Business Associations Spring 2007 (Utset) I. Introduction..................................................................................................................................3 II. The Partnership...........................................................................................................................7 Meinhard v. Salmon (Ct.

. of Appeals, NY, 1928) p. 67...............................................................8 Martin v. Peyton (Ct. of Appeals, NY, 1927) p. 125...................................................................9 Smith v. Kelley (Ct. of Appeals, KY, 1971) p. 129...................................................................10 III. Where and How to Incorporate................................................................................................10 IV. Ultra Vires...............................................................................................................................13 Ashbury Ry. Carriage & Iron Co. v. Riche (House of Lords, 1875) p. 223..............................14 711 Kings Highway Corp. v. F.I.M.s Marine Repair Serv., Inc. (SC of NY, 1966) p. 224.....14 V. Premature Commencement of Business...................................................................................15 Stanley J. How & Assoc. v. Boss (US Dist. Ct, Iowa, 1963) p. 236.........................................15 McArthur v. Times Printing (1892) p.240.................................................................................15 Robertson v. Levy (Ct. of Appeals, DC, 1964) p. 241..............................................................16 VI. Disregard of the Corporate Entity............................................................................................17 Bartle v. Home Owners Coop. (Ct. of Appeals, NY, 1955) p. 254...........................................17 DeWitt Truck Brokers v. W. Ray Flemming Fruit Co. (4th Cir. 1976) p. 256..........................18 Baatz v. Arrow Bar (SC of S. Dakota, 1990) p. 263..................................................................18 Radaszewski v. Telecom Corp. (8th Cir. 1992) p. 268..............................................................20 Fletcher v. Atex, Inc. (2d Cir. 1995) p.272................................................................................20 Stark v. Flemming (9th Cir. 1960) p. 296..................................................................................20 Roccograndi v. Unemployment Comp. Bd. of Review, (Superior Ct. of PA, 1962) p. 297......21 Pepper v. Litton (SCOTUS, 1939) p.303...................................................................................21 VII. Financial Matters and the Closely Held Corporation.............................................................21 Stokes v. Continental Trust Co. of City of New York (Ct. of Appeals, NY, 1906) p.368........26 Katzowitz v. Sidler (Ct. of Appeals, NY, 1969) p. 372.............................................................27 Lacos Land Company v. Arden Group, Inc. (Ct. of Chancery, Delaware, 1986) p. 377..........27 Gottfried v. Gottfried (SC of NY, 1947) p. 383.........................................................................27 Dodge v. Ford Motor Co. (SC of Mich., 1919) p. 386..............................................................28 Wilderman v. Wilderman (Ct. of Chancery, Delaware, 1974) p 390........................................28 VIII. Governance of Close Corporations.......................................................................................29 McQuade v. Stoneham (Ct. of Appeals, NY, 1934) p. 418.......................................................29 Galler v. Galler (SC if Illinois, 1964) p. 423.............................................................................30 Zion v. Kurtz (Ct. of Appeals, NY, 1980) p. 432......................................................................30 IX. Control and Management of Public Corporations...................................................................31 X. Duty of Care and the Business Judgment Rule.........................................................................33 Litwin v. Allen (SC of NY, 1940) p. 670 .................................................................................33 Shlenksy v. Wrigley (App. Ct. of Ill., 1968) p. 676...................................................................35 Smith v. Van Gorkum (SC of Del., 1985) p. 685......................................................................35 In Re Caremark Intern. Inc. Derivative Litigation (Ct. of Chancery of Del., 1996) p. 701......36 Malone v. Brincat (SC of Del., 1998) p. 712.............................................................................36 Gall v. Exxon Corp. (US Dist. Ct., S.D.N.Y., 1976) p. 720......................................................37 Zapata Corp. v. Maldonado (SC of Del., 1981) p. 724..............................................................38

Aronson v. Lewis (SC of Del., 1984) p. 733.............................................................................40 XI. Duty of Loyalty and Conflict of Interest.................................................................................40 Marciano v. Nakash (SC of Del., 1987) p. 759..........................................................................40 Heller v. Boylan (SC of NY, 1941) p. 764................................................................................42 Brehm v. Eisner (SC of Del., 2000) p. 769................................................................................42 Sinclair Oil Corp. v. Levien (SC of Del, 1971) p. 777..............................................................42 Weinberger v. UOP, Inc. (SC of Del., 1983) p. 783..................................................................43 Northeast Harbor Golf Club, Inc. v. Harris (Sup. Jud. Ct of Maine, 1995) p. 797....................46 XII.Proxy Regulation.....................................................................................................................47 Studebaker v. Gitlin (US COA, 2d Cir., 1966) p. 603...............................................................48 In the Matter of Caterpillar Inc. (Admin. Proc. SEC 1992) p. 613.........................................49 TSC Indus., Inc. v. Northway, Inc. (SCOTUS, 1976) p. 630....................................................50 XIII. Transactions in Shares: Rule 10B-5, Insider Trading, and Securities Fraud........................50 Blue Chip Stamps v. Manor Drug Stores (SCOTUS 1975) p. 815............................................51 Ernst & Ernst v. Hochfelder (SCOTUS 1976) p. 819................................................................51 Santa Fe Indus., Inc. v. Green (SCOTUS 1977) p. 822.............................................................52 In Re Enron Corp. Securities Derivative & ERISA Litigation (US Dist. Ct., S.D. Tex., 2002) p. 827..........................................................................................................................................52 SEC v. Texas Gulf Sulphur Co. (US COA, 2d Cir., 1968) p. 840.............................................53 Chiarella v. U.S. (SCOTUS 1980) p. 855..................................................................................53 US v. OHagan (SCOTUS 1997) p. 866....................................................................................54 Dirks v. SEC (SCOTUS 1983) p. 881.......................................................................................55 Basic Inc. v. Levinson (SCOTUS 1988) p. 915.........................................................................56 XIV. Takeovers..............................................................................................................................57 Unocal Corp. v. Mesa Petroleum Co. (Del.1985) p. 1028.........................................................58 Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc. (Del. 1985) p. 1031.............................58 Unitrin, Inc. v. American General Corp. (Del. 1995) p. 1034...................................................59

I. Introduction
Business broad term describing all kinds of profit-making activity. Can be broken into two categories: 1) corporations (e.g. Wal-Mart) 2) unincorporated associations (e.g. proprietorships, partnerships, limited partnerships) Business can also be broken into: 1) closely held (have one or few owners) 2) publicly held (hundreds or thousands of owners whether a public market exists for ownership interests in the business) Questions to ask when examining business situations: 1) who are the parties involved? What are their roles? Do they wear different hats that may lead to problems down the line? 2) how are their interests congruent? 3) how may their interests diverge? 4) what types of conflicts may follow? 5) what can we do via contracts or the law to try and deal with these potential conflicts and reduce the transaction costs of these parties coming together? Overoptimism people tend to be overoptimistic and think that problems will not arise. So, clients will say question 3 and 4 do not matter. So, you must say that these are important without undermining the whole deal. The goal is to bring the people together but anticipate that overoptimism will cloud their perception of what is needed. Options that always exist in a business situation: 1) let law deal with it (common law, statute-based law, etc.) 2) not enter relationship 3) use contract to craft relationship 4) discount the risk What is a corporation it is a legal entity with: Responsibilities Advantages Rights/powers Subject to some kind of law (primarily state law) state law is not the only way to form corporations (some federal statutes). What is trying to be accomplished with a corporation? - liability structure - fiduciary duties/characteristics to protect shareholders - limited liability: if corporation goes bankrupt, creditors can not go after shareholders *contrast with partnerships, which have unlimited liability creditors can go after unprotected assets of partners - by allowing corporations to be formed, states gain a certain value

* job growth, economics, capital * it is a way for individuals to accumulate and bring together their capital and put them together in a form that will allow them to produce certain things which they can then sell for a profit. * limited liability helps with the accrual of capital in corporations Money goes into the corporation, which produces something of value, which is redistributed to the investors. *positive externalities certain things in life require you to bear the full cost of something and keep all the value of it it is an internalized thing. There are positive (do not have to bear cost but get value) and negative (bear cost but do not get all the value) externalities. Certain people take certain actions and do not bear any cost. So, when people form corporations, parties outside the corporations get positive externalities. When you have an Enron situation, parites are getting negative externalities. Corporation Inputs: Debt = bank loans, trade credit, debt securities Capital = shareholders Cash Other types of property, real property personal property intangible property (intellectual property, such as copyrights, patents, etc.) Labor Knowledge/Expertise = human capital The goal is to combine all of these inputs to create something of value and get a return from them. What is the hierarchy of the inputs?? How do you value them? *Cash is usually the easiest to value look at the value at the time and the future value. One of the characteristics of the corporation is that it temporally extends the investment. It is not a spot transaction. *Real property is also easy to value, in some ways there will be different valuation methods, depending on circumstances. * Intangible property is harder to value since there is greater variability in the value of copyrights or patents. *Debt: How is renting an apartment similar to getting a loan from a bank? You are paying to use the commodity for a period of time. You will return it when done with it. Rent is similar to interest. The lender will assess how risky the loan is. If you have greater risk, either with an apartment or the repayment of money, you may have to pay higher rent/higher security deposit, and with a loan you may have to pay a higher interest rate or secure the loan. How do you value human capital?? What would it cost to replace it? One problem is that the more valuable it is, the harder it is to replace.

Market value what are other people willing to pay for it? Think of buying an orange you may have prior knowledge of what will be a good orange, maybe you want prepackaged oranges, or free standing oranges. Maybe value the satisfaction you will get how will you use it? These are all signals as to the value an orange is an experience good it is not until you buy it and eat it that you know the true value of that orange. If it is the only orange left, it may not be good since other people have passed it over. If you want to buy prepackaged oranges, they may not be as good a quality, so you will discount for the risk that some of them may be bad since you cannot examine them like unpackaged oranges. Therefore, the store should discount the price so it is a win-win situation. If they dont rip their customers off, then they will have a good reputation, which is an intangible thing of value. From all these inputs come outputs (goods, services) which when passed to a third party provides cash which is redistributed to the parties who provide input. The group cooperates to produce a surplus that they can all benefit from. Valuation is an important concept in this class the inputs, the output, the distributions must be valued, so it is important in all phases in the life of a firm. There are properties or characteristics that can be used to value an object. Problems with valuation arise when there are informational deficits about the object. OVERALL: Firm/Corporation is a business entity where group of individuals come together to provide a group of inputs that will produce something of value which will give them return down the line. Lawyers are concerned with valuation of the inputs, not only when they put their inputs in, but get their returns. Must anticipate with potential problems that may arise and deal with them contractually, or rely on the law to deal with it, or discount for the risk. Lastly, the transaction may not make sense, so you should advise them to not go through with it if it does not make sense. Agency: Agency is the fiduciary relationship that arises when one person (a principal) manifests assent to another person (an agent) that the agent shall act on the principals behalf and subject to the principals control, and the agent manifests assent or otherwise consents to act. What is an agent how do we know when someone is an agent? Restatement of Agency (Third) is a place to look Agency is a fiduciary relationship. What is meant by that? Managers, board members, other employees are agents for shareholders. Partners are agents to each other. Each of these individuals will owe fiduciary duties to their principals. Duty of care and loyalty are the two principal fiduciary duties owed to board members. Agency fiduciary relationship that arises -> what are the necessary and sufficient conditions for having this duty arise?? Necessary if not there, then no agency relationship Sufficient if there, then it is enough

Always think about the conditions for certain legal rules to apply how are they triggered are they necessary or sufficient?? when one person, Person is defined as an individual , organization, association that has legal capacity to possess rights and incur obligations, government, political subdivision, or instrumentality or entity created by government, any other entity that has legal capacity to possess rights and incur obligations. a principal, manifests assent to another person, an agent, what type of manifestation are they talking about? 1.03 discusses this can be written or spoken words or other conduct. The word assent tells you this is a contractual relationship. Triggers a lot of contract law concepts. These will be very important, since contract can define a relationship. that the agent shall act on the principals behalf and subject to the principals control, and the agent manifests assent or otherwise consents so to act. The agent agrees to this contractual relationship and thus owes duties to the principal. What is fiduciary duty? It can go both ways, where both parties are agents and principals to each other (partnerships, for example, since they both wear an agent hat). Ex: deposit money with a bank do they owe you a fiduciary duty Law firm hires you as an employee to draft contracts you owe fiduciary duty to the partners if the relationship is an agency relationship. For agency, must have someone acting on behalf of someone. Fiduciary is from Latin word for trust Agent agrees to act on behalf of principal this takes this out of a run of the mill relationship. Informational asymmetries between principal and agent agent will have some information that principal will not have. If principal has to micro-manage the agent to make sure they are acting right, then the principal should just do the actions themselves. There is value in delegating to others to take actions on our behalf. Risk arises that the agent will do things that harm the principal. Law establishes in certain types of common relationships that are valuable to society that establishes protections around the relationship in case agent actions harm principal. How do principals police their agent?? How do partners police their other partners? How much effort should they expend?? A principal may monitor their agent. Could draft contractual provisions to deal with potential problems if agent does not act properly. Principal could maybe discount for the risk of not monitoring the agent maybe not pay as much as when you monitored him completely. Or, not enter into the transaction since it is not worth it. Ex: team signs a player or coach and they do not put forth as much effort/quality there are potential problems that may arise, so try to anticipate the potential actions that could be taken that could hurt the principal. One way to align interests of principal and agent is to give incentives (e.g. strike out bonus).

Incentive mechanisms can have side effects (e.g.maybe use steroids to achieve bonus, maybe just excel at bonus requirements, and not put effort forth on other important aspects of the job). Discounting the risk Orange example 50% chance that orange will be bad. Normally, oranges sell for $1. You will only be willing to pay 50 cents for the orange since you recognize the risk ($1 x .50). Focus on the expected value of things = Probability of something x magnitude of value (.5 x $0) + (.5 x $100) = $50 (the expected value after discounting for the risk) The probabilities in an equation cannot add up to more than 1 or 100% People willing to pay the expected value are risk neutral. If someone is willing to pay above the expected value are risk preferring individuals. Most individuals are risk adverse willing to pay less than the expected value. Risk premium extra amount that you are willing to give up in order to be risk adverse (think of insurance people buy it since they want to get rid of certain risks, and they are willing to pay people to take on that risk). If someone is only willing to pay $30 to play a game of chance, when the expected value is $50, they are giving up $20 as the risk premium. Most people are risk adverse they discount objects even more than the expected value. Two types of probabilities we are concerned with: 1) objective probabilities repeating the same thing in the same fashion 2) subjective probabilities these are most common look at situation and analyze information start with information set that will give us a sense of how to attach probabilities to something happening or not happening. Start with an educated guess using the info you have and hone it down over time to make it correspond to the true probability. As a lawyer, you are an information gatherer/verifier. Information and informational asymmetries are very important what info needs to be acquired? How do we verify the info? How much effort should we expend in acquiring it?

II. The Partnership

Partnerships: 1) How is it formed? 2) What legal rights/duties are triggered? 3) What types of parties are involved in partnerships? A) members of the firm B) others who transact/interact with members of the firm 4) What types of conflicts are likely to arise? 5) How can we deal with these potential conflicts? A) contracts

B) the law C) discounting for the risk? Why would someone buy risk? in buying a lot of risk from multiple parties, it will be spread out and lessened. There is a value in having other people do things for us. You could build your own computer, but it would not be as good as one made by other people who have greater knowledge and expertise. Buying a computer is an arms length transaction it is market transaction. There are other types of transactions that involve agency relationships. Buying a computer for Dell you have no control over the person taking your order and making the computer. The line between arms length and agency can be hard to find sometime. Look for someone maintaining control over the goals and how something will be accomplished. What is a partnership? How do we know co-owners when we see them?? Involves some kind of control over the use or sale of the assets of the business (real property, things of value, cash, securities, etc.). This does not mean that every owner had to have complete ability to control all of the assets. (see Meinhard v. Salmon) The amount of control is a question of fact since there are different levels of control. UPA 6 defines partnership as association of 2 or more persons to carry on as co-owners a business for profit. Association denotes some relationship ongoing over time, which means there are risks involved as time passes. 7 tells us some ways of making sense of 6. We care about whether a partnership exists and who is a partner sense there are third parties and liabilities, etc. Meinhard v. Salmon (Ct. of Appeals, NY, 1928) p. 67 Partnership existed between lessee and another person who provided funds to cover the lease and changes to the building. M was to pay S half the money to cover things and S was to pay M 40% of the profits for 5 years, then 50% afterwards. M and S were to bear losses equally. S also acted as manager. S entered into lease of renovated property without telling M. When M found out, he demanded the lease be held in trust as an asset of M & Ss original venture. Court found that lease should be split between M and S since M excluded S from any opportunity of benefit that had come to M because of their joint venture funded by S. Joint adventurers, like copartners, owe to one another, while the enterprise continues, the duty of the finest loyalty. Many forms of conduct permissible in a workaday world for those acting at arms length are forbidden to those bound by fiduciary ties. A trustee is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of honor the most sensitive, is then the standard of behavior . . . Uncompromising rigidity has been the attitude of courts of equity when petitioned to undermine the rule of undivided loyalty by the disintegrating erosion of particular exceptions. Only thus has the level of conduct for fiduciaries been kept at a level higher than that trodden by the crowd. Rule of Meinhard v. Salmon Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior. - this standard is vague. When you encounter a

blurry test or standard, that is an indication that it is not blackletter law, but an arguable standard. May be fact specific. One possible test is someone comes to your office and says they want to stay silent about something to their partner. If they go to court, they have to give a reason, and wanting 100% of profits is not a good sounding reason. THINK how will it look at the time of litigation. At the front end, when you are advising a client, you have to provide a roadmap to your client of what can and cannot be done. Inadvertent partnerships: At common law, a sharing of profits was deemed conclusive of the existence of a partnership. Now, it is seen as prima facie evidence, except in certain situation, no inference shall be drawn. UPA says that someone who receives profits is presumed to be a partner this sounds like it can be rebutted. Martin v. Peyton (Ct. of Appeals, NY, 1927) p. 125 Financial firm (ongoing partnership) is in trouble. Characteristic of general partnership is that if creditors go after a partnership, then they can go after the partners jointly and severally general partners have unlimited liability. Here, people loaned money to a firm, and refused to become partners. Instead, they secured other things of value profit shares, control over decisions, etc. Capital Structure Debt = bank loans, trade creditors who provide stuff, debt securities can be issued Capital Equity = partnership interest (unlimited liability), shareholders (limited liability) Risk increases if you have unlimited liability. It is safer to be a shareholder since there is less risk. Limited liability = if creditors are owed money, then they can go after the assets, but not the individual shareholders. Corporations have limited liability while partnerships do not. So, the people loaned money to the failing firm to help out their capital structure, but refused to become partners. Indicators that something is debt: 1) there is loaned money (the principal) that will not be kept by corporation or partnership must be returned. Is this contribution one that will be returned in a certain period of time? In case, the contributions would be paid back. It was to be used as collateral for the company to get a bank loan. Assets totaled 2 million instead of 2.5 million since the value of the collateral might fluctuate up or down. In determining if it is a loan agreement or a partnership words matter, but form gives way to substance. Since agreement required 40% of profits to be paid until return was made, it might have looked like a partnership, but it included a cap of not above and not below certain amounts, so that made it more in the line of interest payments. Control held by lenders was they could inspect the books, give consent as to the sale of securities (a veto power). Court found that this was more like a loan with strict guaranty and control provisions, rather than a partnership. They exercised ordinary business caution and flat out refused when asked to become partners. Court cautioned that in some situations, looking at all the facts, a partnership could be found. Common type of litigation is that one creditor will go after a subsequent creditor who loans a firm money since they have assets that the company does not.

Company can issue debt securities (go to Goldman Sachs, let them know you want to issue $1 million in debt securities for a fee, they find buyers). Since there will be numerous holders of the debt securities, there must be a trustee who represents them all. Also, there is an indenture, which is cut up so that when people claim their interest, it matches the original and is not counterfeit (think of teeth fitting together). Smith v. Kelley (Ct. of Appeals, KY, 1971) p. 129 Opposite of Martin v. Peyton someone trying to be declared a partner to share in profits. He got a bonus paid out of profits but it is not something automatic like profit sharing bonus is a common way of providing an incentive to an agent to act in accordance with wishes of principal. Even though he was held out to be a partner in public (contracts with third parties, tax returns), it was not enough here. In order to protect creditors against partners claiming they are creditors, a court will try and find a partnership to protect creditors. The courts will not be as inclined to protect someone trying to get the upside of the partnership and share in the profits A partnership is a contractual relationship and the intention to create it is necessary. As to third parties, a partnership may arise by estoppel, but our question is whether the parties intended to and did create such a relationship as would entitle appellant to share in the profits. Partnership by estoppel required something else Represent yourself or allow someone else to represent you as a partner in an existing or non-existent partnership. The person who consents to it is liable to creditors. In representing someone as a partner, you are trying to make it more likely that a creditor will extend credit to the partnership. Estoppel works by not making them an actual partner, but only a partner in fact to the creditor who was represented to that the person was a partner. To form a corporation is different from a partnership there is no such thing as an inadvertent corporation. Must be some written document establishing the corporation. In order to be a corporation, there must be a certificate of corporation with the secretary of state. This puts people on notice as to the existence and liability of the entity.

III. Where and How to Incorporate

How do you form a corporation? 1) why would anyone form a corporation? once you know the answer, you know what they will lose if there is some problem in the formation of it. principal reason is to get limited liability; so if the proper procedures are not followed, there will be a group of individuals believing they are shareholders when they are actually partners with unlimited liability. a creditor will try to get someone declared a partner rather than a shareholder

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4 things you basically need to have a valid certificate of incorporation: 1) corporate name helps avoid confusion with any party that deals with the entity; confusion can be costly if the world is not put on notice that this entity is a corporation and has limited liability. - state can require you to follow its corporation statutes since they are giving you permission to have limited liability as a corporation under their articles of corporation 2) Whether the corporation is authorized to issue shares / how much they can issue - issue = sell; money you get in return is a capital contribution that the company can use - shares represent a share in the ownership, so you must look at who could be hurt by certain actions; if board could sell shares whenever they want, with no limit, then the other shareholders would be hurt since their shares would be less in value = their control would be lessened. Remember that shareholders are co-owners since they share control and share in the residual capital/profits. - of the four things you must have in the corporation certificate, this is the principal one and the most important one; only shareholders can amend the certificate of corporation 3) corporate office address & name and address of initial registered agent at that office 4) name and address of incorporator May include names of initial directors, other provisions not inconsistent with law regarding: purpose(s) for which the corporation is organized, other restriction on the management of the business, restrictions on powers of board of directors or shareholders, par value of shares (minimum amount that has to be put into the corporation when shares are purchased not recommended), imposition of personal liability on shareholders for the debts of the corporation to a specified extent and upon specified conditions (not recommended). Usually best to keep certificate of incorporation limited to just the required elements. When you add other provisions, it creates additional problems without adding real value. The cost of filing a certificate of corporation is small, but the process can still be messed up. Corporate existence begins, unless delayed effective date is specified, when articles of incorporation are filed that is when limited liability is triggered!! ** We are dealing with principals and agents corporate documents that are filed must be exceuted by certain entities the person who executes a document must sign and state beneath it the capacity that they are signing in. This lets us know if a principal (shareholder) or agent (officer, director, etc.) is signing and if they are duly authorized to sign. Corporation they have indefinite duration until dissolution; gives stability, etc. Corporation can have a very broad purpose (anything that is lawful). Can also have limited purpose may want to use this as a commitment device to prevent other officers/directors to enter into businesses you do not want to enter into. Also acts as a signaling device to give focus on what the business should do. Sometimes you may form the corporation under corporate law, but you may be subject to other regulatory requirements there may be a policy reason for restricting the purpose of the organization.

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What steps must be taken after filing? 1. Want to adopt a minutes book it is where any minutes from official meetings will be kept. Minutes record what was agreed to, what was voted on, etc. It keeps track of what has been agreed to and authorized by the board and officers. 2. adopt bylaws of the corporation bylaws constitute the internal set of operating rules for the corporation. They include technical things like how to call meetings, what type of notice has to be given, how many board members, etc. Are they elected or staggered terms?? The board of directors adopts the bylaws on behalf of the shareholders do not need a shareholder vote to change the bylaws (contrast with need of shareholder vote to change the certificate of corporation. Shareholders by shares and make a capital contribution to the corporation in return they get an ownership right they then have a right of 1) control and 2) the residual capital. 1) Only shareholders can amend the articles of corporation and authorize the issuance of new shares. Only shareholders elect board members. 2) The corporation will not be managed by the shareholders it will be managed by or under the direction of the board of directors. 3) Board of directors will turn around and elect officers to run the day to day business of the corporation. If shareholders do not like how the company is being managed, they can get rid of the board. You want a separation of ownership from the management of the corporation this focuses the management of the company. There are a lot of people who may have capital to become shareholders, but who do not have the business savvy to manage the corporation you want to delegate those responsibilities to people skilled at that = your board members and officers. This system aggregates a lot of capital that is put under the expertise of the managers with expertise in making the money grow. Limited liability puts every shareholder in the same boat since they invest a certain set amount per share in a partnership, partners bring different things and investments to the entity, so they are not in the same boat due to unlimited liability. Questions to ask when dealing with a business transaction: 1) who are the individuals involved? 2) what are their common interests? 3) how do their interests conflict? 4) how do they deal with conflict? a) discounting for risk? b) deal with the potential conflicts contractually (reducing the risk of the conflicts) c) let the law deal with the conflict d) may not go through with the transaction

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Questions to ask at the formation of a contract: 1) who are the individuals involved at the early stages of corporations? 2) what are the types of actions that we expect them to take? 3) what are the legal repercussions of these actions? ** By actions, we mean do or not do something. So, do not look for actual actions, but look for omissions or inactions. If someone is under a duty to disclose something, and they dont, then that action may trigger legal consequences. Example: Two individuals 1) scientist/labor 2) money/labor If they decide to form a corporation, they then file the certificate of incorporation with the sec. of state, and in essence create a legal entity. The two individuals should then decide how the shares are split up, and this can be important since you then may have majority and minority shareholders. The majority shareholder (over 50% of the shares) controls the company. There are also certain duties that a majority shareholder owes to a minority shareholder. Next, you go through valuation to see how much the shares are worth. If they are worth $10, you then assign the number of shares to meet the value that is contributed by each individual. If the scientist is putting in $1000 worth of labor, they get that much in shares, etc. Formalities matter at the inception of a corporation they are important in case conflicts arise later. If not done correctly, creditors can use irregularities to gain a foothold in pursuing claims. Partnerships and corporations are taxed differently. Corporation unless they qualify as S-corps under tax law (which is easy to do if you are a small corporation), there is a corporate tax on the profits, and when dividends are paid, the individual shareholders are taxed on the dividends. A small corporation (s-corp) can avoid this and be taxed like a partnership and only have one tax imposed. Partnership shareholders only taxed once when dividends are distributed

IV. Ultra Vires

Ultra Vires: Outside the power not within the scope. Actions taken are beyond the power to take those actions. 1) what was trying to be accomplished by ultra vires If you have a purposes clause that says X, you expect people (investors) to take it at face value RELIANCE and enforcement of the provision 2) why did the doctrine fall away Limited liability can hurt potential creditors. Unlimited liability protects the creditors. If creditors have information, then they know the risk, and limited liability will not really hurt the creditor. They can charge a higher interest rate or have loans be personally guaranteed. Corporations used to be considered too powerful, but over time these worries have subsided, and ultra vires is a relic of this.

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3) when would it still be used 3.04 (b) corporations power to act may be challenged 1) in a proceeding by a shareholder against the corporation to enjoin the act 2) in a proceeding by the corporation through a legal representative against a director, officer, or agent 3) in a proceeding by the attorney general. Subsection c discusses actions to enjoin the corporation they may be done if it is equitable and all affected parties are in the proceeding, and damages may be awarded for loss suffered by a party because of enjoining the act. Basically, all the individuals who may be hurt should be part of the case and those trying to challenge the act may have to pay damages to those who get hurt by the enjoinment attempts to keep people from weaseling out of a contract since you may have to compensate those who are hurt. ** Today, most corporations will set a scope of authority within the limits of the law. They will not restrict or hinder future actions. Ashbury Ry. Carriage & Iron Co. v. Riche (House of Lords, 1875) p. 223 You have a corporation where the articles of incorporation had a limited scope of purpose could sell or lend railway plant, to carry on the business of engineers and general contractors. The company decided to go into business with another company, and were primarily financing it. A dispute arose over a contract, and the court found the contract to be ultra vires. Even though contract was legal, the question focused on the power of the company to make this contract. Court found the contract void since the company could not make the contract (due to competency and power to enter into transaction) A lot of cases arose where individuals tried to get out of contracts claiming ultra vires. Company would enter in contract, and if things went well, they would benefit, and if it went bad for them, they would try to get out of it. This led to strategic behavior and costly maneuvering. Thus, the doctrine came to be eroded. 711 Kings Highway Corp. v. F.I.M.s Marine Repair Serv., Inc. (SC of NY, 1966) p. 224 A corporations articles said it was to do general marine activities. Later, it entered into a lease where the land would be used for a motion picture theater, which had nothing to do with marine activities. Court looked to 203 of NY statute (corresponds to 3.04 of MBCA 1984) which limits who may bring a claim of ultra vires against a corporation limited to shareholders trying to enjoin a corporate act or bringing an action by right of corporation against officer or director. Plaintiff was not entitled to bring the claim, and case was dismissed. Ultra vires doctrine is limited as much as possible. In notes 3 and 4 following 711 case, courts will use the term ultra vires but mean something else like a regulation, etc. If you are going to rely on the doctrine of ultra vires, must show that shareholders are bringing the action (this can be broad), and the best approach for a court is to not rely on the ultra vires doctrine. SO - as a litigator, only use it when you have no other option it is a last resource!! SO, in spotting these issues, look for something exceeding the scope of a corporations authority. If that exists, then look at who is trying to bring an action challenging this. Is it a shareholder, or attorney general?? Who are they suing?? Are all the necessary

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parties involved in the case? Is it equitable or not? Do parties that will be hurt need to be compensated? (Who may be hurt?)

V. Premature Commencement of Business

Promoter person who directly or indirectly is involved with founding or organizing a business or enterprise.Tries to bring parties together may try to identify investors, potential employees, etc. May arrange leases, other necessary transactions. Your client should never ever take any action before the certificate of corporation has been filed and the secretary of state has issued a letter saying it has accepted the documents and the corporation exists. Before then, the limited liability is not guaranteed. Any person who takes actions before the corporation exists will have individual liability, since the corporation does not exist to act the individual is acting. This is the default rule. Another set of rules governs when the corporation is liable. The corporation can step in and say it is liable for something done before the corporation existed, but even if the corporation assumes the liability, the individual/promoter is STILL liable. A new contract would need to be written to novate the old contract. Creditor agrees to release the promoters liability and transfer it to the corporation BUT a creditor does NOT HAVE to enter into the novation. Stanley J. How & Assoc. v. Boss (US Dist. Ct, Iowa, 1963) p. 236 Classic fact pattern for premature commencement case the signature triggered the case. Promoter signed it as an agent for a company not yet formed. He could not be an agent for the corporation at that point since the corporation did not exist when he signed it. Courts sometime look at it as an offer, and once the corporation is formed, the offer is accepted, then it is ok BUT, must have evidence that that is what was intended. Promoters are always liable unless you can show the parties intended otherwise 1) was an offer not to be accepted until formation 2) parties intended promoter was going to be liable only up until formation of the corporation. Unless there is a contract between a shareholder and a creditor directly, then the creditor can only go after the corporation. The creditor then must attack whether there is a corporation at all for there to be limited liability. They could attack the validity of formation no certificate of incorporation filed; filed form was bounced/rejected; contract was formed before corporation came into existence McArthur v. Times Printing (1892) p.240 Whether a corporation has agreed to be bound by a contract that a promoter entered into. Yes if express or implied ratification of the contract. Low threshold, since just actions can be enough. While no formal arrangements were made relating to the contract, all the shareholders and directors knew of the contract. Nobody repudiated or complained of the contract after incorporation. ** If parties wish to have a novation or amendment of a contract, must ask whether the amendment would potentially hurt someone.

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In situation where promoter and creditor enter into contract before a corporation is formed, the question becomes, what type of fact situations arise? Was there a subsequent formation of the corporation? If no, then hard for promoter to argue they have no liability. Could argue that creditor meant to contract with corporation, not the promoter, but that is hard to win also. Defective Incorporation: Robertson v. Levy (Ct. of Appeals, DC, 1964) p. 241 Contract entered into after party sent in articles of corporation. L was to form a record company business which would buy Rs business. Articles were bounced but later were accepted. R sued L for balance due on the note. Question arose as to who was liable for the contract when the corporation failed the corporation or the person who signed it. At what point in time was the corporation formed?? Promoter was liable since he knew there was no corporation. Levy is subject to personal liability because, before this date, he assumed to act as a corporation without any authority to do so. Nor is Robertson estopped from denying the existence of the corporation because after the certificate was issued, he accepted one payment on the note. The existence of the corporation is conclusive evidence against all who deal with it. Under 139, if an individual or group of individuals assumes to act as a corporation before the certificate of incorporation has been issued, joint and several liability attaches. We hold, therefore, that the impact of these sections . . . is to eliminate the concepts of estoppel and de facto corporatenss under the [DC Corporations Act]. It is immaterial whether the third person believed he was dealing with a corporation or whether he intended to deal with a corporation. The certificate of incorporation provides the cutoff point; before it is issued, the individuals, and not the corporation, are liable. De jure valid legal entity when there has been conformity with mandatory conditions precedent. Not subject to attack by anyone, including state. De facto the corporation is one which has been defectively incorporated. Must have 1) valid law under which it can incorporate 2) attempt to organize thereunder 3) actual user of the corporate franchise. Sometimes, good faith in claiming to be a corporation is required. Recognized for all purposes except where there is a direct attack by the state in a quo warranto proceeding. Corporation by estoppel where a party has recognized an entity as a corporation and is estopped from subsequently claiming it is not one. 2.04 MBCA if someone acts as or on behalf of a corporation knowing it was not incorporated, they are jointly and severally liable for all liabilities created while so acting. Cranson v. IBM (p. 246) defines de facto as 1) existence of law authorizing incorporation 2) effort in good faith to incorporate under the existing law 3) actual use or exercise of corporate powers. Where the three elements of a de facto corporation are found, there exists an entity ehich is a corporation de jure against all persons but the state.

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Certainty in the law provides value. If there is more uncertainty, then there is more risk. This all affects whether people will invest in the company and whether creditors will provide loans to the corporation. Having a clear-cut rule also provides you with an incentive to take action and incorporate as quickly as possible.

VI. Disregard of the Corporate Entity

Parent subsidiary assets Creditors will try to get to the assets of the parent company. To do that, must pierce the corporate veil. In reviewing balance sheet, question is whether, if you sold all of the assets, could you pay off your debt. Do the liabilities exceed your assets?? Any leftover assets go to the shareholders. What is relevant to piercing the corporate veil?? Bartle v. Home Owners Coop. (Ct. of Appeals, NY, 1955) p. 254 Veterans organized group to provide low-cost housing to its members. Individuals could not secure contractor, so they organized for that purpose. Eventually, it went bankrupt. Plaintiff wanted to pierce corporate veil to get debts paid by parent company. Defendant owned stock of bankrupt company, therefore it was a parent to the subsidiary. Court found that at all times, parent and subsidiary maintained outward separateness. Does not matter that they formed company to avoid liability. The law permits the incorporation of a business for the very purpose of escaping personal liability. Yes, if you have fraud or misrepresentation, that may make it more likely, but these are not necessary conditions to piercing the veil. Dissent argues that it seems purposeful that they were not keeping funds in the corporation, and the shareholders benefited by keeping the housing outside of the company the burden fell to the creditors. If shareholders knew it was a risky, unviable situation, it puts them in a worse position in defending their actions against creditors. Corporations assets could be siphoned off through paying a salary, dividends, paying off loans and liabilities, etc. When a corporation has assets, first claimants will be the creditors. Shareholders will thus try to take it first by the above methods. Most of these piercing cases will be about under-capitalization - where the cushion of capital is very small or non-existent. That does not mean the courts will always focus on undercapitalization. The word is a term of art. Utset wants us to focus on it in these cases since it is the best way to win the case and pierce the corporate veil. Most states require undercapitalization and something else, but it 1) will always be the best argument and 2) you want to make sure that clients maintain proper capitalization for their businesses to avoid piercing problems in the future. Examples of UC company or subsidiary was run so that it was impossible to make a profit. Cost of production is equal to revenue or there is no profit since the money is being take out for salaries or dividends.

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Negative externality when you take an action, you can bear all the costs of taking an action, or not. There is a tax on the actor when it does not bear all the costs of its actions. (e.g. nuclear plant does not maintain facilities well, outside world bears brunt of these actions. Plant is under limited liability, so does not bear the cost if they get sued. But, law can impose regulations that require company to do certain things to avoid negative externalities.) If limited liability does not create responsibility for actions, then other people will bear the costs. How do you determine undercapitalization?? Look to other companies and compare to see what is reasonable in similar situations. Have they been sued and had the veil pierced?? Look at their balance sheet or annual report. Have they taken out insurance? What types of creditors are they working with contract creditors or tort creditors? Contract creditors banks, trade creditors, employees. Tort creditors what type of tort actions have been brought against a company. If there are potential lawsuits floating around certain types of business, then the company is likely to have extra capital on hand or insurance. Ex: banks are regulated and have capital requirements. DeWitt Truck Brokers v. W. Ray Flemming Fruit Co. (4th Cir. 1976) p. 256 One man owned over 90% of stock of corporation. If a company has only one stockholder or director, then it is an indicator that there is not a group of people making decisions, so the sole decisionmaker will make decisions in their own best interest. Looked less like a corporation and more like a personal shield for the sole beneficiary. He was not trying to put together a corporation in the classic manner. Court affirmed piercing the veil and imposing personal liability. Modern counterpoint to this is that it does not matter if just one person is running the business. Most corporations are that way. These are very fact specific cases not clear which facts are relevant and how the facts should be used to argue one way or the other. Here, defendant was taking out whatever amount was available as a salary rather than taking a fair market salary. In this case, there also was a personal guaranty people with a personal guaranty will be better off, but other creditors may want to pierce the veil. Piercing cases are there to prevent the shareholders and corporations from imposing a negative externality upon creditors. How can creditors protect themselves they know they are dealing with a limited liability entity. They can charge higher interest rate, not enter the transaction, take security over assets, require personal guaranty. A tort creditor, on the other hand, will not have those bargaining tools. Baatz v. Arrow Bar (SC of S. Dakota, 1990) p. 263 Plaintiffs were injured on motorcycle when guy hit them with his car. Driver had been drinking at Defendants Arrow Bar. In this case, the plaintiffs are tort creditors. Plaintiff argues that even though bar has limited liability, the corporate veil should be pierced since owners personally guaranteed corporate obligations. But, court sees this as a contractual agreement and has nothing to do with torts. Guarantees are agreements, and the injured party is not a part of the contract. Also, fact that person made guaranty shows that they are not trying to hide behind the corporation. Also, fact that people got guarantees shows that others did not want to try and

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pierce the veil in their dealings with the corporation. Plaintiff also argued that corporation was the alter ego of the bar owners. Court said there was no evidence of this the owners did not seem to transact personal business through the company. Other evidence might have been commingled funds (allowing shareholders to siphon money off), etc. But none of this was brought forth. Plaintiffs third argument was that corporation was undercapitalized. Court found that Baatz did not show how the $5000 startup money was inadequate. There were personal guarantees to pay off the purchase contract and the stock subscription agreement, which Baatz did not consider. When you extract capital, you shield yourself from some liability. If you do or do not extract capital, and you have a personal guaranty, then you are not shielded from liability. So, best thing is to not extract money so the veil will not be pierced for undercapitalization. Baatz could have also shown undercapitalization shown it by pointing to similar businesses but he did not. Best way to show the presence or absence of undercapitalization is to make a balance sheet of assets and liabilities. Lastly, Baatz argued that the corporation did not display its corporate name. Court said that it met statutory requirements of having inc. in the corporate name. Utset says this should not matter in a court case it does not relate to the rightness or wrongness of piercing the veil. Baatz did not even know that Arrow Bar existed until the accident. Plaintiff would not have acted differently if they had known Arrow Bar was or was not a corporation since they were not dealing directly with the business entity. So, the lack of formality does not have a nexus to the actual harm. Why should insurance be encourage over higher capital requirements? Overcapitalization ties up money and goes against a corporations purpose of growing money. How to approach piercing situations: 1) when advising a client 2) when arguing before a court 3) when in the policymaker role Is the test fact-specific? When it is, you deploy a series of facts to give content to a rule. What facts are relevant?? How can you transform those facts into being relevant?? In piercing situations, how do you show undercapitalization? Lack of formalities? Lack of control? Is there a nexus between undercapitalization or lack of formalities/control and the harm at issue? By not extracting capital, you can be shielded from piercing attacks. Parent-Subsidiary Cases: If you form a subsidiary, you are doing it for a bunch of other reasons than just getting limited liability. So, in these cases, courts are less likely to find that piercing is appropriate. The thing to look for is whether the parent company is throwing a bunch of liability situations and putting them in one subsidiary.

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Radaszewski v. Telecom Corp. (8th Cir. 1992) p. 268 Personal injury claim filed against subsidiary company. Plaintiff injured when motorcycle was hit by truck driven by employee of subsidiary company. Plaintiff in this position needs to show three things: 1) complete, dominant control of not only finances but also policy and business practices so that the corporate entity has no separate mind, will, or existence of its own 2) such control must have been used by defendant to commit fraud, do wrong, do dishonest or unjust acts, violate statute or legal duty, etc. 3) control and breach of duty must proximately cause the injury or unjust loss complained of. This court looked at the fact that the company had more insurance than required by statute. Something more had to be shown, and it was not present here. In this case, court dismissed case doctrine of limited liability is intended precisely to protect a parent corporation whose subsidiary goes broke. That is the whole purpose of the doctrine . . . We think that the doctrine would be largely destroyed if a parent corporation could be held liable simply on the basis of errors in business judgment [here, company did not have much capital, but had a lot of insurance coverage]. Something more than that should be shown . . . in our view, this record is devoid of facts to show that something more. What does parent company control over a subsidiary mean? It is like a shareholders controlhas control over who will be board of directors, etc. Fletcher v. Atex, Inc. (2d Cir. 1995) p.272 Subsidiary of Kodak was sued for carpal-tunnel problems from keyboards they manufactured. Plaintiffs tried to get through Atex to Kodaks assets. Court affirmed that there were independence factors identified by Kodak requiring the court to respect the separateness of the companies NO PIERCING. 1) cash management system which mingled funds was ok it was not complete co-mingling of funds. 2) fact that Kodka had to approve decisions made by ATex was no dispositive many companies are structured that way. 3) Although a lot of Kodak employees sat on Atexs board, it was negligible overlap. 4) the description of the companies relationship in promotional literature does not justify piercing. Overall, Atex never merged with Kodak or operated as a division of Kodak they should not be treated as a single economic entity. ** Fletcher is a good model for a piercing case since it sets out the facts well. What is standard business practice? Need to know about the business background to be able to analyze a business. Stark v. Flemming (9th Cir. 1960) p. 296 Woman put her assets into newly formed corporation and began to draw a salary from it. Government agency found that the company was a sham to get her to qualify for social security payments. Court said that there was proper adherence to corporate requirements. Congress did not provide that what she was doing was disallowed. The Secretary may evaluate her salary amount to see if it is reasonable, but she can still get the social security payments.

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Roccograndi v. Unemployment Comp. Bd. of Review, (Superior Ct. of PA, 1962) p. 297 Family owned wrecking business. Would shift laid off positions to see who would get unemployment compensation. Since members were all stockholders in company, court affirmed finding that they had sufficient control to lay themselves off, therefore they were not entitled to benefits. Pepper v. Litton (SCOTUS, 1939) p.303 P sued company for accounting due to P under a lease. L, the sole shareholder of the company, had company confess judgment to L in form of back salary. P obtained a judgment, then L executed the back salary judgment. L purchased corporate assets at resulting sale. Company then filed bankruptcy. Issue was the power of the bankruptcy court to disallow either as a secured or as a general or unsecured claim a judgment obtained by the dominant and controlling stockholder of the bankrupt corporation on back salary claims. Court affirmed that there was a scheme to defraud creditors. Just because an officer, director, or shareholder has a claim against a company does not move it to the front of the line in bankruptcy proceedings. Those types of dealings with a company are strictly scrutinized the burden is on the party to prove the good faith of the transaction and to show its inherent fairness from the viewpoint of the corporation and those interested therein. The essence of the test is whether or not under all the circumstances the transaction carries the earmarks of an arms length bargain. If it does not, equity will set it aside.

VII. Financial Matters and the Closely Held Corporation

What is the capital structure of the firm?? At issue is 1) control in the form of voting rights and 2) a right to distributions as a return on their investment. Company must figure out what to do with cash coming in from sale of its goods/services. If you are thinking about investing in a company, the question to focus on is how much debt/equity does the firm have? You are worried about the risk of investment in that entity. How do you assess the risk of a firm? Risk is only possible if there are time gaps, so, the greater the time between investment and return, the greater the potential risk. The greater the amount of time, the greater discount you should take for this risk. If a stock will not realize a return for10 years, you should pay less for it than a stock with a return time of 1 year. Another thing to consider is delayed gratification is there more value to something you can get sooner?? You may die between the two points, and you would be better off getting stuff sooner than later. So, you may discount not only for the risk, but also for the delay in receiving the return. Instead of discounting for risk, you could also attempt to manage the risk by being involved with the companys functions. May also want certain additional controls over matters. One principal of corporate law is that shareholders control the corporation because they can elect the Board, but the management is done by the Board. There is a delegation, and there is only a limited number of things a shareholder can do. You get benefits from division of labor and consolidated control. Another thing to worry about is priority who gets paid first?? If there is not enough to go around, this is a BIG issue.

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DEBT: Bonds secured debt Debentures principal type of debt security Cross-default provisions if you fail to pay one of your debt-holders, all of your debentures go into default. EQUITY: Preferred stock Common stock purchase DEBT $ Distribution ongoing Interest & principal liquidation Debt first secured debt debentures since it gets paid first, it is the less riskier thing. control Some control; will have affirmative covenants (you shall do X) and certain negative covenants (you cannot do Y)

Bonds debentures EQUITY preferred common Redeemable Yes but does not have to be

$ labor

Cumulative & non-cumulative dividends dividends rights dividends rights distribution

convertible Debt can turn into equity as either common stock or preferred stock

No must always have at least one share outstanding for voting and distribution rights. 22

Articles must authorize shares that provide for voting rights and dividend distributions this is because someone HAS to have control and a right of distribution because shareholder by law must vote and someone has to get what is leftover if a company goes under. These are common stock holders they will, as a default, have the ultimate power to make certain decisions. Rights of common stockholders have right to 1) amend certificate of incorporation 2) elect the board 3) vote on a merger 4) decide sale of all or substantially all of the assets 5) decide upon dissolution 6) bring derivative suits. Shares are authorized in the articles of incorporation or can be authorized by amending the articles (remember that only shareholders can amend the articles). 6.21: deals with the issuance of shares. Capital structure of a firm: Distribution DEBT ongoing - bonds debentures Control Convertible Redeemable Yes - can Yes be converted into other type of debt

dissolution

EQUITY - preferred stock - common stock

Common stock is paid dividends on an ongoing basis remember there is no right to this ongoing distribution, so you must discount for the risk.

Common stock gets distribution on dissolution if there is any residual.

Why are control rights and residual rights generally held together in common stock? Because someone exercising control should have an interest in making control decisions in interest of the corporation (i.e. would want to have assets left over for distribution to shareholders, so would make control decisions in furtherance of that goal). When talking about voting, we mean common stock holders and their voting rights. When stock is separated into different classes and series, the name must distinguish between these

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groups/classifications. At the time of finalization of the issuance of stock, must make sure that it has all the requirements and features set forth as required in the articles of incorporation. Vanilla preferred stock is just the shell of preferred stock, which you then use by filling in the blanks by using 6.02 board of directors decides if it is convertible, redeemable, etc. An amendment is then filed with certificate of incorporation to show what the stock breaks down into e.g. Class A consists of series 1 through 10, etc. Why would a board wait on filling in vanilla stock details may need to wait and see what happens this is an option value. Once you acquire certain information, you can do or not do something. May wait to see what the capital needs of the company will be, may need to wait and see what the market will be like, etc. The whole point of providing several types of stock and debt options is to appeal to a spectrum of people people who want a lot of risk, people who want less risk, etc. You want to allow the board to determine at the last minute who they want to attract with the stock that will have particular characteristics that take advantage of the market environment. It is very costly to hold shareholder meetings, so by creating vanilla stock, the shareholders then delegate to the board the decision-making power thus avoiding having to be involved in the minutia decisions that will need to be made right before issuance. 6.03 when we say issue, we mean sell. Outstanding means standing outside of the corporation. Do common stocks have a contractual right to distribution? Characteristics of a contract are 1) parties consent to it and 2) it breached, a party can sue on it. Common stock des not have the 2d feature. We will see cases where stock holders sue to force the board to pay a dividend they will usually lose these cases unless the board has abused its discretion in not paying a dividend usually impossible to force a board to pay a dividend. Debt has a contractual right to get paid distribution, while equity does not. Upon dissolution, debt is paid first, and equity later if there is anything to cover it. Common stocks get the residual in a period, if preferred stock has been paid its share. Cumulative preferred stock if dividends are not declared or paid in a quarter, it does not disappear. Each time you are not paid, the amount rolls over to the next quarter. You are owed that money does not mean you have a contractual right to claim the dividend, but does mean that the corporation will not be able to declare a dividend for the common stock until the preferred stock is paid its accumulated amount. This is less risky than non-cumulative preferred stock, so it will cost more. Think of phone plans that allow you to use rollover minutes they get to charge more money for that option. Non-participating preferred stock in a dissolution, secured parties will be paid first, then debenture holders. Anything left behind goes to the equity holders any preferred stock will take a chunk of the remaining assets. Preferred stock will state upon dissolution , you will get paid X per share before common shareholders get anything. This is a fixed preference, and is not a share of the residual common stockholders will divide up the residual and not be limited to a

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fixed amount. Non-participating is where you get the fixed preference of X per share, but you then get a share of the residual equal with common stockholders. Common stock is the riskiest security you can buy in a corporation, but note that risk is related to returns. Arbitrage means being able to purchase something in which the return is guaranteed. True arbitrage means you could buy 100 pairs of jeans in NY today and be guaranteed a profit of $100 per pair in Moscow the next day. If you have the ability to make an arbitrage profit in a market, then the market gets flooded since a lot of people start to meet the demand which previously ensured a return. Another example putting money into T-bills vs. CDs. T-Bills have less risk than CDs. If the T-Bill and CD have the same rate of return, people will flock to investing in the T-Bill, and the return rate will drop, thus making the more risky CD have a higher rate of return. Understand that when we coble together different types of security, we are playing with this risk/return scheme. If something is less risky, the corporation can charge more for it. If you are trying to raise capital, keep in mind that common stock is the riskiest thing, and thus will be sold at a lesser price, so you will have to attract more people to buy into it. When selling shares, what are concerns that you, as a lawyer, may have?? 1) is the price related to the risk of the security? Were the right procedures followed in determining the risk and coming up with the price? 2) upon selling the stock, what type of consideration is acceptable from the purchaser? Cash? Promissory note (more riskier than cash)? How will the note get paid off? Past labor? Future labor? Two types of markets where stocks are sold public and private equity markets. Securities Act of 1933 requires that for public offerings, must 1) register shares with the SEC 2) file a registered status/prospectus so that people have notice of what they are buying. After you have issued shares into the public market, are then subject to Act of 1934s ongoing requirements 1) proxy statements 2) distribution of annual reports containing financial statements (10-K) 3) quarterly reports (10-Q) The requirements are not the same for private markets more potential for fraud (1934 Act has some provisions governing fraud in private markets) - there is a key interplay between the information needed for valuation of selling and buying equity. Sometimes the law requires this information to be transferred, but not always. As a potential buyer, you face a larger risk when this info it not required to be transferred. 6.40 deals with distributions to shareholders. Subject to some limitations- if there is not enough capital, you cannot pay dividends. Dividends are a way to get capital out of the company, which puts creditors at risk. Common stockholders have default power in the company unless a preferred stock has certain voting rights that trump common stock rights. Preferred stock does not, as a general matter, have voting rights. Some provisions allow preferred stock to get voting rights if they are not paid a dividend for a long period of time, or if there is a merger or dissolution coming up, etc.

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Close corporation control/shares held by a small group of people not open to general public offerings. Problems arise since shareholders usually wear more than one hat. Conflicts of interest can easily arise. What interest do the positions have in common, and what are the potential conflicts?? Think of Meinhard v. Salmon gets at the core of many conflicts in corporation law. Public corporation larger amount of shareholders, so control issue becomes more important to make sure everyones rights are being looked after. With stock/voting rights, we want to prevent a tyranny of the majority from interfering with rights of the minority shareholders. Also, want to avoid tyranny of the minority in affecting rights of majority shareholders. The right of first refusal is important in dealing with these issues. Rights are not only the power to vote, but also the ability to share in the ongoing profits/dividends through distribution. Stokes v. Continental Trust Co. of City of New York (Ct. of Appeals, NY, 1906) p.368 Old way of looking at property rights of shareholders. Want to preserve rights, so give preemptive rights. Problem arises when everyone exercises their preemptive rights makes it harder to raise capital from outside sources. Sufficient amount of barriers can arise that leads to problems. Plaintiff was stockholder who brought claim to compel corporation to issue him stocks at par value. Court looked at the nature of the right that a stockholder has in shares inherent right to proportionate share of any dividend declared or of any surplus at dissolution. So long as the management is honest, shareholders cannot interfere with the management of a company. Here, by the increase of the stock issued, the shareholders voting rights were decreased by half. This deprives him of a property right. he cannot be deprived of it without his consent except when the stock is issued at a fixed price not less than par and he is given the right to buy it in proportion to his holding or in some other equitable way. Modern rule is that the default is no preemptive rights, however, shareholders can put them into the articles of incorporation. 6.30(a) & (b). Watered stock stock sold below par value 5000 shares at $100 par value = initial capitalization of $500,000. Even if there was no par value, shares could still be sold for $100 and you would end up with the same amount of capitalization. Book value of share = residual divided by amount of shares. Residual = assets minus intangible assets minus liabilities. If you have par value stock, then the par value amount that goes into the company is frozen and counted differently from residual/surplus.

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Katzowitz v. Sidler (Ct. of Appeals, NY, 1969) p. 372 Preemptive rights exist but are not the problem here focused on procedure and whether it should be allowed. The transaction was an attempt to force shareholder to invest more money in the company. Three parties were initially involved in the corporation. Two tried to oust the third, and then tried to force him to invest money in the company or lose proportion of voting rights. Court found in favor of plaintiff shareholder Directors must treat existing shareholders fairly and equally. A corporation is not permitted to sell its stock for a legally inadequate price at least where there is objection. Plaintiff has a right to insist upon compliance with the law whether or not he cares to exercise his option. He cannot block a sale for a fair price merely because he disagrees with the wisdom of the plan but he can insist that the sale price be fixed in accordance with legal requirements. Here, the disparity between book price and selling price was obviously calculated to force the dissenting stockholder into investing additional sums there was no valid business justification for the price and the only beneficiaries were the other two stockholders. Lacos Land Company v. Arden Group, Inc. (Ct. of Chancery, Delaware, 1986) p. 377 Issue arose over recapitalization of stock in order to transfer stockholder control to one person. This person came up with the plan and seemed to railroad it through the board. In announcing an intent to withheld support for corporate action that might entail . . . the issuance of stock, even if that act might be in the best interests of the corporation . . . [B] could not be understood to have been acting only as a shareholder. As a director and as an officer, [B] has a duty to act with complete loyalty to the interests of the corporation and its shareholders. Bs position as to forcing the plan through does not seem consistent with his obligations. Cannot threaten to break fiduciary duty, even if the ultimate reason is benign. The form will be important, even if in substance, there is no harm. Benign in one case can be very harmful in others, so court will not adopt rule that may have different effects later on. A vote of shareholders under threat by someone cannot be said to be truly consenting. Gottfried v. Gottfried (SC of NY, 1947) p. 383 Minority stockholders brought suit to compel company to pay dividends on common stock. Company is closely held with almost all of its stockholders family members. Majority stockholders took out salaries, so they did not need dividends. Court focused on what is a legitimate reason for taking capital out by salary? Can be used to expand company. Close corporations generally do not pay dividends. Courts will not get involved in these type of disputes unless minority can show majority withheld the dividends for inappropriate reasons like bad faith. With a close corporation, there is no active market it will be very difficult to value the stock of the company. It is not impossible to value, but more difficult. Why would you want to limit the ability to sell shares? Want to limit who is able to come in and make decisions. If an adequate corporate surplus is available for the purpose, directors may not withhold the declaration of dividends in bad faith. But the mere existence of an adequate corporate surplus is not sufficient to invoke court action to compel such a dividend. There must also be bad faith on the part of the directors. The essential test of bad faith is to determine whether the policy of the directors is dictated by their personal interests rather than the corporate welfare. Directors are fiduciaries. Court dismissed the complaint since evidence did not support that there was bad faith.

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Fixed claimants if corporation does very well, that increase in value of the corporation will not translate into the claimant getting more. E.g. debt holders. Residual claimants e.g. shareholders benefit from profits in proportional ways Other constituencies individuals who may not have a claim, but are in some way also affected by companys actions. E.g. competitors who are hurt negatively, residents in the area where a plant is built, consumers, anyone affected directly or indirectly by company General rule corporation should be run to maximize benefit to shareholders. This is because initial goal at organization is to maximize benefit to shareholders they are the owners it is part of the structure of corporate law. We want to provide correct incentive to somebody in the corporation to take actions to maximize the wealth of the corporation. Idea is that if surplus is maximized, fixed claimants will be paid, and more fixed claimants will latch on, thus growing the company to produce more wealth. Want to get people motivated to take action and invest to maximize the size of the pie. Dodge v. Ford Motor Co. (SC of Mich., 1919) p. 386 Ford had a profitable year and wanted to share it with the public by lowering prices rather than distributing dividends. Fords goals seemed to go against the goal of maximizing shareholder benefit. Two factors 1) this was at early time of automobile industry. Ford was trying to use this wealth to grow the wealth of society and broaden their customer base. This would grow the business. 2) the Dodge brothers were minority shareholders who had a dispute with Ford over their contract to build motors, and decided to go into business on their own to compete with Ford needed money to start their own business. Ford did not want the competitor. Ford was hurting one minority shareholder but helping all the other shareholders. There is committed to the discretion of directors, a discretion to be exercised in good faith, the infinite details of business, including the wages . . . and price for products. . . it is not within the lawful powers of a board of directors to shape and conduct the affairs of a corporation for the merely incidental benefit of shareholders and for the primary purpose of benefiting others . . . if the avowed purpose of the defendant directors was to sacrifice the interests of the shareholders [then the courts should interfere.] The court ordered the distribution of dividends. Wilderman v. Wilderman (Ct. of Chancery, Delaware, 1974) p 390 Involved a family situation original interests may eventually diverge. Board of Directors deadlocked since husband and wife are only two on the board. A self-serving bias has an effect in these situations. Court discusses factors to determine if salary husband withdrew was reasonable. Court will look at factors to make a determination of valuation of what the husband should have taken as salary was it reasonable based on the totality of these factors? - what others similarly situated make - does the salary bear a reasonable relationship to the success of the company - amount of salary compared to other salaries paid by the company Where . . . the recipients vote as a director was necessary to the fixing of the amount of his compensation, then the burden of showing the reasonableness of such compensation

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clearly falls upon its recipient. Court was not convinced that he was not entitled to everything he withdrew as salary. Donahue case conflict between minority and majority shareholder. Court goes on the look at factors of close corporations that make them seem like partnerships in certain situations. Court focuses not only on identity, but also on substance and characteristics. Basically lays down a problematic rule that plaintiff and defendant are similar enough that they should be treated equally. Should not allow majority shareholder to have shares bought back by company and then deny minority shareholder the same opportunity to have shares bought back. The equal treatment is problematic since majority and minority shareholders are NOT equal. Majority has more money vested, and has more interest in the company being profitable. If a majority is treating itself different than a minority, they must provide justification that the transaction in question is intrinsically fair. Court ordered that plaintiffs shares be purchased just like the majority shareholders had. Whenever a fiduciary takes an action that is a self-dealing (they appear on both sides of the transaction), there is the potential for conflict of interest and fiduciary must show that the transaction is intrinsically fair. View Donahue case as restricted to buybacks, however, it is still good law in Massachusetts, and is cited often will often cite it after citing to Meinhard.

VIII. Governance of Close Corporations

McQuade v. Stoneham (Ct. of Appeals, NY, 1934) p. 418 This is no longer good law! Important case at the time. Action was brought to compel specific performance of an agreement between the parties entered into to secure control of the company. Defendants did not comply with agreement to use their best efforts to continue plaintiff as treasurer of the company. Court said stockholders may not, by agreement among themselves, control the directors in the exercise of the judgment vested in them by virtue of their office to elect officers and fix salaries . . . Directors may not by agreements entered into as stockholders abrogate their independent judgment. - a shareholder cannot enter into agreements that bind or commit to certain actions future board members or managers. Dont want to allow too much restriction to be placed on future leaders of the business new things may arise (competitors, market conditions, etc.). ** no longer good law, so can enter into agreements that have some restrictions on future board/manager actions. Oppression of minority shareholders: Firing Minority Not paying dividends Over compensating majority Discriminating in buybacks freeze outs Want to separate ownership from management that structure works best for public corporations since there is such a large group of parties involved.

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Work of Hodge ONeal - became apparent that close corporations do not work like public companies needed to look at them differently in certain situations. If you have shareholders enter into contracts with each other, can set up mechanisms to avoid problems that will arise with close corporations where people wear more than one hat. Need to bring in estate planners in close corporations where family business is involved. Galler v. Galler (SC if Illinois, 1964) p. 423 Plaintiff sued for an accounting and for specific performance of an agreement. Agreement covered control, distribution, salary issues. Plaintiff was married to one of the two brothers who founded the company. The agreement is to protect surviving spouses from the potential coalition of the other parties involved want to avoid retaliation in the form of giving monetary gain to one party that will unfairly hurt minority members. If someone feels they are being treated unfairly, they may retaliate by bringing a lawsuit. As the parties to the action are the complete owners of the corporation, there is no reason why the exercise of the power and discretion of the directors cannot be controlled by valid agreement between themselves provided that the interests of creditors are not affected. The court held that the agreement was valid and plaintiff was entitled to an accounting and the relief prayed for. Who has bargaining power at what points in a close corporation? By contracting in advance, you get peace of mind and can plan things in advance since you know the terms. Contracts have value. Why would it not make sense to have a liberal policy that would allow courts to not enforce contracts would screw with the planning element that contracts deal with. What are the costs of contracts?? Mandatory rule rule that must be followed Default rule follow this rule unless you want to use another rule. Is an opt-out rule this is the rule, but if you do not like it, you can opt out. What are the costs associated with mandatory rules? everyone has to follow it; difficult to change, may stay on books longer than necessary. (think gym membership contracts foreclose you from taking other actions in the future). A contract by definition takes away freedom of action in the future. 1) question whether to void a contract will depend on who is potentially hurt who are parties to the contract? At what point in time can they claim they were hurt (ex ante at the beginning of the contract). Try to anticipate unequal bargaining power, opaque contracts, coercion, duress, etc. In this case, the court enforces the contract. Shareholder agreements are valuable ways of getting id of some of the risks that come up in close corporations. Zion v. Kurtz (Ct. of Appeals, NY, 1980) p. 432 Corporation was set up to acquire another corporation. Set up a shareholder agreement that required certain shareholders to consent to any actions taken this agreement was not included in articles of incorporation. Kurtz did two transactions without approval of Zion. State law said that for shareholder agreements to be valid, had to be included in articles of incorporation. If there is a mandatory rule, courts will sometimes let people get around it 1) it is not really

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someone fault that the rule was not followed (e.g. lawyer error); 2) nobody is hurt by the failure to follow the rule. Whole point of requirement to have shareholder agreement in articles is to provide notice to public about the existence of the agreement. Here, no one was hurt, so it was ok. We conclude that when all of the stockholders of a Delaware corporation agree that, except as specified in their agreement, no business or activities of the corporation shall be conducted without the consent of a minority stockholder, the agreement is, as between the original parties to it, enforceable even though all formal steps required by the statute have not been taken. We hold further that the agreement made by the parties to this action was violated when the corporation entered into two agreements without the minority stockholders consent.

IX. Control and Management of Public Corporations

Social Responsibility of Corporations national and international Role of Shareholders Collective action problem Shareholder voting Role of Board of Directors Why a board? What failures lead to Enron type situations?? Theory of the Firm Coases Theory Jensen & Mecklings Agency Theory Firm usually means any type of business organization. What is the black box theory of the firm?? Neoclassical theory you have input and then output. Does not look inside the box to look at all the interactions of shareholders, board members, capitalization, good & services, etc. Economic view that characterized a firm as an entity which translated money put in into profit coming out. Coase theorem - Why are certain things produced in firms and others through markets? (page 7 of chart handout). - want to maximize profits - think of Dell and Intel chips can they do it cheaper and compete with someone who specializes in producing something?? Raises coordination and compatibility issues. What should be outsourced? What should be internally done? Do not have control over whether Intel will continue to produce the needed product. Principal feature of firm is that you govern by fiat can tell people what to do since there is a structure of ownership. Do not have to wait on markets. Have control over situations. Use your resources in the way that you want.

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With the market system, have to worry about contracts, employee strikes, etc. all this stuff that is not 100% in your control. Could be disruption and there is always the cost of bargaining. BUT markets have important feature competition. Can lead companies to make better products. Markets and Firms have different transaction costs. Question of the boundary between the firm and the market is the boundary between the question of producing stuff internally or outsourcing. Coase focuses on these boundaries. Berle & Means Managerialist - 1934 problem is separation of ownership from control. Ability to discipline board members/managers is very difficult. Shareholders (like principals) delegate to board members their managerial duties. Since there is incomplete information about the actions of board members and managers, there is an informational asymmetry. Separation of ownership and control can be recast as an agency problem ability of principal to rein in agent became costly, and people began to wonder if how to keep control over board/managers. If you are not happy with board/managers you can: - Wall Street rule - exit sell shares and leave - try to take over by dropping price of shares after takeover, bring in new management team. - vote for new people to be in charge Hirshman wrote Exit, Voice, and Loyalty discusses conceptualization of decision that shareholders have to make in these situations. Why have separation 1) information asymmetries 2) collective action problem who will bear the cost? Think of dark alley example who should pay for light? Homeowner has two choice- contribute money for a light or not contribute. What benefit do you get from both of these two options? Keep in mind it is for the public good to have light in the alley. Public good is an important type of commodity/thing of value cannot exclude others from using it. If no one can be excluded, then people benefit from waiting until someone else deals with the problem- they get to take a free ride. This is the free-rider problem or the collective action problem. Reason to exercise voice and get rid of bad managers is because the company is undervalued since it is not being managed well shareholder profits are not being maximized. Proxy Fight you say the board members to be elected are a certain slate vote yes or no no other alternatives. Fight occurs when another slate is put forth. No informational problems = no risk since you can predict the future = no need for lawyers

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Theory - Board and managers are disciplined by the market for corporate control. This is a coarse way of disciplining people. Fama theory market for managers if managers are bad, it will be very difficult for them to find new jobs. Not a strong theory in reality. Under collective action theory, if you can form a small enough group that will get enough benefit and split the cost, then you have Schellings theory a subgroup of size K. Role of Board acts as an intermediary between the constituencies of the firm. After Enron Sarbonnes-Oxley act boards need to be more active in monitoring and disciplining managers. Two principle goals of SO ACT 1) reduce agency costs figure out new ways of monitoring/policing/disciplining board members & managers. Imposes disclosure and certification requirements. Social Responsibility does not tell us anything who is society? If you can maximize profits by acting responsible, then you give incentives to companies to act responsible.

X. Duty of Care and the Business Judgment Rule

Litwin v. Allen (SC of NY, 1940) p. 670 occurred as result of Great Depression. Purchase of debentures would shift who had majority of shares. Company charter had a limit of how much money could be borrowed at certain capitalization levels leverage how much money has to be put down. Lesser amount required up front gives you more leverage. Shareholder derivative suit. Principal action was purchase of convertible debentures sold under an option to repurchase. All that it was, in essence, was a secured loan. Fiduciary duty of care did the actor take the right amount of care in taking care of assets of corporation with due care. Potential issues of negligence did not use standard of care that reasonable person would have used. Court says transaction here violates duty of care since it was improvident, risky, unusual, unnecessary contrary to fundamental conceptions of prudent banking practice. Since banks have an additional group of individuals (along with shareholders) who can be harmed (depositors), the standard is higher for them. Directors are liable for negligence in the performance of their duties. Not being insurers, directors are not liable for errors of judgment or for mistakes while acting with reasonable skill and prudence . . . A director is called upon to bestow the care and skill which the situation demands. . . . I find liability in this transaction because the entire arrangement was so improvident, so risky, so unusual and unnecessary as to be contrary to fundamental conceptions of prudent banking practice. . . what sound reason is there fro a bank, desiring to make an investment, short term or otherwise, to buy securities under an arrangement whereby any appreciation will inure to the benefit of the seller and any loss will be borne by the bank?? Court also said that directors are not liable for anything other than what was proximately caused by their own acts/omissions in breach of his duty.

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When thinking about capital structure, there is always a trade off between how much equity one has and debt. A person/company will only borrow money if the return they will receive from using those funds is greater than the amount they pay to rent the money (interest). Debt is a good thing if and only if the return you get is greater than the interest. What facts if present would trigger a collective action problem?? 1) a group 2) group has to be sufficiently large to make it costly to coordinate within the group and share expenses. 3) no one member of the group would a sufficiently large return from taking the action in question. Common stock provides a certain type of return dividends, capital gain or loss when you sell it Debenture has as returns interest until the date that they are redeemed risk comes into play as to who has the debenture at the end and whether the company has the money at the end. Two possible ways a shareholder can sue a corporation 1) shareholder rights rights of a particular shareholder; something that belongs to a shareholder that is being kept from them. 2) derivative lawsuit not suing directly over something they are owed. Any damages go to the corporation and not to the individual shareholder. There is a collective action problem benefit from suing will be small compared to cost of bringing suit. In looking for these situations, look for an action (or an inaction when there was a duty to act) taken by the Board that a shareholder could sue for. Questions to ask: 1) what is the standard of care? i. is there negligence, gross negligence? ii. what do we mean by reasonable or prudent in this situation? a. what is the general reasonable person in this situation? b. are there any special circumstances in this context that require that the standard be higher? How do you determine what is reasonable in a corporate situation? 1) look at case law fact specific issues and rulings 2) is the situation similar enough or different enough?? 3) look at a community of firms and their actions what care is acceptable, prudent?

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Shlenksy v. Wrigley (App. Ct. of Ill., 1968) p. 676 shareholder wants lights installed so night games can be scheduled and attendance would improve. Stockholder derivative suit. Cost v. benefits of putting in the lights was not definitively shown just alleged. Court showed hesitancy to impose their rule on the company would take away flexibility and managers/board is in better position than judges to determine what is best for the company. Another important underlying concept is that judges will not engage in Monday-morning quarter-backing will attempt to limit its review to what was happening and was known at time the challenged decisions was made. Board and managers are not insurers do not cover risk. Court will not second guess them unless facts suggest business judgment rule should be rebutted. When suing a majority shareholder, will be more difficult to argue they violated the duty of case since the standard is reasonable person in similar situation, then arguably, the shareholder will not be doing stuff against their own interest. Would need to prove they are doing something to benefit themselves that hurts everyone else. Smith v. Van Gorkum (SC of Del., 1985) p. 685 court found boards decision to sell company was not an informed business decision. They did not exercise due care in carrying out the transaction. 1) what motivated the transaction? The company was very capital heavy and in a competitive market investment tax credit - if tax incentive was given, then people would spend more and stimulate the economy. Needed to be structured that accounting showed it a certain way. Pricing of companies in business had already taken the accelerated depreciation. It made the company more profitable in a financial statement way. Could charge less for railway leasing. Depreciation was already calculated in if they chose to use the profit as income, then they could not use the investment tax credit. 2) why was it structured as a leveraged buyout? It was calculated as a leveraged buyout, but it could have been valued a different way. Should have hired an investment bank to do an independent valuation. 3) how do we value a company? Look at assets, future profitability, cash flows Do not want to put artificial barriers or ceilings on the valuation. If board members are liable due to a duty of care violation, you cant get damages from them. Statutes like this popped up after Gorkum case. Shareholders have to put something in articles agreeing to this. Information is costly there are costs to searching for it and figuring out what info you need to find. Need to verify the info, understand the info, etc. There are bounded rationalities to what resources we have to process info. How do you buy a company? 1) buy the shares (if acquirer buys enough, then they own the company

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2) merge (acquirer will form a subsidiary which will merge with the target company into a new company). Old shareholders remain over the target company usually the target is turned into a subsidiary company. Mergers require shareholder approval. What is the form of acquisition? 1) merger 2) acquisition 3) purchase of assets How are the shareholders dealt with paid in cash, debt (we agree to pay X over the next five years), stock, etc. How is it financed? In duty of care cases, courts will care about whether the right procedures were established to make sure there was no negligence in taking care of things. There are a lot of things you could that, while legal, can still harm the corporation. If you know or sense illegal things are going on, you have a higher duty to take care of it. Otherwise, you have a legal duty to make sure that if illegal things happen, they come to your attention. First step is to know that something wrong is happening. In Re Caremark Intern. Inc. Derivative Litigation (Ct. of Chancery of Del., 1996) p. 701 Parties to derivative suit seeking to impose personal liability on members of board of directors proposed settlement for court approval. The Court of Chancery, Allen, Chancellor, held that: (1) directors appeared to have followed procedures to inform themselves regarding contracts with health care providers before authorizing corporation to pursue contractual opportunities, so as to be protected under business judgment rule from claims of personal liability when impermissible contracts were entered into; (2) board appeared to have met responsibilities to monitor operation of corporation, even though some illegal contracts were entered into; and (3) settlement was fair, despite consideration for release of claims that was very modest, in view of weaknesses of complainants' case. Malone v. Brincat (SC of Del., 1998) p. 712 Court dismissed complaint alleging that directors overstated financial condition of company several times to shareholders. Alleged breach of fiduciary duty of disclosure. Complaint could be reworded to be a derivative action. If director knowingly disseminate false information that results in corporate injury, then an action can be brought. This duty arises because shareholders have delegate responsibilities to the director/board. - difficult to win under a duty of care case. Must show an officer/board member/controlling shareholder was grossly negligent. Disclosure: 1) affirmative duty to disclose 2) no affirmative duty a. disclose b. not disclose

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If you disclose, it must meet certain standards. We care about disclosures of fact because we can try to verify a fact and find out if it is true. Once the fact is disclosed to shareholders, they can do something or not do something. Information disclosed: 1) Fact a. True b. Not True 2) Opinion Under what situations do you have an affirmative duty? Take action Van Gorkum looking for gross negligence Not Take Action Caremark, Malone looking for affirmative duty to take action good faith Duty of care court applies a presumption called business judgment rule that says we presume that managers in making these decisions were duly informed, followed the right procedures, and were not grossly negligent. This is overcome by showing a reasonable manager/board would not have engaged in the behavior. Dont want shareholders getting upset every time an action is taken they do not like takes more than that. Gall v. Exxon Corp. (US Dist. Ct., S.D.N.Y., 1976) p. 720 Action was brought by stockholder against corporation and the directors to recover allegedly illegal payment from corporate funds of bribes and political donations to political parties in foreign country. The District Court, Robert L. Carter, J., held, inter alia, that even assuming the payments were illegal where made the sound business judgment rule was applicable to decision by special committee acting as corporation's board of directors in deciding not to sue, but that plaintiff should be given opportunity to test bona fides and independence of special committee by means of discovery and, if necessary, at plenary hearing. Defendants' motion for summary judgment denied in accordance with opinion. A lot of hurdles to go over before a derivative lawsuit can be brought. If they are not met, then lawsuit is dismissed since the issue/action was within the boards power. If board forms an independent committee, court will look to see if it is independent enough. Principle policy is the business judgment rule. Do not want to keep second-guessing managers gives them a presumption. Mangers need to try and foresee that something may happen. Must make decisions in a reasonably informed manner. Must look to what type of information is sought about future relevancies. Since business decisions can be risky, will not second guess the decisions but will look at the procedure used to make a decision. If X had been properly informed, then they would have foreseen Y or gathered more info so that they would have seen Z. Broader policy is that corporation will be managed by board and officers. There is a line between what shareholders do and what board/officers do.

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One responsibility of corporation is to bring lawsuits to protect interests of corporation: 1) those brought against third parties 2) those brought against insiders (board members, managers, controlling shareholders). a. board has authority b. board will give authority to shareholders Do not want shareholders to be too involved in management of corporation (expertise and consolidated control theories). By default, fiduciary lawsuits can be brought by board. But, since sometimes action will be against board, the power can be given to shareholders to bring the suit. The goal is to protect the interest of the corporation. Should we take the power to bring this particular lawsuit away from the board of directors? - after Gall v. Exxon, became board of directors AND independent committee. Zapata Corp. v. Maldonado (SC of Del., 1981) p. 724 Stockholder instituted derivative action, on behalf of corporation, to recover against ten officers and/or directors on theory there had been breaches of fiduciary duty. The Court of Chancery denied corporation's alternative motions to dismiss complaint or for summary judgment, and corporation took interlocutory appeal. The Supreme Court, Quillen, J., held that: (1) even though demand was not made on board of directors to sue and the initial decision of whether to litigate was not placed before the board, it retained all of its corporate power concerning litigation decisions; (2) self-interest taint of majority of the board was not per se a bar to delegation of board's power over litigation decisions to independent committee composed of two disinterested board members; and (3) in ruling on the motions, Court of Chancery was to inquire into independence and good faith of the committee and the bases supporting its conclusions, and, if independence and good faith were found, Court was to exercise its own independent business judgment in determining whether a motion should be granted. Reversed and remanded. Lawsuit was filed, demand was not made but this was excused since there had been self-dealing. Burden will be on corporation this is strange since BJR gives presumption in favor of corporation. But, in this case, demand was excused since effort would have been futile, and the independent committee was formed by people appointed by the initial board. It cannot be implied that absent a wrongful board refusal, a stockholder can never have an individual right to initiate an action . . . as stated in McKee , a well settled exception exists to the general rule A stockholder may sue in equity in his derivative right to assert a cause of action in behalf of the corporation, without prior demand upon the directors to sue, when it is apparent that a demand would be futile, that the officers are under an influence that sterilizes discretion and could not be proper persons to conduct the litigation. Board can delegate powers to independent committee to investigate and make decision on suit. SO, 1) court should first look into the independence and good faith of the committee and the bases supporting its decision and then 2) should determine, using its own independent business judgment, whether the motion should be granted. Board is a group of individuals. Decisions are made by majority. If majority of board is interested parties, then the board cannot make and independent decision. But, if there is a subset

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of disinterested/independent individual, then they can be put on an independent committee to decide what action to take with the lawsuit. If committee is used, the inquiry then turns to the committees decisions. (Zapata Test). Possibilities: 1) whole board is interested if that is the case, then shareholders can bring lawsuits since power is taken away from board since they would not vote to sue themselves. 2) majority of board is interested a. can form an independent committee with disinterested members b. inquiry turns to that committee 1. are they interested or are they truly independent - if truly independent, they can decide to bring the lawsuit or not to bring the lawsuit. If they do not choose to bring suit, the shareholders will challenge that decision in court and claim that they were interested or that they violated the duty of case and loyalty in making that decision. Court will look at the decision to make sure it is valid will apply its own independent judgment. - if interested, then shareholders can bring lawsuit 3) majority of board is disinterested shareholders cannot bring lawsuits. Independent committee must be made up of board members. Court will look for self-dealing which violates duty of care and loyalty. Shareholder will either 1) bring a lawsuit without making a demand 2) make a demand. A demand is where they go to the board and say that something has been done wrong and the board should bring suit. General presumption was that you had to make a demand, and if you did not, then you had to say why. Must provide reasons why making a demand would have been futile majority was interested, etc. If you make a demand and it is refused, it looks weak to come and claim later that the board was majority interested, since you brought the demand which shows you did not think it was going to be futile. BJR applies only to duty of care, not duty of loyalty. If it turns out that a majority of board was interested, that is a duty of loyalty case. Zapata is better to end up with than the business judgment rule. BJR does not apply if no action has been taken. Purpose of rule is to protect board action. Independent committee is formed they will engage in investigation (in theory), and look at information and make a decision on whether to continue the lawsuit or ask a court to dismiss it. If they decide to continue the suit, they will allow the shareholders to continue the lawsuit.

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Aronson v. Lewis (SC of Del., 1984) p. 733 shareholder challenged transactions involving consultant Fink (who was given loans, etc.). After Aronson, if you do not make a demand, and cannot show that you met the Aronson test, it will be dismissed and you lose. Aronson test = in the demand futile context, a plaintiff charging domination and control of one or more directors must allege particularized facts manifesting a direction of corporate conduct in such a way as to comport with the wishes or interests of the corporation (or persons) doing the controlling. Stressed that plaintiff must plead facts, not evidence. BJR applies to actions that have been taken. These actions can be challenged as violation of duty of loyalty or violation of duty of care. They (shareholders) are much better off if they can show it was a duty of loyalty case (self-dealing transaction) since then the board members will have the burden of showing that the transaction was intrinsically fair. Questions that arise when you deal with fiduciary duty and derivative lawsuits: 1) who has the authority to bring the lawsuit? Board or shareholder? Shareholder cases when 1) all directors are interested or 2) majority of the board is interested. -suing all board members is not enough since you could include them all in the lawsuit must have sufficient facts in complaint to raise reasonable doubt that majority of board was interested. 2) when is a shareholders demand excused from being mandatory? p. 742 Spiegel v. Buntrock in making a demand, plaintiff tacitly acknowledges the absence of facts to support a finding of futility. Levine v. Smith can use certain rights to inspect minute books Courts recognize there is some need for flexibility in allowing shareholders to gather information, but they will not allow fully fleshed out discovery in gathering that information.

XI. Duty of Loyalty and Conflict of Interest

Marciano v. Nakash (SC of Del., 1987) p. 759 Nakashes made loans to the corporation. Marcianos sued claiming these were interested transactions. Is the value as a going concern greater than the liquidation value? Corporation which was a joint venture for the marketing of designer jeans and sportswear was placed in custodial status and liquidation proceedings were brought. The Court of Chancery, New Castle County, validated a claim for loans made by a faction which owned 50% of the corporation as valid and enforceable debts of the corporation, notwithstanding their origin in self-dealing transactions. Remainder owners appealed. The Supreme Court, Walsh, J., held that: (1) court of chancery properly applied intrinsic fairness test in determining validity of interested director transactions, and (2) finding that challenged transactions were reasonable and fair to the corporation was clearly supported by the record. Affirmed. Difference between loan and capital contribution: Loan = interest; get the principal back

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Capital contribution = dividends; no rights to put the shares to the corporation (put = contractual right to say give me my money back or buy back my shares). Put = common shares do not have this since there must always be an outstanding share that has ownership and control and right to distribution in the company. Intrinsic Fairness or not?? What facts if present will trigger this type of test applying (duty of loyalty case)? 1) when there is self-dealing in the corporation Critical to these cases will be disclosure what info has been disclosed to non-interested parties who will be negatively affected by the transaction (think Meinhard v. Salmon). Is disclosure enough?? Need to include any terms or issues in the disclosure that are relevant to entering into the transaction. The disclosure must be about the self-dealing transaction. Sometimes things are excluded from disclosure (like trade secrets), but if you do not disclose t the very least that you are self-interested, then you will have problems. Self-dealing and duty of loyalty have a higher standard board member involved in the transaction has the burden of proving that it was intrinsically fair. In BJR cases, on the other hand, there is a presumption in favor of the corporation actors, and shareholder has burden of proving that there was a problem. Before turn of the century, if it was a self-dealing transaction, then it was void. We have moved away and now they are voidable (which is not automatically void) since sometimes these transactions are beneficial. So, look to see if the transaction is somehow beneficial to the corporation. Arms length transaction companies will sometimes have formalities in place to create a system where every transaction will go through certain tests. In duty of care cases, there was an abstract third party the reasonable person would they have made the decision the same way. All reasonable person arguments reduce to a question of third parties what type of actions would they have taken. Section 144 if it is self-dealing, it is not per se void or voidable. When advising a client, the key will always be full disclosure. Section 144 technically did not apply in Marciano case since there was no vote the board was deadlocked. If full disclosure, then shareholders (2) or directors (1) vote and get benefit of BJR. If not full disclosure, shareholders and directors must show intrinsic fairness. Court sees this as a partial safe harbor that does not completely preempt the common law. Still possible under common law to have interested parties show that the transaction was intrinsically fair.

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What facts trigger this issue: 1) self-dealing transaction 2) has their been full disclosure? 3) has there been a vote or not? Heller v. Boylan (SC of NY, 1941) p. 764 Derivative action by Esther Heller and others, suing on behalf of themselves and all other stockholders of the American Tobacco Company similarly situated, against Richard J. Boylan and others, wherein Minnie Mandelker intervened. Judgment for plaintiffs in accordance with opinion. Had been brewing since depression and up to WW2. Involved a cigarette company. Upholds incentive compensation scheme in large part because of the procedures followed and the difficulty courts face in finding a standard to judge whether the payments were too much. If you are the plaintiff, you must provide evidence that makes it easy for the court to see that a compensation scheme is too high. Maybe use salary figures from other companies directors, etc. Brehm v. Eisner (SC of Del., 2000) p. 769 After board of directors approved large severance package for former president, shareholders brought derivative action alleging breach of fiduciary duty and nondisclosure claims against directors and breach of contract claim against president. Directors and president moved to dismiss. The Court of Chancery, New Castle County, Chandler, Chancellor, granted motion. Shareholders appealed. The Supreme Court, held that: (1) review was de novo, (2) pre-suit demand could not be excused on the ground that the directors lacked disinterestedness and independence or that the business judgment rule did not protect them; (3) directors relied in good faith on financial expert who advised the board on employment agreement; (4) directors' lack of substantive due care is foreign to the business judgment rule; (5) waste by the directors was not shown; and (6) the president did not engage in gross negligence or malfeasance. Affirmed in part, reversed in part, and remanded. Executive compensation is at issue there is an employment contract that contains compensation benefits and a severance package. This is assurance against the risk that they may be dismissed. The package posed a potential problem since it allegedly gave Ovitz an incentive to leave he would make more by breaking the employment agreement than by staying and riding out the term. The making of the agreement is the transaction being challenged. Court says duty of loyalty is not what they are really looking at. Compensation agreements usually have a fixed amount and then an incentive portion. The incentive portion includes stock options that vest over time. The longer someone stays, the more options they get to cash in. Sinclair Oil Corp. v. Levien (SC of Del, 1971) p. 777 ** involves parent and subsidiary company. Would maybe use a subsidiary to 1) have a company in a foreign country that can comply with laws 2) to limit liability. Derivative action brought by minority stockholder of subsidiary against parent corporation to account for damage sustained by subsidiary on ground that parent as result of dividends paid by subsidiary denied industrial development to subsidiary and for breach of contract between

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another subsidiary and plaintiff's subsidiary. The Court of Chancery, New Castle County, entered judgment against parent and it appealed. The Supreme Court, Wolcott, C.J., held that, in absence of showing of fraud or gross overreaching, parent's decision to achieve expansion through medium of its subsidiaries other than subsidiary in which plaintiff was minority shareholder was one of business judgment with which court would not interfere. The Court held, however, that where parent caused plaintiff's subsidiary to sell products to another subsidiary under contract requiring specified prices to be paid on receipt of products and for minimum quantities, parent breached contract when it failed to have plaintiff's subsidiary seek and receive adequate damages for buyer's failure to pay for products immediately or to purchase contract minimums, in absence of showing that failure to enforce contract was intrinsically fair to minority shareholders of seller or that seller, which sold all the products it produced to buyer, could not possibly have produced or otherwise obtained the contract minimums. Reversed in part and affirmed in part. If it is self-dealing, then the duty of loyalty applies. If it is not self-dealing, then the duty of care applies. If on its face, there is no self-dealing, then the duty of care BJR applies. But that can be rebutted if there are facts present. Self-dealing = any transaction where the majority shareholder gets benefits while the minority shareholder does not get them. Weinberger v. UOP, Inc. (SC of Del., 1983) p. 783 Corporation which was majority shareholder of subsidiary sought, and acquired, remaining shares of subsidiary by merger transaction including payment of cash to minority shareholders of subsidiary for their minority shares. Minority shareholder, on behalf of class of all subsidiary shareholders who had not exchanged their shares for merger price, attacked validity of merger transaction and sought to set merger aside or, in the alternative, an award of monetary damages against subsidiary, majority shareholder of corporation, and investment banking firm which provided fairness opinion prior to merger. The Court of Chancery, New Castle County, Brown, Vice Chancellor, entered judgment for defendants, and minority shareholder appealed. The Supreme Court, Moore, J., held that: (1) merger did not meet test of fairness, where feasibility study prepared by two of subsidiary's directors, who were also directors of parent, indicating that a price in excess of what parent ultimately offered for subsidiary's outstanding shares would have been a good investment for parent, was not disclosed to subsidiary's outside directors, and (2) on remand, minority shareholders would be entitled to damages based on the fair value of their shares as determined by taking into account all relevant factors, including the elements of rescissory damages if susceptible to proof and appropriate to the issue of fairness. Reversed and remanded. A public policy, existing through the years, and derived from a profound knowledge of human characteristics and motives, has established a rule that demands of a corporate officer or director, peremptorily and inexorably, the most scrupulous observance of his duty, not only affirmatively to protect the interests of the corporation committed to his charge, but also to refrain from doing anything that would work injury to the corporation, or to deprive it of profit or advantage which his skill and ability might properly bring to it, or enable it to make in the reasonable and lawful exercise of its

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powers. The rule that requires an undivided and unselfish loyalty to the corporation demands that there shall be no conflict between duty and self-interest. In merger 1) Merger- control shareholders vote 2) Price is determined 3) negotiations 4) agreement to a merger voted on by Board 5) shareholders then vote 6) if merger approved, then it happens new company exists, old company disappears, and minority shareholders in old company are bought out. If merger is approved and you voted against it, then you could go to court and say the price you were paid was too low and have the court appraise the value of the shares and set the correct price. Cases leading up to Weinberger: Santa Fe v. Green 10b-5 does not apply to freeze-out mergers. What happened here was a violation of freezeout duties which is traditionally covered by state remedies. Singer if we were to hypothetically to undo the merger, what would happen? Recissary damages just allow you to look into the future. Delaware had a static view that looked at value before the merger was announced. This is a problem since company values usually increased after mergers were announced- so, valuation should look at the future. Tanzer case (note 3 on p. 795)- views a very broad business purpose test. Under this set of cases, Weinberger arises and tries to undo the whole slew of cases or the principal reason that lead to these case, namely, there was no proper way to value shares. Court says appraisal rights will be the default, but there are other things out there. The issue is freeze out mergers by this we mean cash out merger in which a company undertakes a merger. The shareholders vote to approve the merger but one or more shareholders dissent and oppose the merger. What happens when someone owns a majority of a company that undertakes a merger. They get cash as opposed to shares- what is the remedy?? If they are not paid enough, they can prevent the merger by going to the court and getting the shares appraised and the merger goes through when they pay the right price. Want to protect individual property right they have over the shares. Race to the bottom jurisdictions are competing with each other to get companies to incorporate in their jurisdiction. Lot of companies go to Delaware since the law is more developed and certain.

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Weinberger tries to close the divergence: the test for appraising shares in these types of proceedings will be whatever test the court determines it will provide a relatively accurate value. Weinbergers holding is broader than Stouffers Even though appraisal rights is the primary or default remedy, we are not taking away from the lower courts the right to fashion a remedy appropriate for whatever is at hand. General rule will be Stouffer (default) in general appraisal rights is main remedy. How do we go about valuing shares?? 1) look at the market problem with this is that the shares will be offered at a premium. They are forward looking so they know that they will make the difference in value up in the future profits. Market is not future looking since it wants people to diversify their portfolio all at once and the value will increase over time. 2) each potential shareholder may value shares differently for various reasons (tax rates on different types, etc.) 3) present, future, and past values for those shares When looking to the future, one important aspect is future expected cash flows For tender offers and acquisitions, must understand that immediately the offeror is signaling that they know something that you dont know. This may lead people to want to stick around and not sell out. But if all shareholders do that, they will all be worse off since the merger will not occur. So, in allowing freezeout mergers, the courts are trying to overcome the holdup collective action problem. In valuation, past present and future are all important. Future is the most important, primarily focusing on expected future cash flows. Must consider risk and discount for the risk. And when a merger is sought, that is a signal that something is going on and there must be a premium paid for the shares. Weinberger- what procedural safeguards were in place? Had to be greater than 2/3 Problem is that there was no disclosure. What wasnt disclosed? The decision was put together in a hasty manner that was not disclosed. Also did not disclose that Signal would have paid more than $21 a share. Two things to worry about in this type of transaction 1) not always the case that the non-majority shareholders will be independent. 2) disclose all the information used in coming up with a valuation Line of business test if it is something that the corporation would benefit from, then it is a corporate opportunity. How do we know if something is in the line of business? For annual meetings, 1) notice to shareholders

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2) proxy statements 3) 10K - > annual report Northeast Harbor Golf Club, Inc. v. Harris (Sup. Jud. Ct of Maine, 1995) p. 797 Corporation brought suit against former president, alleging usurpation of corporate opportunity. She had bought property near the golf course and develop it. The Superior Court, Hancock County, Atwood, J., entered judgment for president and appeal was taken. The Supreme Judicial Court, Roberts, J., held that: (1) American Law Institute standards regarding usurpation of corporate opportunity would be adopted, and (2) remand would be required, to allow Superior Court to analyze facts in view of new standards. Vacated and remanded. 1) Line of Business Guth v. Loft 2) Fairness test Durkee test :Mass rests on the particular circumstances of the director in taking advantage of the opportunity. 3) Mimi test both line and business and fairness tests There are different tests to figure out if something is a corporate opportunity and whether taking that opportunity violates the duty of loyalty. 4) American Law Institute test: Corporate Governance Project What are the problems with these tests?? What are the different policies we are weighing? 1) leave autonomy to board members and officers to enter into other business dealings. 2) want to protect shareholders by protecting the corporations assets (corporate opportunities that a corporation can exploit). Fairness test may favor the corporation more. But some people come out the opposite way- line of business favors the officers and directors. If you do not have procedural safeguards in place, the burden will be on the board or officer to prove they acted probably. Penalty default rule: penalize or you lose if you have not made proper disclosure. This is an incentive for them to do the proper thing. What types of facts will trigger corporate opportunity cases: 1) A transaction comes to the attention of an officer or director while undertaking their duties 2) A transaction or discovery or some other thing of value was produced using the equipment, info, property of the company. 3) it is in the line of business that they plan are can be expected to expand into Duty of loyalty and care apply and is owed to common shareholders this is the default rule. Question then becomes are there certain types of situations where it is owed to other types of stockholders or debt-holders. What are those special circumstances?? Preferred stock is essentially a contract, so often it will have terms that discuss what should happen in mergers. So, the general rule (even though it is not always followed), if it is something that should be in the contract, that is the only right they have the only thing that

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would be in the contract would be those things that preferred stock gets that common stock does not. So, with this general rule, courts are saying if you want to be protected, then put it in the contract. Credit Lyonnais case (p. 808) - has been influential. What happens when a company comes close to or is in insolvency. Directors duty shifts from the shareholders to the creditors to preserve the value of the assets.

XII.Proxy Regulation
How do we know a proxy when we see one?? It is an authorization one gives to vote your shares in a particular way. Why do we have them?? Not practical for every shareholder to show up at the companys annual meetings. Also, most of the time, not much happens at the annual meetings there is no real need for the shareholders to meet and interact with the managers. System of proxies developed to allow shareholders to authorize an agent to vote on their behalf. Record date cut off date which says who is entitles to vote (holders as of this date). What types of things do shareholders vote on?? Election for the board of Directors- every year since election of the board is the principal power that shareholders have. Remember distinction between voice (voting) and exit (sell shares) these are the two primary ways that shareholders can discipline managers, directors, officers. Relying on shareholder voting has one big drawback collective action problem!! Arises anytime each member of a group would prefer that other group members take a particular action, but each member is best off not taking that action. Whenever an action provides a public good, we have potential collective action problem. A public good is one that once produced, you cannot exclude others. Approve nominations, appointments, etc. Again, this may not matter to shareholders since it will have little or no affect on their shares. However, it may matter from a fairness point of view shareholders no sometimes feel that compensation packages they have been voting on are unfair. What are the risks to shareholders when they decide how to vote?? By just voting by proxy and agreeing with what the management wants, it is not worth your time to even open the envelope since there will be very minimal benefit to you. Proxies are sent by the board who want you to vote the way they want. They may be approving certain things that they think may affect them economically, or they are voting on stuff they think is unfair. The problem with determining the risks to shareholders is that you have to determine what shareholders value and determine if it is of economic value. The more information we have, the better able we are to evaluate the risks involved. Therefore, the proxy regulation area is all about disclosure. The more that management or a third party discloses in their proxy statement or solicitation, the better that shareholders will be.

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How can the law reduce those risks? Require disclosure!!!!!! 1933 Act when you sell securities, you have to provide certain disclosures about those securities. 1934 Act there are certain ongoing disclosure requirements 1934 Act adopted anti-fraud provision to deal with proxy solicitations. Section 14(a) Person includes non-natural persons Tells us that section 14 is regulating the solicitation of proxies directly or indirectly or other types of authorizations for voting that are analogous to voting. Who has to register under the 1934 act?? 12g-1 says if you have assets of $10 million or more +500 or more holders of an equity security 12a says that for stock or securities to be sold in a national exchange, there must be third party involvement broker, dealer, etc. which means that if you have and equity or debt security registered or traded in a stock exchange, you have to register under the 1934 act. Two triggers for registrations are 1) have a security traded on a national stock exchange, or 2) $10 million and at least 500 holders of equity security. How about if you wanted to de-register reduce the class of people 12(g)(4) to less than 300 or less than 500 where assets have not exceeded $10million for the three previous years. Section 14(a) 1) it shall be unlawful 2) in contravention of such rules - as the SEC may proscribe - 14(a)(9) antifraud provision must file stuff 3) to take action directly or indirectly - solicit proxies, consents, authorizations, etc. - proxies must include proxy statements/annual report 4) in respect to any SECURITY - other than exempted securities 5) registered pursuant to section 12 - 12(a) - 12(g)(1) Studebaker v. Gitlin (US COA, 2d Cir., 1966) p. 603 Appeal by stockholder from an order of the United States District Court for the Southern Distrct of New York, John M. Cannella, J., enjoining use of written authorizations obtained without compliance with proxy rules issued under Section 14(a) of the Securities Exchange Act. The Court of Appeals, Friendly, Circuit Judge, held that in view of Securities Exchange Act provision authorizing Securities and Exchange Commission to seek injunction restraining

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violations of statute and regulations thereunder, injunctive relief at behest of private party bringing suit as supplement to Commission action was within expressly authorized exception to anti-injunction statute. Affirmed. Solicitation of proxies included any action that is part of a larger plan that may lead to solicitation of proxies. Court is concerned about misrepresentations must have facts to show that the original statements are false if you challenge the action. ** Studebaker now remains to cover communications that primes people for disputes and lead to proxy solicitations. SEC amended rule 14a-1 term solicit and solicitations do not cover a communication by a security holder who does not otherwise engage in a proxy solicitation What needs to be in proxy documents that you have to file with the SEC and give to shareholders that you are soliciting? Rule 14a-3 Forms principal types of disclosure will be info about the company and financial disclosures. (Regulation SK and Regulation SX.) If filing a prospectus under 1933 Act, look at regulation S1 and then SK and SX. If filing an Annual Report, will go to form 10-k, if filing a quarterly report, will use form 10-Q. One important thing to understand are SX and SK will be seen again and again in securities law. Regulation SK requires disclosure of facts about the corporation business they are in, subsidiaries, etc. Facts about the company that may be material to what is being voted on. Regulation SX requires disclosure of financial information Must make disclosure about the independent auditor reviewing the financial info to be used for annual report. Have you fired an accountant recently?? Need to disclose it. In disclosure, want to look for invariants things that stay the same over time. Want to get to the heart of the true business of the company and look at how other factors affect it. In the Matter of Caterpillar Inc. (Admin. Proc. SEC 1992) p. 613 Involved Brazilian subsidiary - profits previously reported had been due to wild fluctuation and economic factors in Brazil. Big sin was 1) that they did not disclose that prior profit results were likely to due to things that were not a part of their business (extraneous factors) 2) not to disclose that they new 1989 was an aberration and that the profit levels would likely change in the near future. 14a-9 - tries to ensure that you cant mislead someone in proxy statements. The consequences of failing to make disclosure can trigger civil and criminal penalties. 1) no solicitation subject to the proxy rules - 12(a) -12(g)(1) - Gitlin and what is meant by solicitations

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2) any communication which may include proxy statement, etc. - written or oral 3) containing statements - characteristics: a) false or misleading - at the time - circumstances b) any material fact - any - material (see northway case) - fact (must be something true or false) Rule 14a-9 Time and context are the two principal qualifiers when evaluating to see if a proxy solicitation violates rules. TSC Indus., Inc. v. Northway, Inc. (SCOTUS, 1976) p. 630 A minority stockholder in an acquired corporation brought suit against the acquiring corporation and sellers of controlling interest in the acquired corporation, charging violation of the Securities Exchange Act of 1934 and rules promulgated thereunder in regard to a joint proxy statement issued by the acquiring and acquired corporations. The District Court, granted the sellers' cross motion for summary judgment, and plaintiff appealed. The Court of Appeals, reversed, holding that the claimed omissions of fact were material as a matter of law. On grant of certiorari, the Supreme Court, Mr. Justice Marshall, held that an omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote, that the issue of materiality is a mixed question of law and fact, and that, under that standard, none of the omissions claimed to have been in violation of the rule against incomplete or material and misleading proxy statements was materially misleading as a matter of law. Reversed and remanded.

XIII. Transactions in Shares: Rule 10B-5, Insider Trading, and Securities Fraud
There will be two types of facts to look at when a shareholder is making a decision: 1) omitted facts 2) statements that have been made Section 10(b), Act of 1934: It shall be unlawful for any person 1) to use or employ 2) in connection with the purchase or sale 3) of any security 4) any manipulative or deceptive - device or contrivance Rule 10b-5 was adopted to clarify section 10.

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Proxy Rules What are the problems they are trying to deal with?? Transactions Scope (even close Disclosure soliciting proxies

10b Disclosure purchase or sale of securities

any sec. traded any security that exists, on national exchange registered or not (vis a vis 12(a)) corporations) or an equity security under 12(g)1

Market for lemons used car dealer knows which car is the lemon. So, you separate yourself from lemon dealers by offering a warranty (Akerloff theory) Fraudulent disclosure 1) action - the action is a statement that is untrue or failure to make a statement while under a duty to say something 2) about a material fact 3) reliance 4) in connection with purchase or sale of security (see Blue Chip Stamps case) Blue Chip Stamps v. Manor Drug Stores (SCOTUS 1975) p. 815 Someone was offered securities but they didnt buy it because of materially misleading pessimistic statements. Limited anti-fraud provision to when there was an actual purchase or sale. Retail user of trading stamps brought action against stamp corporation and others claiming damages under the Securities Exchange Act of 1934 and Securities and Exchange Commission rule 10b-5. The United States District Court for the Central District of California, dismissed the complaint, and plaintiff appealed. The United States Court of Appeals for the Ninth Circuit, reversed and remanded, and certiorari was granted. The Supreme Court, Mr. Justice Rehnquist, held that standing to bring a private damage action under SEC rule 10b-5 is limited to actual purchasers' or sellers' of securities, as those terms are defined by the Securities Exchange Act of 1934; that plaintiff, which was offeree of stamp corporation's stock pursuant to antitrust consent decree to which plaintiff was not a party, did not derive any entitlement from such decree and was not, solely by reason of such decree, a purchaser or seller of securities, and thus could not maintain private cause of action for damages under rule 10b-5 on theory that it was dissuaded from accepting offer by reason of a materially misleading overly pessimistic prospectus. Judgment of the Court of Appeals reversed. Ernst & Ernst v. Hochfelder (SCOTUS 1976) p. 819 Person was taking money and using it on his own instead of investing it. Plaintiffs claimed the accounting agency did not discover the fraudulent actions by the president of the firm. Customers of brokerage firm who invested in a securities scheme ultimately revealed as

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fraudulent brought action against accounting firm, which had undertaken audit of brokerage firm's books, to recover for damages sustained due to alleged negligence of accounting firm. The United States District Court for the Northern District of Illinois, Eastern Division, entered summary judgment in favor of accounting firm, and customers appealed. The Court of Appeals, reversed and remanded and certiorari was granted. The Supreme Court, Mr. Justice Powell, held that the private action for damages will not lie under section 10(b) of the Securities Exchange Act of 1934 and rule 10b-5 in the absence of an allegation of intent to deceive, manipulate, or defraud; and as customers had proceeded on theory of liability premised on negligence, specifically disclaiming that brokerage firm had engaged in fraud or intentional misconduct, case would not be remanded for further proceedings. Judgment of Court of Appeals reversed. Santa Fe Indus., Inc. v. Green (SCOTUS 1977) p. 822 Cash-out merger transaction was unfair to minority shareholders but it had been properly disclosed. Minority shareholder brought an action against majority shareholders and a firm which had appraised value of the stock for purposes of permitting the company in question to undergo a Delaware short-form merger. The District Court for the Southern District of New York, dismissed for failure to state a claim. The Court of Appeals, Second Circuit, affirmed in part and reversed in part. After granting of certiorari, the Supreme Court, Mr. Justice White, held that where, on the basis of information provided, the minority shareholders could either accept the price offered for their shares or reject it and seek appraisal in the Delaware court of chancery, their case was fairly presented and the transaction as alleged in the complaint was therefore neither deceptive nor manipulative and therefore did not violate either the Securities Exchange Act provision or SEC rule 10b-5. Mere instances of corporate mismanagement in which essence of the complaint is that shareholders were treated unfairly by a fiduciary are not within the statute or rule. Judgment of Court of Appeal reversed, and case remanded. In Re Enron Corp. Securities Derivative & ERISA Litigation (US Dist. Ct., S.D. Tex., 2002) p. 827 If you are an outside party (attorney, accountant) not directly engaged in a 10b violation, can you be liable directly if you give assistance to the violation?? Yes if they engage in fraud or deceit themselves. Investors brought securities fraud actions against corporation, individual executives, and others, alleging elaborate and large-scale Ponzi scheme to artificially inflate corporation's earnings and to conceal debt using corporation-controlled but unrecognized special purpose entities (SPEs). Secondary defendants, i.e. accounting firms, law firms, and investment banks/integrated financial services institutions, moved to dismiss. The District Court, Harmon, J., held that: (1) misrepresentation about value of particular security is not condition precedent for 10(b) and Rule 10b-5 liability; (2) secondary actor who creates material misstatement on which investor relies can be liable as primary violator under 10(b) even if actor's identity is not disclosed to investor; (3) knowledge gained in banks' lending and commercial areas was imputable to their analysts for purpose of stating scienter element of 10(b) claim; (4) mere presence of disclaimers in financial services institutions' analysts' reports did not preclude statement of reliance element of 10(b) claim; (5) Washington state investor had right of action under Texas Securities Act; (6) investors partially stated scienter element of 10(b) claim by alleging defendants' participation for their own gain in creation of SPEs; (7) investors failed to state 10(b) claim against bank based on private placement letter and executives' subsequent profits; (8) investors stated 10(b) claims against various banks by alleging loans disguised as

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trades, participation in phony IPO, particular interests in SPE transactions, and cooperation with corporation's mark-to-marketing accounting, in various combinations; (9) investors stated 10(b) claim against law firm by alleging participation in SPE creation, drafting of true sales opinions, and drafting of false SEC filings and press releases; (10) investors failed to state 10(b) claim against second law firm by alleging representation of SPEs only; and (11) investors stated 10(b) claim against accounting firm by alleging violation of GAAP and GAAS, destruction of documents, intimate knowledge of corporation's fraudulent activities, and decision by firm's partners to continue working for corporation despite fraud based on lucrative nature of relationship. Motions granted in part and denied in part. Lawyers will have much more leeway than accountants since there is a recognized privilege. Insider trading principle use of 10b. Insider Trading?? 1) how do individuals value security?? 2) what types of advantages do insiders have?? They have access to info about a company that are relevant in valuing it. Those individuals who have better information will be able to better value the stock and therefore have an advantage over others who do not have as much info. If insider trades without having revealed the info they had, they are in violation of 10b. If they give the info to a third party, like a broker, and the third party trades with someone, the broker is also liable because they are a tippee (insider is the tipper) and there is tipper-tippee liability. SEC v. Texas Gulf Sulphur Co. (US COA, 2d Cir., 1968) p. 840 Company came across minerals during exploratory drilling. Took a sample and had it analyzed found out it was very valuable. Before announcing this to public, offered directors opportunity to purchase additional sales. Nondisclosure is important when it is about a material fact (TSC v. Northway) that would have made a difference or if there is a duty to disclose the info. Materiality issue have information, but not 100% sure it will produce results. We care about two things the probability of things and the magnitude. How long do you have to wait to trade on the info? Wait until the info is received by the market. Efficient capital market hypothesis (ECMH) (semi-strong version) if there are a sufficient number of individuals (analysts, brokers, etc.) who are monitoring a stock, new info will get incorporated very quickly into a price along with all historical info. (strong version minority view) Even info from inside information bundle is already incorporated into the price (but no one really believes this since how can price reflect info that has not been disclosed yet). Chiarella v. U.S. (SCOTUS 1980) p. 855 Printer had access to a lot of company documents. He learned the company was planning to do a takeover which would change value of stock since takeovers are done at a premium. Printer got name of target company and bought stock in it before tender offer knew price so it was an arbitrage profit. Printer had no relationship with the target company. Standard to figure out if Chiarella was liable was then whether he had a duty to the shareholders that he traded with.

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Court says 10b talks about deceit, fraud, etc. that usually involves a relationship between two individuals a duty to disclose certain information to somebody. If there is no duty, then there is no 10b violation- this duty must be preexisting before 10b liability. The Supreme Court, Mr. Justice Powell, held that: (1) employee could not be convicted on theory of failure to disclose his knowledge to stockholders or target companies as he was under no duty to speak, in that he had no prior dealings with the stockholders and was not their agent or fiduciary and was not a person in whom sellers had placed their trust and confidence, but dealt with them only through impersonal market transactions; (2) section 10(b) duty to disclose does not arise from mere possession of nonpublic market information; and (3) court would not decide whether employee breached a duty to acquiring corporation since such theory was not submitted to the jury. Reversed. Insider Trading: Classical Theory insiders (officers, board members, majority shareholders, or any other employee with access to the information that is not public); non-insiders (liability only if as in Chiarella they have a duty to the person that you are trading with so fiduciary duty or some other duty to disclose). Under this view, the purchase or sale of a security is with the shareholders of the company whose share price would be affected by the nonpublic information and that nonpublic info can be inside info or market info. Misappropriation Theory fraud and deceit to anybody who is owed a fiduciary duty by the defendant not to use their info Parity of information theory do not want a group of people who have inside info to be able to make arbitrage profit. US v. OHagan (SCOTUS 1997) p. 866 Law firm represented a company in a takeover one of the law partners purchased stock on that information. The Supreme Court, Justice Ginsburg, held that: (1) criminal liability under 10(b) of Securities Exchange Act may be predicated on misappropriation theory; (2) defendant who purchased stock in target corporation prior to its being purchased in tender offer, based on inside information he acquired as member of law firm representing tender offeror, could be found guilty of securities fraud in violation of Rule 10b-5 under misappropriation theory; and (3) Securities and Exchange Commission (SEC) did not exceed its rulemaking authority in promulgating rule proscribing transactions in securities on basis of material, nonpublic information in context of tender offers. Reversed and remanded. Person who is harmed by the stealing of info is different than the person who is harmed by the sale of a security. If you disclose to the person you owe a duty to, you are not liable under 10b. Cady Roberts duty (adopted in Chiarella) if you have a duty, you have to either disclose the non-public info before you trade or do not trade. If you disclose and trade, you must disclose it to the person you are trading with or the markets generally.

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OHagan misappropriation theory if you have a duty to a third party and misappropriate info thereby violating that duty and you use that info in the purchase or sale of a security, then you violate 10b-5. Takeovers occur at a premium over the market price. Secrecy in takeovers is valuable since it keeps the market price down. After Sarbannes-Oxley, time period in which you must disclose info is much shorter. Dirks v. SEC (SCOTUS 1983) p. 881 Dirks had info and he told the Wall Street Journal saying they needed to investigate the company. The info was nonpublic about fraud. Dirks was an analyst, which is a role that ferrets out information. Court distinguished between insiders and non-insiders Cady dealt with insiders, Chiarella dealt with non-insiders. A tippee assumes a fiduciary duty to the shareholders of a company not to trade on material nonpublic info only when the insider has breached his fiduciary duty to the shareholders by disclosing the info to the tippee and the tippee knows or should know that there has been a breach. RULE A tippee is liable if 1) insider breached a fiduciary duty AND 2) tippee has knowledge that the disclosure breaches the duty. If you help someone violate 10b, then you may be liable. A tippee has to owe a duty to somebody, the person they are trading with, to be liable under Chiarella. However, what the court says in Dirks is that you can indirectly owe a duty to the shareholders if you know that the disclosure to you of the inside info violates a duty and you trade on it anyway. Once you know that it was disclosed in violation of a duty, you inherit that liability and duty. Famous Footnote 14 (55 on page 883) deals with temporary insiders (lawyers, investment bankers, etc.) people who are given access to inside info so that they can perform their duties. The company must expect them to keep the info confidential, and if you trade on it, you are a temporary insider, so you are treated as a real insider. To see whether tipper/tippee are liable: Direct gain from trading Indirect gain from trading OR get an indirect benefit from disclosing info to tippee So, as long as tipper gets something from the disclosure, the tippee can be liable. Anytime dealing with fraud, there are certain general requirements that must be met: 1) action or inaction 2) scienter rules out negligence 3) harm or damages 4) causation

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Was there a fraudulent action that caused a negative effect or harm on a third party Basic Inc. v. Levinson (SCOTUS 1988) p. 915 Sellers of stock during period prior to formal announcement of merger brought Rule 10b-5 action in which it was alleged that material misrepresentations had been made due to denial of merger negotiations prior to official announcement. The United States District Court for the Northern District of Ohio, William K. Thomas, J., certified class action, but determined that misstatements were not material and therefore not false and misleading. On appeal, the Court of Appeals for the Sixth Circuit, Boyce F. Martin, Jr., Circuit Judge, affirmed in part, reversed in part and remanded. On grant of certiorari, the Supreme Court, Justice Blackmun, held that: (1) standard of materiality set forth in TSC Industries is appropriate in 10(b) and Rule 10b-5 context; (2) materiality in merger context depends on probability that transaction will be consummated, and its significance to issuer of securities; and (3) presumption of reliance, supported in part by fraud-on-market theory may be applied, but presumption is rebuttable. Vacated and remanded. Denied that merger negotiations were going on three times. Question becomes at what point in time do you have to disclose the negotiations? Idea is that you do not have to wait to announce until you have an agreement in principle. Risk premium difference between the true value and the value with risk discounted. Types of situations: You owe a duty not to make statements of material fact that are false: 1) made a statement 2) fact 3) material 4) false A fact is material but you do not have a duty to disclose it until you have a duty to disclose it. Question becomes, when do you have a duty to disclose?? Answer is 1) if you have to file an annual report (10-K) 2) if you have to file a quarterly report (10-Q) 3) if you have to file a form 8-K Second type of fraud is a statement that is not made but somebody is under a duty to make it if it is omitted it makes other statements false or misleading. By no including it, the disclosure as a whole is false or misleading. In Basic, court says if there is a fact and it is material and you disclose it, you violate section 10b. So if you lie about a material fact, like denying merger negotiations, then you break the law. There are certain types of statements that you have to disclose (10-k, 10-q, 8-k) so you have a duty to disclose. So what becomes important is the timing of the duty vs. the timing of the fact becoming material.

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So, if you make a false statement that is material, you lose. If you stay silent about a material fact, question is if you have a duty to disclose, and if you have a duty, what is the timing of the duty versus the timing of the fact become material??

XIV. Takeovers
Take-Overs: How do you take over a company?? You seek to gain control of the company through the board of directors which is elected by the shareholders. Takeovers Way of combining firms/companies. By combining, the ownership rights allows you to elect a board of directors. 1) proxy battle not really combining two companies, just replacing the management team just choosing which board members will run the company. Expensive way of exercising control very transient. 2) merger agreement/contract where the boards of two companies agree to combine the companies in some way. a. standard merger merge the target into the acquirer every merger requires shareholder approval, so if target is merging into another company, the shareholders of the target must approve this action. So, instead of requiring the shareholders of the acquiror having to vote, common thing is to merge target into subsidiary, since subsidiary only has one shareholder the parent company which is the acquiror. This avoids having to have 2 shareholder votes. b. merger of equals want to retain name and management since reputation of both companies are established. Will just have companies share resources and some management. 3) hostile takeover acquirer will purchase 50%+ of shares of target company. Have target shareholders sell them at X price this goes around the board members/managers of target. Shareholders do not have to sell. There are defensive tactics used by target companies to fend off takeovers. Must look at what acquiror is trying to do ultimately want control of board, so company can 1) stagger elections of board members (see 8.01 of MBCA). Need to meet Unocal rule if you are trying to change the number of board members after a takeover for defensive purposes. 8.04 allows for preferred stock that has contingent or non-contingent rights to elect board members. 8.05 terms of directors and staggered terms under 8.06 allows staggered terms of directors in two or three groups. Every year, shareholders vote to elect board members. If staggered into 3 groups, will only elect 1/3 of the board. This is a defensive tactic since it neuters proxy battles (will take two years before you can control the board). Defensive tactics only work if you have bundled tactics to prevent people from getting around one tactic with loopholes.

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Unocal Corp. v. Mesa Petroleum Co. (Del.1985) p. 1028 Mesa wanted to takeover Unocal. Unocal proposed an exchange offer where if Mesa continued with takeover, it would own a company that had immense debt. Tried to coerce shareholders to tender quickly to get to 50% so that those debt shares would be senior to Mesas shares. Unocal stands for the idea that defensive tactics must be reasonable, and things that you can look at in determining reasonableness are the interests and impacts of others (not shareholders). A minority shareholder making a hostile tender offer for company's stock filed a complaint to challenge decision of board of directors to effect a self-tender offer by corporation for its own shares. The Court of Chancery entered a preliminary injunction requested by minority shareholder, and corporation appealed. The Supreme Court, Moore, J., held that board of directors, having acted in good faith and, after reasonable investigation, found that minority shareholder's two-tier front loaded cash tender offer for approximately 37% of corporation's outstanding stock at a price of $54 per share was both inadequate and coercive, was vested with both power and duty to oppose same and, hence, to effect a self-tender by corporation for its own shares which excluded particular stockholder's participation and which operated either to defeat inadequate tender offer or, in event offer still succeeded, to provide 49% of shareholders, who would otherwise be forced to accept junk bonds, with $72 worth of senior debt. Decision reversed, and preliminary injunction vacated. Williams Act made it more difficult for people to engage in Tender Offers. By allowing the offer to be open for a period of time and allowing people to take back offers, hindered the tender offer process. Junk bonds are debt securities/debentures that are very risky and demand a high interest rate. One way of doing takeovers in the 80s was to se junk bonds and acquire the first 51% and the next 49% with a combination of cash and junk bonds. Until you have taken control of the company, it is still controlled by board members that you are trying to get rid of. So, company could have provision that if someone acquires 20% of shares, automatically, rest of shareholders get right to have their shares purchased at a very high price. This means that if you finance it using debt, you have the company borrow money and buy back the shares. The company debt will rank higher (have greater priority) than the junk bonds you used. So, in the end, you will have an impossibly high rate to pay back the junk bonds, thus it will prevent you from going through on the takeover. This whole situation is a discriminatory self-tender offer since the buying of the shares is not available to the acquiring company. Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc. (Del. 1985) p. 1031 Bidder for corporations stock brought action to enjoin certain defensive actions taken by the target corporation and others. The Court of Chancery, New Castle County, granted preliminary injunction and defendants appealed. The Supreme Court, affirmed, with an opinion to issue. The Supreme Court, Moore, J., held that: (1) lockups and related agreements are permitted under Delaware law where their adoption is untainted by director interest or other breaches of fiduciary duties; (2) actions taken by directors in the instant case did not meet that standard; (3) concern for various corporate constituencies is proper when addressing a takeover threat; (4) that principle is limited by the requirement that there be some rationally related benefit accruing to the stockholders; (5) there were no such benefits in the instant case; and (6) when sale of the company becomes inevitable, duty of board of directors changes from preservation of the

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corporate entity to maximization of the company's value at a sale for the stockholders' benefits. Affirmed. limits Unocal to situations in which there are no questions about the sale of the company someone will buy it either the bidding company or multiple companies in an auction. If that is the case, Unocal does not apply Revlon applies. Must discern whether defensive tactics are being used when a sale might not occur, or if a sale is definite. The duty of board members then turns into one of acting like auctioneers cannot prefer one bidding party over the other must go for the highest price. Unitrin, Inc. v. American General Corp. (Del. 1995) p. 1034 Acquiring corporation attempting to merge with target corporation, and target corporation's shareholders, sought to enjoin target from repurchasing its own stock. The Court of Chancery, New Castle County, preliminarily enjoined target corporation from making further repurchases on the ground that repurchase program was disproportionate response to acquiring company's inadequate all cash for all shares offer. The Court of Chancery certified target corporation's appeal from the interlocutory ruling, and the Supreme Court accepted interlocutory appeal and expedited review. The Supreme Court, Holland, J., held that: (1) Court of Chancery erred in focusing upon whether repurchase program was necessary defensive response; (2) enhanced judicial scrutiny of Unocal was applicable to target's defensive measures; (3) record supported target board's justification for adoption of repurchase program; and (4) on remand, Court of Chancery must determine whether repurchase program was draconian, if not, whether it was within range of reasonableness, and if within this range, board action would be reviewed under traditional business judgment rule. Reversed and remanded. what is meant by disproportionate impact or having a defensive tactic that is disproportionate to the takeover threat. Court will give a lot of leeway to board members to determine what is a reasonable threat and what the appropriate defensive tactics are. This case is a restatement of the Unocal rule.

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