Prof. Hillman Business Associations Page 1 of 87
Warning : this is an unedited class -notes style transcri ption.
Bus. Ass. Prof. Hillman
8th Edit ion by Mel Eisenberg probably in by Wednesday and
Case book supplement and
Statutory supplement (might want to share)
Problems Sheet (Handout)
Outside reading recommended: Wall street Journal on-line or library
Exam is closed book anyway
Th Oct 11 class cancelled, Makeup days set aside:
Monday Sept 10 Noon Make up class
Conflicts with Products Liability, darn it!
1) Introduction Class is mostly about people and the relationships they have when they associate in a
business venture. This is a special psychology course. First 2-3 classes is mostly vocab and info about
forms of association
a) Associational Forms Principle forms of doing business
i) Corporati ons
(1) Most important fro m an econ perspective
(2) Can be small (1 person) to huge mu ltinational/ mult ibillion
(3) Vocab. Identified by INC. or Incorporation (both public and close) this is different fro m
most of the world
(4) Vocab Owners = Stockholders aka Shareholders
(5) Broadly speaking/functionally speaking there are 2 kinds of corp
(a) Public corp aka publicly held corporation Many owners
(i) Most stockholders have small stake, are passive owners, do not participate in
decision making process
(ii) Easy to sell stock if you don‟t like corp policy practice d irection whatever
(iii) Market structure for buying/selling ownership interest in public corps also
makes it easy to buy/sell shares/stock
(iv) Control over corp. management is exercised how?
(v) Managers are accountable to whom?
(vi) How do we avoid manipu lation and fraud when public corps. raise $ for the
bus.? (Answer is Federal Securities Laws)
(vii) Public Corp. Microsoft, Inc.
(b) Close corp aka closely held corporation Few Owners
(i) Owners can all sit down at one table, maybe 1-5 people
(ii) Can be huge $ just means few people
(iii) Tendency for stockholders to be active in management/control of corp.
(iv) One or a few people own enough to control the corporation
(v) Hard to get out of the business because the market doesn‟t exist. Can‟t sell on
line, not publicly traded. You might get trapped while you look for a buyer.
(vi) Example Cl ose Corp. Davis Hardware, Inc. is a close corporation, is
reasonably small, is our business model for this class of a close corporation
1. Hillman has a 60% interest
a. Hillman calls the shots, what are the limits on Hillman‟s control and
power over the corporation?
2. Class has a 40% interest
(6) Characteristics of Corporations both close and public
(a) Legal entity aka legal person has a legal existence separate from its owners
(b) Corp can be formed only through the observance of certain formalities. Cannot be
formed accidentally. Requires a filing with the secretary of state of the state where
(c) Ownership interests are evidenced by what we call shares of stock aka shares aka
stock. Shares are freely transferable at least hypothetically.
Prof. Hillman Business Associations Page 2 of 87
(d) Management of the corporation is centralized. The basic management structure is:
(i) Sharehol ders elect a: Board of Directors
(ii) Board of Directors who oversee the management and elect: Officers
(iii) Officers perform day to day running of the corporation. EG treasurer
(e) Corporation has a continuing uninterrupted existence, doesn‟t die
(f) Offers the owners the benefit of limited liability, shareholders are not personally liable
for claims against the corporation.
(i) Owners have limited liability.
(ii) The liab ility is that shareholders will lose money if the corporation loses $
because their stock will go down in value. Liability is limited to the owner‟s
INVESTM ENT in the corporation because the value of the stock could go down
(iii) Benefit is that the owner cannot be sued personally and lose home, bank
account, whatever else held by owner outside of corporation.
(g) Double taxation.
(i) Corporate inco me gets taxed t wice, and here is how: assume corporation earns 1$
1. Tax rate of corporate inco me is 34% o f the NET income so now corporation
has .66 cents left
2. Now corporation wants to distribute the .66 cents to the owners.
a. Personal tax rate means that owners must pay is 28%. Owners must pay
18 Cents tax.
b. Now shareholders only get .48 cents on the dollar because of double
(ii) Subchapter S (of the Tax Code) is avail on a limited basis for some closely held
(NEVER PUBLIC) corps and eliminates the corporate entity for tax purposes so
that you don‟t get double taxed.
1. In our examp le above the 28% personal tax is applied but not the corporate
2. This Subchapter S thing is only available in a very small nu mber of situations
so it‟s not a real solution to the double taxation problem for most clients.
(iii) Play with the dollar inco me it‟s NET that‟s taxed so increase expenses. Give
big raise to board of directors, in a close corp the expenses go up only get taxed
28% on personal income.
b) The advisability of Incorporation
c) The Jurisdiction of Formation
d) The Incorporation process and Design of the Capital St ructure
i) How Capital is raised
(1) Vocab : Capital = money
e) Corporate purposes and powers: the ultra vires doctrine
f) Federal Securit ies Law
g) Fiduciary Obligations
h) Distribution of Assets (Money) from a Corp
2) Tuesday, August 28, 2001
3) Corporations Continued
a) Main reason to incorporate is to protect personal assets fro m liab ility
b) Main downside is taxat ion
i) Double taxation see above
ii) Inability to pass tax losses though to shareholders
(1) Tax losses are good because they have a real value the reduce tax liability
(2) Tax losses are not the same thing as real economic losses
(3) Tax losses are things that the IRS/Internal Revenue Code (Tax statutes) allo w you to use
as tax deductions
(4) Cannot pass corp tax losses through to shareholders.
Prof. Hillman Business Associations Page 3 of 87
(5) EG Depreciat ion you buy truck for $10 and it is only worth $9 this year. You can deduct
(a) Imagine you have $1 in revenue, you can use to offset to zero tax liability.
(b) Imagine you have zero revenue, you have nothing to offset. Note: can probably carry
over to next year. Corp cannot pass though the tax loss to shareholders to use on their
personal inco me.
(c) Note compare to other forms, that you can pass through ?????? what partnership? Sole
(d) Note that subchapter S does change the double taxation but does NOT address the
inability to pass through tax losses.
(6) Corporate law is STATE law. Each state has a corporations code and there are NO
uniform laws applicable to all of the states. There are considerable variations in the laws
that govern corporations.,
(7) The relationship a mong the participants in a corporation (Officers, BOD, Shareholders) is
(a) Primarily statutory law dictates the form of the organization and the relationship
between the people in the corporation
(b) A little bit contractually, can‟t really change it by contract
4) Partnership = an association of two or more persons to carry on a business as co-owners for profit.
a) General Partnership
i) Most common, mo re general
ii) Has only ONE class of partner
iii) There is uniformity in partnership law via t wo acts. Under both a partnership is an Entity for
most purposes and an aggregation/non-entity/relationship for some purposes.
(1) Unifo rm Partnership Act UPA fo rmerly adopted by all states, replaced by RUPA in ½ the
(a) Defines partnership as an Aggregate.
(b) Modifies rules to make it an Ent ity for many purposes.
(2) Revised Uniform Partnership Act 1994 RUPA
(a) About ½ the jx have the RUPA
(b) Many states changed RUPA when they adopted it eg NV, KS
(c) Defines partnership as an Entity
(d) Modifies rules so that partnership is an aggregate for some purposes.
(3) Characteristics of Partnerships (in contrast to corporations)
(a) Partnership can be sued in its own name. Th is is an entity feature or view and is LIKE
(b) In a general partnership (and the general partners in the limited partnership) liab le
for all acts of the partnership in tort and in K it is as if you are doing everything the
partnership does. RISK. Bad.
(i) Each partner is vicariously liab le for all other partner‟s acts. BA Ddddddddddd
(c) Easy to form in contrast to Corps. No requirement of formal action, no filing, even if
you say it‟s not a partnership and you ACT as a partnership with INTENT to run as
co-owners for profit then you form a partnership.
(d) Not Easy to Transfer. Ownership interests are NOT freely transferable to θ (in
contrast to corp.) This is a serious relationship because of the risk so partner must
consent to transfer of interest to θ.
(e) Tax BENEFIT. Can pass along tax losses to personal taxes.
(i) Imagine prof Hillman 60% o wner class 40%. One dollar tax losses of $1
1. Hillman gets 60 cents tax loss pass through, Class gets 40 cents tax loss pass
though to the personal taxes.
(f) Fragile form of association in contrast to corporation. If a partner d ies or quits then the
relationship is over. The partnership does not survive a change in its owners.
(i) EG law firm entire class is a partner in the law firm. In theory the law firm is
dissolved but in reality it reforms. It‟s a “new” partnership and if the lease K
says that upon dissolution of the partnership the lease terminates, and someone
leaves, then you just lost your lease.
Prof. Hillman Business Associations Page 4 of 87
(ii) RUPA changes this somewhat so that sometimes you can set it up so that a
partner leaving doesn‟t automatically d issolve the partnership.
(g) Structure of Relat ionship.
(i) Contractual. The structure of the relationship is not as controlled with
partnerships as compared to corps. Partnership is contractual. The UPA and the
RUPA says that “here are the rules that apply to the relationship IF you don‟t
have a K that defines the relationship”
(ii) Not centralized management. Each partner has equal power unless modified by
1. K could make one partner centralized manager using a corporate model if
that‟s what they want to do.
2. Contractual freedo m allows partners to modify the notion that each partner is
an agent of the partnership as set up in the statute.
b) Li mited Partnershi p
i) Allows tax benefit with limits on liability for limited partner.
ii) Cannot be formed accidentally. Must file certificate of limited partnership with the secretary of
state of the state in which formed.
iii) Has TWO classes of partner:
(1) General Partner
(a) Gets benefit of tax loss pass through.
(b) Rules for general partnership above applies.
(2) Limited Partner (passive)
(a) Passive. They have a limited role in running the business. Passive investors do not run
(b) Have limited liability. In contrast with the general partner, the limited partner is NOT
liab le fo r claims against the partnership. This partner is like a stockholder in a
(i) Historically had to be willing to be totally removed fro m the business and not
participate in running the business that gave the liab ility advantage.
(ii) Now, with changes in the laws, Limited partners can do a lot more and be a lot
more involved without taking on liability.
(c) Investor, backer, the money person, silent partner.
iv) LUPA and RLUPA are the two statutes
(1) Basically same as UPA and LUPA and even says see them unless rule is different in
LUPA or RLUPA
(2) Wednesday, August 29, 2001
v) Modern Trends
(1) Law has become friendlier toward limited partner participation
(2) People have developed rather complex structures that allow limited partners to
COMPLETELY CONTROL the business and still retain the limited liability!!
(3) Often form takes precedence over substance in bus ass law
(4) EG 60 Hillman 40 Class ownership, we want to be limited partners who control
(a) General Partner Hillman Inc.
(i) Let‟s form a corporation called Hillman Inc. who will be the General Partner
(ii) The General Partner, Hillman Inc., has unlimited liability for claims against the
partnership so we must be careful not to fund Hillman Inc. any more than the
minimu m to keep it going.
(b) Two Limited Partners Hillman and TSPW
(i) We are shareholders and so we elect the BOD
1. As shareholders we elect Hillman, Hillman‟s Wife, and TSPW to the BOD
a. As the BOD we elect Hillman President, TSPW V.P.
(ii) We form a partnership agreement between (Hillman , Inc.) the GP and the two
LPs (Hillman and TSPW)
1. (corporation signs a document through its OFFICERS, so the agreement has
three signatory lines, so Robert W. Hillman as president of Hillman Inc,.
and the two limited partners Hillman and TSPW)
Prof. Hillman Business Associations Page 5 of 87
2. The partnership agreement provides that Income and tax losses go to the
limited partners of the partnership
(iii) As limited partners we have limited liability
(c) What happens to the liabilities of the partnership on dissolution
(i) In contract the K is with the Partnership
(ii) Must be clear with third parties who they are doing business with
(d) Q: What about Alter Ego?
(e) Q: how much business does this corp. Hillman Inc, have to engage in to keep its status
as a corporation?
(i) Ans: all the business will be conducted as Hillman Inc. b/c Hillman Inc. is the
General Partner. Th is is form over substance but it does work.
(f) Courts consistently uphold this structure at the appellate level, but who knows what
the judge will do at the trial level? People may s ettle just to get out of the trouble of
having to appeal.
c) Problem: this is too formalistic. This is form over substance. There is just something wrong with
this. This is slightly sinister.
i) One of the policies favoring this sort of scheme is policy in favo r of limited liability. The fact
that this works signals that policy makers favor limited liability in the business setting.
ii) Early 1990s new fo rm of business: Limited Liab ility Co mpany aka LLC
5) Limited Liab ility Co mpany aka LLC
a) Hybrid offering best of Corporation and Partnership
b) Members are the owners and managers
c) Mostly Partnership
(1) No double taxation
(2) Passthrough of tax losses
ii) K freedom to arrange structure however
iii) Management structure members are managers of the LLC
d) Two kinds in most states
i) Member Managed
ii) Manager Managed
e) Some Corporate
i) Potentially Perpetual Existence
ii) Limitation of Liability
f) This is designed to be the best of all worlds
g) Extremely popular fo rm of association for small businesses, new, some small legal risk because no
body of case law interp the statutes.
h) Public Corporat ions still preferred by really b ig businesses
i) LLC still too new, too risky
ii) Tax disadvantage not as serious for Public Corp
(1) Most large publicly held corp do not distribute $ they reinvest profits.
(2) They reinvest because the business becomes mo re valuable as it g rows shareholders get
$ fro m increased value of stock
(3) If they never distribute $ to shareholders there is no double taxation.
i) Small business may be a corporation in the beginning because
i) Partnership is just taxed to partners individually according to the agreement
ii) If you keep the money in the business, then the business doesn‟t get taxed but we do as
partners. Fro m what money do you pay the taxes? It‟s your personal money, No money is
going to the partners and you are still paying tax so you will have to take that money out of
the business. If the plan is to keep the money in the business, then you might as well have a
corporation because double taxat ion only happens when you distribute money to the
6) Limited Liab ility Partnership LLP very new started in Texas in the 1990s
Prof. Hillman Business Associations Page 6 of 87
a) S&L crisis in the 1980s federally insured and they all went under. Govt. went after lawyers who
had represented an S&L. Idea was that lawyers have a duty to the govt. or s ociety to ensure that
S&L don‟t do bad things. Every partner in a law firm is liable. Govt. would require that the
settlement be substantially above the ins. limit. TX amended partnership law
b) Any Partnership could file to beco me a LLP. By putting a clause in their partnership agreement and
filing with the secretary of state.
i) No malpractice v icarious liability. TX approach
(1) No partner has vicarious liability for claims against the firm fo r malpractice.
(2) Claims against the firm for malpractice are limited to firm assets
ii) Full Sh ield (liability). Modern trend.
(1) No vicarious liab ility for tort, K, malpractice, not anything
(2) Puts the partnership in the same position as a corporation for purposes of liability.
7) NOBODY is forming limited partnerships any more. There are still some around, but the modern forms
of business association are:
b) LLC preferred by some forms of business because it is a cleaner limited liability form. Usually
c) LLP th is is a band-aid on the limited liab ility partnership form and so they usually just convert if
they are already a limited partnership. Usually law firms.
8) If you want to sue, you sue
a) The partnership for what it d id wrong
i) Encouraged to “run the partnership/company dry”
b) The individual partners if they did something wrong
9) Thursday, August 30, 2001
10) Jurisdiction of a Corporation: Where people Incorporate
a) History of the Corporat ion: this is an old form of bus ass. It was recog at least as early as roman
times. I t was certainly an imp ass form in England where a Corp could be formed on ly with the
consent of the sovereign via corporate charter issued to certain individuals. The sovereign was
replaced by the state legis here in the us. The grant of specific charters by the state legis was the
orig way of granting corp charter. Problems:
i) Corps outgrew because the charters were very specific. Eg hotel at certain location, bad during
ii) Charters had the operative fx of granting monopolies, bad during econ expansion
b) Solution: General Incorporation Laws g ive any person(s) who observe certain formalit ies the
right to get a corporate charter. This remains the system until today. Every state has a general
incorporation statute allowing anyone the right (non-discretionary grant, must grant) to a corporate
c) Note: limitat ion of liability is very recent, 20th century, eg CA Limited liab. Came in the 1930s via
CA const. Amendment
d) Today we have Corporations Code in every state. Question arises: where to incorporate?
i) Well, eg Davis Hardware is in CA, owners are in CA, assets are in CA, sales are in CA,
emp loyees are in CA. It would SEEM to be a non-issue but ….
ii) Given the choice, which law would we elect to have govern our relationships? This is a
contractual freedom issue.
iii) Larger, mu ltistate businesses not always so clear where should incorporate. EG M icrosoft of
Red mond WA, but should incorporate where?
iv) Corporation is a legal fiction so can be anywhere. Which law do we want to govern the
relationships among the participants (owners, managers, bod) of the corp . Th is is a choice of
(1) Del. has emerged as the jurisdiction of choice. Del. is selling its corporate law. When a
bus incorps in Del:
(a) Doesn‟t mean corp is in Del.
(b) Very few people have been to Del.
(c) As you can see fro m the reading, this is a calculated decision.
(i) Funds from fees generated for the state: tax benefits, fees generated
Prof. Hillman Business Associations Page 7 of 87
(ii) Benefits the bar association in Del work for lawyers
(iii) Judiciary in Del benefits sophisticated and challenging cases, prestige
(e) Once referred to as a “race to the bottom” for law that didn‟t protect vulnerable
parties. EG if you are Bill Gates you might prefer a law that favors managers and
doesn‟t protect the rights of shareholders, but if it goes too far then no one will want
to buy stock in the company. Thus, there is a market limit on how far the law will go
to benefit corp managers over stockholders.
(f) You are trying to attract businesses to your state‟s law
(i) Managers vs. Sharehol ders rights : t ilt toward managers because managers
decide where a corp. is incorporated / re-incorporated. Shareholders are
somewhat passive in control. Del. does this
1. Law may g ive shareholders veto rights, but they are a large group, probably
not organized or aware of what‟s going on.
2. Even so, management puts it on the agenda for a vote.
3. Shareholders usually fo llo w the reco mmendations of management.
4. Note: EG of rights: do shareholders have the right to fire managers?
5. Remember, market control that shareholders won‟t invest if the law is tilted
too far in favor of the managers
(ii) Majority sharehol ders vs. Minority sharehol ders rights: t ilt toward majority
because majority ult imately controls. Del does this
(iii) Sharehol ders vs. Credi tors as clai mants of assets. Tilts toward shareholders
but remember the fact that if it was too far against creditors then no one would
trust/loan $ to a Del. corporation.
1. Think of the corp as an economic unit made up of assets, bank account. Who
owns the asset? The corporation owns the assets. But go a little deeper.
There are people who want first claim on the assets, and the obvious people
are the shareholders because they are the investor/owners.
2. VOCA B Div idend = Distrib. Of profits to shareholders vocab.
3. Cred itors of the Corporation:
a. IRS and other creditors are interested in the assets as well. PG&E,
Emp loyees, Bank and their claims have to be asserted against the corp
b. It‟s unfair to the creditors if the corp can give div idends while debts are
c. If you look at the assets and the claims against the assets, logically the
shareholders come last, the creditors come first.
d. However, Del. t ilts this a little
(2) Question: how does an investor know what these biases are?
(a) Some investors never invest in a Del. co mpany b/c they don‟t favor shareholders. It‟s
easy to find out.
(b) The market is pretty sophisticated. If investors are at risk because of the lousy law in
the jx where the corp is incorporated, the risk is built into the price of the stock.
(c) The question here is how smart is the market? Ans is that the market is very smart.
The Efficient Market Hypothes is: The markets in the pricing of securities reflect all
available information. So many participants are doing so much research and so the
investors don‟t really need to do their own research. So meone else is already doing
(3) Over half of the Corporations are incorporated in Del. and it ‟s suspicious if they AREN”T
because the management probably isn‟t on the ball if they aren‟t incorporated in Del.
(4) What about Davis Hardware? You are the lawyer. Where do you tell the 60% 40%
owners to incorporate?
(a) Need to ask:
(i) Are you going to go public? How much money are you going to generate?
(ii) Note: if you are in CA (pay franchise taxes) and incorp. in Del, you pay taxes
(iii) Do you really need the benefits of Del law?
(iv) Annual franchise fee in Del. is about 1,000 for a business like Dav is Hardware
Prof. Hillman Business Associations Page 8 of 87
(v) If you have a Corporate franchise take in CA you can offset that against the Del.
(vi) Legal cost is higher because going to Del. is a little b it more comp licated, but
Hillman says it‟s not that much more co mp licated.
(b) In a small co mpany the minority shareholder has a lot more rights than in a large
corporation, so this 40% owner might be able to insist on rights.
(c) If this is a point at which you are forming the corporation, why is that 40 % perso n
there at ALL? The answer is going to be that the 60% person must need that 40%
person and so this 40% person has some leverage.
(d) Ethics: adverse interest between the two clients: are they really adverse interests?
(i) Must find out fro m the parties what their goals for the relationship are. Maybe
the interests are not adverse. This is fact specific.
(ii) Does the minority shareholder even KNOW how adverse it is … this is sort of
like a prenuptial agreement. The minority shareholder should probably have
their own attorney. It does depend on how adverse the situation is BUT
(iii) Late fo r class, will paste outline in here
9bus ass 4 Late for class
1) Some jx limit the ability to choose jx of incorporation e.g. CA section 1215 or 2115 says (close corp)
certain CA stats will apply to corp with ppb in CA no matter where they incorp
2) See supplement law of the state where the LLC is organized governs the organization of the company
and its members. Can choose to organize in any state and so Del has catered to this
3) Note: there is one US corporate law with some exceptions. CA and Del particu larly. Eg
a) Statutory close corporations special ru les in stats of that state for close corporations. Usually
introduce more flexibility to depart fro m the statutory models for close corporations
b) However usually say must elect close corp at the time o f formation to get these special rules.
c) If make the election are still a corporation and with the exception of a few special rules for close
corps the rest of the rules for corps in that state will still apply to the close corporation
d) Usually people who fo rm a close corporation want the flexib ility and so they will want to take a
close look at the codes
e) Remember, must choose at formation to be close corporation to get special rules
a) Formation documents prepared by a group of people/a person
i) Articles/Cert ificates Incorporation
(1) File with usually Secretary of state
(2) Critical docu ment that creates the corp on filing usually called the Articles of
(a) Note: Del calls it the certificate of Incorporation
(3) Easy to do, and can pay a service to do the filing for you. Just call the service, they will
slap the corporation filing together and file it fo r you
(4) Usually the docs name the board of directors
(5) These are public record AOI
ii) Usually have a bod meet ing right away
(1) Adopt corporate by-laws
(a) These are not public informat ion
(b) Usually define and state purpose of the corporation
(c) Say what sort of vote it takes by the bod to change things in the corp
(2) Elect the Officers
(a) President/CEO (chief executive officer)
(i) Keep track o f official corporate records
(ii) Minutes of the BOD meetings
(c) Treasurer / Ch ief Financial Officer (maybe!!! especially if large corp)
(i) Custodian of the corporate funds
Prof. Hillman Business Associations Page 9 of 87
(3) Issue the Stock (Get the money for the corporation)
(a) Issue stock to the shareholders
(4) Decide how the corporation will be run
(a) This is probably the last time that the majority shareholder will listen to the minority
(b) For discussion, controlling shareholder means 51% of the corporation
(c) Minority shareholder could walk away now, and should insist on things in the articles
of incorporation that will protect the minority shareholder
(i) Suppose that the minority shareholder expects to have a job with the corporation?
Then include in the articles of incorporation that all shareholders with 20% of
the stock or automatically have a seat on the bod.
(5) Develop the capital structure of the corporation see p 107 to 112!!!! Of the book
(a) Structure claims against the assets of the corporation (upon dissolution)
(i) Every corp has at least ONE and practically has at least TWO no matter what
because every corporation has at least common stock.
(ii) Co mmon Stock
1. Co mmon stockholders have the residual claim against the assets of the
corporation. In other words, they only get the residual ass ets after everyone
else is paid off. Usually there are substantial assets left over.
2. Articles of Incorporation will say something like “corp is authorized to issue
X nu mber shares of common stock‟ eg 2000 shares
3. Davis Hard ware First BOD meet ing they only issue 1000 shares. Hillman
gets 600 shares We get 400 shares.
a. Corporation can now issue 1000 more shares later (authorized but
unissued shares at this time)
b. Can amend the articles to authorize more shares later if we want to
(iii) Cred itor Claims
1. People who loan the corporation money are not legally speaking invested in
the corp, they expect to be repaid. Black letter legal principle is that
creditors get paid first.
2. However, all they get is what is owed to them. Thus the “upside potential”
goes to the shareholders, not the creditors.
3. Note: Bonds create preferences among creditors. Also debentures which are
the same thing.
a. Bond is a debt obligation of the corporation.
b. Bond holder is a creditor, not a stockholder
c. Bonds don‟t get dividends, bonds get interest
d. Interest on bonds must be paid every year.
e. Bonds are paid off on liquidation before stock.
f. Usually closely held corporation doesn‟t issue bonds rather they get credit
fro m the bank.
g. Usually long term, maybe 30 years, and must pay yearly interest but
don‟t have to pay bond off for 30 years.
h. Large corporations get most capital fro m bonds not stock
i. Must be dealt with in the articles of incorporation?/
(iv) Preferred Stock
1. Not every corporation has this type of stock.
2. Must be provided for in the articles of incorporation
3. It is stock that has a limited preference over the common stock:
a. dividend payments go to preferred stock first. Usually not a huge deal
because the preference is defined in the articles of incorporation. Eg
i. There will be authorized 1000 shares of preferred stock, each share to
carry a div idend right of $1. A ll the preferred stockholders get is
$1 per share, and after that the bod will pay the common
Prof. Hillman Business Associations Page 10 of 87
ii. Div idend is when the corporation disburses corporate profits to the
shareholders. The bod will declare d ividends to be paid.
b. Liquidation Preference: $100 per share upon liquidation, co mmon
stockholders get whatever is left over. No matter how much is left over,
even if it is more than $100 per share, then the common stockholders
4. Better than common only in that rights are defined and superior to common
stock, but if the company is really successful it ‟s not really preferred.
5. Can amend the Articles to add preferred stock later.
(v) EG IBM , who buys preferred stock and who buys common stock?
1. Person looking for a more secure investment and wants the dividends every
2. In some ways preferred stock is more like a bond, you get a fixed annual
3. Co mmon stockholder is investing in growth and appreciation in value of the
12) Tuesday, September 04, 2001 Ultra Vires and piercing the corporate veil
a) Corporate purposes and powers are stated in the Articles/cert of incorporation
b) In examp le Cert of Incorp Delaware See pp 3 wh ich is standard today; the purpose of this corp is to
engage in any lawful act etc
c) Old days
i) In the old way of certifying corps, if bank bought a hotel, the act of buying the hotel was ultra
vires , that is outside the corporate charter, beyond corporate powers, and void.
ii) In the old days people were very specific in purpose of the corp
iii) In the old days if all o f the shareholders approve an action beyond the power of the corp then it
is NOT void but must be unanimous
i) K between parties
ii) Can engage in any lawful activity because usually / and if the articles/cert says any lawfu l act
iii) MUST read book for ultra v ires doctrine
iv) Highlight by teacher corporate gifts
(1) For certain kinds of gifts there really is no longer an issue, eg recognized charitable
institution, the courts will uphold the gift, either on the theory
(a) Good public policy
(b) Corporate benefit in the gift (good pr to give to charity) eg masterpiece theatre is
brought to you by Mobil corporation
(c) Most corp charter/codes now say that corp may give $ to recog charity
(2) A lot of corps say that corp may NOT give gifts to individuals
(a) If they do and not authorized, then it is void and will be set aside
(b) Most often comes up in gift to spouse of deceased employee,
(i) shareholders often successfully challenge these
(ii) Could look at it as K supported by consideration, employee expected it.
v) One area in wh ich there is a continuing vitality for ultra v ires and is NOT in text …
(1) Corp could purposely restrict own purpose and powers
(2) Eg Davis hardware, we could say purpose is to operate a hardware store in Davis
(a) Are θ supposed to be on notice of this purpose??
(b) What if Hillman decides to be a .com co mpany
(i) Now Hillman enters in to Ks with θ for .co m act ivities
(ii) Now I say wait a minute, I thought we were a hardware store, and this is beyond
the corporate purpose and the corporate powers. What is MY remedy?
Prof. Hillman Business Associations Page 11 of 87
1. Could sue for damages, but would have to prove damages caused by
Hillman‟s actions, he will h ide assets and be judgment proof
2. Could we get an injunction?
a. Maybe, but θ are affected by this because they did business with Dav is
Hardware, have Ks
b. BUT θ are on notice!!! Art icles of Incorporation are on file with the
secretary of state and are public knowledge…
c. BUT θ can‟t check the art icles of incorp of EVERY corporation ….
i. CA has a rather θ bias. If θ took action in reliance on the idea that
Hillman was authorized, then court will protect θ
ii. Del. says if not fully performed, K with θ can be set aside.
13) Milestone: finished the 1st Foundation page of the syllabus
14) Piercing the Corporate Veil ho lding the shareholders personally liab le for claims against the
i) Corporation is a legal person and shareholders are not normally liable for what the corporation
does, but sometimes we hold a person responsible for claims against another party:
(3) Alter Ego
b) Statutes statutory exception
i) EG NY corp. code, some p rovisions apply no matter where you incorporate but others if you
incorporate elsewhere they do NOT apply eg
(1) NY corporations code: 10 largest shareholders of a close corp are personally liable for
emp loyee wages BUT this code section does not apply if you incorporate elsewhere!!
(2) Thus, there is a big advantage to incorporating in Del even though you have to apply NY
codes in other areas.
c) Judicial Exception to Corporate Limited Liability is called Piercin g the Corporate Veil, based on
EQUITY two broad categories
i) Torts aka involuntary creditors because persons who have been injured have not chosen to do
business with the corporation see p 226
ii) Tort Victim case 1 of 2 on piercing the corporate veil: Walkoszky v. Carlton 18 NY 2d 414, 276
NYS 2d 585, 223 N.E. 2d 6 (1966)
(1) Facts: Seon cab ran over π in this action
(2) Seon Cab Corp owned by Carlton, who is (in the end, after saying that Carlton is one big
enterprise) the sole shareholder in Seon Corp
(a) Seon Cab Corporation Corp had no $, Seon Corp had assets in the form of cabs, and
they were mortgaged, so in the end has NO money
(3) Enterprise Liability π says Carlton controlled the frag mented corporate entity to the
extent that the divisions were artificial and the only owner is really Carlton
(a) Enterprise liability claim succeeds because it does look like
(4) Alter Ego claim corporation is just the alter ego of the individuals.
(a) Now much allege that the shareholder in Seon (Carlton) is really Seon in disguise.
Look for and prove:
(i) Carlton paid for things that Seon was liab le for
(ii) Carlton took assets from Seon that were not paid as dividends but rather Carlton
just took the $
(iii) Is Seon paying Taxes as its own entity?
(iv) Is Carlton acting in all ways as if Seon is a separate entity, is Carlton respecting
the corporate formalities?
(v) Did Carlton put enough $ in the co mpany for it to run?
1. Some courts will say that if a shareholder undercapitalizes the corporation,
then they will find that the shareholder is personally liable for the clai ms
against the corp. The dissent goes off on this but the court doesn‟t follo w
this standard. The majority here won‟t do this because it would eliminate
Prof. Hillman Business Associations Page 12 of 87
limited liability, but the dissent (Keating) either says this should be
evaluated at the time of inception/formation or maybe dissent is saying that
if the shareholders take assets out when the company is struggling then
they‟re personally liab le .
2. Many other countries will not let you start a corporation with zero $ or
peppercorn like 10 cents as the US will. As a matter of co mmon law many
courts in US will also hold shareholders liable if you do that (but not NY).
a. What are the damages under this doctrine? The full tort claim or the
amount that the corporation is underfunded? Are we trying to
compensate the tort victim or are we try ing to punish the corporation?
(vi) Limited Liab ility During the Deposition, they are going to ask Carlton why
he set the corporation up in such a complicated way?
1. The real answer is probably that Carlton wanted to protect himself fro m
liab ility. As his lawyer, should we let him answer that way? Well, sure, it‟s
okay to incorporate to limit liability.
2. What about the fact that Carlton had only the min imu m insurance? (Isn‟t that
a problem fo r the leg islature?)
3. Limited liability is a public policy that has been advanced throughout the
(vii) Moral Hazard what induces the shareholders to run the company in a safe
and responsible manner if the shareholders are not personally liab le for the
consequences? Carlton can shift the risk to the people who are run over by his
taxi cabs. You could address this by requiring fu ll insurance????????
(viii) Two systems: no limited liab ility but they can insure against the risk. Or
limited liability that you can pierce.
15) Wednesday, September 05, 2001
16) Makeup Class Monday September 10
a) Piercing the Corporate Veil Continued
i) Externalized risk, shift ing the risk to θ by limit ing liability
ii) What is to stop Carlton fro m running the cab company in an unsafe manner???
(1) Cost associated with being unsafe is shifted to the tort victim
(2) One solution: eliminate limited liability for close corporations and make them insure
against the risk. Why would this affect the externalization of risk?
(a) Insurance carrier would enforce the safety. Premiu ms would go up if the cab co mpa ny
was unsafe. Moral hazard reduced.
(b) Note: NY statue required 10,000 wo rth of insurance on cabs.
(3) Another Solution
17) Tort Victim case 2 of 2: M inton v. Cavaney 56 Cal 2d 576, 15 cal Rptr 641, 364 P 2d 473 (1961).
a) Facts & Parties
i) lease on swimming pool by Δ Cavaney [shareholder, secretary, and treasurer and on the BOD
in/of Seminole Hot Springs Corporation, Cavaney is also the corp‟s lawyer]
(1) Since Caveney is a lawyer, Caveney probably has a lot of $, the Lawyer is the deep
pockets. He certainly has more $ than this assetless corporation. He also
(2) As secretary, treasurer, Cavaney kept the records in his office.
(3) Cavaney is a 1/ 3 owner of the corporation
ii) π suing for enforcement of 10,000 judg ment against Seminole Hot Springs Corporation for
wrongful death for dro wning of daughter
b) Is a lease an asset?
i) EG space has a market value of $60 and lease is for $100 no, it‟s a liability
ii) EG space has a market value of $140 and lease is for $100 yes, it‟s an asset
c) Cavaney said the corporation had no assets.
i) The only possibility of something of value is this lease, and it probably has no value or negative
value. We probably can‟t attach it and get $.
d) Traynor says there are 3 situati ons in which we pierce the corporate veil:
i) Stockhol ders treat the corporate assets as their own and add and withdraw at will
ii) Stockhol ders hol d themselves out as personally liable for the debts of the corporati on
Prof. Hillman Business Associations Page 13 of 87
iii) Stockhol ders provi de inadequate capitalizati on AND acti vely partici pate in the
management of the business.
e) Was the capital inadequate in this corp?
i) In this case, it‟s a ZERO cap italization case so it‟s easy. They had no $ in the business and they
had no insurance and it is certainly foreseeable that there would be an injury o r death at a
ii) But what is enough? Is a peppercorn plus one enough? Or is it enough to put in the reasonably
foreseeable needs of the business???
f) AND must find active participation by the shareholder that we are try ing to hold liab le for the debts
of the corporation
i) Why? Because the managers are the ones who should be buying the insurance. Passive
shareholders do not buy insurance. Passive shareholders do not decide to open the pool to the
ii) The active direction/ management of the business should deal with the costs of doing business
and should be held liable for failure to insure against foreseeable risks of the business.
iii) But what does Traynor MEAN by active involvement?
(1) The fact that Cavaney kept the records in his office was enough in this case was enough
for Traynor to say he was actively involved. But he wasn‟t there on a daily basis, he
wasn‟t the president, he wasn‟t responsible for getting insurance…
(2) how important is the active involvement part of the test? Ans: not very. The
undercaptialization, for Traynor, is the important part of this test because it‟s really easy
to find active involvement.
iv) Question: what if person (little old lady pensioner) puts up money but has NO involvement
with the corporation? Only writes check? Ans: this person probably isn‟t deep pockets
g) Hypo: they put $1000 each (so $3000) into this corporation? What is the min imu m level of
capitalizat ion you need to have the benefits of limited liab ility.
h) Note: Bankruptcy law will protect the personal assets of real people to some extent such as
retirement p lan, one car. Corporations don‟t have that protection, you can grab anything they have.
18) What about publicly held corporations? EG General Electric suppose we want to pierce the
corporate veil to get at someone with 10,000 shares?
a) There must be some sort of a pro-rata system, if 10,000 shares is %1 of the shares, then they would
be responsible for 1% of the debt.
b) Since it‟s so hard to find the shareholders and figure out their liability, it‟s just not practical unless:
c) Parent corporation owns %100 of the stock of the subsidiary corporation. We often see cases where
a person has a claim against the subsidiary corporation. The person will attempt to hold the parent
corporation liab le for the claim against the subsidiary corporation. This is really just a closely h eld
subsidiary corporation, and the sole shareholder is the parent corporation.
i) EG General Electric is the parent and GE Mexico is the subsidiary.
ii) This is really just another case involving a closely held corporation!
d) Thus, piercing the corporate veil is only practical for closely held corporation.
e) Note that it is full liability for whoever you reach.
i) EG Cavaney becomes 100% liab le for the claim.
ii) Note that in Cavaney π only sued Cavaney so the others probably don‟t have $. Cavaney could
try to go after them but it doesn‟t look good.
iii) Cavaney might argue that he tried to get the other 2 to fund the corp but they refused.
19) Piercing the Corporate Veil: K claimants
a) One idea is that you should be informed about who you are doing business with BUT:
i) Hillman prepays to rent a video. What if the video store goes under before he can get it?
Hillman is a lot more like a tort v ictim.
ii) Must be careful with the K claimants and not assume that they assumed the risk of doing
business with the corporation.
20) For Monday prepare the first few problems. Reading assignment first and the first few p roblems.
21) Monday, September 10, 2001
22) Piercing the corporate veil continued: Contract claimants
a) Despite that fact that K claimants
Prof. Hillman Business Associations Page 14 of 87
b) Classic Case: “the court will d isregard the entity (corporation) when there is such domination of the
finances etc … that the entity has no mind or will of its own but is merely a business conduit for
the principle…” But this isn‟t very useful.
23) Kinney Shoe Corp v. Polan 939 F. 2d 209 (4th Cir. 1991) p 248
a) Facts: Lincoln Po lan forms corp Industrial Realty Co., Never got around to having a director‟s
meet ing, had no stock, kept no minutes, had no officers, never put any $ into the corp. (is like
Minton v. Cavaney),
i) Indust. Rreal. Co. Forms K with Kinney for lease, Lincoln Po lan PERSONA LLY paid the first
payment, Indus. Realt. Co. defaults on the second payment.
b) Reasons for holding:
i) Polan personally made the first payment:
(1) Cuts for piercing:
(a) Failure to observe corporate formalities
(b) Co mmingling finances
(2) Cuts against piercing
(a) Polan did capitalize by making personal payments
(3) What Polan should have done:
(a) Put the $ into Industrial Realty Co. and had them make the payment
(4) What Attorney in this case should have done:
(a) Argued that it was not under-capitalized, that the practical effect of making the
payment was to capitalize the corp
(b) Argued that large K claimant should protect self (d id do this), however courts said
banks are in the business of evaluating credit risks and so the precedent should not be
applied to Kinney. Many jx would not pierce the veil for Kinney because Kinney
probably does has its own expert realty dept.
(c) All bets are off on piercing the corporate veil: everything depends on how the
judge feels about piercing the corporate veil. Judges di ffer on when they think it
is necessary to pierce the veil to achieve equity.
ii) “Polan was obviously trying to limit h is liab ility by setting up nothing more than a cert of
(1) This court doesn‟t like using the corp to limit liab ility
c) Policy Reasons for Limited Liability
i) Econ Args: see text !
(1) Desirability of facilitating DIVERSE investment (does not explain limited liability for
(a) Decreases need for investors to monitor managers in a regime o f unlimited liability
the shareholders don‟t have to worry about what the corp. managers are doing.
(i) Main reason: Di versified Investments. investors can make a lot of investments
(diversification) because they don‟t have to research each investment.
1. Shakespeare anticipated modern finance theory in the Merchant of Venice.
Antonio in the opening scenes…. NOT mop ing around about his
investments… they are diversified. They are not all in one pot.
(ii) Plus: Li mited Li ability. We want people to invest their money. They can define
the risk as the amount of the investment. The risk would be too overwhelming
for diversified investment if the liability was unlimited
(iii) It‟s mo re efficient because managers can act autonomously. When you have
unlimited liability managers are too conservative and you can‟t make money if
you don‟t take some risks.
(iv) This also leads to the Moral Hazard problem that we talked about last time.
(2) Encouraging proper allocation of capital
ii) Trend in the leg islatures and the courts is to expand the availability of limited liability
24) U.S. v Bestfoods, 524 U.S. 51, 118 S.Ct. 1876, 141 L. Ed . 2d 43 (1998). P 255
a) Piercing the veil under statutory environmental law: actual operation of the facility by the parent
corporation is the standard or test under CERCLA (this is like a tortfeasor std.)
b) Facts: Parent “CPC” owned subsidiary “Ott II” and had the same directors and some of the same
officers (this is fine if you keep straight who you are working for).
Prof. Hillman Business Associations Page 15 of 87
i) There were environ mental hazards at the Ott II site and Ott II was gone by the time the enviro.
regs. were sought to be enforced by the U.S.
ii) Problem for CPC here: there was an officer, Mr. Williams, of CPC who handled enviro. Issues
for Ott II (see p 258).
c) This case is easy because Mr. Williams didn‟t work for the subsidiary, Ott II, he only worked for
the parent, CPC. In another case without this fact it would be much harder to evaluate. HOW DO
YOU KNOW WHAT HAT THE OFFICER IS W EARING? Are we going to hold the parent
liab le if they keep their ro les straight, the supreme court says they will respect the division!
d) This is an evidentiary problem. Look for:
i) Time spent at Parent (P) and Subsidiary (S)
ii) Who paid the wages, travel
iii) Who supervised your work
iv) See also Enterprise Liab ility theory: piercing the corporate veil when they operated as one
economic unit. It looks like one large corporation in some cases. This is not a dominant
theory in the law.
v) As a practical matter you tend to get some facts in the P/S situation that invites the Bestfoods
type of result. Especially because the S often is P to another S. It‟s easy for lawyers to talk
about keeping roles straight but it‟s much harder for business people to keep the roles straight.
25) Conclusion: High Po ints, Factors to Look at for Piercing the Corporate Veil (aren‟t very useful in the
a) Close Corporations: (because doesn‟t seem to work for large/public corps)
i) Undercapitalization Important but not sufficient
ii) Personal rather than corporate capacity
(1) Carlton case did use proper corporate name at all times
iii) Failure to observe corporate formalities
b) Corporate statute applies to all corps large and small, but courts and legis are starting to recognize
that close corporations need some slack in ability to
i) See eg Del. may agree to anything affecting
(1) Could dispense with the BOD o f Dav is Hard ware if it ‟s in the bylaws or art icles because‟
it‟s too cumbersome
(2) Ought to allow people in close corporation to be more informal, but must accomplish that
in a FORMA LIZED way. Can be a K that simplified the corporate model, CA NT just
ignore corporate structure.
26) Problems plus reading assignment on financial statements:
a) I Accounting: Balance Sheet
i) See problems: two sides of balance sheet are supposed to = each other, and that‟s the balance
ii) ASSETS always start on the LEFT side, what is THERE, what we have
iii) LIABILITIES on the right, CLAIMs (a) cred itors, satisfied first (b) Equity (stockholders)
iv) Tells you what is there (assets) and what claims are there, part icularly claims that are superior
to your claim
v) Is a snapshot in time, usually end of corp fiscal year or maybe quarter
vi) Debt to Equity Ratio tells you the ratio of creditor claims to shareholder claims
(1) EG 9:1 is better than 90:1 because at 90:1 you‟d have to get in a long line with the other
creditors, so creditors won‟t want to loan money to this entity because it‟s too risky.
(2) while at 9:1, it ‟s only 90% cred itor claims against the assets and you come before the
shareholders when it‟s time to get your $ out. The shareholders are taking the risk and
giving a 10% cushion to the (outside) creditors.
(3) With 1500 in assets and $900 loan for the machine p lus 600 in the Equity, it‟s 9:6 o r 3:2 if
you reduce, which is really good (end of first year)
(4) Debt Equity is 8:1 (end of second year)
(5) Note that at the end of the third year the claims against the assets by cred itors are $1000
and the assets are only $900 MAX because the machine has probably depreciated, plus
this doesn‟t account for interest.
(6) Note on depreciation and appreciation: accountants want the historical cost because it‟s
too easy to manipulate the dep/appre schedules. Note that RP value often goes up not
Prof. Hillman Business Associations Page 16 of 87
vii) Retained Earn ings: Most adjustments in the liabilities colu mn are to the Ret. Earn ings item.
Note that Retained Earnings don‟t really exist. They are just entries that represent claims.
Retained earnings is an account that is used for balancing purposes.
viii) Question: why can‟t the shareholders put in more $ at the end of year three?
ix) Note: balance sheets are important when disbursing dividends
Assets Liabilities and Equity
Fixed Assets (machine) $900 Liabilities 1,000
[Maybe loan $200]
Equity (aka capital)
Paid In Cap ital (shareholder investments) $100
Retained Earn ings (aka earned surplus) [$-200]
Total $900 Total $900
b) Income Statement
i) Talks about performance, how we d id over a defined period of time, usually 3 mo quarter or 12
ii) Gross Revenues Minus Expenses = Net Income
(1) There are battles about definitions of these terms, eg what if didn‟t actually receive but
have a right to it, when do you have to record expenses
Assets Liabilities and Equity
Fixed Assets $ Liabilities
Equity (aka capital)
Capital Stock (shareholder investments) $
Total $ Total $
iii) The point of problem to is to think about more than what argu ment t o make. Thin k about
(1) The strength of the claims, esp, piercing the corporate veil
(a) In this problem, the sank ship claim is
iv) Tuesday September 11, 2001 World Sh ipping Hypo Continued
v) World Ships Subsidiary was formed to limit liab ility for hazardous substance shipping
vi) Lost some of the notes from the middle o f class
vii) Problems for Piercing the Veil Defense
(1) Similarity of Names people might have thought that they were doing business with the
parent, World Shipping
viii) Not so much of a problem of Defense
(1) Same president for P and S so long as kept roles straight
ix) Missed some more stuff
x) Hypo Mod: what if they never had a BOD meeting but did talk informally about the Ks they
would enter into?
(1) Observance of corp formalities is important
(2) Minutes, Notice, Presence of Required Nu mber o f BOD Members
Prof. Hillman Business Associations Page 17 of 87
(3) Notice of meetings in important
(4) Most important point all semester: too easy to fabricate informal records. Be aware of this,
can‟t really test on it but if you‟re the corp lawyer you have to be sensitive to the
possibility that people may try to do this. Emphasize the importance of corp formalities.
(5) EG Jan 1 was the discussion, now it‟s Sept. 11th . If the records say “Sept. 11 statement of
discussion regarding K that took place on Jan 1” then it‟s truthful. But if the records
produced today say “Jan 1” then they are falsified. You‟d better not let your client do
(a) Do you need to assume that the client is lying?
(b) If you are suspicious, don‟t use the documents.
(c) Question: notes scribbled on napkin and then typed out a few days later o kay, but
date the minutes the day you actually write them.
(6) Never ever backdate the minutes. Go ahead and date them the day they are produced, as a
record produced after the fact.
27) Wednesday, September 12, 2001 Day after trade center disaster
a) World Ships Continued
i) Did they keep separate books?
ii) What did they say when they answered the phone?
b) Piercing the Veil: Each Claimant has to do its own piercing
i) Wells Fargo provided 5,000,000 to World Sh ipping (S)
(1) Bank is in the business of loaning money, has access to info on credit risk, could look at
balance sheet and see debt to equity ratio of 50:1 and knew that it was for hazardous
(2) Somewhat weak, not trivial, just depends
(3) What if co-mingling of assets between P and S? Didn‟t keep separate books…
(a) Depends on if Wells Fargo relied on the info. Was it on the balance sheet? Or did it
happen AFTER the loan?
(b) Depends on the Judge. Maybe judge favors piercing the veil.
(4) This is a long-term debt, isn‟t due yet, except the corp. has gone under.
(5) Might want to settle if it is for a trivial amount. If not, then let them sue.
ii) Texaco (real world Texaco requires proof of ins fro m shippers, forget this though)
(1) 2,000,000 in cargo was lost
(2) Did Texaco Assume the Risk? Texaco might not look at the balance sheet (but Texaco is
big and sophisticated), this is a routine transaction for Texaco, World Sh ips didn‟t get the
“customary” insurance on the ship and the cargo (but it‟s NOT that hard to ask for proof
of insurance), maybe Texaco d idn‟t know who they were doing business with (look into
history), maybe could argue that Wells Fargo had financed the S so Texaco could assume
that S was solvent (but this doesn‟t really help much against World Shipping, maybe
Texaco should advance a claim against Wells Fargo)?
(3) Might want to preserve the business relationship with Texaco and offer settlement. Need
this customer in the future. (maybe applies to Wells Fargo too).
iii) Korean Shipyard
(1) 12,000,000 ship construction K
(2) Litigation: Korean Shipyard sues where?
(a) Probably US. Probably has US litigation firm on retainer.
(b) If they sue in Korea and get a Ko rean judgment against World Shipping. No w how
do they enforce it? File a petition to recognize the foreign judgment. It‟s
discretionary for the US court.
(i) Hypo US court doesn‟t usually recognize foreign judgments, can we just
ignore it. What about our reputation? We‟ll make sure that the world recognizes
P/S relationships, and it was S not P. Korean claimant was unfair. BUT other
courts (countries) could recognize a Korean judgment. Mexico could recognize
the Korean judgment and seize our ships.
(ii) 500,000 release is probably cheaper than a PR campaign anyway.
(c) How strong is their claim?
Prof. Hillman Business Associations Page 18 of 87
(i) We have rights under the ship construction k. Over time the value of a ship goes
up and down. If we have the construction k, we might be getting a 15,000,000
ship for 12,000,000. We might be able to profit fro m this. Maybe we should
assume the K. Maybe we could assign the K to someone else and break even or
make a p rofit.
(ii) They are willing to settle a 12,000,000 claim for 500,000. Maybe that‟s worth it
if we don‟t want to assume or assign the K.
(3) Also consider lit igation stamina in all these claims for both sides…. Maybe they don‟t
have the resources to litigate. Maybe your client doesn‟t have th e resources.
(4) Does bankruptcy of S affect the stock price of the P? If it‟s the same BOD and the same
Officers, it‟s sloppy management. But, maybe it was smart if they resist the veil piercing
effort and put all the risk on other parties. Parent put 100,000 into S, and they lost it.
The S was an asset that disappeared. P owns S.Ownership is evidenced by the stock that
(5) After this they can do this again, set up the same corporate structure, and get insurance
(6) NOT EASY to pierce corp veil. Start with presumption of limited liability, even for courts
that are inclined to do it you have to show a lot. Luck of the draw with judges to pierce
the corp veil.
28) Equitable Subordination 2b and 2c, then section 3
a) Case in Supplement Cheasapeake v. Shore read carefully, tells a story, learn a lot about corp
takeovers, we will use for limited purpose (degree to which interest of management may conflict
with interest of shareholders.)
29) Thursday, September 13, 2001 Statutory Supplement isn‟t in yet.
a) Typo on p 3 of the Problems notch it up, spot the details.
b) Equitable Subordination Problem 2b, page 3 o f the Problems
i) Who gets paid first (vocab) Equitable Subordination
ii) Able and Baker are both shareholders and creditors. Creditors are lin ing up to see wh at they can
get out of the corporate assets. Who gets the $?
iii) Question: Will Able and Baker be put at the back of the line?
(1) 200,000 in other creditor claims
(2) 100,000 in Able and Baker creditor claims
(3) 50,000 in assets
(4) About 16 Cents on the dollar for creditor claims with able and baker‟s claims (they are
looking for about 1/3) [50,000 / 300,000]
(5) 25 cents on the dollar for cred itor claims without Able and Baker‟s
(1) Was the corp adequately capitalized at the time that the “loan” by the shareholders was
(a) Obviously this is subjective
(b) In this case, no outside sources of financing are availab le, which indicates that it was
probably undercapitalized because if it was adequately capitalized (DEBT TO
EQUITY RATIO) then it was probably undercapitalized.
(c) Other Reasons for Loan:
(i) Doesn‟t mean that EVER Y loan means undercapitalized. Maybe shareholders
have $ to put in and can save on the interest rate by not doing it in the name of
(ii) Also less risky to loan rather than capitalize. Maybe it‟s not undercaptialized
when you make the loan but you don‟t‟ know what the future will hold.
(iii) Demand Loan: loan the money but can get it back whenever we demand it.
(iv) Tax consequences:
1. If you put in the money as a shareholder, and you get back dividends then
that‟s taxable. The corporati on does NOT get a tax credit for di vi dends
pai d out. So possibility of double taxation and no tax benefit. OR it
makes the corporation more valuable, cap ital gains, is the other option.
Deferred return, tax consequences later.
Prof. Hillman Business Associations Page 19 of 87
2. If you put in the l oan, you’re just getting repai d on the l oan and the
corporation gets a tax credi t for i nterest on the sharehol der loans.
(2) Are the “loans” by the shareholders in the same ratio as the stock ownership?
(a) If yes, cuts in favor of subordinating their claim. Then the courts are going to say they
are looking like shareholders.
(b) EG Davis hardware, I put up 80% even though I only own 40% of the stock.
(3) Was the management competent and was it just a bad economic break that the corp went
under instead of improv ing?
(4) NOTE: court could say it was only undercapitalized by 50,000 and so the court will
recognize 50,000 as a loan and 50,000 as capital contribution by the shareholders.
v) Policy Arguments
(1) Subordinating Shareholder Loans bad Must be careful, don‟t want to discourage
stockholders fro m putting up money to save the corporation. If you have to put it in as
capital then you probably won‟t get it back in this situation so the corp would
“prematurely” go under.
(a) Don‟t want struggling businesses to go under “prematurely”. Maybe they just hit an
economic downturn … but does that mean that we let the get the full value of the
(b) Maybe the 50,000 in assets wouldn‟t be there at all if they hadn‟t loaned the 100,000
to the corp. Shareholders are trying to help the creditors by loaning the money.
(2) Subordinating Shareholder Loans good At the same t ime, they shouldn‟t be able to
ju mp to the FRONT of the line by making a loan, they get knocked back in line a little.
Not a punitive intent, it ‟s just that the creditors should have more access to the assets than
the shareholders themselves.
(3) Don‟t try to hide shareholder loans by funneling them through other corporations that the
shareholders own. Don‟t try to pull one over on the court. You‟ll have unclean han ds and
the court will punish you for it.
vi) Go back in time: would you advise able and baker to loan or make a capital contribution in the
form of stock?
(1) What‟s the harm in calling it a loan? If the court subordinates the claim, then all it does is
make it like a stock capital contribution. This is not fraud. This is not a criminal statute.
It‟s mo re like a really safe bet.
(2) One thing the shareholders might do is structure it in a way that makes it more difficult to
subordinate. Don‟t exactly match the shareholding ratio when they put up the $.
vii) “Courts try to achieve equity”
30) Limited Liab ility in the LLC setting see 303 of the uniform limited Liability Co mpany Act.
a) Failure to observe formalities is NOT a ground for piercing the veil.
b) Nothing is said about undercapitalization, and we don‟t have substantial case law on this.
i) On one hand we can say that the analysis should be the same (except formalities) as corp
ii) On the other hand, if the leg is wants to have capitalization as a price for limited liab ility, they
could have put that in the statute
(1) But what about the doctrine that legis must expressly contradict long standing tradition in
the common law in equity
iii) WE WILL pick up the pace!!!!!
31) Monday, September 17, 2001 Question: Why the rush to open th e NYSE? Is that just a manifestation of
our darker side, or is there something else that might explain it? What is behind this? Should the markets
be put aside?
a) [statement against terrorism, corps need markets open [so that they can generate capital?] (no t that
direct, sysco, GE and disney are out their buying their own stock right now. NY is selling debt
security right now, markets facilitate capital flo w and capital flow is important for the economy…
tells you valuation? Investment, in all its forms, is the backbone of the economy of this country,
and markets operating correctly encourage investment. They provide a means to sell an
investment, and to make investments. Without markets, you lose investment and you lose jobs.)
b) When people lose confidence in markets they don‟t invest, they don‟t put excess $ into production,
they hide and stockpile instead.
Prof. Hillman Business Associations Page 20 of 87
c) When a corporation buys back its own stock, what is the effect of that?
i) Before Sysco buys back its own stock it reduces the amount of available shares on the market,
the stock demand may go up, it ‟s an attempt to keep the stock price up in the face of massive
pressure to sell. But, on a longer term basis, they are reducing the ownership base. They are
distributing resources to stockholders who are selling and they are reducing the number of
owners. If the Corp has $ they need to do something sensible with the $.
(1) They can build additional productive capacity
(2) Can buy another corp
(3) Can buy a c.d.
(4) Can buy own stock if corp th inks its own stock is undervalued, acting on behalf of the
shareholders who are keep ing stock in the corp, ultimately the shareholders who keep
their stock will have more in the end.
(5) Davis hardware might sell some stock to a third investor to get more $, but if Dav is
hardware has excess $ they might buy back some stock.
(6) Disney is selling BONDS right now so they can buy back their own stock. Disney is
borrowing $ in order to buy their own stock on the market.
(7) The stock that is bought back it is known as TREASURY STOCK. It‟s in limbo. It
doesn‟t vote, it doesn‟t receive dividends. It‟s authorized, though.
(8) Value of the corporation shares on the market times the cost of a share, that‟s called the
market cap italization of a co mpany. That‟s a good indication of the value of a co mpany.
(9) If you agree that a company EG sysco is undervalued, you can also buy the stock back
while the corporation is doing it. There are so many shares out there that the corp can‟t
really deprive the market of those shares to the point that you (private investor or
whoever) can‟t get out there and buy the shares too. It‟s maybe 2% of the total assets of a
co like sysco that they are investing in their o wn stock today.
(10) Is it patriotic to buy stock? Prof says more patriotic to buy goods and services, that‟s
what the economy needs.
32) Moving on…. Management of the Corporation
a) The traditional model of corp management is three levels:
i) Shareholders elect BOD Board of Directors
ii) BOD elects Officers
iii) Officers run the company day to day
b) What defines their duties?
i) Corporations Codes of States
ii) Articles of Incorporations
iv) See Statutory Supplement A LI principles of corporate governance. Not a restatement. Th is
document includes “how things should be” (recommendations) rather than “how things are”
as in restatements.
c) Traditional Model is misleading
i) Academic theory: Nexus of Contracts Theory. A corp is nothing but a set of relationships.
(Shareholders and managers, Corp and employees, Corp and creditors) The corp structure fx
to order the relationships. The whole purpose is that people WONT have to have contracts for
all of these relationships because the relationships are defined. Thus:
(1) EG Shareholders are just claimants against the assets of the corporation. This is an
economic relat ionship.
(2) The whole idea is that being a shareholder isn’t about ownership. This isn‟t a property
ownership situation. But realistically, can a shareholder exert ownership control eg talk to
president of IBM? NO, the law will p rotect shareholder economic interest but not other
(a) EG Davis Hardware. Hillman 60% and Me 40%.
(i) Hillman wants to “squeeze me out”. I get fired. No job. No more d ividends
either. Now Hillman offers me $ for my shares. Nobody wants this stock
because Hillman is being difficult.
(ii) The law will address the fairness of the terms upon which Hillman squeezes me
out (value paid on stock?????) but not the squeeze out itself.
Prof. Hillman Business Associations Page 21 of 87
ii) Formally, shareholders are the owners. Really they are economic claimants.
33) Supplement book case Chesapeake v Shorewood
a) Del code says BOD has power to amend the by-laws on their own (some states say only
shareholders can do it)
b) Del code does not allow BOD to change Articles of Incorp (cert o f incorp) on own, but can
c) Tender Offer vocab. Hypo cisco wants to buy IBM. Could negotiate directly with IBM, and cisco
could buy IBM‟s assets. That‟s not how it works. Cisco goes to the shareholders of IBM and
offers to buy their stock. This is called a tender offer. Usually offers mo re than market value and
tries to get control by being biggest shareholder.
d) Management often tries to block the offer. EG IBM may structure its board so that only 1/3 of the
directors are up for election in any given year and bod members can‟t be removed before up for
e) Tuesday, September 18, 2001
f) Why tender offer rather than open market before corporate takeover?
i) See Shorewood bought 4.6 % of Ches. Stock on the open market. Under securities laws, after
you buy 5% of the stock of a co mpany, you have to
(1) Declare who you are
(2) Declare what you are up to
g) More on Tender Offers: h istorically shareholders who accept the tender offer fare better than those
shareholders who stick around for the takeover.
h) F: Chesapeake made a tender offer to the shareholders of Shorewood in order to take over control
i) When one corp has a controlling interest in another corp, another step is usually contemplated
i) EG Cisco gets 40% interest in IBM because shareholders accept tender offer. Now Cisco wants
to take 100% of the IBM stock.
ii) Can‟t just revoke the stock. Can‟t really force them to sell you the stock.
iii) Can: sell o ff all the assets.
iv) Can: “Make them an offer they can‟t refuse.”
v) Can: “Squeeze them out.”
j) Merger vocab Can cause a “Merger”
i) File a Certificate of Merger with the Secretary o f State.
ii) Vocab : Merger is a co mbination of t wo corporations in which one survives and one disappears.
Here IBM would be merged into Cisco and IBM would d isappear
iii) All assets and liabilities transfer to Cisco automatically.
iv) Usually the BOD has the power to do this with shareholder approval.
v) What do the IBM Shareholders get?
(1) Can structure so that shareholders get either cash based on the value of their interest
(2) or they can get stock in Cisco.
(3) Shareholders have what is called Appraisal Rights
(a) If they don‟t think they are getting enough, they can go to court to assert their
(b) Appraisal rights are about valuation, not control in the normal ownership sense.
k) Takeover Obstacles Corps can put up Obstacles to takeovers.
i) Change the B y Laws that govern the BOD. Assume 9 on BOD. Make BOD be s taggered
terms, maybe 3 year terms and only a few directors up for reelect ion at the same time, also
say that directors can‟t be removed once in office. This is what happened in the Shorewood
case. You make it take longer to take over hoping it will go away
l) Managers vs Shareholders
i) Shareholders like takeovers if they get more $ and they often do because of tender offers.
ii) Managers do not like takeovers because they often lose their jobs.
iii) Note that managers are often large shareholders.
iv) Note that Managers are supposed to always put the interests of shareholders before the interests
v) Back to Cisco / IBM hypo. How do IBM managers package their resistance to the takeover
when they are trying to tell the shareholders to resist the takeover?
Prof. Hillman Business Associations Page 22 of 87
(1) IBM should say our stock is undervalued and Cisco is trying to raid us to get rid of a
competitor. This premiu m that they are offering is illusory. In fact, Cisco is doing this
because they know that our stock is undervalued. You‟ll get a lot mo re $ if you stick w ith
us rather than selling out.
(2) We (IBM management) need to erect defenses to protect the shareholders from
(a) Courts are skeptical about these measures, particularly if they are in itiated AFTER the
takeover has begun.
(b) Think about this, too, if the measures were in place before the shareholders bought
their stock, then they are on notice that the measures exist.
(c) Also, these measures protect the stability of the co mpany.
(d) Also, these measures can force the takeover to be friendly and negotiated with
management, wh ich can drive the takeover price up.
(e) Often the top managers will get an attractive offer, which has nothing to do with the
shareholder‟s interests, which the shareholders won‟t be able to prove. The manages
are supposed to act only in the best interests of the shareholders, and managers will
say that it‟s not about the deal for them, they really thought the offer was good for
the shareholders. Maybe that manager (d irector) won‟t vote on the proposal to
support the takeover.
vi) Shorewood is about the divergence of interest bet the shareholders and the managers.
vii) Davis Hard ware close corporation first rights of refusal in some countries for all
shareholders. All tender offers would have to go to all shareholders. Not here.
(1) Could be a contractual right that I (40% owner in Davis Hardware) put in there. Make it
so that all offers to Hillman must go to ME on the Same Terms.
34) BOD (3.b on the syllabus) Board of Directors
a) Terminology and Concept point: Inside vs outside directors
i) Inside Directors = also officers of the corporation. EG CEO is also on BOD.
(1) Assumed to have some conflict of interest
(2) Getting substantial inco me fro m employ ment with the corp
ii) Outside Directors = not also officers of the corporation.
(1) Less conflict of interest on the BOD
(2) But note that they could own stock
(3) Note if Cisco CEO is on BOD for Bank of A merica and CEO of Bank of A merica might
be on BOD of Cisco. Ho w independent is that really?
(a) Shareholders are becoming more act ive in response to all this back-scratching. It‟s a
challenge, but shareholders are looking at it.
b) Directors are really responsible for management of the corporation. Note that Officers are just
c) See Del § ???
i) Cal. Says all corporate powers must be exercised under the direction of the board
d) Problem: we thin k that outside directors protect shareholder interests better and yet these people
have full t ime jobs somewhere else and have little time to devote to the corp. EG CEO of Bank of
America on BOD o f Exxon.
e) ALI conclusion Publicly hel d corp. is managed by S ENIOR EXEC UTIVES appointed by
the BOD who report to the BOD. Now the BOD is really just monitoring the management.
f) BOD manages by overseeing the activities of the senior executives.
g) Supplement dropped the ALI princip les of corp. Governance. They are quoted extensively in cases,
and Hillman will point out when they become important, such as he did here.
h) BOD has significant responsibilities and significant liabilities. And significant co mpensation.
i) FORMALITIES for BOD
(1) must be
(2) Except Annual meet ing, when the annual meeting time and place is stated in the by -laws,
which it usually is
ii) Quorum the percent, usually majority, of board members/directors needed to take action.
Somet imes can be less than majority but usually no less than one third of the full board.
Prof. Hillman Business Associations Page 23 of 87
iii) Mi nutes History of Board Meetings
iv) Acts of BOD
(1) Resolution formal act of BOD
(a) written consent (Usually unanimous required by state statute)
(b) Deliberate and Vote on Resolution at meeting (usually not unanimous)
(2) Informal Act maybe not whole BOD, need to do something
(3) Commi ttee not full board.
(a) Must have either statutory authorization or it will be suspect. Modern trend is to allow
committee action. Del allows a wide range of BOD actions to be done by
(b) ALI says: for purposes of discussion, corporations fall into three categories First Tier,
Second Tier, and All Others
(i) First Tier: very large public
1. more than 2000 stockholders AND
2. more than 100,000,000 (one hundred million) in assets
3. Mandatory Audit Co mmittee per ALI and also investors/market requires it
According to ALI, must have an AUDIT COMMITTEE which should
consist only of OUTSIDE DIRECTORS. Outside Directors are not
supposed to be interested in inflating the financial status because don‟t have
jobs with the corporation. Fx of Audit Co mmittee are
a. to review/ensure the integrity of the financial overview of the corp
i. Audit committee makes sure internal accounting system has integrity
b. and to oversee the OUTSIDE accounting firm that prepares the corp‟s
i. Audit committee ensures the accounting firm is really independent
4. Co mpensation Committee reco mmended sets the compensation amount
(pay) for the top officers. Should be all or at least majority outside
directors. Most public corps. have such a committee
5. No minating Co mmittee reco mmended Should be all or at least majority of
outside directors. Less of a conflict of interest. Putting names of potential
directors before the shareholders. The pro xies actually vote in behalf of the
a. Pro xy system for shareholder meet ings. So mebody collects proxies to
vote the shares of the shareholders. There are people who have enough
proxies to vote the shares of the shareholders.
(ii) Second Tier: large public
1. More than 500 stockholders and
2. more than 3 million in assets
3. ALI Reco mmends Audit Co mmittee
(iii) All others
35) Shareholders: what is their ro le in management of the corporation?
a) Elect the BOD annually. Doesn‟t meal all BOD is up for election every year.
b) Remove Directors.
i) see Shorewood case, does director have a vested right to remain?
ii) Modern trend is no, director has no vested right. May remove with or without cause.
iii) Mechanically can be difficult to remove director.
c) Usually have the right to vote on major organic changes to the corp
i) EG takeover, usually both corps shareholders have to approve
ii) Selling substantial assets
iii) Statutes say what transactions require shareholder approval
iv) It‟s not all BIG t ransactions and not all transactions, its whatever the statutes say.
d) Part 4 of Syllabus Control by Shareholders
i) Control has been divorced fro m ownership. Shareholders don‟t control the corporation. 1932,
“the modern corp and private property” said this. When you have shareholders who are so
widely disbursed and large in # there is no individual or group of s hareholders who can
effectively assert control over the corporation.
Prof. Hillman Business Associations Page 24 of 87
ii) This is more co mplicated than it may seem because there is significant concentration of
ownership in the hands of institutional investors. About 50% of the stock that is out there of
public corps about half is owned by institutional investors. If you look at top 1000 corps,
60% is held by institutional investors. Includes
iii) See chart on page 160
iv) Institutional Investors
(a) Pension Plans own about 25% of corporate America. Own t wice as much as banks
and ins companies combined.
(b) “investment companies” aka mutual funds,
(c) Insurance companies
(2) Don‟t keep stock long term, usually intend to keep short term
(3) Can send message to management two ways: tell them to change or sell the stock. Usually
institutional investors sell rather than telling management what to do.
(4) Institutional investors are disinclined to argue with management. They don‟t want to go to
shareholder meetings, they just sell. This plays into the hands of management.
(5) This gets even more co mplicated ….
v) Some institutional investors are taking a stand on some issues they feel are important
(1) Cal PERS
(a) Cal Pers general counsel is grad of UC Davis
(b) Cal PERS asserts control aggressively, builds coalit ions of corp investors to affect
(c) Tries to make management more accountable, tries to control corporate governance.
(d) Cal PERS has its own reco mmendations like A LI reco mmendations for Co rp
(i) Directors should NOT be co mpensated just in cash, it should also be stock. Want
to make BOD stockholders
(ii) Outside directors should meet periodically without the Inside directors present.
(iii) Audit Co mmittee should be just outside directors
(iv) No minating Co mmittee should be only outside direc
(v) Co mpensation Comm should be only outside direct
(vi) CEO significant part of co mpensation should be at risk if the corp performance
is not up to standards.
(vii) Cal PERS backed off
1. No director should be considered outside once on board for 10 years
2. No more than 10% o f the dir should be over 70 years old
a) These top officers are the ones who really run things.
37) Thursday, September 20, 2001 Selling Stock Short selling stock that you don‟t own, anticipating a
drop, so that you can pick it up later when it goes up. Hypo: you KNOW that M$ stock will drop
substantially next week. I want to profit fro m this predicted drop in value. Call Bro ker. Get “loan” of the
Bro kerage stock. 51$ per share, borro w 10,000 shares, now it has dropped to 31$ per share. No w go into
the market and buy 10,000 shares to pay back Brokerage. Keep the difference. If you‟re wrong, you are in
big trouble. They get a co mmission on both transactions, by the way. This happens every day. Note that
the drop is LIM ITED but the potential for a raise in stock value is unlimited.
38) Back to institutional shareholders.
a) Problem: hard to figure out who the real owner is. EG Mutual Fund, Fidelity Magellan Mutual
Fund, invests in M$. Who is the investor, you or the Mutual fund? With very few exceptions, it is
the institution that is the shareholder. The Institution managers take the actions.
i) Is that right, should ultimate economic beneficiary be considered the real investor?
ii) Is there anything troublesome about the inst. as a shareholder, given the fact that the inst.
doesn't assert control>?
iii) To who m are the managers account able?
(1) The shareholders ONLY?
(2) Shareholders plus other interested parties? (social responsibility)
Prof. Hillman Business Associations Page 25 of 87
(3) To what extent can the managers of the corporation advance interest OTHER THA N the
interests of the shareholders?
iv) Dodge v. Ford Motors. See p 139
(1) Facts suggest that in 1916 Henry Ford decided to stop paying dividends to shareholders
and put the $ back into the corporation, hire mo re employees, and pay the employees
more. Maybe it was good business to do that.
(a) See top of page 140 “my ambit ion is” to share profits of the corp with the workers and
to spread the wealth and to put the $ back into the corp
(b) Shareholders bring action to stop Henry Ford and to compel Henry Ford to distribute
$ to the shareholders in the form of d ividends.
(c) Henry Ford can‟t p lay with other people‟s money, must give dividends. Ford Motors
is not a charitable organization.
v) ALI Pricinip les of Corp Governance
(1) Standard it is the obligati on of management to enhance corp profit and maxi mize
sharehol der gain. But, management MAY take into account ethical consi derations
and di vert reasonable resources for social purposes.
(2) Still wouldn‟t allo w Fo rd‟s action because that was massive diversion of resources.
vi) A.P. Smith M Fg co v Barlo w Sup Ct NJ case, page 141
(1) $15,000 donation to Princeton University by president of
(2) Sup Ct says p 142 sound investment. Public expects corporations to donate, enhances
good will, creates a favorable environ ment for corp
(3) Addressing these other constituents is good business. Ford could have said this too. Ford
could have said he wanted to raise employee wages so they could afford to BUY Ford
(4) Somewhat troubling standard: wouldn‟t allow contribution to a “pet” charity or to advance
personal rather than corporate aims. But then what was this?
vii) Del courts have periodically toyed with the idea that shareholders aren‟t the only constituents,
but when push comes to shove Del. courts say shareholders are the constituents. Must frame
things as benefit to the shareholders.
viii) Most courts, under any standard:
(1) Would not allow a massive diversion
(a) EG Eli Lilly 30 million donation, isn‟t that massive?
(b) Shareholder claim is/would be that this is ultra vires.
(c) But if it was for the WTO d isaster, court might back them up. Lots of corps are giving
large donations right now.
(2) Would allow a reasonable, moderate diversion or donation to further corporate good will
39) Cu mulat ive Voting [by shareholders] [voting on directors, not on other topics]
a) Allows each sharehol der to cast votes equal to the number of shares that the sharehol der owns
TIMES the number of directors to be elected. AND the sharehol der may accumulate all of
those votes and cast them all for one person! Vocab.
i) Cu mulat ive voting is required in a few states.
ii) Cu mulat ive voting is permitted in most states.
(1) Usually will be in the by-laws if they have it.
b) Designed to allow minority shareholders to have more voice.
c) See problem 4b2 Formu la N=X * (D=1)
N = nu mber of d irectors B gets to elect
X = nu mber of shares B is voting
D = nu mber of d irectors up for reelection now
S = total number of shares being voted
(B is shareholder B)
(A is shareholder A)
Assume 9 d irectors, B has 499 of 1000 shares, B elects 4 directors, 44% representation
Prof. Hillman Business Associations Page 26 of 87
Assume 3 d irectors, B has 499 of 1000 shares, B elects 1 director, 33% representation
Thus, the smaller the board the less the voice on the board of the minority shareholders.
Also, if you stagger the voting, the voice of the minority is smaller. 3 d irectors of nine elected each year,
only one each time for B.
Monday, September 24, 2001
d) Why is it important to have cumulative voting? What good is it if minority representation has only
one seat on BOD?
i) Could make some actions require unanimous vote by BOD.
ii) What about disruption of BOD
iii) Maybe minority shareholders aren‟t trustworthy with corporate secrets
e) Required in a few jx for close corporations, optional in most jx fo r close corporations
40) Inspection of Shareholder Lists and Corporate Records
a) Shareholder has a right to get Shareholder Lists
i) in most jx the burden is on the corp to show that the shareholder does NOT have a proper
purpose for wanting the shareholder list.
ii) In a few jx De minimu m std must own at least 5% of the stock to get the shareholder list.
iv) Addresses of other sharehol ders
v) Why would you want the shareholder list?
(1) Try to consolidate power, co mmun icate, exp ress concern over something management is
doing. All acceptable uses.
(2) Want to make an offer to the other shareholders. Acceptable use.
(3) (Follow investments and maybe watch smart investors? There are more efficient ways of
doing this according to prof. must file)
(4) Co mmercial Mailing list. This isn‟t really an acceptable use, probably does happen.
b) Shareholder does not have a general right to Inspect Corporate Records absent a showing by the
shareholder that the shareholder has a proper purpose for wanting to inspect the corporate records.
i) In a few jx De minimu m std must own at least 5% of the stock to get access to corp records.
ii) Why would the shareholders want to look at the books and records?
(1) Co mmercial Espionage steal the trade secrets of the corporation. Not an acceptable
(2) Evaluate Management and Investigate to determine if you should invest more. But
securities laws make a lot of info public, shouldn‟t we change the securities laws if we
need more investment informat ion?
(3) To facilitate Corporate Takeover by another company. not really an acceptable use.
(4) Social Responsibility Espionage how many rat hairs are in the average Big Mac?
Maybe this is acceptable.
41) Pro xies
a) P 264 Security First Corp v. U.S. Die Casting & Dev. Co. 687 A 2d 563 (1997)
i) Facts Mid Am is regional bank hold ing company with K agreement for Merger with Security
First. US Die is a major shareholder 5% of Security First stock.
(1) Merger Agreement says if merger terminates Security First has to pay a $2 million
(2,000,000) termination fee plus other expenses on the occurrence of other events after
(2) Merger fails, cite “different management philos ophies” Probably the company being
acquired realizes that they are going to get fired, esp. the BOD and major officers realize
they don‟t like the deal.
(3) With the merger, Sec. 1st stockholders would get to sell stock at a premiu m price, when
the merger fa ils the stock price falls. Now the stockholders are burned. F
(4) π US Die wants to see the records on the failed merger.
(5) Div idend payments to Security First stockholders were increased right after the merger
(a) Keep shareholders happy
(b) Make it harder to raid the corporation by decreasing cash and increasing stock price.
ii) Merger agreements - make it d ifficu lt for a party to back out of the merger and merge with
Prof. Hillman Business Associations Page 27 of 87
iii) Analysis of the Merits
(1) Proper Purpose here, mis management of the merger.
(a) This is a heavy burden and it is met here.
(b) § 220 of Del Corp Code in this case. Mini Trial on the issue of manager
mis management. If shown by π on credi ble evi dence, then will get access to certain
(2) Scope of the Inspection
(a) Shareholder List Didn‟t get it because they didn‟t show proper purpose in depo.
This is a π who wasn‟t properly prepared for the DEPO, or maybe the π failed to
remember what the lawyer said?!!!! Said in co mplaint that they wanted to
communicate with other shareholders. . Presumption favors π anyway. Should have
been easy to get.
42) Mandated Disclosures and Intro to Securities Laws
a) Securities Laws Flow of $ aka investment capital. Flow means both vertical flo w and horizontal
i) Vertical sale to public, stock fo r cash. Episodic event. Not ongoing. May happen once or
once every few years. Happens in one day. AKA public offering of stock.
ii) Horizontal Investors trade stock in markets. Corp doesn‟t see this $ directly.
iii) Securities laws facility the free and fair flow of capital or is supposed to.
(1) No fraud.
(2) No market man ipulation.
(3) Generally a level p laying field.
(4) Six separate pieces of legislat ion enacted 1933-1940. Federal Regulations of Securities
(a) History: debate about the form of laws. Two sides were clearly defined.
(i) On one side, the Brandeis view “Other People‟s Money.” Regulatory system
keyed to disclosure. Sunlight is the most effective disinfectant. Disclosure.
(ii) On the other side, wanted mo re regulat ion. William O Douglass, early career in
securities world. “the great reliance placed on truth … as if the public
understood” People are stupid. Must regulate the selling to make sure th at the
transactions are fair to investors. Substanti ve fairness.
(iii) 1933 Brandies won, d isclosure only. Information only. Major premise of
securities laws. So me areas where they protect substantive fairness too, but it‟s
1. Mostly concerned with Vert ical flow.
2. Disclosure is required.
3. Filing of document “Reg istration Statement” required before public offering.
a. Has extensive disclosures about company, industry, management,
conflicts of interest.
b. Filed with the Securities and Exchange Co mission (SEC).
c. SEC does NOT review the document except to make sure that the
disclosures are made.
d. CAN sell so many feet of b lue sky, real estate on the moon, so long as we
make full disclosure that noone is in a position to sell real estate on the
moon. Does not protect except to the extent that it provides
(5) State Regulations Blue sky laws. The reason for the name is they are supposedly
designed to stop people fro m selling “feet of blue sky” (noting) to unwary consumers.
b) 1943 act
i) disclosure emphasis, tries to prevent fraud and insider trading
ii) Reports required by 1943 act, mandatory filing with the SEC:
(1) 10K report: Annual report including certified financial statement by independ. Financial
firm. The 10K annual report is very formalistic, not user friendly, no color graphs.
Prof. Hillman Business Associations Page 28 of 87
(2) 10 Q report: Quarterly report : like annual but doesn‟t have to be done by independent
(3) 8K report: Reports of significant events in the life of the corporation
iii) regulates solicitation of Pro xies
iv) Efficient Market Hypothesis: if the info is good the mkt will rap idly reflect changes via pricing
v) Objective of the Regs: introduce quality info into the markets, prohibit fraud
vi) Regulates horizontal flow, b rokers, lawyers etc
c) The Pro xy System: how shareholders exercise control
i) In theory, anyone can solicit pro xy … anyone can vote proxies
ii) Agency relationship, enables someone to vote shares for you
(1) Maybe you tell how to vote, maybe pro xy voter decides how to vote
iii) Two groups solicit pro xies
(1) Management: to conduct basic business that shareholders vote on
(a) Increase management compensation
(b) Vote on BOD
(2) Dissident Shareholders: with own agenda
(a) Economic Agenda, maybe want to increase profit o r cap executive co mpensation
(b) Social Agenda: see cases assigned for today
iv) Securities laws require disclosures during proxy solicitation
(1) SEC requires a more user friendly annual report given by management to shareholders as
part of pro xy solicitation. Has pictures, less info, easier to read. It‟s not like the 10K.
v) Pro xy rules are in § 14 o f the Securities Exchange Act SEA of 1934, usually called “The 34
(1) Four Ob jectives of § 14 Pro xy Ru les
(a) Disclosure see above, annual report
(b) Prohibit Fraud connected with solicitation of pro xies
(c) Mechanism for stockholders to solicit pro xies of other stockholders
(d) Shareholders who solicit pro xies must make d isclosures about themselves
(i) Who, what are objectives, etc
(2) Rule 14.a.1 Defines important terms
(a) Solicitation: A communication to a stockholder reasonably de3signed to result in a
procurem ent, revocation, or withholding of a Pro xy .
(3) Rule 14.a.3 Any solicitation must be accompanied with or preceeded by a Pro xy
(a) The pro xy statement is the comprehensive disclosure document.
(b) Has to give the shareholder adequate info to decide how to respond to the proxy
solicitation. How much info depends on who is solicit ing. Management = most
extensive. Stockholder: who they are, what their h istory is, objectives.
(4) 14.a.9 Prohibits any material o missions or false or misleading statements in the
solicitation of pro xies. Applies (obviously) to management and to others and who solicit
proxies. What happens if you violate this provision?
(a) Failure to disclose a material fact aka “Material Omission” what is the remedy?
(b) If management makes a material o mission
(i) the SEC can respond in a civil action seeking injunctive releif or seeking to recind
shareholder approval that was obtained this way.
(ii) Criminal prosectutions are refered to the Justice Dept (rare).
(iii) Implied private COA
1. The securities acts include an express civil coa for some vio lations b ut NOT
in § 14. § 14 does not say there is a private coa. So me people say silence
means no COA.
2. See note on page 291. J.I. Case co. v. Borak 377 US 426, 84 S.CT. 1555
(1964) supreme court said yes, there is an imp lied PRIVATE cause of
action. SEC has limited resources, must allow private coa to ensure
enforcement of § 14. First case to address the reasons for the private coa
and implied private coa even when statute is silent.
Prof. Hillman Business Associations Page 29 of 87
3. Courts recently reluctant to find imp lied private COA. You just have to look
at the case law. Depends if it was before 1980, yes probably implied private
COA. In the 1970s the courts were aggressive about applying the securities
acts. In the 1980s the court backed off, signaled its intentions….
(5) 14.a.7,8 Shareholder Proposals
(a) Why do dissident shareholders solicit Pro xies?
(i) May oppose management on a particular issue. Maybe management wants a
merger and some sharholders oppose the merger.
(ii) Maybe shareholders oppose slate of directors that management is proposing and
want their own managers elected.
(iii) Maybe shareholders have a proposal
1. Economic: fire the incu mbent managers
2. Social: get out of the tobacco business, goad company to be more aggressive
in afirmative action policies.
(b) How does management respond to shareholder proposals?
(i) Management never met a shareholder prospoal it liked. If it wasn‟t contrary to
management they probably would have thought of it first. Even if it is neutral,
management doesn‟t like shareholders trying to exert control.
(ii) Management will put up barriers to shareholder proposals.
1. Management always has corporate resources and list of shareholders. Easy to
(c) Dissident shareholders: how do they solicit p ro xies?
(i) Must get a list of shareholder names and addresses. Management response: No.
Delaware law says: proper purpose standard. BOP is on you to show that my
purpose is not proper. Gimme the list. Management: NO. No penalty for
management delay. Must sue the corporation management to get the list.
Minitrial on the issue of proper purpose. Months $ maybe can kill it right there.
(ii) So you get the list. It can be a mess, form isn‟t specified.
(iii) SEC adopted rules 14.a.7 and 8 to address these problems: 14.a.7
1. If management is going to be solicit ing pro xies (they always will) it M UST
furnish another shareholder who so request it the number of stockholders
and the cost of mailing pro xies.
2. If you then want to solicit pro xies. Management can put the shareholder
proxy in with the management pro xy and charge the shareholder, or can just
get the list.
3. If it‟s economic it might be worth the $ to do this. If it‟s social, it might not be
(iv) Rule 14.a.8 better for shareholders, if exception applies kick back to 14.a.8
1. Management must include a shareholder proposal at NO expense to the
shareholder except (in wh ich case go to 14.a.7):
2. Not a proper subject for sharehol der action. Not something shareholders
have the authority to do. EG want to fire Eisner as the CEO of d isney.
BOD appoints the officers, shareholders don‟t appoint officers or corp.
How to get around this? Make it a RECOMM ENDATION. No w it‟s a
proper subject, expressing their will to the BOD. Mag ic is in the way its
3. Proposal violates laws
4. Proposal contains untrue or misleading statements
5. Proposal is a personal grievance against the corporation or its emp loyees
6. Relates to less than 5% of the assets or earnings and is not otherwise related
to the issuer (of the stock)
7. Deals with a matter that is beyond the power of the corporation to effectuate
8. Deals with a matter relat ing to the conduct of the ordinary business operations
of the issuer (because stockholders aren‟t supposed to mess with the day to
9. Relates to the election of directors
Prof. Hillman Business Associations Page 30 of 87
10. If the proposal is counter to a proposal offered by management
11. Rationale for exceptions: The idea is the free ride is for shareholder
INITIATED proposals, not reactions to management
12. If management refuses to include with pro xy under 14.a.8 then must notify
SEC. SEC gets to decide if it fits in the exception or not, usually issues a
“no action” response letter if they agree
(v) Roosevelt v. Du Pont de Nemours & Co. 958 F2d 416 (1992) case page 314
1. Ordinary g rounds for excluding
2. Proposal was social purpose, pollution (fleuorcarbons)
3. Management didn‟t have to put it in with their p ro xies under 14.a.8. WHY?
(SEC, District court, and DC circuit agreed.)
a. First part: It wasn‟t TO phase out, it was WHEN to phase out, it was to
accelerate the phase out so that it was phased out one year earlier
b. It was external pressure fro m White House, public relat ions, customers,
community, so it wasn‟t strictly shareholder pressure.
4. Stockholders wanted management to include “environ mentally sound
substitute” report proposal under 14.a.8
a. Example of why not 14.a.8: can be used to harass management.
b. In Goose liver pate force feed ing case, wanted to force management to
change corporate policies.
c. This case: there is no indication that the corp policy is other than what the
shareholder wants. It was really a fishing expedit ion, because the corp
was going to look for substitutes anyway.
(vi) Almagamatede clothing and textile workers Un ion (as shareholder) v. Walmart
Stores p 321 (1995)
1. Union wants report on affirmat ive action in with pro xies, Walmart wanted to
put in under 14.a.8, SEC agreed. Again next year, same, Union goes to
2. District court says cannot exclude, must include under 14.a.8. Walmart did
not appeal. Why no appeal, why doesn‟t want proposal to go forward.
a. Doesn‟t want higher court to set a precedent. (but you always have to
decide on own facts… these proposals are VERY fact dependent per
b. Public Relations with public, doesn‟t want to be seen fighting it too
much, maybe just initially say they don‟t want to pay under 14.a.8.
i. Why contest at all then?
ii. Want to raise barriers, don‟t want to be too easy on shareholder
proposals or you will open floodgates.
iii. Don‟t want to throw up so many barriers that there is a PR
c. What happened after the shareholders voted on the proposal?
Shareholders rejected the proposal by a vote of 9 to 1. Lesson:
Shareholders are not the right constituency for social responsibility
proposals. They ALMOST NEVER SUCCEED.
d. If you have a really hot social responsibility issue and you get a 15%
support vote, that is considered a huge success.
e. If we‟re talking about economic issues, there is a much greater chance of
f. Note that with social responsibility maybe you don‟t really care if you get
a majority shareholder vote, it‟s just to soften management up. The real
way to get social responsibility change is to apply external pressure.
3. Note that here the atty fees went to shareholder atty under corporate “shared
benefit theory”, theory that all shareholders benefited
d) Expenses for Proxy Solicitati ons
i) Rosenfeld v. Fairch ild p 327 (1955) this is a 3-1-3 opinion with no majority, the 1 is a
Prof. Hillman Business Associations Page 31 of 87
(1) Management lost the proxy fight and got fired
(2) Entertain ment, charter airplanes, etc were charged as expenses
(3) Management expenses were charged to the corporation, as were the expenses of the
dissident shareholders after they won.
(4) Dissident shareholder brought this suit to protest only the entertainment expenses.
(5) Frossel wrote for 3 judges
(a) Test for allowing expenses is: Was it battle over policy?
(i) If fight over policy then can be reimbursed
(ii) If battle over power, then can‟t reimburse the expenses of ???
(iii) Frossel says: it was a battle over the K with the CEO, who is the CEO of the
corporation. Isn‟t that a fight over power?
1. You could say yes, it is. It‟s all about power
2. You could say no, the CEO sets the policy and the only way to change policy
is to fire the CEO. This view can always be sold, and under this test you‟ll
probably get your expenses reimbursed.
(6) Desmond wrote concurring in result but not reasoning.
(a) Only expenses reimbursed should be associated with the notice. Postage not
(b) However, burden is on the challenger to show that the expense is not associated with
notice and the challenger did not show that here
(7) Van Voorhis Wrote for d issent, say
(a) Only expenses reimbursed should be associated with the notice. Postage not
(b) However, burden is on the management to show that the expense is related to notice
and management didn‟t do that here.
(8) Now, in New Yo rk, management isn‟t going to want to incorporate in New Yo rk because
proxy fights are going to have expenses paid for by management.
(9) Who should pay?
(a) Maybe we should have a reasonableness standard, more than bare notice and less than
chartered airplanes and champagne.
(b) Pro xy voting consulting firm: call and badger shareholders to vote proxies.
(c) Lawyers: to make sure it‟s all legal.
(d) Bro kers often hold the stocks, need to call them and tell them the pro xy vote is
(e) Delaware says: power vs policy disctinction, so expenses are almost always paid by
43) Conclusion of discussion control public corp Themes:
a) To who m should management be accountable
i) Shareholders? Which level?
b) How can we hold management accountable
44) Close Corporation
a) Different themes. Run for the benefit of the shareholders, small number of them, o ften live in same
community, typically act ive shareholders and work for the corp.
b) No established market for their stock, no easy exit if shareholder wants out.
c) Know who the co owners are, and care about the identiy of the co owners. Don‟t want new hostile
person in our little group
d) Frequently disreguard corporate formalities because they are not natural for a s mall business
e) Typically the investment is a substantial or the entire amount of the indivicuals income and
investments. Most of their wealth is tied up here
f) Several problems that need to be addressed:
i) Corporate formalities. What formalities can we get rid of
ii) Identity of co owners
iii) Potential deadlock in the management of the corp, eg if 50 50 o wnership two owners
iv) How do we deal with the responsibligy of controlling shareholder to the non controlling
Prof. Hillman Business Associations Page 32 of 87
(1) Fiduciaty standards/duty
(2) Donahue case tomorrw. Not really lookig at fidutiary standars here, we are looking to see
how courts are making special rules for close corporations. 2 tier basis, one set of rules
for public corp and another for close corp.
g) Close Corps: mostly Bus Ass is one size fits all but not close corp law, some flexibility
h) Donahue v. Rodd Electrotype Co. 367 Mass 578, 328 NE 2d 505 (1975) p 340
i) Fiduciary stds background law is pretty set in most areas.
(1) Vocab : We call trustees Fiduciaries, they are the person in who m trust has been placed.
(2) Corp mg rs owe fiduciary duty to stockholders and corps for who m they work
(a) Duty of Care
(b) Duty of Loyalty
(3) Growing recognition at time of Donahue case that shareholders may also be fiduciaries
and have fiduciary duties to minority sharholders.
(a) Good Faith pre Donahue
(b) Fairness pre Donahue
(4) Co mpare to partnership duties: more duties stronger duties
(a) Highest duties imaginable
(b) Famous case quoted all the time 1928 case Nihart v. Salmon Cardozo “Not honesty
alone a punctilio of an honor most sensitive” Define punctilio
(c) We expect the highest standard of conduct from partners.
(d) The relationship is very close and sensitive
(e) Founded in trust
(f) UNLIMITED liability among and between partners
ii) Facts of Donahue
(1) Controlling stockholder Harry Rodd 1930 started along with Donahue, 1955 became
had been a stockholder for a long time, president and general manager. Harry got 200
shares of stock b/c he was a valued and important emp loyee. Harry reco mmended that
Joe Donahue get 50 shares of stock. Total of 1000 shares out there. Joe Donahue was
never in management, worked in plant ops.
(2) In 1970 Rodd controlled the BOD and the company bought back the 750 other shares.
Now only 250 shares total in the co mpany. The old controlling group wanted out, wanted
to retire or something. Th is is alarming to the minority shareholders because the corp
might sell the corp to someone that the min shrehds don‟t like SH = shareholder fro m
now on. Treasury Stock. Why didn‟t Donahue protest? Because he trusted Harry Rodd
(3) DON‟T read these cases like law students, read them like lawyers. Know the story, know
the characters. Know the rationale, know what the problem is and most importantly what
could have been done to prevent the problem.
(4) What‟s the problem here? Well the corp just committed a lot of resources to letting the old
(5) Now Harry Rodd is ready to retire. BOD is Harry‟s kids and Harry ‟s lawyer. Harry has 81
shares right now.
(a) Sells 45 shares to the corp for $800 per share.
(b) Gives 30 of his remaining shares to kids
(c) Sells 6 shares to kids at $800 per share.
(d) If you look at the total shares the kids got, they really only paid $133 per share.
(6) Enter, stage right, π Euphemia Donahue, Joe Donahue‟s widow. She says you made the
corp pay too much for those 45 shares.
(a) Improperly used your control of the corporation to create a buyer for your shares. I
want to be able to sell my shares at 800 per share too
(b) Improperly d istributing assets to the majority SH because you‟re overcharging the
corp $800 per share when the shares are only worth $133 per share. Wasting
corporate assets, looting the corporation.
(7) Court could have said:
(a) Controlling shareholder had fiduciary duty to be fair and this wasn‟t fair. Th is was a
legal std that was available.
Prof. Hillman Business Associations Page 33 of 87
(b) Could have focused on the bod not the SH and said the BOD has a duty not to favor
one shareholder over another SH.
(i) Court said didn‟t want to do this because that would show self-dealing. There is
self dealing here but the court wanted to exp ressly create new law for close
(8) Court created new law.
(a) Higher stricter standards for close corporations:
(i) Act with utmost good faith and loyalty
(ii) Based on partnership law, but
1. easier exit fro m corp than fro m a partnership. Can sell shares w/o consent of
other SH but can‟t sell interest in partnership w/o permission of parners.
2. Limited liablility for SH
3. Somewhat passive or totally passive investor, trust less important
(b) Counter argument: if you want partnership duty, have a parnership. But here these
people didn‟t form the business, the pretty much inherited it.
(c) This case: Minori ty must be gi ven an equal opportunity to have the corp
purchase her shares.
(i) Where does this end?
(ii) Should she get a job?
(iii) Footnote 18 on page 343 no opinion when the corp is not a PARTY to the
action. Hypo: suppose that hillman sells shares in davis hardware to some θ and
that θ will get control of the corporation. Now corporation is not a party to the
transaction and I don‟t really have a right to involve the corp.
iii) Wilkes v Sprinside Nu rsing Ho me 370 Mass. 842, 353 NE2d 657 (1976) p 388
(a) Falling out over the salary Wilkes was getting.
(b) Wilkes Says I should get job and salary under equal opportunity doctrine.
(c) Uses FAIRNESS not equal opportunity doctrine. Must give majority discretion in the
exercize of its judgment.
(2) Corporate Equal Opportunity Doctrine to be further defined in later cases.
(a) Donahue minority shareholder has a right to sell shares to corporation at same
price when controlling shareholder sold shares AND gave gift of shares to BOD.
(i) Illustration of the courts desire to develop special ru les for close co rporations.
(b) Wilkes case 388
(i) Dissent says form over substance, but here what happens is no right under EOD to
job and salary.
(ii) Decided to give job and salary based on fairness. Temper std of utmost good
faith and loyalty …. Not absolute. Donahue was too strong. There is a
balancing. Donahue flattened by this case.
45) Methods of shifting control in the cl ose corporation
46) Dissolution of close corporations next week.
47) Dissolutions of partnerships next week
48) Control and Abuse of Control in the Close Corporation
a) There are lots of ways to abuse the minority shareholders. In the absence of checks on power,
majority can do a lot to abuse minority shareholders.
i) Eliminate dividends discretion of BOD
ii) Fire them/exclude them fro m emp loy ment BOD
iii) Siphon off corporate inco me in the form of HIGH co mpensation for majority shareholders.
Be CEO and have BOD give you a huge raise.
iv) Don‟t share informat ion with minority shareholders
v) Sell land or other major items to corporation at premiu m price.
b) Limits on power of majority SH in the close corporation
i) Donahue fiduciary
ii) Statutory protections for minority
(1) Moslty more enabling powers fo r MINORITY SH rather than direct limits on majority SH
iii) Shareholder agreements (Ks)
Prof. Hillman Business Associations Page 34 of 87
(1) usually puts protections in the in the by-laws
(2) separate ks not in the by laws
(3) procedural protections
(a) SH voting agreements, usually pertains to elections of dirctors (BOD). Early case law
was hostile to SH voting agreements but now they are alloweed.
1. Pool ext ra votes.
2. More effective pooling agreement: eg H pro mises to cast all votes for R
a. You would do this if you trust the person.
b. You could sell the votes to R. Most courts would say that is void against
public policy to sell votes. Won‟t allow d irect sale of votes between
c. What if R gets the votes in exchange for voting to have H CEO of the
company. St ill b ribery, not as direct but still selling votes.
(ii) Pro xies one shareholder empowers another to vote the shares. Principle/agent
agreement. Revokable any time, even the next day.
a. There is a special kind of irrevocable pro xy. Pro xies that are given b ia
shareholder agreements that say they are irrecocable are irrevocable.
(iii) Vot ing Trusts vest a trustee with voting power. Transfer the shares in the
corp to the trustee so that the trustee so that trustee can vote. Could have done
this in ring ling.
1. Corporations code regulates the voting trust because other shareholders
otherwise might not know that the trustee is just a trustee.
2. Corporate books just show trustee, and so voting trusts must be disclosed on
the books and records of the corporation.
3. Term limited to 10 years for voting trust.
(4) Classification of Stock see page 370 et seq for info on this
(5) Shareholder/ management agreement
(a) Addresses specific corporate policies.
(b) For examp le, we have a K at davis hardware that guanrantees me employement with
(c) See McQuade v. Stoneham (1934) page 371 BELOW
(6) substantive protections
(a) emp loyment rights
49) Ringling Bros.-Barnu m & Baily Co mb ined Shows v. Ringling (1947) could teach the whole class
based on this ONE CASE Case page 354
a) Facts. Major shareholders
i) Ringling 315 (2 elect d irectors)
ii) Haley 315 shares (can vote 2 directors)
iii) N 370 shares (can elect 3 directors)
iv) If Ringling and Haley pool their ext ra votes, they can elect an extra d irector. They entered into
a 10 year voting pooling director. They had an arbitrator (Luce, attorney) to decide disputes
between the two of them. Professional responsibility d ilemma of conflicting interests….
v) Luce says cast votes for an adjournment of the shareholder meet ing, Ringling casts her votes for
adjournment and Haley does not. Now the election is going to go on.
vi) Ringling advised to vote for Ringling Ringling and Dunn. Haley advised to vote for Haley
Haley and Dunn. Would have been RRHHNN and Dunn.
vii) Haley voted for Haley Haley and casted NO votes for Dunn. Now it‟s RRHHNNN on the
b) Delaware t rial court says let‟s give the non-breaching SH a pro xy to vote the shares of the
breaching SH and order a new election.
c) Del Sup Ct says that is too broad. The K doesn‟t contemplate pro xy as a remedy. Remedy is to
cancel Haley‟s votes. Don‟t order a new election, that imp licates the rights of non -participatingn
(in the K) SH. Just go back and recount the votes and eliminate the Haley votes. Now Dun n has
enough votes to be on the board.
Prof. Hillman Business Associations Page 35 of 87
d) Now we have a board of 6 and Ringling has 3 BOD.
e) Ringling didn‟t really win, Haley and North are now probably aligned.
f) McQuade v. Stoneham (1934) page 371
(1) New York Giants team, Stoneham sells some shares to McGraw, the manager of the team,
Stoneham is now not the controlling shareholder any more. Also sells some of the shares
to McQuade. McQuade is a city magistrate.
(2) Agreement between Stoneham and McQuade and McGraw that provides for:
(a) McQuade will be the treasurer, $75,000 salary. Looks like a sale o f votes.
(b) Best efforts to continue/put in place Stoneham, McQuade, and McGraw as directors
on the BOD
(3) Stoneham repudiates agreement after a few years and throws out McQuade.
ii) Court says this agreement is void and unenforceable.
(1) This agreement isn‟t just a pooling agreement.
(2) This agreement ties the hands of the BOD and there are shareholders who aren‟t
participating in th is agreement and shouldn‟t be subjected to a side agremeent between
some of the shareholders.
iii) Assume you are lawyer for McQuade. Other protections should you draft to protect him if this
case were still good law?
(1) Employment K between McQuade and the corporation. Problem: So what if the corp
breaches the employment K. It will be very difficult to get specific performance, will
probably only get damages. Duty to mitigate damages by finding another job. So won’t
get very much
(2) Modify K three ways:
(a) So long as McQuade is compentent and faithful as treasurer
(b) Only unanimous vote can an officer be fired.
(c) Shareholder voting agreement that Stoneham, McQuade, and McGraw will cast votes
a certain way (for Stoneham, McQuade, and McGraw).
(3) Specify damages: employ ment K and separate K with stoneham saying that stoneham has
to buy stock back on certain terms if the employ ment K is breached.
iv) Old cases say can‟t take decision making power fro m BOD
g) Clark v. Dodge (1936) page 375
i) Clark owns 25% and Dodge owns 75% of the stock, and so it doesn‟t infringe the rights of the
other shareholders. All SH are singed on to this agreement
ii) Agreement K bet clark and dodge that
(1) Clark gets job so long as competent and faithful
(2) ¼ of the corp profits to clark in the form of d ividends
iii) “Slight” imp ingement on the BOD power o kay here.
iv) Real point is that there is noone left out of this K, all of the SH are in on this.
v) Cred itors might actually be harmed by this if clark isn‟t the best person. Co mpetent doesn‟t
(1) In liquidation, wouldn’t the creditors get first payment?
(2) Dividends standards in theory protect creditors but really don’t always.
(3) It’s easy to pay out dividends and then leave the creditors at risk
vi) Emp loyees of the corp might also be harmed, but the law probably doesn‟t care about them.
Law probably assumes that the employees can get a job somewhere else.
vii) Does the BOD have some responsibilty to the creditors?
h) Galler v. Galler (1964) page 375
i) Facts: 2 bros own almost all the stock in pharm. Corp. was partnership, 30 years as corp
without any agreement in p lace. On advice of accountant, they decide that they need a SH
(1) Side note: mu ltid isciplinary firm especially with accountants and lawyers. ABA is getting
ready to change the rules and allow this. Th is is an enormous development.
(2) Ben and Isadore with spouses (emma and rose) and this guy Rosenberg 5% shareholder.
(a) Rosenberg never paid for his shares
ii) 1955 Agreement
Prof. Hillman Business Associations Page 36 of 87
(1) Amend by laws to have 4 directors
(2) Agreed to vote for each other and their spouses
(3) If brother dies, spouse would select the replacement director
(4) So long as corp has a “surplus” of 500,000 will make certain div idend payments
(5) If either bro dies spouse gets payment continuation, survivng spouse gets income at
double the amount bro woiuld have gotten
(6) Corp will buy stock back if necessary to pay the estate tax.
iii) When ben dies, emma goes to isadore and says what about the agreement. Isadore says forget
it, it‟s void as against public policy
iv) Ill supreme court says:
(1) Close corps are different, SH need to be able to K to protect themselves.
(2) Should be able to K so long as:
(a) No compl aining mi nority sharehol ders outside the agreement
(i) Here we have 95% o f the shareholders in the agreement
(ii) Rosenberg is not complaining about this agreement
1. Isadore just bought rosenberg out. Now Isadore has 52.5 % of the stock
2. Emma only has 47.5
(iii) Major strategic blunder by Isadore should get Rosenberg to complain. But
maybe Emma will get to Rosenberg first.
(b) No fraud to public or creditors
(i) Court says creditors are protected by reserve. But what about the obligation to
buy the stock back?
(ii) Court was an xious to get on record as supporting agreement in close corp.
(c) No clear statutory prohi bition
50) Missed cl ass Wed
51) Thursday, October 04, 2001
a) Review: what is a corp worth? It’s worth what someone/ market is willing to pay
i) Appraisers value based on val uation formulas/theories. Even professionals disag ree on the
right way to figure valuati on, and it can depend on what the client wants.
ii) Earnings based val uation
iii) Assets based valuati on
(1) Book value certainty at expense of departure from reality. What is on the books.
(2) Replacement val ue what it woul d cost to replace assets (Full val ue wi thout
(3) Li qui dation value what you coul d get for them at auction (not full value)
iv) Read the casebook
52) Allen v. Biltmore Tissue Corp (1957) Restrictions on the val uation of shares
i) Restrictions on transferability of the Shares
(1) Intervivos transfer: must first offer the shares back to the corporation, and if SH d ies then
estate must offer shares back to corp. OFFER, corporation can decline offer if value of
shares went down
(2) Only has to pay original price of the shares when buying them back
ii) Notice to SH
(1) According to the By-Laws, copr only has to pay the original price
(2) Also restriction was printed on the certificate of stock (shares)
iii) This is a nice way of giv ing employees worthless stock options.
iv) All of the shareholders/stockholders fit a provile:
(1) Paper Jobbers, such as Harry Kap lan, who bought paper to use in their business
(2) This corporation was more of a cooperative, designed to be a corporation to give access to
(3) Stock is sort of a membership fee in the cooperative, price of getting access to the paper.
(4) Stock not intended to be profitable
v) 1932 corp fo rms, Kap lan gets 5 shares for $25. 1936 Kap lan gets 5 more shares and buys 10
more shares for $100.
Prof. Hillman Business Associations Page 37 of 87
vi) Kaplan wants to sell his shares in 1953, writes to corporation, dies of a heart attack. Estate
wants to sell the shares. Corporation can buy the shares for $125 but it offers $200.
vii) Executor of estate says: this is an unreasonable restraint on alienation of a p roperty right.
(1) Unreasonable: gap in price offered and value of stock
(2) Doesn‟t argue notice, probably should have. Did they really know that they would never
be able to sell the stocks at a profit?
(a) Restriction should appear CONSPICUOUSLY on the face of the stock. Courts differ
on the standard.
(b) Here, all the stock said was read these by law provisions
(c) SHOULD say “If you want to sell this stock you must first offer it back to the
corporation at the price you paid, see by-law sections etc…”
(d) LAW YER M UST investigate the existence of restrictions for client.
viii) Court says: Reasonable restraints are permissible with notice.
(1) Reasonableness is not determined by the amount. In other words, the amount of forfeiture
is not the key. EG PA case: first option case, corp would pay zero if you want to sell your
shares, court said it is reasonable.
(2) Notice: π didn‟t argue, and there was some notice.
53) Dissolution of corporations page 444-51 and 466-69 of 8th Ed. Read book! (duh)
a) Why Dissolve?
i) Death of Corp
(1) Static, corp ceases to exist.
ii) Exi t for Minority S H, Dynamic
(1) Minority shareholder wants out and can‟t find buyer for reasonable price. Might be better
to force a sale of the who le corp. If majority SH doesn‟t want dissolution, majority must
buy the minority SH‟s shares.
(2) How much power should minority SH have to force d is solution
iii) Exploi t Mi nority S H Dynamic see Page case
(1) Majority SH wants Min out, thinks min SH is deadweight. Put business up for auction,
whole business. Who is going to bid on this? Hillman (maj shareholder). Noone is going
to outbid Hillman. Min is replaceable.
(2) How much power should majority have to force dissolution.
b) Vo luntary vs Involuntary
i) Voluntary: majority of shares vote for dissolution in most states, could be different percentage.
(1) Exploi tation of M in by Maj v ia forcing dissolution, what would limit th is?
(a) Built-in K right to continuation of employ ment for a limited time after dissolution for
minority SH (won‟t work because you can‟t force people to work together)
(b) Buy-out provision that requires Maj to buy out Minority at a CERTAIN PRICE under
(c) See Page case: also fiduciary duty case. Is there some kind of duties that run between
the owners of a close corporation, imp lied or imp licit duties?
(d) If Maj fo rces the dissolution and forces the minority out, has maj exp loited the min?
Page case says yes.
ii) Involuntary: contrary to the will o f the majority. There are various standards for when this
will occurr, when the court will grant relief
(1) Disollution for deadl ock: two 50/50 SH cant agree
(3) Dissolution for oppression by controlling shareholders Split of Authority (SOA)
(a) Matter of Kemp & Beatley, Inc. (1984) page 446
(i) Ol d View: actual oppression/misconduct by majority
(b) Modern trend: frustration of the reasonable expectations of the mi nority S H,
even if no misconduct by majority sharehol ders
(i) SOA: courts differ on this: EG: M inority SH is getting drunk on the job, Maj fires
Min, that is oppression because the job was a reasonable expectation.
c) Appointment of provisional director
54) Partnership Dissolution
Prof. Hillman Business Associations Page 38 of 87
a) Used to be very simple but under the revised partnership act it‟s different
b) Partnership Act
i) In corp it‟s the end of the entity but there is no entitty to end in partnership, so dissolution is
defined as a CHANGE 9in the relations among partners caused by one partner ceasing to be a
partner. Partnership is an association. The relat ionship is dissolved by virtue of the departure
of one parner.
ii) Noone can be foreced to remain in a parnership. Any parner can leave at any time and cause a
dissolution of the parntership (relationship).
iii) What happens then? Depends
(1) Normally the assets are put up for auction like in corporate dissolution.
(2) If a g roup of partners want to continue without auction, they need to work out a deal with
the departing parnter to buy the parner out. Usually this is done in the p artnership
agreement. Lets the partnership continue under a new relat ionship.
(3) If the partners have reached an agreement that the parnership will not be dissolved for a
period of time such as 10 years, it can still be dissolved, but the parnter is then liab le for
c) Revised Uniform Partnership Act
i) For most partnerships this changes nothing, but :
ii) Under the RUPA, if you have a term of years agreement, and somebody leaves that doesn‟t
dissolve the partnership
(1) There are buyout provisions for the person who leaves the partnership
(2) Partnership is an entity and doesn‟t dissolve
iii) RUPA still liable for damages if someone pulls out early with fixed nu mber of years
provisions…. Person leaving does have a right to have the interest purchased at fair market
value. Leaving person can request a court adjudication of the valuation. Obviously very
iv) Statute puts pressure on partners to negotiate a valuation for the buy -out.
d) Under both UPA and RUPA, agreement tru mps the statute.
i) Might want to write exit provisions into partnership agreement and select valuation. Note:
selecting book value would be stupid, will almost always be too low. More sophisitcated:
have professional appraiser based on a certain formu la. Could name appraiser in partnership
ii) Law Firm Partnership agreements are usually horrible. Several reasons:
(1) No time to devote to “personal” affairs
(2) Poor management of law firm partnerships
(3) Usually include buy-out provisions, don‟t got into liquidation when someone leaves.
However, leases usually say on dissolution the lease ends. You could lose your lease, but
landlords don‟t usually do that.
55) Fiduciary duties next time, no class next Thursday
56) Monday, October 08, 2001
57) Fiduciary Duties, see page 388 for start Chapter 6 § 5/ Chapter 8 p 520
a) Black Letter Law: There are Fi duciary Duties: 2 categories
i) Duty of Care of Management
(1) Owed by Management
(2) Owed to:
(3) Standard of Care:
(a) Reasonable person handling his or her own money (not the standard!!!)
(b) Reasonable person i n a similar position (eg reasonable director) (other people’s
(i) Higher standard
(ii) Don’t want to deal wi th disgruntled person
(iii) Don’t have right to take unreasonable risks with other people’s money
(c) See P 520 Francis case
Prof. Hillman Business Associations Page 39 of 87
ii) Duty of Loyalty
(1) To corporation
(2) To sharehol ders
b) Duty of Care of Management
i) Scope of the Duty
ii) The Business Judgement Rule
iii) Internal Controls
iv) Statutory Sheilds & Insurances
c) Duty of Care of
d) Donahue v. Rodd (supra)
e) Rosenthal v. Rosenthal 543 A. 2d 384 (Me 1988) page 388
f) Wilkes v. Springside Nursing Home 353 N.E. 2d. 657 (1976) mass sup ct page 388
g) Francis v. United Jersey Bank , 87 N.J. 15, 432 A. 2d 814 (1981) page 520
i) π is trustee in bankruptcy, asserting interest of creditors. There is a suggestion that the duty of
care also runs to the creditors, not just the shareholders.
ii) Re-insurance. EG State Farm gets insurance from Allstate in case certain claims beco me due.
Insurance Cos. Diversify their risk. Small firms “Re-insurance Brokers” handle this business
and pick up the cru mbs. Take the money that goes each way.
iii) Loans to shareholders.
(1) This Re-Insurance firm is run by the Prichard family, the kids Charlie and Billy are
running the firm. They took a lot of money out of the family $ and spent it (10,000,000
ten million). They got “loans” from the firm. This is like equitable subordination
doctrine, but reversed.
(2) Fair deal for corporation? It depends on the facts of the loan.
(b) Reasonable Interest rate
(c) Approved by management
(d) Reasonable expectation of repayment
(3) Why did they bother to call it a loan?
(a) As a loan it shows up on the books (balance sheet) as an asset.
(b) Assume $1 in assets and $1 in liabilit ies. Assume Charlie and Billy take the $1 out of
the cash register. Ho w to balance the balance sheet? Assets: Shareholder Loan $1.
Receivable of the corporation.
(c) All assets are not created equal. The $1 in cash is now a wo rthless “receivable”.
iv) Δ is Lillian Overcash, sister of charlie and billie. Is defending Mom‟s estate in bankruptcy
(1) No sick d irector defense. No drunk director defense. No inco mpetent director defense.
Director makes a comitt ment to know the business of the business.
(2) See chart page 524 activit ies over a period of 5 years. Why are shareholder loans so
big? Anyone should be able to see that there is a problem there.
(3) No bad mother defense, what could she do, she was just one director out of three directors.
(a) She must do something more than nothing.
(b) Powell they spawned their fraud in the backwater of her neglect.
(c) Hypo: mo m h ired you to do something. She owns about 72% of 150 shares, Kids own
about 78% of the shares
(i) First, say something,
1. object at a directors meeting or have atty write a letter to the kids.
2. Have a protest entered into the minutes.
(ii) Next, Resign? Make the fraud public? But doesn‟t that violate her duty to the
insurance companies that rely on the corporation for re-insurance.
(iii) Go through american express for to morro w
h) Revised Model Bus Co rp Act §§ 8.30, 8.31
i) Tuesday, October 09, 2001
i) Francis case continued
ii) Francis Important because first case to hold managers to a standard of care.
(1) Before this case, would have thought this problem was beyond mo m‟s control as a
Prof. Hillman Business Associations Page 40 of 87
(2) This fiduciary standard of care is to be taken seriously, oversight is requr4ed of managers.
(3) This director failed to discharge her duties of oversight and care.
iii) What do we advise Mom to do?
(1) Remember mo m can‟t vote Willliam and Charles out because she does n‟t control.
(2) Remember if mo m resigns then the boys will still run roughshod over the company.
(3) If mo m resigns and tells the world (noisy withdrawl), then it will really collapse the
company and be worse for the creditors.
(4) Reco mmend: First, lodge protest, send letter to boys, put formal protest in the minutes.
(5) Have attorney tell boys that they are guilty of fraud, will give them a chance to pay back
the money and set things right? Boys will d isappear with the $
(6) Mom could resign quietly.
(7) Another option is to inform the current creditors if the boys don‟t pay the $ back, but that
will destroy the corporation too.
(8) Can you get the SEC to step in and freeze the assets (no because not a publicly held corp.)
but could you get an emergency TRO? Maybe, depends on the trial judge.
iv) Standard is what would a reasonable sober director do to protect the creditors in this situation.
(1) Maybe protest plus resignation would be enough for some judges.
(2) Other judges might require further step of seeking court order freezing their assets.
(3) What exaclty does a director have to do?
(4) This case doesn‟t tell you the answer but it does set up a duty.
j) Contrast Francis case (general neglect) with specific decision (A merican express page 536)
k) Kamin v. A merican Exp ress Co. (1976) page 536
(1) Directors make a terrible decision to pay a dividend out. The dividend they paid out was
stock in Donaldson Lufkin Jenrette (DLJ).
(2) In 1972 A m Ex bought $30 million worth of DLJ stock
(3) By 1975 value of DLJ stock was $4 million. A mEx wants to get rid of the stock. Instead
of selling the stock, A mEx decides to distrib it as dividened. Why?
(a) $26 million loss on the balance sheet if the stock is sold and financial statements.
Have to show $26 million loss on INCOM E statement.
(i) Market will respond to that earnings loss by devaluing the Am Ex stock.
(ii) (but that‟s crap, the market already responded to this, you can‟t fool the market
because it‟s too efficient and sophisitcated.)
(iii) Even if it‟s not crap, now the stock price is inflated, and people who sell are
getting more than they should, and people who are buying are getting less than
they should. Benefits people who dump their stock now. Doesn‟t make sense
because your fiduciary duty isn‟t to inflate stock price and encourage dumping.
(b) Bottom line is that dividend payment doesn‟t need to show the $26million loss on the
(c) However, if they took the $26 million loss, then the tax liability of A m Ex would be
POSITIVE $8 M illion. That‟s a tax credit that Kamin would get part of.
(d) This decision by the BOD makes no sense. This decision is harmfu l to the corp.
ii) Deri vati ve action sharehol der brings an action on behalf of the corporati on ag ainst the
corporate directors. Ci v Pro Vocab
iii) Court says
(1) This was a matter of business judgment by BOD.
(2) Court will not substitute own judgment for judg ment of BOD, so long as good faith on
part of BOD, especially when self dealing or conflict of interest is involved.
(3) This sounds like the Donahue case where we decided it really was self dealing.
(4) Here 4 of the 20 directors got performance based bonuses that would be ruined by the $26
million loss because those 4 directors were also corp officers (inside directors.)
(a) court says 4 of 20 isn‟t enough to control the BOD.
(b) What if the inside directors of this corporation are the outside directors where these
outsiders are insiders.
(i) Maybe those 4 directors really do control the corporation.
Prof. Hillman Business Associations Page 41 of 87
(ii) Π‟s lawyer should have looked into this, tried to see how the 4 really controlled
(iii) If court refuses to hold outside directors to fiduciary duty then they have no
reason not to let the 4 control them.
(iv) Court is saying it‟s not reviewable, so there are no checks on the outside
(v) Would have been nice if court said there was nothing on the record showing thast
these outside directors were in the pocket of the 4 inside directors.
(c) The are “hiding” the loss fro m the who? The stock market probably already reacted to
(d) The SH’s real remedy here is SELL the stock. Market solution.
(5) What is the proper corrective mechanis m fo r shareholders who disagree with management
decisions? Court? (no) Market? (sell stock) Shareholder meeting/proxies/votes? (maybe)
l) Smith v. Van Go rko m (1985) page 548 delaware case
i) Facts: Hypo: this company was ripe for a takeover. This co mpany was undervalued, had very
litt le debt, substantial assets. We want to take this company over. We are the officers.
(1) We sell some of the assets and buy all the stock besides ours
(2) We use assets as security to borrow money, buys all the stock besides ours
(LEVERA GED BUYOUT) very co mmon in the 1980s
(3) Price paid fo r stock is based not on a fair price but on what the numbers say will work
(4) Sort of like buying a house. House is security for the loan. Problem here is that the assets
used a security for the loan are the inco me producing assets
(5) Reminds us of: sherwood, hillman forces us out
(6) Reminds prof. of Donahue
(7) This happened with Macy‟s, management bought the stock and it‟s never been the same
(8) CEO (Van Go rko m)in this case said no, I won‟t let you do this. It is a con flict of interest.
That point is never fully developed because he (Van Go rken) asks someone else to buy
the corporation at $55 per share. (Prit zger)
(9) Emergency BOD meeting to review the new o ffer. BOD will reco mmend to the SH to
accept or reject the offer. There is a short deadline on the offer.
(a) Corp must be free to consider other bids for 90 days but promises not to solicit other
(b) Stock is selling at $35 per share right now.
(11) New meeting of BOD, changes to deal
ii) SH sue BOD claiming vio lation of fiduciary duty.
iii) Δ of Business Judgment, doesn‟t work. Why?
(1) Didn‟t investigate actual valuation of shares. How would they do that?
(a) Book Value, etc, shouldn‟t that be reflected in the stock price?
(b) Maybe the management is inco mpetent and that‟s why the stock price is devalued.
(c) Markets reflect the context including the existing management.
(d) Obviously, call an expert consultant to give an opinion on the value of the company
and the reasonableness of the $55 offer.
(2) Didn‟t investigate the deal and how it came about.
(a) Why did Van Gorko m set up this deal?
(b) Where did Van Go rko m get the $55 figure.
(3) Should put a lot of paper in the file showing that you investigated or you won‟t be able to
raise a business judgment defense.
(a) Make a record of investigation.
(b) Don‟t pass the deal deadline without good reason.
iv) If it‟s the deal of a lifet ime and they want you to decide by tomorrow, maybe there is
something fishy. Ho wever, here if the deal doesn‟t go through quickly then other people
might force their way in.
v) If there is a big gap between the market p rice and the offer price that is fishy. On the other
hand, maybe the offer is so good to encourage a quick decision.
Prof. Hillman Business Associations Page 42 of 87
vi) If you don‟t think the offer is serious, that‟s a different situation.
vii) If you don‟t think 36 hours is enough time to investigate, you‟d better spend the 36 hours
investigating and then at the end say it wasn‟t enough time.
viii) Realize that the shareholders are going to vote you out of office next t ime.
ix) 23 million dollar responsibility, ½ covered by insurance,
m) Monday, October 15, 2001 Duty to Ensure that Corp has effective Internal Controls Business
Judgment Continued / /Smith v Van Gorko m continued.
i) BOD cant assert Business Judgment Δ because BOD didn‟t
(1) investigate enough
(2) work hard enough (meeting was 2 hours)
ii) Question: Is there a duty to read the merger agreement?
(1) Should at least have atty read and prepare report summarizing the merger agreement.
(2) Build a record, show that you considered the merger agreement and did exercise business
(3) Of course, if you are the lawyer, mention the limited time that you had to spend reading to
(4) Avoiding risk keeping your head down vs analyzing risk and responding appropriately
n) In Re Caremark International etc (1996)P 569
i) Chancello r Allen ret ired in 1997 and is now law p rofessor at NYU
ii) This opinion concerns the settlement of a derivative action (by shareholder on behalf of the
corp) In order to settle a derivative action must get court to approve.
iii) Corp in a derivative action isn‟t really in a position to review the fairness of settlement because
derivative action usually involves wrongdoing by corporate officers.
iv) Court weighs the size of the settlement vs the strength of the claim.
v) Here: the court says the low probability of success of this claim makes the small settlement
vi) Facts giving rise to this case Caremark was paying out “kickbacks”, corp paid $ to people
for reco mmending Caremark products. Questionable legality, not really settled at this time.
vii) Duty to Monitor / Have systems ensuring that employees do not misbehave
(1) Management may assume that employees are honest
(2) Management must have systems and procedures ensuring that employees comply with law
and that BOD is adequately informed about emp loyee conduct
(a) Knowledge of acts of lower level employees. EG bribes in foreign markets may be
illegal under U.S. Law.
(b) Must have some system to make sure BOD knows what is going on at lower levels,
but how much knowledge, how far does it have to go?
(c) EG email level of detail of monitoring… is business judgment. Can‟t have nothing.
Must have a system in place, but don‟t have to have perfect system. Must have
reasonable system in p lace.
viii) Failure to Monitor Claim
(1) Must show sustained or systematic failure o f the BOD/officers to exercise oversight.
(2) Standard is Management knew or should have known and took no steps to correct.
(3) Policy Reason for hard stds: smart people wont be on the board if we second guess them
too much and expose them to unreasonable liability.
ix) Facts here
(1) Price Waterhouse did provide report
(2) Did have system for reporting imp roper payments
(3) BOD d id do something to investigate.
x) Prior to Francis it was rare to hold Directors liable, duty of care wasn‟t even on the radar.
o) Limits on Liability INSURANCE for BOD and Officers
i) The insurance really only covers negligence, and policy limits aren‟t going to cover gross
negligence or intentional torts. There will still be liability fo r true misconduct, and noone
wants to get sued, and the more negligent the directors are the more the ins will cost. Plus,
bank directors couldn‟t get duty of care insurance after Francis.
ii) Many States (Ohio eg) amended duty of care statutes to include only intentional harm.
Prof. Hillman Business Associations Page 43 of 87
(1) Delaware art icles of incorporation can be amended by shareholder vote to eliminate
duty of care liab ility for directors.
(2) California art icles of incorporation can be amended by shareholder vote to eliminate
duty of care liab ility for directors, but cant‟ eliminate for reckles s where BOD knew etc
(3) CANT eliminate duty of LOYA LTY
(4) This was potentially infinite personal liab ility.
(5) Note that these votes are proposed by management and submitted via pro xy votes, it‟s
paid for by corp. Shareholders always vote to eliminate the liability.
(6) Just repackage the duty of care as duty of l oyalty if there is a problem with
(7) Outside director probably only meets with the BOD 4 or so times a year, how much can
they really know about acts of lower level emp loyees?
(8) ALI has done something with the Business Judgment rule: In A merican Exp ress case, the
decisions of BOD were left pretty unreviewab le. ALI says can only assert Business
Judgment Δ if the Director had no $ interest in the decision being reached and director
must be informed to the extent director believes is reasonable and director must rationally
believe that the business judgment is in the interest of the corporation. So now it is at
least reviewable. Under this std the π in the Amer Exp ress case might have gotten around
(9) Section c5c of syllabus Read well these cases
(a) Zahn v Transamerica p 697
(b) Jones v amenson p728
(c) Perlman v. p 750
p) Tuesday, October 16, 2001 Professionalis m:
i) Integrity eg don‟t backdate the minutes
ii) Advance needs of your client eg clients can call you when you are on vacation, do what is
best for the client no matter what the personal cost to you is
q) Duty of Loyalty
i) Conflict of Interest
(1) Self dealing
(2) Majority gets benefit not shared with the Minority
(3) Director or BOD has a COI in a matter being voted upon: 2 types of cases
(a) Interested Director
(i) Has a direct financial interest in the other side of the transaction
(ii) Eg Davis hardware is about to buy RP fro m Hillman who is Majority SH and on
(iii) EG Hillman has interest in corp that is on the other side
(b) Interlocking Director case
(4) Person is on BOD of both corps involved in the transaction
(a) Historically courts regularly voided decisions involving both kinds of COI.
(b) Around the turn of the century (which turn of the century) courts said okay if 2
(i) Contracts approved by a majority of d isinterested AND
1. Historically, courts said interested if “under the influence” of interested
(ii) Ks fair to the corp involved
(c) Reason: lack of confidence that either standard applied alone would prot ect the duty
(d) MODERN Recently statutes set fort the standards for measuring Ks that involve
Interested and/or interlocking d irectors
(i) Standard is now more objective and more len ient
(ii) Approval by disinterested directors is the more co mmon standard
1. Disinterested means don‟t have a $ stake in the deal and don‟t have family
ties with people who do have $ stake in the deal
(iii) Del § 144
Prof. Hillman Business Associations Page 44 of 87
1. Treats Interested and Interlocking the same, doesn‟t draw a d istinction
2. Ks involving them will be enforceable if
a. Fair AND
b. Approved by either directors or SH (Note: can be interested and/or
3. Ks will be enforceable if
a. Approved by disinterested directors
b. In good faith
c. After full d isclosure of the COI
4. Ks will be enforceable if
a. Approved by SHs (note: can be interes ted SH)
b. In good faith
c. After full d isclosure of the COI
(iv) Cal. § 310
1. Differs fro m Del and most of the rest of the world because distinguishes
between interested and interlocking.
2. Cal § 310(a) Interested Director
a. Ks will be enforceable if
i. Approved by (not counting votes of interested director shareholders)
ii. In good faith
iii. After full d isclosure of the COI
b. Ks will be enforceable if
ii. If d isinterested director approval, rebuttable presumption is that the
K is fair
iii. If not disinterested director approval, rebuttable presumption is that
the K is not fair
3. Cal. § 310 (b) Interlocking Director
a. Ks will not be void if (aka enfo rceable if)
i. Approved by disinterested directors
ii. In good faith
iii. After full d isclosure of the COI
b. Ks will be enforceable if
i. Approved by SHs (note: can be interested SH, can be interested
ii. In good faith
iii. After full d isclosure of the COI
c. Ks will be enforceable if
ii) Lewis v. Vogelstein page 638 Chancellor Allen (1997)
(1) Stock option pl an right to buy stock at a fi xed price even if the price goes up
(a) Usually right to buy at the market price on the day you make the grant.
(b) Option has no value at the time the option is issued, only has value if the price of the
stock goes up
(c) Usually options have a defined life when issued, usually 5 or 10 years.
(d) Usually SH like stock option plans for managers because it aligns the management
interest with the SH interests.
(2) Facts: Mattel BOD approves stock option plan for itself. Two parts: one time grant of 10
year option on 15,000 shares. 2nd part: options upon reelection to the board. They got
shareholder approval for th is plan. Shareholders approved it at the annual meeting via
proxy solcitation. SH challenges on 2 grounds:
(a) SH not told what the value of these options were, so the SH vote is invalid.
Independent wrong in the way the vote was conducted: failure to disclose the true
value of the options. SH is trying to set up a bad faith argument.
Prof. Hillman Business Associations Page 45 of 87
(b) Options were a gift and were therefore corporate waste, and is therefore ultra vires.
Gifts can only be to a recognized charity or by unanimous SH approval.
(3) Del standard: if fair then the K still stands even if the vote was invalid. SH must not only
show that the vote was invalid for lack of d isclosure, must also show that the K is unfair.
(4) Chancello r Allen/ court says:
(a) Too hard to value the option. Can‟t really d isclose the value.
(b) These are custom made options and existing models like Black-Sholes model doesn‟t
really work for a custom option.
(c) Couldn‟t they put a range? Allen says not the fx of the court to make them put an
estimate in. If anyone is going to require option valuation, the SEC or the Del. Legis.
Should do it because they have the expert ise.
(d) This is just common law of fiduciary duty and valuing options is too specific and
requires too much expert ise.
(e) Corporate Waste Principle and Agency law
(i) SHs ratified this stock option plan, and under agency law if the agent acts beyond
the authority of the pricinple but the principle later rat ifies the acts of the agent
then the ultra vires acts of the agent are valid
(ii) Here there is a problem with the ratification, the princip le is split and there are
SH who don‟t go along with the majority of the SH
(iii) Corporate gifts require unanimous approval (corporate waste)
(iv) One time grant of the options not contingent up on future services? can‟t tell,
might be a gift because can‟t tell if there is consideration. I would argue that it
is not consideration because the director can do nothing and still get the option.
(v) Obviously, support with K with consideration, make it “in consideration for X”
stock option to BOD/officer There must be at least some consideration. Past
consideration isn‟t a very good way to go, better to condition on some min imal
(vi) π won the battle on the pleadings and the case settled
b) Wednesday, October 17, 2001 Yesterday we fin ished up 5.b.2 on the outline, today look at
r) Corporate Opportunity
i) When may a corp officer/director (manager) pursue a business opp;ortunity w/o offering it to the
ii) Hypo: Corp opportunity but corp /= have the $ to pursue it at this time
(1) If corp is in bankruptcy, court very lenient toward managers
(2) If corp is still functioning and has no resources to pursue the opportunity, then the concern
is that if the managers put their efforts behind it then the corp will have the $ to pursue te
opportunity. Courts very reluctant to give green light to managers (officers/directors)
iii) What is a Corporate Opportunity?
(1) Cranston‟s Hardware in Woodland one of the oldest bus in Yo lo county, closed in the
last few years. Hillman (hypo) wants to buy the empty building. How do you evalutate
(a) How di d Hill man find out about it? (as officer of Davis Hardware or
(b) How is Hillman going to finance the purchase?
(i) Doesn’t enter analysis because improper to put up Davis Hardware assets as
collateral for Hillman’s purchase.
(ii) Hillman can put own shares up as collateral, and if I don’t like it I should put in
safeguards at formation of business, restraints on Hillman transferring his
(c) Has Hillman disclosed the opportunity to the corporation?
(i) (and if so, how?)
(ii) (maybe not, this doesn’t really matter unless Hillman offers it to the corporation
(d) Is this a corporate opportunity at all?
(i) Coul d Davis Hardware buy it, does Davis Hardware have enough money?
Prof. Hillman Business Associations Page 46 of 87
1. Hillman says no, Davis Hardware doesn‟t have the $ to expand, but that‟s
(ii) Type of Business “line of business” or “ business interest”
(e) Di d Hill man offer it to Davis Hardware?
iv) Northeast Harbor Golf Club Inc. v. Harris sup ct Maine 661 A2d 1146 (1995)
(a) Facts: Golf Club like to have undeveloped property nearby. Nancy is president of the
Club. Nancy buys the Gilp in property near the golf club, and she learns about it as
president of Club. Nancy buys the Smallich property after telling some members of
BOD about it and says she doesn‟t want to develop it. then Nancy buys another piece
of property that is needed to connect the others to the road.
(2) Corporate Opportunities Analysis Trial Judge concludes:
(a) Go lf club couldn‟t have purchased the properties, but it looks like maybe they could
have raised the $.
(b) These business opportunities were land near the golf course, and the golf course has
an interest in keeping the neighboring land undeveloped. This isn‟t really “line of
business” but rather “business interest” or “corporate expectation.”
(c) Key here is probably that Nancy never offered it to the corporation at all
v) ALI Princi ples of Corporate Opportunity:
(1) Communicated to a corporate officer/director and one of the three followi ng applies:
(a) In capacity as officer or director where the person providing the informat ion expects it
to be offered to the Corporation. (Gilpin property seems to fit this one) OR
(b) Off/Dir earns through the use of corporate resources of the opportunity where the
off/dir has reason to expect that the opportunity would be of interest to the
(c) If the Off/ Dir is a full time employee and is closely related to the business of the
corporation, then no matter how the off/dir learns about it. OR
(2) If it is a corporate Opportunity, it must first be offered to the corporation
(3) It must be rejected by the corporation
(a) And the rejection itself is subject to review, must be either
(i) Fair OR
(ii) Approved by disinterested directors. (usually by majo rity)
(4) If offered and rejected, the officer/director may act on the opportunity.
(5) Note: controlling shareholder rules are similar, but must be fair
(6) What does fair mean?
(a) Fair to the corp. and the SH in the best interest or at least fair to the corporate
(7) Do not fall into the Substance over Form trap in Bus Ass, form matters.
s) Obligations of the Majority to the Minortiy Zahn v. Transamerica
Div pref. Annual Callab le Vote Liquidatio Conversion
paid first n
Class A 3.2 + $60 + Div ($20) N/ Y 2xB 1:1
Class B 1.6+ N Y ½A N
The + means also The $20 above is b/c
got common stock of accumu lation
58) Types of Stock Review
a) Preferred Stock
i) Right to a certain (set amount per share) div idend before other dividends are paid and if and
only if a divdidend is paid
ii) Cu mulat ive right to dividend if the dividend (eg 3.2) is not paid in one year, it ro lls over and
Prof. Hillman Business Associations Page 47 of 87
iii) “earned” Cu mulative right if the profit that year would have allo wed the preferred stock
dividends to have been paid, and the preferred stock dividend was not paid, then and only
then the dividend rolls over and accumulates
iv) Preferred stock normally does not vote but if d ividends have not been paid after a set number
of years then the preferred stock acquires voting rights.
v) Normally p referred stock gets only the preference dividend, but here they also got the common
b) Callable Stock corporation has a right to buy back the callable stock at a defined price.
i) This will be in the articles of incorporation authorizing the issuance of stock (or the by -laws
authorizing the issuance of stock?)
ii) Here it was $60 p lus the dividend owed
c) Li qui dation Rights
i) How much each cl ass of stock gets on li qui dati on of the assets.
ii) Here it was A got 2 times B and B got ½ of what A class stock got.
d) Conversion Ratio
i) How much of one class of stock you could trade in for another class of stock
ii) Here it was 1:1 to convert A to B, but B could not convert to A.
iii) Why would the corporation allow conversion?
(1) Because people are willing to pay for the right to convert.
(2) If Bond, will give lower interest rate.
(3) Here, it was stock into stock, and if A SH had been allowed to convert to B then they
would have non-callable stock. But then you would have ½ the dividend, ½ the
liquidation value, but in some cases it might be worth it.
e) Facts here:
i) Trans. Has 80% of the class B stock. Trans buys class A stock and converts it to class B. Why
didn‟t Trans. buy class B directly? (probably because they couldn‟t buy any more class B or
they would have. They had to buy A because the remaining 20% class B holders weren‟t
ii) Trans gets contolling interest, elects directors, calls class A.
iii) Trans liquidates.
iv) Zahn is a Class A SH who brings this suit as a class action in behalf of the other Class A SH.
Zahn bought in AFTER the call was announced. This means Zahn intended to lit igate when
he bought the stock.
v) Alter Ego claim directors are agents of Transamerica.
(1) Court says directors are puppets contolled by transamerica
(2) SH can act in own interest, but when acting in own interest through the BOD to th e
detriment of minority SH then subject to some restraints.
(3) What if the right to call the class A stock was vested in the class B SH? Then they aren‟t
subject to this restrain (as described above)
(4) What was the wrongful act (against Class A)
(a) Call (court in Zahn I talks about this, cannot use the BOD to do something to the
detriment of the minority stockholders.)
(i) Measure of damages is easy, treat as if call never took place. Give them what they
would have received at liquidation as Class A stockholders.
(b) Failure to warn about Liquidation during the call to allow conversion to B
(i) Measure of damages is not what they would have gotten as Class A, it is what
they would have gotten if they had been allowed to convert to B.
(ii) If the fiduciary duty is serious, then it s hould be a voided call. With this result,
you are saying that it is okay to raid the A stock, you let the majority profit fro m
its control. Prof says “splitting the baby” the fiduciary duty is stated
ultimately, but its not that strong
(iii) “punctilio” is on the test per prof
(5) Note: could say that class A assumed the risk of the call
(6) Questions to resolve:
(a) Does it really matter if the action is taken through the BOD or not?
Prof. Hillman Business Associations Page 48 of 87
(b) Is the fiduciary duty really based on the extent of the overreaching?
(7) Paper notes on Monday oct 22
(8) Tuesday, October 23, 2001
f) Jones continued
i) Co mpare
(1) to Donahue corp used as purchaser of Rodd‟s stock
(2) Jones seems to rebut the dicta in Zahn that SH can do whaterver they want if they don‟t
act through BOD
(3) Is this a failure of act ion/non action case? no, those are distractors
g) Problems in Problem Handout
i) Davis Hard ware Hillman doesn‟t share the buyer with me. Control is material b/c buyer is
only interested in control
(1) Should Hillman be forced to let me sell a pro rata portion of the sh ares?
(2) In other words, is this Jones, is this is what Jones means?
(3) Control is material to the buyer‟s interest here.
ii) What if Hillman sells 29% of his shares and retains control. Now there are 3 shareholders and
Hillman still has control. It is excess control that lets Hillman sell so me and still retain
(1) Now the control is not material to the buyer‟s interest, it‟s material to Hillman ‟s
willingness to sell because Hillman retains control.
(2) Is this Jones? Maybe.
(a) This is just someone selling stock.
(b) Could argue that the market is so limited that
iii) Hillman sets up holding corporation and puts all of h is his stock in the holding company.
Hillman sells a minority interest in the holding co mpany to a 3rd party. I am not allo wed to
buy this holding company stock.
(1) Is this Jones? Maybe. Let‟s say yes.
(a) The market for the Davis Hard ware stock has been eliminated by Hillman because
someone who wants to invest in Davis Hardware is better off in the controlling
holding company (Maybe).
(b) Or maybe the problem is Hillman creat ing a market for this closely held corporation
that is denied to the minority SH, and the minority SH are worse off because of the
(2) Note that this is more like #2 than #3 because Hillman‟s excess control is what allows
Hillman to sell part of the stock and exclude the minority SH.
iv) Jones rebuts the Zahn dicta that SH can do whatever they want so long as SH don‟t act through
v) How do you know if there is a fiduciary duty problem? Factors
(1) Slime factor. Were there other ways for the controlling SH to achieve their objective and
include the minority?
(a) Maj in Jones could have allowed minority to participate in United or maj could have
had a stock split.
(2) Coalition rather than simple maj SH. In forming a coalition, they decide who is in and
who is out. A group of SH forms and excludes others. Makes court a little mo re
sympathetic to the minority SH excluded fro m the coalit ion.
(3) Co mplexity and Uniqueness. Use of holding co mpany. Co mplex convoluted structure
whose clear purpose is to exclude some SH fro m the benefit it creates. Un ique and
cumbersome structure will lead to higher court scrutiny.
(4) Effect of Action on minority.
(a) Neutral or is it actually harmfu l?
(b) In Jones, Traynor thought harmful because market for min stock dried up wh en the
holding co was created.
(5) Position of controlling SH after the transaction is over with.
(a) If majority just leaves, then person is just getting out.
(b) If majority sells a part ial interest and is still in control that looks bad.
Prof. Hillman Business Associations Page 49 of 87
(6) Don‟t take these factors too seriously. Don‟t apply them on the exam unless the FACTS
of the case support them. They are a tool for analysis, not the analysis itself.
vi) Jones is a mess for outlines because there is this duty but Jones doesn‟t really define what it is
or tell us how to apply it.
vii) SH have some sort of duty but still can act in o wn interest. So rt of like trust relat ionship BUT
the built-in conflict of interest among SH means the trust relationship doesn‟t fit.
59) Transfer of Control
a) Gerdes v. Reynolds (1941)
i) Stock was wo rth about .75 per share and they sell it for about $2 per share. Buyer is a s mall
securities exchange firm with a good reputation. They agree with buyer to resign fro m BOD.
New SH simp ly LOOTS the corporation.
ii) What are the obligations of the maj SH/Dir Reynolds and Woodward to protect the corp against
iii) Case separates stock sale fro m resignation as managers. Case says ignore stock sale, focus on
resignation, but that‟s not really possible according to prof.
iv) Case says resignation without proper notice left the corporation without proper care and is
therefore breach of fiduciary duty.
v) See problem in handout.
(1) Trend Corp and Baker leaves t take a better offer Breach of duty to take offer at new
corp when Trend stock price plu mmets.
(2) Does Gerdes apply to this problem? Can you really not leave if it will have an adverse
(3) You can leave in this problem and that‟s why Gerdes is wrong to ignore the stock sale.
vi) The reason the director breached in Gerdes had more to do with the premiu m th at the directors
got for their shares in the stock sale and the fact that the remedy was based on the stock sale.
vii) Court says
(1) No “real” investigation of the buyer. But they did do some investigation. Bah humbug.
(a) “assets spread a little thin” means yellow flag. Not necessarily red flag, but does
mean that they might loot without putting their own assets up.
(b) Note: no black letter law on question: is SH required to disclose the details of deal to
sell stock to minority SH.
(2) No notice to the other SH. But what would SH do?
(a) SH might bail, and that wouldn‟t stop the looting, the poor person who bought the
stock would get stuck with the loss. Bah.
(b) Note that Francis was like this, people are selling and you still have creditors.
(c) Notice doesn‟t solve the problem unless the Reynolds and Woodward investigation
was actually lacking. But here the investigation might not have yielded much more.
viii) Maybe what really matters here is the vault full of cash (assets.) this corporation had. It made
them vulnerable to looting.
b) Perlman v. Feldman p 750 3rd Big case
i) Prof says this is a subtle looting case.
(1) Derivative action alleging
(2) Newport steel mfg steel during Korean war.
(3) Feld man sells controlling interest stock ($20 per share) to Willport. Willport wants to be
assured of steel suply. Buys stock over market price ($12 per share) , feld man says
control goes for a premiu m.
(4) Π say in behalf o f corporation NO, there was something more than a simp le premiu m for
(a) Corporate opportunity right to profit fro m steel during periods of steel shortage.
(b) Breach of fiduciary duty of loyalty to corporation to sell the corporate opportunity.
(c) Direct harm to the corporation. Looted a corporate asset.
(5) Test this theory of corporate harm:
(a) Harm only if corporation ended up selling the steel for less than it would if Feld man
never sold his shares to Willport. Otherwise, there is no loss to the corporation, only
loss to the SH who d idn‟t get to sell at premiu m.
Prof. Hillman Business Associations Page 50 of 87
(b) Harm if Willport gets steel at DISCOUNT. But here Willport is merely
(6) Page 752 Quote that is going to be on test
(7) Feld man Plan unethical to raise prices during wart ime (steel) BUT they will take
interest free loans fro m people who buy steel. Court says they lose the Feldman Plan.
(8) BUT assume $100 per ton for steel. Assume they could get $200 per ton because of
shortages. Assume it is the standard to get $100 per ton plus interest free loans.
(a) Now assume Willport buys steel at $100 and doesn‟t get the interest free loans.
Willport is cheating the corporation out of the interest free loans. Assume that the
interest free loans are wo rth $10 per ton.
(b) Breach of fiduciary duty for Willport to help itself to the steel without the interst free
(c) Corporation would have a COA against Willport, what does that have to do with
(9) Lost corporate opportunity to build a patronage with local buyers.
(a) This is pretty speculative. Willport will be buying it so they don‟t need other buyers.
(10) What‟s really going on here is that they lost the opportunity to participate in the grey
market and charge more than the wartime price. Under the table they are probably
getting $200 per ton and it is hidden because it would look too bad.
(a) What‟s really going on is the SH want to profiteer (be unethical) and Willport gets to
act all innocent. FELDMAN sold Willport the right to get around the grey market.
(b) This is looting, the grey market was a corporate asset.
(c) The under the table payments would be a corporate asset, not really h idden like tax
fraud, it was just hidden fro m the public to h ide the profiteering.
(11) Exam Question: what if Feld man said we are not going to profit fro m this war, we are
going to sell our steel at $100 per ton. That is not the same because in the case Feld man
personally profitted. But you could argue corporate waste, gifts can only be approved by
unanimous SH approval. Could argue business judgment, good will, reputation in the
community. Could argue gift to wart ime effort. Could argue business standards either
way (how many are participating in the gray market?)
(12) This is subtle looting. Beware: you have to read between the lines. Look for corporate
opportunity being sold by majority SH.
(a) Look at Jones factors
(b) Look at reasonable amount for premiu m or not reasonable amount
(c) Look if maj shared the buyer or the premiu m with the minority
(13) Case does not mean:
(a) NOT any time majo rity SH gets a premiu m, then everyone gets to share.
(b) Remember, valuation is problematic, especially in closely held corporation.
(c) Is the right to emp loy corporate officers a corporate asset? (No)
(14) 1.3 million is how much Feld man had to pay in damages to other SH. Legal fees would
be around ? Class action bar. Credible threat of lit igation. Surv ive motion to dismiss.
iii) Essex Universal v. Yates (1962) NY
(1) Can sell controlling block of stock at a premiu m
iv) Creat ive lawyering:
(1) If you are minority, ask maj to share opportunity with you, maybe it will float.
v) Fiduciary Responsibility Wrap Up
(1) Duty of Care
(2) Duty of Loyalty
(3) Punctilio of honor most sensitive
(4) Punctilio observance of petty formalities Thanks Ian
(5) This is a SQUISHY area of law. Make the argu ment. Be creative. Dru m up a sense of
righteous indignation. This is borrowed fro m trust law but doesn‟t fit at all because in
trust there is no COI and here there is. The theoretical foundations aren‟t solid, b ut here
are 2 different views:
(a) Moral Mandate View fiduciary duties are aspirational in nature and set the
standard high so that people will act more honorably. People who fo llo w this theory
Prof. Hillman Business Associations Page 51 of 87
are not bothered by the “undivided loyalty” language because ev en though it isn‟t
practical it will make people act better.
(b) Contract Substitute View Fiduciary duties serve as contract substitutes. Law &
Econ basis in a perfect world people wou ld have contracts for all realtionships
and every aspect of every relationship. Since it is too hard to really do this, fiduciary
duties try to figure out what these contracts would say if reasonable parties
contracting on this subject had a actually entered these comprehensive (impossibly
(6) Despite view, what really makes the difference for the outcome in this area is
(a) Quality of lawyering
(b) Quality of judging
(c) EG Jones isn‟t it awfu l that these SH conspired to exclude Jones and the other SH
and then created this holding company and ruined the market for Jones‟ shares and
then offered Jones a horrible price…
a) Insider Trading
i) Using inside information to trade stock, sort of like p layer betting on game
(1) anyone who is in the market who isn‟t an inside trader in that company,
(2) especially people trading stock in that company
iii) Prohibited by act of 1934
(1) § 10(b)
(2) § 16(b)
iv) Act of „34 § 10(b) It shall be unlawfu l [criminal] for any person
(1) In the connection with the purchase or sale of a security
(2) any manipulat ive or deceptive contrivance in contravention of such rules as the SEC may
prescribe [so must see SEC rules!]
v) SEC Rule 10 (b ) (5)
(1) Unlawful for any person in the connection with the purchase or sale of a security to do any
one of 3 things
(a) Emp loy any device, scheme, or art ifice to defraud
(b) Make untrue statement of a material fact or o mit a material fact
(c) To engage in any act practice or course of business which operates as afraud or deceit
on any person
vi) In the Matter of Cady Roberts & Co. (1961) P 778
(1) Facts & Procedure
(a) Member of BOD o f Curtis Wright was Also Emp loyee of securities brokerage firm
excused from meeting, found telephone, and told BOD of other corp to sell Curt is
(b) Admin Proceeding by SEC to discipline a bro ker for doing this
(2) Admin (SEC) says violated 3rd part of SEC rules
(a) Act that operated as a fraud upon everyone else trading Curtis Wright stock
(b) Special obligations when a relationship gives an individual access to inside
(c) Inherently unfair to let people with that privileged info to profit fro m that info.
(3) What about Zahn? Corporation itself was in posession of inside information, if had told
SH about the plan would have cashed in, isn‟t that insider trading by the corporation?
Answer is yes, it was.
(4) What are we worried about here? Why is this public policy?
(a) Efficiency of the Market everyone has equal access to informat ion and market
(b) Confidence Buyers won‟t trust the market
(d) Cost of Prohib iting it Disclosure of Inside Info to Public
(i) Force disclosure of info that isn‟t really reliab le yet. Usually when you have to
disclose too early it isn‟t as reliable
Prof. Hillman Business Associations Page 52 of 87
(ii) Fraud to hide info but must have a little time quarterly reports. Insider trading
will still happen between quarterly reports.
Event Quarterly Report
Price Disclosure of Event to Public
b) P 779 not assigned TexaS Gu lf case but not as important any more
i) First case in which a court applied the SEC ru les rather than the SEC
ii) Corp wanted to tie up rights to the land to firm up the deal and also needed to do some tests.
Mostly delayed disclosing to market to give time to get the land.
iii) Directors bought up all the stock they could even though it was still speculative.
iv) Corporate purpose in not disclosing but this is insider trading. Vio lated 10(b ).
(1) Unfair trad ing advantage.
(2) Intent of congress identical market risk for all members of the trading public
(3) Maybe okay corp purpose but directors couldn‟t go out and buy up the stock Only t wo
choices: either DIS CLOS E or DON’T B UY [refrain from trading]
v) Interesting wrin kle: one director was worried about buying the stock so he timed his purchases
lined up broker and kept an open phone line, as soon as the disclosure happened said
“Buy” through the open phone line. St ill unlawfu l insider trading. It‟s not disclosed until the
markets have had an opportunity to react. Might be ½ hour, 2 hours, a Day. CANT TA KE
ADVANTA GE of INSIDE INFO that isn‟t disclosed.
c) Who can assert a 10(b) clai m?
i) Early 10 B issue does include an implied private COA
ii) 10(b) and 10(b)(5) say purchase, so does the π in a private 10(b) COA have to be a buyer or
iii) Buyer of IBM Stock Yes
iv) Seller o f IBM Stock Yes
v) NO private COA under 10(b) for π who is
(1) Owner of IBM Stock who didn‟t sell based on a fraudulent report or press release.
(2) Early cases say: π in a private COA in a 10(b) case must be a buyer or a seller because
can‟t prove “but for” press release would have sold/bought. Birdbaum rule, approved in
the Blue Chip case
d) Chiarella v. US (1980) p 836
i) Tender offer see above, structured ususally as confidential until required filings with SEC.
(1) Co mpany A is going to make a tender offer to SH of Co mpany B. Ch irella finds out about
ii) Chiarella Th is company printed these required filings. He‟s not working fo r the printing corp
even, he‟s a contractor.
iii) Monday, October 29, 2001 Ch irella‟s firm is independent K for Co mpany
iv) Powell writes for p lurality of 4
(1) Trading on info that others don‟t have is only a fraud if it is a breach of a duty.
(2) Restrained fro m using info only if you have duty not to act.
(3) Examples of duties:
(a) insider of corporation, eg Cady case or TX Gu lf Suphur.
Prof. Hillman Business Associations Page 53 of 87
(b) Fiduciary relationship eg with sellers of the stock for other SH.
v) Stevens Concurrence
(1) Suggests that fiduciary may exist with the acquireing co mpanies and Chirella but that
wasn‟t argued here. Has supported convictions in other cases.
vi) Brennan agrees with the
(1) When you “convert” info, misappropriate info, then you can‟t use the info in securit ies
transactions. But this wasn‟t presented to the jury in this case.
vii) Burger d issents, says that the conversion argument was presented to the jury and so the
conviction should stand. 10(b) applies because it gives the improper posessor of the info an
unfair trad ing advantage.
viii) Blackmun and Marshall dissent, say it doesn‟t matter how you go the informat ion, any
relationship that gives you access to the info also restrains your use of the info.
ix) See problem sheet hypo #3 on page 5
x) Z overhears executives in line for move talking about an upcoming tender offer to co mpany
(like co mpany B in Chirella.)
(1) Powell no duty.
(2) Blackmun access to information, but does there have to be a relationship that gives you
access? Don‟t know.
(3) Burger conversion theory. Depends on additional facts. If Z fo llowed them intending
to hear some inside in formation, then it might be conversion if intent matters.
(a) Does intent to steal the info matter? Seems like intent has to matter if it is really a
(4) But we want to reward investigation if the investigation is fair, then we want to let people
find stuff out and use it in the market.
e) Dirks. V SEC (1983) p 844 SEC d isciplinary p roceeding against person for professional conduct
i) In this Case the SEC went after the wrong person.
ii) Facts Equity Funding attracted huge investment in the 1970s and was a hot stock with top
law and accounting firms on payroll. Th is company was one big giant fraud.
(1) They even had FRAUD PARTIES to fix the books. A former employee figured out what
was going on and called Ray Dirks to investigate.
(2) Got h is clients to sell Equity Funding stock.
(3) Dirks tried to get Blundell at the Wall Street Journal to write a story.
(4) Tried to get SEC to do something, they delayed.
(5) Charged him with aid ing and abetting 10(b) fraud.
iii) What if you proclaim a fraud and noone listens?
iv) Why can‟t Dirks tell his clients to sell their Equity Funding stock?
v) Is Ray Dirks a hero or a villain?
vi) Powell majo rity (6).
(1) Silence operates as a fraud only when there is a duty to speak. Mere possession of
informat ion and investigation is not a fraud absent a duty to speak.
(2) Still troubling when people have fortuitous tip. Duty of person receiving this tip is the
same as the duty as the insider who gave the information. Turns on whether the insider
benefitted fro m the tip. If the tip is proper in that the insider was not expecting to benefit
fro m the tip then the tipee may act on the info. Benefit can be direct or indirect, what
matters is whether the insider was expecting to profit fro m the informat ion/the tip.
vii) Blackmun d issent (for 3) Derivative liab ility does NOT make sense. Dirks had informat ion
that others did not have access to and it is unfair to let him and his clients profit fro m this
viii) This case is the last sup ct decision on TIPEE liab ility.
ix) Footnote 14 o f Dirks case there may be some outsiders of the corp who we will treat as
insiders for purposes of analysis. Direct duty of some outsiders to refrain fro m trading. EG
law firm that handles case for corp and gets confidential info will be treated as temporary
insiders. Must disclose or refrain fro m trading, but since the client info is confidential, then
the duty is to not trade.
Prof. Hillman Business Associations Page 54 of 87
x) Note that if Chirella came along after Dirks and was argued as a tippee with a duty, then his
conviction would have stood.
f) Investigation vs Espionage
g) Tuesday, October 30, 2001 § 10(b) regulates a wide range of actions, insider trading is just one
i) In other countries they didn‟t want to do anything about insider trading and so there was tension
in the international markets. Can buy IBM stock in other countries. Unrelenting pressure of
US prohibit ion on insider trading. But just because they have laws doesn‟t mean they
follow our co mmon law. Other countries probably won‟t adopt Dirks analysis of tippee
h) Carpenter v. US cited in O‟Hagan p855
(1) Winanans was a reporter for Wall street jn and author of “heard on the street” column
(2) Winanans went out and bought stock before he published the column and the paper had a
policy that journalists could not buy stock that they were writing abou t
(3) He bought the stock through his friends that he was passing tips to.
(4) A brokerage firm became suspicious because his friend was too successful in his trading.
Bro kerage firm reported to SEC, SEC pressured him. He told on the group, including
ii) Misappropriation theory used by 2nd Circuit
iii) Govt conceeded that if the Wall Street Journal d idn‟t have a policy prohib iting the trading then
it wouldn‟t be misappropriation, 2nd circuit said maybe that didn‟t matter because there are
other theories besides misappropriation. Here it was theft of informat ion fro m the journal.
iv) This helps analyze Chirella. Misappropriation theory is a valid theory.
v) Theft of info rmation fro m emp loyer is a basis for applying 10(b).
vi) Could the wall street journal sue Winans under § 10(b) ?? No standing because not buyer or
seller of stock.
vii) Market participants (buyers and sellers) can bring a private coa for theft even though the
person the information was stolen fro m can‟t bring a private coa for the theft.
viii) What if the Wall Street Journal deci ded to invest as a corporation in stocks that its
reporters are going write favorable stories about. What has been misappropriated?
What about a duty anal ysis? Maybe duty to readers. This is a hypo that woul d be good
for test review.
ix) Traditional tippee analysis doesn‟t work because even the corp may not know the ifnor that
Winans has. Winans is CREATING info rmation.
i) US v. O‟Hagan US sup ct (1977) page 855
i) Facts and Procedure
(1) 10(b) and 14(e) Case, insider trading
(2) Grand Met, London company hired atty O‟Hagan
(3) Tender offer of Grand Met to Pillsbury
(4) Δ O‟Hagan buys stock “call options” in Aug & Sept1988 and
(5) Δ O‟Hagan sells for
ii) Govt theory: misappropriation 10 (b) fraud to misappropriate informat ion in v iolation of a
duty to the source of the information.
(1) How is this different fro m Z standing in line at the movie theatre?
(a) Does Z have a duty to the markets not to take advantage of the informat ion?
(b) Courts aren‟t going to say Z does have a duty to the markets.
(c) But, if you are Z, you‟d better be careful because they might develop a new
framework that would make Z‟s trading illegal.
(2) There is more here, the sup ct talks about duty
(a) This is a co mbo of the powell and the Burger ops in Chirella
(b) Note footnote 6, says it‟s NOT just misappropriation fro m the market, not that broad.
(c) Duty page 858 Δ owed duty to law firm Dorsey & Whitney and duty to client, Grand
(d) BUT what if the client and the law firm say go ahead and trade on the basis of this
inside informat ion???? It would be risky but
Prof. Hillman Business Associations Page 55 of 87
(e) Maybe the client wants you to do it because if they buy 5% they have to say what they
are up to. Maybe the client wants the law firm to buy up the stock since they (client
and law firm) are “on the same team.”
(f) Blackmun would say special access to information that honest investors don‟t have,
but that is not what the sup ct is saying in O‟Hagan.
(g) Note: they aren‟t saying that O‟Hagan is a temporary insider.
(h) Note: if Pillsbury lawyers knew about the potential tender offer and purchased stock,
then they would be temporary insiders.
(3) VOID FOR VA GUENESS? (sounds like Ex Post Facto application, but the real p roblem
is the law is so broad and the case law so inconsistent that it is impossible for a person to
know if what they are about to do is permitted, encouraged, a breach of a duty, or
criminal. Ask prof. what is the constitutuional basis for finding SEC regulations (admin
agency is part of the executive branch.)
iii) 10(b) Insider Trading Use vs Possession
(1) Assume insider with material nonpublic in fo, officer of the corporation itself. Does an
insider have an absolute duty to refrain fro m trading, or is the duty to refrain fro m using
the information in making trading decisions?
(2) Hypo: M$ insider who knows everything. How can this person ever sell shares? Maybe
this person needs to make an irrevocable decision to sell the shares. This person has
informat ion but isn‟t the USE of the informat ion what we are worried about, not the
(3) Circuits are split on this. 2nd Circuit (NY included) says if you possess the info you can‟t
(4) 11th and 9th circuits say no, it is USE of the info that is prohibited.
(5) O‟Hagan seems more consistent with the use approach but really doesn‟t answer this
(6) SEC new rules in case book supplement (pro mmu lgated last year)
(a) 10(b)(5-1) tries to say when a purchase is based on inside information and adopts as a
general rule the possession theory. Insider with info is prohibited fro m trading … but
sets up an affirmat ive defense. If the sale was pursuant to a prior written binding plan
for the disposition of the stock then there is no violation.
(i) If the insiders want to sell their stock, then they must adopt a binding non
revocable plan for the sale of the stock.
(ii) For this to work, you would have to file the plan with the SEC or publish it.
(iii) Now the class action bar won‟t know if there is a perfect affirmat ive defense.
(iv) Also dramatically increases the possibility of fraud by corporate insiders.
(v) There aren‟t any guidelines saying when the plan has to be filed, how far
inadvance of the trading. The plan is only an affirmat ive defense to use of
informat ion that happens after you make the plan
(vi) Note that SEC may interpret this to mean a binding plan with a third party who
has incentive to enforce the plan.
(b) For the exam???? What if you make a binding plan and then plan corporate events to
take advantage of the plan?
(c) Note: must be material informat ion and so the definition of material becomes
important. If too speculative then isn‟t really material.
iv) Hypos: applying 14-e3
(1) Corporate Raider tips X about the raid and tender offer, X buys stock in corp
(2) After the news about the tender offer breaks, X sells the stock
(3) 10(b) analysis
(a) X doesn‟t have misappropriation plus duty? Not really, after O‟Hagan there isn‟t
really misappropriation without a duty.
(b) Maybe if Corporate Raider to ld X not to trade on the basis of the info.
(i) 10(b)5-2 Circu mstances involving a duty of trust 1. When you agree to maintain
informat ion in confidence and not to trade, then it is violation of a duty. Then
this would be an o‟Hagan case
Prof. Hillman Business Associations Page 56 of 87
(ii) when the history of the relationship makes it reasonable to assume that the person
providing the information expected the tippeee to hold the information
(iii) if the informat ion comes fro m a spouse, parent, child, or sibling, it is assumed
that the informat ion is to be held in confidence subject to an affirmative defense
that there was no expectation of confidence. (note: what about domestic
(c) Under Dirks, X is a tippee but Corporate Raider isn‟t an insider so no transferred
duty. Dirks doesn‟t fit this hypo or Chirella.
(d) This is a big hole in 10(b)5
(4) Thursday, November 01, 2001
(5) Rule 14(e)3 of SEA of 1934 prohibits fraud in tender offers
(a) Deceptive and manipulative pract ice for a person in possession of nonpublic info
about a tender offer to purchase stock if the informat ion was derived fro m the
offering person or the target corporation.
(b) Creates a duty not to trade regardless of fiduciary relationship with anyone.
(c) Not concerned about misappropriation or duty or all the stuff in the 10(b) analysis.
This is clear, if you get the informat ion about the tender offer fro m the offering party
or the target corporation that‟s it UNLESS steps have been taken to commence the
(d) You CAN trade once the tender offer becomes public or when “s teps have been taken
to commence the tender offer”. Remember, though, that this “steps” thing is
(6) Y is a research scientist who is about to make public (publish) findings about a drug sold
by Q. Y has holdings in Q and Y sells them before Y makes the information public.
(a) Blackmun would say it is not okay for Y to do this.
(b) Current hold ings say that we have to find a duty.
(c) This is like Winans in the Wall Street Journal except who is funding Y‟s research?
Does Y have a duty to Y‟s emp loyer/funding source? Yes if there is an employer
policy against this.
(d) If Q gave Y confidential in formation that Y used in the research then Y has violated a
duty to Q.
(e) O‟Hagan and the SEC rules suggest that we must find a duty.
(7) Z in the movie line.
(a) Is Z a tippee? NO because insiders don‟t transfer their status to Z because they didn‟t
intentionally tell Z.
(b) Misappropriation? After O‟Hagan you have to find a duty, so no.
(i) Ahhhhh, but 14(e)3 says that if you get the informat ion fro m the offering party or
the target corp then you can‟t trade on the basis of that informat ion.
v) 10(b) is a catch-all fo r all sorts of investor and service provider (accounting firm, law firm)
complaints agaisnt the corp and its managers.
(1) What is the required intent under 10(b)?
(2) Ernst & Ernst
(i) Δ is a large acct ing firm and had responsibility for autiditng First Securit ies.
(ii) First Securities C EO was perpetrating a fraud on investors. He had investors
send checks directly to him and told his staff never to open his mail
(iii) Δ didn‟t discover this fraud during routine audit.
(iv) Claim is negligence of Ernst & Ernst perpetrated a fraud upon investors.
(i) Negligence is not sufficient in a 10(b) claim.
(ii) Fundamental prohib ition is against man ipulative or deceptive devices or
(iii) This is intentional conduct, not mere negligence.
(iv) Unanswsered question: is gross negligence covered?
1. Scienter is established through grossly negligent conduct or intentional
conduct according to the circuit courts that have looked a this.
Prof. Hillman Business Associations Page 57 of 87
(v) Role of Scienter: has a role.
1. Intent to deceive
2. Grossly negligent conduct.
(3) § 16
(a) review § 14 applies to pro xies and tender offers
(i) §§ 14 and 16 are applicable only to large public (aka reporting companies)
(ii) More than 500 SH and more than 10 million in assets
(b) Establishes bright line standards
(c) §16(a) requires certain people to file reports with SEC
1. disclose ownership of Stock
2. changes in ownership of stock
1. filed by senior officers of co mpany
2. directors of co mpany
3. 10% or mo re shareholders
(iii) § 16(b) Short term (6 months) profit realized by these people (who above) fro m
the purchase and sale of securities in their corporation can be recovered by the
1. Requires a purchase AND a sale within any 6 month period.
2. Don‟t have to show duty. Don‟t have to show inside informat ion. All you
have to show is purchase and sale in 6 mo period and profit.
3. Use the most DISA DVA NATA GOUS method of computation for the insider.
4. Match the lowest purchase price with the highest sales price and ignore
chronology AND ignore Losses!
a. Jan 1 buy at 10
b. Feb sell at 11
c. Mar buy at 7
d. Apr sell at 8
e. For this sequence of events it is $4 per share
5. Hypo: buy 20% of the corporation in january and sell 20% in feburary, this
DOES NOT APPLY because you have to be 10% or more prior to
transaction and was 0% before bought the 20%
6. Hypo: Officer buys stock. corporation goes out of business and officer is
forced to sell or t rade stock for stock in other corporation. Right now there
is no „forced sale‟ exception.
7. There is no defense to this, if you do the trading as described you owe the $
8. Buy at 10 and sell at 8, no profit.
(iv) Fin ish page 6 in the syllabus
(4) § 16 of SEC rev iew, 2 transactions within a 6 mo period of time.
(a) This is supposed to be straighforward and mechanical, but there are some amb iguities.
(b) How to co mpute damages (the worst way possible for insider)
(c) What about forced sellers (too bad.)
j) Types of Fraud that 10(b) covers
i) What about past cases? Beyond insider Trading
(1) Zahn conduct class A shareholders cut out of profit taking
(2) Jones v. Ahmenson holding company, Jones group couldn‟t participate
(3) Donahue claim against Harry R. fo r
ii) Santa Fe. Industries v. Green (1977) p 866
(1) Facts and Procedure
(a) Santa Fe acquired about 95% of stock in co mpany called Kirby Lu mber.
(b) This reminds us of Sinclair Oil. This was between Zahn and Jones. Sinclair owned
95% of Sinven and so on.
Prof. Hillman Business Associations Page 58 of 87
(c) Santa Fe used Del. short form merger provisions that allowed the majority corp. that
owns almost all (usually 90% or more) of a subsidiary corp then majority can cash
out the minority SH. If the minority is unhappy with the cash out amount then they
can seek judicial valuation of the cash out.
(d) The procedure was complied with, see p867. Santa Fe owns Santa Fe Natural
Resources who owns 95% of Kirby. Santa Fe causes SFNR to give all shares in
Kirby to new corp. Forest Products. Now Forest Products owns 95% of Kirby. Now
there is a short form merger, now Forest Products owns all o f Kirby, there is no
Kirby and minority (5%) SH in Kirby are gone.
(i) Why all the layers? Maybe there was a ta x benefit or a liability shield. Claimants
against the corp can‟t go after the parent, maybe taxes.
(e) Santa Fe valued the Kirby shares according to independent valuation by Morgan
Stanley (an investment banking firm. Morgan Stanley loo ked at the assets and came
up with $640 per share based only on the assets and the number of shares. Then
Morgan Stanley said that the Kirby shares were worth $125 and the minority SH
were offered $150 per share.
(i) Market price is not the same as the underlying value of the assets. Morgan
Stanley compared the market price of corps stock when the corp had similar
assets as Kirby and that‟s how they came up with the $125 per share.
(ii) Reminds us of Zahn, the tobacco case
(iii) The $640 includes the cost of converting the timber holdings to cash.
(iv) Minority discount might be part of it.
(v) We don‟t know if this is a “present value” discount.
(vi) You can value based on asset, book, earnings. Maybe the earnings are low and
that‟s why the stock price is lo w. The $640 might be too theoretical. Mayb e
management is firmly in place and doesn‟t care about developing the resourece.
Maybe the assets are not what you should look at in natural resource company,
maybe you should look at earn ings. This is what is going on in this case.
(vii) This case preceeded a wave of aggressive takeovers. We began to see a lot of
corps taking over smaller corps that had these assets. The discount was based
on the notion that management was entrenched and that management wouldn‟t
develop the true value of the assets.
(f) SH could have asked for a Del. Judge to value, but they didn‟t. Why? Because the
corp already used Morgan Stanley and probably wouldn‟t do any better in Del.
getting a judge to help them.
(g) Instead they said it was fraud and the stock was really wo rth $799 per share.
(i) That got it out of Delaware and put it into Fed. court.
(ii) District court dis missed it for Failre to State a COA
(iii) Short form merger can‟t be a fraudlent act, it is governed by state law and that is
the purpose of the law.
(iv) You are co mplaining about the low valuation, which doesn‟t provide a 10(b)
remedy because they disclosed the valuation.
(v) 2nd circuit agrees on the valuation poing said that it IS fraud to eliminate a
minio rity SH without notice. (sup ct overrules this point)
(vi) Supreme Court makes some emphatic points.
1. Disclosure means no manipulat ion and no deception.
2. Therefore, these SH should have pursued rememdys under state law
3. 10(b) is not about substantive fairness it is about disclosure
4. part 4 is sort of dicta, says that 10(b) is limited and courts should not let
private Causes of Action proliferate. There are imp lied private COA
created by the courts but don‟t expand it.
a. Follow the state law governing the relat ionship between corp, mgr, and
b. If 2nd cir had stood then that makes a fiduciary sort of claim possible. But
Prof. Hillman Business Associations Page 59 of 87
(vii) What if the Morgan Stanley report was not provided to the SH? Would you
have a 10(b) claim then? Where is the deception? Is it deception not to inform
the SH that Morgan Stanley decided that based on the assets alone the value was
$640 per share? Is this information material? Would the average, reasonable
investor want to know? (is that the definition of material?)
1. Note that if there is anything material in the report and you don’t
provi de it then there is a 10(b) cl aim.
2. This makes sense because if you provi de the report then they know if
they shoul d exercise their rights under state l aw to get a valuation. If
you don’t gi ve a copy of the report then it becomes a 10(b) case.
3. Do you have a duty to disclose liqui dation val ue? Zahn sai d the damages
were because they di dn’t tell the li qui dati on val ue so that the class A
SH coul d partici pate. There is a 10(b) disclosure problem if corp
doesn’t disclose liqui dati on value to own sh and plans to li qui date
(viii) The point of this case: 10(b) is NOT about fairness, not about fi duci ary
duties. 10(b) is about disclosure onl y. For fairness you must g o to state l aw.
If you don’t like the state law, contract to ensure fairness.
(2) Fraud in the Market Theory simp lest theory is based on efficient market, market will
rapidly respond and price securities accordingly
(3) Basic v. Lev insion
(i) Co mpany in merger negotiation, the stock price will soar if the merger goes
through, highly conficential and there are ru mors in the market about a possible
takeover. Co mpany issues three press releases denying the negotiations.
(ii) At that time, there was an „agreement in p riciple‟ standard because negotiations
were too speculative. As a matter o f law negotiations were not material until
there was an agreement. Since 10(b) only deals with mateial informat ion no
10(b) v iolation.
(b) This court rejects the “agreement in princip le” std.
(i) Old reason, needed to filter out info court rejects that reason
(ii) Old reason for std. Need to keep info confidential or the stock price will sell and
the premiu m price will be too high. Court says clash of policies between truthful
disclosures to the market and corporate confidentiality.
(iii) Basic is not required to disclose, but cannot DENY ongoing merger
(iv) Old reason: need a brightline rule. court says law is comp lex and cant always
have brightline ru les
(c) After this case, how do we decide what is material?
(i) Remember for the test: there is no obligati on to disclose, just can’t lie or
deny if the rumor is material.
(ii) The corporati on can just keep their mouth shut.
(iii) Even a no comment statement coul d be dangerous if the info is material and
they have issued denials when the rumors are false.
(iv) Balance (add?) the probability that the event will occur against (to) its
magnitude if it does occur. This is squishy.
1. Note that magnitude can be characterized as big in a lot of cases. When a
small corp is going to disappear it‟s big for that corp.
2. Probablility factors that the court points out (don‟t these apply to magnitude
a. Degree of interest at the top corporate levels.
b. Investment bankers hired
c. Is this information that investors would want to know or is it too
(v) Agreement in princip le of course is still material even though it is not the
Prof. Hillman Business Associations Page 60 of 87
(d) the fraud on the market part of this case 10(b) class action
(i) if you require each class action member to show reliance on the misstatement
each member of the suing class must show reliance, and since reliance will vary
for each member of the class there could be no class action su its.
(ii) Instead the sup court said that the markets are pretty efficient and so there is a
special rule for fraud on the market misrepresentation cases.
1. Even if the class members don‟t rely on the misstatement itself, they rely on
the market price
2. This case made a fraud on the market class action suit possible based on an
efficient market that will react to the false or misleading statement
3. Dissent said The whole idea of securities law is that individuals read the press
statements and so the fraud on the market theory is unnecessary because the
reliance standard reflects the truth of the markets better
4. Majority ru le: reliance not required for class action suits based on
misrepresentations, can show fraud on the market.
k) Regulation of insider trading by STATES, this is fiduciary law.
i) p912 to 918
ii) Diamond v. Orea muno (1969) NY Ct App
(1) Facts and procedure
(a) Π shareholder in MAI sues officers and directors on a derivative coa (thus in behalf of
(b) MAI financed computer installation and service. Probably leases the stuff to end
users. Subcontracts for service with experts or mfg rs of equip ment. What if IBM
says we are raising our service rates? The corporation has to eat this loss. This info
is not yet public. Uh oh.
(c) They sold their stock. (the insiders sold their stock.) that‟s Cady Roberts. Insiders
have negative nonpublic in formation.
(d) The non insider SH b rought this suit for breach of fiduciary duty.
(e) This is a 10(b) vio lation but these SH don‟t necessarily have standing for a private
cause of action. People who were in the market during this time would have a 10(b)
coa but that‟s NOT our client.
(f) This isn‟t a 16b because that requires two transactions an profit.
(2) Our theory: derivative action in behalf of the corporation against its officers.
(a) Fundamental fairness: insider shouldn‟t use this info, it belongs to the corp. this is
like perlman. They took the informat ion and profited (avoided losses) fro m this.
(i) How could the corporation have benefitted fro m this instead? If the corp profitted
fro m the negative info then the corporation would have a 10b vio lation. The
corp couldn‟t have used the info for p rofit, don‟t take it that far.
(b) Corporate reputation run by scoundrels, people don‟t want to do business with or
buy stock fro m scoundrels. But the SH can vote these people out, maybe don‟t need
to deal with reputation that way.
(c) Remedy: damages go to the corporation. Now the corporation is benefitting fro m the
actions of the managers. Why not give the $ to the sh or a charity?
(d) Note that the client you really want here is the person who was buying when the
officers and dir were selling. That‟s not what you got.
iii) Pleading fraud
(1) War over last 10 yrs between corporate management and π‟s lawyers. Partic in silicon
valley. War is over what magrs think is an abuse of litigation in the form of harassing
lawsuits. Nu isance value settlement, mg rs think π‟s bar is another form of taxes agaisnt
corporation. Corps when to congress in 1995 and thought they won at the time.
(2) Private securities lit igation reform act of 1995 made lit. more d ifficu lt
(a) Changed std for pleadings.
(b) See novack case in supplement (2000) 2nd cir
(i) Ann Taylor guessed wrong on style and were supposed to take a loss. Instead of
writing down the inventory as a loss they put it in a warehouse to hide the loss.
Prof. Hillman Business Associations Page 61 of 87
(ii) 10(b) claim that there were misrepresnetations of the value of the obsolete
inventory on the financial report.
(iii) Scienter must show at least grossly reckless or intentional misconduct.
(iv) Prior to the reform act pleading would just hint at scienter and during discovery
you would try to uncover the real proof of scienter.
(v) Reform act said you must plead with specificity FA CTS sufficent to show
scienter and discovery is stayed pending resolution of motions on the pleadings.
You must have FACTS and set them forth in great detail in the plead ings to
show the state of mind of the Δ and you cannot use discovery to fill in the gaps
in the pleadings. This is tough for π‟s lawyers.
(vi) The mag ic is in how courts apply this standard. In novak this
(vii) Purpose of this case is to show how important the pleadings are.
(viii) 2nd cir The court says they just adopted our old motive and opportuinty std
which is sort of silly since they were really try ing to raise the standard.
(ix) 9th cir probably would have bounced this complaint.
(x) The battles are won and lost on the pleadings. There are many pro minent class
action firms who have never and are not about to try a case. this isn‟t about trials
it‟s about motions.
(xi) Congress attempted to raise the bar and the 2nd cir decided to ignore the bar
(xii) The class action industry is thriving economically, the flipside is the Δ side.
Corporations led the charge to get the Litigation Reform Act of 1995.
(xiii) Vo latile stock prices invite lit igation. The Δ bar has a symbiotic relationsh ip
with the class action bar. Now we‟re talking about the large northern californ ia
law firms. Why do these firms have such large lit igation departments? Δ of
class action claims. If you are a law firm and you are the chair of the litigation
dept, your depts success will be measured by the generation of $ of your dept.
Revenue generator for litigation depts is billable hours. The strategy that works
for Δ to class action lawyers is don‟t settle until you build up a lot of hours to
bill. This sounds SO UNETHICA L!!!!
(xiv) Π class action lawyers are NOT about hours. You want a settlement before you
put in a lot of hours.
(xv) The pattern is predictable. Motion/complaint is filed. Motion to dismiss is filed.
Long time before π responds to motion to dismiss and Δ builds up hours. Cases
don‟t go to trial because that is not in the interest of π. About 1 to 2 years after
the filing of the co mplaint there will be a settlement. Too risky for π to go to
trial and too much time investment for Δ to go to trial.
(xvi) Π class action firms are usually thin ly populated.
(xvii) Insurance probably pays for Δ against the claim. It‟s a cost of doing business.
(xviii) Is there social utility to this system? Well, it does deal with abuses of
institutional power, so maybe this is a bad way to address the p roblem. But there
must be some way to do it. if you get rid of this system, and congress seems to
be trying to get rid of the π class action bar in this area, then you need some
system to fill the gap and protect the market against abuses.
61) Public Issuance of Securit ies
a) This is also securities regulations, but this is a different focus fro m fraud that we have been talking
about. New focus: conditions under which corporations raise $ fro m investors.
b) State law somewhat
c) Mostly Federal law
d) Capital Flow Transactions: Securities Act of 1933
i) Issuance to investors is primary focus of this act
ii) Basic Rule under § 5
(1) Unlawful to offer to sell a security unless a registration statement has been filed
(2) Unless a registration statement is in effect
(3) The registration statement is the omnibus ? something
iii) Sale of securites, so at the next level we look at what we mean by securities
Prof. Hillman Business Associations Page 62 of 87
(1) Definition of Securities
iv) Thrid there are critical exceptions to the requirement of a registration statement. These are
called exemptions this is IMPORTA NT.
v) Backg round on public offering of securities
(1) This is a public offering rather than a private offering so it‟s 100s or 1000s of people being
(2) This can be an IPO, which is an init ial public offering of stock by a corporation
(3) It can be ongoing, eg Further Public Offering, eg IBM sells more stock
(4) Normally when we talk about public offerings we mean stock (assets) but we can make a
public offering of debt called BONDS
(5) Why does a corp have a public offering?
(a) To raise money
(i) To expand, buy another business
(ii) To cover losses
(iii) To pay off debt, substitute stockholders for bond holders
(b) Can Dav is Hard ware have a public offering? No, it‟s closely held.
(i) Hillman might like that. Status for hillman as CEO
(iii) This will d ilute the ownership of the current owners quite a bit.
(iv) There might not be a market for a public offering. Th is is just a hardware store.
(v) Notice will lose the tax benefit o f close corp not being double taxed
(vi) Instead of public offering now should expand and grow store by store until we
get big enough to go public
(vii) Might seek financing fro m a venture capital firm, grow according to businesss
plan to get 20 hard ware stores. The venture capital firm will get some stock and
then when we go public they will cash out of the corp.
(viii) A public offering of stock is not in the cards for us now, but can develop a
business plan for a public offering later.
(ix) Lets say 5 years later we have 20 hardware stores and we want to have 50. We
might sell a block of stock. We might also use the public offering as a way to
liquidate some of our stock.
(x) Our salaries haven‟t been high up to this point and we have been counting on
future prosperity. One way is to sell part of our stock as part of the public
offering. Multip le sellers of stock. Dav is Hardware Corp will sell stock. Existing
shareholders can also sell part of their stock. It provides a market for our stock.
(xi) Can‟t sell all o f our stock. Who is going to buy stock if the owners are bailing
out of the corporation. That is going to alarm potential investors.
(xii) Don‟t want to lose control of our co mpany either. It will dilute our ownership to
that point that we totally lose control. Assume that the corporation is selling
shares, and the public sh will own 70% of the company. Hillman goes fro m 60
to 18 % and mine goes from 40% to 12%. The corporation is now really
wealthy. That works out fine. I now own 12% of a large corporation.
(xiii) What about control though? Even if we act together we only have 30%.
However, maybe it is control. If these people only own a tiny amount of stock
and we own 30% we p robably still control. 30% will own any public
1. This does assume that these other investors are not consolidated.
2. This also assumes that hillman and me are a b lock.
a. This reminds us of the Ringling case. uh oh
b. But this really plays into M Y hands nicely. Hillman needs me now to
form the 30% block. I could jo in with some of these other folks.
(c) Mechanically, how do we do this????
(i) 1000 shares, Hillman has 600 and I have 400.
(ii) Amend the articles of incorporation to authorize mo re shares.
1. Have a stock split, all stock is now 300 shares for every current share. 300:1
2. Now we have 300,000 between us
Prof. Hillman Business Associations Page 63 of 87
a. Hillman 180,000
b. I habe 120,000
3. Now say authorized to issue One Million shares. 1,000,000j
(iii) Corporation will sell (offer) 700,000 shares
(iv) NOW they have 70% and we have 30%
(d) Instead, look at this: we want to liquidate a little GOOD IDEA
(i) 1000 shares, Hillman has 600 and I have 400.
(ii) Amend the articles of incorporation to authorize mo re shares.
1. Have a stock split, all stock is now 400 shares for every current share. 400:1
2. Now we have 400,000 between us
a. Hillman ??0,000
b. I have ??0,000
3. Now say authorized to issue One Million shares. 1,000,000j
(iii) Corporation will sell (offer) 700,000 shares
(iv) NOW they have 70% and we have 30% AND we can sell so me shares
(i) now we have a large nu mber of people we o we a fiduciary duty to.
(i) Securities laws
(ii) Pro xy solicitation ru les
vi) Basic Rule under § 5
(1) Unlawful to offer to sell a security unless a registration statement has been filed
(2) Unless a registration statement is in effect
(3) The registration statement is the omni
vii) Sale of securites, so at the next level we look at what we mean by securities
(1) Definition of Securities
viii) Third there are critical exceptions to the requirement of a registration statement. These are
called exemptions this is IMPORTA NT.
e) Mechanically, how to make a public o ffering
i) Is THIS a good time to have a public o ffering for Dav is Hardware? Actually, it stinks right now.
Markets were good last year at this time. Maybe we need to wait. IPO market is really dried
up right now. Practically speaking we might not even get an underwriter. If we do, we might
be selling the stock at a serious discount. We really better not do this right now. But, on the
other hand, it will be spring or summer of 2002 before this goes on the market. Maybe things
will be better then.
ii) Underwriter Merril Lynch or other co will act as underwriter for a public offering.
(1) Investment banking company. Brings reputation to the table, signals that the offering is
legitimate. That isn‟t a rock solid theory but it works in most cases.
(2) Distribution Net work. Investment banking co has existing retail d istrib. Network, many
(3) If really large offering, may have mult iple underwriters. Eg M $
(4) Find Underwriter, sign them up. Assume it takes a few days to do this.
(5) 4 or 5 months to put the rest of the plan into action.
iii) Prepare a Reg istration Statement
(1) SEA ‟34 § 5 Illegal to offer a security for sale unless regis state filed
(2) SEA „34 § 5Illegal to sell a security unless Reg statement in effect
(3) Consequences of mistake in this document are huge so better do a good job on it
(4) Takes at least a few months to prepare, lot of work
(5) Part 1 Prospectus must put in hands of potential investors
(a) History of the business
(b) Co mpetition in the industry
(c) Risk factors in buying stock
(d) Hire accounting firm to prepare
(i) Balance sheets for 3 years
Prof. Hillman Business Associations Page 64 of 87
(ii) Income statems for 3 years
(iii) Audited financial statement
(e) Narrat ive Management Discussion and Analysis
(i) Evaluation by mg mt of position of corp
(ii) Liquidity to achieve business plans
(iii) What could derail business plans
iv) Part 2 Supplemental Info rmation, availab le but not put into hands of prospective investors
(1) Stuff that isn‟t crit ical but people might want to know
f) Basic Framework of securit ies laws as they apply to these transactions. The whole reg process has
3 periods with two key dates.
i) § 5 of SEA ‟34 regulates the dissemination of informat ion.
ii) Trick is in definit ion of offer, which isn‟t in the statute! Offer means ANY ATTEM PT TO
DISPOSE OF THE STOCK including making the market mo re receptive to the offer. For
example, see pre-filing period because offers are prohibited then.
(1) WHY? Control of quality of information.
(2) Prospectus is the complete disclosure, has bad and good.
(3) Preserves a record of what is said if the prospectus is the only thing you can use.
(4) Note that waiting period allows oral offers.
(5) Note that internet is changing this. Internet calls into question role of underwriters and the
dissemination of informat ion. Right now have to stop flow o f new info pre -filing.
iii) Pre-filing Period
(1) It‟s clear when the period ENDS.
(2) When does the period start? When we have “serious planning” of the public offering.
(a) Practically speaking, it‟s probably when we talk to an underwriter.
(b) So when you‟re just expanding, and you haven‟t talked to an underwriter yet, can you
change your advertising plan? Safe to place the same kinds of ads in the same kinds
of media as when we expanded in the past. Also okay to advertise opening of new
store if that is policy over time. Also okay to advertise every thanksgiving in
different media like tv ad every thanksgiving and continue practice during pre-filing
(3) NO offers and NO sales during this period
(a) No attempts to prime the market
(b) No attempt to generate investor interest
(c) No actual offers
(d) Warning: don‟t change your advertising during this time. EG Hillman has an ad of a
hammer and a nail. Davis Hardware: Nail down your future with us. We have been
advertising in the Davis Enterprise. Occassionallly we run in the Sac Bee.
(e) Now we p lace the ad in the Wall Street Journal. Illegal offer during the pre-filing
period. Prohibited by § 5 of SEA ‟34.
(f) Now we put ad in SF Chronicle. St ill a vio lation
(g) If forbes wants to interview, can‟t even say that we are planning an offering, can‟t
talk to them at all
iv) Waiting Peri od Filing of Registration statement
(1) There may be oral offers but no written offers other than the prospectus itself.
(2) Bro kers can say whatever they want. They can say it on the telephone and puff up the co
as much as isn‟t fraudulent. Merril Lynch can prepare talking points in writ ing for
brokers but merril lynch better make sure that the written talking points don‟t end up in
the hands of investors.
(3) No letter with this prospectus. Can call, can‟t send letter.
(4) Prospectus is grim. Small print. About 150 pages of negativity. Practically speaking the
prospectus is an insurance policy against liab ility for nondisclosure. It‟s going to be very
negative and focus on why you shouldn‟t buy the stock. On ly clearly supportable good
info will be disclosed. Will go on and on about the cycles of the economy and how
unsure everything is. Info on officers and transactions with officers, financial statements,
stuff like that is actually valuable. Designed to be useful to expert to run the numbers.
Prof. Hillman Business Associations Page 65 of 87
(5) The change in the advertising is still prohibited if written, but what about tv and radio?
Written includes broadcast.
(6) If forbes wants to interview, now say that we are p lanning an offering
(7) The only thing that can be in writ ing is the prospectus.
(8) Oral offers are still o kay. You can send the prospectus to people and in fact you‟d better
send the prospectus to people. Bro kers will call clients, tell about the public offering, say
don‟t you want to see the prospectus.
v) Effecti ve Period Date reg statement becomes effect ive
(1) We can have our sale this date
(2) Can have offers and sales.
g) The deal with the Underwriter
i) Usually firm co mmit ment to buy the stock.
ii) They take some risk that they won‟t be able to sell for what they expected.
iii) The PRICE isn‟t negotiated until the day before the end of the wait ing period. The p rice per
share will be negotiated right before the Effective Period.
iv) NOTE: SEC may say the Reg St mtn is defective but might not look at it. don‟t need SEC
approval of the documents !
v) April 1 public offering/ Effective date
(1) We want high price they want lo w price
(2) We are under more pressure because we have to do this
(3) Offers go back and forth, usually the corp caves first
h) Tuesday, November 13, 2001
i) Reform of ‟34 act and ‟33 act (when was this reform???)
i) “Shelf” Reg istration comp lete reg process and put it on hold until
(1) only avail for very largest public corps
(2) usually used only for debt security and bonds
ii) Integrated disclosure policy makes it easier to d isclose when there is already a lot of in fo in
(1) Reg statement of corp already in exs istence incorporate by reference
(2) 10Q and 10K annual reports incorporate by reference. Remember, these are filed only
by the large corps, not small.
62) Definition of Security (2nd Building Block in lawsuit)
a) Gateway Defin ition: Security.
i) Remember, cannot sell or o ffer security w/o registration statement. Thus, this definition defines
ii) „33 act is mostly about the registration and disclosure
iii) „34 act is mostly about fraud in the transaction
iv) MUST look at core defin itions in the acts for the test.
v) One item in the definition that has been subject of discussion: Investment K
(1) There was no accepted def at the time the acts were written.
(2) Much litigation over definit ion of Investment K.
b) What the heck is a security?
c) Hillman‟s worm farm. Hillman is watering his worms with a watering can. How can a worm farm
be an investment K???
i) On a cold rainy day Hillman was reading field and stream and noticed a worm farm ad. Wow,
what a cool investment idea. People will pay $ for bait worms. Worms propigate 4x per day
according to the starter kit info.
(1) Fedex worms to these people.
(2) These people will SELL the worms.
(3) Hillman will share the profits with the other worm farmers.
ii) Hillman‟s worms only prop igate at 2X per day. Hillman wants out. Can he get the SEC to
make these people pay back Hillman‟s investment? Probably according to case law.
iii) 4 part test fro m Howey:
(1) Investment of $
Prof. Hillman Business Associations Page 66 of 87
(a) Is speculative purchase of land, gold, diamonds, oil nvestment? Yes, people would
say that is an investment.
(b) NOT A LL investments are securities.
(2) In a common enterprise
(a) Other worm farmers participate in profit sharing with Hillman
(b) SOA in circuits (fed, obviosly)
(i) Vertical co mmonality relat ionship of promoter to investor
1. Broad vertical co mmonality, satisfied if investor merely relies on the
2. Strict vert ical co mmonality, investor and promoter have to share risk
(ii) Horizontal co mmonality focus on relationship between and among the
1. Profit pooling means commonality
2. No if Separate accounting, no profit pooling, eg hillman‟s worms kept track
3. Can there be a horizontal if there is a single investor? Some cts say yes, some
(iii) Note: some circuits say either strict vertical or horizontal will work
(iv) Just depends on the circuit, they also differ in interpretation of what these sub -
definit ions mean.
(3) With an expectation of profits
(4) Solely from efforts of others (PRIMARILY not solely)
(a) Look for: entrusting $ to θ whose efforts will be IM PORTANT fo r realizing the
(b) EG fro m Avantika, you buy fine silk cloth and import it for designer who will make
and sell clothes. Depends on other factors (maybe vertical co mmonality jx unless
you are )
(c) (solely is stupid, don‟t use this word)
(d) Turner case in notes explores this
(e) Just because Hillman tends the worms doesn‟t mean this fails. The profit depends on
the corp MARKETING the worms.
(f) This aspect of the Howey case is more easily satisfied than the text o f Howey looks, in
other words, primarily rather than solely.
(g) Hillman is doing the work, but the worms are sent back to the sellers.
d) SEC v. Howey (1946) page 1294 o f case book Sup Ct Case
i) Very structured area of securites law. Because all based on one case. Howey,
ii) Definition of Investment K
(1) Investment of $
(2) In a Co mmon enterprise
(3) With an Expectation of Profits
(4) Based Solely fro m the efforts of others.
(1) Sold strips of orange grove to visitors who signed a long term service K with Ho wey.
(2) Howey wou ld take care of orange grove and divide $ with owners.
(3) Sec said this is an investment K. see defin ition above
e) NOT A LL INVESTM ENTS A RE SECURITIES
i) If you are try ing to force something into a definit ion of security, look first for Investment K.
(1) EG Franklin mint is buying gold, we invest in gold and franlkin mint is going to make
cool coins and sell them,. That might be an Investment K
(2) Just buying gold, that is probably not a security, it is just an investment.
ii) Any time your client has spent $ and wants it back, see if you can force it into this framework.
iii) If it is a security, then you start looking around the Securities Exhange Acts and laws for relief.
10(b), 16 etc. for relief
iv) Be careful if your client is using the product directly. If Hillman is fishing with the worms or
selling them himself, not going to work. If Avantika is wearing the silk clothes at her
Prof. Hillman Business Associations Page 67 of 87
wedding, not going to work. If orange buyers are liv ing on the land in the orange grove, not
going to work.
v) Note: K analysis vs sec remedy.
(1) This (defin ition and securities laws) is based on PUBLIC POLICY that is beyond the
power of contrating parites to waive.
(2) But can contract in a way that defeats the ELEM ENTS of the defin ition. EG co mmonality
could be contracted away in the contract structure. Efforts of others might be K away.
63) Exemptions (3rd build ing block)
a) EXEMPT SECURITY
i) Types of exempt securities
ii) Results of having exempt security
(1) Don‟t have to register in order to sell
(2) Still subject to other provisions of securities acts
(a) Fraud in sale in public bonds
(b) Eg NY city bond sales, hid material facts
(c) Orange County junk bond sales.10(b) claims were asserted
b) Exempt TRANSACTIONS
i) Note: Must be an exempt TYPE of transaction AND must be exempt PARTICIPANTS
(1) Type of transactions
(a) Intrastate Offering § 3.a.11 ’33 Act
(b) Private Placement § 4 (2)
(a) Can‟t be exempt t ransaction if Issuer, Dealer, or Underwriter is involved in the sale.
(b) Underwriters: If a person purchases from the Issuer or a Control Person AND
intends to distribute, then they are an underwriter.
(i) If they don‟t purchase fro m Issuer or Control Person they are not an underwriter
(ii) OR if they don‟t intend to distribute (in other words have investment intent) then
they are not an underwriter.
1. Thus, if they do purchase from Issuer or Control person, AND co mply with
Rule 144 then they aren‟t an underwriter. Generally Rule 144 requires them
to HOLD the stock for one year.
(c) PLUS must disclose risks to unsophisticated purchasers, see 504 to 506 below.
ii) EG davis hardware will need $ to expand and so will bring in an other investor to buy common
stock. New person will ave 1/3 interest in the corp. NV resident.
iii) Might be able to exempt this transaction.
c) Wednesday, November 14, 2001
i) Q&A: Can‟t hold stock back and sell it later because must disclose amount of stock to be sold in
the Reg. Statement.
ii) HP Co mpaq maybe merger, markets haven‟t responded well. SH don‟t favor the merger.
iii) Back to Exempt ions: Big Picture, 3 building blocks are Can‟t offer Security without Reg,
Definition of Security, Exemptions.
iv) Review of exempt securities §3 of ‟33 act. NPO, Govt, certain securities issued by banks.
NOT exempt fro m fraud etc, still subject to securitites acts.
v) Exempt Transactions contd. Episodic exempt ions which only apply once.
vi) Davis Hard ware wants to expand and needs $, not ready for public offering. Go ing to bring in
3rd investor. The Wealthy NV Investor (Reno) will purchase a 1/3 interest.
(1) We have 1000 shares outstanding 600/400.
(2) Amend articles to authorize 1,500 shares.
(3) Issue 500 shares to new person (Reno).
(4) Could sell some of our stock but then we get the $, not the corporation!!!!
vii) Hillman isn‟t majority any more, has about 40% of the corporation, which is larger now. Zahn
and Ringling; particularly Ringling. No one has control.
(1) Maybe a McQuiad deal or Ringling deal between Hillman and the new person.
Prof. Hillman Business Associations Page 68 of 87
(2) Why don‟t you let me in on it? (Jones v. Ahmensen) Hillman has a fiduciary duty not to
write me out of the plot. We have a long term relationship and you‟re being unfair and
using this new person to
(3) Hillman has the lit igation stamina.
(4) SEC will not enforce it because of Santa Fe.
(5) Hillman offers to buy my stock
(6) What do you do with a credible legal claim? May not have the resources to pursue the
credible legal claim.
(7) Think about Ringling deal with the new person. Hillman wouldn‟t have let a new
person in unless Hillman already had a SH agreement with the new person. Hillman will
get a voting proxy agreement fro m the new person.
(8) But if Hillman is treating minority SH poorly, Hillman won‟t be able to get new SHs.
Hillman answers that he only needs to do this once.
(9) Under CA law, all SH have to participate in agreement if affects management, but under
Del. law only has to be a majority of the SH.
(10) It is difficult to enforce legal rights. It‟s indeterminant law. Should we just bail on the
viii) BACK to exemptions.
(1) Intrastate Offerings § 3.a.11 ’33 Act
(a) Issuer incorporated in state and doing business in state and offered only to people of
(b) Use CivPro definit ions for doing business? NOOOOOOO, use securities law
definit ion. It‟s predominant amount of the business has to be in that state. 80%
according to Rule 147.
(c) Davis hardware is doing business in Cal. and incorp in Del. and selling to Nev.
Resident. We could move the corp to Cal. but then Hillman would have to get MY
approval of the new management under Cal. law.
(d) Rule 147 deals with Safe Harbor exempt ion defin itions. SEC will g ive you a
checklist and if you comp ly with the checklist then you can be comfortable with the
exemption. If you don‟t comply with all of the checklist items then you might still
have an exemption but it‟s unsure.
(2) Private Placement aka pri vate offering exemption 4(2) of ’33 act
(a) Exempts a transaction by an issuer not involving a public offering.
(b) Watch out, though, because public offering is broader than it seems.
(c) See SEC v. Ralston Purina (1953) case pa 1310
(i) Facts: Purina had a stock purchase plan for “key” emp loyees to buy Purina stock.
1. Remember, they could buy this stock anyway because it was a public
company. What is the point of this offering? To cut out the brokerage
commission, no hassle, makes it easier.
2. Ralston Purina defined almost any emp loyee as a “key” employee.
(ii) SEC said you have to go through registration for this because it‟s a public
offering. Must shut down the program o r reg ister.
(iii) However, SEC said that the NUM BER of people offered to (thousands) means it
is a public offering. Sup Ct said no, the numbers are NOT d ispositive. The
numbers don‟t matter very much at all, it is the need of the offerees for the
protection of the registration statement. Access to information is the key. If the
offerees have access to informat ion equivalent to the information that would be
available through registration then they don‟t need the registration.
(d) SOA After Ralston Purina decision
(i) A number of courts say not only access but also must have to know what to do
with the in formation aka must be sophisticated. Some even say have to be
(ii) Some circuits say access is sufficient.
(iii) What does sophisticated mean? This is a squishy legal s tandard.
Prof. Hillman Business Associations Page 69 of 87
1. Institutional investors are clearly sophisticated, and so the corps are
comfo rtable making the private placement exemtption with instiutuional
b. Mutual fund
2. There is no “sophistication” test for this exemption.
3. Remember, A LSO have to have access to information.
(iv) Safe Harbor for this area: Regulation D
ix) Thursday, November 15, 2001 Weight Watchers IPO is SH selling 17% interest to the public
and it is a closely held corporation. SH is retaining an 83% interest. BAM entertain ment IPO
today, publishes playstation software, $8 public offering price. Up to about 20% over in itial
offering now. EG weightwatchers ipo the program is expensive and so if people had no
hope and were worried about buying luxury items then the market wouldn‟t respond as
favorably to the program. But, maybe, the investors are trying to show that they aren‟t afraid
(?) anyway …
(1) Yesterday was problems of enforcing a legal claims, even if valid, against Hillman. Does
it make sense to invest in a legal claim? This is also a COI because the lawyer will get $
and the client will lose $ if the legal claim is pursued. should discuss all this with the
(a) Likelihood of settlement,
(b) cost of pursuing the compl aint through settlement and litigati on,
(c) litigation stamina of opponent,
(d) alternati ve methods of enforcing legal rights .
(2) Yesterday we had a credible threat of litigation but Hillman was not afraid because he had
more lit igation stamin ia. Alternative methods:
(a) Arbitration, must be a right in the original K or we can‟t force Hillman to participate.
(i) Speed (supposed to be faster)
(ii) Expense (supposed to be cheaper)
(iii) But: Hillman can obstruct the arbitration too
(iv) But: juries favor underdogs and lose that with arbitrat ion
(b) K agreement: if one party enforces legal rights against another party, the losing party
must pay the legal costs of the winning party.
(c) Help your client realize legal rights that have been secured through the initial
bargaining process when the corp was formed or when your client invested.
(3) Public Offering Defin ition
(a) Registration for Davis hardware: not viable. Expensive and time consuming, and the
offerees are not really in need of the protections.
(b) Public Offering has been defined strangely by courts. Factors are access to info etc
see above for test.
(c) If the investor, Reno, is unhappy with the deal, Reno can rescind and say you didn‟t
comply with the securities acts and have no exempt ion.
x) Regulation D Safe Harbor Provisions
(1) Accredited Investor aka superinvestor applies to 505 and 506. This is a person who can
protect themselves so need less protections
(a) Institutional Investors banks,
(b) Insiders of the corporation
(c) Wealthy People has a net worth mo re than 1 million OR annual inco me over
200,000 and are Accredited Investors under Regulation D. Has not changed for about
20 years since reg D was written.
(2) 504 Up to 1 M illion $
(a) applies to offerings up to 1 Million $ only.
(b) Is based on (§ 3(b) of the ‟33 SEA) delegates to the SEC the power/auth to grant its
own exemptions. Rule 504 –06 are these exemptions.
(c) Carries the lowest $ limitation of the three types of offerings, Must be 1 million or
(d) Carries the least restrictions of the three types of offerings
Prof. Hillman Business Associations Page 70 of 87
(e) “Restricted Securit ies” ???
(3) 505 Up to 5 M illion $
(a) applies to Offerings up to 5 Million $ only.
(b) Based on § 3(b) of SEA ‟33
(c) 35(Non Accredited) Investor LIMIT for 506 offering (but don‟t count Accredited
Investors for this rule).
(d) Note: no sophistication requirement so different fro m 506.
(4) 506 No limit on size of offering.
(a) Safe Harbor for Private Placements (§ 4(2) of SEA)
(i) Sophisticated Investor. Means investor is sophisticated or has a sophisticated
1. If Accredited Investor then there is a NON-rebuttable presumption of
sophistication. AI = SI
2. This requirement of sophistication is based on the Private Placement
interpretation in Ralson Purina line of cases.
3. Can the person evaluate the merits and the risks of the investment?
Investment experience, education, prior history with the corporation.
Physicians are ideal investors because they don‟t know a lot about finance,
and they have a lot of $.
4. Okay, well, require them to have an investment advisor.
(ii) 35 (Non Accredited) Investor LIM IT for 506 offering (but don‟t count
Accredited Investors for this rule).
(iii) Non Accredited Investors must get a disclosure document, fairly co mp rehensive
1. Remember, if Reno is rich and stupid we don‟t have to give the disclosure
2. However, if we don‟t disclose the risks of the market then we might be open
to a claim of fraud under 10(b) if so mething horrib le happens. We should
probably warn Reno about the risks of the market.
3. Federal laws are concerned about disclosure and so if we warn Reno and
Reno is too stupid to understand it, then Reno‟s lawyer is fo rced to say that
the disclosure wasn‟t good enough because Reno didn‟t understand it. Plus,
SEC has defined Reno as sophisticated.
(c) Resales Davis Hardware is going to sell to Reno, and Reno is accredited. Reno is
clever, and a month fro m now Reno sells his holdings to Vegas.
(i) We have placed securites with Vegas using Reno as a conduit.
(ii) These securities should not be resold until they have come to rest with Reno
which means that the full investment Risk has vested with Reno
(iii) 504, 505, 506 securities are restricted as to resale.
(iv) Works out to a holding period before the securities can be resold. These are
Restricted Securit ies, restricted as to resale.
(d) Civil liab ility will be QUICK. Meet Monday and Tues next week but not Wed.
xi) Monday, November 19, 2001 Market watch: IPO market as a baro meter of the market broad
based market acceptance per wall street journal. Problem is that this isn‟t like a faucet, this
takes planning and must have been planned well in advance. The registration process takes
time and the market has been so bad most of this year. Smaller investment banking firms are
doing these deals?? Probably a better indicator is the FILING of registration statements, and
even those take time to put together.
(1) BACK to REG D Exemptions
(a) We needed an exemption to form Davis Hardware because NO securities can be sold
without reg statement or exemption.
(b) We probably relied on the 504 exemption, but that means we will have
RESTRICTED stock until it “co mes to rest” with someone.
(i) Co mes to rest means investment intent and not distribution in tent. Which means
that they have a long term interest and are not conduits or underwriters.
(c) Initial Sale Issuer P1(person 1) P2 (Person 2)
Prof. Hillman Business Associations Page 71 of 87
(d) Davis Hard ware (Issuer) Reno (P1) Vegas (P2)
(i) Forget restricted securities for a minute
(ii) Transaction exemption fo r the issuer
(iii) The Resale has to find its own transaction exempt ion. This is a d ifficu lt area of
securities law. Any resale must
(iv) § 4(1) of the SEA ‟33 (?) covers resales and is difficult. Covers a resale that
does not involve an ISSUER a DEA LER (ignore) or an UNDERWRITER.
1. If our sale o r resale does not involve an underwriter then we have an
exemption that will cover it.
2. What does Underwriter mean?
a. Includes: Investment Banking firm is obviously an underwriter.
b. However, statute says that an underwriter is a person who purchases from
the issuer or a CONTROL PERSON with a view to distribution.
i. Control Person (vocab.) means major SH, officer or director.
c. In other words, if transaction involves a Control Person then this
exemption is not available.
3. Will P1 be an underwriter or control person?
4. If P1 is an underwriter, then that is like saying P1 is just a conduit and P1 is
not a real investor and is just flipping the shares over to P2. If that is the
case it is as if Issuer sold to P2. The bottom line is the underwriter makes it
difficult at every level if you are using any investments. How do you make
sure P1 is NOT an underwriter? You RESTRICT fu rther transactions after
P1‟s purchase. How do we restrict the securities to make sure that P1 is not
(v) RESA LE of RESTRICTED SECURITIES is in Rule 144.
1. Holding Period for restricted Securit ies.
2. Usually 1 year hold ing period.
3. Negates presumption of underwriter status for purchaser of the stock who
complies with Ru le 144, in our case P1.
4. Remember, 4(1) is not availab le for sales involving Issuers and in the hypo
we are looking at a sale fro m Issuer (Davis Hard ware) to P1 (Reno).
5. 504/5/ 6 will cover the sale to P1 because § 4(1) is not available because Davis
Hardware is the Issuer. But we still need to make sure that P1 is a true
purchaser or we have a whole new tangle of problems.
(e) Hypo P1 sells to P2.
(i) EG I sell my shares of Davis Hardware to someone else. Needs an exemption.
What about 4(1), transaction not involving an issuer, dealer (ignore) or
1. I am a control person. I am a major SH. Underwriter includes someone who
purchases FROM a control person. So in this eg P2 is an underwriter by
2. ONLY works if I make P2 sign a K RESTRICTING the RESA LE to co mply
with Rule 144. Otherwise have to file a reg istration statement.
(ii) Don‟t wo rry, in this class, about what “view to investment” vs “view to
distribution” other than Rule 144 co mpliance.
(iii) Bill Gates can‟t just sell his stock without a registration statement. It would be
as if M$ itself had a public offering. Hypo: Gates will sell his stock to Cal Pers,
a huge institutuional investor.
1. 506 [4(2)] Wont work because only available to Issuers
2. 506 [4(1)] Private Placement with Cal. Pers., an Institutuional Investor
a. Do what you do under 506 by contractually restrict ing resale by Cal.
Pers to make sure that Cal Pers is not an underwriter.
b. Now, no underwriter, dealer, o r issuer but must make sure there is no
underwriter in the deal by RESTRICTING resale under Ru le 144.
3. Bill Gates has two choices:
a. Private Placement (Institutional Investor) AND restrict ions on resale.
Prof. Hillman Business Associations Page 72 of 87
b. Public Offering with registration statement.
d) Tuesday, November 20, 2001 Magma Design IPO 13 per share at open of trading now up to 20 per
share. They design software or something for ch ip design.
64) Exam Hints
a) Might change a bit but…. Moving toward objective.
b) 100 percent objective. 40 to 50 questions, closer to 50. Mult iple choice of various types.
i) Statement of Law: knowledge of legal p rinciples
ii) Application of Law to Facts: ability to apply law to facts
(1) Short app
(2) Big hypo based on prior essay exam and several questions.
c) COMPREHENSIVE so that luck of guess on what will be tested won‟t be rewarded.
d) Not a trick exam, questions are pretty straightforward. Remember, Multip le choice must be a trick
on some level. That aside, the questions are straightforward. Questions have been refined.
e) CASE NAM ES are important as to majo r cases. All cases we talked about in class are major cases,
but legnth of time we talked about it and the number o f times we talked about it … casual mention
don‟t worry, apro x 20 TWENTY cases or so are major cases.
f) Emphasis on what we talked about in class. Doesn‟t Intentionally go into reading that we didn‟t talk
about in class. However, there may be s tuff fro m the reading. It‟s not too late go back and do
g) STATUTES: know them to the level of detail we covered in class. Don‟t devlve too deeply into
stuff we didn‟t cover in class.
h) Will not release old exam questions. Could release a sample question, but the good questions all
over the board. There are no representative questions. Hard enough to get the questions right,
don‟t want to waste on example questions.
i) Will post office hours for day before exam.
j) The key to preparing: two major points. Co mprehensive, devote your review to the entire course and
don‟t try to guess what Hillman thinks is important. Class discussion, start with that. Can‟t really
game this exam, you have to study. 7 or 8 d ifferent question styles. They are fairly
k) Probably 3 hour exam.
l) No review session. If we get done early, maybe we could talk about it. We could maybe do that.
That means we have to have our stuff in order before the rev iew session.
m) Appreciate the difference between written law and applied law. See p 1321 – 22, yet another
exemption § 4(6) for placements with Accredited Investors.
i) This is a DEA D exempt ion. It was passed 20 years ago to make the SEC to come up with safe
harbors for small issuers trying to raise captial. The SEC adopted Regluation D which keys on
ii) Case book says Accredited Investor means the same thing as in Reg D but that is WRONG.
iii) Use this exempt ion at your peril, in other words IGNORE § 4(6).
n) Regulation A exempt ion based on § 3(b) [as are 504 and 505]
i) Offering Size MUST be under 5 million $
ii) Offering Statement
(1) Requires a disclosure document called Offering Statement
(2) Offering Statement must be filed with SEC
(3) Offering Statement is simp ler and less costly to prepare than Registration Statement
iii) Not a Concern:
(1) Nu mber of purchasers does not matter
(2) Sophistication of Investors does not matter
(3) No Restriction on Resale If sold under this exemption
iv) Co mmonly used for
(1) Internet Offering
(2) a relat ively s mall nu mber,maybe 100 people offered to
(3) “Mini” offering eg
(4) as the IPO market revives, will see Internet Regulation A exempt ions
i) See page 1362
Prof. Hillman Business Associations Page 73 of 87
ii) § 11 of SEA ‟33
(1) material misstatement or omission in the REG STATEM ENT
(2) Δs to a § 11 action are the
(a) Issuer itself, strict liability
(b) Non-Experts directors of the issuer, top officers of the issuer, the underwriters of the
(c) Experts experts who prepare portions of the registration statement (usually
(i) Defenses to Liability
1. Due diligence
2. Part 1 of Reg Statement: Expert ized Part , which means the Financial
Statements it‟s the part
a. Non Experts have a Δ against errors in this part fo r due diligence
i. if they had no reason to believe it was incorrect
ii. Non Experts means directors, officers
b. Experts have a due diligence Δ to this part only if
ii. Proper investigation and on basis of that investigation have no
reason to believe that there is a problem in the registration
3. Part 2 Non-Expert ized part
iii) Big Picture:
(1) 12(a)(2) overshadow § 11
(2) § 17 is the fraud provision of
(3) No private COA under § 17
(4) Remember, there are other fraud provisions
(5) § 11 is the most often applied provision for reg istration statement defects
iv) Case: Escott v. BarChris Cosntr. Co (1968) page 1365
(a) Before this case noone took the duty to prepare the reg statement seriously
(b) This registration statement was very defective
(c) BarChris operates with deferrred cash flow b/c it has to build bowling alleys before it
sells them and gets the $ out. Somet imes people don „t buy them when they say they
will. It may therefore end up operating the bowling alley itself.
(d) BarChris public offering and reg statement is rosy but then the economy turns down.
BarChris is going bankrupt.
(e) Δ under § 11
(i) Russo, CEO of BarChris may have some defenses. The errors in this reg
statement were in both parts. In the expertized part CEO should have a Δ if he
has “no reason to believe” there was nothing wrong with the reg statement.
1. Court says no way, you had every reason to know that there was something
wrong. You knew all the relevant facts.
2. Not clear if this is a rule that CEO knows, but think of it as a rebuttable
presumption that CEO knows.
(ii) Vitolo and Pugliese VP and Directors
1. Court says “men of limited education” and that the corporation exceeded the
capacity of its directors, this is a stupid position to take.
2. What case does this remind us of. “The drunk Mo m Case” Francis.
(iii) Kirsher, Chief Financial Officer (Treasurer)
1. Said he relied upon the lawyers to get the reg statement right
2. Said the whole reg statement was expert ized either by accountants or lawyers
3. Lawyer part icipation does not render it expertised
4. Duty of treasurer to conduct an investigation of non expert ized part
5. Expertized part must have no reason to believe wrong and this guy is the
(iv) Auslander, banker on Board Of Directors and new member at that
Prof. Hillman Business Associations Page 74 of 87
1. Court says that doesn‟t matter that he‟s new other than scope of investigation
but still must conduct investigation.
a. Should look at “minute books” (minutes?)
(v) Grant is outside lawyer who drafted the reg statement, Director
1. § 11 lists directors and that‟s the capacity in which he was sued.
2. § 11 does NOT list lawyer who drafts the reg statement, but more was
probably expected since he did draft the reg statement
a. should have read financial statements
b. should have looked at legal b illing
c. should have checked the informat ion that management provided
d. Monday Nov 26 starts here
(f) Black letter:
1. cant take info provided by management at face value. Must investigate, due
2. Minute books, double check information, read Ks
3. Could be 6 years worth of corporate life
4. In this case, the corp underreported “backlog” of work
5. It‟s boring work, assigned to associates
(g) Accountants are EXPERTS and prepare the EXPERTISED part of the statement
(i) Accountants are liable for not checking the informat ion provided by the company.
(ii) Accountants are not liable fo r mistakes in the other parts of the statement
(iii) Experts are only responsible for the FINANCIA LS
(h) NON EXPERTS are responsible for the entire statement, must have due dilligence in
checking the facts behind the whole statement
p) Monday, November 26, 2001 Correct ions to case book based on 1997 amend ments
i) Page 1318 reg 504 should say offering are “restricted securities” with a very few limited
ii) Page 1320 Ru le 505 should be not ve able to sell for at lest one year [book says two years]
q) Raising Capital, full d isclosure
i) Investor protection is accomplished by full disclosure, but investor also pays for the
investigation because the cost will be built into the price of shares.
ii) Make sure that the “last person standing” is liable. Last person standing means deep pocket Δ
who will survive the corporate collapse and bankruptcy.
iii) Underwriters are deep pockets and are major target fo r § 11 actions
(1) Access to “capital markets” is limited for s mall businesses like Dav is Hardware because
the underwriters have to build in the cost of due diligence and possible liability.
(2) Policy Question: Pro f thinks this is overkill for s mall corps. maybe we should have sliding
scale for corporation size. Full due diligence vs due diligence “lite”. Th is is just a
suggestion by prof.
(3) Note: Investors pay the cost of the due diligence investigation.
iv) Accountants are expertized and are targets of strict liability (for errors in the expert part) and
are deep pockets too.
65) Role of States in Securities Regulati ons
a) Note: ro le of states is less each year. Watch out for old outlines here.
b) Blue Sky Laws
i) State Qualification
(1) Must qualify your public offering or private offerings in any state in which you are
(2) This is a system of extensive duplication
(3) If you are offering in 50 states must qualify in 50 states, BUT
(4) Fed said enough is enough. Exemption fro m this for
(a) Stock listed on some kind of exchange like NY then don‟t need to
(b) Exemption also applies to private placement, certain exempt private placements under
Fed § 4.2 does not need to be qualified in the state.
Prof. Hillman Business Associations Page 75 of 87
(5) Note: offerings that are exempt under 504 or 506 [other than § 4.2 under Rule 505] are
NOT exempt by the fed fro m state qualification.
ii) Not on test: Regulation F D (Fair Disclosure) is designed to deal with the following 2000
(1) It was co mmon for co mpanies to selectively disclose certain analysts. The analysts would
write up little docu ments for their customers, who would then react to it and pretty soon
the market would reflect the leakage.
(2) The playing field was not level, co was disclosing material in formation to some people
and not to others.
(3) Selective d isclosure is now unlawfu l. Cannot selectively disclose to ANYONE. If you are
going to disclose must disclose to everyone. Now co mpanies must have a public
announcement, Yahoo is the center of this. They have a webcast. They have a schedule
of webcasts on Yahoo.
(4) Backlash: financial analysts say that the information isn‟t getting into the markets as
efficiently because companies are waiting until the last possible mo ment rather than
leaking like they used to. Now the markets aren‟t as efficient because there is some delay
as the info is withheld fro m the market until the last possible mo ment.
66) Capital Structure
a) Theme to this material: who gets the $ that is in the corporation, whose $ is it, that‟s all that capital
b) Relationship between the claimants against the corporation
i) Sharehol ders
(1) Common Stockhol ders (S H)
(a) Residual claimants because they don‟t get anything until senior claimants are
(b) Get EVERYTHING that remains after other creditors have been satisfied.
(c) Return on Investment:
(i) If the $ in the corporation goes way up, they win big.
(ii) If the $ in the corporation disappears, they lose to the extent they are invested.
(d) Historically, stock has been issued for PAR VA LUE. The par value is meaningless
now but the balance sheet still g ives valuable information.
1. Footnote on Par Value AND Paid in Surp lus: sometimes they don‟t even put
in what the balance sheet shows! Somet imes it‟s just a promise of future
assets or services.
2. Many states prohibit executory (pro miseses) as consideration for stock. Mus t
check state statute.
(ii) Par value is meaningless because:
1. Davis Hard ware Examp le: we will put up 100,000 So we enter $100,000 on
the balance sheet on the assets side in the cash entry.
2. On liabilities side we will have an entry called: STATED CAPITAL
a. 100,000 is the stated capital aka “legal captial”
b. STATED CAPITA L is a legal term of art that means: collective par value
of all shares that have been issued
3. PAID IN SURPLUS
a. Now, later, we put in some mo re money but we don‟t get more shares.
b. PAID IN SURPLUS: we don‟t get more shares and so when we pay in
400,000 and it‟s over the par value.
c. We don‟t want to increase the par value so we just pay in more without
getting more stock. We don‟t want the par value to go up because par
value is designed to protect other parties by giving them a guaranteed
value for the stock.
d. It‟s easier for us to get the paid in surplus out of the corporation.
e. So let‟s make the par value really low and make the paid in surplus really
f. Let‟s amend the articles of incorp and make the PAR VA LUE $1 and the
PAID IN SURPLUS 499,000.
Prof. Hillman Business Associations Page 76 of 87
g. Courts have accepted this, and it became co mmon practice to issue low
or NO PA R value stock and to have huge paid in surplus.
h. Note that the preferred stock still usually has a real par value. Co mmon
stock will have a meaningless par value, usually pennies or about a
(iii) It did matter once because the issuance of stock at Par Value wh ich represented
the amount of $ that the stockholders put into the corporation in exchange for
1. Article of Incorporation define the Par Value. EG 1000 shares of common
stock ($1,000 par value). Each SH put $1,000 into the corporation for every
share of stock they got.
2. Irrevocably co mmitted this amount of $ to the corp was what Par Value
meant. For every share of co mmon stock there wou ld be $1,000 co mmitted
to the corporation.
3. Note: this does not mean $,1000 cash, it means entry on the balance sheet of
4. Was supposed to mean that the distribution of cash to SH was supposed to be
5. Often SH don‟t contrib cash, so there are immed iate valuation issues. Maybe
SH contributed a tractor. Is the tractor really worth exaclty $1,000?
6. Any time that a SH put in less than $1,000 it was called watered down stock,
and the consequece was that the SH had to pay up the deficiency on a
demand by a creditor.
(e) Tuesday, November 27, 2001
(f) Preempti ve Rights: the right of a SH to purchase a proportionate interest in the
issuance of new stock.
(i) Note: only applies to close corporations.
(ii) Q: can you sell them to a θ? Prof doubts it because the right seems connected to
the proportion of the shares.
(iii) Close Corporations: Davis Hardware. 1000 shares out there, 600 to Hillman 400
to me. Hillman checks the articles of incorporation and amends them to increase
the authorizat ion to 2000 shares.
1. Hillman buys 1000 more shares. Now Hillman owns 80% (1600 shares) and I
2. Assume Hillman pays full value, whatever that means. Ignore valuation
issues for now.
3. I‟m angry now, but not if I have preemptive rights. If I have preemptive rights
I have a right to purchase my proportionate share.
4. What if I don‟t have the $ to buy the proportionate share?
5. Does Hillman have a fiduciary duty to me? What is that duty?
a. Does Hillman have to be fair?
b. What if the corp needs the additional $ in the business judgment of the
(iv) Sources of Preemptive Rights
1. Articles of Incorporation
2. Many state statutes say the SH have preemtive rights unless the Articles of
Incorporation take them away.
a. Del. does not give SH preemptive rights. Must be in the Articles of
Incorporation if Del. corporation.
3. A FEW courts have found preemptive rights based on equitable princip les.
(g) Sources of relief other than preemptive rights
(i) Fiduciary Duty. What case does this remind us of (Zahn and Donahue) but prof is
looking for Sinclair case. Venezuelan subsidiary corporation. Level of review
for fiduciary claims, court said when the corporation is used to give a benefit to
some SH that other SH don‟t get, will look at striclty. If benefit is availab le to all
SH equally then it will be considered business judgment.
Prof. Hillman Business Associations Page 77 of 87
1. Hillman will have to come up with a co mpelling business reason or court will
probably find against Hillman.
2. But remember lit igation stamina.
3. But maybe all we need is an in junction, prelim in j prohib iting issuing the
shares to Hillman, and then it doesn‟t matter to me how long it takes to
(2) Hol ders of Senior Securities (S H)
(a) Senior Securit ies means all securities other than common stock.
(b) Senior securities are “senior” to co mmon stock, wh ich means their right to payment
of claims co mes before common stock.
(c) Preferred Stock (PSt)
(i) Somet imes is issued for full par value, Prof. not sure why that is.
(ii) PSt is defined in the Articles of Incorporation.
1. Div idends are defined and are paid before co mmon stock dividends .
a. Note that dividends are always discretionary, so all it means is that before
the common stockholders can get a dividend the preferred stockholders
must be paid the defined dividend amount.
b. There are legal stds for payments of dividends, can‟t be paid in some
c. Also, even if legally can pay dividend BOD can decide not to pay a
d. Preferred stock does not have a vested right in the payment of d ividends.
e. Preferences that are not paid do not carry over fro m year to year
UNLESS the preference is cumu lative.
2. Cu mulat ive Preferred Stock (accu mulation applies to Dividends)
a. Must be expressed in the Articles of Incorporation.
b. Who likes preferred stock? What good is it? Remember, the value
doesn‟t go up at all.
i. Assume 6% return on investment. This is higher than bond return rate
because the dividend is riskier than the bond interest.
ii. The income is risky because the dividend may not be paid. But if the
corporation is really healthy, it ‟ll be fairly guaranteed to be paid.
iii. Income is the attraction, and it‟s not guaranteed.
3. Inron debacle was trading 85$ earlier this year but now it‟s trading for 5$
per share. Imag ine that the preferred stock was paying 6% div idend. The
value of this preferred stock is going to go down because there probably
isnt‟ enough $ to even pay off the creditors. Assume that preferred stock is
trading at $20 per share now, but then Inron turns itself around. The value
of the preferred stock will go up, maybe to 100 per share. But that‟s still
pretty risky. M ight lose everything when Inron goes into bankruptcy.
4. Convertible Preferred Stock (can convert to common stock)
a. Which case does this remind us of? Zahn. This is like the class A
convertible into class B stock.
b. Must be so described in the articles of incorporation.
c. Why would they make the preferred stock convertible?
i. Assume we are selling preferred stock to Reno? What‟s in it for us to
make the stock convertible? Can charge Reno for the right to
convert the stock later. Can pay a smaller annual d ividend, maybe
$5 per year per share rather than $6 per share per year.
d. How does the conversion work?
i. Assume common stock is sold for $60 per share
ii. Assume PSt is sold for 100 per share
iii. Assume that the conversion ratio is 1:1
iv. The investor is betting that the common stock will go way over 100
and the preferred stock purchaser will make bank converting.
v. This is the NORMA L structure, it‟s 1:1 and is silly at that point.
Prof. Hillman Business Associations Page 78 of 87
e. Note that don‟t even need to convert to realize the profit because the
convertible preferred stock value will also go up.
f. Somet imes conversion has an expiration date, usually a long time into the
g. If there is a stock split of the co mmon stock, there is an automatic
adjustment to the conversion ration, that follows by operation, don‟t
need to say so in the articles of incorporation.
5. Note: if you want the $ out of the investment you don‟t get it back fro m the
corporation, you sell your preferred stock on the market.
6. Liquidation preference, might be defined as par value.
a. If liquidation happens, the defined value is paid before the common
b. But remember, you‟re still junior to all the other creditors of the
(iii) Wednesday, November 28, 2001
(iv) Callable preferred stock see Zahn
(i) Can be convertible just like Preferred Stock, see above. Usually 1:1 conversio n
and will get a lo wer interest rate on the bond in exchange for the right to convert
(ii) Get paid before preferred stock (which gets paid before co mmon stock)\
(iii) Interest gets paid as defined, not at discretion of BOD. If corp doesn‟t pay then
they are in default with the fu ll measure of remed ies.
(iv) Bond payments are tax deductible for the corporation while d ividends are not.
(3) Re-capitalizati on
(a) Means a material change in the rights and preferences of a class of stock
(b) Assume cumu lative preferred stock and dividends have not been paid for a nu mber of
years, and corporation eliminates the accumulated but not paid dividend rights.
(c) See the Acme p roblem, preferred stock with accumulated div idend rights of one
million dollars. Wants to share the profit with all of the SH but can‟t pay both
preferred and co mmon if they have to pay one million to the preferred stockholders.
(d) BOD says they will pay a div idend if the preferred stockholders agree to get rid of the
(i) 51% of the preferred stockholders s ay yes.
(ii) Del. §242 says that you can amend the articles of incorporation to cancel or
otherwise amend the rights to a dividend upon a majority vote of the class of
(iii) Why would they vote for this? Maybe they own common stock. Maybe they
really want the dividend even if it means giving up the accumulation. So meth ing
is better than nothing.
(iv) Idealists say we dissent, we have rights and we paid for those rights. Why should
they be able to waive OUR rights? It‟s a K theory. The courts say no, when you
bought the preferred stock you bought it knowing that it could be changed. The
rights are subject to change by a vote of the majority of the class of stock
(v) APPLIES to ANY RIGHT, not just dividends. Examp le that you have non -
redeemab le preferred stock, let‟s make it redeemab le preferred stock. If the
majority votes for it that‟s what happens.
(vi) Absent a majority vote you don‟t get a change in the class of stock affected.
(vii) Fiduciary duty? Probably, but don‟t forget the practical issues with enforcing
the fiduciary duty.
(viii) Remember, reputation also matters so if they stomp on the shareholders a lot
then they are going to see a devaluation of their stock. It happens a lot but
probably not in the same corporation a lot.
(ix) BOD could buy up a class of stock and then mess with the other class of stock.
But this is going to violate fiduciary duty “Punctilio o f an honor most sensitive”
Prof. Hillman Business Associations Page 79 of 87
prof reminds us again to look up Punctilio. Can say to courts didn‟t have notice
of this kind of abuse.
67) Di vi dends, see page 1234 Distributions to Sharehol ders Chapter 13
a) Variety of ways to get $ out of corporation.
i) Hire selves, employees/officers of corporation
ii) Transact with corp, eg lease land to corp
(1) Div idends
(2) Repurchases of stock (see Donahue, specifically designed to get $ to (roth?)
b) Div idends
i) Transfers assets ($) aka wealth aka cash fro m corporation to SH
ii) Usually paid on a quarterly basis, every 3 months
iii) Discretionary with the BOD, so the BOD has to declare a dividend payment every time
iv) 3 interesting legal problems
(1) when is it lawful to pay a dividend
(2) what happens if you make an illegal div idend payment
(3) to what extent can a SH co mpell dividend payments
v) When can the Corporation Pay Div idends? The most interesting is the when is it legal to pay a
(1) Cred itor claims are superior to stockholder claims, so creditor claims could put dividend
payments in jeopardy
(a) Since corporations are ongoing and always have debt, there must be a way to pay SH
despite some amount of debt.
(b) Can pay dividends if the dividend payment won‟t prejudice the corp‟s ability to pay
(c) Law says: can pay dividends so long as the credotrs are protected. What does that
(2) So long as the creditors are protected, can pay dividend. See state laws.
(3) Do the state laws really protect creditors?
(4) History: 6 different tests
(b) Balance sheet
(c) Nimb le d ividend test
(d) Earned surplus test
(e) Calif. test
(f) Model Act test
(5) Insol vency Test usually used in conjunction with other tests. Insolvency plus.
(a) Corp may not pay div to SH if the effect of that payment would be to render the
corporation unable to pay its debts as they become due.
(b) Note: this is not the bankruptcy test. This is corp test is more fluid.
(c) You can count future earnings, and
(d) It is a predict ion of the future. The BOD makes this prediction.
(e) Most states use this test in combination with another test. Insolvency PLUS.
(f) This is a safety net test, when the board is considering a dividend it uses the other test,
such as the balance sheet test. THEN the BOD looks to the insolvency test.
(6) Balance sheet test th is is also Thursday, November 29, 2001
(a) Historically important, used still in NY and a few other states
(b) Div idend may be paid only to the extent that the assets of the corporation exceed the
sum of the liabilities plus stated capital
(c) D = A –(L=Sc)
(d) The answer is al ways going to be whatever is in the equity section of the
liabilities side of the bal ance sheet that isn’t in the stated capital account. In
other words, all the surplus is there, you still have to count stated captial and the
liab ilites that are fro m loans and mortgages and so on.
(i) BUT also note that you can‟t pay more than you r cash.
Prof. Hillman Business Associations Page 80 of 87
(ii) Now you apply the Insolvency test, are we going to be able to pay the mortgage
payment or whatever? Maybe not, we can count on cash coming in but stil l have
to cover our payments.
(e) EG Davis Hardware
(i) Stated capital of 100,000 because we paid fu ll par value for the stock.
(ii) Assets are 100,000
(iii) Can pay ZERO dividend
(iv) Assume 3 years later we have
1. Assets: 50,000 in cash, 150,000 in RP (real estate) = 200,000
2. Liabilities: Mortgage 100,000, Stated cap = 200,000
(f) Reduction Surplus Decrease Par Value Decreasing the Stated Captial
(i) What are we going to do? We need to get rid of that par value stock in the Stated
(ii) Amend the articles of incorporation to decrease the par value of the stock, reduce
it to $1 per share.
(iii) REDUCTION SURPLUS $99,000
(g) Revaluati on Surpl us Reval ue the Asset some jx don‟t allow, or maybe there
isn‟t anything to revalue
1. But Hillman says we know that the RP is worth mo re than we paid for it
(150,000), we get an appraiser to appriase it and it‟s valued at 200,000
2. Just like they did in the Klang ? case we are revaluing the asset.
1. To balance the balance sheet we increase our residual stockholder claims.
2. REVA LUATION SURPLUS of $50,000
(iii) Delaware case, Klang, helps the SH and hurts the creditors, Klang said go ahead
and take the $
(iv) What about depreciation? SOA between states that use the balance sheet test.
Book is wrong, states are split.
1. Some say use generally accepted accounting principles. Noone has yet carried
it to the point of requiring keeping the balance sheet current all the time
once you do it to give you what you want.
2. Some say go ahead and play with the assets to do what you want, maybe you
can appreciate the RP and ignore the depreciation.
(7) Nimble di vi dend test
(a) Developed in Del.
(b) Regardless of what your basic test reveals, you STILL can pay div idends if you have
current earnings in the corporation.
(c) In Del., if you have profits for this year, no matter how cru mmy your balance sheet
looks you can pay a dividend this year.
(d) If you wait, you won‟t have CURRENT profits any more, so must act quickly.
(e) Still subject to Insolvency test though. Can‟t burn the creditors that much.
(8) Earned surplus test
(a) Has replaced balance sheet test in a lot of jx
(b) Can pay dividend to the extent that you have a surplus that is EARNED SURPLUS
(c) Earned surplus is a captial surplus (is in captial part of balance sheet) that is equal to
the balance of the net undistributed profits, gains , and losses fro m the date of
(d) It‟s a running balance, it‟s the net profit of the corporation fro m the beginning.
(e) See problem in problem set, it‟s just a series of adjustments.
(f) Balance sheet shows 1000 in cash and stated captial of 1000 at beginning.
(g) 1st year $250 profit. Show 1250 cash and stated cap of 1000 and earned surplus of
$250. We declare a d ividend of $100. Cash goes down to 1150 and the earned
surplus goes down to $150.
(h) 2nd year we lose $100. $1050 cash and $50 in earned surplus .
Prof. Hillman Business Associations Page 81 of 87
(i) 3rd year we lose $100. ES is now -$50. That‟s 50 in the hole. Negative number in the
(j) 4th year we profit 50. We are at zero in the ES.
(9) Calif. test more sensitive to creditors than the others.
(a) GAAP Must use generally generally accepted accounting principles. That means
Klang wouldn‟t work here.
(b) Insolvency Test just like others, must be able to pay debts as they become true.
(c) Choose the test that gives you the best dividend.
(d) Test 1 Retained Earnings aka earned surplus. In problem 2 it‟s 10,000 d ividend
(i) Just find the Earned Surp lus entry.
(e) Test 2a and 2b Rat io Test, use the lower nu mber produced below in test 2a or 2b
(i) Test 2a
1. total assets exceed total liab ilities by a factor of 1 ¼ OR
a. 65,000 minus 35,000 would be 30,000
b. cushion is INFLATED liabilities, mu ltiply by 125% ???
c. it‟s about 44,000 for liabilit ies of 35,000 so 65,000 minus 44,000 equals
21,000 div idend
(ii) Test 2b
1. current assets (cash and cash equivalents) over 12 months exceed total
liab ilit ies
a. cash equivalents include accounts receivable. Not as good as cash
because don‟t actually have it and there will be a few deadbeats.
b. Liabilities means things we have to pay within the next year.
c. Thus, this is like insovancy built into the ratio test.
d. 15,000 (current assets) minus 10,000 (current liab ilit ies) = 5,000 dividend
(f) See problem set Dividend Problem 2, inserted above as numbers…
(i) Here can use the highest which is the earned surplus of 10,000 because the ratio
test result is lower ($5,000).
(ii) BUT notice that the current liab ilit ies are 10,000 and since we only have 15,000
cash it will take the cash down to 5,000 if we pay a 10,000 d ividend. How are
we going to pay the current liabilities? Maybe ongoing profit will do it. Th is is
the overriding insolvency test.
(iii) This is modern but also conservative because can‟t recaptialize as in Klang.
(iv) According to generally accepted accounting principles, you almost never
recapitalize. You carry them at their historical cost, no matter what they are
worth now with a few exceptions. Obviously, if they are a loss, like the boat
sinks, then you can‟t carry it at h istorical value.
(v) Davis Hard ware as incorporated in Del. even though located in Calif. will use
the Del. test, just like in Klang.
(vi) Remember Cal § 2115, certain portions of the Calif. Corp. Code appl ies
whereever you incorp. DIVIDEND is one of them BUT only applies to close
corporation. PLUS Del. suit and Del. will probably IGNORE Cal. Corp Code.
Use the Del. test, as in Klang.
(10) Model Act test Most JX, but not imporant states.
(a) Overriding insolvency test
(b) Can pay to the extent that assets exceed liab ilities.
(i) Like calif but no CUSHION mulitip lier of 125% on the liabilit ies
(ii) Just take assets minus liab ilit ies
(iii) Can use any reasonable accounting method, and can use any fair valuation
methods. So can revalue however you want. Don‟t have to use GAAP.
(iv) Can say fixed assets have a “true” value of 75,000 instead of 50,000.
(v) This is sort of like no standard because it is so favorable.
(11) Ways to get $ to SH
(a) Two ways to get $ to SH as SH.
(i) Pay dividend or buy their stock.
(b) Hire them an increase salary. NO limit on salary, no creditor protection.
Prof. Hillman Business Associations Page 82 of 87
vi) Legislatures develop these tests and change them in response to the lobbies. Who is the real
lobby? Isn‟t there a creditor lobby?
(1) State interest in the taxes on dividends, retirement funds, institutional investors
(2) Prof‟s answer: the bar is the lobby that has the most influence on the corporations law.
They are representing SH and so it is pro SH pressure to change the corporations code to
(3) The creditors do have their own lobby
c) Note on Enron: the dividend on preferred stock had been declared, and now it is at risk because the
corporation is collapsing. BOD can‟t make the distribution to the SH to the prejudice of the
creditors, now the dividend payment has been revoked.
i) Not on test, I guess, because he said this was a diversion. He also said this would mean we get
no review session. relationship between the interest rate and the value of corporate stocks and
(1) Example of Risk Free Investment: US Treasury Bond. NO chance that govt will default on
its obligation under the bond.
(a) Obligation to pay interest anually
(i) Interest payable anually or semi-annually example 5%
(b) Obligation to pay when the bond is due
(i) Long term bonds: eg 30 year treasury bond
(c) Use this bond as a risk free benchmark
(2) Corporate bond, example Ajax stable company but not as risk free as US govt
(a) Ajax 30 year bond
(i) Interest must be higher than govt bond because riskier and investors demand that
risk be co mpensated
1. 6% return annually when us govt bond is 5% because must be higher
2. bond won‟t say 6%, they will say $60 because fixing the dollar amount of the
interest they will pay
(ii) bonds are issued in a “face amount”, usually 1,000
(b) 3 years into the life of the bond the conditions change, now it‟s not as stable as it once
was. Investors are worried about Ajax‟s ability to meet bond obligations (interest
and payment when due).
(i) Now the bond is trading for $400 even though the face value is $1000.
(ii) $60 per year pay ment on the bond in interest, which is a 15% return .
(iii) But this is also considerable risk.
(c) Company s pecific risk is when something happens to the company that affects the
value of the bond. Inron examp le
(d) General Market Risk is the risk attributable to the market.
(i) Assume that the risk free rate of return on a us treasury bond is up from 5% to
(ii) You carry this bond that offers 6% interest
(iii) If you bought the bond today it would offer 15% interest
(iv) The 3 year o ld bond has actually gone down in value because people would
rather get a new bond fro m A jax with 15% interest.
(v) Assume 500 is all someone will pay you for the old bond with the $60 per year
return because that is only a 12% return as compared to the 15% return they
could get fro m Ajax.
(vi) If interest rates FALL then they will pay more fo r the $60 per year.
(vii) Much of this also applies to preferred stock! Depends on what the market is
doing elsewhere, the preferred stock available elsewhere.
(viii) So don‟t buy bonds when the bonds start to go up at first because they will
probably continue to go up and the value of the bond you bought when the rates
were lower will go down.
d) Thursday, November 29, 2001 LATE for class only 5 reasons
e) Warren Buffet see page 1238
i) Management decision to pay dividends is usually a conflict of interest
Prof. Hillman Business Associations Page 83 of 87
(1) Management may have stock options at a fixed price, they are better off if the corp has
(2) Trend in later half of th is century is toward not paying diviends
(3) Decreased value of corporation when div paid to SH because Corp has less assets
(4) Tax benefit if keep in corp, if you give the $ to SH you have the double taxation problem,
although keeping $ in the corp just delays the problem
(5) Monday, December 03, 2001 Dividend Prob lem 8D1? Again
(6) Earned surplus again, see above!
f) The So What Question: Liability for Div idend payments
(1) Most states create semi strict liability
(2) Can rely on financial statements and assume that they are true
(a) Accountant experts are not going to give you cover on the revaluation of experts
(b) Klang what would YOU advise the BOD to do to protect against liabilit y for
(i) Responsible disinterested θ opinion. Go to responsible institution and get an
opinion on the valuation. Maybe real estate θ.
(4) Amount of Liab ility for Directors
(a) What is directors AMOUNT of liability? The full amount of the improper d ividend
(b) Minority of states say liability only if harm and amount is amount of harm.
(i) Δ in these states: corporation continued and creditors were not prejudiced.
(c) But if corporation went bankrupt and creditors were harmed, the directors are liable
for the full amount that the creditors were burned.
ii) Tuesday, December 04, 2001
iii) Shareholder Liability
(1) Corporate law covering dividend payments
(a) Trust fund theory: imp roper dividend payment then SH must pay back
(b) Uncertainty is a problem so they set up statutes to give some certain ty that you won‟t
have to pay back the improper d ividend unless the SH KNEW or HA D REASON
TO KNOW that the payment was improper.
(2) Unifo rm Fraudulent Conveyances Act
(a) Entit les creditors to recover payments that have been made on the verge of
bankruptcy (insolvancy) in other words they might be able to get payments back that
you made right before you went insolvent.
(b) This is not corporate law, this is creditor law, and can be applied to dividend
payments to SH if the conditions are met.
(c) This is an unresolved point, there is an argument that the dividend payment provisions
TRUMP the UFCA because the dividend payment statutes in corporate law are
designed to protect creditors.
iv) Co mpelling Dividend Pay ments
(1) This is a problem only for close corps because in public corps you can just sell your stock.
(2) Eg I‟m not an emp loyee of Dav is Hardware hypo: I‟m not getting any return on my
investment. I want to compel a div idend payment, particularly if Dav is Hardware is
rolling in profits.
(3) Court wants to defer to judgment of the BOD on dividend matters. Reminds us of Ford
Motors (Henry Ford‟s change in policy) and Sinclair case (dividend policy was to pay
substantial dividends.) Usually will defer to the BOD in 99 out of 100 cases.
(4) The excpetional case: Miller v. Magline noted on page 1243.
(a) Facts and Procedure
(i) Many SH were emp loyees
(ii) Corp was rolling in profits
(iii) Directors never declared a dividend
(i) Good lawyering AND
Prof. Hillman Business Associations Page 84 of 87
(ii) Activist judge
(c) Limited Remedy
(i) Court ordered a 75$ per share dividend one time.
(ii) Luck of the draw with the judge and if they want another dividend payment
they‟re going to have to sue again.
(5) Minority SH need to worry about things at the FORMATION of the relationship
g) Stock Repurchases
i) Major Cases
(1) Donahue SH objected to stock repurchase
(3) Galler v. Galler SH agreement to repurchase stock in the event of death of
ii) Pro Rata
(1) Corp repurchases a pro rata percentage of EACH SH‟s shares
(2) We haven‟t seen a pro-rata yet
(3) Works like a d ividend because proportion of ownership doesn‟t change
(4) Tax consequences
(a) Unlike a div idend because of TAX benfit !
(b) This is probably taxab le as a corporate gain, lower tax rate than income????
iii) Non Pro Rata
(1) Changes ownership percentages
iv) Usually not paid for in lu mp sum, usually installment payments, see Kramer case.
v) Who might object to corporate stock repurchases:
(1) Cred itors
(2) SH, especially in non-pro rata!
(a) SH who are forced out through buy out. See Rodd Case, corporation made certain SH
the only SH by buying back the shares of the other SH
(b) SH who are not invited to the party. So me people not allowed to part icipate. See
vi) Repurchased stock is called TREASURY STOCK
(1) This is suspended stock, doesn‟t vote and doesn‟t get dividends
(2) Can be resold later, at which point it beco mes active stock againt
vii) What regulates?
(1) Statutory, similar to dividend regulation
(a) To protect creditors
(b) Some older statutes dealt with div idend and repurchase differently
(c) Modern approach is to treat them the same and apply same std to the both
(i) Calif. regulates distributions to SH which includes both dividends and
repurchases of stock. SAM E regs
(ii) Thus, incorporate by reference the dividend payment standards and all that stuff.
(2) Differences: Problem with stock repurchase that doesn‟t come up with the dividend is the
installment payment plan.
(a) When do we apply the stautory test?
(i) At the time the agreement is made, treat as lu mp sum?
1. Wont meet the test very often.
(ii) At the time the first payment is made?
(iii) Each time a pay ment is made to that installment payment?
1. May fail the test sometimes and not others.
viii) Neimark v. Mel Kramer Sales Inc (1981) p 1269 Close Corporation Wisconson
(a) stock repurchase K entered in 1976 with major SH. Kramer‟s health was failing and
wanted to figure things out for wife.
(b) Buy/Sell agreement K: addresses major life events such as death of SH, retirement of
SH, termination of emp loyee SH, and so on.
(c) This Buy/Sell K said on death of SH Kramer corporation would repurchase stock at
$400 per share.
Prof. Hillman Business Associations Page 85 of 87
(d) This reminds us of GALLER case, agreed that if SH died and estate taxes were
pending the corp would buy back some shares.
(2) Fiduciary issues NOT in the case but think about them anyway:
(a) You want the buy/sell agreement to stick and you are worried about fiduciary duties
(b) What case does this make us remember? Donahue. Other SH might object since here
in Kramer the controlling SH is getting a deal fro m the corporation.
(c) How to make the other SH happy: get them to sign on because wife agrees not to sell
to a hostile θ party.
(d) Could also offer deal to them, but may not be able to structure that deal.
(e) Might need to have truly disinterested directors approve it, matters who the BOD are,
not possible in cases where closely held and BOD is the SH who wants the
(3) The Deal
(a) The corporation gets life insurance on the life of the principle SH in anticipation of
the death of the SH. It was only enough to make the down payment.
(b) Additional payments must occur over five years. No w look to distribution standards
because a lot of $ is going out of the corporation
(4) who are the parties
(a) The Δ in this case is the widowed wife and doesn‟t want to go through with the K.
(i) If this agreement is squashed, then wife will get the $ now rather than in
(b) The π seek specific perfo rmance of the K as written.
(i) SH benefit if the K is enforced because it increases their proportionate interest in
(5) Question: how and when to apply the insolvency test
(a) Insolvency Test Court says apply the insolvency test to EACH PA YM ENT. If the
payment would render the corporation insolvent, can‟t make the payment.
(b) Plus Test Apply the EARNED SURPLUS test only once, court gives 11 reasons
but other courts say apply the other (whatever that is) test with each payment.
h) Tomorrow: Inron. Thursday Review Session
68) Enron Wednesday, December 05, 2001
i) built a big dam in India and displaced a lot of workers
ii) One of the largest corp in the world a year ago
iii) Sophisticated companies were heavy investors in this corp. Dirkson case is like this
iv) “blue chip” corporate $80,000 billion
v) at least 10,000 people lost their jobs, pension plans were Enron stocks
vi) principle business was the ownership and operation of a gas pipeline 15000 miles
(1) not a growth business so Enron started to do other things
(2) expanded energy operations and became a major trader of energy as a co mmodity
(3) expanded into broadband service probably because can string cable along pipeline
(4) then expanded into other stuff like video on demand with blockbuster, which failed
(5) traded commodities, pulp, steel, broadband capacity, weather risk hedging
(6) Still, that wasn‟t the problem with Enron (the creative investments)
vii) The problems:
(1) Conflict of Interest Problems
(a) CFO (Chief Financial Officer?)decided to explore the new business opportunities
through separte enitites, related to Enron but not Enron itself
(b) SPE (Special Purpose Entities) were satellite entit ies that CFO and
(c) other top employees at Enron invested in these SPEs (CFO and others)
(2) Accounting Problem:
(a) Liability Reporting Significant liab ilities for these SPEs that En ron took responsibility
for but did NOT appear on the SEC reports that Enron filed
(b) Income Reporting: Enron reported SPE inco me as part of its inco me
(c) Accounting Firms signed off on this scheme, and the accounting standards are in need
of revision if this was deemed an acceptable structure by accounting firms
Prof. Hillman Business Associations Page 86 of 87
viii) The Decline
(1) Stories earlier this year questioning what Enron was doing
(2) August 2001 CEO resigned for “personal reasons” which raised questions
(3) October public statement Enron reports problems with SPEs,
(a) says it will have to write off a b illion $ in assets of SPEs that it had been reporting as
(b) CFO is heavily invested in these SPEs and got 30 million in proft is fro m them AND
(c) CFO is fired (th is is a REA LLY bad sign)
(d) Market reacts with a drop in market price o f shares
(4) October a few weeks later public statement
(a) Quote “The Enron financial statements for ? 99 to 2000 and first 2 and audit reports of
2001 [basically 3 ½ years worth of reports] Should Not Be Relied Upon”
(b) More market drop in price
(5) Dynergy Merger agreement
(a) 10 billion paid for Enron by Dynergy
(b) 13 billion in debt assumed by Dynergy
(c) 1.5 billion cash from Dynergy to Enron now to maintain cash flo w
(d) asures market that another co will buy Enron and put some $ in
(6) The Rating of Stock
(a) People were not inclined to do business with Enron
(b) Enron downgraded to JUNK status, means creditors are highly at risk
(c) Once a debt is downgraded to Junk status, acceleration clauses in debt Ks become
active, now Enron can‟t pay its bills
(d) Assets seem to be evaporating
(7) Dynergy cancelled the merger agreement
(8) Enron filed for bankruptcy
(9) Lawsuits were filed
(10) Assets after failed merger
(a) Important value of business is the trust the market in the co Reminds us of drunk
mo m case,
(b) Dynergy says it owns the pipeline because it put 1.5 b illion into Enron and the
collateral was the pipeline
ix) Bus Ass Review Issues
(1) Culpability of BOD
(a) Large BOD at Enron, which is a warning sign.
(i) Some of them might be ceremonial d irectors, eg ex president might be there just
to give a face for the market.
(ii) Corporate employees
(iii) Outside directors competent, smart people but
1. Most had no financial interest in the corporation. Since they had no stake in
the corp they didn‟t have incentive to look out for the corporation
2. One had 800 million $ in co mmon stock PLUS 800 million in p referred
convertible stock, it‟s all gone.
(iv) Failed to Exercise their Duty of Care
1. Del and Cal says that articles of incorporation can be amended to eliminate
the duty of care
2. Reminds us of/ relevant cases
a. Drunk mo m case
c. Caremart case
(2) Efficient Market Theory
(a) Ray Dirks why didn‟t the market know about these problems?
(b) Only a very few smart short sellers investors read all the footnotes and figured this
(c) Where is Ray Dirks when we need him? Well he got in big trouble with the SEC for
doing a good job.
Prof. Hillman Business Associations Page 87 of 87
(3) Insider Trading
(a) Top officers of the corp du mped HUGE amounts of stock before this all became
public but those were public sales. Market should have reacted.
69) What Minority SH need to do at the OUTSET through Bargaining:
a) Right to Participate in Sale of Shares
i) Right to Salary as Employee
ii) Right to Dividend Pay ment
iii) See Clark v Dodge Case 75 and 25 percent shareholder negotiated a SH agreement that
assured the minority SH a certain level of inco me, (25% o f income either as a salary or a
70) Review Session
a) Review session is optional
b) Will not talk about the exam
c) Can talk substance
d) If you want to ask a question tomorrow:
i) If you want to ask about a statute or a case REREAD it
ii) Don‟t just look at your notes and say “I have a question”