Corporations Outline 2002 (Chanler)
I. Economic and Legal Aspects of the Firm
1. Corporations, partnerships, and limited liability companies are special types of business firms or business
2. The Economic Backdrop
a. Comparative search for best investment- rational individuals will choose to deploy their human and money
capital in the least costly form, given the transaction costs of each business association form ex ante
b. Comparative measurement should be in terms of expected return
c. Transaction costs and Choice of Organizational Form
1. Assuming a venture between two parties who will each use their best efforts and divide profits based
on relative contributions- six choices are presented:
b. long-term contract
a. sole proprietor and agent
c. limited liability company
2. Transaction Cost Factors in choosing:
a. bounded rationality- unable to anticipate plan for every contingency that might affect venture
b. opportunism- opportunistic individuals seek to further their own ends by taking advantage of
information deficits of those with whom they deal.
c. Team-specific investment- when an asset has a higher value in its current team use than its
value in its next best use
3. Limits on Organizing as an Implicit Team- when one party makes a large team-specific investment
relative to the other team member, information asymmetries inherent in separate ownership and control
combine to make opportunism possible.
4. Discrete and Relational Contracting
a. discrete contracting: the parties have no preexisting obligations to each other. As they
approach a contemplated venture, they negotiate a contract that anticipates and provides a rule
governing all contingencies
b. relational contracting:
1. a response to the defects of discrete contracting.
2. Parties do not attempt to provide a contractual answer to all contingencies, opting instead
to build a governance structure that will allow them to solve problems as they arise.
3. The goal is to reinforce the relation itself.
5. Decision to Organize as a Firm
a. discrete long-term contracting creates 3 problems:
1. parties each have their own distinct business interests (rather than a team)
2. specification of rights and duties increases the risk of opportunistic refusal to renegotiate
3. extended duration makes it certain that original contract will not cover all future
b. Thus, organization as a firm is optimal
1. involves greater surrender of autonomy, but solves problems posed by bounded
rationality and opportunism
2. sole proprietorship, partnership, corporation
1. Introduction- Agency law may be thought of as a set of standard form rules that provide a backdrop for
contracts or market transactions among team members.
2. Agency Law and the Choice of Sole Proprietorship Form
a. A sole proprietorship is created simply by unifying the ownership and control of the team in the hands of
one team member.
b. Common law- mutual assent creates the relationship of principal and agent. Unless otherwise agreed, this
relationship is terminable at will by either party.
c. The law of agency imposes a fiduciary duty on agents, and the law of contract imposes some limits on the
principal‟s right to discharge an employee.
3. Restatement (2d) of Agency:
§1 (1) – Agency is the fiduciary relation which results from the manifestation of consent by one person to
another that the other shall act on his behalf and subject to his control, and consent by the other so to act.
§387 – Must act solely for the benefit of the principal in all matters connected w/ his agency.
§393 – Must not to compete w/ the principal until employment terminates
§381 – Agent must use total candor in dealing with principal,
§382 – Must account for all profits flowing from information received while in that service,
§383 – Duty to act only as authorized
§395 – Must not use or disclose trade secrets
a. Community Counselling Service, Inc. v. Reilly (4th Cir. 1963) (15)
1. Facts: CCS is a professional fund raising organization. Reilly was employed by CCS as regional
sales representative. R stole clients and sold his own services rather than P‟s services.
2. Holding: Until the employment relationship was terminated, Reilly owed a fiduciary duty. He
violated this duty and the “fruit of that disloyal conduct Reilly may not retain.”
a. The usual rule is that a former employee, after termination of employment, may compete with his
former employer, the only restraint being that he may not use confidential information or trade
secrets obtained from former employer.
b. Employee has the highest duty of loyalty
c. Fiduciary duty requires employee to be candid with his employer and no information which would
be useful to the employer in the protection and promotion of its interests may be withheld.
d. Fiduciary duty can be described as a device for economizing on transaction costs, imposing a
general obligation to act fairly.
b. Formulations of Fiduciary Duty
1. Fiduciary duty obliges “the fiduciary to act in the best interests of his client or beneficiary and to
refrain from self-interested behavior not specifically allowed by the employment contract.” -Anderson
2. “Socially optimal fiduciary duty rules approximate the bargain that investors and agents would strike if
they were able to dicker at no cost.” –Easterbrook and Fischel
4. Limits on the Proprietor‟s Right to Discharge an Employee at Will
a. The sole proprietor is the firm‟s residual claimant.
1. she is entitled to any of the firm‟s remaining assets after all other claimants have been paid in full
2. she is responsible for making up the shortfall out of her personal estate if the firm‟s assets prove
insufficient to satisfy other claimants.
3. Motivation for owner to use best efforts.
b. Agents don‟t share the risks of the principal, so they have an incentive to shirk.
c. At-will employment counters this incentive (Wood‟s Rule)
1. Foley v. Interactive Data Corp. (Cal.SC. 1988)(22): Foley was fired because he tried to report
embezzlement of his superior.
a. no substantial public policy prohibits an employer from discharging an employee for reporting
info relating to the employer‟s private interests.
b. However, under the relational view of contracts, Foley‟s employment was not terminable at will
because the parties intended a continuing relationship (termination guideliness, etc.)
5. Agency Law and Relations with Creditors
a. Common law- A third party who deals with an agent does so at his peril. The agent‟s actions will bind the
principal only if the principal has manifested his assent to such actions.
b. Manifestations of Assent at Common Law
1. Actual authority- occurs when the principal manifests his consent directly to the agent.
2. Apparent authority- (ostensible authority) arises when an agent is without actual authority, but the
principal manifests his consent directly to the third party who is dealing with the agent.
c. Modern Rule- Courts strain to protect the expectations of third parties even when the principal’s
manifestations of consent were illusory at best.
1. Legal issue: agent‟s acts must bind principal w/ respect to a transaction w/ a 3rd party, or every
transaction would have to be between principal and consumer - too cumbersome.
2. Blackburn v. Witter (Cal.App. 1962)(38): Blackburn was tricked into investing in a nonexistent
company by Long, an employee of Dean Witter.
a. Liability must rest on ostensible agency since P was justified in believing that agent had authority.
b. “Ostensible authority is such as a principal, intentionally or by want of ordinary care, causes or
allows a third person to believe the agent possesses.” –Civil Code § 2317
c. Witter was liable because of the actions of Long, its agent.
d. Should Widow Blackburn have been aware of the scam? No - Dean Witter is the one who is
obligated to avoid this sort of behavior.
II. Partnerships and Other Noncorporate Business Associations
A. Noncorporate Business Associations
1. The General Partnership (UPA §§6, 9, 15, 18-22, 31)
a. Every state except Louisiana bases its partnership law on the Uniform Partnership Act (UPA) or the revised
Uniform Partnership Act (RUPA)
b. Formation: Similar to the formation of the principal agent relationship, formation of a general partnership
requires only a statutorily specified mutual manifestation of consent.
1. persons can associate as joint owners for profit and avoid being characterized as a general
partnership by electing to be governed by different association law.
2. Can‟t avoid general partnership status just by labeling if you‟re associated as joint owners- statements
that no partnership is intended are not conclusive
a. “If as a whole a contract contemplates an association of two or more persons to carry on as co-
owners a business for profit, a partnership there is.”
b. Archetypical Partnership: Small, intimate firm in which each partner participates in all aspects of
the business and has substantial confidence in the other partners.
a. Equal Sharing of ownership and management functions
b. Individual partner‟s adaptability to changed circumstances favored over firm‟s continuity and
adaptability (partner who leaves at will receives cash value of his partnership interest)
c. Advantageous for a small venture pursued by a few players who know and trust each other
UPA § 18(a): Profit/ loss - evenly divided, equally allocated - each partner is residual claimant
§18(e) Ownership and Management - equal
§18(h) Dispute Resolution - ordinary matters = majority decides, other matters require unanimity
§18(g) New Members - unanimous consent of all the partners
§9 Relationship between Partners and Partnership - every partner is an agent - there‟s fiduciary
duty to act fairly and honestly.
§15 Liability - Joint and severable unlimited personal liability. Misconduct of one partner could
result in financial ruin for fellow partners.
§31 – Exit right - at will dissolution
§33: - Exit effect Dissolution terminates all authority of any partner to act for the partnership
Tax Treatment - Flow through - all taxes imposed at the partner level – the entity itself is not taxed.
§7 - receiving a share in the profits is prima facie evidence of partnership
Contract - express or implied.
No filing is necessary
Not even knowledge that you‟re partners is necessary
2. Joint Ventures
a. Common law courts distinguished between general partnerships (X & Y carry on a business as co-owners),
and joint ventures (X & Y join to exploit a particular opportunity).
b. Defined: “the legal relationship between two or more persons, who, in some specific venture, seek a profit
jointly without the existence between them of any actual partnership, corporation, or other business entity.”
1. joint right of control
2. joint proprietary interest in the subject matter of the venture
3. right to share profits
4. duty to share losses
3. The Limited Partnership
a. An association of two or more persons to carry on as co-owners a business for profit
b. Must have at least one general partner and one limited partner
1. Separation of ownership and management functions- under state default rules, limited partners have
no management power and no authority to act as agents
2. Limited liability- limited partners are not liable for the firm‟s obligations unless they take part in
control. But general partners are jointly and severally liable.
3. Firm‟s continuity and adaptability to changed circumstances favored over individual‟s adaptability-
General partners can withdraw at will, but a limited partner must give 6 months notice before
withdrawal. Withdrawal does not cause dissolution.
4. Taxation as either a corporation or a partnership- normally taxed as a partnership, but has the option of
4. Limited Liability Company
a. formed by filing a “constitution,” usually termed articles of organization, with the secretary of state
a. Partnership-like, centralized management: members have powers similar to those of partners in a
b. “members” are the LLC‟s residual claimants
c. may stipulate separation of function by designating in the articles of organization that management
will be by managers
1. Limited Liability- members may participate fully in management without forfeiting limited liability,
unlike in limited partnership law
2. Adaptability- members may withdraw at will, causing a dissolution and liquidation of the LLC.
3. Taxation- Usually taxed as a partnership but can be adapted to qualify for treatment as a corp. when
doing so is advantageous.
5. Limited Liability Partnership
a. formation- an existing or newly created general partnership simply registers as an LLP.
b. Limited Liability- provides protection from vicarious liability for professional negligence
c. Limitations on Distributions: Unlike general partnership law, most LLP statutes prohibit distributions of
partnership assets that would result in the LLP‟s insolvency
d. Otherwise, governance is in the form of general partnership norms
6. S Corp.
a. Must have no more than 35 SHs, none of whom can be other corps, and only one class of stock.
a. Has limited liab.
b. Treated differently for tax purposes under IRS code - taxed much like a partnership
c. Election to become S corp. requires unanimous action by shareholders
d. Attempts to achieve favorable tax treatment and limited liab.
7. C Corp
a. “Double tax” - corp. is taxed and shareholders are taxed on dividends.
b. Can get around double tax by zeroing out taxable income in the form of salaries, etc.
c. IRS scrutinizes to ensure that they‟re not disguised dividends.
Trade off b/t lim. liab. and favorable tax treatment
Insurance can be a substitute for lim. liab.
If insurance can cover the probable risks of the venture then limited liability isn‟t so necessary.
Creditors protect themselves when dealing w/ corporations by charging a higher price than when they deal w/ partnerships, to
compensate for the limited liability in corporations. Creditors can also contract for unlimited liab.
B. FIDUCIARY DUTY between Partners (UPA §§20-22; RUPA §§403-405)
1. The traditional framework
a. In the partnership setting, partners must deal with one another as fiduciaries in all matters affecting the
b. Meinhard v. Salmon (NY 1928) (CARDOZO) (p.72)
1. Facts: Salmon entered into a joint venture with Meinhard, whereby Meinhard supplied funding for
Salmon‟s leasing of a building from Gerry. Salmon retained sole power to manage the property.
Salmon later entered into a subsequent lease with Gerry, without informing Meinhard of the deal.
2. Holding: Salmon breached the fiduciary duty he owed to Meinhard.
a. Joint coadventurers, like copartners, owe to one another, while the enterprise continues, the duty
of finest loyalty.
Dissent: J.Andrews. The venture had a limited object and was to end at a limited time, not covering
C. Dissociation and Dissolution
a. At-will Partnerships and the Dissolution Framework – once dissolution occurs, the partnership must wind up its
business, pay off its debts, and settle accounts with partners
b. Settling Accounts – UPA §18(a) provides that absent agreement to the contrary, profits and losses are shared
equally. Differing results when parties do not make equal contributions of capital and services and do not
1. Kovacik v. Reed (105) FACTS: Joint Venture in that one partner contributes all the capital and one partner
contributes all services and no capital. Does not match with the default rules. HELD: 1) Where one
partner or joint adventurer contributes the money capital as against the other‟s skill and labor, neither party
is liable to the other for contribution for any loss sustained.
2. Florida Tomato Packers v. Wilson (107) HELD: a duty to share in losses actually and impliedly exists as
a matter of law in a situation where one party supplies the labor, experience and skill, and the other the
necessary capital since the event of a loss, the party supplying the know how would have exercised his
skill in vain and the party supplying the capital investment would have suffered a diminishment therof
D. Wrongful Dissociation
1. General Rule UPA §§31, 32, 38 - If a partner dissociates from the partnership before completion of the
agreed term or undertaking, such dissociation will be wrongful. A wrongful dissociation causes dissolution of
the partnership. Partners have the option of continuing the partnership‟s business without the consent of the
wrongfully dissociating partner. Additionally, the wrongfully dissociating partner must compensate other
partners for damages resulting from the wrongful dissociation.
a. Page v. Page FACTS: Oral partnership agreement, trying to say at-will partnership for dissolution
purposes HELD: Partners owe one another a fiduciary duty of good faith, which applies to every aspect of
the relationship, including the decision to end the relationship
2. Partner Expulsion UPA §31(1)(d) – In a term partnership, if the majority outs the deficient partner, this
dissociation could be deemed “wrongful,” exposing the ousting partners to substantial liability. Unless
otherwise provided, the right to expel will be governed by partnership law, including fiduciary duty.
a. Bohatch v. Butler & Binion (134) FACTS: Concerned with over-billing by managing partner, she raises the
issue, and then is expelled from the partnership HELD: 1) A partnership exists solely because the partners
choose to place personal confidence and trust in one another 2) Once such charges are made, partners may find
it impossible to continue to work to their mutual benefit and the benefit of their clients.
III. The Corporate Form
A. Introduction (§§2.01- 2.06, 8.01; §§101-102a, 141)
1. Internal affairs doctrine- law of the incorporating state governs relations among directors, officers, and
shareholders (makes possible the competition for incorporation business)
2. Characteristics of the Corporate Form
a. Separation and Specialization of Ownership and Management Functions
1. Legal separation among shareholders, directors, and officers
2. Directors manage the corporation- they are responsible for determining basic corporate policies, appointing
and monitoring the corporation‟s officers, and determining dividend distribution. Del G.C.L. § 141(a),
MBCA § 8.01(b).
a. BUT management power must be exercised collectively, and individual directors are not given general
agency power to deal with outsiders.
b. Compensated for services rendered but not entitled to share of the residual profits.
c. Outside directors - not simultaneously employed as an officer of the corp.
d. Inside directors - simultaneously employed as officers, so they‟re intimately familiar w/ corp‟s
business, personnel, and markets.
3. Shareholders own the corporation and are entitled to a certain percentage of the firm‟s profits and net assets
a. They are the corporation‟s risk bearers and residual claimants
b. Authority- they may annually elect the corporation‟s directors and approve fundamental changes in the
corporation‟s governing rules or structure, but their right to participate in daily management is very
4. Officers are responsible for the day-to-day operations of the firm
a. newer codes allow the corporation to specify names and duties of its officers in its by-laws.
b. An officer‟s power and authority is subject to the dictates of the board of directors.
c. Often, one person will be an officer, director, and shareholder
b. The Corporation‟s Adaptability to Changed Circumstances
1. Hierarchical decision-making in executing corporate policy
2. Majority rule for significant decisions- Unlike partnership unanimity rule, the state corporation law norm is
3. Exit rights from selling shares, which are liquid. No need to convert the firm‟s assets into cash.
4. Withdrawal or Expulsion of Officers or Directors does not Dissolve the Corporation- officers serve at the
pleasure of the directors, and directors serve at the pleasure of the shareholders
c. Deference to Directors‟ Judgment and Power
1. Business Judgment Rule- courts and regulators do not like to substitute their own judgment for that of the
board of directors
2. Shareholder agreements that are intended to sterilize director discretion
a. to be effective, must bind the shareholders in their roles as directors
b. may be invalidated for impermissibly encroaching on the director‟s duty to use independent judgment
B. Shares, the National Market System, and the Efficient Market Hypothesis
a. the securities markets serve as a quasi-monitor of the corporation‟s managers. If the corporation is being poorly
managed, or if its assets would have a significantly higher value in another use, a new management team may
seek to buy a majority of the corporation‟s shares and replace management.
b. Characteristics of Shares
1. Corporations must specify in articles of incorporation the number and characteristics comprising the corp
2. Within each class of shares, shareholders must have identical rights, preferences, and limitations.
3. Default rule: voting and residual claimant status are assumed to be automatically assigned to all corporate
shares unless otherwise specified in the articles of incorporation. (Common shares)
a. Corporate norms mandate that there be a class of shares that is entitled to receive the corporation‟s net
assets upon dissolution- residual claimants.
b. Another class of shares will have voting rights- including the election of directors.
c. Preferred Shares- differ from common stock as specified by the articles of incorporation. Preferred
shares may be granted a dividend or liquidation preference over the common shares (but often with a
limitation of voting rights)
Order of repayment --> debt before equity (secured debt>unsecured debt>subordinated
debt>preferred shareholders>common shareholders)
2. The Efficient Market Hypothesis: stock prices automatically reflect all relevant information
a. Strong version: market price reflects all public and private info; speculators can profit only through luck.
b. Semi-strong version: market price reflects all public information affecting share value Assumes arbitrageurs
are clearing the market to its efficient price at all times. However, room is left for inefficiency when the
arbitrageurs themselves try to cash in on the common person‟s misguided speculation.
c. Weak form: market price reflect only historical information about a firm
C. Regulating and Defining the Shareholder Governance Role
1. The Shareholder Realm
a. Default rules in state corporation codes anticipate a passive, but important, governance role for shareholders.
b. Shareholder authority
1. annually elect the corporation‟s directors
2. approve amendments to the articles of incorporation, dissolution, a sale of substantially all of the
corporation‟s assets, and other extraordinary matters
3. may individually or collectively suggest policy changes- enhanced by their power to remove and replace
the directors at any time, with or without cause
c. Costs of participation in governance and the liquidity of stock provide a disincentive for shareholders to
attempt to influence corporate policy
d. Berle and Means found that most publicly held corporations were “owned” by geographically dispersed,
passive investors who simply rubber-stamped the officer‟s wishes, including election of directors aligned with
e. Institutional Shareholders changed this view- the existence of a fairly concentrated and sophisticated majority
block of institutional investors makes coordinated participation in decision-making at least plausible for
members of that group.
2. Shareholder Political Activity
a. The State Law Procedural Framework (§§7.01, 7.02, 7.04-7.07, 7.21, 7.22(a)-(c), 7.25, 7.26; §§211-213,
216, 222, 228, 229)
1. Two competing principles
a. the shareholder franchise is critical to the legitimacy of separation of function and the resulting
delegation of power to corporate managers
b. the corporation‟s need to adapt to changed circumstances demands practicality and finality in the
administration of shareholders‟ governance rights
2. Action by vote at formal meetings
a. normally, shareholders may exercise their power – such as electing or removing directors – only by
voting at formally called meetings.
b. Annual meeting- All state corporation codes require the holding of an annual shareholders‟ meeting.
MBCA § 7.01(a).
c. Special meeting- All state corporation codes also allow special meetings of shareholders, usually
upon the call of the board or other persons specified in the articles or by-laws.
1. MBCA § 7.02- authorizes a special meeting called by holders of at least 10% of shares
authorized to vote
2. Shareholder initiated right is omitted in Delaware and New York.
3. Action by consent in lieu of meeting
a. most state corporation codes now allow shareholders to act without a meeting, but only by unanimous
b. in effect, this requirement means that shareholders of public companies can act only by meeting
c. Delaware G.C.L. § 228 – the holders of the minimum number of shares that would be required to
approve an action if a meeting were held and a vote taken may act by written consent.
d. Hoschett v. TSI International (179) HELD: mandatory requirement that an annual meting of
shareholders be held is not satisfied by shareholder action pursuant to §228 purporting to elect a new
board or to re-elect an old one. TSI ordered to hold annual meeting. (However, court may make order
on power of own discretion)
4. Notice- shareholders are entitled to receive written notice of the date and location of any annual or special
5. Quorum- Action may properly be taken only if there is a quorum present. A quorum typically is a simple
majority of the shares entitled to vote.
6. Record Date- Only persons who own shares as of a record date set by the corporation are entitled to vote
at, and receive notice of, the meeting.
7. Proxy voting
a. A shareholder need not be present to vote if he executes a simple agreement appointing a proxy to act
on his behalf
b. The proxy designation may create an agency relationship that requires the proxy-holder to follow the
c. Essential to hold meetings in publicly held corporations; otherwise there would be no quorum.
b. Shareholders’ Power to make or influence Business Decisions under State Law (§§109, 141, 142, 242)
1. Corporate law statutory norms entrust management of corporate affairs to the directors. MBCA
§8.01, Delaware G.C.L. §141(a). (except as otherwise provided in the articles of incorporation)
2. Avenues for change:
a. amend the articles of incorporation to give shareholders the right to make a business decision or to
prescribe directly whatever change is desired
1. difficult to attain necessary votes
2. amendment to the articles may be initiated only by the directors
3. because directors will not initiate an amendment to curb their own powers, §§ 8.01 and 141(a)
effectively are immutable rules for corporations that do not opt out in the initial articles of
b. initiate a change in the corporations‟ by-laws.
1. normally, shareholders can‟t amend the by-laws to make ordinary business decisions or to
establish corporate policies
3. Directors‟ management authority extends to chairing and
controlling the agenda of shareholders‟ meetings
a. management may rule out of order any shareholder‟s attempt to propose an amendment to the articles
of incorporation that would intrude on management‟s authority to make ordinary business decisions or
to establish corporate policies
c. Electing and Removing Directors
1. Default Rule
a. Shareholders may remove directors without cause by a simple majority vote at a meeting specially
called for that purpose.
b. All directors stand for election annually, unless it is a staggered or classified board.
2. Changing the Normal Allocation of Voting
a. Straight voting = 1 share equals one vote (with 3 directors, and 100 shares, you get 300 votes)
However, you can only allocate votes for a particular candidate the amount of shares that you have.
(i.e. may not give all 300 votes to one particular candidate. Therefore, the shareholders with the most
shares will always win.
b. Cumulative voting = shareholder can cast a total number of votes equal to the number of shares
multiplied by the number of positions to be filled, and these votes can be spread amongst as many
candidates as the shareholder desires. [Way to make sure that minority shareholders have some
representation on the board.]
a. Formula: To elect X number of directors, a shareholder must have more than SX / (D+1) + 1 shares, where S
equals the number of shares voting and D equals the total number of directors to be elected. (Adding 1 at the
end assures the number of shares you will need for a proper outcome.
a. Good for a proxy fight; voting directors. Much harder in publicly traded setting, because we don‟t know how
many people will cast votes, etc.
b. Works better in a closely held corporation.
b. Positive: What is the use of cumulative voting when you only get one director on the board. 1) having a voice
to influence 2) get more information 3) may change dynamic of meeting b/c somebody watchin
c. Negative: 1) factionalizing board of directors, which is not necessarily in the best interests of shareholders as a
d. Cumulative voting power falls as the number of directors to be elected decreases.
3. Staggered Board
a. Rules of staggered board §141(d) – must be provided for in articles of incorporation, bylaws, or
amendment of bylaws adopted by the shareholders. (Directors not able to amend bylaws to make
such changes to avoid entrenchment.)
b. Rationality of Staggered Board
1. Anti-takeover mechanism. It takes at least two-years to gain control over the board.
2. Stability – having experienced members on the board at all times
3. Autonomy – since elected for three years less likely to be swayed by management
4. Shareholder Value – staggered boards reduce returns by 8 to 10% to shareholders, because it
takes away control form shareholders, making the stock less desirable
a) Now movement by institutional shareholders to de-classify boards
b) If staggered board created in bylaws, then may amend the bylaws
c) If in articles of incorporation, then directors may block amendment
d) May make a precatory proposal for suggesting that they make an amendment
e) Hostile takeovers allow shareholders to replace poorly performing directors, with better
4. Removal of Directors -§141(k)
a. Removal of Directors
1. The default rule of modern codes generally grants shareholders the right to remove directors
with or without cause by simple majority vote.
2. Del. G.C.L § 141(k): can remove any or all directors without cause, except that:
a) If the directors are divided into classes with staggered terms, their must be cause for removal.
b) If there‟s cumulative voting, and less than the entire board is to be removed, director X can‟t
be removed without cause if the votes cast against X would be sufficient to elect X (in a
cumulative-vote election of the entire board or of the class of directors that includes X).
c) Roven v. Cotter (Del. Chanc. 1988) (pg. 204) HELD: Shareholders may amend a certificate of
incorporation, thereby eliminating a bylaw establishing a classified board of directors, so that
the stockholders can then remove a director without cause
3. Staggered Board w/ Cumulative Voting
a) Since staggered board may only be removed with cause, and director with significant amount
of shares may vote himself back in through cumulative voting, best strategy for removal is:
b) Declassify board in the bylaws (may require amendment to articles)
c) Remove cumulative voting in the bylaws
b. Replacement of Directors; filling newly created positions
1. Most codes allow replacement directors to be selected by either the shareholders or the directors.
See Delaware G.C.L. §223
2. Securing a special meeting
a. Delaware G.C.L. §211(d) does not give shareholders any statutory right to call a meeting. But
by-laws may allow one or more shareholders to do so.
b. If not empowered to call a special meeting, shareholders must
1. wait until the next annual meeting to remove directors, or
2. remove or replace directors via written consent in states that permit this on a less than
Removal for Cause
a. Requires service of specific charges, adequate notice, and full opportunity of meeting the accusation.
b. Show of cause requires notice and opportunity to respond; DPC
c. Campbell v. Loew‟s, Inc. (Del.Ct.Chan. 1957) (p.202)
1. Holding: The stockholders have the right between annual meetings to elect directors to fill newly
a) Under Delaware law, the shareholders have the power to remove a director for cause. A
“planned scheme of harassment” constitutes a legal basis for removing a director.
b) stockholders have the power to remove a director for cause in order to prevent the damage of
an offending director; stockholders may remove a director for cause even where there is a
provision for cumulative voting
c) A charge that the directors desired to take control over the corporation is not cause for
removal. Nor is a charge of lack of cooperation
D. Federal Regulation of the Proxy Solicitation Process
(1934 Act §§12(a),(b), (g)(1), 14(a); Rules 14a-3, 14a-4, 14a-5, 14a-9)
a. §14(a) of the Securities Exchange Act of 1934 -- authorizes the SEC to make rules governing the proxy
solicitation process and makes it unlawful for management or dissident shareholders to solicit proxies in
contravention of such rules.
b. §14(a) applies to any proxy, consent, or authorization in respect of any security registered under §12:
1. any corporation whose shares are listed on the national securities exchange
2. any corporation that at the close of its fiscal year has both a class of equity securities held by 500 or
more shareholders and more than $10 million in assets. ??
c. The goal is to prevent solicitation of proxies or consents by means of inadequate or deceptive disclosure.
d. Rule 14a-3
1. prohibits any proxy solicitation unless the person solicited is first furnished a publicly filed preliminary
or final proxy statement containing basic facts to inform voters: (Schedule 14A)
a. time, date, and place of the meeting to which the solicitation relates
b. revocability of the proxy
c. solicitor‟s identity and source of funds
d. identity and basic info about candidates for director
e. Rule 14a-5
1. regulates the form of the proxy statement, ensuring readability
f. Rule 14a-4
1. regulates the form of the proxy that solicitors ask shareholders to execute, imposing readability
requirements and gives an opportunity to do more than grant the authority requested by the solicitor
2.must provide boxes whereby a shareholder may specify whether she approves, disapproves, or abstains
with respect to each matter covered by the proxy
g. Rule 14a-7
1. requires corporation that is itself (i.e. management) soliciting shareholders in connection with an
annual or special meeting to provide specified proxy solicitation assistance to requesting shareholders
h. Rule 14a-8
1. regulates shareholders proposals by “qualifying shareholders” that owns $2,000 in market value or 1
percent of the company‟s stock for at least one year
i. Rule 14a-9
1. prohibits the making of false or misleading statements as to any material fact, or the misleading
omission of a material fact, in connection with a proxy solicitation
2. Regulating Shareholders‟ Access to the Corporation‟s Proxy Statement (Rules 14a-7, 14a-8)
1. Rule 14a-7 requires a corporation that is itself soliciting shareholders in connection with an annual or
special meeting to provide specified proxy solicitation assistance to requesting shareholders. To do this,
the corporation must (at the requesting shareholder‟s expense) either:
a. provide the requesting shareholder with an accurate list of those shareholders and financial
intermediaries from whom the corporation intends to solicit a proxy
b. itself mail the requesting shareholder‟s proxy materials to shareholders and financial intermediaries
2. Under Rule 14a-8, if a qualifying shareholder notifies her corporation that she intends to present a proposal
for action at a forthcoming shareholders‟ meeting, the corporation must include such proposal and an
accompanying supporting statement in the corporation‟s proxy statement,
a. unless the proposal falls into a Rule 14a-8(c) exception.
b. Such proposal must be on the proxy card, with expenses borne by the corporation itself.
c. May make 1 proposal per meeting, and the supporting statement may not exceed 500 words.
3. To be a qualifying shareholder, at the time of the proposal:
1. proponent must be a record or beneficial owner of at least 1% or $2,000 (??) in market value of the
corporation‟s voting stock for at least one year, and
2. she must continue to own such amount through the date of the shareholders‟ meeting
4. Rule 14a-8(i) exceptions swallow the rule (see p. 807-813):
a. 14a-8(i)(1) allows management to omit a proposal that is not a proper subject for shareholder action
under the laws of the corporation‟s state of incorporation- this causes most proposals to be put in the
form of a suggestion because the power to act is limited to directors
b. (i)(7) allows omission of proposals relating to conduct of a corporation‟s ordinary business
c. (i)(5) allows omission of proposals relating to corporate operations involving an insignificant portion
of the corporation‟s assets and not otherwise significantly related to the registrant‟s business
d. (i)(8) requires dissident shareholders who wish to oppose management‟s nominees for director to do so
through a separate proxy solicitation and at their own expense
e. (i)(12) allows the omission of any proposal that has been submitted for a shareholder vote at one or
more meetings within the preceding 5 yrs, and hasn‟t garnered 3% (first submission), 6% (second), and
10% (all others)
4. Use of 14a-8
a. users of 14a-8 are primarily interested in effecting social change
b. Institutional investors effectively utilized 14a-8 to prevent anti-takeover policies
5. Lovenheim v. Iroquois Brands, Ltd. (p.222): Lovenheim proposed a resolution for research on whether
company participates in the force-feeding of geese. Iroquois relied on 14a-8(i)(5)- only .05% of assets
a. 5% test of economic significance employed
b. rule isn‟t limited to economic significance because of “otherwise significantly related” clause.
c. Because of the ethical and social significance of plaintiff‟s proposal, he has shown a likelihood of
prevailing on the merits, even though the resolution probably won‟t pass.
d. However, could not propose that company immediately cease production of pate – would be violation
of 14a-8(i)(1) “management” and 14a-8(i)(7) “ordinary business”
6. New York City Employees‟ Retirement System v. SEC (p.220): SEC issued no-action letter regarding
Cracker Barrel‟s 14a-8(c)(7) omission of anti-discrimination on the basis of sexual orientation, because
such a policy related to the corporation‟s ordinary business, hiring and firing. This raised a furor and the
SEC reversed itself and stated that it would return to a case-by-case approach:
a. “While we acknowledge that there is no bright-line test to determine when employment-related
shareholder proposals raising social issues fall within the scope of the „ordinary business‟ exclusion,
the staff will make reasoned distinctions in deciding whether to furnish “no-action” relief.”
b. the letter isn‟t binding, the SEC may still bring an enforcement action against Cracker Barrel based on
its failure to include a proposal regarding an employment-related social issue.
3. Chilling Effect of Overbroad Restrictions
1. Rule 14a-1(1): Definition of Solicitation
a. Any request for a proxy whether or not accompanied by or included in a form of proxy
b. Any request to execute or not to execute, or to revoke, a proxy; or
c. The furnishing of a form of proxy or other communication to security holders under circumstances reasonably
calculated to result in the procurement, withholding or revocation of a proxy
2. Rule 14a-2: Exceptions
a. any solicitation through the medium of a newspaper advertisement
b. communications between less than ten shareholders (protection of institutional shareholders)
IV. Fiduciary Duty, Derivative Litigation, and the Business Judgment Rule
A. Introduction (§8.30)
1. Officers and other corporate agents are subject to fiduciary duties
a. fiduciary duty instructs directors to be absolutely fair and candid in pursuing personal interests.
b. Fiduciary duty describes the bounds of acceptable conduct for directors in carrying out their individual and
collective duty to manage the corporation
2. Duty of Loyalty: Must deal with the corporation candidly. Prohibits the director from unfairly competing with her
corporation or unfairly diverting corporate resources or opportunities to her personal use.
3. Duty of Care: Requires directors to exercise that degree of skill, diligence, and care that a reasonably prudent
person would exercise in similar circumstances.
4. Normally, directors owe fiduciary duties to the corporation, not to individual shareholders.
5. Limits on the scope and Impact of Fiduciary Duty
a. Business Judgment Rule- courts will not normally second-guess directors‟ business judgments.
b. exculpation provisions make fiduciary duty a default rule that can be contracted around
c. rules limiting a corporation‟s power to indemnify its officers and directors for wrongdoing in their official
d. rules reducing the role of fiduciary duty as a regulator of conflicting interest transactions
e. regulation of derivative suits, including rules allowing directors under certain circumstances to take control of
B. Fiduciary Duty and Directors’ Conduct of Official Duties
1. Duty to Monitor and Be Informed About Corporate Operations and to Prevent Misconduct by Others
a. Modern trend toward greater separation between officers and directors and a greater emphasis on the board‟s
1. All directors have a fiduciary duty
a. to be reasonably informed about corporate affairs (attend meetings)
b. to participate actively in the monitoring and evaluation of the corporation‟s business (regular review
of financial statements)
c. to take reasonable steps to ensure that corporate agents are acting diligently, lawfully, and faithfully.
2. Liability for negligence: If a corporation suffers a loss because of negligent or dishonest actions by
corporate agents, and the directors could have prevented the loss through reasonable diligence, they will be
liable for breach of fiduciary duty.
a. Proximate cause: a director will be liable only if he could have prevented the continuance of a
corporate agent‟s negligent, fraudulent, or illegal conduct by effectively “blowing the whistle”
b. MBCA §8.30(b) – directors “shall discharge their duties with the care that a person in a like
position would reasonably believe appropriate under similar circumstances.”
2. The Business Judgment Rule
a. Corporate statutory norms grant management power to directors.
1. §14 of the 1934 Act (??) supports this power by recognizing that shareholders have no power to make
ordinary business decisions
2. the business judgment rule is a judicially created device that protects directors‟ management power and
b. The rule is a rebuttable presumption that
1. directors are better equipped than the courts to make business judgments
2. the directors acted without self-dealing or personal interest
3. they exercised reasonable diligence and acted with good faith.
c. How can plaintiff rebut the BJR presumption?
3. Conflict of interest (Duty of Loyalty)
4. Gross negligence (Procedural Due Care)
5. A decision that is a no-win one for the corporation (Substantive Due Care)
d. Shlensky v. Wrigley (Ill.App.Ct. 1968) (p.262)
1. Facts: Derivative suit against the directors for negligence, claiming financial loss because of Wrigley‟s
failure to install lights in Wrigley field in order to schedule night games.
2. Holding: Plaintiff did not show fraud, illegality, or conflict of interest sufficient to overcome the
presumption that the decision to install lights was properly decided by the directors.
a. Unless the conduct of the defendants at least borders on fraud, illegality, or conflict of interest, the
courts should not interfere with the business decisions of the directors.
b. Courts cannot require directors to forego their judgment because of the decisions of other companies;
mere failure to follow the crowd does not show a dereliction of duty
e. Joy v. North (2nd Cir. 1982) (p.274)
1. Facts: From an initial loan of 250K to construct an office building, a bank poured in more money. The
bank, in an effort to salvage its bad loan, poured in millions more, exceeding federal regulations preventing
a bank from extending any one loan that would exceed 10% of its capital. Inside directors made the
decision, prompted by the CEO, North, and the outside directors were uninformed.
2. Holding: the Committees‟ recommendation that litigation was not in the best interests of the corporation is
not deferred to under the business judgment rule, given how negligently things were handled.
a. The Business Judgment Rule does not apply if the corporate decision
1. lacks a business purpose
2. is tainted by a conflict of interest
3. is so egregious as to amount to a no-win situation
4. results from an obvious or prolonged failure to exercise oversight or supervision
b. Outside directors may be liable for their ignorance of other‟s decisions, which they did not supervise
and should have.
c. The Typical Basis for the Business Judgment Rule:
1. Shareholders, to a degree, voluntarily assume the risk of bad business judgment
2. After the fact litigation is an imperfect device to evaluate corporate business decisions
3. Because potential profit correlates to potential risk, it is not in the shareholder‟s interest for the
law to create incentives for overly cautious corporate decisions
Hoye v. Meek (p. 276):
Chairman of the Board of an investment fund that lost almost $1.5 million in 2 years failed to attend
board meetings regularly.
Court ruled that he breached his duty of care and was thus unprotected by business judgment rule.
Directors’ Discretion to Consider Interests of Non-Shareholder Constituencies
1. Delaware Approach
a. Directors may only consider the interests of other constituencies if there is some rationally related benefit
accruing to the shareholders or if doing so bears some reasonable relationship to general shareholder interests.
Revlon, Inc. v MacAndrews & Forbes Holdings, Inc.
b. Shlensky – deteriorating neighborhood = less people coming to games = less money for shareholders
2. Some other states NY, PA have other constituent statutes
a. NY Business Corporation Law §717(a)(b)(2) director shall be entitled to consider (ii) corporation‟s current
employees (iii) retired employees (iv) customers and creditors (v) employment benefits
b. State wanting to keep business in their state
c. Greater risk to shareholders – it gives the directors large leeway, theoretically may take an action that harms
the shareholders so long as it helps some other constituencies (makes decisions by directors virtually un-
d. Permissive Rule – allowing directors to consider other constituencies is protecting them from potential
liability from shareholder derivative suits
e. Anti-Hostile Takeover Mechanism
3. Dodge v. Ford Motor Co. (267)  FACTS: Profitable company president decides to cut price of cars and
cut dividends to shareholders, with plan to share profits back with the public. Argument is that this is not
profitable choice and not in interest of shareholders, because company will loose money. HELD: 1) Business
Judgment Rule 2) making a long-term investment in the reputation of the firm
3. Substantive and Procedural Duty of Care as a Check on Directors’
Official Conduct (§8.30; §141(e))
a. Substantive due care: uses the substantive indefensibility of a decision or course of action as the basis for
finding that directors acted in a grossly negligent manner. (akin to res ipsa loquitor)
b. Procedural due care: assesses how directors reached a particular decision. They must carry out a decision-
making process calculated to provide them with information sufficient to reach a rational judgment.
c. Smith v. Van Gorkom (Del. 1985) (p.349)
1. Facts: Trans Union had a large cash flow, but even more tax credits that went unused. In order to
capitalize on these credits, the sale of Trans Union was proposed. CEO and chair Van Gorkom stated he
would sell his shares at $55, and was approaching mandatory retirement. Van Gorkom assembled a
proposed price and financing structure without consulting the Board except Peterson. In negotiations with
Pritzker, Van Gorkom stated that $55 was the best price and Pritzker agreed to buy provided that he first
purchase 1.75 m shares at market price, and set a 3 day deadline for the Board to act with a 90 day market
test for receipt of higher offers. No one investigated the price or was allowed to solicit counter-offers.
The Board accepted Pritzker‟s terms.
2. Holding: Even though they acted in good faith, the Board of Directors did not reach an informed business
judgment because they relied entirely on Van Gorkom‟s oral presentation
1. Under Delaware law, the business judgment rule applies as an offshoot of § 141(a)- but there is no
protection for directors who have made an uninformed judgment.
2. The determination of whether a business judgment is an informed one turns on whether the directors
have informed themselves prior to making a business decision, of all material information
reasonably available to them.
3. Under § 141(e) directors are fully protected in relying in good faith on reports made by officers,
but Van Gorkom‟s presentation didn‟t qualify.
4. The fact of a premium alone does not provide an adequate basis upon which to assess the fairness of
an offering price -- especially since the market had consistently undervalued Trans Union. The
company was never valued in terms of its cash flow.
3. Factors which may not overcome presumption
a. Demand for immediate approval, without more (i.e. emergency), is not sufficient
b. Relying on collective experience of directors in company is not sufficient
c. Relying on a substantial premium over prevailing and historical market prices is not sufficient
C. Indemnification, Insurance, and Statutory Exculpation Provisions
1. Because directors may incur substantial liability even when acting in good faith, they may be encouraged to be
overly cautious in carrying out their duties, or may not want to serve at all.
a. Three modes of Protection for Directors
1. indemnification- traditionally, corporations would indemnify directors against liability
2. insurance- concerns about the reliability of indemnification prompted corporations to seek insurance
policies insuring against liability for serving for the corporation
3. exculpation provisions- because of the increased cost of liability insurance following Van Gorkom,
Delaware and other states authorized the limitation or elimination of directors‟ liability for negligent acts
that is effected by inserting an appropriate provision in the corporation‟s articles of incorporation
2. Indemnification (§§8.50-8.59; §§102(b)(1), 145)
a. Directors‟ and officers‟ indemnification rights are generally determined by provisions in either indemnification
contracts or corporate by-laws.
b. Delaware G.C.L. § 145(c) requires a corporation to indemnify its officers and directors if they are “successful
on the merits or otherwise in defense of any action, suit or proceeding” related in any way to their service as an
officer or director.
3. Insurance: MBCA §8.57, Delaware G.C.L. § 145(g)
4. Statutory Exculpation Provisions: Delaware G.C.L. §102(b)(7):
a. GCL §102(b)(7) – Corporations may add to certificate of incorporation a provision eliminating or limiting
personal liability for monetary damages, but shall not eliminate or limit the liability of a director: (i) for breach
of duty of loyalty (ii) acts omissions not in good faith or intentional misconduct (iv) any transaction for
improper personal benefit
a. Breach of duty of care is eliminated
b. Corporation is becoming a self-insurer
c. Provisions common among publicly traded companies
D. The Duty of Loyalty
1. Corporate Opportunity
a. General: circumstances in which a director personally takes an opportunity that the corporation later asserts
rightfully belong to it
1. Meinhard v. Salmon  A trustee is held to something stricter than the morals of the marketplace.
Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior. As
to this there has developed a tradition that is unbending and inveterate.
b. Northeast Harbor Golf Club v. Harris (334)  FACTS: Harris is president of Golf Club. Approached
for offer for sale of property adjacent to club. Accepts to buy w/o informing board. Accepts again. Now
wants to develop. HELD: 1) Line of business test has many weaknesses 2) ALI approach requires disclosure
of corporate opportunity 3) Since Harris approached in official capacity, and did not disclose, she breached
c. The ALI Approach §5.05
(a) General: may not take advantage of a corporate opportunity unless
1. Disclosure made concerning conflict of interest and corporate opportunity
2. Corporate opportunity is rejected by corporation, and Definition of Corporate Opportunity
3. Either (A) rejection of the opportunity is fair to the corporation (B) opportunity is rejected in advance,
following disclosure, in a manner that satisfies business judgment rule (C) rejection is authorized in
advance or ratified, following disclosure, and not equivalent of waste of corporation assets
(b) Definition of Corporate Opportunity
1. Any opportunity to engage in a business activity of which a director or senior executive becomes
(A) in connection with performance of functions and would lead director or senior executive to
believe that offer made to corporation; OR
(B) through the use of corporate information that would be of interest to corporation
2. Any opportunity which senior executive becomes aware and knows is closely related to a business in
which the corporation is engaged or expects to engage (LINE OF BUSINESS ONLY APPLIES TO
(c) A party who challenges the taking of a corporate opportunity has the burden of proof
The Key to ALI is Disclosure
1. Under §5.05(a), fiduciary must not take an opportunity unless she first offers it to the corporation,
which then must reject it.
2. Rejection may be by disinterested directors, disinterested shareholders, or a disinterested superior of a
senior executive who is not a director
3. Disclosure allows the corporation to decide for itself
4. ALI GIVES CERTAINTY
Disclosure (Formality) – After the fact testimony is a very thin substitute for an informed board
decision made at a meeting in “real time.” Formality is treated by courts as important because it tends to
focus attention on the need for deliberation and the existence of accountability structures.
Cellular Information Systems, Inc. v. Broz (Del.Ct.Chan. 1995) (p.416)
a. Facts: Broz is outside director of CIS. Also president and CEO of competitor RFP. Broz approached
to purchase Michigan-2 license for RFP. CIS not considered because of current financial difficulties,
bankruptcy proceedings, and selling to of similar licenses. Pricellular is seeking to acquire CIS and
also bidding on license. PC acquires CIS, brings new directors and sues Broz claiming he is required
to look not just at CIS, but at the articulated interests of PC.
b. Holding: 1) CIS was not financially capable of exploiting opportunity 2) Only required to consider
the facts only as they existed at the time he determined to accept the offer 3) although within line of
business, nor clear that they have a cognizable interest or expectancy 4) Broz sought only to compete
with an outside entity 5) DISCLOSURE CREATES A SAFE HARBOR.
c. Broz TEST:
Director may not take a business opportunity for his own if:
1. The corporation is financially able to exploit the opportunity
2. The opportunity is within the corporation‟s line of business
3. The Corporation has an interest or expectancy in the opportunity
4. By taking the opportunity for his own, the corporate fiduciary will thereby be placed in a position
inimicable to his duties to the corporation
Director may take a corporate opportunity if:
1. The opportunity is presented to the director or officer in his individual and not corporate capacity
2. The opportunity is not essential to the corporation
3. The corporation holds no interest or expectancy in the opportunity
4. The director or officer has not wrongfully employed the resources of the corporation in pursuing
or exploiting the opportunity
2. Conflicting Interest Transactions
1. GCL §144: provides that no conflicting interest transaction shall be void or voidable solely by reason
of the conflict if the transaction
(1) is authorized by a majority of the disinterested directors, or
(2) approved in good faith by the shareholders, or
(3) is fair to the corporation at the time authorized.
2. In addition,§144 codifies the common law requirement of complete candor and fair dealing by
making director or shareholder approval effective only if the interested director has disclosed all
3. If no intervening cleansing action occurs, a court will review transaction by requiring the defendant to
prove the intrinsic fairness of the transaction.
4. Oberly v. Kirby (360) 
Facts: All directors of Foundation are also either directors or large shareholders of Allegheny. For tax
purposes do a share swap of Allegheny shares in Foundation. Lawyer bargains for price and gets
market price. Issues of tax liability and restrictions on trading. Buyer asks for discount, lawyer asks for
premium for tax breaks.
Holding: 1) The interested directors bear the burden of proving the entire fairness of the transaction in
all its aspects, including both the fairness of the price and the fairness of the director‟s dealings 2) Fair
Dealing –lawyer given full authority to seek the best possible price for the Foundation, record shows
lawyer negotiated vigorously 3) Fair Price – Congress intended to encourage precisely the type of
transaction that Allegheny and the Foundation entered into. Does not require a formal fairness opinion.
3. The Effect of Disinterested Approval
1. General: Disinterested approval reinstates the business judgment rule, but a conflicting interest
transaction may still be challenged as a gift or waste of corporate assets.
2. Cleansing the Conflict
a. Disclosure + Approval by disinterested directors (do not need a quorum of disinterested directors;
may count all directors for quorum pruposes, but only count votes of disinterested directors.) GCL
b. Disclosure + Approval by disinterested shareholders GCL §144(a)(2), or
c. Entire Fairness GCL §144(a)(3)
3. Lewis v. Vogelstein, Delaware Court of Chancery, 1997; (p. 373)
Facts: Shareholder suit challenging a stock option compensation plan for the directors of Mattel, which
was approved or ratified by the shareholders of the company at its 1996 Annual Meeting. Claim is that
the grants to outside directors of immediately exercisable options (to purchase 15,000 shares) were too
generous, without any reasonable assurance of getting enough value in exchange.
Held: One time option grants to directors of this size seems sufficiently unusual to require the court to
look at the evidence rather than deny SJ.
Waste Standard: A waste entails an exchange of corporate assets for consideration so disproportionately
small as to lie beyond the range at which any reasonable person might be willing to trade, and is usually
associated with a transfer of corporate assets that serves no purpose, or for which no consideration is
4. Conflict Transaction Flow Chart
a. Did majority of disinterested directors approve after full disclosure?
1. No – Defendant must prove entire fairness
2. Yes – Has challenger proven waste, gift, or otherwise overcome BJR?
(a) Yes – Transaction Voidable
(b) No – Transaction is OK
b. Did majority of disinterested shareholders approve after full disclosure?
1. NO – Defendant must prove entire fairness
2. Yes – Was the vote unanimous?
(a) Yes – Transaction is OK
(b) NO – Has challenger proven waste, gift, or otherwise overcome BJR?
4. Transactions with Controlling Shareholders
1. A controlling shareholder will owe a fiduciary duty to a controlled corporation if the controlling
shareholder dominates and controls the directors so that they are not viewed as independent
2. Burden shifting in Parent-Subsidiary Transactions
a. However, presence of conflict is not enough to shift burden to defendant to show entire fairness
b. Plaintiff must demonstrate self-dealing
c. Parent must receive something from the subsidiary to the exclusion of, and detriment to, minority
shareholders of the subsidiary
3. Sinclair Oil Corp v. Levien (1971); p. 387
Facts: Parent, Sinclair, company owns 97% of subsidiary, Sinven. Sinclair caused Sinven to pay out
dividends in excess of its profits at a time when Sinclair needs more cash. Sinclair allocation to other
affiliates move towards expansion, but not for Sinven – argument that Sinclair taking away corporate
opportunities of Sinven. Contract for oil supply to International with minimum and maximum quantities
and payments at specified times
Held: 1) Parent getting no more in exclusion of minority shareholders b/c everyone gets same dividends
2) Parent under no obligation to share expansion opportunities with Sinven 3) International does not
accept minimum quantity and payment not timely, which is breach of contract. Sinclair received
products at the detriment of Sinven‟s minority shareholders 4) Sinclair must show intrinsic fairness to
the minority shareholders
4. Shareholder ratification: Even when no coercion is intended, shareholders voting on a parent
subsidiary merger might perceive that their disapproval could risk retaliation of some kind by the
controlling stockholder. Thus, more difficult to show entire fairness of transaction, but it does not go all
the way to a waste standard. Must show Entire Fairness.
5. S tock ownership alone, at least when it amounts to less than a majority, is not sufficient proof of
dominant control. Even proof of majority ownership of a company does not strip the directors of the
presumptions of independence. There must be coupled with the allegation of control such facts as
would demonstrate that through personal or other relationships the directors are beholden to the
E. Corporation’s Right to Control Derivative Litigation
1. Pre-Suit Demand on Directors
a. To ensure that the shareholder derivative suit is not used illegitimately to usurp directors‟ management power,
shareholders are required to make a demand on directors as a precondition to filing a derivative suit. The
demand must explain the claims which he wishes investigated and remedied.
b. Delaware excuses shareholders from making pre-suit demand in circumstances where demand would be futile,
like where the directors lack the independence to impartially consider the demand.
c. Board determines whether demand is required or futile
1. If required, directors‟ decision not to go forward with litigation will be reviewed under the business
a. making demand on the board concedes its disinterestedness
b. if demand is made, business judgment rule standards apply
2. If futile, may get intrinsic fairness standard
a. however, defendants avoid this result by appointing a special litigation committee to consider the value
of the litigation to the corporation, usually resulting in a recommendation for termination of suit.
b. The question then focuses on the level of judicial review- more intrusive than under business
d. Aronson v. Lewis (Del. 1984) (p.462)
1. Facts: Fink owns 47% of company‟s outstanding shares. Fink had an employment agreement with
Prudential which provided that upon retirement he was to become a consultant to that company for ten
years. Claim of “over compensation” to Fink as waste of corporate assets and Fink too old to render
services. Claim that since Fink controls the board, dominates the directors.
2. Holding: The plaintiff has failed to allege facts with particularity indicating that the directors were tainted
by interest, lacked independence, or took action contrary to company‟s best interests in order to create a
reasonable doubt as to the applicability of the business judgment rule. Only in the presence of such
reasonable doubt may a demand be deemed futile.
a. The demand requirement exists to
1. insure that a stockholder exhausts his intra-corporate remedies
2. provide a safeguard against strike suits
b. Business Judgment can be claimed only by
1. disinterested directors whose conduct otherwise meets the tests of business judgment
a. no appearance on both sides of the transaction
b. no self-dealing
2. directors informed of all material information reasonably available to them.
c. In determining demand futility, the court must decide whether, under the particularized facts
alleged, a reasonable doubt is created that:
1. the directors are disinterested and independent, and
2. the challenged transaction was otherwise the product of a valid exercise of a business judgment
(court must explore the substantive nature of the transaction and the board‟s ratification of it (gift
2. Dismissal of Derivative Litigation at the Request of an Independent Litigation Committee of the Board
a. MBCA §7.44
b. Zapata Corp. v. Maldonado (Del. 1981) (p.484) – INTERMEDIATE LEVEL SCRUTINY
1. Facts: P alleged breaches of fiduciary duty by 10 of D‟s officers and directors. P brought this suit without
first demanding that the board bring it, on the ground that the demand would be futile since all directors
were named as defendants. Several years later, the board appointed an independent investing committee.
By this time, four of the defendants were off the board, and the remaining directors appointed two new
outside directors. The new directors comprised the investigating committee, which recommended that the
action be dismissed.
2. Held: There may be circumstances where the suit, although properly initiated, would not be in the
corporation‟s best interests, and an independent committee possesses the power to seek termination of a
3. Even a board tainted by self-interest can legally delegate its authority to a committee of disinterested
directors under Delaware GCL 141c. If the court is satisfied about the independence and good faith
of the committee and the bases supporting its conclusions, it should apply
a. Tension: stockholder power to bring corporate causes of action must be balanced against the
corporation‟s interest to rid itself of troublesome litigation
b. Court must perform a two-step inquiry:
1. Was the committee acting independently and in good faith, and were its conclusions logically
2. The Court should determine, applying its own business judgment, whether the motion should be
c. ONLY GET TO ZAPATA IF DETERMINED THAT DEMAND IS FUTILE / DEMAND EXCUSED
V. Closely Held Corporations
1. Differences Between Closely Held Corporations and Public Corporations
a. more intimate enterprises
b. no market exists for the shares of close corporations
1. most shareholders expect to eventually sell their shares back to the corporation, to other shareholders, or
pass them to their children
c. Minority shareholders are more vulnerable because majority rules and there‟s no public market for their shares
1. Majority opportunism stems from majority rule, separation of function, lack of guaranteed employment and
dividend rights for shareholders, and denial of unilateral dissolution rights to minority shareholders.
2. The norms that both ensure the firm‟s adaptability and protect the firm from minority opportunism create
the risk of majority opportunism
2. Benefits of the Close Corporation
a. limited liability
b. favorable tax treatment via a Subchapter S election
c. governance rules via ex ante contract and ex post judicial rules
B. Contracting as a Device to Limit the Majority’s Discretion
1. As to Director Decisions (GCL §§141(a),(b), 350-354)
a. Evolution of the Rule
1. McQuade v. Stoneham (NY 1934): 1) An agreement among shareholders that attempts to divest the
directors of their power to discharge an unfaithful employee of the corporation is illegal as against public
policy 2) Stockholders may not, by agreement among themselves, control the directors in exercise of the
judgment vested in them by virtue of their office to elect officers and fix salaries.
2. Clark v. Dodge (NY 1936): 1) Where the directors are the sole stockholders, there seems to be no
objection to enforcing an agreement to vote for certain people as officers 2) Limitation of “faithful,
efficient, and competent”
a. Rationale: 1) Since unanimous agreement, no third party (minority) shareholder is harmed 2) not
complete divestment of director power, since may dismiss for cause
b. Meaning: Director Level Agreements valid so long as they are unanimous
b. Shareholder Agreements (Close Corporations)
1. Delaware G.C.L. §§ 341-356 – basically, any corporation with not more than 30 shareholders can come
under these supplementary rules by simply indicating in its articles of incorporation that it is an electing
a. §350 – specifically sanctions “sterilizing” shareholders‟ agreements.
b. §354 – strengthens shareholders‟ ability to avoid majority rule by directors by permitting agreements
that attempt to treat the close corporation as a partnership
2. Zion v. Kurtz (NY 1980) (p.463)
a. Facts: Zion and Kurtz were the only shareholders. Zion and Kurtz entered into a shareholders‟
agreement providing that the corporation would not engage in any business or activities without Zion‟s
consent. Despite this agreement, Kurtz caused the corporation to act without Zion‟s consent.
b. Holding: 1) May limit director‟s power in the articles of incorporation 2) under GCL §350,
shareholders of close corporation may limit directors in shareholder agreements, but must register as
close corporation first 3) However, since Kurtz agreed to do what is necessary to make Agreement
enforceable – he is estopped to rely upon the absence of those amendments (registration) from the
1. Rationale: 1) Not against public policy, as evidenced by statutes allowing such action 2) since
unanimous among shareholders, no intervening third parties harmed
2. Dissent: 1) Statutory mechanisms there to provide notice, and cannot be ignored 2) permit
deviations from the statutory norms for corporations only under controlled conditions 3) must
protect potential shareholders and potential creditors
3. REJECTED IN DELAWARE: Nixon v. Blackwell – Delaware will not follow Zion v. Kurtz
(create certainty and provide precedent in Court of Chancery)
4. Blount v. Taft (NC 1978) (p.517)
a. Facts: §7 of the bylaws was unanimously adopted to create an executive committee, having exclusive
control over employment. The by-laws were amended by a majority shareholders‟ agreement to form
an Executive Committee, which may exercise all the authority of the Board of Directors, without the
employment language. §4 of the by-laws permits their amendment by majority.
b. Holding: By incorporating the §7 shareholders agreement into the by-laws, the directors made it
subject to majority amendment under §4, despite its original, unanimous adoption.
1. Shareholders‟ Agreement: Refers to any agreement among two or more shareholders regarding
their conduct in relation to the corporation.
2. Bylaws which are unanimously enacted by all the shareholders of the corporation are also
3. A shareholders‟ agreement may not be altered or terminated except as provided by the agreement,
or by all parties, or by operation of law.
4. If a shareholders’ agreement is made a part of the charter or bylaws, it will be subject to
amendment as provided therein or, in the absence of an internal provision governing
amendments, as provided by the statutory norms.
States differ as to whether unanimity is required for a shareholders‟ agreement to change statutory norms.
a. Delaware G.C.L. §350 allows majority agreements
b. MBCA §7.32 sanctions only unanimous shareholders‟ agreements
c. NY Business Corp Law §616(b) states that a supermajority provision in a certificate of
incorporation may be amended by a 2/3 vote unless the certificate “specifically” provides
C. Fiduciary Duty and Threat of Dissolution as a Check on Opportunistic Majority Action
1. Traditional Deference to Majority’s Discretion
a. Corporation law provides 2 major avenues for minority shareholders‟ suits:
1. petition for involuntary dissolution
2. direct or derivative suit for breach of fiduciary duty
b. Shareholders may also sue in their own right to compel the payment of dividends or for other rights, but
business judgment presumptions generally apply
d. Zidell v. Zidell (Or. 1977) (p.494)
1. Facts: Arnold Zidell, a minority shareholder in 4 corporations, sought to compel the directors of those
corporations to pay higher dividends. Prior to Arnold‟s resignation as a director, the customary practice
had been to retain all earnings in the business rather than to distribute profits as dividends.
2. Holding: The low dividends are not unreasonable in light of the corporations‟ projected financial needs,
nor is their evidence of starvation tactics used to force the sale of the plaintiff‟s stock at an unreasonably
a. Insofar as dividend policy is concerned, fiduciary duty is discharged if the decision is made in good
faith and reflects legitimate business purposes rather than the private interests of those in control.
b. The complaining shareholder has the burden of proving that the directors’ failure to issue a
dividend is not the product of good faith, business judgment.
c. A controlling factor in dividend cases is the corporation‟s accumulation of an unreasonably large cash
reserve that can be explained only by the majority‟s bad faith
d. Complaining minority shareholders face the same difficulty in challenging a closely held corporation‟s
salary policy as do complaining shareholders in a publicly held corporation.
2. The Partnership Analogy as a Basis for Enhancing Minority Shareholders’ Rights
a. Donahue v. Rodd Electrotype Co. (Ma. 1975) (p.501)
1. Facts: Plaintiff seeks to rescind Rodd Electrotype‟s purchase of Mr. Rodd‟s shares because she was
not offered a similar deal as a minority shareholder, despite her offer of sale.
2. Holding: To satisfy the strict good faith standard, if the stockholder whose shares were purchased was
a member of the controlling group, the controlling stockholders must cause the corporation to offer
each stockholder an equal opportunity to sell a ratable number of his shares to the corporation at an
a. A close corporation bears striking resemblance to a partnership. To succeed, the relationship
among shareholders must be one of trust, confidence and absolute loyalty.
b. Because a minority shareholder cannot easily reclaim his capital via sale, freeze-outs trap minority
shareholders into selling out at less than fair value.
c. Stockholders in a close corporation owe one another substantially the same fiduciary duty as
partners: utmost good faith and loyalty.
b. Wilkes v. Springside Nursing Home, Inc. (Ma. 1976) (p.501)
1. Facts: Relations broke down between Quinn and Wilkes, and Wilkes asked to sell his shares after an
appraisal of their value. He was severed from the payroll and not re-elected as an officer.
2. Holding: The action of the majority stockholders was designed “freeze-out” for which no legitimate
business purpose has been suggested. Therefore, Quinn, Riche and Connor breached their fiduciary
duty to Wilkes.
1. When minority shareholders in a close corporation bring suit, the court must ask: can the
controlling group demonstrate a legitimate business purpose for its action?
2. If yes, can the minority stockholders demonstrate that the same legitimate business objective
could have been achieved through some alternate, less harmful course?
c. Nixon v. Blackwell (Del. 1993)
1. Facts: Directors of a closely held corporation maintained a policy which favored employee
stockholders by providing an employee stock ownership plan, key man insurance policies, and low
dividends permitting higher compensation. Plaintiffs, Class B stockholders, claimed breach of a
fiduciary duty by this discriminatory policy.
2. Holding: No breach because stockholders need not always be treated equally for all purposes, only
a. Employee Stock Ownership Plan: tax-qualified, profit-sharing plan whereby employees of the
corporation are allocated a share of the assets held by the plan in proportion to their annual
compensation, providing a substantial measure of liquidity (because retiring employees can take
cash in lieu of stock) not available to non-employees.
b. Key Man Insurance Policy: Insured the life of key executives and directors, and funded the
retirement of any unpaid principal and interest on Promissory Notes issued for Class A stock in
c. With respect to the ESOP and Key Man Plans, defendants were on both sides of the transaction so
the entire fairness standard applies.
d. In terms of the squeeze-out problem, the minority purchaser should bargain for protection at the
time of the purchase, and a court imposed buy-out would go beyond party expectations. The
individual who buys into a minority position in a close corporation does so knowingly. (ex ante
contracting to be preferred over ex post judging)
3. The Modern Approach to Involuntary Dissolution (§§14.30,14.34)
a. Courts view dissolution as a viable remedy for truly egregious conduct and are increasingly willing to
order corporations to repurchase the complaining minority‟s shares in order to protect shareholders‟
reasonable expectations or to remedy oppression.
b. MBCA § 14.34: grants the defendant corporation the right to avoid a court ordered involuntary
dissolution by electing to repurchase the complaining minority‟s shares for fair value.
c. In re Kemp & Beatley, Inc. (NY 1984) (p.531)
1. NY §1104-a provides a mechanism for the holders of at least 20% of the outstanding shares of a
corporation whose stock is not traded on a securities market to petition for involuntary dissolution
under special circumstances- for fraudulent, illegal, or oppressive conduct
2. Oppressive conduct is conduct that substantially defeats the “reasonable expectations” held by
minority shareholders in committing their capital to the particular enterprise.
3. Once plaintiff has set forth a prima facie case for dissolution, the defendant may demonstrate an
alternative, adequate remedy.
4. Every order of dissolution must be conditioned upon permitting any shareholder of the corporation to
elect to purchase the complaining shareholder‟s stock at fair value.
d. Gimpel v. Bolstein (NY.Sup.Ct. 1984) (p.535)
1. Facts: Robert Gimpel embezzled from the corporation and now claims to be oppressed.
2. Holding: While the other shareholders need not return him to employment, they must provide some
means for him to share in the profits. However, dissolution under §1104-a is discretionary and is not
the appropriate remedy here.
3. RG must immediately get full access to corporate books, and the majority must either alter the
corporate financial structure so as to start reasonable dividend payments, or they must make a
reasonable offer to buy out RG‟s interest.
a. Two definitions of “Oppression”
1. a violation by the majority of the “reasonable expectations” of the minority
2. burdensome, harsh and wrongful conduct; a lack of probity and fair dealing in the affairs of
the company to the prejudice of some of its members; or a visible departure from the
standards of fair dealing, and a violation of fair play on which every shareholder who entrusts
his money to a company is entitled to rely.
b. The “reasonable expectations” test is inappropriate where the founders who entered the venture
are not parties to the lawsuit
c. Courts are now willing to tailor the relief to fit the circumstances.
A corporation‟s refusal to repurchase shares has been held not to be oppressive, when the owner inherited the shares
from a deceased passive owner. (Goode v. Ryan), Mass. 1986.
VI. The Corporation as a Device to Allocate Risk between Insiders and Outsiders
A. Piercing the Corporate Veil
a. Introduction: Suits in which creditors are allowed to impose personal liability on shareholders
b. General ambiguous rule: “The separateness of the corporate entity is normally to be respected. However, a
corporation‟s veil will be pierced whenever corporate form is employed to evade an existing obligation,
circumvent a statute, perpetrate fraud, commit a crime, or work an injustice.”
c. Three-part Powell Test (applied in more than parent-sub cases)
1. the D shareholder dominated and controlled the corporation, so that corporation had no mind of its own
2. the parent‟s conduct in using the subsidiary was unjust, fraudulent, or wrongful toward the plaintiff, and
3. Actions or conduct were the proximate cause of the loss or injury
d. Factors considered in piercing the corporate veil:
1. Closely Held v. Publicly Held (strictly for closely held corporations)
2. Voluntary v. Involuntary Creditor (less willing when voluntary contract creditor, b/c of forseeability,
contractual protections, access to information, etc. usually applies to involuntary creditors such as tort
3. Enterprise Liability (treats corporations under common ownership as one pool of assets if: (1) they are
essentially part of a single business and (2) separate incorporation merely isolates risk [Walkovsky v.
Carlton – each corporation has only 2 cabs and the minimum required insurance]
4. Failure to Observe Corporate Formalities (unusual for corporations to follow these formalities – so only
produces a weak inference)
5. Commingling of Assets and Affairs (Almost certain liability – using corporate assets for personal affairs)
6. Under-Capitalization and Purposeful Insolvency (under-capitalization, without more, is not enough,
measured from time of formation)
7. Active Corporate Participation (goes to show dominance)
8. Deception, Misrepresentation
1. Piercing the Corporate Veil to Reach Real Persons
a. Contract Cases
1. Consumer‟s Co-op v. Olsen (587)
a. Facts: Corporation formed by Chris, Jack and Nancy Olsen. Meetings routinely held, initial
capitalization of $7000. Consumer‟s Coop charge account was maintained in the corporate name and
all corporate business was done in the corporate name. The corporation suffered financial trouble and
couldn‟t pay its debt, but Co-op kept extending more credit.
b. Holding: No piercing of the veil. Defendant lacked requisite control, and injustice was not present
because the corporation was adequately capitalized at its inception. No improper mingling of personal
and corporate assets.
1. Failure to observe corporate formality, will not pierce the veil unless fraud or injustice are also
2. Waiver and Estoppel- In a volitional contract case, if creditor had the opportunity to investigate
the capital structure of the debtor and knowingly failed to exercise that right, he waives that right
and is estopped from arguing that the corporation was undercapitalized = no piercing.
a. Inadequacy of capital is measured by the nature and magnitude of the corporate undertaking;
must show clear inadequacy, at the time of the formation of the corporation.
b. Inadequate capital alone is not sufficient ground to pierce. Must also have failure to follow
corporate formalities or other evidence of pervasive control.
2. K.C. Roofing Center v. On Top Roofing, Inc. (MI 1991) (p.596)
a. Facts: Through a chain of roofing companies, one after the other doing the same business, the
Nugents avoided debt, but carried on the same business with a “fresh start” through incorporation and
subsequent dissolution, observing no corporate formalities- playing the corporate shell game.
b. Holding: Veil is pierced. Through his domination and control over On Top, Nugent was using this
corporate form for the unfair and inequitable purpose of avoiding their debts to plaintiffs.
1. A court may pierce the corporate veil and disregard the separate legal entity where the
separateness is used as a subterfuge to defraud the creditor.
2. Three part test satsified
a. control- complete domination
b. control used to commit a wrong (Siphoning – large salary, large rent to disguise dividend
payments; Confusion – use of same corporate name)
c. the wrong is the proximate cause of injury
3. Easterbrook and Fischel argue that courts should pierce in contract cases to remedy fraud and
4. Thompson‟s study: courts pierce in 92% of fraud cases, but 8% of the no-fraud cases, and 20% of
undercapitalization cases (that are contract, not tort).
5. Equitable Subordination: comes into play when creditors and shareholders compete for corporate
assets. Shareholders claim is subordinated to that of the creditor.
b. Tort Cases
1. Agency law- The corporate entity has never provided insulation for an individual committing a tortious act
even if the individual purported to be acting as an officer or otherwise in the name of the corporation
2. Baatz v. Arrow Bar (SD 1990) (p.609)
a. Facts: Plaintiffs were injured in a car accident by a drunk who was served by defendant, in violation
of dram shop laws. The Neuroths did not individually serve him.
b. Holding: The D observed corporate formalities, and did not use it as an instrumentality to conduct
personal business. Under-capitalization, without more, is not enough. So no piercing.
1. Factors that indicate piercing: fraudulent representation by corporation directors,
undercapitalization, failure to observe corporate formalities, absence of corporate records,
payment by the corporation of individual obligations, use of the corporation to promote fraud,
injustice, or illegalities
2. the personal guarantee of their loan to the corporation cannot be enlarged to impose tort liability
3. Dissent: This allows circumvention of Dram Shop Act
4. Easterbrook and Fischel argue that courts should be alert to the
need to pierce the corporate veil to prevent corporate managers from engaging in risky activities, whose
social costs outweigh social benefits. Insurance may provide further funds to cover social costs.
3. Piercing the Corporate Veil to Reach Incorporated Shareholders
a. Craig v. Lake Asbestos (3rd Cir. 1988) (p.617)
1. Facts: D mined and distributed asbestos in the U.S. through its wholly owned subsidiaries. Through
corporate shells, D avoided paying tort default judgments.
2. Holding: The involvement in D‟s financial and managerial affairs fails to rise to the high standard of
domination necessary to pierce the corporate veil. (the two corporate groups maintained separate books,
records, bank accounts, offices and staff, each consulted their own financial advisors, accountants, and
a. Under NJ law, the corporate veil will not be pierced unless “the parent so dominated the subsidiary
that it had no separate existence but was merely a conduit for the parent.”
1. Domination must be found to pierce: complete domination, not only of finances but of policy and
business practices in respect to the transaction attacked so that the corporate entity as to this
transaction had at the time no separate mind, will or existence of its own
VII. Friendly Mergers and Acquisitions
1. Mergers occur because:
a. the management team may desire to retire or move to another venture
b. combining the assets of two previously separate businesses may produce a new entity more valuable than the
sum of its parts
c. the current management team may engage in “empire-building” that seeks to protect the value of their own
d. an outside management team may believe they can use the assets of the enterprise more effectively than the
2. Mergers ordinarily require a shareholder vote in addition to director approval.
3. Shareholders who dissent have appraisal rights by which they can require the corporation to buy their shares for
B. Control Transactions Requiring Corporate Action
1. Mergers and Consolidations (GCL §§251, 259-261)
1. In a statutory merger, the legal existence of all constituent corporations, other than the surviving
2. By operation of law, the assets and liabilities of all constituent corporations pass to the surviving
corporation, and the outstanding shares of stock in the disappearing corporation are canceled.
3. The surviving entity is considered a newly created consolidated corporation.
a. The roles of directors and shareholders are dictated by corporate code
1. The board of directors of each constituent corporation must adopt a merger plan stating the terms of
the merger, including
a. what consideration will be paid to the shareholders of the disappearing corporations in exchange for
1. typically, shareholders in the disappearing corporation will receive shares of the surviving
corporation in exchange for their canceled shares
2. modern corporation statutes allow any form of consideration, including stock, cash, and/or notes –
a flexibility that leads to cash-out transactions.
b. what changes, if any, will be made in the articles of incorporation of the surviving corporation
2. The plan of merger is then submitted to the shareholders of each corporation for approval
a. early codes required unanimous shareholder approval for mergers
b. this was dropped in favor of a supermajority (often 2/3) of the shareholders of each corporation taking
part in the merger
c. Now, more that half of the states require approval by only a majority of shareholders, although it must
be an absolute majority of all shares entitled to vote
d. Many modern codes require no approval from shareholders of the corporation surviving the merger in
relatively insignificant mergers (if the number of shares issued in connection with the merger does not
increase the corporation‟s number of issued shares by more than 20%, shareholders equity and voting
rights are not diluted by more than 20%, and the articles of incorporation of their corporation are not
changed in the merger) (MBCA §11.03(g))
3. After approval, the plan of merger is filed with the state corporations commissioner and the merger
becomes effective as set forth in the merger plan.
2. Sale of Assets (GCL §271)
a. An alternative method of transferring ownership and control of corporate assets from one corporation to another
is to convey title by one or more bills of sale.
b. Differences between assets sales and mergers
1. the corporation selling assets does not automatically go out of existence upon consummation of the sale
(although it can, by following the asset sale with a dissolution)
2. the selling corporation need not transfer all of its assets, as will occur in a merger
3. the liabilities of the selling corporation will not necessarily pass to the purchasing corporation by operation
of law (may contract out of liabilities; unforeseen liabilities of selling corporation do not follow)
c. However, an asset sale can be structured to achieve the same results as a merger
1. a corporation sells all of its assets to another corporation
2. the purchasing corporation assumes all liabilities of the selling corporation
3. the selling corporation dissolves simultaneously with the consummation of the sale
4. the disappearing corporation distributes to its shareholders the shares or other consideration received in the
d. If the directors of a corporation wish to sell substantially all of the corporation’s assets, other than in the
ordinary course of business (wholesalers don‟t count), they must submit the proposal to their shareholders
for approval, normally by majority vote.
1. Delaware: shareholders of the selling corporation get a vote but are not provided appraisal rights
2. Shareholders of the acquiring corporation don’t get a vote, and thus no appraisal either. (Delaware
3. Triangular Mergers and Compulsory Share Exchanges
a. Triangular Mergers
1. Triangular merger transactions leave the acquired corporation in existence (for tax, regulatory, or
contractual reasons), but still permit the acquiring company to purchase the enterprise in one corporate
transaction as opposed to many individual transactions.
2. Keeps liabilities of the subsidiary separate from the parent company. Must pierce the corporate veil in
order to get to the assets of the parent company. Relatively easy transaction.
3. The Triangular Merger
a. First, the acquiring corporation incorporates a new entity as a wholly owned subsidiary, capitalizing
the new entity with shares of the parent or other consideration that will be used in the acquisition.
Second, the new subsidiary merges into the target (the acquired company can also merge into the new
c. The shareholders of the acquiring corporation, not directly involved in the merger will not usually get
voting or appraisal rights. (Since rights of subsidiary are indirect, those rights exercised by board.)
b. Compulsory Share Exchange (MBCA §11.02)
1. A compulsory share exchange is a new statutory proceeding that, like a reverse triangular merger
(acquiring subsidiary merges into the acquired corporation), permits one corporation to acquire all the
shares of another while leaving the acquired corporation in existence.
2. Accomplished by simple majority vote of shareholders of the acquired corporation, but needs board
approval only from the acquiring corporation
3. Nonconsenting shareholders are forced to give up their shares subject to their appraisal rights.
4. Shareholders of the acquiring corporation do not receive appraisal rights.
4. Short Form Mergers (GCL §253)
a. Merger between parent and subsidiary – Allows parent to merge subsidiary into itself, as long as the parent
owns 90% of the subsidiary‟s stock.
b. No vote or notice to the shareholders of the subsidiary is required, rather shareholders of subsidiary are
guaranteed appraisal rights.
C. Dissenter’s Right to Appraisal
1. Introduction (GCL §262)
a. If the shareholder dissents when asked to approve a merger or other covered transaction, and if the transaction
nonetheless obtains the requisite shareholder approval, the dissenting shareholder may demand that her shares
be repurchased by the corporation for fair value.
b. If the dissenting shareholder and the corporation cannot agree to a price, then fair value is determined by
1. Delaware G.C.L. §262 -- the shareholder will receive the judicially determined fair value, plus interest,
even if that amount is less than what the corporation offered to shareholders as part of the terms of the
merger. (court can award the corporation legal costs too)
c. Appraisal rights were the tradeoff for the loss of voting power caused from the move from unanimous to
d. Used as a check on conflicting interest transactions
2. Scope of the Appraisal Remedy
a. Statutory Rules (GCL §262)
1. From a policy standpoint, appraisal should be given for transactions where
a. the merger will require the shareholder to invest in a fundamentally different enterprise or will
constitute a cash out and final settling-up of the shareholder‟s investment
b. other protective devices (such as the market or fiduciary litigation) are likely to be ineffective or more
costly in protecting shareholders‟ investment expectations
2. Delaware: Extends appraisal rights to mergers only, not to other control transaction.
a. Market exception: Delaware denies appraisal rights to shareholders that own shares (i) listed on a
national securities exchange (ii) held of record by more than 2,000 holders (GCL §262(b)(1))
b. Exception to exception: If denied appraisal rights under (b)(1) shareholder may get appraisal rights
back if she receives consideration other than (i) stock of surviving corporation (ii) publicly traded
stock of some other corporation (iii) cash in lieu of fractional shares (i.e. merely cash or non-publicly
traded shares) (GCL §262(b)(2))
c. Applies only for share-for-share exchanges, appraisal is available if a shareholder must take cash for
b. The De Facto Merger Doctrine (gilberto: see p. 686-7)
a. In a de facto merger case, shareholders who have been excluded from voting or appraisal rights ask
courts to recharacterize a sale of assets, triangular merger, or other control transaction as a de facto
merger requiring voting and appraisal rights.
b. Farris (Pa.1958)(p.742): illustration of substance over form
c. Does this contradict legislative intent, which has separate provisions worthy of equal respect?
d. REJECTED IN DELAWARE (Independent Legal Significance Doctrine)
2. Applestein (NJ.Superior. 1960) (p.687)
a. Facts: United entered into an agreement for an “exchange of Interstate stock for United stock,” not a
merger. Through this exchange, United would wholly own Interstate, and Epstein, Interstate‟s sole
shareholder, would acquire 40% of United stock, and become United‟s president and director, having
“effective control.” United will assume all Interstate‟s assets and liabilities, and will be dissolved.
United will increase its board from 7 to ll directors. The transaction was submitted for shareholder
approval solely because of NYSE rules. No appraisal rights were granted to minority shareholders.
b. Holding: The transaction was a merger. The proposed corporate action is therefore invalid because it
was not submitted for the required two-thirds approval.
1. Epstein argues that this was a purchase of all of Interstate‟s assets, followed by a merger of United
with its subsidiary, Interstate- granting no appraisal rights.
2. General Rule: When a corporation buys the stock of another corporation, stockholder approval is
not required, and objecting shareholders of the purchasing corporation have no appraisal rights.
But when the transaction is a merger in substance, minority shareholders get appraisal
3. Factors Indicating De Facto Merger:
a. a transfer of all the shares and all the assets
b. an assumption of liability
c. a “pooling of interests” of the two corporations
d. the absorption of the acquired company, and its dissolution
e. a joinder of officers and directors of both corporations on an enlarged board of directors
f. the present executive and operating personnel of the acquired company are retained
g. the shareholders of the absorbed corporation receive shares in the surviving corporation
4. There is no distinction in a merger between the acquired and the acquiring corporation
5. Rationale: Shareholders should not be forced against there will into something fundamentally
different from that for which they bargained when they acquired their shares.
3. Hariton v. Arco Electronics, Inc. (Del. 1963) (p.749)
a. Facts: A sale of assets under Delaware G.C.L. §271 for shares of the purchasing corporation was
effected. The agreement of sale dissolved the selling corporation and distributed the shares so received
to stockholders of the seller, so as to accomplish the same result as a merger. Is the sale legal? This
was done by:
1. Arco agrees to sell all its assets to Loral for shares of Loral
2. Arco calls a shareholder meeting to approve dissolution
3. Arco distributes the shares it received from Loral as a liquidation.
b. Holding: The reorganization accomplished through §271 and a mandatory plan of dissolution (§275)
is legal. This is so because the sale of assets statute and the merger statute are independent of each
other. Independent Legal Significance Doctrine
Delaware courts rejected a case similar to Farris in Orzeck, reaffirming the independent legal
significance of action taken under one section, as opposed to other sections.
D. The Intersection Between the Appraisal Remedy and Fiduciary Duty-Based Judicial Review
1. Controlling Shareholder Dominated Mergers
a. The Business Purpose Approach (§13.02(b))
1. Delaware, in 1977 (Magnavox) – held that the controlling shareholder cannot carry its burden of showing
the entire fairness of the transaction if the merger was caused “for the sole purpose of eliminating a
minority on a cash-out basis.”
2. Coggins v. New England Patriots (Mass. 1986) (p.705)
a. Facts: To reorganize the Patriots and secure 100% ownership, Sullivan merged the Patriots into a new
corporation, and eliminated the nonvoting stock on a cash-out basis. The merger was approved by
each class of stock by majority. Coggins was upset that he was forced to sell.
b. Holding: No legitimate corporate purpose was served by freezing out the minority, nonvoting
shareholders. The merger was used merely to facilitate the repaying of indebtedness by Sullivan
individually (which he acquired in financing his bid for complete team ownership).
1. Judicial Review-- Fairness test applies because Sullivan was a director and controlling
shareholder on both sides of the transaction in a freeze-out merger.
a. Step #1: Business Purpose Test - the elimination of public ownership must be in furtherance
of a legitimate corporate purpose.
b. Step #2: the court should then proceed to determine if the transaction was fair to the minority
by examining the totality of the circumstances.
2. Burden of Proving legitimate business purpose and fairness is on the defendants in a freeze out
3. Rationale for Business Purpose: A director of a corporation violates his fiduciary duty when he
uses the corporation for his or his family‟s personal benefit in a manner detrimental to the
b. The Weinberger Approach (gil, p. 712)
1. Delaware Block Method – in appraising “fair value,” this method requires the court to determine the
corporation‟s asset value, appropriately weigh these values, and then add the weighted values together to
arrive at a “fair value.” (Tends to yield lower value)
2. When a fiduciary duty is breached, appraisal is not the sole remedy. A court may order an accounting,
3. Weinberger v. UOP, Inc. (Del. 1983) (p.714)
a. Facts: Plaintiffs challenged the elimination of UOP‟s minority shareholders by a cash-out merger
between UOP and it majority owner, The Signal Companies, Inc.
b. Holding: burden is on defendant to show entire fairness when on both sides of the transaction
1. D may push burden back to plaintiff by showing a disinterested ratification of INFORMED
2. dispenses with Delaware block method of appraisal in favor of a more liberal, flexible approach-
any techniques or methods which are generally accepted in the financial community
3. appraisal is the exclusive remedy in a cash out merger, except where overreaching, waste,
misrepresentation, or fraud is shown
4. eliminates the business purpose test used in Singer.
A plaintiff in a suit challenging a cash-out merger must allege specific acts of fraud, misrepresentation,
or other misconduct to demonstrate the unfairness of the merger terms to the minority.
Signal, as majority shareholder in UOP, owed a fiduciary duty to both its own stockholders as well as
c. Fairness: encompasses both fair dealing and fair price
1. Fair dealing - involves questions of when the transaction was timed, how it was initiated, structured,
negotiated, disclosed to the directors, and how the approvals of the directors and the stockholders were
2. Fair price - relates to the economic and financial considerations of the proposed merger, including all
relevant factors: assets, market value, earnings, future prospects, and any other elements that affect the
intrinsic or inherent value
3. The entire fairness standard of review applies even where disinterested shareholder approval or an
independent board shifts the burden onto plaintiff
d. Effect: Trying to make valuation procedures the same in appraisal action and class action. However,
recissionary damages are not available in appraisal proceedings. Weinburger allows recissionary
damages by showing fraud, misrepresentation, illegality, or some other misconduct. Since
shareholders must show fraud or misrepresentation in order to get the class action in the first place, it
will be easy to show that shareholders should get recissionary damages. That means that the decision
will have little effect on incentives to bring a class action.
VIII. Hostile Takeovers
A. The Market for Corporate Control
1. A potential acquirer who seeks control without the consent of the current control group can
a. make a tender offer seeking to buy sufficient shares to gain control of the board, or
b. launch a proxy fight seeking the authority to vote sufficient shares to gain control of the board of directors
a. In a large corporation where shareholders lack the ability or incentive to investigate an offer, there is the
possibility of shareholders accepting inadequate offers.
b. The Williams Act and 1934 Act require increased disclosure to prevent outsiders from taking advantage of ill-
1. Under §14(d)(1), a tender offeror must disclose
a. its identity and background
b. the source of funds used to make the purchase, and
c. the purpose of the purchase, including any plans to liquidate or change corporate structure.
2. a tender offer must remain open for 20 business days, blocking a bidder‟s effort to force hasty decisions.
SEC Rule 14e-1(a).
3. if more shares are tendered than the bidder sought to purchase, the bidder must buy a pro rata portion from
each shareholder. This prevents use of a first-come, first-served strategy to pressure shareholders.
§14(d)(6) of the 1934 Act.
4. Bidder must pay the same price for all shares purchased. §14(d)(7).
3. Significant Premiums are Paid to shareholders of the acquired corporation
a. Coffee explains this in four ways:
1. Disciplinary hypothesis: replace inefficient management (creates wealth)
2. Synergy hypothesis: target has a unique value to the bidder in excess of its value to the market generally
3. Empire building hypothesis: bigger is better. (transfers wealth)
4. Exploitation hypothesis: trap shareholders in prisoner‟s dilemma when stock price is depressed under its
value- they sell rather than risk future declines. (transfers wealth)
b. Black has another view- Bidding leads to the winner‟s curse (bidders must offer substantially less than they
think an asset is worth, and be prepared to have only a fraction succeed)
c. Kraakman- mispricing behavior introduced by market noise leads to “bubbles”
4. Definition of Terms
1. bidder/raider- the acquiring company
2. target- company sought to be acquired
3. white knight- a second bidder, thought to be friendly to target management, who makes an offer to rescue
the target from a hostile bidder
4. white squire- a friendly party who acquires a large block of target stock with the acquiescence of target
management, but who does not acquire control
5. Arb/arbitrageurs- regular market participants who seek to make money by short term purchase or sales of
stock when a they deem a company to be “in play”
b. Bust-up takeover- bidder seeks to break up the target and sell it off in pieces
c. Junk bonds- used to finance raiders, they are highly risky and therefore offer a higher premium
d. Front-end loaded tender offer- Two tiered tender offer
1. step #1: the bidder acquires a controlling interest in the target via a tender offer, usually for cash
2. step #2: the remaining shares are acquired through merger, using the controlling interest to push it through
3. In a front-end loaded tender offer, the consideration in the tender offer is worth more than the consideration
in the second-step merger.
4. Viewed as coercive because shareholders who do not tender in the first step will be forced to accept less for
the untendered shares in the second step.
e. Golden parachutes/ tin parachutes
f. Greenmail- a target‟s repurchase of its own shares from a raider where the target pays a premium for the shares
to induce the unwanted suitor to go away. (courts uphold against claims of fiduciary duty. Cheff v. Mathes)
g. Lock-ups and termination fees.
1. Termination fees or stock options- to encourage a white knight to bid, these tools compensate the white
knight for acting, even if the deal falls through. Also acts as a liability forced on a hostile bidder seeking
2. Lock-ups- gives the white knight a right to purchase a corporation‟s most valuable assets, making other
bids unlikely because many of the key assets are now promised to the white knight
h. Poison Pills- refers to stock rights or warrants issued to a potential targets‟ shareholders prior to a takeover.
When hostile acquisition occurs, these shareholders may redeem their shares for prices well above market value
or purchase shares in the acquiring company at a reduced price (flip over) after a follow up merger between the
i. Recapitalizations and leverages buyouts (LBOs) by management (MBOs)- to defend, management of the target
may bid for its own shares, financed by heavy borrowings by the corporation or management.
j. Shark repellent amendments (porcupine provisions) to the corporation‟s charter and by-laws
1. supermajority amendments- raise required vote to effect a merger
2. fair price amendments- focus on 2nd step, waiving supermajority provision if a fair price is tendered in 2 nd
stage of takeover, usually “fair price” is high
3. staggered board amendments- prevents wholesale board replacement from occurring at once
4. dual-class capitalization- management shares have multiple votes or public shares have fractional votes,
further entrenching current management
B. Judicial Review of Tender Offer Defenses
1. Traditional Business Judgment Review
a. Cheff v. Mathes (Del. 1964) (p. 820)
1. Facts: Target corporation defended takeover by buying back its own shares at a price above market, in
order to prevent a raider from coming in and changing its furnace sale policies.
2. Holding: The board decided in good faith that corporate policy was threatened, so business rule applied.
a. Rule: If the board had a good faith belief that it was acting for a proper purpose to serve the
corporation, business judgment presumptions apply in reviewing actions taken.
b. Business Purpose Test
1. if the actions of the Board were motivated by a good faith belief that the buying out of the
dissident stockholder was necessary to maintain what the board believed to be proper business
practices, the board will not be held liable for such decision, even though hindsight indicates the
decision was not the wisest course
2. however, if the board has acted solely or primarily because of the desire to perpetuate themselves
in office, the use of corporate funds for such purposes is improper.
c. Burden of Proof
1. Lies initially with Board of Directors, because it has a conflict of interest
2. burden is satisfied by a showing of reasonable grounds to believe there‟s a danger to corporate
policy and effectiveness presented by hostile stock ownership. (i.e. good faith and reasonable
2. The Enhanced Scrutiny Framework
1. The Revlon duty to secure the best value reasonably available to shareholders attaches when there is:
a. a change in corporate control
b. a break-up of the corporate entity
2. If the Revlon duty does not attach, defensive measures are permitted if they satisfy the Unocal criteria:
a. reasonable grounds for believing that a danger to corporate policy and effectiveness existed
(satisfied by demonstrating good faith and reasonable investigation)
b. defensive measure was reasonable in relation to the threat posed.
3. Non-Shareholder Constituencies: Directors may consider the interest of other constituencies if there is
“some rationally related benefit accruing to the stockholders. Revlon
4. If Revlon duties do not attach, and the Unocal criteria are satisfied, use business judgment presumptions.
b. The Unocal Doctrine
1. Unocal Corp. v. Mesa Petroleum Co. (Del. 1985) (p.885)
a. Facts: At issue is the validity of a corporation‟s self-tender for its own shares which excludes from
participation a stockholder making a hostile tender offer for the company‟s stock. The directors acted
in good faith in concluding, after reasonable investigation, that Mesa‟s two-step tender offer was both
inadequate and coercive. Unocal‟s objective was to either defeat the tender offer, or compensate
shareholder‟s at the back-end of Mesa‟ proposal. Including Mesa would defeat that goal.
b. Holding: The selective exchange offer is reasonable in relation to the threat posed by Mesa‟s coercive
two-tiered tender offer, therefore the board acted in the proper exercise of sound business judgment.
The Court will not substitute its views for those of the board if that decision can be “attributed to any
rational business purpose.”
1. In the acquisition of its shares, a corporation may deal selectively with its stockholders, provided
that the directors have not acted for the purpose of entrenching themselves.
2. Enhanced Scrutiny
a. because of the possibility that the board may be acting in its own interests, there is an
enhanced duty which calls for judicial examination at the threshold before the protections of
the business judgment rule apply
3. For the Business Judgment Rule to apply:
a. First, the defensive measure must be reasonable in relation to the threat posed. (Unocal)
1. possible concerns:
a. inadequacy of the price offered
b. nature and timing of the offer
c. questions of illegality
d. the impact on “constituencies” other than shareholders
e. risk of the deal falling through
f. quality of securities offered as consideration
b. Second, directors must show good faith and a reasonable belief that the raider will thwart
corporate policy and effectiveness. Their showing is materially strengthened by the approval
of a board comprised mainly of outside independent directors.
4. Summary: Once it is shown that the defensive measure is reasonably related to the threat posed,
if the directors are disinterested and acted in good faith (which is plaintiff‟s burden to prove
otherwise), its decision in the absence of an abuse of discretion will be upheld as a proper exercise
of business judgment.
c. The Revlon Rule
1. Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc. (Del. 1986) (p.856)
a. Facts: Pantry Pride attempted to acquire Revlon with Forstmann acting as white knight. Pantry Pride
and Forstmann entered into a bidding war for control of Revlon, whose breakup was inevitable. To
defend against the hostile takeover, Revlon bought shares financed by notes. To protect against
liability on the notes incurred if Revlon was sold to Pantry Pride, Revlon employed lock-up,
termination fee, and no-shop agreements.
b. Holding: Because nothing remained for Revlon to protect, no rationally related benefit accrued to
shareholders as a result of the auction-ending merger agreement with Forstmann. The principal benefit
went to the directors who avoided liability to creditors at the expense of shareholders. The directors
thereby breached their duty of loyalty. When the sale of a company is unavoidable, the duty of the
Board shifts from preservation of the corporate entity to the maximization of the company’s sale
value for stockholders.
d. Refining Revlon and Unocal
1. Paramount Communications, Inc. v. Time, Inc. (Del. 1990)(p.868)
a. Facts: Paramount made an all-cash offer for all the shares of Time. Both to implement a
preexisting corporate strategy and to stave off Paramount, Time entered into a business
combination with Warner. Paramount challenged the move.
b. Holding: The dissolution or breakup of Time was not inevitable, therefore no Revlon duties attach.
Under Unocal, the board reasonably investigated and decided that Paramount‟s offer was not in its best
interests. Time had researched and decided that Warner was the best fit, maintaining the “Time
culture” while expanding into telecommunications. Time repeatedly maintained that it was not for sale.
The Board felt that Paramount‟s bid threatened the Time culture.
c. Because it had a proper purpose to defend against Paramount, the act of carrying forward an existing
transaction in another form was reasonably related to the threat. Therefore, business judgment
1. The distinction of “long-term” vs. “short-term” values is irrelevant because directors must decide
the corporation‟s best interests without a fixed investment horizon.
2. Without excluding other possibilities, two circumstances implicate Revlon duties:
a. when a corporation initiates an active bidding process seeking to sell itself or to effect a
business reorganization involving a clear break-up of the company
b. where, in response to a bidder‟s offer, a target abandons its long term strategy and seeks an
alternative transaction involving the breakup of the company. (this one happened in Revlon)
c. Revlon duties are not triggered, though Unocal duties are, if the board‟s reaction to a hostile
bid is found to constitute only a defensive response and not an abandonment of the
corporation‟s continued existence.
2. Paramount Communications, Inc. v. QVC Network, Inc (Del. 1993) (p.929)
a. Facts: Paramount entered into a merger agreement relinquishing corporate control to Viacom and
agreed to no-shop, termination fee, and stock option provisions that were unusual and highly beneficial
to Viacom. QVC made a tender offer for Paramount, but Paramount decided that QVC‟s bid was not
in its best interests, and never used this leverage to modify its original agreement.
b. Holding: Both Revlon and Unocal duties are implicated. The Paramount board initiated an active
bidding process to sell itself by agreeing to sell control of the corporation to Viacom. Paramount
breached its duty to secure share value by giving insufficient attention to the potential consequences of
the defensive measures demanded by Viacom, and doing nothing to remove these measures which
were impeding the realization of the best value reasonably available to stockholders.
1. When bidders make relatively similar offers, or dissolution of the company becomes inevitable,
the directors cannot fulfill their enhanced Unocal duties by playing favorites.
2. The Revlon duty to secure the best value available to shareholders attaches when there is:
c. a change in corporate control
d. a break-up of the corporate entity
3. Paramount director duties included:
a. to be diligent and vigilant in examining the Paramount-Viacom transaction and the QVC
b. to act in good faith and gather all relevant information necessary to provide the best value
reasonably available to shareholders
c. to negotiate actively both with Viacom and QVC
IX. Federal Law Affecting Corporate Transactions
1. Disclosure makes the exercise of shareholder suffrage more informed
a. Disclosure is the key methodology used in federal law relating to corporate transactions
1. The 1933 Act requires substantial disclosure before the initial issuance of securities unless the transaction is
2. The 1934 Act requires disclosure triggered by quarterly and annual reports [§13]; proxy solicitations
[§14a]; tender offers [§14d]; acquisition of more than 5% of a company‟s stock by third parties [§13d] or
the issuer [§13e]; or insider trading [§16 and Rule 10b-5].
b. The 1934 Act applies only to those corporations listed on a stock exchange or having more than $10 million in
assets and a class of equity securities held by more than 500 shareholders (§12)
1. Exception: Rule 10b-5 applies to fraud in connection with the purchase or sale of any security
c. Disclosure is also an essential part of fiduciary duty
B. Liability Under the Proxy Rules
1. Coverage of §14(a)
a. Relevant Statutes: SEC Act of 1934 §14a; SEC Rules 14a-1 thru 14a-15 and Schedule 14A; SEC Rule 19c-4
b. The federal proxy rules apply to oral or written solicitation of proxies, and are intended to protect shareholders
against unfair treatment in connection with voting, by requiring disclosure and by substantive regulation
1. Rule 14a-3 lists disclosure requirements
2. Rule 14a-4 describes the proxy form
3. Rule 14a-9 creates an implied private cause of action;
4. Rule 14a-9 prohibits solicitation by any proxy statement, notice of meeting, or other oral/written
communication containing any materially misleading statement/omission
5. Rule 14a-8 provides shareholders the ability to communicate using the proxy
2. Rule 14a-9 prohibits any false or misleading statement of a material fact or any omission necessary to make
an included statement not misleading or to correct a statement that has become misleading
Authority for Rule 14a-9: Section 14a of the 1934 Act authorizes the SEC to regulate proxy solicitations “as
necessary or appropriate in the public interest or for the protection of investors.”
Implied Private Cause of Action
1. Relevant Statutes: SEC Act of 1934 §§14(a), 27
2. Rule 14a-9 does not expressly provide for a private cause of action
3. Rule 14a-9 is viewed as an antifraud provision and the elements of common law fraud or the tort of deceit
have been used as guidance:
a. misrepresentation or omission
b. of a material fact
c. with scienter
d. on which plaintiff relies (causation)
Express Cause of Action: Section 21 of the 1934 Act permits the SEC to bring civil actions for violation of the
act and §32 provides for criminal penalties.
4. J.I. Case Co. v. Borak (1964) (p.1040)
a. Facts: It was alleged that a merger was effected by the circulation of a false and misleading proxy.
a. Issue: Whether §27 of the 1934 Act creates a federal cause of action to a corporate stockholder with
respect to a consummated merger authorized pursuant to the use of a proxy statement alleged to
contain false and misleading statements violating §14(a) of the Act.
b. Holding: Private parties have a right under §27 to bring suit for violation of §14(a) of the Act.
1. This right of action exists both directly and derivatively.
2. The possibility of civil damages serves as an effective weapon in the enforcement of the proxy
requirements of §14.
3. That state law questions must be decided doesn‟t preclude a federal question. Federal claims for a
disclosure failing under §14 usually imply violation of fiduciary duty, which is also a state claim.
4. In Touche Ross v. Redington, the Supreme Court changed course to deny that §17(a) provides a
private damages action on behalf of broker’s customers. Plaintiff’s rights must be found in the
substantive provisions of the Act, not in §27.
a. Misrepresentations or Omissions of a Material Fact
1. TSC Industries, Inc. v. Northway, Inc. (1976) (p.1046)
a. Holding: There must be a substantial likelihood that the disclosure of the omitted fact would
have been viewed by the reasonable investor as having significantly altered the “total mix” of
information made available (or, would consider in important when deciding how to vote.)
1. Summary Judgment is rarely appropriate under this test.
2. Virginia Bankshares, Inc. v. Sandberg (1991) (p.1049)
a. Facts: Freeze out merger where 15% of the shares were held by minority shareholders. Investment
bankers said that $42 would be a fair price. The proxy described this price as “high” and “fair.”
b. Holding: If the offer was not a “high” value for the shares, and the directors knew it, they‟re liable.
1. Statements of Belief and Opinion are Material
a. A statement of belief by corporate directors about the recommended course of action, or an
explanation of their reasons for recommending it, can be material – there is a substantial
chance that a reasonable shareholder would consider it important in deciding how to vote.
b. Shareholders know directors have superior knowledge
2. Statements of Reason or Belief are Factual
a. the directors act for the reasons given or hold the belief stated
b. conclusory terms in a commercial context are reasonably understood to rest on a factual basis.
c. BUT, when X falsely claims to believe Y, the deceit is actionable only when Y is objectively
false – otherwise any statement would be subject to review on the basis of a director‟s
skepticism (fear of strike suits)
c. Scienter: Open question whether a showing of intent is required to establish liability
1. The Second Circuit held that negligence was sufficient to establish liability under §14(a).
2. But in Ernst & Ernst v. Hochfelder the Supreme Court held that intentional conduct is necessary to
establish liability under Rule 10b-5.
C. Rule 10b-5 as Applied to Corporate Transactions
1. Introduction (1934 Act §§10(b) and 18, and Rule 10b-5)
a. Rule 10b-5 remedies fraud only in connection with the purchase or sale of securities.
b. Implied private cause of action exists.
2. Rule 10b-5 Elements: Private Causes of Action
Fraud or deceit
By any person
In connection with
The purchase or sale
Of any security (not just nationally traded securities)
Will usually see a foreseeability analysis, plaintiff must show that there was a “material misrepresentation or
omission disseminated to the public, on which the plaintiff relied, which induced him to purchase or sell a security.”
3. Standing; In Connection with a Purchase or Sale
a. Birnbaum v. Newport Steel Corp. (2nd Cir. 1952) (p.1008)
1. Facts: D, as president and 40% shareholder, broke off a merger that would have been profitable for the P‟s,
who allege D made fraudulent misrepresentations to the stockholders of Newport.
2. Held: Plaintiffs were neither purchasers nor sellers in Feldman‟s transaction, therefore Rule 10b-5 doesn‟t
apply. 10b-5 doesn’t cover corporate insiders who aren’t buyers/sellers, nor does it cover fraudulent
mismanagement of corporate affairs.
3. NOTE: “Fraudulent mismanagement of corporate affairs” goes to a breach of fiduciary duty. There is a
cause of action under state law. Would only need to allow such claims in federal court if the state law
procedures were not working. There is no indication of that. And, produces problems of federalism.
b. Superintendent of Insurance v. Bankers Life & Casualty Co. (1971) (p.1012)
1. Facts: investor Manhattan was injured by a deceptive device that deprived it of any compensation for the
sale of a valuable block of securities.
2. Holding: 1) Manhattan was injured as an investor through a deceptive device which deprived it of any
compensation for the sale of its valuable block of securities. 2) Section 10(b) must be read flexibly not
technically and restrictively. Since there was a “sale” of a security and since fraud was used “in connection
with,” it, there is redress under §10(b). 3) Crux of the present case is that Manhattan suffered an injury as
a result of deceptive practices touching its sale of securities as an investor.
Scope of standing is potentially huge under the “touching” standard
Bankers Life is as far as the court was willing to go on 10b-5 litigation.
Complete change of tone when we get to Blue Chip Stamps
c. Blue Chip Stamps v. Manor Drug Stores (1975)(p.1016)
1. Facts: Alleged that Blue Chip intentionally made the prospectus overly pessimistic in order to discourage
respondents, so that the rejected shares might later be offered to the public at a higher price.
2. Holding: A Rule 10b-5 private action is limited to actual purchasers and sellers of securities.
a. The Birnbaum rule bars 3 potential classes of plaintiffs:
1. Potential purchasers of shares who allege that they decided not to purchase because of an unduly
gloomy representation or the omission of favorable material which made the issuer appear to be a
less favorable investment vehicle than it actually was.
2. Actual shareholders who decided not to sell because of an unduly good representation.
3. Shareholders, creditors, and others who suffered loss in value due to corporate insider activities in
connection with the purchase or sale of other securities.
b. Court is trying to limit potential abuse of Rule 10b-5; risk of uncorroborated oral evidence that a
plaintiff decided not to sell because of a prediction that later turned out to be wrong.
d. Santa Fe Industries, Inc. v. Green (1977) (p.1022)
1. Facts: Delaware short form merger used by a majority shareholder to eliminate the minority interest.
Minority shareholder claimed insufficient consideration was paid, but did not pursue their appraisal remedy
in state court. No manipulation or deception was shown.
2. Holding: If a corporate manager breaches a fiduciary duty but without any misrepresentation,
nondisclosure, or manipulation, he does not violate rule 10b-5.
a. Manipulative or Deceptive: The claim of fraud and fiduciary breach states a claim under Rule 10b-5
only if the conduct alleged is “manipulative or deceptive.”
b. Manipulative refers to practices, such as wash sales, matched orders, or rigged prices, that are intended
to mislead investors by artificially affecting market activity.
c. §10(b)‟s purpose was to promote full disclosure, once full disclosure made, the fairness of the
transaction is of tangential concern.
d. State regulation governs fiduciary violations where fraud is absent.
D. Implied Elements of 10b-5 Cause of Action
1. Misrepresentation of Omission of a Material Fact
a. Basic v. Levinson (1988) (p.1033).
1. Facts: Directors publicly denied rumors about merger discussions, even though talks were taking place.
2. Holding: 1) The fundamental purpose is full disclosure 2) With respect to contingent or speculative
information or events, materiality will depend at any given time upon a balancing of both the indicated
probability that the event will occur and the anticipated magnitude of the event in light of the totality of the
company activity. 3) Inquiry based on fact – looking at board resolutions, instructions to investment bankers,
and negotiations b/w principles (FACT SPECIFIC BALANCING APPROACH)
3. Simply because you know of material information, it does not mean that you have a duty to disclose the
information. If it were simply silence or “no comment” then there would be no problem. However, these
directors made a statement that they were not involved in negotiations when they actually were. Once you
speak, you have a duty to speak accurately and truthfully.
4. NOTE: Periodic Disclosure System: Duty to disclose has a temporal nature. Companies may have the
ability to not disclose information for a considerable time, before the duty arises. However, SEC is now
looking for a rapid and current basis of disclosure, so this gap in time may disappear in the future.
c. In re Time Warner, Inc. Securities Litigation (1993) (p.1041)
1. Whether a corporation has a duty to update somewhat optimistic predictions about achieving a business
plan when it appears that the plan might not be realized – YES
2. Whether a corporation has a duty to disclose specific alternative to an announced business plan when
that alternative is under active consideration – YES
3. Whether a corporation is responsible for statements in newspapers and security analyst reports that are
attributed to unnamed corporate personnel – NO
4. Duty to Correct: When a corporation makes an inaccurate statement, the company has a duty to retract
statement or correct the statement by announcing it to the public. Presumption is that the statement is
incorrect when the statement is made.
1. Objective safe harbor: Forward-looking statements are protected when accompanied by “meaningful
cautionary statements identifying important factors that could cause actual results to differ materially.
(“bespeaks caution” doctrine) Cautionary language, if sufficient, renders the alleged omissions or
representations immaterial as a matter of law. Statements made with “actual knowledge” that the
statement was false or misleading are excluded. (LICENSE TO LIE)
2. Subjective safe harbor: Plaintiff must prove that the statement was either false or misleading. No way
that reasonable person making this statement could have believed that the statement was true.
3. Boilerplate risk factors will not be enough.
a. Ernst & Ernst – scienter is a required element for an injunctive action under Rule 10b-5 (negligence is not
enough) Left undecided whether scienter is a necessary element for damages actions; and whether in some
circumstances reckless behavior is sufficient for civil liability
b. Central Bank of Denver – liability cannot be imposed under Rule 10b-5 because a person aided and abetted a
violation of the Rule
c. Agent Exception: any person or entity, including lawyer, accountant, or bank, who employs a manipulative
device or makes a material misstatement (or omission) on which a purchaser or seller of securities relies may be
liable as a primary violator under 10b-5, assuming all of the requirements for primary liability are met.
3. Reliance and Causation
Plaintiff must show:
1. D‟s conduct plaintiff to act
2. Proximate (loss) causation – material omission or act is what actually caused the loss and not something else
a. OMISSION (Face-to-Face Transaction)
Affiliated Ute Citizens – So long as duty to disclose and omission of material fact, then presume reliance.
b. AFFIRMATIVE MISREPRESENTATION (Fraud on the Market Theory)
Basic v. Levinson (1988) (p.1055)
3. Held: Where materially misleading statements have been disseminated into an impersonal, well-developed
market for securities, the reliance of individual plaintiffs on the integrity of the market price may be presumed.
4. Rebuttable Presumption: any showing that severs the link between the alleged misrepresentation and either the
price received (or paid) by the plaintiff, will be sufficient to rebut presumption.
a. Market makers were privy to the truth (“total mix” - materiality)
b. News of the merger discussions credibly entered the market and dissipated the effects of misstatements
(“total mix” - materiality)
c. Plaintiff believed statements were false, and consequently believed stock artificially overpriced
(underpriced), but sold (bought) shares nevertheless because of unrelated concerns [no plaintiff will
actually testify to this]
1) VERY DIFFICULT FOR THE DEFENDANT TO REBUT RELIANCE OUTSIDE OF ATTACK
2) Misrepresentation sends false pricing signals
3) Need this rule for class actions
5. DISSENT: 1) Presumption of reliance based on “integrity” of price suggests that stocks have some “true value”
that is measurable by a standard other than their market 2) many investors purchase or sell stock because they
believe the price inaccurately reflects the corporation‟s worth (PERINO SAYS ONLY STATING TRUANCY)
4. Measure of Recovery
a. Out-of-pocket measure – fixes recovery at the difference between the purchase price and the value of the stock
at the date of purchase
b. PERINO OBJECTION: Damage calculation extremely difficult and substantially overvalues the social cost of
fraud. Because the persons who benefit on the front end and the persons who are injured on the back end tend
to cancel each other out. Essentially the damage measurement produces a wealth transfer with large transaction
costs and large opportunity costs.
X. Insider Trading
A. The Common Law Foundation for Rule 10b-5
1. Majority rule: directors purchasing stock from shareholders had no fiduciary duty to the shareholders (minority
rule is to the contrary)
2. An alternative common law approach focused on duty to the corporation and the unjust enrichment of the insider.
a. “a corporate fiduciary, who is entrusted with potentially valuable information, may not appropriate that asset for
his own use even though, in so doing, he causes no injury to the corporation.” -- the prestige and good will of
the corporation could be ruined by insiders
b. Insiders have an inherent unfair advantage over others
B. Rule 10b-5 as a Regulator of Insider Trading
1. Under Rule 10b-5, a corporate insider who has material non-public information about the enterprise is
under a duty either to abstain from trading or first to disclose the nonpublic information. In re Cady, Roberts,
Insider Trading Analysis
1) Chiarella - classic theory of liability - links disclosure w/ fiduc. duty
2) Dirks - tippee‟s liab. is derivative of tipper‟s liab.
3) O‟Hagan and misappropriation theory
2. Insider Trading as Fraud
a. Securities and Exchange Commission v. Texas Gulf Sulphur Co. (2nd Cir. 1968) (p. 1233)
1. Facts: Insiders bought up TGS stock based on an undisclosed ore strike, which strike was claimed to be
unverified. The purchases took place over several months, including the day that disclosure was made.
2. Holding: The investors were not trading on an equal footing, even on the day disclosure was made.
a. the expectation in the securities marketplace is that all investors trading on impersonal exchanges have
relatively equal access to material information
b. any insider with access to nonpublic information must either disclose or not trade
c. This doesn‟t affect the incentive to seek information – if anyone could have found that same
information, you may act on it without disclosing (the evil here = acting on inside knowledge)
d. Materiality- An “omitted fact is material if there is a substantial likelihood that a reasonable
shareholder would consider it important in deciding” what to do.
1. materiality depends upon a balancing of the indicated probability of an event‟s occurrence, and the
magnitude of that event
2. the importance those who knew about the event attach to it bears on its materiality
b. Chiarella v. United States (1980) (p. 1249)
1. Facts: Chiarella was a financial printer who, through his job, discovered a merger. He bought up target
company stock, without disclosure, on the basis of this inside information.
2. Holding: A duty to disclose under §10(b) does not arise from the mere possession of nonpublic market
information. Chiarella was not an insider and received no confidential information from the target.
Therefore, he had no affirmative duty to disclose, i.e. no fraud.
a. A purchaser of stock who has no duty to a prospective seller because he is neither an insider nor a
fiduciary has no obligation to reveal material facts.
b. Chiarella was a complete stranger to the target sellers and not an insider of the acquiror.
c. Court abandons TGS “level playing field theory”
c. The equal access approach focuses on plaintiffs, the fiduciary duty approach focuses on the defendants.
1. In Chiarella, the Supreme Court held that silence comes within the fraud prohibition only when there is a
duty to speak
2. In TGS, the defendants had fiduciary duties.
3. Accountants, lawyers, consultants working for the corporation as outsiders, may become fiduciaries to the
shareholders and may act as tippers rather than tippees.
3. Tipee Liability
a. Dirks v. Securities and Exchange Commission (1983) (p. 1260)
1. Facts: Dirks received material nonpublic information from an insider-tipper of a corporation (that D
wasn‟t connected to) about that corporation‟s fraudulent practices. He tried to expose the fraud and then
disclosed it to investors who sold their shares upon discovering the fraud. Did D violate Rule 10b-5?
2. Holding: The tipper received no benefit by disclosing information to the tippee and wanted only to expose
fraud. Therefore, Dirks, as tippee, breached no derivative obligation.
a. A tippee assumes a fiduciary duty to the shareholders of a corporation not to trade on material
nonpublic information only when
1. the insider has breached his fiduciary duty to the shareholders by disclosing the info and
2. the tippee knows or should know that there has been a breach of this duty
b. whether disclosure is a breach of duty therefore depends on the purpose of the disclosure
c. The test is whether the insider personally will benefit, directly or indirectly, from the disclosure.
d. Indirect benefit = tipping friends, family, or a stranger in a quid pro quo relationship.
e. Absent some personal gain, insider hasn‟t breached any duty to the shareholders, and there can be no
derivative breach by tippee.
Burger’s Chiarella dissent - there should be liability whenever informational advantage is obtained by some
unlawful means. –What counts is the way in which buyer acquires the info. If it‟s not a result of superior
knowledge, intelligence, skill, technical judgment, or even chance, and it‟s a result of an illegal act, there should be a
duty to disclose.
Arguments against misappropriation (SC rejects them all):
1) O‟H. doesn‟t owe fiduc. duty to corp. whose shares are being traded
2) Breach of confidence wasn‟t in connection w/ purchase/ sale of securities
3) No deception of corp‟s SHs - Santa Fe requires deception to sustain a 10b-5 claim.
Held: Misappropriation violates 10b-5.
1. Misappropriation theory holds that a person violates 10b-5 when he misappropriates confidential info for
trading purposes, in breach of a duty owed to the source of the information.
2. Instead of premising liability on a fiduciary relationship b/t insider and puchaser/seller, liability is premised on
a trader’s deception of those who entrusted him w/ access to confidential info.
a. Classical theory targets a corporate insider‟s breach of duty to SHs. Misapp. theory targets an outsider‟s
breach of duty to the source of the info.
b. Here O‟Hagan couldn‟t be prosecuted under classical theory b/c he was not an insider of Pillsbury.
c. Under misappropriation theory he doesn‟t escape liability simply b/c he was associated w/ the bidder rather
than the target.
3. This makes sense, given the market impact of trading on misappropriated info, and the Congressional purposes
4. This holding is limited to partnerships but could easily be extended to employer-employee relationship,
husband-wife relationship, doctor-patient, etc.
1. Private Recovery: Some courts held that investors could not recover from insider traders without proof that the
trading caused the investor‟s injury
2. Civil government suits: SEC‟s power to combat insider trading has considerably strengthened with provisions
permitting the SEC to recover three times the amount of the trader‟s profits or loss avoided and to also recover
from control persons of the violators.
3. Criminal prosecutions: Criminal prosecutions have increased dramatically since Chriarella.