corporation. h) Not available if the proposal relates to the election of directors. i) Not available if the proposal is counter to a proposal offered by management (1) Logic here is to require voting up or down on given proposal, rather than allowing fifteen competing proposals to run head-to-head. B. HILLMAN: Keep in mind that these exclusions only affect the FREE RIDE. Amalgamated Clothing & Textile Workers v. Wal-Mart Stores II. III. IV. V. VI. Case involves shareholder proposal regarding "social responsibility." 1. Shareholders wanted to vote on a proposal to prepare a report on affirmative action policies of WalMart 2. Management excluded the proposal two years in a row. 3. After the second denial, shareholders sued & D. Court ruled in their favor. 4. Management capitulated, and included the proposal, and it was RESOUNDINGLY squashed by the rest of the shareholders at the meeting. 5. Then, after loosing, shareholders bring action to recover attorney fees, and D. Court grants it, and 2nd. Cir. affirms. Who actually picks up the costs of proxy solicitation. A. Rosenfeld, p. 374 1. Here there is no majority opinion, it is a plurality, we will further discuss this case next time. B. A. 9/22/99 I. NY Rule on proxy solicitation: A. Hillman asks: what is the "rule" that comes out of this case (3-1-3 decision) 1. NOBODY ANSWERS, HILLMAN SAYS: OKAY FIGURE IT OUT. 2. READ LEGALLINES. Control of Closely Held Corps. A. In contrast to other countries, US has a "unitary view" of corps. B. BUT, in recent years there has been some evolution developing special rules for close corporations. Background on Fiduciary Duties A. A "Fiduciary" is a person in whom trust has been placed B. PARTNERSHIP LAW: The fiduciary duties owed by partners to each other are very strong. 1. Each partner is a fiduciary as with respect to all of the other partners 2. Each partner must act with the strictest good faith & loyalty with respect to the others. 3. These duties are so strict because there is no limited liability of partners. C. CORPORATIONS: 1. Because of limited liability there should arguably be a lower standard. But, there are still fiduciary duties. 2. Directors must act with due care and loyalty to the corporation & shareholders. 3. And shareholders also owe fiduciary duties. Donahue case (p. 391): A. Donahue & Rodd start as employees of a corporation. 1. Rodd & Donahue are employees and minority stockholders. a) Rodd has 200 shares. Donahue has 50 shares. Out if 1000 existing shares. b) Then the company buys back the 750 shares of controlling stock. Here, the majority shareholders are causing the company to buy back their stock. c) When this happens, the stock goes into suspension. (1) TREASURY STOCK: Any stock that a corporation buys back and holds in suspension. The stock is not vaporized. (2) After the transaction absorbing the stock, then they will probably not want to sell the rest. d) In effect, what has happened is that 3/4 of the company's assets have been "retired," leaving R&D with 100% interest in a 1/4 size company. e) WHO DOESN'T LIKE THIS TRANSACTION? Creditors. 2. NOW, Rodd who wishes to retire (and only owns 81 shares at this point) wants corp to by him out. B. II. III. IV. 9/23/99 I. Donahue v. Rodd (ctd.) A. Rodd was paid BOOK VALUE for his stock 1. BOOK VALUE is the ASSETS - LIABILITIES a) BUT, the problem of valuing a corporation this way is WRONG for assessing the present value of the corporation, because the value of ASSETS is represented by their cost when acquired. It does not account for appreciation or depreciation of the assets. 2. RODD has other transactions with his kids for his remanining 36 shares. a) First, he gives the kids 30 shares as an outright gift (10 shares each). b) Second he sells the remaining 6 shares to the kids for $800 per share. 3. HILLMAN asks: whats wrong with this picture? a) Why do a gift for most of the shares, and then do a sale for a small handfull of shares. What really seemed to be happening here? We have 36 shares transferred for a total of $4800. Looking at it this way, the value of the shares is $133 per share. b) If we view it this way, all of a sudden we see a significant disparity between the share price to the kids ($133/share) and the share price to the corp. ($800). B. HERE, Mrs. Donahue brings her suit because RODD is treating himself "too fairly." 1. D claims that because this is we have a CLOSE CORPORATION a) D says that R "created a buyer" through the corporation, and b) That D unfairly distributed the corp's assets to himself. 2. D says this is a breach of R's fiduciary duties as a controlling shareholder. C. Here the court says that it is not particularly concerned by the actions of the Board of Directors, because it does not see "self-dealing" by the Board. 1. HILLMAN: Says that this conclusion is WRONG. This is CLEARLY self-dealing, because kids are the board of directors of the corporation. 2. HILLMAN: Says that court BLEW this easy holding so that it could redefined the duties of people who operate in a close corporation than those who operate in a public corp. 3. HILLMAN: Says that the court analogizes a close corporation to a partnership type of relationship. 4. RULE of CASE: CONTROLLING SHAREHOLDER: Owes a duty to act with the utmost good faith and loyalty to the other stockholders. a) HILLMAN: Says that this is a bad decision. WHY on earth should we bring the fiduciary duty to this level for a close corp. b) AND, wouldn't the correct solution be to ADJUST DOWN the share price for the majority shareholders, rather than ALLOW D to INSIST that her share price should be ELEVATED to the $800/share price. D. HILLMAN: What does EQUAL OPPORTUNITY mean after this case? II. III. IV. V. VI. Wilkes v. Springside Nursing Home, Inc. (p. 454) A. Here shareholders get mad because 10 years into corporation's existence the corp sells property to a shareholder. Wilkes says that he knows that the corps. property is worth more, and wants shareholder to pay FMV. Then, all of a sudden nobody on the board will talk to Wilkes, and he is "shut out" of the corporation by the other shareholders. B. In this case the court RETHINKS it equal opportunity doctrine, and reverts to an OVERALL FAIRNESS STANDARD C. Here the court reviews the corporations actions in firing Wilkes to only determine whether there was a legitimate purpose to the corporations' action. D. See quote at p. 458. 1. Here the court "flip-flops" to say that the majority has certain "selfish rights of ownership." Morola case: Supplement A. Minority shareholder gets fired, and court says that there is no right to releif, even if there was no legitimate reason for the firing. SO what is left of Donahue after Wilkes and Morola A. Donahue is good for lawyerly arguments aobut good faith. B. HILLMAN: There is really not much left of the EQUAL OPPORTUNITY doctrine. IT is NOT surviving the test of time. C. BUT, the methodology DOES SURVIVE. In other words, we continue to recognize that we may need to have special rules for close corps as compared to public corporations because of the way the relationships are structured. CONTROL and CLOSE CORPORATIONS A. CORE PRINCIPLE in Bus Ass law: THE MAJORITY RULES 1. Majority means: Majority in Shares. B. What things serve as a check on this power? 1. Courts' willingness to assign rights (such as Donohue's EQUAL RIGHTS doctrine) 2. Statutory rights for minority shareholders a) Typically these are not "rights" granted, but rather "powers" granted to enter into agreements which alter the basic corporate structure to protect their interests. b) IT is now common to see such agreements put in place at the time of formation. (1) Often included in the corporate documents (a) Cumulative voting (b) Requiring certain actions to be taken by unanimous vote (giving minority veto power) (c) Different classes of stock. (2) Also can be done by simple CONTRACTS between shareholders. TWO TYPES of shareholder agreements that affect control over close corps A. Agreements that affect the PROCESS of exercising corporate control 1. e.g., voting VII. Agreements that go directly to management issues 1. e.g., agreements to mutual employment by the corporations (referred to as SHAREHOLDER MANAGER agreements). VOTING AGREEMENTS A. There are three types: 1. Pooling agreements: shareholders agree to pool their votes with other shareholders to reach certain results. 2. Proxy agreements: where one shareholder authorizes another to vote their shares. 3. Voting trusts: shares put into a trust, and the trustee votes the shares/ B. Judicial reaction 1. Originally courts held such agreements void. Because courts felt shareholders should be allowed to exercise "unfettered discretion" in exercisisng their votes. 2. Now, court realize that such agreement help to protect minority shareholders. 3. B. 9/24/99 I. Ringling case (p. 406) A. Here there are three shareholders none of which have a controlling interest in close corp. B. The corp has a cumulative voting structure for BoD C. There is a SHAREHOLDER VOTING AGREEMENT between Ringling & Haley 1. "POOLING AGREEMENT" 2. Ringling & Haley agree that they will vote together, or go to arbitration. 3. Haley fails to comply with directive of arbitrator, and Ringling sues. Haley defends that agreement is void b/c it inappropriately limits shareholders ability to vote their conscience a) Ringling has three theries (1) PROXY by AGREEMENT: Court rejects this theory. Court says that if there is to be proxy, it must be stated in the agreement. (2) VOID the MEETING: Court rejects this because it would adveresely affect (3) VOID the NONCOMPLYING SHAREHOLDER's VOTES: The court follows this directive. D. HILLMAN: Who really lost here? 1. RINGLING: By bringing this case, Ringling has completely undermined her relationship with Haley. The whole idea of the Shareholder Voting Agreement was to pool control. 2. BUT, now, even if the shareholder agreement remains in place, HaleyNorth will be the new coalition, and they will now control. When are POOLING AGREEMENTS a good idea? A. When two minority shareholders would not be able to elect any directors, but combined they could. 1. Suppose a shareholder agreement provides for side payment is this okay? NO. see p. 414(b). 2. BUT, what if there is an agreement retain a job? OR transfer property from the corp? VOTING TRUST A. The STRONGEST of the "species" of voting agreements B. In this case, the shareholders TRANSFER their shares to a TRUSTEE who then owns the shares, but who is to vote the shares in accordance with the terms of the trust. 1. PROBLEM: If this happens, the TRUSTEE shows up as the shareholder. This can create problems for other shareholders finding out who the real shareholders are. 2. STATE STATUTES: Typically require DISCLOSURE of such trusts by recordation on the books, AND provide for limited life (TRUST automatically dissolved and shares revert after a statutory period). CLASSIFIED STOCK II. III. IV. A. V. VI. EXAMPLE: Davis Hardware has 1000 shares of stock outstanding. 600 shares class A, and class A elects 3 directors. And 400 shares of class B, which elects two directors. This is a way of guaranteeing B a couple of seats on the board. B. Combined with supermajority voting on certain issues, can give B some veto control over such actions. To what extent, by contract, can shareholders trump the BoD's power to name the corporation's officers? A. Initially courts reacted hostilely to this type of agreement. B. But today there is a trend to allowing such agreements. McQuade (p. 425) A. Majority sells 140 shares of stock in NY Giants. 70 to McGraw, and 70 to Stoneham. 1. Sale is subject to agreement that they will each "use their best endeavors" to keep all three on Board of Directors 2. And, that all three will be retained as officers at specified salaries. B. A few years later, McQuade is thrown off the BoD and is removed as an officer. 1. McQuade is thrown out for "doing his job" by watching over the corporate treasury. McQuade brings suit saying that Stoneham has repudiated the K. District Court rules that this agreement is void because it abrogates the corporate model. 2. HILLMAN: Assuming that this case is good law, how could McQuade have secured his employment without running into this problem. 3. One way would be to enter a separate employment K with the corporation. 4. Another agreement on the sale of the stock, could be a clause requiring the selling shareholder to buy back if they decide to not appoint the buyer as treasurer. 5. 9/30/99 I. II. Shareholder agreements Clark v. Dodge (p. 429) A. Here Clark is a minority shareholder in close corp. 25/75. 1. Here, the NY court finds two years later that the shareholder agreement is enforceable. 2. The court here DISTINGUISHES the MCQuade case by pointing out that in this case, the directors are the lone shareholders. 3. Another difference is that here there is not an attempt to "sterilize" the Board of Directors. a) But how true is this? The shareholder agreement says who will run the company, and what they will get paid. b) HILLMAN: Suggests that the only "principled way" to distinguish between the two cases is the directors sole ownership. Galler v. Galler (p. 433) A. Two brothers own "almost all" of the stock in a company. 1. Brothers own 95% of the stock. Rosenberg owns 5%. Rosenberg obtained his stock by purchasing 12 shares (six from each brother) in exchange for a promise to pay $21K in 10 years. a) Eventually, Rosenberg never pays for the stock. b) BUT, the 5% stock is enough to affect the "balance of power" in the corporation. B. Gallers go to an accountant to set up a board of directors, and create formal structures. 1. Agreed that shareholders would vote for each other and their spouses. 2. Agreed that board would require quorum. 3. IF either owner dies, agreement provides that spouse will select replacement director 4. Defined a level of dividends to be paid annually if the funds exceed a certain amount. (getting "wild and crazy" here) 5. Provides that estate taxes will buy the stock back. C. ILLINOIS COURT finds the agreement is enforceable. 1. WHO is arguing that the agreement should not be enforceable? a) ROSENBERG? No. Rosenberg is gone. Isadore and Rose buy him out to gain control over the corporation. b) Here, Isadore and Rose buy the control in order to gain control over the corporation. BUT, they wind up losing the case BECAUSE he (foolishly) eliminated the outside shareholder, and thus brought this case more in line with the Clark case than the McQuade case (thus, Isador might have won with the outside shareholder, BUT, in this case, since only directors hold, they will allow the agreement to stand). D. CT HOLDS 1. No COMPLAINING SHAREHOLDERS 2. No FRAUD of the PUBLIC OR CREDITORS III. IV. 3. No "CLEAR" STATUTORY PROHIBITION E. IS there REALLY NO "FRAUD" to CREDITORS 1. Here the creditors do have an interest because if the agreement is enforceable, then paying estate tax by buying back shares IS a reduction in the corporations EQUITY, thus leaving creditors at higher risk. (remember Donahue case -- making pie smaller) 2. The court misses this point entirely and rather simply focuses on the dividend payment provision (which requires a minimum balance) and finds that creditors are protected. STATUTES A. Del § 354 - Statutory Closed Corp. 1. (This just means that the corp has just specified that it is an 'statutory closed corp.') 2. Del. says that a shareholder agreement that provides for a partnership type management is ENFORCEABLE. 3. HILLMAN: IF they forgot to put in the "election" for statutory closed corp. status, is is unclear whether a corp would be able to enforce agreement. B. Cal. 1. Gives shareholders "considerable leeway" in defining management of the corporation BUT, requires agreement of ALL of the shareholders. a) ISSUE IN GALLER is a question of TIMING... (1) IF we measure the "validity" at the time of the agreement, then not enforceable. (2) BUT, if it is measured at time of enforcement, then it is. b) The problem of course is that if a Court follows galler, what we have is an agreement, void at its inception, becoming valid by time enforcement is sought. c) I. II. III. 10/1/99 SHAREHOLDER AGREEMENTS A. California supports 1. Shareholder agreements between ALL of the shareholders SUPERMAJORITY VOTING & QUORUM REQUIREMENTS A. These can exist at the shareholder level or director level. 1. Any voting requiring more than a simple majority 2. In the past, these were considered problematic, but courts have come to realize that these types of arrangements are important ways of protecting themselves. a) e.g., the Galler agreement required 3 out of 4 members present in order to conduct business. Item 3 on the outline RESTRICTIONS on TRANSFERABILITY of SHARES A. We start with the LEGAL proposition that shares are freely transferrable. B. But, in close corps, there are problems with finding buyers. C. There may be situations where shareholders wish to RESTRICT the transferrability of the shares 1. For instance to ensure that shareholders will get along. 2. OR to keep key shareholder/employee in the business D. FORMS of SHARE TRANSFER RESTRICTIONS 1. RIGHT of FIRST REFUSAL a) Gives an identified party in the corp. to match any offer by a third party. b) Not a direct impediment to transfer. Here we are only substituting buyers. c) CHILLING EFFECT: it is possible that having such an agreement in place, then a buyer may not want to deal, knowing that the entire arrangement could evaporate at any moment. d) FAKE OFFERS: Also, on the other side, a seller might arrange an inflated "fake sale" in order to make the other shareholder buy out at a higher price. e) COURT in FLORIDA (1) In Florida, a court said that a "right of first refusal to a third party" does not run to offers by other shareholders. 2. FIRST OPTION a) Here, before obtaining other offers, the shareholder wishing to sell must FIRST offer them to the other shareholder at a predetermined price. (1) May be set by contract as a set number, or by some formula. b) Here, price is DISCONNECTED from what a third party might be willing to pay. 3. CONSENT TYPE RESTRICTION a) Sale cannot be consumated without consent of somebody (other shareholder, the corp itself, etc.) IV. V. PROHIBITION of SALE a) Usually not an "absolute" prohibition, but rather limited to a class. Such as existing employees. 5. BUY SELL AGREEMENT a) Similar to the Galler case b) A MUTUAL OBLIGATION where parties agrees to sell/buy shares on the contigency of a certain event (1) e.g., in the GALLER case, the death of one of the members triggered an obligation for the corporation to buy the shares to pay the estate taxes. c) Often these types of agreements are covered by corporate insurance policies which cover the contingency. (1) i.e., corporate life insurance policies that cover the shareholders lives so that when one dies, the INSURANCE, not the ASSETS of the CORP wind up covering the buy/sell agreement. VALUATION ISSUES in TRANSFER AGREEMENTS A. WHAT GOES INTO VALUATION of BUSINESSES? 1. Read pages 485-92 2. "Seven best pages in this case book." 3. Read it. 4. PUBLICLY HELD COMPANY: easy to value because we just look at the trading price of the stock at the time. 5. CLOSE CORPORATIONS: are more difficult, because we don't have a trading price. a) HILLMAN: this is an exercise in subjectivity. Thus it is a good idea to get multiple opinions. ALLEN v. BILTMORE (p. 492) A. here we have a FIRST OPTION agreement (HILLMAN agrees that this agreements OPERATES a lot like a BUY/SELL AGREEMENT). 1. IN this case, if the shareholder wants to sell, the corporation has a FIRST OPTION to buy the shares at the price that the SHAREHOLDER PAID. This restriction appears in the BYLAWS of the corp and on the certificate itself. a) But warning on certificate only pointed to the bylaws. b) HILLMAN: Thinks that this was never supposed to be a "profitable" business. In this case, the corporation was a "cooperative" arrangement between shareholders that are operating to access the corporations products. 2. FACTS: Here, shareholder buys shares for $125 during depression. Then he offers to sell, and then dies. 3. SHAREHOLDER argues that such restraints are unlawful saying that agreement is "unreasonable" 4. COURT says that "reasonableness" does not key on fairness of priece. 4. 5. 6. 7. 8. 9. 10. TO show UNREASONABLENESS more than a "mere disparity" between market price and the sale price must be shown. PA case: HILLMAN LAUGHS where PA court says that buyback price is ZERO is not "unreasonable." HILLMAN: Says that it is VERY UNLIKELY that an argument about UNREASONABLENESS will win. HE SUGGESTS it is better to argue NOTICE. a) Was the wording on the certificate enough to put the buyer on notice. DELAWARE requires CONSPICUOUS NOTICE in order for the agreement to be satisfied. a) HILLMAN: Would want the buyer to sign a SEPARATE WRITING acknowledging that there is no possibility on return from this investment. DELAWARE approves without regard to "REASONABLNESS" a) Right of first refusal b) First option c) Consent d) OTHER TYPES require reasonableness analysis CALIFORNIA a) Restraint must go into ARTICLES (not bylaws) and MUST be "reasonable." b) 10/5/99 I. DISSOLUTION A. WE can look at this as the "death" of the venture. B. OR, we can look at it as a "way out" 1. For example, the remaining interest holders can BUY OUT the owner that wishes to leave. C. OR, we can look at it as a means of EXPLOITING the weak parties 1. PAGE case, p.83 (supp) a) For example, if a majority shareholder wishes to capture all of the corps. profits, they can "dissolve" the corporation, and then be the only bidder to take over the entire business. FORM DOES MATTER A. The rules for dissolving a corporation are DIFFERENT than the rules for dissolving partnerships or LLC's B. CORPORATE DISSOLUTION 1. Dissolution of the corporation IS THE END of the corporation. 2. In most Jx, dissolution can be dissolved by a majority vote of the shareholders. 3. INVOLUNTARY DISSOLUTION: dissolution against the will of the majority. a) Grounds must be present: (1) Majority shareholder is guilt of some misconduct: generally FRAUD or OPPRESSION of the MINORITY shareholders. (a) What is "OPPRESSION"? (b) Brenner case (supp.) "The Dr. Spock View" Opression exists if the expectations of the minority shareholders have been disappointed REGARDLESS of whether there is a REASON for the disappointment. In other words NO MISCONDUCT of the majority is necessary. (c) Brenner case, wants to find some sort of misconduct before forcing involuntary dissolution. C. HILLMAN: Says - here we should raise a question about FIDUCIARY DUTY... can a majority shareholder really dissolve whenever they want. Dissolution of Partnership. A. Meaning of dissolution is different in partnership context than in corporate context. 1. Partnership is NOT a separate legal person. 2. So, what are we dissolving? The RELATIONSHIP THAT EXISTS between the members of the partnership. B. SO, what this means is that every time somebody leaves the partnership, a dissolution occurs. 1. NO SHOWING of any sort of conduct by any other person. One can withdraw at any time. II. III. IV. V. VI. BUT, we still go back to similar questions: WHO'S BUYING? 1. The remaining partners, and often they will only pay pennies on the dollar. FIDUCIARY DUTIES A. TWO CATEGORIES (really three) of FIDUCIARY DUTIES 1. Duty of Care in Management 2. Duty of Loyalty 3. Obligation of Majority to Minority DUTY of CARE A. Focuses on the Directors and Officers 1. Most cases deal with Directors, but also apply to officers. B. OWE A DUTY OF CARE in the OFFICIAL ACTIVITIES 1. But, what exactly this duty is, and to whom it is owed is unclear. 2. At the least, it means that the duty is owed to the CORPORATION as an entity. 3. PRESUMEABLY this duty also extends to shareholders. 4. WHAT is unclear, is whether this duty is owed to 3rd parties a) i.e., creditors. Bates v. Dresser (p.587) A. Bookeeper of bank embezzles $300K from a bank. 1. Here, the bookeeper would play with the balance sheet, by taking 10% off the top of deposits. At this time, the auditors only checked actual assets against the asset side of the balance sheet. B. WHO brought this suit? 1. The RECEIVER of the bankrupt bank. BUT, who is this? After all, every dollar that is collected goes to the creditors. So, we seem to be saying that there is a FIDUCIARY DUTY to the creditors of the bank. C. ALL of the DIRECTORS are sued for breach of FIDUCIARY DUTY 1. What duty was breached here? a) Having a system in place to prevent embezzlement of $300K. 2. BUT HOLMES doesn't buy this. D. RULE: "Every dog gets one free bite." E. EARLY VIEW of DUTY CARE 1. How "Reasonable People" would handle their own affairs. F. LATER VIEW 1. How people in similar situations would handle their affairs. G. HERE, Holmes finds that the directors aren't liable, BUT DRESSER, the president is. 1. This is because the president DID have notice of shortages, and thus had some idea that there were "funky things" going on. H. THUS: we learn that HOLMES did find somebody liable - The CEO for failure to check out problems that he should have been aware of. 1. C. 10/6/99 I. II. DUTY of CARE Continued.... Distinguishing between A. Sloppy Management, and B. Bad Business Judgment Kamin v. American Express (p. 592) A. Here American Express buys stock at $30 million. Then it drops in value to $4 million. American Express wants to bail on the investment, but doesn't want to take the $26 million hit. 1. IF American Express had sold and taken the loss, they would have saved $8 million dollars in taxes. B. INSTEAD, American Express decides to distribute the stock to the shareholders. By doing this American Express avoids the $25 million loss, BUT also loses the tax benefit. C. SHAREHOLDER brings a derivative actions. 1. What is a DERIVATIVE ACTION? Where a shareholder sues on BEHALF of the corporation, because the people in control of the corporation are the "wrongdoers." D. In this case, the SHAREHOLDER is alleging that there was no good business reason for taking this hit. 1. BUT, American Express had taken the hit because it was afraid that the hit would affect the stock prices. However, this fear is probably unrealistic because the market probably already KNOWS that American Express is holding severely devalued stock. E. SHAREHOLDERS ACTION is for BREACH of DUTY OF CARE F. Court REFUSES to review the Boards Action. G. FIRST: The court states that this is not a case of "self-dealing." 1. Note that also in DONAHUE, the court first started with the statement that there was no "self-dealing." 2. RULE: COURTS RAISE the bar to a HIGHER STANDARD if they find self dealing. a) HILLMAN: But, wasn't there self dealing? In the case thy mention an EXECUTIVE COMPENSATION PLAN that keys on NET INCOME of the corporation (a figure that would be directly affected by taking the $26 million hit). b) HILLMAN says that we do not get to self dealing under the court's opinion because only 4 out of 16 directors were under the plan. BUT, HILLMAN says a good lawyer would argue this because the 4 inside directors on the plan arguably controlled the boards decisions. H. BUSINESS JUDGMENT RULE: IF there IS NOT Self-Dealing, courts will not entertain litigation on particular business decision, and will defer to the business judgment of the directors and officers. 1. BUT, if there is a smell of self-dealing, then the court will examine the individual decision. III. IV. THIS RULE creates a tremendous barrier to shareholder actions against individual decisions. I. SHOULD COURTS hear these kinds of cases. 1. Arguably no: a) Shareholders can "throw the bums out" (theoretically) b) Corporation may be taken over c) Shareholders can sell. Francis (p. 557) A. SLOPPY MANAGEMENT CASE 1. Insurance brokerage operation focusing on "re-insurance industry." These folks put together deals between ceding firms and re-insurance firms a) Under REINSURANCE policies, the ceding companies write original policies, but spread the risk by trying to get other firms to underwrite some of the risk. 2. Here, two of the officers are SHAREHOLDERS and OFFICERS a) How can the OFFICERS get $$ out? (1) SALARY (2) LOANS (3) DIVEDENDS (4) other transactions (i.e., sale of property to corp at inflated rates). B. In this case the two officers decide to give themselves loans of $10 million. 1. Why loans, why did they do it this way? a) Why not dividends? Because if they did this, other shareholders would get dough too. b) Why not salary? Because salary is TAXABLE, and because Salary distributions affect the ASSET SIDE of the corporation. c) BUT, by doing the transaction through loans, the corporation's total assets remain stable. C. HILLMAN: says that this is a PLUNDERING of the corporation by taking loans that the officers do not intend to pay. D. BUT, on the other side, is there anything wrong with loaning money in general? 1. NOTE: this is the reverse of equitable subordination., 2. RULE: No problem if a) Loan make commercial sence b) Reasonable interest rate c) Reasonable expectation of repayment d) No favoring of directors E. NOW, the creditor-directors DISSAPEAR. 1. Mom dies, and the F. DUTY OF CARE: What what a reasonable director of THIS TYPE of corporation have done? 1. Mom has excuses, because she was sick and a drunk, but court does not buy it. This is a Coleman-like maneuver... 2. 2. Mom's next defense: I couldn't have stopped it anyway, because I am only one director. a) Defense rejected because there were things that mom should have done... b) TBC..... c) I. II. III. IV. 10/7/99 I missed the first half of class. Get notes from somebody. Basic standard for Duty of Care is a Negligence Standard. When will people be willing to serve as directors? A. When the risk of liability is not too high. B. Today, Directors' insurance is available to ameliorate liability. C. ALSO, states have changed laws to reduce liability 1. OHIO: Requiring a gross negligence standard (reckless disregard). 2. In DELAWARE: a corporation put a statement of "no duty of care" in the articles of incorporation. This does not extend to "intentional" acts. 3. CALIFORNIA allows the same thing. But limits it to "reckless disregard." QUESTION: Does alteration of duty of care by shareholders affect those cases where it seems we are also implying a duty of care to creditors? A. HILLMAN: Good question. Never been litigated. A good lawyer might argue that there is a separate duty of care that runs outside of the shareholder agreement. B. 10/8/99 I. DUTY of CARE A. Hard to enforce - not much action in courts on this. 1. Courts want to give BoD a break 2. Statute allows abrogation of the duty DUTY of LOYALTY A. Extends to many types of cases 1. Conflict of Interest 2. Self-Dealing 3. Majority Grab for benefits denied to minority DUTY of LOYALTY - CONFLICT of INTEREST A. Two types of situations 1. The INTERESTED DIRECTOR a) A director who has a material financial interest on the other side of the Tx (1) Example, corp. buys property from director. Or corp. buys material from another corp. which the Director has an interest in. 2. INTERLOCKING TRANSACTION a) Here, the Director is a member of BoD of two corps that are interacting. Even may occur where director has no financial interest. B. BREACH of CONFLICT of INTEREST 1. Originally, such transactions were viewed as void, and simply were not allowed. 2. Later, GLOBE WORLD CASE (handout) A. Facts: Maynard is major stockholder of a company that owns two mills. HE is also the chairman of the board of the local power company. HE has no financial interest in the power company, but a significant interest in the mills. The mills use steam power. An executive at the power company, Geenidge, tries to convince the mill to switch to electricity. Maynard pays Greenidge to produce a report on converting the mill to electricity. Then Maynard and Greenidge negotiate a contract for one of the mills to switch over to electricity. The K provides a guarantee that the cost of the electricity will be $300 per month less than similar month before. The K must be approved by the electric company's board. Maynard abstains from the conversation, and board then relies on Greenidge's advice regarding the K. Greenidge's input consists of simply reading the K from top to bottom. B. HILLMAN: Is this disclosure? Or should there be a duty to point out material terms. C. NOW, we come to the second K with the second mill. This time the guarantee term is made explicit in the K. Greenidge tells the board that the K is essentially the same. They spare the reading and approve K. II. III. IV. V. IS THIS AN INTERLOCKING DIRECTOR or INTERESTED DIRECTOR type case? 1. This is INTERESTED DIRECTOR case a) Typically in the past, this K would be void. 2. CARDOZO develops test: a) These contracts will be enforceable if approved by disinterested directors AND they are fair. b) However, there are statements in the opinion which might indicate that this is an OR. c) Nevertheless, most scholars AGREE that "AND" is the rule. E. What is a DISINTERESTED DIRECTOR? 1. Directors with no "financial stake"? 2. CARDOZO says that board was influened by Maynard, and thus they were not "disinterested" because they relied on Maynard. 3. In this case, it appears that the BoD simply failed to critically examine the K, relying instead on Maynard's opinion. F. FAIRNESS: 1. TIMING ISSUE: When do we determine "fairness" exists? At the time of formation? Or at some time after? G. HILLMAN: Now, suppose we flip it around, and now the MILLS want out of the K's. 1. IN this case, we have no FINANCIAL INTEREST by MAYNARD on the other side of the transaction. Here there is an INTERLOCKING DIRECTOR problem. a) Here, we see that in INTERLOCKING DIRECTOR situations, we probably should only be looking at whether the K is fair H. WHAT DOES THIS MEAN? 1. That we should draw distinctions between the two, and have a higher standard for INTERESTED DIRECTOR situations that for the INTERLOCKING DIRECTORS. a) California does make a distinction. STATE STATUTES A. Do place significant weight on the "disinterested director" but define it more carefully 1. Only exists where there is a financial interest on the other side, and where 2. D. 10/12/99 I. C's are valid if A. Approved by uninterested directors, and if they are fair B. And they are fair. How do we define "disinterested" A. Modern view: if director does not have a FINANCIAL INTEREST then they are disinterested. B. NOTE: that this is different than in the Globe Wollen case (handout) where Cardozo found interest. 1. BUT, also remember that Cardozo was using a CONJUNTIVE TEST Delaware statute: A. Lumps interested directors and interlocking directors into one statute 1. K's are good if they are fair, and if they are 2. approved by directors a) NOTE that there is NO REQUIREMENT of DISINTEREST, GOOD FAITH or DISCLOSURE 3. OR, if approved by disinterested directors after disclosure in good faith, REGARDLESS of fairness standard. B. SO, if this was the standard, the POWER COMPANY would not be able to rescind the K in Globe Wollen. C. AND, the lumber company might have difficulty in getting the K voided unless disclosure. CAL A. Cal § 310(a) - K's involving interested directors 1. Such K's are valid only if approved by SHAREHOLDERS after disclosure in good faith. 2. If the K is not approved by SHAREHOLDERS, then the K must be FAIR. a) IF the Directors have approved the K, it is presumed that the K is FAIR, and burden is on plaintiff to show unfairness. b) BUT, if Directors do not approve K, then burden is on interested director to show that K is fair. B. Cal 310(b) - K's involving interlocking directors 1. Allows K to be enforced to a) Approval by disinterested directors b) Approval by sharholders, OR c) Is it fair. C. In Globe Wollen, as the facts lie, we have a 310(a) case (interested director). In this case, because there was board approval, the presumpton is that the K was fair, and it will be up to challenger to show unfairness. D. IF the facts had been turned the other way (mills wanted out) then we would have a interlocking director situation. AS a result, we have both approval by directors and fairness to mills, and so K is probably okay. CORPORATE OPPORTUNITIES A. Question here is what happens with opportunities which are available to the corporation. II. III. IV. V. B. C. D. A corporation should have the ability to prusue opportunities free from competition from its directors and officers. TWO GRAY AREAS 1. What is a "corporate opportunity"? 2. What if corp is financially unable to pursue the opportunity. INSOLVENCY and CORP OPPORTUNITITES 1. IF corp is insolvent, the courts are generally lenient with directors who step in. 2. BUT, courts are careful, because they want to make sure corp really IS insolvent. Courts ask whether the corp could afford to do the business (on the theory that doing the Tx might improve financial status). WHAT is a CORPORATE OPPORTUNITY? 1. ALI PRINCIPLES (supp. N.E. HARBOR GOLF CLUB CASE): a) President of Golf Club which is managed by a board. Board has policy to oppose local development in neighboring lands. Over the years president buys neighboring lands. A couple of years later, a real estate agency calls President AS THE PRESIDENT of the club. President buys land as a private purchaser. Five years later, the postmaster tell president that other land is available. This time president has "informal discussions" with the board. On purchase, she informs the board she will not develop. Finally, she buys a lot needed to provide access to her properties and begins plans to develop. b) HILLMAN: Could the corporation have bought the property? (1) The case suggests that the corporation could have done fundraising to buy the property. (2) And the corporation had $90K in cash on hand (which is more than was paid for at least one of the president's purchase). c) T Court finds that corp. did not have the financial capacity to pursue the first two deals (HILLMAN says this doesn't make sense). d) QUERY: Were these CORPORATE OPPORTUNITIES? (1) What does this n.p. corp do? It runs a golf course. So what is the "opportunity" here? Perhaps the opportunity to create a buffer. 2. ALI RULES: a) There are two sets of rules (1) One DEFINES a corporate opportunity. (2) Second set STATES PROCEDURES for director if opportunity is present. 3. CORPORATE OPPORTUNITY is a) An opportunity communicated to a director or officer is a coporate opportunity IF -- 1. VI. VII. Communication is made with director or officer AS a director or officer of the corp, by a person who expects offer is made to corp. (2) Director or officer uses internal information (3) Where director or officer is a full time employee, if the opportunity is closely related to the business of the corporation. 4. IF a director or officer decides to pursue opportunity a) FIRST must offer opportunity to corp, and b) MUST be rejected by the corp. (1) Rejection must be FAIR to the corporation, OR (2) Must be by disinterested directors. 5. If a person is just a controlling shareholder... a) may not take corporate opportunity unless action is fair or if there is disinterested director approval (thus no REQUIREMENT that the offer be tendered to the corporation first). 6. HILLMAN: Likes the ALI test and feels that courts will be adopting en masse in the future. OBLIGATION of the MAJORITY to the MINORITY A. Three major cases in this section, p. 737, p. 766, p. 787. Zahn v. Transamerica A. Facts: Warehouse of leaf tabacco, market value of $20 million (book value of $6 million). Company has two classes of stock, class A stock and class B stock. 1. Class A stock was "preferred stock" having a $3.20 dividend per share per year. The dividend is cumulative, which means that class A stock had to pay all previous years dividends. Non voting stock. BUT if dividends not payed for a set period, then voting rights accrue (this time had lapsed in the case, and so Class A had voting rights). 2. Class B stock had no dividend rights until AFTER class A gets its share. Once the class A divident was paid, then B had a right to the next $1.60 per share. Voting stock, that elected board of directors. 3. Then, after that, both classes share equally. 4. The Class A stock was CALLABLE (or REDEEMABLE). This means that the corporation can buy back the stock at ANY TIME subject to the following price structire: $60 per share, PLUS any outstanding amount of unpaid dividends. 5. CLASS A stock had a liquidation preference, which stated that if the corp LIQUIDATES, then class A shareholders would receive 2 x B shareholders (i.e., 66% to class A holders, and 33% to class B). 6. CLASS A stock is CONVERTIBLE into class B stock at a ratio of 1 to 1. a) What is the point here? Well if the corporation significantly increases in value, then class A shareholders can take advantage of the corporation's success. B. SO, what happened in this case? (1) 1. 2. 3. Transamerica comes in seeing the possibility of liquidating the corp, and taking huge profits from sale of the undervalued tobacco... To be continued... I. II. 10/13/99 Zahn v. Transamerica (p. 737) cont'd A. Why would somebody want the Class A stock? 1. In this case, the Class A can be converted to Class B stock. a) At the time of stock issuance, Class A stock is going to be twice as costly as Class B stock. b) BUT, as time goes on Class B will increase in value on the market, and at some point will exceed Class A's value. c) Thus, CLASS A is desireable as a long term investment because at some point class A holders will be able to "cash in" on their investment by converting to class B. B. FACTS of the CASE: 1. Principle asset at issue is leaf tobacco: book value $6 million, and $20 million FMV. Transamerica develops a plan to take control of the corporation by acquiring all of the stock on the market, and then liquidating the assets to take the profits. 2. Transamerica buys 80% of the class B stock, and 75% of the class A stock, which they convert into class B stock. This helped them to increase their proportionate control over the voting of the corporation. 3. Nobody knows about this plan. Then Transamerica elects its directors to the board. The Board then CALLS class A. This eliminates the need to pay anybody a 2x liquidation price. If the corporation had simply liquidated, it would have had to pay outstanding A shares $240 per share. Instead, it only pays $60 per share plus outstanding dividends. (perhaps a total of $80 per share). 4. SLIME CHECK: Zahn bought his Class A shares AFTER he realized that the Class A shares were being called. This indicates that Zahn bought in with an eye toward litigating. But this is high risk. Why take the chance? Well, if he can avoid the call, and make the liquidation preference (2x B stock) work for him he could make lots of money. 5. HILLMAN: Zahn is the lawyer or closely related to the lawyer in this class action. Although Zahn's individual claim may have relatively little value, the value of all class A shareholders claims is high. Thus, here we (probably) have a situation where Zahn has engineered this lawsuit in order to reap the attorney's fees. This is considered UNETHICAL, but it HAPPENS FREQUENTLY. QUESTIONS on ZAHN: A. Why was Transamerica sued? Who really did the wrong here? 1. Actually it was the directors of Axton-Fisher who called the stock, who, in turn called the class A stock for the improper benefit of the B shareholders. 2. BUT, we have to name the majority shareholder (Transamerica) because that is the deep pocket. Thus, the argument must be made that the board is just a "puppet" for the majority shareholder. B. See CASE: Shareholders acting as shareholders may act solely in their own interest. BUT, if a shareholder acts as a director, then it must act for all shareholders. (in case somewhere). QUESTION for tomorrow: WHAT WAS THE CORE WRONG? 1. Was it making the call on class A stock? OR, 2. Was it the failure to give a reasonable opportunity to convert to class B stock? 3. 10/14/99 I. ZAHN continued... A. What was the real "wrong" here? Was it converting & liquidating? OR, was it the failure to TELL the Class A shareholders that they were going to engage in the liquidation. 1. IT appears to be the failure to have notified when reading the case (even though the case talks about at p. 742 that interested directors cannot act to the detriment of the minority shareholders). B. What we learn here is that the duty is only to avoid GROSS OVERREACHING 1. Notice that the damages awarded are consistent, because the Court ultimately does not give the full LIQUIDATION PREFERENCE value ($240). Instead, the court awards the difference between the call price (about $80) and the value that would have been obtained by CONVERTING the stock. HILLMAN: A. There is almost no black letter law in this area. As a result, the duty of loyalty is very murky. And the best we can do is to apply the principles as we learn them from the cases. 1. There is a LOT of rhetoric in this area. "punctillio" "undivided loyalty" etc. 2. BUT, once we get to the cases, we moderate these duties with reality. What the courts really do is drawing a line at the EXCESSES that occur. Sinclair Case (p. 748) A. Parent corp. owns 97% of subsidiary company. The subsidiary pays almost all of its earnings out in dividends. 3% minority shareholders bring a suit to challenge this practice (they want money left in Sinven for growth). B. Here the court is looking for a standard of review C. STRICT REVIEW v. BUSINESS JUDGMENT 1. Where there is no evidence of self-dealing, the court will defer to business judgment. 2. BUT, where you do have self dealing (benefits going to majority shareholder that the minority shareholders do not get), then the court will use STRICT REVIEW. D. QUESTION: in this case WHO owes the duty of loyalty? It is SINVEN as the board of directors. The shareholders of SINVEN are not owed a duty by Sinclair, they are owed a duty by Sinven Jones v. Ahmanson (p. 766) A. Often cited for the proposition that a majority shareholder owes a duty to minority shareholders. B. WHAT is this CASE ABOUT? 1. Here, the majority shareholders take away the value of minority shareholder's share by making it impossible for them to sell to anybody but the majority shareholders. 2. FACTS: The core corporation is a S&L. It is owned by Jones (13%) and defendants (87%). Traynor calls this a "closely held" corp. This is not II. III. IV. 3. 4. TRUE, because there are many shareholders. BUT, it is true in a way, because there wasn't much market interest in the stock. There wasn't much market because the stock was valued at about $1,400 per share (difficult to deal with) (this management could have been fixed by SPLITTING the stock). Management also had a dividend policy that paid a minimum compared to other S&L's. Thus, most investors in S&L's would invest in other stock. And, management also did nothing to talk with financial people to create a market. Defendants then set up a holding company (a CORPORATION that just HOLDS STOCK in another corporation), called UNITED. They put all of their stock into United in exchange for 100% of the stock in United. United stock is granted at a 250:1 ratio. Thus, now people who want to invest in the S&L have two was to do so: The dumb way (buy stock from minority shareholders) or the SMART WAY and buy reasonably priced stock in the majority sharholder company, United. To be continued... I. II. III. IV. 10/19/99 What was Wrong in the Ahmanson case? A. Here a coalition of stockholders took actions that not only excluded the minority, but actually reduced the value of their shares. 1. The use of the holding company itself was bad, because it resulted in a convoluted action that benefited the control group at the expense of the 13% shareholders. 2. Another "slime factor" is that the control group retained control after the formation and use of the holding company to keep themselves in power. BEYOND JONES v. AHMANSON - FACTORS to LOOK AT (not a complete framework, but some "things to look at"): A. The uniqueness of the transaction. 1. This would tend to distinguish the first two hypotheticals from the third. 2. When you do something convoluted or unique there will be more explanation or justification required. B. What is the effect of the action on the minority shareholders? 1. IS it only neutral, or does it result in a negative effect. C. What is the nature of the benefit that the control group recognizes from the action. 1. If the control group gets cash, it is easier to regulate. 2. But, if the control group recieves some "intangible" gain, then it will be harder to challenge. TRANSFER of CONTROL A. Gerdes v. Reynolds (p.780) 1. Here, shares are sold for $2 per share for shares that are "worth" $0.75. 2. HILLMAN: Is this really true? Was the stock really only worth 75 cents? Here, we have an investing company. Their assets are CASH and securities in other companies. So wouldn't valuation of the stock be straightforward? Why would somebody pay $2 per share? 3. REALIZE that here, what is being purchased is just a controlling interest. Thus they might pay more just for the control factor. 4. AND, realize that here, the buyers have only PROMISED to pay $2 per share, they did not actually pay the $2 per share. 5. HILLMAN: Here the BoD breached their fiduciary duties a) Hillman thinks that the separation of the court of the sale of stock and the resignation of the board was an interesting approach. It wasn't what they did as stockholders that created the problems. IT was what they did as the directors. (1) THIS is SIMILAR to ZAHN. Here the court says that the breach was the resignation, they cannot resign without leaving the corporation without proper care and protection. (2) See p. 782 PROBLEM VC-2 A. IS there a fiduciary duty not to leave abruptly? Can Baker bail? 1. Does a uniquely qualified individual owe a fiduciary duty to stay around until a replacement is found? V. VI. Probably not. HILLMAN says that statement at p. 782 is an overstatement (re: not being able to resign). FACTORS that the COURT thought were important in delivery of control: A. NO INVESTIGATION of the PURCHASER 1. But note that there was an investigation of the stock exchange company. BUT, realize that the actual transaction was with a principal of the partnership, not the partnership itself. B. QUICK and OVERPRICED nature of TRANSACTION 1. Buyer pays a price that is much more than if they had just gone out to buy their own portfolio of the same assets. 2. Transaction was handled quickly, no notice to other shareholders 3. BUT, what good would notice do? They can't sue, because, at the time of the sale, there is no wrong. C. HILLMAN: What the majority shareholders should have done is unclear. But, what we can learn is that if the corporation is easily looted (e.g., primarily cash and investment assets) then directors may be held to a higher standard. 1. Maybe we should also look at industry practice. IF we look at how corporations that are easily lootable are sold, maybe we will find extra safeguards (such as making sure that buyer is really paying rather than just a promise to pay). Perlman (p. 787) A. This is a more subtle case. When reading it, try to figure out exactly how the buyers looted the corp. IT IS NOT what the COURT DESCRIBED as the CORPORATE BENEFIT that was lost. B. WHAT COULDN'T the COURT SAY in this case?... C. To be continued... D. a) 10/20/99 I. Perlmen v. Feldman (p. 787): A. Derivative action against Feldman: action brought on behalf of corporation for what Feldman did. Feldman sold all of his stock in steel company to a syndicate of steel users. B. In this case, Feldman's sale resulted in transferring control of the corporation. Here the action of the defendant is viewed as a usurpation of corporate authority. C. HILLMAN: What is this case saying? Is there anything wrong with one corporation buying the controlling interest of a supplier corporation. No. 1. The thing that we are really worried about is if an outside corporation to take a controlling interest, because if they bring in their own directors, the new board may take actions that harm the supplier company to benefit the controlling production company. D. Real problem here is that the steel company is operating in a market where there is no price controls (but there is a voluntary freeze on the prices by the steel producers to avoid the appearance of profiteering). The way this works is that prices are frozen, but the steel producers contracts require the buyers to provide interest free loans for a period of time. 1. HILLMAN: The court points to the fact that the buyer could wind up causing the steel producer to sell at the $200 "Frozen" price without the "feldman plan kicker" on the loans. 2. HILLMAN: The problem here is that there is a "looting" going on, but it is a looting that the court doesn't want to talk about. What is it? 3. WHAT the corporation has lost: The ability to operate in the "gray market." In otherwords, they have lost the ability to take "under the table payments" for their steel. The price freeze was only an agreement (that the industry regularly broke). Buyers were ACTUALLY PAYING $450 per ton, even though the "ethical price" was $200. 4. What Feldman sold was the corporations ability to price the steel at its true value, rather than at the "ethical price" of $200. What created the problem here was the sale of the corporation stripped the corporation of the ability to act unethically. 5. QUESTION: If this deal were allowed, and the majority shareholder took the $200 deal, would they be okay if they allowed the minority shareholders to have the same deal. 6. IF a substantial premium is involved in buying a corporation is it per se violation of corporate opportunity? Or a breach of fiduciary duty? 7. ESSEX case: probably not. But, a good lawyer could use it to get some mileage for a side payment to shut the minority up. 8. I. II. III. 10/21/99 A majority sells, and the minority is upset. Now the minority wants to use the Perlmann strategy, and say that a premium was paid. A. BUT, in a REALITY SETTING, HOW do we find out what was paid in order to bring the charges. There is no duty for the purchaser or the seller to disclose the price. Perhaps, one option is to file a general complaint, and then use discovery to find out what the price paid was. BUT, keep in mind that you might loose control of the lawsuit. How else can you get it? 1. Access to the corporate records won't really help, because this is not a corporate transaction. 2. HILLMAN: One option is to open a friendly discussion with the seller and buyer. Ask to have the buyer purchase shares from majority and minority on pro rata basis. Also, weave in language about Perlmann (premium paid). B. HILLMAN: ZAHN & SON OF ZAHN really show that there is a spoken standard and then the actual standard that is applied. The real insight we can find is that fiduciary duties apply to overreaching. Some amount of self dealing is allowed. FRAUD in SECURITIES TRANSACTIONS A. Most of what we are talking about involves "insider trading" 1. This only involves PUBLIC CORPORATIONS (does not apply to close corps). 2. People who have access to non public information who buy or sell stock on the basis of that information is NOT ALLOWED. B. REGULATED by 1934 Act. 1. § 10(b) of the 1934 ACT: a) NOT LIMITED to INSIDER TRADING b) § 10(b) is a GENRAL anti-fraud statute c) "IT shall be unlawful for any person to use or employ in connection with the sale or purchase of any security any manipulative or deceptive contrivance in contravention of SEC rules." (1) This is "similar" to section 14 which requires disclosure in the solicitation of proxies. 2. Rule 10(b)(5): IT shall be unlawful for any person to do one of 3 things in connection with sale/purchase of security a) To employ any device, scheme or artifice to defraud b) To make or omit a statement of material fact c) To engage in any act practice or course of business that operates as a fraud or deceit on any person. Cady, Robers case p. 821 A. Corporation is in trouble. Board of directors has meeting. One member of the Board is also a member of an investment firms. The director called his buddys at the investment firm, and told them of trouble. His buddies then had all of their cutomers pull out before the corp. announced its decision to suspend dividend payments. IV. BOTTOM LINE: If you have some kind of relationship that gives you access to non public information, you may not trade on the basis of that information. 1. BUT, what about ZAHN? Here a corporation was calling stock knowing that there was going to be litigation. Actually 10(b) claims were brough in ZAHN and they were sustained. POLICY of this RULE A. What is the problem? Why are we worried about insider trading? 1. FIRST: It may make people unwilling to invest in securities because the "playing field is not level." 2. Also, this is a form of "theft" of information B. But, what about countering points? Are there reasons to not regulate? 1. First, it may be unfair to Executives who would invest based on OTHER information, but also have access to inside information. 2. Also, somebody WITH inside information will have a better sense of the true value of the stock. a) IF we allow insiders to trade C. POSSIBLE ALTERNATIVE SOLUTION: Just require faster disclosure of information. D. B. 10/22/99 I. Insider Trading A. We really collapse several things into one here 1. Fraud in securities transactions a) The most litigated type is insider trading b) But, there are other forms of fraud c) Section 10(b) is used to regulate insider trading AND other types of fraud in transactions. Texas Gulf Sulfur (not assigned) A. BoD of drilling company decide to buy stock in company on preliminary drilling results. Information is not public. Then BoD issues a misleading press release saying drilling results are uncertain. Eventually the major strike was revealed at a press release. And, at the time of the press release, the BoD was ONLINE with their broker to order immediate buy. B. INSIDER TRADING is unlawful under 10(b) because it operates as a fraud on people in the market who do not have the information. C. CONGRESS INTENDED PARITY of INFORMATION in the market, or at least access to the same information (no DISTINCT INFORMATION ADVANTAGE). D. EVEN THOUGH THE COMPANY had not been buying its own stock, the COMPANY also violated 10(b) by making a false statement as a company into the market knowing that the statement would influence the market EVEN IF the officer making the statement is not trading in the stock. E. INSIDERS have while they are in posession of non public information have a duty to disclose the oinformation or to refrain from trading. F. INFORMATION is not public until it is disclosed to the public and the market has time to react to the information. LATER CASES undercut some of the language in Texas Gulf Sulfer A. The first refinement is "who is protected by 10(b)"? 1. Section 10(b) provides no express cause of action, meaning that 10(b) should generally be enforceable by government as criminal action. 2. BUT, the courts, early on, found an IMPLIED RIGHT of private action a) So WHO can bring a 10(b) claim? (1) Stockholders should be able to sue, but how do we know which shareholders would have sold. 3. VERNBAUM CASE: STANDING REQ'T: To bring an action under 10(b) one must be a purchaser or seller of stock. B. TO WHOM does the LIABILITY EXTEND under 10(b) 1. The CORPORATION (doesn't need to be trading. Just issiung misleading information) 2. Insiders of the Corporation (Officers and Directors). People who are told by the insiders "tippees," and others that will be defined later. CHIARELLA v. US (p. 884) A. Chiarella works in a financial printing shop. These firms are used to prepare documents that will be used in major transactions involving public companies. Much of the activity in these firms centers on corporate takeovers. II. III. IV. V. WAYS for Corp. A to "takeover" Corp. B: a) Deal with B's existing management b) OR, make a TENDER OFFER to the existing shareholders. (1) IN order for the tender offer to work, it must be a total surprise to the market if it is to have its intended effect. 2. Williams Act (provisions of '34) Act: Require the person making a tender offer to disclose many terms of the Tender Offer. (who they are, their plans for the company, etc., etc.). 3. The printing firm is the entity used to prepare these documents. And secrecy until to point of public disclosure is IMPORTANT. 4. Thus, the printing firm generally keeps identities as BLANKS in the draft documents until the night before the offer. 5. In CHIARELLA, the person working on the transactions was FIGURING OUT who the B's were, and then buying the stock. What is wrong? HE had information that nobody else had, and he used it to buy stock. US Supreme Court, REVERSES CHIARELLA's conviction. (BE VERY ATTENTIVE to material after case). 6. There is no clear majority opinion in this case. B. POWELL: Concludes for four justices that CHIARELLA is not subject ot 10(b). A person is restricted only when they are under a DUTY not to profit from the information. 1. CONGRESS NEVER INTENDED a "PARITY OF INFORMATION" RULE. 2. Rather, the question is, if a person has non-public information then they may use it unless they are under a DUTY to not use it. And, the duty does not arise from mere possesion of the information. a) e.g., a corporate insider, or person with independent fiduciary duty. C. STEVENS: Maybe CHIARELLA had a duty because he worked for a firm with a duty not to disclose its information. OR, maybe he even owed a duty to his own company to prevent release of the information. D. BRENNAN: If you have stolen or misappropriated information, you can't use it. BUT, this wasn't presented to jury. E. BURGER: The stealing of the information gave CHIARELLA an unfair advantage, and thus use of the information is violation of 10(b) F. BLACKMUN/MARSHALL: Are not concerned with HOW Chiarella got the information. HE had ACCESS to information that was not in the public eye, but this means that he couldn't use it. HYPOTHETICALS: A. Z standing in line waiting for movie, overhears from officers that a tender offer is pending. Z runs out and buys stock (problem VI-B) (note that this is NOT a "setup" situation). 1. BLACKMUN: Z has the information, it is not public, and so Z cannot use it. 2. POWELL: Would not convict because there is no EXISTING DUTY for Z not to trade. 1. 3. 10/26/99 I. Analysis of Z: A. We are not sure of what Blackmun would do, because at times Blackmun talks about non public information information, at other times Blackmun at other times talks about misappropriated information. B. BURGER: Focuses on misappropriation. C. POWELL: Uses a duty analysis. Would Powell suggest that Z must refrain from trading. No. No duty. Now, suppose a change in the facts. The officers recognize Z, invite him over and they share the information. A. BLACKMUN: Would find this to be insider trading. But, where is the "duty" or the "misappropriation"? None, here, the but Z is a "tippee" and so he would get him. B. POWELL: at 887 n.12 would find "tippees" to owe a special duty. In this case he would assign "derivative liability." Dirks Case (p. 896). A. "absolutely hideous" situation of fraud that was going on for years. Dirks gets a tip from somebody that things are not "Right" with Equity Funding. So Dirks spends a couple of weeks investigating the company. B. HOW do you investigate fraud? Talk to auditors, talk to former employees, etc. C. He says that he tried to get the Wall Street journal to do a story which they refused to do. HE also advises his clients to get out of Equity Investments. He also tries to get the SEC involved. SEC was suspicious, but had never put together a proper investigation over a two year period. D. According to SEC, Dirks should have disclosed. But, how do you do it? WSJ doesn't follow up. SEC doesn't follow up. What should he do? E. Keep in mind that in this case Dirks received a tip from Secrist. Dirks is a "tippee." F. Supreme court exhonerates DIRKS G. FRAMEWORK FOR "TIPPEES" 1. First we can treat them as "tipees" or "temporary insiders" a) For instance if a lawfirm is given information to carry on its professional services, then it is proper to treat them as a temporary insider. b) But, in the Dirks case, we do not have this type of disclosure. 2. POWELL: For majority, says that NOT EVERYBODY who gets information about a company must refrain from using it. 3. The question is: Does a DUTY EXIST 4. In the case of a tippee, the LIABILITY is DERIVATIVE 5. The question is: IS THE INSIDER TIPPING IMPROPERLY H. If the INSIDER TIPPING IS EXPECTING TO RECEIVE A BENENFIT, then the "tippee" may be liable as a derivative function of the tippers improper motive. 1. BUT, if the insider receives no benefit, then the tippee is not liable for using the information. II. III. I. Here, the court finds there is no liability because Secrist received no benefit. This is the framework for a TIPPEE. 1. The tippee can use the information if the tipper did not have the wrong motive and did not receive a benefit. 2. 2. 10/27/99 I. Rule from DIRKS case: A. IF the TIPPOR has not acted with improper motive (to make a profit), then the TIPPEE may trade. US v. Carpenter (p. 910) A. Case involves the "Heard on the Street" column in WSJ. Winans is an author of the column who knew the companies, and who knew that his column would have impacts on the market. BUT, the JOURNAL has a STRICT conflict of interest policy that the material in articles are property of journal, and that writers cannot invest in the companies they write about. B. SO, Winans convinces a circle of friends to invest in a company that he is writing about. This was done REPEATEDLY. C. Eventually however, the brokerage firm suspicious. Brokerage firms have procedures in place to find questionable transactions. The firm found the friends investments TOO suspicious, and turned it over to SEC. D. So, here we have MATERIAL, NON-PUBLIC information. BUT, the information IS NOT coming from the company itself. 1. Thus this is like CHIARELLA. In Chiarella POWELL was talking about a DUTY. 2. The duty can arise from a fiduciary duty or from some other special relationship to the information. 3. Here WINANS had a fiduciary responsibility to WSJ that made it WRONG for WINANS to use the information. 4. HERE, we can actually use the POWELL standard OR the BURGER "misappropriation" standard. 5. In this case, we might say that a misappropriation of the information occurred. A theft of information from the WSJ. 6. Here MISAPPROPRIATION was the theory of the case, unlike CHIARELLA, where this theory was an afterthought. E. BUT, what would have happened if there was no policy at WSJ? How might there still be liability found? 1. Maybe we can say that a theft occured from a) sources of the information? Arguing that the sources disclosed with the intention that information would be disemminated, not used by WINANS. b) the investing public? F. WHAT ABOUT under BLACKMUN theory? 1. Here if you have the information AS A RESULT OF YOUR POSITION then you go down. 2. NOTE, though, that this has been rejected time and again. But it does seem to explain the result best. WHAT ABOUT PRIVATE LITIGATION A. Standing rule: plaintiffs can be anybody who is selling into the market while a tipee is buying (or vice versa, depending on nature of information). B. Can the WSJ sue WINANS under 10b? No, they do not have standing. II. III. C. IV. V. So how do plaintiff's in the market sue? Based on WINANS violation of a duty to WSJ. NOTE: that this is a mismatch between and duty owed. Carpenter v. US A. Supreme court divides 4-4 on 2nd circuit opinion. US v. O'Hagan (p. 175) A. 's firm represents a compnay which is preparing to make a tender offer on Pillsbury. goes out and buys as much Pillsbury as he can before the information is made public. Stock goes from $39 per share to $60 per share. B. Chiarella walked, so O'Hagan must think that he can do so too. C. What is the difference here? D. FIRST: Chiarella walked because the government failed to charge the right COA. E. SECOND: Here we have an ATTORNEY with a direct fiduciary duty. F. To be continued... G. 10/28/99 I. O'hagan A. MISAPPROPRIATION of information 1. Court says: fraud exists under 10b when a person missapropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information (p. 179) 2. In this case O'Hagan is stealing the information from his lawfirm, and from the people that his firm owed a duty to. HYPOTHETICALS on INSIDER TRADING A. PROBLEM IV-B 1. A, a notorious corporate raider, tips X that she is about to launch a tender offer of large, manufacuturing corp. X buys and wins big. a) HOW is this different than Chiarella? In this case, the SOURCE of the information is giving the information freely. b) BLACKMUN: Would definitely find a problem here. BUT, Blackmun's opinion is not law. c) How is this different than DIRKS? Here, we have information that is EXTERNAL to the corporation that is giving information. d) BACK UP one step: IS A prevented from trading? No, because this would be totally circular. A can buy, but subject to the Tender Offer rules (need to disclose ib buying more than 5%, or if X is acting in CONCERT with A, then they must act together. 2. § 14b-3 prohibits fraud in connection with a tender offer. a) LOOK at this in the SUPP. (1) It is deception and manipulation for a person in posession of non-public information to trade if information was obtained from the offering person, or the target. b) CHESMAN case and as O'hagan confirmed (1) All of the baggage associated with 10b is IRRELEVANT with regard to application of 14e-3 (2) 14e-3 will apply once the actual steps to undertake a tender offer has commenced. c) THUS, for these same reasons O'HAGAN and CHIARELLA both had 14e-3 problems. BUT, keep in mind that this ONLY APPLIES to a TENDER OFFER. B. NEXT HYPO at PROBLEM VI-B 1. Y the research scientist is about to release information on safety of a drug manufactured by Q. Y sells his stock in Q before releasing the information. a) Here, we may have a duty like CARPENTER in the WSJ case. b) BUT, this could also be like DIRKS, where we have research done. c) HILLMAN: it has really never been argued that a SELLER in a bear market owes a duty to other shareholders. Generally there has never been a distinction between BUYERS and SELLERS. d) ALSO, WHO IS an "INSIDER" II. III. CADY ROBERTS: says officers and directors. BUT, there can also be "temporary insiders" in the sense that there is information entrusted. (3) But here, there is no facts showing that Y actually obtained information from the company. C. NEXT HYPO: Z standing in line hears about a tender offer 1. Probably If a person IS under a duty to refrain from trading, is that person restricted from trading just by virtue of having the information? Or does the information have to actually be used. A. SEC: Says that POSSESSION of the information prevents trading. B. COURTS, however, are rejecting this theory in favor of the "use" theory. 1. 9th Cir. in US v. Smith, adopted the USE theory. (p. 173) a) Thus, if you formulate a position to buy or sell stock, and then information comes your way, but you still procede to implement your plan, then you have not violated 10b. b) THUS, now the burden is placed on Prosecutors to show ACTUAL USE of the information. 2. S. Ct has yet to rule on this issue. 3. (1) (2) I. 10/29/99 (missed first half of class, get notes) Section 16 of '34 act A. Applies only to "reporting companies" B. 16(a) says who has to report C. 16(b) is the substantive provision 1. Any short term profit that arise from trading in securities can be recovered by the corporation a) OBJECTIVE STANDARD: applies to any short term profit recognized by trading in the securities. b) This is designed to STOP short term trading, and to estalish an objective standard subject to automatic application with no ambiguities. c) SHORT TERM TRADING is SIX MONTHS (1) IF you buy and sell within this period of time, any profit realized is recoverable by the corporation, AND if the corporation doesn't take direct action, a sharehoklder can bring a derivative action. 2. NOTE that the 16(b) action is not a CRIMINAL proceding, it is just a disgorgement of profits from the seller to the corporation. 3. BUT, you CAN go to jail for a failure to follow16(a)'s reporting requirements. D. HOW do we figure profits? 1. The SEC matches the HIGHEST SALE PRICE against the LOWEST PURCHASE PRICE. a) EXAMPLE: (1) Officer Buys 1/1 at $10, Sells 2/1 at $11, Buys 3/1 at $7, sells 4/1 at 8$. (a) Officer will want to say total profit was $2 (the profit on each of the two sales) (b) BUT, using the SEC's methodology, take the lowest Buy price ($7) and then subtract that from the highest sale price ($11). Thus, the amount the corp can recover is $4. E. What happens with INVOLUNTARY SALE? 1. For example officer buys at $10, and then 1 month later the corporation is merged forcing sale at $11. a) Courts recently are making an exception, and not invoking 16(b) to disgorge. b) 11/2/99 I. 16(b) A. Doesn't PROHIBIT ANYTHING. B. Just makes a short term inside trader disgorge profits to the corporation. C. Requires TWO transactions, a buy, and a sell. 16(a) A. Requires you to report. Failure to report is A CRIME. B. Thus, even if only one transaction occurs, the officer MUST REPORT. FRAUD ON THE MARKET A. Efficient Capital Market Hypothesis 1. The markets are "efficient" in an informational sense. The markets rapidly reflect information in the pricing of securities. 2. Thus if Corp. reveals major negative information, within minutes there will be a drop in the market. Thus we see the market rapidly digesting the information and reflecting it in pricing. 3. NOTE: This is a THEORY. BASIC v. LEVINSON A. FACTS: 2 corps are engaged in secret merger negotiations. Both corps are publicly traded. Under the negotiations they talk about Basic being the acquired corp. This is good news for Basic's share holders, because they will get a premium for the shares being bought. For this very reason the negotiations need to stay secret. Unfortunately, for this transaction, there were rumors in the market about the merger that were causing Basic's stock price to rise. B. Threee times Basic's management make public statements that the rumors are untrue. The denials were FALSE. And ultimately the deal was announced. C. Disgruntled actors in the market (i.e., people who sold Basic stock after the false denials) bring a class action against Basic. D. LEGAL OBSTACLES in the CASE: 1. WERE the DENIALS MATERIAL? a) § 10b requires MATERIAL statements. So, is it "material" to squash rumors when the deal has not been made. b) Prior to the Basic decision, many courts said no using a BRIGHT LINE TEST: UNTIL YOU REACH AN AGREEMENT IN PRINCIPAL, THE MERGER IS TOO SPECULATIVE TO BE A FACT THAT CAN BE MATERIAL. c) Under this test Basic was okay. Unfortunately for Basic the S. Ct. took this occasion to change the rule. 2. Whether a statement is a MATERIAL MISSTATEMENT is now FACT SPECIFIC. And in each case one must apply the PROBABLILITY/MAGNITUDE analysis. a) Under this test, the BIGGER an action is, the less likely it needs to be that the event will actually occur. b) It is fact specific, it is case specific. II. III. IV. V. VI. NET EFFECT according to HILLMAN (off the record) is that this leads to "hindsight analysis." IF the event happens, the statements are material, if the event does not happen, not material. 3. RELIANCE as an ELEMENT: In the past must show that they RELIED on the misstatement. a) NOTE that this essentially prevents a class action suit, because every must show that they relied on the material statement in making their decision to trade. b) HILLMAN: Policydrove this requirement. Because it is the court making a decision about whether they are going to allow class actions under § 10b. The net result of the decision is to deny class action cases. 4. SO, in this case the supreme court adopts the FRAUD ON THE MARKET THEORY. a) Now, individual 's do not have to show reliance on specific misstatements. Instead we will assume the relied on the information in the market. And if fraudulent information is out there, the reliance element is satisfied. E. HILLMAN so what do the MANAGERS DO? What do you advise them to do? 1. KEEP QUIET. 10b does not require any kind of affirmation. Only the prevention of misrepresentation. Or omitting to make statements. Thus it is standard corporate practice for the corporation to respond to rumors, "No comment." The ROLE OF STATE LAW in regulating FRAUD and INSIDER TRADING A. As a general proposition Federal law seems to have coopted state law. B. Almost all of the activitity is at the level of federal law and 10(b) C. BUT, there may be some cases where application of state law may be more suited to the situation. Diamond case (p. 989) A. Here corp buys large mainframe computers from co. like IBM, and then leases the computers to companies that uses them. The lease contained a service contract. Corp did not have independent service corp. Instead it contracted with the manufacturer to provide services. Now, IBM states that it plans to increase maintenance prices, but corps' Ks will not allow pass through of costs. Clearly this is negative news that will affect the price of stock. Officers sell stock before information is made public and file 16a reports. Shareholders bring a derivative action against the officers. B. Why didn't shareholders bring an action under 10b? There was no standing. Here, the corporation was not a buyer or seller of its own stock and so there was no standing. C. And there could not be a 16b action, because there was only ONE transaction. D. Okay, why didn't the lawyer bring a case for persons who were buying on the market at the time that the Officers were selling. E. WHY DID THIS LAYWER FILE THIS ACTION IN STATE COURT? 1. The answer is not in the case. It is a LAWYERING question. c) 2. 3. (not answered before class ended)... 11/3/99 I. Diamond continued... A. WHY was the case filed in STATE court under FIDUCIARY DUTY rather than in FEDERAL COURT under 10(b) insider trading. 1. BECAUSE of the CLIENT. The client who came to the lawyer was not trading on the market at the time. Thus the lawyer could not have filed a 10(b) claim because the client wouldn't have standing. 2. IN this case, since the client wouldn't have had 10(b) standing the lawyer had to file in state court under the existing fiduciary duty to the client. 3. BUT, this answer is not 100% correct, because under class actions in 1999 there could have been a class action filed, because surely the attorney could have found at least one active trader as a client. 4. NO CLASS ACTION because when this happens many different attorneys will all file class actions. Thus the attorney will have to share. 5. HERE, because the attorney filed a unique, new theory, he was able to keep the fees all to himself. NOW to the law of the CASE A. RULE: Insider trading can be a breach of fiduciary duty as between the officers and the corporation itself. 1. Thus the officers have no right to use that infrormation. 2. In a way this is a looting of the corporation (like Pearlman v. Feldman) sort of. a) BUT, what's the difference between this and Perlman? Is this really similar? b) In Pearlman the insiders traded away the ability of the corporation to act unethically. c) BUT, in this case there was nothing the corporation could have done. B. In DIAMOND, the court finds that the breach of fiduciary duty because there is harm to the corporation in the form of reducing people's willingess to trade in a corporation run by such a group of scoundrels. C. This is a weak analysis. It would be better to say that we don't like scoundrels to benefit. D. HILLMAN: Also, look at the remedy. Here the corporation is "compensated" for the "harm" suffered by insider trading. But isn't this weird? After all, isn't it strange for a corporation to benefit for the wrongful act of its officers. PUBLIC ISSUANCE of SECURITIES A. Back to 1933 Act. This Act principally regulates the SALE of securities. 1. Here we are primarily talking about sales of securities by the issuers in public offerings. THREE TIERS of this AREA A. BASIC RULE: Its unlawful to offer to sell a security unless a registration statement is in effect. (this is a disclosure document). B. SECURUITIES: what are they? C. EXCEPTIONS to the rule. II. III. IV. V. PUBLIC OFFERINGS A. BUSINESS CONTEXT of PUBLIC OFFERINGS 1. A public offering is a widespread sale by a corporation. 2. IF it the first sale of such securities, it is called and INITIAL PUBLIC OFFERING or IPO a) A public corporation can have ONLY ONE IPO b) But, the public corporation can make additional offerings later. B. Purpose of IPO 1. Raise capital. 2. Help existing shareholders to sell their stock. C. BRIDGE FINANCING 1. When a small corp wants to go public but doesn't have resources, it may go to an intermediary investor or borrow money to expand business first (e.g., Davis Hardware goes from 1 to 10 stores, but now has a significant amount of debt). 2. THEN, IPO is made. a) The money is used for two purposes: (1) Pay down debt from Bridge Financing, and... (2) Use the rest to expand from 10 to 50 stores. D. ONE CONSEQUENCE of IPO is that more than 50% of the stock will now be in the hands of the public. 1. For DAVIS HARDWARE, what we want to make sure is that we retain EFFECTIVE CONTROL of the business. 2. Thus we may PIGGY BACK on the public offering by selling some of our stock. (This is a SECONDARY OFFERING). 3. In this case, the money goes to the holder of the stock instead of to the company. E. TO RETAIN CONTROL, 1. Perhaps we sell 70% of stock to public and retain 30% for ourselves. 2. Example: lets say that Davis Hardware has 1,000 shares outstanding. (Hillman 600, me 400). 3. NOW we are going to amend the ARTICLES of incorporation to increase to 1,000,000 outstanding shares. 4. THEN we do a 300 to 1 stock split. Thus now we have 300,000 shares between us (HILLMAN 180,000 and me 120,000) and 700,000 being sold. 5. BUT, why not do a 400 to 1 stock split AFTER establishing 1,000,000 as the number of shares? a) In this example, there wind up being 1,00,000 shares outstanding. (1) 600,000 are offered by the corporation. (2) 100,000 are offered by HILLMAN and me (3) 300,000 are RETAINED by HILLMAN and me to retain EFFECTIVE CONTROL (30% ownership) of the corp. 6. 11/4/99 I. GOING PUBLIC A. Before going public we own 100% of a small corporation B. After going public we retain a minority interest in a huge corporation 1. We retain about 30% to maintain effective control of the corp. C. PROBLEM 1: We have to increase # of outstanding shares (say from 1K to 1mil). D. Then we do a 300 to 1 stock split. Hillman gets 180K, I get 120K, and we sell 700K shares to public. E. BUT, HILLMAN says that we want some dough. So what we do is a 400 to 1 split. And then we sell the 600K shares, and 100K of our shares. To make up the 70% 1. HILLMAN: Notes that the public doesn't like this, and it will slightly drive the price of the stock down. OKAY, now, why shouldn't we do this? What are the disadvantages of GOING PUBLIC? A. Well, now we could loose control the corporation. B. Process of making IPO can be rather high ($1 million not unusual). C. Increased costs of Being a REPORTING COMPANY under 1934 Act. 1. 10q, 10k reports 2. Extensive disclosures about company and US! 3. Proxy solicitation rules 4. 16a and 16b obligations D. Its no longer "OUR" company (actually, no longer HILLMAN's company) E. We have potentially created a class of 's against us. HOW do we go public? HOW do we sell the stock? A. INVESTMENT BANKING FIRM or UNDERWRITER is required. 1. Examples: Merril Lynch, Dean Witter, etc. 2. Our distribution to the public will be through the underwriter. B. We are the ISSUER of the SECURITIES 1. We sell them to the public THROUGH the underwriter C. UNDERWRITER does work under a FIRM COMMITMENT basis 1. FIRM COMMITMENT: We sell all of the stock to the underwriter at a slight discount from the initial offering price. The money that they make is the difference between the sale and the IPO price. WHAT DOES UNDERWRITER DO? A. They hand registration process B. They provide a distribution network 1. They sell to their customers C. They provide "reputation" to back the IPO 1. The name helps to "validate" our stock in the public's eyes. IS the UNDERWRITER INDISPENSABLE A. NO. there can be offerings without underwriters. For instance, we could create a website with all the appropriate documents and we could take credit cards from folks. II. III. IV. V. B. VI. VII. VIII. IX. X. XI. We would still be missing the security, expertise and reputation that the underwriter lends. 1. HILLMAN: this may make sense, and may happen some day, but it doesn't right now. AND, the SEC is very opposed to this type of offering. 2. Although unsaid, HILLMAN thinks SEC believes that UNDERWRITERS play a major role in POLICING IPO's. OKAY, so we have an underwriter. HOW SOON CAN WE GET the $$? A. LONG TIME 1. FIRST we must DRAFT REGISTRATION STATEMENT 2. THEN REGISTRATION must be approved. 3. SIX to NINE MONTH PROCESS FIRST: REGISTRATION STATEMENT: A. Prepared by attorneys of the corp and the underwriter working together. B. A VERY COMPLETE DISCLOSURE DOCUMENT 1. SIGNIFICANT CIVIL LIABILITY results if the registration statement is defective. Liability extends to company, to us as owners, and to the underwriters. 2. RESULT: Underwriter will tend to take a somewhat "adversarial" role when developing registration statement, because they are the party with the deep pocket. TYPICAL REGISTRATION STATEMENT HAS TWO PARTS A. PROSPECTUS 1. Contains most of the information. 2. IS widely distributed to people before the public offering so public can learn about the corporation. B. SUPPLEMENTAL INFORMATION ITEMS DISCLOSED in REGISTRATION PROCESS A. Hardware business generally B. Davis' hardwares history C. Extensive financial information about business audited by independent accountant D. Extensive information about us 1. Our personal history 2. Our convictions 3. Any loans we have taken from corp. (even if paid back) 4. All of our other dealings with the corp. E. NOTE: That underwriter will be pressing us for more and more information, which makes this uncomfortable., THE SEQUENCE A. FIND UNDERWRITER B. GET BUSY on REG STATEMENT C. FILE REG STATEMENT 1. EXTENSIVE PERIOD OF TIME BEFORE EFFECTIVE D. DAY it becomes EFFECTIVE we MAKE PUBLIC OFFERING HOW MUCH per share WILL IT BE SOLD FOR? A. We don't know when we are setting all this up. XII. We may know a range. (like $8 to $12 per share). But that is about all. While registration statement is being prepared we don't know. We cant set the price until the time of the Public Offering. D. WITH an IPO, the problem is that there is no market price. HOW DO WE KNOW what we will set the price at? WHO SETS the price? E. THE EVENING BEFORE the offering, we need to make our deal with the underwriter. WHAT do we look at to set the price? 1. Other companies that are in a similar line of business provide a starting guide. 2. The underwriter will also have information, because it will have been distributing the prospectus and getting feedback from its clients as to their level of interest. F. NOTE: that at this moment, we have a critical jucture and POTENTIAL for CONFLICT. 1. WE WANT the HIGHEST POSSIBLE PRICE 2. UNDERWRITER wants the LOWEST POSSIBLE PRICE BUT, don't be misled A. THE UNDERWRITER MUST SELL ALL of its SHARES AT THE COMMITTED PRICE B. SO, what is the underwriter's interest? 1. FIRST reduce risk. It wants all of the stock sold NOW. 2. SECOND, underwriter is selling to its EXISTING CLIENT BASE. It wants to keep them. If it wants to keep them happy, it will push for a low price so they can trade up quickly. 3. B. C. 11/5/99 I. BACK to PRICING... A. We are discussing pricing here. 1. We want a high price. 2. The underwriter wants a low price a) Underwriter wants to keep its customers happy, and may even have a fiduciary duty. b) And underwriter does not want a "sticky issue." B. On IPO the corporation cannot buy back for a period of about six months. C. IPO price only goes to the underwriters best customers. General public does not have access to the stock at the IPO price. NOW back to the law A. 1933 Act regulates the setting of pricing through 4 sets of provisions. B. § 2 defines "security" C. § 5: prohibits offer without registratement filed and sale without registration statement effective D. §3 regulates... E. §4... F. missed the last two. TWO CRITICAL DATES in the PROCESS of GOING PUBLIC A. DATE REGISTRATION STATEMENT is FILED B. DATE REGISTRATION STATEMETN is EFFECTIVE Three important PERIODS of TIME A. Pre-filing period B. Waiting period C. Post-effective period §5 A. Tells us what we can do during each of these three periods 1. PREFILING: No offers, no sales 2. WAITING: No written offers other than prospetus, no sales, oral offers are okay 3. POST-EFFECTIVE: Anything goes (not quite that broad, but close enough). BUT, WHAT IS AN "OFFER"? A. It isn't anything resembling K law. B. OFFER means ANY ATTEMPT to dispose of the security. 1. Interpreted VERY BROADLY a) EXAMPLE: If we put an advertisement in Business week that doesn't mention the public offering, but just has an ad that says "Davis hardware, nail down your future now!" This violates the rule. (1) NOTE that there are questions about advertising here. DH can probably continue its existing advertising policies, BUT its existing advertising had better not change ONE IOTA. II. III. IV. V. VI. VII. VIII. IX. ANYTHING that is designed to make investors more or less receptive to the company is illegal. 2. This requires a TOTAL INFORMATION BLACKOUT during the prefiling period. a) ANYTHING that is said can be taken as an offer. C. ORAL OFFER: once we are in the WAITING PERIOD, oral statements are okay. BUT the ONLY THING that can be in writing is the prospectus. 1. Keep in mind that any statement to the press which goes into print is a PRINTED STATEMENT D. PENALTIES 1. WORST CASE: People who buy on the IPO can be force to rescind their purchase. 2. BUT, more typically, what happens is that SEC will invalidate the current offer, force a long wait, and then require a new filing. Where does PRE FILING PERIOD start? A. Certainly by the time that preliminary dicussions occur. B. And, there is a gray area extending back before this time. ORAL OFFERS A. A "written" offer includes ANY broadcast media (radio, TV, etc.). B. NOTE: The company may publish, in writing, the prospectus itself. CONTROLS imposed by the ACT A. Information flow B. Timing of information C. The Way the information is distrubuted. D. BOTTOM LINE: The PROSPECTUS is THE ONLY INFORMATION that we want people to have, and we don't want it contaminated. b) X. I. II. III. IV. V. 11/9/99 PERSONS REGULATED by SEC's REGISTRATION RULES A. issuer and the underwriter 1. Other people who are writing about it, commenting on it, etc. are not subject to the restrictions. DIFFERENT TYPES of REGISTRATION A. SHELF REGISTRATION (just for mention) 1. Special type of registration available for VERY LARGE, already PUBLIC COMPANIES 2. Here, these companies are allowed to complete the registration process and have it become effective, but then hold back for up to two years before releasing the securities for sale. 3. PRIMARILY related to BONDS. And is designed to allow the company to time the release to take advantage of interest rates. 4. NOTE that this is different than regular registration, where the securities MUST BE SOLD IMMEDIATELY when the registration becomes effective. B. The types of registration that we've been talking about involves a particular transaction or offer of stock. Each offer requires a new registration. C. NOW, SEC is considering a system of COMPANY REGISTRATION 1. Here there would be one big registration, and then after that there would only be a minimal requirement for future issuance of securities. NOTES on REGISTRATION A. Be careful of going way into debt in getting the registration together or relying on the sale. End result is that you may wind up HAVING to sell to the underwriter, even if the price they offer is really bad. "TIER II" A. DEFINITIONAL BENCHMARK: what do we mean when we say "SECURITY" what is a "SECURITY"? B. 33 Act describes TYPES of TRANSACTIONS that the rules apply to. This goes to the coverage of the transactions covered. C. 34 Act has the antifraud provisions. D. BUT, to trigger either of these, we need to know what a SECURITY is. E. The 33 and 34 Act have substantially the same definition for the term "SECURITY." 1. Stocks, bonds, options 2. "investment contracts" -- this is where the "mystery" is. What is an "investment contract"? F. EXAMPLE: Hillman's Worm Farm. If Hillman buys worms from dude advertising in paper, is this an "investment K"? Howie case A. Orange grove resort where people come to visit. And when visitors came, they owners would allow visitors to buy a "strip" in an orange grove. IN this case, the people would offer a service package to take care of the trees. So, the visitor buys the strip, and then assigns it back to Howie to manage the strip. In this case, VI. VII. Howie would then manage all of these strips, do the sales, and then distribute the profits. B. SEC came in to stop Howie from doing this until they file a registration statement. Here, the Supreme court agreed with SEC and found that this was an investment K. HOWIE FRAMEWORK to DEFINE INVESTMENT K A. Investment of money, in a B. Common Enterprise with an C. Expectation of Profits D. Solely (really "largely") through the efforts of others. Problems/Ambiguities in this test: A. "SOLELY": what does this mean? 1. For example the worm farm requires growing worms and distribution. a) BUT, clearly the DISTRIBUTION takes more effort than the GROWING of the worms. 2. So, is Hillman's effort going to be enough to take this out of the realm of "solely"? Supreme Court has never revisited this. HOWEVER, the Circuit court's have said that this means LARGELEY. 3. ONCE we conclude that this is a security, then all of the antifraud provisions also apply (thus if the seller of the worms misrepresents reproduction rates, or other facts, 10b claim may result.) B. What is a "common enterprise"? 1. Horizontal approach: there must be some sort of connection between investors (like splitting of profits between investors). 2. Vertical approach: some sort of link between the promoter and the investor. a) BROAD VERTICAL COMMONALITY: Here, if investor is dependent on the promoter for profits, then there is b) NARROW VERTICAL COMMONALITY: Requires that the investor also share risk of the enterprise. C. SIMPLE INVESTMENT IN PROPERTY: is NOT a security (eg., raw land, gold bullion, etc., because we are just relying on the market. D. BUT, what about the CONDO at KIRKWOOD? Here you buy condo, but Kirkwood does all of the work to rent the condo. 1. This would probably satisfy the "largely from the efforts of others" part. 2. BUT what about "common enterprise"? a) Under HORIZONTAL test, it depends on Kirkwood's accounting methods. IF Kirkwood pools the rentals and then distributes costs/prfofits, yes. But, if Kirkwood does accounting for each individual condo, then common enterprise test may not be satisfied. b) I. II. III. 11/10/99 INVESTMENT CONTRACTS, continued A. HOWIE CASE 1. ELEMENTS (see above) B. Real estate & gold discussed yesterday. C. DEFINITION is VERY BROAD, which means coverage of securities Acts are broad. D. BUT, NOT all investments are securities 1. Gold, uncut diamonds, etc. 2. Any time that one is looking to general market appreciation for gains does not count. E. HOWIE is only relevant to an INVESTMENT CONTRACT 1. The HOWIE test is NOT applied to other types of investments. 2. For example, sale of stock to third person in Davis hardware who will become a co-manager. In this case the final element of Howie is not satisfied. BUT it JUST DOESN'T MATTER. Stock is a security. F. The question with investment K's is whether somebody has turned money over to somebody else for that person to generate income for the investor. EXCEPTIONS (Tier III) A. This assumes that we are dealing with a security. B. The question is, WHAT IS EXEMPT? 1. When we talk about exemptions we are only speaking of exemptions from a registration requirement. If an exemption is available, OTHER PROVISIONS of the act still apply. a) THUS 10b-5 action for misrepresentation, etc is still available. TWO TYPES of EXEMPTIONS A. The one we WONT spend time on is the "exempt security" 1. This is a secutiry that will never have to be registered before it is sold. Very specialized types: government securities (municipal bonds). BUT, keep in mind that they are still under the Act's antifraud provisions. Securities issued by a bank, securities issued by non-profit orgs are other examples. B. The one WE DO NEED TO KNOW is the EXEMPT TRANSACTION 1. Here, the exemption applies only to a particular sale of a security. For any subsequent sale of that security, the exemption will have to be reestablished. 2. Thus it is based on a TRANSACTIONAL BASIS. C. EXAMPLE of EXEMPT TRANSACTION: 1. DAVIS Hardware decides to not go public. But we do need more financing. We decide to sell common stock to one wealthy and experienced business person from Nevada. The deal is that the NV person will own 1/3 of Davis Hardware when we are done. 2. Right now, we have ARTICLES that say that there are 1000 shares. We amend the articles to add another 500 shares. And then sell them to the NV investor. D. E. F. WITHOUT an exemption this would be a clear violation of the Registration requirements. EXEMPTION 3a-11 for INTRASTATE OFFERINGS 1. Involves sale of security to investors who are residents of the state by company that is doing business in the state (which means SUBSTANTIAL amount of business) and incorporated in that state. SAFE HARBORS: SEC has outlined conditions in the rule that if complied with will guarantee application of the exemption. But, if you are beyond the guidelines, then you may or may not be in. 1. SAFE HARBORS: you are doing business "in state" if 80% of business. 2. AND, on subsequent trade, if the NEW INVESTOR holds for 9 months then safe harbor apples. EXEMPTION 4a-2 Private Placement Exemption 1. Transaction by an issuer not involving a public offering. 2. BUT, what does "public offering" mean here? a) RALSTON case (1953, p. 1435): Defines public offering in a very broad way. b) To be cont'd. c) 3. I. 11/11/99 EXEMPTION from REGISTRATION REQUIREMENTS (cont'd) A. NOTE: Registration CREATES a PUBLIC COMPANY B. Back to the NV investor in Davis Hardware 1. 3a-11: Intrastate exemption. a) Guidance here is in the form of SAFE HARBORS established by SEC b) IF you don't meet the safe harbor, you may still qualify, but you take your chances. 2. This won't work for example b/c we have an out-of-state investor. C. PRIVATE PLACEMENT EXEMPTION (section 4-2 of the '34 Act) 1. Statute says that there is an exemption for an issuer not making a public offering. 2. RALSTON PURINA CASE a) Here there was a public company with stock that was already out there. b) Company also had a plan that allowed employees to purchase stock. Notice here that there is no discount for the stock. What was the benefit of this plan? At this time, most employees didn't have brokers AND there was no commission on the sale. c) STOCK was only available to KEY EMPLOYEES, but it defined this class very broadly. d) SEC in this case said that this was a public offering. RALSTON said that it was only available to "key employees" and thus not a public offering. e) US S CT. Holds that this is a public offering. f) BUT, S Ct does not agree that NUMBERS control. (1) S. Ct. says that NUMBERS are not DETERMINATIVE. 3. TEST: a) Look to the OFFEREE's need for PROTECTION (1) But, what kind of protection? Protection from what? LACK of INFORMATION. b) Look to see if the buyer needs the protection of the information that would be available in the registration statement. c) IF the do have access to EQUIVALENT INFORMATION, then registration is not necessary. 4. HERE, the Supreme Court finds that the plan is TOO BROAD. How do dock workers know about the financial condition of the company, or the fate of other business units, etc. 5. THUS, S Ct. finds that this is a PUBLIC OFFERING because of the lack of available information. D. NOW CIRCUITS have REFINED THIS: 1. OFERREE's ACCESS to INFORMATION, plus 2. SUITABILITY of OFFEREE II. III. IV. V. VI. VII. Is the offeree "sophisticated enough" to access information and to process it properly. b) Of course, what the hell does this mean? Courts look to education, wealth, etc. E. THE LOGICAL EXTENSION of THIS: 1. If our NV offeree is not "sophisticated" enough, then this could be construed to be a "public offering." 2. SO, what do we do? Well, perhaps we make sure that we deal through a savvy intermediary. BUT, who the hell do we select? 3. There are no bright lines here. Thus leading to uncertainty. F. TWO FACTORS 1. SOPHISTICATION 2. in some Jx: ACCESS to INFORMATION G. SAFE HARBOR provision for PRIVATE PLACEMENT EXEMPTION 1. REGULATION D. THREE DIFFERENT exemptions under REGULATION D A. Rule 504 B. Rule 505 C. Rule 506 RULE 506 is the SAFE HARBOR for PRIVATE PLACEMENT RULES 504 and 505 are based on section 3b of the '33 Act. This provision simply allows for ADMINISTRATIVE EXEMPTIONS for certain transactions below a certain value. REGULATION D, across the board deals with A. ACCREDITED INVESTORS 1. Institutional Investors 2. Top Coproprate Officers 3. Weathly People B. HOW DOES SEC DEFINE WEALTH? 1. If you have net worth of $1 million or greater, you are wealty 2. If you have gross income of $250K / year or more you are wealthy RULE 506 (SAFE HARBOR for Section 4-2 private lacement) A. Any investor who is NOT ACCREDITED, must be SOHISTICATED B. Thus, if an investor is "accredited" they do not have the be "sophisiticated" 1. This is because sophistication is (Theoretically) built in. C. No more than 35 NON-ACCREDITED investors. D. BUT amount of ACCREDITED investors is unlimited. E. IF there are any investors who are not accredited, then they must be provided with fairly detailed disclosure documents. F. Accredited investors do not need to be provided with disclosure document. So, back to Davis Hardware A. All we really want to know is whether this person is ACCREDITED. B. a) I. II. III. IV. V. VI. VII. VIII. IX. X. 11/12/99 WE ARE DEALING WITH HOW A BUSINESS RAISES MONEY WITHOUT FILING A REGISTRATION STATEMENT A. For small business it is CRITICAL that the business finds some way to bring the sale under an EXEMPTION B. § 3a-11 - Intrastate exemption C. § 4-2 - Private Placement exemption DISCUSSION of REGULATION D (cont'd from yesterday) A. Before the Regs, case law was unclear: 1. baybe sophistication is important, but who qualifies 2. IS access to information important? 3. How does wealth play in? B. SAFE HARBOR of Reg. D: § 506 (promulgated under § 4-2) 1. Section 506 requires that investor be "sophisticated." C. Regulation D also has two other sections The "ACCREDITED INVESTOR": Regulation D has a conclusive presumption that ACCREDITED INVESTOR is "SOPHISICATED" A. Inside officer B. Institutional investors C. Wealthy person SO, back to NV investor in Davis Hardware: A. We just want to know if the investor has more than $5 mil. RULES on application A. No more than 35 non-accredited investors B. Disclosure documents required for accredited investors NOW, to § 505 A. Good for offerings up to a total of $5 million (maximum extent of SEC to exempt) 1. EXACTLY the same as § 506, except there is no "sophistication" requirement. Even for the non-accredited investor. 2. GOOD NEWS: We don't care about sophistication. 3. BAD NEWS: There is a cieling. NOW, to § 504 A. Good for offerings up to $1 million. 1. Here the limitations of § 505 and §506 are "peeled away" 2. No limit on non-accredited investors 3. No need for disclousre documents for non-accredit investors. RESTRICTED SECURITIES: A. The result of a sale under any of these provisions is a RESTRICTED SECURITY. (we will discuss this in a moment). SO, Back to the Davis Hardware hypo A. If it less than $1 million, then we'll use 504 B. IF it is between $1 mil and $5 mil we'll use 505 C. If it is over $5 mil we are stuck with § 506 What if we want to take $7 million from the stupid NV investor. A. B. XI. XII. First, HILLMAN notes that the SEC RULES prevent breaking up the Tx. SO, can we take the $$ from the stupid NV investor? 1. If he is using his own money, YES. Because he is wealthy. 2. BUT, if he is borrowing, then what? C. HILLMAN: points out that SEC will not allow us to just make him an officer first. Or, to create a shell corporation as an "institutional investor" won't work. D. WE CAN get our investor a SOPHISTICATED REPRESENTATIVE 1. This helps, but we still have problems. How do we assure ourselves that this representative is sophisticated? E. CAN we GET AN UNDERWRITER or some other obviously sophisticated entity as an intermediary? 1. HILLMAN: No. The SEC will not allow transactions where an intermediary is not the REAL PURCHASER. F. THE ONLY WAY that we can get ABSOLUTE CERTAINTY is to drop the offer to $5 million so that we are under rule 505. 1. Thus, if we want absolute certainty, we have to sacrifice the extra $2 million. G. NOTE: These rules apply EVEN on FORMATION OF CORPORATIONS. Thus, we cannot just form a new corporation with this investor to avoid the rules. H. BOTTOM LINE: The best we can do to obtain the $7 million is to get SOPHISTICATED REPRESENTATIVE, and to present a disclosure document as an "insurance policy" in case the investor later cries foul. RESALE of RESTRICTED SECURITIES A. Resale of securities sold under Regulation D is RESTRICTED. B. The securities, when issued should contain a legend indicating that transfer of the security is RESTRICTED under REGULATION D. C. WHAT is the PROCESS FOR RESALE? RULE 144 RULE 144: A. Sets up a variety of conditions. B. MOST IMPORTANT: HOLDING PERIOD 1. Thus first purchaser MUST HOLD for a sufficiently long period to establish the person as a bona fide investor (1 year is the current holding period). 2. HILLMAN: The problem is that there are additional requirements that make it difficult for close corps. to meet the standards of the rules. This means that there will be resales under 144. C. SO, rule 144 is our safe HARBOR. BUT, under what situations can we resell securities outside of Rule 144. D. HILLMAN: RESALE outside of RULE 144 is okay IF the sale is in the nature of a "private placement." E. NOTE: That rule 4-2 doesn't technically apply, because this is not a sale by an issuer. F. HILLMAN: However, even though rule 4-2 doesn't apply then we apply the "sophisticated" purchaser standard. G. HILLMAN: POLICING of these subsequent sales is acutally handled by the ISSUER. This is because IF the sale is done improperly, it will be viewed as a sale by the ISSUER to the "unsophisticated" re-purchaser. H. I. II. III. IV. V. VI. VII. VIII. IX. 11/16/99 Exemptions from the registration statement. A. Any person who is injured as a result of a failure to register can sue for recission. B. RESTRICTED SECURITIES are what result from a sale of exempt securities. WHEN can we RESELL RESTRICTED SECURITIES? A. Note that the more severe the restrictions on resale, the higher the discount will be when a purchaser buys (since they will have problems). SAFE HARBOR - Rule 144 A. ONE YEAR WAITING PERIOD: Purchaser must hold securities for ONE YEAR 1. OTHER rules independent of the waiting period also apply for the one year period. B. TWO YEAR HOLDING PERIOD: After holding for two years, the presumption is that this is a purchaser for value. ENFORCEMENT: A. The ISSUER of the stock is in the role of ENFORCER. This is because they do not want the transaction to be attributed to them as an improper sale. B. Thus the stock will bear a legend announcing the stock is restricted and that resale must be authorized by the issuer. RESALES outside of RULE 144 A. Issuer can allow the transaction IF it falls within the PRIVATE PLACEMENT exceptions. B. NOTE: That Rule 4-2 is NOT technically available here, because that only applies to an issuer. 1. BUT, we still BORROW from the concepts, and allow the sale if this is a "sophisticated" investor. 2. NOTE, we now run into the same problems as with the actual 4-2 transaction between the issuer. Done with REG D. REGULATION A - Another exception. A. Available for offerings up to $5 million B. Results in a "mini" public offering. C. Issuer must prepare an OFFERING STATEMENT (like a prospectius) 1. OFFERING STATEMENT filed with REGIONAL OFFICE of SEC. D. PRINCIPAL COMPETITOR with REGULATION A is RULE 505 ADVANTAGES of REG A A. No limitation on people who can buy 1. 505 limits to 35 non-accredited investors. B. Resale need not be restricted. Results in unrestricted securities 1. Thus buyers cannot discount purchase price based on limitations. DISADVANTAGES of REG A A. The need to preoare the OFFERING STATEMENT 1. Although less costly than prospectus, still not insignificant 2. Fairly detailed disclosure still required. X. What is the difference b/t disclosure duty to non accredited investors under 505 as compared to disclosure required under REG A A. HILLMAN: Basically the same type of disclosure is required. B. DIFFERENCE is that under 505, there is no need to file the document with SEC regional office. XI. THIS DISCUSSION about EXEMPTIONS applies to ALL SECURITIES, not just stocks. XII. LIABILITIES associated with the REGISTRATION PROCESS A. Registraticon carries with it potentiallyhuge liability if there are defects in thereg statement. B. Section 11 of '33 act Imposes LIABILITY on the PRINCIPAL ACTORS in a public offering. 1. These people are responsible for ommissions or misstatements in the reg statement a) The issuer itself b) Directors c) Top officers d) Underwriters e) Experts who prepare particular provisions of the statement (1) e.g., independent accounting firm that certifies three years worth of financial statements. XIII. ISSUER's LIABILITY A. STRICT LIABILITY 1. If there is an ommission or misstatiemtn strict liability for issuer. XIV. ALL OTHERS A. DUE DILIGENCE STANDARD 1. All others can avoid liability by demonstrating that they exercised due diligence. XV. TWO PARTS of REGISTRATION STATEMENT A. EXPERT TIES SECTIONS 1. Where experts participate. 2. e.g., the Financial portions of the statement B. NON-EXPERT TIES 1. All other portions XVI. WHAT do we mean by DUE DILIGENCE A. Due diligence is satisified with regard to expert ties portions if the NON EXPERT has NO REASON TO BELIEVE that there was a problem. B. BUT for NON EXPERT TIES portions the DUE DILIGENCE standard is higer. 1. Satisfied only if the non-expert after conducting a REASONABLE INVESTIGATION had NO REASON TO BELIEVE that there were problems. XVII. BARKERS CASE (p. 1497) A. This is the case that told the world "Section 11 matters" B. FACTS: Registration statement was horrible. Totally misleading. Prepared by a lawyer who was also a director. Now everybody is being sued. C. D. E. F. G. H. I. CEO's liability: he knew all the relevant facts. 1. BUT, is this true? Is this a factual matter? Or is it just assigned to the CEO as a matter of course. CO-FOUNDERS liability: sued as directors of the company. Court describes them as men of limited education. And that the registration statement would be a "difficult read" for them. 1. HILLMAN: what is this case like? Drunk mom case. Their limited capacity is not enough. They are liable. "KIRSHER" - CFO of the Company (Hillman does not like him) 1. This person knows the most about the financial affairs of the company. But claims "I had no responsibilities for this. The lawyers prepared it. And once the lawyer prepares it, it is "EXPERTISED." 2. COURT disagrees. And finds that mere preparation by lawyers is not enough to make it "expertised." a) AND, the court finds that as CFO, he had reason to believe there were problems. OUTSIDE DIRECTOR: Banker. Is new to the board. And, has joined the board AFTER the registration has already been started. 1. COURT, finds him liable. As to the non expertised part he NEEDED to CONDUCT an INVESTIGATION. a) His newness to the board may affect the scope of investigation, but some investigation is required. GRANT (lawyer/director): Cannot be sued as the lawyer that prepared the statement (LAWYER cannot be sued under this rule). 1. GRANT is sued as a OUTSIDE DIRECTOR. Once again, he hasn't done the investigation required. 2. WHAT SHOULD GRANT have done as a DIRECTOR? a) COURT SAYS: He should have looked at the contracts of the company. If he had, he would have seen that the K's called for guarantees of loans to third parties that should have been disclosed. b) HE should read the minute books of the corp and all of its subsidiaries. Look at all transactions put before the BoD to ensure the registration statement reflects reality. c) HE should have gone to the accountants in his own firm to check the accuracy of the financial information. UDERWRITERS 1. Read all the minutes 2. Read all the contract 3. HILLMAN: "Trust with a little t but verify with a BIG V" p. 1416: Underwriters are just as liable as everybody else. 1. HILLMAN: In fact underwriters are most vulnerable under section 11. a) We expect underwriters, as the ones with most expertise, to do detailed investigations. b) AND, when the dust settles, the underwriter may be the only "deep pocket" that is left to sue. 2. 3. HILLMAN: Therefore, underwriters will tend to assume an adversarial position in the preparation of the registration statement. I. II. III. IV. V. VI. 11/17/99 LIABILITY for REG STATEMENT A. Section 11 '33 act 1. Strict liability for issuer 2. Everybody else has due diligence defense B. Statute describes what must be done to sastifies due diligence 1. In a part that is "expertized" due diligence is satisified by showing that there was no reason to belive something was wrong a) This is very easy to satisfy. 2. BUT, for non-expertized sections, the non-expert must say that the conducted a reasonable investigation , and that as a result of that investigation there was no reason to believe there was a problem. a) This is much more difficult. b) And, it creates delays in the processing of the registration statement because everybody involved is setting up their defense. C. IF problems occur in non-expertized part, the experts are not responsible. ROLE of STATES in SECURITIES REGULATIONS A. Most states have "blue sky" law B. Most states also require a "qualification" process 1. This is essentially like the registration process for federal rules. C. Most states also require disclosure D. Most states (including CA) go even farther to regulate the FAIRNESS of the transactions. 1. In California there are many administrative guidelines to decide what is fair. E. All states have exemptions (which do not parallel federal exemptions) 1. Thus one must be careful as to what exemptions apply. F. Registration that is being offered nationally must also be qualified in all 50 states. 1. HILLMAN: This seems excessive. How much do the states really add to the process. 2. In the last few years, Congress has been going after state regulation and cutting it down significantly. PUBLIC OFFERING OF LISTED SECURITY A. Federal law says that States CANNOT regulate B. This doesn't affect IPO PRIVATE PLACEMENTS A. Federal law provides that States cannot require a qualification for private placements. B. NOTE that this only applies to 4-2 and 506. C. THUS, securities sold under 505, this rule DOES NOT APPLY. D. However, HILLMAN points out that California does have exemptions that would apply to a 505 transaction. CAPITAL STRUCTURE A. Describes the relationship of the claimants to the assets of the corp. TWO LEVELS of CAPITAL STRUCTURE A. VII. VIII. Senior Securities 1. meaning "senior" claim to assets. 2. INCLUDES: a) Preferred stock b) Bonds 3. Fixed and Defined Claims B. Common Stock 1. common stock owners are the "RESIDUAL CLAIMANTS" a) Common stock holders get whatever is left after all other claims are satisified. 2. Remainder after all "fixed and defined" obligations are paid. PAR VALUE and COMMON STOCK A. Today "par value" is a meaningless concept for common stock. B. In the past stock was issued by the corporation to stockhoders at "par value" which represented the amount put into the corp by the shareholder for the stock. 1. Thus in the articles, the corp would state a number of shares at a "par value" per share (e.g., $100/share). 2. If a shareholder put less than par value into the corporation for their stock, then they were liable to creditors. 3. This created all sorts of problem is stock was acquired in exchange for labor or property. C. EXAMPLE: Davis hardware issues 1000 shares of $100 par value stock. We each pay for our shares. 1. Thus, on the Assets Side: we have $100,000 and on the Paid In Capital side of liabilities we have $100,000. D. What do these numbers mean? This was the amount of money that was "forever committed" to the corporation. The theory being that this money would never be taken out as long as the corporation had creditors. E. NOW, suppose that, instead, we put $500,000 into the corporation? 1. We could still have same balance sheet, but now put in an extra line in the liabilities side called "Paid in Surplus" and value that at $400,000. 2. WHY are we doing this? Because having our money "forever committed" sucks. 3. But, this also shows that the par value does NOT represent what the stockholders have put in. F. But, if we are moving in this direction, why not go all the way? Lets make the par value $1 per share (or even 1 penny). 1. We will still invest the same amount. G. RULE TODAY: All states have rules allowing low value, or even NO par value for common stock. About the balance statement: A. The LEFT side of the sheet is "what matters" because that is all that the corporation has. B. The RIGHT side is what the corporation OWES. 1. NOTE, that the Stated or Paid in Capital cannot be found. IX. X. XI. XII. XIII. All of the amounts stated on the right hand side are describing CLAIMS against what is REAL (the stuff on the LEFT SIDE). PAR VALUE and PREFERRED STOCK A. For reasons of tradition, it remains common to issue PREFERRED STOCK at its true par value. PREEMPTIVE RIGHTS A. A preemptive right is the right of the shareholder to subscribe to his proportion of interest in a new issuance of securities by the corporation. 1. This "protects" minority shareholders to some extent. 2. BUT, the fact is that the minority shareholder may not have the money to purchase. Thus allowing the majority to take greater power. B. A MINORITY of STATES make preemptive rights a matter of state law. 1. And a handful of courts may find preemptive rights as a matter of equity. SENIOR SECURITIES A. Preferred Stock 1. Generally has a fixed dividend a) Typically $100 par, $6 dividend. 2. Dividend is cumulative a) IF not paid one year, the amount rolls over. 3. TWO LEVELS of PREFERENCE a) Preference on liquidation of corporation. b) and Preference on receipt of dividends. Preferred stock gets dividend first. 4. Preferred stock does NOT have a claim on RESIDUAL ASSETS. Payment of dividend A. The payment of dividends is OPTIONAL with the board. B. AND, the balance sheet must be in certain shape before dividend can be paid. PREFERRED STOCK A. CONVERTIBLE PREFERRED STOCK 1. This makes preferred stock more attractive. 2. I. II. III. 11/18/99 (I missed most of this class, get notes) DIVIDENDS DISCUSSION A. Can the shareholders in a close corp state that dividendds must be paid on preferred stock under certain formulas? 1. Yes, but coming up with the formula can be tricky (example of such req'ts is in Galler). 2. Also, CLARK v. DODGE, is similar in the sense that there was a payoff based on net income with limit that salaries must be reasonable. B. Don't forget that with preferred stock, that the word CUMULATIVE must be stated in the articles. C. And CONVERTIBLE D. And don't forget about a liquidation preference. E. And, it can be non CALLABLE F. NOW, HILLMAN is really happy with giving me all of this stuff. WHY?? 1. A few years go by, and the corp. is doing well. Hillman gets nervous. And so, decides to AMEND the ARTICLES to remove convertible feature. G. "RECAPITALIZATION" means an action by the corporation that adjusts the rights of the shareholders. ACME example. A. Here there is a corp that has an outstanding accrued right to $1 million in cumulated preferred stock dividends. But now the corp is doing very well, and corp wants to pay dividends to regular stockholders. What can it do? 1. RECAPITALIZE. All state corp codes allow this. 2. to be cont'd... 3. 11/19/99 I. RECAPITALIZATION A. ACME: has a preferred stock with a cumulative dividend. The dividend has been cumulating. Now the company is profitable, and wants to amend its articles to cancel the cumulative right to stock. B. DELEWARE STATUTE: Allows this amendment to be made. But it requires a majority vote of the shares that are affected by the revocation of the cumulation. 1. Why would shareholder agree to wipe out their cumulated rights? Because they will never be paid a dividend unless they do. 2. AND, what about argument that the dissenting majority have had a K or property right that is being stripped? No good, because they bought stock in a Delaware corporation, and thus were on notice of the statute and subject to its provisions. 3. IS there a breach of fiduciary duty here? Maybe, but probably not. C. WHAT can Stockholders do to protect themselves? 1. The can contract in the Articles to require UNANIMOUS VOTE. 2. Fine, so we have a recapitalization clause. 3. What else can the corporation do? MERGER. Create a new corporation, merge the original corporation into the new corporation, and eliminate preferred stock by "converting it" into common stock. 4. Note that in DELAWARE, the courts have found that this action is distinguished from recapitalization, and so even IF there is a provision regarding recapitalization in the articles, MERGER end runs the provision. D. What else can the preferred stockholders do? 1. PUT: Require the corporation to buy if no dividends declared after a certain amount of time. 2. SUPER CONVERSION RATIO: Allow preferred stock to be converted at high ratio to common stock if no dividend declared over time. 3. Maybe build in a DIVIDEND FORMULA to require a dividend. a) There may be a problem here, because dividends are supposed to be discretionary. b) BUT, maybe combine the formula with a buyback requirement. E. NOTE: Recapitalization allows the corp to change ANY rights of the shareholders by the simple majority vote of that class of shareholders: 1. Changing non-callable preferred stock to callable stock. 2. IN fact, ANY provisions of the articles can be changed by a majority vote of the shares affected. F. THIS INVOLVES rights established THROUGH THE ARTICLES: 1. HILLMAN: But, what if there is a CONTRACT, separate from the ARTICLES of INCORPORATION. Here the laws do not address this issue. Open question of law. DIVIDENDS and DISTRIBUTIONS A. WAYS to get MONEY OUT 1. OFFICERS: take salaries 2. DO BUSINESS with corp. sell it property. II. B. III. IV. V. VI. TWO WAYS to get money out as a SHAREHOLDER: 1. DIVIDEND 2. SELL YOUR STOCK BACK to the CORP DIVIDEND A. Distribution of corporate profits to the shareholders 1. Has the effect of reducing the corp's assets. 2. With sound public companies, dividends are typically paid quarterly. 3. And, with "bluechip" companies, there is pressure for increasing dividends from year to year. 4. BUT, some companies don't pay dividends. Shareholders may be happy with this if the stock is increasing in value. 5. ALSO, shareholders might like to avoid PERSONAL TAXATION associated with dividends. B. CLOSE CORPS. 1. Law of dividend payments applies to all. CORE PROBLEM with DIVIDEND PAYMENTS A. It is a transfer of assets to shareholders. B. This bugs CREDITORS, because any of their claims to assets of corp are SUPERIOR to the claims of the shareholders. 1. Shareholder response to this argument: we should be allowed to recoup on our investments, just like the creditors. AS LONG AS an ADEQUATE LEVEL OF PROTECTION remains for the creditors in the remaining assets. LEGALSTANDARDS FOR DETERMINING WHETHER ADEQUATE CAPITAL REMAINS A. A number of different tests have evolved. B. All these tests have ONE PURPOSE: When is it okay to distrubute assets to shareholders without prejudice to the creditors. C. Most Jx have only one principal test from the list, and then one test (the INSOLVENCY TEST) to back that up. D. RULE: INSOVLENCY TEST plus one more test. INSOLVENCY TEST A. Corp cannot make dividend payment if it would render the corporation "insolvent" 1. What does "insolvent" mean? Unable to meet its near term obligations as they become due. 2. This is a JUDGMENT test that is exercised by the BoD. 3. HIGHLY OBJECTIVE test and informed very much by HINDSIGHT. 4. 11/23/99 I. DIVIDENDS cont'd A. Two ways to get money out: 1. Dividends 2. Sell stock back DIVIDENDS A. ARE always discretionary with the board B. DIVIDENDS are declared across a class of stock 1. Dividends may declared in some classes but not others 2. BUT, dividends may not discriminate within the class. THREE ISSUES WITH DIVIDENDS A. When is it lawfult to issue dividends B. What is the liability for improper dividend payment C. To what extent can shareholders comped declaration of dividend WHEN IS IT LAWFUL TO MAKE DIVIDEND PAYMENT A. ISSUE: Stockholders are the "junior" claimants. How can we devise a method to distribute dividends without prejudicing "senior" claimants? B. DIVIDEND STANDARDS strike a balance between allowing reasonable return to shareholders and ensuring the claims of creditors. C. There are MANY tests. THE INSOLVENCY TEST A. Corp cannot make a dividend payment if it would render the corp. "insolvent." 1. INSOLVENT: means the inability to pay near term debts as they become due. 2. This is a LIQUIDITY CONCEPT. B. THIS IS A SUBJECTIVE TEST 1. EXAMPLE: Suppose corporation has a huge debt that isn't due in the near term, but will be due in 5 years. Corp only has small amount of cash, and no other assets. Here, from a "bankruptcy" perspective, the corp. may be "insolvent" (because its liabilities exceed its assets). BUT, for purposes of the INSOVLENCY TEST, the corporation is okay, because there is not a "near term" liability. Thus it would be possible for this corp. to issue a dividend. 2. WHAT is "near term"? This is an uncertain term and can be argued. 3. This test involves JUDGEMENT as its underlying basis, and thus it is DIFFICULT TO APPLY a) Other tests all provide FORMULAS to make the call. INSOLVENCY TEST APPLIES IN ALL Jx. A. Thus, most Jx will have one of the several other tests PLUS the INSOLVENCY TEST. INSOLVENCY and the BUSINESS JUDGMENT RULE A. Directors are "more or less" protected by the business judgment rule. BALANCE SHEET TEST A. The balance sheet test -- a dividend may only be paid to the extent that assets exceed the sum of liabilities plus stated capital. II. III. IV. V. VI. VII. VIII. IX. This test is designed to prevent an "impairment" of capital. STATED CAPITAL is the par value of all outstanding stock. Thus once corporation is started up. THUS, what PAR VALUE really acts as is a "cushion" as a guarantee to creditors in balance sheet Jx's. 3. EXAMPLE: Corp has Assets: $50K case, $150 land & buildings. Liabilities: $100K mortgage Stated Capital: $100K. A - (L - SC) still = 0. 4. BUT, now suppose that the land has APPRECIATED. It is now worth $200K. We'd like to make this adjustment on the books. BUT THE ACCOUNTANTS, under normal practices, won't let us do this. BUT, NY COURTS will allows this (Most states will not). B. NY RULE: 1. Randall v. Bailey involved this type of adjustment. In this case the corporation adjusted its books to reflect present value of its assets. Here the corporation adjusted its assest to reflect appreciation, and then made an entry on the liabilities side called "REVALUATION SURPLUS" with an equal amount. 2. So, in the example, we wind up with a $50K balance in an EQUITY account called REVALUATION SURPLUS that could now be allocated to dividends under the balance sheet. 3. THE PROBLEM WITH THIS TEST: We are working with fake numbers. These amounts have not been actually REALIZED. How do we decide when to engage in this exercise? What assets are included? Who does that valuing? MOST COURTS, realizing these problems reject Randall v. Bailey. C. BACK TO MORE CONSERVATIVE Jx. 1. The problem with our example, is that we introduced par value stock at too high of a value. Instead of 1,000 shares at $100 par. What we do is simply adjust the par value at the outset to $1, and then put the rest of the investment in as PAID IN SURPLUS. D. HILLMAN: ARTICLES of INCORPORATION describe the stock of the corporation. If we did issue high par value stock, lets just amend the articles to reduce the par value to $1 per share. And then put the remainder into an account called REDUCTION SURPLUS. 1. CREDITORS: Could have contracted to prevent amendment to the articles to allow this. 2. THUS, even in non-NY Jx, we can make adjustments to the capital structure. 3. HILLMAN: Points out that this renders the Balance sheet test virtually ineffective for creditors. Because stated capital can be changed practically at will. NIMBLE DIVIDEND TEST A. DELAWARE TEST 1. You can make a dividend payment to the extent of current profits REGARDLESS of the status of the balance sheet. 2. Very favorable for stockholders. 1. 2. 3. 4. To be cont'd.... I. II. III. 11/24/99 BALANCE SHEET TEST (Keys on stated capital / par value) A. Focuses on capital impairment: dividends should not be paid if it would impair capital. B. HOWEVER, on this test, the only "capital" we are talking about is the STATED CAPITAL C. SO, if we have SURPLUS CAPITAL, then we can use this to pay a dividend. 1. Surplus could be created by issuing low par value stock to begin with. 2. In SOME Jx (NY) surplus can be created by revaluating assets 3. Surplus can be created by revaluing par value of stock in articles. 4. THUS, provides virtually no protection. NIMBLE DIVIDEND TEST (DE test, looks to income statement) A. Forget the balance sheet. B. LOOK to the INCOME STATEMENT 1. How did we do in the current period. 2. To the extent that we have current profits we can declare a dividend. C. Current is not well defined. EARNED SURPLUS TEST A. Dividend can be paid to the extent that the corp. has earned surplus (retained earnings). B. EARNED SURPLUS: is the portion of the capital surplus equal to the balance of the net undistributed profits, income, (realized) gains and losses from the date of incorporation. C. EXAMPLE: See HANDOUT 1. Corporation: a) At startup has $1000 assets, & $1000 in Stated Capital. 2. END of YEAR ONE a) WE have $250 cash in the register, and our $1000 in assets. b) So, now we have a EARNED SURPLUS account on the liabilities side: of $ 250. c) So, at the end of this year, we can make a dividend payment. d) We decide to pay $100. e) SO: Cash is reduced to $150, Assets remain at $1000. f) Therefore we have to adjust Earned Surplus down to $150. 3. END of YEAR THREE a) We lose $100 in business operations. b) Thus we have $50 cash, $1000 assets, STATED capital remains at $1000. Thus our Earned Surplus is now $50. 4. END of YEAR FOUR a) We lose another $100. b) Now we are down to $950 in assets. Our stated capital remains $1000. Therefore our Earned Surplus is -$50. c) NEGATIVE NUMBERS are okay in Earned Surplus. 5. END of YEAR FIVE a) We make a profit of $50. IV. V. Now we have assets of $1000 again. And we have SC of $1000. Thus no dividend under earned surplus test. (2) BUT, under nimble dividend test we could pay a dividend. (3) Under BALANCE SHEET test we can't pay dividend. Note that we could (as above) amend the par value in the articles. (4) BUT, this still not allow a dividend under the EARNED SURPLUS test, because a mere change in the par value is not EARNED. Same for a REVALUATION of assets. CALIFORNIA TEST (see p. 2 of dividend handout) A. You must prepare a balance sheet using GENERALLY ACCEPTED ACCOUNTING PRINCIPALS 1. Thus eliminating Randall v. Bailey revaluation manuever. B. USES insolvency as a backstop. C. CA HAS TWO ALTERNATIVE TESTS, and the CORP CAN SELECT ITS CHOICE. D. CA uses the EARNED SURPLUS as one option. E. RATIO TEST is the SECOND OPTIONS RATIO TEST A. Corp. must satisfy BOTH of two tests 1. CURRENT ASSETS > CURRENT LIABILITIES a) Current liabilities means liabilities due in the next 12 montsh. b) "Current assets" is what is currently in. 2. TOTAL ASSETS > TOTAL LIABILITIES by a factor of 1.25x. 3. (1) 11/30/99 I. Tests we've discussed A. Insolvency test B. Balance sheet test 1. Only involves STATED capital 2. Dividend can be paid from surplus 3. test is virtually meaning less a) some Jx (NY) allow RANDALL v. BAILEY maneuver b) Revaluation surplus c) etc. 4. NY test is this test C. Earned Surplus test 1. Focuses on RETAINED EARNINGS 2. NET undistributed profits & gains from the time of formation 3. Look for account titled EARNED SURPLUS or RETAINED EARNINGS this is what can be used a) Note that this prevents the use of "revaluation" accounts or Randal v. Bailey reductions. D. Nimble Dividends 1. DE test 2. Dividends can be paid to the extent of current profits on balance sheet CALIFORNIA TEST A. Balance sheet must be prepared under accepted accounting principals 1. Thus, no Revaluation or Reduction surplus creation B. Insolvency test C. THEN one of two tests: D. EARNED SURPLUS TEST or RATIO TEST E. RATIO TEST 1. Current assets must exceed current liabilities (current meaning due within the next year) AND 2. Total Assets must exceed TOTAL liabilities by 1.25x F. WHAT benefit does the ratio test provide? Well, it requires a 25% "cushion" for the creditors. In essense we are assuming a 25% greater liability load before allowing the payout. EXAMPLE: A. Corporation has assets: 1. $15K cash 2. Fixed Asset (land) $50K 3. TOTAL: $65K B. Corporation has liabilities 1. Current: $10K 2. LT: 25K 3. TOTAL: $35K C. Corporation has 1. STATED CAPITAL of $20K II. III. IV. 2. Thus, earned surplus MUST be $10K in order to balance. D. OKAY, under EARNED SURPLUS test, what dividend can be paid? 1. $10K (but note there may be an insolvency issue here). E. RATIO TEST: 1. Here we have total liabilities of $35K x (1.25) = ~$44K. 2. Subtracting this from Assets we get the number $21K 3. THUS, the LONG TERM figure is $21K 4. Current assets & Current liabilities: a) Here we have $10K in current liabilities b) And we have $15K in current assets (cash) c) Here, the CURRENT figure is $5K F. Under the RATIO TEST dividends may only be paid to the extent of the LESSER of the two tests (current and long-term). REVISED MODEL ACT test A. Beyond insolvency B. Dividend payment may be made to the extent that assets exceed liabilities. 1. When preparing financial statements we can use an REASONABLE accounting methods and we can use any FAIR valuation methods. C. This test provides no protection at all for creditors D. And, how do we determine what accounting princples are "reasonable"? E. I. II. III. 12/1/99 LIABILITY for VIOLATION OF DISTRIBUTION RULES A. DIRECTORS 1. Most states: the directors who vote for or concur in an illegal dividend payment are liable. 2. BUT, its not strict liability a) Directors may rely on financial statements made according to general accounting principles b) Directors proceed at their peril if they rely on a financial statement that is not prepared by GAP. (1) In a case in the supp. the court allowed a statement prepared by an investment banking firm. 3. NEGLIGENCE STANDARD imposed on Directors a) Thus, if directors use good faith judgement and rely on all the data, they will be covered. 4. AMOUNT of LIABILITY: a) MAJORITY: Directors are liable for the amount of the improper dividend b) MINORITY: Directors are liable for "damages" to the corporation (1) This is unclear, because "damage" may be severe, or it may be non-existent depending on what happens to the corp. B. SHAREHOLDERS 1. OLD VIEW: Trust fund theory: shareholders absolutely liable for improper distribution, and must put it back. 2. MODERN VIEW: Shareholders only liable if they had reason to believe that the payment was improper. Where liable, dividend must be returned. OTHER STATUTES THAT MIGHT HELP CREDITORS RECOVER A. BANKRUPTCY: Uniform Fraudulent Conveyances Act 1. Any act that would render a transferring party insolvent to creditors. Note, that this goes beyond corporations to any transferring party. So if assets are conveyed in this fashion, the creditors can ask that the conveyance be undone. 2. THIS test looks at TOTAL ASSETS and TOTAL LIABILITIES. a) Thus this differs from the INSOLVENCY TEST, because that test only looks to near-term liabilities. 3. HILLMAN: Says that the corporate dividend statutes probably trump the UFCA. But, a good lawyer would probably still raise the point because in some cases the dividend statutes will be met, but the UFCA test will not. Whant should creditors look out for besides payment of dividends? A. Excessive salaries B. Ability of corporation to incur debt in the future C. Limiting ability of corporation to buy back its own stock D. Limit ability to make major changes in the business E. Create a "liquidation preference" 1. Either secure the debt with corporate assets IV. V. VI. 2. Require all future debts to be "junior" to the creditors claim. COMPELING DIVIDEND PAYMENT A. Public Corporation - NO. Court will always defer to business judgment of directors B. Close Corporation - ALMOST IMPOSSIBLE 1. Miller case: where large salaries paid to majority shareholders, the corp has huge bank accounts, court orders a dividend payment of $75 per share. 2. BUT, this is a really odd case. 3. So, what can shareholder do to "compel" a payment? a) Include a provision that requires majority to buy the stock back of a dividend is not paid in a certain time. b) Include a formula in a contractual instrument c) Liquidation clause, if no dividend, then dissolve the corporation. STOCK REPURCHASES A. The "second" way to get money out of the corporation. B. REPURCHASES may be pro rata or non-pro rata. C. For example, the corp could buy back 10% of its stock pro rata (this has a equivalent effect of a dividend). D. BUT, if the repurchase is not pro-rata then the shareholders receive disproportionate returns (like DONAHUE case) E. STOCK REPURCHASE: is treated as a capital transaction for the shareholder, whereas a dividend results in ordinary income. F. STOCK REPURCHASE: is a major transaction by a corporation, and may be arranged over a several year period. G. STOCK REPURCHASE: also makes the creditors nervous. H. STOCK REPURCHASED: becomes treasury stock. The corporation holds the stock in a "state of suspension" 1. No voting rights 2. No dividends paid 3. Corporation can resell the stock at which time it is reactivated. STATE STATUTES A. MODERN APPROACH: CA Standard: treats dividends and stock repurchases the SAME (calling the regulated transactions "distributions" to stockholders). Thus the same tests apply. B. SOME OTHER STATES: Apply a slightly more liberal stnadard for the repurchase of stock. C. HOW DO WE DEAL WITH PAYMENTS OVER TIME: When is the state test applied? And how? 1. IS it applied on the day of the repurchase agreement? 2. OR is it applied as each payment comes due and is made. 3. EXAMPLE CASE: Close corporation, repurchase agreement entered when it is clear that the majority sharholders health is declining. Corporation agrees to purchase at $400 per share, shares to go to the corporation immediately, but the payments to be made over time, beginning with a down payment that was funded by a life insurance policy 4. 5. has on the deceased shareholder's stock, and five consecutive annual installments. Then, after this transaction is completed, the shareholder's spouse is given the right to sell back her stock over a two year period. NOTE: This is like Donahue, because the corporation's remaining shareholders are increasing their proportional shares of ownership. SO, WHEN do we apply the test to determine whether the distribution tests are applied? Clearly if we apply the test to the entire amount at the time of the agreement it will probably not meet insolvency standards. VII. 12/2/99 I. Kramer: A. Corporation makes agreement with ailing majority shareholder: the corporation will buy the stock in five installments, the first of which is to be paid from a life insurance policy paid by the corporation. And, after that repurchase the wife of the decedent has an option to sell. B. This is like Galler, in that there is an arrangement made for sale of stock on death. It is different than Galler in that in Galler the amount of stock repurchased only needed to meet the expenses of settling the estate. C. Now, what other case is this like? Allen v. Biltmore (case where corporation had to buy back stock at purchase price). D. Also, this is like Donohue. E. HILLMAN says that this transaction could have created problems because of the interested transaction, but at the time all stockholders approved the transaction (Hillman says that this is a good way to avoid later problems). F. NOW, spouse wants to challenge because stock has risen dramatically over time. IF the orginal deal is followed, decedent's estate will receive $490K. But, if they can invalidate the agreement, they have a buyer that will pay $1 million (double). Their theory of the case is that the dividends tests must be applied up front. G. WISCONSIN COURT: Says that the INSOLVENCY TEST must be applied over time (current assets over current liabilities), BUT, the EARNED SURPLUS test must be applied UP FRONT, all at the beginning. 1. HILLMAN: Notes that there is considerable uncertainty as to how this will be applied. H. PRACTICAL LESSON: There is a real risk in drafting a cash in like this. Klang case: A. Smith's food & drug store being taken over. Corporation, before it is taken over, is going to buy back most of its stock as part of the takeover agreement. DELEWARE law applies B. DE Test (Balance sheet test) applied: the Corporation seeks to do a Randall v. Bailey. THE court allows the corporation to create a revaluation surplus based on the appreciation of the assets. C. HILLMAN: They did this "right" from a lawyer's perspective: Thye hired an EXPERT to come in and PROTECT them. 1. BUT, notice that it was not an accounting firm. They hired and investment banking firm. (not bound by GAP, like an accounting firm would be). And so, the owners hire the firm to come in and give a "solvency" opinion. 2. In this opinion, the banking firm heavily writes up the assets at a heavy surplus. D. HILLMAN: This opinion shows Delawares complete lack of concern for creditors. A FEW ADDITIONAL THINGS II. III.
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