BUSINESS ASSOCIATIONS OUTLINE y 1. INTRODUCTION y 2.

AGENCY AND AUTHORITY o Sole Proprietorship A business carried on by a single owner  The owner is legally the business, no separate identity  No formalities  You are in charge and do what you want with the business  Unlimited liability If the business owes money, you owe money  Taxation Profits and losses of the business are those of the owner  Lifespan is coextensive with the owner  Either no end to it or you sell the assets of the business y Technically cant sell a sole proprietorship because you are it o Agency - A consensual relationship in which one person acts on behalf of and subject to the control of another  Principal The one who action is taken for o Elements of an Agency Relation  Mutual Consent y Both parties must agree as to the elements of the agency relationship (formal or informal, express or implied) y Dont have to consent to the agency itself y Manifestation, objective indication of consent  Action on behalf of another y Motive is irrelevant, doesnt matter that theyre doing it for money  Control y Theres an element of subservience of the agent to the principal y Need not be total or continuous, but the principal must be in charge  No intent requirement, can intend an agency and still not create one o Five types of authority  Actual, Apparent, Agency by estoppel, Inherent agency power, Ratification o Actual Authority  Authority The power of the agent to affect the legal relations of the principal by transactions with third parties y The agent can bind the principal in contract, but limited to the scope of the authority y Central issue, based on the principals objective desires o Though they can do what is reasonably inferred in light of the principals manifestations  Creation Principals manifestations of consent to agent has to be reasonably interpreted and cause actual belief y Objective and subjective y Express (specifying exactly what the agent is to do) or implied (most authority created this way, assuming what actions to take)  Incidental Authority Actual authority includes authority to do acts which are incidental to it, still considered actual authority y Acts which usually accompany or are reasonably necessary 1

Section 118 Both principal and agent have the power to terminate actual authority at will y Though, even with the power, they may not have the right o Apparent Authority (Section 8)  If manifestations of the principal to a third party (or those by the agent to a third party that the principal authorized) would lead a reasonable person in Ts position to believe that the principal had authorized the agent to so act y Power to affect the legal relations of the principle, but professedly as agent y Key element is the principals manifestations to the third party  Examples of apparent authority as opposed to actual y Accidents Let someone use my stationary y A lie To avoid a problem or other reason y Changed circumstances or uncorrected statements Told one person hes the agent and then fired the agent  Creation Principals manifestations of consent to a third party y Agents are always authorized to describe their authority truthfully o Agency by Estoppel  3 Elements: y 1. Belief in the agency relation (3rd party has to believe in it) y . Reliance by the 3rd party, a change of their position y 3. Its the fault of the principal  Very similar to apparent authority, generally subsumed under it o Inherent Agency Power  Section 161 A disclosed or partially disclosed principal is liable for an act done on his behalf by a general agent, even if the principal had forbidden the act, if: y (i) The act usually accompanies or is incidentals to acts the agent is authorized to conduct, and y (ii) The third party reasonably believes the agent is authorized to do the act  Its not very clear what it is, its not authority, apparent, estoppel y Can think of it as a separate theory of authority, but have to have agency power to have inherent agency power y Generally, first ask if there is actual authority, then move to apparent, then agency by estoppel, and if none of those, then inherent agency  In a situation where a third party is harmed by an agent without another kind of authority can deal with it in 3 ways y 1. Create a new rule Secret Instructions to the agent o Because they were secret, the principal is still bound o Probably not the best way to deal with all problems, well have lots of rules . Can stretch the rules to include more y o Stretch apparent authority or agency by estoppel o Happens from time to time too y 3. Create a new category 

o Think of it more as a stop-gap measure when the other rules dont make sense  Always go to it last, there is no clear this is inherent agency o Ratification (Section 82)  The affirmance by a person of a prior act which did not bind him but which was done or professedly done on his account, whereby the act, as to some or all persons, is given effect as if originally authorized by him  Elements Need both y 1. Professedly done on principals account o Agent says it was done on his account y . Affirmance by principal o Manifestation of an intention to treat it as authorized o OR engages in conduct justifiable only with an intention  Go pick up car instead of saying its not his and agent had no power  Ratification is not the same as acquiescence y Acquiescence (R2 43) If the agent performs a series of similar acts without the principal objecting, its an indication that he consents to the performance of similar acts in the future o Acquiescence gives rise to actual authority o Spectrum of Agency  General/Special y General agent When a principal authorizes an agent to conduct a series of transactions involving a continuity of service y Special agent Agent authorized to conduct a single transaction or a series of transactions not involving continuity of service  Master/Servant y Master (principal or employer) Principal has control over the physical conduct of the agent in the performance of the service o Has control or the right to control the manner and means of the agents performance (R3) o Servant (agent or employee) o Agent has caused physical injury to a person or property y Affects the extent of vicarious liability The master is liable for torts of the servant within the scope of employment o Respondeat superior o Whether the ER should be held liable for this tort, its a policy question  Matter of fairness between the ER and 3rd party o Regardless of whether the master authorized it, or even forbade the act o Ex; ER liable for bouncer beating someone up because force was within the scope of liability o Ex; ER probably not liable for taxi drivers accident while using the car for recreation, not within the scope

Some factors to consider, none are necessary in making the determination if someone is a servant: o Extent of control the principal may exercise o Whether its a distinct occupation or regular business of the ER o Whether the EE or ER supplies the tools and location o Duration duration or special agent o Method of payment, by the hour or for the job  Independent Contractor y Can be an agent or non-agent o Not an agent if they cant act for the P, theyre just doing the assigned job  P is liable if its an agent o Is an agent if in terms of doing the assigned job, have more leeway y Basic element is control o To be an agent, P must have some control, but not as much as a master/servant its this if you dont have enough control to be master/servant o This matters because of the extent of vicarious liability  Stranger y Ex; Hiring someone to update a bathroom at home and only telling him the product not how to do it, independent contractor o Handyman then hires someone to give orders to, to help him, likely will be a servant  If a plumber hires an electrician, its an independent contractor agent because hell have some control over his actions, but less than of a servant o Handyman then goes to Lowes the relationship there is stranger, there is no relation o Non-agent o Principals Status Whos liable on a contract between A and third party?  Disclosed When an agent and third party interact, the principals existence and identity are known to the third party y Easy and typical case P is liable, A is not, 3rd party is liable  Partially-disclosed A principal whose existence is known to the third party, but not his identity y Third party is accepting some risk by not knowing the identity y P is liable (unless the third party is not liable) y A is liable (default rule) to third party unless A and the third party agree that A will not be liable y Third party is liable (unless P is excluded from the contract) o Except, third party is not liable if the agent or the principal knew that the third party would not have dealt with the principal had his identity been known  Undisclosed Existence and identity are both unknown y P is still liable, A is liable, third party is liable unless P is excluded o Morris Oil Co. v. Rainbow Oilfield Trucking y 4

Was Rainbow Dawns agent when it incurred debt from Morris? First go through the elements to determine if there was agency y 1. Mutual consent Yes y 2. Acting on behalf of another Tricky in this case, might look like independent contractors o But by lending their certificate to Rainbow, Dawn cannot use it, and so Rainbow is acting on Dawns behalf legally y 3. Control The ability to terminate a relationship that someone else needs is an element of control o Also, contractually Dawn had complete control over operations  Argument against agency relationship y 1. Not acting on behalf of Dawn, really just circumventing the law y 2. The contract expressly says R is not the agent of D o This isnt controlling, the intent of parties does not matter  Actual authority Would have to have been a secret instruction because Morris wasnt aware of the agency  Apparent Authority No because no representation to a 3rd party  Estoppel No, 3rd party didnt know there was agency  Ratification Saying it was professedly done on the Ps account would be stretching it, but dont necessarily need ratification here anyway . FIDUCIARY DUTIES OF AGENTS o Fiduciary A relationship of special trust and confidence marked by utmost good faith and loyalty  An agent is a fiduciary only in respect to matters regarding the scope of agency o 3 types of fiduciary duties:  1. Contractual duties A has a duty to act in accordance with promise  2. Duty of care Have to do it carefully, properly, with due care y Not infinite care, but the appropriate amount y R2 379 Distinguishes between paid and gratuitous agents o Paid Theres a minimum, the skill which is standard for the locality for that kind of work and any special skill they have  Min objective level + your potential  Higher min level you expect of them when paid o Gratuitous Lower standard (reliance), cant make anyone worse off  Just someone doing you a favor, so you cant expect that much of them  3. Duty of loyalty Act solely for the benefit of the P in matters connected with the agency, cannot act for your interests or someone elses y 1.) Accounting for profits (R2 388) Agent who makes a profit in connection with agency must give such profits to P o Big exception is if its customary, tips can be kept y 2.) Non-competition (R2 393) A cant compete concerning subject matter of agency y 3.) No conflicting interests  

4.) Confidentiality A cant use any of the information he receives confidentially for the detriment of P or the benefit of A (very broad, even if the secret doesnt relate to your job) o Can only be used for the benefit of P, even after termination Tarnowski v. Resop P hired the D to be his agent to look into music machines, D does only a superficial investigation and gives P false information while also taking a commission from the third party  Hes suing for the profit his agent made and damages incurred for suing the seller  Accounting for profits - P is entitled to the secret commission (very strict rule) y Theres a good chance the agents profits lessened the principals profits, but its a bright line rule and counts even if his actions didnt hurt the P  Damages (R2 407(1)) P is entitled to secret profits plus damages, even though he already won a judgment from the seller y Usually in business were not trying to make the P better off, just not worse than before y This isnt necessarily a double recovery you cant get a thing plus its value, but you can get recover for 2 things o There are things you can get in a fiduciary duty setting that you cant get in a contractual setting Reading v. Attorney General Sergeant wears his uniform while delivering alcohol in a truck so as not to be stopped and owes that money to the Crown  Accounting for profit He should have to turn over the secret profit  It was probably his role as a soldier that got him the job  P gets to keep the money here, but in other cases why should the P and not the government keep the money? y Probably in large part convenience y It also encourages litigation because otherwise people wouldnt pursue claims if the government is getting the money Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure (Jensen & Meckling)  It is generally impossible for the P or the A at zero cost to ensure that the A will make optimal decisions from the Ps viewpoint y Agency cost is the sum of: o 1. Monitoring expenditures by P o 2. Bonding expenditures by A o 3. Residual loss (Cost of the divergence between the As decisions and those that would be the best for the P) General Automotive Mfg. Co. v. Singer D is liable to P under accounting for profits because he was running his own secret business on the side while working as the manager of Automotive  He violated his fiduciary duties of good faith and loyalty because he didnt disclose the information or turn away the business he was keeping for himself, even if it didnt harm P y He wasnt acting for the sole benefit of the P  This is a VERY strict law y 6

o Bancroft-Whitney v. Glen D is president of the company, decides to leave and work for a rival, but recruits a number of current employees to go with him by using company information to offer higher salaries  Glens duty: 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  Glens actions y He helped raid the company and lied about it to them y Disclosed salary information y Encouraged postponing salary raises there  Even though they are all at will EEs and can leave any time, Glen cant harm or damage the company by helping a competitor raid the company y He went beyond and took them  Even if he had disclosed it, he may still be in trouble y Disclosure is not enough, your actions in fact must be loyal  Regarding his duties to the second company, he owes full loyalty to both y If you cant satisfy both, thats his problem, the law isnt going to give him a way out o The solution is not to put yourself in positions of conflicting duties (temporal issue dont put yourself in that position)  A competitor cannot enlist someone to violate his fiduciary duty y Bender is the competitor, so he has no fiduciary duty to Bancroft, but Glen was Benders agent in violating Glens fiduciary duty y Because he asked Glen to do something that violated his fiduciary duty, he is also liable y He received benefits of Glens infidelity y 4. INTRODUCTION TO PARTNERSHIPS o Partnership An association of two or more persons to carry on as co-owners a business for profit  2 main bodies of law y Uniform Partnership Act y Revised Uniform Partnership Act (revised in a majority of states)  No formalities you can become a partnership accidentally or unintentionally y RUPA allows you to file your partnership but doesnt require it y UPA says a partnership is not different from partners o Under RUPA its a separate entity  Control joint ownership and management, both have ultimate control and managerial decisions y Partners can alter rights by agreement but not necessarily their powers  Liability unlimited plus y Each partner is liable for anything they do and anything other partners do, joint and several liability for business obligations y Partners can alter their own rights and liabilities among themselves, but they are still going to be liable to 3rd parties  Taxation Profits and losses of the partnership are those of the partners

y Direct taxation, pass-through Lifespan at the will of the partners and for the life of the partners y If any partner dies or decides to end the partnership, then it can end y UPA: a change in partner membership creates a whole new partnership y RUPA: not the case anymore, but not that much of a difference  Exit A partner has the power to exit at any time, but not necessarily the right (may be liable for the exit) o Partnership Formation  Statutory elements (RUPA 202(a)) Test for every case y A consensual association But the law will determine if thats a partnership, not you (you dont have to intend to form it) y To carry on as co-owners Not enough to co-own property or share revenues y Business for profit Doesnt mean you have to be profitable, just that you are trying  Sometimes when there is no express agreement, courts use another test for implicit agreements (case law elements) y An agreement to share profits y Agreement to share loses y Mutual right of control or management y A community of interest in the venture (not clear what this really is) y (These aspects arent always good tests, real test should be statutory elements) o Partnership by Estoppel  RUPA 308 Partnership by estoppel, similar to agency by estoppel, but not the same y Not really partners, but youll be liable as if you were  Elements: y 1. Manifestation that suggests a partnership Somehow presented as a partner, either by saying so or allowing someone to say so y 2. Reliance Someone enters into a transaction based on this manifestation o If theres a public/commercial manifestation, then there doesnt need to be reliance  Ex; Young v. Jones Firm allows a group in the Bahamas to use its name and then publicly calls itself a global firm y Even though there is no real partnership, there is a public manifestation of partnership, so reliance is not necessary and a court would generally find partnership by estoppel  Liability: y Theyre liable if manifestation is authorized by all partners o If ABC are partners and they allow Z to present himself as a partner, then the partnership is liable y For a purported partner, liable as a partner if partnership is liable 

o Otherwise, with consenting purported partners y If there is no partnership or if there is one but not every partner approved, the partner who didnt consent wont be liable and it will make the consenting people (both purported partner and partner that consents) liable o Creates a virtual partnership between the purported partner and consenting partner o Property Rights in a Partnership  Partnership property What youre putting into the partnership y UPA Tenancy in partnership o Partners have the right to possess partnership property for partnership purposes, but for nothing else, no personal reasons y RUPA Partners have no interest in the property o The partnership owns it, but partners can still use it for partnership reasons o Not the same, but very similar y Real issue; Is it partnership property or is it partners property being lent to the partnership?  Interest in the partnership (RUPA 502) y Partners own an interest in the partnership o They can sell (assign) this, but nothing else regarding the partnership, not property or the partnership itself y Interest A share in profits and losses and a right to share in the distribution y Assignment doesnt affect partnership (all youre selling is the right to cash flows) o Typically it only includes the profits, not the losses o Can alter the rights to the partnership, but not the obligations  Still liable, even if you assign your interest to someone y If a partner assigns his interest and the rest dont, they have options: o UPA Non-assigning partners can dissolve the partnership (even if they normally wouldnt have the right to)  Protects the remaining partners if that other partner decides to no longer work hard since they are no longer making a profit o RUPA Non-assigning partners can expel that partner o Creditors  Old rule Dual Priorities UPA 36(4), (70-71) y Partnership creditors (creditors of the partnership) have priority in getting paid out of partnership assets y Personal creditors (creditors of a partner) have priority in getting paid out of personal wealth, individual assets of partners y Then if debts to partnership creditors remain unpaid after partnership assets are exhausted, they reconcile the difference with partnership individual assets (Bankruptcy Code allows for this change)  New Rule Partnership creditors first

Its a separate entity, so it must first pay off its debts before it gives any back to partners y If theres not enough money in the partnership to take care of the debts, then the partners have to personally cover it o Capital Accounts  Capital Account An account on a partnerships balance sheet representing a partners share of the partnership capital (or equity) y Capital Account = (Contributions that partners put into the business + profits) distributions (what the partnership pays out to partners)  Indemnification and Contribution y Indemnification Reimbursement of a loss or expense incurred by another y Contribution The right of a person who pays a debt to recover proportionally from others who are also liable on the debt y A partner has the right to be indemnified by the partnership and the partnership can seek contribution from partners o Martin v. Peyton Plaintiffs claim the Ds became partners with them, the firm they were lending money to  Ps claim they were not partners, and their interests in profits should be construed as a measure of compensation for loans, not an interest in profits y Question is whether they agreed to associate themselves with the firm as to carry on as co-owners of a business for profit  Argument they are partners y Share in profits (a big one, makes you look like partners) y They consented to the relationship, whatever that might be y The lenders had a lot of control the right to veto, all access to books, fixed the amount partners could draw, demanded resignation of partners in case they wanted to fire and of them y The right to become partners later on  Argument they were not partners y Their control was still limited, they didnt have the power to initiate transactions on behalf of the partnership y Maybe the profit sharing is just to repay the loan o Its ok to secure a loan y They say they were trying not to be partners  Weighing the elements y Consensual relationship Yes y Business for profit Yes y Carrying on as co-owners Maybe, option to become partners later suggests partnership  In the aggregate, this court says it did not create a partnership, but another court might decide differently o Lupien v. Malsbenden P, Lupien, contracted with Cragen and York Motor Mart for the construction of a Bradley car kit and sues D, Malsbenden, when the contract is breached, holding him to partnership liability Court for P  D claims he was not a partner in York Motor Mart and isnt liable y

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To make the case for partnership: y The loan D makes was made without interest (not unheard of, but this doesnt sound like a loan, it sounds like an investment) y D had the right to participate in control of the business and did so frequently, he was there more often than Cragen  Association, business for profit, carrying on as co-owners y All suggest partnership y He may just not have wanted the liability, but here hes gone too far to say that its just a loan and not partnership o He was taking an active role in a way that pure lender dont o Rappoport v. 55 Perry Co. Question is whether an agreement between two families allowed one to make their children partners without the others consent  Provision under review said consent was required for certain actions, except in regard to their children y Plaintiffs argue it referred to making children partners y Defendants argue it only referred to making assignments, transferring profits  Partnership Law No person can become a member of a partnership without the consent of all the partners (40) y In the absence of an agreement, they can sell/assign their interest in the partnership without agreement, so since they can already do this, does it make sense that they would specifically provide for it for their children? o Probably not, but it doesnt perfectly track partnership law either y Ds may have wanted to prevent assignment to anyone but children because you might not have the same motivation if you give away your profits o You can still agree to give the profits to someone, even if you cant assign your interest  They cant prevent you from doing what you want with money  Court holds that consent was required y 5. RIGHTS AND DUTIES OF PARTNERS o Rights of Partners  RUPA 103 A list of default rules for when the partnership hasnt spelled it out y Equal share in profits (and losses) y Equal rights in management (right to participation) y Right to information y Right to consent to addition of partners y No right to salary  Actual authority of partners Default rule under the UPA is that each partner is an agent of the partnership for the purpose of its business  Apparent authority Authority to bind for apparently carrying on in the usual way the business of the partnership of which he is a member y Ambiguous under UPA, but under RUPA, clear that the apparent course of business means the partnership business OR business of the kind carried on by the partnership  11

Third parties Under RUPA, it is changed so that third parties require actual knowledge or a receipt of notification of a partners lack of authority to prevent partnership liability y You can also change the agreement of rights among partners, but it wont necessarily apply to third parties o Management of Partnership  Every partner is an agent of the partnership y Acts for apparently carrying on business in ordinary course are binding o Unless third party has notice that partner lacks authority y Acts not for apparently carrying on business in ordinary course are not binding o Unless acts are authorized, then they're binding y Partnership liable for wrongful acts in ordinary course of business  Differences in ordinary course of business may be decided by majority (50% plus one) y Every partner has an equal vote y Other differences require unanimous consent  Tension between these rules Partnership is supposed to agree o Obligations of Partners  Under UPA, a partnership is not recognized as an entity and suit cannot normally be brought against an association that is not an entity y Partners have joint and several liability for wrongful acts and omissions of the partnership o But for other obligations, they are jointly liable, so an action on a contractual obligation must be brought against all the partners y Many states have statutorily patched up this rule o Many adopt a Common Name Statute, which allows a partnership to be sued in its own name  Under RUPA, a partnership may sue and be sued in its own name y Still joint and severally liable, but new barrier to collecting against an individual partner o A suit against a partner based on a claim against the partnership, partnership assets must be exhausted before an individuals assets can be reached  Partners have fiduciary duties to each other y Duty of care o Refrain from grossly negligent or intentional misconduct y Duty of loyalty y Concept of good faith and fair dealing o Obligation as opposed to fiduciary duty  They still exist, but RUPA seems to be limiting fiduciary duties y Duty of loyalty and care set forth in RUPA (both limited, narrowed the scope in RUPA) o Differences between partners settled by majority is mandatory 

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Summers v. Dooley One partner sues the other after the first hires an EE and his partner refuses to reimburse him because he never agreed to hire him; Court for D y P claims his partner received profits and benefitted from the third mans labor and should be estopped from denying the need of the EE y Court denies him relief, saying he needed a majority to hire him o Any difference arising as to ordinary matters connected with the partnership business may be decided by a majority of the partners (UPA 53-318(8))  Court holds this language mandatory rather than permissive o But the other partner doesn't have a majority either, only two  Not entirely satisfying y Court says its unfair to make the other partner pay the EE when it was for the sole benefit of one partner o Not a fair statement since he incurred the expense for the benefit of the partnership  Sanchez v. Saylor (In line with Summers) Two partners, one refuses to give his personal financial information to a third party considering lending the partnership money, the other partner sues for breach of fiduciary obligations y Court holds for the D Neither partner has the right to impose his will on the other, differences regarding ordinary matters require a majority o Cites Covalt v. High that in the absence of an enforceable agreement covering disagreements in the partnership, it is dissolution, not an action for breach of fiduciary duty that is the appropriate avenue o Differences between partners are subject to the partnership agreement  National Biscuit Holds that differences MAY be settled by majority, subject to any agreement between them which can be implied based on a course of conduct y Look to default rules every partner has equal rights in management o If they didn't take away authority by majority vote, they have the authority y Sounds more technically correct, but there seems to be logic in Summers  Not always going to be easy to say what is an affirmative step, when you need majority y In many cases that won't be a very satisfying rule y Some states follow one or the other of these two o Conflict of laws or choice of law Law governing the internal affairs of organizations to decide which states laws apply  Corporations, LLP, and limited liability companies y The general choice of law rule is the state where the corporation is incorporated or where its organized  General partnership y Requires no filing of organizational documents, so, under RUPA, its the law of the state where the partnership has its chief executive office o Authority of a Partner 

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RNR Investments Limited Partnership v. Peoples First Community Bank RNR had a provision limiting the general partners spending and when they defaulted on a loan, they claim the bank failed to review the limitations in the limited partnership agreement and was estopped from foreclosing y The partner who got the loan did not have actual authority to make it, but he did have apparent authority o His action could be considered in the ordinary course of business o Third party didn't have notice of the lack of authority y Argument they had notice They were given the partnership agreement, but it doesn't list the exact amount of the loan he could get for them o No way of knowing the amount wasn't authorized, only provisions by which they may have deduced that there was a limit y This doesn't count as notice o It has to be actual knowledge or notice that there is a problem, not facts from which you could decide there was a problem o Liability for Partnership Obligations  Davis v. Loftus Question is whether partners in a firm called income partners are considered partners in the suit under partnership law y Court says income partners are not partners under UPA y Look to the elements: o Mutual consent: Yes o Business for profit: Yes o Carrying on as co-owners: Not really, they don't share in profits and losses  They receive a fixed salary plus a bonus  No right to vote on management or conduct y Argument they should o They were given bonuses, could be seen as share in profits o Titled income partners o Maybe control isn't as important as we think, even though they have no control it's not a big deal o Community of interest, arguably everyone has that o Sharing of losses, can argue that's a question of law, if we decide it's a partnership, we'll say they do have to share losses  Hobo Bob and Bill Gates have to share losses if the court says they're a partnership, even if Gates tries to make Bob pay all the liabilities o The Partners Duty of Loyalty  Meinhard v. Salmon Two partners in a joint venture for 20 years for building on a leased property, then when one gets an opportunity to extend the lease, he leaves the other out, who then sues y Joint ventures, like copartners, owe the duty of finest loyalty y Can argue he shouldn't be keeping secrets from his partner o He was the managing partner and this was related to the business o He couldn't have known about this project unless he told him, can't have that unfair advantage over the other  14

Argue the other way that he maybe shouldn't have to share because he did all the work, made it all possible and Meinhard had already been well paid o Their agreement was also up y Was this in the scope of the partnership? o Pretty close, but it was during the partnership he decided to extend the lease, so maybe it counts o When is close enough will be a factual question y Court says at least he should have told him, given him the opportunity y Ex ante, Salmon probably wouldn't have wanted to bind himself o Almost certainly they wouldn't have come to the courts agreement  Latta v. Kilbourn One partner cannot, directly or indirectly, use partnership assets for his own benefit, he cannot in conducting the business of a partnership, take any profit clandestinely for himself o Suits by a Partner Against a Partnership  Suit for an accounting (UPA 22) When a partner is wrongfully excluded from business, if the right is granted under the partnership agreement, for appropriation of an unauthorized benefit, or whenever else it is reasonable y They are rare and usually indicate mistrust, so dissolution is often more appropriate  UPA 13 Interpreted not to authorize a suit by a partner against a partnership, so courts often limit remedies to an accounting or dissolution y Weak justification that practical difficulties dont allow for other suits, so there are exceptions to it  RUPA 305 Changes it to permit a partner to sue the partnership during the partnership, rather than just dissolution and accounting o Bane v. Ferguson Whether a retired partner has a claim against the firm for acts of negligence that caused the firm to terminate his retirement benefits, duty of care  Court holds that he is no longer a partner and is owed no fiduciary duties y Even if he was still a partner, he probably wouldnt get anything  Their plan just didnt work out and making a bad decision is not the kind of thing you can sue for under the duty of care  Meinhard Court might have dealt with this differently, but that was duty of loyalty, which courts are much more stringent with y Possible selfishness or betrayal type duties, theyre stricter  Could potentially turn it into a duty of loyalty issue y Trying to extend the life of the partnership, like they did in Meinhard y Arguing that the partners making business decisions were being carefree because they had a different risk profile and it didnt matter as much to them if things went awry y This wouldnt work but many times people will try to change duty of care into duty of loyalty y 6. PARTNERSHIP DISSOLUTION o Ending a Partnership  UPA: three stages y Dissolution someone leaves the partnership o Dissociation of any partner triggers dissolution y 15

Winding up process of settling partnership affairs after dissociation o Ex; Manufacturing widgets, have to complete the existing contracts for widgets, finish existing business y Termination the end of the partnership o After dissolution the partnership is really continued until the termination  RUPA: Adds dissociation y Dissolution The beginning of the end of the partnership y Dissociation The change in the relation of the partners caused by any partner ceasing to be associated with the partnership o What was formally known as dissolution is now dissociation o Dissociation may or may not lead to a dissolution y RUPA 801 default rule: partnership continues, dissociation doesnt end it unless one of the events in 801 occurs o Under UPA, the partnership came to an end  But there are major exceptions and the differences between UPA and RUPA are not all that great o RUPA moves to an entity theory to prevent a technical dissociation y In every dissociation o Either the partnership is dissolved and wound up o OR dissociating partners interest is purchased o These are kind of the same thing o Causes of Dissociation (RUPA 601)  Each partner always has the power to dissociate at any time y But they dont necessarily have the right to do it o They have it in an at-will partnership, not for a term  As per partnership agreement by a specified event  By unanimous agreement of the other partners if the partner has assigned her interest in the partnership  Judicial decree from misconduct y If a partners actions adversely and materially affect the business you can go to court and ask for a dissociation (beyond simple misconduct) o Willful and persistent material breach of agreement or duties or something that makes it not reasonably practicable to continue with partnership  Certain bankruptcy events y Bankruptcy is a cause because that partner cant pay their own weight  Death or incapacity y Incapacity could by physical, mental or emotional, but it has to be serious o Wrongful Dissociation (RUPA 602)  In breach of an express provision of partnership agreement  Before the expiration of a term  Judicial decree that kicks you out, still wrongful if you didnt want to  Bankruptcy  Death or incapacity is not y Some culpability associated with these, death isnt your fault y 16

o Causes of Dissolution (RUPA 801) (old rules - UPA 31)  Partnership at will is an exception, dissolution follows dissociation (unless agreement says otherwise) (WHY?)  By agreement of partners  An expiration of a term  Illegality, if the partnership becomes illegal  Judicial decree of impracticability  Judicial decree to protect transferee y If a partner transfers his interest, the transferee can obtain judicial dissolution if it is equitable after the end of the partnership term y Court would try to avoid that as much as possible o Effect of Dissociation  Dissociated partner or partners are no longer members y Authority No longer have actual authority o But they may still have apparent authority o RUPA 702 partnership is liable to third parties for actions of a dissociated partner for 2 years, if the third party reasonably believed he was still a partner  The dissociated partner is then liable to the partnership y Liability for actions before you left, no liability for new obligations o 703(a) for preexisting before dissociation o 806 liable for winding up obligations o 703(b) creates a 2 year window for the protection of innocents  For the protection of other partners who reasonably believe the dissociated partner is still a partner, you are still liable  Dissolution process: Wind Up (UPA 30) y Sell assets Have to sell everything o Historically, this meant you have to sell everything separately o But could sell everything as a package, so even though your dissolving, the partnership is coming to an end, the business is not coming to an end o Liquidation value value of a business if its assets are sold individually o Going Concern Value value of a business if its assets are sold together, as a business  Usually higher than a liquidation value  Courts have hated dissolution because they thought it led to liquidation value, but it could lead to going concern value y Pay off creditors, defined as liabilities (including partners) (UPA 40) o 1. Pay off creditors other than partners o 2. Pay off partners for obligations other than capital or profits  Ex; a loan a partner made to the partnership o 3. Pay off partners in respect of capital o 4. Pay off partners in respect of profits  Distribute net proceeds

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o Farnsworth v. Deaver Regarding distributions in dissolutions (UPA 40(b)) (84)  Court: partners must contribute towards the losses sustained by the partnership according to their share in the profits  Alternative is a buy-out (RUPA 701(b)) y If a partners dissociation doesnt result in dissolution, the default rule is that the dissociated partner must be bought out y The buyout price is the amount that would have been distributable to the dissociating partner if, on the date of dissociation, the assets of the partnership were sold at a price equal to the greater of the liquidation value or the value based on a sale of the entire business o Not theoretically that different from the whole thing dissolving y One reason not to have an actual dissolution is transaction costs o Not that easy to put together a sale of the business and it might not be that easy to find a buyer o Winners curse The fact that the winner of an auction is likely to overpay and thus have regret  Have to be willing to bid more than the people who know the business, since partners inside will likely be bidding y Problem of a virtual dissolution is that the price is going to be someones guess unless we really try to sell it y Dissolution or buyout, but in the end, its the same thing in some ways o But in neither case is the business necessarily destroyed  Consequences of Wrongful Dissociation: y 701(c) damages under 602(b) must be offset against the buyout date y 701(h) deferred payment until the expiration of the term or completion of undertaking (Still get to earn interest) y Under the UPA it said the buyout amount would not earn good will o Goodwill The value of a businesss reputation and other intangible assets; essentially, the difference between a companys asset value and going concern value  RUPA rejects this unless the partnerships goodwill is damaged by the wrongful dissociation y 803(a) no right to participate in winding up o Youre at their mercy, they get to complete the business and youre still liable for what they do o This is pretty important o Girard Bank v. Haley A partner in an at-will UPA partnership sent a letter that said she was terminating the partnership  Court held that under 31 of the UPA, dissolution is caused by the express will of any partner and did not need a justification o Creel v. Lilly Partnership of a retail business between 3, one dies and the other two wind up the business by assessing his value in the partnership, buying out the wife of the third partner, and continuing the business  Wife sues because she wanted actual liquidation  She is not entitled to it because winding up doesnt always mean liquidate 18

Historically, the estate had the right to compel liquidation, but many courts viewed this as a harsh measure and adopted judicial alternatives that were similar to RUPA o Disotell v. Stiltner (Supplement, 6) Although the statute would seem to be in favor of liquidation, this court, like Creel, holds that it does not (basically ignoring UPA)  A buyout can reduce economic waste and their effort to avoid further loss to the partners justifies the buyout  They basically apply the RUPA rule to the UPA, saying others have done so o McCormick v. Brevig Brother and sister in a partnership, she claimed he had engaged in conduct warranting a decree of expulsion and wants liquidation, he wants a buyout  Distinguishes the facts from Creel and holds that when a dissolution is court ordered, partnership assets must be reduced to cash in order to satisfy obligations of the partnership and distribute any net surplus to the remaining partners o Some reasons for wanting to require liquidation  Spite or wife not being able to stand the idea of her husbands business carrying on without him  Might not trust the appraisal, or being bought out and want an auction tell us what the real value is o Page v. Page Two brother in a linen business, one wants declaratory judgment to make them dissolve it to make sure that he doesnt get declared a wrongful dissolution  Trial court said it was a partnership for a term a reasonable time to enable the partnership to pay off its debt y Court holds its a partnership at will and he can dissolve y The other brother really just had a hope that they would pay off all the loses, but that doesnt make it a partnership for a term  Other brother claims that its finally profitable and he wants to dissolve so that he can open his own business, not sharing profits y Court lets him dissolve the partnership, but warns him that if he does open his own business it would be a breach and he would be liable y Expulsion of a Partner o Winston & Strawn v. Nosal P is expelled from a law firm following his request for partnership information and his threat to sue if his request was not granted  Company seeks declaratory judgment that the expulsion was valid Denied y They can expel a partner for just about any reason or no reason o The problem is that he was trying to uncover records from the firm that he was allowed in his position  He thought they were increasing their own shares while decreasing others y Theyre allowed to do that but they cannot do it without the full awareness of the remaining capital partners y Theyre trying to protect themselves by denying him the information  Partners owe one another the duty of good faith and fair dealing y No particular set of standards for this, not easy to pin down o Crutcher v. Smith They tried to say his minor wrongful acts caused a dissolution  Court holds for his argument that the other partners took definitive steps to exclude him from the partnership and stripped his rights as a partner y He was wrongfully expelled from the partnership  19

y 7. LIMITED PARTNERSHIPS o Shortcomings  Sole proprietorship y Very limited funding y Unlimited liability you can lose everything  Partnerships y Too many managers Can theoretically have unlimited people managing y Limited funding only amount the individual partners can bring to bear y Unlimited liability plus your liability plus other partners o Limited Partnership  Limited Partnership (RULPA 101) A partnership formed by two or more persons with two types of members; general and limited partners  Two classes of partners y General partner partner with a right to manage the business and with unlimited liability y Limited partner without the right to manage the business and with limited liability o Under RULPA302 can provide for certain voting rights o Limited liability the legal limitation of an investors liability to her investment in the business, such that business creditors cannot go after personal assets  Limited liability or no liability is known as limited liability o Must be one general partner at all times but there can be any number of limited partners, even zero  From societys perspective need someone liable, from operational need someone to manage it  Advantages y Greater access to funding Those investors who are limited dont have to worry about what theyre really getting into o Dont have to manage the business, worry about losing their home y More efficient management general partners manage the business o Dont have to deal with everyone every time they make a decision o Forming a limited Partnership  RULPA 201 To form a limited partnership a certificate of limited partnership must be filed in the office of the Secretary of State y Cannot be formed accidentally y Minimal information y Notice of existence y Without this filing, its a regular partnership and not limited  Written agreement is optional y Ought to have one, better to create one rather than rely on default laws  Limits to what you can name it y It must indicate limited partnership status (most states L.P. is enough) y You cant contain the name of the limited partner in it o Limited Liability

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Passive investor status y Limited partners who dont run the business, just putting in money y They may be liable as partners if they engage in control of the business  Holzman v. De Escamilla 3 partners in a farming business, 2 claiming they were not general partners, but were found to be general partners y Pretty clear that the two limited partners were really in charge o Limited partners could sign checks without the general manager and he couldnt sign without them o They forced him to quit y They clearly took part in the control of the business, though its not clear how much control is too much for a limited partnership o Suggesting things and voting on fundamental matter isnt enough  Gateway Potato Sales v. G.B. Investment Co. Gateway, a creditor, brought suit to recover payment for goods to the limited partnership, including the limited partner because it participated in the control of the partnership business y In Arizona, a limited partner can be liable beyond its investment even if it had no contact with the creditor o If the control of the limited partner is "substantially the same" as that of the general partner y Statutory interpretation issue RULPA is moving towards requiring direct contact, though here they dont rely on that contact o Arizona continues to apply the substantially the same as test o Youre trying to generalize statutory trend, but in this state it hasnt gone as far as that trend, its not binding yet y You dont need direct contact to have actual knowledge, but the court interprets actual knowledge to having direct contact, even though the statute doesnt require it (Not sure thats right (Prof.))  History of Increasing Availability y Originally; specific purposes o Specifically granted limited liability by legislatures in specific cases y Expanded for industrialization o Then came so many cases, saw that it was necessary for economy to grow, so more and more laws so now we have pretty much universal availability of limited liability y Eventually; universal availability  Increasing Diversity y Originally LPs and corporations only y Eventually LLCs. LLPs, LLLPs, etc. o Expanded the availability of limited liability o Is this a good thing? Policy argument  There are benefits, but also costs  Society seems to have answered, they like limited liability  Just because its a given doesnt mean its necessarily right o Very Basic Finance  Introduction to Debt y Debtor One who owes a monetary obligation to another (Ex; borrower)  21

Creditor One to whom a monetary obligation is owed (Ex; lender) Debt Monetary obligation, no matter how you do it o Usually involves 2 obligations  Repayment of principal  And (usually the periodic) payment of interest  Time Value of Money (why theres interest) y $1 today is worth more than $1 tomorrow (3 reasons why) o 1. Risk You pay me a dollar today, I have it; if you say youll pay me tomorrow, I may never get it o 2. Inflation It will cost more tomorrow because of inflation  Dollar is worth more today than tomorrow o 3. Opportunity costs You give me a dollar today, I can invest it and earn more than a dollar tomorrow y Interest is that incentive to get people to lend o $1 today > $1 tomorrow and thats worth much more than $1 later o Compounding the process of accruing interest upon interest  $1 after one year at 10% interest becomes $1.10 y 2nd year its 11 cents, equals $1.21 y It snowballs over the years y 8. INTRODUCTION TO CORPORATIONS o Corporation A separate legal entity created by authority of law  Shareholders/stockholder The holder of a share of stock; an owner, or residual claimant, of a corporation  Security An instrument that evidences a financial right with respect to a corporation  Management General terms that refers to the directors and offices of a corporation y Actually broken down into two levels officers and directors  Director member of the board of directors  Board of directors The governing body of a corporation y Shareholders elect them  Officers An employee who manages the day-to-day affairs of the corporation y Appointed by directors  Dividends A distribution of a corporations earnings to its shareholders o Corporations  Formalities Many requirements y Doesnt even exist unless you follow formal requirements o Cant form one counter intentionally  Control Separation of ownership and management y Shareholders elect directors, ultimate managers of the corporation o Can elect themselves, though usually only in Mom and Pop o Generally they hire business experts  Legally they are separate, and usually factually as well y They then appoint officers, who are more intermediate managers y Officers hire EEs to the extent necessary  Liability limited to investment y y 22

y Obligations of the business are not the obligations of the shareholders Taxation firm taxation or double taxation (482) y One of the main drawbacks of the corporation y It pays taxes on its income, then shareholders pay taxes on their income o If you have $1 in income in a sole proprietorship, you pay 33 c in taxes at 33% and you get .67, in a corporation you end up with .45 y S corporation Permits owners of qualifying corporations to elect a special tax status with flow-through taxation if they fulfill the conditions  Lifespan indefinite, lives forever or until dissolved y Shareholders deaths dont affect the business  Exit get out of the business by selling the shares y Factually it may be more difficult o Mom and pop wont be any easier to sell than a sole proprietorship o But big corporation its easier o Incorporation Establishment of a business as a corporation (DGCL 102)  First select the state of incorporation (Not necessarily where you operate) y Internal affairs doctrine a choice of law rule under which courts will apply the corporate law of the state of incorporation to determine the internal rights and duties applicable to a corporation o They will use all the external laws of where youre doing business, but the corporate law will be the state of incorporation o Personhood is defined by the state of incorporation o You can choose to incorporate in any state based on the laws that you prefer  Next file certificate of incorporation/charter (DGCL 102) y The constitution of the business pretty much y Has to include your name, o Depends on state laws whether its Co., Inc., but it cant be Bank y Has to include the powers of incorporation 102(a) o Nature of the business or purposes to be promoted o Anything not included in the charter is ultra vires  Used to be a serious problem meant to protect the shareholders and third parties, not everyone else  Today its irrelevant began stating the purpose more broadly and eventually they came to say any lawful activity o Goodman v. Ladd Estates If a shareholder or director participated in the ultra vires act, he cannot thereafter seek remedy under an ultra vires claim  Ps bought the shares of the corporation from the previous owner who was involved in the ultra vires guaranty and they had knowledge y Must list classes of stock 102(a)(4) and 151 (about specific stocks) o Stock A security representing an ownership interest in, or residual claim against, a corporation o Charter has to include the total number of shares of all classes of stock and the number of shares of each stock  23

 List the kinds of stock and the terms (however you want) o Common stock A security representing a basic ownership interest in a corporation  Most companies only have common stock  Typical rights To vote on certain limited matter and the right to the residual profits if the board of directors declares dividends o Classified Stock Stock issued in different classes, the terms of each of which are specified in the charter (when you have more than one type of stock)  Can set out each class of stocks rights  Common second class of stock might be preferred stock o Preferred stock Security representing an ownership interest in a corporation that includes some preferential claims but also some limitations  Preferred stock would be whatever the charter says, but a common one may or may not have the right to vote  Usually has a preferred dividend, preferred shareholders have to get dividends first before the common shareholders y Theres a preference, but often a limitation as well y Has to include incorporator/initial directors o Incorporator A person who files the certificate of incorporation for a business  Usually include incorporators address, not directors o Related term is promoter, person who establishes a new corporation  Technically not the same thing y Mom and pop are the promoters y The incorporator is the technician, could be your lawyer or law firm o Parent corporation A corporation that owns another corporation  Under DGCL 101 Anyone can incorporate a business, even another corporation o Subsidiary Corporation owned by another corporation o Affiliate Anyone who controls, is controlled by, or is under common control with, another  Ex; parent and subsidiary, or co-subsidiaries o Name of incorporator and the initial directors if they are known  Often wont know directors yet, not elected y If a person takes action on behalf of a corporation before it exists, they risk liability for those actions o Until it exists, Im an agent without principal, Im really a principal y Any other matter you want o Can put in rules for the business that will govern the business Hold Organizational Meeting (DGCL 108) y Meeting of directors, or incorporators, if directors havent been chosen

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o Minutes The records of the proceedings of meetings of a corporations shareholders or directors y Adopt bylaws (DGCL 109) o Bylaws A document, more detailed than the charter but subordinate to it, that governs the internal affairs of a corporation  Much more detailed rules for how the business will be run y Issue shares Theoretically owners arent owners yet, until they buy stock o Authorized but unissued shares Shares of stock which have been authorized by the corporate charter but have not been issued  Once you issue shares theyre outstanding  The number you decide to issue is arbitrary y Treasury stock Shares of stock which have been authorized and issued but are not outstanding because they have been repurchased by the corporation (commonly treated as authorized but unissued shares for most purposes) o Modern statutes have done away with this really  Hold Shareholder Meeting (DGCL 211) y 211(b) Annual meeting for the election of directors o One of the least followed rules because of mom and pop corporations y 216 Quorum Minimum presence necessary for a valid meeting o Delaware is the default rule, more than 50% of the shares, though in the Charter you can lower or raise it  Hold Directors Meeting y 141(a) is the key provision the business and affairs of every corporation shall be managed by or under the direction of the board of directors o Board it the ultimate governing body that is consistent with the Charter and bylaws and law y One key task it to appoint and monitor officers o Directorships are actually part time jobs, officers are full  DGCL 142 is flexible to the organization structure as to what type of officers o Officers then hire EEs o Race to the Bottom  Internal Affairs Doctrine y State of incorporation determined by costs and benefits o Can choose any state, so go where its best for you  Competition among states y Why? Taxes and fees o Corporate taxes and fees, that money is pure profit to the state y How? Service and substance o Innovation in the law, clarity in law, consistency, and responsiveness to needs of corporations  Who benefits? y Corporations vs. Society (Race to the Bottom)

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o Normally think law should be passed to benefit society, but states may wish to pass corporate friendly law o Fact of externalities A state might pass a law that is bad for society because the cost of that harmful law is passed across all fifty states, while the revenue goes to that one state  Even if a state doesnt, the state next door can still pass that law and it will apply to business in your state y Shareholders vs. Management (Race to the Top) o States are going to pass laws that please those who decide where to incorporate, the directors  It historically hasnt been that hard for directors to get shareholders to sign off on whatever they want  So its beneficial to directors more than shareholders o Race to the Top theory says that its good to compete and people will pick the laws that are most efficient  Better in the long run for stability  Delaware Regardless, Delaware has won y History Corporation used to not be able to own corporations o Used to use trusts to expand power (why we have anti-trust laws) o New Jersey began allowing corporations to own other corporations, clear winner until Woodrow Wilson got rid of these practices o Delaware stepped in and passed friendly laws and never looked back y Small states have the advantage o They have more incentive  The revenues can be quite large (Delaware is about 17%)  Harm from a bad law will be relatively small since most states just incorporate there and conduct business elsewhere o Less incentive for a large state  The revenue is relatively small (CA is .1% at most)  The harm is quite large, the laws actually matter to the state y Current superiority Good system for corporate law, things done quickly o Good judiciary, they are corporate law experts o Often other states will pass more blatantly pro-management laws and Delaware responds moderately  Increasingly there are more federal law regulations, and the government may step in if Delaware makes such changes  They dont need to as much since they have things other states dont have o Other states dont have to worry, theyre not losing much, but they could gain if government steps in and takes it away from Delaware y 9. THE PURPOSE OF CORPORATIONS o Theories of the Corporation  Traditional View Shareholders are the owners (what were familiar with) y Shareholders elect directors, who are kind of like their agents (or trustees)

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No one else matters under this view, everyone else is a third party with which the corporation deals with at arms length o Profit for the shareholders is the main goal  Contractarian Theory Everyone is an investor  Communitarian Theory Everyone is a stake holder o Dodge v. Ford Motor Co. (Traditional View) Ford, who controlled the board, declared they wouldnt pay any more dividends, but put the $ back into the company  Courts view is the purpose of a corporation was to create a profit y Usually directors get to decide dividends, but their role is the choice of means, not to change the end of making profits itself y Court says his motive was philanthropy, finds that unacceptable  Dividends If not altruistic, he may not want to pay dividends to reinvest, or prevent competition by not giving the Dodge brothers funds, or to avoid double taxation  Prices They didnt like that he was lowering prices, but he may have done that so more could buy cars, making it harder for others to compete  Salaries He may have raised salaries to keep other companies from taking his workers at a time when labor was in demand and turnover was high  Ford was trying to look like a decent man and doing good things, but the court was having none of it y Courts often just dont know what theyre doing when it comes to business o Contractarian Theory Everyone is an investor  Shareholders y Shareholders have no special status, everyone is just an investor y Input cash usually, sometimes property or labor y Rights Expect residual profits and control  Lenders y Input cash into the business y They want interest, which comes first, before dividends, and covenants y Covenant A contractual obligation or prohibition; in a loan contract, a provision binding the borrower, which gives the lender an element of indirect control o Have to promise to use this money for this particular reason, not pay dividends when you cant pay interest  Trade Creditors y Input property y Investing in you and expect something back, payment  Employees y Input labor y They expect wages  Customers y Input revenue, theyre investing in you y Rights are products or services the business makes  Society y

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Invest through security, police, army, infrastructure, roads, things that make business possible, really investing in local areas to get businesses to come to an area y They expect taxes and societal benefits  Its nothing more than a web of contracts, contractual relationships y Most common theory among academics y Not law, but it has influenced the law tremendously  Purpose of the corporation under the contractarian theory is to benefit shareholders, maximize their profits to benefit everyone else y Logically it would seem to benefit everyone, but shareholder benefit is a proxy for societal wealth o Shareholders are the only ones with the proper incentive to run the business since the make all the real profit and take all the real loss y All other persons in this web are naturally risk averse  Shareholders have the proper incentives, but maybe not when theyre insolvent y Healthy business, any extra goes to the shareholders, but when its insolvent, they have zero interest o Shareholders then have little to lose and much to gain in engaging in risky behavior and might become overly risky y Insolvency Inability to pay debts when they are due (Its a state) y Bankruptcy A legal process for the liquidation or reorganization of a business that often is triggered by insolvency  Assets minus liabilities is what the shareholders get y Equity is whatever is left after liabilities y Greater than zero means you have an ownership interest y But you may have more liabilities than its worth in which case you dont own it anymore theoretically o Bankruptcy is to satisfy creditors o Credit Lyonnais In the vicinity of insolvency, the corporations right decision may diverge from what shareholders or another group wants who have improper incentives  Expected values = the sum of (probability x value) y Weighted average value  Corporation y From corporations perspective (anyones) settling for 15.55 makes sense and settling for less does not make sense  Shareholders y If they dont settle and they get the full potential amount, they get 39 million, 25% chance of that happening o Not to settle for shareholders is worth 9.75 million, so they wont want to settle, small chance for a big payoff y If the company is in insolvency the shareholders will want to invest in overly risky investments because of the small chance it pays off well y That risk goes to creditors, they are forced to suffer that 8 million loss  Creditors y

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Creditors will be willing to settle for anything over 5.8 million, fear of that means they will settle for less than 12 million o Fear of going to trial and getting less y They have improper incentives as well  In the vicinity of insolvency they owe a duty to the corporate enterprise y If its a sole proprietorship, you look to that one rationale person y Viewed as a separate person, thats the one with the proper incentives y Pretty decently settled law  NACEPF v. Gheewalla Creditors of a Delaware corporation in the zone of insolvency sue for breach of fiduciary duty y Reaffired the traditional view separation of owners o Directors for the benefit of shareholders o Shareholders are owners y But also rejected Credit Lyonnais o Directors must continue to discharge duties for benefit of shareholders until actual insolvency, even in the vicinity of insolvency o Credit Lyonnais wasnt even under attack, kind of a surprise y General rule is that directors do not owe creditors fiduciary duties beyond contractual terms o Creditors take the place of shareholders in an actually insolvent corporation, first money is going to them  Then they can bring a derivative action, but they cannot sue in a direct action o NACEPF claims the court should recognize creditors right to challenge directors business judgment as breaches of fiduciary duty Court rejects this o Social Responsibility Theory  Concession Theory Earliest version of social responsibility theory y A response to the traditional view of shareholders as owners o But a quid pro quo Society allows corporations to exist and in return, they can make demands that they be socially responsible y As weve moved away to where its not a special concession to get limited liability, this theory doesnt resonate like it used to  Communitarian Theory Not a web of contracts, a web of relationships in which shareholders have no special place, no owners and everyone is a stakeholder y Instead of concluding like contractarians that it has to be in favor of shareholders, they should consciously be run for the benefit of everyone o Socially Responsibly Behavior  Pursue profits at all costs y Profits are good and increase other profits y Its wise to pursue what theyre best at  Excel at business y Could include making profits, but not limited to it y Making money by making products and society can benefit from the whole business enterprise y 29

y More Milton Freidmans position Social consciousness y Take others into consideration too, be green, treat EEs well y Usually what people mean when we talk social responsibility  Charity y Give away your profits or forego them for the good of society  Pursue the interest of society y Profits are secondary y Not realistic, or at least not what people argue for  The real range is the second or third point o Charitable Donations  Social consciousness vs. Charity y Not that different, on one hand o Both foregoing potential profits for some greater good o Fundamentally the law should treat them the same y But charity is entirely optional, social responsibility is not o Social responsibility You are making moral decisions for safety precautions in the office, on products o You cant punt on moral responsibility, you have to decide to what extent morality is bearing on you  Can be moral or immoral, say you only have to go this far, but you still have to decide  DGCL 122(9) Every corporation created under this chapter shall have the power to make donations for the public welfare or for charitable, scientific or educational purposes  A.P. Smith Mfg. Co. v. Barlow Company makes a donation to Princeton and shareholders sue, Court says they can give the donation y Shareholders The Charter didnt authorize it and the state law regarding charitable donations came into effect after the Charter was passed o A corporation is primarily for the profit of stockholders y But before the Charter, the legislature said every Charter was subject to change by the legislature o Justice Story, in a concurrence, had said states could write such laws reserving the power to amend, change the terms y 10. LIMITED LIABILITY o Limited Liability  General Rule Others are not liable for corporate obligations y Includes shareholders, manager, EEs, lenders, etc. y Argument that since proprietors and partners are liable, shareholders should be too o In terms of civil liability you could imagine EEs being liable for certain things, why not lenders o Maybe no one should have special status y 2 Arguments for Shareholder Limited Liability o 1. Corporations are separate legal entities o 2. Double Taxation paying for it with double tax  30

y Legislative trend is not only to preserve LL, but to extend it Limits? y Contracts vs. Torts o When entering into a contract, you are accepting the risk, you can contract around the knowledge that shareholders have LL, so a certain amount of fairness comes from that  With torts, you get hit by a car first and then find out what the corporation is, so that LL justification fails o Contracts are more likely to be less dire, more likely just to be money matters  Torts more likely to be health matters (not always) o Piercing the veil is more common in contracts than tort cases y Public Corporations vs. Small Businesses o A lot of logistical concerns if we got rid of LL for corporations  Shareholders generally have less control of big corporations, doesnt seem fair to attribute corporations actions to them o The real issue is LL in a small corporation  For egalitarian concerns, maybe we should have it y Seems unfair that Bill Gates can have LL, but not Mom and Pop  Reasons for LL disappear more with close corporations y Individuals vs. Corporations o Should LL extend to Corporations when they are shareholders?  Maybe corporations will invest less in safety if parent corporation is not liable for subsidiary o Likely to lead to less expansion and risk taking without LL if we create a rule of LL for corporations  Could be broken down into different corporations y One bad widget could bring down the whole corporation, so we break it down into different subsidiaries for different things, widgets in one  Instead of vertical, parent and subsidiaries, might try to just have separate businesses o Have to think about how people will respond to laws, not just whats the right thing to do y Limited Liability vs. No Liability o We call it limited, but its really no liability for shareholders o Used to have calls on liability  Shareholders put up a certain amount, but if something goes wrong, they might have to put up more y Used to be extremely prevalent, especially for banks y If you didnt then you could lose your stock o Pro rata Liable for a certain percentage Exceptions y Failure to Incorporate o Then its a partnership with unlimited liability, in theory 31

Seems a bit harsh, modern trend it not entirely to enforce that exception o De Facto Corporation Doctrine a legal doctrine under which courts may treat a business that was not properly incorporated as a corporation if the promoters made a good faith effort to incorporate and treated the business as a corporation  Based on shareholder action  McChesney: Doctrinal Analysisand Statistical Modeling in the Law (1) a statute in existence by which incorporation was legally possible, (2) a colorable attempt to comply with the statute, (3) some actual use of exercise of corporate privileges o Corporation by Estoppel a legal doctrine under which courts may prevent someone from denying corporate existence if they acknowledged the corporate entity and would earn a windfall by subsequently denying corporate existence  Based more on third party action o Hypo: Southern-Gulf Marine v. Camcraft First company formed as Texas corporation as Y, having completed the ship, the builder claims that the corporation it built it for never existed and they dont owe them the ship  He contracted to make the ship, an expensive process, now he doesnt want to sell it, maybe because its worth more on the open market  Corporation by Estoppel y Piercing the corporate Veil y Direct Liability o Piercing the Corporate Veil - holding shareholders personally liable for the obligations of the corporation  As a protection against insider abuse, whereby insiders pass risks to outsiders, with gains to insiders and losses, because of LL, going to creditors y Courts dont take this step lightly, they are putting creditor expectations ahead of insider interests in LL y Very rare, most people dont even bother challenging it  1. Failure to respect the corporate form y Failure to maintain corporate formalities o Technical formalities y Failure to maintain separate identities o Making sure its not really just an alter ego, a dummy corporation, for their own personal affairs o Unity of interest in ownership  2. Also requires some form of injustice y By definition, an inability to pay an obligation doesnt count o Fact that a judgment cant be paid isnt enough y Fraud y Undercapitalization failure to provide adequate capital for the business  32

o Radaszewski v. Telecom P cited no evidence of improper motivation or violation of the law, just that it was undercapitalized  COA said insurance counted as being properly capitalized, even if the company didnt have the cash y Syphoning of funds excessive withdrawal of corporate assets o Not just when things go wrong and there happens to not be enough o Hard to draw a direct line between your fault and not y Intentional scheme to evade responsibility Scheme suggests something nefarious, something wrong o Particularly difficult to tell what this means y Unjust enrichment o Walkovszky v. Carlton Business owner sets up ten corporations and each corporation has two cabs with the legal minimum insurance and nothing else in the corporation  If he gets hit with a large judgment, he only loses those two cabs, instead of the whole business y Seems like hes trying to avoid liability y Court says avoiding liability is why we have corporations  Have to look at 2 part test y 1. There is no lack of separate identities, he didnt co-mingle the funds o Carlton did not fail to respect the corporate form y 2. The fact that he was run over is not enough to create an injustice o Maybe undercapitalization  Each company ha no assets, not even the cars, but he did have the insurance required y Money in his pocket or money in insurance  For it to be enough cash, it doesnt have to cover every conceivable event, maybe having insurance means he doesnt need that cash on hand y Issue: allowing LL when a reasonable person might have taken greater precautions  They did not allow him to pierce the corporate veil, but they suggest enterprise liability to the P y Enterprise Liability A legal theory under which a court may hold an entire business enterprise (i.e., a corporation and all of its affiliates) liable for the obligations of a constituent corporation  Some courts use the enterprise liability doctrine to disregard multiple incorporations of the same business under common ownership y It pools business assets to satisfy liabilities of any part of the enterprise, entire business enterprise liable for obligations of constituent organization y Assets of individual owners are not exposed o Even if hes not personally liable, can pierce it sideways and hold all those companies liable jointly o Fletcher v. Atex, Inc. Plaintiffs are trying to sue the parent company and to pierce the corporate veil on an alter ego theory, they must show the two corporations operated as a single economic entity and that an overall element of injustice or unfairness was present  Argument they were operated as a single entity 33

Control to the extent of domination, cash management, control issues, same directors (indicative thats its just a sham and the same company) y Court says on cash management that this is nothing like co-mingling of funds or siphoning of funds, subsidiary still has the money, all cash transactions are at arms length, not treating the money as their own y Referring to the subsidiary as part of one business, the court says theyre just being colloquial, not having an effect y 11. SHAREHOLDERS VS. MANAGEMENT o Directors  Job description y Often part-time, working somewhere else full time y Consist of insiders (CEO and his subordinates), but mostly of outsiders  Agency problem y Key issue is the risk that agents (directors) will serve their own interests rather than those of the principal (shareholders) y Agency cost The costs associated with an agency relation, especially the agency problem y Directors are not agents, they are not subject to anyones control o More colloquial or economic sense we use this term y Essentially trustees, but shareholders have a lot of say, as opposed to how normal trustees work  Directorial Authority y Statutorily very broad o Shareholders and courts do not run the business, directors do o But they must ac in the interest of the corporation (the shareholders) y Equitable fiduciary duties o Law of equity imposes duties of care, loyalty, good faith y Practically limited by certain shareholder rights o Shareholders elect directors, so somewhat accountable o Shareholder Rights  Economic y Right to distributions o Any profit or equity is really theirs, but no right to dividends o Its illusory, theyre not entitled to profit right now y Selling  Control y Fundamental matters certain matters they have approval right o If two companies merge, but not much else y Election of directors o They can often remove and replace them as well  Information y Most of the time youre not entitled to information y The real information rights come from government o Large public companies have to disclose information continually  Litigation y

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y Shareholders can sue to enforce their other rights (Limited) structural accountability for directors y Market for corporate control Developed by Contractarian theory o Shareholders follow the Wall Street Rule An investment policy pursuant to which shareholders buy shares if they are satisfied with a companys performance and, if they are dissatisfied, they sell shares rather than vote against management o The more dissatisfied they are, the more they sell, the less demand for the security which leads to lower stock prices  Incentivize entrepreneurs to come in and turn things around, so they have to keep shareholders happy to keep prices up o Corporate Hierarchy  Purely legal view y Directors are in charge  Old View y Ultimately really shareholders are in charge  Traditional View Berle-Means Thesis y They noted the separation of ownership and control y Executive officers (management) are in charge, not the directors and not the shareholders  New View y Executive officers run the business y Directors monitory officers y Shareholders influence directors o Rational Apathy Indifference based on the reasoned conclusion that attention is futile  Shareholders in public corporations y Dispersed Lots of shareholders, dispersed, no contact with each other y Small Investment Only invested a little extra y Diversification The process of reducing risk by investing in multiple opportunities  Voting rights y Irrational to pay attention It makes no sense to follow the company, even paying attention is a waste of time o Their individual votes are meaningless o Coordination problems and communication issues y Wall Street Rule Dont bother getting involved y Pernicious golden rule Just trust the officer and leave him alone o Changing Circumstances  The rise of the Institutional Investor An institution that trades large volumes of securities, usually by managing other peoples money y They hold a majority of public stock and are run by financial experts y Not that dispersed, maybe dozens in relevant areas y Much weaker case for apathy o Can be economically worthwhile for them to pay attention o Their vote can make a difference 

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o In theory theres less apathy, and seems to be playing out in practice  Voting rights are changing  Shareholder access is changing o Descriptions of directors, different models  1. Agency  2. Trust  3. Representative democracy y Like our government, can pass a sweeping law were all against o But ultimately can be held accountable  4. Division of authority y Maybe they each have their own realm o Shouldnt be telling each other what to do o Charlestown Boot & Shoe Co. v. Dunsmore Shareholders voted to choose a committee to act with the directors to close up the corporations affairs, they refused to work with him and contracted debts larger than legally allowed  In the allocation of legal power, the governing rule of law is that the directors have the right to manage the corporation as they want, dont have to listen to shareholders y Subject to bylaws or Charter, they have discretion y Court says its unfortunate they didnt listen and it cost, but tough luck  Models y Agency Not really the right result since shareholders werent able to tell them what to do y Representative democracy They can vote them out y Division of Authority Probably/arguably wrong decision under this o Directors make business decisions o Shareholders involved in investment decisions, the flow of capital  They wanted to get out of the business, and this is arguably an investment decision o Blasuis Industries, Inc. v. Atlas Corp. The majority shareholders wanted to increase the number of members on the board to get a majority of people on their side; question is whether the board acted against its fiduciary duty when it blocked it in good faith  Court says they acted in good faith to protect the company from this move y But its an offense to the shareholder/director relationship  Models y Representative democracy Most fits this, to agree that shareholders get to vote in who they want y Division of authority Also in line with this y Agency They cant circumvent what shareholders are telling them to do y Trustee Presumably directors could do whatever they feel appropriate  Argument directors should is that they technically have the power to add people y But fiduciary duties go beyond the technical limits of the law o Just because you can do it, doesnt mean its in compliance  Power struggle between directors and shareholders y Ideological underpinning is that the directors are elected by the shareholders and we need to preserve the relationship/voting power 36

y This is a voting context and may not be left to business judgment 2 Part Test y 1. Determine whether the board has acted for the primary purpose of thwarting the shareholders vote (Very lenient part of the test) y 2. They must have a compelling justification o Very difficult to prove, potentially only if theres fraud and youre doing this to gain time to stop the fraud o Condec. v. Lunkenheimer Condec wanted to merge with Lunkenheimer, who resisted, then Condec attempted to gain a majority in Lunkenheimer through tender offers, which Lunkenheimer tried to block by diluting their interest to a minority  Court held that a corporation cant have retaining control as its main purpose in issuing stock, breach of fiduciary duty if not for a legitimate business purpose y 12. CORPORATE ACTION/VOTING o Director Action  Directors must act as a group Only have authority generally as a whole y Meetings Where they act together o Must give notice in advance  Minimum and maximum number of days o Quorum Minimum presence required to have a valid meeting  Can only legally lower it to a certain point in most states, but can raise it o Majority vote An affirmative majority of those present and eligible to vote (Directors action is usually majority vote)  Absentees dont count, only those present y Abstentions count as a negative vote  Different from 2 other standards y True majority affirmative majority of all possible votes (3 must vote for it if there are 5 directors, no matter how many are there) o Absentees and abstentions count y Majority of votes cast Affirmative majority of votes that are cast o Neither absentees nor abstentions count o Most states allow Virtual Meetings y Written Consent without a meeting is allowed o Potential problem with not allowing everyone to hear all options, so we require it to be unanimous  Committees Board of directors can break up into committees y Essentially the same rules apply within the committees y Can be given final authority over a particular matter/area o But usually they are sort of advisory in setting policy  Informal Action If they all agree and dont see the need for a meeting, CEO asks each of them instead for written consent, etc. y Technically not correct, but a lot of times the court will let it go o Particularly if its a close corporation where they dont always follow the detailed rules or public corporations if its a formality  37

Problem with binding a future board Theoretically they cant bind a future one y General principle One board cant bind a future board, but a committee can bind a board with authority on some actions o Even though a board is more powerful, it cant y Any time a committee makes a decision they are taking away the power of a future board to make another decision o Ex; Very difficult to retool a factory built to make widgets  Even if they cant bind them legally, they have pretty much made them stuck with widgets o Officers  Statutory law is woefully inadequate y Some states have no rules y Some states specify certain offices o NY President, VP, Secretary, Treasurer o Tells us little, probably meant different things when written y In general titles are meaningless o President is not usually in charge, its the CEO o CEO, CFO, COO; VP o VP suggests a lot of power but it can also be virtually meaningless  Can be one or 100 VPs o Bylaws may not be very helpful, written in the broadest language  Case law is forced to make difficult decisions y Forced to borrow from agency concepts apparent authority, inherent authority, acquiescence, o Leads to wide disparities in powers courts recognize o Shareholder Action  Limited Voting Rights y Directors manage the business, shareholders dont generally have a say, but there are some things they do o They vote on the election of directors o Right to vote on Charter Amendments  Usually both directors and shareholders  They do have a veto power o Certain fundamental transactions (ex; mergers)  Has to be done through a charter amendment anyway o Other matters put before them  Board may decide at their option to ask  Or some legal requirement  Requirements y Meeting o Still have to be notice and a quorum y Required to vote o Default is majority vote, but staring to see majority of votes cast o Fundamental transactions/matters require a true majority  50% + 1, affirmatively get most of the shares on board o Charter or bylaws can change quorum and vote requirements 

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Written consent o Directors have fiduciary duties, Shareholders dont have fiduciary duties, can do what they want and act selfishly o Very different approaches on this o Election of Directors  Historically directors were elected by Plurality Vote y An election in which the candidates or options with the most affirmative votes win, without regard to absentees, abstentions, or negative votes o Highest number of yes votes wins y Two important consequences o 1. Majority shareholders elect all directors o 2. Incumbent directors always win unless challenged, and not usually challenged y Had plurality vote because of rational apathy; the need to ensure a winner o Here, only need one election and someone is going to win o In a contested election where theres a good chance no one will get the majority, makes sense to make it the one with the most votes y Moving away from it o Less apathy and contested elections are less rare o Worst thing that can be said about it, it prevents shareholders from kicking out directors unless theyre willing to wage a huge contest  Minority Representation y Even before moving away from plurality, people got around it y Class Voting Charter can define the terms of the stock and specify that certain classes of stock elect their own directors o Can distribute representation between different shareholders y Cumulative Voting A voting scheme in which each voter has multiple votes which they can distribute among the candidates freely, including multiple votes per candidate, equal to the number of shares she holds o Usually done in small corporations y Capped Voting Shareholders have reduced voting rights as their holdings increased, they get capped at some point o Providence & Worcester Court upheld a limitation in the Charter that gave 1 vote per share for first 50 shares, but only 1 vote per 20 shares after that, its a form of weighted voting  Purpose of the provision is to make more difficult for anyone to get too much power o Downside is that management, which usually owns a significant amount of shares, suddenly gets their power reduced o In most states voting rights have to be in the Charter  Voting against Directors y Can abstain (cant vote no) o Abstaining would send a powerful signal that theyre unhappy o Didnt really happen because of rational apathy and people selling rather than going against, but if that did happen it was a vote of no confidence and you were doomed y 39

 Once it started becoming more common, its not as true o But shareholders want the power to remove directors Majority voting changes everything o They can only win if they get a majority of the votes  You have to get more approval than disapproval  Can get a director out without running anyone against him o Unprecedented success  Went from extremely rare to the majority in a short time  Now the default in about 5 years Modified Plurality Voting Elected by plurality, but those who dont achieve a majority, the other directors can kick you off, knowing the shareholders wanted him off (Plurality plus) o Often required to tender resignation so others can decide or not to accept it if you dont get a majority o Directors are required to follow their own business judgment in deciding when to kick a director out o This is the alternative directors came up with to majority voting  Directors between shareholders and removing a director  Now only effective if allowed by directors

o Control  True Control = Majority voting power y Majority of shares, pretty much in complete control of the corporation y But you dont need that much power to have control  Effective Control is less than 50% y Not all shares will vote o Say only 60% attend, need only 30% o Rare that theres 100% representation y Influence approximates control o In a large public corporation, a few shareholders with a significant minority of the shares can have a lot of power  Someone with 5% of IBM can have a lot of power o Managers will try to keep you satisfied since you need to convince less people to be on your side to get the majority than they do o Ringling Bros.Barnum & Bailey Combined Shows v. Ringling Ringling and Haley decide to combine their shares to take power away from the third shareholder, North  Shares could be voted cumulatively, by combining, R (315) and H (315) get to vote for 5 directors, N (379) gets to vote in 3, out of 7 directors y General rule on shareholder voting is they can vote for whoever they want, so their attempt to bind each others voting is not illegal o Such pooling agreements have been found valid y Wide liberality of voting as long as he violates no duties to fellow shareholders  Haley wouldnt vote how she was supposed to vote, unfair to their agreement y They entered into this agreement to take power away from North  Court holds that Haleys votes are struck, leaving one vacant seat y Outcome is really not unfair to Ringling, actually more unfair to Haley 40

The agreement contemplated that they were friends when deciding how to vote y So next year will be 3 for R, 2 for H, 4 for N o Classified Stock and Weighted Voting  Corporations can set up two or more classes of stock to ensure that all participants, or a particular minority shareholders will have representation on the board (Ex; Class A given power to elect 3 directors, Class B power to elect 2) y 13. FEDERAL PROXY RULES o Why Proxies?  Proxy Agent, authority, and instrument y (1) one who is authorized to act as a substitute for another (especially, in corporate law, one who is authorized to vote anothers shares); y (2) the grant of authority by which a person is so authorized; y (3) the documents granting the authority; i.e., the agent, the authorization, and/or the instrument under which a shareholders vote is cast indirectly  Most often conducted by management, but soliciting shares by anyone is proxy y Two people competing to get your shares is a proxy contest  Quorum Requirement y Have proxy because you have to have a minimum presence  Rational apathy y Problem is shareholders arent going to go to the meeting o Shareholders are dispersed and may not be near the meeting, and the shares may represent a small fraction of their wealth o Why we have proxies  They are governed by federal law y Very different from state corporate law y Form often trumps substance at state level, but thats not the case here o Why Federal Proxy Rules (Section 14(a) of the Securities Exchange Act)  Accountability y Management is the one seeking your vote o Only officers and directors will be there o Proxy solicitation any attempt to obtain the right to vote shareholders shares y If youre rationally apathetic you dont even care o To the extent that you do, you follow the Wall Street Rule o Things are changing these days, less voting strictly with management y So we need some rules to put limits on them  State law was inadequate y Why federal stepped in y State law was really about fraud If management isnt inclined to say very much, just saying let us vote for you, then its not really fraud and they can get away with a lot y You would think its an internal state affair, but large public corporations are a national concern and if states are dropping the ball, federal government can step in with a uniform rule 

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Mandate adequate and accurate disclosure (14(a)3) y Anyone engaging in a proxy solicitation must have full disclosure in connection with transactions that shareholders are being asked to approve o Adequate amount of information and it all has to be true y By law proxy solicitation is defined extremely broadly o Not just asking for proxies, but even friendly conversations could count  So the SEC had to carve out little situations like chatting with friends y Proxy Statement (Ex; on page 1417) a disclosure document required by federal law to be delivered in connection with a proxy solicitation o Must contain information relevant to the vote  Compensation information, conflicts of interest in ownership stakes, etc. o Must give relevant information on fundamental transaction on which they have the right to vote, like mergers o But its more than that, shareholders want to know about the company, they receive information through the annual report y Annual Report to Shareholders Corporation must send an Annual Report to its shareholders when proxies for the election of directors are solicited on behalf of a corporation that is subject to Proxy Rules either in advance of or concurrently with the proxy statement o Balance sheet, describes the companys performance, financial conditions, in a number of ways  Anyone seeking to come in, seeking to replace a director has to tell shareholders all about themselves  Since people cant go to meetings, theyre like the replacement to the meeting y They have to tell you how they intend to vote y Since its so close to you voting, we want to give you all the information o Also has to be accurate information  Anti-fraud liability the company will be held liable for the information in the disclosure  It has to be materially accurate o Standard of materiality If there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote  Might consider was too loose  Not outcome determinative, either, though  There must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the total mix of info made available o Statute on Fraud (False or Misleading Statements) 14a-9  Prohibits false or misleading statements or omissions of material fact 

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y You cannot lie or deceive, no misleading omissions, no half-truths y Much more demanding than common law fraud  Adequate and accurate information so that investors can then invest wisely y Great idea to give people this information so they can decide how to act, but people are still rationally apathetic o Its an efficient way of gathering information by putting it on the company, but if people dont have the incentive to pay attention, then giving them the information wont change things y Even without people reading it, though, it can serve the function of keeping people accountable o Others might read it institutional investors, analysts  The terms are silent, but the SEC enforces rule 14a-9 y The SEC cannot adequately review proxy statements, there are too many every year, and time doesnt permit independent examination of each one o So look to whether there is an implied cause of action to allow shareholders to sue y Cort v. Ash In determining whether a private remedy is implicit in a statute not expressly providing one: o 1. Is the P a special beneficiary of the act?  Yes shareholders are o 2. Was there legislative intent to allow shareholder action?  No They were silent on this  New securities laws will sometimes say there is no private cause of action o 3. Would it be consistent with the underlying purpose of proxy rules to imply such a remedy?  Yes o 4. Is this an avenue relegated to state law so that it would be inappropriate to infer a cause of action based on federal law?  Maybe, but its really been accepted as part of federal law o They decide to allow an implied cause of action under the proxy rules  Idea generally is enforcement, but we often dont allow more enforcement of a law, perfect enforcement is costly y The mere fact that congress passed a law doesnt mean they want it strictly enforced and the low budget might even suggest they only want them to enforce a certain amount  J.I. Case Co. v. Borak Supreme Court held that a shareholder could bring a private action for violation of the Proxy Rules because it provides a necessary supplement to Commission action y Effective tool of enforcement o Mills v. Electric Auto-Lite Co. Claim that a corporate merger was accomplished through the use of a proxy statement that was materially false or misleading, what causal relationship must be shown between the statement and the merger to establish a cause of action?  Must be materiality, reliance, causation

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Lower courts look to fairness for causation because then they can see if harm was caused y Supreme Court here doesnt like that, they dont really have anything to do with each other, not really causation y Recognition of the fairness of the merger as a complete defense would allow the stockholders to be bypassed  Materiality and Reliance y Materiality, the defect must have a significant propensity to affect the voting process o TSC Industries, Inc. v. Northway later states that a material fact is when there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote y Court holds that if its material we can assume the shareholders relied on it o Now were saying if youve proven materiality, youve proven reliance o Theres a jump there the kind of thing that could have been relied on does not equal reliance, but the court is ok going there  Causation y Proof that the proxy solicitation itself was an essential link in the accomplishment of the transaction o If the votes were necessary, then well say the material falsehood caused the transaction  Proxy solicitation caused the harm if you needed those votes to get what you wanted  No need to supplement it with whether the defect had a decisive effect on the voting o Just because its necessary doesnt mean its sufficient o They dont mention what happens if the votes not necessary  Footnote 5 No need to decide (omitted in our book) o Virginia Bankshares, Inc. v. Sandberg Whether a statement regarding directors reasons for recommending certain corporate action can be materially misleading under 14(a)-9 when the votes are not required by law or corporate bylaws  Court holds that minority shareholders whose votes were not required for approval of a proposed freeze-out merger failed to show that materially misleading statements in a proxy statement caused injury  Although not necessary, proxies were solicited and obtained for the freeze-out merger being enacted, where minority shareholders would lose their interest in the bank and be bought out y Freeze-out action taken by majority shareholders in a close corporation to frustrate the expectation of minority shareholders o Shareholders forced to give up their shares for money y Not entirely unfair because minority shareholders are entitled to the fair value of their shares o They can seek an appraisal of their shares under state law if they think its unfair 

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They got $42 a share from an appraiser, but it was actually worth $60 a share and they knew it while telling them that it was fair and even high y The directors have fiduciary duties to the shareholders, counting on them to tell the truth and they have a duty to do so y We might not care about the opinions of a car salesman, but we do care about those of the directors A boards statement of reasons for approving a merger can be actionable y Look to whether they really dont believe the value was fair o Maybe internal memos, minutes, emails, showing that they knew the price was too low o We are allowed to conclude that they must have been lying o Here there was some evidence that they couldnt have believed it You can sue based on opinions but it also actually needs to be false y To prove it is a false statement of material fact, have to have the objective falsehood, that it is in fact a lie, not just that the opinion was o An opinion can be a statement of fact subject to fraud liability  Both subjective truth that I believe and also as an objective statement that was not true Has to be both Causation y Loss causation a theory of causation requiring proof that the deception, as opposed to unrelated circumstances, caused a loss y Transaction Causation a theory of causation requiring proof that the deception caused the transaction which caused a loss (what the court utilizes) o Sounds a lot like reliance o Because reliance and causation are supposed to be two separate elements, people were increasingly coming to demand loss causation (courts and legislatures) y Dont have to prove too much, just require an essential link o If that was there, then thats enough Proxy solicitation was unnecessary in this instance so why did they solicit? y Plaintiff argues they solicited proxies for appearance, to avoid bad press, to show they were included in the process and that their vote was thus an essential link in the transaction and causation had been proven o Court rejects this as speculative, they dont want to get into that kind of analysis y Another element is that majority shareholder approval may have been necessary as a legal defense o If theres a conflict of interest transaction, approval by a disinterested party will cleanse the conflict of interest  Not fully, but theyll have a legal defense that it was approved by minority shareholders o Claim was that directors did have to get minority shareholder approval and that shareholders lost the ability to challenge y Courts response o Claim was that the shareholders are losing a remedy 45

Even though the vote wasnt essential, the fact that they did seek approval caused them harm because they lost the right to challenge this merger much more easily o They say its a logical non-issue  If the company told the truth, you lose  If as you say, plaintiffs, the company lied in seeking shareholder approval, then shareholder approval was uninformed y Under the law, only informed shareholder approval can be used as the defense, cleansing it  Either was you dont lose a remedy o Rosenfeld v. Fairchild Engine and Airplane Corp. Stockholder sought to compel the return of money to the corporate treasury which had been used to reimburse both sides in a proxy contest for their expenses  Basic rule is that the corporate treasury pays the expenses of incumbents, win or lose; insurgents get reimbursement only by winning  Few cases on this grant the board wide discretion to authorize corporate payment of incumbents voting related expenses y They need only relate to corporate policy as opposed to purely personal quest for power y Any control or issue contest can be characterized as a question of how the corporation should be managed, not who, so all incumbents expenses are payable by the corporation  Must be reasonable but no decision has denied incumbents full amount  This case permitted reimbursement of the insurgent because the proxy contest was over policy not personality and shareholders approved the payment y 14. SHAREHOLDER ACCESS o How important is it that shareholders have access to the corporate proxy  Argument against it is that shareholders dont run the business, directors should be running the business and shareholders arent experts o 14a-8 is a proposal to enhance shareholder democracy (ICC says they have some say)  Addresses when a company must include a shareholder's proposal in its proxy statement y Also includes a list of criteria pursuant to which a proposal can be excluded  Application y The company applies the criteria, with shareholders making a proposal and the company deciding if they feel they can exclude it o If they do decide to exclude it, they have to tell the SEC about it o If the SEC disagrees, theyll tell them they have to include it y Both have the right to pursue it because the SEC isnt the final arbiter  Criteria for inclusion y You have to have a certain minimum holding o $2,000 in market or 1% of the value y Your proposal plus the description has to be 500 words or fewer  Criteria for Exclusion Proposals that may be excluded  46

Proposals on elections o One of shareholders roles is to elect the directors, yet 14a excludes elections, even suggestions for changing election rules o *14a-11 now does allow election y A proposal that is not a proper subject for action under state law o If the proposal would cause the company to violate state law o Anything shareholders cant do, which seems to cover just about everything else y Proposals that deal with moral and religious issues are not excludable o No state law that shareholders have a say here, but none that say they dont  Commission has taken the position that significant social policy issues of the company are generally not excludable because the proposals transcend day-to-day business matters o Its allowed because if its something styled as a proposal for director action, not as a mandate, then that is ok  Youre asking the directors, not telling them  Almost anything that is a mandate it against state law, but proposals can maybe be accepted o That is just made up, a strained interpretation of state law y Proposals on minor matters that account for less than 5% of business o Such a proposal can be excluded  What about companies with a lot of small things under 5%?  What about moral or political issues with no percentage? y Proposals that deal with a matter relating to the companys ordinary business operations o Roosevelt v. E.I. Du Pont de Nemours & Co. Court holds that a proposal From Friends of the Earth Oceanic Society could be excluded because it related to the conduct of ordinary business  The court held that a shareholder does have an implied right of action under 14(a) of the Act and Commission Rule 14a8 when a company refuses to include the proposal y SEC has taken a weird stance o They decide when its worth discussion and not o They dont want all kinds of moral causes o Fluctuated greatly throughout the years  Have gone through periods of allowing a lot, then a little o Today there are a lot of corporate governance proposals (less moral and political)  Corporate governance the entire body of rules and policies that relate to the control the of a corporation; includes, among other things, state corporate law, federal securities law, and corporate charter, bylaws, director resolutions, and contracts y Ex; proposals to eliminate takeover defense, to require more independent directors, to require shareholder approval in more areas  Should they be able to make these proposals? y

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One hand, getting involved in things they dont have a right to get involved in y On the other, these arent about playing the game, but the rules of the game  A few types of corporate governance proposals have become increasingly important y Changing from plurality voting y Voting up or down, or at least approval of executive compensation y The right to nominate directors  Should they have a say on pay of directors? y Pro They own the company, they should have a say y Con They might not be able to comprehend such salaries o Shareholder Nominations  Shareholders absolutely have the right to nominate directors, the question is whether they can get that nomination onto the corporate proxy  It was federal law that created a proxy rule system, but then said you cant put directors on the ballot (proxy solicitation) y SEC has made various proposals to get shareholders the right to nominate  Meanwhile Delaware passes Section 112 Shareholders have the power to nominate directors as long as its permitted in the bylaws y Mostly a good provision, making it clear what they can do y But its bad because this was already true, sort of like an opt in provision that it says they can do it as long as its permitted in the bylaws y Amending the Charter requires permission of shareholders and directors, but shareholders have the ability to amend the bylaws o Shareholders can amend the bylaws to put in a process for electing directors, even if the directors dont like it y Not a very race to the bottom step (unless its just a strategic step) y In any event too little too late Federal law stepped in  14a-11 passed to allow shareholder nominations, but very limited circumstances y 1. You have to be a 3% shareholder for 3 years o Were really talking about institutional investors and since a lot dont hold for that long a lot cant y 2. Very few nominees that they can nominate no more than 25% of the nominees, but at least one o Cant replace the whole board y 3. Cant do so with the intent to control the whole company o Seen as a corporate governance maneuver y If these are fulfilled, can include your nominees regardless of state law o State law can expand it, one that gives more rights, but they cant come up with a regime that reduces the rights o This is binding o Moving beyond non-binding proposals to binding proposals y

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CA, Inc. v. AFSCME Employees Pension Plan Shareholders want to amend the bylaws to encourage proxy contests by refunding people who wage proxy contests under certain circumstances Can that proposal be excluded y 1. Is this appropriate action for shareholders under state law? o Shareholders can amend bylaws o 141(a); says directors govern except as provided in the Charter  141(b) the bylaws may contain any provision relating to the rights and powers of directors, etc.  Theyre in conflict, but you can see 141(a) as saying it includes provisions that say they can change the bylaws  These exceptions perhaps create a loop o Bylaws have to be procedural rules, theyre not substantive rules  So if its a procedural rule that happens to affect director power, thats ok  Not about business provisions, but corporate governance y They said this was a procedural provision y Amending the provision as a procedural rule is ok y 2. Does it violate state law? o They still struck it down saying it was against the law o The law says they are not required to reimburse insurgents  Only if the directors think its a good idea o They ultimately lost, doesnt survive this challenge o Risk and Return  Risk and return are directly related y Risk Uncertainty; the possibility that future returns will deviate from expected returns y In order to make more profit you have to be willing to accept more risk y If you want to make sure you get your money back no matter what you wont be taking the risk and getting higher returns y Knowing an expected return tells you nothing about risk  One type of risk is the risk created from leverage y Leverage The use of debt in a business o More debt means more leverage y The use of debt creates risk It creates a greater potential for gain, but also a greater potential for loss y For a business o Value $1,000,000 o Income $100,000/year o Borrow $1,000,000 o Interest 7%, $70,000 y A = $200,000 o 70,000 o $130,000, 13% o Making 13% instead of 10% y B = $150,000 o $70,000  49

o = $80,000 or 8% y If were right we can make a lot more, or if wrong can reduce profitability y C = $100,000 o $70,000 o = $30,000 or 3% y Leverage creates risk pretty much for everyone  Diversification reduces risk y Process of reducing risk by investing in multiple places y More likely among ten different companies to on average perform average y Reduces the change that your actual return is going to deviate substantially from your expected return y But it wont ever reduce it completely y 15. CLOSE CORPORATIONS o Comparisons  Public corporation  Close Corporation  Many shareholders  Few shareholders  Dispersed shareholders  Close shareholders  Diversified shareholders  Invested shareholders  Apathetic shareholders  Involved shareholders  Public information  Personal knowledge  Formal  Informal  Dividends  Employment  Easy exit  Transfer restrictions  Minority control  Minority has no control  Agency problem  Abuse o Public vs. Close Not always a clear distinction  Close corporation - a corporation with a small number of shareholders, or with a few that have a controlling interest  Public corporation - a corporation with many shareholders and which is required to register with the SEC  Many states have some form of formal close corporations statutory provision y A close corporation can be considered a statutory close corporation (337) o You have to affirmatively choose elect to do so (343) y If you do that you have a set of provisions with less formality y When people say just close corporation, they dont mean statutory close corporation y It exists on the books but people who form close corporations dont always know about statutory close corporations o Only a tiny fraction of new corporation elect to become statutory close corporations o General corporate law is usually very flexible  Contractarian theory has had a huge impact  DGCL 141(a) Business of the corporation shall be managed by a board of directors except as stated in the Charter y Can take away some of the directors discretion 50

142(b) Offices may be chosen in any manner in the bylaws 109(b) Bylaws may contain any provision not inconsistent with law or the Charter y Sounds like it can change any provision  102(a)4 Charter can specify the designations for different classes of stock y Already a lot of provisions where you can shape the business  Close corporations have the ability to change things with these exceptions, but they dont always know about them o Control Arrangements in Close Corporations  Class Voting y Class A and Class B with different abilities y One makes more decisions, one gets more money or any combination y Can arrange affairs in line with classified stock y Subject to few (if any) restrictions y Nixon v. Blackwell Ps were non-employee shareholders who argued that the directors, who were all EEs, were improperly pursuing a liquidity policy that favored EE-shareholders who could receive cash for stock when they retired o Court held stockholders need not always be treated equally and the claim was without merit  Irrevocable proxy y One shareholder authorizes another to vote his shares, binding authority o Expert can be given an irrevocable proxy and the financier can give him his vote while he runs the business y Key problem with proxies was that they were revocable o Common law came up with a solution  They are usually revocable at will but they can be irrevocable if coupled with and interest in the business y Haft v. Haft Father gave son his stock, and in exchange, father got a lifetime proxy to vote the stock o Court held Fathers interests in the corporation by virtue of his position as founder and CEO was sufficient to render it enforceable o DCL212(e), an interest sufficient to support an irrevocable proxy must be either an interest in the stock itself or an interest in the corporation generally o Used to have to be an interest in the stock itself, but was amended to allow an interest generally  Working at the firm is enough of an interest  Not really what was meant by coupled with an interest, but they decided to be generous  Voting Trust y Plan which shareholders transfer their shares to a trustee for the purpose of creating a voting block o They come to an agreement and the trustee will vote how they tell him to for a defined period  

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o Trustee becomes a registered owner, has exclusive voting power over the shares, but the dividends dont go to him o Trustee vote can be based on anything  What the majority wants  What one party wants, in which case it becomes like an irrevocable proxy y It was mistrusted at first and courts invalidated them because they separated shareholders voting power and economic interests o Eventually came to be accepted with limits o Public disclosure required usually with the corporation o Time limit, ten years is common  Pooling agreement y A plan in which shareholders agree to vote their shares together o Shareholder, pooling, voting agreement are all the same thing y Vote together based on majority, based on agreement, based on one party o Its a contract, they decide, formally or informally vote as a block o Sometimes no one shareholder will have voting control and voting coalitions are formed y Difference in enforcement between this and voting trust o Trustee understands the agreement and votes the trust for you o Pooling agreement, you have to vote it, you can decide not to  Modern trend is in favor of granting specific performance for voting agreement  Its going to be difficult to figure out damages in many cases y No requirements like a voting trust o Same rules dont apply o McQuade v. Stoneham Agreement between the shareholders to elect each other as directors and officers, then two of the three refuse to do so  Ds directors must act in the best interest of the company, thus a contract to compel them to keep a director is illegal  P they must keep him on as long as he is loyal  Court Stockholders may not, by agreement among themselves, control the directors in the exercise of their judgment, contract was void y They cannot just listen to shareholders y Shareholders can still get together to decide to vote together but they cannot go further and tell directors what to do, o Cannot bind directors to certain decisions on selection of agents at defined salaries y Directors cannot pool together y Even though they were the same shareholders who had decided to elect themselves as directors, it wasnt ok  Deliver next best thing would have been to say to fire anyone who does not agree to keep these directors on y Dont have to interpret it as binding the directors y But binding the shareholders to do what we want them to do

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Court could say that having made this promise, they were still liable for any damages, or for fulfilling it as far as possible such as firing those who didnt vote for it (But thats not the path that they went) o Clark v. Dodge Two years after McQuade, court holds the opposite, both in NY  Agreement for position and salary between shareholders was held valid o Galler v. Galler Two brothers who owned a close corporation, entered into an agreement that if one of them should die, their family would gain equal control  Normally courts will focus on the fact that all shareholders party to the agreement, if so, theyll enforce it y Here thats not exactly the case, there was another shareholder, but he wasnt complaining  Where no other minority shareholder is complaining, no valid reason for not allowing coming to an agreement they want y Traditional view youre more inclined to see it as mandatory in which case they probably dont have the right to change y If youre a contractarian, you think people should be able to contract as they see fit  Isadore refuses an agreement to pay benefits to his brothers widow  Why should the agreement be legal? y Its compensation, not just a gift after the fact o This is an agreement ex ante, you continue working, well pay you this other benefit y This isnt insurance Benjamin is already ill when they make this agreement (Factually speaking this really was a gift)  General rule in a corporation, shareholders can bind shareholders in an agreement, but not directors y But in a close corporation if all the shareholders are a party to the agreement, the courts will uphold the agreement, will allow the directors to be bound by the shareholders o As long as there is no fraud, prejudice to creditors, or complaining minority interest o S Corporation a close corporation that has elected to be taxed as a partnership rather than as a corporation  Federal law has created this  You avoid double taxation, usually thats pretty good, but not necessarily y If one of the levels of tax is really low, it may not actually be good y Ability to defer payments is also a benefit and in a partnership they have to pay right away y Some instances where its better to be taxes as a close, though usually better to be taxed once  Requirements y Unanimous consent to become an S corporation o Termination by a majority y You have to have 100 shareholders or fewer y All shareholders must be individuals (or states or certain trusts), people, it cant be a subsidiary  53

y No shareholders may be non-resident aliens y You can only have one class of stock y 16. FIDICIARY DUTIES OF CONTROLLING SHAREHOLDERS o Most of the basic corporate-laws norms were designed with an eye to the publicly held corporation and when applied to close corporations their expectations are often frustrated  As a result, many traditional norms can be overridden by an agreement in a close corporation o Donahue v. Rodd Electrotype Sons, who have shares in the corporation, cause the corporation to purchase their retiring fathers shares for $800/share  The problem is that they dont allow the minority shareholder to sell her shares at this price and its not easy to sell shares to anyone else  Generally speaking shareholders do not owe each other fiduciary duties y They can behave selfishly  However, here the Court holds that because of the resemblance of the close corporation to the partnership, essential trust and confidence to the enterprise, and danger to minority interests, they owe the same fiduciary duties to each other as partners  Court called the majority shareholders purchase of shares from a member of the controlling group a preferential distribution of assets y Really not like a preferential distribution, not like theyre giving dividends to the majority shareholder that theyre not giving to minority o Unless the price theyre paying is too high o It might feel like a preferential distribution, but its different, just the opportunity to get out of the corporation o Wilkes v. Springside Nursing Home 4 Decide to work together and after a while 3 decide to cut off the other, firing him as an EE since directors choose the officers  No more salary for him but they still had to pay him the same dividends in theory y But they dont pay out any dividends y The earnings of a close corporation dont usually pay that much in dividends, youre expected to work there  By terminating his employment or position as an officer or director, the majority frustrated his purpose in entering the corporation and denied him an equal return on investment freeze-out y What makes a freeze-out so dangerous, youre investing in the business without getting anything out of it  Breach of fiduciary duty 2 Part test y 1. Whether the controlling group can demonstrate a legitimate business purpose for their actions y 2. Then it is open to the minority shareholders to demonstrate that another course of action could have been conducted that would have been less harmful to the minority shareholders  Here, there was no legitimate business purpose, so dont even get to prong 2 y The others could have fired him as long as they had a legitimate business purpose

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Even if you have a perfectly good business reason for firing him, the route with less harm might be to buy him out y A legitimate business purpose and a personal purpose might blend together, hard to tell o Zimmerman v. Bogoff Says corporations still have a lot of room to do what they have to do after Donahue o Smith v. Atlantic Properties D was a majority shareholder who refused to vote for dividends and the company was fined by the IRS  Court treated Wolfson as majority shareholder, held against him y He only has 25% but they each have veto power and so for some relevant purposes he is considered a majority shareholder  Nothing like fraud or stealing here in the legal sense y He wanted the company to reinvest because you have to pay taxes on dividends, and he is rich, so doesnt need the dividends (why he may be seen as selfish)  Can reinvest or pay dividends to avoid IRS penalties y He argues that the others refuse to do all the repairs a engineer came in and said could be done o Penalty is there because youre not using money y But theyre potentially selfish for not reinvesting and repairing and also because hes not getting any benefit from the dividends y They dont care what he has to pay in dividends  The penalties are the fault of both sides y 2 ways to avoid it and neither wanted to give in on the other y Its the unused cash thats the cause of the penalties  Are they really like minority shareholders here y He has the veto power y But in this case 40% of the voting power could decide to dissolve the corporation o Thus NOT really minority shareholders o There was literally nothing else Wolfson could do while the others could have dissolved the company o Merola v. Exergen Corp. P was a former VP and the corporation and former minority stockholder, brought suit against the majority stockholder, alleging he violated his fiduciary duties to the P by terminating his employment without cause  Court holds that although there was no legitimate business purpose for firing him, neither was the termination for the financial gain of the majority shareholder or contrary to public policy y Not every discharge of an at-will EE who owns stock gives rise to a breach of fiduciary duty  Also, here, hes really an EE, not really a partner (other cases they were partners) y Shareholders who are essentially partners should be treated like partners and get partnership-like fiduciary duties y The case for him being like a partner o He took on the position with the expectation of becoming a majority shareholder  55

Case that he wasnt a partner o Hes not a founder (not necessary, but a factor) o Didnt have quite as big a share as the other cases o No real tie between his salary and his stock shares, he was really employed o He was nothing more than an EE, no special relationship o No evidence he was required to buy stock as part of employment  Shareholders in close corporations do not all have fiduciary duties to all the others y Its just the ones that have partnership like roles y Not for just EEs that arent like partners y 17. VALUATION AND THE EFFICIENT MARKET HYPOTHESIS o Commodities and Special Goods  Commodities Products that are abundant and fungible, e.g. produce y Laws of supply and demand get us the right price for things like apples y Dont have to worry about what it costs, the market tells us  Special goods rare or unique items, like land, each parcel is different y Not always going to be easy to value them, especially if theyre not for sale y Can maybe get an expert to appraise it y Or might have an auction to see what people are willing to pay o Not going to be the highest price that anyone is going to pay, the highest price someone is going to offer o Youre going to get the second highest price plus a topping bid o But its a pretty good indication of the value  Corporation itself is like a special goods y But the stock for a corporation can really be a commodity y If a strong market for an asset then its regulated by supply and demand o What makes a strong market?  1. Liquidity the ability to buy or sell quickly  2. Availability of information Need a lot of information to buy and sell y In a public corporation we do have that, federal laws require disclosure of information, but not for close corporations  3. Efficiency ability to buy and sell shares cheaply o The efficient market hypothesis tries to deal with the question how strong are markets  Efficient market hypothesis Theory that in a strong market, such as the US capital markets, prices quickly reflect all available information y Does not mean that prices are accurate, but its probably the best guess as to what securities are worth at any given time y We have so many buyers and sellers analyzing the company and engaging in transactions that their combined efforts will produce an appropriate value o 3 Forms of the Efficient Market Hypothesis  1. Weak form Current prices reflect all past price information such that you cannot beat the market by looking at trends y

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A falling or a rising price, even if its an all time high or low is not a good reason to buy or sell o Generally speaking, stock prices move up o But around that upward trajectory, stock prices move randomly y Its generally accepted as true o The proof is that stock prices move randomly o New price unrelated to old price 2. Semi-strong form Current prices reflect all publicly available information, past and present y As a result, you cant beat the market through fundamental analysis o If I learn a company is doing well, its probably too late o By the time it gets to you, its old news o So many analysts that know before you that they drive it up immediately y Generally accepted as more or less true o Not as strong as weak form o Proof would be random price movements  New information is random so it supports this notion o But we also have experience, which tells us that mutual funds, etc., consistently beat the market  Few do for a long time  Even if there are a very few that always do, theres a chance these investors are lucky o Or they may not be beating the market at all if you adjust for risk  Every year they may beat the market by a few points, but if youre taking twice as much risk as others, and making the same gains, you not winning out y Efficient market hypothesis is generally known as semi-strong o Seems impossible to have an efficient market o Have all this information, fundamental analysis, but you cant beat the market  But without all that you cant have an efficient market  Depends on analysts who know they cant beat the market, but try o Equilibrium level of disequlibrium analysts can make just enough money to compensate them for their efforts  When the market becomes more efficient, cant do this as much, analysts drop off, then the market isnt as efficient and more analysts come along y If nothing else, maybe someone can beat the market, but not us 3. Strong market - Current prices reflect all available information, whether its public or private y If its true, then you cant beat the market even with inside information o If you have inside information on a company, its already too late o Other people know it and theyve affected the stock price y

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Insider trading the use of material, non-public info in trading the shares of a company by a corporate insider or other person who owes a fiduciary duty with respect to such information y This hypothesis is not accepted as true, more of a theoretical stake holder o Public information should not affect the stock price, by that time it should be a non-issue  The fact is, announcements do affect so this hypothesis cant be correct  Investment then just sounds like its gambling your stocks do well y But if you diversify, then its not like gambling o Then more like an investment than gambling o Lessons for investors  First, dont try to beat the market y Maybe someone can beat it, not us y Have to not just be pretty smart, but smarter than anyone  Diversify Buy into mutual funds that diversify for you, but not without knowing more y There are those that are actively managed, paying someone to try to beat the market for you y Index funds passively invest in the market, not trying to beat it, just make the market return o Efficient market hypothesis says invest in these youre going to save the cost of paying someone to try to beat the market who cant y These two should do the same, earning the same in the long run o The difference is you have to pay a fee to the actively managed and transaction costs and taxes on those transactions, so you earn less o Close corporations  Dont have a market with supply and demand to tell us what things are worth  Old Man and the Apple Tree y First offer of 50$ for the worth of the wood salvage value o A method of valuation y Going concern value and liquidation or salvage value o What its worth as a tree with apples or as firewood o Generally going concern value will be higher y Next offer of $100, which is worth this years crop of fruit o At least hes considering a productive use of the tree o But its going to make apples for more than one year, so not enough y Next of $1500 because it should live for 15 more years o 15 years productivity, for the rest of its life o But didnt consider the time value of money  Dollar today is worth more than dollar tomorrow y $1500 since the last person offered it so that must be the market price o Some intuition in that, willingness to pay is an indication of value o But that doesnt mean you take one persons willingness to pay as the value y

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o Great reality check on theoretical value, but not just anyones willingness to pay y $75 which reflects the book value (assets liability = equity) o But that doesnt equal market value y $225 which counts earning o Revenue expenses y $270 which he offers and is discounted cash flows  Lots of methods people might use in valuation y Any could lead to the right result, but some are more likely to, and any method can lead to the wrong result y Valuation is a difficult game y Should have some sense of it, going to affect your transactions o Dot.com Bubble and the Crash of 1987  People attributed the run-up in prices of dot.com companies to irrational exuberance, arguing that as the bull market developed, it generated optimism about the future and stimulated demand y But if individual investors were carried away, why didnt professional investors step in and force their prices down?  Crash of 1987 demonstrate the difficulty of valuing common stocks from scratch y 1. Investors almost always price stock relative to yesterdays price, adjusting up or down, but when investors lose confidence in that price there may be a confused period before a new benchmark is established y 2. The hypothesis that stock price equals intrinsic value is nearly impossible to test, so the crash didnt conclusively disprove the hypothesis, but many now find it less plausible o Piemonte v. New Boston Ps were stockholders in a corporation whose stockholders voted to merge with the defendant corporation in circumstances which entitled each P to demand payment for his stock from the resulting corporation and an appraisal  Parties raise objections to the judges conclusions, Court holds that the judge followed acceptable procedures, but that there are instances where he may have been in error  Judge used the Delaware Block Approach a method of valuation which weighs three different techniques (market value, asset value, and earnings value) to determine the value of a business in a judicial proceeding y On the theory that each of them individually might not be the right price, but all 3 might give a better idea y Dont have to know how Not our job and no longer used in Delaware y This was a method they used for a long time, but no longer  Need some messy calculations to figure out close corporations y 18. TRANSFER RESTRICTIONS AND BUY-OUTS o Transfer Restrictions A charter provision or agreement that restricts a shareholders ability to sell her shares  Might be to keep a family business in the family or among a group of friends  Problems with transfer restrictions is that they might undermine control, you might not be able to sell if you want to, you may not get full value of shares on a transfer 59

Modern cases hold that reasonable restrictions are valid and enforceable Common types y First refusal shares must first be offered to corporation on the terms the third party offered y First option shares must first be offered to the corporation at a price fixed under the option y Consent restraints prohibits a transfer of stock without the permission of the corporations board or shareholders  Mandatory sales give the corporation or remaining shareholders option to purchase upon one or more contingencies y Ex; option to repurchase stock from an EE when fired or upon death  Pricing provisions problem that in a close corporation, price of the shares cannot be set on the basis of market value y Book value may be unreliable because it reflects historical costs of assets rather than present value and ignores good will value o But not sufficient enough to avoid book value provisions y Capitalized earnings fix the price on the basis of a multiple of earnings, less likely to produce an unfair price than book y Periodic revisions agree on a price that is subject to periodic revision at agreed-upon intervals o Buy-out Agreement An agreement that allows or requires a partner or shareholder to end her relationship with the other partners or shareholders and receive a cash payment in return for her interest in the business  Benefits Might want them because it gives control y To solve problems, depending on the terms of the buy-out y Potentially liquidity if the shareholder wants out  Problem with buy-out agreements is the you might be stuck y Pricing might be a problem o F.B.I. Farms, Inc. v. Moore Family forms FBI, Moore divorces Linda, one of the children, and is awarded monetary judgment, with Linda getting all the shares, Linda never satisfied the judgment and a sheriffs sale commenced to sell the shares in the farm, where Moore bought them  But there was a provision in the Board minutes that if any stock be offered for sale, the farm had the first opportunity to purchase the stock y Right of first refusal an agreement providing that, before a shareholder can sell her shares to a third party, other shareholders would have the right to buy such shares at the price at which they would have been sold to the third party o Corporation tried to cancel the transaction and claim the right of first refusal y He thought maybe the restrictions wouldnt apply o One claim was that he was not a voluntary participant o Another was that the restrictions were manifestly unreasonable  At common law, any restraint on property was not allowed y We might want to not allow restraints if its scarce, want to give it to people who will utilize the land, to stimulate commerce   60

Ownership should mean the ability to sell But most transfer restrictions are legal o Its not just ownership of property, its maintenance of a relationship in a corporation o But they have to be reasonable o Its done by statute, so the ways and times statutes allow it  The corporation loses on right of first refusal because theyre not self-executing y They knew that she was going to sell the shares and didnt say anything y Court interpreted it as having the right of first refusal and failing to exercise it  Court holds the Board of Director Approval requirements are legal y Plaintiff says these are unreasonable since he was divorced and there was a breakdown of the group, have to be designed to serve legitimate purpose o But if you look at the whole thing, maybe this is what the point of such restrictions are about, from point of view of the family y Court doesnt accept the unreasonable argument o Reasonableness of a term of contract is evaluated at the time of adoption and it was reasonable when they entered into it o You dont generally get out of a contract because circumstances have changed y If it is a valid contract that doesnt mean that enforcing it is going to be consistent with good faith and fair dealing o But the point of restrictions might be to deal with family dealings  Plaintiff says they shouldnt apply to involuntary transfers and the sheriffs sale was involuntary y If its involuntary, the person youre seeking to bind was never party to it in the first place o Its not so obvious that a person should be bound by a provision that they didnt agree to y Intent of the corporation was to restrict voluntary and involuntary transfers o But the court partially agrees that it shouldnt apply to involuntary transactions o Sometimes an involuntary transactions can be voluntary  Ex; someone dying, you could think of it as voluntary if they have it in their will or given it when theyre alive  Not having a will is in a sense voluntary o The kind of involuntary transaction that would be ok to get around this would be divorces, perhaps shouldnt be binding o But he didnt get the shares in the divorce  If he had then maybe it would have been involuntary y He went and voluntarily bought the shares it was a voluntary transaction o So he cant now complain that the restrictions shouldnt bind him o Evangelista v. Holland Shareholder agreement that the company could buy out the estate of any deceased shareholder for a set price, sought to enforce it, even though there was evidence that it was worth over double y y

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Court held for the corporation, there was a mutuality of risk when they entered into it and such agreements may have purposes o Gallagher v. Lambert - EE bought stock as an employment provision with the restriction of a mandatory buy-back provision, he has to sell it back if terminated for any reason, and he is an at-will EE  The company fires him just before the date on which the buy-back price would have been higher y Price of the buyback is book value y Issue with that price is that the price after January 31 would be a lot more  He is fired for no good reason, no business related reason y He claims that he was fired because if they kept him on the rest of the month, they would have to give him the 3 million  Majority claims it shouldnt matter, they dont even give much time to it y He got what he bargained for in an at-will contract  Dissent claims there is an implied covenant of good faith and fair dealing in every contract y Doesnt mean you can do everything you want in at at-will contract  Other claim is that there is a fiduciary duty of good faith because he is a minority shareholder y If essentially partners, they have fiduciary like duties y So maybe it depends on whether he was essentially a partner y Hes the third largest shareholder, but it doesnt seen like he was a founder o Tough call (though not for the court it seems) o Jensen v. Christensen & Lee Insurance, Inc. Wisconsin court held an EE didnt have a claim for wrongful discharge because the state limited such actions to those that violate public policy  But they held that he may have a claim that the directors had beached o Jordan v. Duff and Phelps, Inc. EE is under a contract that says he has to sell back his shares if he is fired or quit, he quits for personal reasons and later learns that negotiations for a merger were in process, but hadnt been disclosed to him beforehand  Buy-out agreement was the book value at the end of the fiscal year, so he stayed on until the end of the year and got more money y But in January the company had a merger that increased the value y Generally there is no duty for the company to tell him anything  In this instance they focus on them having a duty to disclose information that are material facts y They dont have to give you information as shareholders but they do have that duty if theyre trying to get you to act o Could say theyre not trying to deal with him, hes just quitting, forcing them to take the shares o Or that there is no fiduciary duty because he isnt in the role of being like a partner  What about them transacting y Fiduciary duties to shareholders when theyre transacting  What if the merger is not complete 

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Could be problematic to have a rule that forces companies to tell quitting EEs about secret moves of a company y In the end, the merger fell apart and there was no deal o Worked out 3 years later  He didnt win on remand y They said he had to prove that he would have dropped his plans to move and would have stuck around for 2 more years until the third merger attempt no way to really prove this o Take-along right - an agreement providing that, before a shareholder can sell her shares to a third party, other shareholders have the right to sell their shares to such shareholder at the price at which the shares would have been sold to the third party  Have to take the other shareholders along  Its about liquidity If one person is able to negotiate a good price to get out, other who might be stuck should be able to go along with that price as well  Might also want it because you dont know if you can trust a new person as potentially a controlling shareholder  Problem with it is that it can make transactions a lot more difficult y Might destroy opportunities for transactions to go through if someone only wants to buy a limited amount of stock o Right of first refusal Can easily be bought by minority shareholder as well  Potentially for the same reason they want take-along dont want another majority shareholder they might not like y 19. CORPORATE DISSOLUTION o Charter Amendment  Not what they were made for, but they can allow for dissolution o Shareholder Vote  In most states, shareholders can vote for the dissolution y Often its a super-majority vote y In NY now its a majority y Some will require director approval before o Judicial Decree  Why seek a judicial decree if the shareholders can vote theres not a majority  Allowed to dissolve it for 3 types of reasons y 1. Waste of corporate assets o If it really just cant be run properly, the court will consider just dissolving the business y 2. Deadlock inability to obtain the votes for any action o Not just for dividends, has to be any action at all o Usually 50% of the shareholders can seek dissolution  On the theory that that proves deadlock o Sometimes states will allow minority shareholders  Sometimes minorities can cause deadlocks o Ex; NY Law 1004 Half the shareholders can seek dissolution for deadlock, or if theres a super-majority provision, then 1/3 can  Problem super majority could be any percent y 3. Oppressive Conduct y 63

o 1. Illegal or wrongful conduct violation of an explicit right  May be difficult to prove, but an easy case  High standard for the P o 2. Good faith and fair dealing  Can reach some subtle forms of misconduct o 3. Reasonable expectations  Frustration of the reasonable expectations of shareholders  A lot less than the violation of an explicit right  Not a mere hope, but a reasonable expectation, objective o Varies from state to state o The law is becoming increasingly liberal o Judicial Reluctance  Court have historically been hesitant to order dissolution y Bad social policy to shut down a profitable business  Over time it was realized thats not a very reasonable concern y Order of dissolution doesnt have to shut down the business and mostly doesnt shut down the business, even partnerships y Can sell the business as a whole, a going concern  Courts can determine alternative forms of relief y Mandatory buy-outs (usually majority buys out minority, but not necessary) y Can just sell the business as a going concern, dont even have to order a mandatory buy-out o Matter of Kemp & Beatley, Inc. 2 former EEs of a corporation, one leaves, the other is fired, bring suit because they still hold stock and whereas before they all received distributions of the companys earnings, they no longer did seeking dissolution  Claim is that fraudulent and oppressive conduct rendered the stock virtually worthless; dissolution is permitted when controlling faction is guilty of oppressive conduct y This statutory language sounds stricter than reasonable expectation y Court interprets oppressive conduct as conduct that substantially defeats reasonable expectations held by minority shareholders y Oppression should only be deemed to arise when the majority conduct substantially defeats reasonable expectations that were central to the decision to join the venture  Court holds its not unreasonable for a fact finder to determine their change in policy regarding dividends amounted to an attempt to exclude petitioners and constituted oppressive action y Court looks for other possibilities, they dont necessarily want to order dissolution y They have broad ability to issue alternative relief, but shouldnt hesitate to order dissolution when appropriate o Meiselman v. Meiselman Many close corporations are based on personal relationships that give rise to certain reasonable expectations, but these become difficult to fulfill if relationships break down  Majority then has the opportunity to exclude minority 64

Interests must be determined by reasonable expectations which are known or assumed by the other shareholders  Also, close corporations shareholder rights are not as narrowly defined as in a publicly held corporation y This can change over time The Duties of Care and Loyalty in Closely Held Corporations  These duties are often insufficient in close corporations where actions that treat shareholders unequally or defeats legitimate expectations found in close corporations, but not public y Reasonable expectations analysis fills that gap in corporate law MacCallum v. Rosens Diversified, Inc. Minority shareholder, who was a director and CEO, is fired and wants to redeem his shares but they cannot agree on the price  Remember previous case that said EEs are not always given fiduciary duties y Or only essentially partners have partnership like duties  Factors to consider how hes treated y His position, his having under 3%, the fact that he was a key employee, almost entirely successful for the financial success of the business o But even a very important EE is still an employee y Doesnt sound like a very persuasive argument  Court finds for McCallum, remand for determining the fair value y They say his reasonable expectations at the inception were defeated y Terminating a CEO, as opposed to an EE without a significant role in management, then offering to redeem his stock at that price was sufficiently unreasonable  They just fired him, didnt fire him then offer a low price on his stock y He said they should buy him out, wasnt a company policy y Courts reasoning suggests it was because they fired him and gave him a low-ball price o Suggesting they could just fire him and not offer a low-ball price y By making the counter offer, which can be seen as a nice thing to do, might be evidence of a freeze out  What may seem generous to you, might not seem to the fact finder Mullenberg v. Bikon Corp. Minority shareholder sued the majority on grounds of oppression, Court agreed and gave him the option of buying out the majority  Courts are not limited to statutory remedies Dissolution Minority shareholder petitions for dissolution are commonly just a trigger for requiring a mandatory buy-out of the minority shareholders stock  Courts often hold that grounds for dissolution exist and then order a mandatory buy-out Charland v. Country View Golf Club, Inc. Minority shareholder sought dissolution because one of the officers was engaged in illegal activities, they opt to buy him out  The parties couldnt agree on a price, so they went to price to seek evaluation  Minority discount a reduction in the pro rata value of a company due to the lack of power held by minority shareholders y Even though their economic rights are the same, their voting rights are very different in minority and majority shares  65

Minority shares are worth less on the market and the discount takes this into account y But if the entire company was going to dissolve there wouldnt be a minority discount, just get your pro-rata value o Should the baseline be selling shares on the market or the company being sold?  Marketability (liquidity) discount a reduction in the pro rata value of a company due to the lack of a market for the companys ownership interests y Dont have to worry about it in a public corporation y But that would affect everyone equally and should already be taken into account in the underlying price of the company o The court seems to view it as only something that affects the minority shareholders  Unfair to include either discount y Starting with the premise that there is some wrongful conduct going on, someone is alleging theyve been harmed o The one causing the harm would gain the benefit of the misconduct o Might tempt people to make you want to dissolve the company and pay you less to kick you out  Court says there should be no discount o Brodie v. Jordan Widow receives her husbands share of a close corporation and is being frozen out; not allowing participation of any kind, no access to any information, not getting any payments  Most lenient standard is reasonable expectations y She didnt expect a job at the corporation or to be part of it, didnt even argue that she did, the company didnt pay dividends y Her reasonable expectations couldnt have been that much o Possibly the ability to sell y In many close corporations people expect money, but they work for it o Her husband got money, but he worked for it  Assuming thats the case what can she expect? y Maybe the court should have framed it in terms of his expectations o Wouldnt she inherit the right not to be frozen out from him o He asked for a buy-out while working there and they said no, then voted him out and he stopped getting paid  Proper remedy for a freeze out according to this court is that the shareholders should be put in a position as if there had been no wrongdoing y Pretty usual remedy, certainly for contractual violations y Whether its the remedy for torts is a dicey question o There was wrongdoing, so should we allow people to commit wrongs and only pay if they get caught o Court is worried about a windfall, but maybe thats better since they committed a wrong  Courts holding as to the remedy was ordering damages y She didnt have an expectation of being bought out or having a job with economic rights y 66

Hard to imagine what the damages will be, even if calculated, the problem wont end y Ongoing relationship that would have to be monitored by the court, not an ideal situation  Without requiring them to buy someone out if they just die, theres no ability to then sell those shares What do the heirs get? y Nothing seems to be as wrong an answer as everything y 20. DUTY OF CARE & BUSINESS JUDGMENT RULE o What should a fiduciary duty of care mean?  Could be that you take reasonable steps to make sure it is well managed  Making sure you make decisions to the best of your ability o Francis v. United Jersey Bank Creditors sue Pritchard because her sons took money from the corporation, is a corporate director personally liable for failing to prevent the misappropriation of trust funds by other directors? - Yes  Directors have a duty to be knowledgeable about the business y Not detailed inspection, just general monitoring y It may not itself uncover wrong doing, but might lead to suspicion and a duty to inquire further y Directors are making decisions about running the business, and should know about whats going on  If she does discover anything she has to take steps y Steps to stop the misconduct o Object and if that doesnt work, maybe file suit y If you try to do these things and they dont work, should resign o Not the ideal solution, but they may have to  Generally directors are accorded broad immunity and are not the insurers of corporate activities y But NJ laws says directors have to discharge their duties in good faith with diligence, care, and skill of ordinary prudent men o She was a director in name only, by any standard she will have breached her duty of care  But did that cause the plaintiffs loss? y Idea is that shes a but-for cause o Her negligence was a substantial factor in causing the loss y We certainly could have causation, but could easily not have it o The court here doesnt want to speculate, she did nothing y Legal basis for not being sympathetic is she is a director, if she didnt want to be one she could have quit  Shareholders are the ones owed fiduciary duty y But those are her sons, likely going to waive it here  Creditors are the ones suing here how? y Could have been based on insolvency y But here its based on the fact that this is more like a bank, which owes fiduciary duties not just to shareholders, but creditors y

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o In re Emerging Communications, Inc. Shareholders Litigation Court held D could be liable because he had specialized knowledge, which imposed a duty on him  His specialized financial expertise made it incumbent on him, as a fiduciary, to advocate the board reject a price he knew to be low o Causation  Issues where (1) the violation is an omission and (2) where the board acted, can an individual be excused because the result would have been the same if she acted differently y Barnes v. Andrews D violated his duty of care by not paying attention to corporate affairs but that the Ps had to prove that the losses would not have occurred if he had properly performed his duties no such showing o Kamin v. American Express Co. Derivative shareholder action, company gives out dividends of stock of failing company they own, shareholders wanted the company to take the hit and sell the stock because they can save 8 million in taxes by doing so  Companys argument that taking a 25 million dollar loss is going to hurt the financial statements and the company y But it doesnt matter what the financial statements say, people know y Shareholders would rather the 8 million as a savings y But a lot of time people will act as if the financial statements matter o So you cant throw it away completely  The court ends up being deferential y They are allowed to exercise their honest business judgment, and mere errors are not sufficient y Dividends are exclusively a matter for the board of directors  They are not above review entirely, but the court says it has to be more than a bad decision y Beyond fraud, etc., maybe a conflict of interest y Directors could have been playing with the financial statements to increase their own salaries, which are dependent on the financial statements o But court says most werent conflicted  Default rule is that the courts follow the business judgment rule and exceptions from that should be rare  But how do we reconcile the Pritchard case, going on about the duty of care, with the this case, which seems to be pretty deferential y We can reconcile them with the divergence of standards of conduct and standards of review o Standard of Conduct and Review  Standard of conduct a legal rule, addressed to an actor, that states how the person should conduct a given activity or play a given role  Standard of review a legal rule, addressed to the courts, that states the test by which an actors conduct should be reviewed to determine whether judicial relief should be granted  They are often the same, but they diverge in corporate law y Standard of conduct in corporate law is you have to act as an ordinary, careful, and prudent person in similar circumstances or in the management of their own business 68

o A lot like standard tort language of ordinary care, avoid negligence y Standard of review is the Business Judgment Rule A legal doctrine that protects business decisions from judicial review; in Delaware, a presumption that, in making a business decision, the directors of a corporation acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company o It protects business decisions from judicial review o If you have an informed basis (careful part) o In good faith (as long as not acting in bad faith) o Rational (does not mean reasonable, people could differ on what reasonable means) y If the business judgment rule applies, management (almost) always wins  Two components to it y Substance and process components y Substance offers almost complete protection o If youre trying to challenge the substance (we should have gone with widgets, rather than gadgets), you will lose o The standard is waste, irrationality, no one could have though that was a good idea  No win situation, youre going to lose y Process Here you have (barely) a chance o If youre challenging the process (you didnt spend enough time thinking about that, didnt consider other things), the deference is still pretty strong, but its not guaranteed youre going to lose o Based on gross negligence y Standard of care is negligence o Applied as avoiding negligence y Standard of review is gross negligence o You should avoid negligence, but well only hold you liable if you were grossly negligent  Why this divergence of standards of conduct and review? o Justifications  Statutory grant of Authority Section 141(a): Directors manage corporations y Not shareholders or courts y Lets leave the decisions alone as much as possible  Business is risky results do not tell us much about quality of decisions y Second-guessing after-the-fact y You can make a very good decision and it just fails y Management is an art, not a science  Assumption of risk by shareholders y You can get rid of that risk by investing in multiple businesses y By not diversifying, youre accepting that risk  Incentives for business people y Willingness to be a director can be affected if youre going to be held liable

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o They dont make that much money and are going to be put on the line for the failure of a business  Have to shield them from that y Even if they were willing to take on being a director, then maybe they wouldnt take risks in business o Why take that risk if they can be sued if wrong o We want businesses to take risks and so we have to provide protection from liability  Spreading costs y Normally when we hold someone liable, its a form of insurance to hold the company liable, who can then spread out the cost by a rise in price y Here it would work the opposite o Shareholders each lose a small amount, but aggregated can have a billion dollar cost against a few directors  Instead of spreading cost, youd be concentrating it  Courts are not business experts y They dont know what theyre doing for the most part y Courts arent all like Delaware who hears lots of business cases o But even there they know theyre not business experts  For all these reasons, we say we ought to have this divergence y But do corporations really deserve a rule that is special from about every other area of law? o Possibly because in business we affirmatively want to take risks  Versus medicine where we would like there to be no risks  Investing our surplus in business, but our lives in medicine, so we dont want our doctors trying to take lots of risks o This gets debated a lot y 21. DUTY OF LOYALTY & ENTIRE FAIRNESS TEST o Guth v. Loth Key duty of loyalty  Corporate officers cant use their positions of trust and confidence to further their private interests  Rule demands of corporate officer or director the most scrupulous observance of his duty, not only to protect the corporation, but refrain from doing anything that would injure it o Once upon a time is was the case that you couldnt have a conflict of interest at all when conducting business, it was automatically voidable  Thirty years later this rule changes  Valid if approved by a disinterested majority of directors  By 1960, general rule that no transaction was automatically voidable, whether there was a disinterested majority or not, but would give it more scrutiny and see if the transaction was fair o Lewis v. S.L. & E. Donald refused to sell his shares under the agreement he and his brothers had entered into because he claims they had wasted the assets of the company by charging too low of a rent and thus losing profits they might have made  It was originally perhaps a good lease for ten years y Lease expires and they continue it 70

They dont get the business judgment rule y 1. Theres a conflict of interest with the directors y 2. The rule requires a business judgment and according to the brothers, they never even gave it consideration o If you dont make a decision you cant claim the business judgment rule, and here any profit being lost by the company was being made by the other company they owned that rented the property  Didnt matter to them who made the profit o It matters to the plaintiff who had no shares in the other company  The burden of proof is now on them to prove the rent was fair and reasonable y They didnt meet that burden it was only covering expenses  Remanded to determine the difference between the fair rental value and what they charged, added to the book value, so no penalty to the directors y Theoretically encouraging this type of behavior by not really penalizing y Book value is usually lower than market value, but the shareholders already agreed to sell according to book value Remedies for Violation of the Duty of Loyalty  Remedies for such a violation are usually restitutionary  Result of this is that the legal sanctions for violation of the duty of loyalty are usually much less severe than the legal sanctions for violation of the duty of care y For violating a duty of care, must pay damages although he made no gain from the wrongful action y For violating duty of fair dealing, need only return a gain to which he was never entitled  But there are some cases where remedies for duty of loyalty make the director worse off Note on the Duty of Loyalty  Fairness requires not only that the terms of a self-interested transaction be fair, but that its in the corporations interest Note on Associates of Directors and Senior Executives  An enterprise or individual that a director or senior executive has a significant relationship with is referred to as an associate y If the director negotiates with the corporation on the associates behalf or advances their interest, the same rules of conduct should apply to D as if he had acted on his own behalf y The associate knew or should have known he was participating in a breach of fiduciary duty, he would be liable as an aider and abetter Sinclair Oil Corporation v. Levien Derivative action by shareholders who sue Sinclair to account for damages sustained by its subsidiary, Sinven, which is engaged in petroleum operations in Venezuela  Basis for fiduciary duty is that they are majority shareholder y Levien owns 3%, Sinclair 97%  Because of Sinclairs fiduciary duty and its control over Sinven, its transactions with Sinven must meet the entire fairness test y High degree of fairness and shift in the burden of proof to Sinclair y Sinclair argues its the business judgment rule  71

But the court holds that when the situation involves a parent controlling the transaction and fixing the terms of the subsidiary, and the parent receives a benefit the test of intrinsic fairness applies  In order to invoke the Entire Fairness Test, there needs to be self-dealing or something that arises like self-dealing y If fiduciary is getting something to the exclusion of minority shareholder y When a fiduciary stands on both sides of the transaction y Act in such a way that they get a benefit to the detriment of the other  P argues they paid out excessive dividends in their self-interest because they needed cash and industrial development of Sinven was prevented y Court holds the dividends were not self-dealing, minority was getting them too, so the business judgment rule is applied y Important to point out that dividends are really left to the judgment of the directors, but if there is a conflict of interest, they might have to get involved y Motive that Sinclair needed the money was irrelevant o Amount of dividends isnt something courts want to get involved in  Corporate opportunity claim that Sinclair prevented Sinven from expanding y Sinclair had lots of opportunities and it decided which to give to which subsidiaries y The law doesnt require a parent to be generous to a subsidiary, just not to mistreat it  Breach of contract claim y They didnt purchase the minimum amount and the payments were late y Sinclair bought all of Sinvens crude oil, but still their breach because Sinclair has control over how much Sinven produces o Self-dealing because contracting with the subsidiary for Sinven products, minority shareholders of Sinven did not share in this  Breached contract was to the detriment of Sinven  So the entire fairness test is applied here o They failed to prove that Sinven couldnt have obtained the contract minimums and are liable o Gantler v. Stephens Ps claim the Ds, who are officers and directors, of First Niles, violated their fiduciary duties by rejecting opportunities to sell the company and instead reclassified it to benefit themselves, and disseminated a misleading proxy statement to induce shareholder approval  Presumably they rejected the offers to allow the recapitalization exchange y Recapitalization exchange - an exchange of securities intended to restructure the companys capital structure, especially with respect to classified stock y They create two classes of stock o One with high dividends and low voting and the other with low dividends and high voting y Public shareholders are going to go for the high dividends and low voting o Dont care about voting anyway y Management holds onto the high voting shares y 72

o They keep control, get to decide the directors and dividends  Shareholders are basically pushed into trading their shares for non-voting shares y Management gets control without any financial loss y Saying theyre doing it to give better value to the shareholders  Whether rejecting another offer in exchange for an internal offer could be selfdealing because the directors stood to benefit y Self-dealing when a fiduciary stands on both sides of a transaction, or causes the company to act in such a way that the fiduciary receives something from the company to the exclusion of, and detriment to, the shareholders y They were facing the possibility of losing their jobs (but courts are really reluctant to allow that because thats always going to be the case) y They had other businesses that would also be affected o That the court says is real, the something more they require o The other shareholders dont have contracts that would be benefitted like them o So its a conflict of interest that rises to self-dealing  What was unfair here y Conflict of interest is not in itself wrong as long as its fair o If Im on both sides of the transaction I may still be ok o But it causes mistrust, not that something wrong has happened y Here they couldnt prove their decision was fair o They neglected two offers, they didnt seem interested in pursuing the sale of the company so that they could instead pursue their own other deal o Going to be hard to prove that you rejected another offer and pursued your own offer if you didnt pursue those offers at all  Another important point, the court points out, is that the court holds that officers have the same fiduciary duties as directors y Fairly big deal that the court holds this o Clash between authority of directors, their ability to take risks, and accountability, they cant just do whatever they want  Courts are trying to find the right balance  Value of authority is seen in the business judgment rule  Versus the entire fairness test y 22. BUSINESS JUDGMENT RULE IN DELAWARE o Smith v. Van Gorkom In a nutshell: the directors approved a take-over very quickly and the shareholders sue because they didnt get the right price  They wanted to sell because they were losing some profits due to taxes y Worth more as a subsidiary or merged y Synergy AB would be greater than A + B  Directors credentials were really good y Argument that they werent well informed o Not given advance notice, relied on a 20 minute presentation, didnt read the actual agreement, decided to sell the company without asking about its value within 2 hours 73

Argument they were o They had recently done their internal finders review and they had recently just considered selling, so might have a good idea already o If its a close call, 2 hours may not be enough, but if its an easy call, might not even take that long What evidence do we have as to whether 55 was fair y The stock price was 38 and the efficient market takes into account all information - 50% premium y We had shareholder approval, suggests they thought it was a good price y No better offer came along, no one was willing to offer more y They were willing to go through with it because there was going to be a market test - an opportunity for the market to present alternatives to a proposed transaction in the way of competing bids; auction The court said the market test was virtually meaningless in face of restrictions y Court was wrong o The original agreement didnt allow for an auction, but it did allow them to entertain offers o It would be public, so it wouldnt matter that thy couldnt solicit o Merger Agreement acknowledged that the directors may have a competing fiduciary obligation to shareholders under certain circumstances  Meant that the company can do whatever they have to do to comply with fiduciary duties  Complete freedom to take other offers o Also, later amended so that they could have an auction o Company even brought in Solomon Brothers to try to find a better offer got two offers that just didnt pan out y In other words, there was an auction and market test Two possible concerns with price y 1. They didnt determine what the right price would be o Intrinsic value theoretical value of company, based on analysis of info; real value, or what price should be (invented in this case)  Directors didnt try to determine the intrinsic value because they thought it was a huge premium already  Court says they knew the market had undervalued their stock, but more likely they just said it was undervalued without any real meaning, as directors do  Who should determine intrinsic value y Courts not comfortable with market or board y But the court is the worst person to decide y 2. Or that they didnt take the best price, whatever that may be o Court doesnt like that they asked if 55 was fair as opposed to what they could get o They ran the numbers to determine what price would be worth a leveraged buy out y

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o LBO the purchase of a business financed primarily through debt, especially junk bonds  You borrow money to buy the company and then you expect the company to pay off the debt, in which case you bought the company for free  Junk bonds high-risk, high-return bonds  MBO an LBO done by management o They were trying to bypass the intrinsic value for a better test  It might have been wrong, but it was a very good strategy  Business judgment rule wouldnt challenge the substance but the procedure y They were trying to figure out the best price they could imagine and then to send it to the market to test it o Court didnt really understand what this was  They offered the price, so didnt negotiate that much y Further negotiations were in the lockup option a provision in an acquisition agreement designed either to preclude a competing bidder from acquiring a company or to provide compensation to the original bidder in case it loses in a bidding contest o Basically a deal that makes it much easier for Pritzker to win and harder for anyone else to win o Company negotiated him down to half the size of the lockup o Thats real negotiations, its about the price the next person would be willing to offer y They also negotiated an auction y The court is just overlooking the negotiations they had  Directors are held liable for gross negligence under the BJR y First case where directors are held liable for breach in the duty of care o Effects of this case very disturbing to the business community  Sent shock waves throughout the industry y People not wanting to be directors, insurance companies not insuring y Advising clients to be more careful with these issues  Many states passed laws that allowed them to eliminate director liability in all cases but the worst DGCL 121(b)(7) y Allows them to put in the Charter that directors are not personally liable for breach of the duty of care (Cant eliminate liability in duty of loyalty) y Exculpation statute a law that limits, or allows the limitation of, director liability for breach of fiduciary duty o Shareholders pretty much across the board accepted it  Some states they can opt out, Delaware they can opt in  Pretty much universal  Court was trying to breathe life into the duty of care y But they got it wrong and as a result it backfired because now theres less liability than ever before, pretty much gone now o In fairness it doesnt eliminate the duty of care, it just eliminates the liability for duty of care y Not very good law anymore, important historically to see what comes after 75

o Cede & Co v. Technicolor, Inc. Whether the boards approval of a merger was protected by the Business Judgment Rule  Court found that even though they were grossly negligent, it was entirely fair y Court has backed off Van Gorken WHY?  1. Its all laid out in the case (the law) y Delaware courts always go through the progression of the law  2. The court is talking about conflicts of interest and whether they were cognizable y Not just any conflict of interest invokes the entire fairness test, it has to be real/material y Though weve kind of limited conflict of interest to dollars and family  3. Individual directors conflict versus the boards conflict y If most of the board is objective, we dont have to worry about it  4. The triad of fiduciary duties y Traditional story was two loyalty and care y Here the court said three good faith, loyalty, and care o Good faith had been out there but no one has ever made much of it o They dont say much about it anyway, presumably deals with something to do with honesty  5. This case redefined the relationship between business judgment rule and the entire fairness test y Used to be straightforward o Duty of Care was under the business judgment rule o Loyalty was under entire fairness test o Then along comes this case and it changes y Business judgment rule is a presumption, court takes that seriously o Start with business judgment rule, Ps have to rebut that presumption  Care Gross negligence  Loyalty Self-dealing  Good Faith Intentional misconduct (eventually this one is developed) o If you rebut it, then it goes to the entire fairness test y Court reworks it we always use the business judgment rule and depending on what happens, always end up with the entire fairness test  Court says they have proven gross negligence, but thats just a rebuttal of the business judgment rule so they send it back to determine it y Despite gross negligence it was perfectly fair y Logically this is not inconceivable, but factually problematic o We used to think that these tests were outcome determinative  Defendants were going to win if they had the business judgment rule o And how could it be fair when it was grossly negligence  The price in the end was fair  This framework remain in effect in Delaware, but it had been highly criticized y 23. DISINTERESTED APPROVAL o Competing values of authority and accountability 76

Courts would rather let the directors go, they can get things very wrong Courts believe it would be better if they could eliminate the conflict of interest than preside over it and review it y One way is to list the things that well recognize as a conflict of interest y Another possibility is to actually eliminate the conflict of interest o DGCL 144 No contract or transaction in which one or more of the directors or officers have a financial interest shall be void or voidable solely for this reason  If theres a conflict we apply the entire fairness test y If its sanitized you get a shift in the burden of proof y Disinterested not having a (material) financial stake  Conflicted transactions can be decided by unconflicted decision makers y 1. If its approved by majority of informed disinterested directors y 2. If its approved by informed shareholders o Doesnt say they have to be disinterested  Potential solution is to not let the disinterested shareholders vote, have them rewrite the law  What they actually did was say read into B that it has to be disinterested o They dont have the right to vote on it until its presented to them y 3. Or its fair and reasonable to the court o Instead of entire fairness test sounds like you can have director or shareholder approval  Courts have in fact decided that in spite of 144, entire fairness test still applies y Instead of reading it A, B, or C, its A, B, and C y Satisfaction of any one of these three would simply preclude it being voidable solely on the basis of self-interest  Many states had this language and were interpreting it in this way long before Delaware adopted this y Legislature knew this and adopted it anyway y Fair to say they meant it this way, what was happening in other states  This statutory provision was to kind of get rid of the old common law rule where any conflict of interest made an agreement voidable o Who has the conflict Director or Controlling Shareholder?  Director interest (most of what weve been talking about) y Default is entire fairness test o Burden on the D to prove entire fairness y Independent director approval unclear o Some states say entire fairness but the burden on the plaintiff o Or could be the business judgment rule with burden on plaintiff  We dont have a conflict of interest, so shouldnt we apply the business judgment  Delaware tends to apply this if at least a majority of the board is disinterested y Independent shareholder approval o Business judgment rule with the burden on P  Controlling shareholder interest y Default   77

o Entire fairness test; burden on D y Independent director approval o Entire fairness; burden on P y Independent shareholder approval o Entire fairness, burden on the P o Cookies Food Products v. Lakes Warehouse Ps claim that the D, by acquiring control of Cookies and executing self-dealing contracts, breached his fiduciary duty to the company and fraudulently misappropriated and converted corporate funds  D enters into an exclusive distribution contract y He then buys more stock, has 5 of the 11 directors, hes paying himself for his work there, he extends his contracts, he started collecting royalties on a taco sauce recipe he came up with  Court says yes, this is self-dealing (which doesnt mean its wrong) y The amounts were talking about are material y Brings us into the entire fairness test  Entire Fairness Test (700) y Two basic aspects; fair dealing and fair price  Fair Price (substance) y Against They could have paid professionals less than he got for the jobs o The fact that theyre not paying dividends and hes taking all the value out as salary for himself  But, they couldnt pay dividends because of a contractual relationship on their debt y In favor He makes and extends the success of the business o They could have paid professionals, but he was the one who did it and others probably wouldnt have done as well  Fair dealing (process) y Against He dominates the board y In favor The contracts in existence are there before he dominated the board, he only extends them o Perfectly unconflicted board  Court decides its fair in the end y Looks like they mostly focus on the success y Even the plaintiffs expert acknowledged that he deserved it, even if they could have maybe found a cheaper person o Effect of Approval by Disinterested Directors of Self-Interested Transactions  Why interested transactions approved by disinterested directors should still be reviewed for substantive fairness y By virtue of their personal relationship, directors are unlikely to treat each other with the wariness of third parties y A review of the substantive fairness can be thought of as a surrogate for review of the fairness of the process  Some states expressly require some form of fairness test even if transactions have been approved by disinterested directors o Waste and Shareholder Ratification

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Waste entails an exchange of corporate assets for consideration so disproportionately small as to lie beyond the range at which any reasonable person might be willing to trade y If there is any substantial consideration and a good faith judgment that it was worthwhile, there should be no finding of waste  Shareholder ratification of waste requires unanimous consent y On theory no one should be forced to make a gift of their property o Kahn v. Lynch Communications Systems, Inc. P claims Alcatel breached its fiduciary duties to Lynch and shareholders by dictating terms of their merger, making false statements, and paying an unfair price  Kahn wants Lynch to buy Telco, but Alcatel wanted them to buy Celwave y Lynch eventually agrees and the other shareholders sue  Alcatel only had 43% of the voting power, but was in fact in actual control y He had a veto power, could stop any other acquisition because they had bargained for a required 80% of shareholders to approve any business combination y But he didnt quite have the majority share or majority of the directors  Should he have a fiduciary duty not to veto a decision y Hard to say he shouldnt use his veto power to vote against the transaction since they bargained for it y Forcing a transaction where he has a conflict of interest can be a problem o Fiduciary duty to otherwise not do things that are harmful just because he wants it  The Independent Committee unanimously rejects the Celwave acquisition y Then Alcatel offers to buy Lynch, committee counter-offers o Sounds like a negotiation y Alcatel says if they dont accept, they will go to the shareholders with a hostile takeover at a lower price o Court really focuses on this claim of a hostile takeover, which a company is legally allowed to do o Shareholders will only say yes to something that is a good offer  If its really worth 17$ they shouldnt accept it anyway o Court thinks this is a threat  Lynch had an independent committee approve the transaction, but Court doesnt believe its really independent y So they are not safe under 144 and they dont get the BJR y Alcatel exercised control over Lynch o They didnt make the decision because they agreed with it, they made the decision because they had to o Court is not convinced it was a disinterested committee despite them meeting halfway  Burden on entire fairness would not be shifted by the use of an independent committee which concluded its processes with what could be considered a quick surrender to the dictated terms of the controlling shareholder y Court holds Alcatel was a controlling shareholder and the burden of proving the entire fairness of the merger remained on Alcatel  79

o Gantler v. Stephens  1. Court said fully informed shareholder vote only approves director action that didnt require shareholder approval y Sanitizing has to be something else, not just a vote thats already legally required  2. The only director action that can be ratified is that which shareholders are specifically asked to approve y No inferences, narrowing this doctrine  3. The cleansing effect of the vote is to subject the challenged action to business judgment as opposed to extinguishing the claim altogether y Some courts had said otherwise (Van Gorken); that it can extinguish the claim altogether y 24. CORPORATE OPPORTUNITIES o Fiduciary should not take for itself an opportunity that belongs to the corporation  It would be theft similar to taking property from the corporation  Subset of the duty of loyalty o Factors to Consider (Some courts use one, some all, just to consider)  Financial ability of the corporation to take that opportunity y If they cant take it, then theres no harm done y Some argue this should be irrelevant because the company may be able to find a way, given the chance o Just accepting they cant, the director may have incentive to make it seem impossible or create impediments to take the opportunity o Some courts consider this, others dont  Line of business y If the type of opportunity in the line of business, direct competition o The more closely related, the better y Some say this should be absolutely necessary, others say irrelevant o Relevant this is what were talking about with corporate opportunity o Irrelevant Companies can get into different lines of business that dont have to be that related  Conglomeration the process of internal diversification; expansion into unrelated lines of business  Related by nature is a fuzzy concept  Interest or expectancy y Best example is Meinhard Partnership had an interest or expectancy in extension of the lease y Ex; If a company finds oil and before they buy it, one EE goes out and tries to buy the land not producing oil yet, but theyre about to y Some say its a rationalization after the fact o But some courts still rely on this  Resulting conflict y Test goes a little further  Source of the opportunity

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Whether you received the opportunity by corporate assets, or on corporate time, or if it was on your own time Very important today y If you use corporate assets, courts are extremely likely to find it to be the source of opportunity  Party involved y Different levels of fiduciary duty depending on whos involved o Officer > Director > EE > shareholder o More likely as officer and so on y Really more a problem of officers who are more likely to be involved in the day to day affairs of the company o Officers are expected to devote everything to this company, we know that directors have other jobs  Fairness y Fairness of holding the manager accountable for his outside activities o Hawaiian International Finances, Inc. v. Pablo President of company advises company of real estate, they buy it and he gets a commission  Court says he was not acting in bad faith y The amount paid was fair y Company wasnt injured o They had to pay the commission and they couldnt have taken it y Argument against is that they could have paid less on the property  Court holds he still had to tell them about it and they had to agree for it to be ok y Not just that he didnt tell them, they have to agree too  Could probably make this decision without the Corporate opportunity doctrine y Cant make a secret profit, general fiduciary o Northeast Harbor Golf Club, Inc. v. Harris Country Club president acquired property adjacent to the golf course, which real estate agent had offered her in her capacity as president and later piece playing golf (Look at the factors (methodical like on exam))  Financial ability of the club y Court is skeptical there was none Evidence they had engaged in fundraising, concern that maybe they would have been able to  Line of business y Court says this is conceptually difficult to answer y Trial court says golf and real estate are not the same o But a golf course may be interested in surrounding real estate, certainly could be important to them  Interest or expectancy y Tough one on the one hand theres nothing special about this land, but on the other its adjacent to the property o Court could go either way on this  Resulting conflict y Not really in competition with the golf course by buying this  Source of the opportunity y First one she gets the opportunity to buy it because of her role as president y Second one shes playing golf not as easy, but a court could find it y

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Party involved y Shes probably like chairman of the board, but still a high a position as there probably is in the organization, or at least up there  Fairness y She came to them after she already bought it, not a good factor o Almost worse this way, if she didnt tell them it may have suggested she didnt even consider it y Court thinks shes acting in good faith (almost surprising because of this)  Court looks at ALI approach (Principles of Corporate Governance 5.05) y Requires disclosure upfront if its a corporate opportunity; central feature o Corporation must then formally reject the offer  Even the rejection of a corporate opportunity has to be fair  But if she didnt seek their approval, she cant even fall back on entire fairness y But it doesnt tell us anything about whether its corporate opportunity y If someone doesnt disclose under the ALI approach then they dont necessarily lose (something close though) o You can get approval after the fact but it has to be fair  Fully informed disinterested approval, specific vote o Heres its too late for this y Under ALI, its better to disclose  Years after shes done this and they know about it, doing nothing, another board decides to sue her y They affirm the corporate opportunity doctrine, but its barred by the statute of limitations o Broz v. Cellular Information Systems Broz owns RFB and is a director for CIS, receives an opportunity to purchase a cellular license, he offers it to CIS, who declined, but PriCellular who had recently agreed to buy CIS sues him for violating duties to CIS  Financial Directors all say they cant afford  Line of business Yes  Interest or expectancy CIS probably dont have much of an interest or expectancy  Resulting conflict Already in some conflict, not going to make it much worse  Source of opportunity Unclear why Broz got the opportunity, could have been because of another of his roles  Party involved Hes a director  Fairness He treated CIS fairly by telling other directors about it y He didnt ask for corporate approval, probably because he thought he didnt need it  Delaware law doesnt require him to disclose y Director or officer can take the opportunity for himself if he doesnt believe the company is entitled to it without formal presentation to the Board y Safe harbor By presenting it to the board, it removes post hoc judicial determination they improperly usurped it y If it ends up being a corporate opportunity then its the entire fairness test  82

y 25. o

Complicated factor Broz is director of CIS, but Price Cellular is the one suing y Saying they had an expectancy interest y They were going to be buying CIS and Price Cellular had plenty of money y Claim he stole an opportunity from his future boss  Assume they would have bought it Court says he owes them no duty y He may in the future be a fiduciary of price cellular, but hes not now, no duty to them Energy Resources v. Porter Porter worked for ERCO, got a joint development grant from the DOE for Howard and ERCO, Howard refuses to work with ERCO, Porter quits and creates a company to get the grant just with Howard  This was a corporate opportunity for ERCO y Company had financial interest y It was in their line of business y They had an interest and expectancy y It would lead to a conflict y Source of opportunity was at least partly ERCO y Party involved is a little weaker, hes the VP of ERCO  Argument it wasnt a corporate opportunity y D claimed it ceased being a corporate opportunity when Howard refused to work with ERCO y Claim that it was maybe a personal opportunity because it was based around Porter, not either of the companies  Before he invokes a refusal to deal he has to tell the company about it y If the company had really refused to deal with ERCO, not able to be persuaded, then maybe he would have been able to quit and work with him  The DOE said Porter is the main guy so basically he gets to choose whether he goes with Howard or ERCO to get the grant either way y It is not the case that if Howard walks away from this ERCO cant have it, only that if Porter leaves y He established the company because Howard refused to work with ERCO o Could no longer not be an opportunity because Howard refused to deal with them DUTY OF GOOD FAITH Historic View  There were two main duties Duty of loyalty and care  Care Business judgment rule (directors win)  Loyalty Entire fairness test (shareholders win) Good Faith, located  Business Judgment Rule y [A] presumption that, in making a business decision, the directors of a corporation acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company.  144 Board authorization y ... if ... the Board or committee in good faith authorizes the contract or transaction ... 

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 102(b)(7) Director exculpation y ... provided that such provision shall not eliminate or limit the liability of a director ... for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law ...  145 - Indemnification y ... if such person acted in good faith ... y Directors could only be freed from liability only as long as they were acting in good faith  Good faith has been out there forever, but we generally talk about the other two when talking about breaching fiduciary duty y Cases were never really clear on what good faith is o Good Faith, Content  Really standards of conduct y Honesty y Sincerity (In the sense of effort, doing your best) y Decency (Appropriate standards, decent in transactions) y Legality (Complying with the law, and also the Charter and bylaws)  Breach of duty of good faith y Might be something like actual dishonesty y Intentional misconduct y Outrageousness y Intentional violation of law  Clearly something different than care or loyalty y Good faith is about being bad, morally bad, different than the others o Cede & Co.  Court said a triad of fiduciary duties, no one had spoken of that before  They didnt say more on what it means, long time before we got guidance on this o In re the Walt Disney Company Derivative Litigation Ovitz is hired as president of Disney, let go after about a year and receives a 130 million severance payout; shareholders brought derivative actions claiming breach of fiduciary duties and waste  Duty of care y Court says they dont act carefully but not held to breach the duty of care because they werent grossly negligent o They say it fell far short of corporate best practices but good enough to avoid liability  Bad faith y Plaintiff complains the trial court changed the definition on the standard for breach of duty of good faith o Previously, conscious and intentional disregard  Proof of subjective bad intent was not necessary o Court says intentional dereliction of duty, a conscious disregard for ones responsibilities is the standard, requires bad intent o Court says theres not that much of a difference y Absolutely not the case that just the lack of due care, gross negligence itself, without any intent, should be a breach of duty of good faith 

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Negligence standard of duty y Gross negligence standard of review for duty of care y Recklessness sound like were moving into a duty of faith  Shareholders want good faith to be the same as duty of care because of the exculpation statutes y Care type issues can become good faith if bad enough o But it is not automatic that a breach of duty of care becomes a breach of duty of good faith  By now most directors wont be held liable for breach of duty of care y Not worth suing for care since they wont generally be liable y Shareholders have been trying to turn a duty of care issue into a duty of good faith issue because its not exculpable o Stone v. Ritter Company EEs break the law by taking measures to prevent Ponzi scheme, directors dont know about it, shareholders bring a derivative action  This is a Caremark case (1996 case) Directors should have known of the illegal conduct of EEs and because they didnt, they breached their fiduciary duties y Caremark was essentially the same case as this one y Suggesting that you do need some kind of system in place for monitoring the company, which Ps try to claim in this case y Court doesnt say theyre overruling it, theyre narrowing or reinterpreting  Court says where a claim of directorial liability for corporate loss is predicated upon ignorance, only a sustained or systematic failure of the board to exercise oversight will establish the lack of good faith necessary for liability y Case is dismissed, the directors had no reason to know about it  Duty of oversight or duty to monitor seems like part of the duty of care y But court puts it under the duty of loyalty o Failure to act in good faith may result in liability does not automatically result in the direct imposition of fiduciary liability, but may result in liability because it is a condition of the duty of loyalty  Saying the duty to monitor is part of the duty of good faith  Duty of good faith is a subsidiary of loyalty y With exculpation statutes, directors wont be liable under the duty of care  Disney and Stone turn Care cases (and should be exculpated) into loyalty cases if its bad enough y On the one hand problematic - taking duty of care type conduct which should be exculpated and turning it in to loyalty which can be prosecuted y Can get past it by saying they could be overlapping fiduciary duties and not liable for a pure breach of duty of care, only pure would be covered by exculpation statute  Results y 1. Case says there is no tried of duties o Faith is a subset of loyalty  Not clear what this means, just saying its a subset o Loyalty includes conflicts and good faith 

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2. Duty of loyalty is not limited to just financial recognizable conflicts of interest, now things like intentional misconduct, good faith  The duty to monitor changes y Makes it more prone to liability, but not by much y Standards to satisfy breach of fiduciary duty for review is a systematic failure, approaching utter failure to do anything o Only a sustained or systematic failure of the board o Failure to implement ANY system o Compliance Programs  Effective compliance program under the Sentencing Guidelines, hallmark is due diligence; at minimum must have: y 1. Standards and procedures reasonably capable of reducing such conduct y 2. Assigned individuals to oversee compliance with standards y 3. Due care not to delegate substantial discretionary authority to those with a propensity for illegal activities y 4. Communicate corporate standards to EEs and agents y 5. Monitoring and auditing to achieve compliance and reporting system y 6. Appropriate disciplinary mechanisms y 7. Respond appropriately if offense is detected  These are not mandatory but sentencing judges are required to consult them y 26. MANAGEMENT COMPENSATION o In re the Walt Disney Company Derivative Litigation Such a large termination payment put in place to get him to join the company  If someone wants Obtiz theyre going to have to pay him something competitive, but then should they be hiring someone who right up front demands something like 150 million?  They refuse to give him an upfront signing bonus, so they change it to give it to him on the backend y Seems like one is less bad than the other, probably better to pay him when hes full of promise rather than when youre firing him  2 duties of care y One in authorizing the agreement o Probably poorly done, but not grossly negligent o One of the key duties is informed-ness  Court concludes they knew enough y Another in terminating it o Brehm v. Eisner  DGCL 141(e) Directors are protected for relying in good faith on information given to them by experts y Nobody made the relevant calculations regarding how much he was getting paid, but no liability because they rely on this y Directors cant be auditors as well, they have to rely on reports, etc. when they get them from other people  Limit on the limit on 141(e) Directors cannot abdicate their power y

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Experts dont have the ultimate authority to make decisions, directors can still make bad decisions under 141(e) o They werent making a judgment here, signing off on something and they dont even know what it is y This provision was about if theres a mistake, or fraud committed upon you, its not your fault and youre liable o Not really about this type of decision but Court holds the Board relied on the experts decision not to fully calculate the amount He is given no-fault termination y Only if fired for good cause do they not give him anything y They had no choice, there was no realistic argument that it was for cause Entering into the contract y May have been a breach of duty entering into a contract they know will later bind them in a way that will be unacceptable at the time o Not that the court says there is Issue of waste (sometimes called substantive due care) y Rather than look at process, look at substance y SOR for waste Pretty low standard o Irrationally squander or give away asset o Cannot be attributed to any rational business purpose y Its not waste by the court, theyre not in a position to judge the risk y Court says its fanciful to think that he would have engineered an early departure, also he had an opportunity to make maybe more at another job o The court is missing the point Its not about whether Ovitz tried to get himself fired, but whether the company entered into a contract that incentivized him to get fired  Court talks about how he had plenty of incentive to stay too y On the 130 million, the court is somewhat sympathetic this is pushing the limit its so high, but they still get the business judgment rule WHY? Courts dont want to get into substance, its process due care only y Courts do not measure their judgments o But in the end, theoretically reserve the right to look at substance Duty of loyalty issues friendship between Eisner and Ovitz y That could very possibly be a conflict of issue reason, but its not y Courts almost always reject friendship claims o All these people are colleagues, could easily turn every care issue into a loyalty issue if you allow friendship to be a cognizable issue y But a lot of times people do things for friends they wouldnt do for money o It can be a more corrupting influence in substance and process This first case is decided just on the pleadings y Even though it pushed the limit of judicial respect, they decided it was still upheld under the business judgment rule y Saying a lot about how important the business judgment rule They re-plead the case and had a trial on the merits y Every claim seemed to go the directors way, not sufficiently proven y

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These are the leading cases on management compensation y They seem to say you can kind of get away with anything y They point out this is not the model of good behavior, hoping perhaps to push people in a better direction, but it was still upheld o Structural Bias A prejudice that members of a board of directors may have in favor of one another and of management  1. Implicit conspiracy quid pro quo y In our interest to work as a team against those shareholders  2. Relationship friendship and collegiality y Dont want to turn on colleagues  3. Psychological phenomenon known as in-group bias y Just by dividing people into groups you can get people to agree to a lot more (Directors versus people)  It has psychological empirical evidence behind it, but courts tend to be skeptical of structural bias y Courts are sort of looking the other way if they say theres no structural bias, though in some cases they have taken it seriously o Hostile take-overs and derivative litigation o Executive Compensation  Considered to be an issue these days y It seems to keep growing, in good times and in bad (ex; recent financial crisis, still huge compensation) y Until recently compensation records were quite poor, so shareholders didnt even know what they were getting  Reasons people justify it y Theyre superstars, like athletes o In some instances probably true, but all worth it? y To pay competitive salaries, we need to pay above average o But companies are then all trying to up each other o In good times, look how good, we need to keep it up o In bad, we need to bring it up and keep the good people or get the good ones to help us  Difficult case, how much executives are be paid is a matter of business judgment y If we had a functioning market we could be very comfortable, but the complaint is that we dont really have a market system y He we have colleagues setting each others salaries from shareholder money  This is the claim of structural bias bias towards management y What we would like is an impartial decision making body o Directors would be nice, if they could do it unbiased o Courts dont want to get into it, they dont know what to do o But do we just turn a blind eye to these problems?  Incentivize management is an idea to fix this y Pay them according to how the company is doing y Great idea people thought o Move to stock-options  88

Stock options A right to buy stock in the future at a price set at the beginning of the contract (Option makes them want to drive stock prices up)  Problems: y 1. How many stock-options are you giving o How many do they deserve, can price it out to see how much its worth, but not really money y 2. Stock prices tend to move up o Theyre going to benefit anyway, even without effort y 3. Makes disclosure of compensation difficult o Stock options could mean a lot of things  End up not being as great as everyone thought they would be y Also maybe incentivizes the company to make the stock price go up, maybe to even commit fraud (Enron)  If stock-options become worthless, theyre then not incentivizing anyone y People can re-price the options, lower the exercise price o Re-incentivizing management y Problem with this is that if youre just re-pricing options every time if goes down, are you really incentivizing them? o Such a problem Congress made it nearly impossible to re-price o Now well just give you new options, no limit on how many new options you get  After Congress attempted they just found a way around o Say on Pay  Increasing shareholder activism Push for shareholder say on pay y Right to approve or not management compensation, doesnt really jive with normal separation of powers y Working as an advisory role in the end at least ask our opinion, and then you can reject it  Shareholders would have a non-binding vote on compensation packages y In theory, to keep management in check y Pretty embarrassing if they keep passing things shareholders rejected y Limited effectiveness because its not binding a lot of people maybe not voting for this reason  But they tend to vote in favor anyway, not what people expected y Possibly rational apathy y Maybe more sinister is that institutional investors own these shares and want to keep executive compensations up for everyone o Federal government on executive compensation  2009 they put a salary cap of 500,000 for executives y A lot of people would say a cap is a bad idea  More acceptable forms of involvement was SEC trying to get better disclosure y Shareholders can really know whats going on y Didnt just have to disclose, you had to expense them o What their worth was and count that as an expense  Required a total compensation number by the SEC as well 

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What is the compensation this year based on expensing options and everything else  Discussion of your compensation practices y How you go about setting your compensation practices and why so that shareholders can understand  Lots of moves regarding executive compensation y If we cant trust them how can we give them BJR, but if we dont give it to them, courts are going to be involved all the time o Compensation Litigation in Close Corporations  It has been difficult in the past to successfully challenge executive compensation in a publicly held corporation when approved by disinterested shareholders or directors y But courts often hold it unreasonable in close corporations o 1. Its usually not approved by disinterested directors or shareholder o 2. Likely to involve a significant fraction of corporations earnings y 27. FIDUCIARY DUTIES OF CONTROLLING SHAREHOLDERS (II) o Zahn v. Transamerica Holder of Class A stock in Axton-Fisher claims that Transamerica caused Axton-Fisher to redeem its Class A stock at 80/share instead of permitting them to participate in the assets on the liquidation of the company  On a simplified version of the facts, look in Charter y Voting rights o Class A = limited; Class B = Control y Liquidation o Class A = B x 2 y Redemption rights o Company can redeem Class A at $60/share o Redemption a forced buy-back of stock by the issuing company o Redeem to force a buy-back of stock by the issuing company pursuant to a contractual right o No automatic redemption rights, it would be in the Charter y Conversion rights o Shareholders can convert Class A into Class B o A convertible bond would be to take the debt security into stock o But it can be among classes of stock o Conversion the exchange of one security for another with the issuing company o Convert to exchange one security for another with the issuing company pursuant to a contractual right  If $60 in assets: y Liquidation o Class A gets $40 (2/3 of total) o Class B gets $20 (1/3 of total) y Redemption o Class A gets $60 ($60) o Class B gets $0 (everything else)  If $240 In assets: y 90

Liquidation o Class A gets $160 (2/3 of total) o Class B gets $80 (1/3 of total) y Redemption o Class A gets $60 ($60) o Class B gets $180 (everything else)  The directors fiduciary duties were implicated y Also majority to minority shareholders y Transamerica held all the Class B stock and had control of the board of Axton-Fisher o When they found out the increase in tobacco they made the plan to redeem Class A and liquidate the company to gain the benefits  The problem in this case is not really redemption or liquidation y It could arguably be unfair either way y The problem was the lack of information Class A didnt convert into Class B because they didnt give them information to know to convert o They thought it was bad times, where it was better to stay Class A  Speed v. Transamerica Corp. the state court decided the duty issued differently y The redemption right is a continuing option on the part of Class B shareholders to buy out Class A in their favor o Redemption Provisions  A redemption provision can only hurt you as a shareholder y The provision itself suggests maybe that the state courts opinion is right o Option to buy you out at any time for $60 so they will only do it when its worth more than that y Its not really cheating the shareholders they entered into it and it says what it means on its face  Not only can they do it, they pretty much have to y Failing to do so may lead to a problem of fiduciary duty y The whole point is to exercise it when it makes sense, when its worth more than the redemption price o Jones v. H.F. Ahmanson Ahmanson had 85% of Savings & Loan Association, Shareholders had 15%, they claim Ds breached fiduciary responsibility in the creation and operation of United Financial  Association is not a public corporation, its shares had an extremely high book value and were not actively traded y To remedy this, Ahmanson deposited its shares into United Financial so they could then be sold to the public o 1 Association share = 250 United Financial shares y Now much more marketable and the price starts to rise tremendously y But S & L shares are worse than before, people wouldnt buy their high priced shares when they could buy UF  The 15% shareholders were denied access to those initially and then after UF was doing well, they were offered the opportunity to join, but now at a discount y Only 51 1, when really it should be 250 1  Minority shareholders then sue majority for breach of fiduciary duty y 91

They are directly hurting minority shareholder, not hurting the company o It was already hard enough to sell the shares, now it was impossible  The majority shareholders could have done a stock-split y Stock-split technical splitting of each share into two or more shares y Amend the charter and each share will turn into 250 shares y Company is still worth the same, idea is that it will increase liquidity o It doesnt affect the business in any way, just makes the shares more marketable because theyre more affordable o At least thats the theory y They dont do this, theyre making more money by splitting it through UF o Taking profit from minority by buying their stock at reduced price o If the majority creates a new company with the shares, he can then sell the rest of the percentage off to the public in the new company  First seemed like they didnt give minority an opportunity, not going to be liable just for not helping y But its actually harming the minority and perhaps trying to get some kind of unfair advantage  Arguably the entire situation is implausible, that the court was duped y Efficient market hypothesis is it really plausible that the minority are going to be kept so low and the others increased so much that this little liquidity problem is going to cause this great a disparity in price? o But then again stock-splits should be irrelevant too, but they tend not to be, despite all logic o Perlman v. Feldmann Claim is that payment for the stock included compensation for a corporate asset, the ability to control the allocation of steel in a time of short supply  Shareholders sued to share the premium  Court agreed, said control was a corporate asset and a controlling shareholders should not be able to sell that control and keep the profit for himself y Since he sold it already, he had to share the profit y Company wasnt really harmed, court was trying to find harm  If you have 1% of the shares, you should have that much of the vote y But if you have 51%, you have 100% of the vote y Taking voting control, something that should be given to all the shareholders y Shes really selling everyone elses 49% of the vote, including hers  This case is not good law y Shareholders can sell their shares at a premium o Zetlin v. Hanson Holdings  A controlling shareholder is free to sell and a buyer is free to buy a controlling interest at a premium price  Aggravating factors Only a problem if theres more y Main one is selling to a known looter who then steals everything from the shareholders o Good idea since its almost looting by proxy, but bad idea because all Im really doing is selling at the best price o We dont stop with known looters, but suspected looters y 92

 

We never really know theyre going to loot, so have to go a little beyond knowledge to should have known What would constitute a known or suspected looter would be very difficult to implement

y 28. SHAREHOLDER SUITS o One of the fundamental debates in corporate law pits the authority of directors to make business decisions against their accountability  Business judgment reflects deference, authority  Entire fairness reflects accountability o Director Accountability  Shareholder Rights y Voting y Selling Sell if you dont like whats going on y Information - More you know, the more you can exercise other rights y Suing  Shareholder Protections y Elections y Markets y Courts Would rather things be decided by elections or markets o Shareholder Suits  Direct actions a lawsuit initiated by an injured person on her own behalf y Declared dividends o Direct action against the company if they dont pay you your dividend y Denial of voting right o Your right, not corporate y Securities laws violations o Federal securities law violations are direct (most, not all)  Derivative actions a lawsuit initiated by one person on behalf of another, especially, in corporate law, a suit brought on behalf of the corporation by its shareholders y Why we allow this in corporate law, might be a conflict of interest o Embezzlement Board isnt going to want to sue itself  Or if they do, might just pursue a slap on the wrist  Money was stolen from the corporation, it was really the corporation that was hurt o Breach of fiduciary duties o Why Allow Derivative Actions  Director conflicts y They may not want to since they were the ones who stole or breached fiduciary duties  To police misconduct y We dont want directors to be able to get away with anything  To enforce indirect shareholder rights y Since they are the ultimate beneficiaries, everything in the corporation ultimately benefits or harms them 93

o Why Not Allow Derivative Actions?  Director Authority y 141(a) directors run the business and were taking away power o Business decision, should we sue or not, maybe leave that to the directors  Shareholder incompetence y We might rather have experts making these decisions y Some shareholders are more incompetent than others, o Might have a vendetta against the company o Or a creditor suing just to cause problems o Or an activist just pursuing a cause  Litigation costs y Recovery might not even cover the litigation costs, just not worth it y Tarnish companies reputation, bad press with public or investors y We might lose and its expensive time-wise  Incentives can be skewed y Directors o Incentive to settle  Low chance of liability under the BJR, but if they are theres a risk its a huge amount  Eliminates the possibility of an outrageous verdict  Dont have to admit culpability  The corporation, not the directors, pay for it o Also a strong incentive not to settle  Dont want to give everyone the idea they can just sue you and get money y Shareholders o Supposedly rationally apathetic, probably dont care o But even if they are paying attention, if they sue theyre going to have to pay litigation expenses  Recovery pays for lawyers if you win, but the recovery goes to the corporation, not directly to you o Probably not worth it, only possibly if youre a large shareholder y Attorneys o Derivative litigation can be profitable for them  If they win or settle, they can get attorneys fees o Entrepreneurial attorney an attorney acting as a businessperson with respect to lawsuits, making investment decisions with her time and taking the risk of profit and loss  Not really about rights of shareholders, but increasing the profitability of the firm y With this is the possibility of strike suits (courts/legislators worried here) o Strike suit - a lawsuit initiated not with the intention of winning on the merits, but with the intention of obtaining a profitable settlement

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Classic is a frivolous suit where you arent going to win, but it might be worth it for them to give you the money to go away  Can also be a strong case we dont intend to follow through on, but want a settlement o Tooley v. DLJ Shareholders sue because of the loss of time-value of money caused by the company delaying in closing a proposed merger  In corporate litigation almost always going to start with direct or derivative y 1. Who suffered the alleged harm o Corporation or shareholders y 2. Who would receive the benefit of any recovery or other remedy o Corporation or shareholders  Court holds they have no claim y Its not a derivative claim o No injury to the corporation and no recovery to the corporation y The right answer is that its a direct claim, except for the fact that they arent harmed and there is no remedy  Lower court held it was derivative by using the special injury test y If all the shareholders hurt, it probably means that the corporations been hurt, but not necessarily  Court goes through the history Courts have not been clear on when its either  Grimes v. Donald A court should look to the nature of the wrong and to whom the relief should go, and P wasnt seeking to recover damages for injury to the corporation y Found it to be a direct action, when it seems like it should be a derivative o They focus on who gets the recovery and since it wasnt the corporation, its direct, but none to the shareholder either  Not only was Grimes wrongly decided, but this court announces in this new test that Grimes was rightly decided y Even with Tooley theyre making mistakes y But we have the benefit of knowing the elements o One test now, they acknowledge the confusion before o Barth v. Barth P brought direct claim against D for substantially reducing the value of his shares of common stock  Generally, shareholders cant have direct action to redress an injury to the corporation, even if the value of their stock is impaired  Court holds this is not always the case in a close corporation y Shareholders in a close corporation stand in a fiduciary relationship to each other and must deal fairly with each other and the corporation y The money has to go back to the corporation for other shareholders and creditors benefit, not implicated in close y Or bad guys might be in charge and the money is then going back to him  Some courts have applied an exception  Delaware doesnt agree o Glen v. Hoteltron Systems, Inc. P claims D diverted assets of their company that only the two of them owned to his own corporation  95

Its a corporate opportunity so the corporation is the one harmed y Seems like a silly formality to be derivative when its just the two of them o But Court says prospect of money going back to the one causing injury exists in any derivative action, no new rule for close corps o Pro Rata Recovery  Involve derivative action, when its granted, the recovery goes straight to certain shareholders y Each get a share of the recovery equal to percentage ownership of stock y They still must satisfy all the elements for bringing a derivative action and the amount of damages is measured by injury to the corporation  Cases suggest it will be decreed when the bulk of the corporations shares are held by persons who could not themselves have brought the suit because they are subject to a personal defense (such as acquiescence or laches or wrongdoer) o Clarke v. Greenburg Whether a P in a derivative action is required to account to the corporation for money from a private settlement YES  Allow plaintiffs to settle y Because then greater incentive to bring suits or because theyre bearing the cost of litigation so it would be unfair to tell them they cant  We maybe shouldnt allow them to settle y Abuse of the system, suing just to get a settlement (strike suit) o But the real risk is a little different than a strike suit  Problem is that by settling, money is going directly to you and the corporation can settle for less and it can harm other shareholders who arent part of it y P must account for money received in a private settlement y They were allowed to sue on behalf of the corporation and they owe that money to the corporation  Attorneys fees It was a legitimate expense if he gets attorneys fees y Attorney would still be entitled to the attorney fees o Modern rule on settlement of derivative actions  Derivative action can settle only when the courts approved it y Not going to allow them to settle on their own y The general standard is fair, reasonable,  Downside is that judges have an interest in pushing settlements anyway y They have lot of cases, both sides saying its a fair deal y Not many courts are going to be willing to say its unfair o Are derivative actions strike suits  Corporate world, courts and sometimes the legislatures seem to think so  Empirical evidence y Shareholders rarely win a trial, suggesting its a waste y If there are settlements, we see that they are small dollar recovery for Ps and large for attorneys, really about attorney  Procedural victory and a change in management tends to follow so may be meaningful y 29. LIMITS ON SHAREHOLDER SUITS o Limitations on Standing 

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Contemporaneous Ownership Rule a rule of standing requiring that, in order to initiate a derivative action, a plaintiff must have been a shareholder at the time of the action complained of and must maintain ownership through the end of the lawsuit  Demand Requirement a rule of standing requiring that, in order to initiate a derivative action, a plaintiff must have made a demand upon the directors that they pursue the action complained of y Two exceptions o Demand futility if it would be futile, many courts wont make you  Futile when the directors are conflicted o Irreparable harm if requiring you to make the demand would cause irreparable harm  Merger would be a reason, wont be able to undo the merger, so could be for injunctive relief o Bangor Punta Operations v. Bangor & Aroostook R.R. Bangor Punta sells BAR to Amoskeag, claim is that Bangor Punta mismanaged the company and directly harmed the corporation before it was sold  The suit was purported to be on behalf of the corporation but the actual beneficiary was the new majority shareholder who bought it after the fact y Even though corporation is suing corporation, they say its really about the shareholders  It matters whether its direct or derivative because of the contemporaneous ownership claim y The shareholder cannot be barred from suing directly y But if its a derivative, then he cant sue because he wasnt a shareholder at the time of the harm  Court is saying in equity, they cant maintain the present action y Where equity would preclude the shareholders from maintaining an action in their own right, the corporation would also be precluded y A shareholder may not complain of acts of corporate mismanagement if he acquired his shares from those who participated or acquiesced in the allegedly wrongful transactions o Presumably having known it, they adjusted the price accordingly  Corporation was in fact injured, but the wrongdoing was already reflected in the price they bought it for, so allowing recovery wouldnt be fair y Court focuses on this concern shouldnt be able to pay less and recover y Thats not something you would need to do in a direct, which it actually is, so the court is looking at it as a derivative  Didnt have to do this through the contemporaneous ownership rule, but they did y But that rule cant really be based on lack of harm o You can be harmed when not a contemporaneous owner, if a corporation was harmed, and that harm persists o Very inclusive rule to say non contemporaneous owner means you werent harmed  Really just to prohibit frivolous lawsuits, prevent the manufacture of plaintiffs y Prevent people from buying and then suing after the fact  97

Here we have a situation that in equity begs for a solution and contemporaneous ownership rule is probably forced into here where its not really a derivative action  This is an odd situation, an odd case, its generally more straightforward y The court really went with equitable principle rather than contemporaneous, even though they said it was that (dont stress on these) o Rifkin v. Steele Platt Buyers bought a corporation without knowing the sellers had made inaccurate financial representations, hes suing on behalf of the corporation on certain things, but also alleging he was defrauded as a buyer elements of both  Breach of fiduciary duty claim is derivative-ish  Defrauded is direct  Matters whether direct or derivative for the same reason y If direct, he can sue, if derivative contemporaneous rule blocks  Unlike the other case, where they didnt make a claim that they were defrauded y It wouldnt be a double recovery here, would be fair to let them proceed  Rule about no recovery if buying from the wrongdoer wont apply if they were defrauding you o Marx v. Akers Complaint alleges the board wasted corporate assets by awarding excessive compensation to IBMs executives and outside directors Question is whether the P had to make a demand on the board to initiate a lawsuit  626 Before a derivative claim, P has to show efforts to secure initiation of action by board, unless such a demand was futile y If its futile it may be excused  Court says it wont be sufficient to just name a majority of the board as defendants in the complaint y You could then just always draft one that includes all the defendants y So courts will look to whether you were really conflicted in the matter  You also have to make particularized allegations of demand futility y Procedurally make allegations, detailed pleadings, specific statements y Very demanding as a substantive matter; you dont yet have discovery o You have to put together a mini case to allow the case to proceed  Demand futility shown by NY rule y 1. Majority of the board is interested in the challenged transaction o Loyalty y 2. The board did not reasonably inform themselves o Duty of care y 3. So egregious on its face o Substance or good faith y Sounds like all the fiduciary duties  Court says demand is not futile on aspect of executive compensation y Most were outside directors so theyre not conflicted and can make a good decision whether or not to sue  But director compensation part they are conflicted y When directors are setting their own salaries, they are necessarily conflicted 

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But court holds there is no cause of action, they have not stated a wrong to the corporation which had to have been compensation rates excessive on their face and not possible to be of a valid business judgment o Sounds like a waste standard, substantive o If its not, then we have to litigate every board of director decision y But waste test is not obviously right because we use that when there isnt a conflict of interest o Conflict we use the entire fairness test y Substance and procedure o Procedure have to prove entire fairness y Some slight of hand here y Have to meet the waste standard, but there is an acknowledged conflict o They dont want to get into compensation, so theyre willing to look past structural bias o Ill-fitting o Delaware Approach slightly different test  Complaint must allege particularized facts which create a reasonable doubt that: y 1. Directors are disinterested and independent; and y 2. The challenged transaction was otherwise the product of a valid exercise of business judgment  Reasonable doubt means something like any reasonable possibility that its true y Pretty low standard to establish, but thats not the way it work, so its unclear why they use that standard y We have to have reasonable grounds to believe is what they really mean  Thats better than proving theres not a conflict, but you still have to demonstrate it with particularized allegations  Also, if you make a demand, you waive demand futility y But in order to not make the demand, you have to plead particularized allegations without discovery y You have a pretty bad choice o Model Business You have to make a demand  After making the demand, 90 days for a response before you can sue  Good idea because why get into litigation before we really have information  Bad idea because the corporation will likely reject it in their business judgment y Can argue its a wrongful decision, but good luck with that o Zapata v. Maldonado Dealings within the company that allowed senior officers to exercise their options before the market price rose as a result of the tender offer, saving a considerable amount of taxes and preventing Zapata from realizing a tax deduction  Derivative action that went to trial y They didnt make a demand but it was dismissed as futile y Then the board made an independent litigation committee that decided it should be dismissed and they moved for dismissal or summary judgment  The committee is two directors who are new and not interested y They were given final authority board couldnt overrule it y

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Theory The corporation gets control of litigation unless theyre conflicted, and since they were here, they can delegate authority to the unconflicted committee y Argument they cant is structural bias o That these are their colleagues, friends o Court kind of agrees seems to justify caution  BIG issue where Courts recognize structural bias y One is compensation issues y The other is derivative litigation y Third is possible takeovers  They create a 2-step test y 1. Look at whether this really was an independent committee o Corporation has to prove that they were independent y 2. Then the court applies their own business judgment o VERY ODD courts dont apply their own judgment o They think theres a structural bias we have to do something about  But the reason for the business judgment rule is that courts dont know business o Intended to thwart instances where it meets step one, but doesnt comply with the spirit o This is not just reviewing something like conflict of interest, which they already proved, this is further saying they get to decide y This is an intermediate standard of review o Conflicts we have entire fairness test o Structural bias in derivative litigation this test  No case heard of that found for in part one and then found against in part 2 o Concept of independence  Historically we focused on whether a director was disinterested, but thats not really enough, so courts are looking to independence y Disinterested not having a (material) financial stake y Independent able to make a decision based on the substantive merits rather than based on extraneous considerations or influences o Special litigation committees  In re Oracle Court Derivative action brought for insider trading, a two-person special litigation committee moved to dismiss the action y SLC was not considered independent because the other person regularly gave money to the university y This kind of analysis takes the concept of independence very seriously y Is it really the case that a tenured professor is going to care about someone who gives money to the university?  Bean v. Stewart Personal friends were nevertheless found to be independent y Court says allegations of mere personal friendship are insufficient to raise a reasonable doubt y Someone could much more easily conclude they were not independent in this case over Oracle y 100

y This is a SC case decided after Oracle More likely to follow Beam y But the truth is courts are wrestling with what to do with this y 30. EXCULPATION, INDEMNIFICATION, AND INSURANCE o Fall out of Van Gorken was exculpation statutes which allows the corporation to limit or eliminate duty of care liability  Opt in provision in Delaware, have to amend the Charter  But you cannot exculpate them for breach of the duty of loyalty o Delaware SC decided it was an affirmative defense  This is after Emerald Partners Protection under 102(b)(7) is in the nature of an affirmative defense; burden of demonstrating good faith is upon the D seeking the protection of the statute on exculpation y Consequence of this is we cant just dismiss on the pleadings  Business Judgment rule had allowed them to get rid of litigation pretty early on y Courts seem to want to get rid of cases early on, less litigation cost y Now if its an affirmative defense, maybe it requires discovery and a trial o This reduces the risk of settlement value strike suit o Malpiede v. Townson Claim is that the sale of Fredericks to Knightsbridge was a breach of the boards fiduciary obligation to maximize shareholder value because they didnt conduct an auction with a level playing field as required by Revlon  Plaintiffs challenging director conduct have the burden to allege well-pleaded facts that the conduct falls within the exceptions of the Delaware statute  No-shop a provision in an acquisition agreement providing that the target may not solicit competing offers, but may entertain them if they arise  No talk a provision in an acquisition agreement providing that the target may not even entertain a competing offer until the current offer is consummated (or terminated) y This one is rare, much more susceptible to breach of duties y Especially problematic in regard to Revlon o If a company is for sale, directors have to seek the highest price and how can you get this if youre not talking to anyone else  Ds say theyre exculpated, they cant face liability for this, seek dismissal y No duty of loyalty claim because the board was not in conflict y Possibly a duty of care claim, but they dont decide because even if it existed, the directors are exculpated o Theres no way to find them guilty, so they can dismiss the case y When only seeking damages (not an injunction) dont have to go to trial o Exculpation protects directors only from money damages o Had they sought injunctive relief, the exculpation would not have released them  But, could still go to a trial and try to determine whether or not there was a breach of care and then not count the exculpation until the damages stage y Even if you cant get money, it might show that they did something wrong y If we dont have these cases, then the duty of care almost does disappear  Revlon issue the D doesnt seem to be seeking the best price, seems like they favor Knightsbridge and the provisions prevent finding a better offer

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Maybe they did seek the best price since it was a year long process, not illogical that a no-talk provision could be a good idea at some point o But if its a factual question, seems hard to get rid of it on the pleadings before you even get to judge o Indemnification and Insurance under 145  Indemnification reimbursement of a loss or expense incurred by another  (a) allows indemnification in direct actions  (b) allows indemnification in derivative actions  (c) requires indemnification if defendant is successful on the merits or otherwise  (d) requires specific authorization for any indemnification payment under a or b  (e) allows advancement of expenses y Allows the company to advance expenses for litigation to you, provided that the agent reimburse the company if you are not entitled  (f) allows additional rights y Increase rights to indemnification in the Charter, to go beyond the legal minimum  (g) allows liability insurance for corporations to fund its indemnification obligations y Might seem problematic to allow insurance, which allows the corp to indemnify indirectly, when we wouldnt allow indemnification directly o Premium payments for such policies based on the probability of risk  Presumably companies with more safety and internal controls will have to pay less o The theory is that the director herself could have bought the insurance and it shouldnt make a difference that the company compensates her by paying the premiums o Corporation is insolvent, insurance allows us to know theres someone to pay the director even when the company cant o Waltuch v. Conticommodity Services, Inc. Silver trader seeks indemnification of his legal expenses from his former employer  P He is entitled to indemnification for both his private and company actions y Indemnification was allowed by the terms of the Charter y But the court doesnt allow indemnification o 145(a) says its limited by good faith  D says its not exclusive and the Charter can expand the right to indemnify so the company doesnt say it needs good faith y Court you can expand, but you cant go against Delaware law o Not requiring good faith is inconsistent with the law  No indemnification under a (direct actions), but he can get it under c (successful on the merits or otherwise) y He was not successful on the merits, but he was successful because he settled and didnt have to pay anything o Escape from an adverse judgment for whatever reason  (a) and (b) are really about if the D loses y He can be indemnified unless acting in bad faith y 102

y For (c) its not optional, they must if he wins y Distinction between power and rights o Citadel Holding Corp. Suit is brought against Roven and he demanded indemnification under the companys general indemnification agreement  Charter indemnification excludes section 16(b), which is the action he assumed, but he still gets indemnification y Allow advancement of cost because he might be entitled to indemnification, but it says he wont be entitled to indemnification o So it seems odd that even though they wont allow indemnification, they have to give him advances, which he has to pay back  Solution is section (c) if he ends up winning the section 16(b) suit on the merits, the corporation must indemnify him, even if they tried to preclude that y 145(c) entitled to it notwithstanding the charter  An unlimited right to advancement of expenses you always have the chance of winning, even if your contract tries to exclude it o In re Landmark Land Co. Agent who participates in illegal conduct against third persons cannot be said to have acted in good faith  Going to mean that were going to put all the onus on this person, even if were granting that it benefits the corporation y Corporation might even be looking the other way, benefitting  Difficult case wheres the cutoff between loyalty and good faith issues y Good faith has generally been defined to exclude intentionally illegal behavior y Policy determination that the law cant condone illegal behavior y 31. SHAREHOLDER RIGHTS TO INFORMATION o Saito v. McKeeson HBOC, Inc. P alleges wrongdoing on companys part and wants access to information to prove it, uses DGCL 220 (Inspection of books and records)  Right to information can be important in making particularized allegations y One way to do this is through inspection rights right of shareholder to inspect the corporations books and records  Shareholders cannot freely seek access to corporation information y Statute says you have to have a proper purpose reasonably related to their interest as a shareholder, including possible corporate wrongdoing y Directors might not want to allow the intent to sue to be a legitimate purpose, but from corporations perspective thats clearly legitimate  Not limited to documents created by the corporation y You can still have access to third party documents, the sources has little bearing on shareholders right to information in corporations possession  Standing limitation y Shareholders who bring derivative suits must be stockholders at the time of the transactions (327) o But this doesnt mean you cant get information before that time y Even if contemporaneous shareholder rule should govern, there can be continuing wrong and background information may be important o Pillsbury v. Honeywell Pillsbury buys stock so they can go to other shareholders and get the company to stop manufacturing weapons 103

Improper purpose Court holds its not a proper purpose germane to his economic interest as a shareholder y Once it is determined the shareholder has a proper purpose, any ulterior motive doesnt matter o Seinfeld v. Verizon Shareholder sues corporation for information on the compensation of its highest officers because he thought they were wasteful/excessive  P was essentially trying to change the standard y He says that in order to have derivative litigation, you must have particularized claims, and he shouldnt have to prove anything now since hed have to prove it at trial y Pretty good argument but court disagrees  Court holds shareholder must have some evidence to suggest a credible basis from which a court can infer wrongdoing y Strike a balance between the rights of shareholders and management y Court is getting something confused, its not that management has rights o They have authority to run the business o They dont have a right not to be bothered by the shareholders y Dont want everyone to be able to pose all kinds of costs on the corporation on fishing expeditions o If you have reason to suspect something, maybe its worthwhile  The threshold y Court calls it the lowest possible burden of proof, but also say its not insubstantial So is it a low burden or a high burden? o This case is only the second time that the court has found the claim to be entirely without a credible basis o Theyre not routinely getting rid of these claims y This test is for when were trying to establish and investigate wrongdoing o Different if trying to communicate with other shareholders  Its not a binary question do you get documents or not, its that you only get the information related to what youre investigating y Not going to get information on wrongdoing if you just ask for the shareholder list y Also cant get information on any kind of misconduct, only specific claim  Its not a proper purpose to want information just on compensation y Same argument that you dont want to let shareholders in on everything y But it also seems that at every turn were going to let corporations pay whatever they want without restriction o Information Rights  1. It can be costly if you have lots of shareholders doing it in lots of corporations y Courts are trying to strike a balance  2. Shareholder lists y Pretty liberal in giving these out under state law (except Pillsbury) y Federal law (14a7) Any corporation must either give shareholders a shareholder list or offer to mail the material to other shareholders at the one shareholders expense 

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When theres a conflict between state and federal, federal would govern o But courts dont consider this as a case of preemption  Under federal law, both can be applied at the same time o Corporation then has an option of giving you the list or mailing on your behalf under federal  If state law didnt say you have to give the list, then federal law gives you the option of those two  So, in most cases, because of state law, you have to give them the list  3. Required disclosure y Traditionally state law doesnt require corporations to disclose information to shareholders y Model Business Corporation Act changes this o Requires annual financial reports  Better than nothing, but still pretty limited y Delaware doesnt even require that, they dont have to talk to shareholders o One exception any time they are asking for shareholder action, they have to give information (Every year election of directors)  4. Candor y Corporation doesnt have to say anything, but if it chooses to speak, it cant mislead the shareholders y Courts used to speak about the duty of complete candor o Now they say a duty of materiality idea being that complete candor means I have to be completely above board o Materiality says for the most part accurate y When it switched the court said there was not real change here  State law information rights are not that big y This, among other things, led to the federal government stepping in o History of Securities Regulation  State securities regulation y Originally securities werent regulated besides common law fraud y Blue sky laws state securities laws o One main feature was merit regulation o If you want to sell securities in a state the state got to regulate it and determine if they wanted to sell it, judge it on the merits o Merit regulation wasnt the best idea  Is the government really able to tell whats a good investment and how can they really enforce it when its a national problem  Stock Market Crash of 1929 y Seemed to have caused the Great Depression y Led to an absolute need for federal securities regulation o Eventually it supplanted state law (its now close to meaningless) o Federal government decided not to engage in merit regulation  They can sell anything and you can buy anything  Federal securities regulation y 105

Mandated disclosure o Adequate and accurate disclosure o Shareholders get relevant stuff, government gets even more o With complete information, they can decide for themselves if they want to buy it y Antifraud liability o Company is liable if the information is inaccurate o A lot more regulation than under state y No merit regulation o Federal Securites Laws  Securities Act of 1933 y Primary markets the market for securities sold by issuers to investors o This is what it regulates for most part o For securities sold by the company to public o IPO Initial public offering  The first sale of stock by a private company to the public y Mandated disclosure Must register securities and file a detailed statement, deliver a prospectus before selling securities to the public o Registration statement document, including a prospectus, which is required to be filed with the SEC in connection with public offering o Prospectus a document used to offer securities for sale in a public offering  Total information about the company  SEC then reviews that for adequacy  Once done, declared effective o Unless exemption if available (Not a public offering, just a private) y Antifraud liability o Company is liable for false or misleading statements or omissions of material fact (deception) o Pretty high standard  Securities Exchange Act of 1934 y Regulates primarily secondary markets o Secondary market - the market for securities sold by investors among themselves o Almost all securities transactions are secondary markets o Similar to primary, but different in rules  Very common, people trading all the time, so cant have the same detailed process y Still have mandated disclosure o But we say they have to file periodic reports on company performance; Yearly and quarterly o Must file additional reports under certain circumstances o Idea being that shareholders will be more or less up to date y Antifraud liability o Manipulation and deception y

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o Company is liable, but you are also liable if you make false or misleading statements, individuals y Securities industry generally y Securities and Exchange Commission - the agency established to oversee the enforcement of the federal securities laws  Federal security law is not the same as state corporate law y State corporate law, form trumps substance y Federal securities law, substance trumps form  Theres no race to the bottom y When federal law is regulating it doesnt care what anyone else is doing like states have to worry about what other states are doing y 32. RULE 10b-5 o Rule 10b-5  SEC rule under Exchange Act 10(b) y Congressionally delegated authority  Forbids, in connection with purchase or sale of securities: y Devices, schemes and artifices to defraud y Practices which operate as a fraud or deceit y False or misleading statements or omissions of material fact  Enforcement y By the SEC y Private investors o Courts have found there to be an implied private cause of action o Not clear it was intended by Congress or the SEC, but it has become a significant provision in litigation in securities laws  Elements y Interstate commerce y Material misstatement of omission required (Deception must significant) y Scienter Intent to deceive (or recklessness) o All lower courts have agreed that recklessness will suffice, though SC has never said so y Connection with a purchase or sale of securities o For you to sue you have to have bought or sold securities y Reliance y Causation y Damages o Can only recover your economic loss, possibly an injunction, not more than that o Basic v. Levinson Basic begins engaging in merger negotiations, but gave false statements that they werent doing so, shareholder sells shares and claim they were injured by selling shares at artificially depressed prices in a market affected by petitioners misleading statements  Materiality Substantial likelihood that a reasonable shareholder would consider important in deciding how to act y Court holds that preliminary merger negotiations arent immaterial

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But when the event is contingent or speculative in nature, this standard makes it difficult to tell, so they go with the probability/magnitude test y Whether merger discussions are material depends on the facts o Case by case y SC rejects the agreement-in-principle approach of lower courts (merger negotiations not material until an agreement had been reached) o Doesnt mean its not material if theres not been an agreement Courts were worried about revealing corporate secrets, so now if you have to reveal merger negotiations, that could be a problem y But this is not about disclosing all material information y Materiality is about accuracy of disclosures, not timing, said SC y You dont have to automatically say anything, dont have to disclose everything all the time, but you have to be accurate about material things o The only thing you can do is to always say no comment when asked about merger negotiations if you want to keep secrets  No comment is the functionally equivalent of silence Reliance and fraud-on-the-market theory y If we require each and every plaintiff to show reliance, we cant have a class action, but its part of the requirements y Fraud-on-the-market theory o Sounds like the efficient marker hypothesis based on the assumption that current market prices reflect current information  So current prices reflect that misinformation  Dont have to have relied on the information if I relied on the market, which should have relied on that information  You lied to the market, so you re-lied to me y Sounds like were getting rid of reliance, but its just a rebuttable presumption of derivative reliance o 1. Court says they can still rebut the reliance by showing it didnt really affect the price o 2. Can also rebut it by showing its not an efficient market, which means we cant assume that a lie affects the price  Not going to work with a stock that trades on the NYSE  But not all businesses will trade on an efficient market o 3. The individual would have sold no matter what, no reliance  Realistically can scratch this third one off the list y Theyre trying to preserve some semblance of reliance o Watered down to the point where we assume reliance (bizarre) Rule requires it to be in connection with a purchase or sale of securities y This case isnt really about those things, but courts have been very relaxed on this one (Dissent takes note of this) y Court basically says there was a fraud and they knew there would be a sale or purchase in association with that later o There just has to be some minimal connection y If we didnt do that 10b5 wouldnt ever really apply to the company

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o Santa Fe Industries, Inc. v. Green Company performs a short-form merger, minority shareholder thinks the price was significantly too low, so sues under 10b-5  Claim Santa Fe knew the valuation was fraudulent y But really its about an improper purpose of trying to freeze out the minority, really nothing more than a breach of fiduciary y They didnt withhold information or misrepresent it  SC says the federal law doesnt protect shareholders against a breach of fiduciary duty without any misrepresentation or lack of disclosure for 10b-5 y Federal securities law isnt really about fairness, only about disclosure o Once disclosed, the fairness of it is at most a tangential concern o Not saying unfairness is ok, but there are other rules for that o 10b5 is about disclosure  Before this the federal laws were being interpreted very broadly y This is one of the first cases where the SC stops it  Looking at fairness anyway y Valued o Ps valuation of the shares was over 700 o Morgan Stanley was 125 o Company gives 150 y If a company is worth more dead than alive, you ought to kill it o If theyre getting out, they should probably be paid the high amount y State court said 254 because theres nothing that said they had to liquidate  Its also not manipulative y The term refers generally to practices such as wash sales o Basically wash is when you buy and sell at the same time to make the stock look active and cause the price to go up, then sell o Hypo Ps decide not to buy based on overly pessimistic evaluation of the company  Then turns out they do really well, and I want to sue  Cant sue, its not really in connection with a purchase or sale of securities  We dont know how many shares the person was going to buy y Goes too far to allow people to sue on what they didnt buy  This is what the SC decides it goes too far y Blue Chips Stamps v. Manor SC says it would open up a can of worms o For a private plaintiff to sue under a 10b5, you have to actually be a purchaser or seller y 33. INSIDER TRADING o Insider Trading the use of material, non-public info in trading the shares of a company by a corporate insider or other person who owes a fiduciary duty with respect to such information o Goodwin v. Agassiz Court found the Ds not liable when shareholders sued insiders in the corporation for purchasing stock from them based on information they had  Court held directors and officers have no such duty, at lest in an impersonal market, liability requires a face to face transaction  Very old case, pre-dates federal securities law o In the Matter of Cady, Roberts & Co. (Modern case law) Those with access to insider information cannot engage in securities transactions to benefit from that information\ 109

Not limited to insiders, who is obligated rests on 2 principles: y 1. Existence of a relationship giving access to information intended to be available only for a corporate purpose, not personal benefit y 2. The inherent unfairness involved where a person takes advantage of such information knowing its unavailable to the one dealing with o SEC v. Texas Gulf This is not the law  New rule in second circuit (767) y Anyone in possession of material inside information must either disclose it to the investing public, or, if he is disabled from disclosing it in order to protect a corporate confidence, or he chooses not to do so, must abstain from trading  But Rule 10b-5 is about deception (767) y Second circuit said that Rule 10b-5 is based in policy on the justifiable expectation of the securities marketplace that all investors trading on impersonal exchanges have relatively equal access to material information o Insider trading is inherently fraudulent y But it might not be true that there should be a level playing field o Why bother playing people play because they might get ahead y There are good reasons for it, but not clear its the perfect fit o Chiarella v. United States Printer who saw documents about target corporation in his line of work and purchased stock then sold after takeover attempt, earning $30,000  He is indicted by the SEC, Court here said SECs position was not correct y Rule 10b-5 doesnt cover insider trading as such, it covers deception y May cover insider trading, so have to ask if its deceptive  Failing to disclose information is fraud only when he is under a duty to do so y Duty to disclose arises when one party has information the other party is entitled to know  10b-5 it has to be about deception, Court says insider trading it not necessarily y Insider trading in breach of a fiduciary duty can be deceptive though o If youre an insider and you have a duty to disclose and you dont, thats deceptive o Fiduciaries implicitly represent that they are acting in good faith, which the public does not represent (Printer doesnt have that duty)  Essentially he is a stranger with no fiduciary duty to the company  Ground work for 10b-5s dealing with insider trading y Have to have a breach of fiduciary duty y Nonfiduciaries dont violate 10b-5 by insider trading o Dirks vs. SEC Secrist was a former insider who tells Dirks the company has fraud and to investigate, Dirks tells others about his investigation, who then sell their stock  SEC only censures him because he helps them expose the fraud y Not concerned with him, just trying to minimize damage from Chiarella  SEC theory Where tippees comes into possession of material corporate information they know is confidential, they must refrain from trading or publicly disclose that information y He has no fiduciary, but they wanted to get him anyway 

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SC rejects SEC There has to be a breach of fiduciary duty here (not because 10b-5 requires fiduciary duty, but because it makes it deceptive) y SEC Tippee automatically assumes the fiduciary duty when they get the info y Court A tippee assumes a fiduciary duty to the shareholders only when the insider has breached his fiduciary duty to the shareholders by disclosing the information to the tippee and the tippee knows or should know that there has been a breach o Test for whether a disclosure is a breach of duty depends on whether the person will benefit from the disclosure  Secrist had no breach of fiduciary duty under this rule because he got no benefit y Since no breach by Secrist, there could be no breach by Dirks o Dirks would have to inherent the fiduciary duty y You inherit fiduciary duty when there is a breach and you know it o Secrest didnt breach, so no one down the line can be in breach o Once one person breaks the chain of both breach and knowing of the breach, it ends it, no one else is liable after y You must have an unbroken chain of fiduciary duty o United States v. OHagan (Court is expanding liability) Grand Met hires law firm OHagan works for in acquiring Pillsbury, he buys Pillsbury stock and sold it after at a huge profit  Tender offer public offer to buy a minimum number of shares from stockholders, usually in an attempt to take control, offered at a premium y Greats opportunity for insider trading  Court says insider trading applies not only to permanent members of the corporation, but attorneys, accountants, etc. who temporarily become fiduciaries y Only attorneys for the relevant client are constructive insiders o Hes an outsider, no duty to shareholders of Pillsbury y Not an acceptable solution since tender offers were a problem of insider trading saying it was ok would have created quite a problem  SEC loses in Chiarella, is somewhat limited in Dirks, so want to expand here y They expand rule 10b-5 under misappropriation theory, Court agrees o A fiduciary who pretends loyalty to the principal while secretly converting the principals information for personal gain dupes or defrauds the principal o Its about an outsider duty to the source of the information  Weak connection to purchase or sales of securities y But the Court doesnt require a strong connection y Securities transaction and breach coincide here o Hes not breaching anything by having the information, he breaches it when he engages in securities transaction  The two then are related o Misappropriation theory comports with 10b language in allowing liability for a lawyer working for the bidder  One big loophole in misappropriation theory is disclosure 

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Full disclosure forecloses liability under misappropriation because then there is no deceptive device y But its still a breach of duty of loyalty under state law y Footnote 7 can still be liable where they owe a duty of loyalty and confidentiality to two entities and they only tell one o Rule 14e3 promulgated by SEC after Chiarella and Dirks  Saying no trading with non-public information, regardless of fiduciary duties  Its a lot like section 10b and yet the SECs theory was rejected under 10b5 but upheld under 14e3 y 10b only authorizes the SEC to proscribe fraud y SEC is authorized to promulgate rules to prevent fraud and that makes 14e a prophylactic measure  Chiarella and Dirks are still good law y Nothing wrong with them, its that 14e3 relates to tender offers y If not a tender offer it goes under 10b5 o 2 major differences in 10b and 14e  14es delegation of authority is much broader than fraud, but scope limited to tender offers y 34. BUSINESS COMBINATIONS o Acquisition a general term that refers to a business combination of any type o Takeover an attempt by an acquirer to gain control of a target  Acquirer one seeking to take over a business  Target business that is the object of a takeover o 3 Main Types of Acquisitions  1. Stock Purchase acquisition in which an acquirer buys the stock of the target from the target shareholders y The target becomes the subsidiary of the acquirer y In relation to the other forms its A + B = A + B o Both there before and after y Shares purchased directly from shareholders (Ex; tender offer) o Theoretically, the target company isnt involved, really a transaction between the target and the shareholders o No say for target directors, each shareholder makes up their own mind, no approvals y If they get enough, they become controlling, if not, they dont  2. Asset Purchase acquisition in which the acquirer purchases the assets (and maybe the liabilities) of the target y One company ends up taking the assets of both o A+B=A y Two companies can technically remain, but in the end theres really only one operating company o The other would be a shell company a corporation without significant operations, often formed for a particular transaction o What usually happens is the target dissolves y Need specific approval of targets directors and shareholders o If selling all the assets, need directors and shareholders y 112

 Shareholders dont get a say in much, they do get it in this o Acquirer approval is not necessarily required  3. Merger an acquisition in which an acquirer and a target combine into one y A+B=AB (AB can actually be A, B, or C) o Can be called any of those, the one corp, the other, or a new name y Constituent corporation corporation party to a merger (A and B are) y Surviving corporation the constituent corporation that survives the merger o If B merges into A, A is the surviving y Resulting corporation new corporation formed as a result of the merger y Need approval of both companies directors and shareholders o Merger Procedures (DGCL 251)  Prepare Merger Agreement y Technical requirement, it sets forth what will happen in the merger y Especially the consideration for the shareholders  Approval of directors of each company for the merger  Approval of the shareholders of each company y Law considers this very significant since it can change the entire corporation, so they let shareholders vote y Delaware, says need a true majority, over 50% o Nos count as no, but so do abstentions o Need affirmative Yes  File with Secretary of State y Generally they file a certificate of merger  Dissenting shareholders are entitled to appraisal rights y The right to forego the contractual consideration in a merger and to receive instead the fair value of the shares  But can have companies from two different states merging, which law governs y Its both laws, the merged corporation doesnt exist yet o Merger Consideration  Standard Merger all combined into resulting corporation y Consideration is shares in the surviving corporation o You had shares of B and in exchange for approving the merger you get shares of C y The number of shares depends upon the value of constituent corporations, not automatically getting the same number of shares o The number of shares may vary in each corporation and each of their individual values then vary  Legal Possibilities y Any consideration o It can also be securities, property as consideration, not just shares  Can be anything (bottles of whiskey) y Different consideration o Can say A gets common stock and B gets preferred stock or any kid of combination

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o Cash-out merger a merger in which one companys shareholders receive cash instead of shares in the surviving corporation  Doesnt really look like a merger, more like an asset purchase o Merger of equals a merger in which there is no real acquirer or target, but two equal companies truly combine into one o Appraisal Rights  Appraisal rights - the right to forego the contractual consideration in a merger (or similar transaction) and to receive instead the fair value of the shares y Most states allow an option of appraisal rights, this is pretty major y Once upon a time required unanimous consent (now usually just a majority)  Delaware y Idea was that if you dont like mergers, sell your shares if its a public corporation o If consideration is bad, youre not going to be able to get the right consideration y In purely public transactions where you receive shares, you dont have to have an appraisal right o Just for mergers, and not all mergers get appraisal rights  Other states y You have more expansive appraisal rights, not just for mergers, but asset purchases and certain charter amendments  Delaware Procedures 262 y Company must give notice of appraisal rights y Shareholder must demand an appraisal before the vote y Shareholder cannot then vote in favor of the merger (no or abstain) y Then petition the court for an appraisal within 120 days y Court then determines the fair value of shares o Any reasonable techniques can be used o Generally no minority discount applied to shares  Argument against it market isnt willing to pay for those shares so why would you get it  If you didnt controlling shareholder could become very oppressive an then dont get fair value o It may be less than merger consideration  1. 262(h) provides that the determination of fair wont include fair value arising from the value of the merger y Synergistic advantage combine certain skills, resources, etc., so the whole is greater than its parts y Supposed to be looking now, not in the future with the benefits of the merger  2. An acquirer usually pays extra, premium y Premium an amount above the market price paid by an acquirer to target shareholders in order to purchase the shares 114

3. Appraisals are costly, theres transaction costs involved y At least in Delaware, the shareholder pays that y In other, the corporation pays and its not a factor y To be able to afford it, should be a pretty big shareholder, and big difference between fair value and appraisal to pay for those litigation costs o Ex; Santa Fe v. Green o Hollinger v. Hollinger Hollinger International wants to sell Telegraph, its biggest asset shareholders sue, claiming its a sale of substantially all the assets  271 Corporation can sell substantially all its property and assets when authorized by a majority of shareholders  D claims 271 not implicated at all because International is not selling its assets, its the asset of subsidiary y Maybe that subsidiary needs shareholder approval, but thats easy because those shareholders are part of the corporation  Court disagrees because the parent company was a party to the agreement, it was a signatory to the agreement y Technically, it didnt have to be there, in which case, then maybe it would have been ok BUT that cant really be o We include them for the buyer, liability, no formal reason o Court here is rejecting the formal argument, looking at substance  Strange because form is supposed to prevail over substance y Possible demarcation point, the court says they dont need to decide since they fail on the other point  Even if they were doing all this, they still have to apply 271 y Courts have just pulled out numbers on what substantially means o Some say over 50%, sometimes even below 50%, sometimes higher y This court didnt really say what that means  They rely on the Gimbel test to decide this (1043, bottom) y 1. Quantitatively vital A big number o Court says it isnt here, its not substantially all y 2. Qualitatively vital Does it substantively affect the existence and purpose of the business o Not saying this was a matter of feelings, still about economics o Could imagine one asset is 30% of the assets, but 100% of the profits that sense it is qualitatively very important  Not just whether its 80-90%, maybe its disguised by just that one number y 35. FORM AND SUBSTANCE IN BUSINESS COMBINATIONS o Loopholes?  Stock-for-assets transaction y Corporation A issues shares of its own stock to Corporation B in exchange for substantially all of Bs assets  Cash-out merger y Merger in which the acquiring company buys the stock of the target company for cash, in effect cashing out the stock of the target company  115

Law allows merger consideration to be anything you want it to be o 3 levels of defense if we think it might not be fair  Fiduciary duties, shareholder vote, appraisal remedy o Nothing inherently wrong with the cash-out merger  Short-form merger procedure under some states laws under which corporation may merge with a subsidiary without a shareholder vote y Delaware 253 provides that a parent can merge with a 90% subsidiary without shareholder approval y It has to be a very simple straightforward merger, no Charter amendments o In a normal merger you can do whatever you want with the charter  Triangular merger between one corporation and the subsidiary of another y The subsidiary is usually just a shell corporation organized specifically for purposes of this merger o There is no law that allows this in particular, they just invented it out of law y Acquirer might want to acquire the target through the subsidiary because the law provides in a statutory merger you need the approval of both constituent corporations o The merger is technically one company and the subsidiary of the other company, you can avoid shareholder vote of the acquirer o Ss shareholders, which becomes B (the buyer) o In a takeover, the acquirer needs to pay a premium and the target, who gets the premium, will be happy with the deal, while the shareholders paying the premium might not be y After the triangular merger, can follow up with a short-form merger o Merge A into B without shareholder approval o In two steps, effectuated a merger, but eliminated the requirement of the vote of the acquirer o This procedure is almost exactly the same as a one step procedure, but without the shareholder vote on one side y This is the height of form trumping o Substantially the same o The only difference is that you cant sneak in charter amendments, but other than that, it is a merger o Perfectly legal (CA some problems page 1081) o Considerations  Structure after the merger y M and AP one surviving company y SP and TM two corporations, parent and subsidiary  Ownership y M, TM, and AP the acquiring corporation will get 100% of everything y SP minority shareholders left over o You dont have complete freedom to do whatever you want  Liability y M joins two companies liabilities, eithers liabilities can ruin it o Unknown past, big risk y 116

SP and TM keep liabilities separate o Unless pierce corporate veil, but generally separate y AP liabilities optional (Can decide whether to buy the liabilities or not) o Might want to buy the liabilities to lower your purchase price  Its reducing the cost of the assets o But theres always the risk the court will find liabilities for you anyway, even if you dont assume them o Exceptions where you may be liable:  1. If you agree to assume them  2. It amounts to a de facto merger, not just purchase  3. Purchasing corporation is merely a continuation of the selling corporation  4. Transaction is entered into fraudulently to escape liability for such obligations  Approvals y Merger needs both sets of directors and shareholders approvals y TM and AP both directors, usually just the target shareholders y SP none, theoretically just go to consenting shareholders o Bypassing directors, just whichever shareholders are willing to sell  Appraisal rights y Delaware only appraisals with merger y Some other states allow it for asset purchases or triangular as well  Consequences y Renegotiation of contract o Stock purchase of TM, no renegotiation may be necessary o A and B will still have separate corporations y Non-transferable rights rights of a company that cannot be transferred to anyone else (such as right to intellectual property) o You could lose the main asset by doing the transaction improperly o SP there is no transfer, the transfers are shares, not at the corporation level, so you wont have to worry about this o M the two become one, some rights will be deemed to be transferred and therefore invalid since you cant transfer them o AP all rights are transferred  You dont automatically get any non-transferable rights y Tax and accounting can be pretty serious o Used to be much more serious o Farris v. Glen Alden Corp. Large corporation, List, purchases 38% of Glen Alden stock, then they agree to have Glen Alden acquire all of the assets of List, Glen Alden shareholders approved, one shareholder sues  In form its an asset purchase, under which acquiring shareholders (Glen Alden) had no rights of dissent or appraisal; structured to look like a merger y End results will be pretty similar, one company, assets both in that company, and shareholders of both will be shareholders of surviving  P said it was done to basically be a merger (substance over form) y This really is a merger, Court says we call it a merger y 117

De facto merger doctrine a rule that transactions which are not styled as mergers but which essentially are mergers may be treated as mergers (for purposes of shareholder vote and/or appraisal rights) y An argument against is that its better for the corporate world to just be able to know what they have to do rather than courts come in and judge what theyre doing  Appraisal remedy is for shareholders rights when they dont want to continue membership after corporation combines and loses its essential nature, they can leave and have value of shares paid y If thats the logic then does it apply here? o Without the right of appraisal the shareholder would have his current stock taken away and another thrust upon him y PROBLEM it wont be so easy to make these distinctions, its not going to be limited to just mergers  Legislature says the shareholders of a corporation shall not be entitled to the rights of dissenting shareholders, not entitled to appraisal rights in an asset purchase Seems pretty clear by statutory language y Court says thats a general rule not in no cases whatsoever o When its an asset purchase but really is a merger, then well give it to them (pretty clearly wrong) o The legislature intended to overrule the de facto merger doctrine  Committee reports say this is intended to overrule o Aftermath they amend the law again saying the goal is to abolish the de facto merger doctrine as part of the statute  Terry v. Penn Central Corp. De facto is gone, but in a case where one is substantially smaller, they reserve the right to, referring to decision in Farris y Even though legislature is saying no o Hariton v. Arco Electronics, Inc. They dont follow the de facto merger doctrine  Equal dignity rule a legal doctrine that different sections of a law are of equal dignity, and that action taken under one section will not be judged by the requirements of another section  This is an adoption of form over substance y Want corporations to be able to plan, just follow the rules and be ok  What you think of the theory may depend on your view of corporate law y If you see it as a set of mandatory rules, then maybe Glen makes sense o Cant let you avoid that approval, its mandatory y But if you view the law as enabling, then maybe this isnt problematic to you at all o You can do an asset purchase, or you can do a stock purchase, were just giving you options on what you can do o Delaware rule is the majority rule  Once upon a time de facto existed pretty much everywhere y By and large its gone, at least with respect to shareholders  But creditors sometimes can why? y Big issue is that shareholders are in control, they have a say, they entered into the Charter, have a say, even if indirect  118

o Matter of internal affairs, and internally people should be bound by the rules y But third parties, that wont be binding o Rule among partners will be liable to third parties no matter what, no matter how they contract for themselves y 36. FREEZE-OUT MERGERS o Cash-out merger a merger in which the acquiring company buys the stock of the target company for cash, in effect cashing out the stock of the company being absorbed  Appraisal rights might cause us not to worry as much about fairness of this y Youll get at least fair value, because if you dont you can pursue it  Also requires majority approval on both sides o Freeze-out a merger in which minority shareholders are forced to receive cash for their shares and to lose their status as shareholders (involuntary cash-out merger)  Dont confuse with a freeze-out action taken by majority shareholders to frustrate minority (not the same, just sound the same)  Sort of opposite in some way y Freeze-out the problem is that minority shareholders cant sell, so the solution is to force a buy-out y In a freeze-out merger, the problem is the forced buy-out o Weinberger v. UOP, Inc. Shareholder challenges cash-out merger between UOP and its majority owner, they withheld information  There is self-dealing so we apply the intrinsic fairness test y Have a parent and subsidiary and parent appoints some of its officers to be in subsidiary On both sides of the transaction o Not a personal financial transaction of directors, its the parent being felt through them  A buyer does not have to disclose their best price to the seller as a rule y Problem is that this study by board members on the highest price was prepared by conflicted directors using information from the subsidiary o Directors of subsidiary, who are also EEs of parent, generated information to give to the parent, but not to the subsidiary directors, even though they owed a duty to them y Not the type of information, its the way it was developed that makes it material information that has to be disclosed y They were also agents of the parent company, with duties to them not to say anything Court says no dilution of obligation with dual duties  Kahn fully informed disinterested shareholder approval will shift the burden to the plaintiff to prove that its unfair y No shareholder ratification because the shareholders werent fully informed Material information was withheld here  No ratification, so Signal has to prove fairness y The concept of fairness has two basic aspects fair dealing (process) and fair price (substance) y Not a two part test one question of entire fairness, with two aspects

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No fair dealing in this case because Signal was creating a lot of time pressure, quickly approved it, didnt have full disclosure, they didnt negotiate the price o Doesnt sound like an arms-length negotiation  Court doesnt ultimately decide the issue of price y Court thought the fairness opinion they got was a hurried process, they were very skeptical, even though it was a high premium y But it really bothered the court that they prepared the opinion with a blank o Sounds weird, but its really not They have someone doing the analysis and were not going to wait on the opinion of price  Just drafting it, and wont submit it if its not fair  May not want to put it in so its not seen before confirmed  Remanded for determination of remedy y Court says remedy should be whatever the trial court deems appropriate o Gave them lots of discretion, particularly with what a fair price would be with an appraisal y Can bring in any kind of evidence you want o They really open up the remedies o Coggins v. New England Patriots Football Club He effects a cash-out merger, shareholders lost their right to the company  Not about price, they just really wanted to be a shareholder of the Patriots  Two part test: (1) Business purpose test (2) Entire fairness  Business purpose there must be a legitimate business purpose for the cash-out y If its satisfied, they should proceed to determining fairness  Logically, almost no situation where there is a legitimate purpose for this y This might be the only case where there is a business purpose NFL wants the companies owned by a controlling shareholder o Court says they already had control and he just wants more o Not entirely true because he had to finance this acquisition  Needed to do an LBO to become a controlling shareholder  Breach to commit the company to paying off his debt for personal shares so he had to get rid of shareholders o As good a reason as youll ever find and the Court rejects it o Maybe saying that freeze-out mergers are just prohibited  Delaware once had the business purpose test, but they get rid of it y Mass rejects Delawares rejection  Plaintiffs wanted their shares back but it got remanded to calculate the value of shares as if there had never been a merger y Impossible to go back in time to get rescission o The amount of the shares had expanded, much bigger recovery o Glassman v. Unocal Exploration Corp. Parent engages in short-form merger with subsidiary, Court holds that in such a merger, appraisal is the exclusive remedy  They dont have to apply all the fiduciary duties; no need to constitute a negotiating committee, hire experts, arms length negotiation y Statute is incompatible with these it would defeat the summary nature of the short-form merger process y 120

Exceptions to it y Duty of disclosure remains because shareholders have to be able to decide if they want to accept the offer or seek an appraisal o They still need information y Fraud and illegality o Almost always going to make an exception here  In Delaware 90% parent can kick out minority shareholders with no other protections except an appraisal remedy y 37. TAKEOVERS o Takeover an attempt by an acquirer to gain control of a target o Hostile takeover doesnt have the support of the board of directors of the target  Hostile to management, not necessarily to shareholders  Usually if you dont have management approval, you need to use a tender offer, go straight to the shareholders o Open market purchases go out and seek as many shares as you can  About 10% if you can, idea is to do it quietly so as not to drive the price up y Once they know youre going to buy, it goes up  Then you do a tender offer to get to 51% at least  Then a freeze-out merger to get to 100% o As a general matter, shareholders like takeovers because they like the premiums  Managers dont because it generally means they loose their jobs as the newcomer tries to improve the business o Reasons for Takeovers  1. Undervaluation market value is less than the fair value (like on sale) y Efficient market hypothesis suggests its a bit doubtful o Doesnt mean its not true  2. Synergy Combination when the sum is greater than its parts y If true, this is a net gain for society y Economies of scale reduction in unit costs generated by buying or producing in volume o Idea that if we have a large fixed cost, costs less per unit o Ex; widgets  Price of factory plus $1 for cost of material  Costs less per widget when you make more y Economies of scope the reduction in unit costs generated by producing similar or related items o That skills or assets may be transferable o Ex; widgets and gadgets are different, but the same machine can make both  2 companies, can combine if theyre both not fully productive to produce both and were saving money y Financial synergy advantage that larger companies have over smaller ones in raising money o Internally financing, can rely on retained earnings rather than go outside 

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o But also externally, even if they have to borrow, they might have 5 or 6 projects and go through transaction costs once y Conglomeration process of internal diversification o Move from widgets to gadgets to trinkets o 50s and 60s we thought this was a good idea  Even if unrelated, financial synergy  Good management in one area can do anything o 70s 80s maybe not such a great idea  Lots of drawbacks that come from this lack of focus  3. Agency Costs costs associated with the agency relation, especially the agency problem (pursuing own interest) y Takeover can reduce agency cost allow shareholders to act together o Being brought together by acquirer, the one who wants the takeover o New controlling shareholder can replace the existing management with better management, thereby reducing agency cost y Why replace them: o Inefficient management  They may not be good enough, smart enough o Excessive compensation  Maybe paying too high a salary o Self-aggrandizement  May be trying to pursue size/power rather than profit  4. Wealth transfer a shift in wealth from one group to another, often without any net benefit to society y EEs are an example of people who get hurt o In cutting costs after a takeover, can affect salaries or even jobs o Taking money from EEs and giving to shareholders y From creditors o The creditors lending the money for the takeover will be charging the appropriate rate of interest, knowing its risky  LBO buying through debt, its all of a sudden more risky o But the preexisting creditors lent money at a certain rate, and now its a lot more risky  Value of that bond is going to drop almost in half because youre only getting half the interest you should be getting o Value of shares is going up but value of bonds and other debt is maybe going down y Government o Takeovers are a lot of times pursued for tax advantages, which means the government is losing out y Wealth transfers probably do account for some of the value o But no evidence that its all or even most based on wealth transfers o Reasons for Defense  Who gets to decide when theres a good reason against the takeover y Shareholders favor hostile takeovers generally, getting paid a premium

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o They have the right to vote and sell shares, since its their property, they should be able to sell their shares in a takeover y Management doesnt like them, losing their jobs or concern about shareholders o So what justifies their interference? Coercive offers y Shareholders arent getting a fair offer, we should be able to defend them y Ex; Two-tier tender offer a tender offer at a premium, seeking control but not full ownership, with the explicit or implicit promise of a subsequent freeze-out merger offering inferior consideration to remaining shareholders o You tender in my tender offer you get a premium, you dont, you get cashed out at a lot less per share ($50 front end, $20 back end) o Even those who dont want to sell might out of fear itll go through anyway and then get the low price o Move from being blatant to less obvious as people realized they were coercive,  Ex; $50 on front end and $50 worth of junk bond on the back end are not really worth the same o Shareholders actually do want protection from coercive offers o Courts are willing to step in and protect y Moved away from these to all cash, all shares tender offer - an offer to buy any and all shares for cash, with the promise to follow-up promptly with a cash-out merger at the same price in cash o Understood to be the perfect non-coercive offer  51% must accept for it to go through, so you get the majority and then minority still get the same price Undervaluation y Market undervaluing the company is a good reason to block a takeover o Efficient market hypothesis suggests this is implausible y Management may know the most about the company, but theyre also conflicted, really cant trust them to tell us the company is undervalued o Shareholders dont generally want this protection o If you think its undervalued, tell me why and let me decide Opportunity loss y Management can argue that a better deal may be there tomorrow o Problem is the negotiating tactic can just become a ruse o You can always say a better offer is possible y At some point have to ask who has the final say o Shareholders like bargaining on their behalf to a point o But theres a problem in finding when it ends Incompatibility y Not enough synergy, maybe losses involved, they dont fit well together o Not the best deal for the business y Sounds plausible, but shareholders dont really care about the fit o They care in a merger, but in a buyout, theyre being cashed out 123

Other Constituencies y Claim they should look to the community, the creditors, EEs o But if they can pursue the interest of everyone generally, there has to be someone who doesnt like this y If you give management the freedom to consider other constituencies, youre really maybe giving them a cover for not wanting it out of fear of losing your job  Entrenchment y Managements efforts to block y Just do whatever they can to keep their jobs o Takeover Defenses  Previously considered: y Constituencies statutes (adopted by many state, not Delaware) o Authorizes them to consider others outside shareholders o But these havent had much effect in the real world  Directors just arent willing to make the claim that theyre not acting in shareholder interest and that its ok y Staggered board o Directors can be staggered, can have elections for 1/3 of the board  Makes it more difficult to replace the board  Well over a year before you can replace the board  Might not do the takeover if they have to wait that long to get control y Voting rights o Class voting most shares might not have voting at all and few shares have high power and just never sell o Capped no one can really have control over the board, youre voting will always be capped o Can make it impossible for a takeover, even if you buy majority of shares  Additional Mechanisms: y Greemail the repurchase by a target of its own shares from an acquirer at a premium o Management can buy back the percentage already bought by the acquirer if they just go away o Shareholders hate this Instead of getting a premium, the offer goes away and we end up paying the premium y White Knight defense takeover defense in which the target convinces a friendly third party to make a superior offer o Prefer independence, but would rather be a subsidiary to a friendly rather than hostile company  Good for shareholders, especially if you can create an auction, unless the white knight is given advantages that get rid of advantages of the process o Termination fee a fee to be paid to a friendly would-be acquirer should the proposed transaction not be consummated 

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Problem is that it raises the acquirers cost theyre getting the target, minus the termination fee o Lock-up option a provision in an acquisition agreement designed either to preclude a competing bidder from acquiring a company or to provide compensation to the original bidder in case it loses in a bidding contest  1. Asset lock up issue to white knight an option for my best assets (Lock up the iphone for Apple) y They get that asset out of the deal no matter what  2. Stock lock up issue white knight an option on say 20% of my shares, new shares y Even if they dont get company, they can buy those shares at their offered price o They get a profit because they bought those shares at the lower price and then got the highest hostile bid offer price for them when it was taken over by the acquirer y Hostile bidder has to raise more money to buy the company o No shop provision a provision in an acquisition agreement providing that the target may not solicit competing offers, but may entertain them if they arise  No talk prevents you from even talking (Highly likely to be a breach of fiduciary duties, so dont see it very often) Poison pill a takeover defense in which shareholders of the target (other than the acquirer) are granted the right to acquire securities (or other assets) at a significant discount o Makes hostile takeovers very difficult, or impossible o Rights become valuable upon the occurrence of a triggering event, like someone buying 20% of the companys shares  Any time before the triggering event, the board of directors can redeem the rights, just cancel them y But once triggered they become valuable  Right allows the shareholders to buy additional shares of stock at a discount y Rights in the hands of acquirer become null and void y Basically means were diluting the acquirers interest  Almost never been triggered o If youre going to succeed, have to find a way around it  1. Negotiate a friendly deal so lucrative management cant resist y They can then redeem the rights before they trigger  2. Get the court to order redemption y They have to act in interest of shareholders and that means getting rid of it y Good luck with that  125

3. Trigger a proxy contest by getting shareholders to get rid of management and replace them y New management can redeem the poison pill y This one is the one that ends up happening in a lot of these o Unocal Corp. V. Mesa Petroleum Co. Whether a corporations self-tender for its own shares which excludes from participation a stockholder making a hostile tender offer for the companys stock is valid YES  Mesa made an offer for $54 on the front end, $54 worth junk bonds back end y After the 51% tender offer took place, the company offered to purchase the remaining 49% for $72 worth high quality bonds y Each shareholder would get the average 54 and 72, average of 63  Mesa is excluded, says its discriminatory and a breach of fiduciary duties  Unocal is worried about the shareholders Mesa was trying to hurt y Mesa was trying to get a deal at the expense of the other shareholders o This is a coercive deal, the type shareholders want protection for y Claim they dont owe them a duty, or at least theyre not breaching a duty while trying to protect shareholders  Court applies an intermediate test y Not exactly the business judgment rule, not exactly entire fairness y There is a conflict of interest here, maybe not to the level of self-dealing o This is the second major adoption of structural bias o Because the board may be acting in its own interest, there is a higher examination before they get the BJR y This is before the switch to using EFT after all 3 of the fiduciary duties y This Court has a threshold inquiry before we determine if they get the BJR o Basic test for reviewing defense to hostile takeovers is this  Two-part test test of reasonableness y 1. Reasonable grounds they believe theres a threat y 2. Must be reasonable in relation to the threat posed  Whether they can defend first depends on if theres a threat y A coercive offer is considered a threat y May include inadequacy of price offer, the nature and timing of the offer, questions of illegality, impact on constituencies  Threat of coercive offer here y Companys response was a collective tender offer o Objective was to defeat the offer or protect second tier shareholders y But this isnt just going to help the second tier, its paying them more o Goes beyond and makes any deal impossible  After this getting 54 on the front end, but 72 on the backend, no shareholder is going to take the front end  When that happens, theres no takeover and also no deal since the companys 72 was only on the backend o Changing it from something everyone has to accept, whether they like it or not, to the opposite 

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Court says there is no argument for discrimination against Mesa y Selective stock repurchases are legal, can buy back from who you want y Accepted before when the company wanted to pay greenmail o Revlon, Inc. v. MacAndrews Court found the Revlon directors had breached their duty of care with their defensive tactics against a hostile takeover  Defensive strategies such as White Knight, lock-up, and poison pill are not per se illegal, only when used to block best price  Poison pill is ok in other circumstances y Moran, recently heard, upheld the poison pill under the Unocal test o Adoption of the poison pill is ok, question is whether its continued use is reasonable during a hostile takeover  If its not the court will generally make them redeem it  In the face of the poison pill, Pantry Pride kept raising their price y The court says this is exactly what we would want to see  Normally the board is in charge of running the company, protecting shareholders y Buyer comes along, they can decide if in their interests, or try to block it y But eventually, a breakup is inevitable, and at that point the duty has changed from preservation of the company to getting the best price y Its not actually necessary to think of it as a different duty, theyre supposed to act in the best interest of the shareholders  Directors tried to say theyre considering the bond holders y Unocal said they could look to other constituencies y Court rejects this they can only consider other constituencies as they benefit the shareholders, end goal is shareholder wealth  Fundamental problem they were not trying to get the best price, they were just trying to benefit the white knight y Court is saying you have to get the best price, but leaving it up to companies discretion, lots of flexibility in how y After Revlon a lot of people though you were in trouble if you brought in a White Knight, you cant make that sale inevitable y Any of those defenses could be used as a tool to get a better price, or in order to destroy the whole auction  You can even promise a fair auction, and then cheat if youre trying to get the best price o Very general process for takeover  When a board is resisting they have to pass the 2 part test  But if get to the point where sale becomes inevitable, they must pursue the best price y 38. OTHER FORMS OF BUSINESS ASSOCIATION o Law of BA has been one of increasing flexibility o Used to just be corporations and partnerships, Then limited partnerships o Eventually get to LLC limited liability company  An unincorporated legal entity created by authority of law  Unincorporated means not a corporation o LLC law is at root simply a mix of corporate law and partnership law  Just takes principles from the other two  127

o Basics starts with terminology  Certificate of formation the document establishing, and governing the internal affairs of, a corporation y Charter for and LLC  Operating agreement an agreement among members that sets forth the structure and terms of an LLC y A lot like partnership agreement, but also like bylaws  Members the owners of the LLC y Like partnerships have partners  Managers designated managers of the LLC y They are optional o Under LLC law, the operating agreement can make the business as much like a corporation or as much like a partnership as you want  LLC can be member-manager or manager-manager y Member like partnership y Manager like a corporation  Can have sharing of profits and loses as desired  Can have limited or unlimited liability y Hard to imagine anyone would choose liability  Continuity or limited life  Member interests can be transferable or not, as desired  Can choose to be taxed as a corporation or a partnership y Single or double  Can even specify fiduciary duties, probably within limits  All in the operating agreement y Could be anything in between these two, whatever you want it to be o Increasingly seeing more and more LLCs  But there are some problems y A lot more uncertainty, not as sure what the rules are unless we digest the operating agreement o LLC complete flexibility  In some sense moving towards this contractarian theory, contract whatever you want  Maybe not really a place for traditional view, or maybe its just another option, creating all the rules, or not o LLP limited liability partnership  Essentially a partnership with limited liability among the partners  Roughly going to be responsible for your own actions, but not those of the other partners

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