Law School Outline - Corporations - NYU School of Law - Kahan 7

CORPORATIONS - KAHAN FALL 1994 INTRODUCTION: THE CORPORATE STRUCTURE I. The Corporate Form A. Taxonomy of Corporations (Klein & Coffee) 1. Corporation - Artificial and separate legal entity a. Limited liability for investors b. free transferability of investor interests c. legal personality d. centralized life span Stock - signs of ownership ofthe corporation Share - Individual units of stock interests of ownership in the corporaion, separate legal entity Shareholder/Stockholder - people who own the shares/stock 2. Types a. Closely-held - privately held cos - few people own all the shares b. Publicly-held i. large number of pasive shareholders ii. a market for freely-trading stock iii. substantial assets iv. limited liabililty 3. Participants of Corporation a. Creditors - lenders to a corporation b. Directors - people who have legal power to run corp on behalf of shareholders 4. Problem a. Different ways Andrea can raise $20 mil to develop a new tech for her start-up i. Debt/Borrow a. Get bank loan b. Issue bonds - certificate of debt ii. Equity - ownership of inerests a. Investors - close partners, b. Issue shares - shareholders, share profits b. Venture capitalist c. Joint venture iii. Want more equity and lest debt (i.e. $7mil equity, $3mil debt) a. Bank less concerned with control than venture capitalist b. Bank has priority claim, if co. sold, bank get $ first, b/f Andrea 5. Allocation of Rights a. Economic - Right to profits, right to interest, right to be paid off b/f others b. Right to control B. The Incorporation Process 1. Process a. Take Certificate of Incorporation to b. Office of Secretary of State c. Filing fee - pay by check C. Law of Corporations 1 1. Relationship b/w Corporation, Creditors, Shareholders & Directors a. Shareholders elect directors i. at annual meeting ii. remove either at special meeting (§211(d) - only Bd directors can call, or persons auth by cert of inc or by-laws) iii. or by written consent Shareholder Management Powers - Extraordinary decisions by directors require approval of shareholders as well i. dissolution of the corporation ii. a sale by the corporation of all its assets iii. a merger of the corp with another corp iv. amend certificate of incorporation b. Board of Directors - legal power to manage the corp i. decide how run bus ii. how much salary they receive iii. declare dividends to shareholders Owe Fiduciary Duties to shareholders/corp i. Duty of Care - non-negl acts ii. Duty of Loyalty - run co for benefit of shareholders, not personal benefit c. Officers help directors manage day-to-day bus operations i. Bound by directions given by Bd directors ii. Types 1. Inside - Directors that are also officers (employees) 2. Outside - not otherwise affiliated with company 2. Sources of Corporate Law - Hierarchy a. Federal laws - Rules of voting, major trans, insider trading b. State Corporation Law (i.e. Delaware) - General rule c. Charter - certificate of incorporation d. By-laws - define power to run co Can trump General rule - "Trump provision" If General rule says "govern unless contradictory rule in charter or by-laws" D. Certificate of Incorporation 1. Seven Articles a. Name Mandatory b. Address " c. Purpose " d. Number of Shares " e. Board of Directors Optional f. Shareholder Action " g. Amendments " Del Gen Corp L §102(a)(1) (2) (3) (4) §141(d) - 1 year term for staggerred board §222(a) - sh can act by written consent §242(b)(1) - Majority of sh entitled vote §102(b)(4) - Can require more than 50% 2. Balance (Captial Markets, Efficient Market Hypothesis) a. Afraid directors overreaching, act in own interests, v. int sh b. Afraid large shareholders overreaching (shortsighted, incompetent), v. int min sh 3. Ultra vires - corporate actions outside of corporate purpose; exceed corp powers a. modern - §102(a)(3) - almost no limits on coporate purpose and powers b. Corp cannot assert as defense in K dispute, only in limited circumstances 2 4. By-Laws a. §109 - shareholders have power to adopt, amend or repeal by-laws b. Since sh approval needed to amend charter, better to put in charter, if want insulate from sh unilateral action and director unilateral action II. Basic Concepts in Valuation and Corporate Finance A. Time Value of Money 1. Money today is worth more than money a year from now 2. Discounting = process to get money in future to present value Discount rate (d) - rate that reflects mkt price for renting money, market rate of return PV = Future Cash Flow 1+d PV 2 years from now = Future Cash Flow (1 + d1)(1 + d2) 3. Rate of Return - profits you expect to make on a specific investment 4. Net Present Value - if positive, good project (usu + if RR>d) 5. Interest Rate - rate determined by K have to pay when use up money B. Risk and Return 1. Expected Future Cash Flow = Sum of Probabilities of Various Cash flows x cash flow 2. Risk = A measure of how much possible payoff can deviate from expected payoff If certain payoff = no risk Ex: Project 1 50% 900 Project 2 50% 500 50% 1100 50% 1500 expected payoff 1000 1000 Project 2 greater risk because greater deviation 3. Variance a. Risk neutral b. Risk averse - need to be paid a risk premium (p) for bearing the risk d = rf + p d = rf If project involve no risk, discount rate = risk-free rate (Gov't debt oblig) 4. Example Borrow $10,000,000 Repay $11,300,000 a) p = 2%, rf = 6.5% i) i = 13% ii) .95 11,300,000 .05 0 Expected Return = 10,735,000 Expected Rate of Return = 7.35% iii) NPV = PV - $10,000,000 = -105,991 = negative = bad project PV = 10,735,000 = 9,894,009 1.085 b) p = 0 PV = 10,735,000 = 10,080,000 1.065 NPV = 10,080,000 - 10,000,000 = 80,000 = positive = good project 3 c) Risk premium = Diff b/w Risk-free discount rate & risk-adjusted discount rate Risk-adjusted discount rate = rate given by market Rate of return = Return on a specific project C. Diversification 1. Diversification - process of reducing the risk by increasing the number of investments Undiversifiable risk - Some risk so fundamental, can't be diversified-need to compensate for bearing the risk by a risk premium (i.e. nuclear war, global recession) more diversifiable -> lower risk premium Diversifiable risk - Investors can get rid of, so don't have to pay a risk premium, d = rf Fully diversifiable - NO investor must have to bear the risk D. Captial Market Efficiency 1. Efficient Market Hypothesis a. Semi-strong - Market price = intrinsic value based on all publicly available information bearing on the expected value of individual stock (favored) b. Strong - Stock prices rapidly reflect both public and non-public information (no body really believes it, DGCL would be diff if accepted hypothesis) c. EMH - should diversify, forget about make abnormal profit -> mutual fund i. If believe in EMH -> believe that CS price reflect business prospects run over pd of bus, whether short term or long term. ii. Actions that maximize share price in long run = action that max in short run d. Paramount v. Times Chancellor Allen - believe in EMH i. There is no distinction b/w any long-term and short-term stock value, at least where there is a large, active, informed market for the shares of the company -> there cannot be a premium for control ii. The nature of such markets is to discount to a current value the future financial prospects of the firm. iii. In a well-developed stock market, there is no discount for long-term profit maximizing behavior except that reflected in discount for time value of money iv. Market value of stock relect value now of future stream of all returns to eternity v. Del L - Dir run co, entitled to disregard stock market valuation b/c more access to info of corp's present and future condition 2. Delaware court generally not subscribe to EMH, Fed cts gen receptive to EMH If EMH not hold, mgmt max profits short run, and cut out long-term investments If mkt sees hi profits now, and share price incr now, if short term mgmt -> decr profits Mkt inefficient b/c what max stock price 1 mo from now NE what max 1 year from now Short term investros sell & bad actions -> want take away power of short term inv to dictate mgmt strategies III.Corporate Securities and Capital Structure A. Introduction 1. Capital Structure - Hierarchy of claims against revenues generated by the business a. Bonds/ Debt - Creditors (K right to interest and repayment of principal) b. Preferred Stockholders c. Common Stockholders 2. Equity Securities - an ownership in a business a. Common stock (can have multiple classes i. usu carries voting rights to elect he Bd of dir 4 ii. hold residual claims for dividends (or liquidating distributions) after all other particpants in corporation have been paid b. Preferred Stock - stock with a claim on the company's residual earnings or assets that comes ahead of common stock i. Certificate of Designation - defines rights ii. Gen, pays a fixed dividend that must be paid before common stock iii. Gen, not have rigt to vote for directors iv. Redeemabe by the corp for a price - convertible into CS at pre-set ratio Co have to pay redemption price + accrued and unpaid dividends thru date To convert or not convert - compare net asset value Conversion Price = dollars in term of liquidation preference per share CS Conversion Ratio = Number of shares of CS per dollar (LP) of PS (1:2) Ex: 3. Steps to create a spin-off (one co which creates more than 1) a. Incorporte new company, International (Marriott own shares of Intl - subsidiary) b. Transfer assets of Marriott to International c. Cash dividend In-kind dividend - assets of co (Marriot pay shares of International) Stock dividend - stock of co that pays a dividend d. Change the name of Marriott to Host Adjusted Conversion Price = Conversion Price (Current Market Price - Fair Market Value prior to spinoff per share CS Dividend per share) CMP per share CS Ct: Transaction prohibited if FMV > CMP, though no express provision 4. Forms of Debt a. Trade debt - Debt owed to suppliers - accounts payable b. Bank Debt - issued under revolving credit agrement c. Bonds i. Debentures - unsecured bonds ii. Notes - Bonds with maturity less than 10 years Bank debt agreeements and Bond Indentures contain covenants limit rts of co (div) Pay interest in cash at a fixed rate Zero-coupon - pay no interest, when due, co pay amt lot higher than when soldit Redeemable (callable) by corp Sinking fund provision - require co to repurchase a certain amount of bonds each yr Convertible to common stock 5. Balance Sheet - snapshot reflects financial pos of co at one specific moment in time a. Components i. Assets ii. Liabilities iii. Shareholders Equity Liability + Equity = Assets 5 b. Assets - What the co has Current Assets - Cash and short term investments (b/c cash very soon) Accounts receviable - trade debt that other people owe you Inventory - goods hold for sale Rent, buildings, equipment c. Liabilities - what the co owes to others Current liabilities - co have to pay less than year Accounts payable - Received but not paid yet d. Stockholder's Equity - Corporation's net worth, amount asets > liabilities Authorized shares = Auth no of shares in charter Issued shares = already sold and received money Treasury shares = shares issued and repurchased by co (owned by co) no rights: no voting, no dividends Outstanding shares = Issued and not owned by co Treasury shares + Outstanding shares = Issued shares i. Stated Capital (Capital Stock) = Par Value x No. Shrs Issued & outst ii. Capital Suplus (Capital in excess of par value, paid-in surplus) = Stated Capital - Real Value in Market iii. Accumulated Retained Earnings (Earnings Surplus) = Accumulated Profits - Accumulated Dividends iv. Debit treasury stock for cost of purchase 6. Credit Priority - Debt has priority over equity a. Co dissolved or liquidatied - Co's assets first to repay creditors then shareholders b. General rule - All debt has equal priority Pro Rata - Each creditor receives a fraction of the amt of debt owed to her = (Debt owed to her / Total debt owed by co) x Total assets held by co Exceptions i. Federal bankruptcy cases - cetain claases of debt (i.e. unpaid taxes) ii. Secured Debt - secured by certain assets (collateral) a. Collateral used first to pay off secured debt Remainder distributed pro rata among unsecured debt b. If Collateral not suff to pay secured debt in full Unpaid portion of secured treated as unsecured debt = receive pro rata portion of assets not constitute collateral iii. Subordination - holders of subordinated debt subordinte their right to be repaid to the right of the holders of senior debt to be repaid First, figure out pro rata absent subordination Then, Adjust for subordination (only to extent rec pay b/c subord) Want more collateral than debt b/c value of collateral & debt could change a. If you are senior, you want more subord so they pay you b. If you are subord, you want more subordinated debt b/c share of the burden to pay to senior is distributed amongst the subordinated debtors Ex: 7. Capital Structure and Leverage 6 a. Capital Structure = liability + shareholders equity More debt, more highly leveraged co is b. Leverage has 2 effects i. Increases riskiness of equity ii. Increases expected rate of return on equity if expected rate of return on assets exceeds interest rate PART I: LIMITED LIABILITY AND THE RIGHTS OF CREDITORS I. Limited Liability A. Limited liability - shareholders protected, by permit shareholders to shift some of risk of business failure to bondholders - Creditors, rather than shareholders will control the business over a broader range or circumstances in which it performs poorly . Easterbrook & Fischel - Rationale of Limited Liability a. Agency Costs outweighed by separation of investment and management - Division of labor, managerial skills & provision of capital (and the bearing of risk) - Costs of separation of investment and management - possibility that the agent will act in her own best interest instead of other's interest - Diversified investor more willing bear the risk b. Decreases need to monitor - investors' potential losses limied to amt of their investment, and no additional liability if shareholder greater wealth - Reduce costs of monitoring managers, other shareholders c. Allows more efficient diversification - Investors can minimize risk by owning diversified portfolio of assets - Firms can raise capital at lower costs /c investors need not bear nondiv risk 2. Hansmann & Kraakman - Limited Shareholder Liability for Corporate Torts a. Excessive risk-taking by permit corp to avoid full costs of their activities b. limited liability permits cost externalization c. Closely held corp - creates incentive for excessive invest & incentive to minimize investment in order to reduce the exposure of the firm's owner to tort damages d. Publicy-traded corp i. potential tort liability may not exceed firm's assets & may not be fully insurable at any premium ii. proposes a Information-based rule - pro rata shareholder liability for any excess tort damages that the firm's estate fails to satisfy II. Agency Costs A. Agency Costs of Debt - undesirable consequences if agents (directors) do not fully take into account the interest of all their principals (creditors) b/c shareholders elect directors 1. Three kinds of costs i. cost of inefficient actions - actions by cos which are are in interests of shareholders, but not in the combined interest of shareholders and creditors ii. costs of designing contracts or laws to prevent this from happening iii. costs of monitoring Limited liability ->Shareholders are willing to take excessive risk because if things turn out well, shareholders gain a lot, if not creditors lose more 7 Ex: III. Dividend Tests in Corporation Statutes A. Creditor Protection Theme: Creditors hurt by funneling assets from co to sharehold 1. Contractual a. Capitalization Requmnt - a min fund of corp assets to satisfy creditors' claims b. State statures - restrict dividend payments to shareholders if firm near insolvency 2. Legal Doctrines a. General fraudulent conveyance law 3. Equitable Doctrines a. Equitable subordination - circumstances in which insiders' debts are subordinated to outiders' debts in bankruptcy b. Veil Piercing Doctrine - circumstances where court will set aside the entity status of corporations and permit crditors to hold hareholders directly B. Divident Tests in Corporation Statutes 1. Paying dividends can benefit shareholders and harm creditors Dividend limitations to protect creditors, reduce agency costs of debt 2. DGCL § 170(a) - Dirs may declare and pay dividends upon shrs of capital stock out of a. Surplus b. Net profits for fiscal year c. Net profits from last year d. (b+c) Surplus = Net assets - Stated Capital Net assets = Total assets - total liabilities = Sh Equity Sh Equity = Retained Earnings + Capital Surplus + Stated capital Surplus = Shareholder Equity - Stated capital = Retained Earnings + Capital Surplus 3. Increase amount available for dividends by Increase surplus a. Reducing stated capital - DGCL §244 i. by "retiring" treasury stock - DGCL §243 ii. by amending charter to reduce par value - DGCL §242(a)(3) c. Revalue assets at their mkt value rather than at accounting "book" value C. Dividend test - not enough protection b/c - can pay out a lot under test - constraint of test - test manipulative by co (decr par value, retire stock) - turn on arbitrary figure- *par value of stock - no practical relevance otherwise IV. Fraudulent Conveyance Law - restraint the law imposes upon debtors for the benefit of creditors by giving creditors the power to void transactions (Reqmt: Debtor co insolvent) A. Void any transfer made or obligation incurred for purpose of delaying, hindering, defrauding creditor - dilute other creditors of pro rata share of payments when incur additional obligations 8 1. Uniform Fraudulent Conveyance Law - state laws 2. Bankruptcy Code §548 - fed law B. Leveraged Buyout (LBO) 1. Permit an acquirer to to borrow, using the corporation's assets as collateral, a sum large enuf to repurchase all of the corp's publicly-held stock a large premium a. debt incurred to finance the deal (Debt-equity ratio 5:1) - More Leveraged b. old public shareholders receive enormous premium for their shares 2. Unsecured pre-LBO creditors of the corp - their relatively secure debt became, over night, insecure debt 3. When companies that underwent LBOs subsequently failed, pre-LBO creditors claim that LBO amounted to a fraudulent conveyance - that should've screened deals to prevent transactions with high probability of subseq ending in bankruptcy C. US v. Gleneagles Inv. Co 1. If GA owns all stock of RC and RC owns all sock of BC, GA has no other assets,and RC has other assets val $3mil and BC has other assets val $5mil 2. ITT loan money to RC and BC, which have real assets, will be repaid more 3. Structural subordination - Worse to be creditor of parent than sub, ITT better off a. Secured (else get pro rata share) b. Closer to assets rather than farther from 4. Penn Uniform Fraud Convey Act §354 - To prevail, creditors π have to show a. no fair consideration (good faith & reasonably equivalent value) b. insolvent after transfer completed (financial status of transferor) 5. Penn Uniform Fraud Convey Act §355 (easier standard to meet than §354) a. no fair consideration b. unreasonably small capital (prop remaining in trsfor's poss after convey) 6. Uniform Fraudulent Transfer Act - Transfer voidable if a. §4(a) - No reas equiv value - Present and Future Creditors - only apply to people who engaged in business b. §5(b) - No reas equ value & debtor insolvent - Present Creditors D. Baird & Jackson - Limits of fraudulent conveyance 1. Principle - Creditors should be able to set aside transfers by insolvent debtors that harm the creditors as a group 2. Creditors rely upon existing legal rules and K to limit unwarranted risk by debtor 3. But, might counter to interests of those creditors who, before the fact, would have wanted the debtor to have the power to enter into such transactions 4. K for protection easier than Kout of protection (co have to K out w/ all creditors) 5. Not realistic for creds to exercise so much foresight, esp. sm; lg become secured V. Preferences can be set aside for benefit of creditors (Debtor corp need to be insolvent) - void ability of debtor to pick and choose favorite unsecured creditor to pay in full, others get nothing, when should be pro rata A. Bankruptcy Code §547(b) Trustee may avoid any 1. Transfer of property of the debtor (Transfers only; Fraud Convey 2. To or For Benefit of Creditor 3. for Antecedent debt 4. made while debtor Insolvent 5. within 90 days (non-insider) or 1 year (insider) of filing of petition, commencement of bankruptcy case 9 6. enabling creditor to receive more than entitled to receive in Chapter 7 B. Three Exceptions 1. Contemporaneous Exchange 2. Payment in Ordinary Course of Business 3. New Value VI. Equitable Subordination A. Principle 1. Permits bankruptcy cts to set aside the claims of shareholders or other insiders against a bankrupt corporation until the claims of outside creditors are satisfied 2. Insider must have behaved unfairly or wrongly toward the corporation and its creditors (i.e. Clark - cases turn on a finding of "fraudulent conduct by the insider, mismanagement of the insolvent corporation, or inadequate capitalization) B. Costello v. Fazio - Grant motion to subordinate the claims of insiders 1. Creditors (copartners b/f inc) claims against bankrupt estate. Trustee objected to claims and moved for an order subordinating them to claims of gen unsecured creditors. 2. At time of incorporation, capitalization was inadequate and by copartners saving promissory notes owedto them by business, acted for personal benefit, detriment of co 3. Not need fraud-Inequitable conduct by fiduciaries when corp assumed liab of p VII. Piercing the Veil - most frequently invoked, more radical than equitable subordination A. Principle 1. The equitable power of the court to set aside the entity status of the corporation to hold its hareholders liable directly on contract or tort obligaitons 2.. Cts agree Veil piercing should be done sparingly (vague guidelines, like eq sub) 3. Factors a. disregard of corporate formalities b. thin capitalizatoon - alone not enuf, even for equitable subordination c. small number of shareholder d. active involvement by shareholders in management B. Zaist v. Olson - Lowendahl test - requires defendant shareholder complete domination of corporate policy used to commit a fraud or "wrong" that proximately causes plaintiff's injury - Ct found veil piercing b/c not really a sep legal entity-corp not try profit C. Walkovsky v. Carlton - Tort creditors of thinly capitalized coporations difer from contract creditors b/c can't negotiate with a corporate tortfeasor ex ante for contractual protections or compensation fo bearing risk. (Taxicab - Court did not find veil peircing b/c no fraud) VIII. Contractual Creditor Protection A. Creditors regularly demand greater protection than offer by general common L doctrines B. Examples - contain covenants detailing such protection 1. Bank credit agreements 2. Indentures - agreements under which bonds are issued C. Palco Indenture - Restricted payments - P creditors limit push money to Palco SH 1. Palco pay dividends to shareholders 2. Subsidiary (maj of stock owned by Palco) buy Palco stock \ P stock value incr 3. Palco (= shareholder of subsidiary) buy Palco stock / no val to creditors (If subsidiary pay dividend - pay to Palco, not to shareholder of Palco) 10 May make RP if a. make profits - Consolidated Adjusted Net Income (P & sub) b. if additional equity - proceeds from sale of stock, issue 11 Part II: Management's Powers and Duties I. Centralized Management and the Business Judgment Rule A. Principle-Corporation's internal relationsip among shareholders, directors, and officers B. Manson v. Curtis - Corp code - Bd of dir manage co for public co, elected by maj share C. Agency Cost of Equity - Instead of acting in the best interest of shareholders, the managers may pursue their own personal interests D. The Business Judgement Rule, Fiduciary Duties, and Shareholder Suits BJR - Presume dir not violate Duty of Care or Duty of Loyalty 3 requirements - informed, independent, disinterested -> Rebuttable presumption Self-dealing transaction at fair price -> rebut presumption (but no breach of loyalty) Breach of duty of care -> Burden show lack of damages shift to directors If there are damages -> breach of a duty - Fall under BJR -> Ct not second guess i.e. Arms length, all cash merger proposal -> BJR (Van Gorkom -> rebutted b/c Bd not informed) - Not fall under -> Ct second guess, not nec different guess, just more indep look (shift burden of issue of damages) Unocal - Ct semi-indep look at dirs - Pick right test if not fall under: (i) Freeze-out; (ii) Hostile t.o.; (iii) Demand futile i.e. Freeze-out - Presumption is rebutted -> Entire fairness test B on dir show fair price/dealing (Weinberger - not always get more remedies) Sinclair - Fair dealing not an issue b/c completely dominated subsidiary, only issue was fair price - High burden on person engaged in fair dealing In ord self-dealing cases - show fair price enough (§144(a)(3) - trans fair) Other cases - If satisfy high burden of proof of fair price -> What are damages? i.e. Freeze-out merger - harder - Fair dealing more prominent i.e. If Committee of indep dir -> lesser or no burden of fair price -> shift burden back onto sh to show price unfair Marciano - if not get approval -> burden on D est fairness Gen, rebut presumption -> init B on dir, not need show both self-deal & unfairness 1. Insulates the board of directors from shareholder suits Broad set of circumstances in which courts will refuse to second-guess decisions by the board of directors Only if BJR not apply, will cts examine actions of dirs more closely to det br fid 2. BJR - Rebuttable presumption that directors are better equipped than the courts to make business judgments and that the directors acted without self-dealing or personal interest and exercised reasonable diligence and acted with good faith 3. Stockholders' derviative action challenging the fairness of a trans approved by a majority of directors of a corporation, to claim benefit of BJR, a director must be a. disinterested Duty of Loyalty b. independent " c. informed Duty of Care (Gries Sports Enterprises v. Cleveland Browns) Once presumption is removed, court must then inquire into fairness of dir's dec 12 4. Kamin v. Amercian Express Company a. Co paid in-kind dividend (AmEx paid stock of DLJ) b. Ct did not find br of duty b/c not self int, (d) good faith, considered-mtg Duty of care - Gross Negligence (Purely process-based duty) Duty of Loyalty - Self Interest 5. Dooley & Veasey - The Role of the Board in Governance a. BJR preserves the statutory scheme of centralizing authority in the board of directors. b. BJR preserves the value of centralized decisionmaking for the stockholders and protects them against unwarrnated inereference in that process by on of their number II. The Duty of Care - Prudent person act in informed basis - gross negligence standard Hard to recover from breach of D of care b/c (i) B of proof of damages (ii) Stat elim pers liab dir A. Principle - Requisite standard of due care (degree of negl must avoid) to escape liability B. Graham v. Allis-Chalmers Manufacturing Co. 1. Claim - Bd of Dir should have found out that employees violate Fed Antitrust L 2. Ct did not find breach duty of care b/c Bd dir went through process, mtg 1/mo Duty of care - have to show went through a minimal process P seldom win on breach of duty of care - Purely process-based Duty C. Smith v. Van Gorkom 1. Merger and acquisition decison of board 2. Ct: Certain decisions, when deal with sale of whole co, require more process 3. BJR is a presumption tht in making a business decision, the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interest of the company (Aronson v. Lewis) 4. Gross negligence standard - BJ reach by Bd of dir informed? (Duty of care) 5. Ct: Dir breach of fid duty to stockholders b/c a. failed to inform themselves of all info reas avail to decide on merger b. failed to disclose all matl info a reas SH would consider import decide No discussion about price, time pressure, did not consult outside opinion, indep dir D. Director Liability Statutes - 41 states adopted statutes limiting the liability of directors for breach of duty of care DGCL §102(b)(7) - Certificate of Incorporation shall set forth a provision eliminating or limiting the personal liability for monetary damages (can injunction) of a director to corp or stockholders for breach of fiduciary duty as director, but not for (i) breach of duty of loyalty; (ii) bad faith; (iii) self-interest III. The Duty of Loyalty - Not to act contrary to interest of sh; disinterested manner A. Principle - Corporate officers and directors (as well as controlling shareholders) must not exercise their discretion over corporate policy to benefit themselves at the expense of their co-investors Loyalty to who? 1. DE - to shareholders 2. 25 states - Constituency amendments - employees, creditors, & community also THREE TYPES OF CONFLICTS: 1. Self-dealing - direct financial incentive 13 - §144, Marciano (ftnt - if comply with approval by disinterested dir,take out of judicial rev completely), Fleigler (even if comply with elem of approval, fairness always) - BJR not applicable - not sure whether ct will look into fairness if adequate disclosure - Always look at fairness if no disclosure 2. Corp Opp - Line of business, Fairness Test, ALI §5.05 3. Exec Comp - not gonna look behind fairness, BJR not apply, more deferential to bd approval B. The Self-Dealing Paradigm §144 - Self-Dealing in DE - compliance w/ not nec mean OK, noncompliance w/ not nec mean not OK Escape route of full disclosure - approval of disint only OK if full disclosure Fairness -> Full disclosure (Van Gorkom, Weinberger - lack of full discl) If get approval by disint & its fair -> Ct not look further Fleigler - comply w/ §144 not nec mean ct will not do anything Lynch v. Kahn - Freeze-out merger subject to §144 Ct: Just b/c approval by disint not mean BJR, just mean shift B of fairness Willingness of ct if want, to go beyond §144 1. 45 states adopted statutes on self-dealing trans b/w dir and corp-Safe Harbor Stat DE - more permissive approach toward self-dealing DGCL §144 - Self-dealing transaction not voidable "solely" because it involves a conflict of interest, if it is (1) adequately disclosed and approved by a majority vote of disinterested directors or (2) shareholders, or (3) is fair (fair price) 2. 6 of 45 states, CA, expressly call for judicial review of substantive fairnes of an interested transaction, even after the transaction approved by disintered dir 3. RMBCA §8.60-8.63 more permissive; ALI §5.02 more hostile tow self-dealing 4. None of safe-harbor statutes can insulate a transaction that constitute corp waste 5. Fleigler v. Lawrence - Ct appl 2tier analysis:(i) §144 (ii)intrinsic fairness test Even if comply with elem of approval, fairness always 6. Marciano v. Nakash - Ct found self-dealing and conflict of interest Conflict of interest means financial conflict of interest (i.e. Andrea CEO make charitable contrib to Met Opera if she on Opera Bd of Trustee, not self-dealing) a. Nakash did not fulfill §144(a)(3) requirement because no approval of transaction b. Nakash did fulfill intrinsic fairness test - Burden on D to establish fairness Ct: OK, if fair, not need approval of directors (footnote - If meets §144(a)(1) (ratified by disint dir) or §144(a)(2) (ratified by disint sh), enuf - BJR invoked and limits judicial review to issues of gift or waste) 7. Eisenberg - Self-Interested Transactions in Corporate Law ALI §5.02 - Conjuntive test - if meet a, shifts burden of proof of b to complainant a. Dir must make full disclosure concerning conflict of int to corp dec maker b. Trans must be fair to the corp C. The Corporate Opportunity Doctrine 1. Corporate opportunity doctrine one-step removed from Self-dealing Once transaction determined to be a corp opp and dir take it = self-dealing 2. Principle - When a director or senior officer can appropriate a business opportunity on her own account that might arguably "belong" to the corporation 14 3. When an opportunity should be deemed to be "corporate" rather than personal, hence presumptively off limits to the corporation's top management 4. Tests are murky a. "Line of business" test: suff related to firm's existing line of business b. "Fairness" test -factors i. how mgr learned of disputed opportuity ii. whether he used corp assets in exploiting the opp iii. good faith and loyalty to the corp c. (a + b) 5. Kerrigan v. Unity Savings Assn. a. Unity make mortgage loans, inside dir form Plaza form insur bus Ct: Closely-relate bus, not disclose bus opp to sh, not ratified - for P b. ALI §5.05 - Fairness, disclosure, ratification D. The Duty of Loyalty of Controlling Shareholders 1. Principle - Fiduciary duties owned by a conrtolling shareholder Disclosure, approval or ratification by ind dir or sh not work as well here 2. Sinclair Oil Corp. v. Levien Sinclair own 97% of Sinven = controlling sh (Sinclair) owe fid duty to minority Min sh: Sinclair caused Sinven to pay out such excessive dividends, dissolution Dir of Sinven dependent on Sinclair, so no indep dir to validate self-dealing trans Sinven is not Disinterested b/c not independent of anybody with interest, Sinclair a. Self-dealing trans - no, div payments OK w/ DGCL §170 - motive unimp b. Corp Opp claim - no opp came to Sinven b/c of practice, policy, expectat c. Breach of K claim - yes, Sinclair's act of King with sub was self-dealing Sinclair failed to meet burden of inrins fair to min shareholders 3. If self-dealing, corp opp, BJR not apply, ct have to do more - fair, approved? 4. ALI §5.12 - Controlling sh Bproof that take corp opp fair to corp if not auth, rat IV. Executive Compensation - Golden parachutes - poison-pill, anti-takeover device A. Solomon - Issues 1. Approval 2. Consideraion 3. Self-dealing 4. Waste B. Graef Crystal scrutiny of CEO pay, shareholder's witness 1. SEC should tighen up disclosure on exec pay, esp stock options (PV) 2. Should independent compensation committee 3. Shareholder proposals, SEC 14-a-8: But "ordinary bus", so not include in proxy C. Golden parachutes - K reward executives after a hostile takeover (entrench managers) 1. State Law - If approved by disinterested directors, outside or "independent" dir good, then BJR, unless waste 2. New SEC Rules - Extensive disclosure requirements exec pay D. Cts apply different law for executive compensation that regular self-dealing transactions Ct not want to make bus judgment, give deference to disint dir. Self-dealing always have waste, but very narrow unless grossly waste. E. Golden Parachute 1. Effective date triggered by change of control 2. Before effective date, employment at will, after, no longer 15 3. Once effect date, hard to fire for cause, exec can quit for good reason - exec BJR 4. If term w/o cause day after change of control, generous pkg to exec 5. If executive terminated prior to effective date & reasonably demonsrate that term was try change in control -> effect date = date prior to termination F. When announce golden parach, stock price inc b/c signal that mgmt anticipate takeover Jensen & Zimmerman semi-strong EMH - stock price go up for reason, not random V. Shareholder Suits A. Principle - most important legal mechanism for enforcing fiduciary duties Derivative suit - Set of legal claims of corp against officers and dirs, only state L Breach of fiduciary duty owed to corp -> corp is damaged. (Allis Chalmers D Care) NOT derivative suit 1. Fed securities law, Fed L: claim = sh, not co 2. Anything when try get something for self instead of for co (Blasius - infringe MY voting rights, Marriot - Preferred Stockholder bring suit) 3. Any suit after co no longer exists (i.e. After freeze-out merger b/c no longer shareholder of co and not seek recovery to co, but for self, B. If co violates fiduciary duty, you can sue mgrs or sue corp 1. Shareholder class actions - direct actions against officers and directors (or corp) (i.e. you, sh not get dividends or all NY sh not get dividends) 2. Derivative suits - actions against officers and directors (or third parties) brought on behalf of corp (directly or indirectly as owners of corp, recovery -> corp) C. Derivative suits most common, b/c breaches of fid duty during normal op of corp = injuries to the corp. Shareholder class actions allege violations of disclosure reqmts of securities act common D. Derivative suit - Three functional elements 1. Standing requirements 2. Set of rules allocating the costs and benefits of suit (collective action prob in enforcing mgmt's fiduciary obligations) If inc corp val, ben > costs 3. Set of procedural screens or filters that can block may otherwise viable der suits a. demand requirement - business interests of corp b. corp's rt to org special litigation committee of disinterested directors Both are largely judicial constructs. FRCP 23.1 E. Demand requirement - focus on bus interests of corporation - 2 ways Bring a. Demand futile - First try Aronson and not make a demand b. Demand and wrongfully rejected F. Special Litigation Committee - auth of bd dir to control co own course of action Ct may dismiss a derivative suit upon motion of special commitee of disint dir G. Zapata Corp v. Maldonado 1. Maldonado sue 10 partners fo breach of fiduciary duty, at that time, no disint dir 2. Four years later, 4 new dir, not dependent on lawsuit, create spec litigation com a. find suit not in best bus int of co b. motion to court to dismiss the suit 3. Shareholders claim demand futile a. Once demand futile, fact that bd directors disinterested bear on degree of deference ct give to decision Ct: Bd always have power, not question of power, but member disqual (NY Ct applies BJR, but lot of claims with merit may not be allowed) 16 b. Zapata test - (If Bd appt Spec Lit Com power get rid of litigation) (BJR: Duty of care & loyalty) 1. Comm must satisfy burden of show indep, good faith, reas invest OPTIONAL 2. Ct discretion whether apply its own business judgment c. Reasons less deference than in executive compensation b/c 1. Derivative suit, ct impose more judgment b/c relate merits of suit 2. Let sh suit go forward, if real strike suit, then not win b/c deference filtered on substantive level 3. Disinterested directors may not act in disinterested manner d. Step 1 - Independent and good faith of committee and basis for conclus Step 2 - Ct may consider to see if sufficient lack of independence 1. best interest of corporation 2. public policy - will only create more suits, not less suits High likelihood, low recovery suits will go forward (misconduct clear, costs > amt recover) - deterrence against misconduct 4. Steps a. Validly institute derivative action by 1. Demand futility - Never make a demand (Aronson test) 2. Demand wrongfully denied - Make a demand & denied wrongly Once you make a demand, means they are disinterested. BJR decision to not go forward not made in informed manner, similar duty of care, very process-oriented, (you make demand, Bd make a committee, appt special counsel, decide no merits, enuf, hard to show a breach b. Co. appoint a Special Litigation Committee §141(c) (* may not be indep c. Zapata test Ct: pragmatic) H. Aronson v. Lewis - Demand not futile (First always try Aronson, not make demand) 1. Derivative suit v. Meyers and inside directors for waste in approve employment K with Fink, old age who can'g perform services 2. Demand Futile b/c all dir - D, Fink selected, dominated, & control dir, all dir approved trans (Not ask directors lead charge against challenged trans) 3. Issue: When is demand futile, so excused from make demand? (P burden prove futile) Pass Aronson -> Zapata Aronson 2-prong test Duty of Loyalty issues - What counts disint, indep (Duty of Loyalty) either a. Directors Independent and Disinterested (maj - at pt litigation instituted) π have to allege specific facts to create reasonable doubt or b. Underlying transaction passes under BJR (dir indep, disint) Reasonable doubt as to breach of duty of care, loyalty, waste 4. Ct: Though committee has instituted and recommended dismissal, ct not respect judgment of that committee, demand not futile I. Proposals for Reform - RMBCA §§7.42-7.44, ALI Princ Corp Gov §§7.03, 7.08, 7.10 J. Romano - Shareholder litigation weak, ineffective instrument of coporate governance b/c 1. Few suits, often settle, minimal amts 2. Top mgmt turn over frequently in sued firms, but not have to pay fin penalties 3. No specific deterrence 4. Firms sued for br duty loyalty not have lower inside ownership 5. Need large no of suits in order to obtain a ruling 17 PART III: THE VOTING SYSTEM - Public Corporations and the Voting System I. Corporate Voting and the Collective Action Problem A. Voting - usually there is no counter-proposal to the recommendation of the directors Automatic approval does not occur when 1. Low level contest under Rule 14a-8 2. Full-fleged opposition - Proxy - granting of the right to vote to another Fundamental aspects of voting 1. Annual Metting 2. Special Meeting 3. Written consent - shareholders sign petition What do you vote on 1. Election of directors 2. Major changes, mergers 3. Removal 4. Charter amendments 5. Sale / liquidation of mot of assets 6. Resolutions What do you need to win a vote 1. Does charter have special provisions on that? 2. For election of directors - plurality of votes cast if at meeting 3. Majority of shars entitled to vote 4. The elction of directors by written consent - assume all shareholders entitled to vote, do vote, need majority Who votes - Record owner of a share - owns shars on record date entitled to vote on records of corporation (Real owners are beneficial owners) B. Management of the public corporation 1. Bd directors retains legal power to "manage" the corporation 2. Shareholders exercise their ownership powers only indirctly, thru elect directors, except when bd propose radical change (i.e. merger or dissolution) or spec request sh ratify C. Cost of meaningful collective action 1. Sec Exch Act §14(a) - increase democracy among passive sh of diffusely-held co 2. SEC proxy rules to encourage informed shareholder electorates, able to vote knowledgeably in corp elections - lower cost org costs of large investors 3. Many accept collective action problem as insurmountable and rely on market controls over the ciscretion of corp mgrs 4. New shareholder's rights movement, led by public pension funds emerged 5. Tho collective action costs large, still not large enuf to prevent shateholders from monitoring mangerial performance - legal constraints, payoffs to sh, sh activism D. Clark 1. When votes are cast a. Annual meetings i. Corporations are required to hold annual meetings ii. Vote for election of directors or oher matters iii. Notice and quorum requirements must be met b. Special meetings 18 i. Held episodically ii. May be called by the Bd of directors or indiv auth in articles or bylaws iii. Notice and quorum requirements must be met c. Written consent i. Allow action by shareholders by written consents from spec prop of sh (i.e. those holding more than 50 percent of the shares) ii. Many corps have adopted bylaw or charter provisions that preclude shareholder action by means of written consents 2. Public corps - widespread ownership and freely transferable ownership interests a. Record date - Those registered as shareholders 'of record" on a date, often set by bylaws, entitled to vote at particular upcoming shareholder meeting b. Street name ownership - Brokerage firm becomes equitable owner of an interest of shares c. Proxy voting - Shareholders cannot be expected to attend sh meetings in person in order to cast their votes, so they sign proxies authorizing specified other persons, often mangement, to vote their shares in a specified way E. Easterbrook & Fischel 1. Voting in Corporate Law a. Corporation - web of contractual arrangements - investors contribute capital, managers entrepeneurial skils, engineers their distinctive skills b. Fiducicary principle - requires actors to behave in the way they would have agreed to do by contract c. Voting - make all decisions not otherwise provided by contract Rules One share one vote, preferred shares, bonds rarely have vote, unless fin difficulty publicly-held corp, ususally not cumulative voting Shareholders select board of directors, who choose managers Shareholders vote by proxy, not in person, and elect the slate of candidates proposed by the incumbents Quorum is half of available votes Investors may not sell the vote independent of the instrument Close copr - Voting trusts, irrevocable proxy where sev sh convey sh to trustee who vote as a bloc according to instructions State statutes require votes on fundamental transactions (mergers, sale of all assets) Fundamental Corporate Changes When extraordinary action - fundamental coporate changes - need sh approval Reduction of agency costs explains sh voting on fundamental corp changes b/c sh, as residual claimants, have most to lose or gain as result of fund corp changes Poss of large gain/loss in these large trans suff to overcome collect act problem make voting on ordinary bus decisions meaningless Shareholders are passive financial investors who lack expertise and incentive to make business decisions Uninformed shareholders prefer to delegate major bus decisions to managers Charter Amendments Shareholder approval commonly required Shareholder's Voting When it is not Required Stock option plans, selection of independent auditor, mergers where no vote required by law, manageres still submit to shareholders 19 B/c shareholder's approval of a trans decreases prob of successful judicial attack Net benefitl of legal rules encouraging shareholders' approval of certain trans 2. Collective Action problem When many are entitled to vote, none of voters expect his vote to decide the contest None of the voters has the appropriate incentive at the margin to study the firm's affairs and vote intelligently a. Federal Regulation of the Proxy Materials 1. Firms have incentives to adopt certain voting procedures - vote on cerain types of issues, disclose certain types of info when votes are taken = optimal allocation of resources on voting procedures 2. Imbalance - separation of ownership and control whereby omnipotent mgrs could , thru control over proxy machinery, perpetuate themselves in office inefinitely wiht no fear of disciplin from impotent shareholders 3. §14 of Exchange Act - Guarantee shareholders a meaningful right to have a voice in the management of their property 4. The behaviorial assumptions of the Proxy Rules - shareholders demand more information about corporate matters than managers provide voluntarily and desire to be more involved in setting corporate policy than allowed under state law. Easy avail exit option thru stock mkt, rational strategy for dissatisfied sh, b/c collective action prob, is to disinvest rather than incur costs in attempting to bring about change thru votng process F. Clark - The Rational Apathy Problem 1. Aggregate costs to sh of informing themselves of potential corporate actions, independently assess wisdom of actions, and casting votes, often exceed expected or actual benefits of informed voting. 2. -> Usual rules that entrust corporate managers with all ordinary business decisions II. Federal Regulation: The Proxy Rules A. SEC Proxy Rules - §14A (Proxy = Right to vote) 1. Disclosure requirements 2. Substantive regulation of the process of soliciting proxies (or votes) from shareholders Amended in Oct 92 - at request of institutional investors 3. General antifraud provision (Rule 14a-9) - allows shareholders a private rt of action for misleading proxy material 4. Specialized "town meeting" provision (Rule 14a-8) - permits shareholders to fore a shareholder vote a corporate expense on certain kinds of shareholder resolutions B. Federal Securites Laws 1. Securities Act of 1933 - regulates the issuance of securities 2. Securities Exchange Act of 1934 - reg activities by co other than issuance of sec a. Empower SEC pass rules (Rule 14a-1, -2, -3, ...) b. Regulates the flow of info b/w cos and investors (less, among investors) c. Requires publicly-held cos to file reports about its bus activities a periodic intervals (10-Q quarterly reports, more info on 10-K annual reports, Sched 14A - actual discl reqmts) d. Additional disclosure requirements in special circumstances e. General antifraud provision prohibiting "false or misleading" statements in conn w/ B/S securiities (Rule 10b-5) 3. Regulation 14A a. Solicitations 20 - Rule 14a-3 - can't solicitation until proxy statement filed - Rule 14a-1(L)(1)(iii) - Solcitiation - any communication to securities holders reas calc result in proxy to anyone (Rule 14a-1(L)(2) - exceptions) b. Exempt from 14a-3 i. Exceptions - not subject to filing requirements - Rule 14a-2(b)(2) - solicit 10 or less people, not subject to 14a-3 - 14a-6 filing requiremnt, still subject to 14a-9 - "false or misleading" statements (If not solict, not subject at all) - Rule 14a-2(b)(1) - (92 amend) - If solicitation does not seekyourself , directly or indirectly, power to act as proxy for security holder, OK (Exceptions - (i)-(x) (i)-(ix) and (x) - Agency: Any person act on behalf of (i)-(ix) (i.e. nominees)) Not subject of 14a-9 as well as filing reqmt ii. Elections can delay - Rule 14a-11(b) - Solicitations prior to furnishing required written proxy statements (1) - No proxy sent prior to ttiem written proxy requred by 14a-3(a) (2) - Identification of participants in solicitation (3) - Written proxy sent to security holders earliest practicable date (Just give you time but eventually have to file proxy statements only want do than when deided want full-fledged proxy contest - Want go as far as can b/f decide) c. What access does TarPERS have to NLS shareholder list?Use §220,not 14a-7 - Rule 14a-7 - company's choice either (i) get info let sh do the mailing; (iii) co mail proxy materials on behalf of TarPERS - co more control - can delay send info out, see b/f everyone - Rule 14a-7(c)(2) - Have to tell NLS (registrant) what proxy about - get paid for your efforts - DGCL §220 - Just need proper purpose - Reasonably related to person's interest as record stockholder (on record of corp) (Beneficial owner can always become recrd owner) Can always get the list d. Steps 1. If no solicitation, not need worry about 14a-9 - Antifraud provision and filing, sending 2. If start solicit - 2 exceptions under 14a-2)b) a. 10 or less, except anti-fraude (14a-2(b)(2)) b. 14a-2(b)(1) - Not seek power act as proxy, just discuss join action, but indiv action. Need agency relationship "act on behalf" (i.e. Sipi can seek proxy on TaPERS behalf, OK b/c not own behalf; Cuomo's campaign mgr -> Yes, "on behalf") 3. Election contest - Minimal disclosure requirements - Require file proxy statment at earliest date (14a-11 - Special exception for proxy contest) 4. Comply with 14a-3 - Furnish proxy b/f solicit, send to sh, SEC (14a-6 - Filing reqmts) III. The PsI-Ipalco Proxy Contest (I) IV. Rule 14a-9 - Antifraud provision applicable to proxy solictiations. §14(a) Implied Private right of action (Borak) A. Rule prohibits "false or misleading" statements of "material fact" in proxy solicitations B. Virginia Bankshares, Inc. v. Sandberg (Sup Ct - 1991) 1. Facts - FABI own 100% of VBI; VBI own 85% of Bank 21 - VBI want Freeze-out merger - Frozen out for cash at certain price for 15% of Bank - FABI hire Ibank price $42 - DE: maj of all eligible votes; VA: need 2/3 of all eligible votes - VBI solicit proxies to approval of merger, but 85% > 2/3 Why bother? - (i) Want friendly merger, (ii) afraid state L invalidate 2. Cause of action - Violate 14a-9 "false and misleading" statement - "Price $42 high" Jury: violate -> Sup Ct 3. Issues a. Materiality - stubstantial likelihood rash shareholder consider it important b. Fact - (What dir believe = fact?) Really motivate shareholder vote b/c reas believe price high. Disbelief or undisclosed motivation, standing alone, inuff to satisfy Fact. Need proof statement asserted something false about its subject matter (i.e. value of the shares) c. False - (i) High price not true motivation for merger (belief fase) (ii) Price wasn't high (fact false) d. Causation - Mills - Proxy solicitation must be essential link for merger (reject actual causation - i.e. need 666,667 of 1 mil shs voting, VBI own 666,666 -> Need 1 vote = Actual) Behavioral assumption that all min votes were influenced by misleading statement in proxy i. Voting causation - if on own not have sufficient votes to pass what want to pass under state L or merger requre more votes (Bankshares poss arg voting causation exist if controlling shareholder himslef was defrauded (i.e untrue statements he not aware - dissent) Here, didn't need votes of Bank minority shareholders ii. Non-voting causation - Virginia Bankshares - open to whether exist or not? Some lower courts accepted that - If loss state law remedy as result of misrepresentation (i.e. Appraisals rights - must have them to lose it; injunctive relief) (Virginia Banks, stock market exception not have appraisal rights to lose NOTE: Hard to show loss of state law remedy (i.e. Weinberger - loss appraisal rights -> but gave Weinberger remedy -> not sure loss state law - so change 1 type of state law remedy for another. Arg: loss state law remedy not suff when gained equivalent remedy) - Better to bring Weinberger remedy than loss of state L remedy - But, Fed L case - jury trial - might be more sympathetic to case, in assess damages b/c already paint D unsympathetic light - lie in proxy statement, and state L - no jury in DE, all corp cases Chanc Ct judge -> Sup Ct. DE very pro-management Nonvoting Causation Theories: (i) Causation would turn on inferences about what the corporate directors would have thought and done w/o the minority sh approval unneeded to authorize action -> Speculative (Blue Chip Stamps, Mills not like speculative claims) (ii) §14(a) should provide a federal remedy whenever a false or misleading proxy statement results in the loss under state law of a shareholder plaintiff's state remedy for the enforement of a state right. Ex, when a min sh has been induced by a misleading proxy statement to forfeit a state-law right to an (1) appraisal remedy by voting to approve a transaction or when a sh has been eterrred from obtain (2) injuction of merger by proxy solicitation. -> No loss of state law remedy.(Va banks dont' get appraisal rts.) Sh ratify void unless full disclosure (Van Gorkom) (3) Derivative suit (4) Breach duty loyalty Weinberger. 22 4. Ct: no cause of action (Not lose duty of care or loyalty actions) 5. Dissent: Maj might not vote for it; wouldn't go thru if min not vote V. Shareholder Proposals and Rule 14a-8 - more popular now, instituitional investors use A. Shareholder Proposals instead of full-fledged proxy contest 1. Rule 14a-8 - entitles shareholders to force the company to include certain proposals into its proxy materials. i. Identity of the shareholder - Rule 14a-8(a)(1) ii. Proposal to be presented w/in 120 days of annual mtg - Rule 14a-8(3)(i) iii. Number of proposals - Rule 14a-8(a)(4) iv. Length of supporting statement - Rule 14a-8(b) - only 500 words v. Subject matter of proposal - Rule 14a-8(c) - Waste Mgmt want exclude Carpenter proposal b/c EXCEPTIONS (1) Not proper subject for action by shareholders, a proposal that mandates certain action by bd of dir (i.e. To change by-laws), rcommendation of action OK - SEC revise to precatory resolution - Recommendation (2) Violate state law - §216 - Plurality provision, but can be changed by by-laws (§109); §212(a) - 1 share, 1 vote unless otherwise provided in charter (6) Beyond power (8) Relates to election - Only refer to election of specific directors, but can amend for apply to dirs one year from now (9) If proposal is counter to a proposal to be submitted by registrant at meeting. x (10) Moot - Rule 14a-11 has other means for sh to govern composition of Bd dir x (3) false or misleading - Rule 14a-9 vi. Companies can request SEC for No-action Letter to approve omission of the proposal - Rule 14a-8(d) - Send copy to sh proponent & Shareholder opportunity to respond to request 2. Advantages - Shareholders low costs - can advance a proposal for vote by fellow shareholders w/o having to file any matls w/ SEC and w/o having to mail matls to indiv sh, to be voted at annual meeting. 3. Types of Issues i. Corporate social responsibilty issues ii. Corporate governance issues (i.e. Golden par, indep dir, rid poison pill) VI. The PSI-Ipalco Proxy Contest (II) VII. State Law Regulation of the Voting System A. Shareholder Information Rights - Access to sh lists and corp books and records 1. Sadler v. NCR Corporation (NY resident v. MD corp) a. Issue - Sh demand list of record shareholders and list of beneficial owners of shares who do not object to disclosure of their names ("NOBO list") in conn w/ t.o. and solicitation of proxy votes to replace directors (if use 14a-7, co can send for you) b. Facts - Sadlers and AT&T are sh of NCR - AT&T t.o. for all NCR shares - NCR mail offer to NCR sh. Bd reject offer and not redeem p.p. - AT&T solicit NCR sh to convene special mtg to replace maj NCR dir: need 80% - AT&T and Sadlers, acting on AT&T's request NCR for stockholder list (reimbourse) and related matls for communication w/ owners NCR shares - CEDE list - brokerage firms w/ shares in street name and NOBO list - nonobjecting ben owners 23 - NCR refuse produce requested matls - NY Bus Corp Law §1315 - NY resid own shs of foreign corp 6 mos obtain list sh c. Ct: NY law auth production of sh and NOBO lists (co forced to compile list ) b/c charter need 80% entitled voters (supermajority requirement) -> if abstain = vote no B. Reimbursement of Expenses - Corp reimbursement for the proxy costs 1. Bebchuck & Kahan - A Framework for Analyzing Legal Policy Toards Proxy Contest a. Cts largely left decision of whether to reimburse proxy contest expenses to discretion of bd of directors -> Cos gen pay all expenses for reelection of incumbents, but reimburse challengers only if they gain control over bd of dir b. Conditions for Reimbusing Incumbents - In practice, reimbursed for all expenses i. If proxy contest involved a question of policy, rather than personnel ii. Expenses imited to thoe reas in amt and reas nec to inform stockholders c. Conditions for Reimbusing Challengers - No affirmative entitlement to remburse i. Contest over policy ii. Expenses must be reas d. Fed proxy rules - Proxy statement must disclose i. Identity of the persons who will bear the costs of the solicitation ii. If about election of dir - Estimated total cost of solicitation, total expense to date, whether reimbursement will be sought from corp -> if ? submitted to sh vote e. Assessing the rules on Reimbursement of Incumbents (Full compen automatic) i. Full compensation of incumbents undesirable effects a. No costs in defending -> few incentives to withdraw from contest b. Impose too few restraints on spending -> incumbents incur excessive exp ii. Compensation of incumbents should be contingent on achieving a threshold level of success -> favor incumbents who expect outside support or are lg shareholders f. Proxy Contests on issues other than elect directors (i.e. Charter amendments, merger agreements, acquisitions of other cos, liquidation plans, stock repos, recap, exec comp) -> seldom compensated b/c dependent on mercy of gen hostile bd i. Should receive more generous reimbusement than control contests b/c usu initiate issue contests only if believe increases value of the stock C. Inequitable Conduct - manipulation of sh mtgs and bd structure to retain control 1. Schnell v. Chris-Craft a. Sh sue for injunction to prevent mgmt from advance date of annual mtg set by-laws b. Mgmt use Del L - legally to change by-law date - try cut P time avail to wage proxy contest against mgmt and refuse sh list so to perpetuate itself in office c. Del law - sh not have duty anticipate inequitable action by mgmt, Rev deny injunct d. Fiduciary duty only co -> sh, not to tender offerer Analysis under Unocal, not Schnell. Limited sense - have to use powers you have. Can't use in arbitrary way. Power to do not mean right to do. Context of shareholder ex voting rights. 2. Blasius Industries, Inc. v. Atlas Corp. a. Facts - Blasius, 9% shareholder of Atlas, want encourage mgmt of Atlas restructured (13D - disclosed explore obtain control of Atlas) Seek by-law amendment - want immed put own 8 people on theboard Atlas change by-law - so add 2 new dir -> 9 (Charter has limit of 15) b. Ct: Not BJR b/c Action designed principally to interferee w/ effectiveness of a vote inevitably involves a conflict b/w bd and a shareholder majority (i) Voting is basic right; (ii) Allocation of power issue, not issue of mgmt of co -> Strict scrutiny 24 Bd Motive - Wanted to avoid sh vote for recapitalization b/c bad for co. Afraid co may be bought by Blasius after reorg. Even if Reas & goodfaith, best interest of shareholders, not find dir motivated by entrench themselves -> not OK if purpose is to get rid of sh vote c. Rule - Neutral bus purpose test - bus purpose unrelated to frustrate shareholder voting, then OK. (i.e. True pupose unrelated to voting b/f proxy contest, OK) (not effects test) Bd dir may not take any action if purpose is to interfere with vote even if Bd dir act in good faith (best for corp) D. Circular Voting Structures 1. Speiser v. Baker - §160(c) addresses evil of inequality b/w equity int & voting int - ex control w/o own 50% of co Co can't own itself, not a real entity (Treasury shares not entitled to vote) (i) Speiser 10% and (ii) Baker 8% owned minority of shares, (iii) ignore Med 42%, of Chem, public co, shs b/c sub of Chem really own Med (iv) Public own 40% of Chem. Chem control 60% (10+42+8) of vote and Speiser and Baker only 35% (10+8)/(10+8+40) of dividen Non-voting shares are ignored -> Speiser not have majority Unfair to use circular structure to acquire voting control Ct: §160(c) extended so apply to significant minority as well. (§160(c) prohibits the voting of stock that belongs to the issuer and prohibits the voting of the issuer's stock when owned by another corp if the issuer holds, directly or indirectly,a majority of the shares entitled to vote at an election of the directors of that second corp.) (Chem own 50%+ of Med, so Chem can vote in Med; Med can't vote in Chem) E. Vote buying 1. Easterbook & Fischel - The Porhibition of vote buying a. The only time buyingthe votes w/oo the shares is advantageous is when the buyer is planning to dilutethe interests of the otherequity owners b. Legal rules tying votes to shares increase thje efficiency of corporate organization 2. Schreiber v. Carney P sue b/c loan transaction constituted vote-buying -> Void a. Jet Capital own 35% of TX Intl, Tex Intl want merge w/ Tex Air b. Warrant - Right to buy unissued shares from co at exercise price c. Option - Right to buy shares from anybody, not nec from co, already issued d. Jet Capital has warrant to buy stock of TX Intl e. If did not ex warrant -> become warrant to buy TX Air new co -> create tax liability f. Not ex b/c no money to pay $13 mil g. Jet Capital threaten to vote against merger - Del L approval for merger (i) Need maj shares entitled to vote; additional (ii) maj of disinterested shs that are voting (JC neutralized b/c not ask to vote in favor, now just need maj of 65% disint - 325,001 instead of 150,001) (500,001-350,000) h. TX Intl try help Jet Capital ex warrant 1. Set up special committee - §144 - Approval by indep dirs 2. Hire indep counsel - Good to insulate from attack 3. Negotiate and come up w/ deal - Van Gorkom: Duty of care ct not like didn't neg 4. Give JC $3,335,000 to exercise the warrant for the stock -> 0 cash flow; at 5% up until expiration date then prime rate b/c dividends cover the 5% int -> 0 cash flow (Prime rate, bank rate to large co, b/c if exercise at expiration date, then would have to borrow at mkt, so end up with same thing. 5% loan: Indiff b/w ex warrant early & ex later) 25 If warrants were in the money, could borrow money to buy shs; sell & pay off i. JC, in consider for advantageous loan, w/drew opposition to proposed merger -> TI purchased JC's nec vote j. Ct: Not illegal per se b/c purpose not to disenfranchise the shareholder (intrinsic fairness test passed) b/c (i) approvedby diinterested sh & indep dirs (ii) trans good for co (iii) JC thought it was good (~ Sinclair contr sh self-dealing - intrinsic fairness test if not approved by maj) VIII. The PSI-IPALCO Proxy Contest (III) PART IV: THE ACQUISITION MARKET I. Corporate Combinations and Appraisal Rights A. Solomon 1. Merger pereferable to sale of assets for transaction costs, financing the transaction, minimizing tax consequences 2. Sale or exchange of assets pref for avoiding the target's liabilities or avoid appraisal rights of dissenting shareholders (in some jurisdictions) 3. Corporate combination - put assets of 2+ corps under the control of 1 mgmt a. Merger - One corp merge into another w/ former cease to exist; latter, surviving corp The shareholders of the surviving corporation retain their shares and those of the disappearing corporation exchange theirs for new shares in he surviving corporation. (Consolidation - Both corps cease to exist and new legal entity created Both sets of shareholders must exchange their stock for shares in he new entity.) i. §251(c) - need approval of maj of sh of A, T entitled to vote and dir of A, T ii. §251(f) - (a) No of voting shares in surviving co not incr by more than 20% as result of merger (b) Not change anything wrt A - charter, shs outstanding -> not need approval of sh of A (NYSE rules require vote of sh of A, though not required by state L, where in the course of the trans the A will issue addtl shares >18.5% of shs outstanding b/f the transaction -> new shs listed on NYSE) a. §251(f) - had meaning 30 years ago b/f triangular merger ~ acquisitions, all cash-mergers (economically is acquisition, pay cash, get assets) b. Triangular merger - (all cash merger can be done as triangular merger) fewer restrictions (requirement similar to asset acquisition §271 - not require sh approval of A - require Dir, sh approval of T) iii. types a. Stock merger - Give T 3 mil newly issued shares of A (i.e. PSI & CG&E) b. Cash merger - Give $50 cash / T share (i.e Virginia Bankshares) c. Short-form merger - §253, RMBCA §11.04 - Merger of an almost-wholly-owned subsidieary into its parent. P own 90%+ of S - merger: only need approval of Dir of P, not need Sh of Sub. Addt'l requirement - no change that affect charter of P d. Triangular merger - Acquiring corp creates AcqSub, just to effect merger taking all of the sub's stock in exchange for the amt of the acq corp's stock to be transferred to T sh in merger. T merged into new sub, with T sh receiving shares of sub's parent - AcqSub b/come owner of T's business. A's assets, apart from 26 $500mil gave to AcqSub, own assets are insulated from cred of T. AcqSub + T = 1 legal entity, limited liability. (Never really need §251(f); §251(c) - need approval Sh AcqSub (=Bd dir of A) and T, dir AcqSub and T) b. Exchange of Stock for Assets 1. Acquiring corp buys the assets of T for stock of the Acquiring corp. Result is Acquiring corp has obtained control over the T's assets and T has become shell or holding co whose assets consist of stock of Acquiring corp. Target may dissolve, distributing these assets to its shareholders. 2. The assets of the Acquired corp must be transferred by deed or by other form of conveyance, paperwork. Acquiring corp assumes liabilities of acquired corp. Or liabilities may be provided for by having the T retain sufficient liquid assets to pay off. 4. Tender offer - primarily hostile control change mechanism 5. If co want own assets of T i. Asset purchase - §271 - Sale of all assets, Not need Sh of A, Need K, paperwork; Merger - get assets of T automatically ii. Buy shares of T a. Hostile tender offer - Need Dir of A, Not need Dir of T (merger, need) Not need voting approval of Sh of T, just get to sell you their shares b. Freeze-out Merger - Sh of T being frozen out B. Timberjack Agreement 1. RR's AcqSub RA make friendly cash tender offer for Timberjack @ $25. Offer open for 20 days (If RA & T agree, can extend); if b/w 50-90% has been tendered, RA can extend for 10 days to qualify for "short-form merger"; or else can extend if T consent b/c the longer the offer extended, (i) $25 worth less to shareholders (ii) T can't make long-term bus decision, and (iii) T limbo, not supposed to do major bus unles RA agree) 2. Timberjack- Surviving co. T charter. RA dir takeover. T oficers. Sh of T get $25. Sh of RA (=RR) get shs of T -> RR own surviving co 3. Not get $25 i. Dissenting shareholders (file for appraisal) ii. Treasury shares (Like auth & unissued shares - get cancelled) iii. Shares of RA (like pay itself) 4. Tender offer instead of merger b/c i. Faster. (20-30 bus days) Merger take few months. Speed important b/c R afraid someone else come in and want acquire T (i.e. Ipalco bid more) (CG&E, PSI merger instead b/c regulatory approval needed, speed not matter) 5. Appraisal rights (Ct's indep evaluation of value of shares) - in order to obtain: i. Notify the co of intention to seek appraisal rights ii. Can't vote in favor iii. Co Notify shareholders that merger succeed iv. W/in 120 days, sh demand appraisal rights or co can demand 6. If believe in EMH - In a merger, not get appraisal rights b/c when co whose sh seek appraisal rights trade on exchange b/c can sell stock in mkt; mkt will protect you? (*Fischel - not believe in EMH, mkt not going to protect you. I.e. If assume mkt believe real intrinsic value of T stock is $28, mkt price will be $25 (a litle less b/c time val) b/c regardless of whether believe in EMH, your shares will be bought for $25) 7. §262(b)(1) - Stock market exception (Mystery!) - if T publicly-traded -> no appraisal rts §262(b)(2) - Appraisal rts are available, despite (b)(1) if you get anything but 27 (i) shares of Surviving Corp (b/c if SC trade at $30, T will trade at $30) (ii) shares of publicly traded co (iii) cash in lieu of fractional shares (i.e. 1025.7 shs & get $ in lieu of .7 sh) (iv) any combination if i, ii, iii (251, 252, 254, 257, 263, 264 -> §251(c) may not get appraisal rights) §262(b)(3) - If short-form merger (§253), then get appraisal rts b/c minority sh votes not count (Parent own 90%) (If sub is publicly-traded and sh of T get shs of parent, st mkt except not apply b/c only relates to §262(b)(2)) Shareholders got $25 cash, so get appraisal rights 8. Tender offer by RA for T shares -> RA became controlling sh of T Merger - terms set when T was independent of RR & terms negotiated at arms-length 9. If became controlling shareholder a while ago and think about freezing out others in freezeout transaction -> Differences a. Vote of minority shareholders of co being acquired not really nec to effect merger trans b. No poss another co may make higher bid (PSI/Iplaco) b/c controlling won't sell c. Arms-length bargaining (indep directors? Controlling put them in bd) Should shareholders of T in freeze-out merger w/ controlling sh or mgmt get anything other than right to vote and appraisal rights? C. Corporate Combinations and Appraisal Rights Appraisal Rights - in order to obtain 1. Notify the co of intention to seek appraisal rights 2. Can't vote in favor 3. Co notify shareholder that merger succeed 4. Within 120 days, shareholder demand appraisal rights, co can demand appraisal rights D. GAF Proxy Statement/Prospectus - Dissenter's Rights to Appraisal 1. §262 Court makes appraisal of fair value of shares "exclusive of any element of value from the accomplishment or expectation of the Merger." Relevant factors: market value, asset dividends, earnings prospects, nature of the enterprise. 2. Fair value determined under §262 could be more than, the same as or les than the Merger consideration they would receive if they did not seek appraisal of their Shares. 3. Upon application of dissenting shareholder, ct may order that all or portion of expenses incurred by dissenting sh in conn w/ appraisal proceeding be charged pro rata against value of all Shares entitled to appraisal. 4. If shareholder demanded appraisal, not entitled to vote the shares subject to such demand or to receive dividends or other distributions on such shares 5. If shareholder who demands appraisal, withdraws or loses right to appraisal, shares will be converted into a right to receive the merger consideration, w/o interest. E. Fischel, The Appraisal Remedy in Corporate Law 1. The purpose of the appraisal remedy is (historical) a. to protect the minority agains oppression by the majority b/c abandoned unanimiy rule for approve transactions altered rts of CS. b. Protect minority from eing forced to either invest in a "dramatically different enterprise" or having to sell in the market 2. Appraisal as an Implied Contractual Term a. Affects probablity ot the transaction taking place, affect all shareholders b. Offers a solution to prisoner's dilemma b/c if sh in second-step trans likely get $40+ in appraisal, bidder who only offer $45 ($60 for 51%, $30 for remaining) will not go 28 forward -> Protect all sh from value-reducing transaction by decr prob of this outcome -> all shares will trade at a higher price. c. All parties benefit from an implied contractual term that induces efficient actions b/c apppraisal remedy, by reducing probability that he shares of min will be acquired at a price unilaterally set b maj, increases price min will pay for shares -> benefit maj, min 3. The Costs of the Appraisal Remedy a. Dissenter s rght to demand that their shares be purchsed by the corporation -> right to withdraw capital from the firm. b. Process is costly - lawyers c. Cost of Uncertainty created by poss dissenters wil be overcompensated 4. The Stock Market Exception to the Appraisal Remedy a. 20 states, DE, eliminated appraisal rights for shareholders whose stock is listed on a stock exchange or is so widely held that a substantial trading market exists b/c since appraisal provides a judicially created market for dissenting shareholders, it is unnecessary where a substantial trading market already exists. b. Critics: Stock Mtk Exception provides insuff protection to dissenting shareholders because it incorporates the assumption that dissenters can receive "fair value" for their shares by selling in the market. (RMBCA, Eisenberg) (i) Capital markets are not efficient - they do not reflect publicly available information about the value of a firm's securities. (ii) Inconsistent with the purpose of appraisal - establishing a reservation price for firm. W/o appraisal rts, majority still able to appropriate wealth from the minority ex post, causing the minority to be willing to pay only a low price for the shares ex ante. F. Manning, Shareholder's Appraisal Remedy 1. Legal rule permitting sh bail out whenever wish require co be maintained at a. high level of financial liquidity (assets: cash or immediately marketable securities) b. avail technique for rapidly determine "value" of their shares (not feasible) (Open end investment company - Co promises to pay not "value" of the shares, but amt based on holder's prop share of aggregate MV of securities held by co (quickly measurable) 2. We must be selective. Appraisal statutes should apply if a. risks to shareholder are great, and b. benefits to minority shareholder > consequent burden imposed upon enterprise 3. Appraisal statutes protect investors against internal risks - transactions brought about immediately by the majority shareholders (or dirs) and objected to by the minority 4. Appraisal sttutes do not protect against external risks (i.e. decline in stock market) or events precipitated by consituents (i.e. suppliers refuse cont' supply) G. Note on Valuation 1. Appraisal right is a put option - opportunity sell shars back to the firm at a "fair" price that is supposed to reflect their value prior to transaction triggering the right. 2. DE - The dissenting shareholder's claim is a pro rata claim on the going concern value of the corporation. Valuation procedures employed by investment banks - discounted cash flow analyses or liquidaion values. (abandoned "Delaware Block Test" in Weinberger) 3. One traditional component of appraisal valuation is pre-announcement market price of shares, but Van Gorkom - Trans Union's Bd knew mkt had undervalued worth of stock) H. Dorfman, "When Valuing a Company" 1. Fair market value can vary considerably from financial value b/c of qualitative factors 29 a. Relate to strategic aspects of a co b. Have potential to affect the level of buyer demand in the acquisition market c. Their impact on value is difficult to quantify (i.e. International presence, mantenance Ks - longer-term relns) 2. Specialist in the industry -> accurate valuation II. Exclusivity of the Appraisal Remedy and Freezeout Transactions Bus reasons to acquire all the shares a. Easier to run business if wholly-owned subsidiary b/c not need worry about unfair, selfdealing if transaction with affiliate b. Every time burden to prove unfairness -> appraisal -> pain Cash-out transactions, in which a controlling shareholder employs a merger or other fundmental transaction to buy out minority shareholders, differ from arms length sales negotiated by managers: 1. A controlling shareholder has statutory power to impose a merger regardless of how minority shareholders value the deal 2. A controlling shareholder can force through a merger without fearing a competing offer from an outside bidder, since no one can compel a controlling shareholder to sell his or her control block Issue: Whether voting and appraisal rights provide sufficient protection for minority shareholders in a "controlled" transaction A. Gilson, The Law and Finance of Corporate Acquisitions 1. The Mechanics of Freezeouts a. Most common technique for freezing out remaining target shareholders - Merger i. Maj vote of T shs to approve merger (Del: if maj sh own 90%, not need T sh vote) ii. Shareholders can (a) accept the consideration offered, or (b) exercise their appraisal rights b. Some state cts followed Singer v. Magnavox Co. in requ business purpose for freezeout merger; Del rejected business purpose test 2. SEC Rule 13e-3 - Going private transactions: share repurchases, tender offers, mergers with affiliates, recapitalizations, reverse stock splits (Effect - dereg under Exch Act) a. Antifraud rule b. Require file and distribute a disclosure doc Schedule 13E-3 i. True purpose of going-private transaction Alternative ways of achieving that purpoe Reasons for timing and structure of the transaction ii. Analyze the probable benefits and detriments of trans to issuer, affiliates, min sh iii. State whether issuer or its affiliates believes trans (un)fair to unaffil sec holders B. Weinberger v. UOP Facts Signal buy at 50% premium UOP stock, have 6/13 directors onto Bd dir elect Crawford, Signal employee to CEO of UOP Feasibility study by A&C, dir of UOP, dir / official of Signal - up to $24 -$17M more to sh Signal offer to buy remaining UOP from Crawford for $20-21 Crawford mention protect personnel no discussion about price not really negotiations, 4 days 30 did get fairness opinion from Lehman Bros, but left price blank 3/6 - Bd meeting UOP Propose cash merger $21/share Subject to approval by majority of minority UOP non-Signal directors consider it and vote in favor of it Submit to shareholder approval Minority shareholders cashed out a $21 Ct: Entire Fairness standard in self-dealing - Fair dealing & Fair price 1. Fair dealing - how approval obtained, duty of candor, structure a. UOP dirs took UOP info that important to UOP use for Signal exclusive benefit b. Press releases about negotiations but not really negotiations ($20-21) c. Hurriedness of Lehman study not disclosed 2. Fair price - comparative premiums, discounted cash flows §262(h) - Any kind of valuation fit with this is ok - Narrow, only eliminates use of pro-forma data (as if merger already occured) and other speculative data Remedies 1. Some circumstances, Chancellor power to fashion equitable relief, particularly if fraud, misrepresentation, self-deal, deliberate waste of corporate assets, gross overreaching 2.Ordinarily have to seek appraisal rights under §262 (got cash -> not stock mkt exception) (§262(b)(1) - don't know why have stock mkt exception) Virginia Bankshares - 14a-9 - not disclose material info would cause vote other way - non voting causation b/c requirement of maj of min Loss of state L remedy of appraisal -> gain better state L remedy Weinberger b/c misrep (Kahan) Misrepresentation -> vote for -> lose appraisal rights -> should get more -> Weinberger C. Rabkin v. Hunt Chemical Minority stockhoders of Hunt, class action v Hunt merger w/ maj stockholder price grossly inadequate b/c Olin unfairly manipulated timing of merger to avoid 1 yr commitment and Olin's 13D = price commitment failed to abide, br fid duties Rescissory damages hard to get (diff b/w now and pre-merger) Trial Ct: Dismiss: absence of deception, Weinberger - appraisal = min's only remedy in cash-out merger Sup Ct: Weinberger broader - merger does not meet entire fairness standard required Unfair dealing = breach of fiduciary duties Reverse and Remand Facts: Merger agreement: Olin (VA) acquire Hunt (DE), recommended by Hunt Bd of Dir 3/1/83 1. Olin bought 63.4% of outstanding of shares of Hunt CS from T&N @ $25/sh 2. One year period - Olin required pay $25 if acquired remaining Hunt stock Olin CEO and COO replace 2 Hunt directors affiliated w/ T&N 1/6/83 Filed SEC Schedule 13D Clear that Olin anticipate own 100% of Hunt 9/16/83 - Olin Interoffice Memo - Danna to Johnstone (then, dir of both Olin & Hunt) Clark to Johnstone and Berry 9/19/83 - Memo 9 pro / 3 con acquire Hunt stock prior to 3/1/84 cost $7.3M more than if wait til mid- 1984 31 can recoup $1.2-1.4M w/in 12 mos through savings increase dilution of Olin's reported earnings from 3c to 5c/share potential neg reaction of Hunt personnel risk whenever Olin buy backend Week b/f 1 yr pd - Bd's auth for its Fin Comm to acquire rest of Hunt if mgmt OK 3/23/84 - Olin sen mgmt met Ibank to discuss poss acquistion and valuation of Hunt min st 3/27/83 - Ibank opinion to Olin: $20/sh fair to minority (not consider Olin 1 yr oblig $25) Olin mgmt present Ibank fairness opinion to Olin Finance Comm rec acquire $20 price based on factors: Ibank analysis, Hunt's net worth, Hunt's earning history, current prospects fo 84, Hunt's failure to achieve earnings projections in bus plans, current and historical mkt value of Hunt stock from 82-83 - Finance Comm unanimously voted to acquire remaining Hunt stock for $20 - Hunt Bd appointed Special Committee of 4 outside directors - fairness of Olin's merger proposal - retained Merrill Lynch - financial advisor and law firm 5/10/84 - Meeting - Min sh filed class actions to enjoin proposed merger - Merrill advise $20 fair to min, but val $19 -$25 Outside directors notified Hunt board that unanimously found $20 fair, not generous, recommend Olin consider inc price above $20 5/11/84 - Olin informed Hunt Spec Comm not raise price 5/14/84 - Hunt outside dir met 5/15/84 - Spec Comm announc unanim $20 fair and recommend approval of merger 6/784 - Hunt issued proxy - favor merger, Olin intend vot its 64% of Hunt shares in favor No requirement of approval by maj of min stockholders Issue - Whether absent deception the π's sole remedy under Weinberger is appraisal π - when procedural unfairness, standard of entire fairness entitles them to relief broader than appraisal (Olin br fidduty & appraisal inadequate b/c 1. alleged wrongdoer not parties to appr proc 2. co should not have to bear fin burden of appr proc 3. overreaching and unfair dealing are not addreessed by appr D - Issue of fair value, appraisal is only available remedy Ct: Weinberger - clear that appraisal is not nec st's sole remedy Trial ct narrow interp of Weinberger - fair dealing (how transaction timing, initiated, structured, negotiated, disclosed to dir, how appr of dir and st obtained) Weinberger not turn solely on issues of deception, broader concerns of proc fainess π: Olin br fid duty by unfairly manipulating merger, timing to avoid pay $25 Ct: Duty of loyalty: The requirement offairness is unflinching in tis demand that where one stands on both sides of a transaction, he has the burden of establishing its entire fairness, sufficient to pas the test of careful scrutiny by the courts. Sustain complaint of br of fid duty, dismiss questioning judgmental factor of valuation Reverse and Remand footnote: Use of indep negotiating comm of outside dirs may have significant advanteages to the majoirty stockholder in defending these types of suits (~ Weinberger) D. Kahn v. Lynch Commun. Sys. Freezeout merger - even if approved by properly functioning board, still look at fairness. Weinberger just shifts burden of prove unfairness) Facts: Alcatel, a holding co, is indirect subsidiary of CGE, French corp 1981 Alcatel acquired 30.6% of Lynch CS (usu for anti-takeover) 32 Lynch amend charter to requ 80% vote shareholders for approval of any bus combo Alcatel obtained prop rep on Lynch board dir rt purchase 40% of equities Lynch offered to 3rd parties Alcatel owned 43.3% Lynch's outstanding stock, 5/11 bd dir 1986 Lynch mgmt ID target, Telco but need Alcatel's consent b/c supermajority vote prov 6/86 Lynch's CEO contacted Suard of Alcatel's parent CGE Suard expressed Alcatel's opposition and propose combine with Celwave, indir sub of CGE 8/1/86 Lynch board meeting - not consider orig combo b/f Lynch/Cewave combo tho ... Indep Comm to neg with Celwave and terms of combo 10/24/86 Alcatel's Ibank present to Indep Comm: prop exchange ratio .95 sh Celwave/ 1 sh Lynch in stock-for-stock merger Indep Comm's investment advisors concluded .95 ratio b/c overvalue of Celwave 10/31/86 Indep Commm express unanimous opposition Celwave/Lynch merger 11/3/86 Alcatel withdraw Celwave proposal Alcatel simultaneous offer to acquire entire equity interest in Lynch (57%) @ $14 11/7/86 Lynch Bd dir revise mandate of Indep Comm, auth to neg cash merger w/ Alcatel Comm determined that $14 cash per share offer inadequate Comm's legal counsel sugested it review alternatives to cash-out merger w/ Alcatel 11/12/86 Indep Comm counteroffer $17 to Alcatel Alcatel respond $15 Indep Comm - inadequate Alcatel raise offer to $15.25 per share Indep Comm rejected this offer Alcatel final offer of $15.50 per share 11/24/86 Meeting of Indep Comm - Alctael "ready to proceed with an unfriendly tender at a lower price" if the $15.50 per share price was not recommended by Indep Comm and approved by Lynch bd dir Alternatives to cash-out merger investigated but impracticable After mtg w/ its fin and legal advisors, Indep Comm voted unanimously to recommend that Lynch Bd dir approve Alcatel's $15.50 With Alcatel's nominees abstaining, Lynch board approved the merger Issue - Whether, despite its minority ownership (43.3%) Alcatel exercised control over Lynch's business affairs Trial Ct: Alcatel did not exercise control over Lynch's business decisions Sup Ct: 1. Alcatel did control the Lynch board. Non-Alcatel directors deferred to Alcatel b/c of its position as a significant stockholder. Alcatel owed the fiduciary duties of a controlling shareholder to the other Lynch shareholders. 2. Entire Fairness Requirement - Dominating Interest Shareholder Weinberger - A controlling or dominating shareholder standing on both sides of a transaction, as in a parent-subsidiary context, bears the burden of proving its entire fairness. Fair Dealing and Fair Price What type of evidence reliableto demo entire fairness - Conduct by a theroetical, wholly independent, bd dir 33 - bargaining power against the other at arm’s length Tr Ct differing views: Effect of an approval of a cash-out mergerby a special committee of disinterested directors has upon the controlling or dominating shareholder’s burden of demonstrating entire fairness. 1. Approval shifts to the π the burden of proving that the trans was unfair 2. Approval renders BJR the applicable standard of judicial review (~ Marciano footnote - §144 - self-dealing trans - approval by maj of indep dir, properly fcning->apply BJR) Sup Ct abolished bus purpose requirement, so if comm truly independent -> shift burden to of prove unfair to π (Weinberger, Rosenblatt) Entire fairness -proper standard for interested merger b/c "interested" trans, scrutiny "in a merger b/w the corp and its controlling st, even one neg by disinterested, indep dir, no ct can tely waht truly indep at arms length. Uncertainty -> even min sh who ratified merger need procedural protectionsbeyond those afforded by full disclosure of all matl facts. More stringent entire fairness standard of judicial review." Before shift burden, careful judicial scrutiny of a spec committee's real bargaining power - 2-part test 1. Majority sh must not dictate terms of merger 2. Spec comm must have real bargaining power it can exercise w/ maj sh on arms length basis 3. Lynch's Independent Committee Same Independent Comm submitted to Alcatel's demand on 8/1/86 Perceive Alcatel ready proceed with unfriendly tender offer at lower price if not accept $15.50 to be a threat Tho impracticability of Lynch's Indep Comm's alternatives to a merger w/ Alcatel 4. The Power to Say No, The Parties' Contentions, Arm's Length Bargaining Duty of Indep Comm to approve a trans in best int of public sh Not suff for dir to achieve the best price a fid will pay if that price is not a fair price Whether spec comm was truly indep, fully informed, and freedom neg arm's length Tr Ct erred b/c ability Comm neg arm's length compromised by Alcatel's threats to proceed w/ hostile tender offer if $15.50 not approved by Comm and Lynch Bd Reversed and Remand - for further proceedings, redetermination of enteir fairness of cashout merger to Kahn and other Lynch min sh w/ Bproof remain on Alcatel, dominant and interested shareholder. * Not functionally independent b/c - quick surrender at any time - Caved into $15.50 threat and prior threats - Not think fair price but accept anyway -> Not shift burden of proof E. Weinberger remedy - Summary Weinberger remedy = state L remedy Just shift burden of proof of fairness. Applicable in freezeout not necessarily applicable in others. May be more, may take out of judicial review completely (Marciano footnote) What exactly have to? 1. No fairness and no approval by anybody -> BAD 34 2. If can prove fairness, Marciano - good enough 3. Just approved by disinteintereest sh, dir, need show fairness? If no approval -> burden on D to show fairness. Unclear. All the way or part of the way to satisfy the test. (ALI - lower standard of fairness if approval. May be implicitly what's hapening in DE) ISSUES OF DISCLOSURE <-> FAIRNESS 1. The court uses discolsure to capture transactons it wants to capture. Weinberger - Got approval by board but not disclose unfairness, unfair dealing Van Gorkom - Shareholder approval, but not tel how negligent. 2. Ct manipulate by using Disclosure to take away effects aproval otherwise had of transaction ANY MERGER YOU HAVE APPRAISAL RIGHTS (Except for stock market exception) 1. Any additional remedies in freezeout in freezeout mergers? don't always have Breach of duty of loyalty, (care) tho ord have in claim self-dealing 2. Later cases: Court deviates from that reading of Weinberger - Rare circumstances have more. 3. Controlling shareholder = classic self-dealing -> should get something?! 4. Appraisal rights - usually exclusive (the only rights); Reg remedies, outside freezeout (i.e. 14a-9) - If only claim is freeze-out - controlling shareholder on both sides and price too low - not going to get more - If can show fraud, misrep to shareholders -> evidence get breach of duty. - If show other unfair dealing but have ful disclosure -> GREY area -> cases -> Get more than appraisal rights? BENEFITS OF WEINBERGER OVER APPRAISAL RIGHTS 1. W: Easier procedurally than appraisal rights - class action, not individual A: Can't bring as class action - have to make a demand & pay lawyer's fee 2. W: no lose proposition b/c Appraisal remedy can get less than $21 (at very least get bid price) b/c class action, attorney sues - can only kick out of suit, no damages -> not have to give anything up because get market value already A: ct may determine is less than if not bring appraisal rights 3.* W: Burden is on D to show fair value. A: no burden, court does independent judgment of fair value How calculated fair value under appraisal rights? Redone calculation of fair value under appraisal rights. From now on, in future, ordinarily but not always appraisal rights should be exclusive remedy of shareholder in freezeout except cases of fraud, etc A. You get right to bring a suit for breach of duty of loyalty under Weinberger entire fairness = where measure of fair value -> used to calculate measure of damages = measure of fair value under appraisal rights proceeding. B. Unique circumstances, not only get right bring breach duty, maybe measure damages not just same fair value as appraisals rights. Rabkin Ct - chan ct to throw case out of court b/c want to know if sh entitle to $25 "promised" under. 35 In appraisal rights, look at co, not determine fairness in appraisal rights, Weinberger But Weinberger: measure of damages should be different. (some cases only get appraisal rights) 1) calculate fair value 2) way bring get case MEASURE OF DAMAGES 1. Ordinary measure of damages same, except burden. 2. Except in exceptional circumstances, show why fair price not enough. 3. Price = fair value of shares. (i.e. Rabkin - Agreement -> entitled to more 4. Ordinarily get, fairly determined price, judicially determined fair price - Same usu 5. But lack fairness -> not enough -> Want more - Weinberger proceeding with other benefits. When can bring Weinberger? UNCLEAR 1. Fraud always enough 2. Less than fraud? (i.e. Kahn v. Lynch - P entitled to Weinberger b/c procedural unfairness in way Alcatel dealt with Lynch) III. Sales of Control Reasons willing to pay premium 1. Comfort of have control 2. Co undervalued 3. Better management GOOD 4. Self-dealing BAD A. Solomon - The Consequences of a Sale of Control 1. Control - power to use the assets of a corp as the controlling person chooses 2. Controlling person has direct power over his investment, has key to corp treasury a. Can impose his will on corp t make bus dec he believes is best b. Can decide to hire himself and salary c. Can cause corp to buy and sell prop to himself d. Can cause other trans in which favored friends can profit 3. Non-controlling sh gains protection if can change control easily, else only if exit corp Voluntary changein control - inefficient mgmt can be displaced by more eficient mgr 4. Beneficial to have means to change control swiftly and with little cost a. For corp b. For economy - relocate mgmt in more efficient hands 5. Theory - Competion fosters efficiency, but mktplace may not be so effective, so some firms operate at less than optimal performance 6. Change achieved only if incumbent controlling person (50%+) cooperae 7. Control premium - Over what noncontrolling person can obtain, he has disincentive to sell, because his power to gain for himself by control can compensate himself despite inefficient mgmt (i.e. High salary to offset low dividend) If law bar pay premium to seller, may impede negotiated sale of control 8. Buyer can recoup premium by a. Improve market price of stock by superior mgmt - elim agency costs assoc with suboptimal performance b. Loot the Corporation - Unlock the treasury and carry off the assets 36 9. Negotiated control transfer a. Value of control - profit opport from use of asssets of corp b. controlling person also lose dominion over the assets 10. Tansaction sell stock w/ sale of control -> controlling person select successor in control 11. Bayne - Control element is a corporate asset. Premium is bribe, v. his fiduciary duty Berle - Premium is a block assembly cost, belong to the individual Thee 2 approaches would deprive controlling person of a value acknow by marketplace -B. Zetlin v. Hanson Holdings, Inc. 1. Minority shareholders sued D who owned 44.4% of Gable's shares (effective control) to Flintkoke for premium of $15/sh want a share in premium paid for controlling int 2. Rule: Absent looting of corporate assets, conversion of a corporate opportunity, fraud or other acts of bad faith, a controlling shareholder is free to sell, and a purchaser is free to buy, tha controlling interest at a premium price. * Policy - Rule don't have to offer $15 to minority shareholders encourage control sales that are desirable b/c no other way to get control change. (If mixed motives - some self-dealing, and do well for co) Can't proxy, hostile tender offer b/c would lose. Only way to get control change is a sale of control. 3. Premium - added amt investor willing pay for priv of directly influencing corp's affairs -C. Brecher v. Gregg 1. Shareholder of LIN sued Gregg, pres of LIN, for sell 4% stock to Post for premium in exchange for a promise of control 2. Contrary to public policy and illegal to premium in exchange for promise of control, with only 4% of its outstanding shares being transferred - Br fid duty owed to corp * Other ways to gain control - proxy contest, hostile tender offer D. Harris v. Carter - Negotiated Sale, not a tender offer Facts Mascolo acquired control of Atlas (DE) Carter owned 52% of Atlas stock Stock Exchange Agreement (3/28/86) Mascolo bought Carter's Stock 1. Carter exchange Atlas stock for Mascolo's shares in ISA 2. ISA owned all of Pioneer and Western stock 3. Mascolo would place in escrow 50,000 shrs of Louisiana Bankshares PS , $10 a. If Atlas consummated exchange merger for all ISA CS w/in 365 days -> return stock to Mascolo b. If no perger w/in spec time -> stock distributed pro rata to Carter members Newly elected Atlas board - Mascolo defendants 1. Change Atlas' name to Insuranshares of America, Inc. 2. Reverse stock split converting 1 Atlas share into .037 shares -> reduce Atlas shrs 3. Reduced Atlas authorized capitalization 4. Approved acquisition of all ISA outstanding CS - 3M post-reverse stock splt shs 5. Elected Mascolo as chairman of board 6. Approved neg of sale of Atlas' oil prop 7. Approved purchase of 200,000 shs of Hughes CS @ $3 w/ option acquire addtl 8. Ratified actions of co's prior oficers and dirs and release from liability 9. Auth payment of $100,000 commission to co, found buyers of Carter's stock neg - Mascolo furnished Carter with draft financial statement of ISA, reflect an investment in LICA, which was fictitious (Draft was suspicious to Atlas' CFO) Claim (P v. Carter Ds) 37 1. Allegations Ds had reason to suspectintegrity of Mascolo, but did not investigate any of several suspicious apsects of trans: - unaudited fin statement - mention of LICA in neg but not in reps concerning ISA'ssubsidiaries - ownership of subsidiaries themselves Investigation would reveal ISA had minimal capitalization and no productive assets 2. Breach of fiduciary duty in connection with approval of payment of finder's fee The ISA Transaction P: 1. ISA is nothing more than a corporate shell 2. Stock Exchange Agreement - Macolo acquired a controlling (52%) stock interest in Atlas in exchange for 518,335 ISA shares - Atlas then acquired all outstanding ISA shares for 3M newly issued shares of Atlas CS -> Mascolo own 75% of Atlas' shares - Minority shareholders of Atlas proportional ownership of Atlas (48% ->12%) b/c ISA transaction 3. Atlas exchange 3M of its shares for stock of this corp shell = issue Atlas stock to Mascolo (holders of ISA stock) w/o consideration The Hughes Chemical Purchase P: 1. Mascolo - stockholders and dirs of Hughes (NC) 2. Mascolo caused Atlas to acquire Hughes shares at price unfair to Atlas and its sh The MPA Transactions (D Devaney, elected by Mascolo to Atlas board, pres and princ sh of MPA) 4/20/86 - Atlas entered into an agreement with MPA for the sale to MPA of Atlas' oil gas properties - MPA issued to Atlas a $5M secured promissory note, 2M shs of MPA CS (31.8% MPA) - Until MPA Note fully paid, Atlas would receive 40% of net cash flow from oil, gas prop P: As a result of MPA transaction, the MPA Note and stock became Atlas' principal assets 6/2/87 - Devaney & Mascolo agreement: rescinded the MPA Agreement 1. Mascolo transferred his Atlas stock to Devaney in exchange for shares of unrelated corp 2. MPA Note canceled and Atlastransferred its 2M MPA shares to MPA in exchange for return of oil andgas properties riginally sold to MPA 3. Devany assumed control of Atlas The EXL Transaction P: Alleges that Carter group hired EXL to find a buyer for the Carter group stock, Mascolo Mascolo and Ds charged with br fid duty in connection with approval as dirs of payment to EXL of a $100,000 finder's fee in conn with Stock Exchange Agreement Issue: Whether a controlling shareholder or group may under any circumstances owe a duty of care to the corporation in connection with the sale of a control block of stock. Ct: In case involving not merely sale of stock, but a sale of control over the corporation Insuranshares principle - when transferring control of a corp to another, may have duty to investigate bona fieds of buyer - take steps as a reasonable person to ascertain that buyer does not intend or is unlikely to plan any depredations of the corp Reject Levy notice rule - only if he had knowledge of improper purpose of his buyer Conclusion: When circumstances would alert a reasonably prudent person to a risk that his buyer is dishonest or in some material respect not truthful, a duty devolves upon the seller to make 38 such inquiry as a reasonably prudent person would make, and generally exercise care so that others who will be affected by his actions should not be injurd by wrongful conduct. Duty of care of controlling sh in spec circum sale of corp control breach by gross negl (~Aronson) DENY MOTION TO DISMISS - permissive standard * Black letter rule - Reasonable investigation in certain circumstances IV. Tender Offers and the Williams Act A. Tender Offer 1.Offer made to shareholders of large public corporations to purchase all the company's shares for cash or stock 2. Often offer substantial premium over market price 3. Only tender offer not require approval of board of directors of target. Bd of dir no legal power to stop sh from selling. Defenses can employ: poison pill 4. Hostile acqusition usually in the form of a tender offer a. Merger \ Need Bd dir approve & b. Sale of substantially all of corporation's assets / shareholder approval c. Proxy fight - Expensive d. Tender offer - Not need Mgmt approval B. Williams Act - to get rid of Saturday Night Specials (no def'n of t.o., statutory interpret) 1. Add §§13(d)-(e),14(d)-(e) to Exchange Act - Disclosure requirements and SEC rules 2. §13 - Purchases on open mkt, Freeze-out Trans and Acquistions by co of its own shares 3. Rule 13d-1(a) - Require anyone who acquires beneficial ownership of more than 5% of co shares to file Schedule 13D w/in 10 days (Sue for 13d alot) Rule 13d-2(a) - If material change (1%) in Schedule 13D, i.e. material incr, decr in % of the class beneficially owned, required to file admendment disclosing such change Rule 13d-3(a) - Beneficial owner, directly or indirectly, has or shares voting power (vote or direct the voting); and/or investment power (power to dispose or direct disposition) 4. Schedule 13D Item 1 - Securiy and Issuer Item 2 - Identity and Background - Person: corp, gen part, l.p., syndicate, or group (d) Whether person during last 5 years convicted of criminal proceeding (e) Whether person party to civil proceed-> subject to judgment of fed/state sec L Item 3 - Source and Amount of Funds or Other Consideration Item 4 - Purpose of Transaction - Major plans for changing T co's bus - can be vague (a) Acquisition of addition securites of issuer, or disposition of (b) Extraordinary corporate transaction, merger, reorg or liqu, involving issuer/sub (c) Sale or Transfer of material amt of assets of issuer/subsidiaries (d) Change in present Bd dir or mgmt (e) Material change in present caapitalization or dividend policy of issuer (f) Material change in issuer's business or corporate structure (g) Changes in issuer's charter, bylaws, or instruments impeding acquisition of control (h) Causing class of securities of issuer to b/c dlisted from national sec exchange (i) A class of equities become eligible for termin of registration <300 record holders (j) Any action similar Item 5 - Interest in Securities of the Issuer (a) Aggregate number and percentage of class of securities beneficially owned (b) Number of shares as to which sole power to vote, sole/shared power to dispose 39 Item 6 - Contracts, Arrangements, Understandings or Relnships wrt Securities of Issuer ie. Transfer of voting of any of the securities (Kahan: Narrow, only about Ks) 5. §14 - Tender Offers a. Open for at least 20 days Offeror incr, decr %, open 10 days aft ann - Rule 14e-1 b. If price incr announced during pd when offer open, highest price to all §14(d)(7) c. If offeror offers to purchase only a portion of the outstanding stock of an issuer and a greater number of shares than it wants are tendered, the offeror must purchase shares from each tendering shareholder on a pro-rata basis, not firstcome first-serve so that offeror can't pressure tender quick §14(d)(6),Rule 14d-8 d. Shareholder can withdraw tender w/in 15 days after t. o. published - §14(d)(5) Adds withdrawal period of 10 days after a competing t. o. is made - Rule 14d-7 6. Reasons a. Gives them time to analyze and decide if should tender their shares b. Enables competing bid to come in and can withdraw and tender to competing bid c. Stock price may increase in 20 days and decide not to go forward d. Target may try to obtain competing bid, investigate acquirer e. Adopted poison pill within 20 days 7. §14(d) - Require tender offerror who, if the offer were consummated, would be the beneficial owner of more than 5% of a scurity disclose ~13(d) and purpose of the tender offer and its plans or proposals for the target. C. Clark 1. §13(d) - Any person who directly or indirectly acquired beneficial ownership of more than 5% of registered equity, need to file with SEC, disclose a. facts about the identity and background of the purchaser b. source of funds used in the acquisition c. the number and percentage of shares held 2. Exceptions - §13(d)(6) a. for acqusitions that, together with all purchases of last 12 mo not exceed 2% b. for acquistion of equity security by issuer 3. §14(d) - Tender offerrer -> beneficial owner 5%+ a. Mandatory disclosure requirements - purpose of t. o. & plans/proposals for T b. General antifraud provision - §14(e) c. Traffic rules designed to protect target shareholders (withdraw/prorate/best price) 4. Exceptions - §14(d)(8) a. Acquisitions by issuer of own secuiriteis b. Offers, that together with purchases over last 12 months = acqu < 2% of T stock c. SEC can exempt if not purpose or effect of change or influence control of issuer 5. SEC apply disclosure rules to solicitations / recomendations of tender offer - Rule 14d-4 Exemptions a. Advice concerning tender offer given by bank, investment adviser, attny, fiduciary not participating in tender offer to client made request for advice - Rule 14d-2(e) b. Communications by T if say no more than considering t. o. - Rule 14d-2(f) NOTE: Creeping tender offer not need comply with 14(d), just buy in market. 5% -> 13(d) V. The Takeover Debate A. Gilson - Conflicts of interest - shareholders and managers 1. EMH, Bad managers, no way to keep them on check, so need tender offers a. Self-dealing 40 b. Bad management c. Self-entrenchment, not yield control d. Excessive salary, perks 2. 2 Forces limit a. Law - good to deal with self-dealing b. Market - good to deal with bad management, ... i. Corporate Control ii. Managerial services, Finance/ Capital, and Product not work so well 3. Bad Job -> Stock Price Falls -> Tender Offer a. Believe in EMH - fundamental values and stock price relations b. If can improve management, will make a lot of money 4. Management's Role a. Provide information to shareholders b/c sh need info b. Solicit competing bids, white knights b/c inability of sh to bargain effectively 5. Defenseve tactics are improper a. Need management not have the power to stop tender offer b/c designed to kick out bad managers b. Management bargaining limited to threat of success ov securing a higher offer from another party is defensive tactic consistent with shareholder interest B. Lipton 1. Advocate permission of defensive tactics, beyond provide info to sh & white knights a. Issue Debt to allow stock repurchases - LBO, recapitalization i. Easy to issue junk bonds & raise money to acquire co (low liquidity b/c high spread and high risk b/c low rating of initial issuer) ii. Targets pay greenmail to defeat abusive, highly leveraged takeover bids b. Dilution i. Co issue more shares, only less 10% company ii. ESOP c. Golden Parachute 2. Takeovers are bad because a. Lead to overleverage i. Bad for creditors & preferred stockholders (fixed returns, not residual) ii. Short term focus of management a. Not believe in EMH b/c think stock price would increase Gilson, EMH, focus on short term profit b/c bad mgmt - st pr dec b. Bad for shareholders b. Scope of corporate governance - shareholders and constituencies integral to corp Hurts employees, middle managers - concerned with self-entrenchment i. Can bargain for better protection ii. Tin parachute iii. Bust-up takeover - Buy & split up & sell divisions C. Easterbrook & Fischel - Auctions and Sunk Costs in Tender Offers (not believe in EMH) 1. Takeovers are beneficial (even w/o auctioneering) a. Get rid of inefficient management (provide incentive for management not to be inefficient) b. Serve as powerful monitoring device -> work for benefit of shareholders Bidders monitor the target's managers, give sh chance replace managers 2. Major advantage to shareholders - Deter, Incentive, Premium 41 3. Against Williams Act b/c encourages competing bids a. Subsequent bidders avoid information costs that first bidders bear (i.e. costs of searching for potential targets and their bids b/c Williams Act discloses info) 4. Against auctioneering decision in T's managers b/c Returns to Gather Info decrease Advocate management to be passive a. Reduce number of tender offers b/c fewer first bids since cost of auctions sunk *b. Reduce monitoring managers, increase agency costs c. Lower prices for shares 5. From shareholders' perspective - low premiums b/c as soon as manager slacks off, takeover happen quickly. If manager slack off a lot, no competing bidder a. If High premium, then takes a big inefficiency for takeover to happen Manager need to account for 30% mismanagement to have high premium b. If investors are diversified, not care about premium b/c merely transfer of money from one pocket to another, since investors in targets (+) and bidders (-) D. Bebchuck (in between, not believe in EMH, but not as much as E & F) 1. Auctioneering rule good - Facilitating competing bids has significant beneficial effects a. Decrease in prospective acquirer's search is unlikely to produce a substantial decrease in buyer-initiated beneficial acquistions b. Decrease in prospective acquirer's search may be desirable (motives for takeovers) i. Tax savings and enhanced market power motive - gains from synergy or improved mgmt incr w/o rule ii. Acquisition may be motivated by foreknowledge that T's stock is & shift rewards currently undervalued (i.e. Given current mgmt, stock price is less than from Seller fundamentals of co) (x E & F - Target mgrs will reveal true value, price to Acquirer increase, shareholders withhold their shares) iii. Expansion motive c. Auctioneering rule produces a desirable increase in prospective seller's search and consequently in the number of seller initiated beneficial acquisitions 2. Regulations that prescribe a mandatory delay period are thus crucial for competing bids 3. Endorse allowing management to provide information to potential competing acquirers (~ Gilson, x E & F) VI. Defensive Tactics A. The Unocal Standard 1. Mesa (owned 13%) two-tiered front-loaded tender offer for Unocal stock ($34 b/f offer) a. 1st tier - $54 Cash for 37% b. 2nd tier - "$54" Junk Bonds for remaining 49% (a > b -> front-loaded) PARTIAL OFFERS ARE ALWAYS COERCIVE Bd: Worry person will engage in self-dealing if get all shares -> no meaningful self-deal 2. Unocal Bd meeting a. Ibank - price too low, at least $60 b. Special meeting of indep dir & entire Bd unanimously reject the offer 3. Second Bd meeting a. Decide to make discriminatory self-tender offer excluding Mesa - $72 for 49% if Mesa succeed in acquire 37% (total = 50%+) (SEC outlaw this,Rule 13e-4(8)) 4. Mesa sue for violation of fiduciary duties 42 Ct: Threshold test b/f BJR kicks in b/c "omnipresent danger board may act in own interest in blocking tender offer rather than interest of shareholders" (Subconscious bias ~ Gilson) UNOCAL STANDARD - 2-prong test - triggered when defensive measure (even if Revlon hold) a. Reasonable grounds that there is a threat to corp / sh i. good faith ii. reasonable investigation b. Defensive measure must be reasonable in relation to threat posed (Balance) - analysis by dirs of nature of takeover bid and its effect on corp - concerns i. Inadequacy of price offered ii. nature and timing of the offer iii. questions of illegality iv. impact on constituencies (i.e creditors, customers, employes, commun) v. risk of nonconsummation vi. quality of securites being offered in the exchange 5. Threats *a. Price is too low - Outside directors advised by Ibank, and spent lot time find $60 b. Coercion - Difference b/w Bid price and value of shares not bought (Bebchuck) i. Partial offer \ Front-loaded -> even if sh think too low ii. Bid price - high premium / rather be bought than stuck w/ back-end Rational possibility that sh prefer Mesa offer over Unocal, but since believe Mesa will go away, then better to tender to Unocal for $72 If only threat is coercion, get rid of by self-tender offer = Mesa front-end $54 (Timberjack t.o.not coercive b/c no diff b/w bid price & post-takeover (freeze-out)) c. Threat of Greenmail - Practice of puying out atakeover bidder's stock at a premium that not available to other shareholders to prevent takeover Bd decide not to pay greenmail - Is that a reasonable response? Threat of greenmail by itself is not a threat Not have to pay Must be coupled with something else (i.e. threat of other constituencies) If Ibank pick 60, easier for Unocal pay greenmail; if pick 55, harder to pay $60 6. Who has the power to decide whether a tender offer should go forward? a. Gilson - shareholders b. Bebchuck - shareholders c. Delaware - outside directors & Ibank or maybe ct decide who has power decide Outside dirs go thru informed process, advice of Ibank & reject-> Ct not block 7. Hostile tender offer (i.e. Ipalco Bd reject then proxy contest, NCR reject AT&T tender offer then ask for sh list & try knock out dir) a. Bebchuck - Tender offer followed by freezeout merger at same price = only offer not coercive. (i.e. Timberjack) Others may potentially be coercive 8. What can Bd do to resist the tender offer? To deter or defeat the raider a. Charter Amendments - need time, need to do b/fhand, need sh approval (i.e. sh right to vote, change bd of dir) b. Poison pill c. Pac man - make hostile t.o. for corp that hostile t.o.you (rare b/c controlling sh) 43 d. Lock-up Option - combine with white knight - make more attractive by give white knight option buy some of our bus at good price e. Crown Jewel - if an attractive part of co's business f. White knight - (find someone else to pay higher price (Gilson think is permitted) g. Golden Parachute - few mil pay not likely to deter a lot, just help mgmt if t.o. succeed, not effective usu h. White Squire - find someone get a stake in the co who won't tender to other person i. Litigation- sue fr fraud in the statements, but usu ct: correct stmnts -> go forward j. Defensive Recapitalization i. Management buyout (MBO) - type of white knight 9. Co deprived Unocal sh of opportunity to accept Mesa offer even if like Mesa offer Policy: Why permit Bd dir to block tender offer that sh may rationally want to accept? Ct: a. Shareholders uninformed, rushed, stupid, short-term want sell (long-term want hold on, not tender, can go out to mkt and buy the shares) (Gilson - EMH, if Bd advise not tender to Mesa, addt'l info. If sh believe -> not tender) b. Protect managers, costly to disclose certain info, may be confidential (Lipton - Ignore mgmt not act in interest of sh) c. Constituencies - community, jobs Del Ct disagree with EMH, else won't believe Bd say value is $60, when CV is $34 still have to persuade sh not EMH and better for them not tender, shift to outside dir (Gilson - EMH, fear mgrs block beneficial offers b/c entrenchment) Ct: OK for outside dir say we make decision B. The Pressure to Tender - Bebchuck - The distorted choice problem B/c should a takeover occur, post-takeover val of minority sh usu lower than bid price 1. Problem of distorted choice in all takeovers, partial or for all shares a. Followed by freezeout merger shortly Bidders may pay min sh in immediate takeout lower than bid price, constrained only by appraisal rights of min shareholders (not give T sh gains from target's acquisition) b. Not followed by takeout - maintain T as partly-owned sub, still take adv of min sh i. Acquire engage in self-dealing ii. Effect a takeout later; divert earnings & market price, (elements of appraisal) so as to leave min sh with less than have to pay in an immediate takeout 2. A bid is likely to fail, only if a. the shareholder's estimates of $V exceed not only expected share acquisition price (takeover is desirable), but also bid price, and b. there is widespread confidence among shareholders that he bid will fail 3. Proposed Arrangement to have undistorted outcomes a. Enable tendering shareholders to tender either "approvingly" or "disapprovingly" b. Bid's success determined by whether the bid attracts majority of approving tenders c. If yes, bidder allowed to purchase as many shares as wish & takeover can't penalize disapproving tenders d. If no, bidder can't acquire a controlling interest, and T remain independent with option purchase non-controlling block e. Shareholder only tenders approvingly if he views expected acq price > indep T value C. Choper - Takeover Defenses - Greenmail and Restructuring 1. Greenmail - selective repurchase by T of a potential bidder's stock, usu at prem > mkt 44 a. Tactic feasible when bidder accumulates a substantial stock position in the T and begins a highly publicized "creeping contol" acquisition b/c they may themselves be seeking to initate an auction contest in which they plan to sell to highest bidder (T) b. Problem for T - once auction begun, T is "in play," other bidders likely to replace initial bidder, who has been bought off (esp if others suspect also offered greenmail) c. Shareholders protest b/c expect receive premium from bidder -> pay premium to it d. Courts refused to find fid breach in bd's decision to pay greenmail - if demonstrate in corp's best interests, decision protected by BJR - good faith & reas inv 2. Restructuring Defenses - Offer T sh cash or securities of greater market value than the cash or securities package offered by the bidder a. Defense works best when bidder's own incentive is the price disparity it perceives between the target's liquidation value and the lower stock market value of its shares b. If T can eliminate disparity, i.e. preempt disaggregation strategy of bidder c. Two basic formats - Subst increasd use of debt, T borrows -> pays cash/debt to its sh i. Leveraged Buyout (LBO) - T mgmt & Ibank form new corp rival t.o. at higher price than first bidder - both sides finance offer by issuing junk bonds which plan repay by sell assets of T or increasing its leverage (D to E ratio) (a) Often evokes a bidding contest -> legal issue - T give preference to mgmt-led bidder, either by grant lock-up option on some prized asset or by providing it fin assistance (b) Sev cts - enjoin such assistance as violation of duty of loyalty (i.e. When hostile bidder offer $50 for all T stock, and T mgmt counter-offer for $51 made by new corp it org w/ help of Ibank. To finance counter-offer, T lend $100mil to new LBO bidder -> reduce T's value, ceiling on bidding -> only modest increment for sh & effectively ended auction) MOST TENDER OFFERS ARE FINANCED AS LBO Most t.o. usu fin by loans borne by target - can only do that if T is yours, else can't shift loan to T LBO - if secured -> when I get co, assets, collateral = guarantee for debts -> pers benefit of raider - difficult to do if not own 100% b/c diff show fairness (unfair dealing) -> want own 100%, creditors, shareholders can't go after. Can only use assets afterward ii. Recapitalization - Public sh exchange most of their stock for a cash payment (+ debt securities) that exceeds the prior mkt price of thier stock. Meanwhile, mgmt receives new shjs or options in lieu of cash -> Public sh retain a reduced equity investment in T, but the firm is now controlled by mgmt (a) Mgmt prefer this over LBO b/c i. Does not require sh vote ii. Does not place specific price tag on co -> bidding contest iii. Gives mgmt larger equity stake in T w/o require them borrow personally iv. May cause hostile bidder to w/draw if highly lev cap structure reduce disparity b/w stock and liquidation values that orig attracted this bidder (b) Cts - more tolerant of restructuring def (when not w/ asset or stock lock-ups) (c) Economists - restructurings, exchange debt for equity better disciplines mgrs, constrain them from cont' unprofitable ops b/c need to pay int, not just div 3. Successful resistance for the T -> neg effect on stock price, sh exp net loss in long run; but some defensive tactics have no impact on mkt (little impact on outcome of takeover 45 contests), while those that offer economic alternatives may be beneficial D. Note on Moran v. Household International Del Sup Ct: Flip-over poison pill as defensive to hostile takeover attempt reasonable response to the threat of "coercive acquisition techniques). However, when afaced with actual t.o., Bd could not "arbitratily reject" the offer. Bd's decison to reject offer and not redeem poison pill would be analyzed under "the same fiduciary standards any Bd dir would be held to in deciding to adopt a defenseive mechanism." Poison pill valued b/c if sh not like can proxy -> kick out bd of dir and get rid of pill E. Poison Pills - Shareholders Rights Agreements, Share Purchase Rights Plan (Targetted) 1. most potent b/c a. Co can create w/o sh approval unlike charter amendment b. Even if not have one when t.o. start, Bd can create one - most modern version of poison pill have a preclusive effect as practical - as long as poison pill in place, tender offer can not go forward, unlike lit, golden para 2. Types - When is the poison released? Trigger event? a. Flip-over - Transaction follow acquisition: a merger or business combo Not make a corp acquisiton-proof b/c may want acq control w/o acq entire co Takeover can still happen - If acquire < 100% of shares -> Freeze-out merger b. Flip-in - When acquire the shares (conduct falls short of merger or bus combo) rights holders may, upon payment of ex price, exchange their rights to acq CS, PS of T having value equal to (act <) 2x the ex price (Modern) - Acquiror can not particiapy in benefits -> economic dilution on acquiror 3. DGCL §203 - takeover statute - 15% threshold to trigger 4. Cts - generally permit bd dirs flexibility in use, absent bad faith or entrenchment pupose 5. Gilson - Mgr should confined to only provide info, not p.p F. McDonald's Rights Agreement - Flip-in pill 1. Share Acquisition Date = When someone acquires 20% of shares 2. Distribution Date = earlier of 10 days after Share Acquisition Date or 10 bus days after commencement / first public announcement of tender offer - When person does acquisition, Rights have to go out so sh can exercise - Time pressure when tender offer completed. When commenced, control not change yet so not bother issue Rights b/c hostile t.o. conditional on rid of poison pill a. Prior to Distribution Date, you have no Rights certificates, just rights to receive Rights b. After Distribution Date, for 1 share of CS, you have 1/100 share of PS for $250 (i.e. 100 share CS -> 100 Rights -> 1 share of PS for $25,000) 3. Subject to Adjustment (A) B/come Acquiring Person except all shares, all cash, 85% (Flip-in pill) B/c of exception (B) When Acq person & inc outstanding shrs of co 1%+ (Flip-over feature in pill) i.e. Freeze-out merger, Co issue addt'l shs / buy shs (trans involve co, incr 1%) If flip-in cover all -> not need flip-over a. You get shares worth $250 x 1 x CMP = $500 You pay $250 x 1 0.5 x CMP The more Acquiring person acquires, the less dilution, actually ~$350 Need enough authorized and unissued no of shares in Charter to issue upon ex p.p. b. Everybody except Acquiring person -> so you don't want to be Acquiring Person c. Unless premium offered by hostile t.o. exceed $250/sh, sh rather keep & get Rights 4. Dilution created by poison pill 46 Hostile t.o. for 99% of the shares, 1% get $250 -> better to keep sh & get p.p. $250 That's why poison pill so preclusive -> t.o. can't succeed w/ it 5. Bd can always redeem shrs before there is Acq Person. Decision whether redeem in presence of actual tender offer -> Unocal test - Bd can't arbitrarily refuse redeem p.p. 6. Alternatives - If you want to make a t.o. for a co w/ a p.p. a. Squeeze under (A) exception b. Offer by person w/ < 1% -> wait 90 days -> Special meeting to vote on Offer c. Proxy contest (i.e. Ipalco, NCR- ATT&T) - get sh kick out dir, new dir d. Sue for injuction - Ask p.p. be redeemed b/c breach fid duty under Unocal 7. Wait 90 days is long time -> time for auctions a. Easterbrook & Fischel - not like auctions - others profit from 1st bidder, want quickly b. Bebchuck - 1st bidder profit too b/c can acquire less 5% stock and make $ G. State Takeover Statutes 1. Regulate hostile takeovers 2. Choper - Overview of State Takeover Statutes a. Balance to favor the target corporation b/c i. Fear that an acquiring co might close local plants or or order layoffs, ben sh but hur economy ii. tendency for target corps to have greater political clout than larger, but more distant, bidders b. Types of statutes i. Control share acquisition statutes - require a sh vote approving the "acquisition of control" by any person ii. Fair Price statutes - Directed against two-tier takeover, it regulates te "secondstep" merger and imposes a supermajority voting requirement for mergers and similar bus combos b/w corp and an "interested shareholder" (10%+) The supermajority vote requmt is waived, however, if the transaction meets statutory "fair price" standards. - To assure that those sh who do not tender will receive a price in any second-step merger or related transaction that is at least as high as the highest price paid for target shares by the "interested shareholder" over a recent period (2 yrs) (could have a "fair price" charter provision instead) iii. Moratorium statutes - prohibits corps from engage in a "bus combo" (merger, liquidation, or sale sub assets) for a specified pd (3 yrs DE) after any sh acquires more that a specified ownership threshold (15% DE) of its voting stock, unless the bd of dirs approved in advance the acquisition of shs in excess of that threshold. a. Bar creeping control acquisitions - No bus combo permitted if a 20% sh purchases addtl stock beyond the 20% level, unless those shares are purchased at a statutor fair price or according to statutory procedure that is designed to share the control premum b. chill "junk-bond"-financed "bust-up" takeovers in whih the bidder repays its acquisition indebtedness by liquidating muc hfo the T in order to realize the disparity b/w the T's salvage value and its lesser "going-concern" value in the stock mkt H. Delware §203 Problem DE statute - Bars business combos b/w DE corp and an "interested sh" (sh own 15%+ of corp'soutstanding voting stock and is affiliates) for 3 years followng any crossing of the 15% threshold that was not aproved in advance by the T's bd. 47 I. From Interco to Time - Unocal standard 1. City Capital Associates v. Interco, Inc. (Del Chancery Ct) a. Rales accumulate stock when price at 40s Interco adopt poison pill Rales want merge at 64 -> 70 Interco Ibank, WP, 70 not adequate price 68-80 trigger for flip-in pill -> 15% Rales can't accumulate stock -> hostile t.o. at $70 conditioned on redemption of p.p. WP 74-80 Interco not want redeem rights -> Rales inc t.o. to $72 Interco, still too low -> create its own alternative restructuring proposal (cash div + subordinated debenture + convertible PS = $66 + Equity stub of $10 = $76) Rales inc to $74 followed by back-end merger at same price = non-coercive b/c people who tender and not get same $74 b. Rales v. Interco for not redeem p.p. so sh no choice Unocal test b/c omnipresent specter i. Reas grounds for believe a threat ii. Response must be reas prop to threat c. Ct not allow bd keep poison pill b/c i. Difference b/w 74 (Rales, all cash) and 76 (Interco, later) not big diff ii. Drexel, Rales says worth less; WP, Interco says worth $76. Mkt not believe WP either. Reasonable investors may prefer Rales offer over Interco Del Ct: Can only keep p.p. for limited pd, buy time to find better deal, alternative Del Sup Ct bidder, alternative restructuring (transaction), neg. After legitimate fcn of p.p. crticize this ended -> p.p. supposed to go. Can't just keep p.p. in place & do nothing 2. Paramount Communications, Inc. v. Time, Inc. (Del Sup Ct) Time's t.o. for Warner wsa deemed reasonable because it was "not aimed at 'cramming down' on its shareholders a management-sponsored alternative" and because it "did not preclude Paramount from making an offer for the combined Time-Warner Company." Ct: - Bd may under certain circum, reject an all cash, fully financed offer at an adequate price -> lot deference and flexibility to board conduct a. Time long term strategy to expand Looked at cos to find best strategic fit, found Warner to be good co start merger neg Initial Stock Merger Agreement b/w Time & Warner - Warner merge into Time subsidiary with Warner as surviving company - Warner owned by Time: Time sub ger shs of Warner; Warner get shs of Time - Time sh own 40%; Warner own 60% of co (i,e, if Time had 100 mil shs b/f, Time have to give 150 newly issued shares of Time to Warner. x = 0.6(100+x) - 2 CEOs; Equal division of Bd of dirs b. Paramount hostile tender offer for Time conditioned on - Redemption of poison pill - Cable Franchise ability - Termination of Warner deal Time's Ibank, WP, said offer was grossly inadequate, and deal w/ Paramount adverse Bd dir think might lose if sh vote; so restructure agreement w/ Warner - Cash offer for acquisition of Warner so not need lengthy approval by Time, W sh - just need 20 days to keep offer open c. Paramount v. Time dirs for breach of fiduciary duty 48 Ct: All actions after Paramount subject to Unocal test i. non-redemption of p.p. ii. recast Warner deal as cash d. Unocal test i. Reasonable grounds for existence of threat ii. Reasonable response to threat e. Threat? (Del Sup Ct: easy to find) i. Interco: 2 threats: (a) Coercion from two-tier offer promising unequal treatment for nontendering sh (b) Inadequate price from all shares, all cash offer at price below market value ii. Del Sup Ct believes Unocal to be flexible - not only 2 threats (a) Timing (b) Risk of non consummation (c) Shareholder ignorance (d) Impact on constituents (e) Legality (f) Quality of securities (g) Uncertainty (h) Corp (Time) culture iii. Bd of dirs acting in good faith, upon reas invest, w/ outside dir determine threat iv. Ct not substitue its judgment for what is a "better" deal for that of corp' bd dir f. Reasonable Response? i. Depends on clear identification of the nature of the threat a. Importance of objective b. Alternative methods c. Impact of the 'defensive' action d. Other relevant factors ii. Depends on what response Time took in relation to the threat a. Time changed original merger deal -> acquisition deal b. Time didn't redeem the poison pill c. Even if redeemed, Paramount couldn't cont' w/ t.o. b/c need regulatory approval in order to obtain required cable franchise, takes time (~ Ipalco) iii. Ct: Reas response b/c just carry forward pre-existing trans in altered form(narrow) Bd has fid duty to mng the corp, include select time frame corp goals (broad) (Every company can have a business plan, but Time has specific plan) Directors are not obliged to abandon a deliberately conceived corporate plan for a short-term shareholder profit unless there is clearly no basis to sustain the corporate strategy Proportionate response b/c revised agreement and accomp safety devices did not preclude Paramount from make offer for Time-Warner iv. Responses that are not reasonable and proportionate - Management actions that are coercive in nature or force upon shareholders a management-sponsored alternative to a hostile offer If sh not like pre-existing plan, can vote new dir to redeem p.p. but after Interco restructuring, too late b/c no one want to buy b/c picked alternative to takeover g. Del Ct not believe in EMH, maybe want to help managers (xGilson - $30 prem -> sh t) J. The Revlon Standard 1. Revlon, Inc. v. MacAndrews & Forbes, Inc. 49 Any sale of control triggers Revlon duties but usually accompanied by discriminatory devices have to be justified REvlon as interpreted by Macmillan - must benefit shareholder and reasonable to benefit to person who get term fee (i.e. - termination fee - stock option agreement) (White Knighte - definitely) Trigger Revlon b/c result of not put prefential bidder on same footing (i.e. Timberjack trigger Revlon even though not define measure to hostile takeover but co thought good for co) Steps of a Tender offer - Create special subsidiary just to make acquisition - Subsidiary borrow money temporarily to finance tender offer - Merger to freeze-out rest of shareholders: Acquiring Co and Target, Liabilities-> T - Refinance initial debt -> Usu want to sell some divisions to pay off debt (Bust-up) Most tender offers are also LBO (Gleneagles; AT&T buy NCR not LBO b/c not need $) - Ultimate aim - Use assets you acquire as backup for debt a. Facts: - Pantry Pride, owned by Perelman, want take over Revlon, init offer $45 - Revlon Bd, (i) Lazard Feres say $45 Inadequate (ii) Wachtell Lipton propose 1 Defensive defensive tactics (a) Share Repurchase (b) Note Purchase Rights Plan - Poison Pill - Revlon adopt both defenses - Pantry Pride cash tender offer for all shares @$47.50 conditioned on (i) Financing (ii) Redeem p.p. 2 Defensive - Bd mtg, Co self t.o. for 10mil shares at $47.50 Sub Notes+ $9(1/10) PS= $57.50 (coercive b/c diff b/w bid price $57.50 and post-bid price, sh pr b/f self t.o. is big b/c create dilution - some shares for more -> Lower rest of shares) - Subordinated Notes have covenants - Limit Revlon ability to incur debt, sell assets, or pay dividend unless approved by "independent" members of board - Shareholders tender -> Revlon accept 10mil pro rata - Covenants impede financing & ability to pay b/c trigger default on Notes - Pantry Pride sub new cash t.o. for 90% @ $42 (~$47.50 b/c after self t.o. & paid premium to 10mil sharholers -> value of remaining stock decrease) -> merge w/ sub and after merger Revlon obligated to pay - Pantry Pride incr offer for more $, still want p.p. redeemed - Revlon start look for White Knight - Fortsmann - First Deal: $56 Cash, partially MBO (Mgmt take over equity), assume the Notes, Revlon redeem Rights & waive Notes covenants - Price of Notes decreased - Perelman new proposal at $56.25 - New Deal with Fortsmann - Raise price to $57.25 (i) Lock-up Option (Van Gorkom on stock) on asset at $125mil below value (ii) No-shop provision - can't entertain other offers (iii) $25mil cancellation fee (confers $150mil benefit to Fortsmann - Absent lockup & cancel fee, willing bid $62.25) - Revlon has 28mil shares outstanding (33mil = 87% & 10 mil were bought) - Revlon approved Fortsmann b/c (i) higher price (ii) protected the noteholders (they are also stockholders, afraid can vote out of office) (iii) financing was firm - Perelman sue injuctive relief from Rights plan and challenge lock-up, cancellation fee, exercise of Rights and Notes covenants b. Ct: BJR 50 1. Unocal test for Initial bid: (a) threat price too low (b) response reas - raise price for sh ->$57.25 2. When (a) Breakup of the co inevitable (b) Company b/come for sale -> No longer preserve co -> But maximize value for shareholder / Get best price for sh -> Revlon test 3. When can take into account constituencies i. When Unocal situation - Noteholders has to be rational related to interests of sh ii. When Revlon mode - No longer a rational relationship b/c sh get $, what happens to Revlon not matter 4. Lock-up option not good if try end auction, ok if induce people bid & incr price No-shop provision same 5. Treated Pantry Pride in discrim way when several bidders -> analyze carefully Ct: When multiple bidders are competing for control, concern for fairness forbids dirs from using defensive mechanisms to thart an auction or to favor one bidder over another. Market forces must be allowed to operate freely to bring the target's shareholders the best price available for theri equity. 2. Mills Acquisition v. MacmillanRevlon duty is to obtain highest P reas avail for co a. Elaboration of Revlon test - Can discriminate among different bidders when properly believe discriminatory treatment benefit shareholders and degree of discrim reasonable b. Revlon - Discriminatory treatment too high degree of disparity (lock-up, no-shop, diff access to info) c. Ct deviate from Unocal allow defenses -> stricter scrutiny of Revlon mgmt actions violate fiduciary duty 3. Paramount v. Time - Ct: Revlon duty is to max immed sh value a. When does Revlon happen? i. Active bidding process seek sell itself, involve break-up ii. T abandon long-term strategy & sell alt trans involve break-up b. If lose Unocal, can proxy contest at next sh annual mtg -> go forward w/ t.o. If sale of co, break-up, change of control -> you can't proxy b/c sh equity int eliminated and sh voting interest eliminated (happen even if not a sale of control) c. Change of control & Breakup or Sale of Co & Breakup -> Revlon d. Sale of all shares (Van Gorkom) Dir have to make informed decision - reasonably believe best price for shareholders (If Revlon confined to sales -> ~Van Gorkom?) Whether or not Revlon is triggered, Unocal review remains applicable to bd conduct involving change of control - requires Ct to assess, on an objective basis, the reasonablenss of the board's defensive conduct in relation to a legitimate threat to corporate or stockholder interest that the boardidentifies in good faith and based on a resonable investigation. 4. Paramount v. QVC - Break-up or sale of (change in) control triggers Revlon Viacom - front-loaded offer QVC - offer Enhanced duties are impose on directors in thetakeover context b/c the recognition that "where issues of corporate control are at stake, there exists 'the omnipresnt specterthat aboard may be acting primarily in its own interests, rather than those of the corporation and its shareholders.' Unocal, Macmillan Defensive action tested under Unocal 51 Conduct leading to a change of control transaction tested under Revlon Change of control is the one opportunity that the stockholders have to receive a control premium - an opportunity that should be vigilantly protected from unilateral board actin that prevents market forces from providing the stockholders a choice of the best available alternative. The public tockholders can only benefit once in the life of a corporation from a sale of corporate control. §203(b)(6) - Sale of more than 50% of a corporation's stock in a tender offer or sale of morethan 50% of corp's assets = Sale of the corporation -> triggers Revlon Time-Warner merger was a stock-for-stock meger - Contol of the corporation would always remain with the public stockholders, "in the market." Change of control test is no threat to true stock-for stock mergers. NO CHANGE OF CONTROL Viacom/Paramount trans - Redstone insist on use cash and non-voting Viacom stock as basic acquisition consideration -> He get absolute control over the combined entity and its future -> Revlon is triggered when the success of a control-changing tender offer for a majority or more of a company's stock becomes assured. Ct: Paramount directors made no attempt to secure a "long-term" for the stockholders A board's use of a rights plan is always subject to review under the Unocal proportionality test. Moran v. Household Intl, Inc (citing Unocal) Rights plans can be used by bd to protect shareholders from the threat of coercive takeover takctics and to enhance bidding, not to entrench mgmt or unfairly favor one bidder over another. Ct: Bd's repeated discriminatory treatment of QVC, rights plan to coerce sh into V's t.o. while precluding QVC offer, not reas pesponse to any threat. a. QVC - Wachtell Lipton Macmillan - sale of control applies Self-entrenchment of Paramount management. From the beginnng, did not focus on price. Weinberger- fair dealing - price is important If true concern is maximize price -> should encourage to make a bid. Viacom offer 1/10 Voting stock (Redstone retain 70% voting pwer) and 9/10 of nonvoting stock and $9.10 cash but first offered $13.50 (total $69.40 -> $63) which was rejected as inadequate, because Redstone bought up stock and stock price increased. Long term corporate strategy to do this merger becasue (Time-Warner) but not enough PROCESS i. NO-SHOP CLAUSE for Paramount entitled to talk to another bidder need written financing and necesary to fulfill fiduciary duty. (But can't K out of fiduciary duty) Del Ct: important for Bed to acquire info - Van Gorkom, Unocal - based on full info - PROCESS BASED ii. LOCK-UP OPTION for 20% stock, $100 mil termination fee (Van Gorkom, Revlon) QVC bid at $80 cash & share worth $50 / share. Lazard: bids come out at much less than stated figures b/cstock price now inflated -> price decrease after merger b/c pay alot of money for Paramount and market not perceive worth that much. 52 Paramount said can't talk to you because don't have written financing -> rejected initial offer that was $4 more b/c price of share at time. Only difference was present price. QVC - now we have proof of financing. Auth management to delay. QVC announced a hostile tender ofer at $80/share. Front-end=cash $80, back-end = securities - $80 worth value at that date but worth less Viacom made a more coercive tender offer b/c front end for $80 cash for larger percentage than back-end a $80 securities - ask P to remove poison pill and renegotiate The next day, Bd approves revised deal with Viacom and kept the termination fee and lockup option which was worth $350mill. (If bid price goes up ($80 to $90) -> value of lock-up go up depend on last QVC bid b/c they price set price for 20% of shares) Paramount agree take away poison pill for Viacom but permitted to put it back if better offer came sh will tender to Viacom if remove pill for Viacom. (B/f can vote it down, now can't vote it down anymore b/c front-loaded and coercive -> tender even if not like deal) i. No collar = get no of securities, whatever they're worth ii. With collar - Total value stays the same - If price go up, you get less securities; if price go down, you get more securities (~Ipalco - price protection) What info did Paramount board have when approved deal with Viacom? i. Investment bank, Lazard values the business, and not mention QVC (offers close) ii. Consulting Co, Booz Allen, runs a bus, said Viacom deal has $3bil in synergies greater than QVC Van Gorkom - Bd dir of Transunion know how run bus, not how to value bus. Paramount went forward with Viacom's $80 offer. Bidding war - QVC increased to 90, Viacom to 85, then 90 Last QVC offer at $90, P decide not to explore QVC offer b/c no written financing. Conditioned on redeem poison pill and rid of lock-up stock option. b. Paramount - Simpson Thatcher Bd fulfilled its duties b/c corp strategy, fit, long-term (~Time-Warner - sale of control not enuf. Revlon duties (Bd duty to achieve max immed and realizable share price b/c no long term) do not arise unless the board abandons the ongoing corporate enterprise to pursue either liquidation of shareholders interest or break-up of a co.) But never talked to QVC about fit just based it on public info. Reas not to inquire into private info b/c no shop and also P would comprise 90%, QVC 10% after. Van Gorkom - when a board agrees to a merger, it must be fully informed about the intrinsic value of co and cannot rely soley on the fact that an offeror will pay premim over curent market - Market check, expert advice compare val of 2 offers. c. Comparisions QVC: i. Not long term b/c lose majority of vote (Revlon) ii. No reasonable basis for long-term b/c no info about QVC (Time - WP told them price was inadequate) Lazard claimed can't tel about fairness b/c mgmt prevent us from talk to QVC due to no-shop provision - not have info iii. Paramount's action inconsistent with notion concerned with long-term benefits d. Issue - Does Revlon apply to sale of control (change in control)? YES i. If not, then Unocal, Van Gorkom. ii. QVC: Macmillan - sale of control applies 53 Paramount: Time-Warner - Revlon not apply unless sale or breakup of co, sale of control not enough iii. Policy arg: Sale of control should apply. Freeze-out, theoretical possibiity -> maybe there is a long-term for Paramount shareholders. But -> discourage strategic mergers. QVC: only if controlling. Viacom insist on pay non-voting stock instead of voting. (Time-Warner regular merger) Sh should receive control premium b/c now or never. (~ hostile takeover - you get control premium) e. QVC need get rid of lock-up option and cancellation fee and egage in selectiveness of poison pill. Paramount board action of p.p. reasonable once QVC made the bid. But lock-up option, unreasonable from the beginning b/c if validly granted -> can't just say lets get rid of it. f. Paramount's main justification for act towards QVC was the no-shop clause, but not excuse failure of Paramount directors to fully inform themselves. Arubment on reasonableness hinge on whether no shop clause was valid. g. Lock-up option - Clearly on Sep 12, Paramount complete discretion whether or not grant lock-up. But on Oct 24, not just up to Paramount to decide for Viacom, worth $350mil. Was uninformed and improperly motivated. Granted for improper purpose of deterring competing bids. h. Sup Ct: REVLON APPLIES TO CHANGE IN CONTROL/SALE OF CONTROL b/c loss of voting power (Schnell v. ChrisCraft, Blasius - ct go out of way to protect shareholder decision making power) i. Majority can freeze-out, break-up, elect directors, change policies, amend charter. What is significance of break-up? Not the only thing that triggers Revlon.(TimeWarner - Chan Ct said need change of control and breakup. Ct found no change of control b/c control stayed in market.) Sup Ct went bak to language of Chan Ct in Time. i. What are obligations once Revlon is triggered? i. DUTY IS TO GET THE BEST VALUE FOR THE SHAREHOLDERS. ii. In order to do that, have to have adequate info. iii. Mean Revlon -> need auction? (one way, not exclusive way) NO SPECIFIC FORMULA - HOW GET BEST VALUE iv. Future strategic value taken into account? Ct: Yes i.e. 100 shares A = $80 long run; 50 shares B = $100 long run. Can pick B -> ~Unocal, not Revlon? Ct: Future strategic value, Long term may not exist. (Mgmt may be changed) Footnote 14: COMPARE THE VALUE OF SHARES WHEN SH GET THEM NOW, NOT LONG TERM VALUE. If A better than B when sh get them -> have to pick A. Cash=Cash. Security is Ibank's reas analysis worth when sh receive them. Very contingent that B may be better than A in future -> tough. Ct discounts it and looks at present value. Ct may take into account value of future alliance, bidder's identiy, bider's prior background and busines, bidder's bus plans - factors when assess value of securities. Shareholders care about long-term b/c get cash and securities. If continue to get securiites of surviving co, care about value of securiites. Time horizon = time shen shareholders receive secuirities. (Timberjack - all cash offer, not care about future bus plans,...) 54 j. k. l. m. n. v. Can Bd dir force shareholder accept offer less value b/c think sh care about htings other than more money? "Get best value for sh" = highest value of whatever get Isn't bd always duty to do best for sh? i. If not in Revlon mode -> long term things, i.e business better, good justification for resist t.o. by acqiror. Not have to focus on time get it. (Time-Warner - not have to abandon long-term for best short-term deal: Paramount tender offer for Time at $175. Bd reject $175 b/c inadequate compared to long-term value by Ibank fairness opinion: Time Warner longterm benefit exceed $175) ii. Under Revlon, compared with Warner, CMV of Time right now prior to Paramount tender offer. $120 b/c price reflect mkt expect b/c announced merger. If focus on present value, Warner price not diff from Time price ~$120 -> have to accept $175. No change in control -> use $200 compare, not $120. Why in some cases Revlon is triggered, others it is not? i. Revlon - compare by market ii. Not - compare long-erm iii. Cash deal simple - no long run - Analogy breakup and loss voting power iv. If offer for 51% look at shares keep - factors: identity of bidder, value of shares after tender offer completed. Amount get - simple. Likelihood transaction would go through - risk of nonconsummation factor. Revlon - get best value for shareholder at moment in time transaction was completed. Can take into account factors (thinly traded stock = value shareholder sell shares after transaction completed) Can take into account factors in how affect price when shareholder recieves it. If believe in EMH - all future strategic value reflects in CMV. i. Bd entitled to not believe EMH. Revlon - Bd not entitled to say market is wrong much less fudge room in predict. ii. What level of scrutiny applied to Bd's action? Give pref to one bidder over another. Unocal Standard too deferential - have to show too things a. Benefit to stockholders b. Action is reasonable in relation to benefit (Macmillan) c. Ct independent review? Ct in Unocal - (a) Pure procedural (b) Substantive. Here, (a) processed-based and (b) substantive. Reasonableness not perfection. Whether action in fact reasonable? iii. Can you ever have an agreement of the type Paramount had with Viacom that involved some kind of lock-up option? Yes, can b/f an auction happens. Negotiated agreement if pass this test. Informed, good for sh, price is right, size of lock-up reas in reln to price. After have competing bidder -> CAN'T What did Paramount board do wrong? Revlon stnadard. Best value. If want prefer one bidder over another - have to pass Macmillian test - substantive scrutiny. Usually market run its course regardless. Ct: Can a no-shop provision limit or define fid duty of dir? No, can't define it. Can have a no-shop clause that say "... except if fid duty require you to do so." Every no-shop clause has fiduciary out condition. i. Is there any value to no-shop provision then? Always need do what fid duty requires. Yes, not have to look for idders. Informed bd concluded deal with Viacom best -> not requird to solicit other bids. But always have duty to respond to unsolicited offer. Is that true generally? Yes, NOT ONLY IN REVLON MODE. CAN'T LIMIT FIDUCIARY DUTIES. 55 o. p. q. r. s. ii. Duty is highest value to shareholder. Need adequate information - figure out value of 2 offers. Conditions relate to likelihood. Bd not have info on ..... Bd say did b/c noshop clause but no-shop clause invalid. a. Bd did not rigorously negotiate with Viacom on defensive provisions and price b. Bd did not try to negotiate with QVC - failed to get info on what QVC offer, it wiling offer more. c. Under Revlon mode - Duty to be informed, compare deal, neg with all bidders iii. Initial defense in Viacom deal - Ct apply Revlon, enhanced scrutiny - process and substance. Revlon mode when change of control (Sep 9,12 when initial agreement with Viacom, no-shop wrong already) Bd fail unreasonble in substance and proccess - invalidate both defenses. Unocal - (mkt is wrong, I'm right. You are smarter than others b/c more info. Rely on own knowledge, experience.) PROCESS important. Uninformed -> not pass Unocal. Time-Warner - revised deal - poison pill. not K bound like Paramount Viacom. Here, bd fail under process and substance. Van Gorkom - require much more process in sale of co case - trigger Revlon too. WHENEVER VAN GORKOM IMPLICATED -> REVLON IN SOME WAY IMPLICATED (no competing bidder, only thing "price too low", defensive measures not really figure in, just if reas info if price was good -> mkt check What if agreement with Viacom contained charter amendment require majority of minority approval to do a freezeout? Revlon still triggered? Ct not address it (ftnt 12)still lose general voting powers. One element of voting power - freeze-out is that enough? maj of min not guarantee still will be a long-term. Revlon triggered when dimunition of voting power generally, not just that won't be around in long-term. i. may not be around ii. you have no control over long-term b/c Redstone decide only chance for control premium Min sh not get control premium in future if there is controlling sh - Redstone get it next entitled to sell w./o share w/ minority. (Zetlin - maj sell for control premium, Brecher min sh get nothing) Why does a break-up trigger Revlon - Immediate value for whole co? Part V: Insider Trading and Rule 10b-5 The Securities Market and Insider Trading Securitiies transactions are regulaed by complex fed and state securities laws. Regulations are distinct from traditional corporate law. Overlap in practice. i.e. Anti-fraud provisions that bar deception or misrepresentation in secuirities transactions. Rule 10b-5, promulgated by the SEC under §10(b) of Securiities Exchange Act of 1924. The broad language of Rule 10b-5 governs disclosurs in all purchases and sales of secuiities. An implied right of action under Rule 10b-5. Two areas of Rule 10b-5 (i) Overt misrepresentation - Decline of the reliance requirement in the "fraud on themarket" theory of Rule 10b-5 liability (ii) Insider trading - more recent expansion of liabilitiy. A. Rule 10b-5 and Securities Fraud 1. Rule 10b-5: Elements of the Cause of Action a. Standing to bring suit - private right of action 56 i. Blue Chip Stamps v. Manor Drug - Plaintiff not entitled to sue b/c not actual purchasers or sellers of securiities involved in the allegedly fraudulent transaction or scheme. D not have to be P or S of securities b. Scienter -intent to deceive, manipulate, or defraud i. Ernst & Ernst v. Hochfelder - accountants negligently failed to audit & discover brokerage scheme - setback to SEC's policy of trying to focus morelegal responsibility for monitoring the conduct of corporate insiders on outside lawyers and accountants. ii. Strain out vexatious litigation. iii. Whether scienter is present if defendant reckless disregard for truth 2. Issues a. Latitude of companies to deny rumors about important new developments which the company is not expressly required to disclose under thereporting provisions of the Securities Exchange Act b. Evidence necessary to establish reliance under Rule 10b-5 c. Standard of Materiality under Rule 10b-5 a. Rule 10b-5 - "It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or the mails or of any facility of any national secuirities exchange, (a) To employ any device, scheme, or artifice to defraud, (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, not misleading, or (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security. b. Important to two lawsuits i. Straignt securiiteis fraud ii. Insider trading (~14a-9) - Implied right of action iii. Elements a. Causation - diff for i, ii b. Reliance - diff for i, ii c. Scienter - D must have known statatement made false or reckless disregard suff d. Materiality - (same for i, ii) 3. Basic Inc. v. Levinson a. Negotiating a merger since 76, concluded in 78 - announced merger and tender offer for Basic stock b. Basic made statements during period: Deny engaged in merger negotiations b/c not want raise false hopes, confidential else open for other bids. Combustion not want other peope make bids (i) Might not acquire (ii) Might have to pay highter price. but shareholder maybe want other bidders. c. P claim for securities fraud b/c were engaged in merger negotiations. d. Ct: Elements (i) Materiality (ii) Reliance e. Test for materiality (same for each P) - Whether reasonable investor would consider significant in making investment decision (TSC Industries - same standard as 14a-9) D: want ct adopt rule - Agreement in Principle Test - have reached agreement on principle terms like price -. negotiations deemed material b/c i. Investors may be misled, not know for sure will happen ii. Preserve confidentiality 57 iii. Easy rule Ct: (i) Investors will not misunderstand, smart enough to figure out may / may not happen (ii) Bidding war like QVC not good (Easterbrook - 7th Cir) (Bebchuck think auctions are good) Disclosure - When say something have to say the truth. Not force to disclose merger negotiations Ct: Reject Agreement in Principle test TEST FOR MATERIALITY (1) Likelihood will occur (2) Magnitude of event (SEC v. Texas Gulf Sulphur) Remand b/c merger negotiations material f. Reliance (Diff for each P) 1. Have to show that P knew about the statement. This is a class action (claim Ps over 2 yr period) -> if not similarly situated -> can't class action -> only large investors have money to sue. So traditional reliance - Identical and $ problems 2. Fraud on the market - link b/w false statement and market price a. Price lower b. Reliance on integrity of market 3. Theory Based on semi-strong form of EMH - Merger negotiations non-pubic. Public info - false - 'No merger neg' -> Discrepancy a. Strong EMH- Market reflect all info - public and private - False denials on part of Basic -> will not be effect on price b/c market already existence of merger negotiations. b. Elements - Relation b/w i. false statement & ii. reliance & iii. market price 4. Purpose of reliance element - D can rebut reliance by a. If people who get price knew the truth -> attack causal link b/w info & price b. Attack Reliance element - would have sold anyways 5. How does fraud on market reliance affect actions? a. When you go into market to buy stock - rely on market so not find out infor about statement 6. Traditional Reliance a. Knew statement b. Believe in statement c. Reliance on statement 7. Why bother find out statement? -> Rely on integrity of market ~ traditional reliance. No info about value can get by look at public info. If not rely -> acqure more info. Co said 'No merger negotiations' 8. Ct: Not have to show that found out the infor. When B/S ususally believe price is right. g. Why hold Basic liable? Did Basic profit from this? Try deceive shareholders? No, no insiders profit from it. Hold Basic liable. Shareholders of Basic who didn't sell end up paying for shareholders of Basic who did sell. 58 Ct: Basic should've said 'No comment' 1 A Engaged in Neg No Comment B Not engaged No 2 No Comment No Comment (stock price might incr attract QVCs) If market expect B say no -> 'No comment' = Yes B/f Basic, Sup Ct - OK to say no -> market not believe you. If B -> Not like agreement-in-principle. Like rule adopted by Sup Ct h. Fraud on the Market Theory - Market react to info (Mkt price would've been higher if not make misleading statement) i. In order to believe false statement affect securities prices ii. Mkt: particular info is important No neg Neg True Value $60 $65 +5 Market Price $50 $55 +5 If all info public, EMH not hold. Causal link b/w false price hold. Info would've raised market price by 5. So not have to believe in EMH, just w.r..t. this info that market is efficient. iii. Causal link (uncontroversial) - not need believe in market (good info -> price incr) iv. Reliance - You rely on integrity of market and not acquire info b/c no point in acquire info b/c if acquire info 99.9% find out P right. Theory of how investors act. 1. Dissent - (iv) is crap. Most people buy stock b/cthink ture price is higher. 2. Majority - Investors rely on integrity of market for 999/100 pieces of info when buy Merck. Peter identify one factor think market wrong, think Merck price incr over long-term. Make $. Other 999 factors maybe market overvalue price, on average balance out. So, can rely on integrity of market in most respects and still trade. Most people who speculate stock on hunch of 1 or 2 factors. (Esp small investors) v. Fraud on market theory i. Can rebut presumption of reliance by show (DIFFICULT) a. Show P knew statement false, not believe the statement. But difficult to rebut b/c too many P and how many P admit knew false? b. Call market makers, traders, stock analysts - Did they know? new spread? ii. Can rebut presumption of causal link by (MAYBE) a. Stock price analysis. Expert witness do study 'Price should drop' -> Drop in price when statement made? Important for assess damages. vi. Merger = good news. B/f statemnt made, negotiations, market believe prob of merger happening ~20%. Rumors and unusual trading activity that merger. If believe statment 'No neg' then Price drop by 20% of value of good news to 0% B. Rule 10b-5 and Insider Trading 1. Disclose or Abstain rule 2. Rule 10b-5 margins - Private right of action against insider traders and in defining the duties of "outsiders" who trade on non-public information, such as tippees, investment bankers, financial printers, and journalists - treat insider trading as fraudulent conduc 3. Three legal theories - Who is subject to Disclose or Abstain rule? a. Equal access b. Fiduciary Duty c. Misappropriation 59 4. Equal Access Theory - All traders owe a duty to the market to disclose or refrain from trading on non-public corporate information. Basis for this duty is "inherent unfairness" of exploiting unerodable informational advantage, confidential information from which other traders are legally excluded a. SEC v. Cady, Roberts & Co - insider trading on the open market. Two principal elements i. Existence of a relationship giving access, directly or indirectly, to information intended to be available only for a corporate purpose, and not for the personal benefit of anyone ii. Inherent unfairness involved where a party takes advantage of such information knowing it is unavailable to hoe with whom he is dealing b. Advantages i. Capable of reach all conduct ~ insider trading (i.e. tippees, financial printers, off) ii. Victims of insider trading easily identified - all uninformed traders to whom the insider should have disclosed c. Risks i. Chilling socially useful trading ii. Why "unfairness" arising from trading on access to superior info defrauds other traders in absence of misrepreentation or a pre-existing duty that. If unfairness itself > disclosure duty -> fraud? Investors always exploit diff access to info. why some forms injustice on uninformed trders, others non? d. SEC v. Texas Gulf Sulphur Co. i. Did not make discovery public b/c and acquire all area around mill where discover oil. Managers bought call options. Ct: Trans in stock, calls Violate 10b-5 ii. 2nd Cir: Insider trading law - Gen rule - Disclose or abstain rule in certain circum Requirements: factual (a) material - when balancing of prob and magnitude relevant to whether reasonable investor influenced (Basic) * (b) must be person subject to the rule easy (c) non-public iii. Reliance - element of private cause of action. Gov't not have to show affirmative reliance (Traditional - (1) knowledge (2) believed (3) acted in response. iv. Ct dispense with reliance in non-disclosure cases having to do with P /S securities (Blue Chip Stamps) Reliance is presumed Who is hurt by insider trading? Redistribution - Insider gains. All outsiders who trade lose - uninformed traders. If not trade -> not lose. Company loses 5. Scott - Insider Trading: Rule 10b-5, Disclosure and Corporate Privacy a. Fair Play concept - To prevent the "the inherent unfairness involved where a party takes advantage of inside information knowing it is unavailable to those with whom he is dealing." b. Informed Market - Facilitates the flow of information to the market, so as that it may better perform its functions of secuirty evaluation and capital allocation. Protect the investing public ... by promoting full disclosure of inside information so that an infrmed judgment can be made by all investors who trade in such markets. Focu on the entire market rahter than the particular trading partner. Damages incurred by all investors who 60 c. d. e. f. g. h. i. traded in the market in the opposite direction from the insiders during the period of nondisclosure. Business Property - protection to the property rights of the firm in inside info, info intended to be available only for a corporate purpose and not for the personal benefit of anyone. (TGS - contribute to rumors of drill finding and raise costs of acquisition andsuroundig land by co) Injured party was the company and that damages would be better measured by the increase in land acquisition costs than by stock market price movements. Note on the Academic Debate - Whether insider trading is necessarily harmful? i. Insider trading is an aproprition of information rights that permits informed insiders to earn systematically higher trading returns than uninformed outsiders can earn. But law merely bars trading on "material" info, so insiders' trading returns on informed decisions to refrain from trading still exceed those to outsiders. ii. Insider trading redistributes returns on securities in favor of insiders, but all disparities in info among traders have similar effects. If uninformed traders antcipate mktwide levels of insider trading, even this redistributive effect may seem to dissolve from an ex ante perspective. Outsiders will simply pay less for securiites. If EMH, then outsiders enjoy the automatic protection of prices that already reflect an informed estimate of future insider trading levels. Insider trading and informed prices - critique of insider trading regulation i. Insider trading leads to more informed prices that may actually increase investor confidence as well as the allocational efficiency of the market. Insider trading as mechanism for signalling the trading value of information that the firm cannot or will not disclose directly (i.e. Prelim merger negotiatins, A new product that might be copied by competitors - such info may only find its way into prices thru insider trading) Interest of informationally efficient prices taht ultimately lead to a more efficient allocation of capital. But inefficiences arise from redistribution effects of insider trading - slow mechanism for releasing info to the mk - prices may take weeks to reflect bulk of its trading value. ii. link b/w allocational efficiency (primary mkt, acquisitons mkt, mgmt compensation pkgs that are linked to share prices) and informational efficiency in secondary mkts Insider Trading as a compensation device i. Efficient device for compensating insiders - weak claim - might interact with other compenaton tools in a efficient mkt for mgrial services. But evid top mgrs retain enormous discretion over theirownjob tenure and compensation Costs of insider trading - fall most heavily on frequent traders and market makers, interfere with market liquidity and the efficient pricing of securities. Insider trading invites an uncompensted redisribution ofreturns from uninformed traders to insiders even stronger in case of outsiders such as investment bankers or financial printers who enter into short-term contracts with the firm. Redistribution occurs even when bidders deliberately leak info about pending offers. Shareholders may also benefit whenever arbitrageurs facilitate hostile takeovers. But not mean their gains exceed their losses from insider trading (1/3+ of val of acqu prem) Fiduciary duty theory - 10b-5 is violates when there is a pre-existing "relationship of trust and confidence" to support a duty to disclose between the insider and uninformed 61 traders on the market. (Comm L fraud - disclosure duty only arise from a fiduciary relationship or an equivalent tie.) Not source of info tht gives rise to duty to disclose. i. Chiarella - Ct rejected equal acces theory - overturn conviction b/c lacked a relationship-based duty to sh of T cos in whos securities he traded. (Officers of T co would have violated) (Burger dissent - misappropriation theory) ii. Dirks - clarified limits of the fiduciary duty by addressing the liability of tippees. Tipper must first violate duty to other traders by tipping improperly. Tippee, who originally owes no duty, then assumes the tipper's duty by trading. Whether tipper violate his duty turns on whether whether the insider tips to secure a personal benefit from the tippee and so, in effect, trades indirectly on his own tip. (strong int in limiting liabiity of security analysts - important investigatory efforts contribute to efficiency of securities prices) iii. Isolate a pre-existing relnship b/w insiders and other traders ~ comm L fraud. But allows a case-by-case review of the relnship b/w putative insiders and other traders > permit cts to target the ban against insidertading selectively. 6. Chiarella v. United States a. Equal Access Theory - all traders must enjoy equal information b/f trading. Anyone who possesses inside info -> not good law. Even under fair play theory - not all discrepancies unfair. (i.e. Analyst study Merck, really smart guy say Merck undervalued) Depend on notion of fairness. b. Chiarella work for Pandick Press, financial printer (send to sh) announcements of takeover bids. §14(d) - tender offers -> Disclose to shareholders. Chiarella figure out c. Govt crim charges against Chiarela. 2nd Cir affirm conviction. d. Issue - Under what circum does silence constitute fraud? Party being defrauded is shareholders with whom you trade. Fraud upon sh who sold. e. 10b-5 (b) May not omit material fact that is misleading to something alrealdy said, any person in connect P/S securities - Not Insider Trading. (a), (c) - Fraud -> Insider Trading. f. CommL: Silence constitute fraud only if have a duty to speak g. Fiduciary Duty Theory - People upon whom fraud perpetuated are securitiy holders by not disclose info b/f transaction. Fraud - Upon sh who sold. Silence -> Duty to speak. Chiarella not have duty to speak. Need fiduciary or similar relationship of trust of confidence to have duty to speak. Ct: Relationship b/w Chiarella and security holders - Strangers Agents/employees of co Stranger FSRTC Fiduciary (state L) Party defrauded - printing co (Bidding co hired printing co) by misappropriate (steal info not belonging to Chiarella. h. Berger dissent - Still fraud under other theories. Not your info to disclose or trade i. Can a corporate insider, director trade after Chiarella? No b/c fid duty under state L i. Most state L - Tho fiduciary duty, trading on inside info not considered breach of that duty. (Legal to inside trade) ii. Fed L - 10b-5 can civil and criminal penalties. Federalize a state L duty. Fiduciary duty come after Chiarella - Fed Comm L iii. Anybdy who get info by reason of position in co subject to duty. Chiarella not agent, employee of co, not fid or sim reln T & C. 62 7. Fischel - Insider Trading and Investment Analysts: An Economic Analysis of Dirks v. SEC 8. Dirks v. SEC a. Facts: Dirks is officer of NY broker / dealer firm. Stock analyst - securiiteies analyst specialist. Secrist - former officer of Equity Funding of America. Stock price should be lower b/c fraud (illegal) - overstate asset and want Dirks investigate and disclose fraud. Dirks investigate and uncover fraud and verify. call Blundell WSJ to write article about fraud, smoe of his clients and tell. Then sell security holdings in co. (Dirks may get some direct, indirect benefit - commissions, good will of clients) Meantime, stock price of co drop $26 -> $15 in very short pd b/c lot information leaking, lot people selling. NYSE halt trading of stock. SEC investigate and file complaint. WSJ publish story. b. SEC: Dirks violate 10b-5 civil (Chiarella - criminal; Levinson, Virginia Bankshares - civil actions) Dirks appeal to Sup Ct c. Issues: Tippee Liability Elaborate on Chiarella Test - whether Secrist fid duty or ~duty of T and C? Fiduciary duty for insider trading different from comm L fid duty where can insider trade. d. SEC propose rule: Tippees General SEC Always assume tipper's duty Anybody reguar access (TGS - rejected) Sup Ct (1) Tipper breaches duty by telling Fiduciary/Similar Duty of T or C (Chiarella) for personal gain (2) Tippee knew breached (scienter) d. Sup Ct: - SEC rule too ~ TGS Equal Access Rule that was rejected (Dirks would be liable b/c Secrist under duty to disclose or abstain - couldn't trade -> told Dirks -> Dirks can't trade) - Sup Ct rule closer to Chiarella rule Tipper duty only if Chiarella, so how is it predicated on equal access rule? Missing elements of (i) Fiduciary duty (ii) Breach of fiduciary duty You have to perpetuate fraud on person - need breach of duty. Tippee liability premised on breach of duty b/c require tipper to have breach of duty. (1) Did Secrist get any personal gain from tell Dirks? Secrist motives to uncover fraud b/c honest guy -> no personal benefits. - What counts as a personal benefit? - Ct not narrow: Pecuniary gain, reputation benefit, anything result in expectation of future earnings, quid pro quo (can be tomorrow), gift to best friend - Secrist not breach duty -> Dirks not liable Dissent: Personal gain does not matter e. Policy: (Powell) Stock market - Securities analyst get info by visit co, talk to insiders. Oftne may get non-public info, may material, often from insiders. Securiites analysts are important b/c they kep stock market efficient. SEC rule would make too hard for securities analysts. f. Lawyers, accountants, investment bankers, fiduciary duty to shareholders ~ temporary insider. Special confidential relationship, get infor for corp purposes. Corp must expect the outsider to keep confid info confidential, and relationship has to at least imply such a duty. (footnote 14) i. If put in K w/ car service - can't trade -> relationship expressly provide for it 63 g. How does Dirks inherit duty of Secrist? i. Need start off with duty (Chiarella) ii. Duty from 1 person -> another h. Hypos i. Ct leave open whether this count as breach of duty - negligence, inadvertence (lawyer, sleep on beach) OK, intentionally give info - no purpose? j. Tipper not breach duty if do it for bus purpoe - for benefit of corp. Public purpose = good purpose. Tell sec analyst so rate better - reflect mkt price. 9. Hamilton Note - Dirks benefit requirement a. Comm L fiduciary responsibility - intent to benefit is not a necesary element. SEC seems to have no problem findig a benefit in most cases in order to meet this requirment (i.e. Close personal relnship with woman, Tippee son of tipper, Received enhanced professional relnship from tippee) b. If tippee is Eavesdropper - Tipper did not disclose info for own benefit - no liability c. A person may become a "temporary insider (i.e. Confidant of corp officer, mgr of office services at law firm) 10. Rule 14e-3 and the Misappropriation Theory B/c of Sup Ct's narrowing of rule 10b-5 in Chiarella and Dirks - SEC try to close loophole by resortingto its jurisdiction over tender offers to promulgate Rule 14e-3 which imposes a duty to disclose or abstain from trading on any person sho obtains inside information about a tender offer that originates with either the offeror or the target. Thus, the SEC reintroduced the equal access norm by regulatory flat in the limited but important domain of corpoate takeovers. Congress - less productive (still no defn of insider trading -> courts) Insider Trading Sanctions Act of 1984 - authorize SEC to seek treble damages civil penalty from insider traders Insider Tading and Securities Fraud Enforcement Act of 1988 - tougher crim penalties, bounty system for detecting insider trading, novel civil penaltes for controlling persons who knowingly or recklessly fail to est or enforce procs for discourage insider trading (i.e. Impose an affirmative obligation on law firm to take appropriation action to prevent insider trading). Added §20A to '34 Act. Second Circuit - developed Misappropriation Theory to reach outsiders who trade illicitly on confidential information - the deceitful misappropriation of market sensitive info is itself a fraud that may violate Rule 10b-5 when it occurs "in connection with" a securities transacton. Relationship that triggers Rule 10b-5 and resulting unfairness both rfoer to insider's SOURCE OF INFORMATION. (diff from Cady, Roberts equal access theory b/c outsider no disclosre duty to issuer's shareholders, so mkt traders lost their private right of action against outsiders who traded on misappropriated information) Attractions of Misappropriation theory i. Can reach almost all forms of insider trading that are comonly condemned, regardless whether they involve traditional insiders. ii. Isolates a real duty and a real fraud - focus on supposed insider's conversion of valuable info rather than on fictional relnship b/w insider and uninformed traders 64 iii. Involves the private appropriation of information rights that belong to someone else. When this appropriation occurs in the context of a fiduciary relationship, it is not only worng but deceitful and therefore fraudulent. Costs of Misappropriaton Theory i. Rule 10b-5 merely requires a fraud "in connection with" the P /S of seuciries, thus can be read to encompass Misapprop Theory. But rule against securities fraud -> rule against fraud effected thru the securities mkt. (Carpenter - Defrauded party was WSJ, not itself a market participant and not owe Chiarella duty to traders in mkt) a. United States v. Carpenter (4:4) i. 2nd, 7th, 9th, 3rd Cir adopted Misappropriation Theory, most of where trading occurs -> Good law tho not sanctioned by Sup Ct. Controlling in SDNY ii. Facts: Defendants: Winans - WSJ reporter 'Heard on the Street'; Carpenter - news clerk WSJ, msg, go-between; Felis & Brant - brokers at Kidder, Peabody. Confidentiality policy of Co. Winans w/ F & B act trades on confid, scheme, call b/f column appeared from pay phone. F & B execute trades - made $690,000 in short time (Chiarella - $30,000) Not want lower quality of column by write false. Kidder Peabody notice and investigate. Lie. Confess. iii. If put false info into column -> 10b-5(b) traditional securities fraud - literally make false statemtn in conn w/ P/S securities. (Basic v. Levinson - Affirmative securities law fraud) (Insider trading is when not disclose.) iv. Misappropriation Theory - form fraud takes here is WSJ is defrauded, reputational loss. Duty of confidentiality from written policy and law of agency, employment relationship. Has to keep employer's confidential. v. D arg: Past cases - duty to sh. Pre-Dirks - Temporary insider - Duty of confidence vi. 2nd Cir: Fraud on any person is enough. Sup Ct: (4:4) Convict - Unable agree if Rule 10b-5 potect WSJ interest in reputation or if limited to protect those who are actually trading in the mkt. Chiarella Shareholder who trade with insider Trading w/o disclosure Misappropriation Theory Source of information Who Defrauded? What form of fraud? What is premise of underlying duty that is breached by trading w/o disclose? Misappropriation of Info Fiduciary or Similar Relation Duty of Confidentiality of T & C Misappropriaton theory reaches both (1) persons who trade in a security of a corporatin to which they do not owe a fiduciary duty, so long as the informatin is "misappropriated" from a party to hom a duty is owed and (2) tippees where tipper receives no benefit and thus did not breach a fiduciary duty. Outer limits of misappropriation theory unclear (~theft, embezzlement) (i.e. Arbitrageur who used a secret listening device to overhear converations involving prominent bidders?; Actual thief who break into an office to steal info? Owe fid duty?) 65 b. Hypos c. '34 Act §20A - Liability to contemporaneous traders for Insider Trading - Grant standing to private plaintiff §20(a) - misappropriation theory sanctioned by Congress - You can sue even though not defrauded. Give traders private right of action if trade contemporaneous tho not defrauded. - Imposes J & S liability on controlling persons for violations of controlled persons, unless the controlling person acted in good faith and did not directly or indirectly induce the violative act. (i.e. Law firm if partner or employee liable for insider trading) §20(d) - illegal to buy derivative - option, warrant, convertible security whenever not entitled to buy security itself. d. United States v. Robert Chestman (2nd Cir en banc; Maj - violate 14e-3, not 10b-5, Minority - violate both rules) 10b-5 misappropriation - duty to owner of info, but talk of fiduciary duty Facts: A&P tender for Waldbaum deal with co friendly t.o. at $50. Mkt $25 -> several mil $ Ira, Pres Waldbaum tell sister Shirley so she give him her share certifiacte - have her shares tendered "keep it quiet" Shirley tell daughter Susan "Don'tell anyone" "Can I tell husband Keith?" OK Susan tell Keith "Don't tell" . Keith tell Chestman - "Tender offer" Chestman bought 3,000 for self, 800 for clients, 1000 for Loeb -> make $25,000 Case: Sued Chestman for violate 10b-5 and 14e-3. 2nd Cir: Reverse both 14e-3 and 10b-5 conviction Rule 14e-3 - only when tender offer and substantial step toward tender offer. For anyone with material, non-public info about offer - comes from offeror, issuer, officer/director of offeror -> Duty to abstain or disclose. Issue: Whether SEC had power to define fraud in this manner? 14e-3 pased after Chiarella Ct: Auth 14e-3 FOUR WAYS TO GET DUTY TO ABSTAIN OR DISCLOSE (matl non-public info) i. fiduciary duty Chiarella \ ii. Misappropriation 10b-5 iii. Tipper / tippee / iv. 14e-3 IN WHAT WAYS 14E-3 BROADER THAN 10B-5? 66 i. Rid of breach of duty required of tippers to get a tippee, Dirks ii. Not let person owning info entitle other people to trade on it Who can trade under 10b-5, but not 14e-3? Eavesdropper entitled to trade. Get rid of i. SEC pos in Dirks tippee liability - Only thing relevant is from whom you got info - if got info from someone with duty - off/dir -> 14e-3. Can't trade - Dirks required breach of duty on behalf of tipper. ii. Officer of A&P - can you buy Waldbaum stock in anticipation of tender offer under 10b-5? No b/c theory of misappropriation b/c duty confidentiality to A&P and would br duty of confid. iii. Under what circum as officer of A&P permitted to buy Waldbaum stock under 10b5? Chiarella theory could. - Offeror could buy stock. iv. Officer of offeror? If agrement b/w A&P and oficer - "Give them right to trade" Rights are A&P's info (like WSJ's info) - can give away. FIDUCIARY DUTY THEORY- duty owed to sh (hard to get sh to sign away) MISAPPROPRIATION THEORY - can get to permit you Under 14e-3, nothing permits that POLICY - 14e-3 - Beneit sh of Target (Waldbaum). Prohibt trade on information disparity. (13(d) - A&P can buy 5% of Waldbaum b/f 5%. Not officers b/c circumvent 5%) Chiarella - prevent offeror A&P buy W stock when fid duty or similar reln b/w dir A&P and sh of W -> not prevent Ct maj: 10b-5 - Crucial issue in determining Keith's liability - Whether relation of Keith with his wife or Waldbaum family is fiduciary or similar trust and confidence? NOT ENOUGH TO BIND YOU TO FID RELN i. family relation ii. someone tell you secret info (Walton v. Morgan Stanley) Methodology of figure out what kind of relations are fid or sim trust and confid - Common law Fid Rela (AmJur) - Share essential ingredients - reliance, dominance, superiority/contrl -> Keith and Susan - no duty to breach -> Chestman no have indep fid duty -> not have tippee liability Winter dissent: Majority - artificial and noncontextual. Opinion 10b-5 based on precedents, unclear, a mess. Everyone cite Cady Roberts - not mesh w/ Chiarella -> we have right to resort to policy. 10b-5 policy arg: Theft, Prop rights of information, protect corps, sh against other people use their prop rights. Should guide us in determine when impose a duty not to trade. Not common law. Taking of property (Keith) hurt legitimate owners of info (Waldbaum) - family and shareholder's prop rights here have to protect 67 Winter 3 factor test - Under what circum impose duty on family member Keith to not trade (violate 10b-5)? Nobody could have traded under this test! i. Expect benefits ii. In pos to learn confid info iii. Know? e. Hypos - 10b-5 i. Could Ira have traded on info? No b/c Pres/ dir Chiarella reln to own sh ii. Could Shirley have traded? (Not under 14e-3) No. Dirks - tippee - depend on whether Ira breach duty - depend on got any benefit/ Told her b/c want help older woman. Sister -> personal benefit - Yes, duty b/c (a) gift to relative (b) reputational gain translate to future earnings. If she said "I won't tell -> can't under Chiarella) iii. Can Susan trade? She not have fid duty. Tipee from tippee? Did Shirley breach her duty? Person al gain? no. "Stop worry about me" to daughter = personal gain? iv. Keith? Why Susan tell husband - very attentuated. If Keith promise to keep secret -> implied agreement confidential. What if Keith nod? If Keith said nothing -> not clear that agree keep confidential -> subjec to duty disclose/abstain. Ct: FIDUCIARY DUTY OR SIM RELA TRUST AND CONFID Chiarella - why do we need fid duty? B/c common law frad - don't have duty to disclose w/ people who you transact Necesity of fid duty T & C - bsed on whom fraud perpetuated? Person transact with. Absetn duty -> not need disclose Misappropriation theory - source of info being defrauded. Comm L - only commit frud upon someone with fiduciary duty? Can you dfraud someone w/o special relationship? Why majority talk about fid or sim T & C duty in context of misappropriation theoy? Where does this rquirement come rom? Fid duty of T & C - Carpenter - duty of confidentiality not fiduciary. (Chiarella Burger dissent - Misappropriation theory?) Duty of confidentiality and illegality of the act similar to theft (Misappropriation = obtain info by unlawful means "Foul play rather than fair play." (Unfairness -> equal access rejected) If Keith agrred with Susan not use info waould he have entered into fid reln with her? Yes, pure Kual duty to confidence -> clear can't use it to trade? Under misappropriation theory. Relation b/wthat and fid relnsip? This case b/c no other relationship impose a duty on Keith? f. Hypos i. ~Keith - expect pending merger b.w A&P and Waldbaum - not tender offer. Can I trade on info or not? Not under 14e-3. (Chestman - can trade 10b-5) ii. Normally charge $10,000. Just permit me to trade on this infor as well. Any problem? If client can trade -> can enable lawyer to trade. Duty of onfidentiality with client so cna't trade w/o permission. Tipper no duty to co b/c else couldn't trade either. (Dirks - can't inherit duty) iii. Co has accounting bill, fairly high. Co want reduce costs -> permit accounting firm trade on info. You learn from co. Dirks footnote 14 - but K expressly deny such a duty. 'Only if client expect you keep confid and relation at least imply such a duty' -> Tippee liability b/c corp under duty and breach duty by permit them for pers gain to trade. NOTE: Sec L - direct claim, not derivative suit (only state L) 68 iv. Can Waldbaum buy its own stock? No b/c duty to sh Dirks Footnote 14 - Relation corp to acct. Relation acct to sh that matters. Acct expected to keep info confiential. Imply a duty -> But corp can't waive this duty by construct new K. NOTE: BJR (claims for br duty under state L) not apply to Fed Sec L v. Can corp give up sh rt not have anyone trade nonpublic info? a. Fiduciary duty - Ftnt 14 allow it. Policy Winter - prop rts in info - trading may have neg impact on tht. Collapse fid duty (about prop rts in info also) into misappropriation theory. b. Misappropriation theory - Fraud upon corp, clear corp can give it away 69