Agency LawAgency:

“Agency is the fiduciary relationship that results from the manifestation of consent by one person to another that the other shall act on his behalf and subject to his control and consent by the other so to act” Jenson Farms Co. v. Cargill, Inc. (1981)

Three general sources of Agency Costs :

1) Monitoring costs: costs owners expended to ensure agent loyalty

2) Bonding costs: costs that agents expend to ensure owners of their reliability

3) Residual costs: costs that arise from differences of interest that remain after monitoring and bonding costs are incurred

Three Agency Problems :

1) Conflict between mangers and investor/owners

2) Ability of majority owners to control returns in a way that discriminates against minority owners

3) Between the firm and all other parties with whom it transacts (e.g. creditors)

How to determine if there is a principal agent relationship*:

1. Is there “mutual assent”?: principal and the agent have to have agreed (2. and 3. is what they’ve agreed to)

2. Agent is to act on behalf of principal

3. Principal controls Agent

-this doesn’t matter to protect a third party who interacts with an agent

-if gaps in control are left, court will allow agent to fill in gaps

Agency Termination:

Once there is no longer mutual assent by either party the agency relationship is terminated

Agency Liability

Principal is responsible for the actions of the agent when acting as their public persona

Jenson Farms Co. v. Cargill, Inc. (1981) (even if parties disclaim agency relationship, it could still exist)

Agency Contract Liability:

question to ask “is the third party reasonable in assuming they can enter into the contract?”

1. Did the agent have actual authority to enter into the contract?

If “yes”: stop here, principal is bound by terms of contract

If “no”: then 2.

2. Did the agent have apparent authority to enter into the contract? I(ask what has the P done to signify to the third-party e.g. show up at Porsche dealer with asst. and say “this is the person that signs my contracts”)

3. Did the principal ratify the agent’s action? (e.g. agent enters contract, principal reprimands, but still uses goods, this counts as ratification)

Authority

1. Apparent Authority:

White v. Thomas (explicit authority to buy is not the same as the explicit authority to sell)

Gallant Ins. Co v. Isaac (2010) (3 rd party reasonably viewed agent as having authority)

PartnershipsVohland v. Sweet (1982) (Partnership: Formation )(Profits are prima facie evidence of a partnership since owners take part in gains AND losses)

Facts:

P/Appellee: Sweet; D/Appellant: Vohland

Sweet worked for Vohland nursery as an hourly employee

Sweet later worked receiving a 20 percent share of Vohland’s net profit, after all expenses paid

no partnership tax returns were filed; money paid to Sweet was listed as “commissions business expense”

Sweet’s returns declared he was a self-employed salesman at Vohland’s Nursery

Sweet managed physical aspects of the business, while Vohland managed financial matters

Sweet’s compensation was put back into the business (buying plants)

Procedural:

Sweet sued for dissolution and accounting of an alleged partnership; won $58,733; Vohland appealed ruling

Issue:

Is the arrangement between Sweet and Vohland a partnership or a contract of employment?

Holding:

It is a partnership.

Reasoning:

Receipt of a share of profits is prima facie showing of a partnership under U.P.A S 7(4)

“commission,” as used and understood between the parties, was meant as a “share of profits”

-greater gains (profits)

-less relative loss (loss); employees don’t share in this (yeah they could lose their job)

(owners share both the upside/downside)

Under common law a partnership can only start by voluntary contract of the parties

Court thinks Vohland was trying to recharctierze their partnership after the fact (page 55)

Absence of contribution to capital is not controlling and contribution of labor and skill will suffice

Sweet contributed physical labor and gardening skills

5.1 Capital Structure

Economic Value/Market Value : if you own a company you get out of it a stream of income (“future stream of income”)

-as economic value rises, companies have new opportunities sell bonds or sell shares

Capital Structure: the mix of long-term debt and equity claims the corporation issues to finance operations

Two types of long-term claims a corporation may sell:

1. Long Term Debt: Corporation may borrow money through issuance of debt instruments (e.g. bonds) a. Affords the buyer/creditor a contractual right to a periodic payment of interest and to be repaid their principal at a stated maturity date

i. if the corporation fails to pay creditor has right to (a) sue or (b) have sheriff seize propertyb. Creditor can add an “accelerated” payment contractual clause that is invoked if the corporation defaults

2. Equity: Corporation may sell ownership claims in the corporate entity by issuing equity securities a. This is typically done in the form of common stock

i. this provides no right-to-sue ii. the buyer can’t demand return of their investmentiii. merely have a right to vote

5.1.1 Legal Character of Debt

Debt need only conform to laws already in place, highly configurable to the parties specific desires

Maturity Date

Maturity Date: the set date of the obligation to repaymost common characteristic of debt

Bond: typically interest is paid periodically (often semiannually), at date of maturity the principal and any outstanding interest is due

“Zero Coupon” bonds: bond with no obligation to repay interest; debtor must repay a much larger amount than was loaned at date of maturity

“Default”: any interest or principal not paid when due-Default on interest payment usually invokes an acceleration of re-payment

Investor Advantages of Bonds:Less risky since investors have a right to periodic repaymentAlso have priority claim over company’s shareholders on corporate assets in the event of default (due to bankruptcy or non-payment)

If creditors are not paid on time they can sue on their debt contract

Tax Treatment-Interest paid by a borrower is deductible from taxes owed

-Consequently cost to corporation of debt is less than that of equity

5.1.2 Legal Character of Debt

Common StockEquity affords holder a right to vote on important mattersControl rights such as the power to elect the board of directorsCommon Stock can be divided into “classes” so that particular classes have differing rights

e.g.: class A can be the orig. share holders, they could have a 1/3 or ½ of the board elected; or they could prevent free transferability of shares

Residual Claims and Residual Control

Residual Claim: Stock holders claim over corporation’s assets and income (priority is to creditor [i.e. bond holder])

Dividend: an amount that can be paid to a stockholder after paying interest to creditors

Preferred Stock

Preferred Stock: equity security the corporate charter has conferred a special right, privilege or limitation     a. typically carry a stated dividend payable only when declared by the board    b. these dividends will be paid prior to dividends associated with common stock    c. this stock has preference over common stock in liquidation of corporate assets    d. usually has no vote, unless the preferred stock dividend is over due

Accumulated Retained Earnings: financial income that could be either declared as a dividend or put back into the company instead (works as an involuntary loan)

5.2 Basic Concepts of Valuation

5.2.1 Time Value of Money

Time Value of Money: Principal that $1 today is worth whatever $1 is worth ten years from now plus whatever you can get from lending $1 for ten years

-time preference (psychological): we want money now, rather than later-risk (e.g. risk of inflation, risk money may become worthless)

-benefit (e.g. you can use it now, invest it now)

Present Value: the value of money today to be paid at some future datee.g.: if $1 in ten years is going to be worth .30 cents; the present value of receiving $1 in ten years is $ .30

- so today, assuming the two are equal (i.e. $. 30 today is $1 10 years in the future), I will trade my promise of $1 ten years from now for anything over $ .30  today

PV =FV/(1+r)^nPV: present valuer: annual interest rateFV: future valuen: number of years$Example: say we have guaranteed yearly million $ income from a factory but it would take 200 million to build, you’d want to know what it’s worth now so you’d calculate as:

PV = FV1/(1+r) + FV2/(1+r)^2 + FV3/(1+r)^3 … FVn/(1+r)^n

FV are inherently risky as they involve guess work (i.e. you’re prediciting the future)

Discount rate: rate that is earned from “renting” money out for one year in the market for money (allows for calculation of present value)

PV +r(PV) = FVPV: present valuer: annual interest rateFV: future value

Positive Net Present Value Projects: projects for which the present value of the amount invested ($1,000) is less than the present value of the amount received in return

5.2.2 Risk & Return

Expected Return/Value: a weighted average of the value of the investment; sum of what the returns would be if an investment succeeded, multiplied by the probability of success, plus what the returns would be if the investment failed, multiplied by the probability of failure

E.g.: if we build the factory there is a 20% chance we make 2 million a year, 60% chance we make 1 million a year, 10% chance we make $100k or a 10% chance we make $0

($2M)(.2)+($1M)(.6)+($100K)(.10)+($0)(.10) = $1.01MThen you must discount this expected return to present value using the PV formula*Note* this is all best guesses, the probabilities are intrinsically uncertain

Risk Neutral: an investor that is concerned only about the expected return of an investment

Risk Averse: volatile payouts are worth less to these types of investors

Risk Premium: amount demanded by risk-averse investors for accepting higher-risk investments in the capital markets

5.2.3 Diversification and Systematic Risk

Diversification allows for the non-payment of a risk premium; by packaging offsetting risky investments together, they become less risky

Systematic risk: risk due to system-wide future events

Unsystematic risk:  risk due to company-specific future events

5.3 Valuing Assets

5.3.1 Discount Cash Flow (DCF) Approach

DCF:  requires a prediction of all future cash flows, and a discount rate to bring those cash flows back to the present to yield a “net present value” (NPV).  This is a very difficult thing to do.

Step 1: requires estimation of all future cash flows generated by the asset;     -this step is fraught with uncertainty (you’re predicting the future)

Step 2: requires calculation of an appropriate discount rate, most accepted way to do this is using a weighted-average cost of capital

weighted-average cost of capital: this is calculated as the weighted average of the cost of debt and the cost of equity

cost of debt: the interest rate that the firm would pay if it were to seek new debt financing todaycost of equity: calculated using the capital asset pricing mode (CAPM), extra risk that must be acquired

5.3.2 Relevance of Prices in the Securities Market

Efficient Capital Market Hypothesis (ECMH): Core hypothesis of modern financial economics is that the stock markets manage to reflect well-informed estimates, based on all available information, of the discounted value of the expected future pay-outs of corporate stocks and bonds

6.1 Mandatory Disclosures

Mandatory disclosure requirements: must provide balance sheets, list of assets etc. to a potential investor (Fed. and/or state law)Penalties for false disclosure corporation has to bear cost of accumulating information

6.2 Capital Regulation

Has to do with how corporations manage cash-flow Some states have default rules for capital structurecan require a pool of money on hand

6.3 Standard Based Duties

6.3.1 Director Liability-Directors owe an obligation to creditors not to render the firm unable to meet creditor obligations by making distributions to shareholders or to others without receiving fair value in return

-These creditor obligations are Governed by the Uniform Fraudulent Transfers Act (UFTA), statutory restrictions on the payment of dividends, and, to a lesser extent common law

-Board of Directors is the Agent; Corporation is the Principal-BoD owes Corporation: duty of loyalty, obedience and care

duty is indirectly owed indirectly by the shareholders to the creidtors

6.3.2 Creditor Protection: Fraudulent Transfers

-Fraudulent conveyance law (general creditor remedy) imposes an effective obligation on parties contracting with an insolvent debtor to give fair value for the cash or benefits they receive

-Designed to void transfers by a debtor that are made under circumstances that are unfair to creditors

-Statutes provide for voiding any transfer made for the purpose of delaying, hindering or defrauding creditors

e.g.: Corp. XYZ has a factory, worth $100 M at market value. XYZ calls creditor NewCreditor and say’s “hey, I’ll sell you this factory for $20 M” creditor OriginalLender will then say whoa, you just took $80 Million out of the bankruptcy estate”

Under the UFConveyanceA (older) and UFTA creditors may attack a transfer either of two ways:1. “Present or future creditors” may void transfers made with the “actual intent to hinder delay, or defraud any creditor of the debtor.2. Creditors may void transfers made without receiving a reasonably equivalent value if:

(a) the debtor is left with remaining assets unreasonably small in relation to its business or (b) the debtor intended believed or reasonably should have believed he would incur debts beyond his ability to pay as they became due or the debtor is insolvent after the transfer

6.3.3 Shareholder Liability

Test is Open Book/Open Note, some multiple choice, at least one essay

6.3.3.1 Equitable Subordination

Costello v. Fazio (1958)

J.A. Fazio & Ambrose filed claims against bankruptcy estate of Leonard Plumbing and Heating supply

Facts:

Fazio, Ambrose and Leonard formed partnership in 10/1948Initial capitalization of the partnership in the amount of $44,806.40

9/1952 partnership was worth $51,620.78 distributed as: Fazio ($43,169.61) + Ambrose ($6,451.17) + Leonard ($2,000)

Fall of 1952 decision to incorporate was made, all three withdrew all but $2,000 each

Fazio and Ambrose got back $41,169.61 $4,451.17 respectively as demand notes (no fixed term or set duration of repayment) issued to them by the newly formed corporation

-effectively swapped equity interest out for a debt interest-tried to cut in line normal hieiracy of payment is: secured creidotrs then unsecured creditors, then

shareholders, they tried to go from shareholders to a secured creditor

10/1954 corporation filed voluntary petition in bankruptcy; at this time the corporation was not indebted to any creditors whose obligations were incurred by the preexisting partnership, except for the promissory notes issued to Fazio and Ambrose

Fazio and Ambrose filed claims against the estate to collect on their demand notes

Procedural:

Bankruptcy court Referee made findings that Fazio and Ambrose did not deal in misconduct (i.e. no mismanagement, no fraud/deception etc.)

District Court affirmed referee’s decision

Trustee Appealed to Appeals Court (AC)

Issue: Should shareholder claims be subordinated to claims of general unsecured creditors, when claimants incorporated a partnership to convert the capital into loans leaving the corporation undercapitalized?

Holding: The claims must be subordinated

Reasoning:

Trustee (def.) Arguments:

1. Corporation has not been adequately or honestly capitalized [insolvency]     -AC determines corporation was “grossly undercapitalized”

        -books clearly illuminate this fact        -three of the four experts testified it was so, and the fourth did not contravene        -lower court finding was clearly erroneous

-AC determines corporation did act for their own personal or private benefit to the detriment of the corporation

2. Corporation has been managed to the prejudice of creditors, or where to do otherwise would be unfair to creditors [breach of duty]

-AC determines same accounting data and expert testimony apply to this argument as well as the first argument above- Expert Witness Laborde: depleting capital account in favor of a debt account was for the purpose of equalizing the capital investments of the partners and to reduce tax liability when there were profits to distribute; Court says in so doing Fazio and Ambrose did so for their own private benefit    -doing so acted to the detriment of the corporation and its creditors

Only because of breach of duty; creditor is able to turn their shareholder is the only time when you could invoke secured creditor has collateral (i.e. the bank loans money on a house or a car) (i.e. chef leases out a space, creditor could come and take the ovens, utensils etc.)unsecured creditor doesn’t have collateral (e.g. loaning cash for implementing a service)

AC States the transaction at issue fails the following two tests : 1. Inequitable Bankruptcy Claim Test: Is the claim within the bounds of reason and fairness?

2. When claims are filed by persons standing in a fiduciary relationship to the corporation an alternate test

is: “whether or not under all the circumstances the transaction carries the earmarks of an arm’s length bargain”

No fraud or mismanagement need be present in addition to undercapitalization to sustain a claim of subordination

6.3.3.2 Piercing the Corporate Veil

Sea-Land Services, Inc. v. The Pepper Source (1991)

Facts:

In 1988 Marchese and his five business entities were sued by Sea-land Services over $86,767.70 that Marchese’s “The Pepper Source”  (PS) corporation stiffed Sea-Land on freight bill

Sea-Land alleged that all Marchese corporate entities were really just his alter ego he used to hide from liability

In 1989 Sea-Land amended to include Tie-Net as a defendant, Tie-Net was unique since Marchese only owned half of the company’s stock (George Andre) owns the other half

SeaLand filed motion for summary judgment (MSJ)

Procedural: District Court granted Sea-Lands judgment, Marchese appealed

Issue: Was Sea-Land’s Motion for Summary Judgment sufficient to show the PS corporate veil should be pierced?

Holding: No, because Sea-Lands inadequately alleged the promotion of injustice prong of the Van Dorn Corporate Veil Piercing Test.

Reasoning:

Van Dorn Corporate Veil Piercing Tes t: Corporate entity affording limited liability will be disregarded when both: 1. There must be such unity of interest and ownership (AKA disrespecting the corporate form) that the separate personalities of the corporation and the individual (or other corp.) no longer exist  AND

-Appellate Court (AC) four factors to assess unity of interest and ownership: 1. failure to maintain adequate corporate records or to comply with corporate formalities2. commingling of funds or assets3. under capitalization4. one corporation treating the assets of another corporation as its own

    -AC thinks there is no mistake this prong was satisfied:-Marchese runs all corporations out of the same single office, none had ever passed articles of incorporation, bylaws or other agreements-Marchese used corporate accounts to fund his personal expenses, in addition to swapping money amongst the corporations-funds and assets commingled with abandon-never held a meeting

2. Circumstances must be such that adherence to the fiction of separate corporate existence would sanction a fraud (defined as: intentional wrongdoing) OR promote injustice (AKA some wrong that would lead to an injustice)

-Sea-Lands didn’t attempt to show fraud, since that’d be too hard for a MSJ; SeaLand went after “promoting injustice”-AC says this wasn’t sufficiently shown on the MSJ (court opines: “But what, exactly, does ‘promote injustice’ mean”)-Test can’t be satisfied by showing an unsatisfied judgment (i.e. the outstanding freight charge), since all potential plaintiffs could show something like this (else why would they bring suit Reese? Ponder and provide a 5 page response)-AC recommends on remand that Sea-Land produce evidence that Marchese used corporate facades to avoid its responsibilities to creditors or that one of the Marchese entities will be unjustly enriched unless liability is shared by all his “shell companies”

Court provided a laundry list of “wrongs” (beyond a creditor’s inability to collect) previously been held by courts to satisfy Promotion of Injustice:

-the common sense rules of adverse possession would be undermined (adverse possession is undermined)-former partners would be permitted to skirt the legal rules concerning monetary obligations (in avoidance of monetary obligations)-a party would be unjustly enriched (unjust enrichment)-a parent corporation that caused a sub’s liabilities and its inability to pay for them would escape those liabilities ()-an intentional scheme to squirrel assets into a liability free corporation while heaping liabilities upon an asset-free corporation would be successful

Kinney Shoe Corp. v. Polan (1991)

Kinney Shoe Corp sued Mr Lincoln M Polan to pay money outstanding on a sub-lease by the "Industrial Realty Company". Polan wholly owned "Industrial", but had never held any corporate meetings or elected officers.

The question is whether Kinney could pursue Mr Polan for the debt.

Facts:

County (fee simple) – Kinney(lease holder) – Industrial(100% sublessee) – Polan, Industries (50%subleesee) – Mr. Polan (paid kinney)Kinney sued Polan to recover money owed them on a sublease between Kinney and Industrial Realty Co.

Polan wholly owned Industrial

Industrial was issued incorporation certificates but no organizational meetings were ever held and no officers were ever elected

Industrial had no assets, no income and no bank account (save for a sublease with Kinney)

First rental payment to Kinney was made out of Polan’s personal funds

Procedural:

DC held that Polan was not personally liable on the lease between Kinney and IndustrialKinney appealed

Issue: Can Kinney pierce the corporate veil of Industrial to hold Polan personally liable for the sublease?

Holding: Polan is personally liable for Industrial’s debt to Kinney.

Reasoning:

Totality of the circumstances test is to be applied when deciding to pierce the corporate veil or notpiercing the corporate veil is an equitable remedy

Legal fiction of a corporate entity should be disregarded when it is urged with an intent not within its reason and purpose and in such a way that is retention would produce injustices or inequitable consequences

West VA 2 Prong Test:1. is the unity of interest and ownership such that the separate personalities of the corporation and the individual shareholder no longer exist AND2 would an inequitable result occur if the acts were treated as those of the corporation alone

Polan bought no stock, made no capital contribution, kept no minutes and elected no officers for Industrial

“Polan was obviously trying to limit his liability and the liability of Polan Industries, Inc. by setting up a paper curtain constructed of nothing more than Industrial’s certificate of incorporation“

Third Prong (assumption of risk) may apply in certain cases, it is permissive and not mandatory; factually third prong was not warranted in this case

-usually applies to financial institutions-permissive for everyone else

6.4 Veil Piercing on Behalf of Involuntary Creditors

Walkovszky v. Carlton (1966)Facts:

There existed a common practice of vesting ownership of a taxicab fleet so many corporations each only owned one or two cabs

Plaintiff was severely injured after being run down by a cab owned by def. Seon Cab Corp.

Cab was negligently operated by Marchese

Carlton was stockholder in 10 corporations including Seon, each has two cabs registered to it carrying the NY minimum insurance coverage of $10,000 per cab

P alleged:1)that the 10 corporations are “operated...as a single entity” with regard to financing supplies, repairs, employees and garaging, and all are named as defendants2)that he is entitled to hold shareholders personally liable for damages sought since the multiple corporate structure constitutes an unlawful attempt to defaud members of the general public, who might be injured by cabs

Procedural:

Carlton (def.) filed motion to dismiss for failure to state a claim; court at Special Term granted motion

Appellate Division reversed court at special term’s decision holding there was a valid cause of action

Carlton appealed to NY’s highest court (New York Court of Appeals)

Issue: Did Walkovszky plead a valid cause of action to pierce the corporate veil

Holding: No, the complaint falls short of adequately stating a cause of action, reversed with leave to serve an amended complaint

Reasoning:

Two Scenarios When Veil Piercing Appropriate:1. Assert that a corporation is a fragment of a larger corporate combine which actually conducts the business

-Only a larger corporate entity would be held financially responsible

2. Assert that the corporation is a dummy corporation where individual stockholders are actually carrying on the business in their personal capacities for purely personal, rather than corporate ends

-The stockholder would be personally liable

Court states that while P alleged that the separate corps were undercapitialized and their assets had been intermingled it is barren of any “sufficiently particularized statements” that def. are actually doing business in their individual capacities, shuttling their personal funds in and out of the corporations without regard to formality and to suit their immediate conveniences.

Court thinks pleading is directed towards the principle of fraud, not agency law, and goes on to state that it is not fraudulent to take out the minimum insurance on a cab

Keating Dissent:Thinks Carlton was deliberately draining money out of the corporations to avoid liability in the event his cab hit anyone

Thinks profits should have been reinvested to maintain coverage in the event of inflicting loss/injury

Advocated that the law should be “a participating shareholder of a corporation vested with a public interest, organized with capital insufficient to meet liabilities which are certain to arise in the ordinary course of the corporation’s business, may be held personally responsible for such liabilities”

Chapter 7: Normal Governance: The Voting System

7.1 The Role and Limits of Shareholder VotingEquity investors in public corporations largely rely on the default terms of corp. law to control agency cost of management.

3 Default Powers of Shareholders:1. right to vote on the board and certain fundamental corp. transactions)2. right to sell if they are disappointed with corp.’s performance

3. right to sue the directors for breach of fiduciary duty in certain circumstances.

The Shareholder Collective Action Problem- This is the important factor affecting shareholder voting in large public companies.- What is it?

In a large public corp., an informed shareholder action (a vote) would require that some investment of information be made by a very large number of shareholders. This is collectively and individually costly.

Any one shareholder’s vote is unlikely to affect the outcome of the vote. Thus, a shareholder with a small stake is likely to get the same proportionate share of any benefit without regard to whether he invests in becoming informed and voting intelligently – economic incentive to remain passive.

In sum, the shareholder collective action problem would preclude informed shareholder action; rational shareholders would be unlikely to challenge board decisions or even inform themselves about the company’s performance.

Attempts for an Active Shareholder Democracy-1934 SEC Act sought to empower shareholders thought forced disclosure of information- 1992 SEC amended proxy rules to allow large shareholders to communicate more easily with respectto forthcoming corp. vote without incurring the expense of filing proxy solicitation materials throughthe SEC.- In today’s modal public corp., collective action costs may be large but not large enough to prevent

shareholders from monitoring managerial performance.

7.2 Creation of a Corporation

7.2.1 Electing Directors- Electing directors is a shareholder’s fundamental and mandatory right.- Shareholders who are registered as of the record date are legal shareholders entitled to vote at the meeting.- Every corp. must have

(1) a board of directors (2) at least one class of voting stock, and(3) an annual election of directors (can elect whole board or staggered board)

- Why does almost all stock carry voting rights? The right to appoint directors is more valuable to common stock investors because their security has no maturity date and no legal right to periodic payments (unlike bondholders who are protected by hard contractual rights).

-Types of voting:(1) Straight Voting (One share-one vote): Each shareholder gets one vote for each share of voting stock owned and may cast it for each directorship or board position that is to be filled at the election.

Ex: If there are seven places on the board to fill, an owner of one share casts one vote for each candidate.

(2) Cumulative Voting: Each shareholder may cast a total number of votes equal to the number of directors for whom she is entitled to vote, multiplied by the number of voting shares that she owns, with the top overall vote getters getting seated at the board. This is designed to increase the possibility of minority shareholder representation on the board of directors.

Ex: In corp. that has 300 shares, A owns 199 and B owns 101. Corp. has 3 board positions to fill. In straight voting, A always wins each seat 199 to 101. In cumulative voting, B can cast 303 votes (101 shares x 3 seats up for election) all for a single candidate. Thus, B would be guaranteed one seat on the board because A’s 597 votes (199 shares x 3 seats) cannot be divided 3 ways so that all three of A’s candidates receive more than 303 votes.

Cumulative voting is not popular because boards with divided shareholder allegiance were said to be too adversarial.

7.2.1 Removing Directors- Corp. state law governs, and SEC for publicly traded corps.- In common law, shareholders could remove directors only “for cause” and is entitled to due process.- State law in all jurisdictions bars directors from removing fellow directors, for cause or otherwise, in the absence of express shareholder authorization.- Some statutes permit shareholders to grant the board power to remove individual directors for cause.- A board can petition a court of competent jurisdiction to remove the director from office if they uncover a cause.

Note on Staggered Boards:Staggered board makes it more difficult for shareholder (even majority holder) to gain control of the

Board, and must win two elections to gain majority control. Staggered boards entrench managers and board members in ways that deter value-increasing hostile takeover.

7.3 Shareholder Meetings and Alternatives

In General: Shareholders may vote to adopt, amend and repeal bylaws; to remove directors; and to adopt shareholder resolutions that may ratify board actions or request board to take certain actions. Should board fail to convene for an annual meeting w/in 13 months of the last meeting, courts will entertain shareholder petition and promptly require a meeting.

Special Meetings: Special meetings by shareholders are those called for special purposes other than the annual meeting. It is the only way that shareholders can initiate action between annual meetings. Usually the matter of meetings is placed in the corporate charter: ex. “special meeting of stockholders when (1) such meeting is called by the board or person authorized in the charter/bylaws to do so, or (2) the holders of at least 10% of all votes entitled to be cast demand such a meeting in writing.”

Why permit special meetings? The more investors monitor corp. management, the lower wasteful agency cost will be, hence, the lower the firm’s capital cost will be.

Shareholder Consent Solicitations: An alternative to special meetings in the form of a statutory provision permitting shareholders to act in lieu of a meeting by filing written consents.

7.4 Proxy Voting and Its Costs

In General: Public shareholders are unlikely to actually attend shareholder meeting. The board and its officers are permitted to collect voting authority from shareholders in the form of proxies. In doing so, management acts on behalf of and at the expense of the corporation.

The Proxy: - Generally, a proxy must record the designation of the proxy holder by the shareholder and authenticate the

grant of the proxy (a signed proxy card). - Proxy holder is bound to exercise the proxy as directed.- Proxy holder may, in most cases, exercise independent judgment on issues arising at the shareholder

meeting for which they have not received specific instructions.- Proxies are revocable unless contracted otherwise.

Cost of proxy voting:

- Cost of soliciting proxies is a matter of normal governance because subsidizing these costs from the corp. treasury is essential for the operation of annual shareholder meetings.

- On the other hand, authorizing the board to expend corp. funds on its own re-election seems to permit a kind of self-dealing.

- E-Proxy rule: In 2007, the SEC promulgated a rule with potential to significantly reduce the cost of soliciting proxies for companies and insurgents. Public companies must post their proxy materials in a publicly available website, and may simply mail a “Notice of Internet Availability of Proxy Materials” to shareholders no later than 40 calendar days before the shareholder meeting.

Rosenfield v. Fairchild Engine & Plane Corp.

Facts: Rosenfield (P) owns 25 shares out of Fairchild’s over $2M shares. He filed a derivative suit to have $261,522 paid to the old, defending board and the challenging new board.

The Expenses: In the proxy contest, $106K was used by the old board to defend their position, $28K were paid to the old by the new board for their remaining expenses, and $127K to reimburse the winning new board which was ratified by a 16:1 majority vote of stockholders.

P argues that they are not authorized charges and sues to compel return of the $261K to the corp. treasury.The appellate court affirmed the judgment of an official referee who dismissed P’s claim.

Issues: Whether directors may make reasonable and proper expenditures from corporate treasury to persuade stockholders of the correctness of their position and soliciting their support for policies, which the directors believe, in good faith, are in the best interest of the corporation.

Holding: In a contest over policy, directors have the right to make reasonable and proper expenditures, subject to the scrutiny of the courts when duly challenged, from the corporate treasury for the purpose of persuading stockholders of the correctness of their position and soliciting their support for policies which the directors believe, in good faith, are in the best interest of the corporation.

The stockholders also have a right to reimburse successful constants for their reasonable and bona fide expenses incurred by them in any such policy contest, subject to the court’s scrutiny. This can be accomplished by an affirmative vote by the stockholders.

Rationale: If reimbursement is not allowed, the incumbent will not be able to defend their positions and corporate policies. Also, here, the stockholders affirmatively voted 16:1 to reimburse the winning board.

7.5 Class Voting

- Voting regimes present risk that majority blocks will advance their private interests. Protection from exploitation is offered to the minority by the class-voting requirement.

- A transaction that is subject to class voting means that a majority of the votes in every class that is entitled to a separate class vote must approve the transaction for its authorization.

- Ex: When the charter creates rights of special classes to elect designated seats on the board.

7.6 Shareholder Information Rights

- State corp. law mandates neither an annual report not any other financial statement.- Federal securities law and SEC rules mandate extensive disclosure of publicly traded securities.- At common law, a stockholder is recognized to have a right to inspect a company’s books and records for

a proper purpose- Delaware recognizes 2 statutory rights of access to information: request for a “stock list” and request for

inspection of “books and records” for any “proper purpose.”

The Stock List- A corp. stock list discloses the identity, ownership interest, and address of each registered owner of

company stock.

- “Proper purpose” for a stock list access is construed broadly – the court will not consider whether the shareholder has additional “improper purposes.”

- An order by the court to produce a stock list includes an obligation to update the list, to produce a second list of stock brokerage firms, and to furnish daily trading information.

Inspection of Books and Records- These requests are reviewed with more care. Plaintiff is formally required to carry the burden of showing

“proper purpose,” and court informally screens the plaintiff’s motives and likely consequences of granting the request.

7.7 Techniques for Separating Control from Cash Flow Rights

It is good policy to award voting rights to investors who claim the corp.’s residual returns -- this helps maximize corporate value. However, some capital structures with dual-class voting, that misaligns control rights and return rights are not prohibited by law.

However, the law does prohibit against a corporation voting shares owned by the corp. directly or indirectly.

7.7.1 Circular Control StructuresThe law prohibits management of a corp. from voting stock owned, directly or indirectly, by the corporation. e.g. Corporation 1 can’t buy up a majority in corporation 2; if corp. 1 does so they lose their voting rights C2

has over C1; majority for triggering voting rights loss is 51%; this rule is to prevent BoD from using corporate funds (as opposed to their own personal money)

Speiser (P) v. Baker (D)

Facts: - Speiser “S” and Baker “B” each own 50% of Health Med’s “Med” stock. Health Chem “Chem” (the operating company) is a publicly traded company with stocks divided as follows: 42% Med, 10% Speiser, 8% Baker, 40% Public. - Chem, Speiser, and Baker, indirectly through Medallion (a wholly owned subsidiary of Chem), owned a convertible preferred stock, carrying 9% of the equity/vote unconverted (and 95% of the vote if converted…but it is presently unconverted). - Speiser and Baker owned the rest of Med’s voting power. This circular voting structure allowed them to retain control of all the companies while owning less than 35% of Chem’s equity. If the 9% preferred stock was converted to 95%, it will increase the public shareholder’s voting power (something S and B don’t want to do).- Speiser, who was presiding of Med, Chem, and Medalion, was able to control Med’s vote.

Note: Speiser was director, held 50% of Med common stock, and 45% of votes for Med…so Speiser can control Med by voting his 45.5% plus having Chem vote its 9% because he also controls Chem by 52% (with his 42% vote through Med plus his own 10%).

- S and B had a falling out. B does not want to attend Med’s annual meeting in fear that he will get booted out.- S brought a statutory action to have the court order an annual meeting under Section 211(c) - B counterclaimed that Med may not use its 42% vote under Section 160(c) and the meeting is to remove B.- S then moved to dismiss B’s counter claims and for a declaratory judgment that Med may vote its 42% stock interest in Chem.

Two Issues:(1) Whether a meeting shall be held, even if it means that one of the two directors will be removed, where a corp. has failed to hold annual stockholder’s meeting for the election of the directors in contravention of the statute.

(2) Whether a stock held by a corporate subsidiary “belongs to” to the issuing corporation and thus prohibited from voting, even if the issuing corp. does not hold a majority of shares entitled to vote at the election of directors for the subsidiary, where a statute prohibits voting by a corporation of stock “belonging to the corporation.”

Holding:

For issue (1): Where a corp. has failed to hold annual stockholder’s meeting for the election of the directors in contravention of the statute, a meeting must be held, even if it means that one of the two directors will be removed.

Rationale: B’s affirmative defense that he will be booted, alleges no wrong to Med or its shareholders that will occur by holding Med’s annual meeting.

For issue (2): When a statute prohibits voting by a corporation of stock “belonging to the corporation,” a stock held by a corporate subsidiary “belongs to” to the issuing corporation and is thus prohibited from voting, even if the issuing corp. does not hold a majority of shares entitled to vote at the election of directors for the subsidiary.

This is based on B’s counterclaim based on 160(c) states: Shares of its own capital stock belonging to the corporation or to another corp., if a majority of the shares entitled to vote in the election of directors of such other corp. Is held directly or indirectly, by the corp., shall neither be entitled to vote nor counted for quorum purposes.”

Rationale: The phrase “belonging to the corp.” when interpreted in light of the statutory history and policy, it supports the known danger posed by structures that permit directors of a corp, by reason of their office, to control votes appurtenant to shares of the company’s stock owned by the corp. itself or a nominee or agent of the corp.

Such structure deprives the true owners of the corp. of a portion of their voice in choosing who shall serve as director – problem that 160(c) tries to solve.

Comments on the statutes show that the statute codified the result in Italo Petroleum where the court held that stock belonging to a 99% subsidiary was stock belonging to the parent corporation.

Stock held by a corp. subsidiary may, in some instances, “belong to” the issuer and be prohibited from voting, even if the issuer does not hold a majority of shares entitled to vote at the election of directors of the subsidiary.

Here, the substantial ownership of Chem in Med is 95% (when converted). Thus, the facts alleged exemplify the problem 160(c) was intended to solve

Class NotesHealth med entirely owns medallionHealth chem. is the only company that actually generates revenues

7.7.2 Vote Buying

A shareholder may not sell her vote other than as part of a transfer of the underlying share.

Easterbrook on Voting in Corp. (Common) Law: Attaching the vote firmly to the residual equity ensures that unnecessary agency cost will not come into being. If the owner of only 20% of the residual claims acquires all of the votes, his incentive to take steps to improve the firm is only 1/5 of the value of those decisions. The risk of shirking would reduce the value of the investment in general, and tying votes to shares can eliminate this risk.

The only time buying the notes without the shares are advantageous is when the buyer is planning to dilute the interests of the other equity owners.

Schreiber v. Carney

Facts: - Plaintiff, a shareholder of Texas International Airlines “Texas Int’l”, challenged the propriety of its loan to Jet Capital Corp. “Jet” who owned 35% of Texas Int’l’s common stock.- Texas Int’l wanted to merge with Texas Air “Air.” Jet refused this merger because of tax consequences unless it can exercise warrants it had with Texas Int’l. Jet did not have enough $ to do this. Texas Int’l formed special committees to go through the merger and decided that a loan to Jet was best to get rid of it as the only obstacle to the merger.- The loan:

Texas Int’l would loan Jet $3.335M at 5%. This loan would not impact cash position of Texas Int’l.This was approved by directors and majority of shareholder (other than Jet) voted for its approval.

- In return, Jet would vote for the merger.

- Plaintiff alleged this was vote-buying and therefore void. P also said it was corporate waste because Jet only needed $800K not $3.335M.warrants: someone has a right to buy stock sitting in a “back room”

Issues: (1) Whether the loan was vote-buying(2) Whether vote-buying is per se illegal or whether it is permissible where it does not prejudice the shareholders.

Holding: For Issue (1): This was vote-buying. Vote-buying is a voting agreement supported by consideration personal to the stockholder, whereby the stockholder divorces his discretionary voting power and votes as directed by the offeror.

Here, evidence shows that the loan was clearly to remove the obstacle of Jet’s opposition to the merger.

For Issue (2): Vote buying is not per se illegal unless the object or purpose is to defraud or disenfranchise the other stock holders. It is permissible where it does not prejudice the shareholders.

Rationale: Although a lot of opinions say that it is per se illegal, the common thread in those opinions is that the challenged plan was made to defraud or disenfranchise the other stockholders.

An agreement involving the transfer of stock voting rights without the transfer of ownership is not per se illegal, and each arrangement must be examined in light of its object or purpose.

Also vote-buying must be viewed as a voidable transaction subject to a test for intrinsic fairness. It is susceptible to cure by shareholder approval. Here, the shareholders approved it.

Notes on Schreiber v. Carney: Contrast Portnoy v. Cryo-Cell where board agreed to add Filipowski to the management slate in exchange for his votes at a meeting. Filipowski’s qualifications did not match the criteria the board established. Portnoy sued claiming illegal vote buying. The court found that the deal was vote buying.Class Notes:

Vote buying (must be done in a way that harms other shareholders [usually fraud/disenfranchisement]):1. consideration (personal)2. change in voting preferences

Fraud/disenfranchisement?If yes: per se illegal (contract is void)If no: contract is voidablepresumption of intrinsic fairness if actually put up for a vote

7.7.3 Controlling Minority Structures There are 3 more ways to separate control rights from cash flow rights: stock pyramids, cross-ownership, and dual class equity. Each of these structures permits a shareholder to control a firm while holding only a fraction of its equity.

Stock Pyramids: Two companies, a controlling minority shareholder holds a controlling sate in a holding company that in turn, holds a controlling stake in an operating company. For any fraction of the firm’s equity cash flow rights held by the controlling-minority shareholder, there is a pyramid that permits a controller to completely control a company’s assets w/o holding more than a fraction of equity.

Cross-Ownership: Companies in a cross-ownership structure are linked by horizontal cross holding of shares that reinforce and entrench the power of central controllers. The voting rights used to control the corp. group are distributed over the entire group rather than concentrated in the hands of a single company or shareholder. It has the advantage of making the locus of control over a company group less transparent.

Dual Class Equity: Two or more classes of stocks with differential voting rights. A planner can attach all voting rights to a fraction of the shares that are assigned to the controller, with attaching no voting rights to the majority of the shares distributed to other shareholders.

American corporate law does not require all shares to have voting rights nor does it require all voting shares to have equal voting rights.

Dual class is structure is rare in public companies and is more problematic when adopted midstream after a firm is already publicly trading.

SEC Rule 19c-4 prohibits the NYSE and NASDAQ from listing shares with unequal voting rights unless initially offered to the market in that structure.

****KNOW THIS**** Dual class voting: multiple classes of common stock (prof. not aware of any states that PROHIBIT Dual class voting)

2 classes 1 has 10 votes per share 1 has 1 vote per share (the 10 vote per share is goin to sell for way more); danger that people could give up their extra votes for a transitory incentive; not illegal to reassign mid-company life, but you can’t ever put this kind of stock on a national market

7.8 The Collective Action ProblemPROF DOESN’T REALLY CARE THAT WE KNOW ABOUT THE BELOW PROPOSED SOLUTIONS

Again, it is a problem where rational shareholders would be unlikely to challenge board decisions or even inform themselves about the company’s performance because if they are the minority, they do not think their vote will change the outcome.

Proposed Solutions: Easterbrook: - Aggregating the shares and the attached votes through acquisitions such as mergers and tender

offers- some sort of collective information-generating agency.

Black: - Make use of financial intermediaries, such as banks, that could provide oversight to corp. and

monitor the actions of corporate managers.- Black says this is not popular now because our legal rules limits the financial institutions

ability to hold large percentage stakes and most banks are limited in their ability to own equity at all.

- If legal restrictions were loosened, the percentage stakes held by large institutions will likely grown and monitoring incentives would correspondingly become stronger.

Pozen: - Raise advisory fees for a venture capital fund manager because current fees (0.7% with max

performance fee of 0.1-0.2%) are set on the assumption that money managers take a passive role rather than being activists for their.

- If higher advisory fee, there would be an assumption that venture fund managers will be actively involved with most of their portfolio companies.

Kahn and Rock (HEDGE FUNDS “HF”): - The collective action problem can be solved by hedge fund managers who are now emerging

as the most prominent shareholder activist.

- HFs would enhance the value of the companies they invest in for the benefit of their own investors (and fellow shareholders)

- HF managers are highly incentivized to maximize the return to their fund investors.- Base fee for HF manager is 1-2% plus 20% incentive fee for profits earned.- Agerage HF managers made $251M in 2004. Lowest paid HF manager made $100M (We are

in the wrong profession!)

7.9 The Federal Proxy Rules

pROXY: someone else get’s to stand in your place for you and vote (usually for voting)Federal proxy rules regulate every aspect of proxy voting in public companies.

4 Major Elements of Fed Proxy Rules:

1. Disclosure requirements and a mandatory vetting regime that permit the SEC to assure disclosure of relevant information to protect shareholders form misleading communication.2. Substantive regulation of the process of soliciting proxies from shareholders3. Specialized “town meeting” provision (Rule 14a-8) that permits shareholders to gain access to the corp.’s proxy materials and thus gain low cost way to promote certain kinds of shareholder resolutions4. A general anti-fraud provision (Rule 14a-9) that allows courts to imply a private shareholder remedy for false or misleading proxy materials.

7.9.1 Rules 14a-1 Through 14a-7: Disclosure and Shareholder Communication

Section 14(a)-1 of the SEC makes it unlawful for any person, in contravention of any rules that the commission may adopt, to “solicit” any “proxy” to vote any “security” registered under Section 12 of the Act. This is to force corps. to disclose to shareholders via proxy statement filed to the SEC and distributed to shareholders. Rule also applies to third parties who might seek to oust incumbent management by a proxy fight.

A proxy is defined as any solicitation or consent whatsoever.

In 1992, SEC amended Rule 14(a)-2 to alleviate some disclosure burdens and released institutional shareholders, in limited circumstances, from the requirement to file a disclosure form before they could communicate it other shareholders.

-14(a) was created since in the past it was generally broad, but we don’t mean to have this as broad as in the past

14(a)-2(b)(1) provides exemption for ordinary shareholders who want to communicate with other shareholders but do not themselves intend to seek proxies.

14(a)-2(b)(2) also provides exemption for solicitations to less than 10 shareholders

14(a)-1(2)(iv) says announcement by shareholders on how they intend to vote are not subject to proxy rules

Rule 14(a)-3 states that no one may be solicited for a proxy unless they are, or have been, furnished with a proxy statement “containing the information specified in Schedule 14a.”

Rules 14(a)-4 and 14(a)-5 regulates the form of the proxy. For example, the proxy must instruct shareholders that they can withould support for a particular director on the solicitor’s slate of candidates by crossing through their name.

must let shareholders express disapproval for a particular director, by simply crossing through their name

Rule 14a-6 lists the formal filing requirements for preliminary and definitive proxy materials, solicitation materials, and Notices of Exempt Solicitations.

Filing Requirements:1. Proxy statement: should have what you want, why you want it, also include personal info. (including financial, int.’ corp etc. ) of those involved in the proposal, info. about the corporation

objective is to communicate what amangers are doing to shareholders and to kick them out if they suck

Rule 14a-7 sets forth the list or mail rule under which, upon request by a dissident shareholder, a company must either provide a shareholders’ list or undertake to mail the dissident’s proxy statement and solicitation materials to record holders in sufficient quantity to assure that all beneficial holders can receive copies.

7.9.2 Rule 14a-8: Shareholder Proposals

Get dissident shareholders proposals in front of board

only when you want to take advantage of corp. spending postage

Rule 14a-8 (the town hall meeting rule) entitles shareholders to include certain proposals in the company’s proxy material for vote by his fellow shareholders without filing with the SEC or mailing his own material to the shareholders. (Management does not like this because they see it as infringing on their autonomy).

Contents and Elements of a Shareholder’s Proposal:- state the identity of the shareholder (Rule 14a-8(b))- the number of proposals (Rule 14a-8(c))- length of supporting statement (Rule 14a-8(d))- subject matter of the proposal (Rule 14a-8(i))

Rule 14A provides specific grounds to permit corps. to exclude shareholder-requested matter from the corp.’s proxy solicitation materials. The corps. generally get SEC approval when excluding a proposal. The SEC’s request for approval is a “no-action letter” stating that the SEC will not recommend disciplinary action against the company if the proposal is omitted.

Grounds to Exclude a Shareholder’s Proposal:- approval of the proposal would be improper under state law (Rule 14a-8(i)1)- the proposal relates to a matter of ordinary business (Rule 14a-8(i)7). Matters of ordinary

business are considered as province of the board.

Most rule 14a-8 proposals fall into either (1) corporate governance or (2) corporate social responsibility (CSR). Corporate governance includes issues such as executive compensation, separation of chairman and CEO roles, or staggered board takeover defenses.

Corporate Governance An important corp. governance question is the extent of the shareholder’s ability to enact bylaws that limit the range of options open to the board in managing the firm.plurality 35% is okay, majority requires more than 50%

Example: CPF filed a proposal with HP to change the director election vote standard so that the elected director is the one who received a majority of the votes instead of the current voting standard where a director can be re-elected with a single affirmative vote, even if a substantial majority of the votes cast were “withheld” from the nominee. HP responded by amending the policy by maintaining the old but adding that a “nominee for director who receives a greater number of “withheld” votes will tender his resignation to a board committee who will recommend the board take action on the resignation. HP also filed a “no action letter” request saying that the proposal has been substantially implemented already, so no need to include it. SEC rejected HP’s request stating they cannot omit the proposal from its proxy materials. The SEC responded by saying HP’s amended policy is fundamentally different from CPF’s proposal – CPF wanted a change in the manner of electing the directors (majority vote instead of plurality vote), what HP is doing is maintaining the manner of voting, but just adding a post-election policy of allowing resignation of director who got elected but received a majority of “withheld” votes.

Note on the rebirth of Rule 14A-11, the Shareholder Proxy Access Rule: SEC proposed new rule 14A-11 that would allow long term shareholders the power to place their own nominees in a public company’s proxy materials under certain limited circumstances.

CA, Inc. v. AFSCME Employees Pension Plan

Facts: - AFSCME, who held stock in CA, submitted a proposal to be included in the proxy materials for CA’s annual shareholder meeting. - The proposal sought to require CA to reimburse reasonable expenses incurred by stockholders (the “nominators”) in elections of directors so long as (1) stockholders are not permitted to cumulate their votes, (2) at least one nominee was elected, (3) election of fewer than 50% of directors is contested in the election…. The amount paid to the nominator shall not exceed the amount expended by the corporation in connection with such election.-CA submitted a “no action” request to the SEC arguing that: (1) the proposal can be excluded under 14a-8 because it related to an election of directors, (2) conflicted with Delaware law (because it would violate section 102(b)(1) because it would limit the Board’s substantive decision-making power), and (3) inconsistent with SEC proxy rules.- Issues in this case were questions certified by the SEC to the Delaware Supreme Court

Issues: (1) Whether the AFSCME Proposal requiring a company to reimburse shareholders for expenses incurred in an election for directors is a proper subject for inclusion in the proxy statement as a matter of Delaware law.(2) Whether the AFSCME Proposal, if adopted, cause CA to violate and Delaware law to which it is subject.

Holding: For Issue (1): A proposal for requiring a company to reimburse shareholders for expenses incurred in an election for directors is a proper subject for inclusion in the proxy statement as a matter of Delaware law. Such a proposal is a purely procedural bylaw that does not improperly encroach upon the board’s managerial authority under 141(a).

Rationale: Court noted that the shareholder’s statutory power to adopt, amend, or repeal bylaws under Section 109(a) is limited by the board’s management prerogatives under Section 141(a). Under Delaware law, a proper function of the bylaws is to define the process and procedures by which substantive business decisions are made, not to mandate how the board should decide specific substantive business decisions. The context of the proposed bylaw amendment here is the process for electing directors, a subject in which shareholders of Delaware corps. have a legitimate and protected interest.

For Issue (2): A proposal to reimburse shareholders for expenses incurred in an election for directors would cause CA to violate and Delaware law to which it is subject.

Rationale: The bylaw does not contain language or provision that would reserve to CA’s directors the power to exercise their fiduciary duty to decide if it is not appropriate to award any reimbursement at all in specific cases. This bylaw would prevent directors from exercising their full managerial power in circumstances where their fiduciary duty would require them to deny reimbursement. This violates DE Corp. law’s requirement that does not allow the board to expend corp. funds to reimburse proxy expenses motivated by personal or petty concerns or to promote interests that do not further those of the corporation (unlike proxy expenses motivated by policy).Class Notes:1. Illegal under state law2. ordinary business

1.appropriate? 2. illegal?process v. substancecompensation has to be made for dissident shareholders when they win regardless

Corporate Social Responsibility Proposals

Generally, Rule 14A permits management to exclude matters that fall within the ordinary business of the corp. However, Rule 14a-8(c) required issuers to include proposals that related to “matters which have a significant policy, economic, or other implications in them.”

Interpretation of Rule 14a-8(c)(7): The “Ordinary business exclusion”: - Mission of the rule is to relieve the management of the necessity of including in its proxy material security holder proposals which relate to matters falling within the province of the management. In applying the “ordinary business” exclusion to proposals relating to social policy issues, the Division applies the most well-reasoned standards possible. - It is a flexible approach and requires a case by case analysis. - Moreover, employment-related proposals (generally falling within “ordinary business”) focusing on significant social policy issues could not automatically be excluded under the “ordinary business” exclusion (contrasting to SEC’s old interpretation in Cracker Barrel they allowed Cracker Barrel to exclude shareholder policy that wanted to change its discriminatory employment practices).

Two central considerations in the policy underlying the rule:

1. Certain tasks are so fundamental to management’s ability to run a company on a day to day that they cannot be subject to direct shareholder over-sight (except for those that focus on significant social policy issues as explained above).2. The second consideration relates to the degree which the proposal seeks to “micro-manage” companies by probing too deeply into matters of a complex nature that shareholders would not be qualified to make an informed judgment on based on their lack of business expertise and lack of intimate knowledge of the company’s business.

7.9.3 Rule 14a-9: The Antifraud Rule

no express private right of action; today court’s wouldn’t allow it

In general, rule 14a-9 is the SEC’s general proscription against false or misleading proxy solicitations, and there is an implied private right of action that arises under Section 14(a) and Rule 14a-9.

Key elements required showing violation of Rule 14a-9:

1. Materiality: A misrepresentation or omission in a proxy solicitation can trigger liability only if it is “material,” that is, “there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote.2. Culpability: Varies with each circuit (no SCOTUS standard determined yet). Some use negligence standard while others use proof of scienter (intentionally or extreme recklessness).3. Causation and Reliance: A plaintiff need not prove actual reliance on a misrepresentation to complete a Rule 14a-9 cause of action. Causation of injury is presumed if a misrepresentation is material and the proxy solicitation “was an essential link in the accomplishment of the transaction.”

-difficult for an individual share holder to prove they relied on something-must prove materiality, and then prove that that vote was nec. to the transaction that at issue

4. Remedies: Injunctive relief, rescission, or monetary damages.

Virginia Bankshares, Inc. (VBI) v. Sandberg

Facts: - VA Bank (Bank) merged with VBI. So now, VBI owned 85% of Bank’s shares. VBI’s parent company, FABI, had the shares of the minority holders evaluated. These minority shareholders would lose their interest in Bank as a result of the merger, evaluated. It was valued at $42. - The alleged misrepresentation: In a proxy solicitation, the directors said that the proposal should be adopted that they had approved of the plan “because of its opportunity for the minority shareholders to achieve a “high” value” for their minority stock and that it was a fair value.- P sued alleging that (1) violation of Section 14(a) and 14a-9 and (2) for breach of fiduciary duty owed to minority shareholders. Under (1), she alleged that the directors had not believed that the price offered was high nor fair, but did so to remain on the board. D argues that the statement was an opinion so it is not a misrepresentation of “material facts” as required by the statute. - Jury awarded P with $18 so that her shares would be valued at $60 per share instead of $42. D appeals. SCOTUS reverses the judgment.

Issues:

(1) Whether an individual is permitted to prove that a specific statement of reason is was knowingly false or materially misleading, even when the statement is couched in conclusory statements (i.e. an opinion) where statutory language addresses misrepresentation of material “facts.”(2) Whether a causation of damages compensable through a federal implied private right of action be demonstrated by minority shareholders whose votes are not required to authorize the transaction giving rise to this claim?

Holding: For Issue (1): An individual is permitted to prove that a specific statement of reason is was knowingly false or materially misleading, even when the statement is couched in conclusory statements (i.e. an opinion) when there is objective evidence that can show the statement expressly or impliedly asserted something false or misleading about its subject matter.

Rationale: 1. Re Materiality: A misrepresentation is material if “there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote. Court said the misrepresentation was material.2. Re Opinion v. Facts: Boards statements of reasons or belief (couched as conclusory statements) are factual in two senses: as statements that the directors do act for the reasons given or hold the belief stated and as statements about the subject matter of the reason or belief expressed. Reasons for directors’ recommendations or statement of belief are matters of corp. record subject to documentation to be supported or attacked by evidence of historical fact.

Here, the whether $42 was “high” and the proposal “fair” depended on provable facts about the Bank’s assets. Moreover, the Bank’s real estate holdings show that the price is not a premium above market price as implied by the statement of reason.

For Issue (2): Causation of damages compensable through a federal implied private right of action cannot be demonstrated by minority shareholders whose votes are not required to authorize the transaction giving rise to this claim.

- The law requires that the proxy solicitation “was an essential link in the accomplishment of the transaction.”- Here, P argued that there is causation because (1) VBI and FABI would have been unwilling to proceed with the merger without the approval from the minority (so they had to say the price was “high”) and (2) there is causation because it was the means to satisfy a state statutory requirement of minority shareholder approval as a condition for saving the merger from voidability resulting from a conflict of interest on the part of one of the Bank’s directors.- Regarding P’s first argument, causation cannot be shown from speculative claims. Causation cannot be shown from hypothetical claims.- Regarding P’s second argument, the Court said that a causation is recognized when a minority shareholder has been induced by a misleading proxy statement to forfeit a state-law right to an appraisal remedy by voting to approve the transaction. Here, the minority votes were inadequate to ratify the merger under state law and there was no loss of state remedy that is irredressable under state law. Judgment reversed.

Concurrence and Dissent: The court’s precedents or the court of appeals’ does not justify the limits the majority placed on possible proof of nonvoting causation and undue emphasis on fears of “speculative claims”. The majority assumes that the majority shareholder will vote in favor for the management’s proposal even if the proxy disclosure suggests that the transaction is unfair to the minority or if the board breached its fiduciary duty to the minority. There is no authority for limiting Section 14a only to situations where the minority has enough strength to successfully oppose the proposal. Facts here shows that had there

been full disclosure, the merger may not have been pursued – ie. Facts showed a link between the nondisclosure and the completion of the merger. This case demonstrates that nonvoting causation theories are plausible where the misstatement or omission is material and the damage sustained by minority shareholders is serious.

Only applies to 14(a)(9); cabin in so that private right of action is unlikely7.10 State Disclosure Law: Fiduciary Duty of Candor NOT TESTED

When-ever directors communicate publicly or directly with shareholders about the corps.’ affairs, with or without request for shareholder actions, directors have a fiduciary duty t

Chapter 8: Normal Governance: The Duty of Care:

Introduction

The shareholders right to elect directors is not the law’s only strategy for corporate governance. Fiduciary standards also play a role in normal governance, just as in agency and partnership law. The duties of a fiduciary-whether a trustee, a partner, or a corporate director, are essentially three:

1. Duty of obedience - a fiduciary must act consistently with the legal documents that create her authority.2. Duty of loyalty - requires that corporate fiduciaries exercise their authority in good-faith attempt to advance corporate purposes (bars directors and officers from competing with the corporation, etc.)3. Duty of care - requires parties to act with “the care of an ordinarily prudent person in the same or similar circumstances.”

Directors (agents) owe duties to the corporation (principal)Partners (agents) owe duties to the partnership (principal)

ALI definition for duty of care: A corporate director or officer is required to perform his or her functions (1) in good faith, (2) in a manner the he or she reasonably believes to be in the best interests of the corporation, and (3) with the care that an ordinarily prudent person would reasonably be expected to exercise in a like position an under similar circumstances.

Directors/Officers can be liable under the Duty of care in two scenarios:

1. Potential liability for directorial decisions2. Liability for failure to monitor

However, there are three mechanisms which insulate officers and directors from liability based on negligence (as opposed to knowing misconduct).

1. Indemnification, 2. Directors and Officers Insurance, and 3. The Business Judgment Rule.

Why do we have insulating mechanism?

Corporate directors and officers invest other people’s money. They bear the full costs of any personal liability, but they receive only a small fraction of the gains from a risky decision. Liability under a negligence standard therefore would predictably discourage officers and directors from undertaking valuable but risky projects.

Gagliardi v. Trifoods International, Inc .

FACTS: Shareholders (P) of TriFoods International, Inc. (TriFoods) brought a derivative action against TriFoods directors (D) for recovery of losses allegedly sustained by reason of mismanagement unaffected by directly conflicting interests. The directors (D) moved to dismiss the action. The issue was thus what the shareholders (P) had to plead to sustain their action.

ISSUE: To sustain a derivative action for the recovery of corporate losses resulting from mismanagement unaffected by directly conflicting financial interests, must a shareholder plead that a director/officer did not act in good faith and/or failed to act as an ordinary prudent person would have acted under similar circumstances?

HOLDING AND DECISION: Yes.

To sustain a derivative action for the recovery of corporate losses resulting from mismanagement unaffected by directly conflicting financial interests, a shareholder must plead that a director/officer did not act in good faith and/or failed to act as an ordinary prudent person would have acted under similar circumstances.

First, absent a direct financial conflict, a director or officer is not liable for corporate losses suffered as a result of a decision that individual made or authorized in good faith.

Also, the actions of officers and directors is protected by the business judgment rule, which provides that if a director is independent and disinterested, there can be no liability for corporate loss, unless the facts were such that no person could possibly authorize such a transaction if he or she were attempting in good faith to meet their fiduciary duty.

These precepts make economic sense, since shareholders would not rationally want directors or officers to be risk averse. In today's corporate environment, it would take only a very small probability of director/officer liability based on negligence, inattention, waste, or like theories to inhibit directors or officers from taking any risk if the directors officers were liable for any corporate loss from a risky project.

Accordingly, it is in the shareholders' economic interest to offer sufficient protection to directors and officersfrom liability for negligence, inattention, waste, etc., so as to enable directors or officers to be confident that if they act in good faith and meet minimal standards of attention, they will not face liability as a result of a business loss. That is whycorporations are authorized to pay for director and officer liability insurance or to indemnify their directors/officers.

Statutory Techniques for limiting director and officer risk exposure

1. Indemnification

Most corporate statues authorize corporations to commit to reimburse any agent, employee, officer, or director for reasonably expense for losses of any sort (attorneys’ fees, investigation fees, settlement amounts, and in some instances judgments) arising from any actual or threatened judicial proceeding or investigation.

The only limits are that the losses must result from actions undertaken on behalf of the corporation in good faith and that they cannot arise from a criminal conviction.

Class Notes: decision that has to be made, leads to bad results, which in turn leads to a lawsuit, if criminally convicted there is no indemnification (even if you acted in good faith); if no criminal conviction

Waltuch v. Conticommodity Services, Inc.

FACTS: As a former employee of Conticommodity (Conti) (D), Waltuch (P) traded silver for the firm's clients, as well as for his personal account. When the silver market fell, clients brought suit against Waltuch (P) and Conti (D) alleging fraud, market manipulation and antitrust violations. All of the suits eventually settled and were dismissed with prejudice, pursuant to settlements in which Conti (D) paid over $35 million to the various suitors. Waltuch (P) himself was dismissed from the suits with no settlement contribution. His unreimbursed legal expenses in these actions totaled approximately $1.2 million. After the actions had been settled, Waltuch (P) sought indemnification from Conti (D), which refused, and Waltuch (P) brought suit for indemnification for his unreimbursed expenses.

The ninth article of Conti's (D) articles of incorporation (Article Ninth) required Conti (D) to indemnify Waltuch (P). Conti (D) contended that Waltuch's (P) claim was barred by subsection (a) of§ 145 of Delaware's General Corporation Law, which permits indemnification only if the corporate officer acted "in good faith," something that Waltuch (P) had not established. Waltuch (P) countered that § 145(f) permits a corporation to grant indemnification rights outside the limits of subsection (a), and that Conti (D) did so with Article Nine (which had no stated good-faith limitation).

The district court held that, notwithstanding § 145(f), Waltuch (P) could recover under Article Nine only if Waltuch (P) met the "good faith" requirement of § 145 (a). Waltuch (P) also claimed that § 145(c) required Conti (D) to indemnify him because he was "successful on the merits or otherwise" in the lawsuits. The court of appeals granted review.

ISSUE:

(1) Does a provision of a corporation's articles of incorporation that provides for indemnification without including a good-faith limitation run afoul of a statute that permits indemnification only if the prospective indemnitee acted in good faith, even if the statute also permits the corporation to grant rights in addition to indemnification rights?

(2) To the extent that a director, officer, employee or agent of a corporation has been successful on the merits or otherwise in defense of any action, suit or proceeding, or in defense of any claim, issue or matter therein, shall he be indemnified against expenses (including attorney's fees) actually and reasonably incurred by him in connection therewith?

HOLDING AND DECISION:

(1) Yes. A provision of a corporation's articles of incorporation that provides for indemnification without including a good-faith limitation runs afoul of a statute that permits indemnification only if the prospective indemnitee acted in good faith, even if the statute also permits the corporation to grant rights in addition to indemnification rights. Section 145(a) limits a corporation's indemnification powers to situations where the officer or director to be indemnified acted in good faith. Critically, § 145(f) merely acknowledges that one seeking indemnification may be entitled to rights in addition to that of indemnification; it does not speak in terms of corporate power, and therefore cannot be read to free a corporation from the good faith limit explicitly imposed in § 145(a}. To hold otherwise would require ignoring the explicit terms of § 145. Additionally, such an interpretation does not render § 145(f) meaningless, since a corporation may grant additional rights that are not inconsistent with § 145(a). For these reasons, Waltuch (P) is not entitled to indemnification under Article Nine, which exceeds the scope of§ 145(a). Affirmed as to this issue.

(2) Yes. To the extent that a director, officer, employee or agent of a corporation has been successful on the merits or otherwise in defense of any action, suit or proceeding, or in defense of any claim, issue or matter therein, he shall be indemnified against expenses (including attorney's fees) actually and reasonably incurred by him in connection therewith. Conti (D) argued that the successful settlements could not be attributed to Waltuch (P), but were the result of Conti's (D) efforts. This application is overbroad. Escape from an adverse judgment or other detriment, for whatever reason, is determinative. "Success is vindication." To go behind the "successful" result is inappropriate. Once Waltuch (P) achieved his settlement gratis, he achieved success "on the merits or otherwise." Accordingly, Conti (D) must indemnify Waltuch (P) under § 145(c) for the $1.2 million in unreimbursed legal fees he spent defending the private lawsuits. Reversed.

145(f) is just miscellaneous category (not tested on applications)145(a) & (b) require good faith this is what the court saidDecision leads to three possible outcomes:

1) Criminal conviction (no indemnification) 2) Successful defense on the merits (indemnification under 145(c))3) Some liability (civil or otherwise) corporation discretionary, only in case of good faith (indemnification under 145(a) with showing of good faith)

if you lose lawsuit, but acted in good faith, with no indemnification clause in corporate charter, corporation is not required to indemnify you145c w/out Indem.Clause. in Corp.Charter.C.C. exists, lose, no clause, you don’t get indemnificationexists, lose, good faith, indemnification happensno indem. clause, lose at trial, show good faith, could get away with a shareholder vote for retroactively applying indemnification clause

2. Directors and Officers Insurance

Provisions authorizing corporations to pay permia on directors and officers liability insurance. These group policies, financed by the corporation, place the financial muscle of an insurance company behind the company’s pledged to make whole those directors who suffer losses as a result of their good-faith actions.

Why do corporations purchase insurance rather than raising salaries (and having the directors/officers buy their own insurance?)

-might be cheaper if the company acts as a central bargaining agent for all of its officers-may standardize director’s individual risk profiles in decision making-tax consequences-directors may under-invest themselves-helps disguise the total amount of management compensation.

Judicial Protection: The Business Judgment Rule

The idea that courts should not second-guess good-faith decisions made by independent and disinterested directors. That is, the business judgment rule means that courts will not decide (or allow a jury to decide) whether the decisions of corporate boards are either substantively reasonably the “reasonable prudent person” test or sufficiently well informed by the same test.

Kamin v. American Express

FACTS: American Express (D) had acquired for investment almost two million shares of common stock in Donaldson, Lufken and Jenrette (DLJ) at a cost of $29.9 million. Kamin (P), a minority stockholder in American Express (D), charged that the subsequent decision to declare a special dividend to all stockholders resulting in a distribution of the shares of DLJ in kind was a negligent violation of the directors' fiduciary duty. He argued that the market value of the DLJ shares was only $4 million and that American Express (D) should have sold the DLJ shares on the market so as to be able to offset the $25 million capital loss against taxable capital gains on other investments and thus obtain an $8 million tax saving that would be otherwise unavailable. In a shareholders' derivative action, Kamin (P) sought a declaration that the dividend in kind constituted a waste of corporate assets and sought damages therefor. American Express (D) moved to dismiss the complaint.

ISSUE: Should the courts interfere with a board of directors' good faith business judgment as to whether or not to declare a dividend or make a distribution?

HOLDING AND DECISION: No.

Whether or not to declare a dividend or make a distribution is exclusively a matter of business judgment for the board of directors, and thus the courts will not interfere with their decision as long as it is made in good faith. It is not enough to charge, as Kamin (P) has in this case, that the directors made an imprudent decision or that some other course of action would have been more advantageous.

For example, the BoD, realized that there were countervailing consideration primary with respect to the adverse effect of a sale would have on the net income figures in the Amex financial statement. Such a reduction of net income would have a serious effect on the market value of the publicly traded Amex stock.

The only hint of self-interest which is raised…is that four of the twenty directors were officers and employees of American Express and members of its Executive Incentive Compensation Plan…would have affected their compensation? However, such a claim, but itself can hardly be regard as sufficient to support an inference of self-dealing.

Thus, the motion for summary judgment and dismissal of the complaint is granted.

Understanding the Business Judgment Rule

What exactly is this rule? ABA, “a decision constitutes a valid business judgment (and gives rise to no liability for ensuing loss) when it:

(1) Independent (2) is made by financially disinterested directors or officers (3) who have become duly informed before exercising judgment and (4) who exercise judgment in a good-faith effort to advance corporate interests.

Why is the rule necessary at all? Since if the elements are met above, what possible basis for liability exists?

Procedural: insulates disinterests directors from jury trials, which encourages the dismissal of some claims before trial and allows judicial resolution of the remaining case-based claims that go to trial.

Substantive: turns “was the standard of care breached?” into the above question.

Why bother at all?

Why announces a legal duty to behave as a reasonably director would behave but apply a rule that no good-faith decision gives rise to liability as long as no financial conflict of interest is involved?

Must be that there is a social value to announcing a standard that is not enforced with a liability rule. Pedagogic function

Van Gorkom-with little outside advice and little advice form senior staff, Van Gorkkom arranged a merger agreement with Mr. Pritzker’s entity. It was alleged that the board had not acted in an informed manner in agreeing to the deal. Court held that the directors had been grossly negligent in their decision making and therefore could not claim the protections of the BJR.

Van Gorkom was the first Delaware case to actually hold directors liable for breach of the duty of care in a case in which the board had made a business decision. The very few previous cases that had imposed liability for breach of the duty of care had done so in cases in which the board had failed to prevent a corporate fraud.

This lead to a change in statutory law (in Delaware) and a rise in the level of premia changed by insurance companies for director and officer insurance.

Specifically Delaware validated charter amendments (102(b)(7) that provide that a corporate director has no liabilityfor losses caused by transaction in which the director had no conflicting financial interest or otherwise was alleged to violate a duty of loyalty (pre-standard was simply “grossly negligent”); must be disinterested. Again, to encourage risk taking by directors.

Section 102(b)(7) waivers are directed to damage claims. The directors’ duty of care still can be the basis for an equitable order, such as an injunction.

Adjudicating duty of care vs. duty of loyalty (I doubt he will discuss this section, but in case he does).

if client waites until last minute, and rushes around for input from indpendnent, your screwed even if it is a good decision; not good enough just to get a good outcome, must take certain steps to become informed, if something jumps up at last minute, that may be okay; but if you know something is coming, it’s not okay (it’s not last minute)

Emerald Partners: corp. bought out companies owned; vote was taken only by those disinterested and independent, controlling share holder stayed in the room; controlling shareholder made lots of money; all of his personal debt was discharged, all that was left was disinterested; presence of controlling shareholder means you have to test for entire fairness (supreme court said that); trail court said entirely fair, and SCOTUS aff’d

The board’s duty to monitor: Losses “caused” by board passivity

What is the scope of director liability for losses that arise not from business choices but rather from causes that the board might arguably have deflected?

In fact, the relatively few cases that actually impose liability on directors for breach of the duty of care are those in which the directors simply failed to do anything under circumstances in which it is later determined that a reasonably alter person would have taken action.

The next FIVE CASES!!!! REALLY? deal with directors who are charged with breaching their duty of care by not sufficiently monitoring the corporation and thus by not preventing a loss that the corporation incurred.

Francis v. United Jersey Bank

FACTS: Mrs. Pritchard (D) inherited an interest in Pritchard & Baird, a reinsurance broker, from her husband.She and her two sons, Charles, Jr. and William, served as directors of the corporation. Her sons withdrew millions ofdollars in the form of loans from client trust accounts, and the firm went bankrupt. Mrs. Pritchard (D) was completelyignorant as to the fundamentals of the reinsurance business, and paid no attention to the affairs of the corporation, thebusiness of which she was completely unfamiliar. After her husband died, she began to drink heavily, her health declinedrapidly, and she died.

The bankruptcy trustee brought suit, claiming that Mrs. Pritchard had been negligent in the discharge of her duties as director. The trial court held her liable for the clients' losses, finding that although she was competent to act, despite her drinking and distraught psychological state of mind following her husband's death, she had made no effort to exercise her duties as a director.

ISSUE: Does individual liability of a corporation's directors to its clients require a duty, a breach, and proximatecause?

HOLDING AND DECISION: Yes.

Individual liability of a corporation's directors to its clients requires a demonstration that: (1) a duty existed; (2) the directors breached that duty; and (3) the breach was a proximate cause of the client's losses. This is a departure from the general rule that a director is immune from liability and is not an insurer of the corporation's success. The director of a corporation stands in a fiduciary relationship to both the corporation and its stockholders. Inherent in this role is a duty to acquire a basic understanding of the corporation's business and a continuing duty to keep informed of its activities. This entails an overall monitoring of the corporation's affairs, and a regular review of its financial statements. Such a review may present a duty of further inquiry.

Here, Mrs. Pritchard (D) failed to exercise supervision over the corporation, including the examination of its financial statements, which would have revealed the misappropriation of funds by her sons. The cumulative effect of her negligence was a substantial factor contributing to the clients' losses. Affirmed.--------------------------------------------------------------------------------------------------------------------------------------------

In general, BoD have a particular obligation to monitor their firm’s financial performance, the integrity of its financial reporting, it compliance with the law, its management compensation, and its succession planning.

Modernly, the BoD must monitor largely through reports from others, whether outside auditors, other professionals, or corporate officers. Failure of appropriate controls can result in extraordinary losses.

What is the BoD responsibility to assure that the corporation functions within the law to achieve its purposes?

Graham v. Allis-chalmers manufacturing Co.

FACTS: Allis Chalmers Manufacturing Co. (Allis-Chalmers) (D), a very large corporation employing over 31,000 individuals, and several non-director employees were indicted for, and pleaded guilty to, violating federal antitrust laws. Shareholders (P) brought a derivative action for damages allegedly suffered by the corporation by reason of the indictments. No director had any actual knowledge of the antitrust activity, or had actual knowledge of any facts that would have put them on notice that antitrust activity was being carried on by some of their employees. Additionally, the operating policy of the company was to decentralize by the delegation of authority to the lowest possible management level capable of fulfilling the delegated responsibility. The shareholders (P) contended that the directors were liable as a matter of law because they failed to take action designed to learn of and prevent the illegal conduct, noting that over 20 years earlier the company had signed consent decrees that it would not engage in such antitrust activities. The few (3 of 14) directors who knew about the decrees satisfied themselves that the company was in compliance with them. The chancery court held that the directors were not liable. The state's highest court granted review.

ISSUE: Is a corporate director who has no knowledge of suspicion of wrongdoing by employees liable for such wrongdoing as a matter of law?

HOLDING AND DECISION: No.

A corporate director who has no knowledge of suspicion of wrongdoing by employees is not liable for such wrongdoing as a matter of law.

First, knowledge by three of the directors that over 20 years earlier the company had consented to the entry of decrees enjoining it from doing something they had satisfied themselves it had never done, did not put the board on notice of the possibility of future illegal antitrust activity.

Therefore, the shareholders (P) must rely on the legal proposition that directors of a corporation, as a matter of law, are liable for losses suffered by the corporation as a consequence of their gross inattention to the common law duty of actively supervising and managing the corporation's affairs. This requires a degree of watchfulness by the board that is premised on employee dishonesty.

To the contrary, a board may rely on the honesty and trustworthiness of its employees until something occurs to put the board on suspicion that something is wrong. "[A]bsent cause for suspicion there is no duty upon the directors to install and operate a corporate system of espionage to ferret out wrongdoing which they have no reason to suspect exists."

Here, it was impossible for the board to know every employee, and thus it was appropriate that the board focused on broad policy decisions. As soon as it had knowledge of suspicions of wrongdoing, the

board responded appropriately to put an end to any wrongdoing and prevent its recurrence. There is "no rule of law which requires a corporate director to assume, with no justification whatsoever, that all corporate employees are incipient law violators who, but for a tight checkrein, will give free vent to their unlawful propensities." Affirmed.

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State corporation law is not the only legal source of a director’s duty of care. Securities law and the SEC also impose negligence-based duties on directors in a variety of contexts.

In the matter of Michael Marchese

FACTS: Marchese (D) was an outside director of Chancellor who served on its audit committee and was anacquaintance of Adley, who was Chancellor's controlling shareholder, chairman and CEO. As part of an acquisitionof another company, a dispute arose between Chancellor's management and its auditors regarding the appropriate acquisition date for accounting purposes, and Chancellor dismissed the auditors. Adley directed that documents be backdated or fabricated to support a date earlier than accepted by the auditors, and new auditors were hired. Based on the falsified records, the new auditors approved the date desired by Adley and management.

Marchese (D) approved the decision to dismiss the original auditors; he was aware of the disagreement between Chancellor's management and the auditors regarding the appropriate acquisition date for accounting purposes; he knew that the disagreement formed part of the reason for the auditors' dismissal; and he approved the engagement of the new auditors. Despite this knowledge, Marchese (D) made no inquiry into the reasons for the different views held by the different auditors, and he did not determine whether there was any factual support for the earlier acquisition date.

Additionally, in connection with the acquisition, Adley caused Chancellor to record $3.3 million in fees to a private corporation he owned, purportedly for consulting services. However, in fact, no significant consulting services had been rendered to Chancellor by Adley's private company. Again, Adley directed the fabrication of documents to support the accounting for the fees, and directed that the fees be recorded as an asset on Chancellor's balance sheet, rather than as an expense on its income statement. As with the acquisition date, such accounting was inconsistent with GAAP, which provides that costspayable to an outside consultant in business combinations may be capitalized only if the consultant has no affiliationwith the companies involved in the acquisition. The year before, in connection with the preparation of Chancellor'syear-end results, Chancellor's auditors had required the company to write off $1.14 million in related party paymentsto Adley-controlled entities because there was no substantiation for the payments. Although Marchese (D) knew of thesewrite-offs of payments to Adley's entities, he took no steps (to determine whether the $3.3 million consulting fee to Adley'spersonal company was substantiated). He inquired neither of the auditor nor of Adley about related party transactions. Asa result of the inappropriate accounting, both as to the acquisition date and the consulting fees, Marchese (D), along with others, signed a Form 10-KSB that was misleading and falsely represented that the value of Chancellor's assets was higher than it really were, and that Chancellor had net income, rather than a loss. Marchese (D) never reviewed Chancellor's accounting procedures or internal controls.

ISSUE: Does an outside director of a corporation who serves on its audit committee violate, and cause his corporationto violate, the Exchange Act and Rules there under by recklessly failing to inquire into the corporation's financialswhen he has knowledge of facts to put him on notice that such inquiry is warranted?

HOLDING AND DECISION: Yes.

An outside director of a corporation who serves on its audit committee violates, and causes his corporation to violate, the Exchange Act and Rules there under by recklessly failing to inquire into the corporation's financials when he has knowledge of facts to put him on notice that such inquiry is warranted.

First, Marchese (D) violated and caused Chancellor's violation of Section lO(b) of the Exchange Act and Rule lOb-s there under when he signed Chancellor's Form 10-KSB. That is because despite his knowledge surrounding the dispute with the original auditors that led to the new auditors approving an earlier acquisition date, Marchese (D) recklessly failed to make any inquiry into the circumstances leading to the new audit firm's approval of the acquisition date, or whether it was correct, and, despite his knowledge of the previous year's write-offs based on related-party fees, he recklessly failed to make any inquiry into the existence of documents substantiating the services for which the fees were purportedly due.

Second, Marchese (D) caused Chancellor's violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the ExchangeAct and Rules 12b-20 and 13a-1 there under, since those provisions and rules require that annual reports be accurate;that every reporting company make and keep books, records and accounts that accurately and fairly reflect the issuer'stransactions; and that a company devise and maintain a system of internal controls sufficient to provide reasonableassurances that transactions are recorded as necessary to permit the preparation of financial statements in conformitywith GAAP. Here, Marchese (D) was reckless in not knowing that Chancellor's Form 10-KSB contained materially misleading statements, and signed that form without inquiring into the basis for the consultant fees payable to Adley's company or the basis for the new audit firm's approval of the earlier acquisition date. Accordingly, Marchese (D) must cease and desist from committing or causing similar violations of these rules and statutory provisions.

In re Caremark international Inc. Derivative Litigation

FACTS: Caremark was involved in providing patient health care and managed health-care services. Much of Caremark'srevenue came from third-party payments, insurers, and Medicare and Medicaid reimbursement programs. The Anti-Referral Payments Law (ARPL) applied to Caremark, prohibiting payments to induce the referral of Medicare or Medicaid patients. Caremark had a practice of entering into service contracts, including consultation and research, with physicians who at times prescribed Caremark products or services to Medicare recipients . Such contracts were not prohibited by the ARPL but they obviously raised a possibility of unlawful “kickbacks.”

However, the government began investigating Caremark. Caremark began making structural changes in response to the investigation, centralizing management. In spite of this, Caremark and two officers were indicted. Several shareholder derivative actions were subsequently filed, charging the board of directors (D) with failure to adequately monitor as part of its duty of care (employee misconduct).

Settlement negotiations began. Caremark agreed in the settlement to cease all payments to third parties that referred patients to Caremark and to establish an ethics committee, which it had, in effect, already done. Caremark also agreed to make reimbursement payments to private and public parties totaling $250 million. All other claims were waived in the proposed settlement. The proposed settlement was submitted to the court for approval.

ISSUE: Does a board of directors have an affirmative duty to attempt in good faith to assure that a corporate information and reporting system exists and is adequate?

HOLDING AND DECISION: Yes.

A board of directors has an affirmative duty to attempt in good faith to assure that a corporate information and reporting system exists and is adequate…so it may satisfy its responsibility (of monitoring the corporation).

Directors generally do not monitor day-to-day operations in a company. The Supreme Court has said where there is no basis for suspicion, directors cannot be liable. However, it would be extending this holding too far to say that directors have no obligation whatsoever to determine whether they are receiving accurate information. The duty of care implies that a board will make a good faith effort to ensure that a corporation's information and reporting system is adequate. In this case, acts that resulted in indictments do not, by themselves, prove that the Caremark board (D) was not adequately monitoring corporate behavior.

On the contrary, the board (D) appears to have been making structural changes all along to gain greater centralized control of the company. And an ethics monitoring group was in place well before the settlement was reached. Given that the evidence on the record suggests that success in the derivative suit was unlikely, but that Caremark is giving up little in the way of concessions not already in place, the settlement is fair.

In re Citigroup Inc. Shareholder Derivative Litigation

FACTS: Citigroup shareholders (P) brought suit against certain current and former Citigroup officials (D), alleging,in essence, that the officials (D) breached their fiduciary duties by failing properly to monitor and manage the risksthe company faced from problems in the subprime lending market, and by failing properly to disclose Citigroup's exposureto subprime assets. The shareholders (P) claimed that there were "red flags" (majority of the directors served on the Citigroup board curing its previous Enron related conduct and they were members of the ARM committee and considered financial experts. That should have given the officials (D) notice of the problems that were brewing in the real estate and credit markets, and that the officials (D) ignored these warnings in the pursuit of short-term profits and at the expense of the company's long-term viability.

ISSUE: Do directors breach their fiduciary duties by failing adequately to oversee a company's exposure to problems in the subprime mortgage market and to ensure that financial and other disclosures were accurate?

HOLDING AND DECISION: No. Directors do not breach their fiduciary duties by failing adequately to oversee a company's exposure to problems in the subprime mortgage market and to ensure that financial and other disclosures were accurate. The shareholders' (P) theory essentially amounts to a claim that the directors (D) should be personally liable to the company because they failed to fully recognize the risk posed by subprime securities. To allow shareholders (P) to succeed on a theory that a director (D) is liable for a failure to monitor business risk would invite courts to perform a hindsight evaluation of the reasonableness or prudence of directors' (D) business decisions. In sum, the shareholders (P) failed to state a claim sufficient to support a theory that the directors (D) did not fulfill their oversight obligations by failing to monitor the business risk of the company. Ultimately, the discretion granted directors and managers (D) allows them to maximize shareholder (P) value in the long term by taking risks without the debilitating fear that they will be held personally liable if the company experiences losses. This doctrine also means, however, that when the company suffers losses, shareholders may not be able to hold the directors personally liable.

“Knowing” Violations of Law

The BJR will not immunize an action they BoD they know to be illegal from judicial scrutiny. Thus, the duty to obey the law can be seen as a judge-created positive overlay on the overall fiduciary duty structure.

Miller v. AT&T

FACTS: The Democratic National Convention owed American Telephone & Telegraph Co. (AT&T) (D) $1.5 million. The directors of AT&T (D) made no attempt to collect this debt for the Corporation (D). Several AT&T (D) shareholders, including Miller (P), brought a derivative suit against all but one director for breach of their fiduciary duty. The complaint also alleged that forgiveness of the debt was an illegal campaign contribution under 18 U.S.C. § 610. The directors (D) pleaded a valid business decision and the court dismissed the case on the basis of the business judgment rule..ISSUE: Is the business judgment rule a defense to an action charging illegal or immoral conduct?

HOLDING AND DECISION: No.

The business judgment rule is based on a judicial recognition of the impossibility of intervening in corporate decision making if the directors' judgment is uninfluenced by personal considerations and was made in good faith after the use of reasonable diligence in ascertaining the facts. However, the sound business judgment rule has no application to situations charging the directors with illegal or immoral acts. Business judgment has no place in the decision to commit such acts. Here, the directors (D) are charged with violations of the campaign contribution laws. A prima facie case has been stated by the complaint. Reversed and remanded.

9.Conflict Transactions: The Duty of Loyalty

Every jurisdiction’s corporate laws impose specific controls on two classes of corporate actions:

1. those in which a director or controlling shareholder has a personal financial interest

a. chapter 9 deals with these types of actions e.g.: self-dealing between company and its directors, appropriations of “corporate opportunities”, compensation of officers and directors

2. those that are considered integral to the continued existence or identity of the company

Duty of Loyalty: requires a corporate director/officer/controlling-shareholder to exercise his institutional power over corporate processes or property in a good-faith effort to advance the interests of the company

-put another way: Duty of loyalty requires corporate director/etc. to fully disclose all material facts to the corporation's disinterested representatives and to deal with the company on terms that are intrinsically fair in all respects

Two Reasons why duty of loyalty is more complex in corporate context:

1. Even though corporation is fictional entity, real people invest in it

2. Constituency is more fragmented and unorganized (e.g. diverse shareholders), so how is enforcement implemented?

Duty of Loyalty requires four actions on the part of the director:

1. Disclosure

2. Approval by disinterested director and/or shareholder

3. Good faith

4. Fairness to the corporation (ties in with duty of care)

9.1 Duty to Whom?

In short, directors owe their duty to the corporation as a legal entity

9.1.1 The Shareholder Primacy Norm

Dodge v. Ford: Ford claimed he was doing it just for the benefit of the public; claimed to be ignoring interest of shareholders; court said no you can’t do it just for the benefit of the public

concept of shareholder primacy is not as strong as it used to be, but if corp. was dumb enough to say the sole reason they didn’t pay dividends was to benefit public, the court would call it back

shareholders is what everything centers on

A.P. Smith Manufacturing Co. v. Barlow (N.J. 1953)

Facts:

Barlow sued AP Smith for donating to Princeton

Objecting Shareholders state:

1. P certificate of incorporation does not expressly authorize the contribution and under common-law principles the company does not possess any implied or incidental power to make it

2. NJ statutes which expressly authorize the contribution may not constitutionally be applied to the P, a corporation created long before their enactment

Issue: Is the donation by P valid?

Holding: Donation by P was valid

Reasoning:

-modern conditions require that corporations acknowledge and discharge social as well as private responsibilities as members of the communities within which they operate

-corporations can contribute corporate funds within reasonable limits in support of academic institutions

-every business has an interest in an educated workforce

9.1.2 Constituency Statutes

In the wake of the influx of “hostile takeovers” seen in the 1980’s managerial advocates rationalized resistance to hostile takeovers by stating that directors owe loyalty to something apart from the shareholders alone; the combination of all stakeholders in the corporation (i.e. creditors, shareholders, managers, employees, suppliers and customers).

Resultantly, state legislatures attempted to save managers by enacting statutes that gave directors the power to balance the interests of non-shareholder constituencies (i.e. creditors, shareholders, managers, employees, suppliers and customers) against the interests of shareholders in setting corporate policy.

-DE has not enacted a constituency statute; but DE Supreme Court precedent allows for “takeover defenses”

9.2 Self-Dealing Transactions

Director’s and Corporate Officers may not benefit financially at the expense of the corporation in self-dealing transactions

there are times when a choice will violate the duty of care and the alternate option would violate the duty of loyalty, this is just how we deal with it

9.2.1 Early Regulation of Fiduciary Self-Dealing

Corporations could add a provision in the corporate charter that interested directors may be counted towards a quorum

Courts upheld these provisions, and therefore they allowed interested transactions involving a majority of the board

Courts required directors to prove interested transactions were “fair” however

9.2.2 The Disclosure Requirement

State Ex Rel. Hayes Oyster Co. v. Keypoint Oyster Co (Wash. 1964)

Facts:

Verne Hayes was: (1) CEO, director and 23% shareholder of Coast Oyster Co. and (2) Owned 25% of Hayes Oyster Co. (his brother Sam owed the other 75%) Hayes was barred from competing with Coast Oyster Co, except for his Hayes Oyster Co. activities; Coast Oyster needed money in Spring 1960; Hayes helped Coast Oyster employee Engman purchase one of Coast Oyster’s oyster beds; Engman was to form Keypoint Oyster Corporation, of which Engman would own half and the other half by Hayes Oyster; Coast Oyster’s shareholder meeting approved the sale to Keypoint with Hayes voting as a majority (via his own shares and others by proxy)

Procedural:

Subsequent mangers of Coast Oyster brought suit against Verne and his brother Sam for their Keypoint shares for breach of duty to Coast Oyster; trial court found in favor of the Hayes brothers

Issue: Did Hayes violate his breach his fiduciary duty owed to Coast Oyster by failing to disclose the Keypoint Oyster purchase?

Holding: Yes, trial court reversed Keypoint Oyster Co. to issue a new certificate for 250 shares of its stock to Coast Oyster Co. and cancel the certificates heretofore standing the name of or assigned to Hayes Oyster Co.

Reasoning:

Rule: If a director or officer can show that a transaction was fair to the corporation such contract cannot be voided. However, nondisclosure by an interested director or officer is by definition unfair

“It is not necessary...that an officer or director of a corporation have an intent to defraud or that any injury result to the corporation for an officer or director to violate his fiduciary obligation in secretly acquiring an interest in corporate property”

9.2.3 Controlling Shareholders and the Fairness Standard

potential for control, not just that you have 50% + 1 currently

controlling shareholder does have a duty to the rest of the shareholders

Sinclair Oil Corp. v. Levien (Del. 1971)

Facts:

Plaintiff, Levien, brought suit as a minority shareholder of Sinclair Venezuelan Oil Company (”Sinven”) which was a subsidiary of Defendant, Sinclair Oil Corporation.

Plaintiff alleged that Defendant caused Sinven to pay out excessive dividends which prevented Sinven from being able to expand.

Procedural: lower court’s Chancellor held Sinclair to test of intrinsic fairness, Sinclair appealed.

Issue: Was Sinclair improperly engaging in self-dealing when they issued excessive dividends?

Holding: Sinclair did not engage in self-dealing by issuing large dividends, business judgment was proper standard for evaluating Sinclair’s expansion policies.

Reasoning:

Defendant complied with Delaware statute 8 Del.C. Section: 170, concerning the payment of dividends, and Defendant’s motives are not a factor when all shareholders (including minority shareholders) benefit from the transaction (i.e. not self-dealing).

If Sinclair owned class a and public was class b, you couldn’t drain all of the value of class b stock

must be disinterested and independent for the business judgment rule to apply

Intrinsic fairness test pops up if their failure of any of 1. disclosure, 2. approval by disinterested directors and/or shareholders, 3. good faith, 4. fairness to the corporation

self dealing: give self benefit at the exclusion of others

RULE: Maj. owes to minority and corp. as whole, not to gain any benefit for itself, at the expense of the minority

-Distribution of dividends will never meet this test, since they benefit everyone

9.3 The Effect of Approval by a Disinterested Party

Approval by disinterested directors or shareholders starts to play a key role in the defense of self-dealing transactions beginning in the early 20th century; codified by the “safe harbor statutes”

9.3.1 The Safe Harbor Statutes

Cookies Food Products v. Lakes Warehouse (Iowa 1988)

Facts:L. D. Cook founded Cookies Food Products, Inc. to produce and distribute a barbecue sauce that he had created. The shares of the corporation belonged to Cook, Duane Herrig (the defendant), and thirty-some other shareholders.

In addition to being a minority shareholder of Cookies, Herrig owned and operated two other corporations: (1) Lakes Warehouse Distributing, Inc., and (2) Speed’s Automotive Co., Inc.When Cookies found itself in dire financial straits after its first year in business, its directors approached Herrig with the proposition that he use the resources of his two other corporations to distribute Cookies’ barbecue sauce.

Herrig entered into an exclusive distribution with Cookies, and his assistance led to a phenomenal growth in sales.

Herrig became a majority shareholder of Cookies upon Cook’s retirement.

Upon assuming control of the corporation, he replaced several directors with his own appointees.

Herrig also took on additional responsibilities within the business, most notably by developing a taco sauce for which he received royalties from Cookies.

The directors also authorized the corporation to pay Herrig $1,000 per month for the time he spent managing the business.

Because Cookies distributed no dividends during this period of growth, the minority shareholders became dissatisfied with their inability to profit from the corporation.

They sued on the ground that Herrig had improperly profited from self-dealing arrangements with Cookies.

Issue: Did Herrig prove that he acted in good faith, honesty, and fairness despitethe self-dealing nature of his arrangements with Cookies?Holding: Herrig proved that he acted in good faith, honesty, and fairness.Reasoning:

J. Neuman: -Nothing suggests that Herrig failed to disclose the profits he made from his relationship with Cookies. -The evidence shows that Herrig was instrumental in the success of Cookies. -Trial testimony suggests that he may actually have been underpaid for the amount of work he did.

J. Schultz, dissenting: -The majority has absolved Herrig of liability without properly analyzing whether his arrangements with Cookies were actually fair.

-The evidence suggests that the corporation could have saved money by hiring other individuals to perform Herrig’s work. -That Herrig contributed to the success of the business has no bearing on whether his dealings with the business were fair.Class Notes:Of these three:disinterested directors or shareholders vote oror just prove fairness; court says go back to common law, so that you only require fairnesscase here shifted burden to plaintiff and off of cookiesself dealing, presumption is on the board, then burden shifts to plaintiff

“how much disclosure is required?” : you aren’t required to provide things that the board could have figured out easily ; Herrig didn’t disclose profits, but board knew what they were paying out; they knew about the revenues but they didn’t know the cost; you don’t have to disclose profits to the board; the board does need to know if he owns what particular revenues

9.3.2 Approval by Disinterested Members of the Board

Approval of an interested transaction by a fully informed board has the effect only of authorizing the transaction, not of foreclosing judicial review for fairness

e.g.: in DE, approval by disinterested directors merely shifts the burden of proving fairness in a controlled transaction to the plaintiff challenging the deal; it does not transform the standard of review to business judgment.

Melvin Eisenberg, Self-Interested Transactions in Corporate Law

-A rule that fairness of price was enough w/out full disclosure would in effect remove decision making from the corporation's hands and place it in the hands of the court

-The real question is whether a self-interested transaction that has been approved by disinterested directors after full disclosure will still be subject to a test of fairness or will be accorded the protection of the business judgment rule

-Two reasons why transactions should be subject to fairness test:

(1) directors are unlikely to treat one of their number with the degree of wariness with which they would approach a transaction with a third party by virtue of their collegial relationships

(2) It is difficult to utilize a legal definition of disinterestedness in corporate law that corresponds with factual disinterestedness

i.e. A factually disinterested director would be one who had no significant relationship of any kind with the subject matter of the self-interested transaction

-If a self interested transaction that has been approved by “disinterested” directors is substantively unfair it can normally be inferred that:

(1) either the approving directors were not truly disinterested or

(2) that they were not as wary as they should have been because they were dealing with a colleague

Cooke v. Oolie (Del. 2000)

Facts:

Sam Oolie and Morton Salkind are directors of the Nostalgia Network (TNN) allegedly the two opted to pursue “an acquisition” that was in their personal best interest, not that of the companyIssue: Did Oolie and Salkind breach their fiduciary duty of loyalty?

Holding: No

Reasoning:

Sec. 144(a)(1): business judgment rule applied to actions of an interested director, who is not the maj. shareholder, if the interested director fully discloses his interest and a majority of the disinterested directors ratify the interested transaction

Disinterested director’s vote to pursue the deal offers strong evidence that Oolie and Salkind acted in good faith and with the interests of TNN and the shareholders in mind

Plaintiff bears burden to show that Oolie and Salkind’s conduct breached their fiduciary duty of loyalty by electing to pursue a particular acquisition proposal allegedly best protecting their personal interests, rather than other opportunities that offered superior value to TNN’s shareholders

business judgment rule assumes good faith, but if you can prove bad faith, bus. jud. rule doesn’t apply

real danger is that people with fiduciary interests, people will act in best interest, but a taint may arise; so if you remove the taint

9.3.3 Approval by a Special Committee of Independent Directors

Help to assure appearance as well as the reality of a fair deal

Operation of Special Committee

-must be properly charged by full board, comprised of independent members and vested with the resources to accomplish its task

Effects of well executed Special Committee

-it only shifts the burden of proving fairness from the defendant to the plaintiff in a controlled transaction

-Burden shift require the plaintiff to show unfairness

9.3.4 Shareholder Ratification of Conflict Transactions

Lewis v. Vogelstein (Del. 1997)

General Principles of ratification derive from the law of agency

-to be effective the agent must fully disclose all relevant circumstances with respect to the transaction to the principal prior to the ratification

-the agent in seeking ratification must act with candor and loyalty

Three factors that complicate general ratification principles to shareholder ratification:

1. there is no single individual acting as principal, but rather a class or group of divergent individuals

2. shareholders “ratification” will often not be directed to lack of legal authority of an agent but will relate to the consistency of some authorized director action with the equitable duty of loyalty

3. when a director conflict transaction is “ratified” the statutory law may bear on the effect of ratification

Shareholder Ratification may be held ineffectual

1. because a majority of those affirming the transaction had a conflicting interest with respect to it or

2. because the transaction that is ratified constituted a corporate waste

Waste: an interested transaction that is so bad, that it is a gift to the person that is interested (no reasonable way you could say the corp. is getting its “monies worth”)

waste requires 100% ratification by shareholders

In Re Wheelabrator Technologies, Inc.

Two circumstances in which Del. Sup. Ct. held a fully informed shareholder vote operates to extinguish a claim:

1. Where the board of directors takes action that, although not alleged to constitute ultra vires (editors note: latin for “beyond power”), fraud or waste, is claimed to exceed the boards authority, and

2. Where it is claimed that the directors failed to exercise due care to adequately inform themselves before committing the corporation to a transaction

Two kinds of ratification decisions that involve duty of loyalty claims:

1. Interested transaction cases between a corporation and its directors and

a. 144(a)(2) provides that these kinds of interested transactions will not be voidable if it is approved in good faith by a majority of disinterested stockholders, b. these kinds of interested transactions invoke the business judgment rule and limit judicial review to issues of gift or waste with the burden of proof upon the party attacking the transaction

2. Interested transactions between the corporation and its controlling shareholder (involve parent-subsidiary mergers primarily)

a. standard of review is ordinarily entire fairness, with the directors having the burden of proving that the merger was entirely fair

b. where the merger is conditioned upon approval by a “majority of the minority” stockholder vote, and such approval is granted, the standard of review remains entire fairness but the burden of demonstrating that the merger was unfair shifts to the plaintiff

c. shareholder ratification does not operate to automatically extinguish a duty of loyalty claim<<End of Monday Notes -- Begin Wed. Notes>>

9.4 Director and Management Compensation

Compensation is a necessary form of self-interested transaction

Salary based compensation drawbacks: fixed salary is unlikely to induce a manager to indulge in risky projects that would otherwise be valuable from a long-term shareholder perspective

High-powered incentive based compensation:drawbacks: hard to attribute compensation based on manager contributions as they relate to the value of the company

managers are more likely to game incentive pay schemes as the monetary stakes increase

Class Notes:if you pay CEO a salary all they’re going to do is maintain the status quo, you need better incentives so that the business growsStock Options: call options give right to buy stock at a certain price, you pay for it now, but don’t actually buy it, just gives you the “option” to get it when it’s favorable

9.4.1 Perceived Excessive Compensation

Shareholder advocates attack excessive compensation on the grounds that:1. overall level of compensation is too high2. it’s form does not sufficiently punish failure3. procedures used for setting compensation are insufficiently disinterested4. common sweeteners such as golden parachutes that reward executives for standing aside gracefully in the sale of their companies

9.4.2 Option Grants and the Law of Director and Officer Compensation

Lewis v. Vogelstein (Del. 1997)

In order for a stock option grant to be valid it must satisfy both:

1. That the grant contemplates that the corporation will receive “sufficient consideration” and

2. Circumstances of the grant must include “conditions or the existence of circumstances which may be expected to insure that the contemplated consideration will in fact pass to the corporation”

(only if waste will the option be overturned)

Shareholder assent is more rational means to monitor compensation than judicial determinations of the fairness or sufficiency of consideration, given that modern age allows from easier communications

9.4.3 Regulatory Responses to Executive Compensation

SEC since 1993 has required more detailed public disclosure, including:-Required disclosure of annual compensation, long term compensation and all other compensation for the top five employees-Required a narrative description of all employment contracts with top executives and disclosure of a Compensation Committee report explaining the committee’s compensation decisions

-Required a graph showing the company’s cumulative shareholder returns for the previous five years along with a broad-based market index and a peer-group index for the same period

SEC in 2006 proposed the “Katie Couric” rule that would require reporting compensation for three non-executive employees that were compensated greater than at least one company executive

Hollywood, Wall Street and professional sports heavily criticized this rule, and as a result the modern rule has an exception for reporting salaries of employees who do not make policy within the company

Section 302 of Sarbanes-Oxley of 2002: company must restate its financials as a result of misconduct, the CEO and CFO must pay back to the company any bonuses, other incentive-based or equity based pay and/or trading profits realized in the 12 months after the incorrect financial information was publicly disclosed

“Say on Pay”: requires public companies to hold an annual non-binding shareholder vote on executive compensation plans and an additional non-binding shareholder vote if the company awards a new golden parachute package while simultaneously negotiating the sale of the company

-historically then-Senator Obama and Barney Frank introduced a bill on this, but it never happened.

Emergency Economic Stabilization Act of 2008 (EESA) & American Recovery and Reinvestment Act of 2009 (ARRA)

-center point of the EESA was the Troubled Asset Relief Program (TARP)

-both the EESA and ARRA place significant compensation restrictions on top executives whose companies received TARP funds

-ARRA prohibits TARP recipients from paying any bonus, retention award, or incentive compensation to top executives

-ARRA requires “Say on Pay” to TARP recipients and a company-wide policy regarding luxury expenditures (e.g. corporate jets, entertainment etc.)

9.4.4 The Disney Decision

Background:

-Michael Ovitz and Disney CEO Michael Eisner are personal friends

-Michael Eisner and Frank Wells ran Disney, Wells was Eisner’s second-hand man

-Wells accidentally dies, year later Eisner has a health scare, the board gets shaken by this and demands a succession plan in the event of any more deaths

-Eisner convinces his buddy Ovitz to takeover as President of the board for Disney-Rapidly it became clear that Ovitz was a poor fit for Disney-Eisner consults with in-house counsel to see if Ovitz can be fired “for-cause”, he can’t-Eisner fires Ovitz “without-cause”, and triggers approximately $38 million in cash severance payments and accelerated vesting of options under his employment agreement-Ovitz nets $140 for fifteen months of service as president of Disney (editors note: SCORE!)

In Re The Walt Disney Company Derivative Litigation (Del. 2005)Facts:-Disney shareholder plaintiffs brought suit on behalf of the corporation claiming that Disney directors breached their duty of care in approving Ovitz’s employment agreement and that the severance payment to Ovitz constituted waste-Disney charter contained a 102(b)(7) waiver which meant that the plaintiffs had to assert that the board had not acted in “good faith”

Procedural:October ‘98 - Chancery court dismissed plaintiff’s complaint on grounds that the board’s decision was made up of a majority of independent directors who had no interest in the transaction On appeal Supreme Court of Delaware reversed in part and directed the plaintiffs be given an opportunity to repleadChancellor sustained the complaint on repleading

Issue: Did the Disney board act in bad faith or intentional misconduct, thereby causing shareholders harm in approving the Ovitz employment agreement?

Holding: No.

Reasoning:

Plaintiffs must prove by preponderance of the evidence that the presumption of the business judgment rule does not apply either because:

1. the directors breached their fiduciary duties2 acted in bad faith or3. that the directors made an “unintelligent or unadvised judgment” by failing to inform themselves of all material information reasonably available to them before making a business decision.

Court found at most “ordinary negligence” on behalf of the board, which is insufficient to show a breach of the fiduciary duty of care

Courts findings related to Eisner:Eisner was the “mastermind” behind hiring Ovitz, they were personal friends after allEisner had the most information pertaining to the hiring, and acted as negotiatorEisner issued press releases that put undue strain on the board to do what he already told the press Disney was going to do (i.e. hire Ovitz)Eisner acted perhaps too autonomously, divorced from the board in some minor decisionsHowever, Eisner’s actions were taken with the subjective belief that they were in the best interests of Disney

Court found that Eisner and Litvack (Disney’s General Counsel) did not act in bad faith in connection with Ovitz’s termination

Court found that the new board was not under a duty to act1. the BoD has the sole power to elect the officers of the Co.2. the BoD has the sole power to determine the “duties” of the officers of the company3. the Chairman/CEO has “general and active management, direction and supervision over the business of the Corporation and over its officers” and that such management direction and supervision is subject to the control of the BoD 4. The chairman/CEO has the power to manage, direct and supervise the lesser officers and employees of the Co.5. the board has the right, but not the duty to remove the officers of the Company with or without cause and the right is non-exclusive and6. because that right is non-exclusive and because the Chariman/CEO is affirmatively charged with the management, direction and supervision of the officers of the Co. together with the powers and duties incident to the office of chief executive, the chairman/CEO, subject to the control of the BoD, also possess the right to remove the inferior officers and employees of the corporation

Essentially, since Eisner had the right to fire Ovitz (via the foregoing logic) without consulting the BoD, the termination didn’t require consultation with the board, even though Eisner had actually told them and it seemed they unanimously agreed with the firing of Ovitz

Eisner contemplated three choices regarding Ovitz1. Keep Ovitz as President

Eisner saw this as an impossibility since he was too hard to work with2. Keep Ovitz at Disney but in some other role than President

Still would have triggered the no fault termination provision of the employment agreement, plus would have likely generated another costly law suit that Disney would have to bear the cost of

3. Fire Ovitzwhat he did

Court sees the above reasoning as exactly what any good faithful fiduciary would have done and therefore found no fault

Take away from Disney : most important aspect of the case is not the holding, but the judges dicta views on the span of the spectrum for the “duty of good faith”:1. fiduciary conduct that is motivated by an actual intent to do harm (classic quintessential bad faith)2. conduct of intentional dereliction of duty, a conscious disregard for one’s responsibilities (the in-between)3. grossly negligent conduct, without any malevolent intent (the not-so-bad-but-bad end)

Stone v. Ritter (five months after Disney): court clarified that the “duty of good faith” is not an independent dutystill have duty of care and loyalty in addition to good faith

Post-Disney Delaware law reflects the following regarding director liability for inattention:1. mere director negligence does not give rise to liability2. facts that establish gross negligence may be the basis for a breach of duty finding and result in liability for any losses that result, however under 102(b)(7) such liability can be waived through a shareholder approved amendment to the corporate charter3. such waivers may not waive liability that rests in part upon breach of the duty of loyalty and under the statutory language, that inability to waive damages is extended to acts not done in “good faith”

this profound level of inattention (older cases call it “abandonment of office”) will have the court conclude that the directors lacked good faith, in this event neither the business judgment rule nor the waiver authorized by 02(b)(7) will protect the defendant from liability

Good faith orig. duty of care not loyalty; sometimes hard to tell the difference; bus. jug and 102(b)(7) were originally for duty of care; but now we have duty of care taken care overduty of care merged in with duty of loyalty; good faith element now present in duty of care what it wasn’t

9.5 Corporate Opportunity DoctrineDistinct branch of the duty of loyalty: when may a fiduciary pursue a business opportunity on their own account if the opportunity might arguably “belong” to the corporation?

9.5.1 Determining Which Opportunities “Belong” to the Corporation

Lagarde v. Anniston Lime & Stone Inc. Expectancy Test [narrowest ]: the expectancy or interest must grow out of an existing legal interest, and the appropriation of the opportunity will in some degree “balk the corporation in effecting the purpose of its creation”

-Key to this test is to look to the firms “practical business expectancy”

“Line of Business” Test: any opportunity falling within the company’s line of business is its corporate opportunity; anything that a corporation could be reasonably expected to do is a corporate opportunity; includes factors

(1) how this matter came to the attention of the director/officer/employee(2) how far removed from the “core economic activities” of the corporation the opportunity lies and

-this is similar to the “Expectancy” test above(3) whether the corporate information is used in recognizing or exploiting the opportunity

-if you use corporate funds for gain, you will not get the benefit-This is probably the clearest test, and the easiest to apply; but it depends on jurisdiction

“Fairness” Test : relies on multiple factors such as:(1) How did a manger learn of the disputed opportunity?(2) Whether they used corporate assets in exploiting the opportunity.(3) Other fact-specific indicia of good faith and loyalty to the corporation in addition to the company’s line of business

Regarding Self-Dealing Transactions: If the BoD has all the information regarding a transaction, the person pursuing a deal doesn’t need to disclose it to the board. Also, board has no right to know how much it would cost you to take advantage. Informed decision is the reason for disclosure, so the company best understands the business implications

If BoD is entitled to Business Judgment Rule (BJR), then even if B comes back and wants to rescind the court will say sorry we don’t get into these dealings. Court will always look to where a decision was first made, if the BJR was applicable at that time the Court will let that decision stand, under the BJR theory.any time fiduciary is charged with a usurpation of corporate opportunity, you always bear the burden of proving the BJR applies

9.5.2 When May a Fiduciary Take a Corporate Opportunity?Some courts have held that a fiduciary may take an opportunity if the corporation is not in a financial position to do so

-critical to these cases is whether the board has evaluated the question of whether to accept the opportunity in good faith

Most courts accept a board’s decision not to pursue an opportunity as a defense to a suit challenging a fiduciary’s acceptance of a corporate opportunity on their own account

-fiduciary who takes the opportunity bears the burden of establishing the defense

9.6 Duty of Loyalty in Close Corporations

Donahue v. Rodd Electrotype Co. (Mass. 1975)Facts:Plaintiff Donahue was minority stockholder in Rodd Electrotype Co. (REC), brought suit to rescind REC’s purchase of Harry Rodd’s shares in REC and to compel Harry Rodd to repay price of shares ($36k plus interest); Plaintiff alleged that the defendants caused the corporation to purchase the shares in violation of their fiduciary duty to Donahue as a minority shareholder

Elderly Harry had his sons (majority shareholders) purchase up his shares at a price that was not offered to Donahue, Donahue got mad and sued.

Procedural: Trial judge found that the purchase was without prejudice, implicitly found that the transaction was carried out in good faith and with inherent fairness

Issue: To what standard are closely held corporations held to in regards to fiduciary duties?

Holding: Stockholders in closely held corporations owe one another substantially the same fiduciary duty in the operation of the enterprise that partners in a general partnership owe to one another.

Reasoning:Close corporation typified by:1. a small number of stockholders2. no ready market for the corporate stock, and3. substantial majority stockholder participation in the management, direction and operations of the corporation

corporate form provides majority stockholders the ability to oppress/disadvantage minority stockholders via “freezeouts”; freezeouts can occur when majority holders refuse to declare dividends, or drain off earnings via exorbitant salaries and bonuses to majority shareholder-officers, or in the form of high rent by the corporation for property leased from maj. shareholders

Can’t escape freezeout, since by definition there is no market to sell your shares on, and no sane person would want to buy in to the minority position, since they would face the same pitfalls

controlling stockholders must cause the corporation to offer each stockholder an equal opportunity to sell a ratable number of shares to the corporation at an identical price, this is consistent with the holding of a most perfect sense of honor that closely held corporations are held to consistent with the holding of the caseClass Notes:If you want to buy back shares, you have to extend the same offer to everyone.Must treat all shareholders equallyStronger Fiduciry duty for stock buy backs, that rule doesn’t require

Frank Easterbrook & Daniel Fischel, Close Corporations and Agency Costs

Fiduciary duties serve as implicit standard terms in contractual agreements that lower the cost of contracting

Fiduciary duties should approximate the bargain the parties themselves would have reached had they negotiated at low costs

Greater judicial review of terminations of managerial employees in closely held corporations makes sense than would be consistent with the business judgment rule

Class Notes:

when F. duty is applied, it can only be applied in a way so that it is used to “fill in the gaps”Why do we have Fiduciary Duties? To protect the principal, and convince people to invest.

Smith v. Atlantic Properties Inc. (Mass. App. 1981)

Facts:

Dr. Wolfson offered the three Plaintiffs, Paul T. Smith et al., to go in equal shares in the purchase and development of some real estate

The partners formed Atlantic Properties with each party becoming a 25% shareholder, and Atlantic then bought the property in 1951

The corporate by-laws provided that any proposals had to be approved by at least 80% of the directors, meaning that in real terms for the group of four there would need to be a unanimous vote

The corporation was profitable every year through 1969 but dividends were only paid in 1964 and 1970

Because so much of the value of the company was in cash, the Internal Revenue Service assessed penalty taxes in seven different years for the accumulation of the money

Dr. Wolfson was the lone dissenter for the voting for dividends, and his vote was enough to defeat the proposals under the 80% plan in the by-laws

Dr. Wolfson maintained that he wanted the money for improvements to the property, and Plaintiffs asserted that he wanted to avoid his own personal tax issues

Plaintiffs then sought damages from Dr. Wolfson for dividends, damages due to the tax penalties and legal expenses, and also asked to remove Dr. Wolfson as a director

The lower court agreed with Plaintiffs that dividends should be issued and that Defendants were liable for the tax penalty amounts

Procedural: Dr. Wolfson appealed from trial court ruling that he committed a breach of his fiduciary duty to other stockholders

Issue: To what extent may a minority shareholders veto power be exercised without violation of the fiduciary duty in a closely held corporation?

Holding: Minority shareholders owe majority shareholders a fiduciary duty in the same manner that majority owners owe minority shareholders, and therefore the majority can seek judicial intervention for decisions that are unjustifiable for the corporation’s interests.

Reasoning:The court held that the determining factor for the fiduciary duty owed is whether a party would be considered a controlling party.

Since Dr. Wolfson was the controlling party in that he alone prevented the dividend payouts despite no real business justification, the court affirms that a fair dividend should be declared.

Wolfson was unreasonable and did not demonstrate utmost good faith and loyalty to the business.

The court had no problem with the by-law provision that allowed for a minority to veto dividends, but rather in the manner in which he utilized his powers to unreasonably prevent the allowance dividends in the face of tax penalties.

Class Notes: In a closely held corporation: rule is you do owe a duty to follow the shareholders;( its not similar to partnerships; prof thinks this is wrong)

Chapter 10: Shareholder Law Suits

There are two forms of shareholders suits: derivative suits and direct action suits (usually class action suits that gather together direct claims sharing common aspects of many individuals).

Direct suits – seek to recover damages suffered by individuals directly.

Derivative suit – is an assertion of a corporate claim against an officer or director which charges them with a wrong to the corporation. Such an injury only indirectly (or “derivatively”) harms shareholders. It is two suits in one: 1) suit against directors charging them with improperly failing to sue on the existing corporate claim and 2) suit for the underlying claim of the corporation itself, usually that the corp. directors failed to vindicate a claim because the director themselves are the wrong-doers.

10.1 Direct v. Derivative Claims

Derivative suit- Injury alleged is to a corporate interest. Alleged breaches of corp. law obligations because directors

breached they duty of loyalty are often the context of derivative suit.- Any recovery that results goes directly to the corporation itself because a derivative suit advances a corp.

claim.- Requires notice to the absent interest parties- Permits other parties to petition to join suit- Successful plaintiffs are compensated from the fund that their efforts produce

Direct suit - Injury alleged is to a personal interest. Suits arising under the Federal securities laws are direct actions

because the injuries alleged is to a person interest such as the right to vote shares.- Requires notice to the absent interest parties- Permits other parties to petition to join suit- Successful plaintiffs are compensated from the fund that their efforts produce

Note on Tooley v. DonaldsonThe suit was brought by minority shareholders as a direct (class) action suit claiming that a delay to close on a cash merger deprived them of time value of the merger proceeds. Court held that whether a stockholder’s claim was derivative or direct turns solely on the following questions (1) who suffered the alleged harm (corp. or shareholders); and (2) who would receive the benefit of any recovery or other remedy (corp. or stockholders individually)? Here, court said that no claim in the complaint because the stockholders had no individual right to have the merger occur at all.

10.2 Solving A Collective Action Problem: Attys. Fees and the Incentive to Sue

Collective Action Problem (again) – Where all investors hold small stakes in the enterprise, no single investor has a strong incentive to invest time and money in monitoring management, nor will derivative or class action suits prove to

be practical if shareholders have no individual economic incentive to expend the time and money necessary to prosecute them.

Solution: Awarding atty. fees to plaintiffs whose litigation created a common fund that benefitted the plaintiffs. Plaintiff’s attys. are paid by the order of the court or as part of a settlement, but do not get anything when a case is dismissed. In form, these attys. are the economic agents of their shareholder-clients.

Fletcher v. A.J. Industries, Inc.

Facts: Fletcher brought a derivative action against corp. alleging mismanagement of the corp. due to director Ver Halen’s domination of corp. affairs, the treasure Malone’s excessive salary, and Ver Halen’s breach of employment contract. A settlement agreement between Fletcher and AJ as reached. The agreement curbed Ver Halen’s authority and voting power, other board members were replaced, and Malone was to be director. Monetary claims against officers were referred to future arbitration. Atty. fees for Fletcher’s action were to be referred to court for award. Over A.J.’s objections, the court awarded $64K in atty. fees and $2.1K in costs on the theory that the action had substantially benefitted the corporation (AJ).

Issues: Whether atty. fees are properly awarded if the corporation has substantially benefited from the action even though the corp. receives no money from the derivative suit.

Holding: Atty. fees are properly awarded if the corporation has substantially benefited from the action even though the corp. receives no money from the derivative suit.

Rationale: There are two doctrines where attys. fees can be recovered absent an express statute permitting such recovery:

1) common-fund doctrine: It is well established doctrine of equity that where a common fund exists to which a number of persons are entitled, an allowance of counsel fees may properly be made from such a fund;

2) substantial benefit rule (applied in this case since there was no common fund yet): a successful plaintiff in a derivative action may be awarded attys. fees against the corp. if the corp. received a “substantial benefits” from the litigation, although benefits were not pecuniary and the action had not produced a fund from which they might be paid.

To find that a benefit was substantial, it will suffice if the trial court finds that the results of the action “maintained the health of the corp. and raised the standard of fiduciary relationships and of other economic behavior,” or “prevent an abuse which would be prejudicial to the rights and interests of the corp. or affect the enjoyment or protection of essential right to the stockholder’s interest.”

Here, the corp. received substantial benefit related to the comparative economy realized by going through arbitration instead of litigation; and benefitted by having immediate changes to the corp. management via the settlement agreement.

Dissent: if a common fund is not required to provide attys. fees, corps. may be faced with a liquidation of assets to pay for the fees, even though the resulting harm to the corp. might be disproportionate to the substantial benefit derived from the lawsuit.

Note on Agency Costs in Shareholder Litigation

The problems: - Plaintiff’s attys. may initiate strike-suits or suits without merit simply to extract a settlement by

exploiting the nuisance of litigation and personal fears of liability.- Problem also arises when shareholder litigation is meritorious and corp. managers face prospect of

liability. Plaintiff’s attys. and corp. defendants who are in control of the corp. have an incentive to settle on terms that are mutually advantageous but that allow the defendant to fully escape personal liability for their conduct.

- Manner in which atty. is paid may create a bad incentive. Ex: awarding P’s atty. a percentage of the recovery may encourage settlement. If they are paid hourly, the atty. might spend too much time litigating.

Solution:- to prevent non-meritorious suits, courts have employed particularized pleading requirements.

10.3 Standing Requirements

Requirements under Fed. Rule 23.1: 1. Plaintiff (P) must be a shareholder for the duration of the action2. P must have been a shareholder at the time of the alleged wrongful act or omission.3. P must be able to fairly and adequately represent the interests of shareholders; i.e. no conflict of interest4. Complaint must specify what action P has taken to obtain satisfaction from the company’s board or state with particularity

10.4 Balancing Boards right to Manage the Corp. and Shareholders Rights to Obtain a Judicial Review

Issue of when a shareholder-plaintiff should be empowered to take a corp. claim out of the hands of the board against the managers will arises in the following contexts:

1. When a company moves to dismiss a derivative suit on the ground that the shareholder plaintiff has a made a pre-suit demand on the board under Rule 23.1, but the board has refused to bring the suit based on its business judgment -- Does Court defer to board’s business judgment or not.2. When plaintiff does not make a demand on the board on the grounds that the board could not exercise disinterested business judgment3. When the board seeks to terminate a derivative suit at a later point in the litigation after the suit has survived the motion to dismiss.

-business judgment rule again would apply

Conflict between shareholder and board of directors:1. Been a shareholder demand, the board considers it, but still not in best interest of corporation, Business Judgment Rule will apply assuming the board was independent, disinterested and not acting in bad faith

if corp. says no you’ve got to dismiss, you have to ask if the board is still capable of looking out for the best interest of the corporation

2. When shareholder sues w/out board consideration since there is no way the board can actually be disinterested; basis for this action require particularized facts for showing the board is compromised on interest, independent or acting in bad faith3. New board decides to dismiss a claim, since they are now disinterested

-business judgment rule applies here4. General issues with settlement of a case; don’t think dismissal is the appropriate outcome, they think some particular settlement is in order [here the BoD again is acting in a capacity so as to look out for Corp. best interest]

10.4.1 The Demand Requirement of Rule 23

Levine v. Smith

Facts: Shareholders (P) of GM brought derivative actions involving a transaction where Ross Perot, a GM director, sold back to GM their holdings of class E stock in exchange for $743M. The repurchase was in response to disagreements between Perot and GM’s senior management about the management of GM’s subsidiary, EDS and the GM business model which Perot claimed were churning out second rate cars. A committee of outside directors negotiated the buyback which the full board approved at a meeting Perot did not attend. Perot also agreed not to publicly criticize the company.

Shareholders alleged the transaction paid Perot a premium for this shares for no reason other than to stop his public criticisms of GM selling “second rate cars.”

Court dismissed the case in rejecting P’s claims of demand futility and wrongful demand refusal and their claims that GM directors lacked independence.

Issues: Whether a plaintiff shareholder claiming demand futility or wrongful demand refusal must allege particularized facts that overcome the business judgment rule presumption in order to withstand dismissal of the derivative action.

Holding/Rules: Yes, a plaintiff shareholder claiming demand futility or wrongful demand refusal must allege particularized facts that overcome the business judgment rule presumption in order to withstand dismissal of the derivative action.

Where demand futility is asserted, two questions must be answered: 1) whether threshold presumption of director disinterest or independence are rebutted by well-pleaded facts; and if not 2) whether the complaint plead particularized facts sufficient to create a reasonable doubt that the challenged transaction was the product of a valid exercise of business judgment. A showing from either prong permits the plaintiff to proceed with the action.

Rationale/Analysis: Here, court was correct in limiting its demand futility analysis to the issue of director independence (the first test). The record supports that P did not plead sufficiently particularized facts showing that GM’s outside directors were so manipulated, misled to the gravity of disputes between the management and Perot, and misinformed that they were subject to the management’s control and can’t exercise independent judgment. P’s allegations were more appropriately related to the issue of director due care and the business judgment rule’s application to the challenged transaction (the 2nd alternative test). Because the directors were not manipulated, misled, or misinformed, P has not pled particularized facts sufficient to raise a reasonable doubt that the majority of GM board acted uninformed such that they failed to exercise due care.

Class Notes:

1. Prove that the BoD was wrong to refuse the lawsuit (only once past this point you mve to two)*

2. Prove that a wrong was committed against the corporation. ( violation of duty of care/loyalty etc.)*-here they claimed the buyout was “bad”

*: Both elements must be pleaded with particularity; need strong facts for both

If you want to show the BoD isn’t entitled look to independence and dis-interest (bad faith is harder to prove)

Note on Pre-suit Demand

Some critics say that the traditional equity rule of pre-suit demand, with exceptions for futility, is the best way to adjudicate the boards claim to sole right the control adjudication of corp. claims.

ALI’s proposed universal demand rule says: P would always be required to make a demand, and if, she is not satisfied by the board’s response, she can institute suit. Court will review the board’s exercise of business judgment in making its response.

Delaware’s non-demand rule says: Whenever P actually makes a pre-suit demand, P automatically concedes that the board is independent and disinterested with respect to the question to be litigate. This leaves the court with only testing for the second prong – whether bad faith or gross negligence may be inferred from the decision itself.

Rales v. Blasband (Double Derivative Suit Case)

Facts: Easco is a wholly owned subsidiary of Danaher. The two Rales brothers (D) were directors and stockholders of both Easco and Danaher. The Danaher board had 8 members including the two Rales brothers. A number of the other

directors have business relationships with the Rales brothers or entities controlled by them. Blasband (P) was an Easco shareholder, but became a Dahaner shareholder when Danaher acquired Easco.

Before Danaher acquired Easco, Easco sold $100M of senior subordinate notes in a public offering The public offering’s prospectus said that some of the proceeds from the sales would be used to invest in “government and other marketable securities. However, Easco used $62M to invest it in highly speculative junk bond offered by Drexel.

Blasband brought a double derivative action alleging that Easco bought the bonds from Drexel because the Rales brothers wanted to help Drexel when Drexel was having trouble selling those types of bonds. Blasband’s complaint described prior business relationships between Drexel and the Rales brothers (ex: Drexel’s junk bonds helped the Rales brothers build Danaher and so they felt a strong sense of loyalty to Drexel.)

Blasband (shareholder of Danaher) alleged misuse of the $62M (an act by Easco, Danaher’s wholly-owned subsidiary) in that the Rales acted only to benefit themselves and that the junk bond investment resulted in a $14M loss to Easco.

The federal court, under which Blasband sued, certified a question to the DE state court as to whether Blasband had established that demand was excused under the substantive DE law.

**Note: This is a double derivatives suit – a stockholder of a parent corporation seeks recovery for a cause of action belonging to the subsidiary corporation.

Issues: Whether the standard for determining demand excusal is “whether the board was capable of impartially considering the action’s merits without being influenced by improper considerations” when the demand excusal is asserted against a board that has not made the decision that is the subject of the derivative action.

Holding: Where the demand excusal is asserted against a board that has not made the decision that is the subject of the derivative action, the standard for determining demand excusal is “whether the board was capable of impartially considering the action’s merits without being influenced by improper considerations.

In a double derivative suit, the plaintiff is still required to satisfy the Aronson test (business judgment) to establish that demand on the subsidiary’s board is futile. Second, demand on the parent board, even where a board of director is interested, would impose an extremely onerous burden to meet at the pleading state, without benefit of recovery.

The appropriate test is to examine whether the board that would be addressing the demand can impartially consider its merits without being influenced by improper considerations.

To survive dismissal, the court must determine whether or not the particularized facts in the complaint create a reasonable doubt the board could have property exercised its independent and disinterested business judgment in responding to a demand as of the time the complaint is filed.

Directorial interest exists where a corp. decision will have a materially detrimental impact on the corp.

Rationale/Analysis: The business judgment test for demand excusal enunciated in Aronson is inapplicable here because the Danaher board did not make the decision being challenged, Easco did.

In examining the other Danaher director’s independence, the court found: Sherman is interested because he has a substantial financial stake ($1M/year); Ehrlich is interested because he’s beholden to Rales brothers who employ and control Ehrlich’s two brother’s corp.; Sherman is not independent because he was Danaher’s president, CEO and Rales positions on the board.

Hence, because there is a reasonable doubt that the majority of the Danaher board could have acted impartially, -- demand is excused.

Class Notes:

no public stockholders in EascoDanaher (shareholder blasland and rales bros) Easco was subsidiary of DanaherEasco bought bad bondsdisinterst can relate to any financial benefit

Basic Rule: is someone demanding at EAsco boad, they’d be entitled to BJR, whoever was challenging would have to prove not disint. not indep not in bad faith

is donaher board capable of making an impartial judgment;

BIG PICTURE: If you can prove lack of dis. or indep., then demand is going to be excused10.4.2 Special Litigation Committees (SLC)

General purpose of SLC: SLCs are permitted as a last chance for a corp. to control a derivative claim in circumstances when a majority of its directors cannot impartially consider a demand.

There is no basis for a procedure where a court, upon a motion of a special committee of disinterested directors, may dismiss a derivative suit that is already underway.

DE and some jurisdictions follow Zapata in giving a role to the court itself to judge the appropriateness of a special litigation committees decision to dismiss a derivative suit.

NY and some jurisdictions follow the Auerbach rule that if the committee is independent and informed, its action is entitled to business judgment deference without any judicial second-guessing.

Zapata Corp. v. Maldonado

Special Litigation Committee: can be used to establish that the board again is capable of looking out for corp. best intersest (indep. disinterst)

Facts: Maldonado brought the derivative suit against ten officers and directors of Zapata, asserting that they breached their fiduciary duties.

Maldonado did not demand that the Defendant officers bring the action because all the directors at the time were named in the suit.

Four years after the suit was initiated, Zapata appointed an “Independent Investigation Committee” (IIC) comprised of two new directors who were not part of the initial suit to investigate Maldonado’s action. The IIC’s decision is not subject to review by Zapata’s board of directors. Committee decided that the derivative suits would be harmful to the company and therefore moved to dismiss the litigation.

First, the court said that the Chancery was wrong in stating that once a demand is made and refused, the stockholder has an independent right to continue the derivative suit for breach of fiduciary duty over the objection of the corp. This is because the general rule is that “a stockholder cannot be permitted to invade the discretionary field committed to the judgment of the directors and sue in the corp.’s behalf when the managing body refuses unless the refusal is a breach of the director’s fiduciary duty.

Issues: 1) Whether a board tainted by self-interest may legally delegate its power to an independent committee composed of disinterested board of directors.

2) Whether the board or its authorized and appointed independent committee is permitted to dismiss pending derivative suit litigation as being detrimental to the best interest of the corporation where a stockholder instituted a derivative suit without first making a demand to the board.

Holding:1) A board tainted by self-interest may legally delegate its power to an independent committee composed of disinterested board of directors.

2) A board or its authorized and appointed independent committee is permitted to dismiss pending derivative suit litigation as being detrimental to the best interest of the corporation where a stockholder instituted a derivative suit without first making a demand to the board and the court shall apply a two-step test to the motion.

Two-step Test: 1) Defendant corporation has the burden to prove that the Committee is independent and is exercising good faith and conducted a reasonable investigation. 2) The court, at its discretion, may apply their independent business judgment. When appropriate, the court should give special consideration to matters of law and public policy in addition to the corp.’s best interest.

The SLC is not entitled to any presumptions of independence, good faith or reasonableness. Rather, the corporation has the burden of proof, which require it to establish the absence of any material issue of fact and its entitlement to relief as a matter of law. Assuming the court is satisfied with the committee’s independence, good faith and reasonableness of investigation, the court may (a) grant the motion and dismiss the action, or (b) proceed, in its discretion, to a second step and apply its own independent business judgment and determine whether the motion should be granted.

Rationale: The court’s two-step test shifts the burden to the corporation to prove the independence, which limits the advantage to a company of appointing an independent group to determine the merits of a derivative suit.

The motion “is addressed necessarily to the reasonableness of dismissing the complaint prior to trial without any concession of liability on the part of the defendants and without adjudicating the merits of the cause of action itself.” After targeted discovery, the court evaluates whether the SLC was independent, whether the investigation was conducted in good faith, and whether the committee had a reasonable basis for its conclusion.

If the court determines that the committee is not independent or has not shown reasonable bases for its conclusions, or if the court is not satisfied for other reasons relating to the process, the court shall deny the motion. If the court is satisfied it can proceed at its discretion to step 2. Step 2 strikes the balance between legitimate corp. claims and the corp.’s best interests. The second step is intended to thwart instances where the corp. passes step 1 but the result does not appear to satisfy the spirit, or where corp. actions would prematurely terminate a stockholder grievance deserving of further consideration in the corp.’s interest.

(A Zapata motion to dismiss brought in response to the report of an SLC is a hybrid motion combining characteristics of a motion to dismiss and a motion for summary judgment.)Class Notes:

In re Oracle Corp. Derivative Litigation(example of court probing the degree of the SLC’s independence)

Facts: Shareholders of Oracle (P) brought a suit asserting insider trading by four members of the board (D) – Ellison, Henley, Lucas, and Boskin, because they knew non-public info that Oracle would not meet its earnings. Oracle formed a special litigation committee (SLC) to investigate the charges and to determine whether to press the claims raised, terminate action, or settle. Two new Oracle directors, Molina and Gundfest, who joined after the breach were named to the SLC.

About the accused directors:Ellison (CEO of Oracle)- Largest contributor to Stanford is the Ellison Medical Foundation. Stanford is beneficiary of nearly $10M from Ellison’s foundation. While Ellison was CEO, Oracle has also made $300, in donations to Stanford.Henley- CFO of OracleLucas- Stanford Alum; contributed $50K in appreciation of Grunfest’s speech at his request. Lucas’s dead brother has foundation where Lucas is Chairman of the board who approves all grants. The foundation has given $11.7M to Stanford. Lucas has personally contributed $4.1M.Boskin- Stanford Alum; taught Grundfest at Stanford

About the SLC:Grundfest- a professor of Law and Business Molina- Chairman of the computer Science department respective, in Stanford.Both were initially paid $250/hr but later agreed to give up their salary if their compensation was deemed b the court to impair their impartiality. The SLC made an intensive investigation and asserted that a hypothetical Oracle executive would possessed all info regarding the company’s performance would not have possessed material non-public info that the company would fail to meet its earnings. However, the SLC failed to report the ties between it, the directors, and Stanford.

SLC argued that even if they had ties with Stanford, the SLC was still independent because the accused board members did not have the ability to deprive them of their current positions at Stanford nor did Stanford have a way of punishing them for taking adverse action to the defendants.

Issues: Whether an SLC meets its burden of showing absence of material dispute of facts about its independence where its members were professors at a university that has ties to that corporation and to members of the board who are the subject of the SLC’s investigation.

Holding: The SLC does not meet its burden of showing absence of material dispute of facts about its independence where its members were professors at a university that has ties to that corporation and to members of the board who are the subject of the SLC’s investigation.

*Key question is whether the SLC can independently make the difficult decision entrusted to it.

Rationale: SLCs are permitted as a last chance for a corp. to control a derivative claim in circumstances when a majority of its directors cannot impartially consider a demand. In determining the SLC’s independence, the law should not only look to control or domination, but also take into account human nature, human motivations, and the social nature of humans (i.e. the court should also consider envy, friendships, love, collegiality, and other like motivators).

Here, ties between the SLC, D, and Stanford were so substantial that it places a reasonable doubt on whether the SLC can impartially consider whether Ds should face suit. Court said the SCL would find it difficult to assess conduct of the Ds without pondering their own associations and mutual associations with them. Moreover, the SLC did not make a showing that they would be indifferent to large contributors (Ellison, Lucas) to their institutions such that they won’t be worried about recommending suit against Ds. Also, court did not buy argument that Stanford showed independence from Ellison by denying his son admission. Court said that the mere fact of accusing a significant person in the community (Ellison), of such a serious wrong doing is no small thing, especially in light all of all the ties between them.

Motion to dismiss denied.Class Notes:misappropriation of corporate information for personal benefit (ie. breach of duty of loyalty)even if not criminal, still a crime

Joy v. North (Court applying its Business Judgment on whether litigation goes forward)

Facts: Citytrust’s Special Litigation Committee (SLC) recommended the dismissal of a derivative action brought into Federal court find that there was “no reasonable possibility” that the 23 outside Defendants would be held liable. The Fed. Court determined that state law would require judicial review of the SLC’s decision. Fed. Court also said that the SLC would bear the burden of proving that continuing the litigation would more likely than not be against the corp.’s best interest.

Issues: Whether a special litigation committee’s recommendation to terminate the derivative action must be supported by a showing that the derivative action is more likely than not to be against the interest of the corporation?

Holding/Rules: A special litigation committee’s recommendation to terminate the derivative action must be supported by a showing that the derivative action is more likely than not to be against the interest of the corporation. The burden of showing this is on the moving party, the SLC.

Judicial scrutiny of SLC recommendations should be limited to a comparison of direct costs imposed upon the corporation by the litigation with the potential benefits. The court is to weigh the probability of future benefit to the corp. and not to decide the merits of the litigation.

Factors court should weigh: atty’s. fees, out-of-pocket expenses, time spend by corp. personnel on the litigation, and non-discretionary indemnification, but not insurance that has already been purchased.

If after weighing these factors, the court fines a likely net return to the corp. that is insubstantial relative to shareholder equity, the court may consider only two other items as costs: 1) impact of distraction of key personnel by continued litigation and 2) potential lost profits which may result from the publicity of trial. The court should not take into account other less direct costs such as negative impact on morale and corporate image.

Rationale: Because the courts have expertise in determining whether lawsuits should be terminated, judicial review of such decisions is not too difficult or onerous for the courts. Director discretion under business judgment rule (BJR) does not apply when an SLC recommends dismissal of a suit. Showing that suit will more likely than not harm the corp.’s interest will be based on the data developed in the course of discovery and of the SLC’s investigation, and the SLC’s reasoning.

Dissent in part: Majority goes beyond Zapata by requiring that the court must proceed to apply its own business judgment, rather than leaving the decision to resort to the second step of Zapata within the trial court’s discretion. The calculus applied by the majority to resolve the issues is complicated, indefinite, and subject to judicial caprice. Court is not able to calculate inherently speculative atty.’s costs or quantify corp. good will and morale. Dissent also finds troubling the majority’s underlying premise that judges are equipped to make business judgments. Whether to pursue litigation is not a judicial decision; it is a business choice. In re the Aurbach standard of requiring judicial intervention if the director committees do not act, the majority’s arg that director committees cannot be expected to act independently is without merit.

Michigan Compiled LawsMichigan codified an alternative rule to Zapata. It is Michigan’s attempt to ensure independence of the directors.

Michigan set some qualifications that must all be met to be deemed an “independent director.” These are: Elected by shareholders; designated as independent by the board or shareholders; at least 5 years of business, legal, or financial experience, or equivalent; in 3 years prior, not have been an officer or affiliate of the corp., engaged in any business transaction for profits involving more than $10k with the corp. or its affiliate; does not have more than 3 years of service as a director of the corp.

Statute also states that the Court shall dismiss a derivative motion by the corp. on motion by the corp. if it finds that and independent director, as defined above, has made a determination in good faith after conducting a reasonable investigation determine that maintaining the derivative action is not in the best interest of the corp.

Class Notes:declare that Connecticut will adopt the DE rulejust jump right in to applying their own BJR (in DE) they skip over the first partsometimes dismissal, sometimes it’s about a settlement (the corp. will be betteroff) usually in derivative shareholder, will agree, but if they don’t the SLC can go to the court and plead to have back the authority if they can show that they cleaned up their actlast issue on settlement; most all cases settle, very little go to trial; if settles before trial, no money is padi out of pocket

10.5 Shareholder Information Rights

10.5.1 Settlement by Class Representatives

Parties are driven to settle the suit to avoid litigation costs.

Risk of going to trial:- Personal liability can attach that can only be indemnified with court approval (compared to indemnifying by company’s bylaws). Trial poses an uncompensated risk on defendants that settlement avoids.

Most corps. purchase director and officer insurance that provides coverage to the corp. for its expenses in defending and indemnifying its officers and directors and provides coverage directly to officers and directors when the corp. does not or cannot indemnify them.

10.5.2 Settlement by Special Committee

Carlton Investments v. TLC Beatrice Int’l.

Facts: Carlton (P) brought suit on behalf of TLC alleging breach of fiduciary duty for board’s approval of $19.5M compensation package to TLC’s former CEO, Lewis. After years of discovery and motions to the court, TLC voted to add two new directors that will form a Special Litigation Committee (SLC) to investigate the allegations of misconduct and determine best action for the corp. in regards to the pending derivative suit. After investigating 11 of its directors for 5 mos, the SLC entered into a proposed settlement agreement with Lewis’ estate where Lewis would pay TLC $14.9M. Carlton says settlement terms are inadequate. The SLC moved to the court to approve the settlement.

Issues: Whether a proposed settlement agreement negotiated by a Special Litigation Committee (SLC) is to be reviewed under the Zapata v. Maldonado (Zapata) 2-step approach of first reviewing the SLC’s independence, good faith, and reasonableness of its decision, and a discretionary review of the settlement’s merits.

Holding: A proposed settlement agreement negotiated by a Special Litigation Committee (SLC) is to be reviewed under the Zapata v. Maldonado (Zapata) 2-step approach of first reviewing the SLC’s independence, good faith, and reasonableness of its decision, and a discretionary review of the settlement’s merits?

Rationale: Courts must consider whether the proposed settlement is fair and reasonable in light of the factual support of the alleged claims and defenses in the discovery before it. The court does not make substantive determinations concerning disputed facts.

In applying the Zapata test: SLC proceeded in good faith throughout the investigation and settlement, were well informed, and the proposed settlement falls within a range of reasonable solutions to the problem. The first part of the test is enough to support the settlement.

If undertaking the second step of Zapata is necessary with the court exercising its own business judgment, court finds that the settlement is a reasonable compromise.

10.6 When are Derivative Suits in Shareholders’ Interests?

Benefits of Derivative Suit:1. Increase corporate value by recovering compensation for past harms inflicted by errant managers.2. Increase corporate value by forcing governance change that prevents that same manager from inflicting future harm on the corp.3. Increase corporate value by deterring future wrongdoing in fear that another future suit will be brought.

Costs of Derivative Suits:1. It imposes direct cost in defending and prosecuting successful suits.

2. Corp. must pay in advance for some prospective costs of managerial liability (ex. Insurance, or compensate directors ex ante for expected litigation cost.

Chapter 11: Transactions in controlWhy does anyone want control? sliding scale from the wholesome (i.e. to better manage the corp. increase profits and to benefit society) to the cynical (i.e. looting, only doing it for your own personal gain)

Generally, this chapter discusses exchanging or aggregating blocks of shares large enough to control corporations (and the policy, regulatory issues therein).

Share for share, controlling blocks of stock inevitably sell in negotiated transactions at a premium over market price of non-control shares. Why?

1. Payment for “private benefits of control,” which may include the power to captures salary, perks, and perhaps self-dealing opportunities.

2. Control permia are paid by buyers who have a superior business plan that will increase the value of the stock in their hands.

Two ways in which an investor can acquire control over corporations.

1. Purchasing a controlling block of shares from an existing control shareholder. In such a sale of control, the incumbent controller will demand a premium over the price of the publicly traded stock for her control to block. The acquirer may expect to finance this control premium by putting the company’s assets to more profitable uses, or private benefits.

Regulation here is focused on mitigating the risks of opportunistic transfers of control to “bad” acquirers without not hindering the efficient transfer of control to acquirer who will use company assets in more profitable ways.

2. Purchasing the share of numerous smaller shareholders (Tender Offer).

Here a similar trade-off exists between the law’s ambition to protect shareholders from opportunism and its ambition to foster efficient transfers of control.

Sales of Control Blocks (1, above): The Seller’s Duties:

What rules govern the sale of a control block once it is obtained? (See 1-3, provided below in outline form).

1) The extent to which the law should regulate premia for the sale of control (ie the difference between the market price of minority share and the price obtained in the sale of a control block

Generally, US jurisdictions do not afford to minority shareholders such a right to sell their own stock alongside the controlling shareholder.

This is based off the Market rule: the sale of control is a market transaction that creates rights and duties between the parties, but does not confer rights on other shareholders.

Zetlin v. Hanson Holdings, Inc (Market Rule)

FACTS: Zetlin (P) held a 2% interest in Gable Industries. Hanson Holdings (D) and members of the Sylvestri family (D) owned 44% of Gable's shares. After the Sylvestri family (D) and Hanson (D) sold their controlling interest at a premium price per share, Zetlin (P) brought suit, contending that minority stockholders were entitled to an opportunity to share equally in any premium paid for a controlling interest in the corporation. The appellate division disagreed. Zetlin (P) appealed.

ISSUE: Absent looting of corporate assets, conversion of a corporate opportunity, fraud or other acts of bad faith, is a controlling stockholder free to sell, and is a purchaser free to buy, that controlling interest at a premium price?

HOLDING AND DECISION: [Judge not stated in casebook excerpt.] Yes. Absent looting of corporate assets, conversion of a corporate opportunity, fraud or other acts of bad faith, a controlling stockholder is free to sell, and a purchaser is free to buy, that controlling interest at a premium price. Certainly, minority shareholders are entitled to protection against abuse by controlling shareholders. They are not entitled, however, to inhibit the legitimate interests of the other stockholders. It is for this reason that control shares usually command a premium price. The premium is that added amount an investor is willing to pay for the privilege of directly influencing the corporation's affairs. Order affirmed.Class Notes:-Minority wanted their cut of the premium stock price; wasn’t that they had issue with the new management-If you’re just selling your shares, you can sell them to whoever or whenever, no one else’s business but your own

Perlman v. Feldman (alternative to Market Rule) (federal court case, not DE law)

FACTS: Newport Steel Corporation operated mills for the production of steel sheets for sale to manufacturers of steel products. Feldmann (D), the dominant stockholder, chairman of the board of directors, and Newport's president, negotiated a sale of the controlling interest in Newport to a syndicate organized as Wilport Company. A steel shortage existed at the time as a result of demand during the Korean War. Perlman (P) and other minority stockholders (P) brought this derivative action to compel an accounting for, and restitution of, allegedly illegal gains accruing to Feldmann (D) and the other majority stockholders as a result of the sale. The trial court found the share price to be a fair one for a control block of stock. Perlman (P) and the others (P) appealed.

ISSUE: Do directors and dominant stockholders stand in a fiduciary relationship to the corporation and to the minority stockholders as beneficiaries thereof?

HOLDING AND DECISION : (Clark, C.].) Yes. Directors and dominant stockholders stand in a fiduciary relationship to the corporation and to the minority stockholders as beneficiaries thereof. However, a majority stockholder can dispose of his controlling block of stock to outsiders without having to account to his corporation for profits. But when the sale necessarily results in a sacrifice of an element of corporate good will and consequent unusual profit to the fiduciary who has caused the sacrifice, he should account for his gains. In a time of market shortage, where a call on a corporation's product commands an unusually large premium, a fiduciary may not appropriate to himself the value of this premium. There need not be an absolute certainty that a corporate opportunity is involved; only a possibility of corporate gain is necessary to trigger the fiduciary duty and recovery for breach of that duty. Hence, to the extent that the price received by Feldmann (D) and the others included such a gain, which rightfully belonged to the corporation, he is accountable to the minority stockholders (P), who are entitled to a recovery in their own right, instead of in the right of Newport Steel. Reversed.

DISSENT: (Swan, J.) The majority's opinion does not specify exactly the fiduciary duty Feldmann (D) violated, either as a director or as a dominant shareholder. As a dominant shareholder, Feldmann (D) did not have a duty to refrain from selling the stock he controlled. There was also no indication that Wilport would use its newly acquired power to injure Newport, and there is nothing illegal in a dominant shareholder purchasing products made by the company at the same price offered to other customers-which is what the Wilport members did. The majority says that the price paid for the stock included compensation for a "corporate asset, which it describes as "the ability to control the allocation of the corporate product in a time of short supply, through control of the board of directors." If the implication of this is that during tight market conditions a dominant

shareholder has a fiduciary duty not to sell his stock to users of the corporation's products who wish to buy a controlling block of stock in order to be able to purchase part of the corporation's output at the same mill list prices as are offered to other customers, such a holding should not stand. Only if Feldmann (D) received value in excess of what his stock was worth, for performing duties he was already under an obligation to perform, should he account for the difference in value. However, the record and trial court findings support that Feldmann (D) did not receive such excess value, since controlling block of stock is worth significantly more than a block without such control. Finally, the majority is incorrect in holding that the shareholders (P) are entitled to recover in their own right instead of in the corporation's right. This holding contradicts the majority's theory that the price of the stock "included compensation for the sale of a corporate asset." If indeed a corporate asset was sold, then the corporation, not its shareholders, should be entitled to the proceeds from the sale of that asset.Class Notes:-Argues control is a part of the corporation and therefore people are entitled to that asset-court sided with plaintiff here-he can’t get paid by someone other by the corporation-12 market price 20 premium price; Dissent – if some part of 8 dollar premium wasn’t control premium that might be some place this could have gone wrong-Maj: if overly opportunistic, take an accounting; put burden on the def. that it wasn’t overly burdensome (but what duty? maybe you’d have to prove all duties)-power to control corporation is especially valuable when selling a corporation-This case has never been followed-willing to give damage award to shareholder instead of corporation (this is crazy; dissent called this out and was correct)

Frank Easterbrook: A defense of the Market Rule in Sales of Control

-Investor’s welfare is maximized by a legal rule that permits unequal division of gains from corporate control changes, subject to the constraint that no investor be made worse off by the transaction.

-Sales of controlling blocks of shares provide a good example of transactions in which the movement of control is beneficial. The sale of control may lead to new offers, new plans, and new working arrangements with other firms that reduce agency costs and create other gains from new business relationships.

-The premium price received by the seller of the control block amounts to an unequal distribution of the gains…however, this unequal distribution reduces the costs to purchaser of control [because the purchaser need only buy the control bloc and not all the shares at the higher price], thereby increasing the number of beneficial control transfers, and increasing the incentive for inefficient controllers to relinquish their positions.

-Do not suggest that the legal system should disregard looting, but we think it is likely that the best remedies are based on deterrence rather than prior scrutiny. The costs of deterrence are probably much lower than the costs of dealing with looting through a system of prior scrutiny that would scotch many valuable control shifts as a byproduct.

-Class Notes: looting leads to drop in share price, since if you’re taking value out of the corporation, the less assets the corp. has on hand the less likely profits in the future there will be-Notion of “should there be a way to detect looters?” everyone who buys a controlling share, has some idea of looting;

2) the law’s response to sales of managerial power over the corporation that appear to occur without transferring a controlling block of stock; and

-How should we analyze the sale of a relatively small block of stock in a widely held firm at a premium price by the CEO or managing directors, who simultaneously promise to resign from the board in favor of the buyer’s appointees upon conclusion of the sale?

3) the seller’s duty of care to screen out buyers who are potential looters.

-Another important qualification of the controller’s right to take whatever the market will bear for her control stake is the duty that the law imposes to screen against selling control to a looter.

Harris v. Carter

FACTS: Carter (D) and his associates owned 52% of the stock of Atlas Energy Corp. The Carter group (D) soldcontrol of the corporation to Mascolo (D) and his associates, receiving in exchange shares of stock in a Mascolo corporation,Insuranshares of America. The Mascolo group (D) then took control of Atlas and, in a series of transactions, allegedlylooted the corporation. Harris (P) and other minority shareholders of Atlas sued not only the Mascolo group (D) butalso the Carter group (D). The gist of their allegations against Carter (D) was that facts were present which should have puthim and his associates on notice of Mascolo's (0) intentions and that their failure to investigate constituted a fiduciarybreach. The Carter group (D) moved to dismiss for failure to state a claim.

ISSUE: Maya majority shareholder be liable if he negligently sells control and such sales damages the corporation?

HOLDING AND DECISION: (Allen, Chan.) Yes. A majority shareholder may be liable if he negligently sellscontrol and such sale damages the corporation. It is an established legal doctrine that, unless privileged, each personowes a duty to those who may foreseeably be harmed by his failure to take reasonable steps to prevent such harm. Whilethis doctrine is usually cited in the context of tort law, it also applies to fiduciary obligations. When a corporate fiduciary'saction may forseeably harm the corporation, his negligent acts causing such harm are compensable. In the context ofthis case, the Carter group (0) controlled the corporation as majority shareholders and officers and were thus fiduciaries.Harris's (P) complaint states a claim for breach of a duty of care owed by the Carter group (0). Motion to dismissdenied.Class Notes:Market rule is not really the market fule when they’re negligent and a reasonably prudent person would have suspected somethingIs there a duty under tort law to act non-negligently? no, currently there is no such duty; you have to identify a specific duty and that breach.

Class Notes:Why be concerned about someone with a controlling share being elected to the board? Vote buying; we’re concerned with people who want to vote shares without actually buying the shares; that’s why it’s illegal to buy votes; reason is to protect corporation, you’re going to be more risky; if you do poorly you don’t lose that much (say you only owe 10%) ; sale of corporate office messes up incentives by creating incentives giving too much riskMarket Rule: basic rule in every major jurisdiction, but (1)looting, there is aparticular duty (2)if you sell your stock and just walk away, you’re pretty well going to be okay; danger though is particular plans for corporation and certain corp. regs/rules limit ability to buy controlling interest and then interact with corp.DE Rule 203: limit ability to use controlling interest to transact business with corporation, it imposes a waiting period; want to make sure corporate board waves Rule 203; minute they do that you implement the dissent in Perlman v. Feldman; that payment may be violation of duty of loyalty to corporationAs a practical matter be aware, that if client wants to buy controlling interest, let them know they are goin to have to wait a period of time prior to transacting, or be very specific about how to get rid of Rule 203or any other pertinent rule; -hypo: client wants to buy ctrl. interest of corp. and wants transacting immediately, how to go about to make sure that this doesn’t bite you later on? Prof. suggests: ask shareholders to ratify or ratification by independent directors

Tender Offers: The Buyer’s Duties (see 2, above)

Large public companies in the US generally do not have a controlling shareholder. Thus, an investor who wishes to purchase a control stake in a widely held company must do so by aggregating the shares of man small shareholders.

Two ways: the buyer might approach the largest of the small shareholders singly, or the buyer might make a general offer, a tender offer that is open to all shareholders.

Tender offer: an offer of cash or securities to the shareholders of a public corporation in exchange for their shares at a premium over market price.

Prior to Williams act there were no duties on the buyer.

Williams Act provides shareholders sufficient time and information to make an informed decision about tendering their shares and to warn the market about an impending offer. Also intended to assure shareholders an equal opportunity to participate in offer premia and to discourage hostile tender offers on the margin.

Elements of the WA:

1) an “early warning system” which alerts the public and the company’s managers whenever anyone acquires more than 5 percent of the company’s voting stock.

-assists the BoD

2) mandates disclosure of the identity, financing, and future plans of a tender offeror, including plans for any subsequent going-private transaction.

3) an antifraud provision that prohibits misrepresentations, nondisclosures, and “any fraudulent, deceptive, or misrepresentative” practices in connection with a tender offer.

4) dozen rules that regulate the substantive terms of tender offers, including matters such as how long offers must be left open when shareholders can withdraw previously tendered shares, and how bidders must treat shareholders who tender.

Brascan Ltd. v. Edper Equities Ltd (What exactly is a tender offer?)

FACTS: Over two days, Edper (0) purchased 24% of Brascan (P), a Canadian company trading in Canada, in theUnited Kingdom, and on the American Stock Exchange. Edper (D) already held a 5% stake in Brascan (P) and hadproposed a friendly acquisition, which Brascan (P) had rejected. Edper (D) then decided to purchase an additional3 million Brascan (P) shares, and to do so through the American Stock Exchange to avoid Canadian regulations.Edper (D) informed Connacher, president of Gordon Securities Ltd., it might purchase up to three million shares at a premium price if these were available. Gordon Securities contacted between 30 and 50 institutional investors and 10to 15 individual investors, who held large blocks of Brascan (P) shares, telling them that Edper (0) might be willing to purchase three to four million shares at 22% (which was several dollars above the trading price). Edper (D) authorizedits broker to purchase 2.5 million shares at 22%. Edper's (D) broker on the Exchange acquired 2.4 million shares (2 million of which were offered by Gordon Securities on behalf of the shareholders it had just solicited). By the end of the day, Edper (D) had purchased 3.1 million shares. Edper announced, in response to a demand from Canadianofficials, that it had no plans to buy any more shares at that time. Nevertheless, the next day, without further public announcement, Edper (D) resumed its buying activity, and Gordon Securities again solicited large holders of Brascan (P). Edper (0) purchased 3.2 million shares at 22% or slightly higher, almost half of which came from Gordon Securities or its customers. Brascan (P) sued Edper (D) in federal district court, seeking to require Edper (0) to divest itself of the shares it had bought, claiming that the failure to announce that it was making further purchases violated § 14(e) of the Williams Act.

ISSUE: Does the mere acquisition of a large portion of a company's stock by itself constitute a tender offer forpurposes of § 14(e) of the Williams Act?

HOLDING AND DECISION: (Leval, J.) No. The mere acquisition of a large portion of a company's stock by Itself does not constitute a tender offer for purposes of 14(e) of the Williams Act. The conduct Edper (D) engaged In does not constitute what is commonly understood as a tender offer.

Edper (D) did not solicit numerous shareholders; its purchasing was not contingent on a minimum fixed number of shares being offered; it did not put out an offer at a fixed price; and the form of the transaction did not provide for tenders by the selling shareholders to be held for some period of time by the purchaser or a depositary. All Edper (D) did was to acquire a large amount of stock in open market purchases. Also, contrary to Brascan's (P) argument, Connacher was not Edper's (D) agent-just its broker. Even if Connacher was deemed to be Edper's (D) agent, Connacher's conduct also did not amount to a tender offer, since Connacher merely scouted between 30 and 50 large institutional holders of Brascan (P) stock, plus about a dozen large individual investors, to collect a large block for Edper (D) to purchase at a price agreeable to both sides of the. transaction. This is privately negotiated block trading, which the Williams Act's legislative history indicates was not intended to be covered by the Act, even if such trading is a large accumulation of stock.

Finally, Edper's (D) conduct fully meets only one of eight criteria for a tender offer. The first criterion calling for active and widespread solicitation of public shareholders is clearly not met. The second criterion, calling for a large accumulation of stock, is met. The third, calling for a premium over the prevailing market price is met, but only to a slight degree. The fourth criterion calling for firm offer terms, rather than negotiable terms, is not met. The fifth criterion, calling for the offer to be contingent on the tender of a fixed minimum number of shares, is met only to a slight degree. The sixth criterion calling for the offer to be open only for a limited period of time is not met. The seventh criterion calling for the offerees to be subjected to pressure to sell their stock was not met. And finally, the eighth criterion calling for public announcements of a purchasing program preceding or accompanying a rapid accumulation was not met. Therefore, Edper (D) did not violate § 14(e) of the Williams Act. Judgment on this issue for defendant.Class Notes:

not an official test, but highly recommended to learn those 8 factors; the 8 factors will be on the exam (see page 438 in the book)

The Hart-Scott-Rodino Act Waiting Period

Apart from the Williams Act, a second legal constraint on the immediate acquisition of control of large US companies is the HSR act, which was intended to give the FTC and the DOJ the proactive ability to block deals that violate the antirust laws.

Chapter 12: Fundamental Transactions: Mergers and Acquisitions

Among the most important transactions in corporate law are those that pool the assets of separate companies into either a single entity or a dyad of a parent company and a wholly owned subsidiary.

Three legal forms: the merger, the purchase (or sale) of all assets, and the compulsory share exchange.

A merger is a legal event that unties two existing corporations with a public filing of a certificate e of merger, usually with shareholder approval.

Acquisitions comprise a generic class of “nonmerger” techniques for combining companies, which generally involve the purchase of the assets or share of one firm by another.

M&A transactions provide a useful platform for revisiting two fundamental questions of policy in corporate law: the role of shareholders in checking the board’s discretion and the role of fiduciary duty in checking the power of controlling shareholders. Class Notes:M&A occur to improve a firm’s efficiency (non-cynical)they want to be monopolies (cynical view)

Economies of Scale: really high fixed costs, have to pay these costs regardless, if you combine with low variable costs – if you can make really big you can bring the average cost for each unit down; it’s the reason why in-n-out is very small (vertical integration)merger is a substitute for doing it yourself; you can either buy it (merge with an existing business that does what you need) or make it (start from scratch)

Economies of Scope:

Economic Motives for Mergers

The law of M/A transactions provides (relatively) quick and inexpensive ways to reform the partitioning and management of corporate assets.

Positive:

1) Gains from integrating corporate assets arise from economies of scale (horizontal mergers between firms in the same industry), scope (spreading costs across a broader range of related business activities), and vertical integration (merging a company backward, toward its suppliers, or forward, toward its customers..

2) Generate value relating to tax (deducting losses, and setting those assets off against income in subsequent years), agency costs (think hostile takeovers), and diversification (diversifying a company’s businesses projects, thus smoothing corporate earnings over the business cycle).

Negative:

There are opportunistic motives to enter mergers that increase shareholder value or management compensation at the expense of another corporate constituency.

1) Squeeze-out merger, in which a controlling shareholder acquires all of a company’s assets at a lower price, at the expense of its minority shareholders.

2) creating market power in a particular product market and thus allowing the post merger entity to charge monopoly prices for its output

3) Mistaken mergers, misjudging the difficulties of realizing merger economies.

The evaluation of the US Corporate Law of Mergers

Technological change in the last decades of the 19th century increased the efficiency of many industries. Toward the end of the 19th century, corporation statutes were amended to permit merges and charter amendments that received less than unanimous shareholder approval, providing that they were recommended by the board and approved by a majority.

Today, Delaware and many other states allow mergers to proceed with the approval of only a bare majority of the outstanding shares of each class of stock that is entitled to vote on them.

Additionally, originally, shareholders of a merging company could receive only equity in the surviving company in exchange for their old shares, however, now consideration beyond securities in the surviving corporation are allowable, most notably cash. Class Notes:Before 1850 Mergers didn’t happen since you had to go to the state legislatureshareholder sof target corp. are always going to have to give up their shares in the targetThere are no limitations on merger consideration (there used to be a req. “stock for stock” but since mid 1900s those are gone)

The Allocation of power in fundamental transactions

The merger is the most prominent among a handful of corporate decisions that required shareholder approval.

Why does the law usually require shareholder consent for mergers and certain other transactions?

1) consider the universal requirement that shareholders approve material amendments of the articles of incorporation, the basic “charter” of the corporation. To protect investors’ reasonable expectations, the law must provide a shareholder veto over all transactions that might effectively amend the charter. Thus, shareholders must approve both corporate dissolution, which nullifies the corporate charter, and corporate mergers, in which the surviving corporations’ charter maybe amended.

2) it may depend on the issue, who has the best information and who has the best incentives. Thus, Bethe-company operations decisions do not require a shareholder vote since shareholders generally lack the ability and info to make them, relative to the alternative decision maker, the board and top managers.

Class Notes:-managers have best information-shareholders have the best incentives-mergers can change what you’re invested in, could be fairly dramatic change; shareholders may actually care and find out some basic info.-Some decisions that seem to fundamentally change an investment

3) and maybe most importantly is that M/A transactions that require shareholder approval are those that change the board’s relationship to its shareholders most dramatically, reducing the ability of shareholders to displace their managers after the transaction is completed.

Overview of Transactional Form

How is the acquisition of a business to be structured? Three principal legal forms of acquisitions:

1) The acquirer can buy the target company’s assets2) the acquirer can buy all of the target corporations’ stock, or 3) the acquirer can merge itself or a subsidiary corporation with the target on terms that ensure its control of the surviving entity.

In each of these transactional forms, the acquirer can use cash, its own stock, or any other agreed-upon form of consideration.

1. Asset Acquisition

The acquisition of a business through the purchase of its assets has a relatively high transaction cost (but a low liability cost).

As discussed, a sale of substantially all assets is a fundamental transaction for the selling company, which requires shareholder approval under all US corporate law statutes.

Katz v. Bregman (what is substantially all the assets?-51% is enough)

FACTS: Katz (P) was the owner of approximately 170,000 shares of common stock of Plant Industries (Plant), whichhad operations in the U.S. and Canada. After selling off Plant's unprofitable U.S. operations, Bregman (D), Plant'sCEO, embarked on a course of action designed to dispose of Plant's Canadian assets, which allegedly constituted Plant'sonly income producing facility during the four years prior to the proposed sale. The purpose of the sale, which would havedisposed of around 51% of Plant's total assets, which produced 45% of its income, was to improve Plant's balancesheet. Plant entered into a firm bid with Vulcan, which was later matched and then topped by Universal. Katz (P) thenbrought an action to enjoin the sale of the Canadian assets, contending that a sale of all or substantially all the assets of a corporation required the unanimous vote of the shareholders.

ISSUE: Under Delaware law, does the decision of a corporation to sell all or substantially all of its property and assets require the approval not only of the corporation's board of directors, but also a resolution adopted by a majority of the outstanding shareholders of the corporation entitled to vote?

HOLDING AND DECISION: (Marvel, Chan.) Yes. Under Delaware law, the decision of a corporation tosell all or substantially all of its property and assets requires not only the approval of the corporation's board of directors,but also a resolution adopted by a majority of the outstanding stockholders of the corporation entitled to vote. Katz (P),in his bid for relief sought, relied on the fact that the board studiously refused to consider a potentially higher bid for theassets in question. Here, the proposed sale of Plant's Canadian operations would, if consummated, constitute a sale of substantially all of the assets of Plan Industries as presently constituted. Thus, under the law of the State of Delaware, an injunction should issue preventing the consummation of such sale at least until it has been approved by a majority of the outstanding stockholders of Plant, entitled to vote at a meeting duly called on at least 20 days' notice. A preliminary injunction against the consummation of such transaction, at least until stockholder approval is obtained, will be granted.Class Notes:If directors are to sell all (or substantially all) assets they need shareholder approval (very little protection of shareholders, when it comes to sale of assets)all or substantially all does not mean half it means substantially everything (see page 457, last two lines)On test, you’d see something like this on an essay, with list of tangible and untangible assets, and you’d have to argue why or why not it was/was not substantially all assetsAssets may have title issues, e.g. UCC Title 9 issues, this could incur more costs for acquisition of the asset

2. Stock Acquisition

See chapter 11, a company that acquires a controlling block of stock in another has, in a practical sense, “acquired” the controlled firm. Thus, tender offers and the purchase of a controlling block of stock may be thought of as acquisition transactions.

To acquire a corporation in the full sense of obtaining complete dominion over its assets, Acquirer must purchase 100 percent of its target’s stock, not merely a control block.

This is in effect a tender offer negotiated with the target board of directors that, after approval by the requisite majority of shareholders, becomes compulsory for all shareholders. The acquiring company’s stock (or the reconsideration ) is then distributed to the target’s shareholders pro rata, while the acquire becomes the sole owner of all of the stock of the target. Class Notes:Short Form Merger: if you get 90% of stock in a corp. you can force other 10% to sell their shares; can be in form of stock or cash;

Compulsory Stock Exchange: negotiation with BoD, BoD puts up for shareholder vote, and if enough shareholders vote in favor, then every shareholder has to tender their shares (for cash or stock in acquiring corporation). look to corporate charter to see if right amount of shareholder voted in favor

Two Step Merger (name in DE): As with compulsory stock exchange, you go through board, board puts tender offer to shareholders, when enough shareholders assent you merge the corporations and cash out any leftover shares.

3. Mergers

A merger legally collapses one corporation into another; the corporation that survives with its legal identity intact is termed the surviving corporation.

After the board formally authorizes the execution of this agreement the board will in most instances call a shareholders’ meeting to obtain shareholder approval of the mergers.

Remember, a valid merger requires a majority vote by the outstanding stock of each constituent corporation hat is entitled to vote.Class Notes:Officers are usually the likely culprit to instigate a merger.Structuring the M/A Transaction

To choose the right structure for an M/A transaction, the interaction of many variables must be considered:

Timing

Regulatory approvals, consents, and title transfers

Planning around voting and appraisal rights

Sometimes, planners may voluntarily condition transactions on shareholder approval or provide appraisal rights.

Due diligence, representations and warranties, covenants, and indemnification

In any deal, the buyer will wish to acquire reliable information about the target. In many deals involving public companies, acquiring this information is don much easier by public SEC filing and the availability of financial statements audited by an independent public accountant.

Deal protections and termination fees

Most important of a friendly merger agreement are those terms that are designed to assure a prospective buyer that its investment in negotiating in good faith with a target will result in a closable transaction.

Accounting treatment

In a direct merger the surviving corporation will typically record the assets acquired at their fair market value. The extent that the merger consideration excess the total of the fair market value of thee assets the survivor will record this excess as an intangible asset, “goodwill” The value of this goodwill need not be amortized against earnings so long as it continues to represent this economic value.

Class Notes:in order to know what is fair you have to know what your corp. is worthNeed to file SEC paperwork, at corporate level and in target co and acquiring co. you need a shareholder vote; before that can take place, you need to have meeting/notice and proxy vote; prior to proxy requests you have to send SEC proxy materials for approvalTriangle Merger: parent co. subsidiary of parent and the target corp.; if target sticks around you have a reverse triangle merger (multiple choice question on exam); if subsidiary sticks around it’s a forward merger (retains corporate veil)shareholders of target are either bought out with money or they end up with stock in the parent corporation. Which ever one remains (i.e. target or subsidiary) becomes wholly owned by the parent

Benefit: merger can be beneficial if a lot of titles to assets, cause you can do it all at oncethe way in which you expand, there are a lot of options; take into consideration the public relations perspective of a merger; not just economies of scale/scope; corporations rely on good will (public perception); need to account for thisTimber Jack agreement was not intended to be covered; just know what they’re talking about;

Taxation of corporate combinations [this is incredibly complicated, likely to bring malpractice, if you odn’t involve a tax attorney; NOT TESTED ]

In the US federal taxes are levied on income, which includes gains in the value of investments as they are realized and recognized. Gain is calculated as the excess of the net amount realized on sale over the taxpayer’s adjusted cost basis. The ACB of an asset is its cost after reduction for the depreciation charges made against the asset’s cost in calculating annual income taxes.

Thus, for example, the shareholders of the target corporation will generally realize a gain or a loss upon the sale or exchange of their stock in either ran individual transaction of a corporation transaction.

Therefore, an important aspect of tax planning for M/A transactions is to attempt to defer the recognition of any realized shareholder gain.

Tax-Free Corporate ReorganizationsAlthough tax inevitably affects economic activities, tax law ought to interfere with capital allocation it eh market no more than is necessary. That is why the Code does not recognize taxable gain for transactions that, in economic substance, merely reorganize ownership interests without fundamentally changing the identity for the owners.

Lastly:

there are certain times, in a target corp. the default rule is all common stock hoders get a vote; if in dE perferrred may ormay not get a vote; if your in surviving corp sometimes you do sometimes you don’t

12.8 The Appraisal Remedy

12.8.1 History and Theory

In the event of a “silly deal” (the books choice of words, not mine) the United States corporate law uniquely allows prudent shareholder to demand the “silly deal” making shareholders to buy them out at a reasonable price

Every US jurisdiction provides an appraisal right to shareholders who dissent from qualifying (i)corporate mergers or(ii) substantial sales of assets; DE mandates appraisal only in connection with (certain) corporate mergers and then only in certain circumstances DGCL 262

Originated as a way to provide a liquidity event for shareholders that, as a result of a merger, may have ended up with an illiquid investment (i.e. back when stock-for-stock merger was the only form of merger contemplated;)

12.8.2 The Appraisal Alternative in Interested Mergers

In the modern era of cash mergers and large security markets the liquidity explanation makes little sense in the case of public companies

A Plaintiff in an appraisal proceeding is entitled to claim only a pro rata share of the FMV of the company without regard to any gain caused by the merger or its expectation

Class Notes: it was unfair to get stock in a company that I didn’t even want, and since I don’t have a say in it, I should get an appraisal. If you claim breach of fiduciary duty, you can get monetary damages, you might even be able to stop the merger; appraisal remedy would require accounting, difficult to stop the merger with an appraisal, sometimes market out rule might apply, you might be in DE and not have a merger to invoke it;

Appraisal is to get you a FMV, but that is really hard to do (chapter 5)

12.8.3 The Market-Out Rule

Appraisal is denied when shares of target corporations are traded on a national security exchange or held of record by 2K registered holders. Appraisal is denied if the shareholders were not required to vote on the merger; but the statute restores the appraisal remedy if target shareholders receive as consideration anything other than:

i. stock in the surviving corporation

ii. any other shares traded on a national security exchange

iii. cash in lieu of fractional shares or

iv. a combination of those items

[Market-Out Rule]

Shareholders in a privately traded firm (shareholders <2k) will always have appraisal rights in a merger if they are required to vote on it, however shareholders in a public company with more than 2k shareholders have no appraisal rights in a stock for stock merger;

12.8.4 The nature of “Fair Value”

Two dimensions of appraisals:

(1) the definition of the shareholder’s claim (i.e. what it is specifically that the court is supposed to value)

-DE law clearly defines the dissenting shareholder’s claim as a pro rata claim on the value of the firm as a going concern

-DE says to value dissenting shares devoid of any element of value that might be attributed to merger

-but DE says merger value must include future value that was present at the time of the merger, excluding only speculative elements of value

(2) the technique for determining value

“DE Block Method” of value appraisal: look at earnings of the firm and price earnings multiples in the industry, asset values, and share market prices

Often time valuation comes down to a “battle of the experts” as plaintiff and defendant provided expert’s valuations vary widely

12.9 The De Facto Merger Doctrine

A self-identified sale of assets that results in exactly the same economic consequences as a merger will nonetheless be governed by the (lesser) shareholder protections associated with a sale of asset, and not the full panoply of merger protections.

Hariton v. Arco Electronics (Del. 1963)

Facts:

Plaintiff was stockholder in defendant Arco Electronics Inc. (DE corp.) which comprised:

-Arco distributed wholesale electronic components

-486,500 shares of class A common stock and

-362,500 shares of class B common stock

-stock class only differed in dividends paid out

-’61 total assets $3,013,642

-Net income for preceding year was $273,466

Complaint challenged validity of the purchase by Loral Electronics Corp. (NY corp.) of all Arco’s assets

-Arco engaged in the R&D and production of electronic equipment

-total assets of 16,453,479

-Net income for ’61 was 1,301,618

Causes of action:

(1) the transaction is unfair to Arco stockholders and

Plaintiff conceded this was unsustainable

(2) the transaction constituted a de facto merger and is unlawful since the merger provisions of the DE law were not complied with

arms length negotiation between two companies

Purchase agreement required:

Arco will convey and transfer to Loral all of its assets and property of every kind, tangible and intangible; and will grant to Loral the use of its name and slogans. Loral will assume and pay all of Arco’s debts and Liabilities. Loral will issue to Arco 283,000 shares of its common stock. Upon the closing of the transaction Arco will dissolve and distribute to is shareholders pro rata, the shares of the common stock of Loral. Arco will call a meeting of its stockholders to be held December 21, 1961 to authorize and approve the conveyance and delivery of all the assets of

Arco to Loral. After the closing date Arco will not engage in any business or activity except as may be required to complete the liquidation and dissolution of Arco.

Special Meeting of Arco on 12/27/61 had three states purposes:

(1) to vote upon a proposal to ratify the agreement of purchase and sale, a copy to which was attached to the notice

(2) to vote upon a proposal to change ht name of the corporation and

(3) if Proposals (1) and (2) should be adopted, to vote upon a proposal to liquidate and dissolve the corporation and to distribute the Loral shares to Arco shareholders

Issue: If the joining of Arco and Loral was a de facto merger, should the plaintiff be afforded a right of appraisal?

Holding: The joining of Arco and Loral was a sale of assets, and therefore not accorded a right of appraisal under DE law.

Reasoning:

Defendants contend that since all formalities of sale of assets pursuant to 8 DE Code Section 271 were met the transaction is a sale of assets; court noted that nowhere did plaintiff allege that such provisions were not followed.

Court thinks application of the “right of appraisal” claim in merger statute situations should be left to the legislature, currently DE only provides for an appraisal if a merger is at issue

Stock purchaser was on notice of the provisions of 271 allowing corp. to sell all assets for stock in another corp.

Not a de facto merger

Class Notes: In DE an asset sale is not a de facto merger

12.10 The Duty of Loyalty in Controlled Mergers

Tension exists between a controlling shareholder’s exercise of voting rights (which can reflect one’s own selfish interest) and exercise of “control” over the corporation or its property (which cannot)

Controlled mergers expose minority shareholders to an acute risk of exploitation (e.g. “cash-out” “freeze-out” or “going-private” mergers)

Stock split: if value gets too high it might deter investors; (e.g.can’t afford $4k a share) it might be good to split the stock; so you do a 100:1 split, for every 1 shares you owned you now own 100 (now worth $40); this facilitates more trade)

Reverse Stock Split: turn 100 shares into 1, if you don’t have at least one share after the RSS, you get to cash out all the “fractional” share holders; this way you can get rid of minority shareholders

12.10.1 Cash Mergers or Freeze Outs

Weinberger v. UOP Inc. (Del. 1983)

Procedural:

Post-trial appeal reheard en banc from a decision of the Court of Chancery

Facts:

Signal Companies, Inc. is majority owner of UOP; Signal is a diversified, technically based co. operating through various subsidiaries; UOP was a diversified industrial co.; In 1974 Signal acquired a 50.5% of UOP at $21 a share when UOP shared had traded at $14 a share; signal nominated and elected six of UOP’s 13 directors on UOP’s board; Five of the six were directors or employees of Signal; the sixth was a banking firm partner at Lazard Freres & Co. and was one of Signal’s representatives in negotiating and bargaining with UOP concerning the tender offer and purchase price of the UOP shares; two signal officers Arledge and CFO Chitiea concluded it would be a good investment for Signal to acquire the remaining 49.5% of UOP shares At any price up to $24 each; Signals’s Executive Committee meeting was called to propose Signal acquire UOP reaming stock through a cash-out merger in the range of $20-21 dollars a share; UOP president Crawford attended that meeting and was told of the purchase price proposed, he thought it was fair but voiced concerned about existing UOP employees job security, stock plans etc. so as to maintain the quality of UOP; After the meeting Signal issued a press release disclosing proposed buyout and obliquely referenced closing price that day which was $14.50 a share (not 20-21); Lehman Brothers issued a “fairness” letter stating $21 a share was fair for a $150k fee; Signal’s board unanimously adopted a resolution authorizing Signal to propose to UOP a cash merger of $21 a share. Req’d merger to be approved by a maj. of UOP’s outstanding minority shares voting at the stockholder’s meeting at which the merger would be considered and that the minority shares voting in favor of the merger when coupled with Signal’s 50.5% interest would have to comprise at least 2/3 of all UOP shares, else it would be disapproved; At UOP’s annual meeting 56% of minority shares were voted of those 51.9% of the total minority voted for the merger; when signal’s stock was added to the minority shares voting in favor, a total of 76.2% of UOP’s outstanding shares approved the merger while 2.2% opposed it

Issue: What is the scope of entire fairness?

Holding: Entire Fairness covers fair dealing and fair price.

Reasoning:

Arledge and Chitiea’s analysis was not disclosed to UOP, was solely for the use of Signal and therefore they failed to meet fiduciary standards applicable to such transaction

ROI of $21 would be 15.7% while 24 would be 15.5% to Signal this was only two-tenths of one percent while it meant over $17 M to the minority

Study was prepared by two UOP directors, using UOP information for the exclusive benefit of Signal

Nothing was done to disclose the data to UOP, therefore there is a breach of fiduciary duty

Fairness has two basic aspects:

(1) Fair dealing (e.g. timing, how initiated, structured, negotiated, disclosed to directors and how approval was obtained by directors and stockholders), and;

(2) Fair price (account for assets, market value, earnings, future prospects, and any other elements that affect the intrinsic or inherent value of a co.’s stock)

Must examine two aspects as a whole not piecemeal

Class Notes: valuation takes place prior to the merger according to Weinberger

On the exam know that the statute is completely irrelevant because Weinberger is controlling, the legislation hasn’t changed the statute; controlling gprecedent is Weinberger when it comes to deciding a fair value; one and only case where common law supercedes statutory law; essentially statute says don’t include perceived gain of pending merger, case law of Weinberger says you should include this value;

state of the law is that fairness is paramount, but ex ante it’s impossible to know what fairness requires

Understand that the catchword is “fairness” “fair price” on the exam; if you want to buy a corp. divest yourself entirely and then give a huge tender offer

12.10.2 What Constitutes Control and Exercise of Control

Self-dealing fiduciaries have two principal devices to ease burden to prove entire fairness:

(1) Shareholder ratification and

(2) Independent director approval

Still available in controlled mergers but controlled mergers may raise some distinct issues such as:

(1) Whether the practical context of a parent subsidiary merger offers reasons for the legal system to be even more suspicious of the efficiency of these procedural devices

(2) What a well-functioning special committee of independent directors entails

-what powers, what advisors and what degree of independence should the committee have

(3) What effect is to be accorded the act of a well-functioning special committee in a controlled merger context

Kahn v. Lynch Communication Systems Inc. (Del. 1994)

Alcatel was a subsidiary of Alcatel SA who was in turn a subsidiary of CGE

Alcatel owned about 43% of Lynch which game them a significant interest, but not majority control

Lynch’s management recommended they buy a company called Telco. Alcatel opposed the purchase and suggested that Lynch acquire a similar company called Celwave (which was a CGE subsidiary)

Lynch’s CEO Dertinger put together an independent committee (IC) to evaluate a possible purchase of Celwave, which ultimately recommended not buying Celwave

Alcatel responded by proposing to buy up the rest of Lynch’s stock in a cash-out merger. $14 per share was proposed, but the IC found that to be too low and suggested $17.

Alcatel issued the IC an ultimatum, either accept $15.50 per share or Alcatel would proceed with a hostile takeover at a much lower price

The IC recommended Lynch take the $15.50 offer

Lynch shareholders led by Kahn sued arguing that Alcatel owed a fiduciary duty to the other shareholders and violated their duty by vetoing Lynch’s acquisition of Telco and forcing the cash-out merger. Alcatel argued that they owned less than 50% of Lynch’s stock, there was no majoritarian ownership and therefore owed no fiduciary duty

Trial Court found for Alcatel, Kahn appealed

Trail court held that Lynch’s non-Alcatel directors deferred to Alcatel because of its position as a significant stockholder and not because their business judgment told them Alactel’s position was correct; found that the IC’s actions were “sufficiently well informed and aggressive to simulate an arms-length transaction”

Appellate Court rev’d, remanded; found two aspects to entire fairness:

1)fair dealing: includes considerations of when the transaction was timed, how it was initiated, structured and negotiated, how it was disclosed to directors, and how the approvals of the directors and shareholders were obtained

2) fair price: includes economic and financial considerations of the merger, including assets, market value earnings future prospects and other things that could affect stock price

Court found that existence of an IC is evidence of fair dealing, however if the maj. Shareholder dictates the terms of the merger or the IC does not have real bargaining power then that is evidence that there was not fair dealing; court held that the facts at issue here were strongly indicating that there was no fair dealing

Court remanded to TC placing the burden on Alcatel to show the transaction met the test of entire fairness; Court found that the controlling stockholder has “the initial burden of establishing entire fairness…however, an approval of the transaction by an IC of directors or an informed maj. of minority shareholders shifts the burden of proof on the issue of fairness from the controlling or dominating shareholder to the challenging shareholder-plaintiff”

On remand, the TC again found for Alcatel, Kahn appealed

The trial court looked to Weinberger and found that the transaction met the relevant factors (e.g. timing, structure etc.)

Appellate Court Aff’d

The Appellate Court found that there was fair dealing because all the Lynch shareholders were treated equally, and the independent committee did have at least some power to negotiate price ($14 to $15.50).

The Court found that there was fair price. Both Alcatel and Kahn had presented evidence of what the price should be, and the Trial Court thought that Alcatel's accounting method was more persuasive.

For Exam Know: making it impossible for them to walk away is not fair, this is the law in DE

12.10.3 Special Committees of Independent Directors in Controlled Mergers

Courts can either:

(1)Treat special committee’s decisions as that of a disinterested and independent board, which merits review under the deferential BJR

-this approach assumes that courts are better judges of the integrity of the process than of the merits of a deal

(2)Continue to apply the entire fairness test, even if the committee appears to have acted with integrity, since a court cannot easily evaluate whether subtle pressure or feelings of solidarity have unduly affected the outcome of the committee’s deliberation

Lynch held that independent committee’s approval of a transaction with a 43% shareholder had no effect at all, given the controlling shareholder’s conduct ; Dicta of Lynch states that even a truly independent committee decision could only shift the burden of proving the unfairness of the transaction to the plaintiff’s

In re Western National Corp. Shareholders litigation

Shareholder plaintiffs attacked the fairness of a merger between Western National Corp. (WNC) and American General Corp. (AGC)(46% shareholder of Western National)

AGC offered $29.75 a share; Preannouncement price of WNC was $28.19 a share; Due to a “standstill agreement” between the WNC & AGC, AGC was limited to nomination of two of WNC’s eight directors; (3 of the remaining directors were officers of WNC and three were unaffiliated outside directors).

3 nonaffiliated directors suggested that WGC should be sold; AGC responded that it would not vote for any sale transaction; Thus the independent directors were left with a single potential buyer AGC with whom they subsequently negotiated a merger that was the subject of litigation.

Shareholders attacked the deal as unfair; DE chancellor held BJR applied since AGC was not a controlling shareholder (i.e. the court respected the independent board committee the same as if they had engaged in an arm’s length transaction

Take Away: “standstill agreements” can determine whether a large shareholder will be treated as a controlling shareholder when a court assesses the action of independent director committees

12.10.4 Controlling Shareholder Fiduciary Duty on the First Step of a Two-Step Tender Offer

In the event a controlling shareholder “offers” a transaction to a board, which then accepts the offer through its independent directors Lynch holds that the controlling shareholder must still pay a fair price, although the burden lies with an objecting shareholder to prove its price unfair

shareholder has duty under corporate and federal securities law to disclose all material info. respecting an offer directly offered from a controlling shareholder; There is no federal law duty to pay a “fair” price; Furthermore there is no duty under fiduciary principles

as long as an offer is not “coercive” (Controlling shareholder threatens to stop paying dividends if you don’t sell) entering into such a transaction is voluntary on the part of the minority shareholders

In re Pure Resources, Inc., Shareholders Litigation (2002)

Facts:

Plaintiffs sought to enjoin an exchange offer by Unocal Corporation (Unocal) who held 65% of the shares of Pure Resources, Inc. (Pure), for Pure’s remaining shares. Pure’s CEO Hightower, held 6.1% of its shares; Pure’s managers in aggregate held between a quarter and a third of its non-Unocal stock.

Voting Agreement Stated:

Pure’s eight member board had five Unocal designees, two Hightower designees and one joint designee.

If Unocal obtained more than 85% of Pure’s shares Pure’s mgmt. shareholders had certain put rights that other minority shareholders did not have.

Unocal initiated a surprise exchange offer for Pure’s minority shares at a 27% market price premium, contingent upon increasing Unocal’s ownership to 90% of Pure’s shares; Offer was announced by Letter to Pure’s board and by oral presentation by Ling and Chessum (Pure directors who were also Unocal’s President and Treasurer). Pure created a Special Committee comprised of Covington (joint designee) and Williamson (Unocal designee with no material ties to Unocal) Special committee hired investment banking firms “First Boston” and “Petrie” to advise it

Special Committee’s responsibilities were narrowly drawn: (i) study the offer; (ii) negotiate with Unocal; (iii) and make a Rule 14D-9 recommendation to Pure’s minority shareholders. Special Committee did not seek/obtain a poison pill that might have given it a veto power over Unocal’s exchange offer. Special committee did vigorously seek a higher exchange ratio than the ratio Unocal had originally proposed; Unocal did not increase its proffered consideration and Special Committee voted not to recommend Unocal’s offer to Pure’s minority shareholders based on the financial advisors’ advice; Unocal decided to launch its offer in the face of opposition by Pure’s Special Committee.

Shareholders argued that the Offer should be governed by the entire fairness standard of review; argue Pure board breached fiduciary duties by not giving the Special Committee the power to block the offer by deploying a poison pill

Issue: What equitable standard of fiduciary conduct applies when a controlling shareholder seeks to acquire the rest of the company’s shares?

Holding: Court applies the Solomon Line of cases.

Reasoning:

(i) Lynch line of cases applies to situations where controlling stockholders negotiate a merger agreement with the target board to buy out the minority; law emphasizes protection of minority stockholders against unfairness

(ii) Solomon Line of cases applies to when a controlling stockholder seeks to acquire the rest of the company’s shares through a tender offer followed by a short-form merger; DE case law facilitates the free flow of capital between willing buyers and willing sellers of shares, so long as the consent of the sellers is not procured by inadequate or misleading information or by wrongful compulsion

Solomon line of cases does not eliminate the fiduciary duties of controlling stockholders or target boards in connection with tender offers made by controlling stockholders

Our law should consider an acquisition tender offer by a controlling stockholder non-coercive only when (1) it is subject to a non-waivable majority of the minority tender condition; (2) the controlling stockholder promises to consummate a prompt Section 253 merger at the same price if it obtains more than 90% of the shares; and (3) the controlling stockholder has made no retributive threats;

goal of the above is to minimize distorting influence of the tendering process on voluntary choice

Regarding P’s Poison Pill Argument:

the court is reluctant to add a new rule to the common law of corporations that would compel the a device that the statutory law only obliquely sanctions and is subject to misuse

Regarding Coerciveness of the Offer:

Unocal’s offer was coercive since it includes within the definition of the “minority” those stockholders who are affiliated with Unocal as directors and officers; It also includes the management of Pure, whose incentives are skewed by their employment, their severance agreements and their Put agreements; court advises Unocal to amend the Offer to condition it on approval of a majority of Pure’s unaffiliated stockholders.

Court concludes that Unocal’s Offer satisfies the other requirements of “non-coerciveness” ; and that plaintiffs do not have a probability of success on the merits of their attack on the Offer, with the exception that the majority of the minority condition is flawed.

Plaintiff’s Disclosure Claims:

Plaintiffs argued that neither of the disclosure documents provided to the Pure stockholders made materially complete and accurate disclosure

When controlling stockholders make tender offers they have large informational advantages that can only be imperfectly overcome by the special committee process which almost invariably involves directors who are not involved in the day-to-day management of the subsidiary; financial advisors serves to offset this imbalance

Court concludes that the balance of hardships favors the issuance of a preliminary injunction

Class Notes: if you go straight to shareholder

Pure Resources deals with using board to procure tender offers

3 elements for tender offer, point it to make sure it’s voluntary tender offer [Solomon Line of cases]; if go straight to shareholder have no burden; tender offers are easier then an attempt at a merger regarding fiduciary duties;

P’s disclosure claim, P’s said they weren’t told enough info. on how to vote; claimed they were coerced; court says that the internal report (or external), that was used to convince minority shareholders to approve a tender offer, you can’t just provide the conclusion; Pure Resources stands for the principle that you have to provide the full report to shareholders, so they can decide if the price is fair; this is so institutional investors have the capacity to provide the report, the reporting isn’t for individual shareholders

13. Public Contests for Corporate Control

13.1 Introduction

Control Contests good for acquiring managers, unpleasant for incumbent managers

Thus control contests are generally an important potential constraint on manager-shareholder agency costs

Two Traditional Avenues for Opening Hostile Change in Control:

1). Proxy contest: running an insurgent slate of candidates for election to the board; often costly and unsuccessful [popular pre-1960’s]

2). Tender offer: purchasing enough stock oneself to obtain voting control rather than soliciting the proxies of others [popular post-1960]

Courts reviewed board’s responses to contest for control at the outset just as they would review any other corporate action; i.e. they would look to see if the response were self-interested, if so the board would be required to demonstrate that it was intrinsically fair, otherwise it would be reviewed under the BJR

DE Supreme Court began grappling with the complexities of the boards duties in contests for corporate control in a series of three cases argued in 1985 which together set the framework for analysis of director’s fiduciary duties in M&A transactions and for defenses against hostile takeovers:

1). Smith v. Van Gorkom: arose out of friendly two-step acquisition consisting of a cash tender offer followed by a cash-out merger. case is about corporate director’s duty of care; court held entire board liable for “gross negligence” under circumstances most experts would have said its directors had met their standard of care

2). Unocal Corp. v. Mesa Petroleum Co.: dealt with Unocal’s board’s efforts to defend against a hostile tender offer; articulated the first standard of judicial review intermediate between lax business judgment review and tough entire fairness review to address board efforts to defend against a threatened change-in-control transaction

3). Revlon v. MacAndrews and Forbes Holdings, Inc. addressed the efforts of an incumbent board to resist an unwelcome takeover; Revlon’s board attempted to resist by pursuing an alternative transaction, which is the focus of the case; court adopted a form of heightened review short of intrinsic fairness

Two Earlier Cases that Sought to Introduce Flexibility into the BJR/EF dichotomy:

1. Cheff v. Mathes: 1964 DE SC opinion in which shareholders attacked a corporate repurchase at a premium price of all the stock belonging to a dissident shareholder/director. Court agreed that the repurchase had the effect of securing the directors in control but held that as long as the board’s primary purpose was to advance business policies the buyback did not violate the board’s fiduciary duty

2. Schnell v. Chris-Craft Industries: found a breach of fiduciary duty when a “disinterested” board advanced the date of the company’s annual meeting as it was permitted to do by statute solely t in order to make a hostile proxy solicitation impossible to mount.

Cheff and Schnell dealt intelligently with a board’s use of corporate power to maintain control, neither case afforded useful doctrinal tools for examining entrenchment measures more generally. Private legal innovation such as the poison pill has made most state takeover legislation as well as much of the Williams Act very much less significant.

13.2 Defending Against Hostile Tender Offers

Unocal Corp. v. Mesa Petroleum Co. (Del. 1985)

Facts:

Mesa made a hostile takeover bid (aka a tender offer) for Unocal for $54 a share

Mesa warned that if people didn’t take the offer, and Mesa got control of Unocal mesa would forcibly cash-out all those who wouldn’t sell, but instead of cash they’d get risky junk bonds in exchange for their stock.

In response, Unocal’s directors offered to repurchase its stock from shareholders for $72 a share (aka a self-tender offer) but excluded Mesa from the offer; since shareholders would rather sell their stock to Unocal for $72 than Mesa for $54, the deal ensured that Unocal would not be owned by Mesa. However, it did incur a lot of debt.

Unocal is taking away the threat by stating that if Mesa takes 51% control at their listed $54 price, Unocal will offer $72 per share for any remaining stock; this makes people want to wait to have their co-stockholders buy up the $54 offer, so they can cash in higher at $72 later on

Mesa sued; Mesa argued that the Unocal directors were acting not in the best interest of the corporation, but solely to save their jobs as directors; the directors argued that their actions were covered by the BJR

BJR requires a threshold:

-(i) directors must perceive a threat & (ii) response must be reasonable

Procedural:

Trial Court found for Mesa; directors appealed; trial court found that a selective exchange (aka offering to buy stock from everyone except Mesa) was not allowed under DE law because it discriminates among existing shareholders and that fails the fairness test

DE SC reversed;

Issue: Did Unocal’s directors have reasonable grounds for believing Mesa represented a danger to the Unocal’s shareholders if they took over?

Holding: Yes, Unocal directors had a defensible position.

Reasoning:

DESC noted that there is an inherent conflict of interest when directors use a takeover defense to stop someone like Mesa from taking over the corporation; the court found that when there is a takeover defense the directors are under an “enhanced duty” to show that their decisions are meant to further the welfare of the corporation and not just to protect their jobs; basically, in order to benefit from the BJR directors must demonstrate that it was responding to a legitimate threat to corporate policy and effectiveness and that is actions were “reasonable in relation to the threat posed” Note that this is an intermediate test partway between the standard BJR and the EFT

In this case the Court found that Unocal’s directors had reasonable grounds for believing that Mesa represented a danger to the continued existence of Unocal, and if Mesa took over, there would be a serious risk to the shareholders. Therefore their takeover defense was allowed under the “enhanced duty” BJR; basically this case said

that there is a two pronged test that directors must satisfy when they take action to deter a potential hostile takeover:

(i): directors must have reasonable grounds to believe that a danger to corporate policy and effectiveness exists and;

(ii): that the defensive measure adopted is proportionate to the threat posed

Class Notes:

Page 518, factors to consider when it comes to whether or not the response was reasonable

Impact on constituencies other than shareholders, aka community at large, employees etc.

any time you attack a defensive measure Unocal will be applied (1) act in good faith (2) only after informing themselves (3) perceive a danger (4) respond reasonably

if directors don’t meet their burden BJR is out and back to fairness;

was the Risk reasonable? if yes we have a question of bad faith or failure to inform; if no case is dismissed

if risk was not reasonable we go straight to ask was it fair

Unitrin v. American General Corp.

American General Corp tendered an offer for a controlling block of shares of Unitrin. The Board of Directors of Unitrin, who held 23% of the shares, did not think the price offered was adequate and so initiated a poison pill and offered a buyback to increase their holdings to 28% of the total shares.

The trial court found that the offer represented a threat of "substantial coercion", and based on the Unocal v. Mesa Petroleum test, the poison pill was reasonable but the repurchase was not. The issue before the Supreme Court of Delaware was whether the repurchasing was a reasonable reaction to American General's threat.

The Supreme Court found that the lower court erred in applying the Unocal standard. The court must first determine whether the defensive measure is draconian in that it has the effect of precluding or coercing shareholders choice. Only after that determination should the inquiry shift to whether the measure is within the range of reasonableness in response to the perceived threat.

Take Aways:

1. Unocal/Unitrin show that the target’s directors, not the plaintiff, bear the burden of going forward with evidence to show that the defensive action was proportionate to a threat

2. Action that is “preclusive” or “coercive” will fail to satisfy Unocal’s test

3. Assuming that a defensive measure passes the preclusive/coercive test (that it is not “draconian”) then it will satisfy Unocal so long as it is “within a range of reasonable action” Properly understood this last aspect of the test is operationally similar to the business judgment rule: an action will be sustained if it is attributable to any reasonable judgment; it will not matter if the court would have regarded some other action as more reasonable

13.3 Private law Innovation: The Poison Pill

Poison Pills came about as a way to empower the board to act as a bargaining agent for shareholders in tender offers.

Shareholders’ rights plans take the form of capital instruments: rights to buy a capital asset, such as a bond, common share, or preferred share. The real function is to alter the allocation of power between shareholders and boards

Person whose stock acquisition triggers the exercise of the rights is herself (or in the case of a corporation itself) excluded from buying discounted stock. Thus her holdings are severely diluted; she will end up losing the greatest part, perhaps most, of her investment in the company stock. Result is that buying a substantial block of stock without the prior consent of the target’s board will be ruinously expensive. This effect gives the board the practical power to veto a tender offer, just as it is able to veto a merger or asset sale under the corporation law.

Flip-over:

A flip-over is one of five types of poison pills in which current shareholders of a targeted firm will have the option to purchase discounted stock after the potential takeover. The strategy gave a common stock dividend in the form of rights to acquire the firm's common stock or preferred stock under market value. Following a takeover, the rights would "flip over" and allow the current shareholder to purchase the unfriendly competitor's shares at a discount. If this tool is exercised, the number of shares held by the unfriendly competitors will realize dilution and price devaluation.

Flip-in:

The flip-in is a provision in the target company's corporate charter or bylaws. The provision gives current shareholders of a targeted company, other than the hostile acquirer, rights to purchase additional stocks in the targeted company at a discount. These rights to purchase occur only before a potential takeover, and when the acquirer surpasses a certain threshold point of obtaining outstanding shares (usually 20 - 50%). If the potential acquirer triggers a poison pill by accumulating more than the threshold level of shares, it risks discriminatory dilution in the target company. The threshold level therefore effectively sets a ceiling on the amount of stock that any shareholder can accumulate before being required, for practical purposes, to launch a proxy contest.

Moran v. Household International, Inc. (Del. 1985)

Facts: Household International’s directors adopted the Rights Plan a “flip-over poison pill” designed to discourage hostile takeovers. Under the plan Household’s shareholders automatically acquired the option to buy at 50% discount shares of any corporation that successfully gained control of Household in a hostile takeover. Moran challenged the directors’ authority to adopt the plan

Issues: Should the adoption of the Plan be reviewed under the BJR?

Holding: Yes, the adoption of the plan should be reviewed under the BJR.

Reasoning: Since the plan is designed to facilitate the exercise of BJ by forestalling situations in which a hostile takeover may force the directors to make a hasty decision, the adoption of the plan should be reviewed under the BJR. DE general corp. law contains no restrictions on the creation of poison pills. furthermore, poison pills tend to incur fewer costs than other means of warding off hostile takeovers. The plan does not preclude Households shareholders from accepting a hostile tender offer as certain maneuvers can allow a determined purchaser can overcome the plan. Finally fiduciary duties constrain the use of the plan, as household’s directors may not use the plan to frustrate at transaction that would benefit shareholders.

Class Notes:

court thinks this is a mild pill, and therefore okay; if there is a resasonble perceived overall threat

after moran you don’t need a “specific threat’ just a broad “well there are a lot of takeovers going on today” to be sufficient

if a director is using a poison pill it is likely saying that the directors are bad at what they do; it’s like admitting “well we’re at risk of getting taken over, so let’s prevent that from happening”

a mild pill will be a reasonable rsesponse toa threat of a “general” takeover

if there were a specific threat, we can still consider this, stare decisis will not apply

13.4 Choosing a Merger or Buyout Partner: Revlon, Its Sequels and Its Prequels

Smith v. Van Gorkom (Del. 1985)

Facts:Marmon was attempting a leveraged buy-out of TransUnion. TransUnion's CEO, Van Gorkom proposed a price of $55 a share. Van Gorkom and his CFO didn't bother to do any research to see how much the company was actually worth. He didn't even inform TransUnion's legal department about the transaction. $55 a share was only about 60% of what the company was later appraised at. In Van Gorkom's defense, at the time of the merger, the stock was only selling for $37.25 a share, so $55 seemed like a lot.

Van Gorkom called an emergency meeting of the board of directors, proposed the merger, and the directors gave preliminary approval. Van Gorkom failed to disclose a number of things at the board meeting where the vote was taken, including the fact that there was no basis for the $55 price, and that there had been objections by TransUnion management regarding the merger. Van Gorkom didn't even provide the directors with copies of the merger agreement. In short, there was some wheeling and dealing and the directors eventually wound up recommending that the shareholders approve the merger, even though the directors never really bothered to learn if the terms of the merger were a good deal for the company or not. Some shareholders instituted a derivative lawsuit against the directors for breach of fiduciary duty.

Procedural: Trial Court found for Van Gorkom on grounds that Van Gorkom’s actions were justifiable in view of the BJR. The shareholders appealed.

Issue: Did Van Gorkom breach his fiduciary duties as director?

Holding: Yes.

Reasoning:

The Appellate Court reversed. The Appellate Court found that the directors were grossly negligent because they approved the merger without substantial inquiry or any expert advice. Therefore they breached their duty of care. The Court found that the directors breached their fiduciary duty by their failure to inform themselves of all information reasonably available to them and relevant to their decision to recommend the merger, and The Court found that there was a failure to disclose all material information such as a reasonable stockholder would consider important in deciding whether to approve the merger. The Court

found that Van Gorkom breached his duty to care by offering $55 a share because, "the record is devoid of any competent evidence that $55 represented the per share intrinsic value of the Company." The Court found that the BJR was not a defense because the directors and Van Gorkom didn't use any "business judgment" when they came to their decision. "The rule itself 'is a presumption that in making a business decision, the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.' ...Thus, the party attacking a board decision as uninformed must rebut the presumption that its business judgment was an informed one." "Under the business judgment rule there is no protection for directors who have made an unintelligent or unadvised judgment." Basically, the actual decision is not so important, what the courts will look to is whether there was an adequate decision-making process.

In this case, the Court basically said that in order to hide behind the BJR, you have to show that you made an informed decision based on some principle of business. If you pull numbers out of thin air or cast votes without doing due diligence, then the courts can overturn your decisions. The idea behind the BJR is that people who work in the business have more experience and are better judges of what a corporation should do than a court would be. But when businessmen show that they didn't use any of that experience to make a decision, then there is no reason for the courts to defer to them.

Class Notes:

fairness requires: procedure must be fair and the price must be fair

market test: put com. out on market to see if you can generate other bids; this at least helps to generate what a fair price would be

actually have to let the market decide a fair price;

Jay Pritzker & Jermoe Van Gorkom Sidebar Page 539

Pritzker was grandson of Ukranian immigrants, whose parents becaume established in the Chicago business scene; Pritzker graduated high school at 14 and went to NW university, after a law degree and WWII service he returned to form the Marmon Group, that bought underperforming industrilzied businesses, made him a billionaire. While at a ski chalet in the swiss alps he met Van Gorkom CEO of trans union, their friendship led to this suit above.

Note on Smith v. Van Gorkom

Smith was a jolting break in the tradition of courts allowing disinterested director’s their regular business discretion to make regular decisions. Professors Jonathan Macey and Geoffrey Miller state that Van Gorkom should be understood not as a director negligence case but rather as the first of several important cases in which the court struggled to construct a new standard of judicial review of “change in control” transactions such as mergers.

Note: Introducing the Revlon Decision

Revlon mgmt. opposed the takeover using two defensive tactics:

1. It adopted a form of flip-in rights plan as described above

2. It repurchased 20 percent of Revlon’s stock with unsecured debt at a premium price,

Repurchase had two useful effects:

1. Notes clouded Revlon’s balance sheet and thus made it harder for Perelman to find financing to support his buyout, and;

2. The notes gave management a vehicle for inserting a covenant that barred Revlon from selling or encumbering its assets w/out the approval of its independent directors.

Revlon’s mgmt. attempted to solicit a competing bid from a friendly bidder (Frostmann). In order for the strategy to take Revlon had to remove the restrictive covenant contained in the notes that it had exchanged with its shareholders, since this covenant not only interfered with Perelman’s financing but also precluded friendly bidder from financing the new alternative transaction.

Stripping the restrictive covenant from the Notes sharply lowered their value, within days lawyers representing Revlon’s note holders threatened to sue the board for bad faith and breach of duty

Revlon made a final deal with Frostmann providing a “lock-up option” to purchase Revlon’s most valuable assets at a bargain price if another bidder (i.e. Perelman) were to acquire more than 40 percent of Revlon’s stock; in exchange Frostmann would increase its offer for Revlon’s stock to $57.25 and support the price of Revlon’s notes (thus satisfying claims of note holders)

DESC firmly rejected what it considered to be Revlon’s attempt to “rig” the bidding holding that when the sale of the co. became “inevitable” “the director’s role changed from defenders of the corporate bastion to auctioneers charged with getting the best price for the stockholders at a sale of the co.”

White Knight: late coming competitive bidder that will rescue a corp. from their woes;

Revlon Inc. v. MacAndrews and Forbes Holdings Inc.

Facts:

See above

Issue: Did the directors breach their primary duty of loyalty?

Holding: Yes.

Reasoning:

A board may have regard for various constituencies in discharging its responsibilities, provided there are rationally related benefits accruing to the stockholders [Unocal]; however, such concern for non-stockholder interests is inappropriate when an auction among active bidders is in progress and the object no longer is to protect or maintain the corporate enterprise but to sell it to the highest bidder; Nothing remained for Revlon to legitimately protect, and no rationally related benefit thereby accrued to the stockholders

Revlon’s directors owed a fiduciary duty to the shareholders and the corporation, but once it was evident that Revlon would be bought by a third party the directors had a duty solely to the shareholders to get the best price for their shares. Any duty to the note holders is outweighed by the duty to shareholders. By preventing the auction between Pantry Pride and any other bidders, the directors did not maximize the potential price for shareholders; essentially Unocal duties don’t extend to a corporation once it is determined to be sold

ClassNotes:

decision to sell by board is a pivotal moment since now their only goal is to maximize share price

at moment corporation is detrmined to be sold, no more “corporate vision” only thing left is to act as an auctioneer

Unical still applies, but you are allowed to implement all these measures; but minute you decide to sell your only responsibility is to maximize shareholder’s received payout

Revlon applies when decision to sell has been made

tell someone no if a company wants to feed you confidential data; favored bidder does all the work and the nonfavored can free ride

Ronald Perelman & Ted Forstmann Sidebar Page 544

Perelman was born into a wealthy Philly family, as a child Perelman would sit in on his dad’s corporate board meetings, went on to graduate from UPENN, made a living in NY buying underperforming co.’s and selling off their assets; this made him a billionaire.

Forstmann started a firm that innovated leveraged buyouts; when junk bonds became popular, Forstmann found he wasn’t able to raise money as fast as junk bond backed competitors; infamously attacked junk bond industry as greedy in a WSJ article

13.5 Pulling Together Unocal and Revlon

Paramount Communications, Inc. v. Time Inc. (Del. 1989)

Facts: Time decided to seek a merger or acquire a company to expand their enterprise. After researching several options, Time decided to combine with Warner. Time was known for its record of respectable journalism, and Warner was known for its entertainment programming. Time wanted to partner with a company that would ensure that Time would be able to keep their journalistic integrity post-merger. The plan called for Time’s president to serve as CEO while Warner shareholders would own 62% of Time’s stock. Time was concerned that other parties may consider this merger as a sale of Time, and therefore Time’s board enacted several defensive tactics, such as a no-shop clause, that would make them unattractive to a third party. In response to the merger talks, Paramount made a competing offer of $175 per share which was raised at one point to $200. Time was concerned that the journalistic integrity would be in jeopardy under Paramount’s ownership, and they believed that shareholders would not understand why Warner was a better suitor. Paramount then brought this action to prevent the Time-Warner merger, arguing that Time put itself up for sale and under the Revlon holding the directors were required to act solely to maximize the shareholders’ profit. Plaintiffs also argued that the merger failed the Unocal test because Time’s directors did not act in a reasonable manner. Plaintiffs, Paramount Communications, Inc. et al., sought to enjoin Defendants, Time, Inc. et al., from moving forward with a tender offer for 51% of the shares of Warner Communications, Inc. Paramount made its own bid to acquire control of Time.

Issue: Whether Time’s proposed merger acts as a sale of Time that would trigger a Revlon analysis that would render the merger invalid?

Holding: Time was not perceived to be determined to sell itself, so the court applied Unocal analysis.

Reasoning: The Delaware Supreme Court affirmed the lower court’s holding in Defendant’s favor. The court distinguished the Revlon decision as concerning a company that already was determined to sell itself off to the highest bidder, and therefore the only duty owed at that point was to the shareholders. In this case, Time only looked as if it were for sale as it moved forward on a long-term expansion plan. Various facts, such as Time’s insistence on ensuring the journalistic independence and its temporary holding of the CEO position, illustrated that the directors were not simply selling off assets. Once it was determined that the directors’ decision passed the Revlon test, the Unocal test was applied. The directors also passed the higher standard called for in Unocal to directors who are rebuffing a potential buyer. The directors reasonably believed, after researching several companies, that a merger with Warner made the most sense as far as future opportunities and maintaining their journalistic credibility.

The court has now applied a dual Revlon/Unocal test to determine if the directors acted reasonably. Once it is determined that a company is not simply putting itself up for sale, then the courts will apply the Unocal standard.

In brief, directors are not required to favor a short-term shareholder profit over an ongoing long-term corporate plan as long as there is a reasonable basis to maintain the corporate plan.

Class Notes:When sale becomes inevitable (board will say so); fact that someone wants to buy you doesn’t invoke Revlon; it matters that the board has opened itself up for sale

Paramount I: engaged in merger is not enough to trigger Revlon duties; Revlon duty is only triggered when you abandon your corporate vision; at that point you can’t implement defensive measures that impede the bidding process

Paramount II (qvc): paramount wanted to sell itself to Viacom, at that point they had decided to sell, and therefore would have triggered Revlon; since defensive measures are intended to chill the bidding process, but in Paramount II it didn’t actually chill the bidding; can’t keep defensive measures that might chill the bidding process (i.e. preclude someone from bidding); your duty at this point is just to sell at the highest value for your shareholders;

In the market, so no controlling shareholder;

Paramount Communications Inc. v. QVC Network Inc (Del. 1994)

Facts: Paramount was looking for possible merger or acquisition targets in order to remain competitive in their field. The CEO of Paramount had a meeting with the CEO of Viacom wherein they discussed Paramount merging into Viacom. The discussions hit a dead end until QVC sought to acquire Paramount. The discussions between QVC and Paramount were renewed, and the parties entered a merger agreement that had several defensive measures to prevent other companies, namely QVC, from bidding against Viacom.

Defensive measures included: (i) a no-shop provision that prevented Paramount from soliciting other bidders; (ii) a termination fee provision that paid Viacom $100 million if they were eventually outbid; and (iii) a stock option provision that allowed Viacom to purchase 19.9% of Paramount’s shares at $69.14 per share. The stock option provision also allowed Viacom to pay for the stock in subordinated notes or Viacom could elect to get a cash payout for the difference between the option price and market price. The stock

option was significant because Paramount’s shares rose sharply and would have led at one point to a $500 million payout to Viacom if the merger fell through. QVC started bidding against Viacom’s offer which forced Viacom to renegotiate with Paramount to raise their offer – although the defensive measures were never renegotiated. QVC raised their offer even further, but the Paramount believed that the offer was too conditional (similar to Viacom’s offer, it was two-tiered) and the board still felt that the merger was not in the company’s best interests. Therefore, the Paramount board turned down a QVC offer that could have been about $1 billion more than Viacom’s offer.

Procedural:

QVC successfully enjoined Paramount from carrying out the merger agreement, Paramount appealed.

Issue: Whether the Paramount board violated their fiduciary duty to shareholders by not fully considering the QVC offer.

Held: Defensive provisions removed fiduciary duties to shareholders and therefore violated the board’s duties.

DESC stated that the merger between Paramount and Viacom should be enjoined, and that the merger agreement between Paramount and Viacom was invalid. Defendants argued that they were under no obligation to seek the maximum value for shareholders under the Revlon rule because there was no breakup of the company, but the court determined that the company was shifting its control to another entity and therefore the sale of Paramount reached the point to where the prime concern for the Paramount directors was to maximize shareholder value. Paramount was under no contractual obligation to avoid discussions with QVC because the merger agreement between Viacom and Paramount was invalid. Paramount could not contract to remove their fiduciary duties to shareholders, and the defensive provisions had that effect.

The court looked at what the shareholders would be losing if Paramount was acquired, and with Viacom, unlike the case between Time and Warner in Paramount Communication, Inc. v. Time, Inc., the Paramount shareholders would lose complete control. Therefore there was a heightened scrutiny of the directors’ actions when seeking a merger.

In brief, a merger agreement between a target company and an acquiring company that restricts the target company’s directors from upholding their fiduciary duties owed to their shareholders is invalid.

Barry Diller & Sumner Redstone Sidebar Page 564

Barry Diller dropped out of UCLA, working in the mailroom of talent agency William Morris; from there he became VP of primetime programming for ABC; he went on to be CEO of paramount, then went to Fox; he shocked the corporate world to go work for QVC, from where he would mount his attack on former employer paramount

Redstone was a Harvard Law grad.; took over his family’s movie chain, and making investments in Hollywood, all the while teaching classes at Harvard; his hostile takeovers of Viacom and subsequent acquisitions of cable, tv and radio left him yearning for a movie studio; this led to the bitter battle with former friend Diller over Paramount

Problem page 566

Xenor corp. wants to acquire T Corp.; must T’s board treat Xenor’s offer as a Revlon transaction?

(see additional facts on page 566)

Approach to Problem page 566

Revlon duties are based on the assumption that BoDs are better able to value a Co.’s than are shareholders – but -- in some circumstances boards must maximize short-term value, since this is the only value that shareholders are likely to receive; courts defer to boards when all-stock deals between two companies the same size, since courts feel BoD has substantial advantage over shareholders in evaluating long-term value of surviving co. as well as long-term value of the merger consideration; in cash deals courts will not defer, in stock-for-stock mergers of equals they will defer a great deal

In short, the more opportunity there is for a directorial informational advantage the more deference is likely

Back to Xenor problem, the board will need to be prepared to explain its decision…

Lyondell Chemical Co. v. Ryan (Del. 2009)

Facts:

Basell (corp.) was interested in buying Lyondell. They made an offer but Lyondell’s directors refused saying that they were not interested in selling; Basell eventually raised their offer price from $26.50 a share to $48 a share. Lyondell’s directors met several times to consider the offer and voted to recommend the merger to the shareholders; The directors hired a financial analyst who found $48 to be a great deal for Lyondell.

Shareholders voted to approve the merger. Some shareholders who didn’t like the deal started a derivative lawsuit; shareholders led by Ryan argued that the directors had breached their fiduciary duties by not attempting to obtain the best possible price for the corp.; Directors never solicited offers from anyone else, which might have bid up the price; the directors had a provision in Lyondell’s charter that exculpated them from breaches of the duty of care, so Ryan would have to show that they breached the duty of loyalty (hard to prove); that requires a showing that they were motivated by self-interest or ill will and failed to act in good faith

Procedural: Trial Court found for Ryan, Lyondell appealed; Trial Court found that based on Revlon duties, Ryan had established enough of a case that Lyondell was denied summary judgment.

Issue: Did the Lyondell directors breach their fiduciary duty by not seeking out competitive bids?

Holding: No, directors used business judgment to realize Basell

Reasoning:

DESC reversed and found for Lyondell on Summary Judgment; Revlon said that when a corp. is definitely up for sale, the directors are under an obligation (aka Revlon duties) to get the best possible price; DESC found that Revlon duties do not require the directors to seek out competing bids only that they get the best price; Court found that the directors had a good idea of what their corp. was worth, and drove a hard bargain with the buyer. They acted in good faith to get what they believed was the best price. Therefore, under the BJR the court shouldn’t second guess how the directors came to their decision; Directors felt that Basell was making them an offer that was too good to pass up, so taking it immediately was better option than trying to shop the company around to a bunch of other people to see if they could get a higher price.

Class Notes:

Board said they’d consider the 48 per share, but need something more (i.e. put it in writing, how is this financed?)

when sale is inevitable, when the board decides they’re going to sell is when Revlon duties kick in.

Revlon duties & go-shop provisions are to foster competitive bidding; this will clear up at the beginning that you can go shop the co. around

-always a good idea to ask for a go-shop provision

having deutschebank review offers doesn’t kick in Revlon duties, they’re still deciding; go-shop provision

to prove breach of duty of loyalty, have to show not acting in good faith, have to show not independent, not interested etc. here there was no allegation of self interest, just alleged the price wasn’t fair

how does BJR sneak into Revlon duties?

Decision to negotiate is subject to BJR; BJR might be applied when deciding how to compete the bid; Revlon establishes a goal – to seek the best price for your shareholders—Revlon doesn’t mandate a specific way to get there or that you have to go with the highest dollar value. (still must be best price though).

-courts will give deference on how to arrive at best price and what constitutes the best price

-breach of a duty of care can be a breach of a duty of loyalty; breach of a duty of care that reaches some threshold will rise to breach of a duty of loyalty (escaping 102b7 waiver) but only if it is a complete and abject failure (i.e. egregious)

102b7 clause van gorkum , thing will be on exam

13.6 Protecting the Deal

“Lock-up”: any contract, collateral to an M&A transaction that is designed to increase the likelihood that the parties will be able to close the deal; two major types of lock ups are:

(i) Options to a target’s assets; and

-asset lockups create rights to acquire specific corporate assets that become exercisable after a triggering event (e.g. target shareholder vote disapproving a merger or a target board’s decision to sign an alternative merger agreement

-asset lockup has been virtually nonexistent since Revlon, which struck down an asset lock-up granted to Forstmann little

(ii) Options to a target’s stock;

-options to buy a block of securities of the target company’s stock at a stated price

Termination Fees/Breakup Fees:

Cash payments in the event that the seller elects to terminate the merger or otherwise fails to close; Often justified as necessary to compensate a friendly buyer for spending the time, money, and reputation to negotiate a deal with a target when a third party ultimately wins the target

Buyers rights under deal protective provisions are commonly triggered by:

(i) a failure of the board to recommend a negotiated deal to shareholders in light of the emergence of a higher offer

(ii) a rejection of the negotiated deal by a vote of the target’s shareholders or

(iii) a later sale of assets to another firm

A board decision not to recommend a negotiated acquisition is an accepted trigger for a termination payment

Class Notes:

Reasons for deal protections:

1. deterrence: keep away another potential bidder

2. compensation:

is no shop worth anything if there is a fiduciary out clause?

13.6.1 “No Shops/No Talks” and “Fiduciary Outs”

Buyers seek large lock-ups

they may seek certain covenants from the seller that will protect their deal (e.g. target ball will asked to promise (a) not to shop for alternative transactions or supply confidential information to alternative buyers (b) to submit the merger agreement to the shareholders for approval and (c) to recommend that shareholders approve this agreement; )

In general DESC will declare contracts unenforceable if they violate a fiduciary duty; contract damages may not ever be available against a corporation that abandons a transaction subject to Revlon duties on the grounds that a better deal is available;

Class Notes:

Unocal test applies whenever any defensive measure may be implicated (risk and reasonable response to that risk)

Under Revlon no shop/no talk probably doesn’t fly since you’re precluding a higher bid from anyone else

-termination fee will fly under Revlon; bigger termination fee the more likely will be to chill bidding, also may be unreasonable in regards to a defensive measure regarding Unocal

no shop/no talk only prevents actively soliciting bids, should bids come in unsolicited NSNT still disallows talking, but, fidicuary out clause allows you to talk to people if the bids do come in, this allows you to be compliant in your fiduciary duties

13.6.2 Shareholder Lock ups

Does a transaction constitute a “change in control”?

If the board’s process is deliberate and informed and the board is truly independent, the law must let the board make business decisions without fear of being second-guessed

When the transaction is a “change in control” that deference will be expressed in some form of heightened scrutiny; when not a Revlon transaction, deference may indeed be expressed in the language of the BJR

DE courts construing corporate law does not seem to mandate specific terms of merger agreements, but requires a process that is informed and honestly pursued in the interests of the corporation and its shareholders; Omnicare is an exception to this general rule

will be on exam

Omnicare Inc. v. NCS Healthcare, Inc. (Del. 2003)

Facts:

Omnicare offered to acquire NCS’ assets for $225 million (then to $270 finally to $313) in a bankruptcy sale, since Omnicare offered less than NCS’s outstanding debt, shareholders were to get nothing and creditors of NCS weren’t going to be fully paid off, negotiations between the two stalled. Then Genesis proposed a merger with NCS to pay off most of NCS’ creditors, plus a small return to NCS’ shareholders; NCS then formed a special committee of independent directors to conduct the negotiations; Genesis insisted on an exclusivity arrangement pursuant to which NCS would not conduct merger negotiations with any other potential bidder while NCS/Genesis negotiations were happening. Omnicare tried to reopen negotiations, but fearing a Genesis walkaway, NCS honored the exclusivity agreement. Genesis demanded deal protections consisting of: (i) termination fee of $6Mill (ii) NCS’ board agreed to submit the Genesis deal to a shareholder vote even if the board withdrew its recommendation that the shareholders approve the deal (iii) the agreement contained a no shop clause and (iv) Genesis insisted on a shareholder lockup. Genesis also insisted that NCS’ board chairman and CEO (who held 10 votes per share class b stock, and voting control) vote in favor of the merger; when Omnicare subsequently offered a higher price, Omnicare and NCS shareholders sued to invalidate the agreement.

Issue: Did the NCS directors breach their fiduciary duties by ratifying an agreement that left them with no fiduciary out, even though there was to be no change in control?

Holding: Yes, even though no change in control the board’s actions were not within the range of reasonableness under the circumstances and were invalid and unenforceable.

Reasoning:

DESC held that Unocal scrutiny applied (consistent with Paramount v. Time); DESC disagreed with court of chancery and said “ the record does not support the conclusion that the defensive devices adopted by the NCS board to protect the Genesis merger were reasonable and proportionate to the threat that NCS perceived form the potential loss of the Genesis transaction” since stockholders were forced to accept the Genesis merger because of the defenses approved by the NCS board (i.e. stockholders could have voted against merger, but based on stock class arrangements the maj. outweighed them); this coerciveness leads to Unocal’s enhanced judicial scrutiny; DESC said lack of a “fiduciary out” prevented the NCS board from discharging their fiduciary duties

Dissent: took issue that the court wasn’t leaving the director’s alone to exercise their best business judgment

dissent states maj.’s “new” rule as : “a merger agreement entered into after a market search, before any prospect of a topping bid has emerged, which locks up stockholder approval and does not contain a “fiduciary out” provision, is per se invalid when a later significant topping bid emerges”

bright line rule applies regardless of (1) circumstances leading up to the agreement and (2) the fact that stockholders who control voting power had irrevocably committed themselves, as stockholders to vote for the merger

thinks there was no meaningful minority stockholder voting decision to coerce

Class Notes:

competitive bidding had already been held; court won’t require you to go back and try competitive bidding again. not require to indefinitely continue search

if you’re going to apply Unocal, first look to see what the threat is (here it was the threat of a loss of the genesis transaction)

if you take away shareholders right to choose, that is coercions under Omnicare

Take Away: when you don’t have a choice (had a fiduciary responsibility to withhold vote since predetermined outcome, but had contractual duty to submit it to shareholders) adopt the fiduciary out clause; i.e. it is required to have a fiduciary out clause

if outcome is predetermined, board may have a duty to not submit it to the shareholders; court isn’t specific as tho how far this rule should go; you were wrong to submit it the shareholders since the outcome was predetermined (not clear what this means)

13.7 State Antitakeover Statutes

13.7.1 First and Second Generation Antitakeover Statutes

First generation statutes, such as the Williams Act, addressed disclosure and fairness concerns and was generally limited to attempted tak-overs of companies with a connection to the enacting state. It required that any offer for the shares of qualifying target companies be registered with the Secretary of State and after that a 20 day waiting period begins where the secretary can call a hearing.

Second generation statutes attempted to avoid preemption by the Williams Act by maintaining an appropriate balance between the interested of the offerors and the targets. Ex: requiring that minority shareholders who are frozen out of the second step of such a takeover receive no less for their shares than the shareholders who tendered in the first step. Second generation also includes “control share statutes” that resists hostile takeovers by requiring a disinterested shareholder to vote to approve the purchase of shares by any person crossing certain levels of share ownership fair price statutecontrol share statutes: allow stock purchase, but don’t have voting rights attach, unless rest of shareholders decide they do

CTS Corp. v. Dynamics Corp. of America

Facts: Indiana enacted a statute where large Indiana public corps, of so adopted, could require any entity acquiring a 20, 33, or 50% interest to be subjected to shareholder referendum wherein voting power of those shares can be withheld. Dynamics is holder of 9.6% of CTS shares. Dynamics announced a tender offer that would have brought its control to 27.5% which triggers the statute. Dynamics challenged the statute as void because it pre-empts the Williams Act and violates the commerce clause.

Issue: Whether a statute requiring shareholder approval prior to significant shifts in corporate control preempts state law and is constitutional.

Holding: A statute requiring shareholder approval prior to significant shifts in corporate control does not preempts state law and is constitutional.

A statute can be preempted only if it frustrates the purpose of the federal law.

Rationale: Pre-emption: By allowing the shareholders to act as a group, the Act protects them from the coercive aspects

of some tender offers. Unlike the Illinois statute in Mite, the statute here protects independent shareholders. This furthers the federal policy of investor protection.

Constitutionality: principal object of the commerce clause scrutiny is whether that statutes discriminate against interstate commerce. Here it does not because it applies to both Indiana and non-Indiana would-be acquirers. Also, here interstate commerce is no subject to inconsistent regulation because Indiana’s laws would be the only regulation applicable here.

Corps. are creatures of state law and states are free to formulate policy regarding internal operations of its corporations.

13.7.2 Third Generation Antitakeover Statutes (1987-2000)

These statutes followed after the CTS case. An example is the “business combination statute” or the “moratorium statute.” It prohibits a corp. from engaging in business combinations within a set time period after a shareolder acquires more than a threshold level of share ownership. It acts as a ban on immediate liquidation of an acquired entity but not a sfar as takeovers where the acquirer will continue to operate the business of the target.

DLG Section 203- Book says see statutory supplement for text of statute.- DGL 203 is meant to deter “junk bond” financed takeovers. But statute does NOT apply if the bidder can

acquire 85% of outstanding voting stock in a single transaction or if acquiring 15-85%, a bidder can secure 2/3 vote form the remaining shareholders other than itself as well as board approval.

Class Notes:203 prevents you from doing a leveraged buy out (i.e. transfer your personal debt to the corporation) unless you acquire 85%; could also have board waive it, or have disinterested shareholders ratify it

Note 3: Disgorgement: Some statutes mandate the disgorgement of profits made by bidders upon the sale of either stock or assets in the target. Profits realized by a controlling person from the sale of equity security w/in 18 mos of becoming a controlling person belongs to the target.

Constituency Statutes: Statute either allows or requires the board of a target to consider interests of constituents other than the shareholders when determining what response to take to a hostile takeover offer.

Indiana Code Section 23-1-35-1 (standard of conduct; liability; reaffirmation of corp. governance rules)See pgs. 596-597 – this section has text of statute only

13.8 Proxy Contests for Corporate Control

In General: there are two ways to effect change of management (1) negotiate with the incumbent board or (2) running a proxy contest an a tender offer simultaneously.

Schnell v. Chris-Craft Industries, Inc.

Facts: Dissident group of Chris-Craft (CC) shareholders attempted to wage a proxy fight. To give insurgents less time, the BoD reset the date of the annual shareholder meeting by other a month (moved it up from Jan ’72 to Dec ’71). Schnell et al. sought injunctive relief to reset the meeting date. TC denied, Schnell appealed.

Issues: Whether an inequitable action is permissible because it is legally permissible.

Holding: An inequitable action does not become permissible simply because it is legally permissible. Legal power held by a fiduciary may not be deployed in a way that is intended to treat a beneficiary of the duty unfairly.

Rationale: Here, the date was moved up for the sole purpose of obstructing the legitimate efforts of dissident stockholders in the exercise of their rights to undertake a proxy contest against the management.

Dissent: application of injuctive relief came too late because of the length of time leading up to the events.

Class Notes:moved shareholder meeting to avoid proxy war; when people are relying on the governing date found in the charter, the board can’t take action with the specific intent to stop it

Blasius Industries, Inc. v. Atlast Corp.

Facts: Blasius acquired roughly 9% of Atlas’ voting stock. Blasius presented Atlas’ BoD with a restructuring proposal that involved a major sale in Atlas assets, new debt financing, and disbursement of a very large cash dividend. Atlas BoD refused restructuring. Blasius then announced it would pursue campaign for shareholder consent to increase BoD from 7 to 15 and to fill the 8 new seats with persons of its choosing. This would give Blasius control. BoD responded by voting to enlarge BoD to 9 and choosing persons to fill the new seats. Blasius filed suit to invalidate BoD action as breach of fiduciary duty.

Issues: Whether a board of directors may enlarge the size of the board for the purpose of preventing a majority of shareholders from voting to expand the board to give control to an insurgent group.

Holding: A board of directors may not enlarge the size of the board for the purpose of preventing a majority of shareholders from voting to expand the board to give control to an insurgent group.

Rationale: Board’s action was a selfishly motivated effort to protect the incumbent board form a perceived threat to its control of Atlas. Any effort by the directors to frustrate the will of the majority, even if taken for the most unselfish reasons, must fail. Even though it was apparently taken by the Board out of concerns for the welfare of the corp. and as a defensive measure from this “threat” of recapitalization posing policy differences, it was an invalid attempt to thward shareholder voting power. The action must be voided. Shareholder franchise is the ideological basis for directorial power. Directors are agents of shareholders.

Note 2: Director action that interferes with voting process is presumptively inequitable. Because this can also be seen as a defensive act, courts may apply the Unocal test to them: Review under Unocal is less demanding than review under Blasius. In both, directors have burden of showing compliance with standard. In Unocal the action must be reasonable in light of something else. Under Blasius the justification for the act must be compelling in light of something else. Difference between the two is that Blasius requires a powerful justification to thwart shareholder franchise for an extended period and corporate action to defeat a proxy context cannot be justified by a parallel belief that the voters simply do not understand the foolishness of voting for the insurgent slate.

Note 3: Liquid Audio v. MM CompaniesLA rejected a cash offer from MM in favor of a stock-for-stock merger with Alliance. MM forced LA to hold

its annual meeting to challenge incumbent directors up for reelection and to propose bylaw amendment to expand BoD from 5 to 9. Shareholders voted to elect two MM directors but refused to add 5 more seats. MM sued alleging Unocal and Blasius violations. Court declined to apply Blasius because LA’s action would not have prevent MM from

achieving board control had its board expansion amendment succeeded. SCODE reversed holding that Blasius applied because the “primary purpose” of LA’s actions was to reduce MM director’s ability to influence board decision.

A Note on Hilton v. ITT Corp.Hilton initiated a $55 per share cash offer and proxy contest to replace ITT Board. ITT responded by delaying

the annual meeting and then structured a reorganization. It transferred subtantailly all assests to a new subsidiary, ITT Destitnation. ITTD would be formed with a full stable of antitakeover mechanisms including poison pill and staggered board. Hilton sued stating the reorganization was w/o shareholder approval. Court said this was preclusive and coercive under Unitrin.

blasisus; board took actions to stop shareholders from taking a legitimate action; under blasius, if you think board ahs taken action to thwart shareholder control under the corp. you have to prove the actions the board took were for that purpose; if you can prove they took the type of action in schnell and blasisus, tha tit was only to get in way of shareholder control, then it shifts to directors who would have to show a heavy burden of some other business decision13.9 The Takeover Arms Race Continues

13.9.1 “Dead Hand” Pills

Dead hand pills permit a board to limit the ability of shareholders to designate those with board power, i.e. they recognize a power in current boards to restrict authority of future boards. The pill usually cannot be redeemed by the “hostile” board that is elected in a proxy fight for a state period of time.

In Delaware, such a device is invalid because (1) it creates two classes of directors (continuing and new) and (2) it unduly conditions the rights of shareholders to elect new directors. DE courts have struck these down by the Unitrin/Unocal analysis. The present board does not have authority to restrict the power of future boards through exercise of stock right plans, to exercise their business judgment.

Example of pill: Board had redemption power but it had no such power for the six months following election of a new board.

Other courts (GA) upheld continuing director dead hand pills.

Class Notes:

only people who can redeem pill (that is get rid of it) are continuing directors; enve if succesul in proxy battle, you can’t vote to redeem; dead hand pill, dead hand still controls, new board can’t get rid of it even if there is unanimity

13.9.2 Mandatory Pill Redemption Bylaws

Some proponents of the pill has sought techniques to gin control of the decision of whether or not to implement a poison pill. The technique involved a shareholder bylaw that requires the BoD to redeem an existing pill and to refrain from adopting a pill without submitting it to shareholder approval.

This pill creates controversial issues: (1) is a bylaw that mandates the board to exercise its judgment in a particular way a valid bylaw? (2) whether managers must include in the company’s proxy solicitation, materials respecting any such proposal. (3) whether the law should recognize shareholder power to amend bylaws to eliminate or alter pills – when are the efficiencies that we gain from delegating authority to centralized managers outweighed by the expected agency costs associated with that delegation?

Most leading DE firms have opined that a mandatory bylaw would consitutute an invalid intrusion by the shareholders into the realm protected by Section 141(a) of the DGCL. The idea is that boards have rights and duties to make independent judgments respecting the management of the firm. Shareholders are not given power to co-manage.

Unisuper v. News Corp.

Facts: As part of reincorporation, News’s BoD agreed with certain institutional shareholders to a board policy that ny poison pill adopted by News would expire after one year unless shareholders approved an extension. BoD later announced it might not hold to its board policy. One year after it implemented pill, News extended the pill in contravention to its earlier policy. Shareholders filed suit alleging breach of K.

BoD argued two things:(1) The agreement is inconsistent with the general grant of authority to the board in Section 141(a) of DGCL which vests the power to manage in the BoD and requires that any limitation on this power be in the certificate of incorporation. So an agreement to hold a shareholder vote on poison pill is unenforceable unless memorialized in the certificate of incorporation.

(2) The agreement should be unenforceable as a matter of law because it requires board to refrain from acting when the board’s fiduciary duties require action.

Issue: Whether a contract between a board and its shareholders to permit a shareholder vote on defensive measures invalid as a matter of law.

Holding: A contract between a board and its shareholders to permit a shareholder vote on defensive measures invalid as a matter of law. When the principal makes known to the agent (board) exactly which actions the principal wishes to be taken, the agent must act in accordance to those instructions.

Rationale: (1) A contract between a board and its shareholders to permit a shareholder vote on defensive measures is consistent with the DGCL’s grant of authority. Section 141(a) does not say that board can’t enter into contracts. Here, the contract cede power over poison pills to shareholders not a third party so it is valid. Once shareholder exercise their power to vote to assert control over the business and affairs over the corp., the board must give way because its power is derived from the shareholders who are the ultimate holder of power in DE law.

(2) The three cases the BoD cited to support argument that a K is invalid because it requires board to refrain from acting when the board’s fiduciary duties require action do not support that proposition. Those cases took power away from the shareholders. Here, BoD entered into a contract that empowered shareholders. Granting powers to shareholders does not disable BoD’s fiduciary duties because fiduciary duties exist to fill gaps. Shareholders should be able to fill gaps in a corporate contract if they wish to do so.

Motion to dismiss denied.

class notes:

Do shareholders and boards have right to come to agreement as to how pills can be used; can bylaw actions constrain the board? they’re for procedure (bylaws);

in unisuper, it wasn’t change in bylaws, just in agreement between directors and shareholders that they wouldn’t use pills for a year without shareholder approval; pills at beginning are good, (for a year sure) since they boost sales; after a year must submit to shareholder approval;

if board is divested of discretion in favor of shareholders that is redefining boundaries of principal agent question; principal agent relationship arises from mutual assent

basic rule shareholders are the boss, they are the principal

Chapter 14: Trading in the Corporations’ Securities

-Deals with the obligations of directors, officers, and issuing corporations when dealing in the corporation’s own securities.Class Notes:Chapter deals with how we deal with fraud in the trading of corporate securities.If you are trading in your corp. securities to the detriment of shareholders that is a violation of agency law, lacked fiduciary dutiesIf you bought stock in an impersonal market (i.e. broker buys 100 shares of some stock) you’re off the hook, no grounds to say you defrauded someone; Contrast this with sitting down face to face with someone to discuss buying their shares

from a practical perspective it’s too difficult to impose a burden to require they let the seller know about the corp.from a fiduciary view point, if you are a director a buyer/seller may trust you more because of your status

Common law of directors’ duties when trading in the corporation’s stock

Strong-a shareholder offered to sell his stock to a company director who knew, but did not reveal, that the company was about to conclude negotiations on a highly favorable contract. SC affirmed judgment for the former shareholder on the grounds that, where special facts exist, a director has an obligation to disclose these material facts or refrain from buying corporate stock in a face to face transaction (when a fiduciary (trustee) was a party to the transaction).

Goodwin v. Agassiz

Facts: Plaintiff owned shares in Cliff Mining Company, a mineral mining company, and Defendant was President of Cliff Mining. Using a geological survey, Cliff Mining conducted initial explorations to find copper, but were unsuccessful. An article was published, independent and unconnected to Defendant, which disclosed the failure of the initial exploration. Plaintiff reacted to this news by selling his shares. Unbeknownst to Plaintiff, Defendant was informed by a geologist that there was still a good probability that copper would be found. Defendant reacted by buying shares before this news became public. Plaintiff sought damages from Defendant, claiming Defendant, as president of the company and the purchaser of Plaintiff’s shares, owed Plaintiff a fiduciary duty.

Issue: The issue is whether Defendant, as president and the purchaser of Plaintiff’s shares, owed Plaintiff a duty to disclose information that would affect the value of the shares.

Held: The Supreme Judicial Court of Massachusetts held that Defendant did not owe Plaintiff a fiduciary duty to disclose what Defendant knew. First, Defendant did not buy the shares from Plaintiff directly – they were purchased through a broker. Second, the information did not disclose an absolute certainty that copper would be found, but rather was only an opinion (theory).

Discussion. The court believed that the facts of this case did not disclose a direct relationship between the parties that would have made a full disclosure necessary. The opinion does not concentrate on whether Defendant was unfairly benefiting from the information but just whether Plaintiff unfairly lost his shares.Class Notes:Good statement of the common law.If you are going to issue stock you are governed by 1933 securities act; once you have issued the stock you must determine if you’re closely held or publicly traded; if the latter you will be regulated by 1934 securities exchange act, and all your own securities will also be governed by 1934 act [will be on the test]privaltely held, don’t have to worry about 10(b)(5) (whatever this means…)

The Corporate Law of Fiduciary Disclosure Today

-Claims are usually brought in federal courts under federal securities law, but state fiduciary duty law continues to play an important role in two situations:

1) a corporation can bring a claim against an officer, director, or employee for trading profits made by using information learned in connection with his corporate duties; and

2) shareholders can invoke state fiduciary duty to challenge the quality of the disclosure that their corporation makes to them.

Corporate Recovery of Profit from “Insider” Trading

Remember, an agent may not use her principals’ information for personal profit. It does not matter that the principal (or the corporation) is not “injured” in any respect by the agent’s trading; equity places a constructive trust on the profits from insider trading in order to discourage fiduciaries from violating their duties.

Thus, under the fiduciary or agency theory, the corporation or its shareholders as a collectivity should be able to sue the insiders derivatively to capture their profit on behalf of the corporation.

However, the law has simply not evolved to this point. Two aspects of this fiduciary duty theory are particularly notable.

1) since the corporation is seen as “owning” its nonpublic information, it could allow its agents to trade on it if there were no other legal considerations.

2) the fiduciary duty theory does not attempt to compensate the uninformed stockholder with whom the insider trades.

Freeman v. Decio

Facts: Plaintiff stockholder filed suit against defendant chairman of the board, defendant president of the corporation, and defendant directors of the corporation in which she held stock, alleging that defendants sold the corporation's stock on the basis of material inside information during two distinct periods. The trial court granted summary judgment in favor of defendants. On appeal, the court held that in light of defendants' affidavits and documentary evidence, plaintiff failed to create a genuine dispute as to whether the defendants' sales of stock were based on inside information. Alternatively, the court held that the plaintiff had failed to state a cause of action in that Indiana law had never recognized a right in a corporation to recover profits from insider trading.

Held: Order granting defendants' motions for summary judgment affirmed because, in light of the evidence presented by defendants, plaintiff was unable to create a genuine dispute as to whether defendants' sales of stock were based on inside information.

Class Notes:sold shares ahead of time knowing stock price was going to plummet; court looked for fraud, found none, found no harm to corp. therefore no breach of fiduciary dutyfreeman brought claim of the directors lying in the 1971 report that was publishedwhen you’re being paid to be an agent of someone, you’re not allowed to make more than your principal has agreed to pay you

you can’t use your position as an agent to make more than the principal had allowed you to make [basis of claim brought in freeman]court here said there had to be a showing of fraud

determine whether or not the information is actually a corporate asset, here on these facts, the corp. couldn’t reveal the information, because it would have opened them to liability(e.g. criminal penalties); if the info. is a corporate asset the directors can’t use it to make more money

if you bring a 10(b)(5) claim the plaintiff gets the remedy

Board Disclosure Obligations under state law

Although federal law is the principal arbiter of disclosure obligations, there is an important common law duty of disclosure arising out of recent Delaware cases.

The directors duty of candor under state law require them to exercise honest judgment to assure the disclosure of all material facts to shareholders. Failure to disclose a material fact, however, is unlikely to give rise to liability unless this failure represented intent to mislead.

Otherwise, the common charter waiver of liability for damages, independent of a loyalty violation under statues such as 102b7 will protect directors form good faith (when negligent) failure to adequately disclose.Class Notes:fraud by omission is evolving into a colorable claim

Exchange Act 16(b) and Rule 16

Section 16(b) requires statutory insiders to disgorge to the corporation any profits made on short-term turnovers in the issuers’ shares (purchases and sales within six-month periods).

Problems: 1) How to calculate profits on short-swing transactions; 2) Delimiting the class of statutory insiders or “covered person”; 3) and formulating the exact criteria for a “purchase or sale.”

Class Notes:Only part that explicitly deals with insider trading16(b) is a strict liability statute

Exchange Act 10 and Rule 10b-5

Section 10. It shall be unlawful

(b) to use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may proscribed as necessary or appropriate in the public interest or for the protection of investors.Class Notes:Prof. thinks courts have tried to mangle 10b to deal with insider trading, when it is really about fraud;Problems with the statute: doesn’t say who is supposed to enforce the rule; doesn’t say what the remedy for a violation actually is

Rule 10b-5:

It shall be unlawful: (a) To employ any device, scheme or artifice to defraud, (b) to make any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in the light of the circumstances in which they were made, not misleading, or (c) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

Thus, the elements of a rule 10b-5 implied cause of action must resemble those of common law fraud ((1) false or misleading statement (2) of material fact that is (3) made with intent to deceive another (4) upon which that person (5) reasonably relies (6) and that reliance causes harm.), but they must also reflect the realities of the market-based transaction s at which the rule is chiefly directed.Two most controversial elements; the first is the duty issue in omission cases. Second, is the reasonable reliance.

Class Notes:Still missing who enforces and what the remedy is going to be with 10(b)(5)some federal judge came up with the private right of action:

Violation of a legislative enactment, when it was to protect rights/interests, and it violates those rights/interests

Courts have adopted a slight modification on the common low fraud; ((1) false or misleading statement (2) of material fact that is (3) made with intent to deceive another (4) upon which that person (5) reasonably relies (6) and that reliance causes harm); when dealing with purchase/sale of securities

-have to have actually bought or sold in order to bring a 10(b)(5) within a relevant time period

info. only available for corporate purposes; fiduciary duty, if info. was only for corp. it’d be a violation for a director to use it for it’s own personal benefit;

False or Misleading Statement or Omission

What types of omissions?

I. SEC and 2 nd Circuit: any possession of relevant, material, nonpublic information gives rise to a duty to disclose or abstain from trading.

SEC v. Texas Gulf Sulphur

Brief Fact Summary. Plaintiff, the Securities and Exchange Commission, brought this suit against Defendants, Texas Gulf Sulphur Co., et al., after Defendants bought shares of Texas Gulf while they secretly had positive information regarding mining activities carried out by the company.

Synopsis of Rule of Law. Insiders cannot act on material information (information that a reasonable man would deem important to the value of the stock) until the information is reasonably, publicly disseminated.

Facts. Defendants were officers, employees or were closely tied to employees of Texas Gulf. Texas Gulf, utilizing a geological survey, was conducting mining exploration in Canada. One area, called Kidd 55, was deemed promising by the survey, and a hole was drilled with the resulting core analyzed. The analysis showed that the minerals present in the area were extremely rich in minerals. Several other samples verified the findings. Defendants did not disclose the results of the analysis to outsiders, including other officers of Texas Gulf. Defendants did proceed to purchase shares and calls once they knew about the results. The trading activity and sample drilling did prompt rumors in the industry of a significant find by Texas Gulf, and on April 12, 1964 Defendants sent out a misleading press release to calm the speculation. The press release misrepresented the actual results of the samples. Defendants decided to announce the results on April 15, although the news did not reach the public until April 16. Defendants still traded between April 12 and the announcement. Defendants claimed that the information was not material to the value of the company and therefore did not feel obligated to publicly disclose the information. They also argued that any trading after they released the news at midnight of April 16 was legitimate because technically the news was disseminated to the public.

Issue. The issue is whether Defendants utilized material inside information when they purchase shares and calls of Texas Gulf stock.

Held. The Defendants withheld information that was material to shareholders and therefore were acting on insider information when they purchased their shares and calls on Texas Gulf stock. The court looked at the conduct of Defendants as evidence that the information was material: they purchased a great deal of shares in Texas Gulf, they deliberately kept the information from others, and the timing of their purchases occurred during the period that they exclusively held the information. It did not matter that there was still an element of uncertainty in the eventual mineral mining, but the key element was whether a reasonable person would believe that the information would be relevant to

the price of the stock. Further, Defendants should not act upon the information until the information is disseminated to the point that the public would have had a reasonable opportunity to act on it.

Discussion. The court has moved away from Goodwin v. Agassiz where the emphasis was placed on whether a plaintiff suffered any damages and was directly wronged by a defendant insider. Now the test is whether defendants have an advantage over anyone without the information.

Class Notes:

equal access theory[fairness rule]: either disclose what you know or don’t trade; here, if they had revealed upfront, they would have paid a lot more for the land, thereby making it more difficult to actually purchase, so they couldn’t disclose; if you can’t disclose abstain from trading

Problems with the implementation of the Texas Gulf rule, which led to the next case which attempted

II. SCOTUS -necessary that the insider breach a fiduciary duty in trading on inside information in order to find 10b-5 liability.

Santa Fe Industries Inc. v. Green

Brief Fact Summary. Plaintiffs, Green et al., were minority shareholders of Kirby Lumber Corp. Plaintiffs brought this action to recover a greater share price after Defendant majority shareholder, Santa Fe Industries, Inc., forced Plaintiffs to sell their shares.

Synopsis of Rule of Law. Section 10(b) of the Securities Exchange Act and Rule 10b-5 prohibit conduct involving manipulation or deception, but are not so expansive as to govern incidences of fiduciary breach.

Facts. Defendant acquired a 60% share in Kirby in 1934. By 1974, Defendant owned 95% and wanted to own the entire 100%. Defendant utilized Delaware’s short-form merger statute that allowed a parent corporation owning at least 90% of the stock to merge with the subsidiary and force the minority shareholders to sell their shares. The minority shareholders must be notified within ten days, and Defendant did so in this case. Defendant offered $150 per share after it was valued by Morgan Stanley at $125. However, Kirby’s assets were valued to be $640 per share. Delaware law allows a minority shareholder to petition the Delaware Court of Chancery if they believe the payout is unfair. Instead, Plaintiffs brought an action under federal law, claiming that the majority owed a fiduciary duty to the minority, and that breach violated Rule 10b-5. The trial court believed that fiduciary duty breaches were not covered under the federal law, but the Court of Appeals reversed, concluding that it was within the purview of the federal law.

Issue. The issue is whether a breach of fiduciary violates Rule 10b-5.

Held. The United States Supreme Court held that Rule 10b-5 will not govern breaches of fiduciary duty. The language used by the legislature in Section 10(b) refers to manipulation and deception and there is no evidence that the legislature meant to have an expansive reading of those terms. The Court did not want to open the door to more litigation by expanding the scope of the statute. The states traditionally regulated the behavior at issue, and the Court reasoned that it was up to the legislature to act if they felt there was a need to have uniformity across the states.

Dissent. The dissent agreed with the appellate court.Concurrence. The concurring opinions believed that there was no need to decide whether fiduciary breaches were under federal law because there was no actual breach by Defendant.

Discussion. The Court is not getting rid of any remedy for breaches of fiduciary duty, but a plaintiff will have to use state courts.

Class Notes:

-This case dealt with the influx of cases brought under the holding in Texas Gulf-10(b)(5) requires evidence of fraud or deception or manipulation, here they gave the plaintiff everyting, so no showing of deception-court said manipulation requires a scheme, here there was no scheme; usually they require non-disclosure (the schemes); -no deception cause all the evidence was turned over in Santa Fe

III. Lastly, the SC has adopted the intermediate stance of augmenting the fiduciary duty theory with the more far-reaching misappropriation theory.

Chiarella v. US

Brief Fact Summary. Petitioner traded on confidential information acquired during his work at a financial printer regarding the possible takeover of a corporation without first disclosing this information to the public.

Synopsis of Rule of Law. A duty to disclose arises under section 10b under the Securities Exchange Act of 1934 when there is a relationship of trust and confidence between the transacting parties.

Facts. Petitioner worked for a financial printing company, Pandick Press, as a markup man. Petitioner handled documents announcing corporate takeover bids. The names of the acquiring and takeover corporations were disguised, but Petitioner was able to deduce the companies by other information on the documents. Petitioner purchased stock in the target companies and sold the shares immediately after the takeover attempts were announced to the public, making $30,000 in profit over a 14 month period.In May 1977, Petitioner entered into a consent decree with the Securities Exchange Commission (SEC) to return his profits to the sellers of the shares. In January 1978, he was indicted and later convicted on 17 counts of violating Section: 10b and SEC Rule 10b-5. The Court of Appeals for the Second Circuit affirmed his conviction. The United States Supreme Court granted certiorari. The issues involving Rule 10b-5(b) were dismissed.

Issue. Whether a person who learns about a corporation’s plan to takeover a target corporation through confidential papers discovered while working at a financial printer violates Section:10b if he fails to disclose the impending takeover before trading in the target company’s securities?

Held. No. Silence does not amount to fraud under Section:10(b) if there is not a duty to disclose based on a confidential relationship between the transacting parties. The Court of Appeals decision is reversed.Dissents. The language of Rule 10b-5 and Section:10b encompasses the principle that a person has an absolute duty to disclose misappropriated nonpublic information or to refrain from trading if he does not disclose. Petitioner’s conduct was fraudulent under the meaning of Section 10(b) and Rule 10b-5 because he wrongfully acquired confidential information and participated in manipulative trading based on it.

Discussion. Silence in connection with the purchase or sale of securities is actionable as fraud under Section:10(b) if there is a duty to disclose such information arising from a relationship of trust and confidence between parties to a transaction. Here, Petitioner did not have a duty to disclose because he had no special confidential relationship with the transacting parties

Class Notes

If you stumble across insider info. you’re free to use it, only thing giving rise to the duty is some specific relationship (i.e. you are a fiduciary)

no duty to the target corp. only stock he bought was of target; only had a relationship with the acquiring corp.;

everything boils down to two competing arguments: (i) basic fairness/equal access or (ii)fiducirary duties, Chierella comes down on this side

Dirks v. SEC (Fiduciary approach and when derivative fiduciary attaches to tippee)

Facts: Dirks was officer of brokerage firm. Secrist, the insider, told Dirk that Equity Funding (EFA) was engaging in corp. fraud. Dirks then investigated the EFA to verify Secrist’s information. Dirks nor his firm traded or owned any EFA stock but during his investigation, he openly revealed to clients and investors that he was investigation EFA for fraud. This caused many of them to sell their EFA stock.

After 2 weeks of investigation and word spreading, EFA stock price dropped from $26 to less than $15. Shortly after, California insurance authorities investigated and SEC finally filed a complaint against EFA.

SEC also investigated Dirks and found he aided and abetted violations 17(a) of 1933 act and 10(b) of 1934 Act, but ended up only censuring him since he helped bring the fraud to light.

Issues: Whether a tippee will automatically be liable for openly disclosing nonpublic information he received from an insider.

Holding: A tippee will be held liable for openly disclosing nonpublic information received form an insider if the tippee knows or should know that the insider will benefit in some fashion for disclosing the information to the tippee such that the insider breached his duty to the shareholders.

Rationale: Mere receipt of nonpublic info by a tippee from an insider does not automatically carry with it a fiduciary duty of an insider. A tippee assumes a fiduciary duty to the shareholders of a corp. not to trade on material public information only wen the insider has breached his fiduciary duty o the shareholders by disclosing the information to the tippee and the tippee knows or should know that there has been a breach. There must be a breach of the insider’s fiduciary duty before the tippee inherits the duty to disclose or abstain.

Here, Secrist the insider did not get any benefit for his disclosure of nonpublic info to Dirks; i.e. no breach of Secrist’s fiduciary duty to shareholders). Since no insider’s breach of fiduciary duty, there is no derivative breach by Dirks for disclosing the nonpublic info to clients.

Dissent: Personal gain is not an element to the duty. The duty should be addressed to the insider’s action and its consequence to the shareholders. Here, Secrist used Dirks to disseminate info which eventually hurt the shareholders by misuse of the nonpublic information.

Class Notes:if tipee has reason to know the tipor is going to benefit from disclosure, and tiper has fiduciary duty

fid. duty between tipper and fiduciary duty; someone has to have had a fid. duty and breached it (had to be a breach)person reaceiving info. has to know or should have known

first look who got info, then look to who theypassed info onto, did they benefit for passing it off (reputation, money, help later on); if that happens and the person receiving the info. knows whats going on, then there is a breach; now the liability that would have attached to the tippor, is passed on to the tippee, always trace it back to the insider

no harm to shareholder required to prove breach

NOTE: RULE 14E-3 and REGULATION FD

14e-3 imposes a duty on any person who obtains inside information about a tender offer that originates with either the offeror or the target to disclose or abstain from trading. (This rule reintroduces the “equal access” norm by regulation)

Regualtion Fair Disclosure (FD) – is directed to issuers that sometimes publicly disseminate material business information through a process where certain favored analysts, brokers, or journalists are called to a press conference where material information would be released to the public. It requires issuers to make info they received to be either simulataneously or promptly made public (to prevent them from benefiting from early access to info).

Class Notes:Insider trading in relation to tender offers is illegal

NOTE: THE RESPONSE OF CONGRESS AND THE COURT TO DIRKS

Courts extended the theory of misappropriation to reach outsiders who trade illicitly on confidential information. Deceitful misappropriation of market sensitive information is itself a fraud that may violate Rule 10(b)(5) when it occurs in connection with a securities transaction.

Benefit of misappropriation theory is that it can reach almost all forms of insider trading that are commonly condemned. Misappropriation theory also places a real duty and a “fraud” by focusing on the putative insider’s illicit conversion of valuable information rather than on a fictional relationship between the insider and the uninformed traders.

U.S. v. Chestman (Misappropriation approach; en banc decision)Facts: Waldbaum, the controlling shareholder of Waldbaum, Inc told some members of his family that he was selling the corp to A&P for $50/share. He told his three children who are all employees of Waldbaum Inc, and told them to keep it secret until they publicly announce it. He also told his sister, Shirley Witkin, and told her to keep it secret. But Shirley told her daughter Susan who told her husband Keith Loeb in confidence.

Chestman learned from Loeb that Waldbaum Inc was to be sold to A&P for more that the market price. After receiving this info, but before public announcement of the sale, Chestman purchased 3,000 shares at $24.65. He also bought some for his other clients including 1,000 shares to Loeb. Loeb called Chestman again for advise on what to do and Chestman said no worries – he bought based on his research.

After investigation by the SEC, Loeb cooperated and agreed to disgorge his profits of $25k and to pay a $25k fine. Chestman was indicted and convicted for violating 10b-5 and 14e-3. On appeal, the 2nd ckt set aside his conviction. US appealed resulting in this en banc hearing

Issues: (1) Whether the SEC exceeded its statutory authority by promulgating rule 14e-3(a) even thou that rule omits the common law breach of fiduciary element of fraud.

(2) whether one who misappropriates material nonpublic information in breach of a fiduciary duty or similar relationship of trust and confidence and uses that information in a securities trade violate rule 10b-5.

Holding: (1) The SEC did not exceed its statutory authority by promulgating rule 14e-3 which prohibits trading on the basis of material nonpublic information concerning a tender offer that he knows or has reason to know has been acquired directly or indirectly from an insider of the offeror or issuer.

(2) One who misappropriates material nonpublic information in breach of a fiduciary duty or similar relationship of trust and confidence and uses that information in a securities trade violates rule 10b-5.

Rationale:(1) Rule 14e-3a prohibits trading on the basis of material nonpublic information concerning a tender offer that he knows or has reason to know has been acquired directly or indirectly from an insider of the offeror or issuer. 14e-3 is a disclosure provision that creates a duty in those traders who fall within its ambit to abstain or disclose without regard to whether the trader owes a pre-existing fiduciary duty to respect the confidentiality of the information. Congress delegated broadly and SEC acted within its authority. Rule is valid and there’s sufficient evidence to convict Chestman under 14e-3(a).

(2) A fiduciary duty cannot be unilaterally imposed by entrusting a person with confidential information, and mere kinship does not establish a confidential relationship. A similar relationship of trust and confidence may be equivalent to a fiduciary relationship. However, here, evidence does not support such a relationship between Loed and the Waldbaum family. Absent any fraud by Loeb, Chestman cannot be derivatively liable as Loeb’s tippee or as aidor and abettor. So Chestman’s convictions under 10b-5 cannot stand.

Class Notes:for general fraud apply Santa Fe test; when general fraud isn’t in the facts, try this case10b5-2 codified the case; duty to keep quiet when you get info. from a family member; the statute takes chestmen rule and shifts burden to the defendant to show that the relationship

U.S. v. O’Hagan ()

Facts: O’Hagan was a partner in the law firm of Dorsey & Whitney. Grand Met retained Dorsey to represent them in potential tender offer for common stock of Pillsbury. O’Hagan did not work on the representation of Dorsey with Grand Met. But he bought 2,500 Pillbury options and 5,000 shares of common stock at $39/share. When Grand Met announced its tender offer, the price went up to $60 and after selling his options and stock, O’Hagan profited more than $4.3M.

SEC investigated him and issued at 57 count indictment and 41 months in jail. He appealed and all convictions were reversed with the court reasoning that misappropriation theory was not a proper basis for securities fraud and rule 14e-3a exceeded SEC’s rulemaking authority. SEC appeals.

Issues: (1) Whether the SEC exceeded its rulemaking authority in adopting rule 14e-3a.

(2) Whether a person who trades in securities for personal profit, using confidential information misappropriated in breach of a fiduciary duty to the source of information is guilty of violating SEC 10b.

Holding: (1) The SEC did not exceed its statutory authority by promulgating rule 14e-3 which prohibits prohibits trading on the basis of material nonpublic information concerning a tender offer that he knows or has reason to know has been acquired directly or indirectly from an insider of the offeror or issuer.

(2) A person who trades in securities for personal profit, using confidential information misappropriated in breach of a fiduciary duty to the source of information violates SEC 10b.

Rationale:(1) Rule 14e-3a prohibits trading on the basis of material nonpublic information concerning a tender offer that he knows or has reason to know has been acquired directly or indirectly from an insider of the offeror or issuer. 14e-3 is reasonably designed to prevent fraud in tender offers and therefore qualifies under section 14e’s rulemaking authority. SEC may prohibit acts, not themselves fraudulent under cmmon law or section 10(b) if doing so will prevent fraudulent acts or practices.

(2) A fiduciary’s undisclosed, self-serving use of a principal’s information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of the information. Here, O’Hagan owed a duty of loyalty to the firm and the firm’s client yet he took their information that they owned and used it to make securities trades. This is an action that the SEC act seeks to eliminate to ensure the maintenance of fair and honest markets. While piror cases held there’s no duty disclose between members of the market place, when a special relationship exists, misappropriation is sufficient basis to support conviction under Section 10b and rule 10b-5.

Class Notes:

14e3 goes beyond SEC rulemaking authority; insider trading is wiped out (don’t use 10b5) any insider trading as applied to a tender offer is illegal under 14e3

NOTES ON INSIDER TRADING AND SECURITIES FRAUD ENFORCEMENT ACT (ITSFE) OF 1988ITSFE responded to serious episodes of abusive and illegal practices in Wall Street by increasing enforcement and penalties

Section 20A (78t-1): Liability to Contemporaneous Traders for Insider Trading.(a) Creates a private right of action based on contemporaneous trading. Any person who violates this chapter, the rules, or regulations, shall be liable in action in any court to any person who contemporaneously with the purchase or sale of securities that is the subject of the violation, has purchased or sold securities of the same class.(b)(1) contemporaneous trading actions recovery is limited to profit gained or loss avoided.(b)(2) Total amount of damages shall be diminished by the amounts, in any, that such person may be required to disgorge.

20A provides an alternative to rule 10b-5. Under 20A it appears possible for a shareholder of the target to sue a person who misappropriates info from the bidder.

Class Notes:Information is a corporate asset; fiduciaries of a corp. can’t use that for own personal gainif bringing private right of action, don’t bring under haggin/misappropriation (misappropriation is for criminal prosecution of insider trading); all under 10b5 but: in general apply santa feif private right of action: dirks/ciearleaif criminal: ohagin/misappropriatino

14.4.2.5 Elements of 10b-5 Liability: Materiality

Basic Inc v. Levinson

Facts: Combustion was interested in merging with Basic and approached Basic’s management about this. Basic made a series of 3 public statements denying the merger rumors that were circulating. Plaintiffs were former shareholders of Basic who sold their shares between the first public denial and the public announcement of the merger. They claimed Basic violated 10b-5. District court said this misleading statement was immaterial. Court of appeals reversed saying merger discussion that might not have been material became material because of the statement denying it.

Issue: Whether a misstatement regarding merger negotiations is material if there is substantial likelihood that a reasonable shareholder would consider it important in deciding whether to buy or sell.

Holding: A misstatement regarding merger negotiations is material if there is substantial likelihood that a reasonable shareholder would consider it important in deciding whether to buy or sell.

Fact finder needs to look to (1) indicia of interest in the transaction at the highest corporate levels and (2) assess the magnitude of the transactions (size of firms and potential premiums over market value) to determine if

merger discussion is material. No particular even needs either be necessary or sufficient to render merger discussion material.

Rationale: The purpose of the 1934 SEC acts was to prevent market manipulation to guarantee honest and complete dissemination of information. To hold that all misstatements are material lets a low threshold and will cause management to burry shareholders in too much trivial info. Better to view it objectively and ask if it would influence a shareholder’s decision.

Deciding when info is material or not requires investigation of the totality of the facts and to look to indicia of interest in the transaction at the highest corporate levels and assess the magnitude of the transactions.

Re: agreement-in-principle (AIP): Court rejected to adopt AIP that says preliminary merger discussions do not become material until there is an agreement in principle as to the price and structure of the transaction. Court adopts a balancing test: balance the indicated probability event will occur and the anticipated magnitude of the even in light of the totality of the company activity.

Remanded for fact finding if shareholders would rely.Class Notes:

you can keep quiet, but when you say something, you can’t lie

14.4.2.4 Elements of 10b-5 Liability: Scienter

- Common law requires scienter or intention to deceive.- SCOTUS confirmed that Rule 10b-5 requires specific intent to deceive, manipulate, or defraud.- Courts are split as to what is required for P to plead to survive 12b6 motion to dismiss for failure to state claim.

1. 9th ckt: P need only state in pleading that D acted with scienter.2. 2nd ckt: P needs to plead facts that give rise to a strong inference of fraudulent intent.3. Private Securities Litigation Reform Act: P shall state with particularity facts giving rise to a strong

inference that D acted with the required state of mind.

Affirmative Defenses to 10b-5-1: D can show (1) proof that a person had given instructions or adopted a written plan ot purchase before acquiring information and (2) proof that, in case of an investing entity, the natural person making the investment on behalf of the entity was unaware of inside information and the entity itself had implemented reasonable measures to protect against illicit insider trading.Class Notes:

not standard in civil cases,

14.4.2.6 Elements of 10b-5 Liability: Standing

Plaintiff must have been a buyer or seller of stock in order to have standing to bring a complaint about an alleged violation of Rule 10b-5.

14.4.2.7 Elements of 10b-5 Liability: Reliance

Basic Inc v. Levinson

Facts: Combustion was interested in merging with Basic and approached Basic’s management about this. Basic made a series of 3 public statements denying the merger rumors that were circulating. Plaintiffs were former shareholders of Basic who sold their shares between the first public denial and the public announcement of the merger. They claimed Basic violated 10b-5.

Issue: Whether reliance on materially misleading statements by a corp. be presumed for a class action plaintiff asserting a rule 10b-5 claim where he relied instead on the integrity of the price set by the market in trading.

Holding: Reliance on materially misleading statements by a corp. may be presumed for a class action plaintiff asserting a rule 10b-5 claim where he relied instead on the integrity of the price set by the market in trading.

Rationale: Court finds support based on fraud on the market theory (FoM) and said the district court correctly applied a rebuttable presumption of reliance. FOM is based on the premise that misleading material information in the open market will affect the price of a company’s stock, whether or not the individual investor relied on the misrepresentation. Here it is permissible to presume that the shareholders traded in reliance on Basic’s depressed price and that because of its material misrepresentation, that price was fraudulently depressed. The presumptions allow the court to manage circumstances where direct proof is difficult to obtain. This presumption is consistent with Congress’ intent in enacting the 1934 Act to facilitate investor’s reliance on the integrity of market information. Since shareholders established their loss, burden is now on Basic to rebut that the shareholders relied on their misrepresentation.

Dissent: FoM presumption may not be accurate. It is doubtful that the court is in a position to assess which economic theories aptly describe the functioning of the securities industry. Therefore the majority errs in its effort to reconfigure securities law based on recent economic theories to better fit what it perceives to be the new realities of the financial markets. Congress should decide, not the court.

Class Notes:

14.4.2.8 Elements of 10b-5 Liability: Causation

Proof under 10b-5 also requires 2 types of causation: (1) transaction causation: The misstatement or omission must cause the plaintiff to enter the transaction. (2) loss causation: The misstatement or omission must cause the plaintiff’s loss.

Class Notes:(i)show it caused you to enter transaction and (ii)to enter at a time when you would have been harmed (e.g. price was to high when buying or sell when price was too low)14.4.3 Remedies for 10b-5 Violations

Elkind v. Liggett & Myers, Inc. (court adopts the disgorgement approach)

Facts: Shareholders brought class action against Liggett for wrongful tipping of inside information about an earnings decline to persons who then sold Liggett’s shares on the open market. When the earnings decline went public, stock prices fell. The earnings were made public on July 18 and effectively disseminated in a Wall Street Journal on July 19. Tippees traded on July 17 before the public disclosure at $55.25/stock. On July 19, stock dropped to $46 and 3/8ths per share. Shareholders who purchased at the higher July 17 price sued shareholders who sold their stock on July 17 and benefitted from the inside information.

The district court awarded the shareholders damages based on the difference between the price paid and the value of the stock had the information been available to all investors.

Issue: Whether the measure of damages available when inside information indicating a stock decline is involved equal to the decline in the purchaser’s stock up to the amount of the tippee’s realized benefit.

Rule: The measure of damages available when inside information indicating a stock decline is involved is equal to the decline in the purchaser’s stock price up to the amount of the tippee’s realized benefit.

A plaintiff is simply required to prove (1) the time, amount, and price per share of his purchase, (2) that a reasonable investor would not have paid as high a price of made the purchase at all if he had the information in the tippee’s

possession, and (3) the price to which the security had declined by the time he learned the tipped information or at a reasonable time after tie became public, which ever event occurred first.

Rationale: There were four ways to measure damages: (1) out of pocket approach, (2) the value method, (3) recover any decline in value caused by tippee trading, and (4) disgorgement approach. Court chose the disgorgement approach.

The different ways to measure:(1) The court rejected the district court’s “out-of pocket” measure, which is the difference between the

price paid and value of the stock when bought. It is usually used where a buyer is induced to purchase stock by materially misleading statements or omissions. This does not apply here because the uninformed traders on an open market are not induced by representations on the part of the tipper or tippee to buy or sell. This is also inappropriate because the “value” of the stock is hypothetical.

(2) Value method: method that rests on assumption that the tipped info is substantiallyt eh same as the later disclosed info and that one can determine how ht emarket would have reacted to the public release of the tipped info at a later proximate time. This measure risks imposition of exorbitant damages that are not proportional to the wrong.

(3) Recovery of decline in value caused by tippee trading. It avoids windfall recovery but it does not permit recovery for tippee’s violation of his duty to disclose insider information before trading. Also hard to prove when market was actually affected by tippee’s conduct.

(4) Disgorgement approach: The difference between the decline in the purchaser’s stock price up to the amount of the tippee’s realized benefit. This is easier to quantify. Even though gain to wrongdoer should not be a prerequisite to 10b-5 violation and sometimes total claims exceed wrongdoer’s gain, it is the best suited for achieving an equitable result in this case.

Using disgorgement, court found P is entitled to 1,800 (# of tippee shares traded) multiplied by $9.35 per share.

14.4.4 The Academic Debate: Deregulation as the solution?Some academics debate whether insider trading should be regulated at all.

Reasons for deregulation: -legal restrictions on insider trading only affect a portion of insider’s higher returns since existing law bars

trading on “material” information – the law cannot reach insiders’ informed decisions to refrain from trading.-fact that insider trading redistributes returns on securities in favor for the insider bears little on fairness. All

disparities in information among all the traders have a similar effect.-If securities prices are efficient and well informed about insider trading, then outsiders enjoy the automatic

protection of prices that already reflect an informed estimate of future insider trading levels.

14.4.4 .1 Insider Trading and Informed PricesPro deregulation rationale: insider trading leads to more informed prices that may actually increase investor confidence because it signals the market of the trading value of the information that the firm cannot or will not disclose directly.

Anti-deregulation response: insider trading is a slow mechanism for releasing information to the markets that can fail to move prices if the level of background “noise trading” is sufficiently high.

Alternative approach: require insiders to disclose at some point before trading, the identity and size of their intended trades.

14.4.4 .2 Insider Trading as a Compensation DevicePro deregulation rationale: insider trading is an efficient device for compensating insiders and cuts back on contractual costs associated with managers having to renegotiate his compensation for the value-increasing project he’s brought to the corp.

Anti-deregulation response: fact that managers can increase their compensation via insider trading deprives the firm of control over the total levels of individual compensation and it does not guarantee that the originators of successful projects will reap the rewards. It will also incentivize manages to hoard valuable information at the expense of the shareholdes.

Alternative approach: require insiders to disclose at some point before trading, the identity and size of their intended trades.

no general fraud claims versus insider trading (same rule, but the rule has a split persoonalty) rule deals with general fraud and insider trading differently.