I. Agency
A. Vicarious Liability in Tort 1. A principal can be liable for the torts and contractual liabilities of his agent. A) Issue of agency usually arises from contract. B) Agency can be implied by the court. C) Agency has only two features: 1) Terminable at will by either party. 2) Fiduciary relationship. D) Must satisfy both features to be enforceable relationship. 2. Why have VL/who should be liable? A) Deep pockets of principal versus agent: we want P to collect. 1) Agents may be judgment proof. B) Principal is usually in best position to control risk/avoid costs. 1) We place blame on cheapest cost avoider (CCA) in order to maximize social benefits. (Calabresi) 2) Note: we should look to who can affect safety precautions. a) Oil Co. may be able to by mandating certain guidelines, being more cautions on hiring agents etc. C) Note: what are effects on imposing liability on principal or agent? D) See torts outline page 25-26. 3. Master/Servant Relationship A) Restatement of Agency 2nd, Section 2: to what extent does principal have control over agent? B) RS 220: definition of servant: (most are control based) (a) the extent of control which, by the agreement, the master may exercise over the details of the work; (b) whether or not the one employed is engaged in a distinct occupation or business; (c) the kind of occupation, with reference to whether, in the locality, the work is usually done under the direction of the employer or by a specialist without supervision; (d) the skill required in the particular occupation; a) Higher the skill level, less control employer has, less liability. (e) whether the employer or workman supplies the tools and place of work for the person doing the work; (f) the length of time for which the person is employed; (g) the method of payment, by the job or by time; a) If paid by the job, servant left alone, if paid by the hour, then employer watches them and has greater control. (h) whether or not the work is part of the regular business of the employer;
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(i) whether or not the parties believe they are creating the relationship of master and servant; and (j) whether the principal is or is not in business. C) Key is control. 1) Humble: high control. a) Humble tells agent what to do except in hiring and firing. b) Can only sell Humble products. c) Terminable at will. d) Humble retained title to goods. e) Compensation via paying some expenses: like commission salesman: agent not as concerned about costs. f) Contractual reservation of power by Humble. 2) Sunoco: low control. a) Agent owned goods. b) Mutual termination provision. c) Can sell other products. d) Sunoco give advice, not demands: agent control day to day operations. e) Profit sharing, not commission salesman. f) More interest and care in running station. 4. Scope of Employment A) RS 219: A master is subject to liability for the torts of his servants committed while acting in the scope of employment. (1) 1) Master is not liable for torts when servant acts outside of scope of employment, unless: (2) a) master intended the conduct or consequences; or b) master was negligent or reckless; or 1. e.g. master hires know psycho. c) conduct violates a non-delegable duty of the master; or 1. e.g. blasting stuff. d) the servant purported to act or speak on behalf of principal and there was reliance on apparent authority or servant was assisted by existence of the agency relationship. 1. See apparent authority, pg 3. B) RS 228: Conduct of servant is within the scope of employment if: (a) it is the kind he is employed to perform; and (b) it occurs substantially within the authorized time and space limits; and a) Should have deterrent factor b/c principal should be able to control this activity. (c) it is actuated, at least in part, by a purpose to serve master;
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a) Reasoning: there is an inability to monitor and control when activity is motivated by non-job related things. b) Getting drunk on navel base considered intent to benefit government by enhancing morale: Calabresi in Taber. 1. Government has control over base activities. 2. Harm of drinking on base is foreseeable cost. c) Exception: AA in tort. (d) if force is intentionally used by the servant against another, the use of force is not unexpectable by the master. C) RS 230, 231 and 232: Forbidden, criminal, or failure to act, respectively, may be considered within the scope of employment. D) May also look to fairness: Friendly in Bushey. E) Activity level-CCA justification: If force enterprise to internalize costs, they can control the amount of activity, and thus the total risk, even if can‟t control the activity: Calabresi and Kraakman. B. Authority Doctrines 1. Actual Authority: agent reasonably believes, as a result of principal‟s words or actions, that they were authorized to take action on principal‟s behalf. A) Express Authority: communication by principal is explicit. B) Implied Authority: action, though not explicitly authorized= reasonably calculated to discharge principal‟s explicate instructions. (RS7,20) 2. Apparent Authority (AA): authority a 3rd party reasonably believes the agent to hold, based upon the conduct of the principal. A) Source of principal‟s liability on K debts and important exception to scope of employment requirement in tort. B) Turns on principal‟s, not agent‟s, communication to 3rd party. (Jennings) 1) Principal knowingly permits agent to act; or 2) Principal holds agent out as possessing authority. C) Ordinary transaction: fact that agent has repeatedly done such deals in past may bind principal. 1) Look to similarity with prior transaction. 2) Look to degree of repetitiveness of transaction. 3) 3rd party must know or else need to try it under IA. D) Corporate office (e.g. VP) does not clothe agent in AA. (Jennings) 1) Holding otherwise would undercut structure of corporation. 2) Too much uncertainty in assuming authority based on title. 3) President has authority to bind corporation in ordinary business transactions. (Clark) E) Extraordinary transactions: Ps should be more careful in relying on agents word. 1) CCA: e.g. it would be cheaper for Jennings to have checked with the board rather than the principal monitoring all of its agents.
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2) No AA here. 3) No AA if t-action must b executed by seal or statutory person. F) Agent can not invest self w/ AA. (Jennings) G) AA must involve actual agent. 1) e.g. random person in J.C. Penny claiming to be salesman rips you off: probably no remedy under agency law but maybe tort. H) Usually no punitive damages here but may have them to force corporation to internalize costs. (ASME) 1) May not matter that corporation is non-profit, they may still derive benefit and may survive notwithstanding judgment. (ASME) 3. Inherent Authority (IA) A) RS 161: Disclosed or partially disclosed principal is liable for agent‟s acts which are incidental to authorized transaction, even if act is forbidden by principal, if 3rd party reasonably believes agent is authorized and has no notice otherwise. 1) Applies when agent has neither authority nor AA. 2) Based on fairness that principal is liable for losses caused by appointed agent which is part of principal‟s organization. 3) Base on VL theory not K law. 4) This section probably just overlap w/ AA: 194 more important. B) RS 194: general agent subject undisclosed principal to liability for acts done on his behalf, if usual or necessary in transaction, even though its forbidden. 1) No AA if principal is undisclosed. 2) Don‟t want to allow undisclosed principal to dress up judgment-proof agents as independent businessman. 3) Agent may also be liable here. a) Need principal liable also b/c of deep pockets. C) Principal must ratify agent‟s act. 1) Principal learning of agents act and not taking measures to repudiate it are sufficient: tacit ratification. D) Overlaps with AA in many Js. 4. Authority in K, respondeat superior in tort. C. Agency Contract and Fiduciary Doctrines 1. Fiduciary relationship: arises when a beneficiary entrusts a fiduciary to control and manage an asset. A) Fiduciary relationships include: 1) Principal-Agent. 2) Trustee-Beneficiary. 3) Partnership. B) Fiduciaries obligations are open-ended. 1) Asset management involves risk so can‟t dictate behavior in advance. 2) Monitoring of fiduciary behavior is too costly. C) Fiduciary may do 2 things wrong:
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1) Misappropriate the asset. (Malfeasance) a) Governed by duty of loyalty. 2) Neglect management of asset. (Nonfeasance) a) Governed by duty of care. 2. Principal-Agent. A) RS 387: agent has duty to act solely for benefit of principal. 1) Agent can‟t use confidential info to disadvantage principal. B) RS 388: agent must give to principal any profit made in connection with transaction on behalf of principal. C) RS 389: agent can‟t act as adverse party to principal in t-action w/o consent. D) RS 390: if consented, agent must deal fairly and disclose all facts agent knows will affect principal‟s judgment. 1) Payment of less than market value for property sold by principal is evidence bargain was unfair. a) But deal w/ non-dependent principal is not voidable simply due to price discrepancy if agent fully discloses. b) e.g. on I-43: 1. Real estate agent should have know house was worth more. 2. Price discrepancy too great. E) Remedies. 1) Any secret profits + any other damages associated with transaction. 2) Quasi-punitive in that principal gets secret profits and damages. a) P not overcompensated b/c acts as a deterrent to agent. b) At common law, don‟t get punitive damages for breach of fiduciary duty. 3. Trustee-Beneficiary. A) RS 203: Trustee is accountable for any profits made arising out of administration of trust even though profits don‟t arise from breach of trust. 1) Gleeson is perfect e.g. b/c trustee acted in very noble manner and still lost. B) RS 205: if trust is breached, trustee liable for: (a) loss or depreciation in estate; (b) profits made from breach; and (c) any profit that would have accrued had there been no breach. C) RS 206: 205 also applies to breach of loyalty as well. D) Fiduciary norms are tougher in trust than in other areas: 2 rationales: 1) Its easier to cheat here. 2) Tougher rules don‟t lead to opportunity costs b/c not commercial. E) Above rules are per se, so even Gleeson guy gets screwed. 1) Managers of estates may not agree with rule but are under fiduciary duty themselves to enforce it against other trustees.
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4. Partnership/JV A) Duty to inform: partners or JVs must inform one another about other business opportunities that arise out of their joint p-ship. 1) This does not require an offer in stake of new deal, only disclosure of availability. 2) P needs opportunity to compete. 3) Punctilio language of Meinhard: when cited, D loses big. B) Possible ex ante solutions: what would two businessmen have decided? 1) Meinhard option: partners have option to invest in new venture on same terms as old. a) Pro: Sharing is fair, Salmon is greedy. b) Con: Meinhard gets windfall. 2) Salmon option: Salmon gets to keep project for himself unless he wants to invite Meinhard to join. a) Pro: Future opportunity based on success of current project so Salmon has incentive to maximize its value so Meinhard benefits. b) Pro: Makes for cleaner JVs: doesn‟t allow for penumbra of other claims on related projects. c) Con: Salmon may delay profits at end of term and recognize them at beginning of solo project. 3) Renegotiation option: what fiduciary duty actually requires from Salmon: partners renegotiate or compete for any new opportunity that arises: Cardozo says this is default rule. a) Pro: They smart enough not to compete and drive value of venture down, so they negotiate new deal b/w themselves that they take to 3rd party. b) Con: 3rd party benefits if parties compete, its easy to let the Salmon partner do the negotiating. C) Possible considerations: 1) Size of new project. 2) What each party contribute to project. 3) Who hears of it. 4) Does active P have higher fiduciary duty? 5) Was new business connected to old one? D. Problem of Agency Costs 1. Agency Relationship: K under which one or more persons (principal) engage another (agent) to perform some service on their behalf which involves delegating some decision making authority to agent. A) Can occur between co-owners in JVs, partnerships and between manager and passive SHs in corporations. B) Incentives of principal and agent are not same, thus agency costs.
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1) Solution: make them same by paying via commission or for managers, in out of money stock options. (Pratt et al.) a) May need to limit ability to reprice options or else incentives decrease. 1. I say may lead to managers acting risky: if it fails, reprice options, eventually they succeed and make $$ while SH lose. 2. Counter: manager will get fired and has other fiduciary duties (but has BJR protection). C) Information can not be shared without cost, thus agency costs. D) Goal of corporate governance is to reduce agency costs. 1) Can‟t reduce all the way but try to minimize it. (Pratt et al.) 2. Agency costs arise out of general K‟ing problems inherent in any relationship: A) Monitoring Costs: Incurred in limiting aberrant activities of agent. B) Bonding Costs: Arise from the need to guarantee that the agent will pay for any damage done to principle. 1) Must pay agent to expend own resources. C) Residual loss: Costs of agent doing things principal would not do. 1) e.g. managers use of corporate jet.
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II. Partnerships
A. Formation 1. Reasons for formation: A) Raise capital: its cheaper and easier to raise $$ by taking on Ps. 1) Hard to get lender to lend you such a large amount. B) Other management expertise. 1) Each partner may have a special talent needed for business. C) Ps have incentive to work hard b/c they have direct stake in venture. 1) E.g. see Vohland v. Sweet. 2) Note: may conpensate via profits b/c owner has no other way to pay worker. a) This was not the case in Vohland. 2. UPA 6-7: Partnership-in-Fact. A) Partnership: association of two or more persons to carry on as coowners of a business for profit. (UPA 6) 1) Sub-P-ship consisting of P in firm and 3rd party may exist where business of sub-P-ship is investment in original P-ship. B) Sharing in net profits (4), but not in gross returns (3) is PF evidence of partnership liability. (UPA 7) 1) Reasoning: person sharing profits takes on risk and incentive to control costs. a) Gross return person is simply commission salesman. b) Similar to agency, it issue of control. 2) Sharing of profits not evidence if payment made: (a) on debt; (b) as wages to e‟ee or rents to LL; (c) as annuity to representitive of deceased P; (d) as interest on loan even if payment varies with profits;or (e) as consideration for sale of goodwill of a business or property by installments. C) Don‟t need contribute capital to become P, labor is enough. (Vohland) 1) Person may actually be contributing if $$ from gross sales gets pumped back into business. D) Form of P-ship is irrelevant. 1) Can‟t K out of liability. a) Sweet was called “commission salesman” in K but this was irrelevant. b) Not being listed as P may not matter. (Vohland) 1. e.g. look at tax return. 2) If intent to share in net profits and liabilities, there is P-ship. 3) Would person arguing someone is not a P change his position if tables were turned and P-ship was getting sued for liability? a) AKA would Vohland argue Sweet was P if he was sued?
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E) This type of case usually involves 3rd party creditor suing possible P. B. Creditor‟s Rights 1. Who is liable for P-ship debts? A) Creditor can sue any P. 1) Including P not a P when liability incurred. a) Exception: new P will only be liable to extent of P-ship property. 2) Assignment of P property only includes right to receive profits, not assignment of losses or control. (UPA 27) 3) Ps are liable for lossses of other Ps incurred in ordinary course of business. (UPA 13) a) Ps also bound by breach of trust where other P: UPA 14 1. acting w/in scope of AA recieves $$ from 3rd party and misapplies it. (a) 2. misapplies $$ received by P-ship during course of business. (b) 4) Ps are J&S for anything (torts) under UPA 13&14: UPA 15(a) 5) Ps are jointly (must sue everyone) liable for all other (Ks) debts of P-ship: UPA 15(b) a) But P can enter separate obligation to perform P-ship K. 6) Ps J&S liable for K and tort under RUPA 306(a). B) UPA 16: Partner by Estopple: if you are held out, w/ your consent, as P, you may be held liable as a P. 1) Similar to AA. C) Sub-P-ship: Person may be P with a P in whole enterprise. 1) Can‟t be P in main P-ship b/c need consent of all Ps. UPA 18(g) D) Lenders worry about being liable as Ps when they give loan and get share of profits and/or some veto power over P-ship acts. 1) Kraakman thinks they usually not Ps b/c they resemble bank workout situations where banks are not held liable. 2. When do exiting Ps escape liability? A) Ps can‟t escape liability by simply retiring. 1) Problem: P has risk but no control. B) P only liable for debts incurred before he retires. C) Deceased P same as retired P except personal ceditors are satisfied 1st. D) Retiring P can be discharged from obligations if sign indemnification agreement w/ other Ps and P-ship creditors. UPA 36(2) 1) Can infer creditor assent by its actions after it knows of dissolution. 2) May not work if other Ps go bankrupt. E) Retiring P may be discharged from obligations if creditors and other Ps renegotiate and there is a “material alteration in the nature of time or payment of the obligation. UPA 36(3) 1) Policy: retired P can‟t effect decision once gone.
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2) Policy: keeps existing Ps from overreaching limits in renegotiation. 3) Problem: creditors may be hesitant to renegotiate K. 4) Doesn‟t only apply to debts, may apply to executory K. (Munn) F) Policy: should retiring P be liable? 1) No: a) P is innocent. b) Creditor is CCA in monitoring Ps. 2) Yes: a) Creditor is innocent. b) Loss of flexibility in renegotiation b/c existing Ps rather go to court/not renegotiate and keep retiring P in mix. G) Note: dissolution does not mean business is coming to an end under the UPA. 3. Competing Creditor Claims. A) P-ship property as entity property: tenants in P-ship (RUPA not UPA). 1) P-ship has segregated asset pool 2) P can‟t assign right to P-ship property. UPA 25/RUPA 202 a) Except in connection w/assignment by all Ps. 3) Creditors of P can‟t attach right to property and heirs can‟t inherit it. a) If P dies, P-ship property right goes to other Ps. B) Ps transferrable interest. 1) P can t-fer right to receive profits. UPA 27/RUPA 503 a) T-fer may be void if forbidden in P-ship K and transferee knows. RUPA 503(f) C) P-ship in bankruptcy. 1) P-ship can go bankrupt even if Ps are solvent. a) Court may stay suits against Ps personal assets to stop creditors from end-run around b-rupcy of P-ship. (Comark) 1. Policy: want to protect bankruptcy estate. 2. Policy: allows for fair and equal distribution to creditors and orderly reorganization. 2) Jingle rule: still applies in some state laws. UPA 40. a) P-ship assets: P-ship creditors have 1st shot. b) Individual assets: individual creditors get 1st shot. 3) 1978 UPA amendment and RUPA change rule. a) P-ship assets: P-ship creditors have 1st shot. b) Individual assets: All creditors on = footing. c) Change b/c P-ship creditors are individual creditors too. 1. They take into account personal assets when giving P-ship loans. 2. This allows Ps to pledge personal assets. a. Thus, P-ship can K more. 3. Makes P-ship closer to unlimited liability.
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a. Preserves difference b/w C and P-ship. 4. Individual creditor is CCA in monitoring Ps assets rather than P-ship creditor. 4) When Ps and P-ship go bankrupt, UPA and B-ruptcy Act clash. 1. B-ruptcy Act (Non-jingle rule) usually wins. C. Authority 1. Default rule: Disputes of ordinary matters settled by majority vote. UPA 18(h) A) Except: act done in contrevention of P-ship agreement must be unanimous. B) Ordinary acts of Ps are binding on others. UPA 9(1) 1) Can‟t block t-action simply by telling creditor “I‟m not bound by other Ps acts.” (Nabisco) a) Policy: protects Ps b/c otherwise 3rd party wouldn‟t K w/them. 2) How can creditor know if their K is part of ordinary course? a) Get permission of all Ps. b) UPA lets P-ship file statement w/state re: their authority. 3) Extraordinary acts are not binding. UPA 9(2) 4) One or more but less than all Ps can not: (a) assign P-ship property to creditors; (b) dipose of goodwill of business; (c) do act which makes impossible to carry out ordinary business of P-ship; (d) confess judgement; or (e) submit P-ship claim or liability to arbitration. 5) Need intent to benefit P-ship. UPA 9(2), (Nabisco) a) Must occur in ordinary course of business: RUPA 305. C) ½ of P-ship is not a majority. (Nabisco) 1) Policy: protects Ps b/c otherwise 3rd party wouldn‟t K w/them. 2) How can P avoid this? a) K out of default rule. b) Dissolve P-ship. 1. P-ship-at-will can be dissloved by any P. 2. Problem: dissolution takes time and wouldn‟t be in time to stop K that P is trying to avoid. 3) Voting measured by person, not by equity stake. a) e.g. 80% holder only gets 1 vote and can be out voted by other two 10% holders. b) Policy: each P is personally liable to extent of assets so its only fair. c) This rule can be K‟ed out of in P-ship ageement. D) No conflict b/w 9(1) and 18(h) b/c 9(1) deals with external relations and 18(h) internal.
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D. P-ship Accounting and Dissolution. 1. Accounting: standard accounting principles apply 2. Dissolution: any change caused by the exit or entrance of a P. UPA 29 A) Full liquidation leads to termination of P-ship. B) Note: RUPA allows dissassociation w/o dissolution. 1) Under RUPA dissolution = termination. C) P-ship for term: P-ship lasts for set amount of time. D) P-ship at will: any P can rightfully cause dissolution. (R/UPA) E) UPA 38(2): dissolution in contravention of P-ship agreement. 1) This is a wrongful dissolution. 2) Does not necessarily lead to wind up. a) P-ship can K out of wind up rights (statutory dissolution) and provide for continuation if it sets forth method of paying w/drawing P and doesn‟t affect creditor‟s rights. (Adams) 1. Policy: otherwise would cause chaos if any P wind up P-ship. 2. 90% of P-ships elect this option. 3. Firm w/ little $$ can pay departing P over period of time to avoid cash flow problems. 4. Other Ps may delay submission of bills so departing P doesn‟t get accounts receivable. a. But other Ps still have fiduciary duty. 3) Other Ps have right to damages caused by wrongful dissolution. F) Statutory dissolution. 1) P-ship agreement usually dictates how assets distributed. a) e.g. Adams. 2) Majority rule if not provided for in agreement: business will be auctioned and distributions in cash, not in kind. (Dreifuerst) a) 38(a) of UPA meant to protect creditors b/c they get paid 1st, before Ps. b) Otherwise may lose going concern value. c) Assures fair value of firm. 1. Or else judges must decide when splitting assets. d) Problems: 1. May have taxable gain which hurts all. 2. Bidder most likely one of Ps but they may not have the $$ to do it. 3) Minority rule: ABA: majority of Ps in at-will P-ship can continue w/o wind up if they buy out exiting P at fair value. a) Form of appraisal rights. b) Problem: court must do valuation. 4) When in kind distribution O.K. (Dreifuerst) a) No creditors need to be paid;
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b) No one other than Ps interested in assets; c) It would be fair to all Ps; and d) All partners agree. (Dreifuerst) 5) Valuation method when P-ship will continue. a) Going concern value: Kraakman. b) Higher of going concern or liquidation: RUPA 701(b) 1. UPA doesn‟t say. c) Value of firm minus goodwill: UPA 38(c)(2) 1. This involves punitive element for wronfully exiting P. d) All of the above also subject to reduction for damages only if dissolution is wrongful. 6) Damages of dissolution offset against payout. 701(c) 7) If wrongful dissolution before end of term, P may not get $$ till end of term unless can show won‟t cause other Ps hardship. 701(h) 8) Exiting P shall be indemnified for liabilities except those caused by him before he left. a) But if other Ps are b-rupt, he‟s on hook unless can argue tacit agreement by creditors to let him off. G) Limit on Ps right to dissolve P-ship under 31(1)(b): dissolution when no particular term or undertaking is specified. 1) Court may not imply P-ship for term, term being until all obligations paid off, where no express agreement. (Page) a) To do so would gut the notion of at-will P-ships. 1. Any P-ship w/debts could make this argument. b) May be preferrable to protect “little Pages.” 2) However, Ps have fiduciary duty to give each other fair value when P-ship dissolved. a) This acts to protct the “little Pages.” b) More fiduciary duties here b/c it is P-ship, not JV. 3) Problems of #2: a) No bright-line rule. b) Obstructs desire to have P-ship at-will. c) Can protect little “little Pages” via judicial sale. d) Dominant Ps are dissuaded from P-ships. H) Disparities in P-ships cause problems: better to have 2 active Ps. 1) Passive P may cut P-ship short to get $$ back. 2) Active P may threaten to pull plug if terms not negotiated. E. Limited P-ships and LLCs 1. LP-ship consist of one or more GPs w/unlimited liability and LPs. A) LPs can share in profits but have no control in management beyond voting on major issues such as dissolution. See ULPA 303(a) 1) Control is key: it is basis for liability. B) LP-ships are registered entities.
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C) LP-ships (and LLCs) enjoy tax advantage of P-ship unless equity is publically traded. D) LPs are protected from GP via fiduciary duty. 1) This can work both ways. E) LP-ship is usually for a term. 1) We pay GP low salary and he gets big payoff at end of term. a) This stops GP from ripping off LPs. F) In past, LPs couldn‟t use corporate veil as limit on liability. (Delaney) 1) This would be too large a loophole b/c LPs could operate corporation with minimum capitalization and little liability. a) May lead to inefficient incentives. 2) Case is NO LONGER GOOD LAW. a) Policy: should only hold people liable if they hold themselves out as GPs. b) ULPA 303(a): if LP excercises control of business, only liable to 3rd parties who, based on LPs conduct, reasonably believe he is GP. c) ULPA 303(b): delineates what is not considered as participating in control of business. (1-8) c) ULPA 303(d): if LP lets his name be used in LP-ship, he is liable to creditors who don‟t know he isn‟t a GP. 2. LLCs A) Combines tax advantage of P-ship w/ limited liability of corporation and LP. 1) Also LLGP-ships. 2) Seems OK for K creditors b/c the are protected by misrepresentation rationale. 3) Tort creditors may get screwed here. 4) Breaks common law nexus b/w control and liability. 5) W/ LLC can chose whichever tax set up you want. a) Chapter S corpoation and only 1 level of taxation; or b) LLP w/corporation as GP. 6) Some minimum capitalization is necessary for this structure.
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The Corporate Form
A. Introduction 1. Comparing P and Corporation (C): A) Ps vs. individual investors. B) Unlimited personal liability vs. liability limited to investment. C) Illiquidity vs. free transfer of investors assets. D) Diffuse management vs. centralized management. E) Unstable vs. legal personality. 2. LLC and LP-ship have A,B, and E but not all five. A) Some Cs, e.g. Close C, may not have all five. 1) They may not have C or B. 3. Process of incorporation. A) Usually done by service in Delaware. 1) Don‟t worry much about technical aspects: even if incorporator screws up, court will recognize intent to create C. B) DGCL on incorporation. 1) Subchapter 1: 101-110: deals w/ formation, articles of incorporation and by-laws. 2) Subchapter 2: 121-127: deals w/ corporate powers. 3) Subchapter 3: 101-110: deals w/ certain procedural requirements. 4. Ultra Vires A) Constraint on corporate activities that is no longer really recognized. B) Sole exception: DGCL 124. 1) SH can sue C to enjoin any unauthorized act or t-fer of real or personal property by C. (1) 2) C, though a representative can sue director etc. due to unauthorized act. (2) 3) AG can sue to dissolve C or enjoin C from unauthorized act. (3) B. Valuation 1. Time value of $$: See appendix of outline and CF outline. 2. Risk and return: See appendix of outline and CF outline. 3. Diversification: See appendix of outline and CF outline. 4. Relevance of prices in securities market. A) Efficient Market Hypothesis. 1) Not treated as sacred text in valuation. (Paramount) B) Non-systematic vs. systematic. 5. Capital structutre and the incorporation bargain. A) Equity securities: in order of preference on assets. 1) Warrants. 2) Common Stock: DGCL 151. 3) Preferred Stock: DGCL 151. a) May have cumulative dividends.
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b) May have rights to elect board members if no dividends paid for certain period (6-8 quarters). c) May be convertible into CS so can get votong rights if desired or cash in on capital appreciation. d) May have its own voting rights. 1. CS holder may not care about PF holder welfare. e) Usually blank check preferred is authorized so B of D can dictate its terms as needed in deal. B) Debt: in order of preference on assets. 4) Subordinated debt. 5) Bank debt. 6) Mortagage bonds/secured debt. C) VC e.g. see outline page 22. 1) VCs may control of B of D but E is CEO w/day to day control. 2) E usually starts w/ control but loses it if screws up (under PF shares agreement). a) E has incentive to be risky b/c has nothing to lose. D) Corporate Debt: 1) Bonds a) Optional (callable) vs mandatory redemption (sinking fund). b) Zero-coupon. c) PIK bonds: interst paid with more bonds. 1. Useful if C won‟t have cash flow for a while. d) Indentures: agreement signed w/lender which limits ability of C to do certrain things via covenants. 6. Capital Structure and Leverage. A) Benefits of Leverage: 1) Tax: interest payments come out of pre-tax profits. 2) Debt is cheaper than equity. 3) Management LBO may give management incentive to work harder b/c if succeed get whole potato. B) Problems w/ leverage: 1) Low flexibility: if miss a payment, can go bankrupt. C) Both: 1) Its risky; it magnifies gains but also losses. C. Limited Liability 1. Case for LL: Clarke. A) Lenders are better risk bearers than SH. B) Collection and administrative costs would be greater if had to go after diffuse SH: 1) Counter: B-ruptcy courts do it all the time: K-man. 2. Case for LL: Easterbrook and Fischel. A) Decreases need to monitor b/c SH risk is only limited to investment.
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B) Reduces costs of monitoring other SH b/c their wealth has no affect on you or value of shares. C) Gives managers incentive to act efficiently by promoting free transfer of shares. 1) As long as shares can be easily exchanged and tied to votes, bad firms can attract new investors who replace bad management. D) LL makes it possible to value shares b/c w/o it, value would depend on what assets investors had. E) Allows more efficient diversification b/c investors know how much they are risking. F) Allows for optimal investment decision by management who otherwise would reject risky projects w/ + NPVs in order to reduce risk. G) B,C,D rebutted by Kraakman‟s pro rata rule. 3. Other: Kraakman. A) LL allows people to be strategic and exploit creditors. D. Creditor Protection 1. Regulatory measures: ex ante. A) World: 1) Minimum capitalization for companies. a) e.g. EU requires about $30Gs capitalization. b) Pro: easy way to protect creditors. c) Pro: encourages creditor lending. d) Con: we don‟t use in U.S. b/c it stifles small business. 1. We only use it in LLP. B) U.S.: two methods. 1) Dividend distribution test: 4 types. a) Stated capital distribution test: can‟t distribute if would impair stated capital. 1. e.g. can only pay up to amounts in capital and earned surplus (retained earnings). 2. Doesn‟t mean much b/c can reduce stated capital account. (NY516) b) Earned surplus test: can only pay out of retained earnings. (majority of states includes this: NY) 1. Doesn‟t mean much b/c can reduce stated capital account w/SH vote but at least creditor alerted. c) DGCL 170(a): most flexible test. 1. Can pay out of capital surplus; or 2. Profits of current or preceeding year. d) RMBCA 6.40 1. Able to meet current debt obligations. (c)(1) 2. Equity insolvency test: Assets greater than liabilities. (c)(2)
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a. But (d) allows directors to ignore GAAP valuation of assets if they fail test and use other values. 1. Problem: creditors can no longer rely on books to monitor. e) See appendix B of outline. 2) Fiduciary duties. a) Allows court to step in when above tests fail (often). b) Duty on B of D near insolvency may run to creditors ahead of SH. (Geyer) 1. e.g. where only assets is judgement and expected value of appeal worth more than settlement to SH but bondholder prefer settlement. c) Problems: 1. Hard to tell when “near insolvency.” 2. Directors only owe duty to SH 3. Bondholder overcompensated b/c risk included in interest rate. d) No strong law protects creditors yet but its developing. e) Policy against duty: 1. Don‟t want to make directors too risk averse: hard for them to know when C near insolvency. 2. Creditors make extend credi knowing that directors favor SH so conpensated via interest. 2. Creditor remedies: ex post. A) Fraudulent conveyance: broad statutory framework for voiding transfer by insolvent debtor for purposees of delaying, hindering or defrauding creditors. 1) UFTA 4: Present or future creditor can void t-fer if: a) Didn‟t receive reasonably equivilant value in exchange for t-fer; (2) and b) Debtor left w/unreasonably low capital. c) Can consider for evidence: 1. transfer to insider (directly or indirectly)? 2. debtor retain control of property? 3. timing? 4. actual value? 2) UFTA 5(a): Present creditor can void t-action if: a) Didn‟t receive equivilant value; and b) Debtor was insolvent or became insolvent as a result.OR c) T-fer to insider for antecedent debt and; d) Debtor insolvent at the time; and e) Insider has reason to know of insolvency. 3) As applied to LBO: a) Overpaid for stock; and
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b) There was unreasonably low capital. 1. Look to: a. capital before and after t-action. b. debt load c. ability to make payments. 2. Problem: hindsight distorted by failure of business: may have been reasonable at time. 3. Bigger Problem: chills LBO which is often an efficient t-action. a. Thus, want to avoid per se rule. c) Assets depleted so C went b-rupt. d) Impossible to get $$ from public SH but can get from intermediaries (bank fees). 1. Court reject suits vs. SHs b/c they are not at fault like banks who put together t-action. 4) Why have FC? a) Cost to K would increase too much for creditor. b) Serves as minimum base for creditor. c) Allows for stable debt K‟ing or else C could bait and switch by showing capital then getting rid of it. 5) Cases go both ways. B) Equitable subordination. 1) Court sets aside insiders claim against b-rupt C until claims of outside creditors are satisfied. a) Different from FC b/c applies only in b-rupcy situations. b) Same as FC in that it undoes t-action. c) Different than veil pierce b/c here, SH not liable for personal assets, only loses credit to b-rupt C. d) Similar to UPA 40(b) where Ps loans are subordinated. 1. Why not have per se rule in C as well? a. May be dangerous where SH give loan instead of investing in C b/c we want to encourage SHs to give loan if C in trouble and bank won‟t help. b. In P-ship, per se is trivial b/c since Ps are liable to creditors anyway so even if they did collect 1st, creditors still get $$. 2) Insider typically held liable if any evidence of fraud or unfairness: See Costello a) Undercapitalization never enough under any theory. 1. Thus, if Costello was a start-up C w/ only 6G capitalization, SH may have avoided subordination. 2. e.g. LBO and FC law: need more. b) Different from LBO: 1. Here future, not past, creditors get defrauded.
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2. LBO not transparent effort to defraud creditors. c) Unclear if unreasonably small capital test applies to future creditors. 1. Probably need intent to defraud creditors which arguably exists in Costello. C) Veil-piercing on behalf of K creditors: 1) In case of SH miscounduct, creditor can pierce veil of C and get at personal assets. 2) Different from FC or ES b/c those only run to amount of loan or FC, here runs to all personal assets. 3) 2 general components: a) Lack of seperation b/w SH and C. 1. No formalities (charter, bylaws, incorporation fees, officers elected, stock issued). 2. Comingling of assets. 3. SH domination of corporate decisions/ alter ego. 4. SH knows of undercapitalization. b) Use of above to do something wrong. 1. Misrepresentation is central factor. (Kinney) 2. 2 aspects to misrepresentation: a. Explicit: SH lies outright. b. Implicite: creditors should be able to have some reasonable expectation of assets of C. c) C never pierced against: 1. Public SH. 2. Passive SH. 3. Minority SH. d) Usually pierce vs. active, sole SH. 4) Lowendahl test: SH must have completely dominated corporate policy used to commit the wrong. 5) Van Dorn test: must be: a) Unity of interest and ownership b/w C and individual (or individual‟s C); and b) No pierce would sanction fraud or injustice. 1. “I got stiffed” not enough. (Sea-Land) a. If so, would always be satisfied. b. Need wrong beyond creditor‟s inability to collect. c. Finding actual fraud enough as in remand of Sea-land (which set bad case right). 1. But tax fraud shouldn‟t have been enough but court out to get bad D. 2. e.g.‟s from Sea-Land: a. Unjust enrichment.
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b. Ps avoid legal rules re: $$ obligations. c. Parent causes sub‟s liaiblities and isn‟t responsible for default. d. Intentional scheme to keep assets w/ liability-free C & liabilities w/ asset-free C. 3. E.g.‟s are intentional bait and switch using veil. c) Why need intent, we don‟t in FC? 1. Only need for future creditors, not past. 6) Kinney test: a) Lack of C formalities. b) Undercapitalization results in damage to creditor. c) Creditor may be required to do minimal investigation which would turn up undercapitalization. 1. Not mandatory prong. 2. Only is necessary for equitable result. 3. Arguably necessary here b/c creditor was savvy, willing to gamble and should know better. 7) #6 and #5 are not really reconciliable. a) Courts generally look for misrepresentation even more than undercapitalization. See Thompson study (92%). 1. Thus, court more likely to pierce for K not tort creditor. 8) Reverse piercing: pierce through C veil to get at assets of other C, not of individual. a) Occur only when each C entity is not free standing entity but fragment of whole: comingle sufficient. (Walkovsky) b) May not work as in Sea-land if only would get shares of a final C b/c then you are on par w/ creditors of that C and as SH, shares may be worthless. c) Is this policy good? 1. Yes, protects against Sea-land problem. 2. Yes, only effect sham Cs. 3. No, unfair to other creditors of 3rd C which did their job in investigating and didn‟t consider other creditor‟s loan in making theirs. 3. Protecting involuntary tort creditors. A) Less likely to succed b/c no misrepresentation. 1) Kraakman uneasy about this b/c tort creditor can‟t negotiate ex ante for K provision bearing risk and can‟t monitor D. 2) LL is bad: courts imply can opt out of tort law by incorporating. a) This is OK in K b/c of ex ante negotiations. b) Dangerous b/c want cab C to have proper incentive. B) Undercapitalization insufficient grounds for piercing. 1) Test looks more to formalities and comingling of assets.
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C) LL is good: Easterbrook and Frischel: piercing may be worse than none b/c small cab Cs are better off and they carry less insurance. 1) Kraakman disagree: no reason to think that caretaking decreases if allow disaggregation. D) J. Keating dissent: Should pierce veil when C fails to maintain reasonable capital and insurance coverage. 1) Kraakman agrees w/this but recognizes problem: a) Too uncertain, doesn‟t go far enough, need certainty. b) Some argue legislature already set it up w/ minimum inurance requirement but its not enough. E) Liquidation of C before tort claim matures. 1) DGCL 278&282 provide P w/ 3 year window to demand amount extracted out of C by SH. a) SH pay pro rata. 2) RMBCA 314.07(c)(3): provides P 5 years. 3) Other protections: successor liability. a) Buyer of assets liable to past tort creditors if continue w/ C‟s product line. F) Kraakman‟s view: against LL in tort: review again: BIII:73-80. 1) Should be pro rata liability for C torts: most appropriate in public Cs. a) Would force C to internalize costs: P 1. Makes Cs take proper amount of care: not overinvest in hazardous industry since most firms highly leveraged w/ little assets due to M&A. 2. LL creates incentive to overinvest in expanding b/c only marginal increase in liability but also underinvest in expanding b/c as firm increase value, more for all tort creditors. 3. Not enough public Cs go bankrupt b/c of tort liability b/c claimants have incentive to settle. 4. Must have for public Cs b/c if only for private Cs then have incentive to sell stock to avoid liability. 5. Need prorata not J&S so all shares trade = value. b) Rule for when liability attach: see top of III. 78. c) Cost of collection not too much: b-rupcy courts can do it. d) Diversified portfolios make it reasonable risk. e) Only would be problem for SHs in catastophic tort which is exactly when need to prevent Cs from externalizing costs. 2) Conclusion based on fact that no persuasive case made for LL. 3) If argue against too great liability, this is argument for tort reform, not for LL.
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4) Won‟t scare people out of markets b/c adults drive cars everyday and expose self to unlimited liability but few purchase very high insurance or don‟t drive b/c of it. 5) Biggest problem: equity bought by offshore accounts or investors transfer assets offshore after liability attaches. 6) Best evidence against critics fears: 1960s AMEX used to trade on NYSE w/o LL and there were no ill-effects even if suits pending for more than net assets. 7) Alternatives: a) Mandatory coverage for risky firms. b) Criminal penalties for risky decision-makers. 1. I say may lead to overdeterrance. c) Give tort creditor priority over other creditors. 1. I say unfair to creditors. 2. Counter: savvy ones can measure risk. E. Centralized Management and the Public Corporation 1. C control depends on ownership structure. A) A large SH probably has a high degree of control. B) Diffuse SH allows top management to control C. C) SH give up day to day control but retain power to decide extraordinary transactions. 2. SH can K out of a majority voting rule: Automated Self-Cleaning. A) May opt for supermajority voting in charter for three reasons: 1) B of D are experts, SH are not. 2) Protect minority SH from majority. a) A 51% SH could otherwise do what wants. b) B of D has fiduciary duty to protect minority SH. c) Counter: controlling SH will eventually control B of D so won‟t matter. 3) Who knows what will happen if let a lot of people try to run SH meeeting (majoritarian decisionmaking). 3. DGCL 271: sale of assets of C: SH have no authority to sell C‟s assets. A) Board must propose sale and majority of outstanding shares ratify. B) How avoid problem of A)? 1) Removal of directors w/ slate willing to sell assets. 4. Removal of Directors: DGCL 141(k): any director or the entire board may be removed w/ or w/o cause by majority of shares at an election except: A) Classified board: can only remove directors for cause if board is classified (unless charter provides otherwise). 141(k)(i) 1) For cause is very hard and costly standard to meet. B) Cumulative voting: if less than the entire board is to be removed, no director can be removed w/o cause if votes cast against his removal would elect him if cumulatively voted at an election of the board. 141(k)(ii)
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1) Policy: if didn‟t have this, majority SH could simply remove director placed on board by minority AKA would defeat point of cumulative voting. 2) Note: can remove whole board w/o cause. 3) If director voted in by class of shares entitled by charter to elect a director(s) then need majority of that class. 5. Classified board: DGCL 141(d): directors may, by charter or by-law, be divided into 1,2, or 3 classes each with term of up to 3 years. A) Charter can give holders of a class or series of stock right to elect one or more directors in a class. 1) Charter may fix term of above director. 2) Charter may also fix power of this director(s) so that they have more or less than 1 vote per director. B) If classification is provided for in by-laws, SH may amend it and new directors voted directly in at next meeting: DGCL 109 C) SH must decide by majority of shares voting at meeting if board will be classified by amending by-laws; unless charter or bylaws requires more than a majority of outstanding shares to amend by-laws: DGCL 216. D) MA adopt mandatory classification for a two year period in order to fight possible hostile takeovers. 6. Cumulative Voting: DGCL 214: SH can vote number opf shares of stock multiplied by number of directors on board. A) Charter may provide for CV. B) Allows for minority protection. C) To ensure election of N1 directors, formula: X= YN‟+N+1/N+1. 1) Y= total shares outstanding. 2) N= directors to be elected. 3) N‟= directors SH wants to elect. 4) X= # of shares needed to elect N‟ directors. 7. Corporate raider gaining control of board. A) Amending charter: DGCL 242(b)(1): only can be initiated by B of D, then SH vote. B) Amending bylaws: DGCL 109: power rests w/ SH in Delaware and can‟t be divested unless by contractual provision. 1) May use to decrease # necessary for quorum. C) Increasing size of B of D: DGCL 223(a): can be done by SH if number is fixed in by-laws and not charter [141(b)], but B of D fills added seats. 1) But can be trumped via SH amendment if B of Ds right to fill seats is in by-laws. a) Best protection is for C to have a majority of seats filled: e.g. if charter allows 15, have at least 9 filled. 2) Also will be inelegant b/c may have to increase size by big #. D) Call special meeting 211(d): must be provided for in charter; or written consent 228, unless charter says SH don‟t have it. E) Shares vs. votes: 251 may require majority of shares not votes.
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F. Close Corporation (CC): In Tension With the Coporate Form 1. Definition of Close Corporation: DGCL 342. A) 30 or less SH. (a)(1) B) Transfer restrictions. (a)(2) C) No public offerings. (a)(3) D) Must elect to become CC: DGCL 344. E) DGCL allows for flexibility in customizing C form: DGCL 342-356. F) Other Js are not as generous. 1) DE allows C to K out of whole statute via subsection XIV. 2) Other Js allow C to K out on provision by provision basis. a) E.g RMBCA 8.01(b). G) Donahue: CC has small # of SH, no ready market for stock, and substantial majority SH participation in management. 2. Problems: A) Difficult to draft documents, charter, bylaws, classes of securities, SH agreements etc., in oder to get right distribution of risk and return. B) Ex post problem of disagreement and opportunism among SHs. 3. Transferability restrictions: no unfair restriants: Biltmore Tissue. A) Option repurchase price set at original purchase price is not unfair restraint on t-ferability of shares. Biltmore Tissue. 1) Fact that shares worth much more than option price irrelevant. a) Policy: don‟t want court going into every C and trying to value shares. B) Why limit t-ferability? 1) SH know each other and don‟t want new SH coming in and screwing up business plan. 2) Point of CC was SH cooperative and didn‟t want competitor coming in and taking advantage. C) Key factor: restriction on shares must exist before sale not retroactive. 1) Even irrational restriction crafted for prior era will be upheld if not imposed ex post. D) Importance of restrictions: unlike P-ship, can‟t exit or dissolve and get fair share of assets, there is a high lack of liquidity. 1) Only majority of CC could vote to dissolve and distribute assets. 4. Problem of minority in CC. A) Illiquidity: majority manipulates minority to sell out at low price. 1) Solution: weaken reastriction on exiting. a) Have right to sell shares back to CC at reasonable price (may set up formula) or buy shares of others at same price. 1. Does in effect what 38(1) of UPA does via dissolution rights b/c bidder on assets will be Ps. B) Controlling SH dictates distribution of any funds (dividends, salary etc.) and extracts non-pro rata gains for self. 1) Solution: K around centralized management. (see section #5)
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a) Basically use voting trigger so minority gets majority vote if certain (inequitable) events occur. 5. K‟ing around centralized management: DGCL 151. A) DGCL 151 gives wide range of ways to allocate power and control rights. 1) 151(b): recallable stock in case of certain events. a) If C does well, one class of VCs voting shares get recalled b/c E proves he can manage. b) Material deviation from business plan. c) Fail to meet minimum earnings in X consecutive quarters. 2) 151(c): preferred stock: can be convertible 151(e) into CS if certain objectives are not met. a) Voting trigger allows control to switch to VC even if have minority equity stake. 1. e.g. PF convert to supervoting shares. 3) DGCL 218: voting trust. a) Voting agreements: signed K that E will always vote for X number of VCs board members. 4) Classify board. a) May give VC a class of shares having right to elect X board members on each slate. 5) Cumulative voting. a) May ensure that VC w/ minority stake can elect at least X board members. 6. Legal protections for minority SH: A) Oppression remedy: Oppression is departure from standards of fair dealing, a violation of fair trade and fair play that SH entitled to. 1) Oppressive conduct is judicial wild card to intervene. 2) 2 Remedies: a) Appointment of custodian w/ power to continue business and pay dividends. 1. Problem: big cost make in impractical for small C b) Dissolution: DGCL 275/355 vs. RMBCA 14.30. 1. DGCL: must K for remedy in charter ex ante. 2. RMBCA: court may come in ex post. 3. Problem: may not want to do this b/c lose going concern value. 4. May be availible w/o need for litigation if statute or charter provides for it. (Smith) c) May be only 2 remedies availible: White. 1. If both are unacceptable, as in White, then parties will be forced to settle, as in White. a. This protects minority SH.
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d) Problem: If remedies are too easily granted, may give minority incentive to litigate. e) Problem: lose C form and turn into P-ship. B) Fiduciary duty remedies. 1) UGFAL: original obligation SH in CC owed to each other: “utmost good faith and loyalty.” 2) Problem: too much litigation and standard failed: e.g. Donahue. a) Donahue: UGFAL require pro-rata share repurchase. 1. Nothing else shady was going on except majority SH repurchase dad‟s shares and not Donahue‟s. b) Fails b/c interferes w/ form of CC that parties K‟ed for. c) Solution: Easterbrook and Fischel: fiduciary dities should approximate what SH would require if they negotiated. 1. No one ever negotiated pro-rata repurchase agreement in DE (but have it in MA CC law). 3) QUGFAL: qualified UGFAL: majority SH can act selfishly if there is legitimate businmess reason for doing so (burden shift to minority to show pretext when this shown). (Smith) a) This is tradeoff b/w protecting minority SH and allowing majority SH to control and extract value from C. b) Not paying dividends for personal tax reasons is OK but causing C to incur tax penalty is not. c) SH business interest may harm other SH but MAY NOT harm the C. 1) At that point, injury to other SH will probably exceed benefit to majority SH. 2) When C not harmed, can justify behavior on grounds that other SH K‟ed for this set up. 3) Fiduciary duties are more traditionally ties to C not to SH. C) “Minority” may not be equity minority but whatever % of shares that can‟t affect a C action. 1) e.g. Smith: 80% vote required for certain actions (K out of centralized management) and 25% SH “oppress” other 75%.
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IV. Fiduciary Duties and SH Litigation
A. Business Judgement Rule (BJR) 1. Formulation of the rule A) ALI 4.01(c): Good faith actions of directors and officers are protected by BJR when they are: 1) Disinterested; (1) a) Any personal benefit or self-dealing in t-action? b) e.g. Kamin: managers may not want to take charge vs. net income b/c their compensation is pegged to it. 1. Court overlook this b/c give board some leeway. 2. No indication of bad faith. 2) Independant; (1) a) Any connection w/ 3rd party in t-action? 3) Informed; and (2) a) Did board discuss issue? b) Was presentation made? 1. Could directors rely on presentation? a. See Van Gorkom where this fails b/c presentations were: 1. By uninformed VG; and 2. Not on point. 4) Made in a rational way. (3) a) What was decisionmaking process? b) As long as have legitimate business reason, its OK. c) Kamin board‟s argument that higher PE effects stock price is irrational under EMH but was rational to them. 1. But standard is rational (subjective) not reasonable (objective) so it was OK. d) ALI 4.01(a)(2): what director may rely on. 1. 4.02: Information, opinion, finanacial staements etc. prepared by: a. Directors, e‟ees, etc. who director reasonably believes merit confidence. b. Lawyers, accountants, etc. who director reasonably believes merit confidence. 2. 4.03: (a) Decisions, judgements etc. or (b) Information, opinion, finanacial staements etc. prepared by authorized board committees who director reasonably believes merit confidence. B) Rule acts as rebuttable presumption that directors are better equipped that courts at making business judgements. 1) Failure of duty of care or loyalty result in loss of BJR protection. 2. Justifications A) Institutional competence: directors more competent than courts.
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1) Especially true when we take re: ex post second guessing vs. ex ante decisions. B) Agency problem: But for BJR, directors would be risk averse and incentives to maximize SH wealth (via risk and innovation) skewed. C) Allocation of power in corporate form: don‟t want to t-fer decisionmaking power from director to SH b/c centralized management is efficient. D) Directors make poor cost avoiders, better for SHs to bear risk of misjudgment. B. Duty of Care 1. Nonfeasance: monitoring and responding. A) Narrow view: Directors may rely on honesty of e‟ees unless there are grounds to suspect deception. (Caremark interpretation of Allis-Chalmers) 1) E‟ee‟s trusted unless they prove otherwise. 2) Board actions that invite e‟ee misdoings may impose duty to monitor. a) Pressure for e‟ees to make $$ might be enough to impose duty to monitor says Kraakman. 3) e.g. Francis knew of sons wrong doing but failed to monitor after they said they would stop: grounds for deception existed. B) Broad view: Directors have no responsibility to assure that proper reporting systems are established by management. (rejected by Caremark) 1) Unless evidence of misconduct, no duty to watch e‟ees. 2) Directors may have a duty today to put control system in place under Caremark. C) ALI 4.01(a)(1): Director has duty to monitor when circumstances would alert reasonable director for the need to. D) Failure of duty of care to monitor could lead to SH suit for not putting monitoring devices in place to avoid penalties of e‟ees crimes. (Caremark) 1) Thus, narrow view brings together SH and public interests in Caremark where high default penalty for C w/o monitoring system. 2) May be argument in favor of going after C instead of managers or actual wrongdoing e‟ees. E) Problem w/ using duty of care to remedy general illigal activity: 1) Board may argue that monitoring or stopping misconduct is unprofitable so board should not monitor. a) Board would lose but they are right. F) Causation: must prove no injury would have occured if director was vigilant. (Francis) 1) e.g. Francis could have done something (voted against loans, hired lawyer etc.) to stop sons. 2) Failure of care need not be primary cause of loss. a) e.g. comingling of funds and sons looting was primary reason. (Francis)
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3) General mismanagement may not be avoidable so no liability. a) e.g. Barnes: Hand noted it wasn‟t illegal loan but bad judgement. 1. Too speculative to say if director could have helped. 4) Director can usually avoid liability by informing other directors and voting for proper course of action or resign in protest. G) 2 possible duties: 1) Monitoring: director must inform self about C. (Francis) a) e.g. read financial statements etc. 2) Response: director must blow-whistle/act if see possible wrong doing. (Francis) a) e.g. hire lawyer, accountant, warn wrongdoer etc. 3) Duties may expand if: a) C in precarious financial position. b) Fiduciary relationship to clients and implied trust in holding funds (bank etc.). c) Unclear if sophisticated directors (lawyers, bankers etc.) have higher duty of care. 4) Reason for hesitance in imposing too great a duty for 1 or 2: a) Hard to determine when or whether duty should start. b) Costs of retaliation by wrongdoers. c) Costs of directors blowing whistle improperly. 1. Whistleblowing not required in US custom via good samaritan law. H) May need this remedy if others, e.g. FC do not allow for recovery. 1) E.g. could have gone after Francis‟ sons under FC but probably had no $$. I) Liability for e‟ee crimes summerized: 1) If no monitoring in place, federal criminal penalties much greater than if have monitor system in place. 2) Thus, its in interest of SHs for C to monitor and uncover illegal acts even if C profiting and even if must pay fines if find illegality. 3) For civil crimes, no such law so stuck w/ respondeat superior. a) Thus, although not good for SHs, smart director sets up monitoring system to avoid getting personally sued and SHs who don‟t like can‟t complain b/c he‟s doing right thing! 2. Malfeasance. A) Director decisions violate duty of care and thus are not protected by BJR if director‟s judgement was made w/ gross negligence. (Van Gorkom) 1) DGCL 141(e): directors can rely on opinions, reports etc. made by officers. a) VG fails here b/c:
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1. VG was uninformed himself re: the document he was talking about. 2. Officer‟s talk re: price did not discuss valuation. 3. Legal advice said may be liable for rejecting merger but didn‟t address liability for acceptance. 2) Substantial premium may be consideration in recomendation but need basis to assess fairness (IB fairness opinion). B) Violation may be cured by informed SH vote. (Wheelabrator) 1) Failed in VG b/c SH not fully informed. 2) Failed b/c by time of vote, Pritzker deal was only viable option. C) Damages: 1) S.C. rejects Allen‟s notion that need injury to recover on duty of care breach. (Cede) 2) S.C. upholds idea of entire fairness where directors may be absolved in event of breach if t-action was entirely fair to SH. (Cinerama) 3) Types: a) Compensatory: value of shares now vs. price paid. b) Recissory: value of assets since t-action vs. price offered. D) VG tied directors hand by making them take more time in evaluating M&A decisions but this is helpful b/c takes away raiders threat of taking deal off table if not acted on in X days. (Macey & Miller) 3. K‟ing out of personal liability. A) In response to VG, legislatures step in to allow C to remove directors from personal liability. B) DGCL 102(b)(7): allows C, via charter, to indemnify directors for breach of duty of care. 1) Does not cover: a) Breach of duty of loyalty; b) Intential misconduct or bad faith. 2) 90%+ of Cs adopted this provision. 3) 41+ states have a similar statute. 4) Statute only limits monetary damages, does not prevent: a) Suits vs. officers; b) Breach of loyalty or bad faith; c) Enjoining deal; or d) Recind deal. 5) Why would SH approve 102(b)(7)? a) Cheaper that insurance. b) Don‟t want directors to be risk averse. c) Helps get good quality directors. 6) 102(b)(7) is form of self-insurance. C) DGCL 145: C can not indemnify director for judgement against him, must be settlement.
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D) Even if don‟t have statute, C can insure director for most things. 1) Insurance covers 2 parts: a) C for any indemnification payments. b) Officer and directors personally for liability above indenification amount. 2) Insurance will not cover fraud, breach of duty of loyalty etc. E) Indemnification may be better for C b/c: 1) No t-action costs from dealing w/ 3rd party insurers. 2) No litigation costs. 3) Statute might lessen suits which help police bad directors. 4) In insurance there is a cap above which directors must pay. F) But insurance may be better b/c indemnification may look bad for C especially if directors are lowlifes. C. Duty of Loyalty 1. Duty to whom? A) Traditionally duty runs to C and SH. B) Exception: if C near insolvency, duty may run to creditors. 1) Justification: at this point, creditors may “own” C. C) Many states codify this via consituency statutes that allow directors to take interests of e‟ees, community etc into account. 1) Neither DGCL nor RMBCA has this, however. 2) Problem w/ provisions is it deliberately fuzzes who duty runs to. 2. Self-dealing. A) Importance of disclosure. 1) Non-disclosure=per se unfairness. Hayes Oyster & ALI 5.02(a) 2) Non-disclosure may be cured by fairness of t-action. DGCL 144(a)(3) & RMBCA 8.61(b)(3). a) RMBCA speaks only to directors, not officers or SH. b) DGCL 144 does not speak to self-dealing SH. c) Self-dealing SHs subject to enitre fairness. 3) Regulation S-K 404(a): must disclose all material (over 50Gs) transactions unless self-dealer ownes less than 10%. B) Consequences of SH approval. 1) Majority vote of disinterested SH can authorize or ratify a selfdealing t-action. DGCL 144(a)(2) & RMBCA 861-62 & ALI. a) Governing standard is BJR under DGCL and RMBCA. b) ALI: can not be attacked (unless waste). 2) Corporate waste can not be approved unless unanimous SH vote. (e.g. ALI 5.02(a)(2)(D)) a) Policy: protects minority SH. 3) In case of merger w/ controlling SH: standard is entire fairness and burden of proof is on D. (Weinberger)
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4) In case of merger w/ controlling SH conditioned on and receiving approval of majority of minority: standard remains entire fairness but burden of proof shift to P. (Lynch) 5) Controlling SH treated differently b/c violation more likely. C) Consequences of approval by disinterested directors: 1) RMBCA/DGCL: a) Authorization or ratification: BJR. 1. Policies: a. Institutional competence. b. Don‟t want to chill t-actions. c. Don‟t want to undercut corporate structure. b) Neither: fairness: fair process and price: same as entire. 2) ALI/Eisenberg: a) Authorization: reasonable belief & fairness. 5.02(a)(2)(B) 1) This allows court to get into t-action and evaluate it. 2) This is subjective, not objective standard like fairness. 3) This gets lower standard and shifts B of P. b) Ratification: fairness. 5.02(a)(2)(C) c) Neither: fairness. 5.02(a)(2)(A) D) Policy considerations: Eisenberg. 1) Why both disclosure and fairness are required: a) Only fairness test would switch decisionmaking from board to court. b) Hard to know what other deal C may have made if knew they were dealing w/ insider. c) If no penalty, there‟s no control for non-disclosure. 2) Why need fairness even if disclosure: a) Board won‟t be as wary if dealing w/ insider. b) Hard to distinguish “disinterested” directors. 3) Approval acts to: a) Change standard. b) Shift B of P. E) Remedy: disgorge secret profits or, enjoin or reverse t-action. 3. Corporate opportunity doctrine. A) Scope 1) 2 issues: a) Is opportunity close enough to belong to C? b) If so, is there a D? 2) Various tests: a) Line of business test: belongs to C if sufficiently close to C‟s line of business.
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b) Fairness: looks to 1. Line of business. 2. How D or O heard of opportunity. 3. Whether used corporate assets in expoilting it. 4. Other indicies of good faith. c) Combo of a & b: if it is w/in line of business, D can prove that C was unable or unlikely to exploit opportunity. d) Interest test: looks to Cs ties w/ opportunity. e) ALI 5.05(a): Rule: Director or officer can‟t take opportunity know comes through C unless: 1. Disclose and offer to C. 2. C rejects opportunity. 3. Rejection is fair, authorized in fair manner by board or SH and isn‟t waste. 3) If not deemed C opportunity, use BJR. B) Officers and directors. 1) Broz: Court looks to variety of factors: a) Who liscense offered to. b) License not going to be offer to CIS. c) License no longer interest of CIS. d) CIS had no $$ to buy license. 2) Broz did not state how many factors need to be satisfied. 3) ALI 5.05: definition of corporate opportunity: a) (b)(1): one which director or officer becomes aware of: 1. In connection w/ job that leads them believe will be offered to C; or (A) 2. Through use of C property that leads them to believe that C would be interested in it. (B) OR c) (b)(2): one which officer becomes aware of and knows is closely related to C business. 4) If merger in works, no duty to present to other Cs board until merger complete. (Broz) a) Policy: Certainty and predictability of rule. C) Controlling SH. 1) ALI 5.12(a): Can‟t take opportunity unless: (1) Its fair to C. (2) Its authorized or ratified by disintersted SH after disclosure and its not waste of assets. 2) ALI 5.12(b): C opportunity is activity that: (1) Developed or received by C or comes to SH via relationship to C; or (2) Is held out to SHs by controlling SH as type of activity w/in C‟s scope and not w/in scope of controlling SH‟s C. 3) Sinclair: used BJR instead of fairness b/c SH knew C would only get opportunities in Venezuela.
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D. Executive Compensation 1. Introduction. A) Its considered proper for C to staff compensation committee w/ “independant” directors. 1) Helpful to prevent SH suits. B) New 1993 federal proxy rule require more disclosure as to compensation of top 5 managers. C) Compensation is kind of self-dealing. D) Goal of compensation: make incentives of managers=SH‟s incentives. 2. CEO employment K. A) Effective date: based on change of control, or else K is at will. B) After change in control, hard to fire CEO, for cause satndard. 1) CEO can stay, or leave for a number of reasons. 2) New owner can fire CEO, just needs to keep paying him. a) This is golden parachute. b) No duty to mitigate. C) Change of control definitions: 1) Outsider gets 25% interest. 2) Current board or handpicked successors lose control of board. 3) M&A or corporate restructuing leaves less than 75% of shares w/ old SHs. D) Pro of parachutes: 1) Gives managers incentive to sell. 2) Attracts better managers. E) Cons: 1) Deters takeovers b/c of increased costs. 2) SH fear of electing new board so don‟t trigger parachute. 3) May not be proper but evaluated under BJR not fairness. F) K may be attacked on waste: Rogers: great depression tobacco case. 1) In reality, tough to do: need highly disporportionate to contribution. 2) May also argue board not disinterested. 3. When are executives paid too much? A) Laws don‟t really regulate here. B) May be OK if tied to C profits b/c of incentives. 1) Easiest way is via stock optionjs not in the $$. 2) Problem: C may do well but market keeps stock down. 3) Only works for managers who can really make a difference. C) Ratification of waste. 1) SH vote as to original ESOP should insulate B of D from suit. a) May be easier for plan to allow for compensation committee to modify w/o subsequent SH vote. 2) Can‟t ratify waste unless unanimous.
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D) DGCL 157: B of D has discretion to decide value of options but not if there is “absolute failure of consideration.” (Michelson) E) If allow B of D to cut strike price of options due to stock drop, incentive of manager decreases. 1) I say this also leads to inefficiency b/c managers have incentive to take higher risks than normal: if fail, stock drop and options cut and then try again, eventually they will win. 2) Counter: But if options so far out of $$, may not have incentives anyway. F) Seeing if manager asks for options is good screen to get good manager. G) Use fairness test but its a weak standard. 4. Federal regulation of executive compensation. A) W/o properly certified profit incentive plan, manager can‟t take certain tax deductions over 1 million $$ B) C must disclose certain issues in proxy: 1) Compensation of top 5 executives. 2) #1 must include proper valuation of options. 3) If want to reprice option plan, need: a) Disclosure. b) Ratification by SH ex post. 4) Performance chart showing C vs. similar Cs E. SH Suits 1. When are derivitive suits in SH best interests? A) 2 types of suits: 1) Direct: class action (CA) suit on behalf of SH. a) To enforce fiduciary duty; or b) To enforce federal securities law. c) e.g. impair voting rights, dividend payments, etc. 2) Derivitive: on behalf of C. a) Same reasons as 1). b) Most fiduciary duty cases and almost all self-dealing cases fall here. c) Most cases start here and if can‟t pass screens, try CA. 3) Key differences: a) Who collects damages. b) Applicability of federal class action rules. c) B of D can get derivitives suits dismissed if demand requirement not satisfied. B) Derivitive suits: 1) Adding value to C. a) $$ recovery from errent managers. 1. No real benefit b/c C pays out of D&O premia. 2. Value added only to extent manager pays from personal assets.
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b) Blocking corrupt t-action. c) Deters wrongdoing. 1. Managers reputation on line. 2. Lose job. 3. Criminal prosecution. 4. Fear of losing judgment not really an issue b/c managers rarely pay damages out-of-pocket. 2) Imposing costs on C. a) C must pay for defending and prosecuting suit. b) Raises costs of hiring managers. 1. Losing good managers. 2. D&O insurance. 3. Indemnification costs. 4. Must increase manager‟s salaries. c) Waste Cs time. d) Makes managers risk averse. e) Strike suits. C) D&O insurance. 1) Ex ante: looks like a bad deal b/c value of premia is gretaer than value of future recovery. 2) Ex post: looks good when C gets big check from insurance. D) Goal of suit: maximize corporate value. 1) SH should prefer derivitive suit when: a) It will deter fiduciary breach. b) C‟s expected recovery exceeds expected litigation costs plus additional insurance or settlement cost of suit. 2. Standing requirements for derivitive suits. A) Policy: pick SH who have highest incentive to bring case. B) Requirements: 1) P must be beneficial owner of shares; RMBCA 7.40 2) Contemporanious ownership: RMBCA 7.41(1): At time act or ommission was complained of. a) Can also have become SH via operation of law from SH who satisfied above requirement. 1. e.g. inheritance. b) Policy: those who buy after announcement pay discounted price based on negative value of wrong. c) Other Js give standing to SH at time wrong occured. 1. Problem: above policy not satisfied. 3) SH must fairly and adaquately represent interests of C. 7.41(2) C) Requirements don‟t prevent many suits b/c many SH will satisy them. D) Current and proposed rules. 1) Current federal rule: permit largest SH willing to assume control of suit. 2) Proposal #1: Restrict suits to largest SH 500Gs or 3%.
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3) Proposal #2: auction off suit to highest bidder. 3. Attorney‟s fees and the incentive to sue. A) Different rules: 1) Contingent fee rule: court sets fees at 20-30% of recovery. a) No recovery, P lawyer is out of pocket. b) Rationale: If not, P bear all costs and only share in % of benefits pegged to % of C he owns. c) Problems: rule doesn‟t create optimal # of suits. 1. 20-30% arbitrary #. 2. Only looks at ex post factors (recovery and costs) not ex ante (deterrant value and salary costs). 3. Gives lawyer incentive to settle early b/c cheaper than going to trial but P recovers less. 2) Substantial benefit rule: lawyer gets fees when suit generate substantial benefits to C if no $$ recovery. a) Standard: Fees if court finds results of action maintain health of C and raise standards of fiduciary relationships or prevents abuse. (Fletcher) b) Possible non-$$ substantial benefits: 1. Change on board. 2. Change in C structure. 3. Resolution of suit move to arbitration/save litigation fees. a. Criticism: too speculative. b. Criticism: will cause too many suits. c. Criticism: can‟t exclude b/c lawyer can always drag out suit. c) Criticisms of rule: 1. Benefits too hard to measure: need $$ for benefit. 2. Too liberally applied: C pays for change would have made anyway. 3. Anything can be cast as substantial benefit. 4. 2X Agency problems: increase strike suits and guilty managers have high incentive to settle quickly. a. This leads to increase in D&O insurance. 3) Common fund: when fund set up for beneficiaries of successful suit, court may award $$ from here so benficiaries pay pro rata. a) Abandoned in Fletcher. B) Motivation for SH suits. 1) Usually suits brought by lawyers who want fees, not to increase SH wealth. a) SH usually a pawn client of lawyer. b) Incentive to bring high settlement $$ suits, not one‟s that maximize SH value.
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1. Big settlement may be outweighed by above cost. 2) Bad suits are brought b/c ex post, they yield high fees but ex ante before insurance premia are paid, SH don‟t want suit. 3) We want suits w/o high recovery brought if will have aggregate effects outside of C in question: benefits to other Cs and society. C) Above rules act as exceptions to standard “each pays own cost rule.” 4. Indemnification, insuarance and source of settlement funds. A) Facts from Romano: 1) Most suits settle (2/3 and 1/3 dismissed) and lead to fee award. 2) ½ settlements result in monetary recovery. 3) D&O insurance pays for most of settlement. 4) D&Os never face out of pocket costs. B) C can indemnify directors before judgement 145(b) and can insure them for costs even after judgment 145(g). 5. Legal screen on derivitive suits. A) Demand requirement. 1) Every case must get over this hurdle. 2) P must serve demand on B of D to remedy problem. 3) If no demand served, court either excuse or dismiss case. 4) Problem w/ DE rule: there is incentive not to make demand b/c if so, P waives right to challenge imdependance of B of D. a) Most times demand is served, board dismisses case. b) Rales implies that board must do factual investigation into demand letter and this inquiry is vunerable to attack. 1. Like VG case, B of D didn‟t evalute demand thoroughly enough. 2. This is only a hint in case, not definite so argue both ways that demand not so bad anymore. 4) Standard: court excuses demand if P shows it would be futile. 5) Futility test: Levine: (disjunctive test, was conjunctive) a) Threshold presumption that directors are independant and disinterested rebutted by well pleaded facts; or b) P creates reasonable doubt that challenged t-action was product of valid business judgement. 1. This prong easier to satisfy. 2. Showing 2 of 13 directors were clueless is not enough. (Levine) 3. Probably need to show that at least a majority of directors made faulty judgements. 6) Double derivitive suits: when B of D in question is sub of parent that P serves demand on. a) Different board does underlying t-action so it has no evidenciary value and test is only 1st prong. 1. Applies in 3 cases: Rales a. Double derivitive.
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b. Majority of B of D replaced since t-action. c. Subject of suit is not business decision. b) But if there is overlap b/w B of D doing t-action and B of D reviewing demand, lack of BJR in underlying t-action is enough to show non-independance. (Rales) 1. So 2nd prong actually applies in evidenciary form. c) Rales implies that SH can use DGCL 220 to get information re: underlying t-action. 7) Definitions of interested and independant: (Rales) a) Interested: When director will receive personal financial benefit or material detrimental impact from t-action unequal to that of SHs. b) Independant: When director decision is based on corporate merits, not other considerations or influences. B) Special litigation committee (SLC). 1) Kicks in only where demand requirement is excused. 2) B of D sets up SLC to to decide if dismiss suit b/c no wrong or cost outweigh benefits. 3) Standards: a) Minority: Auerbach: NY: SLC decision to dismiss was business judgement and only could attack procedures. 1. Court assess if SLC was independant and decision was in good faith. 2. SLC very powerful, suits usually dismissed. b) Majority: Zapata: DE: SLC decision could be attacked on whether SLC had independance/good faith and used reasonable procedures and court can apply own BJR. 1. Procedure of SLC may be OK even if members selected by interested directors. (Zapata) 2. But court recognizes structural bias of #1 and thus apply 2nd part of test. 3. Standard is tougher on B of D than under demand requirement b/c: a. SLC occurs at later stage in litigation. b. If B of D too interested to pass jugement on demand requirement, odds are SLC structure will be suspect. 4. Joy goes farther seemingly requiring 2nd part. 4) Court‟s excercise of business judgement. a) Joy v. North: Court must consider suit a monitary investment and see if have positive NPV. b) Factors that must be looked at: 1. Attorney‟s fees and other litigation expenses. 2. Time spent by C personel preparing for trial.
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3. Discounted value of possible indemnification. c) Factors that may be looked at: 1. Distraction of key personnel. 2. Lost profits as a result of publicity of trial. d) Factors that must not be looked at: 1. Discretionary indemnification. 2. Non/existance of paid insurance premia. 3. Negative impact on moral and C image. e) Problems w/ Joy: 1. Looks only ex post and not at ex ante. a. Ignores D&O premia, indemnification payments and increase in salaries as a cost. b. Ignores deterrance as benefit. c. Although misconduct already occur, C has future so must think ex ante as well. 1. e.g. need to deter next B of D and there are future D&O payments. 2. Court not qualified to make business decision. a. What will court use to make decision? 3. Counter: decision is whether to continue w/ suit which court does everyday: 12(b)(6), Rule 56 etc. 4. Counter: Structural bias, can‟t trust B of D. 5. Counter: No hindsight distortion as in FC law looking at LBOs b/c its real time. 6. Thus, this is unique are where can use court BJ. f) Zapata: look to public policy and deterrance. C) Proposals for reform. 1) K-man prefers to toy w/fee rule to give lawyer proper incentive. a) Make fee award track increase in SH value. b) Have something measurable happen to bad guys (pay cut, fired etc) so plausibly conclude suit leads to deterrance. c) Establish net benfits that don‟t come from insurance C/SHs who pay premia like Pritzker‟s paying up or D or Os paying out of pocket. 1. Wouldn‟t get far b/c hurts both sides of bar. d) We want to break out of circle where C worse off ex ante if suit not filed. 2) K-man: perhaps make standing for 1% or 500Gs SHs only. 3) Tighter screening w/ more specificity in pleadings. 4) ALI always required demand unless P shows irreperable injury would otherwise result to C. a) Dismissal reviewable: 1. Duty of care breach: BJR 2. Duty of loyalty breach: was board reasonable in rejecting suit and adaquately informed?
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a. Intermediate negligence standard. 3. Retention of significant improper benfit: can P prove D has been unjustly enriched? 5) RMBCA 7.42: demand required in all cases. a) No action can then be brought until: 1. 90 days pass w/o word from B of D. 2. Demand rejected. 3. Irreperable injury will result if wait 90 days. 6) RMBCA 7.44: dismissal: by B of D if determine in good faith after conducting reasonable inquiry that suit not in C‟s best interest. 7) Both ALI and RMBCA try to correct DE flaw of disincentive to bring demand. D) Empirical studies. 1) Romano‟s critique of derivitive suits: litigation control not worth costs, Ps bar only one that benefits: see pg 59 of outline. a) When SH suits filed, stocks don‟t react. 2) Kraakman: Romano‟s data is true but can‟t test for what rules actually deterred.
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V. The Voting System
A. Corporate Law Fondations 1. Overview. 2. Voting rules and quorum requirements. A) Annual meeting requirement. 1) DGCL 228: written consent: a majority of outstanding shares can ratify a action that would normally be done at a meeting if provided for in charter. a) Higher standard that at meeting where only need a majority of shares present. 2) DGCL 211(d): special meeting: SHs can call meeting if provided for in charter. a) RMBCA: need at least 10% of SH to request meeting. 3) DGCL 211(c): SH can get judicial order to force meeting if not called in timely manner (13 months since last meeting). 4) Lipton suggests annual meeting should be held every 5 years. a) Rationale: It would insulate board from SH pressure and protect from short term earnings problems. 1. This would remove board incentive to maximize short term and not long term earnings. 5) SH may still vote where not leagally required to protect board from SH suits. a) Easier to satisfy entire fairness where majority of minority approve merger. B) Voting by proxy. 1) DGCL 212: SH can send in proxy card and give manager right to vote for them. 2) Proposal: 1-2% SHs could nominate person for board so insurgents wouldn‟t have to solicite SH seperately. C) Approval thresholds and quorum requirements. 1) DGCL 216: directors must be elected by plurality. a) Default rule: majority of shares enetitled to vote is quorum: 216(i). 1. May be reduced to 1/3 by charter or bylaws. 2) DGCL 251(c): requires majority of shares entitled to vote to approve a merger. 3) Quorum and majority shares provisions designed to prevent minority SH from controlling vote (anti-vote manipulation). 4) We allow depositories to cast votes in uncontested, but not in contested elections. 3. Access to SH lists, books and records. A) Much litigation in this area b/c management don‟t want to give up lists.
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B) If there are high institutional holdings, this issue is less important b/c holder are publically reported. C) 2 areas where SH request lists: 1) Takeover context. 2) Social protest: Pillsbury. D) DGCL 220: SH needs proper purpose for SH lists. 1) Proper purpose: some sort of investment intent. (Pillsbury) a) Court may reject request b/c P has too few shares. b) Ethical interest alone is not sufficient. 1. Can solve by arguing unethical profits ultimately do more goodwill damage than worth. a. e.g. Chevron: P wins b/c says project creates unacceptable risks. 2. Argument works both for SH and for C when turn down possible profitable project (BJR). 3. Rationale: if allow from get go, its OK but otherwise it changes K b/w SH and C. c) Desire to purchase C is not proper: Thomas & Betts. d) Desire to investigate waste or mismanagement is proper if P can show that it may have occured: Thomas & Betts. 2) DGCL 220(c): once P put forth proper purpose, B of P shift to C to prove improper purpose. 4. Reimbursement for proxy expenses. A) Managers have authority to make reasonable expenditures, subject to judicial scrutiny, in proxy contests over policy, not power. (Rosenfeld) B) Insurgent may be reimbursed if authorized by SH: AKA if they win. 1) May do too little for insurgents b/c high collective action costs. C) Share price usually goes up during proxy fight. D) Majority rule: incumbants always get $$ back, insurgent only if they win. (Fossel rule) 1) Equation of majority rule: P(S[G-T] - P[MC+S(SC)]>0 P=probability of success, S=% of shares held by insurgents G=gain from fight, T=MC+SC, MC=directors cost, SC=SH cost. 2) This equation is heart of collective action problem: incentive is less if only get fraction (S) of gain. E) Super Fossel rule: insurgents always reimbursed. 1) Would allow proxy contest in greater range of possibilities. 2) Overcomes collective action problem. 3) Problem: need some screening to avoid frivolous fights. F) Van Voorhis rule: pay neither. 1) Problem: managers w/ low stake in C have no incentive to engage in proxy fight even if in interests of C. a) Thus, managers must be reimbursed. b) Don‟t want to leave it up to manager raising cash from SH or else get many side deals.
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G) Pro rata rule: insurgent gets paid pro rata based on % voting for him. 1) Problem: insurgent probably knows will get e.g. 65% of vote but that still won‟t be enough incentive due to high costs. 5. Manipulation of voting system. A) B of D can move up SH meeting but not if intended to preempt proxy contest. (Schnell) 1) Policy: Boards move is legal but inequitable b/c SH couldn‟t have anticipated move. 2) Opinion sounds in bad faith. B) B of D act may be struck down even if done in good faith. (Blasius) 1) Stroud narrowed scope of Blaisius so need board act: a) To have primary purpose of interfering w/SH vote rights; b) Interference not approved by SHs after disclosure. C) Standard for B): Director action that interferes w/ the voting process of SH is presumptively inequitable. 1) May not apply in hostile takeover context. (Unocal) a) Cravath speaker said it would though in Hilton/ITT e.g. 2) Standard for Blasius is fairness but scope of case is limited. D) Any board action done for purpose of throwing proxy contest implicates Blasius. 1) Greenmail may be allowed if occurs in reaction to proprtional threat before proxy contest begins. (Levin) a) Perot was threat to GM and court held premium was proportion to size of threat. (Levin) 6. Circular voting structures. A) DGCL 160(c): C can‟t vote treasury stock (stock owned by C) or stock held by a majority owned sub. 1) Unless its held by C in fiduciary capacity. 2) Court looks to potential voting power, not necessarily actual voting power of parent in sub. (Speiser) a) e.g. Chem has 9% voting power in preferred stock but its convertable to 95% voting. 1. Thus, $$ to buy Chem stock comes from Chem. 2. Court will see through strategic behavior. b) Policy: Agency costs: court does not want managers to be entrenched b/c then incentives improper. 1. e.g. Speiser & Baker control much more than they have in residual equity. 2. Managers can extract non-pro rata gains. 3. Problem more accute in close C. 3) 25% circular ownership (A owns 25% of B, B of C, C of A). a) Used in Europe, not US b/c of taxes. b) In US probably would be allowed absent collusion. c) If necessary, could cram under 50% sub provision of 160.
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7. One share, one vote? A) Problem of vote buying: most votes are not dispositive so SH not getting proper compensation for vote, will sell for 1 penny. 1) Could solve problem by organizing SH to see if they will sell or by competitive bidding for votes. B) Problem #2: Vote buyer has misplaced incentives b/c has high power but low residual equity in C. C) Vote buying not void per se but voidable. (Shreiber) 1) Fraudulant vote buying is void per se. (Brady) D) Standard for vote buying: intrinsic fairness. 1) Burden is on B of D unless ratified by SH, then its cured if full disclosure. E) Court couldn‟t stop SH from holdup b/c could veto merger on any issue and force C to buyback shares which would include holdup premium. 1) Thus, court impose intrinsic fairness test. F) Major exchanges now have rule that doesn‟t allow existing C to mess w/ SH voting rights by selling stock that not 1 share/1 vote. 1) Exception: In IPOs C can sell no or low voting stock. 2) Policy: can‟t strip SH of voting rights midstream. 3) Speaks to collective action problem that SH allow C to ever strip SH of vote. G) Is there a difference b/w vote buying and supervoting stock? 1) Yes, latter is permanent sale of vote. 2) Yes, don‟t have to approach as many SH w/ supervoting. 3) No, differences not deep but we allow seperation of control from economic rights in several places (e.g. voting trust). 4) Corporate law is inconsistant b/c doesn‟t allow vote buying but allows dual class stock and voting trust. B. SHs Collective Action Problem 1. Market model: SH seek to change C policy by aggregating shares/votes via mergers and TOs. 2. Political model: activist SH seek to change C policy by developing voting support from dispursed SH rather than by purchasing voting power. C. Federal Regulation: Proxy Rules 1. Disclosure and SH communication. A) What is a solicitation? 14(a)(1)(l). (i) Any request for proxy whether or not accompanied by or included in form of proxy; (ii) Any request to not/execute or revoke a proxy; (iii) Furnishing of form of proxy or other communication to SH under circumstances reasonably calculated to result in procurement, w/holding or revocation of proxy. (2) Does not apply to: (i) Furnishing of form of proxy upon unsolicited request;
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(ii) Performance of acts required by 14a-7 (C sending out proxies for other SHs) ; (iii) Performance of ministral acts on behalf of person soliciting proxy; or (iv) Communication by SH otherwise not involved in proxy solicitation stating how SH intends to vote and why provided that communication is: (A) made via public speach, press release or other public medium disseminated on regular basis; (B) directed at persons whom SH owes fiduciary duty in connection with shares in question; or (C) made in response to unsolicited requests for info w/ respect to prior communication made persuant to (l)(2)(iv). B) Is solicitation exempt?: 14a-3 - 14a-15 apply to every solicitation w/ respect to securities registered under Section 12 of ‟34 Act: 14a-2 (a) Rules 14a-3 to 14a-15 do not apply to: (1) Solicitation by brokers or Cs like Cede; (2) Solicitation w/ respect to securities solicitor owns; (6) Solicitation via WSJ ad informing SH where can get copies of proxy statement, form of proxy etc. if only says: (i) name of C (ii) reason for Ad. (iii) identity of proposals to be acted on by SH. (b) Rules 14a-3 to 14a-6 (other than 14a-6(g)), 14a-8 and 14a-10 to 14a-15 do not apply to: (1) Solicitation by or on behalf of person not seeking, directly or indirectly proxy and doesn‟t furnish or request proxy, revocation, abstention, consent, or authorization provided that exemption doesn‟t apply to: (i) C or affiliate of C (other than D or O); (ii) D or O engaged in solicitation financed by C; (iii) D, O affiliate or associate of person inelegible to rely on exemption; (iv) Any director nominee involved in proxy; (v) Any solicitation opposing merger or other extraordinary t-action approved by B of D who intends to propose alternative t-action. (vi) Person required to report beneficial ownership under 13D. (vii) Person who gets $$ from ineligible person. (ix) Person who would receive non pro rata beenfit from successful solicitation other than benefit as e‟ee of C; and (x) Any person acting on behalf of the foregoing.
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(2) Solicitation where total # of persons is less than 10. (3) Furnishing of proxy voter advice by proper advisor. C) Assuming must file, what type of burden imposed? 1) 14a-11(b): Don‟t need to file before solicitation provided: (1) No form of proxy is sent to SH unless it meets proxy statement meets requirements of Schedual 14A. (2) ID of solicitors and description of direct/indirect interests are sent w/ material; (3) A written proxy statement meeting above requirements is sent to SH as soon as possible. 2) 14a-11(c): must send 8 copies of statement sent to SH required by 14a-3 to commission and 3 copies to national exchanges. 3) 14a-6(g): need to file w/in 3 days any solicitation subject to 14a-2(b)(1) if own more that $5 million in shares. 1) Thus, any large institution SH talk requires filing if may lead to giving of proxies. D) Short slate election: 14a-4(d)(4): bona fide nominee rule: Solicitor can only put his nominees on proxy, not incumbent director unless consented. 1) Problem: if solicitor can‟t choose, harder for directors to win. 2) Solution: new rules allow solicitor to say vote for my 3 and don‟t for these 3. E) SH lists: 1) If C making proxy solicitation, then must, upon SH request give SH lists or do mailing for them. 14a-7(a). 2) Problem: if C mails, solicitor doesn‟t get list. 3) Problem #2: if C mails, can hold onto it for a while. 4) DGCL 219: C must make SH lists availible at C office but not until 10 days before meeting. a) Too soon to use for proxies. b) But means less today b/c 50% shares held by institutions. F) Goals of certain sections. a) 14a-(2)(b)(1): goal was to allow SH to talk to one another. 1) Fine line b/w indirect and no solicitation of proxy and big institutions probably wouldn‟t want to mess around. 2) Must be careful b/c C will look at everything hoping to file 14a-9 fraud action. b) 14a-6(g): put in to mollify management who fear big investors cut deals in smoke filled room. 2. Rule 14a-9 suits: false or misleading statements in proxy communication. A) Private right of action recognized in Borak. B) Elements of C of A: 1) Materiality: substantial likelihood that reasonable SH would consider fact important in deciding how to vote.
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a) Can‟t just show opinion isn‟t true, P must prove opinion misleads materially as to underlying fact. (VA Bankshares) 1. Did directors have information showing their opinion was misleading? 2) Culpability: circuit courts split on standard: a) 2nd&3rd: Negligence. b) 6th: Scienter: intentional or extreme recklessness. 3) Causation: can infer if misrepresentation is material and proxy solicitation was essential link in accomplishment of t-action. (Mills) a) Is it close vote? Maybe SH would vote differently. b) Reliance: not necessary says SC. c) If vote not necessary, no causation. (VA Bankshares) 1. Dissent points to 2 non-voting causation arguments: a. Necessary for PR and C wouldn‟t have gone through w/ it w/o majority of minority. 1. Counter: too speculative (even if its not). b. Could go to state court and & challenge taction but vote destroyed remedy. 1. Counter: no loss of C of A b/c if vote tainted, its no vote and can challenge t-action. 2. We don‟t know the fate of non-voting causation after (VA Bankshares). 4) Remedies: Mills contemplated injuctive relief, recission or $$. a) P may prefer federal court due to state damage caps. C) S.C. does not want to read 14a-9 too broadly and have federal courts take too many cases. 1) Judicial economy. 2) Comity: P can go to state court. 3. Rule 14a-8 suits and SH proposals. A) SH have C send out proxy material b/c saves $$. 1) Public pension and labor union 2 biggest users on provision. B) 14a-8 requirements: 1) Hold onto $1000 or 1% of stock for at least 1 year. (a)(1) 2) Must be sent w/in 120 days of C sending out their proxy materials. (a)(3) 3) Can only include 1 proposal per SH. (a)(4) 4) Supporting statement: Proposal in 500 word blurb. (b)(1) C) C can omit proposal under the following circumstances: (c) (1) Not proper for SH action under state law. a) Would proposal violate charter, bylaws or DGCL? b) Most used defense.
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(2) Implimented proposal would require C to violate any law. (3) False and misleading statementes violating 14a-9. (4) Proposal designed to benefit a person non-pro rata to all. (5) Proposal relates to operation which account for less than 5% of C‟s assets. (6) Proposal deals w/ matter C can‟t affect. (7) Propsals deals w/ conduct of ordinary business. (8) Proposal relates to election to office. (9) Proposal is counter to proposal submitted by C at meeting. (10) Proposal rendered moot. (11) Proposal substantively same as proposal submitted by other SH and included in proxy. (12) Proposal deals w/ substantively same matter as prior proposal submitted to SHs in proxy w/in preceeding 5 calander years can be omitted w/in 3 years after last submission provided that: (i) Proposal was submitted at only one meeting during period and receive less than 3% of votes. (ii) Proposal was submitted at 2 meetings during period and received less than 6% of votes at 2nd meeting. (iii) Proposal was submitted at 3 or more meetings during period and receive less than 10% of votes at 3rd meeting. (13) Proposal related to specific amounts of stock or dividends. D) Omission must be folowed by explanation: 14a-8(d). E) Power to amend by-laws: Fleming & Healthdyne cases. 1) Speaks to allocation of power b/w SH and directors. 2) What should SH be able to do? a) Fundmental vs ordinary business decisions. b) Can‟t use marketability of shares as distinction b/c any proposal can be said to effect this. c) Procedural vs. substantive. d) Governance vs. business. e) Future vs past decisions. f) Restrictions vs affirmative orders. F) SEC reverse Cracker Barrel policy and allow politically oriented SH proposals w/ respect to personnel. D. Political vs. Market Controls on Corporate Managers 1. Pound finds that political model becoming more prevelant due to increased institutional holdings and thus decrease collective action problem. A) If managemnt know will lose proxy fight, they will negotiate w/ inmstitutions and this is more efficient than takeover. 2. Benefits of political model: A) Flexibility: can address specific problem at C w/o change in control. 1) This save t-action costs. B) Accords w/ values of DP, debate etc.
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1) Market model leads to public suspicion. 3. Problem w/ market model. A) Too extreme: offer one remedy for problem, takeover. B) Promotes instability in governance.
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VI. Acquisitions Market
A. Corporate Combinations and Appraisal Rights. 1. Basic forms + one new invention. A) Statutory merger/consolidation: DGCL 251, 253 RMBCA 11.01. 1) Merger: 2 Cs come together w/ one “merging” into other where one ceases to exist as legal entity. 2) Consolidation: 2 Cs come together to create a third, new C. a) RMBCA comment states that not used much anymore. 3) Since assets and obligations are t-ferred by operation of law, no formal conveyance or assignment is necessary. a) I say K may require it though. 4) There are no longer restrictions on what consideration can be for a merger (used to have to be stock of acquiror). 5) Voting requirements: generally, a majority of outstanding shares of both Cs need to approve t-action. 6) Ways around voting requirement in mergers. a) Short form merger: DGCL 253(a), RMBCA 11.04: if C owns more than 90% of a sub, merger can occur w/o vote of C or target (T). 1. T‟s SHs have appraisal rights. 253(d), 262(b)(3) b) 20% rule: Acquiring C‟s SH don‟t need to vote on merger where increase in shares outstanding is >20%. 1. Rationale: similar to purchase of assets. 2. Rationale: SH vote only needed if fundamentally change character of C. a. Counter: so if goal is continuity, why not look at change in type of business, not %. b. Recounter: 20% is about size of controlling block which can lead to change. c) Acquirors don‟t get vote unless charter of C will change. B) Sale of assets: DGCL 271, RMBCA 12.02. 1) Target C accepts considerations (cash, stock etc.) for all of its assets and typically distrubutes them all to SHs and C dissolves. 2) Sale may not include liabilities. a) Target C still has assets, consideration paid for their assets, so it can satisfy its liabilities. 3) Voting rights: Acquiror SHs have no voting rights, Ts might. 4) Ts SHs have no appraisal rights in DE but may elsewhere under RMBCA. C) Merger vs. Sale of assets. 1) Benefits of mergers: a) Transaction costs lower b/c don‟t have to assign rights to all assets. b) Tax advantage.
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2) Benefits of sale of assets. a) Possible to avoid liabilities of T. b) Avoid appraisal rights of T‟s SH. 1. Next section discusses how might not be a good thing b/c ARs are better than getting sued. c) Acquirors don‟t need SH approval. D) Compulsory share exchange: RMBCA 11.02. 1) Shares of T are exchanged for C. 2) Both C entities survive w/ T becoming sub of C. 3) Voting rights: T SHs have them, Cs don‟t. a) Note: C‟s SHs may have to vote to amend charter if C needs to increase authorized shares to issue shares. 4) T‟s SHs have appraisal rights. 5) Benefits: a) T‟s identity as a K entity remains intact. b) T‟s legal relations and goodwill remain intact so t-action costs lower. c) C gets insulation from T‟s liabilities. d) Its manadatory exchange so SHs can hold on and be minority in sub which can be a pain. e) Cs SHs don‟t get a vote unless issue more than 20%. 1. Exception: even if issue more than 20% in stock, can avoid vote if do it in triangular form. 2. NOTE: exception doesn‟t apply to NYSE rules! 6) Why not have in Deleware? a) Can get same results from (reverse) triangular t-action. E) (Reverse) triangular merger. 1) C sets up sub, exchanging sub‟s stock for cash or its stock. 2) Sub merges into T w/ T ceasing to exist. 3) Ts SH get cash or Cs stock as consideration for their stock. 4) It reverse triagular if sub ceases to exist (which is more likely). 5) Allows you to avoid 20% rule and acquiror SH vote. F) 2 step merger: Tender Offer (TO). 1) 1st make cash TO for all outstanding shares. 2) Make TO conditioned on getting at least 70% tendered. a) C hopes to get 90% + so can do 253 short form. nd 3) 2 step: freeze out merger at same price, which can ususally be done under state law if controlling SH (see VA Bankshares) 4) Purpose: a) Prevents other C from stepping in and putting up bid. b) TO takes 20-30 days where C gets about 70% of stock. c) At this point, too late for hostile C to up bid. d) Merger would take 3-4 months leaving a longer window open for a hostile deal. e) TO acts as substitute for vote so process speeds up.
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5) C surviving 1st step is only formal b/c most things, SHs, directors, bylaws etc don‟t survive. 2. Appraisal rights (AR). A) T SHs usually get appraisal rights when get voting rights. 1) Exceptions: a) 253 short form merger, no voting but get AR. b) 271 sale of assets, voting but get no AR. 1. Even though may have same effect as 251 merger, equal dignity rule says that you still don‟t get AR. (Hariton) 2) AR suit may be brought at same time as class action but one may be stayed pending outcome of other. a) Allowed so P doesn‟t lose remedy. B) DGCL 262: 1) SHs must hold shares continuously throughout effective date of merger. (a) 2) Must not vote or consent to merger. (a) 3) SH must apply in timely manner (20 days) to chancery court. (d) 4) Court determiones fair value of shares including interest. (h) a) Problem: process may take 2-3 years. 5) Court may shift attorneys fees and expenses to C or all dissenting shares pro rata. (j) 6) Basically, you get AR if deal involves cash or debt as consideration. C) RMBCA 13.02: 1) SH get bulk of value up front. 2) C has burden of going to court, not SH. 3) Does not have stock market exception. a) Good b/c it makes no sense anyway. 4) SHs get AR in sale of assets t-action unless: a) Its court ordered sale; or b) Its cash t-action and T dissolves w/in a year. D) Limits to AR in DE. 1) Costs too high for small SHs: structural limit. 2) Stock market exception: 262(b)(1): No AR if: a) No vote required in 1st place; or b) T is traded on any national exchange; or c) 2000+ SHs. 3) Except (exception to above exception): if they are required to accept for their shares anything except: (2) (a) Shares of stock of surviving C; or (b) Shares of stock of other C whose shares are listed on national exchange; or
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(c) Cash in lieu of fractional shares of stock listed under (a) or (b); or (d) Any combination of (a)(b) or (c) above. 4) Purpose of (b)(1) & (2): new shares have a market to trade on. a) Problem: this explanation doesn‟t make sense b/c market price of T will reflect the bad deal. 5) T gets no appraisal rights in sale of assets. E) Problems w/ AR. 1) Not always availible: a) Sale of assets which are de facto 251. 1. Some states have AR in de facto mergers. b) Stock market exception. 2) Costs prohibit small SH from using them and there is no P bar like in calls action to bring case for SHs. F) Purpose of AR. 1) Minority SH protection. (Fischel) a) Protects all SH from value reducing t-action (if FO is at lower price). 2) Reasons SH votes don‟t offer protection: a) If controlling SH wants to buy firm, votes don‟t matter. b) Management may have split loyalty to SHs and possible new owner. c) Collective action problem: SH tend to follow board and non-dispositive votes aren‟t worth anything. 3. Valuation of AR. A) Nature of claim. 1) DGCL 262(h): claim is fair value of dissenting shares at time of t-action w/o reference to value conferred by merger. a) Tries to avoid speculative claims but otherwise, all else will be considered. (comment to (h)) b) Shouldn‟t be able to vote against merger and get value conferred by merger (sounds fair). B) How court should value claim. 1) There is no minority discount in DE. (Vision Hardware) 2) Old rule: DE block test: a collection of various valuations. 3) New rule: Value is any one given by accepted investment banking technique. (Weinberger) 4) Problem w/ 3): IBs may value assets same but value debt differently: e.g. Vision Hardware. 5) Solution: court accepts face value, not market value of debt in valuation. (Vision Hardware) a) Rationale: for SH to say that C so bad that debt worth less/stock worth more and creditors should lose is crazy. 6) Value of C: pro rate share of going concern. (Cede) a) Allen: going concern of C in hands of old board.
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b) S.C. overruling Allen: going concern of C at 2nd step of merger. 1. Value added by Perlman beginning to impliment plan is added to remaining shares. 2. SC says nothing speculative about this. 3. Court reads Weinberger narrowly to only exclude speculative value. 4. Allen reads statute as “but for” merger, value not added. 5. Depends on if focus on Weinberger or statute. c) Use 2 step merger to lock up control but don‟t want to wait for 2nd step to start plan. d) Problem: large SH won‟t tender so can get added value but then TO won‟t get minimum shares and fail. e) Problem: if postpone plan, it costs $$. B. Exclusivity of the Appraisal Remedy and FO Transactions: 1. Methods of FO minority SH: A) Cash out merger: method of choice. 1) Even though this involves AR and other 2 do not, it is used b/c self-dealers want AR so as to avoid other litigation down the line. a) If do merger, raider looks better and has better chance of precluding class action later on. b) In other Js, AR exist for all three methods. 2) Only a few SH use AR (5%) whereas class action gets around collective action problem so they are more expensive b/c must pay all SH fair price, not just dissenters. a) This assumes a world where AR and class action remedies run simultaneously. b) We are at point where running simultaneously but in past, court cuts back, then slowly allow it in certain cases until it eventually comes back to simultaneous running. 3) Use cash b/c if use stock, SH not really gone and stock issuance may dilute earnings. B) Sale of Assets. C) Reverse stock split. 2. At FO stage, minority voting protection is worthless so it is best place to have judicial protection in form of AR or other fiduciary protection. A) In 60s, only rights that existed in FO were AR until Singer which laid down 3 rules: 1) Class actions are not precluded by AR. 2) Per se rule: deal unfair w/o colorable business purpose besides kicking out minority SH. a) Abandoned in Weinberger and replaced w/ fairness. 3) Minority could get recissory damages above their actual loss.
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3. Exclusivity of AR: preclusion issue. A) Can bring a class action if there is self-dealing, fraud, waste or gross or palpable overreaching. (Rabkin‟s interpretation of Weinberger) 1) Overreaching is wildcard that give court ability to allow any class action w/o AR precluding it. a) Thus above conclusion that remedies run simultaneously. b) Used in Rabkin for D who waited 1year and 1 day to avoid K made w/ selling SH. 1. Following Schnell, this is fairness/fiduciary duty violation and hence termed overreaching. 2) Any kind of suspicious situation will get class action. (Lynch) 3) If file AR, then find could have brought class action, can do it. a) Court doesn‟t want P to lose AR if process turns out to be fair. B) Not really an issue any more. 4. Valuation of AR: appraisal issue. A) AR can be any economic valuation accepted in IB field, same method as class action. (Weinberger) B) Remedies: 1) Recissory. 2) Actual value of pre-merger shares. 5. Standard of review: A) Controlling SH has duty of entire fairness: 1) Fair dealing or process; and a) Can‟t press negotiations too hard and threaten TO at lower level, no bear hugs. (Lynch) 2) Fair price. a) Should be similar to what would get at arm‟s length. b) At least what D would have to give up to P‟s bar. 6. How to advise client (parent) in deal for its sub: A) If parent has members on board, don‟t tell them any information you don‟t want sub to know b/c have fiduciary duty to tell them. (Weinberger) B) Set up independant committee of SH on target. (Weinberger: FN7) 1) Will leave burden on P unless IC was coerced. (See Lynch) C) Get a majority of minority to vote for t-action. 1) May not do much since: a) P can argue vote wasn‟t informed. b) Only shifts burden of proof back to P, doesn‟t shift from entire fairness to BJR. (Michelson) D) Get a good IB fairness opinion, not a rush job. E) Provide evidence of real negotiations looking like arms length t-action. F) Since in fiduciary relationship, don‟t be fair, be generous. (Rabkin) G) Disclose everything.
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H) Don‟t say anything stupid during board meeting like “you have to listen to us, we are controlling SHs.” (See Lynch) 7. Note: Kraakman expects that people take possibility of suit into account when do deal. A) Thus, it may be easier for controlling SH to negotiate w/ P bar and not w/ C so as to settle inevitable suit up front. 8. Controlling SH: don‟t need > 50%, depends on actual control exerted. (Lynch) 9. Scope of class actions. A) Kraakman is unsure if above arguments work in: 1) Friendly or hostile 2 step deal (at 2nd step where FO occurs). 2) TO for all shares that plans FO at same price on back end. 3) TO by majority SH. a) Against extension: no need to tender, just hold on. b) For extension: its lonely being 1 of a few minority SHs especially when market for shares disappears. 4) Independant committee duty to accept good offer from controlling SH. (Roto-Rooter article) 5) Put together arguments for/against extension in 1-3. C. Sales of Control 1. Regulation of control premia. A) Control sales are like market t-actions, no need to share premium w/ minority investors. (Zetlin) B) Control is a legal and practical concept, % is whatever is necesasry to control board. 1) Control allows SH to do FO, elect officers, set salaries, deal w/ wholly-owned suppliers, consultants and other non-pro rata gains. 2) Control is not asset per se but trades at premium. 3) Problem: lower equity stake controlling SH has in C, then looting becomes more valuable/probable. C) Tension b/w high protection of minority SH in FO (above) and here where not much. 1) Symmetry b/w 2 cases: a) FO: minority SH locked out of C. b) Control sale: minority SH locked into new C. 2) Minority SH have high interest here b/c different management team takes over so its different C. 3) Rationale: incentive for controlling SH to increase value of firm b/c of equity stake. a) Doctrinally, it remains anomoly: some Js including England allow minority SH to cash out. b) In FO, forced to sell, here market still exists c) K-man thinks doctrine ignores value of non-pro rata gain. D) 2 reasons to buy control block:
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1) Better management will increase value. 2) Better looter: extractor of non-pro rata gains. E) Less important issue b/c less control blocks in world and more aggregating control. 2. Exception #1: Collective opprtunity. A) Any compensation in premium for value of C opportunity must be turned over by selling SH. 1) Perlman required recovery to go only to minority SH so controlling SH (who doesn‟t deserve gains) gets none. a) Kraakman says court has sanctioned this exclusion elsewhere if it would be unjust for other SH to get $$. 2) P don‟t go after controlling SH b/c it would be near impossible to prove extraction of non-pro rata gains under BJR. B) B of P is on D. C) = opportunity rule vs. market rule. 1) 2 versions of = opportunity: a) Must buy whole C. b) Must buy whatever shares want pro rata from all SH. 2) E & F argue either = opportunity rule is inefficient b/c would deter some effcient t-actions. a) 1st would be too expensive. b) 2nd majority SH wouldn‟t have incentive to sell b/c buyers price for whole firm is < value to controlling SH. 3) = opportunity would however deter all inefficient t-actions also. 4) E & F: gains come from management/synergy and if SH is looter then we punish them ex post for deterrance. a) Problem: they may disappear if loot enough or be judgement proof. 5) Market rule: OK to let some bad t-actions through in order to ensure good ones get through also. 6) In practice, we may not have market rule but rule w/ latitude to qualify things that are shady. 3. Exception #2: sale of corporate office. A) Sale of control is OK, not office. B) If office goes w/ sale of control its OK (sale of 50%+). C) Sale of office occurs when part of premium is for assurance of certain positions on board or as officer. 1) SH ratification: may act to cleanse deal or “anti-ratification” (fire new CEO in 2 weeks) may be evidence of sale of office. 2) Low (10) %: lower share % representing control, higher chance sale of office. a) Brecher: 4% sale coupled w/ CEO stepping down and 2 directorships is a sale of office. D) Purpose for distinction b/w sale of control and office.
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1) SH w/ lower % shares has higher incentive to loot b/c profit from C efficiency is only in proportion to equity block. 2) Cost of deterring t-action is less: 10% is not real control, can easilty be pushed out so no efficient t-action going on here. 4. Exception #3: looting. A) Controlling SH has a “red flag” duty of care to investigate buyer if sees suspicious circumstance. 1) e.g. Shady financial statements in Harris or very high premia for C w/ very liquid assets like investment C. 2) Similar duty to Allis-Chalmers. 3) Not necessarily fiduciary duty but tort duty. a) This is gatekeeper liability from 1st week of class. B) Rationale for suing seller. 1) CCA. 2) Looter may be gone or judgement proof. C) Minority SHs not responsible b/c can‟t be expected to investigate. 1) Its only b/c have large stake that due dilligence is just small cost. D. TOs and Williams Act 1. TO: offer of cash or securities to public SH in exchange for their shares at a premium price. A) TO is away of arrgegating control block if none exists. B) Act favors defense of managers. C) Rules are SEC intrpretation of SEC act of 1934. 2. 4 elements of Williams Act: A) Early warning system to management: 13d. B) Disclosure: 13d and 14d. C) Antifraud: 14e. D) Substantive regulation of TO. 3. Early warning system: 13d. A) Rule 13d: anyone who acquires 5% beneficial ownership in Section 12 C must disclose to C, exchanges, and SEC w/in 10 days. 1) Disclosure must include what their plans are including if plan to take control of C. 2) Exception: large institutions who acquire solely for investment. 3) Arbs register when they buy over 5% but never go over 10% or else can‟t sell for 6 months (16-b). B) 13d-5(a): Person must register if acquire 5% through purchase or otherwise. 1) Seems to cover inheritance and stock buybacks as well. C) 13d-5(b)(1): if 2 or more persons act together for purpose of acquiring, holding, voting or disposing of securities, group formed required to register if aggregate more than 5%.
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1) Filing must occur as of date of actual agreement to act, not purchase or when 1st get together. a) e.g. institutions agree to vote against merger, when agree, they file b/c already own securities. 1. Even if havn‟t bought securities yet must file. 2) 14a makes it easy to talk (not 6g) but 13d puts some limits here. a) Determination of group is broad. 3) 13d is important outside of TO to SH collective action. D) Why can‟t a SH just buy whole C in 10 days? 1) Poison pill probably kick in. 2) Market price will go through roof and cost more than TO. 3) After 10%, run into 16b insider trading problems. a) So at most, usually by 9.9%. E) 13d allocates distribution of t-action gains to T SH not raider. 1) 14e-3 prevents raider from tipping off allies who would get value of information instead of SH. a) Also prevents raider from recouping part of premium by exchanging e.g. information of TO for financing. F) Who can sue? 1) T SH and T itself. 2) Unlikely to get more than injunctive relief. a) May get recissory damages if some sort of fraud. G) Benefits: 1) To management: information allow management to engage in defensive tactics. a) May be detriment to SHs. 2) To SH: transfer of gains to them from raider. H) Problems: 1) Disclosures often boilerplate w/ vague plans. 2) Once buyer crosses 5%, can get another 4.9%: leg-up. 4. Disclosure: 13d and 14d. A) Only applies to section 12 Cs. 1) Exception: 14e applies to all TOs. B) What must be disclosed after public announcement of TO: 1) Financing sources. 2) Plans for business. 3) Side deals w/ T management. 4) Plans/terms of FO. C) 14e-2(a): T has duty to respond to TO w/in 10 days: T must: (1) Recommend rejection or acceptance of TO; or (2) Express no opinionas to TO; or (3) Say unable to take position and why. 4) If anymaterial change occurs in decision of T after initial disclosure, it must be disclosed. D) 13d-4: Self-tenders have similar disclosure requirements.
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5. Antifraud: 14-e: only applies to TOs. A) Similar to 14(a)(9), can‟t have fraudulant acts, misstatements etc. in TO or disclosures. 1) Requires an element of desception, not just breach of fiduciary duty. (Schreiber) B) Who can sue? 1) T or T SH can sue for damages or injunction. 2) Acquiror can sue for injunction if T acts fraudulently. 3) Standard of proof is scienter. (Piper) 4) Can sue even if don‟t tender. a) Under 10b-5 can‟t sue unless tender. 6. Substantive regulation of TOs. A) Most regulation is in SEC rules, not Act per se. B) 14d-7: Best price rule: all SH get highest price even if they tender before offer price is raised. C) 14d-8: Pro rata requirement: if TO is for less than all shares and it is oversubscribed, must buy shares on pro rata basis. 1) Extends pro ration period of 14d-6 from 10 days to whole TO. 2) This avoids coercive time pressure of tendering. D) 14e-1: A TO must be open for at least 20 business days. 1) Act actually says 7 days for total TO, 10 if partial. 2) If offeror increases or decreases % of securities being sought or raises offer price, TO must stay open an additional 10 business days from day of increase. E) 14d-7: withdrawal rights: SH can w/draw tendered shares any time before end of TO. 1) Protects SH so can take better offer if it comes along. 7. What is a TO? A) Not all attempts to acquire control are TOs. 1) e.g. buying control block or creeping acquisition. B) Wellman 8 factor test: 1) Active and widespread solicitation of public SH. a) Broker is not buyers agent but sellers. (Brascan) 2) Solicitation made for substantial % of Ts stock. 3) Offer to purchase made at premium price. 4) Terms of offer are firm, not negotiable. 5) Offer contingent on tender of fixed # of shares, often subject to maximum # to be purchased. 6) Offer open for limited time. 7) Offeree feels pressured to sell stock. a) Court thinks savvy arbs can‟t be pressured. (Brascan) b) Kraakman disagrees, this isn‟t how define pressure. 8) Public announcement of purchasing program of Ts stock. C) Court never has weighed factors or said how many must be met.
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D) Whereas open market purchases are probably safe, private purchasing is more likely TO. E) Brascan Court dubious of test and prove it may be applied in “rigged way.” 1) See outline appendix E for how Brascan could go other way. F) Market sweep may not be tender offer. 1) Hostile TO drops offer but buys 25% of stock as price drops from 5 arbs. (Hanson) a) Held no TO b/c fails 8 factor test. b) Could not do this intentionally. 2) 14d-11 proposed that offeror could buy Ts stock until 30 days after announce discontinuing of TO. a) Proposal never went through. 8. Effect of SEC rules: A) Gives 3rd parties more time to make counter offer and sets up auction. B) Increases time for management to set up defenses. C) Increased auctions and control premium. D) Increases time for SH to figure out deal. 1) Problem: this isn‟t necessary b/c that‟s what arbs do and they don‟t need lots of time. (E&F) E. Auction Debate and Takeover Motives 1. Easterbrook and Fischel: anti-Williams act and takeover defenses. A) Problem w/ auctions: decreases# of value-increasing takeovers. 1) 1st bidder incurs search costs, others don‟t. 2) Auction reduces benefit of search and thus incentive to search. 3) Return on search will decrease. 4) Increase cost of monitoring by protecting bad managers. 5) Decrease in auction hurts SHs 3 ways: a) Get less takeovers. b) Get less monitoring so all SHs lose out. c) Extra premia only t-fers wealth from 1 pocket toanother b/c for every takeover in portfolio will also have buyer which loses due to extra costs or premia. 1. Auction only increases t-action costs. 2. Assumes buyer = public C and not KKR. B) Why takeovers are good: 1) They are efficient via synergy and management gains. 2) Threat makes good disciplinary device for bad managers. C) Believe gains of takeovers should go to raider, not minority SHs. 1) Poposes that managers shouldn‟t be able to use defenses. 2. Bebchuck: A) Auctions are good b/c increase efficiency of takeovers while having modest impact on value enhancing transactions. 1) Only rich premium deals are worthy deals.
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2) 1st hostile bidder always has incentive to bid b/c can always buy up 9.9% on market before deal. a) If win auction, save premium on 10%. b) If lose, get “tip” for finding T and make $$ on 10%. 3) 1st friendly bidder has incentive b/c negotiate lock up or break up fee for “tip.” B) Agrees w/ E&F: auction will result in fewer takeovers. 1) But disagrees that effect is very large. C) Disagrees w/ E&F: need auction to ensure takeovers are efficient. D) Disagrees w/ E&F: control premia doesn‟t always come from management or synergy. E) Disagrees that 2nd bidder don‟t incur search costs. F) Disagrees that premia should go to raider b/c thinks will lead to under investment in possible Ts. 1) E&F say that since can‟t know who is T (and if so it priced into value), this fails. F) Other inefficient sources for control premia: (Kraakman) 1) Undervaluation of shares on market: neutral. 2) “Inside” information: neutral. 3) Exploit monopoly power: bad. 4) Breaching implicit promises b/w T and others: bad 5) Hubris: bad 6) Misinvestment: bad. 7) Tax reasons: neutral. G) Auction ensures asset goes to person who values it most. 3. Source of control premia as key. A) What you think re: source of control premia influences where stand on auction. B) If only source of gains are synergy/management, must agree w/ E&F. C) If think gains come from neutral sources, then agree w/ E&F who want all gains to go to acquirors so have incentive to bid. D) If think gains come from bad sources, then want tougher regime and defend management defense tactics. F. State Anti-Takeover Statutes 1. CTS: Gave states ability to regulate anti-takeover via corporations statutes. A) Old statutes regulated TO directly but these were struct down by court and pre-empted by Williams Act. nd 2. 2 generation of state anti-takeover statutes: worked through internal governnace of Cs. A) Controlled share acquisition: if SH go over certain threshold (~20%), they need to get approval of other SHs to get full voting rights. 1) Over ½ states have this. 2) Not really effective b/c TO for voting block made contingent on getting voting rights approval.
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3) Regulates at 1st stage of TO. B) Fair price: requires supermajority voting on FO merger unless certain fair price threshold is paid by interested SH. 1) Fair price usually at least as high as interested SH has paid for his shres over past 2 years. 2) Regulates 2nd step of TO. C) Moratorium or business combination statutes: DGCL 203: bars transaction for 3 years after acquiroir gets 15% unless: 1) T-action approved by board before threshold is passed. 2) SH goes from <15% to >85%. 3) SH get 2/3 of disinterested SH to approve t-action after control block purchase. 4) Designed to stop acquirors who plan to break up company and sell assets to finance acquisition. a) Can‟t sell assets till get 100% so need bridge fianacing until get 100%. b) Acquiror can‟t relize synergy and other gains until owns 100% or else must share w/ minority SHs. c) Acquiror can make TO contingent on getting 85% but if amnagement can get white squire to buy 10%, all need is another 6% to block t-action. 1. Usually can get at least this 6% in that typical ballot casting only gets about 80-90% of total. d) Danger for acquiror here is if get 84% they are screwed b/c then need 2/3 of 16% which probably won‟t get. 1. Better to tender for 51% and get 2/3 of other 49% b/c most of will want to tender whereas many of 16% who didn‟t before probably won‟t later. 5) Best way around 203: a) Best strategy: proxy contest to replace board and new board approves deal before TO is made. b) Make TO sweet so get 85%. c) Make side deal w/ management. 6) NY statute harder b/c time is 5 years and bars any sale or merger not just those involving buyer/affiliates. a) Thus, in DE, buyer can still bust up C as long as sells assets to 3rd party. 7) Regulates 2nd step of TO. D) Redemption rigths: gives minority SH right to demand “fair value” for shares after control block is sold, where fair value includes pro rata share of control premium. 1) Has similar effects to British system. 2) Chills partial bids b/c requires buyer to be able to buy whole C. 3) Regulates 1st step of TO. E) Constituency: permits Ts board to consider other interests besides SHs.
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1) Other interests: e‟ees, suppliers, community, customers and any other factors they deem necessary. 2) Not a mandatory consideration and no heirarchy. 3) Does not exist in DE (we looked at Indiana statute). a) Indiana staute specifically says ignore DE law: Revlon). b) PA has as well but can opt out (SHs pressured for this). 4) Helps managers keep pill in place in face of TO. 5) Court can‟t review decision unless management favors „selves. 6) Regulates 1st step of TO. G. Defensive Tactics and Fiduciary Duties 1. Types of defensive tactics: A) Poison pill: SH rights plan: Moran. 1) Flip in: gives SH (except acquiror) rights to buy common stock at 50% market price in certain % threshold triggered. 2) Flip over: directed at 2nd step. It allows SHs of T to buy shares of acquiror on the cheap. a) Not used b/c doesn‟t stop taking of control block b/c there is no 2nd step. 3) Acquiror must force board to pull pill by offer sweet premium or win proxy contest and have own board redeem pill. 4) Key aspect: Don‟t require SH vote to install or pull. 5) Courts deicde whether decision to pull pill or not is appropriate. 6) Court may force board to redeem pill: Pillsbury. a) Court has moved away from this. 7) Old pills forced C to self-destruct b/c trigger would make C buyback all shares at high premium and C would be destroyed. B) Greenmail: paying off annoying SH by buying back his stock at sweet premium. C) Restructuring: T offers better deal, in cash or debt securities, than hostile acquiror. 1) Works best when incentive of TO is assets of C are undervalued b/c T eliminates disparity by upping price. 2) Done via LBO or recaipalization (issue debt for stock). D) Shark repellant: adoption of state anti-takeover measures which can be any one listed (poison pill etc.) or supermajority provisions etc. (see state takeover statutes). E) Propaganda against hostile acquiror: e.g. Pennzoil. F) Sue acquiror for variety of reasons. 1) Jarrell: leads to higher return for T SHs. G) Defensive acquisition: buy C that would create antitrust problems for acquiror or make T less desireable. 1) Problem: acquiror can divest self of asset after deal. H) White knight. I) Lockup w/ white knight: crown jewel.
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J) White Squire: issue shares to friendly C who won‟t tender to hostile C. K) Pac-man defense: T make TO for hostile bidder. 2. Effects of Ds: if hostile acquiror loses, 2 scenarios: A) More likely: a second player comes in and SH get better price than original. B) Possilbe: C stays independant and in about 2 years, shares sink below where were before original offer. 3. Standard of review: Unocal. A) Fundamentally, merger should be either BJR or fairness but what box put it in? 2 possible angles: 1) Self-dealing: need fairness. 2) Business decision: BJR. B) Intermediate standard used: 2 part test: 1) Good faith: did directors have reasonable grounds for believing threat to corporate policy and effectiveness existed b/c of another stock ownership? a) Was offer coercive? Look to structure or substance. b) What are quality of securities offered? c) Was price inadaquate? Paramount I. d) Any illigality going on? e) What are risks of not accepting offer? f) What is reputation of acquiror? Greenmailer? g) What are best interests of SH? 1. Revlon seems to disapprove of solely looking at other constituencies. h) In general, 3 catagories: 1. Structural coersion. 2. Substantive coersion. 3. Opportunity loss: deprive SH of opportunity to accept better offer from management or 3rd party. 2) Proportionality: Was response reasonable in relation to threat? a) Unitrin‟s filling out of test: 1. Is measure draconian? a. Interference w/ acquiror‟s proxy contest is draconian. b. If defenses preclude any future offers, may be draconian. 1. Court seems to think no preclusion as long as SHs can vote board out if displeased w/ defense: Unitrin FN39. c. Is defense coercive? 2. Does action fall w/in range of reasonableness? a. If action takes various SHs into consideration, may add to reasonableness.
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b. Buyback program does this by adding liquidity for short term SHs and increasing value for long term SHs: Shamrock, Unitrin. c. Is action statutorily authorized form of business decision routinely made in nontakeover context? d. Is it (strictly) proportionate to threat? b) Poison pill is reasonable response: Moran. c) If there is a long term business plan in place, almost anything will be proportional: Paramount I. 1. After case, Cs put long term business plans into effect as a defensive mechanism. 2. What may not be disproportionate: a. New management plan. b. Recapitalization of C that prevents any future offers. c. Drastically changing C. d. Disinfranchising SHs: Unitrin. d) Lock-up may be void unless used to bring in new bidder. 1. Size of lock up must be compared to size of deal. 2. Good benchmark is what would value of “leg up” (letting knight get 9.9%) be? 3) If pass, its BJR, if not, its fairness. 4) After Unitrin, this test doesn‟t offer SHs much protection. C) Coercive TOs: FO price less than original TO. 1) Defense probably will pass test reasonableness test. 2) Junk bonds for 49% FO probably coercive. a) SH don‟t want bonds. b) Bonds very risky. 1. But interest rate will reflect risk. 2. But still not worth it. 3. But if breakup and sale, bondholders get paid 1st. 3) Unocal repsond to coercive TO w/ own coercive offer. a) If Mesa won, other 49% SH would get all assets. b) If Mesa loses, SH no worse off. c) Unocal ultimately says they‟ll buy 30% anyway. d) Either way, C better off b/c $$ used to buyback stock taken from worthless exploration excercises. e) Today, this may be voided due to coercive nature. 4) Why can Mesa be excluded from Unocal TO? a) If participate, they can finanace their own offer. b) Mesa doesn‟t need protection from own offer. 5) 13e-4 and 14d10: discriminatory self-tenders no longer allowed.
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6) Coercive TO not per se illegal but hard as hostile offer b/c board will put in pill and court will not make them redeem it. D) Non-coercive TOs: Court still allow pill use: also see #4 (K-man&G). 1) C may maintain pill if following a long term business plan that hostile acquiror will screw up. (Paramount I) a) Allows directors to “just say no.” 2) Reasoning: paternalistic: DE SH will be fooled to take lower price so pill is OK. 3) My problem: Arbs will protect minority SH by bidding price higher than offer and forcing acquiror to raise so don‟t need pill. E) Court doesn‟t judge b/w defensive tactics, just sets standard of review. 4. Kraakman and Gilson: Substantive coersion. A) Non-coercive offer may still be “coercive” in that offers high price which fool SHs into thinking getting good deal. B) SHs aren‟t idiots but may not believe management claims about potential value they can create. C) 3 ways management can create new value: 1) Bargining for better price. 2) Finding white knight. 3) Operating firm better and getting more value out. D) Court‟s need to look at managment‟s represenations re: future value creation and decide if there is threat. 1) Courts may be better than market at valuing managements proposed improvement to hostile b/c can reveal hidden info. 2) Courts must be able to see when management right and wrong for substantive coersion to work. 5. McDonald‟s SH rights plan: weak one. A) Unusal in that allows acquiror to call SH meeting for vote even if don‟t own shares. 6. Revlon duties: once firm is up for sale, board has duty to auction company and sell to highest bidder. A) Defensive tactics can be used to draw other bidders in but not to force them out. 1) Lock-up in Revlon voided b/c FL was already in bidding so don‟t need to induce them further w/ lockup. 2) Unconscionable defensive tacitcs may not be enforcable by white knight getting lock-up. B) No specific form of aution necessary and can favor one buyer over other if it will maximize SH wealth: MacMillan. C) Trigger = change of control of C: what is change of control? 1) Stock for stock swap is not change of control: Paramount I. 2) May be if one C is considerably larger than smaller C. a) This is my test saying depends on what control old SHs have in new C. (K-man says plausible).
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3) Bust-up buyout: may trigger Revlon depending on what % of assets sold. a) Problem: no bright line as to the sale of how many or which assets will trigger Revlon. b) Control shift is when corporate entity is destroyed: this is essentially Horsey‟s rule in Paramount I, but court adopts Allen‟s control shift test from Paramount II. 4) Cash TO. a) All cash: automatic Revlon. b) As % cash decreases, likelihood of Revlon decreases. c) My theory would hold that once get enough stock to retain “control,” then no Revlon. 5) Partial sale of assets by management: may not be here b/c same management still controls remaining assets which K-man looks to. a) Composition of management team not viewed as trigger. b) K-man says should be if Ts management team stay on b/c in diffuse C, management runs things: court ignores this! 6) Acquiror owned by controlling SH: Paramount II. a) Rationale: control premium of Paramount shifts to Sumner who can FO SHs or sell bloack to 3rd party. b) MacMillan: 36% was control block. 7) Any aggregation of control block. 8) Cash or stock TO for 51% and then FO in = amount of stock: probably won‟t trigger says K-man: UNLESS: a) Back end is not fixed amount before TO made. b) Back end is coercive, even if fixed b/x pushes SHs totake $$ part of offer. 9) MBO, perhaps even if no other bidders, must put C on block. 10) Merger w/ private C will trigger Revlon. 11) Whatever t-fers control premia from T to acquiror. a) Rationale: SHs entitled to max value if control changes hands. b) K-man doesn‟t buy this. 12) Whenever minority needs protction from majority opportunism. 13) Extent to which there is no continuity of interest: where T SHs don‟t get chance to participate in new synergies: e.g. cash TO. D) Rationale for change of control trigger: 1) Directors and SHs interests diverge if control changes; a) If management chooses, they‟ll do side deal and take part of SH‟s premium. 2) T SHs lose voting control and may be cashed out so Ts long term plan in jeopardy. E) Exceptions:
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1) If Revlon would normally be triggered but there is minority SH protection in acquiror‟s charter, Revlon may not apply. a) Supermajority voting provisions in charter for extraordinary actions. b) 2nd step of TO is fixed price. 2) Duty and then exception reflects fact that minority SHs not protected much in DE. 7. Problem w/ Unocal and Revlon: gives management incentive, if can‟t sell C to friendly acquiror, not to sell to anyone so SH may get screwed. 8. Transactional vs. operational justifications. A) If dealing w/ normal business decision, B of P on P. B) If deal w/ t-action, B of P on D.
VII. Insider Trading
A. Securities Market and Insider Trading. 1. 2 contexts (mostly 10b-5): A) Overt misrepresentation of some sort in connestion w/ purchase or sale of securities. B) Regulation of insider trading. 2. 10b-5 becomes private right of action: elements: A) Misrepresentation or omission; 1) Can‟t be just breach of fiduciary duty or unfair t-action, need some hint of fraud/manipulation in sense of deceit. (Green) 2) Green stopped 10b-5 from nationalizing corporate law. 3) P had argued that absence of business purpose for deal was sufficinet to satisfy fraud. A) Court reject b/c said congressional intent was to stop deceit via full disclosure B) Also there were plenty of state law remedies and comity becomes issue. 1. Actually, lower courts had bought Ps argument b/c at time, DE had little protection for minority SH and courts were pissed. B) Material and non-public information: D must trade for IT; or utter misrepresentation. 1) See part B. below and Basic v. Levinson. C) Scienter: Knowledge or gross recklessness of misrepresentation. 1) D tipper, tippee, etc must know info is material and non-public. D) Causation; (ignore) E) Reliance: FOM can be rebutted. 1) See part B. below and Basic v. Levinson. 2) Only required in cases of misrepresentation, not in classic IT. F) Injury: P must trade.
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1) P must actually sell shares to claim injury, can‟t say fooled into not selling as in 14e-4. 2) K-man doesn‟t understand this b/c can be just as hurt by not selling as if sell. a) e.g. controlling SH make misrepresentation and dumps his shares while others hold. 3) Damages: see B. 4. below. G) Jurisdiction: msu be some IC hook but there usually is. 1) Telephone used, major exchange etc. 3. Green stopped the 10b-5 explosion but still expanded after that: Goldberg. A) Goldberg: upheld suit where controlling SH didn‟t disclose overvaluation of assets that C bought. B) Thus, duty of loyalty dragged back into 10b-5. C) To succeed under Goldberg, need to show: 1) Misrepresentation or nondisclosure; 2) That causes loss to SHs. a) Causation demonstrated by showing remedy forgone b/c of lack of disclosure (like VA Bankshares) b) Circuits disagree as to how show lost remedy: 1. Kidwell: 9th Circuit: must show would have succeeded if actually brought suit. 2. Healy: 3rd Circuit: only need to show reasonable probability of success. B. Market Efficiency, Disclosure and Reliance. 1. Materiality and Basic: information is material depending on its probability of occurance and magnitude of the event. A) Old test: done in principle: 2 justifications. 1) Paternalistic view of SHs, don‟t want them to get overly optimistic. a) Seems to ignore EMH and role of Arbs. 2) Confidentiality of discussions important to thwart hostile bid. a) This is trade off for SHs b/c if require disclosure there will be fewer deals which is bad for all SHs. B) Does not imply that must disclose merger talks whenever they begin: just say no comment: FN 17. 1) Only works if always say it or else no is no and no comment becomes yes. 2) e.g. Dr. Pepper and Cadbury “nothing on boards.” C) Implication: don‟t have to report every piece of info that SHs would find important. D) Factors to look at for probability: board resolutions, instructions to IBs, actual negotiations etc. E) Factors to look at for magnitude: size of Cs and potential premium.
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F) No event short of actual closing is either necessary or sufficient to finding of materiality. 2. Reliance and Basic: if rely on market efficiency than have reliance even if don‟t hear misrepresentation b/c it will effect market price anyway: fraud on the market. A) Assumes EMH. 1) See CF outline for EMH discussion. 2) Not all markets are efficient so may not hold there: OTC, muni bonds market etc. 3) Gordon and Kornhauser: only need 1st step of EMH, not 2nd. a) 1st step: share prices represent value of shares given all public info: SS EMH. b) 2nd step: share price represent value of underlying assets. B) Can rebut reliance if: 1) D can prove SH would have sold anyway: a) Tax reasons. b) B-ruptcy liquidation. c) Poterntial antitrust problems. d) Political pressure from other businesses. 2) Market makers knew info was false. 3) P knew info was false. 4) K-man says these are worthless, if lie and its reflected in market, your liable. 3. SHs don‟t really benefit: often Cs are the Ds so just shifting wealth from one pocket to another. 4. Damages: we want to compensate solely for loss. A) Recovery = stock value when truth announced minus sale price. B) Problem: this overcompensates b/c at time of sale, merger not done so shares were not worth same as after deal done. C. Insider Trading (IT). 1. Introduction. A) Historically, no state law reached IT. B) Could have made Agency argument and breach of fiduciary duty but few cases went this way: Diamond: NY. 2. Section 16a-b: not about eliminating IT but about short swing profits. A) Rule 16a-2(b): 1) Defines statutory insider as D, O, or 10% beneficial owner. 2) Insiders must disclose trades/holdings 10 days after close of month. 3) D&Os must report all trades made while they are D&Os and any trade after the leave position if w/in 6 months of an opposite taction while D or O. 4) T-action where person becomes 10% owner not subject to Act.
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B) Section 16b and Rule 16a-2: C or SHs can bring suit to disgorge short swing profits. 1) Enforced by Ps bar. 2) Profits = any profits, not just those based on inside information. a) This irributable bright line rule. 3) Note: spinning not enforced here but may be soon. 4) Insiders liable for profits w/in 6 months, if leave and make sale after gone (a)(2)(b) or purchase before become insider (a)(2)(a), as long as can pair w/ opposite sale during previous 6 months. 5) 10% owner is only liable for purchases after becomes 10% (McKesson) and sales while he is 10% owner including one that puts him under 10% (Reliance). a) Rationale: access to info only occurs after get 10% block. b) Covers equity securities only if are 10% on as converted basis: Chemical Fund. 6) Profits decided on lowest in highest out basis of matching up various trades during 6 month period: Smolowe. 7) Investment Co., pension plans etc are exempt if buy only for investment purposes. 8) Unorthodox t-actions: if so, take pragmatic look to see if liability should attach, if not, use objective approach. a) Doesn‟t apply in case of merger where buy stock of target and sell stock of acquiror (after deal) as long as getting acquiror stock wasn‟t voluntary act (agree to merger): Kern. 1. Rationale: its 2 different Cs so probably have no inside info on acquiror. b) Sale doesn‟t occur when option is granted. c) If sell for cash w/in 6 months b/c lose tender offer and don‟t want to wait for deal to go through, liability attaches b/c no unorthodox t-action so court takes objective not pragamatic look. 3. 10b-5: A) IT discussion: 1) IT about systematically diverting returns from outsiders to insiders. 2) Who hurt most by IT? a) Sophisticated analysts who invest in info and trade every day. b) Small SH may not even know what‟s going on. 3) Hard to ground IT in 10b-5 b/c need fraud and if no misrepresentation, need a fiduciary duty.
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a) Problem is that 10b-5 doesn‟t create a fiduciary duty, need a broad duty to market like = access theory of TGS which is rejected in Chirella. 4) Occurs if insider, buy/sell when have material, non-public info and P is injured due to insiders buy/sell. B) Equal aceess theory: TGS. 1) Overruled in Chirella. 2) All traders have duty to market to disclose or refrain from trading on inside info until becomes public: Cady. 3) Insider is anyone w/ info that public doesn‟t have. 4) Anyone who trades opposite insider (on same day) is defrauded: fraud on market theory. 5) Advantages: a) Can reach all types of insider traders even if info comes from outside C. b) Victims easily identified: all uninformed traders. 6) Disadvantages: a) May chill good trading. b) 10b-5 requires fraud and w/o misrepresentation, need fiduciary duty for fraud which is not created by 10b-5. 1. Its hard to argue that have duty to whole market and w/o duty, no one harmed b/c people trade on superior info all the time. C) Fiduciary duty theory. 1) Insider/tipper liability: RETAC: need relationship of trust and confidence w/T for liability to attach: Chirella. 2) Who has RETAC? a) T has it w/ SHs. b) D&O. c) Temporary insider: D trusted w/confidential info: IB of T d) Agents of T. 1. Notion is whether we expect that in the e‟ee-e‟er relationship there is this general promise not to divulge secrets. e) Switzer: not liable b/c info gotton by chance or diligence. f) Cs can K out of law by giving info away but court/SEC is quick to find QPQ so its dangerous. g) Family member of T w/pre-existing fiduciary relationship 1. Had discussed confidential family business before. 2. D promise to relative to keep confidential. 3. D trade for relative. h) This is a SC created fiduciary duty.
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3) Tippee liability: liable only if tipper breached fiduciary duty in telling you: Dirks. a) Requires scienter: knowing info was material nonpublic. 1. Seems silly b/c if hear of TO, of course its material and if price not move its not public. b) Duty breach transfers to tipee. c) May go to tipee #2 and down line as well if QPQ. 4) Tipper only violates duty if get QPQ for info. a) Blakmun‟s dissent: but harm to other traders either way. b) Counter: duty doesn‟t derive from harm but from RETAC. c) Rationale: always soft core IT w/ analysts and Cs but we encourage it and don‟t want to chill analysts activities. d) SEC/courts will; stretch to find QPQ and may depend on if disclosure was pre-meditated and not just accidental. e) SEC will read it as $$ gift and QPQ. D) Misappropriation theory: deceitful misappropriation of inside info is itself fraud when done in connection w/ purchase or sale: O‟Hagan. 1) Tipees of misappropriators also liable (under same requirements of fiduciary duty theory.) 2) Who can misappropriation theory reach? a) Fiduciary relationship w/ acquiror. b) Broadcaster or publisher such as WSJ. c) $$ management firm. d) Main issue: was there express or implied confidentiality agreement. 3) K-man agrees w/ it but says it decouples fraud from trading. 4) SC stretch doctrine b/c hard to see how fits w/ securities fraud. 5) Still about deception but of those who entrust D w/ inside access a) Liability dissolves if trader tells person he is using info. 6) Advantages: a) Can reach all sorts of IT. b) Isolates real duty and fraud by focusing on conversion of valuable info and not fictional duty b/w uninformed traders and ITer. c) Reflects idea that IT wrong b/c of conversion of info not info disparity w/in market. 7) Disadvantages: a) Transforms securities fraud into fraud on market. b) E‟ers may be able to opt out of it. c) Family members cover for each other. 1. Hard to show which family member are insiders, which have duty to family, if duty to spouse etc.
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2. Court just kind of makes up why certain family members may be liable. 3. Joint assets maylead to liability b/c its as if insider traded. E) Put together some kind of list of various arguments that can be made either way. 4. 14e-3: imposes duty to disclose or abstain on any person who gets info originating from T or acquiror, A) Only applies in context of TOs. B) Imposes general = access theory. C) Tippers can‟t tip if reasonably forseeable that tipee will trade AKA tip not made in good faith: 14e-3(d). D) Rationale: prevent acquirors from tipping friends who then capture part of premium paid by acquiror (especially if QPQ involved). E) Scienter: trader must know or have reason to know that info came directly or indirectly from T, acquiror or agent of either of them. F) Doesn‟t apply to purchases by broker of acquiror 14e-3(c)(1). 5. Damages: A) ITSFEA: 1) Allows SEC to impose treble damages + disgorgement or else expected return on IT would be +: 21A-a(2). 2) Private right of action: 20A(a). 3) Bounty hunter provision, up to 10% SEC recovery: 21A-e. 4) SEC can impose civil fines of up to 1 million or treble damages on controlling person of insider trader: 21A-a(3). a) Requires scienter: 21A(b)(1)(A)&(B). 5) Tipper J&S liable: 20A(c). B) Ligget: posibilities for damages: 10b-5 case. 1) Out of pocket: amount stock incresed or decreased after revelation of info minus sale price. a) Problem: Too much recovery, too draconian. 2) How much IT actually effect market price. a) Problem: great idea but too hard to measure. 3) Limits to recovery: a) Profit D made. b) If its loss avoided, compare sale to price reasonable amount of time after info announced: 21A(f). c) Disgorgement by SEC is offset againt liability under 20A(b)(2) but no offset under 10b-5. b) Benefits: 1. Avoids above problems. 2. Avoids windfalls for Ps. 3. Roughly proportionate to amount of harm done. C) Acquiror may be able to recover D‟s profits or loss cause by increase in acquisition price: not sure under what theory.
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D) Fraud on Market vs. IT actions: 1) FOM brought by P‟s bar b/c recovery is out of pocket but IT brought by SEC or Justice Department b/c recovery much less and not worth the suit. F) Academic debate for IT: 1) Scott: IT is part of systemic risk and share prices reflect IT risk so shouldn‟t worry about SHs, a little more risk OK, can diversify. a) Arguments for Scott: 1. Maybe makes markets more efficient b/c stock prices reflect info better: e.g. HK where banks use stock price as measure of stability b/c IT was OK. 2. We need some IT (good kind) b/c w/o it, we lose coupling of managment and SH interests via common ownership of stock. b) Against: 1. If SHs can‟t trust market, they may go elsewhere and cause big problem: (deter investing). 2. Scott‟s arguments also work for endorsing officers stealing $$, SHs could anticipate it and reflect in stock price but this would be inefficient. 2) Fischel: SHs may prefer it b/c makes share prices informationally more efficient. a) Arguments for: 1. Make risk averse managers take on optimum amount of risk. 2. Make manager work harder so aligns them w/SH. 3. Allows Cs to reduce salaries and leads to cost free method of compensation negotiation. b) Against: 1. May lead to perverse incentives: a. Competition b/w managers to trade 1st. b. W/holding info till can trade on it so market is less efficient. c. Increase risk of firm b/c they profit either way: my risk/reward point. 1. Counter: restrict trading to calls and long stock. 2. Use ESOPs for incentive. c) Why not at least allow Cs to opt out of it? 1. K-man answer: b/c of collective action problem, we would be suspicious if SHs actually approved it. d) Its all about property rights and allocating b/w parties and what most efficient allocation is. 3) What‟s missing in debate?
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a) 3rd party effects cause more costs than people realize. 1. Counter: some may be + externalities: HK banks. 4) Arguments for (E273-74) and against (E270-73) IT: a) Against IT: 1. May move price enough to induce trader. 2. Lead to managers running C in inefficient way b/c concentrate on spotting good trading opportunity, not SH value. b) For IT: 1. Allows for truer valuation of stock when disclosure can‟t be made (to protect Cs interests). G) K-mans take on it: VII 109-114. 1) Deregulatory argument serve to help us describe what IT is and what banning IT accomplishes: allocating property rights to firm. 2) Critics are correct in that its hard to ascertain how those who trade opposite ITs lose. 3) Also correct b/c redistributuion to insiders has little bearing on fairness. 4) Insiders have higher returns anyway b/c of non-material inside information. 5) IT makes prices more informed but not as much as critics of IT may claim b/c may trade in a way that it has little effect on market. a) Thus, K-man says why not just change regulations to require insider disclosure immediately after they trade. 6) Compensation idea of IT is wrong: a) Allows managers to unbundle incentive features by profiting on gains or losses of C. b) Takes away firms ability to regulate amount of compensation mangers get. c) Managers may hoard info. d) Person who comes up w/ good idea may not reap reward but supervisor may and this = perverse incentive. e) It would allow managers to get large rents from SHs w/o any check. f) SHs would suffer ex ante b/c they value shares assuming IT but same argument made for theft. g) Since most loss falls w/ most active traders, market liquidity may be hurt. h) Leaking to arbs before deal (generally accepted in market) may hurt SHs, even if it facilitate hostile bids, b/c up to 1/3 premium may be eaten up by this and loss may outweigh gain. H) How does IT play out in theme of course? 1) Principle-agent problem: insiders are taking advantage of SHs.
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a) Fischel sees it as form of compensation but then why not C opportunity also? b) We get back to Meinhard: who is proper rights holder? 1. Fischel argues for Salmon. 2) Mandatory v. default terms: Fischel: why not let SHs decide? a) Much of C law is default and can opt out, only a few are mandatory like IT. 1. Actually a limited form of opt out as in Dirks. b) Why not have default? 1. Collective action problem: see above argument. 2. Externalities: it effects the market more than just C‟s SHs: distrust of Cs, distrust of O‟Hagans and Chirellas, animosity towards market etc. 3) Market efficiency: a background issue throughout the course. 4) Who makes C law and what do we think about this? a) Its odd amalgam: state courts (especially DE), NYSE rule makers, ALI/RMBCA scholars, and securities law (Congress/SEC). b) Largest deals are being governed by Revlon, Unocal etc which are confusing, ex post common law regualtions: c) Thus, why not have ex ante regulation by legislature and not by common law? 1. “C law is not static. It must grow in response to, indeed anticipation of, evolving concepts and needs. Merely b/c GCL is silent as to specific matter, it doesn‟t mean that its prohibited.” Unocal. a. Demonstrates how legislature made law is good for general precepts but not specifics. 2. Holmes: “common law can‟t be dealth with as if contained only axioms and correlaries of book of mathematics”: CL lends self to this developing style. 3. IT: congress don‟t define b/c don‟t want to leave things out, easier to leave to court/common law.
Course Overview
A. See outline page 106. B. Note the 5 characteristics of Cs. 1. Limited liability was around before C law, it was K‟ed for: law comes from economic rationales not from law itself. A) This is reason to prefer common law over legislatutre made law: it comes from economic rationales which are always evolving in market; it is easier to leave to common law, the Revlons and Unocals will clear up. 2. Centralized management: have agency problems. A) Protect SHs from B of D.
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B) Proptect minority SHs from majority. C) Protect non-SH constituencies. D) How protect? 1) Direct representation of SHs on board. 2) Direct deciding by SHs: those major decisions like M&A that they get say in. 3) Fiduciary duty coupled w/ judicial review. 4) Regulation control SH t-actions (self-dealing). 5) Regulate misrepresentation on market.
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