1 I. THE CORPORATE ENTITY I. CHARACTERISTICS OF A CORPORATION A. JURAL PRESENCE: can own and dispose of property, can contract B. Can sue and be sued C. Can have perpetual life D. Transferrable shares E. No individual liability for managers or s/h F. Can only exist by act of state (statute) G. State law determines rights and remedies, but overlay of federal law is Securites Acts of '33 and '34 H. Law is directive--provisions of statute cannot be contracted away (tells in significant detail all that governs) I. Investment must remain until creditors are paid off (Wood v. Drummer) II. TYPES OF BUSINESS FORMS A. SOLE PROPRIETORSHIP 1. must adhere to FICTITIOUS NAME STATUTE--register so people know who they are dealing with. This is the only governmental involvement. In NY, not filing is a misdemeanor. 2. Business is NOT an independent legal entity--same assets, income and liabilities as owner B. GENERAL PARTNERSHIP 1. DEFN: Association of 2 or more persons to carry on as co-owners of business for profits 2. FORMATION: by contract of partners, not by state. The only requirement to be met is the STATUTE OF FRAUDS. 3. ENTITY CHARACTERISTICS: Law is unclear as to whether partnership is entity. a. owns property b. common name statute adopted by every state c. partnership can sue and be sued in common name d. partnership is for LIFE ONLY--dissolved by death, incapacity or bankruptcy of partner unless partners agree that when one dies others will buy out his interest e. not freely transferrable f. LIABILITY: PERSONALLY AND UNLIMITEDLY LIABLE for all debts and obligations of firm g. partners can bind other partners to a contract h. FIDUCIARY RELATIONSHIP between partners i. TAX REPORTER: files return showing individual partners' income and deductions but does not compute or pay tax j. UNIFORM PARTNERSHIP ACT is interstitial--only applies in absence of agreement of the 2 partners. Since UPA is unfavorable, it encourages partners to make their own contracts. C. LIMITED PARTNERSHIP 1. DEFN: 2 classes of partners, 1 class consisting of 1 or more partners not personally liable for debts of partnership and not expected to participate in day-to-day affairs of partnership 2. Created exclusively by state statute, and must have public filing to create it 3. Name must contain "ltd" 4. Uncertainty over exactly what limited partners can do to have shield of limited liability 5. Taxed as a partnership D. CORPORATION 1. Created by STATE; statutory formalities 2. PERPETUAL life, as stated in charter documents 3. LIABLE for debts and obligations itself--s/h, officers and directors not personally liable 4. directive state statutes govern 5. is an ENTITY 6. TAXPAYER: files return and pays taxes just as individual would III. FORMATION OF CORPORATIONS A. INCORPORATOR: only lasts as long as it takes to incorporate--incorporator signs articles of incorporation 1. NY 401: 1 or more natural persons, 18 or older 2. DE 101: any person, partnership or corporation 3. Incorporator's role ends once Bd of Dirs elected B. WHERE TO INCORPORATE: 1. Simple business should incorporate in state where it's doing business (local)--if incorporate in another state, must pay tax where doing business and where incorporated 2. Public corporation should incorporate in Del (must have office in Del) b/c: a. Del law is extremely well-developed and therefore high level of predictability b. Law is ascertainable b/c precedent on every issue c. Equity cts handle most law d. Sophisticated bench b/c experienced C. NAME OF CORPORATION: 1. Must be unambiguous that it is a corporation--best to use corp, corporation or inc. 2. restrictions on name of corpn--NY 301(a), Del 102(a)(1) 3. can pre-clear proposed name with Secy of State 3 4. can make sure name will be available by time papers are drawn up and reserve name for 60 days in NY (303) or 30 days in Del (102(a)(1)) D. CERTIFICATE OF INCORPORATION 1. Filing with Secy of State triggers corporate existence (NY 403, Del 101, 102, 106) 2. MUST CONTAIN: a. NAME (NY 402(a)(1) and Del 102(a)(1)) b. PURPOSE: "any lawful purpose" (NY 402(a)(2), Del 102(a)(3)) 1. Prior to "any lawful purpose" language, had to list purposes, and if corpn engaged in activity beyond what was listed, there was great danger of ULTRA VIRES suit with unlimited liability and act declared invalid. 2. Del 124 and NY 203 limit thrust of ultra vires doctrine--no act of corpn shall be invalid just b/c corpn lacked power to act in such a manner. S/h can sue to enjoin any acts of the corpn, corpn can sue director for loss due to his act, or attorney general can enjoin or dissolve corpn. But this is never done, so in effect the ultra vires doctrine is eliminated. 3. Some s/h want to confine corpn to business they were originally told about. c. DURATION (if other than perpetual) 1. NY 402(a)(9) and Del 122(1) d. AGGREGATE NUMBER OF SHARES CORPN IS AUTHORIZED TO ISSUE, PAR VALUE 1. NY 402(a)(4) and Del 102(a)(4) 2. Prevents the problem of OVER-ISSUE. S/h knows the exact % of profits he's getting. e. CLASSES OF STOCK AND RELATIVE RIGHTS OF EACH 1. NY 402(a)(5), (6) and Del 102(a)(4) f. LOCATION OF MAIN OFFICE 1. NY: a. County in which office will be located (NY 402(a)(3)) b. 2. name and address of registered agent (NY 402(a)(8)) 2. Del: a. address of registered office and name of registered agent (Del 102(a)(2)) b. name and mailing address of incorporators (Del 102(a)(5)) g. Secretary of state acts as agent of corpn and accepts service of process (NY 402(a)(7), Del 321(b)) 4 3. OPTIONAL: C/I may include: a. LIMITATION OF LIABILITY: may limit or eliminate personal liability of directors for negligence but not for corprorate wrongdoing. 1. NY 402(b) and Del 102(b)(7) b. Provision regarding internal governance and any other provisions required to be in the bylaaws (Depends upon whether incorporators want to consitutionalize these procedures) 1. NY 402(c) and Del 102(b)(1) 2. Best not to put in certificate of incorporation b/c then difficult to amend 4. Sign, notarize and file certificate of incorporation (NY 403 and Del 106) 5. Hold meeting to adopt BYLAWS and decide fiscal year. 6. Elect board. (Incorporators resign) E. BENEFITS OF INCORPORATING 1. Lower transaction costs than a partnership b/c don't have to negotiate everything--in the statute 2. LIMITED LIABILITY, but this is something corpn grows into. Initially Joe and Louie get credit based on their own personal guarantee, so only get limited liability at the point where creditors trust you. 3. Corpns starting out get special tax rate lower than partnership rate--the first $50,000 is taxed at special 15% tax rate. F. DOUBLE TAXATION 1. Corpn pays taxes on its earnings, and s/h pays taxes on its dividends. a. Compare corpn to partnership: Req. Corp. Earn.=Demanded Return/(1-IR)(1-ER) If DR=5,000, IR=ER=36% For partnership: RE=5,000/(1-.36)(1-0)=7,812 For corpn: RE=5,000/(1-.36)(1-.36)=12,207 So need to earn more as a corpn to achieve the same demanded return. 2. BUT Subchapter S permits some corpns to be taxed like partnerships (tax reporters, not taxpayers). Only s/hs are taxed on their personal incomes, which includes their share of the corporation's earnings. Also, if corpn loses money, Joe and Louie can deduct the losses from their personal returns. Terminate Subchapter S election once corpn begins to make profit b/c Joe will get his money out as a salary, not dividends, and salaries are deductible to corpn. G. Once incorporate, place of incorporation's law applies. 1. McDermott: (Delaware) McD Del (sub) reorganizes with McD Panama (parent) by swapping shares. In U.S., subsidiary cannot vote shares of its parent. But this is not true in Panama. B/c this is a 5 Panamanian corpn, Panama law is followed, and subsidiary can vote shares of parent's stock (INTERNAL AFFAIRS DOCTRINE) a. POLICY: In general, U.S. sub doesn't vote for parent b/c we consider the sub to be controlled by parent, and consequently it's like the dirs using all of the sub's shares to vote for themselves. 2. This law provides certainty. IV. DEFENSES RAISED IF DEFECTIVE FORMATION A. DE FACTO CORPORATION: Although corpn is not properly formed under state law, things have gone far enough in corporate process that state will see it as existing. 1. Many states have formally abolished de facto corpn doctrine. If de facto doctrine exists, directors and s/hs are not personally liable. 2. 2. REQUIREMENTS: a. statute exists under which corpn could have been organized b. good faith effort to organize under the statute c. some activity carried on in name of corpn 3. De facto corpn status is only defense against 3rd party, not against the state. 4. Timberline: (Oregon) D was a de facto corpn before C/I was filed. D rented equipment from P. D defaulted on payment. P attempts to hold D's president personally liable. Ct rejects de facto coprn defense and holds D personally liable b/c Oregon follows Model Business Corpn Act which abolished de facto corpn doctrine. 5. De Facto status arises if: a. corpn doesn't have perpetual charter and it lapses unbeknownst to corpn b. corpn is delinquent in public filing (tax return), so corporate existence terminates for failure to file. B. CORPORATION BY ESTOPPEL: 1. used if can't show it's a de facto corpn 2. one who has recognized an organization as a corpn in business dealings should not be allowed to argue that it is not a corpn 3. This is effective for only a specific transaction. 4. Timberline: D argued P was estopped from denying D's corporate status. Ct rejects b/c P did not misrepresent state of affairs, D did. (P wasn't estopped b/c roles of parties are reversed--usually estop the party who made the misrepresentation.) 5. Use corpn by estoppel if: a. D claims it's a corpn; P relies; D denies 6 corporate status when sued by P; P assert corpn by estoppel. b. Defective corpn (P) sues D; D argues P is not a corpn; P argues corpn by estoppel. OR c. P sued indl s/h (D) who argues corpn by estoppel to avoid personal liability. 6. Corpn by estoppel is similar to de facto corpn but a. de facto theory can apply to involuntary creditor (tort claimant) and estoppel can't b. estoppel is easier to show so only use it if can't show de facto corpn b/c de facto is stronger argument 7. Cranston v. IBM: 3rd party dealt with business as if it were a corpn. In fact, it wasn't b/c without knowing the attorney had negligently failed to file the cert. of incorpn before the transaction with the third party. Ct applied estoppel and 3rd party won. C. If there is no corpn, who is potentially liable to 3rd party? 1. Timberline: Oregon statute says "all persons who assume to act as corpn"; Ct interpreted this as those who invested in and participated in decisions of organization 2. s/h active in the business 3. AGENCY RULE followed in NY and Del: 1. IMPLIED WARRANTY OF AUTHORITY: Whenever X deals with Y on behalf of X's employer, and X purports to bind Y, X is making an implied warranty that X has the authority to bind. If X actually lacks authority, Y can sue X for breach of this implied warranty, and X can sue the directors. D. D. QUO WARRANTO 1. DEFN: A proceeding brought by the STATE designed to test the corporate status of an entity. 2. Defective corpn will argue that it has de facto status, but this argument will fail b/c this is only a defense against a 3rd party and is not applicable against the state. 3. DE MINIMIS exception: If noncompliance is extremely insubstantial, cts are likely to treat a corpn as existing de jure. V. DISREGARDING ENTITY OF CORPN: "PIERCING THE CORPORATE VEIL" A. The general rule of corporate business is that s/h may not be held personally liable. B. Piercing the corporate veil will emerge in 2 situations: 1. PARENT/SUBSIDIARY RELATIONSHIP where parent should be held liable for actions of sub. 7 2. CLOSE CORPORATIONS: Companies, all of whose stock is owned by relatively small number of people so that individual s/h may be held liable for actions of close corpn. Absence of public market. Overlap between mgt and ownership. C. When is the veil pierced? 1. FRAUD: a. Use of the corporate form to evade creditors b. Corpn is specifically formed for evasion of statute or some other duty 2. INADEQUATE CAPITALIZATION: Corpn is formed to avoid liability likely to be incurred in unreasonably risky operation. 3. INTERMINGLING: a. Failure to observe the corporate form or statutory requirements. b. S/hs in close corpn using the corpn to further their own personal interests c. Comingling of personal and corporate funds D. Penntech: (Federal court--Maine) (parent/sub) 1. FACTS: P acquires K through TP. K is losing money. P agrees to pay off K's creditors and a % of claims. P does this b/c it wants to keep the agreement between the Union and K and avoid collective bargaining problem. After P pours money into the company, it closes down. Union wants to compel P to arbitrate even though P is not a party to collective bargaining agreement--wants to disregard corporate entity of K and arbitrate with P so that it can get arbitration award from P. a. Note: DOWNSTREAM MERGER to change place of incorporation. K(NY) formed sub called K(ME) and then transferred everything to K(ME) and then merged the 2 corpns so that only K(ME) was left. b. Creditors of K favored acquisition b/c P gave them business and there was a potential for their former claims against K to be paid off. 2. Ct applied INSTRUMENTALITY TEST--disregard corp. entity of sub and hold parent liable if: a. complete domination by parent over sub--court said this was present b/c officers and directors so intertwined b. control by parent used to commit fraud--ct said not present b/c P did not buy K to defraud employees AND c. control and fraud was proximate cause of plaintiff's injury 3. Ct also held that the corporate veil can be pierced if it's the only way to protect a substantial federal policy or interest. 8 E. Riddle v. Leuschner: (California) (close corpn) 1. FACTS: P, the creditor of Y, sought to hold K and Leuschners liable for amount due. P claimed corpns were the alter egos of Leuschners. Records showed numerous loans from Ls to both corpns with no evidence of director or s/h approval, so it's possible to conclude that L was using corpn for personal advantage. No formalities were upheld. Both corpns were "controlled, dominated, managed and operated" by Ls. Ls transferred assets from Y to K. 2. Ct held that there are 2 requirements for disregarding corporate entity. a. UNITY OF INTEREST AND OWNERSHIP so that separate personalities of corpn and indls no longer exist. AND b. if acts are treated as those of corpn alone, an INEQUITABLE RESULT will follow. So Mrs. L and L, Jr. were held personally liable. F. ENTERPRISE LIABILITY: Walkovszky v. Carlton (NY) 1. FACTS: D owns many cab corpns, each consisting of 1 or 2 cabs and legally minimal amount of insurance. P, injured by taxi owned by Seon Corp., wants to reach assets of all cab corps and hold D individually liable for damages. P alleges corpns are operated as single entity for purpose of limiting liability, which is a fraud on the public. a. Note: D would have to pay a higher insurance for each cab if all cabs were in 1 corpn b/c had he put them all in 1 corpn, his whole business would be at stake. b. Note: All the big respectable cab companies would go out of business b/c they'd have so much insurance to pay. c. Note: Ct has special sympathy for P b/c P is an involuntary plaintiff--he was hit--as opposed to contracting with an insolvent company. 2. Ct held: a. pleadings were insufficient to hold D personally liable b/c there was no evidence of shuttling funds between the various corpns. b. since D was acting according to the statutory minimum, it's a legislative issue--if insurance coverage is inadequate, have legislator raise it. 3. ALTERNATIVE VIEW held by Berle and rejected by ct: Where a number of corpns are doing business as 1 enterprise, each corpn should be liable for debts 9 and obligations of the others. Look not at the number of corporate charters but at the number of discrete businesses. a. This is not widely accepted under state law but it is under federal. G. Disregarding corporate entity is highly dependent on state law: 1. NY ct generaly refuses to disregard entity to reach s/h. NJ did allow. Cts are generally more willing to disregard corporate form as they get further west. VI. CAPITALIZATION AND DISTRIBUTION UPON INSOLVENCY A. Differing definitions of CAPITAL: 1. physical assets used to produce more wealth 2. business person's view: money that will not be withdrawn until demand is made (bonds, stocks). Form of $ coming in is of utter indifference to person running business as long as he can control $ going out. 3. lawyer's view: money invested in business in exchange for shares of stock. Corporate capital cannot be withdrawn until creditors have been paid off. This is different from loans made by s/h. B. More common for s/h to make LOANS to corpn than invest capital b/c: 1. Dividends are taxable to s/h and not a deduction to corpn. Interest on loan is deductible. Req. Corp. Earn. = Demanded Return/(1-Corp Tax Rate) Assume DR = 5,000 and Corp. Rate = 15% If loan interest is paid to s/h, then RCE = 5,000/(1 -0) = 5,000 b/c interest is deductible. If dividend is paid to s/h, then RCE = 5,000/(1-.15) = 5,882 So need to put in less money to get the same amount out if put it in as loan. 2. If business fails, there's a chance at getting money back at the end as a creditor but not as a s/h. 3. If buy stock and later sell it back to corpn, then the money you collect when you sell it back is treated as a dividend and thus taxed. C. Mader's 1. FACTS: G and H (s/h and officers) loaned money to corpn. The business failed, and corpn sold all of its assets. Receiver was appointed to keep track of the assets and handle creditors' claims. Receiver wants G and H's claims to be recharacterized either as subordinated to all other creditor claims or to be treated as capital 10 contribution by s/h. 2. Trial court used Brady standard to see if loans should be subordinated--SUBORDINATE IF: a. corpn is in bad financial shape at time loans made b. money needed and couldn't be gotten from banks AND c. notes given by corpn to lenders were demand notes bearing a moderate rate of interest 3. BUT Brady test discourages s/h investment, so Supr. Ct. used WISCONSIN RULE. SUBORDINATE IF: a. loans were made by s/h in position of control b. loans were not meant to be repaid in the ordinary course of corpn's business but rather to remain part of corpn's financial structure AND c. amount of stated capital must have been unreasonably small relative to the nature and size of the corpn's business. 4. G's claims are not subordinated b/c only (a) of Wisconsin rule test was met. So they were considered loans. D. ORDER OF PAYMENT UPON INSOLVENCY: 1. Generally, subordination of debt is contractual. 2. SECURED CREDITORS: a. Collateralized debt and creditors use collateral to satisfy obligation. b. Secured creditor's claims can be recourse or non-recourse: 1. NONRECOURSE obligation: secured creditor only gets amount = to security interest (collateral) 2. RECOURSE obligation: secured creditor is entitled to entire amount of his claim, but amount beyond security interest is ranked as general creditor claims. 3. PREFERRED CREDITORS: a. wages b. taxes and other government claims c. costs of administering an estate 4. GENERAL CREDITORS: unsubordinated, unsecured and unpreferred a. suppliers; accounts payable; loans b. Declared but unpaid dividends c. To see what each general creditor gets: (remaining assets/remaining liabilities)*claim 5. SUBORDINATED CREDITORS 6. CONTRIBUTIONS TO CAPITAL AND SHAREHOLDERS E. SUBORDINATION: 1. DEFN: Senior creditors are entitled to collect the amount due them before holder of subordinated claim 11 2. TYPES: a. INCHOATE SUBORDINATION: Junior debt is subordinated to senior debt but only in the EVENT of a voluntary or involuntary distribution of assets among creditors or an event of default on the senior debt. 1. Since subordinated debt resembles common stock (i.e. it doesn't get paid until debts are paid), it broadens the equity base and makes borrowing easier. (But subordinated debt is still debt.) 2. Creates a cushion for senior lenders b/c in the event that the company goes bankrupt, senior lenders will get their share of the pie and junior lenders' share of the pie, too. 3. Typically found in public companies. b. COMPLETE SUBORDINATION: Junior debt is IMMEDIATELY subordinate to senior debt and cannot be paid at all until senior debt is paid. 1. Comes up in small business context (Ex. Bank will demand that loans by mgt to corpn be completely subordinated to the bank's loans.) 3. If A's claim is subordinated to B's claim, B takes up to the amount needed from A's normal distribution to make B whole. Called "DOUBLE DIVIDEND". 4. Why issue subordinated debt instead of stock: a. interest paid by corpn on sub debt is tax deductible b. interest rate on sub debt is usually lower than dividend rate on preferred stock, which is an alternative means for corpn to raise money. So subordinated debt increases the borrowing capacity of corpn. c. sub debt broadens the equity base w/o diluting ownership interests F. SUBROGATION: "stepping into the shoes of another" 1. Following payment of claims, subordinated debt is subrogated to the senior claim. Sub debt paid off bank and has claim against corpn for unpaid balance. Sub debt has right to get his entire claim back. Subordinated debt did receive the money, but since he had to pay off the bank, he is still entitled to receive his entire claim. 12 II. THE DIRECTOR'S ROLE A. Business affairs are managed by or under the direction of the Board of Directors. 1. NY 701: Business of corpn is to be managed under Board of Directors. 2. Del 141(a): Business and affairs of corpn shall be managed by or under the direction of the board. This can be modified to give such duties to other individuals as provided in cert of incorpn or bylaws. 3. Continental Secs v. Belmont: (NY) S/h derivative suit in which s/hs, on behalf of corpn, sued dir to cancel shares of stock he issued w/o receiving consideration. Dir moved to dismiss b/c s/hs didn't ask s/hs as a group to bring the action. Ct denied motion to dismiss and said since S/H CAN'T INITIATE ACTION or require corpn, dirs or officers to initiate action, there's no need for s/h to ask group of s/hs to sue. ONLY DIRS CAN ACT RE: ORDINARY BUSINESS OF CORPN unless statute gives power to s/hs. S/hs can only agree, request or recommend action to Board. a. Notes on S/H DERIVATIVE SUITS: 1. X corpn has claim against Y but decides not to pursue the action. S/h of X corpn demands X corpn sues Y. X corpn refuses, so s/h sues X corpn and Y. 2. DEMAND REQUIRED CASES: S/h must make demand on Bd of Dirs to sue Y. 3. DEMAND EXCUSED CASES: S/h need not make demand on Bd of Dirs to sue b/c Bd is in cahoots w/Y, so it's a waste of time to demand a suit. 4. CONTEMPORANEOUS OWNERSHIP RULE: S/h cannot maintain a derivative suit unless he was a s/h at time of events he's complaining about, unless shares were devolved upon him by operation of law (i.e. inheritance). 5. Proceeds of suit if s/h wins go to the corpn, so the only reason s/h brings suit is for attorney fees. B. QUALIFICATIONS TO BE A DIRECTOR: 1. NY 701: Must be 18 years old (Cert of incorpn and bylaws may prescribe other qual.) 2. Del 141(b): Completely within internal control. Only what bylaws and cert of incorpn require. C. NUMBER OF DIRECTORS 1. NY 702(a): a. Not less than 3 dirs, but if there are fewer than 3 s/hs, can be fewer than 3 dirs but not less than number of 13 s/hs. b. Any number of directors above 3 may be set by the bylaws or by a vote of s/hs if the bylaws permit. If not stated, number is 3. c. ENTIRE BOARD means the total number of directors which corpn would have if there were no vacancies. 4. NY 702(b): Number of directors may be changed by a bylaw amendment. If the bylaws allow the number to be changed by the Bd itself, then it must be changed by the ENTIRE BOARD. No decrease in number of directors required shall shorten the term of any incumbent director. 5. NY 707: Quorum is majority of entire board (Note that C/I or by-laws may fix quorum at more or less than majority but not less than 1/3) 6. Del 141(b): a. Only required to have 1 director. b. Number may be fixed by bylaws or cert of incorpn. c. Dirs need not be s/hs unless so required by cert of incorpn or bylaws. d. Majority of total number of dirs is a QUORUM unless cert of incorpn or bylaws require higher number. Bylaws may have quorum less than majority but at least 1/3. e. To approve most corporate action, the majority of a quorum is required to vote for it. D. ELECTION OF DIRECTORS: 1. In NY and Del, all directors are elected annually by a PLURALITY of present voting shares in the presence of a quorum of s/hs unless cert of incorpn says otherwise. a. Quorum of s/hs is majority of all shares outstanding entitled to vote. b. So the number of present voting shares must be at least a quorum, but it can be more than a quorum. So the number of votes needed to elect a director must be a plurality of the present voting shares. 2. 2 types of BOARD STRUCTURES: a. CLASS VOTED BOARD: Cert of incorpn may provide for the election of 1 or more dirs by the holders of the shares of any class or series of stock. Terms are generally 1 year. 1. NY 703, Del 141(d) b. CLASSIFIED BOARD: Dirs serve for multiple year terms. Elections are staggered so that some portion of Bd is elected each year. 14 1. NY 704: Dirs may be divided into 2, 3 or 4 classes, as equal in number as possible, each with no less than 3 dirs (so there's a maximum term of 4 years.) 2. Del 141(d): Dirs may be divided into 1, 2 or 3 classes (so the maximum term is 3 years.) 3. Purpose of using a classified board is to ensure stability in the board and is an anti-takeover device b/c it would take a few years for the tender offeror to control the Bd of the company being taken over. (Slain doesn't think this works as an anti-takeover device b/c dirs will resign if they don't agree with the takeover.) E. MEETINGS OF BOARD OF DIRECTORS 1. Valid board action can occur only when QUORUM of Bd if present. 2. NY 707: a. QUORUM is majority of the entire board (defined in 702(a) as total number of dirs corpn would have if no vacancies). OR b. Cert of incorpn or bylaws may allow quorum to be more or less than a majority, but not less than 1/3. c. Ex. If X corpn is authorized to have 20 dirs but at present only has 15 dirs, nevertheless need 11 dirs to make a quorum, assuming that quorum is a majority. d. BUT if the number of people currently on the Bd is less than a quorum, that number is treated as a quorum only for purpose of filling a vacancy. So need majority of dirs in office to vote to fill vacancy. (Dirs can temporarily fill vacancy until next annual mtg, when s/hs vote for dirs. NY 705(a), (c), Del.) 3. Del 141(b): Same as NY (including the 1/3 limit). But if only 1 dir, 1 shall be the quorum. 4. NY 708(d), Del 141(b): Vote of the majority of the dirs PRESENT at the meeting (not entire Bd) at which a quorum is present is sufficient to bind the Bd. (Ex. So if X Corp. is authorized to have 20 dirs, need 11 to make quorum. So if 12 are present at mtg, need vote of 7.) 5. Bd must act COLLECTIVELY through a validly convened meeting to bind the corpn. BUT: a. NY 708(b), Del 141(f): Action is allowed without Bd meeting if ALL dirs consent in WRITING authorizing the action. b. NY 708(c), Del 141(i): Participation at mtg 15 through conference phone constitutes presence at mtg. (In NY, must be authorized in bylaws.) 6. SUPERMAJORITY PROVISIONS: a. NY 709 and Del 141 provide that cert of incorpn may require more than a majority of those dirs present at the mtg to bind the Bd--up to unanymity. b. These provisions are important in close corpns b/c they limit what the majority can do. c. Problem is that someone with very little at stake can have the power to veto. Convincing that party not to veto can cost a lot. (Ex. Smith v. Atlantic Props 4 dirs, and cert of incorpn said they could not act w/o 80% agreement, meaning that 1 dir has veto power. So they wound up getting fined by the IRS b/c 1 dir was in dispute w/the other 3) 7. NOTICE OF DIRECTORS' MEETINGS a. NY 711--NO DEL STATUTE. b. Time and place of REGULAR MEETINGS is usually fixed in bylaws, so no further notice needs to be given. Only ordinary business can be discussed unless special notice is given or all dirs show up. c. Notice is required for SPECIAL MEETINGS. Notice provides stated purpose of mtg, so this protects those who chose not to come, b/c nothing else can be discussed at mtg. F. DIRECTORS' TERMS IN OFFICE 1. NY 703(b), Del 141(b): A director remains in office until his successor is elected and qualifies. 2. If no one is elected and qualified, Bd becomes HOLDOVER BOARD. Only remedy is a MANDAMUS ACTION to compel a dir to call a s/h mtg to elect dirs. G. FUNCTION OF BOARD 1. Generally, Bd manages corpn, and officers, as employees of the Bd, actually run the business. 2. Bd acts as agent to the outside world and as fiduciary to the s/h. a. DIRECTOR LACKS INDIVIDUAL POWER--they only act as a group. b. Bd must act collectively through validly convened mtg to bind the corpn. 3. DIRS ARE FIDUCIARIES TO S/Hs. 4. Francis v. United Jersey Bank: (NJ) a. FACTS: Mrs. P is REINSURANCE broker. In reinsurance, ceding co. sells some risk and premium to reinsurance co. through broker. Until broker pays the reinsurance co., he has the $ to work with--the "float". Interest on 16 float makes up large part of broker's income. Broker is supposed to segregate insurance funds from his general accounts. Mrs. P's sons comingled their commissions w/client's funds and "borrowed" clients' $. The loans were not properly paid back and eventually caused the co. to go bankrupt. Mrs. P was a dir of corpn and had no idea what was going on or how the business was run. b. Ct held that she was liable for negligence b/c she had duty to corpn, and her nonfeasance proximately caused the harm. c. DUTIES OF DIRS: 1. must have at least a basic understanding of the business 2. must attend bd mtgs, review financial stmts, object and resign if they know corpn is engaging in illegal conduct, seek counsel's advice and take reasonable means to prevent illegal conduct. 3. in $ mgt business, dirs are held to higher std of care. Note that in reinsurance dir has fiduciary duty to clients. 4. fiduciary duty to corpn and to s/hs but to creditors only if insolvency 5. Today, Francis may argue that she is exculpated under NY 402(b) b/c she didn't act in bad faith or fraudulently. Slain doesn't know if she'd win or not. d. BUSINESS JUDGMENT RULE: So long as dirs'judgment has a rational basis, they can't be held liable if it's a bad decision. 1. Mrs. P was not protected by Bus Judgmt Rule b/c she's acting like a trustee by holding other people's money and b/c she made no decisions, not bad decisions. e. DISCLAIMER OF PERSONAL LIABILITY: 1. NY 402(b), Del 102(b)(7): Generally, dirs dislcaim personal liability except if there's fraud or intentional misconduct or bad faith. 2. Corpn is a risky business, so in general we don't want personal liability b/c no one will want to be a dir. In general, dirs are not considered trustees, and should not be. (Note money mgt business is different.) 17 III. STOCKHOLDERS' MEETINGS AND ROLE A. STOCKHOLDERS' MEETING 1. ANNUAL MEETING: NY 602, Del 211 a. General meeting may be held wherever bylaws say, or in NY if bylaws don't say at office of corpn. NY 602(a), Del 211(a) b. Require annual meetings for s/hs to elect directors and to do other general business. NY 602(b), Del 211(b) c. S/hs receive notice as to time, date and place of mtg. 1. Note that s/hs always receive notice of mtgs, while dirs only need to receive notice of special mtgs if times and places for annual mtgs are fixed in bylaws. 2. SPECIAL MEETING: a. Bd may call special mtg of s/hs. Only the business listed in notice may be transacted. NY 602(c), Del 211(d). b. Requires special WRITTEN NOTICE that lists the specific business to be conducted. NY 605(a), Del 222(a). c. Notice must be given no less than 10, no more than 50 days in advance of mtg date (NY 605(a)); no less than 10, no more than 60 days (Del 222(b)). d. Notice is effective when mailed. e. If corpn is subject to proxy laws, notice must comply. f. If special mtg is adjourned, no additional notice is needed if date adjourned to is announced at meeting at which adjournment is taken (unless required by the bylaws.) NY 605(b), Del 222(c). 3. NO NEED FOR MEETING IF WRITTEN CONSENT: a. Del 228(a): Anything which requires a mtg can be done w/o a mtg if number of s/hs who consent in writing is equal to the MINIMUM NUMBER OF VOTES NEEDED TO AUTHORIZE SUCH ACTION IF A MTG WAS HELD WHERE ALL SHARES ENTITLED TO VOTE WERE PRESENT. b. NY 615: Anything which requires a mtg can be done w/o a mtg if number of s/hs who consent in writing is equal to ALL OUTSTANDING SHARES ENTITLED TO VOTE. 4. DATES OF MEETING: a. Notice of mtg is given to people who are s/hs as of the RECORD DATE. Eligibility to vote is frozen on the record date. b. If sell after record date, can still vote. If buy after record date, can't vote unless proxy was sold with the share (so people who learn about the mtg and vote are not exactly the same individuals who own stock.) 18 c. FIXING RECORD DATE: 1. NY 604(a): To determine which s/hs are entitled to notice, Bd may fix record date which shall not be more than 50 nor less than 10 days prior to meeting. Record date may also be fixed in bylaws. 2. Del 213(a): Same as in NY, but not more than 60 days prior. No provision for fixing in bylaws. d. The right to vote rides on ownership of stock on the record date b/c: 1. it's impossible to have an up-to-date list of s/hs at the time of the mtg (verification problem) 2. need time to send and receive proxy f. In NY and Del record date is also used to determine who receives dividends. 5. QUORUM AND REQUIRED VOTING OF SHAREHOLDERS (NY 608, Del 216): a. MAJORITY OF SHARES ENTITLED TO VOTE shall constitute a QUORUM at a mtg of s/hs for the transaction of any business. 1. Cert of incorpn or bylaws may provide for more or less than 1/2 but no less than 1/3 to be a quorum. b. Need a MAJORITY of those PRESENT or represented by proxy to bind corpn. (Note: In both NY and Del need only a PLURALITY to elect directors.) c. If quorum of s/hs shows up and then leave, quorum is not broken. d. If voting by class, majority of each class constitutes a quorum, and vote of majority those present binds class. 6. Matter of Auer: (NY) a. FACTS: Mandamus action by s/h to compel president to call special mtg to remove directors for cause and to elect successors. Bylaws required Pres. to call mtg if s/hs requested in writing--if no such bylaws, s/hs would have to wait for next mtg. b. Ct held that s/h can't compel calling of mtg to reinstate pres b/c election of officers is within Bd's power, but s/hs can compel calling of mtg to amend bylaws and remove dirs for cause. c. WHAT S/Hs CAN DO: 1. PRECATORY RESOLUTION: s/hs can make their views known by holding a mtg and passing a resolution (make a wish/warning) 2. AMEND BYLAWS: S/hs can amend bylaws to increase size of quorum of directors 19 (NY 601(a), Del 109(a)) 3. REMOVAL FOR CAUSE: S/hs may remove dirs for cause. a. In order to prove cause, there must be a mtg held where the dir can defend himself. Slain says this mtg is purely procedural b/c it's not an objective forum. b. In Campbell v. Lewis, ct said conducting oneself in a way detrimental to the running of the business is cause. 4. REMOVAL WITHOUT CAUSE: S/hs may remove dirs w/o cause. Note that Del 141 and NY 706 didn't exist at time of Auer. B. STOCKHOLDERS' VOTING 1. S/hs must vote on: a. election and removal of DIRS b. FUNDAMENTAL CORPORATE CHANGES (sale of assets, amendment of cert of incorpn, merger or consolidation, liquidation or dissolution) c. AUTHORIZATION OF STOCK (normally done by charter amendment) 2. S/h cannot make decisions regarding the ordinary business of a corpn. They can only request and recommend and enforce their wishes at election. 3. PROXY a. Del 212 1. Del 212(a): Each s/h is entitled to 1 vote for each share of stock, unless cert of incorpn says otherwise. 2. Del 212(b): S/h is entitled to vote by proxy. Proxy may be voted for up to 3 years from date signed unless it provides for longer. 3. Del 212(e): Executed proxies may be made irrevocable if stated irrevocable and coupled with sufficient interest. 4. It's implicit in Del statute that proxy must be on paper and signed by s/h. 5. S/h may authorize person to act as proxy by telegram or fax so long as proxygram shows it was authorized by s/h. a. Proxy must be in writing, but it can be executed by an agent even if the agent's authority is only oral. b. Slain says problem with this is that anyone who knows the number of shares the s/h owns can call and vote those 20 shares. Del adds mechanism to authenticate identity of person voting shares over phone in 212(c)(1), (2). b. NY 609: 1. NY 609(a): S/h may vote by proxy. 2. NY 609(b): Proxy must be signed by s/h and is only effective for 11 months from date signed unless it provides for longer. It's revocable unless otherwise provided. 3. NY 609(f): Irrevocable proxy must be coupled with sufficient interest. a. NY 609(g): Proxy nonetheless becomes revocable within 3 years or when there is no longer sufficient interest, whichever is less. 4. NY 609(c): Death or incompetence of s/h who executed proxy will not revoke proxy. 5. NY 609(e): If s/h is selling share, he can sell proxy with it, but cannot just sell proxy. c. Carey v. Penn Enterprises: Pa. 1. VOTING OMNIBUS PROXY Co. issues proxy to Cede for NYSE stocks and to Loriot for DRIP plan. They send proxy to member firms (brokers) (Mfrs Hanover, Merrill Lynch) who in turn send it to indl s/hs. Indl s/hs vote and return proxy to member firms. Member firms tally up votes and submit them to certificate nominee (i.e. Loriot or Cede) who send final result of proxy vote to company. 2. STREET NAME: Broker buys security for indl and hold it in broker's name (doesn't get certificate in indl's name to save time). So company doesn't know who its s/hs are--co. sees Cede as s/h. 3. BROKER OVERVOTE: One customer can send in 2 ballots or more. Broker doesn't realize that customer already voted, and therefore doesn't cancel the first vote. B/c broker doesn't care which way customers vote, have problem of overvote. 4. Facts: Carey is s/h trying to take over PEI. Dirs of PEI want to amend charter document to effect stock split as a defensive technique to prevent takeover. (Stock split results in diversity of ownership b/c price of each share decreases and s/hs are more likely to sell and buyers are more likely to buy. 21 Carey doesn't want stock split b/c the more people who own stock, the harder it is for him to acquire co.) Carey challenges the proxy vote b/c a lot of the proxies used by PEI came from beneficial s/hs whose shares were held of record in a Dividend Reinvestment Plan (DRIP) by Cede and given to Mfrs Hanover to vote as omnibus proxy. Carey is concerned with the process--the beneficial owners didn't send their proxies back through the "chain". Thus, Carey wants to invalidate those votes. 5. Ct held according to Pa. corporate law, s/hs authorized to vote are those of record. A DRIP w/a "promise" allowing beneficial owners to vote but without a formal proxy does not enable the beneficial owners to vote. 6. INSPECTORS OF ELECTION are authorized to mediate and provide and inspect proxies. 1. Del 231 restricts the discretion of inspectors to only look at the 4 corners of what is mailed to them (including envelopes.) 2. NY 610 and 611 does not address these issues. 3. Slain disagrees with result in Carey--ct should have paid more deference to inspectors of elections b/c they are the experts. C. VOTING AGREEMENTS BETWEEN SHAREHOLDERS 1. S/h agreement to vote stock together (to pool) is enforceable in every state. a. Most frequently, these agts appear in CLOSE CORPNS as a way of controlling the Bd or as a condition of issuance of new stock. b. NY 620(a): Voting agts allowed btwn 2 or more s/hs so long as in writing and signed. They may provide for specific outcome in agt, or they may provide that the parties will vote as agreed among themselves. Duration of agt is not limited. c. Del 218(c): Same as NY 620(a), but agt remains in force for only 10 years. May be renewed thereafter for additional period, each period not to exceed 10 years. d. Del 218(e): Del 218(c) will not invalidate any voting trust or proxy not otherwise illegal. 2. In NY, a cert of incorpn provision otherwise prohibited by law b/c it restricts Bd in mgt of 22 business or improperly transfers mgt capabilities to s/h shall nevertheless be valid under NY 620(b) if: a. it's in the cert of incorpn b. anyone to whom shares are transferred has notice of such agt and consents in writing. (Best way to ensure this is to print a legend on the share explaining the relevant provision) AND c. it's a close corpn (i.e. not listed on national securities exchange or on OTC). (NY 620(c)) d. To amend a voting agt restricting the Bd requires 2/3 vote of shares entitled to vote (or more if the cert of incorpn requires) (NY 620(d)) e. Effect of voting agt restricting the Bd is that liability shifts from dirs to s/hs. (NY 620(f)) f. A s/h voting agt restricting the Bd must appear in writing on all the shares. (NY 620(g)) 3. Del 102(b) allows restricting dirs or s/hs if such provisions are not contrary to state law. 4. Once s/hs have agt on how to vote, IRREVOCABLE PROXY ensures that s/hs will vote according to their voting agt. 5. McQuade v. Stoneham: NY: This case occurred before 620(b) was enacted. a. FACTS: Action for specific performance of voting agt. 3 s/hs enter into agt which said that they would do their best to vote together to elect themselves as dirs and officers. They fail to elect McQ as treasurer and claim that agt is void b/c exercise of their s/h's right to vote for McQ would be an abuse of their positions as dirs b/c it compels keeping a dir when dirs should be acting for best of corpn. b. Ct held that s/hs may agree to vote together to elect dirs. c. However, s/hs may not agree as to how to vote as dirs. (Note that under 620(b) s/hs can agree to this.) d. S/hs may not infringe on the exercise of dir's power. An agt in which dirs gave away power vested in them as dirs is void as agst public policy b/c it prevents Bd from operating. e. But note that NY 620(b) restricts dirs in a close corpn if it was agreed to in cert of incorpn and everyone knows about it. 6. Galler v. Galler: (Illinois) Pooling agt btwn 2 23 brothers providing for how s/hs will vote for dirs, mandatory declaration of dividends, continuation of salary to decedent s/h's family and silent on duration. One brother died and other refused to uphold agt. a. Ct upheld agt by finding that the minority s/hs had not been harmed or defrauded and that creditors were protected b/c of the existence of retained earnings. (But note that retained earnings assures creditors of cushion only if company can pay debts as they come in.) b. TEST TO SEE IF VOTING AGT SHOULD BE UPHELD--valid so long as: 1. close corpn AND 2. no objection from minority s/h, creditor or public c. Such agts may be necessary in a close corpn to ensure smooth running of business. d. BUT note that Slain thinks this agt is bad b/c it demands that people w/adverse interests work together. Second generation fights b/c they take it for granted that business will prosper. Better to separate the families. D. CUMULATIVE S/H VOTING 1. NY 618, Del 214 a. Cert of incorpn may provide for cumulative voting at all elections of dirs or at elections under specified circumstances. b. S/h gets as many votes as the number of votes to which he is entitled (usually the number of shares held) multiplied by the number of dirs being elected. c. The votes may be for a single dir or DISTRIBUTED among the various dirs being elected at the s/h's discretion. 2. CUMULATIVE VOTING, GENERALLY a. Representation concept designed to give MINORITY greater power in corporate governance. b. In NY and Del, cumulative voting is PERMISSIVE so it must be in the cert of incorpn in order to be used. In several states and with several industries, it is mandatory. c. Rarely is cumulative voting used in public companies. Usually cumulative voting is in close companies w/a substantial minority interest b/c it protects the minority interest by giving them a seat on the Bd of Dirs and thus requires mgt to observe corporate formalities which decreases mgt's prospects of engaging in self-interested transactions. It makes Bd keep its fiduciary duty to s/hs (can't fake the mtgs). 24 d. Ex. If 6 seats are available, mgt has 5,000 shares and dissident has 4,000 shares, dissident gets 4,000 * 6 which = 24,000 votes, and mgt gets 5,000 * 6 = 30,000 votes. 3. CUMULATIVE VOTING FORMULA a. X = ((S x D)/(N + 1)) + (1/N) b. X = # of shares needed to elect D directors S = total # of shares voting at election D = # of directors you want to elect N = total # of open seats c. Ex. 1. If mgt has 5,000 shares and dissident has 4,000 shares, S = 9,000. 2. N = 6 3. Mgt has 5,000 * 6 = 30,000 votes 4. Dissident has 4,000 * 6 = 24,000 votes 5. To determine maximum # of seats each can get, try numbers. For ex, try 3. X = (9,000 * 3)/(6+1) + 1/6 = 3858 shs 6. Is this possible? Multiply X by the total # of seats. a. 3858 * 6 = 23,148 (this is less than 24,000, so it is possible.) b. If D = 4, X = 5,143; 5,143 * 6 = 30,857 so greater than 24,000. d. To determine number of dirs (D) when given the # of votes needed (X): D = ((X -1)*(N + 1))/S Round down to lowest integer b/c fractional dir can't be elected. e. AVOID TIES: In above problem, when distributing the votes 3 ways, s/h wants to avoid ties among his candidates. Although 24,000 divided by 3 is 8,000, vote 7,999, 8,000 and 8,001. Use extras towards a 4th candidate. 4. Often the bylaws provide that s/h can't cast fractional votes when doing cumulative voting. Without such a bylaw, it's unclear whether fractional shares can be voted. 5. STRAIGHT VOTING: Each s/h gets the same number of votes as it has shares, and it can cast up to that number for each seat. So the side w/the most shares will always get the seats. Ex. Mgt has 5,000 shares and dissident has 4,000. For each of 6 seats, mgt outvotes dissident 5-4. E. REMOVAL OF DIRECTORS BY SHAREHOLDERS 1. At common law, dirs could not be removed, except for cause. Ex. In Campbell v. Lewis, ct said conducting oneself in a way detrimental to the running of the business is cause. 2. Del 141(k): Majority of s/hs entitled to vote at 25 election of dirs can remove any or all directors with or without cause BUT there are restrictions on removal without cause: a. if the corpn has a CLASSIFIED BOARD, then only removal FOR CAUSE. b. if there is CUMULATIVE VOTING, no director can be removed WITHOUT CAUSE if the number of votes opposing his removal would have been enough to elect him if cumulatively voted at the election of the entire Bd of Dirs. (Gives minority veto power when no cause. In cumulative voting, dir could be elected by minority, and don't want majority to remove him b/c that would defeat the purpose of cumulative voting) 1. Note that if cumulative voting and removing FOR CAUSE, main rule applies that s/hs can remove dirs by a majority of shares entitled to vote at election of directors. c. If class gets 1 directorship, then that director may only be voted out by majority of that class. 3. NY 706: a. Can always remove dirs for cause. b. NO REMOVAL WITHOUT CAUSE unless there's a specific bylaw or a cert of incorpn provision for such removal. c. With or without cause, if there is CUMULATIVE VOTING, no dir can be removed when the votes cast against his removal would have been enough to elect him if cumulatively voted at election of entire Bd of Dirs. d. With or without cause, when class voting occurs, any such dir can be removed only by class vote. 4. Note that it's easier to get rid of dirs in Del than in NY b/c need cause in NY unless C/I or bylaws says otherwise. 26 IV. INSTITUTIONALIZATION OF INVESTORS A. Institutional investors collect and invest other people's money. They include life insurance companies, pension funds and investment companies (i.e. mutual funds). They have the power, if they band together, to dominate and control large public companies, but since they see their roles simply as investors and not managers, they vote their shares in favor of management. If they're dissatisfied with management, they prefer to sell their shares rather than struggle for control. B. Continual decrease in % of indl ownership on NYSE as compared to institutional ownership. Why? 1. Growth in PENSION PLANS 2. transaction costs of going in and out of market are too large so indls buy MUTUAL FUNDS. a. mutual funds: pooling of indls' money into one account; each indl gets % of profit from the dividends of the stocks. Investment companies choose the stocks that make up the mutual fund and get all the people to join. 3. adoption of SEMI-STRONG version of EFFICIENT MARKET HYPOTHESIS. a. PRICE OF PUBLICLY TRADED SECURITY AT ANY TIME ACCURATELY IMPOUNDS ALL PUBLICLY AVAILABLE INFO RELATING TO THE VALUE OF THE SECURITY. If this is true, there are never any real bargains or losers, can't predict future movement of stock prices based on presently available info, and in-and-out trading is a losing strategy b/c can't beat the market. b. 2 kind of variables in a securities price: 1. ALPHA RISK: the INDIVIDUAL RISK of this particular security (unaffected by what's going on in the market). a. The good alpha risks balance out the bad alpha risks if you own more than 12 different securities. 2. BETA RISK: SYSTEMIC RISK of the market. a. The beta coefficient is the relation between the volatility of particular co's stock and the volatility of the whole market. So if stock's riskiness is twice market's riskiness, beta coefficient = 2. c. The semi-strong EMH affects investment decisions: 1. Graham & Dodd Approach Fundamental Analysis: If buy undervalued stocks in company you will make a lot of $. 27 BUT EMH says that there are no undervalued stocks so if you believe in EMH this can't be. 2. Invest in MUTUAL FUNDS: d. So Slain says market is speculatively efficient but not allocatively efficient--market is efficient as to stocks in general but not necessarily as to particular stocks. e. WEAK FORM of EMH: Prices do not have memories; markets do not have memories. No inferences can be drawn about what will happen to any security in the future from what has happened in the past. f. STRONG FORM of EMH: Market performs so well that inside information won't help in investing. 28 III. SOME MATTERS OF FINANCE I. LEGAL CAPITAL AND DIVIDENDS A. AUTHORIZED CAPITAL STOCK 1. GENERALLY: a. STOCK: the residual but unlimited right of the investor to the assets of the corpn after the creditors have been paid. Bundle of rights. b. CAPITAL STOCK/COMMON STOCK: gives investor right to assets of corpn after creditors are paid. c. PREFERRED STOCK: carries rights expressly provided for in cert of incorpn which differ from those of common. Generally, it does not include voting rights. 2. AUTHORIZED STOCK IN CERTIFICATE OF CORPN a. PURPOSE is to solve legal problems associated with overissue. b. Del 102(a)(4): In for-profit corpns, cert of incorpn shall include: 1. total number of shares of all classes, numbers of shares of each class, and shall specify par value or no par value of each class. 2. designations, powers, preferences, rights, qualifications, limitations or restrictions permitted by sec. 151 in respect of any class or classes. c. NY 402(a)(4) & (5): C/I shall state aggregate number of shares, whether classes, par value or no par value, rights, preferences and limitations of shares of each class. 1. Note: same as Del 102(a)(4) d. Del 102(a) and NY 402(a)(6): Blank series preferred authorizes the creation of up to X number of preferred shares open to Bd of Dirs to determine exact provisions. 2 occasions when you want to issue preferred stock: 1. You want to take over a company and use the preferred stock as consideration. Can tailor the details of the stock to the deal. 2. Preferred is used as ALTERNATIVE TO DEBT FINANCING--keep provisions flexible so that it will depend on what the interest rate is. Note: Slain thinks this goes against "$, labor done or property received" statutes b/c it allows Bd to fix terms favorable to the buyers of the preferred. 3. VOTING AND RELATIVE STOCK RIGHTS a. Del 151 1. Del 151(a): Corpn may issue 1 or more classes, each of which may have one or more series. May be with or withour par. Voting rights, preferences, limitations, qualifications, and restrictions to be stated in C/I or Bd resolutions (if Bd is authorized by C/I to so control). Voting 29 rts may be dependent on facts not in C/I or Bd resoln provided that the way in which such facts will affect voting rts is stated. 2. Del 151(b): Any class of stock may be REDEEMED either at company's option or at holder's option so long as at least 1 class or series with full voting powers is not subject to redemption. 3. Del 151(c): PREFERRED STOCK dividend payments are to be set forth in C/I or Bd resoln and paid before other distributions. 4. Del 151(d): DISSOLUTION (LIQUIDATION) RIGHTS of pref stock are set forth in C/I or authorized Bd resolns. 5. Del 151(e): Corpn may issue CONVERTIBLE STOCK subject to C/I or Bd resolns--stock of 1 class or series is convertible into shares of any other class or series at the option of the s/h or corpn. a. Usual transaction is preferred into common. 6. Del 151(f): Stock subject to any of the above provisions must bear a LEGEND to that effect, and s/hs must be given information. 7. Del 151(g): If voting rights are set forth in Bd resoln rather than in the C/I, certificate of designations setting forth copy of resoln and number of shares to which resoln applies must be filed. b. NY 501 1. NY 501(a): A corpn may issue the number of shares allowed by C/I, and it may designate different rights, liquidation preferences, dividend preferences, but at least 1 class must have full voting rights, dividend rights or liquidation rights respectively. 2. NY 501(b): If there is to be more than 1 class of stock, share must so indicate. (need LEGEND) 3. NY 501(c): The rights of 1 share must be equal to rights of every other share in the same class. c. NY 512: Same as Del 151(b)--allows redemption so long as at least one class of common is not subject to redemption. 4. PAR AND NO PAR a. Par value sets minimum consideration for which a company may issue stock and is used to compute whether corpn is able to pay a dividend--it constrains ability of corpn to make voluntary distributions to its s/hs. 1. The stock may be sold for more but not 30 less than par value. (NY 504(c)) 2. Par value has no effect on price at which share may sell. b. Par value defines the stated capital of the corpn. 1. STATED CAPITAL of the corpn is number of shares issued and outstanding multiplied by par value of those shares. a. Par value is kept at a low number now to limit ASSESSMENT (corpn can only go after s/h for par value of stock) b. Wood v. Drummer: stating that the original investment by s/hs is a trust fund for the benefit of the creditors. Prevents s/hs from taking dividends and creditors not getting paid. c. NO PAR STOCK: NY 506, Del 154: If corpn issues shares without par value, entire consideration received goes into stated capital unless the Bd, within 60 days, allocates a portion of the consideration to surplus. There is no std as to how to allocate consideration--can be arbitrary. 1. When no par shares were given, the federal excise taxes were too high b/c statute made up a hypothetical high par value for no par stock, so no par stock is not used anymore. d. HOW TO DETERMINE IF ORIGINAL S/H'S PAYMENT WAS ENOUGH AND WHAT TO DO IF IT WASN'T: 1. If s/h buys one share of $1 PV stock for $1 in cash, no problem. Stock is fully paid, NONASSESSABLE--no one can ask s/h for more $. 2. Usually, to receive stock, s/h must give cash, property or services already performed. To value contribution other than cash: a. TRUE VALUE RULE: valued by judge at time of valuation, not at time of exchange. b. GOOD FAITH RULE: consideration is what a reasonable person thought it was at time of exchange. 3. If something less than par was paid, stock is ASSESSABLE at par value--s/h is liable to corpn for difference. 5. GENERAL ACCOUNTING TERMS: a. STATED (OR LEGAL) CAPITAL: Number of shares outstanding multiplied by the par value of each share. NY 102(a)(12). b. CAPITAL CONTRIBUTED IN EXCESS OF PAR (CCIP or CAPITAL SURPLUS): amount paid in aggregate by s/hs in excess of par. NY 31 102(a)(2). c. RETAINED EARNINGS (EARNED SURPLUS): amount by which s/h's interest has grown due to business operations. 1. If RE is a negative number, then it's the amount by which the s/h interest has decreased b/c the business did poorly. 2. RE is accumulated profits or losses of company since its operation started. 3. RE tells a creditor something, but not everything, about the amount of asset that will be available to pay creditor. 4. RE helps dictate how much dividends will be paid. d. CURRENT ASSET: cash or an asset that will become cash during operating cycle of the business or within 1 year, whichever is longer (cash, mktable secs in another co., A/R) e. CURRENT LIABILITY: debt now due and payble or which will become due and payable within 1 year or within operating cycle of business if operating cycle is greater than 1 year (A/P) f. LONG TERM ASSET: property, plant, equipment, land, goodwill g. LONG TERM LIABILITY: mortgage, deferred revenue h. NET ASSETS: Total assets -Total liabilities i. SURPLUS: Net assets -stated capital (or RE + CCIP) j. GOODWILL: premium paid for a bundle of assets of an ongoing business in excess of their fair market value. k. DEPRECIATION: the rate at which an asset turns into an expense; allocation of cost of asset in various accounting periods benefitted by its ownership. B. DIVIDENDS: voluntary distribution of assets to s/hs 1. Determination of whether or not corpn can legally pay dividends can depend on the following: a. insolvency b. surplus c. capital impairment d. net profits Note: must check the statute's restrictions; then see if C/I imposes further restrictions 2. NY RULE ON PAYING DIVIDENDS: NY 510 a. NY 510(a): Corpn may pay dividend unless the payment of the dividend would force corpn to become insolvent, or would violate a provision of the C/I. 1. INSOLVENT means being unable to pay debts as they come due in the normal course of the debtors' business (i.e. not being able to pay off current liabilities) 32 b. NY 510(b): DIVIDENDS MAY ONLY BE PAID OUT OF SURPLUS, meaning that the corpn's net assets after distribution of the dividend must be at least equal to the amount of its stated legal capital. 1. Net Assets=Assets-Liabs Surplus=Net Assets-Legal Capital=RE+CCIP c. NY 510(c): When dividend is paid out of source other than earned surplus (i.e. paid from CCIP), it must be accompanied by WRITTEN NOTICE to s/h. 1. The purpose of the notice is to inform the s/h that they are getting back a portion of the consideration they paid for the stock (decapitalizing) 3. DEL RULE ON PAYING DIVIDENDS: Del 170: NIMBLE DIVIDENDS a. May pay DIVIDENDS OUT OF SURPLUS (like in NY), OR if no surplus, out of NET PROFITS for fiscal year in which dividend is declared and/or preceding fiscal year. 1. Net profit = increase in RE from 1 year to the next. b. Good for company with large losses but plans to stay in business. Although company can't get new creditors, it can get new s/hs b/c s/h has a chance at getting dividends even if company is losing $. c. Problem is that it limits protection for creditors--by the time liquidation comes about, all the company has left is stated capital which probably won't cover creditors' claims. 4. Main problem is that Del and NY rules do not really protect creditors b/c par value and RE are very manipulable. It depends on how much stated capital there is, which is chosen randomly and can be changed by amending C/I. a. Solution is Cal, which uses an INCOME STATEMENT TEST--ability to pay dividends is a function of profitability and is unbundled from the concept of par value and stated capital. If RE is at least equal to the amount it will pay in dividends, or if assets (exclusive of goodwill) are 125% of liabilities, it can pay dividends. b. Alternative solution is CURRENT RATIO TEST: If have enough current assets to pay current liabilities, corpn can pay dividend. 5. Smith v. Atlantic Properties (Mass) a. Facts: Close corpn formed to purchase land. 33 C/I and bylaws provide that no action can be taken unless 80% of common s/hs agree. Since each of the 4 s/hs here have a 25% interest, the effect is that each has veto power. The corpn earns $, but 1 member (Dr. W) refuses to permit dividend to be declared. IRS imposes accumulated earnings tax, but Dr. W still refuses to declare dividend. The other 3 s/hs sue the corpn (they're really suing Dr. W) to get the court to order payment of dividend. b. Holding: Ct held Dr. W had to pay penalty taxes and corpn had to pay dividend (details to be determined on remand). Minority s/h has duty of utmost good faith and loyalty to the majority s/hs in situations such as this where the minority is effectively the majority s/h b/c of his veto power. Since CONTROLLING S/H HAS FIDUCIARY DUTY TO CORPN, and 80% provision makes Dr. W into a controlling s/h, Dr. W had fiduciary duty to corpn. c. Note: Generally, decision to declare dividends is within Bd's discretion, and ct will only compel payment of dividends if accumulated earnings tax is imposed. 1. Rare exception: Dodge v. Ford Motor Co.: Ct ordered Ford to declare dividend b/c decision not to declare was an arbitrary refusal to do what was required since Ford was very prosperous and was expected to continue to profit. II. ISSUING STOCK A. SUBSCRIPTIONS: 1. A subscription for stock is an agreement that you will buy the stock at an agreed price at some later date when the stock becomes available for sale. So typically enter into subscription agreement before corpn is organized. 2. PURPOSE: a. means of getting commitments to put $ into business--may be an incentive to future investors. b. used to be a big deal b/c process of forming corpn was expensive and time-consuming. This is no longer the case. 3. STATUTES: a. REVOCABILITY OF SUBSCRIPTION AGREEMENTS: 1. Del 165: Subscription agreement is irrevocable for 6 months after made unless: a. it expressly provides that it is revocable. OR b. all subscribers unanimously consent to revocation. 2. NY 503(a): Subscription agt is irrevocable 34 for 3 months after made, subject to same exceptions as in Del. b. STATUTE OF FRAUDS: Del 166, NY 503(b): Subscription agt must be in writing and signed by subscriber (or his agent in Del). c. PAYMENT PROVISIONS: NY 503(c), Del 152: Subscriptions must be paid in full when Bd says so. d. EVENT OF DEFAULT: NY 503(d): If default, corpn may proceed to collect amount due, or Bd may declare forfeiture of subscriptions if amount due remains unpaid for 30 days after written demand for payment is made. B. CONSIDERATION: Del Art. IX, sec. 3, Del 152 & 153, NY 504 1. A corporation may only issue stock for CASH, LABOR DONE, OR PROPERTY RECEIVED. a. MBCA eliminates this requirement--dirs decide whether to issue stock and are restrained only by their fiduciary duty to existing s/hs. 2. In the absence of fraud, judgment of Bd or s/hs as to value of consideration is conclusive (deciding how much the property is worth). 3. Judgment of the Bd determines the amount of consideration. a. NY 504(c): Shares with par value may be issued for consideration fixed by the Bd but not less than the par value. 4. What can be consideration: a. In NY PROMISSORY NOTE is not consideration, even if secured by some sort of collateral. If it's secured, it may be consideration in Del. b. TREASURY BILLS can be consideration. c. TRADE SECRETS are not consideration, but Slain thinks they should be b/c they're worth a lot. 5. Del 152: Issued capital stock is FULLY PAID and NONASSESSABLE if: a. entire amount of consideration has been received by the corpn. OR b. not less than par value has been received and corpn has received a binding obligation by the purchaser to pay the balance of the consideration (i.e. surplus) 6. NY 628(a): S/h is only obligated to pay amount of consideration for which shares could be issued lawfully. a. Other states' laws have different rules--s/h is obligated to pay corpn only what he contractually agreed to pay, but s/h may have further liability to creditors to pay what the stock is worth. C. TYPES OF STOCK 35 1. Generally, a corpn can have as many types of stock as C/I authorizes. 2. COMMON STOCK: A claim against the residual net assets of the corpn. a. Subordinated to all other claims, but unlimited right to get the remaining assets of the company upon liquidation. b. Common s/hs carry voting rights. c. All common s/hs have a right to dividends. d. In Del, common is not considered a class. It's not clear in NY whether common is considered a class. 3. PREFERRED STOCK: In some way preferred as to common. May or may not be described in detail in the C/I. a. Preferred s/hs' rights are limited to those in the C/I (called the Preferred Shareholder's Contract) b. The only legal consequence of not declaring and paying a preferred dividend is that company cannot pay dividend to any junior security. c. Ex. 6% $100 PV Preferred: entitled to preferred dividend of $6/year. Preferred s/h gets dividend before common s/h does. d. Thought of as more akin to a bond than to common stock (b/c corpn is paying a fixed amount each year). However, PREFERRED is not a debt--it ONLY BECOMES A DEBT WHEN BD DECLARES DIVIDEND. On liquidation, declared but unpaid preferred dividend becomes a general creditor claim. e. General uses of preferred stock: raise cash (b/c it works like a bond); tailor acquisitions (blank series preferred); repel takeovers (poison pills are special preferreds which are meant to block takeovers). f. Price of preferred stock is interest-rate sensitive, just as a bond is. In order to get people to buy preferred stock instead of bonds, company must lower price of preferred stock. % yield/market price=effective interest rate. So effective interest rate must be greater than interest rate on bond in order to entice people to buy preferred stock rather than bonds. g. TYPES OF PREFERRED AS TO DIVIDENDS: 1. PARTICIPATING vs. NON-PARTICIPATING: a. PARTICIPATING: Once preferred s/h gets paid, he shares further dividend with common s/hs. b. NON-PARTICIPATING: Preferred s/h gets paid and is out of the picture. Also called limited. This is the TYPICAL STRAIGHT PREFERRED. 2. CUMULATIVE, ETC. a. CUMULATIVE: If dividend is not paid, right to receive dividend rolls 36 forward to next year, when preferred s/h has right to receive 2 years' worth of dividend. 1. This right exists whether dividend is declared or not--whether cumulative or noncumullativ has nothing to do with declaring dividends. 2. Frequently the cumulative will carry contingent voting rights triggered by nonpayment. (Baron) b. NON-CUMULATIVE: If dividend is not paid, s/h never receives dividend for that year, so noncumullativ preferred stock is unusual b/c no s/h wants them. Only comes into existence if given to a junior claimant in a bankruptcy reorganization. Big danger of abuse. c. CUMULATIVE IF EARNED: Dividend is cumulative to the extent of the actual earnings that year. If company had a loss, dividend disappears as if noncumulative. (Ex. 6% $100 PV cumulative if earned preferred: Co. earns $2 and doesn't declare a dividend, but should pay dividend of $6. So $2 rolls over to the next year, and $4 is lost b/c it wasn't earned by co.) h. CAN BE PREFERRED UPON LIQUIDATION: Usually par value plus accrued dividends. Most preferreds are preferred upon liquidation. i. PREFERRED'S VOTING RIGHTS: May have: 1. FULL: each preferred s/h votes on all issues, and its vote is a multiple of the common s/h's vote. So the PREFERRED'S VOTE COUNTS MORE THAN COMMONS. THIS IS EXTREMELY RARE. 2. CLASS: This is commonplace b/c usually the number of preferred s/hs is small compared to the number of common s/hs. 3. CONTINGENT: Ex. failure to pay dividends triggers voting rights (Baron). a. This is quite frequent. b. NYSE requires listed preferreds to have at least this much voting power. 4. LIMITED: limited on some matter of significance to the preferred (i.e. amending C/I or adding a new class) 5. NON-VOTING: Note that almost every state statute confers voting rights under some circumstances on stock with no contractual voting rights. j. PREFERRED STOCK IS TYPICALLY REDEEMABLE: Corpn can buy back the preferreds. Corpn reserves this right b/c if the interest rate drops, it wants to refinance. 1. Ex. If co. issued stock in the 80s when cost of $ was high and company is paying 12%, now it can pay 37 interest of 6%, so it will want to call in those preferreds, redeem them, and issue new preferreds at lower rates. 2. Buyers typically will not purchase if company's callable rights are unlimited. Usually, there's a time provision--i.e. can't replace high interest preferred with low interest preferred for a set number of years. 3. Generally, COMMON STOCK IS NOT REDEEMABLE b/c common s/hs own the residual equity in the business. a. Exception in Del and NY where classes of common can be redeemable provided that there is at least 1 class of common that is nonredeeemable k. PREFERRED STOCK CAN BE CONVERTIBLE: C/I sets forth fixed exchange ratio by which preferred s/hs can turn in their stock for shares of common stock. 1. Ex. I pay $100 for 1 share of preferred stock with right to convert into 10 shares of common. So if common is selling at more than $10/share, the conversion right is valuable b/c can get common for less than the market price. 2. But even though the conversion right is valuable, the preferred s/h will not convert--instead he'll sell his preferred shares. The dividend on common stock is typically much less than the dividend on preferred stock, so rather than convert the preferred stock into common stock, preferred s/h will sell the preferred stock b/c the price of the preferred represents the conversion right plus the right to get the preferred dividend. 3. Convertible stock is almost always REDEEMABLE/CALLABLE. Redemption is the way the company can coerce conversion b/c redemption price is only liquidation price (par value plus accrued dividends), whereas on conversion receive common for less than the market price. 4. Baron: Delaware a. Facts: Business was doing poorly and preferred dividend went unpaid for 6 quarters. Preferred s/hs exercise a contingent voting right given in C/I to take over management of the business if 6 or more quarterly dividends are in default, and thereafter things go much better. Now co. has money to pay dividends, but they don't so they can stay in office. (C/I says control reverts once dividends have been paid.) Common s/hs sue Bd not for payment of dividend (which could not be compelled anyway) but for a new election b/c 38 of failure to pay dividends and thus a return of control to the common s/hs. b. Holding: 1. Ct says that decision to declare dividends is in Bd's discretion and thus Bd cannot be forced to exercise its power to pay dividend. (Ct can only interfere with Bd's decision if fraud or gross abuse of discretion.) Ct finds no such showing and refuses claims of common s/hs. 2. Ct notes that Bd must make a good faith effort to pay preferred dividend and return control to common s/hs. PRIMARY FIDUCIARY DUTY OF BD RUNS TO COMMON S/Hs (even though preferred s/hs elected the Bd). 5. Rothschild: Delaware a. Facts: Ligget amended C/I to authorize issuance of 7% $100 PV preferred. These preferred shares had a PV and liquidation value of $100. GM made tender offer to buy Ligget stock. GM acquired almost all common stock and other class of preferred but only 40% of the 7% Preferred. Since the 7% Preferred had no class voting rights for merger, and GM now controlled common and other Preferred, GM had enough voting power to approve follow-up merger whereby all Ligget s/hs were eliminated in exchange for cash of $70/share. 7% Preferred s/hs argue that Ligget and GM breached fiduciary duty to them by agreeing to takeover and recommending terms of takeover to Ligget s/hs even though it would give 7% Pref s/hs less than liquidation value of $100. b. Holding: 1. Pref s/hs are entitled to what C/I provides and nothing else. 2. Here there was nothing in the C/I that dealt with special rights in the event of a merger. So preferred s/hs must take what they get or sue for appraisal. 3. Tender offer and merger are not liquidation even though effect of transaction is same b/c company still existed as separate corporate entity following the tender offer and merger. 4. Preference rights of preferred stock can be eliminated legally through merger process. Under DELAWARE INDEPENDENT LEGAL SIGNIFICANCE DOCTRINE, if there are multiple ways to effect a transaction, Bd can pick any way and is not constrained just b/c preferred s/hs would be better off if done another way. 39 5. A claim of breach of fiduciary duty would not succeed b/c, like creditor, preferred s/hs are only entitled to honest performance of the contract. a. Fiduciary duty of Bd runs to common s/hs and participating preferreds. Little fiduciary duty owed to the non-participating preferreds. 40 IV. FUNDAMENTAL CHANGES I. GENERALLY A. Fundamental changes constitute the exception to the rule that the corpn is to be managed by its board. 1. ALL FUNDAMENTAL CHANGES REQUIRE S/H APPROVAL. 2. In some instances, s/hs who dissent are entitled to appraisal rights. B. Classic fundamental changes are: 1. merger 2. sale of all or substantially all of corpn's assets 3. charter amendment 4. liquidation or dissolution C. Authority for altering s/hs' contractual rights with corpn is the RESERVED POWER of the state. 1. Corpns are creatures of contract. All contracts need complete unanymity of all parties to contract to modify it, and state may not interfere with an existing contract. 2. Way to get around unanymity requirement: Trustees of Darmouth College v. Woodward: Justice Story said although charter is a 3-party contract among s/hs, corpn and state, it is subject to the reservation by the state of the power to amend the charter. 3. Following Dartmouth College, the reserved power to amend was included in most state corpn statutes. a. A state can reserve for itself the right to amend the charter, and changes may apply retroactively. b. NY 110, Del 394 c. NY Art. X, section 1 of state constitution II. CHARTER AMENDMENTS A. Del 242 1. Del 242(a): The corpn may amend its charter after it has issued and received payment for stock, including but not limited to the following changes (all of which could have been included originally) a. Name change b. Change scope or purpose of business c. Increase, decrease or reclassify its capital stock by changing the number of shares, par value of shares, designations or preferences, relative, participating, operational or other rights of shares, or the qualifications, limitations or restrictions of such rights. d. CANCEL THE RIGHT TO RECEIVE DIVIDENDS WHICH HAVE ACCRUED BUT HAVE NOT BEEN DECLARED. e. create new classes of stock which have rights prior and superior to old stock, or rights subordinate and inferior. f. change duration 2. Del 242(b)(1): PROCEDURE FOR AMENDING THE CHARTER a. NECESSARY FIRST STEP: Bd of dirs must adopt 41 resolution which: 1. sets forth proposed amendment 2. says whether or not Bd thinks it's advisable AND 3. calls for special s/h meeting to vote, or raise question for next annual meeting. POWER TO INITIATE IS WITH BD OF DIRS AND NOT S/Hs. b. CHARTER AMENDMENT PASSES IF RESOLUTION IS ADOPTED BY: 1. majority of s/hs entitled to vote AND 2. majority of each class entitled to vote as a class 3. Note: To approve most corporate actions, all that is needed is a majority of those s/hs present in the presence of a quorum, but to approve a charter amendment, need a majority of outstanding shares entitled to vote. 4. Ex. Have 1.5 million shares outstanding entitled to vote. 500,000 are preferred with class voting rights. 1 million are common. So need 750,001 total votes to pass amendment, 250,001 of which must be preferred. In this way, have majority of total shares and majority of class. a. Preferreds are only counted if they have contractual (i.e. given in C/I) or statutory (b/c fundamental change adversely affecting them) voting rights for this particular proposal. 3. Del 242(b)(2): WHO MAY VOTE: a. The people who have contractual voting rights under the C/I get to vote. AND b. For those who don't have contractual voting rights, the holder of a class of stock may vote as a class if: 1. the amendment would: a. increase or decrease the aggregate number of authorized shares of that class OR b. increase or decrease the par value of shares of that class OR c. adversely alter the powers, preferences or rights of shares in that class. (Doesn't need to be wholly adverse--just need something adverse.) 1. If the adverse change only affects a series within that class, then only the holders of that series may be considered as a class for this purpose. c. In other words, class voting is triggerred by a change INTERNAL TO THE CLASS. So if a new class is being created superior to ours, our rights are not changed, and thus we have no vote. (Note: different in NY 804(a) which says that creation of superior class triggers 42 class voting rights.) (This rule applies to both preferred and common stock) d. The number of authorized shares in a class can be increased or decreased by affirmative vote of the majority of all s/hs entitled to vote, in spite of this section, if C/I so provides. So C/I can trump statute by not requiring majority of class to approve amendment to change number of authorized shares. 4. Del 242(4): a. If the C/I provides for a supermajority vote in any of the foregoing situations, then the C/I trumps. b. Cannot eliminate the supermajority provision in C/I by a vote of less than the supermajority. c. NY has no such provision. 5. Note that in Del no appraisal right is given to minority s/hs if C/I amendment restricts their rights or preferences. a. Appraisal rights in Del are only for mergers unless C/I provides for appraisal rights in other instances. b. This is different from NY 806(b)(6) which gives appraisal rights for both merger and C/I amendment which adversely affects minority s/hs. B. NY STATUTES: 1. NY 801(a): Corpn may amend its C/I. 2. NY 801(b): Amendments may include but are not limited to change of: a. name b. purpose c. address (can also be done by Bd alone) d. address for service of process (can also be done by Bd alone) e. designation of agent (can also be done by Bd alone) f. duration g. increase or decrease of the aggregage number of shares, or shares of any class or series h. remove from the authorized shares any class of shares or any shares of any class whether issued or unissued i. increase or decrease par value of authorized shares whether issued or unissued j. change authorized shares into different number (stock split) k. TO FIX, CHANGE, OR ABOLISH ANY RELATIVE RIGHTS, DESIGNATION, PREFERENCES, INCLUDING PROVISIONS RE: UNDECLARED DIVIDENDS, WHETHER OR NOT CUMULATIVE OR ACCRUED, OR THE 43 REDEMPTION OF ANY SHARES, OR THE SINKING FUND FOR REDEMPTION. l. to change preemptive rights to acquire shares or other securities m. to grant or revoke authority to the Bd to change the relative rights and preferences between series of preferred class n. Note that anything that could be effected by a bylaw change can be done by C/I change. 3. NY 803: Amendment to C/I may be initiated by a vote of the Bd. 4. NY 804(a): All amendments must be approved by: a. majority of all s/hs entitled to vote AND b. majority of class or series affected if: 1. the amendment would exclude or limit classes' voting rights 2. would adversely alter the rights and prerogatives of the shares in question, including dividends and convertibility provisions 3. would subordinate the rights of the shares in question c. Note: The only difference between NY and Del is that under NY 804(a)(3), the creation of a class superior to yours is considered an adverse effect on your class and thus give you class voting rights. 5. NY 804(b): If only one series in a class is adversely affected, then only that series gets special voting rights. 6. NY 806(b)(6): Note that appraisal right is given to s/h who dissents from amendment to C/I if amendment would: a. alter or abolish preference b. change redemption rights c. change preemption rights OR d. limit voting rights Note this is different from Del which does not give appraisal right for amendment to C/I unless C/I so specifies. C. McNulty: (NY) Ct held that corpn could amend C/I to eliminate accrued but undeclared preferred dividends and the amendment could apply retroactively to dividends accrued before its enactment. Even under reserved powers, corpn can't be deprived of its property, and rights of 3rd parties can't be taken away. But here, right to accumulated dividends isn't a debt until the corpn declares the dividend, so no right is being taken away. And the purpose of the legislation is to eliminate the situation where corpn has a lot of accrued but undeclared dividends b/c of the Depression. Note: Slain disagrees with this case b/c property rights are obviously being taken away. 44 D. Bowman: (Ill) Ct disallowed amendment to C/I which would authorize Bd to redeem cumulative preferred stock for a subordinated debenture. Ct said would convert s/h into creditor and would be redeeming stock for something other than money, which is not allowed under the Bus. Corpn Act b/c it changes the nature of the redemption price. 1. Slain says this is triumph of form over substance b/c there's no real difference between the position of s/hs at beginning and end of transaction. 2. Del 151(b) allows redemption of stock for property other than cash (i.e. debt securities). Less clear under NY 512(a) and 513(d) b/c it leaves open whether stock can be redeemed for debt securities. III. MERGER, CONSOLIDATION AND SALE OF ASSETS A. MERGERS AND CONSOLIDATION: 1. STATUTORY MERGER a. Bd of each corpn must adopt a resolution proposing that the merger take place. b. S/hs of each corpn must vote on the transaction and approve it by either a majority (Del) or a 2/3 vote (NY) b/c this is a fundamental change. c. A certificate of merger must be filed with the state of incorpn of the surviving corpn, or sometimes the state of both corpns if the statute so requires. d. When A corpn is merged into T corpn, A corpn ceases to exist, its stock is cancelled, and T succeeds to all of its assets and assumes all of its liabilities, both presently known and unforeseen. 1. To see which corpn disappears, must look at merger agreement, b/c decision is arbitrary. 2. CONSOLIDATION: Where 2 or more existing corpns consolidate to form a new corpn after which they both cease to exist. This is practically no different from statutory merger, but statutory merger is easier to do. 3. TRIANGULAR MERGER: A forms wholly owned sub which B merges into. T s/hs receive A stock in exchange for their T stock and become A s/hs. Sub's s/hs remain unaffected. a. Used when A wants to keep assets acquired from T in a separate corpn. b. A and its subsidiary survive and T disappears. 4. REVERSE TRIANGULAR MERGER: A forms wholly owned sub which merges into T. Sub shares get converted into T shares, and prior T shares get converted into A shares. a. Used when it's critical that corporate entity 45 of T stays in tact (i.e. T is a publisher and has copyright permissions which won't survive merger in which T is a disappearing corpn) 5. STATUTES: Del 251, NY 901-03 a. NY 902(a), Del 251(b): Bd of each corpn must initiate and adopt resoln approving an agreement of merger or consolidation. Resoln must contain: 1. names of all corpns merging and surviving 2. terms and conditions of transaction 3. For merger, all amendments/changes to C/I of survivor; For consolidation, all statements in a new C/I. AND 4. description and breakdown of capital structure of each constituent corpn b. NOTICE of meeting mailed to all s/hs voting and nonvoting. (Notice is not co-extensive with right to vote.) 1. NY 903(a), 604(a): between 10 and 50 days prior to meeting 2. Del 251(c): at least 20 days prior to meeting 3. Meeting can be special or annual. 4. Del 251(c), NY 903(a)(1): Notice must contain copy of merger agreement or brief summary of it. c. AUTHORIZATION BY S/H 1. Del 251(c): a. To approve merger, need majority of outstanding stock entitled to vote of both constituent corpns b. No class voting, so non-voting stock cannot vote on a merger (as opposed to when the fundamental change is solely a charter amendment). 2. NY 903(a)(2): a. To approve merger, need 2/3 of outstanding shares entitled to vote of both constituent corpns. AND b. If class voting, need majority of all outstanding shares of each class entitled to vote. 1. There is class voting if any of the changes in NY 804 (i.e. amending C/I to adversely affect a class' right) occur, or if C/I so provides. 3. So in NY if there are 1 million common s/hs and 500,000 preferred adversely affected without contractual voting rights, need vote of 2/3 of 1.5 million, 250,001 of which need to be preferred. 4. But in Del just need vote of 500,001 common s/hs. d. PLAIN VANILLA STATUTORY MERGER is classic 46 merger where s/hs of disappearing corpn receive only stock in suriving corpn. This is TAX-FREE for all participants. e. But instead of getting shares, s/hs of disappearing corpn can be CASHED OUT, meaning they receive cash or debt securities as consideration. This is taxable. Del 251(b)(5) and NY 902(a)(3). f. ABANDONMENT: Despite s/h approval, Bd may abandon transaction without further action by s/h prior to consummation, if plan of merger so provides. Del 251(d), NY 903(b). g. COMPLETION: Must draw up and file certificate of merger w/Secretary of State. Del 251(c), NY 904. h. APPRAISAL: 1. Del 262(a): Dissenting s/hs of both corpns have right to appraisal subject to the ordinary restrictions in 262(a). 2. NY 910: a. Dissenting s/hs of disappearing corpn have right to appraisal. b. Dissenting s/hs of surviving corpn have right to appraisal only if one of the adverse changes under 806(b)(6) (Charter Amendment) occurs. i. RESULTS: 1. Merger agreement automatically amends C/I of survivor. Del 251(e), NY 906. 2. SURVIVOR POSSESSES: a. All rights and powers of each constituent corpn. Del 259(a), NY 906(b) b. All property, liabilities, and legal claims by and against disappearing corpn. Outstanding lawsuits may be prosecuted as if merger hadn't taken place. Del 261, NY 906(b)(3) B. SALE OF ALL OR SUBSTANTIALLY ALL ASSETS 1. GENERALLY: a. Alternative to merger or consolidation, which has substantially the same effect but for some key differences. b. In SALE OF ASSETS, A buys all assets of T, either in exchange for stock of A or cash or property. c. A must also assume all of the liabilities of T. UNLIKE A MERGER, A ONLY ASSUMES THE LIABILITIES ON THE BOOKS OF T AT THE TIME OF THE SALE. (Only known liabilities.) d. 2 ways for T to dissolve: 1. A buys all of T's assets for cash. T distributes the cash to T's s/hs and then dissolves. OR 2. A gets all assets and liabilities of A and T. T is a holding company with the 47 shares of A. T distributes the shares of A to T's s/hs and dissolves. a. Note: T must liquidate in order for this to be a tax-free deal. e. ADVANTAGES OF SALE OF ASSETS OVER STATUTORY MERGER: 1. Historically, state law didn't permit mergers, so no choice. 2. Usually, target is a small company under close management. Concern that liabilities are more severe than those on the books. Only assume express liabilities in asset acquisition. f. EXCEPTION TO LIMITED LIABILITY RULE in products liability area in NJ and Cal which have drafted successor liability rules so that if A buys T's assets and continues to manufacture T's products, A takes over known and unknown liability exposure. g. STATUTES ABOUT SALE OF ASSETS: 1. Del 271: a. Del 271(a): A corpn may sell all or substantially all assets, provided that a MAJORITY OF THE SELLER'S shares entitled to vote on the transaction approve it at a meeting duly convened on at least 20 days notice. (Note that only the seller (T) votes.) b. Del 271(b): Bd may subsequently abandon the deal. c. Although not explicit, statute implies that BD MUST INITIATE TRANSACTION. d. NO APPRAISAL RIGHTS for sale of assets in Del. e. NO CLASS VOTING RIGHTS unless in C/I. 2. NY 909: Sale of assets not in the ordinary course of business requires: a. adoption by BD RESOLN b. NOTICE to each s/h of record both voting and nonvoting. c. APPROVAL BY 2/3 OF SHARES OF outstanding stock of SELLER entitled to vote. (Note that only the seller (T) votes.) d. Note that if acquiring corpn has same name as selling corpn, then after 30 days from the filing of acquiring corpn's C/I, selling corpn will automatically dissolve. e. In NY, sale of assets gives APPRAISAL RIGHTS. NY 910. f. NO CLASS VOTING rights unless in C/I. 48 3. Although under statute s/hs of acquiring corpn don't get right to vote, under NYSE MANUAL RULE 312.03(c), vote of acquiring s/hs must be held on transaction which will result in additional shares listed on NYSE. So practically will result in s/h vote b/c, since can't have listed and unlisted shares in the same class, NYSE will delist the other shares if no s/h vote is done. C. DE FACTO MERGER DOCTRINE: 1. GENERALLY: Since sale of all assets transactions may have same effect as a merger, some courts have held that such transactions are subject to the same procedural requirements as merger--appraisal rights or s/h approval. Absent such protection, ct may enjoin transaction. 2. Farris v. Glen Alden Corp.: (Penn) a. Facts: Upside down transaction. GA (tiny company) was acquiring List (large company). In reality, List is acquiring GA. Deal wasn't structured as merger to deny GA's s/hs their appraisal rights--only get appraisal rights in Pa. if statutory merger--and to allow GA to use its NOLs and to avoid paying transfer tax. b. Steps to transaction: 1. List acquired 38.5% of GA and takes 3 seats on GA's Bd. 2. All the assets of List are sold to GA. 3. In consideration, GA issues 3.6 million shares of its stock to List s/hs (requires charter amendment, which it gets via proxy.) 4. Name of GA becomes List Alden. 5. List is dissolved. c. Plaintiffs are GA s/hs claiming that this is a merger (not mere issuance of stock in exchange for assets), so they deserve appraisal rights. Ct looks at book value and finds co. is losing lots of $, but market value shows the opposite. GA is in the coal business; assets are worth much more than its stock. d. Ct held that sale of assets transactions which for all practical purposes are mergers are subject to the merger requirement. TEST TO SEE IF SALE OF ASSETS IS A DE FACTO MERGER: 1. If buyer issues his own stock as consideration, rather than cash or other property, then it may be a merger. 2. If sale contract requires that seller of assets dissolve and distribute the stock it received after transaction is complete, then it may be a merger. 3. Here, 1 corpn dissolved, its liabilities were assumed by survivor, its dirs took over management of 49 survivor and, as consideration for transfer, its s/hs acquired a majority of the shares of stock of the survivor and thus considered merger. 3. STATUS OF DE FACTO MERGER DOCTRINE: a. DELAWARE doesn't follow it at all. Rather, Del 271 requires that s/hs of seller approve sale of assets transactions by majority--no approval by s/hs of acquiring corpn and no appraisal rights for dissenting s/hs of selling corpn. 1. Hariton: (Del) a. Facts: Arco (Del) sells its assets to Loral (NY) in exchange for Loral stock. Arco liquidates and distributes shares to s/hs. Situation resembles merger, but Arco s/hs are denied appraisal. b. Ct held that once transactional form is chosen, must take consequences of that form. S/hs have no veto power. Loral has right to structure the transaction however it wants. c. This is known as the INDEPENDENT LEGAL SIGNIFICANCE DOCTRINE. Each part of the statute has independent legal significance. Can do deal under 1 part of statute even if couldn't do it under another. And if there are multiple ways to do a deal, can pick one even if another way would give different rights to s/hs. 1. Note that many changes can be effected through a merger (i.e. amending C/I) that would otherwise trigger class voting. b. NY: S/hs of selling corpn have appraisal rights in a sale of assets transaction; thus, they don't need de facto merger doctrine. 1. But it's an open question as to whether s/hs of acquiring corpn have appraisal rights. IV. SMALL MERGERS AND SHORT FORM MERGERS: NOT FUNDAMENTAL CHANGES A. SMALL MERGERS: Del 251(f) (NO NY ANALOG) 1. Only in Del. 2. No s/h vote of acquiring corpn is necessary to authorize small merger but still need majority of outstanding s/hs entitled to vote of disappearing corpn. 3. Requirements: a. Merger agreement does not amend the C/I of survivor in any way. It is designed to ensure that doing small merger will not be used to eliminate voting rights. b. No changes are made in the stock of surviving corpn. AND c. Either no common stock of survivor is to be issued under the plan of merger, OR authorized unissued shares of common stock of survivor do not exceed 20% of common stock of 50 survivor outstanding prior to merger. 1. Has to do with NYSE listing requirements, which provide that s/h approval is necessary for transactions effecting 20% or more of stock. If no s/h approval, not listed on NYSE. 2. If GM acquires small coffee shop, no vote by GM s/hs is needed b/c the new shares GM will issue is surely less than 20% of GM's outstanding shares, and it will not affect GM's C/I. 4. Rationale why s/h approval by surviving corpn is not needed: Usually get s/h approval for large structural changes, which this is not. In fact, costs of notifying s/h and getting approval may be too high. This is NOT A FUNDAMENTAL CHANGE. 5. APPRAISAL RIGHTS: a. Del 262(b): No appraisal right for dissenting s/hs of surviving corpn (b/c their vote wasn't required for approval of small merger.) b. But dissenting s/hs of disappearing corpn subject to normal appraisal rule for mergers. B. SHORT FORM MERGER: parent/sub 1. Both NY 905 and Del 253 provide that a merger may be effected by the adoption of a Bd resoln without s/h approval if the corpn owns at least 90% of the company being merged. 2. Note: No real change in circumstances for s/hs of parent; material changes for s/hs of sub, but since 90% of sub belongs to parent, they have no chance. a. EXCEPTION: If parent is not surviving corpn, this would be a fundamental change and need s/h approval by parent's s/hs. 3. Also allows the parent to merge into the sub (i.e. sub survives) under the same rule, but need parent s/h approval, and stock of surviving corpn is issued to parent s/hs. 4. Del 253(d), NY 910: If parent didn't own 100% of sub's stock prior to merger, sub s/hs have appraisal rights. V. APPRAISAL AND VALUATION A. GENERALLY: 1. Appraisal is the right of a s/h who has dissented from a transaction to receive the appraised (fair) value of his shares. 2. In NY, right to appraisal and right to vote flow together. In Del, appraisal only exists for mergers. 3. Purpose of the appraisal is to coerce settlement. B. STATUTES FOR APPRAISAL 1. Del 262: very narrow right of appraisal a. 262(a): S/h who neither votes in favor of nor consents in writing to merger is entitled to appraisal (but not 51 s/hs of surviving corpn in small merger under Del 251(f)). b. 262(b): 1. Appraisal right is NOT available if: a. shares are LISTED on national stock exchange b. stock is HELD BY MORE THAN 2000 s/hs OR c. it's a SMALL MERGER under Del 251(f) 2. If appraisal right is not available, dissenting s/hs may still receive appraisal if s/hs are given anything other than: a. stock in survivor b. stock in another co w/more than 2000 s/hs. OR c. cash or combo of stock and cash 3. Appraisal is available to sub's s/hs if it's a short form merger under Del 253 and parent didn't own 100% of sub's stock prior to merger. c. 262(c): Although not provided for by statute, appraisal rights for merger or charter amendment or sale of all assets may be expressly created in C/I. d. 262(d): NOTICE OF RIGHT TO APPRAISAL 1. S/hs must be given NOTICE of right to appraisal at same time they're notified of right to vote on merger (at least 20 days prior to merger). Copy of statute should be furnished. If s/h chooses to dissent, he must do so in writing before the merger takes place. If the merger passes, corpn must submit those shares to court for appraisal within 10 days. 2. If short form merger, corpn must furnish s/h with notice that it took place w/in 10 days of merger, and then s/h can request appraisal afterwards in writing w/in 20 days after notice mailed. e. 262(e): W/in 120 days after effective date of merger, s/h may file petition in court demanding valuation of stock. W/in 60 days of effective date of merger, anyone who has filed for appraisal may change his mind and accept terms of merger. f. 262(h): After determining which s/hs are entitled, ct shall determine their fair value exclusive of any element of value arising from the merger or consolidation. Also entitled to interest for time they've waited for payment and to discovery. g. 262(k): S/h cannot vote his stock while appraisal being done. h. Del does not say whether appraisal is exclusive or not. 2. NY: a. NY 806(b)(6): Appraisal is available for 52 CHARTER AMENDMENT if amendment: 1. alters or abolishes any preferential right 2. creates, alters or abolishes redeption right 3. alters or abolishes preemptive right to acquire shares or other securities OR 4. excludes or limits right of s/h to vote b. NY 910: Appraisal is available for s/hs dissenting from: 1. MERGER OR CONSOLIDATION UNLESS: a. he is a s/h of parent corpn in short form merger (NY 905) or merger between NY and non-NY corpn (NY 907(c)) OR b. he is s/h of surviving corpn in merger unless one of the adverse changes in 806(b)(6) occurs. 2. SALE, LEASE OR EXCHANGE OF ALL ASSETS, UNLESS transaction is entirely for cash, where s/h approval is conditioned on dissolution of corpn and distribution of substantially all net assets to s/hs. c. NY 623(k) has attempted statutorily to make appraisal an exclusive remedy, but generally the mere availability of an appraisal right does not preclude a s/h from receiving equitable relief from self-dealing or fraud. So if s/h seeks injunction rather than damages, he can avoid exclusivity. c. Bove: (RI but used Del law) 1. Facts: Community Hotel Corp. had only 1 asset, a hotel in Newport. Also had large accumulation of unpaid dividends it wanted to get rid of. It could have done so by amending charter, but would need a unanimous vote. Solution is to form a new subsidiary capitalized with 80,000 authorized shares of common stock, of which only 1 share was issued to parent for $10. Need only 2/3 vote of preferred and common of parent for merger to be effective. Downstream merger of parent into sub, in which preferred s/hs of parent will get 5 new common shares of sub, common of parent will get 1 new common share of sub. 2. Preferred s/hs claim that this is a de facto charter amendment, and only purpose of transaction is to wipe out dividends on preferred. Preferreds think common s/hs shouldn't get anything, but management needs common's vote. So common s/hs have the "going concern", which is that b/c they have the right to vote, management can't do the deal without them, so their vote is worth something. 3. Ct borrowed INDEPENDENT LEGAL SIGNIFICANCE DOCTRINE from Del. a. The transaction is w/in corpn's powers, b/c even though the s/hs' rights have been altered, corpn is permitted by reserve power to amend or repeal contract between 53 preferred s/hs and corpn. b. S/hs may exercise appraisal right and force corpn to buy shares for fair value. c. Note that although in RI appraisal is not an exclusive remedy as a formal rule, RI courts make it de facto an exclusive remedy by not listening to arguments concerning the fairness of the transaction. d. NY has attempted statutorily to make appraisal an exclusive remedy (NY 623(k)), but generally the mere availability of an appraisal right does not preclude a s/h from receiving equitable relief from self-dealing or fraud. So if s/h seeks injunction rather than damages, he can avoid exclusivity. e. Del does not say whether appraisal is exclusive or not. f. In Cal, appraisal really is exclusive--if have appraisal remedy, only issue that can be litigated outside appraisal is the vote itself. D. VALUATION OF COMPANIES 1. GENERALLY, valuation is the process of trying to look into the future and find the present discounted value of what this property will be worth. a. Extremely inexact method. 2. The implications of EMH for appraisal: a. S/hs sue for appraisal b/c they want the fair value of the security. b. Semi-strong EMH says fair value is what security is trading at in market. c. If publicly held security, only consider trading price. d. Del and Cal have statutes that provide no remedy of appraisal if security is publicly traded b/c they feel s/h can just sell his shares on the market. Slain questions if this is fair b/c then these s/hs have no special right and all s/h can get is market price after the merger, which doesn't reflect the pre-merger value of the stock. 1. Effect of Del and Cal rules: If s/h wants to know value of securities before transaction occurs, s/h can't b/c it's impounded into price. This shows Del and Cal believe in the EMH. 3. DELAWARE BLOCK METHOD a. Used in many jurisdictions, but no longer in Del after Weinberger. b. Assumes the validity of semi-strong EMH. c. Takes the weighted average of several factors including: 54 1. MARKET VALUE OF STOCK: closing price on day before merger announced 2. NET ASSET VALUE 3. EARNINGS VALUE: Valuation of earnings over past 5 years, excluding extraordinary gains and losses. (Note: We're looking at present value of past earnings, but really interested in anticipated future earnings, which we determine by taking present earnings times a multiplier--multiplier is determined by examining other companies in similar business or using expert testimony.) d. Assign a weighted average to each value (very arbitrary). 4. Piemonte: Mass a. Facts: Old Garden did downstream merger--formed sub (New Garden) and merged into it in order to shake loose the minority s/hs. Dissenting minority s/hs sought appraisal rights. Mass ct used Del block method. b. MARKET VALUE: Ct used price of last sale before merger even though not much trading. (Note: not fair market value.) If no market, ct had option of reconstructing mkt (i.e. looking at other companies). Slain thinks if market is reconstructed, it's hard to see how this differs from earnings value. Slain thinks looking at other companies is not efficient. c. EARNINGS VALUE: Present value of future earnings. (Problem here was that ct capitalized past earnings, not expected future earnings.) d. NET ASSET VALUE: Total market value of assets divided by number of shares. Difficult to measure--use book value? liquidation price? replacement value? Nothing is sufficient. Here, ct used book value as baseline and then plucked net asset value out of the air. e. Ct assigned arbitrary weights to each factor. 1. Slain says that in spite of its reputation, there's no evidence that Del block method is inferior to any other. 2. Value of anything in future is unascertainable. Value is judgment about the discounted present value of utility that can be derived from owning something in the future. 5. ENTIRE FAIRNESS TEST: S/hs' rights other than appraisal. a. Mostly arises in the area of tender offers, where the acquirer wants to do a "back end take-out merger" to get rid of the minority s/hs left in the target. A two-tier tender 55 offer where offeror will pay a lot for the 51% and then back-end merge the minority at a lower price could present coercive situation b/c offeror is threatening s/hs of target co. to get s/hs to tender their shares. Therefore, entire fairness applies b/c minority s/hs may have felt forced to tender their shares. b. Singer: Singer's business purpose requirement is overruled by Weinberger. 1. Minority s/hs claimed right to have merger unwound b/c it was abuse of controlling s/hs' FIDUCIARY duty to minority s/hs. 2. Del ct held that transaction had to have a VALID BUSINESS PURPOSE. If no business purpose, controlling s/hs abused their power. Minority s/h is not limited to appraisal--can get damages for tort of conversion equal to value of minority s/hs' stock determined at time of merger using evidence found relevant and credible--not bound to appraisal methodology. 3. Slain thinks this is meaningless--what isn't a valid business purpose for a merger? He calls this the ECTOPLASMIC TORT--tort with only element being that minority s/h is being forced out of company by deal and doesn't want appraisal remedy, so he sues for tort. c. Weinberger: 1. Facts: Tender offer occurred. Signal acquired 50.5% of UOP at $21/share. Signal, now majority s/h, is trying to eliminate 49.5% of UOP left by doing cash-out merger. 2 Signal officers, who are also UOP dirs, did feasibility study on what was fair price and said anything up to $24/share. But they disclosed to Signal management that price of $20-21 would be right. Since the acquirer owns a majority of the target, it can vote to merge. 2. Ct held that preparers of feasibility study breached their fiduciary duty to UOP--FIDUCIARY duties to both corpns doesn't lessen the fiduciary of either. If dirs are on both sides of the transaction, they must show good faith and fairness. a. Footnote 7 holds that an independent committee should be created to determine the price of the shares b/c if the dirs are dirs of both corpns, they have a divided fiduciary duty. Footnote 7 has become the standard when there is no real independent management. 56 3. This case explicitly overruled the business purpose requirement for cashoou mergers of Singer. 4. Ct defined ENTIRE FAIRNESS as both procedural (FAIR DEALING) and substantive (FAIR PRICE). Generally, proponents of transaction have burden to prove entire fairness. a. FAIR DEALING: involves timing, structure, negotiation, disclosure and how approval of s/hs and dirs is obtained. 1. Here, feasibility study was for the sole use and benefit of Signal not for negotiations, not at arms length b/c Signal structured the transaction. Conflicts of interest by preparers of the feasibility study were all resolved in Signal's favor. No disclosure of circumstances surrounding fairness opinion. 2. Approval by an informed vote of a majority of the minority s/hs shifts the burden to opponents of the transaction (i.e. minority s/hs) to show unfairness to the minority. b. FAIR PRICE: Traditional Del block method is outmoded for any purpose including appraisal. In appraisal valuation, significantly broadened factors that a ct may take into account, most notably methods used in financial community, including discounted cash flow and earnings per share. Slain says if plaintiff claims only procedural fairness, no case--need economic unfairness. 1. Economic fairness is what the Weinberger ct relied on. 5. Effect of Weinberger: a. Gets rid of Singer ectoplasmic tort claim--any plaintiff who raises claim that he didn't want to be merged out is remitted to appraisal. 1. Slain says this makes sense if controversy only relates to the value of stock but leaves open the possibility of maintaining an action for fairness of process claims. b. Weinberger says that a plaintiff is left to an appraisal remedy, but in a few narrow situations, appraisal may not be adequate b/c there may have been unfair process. In such a case, entire fairness remedy may provide a 57 plaintiff with something more b/c entire fairness means fair price and fair dealing. c. If the transaction is fair but s/h doesn't like it, he gets appraisal rights; if the transaction is unfair, he still gets appraisal rights. 6. Note on BUSINESS JUDGMENT RULE: BJR can only be used with total strangers, whereas interested parties use the entire fairness doctrine. d. Rabkin: (Del) 1. Facts: Olin bought 63.4% of Hunt common stock at $25/share and agreed to pay $25/share if it acquired the remaining Hunt stock within 1 year of the merger. 1 week before the 1-year commitment period was up, the majority approved paying only $20/share. 2. Ct said minority s/hs had remedy broader than appraisal. Majority s/h breached fiduciary duty and engaged in unfair dealing by purposely timing the merger and thereby unfairly manipulating it to avoid the 1-year commitment. 3. Slain doesn't understand what the majority s/hs did that was so bad. VI. DISSOLUTION OR LIQUIDATION A. STATUTES: 1. Del 275: a. Del 275(a): If the Bd decides that corpn should be dissolved, BD SHOULD ADOPT A RESOLUTION approved by majority of entire Bd without vacancies and give notice to every s/h entitled to vote. b. Del 275(b): If a MAJORITY OF S/Hs entitled to vote votes for dissolution, file certificate of dissolution. c. Del 275(c): Dissolution may be authorized without action of directors if all s/hs entitled to vote consent in writing and file certificate. d. Del 275(e): Bd may abandon proposed dissolution if resolution so provides. e. Del 275(d)-(f), 278-82: Plumbing 2. NY a. NY 1001: A corpn may be dissolved if authorized by 2/3 OF ALL OUTSTANDING SHARES ENTITLED TO VOTE, unless C/I says otherwise. b. NY 1006: Dissolved corpn may continue to function to wind up affairs of corpn as if dissolution hadn't taken place. c. NY 1007: After dissolution, corpn may require all creditors to present their claims in writing. d. S/H PETITION FOR DISSOLUTION: 1. NY 1103: a. If s/hs adopt resolution stating that they find its assets insufficient 58 to discharge its liabilities or that dissolution would be beneficial to them, s/hs may petition for dissolution. b. S/h mtg to consider such resolution may be called by holders of 10% of outstanding shares entitled to vote. c. Resolution may be adopted by vote of MAJORITY OF ALL OUTSTANDING SHARES entitled to vote. 2. 1104(a): Holders of 1/2 of all outstanding shares entitled to vote in election of directors may present petition for dissolution if: a. directors are so divided that votes required for action can't be obtained b. if s/hs are so divided that votes required for election of directors can't be obtained OR c. there's internal dissension among s/hs. B. Common law attitude toward dissolution made it hard to get dissolution. The focus was on the ability of the business to function in SOME way rather than on the s/hs. 1. In re Redon: Echo of Galler a. Facts: Brother and sister own stock equally and are joint signatories on all bank accounts so need both to agree to do anything. They make lots of money, but sister won't sign brother's paycheck. Brother sues for dissolution. b. Ct held that since no problem with day-to-day running of business, dissolution was not allowed. c. Note: This is the situation which NY statute is intended to remedy. 2. Central Std Life Insurance Co.: Echo of Bove a. Facts: Life ins. co. organized and bought stock in hotel. Common stock owned by family; preferred stock owned by the company. Preferred stock didn't have enough contingent voting rights to give themselves control in the event of non-payment of dividend. No dividend was paid to them. Common s/hs refused to agree to dissolve b/c they'd lose their jobs. So preferred s/hs (life insurance co.) sued for dissolution. b. Ct held no dissolution allowed b/c although business has lost money for the last 40 years, no one can imagine it ever making money, the business was still alive. C. In re Kemp and Beatley: laxer than common law std 1. Facts: Two s/hs holding 33% of stock of close corpn and who were former employees of corpn petition 59 for dissolution b/c they were "frozen out" of co.'s earnings. Corpn had policy of awarding de facto dividends in the form of extra compensation. When plaintiffs' employment ended, the policy was changed so that stock ownership is no longer used as a basis for payment. Rather, basis of payment became services rendered to corpn. 2. Ct held that corpn's actions were oppressive to plaintiffs and that dissolution was the best way to protect their interests. Oppression occurs when the majority defeats expectations that from an objective std were reasonable and central to the plaintiff's decision to join the venture. Here, change in policy was an attempt to exclude the 2 s/hs from getting a return on their investment. 60 VI. DUTIES OF MANAGERS AND OTHERS I. THE FIDUCIARY PRINCIPLE A. GENERALLY: 1. A FIDUCIARY is someone upon whom the law limits the usual right to act with reference to his own interest by imposing a duty to prefer the interests of another. 2. SEC v. Chenery: (SCt) Reorganization of company where officers and employees who bought preferred stock are precluded from enjoying benefits inuring to other holders of stock on grounds that they are fiduciaries. In striking this down, Frankfurter notes that TO DESCRIBE SOMEONE AS A FIDUCIARY MEANS THAT ONE MUST INQUIRE: a. as to WHOM the person owes a fiduciary duty b. WHAT those obligations are AND c. HOW they have been breached Note: There is no general fiduciary principle, but must be owed to some person and consist of some defined duty. No one is a fiduciary as to every aspect of his life for the rest of mankind. II. THE DUTIES OF MANAGERS A. THE DUTY OF CARE 1. Duties of officers should be greater than that of directors b/c officers work full time while dirs don't. 2. Directors have a duty of care to discharge their duties in good faith and with that degree of diligence, care and skill as ordinary prudent people under similar circumstances in like position. THE DIRECTOR IS IN A FIDUCIARY RELATIONSHIP TO THE CORPN AND ITS S/Hs. 3. Francis v. United Jersey Bank: (NJ) a. FACTS: Mrs. P is REINSURANCE broker. In reinsurance, ceding co. sells some risk and premium to reinsurance co. through broker. Until broker pays the reinsurance co., he has the $ to work with--the "float". Interest on float makes up large part of broker's income. Broker is supposed to segregate insurance funds from his general accounts. Mrs. P's sons comingled their commissions w/client's funds and "borrowed" clients' $. The loans were not properly paid back and eventually caused the co. to go bankrupt. Mrs. P was a dir of corpn and had no idea what was going on or how the business was run. b. Ct held that she was liable for negligence b/c she had duty to corpn, and her nonfeasance proximately caused the harm. c. Duties of dirs: 61 1. must have at least a basic understanding of the business 2. must attend bd mtgs, review financial stmts, object and resign if they know corpn is engaging in illegal conduct, seek counsel's advice and take reasonable means to prevent illegal conduct. 3. in $ mgt business, dirs are held to higher std of care. Note that in reinsurance dir has fiduciary duty to clients. 4. fiduciary duty to corpn and to s/hs but to creditors only if insolvency d. Today, Francis may argue that she is exculpated under NY 402(b) b/c she didn't act in bad faith or fraudulently. Slain doesn't know if she'd win or not. B. THE BUSINESS JUDGMENT RULE 1. Generally, directors are not held liable for the consequences of their business decisions if those decisions were based upon reasonable information and made with some rationality. Courts allow directors discretion if these conditions are met and will not second guess their substantive business decision. a. Do not use if there's a conflict of interest. 2. Rationale for the BJR: (from Joy v. North) a. Caveat emptor: S/h purchases with an awareness of the risks of bad business judgment. b. Cts recognize that after-the-fact litigation is an imperfect device to evaluate corporate decisions--a reasoned decision may seem like a wild hunch viewed years later against a background of perfect knowledge. c. Judges may not be competent to evaluate the costs of benefits fo engaging in certain actions. d. Desirability of risk-taking: This encourages directors to take those risks necessary for maximization of s/h welfare without the chilling effect of causing them to make overly cautious decisions b/c their judgment will be reviewed by the court. 3. NY STATUTES: a. NY 717: Provides that director perform duties in GOOD FAITH and with that degree of care which an ordinarily PRUDENT PERSON in a like position would use under similar circumstances. 1. Dir can rely on info presented by employees of corpn or professional experts. 2. In actions which may cause a change in control of corpn, dir can consider long and short-term interests 62 of corpn and its s/hs and effects corpn's actions may have on corpn's potential growth and profitability and ability to do its work. b. NY 720: Provides that corpn, receiver or s/h may bring action against director or officer to compel him to account for violation of duties, for waste of corporate assets due to violation of his duties or to set aside or enjoin an unlawful conveyance. 1. Executive Committee can perform the duties of the Bd. Note that Del 141 is more limited. 4. Kamin v. American Express: (NY) a. Facts: Derivative action alleging that the corporate decision to declare a dividend was a breach of its fiduciary duty b/c corpn could have sold its stock and taken a capital loss for tax purposes. (AMEX would have had $8 million if they had sold the securities.) b. Ct held that absent a claim of fraud or selfdealling oppression, arbitrary action or a breach of trust, a complaint which states that director should have taken a more advantageous course of action does not state a cause of action b/c of the BJR. c. Note: This case shows that the parties don't believe in the EMH. The EMH says price includes all public information about corpn, so it should include the $8 million loss. Yet AMEX is saying it's not taking loss so that the market price of the stock would remain high. This is inconsistent with EMH. d. Note: High stock price is important in order to ward off tender offerors and b/c institutional investors care about the price of their stock. C. CONFLICTS OF INTEREST: can't use BJR if there is a conflict of interest 1. Common law rule: Any contract made between the director and the corpn was voidable at the insistence of corpn or s/h. It doesn't matter if the transaction is fair or if approved by a majority of disinterested directors. a. POLICY: Person can't act for himself and be an agent simultaneously. 2. MODERN RULE: a. Del 144: Transactions between corpn and 1 of its directors or between corpn and other organization in which 1 of its directors is a director or has a financial interest are not voidable if: 1. Disclosure of relationship/interest and transaction is made to Bd, and majority of disinterested directors approve transaction even if disinterested dirs are less than a quorum of total dirs. 2. Disclosure of interest and transaction are 63 is made to s/hs, and they approve transaction OR 3. The transaction is fair. (Apply ENTIRE FAIRNESS TEST to see if transaction is fair.) 4. This statute cannot be read literally b/c then plaintiff could never get to court claiming unfairness b/c it's possible to get approval of disinterested dirs but still be an unfair transaction. Therefore plaintiff may use entire fairness test to oppose the transaction. Follow Weinberger--Without approval by majority of disinterested dirs, proponents of transaction (defendant Bd of Dirs) have burden of proving transaction is fair. But if majority of disinterested dirs approve the transaction, burden of proof shifts to plaintiff (opponents of transaction) who must show it wasn't fair. b. NY 713: Transactions with interested directors are not voidable if: 1. disclosure is made to the Bd and majority of disinterested dirs (w/o counting interested dirs) approves transaction. If this is less than a quorum of dirs, then the approval by disinterested dirs must be unanimous. OR 2. disclosure to the s/hs, and they approve transaction 3. If neither 1) nor 2), then corpn may avoid transaction unless interested director can show that the transaction was fair. D. CORPORATE OPPORTUNITIES 1. Directors and officers may not appropriate the corporate opportunities of a corpn for their own benefit. This is an application of the AGENCY PRINCIPLE that an agent may not capitalize upon information gleaned while serving as an agent. This is a FIDUCIARY PRINCIPLE which limits the powers of officers, directors and employees to take personal advantage of opportunities that belong to the corpn. 2. TESTS: a. Lagarde test: Director has wrongfully appropriated corporate opportunity if: 1. Dir or officer acquires property in which the corpn has an interest or an expectancy growing out of a right. OR 2. interference will in some degree balk the corpn in effecting the purposes of its creation. 3. Note that use of the test is unclear and unduly narrow. b. LINE OF BUSINESS TEST (Del): Dir has wrongfully appropriated corporate opportunity if the opportunity rests within the corporate line of business. This occurs if: 64 1. opportunity embraces an activity as to which corpn has fundamental knowledge, practical experience and ability to pursue 2. opportunity is adaptable to business of corpn having regard to corpn's financial position AND 3. opportunity is consonant with corpn's reasonable needs and aspirations for expansion 4. If offer is made to director as an agent of the corpn, use the test above. But if offer is made to director as individual, then liability only arises if the opportunity is essential to the corpn or if the director uses corporate resources to exploit the corpn. c. FAIRNESS TEST: depends on an assessment of the fairness of the transaction under the circumstances--ethical stds of what's fair and equitable. E. SETTLEMENT OF LITIGATION 1. DERIVATIVE SUITS a. Generally, a derivate suit is one brought by the s/h in the name of the corpn against a wrongdoer. To achieve res judicata, the corpn is involuntarily joined as a nominal defendant, since it won't join as a plaintiff. For purposes of determining diversity jurisdiction, corpn may be realigned as a plaintiff. Any recovery inures to the corpn. So no direct benefit to the individual s/h. However, the s/h will recover attorney fees. b. DEMAND REQUIRED: Where a s/h desires to bring a suit involving the normal business of the corpn, he must first make a demand upon the Bd to initiate such a suit. If the Bd declines, he may institute a derivative suit but the judgment of the Bd is protected by the Business Judgment Rule. c. DEMAND EXCUSED: Where a s/h alleges a breach of fiduciary duty or conflict of interest on the part of the Bd of Dirs, he is excused from having to make a demand upon the Bd before instituting the action. d. CONTEMPORANEOUS OWNERSHIP RULE: Under FRCP 23.1, only a s/h who owned shares at the time of the transaction complained of may bring suit. This is in furtherance of the policy against purchased suits. e. FEDERAL/STATE LAW CONFLICT: If uncertain whether an action is demand required or demand excused, usually should demand to keep the issue from arising later. 1. However, under Del law, a demand to the Bd is treated as a concession that suit is demand required. 2. Under federal law, however, might have to 65 make the demand under FRCP 23.1 as a prerequisite to any action. 3. 2d Cir. has held that where the 2 policies are at odds, state law controls. 4. 7th Cir. has held t