Corporations: GSU COL Fall 2003 Professor Knowles Fixed-income instrument: Instruments that have a fixed repayment Bond: Debt instrument in which the bond grantor receives interest and the balance of the bond later
TABLE OF CONTENTS
Forms and Types of Companies .................................................................................................................................................................................. 2 American Law Institute – Restatement Of The Law Third – Agency ..................................................................................................................... 5 Duties of Partners to Each Other ................................................................................................................................................................................. 6 Partnership Accounting ................................................................................................................................................................................................ 6
Taxation & Limited Partnerships ........................................................................................................................................................................................................................................................................................ 7
Characteristics of Alternative Types of Business Organization .............................................................................................................................. 9 Process of Incorporating ............................................................................................................................................................................................... 9 Direct v. Derivative Suits ............................................................................................................................................................................................ 12
PROMOTERS ...................................................................................................................................................................................................................................................................................................................... 12
Defective Incorporation: ............................................................................................................................................................................................. 14
De Jure Corporation: .......................................................................................................................................................................................................................................................................................................... 14 De facto Corporation .......................................................................................................................................................................................................................................................................................................... 14 Corporation by Estoppel .................................................................................................................................................................................................................................................................................................... 15 Certificate of Incorporation Required ............................................................................................................................................................................................................................................................................... 15
Disregard for the Corporate Entity – Piercing the Corporate Veil ........................................................................................................................ 15
Instrumentality or Alter Ego Doctrine .............................................................................................................................................................................................................................................................................. 15 INTERNAL AFFAIRS DOCTRINE: .................................................................................................................................................................................................................................................................................. 16 Uniform Fraudulent Transfer Act (UFTA) [Adopted in GA] ......................................................................................................................................................................................................................................... 17
Reverse Piercing Of The Corporate Veil ................................................................................................................................................................... 18
Deep Rock Doctrine: ........................................................................................................................................................................................................................................................................................................... 18
Successor Liability ....................................................................................................................................................................................................... 19 Financial Matters and the Corporation ..................................................................................................................................................................... 19
Debt and Equity Capital .................................................................................................................................................................................................................................................................................................... 19 Types of Securities .............................................................................................................................................................................................................................................................................................................. 20 Authorization and Issuance of Common Shares Under the MBCA .............................................................................................................................................................................................................................. 21 Debt Financing .................................................................................................................................................................................................................................................................................................................... 22 LEVERAGE: ........................................................................................................................................................................................................................................................................................................................ 23 Planning the Capital Structure for the Closely Held Corporation ................................................................................................................................................................................................................................. 23
PUBLIC OFFERINGS .................................................................................................................................................................................................. 23
Test to determine whether there is an investment K: .............................................................................................................................................................. 25
Issuance Of Shares By A Going Concern: Preemptive Rights, Dilution & Recapitalizations ........................................................................... 26
Business Judgment Rule: ................................................................................................................................................................................................................................................................................................... 28 Distributions By A Closely Held Corporation ................................................................................................................................................................................................................................................................. 28 Distributions V. Investments: ............................................................................................................................................................................................................................................................................................ 29 Testing the Validity of Distributions: MBCA Provisions on Distributions ................................................................................................................................................................................................................... 31
Management and Control of Corporations .............................................................................................................................................................. 32
TRADITIONAL ROLES OF SHAREHOLDERS AND DIRECTORS ............................................................................................................................................................................................................................. 32
Deadlocks ................................................................................................................................................................................................................... 36
Gearing v. Kelly, 11 NY2d 897 (1962) ............................................................................................................................................................................................................................................................................... 36
Dissolution Statutes ..................................................................................................................................................................................................................... 37
Remedies For Oppression, Dissension Or Deadlock .............................................................................................................................................. 37 Control and Management in the Publicly Held Corporation ................................................................................................................................ 39
SOCIAL RESPONSIBILITY, OR THE LACK THEREOF ................................................................................................................................................................................................................................................ 39 Institutional Investors ........................................................................................................................................................................................................................................................................................................ 40
Sarbanes-Oxley Bill, Law In 2002: Securities Laws ................................................................................................................................................. 41
False Or Misleading Statements In Connection With Proxy Solicitations ..................................................................................................................................................................................................................... 42
Duties of Directors ....................................................................................................................................................................................................... 45 Duty of Care and the Business Judgment Rule ........................................................................................................................................................ 45
Duty of Loyalty and Duty of Care are the two primary duties of directors.................................................................................................................................................................................................................. 45
Fiduciary Relationship of Directors to Corporation................................................................................................................................................................. 45 Required Degree of Care and Capability, Negligence ............................................................................................................................................................. 45 Bank Directors Held to Higher Standard of Care..................................................................................................................................................................... 46 (MBCA) Director Liability Standard of Care is Based on Process Judgment: ....................................................................................................................... 46
Director’s Fiduciary Capacity/Duty .................................................................................................................................................................................................................................................................................. 47 Delaware General Corporate Law: §102 – Contents of Certificate of Incorporation ................................................................................................................................................................................................... 47
In Re Caremark Intern. Inc. v. Derivative Litigation, 698 A.2d 959 (1996) ............................................................................................................................ 48
Duty of Loyalty and Conflict of Interest ................................................................................................................................................................... 51
SELF-DEALING, INTERESTED CONDUCT ................................................................................................................................................................................................................................................................... 51
INTERESTED TRANSACTIONS................................................................................................................................................................................................ 51 TEST: Assessing transactions for fairness (not an exclusive list) ............................................................................................................................................ 51 Transactions will be approved when: ........................................................................................................................................................................................ 52 MBCA §8.31: Conflict of Interest ................................................................................................................................................................................................ 52
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Exec Compensation in Closely Held Corporations: ................................................................................................................................................................. 52 Exec Compensation in Publicly Held Corporations:................................................................................................................................................................ 52 Executive Compensation of Closely Held Corporations: ........................................................................................................................................................ 54 Majority Shareholders Owe Duty to Minority Shareholders: ................................................................................................................................................. 54 Subsidiary Relationships: ............................................................................................................................................................................................................ 54 Intrinsic Fairness Test Applicable .............................................................................................................................................................................................. 54 Corporate Opportunity ............................................................................................................................................................................................................... 54
Corporate Opportunity: Defined ...................................................................................................................................................................................................................................................................................... 55
Controlling Law: American Law Institute Approach .............................................................................................................................................................. 55
Insider Trading and Securities Fraud ............................................................................................................................................................................................................................................................................... 56
Rule 10b-5: Employment of Manipulative and Deceptive Practices ...................................................................................................................................... 56 Procedural Advantages of Rule 10b-5: (Fed Jurisdiction) ....................................................................................................................................................... 56 Insider Trading Under Rule 10b: ................................................................................................................................................................................................ 57 Defenses to Insider Trading: ....................................................................................................................................................................................................... 58 Stock Options as Compensation ................................................................................................................................................................................................. 58 Misappropriation: is a basis for a §10b violation ...................................................................................................................................................................... 58 Rule 14(e) Deception/Fraud in Tender Offers ........................................................................................................................................................................... 59 Fraud on the Market: ................................................................................................................................................................................................................... 59
Securities and Exchange Act of 1934 ......................................................................................................................................................................... 59
21A Civil Penalties for Insider Trading (Controlling Person Liability) ......................................................................................................................................................................................................................... 59
Insider Trading and Securities Fraud Enforcement Act of 1988 ............................................................................................................................................. 60 §20A Selling Same Type of Security as that of Violation ......................................................................................................................................................... 60 §16: Directors, Officers, and Principal Stockholders ................................................................................................................................................................ 60
Takeover Movement ................................................................................................................................................................................................... 60
Cash Tender Offers ...................................................................................................................................................................................................................... 61 Leveraged Buyouts ...................................................................................................................................................................................................................... 61
TAKEOVER DEFENSES: ................................................................................................................................................................................................................................................................................................... 62
Modified Business Judgment Rule for Selective Exchange Offers ......................................................................................................................................... 62
FORMS AND TYPES OF COMPANIES
Types of Businesses: Sole Proprietorship – business owned by a single person o Liable on all business obligations o No legal separation between owner and business o Risks grow as business grows o Small businesses o Minimize risk by transferring to wholly owned corporation or an LLC (then owner becomes shareholder, director, officer of corp.) Corporation o Nexus of Contracts Theory What the parties would have defined and decided upon, had they gone through all of the scenarios available to them Team Production Model Employees, managers, directors – the layers in a corporation that create and produce on behalf of the corporation Shareholder primus – directors have the sole responsibility to protect the interests of the shareholders of a corporation But this model says that directors‟ job is to mediate between the different groups of a corporation Problems arise with this model when the following three things happen: o Economic production requires a team with input from two or more individuals o Some of the resources team members must invest to produce are „team-specific‟ and have a higher value when used by that team and not in their next best use o Gains are joint and non-separable, making it difficult to attribute gains to any single team member‟s contribution o Closely held corporation, LLC, or Publicly held corporation o Subject to Fed Inc Tax o Mandatory procedural req‟s that may increase cost of operation to some extent o Independent entity, separate from its shareholders (but it is a legal fiction that does not, on its own, do things, but the people who work there act as agents) Page 2 of 64
Enters into Ks, borrows money, sues and may be sued in its own name, may own real estate DE Courts – Historically, states were competitive about getting companies to incorporate in their state, because the state receives income tax from the corporation State of Incorporation – Choice of law is governed by choice of law of the state of incorporation Lots of companies choose to incorporate in DE because the choice of law statutes are so flexible/beneficial to corporations o Active and passive investors and participants in a corporation have limited liability o Formed by following MBCA §§ 2.01-2.03, 2.05 Filing of Articles of Incorporation with the SOS o When advising clients on incorporating: Tax implications, tax payment structure Liability concerns Internal decision making Mandatory formalities o Tiers of Involvement in a Corporation: Shareholders – ultimate owners of corporation Board of Directors – managers of corporation affairs Officers – act for the corporation and implement decisions of the directors General Partnership o Default form for businesses owned by more than 1 person o Co-ownership need not be express o Oral agreements to share profits may be enough to establish a partnership even though each party does not contribute $$ to start it o Fragile form of business b/c one partner can end it by his/her own will to do so, expressly stated May result in dissolution or dissociation o Liability imputed to partner-owners even though one of them was Not part of the actions giving rise to the liability One did not receive economic benefit or enrichment from those actions Limited Partnership o As long as there‟s 1 general partner who has his/her assets at risk Limited Liability Company Limited Liability Corporations o Available in GA o Only the amount of money put into the corporation by the shareholders is available as assets, recoverable by creditors Limited Liability Partnership o General partnership in all respects except that the statute states that the partners have no personal liability for firm obligations exceeding the assets of the LLP o Partners have liability for claims against them for personal misconduct o Often law and accounting firms, but not often commercial business o Available in GA Limited Liability Limited Partnership
Important to know how they are held: Closely held – one or a few owners; usually unincorporated or corporations whose stock is not publicly held o While not usual for a corporation‟s officer to be immune from liability, in closely held corps, if fraudulent or negligent conduct (if the person is a tort feasor Publicly held – hundreds or thousands of owners; public market exists for ownership interests o State “Blue Sky” laws govern registration to sell stock o Must register with the SEC Businesses have two classification categories: Corporations Unincorporated Associations Page 3 of 64
Types: Proprietorships Partnerships Limited Partnerships o Benefits: Some forms grant the advantage of limited liability for all owners of the business Changes in regulations within IRC give unincorporated firms and their owners considerable freedom in electing how their income is to be taxed Relevant statutes: The Uniform Partnership Act (1914) [“UPA (1914)”] The Uniform Partnership Act (1997) [“UPA (1997)”] The Uniform Limited Liability Company Act of 1996 (ULLCA) The Model Business Corporation Act as amended through December 31, 2002 [MBCA] o GA Uses a modified version of this The financial provisions of the Model Business Corporation Act of 1969 [MBCA (1969)] o
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AMERICAN LAW INSTITUTE – RESTATEMENT OF THE LAW THIRD – AGENCY
§ 1.01: Agency Defined Fiduciary relationship Principal assents to the agent acting on their behalf, while retaining control of the actions the agent partakes on behalf of the principal §1.02: Parties’ Labeling and Popular Usage Not Controlling Agency relationship only arises when parties meet the §1.01 req‟s Reference between the parties that the relationship is an agency, industry or popular usage of the term agency is not controlling §1.03: Manifestation By written or spoken words, or other conduct §1.04: Terminology 1) Co-agents: 2 agents have an agency relationship with the same principal 2) Disclosed, undisclosed, and unidentified principals: a. Disclosed principal: principal is disclosed if, then agent works w/3rd party, that 3rd party is put on notice that agent is acting for principal and knows of the principal‟s identity b. Undisclosed Principal: Agent and 3rd party interact, and the 3rd party has no notice that agent is working for a principal c. Unidentified Principal: 3rd party has notice that agent is working for a principal but the 3 rd party does not know who the principal is d. Dual agent; joint principals: dual agent acts for > 1 principal regarding the same transaction and such principals are joint principals I. Notice: Notice is when one knows the fact, has reason to know the fact, has rec‟d effective notification of the fact or should know it to fulfill a duty to someone else; such knowledge is imputed to the principal under § 5.03 and § 5.04; notification to the agent = notification to the principal II. Person: A. Individual B. Organization or association that has legal capacity to possess rights and incur obligations C. Government, political subdivision, instrumentality created by gov‟t D. Other entities that have legal capacity to possess rights and incur obligations § 2.01: Actual Authority 1. When agent acts w/legal consequences for the principal if the agent reasonably believes the principal wishes him to do so § 2.02: Scope of Actual Authority 2. 1) Agent has actual authority to take action designated or implied by the principal, and/or acts necessary or incidental to achieving the principal‟s objectives 3. 2) Agent may claim reasonable interpretation of a principal‟s manifestations if it reflects any meaning known by the agent to be ascribed by the principal, or as a reasonable agent would in light of the context 4. 3) Agent‟s understanding of principal‟s objectives is reasonable when it accords w/inferences a reasonable person in agent‟s position would have understood from the circumstances creating the agency § 2.03: Apparent Authority Third party reasonably believes actor has authority to act on behalf of the principal and that belief is traceable to the principal‟s manifestations § 2.04: Respondeat Superior Any time employee is acting within the scope of their employment, employer is liable torts committed by employee § 2.06: Estoppel of Undisclosed Principal One (principals) is liable to a third party who justifiably is induced to make a detrimental change in position because the transaction is believed to be on the person‟s account if: o Person intentionally or carelessly caused such belief Page 5 of 64
Person had notice, knowing that others may change their position in reliance of it, but the person did not take responsible steps to notify them of the facts § 2.07: Restitution of Benefit Principal who is unjustly enriched by agent or apparent agent must make restitution § 3.10: Manifestation Terminating Actual Authority Notwithstanding any agreement between principal and agent, agent‟s actual authority ends if the agent renounces it by a manifestation to the principal or if principal revokes agent‟s actual authority by manifestation; effective when the other party has notice of it § 3.11: Termination of Apparent Authority Termination of actual authority does not end apparent authority Apparent authority ends when it is no longer reasonable for the third party dealing w/agent to believe the agent acts w/actual authority o
Employees: When employees‟ apparent authority is greater than the actual authority, Respondeat superior makes the employer liable
DUTIES OF PARTNERS TO EACH OTHER
Meinhard v. Salmon, 249 N.Y. 458, 164 N.E. 545 (1928). a. Joint interests between co-partners terminates at the end of the joint venture b. Salmon got a new lease on property by himself without his partner‟s knowledge, essentially cutting Meinhard out of the opportunity to continue their existing business relationship or to give meinhard a heads-up about the opportunity for a new lease c. Meinhard attached a trust to the lease in the lawsuit and the ct held that Salmon had the option to accept stock shares, in lieu of award for the lease in trust d. Moral Standard of Business Relations Between Partners i. Joint-adventurers or those with a fiduciary relationship owe each other “the duty of the finest loyalty” ii. “A trustee is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior.” e. JUSTICE ANDREWS DISSENT: said essentially that when the joint interest terminates, the duty within the relationship ends as well
PARTNERSHIP ACCOUNTING
Capital Account Sets out partner‟s ownership interest in the partnership UPA (Uniform Partnership Act [1997]) § 401 describes how each partner‟s capital account is to be constructed and maintained If there is a negative balance in the Cap Acct, then tax payer will have to deposit funds to cover the difference at the time of final settlement of accounts or when the partnership is terminated Often, each partner has his or her own capital account, however it is not necessary May also have another account/set of books to determine tax accounting Basic Accounting Principals Equity = Assets – Liabilities (equity is ownership or net worth) Assets = Liabilities + Equity Income = Revenues – Expenses Revenue – Cost of Goods Sold = Gross Profit/Receipts Gross Profit/Receipts – Operating Expenses = Net Profit Accounting Periods: accounting period for a company can be a Fiscal Year (beginning at a time that is not the beginning of the calendar year, often by quarters) or a calendar year Realization of Revenue: business must determine when they will realize their revenue realization usually set to be when the business is entitled to the receipt of the money sales realization may be at time of shipping, not order Page 6 of 64
Assets
realization based on disposition of property is at the time of disposition, not the K to sell it – formally this is termed Accrual Accounting cf. Cash Basis Accounting in which the revenue is recorded @ time of receipt. Balance Sheet __________ Liabilities + Equity __________ One Balance Sheet per Business, even if a client owns multiple businesses. All amounts should be shown in U.S. Dollars (or a single currency) Assets include debt owed to the business, rights to a patent, anything that can be assigned a dollar value Liabilities include a recognized debt or obligation owned to someone else, payable either in money or something reducible to money Balance sheets must balance! They represent a snapshot of a business‟ finances/an instance in time. The balance sheet considers the business as its own entity All transactions must be recorded in at least two places (double-entry bookkeeping) in order to balance out – cash used to buy an asset reduces the cash amount but increases the asset in the value of the asset
TAXATION & LIMITED PARTNERSHIPS Two types of business taxation: Corporate taxes and Partnership taxes o Corporate Taxation: Governed by Subchapter S and C of the IRC o Partnership Taxation: Governed by Subchapter K of the IRC Individual Tax Rates: 4 schedules based on situation (single, married, head of household, married filing single) Taxes on Capital Gains/Losses: assets held for the production of income, max rate for LTCG (> 1 yr held) is 20%; short term capital gains (STCG) = ord income; losses offset gains at max of $3000 over ord income with excess losses carried over Estate Taxes: based on size of decedent‟s estate less allowable deductions; estate tax will be phased out by 2010 Basis: cost of the investment o Substituted basis: basis of transferred property may be the same as that of the donor o Stepped-up basis: FMV of the assets @ TOD o Adjusted Basis: Adj Basis = basis + capital improvements + (commission, legal costs, etc.) – capital returns (such as depreciation deductions) Capital Returns: may include depletion, casualty losses, insurance reimbursement o Marginal Tax Rates: the $ over the margin setting is taxed at the higher rate, makes the average tax rate on the client‟s income Amount Realized: amount seller/transferor receives on a transaction Gain: amount realized – adjusted basis (if different, it is a loss) Taxation & Proprietorships Reporting: sales and losses are reported along with the proprietor‟s financial information Schedule C must accompany each 1040 individual filer‟s return and they should have a separate schedule C for each business Taxation & Unincorporated Business Forms General partner, limited partnership, LL Partnership, LLC Publicly traded partnerships are treated as corporations Losses and profits are shown on an informational return, then the partners will owe taxes on their portion based on the partnership agreement which are reported on their personal IRS return Taxation & C Corporations Have their own tax schedule Distributions to shareholders are taxed twice – once to the business and then to the dividend recipients Max tax on dividends is 15% Taxation & S Corporations Gives some relief to the double taxation problems of C Corps AKA “ Sub-s corporations” Must elect to be an S-Corporation when registering No more than 75 shareholders Issue only 1 class of stock Page 7 of 64
Business Tax Planning All businesses have to file a return and pay the taxes required Know the difference between “tax planning” and “tax fraud” when people seem to be avoiding the payment of taxes If there are multiple investors/owners, use the tax structure that benefits the person in the group in the highest tax bracket Business Classification Forms – “check the box” or “Check Box Regulations” Corporation – if described as “incorporated, corporation, body corporate, body politic, joint-stock company, and joint stock association” and is taxed as a C Corporation or an S Corporation if it qualifies Corporation – when comp has at least 2 members and files its first return as a corporation; if they don‟t formally elect to be called a corporation then they are automatically considered partnerships When 1 member can be taxed as a corporation or it will be taxed as “nothing” as if it was not separate from the owner of the company Once a company is formed in a specific manner, they cannot change for 5 years without permission of the Commissioner; if it goes from a corporation to a partnership – the corporation will close and the new partnership open simultaneously (a taxable event on both sides) If you are a corporation you can choose to be taxed as an S-Corp – but only if your company qualifies Representing the corporation and potential conflicts – must have full disclosure to both parties.
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CHARACTERISTICS OF ALTERNATIVE TYPES OF BUSINESS ORGANIZATION
Characteristics Formation Sole Proprietorship No filing req‟d General Partnership No filing req‟d; Agreement of parties involved. No permission req‟d Dissolved by Partner‟s death or bankruptcy Partners have unlimited liability Limited Liability Company S-Corporation Filing of State Official Req‟d Corporation
Duration
Sole Proprietor Determines Sole Proprietor has unlimited liability
Sometimes limited by state law
Perpetual
Liability
Simplicity of Operation Management Sole proprietor has full control of management and operations Not a taxable entity. Sole Proprietor pays all taxes
Taxation
Members not typically Shareholders are typically not personally liable for the debts of liable for the debts of the corporation the LLC Yes More formal than sole Formality of board of directors, officers, proprietorship, less annual meetings and annual reporting formal than corporation Typically each Members have The corporation is managed by or under partner has an = voice operating agreement the direction of the board of directors who unless otherwise that outlines are elected by the shareholders arranged management Not a taxable entity. Income/loss passed through to the members of the Corporation is a LLC taxable entity.
Double Taxation Cost of Formation Raising Equity Capital
No None Not unless individual puts in money No Contributions from partners or an addition of more partners No Filing Fee with the State Possible to sell interests; Subject to operating agreement restrictions Possibly Sell share of stock to raise capital.
Yes
Sell shares of stock to raise capital.
Transferability of Interest
Yes, subject to consent
Share of stock are easily transferable
PROCESS OF INCORPORATING
I. Where to Incorporate A. Depends upon factors such as: 1. Dollars-and-cents analysis of the relative cost of incorporating, or qualifying as a foreign corporation, under the statutes of the states under consideration 2. Consideration of the advantages and disadvantages of the substantive corporation laws of these states 3. Generally the local state jurisdiction or Delaware a. Delaware increased its franchise taxes b. May cost more to incorporate in DE and the local state c. Still have to pay franchise taxes in DE and local state d. May have to defend suit in DE and local state GCL § 831 allows a corporation with < 30 shareholders to be managed directly by the shareholders e. Many states have adopted § 7.32 of the MBCA, which also permits non-traditional management arrangements II. How to Incorporate A. Need the following documents: 1. GA REQUIRES PUBLICATION 2. Shareholder‟s Agreement – does not need to be filed 3. Bylaws – do not need to be filed a. Constitute the internal set of operating rules for the corporation MPCA §2.06 b. Includes (when pertaining to directors): (1) # of Qualifications (2) Increase or decrease in number Page 9 of 64
B.
C.
D.
E.
(3) Resignation and removal (4) Filling vacancies (5) Powers and Duties (6) Meetings of directors (7) Committees (8) Compensation and indemnification 4. Articles of Incorporation a. Usually only contains the provisions necessary by law 5. Initial Board of Director‟s Meeting a. Everything done b. Documented as minutes (1) Distributed c. Elect corporate seal d. Sell corporate stock e. GA Has adopted the sections allowing such meetings to take place via phone Specifics must be documented 1. See MBCA §§ 2.01-2.03, 2.05-2.06, 7.32 a. 2.01: Must show within the name “Inc.” or “Corp.” or some delineation that it is an incorporated company b. Number of shares authorized to issue c. Registered agent/office information (1) Address / But may not be its Principal Place of Business d. Name/addr of each incorporator e. Principal address f. MAY but does not have to include: (1) The identity of the initial directors (2) Provisions not inconsistent with Law 2. SOS has no discretion to dispute any information on the articles of incorporation – SOS has a statutory duty to file if the document meets the minimum requirements 3. 7.32 – Agreement among shareholders, enabling it to do away with the typical management structure – must have (this is an opt-out provision): a. Applies in GA (1) Only lasts for 20 years (2) MBCA is 10 years b. Unanimous approval by stockholders c. Show on stock certificates d. Put it in the corporations articles e. ** This is a risky way of doing this b/c of divorce, etc. Formal requirements for filing 1. See MBCA §§ 1.20 – 1.26 2. Some states perform electronic filing – this is becoming the trend 3. Some states (about 12) require the corporation to also file in a local county office 4. Some states (about 6) require publication of the Articles of Incorporation Other miscellaneous provisions: 1. MBCA § 6.01: Issuing shares of stock of more than one class 2. MBCA § 2.02(b)(4): Limiting liability of directors 3. MBCA §§ 2.02(b)(5), 8.50-8.59: Adjusting scope of right of directors and officers to indemnification Creation 1. MBCA § 1.25 describes how the filed documents should be processed 2. MBCA § 2.03 determines the date 3. MBCA § 2.02(c) sets out corporate powers a. Better to not make this an explicit provision, since omission of other factors may infer that those powers do not exist 4. MBCA § 4.01(e) – corporations may generally conduct business under an assumed or fictitious name, use of such is governed by state “assumed name” statutes a. Filed in local state offices Page 10 of 64
b. Reserved names MBCA § 4.02 c. Registered names: United States v. Dunn F. Duration 1. MBCA 3.02 [see also 54(b) and 3.02] grants corporations “perpetual duration and succession in its corporate name” so long as the Articles of the corporation are the same G. Purposes 1. Statement of Purpose for the corporation/company charter 2. Should be broad as possible but now often they just say “for the transaction of any lawful business” 3. MBCA § 3.01 allows and encourages no statement of purpose or at least a narrow statement of purpose: a. Some types of corporations may be engaged in a type of business that is regulated @ the state level b. Some people may be wary of getting involved with a company that cannot/does not give useful information about the corporation from the Articles of incorporation c. In closely held corporations, a limited purposes clause should be used when one or more persons interested in the corporation, because a limited purposes clause allows the stakeholders to define the boundaries of their business 4. Powers – MBCA § 3.02 a. “Powers” and “purposes” are not synonymous b. Statutorily not required, these powers have been given to the corporations 5. Initial Directors – used to have a set of directors at the beginning a. Named in the Articles of Incorporation b. Contrasted with “incorporators” who execute the Articles of Incorporation c. No longer necessary to name or list the 6. # of Incorporators, Directors, and Shareholders: no longer an issue a. In some states, the requirement is 3 b. Under MPCA there may be only one initial director and one initial incorporator c. These people are not required to meet with each other d. Annual Election of Directors (multiple years‟ may seem like protection against takeovers 7. Initial $ Requirement: used to have a $1000 in capital before showing why one needs to be registered a. Some companies included a provision stating that the would IPO shortly after incorporating (1) Doing so may require amending the article of inc, and bylaws b. Modern statutes DO NOT HAVE THIS REQ‟T c. Some states require par value for shares (can be omitted and leads to issues to be discussed later) 8. Presumption of Assent: a. Assent will be assumed if you do not show up or if you are silent to the matter 9. §2.01(4) and (5): a. §2.01 (4) Eliminating or limiting liability of a director (may include this provision with the applicable exceptions) b. §2..01 (5) May include a provision indemnifying directors for liability; board may take into account interests other than the shareholders‟ interests (no board has ever relied on this statute in a lawsuit) – does not work as a takeover device 10. “ANY CONSTITUENCY” Provisions: provides directors a defense from being sued for not taking the highest offer in a take-over bid a. GA Has adopted these types of statutes b. Adopted by states wanting to keep Corps local c. Doesn‟t really work H. Ultra Vires Doctrine: (Lat. “Beyond Granted Powers”) 1. When corporations engage in conduct that exceeds their powers granted to the corporation through the Articles of Incorporation/State Law 2. Amend incorporation papers in order to be able to have the new suit or claim (even if it is not part of the corp powers to do that) 3. Only shareholders or the State through its Attorney General can bring an action for ultra vires against a corporation 4. What makes an Ultra Vires Case? a. Clauses that involve purposes clauses that are narrower than the activities already actually engaged in by the corporation b. One side may breach a K, and not have to pay if it can assert an applicable legal defense Page 11 of 64
5. 6.
c. Corporations are not allowed to commit ultra vires acts d. Other doctrines include: estoppel, unjust enrichment, quasi-contract, and waiver (1) Also, Ks of guaranty and suretyship, purchases of corp‟s own shares, building homes for corp employees (or below-market interest rate loans on houses for employees), building villages for employees §3.02 – Powers: may include ability to make donations (slightly different in GA) [e.g., lobbying Sup Ct: held that corporations have the right to speak out against those issues of interest to the corporations
711 Kings Highway Corp. v. F.I.M’s Marine Repair Service 273 N.Y.S.2d, 299 (1966) Just because a corporation‟s charter papers do not state a specific type of business activity, it does not preclude that business from performing some other duty outside of the scope and authority conferred in the documents, rather the following exceptions exist to NY‟s §203 of the New York Business Corporation Law o The following exceptions are not constrained as a defense to only Ultra Vires claims o The following actions would not be dismissed under Section 203: Actions by shareholder to enjoin a corporate act Action by or in the right of a corporation against an incumbent or former officer or director of the corporation Action or special proceeding brought by Attorney General Theodora Holding Corp. v. Henderson, 257 A.2d 398 (1969) Sets out a test to determine whether a corporate officer‟s order to give a gift to a charitable is appropriate o Cites the case A.P. Smith Mfg. Co. v. Barlow 98 A.2d 581 which held that for a corporate charitable or educational gift to be valid, it must merely be within reasonable limits both as to amount and purpose o NJ Statute set limits: cannot be made when donee owns > 10% of voting stock of donor and the gifts are limited to 5% of capital and surplus unless authorized by the stockholders o Delaware uses a „reasonable amount‟ of a „charitable or educational nature‟ standard o Here, the test is based on the IRC sections pertaining to charitable gifts by corporations < 5% of Gross Income of the Corporation Ct allowed the gift to the charity because it was within those provisions, and as a matter of public policy, it is beneficial to move money from private to public holding
DIRECT V. DERIVATIVE SUITS
Direct: o Shareholder sues on their own behalf Derivative: o Shareholder comes into court, as of X date, I owned X # shares of this company; and an officer of the company did some act which injured the company o §7.4-7.47: Suit on behalf of the corporation by the shareholder (of course you have to be a shareholder Recovery goes back to the corporation PROMOTERS Often referred to as the “founder” or “organizer” of an enterprise o Sets in motion the activities that bring about the corporation o Brings together persons interested in the enterprise o Promoter owes fiduciary duty to the corporation and other participants of the venture [Post v. United States, 407 F.2d 319 (D.C. Cir. 1968).] Must faithfully make known all facts which might have influenced prospective members to the association Full disclosure includes duty to refrain from misrepresenting material facts and make known the promoter‟s personal interests in the enterprise Intentional conversion of funds obtained for the enterprise is fraud Funds for the enterprise are in the nature of a trust to benefit the future corporation Acts on behalf of a not-yet-formed Corporation Those who have a cause of action against a promoter o General creditors of the corporation or their representatives, usually trustees in bankruptcy o Co-promoters Page 12 of 64
The corporation that will be formed May be governed by statute MBCA – identical to GA 14-2-204 (would be 2.04 of the MBCA) o May be governed by Federal Statute where promoter seeks $ on behalf of the future corporation Rule 10(5)(b) of the Federal Securities Act of 1933: 1. Unlawful to use means of interstate commerce or the mails to sell publicly a security unless a registration statement has been filed with the SEC, and requires the following disclosures: o Names of promoters o Nature and amount of anything of value received or to be received by promoter, directly or indirectly o Assets acquired for the registrant from a promoter Amount of assets Principle to be followed in determining such amount and identity of the persons making the determination and their relationship with the registrant RULE: General principle that promoters are personally liable for Ks entered into on behalf of to-be-formed corporation unless o Exception that K is made “on behalf” of the corporation and other party agrees to look to corporation only for pmt – this extinguishes promoter liability o K made by promoter does not become a K for the corporation when it is formed o Promoter is not liable for K when other party knows the corporation does not exist (Yari v. Giles) Release of Promoter from Liability o Does not have to be express and may be shown from circumstances Party knows of corporation does not exist 1. But does not indicate agreement to release the promoter 2. Promoter should be liable until the other party agrees to release promoter Promoter tells other party that his intent for creating the corporation is to limit promoter‟s liability 1. Does not indicate an affirmative assent to limit promoter‟s liability Progress payments made to corporation 1. Dissent: Unless a party expressly or impliedly adopts or ratifies the K, then the K will appear to be generally accepted o o
Stanley J. How & Assoc. v. Boss, 222 F.Supp. 936 (1933) Facts: o Architect performed svcs for Boss o Partial payment of the K w/checks drawn as corporation o Boss modified the K to state “By: Edw. A. Boss, agent for a Minnesota Corporation to be formed who will be the obligor” o Corporation didn‟t exist b/c no corporate charter, by-laws, or resolutions were offered into evidence @ trial o K theory that parties did not have a meeting of the minds and the corporation ratified the K by performance Promoters act on behalf of the projected corporation and not for himself, will be personally liable on his K unless the other party agreed to look to some other person or fund for pmt Restatement of Agency §236 Comment b: to illustrate intent of the parties o Party is making revocable offer to the nonexistent corporation which will result in a K if corporation is formed o Other party is making irrevocable offer for a limited time supported by consideration express or limited promise by promoter to organize the corporation and use promoter‟s best efforts to cause other party to accept the offer o [Novation] Agree to a present K, binding promoter, and liability of promoter terminates if no corporation is created K not ratified if corporation is not created Page 13 of 64
Agree to present K on which, even though corporation becomes a party to the K the promoter remains liable primarily or as surety for the performance of the K Ambiguous words in K require use of rules of interpretation o How didn‟t intend for the corporation was to be sole obligor to the K RULE: Person signing the K for the nonexistent corporation is normally person liable D did not plead waiver of rights, so because P did not require strict compliance of corporation‟s existence ct would not penalize P by ruling for D Promoters abandoned their purpose for forming corporation, thus promoter was liable unless K stated explicitly: o P agreed that it would look solely to the new corporation for pmt o Promoter did not have any duty toward P to form corporation and give corporation opportunity to assume liability Attorney should look to the minute book to determine whether a party is authorized to enter into agreements on behalf of the corporation o The requirements that something appear in the minute book is what determines who may bind the corporation o Apparent authority of someone does not automatically bind the corporation But may show as extrinsic evidence as industry trade practice if ever litigated Judgment for P o
Robertson v. Levy, 197 A.2d 443 (1964) Levy was to form a corporation to buy/take over Robertson‟s business Articles of Incorporation were filed but the certificate of incorporation were rejected however Levy began to operate the business and made it look like it was incorporated because he used the Inc. name Issue: Whether the president of an association which filed its articles of incorporation and were later rejected and then subsequently accepted holds a president personally liable on an obligation entered into by the association before the certificate of incorporation has been issued and if the creditor is estopped from denying existence of the corporation Business went bust Levy was liable Ct said DC had a statute that barred Corporation by Estopped o You only have a corporation when you comply with the statute o Policy reason for holding this is because we want people to follow the rules/laws of incorporation MBCA §§ 50 and 139 (1950) o All persons who assume to act as a corporation without authority so to do shall be jointly and severally liable for all debts and liabilities incurred or arising as a result thereof.
DEFECTIVE INCORPORATION:
Before Certification as a Corporation, it may be one of the following types of corporations: DE JURE CORPORATION: o Results when there has been conformity with the mandatory conditions precedent o Has been incorporated as against all others o Not subject to direct or collateral attack either by the state in a quo warranto (by what authority) [proceeding questioning the right of an individual to take certain action] o Liability is limited as against the world DE FACTO CORPORATION o (rejected by the ct in Robertson v. Levy) o Is a corporation that has been defectively incorporated and thus is not de jure o Protects the promoter from liability o Requirements to be a de facto corporation, per the Sup Ct Valid statute under which such a corporation can be lawfully organized Attempt to organize as a corporation Actual user of the corporate franchise Corporation has done some business and is in good faith Corporation is recognized for all purposes except where there is a direct attack by the state in a quo warranto proceeding Page 14 of 64
§ 2.04 – if you acted as a corporation but there was no corporation then you are individually liable In Levy, Levy knew his articles were rejected but in Cantor v. Sunshine Greenery, Inc. the fact that the papers were sent and Sunshine didn‟t know the papers were never received o If all papers were signed, and party believed that they were dealing with a corporation, falls under Corporation by Estoppel (under NJ law) CORPORATION BY ESTOPPEL o No corporation o No acts of intent to fulfill the statutory requirements to become a corporation o Other party cannot hold out that a corporation existed and is estopped from doing so If a party accepts a dealing with another party as a corporation and does not rely on an individual for the credit, the party is estopped from claiming the corporation does not exist CERTIFICATE OF INCORPORATION REQUIRED o Serves as the cut-off point where a party may hold an individual and not the corporation liable o As of the DATE OF FILING, corporation is in existence, not to exceed 90 days from date of filing Filing is conclusive evidence that all conditions precedent required to be performed by the incorporators have been complied with Investors Not Liable: o Persons who assume to act as a corporation does not include those whose only connection with the organization is as an investor o o Frontier Refining Company v. Kunkel’s Inc., 407 P.2d 880 (1965) Kunkel contracts to take over a petrol station Refining company insists on Kunkel incorporating Kunkel held out that he had incorporated Kunkel submitted his personal financial statement to Frontier Fairfield denied that Frontier spoke to him about requirement to incorporate Kunkel signs Ks as Clifford D. Kunkel DBA Kunkel‟s Inc. o When he goes bust and disappears, the Refining Company is on the hook for the bill of petrol sold to Kunkel‟s o Fairfield and Beach signed to support Kunkel‟s business, so they were sued as individually liable Ct said they were not liable because they did not agree to be partners, they only agreed that Kunkel would incorporate MBCA 2.04 – statute does not recognize de jure or de facto corporations; but ct inferred from the indebtedness that the co was not incorporated because of the DBA designation by Kunkel Fairfield and Beach did not hold themselves out as part of Kunkel‟s But Frontier extended credit and obtained a chattel mortgage from Kunkel individually and DBA Kunkel‟s, giving up their claim against Fairfield and Beach Comes down to who is in the better position to bear the responsibility o Frontier should have done due diligence to check and ensure Kunkel was incorporated
DISREGARD FOR THE CORPORATE ENTITY – PIERCING THE CORPORATE VEIL
I. To what extent the corporate fiction exists – when a third-party may get to the personal assets of the corporate (MBCA 6.22) A. Separate Entity is a Legal theory and the cts will decline to recognize it whenever recognition of the corporate form would extend the principle of incorporation „beyond its legitimate purposes and would produce injustices or inequitable consequences‟ B. Party asserting a claim that the corporation is a façade has the burden of proof
INSTRUMENTALITY OR ALTER EGO DOCTRINE 1. Elements determining when a corp‟s veil will be pierced: Whether, (will not rest upon any single factor); “the two entities operated as a single economic entity such that it would be inequitable to uphold a legal distinction between them” 2. Corporation was grossly undercapitalized a. When do you measure capitalization? Beginning, periodically, upon dissolution… initial capitalization is not required by statute so it is different for every corp? Page 15 of 64
Brother/Sister Corps: may be able to impute liability by piercing the veils between each sibling corporation and not just the main shareholder c. CASH MANAGEMENT SYSTEMS: parent corporation funds the smaller subsidiary corporation by giving the subsidiary cash when it needs it – the accounts are connected and parent corporation provides funds to sub as the sub needs it (1) The pool of cash is much larger, but it benefits the sub(s) and parent because each corporation reaps much higher benefits on a larger amount of liquid resources (2) Also allows the parent corporation to manage resources more effectively (how they pay back $ used to buy the sub corps) (3) Must keep STRICT and SEPARATE books even though their cash may be intermingled to optimize its use 3. Failure to observe corporate formalities 4. Non-payment of dividends 5. Insolvency of the debtor corporation at the time 6. Siphoning of corporate funds by the dominant stockholder 7. Other officers or directors who serve no function 8. Absence of corporate records 9. Use of the corporation to promote fraud, injustice, or illegalities 10. Payment by the corporation of individual obligations 11. Corporation is a façade for operations of the dominant stockholder 12. A showing of fraud is not required C. When one who is the sole beneficiary of a corporation‟s operations and who dominates it, induces a creditor to extend credit to the corporation on such an assurance as given here, that fact has been considered by many authorities sufficient basis for piercing the corporate veil D. Tort victims usually cannot inquire into the corporate background in order to see if they can pierce the corporate veil E. K cases usually allow piercing of the corporate veil F. Subsidiary Corp: in personam jurisdiction may be found for a parent corp to impute liability of its sub corp – another way to pierce the corporate veil 1. P‟s burden of proof is to show: a. That the parent and the subsidiary “operated as a single economic entity” b. That an “overall element of injustice or unfairness” was present INTERNAL AFFAIRS DOCTRINE: 2. Internal affairs of a corporation are governed by the state in which the corporation was incorporated a. State law governs cases of piercing G. CORPORATE LAW is governed by state law 1. But Federal Cause of Action may use a State Law Doctrine – as in probate where the state law designating beneficiaries would control the distribution of assets/benefits provided under a federal law, such as social security Bartle v. Home Owners, Corp., 309 N.Y. 103, 127 N.E.2d 832 (1955) D co created a subsidiary that would provide homes to Veterans The subsidiary did not fare well and was adjudicated bankrupt after 4 years of operation Trustee in BK claims D pierced the corporate veil and was liable under K theory of unjust enrichment because D pledged its assets as security for D‟s Subsidiary co debt Lower cts said it was OK for D to make a separate corp for the purpose of escaping personal liability and since D always maintained the separate companies, did not commit fraud, and all creditors were aware of which co they were extending credit to – then D was not liable for the BK co‟s debts Dissent: Judge Van Voorhis dissented stating that business was done such that the subsidiary co could not make a profit, and being a wholly-owned sub with the same corporate board, then they should be liable for sub co‟s debts o Subject of the sub co was to allow the board to build their homes @ cost with no builder‟s profit o Said that Home Owners‟ co was an agent of Westerlea (the primary co) and the benefit went directly to Westerlea stockholders
b.
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Dewitt Truck Brokers v. W. Ray Flemming Fruit Co., 540 F.2d 681 (1976) P‟s company was hired to ship fruit for D‟s co o Flemming‟s company was to receive commissions and transportation fees for the sales it made on behalf of growers o He would keep the transportation fees for himself and induced the P to continue shipping for him on credit D‟s founder did not maintain the corporate identity separate from himself and did a number of things to subvert the corporation o Was not forthcoming about who the stockholders were o Issued 5000 shares of stock then could only account for ownership of 3000 o Kept no corporate records of a real director‟s meeting o Contacts with the only other person he said was on the board, Bernstein, were only via phone and Bernstein was merely a figurehead who never received payment for his services o Never held a stockholders‟ meeting o Flemming kept the company‟s operating capital at zero No one other than Flemming rec‟d salary Any amount that was available in the corporation‟s accts was withdrawn by Flemming as salary Flemming also gave assurance to P that he would pay the debts of the co even if the corporation could not District Ct‟s rulings that there was no error in holding Flemming liable for the debt of the co (piercing the corporate veil) and affirmed their ruling UNIFORM FRAUDULENT TRANSFER ACT (UFTA) [ADOPTED IN GA] For specifics, see casebook pg. 354 Adopted in about 40 states and sets out the definition of fraudulent transfers between creditors and debtors Depends highly upon the debtor‟s intent in receiving the transfer o When determining intent, it takes into account issues such as debtor insolvency soon after the transfer, whether debtor was an insider, location of debtor‟s assets, etc. Remedies to creditors include “avoidance of the transfer or obligation to the extent necessary to satisfy the creditor‟s claim” and “any such other relief the circumstances may require” United States v. Best Foods, 524 U.S. 51 (1998) CERCLA (Comprehensive Environmental Response, Compensation, and Liability Act) – 42 USC § 9601 is a statute that allows the government to sue companies that commit industrial pollution in order to receive damages that will pay for the clean up efforts A parcel of land had been identified as being polluted – the gov‟t ordered it cleaned up and a company called Aerojet bought it from the Trustee administering the estate of bankrupt debtor Story Chemical Company Through years of litigation, this action came to determine whether: o A parent corporation that actively participated in, and exercised control over the operations of a subsidiary may, without more, be held liable as an operator of a polluting facility owned or operated by the subsidiary Ct said NO – unless the corporate veil could be pierced Would only be held liable when it actively participates in, and exercises control over the operations of the facility itself – then the parent company may be held directly liable in its own right as an operator of the facility Dist Ct held that operator liability may attach to a parent corporation both directly, when the parent operates the facility, and indirectly when the corporate veil can be pierced under state law o When exercising dominion over activities that included pollution = yes, pierce the veil o When exercising oversight in a manner consistent with the investment relationship between a parent and its wholly owned subsidiary ≠ pierce the veil Owner Liability v. Operator Liability o Operator Liability of the parent company will depend upon whether the degree to which it controls its subsidiary and the extent and manner of its involvement with the facility, amount to the abuse of the corporate form that will warrant piercing the corporate veil and disregarding the separate corporate entities of the parent and subsidiary Norms of corporate behavior are crucial reference points, and if those norms are being employed, liability will not usually be imputed, those norms of corporate behavior may include: Page 17 of 64
Monitoring of the sub‟s performance, Supervisions of the sub‟s finance and capital budget decisions Articulation of general policies and procedures
Stark v. Fleming, 283 F.2d 410 (1960) Ms. Stark was denied Social Security benefits, so she created a corporation, transferred all of her assets to it, and drew $400 salary off of the company as salary Ct ordered secretary of Health, Education and Welfare to investigate the proper amount of salary she should have received (using comparable data), reversing the prior ct‟s decision o Salary would have had to be a reasonable salary Roccograndi v. Unemployment Comp. Bd. of Review, 197 Pa.Super. 372 (1962) Group of family employees with equal stakes in a wrecker company Would hold stockholder meetings when business was slow and lay decide who to lay off (they took turns) and then collect unemployment Board of Review for Unemployment said they could not get unemployment because they were self-employed, or were self-employed persons whose business venture had a lag in remuneration o They would have had to have been involuntarily unemployed Decision to deny them Unemployment Benefits was affirmed
REVERSE PIERCING OF THE CORPORATE VEIL
Cagill, Inc. v. Hedge, 375 N.W.2d 477 (1985) An owner-occupant of a farm placed his land in service with a family farm corporation, and in doing so, he rendered his ability to use the homestead creditor exemption for owning/running a farm useless A house, dwelling place, and land are constitutionally protected from judgment creditors under the Minnesota Constitution o Reverse piercing goes toward, as a policy reason, supporting the MN Const The Hedges sought to save 80 of 170 acres under the homestead exemption because the sole stockholder of the corporation is debtor‟s wife and she is not the debtor Reverse piercing has to do with the gov‟t/cts deciding that although there are two entities (principal and corporation) it may be necessary to pierce the veil in order to disregard the corporate entity when there is a sole stockholder of the corporation It will depend upon the degree to which the alter ego is the same as the sole or majority stockholder, and to what extent a creditor or other stockholder would be harmed Here, although the Hedges maintained some formalities, they essentially ran the farm corporation as their own; individual family members were the officers of the company Ct reverse-pierced the corporation and deemed the creditor‟s execution sale of their remaining 80 acres void Pepper v. Litton, 308 U.S. 295 (1939) Case considers the BK Ct‟s ability to set aside a judg‟t (regardless of whether it was secured, unsecured, or general claim against the BK estate) Dixie Splint Oil Co (sole owned by Litton) owed Pepper royalties under a lease; Litton then gave himself a judgment from Dixie for back salary; when Pepper got its lease judg‟t, Litton sold himself the Dixie corporate assets in an execution to satisfy his own judg‟t; Litton then filed a bankruptcy petition on behalf of Dixie; the Trustee sued in STATE Ct to set aside Litton‟s judgment and get the assets back, but lost; Litton then filed a claim against Dixie‟s bankrupt estate for the remaining balance of the judgment due to Litton by Dixie; but the Dist Ct disallowed Litton‟s claim and further directed that the proceeds from Litton‟s execution sale of Dixie‟s assets be set aside in favor of the Trustee BUT when Litton appealed the Dist Ct‟s ruling, the Ct of Appeals reversed the Dist Ct on grounds of Res Judicata DEEP ROCK DOCTRINE: Controlling shareholder will not be rewarded for misconduct or unfair dealing in courts of equity o BK Cts hold proceedings of equity and have original jurisdiction over bankruptcy cases Burden is on Litton to prove that the transaction of the judg‟t was in good faith and in the best interests of the corporation because he had a fiduciary duty to the corporation – if it was not an arms length transaction, then equity will set it aside Page 18 of 64
SUP CT said that the Dist Ct was RIGHT IN SETTING ASIDE THE STATE CT DENIAL OF LITTON’S JUDG’T
SUCCESSOR LIABILITY
Nissen Corp. v. Miller, 323 Md. 613 (1991) Nissen purchased from Atlantic a treadmill company – its trade name was American Tredex, and Nissen assumed assets, patents, etc. but not liability for injuries of prior goods sold American Tredex would continue as AT Corporation for 5 years o AT Corporation went bust a year after a Mr. Brandt was injured on a treadmill and sued: American Tredex AT Corporation Nissen (motion for summary judg‟t = granted) Atlantic (cross-claimed Nissen for indemnity and contribution) also appealed with Brandt to Ct of Special Appeals which set aside the trial ct Issue: Whether the general rule of nonliability of successor corporations should be adopted (4 exceptions thereto – or to add a 5th exception) General Rule of Corporate Successor Liability o A corporation which acquires all or part of the assets of another corporation does not acquire the liabilities and debts of the predecessor, unless: There is an express or implied agreement to assume the liabilities The transaction amounts to a consolidation or merger The successor entity is a mere continuation or reincarnation of the predecessor entity The transaction was fraudulent, not made in good faith, or made without sufficient consideration o Appellees want to ADD another exception to the nonliability of successors: [THIS CT DECLINES TO ADD THIS EXCEPTION, BUT THE DISSENT WOULD INCLUDE IT] Expand the mere continuation exception or add a continuity of enterprise exception Exists when there is a continuation of directors and management, shareholder interest and in some cases inadequate consideration – focuses on continuation of management and ownership Mere continuation equates to continuation of the corporate entity rather than the continuation of the business operation Brandt argues that a corporation should not be able to purchase only the benefits of another corporation when it puts products into the stream of commerce Ct adopted strict liability for the injury – no causal relationship between Nissen and Brandt‟s injury
FINANCIAL MATTERS AND THE CORPORATION
DEBT AND EQUITY CAPITAL 1. Capital Defined: Financing that firms use to fund their business activities a. Basis for Credit: Capital of a corporation is the basis of its credit b. Substitutes Liability: Capital is a substitute for the individual liability of those who own its stock c. Creditor Reliance: Creditors and others may rely upon the assumption that a corporation has paid in capital to the amount which it represents itself as having d. Fraudulent Representation of Capitalization: if a creditor provides credit to a corporation on the faith and reliance of how the corporation represents its capitalization of the corporation, if the representation is false, it is fraud against the creditor 2. Capital can be obtained by: a. Borrowing from friends, banks, or credit cards b. Capital contributions from the owners of the firm c. Capital contributions from outside investors who thereafter either remain inactive or become active coowners of the firm d. Retaining earnings of the business rather than distributing them to owners 3. Equity = market value of property – market value of debts that are liens against that property a. Debt: Differs from debt which has to be repaid, interest must be repaid and the repayment of the total debt is not contingent on the success of the business i. Fixed Claims: debt is considered a fixed claim and has priority of payment over equity claims Page 19 of 64
ii. Equity Claims: considered “residual claims” and those who have those claims only receive on their claims once fixed claimants are paid; interest in the business, ownership stake and is dependent upon the success of the business TYPES OF SECURITIES 4. Shares Generally: Units into which the proprietary interests in a corporation are divided a. Can have multiple classes of shares: Common Shares and Preferred Shares which are defined in the articles of incorporation i. Common Shares: MBCA § 6.01(b) defines rights of common share holders [same in GA] (1) Vote for the election of directors and other matters (2) Entitled to the net assets of the corporation (after debts paid) when distributions are made in the form of dividends or liquidating distributions (3) Holders of common stock have a right to inspect the books and records of the corporation (provided it is for a lawful purpose) (4) Have a right to sue on behalf of the corporation to right a wrong committed against it [derivative suit] (5) Characteristics of Common Shares (according to US Sup Ct): (a) Receive dividends contingent upon an apportionment of profits (b) Negotiability (c) Ability of those shares to be pledged or hypothecated (d) Conferring of voting rights in proportion to the number of shares owned (e) Capacity to increase in value ii. Preferred Shares: preferential to those assigned to the common shares, but limited in some way (terms are defined in the Articles of Incorporation) (1) Usually, but not always non-voting shares (2) Grant a “priority” or “preference” in payment as against the holders of common shares (a) Preference may be in the payment of dividends or in making distributions out of the capital of a corporation, or in both (3) Holders may have limited or „capped‟ rights to earnings (4) Defined in the articles of incorporation in a “preferred shareholder‟s contract” (a) Thus have a contract right against the board conversed from Common Shareholders who are owed a fiduciary duty by the board b. Dividends and Distributions: distribution of corporation funds i. Dividend: distribution from current or retained earnings (1) No rules by MBCA for dividends (2) Paid by business judgment of the directors (3) Legal tests apply to when a corporation may declare a dividends ii. Distributions: payments to shareholders out of capital (1) MBCA sets the rules on how these are paid out 5. Securities Act of 1933, 15 USCA §77a: Imposes substantial disclosure requirements on the public sale of securities using the mails or the facilities of interstate commerce; public offerings must be registered with the SEC; emphasis on public disclosure as req‟d by Fed Stat; also regulated by Blue Sky Laws (state regs) 6. Rights and Privileges to Publicly Traded Shares: a. Cumulative dividend rights: If a preferred dividend is not paid in any year, it accumulates and must be paid (including prior year dividends) before a dividend can be paid to common shares in a later year b. Non-cumulative Dividend: not carried over from year to year and if no dividend is declared during the year – preferred dividend holder loses the right to receive the dividend for that year c. Partially Cumulative Dividend: would only pay dividends in profitable years d. Voting Rights: usually preferred stock holders do not have voting rights, but if dividends are not paid out for a specified period, it is customary to provide that nonvoting preferred shares obtain a right to vote for the election of a specified number of directors e. Liquidation Preferences: fixed @ specified price per share, payable upon dissolution of the corporation before anything may be paid to the common shares; not a debt, but a claim to priority if and when funds are available f. Redemption Rights: preferred shares may be redeemable at the option of the corporation @ a price fixed by the articles of incorporation Page 20 of 64
7.
8.
Corporation has the right to redeem, “call” the shares at a set price and shareholder must accept that price (a specified period of time must have elapsed) g. Conversion rights: preferred shares may be convertible at the option of the holder into common shares at a fixed ratio specified in the articles of incorporation i. Typically conversion ratio is set so that the preferred shares must appreciate considerably before they are profitable under conversion ii. Convertible shares are often also redeemable h. Protective Provisions: i. Sinking fund provisions: require the corporation to set aside a certain amount each year to redeem a specified portion of the preferred stock issue ii. Protection from Dilution: provisions which protect the conversion privilege from dilution in case of share splits, issuance of additional common shares i. Participating Preferred: all preferred stocks not designated participating preferred are limited to the amount pre-designated as their value; but participating preferred shares are entitled to the specified dividend, and after common shares are paid dividends, the two types share in the additional distributions on some predetermined basis (may be called “Class A Common” because it is common in its receipt of proceeds but enjoys a higher preference over basic common stock) j. Classes of Preferred: Corporations may issue different classes, Class A Preferred, etc., and give each class different dividend rates, rights on dissolution and priorities k. Series of Preferred: MBCA § 6.02a2 – refers to “one or more series within a class” i. Because issuance of new types or classes of preferred stocks require modifying the articles of incorporation, corporations create a class of preferred shares which have no financial terms, but the board of directors may carve out series within that class ii. AKA “blank shares” iii. Within a class – all shares have the same financial terms iv. Within a series – all shares have the same financial terms Classes of Common Shares: a. Authorized by statute in the MBCA § 6.01: i. Classes of common shares by appropriate provision in the articles of incorporation ii. Each individual class may have different financial, management, and voting rights b. Flexible Rate Preferred Shares: amount of dividend is tied to an objective standard, such as market interest rates c. The designation of the name of the type of shares is of no major import as the board of directors may choose whatever name they want Share Subscriptions: a. Initially used as a method before incorporation to raise capital b. Actual formation of corporation would not happen if the minimum number of subscriptions had not been sold c. Once the subscriptions are made, the corporation “calls” on the amount owed to it for the shares (this is governed by MBCA § 6.02 d. Financing by subscription is now the exception and not used often
i.
AUTHORIZATION AND ISSUANCE OF COMMON SHARES UNDER THE MBCA 9. Any number of shares may be issued at any price so long as the combination (number of shares X share price) totals the amount of the issue amount overall (so if they were set to raise $10K capital thru issuing stock, the shares could be 2 x $25K or 10,000 @ $1) 10. Number of shares authorized in the corporation‟s articles of incorporation must not exceed the total number of shares that the corporation plans to issue; and there should be a limit to the # shares because: a. Limiting the number of shares protects minority share holders because majority holders may authorize issuance of more, thus diluting their value b. Some states impose taxes on authorized shares 11. Eligible/Ineligible Consideration for Shares: a. §§ 19, 25 of MBCA provide for how actual receipt for value is accomplished for stock issues; sometimes it may be services, sometimes the board can consider services already rendered; provides for a type of protection to: Page 21 of 64
Protects creditors of the corporation who may rely upon its capital in extending credit, since it attempts to assure that there is something “real” which can be levied against and sold; ii. May protect other investors, who do invest real assets such as money and property, from dilution of their interests b. Shares may not be issued for the consideration of a promissory note c. Shares must be paid for in order to protect shareholders from liability d. Loans by shareholders to corporation are debts, and not assets of the corporation 12. Ways to Value Things: Makes it difficult to value things in closely held corporations a. Par Value – Arbitrary value assigned to the stock b. Market Value - For anything of value; harder to fix c. Book Value – what the corporation says something is worth on its books i. May be dependent upon depreciation d. Liquidation Value – the amount things could be sold for to liquidate the company (small value compared to the others) 13. Par Value and Stated Capital: a. Par Value: an arbitrary dollar value assigned to shares of stock, which represents the minimum amount for which each share may be sold i. Only required to sell @ par value during the initial offering ii. Plays no role in the reissuance of shares b. No Par Value: shares that the Board of Directors will assign a value to, below which the stock cannot be issued c. 22 States say that Par Value must be stated in the articles of incorporation d. Remaining states say that No Par Value is Ok e. Watered Stock Liability: stock that a corporation issues for less than the stated par value; those who receive it for the lower-than-par may be liable i. Remembering that promissory notes are not adequate consideration for shares of stock, shareholders will be held liable for the corporation‟s activities if those shares are not paid for (Only liable up to the par value?) ii. Shareholders have a statutory duty to pay for shares that were issued to them (1) Only once paid for, they will be subject to personally liability because limitation to personal liability by being incorporated is not free iii. But generally, shareholders are not liable for corporate debts beyond the capital they have contributed to the corporation iv. Generally recognized RULE: A shareholder is liable to the extent his stock has not been paid for (1) Corporations issuing stock as a gratuity violates the rights of existing stockholders who do not consent commit fraud against subsequent subscribers and creditors who deal with it on the faith of its capital stock (2) Also liable to the extent of the difference between par value and the amount actually paid f. GA does not require par value 14-2-601(g) – tax or fees on par value, it is $.01 g. Future Performance: shares can be put in escrow until performance is completed; must provide notice to other stockholders 14. Treasury Shares: stock repurchased by corporation and kept in its treasury – abolished by MBCA 1969; But NOT ABOLISHED IN GA, it still has effect 14-2-631 DEBT FINANCING 15. Debt Securities: unconditional promises to pay a stated sum in the future with periodic interest payments a. Characteristics of Debt Securities: i. Fixed obligation to pay interest, due in any event, and based on a percentage of the face value; see also Registered, Income, and Participating Bonds infra ii. Subject to redemption, permitting corporation to pay off early @ a premium of the face value iii. May be subordinated to the payment of other obligations iv. May be convertible into other classes of stock, usually common b. Bonds: secured by a lien or mortgage on corporate property; but bonds may refer to both bonds and debentures Page 22 of 64
i.
Registered bonds: registered in the name of a specific individual, and are used today to keep check over tax evaders ii. Income Bonds: condition the payment upon corporate earnings iii. Participating Bonds: (somewhat rare) interest obligation increases with corporate earnings iv. Both types are transferable v. Some states grant authority for the holder to participate in selecting the board of directors c. Debentures: unsecured corporate obligation; can be convertible to other classes of stock d. “Zeroes”: pay no interest but sell @ discounted rate and once mature, holder gets complete face value (have to pay tax on the diff b/w face – discount price) e. Junk Bonds: below investment-grade debt instruments f. Currency Risk: fluctuation of currency rates LEVERAGE: g. Created by debt owed to third parties h. Favorable when borrower earns more on the borrowed capital than the cost of borrowing the debt i. Excess amount is allocable to the equity accounts of the corporation j. Tax Treatment of Debt: C Corporation can receive a loan from a stockholder instead of contributing to capital i. Interest paid to the shareholder for the loan is deductible by the corporation ii. Dividend payments are not deductible to the corporation iii. Be careful that the interest isn‟t really capital that is being treated as a loan k. Debt as a planning device: PLANNING THE CAPITAL STRUCTURE FOR THE CLOSELY HELD CORPORATION 16. Concerns about capital structure: a. Will it stand up in the event of later disagreement and possible legal attack? b. Will the structure actually provide desired result? E.g., some investors have to be made aware the preferred stockholders do not often get dividends c. Will the tax treatment they are seeking be available and is it probable/certain that the desired treatment will be applicable to them? Esp. S Corporations d. Would the capital structure give rise to unexpected liability issues? – piercing the corporate veil, par value/watered stock e. Are clients‟ financial contributions reasonably protected and reasonably fairly treated in case of termination of the venture? 17. S Corps – don‟t have the double taxation problem (limited # shareholder, no foreign corporations are shareholders, only 1 class of stock) a. You would not have the same double taxation as a C Corp but you are substantially limited 18. Debt :: Equity Ratios: a. Danger in undercapitalized companies that, if they dissolve through bankruptcy, if there is substantial debt by one of the founders, or someone on the board, the BK Ct may look at it and consider it to be capital – and not debt – for which the corporation will not have to repay to that creditor until the other secured creditors are paid (in “Thin” Corporations – those carrying high debt to equity ratios) b. Safe Harbor for Straight Debt: straight debt is debt that involves a written unconditional promise to pay a sum certain in money if, i. Interest rates and interest payment dates are not contingent on profits, borrower discretion or similar factors ii. No direct or indirect convertibility into stock iii. Creditor is an eligible shareholder under Chapter S
i.
PUBLIC OFFERINGS
19. Initial Public Offering (IPO): First public issue of shares in the corporation through an underwriter 20. Benefits: a. Raise capital for expansion b. Reduces corporation need to rely on debt c. Helps raise funds to pay down debt Page 23 of 64
d. Gives existing shareholders liquidity e. Provides capital to acquire other companies f. Allows a company to better compete for employees by offering them options g. Helps make the corporation better known 21. Costs: a. Discomfort with the amount of public disclosure about the corporation b. Management must tighten up its balance sheet before IPO c. Legal Risks i. Liable for mistakes under §11 of the Securities Act of 1933 for material misstatements and omissions in the Registration Statement (1) Registration statement includes prospectus and other documents d. Financial reporting required quarterly and annual report i. Strict accounting/recording methods must be employed e. Corporation forced to deal with analysts and outside shareholders f. Truth in Securities Act led to the creation of the Securities Exchange Act and the Securities Exchange Commission (SEC) – must file a registration statement i. Prospectus to be distributed to actual and prospective investors ii. Additional public information SEC requires but does not have to be included in the prospectus iii. Registration statement usually approved w/in 20d 22. Available Exemptions: a. Register with GA (Blue Sky) Securities 10-5-1 to meet the state law requirements b. 1933 Securities Act: companies may be able to exempt themselves from certain requirements in making stock offerings i. Based on full and honest disclosure about a company c. 1934 SEC Created: i. Compliance with this act is expensive for small companies needing to only raise a small amount of capital ii. To be listed on national index, one must be registered with SEC iii. Underwriters: are the intermediaries of the transaction between the company and the public – they make their money on the spread of what they pay the corporation and what the end-investors pay for the stock d. Specific Exemptions: i. Private Offerings (1) Limited offering to people who do not need the benefit of the registration information (2) Cannot advertise (3) Investors must be allowed specific information about the company, the same type of information about the company one would receive in a prospectus of a registered company (4) Can‟t sell to anyone who would be in the protected class of people (those who don‟t know about securities) (5) If those persons later want to sell those securities, they are subject to the same restrictions (because there is no underwriter) (6) Must be to a select group of people who would be privy to the right information ii. Intrastate Offering (1) Investors within the state who would be informed because they are local to the company (2) Permits them to use the mails without registration (3) Must spend the money raised in the local area (4) Must not accept 1 single out of state investor or it will be an invalid exemption iii. Small Business Offering – Regulation D (1) If you sell to certain types of people and to raise certain amounts (a) People – “accredited” individual investors (rich people who earned $200K or $300K jointly as married), financial institutions, charities i) Thought not to need the regular disclosures usually provided in a prospectus iv. Regulation A: Can integrate state and federal filing (1) Can raise money from accredited investors (2) Certain # of investors used to create ___ dollars (e.g., 1000 investors to raise $1M, 2000 investors used to raise $2M) Page 24 of 64
Securities and Exchange Comm’n v. Ralston Purina Co., 346 US 119 (1953) e. Purina offered unregistered stock purchases to its employees f. Purina claimed the defense of private offering exemption i. Statute designed to protect investors by promoting full disclosure of information thought necessary to make informed investment decisions ii. The idea of exempt offerings is intended because the persons being offered the non-registered stock know the situation of the company iii. Turns on whether the particular group of persons affected need protection of the Act g. “To be public, an offer need not be open to the whole world.” i. SEC often looked @ number of offerees to determine whether the exemption was appropriate or not ii. Ct said the SEC may apply a numeric test to determine whether a corporation would be investigated, but the SEC cannot use just that criteria to determine whether the exemption was valid or not iii. Ct said employees are members of the public and should have access to the same kind of information as would be shown in a registration statement iv. Burden of proof is on the issuer to show that the exemption was valid (1) However, the ct also held that while Purina‟s motive was just and correct, the application of how it happened was not exempt because the investors need protection (a) The test is how much knowledge the investors have available to them h. Selection of individuals for a private offering of stock: i. Bear a reasonable relationship to the class chosen ii. Purpose is to keep part stock ownership of the business within the operating personnel of the business and to spread ownership throughout all departments and activities of the business i. Regulation D of the Securities Act: created under the “Small Business Investment Act of 1980” changed the Securities Act: i. Added an exemption in §4(6) for offers and sales solely to accredited investors ii. Increased the ceiling of §3(b) from $2M to $5M iii. Added §19(c) which authorized “the development of a uniform exemption from registration for small issuers which can be agreed upon among several States or between the States and the Federal Government” Smith v. Gross, 604 F.2d 639 (1979) j. Smiths appeal a dist ct ruling granting DWOP for lack of SMJ, ruling that there was no security involved in the transaction; this ct reversed the holding in Dist Ct on grounds that it found an investment contract existed k. Facts: i. Gross (+2 other corporate defendants) had solicited help in an advertisement to farm earthworms used for fishermen, promising that Gross would buy the worms back for $2.25 per pound, etc. ii. Smiths responded to the ad and Gross promised them he would repurchase the worms @ 2.25/lb and that Gross would handle the marketing iii. Smiths found that Gross had misrepresented the repro rate of worms, the price he promised to pay them was over market price for bait worms, and there was very little market for fishing worms in Phoenix AZ (duh) l. Analysis: i. Ct reasoned that the parties had an investment K type of security, as defined in § 2(1) of the Securities Act of 1933 (in footnote of case) (1) Why Federal Court heard the case Test to determine whether there is an investment K: (2) An investment of money (3) In a common enterprise (4) With profits to come solely* from the efforts of others (a) If you do any work, then it is not an investment K; that‟s why franchises are not included (b) E.g., the investor‟s fortune is interwoven in the fortune of another (c) *Or as Sup Ct held in SEC v. Glenn W. Turner Enterprises, Inc., 474 F.2d 476 (9th Cir. 1946) – “whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise”
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ii. Ct found this case to be identical to Miller v. Central Chinchilla Group, Inc. where people were told they could buy chinchillas, breed them, and sell them back to CCG Inc. – this court found the following things identical between the two cases: (1) Defendants persuaded plaintiffs to invest by representing that the efforts required of them would be very minimal, and that (2) If the plaintiffs diligently exerted themselves, they still would not gain the promised profits because those profits could be achieved only if the defendants secured additional investors at the inflated prices iii. Defendants try to distinguish Turner by saying that plaintiffs did not have to sell back to defendants, therefore the agreement was not a common enterprise – ct disagreed b/c the plaintiff‟s ability to make a profit was tied to defendants‟ ability to procure more investors @ inflated prices iv. Defendants argue that the parties had a franchise agreement, but the ct stated that it is not analogous because a franchisee may determine their own success and it is not dependent upon sale back to the original investor v. Ponzi Scheme: Raise money from people with promises of enormous returns and can only pay those returns from subsequent investors (1) E.g., Sale of insurance policy proceeds to one who pays a discounted amount now of the face value now and then becomes the beneficiary upon death vi. Howey Test: investment K if it is for cash, common enterprise and make $ from the exertion of others (1) The sale of all or a majority of the shares of a closely held corporation
ISSUANCE OF SHARES BY A GOING CONCERN: PREEMPTIVE RIGHTS, DILUTION & RECAPITALIZATIONS
Stokes v. Continental Trust Co. of City of New York, 186 N.Y. 285 (1906) m. Issue: Whether Stokes‟ may purchase pro rata shares at the par value? i. If the number of shares are increased it devalues/dilutes his voting rights because the pool has become much bigger – Stokes did not have an issue with the # of new shares, he was more concerned with the proportion of his # of shares remaining constant n. Facts: i. Stokes held 221 shares of defendant corporation ii. Defendant corporation was approached by a private banking firm that if defendant‟s stockholders voted for an increase in the capital stock they would purchase it at $450 per share and wanted to be able to nominate 10 of the 21 trustees to be elected after the meeting to increase the shares iii. By majority, the issue of increased stock was approved by the stockholders iv. Plaintiff wanted to purchase his own stock for par value ($100) but the request/demand was refused (1) This is a key fact because the plaintiff did not vote for the consolidation, therefore he did not waive his right to have a proportionate voting share v. The stock increased in value during litigation from $450 in 9/1901 to $700 in 4/1904 vi. The problem with the new issue of stock is that it diluted plaintiff‟s voting rights without compensating him proportionately (1) As in a split where there is an exchange, for example, 2 for 1 – but here plaintiff‟s shares were diluted 1 for 2 and his legal rights to have a proportionate vote for number of shares owned was abridged o. Lower Ct Held: D had no right to deprive P of the right to subscribe for the stock and awarded the difference between the market value on 1/20/1902 and plaintiff‟s par value; on appeal it was reversed i. Ct had no cases on point ii. Shareholders DO NOT MANAGE the corporation (1) But they do have voting rights (these are the preemptive rights) Stokes‟ right here was violated (2) Rights to dividends (3) Rights upon dissolution iii. Directors manage the corporation by hiring managers, etc. p. Analysis: i. Power of an individual stockholder to vote in proportion to the number of his shares is vital and cannot be cut off or curtailed by the action of all the other stockholders, even with cooperation of directors and officers Page 26 of 64
ii. It is not of import to right the wrongs of the other stockholders, because they waived their rights by voting for the new stock issue – those stockholders may have been able to give their stock away at a diluted price, but this plaintiff did not have to make the same choice q. RULE: A stockholder has an inherent right to a proportionate share of new stock issued for money only and not to purchase property for the purposes of the corporation or to effect a consolidation i. Case Holding: “Preemptive Rights Exist” ii. Stockholder may waive that right iii. Stockholder cannot be deprived of that right without his consent except when the stock is issued at a fixed price not less than par (basic corporations law) iv. Stockholder must be able to protect his interests by receiving a price in proportion to his holding r. Ct awarded damages by calculating the difference between the $450 sale price and the $550 market price = $22,100 + pre-judgment interest, without costs i. Issues went back and forth regarding market price/sale price, etc. and that Stokes could not have purchased the shares @ $100 par value s. DISSENT: Justice Haight, joined by Justice Barlett – agreed with the majority that a stockholder should be compensated proportionately for the stock they hold, however the justices dissent because there was no showing that plaintiff was ready, willing, and able to purchase stock for $450 per share (he was only offering $100 per share) and that he essentially waived his right because of his refusal to purchase at the higher price offered by the private investment bank 23. MBCA § 6.30 was designed to protect voting power within the corporation from dilution a. IN GA: This is an opt-in option to provide preemptive rights Katzowitz v. Sidler, 24 N.Y.2d 512 (1969) b. Facts: i. Two of three business partners decide to push the third out; they have a meeting of directors (just the two of them) deciding to issue 25 shares to each shareholder to be purchased by a date certain and without purchase by that date, the shareholder waives his right to acquire the additional stock – the third director waived his right to purchase those shares when he let his time go by ii. The reason for the additional issue of stock was to pay an outstanding amount due to the third director, and under stipulation he decided to withdraw from the daily workings of the corporation in exchange for the right to equal compensation as the other two directors iii. When the only asset of the corporation, a semi-truck, was destroyed, the corporation dissolved and payout based on the number of shares resulted in defendants receiving $18,852 and plaintiff only receiving $3147.59 iv. The deal made no sense for the 3rd investor to participate in the new stock offering, b/c he doesn‟t want to reinvest back to the company c. Procedural Posture: i. Special Term found book value of the stock @ time of offer to be $100 per share ($1800 for plaintiff); ct said plaintiff waived his right to purchase the stock or object to its sale by failing to exercise his preemptive right ii. Appellate court agreed with Special Term about the book value but stated that showing a disparity between book value and offering price was not enough without showing fraud or overreaching; Agreed that disparity in price does not equal proof of fraud and that plaintiff had waived his preemptive right or right to prevent the sale of the stock iii. This Court REVERSED, with costs and judgment against each defendant individually d. Preemptive Rights: Concept fashioned to safeguard two distinct interests of stockholders: i. Right to protection against dilution of their equity in the corporation ii. Protection against dilution of their proportionate voting control e. Analysis: i. Directors, who have fiduciary duty to shareholders and when issuing new stock, must treat existing shareholders fairly ii. Dilution: lessening the value of stock by (1) Issuing stock for less than fair value (2) Lessens shareholder interest in the corporation‟s surplus (a) In current and future earnings (b) In the assets upon liquidation Page 27 of 64
(3) Normally protected from dilution by receiving an interest the stockholder may exercise or sell to compensate for the dissolution iii. Right also exists to NOT purchase stocks without being confronted with dilution of existing equity if no justifiable reason is available BUSINESS JUDGMENT RULE: iv. Cts don‟t second guess business person‟s judgment, UNLESS (1) They have violated someone‟s rights (2) Here they violated a minority shareholder‟s rights (3) Whether doing something that is not a valid business purpose Lacos Land Company v. Arden Group Inc., 517 A.2d 271 (1986) f. An amendment to initiate a Class B stock offering was deemed void by the Court of Chancery because the CEO and director of the board of the company threatened that, if the proposed amendments (to add Class B with 10 vote rights per share) were not authorized, he would oppose transactions “which could be determined by the Board of Directors to be in the best interests of all the stockholders” i. As director/officer Briskin (D) has a duty to act with loyalty to the interests of the corporation and its shareholders ii. There was no threat/evidence that there was a takeover, he just wanted to protect his role within the corporation g. Shareholders must consent to corporate charter amendments h. P‟s motion to enjoin the issuance of the Class B stock was granted i. THERE IS NO FIDUCIARY DUTY BETWEEN SHAREHOLDERS (as in one shareholder to another owes no duty to others or the corporation, contra directors who owe fiduciary duty) i. Here D says he did not breach a duty because he was acting as both an investor, Director/Officer of the corporation ii. The duties of a shareholder is not the same as the duty of an officer of the corporation (1) Cannot threaten the shareholders DISTRIBUTIONS BY A CLOSELY HELD CORPORATION Gottfried v. Gottfried, 73 N.Y.S.2d 692 (1947) j. Facts: i. Children and their spouses of a closely held bakery corporation wanted to vote to compel the board of directors to declare dividends on its common stock (the Ps say that the dividends were not paid in the right amount) ii. 2 Ds – Gottfried distributes at wholesale and Hanscom was a wholly-owned sub of Gottfried iii. 2 classes of stock: (1) Class A has no nominal or par value and an $8 per share before any dividends may be paid upon the common stock as well as participation in future earnings (2) Common Stock without par value iv. P‟s are minority shareholders in the corporation and are being squeezed out by the majority stockholders, the board particularly, in order to compel them to sacrifice their stock to the majority for an inadequate price k. If an adequate corporate surplus is available for the purpose, directors may not withhold the declaration of dividends in bad faith shown here by: i. Not allowing any of the minority shareholders to be employees ii. Hostility of the controlling faction against the minority iii. High salaries, bonuses, and corporate loans made to the majority holders iv. If dividends are paid, the majority will incur high personal income taxes (aww too bad) v. Majority controlling directors tried to buy out the minority as cheaply as possible l. Test of Bad Faith: whether the policy of the directors is dictated by their personal interests rather than the corporate welfare i. Directors are fiduciaries who owe the highest duty to the corporation and the stockholders as a body ii. OR Test for “Abuse of Discretion” (1) Directors have enormous discretion in establishing dividend distributions m. Holding: Complaint dismissed and judgment for defendants; policy was not created in bad faith Page 28 of 64
Dodge v. Ford Motor Co., 204 Mich. 459, 170 N.W. 668 (1919) n. Directors of Ford are refusing to pay further dividends upon the stockholders, even though the company was flush at the time o. A business corporation is organized and carried on primarily for the profit of the stockholders and powers of the directors are to be employed to that end p. Henry Ford as CEO did not want to pay out additional dividends, although the minority shareholders were trying to compel him to do so i. He refused on the basis that he wanted to put the profits back into the company or output less cars at a lower cost q. This ct says, “… that the court of equity is at all times open to complaining shareholders having a just grievance.” r. Decree of the lower ct fixing and determining specific amount to be distributed to the stockholders is affirmed Wilderman v. Wilderman, 315 A.2d 610 (1974) s. Case involves an ex-wife who is suing as a derivative plaintiff (shareholder on behalf of her company and any damages go to the company) and as a direct plaintiff (as a shareholder who would have been entitled to dividends) the president (and ex-husband) of the corporation for excessive payments to president; each side of this dispute is a 50% shareholder in the corporation t. P seeks excess monies to be paid back to the corporation that D received as unearned and unauthorized salary and bonuses (concerns fiscal years 1971-3 u. P also seeks injunction to against the disbursement by D of funds held in the corporation or transfer of funds by D without the approval of the board of directors (P here); P also seeks an order directing the continuance of the corporation under a custodian, per Del.C. §226; D also paid himself a large bonus (about $71K) + compensation ($20,800) while this litigation was pending v. Burden is put on the person allegedly acting in a self-interested way to show that what they did was reasonable i. Can prove reasonableness by comparing between others situated similarly w. Corporation was paying „as compensation‟ large sums of money to D in order to keep the corporation not profitable and thus those monies would have escaped double taxation i. IRS reduced the deduction allowance of the corporation resulting in (1) Amount of disallowance was taxed as income to the corporation and (2) The amount of disallowance less the tax due became a de facto dividend x. RULE/S: i. QUANTUM MERUIT Argument: (1) Ct said additional monies should be viewed from the Quantum Meruit theory ii. The authority to compensate corporate officers is normally vested in the board of directors which is usually a matter of contract iii. Review under the standard of looking @: (1) Whether the salary bears a reasonable relation to the success of the corporation (2) Ability of the executive (3) Whether the IRS has allowed the corporation to deduct the amount stated as salary (4) Amounts previously received as salary (5) Amount of salary paid as compared by the employer y. Disposition: D must pay back the pension fund in the same ratio as he was compensated 24. Overview: a. Shareholder have rights to proportionate voting rights to the amount of stock they own b. Payment of dividends is a right of stockholders DISTRIBUTIONS V. INVESTMENTS: c. Investment: when corporation purchases stock in another company d. Distributions: when corporation purchases back its own stock i. Treasury Shares: unissued shares or shares that have been reacquired by a corporation (1) Saleable (2) But NOT an asset until resold or retired (a) Because it just reduces the holdings of the shareholders Page 29 of 64
(b) Shows a reduction in the cash (c) Enriches shareholders and does not change their proportionate position ii. Disproportionate Distribution: corporation does not have to purchase the same # of shares back from each stockholder, it can repurchase stock from a single shareholder iii. Redemption: shareholder sells back to the corporation for $; may alter the distribution of earnings in C corporations Donahue v. Rodd Electrotype Co., 367 Mass. 578, 328 N.E.2d 505 (1975) e. Facts: P brings action against the corporation for unlawful distribution of corporate assets when the corporation purchased the prior president and treasurer of the company‟s shares for $800 per share; P wanted the same deal; Ds received their shares from their father, the former president and treasurer of the corporation f. Procedural Posture: P‟s claim was dismissed on the merits and that the purchase was without prejudice and was carried out in good faith and with inherent fairness i. This Ct reversed, limiting the applicability of their holding to close corporations g. Analysis: i. Close Corporations are typified by: (1) Small number of stockholders (2) No ready market for the corporate stock (3) Substantial majority shareholder participation in the management, direction and operations of the corporation (4) Closely resemble a partnership ii. Because Close Corporations are like partnerships they confer the same duties on directors (1) All participants must rely on one another and enjoy loyalty, trust, and confidence between them (2) Stockholders in such corporations must deal with each other “fairly, honestly, and openly with his fellow stockholders” but shareholders don‟t owe a specific duty to other shareholders – the BOD has the duty (3) “Corporate directors are held to a good faith and inherent fairness standard of conduct.” (4) “Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior.” – Chief Judge Cardozo of NY Ct App in Meinhard v Salmon iii. Freeze-outs: majority shareholders oust a minority shareholder, done using the following actions (1) Refusing to issue dividends (2) Drain off corporate earnings in the form of exorbitant salaries and bonuses to the majority shareholders-officers and perhaps to their relatives or in the form of high rent by the corporation for property leased from majority shareholders (3) Deprive minority shareholders of corporate offices and of employment by the corporation (4) Cause the corporation to sell off its assets at an inadequate amount to the majority shareholderofficers iv. Minority Shareholder Remedies from Freeze-outs: (1) Initiate suit against the majority and their directors (2) Self-serving conduct by directors is a breach of fiduciary duty (3) Dividend and employment policies are HARDER to prevail in as claims (4) ** COURTS PREFER NOT TO INTERFERE WITH THE SOUND FINANCIAL MANAGEMENT OF THE CORPORATION BY ITS DIRECTORS (UNLESS A PLAIN ABUSE OF DISCRETION IS PRESENT) (5) Their $$ is tied up in the corporation with little right to have their issues heard/resolved v. Purchasing Shares in a Close Corporation: (1) Corporations reacquiring its own stock is subject to the requirement that they (a) Act with the utmost good faith and loyalty to the other stockholders (b) If the stockholder selling back to the corporation is a member of the controlling group, then those controlling stockholders must cause the corporation to offer each stockholder an equal opportunity to sell a ratable number of their shares at an identical price (c) Controlling group may not utilize its control of the corporation to obtain special advantages and disproportionate benefit from its share ownership i) Selling back to the corporation creates a market for the shares that was not available to the other stockholders ii) Selling back distributes corporate assets to the seller Page 30 of 64
(2) Delaware does not follow Donahue doctrine – but prefers corporations to enter into K to sell stock within its articles of incorporation h. Holding: i. Purchase was a breach of fiduciary duty ii. Purchase distributed corporate assets to a member of the controlling group in exchange for selling the shares iii. Plaintiff and her son (minority shareholders) were not offered an equal opportunity to sell their shares to the corporation iv. Plaintiff and her son did not ratify the transaction to sell the shares v. Requests by Plaintiff and her son to sell shares for the same price as the president of the company were refused i. Disposition: i. Judge below to render appropriate judgment in the case for Harry Rodd to buy back his shares from the treasury shares for $36K plus interest ii. Or Defendant may purchase all of plaintiff‟s shares for $36K without interest iii. These rulings represent the equal opportunity the plaintiff should have received j. Concurrence: did not agree on the analogous comparison of the close corporation with a partnership for the purposes of salaries and dividend policy TESTING THE VALIDITY OF DISTRIBUTIONS: MBCA PROVISIONS ON DISTRIBUTIONS k. Equity Insolvency Test: MBCA § 6.40(c)(1) – Dividend payments are prohibited if, at the time they were made, the corporation was insolvent, or the act of the payment would result in the corporation becoming insolvent l. Balance Sheet Test: MBCA § 6.40(c)(2) – After giving effect to a distribution, corporation‟s assets should equal or exceed it liabilities plus the dissolution preferences of senior equity securities; requires more judgment calls and is subjectively based on accounting conventions i. Generally Accepted Accounting Principles (GAAP): brd of dir should be able to rely upon financial statements prepared on the basis of GAAP to determine whether the balance sheet test has been met; Not “required” because GAAP changes ii. Can also use fair valuation or other reasonable methods that would be reasonable under the circumstances iii. Can rely upon people BOD could reasonably believe to know what they were doing as experts in accounting, etc. m. Preferential Dissolution Rights and the Balance Sheet Test i. Distribution may not be made unless assets > liabilities + amount needed to satisfy a shareholder‟s superior preferential rights upon dissolution if corporation were to be dissolved @ time of distribution n. Application to Reacquisition of Shares i. Tests are applied to the distributions involving the purchase, redemption or other acquisition of the corporation‟s shares (§6.4) (1) Time of Measurement happens at the earlier of (a) Payment date (b) Date shareholder ceased to be a shareholder (2) When applied to redemption-related debt: measured @ the time of issuance or incurrence of the debt – not later when the debt is actually paid (3) Priority of Debt Distributed Directly or Incurred in Connection with a Reacquisition of Shares: on par with unsecured general creditors unless subordinated by agreement o. Treatment of Certain Indebtedness: When measuring the distribution for testing against the balance sheet test or the GAAP test, indebtedness from distribution or redemption is not taken into account p. OLD Close Corporation Statutes: not used to initiate corporate businesses anymore but may run into one that was incorporated in such a way in the past 25. Non-MBCA Statutes: (State tests of insolvency) – unnecessary to know the specifics of these in exam, just know that they exist a. Pure Insolvency – if the distribution results in the insolvency of the company then directors held liable (MASS) b. “Earned Surplus” Dividend Statutes: Testing legality of a dividend against Page 31 of 64
i. Availability of “earned surplus” out of which the dividend may be paid ii. Solvency test applied immediately after the dividend c. “Impairment of Capital” Dividend Statutes: Based on balance sheet rather than income statements; different states value the capital differently (some against par value, some based on remaining net assets) d. Distributions of Capital Surplus: Distributions allowable out of “capital surplus” with proper authorization
MANAGEMENT AND CONTROL OF CORPORATIONS
TRADITIONAL ROLES OF SHAREHOLDERS AND DIRECTORS a. By statute and common law, BOD RUNS THE CORPORATION and in a CLOSELY RUN CORPORATION those people are one in the same b. McQuade v. Stoneham, 263 NY 323 (1934) i. McQuade sued (on his own behalf as a board member, and not on behalf of the corporation) to compel specific performance of an agreement between himself and the defendants Stoneham and McGraw to secure majority control over the National Exhibition Company (AKA the NY Giants/Baseball Club/New York Nationals) ii. Stoneham became the owner of 1,306 shares of National Exhibition Company and sold both McQuade and McGraw (then the manager of the Giants) 70 shares each; McQuade paid $50,338.10 for his 70 shares iii. They decided on the following agreement as officers of National Exhibition Company (the shareholder agreement) 1. Each was on the board of directors 2. Stoneham had discretion to name all remaining/additional directors he wanted 3. Stoneham was President, McGraw Vice President, and McQuade Treasurer 4. Each would remain an officer of the corporation 5. Each was paid a determined salary 6. By-laws could not be changed that would affect minority stockholders unless by unanimous decision of all parties to the shareholder agreement 7. Shareholder agreement remains in effect until a party is not a stockholder of the stated amounts iv. Directors may not contract-away their function to choose officers v. McQuade was ousted as treasurer by Stoneham‟s new appointees to the board of directors who appointed a new Treasurer (both Stoneham and McGraw did not participate in the vote) 1. Ds agreement to “use their best efforts to continue McQuade as treasurer” 2. Stoneham was frustrated with McQuade because McQuade challenged him on some things Stoneham wanted to do which would have affected minority stockholders vi. Defendant‟s Arguments: 1. K is void because any K charging a director to vote to keep any particular person in office and at a particular salary is illegal – they cannot contract to keep anyone in a position if that person is not performing their duties – it is beyond the scope of their authorities vii. Plaintiff‟s Arguments: 1. K is valid because an agreement among directors to keep an officer on the board of the corporation is not to broken as long as that officer is loyal to the interests of the corporation viii. Ct‟s Reasoning: 1. It is illegal as against public policy for stockholders to divest directors of their power to discharge an unfaithful employee 2. Stockholders may not, by agreement between themselves, control directors in their exercise of business judgment to elect officers and fix the salaries of those officers a. Stockholder may however, combine their power to elect directors b. The united power of stockholders may only be used to i. Elect directors ii. BUT NOT to create Ks which limit the power of the directors‟ ability to manage the business of the corporation 1. But not followed in some jurisdictions 3. Stoneham and McGraw were trustees of the corporation and not to McQuade as an individual a. McQuade is bringing this action on behalf of himself Page 32 of 64
The minority stockholders are not being harmed by McQuade‟s being bypassed as treasurer 4. Ct said it was constrained by authority to hold that a K is illegal and void which precludes the BOD, at the risk of incurring legal liability, from changing officers, salaries or policies or retaining individuals in office except by consent of the contracting parties ix. Ct’s HOLDING: Reversed the Appellate Court‟s ruling refusing to reinstate McQuade and his award for damages and the right to sue for future damages; this Ct DISMISSED with costs in all courts c. Modern Role of Directors: Fiduciaries whose duties run to the corporation but their relationship with the corporation is sui generis (unique, one of a kind) since they are not trustees d. Long-term Management: is more efficient and when the BOD is only in effect for 1 year at a time, what happens when they enter into a 5-year lease? Cts say it is a de facto amendment to the bylaws Galler v. Galler, 32 Ill.2d 16 (203) i. P – Emma Galler, is suing her Brother-in-law and sister-in-law in equity for an accounting and for specific performance of a K stockholder agreement between P‟s deceased husband and the brother-inlaw ii. 2 brothers plus their wives are the BOD, brothers splitting all but 12 shares which were bought by an employee (Ds bought the shares from employee which is another related action between the parties) 1. When Emma‟s husband Benjamin fell ill, his brother Isadore brought two powers of attorney for Benjamin to sign a. granted Emma benjamin‟s bank acct b. granted Emma benjamin‟s voting rights 2. This was the agreement that the Ds, Emma‟s brother- and sister-in-law and their son, sought to destroy; they decided to not honor the agreement 3. Benjamin executed a trust for Emma a year later a. Included the shares with voting rights i. Emma asked Ds to transfer the shares into her name, per the trust and they tried to get her to abandon their powers of attorney agreement and sign a “noninterference agreement” and allow their son Aaron to run the company for a year – Emma refused to set aside her rights to the shares, but allowed the son to run the company and she would not interfere ii. Emma tried to get the terms of the agreement adhered to for the last year Ben was alive but Isadore would not see her iii. Aaron offered to amend the agreement allowing Emma salary but not to be one of the directors iv. Both Aaron and Isadore drew salary; everyone was paid their dividends 4. Bylaws: a. 4 directors w/necessary quorum of 3; no meeting held w/o 10d notice to all dirs b. shareholders (Ben, Emma, Isadore, and Rose) cast votes for dirs @ meeting that has it sole purpose to elect such dirs c. If either brother dies, wife may nominate successor * this may not be a right that can be conveyed d. Specific dividends will be declared by corp * but by law, only directors can declare a dividend (this is unlawful under McQuade) e. Salary continuation for widow of either brother - @ rate of 2x normal brother‟s salary, for life or if widow remarries w/in 5 years, @ time of new marriage f. Corporation can buy back its own stock from a brother if one dies, @ book value i. But Book Value is sometimes too low a value and could be considered unfair on the party wishing to sell out ii. Representation of all stockholders should not be affected by such a buy-back iii. BUT this is not usually part of a shareholder agreement because they DO NOT RUN THE CORPORATION and cannot make such a determination g. If anyone wants to sell, they have to offer it to the other brother first h. If you have a shareholder agreement, the certificates must state that it exists iii. RATIONALE: 1. Using public policy to invalidate the agreements is too far reaching and may be abused Page 33 of 64
b.
2.
3. 4. 5.
6.
7.
8.
Close corporations are hard to define, but here: a. Stock is held in a few hands or a few families b. It is not at all, or even rarely dealt in by buying or selling Other shareholders usually have all their $ tied up in the corporation, so they cannot always afford to buy when the other wants to sell When corporation is so close, then it is difficult to establish a completely objective board, free from personal motives Although shareholder agreements in close corporation may violate the Business Corporation Act, cts may uphold them even though they: a. Have not resulted in public injury b. No minority interest is complaining of the agreement c. No prejudice to creditors is present d. Cts will allow “slight deviations” from statutory compliance in order to give effect to common business practices i. Potential harm to creditors and potential investors is often absent ii. When K damages no one, ct asks – why enforce it? Only when it impedes the rights/obligations of the BOD Specific Issues Ct Addressed w/K: a. No specific end date b. But because of wording, it appeared to ct that it was for duration of Ben‟s life c. Dividend payment plan was OK because it was designed to protect creditors by ensuring that enough earned surplus was available before paying said dividends d. Salary Continuation to Emma would not be enforceable as an ultra vires gift if there had been other shareholders, but because there are none here, and the shareholders are the parties to the K, then it does not apply to invalidate the salary provision (shareholders do not determine salaries – this is a violation of Stoneham) i. NOTE: Salary provisions, payable @ 2x salary of decedent are allowable, fairly common part of executive employment, and are deductible by the corporation. e. Ct leaves it for the legislature to resolve such an agreement for close corporation Close Corporations Enjoy More Leniency: a. There are now close corporation statutes i. Numerical limit of # shareholders ii. Must “opt-in” to being a close corporation 1. If a DE Closed Corp does not OPT-IN, it cannot have the benefits of the flexibility of a close corporation b. MBCA – now allows modification of shareholder agreements to include i. Voting Trusts: trustee who votes the shares and the beneficiaries who get the $; gives the entrepreneurs voting control of their corporations; very strict rules govern such trusts 1. Shares are appointed as entrusted to a trustee who will vote the shares on behalf of beneficiaries who will get the dividends 2. Last only 10 years ii. Voting Agreements iii. Shareholder Agreements c. GA – i. Voting Trusts 1. May be extended past the 10 year time ii. Voting Agreements 1. 20 years iii. Shareholder Agreements iv. Integrated Close Corporation Section Procedural Posture: a. Superior Ct allowed the accounting and specific performance b. 1st Dist App Ct reversed, denying spec perf but affirmed part of the order granting an accounting and modifying the order, awarding master‟s fees Page 34 of 64
c.
Here, the Ill Sup Ct Affirmed the master‟s fees; Ordered an accounting since Sept 25, 1956 (when Aaron became president); Reversed and Remanded App ct‟s ruling – except for the fees
Zion v. Kurtz, 50 NY2d 928 (1980) iv. RULE: If a corporation agrees that no business or activities shall be conducted without the consent of minority stockholders, such agreement is enforceable, even if not statutorily followed by the parties to the agreement. The time such an agreement will be deemed violated is the time any other minority stockholder-unauthorized agreements are entered into. 1. Conflicting clauses: one clause said no business or activity without minority approval, the other clause said to be governed by the laws of the state of Delaware 2. DE Law: Relating to close corporations, written agreements b/w majority stockholders are not invalid as between the parties if it relates to the conduct of the business and affairs of the corporation – general DE Corporation law says corps should be managed by a BOD (not stockholders) a. But some corporations are run by people who serve both ends of equation b. This corporation was not opted in as a close corporation, the shareholder agreement was not included in the articles of incorporation 3. Internal Affairs Doctrine: a. The goings on amongst the shareholders, BOD are governed by state in which corporation was incorporated b. The parties here had a choice of law provision setting out Delaware law as the governing law of the K 4. Dissent: not allowed to give power to a party which is not included in the articles of incorporation; can‟t allow retro-active amendment of articles just to conform; there has to be reasonableness in enforcing shareholders agreements Ringling Bros.-Barnum & Bailey Combined Shows v. Ringling, 29 Del.Ch. 610 (1947) v. Stockholders may enter into share pooling agreement whereby they predetermine how they will vote their shares vi. If they agree to submit to arbitration if they cannot agree: 1. the arbitrator is not a party to the K 2. He does not take on any duties of the shareholders 3. Shareholders may substitute named arbitrators 4. No decision of the arbitrator could ever be enforced if both parties to the agreement were unwilling that it be enforced vii. Method of voting by the parties here did not construe the agreement as creating powers to vote each other‟s shares viii. Rev Code Del §2050 – does not deal with agreements whereby shareholders attempt to bind each other as to how they shall vote their shares 1. Ct said this was not a voting trust but a shareholder agreement ix. Ownership of voting stock imposes no legal duty to vote at all x. Group of shareholders may vote their shares to obtain advantages of concerted action xi. Shareholders may contract with ea other to vote in the future in a specific way xii. Here: 1. Failure of Mrs. Haley to exercise her voting rights in accordance with the decision of the arbitrator was a breach of her K with Mrs. Ringling 2. When such a breach happens, the ct may nullify those votes on the basis that the violate the rights of another person 3. Mrs. Haley‟s votes were nullified Lehrman v. Cohen, 43 Del. Ch. 222 (1986) xiii. Stockholder brought action against other stockholders, directors and corporation challenging creation of new class of stock and election of one defendant as president. On motions and cross motions for summary judgment as to claim that creation of new class of stock was illegal, the Court of Chancery granted summary judgment for defendants, and plaintiff appealed. The Supreme Court, Herrmann, J., held that arrangement whereby new class of stock was created and one share having $10 par value Page 35 of 64
e.
was issued in order that holder might elect fifth member to board of directors to break deadlocks was neither a trust nor pooling agreement and was not a voting trust illegal under statute requiring 10year limitation on voting trusts. Affirmed. xiv. Ct says it is OK to have a tie breaker xv. Voting Trusts: not favored by courts because they give control of major corporations by tycoons who do not have a financial interest in the outcome of the company 1. Elements: a. Voting rights in stock are separated from other attributes of ownership b. Voting rights granted are intended to be irrevocable for a definite period of time c. Principal purpose of grant of voting rights is to acquire voting control of corporation. 2. Regulate: Trusts and pooling agreements amounting to trusts, not other and different types of arrangements and undertakings possible among stockholders 3. Purpose: a. To control is the separation of vote from stock, not from stock ownership i. The rights to the dividends may be separated from the voting right b. To avoid secret, uncontrolled combinations of stockholders formed to acquire voting control of corporation to possible detriment of nonparticipating stockholders xvi. Voting trust statute does not require that all stock of a Delaware corporation must have both voting rights and proprietary interests 1. A stock may have only one or the other; classes and series of stocks and rights thereunder permits creation of stock having voting rights only as well as stock having property rights only xvii. Directors may not delegate their duty to manage corporate enterprise Cumulative Voting: MBCA/GA is an OPT IN provision in which cumulative voting is not assumed i. A shareholder may use all of his or her votes across any number of directors and can pile on all shares on one candidate ii. Compared to Straight Voting in which all shares go to one particular person iii. SEE FOOTNOTE ON P 545 FOR FORMULA – NEED THIS FOR EXAM iv. ALSO NEED TO OPT IN FOR CUMULATIVE VOTING
DEADLOCKS GEARING V. KELLY, 11 NY2D 897 (1962) v. Meacham, a member of the BOD of Radium Chemical Co. Inc., did not attend a meeting (although she had notice) to elect board members, in order to prevent a quorum from being formed and keeping the BOD from being voted on vi. Gearing is requesting that the election of a director on the day Meacham missed the meeting should be set aside as void vii. Gearing is asking for an equitable remedy to have the election of Julian Hemphill set aside because she and her daughter will then have an unequal share of the business; ct said that had already happened in 1955 when Kelly Sr., the respondent here (they are fighting about that in another suit) viii. Majority: Since Meacham didn‟t show up, and because if she did the outcome would probably be the same, then there will be no purpose for a new election – request to set aside prior election was denied ix. Dissent: Dissent said that even if the BOD was deadlocked, that was their problem and not for the ct to solve since the BOD had other methods available to them to solve the problem 1. §25 of General Corporation Law: In case of deadlock the court may a. Confirm the election b. Order a new election as justice may require (which DOES NOT include deciding what a new election‟s results would be anyway, and thus foregoing it; no basis here for the doctrine of estoppel) c. Gearing was not a director but a shareholder, so no estoppel was even possible against her – you cannot compel a stockholder to vote x. MBCA §8.05(e): Any vacancy occurring in the BOD may be filled by affirmative vote of a majority of remaining directors though less than a quorum 1. §8.10(a)(3) – filling vacancies: if fewer than quorum, all dirs remaining in office, if a maj of them vote for someone, that person is in xi. Continuance of Office: A director continues in office until their successor is elected and qualifies Page 36 of 64
xii. What Meacham Could Have Done: 1. Added another shareholder – with 1 voting share to break deadlocks 2. Define in bylaws the situation of deadlocks that no vote can occur without quorum In re Radom & Neirdorff, Inc., 307 NY1, 119 N.E.2d 563 (1954) xiii. Music composition printing co. and one of the equal shareholders wants to dissolve per §103 of the General Corporation Laws, “if the votes of the stockholders are so divided that they cannot elect a BOD, the holders of one-half of the stock entitled to vote at an election of directors may present a verified petition for dissolution of the corporation as prescribed in this article” xiv. Henry Neirdorff died and left his half of the business to his wife, who subsequently refused to pay Radom his salary or to elect a BOD for the corporation xv. Appellate Ct DWOP (so he may bring other COA) Radom‟s petition to dissolve the corporation, noting: 1. Stockholders dislike and distrust each other 2. There is no impasse or stalemate as to corporate policies 3. Corporation is flourishing 4. Dissolution is unnecessary for the corporation for either of the stockholders 5. Petitioner has no grievance cognizable by a ct except for the non-payment of his salary which is not grounds for dissolving the corporation 6. Corporation‟s activities have not been paralyzed, rather profits have increased 7. Respondent has formally offered to have a third director named by American Arbitration Association or any recognized and respected public body xvi. Appellate Ct said there was no absolute right to dissolution under these circumstances, but only when competing interests “are so discordant as to prevent efficient management” and the “object of its corporate existence cannot be attained” xvii. DISSENT: Statute is clear – stockholder with ½ shares may request dissolution if the vote is so divided that they cannot elect a BOD – this is the exact case here. 1. Corporation was running smoothly until Nierdorff‟s wife was involved; now creditors are not getting paid, no BOD elected, no dividends declared or distributed even though profits have been made 2. Petitioner‟s integrity, never before in question during 30 years in business, have come under question in a stockholders‟ derivative suit 3. Petitioner has attempted to buy out responded to end the feud to no avail 4. The smooth running of the corporation cannot continue with the ongoing litigation and ultimately the stockholders will suffer 5. Dissolution will serve the interests of the shareholders and creditors as well as public policy 6. Petitioner has no other choice a. Should not have to continue working as president and manager of corporation with salary b. Should not have to quit the business and lose his interests in it c. If he starts a new business, he will risk liability of suit for breach of fiduciary duty to the corporation 7. Respondent‟s request for arbitration is not relevant here – the deadlock is between the stockholders and not directors – so §103 applies and dissolution would be more applicable 8. Deadlocks have nothing to do with the profitability of the company and everything to do with the ability of the stockholders to agree with each other Dissolution Statutes f. 14.10 Dissolution for Corporation After Just Being Started g. 14.20 Administrative Dissolution h. 14.30 Grounds for Administrative Dissolution i. Discretionary and can be brought by Attorney General, SH, Creditors
REMEDIES FOR OPPRESSION, DISSENSION OR DEADLOCK
Davis v. Sheerin, 754 S.W.2d 375 (1988) ii. Trial ct declared Sheerin owned 45% of corporation and ordered the majority stockholders to do a “buy-out” of his stock, values at $550K Page 37 of 64
iii. Appellants Sheerin bring charges of error in their appeal 1. Buyout not available to minority shareholder under TX law a. True – no allowance under TBCA (Tex Bus Corp Act) or case law for min shareholder to rec a buyout BUT TBCA allows for receivership with possibility of liquidation if an aggrieved shareholder can establish: i. Illegal, oppressive, or fraudulent conduct by those in control of the corporation b. Buyout OK if procured as a provision in a K beforehand 2. Even if buyout is available, it is not appropriate here and there was no oppressive conduct iv. WHY Trial Ct Ruled Buyout Option Appropriate: 1. Conspiracy to deprive Davis of his stock 2. Oppressive action against Davis which would likely continue v. BUYOUTS: 1. Buyout is a less severe penalty than liquidation of a corporation 2. Allowable as an alternative in many states over liquidation 3. Allowed as relief for an aggrieved shareholder 4. Most often the remedy for oppressive conduct, esp in close corporations a. Because the maj shareholders are squeezing out minority SH who do not have a ready market for their shares in the corporation vi. OPPRESSIVE CONDUCT: 1. Ct here did not want to make a narrow def of oppressive conduct a. Ruled that there was no error in ordering a buyout because trial jury found that Sheerin had conspired to deprive Davis of his stock 2. Arises only when the maj‟s conduct substantially defeats the expectations that, objectively viewed, were both reasonable under the circumstances and were central to the minority shareholder‟s decision to join the venture 3. Independent ground for relief a. Does not require a showing of fraud, illegality, mismanagement, wasting of assets, nor deadlock which are normally grounds available for shareholders to bring claims 4. Burdensome, harsh and wrongful conduct vii. RULE: TX Cts may under general equity power, decree a buyout where less harsh remedies are inadequate to protect the rights of the parties viii. GA Bus. Corp. Code: 1. Extraordinary Relief: granted in cases of oppression or deadlock and includes involuntary dissolution or buyout 2. Ordinary Relief: granted in all other cases and includes: a. Setting aside an action by the corporation, shareholders, directors, etc. b. Canceling a provision in the articles of incorporation, bylaws, or an agreement among the shareholders c. Removing a director or officer from office d. Appointment of individual as director or officer e. Appointment of custodian to manage the business or of a provisional director (appointed by ct) f. Payment of dividends g. Award of damages by an aggrieved party Abreu v. Unica Indus. Sales, Inc., 224 Ill.App.3d 439 (1991) ix. Facts/Procedural Posture: 1. Abreu‟s husband left her his half of the corporation which was a food prod manufacturing corporation that Ds were ½ owners of also; Ds ran their own other company and were trying to steal trade secrets from Abreu‟s co for their own co 2. Because the shareholders were deadlocked, Trial ct ordered a third party to serve as interim director to serve as a tier breaker; Ds contend that because the person the Trial ct appointed was Abreu‟s son-in-law he was not an impartial party 3. IBCA (Ill. Bus. Corp. Act) §12.55 “Alternative Remedies to Judicial Dissolution” allowed for the appointment of a provisional dir/custodian/or the order of a buyout Page 38 of 64
x. Provisional Director Limitations: 1. Cannot make decisions generally reserved for stockholders or committees – such as hiring an auditing firm and ordering the payment of attorney fees in lawsuits 2. Follow ct orders as to duties – here Vega was only to vote on deadlocked matters, in the best interests of the corporation xi. RULE: 1. Provisional dir does not have to be impartial, merely has to help guide the company through crisis toward a goal of stabilization and prosperity – 1st duty is to the corporation 2. A split in votes does not create a de facto majority nor does it disenfranchise a shareholder Black v. Harrison Home Co., 155 Cal. 121, 99 P. 94 (1909) xii. Facts/Procedural Posture: 1. Mrs. Sarah Harrison and Mrs. Olive Harris (Sarah‟s daughter) were equal 50/50 shareholders; Olive dies, without husband or issue 2. Sarah tried to enter into a K to sell land owned by the corporation; just before the closing, the sale fell through because Sarah was determined to not be authorized to pledge the assets of the corporation in a K, as the K‟s president 3. Olive died intestate; creditors would have a claim on the estate xiii. RULE: President of a corporation does not have power, merely because he is president, to bind the corporation by K, unless: 1. Authorized in the bylaws 2. Authorized expressly by BOD 3. By having assumed an exercised that power in the past 4. Ratify the K or accept the benefits of it Debaun v. First Western Bank and Trust Co., 46 Cal.App.3d 686 (1975) xiv. Issue: Whether a majority shareholder has a duty to investigate one whom may purchase corporate assets xv. RULE: Majority shareholder has a duty to reasonably investigate those to whom they may sell controlling shares of the corporation xvi. The court held that a majority shareholder who is in the possession of facts establishing a reasonable likelihood that the purchaser of the controlling shares intends to exercise the control to be acquired by him to loot the corporation of its assets, owes a duty of reasonable investigation and due care to the corporation, and that there was substantial evidence that the bank was in possession of facts that would have alerted a prudent person that the purchaser was likely to loot the corporation and that the bank therefore owed a duty to the corporation and its minority shareholders to act reasonably, but that it breached that duty by making no investigation of the facts in its possession
CONTROL AND MANAGEMENT IN THE PUBLICLY HELD CORPORATION
SOCIAL RESPONSIBILITY, OR THE LACK THEREOF 1. Greenfield: a. Shareholder value of a company measure by that specific day‟s stock price b. Looking @ stock price is wrong c. Looking @ only shareholders as important in a corporation is wrong d. Profit sharing plans assist growth because labor – balance the need to boost labor efficiency 2. Law and Economics a. Nexus of K theory: Ks are burdensome to keep making over and over again, there should be a form or boilerplate K available and ability of others in the enterprise to protect their rights using the same form i. Same with forming corporations – as in an off-the-shelf corporation b. Team Management Theory: there are multiple contributors to the wealth creation process; not just shareholders (they only give capital) bond holders, workers give labor, communities build roads, schools, etc., and universities or educational institutions which aid in recruitment of trained employees; BOD has duty to also mediate between all of these groups to ensure benefits c. Milton Freedman – would only invest in a straight property scheme –he believes that the corporation should not spend any time, money or effort on anything that is not directly attributable to the bottom line of driving profit for shareholders Page 39 of 64
3.
Companies Abandoning Small Towns: a. Law is not very developed in this area b. Statute – employer (plants which are of a certain size) is required to notify employees within a certain amount of time before closing c. Employee Arguments: i. If any history of dealings, such as voice mail – detrimental reliance ii. We have a property right to our employment (1) Town exists for the sole purpose of the plant and therefore has an ownership interest in the plant (2) Adverse possession of the plant in the interests of the employees (3) Rejected because it is an „invented‟ property right that developed because of a relationship (4) Town built up an infrastructure to support everything the plant brought to the corporation d. Employer Arguments: i. Depends upon how the company‟s profits are defined ii. Even if the plant is profitable, the company overall may not be profitable iii. Ct does not determine, in the business sense, how a company defines what profitable may mean (1) Expenses that are charged across the organization (2) Advertising, inventory, machinery e. BOD: Duty may be to i. Shareholders ii. But not employees – so no duty to not mislead employees, according to US Steel
INSTITUTIONAL INVESTORS 4. Types: a. Pension funds created by corporate employers, states and cities for their employees, and by universities, churches and foundations b. Mutual funds (and other types of investment companies) that offer opportunities to invest in broad portfolios of securities c. Life and casualty insurance companies d. Foundations e. University and charitable endowments f. Banks investing trust funds g. Brokerage firms h. Variety of investment vehicles for sophisticated investors, often in the form of limited partnerships 5. Duties of Institutional Investors: a. Duties are owed to the persons whose money they are managing b. Fiduciary duties may be owed to persons other than the issuers of the portfolio securities c. Pension funds owe duties to the employees covered under those pension schemes – to maximize the funds available for retirement benefits d. Reason behind these duties – in short-term investment cases, the objective is to achieve maximum gain in a short time because there is a large number of investors who collectively own over 50%, while the pension schemes are viewed with the mindset of permanent investors 6. Own 60% of the market; don‟t put a large percentage of assets in any one investment 7. Agency: Personal wealth increase is for one‟s own interests; large corporation investment companies use agents who are bound under duty to do this in the company‟s best interests a. Berleigh Means: 1000s of people owning shares of company, no one person can monitor the agents; a smalltime share owner can do little to ensure that managers of the company she has invested in is managing the company properly, but BOD does not often do right solely by shareholders; this led to another method to monitor the agents – institutional investment firms, which became the most efficient type of agent to monitor the management of companies (but mutual funds, charities decline the monitoring function) cf. public pension funds which are highly visible in their dealings and involvement with the management of the companies they are investing in, since they are managing other people‟s money 8. “monitors of corporate governance” – once the funds get very big, they can‟t follow the Wall Street Rule as easily (because then it is harder to sell the large blocks of stock, modifies the market; additionally it is not very diverse if they own too much of 1 company)
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B. ALFRED CONARD‟S VIEW: INVESTOR CAPITALISM – Investors are wise to forgo active participation in corporate governance because they can protect their interests with less effort by just selling off their shares if the corporation is ineffectively managed and switch their resources to better-managed companies, AKA the “Wall Street Rule” C. BERNARD BLACK‟S VIEW: SHAREHOLDER PASSIVITY – used to be an issue where large numbers of shareholders who held small amounts of stock did not exercise their rights to vote; the trend is now changed since the larger public investment funds place fewer direct conflicts of interest in monitoring corporate managers than the corporate pension funds by combining forces and forming trade groups to represent their collective interest and in that capacity act in one way or another as monitors of the corporate managers D. ENRON 1. Questionable accounting practices a. SPEs (Special Purpose Entities): at its height, there were 8000 of them, which Enron used to report revenue but hide liabilities; i. These companies were off the books, ii. Generally this is fine, so long as it does not put the company @ undue risk b. Banks started questioning Enron‟s credit worthiness i. Credit rating agencies had lowered their ratings to the point that the were ii. Falling below investment-grade bonds (1) Creditor may call in the bonds c. Generous bonuses to the executives 2. Accounting/Auditing firms a. Auditing functions and accounting functions are not separated to different companies
SARBANES-OXLEY BILL, LAW IN 2002: SECURITIES LAWS
Corporate Disclosure and CEO/CFO Certification Maintenance of Internal Controls for Monitoring Creation of a new Board to oversee accounting firms that audit public companies Audit committees of corporate boards of directors Executive compensation, loans to executives and disgorgement of incentive-based compensation Professional standards for attorneys Whistleblower protection provisions: system for protecting ppl telling about violation of law or new code of ethics 10. Barring people from serving as officers and directors of public companies 11. Securities analysts‟ conflicts of interest E. ATTORNEY REQUIREMENTS: 1. Report up the ladder 2. Noisy withdrawal: resign, telling the SEC why you resigned; infringes upon attorney/client privilege – so now you have to go up the ladder to make complaints 3. If no satisfaction, then go up through the ranks F. PROXY REGULATION 1. Must register with SEC pursuant to §12 – and certify that it is all true – proxy stmt must be filed, or it is a violation of the rules 2. Must send out annual report: contains financial information about the company 3. Must invite shareholders to attend shareholder meeting to elect BOD (vote “for” or withhold vote), choose CPA firm or vote on any other matters 4. Include a proxy report, which will include information of the type related to the issue that will be voted upon 5. MD&A (Management‟s Discussions and Analysis of Financial Condition and Results of Operations) – must file this or it is in violation of the SEC rules a. Discusses the financial condition, changes in financial condition, and results of operations, such as liquidity and capital resources and is required to include information that the registrant believes to be necessary to an understanding of its financial condition, changes in financial condition and results of operations; esp when companies with many subsidiaries have consolidated financial statements i. International companies carry additional currency risks b. Backward Looking Information: Historical data i. What happened and why c. Forward Looking Information: Forecasting i. What may have a possible impact on the company moving forward Page 41 of 64 3. 4. 5. 6. 7. 8. 9.
ii. Potential earnings of the company d. When disclosure on MD&A is required: Where a trend, demand, commitment, event or uncertainty is known, management must make two assessments i. Is the known trend, demand, etc., uncertainty likely to come to fruition? If management determines that it is not reasonably likely to occur, no disclosure is required. ii. If management cannot make that determination, it must evaluate objectively the consequences of the known trend, demand, commitment, event, or uncertainty on the assumption that it will come to fruition. iii. Disclosure is then required unless management determines that a material effect on the registrant‟s financial condition or results of operation is not reasonably likely to occur. FALSE OR MISLEADING STATEMENTS IN CONNECTION WITH PROXY SOLICITATIONS e. Misleading information may be: i. Predictions of future market values ii. Character charges without factual foundation iii. Proper identification of the person soliciting the proxy statement iv. Claims made prior to the meeting regarding the results of a solicitation J.I. Case Co. V. Borak, 377 U.S.426, (1964) v. Facts (1) The merger between case and American tractor Corp. effected by circulation of false and misleading proxy statement by those proposing the merger (a) Preemptive rights of the respondent were deprived (preemptive rights are opt-in) (2) Two counts in complaint (derivative action – suit brought on behalf of the company by a shareholder: and the recovery in this action will go to the company) (a) Diversity, ach of directors fiduciary duty to stockholders i) State Law Claim (b) Violation of section 14 (a) of the securities exchange act of 1934 regarding proxy solicitation material i) Federal Law Claim vi. Security requirements: (1) 19 states have statutes that permit the Corporation to require a plaintiff in a derivative suit to provide security for the expenses, including attorney fees, that may be incurred in the defense of the suit (a) Amount of security is determined by the court (b) In some exceptional cases, this may only apply to plaintiffs whose stockholdings fall beneath a percentage amount stated in the statute; t may also be satisfied by seeking the intervention as plaintiffs of additional stockholders, so that the aggregate holdings of the plaintiffs and intervenors exceed the amounts were percentage provided by the statute vii. Case Co. stockholders proxies were used in solicitations used at a special stockholders meeting, at which the proposed merger with a T. C. was to be voted upon. The proxy solicitation material was also misleading in violation of section 14(a) of the act; the merger was approved at the meeting by a small margin of votes and was thereafter consummated; merger would not have been approved but the false and misleading statements sing damage to the case stockholders viii. The purpose of section 14 (a) is to prevent management others from obtaining authorization for corporate action by means of deceptive or inadequate disclosure in proxy solicitation (1) It is unlawful for any person to solicit to permit the use of his name to solicit any proxy or consent or authorization in respect of any security… In the public interest or for the protection of investors (2) The injury a stockholder suffers from corporate action because of a deceptive proxy solicitation, is damaged done to the Corporation, rather than from damage inflicted directly upon the stockholders (a) Damage is suffered from the deceits practiced on the stockholders as a group ix. Enforcement of proxy requirements: antitrust travel damage litigation and the possibility of civil damages for injunctive relief serves as a most effective weapon in the enforcement of proxy requirements Page 42 of 64
Jurisdiction: where legal rights have been invaded, and a federal statute provides for a general right to sue for such invasion, federal courts may use any available remedy to make good the wrong don xi. Violations of rule 14 a – 9 gave rise to a private cause of action Mills v. Electric Auto-Lite Co., 396 U.S. 375 (1970) xii. Defines materiality: conclusions that the defect was of such a character that it might have been considered important by a reasonable shareholder who was in the process of deciding how to vote TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438 (1976) xiii. A minority stockholder in an acquired corporation brought suit against the acquiring corporation and sellers of controlling interest in the acquired corporation, charging violation of the Securities Exchange Act of 1934 and rules promulgated thereunder in regard to a joint proxy statement issued by the acquiring and acquired corporations. xiv. Procedural Posture: (1) The District Court, 361 F.Supp. 108, granted the sellers' cross motion for summary judgment, and plaintiff appealed. (a) Interlocutory Appeal (28 USC §1292): Judge may determine that the ruling involves a controlling question of law as to which there is substantial ground for difference of opinion and that an immediate appeal from the order shall materially advance the ultimate termination of the litigation – judge shall so state in writing in the order (2) The Court of Appeals, 512 F.2d 324, reversed, holding that the claimed omissions of fact were material as a matter of law. (3) On grant of certiorari, the Supreme Court, Mr. Justice Marshall, held that an omitted fact is "material" if there is a substantial likelihood that: (a) A reasonable shareholder would consider it important in deciding how to vote, that the (b) Issue of materiality is a mixed question of law and fact, and that, under that standard, i) E.g., the established omissions were “so obviously important to an investor, that reasonable minds cannot differ on the question of materiality (c) None of the omissions claimed to have been in violation of the rule against incomplete or material and misleading proxy statements [here] was materially misleading as a matter of law. Reversed and remanded. xv. Rule 14a-9: Purpose of this rule is to ensure disclosures by corporate management in order to enable the shareholders to make an informed choice Virginia Bankshares, Inc. v. Sandberg, 501 U.S. 1083 (1991) xvi. Losing a state remedy will not bar someone from being able to stay in court for other claims (1) Appraisal: If you don‟t like the price you are being offered for your stock in a merger, you have a state statutory COA (MBCA 13.01) (2) But this stockholder is claiming that the stock price is too low because the BOD want the price to stay low until P sells out (** Covered by the laws of “Duty of Loyalty” which is beyond negligence allegations and is also a state COA **) (a) The BOD can remedy this with full disclosure to everyone xvii. Statements of reasons, opinions, or beliefs are statements with respect to material facts, so as to fall within strictures of Securities and Exchange Commission (SEC) rule prohibiting solicitation of proxies by means of materially false or misleading statements f. Communicating with Shareholders: i. Rule 14a-7: Obligations of Registrants to Provide a List of, or Mail Soliciting Material to, Security Holders (1) State law gives inspection rights under MBCA – one may demand to look @ books (a) GA: Financial records are available via request ii. Rule 14a-8: Shareholder Proposals: proposals by those who own shares in the company if they meet certain substantive [what you can propose about] and procedural req‟s [currently the content of these laws are under review by SEC] (1) SEC is Considering: Shareholders of a certain %age of stock to nominate representatives to the Proxy statement (2) Must include all proposals in the proxy statement that have managed to get the
x.
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iii. New Requirements: (1) Requirement of Fair Disclosure (2) Material, non-public information must be disclosed to EVERYONE (a) In press releases (b) Sarbanes Oxley: listing req‟s for all stock exchanges; makes audit committees responsible for hiring the CPA firm, and that the CPAs don‟t do any work they don‟t need to be doing Rauchman v. Mobil Corp., 739 F.2d 205 (1984) iv. Write letter to SEC about shareholder proposal which violates the rules, explaining such belief, and if SEC agrees with company (by issuing a “No Action Letter”), it may be if omitted (1) If omitted – corporation may be sued by the shareholder and the SEC – damages may be inclusion in next year‟s proxy statement v. Rauchman proposed that people from OPEC to sit on the BOD which deals with an election – since shareholder proposals may not have to do with director elections (1) PRECATORY Resolutions: Shareholders may suggest changes in directors, etc., by using such resolutions
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DUTIES OF DIRECTORS
A. Duty of Care/BJR – P carries the Burden in these Cases to Prove BJR was not Followed 1. Demand required and subsequently excused (DE) 2. Universal Demand (MBCA, GA) to a Dir/CEO B. Duty of Loyalty – NOT BJR: D carries the burden in these cases that they did comply with Duty of Loyalty 1. Self Dealing 2. Corporate Opportunity C. “Cleansing” 1. Vote of Approval by Majority of Disinterested SH 2. Vote of Approval by Majority of Disinterested Directors 3. Entire Fairness of Transaction
DUTY OF CARE AND THE BUSINESS JUDGMENT RULE
DUTY OF LOYALTY AND DUTY OF CARE ARE THE TWO PRIMARY DUTIES OF DIRECTORS D. Duty of Care + Business Judgment Rule 1. Judges are not business-people and will not interfere or second-guess business decisions Litwin v. Allen, 25 NYS2d 667 (1940) E. Debenture: a particular certificate issued by a corporation acknowledging a debt and promising to repay the loan with interest; an unsecured bond 1. Convertible security: convertible by the holder from a bond to a stock Fiduciary Relationship of Directors to Corporation 2. If a particular director objects to an action taken by the board, should formally object at the meeting to establish the timing of the liability and the participation in the decision making process – to determine whether additional advice was necessary 3. Corporate directors are "trustees" in the sense that in performance of their duties they stand in a "fiduciary" relationship to the company, and are bound by all rules of conscientious fairness, morality, and honesty in purpose which law imposes as guides for those who are under fiduciary obligations and responsibilities, and are held, in official action, to the extreme measure of candor, unselfishness, and good faith 4. A director owes to corporation a loyalty that is undivided and an allegiance that is influenced in action by no consideration other than corporation's welfare 5. The "fiduciary" relationship of director to corporation imposes a duty to act in accordance with the highest standards which a man of the finest sense of honor might impose upon himself, and rule of undivided loyalty will not be undermined by particular exceptions. 6. A director is in the position of a "fiduciary", and will not be permitted improperly to profit at expense of corporation, but his undivided loyalty will be insisted upon, and personal gain will be denied when it comes because director has taken a position adverse to or in conflict with best interests of corporation Required Degree of Care and Capability, Negligence 7. A corporate director is required to use independent judgment and act honestly and in good faith, but he must also exercise some degree of skill, prudence and diligence 8. Directors are liable for negligence in performance of their duties, but are not insurers and are not liable for errors of judgment or for mistakes committed while acting with reasonable skill and prudence 9. In the last analysis, whether corporate director has discharged his duty or has been negligent depends upon facts of particular case, the kind of corporation involved, its size and financial resources, magnitude of the transaction, and immediacy of the problem presented, and director is called upon to bestow the care and skill which the situation demands 10. In determining whether transactions approved by a director subject him to liability for negligence, court must look at the facts as they exist at the time of their occurrence, not aided or enlightened by subsequent events, since no man should be judged by wisdom developed after an event, having such event and its consequences as a source 11. A director is not liable for loss or damage other than that proximately caused by his own acts or omissions in breach of his duty. 12. If bank directors make a decision for which there is reasonable basis, in good faith, on loan in which they have no personal interest, as result of their independent judgment and not influenced by any consideration other than what they honestly believe to be for bank's best interests, court should not say that it would have acted differently, and charge directors for loss Page 45 of 64
Bank Directors Held to Higher Standard of Care 13. A bank director is held to stricter accountability than director of an ordinary business corporation, since he is entrusted with funds of depositors and stockholders look to him for protection from imposition of personal liability 14. Clairvoyance is not required of bank director, but director will be absolved from liability if he uses that degree of care ordinarily exercised by prudent bankers, although his opinion may turn out to have been mistaken and his judgment faulty 15. The statutory oath of bank director merely adds solemnity to obligation which the law itself imposes, to diligently and honestly administer affairs of the bank or trust company. 16. Mere honesty of bank directors in administering bank's affairs does not suffice, but there must be diligence, care, and prudence as well. Shlensky v. Wrigley, 95 Ill.App.2d 173 (1968) F. Derivative suit to cause the corporation to install lights at Wrigley field and to have the Cubs play night games G. Issue: Whether the P‟s amended complaint states a COA 1. P‟s Argument: Fraud, Illegality and Conflict of Interest are not the only bases for a stockholder‟s derivative suit against directors 2. D‟s Argument: Courts will not step in and interfere with honest business judgment of the directors unless there is a showing of fraud, illegality, or conflict of interest H. Rule: 1. Courts of equity will not interfere with the management of the directors unless it is clearly made to appear that they are a. guilty of fraud or misappropriation of the corporate funds b. refuse to declare a dividend when corporation has surplus of profits, which it can (financially) safely distribute to shareholders c. withholding a dividend in bad faith as to amount to an abuse of discretion I. Holding: This ct affirmed dismissal of the P‟s derivative suit against the corporation because no fraud was found and it cannot be said that directors, even those of corporations that are losing money, must follow the lead of other similar corporations Smith v. Van Gorkom, 488 A.2d 858 (1985) J. Business Judgment Rule: Minimum of interference by the court in internal corporate affairs (MBCA) Director Liability Standard of Care is Based on Process Judgment: a. Not a question of substance b. If there is no illegality, fraud, or conflict of interest – the directors come to court clothed in the presumption that they exercised sound business judgment – a difficult hurdle and burden for P to overcome in proving that directors had acted negligently The end result is not and will not be @ issue because the result will not be of import because they are not judged as of the time or result after the fact, but as of and at the facts of the time and process when they actually made the decision MBCA 8.30 – does NOT follow an “ordinary prudent person” standard, but adopts something different as the standard of care and looks mainly @ the PROCESS c. Based upon the process employed by directors used to make themselves informed of the information 2. Business judgment rule exists to protect and promote full and free exercise of managerial power granted to directors of corporations. 3. Under business judgment rule there is no protection for directors who have made unintelligent or unadvised judgment. 4. Director's duty to exercise informed business judgment is in nature of duty of care, as distinguished from duty of loyalty. 5. Where there were no allegations of fraud, bad faith, or self-dealing, or proof thereof, presumption arose that directors reached their business judgment in good faith, and considerations of motive were not relevant in determination of whether actions were protected under business judgment rule. 6. Under business judgment rule director liability is predicated upon concepts of gross negligence, and concept of gross negligence is also proper standard for determining whether business judgment reached by board of directors was informed one. 7. Where all directors of corporation, outside as well as inside, took unified position, all would be treated as one in determination of whether they were entitled to protection of business judgment rule in their approval of cash-out merger of corporation. Page 46 of 64
K. Buy-Out: the company had investment tax credits it could not use 1. LBO: Leveraged Buy-out 2. MBO: Management Buy-out DIRECTOR’S FIDUCIARY CAPACITY/DUTY 3. Director's duty to inform himself in preparation for decision derives from fiduciary capacity in which he serves corporation and its stockholders. 4. Since director is vested with responsibility for management of affairs of corporation, he must execute that duty with recognition that he acts on behalf of others, and such obligation does not tolerate faithlessness or self-dealing. 5. Fulfillment of fiduciary function of director of corporation requires more than mere absence of bad faith or fraud, but rather, representation of financial interests of others imposes on director affirmative duty to protect those interests and to proceed with critical eye in assessing information. 6. Only agreement of merger satisfying statutory requirements may be submitted to shareholders. L. Rule/Analysis Here: 1. Board of directors did not reach "informed business judgment" in voting to sell company for $55 per share pursuant to cash-out merger proposal, but rather, were grossly negligent in approving sale of company upon two hours' consideration, without prior notice, and without exigency of crisis or emergency, where directors did not adequately inform themselves as to role of chairman and chief executive officer of corporation in forcing sale of company and in establishing per share purchase price, and directors were uninformed as to intrinsic value of corporations 2. At minimum, for report to enjoy status conferred by statute protecting from liability directors who rely in good faith on reports made by officers, report must be pertinent to subject matter upon which board of directors is called to act, and otherwise be entitled to good faith, not blind, reliance 3. Board of director's unexplained failure to produce and identify original merger agreement permitted logical inference that instrument would not support their assertions that merger agreement was effectively amended to give board freedom to put corporation up for auction sale to highest bidder 4. Burden falls on board of directors who claim ratification based on shareholder vote to establish that shareholder approval resulted from fully informed electorate. 5. Specific breaches of duty: a. Did not take enough time to study the information b. Had a meeting with no written backup, hasty board meeting to sell a multi-million $ company c. Did not examine the merger price, the most important information to the shareholders d. Did not get a summary from their attorneys e. Did not find out anything about the pricing of the shares of the company (intrinsic pricing – the price could be determined by any number of factors – not just the market price, which could be bloated or altered by outside factors) f. Leaving the offer open for 90 days was a good idea, but no one could do due diligence because there was not enough additional information available for potential investors g. Informed judgment h. Damages are enormous when the damages are assessed (paid out by D&O – Directors and Officers Insurance) on a per-share basis of what they should have gotten and what they actually got (expectancy damages) 6. Boards now will always require: a. Opinions from attorneys, accountants, business analysts will not be required before trying such transactions DELAWARE GENERAL CORPORATE LAW: §102 – CONTENTS OF CERTIFICATE OF INCORPORATION M. (b) may also contain any of all of the following… (7) Provision eliminating or limiting personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty as a director, provided so long as it does not limit such duty for 1. breach of loyalty to corporation or its stockholders 2. acts or omissions not in good faith/intentional misconduct 3. knowing violation of law under §174 of title (unlawful dividends, stock repurchases, redemptions) 4. for a transaction director derived an improper personal benefit N. No provision will limit liability for acts committed prior to the date such provision becomes effective Page 47 of 64
In Re Caremark Intern. Inc. v. Derivative Litigation, 698 A.2d 959 (1996) O. Facts/Background: 1. NYSE Corp. involved in patient care and managed care services 2. Significant source of revenue for Caremark was 3rd party payments, insurers, Medicare and Medicaid – such payments are federally regulated by ARPL a. Anti-Referral Payments Law (ARPL): Prohibits health care providers from paying any form of remuneration to induce the referral of Medicare or Medicaid patients 3. Caremark got busted paying physicians for monitoring Medicare and Medicaid patients and was subsequently charged with multiple felonies a. In return for a guilty plea for 1 count of mail fraud with the gov‟t and payment of a massive fine, they would be allowed to continue participating in the Medicare and Medicaid programs b. Settlement amount was approximately $250M to settle all claims c. No senior officers or directors charged with wrongdoing 4. Derivative Suit filed seeking on behalf of the corporation to recover damages for all losses suffered by Caremark 5. Proposed Settlement by Directors to Caremark: this case is up on motion to approve the following proposed settlement as fair and reasonable a. Take steps to assure that no future violations of ARPL occurred b. Advise patients in writing of any financial relationship between Caremark and a healthcare professional or provider who made the referral c. Create a compliance and Ethics Committee composed of four directors, including two non-management directors to monitor future conduct P. Court of Chancery Ruling/Reasoning: 1. directors appeared to have followed procedures to inform themselves regarding contracts with health care providers before authorizing corporation to pursue contractual opportunities, so as to be protected under business judgment rule from claims of personal liability when impermissible contracts were entered into a. Even if a judge and/or jury determine, after the fact, that a claim of directorial liability should stand for a decisions which they see as “stupid” or “egregious” provides no ground for director liability under the business judgment rule so long as the court determines that the process employed at arriving at decision was either rational or employed in good faith effort to advance corporate interests b. Includes assumptions by directors that their employees have integrity and deal honestly on the corporation‟s behalf 2. board appeared to have met responsibilities to monitor operation of corporation, even though some illegal contracts were entered into a. Board members have a duty to be reasonably informed regarding the corporation’s affairs; Includes members of board that info and reporting systems exist that are designed to reasonably provide accurate, timely info to Sr. mgmt and board to allow them (each w/in their scope) to reach informed judgments RE corporation‟s compliance w/law and business performance 3. settlement was fair, despite consideration for release of claims that was "very modest," in view of weaknesses of complainants' case 4. Settlement approved a. Corporation and absent stockholders will be barred from bringing future litigation once the settlement has been approved b. The parties proposing settlement bear the burden to prove that it is fair and reasonable Malone v. Brincat, 722 A.2d 5 (1998) Q. Facts: 1. Class action suit brought in the Court of Chancery alleging that the directors of Mercury Finance Company breached their fiduciary duty of disclosure because they materially overstated on earnings, financial performance, and shareholders‟ equity statements R. Posture: 1. Chancery Court granted a motion to dismiss with prejudice for failure to state a claim upon which relief may be granted
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S.
Here, the court agreed, but determined that the court should have dismissed without prejudice, allowing the plaintiffs to amend their complaint a. Ct of Chancery Rule 23.1 requires pre-suit demand or cognizable and particularized allegations that demand is excused 3. Affirmed in part, reversed in part, and remanded for further proceedings Rules: 1. Breaches and claims for breach are regulated by the Securities Litigation Uniform Standards Act of 1998 a. Violation of fiduciary duty gives rise to a derivative claim on behalf of the corporation, a COA for damages, or some other equitable relief 2. BOD is under a fiduciary duty to disclose material information when seeking shareholder action 3. Equitable principles act in those circumstances to protect the beneficiaries who are not in a position to protect themselves 4. BOD has the legal responsibility to manage the business of a corporation for the benefit of its shareholder owners, imposing fiduciary duties on the directors to regulate their conduct when they discharge that function 5. Director‟s fiduciary duty tripartite: due care, good faith, loyalty – the “constant compass by which all director actions or the corporation and interactions with its shareholders must be guided” 6. Duty of truthful dissemination: accurate and complete information material to a transaction or other corporate event that is being presented to them for action 7. Contexts of Information Dissemination by Directors: inaccurate information in these contexts may be the result of a violation of the fiduciary duties of care, loyalty, and good faith a. Public statements made to the market, including shareholders b. Statements informing shareholders about the affairs of the corporation without a request for shareholder action c. Statements to shareholders in conjunction with a request for shareholder action 8. General Corporation Law does not require the directors to convey substantive information beyond a statutory minimum 9. An action for a breach of fiduciary duty arising out of disclosure violations does not include the elements of reliance, causation, and actual quantifiable monetary damages a. Action requires that the challenged disclosure has a connection to the request for shareholder action [such as in detrimental reliance] and if the alleged omission or misrepresentation was material Materiality is determined with respect to the shareholder action being sought Duty to disclose all available material information must be balanced against its duty to protect the corporate enterprise
2.
Zapata Corp. v. Maldonado – “Demand Excused” 10. BJR is not relevant in corporate decision making until after a decision is made a. Generally used as a defense to an attack on the decision‟s soundness 11. Cites the McKee Rule: “A stockholder cannot be permitted…to invade the discretionary field committed to the judgment of the directors and sur in the corporation‟s behalf when the managing body refuses” 12. The exception to the McKee Rule provides SH 2 options a. Demand Derivative Suit SH must demand suit be brought and demand subsequently refused SH charges wrongful refusal If it was wrongful, the SH has recourse b. No Demand due to Futility SH would have made demand but such demand would have been futile b/c BOD are under influence sterilizing them f/discretion SH, if futile demand may be shown, will have standing to sue in equity in corporation‟s behalf 13. When BOD May Cause Properly Initiated Litigation to be Dismissed a. Anytime, so long as the decision is not wrongful b. When it determines the litigation would be detrimental to the corp c. ** Purpose for the ability of BOD to end litigation is to stop dissident SH from crippling the BOD/Special Litigation Committees 14. §141c of DE Corp Law says BOD can delegate authority to a committee, so said committee would have the power to move for dismissal or summary judgment as if the BOD had Page 49 of 64
15. BALANCING POINT OF INTERESTS: a. Balance between the power of a bona fide SH to bring corporate COA cannot be unfairly trampled by BOD b. Corporation can rid itself of detrimental litigation 16. Ct will use Substantive Judgment: Ct says "The final substantive judg‟t whether a particular lawsuit should be maintained requires a balance of many factors – ethical, commercial, promotional, public relations, employee relations, fiscal as well as legal” 17. Corporation Will File a Pretrial Motion to Dismiss a. Basis = Best interest of corporation b. Include written record of the investigation, findings, and recommendations c. Each side may make a record on the motion d. How the ct will test the motion: Independence and Good Faith of the Litigation Committee; bases supporting its decision; corporation bears the burden of proof of good faith and reasonable investigation (Good Faith & Reasonableness are NOT presumed) Whether or not to grant the motion; event if the committee jumps through all the hoops, if it is not in the spirit or was a premature dismissal of a SH‟s grievance – these are all issues ct will review along with public policy and considerations to matters of law - the ct must weigh in determining whether or not to grant the motion for summary judg‟t **STOPPED UPDATING NOTES HERE** Gall v. Exxon Corp., 418 F. Supp. 508 (1976) 18. Facts: a. Exxon was making payment using corporate funds to Italian political parties and others to secure political favors as well as other allegedly illegal commitments b. The BOD resolved to establish a Special Committee on Litigation (hereinafter the “Committee”) composed of ppl who were not on the board @ the time the alleged pmts were made, and who confirmed that he or she had no connection with the alleged pmts The Committee spent 4 months investigating and wrote an 82-page rpt (based on the investigation and interviews of over 100 Ws), determining to not pursue legal action against the prior directors on behalf of the corporation (or anyone else) because: o Unfavorable prospects for successful litigation o Cost of conducting litigation o Interruption of corporate business affairs o Undermining of morale Said it would be contrary to the interests of Exxon and its shareholders for Exxon or anyone on its behalf to institute or maintain a legal action against any present or former Exxon director or officer c. Here, several of the Ds: Were aware of the existence of at least the political payments Had been advised of the existence of the payments Had urged that the contributions be phased out as promptly as possible Were aware of payments out of secret bank accts 19. Ct‟s Holding/Reasoning: a. It is the responsibility of the directors of the corporation to determine if an action should be brought on behalf of the corporation, resting on the sound business judgment of the MANAGEMENT b. Courts interfere seldom to control such intra vires the corporation, except where directors are guilty of misconduct = to breach of trust or where they stand in dual relation which prevents unprejudiced exercise of judgment c. “If a stockholder could compel the officers to enforce every legal right, courts, instead of chosen officers, would be the arbiters of the corporation‟s fate.” d. Issue is whether the Special Committee, in the sound exercise of their business judgment, may determine that a suit against any present or former director or officer would be contrary for the best interests of the corporation
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e.
RULING: Summary judg‟t is improper @ this stage of litigation because it is premature given P must be given an opportunity to test issues and the independence of the Special Committee (which it had challenged)
DUTY OF LOYALTY AND CONFLICT OF INTEREST
SELF-DEALING, INTERESTED CONDUCT 1. Why do we require judicial oversight of interested transactions? a. Voluntary transactions on part of self-dealing director b. Provide an opportunity for direct pecuniary enrichment @ expense of the corporation by the self-dealing dir Marciano v. Nakash, 535 A.2d 400, 1987) c. Long-established principle of DE law that because of the fiduciary relationship, Directors are limited in the extent to which they may benefit from dealings with the corporation he serves d. Voting on/Receiving Compensation: May be considered “constructively fraudulent” in the absence of shareholder ratification, or statutory or bylaw authorization e. Per Se Voidability for Interested Transactions (also called the Common Law Rule): Self-interested transactions voidable because a vote including the vote of an interested director cannot be counted as whether or not the vote received a majority – so on its face, the loans given to Marcianos was void f. §144(a) of the DE General Corporation Law: provides the test for „immunizing‟ transactions of interested parties i. BUT this ct says that §144(a) is not the ONLY standard for validating interested transactions ii. Relationship alone is not the controlling factor for interested transaction from previous case (Fiegler) to review (1) Apply §144 as a touchstone (2) Apply a BASIC FAIRNESS TEST (provides a subjective standard against which evidential burden of the interested director(s) is applied) iii. If §144 criteria are met, then it removes the „interested director‟ cloud and will not invalidate a transaction solely on the basis of the dir‟s relationship w/corporation iv. But if there is a shareholder deadlock, then use of §144 is frustrated v. Lots of states have statutes containing provisions restricting or prohibiting loans to employees or dirs INTERESTED TRANSACTIONS vi. Subject to close scrutiny (1) If approved by fully informed disinterested directors/shareholders, then directors may invoke the business judgment rule (a) Then it can only be reviewed by standards of waste or of gift (b) Burden shifts to the party attacking the transaction vii. How it is Reviewed (Start by Looking @ §8.60 MBCA) (1) Look @ how fair it is vis-à-vis other nonparticipating shareholders (2) Determine whether the disputed conduct received the approval of a non-interested majority of directors or shareholders (3) §8.60 of MBCA TELLS EXACTLY WHICH PPL ARE COVERED UNDER THE COI LAWS (a) CTS MAY NOT INTERFERE IF A TRANSACTION IS NOT CONSIDERED AN “INTERESTED TRANSACTION” i) Creditor/Debtor Relationship is not within a COI defined relationship; President of a Golf Club is not COI relationship (b) MBCA §8.62, §8.63 show how to Cleanse the Transaction (Dirs and SHs) – see p. 915 i) Full disclosure is required before transaction cleansing happens TEST: Assessing transactions for fairness (not an exclusive list) (4) Voidable if transaction is not approved or ratified by disinterested majority of dirs or by the shareholders regardless of transaction‟s fairness (5) Not voidable if dir can show it to be fair to the corporation (6) Voidable if P can show it was unfair to corporation (7) Voidable if constitutes fraud, waste, or serious overreaching (8) A “Normal Course of Business” type of transaction (9) Not voidable if approved by disinterested majority of dirs – no further inquiry as to fairness needed Page 51 of 64
(10) Not voidable if approved by disinterested majority of shareholders – no further inquiry as to fairness needed (11) Transaction ALWAYS voidable if vote of disinterested dir is necessary to approve transaction or if dir‟s presence is necessary to form a quorum (12) Always voidable if interested party participates in decision-making process, urging approval, but not voting (always view as to how they may taint the outcome) Transactions will be approved when: (13) Ct feels that trans = fair to corporation (14) If director uses corporate assets w/o paying for them, then transaction will be set aside (or if it includes fraud, undue overreaching, or waste of corporate assets) , transaction will be SET ASIDE (15) Ct feels that no fraud, duress, undue overreaching, ct may still not be satisfied and would require dir to show: (a) Really was a majority group of disinterested directors and subject did not participate in decisions making, or (b) Majority of disinterested shareholders, after full disclosure of all relevant facts MBCA §8.31: Conflict of Interest g. Conflict of interest (COI) defined: transaction in which dir has a direct or indirect interest; is not voidable solely b/c of dir‟s relationship w/corporation if one of the following 3 is true: i. Material details were disclosed, BOD or committee thereof authorized, approved or ratified trans ii. Material facts of trans disclosed/known to shareholders and subject to vote – shareholders authorized, approved, or ratified the transaction iii. Transaction was fair to the corporation h. Also indirect interests where i. Dir has material financial interest in another entity which is party to a trans w/corporation ii. Another entity of which he is a dir, officer, or trustee is a party to the trans and trans should be considered by BOD of the corporation i. COI is approved w/majority of disinterested dirs on BOD (or of shares) voting to OK it 2. IRS Test: Reasonableness 3. Statute Test: Tax code 4. Sarbanes-Oxley Act: includes “Enhanced Conflict of Interest Provisions” re personal loans to corporate officers 5. Executive Compensation: a. Issue for both directors and officers and is often attacked with charges that: i. Self-dealing is involved with the comp ii. Retroactive payments are invalid as being without consideration iii. Compensation is excessive and constitutes corporate waste Exec Compensation in Closely Held Corporations: iv. Dirs and Ofcrs will often just take compensation b/c it is a tax deduction for the corporation but dividends are taxed twice (1) Tax Issues: Was salary reasonable? Based on company size, officer‟s position in corporation, and salaries in comparable companies in the industry [look @ the same issues for shareholder suits] v. Authorization: Was the compensation authorized by an independent board and/or shareholders; also looks to whether the BOD is interested in the transaction of officer comp vi. Forms of Compensation: Salary, bonuses, stock plans/options (AKA “Equity Compensation”), deferred compensation (cash after retirement), pension or profit sharing compensation plans, fringe benefits (1) But payment in excess of $1M must be adopted by SH Exec Compensation in Publicly Held Corporations: 6. Same as closely held corporations except that ratification (by BOD) is less likely to happen by “interested” groups; also provides greater flexibility in comp plans Heller v. Boylan, 29 N.Y.S.2d 653 (1941) a. Only concerned with incentive compensation plans portion of this opinion b. Rule: Must prove waste c. Facts: Derivative suit in which salaries and bonuses of executives were charged as being waste i. Although the comp was big $, the shareholders ratified the comp plan in their bylaws – ct will not replace the shareholder‟s actions with judgment Page 52 of 64
ii. Reasonable Relationship to Value of Services: (1) If a bonus bears no reasonable relationship to value of svcs, then even majority shareholder cannot give it, because it is waste of corporate assets/income and adversely affects shareholders (a) ** BUT MUST BE PROOF OF WASTE BEYOND THE MERE PAYMENTS in order to prevail on a waste theory (so ct will not go against ratified bylaws – kind of similar to Bus. Judg‟t Rule but for shareholders) i) But remember that shareholders can make a proposal [precatory advisory] – which could include an amendment of the corporation‟s bylaws – but then, who decides how much compensation should be within any company – the courts? No. They won‟t disturb decisions made by business people. Brehm v. Eisner, 746 A.2d 244 (The Walt Disney Case) d. Claims: i. Derivative suit alleging breach of fiduciary duty and nondisclosure claims against Directors by agreeing to a non-fault termination of Michael Ovitz in which he was paid a substantial severance package (claim alleges the package pmt was waste) ii. Breach of K against President of Corporation e. Pleading Problems: i. There were problems with the form of the pleadings – no particularized claims ii. P was given opportunity to amend their pleading in order to please particularized facts (they should have done this in the first place) (1) BOD never saw final draft of severance agreement (2) Crystal never advised on the severance (no expert opinion) (3) Ct cannot second-guess the severance agreement or what an appropriate compensation package should be f. Holdings: i. Pre- suit demand could not be excused on the ground that the directors lacked disinterestedness and independence or that the business judgment rule did not protect them; ii. Directors relied in good faith on financial expert who advised the board on employment agreement; iii. Directors' lack of substantive due care is foreign to the business judgment rule; iv. Waste by the directors was not shown; and v. President did not engage in gross negligence or malfeasance g. Arguments: i. P says Eisner sought to maximize his compensation @ the expense of the corporation – ct did not agree and the pleading did not allege with enough certainty such facts; additionally, Eisner had millions of option shares, to give shares to Ovitz for nothing would be against Eisner‟s pecuniary interests ii. Objective Tests for Reasonableness, Test for Materiality and Gross Negligence (1) BOD does not have to be informed of every fact rather, only the material facts which are reasonably available (not those out of BOD‟s reach or which are immaterial) iii. P says Old Board breached duty when it approved the employment agreement (1) Crystal (the financial consulting co.) and the New Board both had reasonably available to them the info from which they could calculate the compensation (2) Crystal‟s lack of quantifying the real cost to the corp of the agreement does not create reasonable inference that BOD failed to consider such cost to Disney (3) Because of the Business Judgment Rule – ct cannot apply 20/20 hindsight against the BOD unless it was so egregious on its face – but just b/c Disney didn‟t do the calculations does not make the agreement egregious (a) Old BOD gets the presumption that it exercised good business judgment (b) A BOD‟s decision on executive compensation is entitled to great deference iv. P says that the package was an incentive to get out of the agreement as soon as possible (1) Vesting schedule was actually a disincentive for Ovitz to leave Disney v. Waste Test: An exchange that is so one-sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration (1) Cannot find waste if there is a good faith judgment that in the circumstances the transaction is worthwhile Page 53 of 64
Executive Compensation of Closely Held Corporations: 7. Too few disinterested board members to create a majority 8. Make sure it is reasonable a. Comparables b. General pay in the field is 9. If it is way out of line, the IRS may pay attention, since the corporation can expense the pay and the TP only has to pay taxes on it Majority Shareholders Owe Duty to Minority Shareholders: 10. A shareholder cannot sell his vote and majority votes are not always effective if it‟s result is “unfair” to the minority shareholders 11. Duty of Loyalty and Good Faith: Majority SH have fiduciary relationship to the corporation and minority SH a. Transactions will be closely scrutinized against this duty: i. As in a K relationship to see if minority SH are being treated fairly (as in when a majority SH gets a loan from the corp) or ii. If a transaction will happen b/c of majority SH‟s voting ability, the result as it bears on the minority SH will be reviewed by cts to see if transaction was in “good faith” and not to specific detriment to minority SH Subsidiary Relationships: Sinclair Oil Corp. v. Levien, 280 A.2d 717 (Del. 1971) b. Facts: i. Oil Corp had a subsidiary in S. America and drained off dividends of the sub in order to meet parent co. cash needs; Levien was a SH of the sub and filed a derivative suit b/c: (1) Dividends paid to the parent co exceeded the earnings of the sub for the same period (2) Said pmts limited ability of sub business to grow (3) K between sub and parent – parent corp was not paying on time or purchasing the amt of oil stipulated in the K c. Issue: Is application of the “intrinsic fairness” test appropriate standard to define fiduciary relationship between parent corporation to controlled subsidiary? Held = Yes d. Reasoning: Intrinsic Fairness Test Applicable (1) When self dealing present (2) Burden is on majority SH to show transaction with sub was objectively fair (3) But on dividends here – SH and parent corp both were paid pro rata on their holdings, so no problem with dividend payment (4) RE: Impeding growth of sub – the parent corp did not usurp any opportunities that would normally have gone to sub – ct applied Business Judgment Rule here and there was no evidence of gross overreaching so the ct left the transaction alone (5) Ct did find for subsidiary on the breach of K issue about failing to pay on time and to order stipulated amts (6) Decision to pay out dividends always falls under the Business Judgment Rule – it wasn‟t a business opportunity that the parent corporation took advantage of Corporate Opportunity e. Test of Good faith and fairness for valuing a corporation i. Fair dealing (1) How the transaction came about (2) How it was structured (3) How much time was spent on working it out ii. Fair Price (1) Feasibility study (2) Stock price (3) Assets, market value (4) Can be any reasonable valuation method f. Cleanse a Self-dealing Transaction
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g.
Cash-Out Mergers: i. Defined: Parent corporation owning more than 50% of subsidiary corporation may compel the minority shareholders of the subsidiary to accept cash for their shares in amt determined by parent ii. When Min SH don‟t agree, they must bring an appraisal lawsuit (1) Notice to corporation that you don‟t like the transaction (2) If you don‟t like the response, go to court (3) Why is this unfair type of suit for minority shareholders? (a) Litigation takes a long time (b) Min SH have to pay for litigation (c) Min SH gets nothing until the issue of fair value has been completely exhausted (all the way through the appeals process) (d) Min SH do not get pre-judgment interest and is discretionary by court and some Min SH may not even be awarded it (4) How Ct should look @ it: (a) View as a whole to determine whether it was tainted w/fraud, illegality, or self-dealing (b) If Min SH were dealt with fairly (was there full disclosure to them) (c) If independent corporate purpose existed for the merger iii. Business Purpose Test (1) A general business purpose must be present for the merger other than to remove the Min SH (2) Benefit need not be great, but must be FBO corporation
CORPORATE OPPORTUNITY: DEFINED h. A corporate officer/director cannot use their position, influence, or knowledge of the affairs of the corporation to gain personal advantage i. Line of Business Test: Whether a business opportunity is so closely associated with the existing business activities as to bring the transaction within that class where the acquisition of the property would throw the corporate officer into competition with the corporation [not used] j. Key Prevailing Concept: Disclosure: Corporation should have opportunity to reasonable reject the ability to pursue the business opportunity Controlling Law: American Law Institute Approach i. Offer opportunity to corporation first ii. Disclose conflict of interest and the opportunity itself iii. Corporation rejects the opportunity and one of the following conditions exist (1) Rejection of the opportunity is fair to the corporation (2) Opportunity is rejected in advance after disclosure, by disinterested directors/superiors, in a manner that satisfies BJR (3) Rejection by disinterested SH and the rejection does not constitute waste of corporate assets iv. Definition of Corporate Opportunity *************** PAGE 961 NOTES HERE 12. Other Constituencies a. Preferred Shareholders: PSH are held to the K provisions of their shares; they are on notice that they are not owed fiduciary duties the same as common share holders b. Holders of Convertible Securities: convertible security is one that can be traded in for common stock (usually bond); no fiduciary duty to these holders, bound by K; may have duty to inform holders of their rights c. Creditors: Entire relationship governed by K; no fiduciary duty owed; may not sell assets from under the creditor i. When in the vicinity (whatever the “vicinity” is) of bankruptcy, directors owe duty to CREDITORS and not SH
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INSIDER TRADING AND SECURITIES FRAUD Rule 10b-5: Employment of Manipulative and Deceptive Practices d. Unlawful to make use of interstate commerce or of the mails or of any facility of the SEC to (amended to include use of intrastate means/methods such as fax machines, computers, etc.) i. Employ a device, scheme, or artifice to defraud ii. Make untrue statements of material facts or to omit to state a material fact necessary in order to make the statements make not misleading iii. To engage in an act practice or course of business which operates or would operate as a fraud or deceit upon any person iv. in connection with the purchase or sale of any security e. History of 10b-5: was in response to a corporation president buying up his corp‟s stock because he knew earnings were about to skyrocket, but he was lying to SHs f. Sarbanes-Oxley (Fed) v. State COAs: Rule 10b-5 creates an implicitly Federal Remedy i. 10b-5 is broader than common-law fraud because, unlike fraud, it includes omissions g. 10b-5 can be the basis for a private suit to rescind a securities transaction – existence of a remedy is implicit under general principles of law; Other COAs include: i. Requirements (1) Buyer and/or seller of security (2) Scienter/intent to act or omit information that is a (3) MATERIAL MISREPRESENTATION in connection with the transaction (a) Test for Materiality: Stmnt is such that a reasonable investor would think it was important in how to make up their mind ii. SEC can bring an enforcement action on behalf of the public iii. securities fraud iv. deception v. trading in securities on the basis of undisclosed information (both public and closely held corporations) vi. Misrepresentations in mergers via proxy solicitations vii. Applies to activities that involve scienter – for both private and public (by Gov‟t) COAs (1) Must have intent, negligence is not enough viii. DOES NOT apply to claims based on aiding and abetting (after 1993) for private COAs ix. Implied Right of Contribution among defendants in §10 and 10b-5 cases (reserves the right of contribution among persons who are found liable for the same damages, but in proportion to their relative responsibility) x. Normal Business Practices (1) Mail Rules – only 1 person can open the mail (2) Vacation Rule – everyone has to go on vacation at least 2 weeks per year xi. Bad Faith Breach of K: Failure to disclose intent to breach K constitutes fraud, thus a 10b-5 violation xii. Short Form Mergers: parent owns 80% of sub and then offers SHs price; if price too low, it may be a breach of fiduciary duty – but 10b-5 does not recognize a COA for breach of fiduciary duty (breach of duty of loyalty or breach of duty of care) – seek a COA for appraisal Procedural Advantages of Rule 10b-5: (Fed Jurisdiction) xiii. Nationwide service of process under §27 of the SEC act of 1934 which is not available under state law xiv. Liberal venue provisions xv. Generous discovery rules xvi. Applicable SOLs (may have shopping among states b/c of SOL) xvii. Pendent jurisdiction allows Fed Ct to hear both a Federal and State claim in a single proceeding while a state could not hear a 10b-5 claims; additionally, because it is not brought in state court, the state security-for-expenses statutes for derivative suits does not apply – P will not have to put up a bond to bring the claim xviii. 10b-5 Claims may also be brought in addition to other provisions available via securities laws xix. Requires that the claimant and respondent follow the Birnbaum Rule: (1) Ps, as a class, are limited to those who have at least dealt in the security to which the prospectus, representation, or omission relates
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(2) Ds may also be deemed to have violated 10b-5 even though they are not a purchaser or seller of securities, by influencing the market by a false press release or preparing a prospectus that contains false statements (3) Advantages of Applying Birnbaum Rule to 10b-5 Actions: (a) Limits the class of plaintiffs in a reasonable way (b) But still excludes those plaintiffs who are still wronged – but ct said there HAS to be a limit xx. Requires proof similar to common law fraud claims – “preponderance of the evidence” xxi. SOL: Claims must be brought (1) Within 1 year after the discovery of the facts constituting the COA, and (2) Within 3 years after the cause of action accrued (3) No tolling or delayed accrual (4) *** BUT SARBANES-OXLEY is different for Securities Fraud Claims: (a) Within 2 years after discovery of the facts constituting the fraud, OR (b) Within 5 years after the violation (c) Applied to proceedings after July 30, 2002 In Re Enron Corporation Securities Derivative & ERISA Litigation, 235 F.Supp.2d 549 (2002) xxii. Lawyers Liability: (1) Liable because even if they are a secondary actor, if the facts in the claim are true, then they are elevated to a primary actor (2) Participation in public statements takes this out of the attorney/client privilege protection xxiii. Arthur Anderson: (1) Same liability as the attorneys because they were acting as primary actors (2) Accounts do not have privilege (3) Motive was to inflate fees xxiv. Investment Banks/Banks: By issuing statements of opinion to the public xxv. Company‟s Value comprised of (1) Corporate Bond Rates by (a) Standard & Poors (b) Moodys (2) Value (3) Grades include (a) Investment Grade (Junk Bond Status) (b) Ratings e.g., AAA or B- Insider Trading Under Rule 10b: h. Use of Inside Information: i. Unfair to use one‟s position of knowing inside, non-public corporate information to execute transactions for personal benefit ii. Requires: (1) [Presumed] Reliance on the misrepresentation is required to link a causal connection between D‟s misrepresentation and a P‟s injury, proved by (a) Face-to-face negotiations (b) Did buyer subjectively consider the misrepresentations (c) Dissemination or withholding information by an issuer (of stock) affects the price of the shares – and SHs depend and rely on the stock price iii. Reliance on the misrepresentation and resulting injury is PRESUMED (1) Because it may be too hard to prove with direct proof (2) The Defendants bear the burden because investors have relied upon the market price as an indication of the market value (3) D may rebut the presumption that Ps were relying on misrepresentation/omission (a) D can show that the misrepresentation did not affect market value of the stock because market makers knew the real facts and set price accordingly (b) D can show that the investor sold the shares for a reason other than the market price, knowing that Ds had probably misrepresented the status of merger negotiations iv. Call: option to buy at a certain price within a certain time frame Page 57 of 64
Defenses to Insider Trading: v. Not an insider of the company, but merely an employee (1) But someone who knows material information may be considered an insider because of their knowledge (may disseminate information to someone who wasn‟t even an employee) (2) Lawyers/Accountants can be insiders – when they know non-public material information they become a temporary insider vi. The information was not material non-public information (1) Something is material if a reasonable investor would think the information was significant in deciding on a specific course of action (2) Must be a substantial likelihood that disclosure would have made a difference to a actual or potential investor vii. Policy Considerations: (1) Not good to allow insiders to trade before non-public information because even so, the information gets out and notifies the public too soon; and if people knew the insiders were trading then they too may do the same things (a) Insiders must file a report with the SEC within 3 days that an insider has traded shares viii. Duty to Disclose/not to Trade (1) Just because someone has non-public information != insider with a duty not to trade until the information becomes public (2) Those controlled by 10b (a) Insiders (b) Tipees of Insiders (c) Those who use non-public material information for their personal gain i) Someone overhearing an outsider = no duty to not trade ii) Reporter who hears a press release then goes directly and calls broker to execute a transaction = duty to not trade iii) Secretary overhearing things in the office that seem to be favorable = duty to not trade iv) Someone who receives information from a tipee (called a „sub-tipee‟ on the basis that they believe the tipee knows something = duty to not trade v) Tipee liable only if the Tipper is in breach of duty and Tipper is only in breach if he or she obtains a personal benefit i. Does taking information gained through/from your employer = misappropriation of information – is a 10b violation j. Does taking non-disclosed, material information from someone who has no duty to the entity the information is about create a duty? i. Such as when an attorney knows something about clients of the firm (1) Creates a duty to abstain from trading (in a tender offer situation) k. When Can an Insider Trade? i. After information has been effectively disclosed to the public ii. After press releases usually Stock Options as Compensation iii. Option must be exercised within a certain amount of time iv. Board offers stock options to employee – employee must disclose that he or she cannot accept the options or surrender them (but such an action is making a statement that there is some reason to believe that the corporation‟s info may affect the options‟ value) v. Employee should rescind their acceptance of options Misappropriation: is a basis for a §10b violation vi. Occurs when someone, in connection with a securities transaction, misappropriates confidential information for trading purposes (1) Breach = breach of duty owed to the source of the information (2) Liability is NOT premised on a fiduciary relationship (3) Liability IS premised on a trader deceiving one who entrusted him with access to confidential information vii. To be a 10b violation, the misappropriation must also be through “deceptive” conduct “in connection with” a securities transaction Page 58 of 64
(1) Deception when one claims loyalty to a company while he or she is actually using the information for their own gain (2) DEFENDSE: If a trader tells the corporation that he is planning to trade on the confidential information (3) Person being deceived does NOT have to be a party to the transaction viii. To satisfy the “in connection with the purchase or sale of a security” requirement [to prove a 10b violation], it is enough that the D has knowledge of the information and uses it in deciding to make a purchase or sale Rule 14(e) Deception/Fraud in Tender Offers l. Tender Offer is an offer by a corporation to purchase shares of another corporation (the tendered corporation) which is made directly to the SHs m. SEC Act of 1934 requires reporting, disclosure i. Report within 12 mos once acquire 2% of a class of a registered equity ii. If >5% then requires filing an information statement with SEC + copies to issuer n. Prohibits fraudulent, deceptive or manipulative acts in connection with a tender offer o. 14(e) Violation if traded on material nonpublic information even without fiduciary duty meaning that anyone may be liable since fiduciary duty is not required – this is for TENDER OFFERS ONLY p. 14e-3(a): Prohibits fraudulent, deceptive, or manipulative acts or practices in relation to tender offers and grants rule making authority to the SEC; test for 14e3a violation is: i. Individual trades on the basis of nonpublic information ii. Regarding a tender offer that the individual iii. Knows or has reason to know has been acquired directly or indirectly from an insider of the offeror or issuer, or someone working on their behalf q. SEC may make rules, pursuant to power granted in 14e that regulate non-deceptive activities as a means of preventing manipulative acts so long as it is reasonably designed to prevent acts and practices that are fraudulent Fraud on the Market: r. “Efficient capital hypothesis” says that market price = correct price s. Economic theory that stock market it efficient and anything that is going on is reflected in the market place t. Rebuttable presumption that market price is composes of all publicly known information i. D can show that class members behaved differently and did not rely on the publicly traded price 13. Test for Materiality: What is material information? a. Something that leads to a substantial likelihood that a reasonable SH would consider it important; e.g., is it something that would influence a reasonable investor b. BUT if a fact is immaterial then it is of no consequence that someone made a misrepresentation of the fact c. Issue is timing – and ct does not define process and procedure 14. Certainty of a Transaction: a. The issue with when something is material, depends upon how certain a particular transaction may be (such as a merger, acquisition, etc.) b. Merger Discussions: i. Merger discussions are material, and become a material issue when variable factors, of a reasonable investor – would this fact significantly affect one‟s decision to invest
SECURITIES AND EXCHANGE ACT OF 1934
21A CIVIL PENALTIES FOR INSIDER TRADING (CONTROLLING PERSON LIABILITY) c. Commission may bring action in Dist Ct (confers upon itself jurisdiction) to impose a civil penalty for violations d. Allows court to bring action against employers or those in control (directly or indirectly) of violator e. SEC has ZERO TOLERANCE FOR INSIDER TRADING f. Penalties Imposed: i. Person committing violation = 3x profit gained or loss avoided as a result of the unlawful purchase, sale or communication
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ii. Person in control of someone committing violation = no greater than $1M or 3x amount of profit gained/loss avoided as a result of the controlled person‟s violation (1) But mere employment of someone in violation != liability unless they are a controlling person as described in this section (2) Profit Gained/Loss Avoided = Purchase Price or Sale Price – Value of Security measured by trade price a reasonable time after the nonpublic information is available to the public g. Only liable when commission finds that: i. Controlling person knew or recklessly disregarded the fact that controlled person was likely to engage in violation of rules + failed to take steps to avoid/prevent before acts occurred ii. Controlling person failed to establish, maintain, or enforce policy or procedure regarding insider trading required under 15f (requiring written, enforced policies) and failure to maintain policies contributed to or permitted the occurrence of the act or acts constituting the violation h. SEC may deem certain people, transactions or class of persons to be exempt i. Penalties payable to US Treasury i. Someone who provides information leading to the imposition of a penalty shall receive bounty on the violator in amt not to exceed 10% of the penalty imposed Insider Trading and Securities Fraud Enforcement Act of 1988 j. Penalties for willful violation of the Securities Acts or regulations can be from $100K+5 years prison to $1M+10 years prison for individuals; corporations or other non-person entities = fine up to $2.5M §20A Selling Same Type of Security as that of Violation k. So if violating and selling 1 security illegally, other securities of the same class also fall into the violated trades l. SEC will impose highest penalty possible m. Joint and several liability of those communicating material, non-public information §16: Directors, Officers, and Principal Stockholders n. Direct/Indirect owners of >= 10% of any class of non-exempt stock must register before transacting stock o. Short Swing Trading Prohibited: to buy in and sell out stock of the company within 6 months each other i. Must register to show what your ownership amt is in the company ii. Reporting is an ongoing requirement (1) Must report any trading of the corporation stock within 2-3 days iii. To buy/sell sort term (within 6 months) iv. Per se violation v. Private Cause of Action vi. Figures of the trade to determine the penalty = the biggest amount they can determine vii. No scienter needed viii. Must be within the class (1) Presumption is that if you are coming in and out of the stock in a short amount of time, that you know something material
TAKEOVER MOVEMENT
15. History/Generally a. Friendly or Hostile Takeovers b. Inefficient companies i. Takeovers of economically inefficiently-run companies b/c parent would run more efficiently ii. To deter a takeover – defense c. National Market for Corporate Control: 16. Forms of Takeovers: a. Proxy Fights i. Takeover aggressor has shares in another company and uses those shares to solicit SH votes taking over BOD which in turn changes the management of the corporation; proxy is an appointment of an agent to vote ii. If soliciting proxies – be sure that the information about the candidates is accurate b/c liable under SEC rules iii. Can‟t quietly buy up shares anymore – have to file w/SEC once you reach a threshold %age of votes iv. Corporations pay for incumbent‟s proxy fight v. Acquirer pays for expenses of proxy fight vi. If the proxy fight is b/c someone managing = personnel Page 60 of 64
vii. If proxy fight is regarding what the company is doing = Management viii. Notice is required to the management of the corporation (1) So they can‟t be taken by surprise Cash Tender Offers ix. Offer for the shares of the company; Bidder buys up shares of target company on open market x. Bidder makes lump offer to public shareholders xi. Williams Act: (1) to ensure tender offers are kept open and more fair, saving people from having to rush or be bullied to make a decision (2) Everyone who tenders has to receive the highest price (3) SH will get their shares purchased @ pro rata rate of tendering (a) If X owns 2% then out of the tender, 2% goes to X (4) Certain rules of making the tender offer [timing, e.g., # of days] (5) Challenges to Williams Act: (a) Federal Preemption: interferes with the bounds in order to effectuate the takeover; Places investors in equal footing (b) Constitutional Argument: commerce clause – essentially that there is a national market for “corporate control” which the states cannot interfere with i) Statute does not unduly burden the market for corporate control ii) Does not discriminate against interstate commerce iii) Does not affect international commerce iv) Function of state law [always has been] to determine how corporation will govern itself v) Law is set up to protect Illinois residents and businesses a) Narrow law because it wanted to get by the Sup Ct challenges xii. Junk Bond Markets: [junk bonds are rated below investment-grade bonds] (1) Problem with investing in junk bonds was that in the 60‟s – 70‟s there was no market for them xiii. Some SH may sell for less than the tender offer Leveraged Buyouts xiv. LBO = All or most of the outstanding stock of a corporation is purchased by an aggressor at a premium over the market price (1) Funded to effectuate tax deduction (2) Funded sometimes with “bridge loans” in which only interest was payable, and said interest was a deduction (3) Funded sometimes with low-grade, high-interest junk bonds xv. Minority Stockholders (1) Obliterated once 80% ownership by aggressor xvi. Back-end loaded Mergers: (1) Those who did not participate in the LBO early-on get screwed (2) Another method to get rid of minority shareholders xvii. State laws and SEC Rules govern LBOs and Tender Offers (1) When you buy = don‟t get voting rights unless the other disinterested SHs grant you voting rights; those who vote will be able to replace the board, thus replacing the board = replacing management (a) Need to get control of the voting rights (b) And the aggressor will have his shares taken/purchased back from him, but not at a premium – mainly this is set up to ensure cooperation and to lessen takeovers (2) DE Has Anti-takeover statutes (a) 2nd step transactions, regulates how a target company (b) Upheld on constitutional challenge (3) GA has takeover (a) Hostile takeover management must grant a right to the minority SH upon acquiring specific shares xviii. Helps corporation get out of debt (1) Tax deductions of target corporation debt (2) Selling off assets of the target corporation Page 61 of 64
b.
(3) Run the target corporation around and then sell it again to make $ Attorney Billing: contingency billing for takeovers
TAKEOVER DEFENSES: c. Cases: i. Revlon Cosmetics (1985): used an auction to get highest price for their SHs when it becomes apparent the corporation will be sold ii. Moran v. Household Intern, Inc. (1) No outstanding offer to take over Household Intern (a) HHI was undervalued – would be easier to sell off the assets (which were more valuable than the share price) (2) SHs were able to purchase stock at a much lower price (a) Condition of the sale happens then triggering events occur (3) Motive of a BOD to structure the financials of a corporation (4) Use of a poison pill may differ for different scenarios (a) May be taken back by BOD (5) Most effective anti-takeover device iii. Unical: p 1228 (not on exam) two-step tender offer (now not allowed via SEC) (1) Terms: (a) Buy up to 15% @ $44/share (b) Remainder by exchanging for other highly subordinated (low grade) securities (2) Selective Exchange Offer: (a) $75 per share (3) Cannot discriminate against those doing two-step tender offers iv. Unitrin, p. 1236 International Brotherhood of Teamsters v. Fleming Companies (1) Whether SH can vote for a shareholder proposal (2) Here, SHs wanted to implement a shareholder proposal and the BOD said no – then Teamsters wanted to amend the by-laws to void poison pills (3) Precatory COA in which SHs can seek to enforce their SH proposal (4) Case was certified question by the state Sup Ct (5) SHs can restrict Poison Pills by using bylaw amendment (as a corporate finance scheme) (a) SH can modify the and (6) SH Rights: voice via elections, votes; may modify Mentor Graphics Corporation v. Quickturn Design Systems: (7) Amended bylaws without a shareholder meeting (8) Dead-Hand Poison Pill: continuing directors who used to control are considered the “Deadhands” and only they can vote to do something with the acquirer – any new directors (elected by the old BOD) are precluded from making any deals with the acquirer (a) GA: Continuing Directors Provision: (9) No-Hand Poison Pill: Not allowed because it is a violation of the Modified BJR – not reasonable in relation to the takeover (out of proportion, because it delays excessively to keep one from making offer) (a) Includes time limits (b) Possibly legal as a financing scheme (in GA) i) Dead-hand Poison Pills = OK in GA as a financing option defined in GA code (10) Timing is often key to the acquirer: a funding company could require that the deal close within a certain period of time (11) P. 1221: Directors manage the corporation, hire those who manage – directors may protect the corporation from takeovers and the BOD can determine if it wants a poison pill Modified Business Judgment Rule for Selective Exchange Offers v. Defensive tactic must be reasonable in relation to the offer given vi. If the offer was reasonable, certain defenses are not allowed vii. Enhanced judicial scrutiny threatens the self-interest of the management and the BOD Page 62 of 64
(1) Most often used in DE viii. BJR applies: (1) Not like self-dealing (2) It is treated as a business choice made by the BOD (In Moran there was no actual offer being evaluated) d. White Knight: a financier who buys the company or the most important assets to dissolve the interest of a party wanting to takeover the corporation – thus the White Knight “locks up the valuable assets” and takes the valuable assets out of the company e. Poison Pill (Shareholder Rights Plan): Proposed by Marty Pipton – any law firm with corporate clients; floods the market with ppl buying the stock when SHs are given opportunity to buy share at extremely low price i. Ability to do such an offering occurs when triggering events happen ii. Ability to use poison pill for financing arrangements requires information in bylaws iii. Company is diluting its shares in order to make it too expensive to acquire iv. BOD can legally do it (in DE) because it is making use of its powers to define and implement a financing arrangement v. Most useful to buy time and negotiate with the acquirer vi. Important to ensure that there is a sunset provision on the poison pill (1) Fosters negotiations (2) May inhibit someone wanting to do a quick purchase vii. Similar to a stock option plan (because it offers SHs shares for lower prices) f. Auctions to Find Highest Bidder for the SHs (“Revlon Duty”): takes corporation out of a defensive mode (once a company is identified as a target) i. When Revlon Applies: (1) Once preliminary meetings RE takeover happen TABLE OF AUTHORITIES
Meinhard v. Salmon, 249 N.Y. 458, 164 N.E. 545 (1928). ................................................................................................................................................................................................................................................... 6 711 Kings Highway Corp. v. F.I.M’s Marine Repair Service .......................................................................................................................................................................................................................................... 12 Theodora Holding Corp. v. Henderson, 257 A.2d 398 (1969) ......................................................................................................................................................................................................................................... 12 Stanley J. How & Assoc. v. Boss, 222 F.Supp. 936 (1933) ................................................................................................................................................................................................................................................ 13 Robertson v. Levy, 197 A.2d 443 (1964) ............................................................................................................................................................................................................................................................................ 14 Frontier Refining Company v. Kunkel’s Inc., 407 P.2d 880 (1965) ................................................................................................................................................................................................................................. 15 Bartle v. Home Owners, Corp., 309 N.Y. 103, 127 N.E.2d 832 (1955) ............................................................................................................................................................................................................................. 16 Dewitt Truck Brokers v. W. Ray Flemming Fruit Co., 540 F.2d 681 (1976) ................................................................................................................................................................................................................... 17 United States v. Best Foods, 524 U.S. 51 (1998) ................................................................................................................................................................................................................................................................ 17 Stark v. Fleming, 283 F.2d 410 (1960) ................................................................................................................................................................................................................................................................................ 18 Roccograndi v. Unemployment Comp. Bd. of Review, 197 Pa.Super. 372 (1962) ........................................................................................................................................................................................................ 18 Cagill, Inc. v. Hedge, 375 N.W.2d 477 (1985) ................................................................................................................................................................................................................................................................... 18 Pepper v. Litton, 308 U.S. 295 (1939) ................................................................................................................................................................................................................................................................................. 18 Nissen Corp. v. Miller, 323 Md. 613 (1991)....................................................................................................................................................................................................................................................................... 19 Securities and Exchange Comm’n v. Ralston Purina Co., 346 US 119 (1953) ................................................................................................................................................................................................................ 25 Smith v. Gross, 604 F.2d 639 (1979) ................................................................................................................................................................................................................................................................................... 25 Stokes v. Continental Trust Co. of City of New York, 186 N.Y. 285 (1906) ................................................................................................................................................................................................................... 26 Katzowitz v. Sidler, 24 N.Y.2d 512 (1969)......................................................................................................................................................................................................................................................................... 27 Lacos Land Company v. Arden Group Inc., 517 A.2d 271 (1986) .................................................................................................................................................................................................................................. 28 Gottfried v. Gottfried, 73 N.Y.S.2d 692 (1947) .................................................................................................................................................................................................................................................................. 28 Dodge v. Ford Motor Co., 204 Mich. 459, 170 N.W. 668 (1919) ...................................................................................................................................................................................................................................... 29 Wilderman v. Wilderman, 315 A.2d 610 (1974) ............................................................................................................................................................................................................................................................... 29 Donahue v. Rodd Electrotype Co., 367 Mass. 578, 328 N.E.2d 505 (1975) ..................................................................................................................................................................................................................... 30 Galler v. Galler, 32 Ill.2d 16 (203) ...................................................................................................................................................................................................................................................................................... 33 Zion v. Kurtz, 50 NY2d 928 (1980) .................................................................................................................................................................................................................................................................................... 35 Ringling Bros.-Barnum & Bailey Combined Shows v. Ringling, 29 Del.Ch. 610 (1947) .............................................................................................................................................................................................. 35 Lehrman v. Cohen, 43 Del. Ch. 222 (1986)........................................................................................................................................................................................................................................................................ 35 In re Radom & Neirdorff, Inc., 307 NY1, 119 N.E.2d 563 (1954) ..................................................................................................................................................................................................................................... 37 Davis v. Sheerin, 754 S.W.2d 375 (1988) ........................................................................................................................................................................................................................................................................... 37 Abreu v. Unica Indus. Sales, Inc., 224 Ill.App.3d 439 (1991) ........................................................................................................................................................................................................................................... 38 Black v. Harrison Home Co., 155 Cal. 121, 99 P. 94 (1909) .............................................................................................................................................................................................................................................. 39 Debaun v. First Western Bank and Trust Co., 46 Cal.App.3d 686 (1975) ...................................................................................................................................................................................................................... 39 J.I. Case Co. V. Borak, 377 U.S.426, (1964) ........................................................................................................................................................................................................................................................................ 42 Mills v. Electric Auto-Lite Co., 396 U.S. 375 (1970) .......................................................................................................................................................................................................................................................... 43 TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438 (1976) .................................................................................................................................................................................................................................................. 43 Virginia Bankshares, Inc. v. Sandberg, 501 U.S. 1083 (1991) .......................................................................................................................................................................................................................................... 43 Rauchman v. Mobil Corp., 739 F.2d 205 (1984) ................................................................................................................................................................................................................................................................ 44 Litwin v. Allen, 25 NYS2d 667 (1940) ............................................................................................................................................................................................................................................................................... 45 Shlensky v. Wrigley, 95 Ill.App.2d 173 (1968).................................................................................................................................................................................................................................................................. 46 Smith v. Van Gorkom, 488 A.2d 858 (1985) ...................................................................................................................................................................................................................................................................... 46 Malone v. Brincat, 722 A.2d 5 (1998) ................................................................................................................................................................................................................................................................................. 48 Zapata Corp. v. Maldonado – “Demand Excused” ......................................................................................................................................................................................................................................................... 49 Gall v. Exxon Corp., 418 F. Supp. 508 (1976) .................................................................................................................................................................................................................................................................. 50 Marciano v. Nakash, 535 A.2d 400, 1987) ......................................................................................................................................................................................................................................................................... 51 Heller v. Boylan, 29 N.Y.S.2d 653 (1941)........................................................................................................................................................................................................................................................................... 52 Brehm v. Eisner, 746 A.2d 244 (The Walt Disney Case) .................................................................................................................................................................................................................................................. 53
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Sinclair Oil Corp. v. Levien, 280 A.2d 717 (Del. 1971) ..................................................................................................................................................................................................................................................... 54 In Re Enron Corporation Securities Derivative & ERISA Litigation, 235 F.Supp.2d 549 (2002) .................................................................................................................................................................................. 57 International Brotherhood of Teamsters v. Fleming Companies ................................................................................................................................................................................................................................... 62 Mentor Graphics Corporation v. Quickturn Design Systems:........................................................................................................................................................................................................................................ 62
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