Law School Outline - Corporations - NYU School of Law - Daines

CORPORATIONS OUTLINE Professor Daines Stacy Aronowitz Fall 1997 OVERALL THEMES: A. Its all about wealth maximization B. Formation: 1. Incentives are clear, so… 2. Ex ante: key time to look at legal rules B. Information: 1. What parties knew & when 2. Necessary for consent (K view) 3. Courts require C. K: 1. what parties specified 2. if K doesn‟t cover, look to what parties would have done- default structure 3. Default rules: i. implied K terms ii. reduces K costs D. Costs: Agency & Monitoring 1. align incentives 2. vote 3. threat of lawsuit 4. monitoring or bonding up front E. Institutional Competence: 1. Courts: good at ex post 2. Markets: good at valuation 3. Parties: good at ex ante F. Tension between preventing opportunism & respecting discretion 1. Eg: Page, Meinhard, Tarnowski THREE CONSTRAINTS ON AGENCY COSTS: limit management’s ability to take or grab 1. Fiduciary Duties 2. Voting 3. Takeovers 1 I. AGENCY LAW & THE PRINCIPAL-AGENT PROBLEM tort or K Principal (P) --------- Agent (A) ======== 3 rd Party A. Agency law: almost entirely a matter of K 1. Less dependent on what law requires b/c parties free to do a lot via K. 2. Enabling: lets people make own decision 3. Need agency law when: i. 3rd parties effected; their rights not covered by K a. 3rd parties affected in tort: look to vicarious liability b. 3rd parties affected in K: look to authority doctrines ii. other K problems: a. externalities b. asymmetric info c. high K costs B. Vicarious Liability in Tort 1. P------ A ===(tort)=== 3rd party 2. P liable if both: i. Master/Servant Re‟ship (respondeat superior triggered) [gas station cases] a. P ------- A ------- Servant ===(tort)=== 3 rd party Agent? liability clear here b. §220: Master/Servant v. Independent Contractor Factors: 1. Control: i) P can control A‟s behavior: M/S ii) P has less control over A‟s behavior: IC 2. Skill required: i) Less skill- easier for P to monitor A: M/S ii) Higher skill- easier for A to monitor self, less effective & more expensive for P to monitor A: IC 3. Work part of regular business: i) Yes- P more likely to know stuff b/c knowledge base: M/S ii) No- P unlikely to know answers: IC 4. Method of payment: i) By time- P more likely to monitor b/c A less concerned w/ own productivity: M/S ii) By job- P less likely to monitor: IC 5. Other factors: i) Hours (who sets?- points to control) ii) Ability to sever P-A contract: a) Easier to sever re‟ship: M/S b) Tougher to sever re‟ship: IC iii) Control over subordinates: a) P controls A‟s subordinates: M/S b) A controls A‟s subordinates: IC iv) Where risk of profit & loss placed? a) P bears risk- A less incentives, needs monitoring: M/S b) A bears risk- A incentive to avoid loss, needs less monitoring: IC c. Policy: 1. Who should be monitoring? i) Should place liability on one in better position to deter (cheapest cost avoider). ii) Parties can K, find efficient allocation. iii) If party has right to control & bears portion of operating cost, probably a lot of actual monitoring &/or screening. 2. Deep pockets 2 d. M/S or IC? 1. Advantages to M/S: i) Can control how products are sole & distributed ii) Can better protect product & co. reputation 2. Disadvantages to M/S: i) Liability ii) Administrative costs- monitoring is expensive e. Alternatives to Monitoring: 1. Insurance 2. Screening ii. W/in Scope of Employment [drunken seamen cases] a. M ------ S ===(tort)=== 3rd party b. Actuality: this prong of test ignored c. Requirements (attempt to get at control): 1. A does work hired to do 2. A does work w/in time & space authorized 3. A does work w/ “intent to benefit” P i) don‟t need sole intent to benefit, okay mixed motives (Nelson) ii) Can look beyond intent to benefit: a) which party can deter, cheaply monitor b) activity level; externalities (Ira S. Bushey) 1) Activity level- if don‟t find P liable for the tort, might encourage too much of the activity. P should have to pay if the tort is one of the costs of doing business 2) But this assumes that can figure out what the harmful activity is, who is hurting who. (apple & cedar trees) 3. Overall reasons for holding P liable: i. Deterrence by cheapest cost avoider: a. Nitty-gritty control (gas station cases) b. Screening (Humble) ii. Adjustment of activity level (Ira S. Bushey) C. Authority Doctrines (K) 1. P ------ A ===(K)=== 3rd party  (authority doctrines) 2. Types: i. Actual Authority: based on P‟s communication to A: if from that, a reasonable A would believe A had authority a. Actual Express Authority (AEA): b. Actual Implied Authority (AIA): incidental 1. Efficient: saves transaction costs between P & A so don‟t have to go through every possible option ii. Apparent Authority: a. based on P‟s communication (direct or indirect representation) to 3 rd party: (eg: P putting own name on A‟s actions) b. Efficient: 1. reduces transaction costs b/w P & 3 rd party 2. Enables P to work through an A; A easily binds P. 3. Mistakes can be avoided at low costs. c. Consensual d. If P is putting person in position to do harm, P better monitor iii. Inherent Authority: (Rest. §161) 3 a. based on power of A‟s position: if P appoints A to a standard role, 3 rd parties can rely on traditional authorities associated with that role. b. If extraordinary transaction for A to partake in, & 3 rd party knows this, 3rd party will bear cost of transaction. 3. Authority doctrines : help to delineate when P will be liable for A‟s actions i. 3rd parties want to get to P b/c A often judgment proof ii. Degree to which P wants to be easily bound to Ks b/w A & 3 rd parties: a. Ex ante (b/f K): P will want A to easily bind P to Ks b/c easier to make credible commitments and get customers b. Ex post (after K): P will not want A to easily bind P to Ks; if A had no authority to act, P can avoid liability. 1. P will want to break K OR 2. P will keep K, but not bear cost (3 rd party or A will bear cost) iii. Incentives to minimize costs: a.  Costs: 1. Transaction costs: b/w P & A & b/w P/A & 3rd party 2. Monitoring costs 3. Bonding costs (to make 3 rd parties trust P) b. Bind cheapest cost avoider if no actual authority: 1. Bind Pi) If symmetrical info ii) Ordinarily, P cheaper cost avoider b/c control, screening. a) Often situated to deter violations (Asme) iii) P can be bound even if A had no intent to benefit P a) Law wants to make expected value of breach of K equal to amt. it would cost to deter the breach. b) Need to  risk of low visibility offenses- b/c of the lower cost (b/c low probability of being caught). 2. Bind 3rd party- when unusual transaction (for P or A)- if 3rd party should have known A had no authority (Jennings) COSTS extraordinary transaction ordinary transaction c. 3rd Party low costs high costs P high costs high costs Prevent parties w/ superior information from acting opportunistically: 1. stop Ps- Ratification: If P discovers that A has exceeded authority, & signals it was okay, P held to ratify the authority 2. stop 3rd parties- Inherent authority: if A does not have inherent authority, if nature of A‟s position does not traditionally authorize actions, 3rd parties penalize d. If asymmetrical info: cost on party w/ superior info i) party who did not disclose could have prevented ii) will likely be 3rd party in an usual transaction iii) will likely to P in ordinary transactions P on Notice Yes 3rd Party on Notice Yes No (symmetrical info) No (asymmetrical info) P pays (asymmetrical info) 3rd party pays (symmetrical info) P pays P pays 4 D. The Agency Contract & Fiduciary Doctrines 1. Importance of K: Most important set of restraints NOT fiduciary duties, but is K: parties free to K around the law. i. If default rule, can K around. ii. If non-optional can sort of be Ked around by making irrelevant iii. But, not complete freedom of K; 2 restrictions: a. Termination: cannot make an irrevocable K 1. But, can make this rule irrelevant via K: Eg: in employment: i) Severance payment (makes it harder for P to fire A) ii) Give A some ownership in co. b. Fiduciary Duties: 1. Still have K basis in sense of K defines whether or not & when a fiduciary duty will intervene 2. Fiduciary Duties i. Types: Duty of Care (DOC) & Duty of Loyalty (DOL) ii. Breach: result will depend on K iii. Form: a. P ---- A === 3rd party  fiduciary duties b. Generally: 1. ex post application 2. common law development 3. strong moral flavor 4. broad statements- little evidence of tailoring c. Need agency law if K problems- fiduciary duties as a solution 1. Goal: i) Making $; wealth maximization; efficiency ii) Use law to  size of pie 2. Agency Problems: i) Separation of ownership & control: a) use of A enables division of labor ( output), but b) Agency costs 1) reduce size of pie 2) may benefit A less than P is harmed c) P must invest in monitoring ii) P & A - divergent interests (how you‟re paid matters): a) A gets wage b) P gets residual interest (profit) iii) P & A want lower agency costs: a) P & A want to be bound b)  size of pie iii) P & A invest in reducing agency costs to optimal level Goal Problem (for P & A) Solutions: v. Wealth maximization Agency costs (costly to align incentives, monitor defections, & pre-commit to avoid defections) K or common law Alternative Solutions a. Contractual solutions: b. parties free to alter fiduciary duties via K by tailoring default rules 1. Problems w/ Ks: i) A‟s obligations often cannot be neatly specified a) obligations change ii) Ks are costly: need info & consent 5 negotiation implementation rigidity costs (hard to change) imperfect measures residual loss evidence of K (rare to custom tailor fiduciary duties-except to K out of DOC) iii) Hard to improve: “Work hard & be loyal” may be as good as you can do. b. Common law solutions: What can law do to  size of pie? 1. Use of common law: i) usually- cooperation; law only solves problem cases ii) ex post 2. Can choose rules parties would have chosen if they could have easily negotiated; fiduciary duties apply ex ante b/c K costs to spell them out too high: i) saves transaction costs where K costs high ii) Gets right answer when K costs high 3. Allow parties to customize obligations: offers “off the rack” default rules that parties can tailor to their needs via K 4. Restatement: Scale: Respect for K that purports to authorize A‟s conflict: Minimal Respect (quality of info poor)  A violates duty even if consent from beneficiary & principal (Gleeson); Per se rule- A violates duty even if no showing of actual damages (Tarnowski)  Given dependent P, if no secret profits, then fair. A‟s conflict okay. Maximum Respect  If independent P, no inquiry into fairness (§§388-390). Fiduciary duties free A from liability. a) b) c) d) e) f) I----------------------------------------------------------------------------------------------------------------------------------------------I i) §387: A has duty to act solely for benefit of P in all matters connected w/ his agency a) Default (“unless otherwise agreed”) ii) §388: A must account for profits arising out of employment A can enjoy no secret profits (Tarnowski) A must account for profits if exploits confidential info acquired in course of job a) does NOT look to whether P harmed b) Default iii) §389: If A acts as adverse party w/out P‟s consent, voidable a) Looks at disclosure, NOT fairness 1) Hard to do fairness inquiry if no readily observable mkt price. 2) Consent as ready substitute for fairness b) Default iv) §390: A can act as adverse party w/ P‟s consent a) Mandatory If P is dependent: (In Re Gleeson 1) b/c of concern about Ps being taken advantage of: bright line rule eliminates potential conflict of interest; costs of rigid rule may be low here. b) Fairness scrutiny 6 5. What is DOL? (Meinhard v. Salmon) : i) Must consider P/joint venturer‟s interests, so owe: a) information disclosure (so chance to compete) b) opportunity to participate on same or = grounds ii) Rationale: a) Joint venture (j.v.) b) Managing co-venturer- higher duty to look after other‟s interests iii) Objection: j.v. is more limited than p‟ship; this is new project iv) Fiduciary duties apply ex ante when K costs too high to spell out what re‟ship the parties would want. a) parties did not clarify intentions v) 3 possible rules they would have agreed to: a) If new opportunity, will be j.v. under same terms (Cardozo) 1) DOL?: fiduciary duty on new projects 2) but unlikely that new terms applicable 3) penalty default & info forcing rule 4) forces party to K b/c this is bad option b) Competition (must disclose, so can compete) 1) DOL?: fiduciary duty to disclose 2) But, might not want to agree ex ante to compete ex post (know each other‟s ability to compete too well?) c) Each party has option to do what it wants 1) DOL?: no fiduciary duty on new projects 2) Private wealth maximization; gives parties incentives to find new opportunities 3) Unblurs line b/w partner & j.v.; parties can still K for a limited purpose. vi) If the court cites Meinhard,  loses… E. The Problem of Agency Costs 1. Agency Problems: i. Separation of ownership & control: a. use of A enables division of labor ( output), but b. Agency costs 1. reduce size of pie 2. may benefit A less than P is harmed c. P must invest in monitoring ii. P & A - divergent interests (how you‟re paid matters): a. A gets wage b. P gets residual interest (profit) iii. P & A want lower agency costs: a. P & A want to be bound b.  size of pie iv. P & A invest in reducing agency costs to optimal level 2. How to reduce: i. give A has ownership interest ii. give P control over & monitoring of P‟s actions 3. Problems: want to give As some degree of discretion so that can perform jobs 4. Agency costs in other, non P----A re‟ships? i. Agency problems b/w partners as have b/w P ---- A b/c each partner is an agent. 7 II. PARNTERSHIP LAW A. Relationship to corporations: 1. Comparison w/ corporations: ISSUE LIABILITY LIFE OF ENTITY PARTNERSHIP Unlimited (limited only by extent of loss) Limited: terminate at event or death (can K around, eg: that business will continue upon death or partner) 1) Default rule: each partner is an A w/ equal control- proportional to # voting 2) Can use executive committee & limit authority w/ notice & agreement by others Often UPA; some mandatory rules; conflict of laws CORPORATION Limited (to extent of investment) Unlimited CONTROL/ MANAGEMENT 1) Centralized management 2) But poses risks to minority s/hs (freeze-out) GOVERNING LAW DEFAULT RULES FLEXIBILITY TRANSFERABILITY Extensive Great 1) Unanimity to sell- UPA § 18(g) 2) default- can K around (eg: can delegate to executive committee) single tax 1) Some think it is complicated 2) entity/aggregate distinction a) entity: separate thing b) aggregate: nothing of itself 3) lawyers like it; others think its seedy 3) parties choose state law 4) which seems to include more mandatory laws- although even those are chosen b/c parties choose which state More extensive Often acceptable (especially if private) Freely transfer shares (but often K for restrictions) 2 taxes (corp. taxed on earnings & individual taxed on dividends) 1) Easier (at first) 2) Sounds better on business card TAX MISCELLANEOUS 2. Hybrids: i. Limited Liability Partnership (LLP): p‟ship w/ some limited liability; filing required ii. Limited Liability Company (LLC): hybrid; flexible; can achieve p‟ship taxation iii. Limited Partnership: limited liability for limited partners, if they do not participate in control; can use corporation for general partner B. Introduction: 1. Law creates entity status (can‟t be created by K b/w partners alone) 2. Background Rules: i. Partnership (inter se) rules: a. Default b. Types: 1. control (majority rule) i) §18(h): ordinary matters decided by majority or partners ii) §18(c): equal rights in management of business iii) §18(g): need every partner‟s consent to bring someone new into p‟ship (thus can‟t just sell shares) 2. profits i) §18(a): share equally in profits ii) most p‟ships K around this iii) this is penalty, info-forcing default rule b/c most times wouldn‟t want = profits b/c rarely have = contributions 8 3rd party rules: a. Immutable: set by law; not really alterable by K b/w partners b. need 3rd party disclosure c. Types: 1. agency (§9: every partner has power to bind p‟ship via apparent authority) 2. unlimited liability (§15: personal liability for p‟ship debts) i) jointly liable for all contractual debts ii) jointly & severally liable for all tort debts (100% of debt could fall on 1 partner) 3. Why Joint Ownership?: i. equity capital (instead of debt capital) a.  amount of funds b. cheaper to get $ in form of equity than debt (financing effects size of pie) c. equity = a piece of the action/ownership interest ii. incentives a. bonding: partners have power to bind p‟ship b. moral hazard: if equity low enough, moral hazard to take more risks c. agency cost 1. less b/c less incentives to take risks 2. less b/c when one contributes equity (as opposed to lending $), give them an ownership interest, which reduces agency costs 3. if equity interest, desire to work harder ii. C. Formation 1. The Potential Significance of Formation Questions i. p‟ship can be inferred from parties‟ acts a. even if did not intend for re‟ship to be p‟ship- can still infer one; parties intent not despositive b. harder to tell if p‟ship formed than if corp. formed ii. potential personal liability in tort & K iii. potential claim on p‟ship assets a. partners have power to bind partnership via K 2. What indicates parties formed a p‟ship? i. §6:intent does matter ii. §7:means of payment matter (2) joint ownership does not establish a p‟ship (3) sharing of gross returns (income) does not establish a p‟ship (4) sharing of profits (income - costs) is prima facie evidence of p‟ship costs matter when sharing profits; incentive to manage costs stronger when share profits than when just share income profit as proxy for control (b) if sharing of profits was just wages, defeats presumption 3. Courts will look beyond intent to actions (Vohland v. Sweet- nursery) i. Was  “partner” or “commission salesperson”? ii. UPA: a. §7(4): net profit presumption (since shared profits, presume p‟ship). b. §18(a): each partner shall be repaid his contributions & share equally in profits & surplus c. §7(4) + §18(a): If parties share profits, shows intent to be partners, so each party will get a share of the profits. 1. On facts here: b/c parties shared profits pre-inventory, each will get a share of the profits, which includes the inventory iii. Inventory: a. if not a partner, then no reason to build up inventory: 9 1. If want to maximize inventory, then want to give person who controls inventory an incentive to maximize it. 2. If profits include share of inventory, giving this to person who controls the inventory an incentive to maximize it. 3. Would make no sense to compensate  from post-inventory # unless  is a partner- otherwise not giving person who controls the inventory an incentive to maximize it. b. but do partners always want inventory? 1. In some industries, inventory expensive- want to minimize it. iv. Interpret the ambiguity against /owner, who may have wanted it both ways: a. Owner wanted  to maximize inventory, work hard, & mind costs- but didn‟t want pay him share of inventory. 1. Don‟t want owners manipulating employees like this. b. Problem w/ this rationale: 1. companies often pay employees out of profits a. reduces agency costs b/c … b. gets employees to act like owners. 2. Want to encourage firms to pay out of profit like this a. don‟t want firms to have to fully share profits 3. If interpret all profit-sharing as an indicator of a p‟ship, firms will be less likely to use this method of payment c. employment Ks should reduce agency costs D. Creditor’s Rights 1. General: who can creditor‟s pursue? i. Type of debt: a. K debts: partners jointly liable b. Tort debts: partners jointly & severally liable 2. W/drawl of partner i. §36(1): dissolution of p‟ship does not of itself discharge existing liability of any partner a. default rule b. liable for debt pre-w/drawl, even after w/drawl 1. had control b/f w/drawl, so liable for debts 2. NOT liable for debt p‟ship incurs after w/drawl c. rationale for NOT letting exiting partners escape liability: 1. would create opportunism; encourage exit 2. would five incentives for extra risky behavior 3. would enable exploitation of 3 rd parties ii. Opting out (occasionally, will let exiting partner escape liability) a. means: 1. §36(2): not liable if creditors agree (info + consent) 2. §36(3): not liable if material amendment to debt after exit i) Munn v. Scalera b. rationale: 1. not active member- no longer has control 2. prevent other partners & 3 rd parties from exploiting exiting partner i) 3rd party might be in good position to monitor & know best if change in risk or change in behavior ii) Make party who should have known better bear the cost 3. Partnership property i. Property is ownership of p‟ship, not the individuals ii. leans toward “entity view” (separate thing) a. §25: partners can pledge their p‟ship interest b/c it‟s an identity apart from p‟ship. b. p‟ship bankruptcy 10 1. Old rule (jingle rule): p‟ship creditors privileged; have 1 st claim on p‟ship assets (prevent race to court house- which would be inefficient & destroy going concern value) 2. now: p‟ships can file for bankruptcy (In Re Comark) 3. §28: partner‟s interest subject to charging order: i) creditor can go after share of profits ii) creditor can sell interests of partner 4. This breaks apart the p‟ship (dissolution) E. Authority: 1. Ordinary decisions decided by Majority Rule: i. §18(h): majority rules, absent decision to contrary (default rule) ii. agency: all partners bound if majority rules (Nabisco v. Stroud) a. minority partners can not opt out (& avoid liability) by informing 3 rd parties b. rationale: 1. protects 3rd parties, who may be unclear as to who is in charge 2. valuable for p‟ship b/c partners able to pre-commit i) allows for credible commitments (3 rd parties can rely) ii) need to allow a partner to act 3. otherwise, give a virtual veto power to each partner over affairs, which would de-stabilize p‟ships & thus impose large costs c. good rationale? 1. p‟ships are unstable anyway; this rule does little to stabilize 2. stunts definition of what constitutes action: i) placing orders privileged over canceling them (Nabisco) a) misses broader conception of action b) neglects that equal importance for co. to act & to stop an action 2. Possible rules for „tie-breaker” b/w partners: i. partner who does not want to pay trumps ii. partner who does want to pay trumps a. the buying partner can bind p‟ship unilaterally b. law chose this rule 3. Steps than can protect partner from liability i. ex ante: structure different regime; inform creditors & suppliers ii. ex post: dissolve p‟ship (not great alternative…) F. Partnership Accounting & Dissolution 1. Accounting: i. Balance sheets: a. snapshot of finances at any one time (so doesn‟t show overall value) b. must balance: 1. Assets = liabilities + equity 2. definitions: i) assets: what co. has ii) liability: what co. owes iii) equity: what co. “really” has 3. If expenses , equity will  ii. Income (flow) statement: a. portrays financial condition over a period of time b. more important financial measure than balance sheet 2. Dissolution i. ways to break up a p‟ship: a. Dissolution: aggregate definition covering change in re‟ship of members b. Winding-up: liquidation & paying everyone (partners & creditors) c. Termination: everything is over (death certificate) 1. dissolution does NOT necessarily lead to termination 11 ISSUE When is a wind-up triggered? Adams v. Jarvis How will wind-up occur? Dreifuerst Why may wind-up be triggered? (limits) Page 2. winding-up does lead to termination ii. §29: if any partner exits it is a dissolution iii. §38: dissolution leads to wind-up a. leads to instability b/c 1 partner can dissolve & it ends p‟ship, but… b. default: can otherwise agree that a w/drawl of 1 partner, for example, will not lead to wind-up. 1. If K around this instability: i) every partner still has power to start dissolution ii) but now lacks right to start dissolution 1) would owe damages to p‟ship (liability rule protection) 2. agreement trumps statute (Adams v. Jarvis) 3. continuum: i) one end: respect for discretion of parties (respect K) ii) other end: minimize opportunism & agency costs iv. DISSOLUTION & W IND-UP: §29-38 BACKGROUND MUTABLE? HOW? RATIONALE RULE §38(1): Default (K Mutable via K, if agreement: 1) want to avoid losing statutory trumps 1) provides for continuation going-concern value dissolution statute; easy 2) sets forth how to pay 2) avoid start up costs triggers windto opt out of w/drawing partner his 3) makes everyone happy ex up. default) share ante 3) doesn‟t jeopardize rights of creditors 4) is enforceable (equal bargaining) Default: trial ct: trial ct: probably if majority trial ct: trial ct: can probably wants it 1) don‟t want to avoid sale through sale change it to 2) interests may diverge can opt out byin-kind appellate ct: appellate ct: sale is objective 1) appellate ct: appellate ct: §38; sale a) ex ante agreement OR test to see what co. is worthmutable b) ex post unanimous vote so make it hard to change. 2) no debts, fair, only Better for cts. Maybe also interested parties are better for partners- don‟t have partners (appellate ct to break-up business & lose rejects) its value. 3) allow a majority of to allow majority to partners to continue repurchase minority interest: business w/out windingsaves transaction costs up if majority repurchases disassociating minority‟s interest at fair values. Not going to Not clear Don‟t want to imply term that imply a term; parties didn‟t K for b/c can wind-up disincentive to others to enter (but allows for p‟ship if cts will imply term opportunism & making it hard to get out breach of fiduciary duty owed to partner) G. Limited Partnership (controlled by Uniform Limited Partnership Act) 1. Features: i. Shields from unlimited liability (liable to extent of investment) 12 2. 3. 4. 5. ii. Passive investment; lack control iii. Creature of statute iv. Often for a specified term Agency problems: i. b/c limited partners lack control, place control in hands of general partners ii. control devices (limited partners can use to prevent agency costs): a. limit by term b. require access to info c. specific roles written into K d. align incentives (tie pay of general partner to $ limited partners receive) e. voting by limited partners f. fire general partners (but, might hurt limited partners ex ante b/c if general partners know can easily be fired, may not enter into the agreement or may charge more) Liability of limited partners i. If do participate in management of the p‟ship, risk being deemed general partners & losing their limited liability protection ii. Old rule: If limited partners are controlling general partner (if limited partners have control), they should have unlimited liability. (Delaney) a. Good rule?: 1. yes: if choose p‟ship form (& not corporate form), must be liable 2. no: dealing w/ K (not tort) creditors; knew what they were getting into; could have gotten personal guarantees on loans 3. who cares?: as long as clear ex ante, let parties K for whatever iii. §303(a) & (b): limited partners have double protection- to be liable must a. Exercise control AND b. be held out as a general partner Formation: ex ante; incentives are clear, so key time to look at legal rules & K around Combines limited liability & single tax characteristic of p‟ships 13 III. CORPORATE FORM A. Introduction 1. Basic Attributes: i. entity theory (separate existence) ii. centralized management a. bd of directors that controls corp. b. bd technically doesn‟t have to listen to s/h, but have fiduciary duty to s/h (Jennings) iii. limited liability a. corp. is liable for all of its debts, but… b. creditors can‟t get to s/h P(s/h) ---- A(corp) ==== 3rd party  limited liability puts thick wall here (corporate veil) iv. freely transferable a. easy to exit or enter b. solves p‟ship problem that each can threaten dissolution via exit v. unlimited life 2. Acts only through people: i. players: SHAREHOLDERS  DIRECTORS/OFFICERS  distributors    service creditors  CORPORATION  employees customers  ii.  suppliers Directors & officers: job is to maximize s/h wealth a. Director: a s/h on the board 1. voted by s/h b. Officer: management 1. may or may not be a s/h 2. may or may not be on board 3. Formation: DGCL §101: sets up statutorily what has to be done & by who (establishes right, powers, obligations) 4. Stocks & Dividends: i. how $ gets paid to s/h ii. s/h: b/c own stock, “own” share of corporation a. entitled to profits b. get $ via dividends (which are controlled by board) iii. stock transfers: DGCL subchapter 7- when & to whom s/h can sell to 5. Charter & Bylaws: i. Bylaws: a. Amending: 1. easier to change than charter 2. s/h can amend directly ii. Charter (Articles of Incorporation): a. Amending: 1. tougher to change than bylaws 2. DGCL: must put include in charter if going to allow Bd to change it b. What‟s Included: 1. Name (mandatory- DGCL §102(a)(1)) 2. Address (mandatory- DGCL §102(a)(2)) 3. Purpose of corp. (mandatory- DGCL §102(a)(3)- but optional as to what‟s stated) 14 4. # of shares i) common stock (mandatory- DGCL §§102(a)(4), 151) ii) preferred stock (mandatory- DGCL §§ 102(a)(1), 151) 5. what directors are not liable for (mandatory- DGCL §102(b)(7)) i) can not excuse directors from liability for certain acts (mandatory) a) breach of DOL b) acts not in good faith c) acts for personal benefit of director ii) can excuse directors from liability for certain acts (default) a) breach of DOC B. Basic Concepts of Valuation  Note: market is better at valuation than judges 1. Time Value of Money: i. Present Value (PV) PV = amount of $ 1 + discount rate discount rate (r) PV  as r  a. For 1 year period: PV = FV (1 + r) b. For t year period (if same interest rate for all years): (make more each year b/c earning interest on interest & principle) PV = FV (1 + r)t ii. Future Value (FV) a. For 1 year period: FV = PV(1 + r) b. For t year period (if same interest rate for all years): (make more each year b/c earning interest on interest & principle) FV = PV(1+ r)t c. For t year period (if different interest rates): (make more each year b/c earning interest on interest & principle) FV = amount of $ + interest in year 1 + interest on interest + interest in year 2 + interest on that interest + interest in year… t. iii. Net Present Value (NPV) a. NPV = PV- Costs b. Determines if it is worth it 1. if NPV > 0, then invest. 2. if NPV  0, don‟t invest. iv. Example a. One dollar to bank for one year (r = 10%) 1. PV = FV 1+r 1 = FV 1 = FV FV = 1 X 1.10 FV = 1.10 1+.10 1.10 2. FV = PV (1 + r) FV = 1 (1 + .10) FV = 1.10 b. Review session valuation problems 2. Risk & Return i. Uncertainty a. Expected Value (EV) 15 1. value of outcomes weighted by the probability they‟ll occur 2. EV = (Probability of A X Value of A) + (Probability of B X Value of B) EV = (VA)(%A) + (VB)(%B) b. More times you do something, closer it will come to EV c. If EV is more certain, willing to pay more for a risk ii. Risk measures: a. Risk: Difference b/w actual outcomes & EV 1. bigger the difference b/w outcomes & EV, greater the risk b. Default risk: chance of default 1. eg: chance that debtor will not pay back loan c. Variance volatility: how much an outcome can deviate from the EV d. Risk premium: difference b/w EV & certainty equivalent (how much need to be paid to take a risk) iii. Risk matters: a. Risk neutral: VA = EVA b. Risk loving: VA > EVA 1. If risk loving, going to pay more for opportunity to make more $ c. Risk averse: VA < EVA 1. Risk premium: difference b/w EV & certainty equivalent 2. Diminishing marginal utility of money: i) $ matters more or less- depends on how much you have ii) more risk averse if have more $ 3. if risk averse, going to pay less for opportunity to make more $ 4. risk aversion can go away w/ via diversification & insurance iv. Risk affects discounting & PV: a. Discount certainty equivalent b. Convention: adjust discount rate 1. Discount rate  as risk aversion  b/c risk premium (need to get paid to bear risk) v. Problems (pg III-15.) 3. Diversification: not all eggs in one basket; can act more risk neutral i. Implications for price (value) of financial assets & for risk aversion a. If EV is more certain, willing to pay more for a risk b. Diversification makes EV more certain- willing to pay more for risk c. Risk aversion matters less if can diversify ii. Diversifiable risks a. can ensure return b. should trade right near EV c. investors can‟t charge risk premium d. idiosyncratic risk (b/c can diversify b/c can invest in different co.) iii. Undiversifiable risks a. market risk (b/c whole mkt is effected) b. investment of human capital undiversifiable 1. Managers invest human capital- can‟t fully diversify 2. S/h invest $- can fully diversify 3. arises to tension b/w s/h & management 4. Market Prices of Securities i. Can perform a valuation 2 ways a. discounted cash flow analysis (smart way) b. mkt price of securities: worth = stock price X # of shares outstanding (lazy way) ii. Efficient Capital Market Hypothesis: a. mkt does better job at valuing b. mkt price as objective value 16 5. Capital Structure & the Incorporation Bargain i. Capital Structure: a. Debt (fixed claim) 1. Senior Secured (eg: mortgage) 2. Senior (unsecured) (eg: visa charges) 3. Subordinated (eg: parental loan) b. Equity (residual claim- gets what is left over after debt) 1. Types of Stock: i) Preferred Stock: a) dividend b) typically no vote c) convertible to common stock (so can exercise some control) d) 1st in line b/f common stock e) liquidation preference- get back what invested ii) Common Stock a) gives control via vote 2. Equity owners: get % of co. profits 3. DGCL §151: Incorporation bargain(a) do all of this in certificate of incorporation (c) allows for flexibility to structure incentives control ii. Differing incentives a. Equity owners: 1. more incentive to maximize value b/c will get more $ 2. might want to take risks that debt ppl (creditors) don‟t, b/c creditors get all of the down side & limited upside. 3. less risk averse than creditors b. Debt owners (creditors): get all downside, so more risk averse. 6. Capital Structure & Leverage i. Leverage: a. Debt financing is providing some capital b. The higher the ratio of a corp.‟s debt to equity, the more leveraged corp. is (corp. is called thinly capitalized) c. High debt financing  potential for large returns (& large losses) on the equity investment 1. B/c debt obligation is fixed, high earnings will produce a high return on equity (ROE) 2. To calculate ROE, subtract the fixed debt obligation from the earnings ii. Note: if debt is held by same persons who hold the equity, the effect of leverage is meaningless b/c the overall return on investment doesn‟t change iii. Debt: doesn‟t change worth, but can change value of corp. a. Discipline of debt: 1. makes corp. work harder, so changes incentives & reduces agency costs b. Bankruptcy costs: 1. if default on debt, bankruptcy 2. bankruptcy is expensive & lowers value of corp. c. Taxes C. Limited Liability: 1. Rule: 3rd parties can only get to what s/h invested i. Default?: a. K creditors: could structure it so not limited liability b. Tort creditors: can NOT structure it differently (b/c no “b/f the fact”) 1. limited liability on part of corp. for torts leads to high agency costs 17 Efficient: a. in most corp., even if unlimited liability, high collection costs b. s/h could evade liability (eg: could sell shares to someone who‟s judgment proof) c. monetary advantages d. people (investors) prefer limited liability iii. Creditors need protection: a. s/h, if not constrained, would 1. put themselves 1st in line 2. limit how much debt corp. could take 3. require corp. to insure 4. pay $ out via dividends or share repurchase b. Creditors hurt by: 1. dilution of creditor claim (making other claims more senior) 2. dilution of assets (sending $ out the door) c. Tension: 1. creditor protection v. s/h control i) creditors: 1st in line (1st claim on assets), BUT ii) s/h have control, can take out assets 2. Who‟s hurt by tension & opportunity for s/h opportunism: i) ex post: creditors ii) ex ante: s/h (b/c creditors will charge more interest) a) inefficient- pie is smaller 3. Does it matter? i) for K creditors- Maybe not a) ex ante: parties can K for a different outcome 1) eg: s/h can offer securities b) problems w/ K here 1) expensive to K; default rule is cheaper 2) Ks can‟t perfectly constrain s/h opportunism 3) Ks can be too rigid- s/h need flexibility 4) Ks can deter valuable transactions ii) for tort creditors- YES iv. Best Rule: a. prevents s/h from advancing place in line when $ owed to creditors b. allows s/h to take $ when not in debt D. Creditor Protection Devices (Checks on Limited Liability) 1. Pre-insolvency Measures (Regulatory Measures) Ex Ante Creditor Protection Devices Capitalization Requirements Distribution ConstraintsDividend Tests 1) insolvency limits 2) trust fund protection 3) RMBCA §6.40 Fiduciary Duties to Corp. How it protects creditors makes sure corp. has enough $ to start w/ prevent s/h from distributing all corp.‟s $ via dividends 1) bars dividends if corp. insolvent 2) bars dividends that reduce a cushion 3) bars dividends if insolvent- based on balance sheet or some other valuation prevents s/h from opportunistically taking $ out of corp ii. i. Capitalization Requirements: a. make sure corp. has enough $ to start w/ 18 ii. b. done in Europe, not in U.S. c. Good idea? 1. Pros: i) efficiency gains: can save K costs b/c don‟t have to put requirements into every K ii) protects tort creditors 2. Cons: i) easier for corp. to get out of the business ii) too blunt of an instrument; hard to tell what amount corp. needs to start off w/ 3. doesn‟t make much difference as long as people know ex ante what they‟re getting- will charge the right price Distribution Constraints: prevent s/h from sending all $ out of corp. a. These tests can depend on definitions set in charter & bylaws; but s/h‟s can change charter & bylaws b. Stockholder‟s equity: 1. total ownership interest that all s/h have in corp. 2. represents corp.‟s net worth (amount by which assets exceed liabilities) 3. 3 equity accounts/categories (DGCL §§153, 154): i) Stated or legal capital: a) s/hs investment: value that s/hs transferred to the corp. in exchange for shares b) (par value of stock) X (# of issued & outstanding shares) ii) Capital surplus: initial purchase price less the par value of stock iii) Earned surplus: accumulated retained earnings c. Dividend Tests (ex ante) 1. Insolvency limits: bars dividends to s/h if corp. insolvent i) balance sheet insolvency: if s/h equity is (+), can pay dividends ii) functional insolvency (repay debt) or equity insolvency: a) corp. insolvent if can‟t repay someone b) can‟t always use test b/c: 1) might be short-term barriers to access of $ 2) could have debt due later, but no current mkt for debt c) appraisal option 2. Trust fund protection: bars dividends that reduce a cushion i) Ways to define fund/cushion: Statute NYBCL §510 MCBA §45 DGCL §170 ii) Cushion stated capital (traditional) earned surplus stated legal capital OR profits earnings Mutability mutable (so collapses into insolvency test) mutable (notice to creditors not required) NOT mutable If standards are mutable: a) Rationale: 1) want s/h to have value- instead of having that $ sit in trust fund 19 2) creditors know bd can opt out of this requirement; can K for some other protection b) Risks: 1) accounting is poor measure of value 2) creditors can be hosed 3. RMBCA §6.40(c) & (d) (modern approach) i) Equity: insolvency/ balance sheet test: if s/h equity is (+), can pay dividends OR other valuation a) allows for appraisal by experts to get to true value b) can skip accounting ii) NOT mutable 4. Generally: i) Main theme: protect s/h‟s flexibility rather than creditor‟s flexibility. a) rationale: s/h flexibility allows for valuable transactions that might otherwise be deterred b) most rely on K alternatives (eg: s/h offers securities) ii) Turns on valuation: a) relies on accountants, creditors, bankers, legislators to value corp (unlike fid. duties, where bd or ct values corp.) iii) What about info? (i.e. notice 1 st?) iii. Fiduciary Duties to corp. a. Prevent s/h from opportunistically taking $ out of corp. b. Interests b/w maximizing corp.‟s value v. s/h wealth may diverge 1. b/c s/h don‟t bear full down side 2. eg: in leveraged corp. near insolvency c. Duty to maximize value of corp- new (traditionally, duty was to s/h) 1. implied duty of bd to corp itself, separate from duty to s/h; 2. duty of bd jumps from s/h to corp. as co. nears insolvency 3. exception to usual trend to maximize duties to s/h d. Good idea? 1. Pros: efficient- value maximizing ( size of pie) 2. Cons: i) K: s/h v. creditors a) bd‟s duty should be to s/h, not creditors b) goes against idea that should maximize s/h wealth c) disincentive to ppl to be s/h ii) Info: usually, complicated to know values so clearly- not clear whether close to insolvency iii) Relies on ct to decide value of co. iv) Agency Costs : a) bds don‟t know whether duty to creditors or s/h b) if bd has 2 bosses, likely that beholden to neither (no man can have two masters) 2. Post-insolvency Measures (Ex Post Creditor Remedies) i. Fraudulent Conveyance: a.  pool of assets:  must put $ back 1. creditors can set aside certain transfers by debtors when no equivalent value was received & the debtor was left w/ unreasonably small capital (UFCA §§4, 5, UFTA §4) 20 2. law seeks to prevent fraudulent conveyances 3. designed to protect against debtors acting in own self interest & currying favor w/ certain creditors when corp. close to insolvency b. Scope: long history of regulating all creditor re‟ships 1. application to corporations (dividends) i) implicit sale or loan ii) gift to s/h? Clark says yes c. Relevance: applies mainly in leveraged buy out (LBO) area: 1. LBO:  use of debt ( debt to equity ratio) 2. Use: to protect creditors of corp. b/f it was leveraged: i) thought it was low risk investment; now they‟re pissed 3. Negligence (UFTA) v. per se rule: i) per se rule prohibiting LBO‟s all together: a) might deter valuable transactions b) but would protect creditors ii. Equitable Subordination: (only when corp. in bankruptcy) a. Limits claims by s/h (s/h can‟t cut in line) 1. s/h can‟t come b/f creditors if what they are doing is making their equity look like a loan (Costello v. Fazio) 2. Formation: can‟t intentionally set up undercapitalized corp. & misrepresent self to creditors b. Good rule? 1. Benefits: i) want to encourage creditors to give loans ii) protects creditors if their space in line is secure 2. Risks: will discourage s/h loans if they‟re always subordinate i) loans from s/h are good- lower interest rates c. Inequitable conduct? Guiding principle? (fraud? egregious mismanagement?) iii. Piercing Corporate Veil (PCV): a. Opens up s/h to liability 1. ignores entity status 2. places unlimited liability on s/h 3. remedy for something a corp. or s/h did wrong b. Ostensible principles- PCV if: 1. Lack of separateness b/w s/h & corp. i) domination ii) capitalization iii) co-mingling iv) formalities v) sham 2. Use of corporate form may be wrong, unfair or inequitable i) bad debts, no clear boundaries ii) wild card- cts can do anything here c. Actual principles1. if a public corp., no PCV 2. if s/h passive, no PCV 3. if corp. follows formalities, no PCV i) doesn‟t seem to be about info, b/c no requirement of reliance on info d. Reverse Piercing (RCPV) : get s/h, then get other corp. s/h are also s/h of (Sea-Land Services) 1. RPCV? Or is taking the stock sufficient? PROS TO RPCV CONS TO RPCV 21 s/h may be hiding assets may be only way to get damages other s/h or creditors may get hurt; shouldn‟t be able to cut in line ahead of legit creditors  monitoring costs: don‟t want corp. to have to look at whether other corp. are acting okay e. 2 prong test: (Sea-Land Services; Kinney Shoe Co.) 1. Unity of Interest (2 corps not really separate) i) Factors: a) absence of corp. formalities b) co-mingle funds or assets c) under-capitalization d) s/h domination e) 1 corp. treating assets of another corp. as its own ii) Why does lack of separateness matter? a) if it was geared at requiring info, there‟d be a causation requirement (require reliance on info) b) “you want to be treated like a corp., you better act like one…” idea 2. Fraud OR injustice (inequitable result if don‟t PCV) i) sneakiness or implicit misrepresentation a) (eg: shifting assets liabilities; changing forms) b) reducing these reduces the cost of K-ing ex ante. ii) under-capitalization not enough to be fraud or injustice a) reason no PCV Sea-Land iii) wild card- allows ct to do whatever it wants iv) if this prong was really about sketchy behavior, it would limit damages to amt of $ s/h took from corp. 3. Protection of Involuntary Creditor (Tort Creditor) i. What about ppl who use corp. to externalize costs of doing business? a. under-capitalization is problematic b. possible theories of liability: (Walkovsky v. Carlton) 1. enterprise liability (get to whole corp, not to s/h) 2. agency theory: i) but s/h can w/draw all the $ 3. PCV i) not distinguished from agency, so not PCV ii) but should insufficient capitalization allow PCV? ii. Policy analysis: a. Choices: 1. insurance (corp. should insure to cover claims of tort creditors) 2. do nothing (Walkovsky v. Carlton) 3. PCV (& allow tort creditors to get to s/h-owner) b. Efficiency: 1. Impact on activity level: i) if allow ppl to externalize costs via corp. form (ie: limited liability), will have too much of the activity. ii) if force internalization, correct amount of activity. 2. Impact on raising capital: iii. 3 Possible Rules for Tort Creditors: a. NOT PCV: (Easterfish & s/h like) 1. Good rule? i) Costs: externalities: corp. doesn‟t bear full cost ii) Benefits: 22 a) PCV promotes corp. disaggregation b/c PCV gives small corp. an advantage (violates economies of scale) b) PCV doesn‟t help; corp. still has to buy minimal insurance c) legislature should decide, not activist cts 2. instead of PCV,: i) insurance ii) subordination of K creditors to tort creditors 3. (good rule for K creditors) b. Partial PCV (Walkovszky) 1. can go sideways to other corp.‟s assets 2. can‟t PCV solely on grounds of inadequate capitalization c. Full PCV 1. separateness requirement i) where most differs from Not PCV 2. Should under-capitalization be enough to PCV in tort? i) Keating thinks under-capitalization enough to PCV unless: a) if under-capitalized b/c times are tough, but started out okay b) ??? ii) Costs: a) institutional competency: 1) hard to determine under-capitalization 2) cts not well suited b) legislature did not choose to have a capitalization requirement- judges shouldn‟t 1) but maybe legis. didn‟t b/c background of activist cts in corp. law (Keating) c) deters investment in under-capitalized corps. 1) but maybe this is good thing… d) doesn‟t go far enough- why distinguish b/w new co. & old co. 3. good rule for tort iv. Have unlimited pro rata s/h liability in tort? (Hansman & Kraackman) a. will  monitoring b. will adjust activity level & thus  amount of torts E. Centralized Management & the Public Corporation 1. Players: i. s/h: a. equity interest; get residual claim on assets b. Vote: (to protect equity interest) 1. to elect directors to the Board 2. to approve extraordinary transactions 3. adopt, amend, & repeal bylaws 4. remove directors (for cause OR if right to remove via K) 5. adopt s/h resolutions i) ratify board actions OR ii) request the board take certain actions a) DGCL §271: s/h can authorize sale of assets or dissolution via resolution, but Bd must deem it in best interests of corp. c. Majority s/h- actually have power over bd 23 d. Typically- passive s/h in public corp. Board: a. statutorily- run the corp. 1. power to manage corp. 2. but usually just supervise the management b. hire & fire management c. not employed by corp; get fee for giving advice iii. Management (Officers): a. reality- run & manage the corp. 1. nominate people to board- power to pick Bd important 2. control info disseminated to board b. employees of corp., in trenches doing the dirty work ii. 2. Why do s/h give up control to Bd (eg: K that s/h prevail only in super-majority vote)? i. s/h haven‟t given up complete control: a. b/c majority s/h can replace board b. have safety net of super-majority vote to overrule board ii. rationale for relinquishing control: a. protects minority (from self-dealing on part of majority) b. co. harder to dissolve 1. officers have greater job security 2. can pay officers less (job security is part of compensation pkg) c. board is in touch w/ what‟s going on- so better decision makers 1. s/h avoid temptation to overrule bd by requiring super-majority vote to overrule iii. Ct will only interfere w/ this charter/K if fraud (Automatic Self-Cleansing Filter) F. Close Corporations: in Tension w/ the Corporate Form 1. Characteristics: i. small # of s/h ii. majority s/h participate in management a. majority s/h get returns from dividends & salaries b. leaves minority s/h vulnerable (to freeze out) iii. restrictions on share transferability a. no open mkt for shares (mkt restrictions) b. Restricted transferability of shares: (K restrictions) 1. rationale: it‟s a small room- don‟t want just anyone in there w/ you 2. enforceable: i) enforceable if reasonable (Allen v. Biltmore Tissue) ii) rationale: a) ct avoids having to do valuation b) close corp. reflect high customization & quirky Ks 3. techniques TECHNIQUES Rights of 1st refusal 1st options FEATURES b/f can sell to 3rd party, must offer to corp. &/or other s/h price set by terms offered to 3 rd party b/f sell to 3rd party, must offer corp. &/or other s/h price set in agreement creating the option -can be problematic if set price at time when corp. had very different value consent powers buyback rights buy-sell arrangements s/h agree to buy or sell shares specifies qualified events when can exit 24 provide means & terms of repayment provide for method of valuation [appraisal OR accounting (income or assets) OR fair division] iv. Re‟ship to other forms: a. Similar to partnership BUT b. Some characteristics of corp. (limited liability; unlimited life; centralized management) 25 2. Majority S/h Opportunism Corporate Quality Limited transferability of shares: (no mkt; K restrictions) Problem Re‟ship to other Forms p‟ship: any can exit, leads to dissolution corp: sell shares on mkt Contractual Response (Ex ante) improve s/h exit power a) sell option; b) buy-sell agreement Cts‟ Response (Ex Post) Eg: LOCK IN (can‟t sell; no exit) Centralized management majority s/h opportunism: -dividends -employment -share repurchase minority has no voice FREEZE OUT (must sell b/c majority made life so bad) p‟ship: all have voice corp: only Bd has voice customize allocation of control a) give s/h veto power, DGCL §§218, 151 b) give s/h bd position  voting power employment K (tie salary to mngemnt salary) Improve s/h exit power via forced dissolution RMBCA §14.30(2): oppression remedy if: 1) fraudulent, illegal, or oppressive director conduct (wild card for cts) 2) Bd deadlock causing irreperable harm 3) s/h deadlock 4) wasted corp. assets problems w/ forced dissolution: kills corp., risks going concern value fiduciary duties remedy (DGCL) -UGFAL (utmost good faith & loyalty): a) not default b) *only pro rata share repurchase [Note: may hurt minority s/h ex ante: majority will pay less for shares will discourage investment a) non pro rata share repurchase can be valuable b) may want to kick out some managers & want to be able to buy out shares parties probably would K for nonpro rata share repurchase (Easterfish) White v. Perkins dissolve if oppressive Donahue v. Rodd UGFAL i. Ex Post Response to Freeze Out: Fiduciary Duties (fid. duty to limit oppression) a. tricky b/c s/h-manager has conflicting duties: s/h expected to be greedy, but manager expected to look after s/h METHODS to get $ to s/h Dividend Employment/Salary Share Repurchase COMMON LAW NORM Equal treatment across classes of securities (everyone gets pro rata) Unequal treatment b/f Donahue: unequal treatment after Donahue: equal treatment b. UGFAL- BUT, majority s/h be a little selfish… 1. can get around UGFAL via employment or severance pkgs, which do not need to be evenly distributed if (Wilkins) i) Legit business purpose & least harmful way of doing it 2. not so much selfishness that hurts corp. (Smith v. Atlantic) 26 IV. FIDUCIARY DUTIES & SHAREHOLDER LITIGATION FIDUCIARY DUTIES A. Intro: constraint on agency costs- limits management’s ability to take or grab 1. Different from fid. duties in agency law b/c: i. Principal: not really the s/h, but the corp. ii. sheer # of s/ha. collective action problems- no s/h has incentive to enforce fid. duties b. response: s/h derivative suits & class actions to give incentives 2. 2 doctrines: i. Duty of Care (must pay attention & not be grossly negligent) ii. Duty of Loyalty (must be honest) Fiduciary Duty   DOC DOL   Self-Dealing Corporate Opportunity 3. Opting Out: i. charter provisions & amendments ii. insurance iii. indemnification 4. Source- main function of corp.: facilitate collection of capital & specialization of labor 5. S/h have priority over management, but management has control i. agency costs to ensure that management keeps s/h interests in mind ii. DOC & DOL: response- limit management‟s ability to do fraud/self-dealing PRIORITY s/h should have control- not management creditors 1st in line b/f s/h REALITY management has control- not s/h s/h 1st in line b/f creditors DOCTRINE DOC & DOL PCV B. Business Judgment Rule (BJR) 1. (BJR) i. BJR insulates business decisions by Bd from legal attack in s/h suits a. if Bd entitled to protection of BJR, then cts shouldn‟t interfere or 2 nd guess b. rebuttable presumption that: 1. Bd is better equipped then cts to make business decisions & 2. Bd acted w/out self-dealing & exercised reasonable diligence & acted w/ good faith c. party challenging the bd bears burden of rebutting the presumption ii. BJR as long as Bd looked at all it‟s options (AmEx v. Kamin) a. process oriented rule, doesn‟t pay attention to substance of decisions 1. just get advisers (lawyer, investment banker) to point out all options (create paper trail) 2. okay even if choose stupid option b. BJR as long as fulfill prerequisites- DOL & DOC c. Rationale: s/h can fire Bd, don‟t need to sue iii. Justification of BJR a. Role of Bd in governance concentration of decision making authority in Bd 2. Makes it very hard for s/h to get to managers i. DOC & DOL- thin protections for s/h- not very protective 27 C. Duty of Care (DOC) 1. Generally: i. must pay attention (can‟t be lazy or grossly negligent) a. can‟t miss out on a business opportunity that can earn corp. $ OR b. can‟t overlook something that loses corp.‟s $ ii. Default rule a. Opt out or not? 1. DOC keeps directors from being grossly negligent BUT 2. DOC can hurt- judges make wrong decisions, wasteful litigation b. 90% of corporations have opted out- most think DOC is hurtful iii. Breaches of DOC: a. liability turns on negligence (or “gross” neg.) standard b. compared w/ breaches of DOL 1. less morally troublesome 2. less profitable to “breacher” c. Cts rarely find breaches of DOC iv. Origin of problem: a. division of labor & problem w/ centralized management b. DOC- tries to get best of specialization of labor w/out downside 2.  When evaluating DOC, ask 4 questions:  What did Bd do?  Why did Bd do it?  What else could Bd have done?  What happened? Any damages? 3. Requirements under DOC (to avoid liability): i. Must Look: (AmEx) a. If Bd looks at all options, cts excuse dumb decisions (BJR if look) ii. Must Look when Red Flag (actual notice of problem) (Graham v. Allis Chalmers): a. Bd must look if there‟s a warning or actual notice of a problem b. How hard does Bd have to look?: 1. Only part of Bd has to look: their knowledge imputed to rest of Bd 2. Do not have to do much monitoring i) BUT inefficient: a) Bd clearly in control b) could be cheapest cost avoider ii) So why doesn‟t Bd monitor here? a) s/h K w/ managers- no externality or 3rd party who will bear the costs b) other costs- s/h want to minimize lots of costs 3. Good rule? i) too lenient: a) worry about setting up corp. ex ante to relieve self of liability ex post b) shouldn‟t let Bd get off b/c set up broad, sprawling co. where easier to avoid monitoring ii) too strict: a) s/h might be better off if management allowed to do some “bad” stuff- might make pie bigger 1) not purely wealth maximizing objective (b/c need to be in conformance w/ law) b) no liability for Bd may benefit s/h b/c can hire experience ppl (who usually have more $) 28 1) if liability for Bd, will get ppl w/ less $ & probably less business acumen c) If hold Bd liable, should Bd reimburse s/h? 1) if activity benefited s/h, should s/h get it? 2) if s/h get $ via damages, not clear that better off iii. Must Open Eyes & Look (Francis v. United Jersey Bank): a. No willful blindness (like the good widow Pritchard) b. basic duties of a director 1. 3 basic duties i) learn basics of business ii) keep current on developments iii) read financial statements 2. 4th implied duty? i) duty to respond a) exit- stop being director b) voice- talk to other members of Bd c) inform- tell authorities d) sue- other members of Bd e) look further c. NOT a normal DOC case b/c Cts rarely find breach of DOC as did here 1. Why here? i) industry here- higher level of trust ii) corp. near insolvency- so duty runs to creditors (Allen) a) case brought by creditors, not s/h- odd iii) sons are not sympathetic characters (good widow is dead) iv. Must Look around some (or hire someone to look) (In re Caremark) a. Bd does have to look & set up a compliance system 1. Not liable if Bd has implemented info gathering systems where reasonable to conclude, in good faith, that corp. is in compliance w/ law: i) gathered info a) looked into law- inside & outside counsel b) internal auditors ii) disseminated policy iii) enforced policy 2. Twin difficulties of DOC & DOL: i) DOC case difficult for  (b/c hard to win) a) Ct looks at good faith & actions ii) DOL case difficult for ct b. Policy Justifications: 1. Non-Diversification Assumption i) generally assume s/h diversified & wants Bd taking risk a) but, if reasonableness standard, Bd won‟t take risk ii) Here, rule assumes: a) reasonable s/h is risk averse & is not diversified b) duty to corp., not to s/h c) don‟t want Bd taking risk that may kill corp. 2. Blame the Victim i) s/h picks these directors- so tough on them a) no externalities, only harm is to corp. ii) could have K for different result 3. Labor Mkt for directors i) would have to pay much more if directors held liable 29 v. Must Not Act Quickly W/out Full Info (Smith v. Van Gorkom) a. Duty of Bd owed to s/h when evaluating an offer to buy corp. 1. Ends: must get fair price 2. Means: take a long time & hire a lawyeri) Get full info: independent investigation & valuation a) don‟t trust info & price of acquirer b) hire investment bankers & lawyers 1) DGCL §141(e)- Bd not liable if reasonably & in good faith rely on them 2) can rely on advisers if they‟re informed c) get reasonable assessment of assets & worth of shares ii) Take time: written (not just oral) proposals; long meetings b. Bd liable here 1. Terms of offer Bd accepted i) short-fuse rule (offer only open for a few days) a) target can‟t shop around to get better deal b) b/c if acquirer loses deal, lose $ invested in getting the deal together (eg: search costs) ii) Financing option out for acquirer (buy only if can get $) iii) offer price 50% above stock mkt price iv) cash out merger (so s/h voted) v) Lock-up: if someone else buys other than acquirer, acquirer gets option to buy shares at cheap price a) compensates acquirer- found target, put it on mkt b) makes someone else less likely to buy 2. Shocking: reasonable directors usually not held liable c. Good rule?: 1. Impacts on parties: i) not clear that s/h helped ii) future Bds helpeda) now have clear guidance on how to act b) helps them if want to resist offers iii) lawyers & investment bankers helped- who will get hired iv) Bd not hurt- have director & officer (D & O) insurance 2. Info limited & expensive- must allow Bd to act w/out full info d. DOC now mutable for directors (protect Bd) 1. DGCL §102(b)(7): i) DOL still mandatory ii) DOC is now DEFAULT a) still the background rule b) but can opt out via charter or charter amendment iii) DOC still mandatory for officers 4. K out of personal liability: i. DOC has always been “mutable”, even b/f §102(b)(7) : a. “D & O” insurance OR b. Indemnification (sometimes) BREACHES OF DOC… Bd Liability for breaches of DOC Bd Insulated from paying if liable? 1) insurance 2) indemnification B/f Van Gorkum Yes 1) Yes 2) No- not in s/h Response after Van GorkumYes, but default 1) Yes 2) No 30 derivative suit 31 D. Duty of Loyalty (DOL) 1. Generally: i. Duty of Loyalty: must be honest- can‟t take $ from corp. cash register a. Mandatory b. Agency law: corps. use A, who may look after selves instead of P 1. If A (director) cheats P (s/h) by breaching DOL, who‟s hurt? i) ex post: s/h hurt ii) ex ante: a) Director also hurt by potential breaches of DOL b/c s/h less willing to trust director, so pay less b) Both want to do away w/ breaches of DOL- better off aligning incentives 2. Who cares if breaches of DOL? i) who cares: a) P- if anticipate DOL breaches, will reflect that in price paid to directors/officer b) s/h- will pay less for a share if director/officer allowed to breach DOL ii) incentives to do this privately (K) not via cts c. Breaches of DOL: 1. liability framed under 1 of 3 conflict of interest standards i) basic self-dealing ii) misappropriation of corp. opportunity iii) “waste” of corp. assets 2. compared w/ breaches of DOC i) more morally troublesome ii) more profitable to “breacher” ii. DOL to whom? a. s/h probably- should maximize long term profits of corp., but… b. other constituencies (management? employees?) 1. some states say Bd can consider more than s/h interest 2. but no man can have 2 masters… so DOL to none iii. Why Fraud & Self-Dealing are Wrong: a. Objections to Fraud: 1. Makes mkt imperfect- mkt relies on ppl w/ full & correct info 2.  transaction costs b/c undermines credulity & trustworthiness i) leads to costly investments in checking & verifying info ii) must obtain & pay for guarantees of trustworthiness OR insure against losses from untruthfulness b. Objections to Self-Dealing: 1. Unilateral rather than bargained for taking of property 2. create unproductive uncertainty i)  cost of capital (pay less for share if expect self-dealing) ii) un-diversifiable b/c anticipate unfair self-dealing by managers of all corps. iv. Types of DOL: Self Dealing & Corporate Opportunity DOL   Self-Dealing Corporate Opportunity     Disclosure Approval D/O Parent/Subsidiary   S/h Bd (ratification) (authorization) 32 2. Self-Dealing: Arises when directors favor own interests over those of s/h. Transaction b/w director & corp: i. (Non)Disclosure: (If don‟t disclose, more likely to be liable for breach of DOL) a. C/L rule: non-disclosure is per se violation of DOL, regardless of fairness of transaction (Hayes Oyster) 1. rationale: i) if don‟t disclose, likely something fishy is going on ii) institutional competence: cts not good at evaluating whether fair price or not 2. Remedy for failure to disclose: punitive- disgorge secret profits b. ALI §5.02(a): non-disclosure is per se violation of DOL c. DGCL §144(a)(3): undisclosed transactions 1. subject to entire fairness review (will look at price & process) 2. must have s/h or Bd authorization, approval, or ratification 3. rationale: want to encourage valuable transactions- sometimes that will be w/ directors d. RMBCA §8.61: Fairness review for undisclosed transactions, but directors must have had a good reason for failure to disclose ii. Approval by s/h or Bd a. Ratification (usually s/h, approval ex post): 1. must be disinterested to ratify 2. Ratify b/c may be too costly to switch if deal already done b. Authorization (Director approval ex ante) 1. must be disinterested to authorize iii. Policy Considerations a. How beneficial to corps. are self-interested transactions by directors? b. How well does authority or ratification cure things? c. How well can cts do this if Bds can‟t do it via authority or ratification? d. Matter of compensation: 1. allow some self-dealing, pay Bd member less iv. Standards of Review: a. BJR- lowest standard of review 1. looks to process to see if fair 2. rationale: institutional competency & will chill valuable transactions if threaten liability b. RBF (reasonable belief by Bd in fairness of transaction): 1. looks to price to see if fair 2. rationale: a bit suspicious of directors c. Entire Fairness: highest standard of review 1. looks to price & process to see if fair (Wheelabrator) 33 SELF DEALING Authorization by Disinterested Bd members + disclosure Ratification by Disinterested S/h or Bd + disclosure DGCL §144 BJR [look at process] RMBCA §8.60-8.63 §8.61(b): BJR [look at process] BJR §8.62(a): BJR ALI §5.02(a) RBF (reasonable belief by Bd in fairness of transaction)- [look at price/substance] entire fairness- look at price & process Burden of Proof  , but burden may shift to  (eg: if  could have gotten authorization b/f the transaction, ALI §5.02(a)) NO Approval by Bd or s/h + 1) NONdisclosure 2) disclosure 1) violation of DOL 2) entire fairness 1) violation of DOL 2) entire fairness 1) violation of DOL 2) entire fairness 1) violation- no burden of proof 2)  3. Corporate Opportunity Doctrine: i. Rule: D/O can only take opportunity if they disclose to corp. & corp. declines ii. Director/Officer (D/O) a. Corporate Opportunity: 1. Must disclose 2. Tests: (Broz v. Cellular Info Systems) i) in line of business of co. OR ii) look at nature of opportunity: a) Factors: 1) how it came to D/O (i) via individ. capacity? via corp.? 2) D/O offer opportunity to corp.? 3) D/O have influence & power over corp.? 4) financial capability of corp. to exploit opportunity? b) Not very predictable test 1) no factor despositive & don‟t know how heavily to weigh each 2) Rationale for rejecting bright line test: (i) factors as proxies for intent (ii) line of business rule is dumb: (a) want ppl on Bd who are in same field as corp. is in (b) better to rely on mkt forces & imperfect judicial tests then have directors from diff. field 3. Matter of compensation: pay D/O less, but let them have some corp. opportunity iii. Shareholder/Parent (controlling s/h) a. Background rules: 1. transactions b/w controlling s/h & subsidiary are subject to intrinsic fairness test 2. controlling s/h has burden of proof 3. test only applies when s/h getting something out of corp. 34 b. Parent owes fiduciary duty to its subsidiary (Sinclair Oil) 1. If non pro rata distribution (don‟t distribute to minority s/h)- maybe corporate opportunity 4. Self-Dealing in Executive Compensation i. Management Compensation: a. cash/salary b. bonuses c. allow some self-dealing & stolen corp. opportunity (breaches of DOL) d. golden parachutes e. stock options f. percentage of earnings Management compensation pkgs Pay DOL breaches K A B C $1 No DOL breaches Grab-bag $100,000 DOL breaches Some K restraints on management behavior higher salary, more K restraints, compensation less tied to performance mid-management $60,000 w/ bonus tied to profits DOL breaches Few K restraints on management behavior compensation tied to performance (align incentives) so need less judicially enforced constraints CEO Explanation Who gets this… ii. Ks favored (salary, bonus) over permitted breaches of DOL by cts a. Doctrinal reasons: 1. employment Ks easy to approve by Bd 2. S/h can only complain of Bd‟s: i) gross negligence ii) waste (no reasonable re‟ship b/w compensation & value of services given) 3. easy to do via K b. Economic reasons: 1. monitoring reasons (harder to monitor breaches of DOL) i) can monitor breaches of DOL if disclose, BUT ii) higher monitoring costs if compensate managers via wide array of transactions- hard to get their true value 2. agency costs: i) easier to align interests via K (tie bonus to performance) iii. Ways to Pay Management: a. Golden Parachutes: 1. K creation 2. cons: Management entrenching effects i) harder to fire, but usually can quit for any reason ii) triggers generous severance pkg iii) prevents takeovers b/c  cost a) acquirer usually wants to fire management iv) may  agency costs: a) harder & more expensive to fire manager b) manager may not behave in way that  s/h wealth 35 3. pros: S/h wealth enhancing effects (despite  agency costs) i)  ability to attract best managers ii)  management resistance of takeovers (which are good for s/h) b. Percentage of Earnings: (bonus tied to performance of corp.) 1. pros: i) for manager to  compensation, must  earnings of corp. ii)  agency costs 2. cons: i) earnings of corp. depend on a lot, not just what management is doing ii) can get out of whack if corp. does really well c. Stock Options (right to buy shares): (Michelson v. Duncan) 1. profit if market price is greater than exercise price (EP) 2. pros: aligns incentives (make manager act like owner) i)  monitoring ii)  agency costs 3. cons: i) can change EP mid-stream (Michelson) a) via centralized management- (insiders on Bd or management petition of Bd) b) if reduce EP,  incentives to work harder c) Allow waste claim if change EP mid-stream? 1) No- waste claim is bad: (i) need to re-align incentives (ii) if mkt wide decline (not idiosyncratic to this corp.) (iii) DGCL §157: Bd decision conclusive 2) Yes- waste claim is good: (i) ex ante:  management incentive to work hard if can go to Bd & get new EP (ii) ex post: don‟t want management influencing Bd like this ii) Options are “noisy” signals as to value of corp. a) reflects mkt wide effect & management effort b) solutions 1) Change options- so linked to firm value, not mkt value (i) Tie to mkt share & revenue (ii) options if out-perform peers 2) Give s/h more discretion ex ante 36 ENFORCING FIDUCIARY DUTIES & SHAREHOLDER SUITS A. Generally: 1. Types: a. Derivative b. Direct (class action) Type of suit DERIVATIVE DIRECT Harm to corp. s/h Law or Equity? equity law &  (s/h) (corp)3rd party  (s/h) (D/O) path of $ $ to D/Os/h $ to corp.s/h (to extent that have shares) 2. Differences: a. Classification b. Economic (who pays whom) c. Procedural i. what procedures apply ii. whether suit can be dismissed by itself B. Derivative Suit: 1. Generally: i. Response to collective action problem: a. w/out derivative suits: 1. s/h pays for all litigation BUT s/h recovers only pro rata share of benefits 2. reduced incentive to sue b. derivative suits altered ‟s compensation 1. but creates problem of strike suits ii. In S/h interests? a. can  corp. value: 1. allows recovery for past harms or enjoin prospective harms 2. deters director wrongdoing b. can  corp. value: 1. direct cost of litigation 2.  cost of hiring managers- b/c corp. must buy D & O insurance 2.  Compensation i. S/h have little incentive to bring suit, so law rewards ‟s attorney fees: a.  Attorney Fees if: 1. common fund (s/h won settlement, $ went to corp.) OR 2. corp. enjoyed substantial (non-monetary) benefit (Fletcher v. AJ) i) governance changes a) must be a (+) thing s/h want to pay for, but… b) problems: 1) governance changes don‟t have to be related to cause of problem & the suit 2) valuation problems- hard to tell how much governance changes worth ii) if ‟s attorneys settle (& save corp. litigation expenses) a) but this encourages more strike suits b. Objections: corp. might have to liquidate assets to pay attorney‟s feeslose going concern value ii. Strike suits brought just for settlement value (97% settle) 37 a. create bounty hunter settlement b. Settle b/c no one really looking after s/h rights: 1. S/h: collective action problem, not looking after own rights 2. Attorneys: if settle, get fees 3. Interested directors (ones being sued): i) if loyal- DOL to look after s/h, so may settle to save s/h $ ii) if not loyala) if Bd settles, attorney‟s fees indemnified by corp. b) if lose at trial, attorney‟s fees not indemnified 4. Independent directors: structural bias- look out for other directors 5. Cts: can‟t really reject settlement that all parties agree to it 6. D & O insurance: don‟t really care, b/c as long as things are predictable, can alter the premiums c. Bd may settle w/  who can be bought off more easily (Kahn v. Sullivan) 3. Attempted Solutions to Strike Suits i. Standing/Technical Requirements: a. Beneficial owner: 1. Continuing interest: s/h for duration of action. RMBCA §§7.40-41 i) internalizes costs & benefits- if still a s/h, deterred from doing something that will  stock price ii) but rule doesn‟t work as well if s/h can own just 1 share 2. Contemporaneous ownership: s/h at time of alleged wrongful act. RMBCA §7.41 i) prevents going in & buying a share when see a problem a) but this is not necessarily bad: 1) drives price up- not so bad 2) price of stock reflects corp. assets, which include expected value of litigation ii) doesn‟t matter- ‟s attorneys own stable client portfolio b. Able to fairly & adequately represent s/h interests (no conflict of interest) c. Bond requirements- so lose $ if suit is frivolous- but judges get around it d. 1st try to obtain satisfaction from Bd (demand requirement) ii. Screening Doctrines a. derivative suit is corp.‟s asset; Bd must 1 st get a chance to take it over ct reviews w/ BJR usually loses Bd Action (sue, get $, or no action; usually no action)  Yes ct discretion- SLC review standards (Auberach, Zapata, Joy v. North)  Yes  DEMAND ON BOARD?  No Recommend  Dismissal?   No Yes Bd establishes  SLC?   No  Case proceeds w/ corp. as  (which never happens)  Yes Demand  Futile?  ct discretion  Case proceeds No  Dismissed 38 b. Demand Requirement: 1. Futility of Demandi) Ct‟s discretion whether it was useless to ask Bd to solve problem ii) Test: (Aronson; Levine v. Smith - Perot) a) Reasonable doubt that Bd could‟ve exercised BJ? 1) Bd (dis)interested? 2) Bd (in)dependent? OR b) Look at specific transaction- reasonable? 1) really a 1 part test this just a proxy for whether Bd could‟ve exercised BJ (Rales v. Blasband) 2. Special Litigation Committee (SLC)i) SLC a) made up of independent directors b) decide whether or not corp. should take over case ii) Ct‟s discretion to defer to SCL decision to proceed or not iii) Standards of review: a) review under BJR (Auerbach- NY) b) two step review (Zapata- Del.) 1) SLC must be independent (i) look to procedure (ii) good faith? good try? 2) Ct own BJ (i) is litigation is NPV or not? (a) replicate decision of loyal Bd (Joy v. North) (b) NPV= recovery - costs reputation costs (1) (+)- don‟t dismiss (2) (-)- dismiss (ii) factors: (a) corp.‟s best interest (b) law (c) public policy (d) anything it wants (eg: employees‟ interests) 39 V. VOTING A. S/h vote: 1. Purposes: i. s/h means of direct participation ii. keep managers in line a.  agency costs b. align incentives iii. mechanism for takeovers 2. For what: i. for directorsa. when- DGCL §211 1. at least annually, some directors elected 2. default- can vote more often if opt out via bylaws 3. at special meeting for any reason Bd determines b. staggered Bd- vote annually, but only for part of Bd- DGCL §141(c) ii. for extraordinary transactions- DGCL §§251, 271 a. which transactions: 1. mergers 2. sales of assets 3. dissolution 4. amendments of articles of incorporation b. rationale- (Easterfish): more is at stake for management iii. for s/h proposals (which management usually proposes) iv. for charter amendments a. charter is K b/w corp. & s/h b. charter could say, ex ante, that management can change charter w/out s/h vote, but this will  share price v. Bd can have s/h vote on anything: a. if self-dealing by director, s/h ratification thwarts future litigation b. repeat players, concern for reputation 3. Can vote by proxy- DGCL §212 4. One Share - One Vote- default rule 5. Approval & Quorum- DGCL §151 i. directors must be approved by majority of shares cast ii. charter amendments must be approved by majority of shares entitled to vote 6. Which law? i. substantive rights- state law ii. how state law rights are exercised- federal proxy rules if public co. B. Books & Records: Access to S/h list 1. Need proper purpose- economic concern (Pillsbury v. Honeywell) i. very hard to opt out of , but default, can K out of ii. rationalea. reasonable for majority to expect that corp. is there to make $ b. if management has too many purposes, hard to monitor; easier to monitor if looking out for only economic concerns c. prevents corporate waste C. Proxy Expenses: 1. proxy fights: to solicit votes (only other way to get a vote is to buy share) 2. Compensation of proxy expenses (usually $5-10 million): (Rosenfeld v. Fairchild) i. Incumbents reimbursed if: a. reasonable expenses (reviewed under BJR) b. good faith c. about policy (not personnel) ii. Insurgents reimbursed if: 40 a. s/h authorize b. in practice- must win 1. management must propose for s/h to authorize 2. management will only do this if insurgents are on Bd 3. Problems w/ compensation: i. over-compensates: a. incumbent rule- b/c hard to distinguish policy fight from personnel fight b. proxy fights- not useful- if compensate might encourage ii. under-compensates: a. incumbent rule- might also want to compensate for personnel changes b. insurgent rule- might benefit co. even if lose 1. stock prices  during proxy fight i) ppl pay attention ii) monitoring of management  2. collective action problem for insurgents i) lack incentives to bring proxy fight a) if lose, pays own expenses b) if win, get pro rata share of benefit change bring ii) proxy fight might have (+)NPV, but might not be brought c. under current rule, have too few proxy fights 4. Alternative rules: i. Alter the payoffs: a. pay all insurgents 1. but then would have too many (like strike suit problem…) b. incumbents pay own way if lose (like insurgents) 1. corp. will have to pay directors more b/c will have to compensate Bd for anticipated expenses of proxy fights 2. would pay directors via indemnification, not via salary c. over-compensate successful insurgents 1. only pays for non-frivolous proxy fights ii. Screening doctrines: a. different standards if proxy fight over issue v. control b. screening based on major s/h view 1. wealth-maximizing s/h won‟t approve value destroying proxy D. Restrictions & Regulations on Voting 1. Manipulation of Voting System: i. Bd‟s power over agenda, meeting dates a. delegate to management b. management can manipulate to entrench themselves ii. Okay to manipulate? (eg: move up election date at last minute): a. Yes- it‟s in bylaws, s/h know Bd & management can do this b. NO- voting is special, will scrutinize more closely (Schnell v. Chris Craft) 1. Allowed to do some things to keep selves in power i) can refuse if s/h vote to sell corp. if they don‟t want to a) s/h delegate this power to management b) rationale: s/h can not be trusted to sell ii) can authorize super voting shares & give to friendly grp iii) can buy back shares of enemies 2. Even if technically okay, can not manipulate if… i) in bad faith- will look to purpose (Schnell) a) eg: can‟t fiddle w/ bylaws opportunistically b) not even if good business reason (b/c can always come up w/ one) c) even if independent Bd, might not be okay ii) too strategically- will look at effect & purpose (Atlas) 41 a) if impedes s/h vote, not okay, even if in good faith b) screens out defense protection takenen today; carves back attempts to entrench self- slightly 1) allows offensive moves- taken in advance 2) only influences poorly advised bds trying to entrench selves 1. Line b/w what can do & can‟t do to keep self in power is fuzzy. i) rationale: s/h can be trusted to vote, but not to sell iii. Problem w/ treating voting rights as special- s/h can exit 2. Circular Voting Structure i. DGCL §160(c): corp. cannot vote the shares it owns a. can‟t misalign investment & voting power (Speiser v. Baker) b. economic interests should align w/ voting interest c. rationale: want person in control to have right incentive 3. Vote Buying- S/H Collective Action Problem i. Cannot separate vote from economic interest: a. Can not buy vote alone, separate from equity interest 1. avoids unnecessary agency costs b. Can give vote alone (via proxy), separate from economic interest ii. Vote buying not illegal per se: (Schreiber) a. purchase of vote voidable (can be approved by s/h ratification) b. illegal if intent is to disenfranchise s/h (not if intent is to benefit corp.) iii. 3 problems vote-buying causes: a. Fraud (of corp.) or Disenfranchisement (of s/h) b. Distorted choice - less ability to rely on s/h judgment 1. now rejected justification for ban on vote buying 2. info-forcing rulei) if one s/h knows why vote should go 1 way, ban on vote buying prevents buying of that s/h‟s silence ii) forces info to be disclosed c. Collective action problem: Hold-ups (Schreiber v. Carney) 1. threat from s/h to hold-up vote 2. credible threat? Might not be if vote will  stock price 3. hold-ups always harm corp. (make pie smaller) i) ex post: a) if hold-up, vote-buying will always benefit corp. b) so vote-buying here is allowed under Schreiber ii) ex ante: better to prevent hold-ups via making vote buying illegal per se iv. Collective Action Problem: b/c of splintered ownership a. collective action problem make voting a weak check on management 1. individually- rational to sell vote separate from equity interest i) won‟t sell if vote hurts equity interest ii) individual considers that vote won‟t matter a) value of vote = gain X share interest X probability vote matters b) all s/h will think individual vote does not matter iii) so all s/h will sell votes If all s/h… individual s/h will… sell vote sell don‟t sell sell 2. collectively, irrational to sell vote b. if less splintered ownership: if ppl had more shares (i.e. institutional investors), more willing to monitor & less collective action problem 42 E. Federal Regulation: Proxy Rules (one response to collective action problem) 1. General purpose: i. proxies- so can inform s/h cheaply & enable them to act collectively ii. reduce collective action problem so voting is stronger tool to check management iii. determines how state substantive voting rights are exercised for public corp. 2. Critiques of proxy rules: i. Easterfish: no one listens to them, so they are a waste ii. Black: create legal obstacles to institutional investors b/c management friendly a. can rely on institutional investors to monitor & act 1. own more shares, so bigger expected gain 2. economies of scale, so less costs 3. Why solicit proxies if don‟t have to? i. if self-dealing & conflict of interest, s/h ratification prevents later liability ii. if repeat players, concern for reputation 4. §14(a): can‟t solicit proxy unless comply w/ SEC regulations in 14A: i. what needs to be disclosed ii. process iii. 14a-8: town meeting rule (via proxies, can participate in governance) a. get ideas to other s/h cheaply- send proposals w/ management‟s proxy b. requirements: 1. own $1000 worth of stock 2. proposal <500 words 3. file w/ management 120 days b/f it‟s proxy 4. proposal can‟t run afoul of restrictions i) must be proper subject for s/h vote ii) relate to something worth more than 5% of business iii) not ordinary business decision iv) not management proposal related v) not related to elections c. 2 types of s/h proposals 1. social proposal (to raise consciousness) 2. proposal about corporate governance iv. 14a-9: anti-fraud rule a. implied right for s/h to sue if make misstatement in proxy (Va. Bank) b. elements of c/a: 1. false misleading statement or omission i) must misstate belief & misstate facts (Va. Bank Shares) 2. material (if material, presume reliance) 3. causation (causes damages) if Bd thinks X & says X  loses- no misstatement of belief if really X if really Y if Bd thinks Y & says X  loses- no misstatement of facts  loses- no misstatement of belief  may win c. critique of liability rule: 1. allows Bd to be: negligent (stupid) or even stupid & dishonest i) if Bd dishonest, probably lying about other stuff ii) but: no damages to s/h 2. makes it very hard for s/h to have federal c/a i) if co. lied, have a state ct suit a) no ratification if Bd lied ii) if co. told truth, no c/a 43 VI. ACQUISITIONS MARKET A. Corporate Combinations & Appraisal Rights 1. Corporate Combinations i. Forms - goal of all the forms- end up w/ 1co. a. differences b/w forms: 1. protection of s/h 2. tax implication 3. liabilities & form of surviving co. 4. transactions costs b. Why offer prices > stock mkt prices: 1. stock mkt has undervalued 2. tax credits 3. control premiums: i) current management is value destroying ii) plan to loot ii. STATUTORY MERGER- DGCL §251(c) a. A takes over T 1. if give stock of A (classical): s/h T & s/hA now s/hA 2. if give $: s/hT have $ b. Features: 1. S/h Rights: a. Voting Rights- s/hT & s/hA b. Appraisal Rights- s/hT & s/hA 2. A acquires T‟s liabilities- but can K around K liabilities iii. ASSET PURCHASEa. A buys assets of T 1. s/hT get any remaining assets & $ A paid b. Features: 1. Voting Rights: s/h T 2. Transaction costs: must make deed & K for each asset 3. If close corp., s/hA may have veto rights or buy-sell agreement iv. STATUTORY SHARE EXCHANGE- RMBCA (not available via DGCL) a. A gives shares of A for shares of T: 1. s/hT & s/hA now s/hA 2. T becomes wholly owned subsidiary of A b. Features: 1. Limits liabilities b/c leaves T as separate subsidiary i) unless PCV to s/h, which is A (100% s/h of T) 2. Voting rights: s/h T 3. Same result as DGCL‟s triangular merger v. TRIANGULAR MERGER a. A creates subsidiary to acquire T 1. S gives some shares to A for shares of A 2. S acquires T, exchanging its shares of A for shares of T 3. T/S becomes wholly owned subsidiary of A i) Reverse triangular merger- if T left standing ii) Non-reverse triangular merger- if S left standing b. Features 1. merger b/w S & T looks like statutory merger 2. Limits liabilities b/c T as separate subsidiary i) unless PCV to s/h, which is A (100% s/h of T) vi. SHORT FORM MERGER- DGCL §253 a. A owns at least 90% of stock of T, can just merge easily 1. probably part of 2 step take-over: (a la Timberjack) 44 i) ii) tender offer b/f merger to accumulate the 90% short-form merger b. Features 1. no other bidders have time to come in 2. Voting: neither s/h T & s/hA for merger 2. S/h Protection: Voting & Appraisal Rights FORM OF MERGER Statutory Mergers DGCL §251(c) RMBCA ACQUIRER S/H PROTECTIONS Vote Appraisal DGCL: Yes RMBCA §11.03, .04: Yes DGCL: Yes RMBCA §13.02: Yes TARGET S/H PROTECTIONS Vote Appraisal DGCL: Yes RMBCA §11.03, .04: Yes DGCL: Yes* RMBCA §13.02: Yes Small Scale (<20% new shares) DGCL: No DGCL: No DGCL §251(f) Short Form Merger (A owns >90% of T) DGCL: No DGCL: No DGCL §253 Triangular Merger DGCL: No DGCL: No DGCL RMBCA: No RMBCA: No RMBCA Statutory Share RMBCA §11.03: No RMBCA §13.02: No Exchange Asset Purchase DGCL: No DGCL: No DGCL §271 RMBCA: No RMBCA: No RMBCA No No Stock Purchase (tender offer) ( “*”: no appraisal rights under DGCL if publicly or widely traded) i. ii. DGCL: No DGCL: Yes RMBCA §11.03: Yes RMBCA: Yes DGCL: Yes RMBCA §12.02: Yes tender shares? DGCL: Yes* DGCL: Yes* RMBCA §13.02: Yes RMBCA: Yes DGCL: No (Hariton) RMBCA §13.02: Yes tender shares? S/h need more protection than Bd negotiating (can‟t rely on fiduciary duties) Voting: majority rule (no hold out problem as would if needed unanimity) a. s/hT almost always vote b. s/hA rarely vote (only DGCL §251(c) or if management lets them) 1. rationale: corp.‟s buy lots of stuff; can‟t always go for s/h approval iii. Appraisal rights: a. if vote against merger, can force corp. to buy shares, cts appraise worth b. rationale: minority s/h in bad position if future A owns 51% of T‟s stock 1. protect minority s/h, get them right price i) especially if A is s/hT (if A on both sides of table, can act to detriment of T & minority s/h T ) ii) if A not s/hT (A not on both sides) then T‟s Bd might protect s/hT : a) unless directors figure they are out of there anyway, so no concern for s/h best interest 2. encourages investment by supporting ppl‟s expectations ex post 3. s/hT can exit & sell shares, but stock price will be lower b/c will reflect A‟s ability to exploit minority s/h 4. voting offers very little protection 5. protect against collective action problem i) Fischel‟s prisoner‟s dilemma ii) such as in 2 tiered freeze out merger c. problems w/ appraisal rights: 1. institutional competence, cts not good at valuing 45 2. avoided via sale of assets (DGCL §271; Hariton v. Arco) i) some cts will call sale of assets a de facto merger b/c same functional result, & grant appraisal rights to s/h T 3. under-used: collective action problem in getting s/h to bring: i) similar to collective action problem w/ derivative suits ii) individual s/h must bring suit, but doesn‟t get all benefit iii) DGCl §262(h),(j): ct can redistribute costs a bit, so alleviates somewhat 4. doesn‟t deter T from accepting low price for s/h T i) appraisal rewards value of share (make s/h whole) ii) no punitive damages iii) if only must pay value, will try to screw s/h, b/c most s/h don‟t use appraisal rights b/c of collective action problem 5. better to have class action remedy like in derivative suits? d. if voting rights  appraisal rights 1. 3 exceptions: i) DGCL §253, short form merger (s/h T get appraisal rights, but no voting rights) a) voting right would be useless here b/c A owns 90% of T‟s shares ii) DGCL §262(b): publicly or widely held co. (s/h T get voting rights, but no appraisal rights) a) if stock s/h gets in A is publicly traded or if stock s/h owns in T is publicly traded widely held. b) rationale: already a mkt for shares protects against unfair prices of opportunism c) problem: stock mkt price might not be a fair pricemight reflect A‟s bad treatment of s/h T d) RMBCA does not have this exception iii) sale of substantially all assets of T (s/h T get voting rights, but no appraisal rights) (Hariton v. Arco) a) rationale: $ from sale of assets gets paid pro rata, don‟t need protection of appraisal rights (majority s/hT not going to screw the minority s/h T , b/c they‟d just screw themselves) b) problem: if s/hT also s/hA, & has greater interest in A, will send more $ to A & screw over T & s/h T.. e. Valuation of the share: 1. method: i) old Del. method: avg. asset value, mkt value, & earnings ii) modern approach: use whatever investment bankers use (Weinberger) 2. value: DGCL §262(h): ignore value that arose from merger 3. valuing of assets: i) consider assets as used under T or A? a) old assets at old uses? OR b) old assets at new uses? OR c) new investment at new uses? 1) projections? 2) actual results? ii) new investment at new uses (Cede & Co.v. Technicolor) a) s/hT invested in T b/c ripe for new investment b) ex ante, s/hT will pay more if think an A will come in & get rid of T‟s bad management 4. valuing of debt (In Re Vision) i) face value or liquidation (mkt) value 46 ii) if corp. near insolvency, then face value iii) want to give incentives for value maximizing transactions 47 FRIENDLY ACQUISITIONS B. Freezeout Transactions: Appraisal rights Exclusive? Or Class Action Remedy? 1. Freeze-outs: self-dealing by controlling s/h i. high risk of self dealing (vote, mkt for corp. control, & bargaining offer little protection) ii. Policy: cases focus on risk of s/h being paid too little a. but s/h get more than mkt value- just don‟t get as much as A willing to pay b. *debate about whether s/h of parent or s/h of subsidiary get the surplus 2. Class actions permitted if parent or controlling s/h on both sides of transaction?: i. Cts have flipped flopped: a. Traditionally: appraisal is exclusive remedy b. Class actions authorized in 1970‟s (Singer v. Magnavox) 1. limited freeze-outs to legit “business purpose” 2. expanded remedies: recissiory damages c. Class actions not always prohibited (Weinberger v. UOP) 1. very vague as to when class actions okay 2. class actions under only strict conditions (Rabkin) ii. Appraisal rights are significant screen b/f class action allowed a. s/h can‟t just pass on appraisal rights & get a class action iii. Weinberger class actions possible in freeze out merger: a. available if: 1. no bargaining 2. no full disclosure of facts 3. no independent committee w/ real bargaining power (Kahn) b. remedy: legal fees & recissory damages (which are > appraisal damages) 3. Policy: i. Appraisal rights are problematic for ct a. institutional competency- cts not good at valuation b. particularly bad at valuing surplus (difference b/w mkt price & reservation price- highest price A willing to pay) ii. Penalty default- impose class action costs a. try to push parties to do it themselves b. Opt out via various screens (which give minority s/h some power): 1. fairness opinion 2. minority s/h vote 3. independent committee w/ real leverage c. penalty- class action much more so than appraisal iii. Try to manage controlling s/h opportunism iv. same class action problem as w/ derivative suits 48 CLASS ACTIONS Preclusion of Class Action Weinberger (class actions might be okay) Rabkin (class actions okay under strict conditions) Kahn (content to when class actions okay) Fiduciary Duty Remedy -valuations? Class action not precluded if: fraud or overreaching unfairness Ambiguity as to when precluded: yes if breach of fiduciary duty probably no if cash-out merger- go to appraisal rights Might breach DOL if: use info from T to help parent bargain w/out independent committee move too fast not candid Avoid breach of DOL if:  fairness opinion as to price for T‟s shares independent committee made up of T/subsidiary‟s directors not affiliated w/ A/parent Liberal valuation method: all relevant factors anything ct of equity could say is ok recissory damages (what would have been if transaction never occurred) a) grants more than appraisal, which gives what stock worth at time b) rationale: so s/h don‟t hold up transaction; option value this is very bad for /A/parent Class action precluded if: only problem is w/ price (only get appraisal rights) Class action not precluded if: problem w/ process (particular incidents of fraud, etc.) Might breach DOL if: ”sharp conduct” bad attitude Might breach DOL if: special independent committee has no bargaining power (must have committee w/ real leverage & bargaining power) C. Sales of Control 1. Control blocs i. can be < 50% of co. ii. worth more than minority blocs iii. costly to aggregate: a. buy from someone who has it (more typical) b. create control (via tender offer) iv. source of control premium: a. 2 sources: 1. value adding i) shares might be more valuable in A‟s hands ii) new management might better handle corp. 2. looting (will loot from corp.) b. can tell which source: 1. look to mkt (Easterfish): i) if going to loot: stock price will  ii) if going to be value adding: stock price will  2. But, stock price reflects assets & expected remedies/damages 49 i) avoid this problem & judicial valuations if can figure out what part of stock price is assets v. expected remedies 2. Mkt Rule: i. If sell control block, don‟t have to share control premium (Hanson Holdings) ii. 2 Exceptions: a. Corporate Opportunity (Perlman v. Feldman): 1. if control premium reflects value of corp. or collective opportunity that rightfully belongs to all s/h, must share premium (eg: a “plan”) 2. exiting controlling s/h must share what is above true value, if not for control premium b. Looting 1. if looting transaction, must share premium 2.  cost of transferring control, so deters all sales of control i) will deter looting (if must pay premium to everyone, everyone will tender, no one left to loot) ii) also deters value creating transactions (Easterfish) a) is value creating if mkt price  iii. If sell control bloc after saw reasonable threat of looting that didn‟t avoid, liable (Harris v. Carter) a. can‟t shut eyes or ignore red flags b. sue sellers of control bloc, not looters (better for deterrence) D. Tender Offers & Williams Act: 1. Tender Offer: i. offer of cash of securities to s/h of public corp. in exchange for their shares at a premium over mkt price ii. usually, attempt to acquire control bloc in diffusely held corp. w/out controlling s/h iii. not defined under Williams Act: iv. SEC 8 factor test (Brascan)- gives judge lots of flexibility a. active & widespread solicitation of public shares b. solicitation made for a substantial % f the issuer‟s stock c. premium over prevailing mkt price d. terms of the offer are firm rather than negotiable e. whether the offer is contingent on tender of a fixed minimum # of shares f. whether the offer is open only for a limited period of time g. whether the offerees are subjected to pressure to sell their stock h. whether public announcements of a purchasing program precede or accompany a rapid accumulation 2. Williams Act: protects s/h from coercion i. Early warning system: a. §13(d): must file w/ SEC if cross 5% ownership line b. §13(d)(3): applies to ppl acting in concert if together, amass 5% ii. Disclosure requirements: a. §§13(d), 14(d)(1): must disclose what plan to do if launch a tender offer b. “I‟m going to maximize s/h value” is okay c. gives management time to get defenses ready iii. Anti-fraud provision §14(e): can‟t lie iv. Substantive regulations of tender offers §14(d)(4-7): 50 HOSTILE ACQUISITIONS cts see when a would-be A or s/hT challenges defensive tactics of T‟s Bd OR T seeks to enjoin A‟s bid 4 sets of rules govern behavior of T when T faced w/ unsolicited merger: 1. Fiduciary duties 2. K: i. ex ante: defenses in charter (eg: poison pill) ii. ex post (after offering): install defenses mid stream (eg: staggered Bd, poison pill) 3. Williams Act i. raiders/buyers- forced disclosure ii. procedural rules force an auction: (w/drawl rights; open for 20 days; must offer same price to all s/h (can‟t do what Unocal did) & best price to all s/h) 4. State Anti-Takeover statutes D. Defensive Tactics & Fiduciary Duties 1. Tender Offers i. One-Tiered (no back-end merger) a. Free-rider problem: (incentive to not tender) 1. if tender offer does not succeed: get same price (mkt value) whether tendered or not 2. if tender offer succeeds: better off not tendering b/c can & wait for everyone else to tender & free ride on value A adds Tender offer price  Yes  TENDER OFFER SUCCEED?   Yes No   Mkt price TENDER? > tender offer price (A wouldn‟t do it if didn‟t expect)   No Yes   TENDER OFFER SUCCEED?  No  Mkt value ii. Two-Tiered Tender Offer a. 2 tiers: 1. front end: tender offer 2. back end: freeze out remainder of s/h for < tender offer price b. structurally coercive; s/h pressured into tendering 1. ex ante: better off tendering b/c not going to be worse off 2. will tender regardless of what think outcome will be c. if low price: s/h on front end harmed; s/h on back end harmed even more d. Coercive tender offers not allowed 1. coercive tender offer outlawed in Unocal 2. 13e-4 & 14d-10 prevent discriminatory, non pro rata tender offers (by A‟s & by issuing corp.) 51 3. Defensive Tactics (when faced w/ takeover(s)): i. Examples: a. Greenmail: selective repurchase by T of a potential bidder‟s stock, usually at premium over the mkt price 1. DGCL: greenmail okay; default (opt out via charter) 2. Bd can buy back shares for business purpose (Cheff v. Mathes) i) can not do it to entrench selves ii) okay if takeover presents danger to corp. policy a) can always come up w/ some policy reason b) policies that justify: save jobs; liquidation threat iii) low burden on Bda) good faith & reasonableness b) hard for s/h to challenge 3. Ct‟s standard of review: >BJR if potential conflict 4. Fiduciary Duty: i) to s/h to maximize profits a) takeover usually good for s/h;  aggregate wealth b) s/h might make more $ if A comes in & liquidates assets (eg: if T‟s management is really bad) ii) to other constituents? (community, employees) a) if Bd has duty to more than one, duty to no one 5. Good for s/h? i) ex post: s/h worse off (corp. paying more than getting) ii) ex ante: maybe good a) agency costs: management owns more shares, aligns incentives for long run b)  monitoring costs: rewards raiders who search for under-valued or badly managed corp.; management works harder to avoid b. Poison Pills: 1. Right distributed to s/h that becomes valuable when someone acquires specified portion of shares i) s/h can buy stock cheaply OR ii) s/h can sell stock at expensive price back to corp. 2. deters takeovers i) no takeover will succeed w/ pill in place b/c A be diluted ii) no one has ever trigged a poison pill iii) takeovers always conditional on Bd pulling the pill 3. Pulling the Pill: i) A can force Bd to pull pill: a) proxy contest & get control of Bd OR b) compel T bd to pull the pill ii) do not require s/h vote to pull 4. Reasonable to adopt in advance of threat (Moran) i) do not require s/h vote to adopt c. Restructuring Defenses 1. Discriminatory self-tender: i) offer to buy to non-A s/h to tender to corp. for price even higher then tender offer price (Unocal) ii) scorched earth policy; assures Bd will win iii) 13e-4, 14d-10: now forbid such discriminatory non pro rata share repurchases (by issuing corp. or by A) 2. Giving of debt notes (IOUs) for some of the shares 52 thwart takeover by placing restrictive covenant on notes that corp. cannot borrow any more debt (Revlon) ii) ties hands of future As: A must borrow $ to make bid, but can‟t secure loan on T b/c T can‟t take on any more debt d. Golden Parachute ii. 2 questions to be asked when reviewing defensive tactics: >BJR (intermediate level of review) b/c Bd has conflict of interest (want to entrench themselves)  Bd has enhanced duty that calls for judicial exam reasonable grounds that danger to corp. policy (Cheff) good faith (Smith v. Van Gorkum, Unocal) defensive measure must be reasonable in relation to threat (Unocal) a. When Bd faced w/ takeover, what constitutes a threat? What is a reasonable response? -Unocal, Paramount I (Time-Warner), Moran1. Response Reasonable in relation to threat? (Unocal) 2. Exactly what is a “threat” is an open question. Threat Low price Coercion Is Threat Valid? Valid (Unocal, especially if 2-tiered tender offer & backend freeze out) Valid (Unocal, s/h may get too little; raider shouldn‟t be able to buy in) Not valid if all s/h getting same price (Time-Warner) Valid (Unocal) critique: a) scorched earth is sledgehammer to kill a fly b) no real threat of greenmail in freeze-out, b/c A wants all stock or none Valid (Unocal) critique: corp. does not need own protection Valid (Cheff) critique: employees don‟t lose jobs after takeovers a) only lost jobs are top management b) can help employees w/out thwarting takeover via employment Ks & severance pkgs. Valid (Cheff) critique: s/h might make more $ if corp. liquidated, especially if T‟s management was value destroying Not valid (Revlon, can‟t favor debt holders over s/h) critique: sometimes cts find a fiduciary duty to debtors, but Bds can not anticipate when (strikes like lightening) Valid (Cheff) Valid (Time-Warner) critique: a) lets anything count as threat b) seems to gut Unocal Valid (Time-Warner) critique: treats s/h as dumb, unable to see long-term Not valid if concern is that s/h might tender into excessively conditional offer (QVC) i) Greenmail Threat to corp. enterprise Threat to community/employees (other constituents) Liquidation Bond holders (debtors) may not get paid Threat to corp. policy/strategy a) “can‟t do what was planning to do” b) *if plan in place b/f hostile offer c) threat to corp. culture Misunderstanding/confusion by s/h (s/h might be short-sighted) 53 b. Once Bd has decided to “sell” corp., what transactions trigger auction duty (where can‟t use defensive tactics)? -Revlon, Paramount II (QVC)1. Once corp. will inevitably be sold/broken up, Bd can not just defend anymore (Revlon) i) must act like auctioneer & sell to highest bidder (Revlon) ii) can‟t resolutely favor 1 bidder over another a) why Bd might favor 1 bidder: 1) side payments 2) protect s/h from low freeze-out (i) so favor bidder offering s/h same price at front & back end 3) putting directors on new Bd (i) might bring added value if keep some directors or management b) ways Bd will favor 1 bidder over another 1) lock-up (i) sell favored bidder big asset or option buy shares cheaply if other A acquires (Van Gorkum) 2) no-shop K (won‟t look for other As) 3) termination fee to favored bidder if other A acquires 4) give greater access to books c) lock-ups not illegal per se 1) must look what give v. what get 2) don‟t want to give lock-up to bidder who‟s already winning (doesn‟t benefit s/h) 3) lock-ups ok to tempt a bidder into auction d) can favor to tempt a bidder into auction 2. Scope of auction duty (when is corp. inevitably “sold”?): i) if hostile tender offer & white knight (Revlon) ii) if sale of control/control shift (QVC) a) if diffuse ownership & control b/f, but controlling s/h after, then sale of control (QVC) 1) minority s/h now vulnerable; only fiduciary duties to protect them 2) must conduct auction to ensure takeover premium to compensate s/h for this harm b) if diffuse ownership & control b/f & after acquisition, then no sale of control (Time-Warner) 1) BUT, distinction makes no sense. S/h actually probably better off if controlling s/h ( agency & monitoring costs. 3. Auctions Good or Bad? auctions  premium paid to s/h T from 20% to 50% Williams Act: essentially forces an auction i) BAD: (Easterfish) a) takeovers are good: (*but only winners are s/h) 1) efficient (synergy gains) 2) threat of takeover is good discipliner of management ( monitoring costs) b) auctions  amount of takeovers 1) auctions  amt As must pay to takeover 54 ii) auctions  returns to search will have  searches &  takeovers & Williams Act prevent takeovers  chance of getting any premium b/c  chance of a takeover. 2) empirically- auctions  amt of takeovers, but premiums to s/h T don‟t  much d) probably would rely on mkt to screen defenses GOOD: (Bebchuck) a) auctions only  search a little - -  search muted by fact that A hold shares of T (<5%) b) society better off w/ auctions c) takeovers not necessarily value-creating 1) only clear winners are s/h T 2) takeovers b/c: (i) tax savings (ii) better management (iii) monopoly gains (iv) mkt inefficient (v) exploit labor 2) auctions & Williams Act will likely deter these “inefficient” takeovers d) auctions- ensure bidder who values T most gets it 1) but 2nd buyer can acquire from the 1 st bidder if 2nd one values it more, auctions 2) (*transaction costs of bidding & auctions) 2) 3) c) Revlon 1) No Defense/No Auction No Defense/Yes Auction Yes Defense/NO Auction    -------------------------------------------------------------------------------------------------------------------(Easterfish) (Bebchuck, Gilson, Kraackman) E. State Regulation of Takeovers 1. Constitutional 2. Rationale i. protect s/h: low price; coercion ii. protect management iii. protect employees (if this was goal of statute, it would deny takeovers that pose threat to employees, but allow others. Not what statutes do, so not true concern) 3. PA (very honest) anti-takeover statute: i. Bd can consider anything it wants; can leave poison pill in place for any reason ii. disgorges profits from raider who buys block & later sells iii. protects employees: (severance pkg; all labor Ks remain in play after takeover) iv. default: many have opted out of at least some v. PA corps. have lost $4 billion ( agency costs b/c no fear of takeovers) 4. Impact of anti-takeover legislation: i. winners: top management (keeps jobs) ii. losers: s/h who currently hold stock when law passed 5. DGCL §203: i. bars interested s/h (crossed 15% threshold) from any merger for 3 years unless: a. Bd approval b/f acquires 15% OR b. Bd & s/h approval OR c. crossed 15% in transaction (ie: tender offer) in which got 85% of shares ii. deters potential As: interferes w/ debt financing; A must share all synergy gains iii. can get around: proxy contest to replace Bd, then make takeover bid; tender offer for 85% of stock; wait 3 years; negotiate deal w/ incumbent management 55 VII. SECURITIES MARKET & INSIDER TRADING A. Anti-fraud provision: 1. Rule 10b-5, under §10(b) of Securities Exchange Act of 1934 i. like anti-fraud provisions in proxy rules (14a-9) & Williams Act (14e) ii. §10(b): prohibits use or employment of any manipulative or deceptive devise in sales of securities iii. 10b-5: prohibits, in connection w/ purchase or sale of security: (a) device, scheme, or artifice to defraud (b) untrue statement or omission of material fact (c) fraud or deceit iv. SEC & private c/a a. private c/a: 1. Ct carved back on implied right of action (to limit # of claims) i) doesn‟t govern s/h & management re‟ship- that‟s state law 2. But if lose ability to get some remedies (eg: injunction) in state ct & controlling s/h breaches fiduciary duties, may be able to get to fed ct (Goldberg) b. SEC: 3 remedies 1. civil injunctive action 2. disgorgement 3. administrative proceedings to bar ppl from business c. criminal actions (U.S. Attorney) 2. 2 contexts: i. Securities fraud- overt misstatement or omission ii. Insider trading B. Outright Misstatement or Omission 1. Elements of c/a: i. Misrepresentation or omission (Santa Fe) a. Okay as long as tell truth (sharp dealing okay if don‟t lie about it) b. no requirement that business purpose for freeze-out; just can‟t lie ii. Materiality (TSC) a. whether reasonable investor would view matter as significant 1. balance probability of event & price impact of event (Basic) 2. Not when reach agreement in principle iii. Scienter (knowledge or recklessness) (Ernst) iv. Causation (Goldberg) v. Damages vi. Reliance (but might not have to show actual reliance) (Basic) a. 10b-5 can be enforced in a class action (Basic) b. Reliance can be presumed (if mkt believed the deception) 1. enables class action (not required to show individual reliance) 2. even if s/h didn‟t know of deception, the mkt did c. Fraud-on-the-Mkt Theory 1. misstatement deceived the mkt (mkt as agent of s/h) 2. s/h rely on mkt (which knew of the deception) 3. if mkt believed the deception, influenced the stock price 4. mkts are speculatively efficient (reacts quickly to info) d. Rebuttable presumption 1. rebut by showing no reliance by s/h or no change in price Traditional Rule Reliance Presumption of reliance Post-Basic Rule Presumption of Reliance False statement Silence/omission 56 C. Insider Trading (I.T.) 1. History: i. permitted at C/L (permitted at time 1934 act passed) ii. Old approach to combat I.T. under 1934 act (can still use): a. §16: must disgorge of profits if insider buys & sells w/in 6 mo. period 2. 10b-5: i. does not explicitly prohibit I.T. ii. does not define insider trading 3. What‟s wrong w/ I.T.? i. Corp. concern: insider shouldn‟t control destiny of corp. ii. Societal concern: don‟t like ppl who cheat iii. Mkt concern: need foundation of integrity (otherwise, disincentive to invest) 4. 3 Theories- Liability for I.T.? i. Equal Access Theory: buyers & sellers entitled to level playing field a. 2 principles (Cady v. Roberts) 1. general DOL to s/h 2. inherent unfairness if have more info (TGS) i) can‟t trade w/out disclosing ii) insiders subject to materiality standard (probability X magnitude) iii) view whether misleading from perspective of investor iv) corp. liable for deeds of insiders even if corp. didn‟t trade b. If have superior info- can‟t trade on it unless disclose (TGS) 1. all investors should have = access 2. managers & employees: disclose or abstain from trading c. Good rule? ADVANTAGES DISADVANTAGES 1) can reach all “I.T.” 1) discourages search & research b/c can‟t conduct, even if info capture gains originates outside corp. 2) 10b-5 requires fraud: if non-disclosure, 2) victims of I.T. easily must have duty to disclose. If no duty, identified: all uninformed ppl are not hurt. There are always ppl w/ traders to whom insiders more info- shouldn‟t have to disclose should have disclosed unless have a duty. d. REJECTED (Chiarella) 1.  access is not fraud: must be fraud or deceit to be violation ii. Fiduciary Duty Theory a. RETAC (pre-existing re‟ship of trust & confidence) (Chiarella) 1. Must find breach of RETAC to person on other side of trade 2. if owe no RETAC (to s/h of corp. that have info about), then owe no duty to disclose 3. no general duty to mkt 4. duty must be independent of 10b-5 b. Who has a RETAC? 1. Officers & Directors 2. Investment banker or lawyer on deal (“temporary” insider) (Dirks) 3. not person who overhears c. Tippee liability (Dirks) 1. tip must constitute a breach of a duty i) eg: traditional insider‟s duty ii) breach only if tipper reaped a personal benefit by providing tip 57 iii) if no personal benefit to tipper, then RETAC doesn‟t stick 2. tippee must know or have reason to know of the breach d. Good rule? ADVANTAGES DISADVANTAGES 1) avoid liability for security 1) Under-inclusive: does not get analysts (imp. investigatory to person who trades in corp. that don‟t have RETAC to. efforts); s/h better off w/ some  a) only gets ppl who owe info (better off w/ security duty to selling s/h analysts) b) must owe duty to X & 2) b/c so vague, even more of a trade X‟s shares deterrent c) if A plans to buy T, & 3) good if diversified, b/c RETAC insider of A buys stock obligates disclosure of things in T, not I.T. under that will  stock price (eg: fiduciary duty theory fraud); good b/c if diversified, 2) Very vague, hard to structure likely to be on other side of behavior ex ante transaction in another situation 3) not good if not diversified, b/c RETAC obligates disclosure of things that will  stock price iii. Misappropriation Theory (O’Hagan) a. abuse of some relationship b. property rights theory (dissent, Chiarella) c. Must deceive- no liability if disclose that trading d. Can misappropriate the good reputation of employer 1. journalist can‟t trade on “inside” info b/c would sully reputation of newspaper for which he works d. Good rule? ADVANTAGES DISADVANTAGES 1) more inclusive: don‟t have to have duty to 1) doesn‟t really fit selling s/h language of a) if owe duty to X but trade on securities 10b-5 of Y, can be liable here 2) employers can b) generally, corp. owe duty to will be opt out of source of info liability for its 2) can reach almost all forms of I.T., regardless employees of whether traditional insiders are involved. 3) isolates a real duty & a real fraud 5. §14e-3(a): pure liability rule i. liable if: a. *tender offer context b. got inside info c. trade on inside info 58