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Law School Outlines - Business Assoc 2

VIEWS: 168 PAGES: 80

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									BUSINESS ASSOCIATIONS—FALL 2000—PROF. FAIRFAX
I. Introduction, Choice of Entity a. Subject in General i. Classification by business form naturally breaks into two categories: 1. Unincorporated Associations: Other than a general partnership all other business associations require formal filing of documents. a. Proprietorships b. Partnerships: UPA (1914), revised 1994 adopted by almost all states. c. Limited Partnerships: ULPA, most states adopted d. New Forms (Post 1990) i. Limited Liability Company ii. Limited Liability Partnership iii. Limited Liability Limited Partnership 2. Corporations: MBCA, to be used as a model for state statutes. ii. Developments during the last decade have greatly increased the attractiveness of unincorporated forms of business for closely held firms. iii. New Developments 1. The universal recognition of new unincorporated business forms that grant the advantage of limited liability for all owners of the business, particularly the LLC 2. Changes in the Internal Revenue Code income that permit unincorporated firms in effect to elect how they are to be taxed. iv. Statutes 1. State Statutes a. Each state has its own corporation statute 1

b. Model Business Corporation Act (MBCA) represents current thinking on what a corporate statute should look like. c. DE, CA, NY do not follow MBCA d. Same statute applied to mom & pop corporation as applies to General Motors e. Focus of state statutes: rights, obligations, and duties 2. Federal Statutes a. Securities Act of 1933, Securities & Exchange Act of 1934 b. Apply to publicly held corporations: involves disclosure c. Focus: an informed marketplace emphasizes disclosure, letting market forces play out. b. Taxation of Partnerships and Corporations i. Proprietorship: A proprietorship is not a separate taxable entity. Its income or loss is reported on the proprietor’s personal income tax return. ii. Partnerships: The income or loss from the partnership is allocated among the individual partners in accordance with the partnership agreement. Each partner must then include in his or her personal income tax return the amount of each item so allocated. iii. Corporations 1. C Corporation a. Generally, a corporation is taxed as an entity distinct from its owners b. I.E.: It must pay income taxes on any profits that it makes, and generally shareholders do not have pay income tax on the corporation’s profits until the profits are distributed.

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c. Double Taxation: When the corporation does make distributions to shareholders, the distributions are treated as taxable income to the shareholders even though the corporation has already paid taxes on its profits. 2. S Corporation a. S corporations are taxed on a modified conduit basis that is similar in many respects to that applicable to partnerships: i. The corporation files a return showing the earnings allocable to each shareholder. ii. The shareholder must include this amount in his or her personal income tax return. iii. That amount is includible whether or not any distributions are made by the corporation. b. Eligibility for S treatment: To be eligible for S corporation treatment, corporations must have fewer than 75 individual shareholders. 3. Minimizing Corp. Tax a. File an S Corp. election b. Instead of cash distribution of dividends use fringe benefits. c. Limited Liability i. Historically, the corporation was the business form that minimized the likelihood that the entrepreneurs would be personally liable for debts of the business should it fail. HOWEVER, its lack of flexibility and adverse tax treatment increased its cost to owners of closely held businesses. ii. New types of business forms permit limited liability to be introduced into unincorporated entities that combine limited

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liability and partnership tax treatment: LLCs, LLPs, and limited partnerships with corporate general partners. iii. The importance of limited liability depends primarily on possible exposure to tort liability. iv. An individual or partner routinely obtains considerable protection against individual liability simply by the purchase of insurance. v. Doing business in a limited liability form avoids individual responsibility for these often-substantial liabilities in theory. However, the other parties to such contracts are usually sophisticated and well understand the implications of limited liability; if they are concerned about the possibility that a limited liability entity may not have adequate resources to meet its obligations they will demand personal guarantees. vi. To the extent a LLC looks like a partnership or corporation will determine its liability and the authority of its agents. d. Comments on Delaware Corporate Law i. 50% of the companies on the NYSE are incorporated in DE. ii. DE corporate law serves as a “federal” model that many states use. iii. DE has a specialized court that only hears corporate law; a large body of law has been created that provides guidance and precedent that is lacking in other states. II. Partnerships a. Establishing a Partnership i. A partnership can be created through just a handshake or oral agreement. ii. HOWEVER, a written partnership agreement helps to clarify things. 1. It may avoid future disagreements over what the arrangement actually was. 2. The written agreement is readily proved in court.

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3. It may focus attention on potential trouble spots in the relationship which may be unnoticed in an oral agreement. 4. The Internal Revenue Code treatment of partnerships permits partners by agreement to allocate the tax burdens among themselves within limits, and a written agreement is clearly desirable where advantage of such provisions is taken. 5. UPA contemplates that upon the death or retirement of a partner, the business is either to be disposed of or the interest of the deceased partner is to be purchased by the partnership or by the other partners. It is usually sensible for the partners to agree on what should happen in advance of such an event, and such provisions should be in writing since they may affect surviving spouses, executors, and others who are strangers to the agreement and are unfamiliar with their rights. 6. A partner may wish to lend rather than contribute specific property to a partnership. A written agreement clearly identifying that property is contributed and which is loaned is necessary to protect the partner’s interest in the loaned property. 7. Where real estate is to be contributed as partnership property or the agreement includes a term of more than one year, a written agreement may be necessary to comply with the statute of frauds. 8. It’s advantageous to the attorney: not only may it justify a higher fee but also it places suggestions and advice in concrete form so that there is less possibility of misunderstanding. iii. Joint Venture 1. It’s a partnership for a specific task/transaction.

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2. Example: construction of an office building. iv. General Partnership b. Sharing of Profits and Losses i. Rule: Absent any writing profits and losses are divided equally (Richard v. Handly p. 33). ii. Rule: The respective rights and duties of partners or joint ventures cannot be determined until the terms of all agreements between them have been ascertained. (See Richert v. Handly p. 30) iii. A written agreement allows the profits and losses to be divided in numerous ways 1. Flat Percentage Basis 2. One or more partners may be entitled to a fixed weekly or monthly “salary.” 3. Percentage basis with the percentages recomputed each year on the basis of the average amount invested in the business during the year by each partner. 4. Fixed percentage rate 5. ETC. iv. In a partnership all partners are jointly and severally liable for the legal obligations of the partnership. 1. As a partner you have the right to indemnification. 2. Every partner must be served in a civil action1 otherwise the suit can be dismissed. v. According to the 1994 UPA when a plaintiff sues the partnership, they must exhaust the partnership assets before going after the individual partners. c. Management and Authority i. The state in which the partners reside is the state whose law governs the partnership’s activities. ii. Authority, UPA § 9
1

Non-joint/non-severally liable claim

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1. Actual Authority: a. Definition: The words or actions of the principal authorize the agent to act on behalf of the principal. b. Types: i. Implied ii. Express iii. Incidental c. Rule: The acts of a partner, if performed on behalf of the partnership and within the scope of its business, are binding upon all copartners. (See National Biscuit Company v. Stroud) d. Revoking Actual Authority i. Partnership of 2 people: 1. Actual Authority can be revoked by dissolution of the partnership and giving notice to others about it. 2. It can also be revoked if one partner buys out the other partner (assuming there are only two partners). 3. A partner cannot be stripped of his/her authority since there are only two partners. Every partner has an equal vote in a partnership and here the partners will be deadlocked. ii. Partnership with 3 or more people: 1. In this situation the partners can vote to strip a partner of his/her authority. HOWEVER, you can still bind the partnership by using apparent authority. 2. Apparent Authority

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a. Definition: The principal creates an impression in the minds of 3rd parties that his/her agent can act on behalf of them (the principal). b. It’s not enough for an agent to say he has authority. The principal(s) must do something to create an impression in third parties. c. Rule: i. If you act within the scope or apparent scope of your authority it will bind the partnership. (See Smith v. Dixon) ii. Reasoning: It’s not a 3rd party’s duty to figure out the relationship in the partnership. d. Ask what type of authority is it? i. Actual Authority or Apparent Authority? ii. If it’s apparent authority, does the act of a partner fall within the scope of the business? 1. Is it the general product/service part of the business? 2. Are the goods excessive? iii. How do I revoke it? e. In Rouse v. Pollard p. 46, the Court said the investment behavior is outside the scope of behavior for a law firm. i. D had no actual authority. ii. No apparent authority either 1. Law firms in NJ normally don’t normally engage in this type of activity. 2. Investment in mortgages is outside the scope of the law firm’s business.

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iii. If the partners had knowledge but said nothing then it looks like apparent authority is created. iv. Also the Court said P’s reliance was unreasonable. f. It doesn’t matter whether or not the action is illegal. i. Actual authority can bind the partnership. ii. The same can occur with apparent authority. 3. Vicarious Liability a. Roach v. Mead i. Facts: The attorney gave negligent legal advice. The advice falls within the scope of the business (at least the Court thought so). The other partners were held vicariously liable for the attorney’s negligent acts. ii. Rule: Each partner is responsible to 3rd parties for the acts of the other partner when such could reasonably have been thought by the third party to fall within the purpose of the partnership. iii. The attorney should have allowed the client to seek a second legal opinion because of a conflict of interest. b. Reconciling the Roach case and the Rouse case i. Rouse case: reasonableness of P’s assumption ii. Roach case: nature of the legal advice d. Duties of Partners to Each Other i. UPA § 21 ii. Meinhard case p. 54 1. Covers fiduciary duty

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2. Partners have a broad responsibility toward each other. 3. The Court assumed there was no fraud. It was near the end of the 20-year lease period. M had a right to compete in the venture. The Court didn’t like the fact that S had an advantage as manager of the business. S should have put M on equal ground. iii. Fiduciary Duty: joint adventurers owe to one another, while their enterprise continues, the duty of finest loyalty, a standard of behavior most sensitive. A partner has a duty to inform the other partner(s) of the perks/ventures that involve the partnership. iv. Question to Ask 1. Is a transaction incident to the partnership? v. It seems like the manager is held to a higher standard than the passive investor vi. Can the fiduciary agreement be waived? 1. It can’t be totally waived by agreement. UPA 1994 won’t allow it. 2. It can be limited in some aspects by contract. e. Partnership Dissolution i. Dissolution: 1. Dissolution is a change in the legal relationship caused by any partner ceasing to be associated in the carrying on of the business. 2. Dissolution terminates actual authority. 3. BUT apparent authority can only be terminated by notice. a. Therefore, send letters to all 3rd parties (creditors and business associates) and publish that your partnership is at an end. ii. “Winding Up” Period: 1. Steps in this period a. Settling of Accounts

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b. Payment of Debts c. Payment to Partners 2. There is a heightened duty toward creditors and partners during the windup phase. iii. Termination of the Partnership: 1. Partners are still liable for their past actions. 2. If a partnership continues to do business after it has been formally dissolved, the noncontinuing partner or his representative may elect to receive his share of the profits earned by the firm after the date of its dissolution. a. See Cauble v. Handler p. 78 i. The assets should have been liquidated on market not book value. ii. P gets the market value of her late husband’s interest in the partnership AND a choice between the interest on the assets belonging to her husband or a slice of the profits because the other partner is still using her husband’s interest to continue the business. iv. Right v. the Power to Dissolve 1. Rule: A partner who has not fully performed the obligations imposed on him by the partnership agreement may not obtain an order dissolving the partnership. (See Collins v. Lewis p. 75) III. Limited Liability Companies and Other Business Forms a. General Information i. Alternatives to partnerships and corporations ii. Benefits: Tax treatment like a partnership and limited liability like a corporation. b. Limited Liability Partnerships (LLPs) i. See p. 36

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ii. This form was created as a result of the savings & loan crisis. iii. Characteristics: Any partner not directly involved or having direct oversight duties will not be held liable for tort liabilities. 1. Narrow Shield: only protects against tort claims 2. Broad Shield: protects against all liabilities (i.e. contract claims & tort claims). iv. LLPs have the same fiduciary duties as general partnerships. c. The Limited Partnership i. Consists of general and limited partners (LPs). ii. LPs are not liable as long as they play a passive role in the partnership. iii. When will LPs be exposed to liability? 1. See Continental Waste System, Inc. v. Zozo Partners p. 121 a. D is not a LP because of: i. Improper filing ii. D had managing authority. He acted like a general partner. iv. Limited partners can’t bind the partnership v. A general partner has a higher fiduciary duty than the limited partner. vi. In re USACafes, L.P. Litigation 1. Fiduciary duty owed by the directors of the corp. (USA) to the limited partners. 2. The directors essentially conduct the business affaires of the corp. (the general partner). The directors argued that the liability should stop at the general partner’s assets and not the directors’ assets. 3. The Court said that since the directors are in charge of the general partner, they owe a duty to the limited partners.

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4. The Court doesn’t address the directors’ duty when the shareholders’ goals conflict with those of the limited partners. d. Limited Liability Limited Partnership (LLLP) e. Limited Liability Companies (LLCs) i. An LLC has a combination of corporate and partnership benefits. ii. Benefits 1. No restrictions on terms of management structure. 2. The LLC can be run directly by the members OR through a board of directors. iii. Downside 1. People are still unclear about how the structure is run. 2. It costs more to file the forms for a LLC. You need a tax lawyer. 3. Different states have different laws on LLC. f. Review of Federal Tax Issues i. Corporations: Taxation on business earnings. The shareholder distributions of dividends are taxed again as personal income. This does not apply to S Corporations (SCORPs)(see p. 151). ii. Partnerships: If it is run like a corporate structure, then it will be treated as one in terms of taxation. IV. Formation of a Corporation a. The Process of Incorporation2 i. Decide where you want to incorporate. 1. Delaware or home state. ii. Pick a name 1. It can’t be similar to another corporation’s name. iii. Select and Identify an agent and their office iv. Shares 1. How many shares of stock?
2

Many people use corporation service companies when incorporating in an outside state.

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2. What will be the stock’s par value? 3. Set out the differences in the stock shares v. Names of director(s) 1. Number of directors 2. The names can be in the charter or can be determined at a later date. vi. Creation of the By-Laws vii. Addition of Opt-In Provisions & Opt-Out Statutes 1. Opt-In: The provision must be in or it doesn’t apply. 2. Opt-Out: The provision must be specifically excluded or it’s automatically assumed in. viii. First Meeting ix. Check the Charter and By-Laws 1. You are bound by these 2. Restated Charter: Integrate the original certificate with any amendments b. The Ultra Vires Doctrine i. It means “beyond the powers” of the corporation. ii. Old Rule: If a corporation enters into a contract and the charter does not authorize it then the corporation can void the contract. 1. Purpose: It protects shareholder interests. iii. New Rule: 1. Charters are now construed very broadly. 2. Corporations can have general-purpose clauses. c. Premature Commencement of a Business i. Three Ways to Lose Limited Liability 1. Defective filing 2. Promoting the Corporation 3. Piercing the Corporate Veil ii. Promoters

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1. Definition: A promoter is a person who undertakes to form a corporation and procure for it the rights, instrumentalities, and capital by which it is to carry out the purposes set forth in its articles of incorporation. The promoters usually act as the incorporators. However, acting as an incorporator is not necessary to make one a promoter, their capacities are separate and distinct relationships to the corporation. 2. If you are a promoter of a corporation you could be held liable because the promoter is viewed as an agent of the corporation. 3. Stanley case p. 225 a. Rule: A promoter will be liable on a contract he entered into on behalf of a corporation yet to be formed unless the other party agreed to look to some other person or fund for payment. b. The promoter is liable for contracts signed by him for the corporation to be formed. c. There are three exceptions to this rule: i. The contract is treated as an option which can be accepted by the corporation when it is formed, and the promoter agrees to form the corporation and give it the opportunity to pay. ii. A novation with the corporation assuming the promoter’s liability and replacing him in the contract. iii. The promoter remains liable even after formation but only as a surety. 4. In Stanley, D should have waited until the corporation was up and running. He also should have used the correct corporate signature.

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a. Incorrect Method Joe Smith President, XYZ, Inc. b. Correct Method XYZ By:________ Title:______ iii. Defective Incorporation 1. MBCA § 2.04 Liability for Pre-incorporation Transactions: All persons purporting to act as or on behalf of the corporation knowing there was no incorporation is jointly and severally liable for all liabilities created while so acting. 2. Robertson v. Levy (p. 236) a. The charter is defective—forgot to pay fee, sign it, so the corporation does not exist. b. Difference from Boss case i. Boss: both parties knew of the defect, liability on the promoter ii. Robertson: Only Levy knew the corporation was not yet formed but continued to act as though it was incorporated. Robertson knew nothing. Levy, runner of the business, held liable. 1. Agreement between Levy and Robertson 2. Articles filed, no certificate 3. Lease signed (neither knew of defect) 4. Rejection of articles

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5. Levy executes note (Levy knew of defect, not Robertson) 6. Certificate of incorporation issued c. De jure v. De facto Corporation i. De jure: Corporation by law; followed the rules of incorporation, etc. ii. De facto: Corporation, but not by law, considered corporation of followed these prerequisites, unless challenged by state. Using this doctrine, Robertson would not have a claim if: 1. Valid law under which corporation could be organized 2. Attempt to organize there under 3. Actual user of the corporate franchise 4. Good faith iii. Court holds: De facto corporation is no longer a defense. d. Prior to modern rules: the rationale for the de facto rule i. To be incorporated, secretary of state would do a substantive review which would take a while. ii. While waiting to hear, parties would engage in business although they were not officially incorporated. e. TODAY under the rules3 NO justification for the de facto rule because:

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The old rule is still in effect in a few states.

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i. Incorporation happens much more quickly, no waiting period. ii. Much more simplified process iii. If the corporation is in good standing, a certificate of incorporation will be issued the day the papers are filed. f. Levy held personally liable because the corporation was not yet formed. i. Even though Robertson did not ask to secure personal liability. ii. There was no injury to Robertson as a result of the misfiling. iii. Appears to be giving Robertson (P) an unjustified windfall. g. De Facto doctrine still exists i. Large corporations with many subsidiaries must pay franchise taxes to operate in states other than their state of incorporation. ii. Must pay them promptly or their charter will be revoked. iii. De facto doctrine is used to prevent liability in these situations. V. Piercing the Corporate Veil a. General Doctrine i. Ignores corporate structure and places liability on the shareholder (Bartle and Dewitt demonstrate the difficulty in achieving consistent results). ii. Happens most often in closely-held corporations iii. Corporate existence will continue after veil piercing iv. Does not mean all shareholders are liable, only those implicated in the action.

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v. When is piercing appropriate? 1. Fraud (can be less than tort fraud) 2. Alter Ego (no separation) a. Mere Instrumentality Doctrine: the shareholders are using the corporation for their own ends. b. Enterprise Liability: occurs if there are different corporations operating together with mixed assets. 3. Didn’t follow corporate formalities vi. Bartle v. Home Owners Coop. (p. 250): shareholder is the parent of the wholly-owned subsidiary 1. No piercing the corporate veil—no liability a. Parent was a non-profit; sub was for a profit created to build low-income housing for war veteran members of the non-profit parent. b. P was trustee in bankruptcy for the sub, trying to recover from the parent shareholder. c. Generally, subs don’t sue parents because their existence depends on the parent but when sub is bankrupt, they are now adverse to each other and the trustee (P) must try to satisfy the sub’s creditors. d. No liability for the parent i. No fraud ii. No misleading of creditors iii. Two corporations were always maintained separately iv. Parent did not deplete the sub’s assets. v. But the creditors did not know that the parent set prices for the sub (at cost housing). This could be close to fraud. 2. Dissent—there should be liability—corporate veil should be pierced

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a. Same officers and directors of both b. Subsidiary could not make a profit (at cost)—sub could not exist without parent, not really separate vii. Dewitt v. Flemming (p. 252) 1. Not following corp. formalities (e.g. not holding stockholder meetings) will weigh against a defendant in piercing the corporate veil. 2. Undercapitalization also makes a difference 3. More importantly is the siphoning off of revenue from the corporation. 4. Absence of records 5. Deception of Creditors viii. When will a Court pierce the corporate veil? 1. No real clear-cut rules. It’s result oriented. 2. Pierce the veil to avoid injustice (e.g. misrepresentation, etc.). 3. Factors to Consider a. Failure to observe corp. formalities b. Lack of corp. records c. Undercapitalization d. Co-mingling of assets (e.g. using corp. funds to pay off personal assets) e. Domination or control over the corporation (Alter Ego Theory) f. Element of Injustice b. Tort Cases i. Contract Cases v. Tort Cases 1. Contract Cases: In contract cases creditors can always ask for a guarantee or no deal. Negotiation is possible, have knowledge of the ability of the corporation to pay, voluntary transaction.

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2. Tort Cases: More of an involuntary transaction on the part of the plaintiff did not plan to have to deal with this company. 3. So theoretically piercing should occur less with contract cases than tort cases. However, they are most often treated the same. ii. Baatz v. Arrow Bar (p. 260) 1. Tort claim, not contract a. P was injured when they got into a collision with a person who had been served drinks at Arrow Bar. P wants to reach Arrow Bar Stockholders. 2. Majority—no piercing—no liability (S.D. law not very favorable towards plaintiffs, S.D. had overturned legislation attempting to hold restaurants liable in these situations). a. Not Undercapitalized i. Didn’t have dram shop insurance (lawyer will be guilty of malpractice for this) ii. They are running a business to serve drinks—they have adequate capital. iii. The dissent disagrees—they are serving drinks to intoxicated drinkers which is a high-risk enterprise that needs much more capital in the form of insurance. Adequate capital must include capital for liability. Absence of insurance is a problem. iv. Used to be minimum capital requirements for corporations, NO LONGER v. Used to be maximum capital requirements because of a fear of big corporations, NO LONGER

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vi. Why should the courts resurrect these requirements? b. Ds personal guarantee of the note only confirmed adequate capitalization and was on contract, no tort c. Personal business under corporate façade-Alter Ego-NO i. Baatz failed to show any evidence of using corporate funds to pay personal obligations. d. The fact that D may have served the drinks himself is not a piercing issue, it would be a tort issue e. Failure to follow corporate formalities i. P argues that corporation’s name is insufficient (MBCA § 4.01) because Inc. is not listed on signs or advertising—NO—bad argument-Inc. was listed on all corporate paperwork, etc. iii. Radaszewski v. Telecom Corp. (p. 266). 1. Tort claim, P in accident with truck owned by the sub, can the parent be held liable? NO, no veil piercing (corporate limited liability v. Uncompensated tort victim). 2. Trying to pierce the corporate veil to reach the parent because of the insolvency of the subsidiary. 3. Three Part Test: To pierce the veil, one must show: a. Control, not mere majority or complete stock control, but complete domination of finances, policy, and business practice with respect to the transaction so that the corporation has no separate mind or existence of its own. b. Control was used to commit fraud or wrong. i. Telecom 1. Undercapitalization

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2. Yes, the sub was inadequately capitalized in the business/accounting sense. 3. Most capital was in the form of loans, not equity. 4. Insurance, although their insurer was insolvent, the amount of insurance was enough to cover the claims within the scope of liability to P— obligation specific—may no have been enough to cover other claims, but enough to cover this claim. 5. Should all insurance be treated equal—low premiums, no good coverage, high premiums, better coverage? 6. Capital requirement is met. 7. Dissent—insurance coverage should not preclude piercing the corp. veil. ii. Baatz: if it was one of 1000 Arrow Bars (a franchise) 1. Majority: NO 2. Dissent: Yes, the “corp. policy” was to serve alcohol to drunks. c. The control and breach of duty must have proximately caused the injury or unjust loss. iv. Undercapitalization alone isn’t enough to pierce the corporate veil. You need other factors as well. c. Liability of Parent i. Fletcher v. ATEX, Inc. (p. 273)

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1. Delaware law applies because that is where Atex is incorporated. 2. To prevail on an alter ego claim under DE law, P must show: a. That the parent and the subsidiary “operated as a single economic entity.” b. AND, that an “overall element of injustice or unfairness” exists. 3. There was a cash management system (pooling of ATEX’s and Kodak’s assets) for lower interest rates. However, ATEX still maintained control over its assets a. Good records were kept as well. 4. Control over CEO (Hiring and Firing) a. Evidence of parent company’s control over sub. b. However, as long as the boards are separate it should be OK. c. It’s assumed that the board members will think for themselves. 5. Whenever you deal with the internal affairs of a corp., you look at the law of the state of incorporation. 6. If the sub acts as parent’s agent (if authority exists) the parent could be held liable. ii. U.S. v. Bestfoods (handout) 1. If you could pierce the corp. veil the parent could be held liable. 2. The parent could also be held liable if it is seen as an “operator.” VI. Financial Matters a. Debt & Equity Capital i. Equity 1. Ownership rights possessed by shareholders

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a. Voting rights b. Financial Rights i. Dividend Rights: entirely discretionary ii. Rights upon liquidation 2. Equity rights are contained in the articles of incorporation a. Different classes of stock b. Number of stock shares 3. Stocks are regulated ii. Debt 1. Debt holders are entitled to a specific payment at a specific time. 2. Examples of Debt: bank loans, bonds, etc. 3. Debt holders are entitled to a specific payment at a specific time. b. Types of Securities i. MBCA § 6.01(b) Authorized Shares ii. MBCA § 6.03

iii. Two Different Types of Shares 1. Preferred Shares a. PS holders pay a premium for their shares. In exchange they get first dibs in the liquidation assets after the creditors. b. PS holders get a fixed dividend each year. c. PS holders do not have voting rights i. BUT it can be triggered if the corp. defaults on the payment of dividends. 2. Common Shares a. Voting Rights iv. Cumulative Dividends 1. If the corp. does not pay dividends in year 1, the PS holder dividends carry over into year 2, 3, etc.

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v. Redemption Rights 1. Call Option: corp. forces shareholders to sell shares back to the corp. 2. Quit Option: shareholders force the corp. to buy back their shares vi. Conversion Rights 1. Preferred Stock converted into Common Stock 2. It works the one way but not the reverse. vii. Anti-Dilution Rights 1. Prevents the corp. from reducing your voting rights via the issuing of more shares. 2. Preemptive rights, Stock Splitting a. Additional stock will be issued to balance out the rights of existing shareholders. viii. Watered Stock 1. Examples a. Discounted stock b. Issuance of stock for property whose value is overstated c. Bonus shares of stock c. Issuance of Shares i. Requirements 1. The stock (at the very minimum) must have voting rights and liquidation rights. ii. Common Shareholders 1. Voting Rights 2. Anti-Dilution Rights in most situations (PS holders have this also) iii. Preferred Shareholders 1. Fixed dividend rights 2. Superior liquidation rights

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3. Redemption rights a. It works the opposite way also (call option) 4. Anti-dilution rights iv. Example: As participating shareholders, C receives $1.25 and they participate with the common shareholder dividends. BUT they don’t participate fully with the common shareholders. They are at least entitled to the $1.25. Y1 A $3 cumulative Y2 A $6 cumulative

B $2 non-cumulative B $2 non-cumulative

C $1 participating

C $1.25 participating

Common

Common

d. Debt Financing i. Short Term Financing: loans ii. Long Term Financing: securities such as bonds and debentures iii. The interest must be paid at a specific time. iv. In liquidation, debt holders have a superior right than stockholders v. The higher the debt/equity ratio the riskier the investment for the creditor. vi. Advantages of Debt Financing 1. You don’t have to raise the money yourself. 2. If your earnings are high you only have to pay out the specified interest payments and can keep the rest of the revenues. 3. The interest is tax deductible. e. Preemptive Rights and Dilution 27

i. Stokes v. Continental Trust Co. (p. 354) 1. Rule: A corporation must allow a shareholder to purchase newly issued stock at the fixed price to allow him to keep his proportionate share of the stock. ii. Katzowitz v. Sidler (p. 358) 1. Rule: When new shares are offered in a closed corp., existing shareholders who do not want to or are unable to purchase their share of the issuance are not estopped from bringing an action based on a fraudulent dilution of their interest where the price for the shares is inadequate. f. Distributions i. Gottfried v. Gottfried (p. 363) 1. Rule: If an adequate corporate surplus is available for the purpose, directors may not withhold the declaration of dividends in bad faith. 2. The Bad Faith Test: The essential test of bad faith is to determine whether their personal interests rather than the corporate welfare dictate the policy of the directors. ii. Dodge v. Ford Motor Co. (p. 367) 1. Unlike the previous case there is a huge surplus here. 2. There must be a legitimate business reason to withhold dividends when a surplus exists. VII. Fiduciary Duties of Officers, Directors and Controlling Shareholders a. Duty of Care and the Business Judgment Rule i. MBCA § 8.03 Number and Election of Directors ii. Basic Principles 1. Shlensky v. Wrigley (p. 671) a. Shareholder derivative suit b. There was more money involved in the Dodge case than this case.

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c. Rule: A shareholder’s derivative suit can only be based on conduct by the directors which borders on fraud, illegality, or conflict of interest. d. In this case there were valid reasons for the refusal to install lights in the stadium. D suggested that night games in Wrigley Field would have a detrimental effect on the neighborhood. D’s decision falls within the business judgment rule. 2. Smith v. Van Gorkom a. In this case, the directors tentatively approved the merger the first time it was presented to them. They had no, and requested no, substantiating data regarding the feasibility of the $55 per share price. No consideration was given to allowing time to study the proposal or to gain more information. Their actions are not covered by the business judgment rule. b. Rule: Directors are bound to exercise good faith informed judgment in making decisions on behalf of the corp. c. The directors tried to blame it on their lawyer. The Court said that the directors did not reasonably rely on the lawyer’s advice. d. Active v. Passive Directors i. The dissent makes this point. e. The Court held all of the directors liable. Everyone is treated the same. f. In reaction to this decision, the DE legislature passed laws which allow corporations to reduce director liability (see p. 703) g. Corporations also have director insurance.

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3. Business Judgment Rule a. Doctrine relieving corp. directors and/or officers from liability for decisions honestly and rationally made in the corporation’s best interests. b. As long as the director(s) makes a rational, business judgment no liability occurs. c. Courts will grant deference to the corp. directors. 4. Questions to Ask a. Does the director have a duty of care? b. If YES, then does the conduct violate the business judgment rule? iii. Demand Rights 1. Derivative Suit: a. A lawsuit brought by a shareholder on behalf of the corporation. b. The damage award goes to the corp. not to the individual shareholder. 2. Delaware View a. Demand: Required or Excused? i. Demand is required unless Board action is so self-interested and board acted with gross negligence (Aronson). 1. P has the burden of proving that demand is excused without the benefit of discovery. 2. Nearly Impossible for P to prove. ii. If demand is excused b/c board is interested (highly unlikely) 1. Litigation committee’s judgment will be subject to the two-part test from Zapata.

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2. Corporation will have the burden. iii. When demand is required and refused: SUBJECT TO THE BUSINESS JUDGMENT RULE 1. P must show that the decision not to allow the suit to go forward did not conform to the process of the BJ rule. (Basically, same test as New York, Gall case) 2. This generally what happens because it is utterly impossible to prove that demand was excused based on the Aronson standard. b. Problems with this i. Must be proven without discovery: You are not entitled to discovery until you show director interest. But you can’t show interest until you have discovery. ii. Decisions are res judicata, later claims precluded, even though P has never had a chance to discover (a decision on the demand issue is a decision on the BJ rule) and suit cannot go forward. c. Zapata Corp. v. Maldonado p. 713 i. Facts: P initiated a derivative suit charging officers and directors of D with breaches of fiduciary duty, but four years later an “independent investigation committee” of two disinterested directors recommended dismissing the action.

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ii. Rule: When the making of a prior demand upon the directors of a corporation to sue is excused and a stockholder initiates a derivative suit on behalf of the corporation, the board of directors or an independent committee appointed by the board can move to dismiss the derivative suit as detrimental to the corp.’s best interests, and the court should apply a two-step test to the motion: 1. Has the corp. proved independence, good faith, and a reasonable investigation, 2. AND, does the court feel, applying its own independent business judgment, that the motion should be granted? d. Aronson v. Lewis p. 721 i. Facts: The trial court dismissed this derivative suit for failure to meet the prerequisite of making a demand on the Board of Directors to bring the suit. ii. Rule: A prior demand can be excused only where facts are alleged with particularity which creates reasonable doubt that the director’s action was entitled to the protections of the business judgment rule. iii. Was the Board being dominated? 1. Must show particular facts. a. Merely having a lot of stock alone does not mean the directors are beholden to the

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majority shareholders. You must plead with particularized facts. 2. You must tie things to profit or a direct interest. iv. First Prong: Has there been a reasonable doubt that the directors did not use independent judgment in deciding to terminate the litigation? v. Second Prong: Is the transaction an exercise of good business judgment? 3. Demand a. Definition: Demand is a request by a shareholder to the corporation. b. Demand Required (DR) i. The shareholder has to make the demand or concede making a demand is required. ii. If the corp. dismisses the action the BJ Rule applies. c. Demand Excused (DE) i. Shareholder doesn’t have to make the demand. ii. The Test (Zapata case) 1. Independent, Disinterested board 2. BJ Rule as applied by the court. 4. Purpose and Use of the Demand Requirement a. Originally it was to serve an alternative dispute resolution function. b. But so much litigation involved the demand requirement itself that ALI and MBCA now require demand.

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c. A Board is best advised not concede that demand is excused because they will be held to the independent business judgment of the Court. d. If you are a shareholder, you are advised to contend that demand is excused because if you make a demand on the directors you are conceding that the Board is disinterested. And it places things right in the hands of the director as subject to the BJ rule. e. If P does make demand and demand is refused, P tries to challenge this by conducting limited discovery. Court held that discovery would not be permitted following a refusal of demand (ALI and MBCA are a little more accepting of discovery). f. MD handles derivative suits through case law, not through statutes. i. Disinterested Board: BJ rule applies ii. Interested Board: BJ does not apply 5. Universal Demand Requirement a. Cuker v. Mikalauskas (PA law) p. 734 b. Facts: PECO Energy Company’s board of directors (D) sought to quash two derivative actions initiated by its minority shareholders (P). c. Court’s Opinion: BJ Rule permits the Board to terminate derivative lawsuits. i. Structural bias issues are not as strong— officers separate from directors ii. Court adopts ALI procedures—if these have been carried out, the BJ rule will apply 1. Allows limited discovery by P with respect to the Board’s decision to dismiss.

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2. Evidentiary hearing to determine whether or not the directors were independent. 3. Written report prepared 4. Assisted by outside counsel or auditor 5. Adequate investigation 6. There is a judicial review mechanism. iii. Mandatory demand (like MBCA) iv. A much better system for the plaintiff than the Delaware system. At least it gives the P some time to discover facts relevant to the Board’s decision (rather than being forced to base it on public knowledge like Delaware). b. Duty of Loyalty and Conflicts of Interests i. Duty of Loyalty: A breach of this duty means there was a conflict of interest. 1. BJ rule does not apply to breach of duty of loyalty. 2. Entails more than conflict of interest transactions and also includes transactions between fiduciaries. 3. Once sanitization of a transaction has occurred, the BJ rule will be reinvoked and the burden shifts back to P. 4. Not codified—except for Conflict of Interest at § 8.60-8.63 (see below) a. Analytically it is just like the duty of care, but stronger b. Acting in the best interests of the corporation. ii. Self-Dealing 1. Intrinsic Fairness Test a. Marciano v. Nakash p. 102

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i. Facts: Nakashes loaned the corp. money, Marciano tried to void the transaction. 50/50 stock ownership. Deadlock. This is why the transaction was not approved. ii. Del Statute § 144: Conflict of interest transactions will not be voidable if: 1. Disclosure and authorization by a majority of the disinterested directors. 2. Disclosure and authorization by Shareholders. 3. Fair to the corp. at the time authorized. iii. These facts are not covered by the statute b/c the transaction was never authorized by the Board b/c of the deadlock. iv. The Court goes outside the statute and created another way to approve the transaction (Intrinsic Fairness Test). v. Rule: A transaction by a corporation with its insiders will be valid if intrinsically fair. b. INTRINSIC FAIRNESS TEST i. Factors to be Considered 1. Motives of the directors 2. Effect of the transaction on the corporation 3. FAIRNESS 4. Approval of non-interested directors and shareholders.

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ii. If there is no independent, disinterested committee to decide whether the transaction is fair, the court must step in. c. Sinclair Oil Corp. v. Levien p. 773 i. Facts: A minority stockholder in Sinven, P accused D, the parent company, of using Sinven assets to finance its operations. ii. Rule: Where a parent company controls all transactions of a subsidiary, receiving a benefit at the expense of the subsidiary’s minority stockholders, the intrinsic fairness test will be applied, placing the burden on the parent company to prove the transactions were based on reasonable business objectives. iii. Sinclair causes Sinven to pay out more dividends than its earnings. Although a lot of dividends were paid out, the minority shareholders also benefited. 1. The Intrinsic Fairness Test doesn’t work. d. Weinberger v. UOP p. 778 i. Facts: Claiming that a cash-out merger was unfair, P a former minority shareholder of D, brought a class action to have the merger rescinded. It’s a conflict of interest with interested directors. One party withheld key information, namely the price study. ii. A fairness opinion by an independent party is not enough. You have to look at other factors.

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iii. Rule: When seeking to secure minority shareholder approval for a proposed cashout merger, the corporations involved must comply with the fairness test which has two basic interrelated aspects: 1. Fair Dealings: which imposes a duty on the corporations to completely disclose to the shareholders all information germane to the merger, AND 2. Fair Price: which requires that the price being offered for the outstanding stock be equivalent to a price determined by an appraisal where “all relevant nonspeculative factors” were considered. iii. Corporate Opportunity 1. Part of the Duty of Loyalty: beyond conflict of interest and self dealing a. Involves fairness: the burden of proving fairness is on the fiduciary, and the BJ rule does not apply. b. Subchapter F of MBCA does not apply to corporate opportunities because the corp. is not a party to the transaction. 2. A breach of corp. opportunity occurs when a fiduciary takes a personally profitable business opportunity which belongs to the corp. 3. Purpose: The doctrine is designed to prevent transactions where directors gain a secret profit where the corp. should have had that opportunity/benefit. 4. Tests

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a. Interest of Expectancy: corp. has an interest in the transaction b. Line of Business: directors can’t engage in transactions that compete against the corp. c. Fairness Test 5. Example: A director’s real estate company sold office space to the corp. at a premium price. The director makes a profit. c. Insurance and Indemnification i. Many states allow corp. to reduce the liability of their directors 1. Mostly applies to unintentional acts 2. Duty of care and fiduciary duties ii. a d. Duties of Controlling Shareholders i. Majority shareholders have a fiduciary duty to minority shareholders. ii. Donahue v. Rodd Electrotype Co. p. 378 1. Rule: P had a right to have the corp. repurchase P’s shares just as the corp. repurchased Rodd’s shares. 2. This seems like a crazy ruling. 3. Reasons for this outcome: a. Closely Held Corp. i. No ready market to sell the shares. ii. Can’t dissolve the venture like a partnership. 4. Concurring Opinion a. The majority rule does not apply in other situations (e.g. hiring policy, etc.) iii. Other ways to argue the Donahue case: 1. BJ Rule violation 2. Conflict of Interest transaction iv. Many other states did not adopt the Donahue rule.

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v. Zetlin v. Hanson Holdings, Inc. p. 937 1. Facts: P contended minority shareholders should share in the premium price paid to D for its controlling shares in the corporation. 2. Rule: Minority shareholders are not entitled to share in any premium price paid for the controlling shares of a corp. 3. Controlling shares of a corp. are more valuable than minority interests. Control affords the holder the power to direct corp. activities and to govern the allocation of corp. assets. vi. Debaun v. First W. Bank & Trust Co. p. 938 1. Facts: D sold the majority shares to a “shady” character who later looted corp. assets. 2. Rule: A controlling shareholder owes a duty to his corp., when selling his control in the corp., of reasonable investigation and due care when possessed of facts establishing a reasonable likelihood that the purchaser of control intends to loot the corp. 3. What if the buyer didn’t loot the corp. a. Could go either way, but the failure to disclose is an important breach. vii. A controlling shareholder selling his control should: 1. Inform the other shareholders. 2. Reduce the risk by reasonable investigation of the buyer. viii. Perlman v. Feldmann p. 947 1. Facts: D, a director and dominant stockholder of Newport Steel, sold, along with others, the controlling interest of that steel manufacturer, to steel users, along with the right to control distribution. 2. Rule: A corp. director who is also a dominant shareholder stands, in both situations, in a fiduciary relationship to both

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the corp. and the minority stockholders if selling controlling interest in the corp. is accountable to it (and the minority shareholders) to the extent that the sales price represents payment for the right to control. e. Doctrines (Summary) i. Duty of Care 1. Directors, shareholders, officers 2. The duty is reasonable investigation when appropriate. 3. Was proper procedure observed? ii. Business Judgment Rule (BJ Rule) 1. As long as director(s) actions are reasonable and not selfserving they are shielded from liability. iii. Duty of Loyalty 1. Prevents self-dealing 2. Duty of disclosure to fellow shareholders a. Is there self dealing? b. If Yes, then the Intrinsic Fairness Test applies. 3. Demand required v. Demand Excused iv. Corporate Opportunity Doctrine 1. Another species of the Duty of Loyalty Doctrine v. Controlling Shareholder Duties 1. Duty of Care 2. Duty of Loyalty 3. Duty of Reasonable Investigation VIII. Management and Control of the Corporation a. Roles of Shareholders and Directors i. Authority of Directors and Officers 1. MBCA §§ 8.01, 8.21 2. Directors have broad powers, therefore they have a fiduciary duty to the shareholders.

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3. The only way a corp. is bound by a director’s action is if he/she has authority. a. Actual Authority b. Apparent Authority: e.g. the board passes a resolution. 4. A quorum of the board must be present to authorize transactions. 5. Things that have a great impact on the corp. (e.g. a merger) a supermajority is required (2/3 of the board). 6. Baldwin v. Canfield p. 504 a. Rule: A board of directors has no authority to act except when it is assembled at a board meeting. b. This rule of law is no longer valid with the adoption of the MBCA. 7. Mickshaw v. Coca-Cola Bottling Co. p. 506 a. Rule: An act of a single director will be binding upon a corp. if it is subsequently ratified or acquiesced in by a majority of the corp.’s directors. ii. Authority of Officers 1. MBCA §§ 8.40, 8.41 2. Checking the Authority of an Officer a. By-Laws b. Past Resolutions c. Prior Conduct 3. Black v. Harrison Home Co. p. 513 a. Facts: President made a transaction without specific authorization. The bylaws suggest the president may have the power, but it is severely curtailed by the board. b. Rule: The president of a corp. (or any officer) has no authority to execute contracts on behalf of the

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corp. in the absence of a bylaw or a resolution of the board of directors permitting him to do so. 4. Lee v. Jenkins Brothers a. Rule: As long as the acts are part of the ordinary authority of an officer, the acts are binding on the corp. b. Ordinary Act v. Extraordinary Act i. Look at the impact the act has on a corp. ii. Has the corp. received a benefit? 5. Drive-in Dev. Corp. p. 522 a. Rule: Statements of a corp. officer, if made while acting within the scope of his authority, are binding upon the corp. b. Once you get a copy of certified resolutions there is authority. In this case the corp. secretary falsified the resolution and the other party reasonably relied on it. iii. Shareholder Authority 1. Shareholder powers a. Ability to Elect Directors i. Plurality vote b. Ability to Remove Directors i. With or without cause c. Ability to Amend the Bylaws i. Directors also have this ability except for powers relating to the director position d. Approving Merger Transactions i. Veto power only e. Conflict of Interest Transactions 2. McQuade v. Stoneham p. 401

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a. Facts: 3 shareholders agree they would use their best efforts to: i. Keep directors in office ii. Vote for each other as directors iii. Set the salary of officers & officer selection b. #iii is the problem. This authority falls into the discretion of the officers. c. Rule: The point of a corporation is to have these different levels of authority. Agreements eliminating these levels of authority are therefore invalid. You must operate consistent to corp. principles. d. Some courts have reduced the strictness of the McQuade decision. i. Clark v. Dodge p. 405: Arbitrary Test 3. Galler v. Galler p. 407 a. Rule: Close corporations will not be held to the same standards of corp. conduct as publicly held corporations in the absence of a showing of fraud or prejudice toward minority shareholders or creditors. b. In the real world close corporations are more like partnerships. Without shareholder agreements the minority shareholders have no recourse (i.e. can’t sell their shares on an open market). 4. Zion v. Kurtz p. 417 a. Rule: A shareholder’s agreement requiring minority shareholder approval of corp. activities is enforceable. b. Reasonable restrictions on director discretion are not against public policy and are not precluded by

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statute. The key factor is the minimal harm to other parties. c. However, exercising this type of control in a corp. (close corp.) can lead to the piercing of the corp. veil. d. In Delaware, you must file as a close corp. This puts outside parties (e.g. creditors) on notice that the directors’ powers can be limited. 5. Matter of Auer v. Dressel p. 426 a. Facts: Agreement to hold a special meeting when 55% of the shareholders call the meeting. The meeting called concerns a subject that the shareholders have no authority over. b. Rule: Corp. management must call a special stockholders’ meeting when the necessary number of voting shares back such a request and no purpose for the meeting is improper. c. The Board should not be allowed to deny a meeting where the shareholders want to bring something to the directors’ attention. Otherwise, how would the directors be held accountable? b. Shareholder Voting and Agreements i. MBCA § 7.28 ii. Shareholders have limited power and cannot take power away from the directors (McQuade rule) 1. Over time this rule has slowly become more lenient. 2. Ways for a minority shareholder to gain a say: a. Pooling Agreement b. Cumulative Voting iii. Voting Methods for Shareholders 1. Straight Voting

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a. One vote per share b. Majority shareholders always win 2. Cumulative Voting (CV) a. Shareholders can cumulate their votes and distribute them any way they want. b. In cumulative voting, a minority shareholder could elect at least one director to the board. This gives them a voice on the board. c. CV is an opt-in clause. d. Notice of CV must be provided before an election. 3. Ringling Bros case p. 444 a. Rule: A group of shareholders may lawfully contract with each other to vote in such a ways as they determine. 4. Voting Trust a. Definition: It's the transfer of "legal" rights of the shares to a 3rd party. The trustee can vote the trusts. b. A pooling agreement is different. In a pooling agreement you still own and can vote your shares. c. Brown v. McLanahan i. Rule: Under a corp. voting trust agreement, "a trustee may not exercise powers granted in a way that is detrimental to the cestuis que trustent (i.e. actual owner of the voting shares); nor may one who is trustee for different classes favor one class at the expense of another." 5. Stock Restrictions (Ling and Co. v. Trinity Saving and Loan Ass'n.)

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a. Rule: A corp. may impose restrictions upon the transfer of its stock as long as those restrictions do not constitute unreasonable restraints. iv. MBCA §§ 7.30, 7.31, 7.32 c. Deadlocks i. In General 1. With advanced planning this won’t occur. 2. Shareholders: If 50/50 split there is a problem because there is no majority. Cumulative voting solves this problem. 3. Directors: When the board has an even number of directors a deadlock could occur. The problem is heightened with supermajority standards. ii. Deadlocks don’t necessarily mean the company can’t continue doing business. iii. Deliberate Deadlock (Gearing v. Kelly p. 480) 1. Facts: When P refused to attend a directors’ meeting, D elected Hemphill, and the P faction objected. 2. Rule: Where a shareholder-director deliberately causes a lack of quorum required for a director’s meeting by refusing to attend, equity will refuse to set aside a board decision held at such a meeting for lack of quorum. iv. Dissolution of a Corporation (In Re Radom & Neidorf, Inc. p. 483) 1. Facts: P and his sister D were the sole shareholders in a music publishing corp. Due to a mutual dislike and distrust, they were deadlocked as to the election of directors and the declaration of dividends. 2. Rule: Where corp. dissolution is authorized by statute in the case of deadlock or other specified circumstances, the existence of the specified circumstances does not mandate the dissolution. The court will exercise its discretion,

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taking into account benefits to the shareholders as well as injury to the public. 3. Other Solutions: a. You can put a provision in your by-laws for dissolution in this situation. b. Buy-out Agreement: One will buy out the other as an exit strategy. i. Between 2 shareholders: e.g. when one dies. ii. Between the shareholder and corp.: corp. uses funds to purchase back SH’s shares. The only problem is lack of funds. v. MBCA-Chapter 14-Dissolution 1. Voluntary Dissolution a. § 14.02—Dissolution by Board of Directors and Shareholders b. Directors may propose dissolution for submission to the shareholders. 2. Administrative Dissolution (NOT ON THE SYLLABUS) a. § 14.20—Commenced by Secretary of State if franchise taxes have not been paid, annual report has not been filed, period of duration of corp. expires, etc. 3. Judicial Dissolution (generally applies to closely-held corp.) a. § 14.30(2) The Court may dissolve i. Makes it very discretionary on the part of the court. ii. Not as available as a remedy as it is for partnerships. iii. Typical of the statutes adopted by most states.

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b. Some states have narrower grounds for dissolution (NY must have 20% holdings) c. Some states have broader grounds (CA—“persistent unfairness to the minority”) d. Remedies i. Buy-outs ii. Arbitration iii. Dissolution of company iv. Advanced Planning: Use odd number of directors on the board. IX. Public Offerings (Securities Act of 1933) a. Introduction i. 1933 Act regulates offers & sales of securities. 1934 Act regulates everything else. ii. Definition of a Security: The courts have defined this term broadly. A good rule of thumb for determining whether something is a security is to ask whether the investor expects to take part in the management of the business being invested in. If the investor is passive—i.e., is relying solely on the management of others— the investment most likely is a security. Thus, stocks, bonds, debentures, stock options, and stock warrants are considered securities. iii. Securities Law is guided by statute. Section 5 of the 1933 Act is the main thrust. b. Purpose (1933 Act) i. To assure that investors have sufficient information on which to make an informed investment decision. ii. The Act accomplishes this goal by requiring most issuers to: 1. Register most new issues of securities with the SEC. 2. AND, provide prospectuses containing material information regarding the securities to prospective investors.

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iii. State Law: some states also consider the worthiness of the security c. Who is Regulated? i. The 1933 Act is targeted primarily at sales by: 1. Issuers: entities whose securities are to be sold 2. Underwriters: entities who undertake to sell the issuer’s securities 3. Dealers: people who sell or trade securities on a full or part-time basis d. Registration Requirement i. Most securities cannot be sold unless they are first registered with the SEC. The purpose of registration is to put on file all information that a reasonable investor would consider important in deciding whether to invest 1. Example: a balance sheet and profit and loss statement, facts affecting the security’s price or risk, remuneration of directors, etc. ii. Prospectus 1. The registration must include a copy of the “statutory prospectus.” The prospectus summarizes the detailed information required for registration and must be given to purchasers of the security prior to or contemporaneously with any sale. e. You need the following to comply with the 1933 Act i. Registration Statement ii. Prospectus f. Amount of Information Required i. Initial Public Offering (IPO): A lot of information is required for disclosure. ii. Public Offering (PO): Not as much information is required as the IPO since there is already information on file.

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g. Exemptions from the Registration Requirements: The Act is concerned only with sales by issuers, underwriters, or dealers. Other sales are “casual” sales and are not covered. The Act also has two other types of exemptions: i. Securities Exemptions (which exempt issuances of certain types of securities) 1. Section 3 of the 1933 Act specifically exempts certain securities, such as those issued by banks, governments, or charitable organizations. If a security qualifies for a securities exemption, it will continue to be exempt no matter how or when sold. ii. Transaction Exemptions (which exempt securities issued in certain types of transactions): While the availability of securities exemptions depends primarily on the nature of the issuer, transaction exemptions depend on the nature of the offer. Transaction exemptions are specific to the transaction in question, so if the securities are reissued they will have to be registered unless the reissuance itself qualifies for another exemption. 1. Intrastate Offerings a. Section 3(a)(11) of the 1933 Act provides a transaction exemption for any security that is part of an issuance offered and sold only to residents of a single state, where the issuer of the security is also a resident and doing business within that state. b. Rule 147 deems a company to be doing business within a state if it derives at least 80% of its operating revenues within the state; has at least 80% of its assets located within the state; and applies at least 80% of the proceeds of the offering to operations within the state. Purchasers cannot resell the securities for at least 9 months.

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2. Private Offerings: Regulation D a. The registration requirements apply only to public offerings; private offerings of securities are exempt under section 4(2). b. Whether an offering will be considered private depends on a number of factors, including: i. Sophistication of the investors and their access to information ii. Diversity of the offeree group iii. Whether the offering has the appearance of a public offering iv. The marketability of the securities v. The manner of the offering 1. Is there public advertising or private solicitation? c. Rule 506 is the most significant exemption. An offering can be made under Rule 506 in any dollar amount, but: i. There can be no public advertising of the offering ii. AND, sales must be limited to accredited investors 1. Banks, 2. Investment companies, 3. Business with at least $5 million in assets, 4. OR individual with at least $1 million in assets or annual income of at least $200,000.

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iii. AND, no more than 35 unaccredited investors who are sophisticated in business and financial matters. 3. Small Offerings: Regulation A a. Regulation A does not provide an exemption from registration, but rather provides a “short form” registration less costly to prepare than a full registration statement. b. This regulation can be used only if the securities issued in the public offering do not exceed $5 million in the aggregate in any 12-month period. h. Waiting Period i. Purpose: It gives investors some time to think it over. Also it allows the SEC to comment on the disclosure. ii. You can make oral and written offers based on the preliminary prospectus during the waiting period. iii. You cannot accept offers until the SEC approves your securities. i. Civil Liabilities Under the 1933 Act i. Section 11 Liability 1. Cause of Action: A plaintiff needs to show only two things: a. A material misstatement of fact in a registration statement signed by the defendant b. AND, damages 2. Plaintiffs can sue: a. Everyone who signed the registration statement b. Directors c. Underwriters d. Lawyers and every expert who made a statement in the registration statement 3. Material Fact

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a. A fact is considered to be material if there is a substantial likelihood that a reasonable person would consider it important in making an investment decision. b. See TSC Industries, Inc. v. Northway, Inc. 4. Privity NOT Required a. A plaintiff under section 11 does not have to show that the misrepresentation was actually directed to her, since the statute refers to “any person acquiring such security.” 5. Defenses a. Due Diligence i. If D can show due diligence--i.e. that after reasonable investigation she had reasonable grounds to believe that the statements in the registration were true and that there were no material omissions—she will not be liable. b. Knowledge i. If the plaintiff knew at the time she acquired her security that there was an untruth or omission in the registration statement, D has a defense. c. Withdrawal i. It is a defense for directors or officers that they had resigned or taken steps to resign before the effective date of the registration statement and that they had advised the SEC in writing that they would not be responsible for the registration statement. ii. Further, they may show that the registration statement became effective without their

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knowledge and, upon becoming aware of the fact, they gave public notice that it had become effective without their knowledge. ii. Prospectuses and Communications: Section 12(a)(1) imposes liability upon any person who offers or sells a security in violation of the registration provisions, and section 12(a)(2) imposes liability upon any issuer or controlling shareholder that offers or sells a security by means of an untrue statement or omission of a material fact in a “prospectus.” 1. Violation of Registration Requirements: Section 12(a)(1) 2. Privity a. There is a privity requirement in section 12, in that the plaintiff must have purchased the security from the person who is allegedly liable. Only the first purchaser of the security is entitled to use section 12 as a remedy. 3. Defenses a. Plaintiff knows of Untruth or Omissions. b. Defendant did not and could not know the untruth. iii. Safe Harbor for Forward Looking Statements 1. There is a safe harbor provision relieving issuers, persons acting on behalf of issuers, and outside reviewers from liability arising from forward looking statements (i.e., statements that set forth plans for the future or that project future economic performance). 2. The safe harbor applies only in a private action for securities fraud based on untrue statement or omission of material fact. 3. Two forms of protection are provided:

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a. Defendants cannot be held liable unless P can show that the statement was made with actual knowledge of its falsity. b. Even if P can show such knowledge, a defendant cannot be held liable if the forward statement is accompanied by a “meaningful” cautionary statement identifying factors that could cause results to differ materially from those in the statement. c. NOTE: the safe harbor provision is not available for statements made in connection with an initial public offering.

X.

Proxy Regulations (Securities Exchange Act of 1934) a. Scope of Regulation i. Status Oriented ii. Periodic disclosure by corporations that have a certain status determined by 1. How the stocks are traded 2. Number of shareholders 3. Assets iii. 10(b)(5) regulations apply to all corporations iv. Proxy regulation only applies to shareholders v. Studebaker Corp. v. Gittlin 1. Rule: Any communication that seeks a shareholder’s support in an action that is part of a continuous plan for the solicitation of the shareholder’s right to vote is considered a “p required to comply with the proxy solicitation rules.” b. Proxy Forms i. Registration

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1. Integration of the 1933 and 1934 Acts: The provisions of the 1933 and 34 acts have been incorporated through an integrated disclosure program to permit issuers that have filed reports under the 34 Act for more than three years to incorporate by reference this information in its 1933 Act filing, thereby greatly simplifying the registration process. 2. Proxy: A grant of authority by the shareholder to transfer his/her voting rights to someone else. Mostly regulated by federal law, not much state law on proxy regulation. 3. Very expensive and confusing to comply with the 1934 Act. 4. Used to be focused on historical-fact oriented disclosure with no emphasis on predictions and speculation. NOW it permits projections and future predictions. a. Future predictions are what is important to investors b. SEC now requires disclosure of this information but provides “safe harbor” provisions so that liability will be reduced for incorrect predictions. 5. Prior to the 1934 Act a. Solicit proxies b. Disclose nothing c. Everything the Board wants will be approved. 6. Registration under the 1934 Act a. Three requirements i. Must disclose the nature of the vote to be taken. ii. Non-Management solicitations must be facilitated. iii. General fraud prohibition against false and misleading statements. b. § 14 Requirements (p. 593-94)—Criminal Statute

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i. Unlawful for any “Person” = issuer, shareholder, any other person “to solicit or to permit the use of his name to solicit any proxy or consent or authorization in any security,” … “in contravention” of SEC rules c. § 12 Registration Requirements i. Any security (including debt or equity) ii. “Affecting interstate commerce” iii. (G)(1)(A): now raised to $10 million in assets and class of equity held by 500 shareholders. 1. Class: stocks can be aggregated to meet this amount if they are “substantially similar” 2. “Of record”: the issuer only knows how may shareholders of record there are, doesn’t know about others (thus “of record” is no necessarily equal to the number of true beneficial owners of the shares.) iv. (1)(b) 500 to 750, $10 million in assets d. What you need: i. Proxy card ii. Disclosure statement iii. Info about yourself and the person you’re nominating (if applicable). iv. Statements of the company e. HYPOS: Must these stocks be registered?

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i. Company A—total assets of $10 million, 450 shareholders—NO, not enough shareholders to meet the 500 requirement. ii. Company B—total assets of $4.8 million, 700 shareholders—NO, not enough assets. iii. Company C--$4.8 million, 450 shareholders—May its registration be terminated? YES, exemption if assets fall below $10 million, less than 500 shareholders. iv. 300 shares of common, 400 shares preferred, $20 million in assets. NO, different classes of securities. The different classes cannot be aggregated to meet the 500 requirements. v. 400 voting common, 400 non-voting common, same dividend rights. If they are considered to be “substantially similar” YES, they can be aggregated to meet the 500 amounts if there is over $10 million in assets. ii. In the Matter of Caterpiller, Inc. 1. Facts: D failed, in annual and quarterly reports, to adequately comply with the disclosure requirements of § 13(a) of the 1934 Act. 2. Rule: Disclosure is required where a known trend, demand, commitment, event, or uncertainty is likely to occur, and, where such a determination cannot be made, an objective evaluation must be made of the consequences of such an occurrence on the assumption that it will occur. c. Proxy Solicitation

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i. Typical proxy card and communication from broker to stockholder will say, “If we don’t hear from you, we will vote your shares as management recommends.” If out of the ordinary issues are being considered, this rule does not apply and the broker must wait to hear from the shareholder before voting. ii. Annual Reports in General 1. Must be submitted with proxy materials if a solicitation is by management and relates to an annual meeting where directors are to be elected. 2. Annual reports are generally more readable and try to avoid legalistic and technical terminology. 3. Most important section, “Management’s Discussion and Analysis of Financial Conditions and Results of Operations” or “MD & A” (Item 303) a. Provides financial condition report, projections of financial data, goals and objectives for future performance, etc. (see discussion above—shift from fact to predictions) but still includes both historical and prospective data. b. Safe harbor provisions allow future predictions to be made: No liability if the statement were made without actual knowledge that they were false or misleading. Nonetheless, these requirements have still created a culture of reluctance to make predictions under Item 303. c. SEC has not been pleased with compliance with Item 303, intentional are criminal. iii. False or Misleading Statements in Connection with Proxy Solicitations (p. 615) 1. § 14(a) “false or misleading with respect to any material fact or which omits to state any material fact necessary in

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order to make the statements therein not false or misleading or necessary to correct any statement in any earlier communication with respect to the solicitation” a. Includes statements and omissions b. Includes facts and opinions that act as facts. (If you say something not believing it to be true.) An opinion can be a fact if it’s not what it purports to be. c. HYPO: “All directors who support the minority approved the merger.” i. False: No directors support the minority. ii. Misleading: True, but misleading because qualifications are lacking. d. Omission HYPO: CEO statement, “We will oppose the takeover offer if it’s not in the best interest of the shareholders.” i. He does not oppose, but it’s not in the best interests of the shareholders. ii. His reason for not opposing was because he got a large employment contract with the takeover company. iii. Non-disclosure of this information is a violation. e. “Predictions as to specific future market values” may be considered misleading. i. But these are difficult to predict with total accuracy, market values of shares are always changing with the market, much easier to predict expected earnings, etc.

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ii. Reflects the importance the SEC gives to this information (see MD & A disclosure above) iii. Cannot make predictions about market values of shares BUT you can state future issuers’ earnings. f. Proxy statements are 100+ pages long because of this—they are written with an eye toward and in anticipation of litigation. 2. Private Right of Action under § 14(a): J.I. Case Co. v. Borak a. Rule: When a federal securities act has been violated, but no private action is specifically authorized or prohibited, a private civil action will lie and the court is free to fashion an appropriate remedy. 3. Implied Private Right of Action—Causation Defined: Mills v. Electric Auto-Light a. Common law causation for fraud—must be reliance to one’s detriment—but how can the reliance be established with respect to 10,000 shareholders— 10,000 depositions? b. Court has adopted something less than this standard in the context of securities regulation. c. You don’t need to prove reliance anymore. d. Test for Causation: Where there has been a finding of materiality, a shareholder has made a sufficient showing of causal relationship between the violation (misleading statement) and the injury (ex. Merger) if, as here, he proves that the proxy solicitation itself, rather than the particular defect in

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the solicitation materials, was an essential link in the accomplishment of the transaction. i. This test avoids the impracticalities of determining exactly how the votes were affected. ii. This test answers the question of causation open in Borak. e. Test for materiality of the misstatement or omission was whether “it MIGHT have been considered important by a reasonable shareholder who was in the process of deciding how to vote.” 4. Implied Private Right of Action—Materiality Defined: TSC Indus., Inc. v. Northway a. Need materiality to determine causation, because we can’t use reliance (see Mills). b. Rule: A fact omitted from a proxy solicitation is “material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote. 5. Non-Voting Causation under § 14(a): Virginia Bankshares, Inc. v. Sandberg a. Facts: After a freeze-out merger, in which the minority shareholders of (Bank) lost their interest, P and other minority shareholders sued for damages, alleging violation of § 14(a) and Rule 14a-9 and a breach of the fiduciary duties. b. Rule: i. An individual is permitted to prove a specific statement of reason knowingly false or materially misleading, even when the statement is couched in conclusory terms.

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ii. Causation of damages is compensable through a federal implied right of action cannot be demonstrated by minority shareholders whose votes are not required to authorize the transaction given rise to the claim. c. Proxy solicitation here wasn’t necessary to obtain votes legally required to authorize the action. i. Why do it? 1. Puts shareholders on notice of major transactions d. If you can show that directors solicited proxies in order to get minority shareholders to abandon their appraisal rights, you have a cause of action. d. Shareholder Proposals and Communications with Shareholders i. Most shareholder proposals are never actually adopted. ii. Rule 14a-8: 1. A shareholder can include a proposal if they hold 1% of outstanding securities. One proposal per shareholder 2. Corp. can exclude some proposals from the proxy statement. a. Why? i. Too much information for shareholders to digest. ii. Too costly to print all that information. 3. SEC can force the corp. to include some proposals. iii. Proxy Statements 1. Can be in different forms. 2. Usually the management will do it to elect board members. Easier when the shareholders are spread out. 3. Shareholders can also do it.

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iv. Prohibitions: Things excludable from proxy statements 1. You can’t put personal grievances in proxy statements. 2. Things that deal with “ordinary business matters” 3. Management may try to exclude socially, political proxy statements in by-laws. 4. Proposal related to director elections. a. See Rauchman v. Mobil Corp. p. 655 XI. Securities Fraud and Insider Trading a. Rule 10b-5 (from the 1934 Act): Under this rule, it is unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or the mails, or of any facility of any national securities exchange to: i. Employ any device, scheme, or artifice to defraud; ii. Make any untrue statement of a material fact or omit to state a material fact necessary in order to make the statement made, in light of the circumstances under which they were made, not misleading; iii. OR engage in any act, practice, or course of business that operates or would operate as a fraud or a deceit upon any person, in connection with the purchase or sale of any security. b. A violation of 10b-5 can result in: i. A private suit for damages; ii. An SEC suit for injunctive relief; iii. OR criminal prosecution c. Elements of a10b-5 Cause of Action i. Intent to Deceive ii. Manipulation 1. affirmative act to deceive 2. silence in the face of a duty to disclose 3. a breach of fiduciary duty IS NOT enough iii. “Materiality” of the information

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1. reliance is presumed 2. the info would have impacted a reasonable investor’s decision 3. Can be a subjective test. a. If you start trading on the information it can become material. iv. Duty v. Causation

d. Rationale for the Rule: You should only use inside information for the benefit of the corporation not for your own personal benefit. e. Duty to Disclose & The Classic Insider: SEC v. Texas Gulf Sulphur p. 837 i. Facts: D made a significantly large discovery of mineral deposits. While concealing the magnitude of the find, certain corp. employees purchased large amounts of D’s stock. A misleading press release was issued to suppress the effect of rumors of the large discovery. Some nonemployees bought D’s stock just prior to public release of the discovery based on their advance knowledge of the release. ii. Scenarios: C knows there are valuable minerals on B’s land. B is a subsidiary of C. C offers to buy B’s land. C has a fiduciary duty to B because of the subsidiary relationship. C could be liable for the first (fraudulent) press release. iii. Materiality: The info affected the investors’ decision to invest. 1. When did it become material? iv. Rule: If a corp. employee has inside information, he/she must abstain from trading OR they must wait until the info is disclosed before trading. v. Rule: A corp. that issues public statements concerning a matter which could affect the corporation’s securities in the marketplace

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must fully and fairly state facts upon which investors can reasonably rely. Any departure from that standard subjects the corporations to liability for violation of Rule 10b-5. f. There must be a Duty to Disclose for liability to attach: Chiarella v. US p. 850 i. Facts: While employed as a printer, D saw information that one corp. was planning to attempt to secure control of another, and he used this info by going out and trading stock. ii. Rule: 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 disclose material information he has acquired, and his failure to disclose such information does not, therefore, constitute a violation of 10b-5 of the 1934 Act. g. Misappropriation Theory (2nd method to find a duty) i. Theory: To the extent you owe a duty to the information provider and use inside information to trade for your own personal benefit, you have misappropriated the information. ii. US v. O’Hagan p. 861 1. Facts: D, an attorney, was indicted for trading securities in Pillsbury based on confidential information he obtained by virtue of his association with the corporation’s law firm. 2. Rule: a. When a person misappropriates confidential information in violation of a fiduciary duty, and trades on that information for his own personal benefit, he is in violation of SEC §10(b) and Rule 10b-5. b. The SEC did not exceed its rulemaking authority by promulgating Rule 14e-3(a), which prohibits trading on undisclosed information in a tender offer

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situation, even where the person has no fiduciary duty to disclose the information. h. Tipper/Tippee Liability: Dirks v. SEC p. 873 i. Rule: 1. A tippee assumes a fiduciary duty to the shareholders of a corp. not to trade on material nonpublic info only when the insider (tipper) breached his fiduciary duty AND the tippee knows or should know that there has been a breach. 2. The tipper only breaches his/her fiduciary duty if they gain a benefit from tipping the info. i. Relationship of Trust & Confidence i. US v. Chestman p. 881 1. Facts: After stockbroker D purchased shares of a corp. when he acquired nonpublic inside info, he was indicted and convicted of violating the 1934 Act. 2. Rule: One who misappropriates material nonpublic info in breach of a fiduciary duty or similar relationship of trust and confidence and uses that info in a securities trade violates Rule 10b-5. 3. Misappropriation theory won’t work because D owes no duty to the family (where the info originated). 4. Why shouldn’t Ira (the father) be held liable? 5. Did Keith (the tipper) breach a fiduciary duty or similar relationship duty to his wife? a. You need to prove a breach in order to get D (tippee). b. The Court says there is a difference between sharing secrets and sharing of business secrets. To have a duty there must be regular business communication. c. Here, there is no such duty between the tipper and his wife so D can’t be held liable.

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6. What if Susan (the wife of tipper) told the broker instead of her Keith? a. There would be a breach of duty. b. Here, Susan promised her mother not to tell anyone. Keith did not agree to a confidentiality agreement with Susan. j. How do you prove reliance? i. In Basic Inc. v. Levinson p. 906, the Court goes with the “fraud on the market” theory. ii. Who should bear the burden of proving reliance? 1. It’s a rebuttable presumption of reliance. iii. Court will presume a reasonable investor relied on the info. k. Rules Recap i. You have to trade on material, non-public info to be liable. 1. It’s difficult to disprove if you trade on the info. ii. The trader must allow adequate time for the public to analyze and digest the info. iii. There must be reliance on the info. 1. It’s a rebuttable presumption of reliance. iv. There must be a breach of fiduciary duty for liability. l. How to Approach an exam question on inside trading: ASK i. Is the info material? ii. Is the info confidential or public knowledge? iii. How did the trader get the info? 1. Classic Insider or Temporary Insider 2. Misappropriation Theory: see p. 865 3. Tipper & Tippee Liability a. The tipper must gain a personal benefit from tipping. b. Tippee must know or have reason to know the tipper breached a fiduciary duty.

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m. Hypos i. A wife overhears her husband (VP of corp.) talking about a tender offer. Wife trades on the info and makes a profit. Can she be held liable? 1. Traditional Insider: NO 2. Misappropriation Theory: Need two things a. Regular sharing of confidential business info between H and W. b. H had an expectation that W would keep the info confidential. 3. Tipper/Tippee Theory: W could be liable. H arguably received a benefit because their family income increased. W probably should have known H breached a fiduciary duty. ii. Former employee did research for a corp. (10 years earlier). Afterwards he followed the company and bought stock. 1. No liability: the information is too old to be material. iii. Maid finds confidential info in the trashcan at the corp. She trades on it and makes a profit. 1. Classic Insider: Could get her on this if she works directly for the corporation. If she worked for a Maid Service check the agreement between the corp. and the service. iv. Thief steals corp. info: NO DUTY; NO LIABILITY n. New Regulations & Amendments (NOT ON THE EXAM) i. Regulation F-D 1. Went into effect October 22, 2000 2. Selective disclosure of info is prohibited. ii. New Amendments to 10b-5 1. If you are aware of the info, you have relied on it. 2. 10b-5(2): Relationship in which you share confidence is enough to establish a duty.

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XII.

The Takeover Movement a. Tender Offer: A buyer issues an advertisement to shareholders offering to buy their shares usually at a premium price. i. General Info 1. Most tender offers are designed to take over the board. It’s easier than forcing a shakeup on the board. 2. In most situations, the buyer is not obligated to buy the shares unless they get majority control. 3. The buyer accepts the stock either on a first come first serve OR Pro-rata basis. ii. If there were no federal securities law (hypothetically) how would you regulate buyers? 1. General Fraud Statutes iii. Defensive Tactics to Counter Tender Offers 1. To counter a tender offer management will sometimes have an auction or sell the shares at a discount price to a “white knight” (friendly buyer). a. Problems: i. If the tender offer has a short time window (“Saturday Night Special”) finding a “white knight” could be difficult. ii. Management may be breaching their fiduciary duty. 2. Management could contract to sell off the corporation’s key assets if the tender offer is consummated. 3. Counter Tender Offer iv. Methods to reduce the likelihood of the buyer gaining control of the board: These plans force the buyer to negotiate directly with the directors. The directors can repeal these provisions if they approve the transaction. 1. Shark Repellent”: see p. 991

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2. Staggered director terms 3. Cumulative voting 4. Require supermajority voting (2/3 approval) 5. Fair price provisions a. In the 2nd step the buyer must pay the shareholders a fair price for their shares. 6. “Golden Parachute” contracts for top management 7. “Poison Pills” (Shareholder Preferred Rights Plans) a. The rights plans are triggered after a tender offer usually when the buyer acquires a certain % of shares. The aggressor can’t participate in any of the “poison pill” benefits. b. Flip Over Provision: Shareholders can purchase shares of the new corp. at a discounted price. c. Flip In Provision: Allows people in the target corp. to purchase discounted shares. It’s triggered when a buyer acquires a certain % of stock. b. The Williams Act i. Introduction: Congress amended the 1934 Act and added the Williams Act in 1968. ii. Duties under the Act: 1. Mandatory Disclosures 2. No false or misleading info used in tender offers. See sect 14(e) 3. Minimum time window a. Offers must be held open for at least 20 days. 4. Board must issue a statement about the offer within 10 days. 5. Unlawful to pass confidential info. c. Leveraged Buyouts: In this situation most of the purchase price is financed through loans and junk bonds.

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i. Purpose: The seller hopes the company’s assets will repay the loans by generating income. d. Responses by State Legislatures i. Rule: The Williams Act, the federal law regulating tender offers, does not specifically preempt state law. Therefore, preemption will occur only if the laws contain inconsistent provisions such that mutual compliance is impossible, or if the state law violates the intention behind the federal law. See CTS Corp. v. Dynamics Corp. of America p. 1010 e. Judicial Review of Defensive Tactics i. Should the Board be active or passive during a takeover? 1. A Board can’t remain totally inactive. The Board must make recommendations to the shareholders. 2. They should try and figure out if the price offered is a good one. 3. They should gather information about the deal. 4. They should make sure the shareholders get a fair price. a. The Board can take other factors into account when mounting a defensive attack: i. General public’s interest ii. Company employees iii. Coercive factors ii. Analyzing the Board’s defensive action in hostile takeovers: Delaware Law 1. Board needs to show that a legitimate threat to the company’s interests exists. a. Example: employee layoffs, forcing the shareholders to sell or take inferior junk bonds, etc. 2. The Board’s response must be reasonable related to the threat. a. Unocal Corp. v. Mesa Petroleum Co.

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b. Facts: Mesa, which already owned 13% of Unocal, instituted a two-tier front-loaded tender offer for another 37% of Unocal. The offer indicated that if it were successful, Mesa would then bring about a back-end cash-out merger in which the remaining half of Unocal stock would be bought out for junk bonds. Unocal’s board then offered to have Unocal repurchase up to 49% of its shares in exchange for debt that Unocal claimed to be worth $72 per share. But this repurchase program would backfire if Mesa was allowed to participate by reselling its shares to Unocal for the $72 debt package because Unocal would be subsidizing Mesa’s takeover by paying $72 for shares that Mesa had just bought for $54. Therefore, Unocal’s offer to repurchase its shares specifically excluded Mesa. c. Holding: The Delaware Supreme Court upheld the repurchase program and its exclusion of Mesa. Unocal directors had the burden of showing reasonable grounds to believe: i. That Mesa’s takeover posed a danger to the corporation’s welfare (not just to directors and management) ii. AND, that the repurchase program undertaken as a defensive measure was proportional to the threat posed. iii. Poison Pill Plans: In general, courts have upheld the validity of poison pill plans. But a few plans have been struck down. A key element to the fate of a poison pill plan is likely to be the degree to which it discourages hostile takeovers: if the plan so economically burdens bidders that practically no bidder is likely to come

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forward, the court is much more likely to strike down the plan than if it has merely a minor impact on the whole takeover process. 1. Moran v. Household Int’l p. 1034 a. Question: Does the board have authority to create poison pills? i. The provisions are in effect before the tender offer. So the aggressor has full notice. b. The court allowed the poison pill provision to go through i. The aggressor could always buy 19% of the stock (20% triggers the pill). Then they could wage a proxy contest to gain control and deactivate the pill. ii. Problems: It’s not very practical since the aggressor must disclose its intentions in the statement. But it’s still legal. c. Rights plans are often passed without shareholder approval. i. The statute allows it. ii. Blank check provision in the charter. It gives the board the ability to issue any type of stock. 2. Poison pills will probably not be upheld if the triggering % is too low and/or the flip-in price is too low. See CTS Corp. iv. “Level Playing Field” Rule: Revlon, Inc. v. MacAndrews & Forbes Holdings Inc. p. 1046 1. Facts: Revlon had a poison pill provision. In response Pantry Pride (the aggressor) increased its bidding price if Revlon would waive the pill. Revlon also searched for and

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found a white knight and entered into a lock-up agreement to purchase two of Revlon’s divisions if another acquirer got 40% of Revlon’s shares. 2. The Court ruled: a. The first response (poison pill) was fine because the price was too low. b. The second response (lock-up) was inappropriate in this situation. 3. New Rule: Once a sale or breakup of the company becomes inevitable, the board must seek to obtain the highest possible price for the shareholders and may not consider the interests of other constituencies. 4. When is the duty triggered? a. The duty is only triggered if the board starts a bidding war (e.g. the selection of a white knight) OR if they make a response to a hostile takeover. See Time Warner case p. 1049-1050 b. In the Revlon case it was triggered when the board went to the white knight and acknowledged the company was for sale. At this point it became clear that a sale would occur either way. 5. Once a Revlon duty is triggered can the board take into account outside and long-term interests? a. NO, unless these factors could reasonably affect the best price. 6. To the extent the company is not for sale (no Revlon duty triggering), the board has the freedom to do what they want with offers. XIII. Business Combinations a. 3 Ways to Acquire Another Corp. i. Purchase Stock

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1. Benefits: a. Non-taxable transaction b. No interface with the board or announcement c. No transfer of liabilities or debts to acquirer 2. The board of the acquieree must approve. ii. Buy Assets of the Other Corp. 1. Benefits: a. Just need board approval. b. No shareholder approval needed c. You only acquire the liabilities you choose 2. Downside: Can’t liquidate the acquired corp. until all of its creditors have been paid. iii. Merger: Once the merger takes place the surviving corp. assumes all assets, liabilities, and debt of the defunct corp. b. Mergers i. Types of Mergers: See notes from 11/27/00 for diagrams 1. Statutory a. A simply merges into B. 2. Triangular a. C merges with B, B is A’s wholly owned subsidiary. b. Approval from A’s shareholders is not required. 3. Reverse Triangular a. C is the survivor; B is absorbed by C b. A will be the parent of the surviving corp. which is C. c. A doesn’t want the debts and liabilities of C. But for some reason A wants C to stay alive. 4. Freeze Out a. A sets up B as a wholly owned subsidiary. A owns 51% of C.

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b. C merges with B, the minority shareholders are paid and cashed out. c. Protections Given to Shareholders During Mergers i. Duty of Care from directors 1. Heightened duty during the merger ii. Controlling shareholders have a duty of care to the minority shareholders. iii. Shareholder approval for mergers 1. Past: unanimous shareholder approval of mergers a. Rationale: i. You believe that when you invest in a corp. that corp. will continue to exist. ii. Hostility toward mergers. 2. Present: Unanimity no longer required. Only a majority of shareholder approval is required. iv. Moratorium on a Merger (DE law): If you (aggressor) acquire a controlling group of stock in a corp. you must wait for five years before commencing a merger unless 2/3 of the shareholders approve the transaction. v. Minority Rights (Appraisal Remedies) 1. See below d. Appraisal Rights i. Purpose: Shareholders who are dissatisfied with the terms of a merger, consolidation, or sale of assets other than in the normal course of business are permitted to compel the corp. to buy their shares at a fair value. However, this right usually does not extend to reductions of capital and other changes that only involve amendments to the articles of incorporation. The shareholders’ right to dissent is founded upon the belief that it would be fundamentally unfair to force dissenters to remain owners of a fundamentally changed corp.

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ii. How it works: 1. First, the minority shareholder must object to the proposed merger and put it in writing. 2. Second, the shareholder must make a demand for an appraised value of his/her shares. 3. Third, the shareholder gets appraisal rights. iii. PA Law: Farris v. Glen Alden Corp. p. 1088
1. Facts: D and List Corp. entered into a reorganization agreement under which D was to acquire List’s assets. P, a stockholder in D, sued to enjoin performance of this agreement on the ground that the notice to the shareholders of the proposed agreement did not conform to the statutory requirements for a proposed merger. D defended the action on the basis that the form of the transaction was a sale of assets rather than a merger so the merger statute was inapplicable.

2. Holding: The Court said the transaction was a de facto merger. A transaction is a de facto merger, and the minority shareholders get appraisal rights, if the agreement will so change the corp. character that to refuse to allow the shareholder to dissent will, in effect, force him to give up his shares in one corp. and accept shares in an entirely different corp. 3. Problems with suing on a fiduciary duty breach instead of a de facto merger a. Tougher burden of proof 4. DE and most other states do not follow the de facto merger doctrine. iv. Duties under Freeze Out Mergers: Coggins v. New England Patriots (handout) 1. Under what test do you apply a freeze-out merger? a. Business Purpose Test b. OR, Intrinsic Fairness Test 79

c. OR, Both (The court follows this) XIV. Social Responsibility

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