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					Corporations Class Notes                            Gerald R. Prettyman                                                  7/11/2011


January 14, 2004 ............................................................................................................................. 4
  Introduction to Corporations, “Business Associations”.............................................................. 4
     Professor.................................................................................................................................. 4
     Course Information ................................................................................................................. 4
     Briefing cases:......................................................................................................................... 4
     Background to Corporations, “Business Associations” .......................................................... 4
     Principles of Agency Law....................................................................................................... 4
     Agents ..................................................................................................................................... 4
     Principals................................................................................................................................. 5
     Business Entity Forms ............................................................................................................ 5
     Business Association Structure ............................................................................................... 5
     Corporation Structure - Three tiers ......................................................................................... 6
     Richert v. Handly - Sweat equity ............................................................................................ 6
     Hierarchy of Dissolution ......................................................................................................... 7
     Statute...................................................................................................................................... 7
     Order of Repayment on Dissolution ....................................................................................... 7
     Law Firms ............................................................................................................................... 7
January 21, 2004 ............................................................................................................................. 7
  Review ........................................................................................................................................ 7
     KPW........................................................................................................................................ 7
January 28, 2004 ............................................................................................................................. 8
  Basic Principles of Federal Income Tax ..................................................................................... 8
     Corporate tax rates - marginal and average ............................................................................ 8
     Individual tax rates - the deduction game ............................................................................... 8
     Estate and gift taxes ................................................................................................................ 9
     Taxation of different business forms ...................................................................................... 9
  Limited Partnerships, LLC‟, & Introductions to Corporations ................................................... 9
     Limited Liability Corporations, p. 199 ................................................................................. 11
February 4, 2004 ........................................................................................................................... 11
  Chapter 5, p. 222, Development of Corporate Law in the United States ................................. 11
  Chapter 6, p. 258, Formation of a closely held corporation ..................................................... 12
     Problems of Incorporation .................................................................................................... 13
February 11, 2004 ......................................................................................................................... 14
  Corporate Finance - Part I ......................................................................................................... 14
     Debt & Equity Capital........................................................................................................... 14
     Problem Review .................................................................................................................... 16
February 18, 2004 ......................................................................................................................... 17
February 20, 2004 ......................................................................................................................... 20
February 25, 2004 ......................................................................................................................... 23
     Galler v. Galler...................................................................................................................... 23
     Zion v. Kurtz ......................................................................................................................... 23
     Shareholder Voting and Agreements .................................................................................... 24
February 27, 2004 ......................................................................................................................... 26
  Problem 7 (MPRE) ................................................................................................................... 26
  Martha Stewart - Fraud charges dismissed ............................................................................... 26
     Management and Control - Part 2 ......................................................................................... 26

                                                                Page 1 of 65
Corporations Class Notes                            Gerald R. Prettyman                                                  7/11/2011


March 10, 2004 ............................................................................................................................. 30
  Publicly Held Corporations....................................................................................................... 30
March 12, 2004 ............................................................................................................................. 32
  Corporate Governance – 2000 (p. 701)..................................................................................... 32
  The Fall of Enron ...................................................................................................................... 32
     Dominoes begin to fall:......................................................................................................... 32
     “Special purpose entities” – the art of hiding the ball .......................................................... 32
     Sarbanes-Oxley ..................................................................................................................... 32
March 13, 2004 ............................................................................................................................. 34
  Practice exam review ................................................................................................................ 34
     Thought process…. (Show the details of how you thought out the problem.) ..................... 34
     Review of material so far… .................................................................................................. 34
March 17, 2004 ............................................................................................................................. 37
  Proxies....................................................................................................................................... 37
     Caterpillar.............................................................................................................................. 38
March 19, 2004 ............................................................................................................................. 40
March 24, 2004 ............................................................................................................................. 42
March 31, 2004 ............................................................................................................................. 45
  Rule 10b-5, Insider Trading ...................................................................................................... 45
     ENRON - The General Scheme ............................................................................................ 46
  Review of Problem 12............................................................................................................... 47
April 7, 2004 ................................................................................................................................. 48
     Section 21A - Civil Penalties for Insider Trading ................................................................ 48
     Section 20A - Liability to Contemporaneous Traders for Insider Trading .......................... 48
     Section 16(b) ......................................................................................................................... 49
     Basic Inc. v. Levinson, 485 US 224 (1988), p. 1091 ............................................................ 49
     The Efficient Capital Markets Hypothesis, Note 2, p. 1107 (ECMH).................................. 50
April 14, 2004 ............................................................................................................................... 51
  §16(b) ........................................................................................................................................ 51
  Indemnification ......................................................................................................................... 52
     Defined.................................................................................................................................. 52
     Attorneys fees ....................................................................................................................... 52
     Settlement.............................................................................................................................. 52
     Rational ................................................................................................................................. 52
     Choices.................................................................................................................................. 52
     Merritt--Chapman & Scott Corp. v. Wolfson, 321 A.2d 138 (Superior Ct. Del. 1974), p.
     1134....................................................................................................................................... 52
  Takeovers .................................................................................................................................. 53
     The Beginning of the Takeover Movement .......................................................................... 53
     Cash Tender Offers ............................................................................................................... 54
     Leverage Buyouts ................................................................................................................. 54
     §B. Defenses to Hostile Takeovers - State Legislation, p. 1176........................................... 54
April 21, 2004 ............................................................................................................................... 54
     Final Exam Context .............................................................................................................. 54
     Takeovers, Part 2................................................................................................................... 55
  Chapter Sixteen – Corporate Books and Records ..................................................................... 57

                                                                Page 2 of 65
Corporations Class Notes                            Gerald R. Prettyman                                                  7/11/2011


April 24, 2004 - Final Review ...................................................................................................... 58
  State bar exam questions........................................................................................................... 58
  Management & Control – Shareholder Voting and Agreements .............................................. 59
     Voting Styles......................................................................................................................... 59
     Share transfers....................................................................................................................... 59
     Valuation & buy-sell agreements.......................................................................................... 59
     Modern Remedies for Oppression, Dissension or Deadlock ................................................ 59
     Actions by D&O ................................................................................................................... 59
     Social Responsibility of Corporation .................................................................................... 60
     Who Controls the Corporation? ............................................................................................ 60
     Efficient Capital Market Theory ........................................................................................... 60
     Institutional Investors............................................................................................................ 60
     Outside directors ................................................................................................................... 60
     Business Judgment Rule/ Director‟s Duty of Attention ....................................................... 60
     Corporate governance ........................................................................................................... 61
     Sarbanes Oxley ..................................................................................................................... 61
     Proxy Regulation................................................................................................................... 61
     Securities Exchange Act of 1933 §§ 14(a), 12(a), 12(g) ...................................................... 61
     Proxy Regulation................................................................................................................... 61
  Duty........................................................................................................................................... 62
  Rule 10b-5, Insider Trading - Fraudulent Transactions ............................................................ 63
     Enron ..................................................................................................................................... 63
     Chiarella ................................................................................................................................ 64
     14e-3(a) & 10b-5................................................................................................................... 64
     §16b short-sales..................................................................................................................... 64
     Basic - relevant standard of materiality ................................................................................ 64
     The Private Securities Litigation Reform Act of 1995 ......................................................... 64
     Securities Litigation Uniform Standards Act........................................................................ 64
     Indemnification ..................................................................................................................... 64
  Takeovers .................................................................................................................................. 65
  Defenses: ................................................................................................................................... 65
     State Legislation - prevent the loss of business and jobs, constituency acts. ....................... 65
     Poison Pills - Moran.............................................................................................................. 65
     Lockup provisions................................................................................................................. 65
  Books & Records ...................................................................................................................... 65




                                                                Page 3 of 65
Corporations Class Notes           Gerald R. Prettyman                           7/11/2011


January 14, 2004
Introduction to Corporations, “Business Associations”
Professor
Associate Professor Marc H. Greenberg, Director of the Intellectual Property Law Program;
Office: 536 Mission Street, Room 2323
Office Hours: Monday and Wednesday 1:30 - 2:30 p.m. and by appointment; Telephone: (415)
442-6611; Email: mgreenberg@ggu.edu
Course Information
Film Clip: “Wall Street”, Mike Douglas
Friday meetings: 2/6, 2/20, 2/27, 3/12, 3/19
Cybercampus: Problem method approach to the class; post response by Tuesday night in a short
outline fashion.
Briefing cases:
What is the court?
When was the trial?
Who are the parties?
What were their relationships to each other?
What was the procedural history (holding & why)?
Background to Corporations, “Business Associations”
Why Incorporate: Avoid personal liability, or raise money by selling an ownership interest in the
business.
Distinguish “public” corporations (ownership interest available to the public) from “c losed”
(closely held=private) corporations.
Partnerships and LLP‟s are closely held unincorporated associations.
Corporations law is driven by statute, pp. 2-3.
Principles of Agency Law
Agents
Defined, Restatement (Third) of Agency §1.01, Supp. p. 1 , Text, p. 4; Agency is the fiduciary
relationship that arises when one person (a “principal”) manifests assent to another person (an
“agent”) that the agent shall act on the principal‟s behalf and subject to the principal‟s control,
and the agent manifests assent or otherwise consents so to act.
Agency is the placing of responsibility by one person for the acts of another person (not
including children and parents). It is a relationship of trust. Thus, an agent cannot go onto work
in competition for the principal as that violates the trust and scope of authority. Other duties of
the agent is to carry out what they are asked to do in a competent fashion. An agent must meet at
least the standard of competence and skill (tort law) in this locality, just like medica l care. An
unpaid agent may have a lesser duty.
Duties of the Principal back to the agent, §2.5, act in good faith, cooperate, and don‟t interfere
(no micromanagement).
The key distinction of independent contractor to agents is who controls the work environment
and experience.
A principal is for the agent‟s torts, but not those of the independent contractor.
How much authority is given to the agent? A president is an officer of the company, but is still
an agent of the company since the authority of president binds the company‟s responsibility, text,
p. 5, Supp. p. 7. Express authority.
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Corporations Class Notes            Gerald R. Prettyman                             7/11/2011


What is the scope of the authority? What if a president takes contractual acts without authority of
the board? The president‟s scope of authority is granted by the board. Actual authority, §2.01
Apparent Authority, Supp. pp 7-8, deals with the authority that the agent conveys to third parties.
Thus, a paralegal conveys Apparent Authority to a third party by virtue of using the position in
the name of the principal. A third party may not rely solely on the words of an agent for the
authority of the agent, e.g., parent-child-doctor)
Inherent and Incidental Authority -
Inherent Authority - A badge and a gun are inherent authority, the nature of the office creates the
authority.
Incidental Authority - Acts that are incidental to performance of the assigned task.
Implied Authority - involves a course of dealing over a period of time where there is apparent
authority. Lack of notice may be a basis for an authorized grant of autho rity. The principal must
advise the third-parties that the agent no longer as authority.
Principals
Three types §1.04, (1) disclosed - the name of the principal is known; (2) partially disclosed - the
capacity or role of the principal is disclosed, but the name is unknown; (3) undisclosed, the agent
says they are working for an undisclosed principal, such as an auction-buyer, unborn
beneficiaries, straw man property purchasers working for a developer.
Respondeat Superior §2.04, - “let the superior respond,” vicarious liability, the employee is
acting on behalf of the employer so the employee‟s acts will be attributed to the employer.
Termination of agency relationships, §§3.10, 3.11, the employer must advise (give notice) to
third parties that the employee not longer has authority to act for the employer.
Problem, p. 8 - A contributes $100,000 capital, B works the enterprise AB Software stores. Is B
an agent of A? B is not putting any money in, and A has veto power. B is putting in time and
effort, a.k.a., sweat equity. This is the usual start- up business scenario. This is a partnership. A &
B have agreed to equally split the profits, and B will be paid $3000 each month. The profit
contributor will sometimes receive more at first until they get back their investment.
Business Entity Forms
Sole Proprietorships - all the risk, and all the profits, owned by one person; get a business license
and a tax ID (to hire employees).
General Partnerships (UPA 1914) - two or more people doing business together sharing and
spreading out the liability exposure.
Limited Liability Partnerships (LLP) and Limited Liability Company (LLC) - where people want
to be partners, but can‟t afford liability; developed in the last 24 years as a compromise to allow
people to have day-to-day responsibility running the business without the liability. Not much
case law yet. There are disadvantages to the LLP.
Insurance is the best shield, people will try to “pierce the corporate veil.” The best purpose of a
corporation is to raise money for the company and limit the investor, shareholder, partner
liability to the amount invested.
Traditional Liability Partnerships (LP) - finite limitation of existence, the partnership is dissolved
at a specific stated time to return the partner‟s equity, while they get annual payments. Made
with OPM - other people‟s money.
Corporations - has an indefinite existence without a specific dissolution date.
Business Association Structure
Nothing is needed in writing or filing to set up a General Partnership, except for a legally
required K-1 tax return for the IRS. The UPA governs most GP‟s. California has statutes which
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Corporations Class Notes            Gerald R. Prettyman                             7/11/2011


are a restatement of the UPA. These govern what happens if there is not a written agreement.
One problem under the UPA is that in the event of a partner‟s death, the partnership dissolves.
Tell the client in writing to put the partnership in writing. See Nolo Press for Partnership
Agreements.
Limited Liability Partnerships and Companies are all required to file initial creation documents
with the Secretary of State. A failure to file invalidates the LLP or LLC. Failure of an attorney is
malpractice. There may also be county filings (fictitious business name, etc.) To dissolve these
entities also requires a filing. The first filing is with the Franchise Tax Board to show payment of
taxes.
The Articles of Corporation must be created and filed with the Secretary of State. Bylaws and
Organizational Resolutions are required to be created, but are not required to be filed with the
State or Federal government. Failure to create these documents and keep them up to date can
cause failure of the corporation and personal liability.
The federal government comes in where a corporation will solicit public funds (IPO).
Private companies issuing shares must file their intent with the State.
Corporation Structure - Three tiers
Shareholders; Board of Directors (managing members of the board), Officers acting under the
direction of the board who may, or may not own shares.
Contractual Theories of business associations - not the case!
Partnerships - The Basics
Definition: UPA §6, two or more people doing business and sharing the profits.
Duck test UPA §7 (Supp p. 17)
The Need for a written agreement.
Different ownership interests are perfectly OK, and can change over time. The allocation of
(profits and losses) can be unequal among the partners, but must be fair. The share of losses
cannot be different than the share of losses for the same partner. Partners get income as „draw,‟
there is not a salary for partners. Whatever is left at the end of the year can be disbursed.
Joint and Several Liability, §§9, 11, 12 13 ,14, 15 & 17.
Any partner can create a liability for the partnership. Individual assets are liable to the
partnership.
9 Partner is an agent
11 Partner binds partnership
12 Partner creates liability
14 Breach of trust
15 Joint & several liability
17 Partner coming in is liable for past debts to their share of the full interest they contributed had
before and then have thereafter..
22 Each partner has a right to an accounting.

Richert v. Handly - Sweat equity
Washington Supreme Court, 1957
Capital by one, sweat by the other, w/ agreement to split profits, but w/o agreement on losses.
Richert thought that Handly would be paid after he was repaid his original investment. The court
said, no. Without agreement in writing for losses, the losses are shared.
Capital was $26,900; expenses were $26,800. Richert had received $10,000, and the court said
he was due $6,000 more from Handly to share the loss.

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Corporations Class Notes            Gerald R. Prettyman                           7/11/2011


The loss is shared at the beginning, not at the end.

Hierarchy of Dissolution
Statute
Under California law, if 50% of the partners want to leave (regardless of ownership) then the
partnership must dissolve unless the Partnership Agreement states otherwise. Expulsion of a
partner may therefore cause dissolution of the partnership.
Order of Repayment on Dissolution
   1. Third party creditors get paid first.
   2. Repayment of money loaned to the partnership
   3. Capital - a partner‟s contribution (decide these values at incorporation) at incorporation
      and capital calls during the partnership attached to the partnership agreement.
   4. Profit distribution based on the agreement
Law Firms
Compensation Structures
Origination Credit - Partners who bring in business get to keep 10% of the billing for so me term
(or life of the client)
Marketing - the rainmaker, who brings in the business.
Associates and Partners
Two-tiered partnership: Income partners - work for a salary but don‟t share profits; Equity
partners- rainmakers who bring in business.
January 21, 2004
Review
Two-tier attorney structure
Contract attorney - attorney hired on a contract basis as hourly or paid to work on a specific
project..
„Of Counsel” used to mean a senior attorney who retired but yet had space in the office. Now the
term means any loose association of an attorney to a partnership. This has created questions of
agency and partnership, such as the use of business cards, or stationary. Some firms use people
as independent contractors and call them „Of Counsel.”
Payment schemes - salary, share by productivity or seniority, pension..
Bane v. Ferguson

KPW
The general partner has the liability to the bank, but does he have liability to the investors? Can
the limited partners se Kent since he is the general partner. No, this is a nature disaster, and Kent
has not performed any wrongful act, therefore, he is not liable to the partners.
Is the KPW firm liable to the bank? Kent and their ownership interest were in the (course and)
scope of his partnership business. Therefore, KPW has a fiduciary duty to the limited
partnership, but the question of whether that liability extends to the bank is uncertain. The
question is whether KPW had other course of dealing that showed apparent authority of KPW for
Kent to act as a general partner for a client.




                                            Page 7 of 65
Corporations Class Notes           Gerald R. Prettyman                           7/11/2011


LP partners lose LP status if they take a management position. The LP partners lost their $500K
when the last was destroyed. If this was a recourse loan, then the bank can try to pursue other
assets. If this was a non-recourse loan, the bank is SOL.

Where there is a LLC, lenders will want a personal guarantee of the officers. Most law firms
have this problem with the LLP and the lease. Thus, most partners have to sign personal
guarantees for the lease.
Duties of partners to each other. See Meinhard, etc.
Partnership Accounting, p. 93
Equity and Balance Sheets - Four factors
Business has to be separate entity
Entries are in dollars for US companies (euro dollars in the US)
All transaction need to show up in two ways (double entry)
Loans are on the left as cash on hand, and on the right as a liability.
Leased equipment is on the left as an asset, and the lease is on the right as a liability.
Profit and loss statements.
Cash flow analysis.

January 28, 2004
Basic Principles of Federal Income Tax
Corporate tax rates - marginal and average
Corporate tax rates are referred to as marginal (the highest applying rate) and average(the
average tax paid for all the income.)
Corporations pay taxes separately on their income from the income of the shareholders, who also
have to pay tax on it. The corporation files it own tax return. There are different subchapters, C,
S and K in the tax code. C and S apply to corporations, K applies to partnerships (hence the term
K-1). The rates in the book, page 162, are for S-Corporations. Tax rates are called mildly
progressively since the tax rates go up incrementally as income goes up.
Individual tax rates - the deduction game
Deductions
Home mortgage interest payments are deductible as public policy to encourage home owner ship
and public stability.
The top marginal rate was 90%. In the 1980‟s that was reduced to 26%, but has now crept up to
about 26%.
Self-employment tax is for those self-employed, about 11%, plus income taxes. This is offset by
the business deductions that a person can take.
The theory of basis, capital gains and losses
Gains from investments are called appreciation, which is the difference between the cost as
acquired (Basis), and the value received when transferred (sold). For income purposes, this is the
capital gain.
Capital losses do not occur frequently in residential real estate, but do occur more frequently in
commercial real estate according to the occupancy rates. Capital losses are deductible fully
against capital losses, but only up to $3000 against income.



                                           Page 8 of 65
Corporations Class Notes             Gerald R. Prettyman                             7/11/2011


Estate and gift taxes
In estate and trust law, step- up refers to the change in basis for the heir at the time of death of the
decedent. This step-up applies from parent to child and through multiple generations.
Taxation of different business forms
Unincorporated business forms
Proprietorships
Proprietorships show on the owner‟s income tax, and are taxed as ordinary income to the owner.
Partnerships
Partnerships, both General and Limited, are not taxed by themselves. The income and expenses
are „distributed‟ to the partnerships. The partnership files a K-1 Informational Return for itself,
and then for each of the partners. The partnership does not pay separate income, but does „retain
earnings.‟ The retained earnings are held and listed against liabilities, and taxed to the individual.
Limited Liability Companies
In Limited Liability Companies, the income is taxed as if it were partnership income.
Corporations
Corporations pay income tax on their income. As a viable business, companies have to retain
earnings for continued operations.
C-Corporation shareholders also pay tax on the dividends, so that gives the problem of double
taxation. S-Corporations try to get relief by „zeroing out,” and paying out virtually everything as
expenses.
Subchapter S-corporations are pass-through corporations were the income goes directly to the
owners. This avoids the double taxation problem of C-corporations. A publicly traded
corporation cannot qualify as a sub-S corporation. The S-corporation is also limited to 75
shareholders.
Flat Tax Proposal
Drops all deductions and each person pays the flat percentage income tax.

Limited Partnerships, LLC’, & Introductions to Corporations
Limited Partnerships with Corporate General Partners - from small
companies to large investment vehicles and how investment tax credits affect
this option.
Investors in closely held corporations are locked in and unable to liquidate until the termination
date. The classic limited partnership was the family who would fund a younger generation in a
venture.

In the 1970‟s the Limited Partnerships boomed, as the investment tax credit allowed investors to
invest for a period of time, and deduct losses in the partnership (oil & gas companies), over the
amount of the investment cost. The IRS closed this loophole in 1985. Many of the non-real estate
partnerships then folded.

LP‟s are closely held, so the investor cannot liquidate. An investor can only leave the LP by
termination of the LP, or by being bought out by the other partners. An LP can convert into a
closely held corporation by unanimous investor consent.



                                             Page 9 of 65
Corporations Class Notes             Gerald R. Prettyman                             7/11/2011


The dance in LP‟s was who was going to be the general partner subject to all liability. The
incentive before was that the GP got money, and more units, but the liability was still too high.
Then the idea developed for the GP to be LLC itself. Thus, the largest owners of an LP form an
LLC as GP. There are still problems for fiduciary duty.

Liability per ULPA §303, and how to lose this status
The 1976 §303 revised the 1916 section. Formerly, where a GP might be paid with two units of
interest, and an LP has more units, the LP might object, but under the 1916 rules, any
interference in management was construed cause the loss of the LP‟s limited liability status. The
new §303 defines control of the business. Thus, advice, surety, suit and meetings are not
participation. These are items regarding crisis management.


In re US Cafes, L.P Litigation, p. 182
The Wyly brothers were the owners of USCafes, Inc. which was the GP of the US Cafes
Partnership. They sold the partnership to Metsa, and the partners sued with allegations that the
brothers/GP owed a duty to the partners, and that the brothers accepted $16 million as side
payments to sell the partnership below a fair price. The Wyly‟s defended on the principle that
they owned a first duty to the GP. The court disagreed, saying that the corp. as GP owed its duty
to the partners.

Master Limited Partnerships and the Kintner Regs, p.187
The Kintner regulations set forth the test of whether a master limited partnership would be
treated as an association taxable as a corporation or as a partnership. These regulations identify
six characteristics that are found in a pure corporation which, taken together, distinguish it from
other organizations. „ These characteristics are: “(i) associates, (ii) an objective to carry on a
business and divide the gains, (iii) continuity of life, (iv) centralization of management, (v)
liability for corporate debts limited to corporate property, and (vi) free transferability of interests.
Where a business interest is available for sale to the general-public, then the company is taxed as
a C-corporation, no matter what business form is adopted.
The Kintner Rules created a cottage law industry for interpreting the regs, and suing people.

Check the Box - clarifying Kintner, p.190
(1) Creation under a corporate statute means the company is a corporation.
(2) A company not created under a corporate statute and with at least two members may select its
status on its first tax return.
(3) A company with one member will be taxed as an individual unless it elects for taxing as a
corporation.
(4) A company may only change its status once every 5 years.

Limited Partnerships in the 21st Century, p. 191

In re Spree.com Corp. p. 194 - “What do we want to do with this puppy?”
A venture capitalist made less than flattering statements to the Wall Street Journal. The VC
confidentiality agreement prohibited him from revealing confidential information. Issues: (1)
Was he bound to the agreement? (2) Did he breach the agreement?
                                            Page 10 of 65
Corporations Class Notes            Gerald R. Prettyman                            7/11/2011


“Puppy” was irrelevant. He was bound to the agreement, but he did not say anything that anyone
did not already know.

Limited Liability Corporations, p. 199
Background
These give the flow-through and management of partnership. In LLC, the owners are called
members. Management of the LLC can be done by the members, or by an appointed manager.
Each state has different rules for structuring an LLC. Some states require filing of an organizing
statement (article of corporation). An operating agreement is also required. There might also be
bylaws.
LLC‟s are very flexible since the idea is to avoid formality. This can create uncertainty in
operation. There is not a requirement for investor meetings. Some investors are not involved in
the operation of the business. The law is silent about meetings and information dissemination.
Thus, is there any basis to invalidate the liability veil to go after the individual members? So far,
the answer is yes, and for the same reasons that the corporate veil may be pierced.
Features of an LLC: Limited liability, Partnership tax features, management choice, and creditor
protections, p. 203. Note 3.
It is hard to convert an LLC to IPO since assessing the company‟s worth is difficult.
The Uniform LLC Act
Adopted in 7 states, others adopted their own versions.
Contract Rights and obligations of LLC’s.
Elf Atochem North America, Inc. v. Jaffari and Malek LLC
The corporations of Elf (of Pennsylvania), Malek Inc (of California) and Jaffari formed a
Delaware partnership called Malek LLC with a written agreement signed by the two firms &
Jaffari, but not „by‟ Malek LLC. All the players had signed, and the fact that it was a different
entity did not matter. Not all jurisdictions agree here. The rule is make sure that everyone signs.
Absent an operating agreement limiting member authority, any of the members may bind an
LLC.

Poore v. Fox Hollow Enterprises
Since an LLC is a fictional, but legal entity, a non-attorney for the corporation may not appear or
conduct business in court without representation of licensed counsel.

Problem Review
Managers - a one-year term is common but not everyone wants to manage.
Meetings - At GGU faculty meetings, participation by mail or telephone is not permitted, only
personal attendance counts.

February 4, 2004
Chapter 5, p. 222, Development of Corporate Law in the United States
History
Corporations started as 19th century vehicles for raising money from investors for business
development and growth. Centralized management was another key. In the mid-19th century,
limited liability was not necessary since few lawsuits were filed over business practices. Federal
corporation law would exceed the scope of the Commerce Clause for intrastate businesses. Also,
                                            Page 11 of 65
Corporations Class Notes            Gerald R. Prettyman                            7/11/2011


local governments would be faster to respond to local business needs. State corporation is
somewhat an anomaly in that companies can incorporate in states where they do not do business.
Delaware
Delaware is popular to incorporate because the state is small and reacts q uickly. Population =
548K, 733 lawyers, 423 in private practice. The state legislature reviews its laws annually. Its
judges know corporate law. See the Dole Proxy. The Chancery Court is a specialized court.
However, Delaware also issues a tax based on the number of shares. California judges do not
understand corporate business litigation. Delaware judges do understand corporate business
litigation. The Fed. Ct. is similar for handling IP cases.
Flexibility
Delaware law attempts to be flexible, and isn‟t necessarily bias against shareholders.
Chapter 6, p. 258, Formation of a closely held corporation
How to Incorporate, p. 259
A company can incorporate in any state, but the best option is to incorporate in the state where
you do business, whether that is your domicile or not. A company can change its incorporation
state, but its not time consuming.
Normal practice is to reserve three names. A corporate name reservation does not give trademark
rights. If the Secretary does not find any similar names, then the company has 60-days to register
the name, first by preparing the article of incorporation.
A corporate name may include Incorporated, Inc., or Ltd (for the British feel), and that suffix
must be used in all communications.
California requires a purpose clause, which may result in an ultra vires act unless the clause is
not too definite.
An agent for service of process receives documents in the event of lawsuit. Could be the
president, vice-president, or secretary.
The articles if incorporation states who the person is. The attorney who sets up the company may
not have later contact with the company. Thus using the attorney who sets up the company is
difficult if the company does not keep contact with him.
A corporation usually sets up a single type of stock as stated in the articles of incorporation.
More shares can be issued later, but an amendment to the articles of incorporation is needed.
A powers clause identifies the powers to the offices of the incorporation, but a powers clause is
not required, and is oft a problem for limiting an officers ability.
There is not a minimum number of shareholders, nor is there is not a minimum amount of
capitalization,
Articles of Incorporation
Statement of Domestic Incorporation - identified the names of the directors, and officers, of the
corporation, which is filed with the Secretary of State.
Initially only the articles of incorporation must be filled with the Secretary of State along with a
$100 fee (in California), along with annual changes. The bylaws and other documents are not
required. The corporation must also pay an annual Franchise Tax Fee, which is an advance tax
fee. The fee can be recouped in that tax year, but does not rollover into the next year.
Bylaws and Organizational Minutes
Do not use boilerplate forms. Bylaws explain how the company is going to run, the number of
meeting, the various offers, etc. The bylaws can also handle the transfer of shares.


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Misc. Features of the Organizational Minutes
Organization resolutions (minutes) are the report of the first meeting of the directors, names,
compensation, issuance of stock, distribution of stock, capital contribution. 26 USC 1244
Corporate Stock Rules; Election of type of subchapter, S or C. Number of shares being issued,
par value of the shares.
A closely held corporation can issue stock to its shareholders without going through the SEC by
requesting permission from the California Commissioner of Corporations, under California Corp.
Code §25102(f).
Ability of officers to sign documents. Annual set of minutes of the corporation‟s activities.
Corpex - Sells Corporate Minutes Book, Stock Certificates, Corporate Seal, and Stock Tracking
Log in a nice embossed book.
Issue the stock, based on its par value, and who is receiving it.
The Legend is the words written on the stock that limit the transfer of the stock.
You can‟t sell stock in a closely held corporation w/o offering to the corporation, and the
shareholders. If no one wants to buy it, no one else may buy it. It is not saleable.
Ultra Vires in the Model Business Corporations Act (1984)
The doctrine of Ultra Vires is that a corporation should not be able to claim limited liability for
acts outside of the course and scope of the corporation.
Such cases typically arose when the company allowed such conduct. Shareholders do not want
the company to have liability for those acts, but rather, let the officers accept responsibility for
their acts. The manner of eliminating ultra vires cases was to change the scope of the purpose to
be general, as the California law states. Such purposes still allows for personal tort actions
against officers and directors to protect the investors. The purpose of such laws is to promote
investment by limiting liability of the investors to their investment.
711 Kings Highway Corp. v. F.I.M.'s Marine Repair Serv., Inc., p. 277
Ultra Vires allows the state or the shareholders to sue a company under ultra vires, but not a third
party. Options: (1) The third-party becomes a shareholder. (2) The contract includes a provision
that the corporation represents that it is authorized and entitled to enter into the agreement, and
presents a resolution signed by the directors authorizing the agreement.
Theodora Holding Corp. v. Henderson, p. 280
Corporate gifts are permissible where reasonable and are encouraged in the interest of public
improvement, up to 5% of gross income. A shareholder cannot use the doctrine of ultra vires to
prevent reasonable and legal acts by a corporation.
Problems of Incorporation
Two types of problems
(1) Premature Commencement of Business Promoter
(2) Defective Incorporation
Issue: May the promoter be held liable for doing business too early, or filing incorrectly.
Rule: A promoter owes a fiduciary duty to the shareholders.
(1) Premature Commencement of Business Promoter
The scope of these fiduciary duties is on Post (p. 286). Post v. United States, 407 F.2d 319, (D.C.
Cir. 1968)
A promoter owes significant fiduciary duties to other participants in the venture. By elementary
legal principles, promoters stand in a fiduciary relationship exacting good faith in their intra-
company activities and demanding adherence to a high standard of honesty and frankness. Not
the lesser of the promoter's manifold responsibilities outlaw secret profit making and command
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Corporations Class Notes           Gerald R. Prettyman                            7/11/2011


the dedication of corporate funds to corporate purposes. And it cannot be doubted that promoters
of stock corporations who employ the mails in deceitful violation of their fiduciary obligations
may incur the full condemnation of the law.
* * If the promoters intentionally diverted funds to their own use, then they are personally liable.
Most cases are injured persons going after the promoter. Suppose the corporation makes a deal
before incorporation that binds the corporation. The corporation may then use if the promoter
violated his or her duty to the soon-to-be corporation.
Stanley J. How & Assoc., Inc. v. Boss, p. 288
Conditions for suing a promoter: Representation, and evidence of authorized representation. N.B.
An expectancy cannot be bound when it never existed.
Quaker Hill v. Parr
Everyone expressly understood that only the corporation would be bound, so the plaintiffs could
not change their position afterwards to seek liability from the promoter. Moral: Promoters need
express contracts for all players in the corporate transaction that only the corporation will be
bound to the liability.
(2) Defective Incorporation - Why don’t they just wait (or follow through)
Robertson v. Levy, p. 297
Levy did not wait for the acceptance by the Secretary of State, so he made himself personally
liable.
Is there such a thing as a de facto corporation? What was the intent of the parties? A court may
permit a de facto corporation in the event of a failure by the state.
Frontier Refining Company v. Kunkel's, Inc., p. 310
When is a partner not a partner? The court was uncomfortable imposing liability on the outside
partners when the corporation was defective, and Frontier violated its own procedures.

February 11, 2004
Corporate Finance - Part I
How to acquire Other People‟s Money
Debt & Equity Capital
Debt capital is the money who have that you borrowed.
The basic formula to remember is that the market value of property (P) minus the market value
of debts (D) that are a lien against the property equals the owners equity in that property: P-D =
Equity
Equity capital is property that you own, and is made of 3 elements
     Initial contributions by the original entrepreneurs
     Capital contributed by subsequent investors (selling stock) in exchange for ownership
        interests (equity securities)
     Retained earning of the company (income earned but not yet spent or otherwise
        allocated)
Assets (cash, furniture, etc.) - Debt (loans) = Equity
The words stock and shares are interchangeable. A share represents a unit of proprietary fraction
in the company, based on the equity that the company has. MBCA §1.40(21)
Stock is usually issued as one class, referred to a Common Stock. All shares in a class must have
the same rights (voting, distribution, etc.)


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If the corporation issues only one class of shares, they are known as common shares, or capital
shares, or simply shares or stock.
For the corporation to operate sat least one share of stock in each class must be issued.
Common Shares
Holders have the right to vote for directors and on other shareholder matters.
Holders are entitled to net assets of the corporation when distributions are made in the form of
dividends or liquidation.
Holders‟ shares can increase or decrease in value.
Shares are negotiable but are subject to limitations in closely held corporations because the
shares cannot be publicly sold in a closely held corporation.
Shares can be pledged or hypothecated (transferred) but are subject to limitations in closely held
corporations because the shares cannot be publicly sold in a closely held corporation.
Income comes in dividends from current or retained earning or distribution from capital of the
corporation. These are the same sources for preferred stock.
Preferred Stock - Privately Held
The preference applies to a right of distribution. The benefit is that the distribution to preferred
shareholders is for a fixed amount or a percentage of earning, usually capped, and must be paid
to them first before common shares receive any dividend or distribution. The downside is that
only the fixed amount must be paid, so if the stock does very well, common stock holders enjoy
more gain than preferred holder.
Preferred stock is usually non- voting.
Special rights of publicly traded preferred stock, p. 386
Cumulative dividend rights
Voting rights if dividends are not paid
Liquidation preferences
Redemption rights, such as when Levis bought all the public stocks to return the company to
being privately held
Conversion rights but not upstream, the ability to convert preferred status to common status. A
holder of common shares cannot convert common shares to preferred shares.
Protective provisions means protections against anything that would dilute the basic value of the
stock, and rights to dividends so that the company has to hold out funds to preferred dividends.
Participating preferred stock changes one element in that the holder also gets to participate in the
general rise of the stock price. Also called “Class A” Common Stock
Classes of Stock
Classes and series of preferred stock: There may be different elements of these rights broken up
and offered in different classes of stock, e.g., Class B, Class C, etc.
Classes of Common Stock - Common stock benefits may also be broken into different levels of
stock, Class A with voting rights, or Class B without voting rights.
Redemption Rights, Page 390
Generally in a Closely Held Corporation. there are no Redemption Rights at the option of a
shareholder. Such a stock would be nothing more than a loan.
Publicly corporations generally cannot have the right to recall all their common stock as this
would allow corporations to take the company private too easily.
Issuing Shares
The number of authorized shares found in the Article need not be the number of issued shares.
Generally, you should leave some shares in the co mpany.
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Corporations Class Notes            Gerald R. Prettyman                             7/11/2011


Par Value
Par value is an arbitrary dollar amount assigned to shares of stock representing the minimum
amount for which shares may be sold. A dollar a share or less is common now where par value is
used. You can also issue shares with no par value.
Watered Stock
If stock is issued and the recipient fails to either pay the par value, or only pays partial value for
the stock, those shares are called “watered” (diluted) or “bonus” or “discount” stock, which may
give rise to fraud claims if the value used to inflate the value of the corporation. Watered stock
dilutes the value of the company by showing that more stock value exists than the company
actually has in value. If a creditor relies on the representation, and the company fails to repay the
creditor, then the creditor may seek repayment from the holder of the diluted stock. This can also
be a basis for piecing of the corporate veil.
Share subscriptions, p. 391
Publicly traded companies file with the SEC. Subscription agreements are used for private ly held
corporations that are not required for SEC filings to provide information for prospective
investors of what the risks are. The subscription agreement assures that the investor is „qualified‟
in that the investor has to sign certain documents as proof that they can invest in the company.
Hanewald v. Bryan's Inc., p. 397
This is a classic example of under-capitalization. They took a loan and claimed it was a capital
asset, which it was not. This case applies the subordination rule via the use of MBCA §25
(1969). The lower court held that the corporation protected the Bryan‟s, and that the loan was
sufficient capitalization. This was error by the court because a loan is not capital.
Consideration for shares - what works, and what doesn’t work
Money works
Tangible personal property works for reasonable value assigned to it.
Intangible personal property might work if it is valuable
Labor or services previously performed are valid consideration for shares
Labor or services to be performed are not valid consideration for shares. However, the shares can
be placed in escrow and paid out as the labor or services are rendered. (Hanewald, 429 NW2d
414)
Promissory notes are not valid consideration for shares.
Par Value
Nominal par value is a popular method for share valuation because of the flexibility it affords.
For an example of the lack of flexibility caused by a fixed par value, see Torres (268 AD2d 253).
Par value only relates to the original issuance of shares. Subsequent shares are based on market
value.
A side effect of that trade creditors, knowing that the number of shares issued, or the par value is
not a valid representation of corporate finances.
Problem Review
The Purpose of Section 19 is to prevent share value dilution. The other basis is that Jackson
breached his fiduciary duty as promoter and committed fraud by issuing the shares to himself
without consideration. Also, preferred shares could be redeemed, but common shares cannot.
Can the majority render the other shares valueless without justificatio n? No.



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Corporations Class Notes           Gerald R. Prettyman                            7/11/2011


Debt Financing
Debt Financing through bonds and debentures. Debentures are unsecured corporate obligations.
Bonds are secured corporate obligations. Secured means the creditor has the right to seize the
asset and sell it off to pay off the debt. It is important to record the debt to prevent the owners
from taking on more debt than the worth of the security.
Registered bonds, zero coupons bonds, junk bonds.
Debt financing is a critical element of corporate finance, and is the primary finance vehicle after
initial capitalization.
Leverage - essentially borrowing as the use of other people‟s money to raise more money than
the cost of the money. The difference between the cost the return is leverage.
Tax treatment of debt, and the debt to equity ratio. Interest payments are deductible against
income, so people borrow money for the interest deduction, and the lender gets interest income.
The lender does not share any in increase in the interest. The state maximum personal interest
rate is 12%. Companies are not included in this requirement.
The thin corporation.

February 18, 2004
Review Sessions in Room 2202,
Saturday, March 13th, noon to 2 PM and Saturday, April 24th, noon to 2 PM
Email questions to Prof. Greenberg for review and quiz topics.
Problem Review
A loan to the corporation carries a repayment date, and a higher priority in the debt scale.
However, a loan is not an asset, but is a liability, so the corporation could be undercapitalized.
Most states do not allow promissory notes in exchange for stock, which gives watered stock and
liability.
(a) B did not make a contribution so he has watered stock liability.
(b) B has two future problems. First, is the loss of the value of his effort if A closes the business
before B completes 2 years, and second are potential questions as to whether his effort was worth
$100,000 to the corporation for the stock he will then receive.
(c) Promissory note gives watered stock unless state allows Promissory notes. What happens in
an early buyout? Re-calculate, or windfall for „B‟? Must re-calculate for effort given.
(d) What happens if there is a first. It‟s lawful to issue stock at different sale prices, but that
carries a problem at early dissolution. At subsequent stock issues, the price is based on the
market value of the company.
(e) B has equal voting power for a 1/10th of the price, and possible watered stock issue. Are
dividends then given by shares, or voting power.
(f) This is a thin corporation. It has more loans than capitalization.
(g) A has so much preferred stock that B has little chance of ever getting a dividend.
(h) Ten shares of common are issued to A and B for $100 each; A is also issued 5,000 shares of
preferred for $50,000 and lends the corporation the remaining $49,800. Selected
best by the class.
(i) Still have a watered stock disparity.

(h) Provides for adequate capital without watered stock. A & B have equal voting power. A gets
interest while the corporation gets an interest deduction. Ensures that the corporation is not
undercapitalized. Although A loaned 49,800 to the corporation, it was not the sole means of
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Corporations Class Notes           Gerald R. Prettyman                            7/11/2011


capitalization. And A gets a tax deduction for his loan to the corporation. (H) gives A and B
equal rights and it gives A priority to get paid first since he has some preferred stock.

H is best if subchapter S is not selected. There may still be a subordination problem. Option H
provides capitalization, equal voting power, distributions, and tax deductions. B has a job and
still gets a distribution.

Corporate Finance - II
Planning capital structure for a closely held corporation.
In addition to the items listed on pp. 414-415, what other considerations should the attorney
doing this planning take into consideration.
     What is the long-term goal? Closely- held, or go public (leave money in and be
        attractive)?
     How many classes of stock are needed? During the time the corporation is closely held,
        will additional stock sales be necessary?
     What are the expenses? What is the risk of undercapitalization during the next two years?
        Make proforma balance sheet for two years. Write down everything that will be an
        expense for the first 6 months, and then double that. That will be very near the true value.
     How do you handle the tax issues relating to non-cash contributions? Putting land into the
        corporation means that the individual must pay the capital gains tax for the transfer.
     How does the attorney handle dispute between initial owners of the corporation regarding
        capital structure issues? Potential conflict of interest problem. Need a waiver of co nflict
        letter signed by the clients so they understand they need to find individual representation,
        or waive it.
     Do the same problems regarding capital structure arise in planning for an LLC? No, LLC
        is different. Determine each parties‟ contribution. Can‟t be converted into IPO. Must go S
        or C first.
Going Public
      The process of going public (the IPO) carries risks, expenses, and is time-consuming. So
       why do it? The company can set the IPO price. Won‟t be directly related to the assets of
       the company. The IPO price will hopefully be higher than the capitalization price.
           o The money is often used to pay down debt. The IPO also allows insiders to sell
              their stock 6- months after the IPO, making the initial investment liquid.
           o The stock and information is then available to the general public, anybody can
              buy it, and full disclosure of all risk factors is then required.
      What issues prompted Congress to pass the Securities Acts of 1933, and 1934?
           o The Securities Act of 1933 requires registration of securities/ stock being placed
              in the hands of the public. If an investor is harmed by errors or omissions of
              information, remedies are available according to the act. The biggest risk in any
              IPO is better the marketing (optimistic) people, and the accountants and lawyers
              (pessimistic) people. Can‟t have puffing, though.
           o The Securities Act of 1934 created the SEC to handle these issues.
           o What are “blue sky” laws and what are their purpose? State regulations for
              complete disclosure of risk factors, in an effort to avoid fraud.
      What are the steps involved in taking a company public and registering its stock?


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Corporations Class Notes          Gerald R. Prettyman                            7/11/2011


          o The cost will be at least $150,000 since the attorney and accountant must review
            the books and documents to prepare the prospectus.
          o See page 421 for more requirements. This is essentially a house-cleaning.
          o Use a firm that regularly does this work since it is highly specialized with high
            stakes for error.
Exemptions
      What are non-public offering exemptions? Why do they exist? Most corporations do not
       go public, but do want to issue stock without going through IPO. An exemption allows a
       public to issue public stock without „going public.”
      SEC v. Ralston. Why do the disclosure and registration requirements apply to this stock
       transaction. Why doesn‟t this transaction qualify as an exempt one? Ralston said that they
       were only soliciting „key employees‟ but the composition of the group was not really
       „key employees‟ because they did not have information about the company to be able to
       understand the risks. The court said it was a public offering since Ralston did not provide
       sufficient information. Employee stock sales provide problems of coercion. A sole
       shareholder cannot avoid the requirements of the Act by selling the shares herself.
      Stock sales are either registered and sold by IPO, or they are exempt. There is not any in
       between sale to friends and family.
      Section 3(a)(11) of the Securities Act of 1933 provides an exemption for stock offerings
       limited to residents of a single state. What is the rationale behind this exemption? There
       is also a California statute. Rationale: No interstate commerce so no federal jurisdiction,
       state laws applies, greater chance of familiarity, easier to file suit, local ties to the
       community, and easier due diligence to investigate the company.
            o What is Regulation D? A way to allow you to offer stock in a closely held
                corporation if you met a number of exemption criteria.
            o Note the requirement for an “accredited investor” for §(230.)501(a) exemptions.
                Banks, IRS organizations, business trusts with $5MM+, any natural person with
                assets over $1MM, over two plus years of income over $200,000. The
                presumption is that if you are smart enough to get the money, you are smart
                enough to keep it. Get the person‟s acknowledgement of their accredited investor
                status in writing with a notary acknowledgement. This is a valid defense where
                the person later claims to not be an accredited investor, unless the information
                presented truly was fraudulent.
            o Note also the limitations §502(c)(d) on advertising and resale rights in order to
                qualify for an exemption from full registration. You can‟t advertise a closely held
                corporation‟s stock as for sale. Private placement ad might say. “Interesting
                business opportunity.” They are generally done by word of mouth. A private
                placement memorandum is not as detailed, but does provide market and risk
                analysis. A business plan may be present, but these are also available
                commercially for about $15,000. These are not made by lawyers. They are sold as
                „business contacts.” Too often these are scam operations. Word of mouth is still
                the best method.
            o §502(d) limits resale except for registration or exemption. There also must be
                legend statement on certificate that the stock is not registered.
            o Note the dollar limitations in §§504 & 505, and the lack of limitation in §506, and
                the limitation on the number of purchasers found in §505. See also Cal. Corp.

                                          Page 19 of 65
Corporations Class Notes           Gerald R. Prettyman                            7/11/2011


             Code §25102(f), which is the same as §505(d). Exemptions for limited offerings
             of less than $1MM. In part (b)(2)(ii) no more than 35 purchasers are permitted to
             limit the number of investors to small numbers of accredited investors. This is for
             each time stock is issues, not forever. These 35 could be natural people or
             companies, couples (as joint property), etc. The §506 unlimited dollar amount
             exemption still retains the 35 purchasers. Accredited investors are not counted
             towards the 35 in any calculation. §501(e)(iv).
           o Regulation A also provides a basis for an exemption for a small business stock
             issuance. Which to choose, see the analysis on p. 438.
           o Private offerings, rule §505. If more than $5MM then exemption will likely not
             apply so registration will likely be required.
           o If the investor is not truly an accredited investor, then the court may rescind the
             transaction, or re-characterize the transaction as a loan with interest due.
Smith v. Gross - Earthworms, pyramids, and ponzies
Gross made an offer to the Smith‟s. Is a Reg. D exemption applicable? No, there was not any
registration, nor accredited investor, nor adequate disclosure. The court sees this as a scam.
Gross had the proposal, and the regulations required full disclosure, even under full disclosure.
He did not want it characterized as an investment contract since he knows the trouble that will
follow. All unregistered, non-exempt investment contracts are illegal.
Stokes v. Continental Trust
Preemptive rights, What are they? What impact do they have in this case?
Continental Trust issued a second set of stock and sold it to another company- investor which
diluted Stokes‟ stock power. Stokes claimed that Continental Trust owned him the same number
as shares as he owned to maintain his stock power.
Katzowitz v. Sidler
Even if preemptive rights are available, the post-incorporation offer to issue additional shares can
be used to „freeze-out‟ a shareholder, which is an unlawful goal and result which a court will
typically reject.
Three guys were doing business with each other for 25 years, and they wanted a „divorce.‟ Since
the company owned them each $2500, two of the guys wanted to convert the debt to stock and
did so at a great discount. Katzowitz did not take his because he wouldn‟t add more money to the
company. Afterwards, they then had more share power than he did so when the company
dissolved, he lost the benefit. The lower court said it was OK, but the higher court ruled against
it since the shares were not issued at fair value.
Lacos Land v. Arden Group
Mr. Brisket is a major shareholder (4.5% of preferred stock) and president. He told the board to
issue stock with superior voting control to him so he would control the voting power of the
shareholders, or he would not agree to decisions to prevent takeover. On page 456 the court
noted the explicit threat that he made to the board. The court noted that he broke his fiduciary
duty. While his desire to protect the company was not so bad (recapitalization to give one person
control) his method was bad.

February 20, 2004
Shares in a closely held corporation are not open to the public, so the share‟s are illiquid. The
corporation may have a first right of refusal option for the shares (the shareholder must ask the
corporation first), or a corporation have a right to match any bona fide option from another
                                           Page 20 of 65
Corporations Class Notes            Gerald R. Prettyman                             7/11/2011


shareholder. These options held the corporation maintain stability and equality in shareholder
equity. This is particularly important in a corporation where the majority shareholder wants to
maintain that status.
Distributions by a Closely Held Corporation
Gottfried another bitter family corporation case, which turns on the definition a nd evidence in
support of a finding of bad faith refusal to issue a dividend. The Court analyzes the business
justification offer by the corporation for declining to issue a dividend. Is the court second-
guessing management?
Dodge v. Ford
Note the importance placed on meeting shareholder expectation, even at the expense of
charitable works by the corporation. Query - is the court equipper to determine how much
surplus is too much?
Wilderman
Still another butter family corporation case. Here the focus is on the reasonableness
compensation paid to corporate officers. It must bear a reasonable relation to the value of the
services provided.
By paying himself the bulk of the income at the end of the year, the company president avoided
double taxation issue. However, he had to show reasonableness of his compensation to other
firms (competitive salary & retaining salary).
Corporate Redemption Transactions
What of value does the corporation receive? What are “treasury shares?”
A solution to the problems created by proportional purchase transactions is to have the
corporation purchase and retire the shares of the departing shareholder. Deferred payments on
proportional purchase deals are risky if the corporation becomes insolvent.
P. 472 Types for problems on buyout deals.
This is an issue that always comes up when one person wants out. The idea solution is to have
the company buy the shares of the departing person. But if you obligate the corporation to a
shareholder buyout, that can place the corporation in a risky financial position. The structure is
typically a partial payout and a promissory note for 3 to 5 years. If the corporation isn‟t solvent
without both parties, the usual result is failure in a year or 2. The ex- shareholder with the note,
loses half of the note value, and the remaining shareholder loses all their value.
Donahue
Another family mess. Why didn‟t the Rodds offer the Dona hues the same amount for their stick
that Rodd received? The Rodds had previously offered the Donahues $200 to $300, and then
bought Mr. Rodd‟s shares at $800 per share. Mrs. Donahue alleged a breach of fiduciary duty for
failing to offer her the same deal.
The court made the comparison of the closely held corporation as being a partnership.
Shareholders are not always simply passive persons. Although there is limited liability, the court
also said that fair dealing applied.
In freeze-out situations, the court is dealing with (a) majority shareholder(s) using their power to
control and effect a result (employment) on a minority shareholder. The majority shareholder
might rent their property to the corporation at a high rent, or employs herself at a very high
salary. Either way, the minority gets the shaft.



                                            Page 21 of 65
Corporations Class Notes           Gerald R. Prettyman                           7/11/2011


What is the hidden goal of the freeze-out? Make life so uncomfortable for the minority
shareholder that she sells cheaply to get out. Freeze-out cases are difficult to prosecute for the
frozen-out plaintiff.
What is the duty owned to each other by stockholders in a closed corporation?
From what other business form us this duty derived?
On page 479, Corporate directors are held to a duty of care.
Page 480, “the purchase is subject to the additional requirement, that the controlling shareholders
must act in good faith and loyalty. To meet this test, the shareholders must allow all shareholders
to sell at the same price. This is a strict fiduciary duty.”
The Court announces a test for equal opportunity in a close corporation. What is the test?
On page 481, “in any case, of power exercised inequitably by the controlling shareholder s over
the minority shareholders, the minority shareholders are entitled to relief.”
In the final analysis, what did the corporation do wrong here?
The didn‟t offer to buy the Donahue‟s stock at the same price as Rodd‟s.
This duty has been adopted by about 25 states, but DE, NY, NJ, OH did not adopt the Donahue
principles.
One focus is whether the majority had a valid business purpose, and looked by due diligence into
alternative avenues for minority shareholders unable to participate. This is a pretty tough test.
The key issue and test is whether the majority in voting the redemption at issue can show a valid
business purpose for it and that there was no other course which would have been less harmful to
minority shareholder interests.
Is there an ethical issue here for attorneys who represent the corporation? Yes. The corporate
attorney represents all shareholders, and cannot represent the majority or minority shareholders.
What if they represent the individual shareholders? Here, the attorney can still draft the
document since there is not conflict of interest.
Note how the minority shareholders can also create situations for abuse of the redemption
process. See page 486. The minority shareholders can use their own bargaining advantage (threat
of lawsuit) to a negotiated buyout.
Delaware law has largely rejected the Donahue approach and uses the „entire fairness‟ approach.
The note on page 488 makes it clear that DE‟s alleged rejection may just be an allegation. No
case in DE has been held that the fiduciary duty held by Donahue is not applicable in the state,
and the case Riblet v. Nagy suggests that such liability may be imposed.
Legal Restrictions on Distributions
MBCA §6.40, supplement page 135.
The equity insolvency test is a simple concept. If as a result of paying a distribution, the
corporation would be insolvent, the distribution cannot be paid. This is not an income test.
MBCA 8.30(d) page 156, In discharging his duties, a director may rely on the opinion of others.
The balance sheet test, 6.40(c)(2) No distribution is the sum of assets is less that sum of
liabilities. But all books are not the same.
MBCA 6.40(d) Distribution is not prohibited if the accounting is … reasonable in the
circumstance.
Generally Accepted Accounting Principles (GAAP)
MBCA 6.40(c)(2) You can‟t make a distribution unless the assets exceed liabilities plus the
preferred shareholders dividend.
MBCA 6.40(f) In the case of a stock redemption right, the shareholder who is supposed to
receive a stock redemption sits as a creditor before the distribution may be paid.

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Corporations Class Notes           Gerald R. Prettyman                           7/11/2011


Massachusetts uses the pure insolvency test.
Is there enough money in retained earnings that the corporation can make the distribution w/o
being insolvent.
Impairment of Capital Dividend Statutes - is the corporation allowing enough money for the
corporation to pay its debts.
Distribution of Capital Statutes, MBCA 1969 §46, page 497, distribution can be made with
approval after dissolution.
February 25, 2004
Galler v. Galler
Missing clauses
Integration Clause - this is the entire contract and no other agreements exist. No parole evidence
may be used to supplement the agreement, except to explain, clarify, or define any ambiguous
terms of the agreement.
Severance/ Voidability Clause - if any term or clause is found invalid, the remainder of the K is
still valid.
The Agreement
Stated Purpose of the Agreement
What is the purpose of the shareholder agreement in this case?
Duration - no duration was stated in the K, court assumed her lifetime
Salary Continuation
Not at all uncommon for a term, 1 to 2 years, usually.
If there were other shareholders there might be problem because the board was not paying the
shareholders. There was no showing of harm here.
BCA Violations
Why does the court excuse violations of the Business Corporations Act found in the terms of the
shareholder agreement here? The terms that violate the corporations act are not invalid in a close
corporation, which is like a partnership. Courts will allow more flexibility because no one is
harmed that wasn‟t aware of the clause or term. A public corporation is held to a higher standard
because the public is not as familiar with the operations of the corporation. Thus, the failure to
comply to BCA formalities serves to help pierce the corporation veil in s uch circumstances.
Are Close Corporation Statutes Necessary?
A number of states have passes specific close corporation statutes. The hope of making it easier
to set- up and run close corporations have been a failure. Most attorneys ignore them and use the
C or S rules. See Note on Page 514.
Zion v. Kurtz
What is the purpose of the shareholder agreement in this case?
Keep the minority shareholder happy in a belief that he had control in the corporation.
The action was for breach of contract.
Kurtz defended himself in that the Group was not a close corporation, and the agreement was not
in the articles of incorporation, so the corporation did not have to follow the agreement.
The court pointed out that (1) law does not preclude shareholders form such an agree ment, and
(2) that the agreement stated that reference to the parties would add the agreement to any
required documents (such as the articles), so Kurtz was bound to amend the articles and add the
agreement in and follow it.

                                          Page 23 of 65
Corporations Class Notes           Gerald R. Prettyman                            7/11/2011


Is the dissent right? Does this sterilize the board? The effect of the agreement is to add outside
veto power.
In a close corporation shareholder agreements will be held valid unless they damage the rights
of the shareholders or violate the law in some fashion.
Shareholder Voting and Agreements
Proxies
The proxy must also be a shareholder, but the proxy is not required to be of the same share class
to vote the proxy.
The record holder of stock is the person/ company listed in the corporate records as owning the
stock. This may be an agent holding the stock for the beneficial owner. This is the same as street
name.
The Beneficial owner is the person for whom the agent holds the stock, but does not get to cast a
vote directly.
Quorums
The number of shareholders needed for voting. Usually a 50% majority (or 2/3) of voters present
is needed to approve actions, unless the Articles say otherwise.
What percent of votes is necessary for the corporation to take action. If the requirement is 50%
of the shareholders, but only 49% vote, no action can be taken, even if everyone present voted
for it. The better course is to simply require a majority of the shares present and voting.
Salgo v. Matthews
Shepard had been the owner of the shares, but now the receiver was. The receiver appointed
Shepard to vote the shares, except that the receiver had not requested the transfer on the books of
the corporation. The inspector was required to check the record and determine who was the
proper authority to vote the stocks.
How could the beneficial owner have asserted rights here? The receiver should have transferred
the stocks in the records of the corporation.
Receivership
When a company is dissolving (“winding up”), it can request a court “receiver” as a neutral third
party to assist in the dissolution.
Breaking a Quorum
Page 536, Can a number of people leave to break a quorum? See MBCA 7.25(a) - Once a
shareholder appears, they are deemed present for the entire meeting, even if they leave. In the
absence of a quorum, you cannot hold a vote. A quorum can be a percentage of the shares, or of
the shareholders.
Cumulative v. Straight Voting
In cumulative voting, each shareholder can accumulate all of their votes and put them towards a
limited number of candidates. It is a way to provide some input and participation by minority
shareholders.
Cumulative voting is primarily used in voting for directors, or five or six different approaches. It
is a way to try to get minority shareholders to have a say in voting for the number of vacancies in
the board of directors.
Humphrey v. Winous
Is the right to cumulative voting also a guarantee of effective representation of minority
shareholder viewpoints? No. The right to cumulative voting does not require multiple director
elections. One view is that increasing diversity causes more problems than it solves because the 1

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Corporations Class Notes            Gerald R. Prettyman                           7/11/2011


shareholder does not have any overall effect on the board. Creating staggered directors
effectively blocks cumulative voting.
Voting Trusts and Agreements
Voting Trust
Investors agree to place the voting rights of their shares into the hands of a trustee, and give
directions to the trustee as how to vote. Other times, the trustee simply has general principles to
vote to. Creates an agency agreement, and a fiduciary relationship between the trustee and the
shareholders.
Voting Agreements
Agreements between shareholders to vote a particular way on a particular issue.
Ringling Bros.--Barnum & Bailey Combined Shows v. Ringling (1947)
“A real circus of a case.” What was the purpose of the voting trust?
Are the parties to the trust bound to its terms, or can they breach them at will?
They knew that Mr. Loos would vote their way, so they used him to arbitrate.
The terms of the agreement said that they would abide by the decision of the arbitrator. Here,
though, Mr. Haley did not follow the instructions of the arbitrator.
They were suing to compel the vote to the agreement. Mr. Haley defended on the basis that it
voting agreement was an illegal deal because the deal gave power to the arbitrator who was not a
shareholder. The court said that the deal was not illegal because the parties cast their votes their
own way and the agreement also allowed that if both parties disagreed with the arbitrator, then
the agreement did not require them to vote according to the arbitrator‟s choice. Here, both parties
selected the arbitrator, and some presumed reasonable factors.
How else to solve a deadlock? Abolish the agreement, flip a coin, etc. This was as good a
solution as any other.
Page 549. There was not a challenge to the arbitrator‟s good faith, and both parties mutually
exchanged promises.
New York---McKinney's Bus. Corp. Law
§609 Proxies, p. 551
Proxies are revocable at any time. Irrevocable proxies are proxies coupled with an interest, e.g., 1
person gets 10 shares to vote someone else‟s shares.
Proxies and Vote Buying
Proxies are the grant of the power to vote for a shareholder. These play a major role in large
corporation with many shareholders, and les of a role in smaller companies. As to vote buying, is
it ever legal? Now per se legal.
Courts recognize that vote „buying‟ will go on regardless of law, and Delaware will tolerate it so
long as minority shareholders are not harmed.
In the HP-Compaq merger, Deutsch Banc was against the merger until HP offered big business
to Deutsch Banc if the merger went through.
Now the battle is at Disney with the Comcast bid.
See also, “Three Blind Mice”
The law school does not allow proxy voting. Prof. Greenberg is working to allow online
presence for traveling professors. The digital revolution may eliminate proxy voting. Some
companies now have complete online meetings.
The bylaws must provide meeting rules, such as quorum and notice requirements. Now email is
being used more often.

                                           Page 25 of 65
Corporations Class Notes            Gerald R. Prettyman                             7/11/2011


Notice of Changes and Transfers
Brown v. McLanahan
Trustees of a voting trust may not use their power to extend and modify the terms of the trust in
derogation of the rights of the beneficiaries of the trust.
The trustees did not approach the shareholders (or give notice) that they were going to change
the terms of the trust. Had the trustees put the change to a vote of the shareholders, the result
would have been valid. Had the trustees given adequate notice to the shareholders, the court
might have upheld the change.
Ling and Co. v. Trinity Saving and Loan Ass'n
The court said that while Ling had the right (and requirement by the SEC) to limit transferability,
and the notice terms were proper, but the notice form was not proper.
Trinity could request the court to sell the stock, as an asset, and to place a lien on the proceeds of
the sale for Trinity.
Type all restrictions in BOLD CAPS right above the signature line so that the form fulfills
adequate notice requirements.
Share transfer restrictions serve as notice to shareholders of restrictions on the transferability of
stock.
Buy-sell agreements and option agreements are the two most common stock transfer restrictions.
The closed corporation stock certificates also contain legends regarding the limited market for
resale of the stock. This is used for the ESOP plan, and places the prospective creditor on notice.
Banks don‟t check collateral first, and try to enforce the collateral afterwards, but are limited by
the transfer restriction.

February 27, 2004
Problem 7 (MPRE)
Replacing Jean Genie (David Bowie)
Wait until the next annual election of directors
Call for a special election with nominations by the nominating committee
In general closed corporations wait for the next annual meeting.
Most articles provide for shareholder voting of directors, others may provide only for director
election of directors.
Cumulative Voting
 A possibility exists to vote in a minority director unless there is only one candidate to vote for.
(Best was the original Beatles drummer.)
Straight Voting - no opportunity to vote in a minority director.
Martha Stewart - Fraud charges dismissed
The government alleged that Stewart‟s statements of innocence amounted to securities fraud in
her position as CEO. The judge dismissed the charge as unsubstantiated for trying to hold a
corporate officer liable for asserting her constitutional rights. The only charges left are
obstruction of justice and making false statements. Only the government‟s witness testified,
Stewart did not testify (she might lose her temper on the stand.)
Management and Control - Part 2
Buy-out Agreements
      What are the triggering factors?

                                            Page 26 of 65
Corporations Class Notes           Gerald R. Prettyman                            7/11/2011


This need arises to prevent outside persons from gaining control of the corporation by death,
divorce, bankruptcy, incapacity, or criminal or uncivil act of the controlling shareholde r. See
paid 580.
     How is the value set for the stock?
This is almost impossible to do as a lay people. Typical business people almost always overvalue
their business. Valuation for buy-sell agreements is best handled via the use of a formula or
formulas for calculating business value. One which incorporates an analysis of tangible ands
intangible business assets using objective and acknowledge subjective factors, coupled with full
disclosure of all liabilities. Professional appraisers are best since they use objective formulas of
math and accounting functions using pre-determined accepted factors.
    Prof. Greenberg used (1) Five years of accounting records, (2) Balance sheet, (3) Income
stream, and (4) Book value. Add them all up and divide by four. This misses goodwill and
longevity of income averaging.
    A good appraiser uses objective numbers as a base and adds in acceptable subjective
valuation factors. This is not the FMV, since the arms-length Ready, Willing and Able Buyer
who is not under the gun has not yet bought the business.
    These details must be put into the stock agreement so that when a triggering event occurs, the
company can move directly to appraisal without litigation over the terms of the litigation and
whether the company can buy back the stock.
     How is the person paid for the stock?
Over-time, or all at once? Is it reasonable to impose a mandatory buy-out obligation on a small
business? Buy-sell agreements should be created in virtually all closed-corporation situations,
using wither a cross-purchase or stock-redemption approach. Cross-purchase is the spouse-
spouse buyout. The stock-redemption is where the corporation buys the stock. Stock-redemption
reduces the number of shares outstanding, so the result is the same.
        In a spouse-spouse corporation, there is not public market for the stock, so a buy-sell
agreement is usually mandatory between the spouses. In multiple shareholder closed
corporations, the agreement usually requires the departing person to offer the shares first to the
corporation before offering the stock to the other shareholders. In a stock-redemption case,
where the corporation is going to buy the departing shareholder stocks, then a term buy-out (2 to
three years) is good to avoid a sudden cash drain on the corporation. If the sale is between
shareholders, then the parties can make their own agreements. If the shares are not paid for
before voting rights transfer, then the stocks are watered stocks. The buy-sell agreements should
then require full payment for each share transfer before voting and dividend rights transfer.
        A mandatory buy-out agreement in closed corporations may aid in getting investors, but
may also create unexpected and untoward ransom demands by minority shareholders. Timing of
stock-redemption is therefore a critical factor that keeps mandatory buy-out agreements from
being required.
Oppression, Dissention, or Deadlock
Remedies
Traditional: Dissolve the corporation.
Modern: Buy-out of one of the parties
Oppression
Where majority shareholder use their status to defeat the reasonable expectations of minority
shareholders. A significant factor in determining the presence of oppressive conduct is whether
the actions taken disappoint the reasonable expectations of the minority shareholders.

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Corporations Class Notes            Gerald R. Prettyman                            7/11/2011

Davis v. Sheerin
Davis‟ trying to deprive Sheerin of stock ownership, even the corporate records showed that
Sheering did owe the stock was oppressive. Davis did not challenge the trial court‟s valuation
amount, which the court felt backed up his conduct.
Equity Power
Courts have the power, in equity, to remedy harm done by oppressive conduct of majority
shareholders, by ordering them to buy out at fair market value, the interest of the minority
shareholders. Note the various and broad definitions of conduct constituting “oppression” of
minority shareholders.
Rational and Problems
This is a better result than to force a dissolution of the corporation. However, it causes the
minority shareholder to lose out on future growth of the corporation.
The valuation of stock in a buyout remedy is a thorny issue. What if the share value is depressed
by the conduct of the majority shareholder? The shareholder being bought out has to prove the
monetary value of the damage they should recoup by the shareholder.
Clean Hands Doctrine
P. 600-601 J Bar H, Inc. v. Johnson - Minority shareholder fired & registers the corporate name
after the corporation forgets to renew its name. The corporation asserts Johnson breached his
shareholder duty. Johnson replies that the corporation froze him out. The court agrees that the
corporation‟s unclean hands prevent them from asserting his acts where contrary to his
shareholder duty.
Abreu v. Unica Industrial Sales, Inc.
This case examines the role of the provisional director appointed in lieu of a dissolution, and the
limits placed on that director in making decisions regarding corporate governance. Note the
Court‟s encouragement of the use of outside counsel. The appointment was valid.
P. 606 - Unless corporate bylaws provide otherwise, that it is improper for management of a
corporation to directly hire the auditors whose mission it is to evaluate management's
performance. Auditors are often selected by a committee of independent non- management
directors or by a full board of directors. Any decision regarding the selection of a new auditor
should have been reserved for the full Board of Directors and not made unilaterally by
management, absent any contrary corporate bylaws. We find invalid Vega's unilateral
appointment of an auditor and order the full Board o f Directors to vote on selection of an auditor.
[N.B. That Enron failed to follow this „rule.‟]
Page 607 - We reiterate the trial court's admonition that in a uniquely structured corporate
situation such as this, it is highly prudent to retain outside counsel to avoid further complications
in the decision- making process. Complex issues regarding legality of votes and the division of
corporate responsibility between management and the board need to be examined carefully in
order to adhere to corporate bylaws and corporation law. [This message was for Mr. Vega.]
Actions By Directors and Officers
Drive-In Development (Tastee-Freez)
Third parties are entitled to rely on the validity, absent reason to question, of documents bearing
the corporate seal and purporting to be true corporate authorizations. Where a corporate officer
presents herself or himself as authorized by the corporation and presents a authorization
document, such as a corporate resolution, a third party is entitled to rely on the corporate seal.
Whether the presenter is not a corporate officer is not dispositive of the seal‟s authenticity.
Where the acts are outside their scope of employment, the corporation or shareholders (as a
derivative suit) may sue the employee.
                                           Page 28 of 65
Corporations Class Notes            Gerald R. Prettyman                            7/11/2011

Black v. Harrison Home Co.
Mrs. Harrison was president of the corporation & sold corporate property, but that was the
provenance of the board of directors. The power of a president to act to bind the corporation to a
contract must be given to the president by the board of directors. This brings us back to agency
principles, specifically those dealing with actual and ostensible authority. Contracting parties
may require a board authorization to seal the contract. In apparent authority cases, the parties
should request authorization from the corporation. Black knew he was dealing with a corporation
and could have had an enforceable contract if he had authorization from the board of directors.
Black made the error of assuming that Mrs. Harrison had already inherited the daughter‟s stock,
although creditors and other third parties would have had a claim against her estate. In
California, the statutory period is one year for claims against an estate.
Transactions in Controlling Shares
Zetlin v. Hanson Holdings
Absent a showing of harm to the corporation, the sale of a controlling interest in a company‟s
stock may be for a premium not shared with minority shareholders. A controlling shareholder
can sell their stock for more than the market rate since it also sells control of the corporation. The
minority shareholders are not injured by the sale. [They are often helped by the ensuing rise in
the stock value.]
DeBaun v. First Western Bank and Trust Co.
If a majority shareholder knows that the sale of its controlling interest is likely to result in the
buyer looting the assets of the corporation, the seller has a fiduciary duty not to do the sale. Here,
the bank had notice of Mattison‟s negative history and failed to take reasonable steps to do due
diligence and investigate.
Every court keeps a plaintiff-defendant checklist to allows someone to see if a person has a
court-record, and what judgments have been assessed against them.
Here, the bank is a shareholder, and has a duty to do the best thing for the corporation, which
would have meant not selling their shares to Mattison.
The Court ordered damages of the negative net worth (liabilities), plus the loss of assets, plus a
reasonable income loss. Mr. Johnson left the company in the trust of the bank to care for his
employees income and retirement. Thus the court ordered the bank to pay the shareholders
(DeBaun & Stephens) for their income loss, retirement loss, and debts incurred against them.
What we don‟t know is whether the bank made a side-deal with Mattison that he would repay the
old debt as well as the new debt. This could explain their favor towards Mattison, but does not
justify it.
Perlman v. Feldmann (Steel)
Contrary finding to Zetlin. Here the Court orders that the minority shareholders must be allowed
to share in the increase in value of the stock obtained by the majority in its sale. Does this
reasoning hold up to the scrutiny? Isn‟t there a contradiction in these cases that the majority
shareholder can act in their own interest? The majority says Feldman was wrong to sell his
majority interest for an unfair profit to that of the minority shareholders. The dissent said that
Feldmann acted in the best interest of the corporation to act for its longevity, and their was not
evidence of Feldman acting in bad faith.
Petition of Caplan
What allowed Cohn to get control of the board while owning only 3% of the stock?
The Court refuses to allow purchases to maintain this same degree of control, disproportionate to
their ownership interest. This is a case of the amazing power of Roy Cohn, McCarthy‟s sidekick
during the 50‟s. What did he have on the company?
                                             Page 29 of 65
Corporations Class Notes            Gerald R. Prettyman                            7/11/2011


Just because Roy Cohn could do it, doesn‟t mean others can.
March 10, 2004
Publicly Held Corporations
Control and Management of Publicly Held Corporations
What is the obligation to do the right thing? What is the right thing?
Society sets socially responsible agendas because some corporations have a lot of power to
significantly affect society, and causing a significant bad effect on society is against public
policy.

The social responsibility issue.
Are they agents of capital, or agents of society?
Whose interests do the Directors and corporate managers serve?
Are there good business reasons for “doing the right thing?”
What is the liability exposure from shareholders when management does the socially or morally
right thing, to the derogation of the short term interests of the shareholders?
Do non-corporate business entities have the same moral issues debate? No.

Who really controls the corporation?
Do the shareholders of a public company really effect policy, or is it in the hands of
management?

The efficient capital market theory
The concept here is that the stock market will flush out the true status of most companies and
that status will be reflected in the company‟s stock price. The theory also asserts that managers
are for various reasons, self- interested in the companies‟ success and that managers‟ interest are
therefore not adverse to shareholder interests. On balance, the theory is that the market does not
get it wrong very often.

The un-diversified investor poses certain risks for management. If the company is made up of too
many un-diversified investors (employees), fluctuations in share prices affect them and they have
more concern over losing their “nest egg.”

The Growth and Impact of Institutional Investors
Although they hold large blocks of stock, the total amount of stock outstanding in publicly traded
companies results in institutional investors rarely being able to successfully challenge
management through a proxy fight. On average, institutional investors only own 3% of the
company‟s stock. Institutional investors may try to have a proxy fight, but this happens very
rarely. Institutional holders do not have the clout.

Shareholder Passivity - inevitable or changeable?
Is the best limit on managerial excess market forces, such as takeovers, and voting with your feet
by selling the stock? The company directors may have a poison pill provision, but some
shareholders may not like the management and give their approval to the merger.
How likely is it that institutional holders will join together to create a voting block. This rarely
happens.

                                           Page 30 of 65
Corporations Class Notes           Gerald R. Prettyman                            7/11/2011



Nominees, book Entry and “Street names”
Nominees are usually brokerage firms or Cede or Co.
Book entry has largely eliminated the need and practice of issuing individual stock certificates.
The combination of Nominees and Book entry does create some problems regarding voting by
proxy, and distribution of annual reports, as well as delays in completing proxy voting in time for
shareholder meetings.
Transaction settlement times have not been adversely affected, and in fact are getting shorter.
Was T-5 and is not T-5.

The role of Outside Directors
It is important to recognize that micro-managing a huge publicly traded corporation is
impossible, particularly for outside directors. Inside directors are people who are employees of
the corporation. Inside directors usually own stock.
Outside directors are not employees of the corporation, but often own or earn stock as part of
their directorship. Outside directors may bring a much needed lack of bias due to vested
interests, and it is always a question as to how much of an interest to give them, while still
preserving their neutrality. Outside directors cannot receive salary, but their expenses must be
paid.

Encouraging Director involvement
Director involvement in publicly trade corporation is greatly influenced by the CEO and the
relevant corporation culture. While Boards sometimes question CEO‟s that is not often. Michael
Eisner lost favor at Disney because he let Pixar (Scully & Lassar) go, and the movies that Disney
made were not doing as well. Recall the Apple-Jobs-Scully turmoil of the 1980‟s.

Corporate culture
The values that the corporation holds in the way that deal with people and soc iety. It comes from
senior management. The Apple - IBM joint venture was a corporation culture fiasco. Culture
clash has been an important factor in merger and venture failures.

The Business judgment Rule and the Director’s Duty of Attention
As a practical matter, the amount of time an outside director can devote to Board matters is very
small. As a consequence, only a few matters of importance to the company reach the Board.

Outside directors are often chosen for their industry knowledge or contacts, no t their
management expertise. Directors are entitled to rely on professional advise until they get some
reason to believe that the advice was questionable validity.

Directors cannot sit back and refrain from taking action if they are aware of crisis conditions in
the company. Under the new rules, a director who becomes aware of a problem must bring it to
the attention of the board. If the corporation attorney learns that the corporation is about to
engage in an illegal act, the attorney must notify the SEC, or else the attorney is subject to
criminal sanctions.



                                           Page 31 of 65
Corporations Class Notes           Gerald R. Prettyman                          7/11/2011


Business judgment takes into consideration a different set of factors than legal judgment. This
must be taken into account in evaluating the merits of Board action.
Business people are used to taking risks. Lawyers are not.

March 12, 2004
Corporate Governance – 2000 (p. 701)
Majority independent and supermajority independent boards are now the norm (most board
members are not corporate insiders)
Once a year, board meets to evaluate CEO (without a ny insiders present)
Now boards usually only have 12-15 members
Role of the audit (finance) committee has expanded and is critical to contemporary corporate
governance – review financial status of the company, as well as reports from external auditing
companies
Nominating (recommends candidates for board positions, as well as reelection of current
directors) (CEO typically not a member)
Compensation committees (recommends compensation for directors and corp officers)
(compensation to directors is usually stock now)
Special committees are made up of board members
Long-term planning committee
Philanthropy committee
Political activities committee (decides how much $ donated to support political campaigns)
Environmental compliance
Management development (training of sr- level executives)
Technology
Employee benefits
Efforts to evaluate the impact of governance via econometric models have not demonstrated any
difference in profitability
“bottom line” is not the only indicator of corporate success
Sarbanes-Oxley moves closer to “corp as agent of society”

The Fall of Enron
Results of multi- year Enron Probe www.abajournalreport@ABANET.ORG
Dominoes begin to fall:
WorldCom, Inc.; Tyco; ImClone (taking Martha Stewart with them)); Adelphi Communications
“Special purpose entities” – the art of hiding the ball
Independent spin-offs
Losses written off to SPE‟s, so parent corp. (Enron) looked better
“Restatement of earning” crisis – WorldCom‟s 3.8b restatement was largest single restatement
ever made by US company
Impact of fall on un-diversified investor/employees
Employees had entire retirement wiped out

Sarbanes-Oxley
Key terms
Corporate Disclosure and CEO/CFO Certification
                                          Page 32 of 65
Corporations Class Notes           Gerald R. Prettyman                           7/11/2011


CEO and CFO need to certify annual reports; certification brings liability if information not
accurate
Quarterly and annual reports must disclose all material off-balance-sheet transactions
CEO and CFO need to certify that they have disclosed any fraud to outside auditors
CEO and CFO can be personally liable if info incorrect
Maintenance of Internal Controls for Monitoring
Develop internal control system
Annual report needs to contain internal control reporrt
Creation of the Public Company Accounting Oversight Board
Public accounting companies must register and submit annual reports to this board
Must submit detailed application and agree to cooperate with board investigation
Lead audit partner must rotate every 5 years
Large firms get audit by this board every year
Audit Committees of Corporate Boards of Directors
Must be made up of independent directors §301(3) and they can‟t accept any consulting,
advisory or any compensatory fees (can‟t get paid a consulting fee; must be truly independent)
Don‟t all have to be financial experts, but if they are, it has to be disclosed
Establish procedures for getting info from whistleblowers, internal reports, confidential
submissions
Make it easy for employees to bring in information and blow whistle
Executive Compensation, Loans to Executives and Disgorgement of Incentive -based
Compensation
When a restatement occurs to show a lower amount and executive gets a bonus, exec has to
disgorge bonus
Strict liability clause
No more loans b/c they take $ directly off bottom line of company
Professional Standards for Attorneys
§307 – must report evidence of material breaches of securities law
“up the ladder” – to the board if necessary
Whistleblower Provisions
Makes it easier to blow whistle
10 years in prison for harming a whistleblower
Barring People from serving as officers or directors of public companies
If conduct is unfitting of a CEO
e.g., Martha Stewart
Securities analysts
New Rules for Corporate Counsel and Accountants
Accountants have to refrain from practice of management consulting and auditing being dome at
the same firm – this has resulted in some firms splitting up
Separation of the consulting and audit functions prevents audit results compelled by financial
factors
Attorneys now have “up the ladder” requirements – how high?
What is a QLCC? Qualified Legal Compliance Committee
Outside committee set up to review compliance with S-O (this fulfills the ladder requirement


                                          Page 33 of 65
Corporations Class Notes          Gerald R. Prettyman                          7/11/2011


March 13, 2004
Tip - Think of reducing each class down to one page – identify key points
Practice exam review
Thought process…. (Show the details of how you thought out the
problem.)
Key points
·      CA law
·      “Sweat equity deal”
·      Discuss and analyze the other types of structures!
·      Watered stock – dilution … but if not a corporate structure, don‟t have to worry about
this
o      Non-corp. structure would work for this group of 5, but maybe not for everyone else
·      Analyze the other types of entities and evaluate which would be the best one
·      Second group of investors
o      Can‟t have p/t people in a limited partnership…rule out LP
·      Group 3
o      Preferred stock! – need corp. structure to accommodate this
·      3 investor groups with different needs and for each a different entity might be best
·      Acknowledge that you probably can‟t give group 1 full interest now, but can give them
some interest now
·      Part of group 3‟s $ as a loan? Gives some security to those investor…but impacts corps
bottom line and lender can‟t participate in equity (?0
o      Suggest that some stock be held in common stock as well or possible conversion option
·      Taxation issues
·      Did I mention the importance of showing “thought process”?
·      Mention business considerations as well as law factors (here…go to the $$$ - i.e., make
the $100k investors happy first)
Review of material so far…
Agency Law
·      Fiduciary – A owes duty to P
·      P‟s duty to A is not to undermine authority
·      Most cases involved agent breaching duty
·      Independent contractor vs. employee
·      A has power to effect P‟s obligations, right, and duties
·      A can bind P to K
·      Actual authority – A can speak for P
·      Apparent – Q appears to be able to speak for P + something further from P that A has the
power to take that action; if not, K might not be enforceable
·      Inherent – A has been acting in a way consistent w/ title or role A holds
·      Implied – implied in the circumstances (current transaction or history of parties)
·      Principals – disclosed, undisclosed, partially disclosed
·      Respondeat superior – duty owed by employer for actions of employee
Business Entity Forms - Know differences
o      Sole Proprietorship – one person has full ownership interest
o      General Partnership – two or more persons get together to do business
                                         Page 34 of 65
Corporations Class Notes           Gerald R. Prettyman                               7/11/2011


       §      Key – joint/severable liability
       §      Joint venture – AP for limited purpose and time (e.g., concert, movie)
o      LLP – replacement for professional corp
o      LP – general partners and shareholders (owners of LP ownership units)
       §      GP can have personal liability – bring in LL entity to solve this
       §      For a limited term and then end. Owners get back original investment plus any
              profits made over the time period (e.g., real estate operations)
o      LLC – like both partnership and corp.
       §      Pass thru entity
       §      Limited liability – amount of capital contributions
       §      Can‟t be directly converted into a public corp. (cumbersome process)
o      Corps
       §      C-Corp
       ·      Indefinite period of time
       ·      Closely Held Corp – limited market for the shares
§      S-Corp
Partnerships
·      “Duck test”
·      Must have written agreement, otherwise UPA governs
·      Can have varying profit/loss arrangements
·      Dissolution/wind- up process
       o      Pay off outside creditors first, then partner loans, then initial capital contributions,
              then any profit left (same for corps)
·      Management of partnerships
       o      limit authority – one partner can‟t make limit on other partners‟ actions, unless
       agreement made by partnership
       o      actions taken in scope of business impose liability on partnership (gives rise to
       apparent authority)
       o      fiduciary duty owed to each other
·      Distinction between property owned by the partnership and that owned by individual
partner
·       Accounting basics (Equity = Assets – Liabilities)
·       Dissolution & Winding down
        o      After decision to dissolve, period of existence to finish things up
Basic Income Tax Principles
·      Taxation of different entities
       o      Proprietorships – pass-thru
       o      Unincorporated – pass thru
       o      C-Corp – 2x taxation; Corp taxed first on profit and paid dividends are taxed
       again
·      Capital gains are taxed a generally lower rate than personal gains
·      Capital losses can be carried forward over a few years
·      Basis – increase over basis = capital profit/gain
LP’s, LLC’s, intro to corps
·      “Check the box” process
·      LLC – flow thru tax, and management flexibility
                                           Page 35 of 65
Corporations Class Notes           Gerald R. Prettyman                              7/11/2011


How to Incorporate
·      For large corps, go into DE, otherwise stay where you are
·      Know procedure:
       1.      Name clearance, reservation; AI
       2.      Prepare bylaws and organizational meeting minutes/resolutions
       3.      Arrange for stock issue certificates (legends for transferability)
       4.      CA – file statutory exemption certificates for …. (see slide)
Ultra Vires
·      Acts going beyond stated purpose can incur liability
Premature commencement of business
·      Promoter can be liable for doing business before corp is formed
Defective incorporation
·      In improperly incorporated, can be held liable for debts, etc.
PCV
·      Purpose is to prevent fraud on creditors
·      Disregard of corporate formalities and undercapitalization are principle grounds for alter-
ego
·      Parent-subsidiary – work up the chain
·      In fed-state cases, relationship between parent- facility overrides relationship between
parent-subsidiary
·      Reverse piercing (not likely on final…but keep it in mind)
Successor liability
·      Successor may be bound unless specific steps taken to avoid it (Bulk Sales Transfer Act
in CA)
Corporate Finance
·      Debt/Equity Capital
·      Equity = initial contributions + later capital contributed + retained earnings
·      Stock
       o       Must issue stock to be a corp.
       o       Common shares – know rights
       o       Preferred shares
       §       Publicly traded preferred rights (see slide)
       o       Authorization and issue
       §       Par value – arbitrary value
·      <PV ….watered, discount, bonus stock
       o       consideration – no promissory notes or future work
·      debt financing – bonds (secured), debentures (unsecured)
       o       leverage – borrow $ and invest in something that generates more income than
       payments back
       o       “thin corporation” – debt close to or < equity
·      IPO process
       o       Blue sky laws – must notify potential investors of all risks involved
       o       Non-public offering exemptions – can issue stock in Ch corp w/out Blue-sky
       requirements §3(a)(11) Securities Act of 1933 – all investors in same state
       o       Regulation D – requirements for issuing an exemption
       o       §§504, 505, and 506 $ limitations for exemption
                                          Page 36 of 65
Corporations Class Notes           Gerald R. Prettyman                            7/11/2011


·      Fraudulent schemes
·      Distributions by a CH corp
       o       family cases, redemption transactions
       o       majority SH taking advantage of minority SHs
·      Redemption transactions – “treasury stock”
·      Proportional purchase transaction – corp agrees to buyback shares of incapacitated or
deceased majority shareholder over time (risky if corp becomes insolvent)
·      “freeze out” – majority shareholder tries to force min SH to sell shares back to corp for <
value
·      Donahue – know case
·      Distributions – know limitations
Management and Control
·      SH voting and Agreements
       o       Voting trust vs. proxy
       §       VT is valid until revoked (trustee votes for your interest), while proxy needs to be
               sought for each election
       o       Vote-buying generally illegal, unless sometimes when not harmful to company
       o       Beneficial owner vs. record holder
       o       Quorums
       o       Can include proxies
       o       Cumulative vs. straight voting
       o       Share transfer restrictions
       o       Valuation for buy-sell agreements

March 17, 2004
Proxies
Proxies are the method by which directors solicit the votes of remote shareholders, and other
shareholders who could not attend the meeting.
Disclosure requirements - adequate notice and disclosure to shareholders.
Common issue - mergers, such as HP - Compaq merger. Where the shareholders getting the full
truth about the prospective results to shareholders. A merger usually means that 1 set of
shareholders stock is swapped for stock of the other company.
Two Statutes - SEC 1933 §14(a), 12(a), 12(g)
SEC 1933 §14(a), see p. 723
§14(a) requires that all proxy solicitation be made in accordance with SEC rules. The central
concern is with the adequacy of disclosure.
Section 12 details the requirements for registration of securities for large publicly trades
companies.
Note that amendments have raised the total assets registration requirement from one million
(1964) to 3 million (1982) to 10 million (1996).
The registration requirement is in additional to the requirement that all proxy solicitations must
be registered.
Problem Review -
Under Section (15 USC § __) 12(g) and Rules (17 CFR 240.__) 12g-1 and 12g-4, how should
the following problems be resolved?

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Corporations Class Notes             Gerald R. Prettyman                              7/11/2011


(a) Company A sells securities under Section 4(2) of the Securities Act of 1933 every year for
three years. It eventually has total assets of $11 million and 450 shareholders. Does Company A
have to register under Section 12? [NO, not enough shareholders.]
(b) Company B sells securities under Section 4(2) every year for three years. Eventually, it has
total assets of $9.8 million and 700 shareholders. Does Company B have to register under
Section 12? [No, not enough assets.]
(c) Company C has been registered under Section 12(g) for four years, and has consistently had
$9.8 million in total assets and 450 shareholders. May its registration under Section 12 be
terminated? [Yes, it is below both the shareholder & asset value.]
Studebaker Corp. v. Gittlin, 360 F.2d 692 (2nd 1966) p. 727
Gittlin wanted the stockholder‟s list but Studebaker refused to give it to him. Gittlin then
solicited proxies from 42 other stockholders.
Studebaker argued that Gittlin had not registered the proxy solicitation with the SEC before
sending it out.
Gittlin argued that he was only after the stockholder list, so he did not violated the Code and
Rules.
The Court noted that a (continuous) plan that would result in a future proxy solicitation must
follow the rules also. The Court also noted that the SEC felt that even getting the shareholder‟s
list would require compliance. Thus a request for the stockholders list gives a presumption that
there is a continuous plan for a proxy solicitation.
Section 14(a) is construed to extend to a request to inspect stockholders lists, whether the
ultimate goal of the request is to solicit proxies or not. Gittlin‟s failure to file his proxy requests
with the SEC before he got consent of 42 other shareho lders was his fatal error.
Page 730, Note 3 - less than 10 rule
Page 730, Note 4 - speeches and public statements are permitted if there is a definitive proxy
statement on file, and no proxy solicitation is not given out.
Proxy Review and Instructions, pp. 732-733
The beneficial owner can either fill out and sent the proxy, or not fill out the proxy, and allow the
record owner to vote the shares, or show up at the meeting.
If you are selecting an accountant, the issuer must follow 17 CFR 240.14a-101, Item 9.

Proxy Forms, Statements and Annual Forms
The goal of proxy forms and statements is to provide adequate disclosure of subject matter and
voting rights.
The Management Discussion and Analysis (MD&A) report contains historical information, but is
valuable primarily for its forward looking statements and all variable in those statements must be
fully and honestly disclosed.
The 1979 amendment added the safe harbor provision for forward looking statements made in
good faith based on reasonable analysis.
Companies usually plead good faith in their projections, and lack of knowledge of the
forthcoming bubble burst.
Caterpillar
Although Caterpillar had traditionally presented a consolidated report, the unique circumstances
of the prior and prospective financial status of CBSA should have put them on notice for the
need to break that division‟s activity report out of the consolidated report.

                                             Page 38 of 65
Corporations Class Notes           Gerald R. Prettyman                            7/11/2011


The General Counsel erred by disregarding the knowledge of the board and signing off on the
report anyway.
What does Regulation S-K require with respect to disclosures in the MD&A report? If the
company has an unusual event (great profits), it should break out that information as an
addendum to the consolidated report when there are foreseeable uncertainties inconsistent with
the previous year.
What did Caterpillar do in violation of its regulation under Reg. S-K? Caterpillar did not put in
any false information. It just omitted relevant information.

False and Misleading Statements in Connection with Proxy Solicitations
Regulation 14a. Solicitation of Proxies, p. 746 - 17 USC 14a-9, False and Misleading Statements
- Note the four examples of kinds of representations that can be false or misleading.
JI Case v. Borak
Under Wisconsin, Borak was supposed to post a $75K bond, but he did not, so the court
dismissed his state action. On appeal, Borak tried to press the federal part of the case.
The key issue here is whether under §27 of the Act, a private cause of action can be stated for
rescission or damages with respect to a consummated merger arising out a violation of §14.
The Court concluded that Borak did have a private cause of action under §§ 14a & 27.
Courts are not thrilled to follow Bork, but the case has not been overruled, although it has been
reined in.
Mills v. Electric Auto-Lite - One party posing as another
Should a misleading proxy solicitation which is shown to be material be disregarded if the vote
would not have come out any differently if he solicitation was accurate. The Supreme Court says
no. Courts should not substitute their judgment for that of the shareholders.

Should a court unscramble a merger, only if that is the only relief. Generally $$$ is the remedy.
Note also that attorneys fees and damages are hard to recover. There is not a contract to provide
for attorneys fees, so the private attorney general theory may apply, and award attorneys fees in a
14a-9 claim if the plaintiff shows a benefit to a significant number of shareholders. The majority
says no. If Congress wants to provide for attorneys fees, Congress should add that to the law.

TSC Indus., Inc. v. Northway, Inc, 426 US 438 (1976), p. 758
What is the appropriate standard/ definition of materiality a representation in a proxy solicitation
for Rules 14a-3 and 14a-9.
The Appeals Court said “might affect the reasonable shareholder‟s decision” (e.g., “a mere
possibility”) The Supreme Court tightened this to „would affect the reasonable shareholders
decision.‟
“An omitted fact is material if there is a substantial likelihood that a reasonable shareho lder
would consider it important in deciding how to vote.”

Virginia Bankshares, Inc. v. Sandberg, 501 US 1083 (1991), p. 762
The directors held that their statements were opinions that were not material.
The Supreme Court said that statements of this sort by senior management are reasonably
perceived as statements of fact by shareholders because of the director‟s fiduciary duty.



                                           Page 39 of 65
Corporations Class Notes           Gerald R. Prettyman                            7/11/2011


March 19, 2004
Page, 723. In 1964, there were two commissions, the Securities Commission, and the Exchange
Commission. The 500 and 750 number of shareholders figures are leftover from those laws then
on the books.

Business Judgment Rule
The business judgment rule exists to provide protection from liability from judgment for
business persons making routinely risky decisions. The business judgment rule has two elements,
(1) investigation, and (2) a decision that is reasonable based on the results of that decision. Thus
any review looks at whether the investigation was reasonable, and whether the decision was
reasonably based on the reasonable decision (or ignored the reasonable decision.)

Litwin v. Allen, 25 N.Y.S.2d 667 (Sup. NY 1940), p. 800
Directors as trustees of the corporation for the shareholder, stand in a fiduciary duty with the
corporation, and are liable for negligence in the performance of their duties, but clairvoyance is
not required.

Here, the bank bore the all the risk, and had no gain possible.
All directors and officers who participated in the option vote are found liable here, even though
the vote was only to ratify.

The court held liable all the directors who ratified the management proposal. Directors are not
permitted to rubber-stamp management. Directors must question management about their
proposals.

The court cannot judge in hindsight, but reviewed with the information with what the directors
knew at the time of the decision.

Shlensky v. Wrigley, 95 Ill. App.2d 173 (Ill. App. 1968), p. 807
Wrigley felt that the lights would be disruptive and not conducive to the neighborhood.
Shlensky found that most other teams had night games.
Absent evidence of fraud or a breach of good faith, courts should not interfere with the judgment
of the board of directors of a company.
What evidence would change the outcome here? If Shlensky had shown that the lights would
solve the company‟s money woes, then Wrigley would have breached his duty to the corporation
by not bringing in lights. The court said that Dodge v. Ford did not apply because Ford was
sitting on a pile of money, and they were unable to show that they had to hold unto the money.
Dodge v. Ford was an aberration, p. 810, judges are not business experts absent evidence of
fraud to illegality. These are business judgment decisions, and a court won‟t interfere absent
substantial support for the contrary view, fraud, or bad faith.

Notes, p. 811
(1) MBCA old §8.30(a) - similar circumstances, good faith, ordinarily prudent person with
reasonable belief. This does not entail the risks that business people normally take in order to
remain competitive and grow the business. The revised MBCA §8.30(a) broadens risk-taking.

                                           Page 40 of 65
Corporations Class Notes            Gerald R. Prettyman                            7/11/2011


(3) Good faith, coupled with conduct reasonably believed to be in the best interest of the
corporation.
(4) Courts recognize that businesses make balanced decisions that courts will not review with the
benefit of hindsight.

Smith v. Van Gorkom, 488 A.2d 858, (Sup. Del. 1985), p. 818
Smith sought rescission of the Trans Union LBO.
This case is described as a bomb on the ability of companies to attract outside directors. The
court seems to feel that the absence of a valuation study is evidence of a failure to apply due
care.
Why wasn‟t the reliance on legal advice a valid defense here?
Should the “unified position” rule apply to dissenting directors?
The court‟s conclusion was that the board acted hastily and without due care.
Some members of the board dissented, but the court still held then liable. The Musketeer
principle does not protect dissenting directors. Such directors must resign. Although the director
does not have to make a „noisy‟ resignation, she should make her statements in a board meeting
to they go on record.

Why don‟t we impose a duty on directors to call SEC when they find out about malfeasance? It
will negatively the company‟s value, and if false will be wrong. It may stimulate more
discussion, fear of reprisal (now eliminated by Sarbanes-Oxley).
Dissent
The dissenting opinion thought deference to the board‟s intelligence experience was in order.
This was the closing argument by Stewart‟s attorney.
Aftermath
Afterwards, corporations got outside independent opinions, and papered their files to justify and
cover their positions. The upside is that maybe they get better opinions. The outside is that a lot
of outside directors did not want to get involved. The unified position rule makes it difficult for
adverse outside directors to stay on the board.

Notes on the Business Judgment Rule
The result of Gorkham is to suggest that corporations must add significant costs to director‟s
actions in the form of more consultant and epxert opinions. Is this a good thing?
Outside directors reassessed their involvement after this decision.
The “unified position” rule puts dissenting directors in a tough spot, resign or accept the risk of
liability for actions you opposed.

Malone v. Brincat, 722 A2d 5 (Sup. Del. 1998), p. 851
The Del. Ct of Chancery dismissed the case (failure to state a claim) saying that there was not a
state cause of action, only a federal cause of action. The Ct of Chancery said that directors do not
have a duty unless they are asking the shareholders to do something, so the remedy was in
federal court, not state court.

Although directors are typically only required t make disclosures of the status of the corporation
in connection with the request for shareholders actions, if they do make discrimination

                                           Page 41 of 65
Corporations Class Notes            Gerald R. Prettyman                             7/11/2011


disclosures without making such a request, they are still held to their fiduciary duty to make
disclosures which are rue, and are based on valid research and investigation.

The knowing dissemination of false information about the corporation‟s financial status is a
violation of the director‟s fiduciary duty to shareholders. When you make disclosures, the
information should be accurate.

So, is the answer for directors to never make unsolicited disclosures? Maybe, but real world
issues come into play like the need for a positive public position.

Zapata Corp. v. Maldonado, 430 A.2d 779, (Sup. Del. 1981) p. 866
Derivative suits are brought on behalf the corporation by a shareholder representing the interest
of the corporation. A third party cannot bring a derivative suit.
Since a shareholders derivative lawsuit is brought for the purpose of defending the corporation
from the actions of directors which allegedly are harmful to the corporation, a committee of
disinterested directors has generally been empowered to direct the dismissal of the suit. The issue
here is whether the “business judgment” rule protects those directors if it is determined that the
order to dismiss the suit is wrongful.
The Court provides for a procedure for the committee to seek a judicial determination as to
whether the claim should be dismissed. See page 873 for details.
This is a balance between the rights of a disgruntled shareholder and the rights of a board of
directors to act independently and in good faith.
See the procedure on page 873.

Aronson v. Lewis, 473 A.2d 805, 811 (Del. 1984), p. 874
Before a derivative suit can be filed, the shareholder must first make demand on the
corporation‟s board. The demand requirement is excused if making it would be futile, referred to
as demand futility.”
The criteria for determining demand futility is found on page 879.
Unless there is a strong history that demand would be futile, make the demand, with a reasonable
time period for response.

March 24, 2004
Marciano v. Nakash, 535 A.2d 400, Del. 1987
In this case, where director/ shareholders interests were evenly split, causing a deadlock that
prevented majority ratification of loans made by directors to the corporation. Delaware
Corporations Code §144 could not grant the self- interest transaction immuity because there was
not a majority by either party to vote approval, and the transaction would under §144 be
voidable. (The code did not anticipate deadlock.) This Court, however, finds that §144 is not the
sole immunity. A common law standard of intrinsic fairness is also applicable.
[The Corporation used the loan from the Nakash‟s to pay its debts to other companies owned by
the Nakash‟s.] Thus, the question here is whether the Nakash‟s put themselves ahead of other
creditors, and that would be self-dealing to the detriment of the corporation.
Self-Dealing, Part 1
Does subsequent ratification of a self- interest deal by disinterested directors validate the
transaction entirely, or merely open it up to review under the business judgment rule?
                                            Page 42 of 65
Corporations Class Notes             Gerald R. Prettyman                             7/11/2011


Conclusion
If the self-dealing transaction is intrinsically fair to the corporation, then the procedural rule of
not counting the votes of interested directors is less relevant.
Notes
A ratification by disinterested directors probably does not validate a transaction, but would shift
the burden of proof by the business judgment rule to the person against the transaction.
Note 4(a)-(c) on page 912-913, provides a valuable summary of the principles underlying most
self-dealing decisions.
p. 915
        (a) Defintion of BJR
        (b) Tyco
        (c) conflicting interests, deference to disinterested directors, but proving „disinterested‟ is
        not easy
Note 10(b) on pp 914-915 provides a good definition and example of “conflicting interest”
situations; subpart (d) explains the new term “qualified director” in MBCA §8.62(d), as the
director entitled to vote to approve a director‟s conflicting interest transaction (without any
interest in the transaction.)
Notes 14 and 15 on pp 917-918 detail the prohibition, both under the 1960 MBCA, and now
under Sarbanes-Oxley, against loans by the corporation to corporate officers or directors. In
some cases the executives bypass this prohibition by simply authorizing huge compensation or
similar benefits.
No loans anymore by publicly traded corporations.
A mixture of cash and stock provide incentive to senior management to stay and help the
company perform. The problem is where external market factors drive the price of the stock up
and the manager reaps the benefits without the effort.
Brehm v. Eisner, 746 A.2d 244, Del. 2000
The shareholders sued for both the employment agreement, and the severance package.
The court is unhappy with the handling of this case, noting that the Ovitz deal is “exceddingly
lucrative,” and the analysis leading to its approval was “casual, sloppy, and perfumctory.” But
the complaint was so poorly drafted that there is little the court can do.
The business judgment rule is key here. There is no evidence of a failure to observe a duty of
loyalty here. This was just massively bad judgment, which the court [implies] simply is not
entitled, after the fact, to second guess.
The severance package was so good, it was an incentive to leave. The court did not address this
as a bad business judgment, but rather from the view that Eisner pushed the package which was
detrimental to the corporation.
Deference to Business Judgment Rule. Cases like that will depend on whether the court views
the case as one involving duty of care, or duty of loyalty.
Self-Dealing, Part 2
An important element in the issue posted by the Brehm case is that although the public in general
is outraged by high executive compensatikon, shareholders are generally not even when the
corporation is not doing well.
Note the strategy of typing compensation to performance via compensation in stock instead of
cash.
Limitation Concepts

                                            Page 43 of 65
Corporations Class Notes            Gerald R. Prettyman                             7/11/2011


(1) Note 12 on pp 933-934 details SEC rules for disclosure of corporate compensation of top
executives.
(2) The effort to limit executive compensation by disallowing corporate deductions whjere
compensation exceeeds $1 million (IRC §162(m) has had limited success. See note 12(b) on p.
934.
Weinberger v. UOP, Inc., 457 A.2d 701, Del. 1983
The hurry was that there was a tax reason for Signal to move quickly.
This Court takes a hard line in this case, holfing that the failure of the Signal/UOP directors who
conducted a feasibility study to determine an offering price for the UOP minority shareholders‟
interest, to disclose the results of their study, exposes Signal to liability for breach of fidusicary
duty.
The Court focuses on the speed of the transaction, and implies that the fairness opinion of
Lehman Brothers can‟t be right because it was done too quickly and in a cursory manner.
What do we do about the fact that UOP stock was trading at $14, and the offer to the minority
shareholders for their interest was the same paid for the majority interest.
The Court felt that Delaware Block appraisal method (assets, market pirce, earnings) was
outmoded.
Problem Review
(1) Skeltons
        Alternative dispute measures as within the articles of corporation,
        Bylaws providing for discovery processes.
(2) Long delay in payments
        Agreements to binding arbitration in the bylaws
(3) Payment of litigation expenses
        Agreements to binding arbitration in the bylaws
        Class action suit to lower per person costs (unfair since some people benefit without
paying the costs.)
(4) Valuation method
        Provide a valuation system in the bylaws, just as providing a termination provision.
(5) Discretionary interest payment method by Court
        Agreements to binding arbitration in the bylaws

The Appraisal method reconsidered
The Weinberger Court rejects the use of the Delaware Block valuation method and prosposes a
new more flexible standard.
The list of five problems with the traditional appraisal remedy in cash out merger deals are all
solvable with careful planning.
Note 4 summarizes the NY approach to the problem, characterized by a review of the transacton
as a whole, seeking seeking of fraud, illegaility and overa ll fairness.
“Fairness opinions,” (Note 9 pp. 955-56) are now critical to any “cash out” mergers.

The corporate opportunity doctrine - Northeast Harbor Golf Club v. Harris
See Note 1 p. 964 - the club took long to take any action.
The corporate opportunity doctrine, like the ultra vires doctrine, is plagued woth uncertainty and
vagueness.


                                            Page 44 of 65
Corporations Class Notes            Gerald R. Prettyman                             7/11/2011


The Delaware Court opinion in Gutgh v. Loft offers one set of criteris for evaluating whether the
doctrine has been violated using the test elements outlined on p. 959.
The Court in Harris instead adopts the ALI test found on page 961-62.
Still another set of test elements is found in Michael Begert‟s article, summarized in Notye 5 on
pp. 966-967.
One common thread seems to be whether the corporation has the assets to take advantage of the
opportunity at issue.
The Court basically says thaty disclosure is the requirement, and if the corporation passes, then
the director can proceed. Proceeding without disclosure is highly risky for liability.

March 31, 2004
Rule 10b-5, Insider Trading
Section 10 of the ’34 Act
Key terms, see p. 974 of the case book
    “by the use of any means or instrumentality”
    “in connection with the purchase of sale of any security”
    “any manipulative or deceptive device”
    “in the public interest to for the protection of investors”
Section 10 is limited deceptive activities relating to the sale or purchase or securities

Rule 10b-5
Interstate only, federal claim, so limited to publicly traded companies on national exchanges. Not
limited to fraudulent disclosures. Not stating what has to be said is as serious as fraudulent
disclosures. Rule 10b-5 is preemptive in that it eliminated state laws relating to insider trading of
multi-state corporations.
Early Cases
Strong v. Repide, p. 976 (1909)
The director-negotiators does not share information with minority shareholders. The court held
that was fraudulent.
Hotchkiss v. Fisher, p. 977 (1932)
Shareholder want to keep the shares if a dividend is to be paid. The president of the company
would not tell her yes, or no, and bought her shares from her, knowing that a dividend was about
to be declared. The court held that was fraudulent.
Bailey v. Vaughan, p. 978 (1987)
A director who solicits a shareholder‟s stock has a duty of disclosure to the shareholder before
buying the shareholder‟s shares.
Kardon v. National Gypsum Co., p. 979 (1947)
Private shareholders, one shareholder agrees to sell the company, and buys out the other
shareholders, and then makes the sale. This case provided for a private cause of action under
Rule 10b-5.
Co-joint Issues - good exam question
Rule 14 deals with fraudulent proxy solicitations.
Rule 10b-5 deals with fraudulent share transactions.
Thus a fraud under Rule 14 may lead to a Rule 10b-5 violation.
These two are often tied.
                                            Page 45 of 65
Corporations Class Notes           Gerald R. Prettyman                           7/11/2011


Reasons why 10b-5 is better than state laws, p. 982
Nation wide service of process, forum, etc.

Private Action
Blue Chip Stamps v. Manor Drugs (Birnbaum applied)
Birnbaum held that private plaintiffs in Rule 10b-5 cases should be limited to actual purchasers
or sellers of securities.
This rule is founded on a concern that a broader range of plaintiffs may lead to vexatious
litigants filing suits lacking merits, which tie companies up with extensive discovery, and which
are based on oral testimony and hazy history.
Fraud allegations are difficult to resolve by summary judgment since the details may only come
out during discovery. P. 984-6
Burden of proof is by a preponderance of the evidence, rather than by clear and convincing
evidence. Thus these cases are easier to prove.
Scienter
Ernst & Ernst v. Hochfelder, 425 US 185 (1976), p. 987
This cases established the need for proof of scienter in 10b-5 cases. Subsequent cases establish
that a reckless disregard of the truth meets the scienter requirement. Note, p. 992
Miscellany
      Statute of Limitations the 1 -- 3 rule, the statute of limitations echoes state law on fraud
       (CA is 3- years from discovery of the fraud). The SOX (Sarbanes-Oxley) changes the
       Rule 10b-5 Statute of Limitation to two years after discovery of facts constituting the
       violation, or five years after the violation.
      Aiding and Abetting - there are no such claims under 10b-5; helping someone else violate
       the law is not actionable itself.
      Right of Contribution - proportionate liability only is the law now; not like partnership
       wear where partner in a partnership is joint & severally liable, p. 997, this law is
       beneficial for multiple defendants to minimize their liability, both in acts, and by ratting
       out other parties.
      Bad faith breach of contract can be the basis of 10b-5 claim
ENRON - The General Scheme
The Ancillary Players
     Law firms and Attorneys
     Accountants
     Banks
The key to this discussion is the issue of whether the allegations against the banks, accounting
and law firms are an attempt to assert liability based on “aiding and abetting,” which is not
allowed under 10b-5, or whether these allegation state a claim against the banks, accounting and
firms are “primary violators” of the Rule. The Court denies the dismissal motion, finding that
they are all primary violators. Why?

Judge Harmon stated that although 10b-5 did not expressly state the ancillary players were
primary violators, the Supreme Court and other courts (Denver) did not hold that banks,
accounting and firms could not be “primary violators.” Quote from Denver Banks.


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Corporations Class Notes           Gerald R. Prettyman                            7/11/2011


The firms came across this information as a result of their confidential relationship with Enron.
The Court pointed out the ABA Ethics Rules require that attorneys may not knowingly assist a
client to commit a crime, which includes public reliance by law firms regarding client
statements. While an attorney cannot disclose a client‟s prior crimes, the attorney can (and may
be required to) disclose future crimes the client plans to commit.
There is not an accountant-client privilege.
The court then discusses the SPE‟s activities, and how Enron needed the help of the Law firms
and Attorneys (to create the SPE‟s), Banks (i.e., Citigroup, to create and fund accounts) and
Accountants (to create glowing reports.)
Vinson & Elkins - created the companies, and hired V&E attorneys.
Arthur Anderson - lack of independence, a meeting about their concern of Enron followed by a
discussion of the $100MM anticipated fees, and decision to keep Enron as a client. Anderson
knew the SPE‟s had no business but to cover up the debt. $51 MM identified by Anderson but
Enron refused to make the changes, and Anderson cooked the books.
The court noted that the transactions were not isolated, but in a regular pattern, and paid by
enormous fees. P. 1007
Strong inference of scienter, p. 1009

Chiarella v. United States, 445 US 222 (1980), p. 1028
Chiarella was an outside printer at Pandick Printer. He sought a reversal because he didn‟t have a
10b-5 duty to the shareholders, or the companies involved. The result in this controversial
decision turns in part on several factors in Chiarella‟s defense.
He didn‟t owe a duty to disclose to any shareholders, since he wasn‟t a shareholder or director.
The Court agreed, noting that the jury instructions lacked a statement regarding that there was
duty requirement. The Court mentioned a possible duty to the printing company (his employer),
but did not discuss it. (Recall Robin William‟s movie, “One Hour Photo.”)
The Court said that a duty to disclose does not arise from the mere possession of nonpublic
market information. He may have had a duty to not act, or perhaps to disclose.
Chief Justice Burger, in his dissent, argues that a duty to disclose should exist in this situation,
and that the failure to disclose violates 10b-5. Is he right?
His concern that that the majority limited the scope of Rule 10b-5 too much, and that
misappropriators had a duty to disclose or to not act. CJ Burger said that Chiarella stole the
information and violated the spirit of 10b-5.
Justices Blackmun and Marshall fear that the majority view unnecessarily limits the scope of
10b5. Do you agree? The JJ‟s said that Chiarella had a relationship to the takeover companies
with his intimate access to guarded information and that his trading was inherently unfair.

There is a presumption that insider information is so strong that a person in fiduciary duty cannot
act on the insider information even if the information is publicly rumored.
Thus, even the author of a document (even a whistle-blower selling her stock) that will affect the
company is precluded from insider trading. This is the Imclone/ Waxell -Stewart case.

Review of Problem 12
(a) A secretary has a duty to the employer and would violate 10b-5 by acting on the information.
It doesn‟t matter what level you are at.


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Corporations Class Notes            Gerald R. Prettyman                            7/11/2011


(b) A person who has only a public relationship to the source of the information overheard does
not have a duty to those persons, and would not violate 10b-5. Is a statement made in a restaurant
a public statement? Depends on the context. Should the person have known who the speaker
was?
(c) The reporter has misappropriated the information.
(d) The subtippee probably may not.

United States v. O'Hagan, 521 US 642 (1997), p. 1039
This case is about the intersection of Rules 10b-5 and 14e-3(a).
In this case, the Supreme Case tried to settle the dispute over the applicability of the
“misappropriation theory” to Rule 10b-5, by holding that the theory does provide a right of
recovery and a basis for criminal liability under the Rule.
In a sense, the “misappropriation theory” is a way to hold outsiders liable for insider trading.
This holds for lawyers, accountants, and bankers, but not over the counter printers.
The justification for this extension of this Rule is found in the fact that the Rule deals with
deception of any particular purchaser or seller. The court said here is that O‟Hagan‟s fiduciary
duty was to the source of the information (his firm), p. 1042.
The dissenters attack the theory on the grounds that it is incoherent and inconsistent in its
application. There are telling arguments in the case that the misappropriation theory is invalid as
applied is some cases, and will not be used across the board.

April 7, 2004
Section 21A - Civil Penalties for Insider Trading
The power to impose civil penalties, on top of requiring disgorgement of profits, has had the
intended effect of increasing the risk of insider trading and serving to deter it.
        Example: $1 million profit for insider trading
        Benefactor: disgorge $1MM, plus 3x ($3 MM) penalty = $4MM total
        A controlling person is the person directly or indirectly controlling the person making the
        trade. Subpart iii permits the penalty of 1x, here = $1MM.
        Bounties to informants: SEA §21A(e) provides a 10% bounty, p. 1078,
        PP. 1080-1081: Attorneys prosecuted for insider trading.
The SEC‟s “zero-tolerance” approach, evidenced by a willingness to pursue both small dollar
and large dollar cases, has also served to deter trading transactions. Note 4, p. 1079
The penalty increases under the Insider Trading and Securities Fraud Enforcement Act of 1988
have further deterred this kind of activity.
Section 20A - Liability to Contemporaneous Traders for Insider
Trading
Added by ITSFEA in 1988, this section had not led to many successful actions due to the
ambiguity in the definition of the term, “Contemporaneous” and how particularized the
allegation must be to show the defendants possessed material non-public information at the time
of trading.
        This section is rarely enforced because it separately imposes liabilities for insider trading,
and the definition of contemporaneous is unclear, and how clear the allegation must be in the
complaint.


                                            Page 48 of 65
Corporations Class Notes            Gerald R. Prettyman                            7/11/2011


Section 16(b)
This is a strange action, imposing liabilities against insiders in a company who use inside
information to buy securities and then sell them within 6 months of the time of purchase.
Avoiding liability under thus section is as easy as holding the stock for more than 6 months.
One thought is that its true purpose is to prevent insiders from manipulating corporate affairs to
create opportunities to trade stock profitability, via a quick turnover. By requiring insiders to
hold the stock for more than 6 months, you can stop that kind of activity.
See the analysis of how profits are determined on p. 1086-7.
The initial rush of action brought under 16(b) slowed when the exemptions were adopted by the
SEC in 1991. See Note 9, pp. 1088, 1089.
Takeovers, See Note 10, p. 1090-91.

Basic Inc. v. Levinson, 485 US 224 (1988), p. 1091
The relevant standard of materiality is that “there must be a substantial likelihood that the
disclosure of the omitted fact would have been viewed by the reasonable investor as having
significantly altered the “total mix” of information made available - a reasonable investor would
consider it important in deciding how to vote.” TSC Industries.

Information regarding merger discussions may be material.

The requirement that an investor rely on the material misrepresentation as a condition of stating a
claim under Rule 10b-5 can be satisfied by the investors reliance on the public material
representations reflected in the market price for the security.

Many disclosures, such as day-to-day operations are not required for disclosure. Such
information could be confusing to the market-place, and to the employees.
Some disclosures are required. There is no bright- line, but the Court adopted the TSC Industries
standard.

On pp. 1094-5, there is a modification that each case is fact-specific, The determination of
materiality requires delicate assessments of the inferences a reasonable shareholder would draw
from a given set of facts and the significance of those inferences to him.”
“Under such circumstances, materiality will depend at any time on a balancing of both the
indicated probability that the event will occur and the anticipated magnitude of the event in
light of the totality of the company activity.” SEC v. Texas Gulf Sulphur .

The plurality says that Fraud on the Marketplace satisfies reliance for an action in Rule 10b-5.

Justice White agrees with the materiality standard, but is mystified by the Court‟s adoption of
Fraud on the Marketplace. The Justice says that Court should not enter into economics for which
is it ill-prepared, but he does so himself to poke holes in the plura lities opinion.

The concept is that the price of stock is an effective and relatively accurate value of the stock.
The price is equivalent to the value of the stock. This is the best assessment unless tainted by
fraud. However, the stock price may be changed by factors outside of the company. Thus, the
stock market may be affected by military and economic affects.

                                           Page 49 of 65
Corporations Class Notes           Gerald R. Prettyman                            7/11/2011



The plurality decision in Levinson in allowing reliance to be shown by the public market price
for the stock adopts the “fraud on the market” theory. If the issuer‟s misrepresentations affect the
market place of the stock and the purchaser relies on that market price in making the decision to
buy or sell, then the reliance element needed in a Rule 10b-5 case is satisfied.

The dissent by Justice White is critical of the merit of the “fraud on the market” theory noting
that many times purchasers do not rely on the market price, and in fact may base their decision to
buy based on the value that the market has inaccurately determined the value of t he stock in
setting its price.

The Efficient Capital Markets Hypothesis, Note 2, p. 1107 (ECMH)
The concept here is that an open and developed capital market, such as the NYSE, or NASDAQ,
operates quickly based on the constant flow of new information, and processes and applies that
information flow to the pricing of a given stock, such that absent fraud, the market price is a
good indictor of the true value of the stock. Critics of the theory note that sometimes the market
reacts to political or other new developments that are not directly tied to the fortune of a
particular company, and thus this renders the market price a poor indicator of the “true value” of
the security.
How else can we set value for purposes of Rule 10b-5 analysis? Is the fraud on the market theory
and the ECMH hypothesis better than not theory at all?

Problem - Insider Trading
See Problems\Corp12InsiderTrading.doc

The Private Securities Litigation Reform Act of 1995, p. 1117
PSLRA was primarily enacted to stem the damage perceived to be caused by “strike suit” class
actions file not on the merits of provable insider trading, but by plaintiff and their counsel,
following a significant change in as securities‟ market price, for the purpose of extracting a big
settlement fee, paid by the corporation sa as to avoid the costs f litigation and extensive
discovery.

PSLRA attempted to address those issues by generating new procedures for: qualifying class
representatives delaying discovery, limiting liability (from joint and several to propor tionate),
strengthening Rule 11, heightening pleading requirements, imposing new measures of damages,
and adding new duties for auditors.

Class Action Procedures, p. 1117-1118 (plaintiffs rules)
The class representative had to certify that they had read the complaint, bought the stock without
inducement by the attorney, and were not professional plaintiff‟s.
The Rule also capped lead attorneys fees, and tied attorneys fees to the recovery,
The Rule also allowed that discovery would not occur until after the court heard a motion to
dismiss. This reduced fishing expeditions. This is only based on the pleading to state a cause of
action with particularity. The Rule is not a summary judgment action to dismiss the case. The
plaintiff could still file a better complaint.
Rule 11, p.1119 (Cal.Civ.Code §128.5) Certainty of the merits of the pleading
                                           Page 50 of 65
Corporations Class Notes           Gerald R. Prettyman                            7/11/2011


Loss causation
No damage award may exceed the difference between the ____ price and the 90-day average.

Note 8, p. 1121, Safe Harbor for Forward-Looking Statements (MD&A) [provided they are
supported.]

The PSLRA has led to unexpected consequences. Cases are taking longer to litigate, there are
more battles over the selection of lead counsel, and most importantly, counsel for plaintiffs in
class action Rule 10b-5 cases have simply moved their cases to state court, to avoid the
discovery limitations and other elements they viewed as overly restrictive.

To stem the tide of this migration into state court, Congress passed the Securities Litigation
Uniform Standards Act (1998) which preempts most securities fraud action brought in state
court.

The parallel lawsuits have led to serious problems.

The “covered securities” limitation, and the “Delaware carve-out:” limit the effect of the SLUSA
preemption. Preemption does not apply where the suit is filed in the same state as the state of the
corporation‟s incorporation.

MDCM Holdings v. Credit Suisse First Boston
Defendant‟s argument that SLUSA preemption applies in this case fails because of a well-drafted
complaint. All of the allegation in the complaint are based on state court breach of contract
remedies. There are no fraud allegation. Therefore, preemption is similarly inapplicable.

The complaint was all breach of contract, without any allegation, “in which the plaintiff has
alleged either a "misrepresentation or omission of a material fact" or "any manipulative or
deceptive device or contrivance." Thus, this was not a Rule 10b-5 case, and SLUSA was not
applicable.

Gibson v. PS Group Holdings
This case illustrates the effective use of the Delaware carve-out exception to the SLUSA
preemption. This exception allows a state class action fraud suit where the defendants have
breached state law in the state where the issuer is incorporated.

The Delaware carve-out does not actually require that the case be filed in Delaware. A suit
against an issuer of another state must be filed in that that state‟s court.

April 14, 2004
§16(b)
§16(b) imposes strict and automatic liability against insiders for short-swing (6 months or under)
trades. This is a bar testable question. The bar question also tested agency. A company/ person
using an insider to buy and sell becomes an insider, and is also guilty of violating §16(b).


                                           Page 51 of 65
Corporations Class Notes           Gerald R. Prettyman                            7/11/2011


Indemnification
Defined.
Corporation pays judgments and expenses, attorney fees, in good faith situations.
Attorneys fees
Attorneys fees are typically part of indemnification even though they are not damages, nor are
they costs. Attorneys fees are expenses to a litigation. An award to recover costs of suits does not
include attorneys fees, unless there is a statute providing for attorney fees/ expenses.
Generally, an award for attorneys fees means reasonable fees are directed by the court. Where an
indemnification contract provides attorneys fees, that means all attorne y fees.
Settlement
Would indemnification apply to a settlement?
What if the indemnification provision only applied if the party was successful?
Then, the question is whether a settlement is „win.‟
Statutes may provide for indemnification if the acts were in good faith. This is not always the
fairest outcome.
Rational
The rational behind providing indemnification to corporate officers and directors.
D&O indemnification acts to entice good, but personally cautious persons to director and officer
positions.
Choices
If the corporation pays, does the corporation also choose the attorney.
What if the charges are against the Director or Officer?
Since the suit may affect the „good name‟ of the Director or Officer, should the Director or
Officer have the option to not settle to not taint their name.
Companies may claim that indemnification provisions are standard, but that is B.S. NOTHING
IS STANDARD in NEGOTIATIONS

Merritt--Chapman & Scott Corp. v. Wolfson, 321 A.2d 138 (Superior Ct.
Del. 1974), p. 1134
Note the distinction between when companies may provide indemnification, and when they must
provide it. See Title 8, Delaware Code §145(a) & (b).
Subchapter E of MBCA Chapter 8 defines the scope of permissible indemnification. See p. 1138
of the casebook.

§145 allows that a person accused by reasons of her status, and she acted in good faith, best
interest, … (if criminal) and reasonably didn‟t believe the act was unlawful, the board had
discretion to award indemnification. If the board does not provide indemnification, the D/ O may
sue the corporation for abuse of discretion and breach of contract.

Under Del. §8-145(c) a corporation MUST provide indemnification to a D/ or O who was
successful. See also MBCA §8.51(d).

MBCA §8.51(b) also provides for indemnification where boards change their retirement plans.

Read all MBCA §8.5x rules.

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Corporations Class Notes           Gerald R. Prettyman                            7/11/2011



Indemnification of Directors in Actions Directly by the Corporation: Must the
Corporation Finance Its Opponent's Defense? Diane H. Mazur, 19 J. Corp. L.
201, 202-205 (1994), p. 1143
The Public Service Company of New Mexico case says you do, if the elements of statutes and
contract language allowing this result are present.
Note that the importance of good faith on the part of the person seeking indemnity. Cases where
the directors are found guilty and still receive indemnification because they acted in good faith
are rare.
What is the officer‟s side of this issue?
This is the result of „good‟ indemnification provisions gone wrong. The corporations want to get
good people, but sometimes hire the wrong person, who „believes they were entitled; to what
they took. The standard is weighed in favor of granting indemnification, not denying it.

McCullough v. Fidelity & Deposit Co., 2 F.3d 110 (Fifth 1993), p. 1149
Note the critical importance of giving timely notice of claim under a D&O policy.
Since policies are temporal contractual agreements, timely notice is important so that the
company and insurer can determine whether the claim properly triggered the coverage.
        What is the difference between a “claims made” and an “occurrence policy?”
A claims made policy provides coverage for claims first made against an insured during the
policy period. Thus, an insured is only protected for claims arising and asserted during the policy
period. If the insured retires, or changes employers, or insurers, the insured will not have
coverage for earlier arising claims.
An occurrence policy provides coverage for injuries that take place during the policy period
regardless of when the claim is asserted. Thus a later insurer is liable for events occurring
before coverage started.

Directors and Officers Liability Exclusions, p. 1134
Coverage exclusions are extensive, including but not limited to these.
Personal profit or advantage exclusions; dishonesty exclusions; bodily injury/ property damage
exclusions; ERISA exclusions (avoid overlapping coverage);
Section 16(b) short swing profit exclusions (16(b) is strict and automatic);
Return of illegal remuneration exclusions (e.g., Tyco); pollution exclusions; pending or prior
litigation exclusions; and regulatory exclusions. [N.B. A number of these are not in the *best*
interest of the corporation (leaving out the happiness of the director or officer.)

Takeovers
The Beginning of the Takeover Movement
The initial approach to takeovers was via proxy fight for control of corporate management. The
insurgent usually has a difficult time convincing the shareholders to have the same view. Proxy
fights were also expensive for the court battles over shareholder lists, and the costs necessary to
contact millions of shareholders. Over time, this method became unwieldy due to the number of
shareholders in large companies and the prohibitive cost of proxy fights. This approach was
replaced by cash tender offers.


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Corporations Class Notes           Gerald R. Prettyman                          7/11/2011


Cash Tender Offers
Since cash is not a security, these offers did not require registration with the SEC, and were
offers made directly to shareholders. To buy their stock at a price in excess of the then market
price, by about 15 to 20% plus. Cash Tender Offers were not successful where the shareholders
thought the stock would go up. Cash Tender Offers were successful for troubled companies. The
1968 Williams Act amendments (to SEC §§13 & 14) cleaned up cash tender offer problems by
requiring disclosures by the bidder, 20-business day purchase offer, revocable sales within the
offer period, the highest price applies to all sellers, over-subscriptions are pro-rated to the
number of shares to be acquired.
The policy of the Williams act was fairness for shareholders and something to slowdown the
runaway takeovers that were occurring.
Leverage Buyouts
A risky form of takeover financed by debt owed by the target corporation. The targeted
companies were usually already in trouble. The corporation then had enormous debt. If the
takeover went wrong, bankruptcy was the usual result.
See “Greed,” “Wall Street,” and “The Barbarians at the Gates” (KKR takeover of RJR Nabisco).
The money comes from banks, junk bonds, brokerages, partnerships and other investors. See p.
1172
§B. Defenses to Hostile Takeovers - State Legislation, p. 1176
One concern of the Hostile Takeover is the impact on the local economy. Nations Bank
(Georgia) took over Bank of America (San Francisco). Many states became concerned over
business and employment losses, and passed statutes to limit takeover based corporate exodus.
Flint, Michigan (See “Roger and Me”) suffered significant losses from a takeover exodus. The
laws were called stakeholder statutes.
CTS Corp. v. Dynamics Corp. of America, 481 US 69 (1987), p. 1176
(continued)
The majority also rejects the claim that the Act imposes a longer period (50) days than the
William‟s Act 20 day period for acceptance of a tender offer.
The majority view is essentially a “states right” view, arguing that applying preemption in the
area of corporate law should be some sparingly.
The dissent by J. J. White, Blackmun and Stevens notes that the effect of the Indiana Act will be
to foreclose tender offers and to undermine the rights of minority shareholders.

April 21, 2004
Final Exam Context
Exam is closed book, no notes, no outline.
1 essay - 60 points, about 10 (8-11) issues, each worth 6 points.
40 multiple choice questions, worth 1 point
2 formats, 4 groups, fact pattern & 5 questions, 20 stand alone questions.

____ (the client) would like to (Call of the question)
The Client‟s position is that ….
The plaintiff‟s causes of action are : …..
The elements of ____ are ____

                                           Page 54 of 65
Corporations Class Notes            Gerald R. Prettyman                            7/11/2011


The opposing parties position is --
The (opposing party) position is (not) supported by the law that …..
This case similar to where the …….
Based on the facts presented here, a court would rule for ….

Takeovers, Part 2
Defenses - Poison Pills
Moran v. Household Int’l Inc.
The effect of the shareholder rights agreement adopted by Household would have t he effect of
severely diluting the value of the aggressor‟s shares - here by 50%.
The court applies the business judgment rule as the standard of review for the Rights Plan - and
finds that there were worse mechanisms available, that the effect on proxy co ntests will be
minimal, that Household was vulnerable to coercive acquisition techniques, and that it adopted a
reasonable defense mechanism to protect itself.
Note the variations on the poison pill defense: the flip-over, the flip- in, and the back-end rights.
See p. 1202 n.(1).
The nature of the plan was that existing shareholder would have the right to buy $200 of stock
for $100 in the acquiring company. The are about 20 types of poison plans. Know that there are
any number of means to discourage a takeover.
D-K-M challenged the Poison Pill Provision. The Court said that a Poison Pill Provision is
invalid if the purpose was to keep the board in place; but is not invalid to delay for the purpose to
get other bidders, make counter-bids, or there is a reasonable belief that the acquiring company
was tear-apart the question to the detriment of the shareholders.
The court is looking to the Business Judgment Rule as the determining standard.
Three ways around poison pills & variation
Negotiate a friendly transaction with the target company - not often available, but sometimes
possible for the right price.
File suit seeking a declaration that the Board has breached its fiduciary duty to shareholder by
refusing to redeem (withdraw) the poison pill (for entrenchment - must prove intent). Also tough
because courts are hard to persuade on this one.
Launch a proxy contest - take over the board and have the new board vote to redeem the poison
pill rights - expensive and time consuming.
Variation on the Poison Pill - the continuing directors or dead hand poison pill.

Mentor Graphics Corporation v. Quickturn Design Systems, Inc., 728 A.2d 25 (Court
of Chancery, Del. 1998) p. 1204
This case presents another variation - the no hand poison pill - whose intent is to discourage
attackers via a length six month delay (through the DRP) in the date a new board could redeem
the Rights provision - this plus a term establishing a 90-day delay in shareholder action mean
acquisition could be delayed 9 months.
The Court establishes a different standard of review for poison pill actions p- “enhanced judicial
scrutiny” to determine of the corporation reasonably believed that it was facing a threat to its
policies and effectiveness and if the measures adopted were appropriate to the threat
Note the types of threats outlines on page 1210.


                                           Page 55 of 65
Corporations Class Notes            Gerald R. Prettyman                             7/11/2011


Commentators have categorized three types of threats: (i) opportunity loss where a hostile offer
might deprive target shareholders of the opportunity to select a superior alternative offered by
target management [or, we would add, offered by another bidder]; (ii) structural coercion, ... the
risk that disparate treatment of non-tendering shareholders might distort shareholders' tender
decisions; and (iii) substantive coercion, ... the risk that shareholders will mistakenly accept an
under-priced offer because they disbelieve management's representations of intrinsic value.

Note (1) The Supreme Court of Delaware affirmed the Mentor/ Quickturn decision on the same
grounds, and added that the DRP “would prevent a newly elected board from completely
discharging its fundamental duties … for six months * * in an area of fundamental importance …
- negotiating a possible sale of the corporation.” The Court found the DRP therefore invalid
under §141(a).
Suppose that the A/I allowed such a limitation in the articles. Would there be a different result?
No - the provision too much limits the boards power. Anything that restricts the rights of board
gets a strict review by the Delaware Supreme Court.

International Brotherhood of Teamsters v. Fleming Companies, 975 P.2d 907 (Okla.
1999), p. 1216
 -- Is the right to adopt shareholder rights plans (SRP) limited to the B/D? No, says this court.
-- May shareholder propose that SRP‟s be submitted to shareholder for vote? Yes, says this
court.
-- The rise of institutional investors arguing that mergers may be in their best interests, even if
they are not so perceived by the board - Court see the SRP as akin to a stock option plan.

The Court likened SRP‟s to stock option plans, and said that unless the A/I prohibit shareholder
from presenting an SRP, then the shareholders can present an SRP.

Delaware’s Response to Shareholder Rights Law
-- IBT was an Oklahoma case. Note that Delaware has a different approach.
-- Delaware‟s strong support of the right of B/D to control the operation of the corporation
results in a rejection, in most instances, of SRP‟s in Delaware.
-- This is not to say that Shareholders can‟t challenge the adoption of an SRP. Shareholder
simply cannot adopt an SRP without Board approval.

Takeover Defenses and Judicial Review
The typical claim against boards adopting takeover defenses is that they are entrenched and
violating their fiduciary duty to put the needs of the corporation first.


Seven reasons to avoid a tender offer/ public bid. Page 1222
Examples include (1) the offered price is too low and does not reflect the "true" value of the
corporation's business; (2) the aggressor's reputation for sound fiscal management is not good;
(3) the aggressor is assuming debt obligations which it probably cannot meet without using the
target's assets, thereby injuring remaining shareholders or senior security or debt holders; (4) it is
simply in the best long-run interests of the shareholders for the corporation to remain
independent (the "just say no" defense); (5) management has already embarked on long-range
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Corporations Class Notes            Gerald R. Prettyman                             7/11/2011


plans to improve the corporation's profits and stock price, and the decision to pursue those plans
is protected by the business judgment rule; (6) the proposed transaction would result in the
violation of the antitrust laws or some other federal or state statute; or (7) the offer is a partial
one and is structured in a way that makes it unfair to shareholders by "coercing" them to tender

-- List of defenses, including three-tier plans, Just say no, p. 1225
-- More options, such as staggered B/D terms. Fair price charter amendments, and dual class
capitalization plans - see pp. 1226
-- Be familiar with Unocal, Revlon, & Unitrin.

Revlon v. MacAndrews & Forbes Holdings, 505 A.2d 173 (Del. 1985), p. 1231
A B/D‟s fiduciary obligation changes from protecting the corporation to getting the best deal for
its shareholders when takeover is inevitable.
Prof. Coffee - Easier said than to apply.
Unitrin Inc. v. American General Corp., 651 A.2d 1361 (Del., 1995), p. 1236
The B/D action must be proportional to the threat.

Lock-ups
-- Lockup provisions are terms added to a proposed friendly merger to defend the deal from
subsequent hostile bidders.
-- Examples of lockup provisions are irrevocable stock options, asset options (crown jewels),
topping fees, expense reimbursement provisions, and termination fees.
-- The validity of lockup provisions is tested by determining if the lockup is solely a defensive
measure against a hostile threat (those are valid) or if it results n an artificially lowered value for
the shares and prevents the company from receiving a maximum value offer for its shares that
might be deemed preclusive and invalid.
-- The question is whether the lockup defensive against a third party, or to serve entrenchment
of the B/D.

Recent Fundamental Changes in the MBCA, p. 1246
See CorpReadNotes.doc

Chapter Sixteen – Corporate Books and Records
-- There is no federal law regarding Corporate Books and Records, only state laws about what
has to be recorded, and who can look at them, and why.
MBCA Chapter 16
-- Aside from laws allowing shareholder access to corporate books and records, most states
impose no other requirements.
-- MBCA Chapter 16 is not adopted in all states. It adds to the requirements for corporations to
maintain appropriate financial records and to keep specified corporate records. Note the
difference between “Keep” and “Maintain”
---- Keep means to retain indefinitely.
---- Maintain means to retain current records only without regard to how long.




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Corporations Class Notes            Gerald R. Prettyman                              7/11/2011


Thomas & Betts Corporation v. Leviton Manufacturing Co., Inc., 681 A.2d
1026 (Sup. Ct. Del. 1996), p. 1255
Shareholder seeking access to corporate records have a normal preponderance of evidence
burden to meet to show that the primary purpose for their request is a proper one.
The mismanagement claims here are not made in good faith.
In cases where the plaintiff cites alter ego liability, the plaintiff must provide specific instances
(particularity) for suit to advance.

Saito v. McKesson HBOC, Inc., 806 A.2d 113 (Sup. Ct. Del. 2002), p. 1265
Saito did hold stock in the merged company, only the parent company.
Delaware‟s §327 limiting inspection of records to persons who were stockholders at the time of
the transaction of which thy complain, does not limit the scope outlined in §220 for such
investigation, since records predating the requesting parties acquisition of stock may be relevant
to the inquiry.
The source if the documents and the manner obtained have little or not bearing on a shareholder
inspection rights.
Shareholder of a parent corporation are not allowed to inspect as sub‟s books absent a showing
of fraud.

Parsons v. Jefferson--Pilot Corp, 426 S.E. 685, (Sup. Ct. Del. 1993), p. 1269
-- The NCBCA did not preclude a shareholder in a publicly held company from exercising the
common accounting records for a proper purpose.
-- The NOBO list is not a shareholder lists since it is not a list of registered owners and thus may
not be compelled to be produced where the corporation itself does not maintain such a list. It
cannot be compelled to create one in response to a request to produce.
If the corporation does have a NOBO list, it must disclose it in response to a proper request.
-- Meeting the requirement to specific requested items with particularity is subject to the
knowledge of the requesting party.

Corporate Dissolution
(1) With respect to any taxing authority, you must paid all taxed up to date, franchise taxes,
corporate taxes, etc.
(2) Get certification that all taxes are paid.
(3) File a notice of dissolution in the state of incorporation
(4) Liquidate corporate assets according to the hierarchy of payments, secured creditors first,
then unsecured creditors.
(5) Then pay loans to shareholders and directors.
(6) Initial capitalization costs.
(7) Distribution of profits, if anything is left.

April 24, 2004 - Final Review
State bar exam questions
Go to the State bar website, exam portion, and download questions and sample answers.
Of the 5 years, there are two years with corporation questions. Take the exams
See 2/2002 Question 3 (16b question, duty of loyalty) and 7/2003 Question 1 (Issuance of stock)

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Corporations Class Notes           Gerald R. Prettyman                           7/11/2011


       http://www.calbar.ca.gov/state/calbar_generic.jsp * * *
       Bar Exam
       Examinations (on left)
       Essay questions & selected answers
       Exam is in abode pdf format
Opening format of answer- “There are three issues here: duty of care; duty of loyalty, and
corporate management & control.”
Management & Control – Shareholder Voting and Agreements
Galler - Shareholder agreements, allow minority shareholders to have some control in the
corporation. Let one minority view director on the board, without getting control of the board.
Remember that there is a significant difference between record holder (brokerage house) and the
beneficial owner (purchaser of stock) [Shareholder agreements are not real important]
Voting Styles
Straight voting - 1 vote for 1 share
Cumulative voting -
Cumulative voting provides input but not control (Humphrey - right to cumulative voting, but no
other)
Voting trust is difference from a voting agreement (block voting)
Voting trust - trustee to vote their interest, trustee can‟t breach that trust
Proxies - small corporation does not need proxies; large corporation must have proxies.
The right to vote goes to a designated party.
3 reasons for proxy solicitation: mergers, election of officers, dissolution of the corporation.
Brown - voting trustees cannot extend their power
Share transfers
Restrictions written on share
Privately held corporation shares cannot be sold on the open market - either the corporation buys
the shares backs, or the corporation goes IPO, or the corporation dissolves
Option agreements - employee can obtain stock, may have to remain employed
Valuation & buy-sell agreements
Buy-sell agreement to provide for privately held stock sale/ transfer/ payoff.
Without a Buy-sell agreement, one party could force a dissolution.
With a Buy-sell agreement, the departing party can be forced to take payments, payout scheule,
& not put the corporation out of business.
Mandatory buy-out provision is not required.
Modern Remedies for Oppression, Dissension or Deadlock
Settling differences of opinion & personality between shareholders.
Courts have the power to remedy harm done by oppressive shareholders
Remedy is usually FMV buy-out of the minority shareholders.
What if the majority has driven the price down?
Plaintiff needs to show what the price „was‟ before the majority‟s behavior drove the cost odwm.
Minority shareholder‟s claims must be reasonab le.
Actions by D&O
D&O‟s can bind the corporation if they have the authority.
The Board must pass resolutions to grant the president authority to negotiate, or execute.
An agent cannot bind a principal without evidence of authority.

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Corporations Class Notes            Gerald R. Prettyman                            7/11/2011


A third party cannot rely on an agent‟s statement of authority.
Ask for a resolution from the board.
Exception - where the action is part of a continuing stream/ course of dealing.
Transactions in Controlling Share - whether a majority shareholder can sell their stock for a
premium with the controlling interest. [YES, but there are limits]
If the majority shareholder knows the purchaser will loot the corporation, the majority
shareholder has a duty to the minority shareholder. If there is not a reason to believe/ anticipate
the problem, then there is not a problem.
Perlman - Minority shareholder must be allowed to share in the stock value increase. Probably
not followed.
Social Responsibility of Corporation
Corporations are regulated bodies - does the grant of a license impose other requirements.
Corporation outsourcing is the current Social Responsibility issue.
Middle ground is our answer, it is a balancing test to preserve the social issue, and the profit
issues of the corporation .
Liability Exposure to shareholder, so shareholder can sue.
Non-corporation entities do not have this same issue.
Who Controls the Corporation?
Privately- held: management, D&O and shareholder are the same.
Public - management is not driven by shareholder. Board & Senior management is the key to
control.
Efficient Capital Market Theory
The market responds and flushes out the true strength of the corporation.
Managers interests is also in the corporation, so usually this is the same as the shareholder
Exception is the takeover - for shareholder the stock value may go up, for management, they may
be fired.
Diversified investor - same interest as the management
Un-diversified investors are usually employees would not be happy with some decisions.
Institutional Investors
The total amount of stock owned is very large, so Institutional Investors do not have that much
effect. Best either is a proxy fight, or stock sell-off (but is tool ate.)
Nominee- the record owner brokerage house is the nominee for the beneficial.
Book Entry - the record owner brokerage house has the names of the beneficial owner, the
corporation only has the names of the record owners.
Transaction settlement time has not been changed from the switch to beneficial owners.
Outside directors
More important now with Sarbanes-Oxley
Should be neutral - not interest in the corporation
Necessary for audit committees.
Insurance required by indemnification.
No time to be involved in day to day management.
Business Judgment Rule/ Director’s Duty of Attention
Directors need to rely on inside and outside advice.
When can directors be held liable for relying on inside and outside advice.
Factors

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Corporations Class Notes           Gerald R. Prettyman                            7/11/2011


What did the director‟s know?
–Directors cannot sit back and refrain from taking action if they are aware of crisis conditions in
the company
–Business judgment takes into consideration a different set of factors than legal judgment – this
must be taken into account in evaluating the merits of Board action.
Corporate governance
The Fall of Enron has changed corporate governance; Sarbanes-Oxley;
Now the norm is that directors are independent outsiders, and the supermajority are outside
directors.
Additionally boards & committees.
Important for corporations to improve governance to avoid problems.
Enron was about hiding losses to show profits.
The recording requirements then had substantial misstatements (fraudulent statements).
Sarbanes Oxley
Tightens the strings of corporation governanace.
The CEO & CFO must certify the disclosures
Monitoring of internals controls
***
Attorney standards
Must report all problems up the chain of command
No requirement to report outside the corporation.
Whistleblower protection.
Accountant Standards
No auditing & management counseling for the same client - many have now spun off.
Proxy Regulation
Proxy Solicitation - the SEC was concerned about election of officers & takeovers where
insufficient information went to shareholders, missing relevant facts.
All proxy solicitations must be registered, §12; Assets requirements now 10 million dollars
(NAV) to register
Securities Exchange Act of 1933 §§ 14(a), 12(a), 12(g)
–Section 14(a) requires that all proxy solicitations be made in accordance with SEC rules – the
central concern is with the adequacy of disclosure
–Section 12 details the requirements for the registration of securities for large, publicly traded
companies
–Note that amendments have raised the total assets registration requirement from one million to
ten million
–This registration requirement is in addition to the requirement that all proxy solicitation must be
registered.
Proxy Regulation
•Studebaker Corp. v. Gittlin –Section 14(a) is construed to extend to a request to inspect
stockholders lists, whether the ultimate goal of the request is to solicit proxies or not.
Must be registered - adequate disclosure and ****
MD&A report - finally annually with SEC for financial status.
What does the corporation think that it will do in the future?
Uncertain, so SEC has backed off liability; must only be reasonably based;

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Corporations Class Notes           Gerald R. Prettyman                           7/11/2011


If circumstances change, then the corporation is not liable because of the change was not
reasonably foreseen.
Caterpillar - lumping was unreasonable in consolidated report because the circumstances
between the two years was so different that corporation was aware of the significance.
False & Misleading Statements Not permitted- Reg. 14(a); can‟t omit material fact.
What‟s a material fact? shareholder would change their action
What if the misrepresentation would not have changed the outcome.
The policy is more important - 14(a) is still violated.
TSC - modification of standard for materiality, “might” is to loose, “would” consider is the
standard.
VBI - knowingly false conclusory statements without facts is still wrong.
Opinions & beliefs of misrepresentation or omission are still wrong under 14(a) if the opinion
comes from a source that the shareholder would rely on.

Duty
Duty of Care & the Business Judgment Rule
Trustee/ Fiduciary Duty
Litwin & Wrigley - Directors are trustees of the corporation & have a fiduciary duty to the
corporation, but they can be wrong so long as they had a reasonable, good faith belief to justify
their acts. Absence fraud or breach of a reasonable, good faith belief, courts will not interfere
with the judgment of the B/D.

Standard
Entrepreneurial v. Ordinarily Prudent Person - The Ordinarily Prudent Person standard is
incorrect for Entrepreneurial business. Thus, the standard is “absent a showing of bad faith or
some other corrupt motive, directors are normally not liable to the corporation for mistakes in
judgment.”

Showing of Effort
Careful gathering of information, reasonable deliberation
If study results would be useful, they must be procured.
Legal advice is not dispositive of lack of reasonable effort.
Dissenting directors are just as liable under the unified theory unless they step down from the
board. It‟s a tough place to be, but that‟s the rule.
Look for evidence of diligence, & duty of care.
Is the action taken in the best interest of the company, and the director has reasonable belief
based on “careful gathering of information, & reasonable deliberation”
Malone - While normally not required to make statements (except proxies) if the B/D undertakes
a voluntary statement, it must be accurate.
Zapata - May a committee of disinterested directors dismiss a derivative suit agains t the other
board members? If there is a conflict between the board and the shareholders, the disinterested
directors should request a stay on the derivative suit and request a declaratory order from the
court of how to proceed.
Aronson v. Lewis - demand is necessary unless futile, see criteria on p. 879

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Corporations Class Notes            Gerald R. Prettyman                            7/11/2011


Duty of Loyalty/ Conflict of Interest/ Self-dealing
The standard is intrinsic fairness, was the conduct intrinsically fair.
Internal context - are the directors acting in their interest?
External - Are the directors taking the outside act for themselves.
Self Dealing
–Note 4 (a)-(c) on pp 912-913, provides a valuable summary of the principles underlying most
self-dealing decisions
Court may void Self Dealing transactions
–Note 10(b) on pp 914-915 provides a good definition and examples of “conflicting interest,”
such as a decision to not disclose that give benefit to the director who knows.
–Notes 14&15 on pp 917-918 detail the prohibition, both under the 1960 MBCA, and now under
Sarbanes-Oxley, against loans by the corporation to corporate officers or directors (- this is a
conflict of interest) –executives may bypass this prohibition by simply authorizing huge
compensation or similar benefits.
Valuations
Eisner - this was a bad deal for Disney, Ovitz got too good a deal, but the B/D reasonably
believed were acting in good faith. A bad judgment is not a breach of loyalty.
Compensation levels generally are not reflected in stock price, the cost is small to revenue, the
B/D says they must offer comparable salaries.
Weinberger - directors serving on both companies in a merger are in a breach of loyalty for not
disclosing material (FMV) information to minority shareholder, such as the highest amount study
showed. Rejected the Delaware Block Evaluation standard as too loose.
The Appraisal Remedy reconsidered -
Cash-out
Problems with traditional remedy
New York method
Get a fairness opinion from the evaluator to avoid problems
B/D should get neutral, outside opinions on fairness, and proper disclosure.
Failure to get the opinion may not be excused by the Business Judgment Rule in the absence of a
showing of reasonable reliance
The Corporate Opportunity Doctrine, p. 959 test elements
Able? In the line of business? Practical? Conflicts?
Look at the criteria - if there is any way the corporation could do it, then you must act.
The best option is to disclose it. Not disclosing the information runs the risk of breach of duty.
Rule 10b-5, Insider Trading - Fraudulent Transactions
Deals only with the purchase and sale of securities.
Through the use of any manipulative or deceptive devices.
No corporate opportunity unless there is a purchase or sale of securities
If it is a private person, they must be the actual buyer or seller.
No third parties.
Proof of a violation by a preponderance of evidence, less than clear & convincing
Scienter is required - Reckless disregard is evidence of scienter.
No aiding & abetting claims under 10b-5
Enron
Classic 10b-5, SPE hid the losses so Enron showed well & induced people to buy stock.

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Corporations Class Notes           Gerald R. Prettyman                            7/11/2011


The –Law Firms and Attorneys –Accountants –Banks were still liable as primary violators even
thought they were third parties because they participated in creating the SPE‟s that led to the
disclosures.
Chiarella
- He didn‟t owe a duty to disclose to any shareholders, since he wasn‟t a shareholder or director,
a duty to disclose does not arise from the mere possession of nonpublic market information.
Dissent fears that the majority view unnecessarily limits the scope of 10b-5.
14e-3(a) & 10b-5
O‟Hagan - Outsiders can be liable by acquiring insider information
Week 13 – 8 Slides - Insider Trading Part 2
§ 21A – Civil Penalties for Insider Trading on top of disgorgement of profits.
MBCA has not been successful & is not used
§16b short-sales
Know the formula for determining liability and damages!
Highest transaction price - lowest transaction price = damages (regardless of whether the
transaction was a buy or sell)
Based on conduct only, no scienter required.
Look for 16b exemptions!!!! (see pp. 1088, 1089)
Basic - relevant standard of materiality
- a reasonable investor would consider it important
Fraud on the market theory - plurality opinion
If the market has been defrauded by the misrepresentation, then reliance is presumed for liability.
Justice White dissented - people look at the market price as a reference to what they believe, is
the market price undervalued? The market price is a poor indicator.
There isn‟t another way, even though we know of problems.
The Private Securities Litigation Reform Act of 1995
Make it tougher to bring class action suits based simply on market response.
Didn‟t stream line, longer time, more battles over lead plaintiff.
Moved the cases to state court.
Securities Litigation Uniform Standards Act
Securities cases can‟t be in state court.
Plaintiff then filed in federal court, & then in state court, & stayed the federal action.
MDCM Holdings, Inc. v. Credit Suisse First Boston Corporation - no fraud alleged, so no 10b-5,
so SLUSA, so no limitation to federal court.
Indemnification
Indemnification defined
corporation pays judgments and expenses (atty fees) in good faith situations; critical to bring in
outside directors
These are good faith situations. Bad faith invalidates indemnification.
Absent a K, payment is elective if there is an pending claim
If adjudicated in favor of the director, the corporation must pay the bill - no election
Public Service Company of New Mexico
Directors had broad indemnification K, so the corporation was bound to pay for their defense.
Even if the director was guilty, indemnification applies for good faith.
***–What is the difference between a “claims made” and an “occurrence” policy?***
                                           Page 64 of 65
Corporations Class Notes            Gerald R. Prettyman                            7/11/2011


Know this and Know the Directors and Officers Liability Exclusions
Takeovers
Proxy fights are now too expensive, to many people, to much effort to get lists, very expensive.
Cash tender is popular since there is not an SEC disclosure requirement.
Know the Williams Act amendments cleaned up cash tender offer problems (for the exam.)
Leveraged Buyouts
Defenses:
State Legislation - prevent the loss of business and jobs,
constituency acts.
The Supreme Court rejected the argument of Williams Act frustration, state‟s rights case
Majority decision, so the law stands.
Poison Pills - Moran
3 general forms
3 ways to defeat, but all not good
Dead hand, no hand
Shareholder rights
Directors rights DRP
See p. 1210
Shareholder adoption is OK, but is unlikely in the absence of clout.
Delaware says no Shareholder adoption of poison pills - infringes board rights
P. 1225/p. 1227
Lockup provisions
Ways to defend a deal - add a penalty if a third party frustrates the deal
Know the forms.
Invalid lockups - where the board passes a lockup to turn down a good deal that is detrimental to
the board.
(Check the recording)
Books & Records
No federal law
State law applies
MBCA Chapter 16 is optional
Shareholder can see books in good faith with good reason.
No fishing expeditions
Del. §327 - a shareholder request is allowed to reasonably look back.
A NOBO list is not a shareholder‟s list since it is not a list of record owners.




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