CORPORATIONS I. INTRODUCTION: THE CORPORATE STRUCTURE II. The Corporate Form A. The Corporate Form 1. The corporation is the standard form of almost all American firms--Why? The key attributes of the corporate form all depend, directly or indirectly, on the legal identity of corp. as distinct 'persons' apart from their shs and bods: a) Limited liability for investors 1. ie. a sh's liability is normally limited to the amount he has invested. 2. exception--when corporate veil is piereced. b) Free transferability of investor interests 1. ie. liquidity/right to exit at will c) Continuity--seperate legal entity survives shs d) Centralized management 1. allows for seperation of labor and investment. 2. shs elect bod which elects officers (officers manage daily operations per bod instructions) 2. The corp. form is well-adapted to raising equity capital from passive investors. a) ie. designed to raise funds on a capital markets. 1. share--unit of stock 2. stock--interest of ownership b) corporation--"capitalist cooperative" vs. c) partnership--"labor cooperative" 3. The corp. form may differ in appearance and function: a) Closely Held Corp.--has special rules 1. small #'s of shs that rarely trade shares 2. shs are top managers b) Public Corp 1. large #'s of shs w/no control and who desire inactive investor status 2. professional managers w/legal power to run corp. on sh behalf. B. The Incorporation Process 1. Articles of Incorporation must be filed w/the Secretary of the State 1. process includes filing and payment of fee. 2. formal existence commences w/filing of articles of incorp. 3. after filing, organizational meeting must be held where first bods are named or if they named in the articles of incorp., by the bods themselves. C. The Sources of Corporate Law 1. Once you have formed a corporation, it is governed by the "law of corporations"→relationships of power (ie. relationship b/t and among the corp, the shs and bod). 1. The hierarchy of controls on bod is (ie. "higher" rule trumps): 1. Fed law 2. State law (statutes and case law) 3. Charter (cert. of incorp.) 2 4. By-laws 2. Federal Law and Regulations 1. Main source of fed law is 1934 Securities Exchange Act and SEC. 2. important regulations are those on voting, acquisitions of corps., and insider trading. 3. State Law a) State Corp. Statutes (1) The most important laws on corps. are the state corp. statutes. (2) Though there is general uniformity of structure among states, most large corps. are in Delaware and are governed by DGCL. (3) Basic allocation of power laid down by corp. statutes: (a) SHS--main power is election of bod at annual meeting. 1. if dissatisfied with bod, can (a) elect new bod at next meeting or (b) remove them at special meeting or (c) by written consent. (b) BOD--legal power to manage corp. 1. ie. decide dividends, salaries, business decisions (c) Officers--manage day-to-day operations (ie. CEO). 1. officers are bound by bod directions. 2. officers that are also directors are inside directors. (d) Bod must get sh approval for certain big decisions: 1. dissolution of corp. 2. sale of all or most of corps. assets 3. merger of corp. with another corp. 4. amendment to certificate of incorportation. b) State Case Law 1. In particular, case law defines duty of care (ie. not to be negl. in management) and duty of loyalty (ie. to manage for shs, not self). 4. Corporate Contracts a) Charter Provisions (1) Charter provisions are only valid if they are not inconsistent with fed. or state law. (2) Charter=Cert. of Incorporation→two types of provisions: (a) mandatory provisions--DGCL 102 (a) 1. ie. name, addresss, # of shares, purpose (b) optional provisions--DGCL 102 (b) (i) ie. bod, sh action, charter amendments (ii) DGCL 141 (governs bod)--must have elections every year under two options of 141(d): (a) elections every year for all bod (b) multi-year terms w/staggered elections (iii) DGCL 141(k)(1)--Any director, or the entire bod, may be removed, w/or w/o cause, by the majority of shs entitled to vote, unless: 1. charter provides only for cause; or if cumulative voting, it must be for cause. (iv) *For other examples of charter provisions and the extent that they dole out more or less power to the bod and shs than the law allows, see xyz charter (I-12)---DGCL is the standard measuring tool. (3) How much power should bod be given? (a) Pro-Bod: 1. Small shs want strong bod to protect from big shs--ie. removal of bod only for cause so biggies can't dominate at will (shs are generally shortsighted). 2. Bod are also believed to be experts while shs are too incompetent and short-sighted to make decisions. 3 (b) Pro-SH: 1. Shs own the company, not the bod, and they don't trust bod to achieve their goals. (c) The lawattempts to balance these fears/views. (4) Ultra Vires/Purpose (a) Classically, acts beyond the corp's charter were held to be "ultra vires" and were unenforceable against or by the corp. 1. ie. used as a strong tool against honoring K's (b) Today, a corp. has the power to do anything under DE law 1. ie. even implied power to make charitable contributions or fringe benefits to employees. b) By-Laws (1) By-laws and charters can modify state corp. statutes only if corp. statutes contain "default" rules--ie. if law provides for it by their own terms. (otherwise, the rule is governed by default rule in state corp. law). (2) By-laws are easier to change than charter--unlike charter, majority of sh approval not required--bod alone may amend. (3) DGCL 109(a)--amending by-laws (a) Before corp. has received $ for stock--Bod may change by laws. (b) After corp has received any $ for stock: 1. General rule--shs 2. Special rule--shs and bod may change by-laws if it is in charter. (c) Comparison--DGL 242(b)(1)→majority of outstanding stock needed to amend charter. c) Should provisions go in Charter or By-laws? (1) According to DE law, most provisions can go into either. 1. If you wish to prevent bod from changing them, put them into charter. 2. However, if bod wish to have the power to change the provisions, they should provided for that in the charter also (ie. b/c the bod and shs must act together to amend the charter→bod must make the proposal). III. Basic Concepts in Valuation and Corporate Finance 1. (Ch. is an interruption to learn some stuff that is imp. to the understanding of corp. law). A. Time Value of Money and Discounting 1. Basic concepts: a) today is worth more than $1 a year from now. 1. ie. you get a renter's fee (interest) on the $1. b) How much more is it worth today? (1) Answer will depend on the alternatives→all alternatives must be translated into present value (method of doing so is called discounting). (2) Present Value--the value today of money at some future pt. (3) Discount Rate--equivalent to the amount you could earn from interest for one year (only applies to market rate of return, not from an investment). 1. ie. discount rate of 10% means you get $.10 interest on $1 for one year. 2. Or, the discount rate is the market rate of return. c) Present Value = (future cash flow) ÷ (1 + discount rate) 1. Or, for multiple years, PV = (future cash flow) ÷ (1 + D1)(1 + d2). 4 2. Or, for multiple years at same rate, PV = (future cash flow) ÷ (1 + D1)² (or, for however many years). 3. Discount factor→(1 + Discount rate) (1) Net Present Value = the difference b/t the present values of the amounts invested and of those received in return (a) ie. NPV will be positive if the rate of return (amt. earned if you invest in particular project) exceeds discount rate (market rate). (b) The discount rate is determined by the market while interest rates are determined by K when you borrow or lend money. d) The higher the discount rate, the lower the present value. (1) ie. the more interest (discount rate) you will earn over the year, the less is must be worth today in order to reach a similar amount at a lower discount rate. B. Risk and Return 1. In real world, must consider how uncertainty of investments affect the concepts of discounting and present value--ie. have to calculate expected future cash flows and adjust the discount rate. a) Expected cash flows--weighted ave. return (ie. 50 if you win, 0 if you lose, 15% chance you win→(.15 x 50) = $7.50. (*you have to add up all the sums of the seperate probabilities times their payoffs). Thus, (1) PV = (Expected future cash flow) ÷ (1 + Discount Rate) (2) Risk associated w/investments is defined it terms of how much the possible returns deviate from the expected returns. b) Risk--as most investors are risk averse (ie. dislike risk), they must be compensated with a risk premium (1) Risk neutral investors don't care as long as projects have the same expected return→ use risk free discount rate. (2) Take account of risk by discounting at a higher rate (a) ie. because a higher discount rate means lower present value, a highly risky project should lower the present value even more--thus, the higher rate. (b) ie. a bird in hand is worth two in the bush. (3) Risk Premium--the difference b/t the expected return of a risky project and the certainty equivalent (ie. amount one would give up in order to be rid of the risk in the project). (a) *Risk Adjusted PV = Expected Cash Flow ÷ (1 + (risk free rate + risk premium)). (i) Thus, for the risk free discount rate for a project, look at interest rate of 1 year treasury bond; but for all else, the discount rate differs from interest rate. (ii) ie. more risk in expected future cash flows means, of course, a higher risk premium and a higher risk-adjusted rate (modified below). C. Diversification--risk aversion means that investors are only averse to risky investments that they actually have to bear→it is possible to reduce risk by investing in many diff. projects (ie. don't put all your eggs in one basket). 1. Undiversifiable risk--risk that investors must be compensated for by a risk premium. a) also, some risks are so fundamentally important, they are not subject to diversification--ie. nukes, global recession. b) if, however, an investor can fully get rid of diversifiable risk, must use risk-free discount rate. 5 2. Full Diversification--it must be that no investors have to bear risk--ie. everyone can find other projects that would diversify the risk (mets/yankees example). a) Test--if the risk from a certain bad event taking place is so minimal, that the investor doesn't care/is neutral. b) If a risk is undiversifiable, there will be some people who get hurt (even if some are not)→ those who do bear risk, get the premium. (1) However, the mroe corporations that there are, the risk 3. Thus, the higher the amount of undiversifiable risk, the higher is the risk premium and the risk adjusted discount rate. D. Capital Market Efficiency 1. Intrinsic value of stock is the PV of all future dividends. Market Value is the closing price on stock exchange. These values will generally be equal. What set of information is the intrinsic value estimate based on? 2. How close are these two values? a) Efficient Market Hyp (EMH) (1) Strong Form says that they are the same since all inflo (private and publicly available) is accurately reflected in market price (bullshit) (2) Semi-strong Form--says that they are pretty close since all publicly available info. is accurately reflected in market price. Thus, only new info affects price. (a) Some semi-strong proponents argue that the market undervalues companies with long term projects, and that bod should focus on short term (liquidity premium may compensate short term investors). b) No one really believes in strong form but many believe in semi-stong form. ie. market prices are relevant to some extant. 3. Thus, extent to which you believe market prices are relevant to intrinsic (true) value of stock will effect your view of how corporate law should be structured. a) the EMH has an imp. influence on devel. in securities law---Del. cts. skeptical. 4. Thus, if you only have public info., it is better to go with market value than with your own guess as to the intinsic value of the stock→market value is still best estimate. a) Under strong form, you never make abnormal profits. b) Under semi-strong form, you make abnormal profits only if you are lucky. Best thing you can do is to diversify your portfolio. IV. Corporate Securities and Capital Structure A. Introduction 1. Assuming that a business decides to incorporate, it must also decide how to design and distribute its corporate securities. a) Generally, corp. must raise money by either equity contributions or by borrowing. b) All of the corp's equity, and often much of its debt, are raised by issuing securities. (1) Authorized Stock--# of shares allowed by charter (2) Issued Stock--stock that corp. is not only entitled to give out but has been sold in fact. (3) Treasury Shares--shares held by the corp. itself (ie. issued and bought back). 1. treasury shares are considered issued shares b/c received value for stock at one pt. 6 2. However, treasury shares have no voting or dividend rights. 3. issued shs -treasury shs = issued and outstanding (4) Stockholders Equity = par value x # of shares issued (a) Shs equity is the total ownership that all shs have in the corp (ie. the corp's net worth) (b) par value is an arbitrary $ that is completely unrelated to stock's value. 2. This will yield a capital structure: a hierarchy of claims against the revenues generated by the business. a) ie. creditors with hard contractual rights get paid first; then shs may receive dividuends. 3. The ownership interest (stock) has two formal rights: (1) claim on firms residual earnings, and (2) right to vote. a) Corp. statutes place few restrictions on precisely how control rights and earning claims are to allocated among classes of stock. b) However, there are two generic categories: common and preferred stock. 4. Common Stock: usually carries voting rights. a) classes of common stock remain common b/c they hold residual claims for dividends that can only be exercised after other claims are satisfied. B. Prefered Stock: stock with a claim on dividends or assets that come ahead of common stock. 1. If company makes a profit, how is profit distributed to investors (2 elements): a) Order--who gets payed first? who gets more? (1) in order to determine order, give shs different classes of securities. b) Magnitude--among classes which get paid in same rank, what % does each get? c) ie's--(a,b,c each get a third) (a gets first mil, b gets 75% of rest, c gets 25% of rest) (a gets two-thirds of first 2 mil, b gets one-third, c gets rest) (a gets first mil, b gets 2nd mil, c gets rest) (1) Option 1--only need 1 class of security--cs (2) Option 2--2 orders of magnitude, therefore need 2 classesof stock (give A either either ps or bonds for one mil, and 75 cs for b, 25 cs for c) (3) Option 3--2 orders of magnitude. A and B can get ps or bonds (A gets $1.3 mil, B gets $.67 mil), C gets cs. (4) Option 4--A gets $1 mil in bonds, B gets $1 mil ps, C gets the rest in cs. d) Every entity must have residual owners. In a corp., the residual owners are the common shs (every company must have cs class) (1) generally, the lower the seniority of payment, the higher the level of control. (2) ie. common shs have power to elect bod b/c the lower the rank, the greater the incentive to make sure corp is doing well all the way through→the residual owner cares. (3) Generally, preferred stock does not carry the right to vote for bod but the preferred contract may shift this right from common to preferred stock if no dividends are paid to preferred holders for long time. (a) if nothing said, presumption that ps has same voting rights as cs. 2. Conversion--right to exchange your secuity for a different security. a) If you convert, you do it at a pre-specified rate in the K. (1) precise rights of preferred shs may vary and are defined in "certificate of designation" or charter (2) The certificate must have provisions relating to: 7 (a) dividends and liquidiation (b) conversions b) If ps is redeemable, corp. can force you to sell/convert. C. Adjustment Rights and Preferred Stock Protection--Marriott Corp (*imp--see review class notes from 9/27) 1. Adjustment rights are supposed to stop funny games by bod and cs holders--value outcome should be roughly the same if you convert b/f or after the issuance of dividends to cs holders (see below). 2. Spin-off--same shs will own the 2 new companies. This is accomplished by a three step process: a) Creation of new corp. (ie. a subsidiary) b) Transfer of assets to new corp 1. ie. from Marriot corp. to Marriot Int'l c) Payment of special dividend of stock in new subsidiary to all holders of common stock of the parent corp. 1. This is the crucial step--creates a seperate corp. w/assets, but in the hands of the same shs. 3. New Corp. must cope with dividend issue--ie. what is the effect on the preferred stock holders of the parent company if the parent is left with a disproportionate debt burden. a) ie. In Marriot, Int'l and Marriot will be paying the same dividend rate but ps may not get anything b) ps claim that Marriot is coercing them into converting before the special dividend, by suspending future dividend payments, in order to keep family in control (ie. if there will be no more dividend payments, shs will want cs in new corp). 1. ie. if ps convert after the spin-off, they will get many more shares of Host Marriott and have control of it. If they convert b/f the spin-off, there shares will be in both companies and family will still have control. 2. Thus, the coercive pressure is to sell b/f the spin-off in order to realize the true market run-up. 4. Ct said that protection already existed in the K itself and bod can therefore suspend dividends as it sees fit. Ct. will not imply fiduciary duties in the face of a K. a) Protections include: dividends, liquidation preference, redemption price, vote out bod, conversion, adjustability of conversion price (p.I-40, and *review session 9/27) b) However, these rights do not help the ps if they do not convert--ie. rights are only in Host. 5. Adjustment to Conversion Price occurs if you do convert (9/9 handout) a) ie. whenever Marriot (or other corp) distributes assets to its common shs, conversion provision protects the value of the preferred conversion right by reducing the conversion right. b) Adjusted conversion price = (conversion price x current market price of cs) -(fair market value /current market price of cs) 1. Normally, this formula works in most cases, except when the dividend is so large that what is left in the corp. is itself worth less than the pre-distribution value of the ps (value of dividend is higher than market price). 2. ie. there cannot be a negative conversion price--in such cases, the chancellor must declare the transaction invalid→must protect the rights of the ps as implied by the adjustment clause. D. Forms of Debt 1. Three main sources of debt: a) trade debt--owed to suppliers, little legal baggage, paid quickly b) bank debt--more complex, may be under a revolving credit agmt. 8 (1) bank debt agmts may contain convenants which may limit right of corp. to pay dividends, invest, or incur more debt. c) bonds--often redeemable (callable) by the corp (w/interest or for cs) (1) most bonds pay interest in cash at a fixed rate E. Creditor Priority 1. Generally, all creditors are treated equally (pro rata basis) in a dissolution or liquidation. There are 3 exceptions to this general rule: a) Statute--ie fed. bankruptcy law says otherwise b) Secured debt (1) collateral goes first and fully to secured creditors but only to extent it is needed. (2) if there is not enought collateral to cover all secured debt, the rest of the debt is treated as unsecured debt (pro rata distribution) (3) to be unsecured does not mean it is subordinated c) Subordination Agmt.--agmt by which subordinated claims agree to be behind senior claims in priority (1) such agmts are b/t specific creditors and do not affect non-parties 2. HINT--if you have both secured and subordinated debt in the same problem, it is best to deal with the secured debt first and then the subordinated debt. (1) secured debt--figure out how much of the collateral is to be used and then how the remaining assets will be distributed (2) subordinated debt--first figure out how much each get absent subordination and then adust for it. 3. Why would anyone be subordinated or unsecured? a) to induce new lenders if corp. is weak (ie. esp. an owner/cred) b) to get higher interest rate on repayment c) belief that the corp. is safe (ie. doesn't matter) d) No choice (trader creditors, tort claimants etc.) F. Leverage 1. Generally, the greater the disparity b/t debt and equity, the higher is the leverage 2. Greater leverage has 2 effects: a) increases the riskiness of equity (1) ie. more debt means that there are more people ahead of you since debtors get paid first. b) increases the expected rate of return on equity (provided expected rate of return on assets > interest rate paid on the debt) p. I-59 (1) leverage makes the equity investment more volatile/risky--ie. expected rates of return on equity investment will be higher and lower at extremes with 50% debt than with all equity. (2) w/debt, must always make interest payments 3. Factors to consider when choosing b/t debt or equity for $: a) affect on cash flow (with equity, dividends are discretionary, interest payments are not) b) possible loss of control (voting rights for shs) c) risk to corp. assets (debt creditors can force liquidation) 9 V. PART I: LIMITED LIABILITY AND THE RIGHTS OF CREDITORS VI. Limited Liability A. General Tension 1. Limited liability permits shs to shift some of the risk of business failure to debt-holders. Shs w/limited liability can easily abandon obligations of the firm that goes bankrupt, leaving creditors in control of business when it performs badly→thus, creditors want to be able to collect and do not want to see assets depleted in favor of shs. B. Arguments for Limited Liability: 1. lowers the monitoring costs of management and other shs a) ie. if overall risk is so low (b/c of diversification), monitoring isn't worth the cost--identity of other shs is irrelevant 2. lowers the cost of equity capital a) ie. shs willing to tolerate seperation of investment and management. 3. allows for liquidity of shares and market efficiency 4. allows for diversification of risk--if not limited liability, greater diversification would only make investment more risky C. Arguments for Unlimited liability--although limited liability is accepted, there are claims that shares should reflect tort costs and bod should be more risk aware. Won't happen b/c: 1. would impair markets ability to diversify risk and value shares 2. alter id's & investment strategies of shs (go for fixed rate securities) 3. induce market participants to monitor excessively. VII. Agency Costs of Debt A. Generally--talking about a company as an agent for creditors 1. Concern (by creditors) that bod may act to increase value of shares, as opposed to acting to maximize value of company (value of shares and debt) B. Types of Agency Costs 1. actions by corps. in the interest of shs, but not in the combined interest of creditors and shs a) ie. risky investments--shs want more risk b/c big benefits if it works out, and if it is bad, shs lose but creditors lose more. 2. costs of designing K's to prevent bod from taking such actions a) ie. limitations on bod's ability to pay dividends or repurchase or redeem stock 3. costs of observing and monitoring compliance of agents (bod) VIII. Dividend Tests in Corporation Statutes A. Generally, corp. cannot pay dividend if it would result in insolvency (ie. as assurance to creditors) 10 1. remaining legal sources of creditor protection are: a) fraudulent convenyance law b) equitable subordination--insiders debts subordinated to outsiders c) veil piercing B. DGCL 170 provides an alternative to the minimum capital req't (results in ineffective protection for creditors). Dividends may be declared: 1. out of surplus 2. out of profits for current year 3. out of profits from previous year 4. out of sum of profits from this and last year. C. Surplus (dgcl 154) = Net Assets (amt. that total assets > total liabilities (aka, shs equity)) -Stated Capital (par value x number of shares issued) 1. This provides the bod with loopholes that favor shs b/c stated capital can be lowered by: a) canceling # of shares issued/retiring treasury shares b) reducing par value (by amending charter w/sh and bod approval) c) or, can increase net assets through revaluation IX. Fraudulent Conveyance Law A. Generally, it is a broad statutory framework for voiding any transfer made for the purpose of delaying, hindering or defrauding creditors 1. ie. can't defraud creditors through a bogus transfer of assets B. Fraudulent conveyance law plays an imp. role in creditor challenges to LBO: 1. Leveraged Buy-Out accomplished by: a) acquiror buys another corp. with borrowed money and target's assets as collateral (all of public stock usually bought out at large premium) b) combined corp.(of holding co. and target) must repay debt (1) winds up with much more debt and no new assets c) everyone is happy, except for unsecured, pre-LBO creditors (whose pro-rata share of debt significantly decreased) (1) when LBO corps failed, creditors claimed it amounted to a fraudulent conveyance and wanted debt claims of LBO lenders subordinated to their own. C. Gleneagles Investment Co.--imp. precedent that later cts. follow (see 9/21 handout) 1. Facts--Greate American (Hoffa et.al) was a holding co. whose only assets where an option to buy RC, but they had no $. ITT gives $ to RC and subsids (secured and guaranteed debt), who loans $ to GA for an unsecured note. GA bought out all shares of RC. In bankruptcy, trustee (on behalf of creditors) of RC sought to void transfer of security interest to IIT as a fraudulent conveyance. a) In exchange for $, IIT got: 11 (1) mortgage (secured debt) on assets of borrowing co (RC) (2) guarantee by non-borrowing corps. to repay which was secrued by assets of borrowing corps.--everyone liable. 2. Court held: a) Tranaction invalid b/c afterwards, RC had huge secured debt to IIT, some residual cash, worthles note, and new management. Ct. said no fair consideration. 3. Why did they try this round-a-bout way (LBO)? a) b/c GA had no assets and was not a good credit risk. b) end result was that RC had a lot of debt and only an unsecured note to show for it. 4. IMP. PT.→you always want your obligations to be in the real asset corp. rather than the parent corp. If obligations are in parent co, its debt becomes subordinated by the debt structure and you get paid last. a) Best to last: (1) secured debt in real asset co. (2) unsecured debt in real asset co. (3) debt in parent co b) Since shs get remainder after creditors are paid, if subsid. corp is liquidated, its shs (parent corp) gets remainder. Thus, if ITT secures its LBO loans in assets of subsids, it will get much more than if we had follow remainders up debt structure (see class chart on 9/21). 5. Statutes relied on by PA ct. here (constructive fraud tests--intent of transferor/ee not in is issue): a) § 354--must show no fair consid. and insolvency. (1) fair consid. includes good faith, reasonably equiv. value b) § 355--must show no fair consid. and unreasonably small capital. c) Ct. said that no fair consid. here b/c RC was basically paying itself and no good faith b/c ITT had knowledge of RC's insolvency and fact that no consid. (1) In LBO, lender can only prevent secured assets form being invalidated by court if: (a) corp. is not insolvent (hard to do) (b) make sure there is good faith D. Fraudulent Conveyance vs. LBO (Baird and Jackson) 1. View that fraudulent conveyance shouldn't apply to LBO's: a) Unsecured creditor's should have bargained for LBO protection in K (and take lower interest rate). (1) ie. as Del. ct. believed ps holders had done in Marriot (2) necessary for all creditors to K out for all to benefit--easier to contract in (weird view) b) LBO is analagous to case where frim takes out a loan and uses the proceeds in a dividend for existing shs (if creditors weren't sophisticated enought to get protection there to set transaction aside, then it shouldn't be diff. here) X. Preferences A. Generally 1. Law of preference is meant to stop the payment of some creditors to the detriment of others→ reduces risk of a "run" on corp. assets by allowing recovery of payments (to favorites) made just before filing. 12 a) Only applies to transfers of assets/properties (transfers of obligations allowed) b) if something is identified as a voidable preference, it must be returned. c) even if something is not a voidable preference (ie.b/c person is not a creditor), it still may be a voidable 2. Preferences reduces creditors monitoring costs & agency cost of debt a) otherwise, creditors would call in debt at early signs of financial problems B. A transfer is a voidable preference if : 1. transfer of property 2. to/for benefit of creditor 3. for antecedent debt (ie. not prepayments on future goods) 4. must be insolvent at time of transfer 5. transfer took place w/i 90 days of bankruptcy (1 year if insider) a) year for insider b/c better info., power to decide payments, and power to delay filing. 6. creditor received more than it would have in Chap. 7 liquidation a) Ch. 7 is liquidation acording to cred/sh structure we studied b) ie. ok if secured debt b/c it would have been paid anyway C. Exceptions: 1. Contemporaneous Exchange--simultaneous exchange isn't preferential a) however, 30 days may be too long 2. New Value--exception if existing creditor gives debtor new value AFTER an otherwise preferential debt payment--only the difference b/t repayment and new value must be returned. 3. Ordinary Business--trade creditors excepted XI. Equitable Subordination A. Generally (*only for bankruptcy) 1. Equitable subordination permits bankruptcy courts to set aside the claims of shs or other insiders against a bankrupt corp. until the claims of outside creditors are satisified. 2. Insider must be held to have behaved unfairly or wrongly toward the corp. or its creditors → whether transaction can be justified w/i bounds of reason and fairness a) ie. cases turn on a finding of "fraudulent conduct by the insider, mismanagement, or inadequate capitalization" b) However, lower standard than piercing veil--less drastic as well since not going after shs' other assets 3. Problem with Equitable Subordination a) law provides an incentive for corp. to take $ out early→if capital is taken out in cash, there is no debt to subordinate outsider creditor's debt to. b) however, insiders may then run into problem with fraudulent conveyance or B. Costello v. Fazio 1. Facts: 13 a) person partnership incorporated and converted equity into corp. debt (assets and liabilities of p'ship is transferred to corp). b) however, the partners were still liable for existing outside debt (corp. can assume it & be liable, but you are still responsible) c) years later, corp. files for bankruptcy and ind. partners are among creditors 2. Court equitably subordinated their claims to other unsecured creditors--why? a) stripped corp. of capital for personal gain b) undercapitalization (not enough by itself) c) knowledge that such a capital structure would be detrimental to corp. and creditors→intent. 3. Important to note that here the outside creditors were pre-incorp. creditors so they couldn't have contracted for protection. a) also, it may not be a fraudulent conveyance here b/c they were the only representatives of the p'ship--no one else could bring claim XII. Piercing the Corporate Veil A. Generally 1. Equitable power of the court to set aside the entity status of the corp. to hold the shs personally liable on contract or tort obligations a) most frequently invoked, and most radical, check on limited liability b) piercing is almost by definition done in to a closed corp (although can arise w/i corps.--parent and subsid) c) judge made law--thus, rather vague, unclear, and fact-based 2. Piercing is more extreme than equitable subordination (where only debts owed to shs is w/i reach of creditors)→used sparingly 3. Lowendahl Test: a) complete domination of corp. policy by defendant sh (easy to find) b) control used for wrong or fraud c) wrong was cause of harm B. Factors in holding Shs personally liable: 1. No corp. formalities--ie. no meetings, no shares issued a) ie. demonstrates that corp is alter ego of sh 2. Undercapitalization (never enough alone) a) Pt.--only deal with piercing when there are insufficient funds and corp. is bankrupt--ie. subsid never had sufficient funds 3. Fraud (ie. P was unaware of true ownership--perhaps careless) 4. Alter ego (sh treats corp. assets as his own) 5. No independence form other entity (parent:subsid. context) 6. Tort creditors (more likely b/c invol. and couldn't negotiate protection) 7. More likley done against active shs (v. passive) C. Zaist v. Olson 14 1. Facts: Olsen Inc. (olson owns 99%) hired contractor to clear land, but says to bill East Haven subsidiary (of which the Olson corp. owned 99%). Subsid went under (b/c Olsen didn't try to make a profit) and contractor wants to collect from Olson personally. 2. Court pierced veil using the Lowendahl "instrumentality" rule--how does this case differ from normal case of closely held corp? a) Court--Olson manipulated and planned his own enrichment--never tried to make any money through corp. b) Kahan--this is a bad decision--what was the wrong? should Olson have to inform all contractors of risks? Dissent says there should be "fraudulent or illegal purposes" test. D. Walkovszky v. Carlton (leading tort veil piercing case) 1. Facts--Calrton takes out minimum in insurance for each cab--each of 10 cabs has its own corp. Minimum assets in each corp. P wants (a) all ten corps. liable b/c treated as part of same org. and (b) Carlton to be personally liable. 2. Carlton gets off--but Kahan says also wrong decision. a) Thin capitalization here, but medallions are judgment proof and he carried only legal minimum of insurance statute (1) Cab co. made $ but it was siphened to Carlton right away--results in permanent undercapitalization. (2) This isn't any better than Olson not trying to make any money at all. b) P here couldn't choose who to deal with whereas Zaist could have done research or contracted for protection--reason why it should be reversed. (1) hard to reconcile two cases--agree with dissent in both. 3. However, other nine cab corp. held liable b/c can't split up a true company in fact into diff. corp's on paper (however, 10 x 0 = 0) E. Dissolution and Successor Liabiltiy 1. shs can eventually escape liability by dissolving the corp. and abandoning the assets (DGCL 278--can still sue corp. for up to 3 yrs) 2. it is harder to escape tort costs by selling corp. assets b/c of successor corp. liability: a) if purchasor is aware of defectiveness of product line, offering price will be reduced by amount of expected liability b) to avoid successor liability, purchasing firm must have no operation identifiable as continuous with the selling firm's product line. (1) ie. factories, machines, and trademarks must be sold piecemeal or destroyed XIII. Contractual Creditor Protection A. Generally 1. Creditors regularly demand greater protection than is provided by general doctrines of fraud. convey, preferences, equit.subord, and piercing→Covenants are often used in bank credit agmts. and indentures (credit agmt. b/t company and public bond holder) a) Thus, Convenants are contractual protection for creditor B. Things that Creditors (bond-holders) should Protect against (see Palco indenture): 15 1. Restricted Payments--Deals where $ flows out for nothing in return a) Parent pays out dividends (if subsid. gives divs, they go to parent-ok) (1) exception--dividends payable in Capital Stock b/c no asset transfer and creditors aren't effected (Capital Stock refers to definition on p. 108 but same as capital stock generally) (2) Capital Stock--all stock except that redeemable before 1996 (when loan is repaid)--ie. if it is redeemable, assets might go out. b) Parent or subsid. pays out assets--ie. stock repurchases (1) But, don't care about repurchases of subsid's stock (by subsid) b/c it either increases parents relative share of pie or results in cash in parent's coffers (depending on who it is bought back from) 2. Restricted Borrowing a) More borrowing--only expands creditor pie 3. Transactions with Affiliates--restrict all deals except those b/t corp. and wholly owned subsids. a) can't enter into agmt w/affiliate unless the terms are fair to corp. (as measured by whether it would enter into that agmt with non-affiliate) b) definition of affiliate--person/entity directly or indirectly controlling corp. ie. can't deal with sister corp (1) Stops payments of large salary or worthless sales of pianos to company at high price in order to remove assets. C. Palco Agmt. Restiction on Payments--section 3.08--Prohibited deals: 1. Palco can't pay dividends 2. Subsids can't buy Palco stock 3. Palco can't buy Palco stock 4. No restriction on divdidends by subsid. b/c shs is Palco itself D. How much $ is available for restricted payments (end of sect. 3.08)? I-110 1. of agg. net income (profits)] + [net agg. proceeds (what you get from stock)] -[agg. prior resticted payments] 2. Consolidated Net Income--Must add up all income (net) since startng date (defined on p.109) a) if sum is a negative number, you can't make restricted payments b) if agg. net income is negative, you don't divide by half, but merely subtract as deficit (remember, it is all agg. so there may be remainder from previous period). XIV. Summary of Creditor Rights A. Fundamental ways in which Creditors are hurt: 1. Funneling off assets from corp. to shs a) Costello case--insiders receiving payments first b) Zaist--corp. never tried to turn a profit c) Gleneagles--LBO--corp. stuck with debt and nothing in return d) Calrton--profits continually drained from corp. e) Preferential treatment for insiders--higher agency costs of debt 2. Taking greater risks 16 a) law here isn't as clear of prevalent--ie veil piercing B. Questions to Ask about Creditor Protection : 1. Which protection devices are more effective? a) restricted payment agmts > fraudulent conveyance>veil piercing 2. Which strategies are more precise? a) restricted payment agmts> fraudulent conveyance>veil piercing 3. *Where are these strategies addressed? a) Restricted payment agmts--contracts b) Veil piercing--courts c) This is not a coincidence--situations where creditor acts to protect himself are more effective. PART II: MANAGEMENT'S POWERS AND DUTIES XV. Centralized Mangement A. Generally--Manson v. Curtis (1918) 1. RULE--Shs cannot act in relation to the ordinary business of the corporation or control the bod in the exercise of their judgment b/c: a) shs lack the expertise b) impractical c) shs need to be protected from themselves and their short-term desires 2. Court says that while it is ok for shs to conspire on corp. policy or selection of bod, shs cannot create a sterilized bod→under state statutes, bod are exclusive, executive representatives of corp. a) ie. management's role is derivative, shs's role is reactive--can only vote yea or nay and cannot amend bod propositions 3. DGCL 102(b)(1), however, allows for charter provisions limiting and regulating the powers of the bod and shs. a) --affairs of corp. shall be managed by bod unless otherwisw provided b) -charter of close corp. may provide that corp. shall be managed by shs rather than by bod. 4. If bod breaches a duty to corp (shs), every bod is held joint and severally liable unless they demonstrate why some should be less liable. a) Remedy is injuction of action not yet taken but if not satisfactory, then damages. B. Agency Costs of Equity 1. Generally a) The relationship b/t shs & bod creates agency costs of equity; instead of acting in best interests of shs, bod may pursue their own interests. b) This problem results when you have bods whose own $ is not at stake. (1) agency costs of equity lead to arg. that shs should govern. 2. Thus, there will be conflicting interests b/t shs and bod, some bigger than others. Key areas of conflicting interests are: a) compensation issues ($) 17 b) control c) personal gain (1) sales/transactions with oneself, hours etc. 3. Key factors that effect extent of conflict by influencing bod's desire to pursue shs interests: a) % of ownership (monetary stock held bod members) b) Fear of large shs (or friends of large shs on bod) c) makeup of bod (your friends, monetary interests of bod members) (1) ie. director is pres. of foundation to which corp. gives $ XVI. The Business Judgment Rule and Fiduciary Duties A. Generally 1. RULE--There is a rebuttable presumption that bod did everything right→shs/plaintiff must show otherwise. a) cts. will refuse to second-guess decisions by bod unless business judgment rule doesn't apply. (1) applies to "transactional justification" and for bod protection from personal liability b) Basically, bod gets a favorable presumption unless a clear caseis made out of fraud, oppression, arbitrary action (gross negl) or breach of trust (1) if there is a breach or rule doesn't apply, then the ct. will scrutize the intrinsic fairness of the corp. c) Courts acknowledge their general lack of competance to review decisions (1) encourages corporate risk taking and innovation 2. REQUIREMENTS--Director need only show that he is: a) disinterested (no self dealing) b) independent (ie. not controlled) c) informed sufficiently about transaction (no gross negl) B. Kamin v. Amer. Express 1. Facts--Corp. paid in-kind (stock) dividends to shs (bought at $30 but now worth $4). Shs brough derivitive suit b/c sale of stock would have generated tax savings (ie. capital loss). Thus, shs claim that bod breached fiduciary duties by giving dividend. 2. Ct. said there was no breach of duty b/c busines judgment rule applies: a) there was good faith (ie. no allegation of fraud or self-dealing) b) bod considered other options c) no self-interest 3. Ct.said that mere errors of judgment are not sufficient grounds for equity interference--bod's powers are discretionary XVII. Duty of Care A. Generally---it is the less important duty 1. Duty of care is purely processed based duty 18 a) unlikely that merits of decision will ever be discussed except for Doctrine of Waste situations (decisions that are really, really flagrantly stupid). b) issue will thus be what the requisite standard of due care that must be employed to escape liabity (1) ie. expressed in tort terms of negligence & reasonable personage 2. Directors must show that they went through a reasonable inquiry a) Plaintiffs will win only rarely b) Most decisions on day to day operations are therefore sacred if bod follows minimal process--otherwise corp. America could not function c) Reasonableness of inquiry depends on "ordinary director" standard (1) since bod can delegate, they must be on notice of subordindate's wrongdoing in order to incur obligation to investigate--ie. don't have to suspect everyone. 3. Why should bod be penalized for taking actions for the benefit of the corp? a) don't want bod to violate the law--very simple. Prevented by: (1) liability to shs or corp. if caught (if not, corp and shs benefit from action anyway) (a) if bod not certain action is illegal, outcome might depend on reasonableness of risk (2) prison, fines b) Breach of duty of care, however, turns out not be a very imp. duty. (1) very few bod's lose on poor process (even if you lose, there are director liability statutes--can only get an injunction) B. Graham v. Allis-Chalmers (Del. S.Ct. 1963) 1. Facts--P's claim that bod should have found out that employees had violated anti-trust laws. Corp. has 30,000 employees and bod meets once a month (88 hrs/year). Thus, bod isn't reviewing corp. all that intensely (officers spend more time on the corp). 2. Held--no violation b/c bod's effort (no knowledge of crime or gross inattentiveness) is sufficient to meet process based duty of care. a) By necessity, bod of large corp. can only deal with broad policy and must rely on information of officers. b) ie. ct. said that there is no rule of law which requires corp. bod to assume, with no justification whatsover, that all employees are incipient law violators. C. Smith v. Van Gorkom 1. Facts--Trans Union has a lot of tax losses and is trying to do something about it. Van Gorkom (ceo) is told that a LBO would be a possible strategy and come up with $55 share price after feasibility study ($ chosen b/c it was minimum that VG wanted for his shares). VG arranged a buyout by Pritzker at this arbitrary price. VG presented the plan at bod meeting and convinced somewhat sophisticated bod to accept. Shs sued for breach of duty of care and won. 2. Held--only concern here is duty of care, of which standard is gross negl. Standard only relates to process of making the decision, not to substance (substance is protected by business judgment rule). a) Court says this process was faulty, non-informed business judgment b/c: (1) bod should have asked for info on how $ was arrived at (a) uninformed about intrinsic value of co. (b) unaware of Van Gorkom's role in deal 19 (2) valuation study never done and bod should have considered this (ie. never talked to invest. bankers) (3) no negotiating over price--which was too low, even with premium (although ct never talks about price/substance) (4) bod met for only two hrs. and didn't read K (5) bod failed to disclose all material info. that a reasoable sh would consider imp. 3. How is this different form Allis Chalmers (diff. verdicts)? a) magnitude of decision (sale of whole corp), and b) lack of discussion time 4. Van Gorkum made new law--Cts will require greater process for such tremendous decisions (most people thought it would go other way) a) Now, it is required that: (1) disclosure of all relevant info. to shs (2) process significance (3) no coercion/time constraints in making decision (a) message that rush offers need not be entertained (4) full valuation studies for corp. and tender offer by outside investment banks. (a) premium price is not really relevant as long as value is properly ascertained (5) all bids encouraged and consdiered b) Director Liability Statutes result: (1) Many states (including Del) changed laws--DGCL 102(b)(7) allows charter to include provision protecting bods form liability for breach of duty (but not breach of loyalty or bad faith). (a) of Del. Co's have passed charter provisions to greatest extent allowed by the statute (2) Legis. basically saying that ct. went too far here (a) can still sue for injuction, but not damages c) Winners from Van Gorkum--lawyers (for advice), invest. bankers, shs (more competing offers), insurance co's (for liability insurance), society d) Losers from Van Gorkum-CEO (less power), bod (higher standard to meet), shs (management has less flexibility, must pay for studies, lawyers, fewer mergers) XVIII. Duty of Loyalty A. Generally---it is the core of bod's fiduciary duty 1. Corporate officers, bods, and controlling shs must not exercise their discretion over corp. policy to benefit themselves at the expense of shs a) Weirdness of corp. context--bod defines the corp's interests of which they are charged with ignoring in violation of bod's duties. Raises two imp. questions: (1) how do you define corp's interests for loyalty purposes? (common econ. interest of shs?) (2) what should be the role of bod in determining breach of duty by officer or director? 2. To whom is the duty of loyalty owed?---answer is still ambiguous! a) Del.--loyalty to "the corp. and its shs" b) Thus, primacy of shs interests (as opposed to interests of corp.) has never been firmly established in U.S corp. law 20 (1) accordingly, 25 state statutes (but, not Del) now allow corp. bods to consider "constituencies" in defense from hostile takeovers--emplyees, creditors, community (a) ie. duty to creditors during bankruptcy is diff. situation (2) however, cts never allowed bod action which favored another constituency at the expense of shs--but can consider other groups when in long-term interest of co. 3. Areas of Confict--cts. have diff. doctrines for each type of transaction: a) Self-dealing b) Corp. Opportunity c) Exec.Compensation d) Dismissal of sh derivitive law suits B. Self Dealing 1. Generally a) Clear that bod and officers are not entitled to favor their own interests in self-dealing transactions w/corp. b) Law is mixture of judicial review and stautory safe harbor. 2. Self-Dealing Statutes--DGCL 144--45 states have statutes saying that a self-dealing transaction will not be voidable "solely" b/c it involves a conflict of interest if it is adequately disclosed and approved by a majority vote of disinterested bods or shs or it is fair. a) DGCL 144: Conflict may be OK if there is disclosure of conflict and: (1) approval by disinterested bod (shifts burden of fairness), OR (2) approval by majority of disinterested shs (usually dispositive) OR (3) if no disclosure, if transaction is fair at time it was made. b) Law is unclear--even if you comply with DGCL 144, there may always be an additional requirement of fairness. ie. cts may require disclosure and fairness at their discretion. Why? (1) interested director could disclose fact, but withhold honest advice (2) disclosure alone may not stop friendly directors from helping interested one. (3) fairness is usually a range, and if also disclosure, corp. may get a better point in range c) *Fn. 3 (II-37) to Marciano, however, seems to say that approval by shs or bod is sufficient to invoke business judgment rule. (1) fn. 3 is contrary to Fliegler, but Marciano as a whole seems to be supportive of Fliegler. (2) Fliegler--144 + fairness test (ie. sh ratification doesn't always remove burden of fairness) (3) Fn. 3 to Marciano--only 144 d) However, none of the safe harbor statutes (including Del 144) can insulate a transaction if it is held to constitute corp. waste. 3. Mariciano v. Nakash (Del. 1987) a) Facts--director gave loan to corp. w/o approval. Corp. went bankrupt and put in claim as creditor. If repayment, then no proceeds go to sh. Bod was deadlocked so cannot affirm deal. b) Held--ct. says that loan was fair b/c of bona fide good intentions and terms. Ct. appears to suggest that 144 validation is not exclusive under Fleigler (also b/c of deadlock, it is impossible), then judicial scrutiny is required--fairness proved. C. Corporate Opportunity 1. Generally 21 a) Issue of when a bod or officer can appropriate a business opportunity on her own account that might arguably "belong" to the corp. (1) Cases tend to focus on when opportunity should be deemed corporate, and off-limits, rather than personal (self-dealing is presumed) (a) opportunity that might arguably belong to corp. under charter--ie. used car purchase is clearly not a business opp. (b) Insiders will be held to higher standard that outside directors. 2. TEST: a) Is there a corp. opportunity? (1) see various tests below b) Is there self-dealing? (1) Once we have determined that something is a corp. opportunity, analysis becomes very similar to self-dealing--ie. disclosure, approval, fairness (2) Must usually disclose to corp. and offer it the opportunity. 3. Law on when corp. opportunity exists. is murky. a) Line of Business Test--opportunity belongs to corp. if it sufficiently closely related to the firms existing (not speculative) line of business. (1) what if corp's business is to make money--higher standard of director's personal transaction will be used b) Fairness Test--in addition to "Line of Business Test," Ct. also looks into other factors: (1) how manager learned of disputed opportunity (2) whether corp. assets were used in exploiting the opportunity (3) effort level that insiders must expend b/f determing that an investment is not a corp. opporunity (many cases turn on such general issues) (4) parties expectations (5) other specific facts indicia of good faith & loyalty c) Two-step Analysis--some cts allow managers who have appropriated an opportunity w/i corp's line of business to exculpate themselves by establishing that corp. would have been unable or unlikely to exploit the opportunity. 4. Unity Savings v. Kerrigan (Ill. 1974) a) Facts--Directors of mortgage brokerage firm formed insurance corp and referred mortgage customers to it. b) Held--Ct. said there was breach of loyalty to corp. and that directors have to make disclosure to corp. (shs, in this case) before seizing opportunity. Although Bod claimed the belief that Unity couldn't legally have taken adv. of opportunity, ct. said that disclosure is still necessary b/c their opinion cannot substitute for independent evaluation by corp--Unity might have desired to enter the insurance business in future (1) Clearly, w/o disclosure, bod was actively exploiting their position as directors for their personal benefit. D. Duty of Loyalty of Controlling Shs 1. Generally a) Fiduciary duties are owed not only by the bod and officers, but also by a controlling sh. (1) self-dealing in this context is done to the exclusion of the minority shs b) Procedural safeguards of disclosure and approval by independant directors or shs doesn't work well when one sh is dominant 22 (1) ie. controlling sh makes corp. policy, but duty of loyalty is to minority shs 2. Sinclair Oil Corp. v. Levien--doesn't give any clear answers--try to apply reasoning (although a bit circular) a) Facts--Sinclair owns 97% of Sinven (Sinclair owes duty to Sinven). Sinven claims that Sinclair caused Sinven to pay out excessive dividends which prevented its industrial development. P's brought 3 claims. b) Held--when a situtation involves a parent and a subsid, w/the parent controlling the transaction and fixing the terms, Intrinsic Fairness Test must be applied (but only when there is self-dealing). (1) Paying out of dividends (a) not self dealing b/c all shs got dividends in proportion to the ownership share (minority shs not excluded) (b) Thus, business judgment rule should have been applied here--satisfied b/c P did not show improper motives or waste. (2) Corp. Opportunity claim--shs claim that Sinclair took oil-drilling opportunities from Sinven and gave it to other subsids (a) not a corp. opportunity b/c no evid. of unique need or ability of Sinven to develop these opportunity, and since out of Venezuela, Sinclair could have given it to any subsid--how to choose? (b) Thus, since no usurpation of corp. opportunity, business judgment must apply--satisfied (3) Breach of K Claim--shs claim that Sinclair caused one of Sinven's K's to be breached: (a) Ct. says this is self-dealing and therefore Sinclair has duty to show that it is intrinsically fair to minority shs--couldn't meet this burden, so liable to shs. c) What could Sinclair have done here? (1) Buy out remaining 3% or appoint outside directors E. Executive Compensation 1. Generally (see Clark) a) Executive compensation has been dealt with as a straightforward self-dealing transaction (but, lower standard--no fairness required). (1) If compensation package is approved by disinterested directors or shs, the fact of selfdeaalin is ignored and transaction is valid, unless: (a) waste (b) in case of board approval only, any attempt to circumvent business judgment rule (ie. domination, bad faith) (c) ie. if approval by shs or disinterested directors, burden of attacking b.j. rule is on P. (2) Why not same test under state law as for other self-dealing transactions (ie. why isn't intrinsic fairness test required for compensation)? (a) need to pay execs. enough to keep them at the corp. (but don't want to pay so much that is wasteful) (i) findings suggest that large managerial shareholdings reduce manager-sh conflicts of interests at times of takeovers (ii) however, no answer as to whether exec. comp. is too high. (b) product differentiation--different directors, so how to decide fairness 23 (c) execs. wouldn't stand for strict scrutiny of their own packages b) Good practice to staff the Compensation Committee of the board with outside or independent directors (must be truly indep). (1) Thus, state courts only rarely void compensation arrangements under the waste doctrine--only when consideration is bizarrely disproportionate to management's contributions. (2) ie. Rogers v. Hill--six top officers given 10% of co's profits c) Trend--Extensive disclosure required under federal proxy rules (1) corps. must make detailed public disclosures about the compensation of their top five corp. officers (a) however, a company may choose not to value stock options or to do so in any manner they want. (b) such plans (esp. w/o req't of continued employment) raise spectre of unreasonable consideration (waste) (2) easier for shs to judge total compensation and evaluate it in relation to corp. performance and industry standards. 2. Golden Parachutes--agmt. that protects exec. in case of a change in control (ie. see K on II-59) a) Effective Date--date of which change of control takes place (1) on such a date, bod's ability to terminate K changes (2) prior to effective date--at will employment (3) after effective date--continued 2 year employment under special rules b) What constitutes a change in control (1.1)? (1) majority of bod switches hands (2) if another entity takes over corp. (3) can be triggered by request of third party who has taken steps reasonably calculated to effect a change in control (ie.sh) c) Once change in control/effective date occurs, employment status changes (1) can only be fired for cause (5.3 of employ. agmt): (a) any act of fraud, misapprop, or bad faith (b) repeated and material violations of exec's obligations under agmt. (must also give exec. chance to remedy it) (2) ie. note that Roger's Golden Parachute with PSI was effective immediately--PSI cannot fire him before change in control w/olarge severence payment d) Exec. may also quit for "Good Reason" (5.4) and give big termination payment if: (1) there is any change in exec's duties (outside of an isolated rermediable action) (2) exec. determines what "good reason" is and it is binding on co. (a) ct. only reviews for good faith determination e) If fired w/o cause or quits w/good reason after the effective date, then: (1) base salary for two yrs (ie. end of employent agmt) (2) profit sharing plan (3) stock options/incentive plan (4) no duty to mitigate or reduction in amt. earned if there is new job f) Shs point of view: (1) Good K b/c: (a) exec. is more open to takeovers--short-term pay-offs 24 (i) reduces agency costs--managers will be less inclined to resist takeover in protecting their job. (ii) plans tend to align mgt and equity--exec. comp. are positively related to stock price performance (b) stock prices increase when there is a golden parachute--anticipation of takeover (2) Bad K b/c: (a) acquiror doesn't want to be stuck w/old really expensive exec. (b) award bad execs. more than good execs. (who will be able to get job anyway). F. Shareholder Derivative Suits 1. Generally a) Most important legal mechanism for enforcing fiduciary duties. (1) while bod have general discretion to bring suits on behalf of corp, these suits present conflict since bod is a party. b) Sh suits in the context of public corps. fall into two categories depending on the nature of their claims (ie. who got hurt): (1) sh class actions--direct suits against officers, bod, or corp (a) shs injured directly and are entitled to recover directly (i) ie. NY state residents didn't get dividends and other states did. (b) class actions often allege violations of the disclosure requirements--and are at least as common as derivative suits (2) derivative suits--suit by the company against the bod. (a) when injury to sh is indirectly as the owner of corp. (i) ie. bod sells off assets, self-dealing etc. (b) any recovery from suit goes to corp. (c) most alleged breaches of fiduciary duties are conceived of as injuries to corp. and give rise only to derivative actions. 2. PROCESS of Derivative Suit: a) P must have been/still is a sh b) Sh must demand bod to bring suit (1) demand requirement may be excused if it would be futile c) If demand is refused, it can be challenged as wrongful d) Demand can be answered by a special committee (bod delegation) (1) special committee recommendation can be challenged 3. Functional Elements of a Derivative Suit a) Standing requirements--who is entitled to bring suit (not important) (1) member of P's bar is the real party in interest b) Rules allocating the costs/benefits of suit (1) small shs face a large collective action problem in enforcing management's fiduciary duties (a) ie. no one would bring suit for an increase in value of corp's stock (2) deriviative suit regimes offer generous inducements to successful P's that far exceeds out-of-pocket expenses c) Procedural filters that block otherwise viable suits (judicial constructs) 25 (1) Filters shift discretion over whether to pursue derivitive litigation out of the hands of shs and into those of cts, the bod, or both: (a) demand requirement (b) special litigation committee of disintered directors to evaluate derivative actions (2) charter provisions that exclude entire classes of suits, such as 102(b)(7) might also be considered a screeening device. (3) there is much concern over giving discretion to screen suits to bod, who are considered structurally biased toward managers. (a) these filters don't focus solely on the legal merits of the claims, but on the business interests of the corp. and the authority of the bod to control the corp's own course of action 4. What are the cost and benefits of suits to the corporation? a) shs shouldn't care about who brings suits as long as those that are brought ultimately benefit the shs b) thus, suits against violation of fiduciary duty should only be brought when they will increase corp. value, ie. benefits outweigh costs 5. Special Litigation Committee (clark 645) a) Generally (1) Bod can appoint independent committee to determine whether to continue suit (a) adopted by state courts and is now a standard feature of derivative suit doctrine, although it isn't triggered in every case (2) It is normally the bod the decides whether to bring suit as a business decision→ governed by the BJ rule (and ct's own BJ). (a) committee usually afforded protection of BJ rule--can't challenge unless not independent (duty of loyalty) or investigation was bogus (duty of care) (b) Also, (after Zapata), cts also retain right to use their own independent business judgment at their discretion. (c) However, if bod decides wrongly not to sue itself, it is clearly self-dealing. b) Zapata v. Maldonado (Del. 1981) (1) Facts--shs demand a derivative suit and bod gives power to 4 new directors to decide whether or not to bring suit against bod. (2) Held--Ct. says that a demand is analyzed under a different rule than BJ rule (ct. is afraid that a lot of meritorious claims will be dismissed) (a) TEST-(i) Independence and good faith of committee, disinterestedness, reasonable investigation (ie. BJ factors w/burden on committee), AND (ii) Ct. applies its own ind. business judgment (like fairness test (a) at discretion of ct. to use or not (unique aspect) (3) Ct. didn't apply pure BJ rule b/c it believes that directors are not truly disinterested. This is diff. situation than exec. compensation b/c: (a) deciding validity of a suit "is not beyond judicial reach"--ie trust ct's strong ability to decide whether suit has merit. (b) really tough for disinterested directors to act disinterested here (ie. asking directors to sue fellow directors). (c) right to bring suit is a fundament right of shs--not asking for review of substanitve claim (4) What factors into Ct's BJ test? 26 (a) ethical, commerical, fiscal, and legal factors (II-77) (b) public policy--ct. can (although may not want to) let suit go forward in name of public policy even if not in the best interest of the corp. (5) Zapata comes up once a demand has been validly instituted--but there may be times when you can bring a derivative suit w/o a valid demand (see below) c) Joy v. North (2nd Cir. 1982--diff. than Zapata/Del) (1) Ct. rejected the recommendation of special litigation committee to dismiss. (2) Held--the wide discretion given to bod under BJ rule doesn't apply to special litigation comm. recommedation to dismiss. (3) RULE--Cts. must do a cost/benefits analysis of all potential factors (ie. judicial BJ): (a) costs to corp.--attorney's fees, expenses, impact of distraction of key personnel, lost profits from trial publicity (b) benefits--likely recoverable damages (discounted by the probability of finding liability) 6. The Demand Requirement a) Sh can get around demand requirement if: (1) Demand futility (2) Demand made and wrongfully denied (a) if you claim that it was wrongfully denied, you are admitting disinteredness of bod--must claim that decision to deny demnay wasn't informed. b) What does it take to show demand futility? (1) TEST--Aronson v. Lewis (Del.)--P's must reasonably show that: (a) Directors are interested (biased) and not independent AND/OR (b) Decision invalid under BJ rule. (2) Ct. confused but presently it is either one OR the other in order to show futility. (a) ie. must question either bod's impartiality or the soundness of their decision. c) What is strongest reasons for futility in making a demand on bod (ie. factors that would throw doubt on bod's ability to decide)? (1) financial interest of bod (2) selection of bod's members is not enough (but, specific facts needed to show that bod is dominated or controlled) (3) fact that directors approved transaction is not enough (must show particular facts of violate of duty or waste) d) ALI Proposal: (1) always require demand, but just to give notice. ie. Shareholders have presumption and it should be bod's burden to rebut. (2) proposal is based on structural bias belief--weak arg. (a) also downplays corp. costs spent for bod's likely defensive maneuvers 7. Comparison of Zapata and Aronson Test a) With Aronson, b/c no demand was ever made, investigation of suit by bod is not a factor (as it was under Zapata) (1) Zapata--duty of care and loyalty (2) Aronson--only duty of loyalty issues b) First step of Zapata and Aronson are relatively equal--same thing counts for independence. (1) majority of directors at time that litigation was instituted 27 (2) It is possible to pass under step 1 of test but not step 2 if bod was disinterested at time of litigation, but not when deal itself was made. (a) ie. reschuffling of bod b/f suit instituted c) Step Two--other than Zapata being optional, what is the relationship? (1) Zapata: (a) suits w/o merit fail (b) suits w/merit may go forward (depending on cts. use of other factors) (2) Aronson: (a) if reasonable doubt, possibility of merit (b) if no reasonable doubt, no merit (won't go forward unless first prong of independence is satisfied. PART III: THE VOTING SYSTEM XIX. Corporate Voting and the Collective Action Problem A. Institution of sh voting is potentially central to every aspect of the management of the public corp. . 1. shs use ownership powers indirectly through election of bod (annual meetings), except in rare situations when bod proposes a radical change of direction or specifically requests sh approval (special meetings). a) ie. along with duties and contract, voting rights help keep bod in line. B. For most part, voting in corp. is an uncontested formality: 1. Why? a) controlling shs can dominate b) if many shs, won't inform themselves or participate beyond following price of the stock→ collective action problem. (1) there is a low likelihood that your vote will effect outcome→must look at expected value of investing your time/income. (2) outcome matters less to my wealth (diversification)--combined, there is little incentive to vote c) thus, shs routinely reelect bod's own slate which will be dominated by inside directors (corp officers) 2. exeptions where there is competition for votes: a) low level contest under sh proposal rule--14(a)(8) b) full-fledged organized opposition to mangement (ie. proxy fight) C. Most states allow corp's to establish almost any voting practice they please, w/only a few statutory limitations: 1. can't sell voting rights w/o selling shares--ie. proxy votes are revocable 2. required votes on big fundamental transactions a) required b/c shs are most effected but they are still merely passive investors w/o expertise 3. bod must submit proposals to shs when a sufficient number of shs or managers request it a) ie. usually when the need for monitoring is high like self-interested tranactions 4. Recent trend is toward greater democracy in the large corp. 28 a) of Securities Exchange Act--proxy rules b) shs right movement of public pension funds--no longer extreme situations where collective actions costs are preclusive (1) such concentrated equity is able to put pressure on bod to be independent and not to block takeovers (2) large investors have a fiduciary responsibility to smaller investors D. Actually voting: 1. To win a vote, you need: a) election of bod--plurality of votes cast b) everything else--majority of shares entitled to vote 2. Who gets to vote? a) persons who are registered as shs "of record" on the record date (set date prior to meeting) b) record owners are the beneficial owners XX. Federal Regulation: The Proxy Rules A. Generally 1. Federal securities law is most pervasive in the regulatoin of the voting system. SEC proxy rules (regulation 14a) has four major elements: a) disclosure requirements and mandaory voting regime b) substantive regulation of proxy solicitation process c) general anit-fraud provision (14a-9) that gives shs a private right of action for misleading proxy materials. d) specialized town meeting provision (14a-8) that allows shs to force a sh vote at corp. expense on certain sh resolutions. 2. Section 14(a) authorizes Regulation 14A = Rules 14a-1 + Schedule 14A a) Section 14(a)--Section of SEC Act of 1934 that authorizes SEC to make regulations b) Reg.14A--consists of all regulations derived from section 14(a) c) Rule 14a--doesn't say what you have to disclose, only covers rules for doing so (1) says a sched. 14a proxy statement must precede/accompany any solcititation (broadly defined) d) Schedule 14a--contains actual disclosure requirments 3. Proxy--enables management (or opposition group) to solicit votes of shs and get authority to vote on their behalf. a) Section 14 was meant to guarantee shs a meaningful right to have a voice in the management of corp. b) however, shs involvement in the voting process has not increased with the adoption of the new rules c) although disclosure requirements makes cost of research less for shs, there is no reason why shs should have any interest in managing corp. affairs (1) asumptions underlying proxy rules were unfounded--can't overcome collective action problem B. Federal Securities Laws 29 1. Securities Exchange Act of 1934--most imp. statute a) Most provisions apply only to publicly-held companies--regulates the flow of info. b/t companies and investors (and, also b/t investors). 2. Basic Overview (*read rule 14a) a) 14a-3--b/f soliciting a proxy, you must send a very expensive proxy statement (exceptions found in 14a-2) b) 14a-1(l)--solicitation consists of any circumstance reasonably calculated to result in procurement of a proxy (1) definition of solicitation is broad and hinges on reasonable intent to get votes c) 14a-11--you can solicit prior to filing a proxy statement (14a-3) if solicitation relates to election or removalof bod, provided that: (1) no actual proxies sent b/f statement sent (2) you identify yourself and give description of your interests (3) proxy statement is sent at earliest date d) Schedule 14(b) ( read)--can solicit votes in opposition to mgt. by filing Sch 14(b)--less onerous than filing Sch. 14(a) e) 14a-7--gets you a list of shs. (1) You have right to know: (a) # of shs (b) cost of mailing a statement (c) right to have such info. w/i 5 days after request (2) Either you get the list or company will mail it for you--company's choice (a) ie. corp. might want to keep control or see materials ahead of shs (b) But, limited to stuff relating to upcoming/schedualed meeting (3) DGCL 220--any sh of record has right to inspect list of shs and make copy if it is for a proper purpose (a) duplicate provision, but motives must be "reasonably related to persons interest as a sh" (b) Pillsbury (Minn Case)---proper purpose is one affecting investment value (political purpose is excluded) 3. **Thus, you have 5 basic options when dealing with Rule 14a: a) Talk w/o engaging in solicitation (1) ie.--if no solicitation, then no rule 14a concerns b) Solicit, but fall under 2 exceptions under 14a-2(b): (1) (1)--don't seek power to act as proxy on your own behalf (2) (2)--solicit 10 or less people c) Solicit w/o statement if it relates to election (14a-11) (1) but, you eventually have to send a statment so it really just buys time d) Comply with 14a-3: send statements with solicitation C. PSI-Ipalco Proxy Contest 1. What factors should PSI sh consider in deciding for whom to vote? a) price premium/dividends (1) cash out option (if so, don't care about dividends) 30 b) other factors (should be reflected in offering prices if you believe in semi-strong form of market efficiency): (1) regulatory process--don't want to be left high and dry (2) amount of savings going back to shs (3) business fit/synergy (4) prior performance of companies/stock (although the info they provide is very biased) XXI. Rule 14a-9 A. Generally 1. Although nothing in the 1934 act or the SEC's rules give a shs the right to sue if the proxy rules are violated, the S.Ct. has recognized an implied private right of action on behalf of inds. injured by proxy viol. a) implied right of action established in the Borak case (1964) 2. Elements of private right of action under 14a-9 (false/misleading statements: a) Materiality (TSC and Virg. Bankshares) (1) sh/P must show that there was a material mistatement or omission in the proxy materials (2) fact must have been regarded as important in the decision making of a reasonable sh. b) Causation--breach was essential part of transaction (Mills and Virg. Bankshares) (1) ct. will presume injury was caused so long as the falsehood was material and the proxy materials were an essential link in the ultimate transaction. c) Standard of Fault--mere negligene is sufficient (1) S.Ct. has never ruled on whether scienter (intent to deceive) is needed B. Materiality--Virginia Bankshares (S.Ct 1991) 1. Two important issues: a) whether a statement of the reasons for which bod is recommending a certain action can be materially misleading (1) yes, if sh also shows that the statement of reasons expressly or impliedly asserted something false about the statement's subject matter (2) ie. "proof of mere disbelief by P should not suffice for liability under 14(a)" b) whether causation of damages can be shown by minority sh whose vote is neither needed (b/c of controlling sh) or required by law (1) no--see below (causation) 2. Facts a) FABI (bank holding co) owned 85% of shares of Bank. FABI wanted to get rid of other 15% so bods entered into merger agmt where Bank would become a wholly owned subsid of FABI. b) FABI (not Bank) hired a firm to give fair price and Banks bod agreed to merger at that price ($42). c) Bank's minority shs sent a proxy solicitation in which Bank's bod urged the merger to be approved. (1) *in solicitation, bod stated that they had approved the plan b/c it would give the minority shs the opportunity to get a "high" value and a "fair price" for their stock 31 d) The entire proxy solicitation was not required by law (less extensive statement could have been used) or needed--don't know why bod asked for votes: (1) maybe to get goodwill of shs/thought it would insulate themselves from suit? (2) most minority shs approved it. P did not--asserted that fair price was at least $60. 3. Held a) Materiality (1) the reasons why the bod was recommending the transaction can often be (and clearly was here) the sort of info. on which a sh might reasonably rely in deciding how to cast vote. (a) ie. use of word "high" can be material is sh would rely on it. (2) Caveat--not enough, however, to show that bod didn't believe in statement. Must prove that: (a) bod didn't believe in statement or wasn't acting for stated reason AND (b) statement asserted something false or misleading about its subject matter (ie. statement was false in fact) C. Causation--Mills and Virginia Bankshares 1. Generally a) once the P has proved that the falsehood was material, he must show a causal link b/t misleading proxy materials and damage to shs. 2. Mills (S.Ct. 1970) a) Majority sh had over 50% shares but needed 2/3 of votes for merger. Bod sent proxy materials that didn't disclose the identity of the directors b) Held--ct. said that Ps merely had to show that the merger could not have been carried out w/o the submission of proxy materials to the minority shs→causal link would be established. (1) thus, there is a presumption that all minority shs would not have voted for merger if they were aware of correct info. (2) ie. to hold that Ps had to show that enough minority shs would have changed their vote if the info. was correct was "impracticable" 3. Virginia Bankshares a) Remember, majority sh (FABI) had so much stock that he didn't need any minority votes at all. b) Held--if the P is a member of a minority class whose votes were not necessary for transaction to go through, the P may not recover no matter how material or intentential the deception was b/c it was not the cause of its passing. (1) to allow otherwise, would give rise to speculative claims and procedural intractability (besides, congress couldn't have intended this result) c) Dissent/Cons of Decision (1) dissenting judges would have allowed recovery as long as the solicitation of proxies was an essential link in the transaction (a) ie. fact that bod thought shs approval was needed, this is enough to make solicitation an essential link. (2) decision was odd b/c there was evidence that if minority shs had voted against merger, then bod would have agreed. (a) public policy supports giving weak minority shs all the more disclosure (3) decision also ignores fiduciary duty to minority shs (assumes that bod will vote in favor of merger irregardles of sh vote) 32 (a) also, majority sh will not be influenced by mistatement b/c they knew the truth. D. What, then, prevents corps. from making misleading statements in proxy materials where vote is secure? 1. SEC 14a-9--cannot make misleading statements about material facts a) can't tell blatent truth about "fairness" of price either b/c of duty of loyalty (don't want to create a cause of action for shs)→thus, must walk a fine line b/t truth and lies. 2. Loss of State Law Remedies a) even though ct. denied remedies in Virg. Bankshares (where minority would have no effect), a sh will lose some state-law right by approving the transaction. (1) ie. by approving transaction, shs may lose his right to an appraisal for his shares and a payment based on appraisal price. (2) ie. may also lose his right to attack tranaction as being a director conflict of interest transaction b) *Thus, sh may claim damages from loss of state law remedies (appraisal price) if he was induced to vote for merger on basis of misstatements (even though he couldn't effect the outcome with his vote). XXII. Shareholder Proposals and Rule 14a-8 A. Generally 1. Rule 14a-8 contains the most imp. sh proposal rule→entitles shs to force the corp. to include certain proposals in its proxy materials. a) advantage of low costs to sh. (1) ie. shs can advance a proposal for a vote by fellow shs w/o having to file any materials with the SEC or having to mail materials to ind. shs. b) today, there are many corp. governance proposals (1) used increasingly by institutional investors to introduce measures that tighten the reigns on inside directors (a) ie. Carpenters Pension Fund as sh of Waste Mgt. (2) exec. compensation and social/ethical issues are typically valid subjects 2. Right to have one's sh proposal included in the corp's materials is subject to several limitations: a) rule 14a-8(a)(1)--sh must own 1% of stock or $1000 in market value for at least one year b) rule 14a-8(a)(4)--sh may submit no more than one proposal and an accompanying statement (1) 14a-8(b)(1)--statement may not be greater than 500 words c) *rule 14a-8(c)--corp may deny a proposal if the subject matter: (1) is not proper subject for sh action (under state law) (2) would require illegal action by corp. (3) contrary to SEC's proxy rules, including 14a-9 (4) relates to redress of personal claim (5) relates to operations which have miniscule effect (< 5% of corps. assets) (6) beyond corp's power to affectuate (7) relates to an election to office* (8) is counter to a proposal to be submitted by corp. at meeting 33 3. If corp. doesn't want to include a proposal (under 8(c) or otherwise) it must request a "noacttion letter from the SEC (14a-8(d)): a) "no-action" b/c it means SEC will not recommend any disciplinary action against the corp. b) sh porponent has the oppourtity to respond to no-action request B. Waste Management/Carpenters Pension's Proposal 1. Facts a) Sh proposal to require that bod consist of disinterested directors at all times b) Waste requested a no-action letter based on several 14a-8(c) theories c) Where Waste's arguements had merit, SEC told them to allow shs to amend proposal and then include it. 2. Kahan--problems with mandating make-up of bod: a) It would violate the by-laws b/c if ind. bod becomes non-independent, someone must be fored to resign for no cause (1) so, must leave them in office, which is not the point of the proposal. b) Disenfranchises shs (1) if plurality elects a dependent bod, an independent bod may take office instead (2) if the plurality doesn't always win, it is violation of DGCL 216(3)---unless it is changed in by-laws (as here) (3) however, DGCL 212(a) says one share, one vote unless it is changed in charter (not here) (a) argument is that shs must look at eligibility of candidates before voting--1 share/1 vote intact c) Why don't shs just amend by-laws on their own (ie. in the proposal) rather than demanding management do it. (check on this) (1) word limit (2) SEC said a demand on the bod would be a violation under 14a-8(c)(1) if it mandates bod undertake an act--but, ok if changed to a precatory request. XXIII. State Law Regulation of the Voting System 1. notwithstanding the importance of the SEC's proxy rules, state corp. law erect the basic structure of the voting system and decides many imp. issues affecting the sh franchise: 2. ie. sh information rights, reimbursement of expenses, inequitable conduct, circular votings structures, and vote buying A. Shareholder Information Rights 1. Nearly all states give shs some right of inspection of corp. books and records, including the shs list. a) details of inspection vary from state to state b) ie. RMBCA 16.02--allows inspection of sh list if the demand is made in good faith and for a proper purpose to which the records are reasonably related (1) ie. proxy fight is reaonable purpose to which shs list is directly connected 2. NOBO list--some state shs-list-access statutes have been interpreted to allow shs the right to inspect a list of the corp's "non-objecting beneficial owners" 34 1. remember, beneficial owner is the person w/the real, effective, econmic ownership of a share that is held in corp's own books in "street name" a) CEDE List--list of brokers and record owners 3. Sadler v. NCR a) Facts (1) Sadler gets list of shs for ATT so they can takeover NCR (under NY law, shs can turn over list to other shs for proxy purposes) (a) wants takeover to go forward (b) friends of lawyers? (2) ATT has 100 shares but not for 6 months (a) can't get it under Del law--can only force them to make CEDE list, if not already in existence (b) 14a-7--don't get to see the lists if corp. decides to mail it for you. b) Held (1) 2nd cir. held that NY law (sec. 1315) gives any sh of 6 months of a non-NY corp. doing substantial business in NY the right to a NOBO list (a) if a NOBO or CEDE list is required to put both sides in a proxy contest on equal footing, the corp. will be required to compile the list if it doesn't already have one. (2) there is no difference b/t lists and as lists are necessary for a successful proxy fight (charter requires 80% vote of outstanding shares for bod to be replaced), NCR will be making lists anyway (a) NCR's Motives--if you can't reach shs, they won't vote, which is same as a "no vote" B. Reimbursement of Proxy Expenses 1. Incumbent bod's cost are generally paid by corp. a) this provides no incentive for bod to be thrifty in mailing materials b) also, no incentive to withdraw from contest c) reform--incumbents get less the full, challengers get more than 0. 2. Challenger's cost are usually not paid unless they win a majority of the bod--there is no affirmative entitlement to reimbursement. a) thus, costs for proposals or victory of only a few directors are usually not reimbursed (1) challengers who try but fail to gain control get reimbursed only in rare circumstances (2) results in sh proposals only when the sh thinks it will increase value of stock--Kahan thinks they should get more reimbursment here than in control contests b/c no private benefits b) ie. one reason why staggered bods serve as a deterrent to proxy contests 3. Note that fed. proxy rules require that the proxy statement must state the identity of persons who will bear costs of solicitation. a) if contest is over bod election, statement must contain estimated total cost of the solcititation, expenditures to date, and terms of contest settlement if there was one. C. Inequitable Conduct 1. Generally a) legality of action does not make it permissable--cts. will try to preserve equitable voting processes 35 2. Schnell v. Chris-Craft Industries (Del. 1971) a) Del ct. says that bod can't move up date of annual meeting w/purpose of frustrating proxy contest, despite fact that by-laws allow it. (1) moving date would be inequitable given sh reliance b) purpose of action is the key factor 3. Blasius v. Atlas (Del. Chanc. Ct--1988) a) Facts (1) Atlas expanded size of bod in order to preserve majority in face of 9% sh Blasius's intentions to restructure corp. or obtain control (a) made a by-law amendment at an emergeny meeting. b) Held (1) Ct. said that the bod's motive in thwarting the recapitalization was OK--valid business decision in good faith and reasonable (see Unocal) (a) ie. it was bod's BJ that Blasius would be bad for Atlas (b) possible that bod just wanted to preserve their jobs but also possible that they just want a new bod (drum up business, good directors) (2) *However, Ct. struck it down anyway b/c there is an exception to deferential business judgment rule when bod acts for primary purpose of interfereing with sh vote/entrenchment. (a) Ct. believes that voting by shs is really imp: (i) basic sh protection (or, they can sell) (ii) defeats bod's legitimacy if they use their power to preserve themselves (iii) bod's decision here didn't involve exercise of the corp's power over its property (valid), but rather the allocation of power b/t shs and bod (invalid) c) Blasius is a Purpose Test (vs. an effects test) (1) any action designed principally to interfere w/effectiveness of vote is wrong, even if has beneficial effects (2) ie. even if isn't for selfish purposes (which it might have been here), action isn't ok if it is meant to thwart shs. D. Circular Voting Structures 1. Generally a) Guiding principle is that the majority of equity should hold majority of voting rights b) circular voting structures have the principle effect of muffling the voice of the public shs→ such schemes have long been struck down 2. Speiser v. Baker (Del. Chancery Ct. 1987) a) Facts (1) Speiser and Baker set up a scheme using two tiers and preferred non-voting stock so while they together owned 35% of the equity, they were able to control Chem (see chart on III-112) (a) Chem (through a wholly owned subsid. named Medallion) owns 95% of Health Med. However, Chems's 95% of Health Med is not represented by 95% of Health Med's voting power b/c it is preferred stock w/only 9% of voting power. (b) Speiser and Baker own remaining 5% of stock which gives them 91% voting power of Health Med and effective control over Chem as well. (c) Falling out b/t Speiser and Baker led to suit. 36 (2) DGCL 160(c): (a) shares of corp. A belonging to corp. A cannot be voted. (b) shares of corp. A belonging to corp. B cannot be voted if corp. A has > 50% of corp. B. (3) Thus, if Chem only has 9% of Med, it can vote. But, if converted, Chem will have 95% of Med, and therefore cannot vote. b) Held--stock held by a corp. subsid may "belong to" to the parent and be prohibited form voting, even if the parent does not hold a majority of shares entitled to vote for subsid's bod (ie. shares of Med, of which Chem is the legal owner, are deemed to belong to Chem) (1) Ct. says that 160(c) was meant to address bod keeping themselves in power at expense of public shs (a) here, bod is keeping themselves in power w/o owning 50% of control. (b) ie. capital of Chem. has been invested in Med. and that investment is used solely to control votes of first corp (Speiser and baker have control over both) (2) Judge says precedent has expanded wording of text from preclusion of voting shares where corp. indirectly owned majority of it own voting rights to preclusion of voting shares where corp. indirectly owned a majority of its own equity. (a) bod should not be allowed to count votes in their favor that are cast by a whollly owned subsid which is therefore controlled by bod. (3) Focus was shifted to contol as defined by "economic ownership" and fact that corps. shared directors (not just control based on voting power): (a) reason is that such a system could be set up after sales of stock w/o knowledge of shs (b) basically, only need to set up a subsid, give it money, and have it buy stock in the parent. E. Vote Buying 1. Generally a) Vote-buying is a voting agmt supported by consideration personal to the sh, whereby the shs divorces his discretionary voting power and votes as directed by the offeror. b) Public policy wants each sh to excercise independent judgment (1) vote-buying is illegal per se if its object or purpose is to defraud or disenfranchise the other shs (ie. a deceit uon the property rights of another) (a) each sh should be able to rely upon the independent judgment of his fellow shs (b) ie. the security of the small shs is in the natural disposition of each sh to promote the best interest of all, in order to promote his own ind. interests. (2) if its purpose is not to disenfranchise, then vote-buying is subject to intrinsic fairness test (burden on bod) (a) want outcome to best one for corp. (b) but, b/c vote buying is susceptible to abuse, it must be viewed as a voidable transaction subject to fairness test ie. sinclair test (sh derivative test) 2. Schreiber v. Carney (Del. Chancery 1982) a) Facts (1) Jet Capital owned 35% of Texas Internt.--voted against merger w/Texas Air b/c: (a) if Jet votes for merger, it must exchange its Texas Internt. warrants and it will be taxed a lot (b) if exercise warrants prematurely, it also too expensive ($3 mil) 37 (2) Thus, Texas Air set up an independent committee b/c of common bods (to avoid selfdeaalin under DGCL 144)→decides to give Jet a loan if they vote in favor of merger. (a) committee had indep. study done and loan was disclosed and approved by a majority of outstanding shares and majority of disinterested shares. b) Held (1) Ct. said that Del. law has discarded the presumptions against voting agmts--each arrangement must be examined in light of its object or purpose (2) Here, loan was not meant to disenfranchise: (a) approval by disinterested shs and obods (b) transaction good for company (but, according to whom) (i) Jet thought it was good--loan terms weren't great so it wasn't the inducement to make the deal. Only reason to do it was b/c shares go up if merger goes through. (3) Significance of special voting rule here--majority of disinterested shares voted required: (a) majority of shares voted is diff. than majority of outstanding shares (as normally under Del. law) (b) ie. if jet capital didn't vote (not allowed) under outstanding shares rule, it is same as voting no→this is more fair. PART IV: THE ACQUISITIONS MARKET XXIV. Control Transactions A. Ownership structure of corp and voting system allocates control among corp. actors. However, a variety of transactions can restructure, extend, or transfer corp. control→control transactions 1. ie. 50% sh has absolute control b/c he can dominate bod. 30% sh has de facto control b/c he can put up a formidable defense against any competitor and can get entire control with a relatively small purchase. 2. but, as dominant sh fall below 20%, ind. control becomes contigent on size of other sh blocks, firm size, and legal rules governing hostile tender offers and defensive maneuvers. B. Management retains considerable power to dispose of corp. assets and block outsiders from purchasing control, even when bod has little or no equity interest in firm (if no large shs) 1. of course, even 50% shs have fiduciary duties to minority shs. 2. Thus, in 1980's most mergers followed two-step process: a) purchase control over the bod b) implent a merger transaction to force minority shs to exchange shares for cash or debt. C. categories of control transactions: 1. corp. mergers and sales of assets a) focus is on statutory protections enjoyed by dissenting shs b/c of compulsory nature of buyouts (ie. appraisal rights) 2. freeze-out merger a) inititated by controlling sh for purpose of getting rid of minority shs 3. sale of control to outside acquiror 38 a) has effect of "freezing in" minority shs 4. hostile tender offers a) acquiror's side--William's act and state anti-takeover legis. b) target's side--bod's ability to defend against an outside acquirer or select its own buyer, regardless of shs wishes XXV. Corporate Combinations and Appraisal Rights A. Generally 1. Choice of form of corp. combination is a matter of convenience--sale or merger. a) for purpose of lowering of transaction costs, financing, and taxes, a merger form is preferrable to a sale of assets. (1) for hostile tender offer, need approval of shs to sell you their shares but bod of target's approval is not needed--automatic transfer of assets (becomes a subsid) b) for purpose of avoiding the target's liabilities, a sale of assets is the more attractive form. (1) for sale, you need approval of bod and shs of acquiring corp, but it requires much paperwork and K's 2. Why acquire/merge with a company? a) diversification, economies of scale, add value through synergies or better mgt, better utilization of existing assets b) want to minimize total transaction costs--consider: (1) need for various approvals (ie. PSI/Ipalco) (2) risk of tyranny of minority (3) need to amend charter/increase authorized stock 3. Basic Mechanics ***(see chart from 11/2--approval and special reqts.) a) Goal is to put assets of 2 corps. under the control of 1 management, either as one legal entity or as parent/subsid. (1) more than one way to accomplish that (2) three basic techniques for accomplishing change in control are merger, exchange of shares, and exchange of stock. b) Approval of shs of both corps. is usually needed. Two exceptions: (1) merger of wholly owned subsid. into a parent (at least 90% ownership)--vote of shs of subsid would be a formality (see triangle merger--same thing) 1. considered a short-form merger (sec. 253)--parent owns more thant 90% of subsid. 2. minority shs can still get appraisal rights (2) mergers b/t corps. of very diff. sizes (considered a 251(f) merger) (a) if the number of outstanding shares of the larger corp. will increase by no more than 20%, there is little need to submit the merger to acquiror's shs for approval--no fundamental alteration. (b) NYSE rules require such a vote, even if not required by state law, if acquiring corp. will issue additional shares > 18.5% of previously outstanding shares c) Triangle/Subsid. Merger (1) if subsid. acquires target, then you never need approval of own shs as a matter of state law→most mergers done that way. (a) ie. acquiring corp. is the sole sh of subsid. (2) however, you might need sh approval: 39 (a) to amend charter to issue new shares (b) if on NYSE and you issue more than 18.5% new shares (3) everything you can do under 251(f) (20% merger), you can do under a subsid. merger. (a) neither need sh approval of acquiror, BUT with subsid. merger, subsid takes on target's liabilities, not parent. (b) thus, 251(f) is not used very much. d) Regular Merger--sec. 251(c) (1) easiest way to combine 2 corps. into 1 with one of the corps. designated as surviving corp. (a) need approval of bod and shs of both corps. (b) which corp. is the surviving one means little--pick more popular name? (2) can be either: (a) stock merger--PSI/CGE (b) cash merger--van gorkum, virginia bankshares (i) treasury shares (non-issued shares) and shares owned by either corp. don't get paid. (3) long form merger (251) can be used to force all shs to "sell" their shares as long as the merger is approved by the requisite majority. (check on this) (a) ie. DGCL 251(b) says that merger consideration may be cash, property, or debt securities e) It is rare that all shs will sell shares in a hostile tender offer. If you want 100% ownership, you must do a freeze out merger. (1) Two steps: (a) hostile tender offer and kick out bod (i) > 90%--short form merger, <90%--reg. merger (b) freeze out merger (i) minority shs get appraisal rights B. Appraisal Rights 1. Generally a) DGCL 262--hodlers of sh may demand an appraisal of the fair value of their shares and payment in cash thereof in lieu of accepting the merger consideration. (1) Stock Market Exception--262(b)(1)--you can't always get appraisal rights--if stock is listed on a stock exchange, you don't (b/c if you believe in EMH, you believe that a sale of stock on the market will represent fair value of stock) (a) Fishcel believes in EMH but doesn't think there should be an exception for publicly traded corps. b/c market won't protect dissenting shs (b) KAHAN--doesn't think there is any rational explanation for this exception. (2) Exception to Stock Market Exception--262(b)(2)--you get appraisal rights despite a company being listed if you get anything but: (a) shares of stock (b) shares of stock of any other listed corp. (c) cash in lieu of fractional shares (d) combination of above (e) ie. if you get real cash (not just a fractional amount), then you still get apprasial rights 40 (3) Also, if there is a short-form merger (253), you get appraisal right under 242(b)(3) b/c votes of minority shs don't count (a) stock market exception doesn't apply (it is one of the mentioned enumerated sections). b) Requirements: shs of record who desire to exercise their appraisal rights must: (1) hold shares on date of making appraisal demand (2) continuously hold shares through effective date (3) not vote in favor of the approval of bod merger agmt (must vote no or abstain) c) Procedure (dgcl 262) (1) must notify corp. of intention to seek appraisal rights before vote (2) can't vote in favor of merger (3) if merger succeeds, surviving corp. must notify shs that merger went through (4) w/i 120 days, sh or corp. must demand appraisal rights (or withdraw demand w/i 60 days and participate in merger) (5) ct. appraises fair value of the shares. (a) ct. may also order sh to pay for costs of proceedings d) Rationale (1) once majority had the power to override the will of the minority shs, appraisal remedy was developed as protection for minority against majority. (a) gets rid of prisoner's dilemma for shs in second step of transaction→protects all shs from value-reducing transactions (b) ie. by decreasing the probability of any one share getting a negative outcome, it causes all shares to trade at a higher price. 2. Determination of Value a) Apprasial right is a put option--opportunity to sell shares back to the firm at a "fair" price that is supposed to reflect their value prior to transaction that triggere the right. (1) excludes value created by merger--dissenting shs cannot reap benefit of control premium (2) dissenting shs claim is a pro-rata claim on the going value of the corp. b) Delaware allows any "generally accepted" method of valuation, including expert testimony from the investment banking community--ie. Weinberger. (1) pre-announcement market price is a factor (but, may not represent true value and be poor protection) (a) ie. based on presumption that a corp. is worth what the highest bidder would pay for it in an arms-length transaction (2) Del. provides for interest--costs distributed equitably XXVI. Exclusivity of the Appraisal Remedy and Freezeout Transactions A. Generally 1. Freeze-out/Cash-out transactions by controlling shs differ from arms lenght mergers negotiated by bods in two respects: a) a controlling sh has the statutory power to impose a merger regardless of how minority shs value the deal (1) a majority vote can bind all shs--those who voted for and those who voted against--to accept the consideration offered or exercise their appraisal rights. 41 b) a controlling sh can force through a merger w/o fearing a competing offer from an outside bidder, since no one can compel the controlling sh to sell his control block c) rule 13(e) governs disclosures for freeze-out transactions and acquistions of a corp's own shares 2. Freeze-out mergers force minority shs to go away for cash. They can be either: a) cash-out merger (most common) b) short form merger (cash instead of stock) c) reverse stock split resulting in fractional shares--by-law reqt. that fractional shares be cashed in is enforced. 3. Power of controlling sh raises question of whether minority shs have sufficient protection: a) voting b) appraisal rights c) case law--entire fairness doctrines (see below) 1. Del. law concerning freeze-out mergers was overhauled by Weinberger 2. old line said that controlling sh must have a business purpose for freezeout merger--otherwise, it is corp. abuse. B. Case law--Substantive Unfairness 1. shs may seek injunction/damages based on unfairness. If procedure is fair, P then has the burden of proving that bod approved a grossly inadequate price (very hard). 2. But, if self-dealing, D has the burden of showing "entire fairness" (see below) 1. Weinberger v. UOP (Del. S.Ct. 1983) a) Facts (1) Signal bought 50.5% of UOP, had 6/13 directors, CEO--purpose of purchase was to invest extra cash (2) Signal decides to buy the rest of UOP--Signal officers on bod of UOP did a secret feasibility study and named a price. (3) UOP bod accepts with little review or negotiation (ie. van gorkum) (a) there was no reason to rush b/c there could be no other competitors (b) bod looked at financial data, mkt. price, and independent directors made decision to avoid self-dealing (c) signal conditions freeze-out on approval of majority of minority shs (ie. jet capital) b) Held--Ct. announces a new theory of judging controlled transactions→entire fairness doctrine. (1) Two elements of "entire fairness": (a) Fair dealing--procedural, AND (i) ie. disclosure, approval (b) Fair price--any kind of valuation method accepted in financial community and that fits into 262 is OK. (i) fair value must consider all relevant factors (ii) -exludes pro forma data and other speculative elements (2) Remedies (a) Weinberger Remedies--in future cases, chancellor can fashion equitable relief in case of fraud, misrepresentation, self-dealing, and waste (i) relief might be injunctive or non-appraisal relief 42 (b) Ordinarily, however, shs have to seek appraisal rights only under 262. (i) fair value based on all relevant factors (ii) shs now allowed to share in synergistic gains from the transaction. (3) Here, Ct said: (a) no fair dealing because: (i) feasibility report was never disclosed and duty of loyalty breached (signal bod used uop info. for signal purposes) (ii) bargaining was false or weak (iii) and, b/c info. wasn't disclosed, vote doesn't count (b) no fair price because: (i) chancellor used old Del. block method of valuation--ct. says it uses limited info and is therefore misleading. c) Incentives for Fair Dealing: (1) Controlling sh has little incentive to deal fairly with minority shs because shs don't get any new remedies (a) ie. shs will typically get appraisal rights whether there is fair dealing or not. (2) However, there is now possibility of equitable relief if bad dealing is egregious enough (and, fear of future repercussions in capital markets). (3) Shs do care about which remedy they get even though they only get fair price (through appraisal or Weinberger): (a) appraisal rights are quicker and cheaper--but, sh might get less than offering price (b) Weinberger is brought as a class action on a contigency fee basis--worst sh can get under Weinberger is offering price. 2. Rabkin v. Phillip Hunt (Del. S.Ct. 1985) a) Facts (1) Olin bought 65% of Hunt from majority sh for $25 under K promising that if Olin bought any more shares w/in one year, they would pay $25 for them. (2) Olin waited a year and a couple of weeks and then did freeze-out offer for $20. (a) Hunt forms committee of outside directors who get fairness opinion that $20 is fair, but not generous. (b) Olin refuses to raise price so committe approves merger and solicits approval of shs. (c) There was no misrepresentation or disclosure prob. (3) Chancery ct. says that you only get more than appraisal rights if deception or fraud. b) Held (1) RULE EXPLAINED--S.Ct. says that chancery ct. interpreted Weinberger too narrowly--you get more than appraisal rights particularly when there is fraud or deception, but they are not the only times. (a) here, there is a problem of procedural unfairness--manipulated timing of the offer to get around one year provision, and knew all along they would buy out minority shs. c) When do you get more than appraisal rights after Weinberger and Rabkin? (1) Weinberger--fraud, deception, misrep, and waste (2) Where appraisal doesn't do justice or cannot address problem of procedural unfairness (w/o relation to fairness of price) (a) ie. procedural unfairness outside of weinberger 4. 43 (b) ie. where unfair dealing reasonably effected the price 3. Kahn v. Lynch (Del. S. Ct. 1994) a) Facts (1) Alacatel owns 43.3% of Lynch at time of merger and has 5/11 of Lynch bod. (2) Old management of Lynch wants to expand into fiber optics (Telwave). However, Alcatel says no--merge with Clewave instead (subsid of Alcatel). (3) Independent committee is set up to negot. with Celwave and rejects offer. (4) Thus, Alcatel decides to take over Lynch--there is bargaining, but when Acatel says they will proceed w/hostile offer at a lower price, Lynch gives in. b) Held (1) Ct. says that Alcatel is a controlling sh with a fiduciary duty to minority shs, even though they have less than 50% (a) alcatel dominated business decision b/c of ownership, not b/c of good business judgment. (b) thus, there is a duty, and Alcatel must comply with "entire fairness" in freezingoou minority shs. (i) Alcatel breached duty of fair dealing b/c there must be the power to say no--not here. c) views on issue of shifting burden--if get approval of independent committee: (1) law--shift to P to prove fairness (a) b/c this a self-dealing transaction, law says you don't get BJ rule presumptions even if you do everything right. (i) might be hidden threats shs as well--ie. withhold dividends→ct. just being pragmatic (it is like special litig. committee) (b) only result of procedurally correct committee is to shift burden. (i) here, committee didn't function properly b/c they had to give in to Alcatel's last offer, so burden of proof doesn't shift. (2) alternative view--apply business judgment rule (similar to DGCL 144--see Marciano fn) XXVII. Sales of Control A. Generally 1. Instead of a tender offer, once could buy corp. control from a big or majority sh. This usually requires a control premium b/c control is not equally proportionate among shs--51% gets you: a) gain control over your investment (command corp. assets) (1) ie. keys to corp. treasury b) control own salary and fate c) Strategic opportunities--implement better mgt. to increase earnings and return (1) assumes belief that buyer believes corp. is undervalued 2. However, buyer may not want to pay a premium for or even buy remaining shares: a) if you are trying to improve mgt, you only get increased risk w/o further control advantages--won't buy b) if you are looting, you don't want to own more than is needed--shares won't be worth anything when you are through 44 (1) ie. to profit from self-dealing, there must be minority shs to take from or harm. If you own the whole corp, you can't profit b/c you are really taking from yourself. (2) controlling sh will only be willing to buy minority shs if total price (controlling + minority shares) allows for some self-dealing c) looting drives value of other shares down, while implementing better mgt. drives value up. 3. Value of control is determined by the value of the assets of the corp.over which control is exercised. However, there are limitations: a) can't cause corp. to sell assets to himself (thereby getting assets and proportional share of money back) b) can't sell control/office for less than 50% of stock--buyer may sell of assets (see Brecher) (1) ie. if there is no sh with large shares, effective control of assets is by management (2) if amount of stock sold is more than 50%, then the investment properties and control properties are inseperable. 4. Why not make a rule saying that you have to pay a premium to all shs: a) Do it only if you think looting is an imp. problem (1) such a rule would discourage looting b/c buyer would own 100% of shares b) However, the rule would discourage sale of control when better mgt. is the idea b/c of increased risk, lack of diversification and increased purchase cost. B. Case law 1. Zetlin v. Hanson (NY Ct of appeals 1979) a) controlling sh sold 44.4% of stock to Flinkote for twice the prevailing mkt. price b) Held--absent looting of corp. assets, fraud or bad faith, a controlling sh is free to sell the controlling interest at a premium price. (1) although minority shs are entitled to protection from abuse, they cannot inhibit the legit. interest of sh in premium price. 2. Brecher v. Gregg a) Gregg, President of Lin, sold 4% share at 30% premium w/agmt. to give control to new shs. b) Held--ct. says that purchase of control w/small block of shares is not permitted--must give premium to corp. (1) it is really just a sale of office that was given away by sh--ie. a bribe (2) w/small block of shares, you can do a hostile tender offer to get other shares at less than a premium price--no large block of shares to reject it. (a) if large shs owns control, it serves to align itnerest of mgt. with shs. 3. Harris v. Carter (Del. Chancery Ct. 1990) a) Facts (1) Carter (52% owner of Atlas) has stock exchange agmt. w/Mascolo (owner of ISA shares) (2) Carter group resigns one by one and remaining majority puts Mascolo people on Atlas bod (3) The new bod does a lot of self-dealing: (a) reverse stock split (b) buys Hughes Chem (self-dealing at high $) (c) give large commission to finding company (d) buys ISA stock--which had little value (more self-dealing 45 (4) Sh sues Carter group for selling block of shares w/o fulfilling duties (ie. had reason to be suspicious and didn't investigate) (a) Both Carter (was given bad ISA shares in deal) and minority shs were hurt. b) Held (1) RULE--in circumstances where reasonably prudent person would be suspicious, seller must satisfy himself of good intentions of buyers (a) ie. must ensure that minority shs don't get hurt (b) ct. denies motion to dismiss--doesn't rule on whether there was reasonable susp. or investigation here. (2) What kind of questions should an investigation contemplate? (a) line of busiess of buyer (b) capitilization of structure (all cash is bad sign of looter) (c) business consultent group--have identity and past history verified XXVIII. Tender Offers and the Williams Act (see IV-76 for example) A. Generally 1. A tender offer is an offer of cash or securities to the shs of a public corp. in exchange for their shares at a premium over market price. a) goal is to get a control block in a corp. that doesn't have a dominant sh--thus, premium price is analagous to control premium b) hostile tender offer is when bod disagrees and friendly is when bod agrees (1) ie. bod has no legal power to stop shs from selling, but there are ways for bod to stop transaction (poison pill) 2. Regulated now by the Williams act (part of 1934 act)--general goal is to ensure full and accurate info. is available to shs to make market function efficiently. a) act provides shs with the time and information to make an informed decision about whether to tender their shares b) gives the market an early warning of impending offer. c) assures shs an equal opportunity to participate in offer premium 3. principle elements of regulatory structure set up by Williams act a) --erects an early warning system of future change in control (1) Disclosure obligations are at 5% threshold--w/i 10 days of the acquision, buyer must disclose: (a) identity and background of purchaser (i) must disclose previous violations of securities or criminal law (b) source of funds used in the acquisition (c) number and percentages of shares held (i) must disclose any K's, arrangements, understandings w/respect to stock of corp. (ii) applies to groups (loosely defined) that hold stock together or planned formation of group (but w/o purchase as of time of disclosure) (d) future plans and purpose regarding corp. (i) if just exploring options, don't have to disclose, but if you have a plan, you do.--ie. merger, effect bod, buy more shares etc. 46 (2) These obligations are less complete than 14(d)(1)--which has similar obligations for any tender offer (a) ie. 13(d) is not necessarily provoked by a tender offer--just the accumulation of 5% of stock (b) since 13(d) is easier to comply with than 14(D), acquiror may want to characterize deal as "not a tender offer"--if possible (b/c sec uses broad def. of tender offer) b) (4-7)--regulates the substantive terms of tender offers themselves--meant to stop coercion: (1) Requires extensive disclosures (Sch. 14D-1 filed w/SEC, target, other bidders and stock exchanges) AND (2) Traffic Rules for tender offers: (a) offer must be open for 20 business days (i) gives sh time, allows competing offers, market price may rise over premium, target corp. may put out info, or make offer themselves, pill (b) Best price rule (i) any increased consideration must be offered to each sh whose shares were tendered before expiration and which are purchased (c) Withdrawal rights (i) target shs may withdraw securities at any time w/i 15 business days (ii) added 10 days afte a competing offer is made (d) Pro-rata Purchasing (i) buyer msut pruchase on a pro rata basis from each tendering sh c) --antifraud provisions to prohibit misreps, nondisclosures and fraudulent practices in connection with the tender offer (1) provides a private cause of action against acquirors whose tender offers contain material misreps or omissions. XXIX. The Takeover Debate--Hostile Tender Offers: Good or Bad? A. Generally 1. There is much debate as to desirability of hostile tender offers and the proper role for target mgt. B. Gilson--let market work. Raiders are monitors of mgt. (keeps mgt. on their toes) and takeovers are their reward→efficient. 1. Corp. control market is important mechanism for dealing with bad mgt: a) If the bod does a bad job, stock price goes down. Tender offer is favored displacement method--bod can't be allowed to stop tender offer (self-entrenchment if no other valid purpose) 2. incumbent bod should be to provide info. to shs and solicit competing offers--leads to better decisions by shs (Kahan agrees) a) however, bargaining by the bod limited to securing a higher offer is a defensive tactic that is consistent with sh interests b/c it aids rather than interferes with market for corp. control→ little danger of mgt. misuse of bargaining process for self-serving ends. C. Brealy and Meyers--raiders provide a check against self-dealing managers and defenses frustrate this. 47 D. Lipton--not as concerned with bad mgt.→more concerned with growing amt. of takeovers and use of debt under short-term focus. 1. Problems with highly leveraged takeovers: a) hurts existing creditors b) not productive and hurts employees (except for the service industries) c) mgts. short-term focus is on debt management and high profits to drive up price (1) ie. corps. will focus on not becoming a target--no expansion, research or long-term goals (Kahan agrees with this too) 2. Thus, Lipton advocates use of defensive tactics beyond white knights and merely providing info. to shs--doesn't matter if there are less takeovers a) today, raiders ahve financial means to take over any company (ie. junk bonds, LBOs) b) but, if you takeover corp merely b/c market value is low w/o taking over mgt, there is no change or benefit (only change in location of money) E. Easterbrook/Fischel--oppose auctions and want to remove Williams Act b/c it encourages multiple bids. 1. Believe that mgt. should cooperate w/raiders to maximize everyone's wealth b/c takeovers are beneficial: a) gets rid ofinefficient mgt b) takeovers provide incentives for bod not to be inefficient 2. The bigger the slack-off by mgt, the greater the premium--must believe in EMH to believe that premium will compensate shs for amt. of slackoff by mgt. (Easterbrook apparently does) F. Bebchuk--auction rule increases proportion of knowledgable mergers--on the whole, takeovers increase social welfare. XXX. Defensive Tactics A. Generally 1. bod doesn't have direct veto power over a tender offer--devices are used as a round-about means of takeover resistance. Shs have final say. a) Shs will prefer bid to succeed (and will tender accordingly) if and only if he veiws the expected acquistion price as higher than the target's value (Bebchuk). b) all-share, all cash offers may be coercive according to Gilson b/c post-takeover price is always lower than bid price--always incentive to tender (1) ie. timberjack offer was not coercive b/c the freezeout offer was at the same price as original tender offer 2. Why should bod be allowed to block a tender offer that shs may rationally want to accept? a) protecting interests of uninformed shs, rushed or stupid shs, long-term shs, mgt, community and jobs? 3. What can bod do w/i its fiduciary duty? (besides poison pill--see below) a) charter amend.to require super-majority or majority of disinterested shs to approve merger (1) but, must be in place before offer b/c sh approval will be needed b) pac-man--make hostile tender offer for other corp. that is buying you. 48 c) white knight--endorsed by Gilson. (1) use lock-up options to make more attractive (ie. van gorkum, psi) (2) crown jewels--lock-up of most attractive part d) defensive recapitalization (1) LBO--mgt. buy out (2) Non-discriminatory self tender offer e) state anti-takeover statutes--DGCL 203 B. Poison Pill--"Shareholder's Rights Agmt's" (read K--IV-128) 1. Generally a) Poison Pill is most effective defense b/c: (1) corp. can create them w/o sh approval (2) can create one immediately, even if there isn't one when tender began. (3) poison pills are deadly--raiders will not swallow them. b) Flip-in Pill (1) rights that harm raider and come into play when large number of shares are acquired c) Flip-over Pill (1) rights that come into play when freeze-out merger is attempted 2. Mechanics of Poison Pills a) Reference to dates: (1) Share acquisition date--date that shares of target frim acquired (ie. when person becomes an "acquiring person" (2) Distribution date--when rights are given out to shs (10 days after share acquisition date or announcement of tender offer) (3) Ajdustment date--if purchase goes through, poison is released b) What rights do Rights give sh after distribution date (before distribution, there are no rights)? (1) can buy 1/100 of preferred stock share for $250 or 1 share of preferred stock for $25K →subject to adjustment. (2) w/o adjustment, the right to buy one share for $25K is not very valuable. c) Adjustment--instead of getting fraction of PS, you get common stock in amount of: (p. 139) (1) (current purchase price of right) (# of cs shares that 1/100 of ps is worth) /(50% of the market price of cs) (2) thus, after adjustment, everyone but acquiring person gets $500 worth of stock in acquiring corp. for $250. (a) acquiring person would rather keep shares then suffer such dilution--in reality, pills are never triggered (b) imp. date for triggering poison is therefore the adjsutment date d) When does adjustment take place (IV-139): (1) when you become an acquiring person (a) unless all shares, all cash, and 85% ownership→no adjustment. (2) if acquiring person exists and then gains 1% more of outstanding stock (a) during such time as there is an acquiring person, if there is a recapitilization, reorganization, otr transaction involving the corp which increases proportionate share by more than 1%, adjustment is triggered 49 (b) ie. acquiring person can buy someone else's shares on market b/c it doesn't involve corp. but, even if 85% exception, can't do freezeout b/c it involves corp. e) Bod can change distribution date: (1) b/c you know that tender offer will not really close, corp. does not have to issue the rights---only have to if there is an actual acquisition (not just the tender) (2) ie. raider only gets control when the tender is completed--if tender offer is merely announced, corp. doesn't have to send out rights b/c upon adoption of pill, raider will withdraw offer until pill is removed. f) *Bod can redeem rights before there is an acquiring person and allow tender offer to go through (ie. if bod fears being voted out) (1) decision to redeem or not is under Unocal standard. (a) eventually, pill must be removed if apparent that corp. will be bought (see Interco) but it serves to buy time. (2) or, acquiror can get around pill by: (a) proxy fight for bod members (b) litigate for injuction to have pill redeemed on basis that bod breached fiduciary duty (c) squeeze in with all cash/all share offer (d) special sh meeting 3. City Capital Assoc v. Interco (Del. Chancery Ct 1988) a) Facts (1) Interco (aka Intern. Shoe) had poison pill and was trading at $40. (2) CCA proposes $72 for merger--Interco says too low and decreases pill trigger range to 15% ownership. (3) Interco proposes own restructuring but CCA goes even higher with an all-cash, allshaare at $74 but Interco refuses to redeem pill. CCA goes to ct. and claims bod breached duties. b) Held (1) Ct. looks to Unocal standard and says that pill is a reasonable measure, but only up to a point. (a) Del. law allows you to keep pill in place of a tender offer b/c: (i) get better offer from tenderor (ii) arrange other transaction; (b) BUT, pill must go after negotiation period has ended and legitimate function is gone. (i) only valid use of pill with a non-coercive offer (ie. threat of low price) is to get better offer or negot.→but, can't just sit on offer. (ii) Ct. says there are only 2 reasonable threats--coercion and inadequacy (overruled by Paramount v. Time) (2) Here, this is not even a close case for allowing bod to keep the pill b/c sh could