Outline Corporations Prof. Michael Dooley Fall 2008
Corporations
AN OVERVIEW OF THE LAW AND ECONOMICS OF THE FIRM................................................................................2
TOWARD A THEORY OF THE FIRM.................................................................................................................................................2
THE LEGAL ENVIRONMENT..........................................................................................................................................................3
AGENCY................................................................................................................................................................................... 4
PARTNERSHIP.............................................................................................................................................................................6
CORPORATIONS..........................................................................................................................................................................8
SHAREHOLDERS AND CREDITORS......................................................................................................................................9
LIABILITY, RISK AND RETURN..................................................................................................................................................... 9
CREDITORS REMEDIES AND PROTECTIONS AGAINST SHAREHOLDERS................................................................................................10
PIERCING THE CORPORATE VEIL.................................................................................................................................................11
FRAUDULENT CONVEYANCES & EQUITABLE SUBORDINATION......................................................................................................... 13
CAPITAL STRUCTURE................................................................................................................................................................14
VALUATION FINANCE THEORY ...............................................................................................................................................15
PRIVATE AGREEMENTSCORPORATE INDENTURES....................................................................................................................... 17
AUTHORIZATION, ISSUANCE AND CLASSES OF SHARES................................................................................................................... 17
Common and Other Shares.............................................................................................................................................17
Rights, Warrants and Options........................................................................................................................................18
GOVERNANCE AND MONITORING....................................................................................................................................19
THE DECISION-MAKING STRUCTURE...........................................................................................................................................19
Shareholder Voting Procedures................................................................................................................................................... 19
Management................................................................................................................................................................................ 22
LEGAL REMEDIES FOR INCOMPETENT MANAGEMENT..................................................................................................................... 25
The Business Judgment Rule (Common law/used version here, ALI is below)..............................................................25
Oversight Responsibility: Two Main Types....................................................................................................................29
SUITS: DERIVATIVE AND CLASS ACTION........................................................................................................................................ 31
INDEMNIFICATION.....................................................................................................................................................................34
SHAREHOLDER VOTING ............................................................................................................................................................35
Shareholders have right to elect and remove directors..................................................................................................35
The Securities Exchange Act.......................................................................................................................................... 36
The Proxy Rules: 14a, 14b, 14c......................................................................................................................................37
MARKET MECHANISMS OF CORPORATE CONTROL.........................................................................................................................40
Efficient Capital Market Hypothesis.............................................................................................................................. 40
Theory: Does change in ownership create value? Brudney & Chirelstein: 3 types...................................................... 41
Market for Corporate Control .......................................................................................................................................41
Defensive Tactics for Tender Offers...............................................................................................................................43
The Business Judgment Rule Applied to Defensive Tactics (Regular)...........................................................................44
BJR for defensive tactics (DE Style)...............................................................................................................................46
CONFLICTS OF INTEREST AND PROPERTY RIGHTS .................................................................................................47
THE DUTY OF LOYALTY........................................................................................................................................................... 47
BARGAIN POLICING RULES (DIRECTORS TRANSACTIONS)...............................................................................................................47
Essays: Director Transactions....................................................................................................................................... 48
SHAREHOLDERS TRANSACTIONS (PARENT/SUB, CONFLICTS BTWN CLASSES, FINAL PERIOD)........................................................... 49
Parent-Subsidiary Transactions.....................................................................................................................................49
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Conflicts Among Classes................................................................................................................................................50
THE FINAL PERIOD PROBLEM WEINBERGER V. UOP, INC AND TAKEOUT MERGERS............................50
PROPERTY RIGHTS RULES AND THE DUTY OF LOYALTY.................................................................................................................53
INSIDER TRADING(10B AND RULE 10B-5)..................................................................................................................................53
Developing the Prohibition on Insider Trading........................................................................................................................... 53
STATUTES AND THE VIOLATIONS..................................................................................................................................................54
THE RULES:............................................................................................................................................................................54
RULE 14E-3: FOR TENDER OFFERS ONLY.................................................................................................................................. 56
An Overview of the Law and Economics of the Firm
Toward a Theory of the Firm
Why do we have firms?
o Threshold: Firms exist because of (1) specialization of labor and (2) voluntary exchange
among individuals.
But these are necessary buy not necessarily sufficient conditions.
o Ultimately, Efficiency
a. Premised on idea that facilitating individual econ interests is good for pubpol
Definition 1: when distributed in a way that no reallocation of resources can
make at least one person better off without making at least one worse off
o
Pareto-optimal
o Most basic
o Assumes fixed starting point and doesnt care about initial starting
o Very difficult if not impossible
Definition 2: at least one gains after all who suffer are fully compensated
o Kaldor-Hicks
o Most intuitive
o Utilitarian
o Ignores consequences of imposing the ideas
o Current thinking
Ex: Dealt with regularly in Integration vs. Contracting
o Cost vs other issues (time sensitive, convenience, etc)
o Control, credibility, better deals
Trying everything through Ks would be daunting legal issue
Can control more easily
o Other theories that determine efficiency:
When market transactions are more costly than making a firm Coase, The Nature
of the Firm:
Coases theory depends on a classical economic contractorthe
entrepreneur; someone who can give direction and is more efficient than
long term contracting because of their superior disciplinary ability.
Op of a market costs something, and by forming an organization and
allowing some authority (an entrepreneur) to direct the resources, certain
costs are saved.
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No entrepreneur in modern day firm; its the ability to reward each input resource
according to its productivity, Alchain and Demsetz, Production Information
Costs and Economic Organization
Hard to measure since firms rely on using multiple inputs
o But thats what monitors are for
Assumptions:
o (1) possible to increase productivity through team focus production.
(2) It is economical to estimate marginal productivity by observing or
specifying input behavior.
o These preconditions leas to the contractual organization of inputs,
known as the classing capitalist firm
o Dooley: May work for partnerships and perhaps private corporations,
doesnt work for publicly owned corporation. There, separation
between ownership (shareholders) and control (a board of directors).
The Legal Environment
The Firm and the Law:
o Firm is simply a convenient way of describing a set of contracts among the parties
who have contributed inputs to a common venture.
Leads to con of interest as individuals diverge from group goals to pursue own ends.
o Law is trying to reduce transaction costs incurred from operating a firm,
discouragement of opportunism, and the encouragement of cooperation.
BUT costly to operate a legal system too
There are different types of firms because of 1) liability concerns and 2) tax considerations.
o The corporation is a separate legal entity, and the partnership is not; this is what matters
Initially, personal liability depended upon whether entity was a separate legal person or the
aggregate of its owners (with a few exceptions).
Summary of the Features of the Various Types of Firms:
Type of Firm
Proprietor
(governs as
soon as a
person hires
an employee)
General
Partnership
(two or more
persons that
carry on a
business as
co-owners,
splitting
Organization
al
Requirement
s
None
Duration
Transferable
Interests
Until death
Yes
of proprietor
Persona Common law of
l
agency
None (could
even become
an inadvertent
partnership);
there may still
be a written
agreement
If nothing in
agreement,
partnership
at will, until
death or
incapacity
of partner,
as per
Persona Uniform Partnership
l
Act (1914)
Revised UPA (most
states have adopted).
These are default
provisions for the
most part.
No (can only
transfer the
economic
benefits of the
partnership
interest, but
not the
interest itself)
Liabilit Governing Law
y
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profits)
Limited
Partnership
Agreement
State Filing
1 Gen. Partner
Corporation
Articles of
Incorporation
of Certificate
of
Incorporation
(Charter)/
Filing
Articles of
Org
Filing
Agreement
Filing
LLC
LLP
agreement,
or until term
of years or
occurrence
of event
Term or
event
For general
partner No
For limited
partner Yes
Perpetual
Yes
General ULPA/RULPA
partner
Persona
l
Limited
partner
Limited
Limited State Statute
Perpetual or
per Articles
Yes
Limited State Statute
Same as GP
No
Limited State Statute
Agency
Agency: Agency is the fiduciary relationship that arises when one person (a principal)
manifests assent to another person (an agent) that the agent shall act on the principals
behalf and subject to the principals control, and the agent manifests assent or otherwise
consents so to act. 1.01 3rd Restatement of Agency:
2. Elements:
a. Agency is the fiduciary relationship
i. 8.01: Fiduciary duty is to act loyally for the principals benefit in all matters
connected with the agency relationship
b. that arises when one person (a principal) manifests
i. Manifestation
1. Express
2. Implied (express power to hire a cameraman, implied to pay reasonable
rate)
a. International hotel chains seem to be kind of outliers;
ii. Doesnt have to be verbal or written, but it must be reasonably understood from
the action or speech of the principal that she has been authorized to act on the
princiapals behalf
iii. Note: can use both kinds to remove specific power from agent
c. assent to another person (an agent)
1.
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i. Actual
when, at the time of taking action that has legal consequences for the
principal, the agent reasonably believes, in accordance with the
principals manifestations to the agent, that the principal wishes the
agent so to act Deff: 3rd Agency Restatement 2.01:
2. Includes incidental authority (those reasonable steps necc to doing the
required action)
ii. Apparent
1. 1) reasonably believes actor has authority to act on behalf of principal
and 2) that belief is traceable to the principals manifestations 3rd
Agency Restatement 2.03: when
2. When a reasonable 2rd party would infer that the P conferred authority;
3. Notes: need for efficiency of economy balanced with protecting principal
d. that the agent shall act on the principals behalf and subject to the principals
control
i. Scope on behalf
1. Special agents: limited to single act or transaction
2. General Agents: series of acts or transactions
ii. Relationship of control
1. Master/servant (manual worker)
2. Independent Contractor (prof construction company)
3. Absent principal and indicia, the agent does not have apparent authority
merely because she says so
a. White v Thomas: used agent for auction, authorized up to certain
amount, bid higher than changed the property to get under certain
amount. NOT valid.
e. the agent manifests assent or otherwise consents so to act.
i. Consensual
3. Revocation
a. Either can stop it; But if K says for certain time frame, leads to breach problems
4. Liability:
a. A creditor who assumes control of his debtors business may became liable as
principal for acts of the debtor in connection with the business, including torts.
(Jenson)(Humble Oil)
i. Jenson Farms v. Cargill C credit to W. C eventually took operational control of
Ws business decision making, reviewing the books.
1. Held: C was entangled enough in Warrens business that it was acting as
Warrens principal and therefore was liable for Warrens debts
a. Basis for control
i. First right with veto over actions
ii. Exclusive right to finance every purchase
iii. Giving direction on business matters
2. Ct indicated that enough involvement to be called principal, even though
R1 says must be on principals behalf
b. A franchisee is independent of franchisor if franchisee retains control of inventory
and operations. (Hoover v Sun Oil: gas station franchisee owner left to control
everything)
c. A principal is liable for the actions of agent, even if principal never manifested a
person is agent, if a 3rd party is justifiably induced to believe (2.05)
1.
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If Justifiably induced by one of these factors
1. Principal intentionally/carelessly caused this belief
2. Knew might induce others to change material position and didnt stop
them
A party who transacts with someone purporting to be anothers agent can force if:
i. agent acted in usual and ordinary scope of its authority,
ii. 3rd party can reasonably believe the agent has authority to conduct the action,
and
iii. the 3rd party is not on notice that the agent is not authorized
1. Gallant Insurance v Issac: Car insurance where the agent had been told it
needed writing but it then offered insurance w/out the writing to
customer.
K is between 3rd party and principal (6.01, 2.06)
i. If principal is undisclosed, K extends to anything reasonably infer upon agent
If the agent is undisclosed, K is temporarily with agent too
i. Can still shortchange 3rd party if he doesnt know of agents deep pockets
Profits and Damages:
i. Agent is liable to principal for all agency profits made during agency
(Tarnowski)
ii. Agent is liable to principal for damages caused by agents breach of his duty of
loyalty (Tarnowski v Resop)
iii. Trustee of real property who is tenant of trust property must account to trust for
profits made as tenant (In re Gleeson)
See management for dealing with CEO vs Board
i.
d.
e.
f.
g.
h.
Partnership
A.
Partnership: (often implied, even when no formal agreement Volhand)
a. Possesses these 4 characteristics
i. Dedicated pool of business assets
ii. Class of beneficial owners
iii. Delineated class of agents to act for the entity (the partners)
iv. limited liability
b. One partner can contribute labor and expertise, one can contribute capital only
i. Vohland v Sweet: nursery (trees) that was taken over and called partner
c. Default Rules:
i. Right to vote(18h)
1. can always opt out (like most law firms);
ii. Any act of a partner, on behalf of other partners and within scope of
business, is binding on all co-partners
1. National Biscuit v Stroud: one partner said no more bread, other ordered
it subsequently
iii. Any change in partnership results in dissolution with a partnership at
will (no term limit)
1. Can K out (Buy-out)
a. K out of this with buy/sell agreements
i. Buy/sell agreement: forces a small cut (.9 FMV), spells
out what FMV standard is used, right to buy in
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ii. works unless there is are 1) liquidity restraints or 2) issues
with it being marketable
b. Winding up: settling partnership affairs (pay off X at dissolution)
i. Even valid when seems unfair
1. Adams v Jarvis: Accounts receivable goes to
annual profits, and other partners will delay billing
to shift profit from this year to next
2. Dreifurst v Dreifurst: brothers could come to bid
on the property; (no right answer)
2. Cannot trigger this in bad faith: freeze out (know other P has no cash)
3. Arguments against opt out:
a. Not about protecting 3rd parties, about protecting the partnership.
b. Could hold up (and extort) from partner
c. Look up Frandsen v Jenrner
4. Issues to address:
a. Triggering events
b. Procedures to assert right
c. Valuation
d. Method of payment
e. funding
d. There is a duty of loyalty among partners, though a lesser one
i. No clear rule (Meinhard)
1. Majority: dont profit at the expense of your partner (Majority)
2. Minority: all thought of self is to be renounced (Minority)
a. Kordana says cant be true since theres no K for life
b. BUT: held to stricter morals than the marketplace.
c. Meinhard v Salmon: partnership to renovate hotel; one of the
partners then agrees to a later lease to renovate further by himself
i. Held: (Cardozo): breached duty of loyalty and particularly
since managing partner
ii. These are default: Can bargain around this too
e. Property held by partnership is tenancy in partnership
i. Cannot possess or assign rights
1. Except right to profit, and can assign this right
ii. Heris cant inherit the property
iii. Partners creditors cant attatch or execute on it
f. Liability in Partnerships
i. Creditors have first right partnership assets, personal creditors to
individual assets (Jingle Rule)
1. Somewhat amended to allow equal footing for individual assets
ii. Once partners leave the partnership, no liability follows for future debt
1. Still liable for debts prior their departure
a. Potential problem if firm doesnt pay back
iii. Ps get released anyway if Kd around it 36(3):
1. Rationale: Should sometimes be liable for debts of partnership because
balance between solidarity of firm being stuck forever
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Corporations
a. Corporation has these 4 characterisitcs
i. Limited liability
ii. Legal personality w/ indef lifespan
iii. Centralized management
iv. Management appointed by equity investors
b. Differences among corps usually depend on tax objectives and transaction costs
i. How held
1. Public
a. Usually done for capital raising reasons
b. Rationale: Why allow public to hold?
i. Condorce Jury Theorem: if consult enough people who
are more likely to be right than wrong, collective
judgment likely > than expert 90% correct
2. Closely held/close (Control Bloc)
a. Usually a corp for tax reasons, not capital raising
b. Usually opt out of default rules to make themselves more like
general partnership
c. Major concern is majority exploiting the minority shareholders
ii. How controlled
1. Single/small group
a. Controlled Corporations
2. Larger number
a. In the market
c. Requirements for a corp:
i. Actual person or other entity to be incorporator for the articles of incorp
ii. Be for any lawful activity
iii. Constitutional Documents
1. Charter that spells out
a. Voting stock
b. B of Directors
c. Shareholder voting
d. Original incorporators
e. Corps name
f. Fixed capital structure
g. Business intent (very broadly)
iv. Bylaws (Least fundamental)
v. Fix the operating rules, but basically taken from the Charter
vi. Shareholder Agreements
1. Restrictions on alienation
2. Voting requirements
d. Corporate Buy-out
i. Purpose: to specify when SH or Board has right to buy shares from other SH
ii. Trying to remedy problem of leaving the minority SH out to dry
iii. Issues to address:
1. Triggering events
2. Procedures to assert right
3. Valuation
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4. Method of payment
5. funding
Shareholders and Creditors
Liability, Risk and Return
Background: Conflict between shareholders and creditors:
o Actual problem: all owners want firm to succeed; not every employee gives 100% effort.
o Underlying Problem: the divergence in interests of shareholders and creditors.
Risk is measured by variation in probable outcomes that an investment is expected to have;
magnitude of the divergence
o Risk Preferences:
Shareholders systematically prefer investments that are riskier than creditors
Because the claims of creditors are limited; want chances some return
SH gain nothing until creditors are paid, want greater upside potential
Return is the profit made
o Posers Formula: Return = Interest Rate which is made up of two components
(1) real rate = riskless rate of return (short term t-bills are here)
(2) risk of this investment
Posner suggests that if the loan is nonrecourse (i.e. there is limited liability),
the creditor can compensate for the increased risk by charging a higher rate
of return.
Posner, The Rights of Creditors of Affiliated Corporations: Risk has to be viewed in
relation to return.
o Dooley: Not real; transaction costs are very low in this example. But he makes a good point
with low transaction costs, the rule of limited liability makes no difference. The parties
will adjust by varying the rate of return. The tradeoff then for shareholders is between a
lower rate of interest or limited liability.
o Even though creditors are semi-risk averse, they will accept for higher return
Limited liability exists because of the need to raise $ to start companies
o Was only way ppl would invest in large firms
Rationale:
monitoring costs (hard to monitor wealth of firm and other investors)
SH efforts end up with freerider problem
o Smaller firms dont have same issues (so why allow small?)
o Modern trend is towards more allowance of LL
o NOTES:
Creditors not really disadvantaged by limited liability in large corporations
(wouldnt monitor anyway) and can afford for smaller monitoring.
Partnerships have developed ways to manage liability, not limit it.
o Weaknesses are dealt with by piercing the veil and equitable subordination.
o Arguments for LL:
Judge Easterbrook and Daniel Fischel: Benefits of sep and specialization outweigh
the costs, but LL reduces the costs
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Decreases need to closely monitor managers
Reduces costs of monitoring other shareholders
Free transfer of shares promotes econ efficiency
o Though can be Kd around
Limits the $ needed to be spent reasearching firm
Allows efficiency by diversification
Encourages optimal investing
o Default rules try to remedy these issues too
SH choose the directors (who choose the managers), not judges
How can the law help shareholders acting collectively against managers
Encourage co.s to make investment decisions best for shareholders
Arguments Against LL:
o LL may exacerbate traditional problems of debtor-creditor relationships
Opens opp for misrep in debit/credit
Shift assets out of corp after credit has been extended
o Costly to check on
Creditors Remedies and Protections against Shareholders
Prior to insolvency, 3 controls:
o Extensive mandatory disclosure duty (but no state requires any)
o Make rules to regulate the amount of capital in firm
Minimum capital contribution by firm as determined by:
Balance Sheet: short/long assets (though reflects history, not current)
Stockholders Equity (owners economic interest)
Income Statements
o Doesnt show amount available to owners
States that use some form:
NY: 510: cant render the corp insolvent (unable to pay its current
obligations)
o Weak because BofD can shift stated capital into surplus account if
allowed by shareholders (and think of close-held corps)
CA: tighter two part system
o Can pay dividends from retained earning or assets, so long as 1)
assets remain at least 1.25 times the liabilities 2) current assets are at
least equal to current liabilities
Majority: very minimal
o 1k, and only required at very beginning of life
o Make duties on corporate participants, officers, and shareholders
Directors: Under certain circumstances, cant make distributions to shareholders
without getting fair value in return. More developed in EU.
Interesting fiduciary duties in DE courts seem to be appearing
After insolvency, creditors may be able to enhance their recovery by invoking one of several
equitable remedies against the shareholder.
o (1) Pierce the corporate veil
In the most extreme case
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o
o
o
Hold the individual shareholder/corporate parent liable for the insolvent firms debt.
(2) Debt owed by the insolvent to the shareholder becomes subordinated to creditors
claims, thereby increasing their net recovery.
(3) Determine there were fraudulent conveyances
For specific transactions, such as transfer of property from corporation to
shareholder
Then set aside for the benefit of creditors
(4) Substantive Consolidation: A bankruptcy equitable remedy that consolidates assets of
corporate subsidiaries for the benefit of creditors for the various corporate subsidiaries
Kind of a horizontal veil piercing
Bankruptcy is federal, and this seems like an intrusion;
If continues, could erode utility of why corps exist
Piercing the Corporate Veil
o Holding the individual owners responsible for the actions of the company
o Reverse piercing: claim against person to hold the corp assets responsible.
o Can be used for forum shopping
Can be used by Real Contract, Trade Creditors (B2B), Tort victims
For Contract and Trade Creditors: (sparingly)
o Few bright lines
o When there is a unity of interest and ownership between person and corporation,
and when not finding it would sanction fraud or lead to injustice
Unity of Interest: officer uses corp for personal business and no distinction
btwn acting for corp and acting for self(Walkovsky)
Complete control of the corp means nothing unless no distinction
between acting for corp and acting for self (Carter-Jones Lumber)
Fraud or lead to injustice: includes bad intent (Walkovsky)
Misrepresentation
o Hard: explicit lies
o Soft: nondisclosure of facts that contradict legit expectations or
the creditor and doing things to thwart the expectations
Sea-Land Services v Pepper Source: S unable to collect shipping bill cause Ps
control person took $ and ran
MD: Co-mingling of funds is the big problem here
Kinney Shoe v Polan: completely unfunded corp defaulted on sublease
Held: no funding is the problem
o MD: 1) no corp formalities and 2) cts seem to think need to have
minimal due diligence if the person gets beyond the threshold
minimal corp
Carter-Jones Lumber v LTV Steel: CEO directed company to commit
environmental crime (Read over, not sure about this one)
Not really a corp veil case: the CEO directed the crime
o Indicators likely to increase allowing it:
Thin capitalization
But alone, not enough!!!
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Can also be a non-issue if ct thinks victim should have reasonably
known and could have easily performed credit check (Kinney)
Small number of shareholders
Small number of shareholders manage
Failure to keep formality of corporation (Sea-land Services v Pepper Source)
(Kinney Shoe)
o Other proposed guidelines:
Lowendahl Test:
One shareholder
Completely dominates corp policy
o Usually means failure to treat the corp formality seriously
Uses control to commit fraud/wrong that
Proximately causes the injury
Krivo v National Distillary Test: when recognition of veil would extend
principal
Beyond legit purposes; AND
Produce injustice/inequitable consequences
o Trade creditors can contract around to get directly at whoever they want
For Tort Creditors (involuntary)
o Apply the rules from above
Different from K creditors by not relying on creditworthiness of corp and
couldnt negotiate with them about risk
o If corp is a subsidiary, and part of a larger corp, cant pierce to the parent
o Walkovsky v. Carlton: C owns 10 corps, each with one or two cabs. Seon Cab Corp
owned the cab that ran over Walkovsky. W against C in his personal capacity on the
theory that these were all Carltons business and are operated solely for his benefit.
o Held: No bad faith and was operating as corp
o Dissent: grossly undercapitalized
o MD: might have been gotten substantive consolidation (horizontal pierce)
o Essay: Contract vs. Tort Claims in Court: Thompson. Piercing the Corporate Veil: An
Empirical Study, Thompson suggests that there are actually more K claims, and that K
claims are more successful. Due to grounds in K claims in frequently fraud or
misrepresentation. Nothing in limited liability law that shields shareholder from his own
misdeeds. These cases arent really about veil piercingyou are holding the
shareholder liable for his or her own misdeeds.
o Essay: Can limited liability in tort be justified? (Hansmann and Kraakman) No
Closely held corps
Incentive to misinvest
o Too little on stuff to avoid accidents
o Encourages overinvestment on hazardous industries
o Opp to over and under invest
Over: externalizes costs to protect
Under: not wanting to have too much on hand in case get
sued
Publicly traded:
Incentive to assume too much risk, but added layers
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o Managers (unliable)
o Passive shareholders
o Market for freely traded stock
o Substantial assets
o Inability to insure those assets from suing
Designing the unlimited liability rule
For SH: pro rata liability for any excess tort damage that the firm estate
doest cover
o Information based rule earliest of
Tort claim filed
Companies management first became aware likely to be
filed
Corp dissolved without successor
Why costs of collection wouldnt be too high:
o Rarely force shareholders into insolvency, cause judge would
likely cap the % loss to each shareholder around 5X the amount
invested
o Stock often held by wealthy institutions/ppl
o Court directed orders would usually be followed
Why wouldnt affect market transactions much
o Ppl can diversify just as much
o Ppl take risks with driving when they have full responsibility, but
just buy more insurance
o Discussion: Affects of Walkovsky
Posner: force insurance; MD says risk level is undetermined here
Manning: create a public system of compensating tort victims).
Clark: give tort claimants a priority in bankruptcy.
Fraudulent Conveyances & Equitable Subordination
Fraudulent conveyance: transfers made by insolvent person to frustrate creditor claims.
o Ex: stock to wife just before bankruptcy
o If parties contracting with a soon to be insolvent company, must pay FMV or risk being
forced to give back those assets to the creditors estate
Method 1: present OR future creditors can make transfers void when 1) actual intent
to 2) hinder, delay, or defraud 3) any creditor of the debtor
Method 2: Can void when 1) no transfer of reasonably equivalent value if the debtor
is left with 2) remaining assets unreasonably small in relation to its business OR 3)
the a) debtor believed, intended, or reasonably should have believed he would b)
incur debts beyond his ability to pay as they became due
Equitable subordination Places other creditors above SH creditors during bankruptcy
o Applied when creditor is SH and creditor and misconduct
Only upon showing that there has been misconduct (Deep Rock, Pepper v. Litton)
Look for pattern of conduct: separate bank, separate financial records, the
formality of the flow of funds between shareholders and corporation
Origin: Deep Rock Doctrine case (Taylor v. Standard Gas & Electric Co):
Pepper v. Litton (p. 73): A fraudulent conveyance case treated as
inequitable subordination case. Controlling SH assigned a (worthless) claim
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to himself for the sole purpose of defeating a judgment creditor.
Subordination may be granted for both fraudulent and inequitable conduct.
o If corp is severely undercapitalized AND there appears to be attempt to scheme for
personal benefit at detriment of corp, the court is more likely to find inequitable
subordination (Costello v Fazio)
Costello v Fazio: 3 partners incorp, transfer personal equity to debt. Corp losing $
and undercapitalized. Corp goes under and they try to hold against firm.
Held: Inadequate capital AND withdrawl of capital
MD: capital didnt go anywhere and creditors care about future of this.
Maybe impt thing was sale of assets from partnership to corp, not
insolvency because they could pay
Discussion: maybe not arms length
o To defend agains this claim, show that corp is being run as an independent business
It is the pattern of conduct that matters.
Is the corporation pursuing a purpose separate and distinct from its shareholders?
o Essay on subordination and parent-subsidiary (Landers/Posner)
Posner: in big stuff, subsidiaries are treated as independent profit centers.
Landers: Need automatic subordination of parent creditors.
Said that parents ignore separate identity of subsidiaries and regard them as a
larger part of the parent, and use it in the best interest of the parent, not sub.
Bankruptcy law rejected rule of automatic subordination
Why reject automatic subordination?
o Monitoring costs of creditors (both parent and sub) would increase.
o Could result in more insolvencies
Bankruptcy Hierarchy (from Dooley)
o Diff types of creditors
o Secured creditors
o Debenture holders
o Preferred
o Common
o Chpt7 bankruptcy: secured get first dibs, decending order
o Chpt 11: (corp just re-orgs) gives bonds and pays out over years time
Capital Structure
Capital structure is selling legal claims to assets and cashflows (secutiries: 2 ways
o Borrow through regular debt ( getting loans and notes)
Characteristics:
Advantage over stocks cause
o Less risk (first dibs on default stuff)
o Regular payments of interest
o Can sue on contract
Get periodic payment and principal back
Often customized in contracts:
Legal Implications:
Contractual (ie, great flexibility, allocates risk and 14esponsibilities)
Has maturity date (stated date at which must repay)
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o
o Often principal+outstanding interest
o Interest rate usually stated
o Usually creditor gets right to accelerate if debtor defaults
Tax implications:
Interest paid to borrower is deductable for the firm
Sell ownership claims by issuing equity securities (issuing stock)
Shares: units into which proprietary interest exists
Possible charter options:
Anti-dilution (cant issue more shares to dilute stock values)
Anti-destruction
Advantage over debt
Votes: One vote per share
Distributions/dividends (but only as declared by directors)
Legal Implications:
Clear default rules for relationship
o One vote per share (for at least one type)
Common stock has few legal claims
o No right to periodic payment or ROI
o Merely have right to vote
o Residual claims over assets and income
o They are so well understood, can just put into charter X issuance of
common shares
Preferred: different animal (just as customizable through contracts as bonds)
except paid when decided by board (Dooley hit hard on this)
o Preference over common stock in liquidation of company and/or
dividends, so less risky
o Often have charter laws that say cant pay to common, unless pay X
to preferred
o Convertible:
Can put triggering into the charter
Valuation Finance Theory
Valuation is equal to all outstanding claims(debt and equity) plus assets plus capital
a. Think of corp as reservoir of funds: always coming in and going out;
i. so how to determine the levels and depth:
1. top level is debt,
2. next is preffered,
3. next is common,
ii. Estimating what will look like in future
B. Attempting to get the capital needed for the corp, at the lowest cost to the corp .
a. Requires understanding the following
b. Issue 1: Time value of $
i. Rental charge on the buck (opportunity cost)
ii. Present value: value of $ today to be paid at some point in time
1. Dooley: its the exact reversed mirror image of compound interest
iii. Discount rate: rate earned for renting out money for one year
A.
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iv. Bonds are issued in 1k issuances or more; increments of 100
c. Issue 2: Risk and Return
i. Risk is the standard deviation of expected return from actual return
ii. Background: Rating agencies review info and determine level: AAA, AA, A, etc
iii. Bond: 1) annuity of stated interest until maturity and 2) return on principal
1. Long v Short: largely the same, slight differences
iv. Expected return: (the sum of what the returns would be if the investment
succeeds, multiplied by probability of success) + (returns on if the investment
failed, multiplied by probability of failure)
1. Effectively: Total return X probability = expected return
v. Risk neutral: only care about the return, not risk;
vi. Risk averse: care more about the risk; most are risk averse and demand more
compensation to make the riskier investment
d. Issue 3: Stocks:
i. Return is equal to dividends + Enduring principal (begin price) + interest
ii. Earnings Per Share (EPS): available to common / # of shares
1. This gives the price and capitalization rate
a. Capitalization rate just means rate of return
2. If publicaly held, easy to configure; if not, its not
3. All else being equal, higher the risk, the higher the return
e. Issue 4: Systematic Risk and Diversification
i. Two types:
1. Systematic: refers to things that are market wide (cat escape it)
2. Unsystematic: specific to task at hand
ii. Packaging risks together (diversifying) to reduce the riskiness likelihood
iii. Can make it so there is small to no risk premiums
iv. Risk averse investors dont put all eggs einto one basket unless paid well enough
C. Discount Cash Flow (DCF) Approach predicts all future cash flows and makes discount
rate for new present value
a. Steps (More art than science)
i. Estimation of all future cash flows generated by the asset
1. Huge degree of uncertainty
2. Usually uses a terminable value to cut off the stream at a certain time
period and cuts off at that point
a. Large piece of the overall cash flow
b. Therefore small changes here can have big effect
ii. Calculation of the discount rate (best is Weighted Average Cost of Capital)
1. Weighted average of
a. cost of debt and
a. before tax this is the interest rate that fiurm would pay if
seeking new debt financing
b. after tax this is sig lower cause corp can deduct interest
b. cost of equity
a. More difficult to determine
b. Best accepted is Capital Asset Pricing Model (CAPM)
1. Effectively says more risk means more payout to
investors
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2. Looks at systemic risk (system wide for
investments) and unsystemic (specific to the
investment)
c. Another approach is the historical approach
iii. Relevance of prices in the securities market
1. While traditional discounting principals are a good guide for valuing
assets, for risky assets an alternative approach exists
2. Stock managers make it good by estimating prices, because it makes it
easier for the modern economics
3. This all depends on free-flowing information
D. Firm is not valued by present depth; its future relationship between income and expense
Private AgreementsCorporate Indentures
Because SH protection over creditor protection promotes industry growth, Gov protects SH
and let other people bargain for whatever protections they can get.
o Leads to collective action problem
Bondholders rights: indenture complicated agreement in which the firm agrees not
to engage in certain kinds of acts that may increase the bondholders risk.
o Solutions/Aspects of the problem
Use of Underwriters: The use of the underwriter has several functions:
Bear the initial investment risk (actually buys and then re-sells)
Reputational intermediary (good for first-time corps)
Enforcement:
All enforcement rights under the indenture are vested in an independent
indenture trustee(large commercial bank or broker trust company)
Events of Default allows acceleration of debt/payment plus penalty
Indenture provisions: The main issues in drafting a provision?
o Production/Investment want risk level of company to stay the same;
o Dividend payments by the firm used to retain earnings and now they are paying
dividends
o Investments Could prohibit the corporation from making investments in any other firm
Mergers what happens?
o Additional debt
o Asset maintenance
o Calls and Sinking Funds: These provisions are typically included in the indenture and are
meant as provision to provide for changing conditions.
Call: A call gives corporation the right to call in debt early and pay off principal.
Sinking Funds: Not for the benefit of the issuer, but rather the bondholder. The
purpose of the sinking fund is to avoid having the entire principal amount of the
bonds come due at one time
Authorization, Issuance and Classes of Shares
Common and Other Shares
o Authorization:
o Required in Charter: Total # of shares of each class that the corp is authorized to issue.
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Authorization simply means the number of shares stated in the charter to be
authorized for issuance.
Classes of Shares: Allows for different rights/benefits among equity security-holders.
o Different types of Rights:
Dividend Preferences: Shares may be preferred with respect to dividends;
Rate is usually fixed and expressed as a stated $ amount or % of the par
value of the shares.
Liquidation Preferences: Shares may also be preferred with respect to the proceeds
from the liquidation of assets.
Voting Rights: More often than not, preferred shares do not have voting rights,
except where class voting is in effect (see infra for more on voting rights of shares).
Conversion: Equity shares and debt securities may be made convertible into other
securities of the corporation (or of a subsidiary or affiliated corporation).
o Redemption: Shares other than common may also be made redeemable at the option of the
holder, the corporation or upon the occurrence of a specified event (the MA says can also
be at the option of anyone else that is specified).
General prohibition against common shares redeemable at the option of the
corporation: K around it.
Distinction between conversion and redemption:
Redemption = cashing out of your interest,
conversion = changing your interest into another interest.
Is redemption prejudicial to creditors? No. Is a distribution, and is subject to the
distribution limitations in 6.40.
Publicly held corp wouldnt want redeemable stock. But publicly held corp might
find them useful dont want a fuss about the buy-back price.
What happens if everthing is redeemed? See MA 6.03(c) at all times the
corporation must have outstanding one or more shares that have the right to vote and
receive the net assets of the corporation at redemption.
o Series: Classes of shares may be further divided into series of shares. The principal
advantage of serial shares is flexibility.
o Issuance: The boards discretion in issuing shares is unfettered. So long as there are
sufficient shares authorized, the board may issue shares for any valid corporate purpose.
(See Model Act 6.21).
But boards judgment may be open to attack in a shareholders suit
Rights, Warrants and Options
o Options: We need to distinguish between options issuable by the corporation and options
that can be created by individuals.
o By Corporation:
Stock Options: most familiar use of options are stock options issued usually as a
form of incentive compensation. The option has to be issued at fair market value on
the date of grant strike price is whatever the price of the stock was on that day.
Variations include
o restricted stock
o SARS (stock appreciation rights, or phantom stocks) a bonus that
is tied to the increase in the value of the companys stock.
These types of incentive compensation are attractive because they do not
count against the $1,000,000 of compensation that is deductible by the
corporation.
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o
Options have become very controversial (whether they should be recorded as
an expense).
Other types of Options can be created for any valid corporate purpose, and can be
created on authority of the Board alone:
Warrants: generally issued with another security as a sweetener, e.g. can
issue debentures + common stock warrants. Warrant gives the holder the
right for a period of time to purchase common stock at a price above the
market price when the warrant was issued on a stepped up basis (similar to
an option). E.g. at time created FMV = $20; exercise price = $25.
Rights: AT&T did virtually all its financing this way. Suppose we want to
issue 1M shares @ $20 per to the public, but we think that there is a real
demand for additional shares among our own stockholders. In a typical
rights offering, before the public offering, for 30 days give your existing
shareholders the right to purchase at a discount ($19 for instance). If your
shareholders buy the entire issue
o Also defensive mechanism a poison pill.
By Individuals:
Put The right to sell a share at a particular price.
Call The right to purchase a share at a particular price
Futures The difference here is that no shares change hands, but money does.
Governance and Monitoring
The Decision-Making Structure
All corp powers shall be exercised by or under the authority and the business and affairs of
the corporation managed by BOD See MA 801(b)
o The SH work under this principal
Performed for SH welfare
Shareholder Voting Procedures
Actions of shareholder meetings and alternatives
o In addition to board elections
o vote to adopt, amend, and influence laws
o Special Meetings: Those meetings called for other than the annual one
Often for fundamental transactions
Can be a key power since its the only time they can initiate action
o Shareholder consent solicitations
SH can also act if corp statue allows file written consents instead of meetings
Some states require votes on actions
Voting Procedures and Rules:
o Notice and Quorum:
Occurs in connection with formal meetings, either annual or special.
Meetings cannot be conducted unless a quorum of shareholders is present in person
or represented by proxy.
Quorum requirements are set for individual matters and with respect to
voting groups.
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In the absence of a contrary charter provision, the required quorum
under 7.25(a) of the Model Act is a majority of the votes entitled to
be cast by the voting group on that matter.
o Same exact rule for DE (216).
o There is no minimum quorum requirement for MA; 1/3 for DE.
o Once a quorum is present, a simple majority suffices to take action,
unless a higher percentage is required by statute, charter or by-law.
How to define majority of votes? It could be the following (1) majority of
votes entitled to be cast (greater than 50% Yes) or (2) more yes votes than
no (election of a director requires a plurality). The state statutes often use the
first for some situations and the second for others. The Model Act sticks
with #2 for all matters.
o SEC rules added a wrinkle for publicly held corp soliciting proxies,
shareholders had to be given the option to vote yes, no, or abstain.
There is a problem with counting this. If the voting requirement is
the majority of those entitled to vote, and abstention is in effect a no
vote. If it is more yes than no, then abstentions dont count. Note
that the MA avoids this problem
Proxy voting: Most shareholders in publicly held firms will exercise their franchise by
proxy(agency).
A proxy is revocable at any time, and the shareholder may revoke by simply voting
his shares personally or by giving a subsequently executed proxy to another.
Management typically reserves the right to vote the absentee shareholders shares as
it sees fit on any matter brought up at the meeting of which management had no
foreknowledge.
Voting rights: Statutory voting rights vary slightly from state to state, and many statutes
permit further modification through the adoption of optional charter and by-law provisions.
In the typical firm, only SHs vote and they vote on the basis on one vote per share ;
Election and Removal of Directors
Elections: Normally all members of the board of directors will be elected for
one-year terms.
o By charter provision, any class or series of shares may be given the
exclusive right to elect one or more members of the board.
o Many states, including Delaware, authorize a charter or by-law
provision dividing the board into as many as three classes having
staggered terms so that only one-half or one-third of the directors
will stand for election in a given yearthese are permitted under the
Model Act 8.06, but only for boards having nine or more members.
Removal: Shareholders have an inherent, common law right to remove any
and all directors at any time for cause. Under DE 141(k) shareholders may
also remove without cause, except in two situations:
o First, if the board is classified, directors can only be removed for
cause, absent specific authorization in the charter.
o Second, directors who have been elected by a special class can be
removed without cause only by a majority vote of the class that
elected them.
Amendments to By-Laws and the Charter
o
o
o
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Bylaws: the right to amend the by-laws was a shareholder prerogative at
common law, but problems of coordination have led some states to give the
board the exclusive right to adopt, amend or repeal the by-laws, subject to a
contrary charter provision vesting such power with the shareholders.
o DE 109 has the opposite presumptionexclusive amendment
power in the shareholders, unless power reserved to board in charter,
and even then such reservation shall not divest the stockholders or
members of the power, nor limit their power, to adopt, amend or
repeal by-laws.
Charter: Must be approved by a majority of the outstanding voting shares.
Fundamental changes
Mergers: Depends on what side their on.
o Seller always have right of approval (51% for DE and MA)
o Buyer approval is not required unless the merger will increase the
outstanding shares of the buyer by more than 20% or require any
significant amendment to the buyers charter.
Under stock exchange rules and MA 6.21(f) any sale of
shares for other than cash consideration that will result in
more than 20% increase (like mergers) requires voting.
Share exchange: Basically the same effect as a merger but one class of
shares is obtained. Buyer offers to exchange its shares for the voting
common of sellers. If 51% of sellers shareholders approve, buyer gets 100%
of shares. S retains its corp. existence and preferred remain shareholders of S
corp, and the only difference is that it is now controlled by B.
o Normally, outstanding shares in another corporation are acquired
directly from its shareholders in a negotiated transactions or in a
public tender or exchange offer. In either case the sale of outstanding
shares is a decision made by shareholders individually, and there is
no formal action to be taken by either the shareholders or the board
a significant distinction as we shall see below.
Sales of assets
o Seller corporation shareholders have the right to approve
o Buyer corporation No
Dissolution/Liquidation: Yes shareholders get to decide to dissolve the
corporation and distribute the surplus.
o The implications of these rules:
Board is gatekeeper
Shareholder prerogative special meeting (important in takeovers)
All states give some protections for Minority Shareholders by special statutory voting and
appraisal provisions.
o Group Voting: Voting groups are determined on the basis of individual questions put to the
shareholders, so if there is a meeting on which 5 matters to be voted on, there will be 5
different voting groups, and there could be different quorum requirements.
Balance of dont want to let opportunistic shareholder block what the majority
wants to do and dont want majority running roughshod. Result is give the
preferred (though nominally nonvoting) the right to vote in any situation where the
preferred is going to be differentially and adversely affected, and also a veto power.
o Limits on Group Voting:
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Majority is a quorum. Approval once quorum is reached is by more yes than no
sufficient to take action. Throws out abstentions.
Amended act clarifies that it is the voting power of shares rather than the number of
shares that counts focusing on the outstanding voting shares, not all shares.
Majority of the voting power entitled to vote on the question, but approval is more
yes than no in any voting group.
On most questions, all voting shares will be lumped together into a single
voting group. So with 300 votes, quorum is 151, and plurality controls the
outcome.
Where a proposed corp action would differentially and adversely effect different
classes/series of shares, transaction has to be approved by each voting group.
o Appraisal: The second protection applicable is some cases is the right to demand appraisal.
Appraisal is a judicial proceeding in which a shareholder that dissents can demand to be
paid the fair cash value of his or her share if they disagree with action taken.
Big for DE where non-voting classes are powerless in mergers to new corps that
reduce their rights
This is a no-fault provision.
Management
Sources of Authority (in descending importance):
o Statute
o Articles
o By-laws
o Board Resolutions
o Shareholder vote (if needed)
o Other corp contracts (e.g. outstanding loan agreement that prevents corp from getting rid of
a particular asset)
A rule of thumb, anything that looks like a major transaction will require Board approval.
o If doubt on officers authority, should insist on a resolution from the Board.
o Procedure: Check the Articles for restrictions, check by-laws for notice requirements,
check to see if consistent with statute, look at loan agreements, check to see if sale of
substantial assets and shareholders must approve.
Delaware courts have been foggy about what substantial means.
MA check to see if sale of assets would leave corp without significant
continuing business, and the MA then proposes a safe harbor (25% net assets
earnings).
A corp officer does not have apparent authority to make decisions that, for corporation, are
extraordinary
o Jennings v Pitt Mercantile: CEO agreed to make a buy-leaseback transaction that was a
power held by the Board, not the CEO
Separation of Ownership
Berle and Means: Consequences: The Separation of Ownership and Control
o Overview: Surveyed corporations method of control and determined that ownership
and control of the corporation had become separated. New form of property
The first study in this field Adolph Berle and Gardner Means The Modern
Corporation and Private Property, first published in 1932.
o Berles Study: Positive Aspects of the Separation of Ownership and Control:
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They found the following control methods/Patterns:
(1) Control by an individual or small group
o Classic closely held corporation
(2) Control by majority shareholders
o could be an individual or family group likely to be a smaller to
medium size publicly held corp, although for some period of time,
family dominated corps still held sway in the US (e.g. Ford family
controlled Ford Motor Company)
(3) Control by legal device
o No longer relevant. This is a pyramid corp where the voting stock is
in few hand, and all publicly-traded stock was non-voting. This is no
longer legal this was the target of the Public Utility Act (utilities
used to be set up this way).
(4) Minority ownership
o Characteristic of publicly held corp. One set of hands has less than
majority of stock, but has control. Presumptively, 20% is control.
(5) Management control
o Characteristic of publicly held corp. No identifiable group of
shareholders with any control at all. This is like AT&T, General
Motors where shareholding so dispersed that no individual
shareholder or group of shareholders has much control.
What makes (4) and (5) work? Proxy system.
Minority/management can control who will succeed them as
well.
Berle and Means concluded that ownership and control of the corporation had
become separated. (Although this wasnt exactly all that newAdam Smith
identified this phenomenon in 1776.)
This is also where the Alchain and Demsetz model of the firm breaks
down. Recall that A+D saw a classic capitalist firm as having the following
characteristics: (a) joint input production (b) several input owners (c) one
party who is common to all the contracts of the joint inputs (d) who has the
rights to renegotiate any inputs contract independently of contracts with
other input owners (e) who holds the residual claim and (f) who has the right
to sell his central contractual residual status. They said authority to make
decisions is given to residual claimants, but as we can see from Berle and
Means work that shareholders arent acting as monitors.
Berles (Faulty) Conclusions:
(1) Berle thought he found a new form of property, which he bifurcated into
active and passive property.
Passive property (shares of stocks or bonds) give its possessors an interest
in an enterprise but little control and involves no responsibility.
Active property (plant, good will, organization, etc. that actually make up
the firm) are controlled by individuals who only have minor ownership
interests in it.
Notes:
o Berle thought directorships would become hereditary and since
shareholders dont own the corporation, no one does. Is this true?
Certainly not!
o
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Berle says that the corporation is not like a horse but this analogy
breaks down. Can syndicate members decide what to do with the
horse ride whenever they want? No. Syndicate members own
right to share in stud fees and race purses generated by the horse.
(2) Berle is confident that separation of ownership and control is accidental
byproduct of the product of development of public trading markets and the
resulting wide dispersal of shareholdings in larger firms.
MD: Berle is wrong about the history of the corporation. Multishareholder
corporations were present from the beginning of the Republicsince at least
1793. Didnt have many until 19th century, but there wasnt a need for them.
Technological innovations are what spurred the large corporations because
companies needed to raise a lot of capital. And even then the governance
system was exactly like what we have today: shareholders had a passive
role.
Evidence is that the separation of ownership and control is not an
accidental byproduct, but is intended by the corporate form.
o In this view the separation of ownership and control is seen as the
raison detre of incorporation, rather than, as Berle perceived it, a
perversion of the original ideal.
Hobbes Argument: authority is needed to achieve coordination of orgs
o Coordination keeps ppl is more productive
Keeps from competin
Coordinates efforts
o Optimum join decisions need info dispersed among the ppl
o Since transmitting info is costly, easiest to get it to everyone in
central place
When interests of info differs from person to person, costs
rise
Its the polar opposite position of governing by consensus
Small firms not incorporated until the 40s because of tax considerations, not
because of any sort of beneficial structure to the shareholder-manager form.
o Two Reformist movements from Berle Tradition
Corporate social responsibility movement
Corp as a social institution is illegitimate because it is not responsible;
o Dooley: This movement is confusing because no soul to damn, no
ass to kick. But this doesnt mean no responsibility.
Corp should pursue social ends that conflict with the presumptive
shareholder desire to maximize profits
Dooley: saying theyre irresponsible because no soul to damn, no ass to
kick. But this is faulty; the only form of responsibility is not a nave form
of property ownership.
Proposals: Balkanize the Board (assign responsibility)
Shareholder democracy movements:
Wants to reduce gap between ownership and control.
People wont accept the separation beween control and ownership
o
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SEC tries to empower shareholders by forcing more information and
incentives to vote; BUT there are intractable collective action and free rider
problems; ppl dont read the info.
Dooleys thoughts:
o Corp isnt owned by anyone (like a racehorse)
o Berle says corps have eroded, but got like this for reason. They were around from
beginning and have become survival of fittest
o They continuously evolve into their management styles:
Arrows Decision making:
Bargain
o When parties have identical info, different interests
Consensus
o Identical info and interests
o Good example of general partnership
Authority
o Different info, different interests
o Good example of pub held corp
Info given up, decision handed down
Rationale for Separation:
o Different for each type of corp,
o Why SH are willing to purchase a bundle of ill-protected rights and expectations.
Close Corporations: model after partnerships with protection
Large and Public Corporations:
Kenneth Arrow suggested an explanation. He suggested that [A]uthority is
needed to achieve a coordination of the members of the organization.
The alternative would be consensus by bargaining.
o Why do some very large organizations (i.e. law firms, accounting
firms) continue to form partnerships, instead of corporate forrms?
Arrow suggests that if group has common value system.
Suggests form of governance is not a function of size, but
rather the decision-making process.
Legal Remedies for Incompetent Management
The Business Judgment Rule (Common law/used version here, ALI is below)
A. NOTE: This is extremely difficult to overcome
B. In the absence of proving exceptions
a. illegality, fraud, bad faith, conflict of interest (usually a pecuniary interest), etc.
i. Shlensky: It is not [the courts] function to resolve for corporations questions of
policy and business management. The directors are chosen to pass upon such
questions and their judgment unless shown to be tainted with fraud is accepted
as final. The judgment of the directors of corporations enjoys the benefit of a
presumption that it was formed in good faith and was served to promote the best
interests of the corporation they serve.
ii. Shlensky v. Wrigley: S is a minority SH in org that owned Chicago Cubs and
operated Wrigley Field. Cubs decided no night games. S said negligent, as it
caused the operating loss sustained by the Cubs from 19611965.
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1. Held: 1) No cause of action, 2) no alleged illegality/fraud/other bad faith
move (conflict of interest).
iii. Illegal and immoral (Miller v AT&T: DNC hired AT&T, never charged)
b. Duty of Care
i. Will not be held to account for honest mistakes of judgment.
1. Cant seek reasonable person standard
ii. The Common Violations of Fiduciary Duty:
1. Process is the major issue: (up to decision, did/did not do)
a. Imprudence (ie didnt make informed business decision)
i. Management brings transaction to Board with short fuse
(Signal)
ii. Quick valuation of the company in selling (Signal)
iii. Rushed a decision (Van Gorkom)
iv. Didnt seek more info (Van Gorkom)
1. No shop/Lock up
b. Board hid something: Didnt disclose all material facts, which
they knew or should have known, before securing stockholders
approval (Van Gorkem)
2. Procedure is other issue
a. For Van Gorkom, Board didnt review agreement
b. Lawyer didnt really explain in Van Gorkom either
iii. If violation of duty of care is found, auto case of personal responsibility and
burden is on D to show no breach of loyalty or face possible recisiary damages
(Cinerama)
1. Must show entirely fair to corp
2. Fairness= process(trying to do right thing) and price
iv. Degrees of Negligence (MD thinks impossible to distinguish)
1. It is a clear violation when intentionally and consciously disregard
responsibilities on a material corporate matter (In re Walt Disney)
a. In Re Walt Disney: Board hired Ovitz as new co. president, soon
ousted & received large not-for-cause termination payment
specified in his contract. Directors believed Eisner had power to
fire Ovitz, and Board never voted on the firing or did an
investigation to see if cause existed for the firing.
2. Personal Preferences: tricky, ultimately rests on whether its also good for
corporate motives. Ex: CEO of pharmacy who opposes birth control
v. Applied to any SH with majority control (Kahn v Lynch)
c. Supporting Cases:
i. Gimbel v. Signal: S sold subsidiary to B Oil. The sale approved in special
meeting of BofD, and only one member S board would be getting a job with B.
P claims that S Oil is worth much more than selling price, though was above
market price.
1. Held: Board was not fraudulent, but was imprudent and hastily decided,
even though strapped for cash. Didnt not bring proposed transaction to
attention of board. Hasty method of valuation.
2. MD: remember difference of thick/thin markets and oil volatility in 70s
(when this case)
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Smith v. Van Gorkom: sale of TransUnion to New T. Board approval required,
then SH. Buyout SHs for $55 per share. Wanted to sell because had tax credits
that they were unable to use. Was leverged buyout(borrowed $)
1. Held: Was Not informed business decision, weak effort to negotiate
price, and Board didnt disclose all facts. Should have determined
intrinsic value since shares were depressed.
2. MD: Van Gorkom is narrow holding
iii. Cede & Co. v. Technicolor: T sells self to a turn-around specialist; Minority SH,
Cinerama, opposed the deal and sues for violation of duty of care. Says Bd was
insufficiently informed, though stock was paid over market price)
1. Held: Gross negligence; three obligations: good faith, due care, loyalty.
iv. Cinerama v. Technicolor: Against T board; MAF acquired bought all T stock
for more than market price. C, minority owner, resisted at first then sold when
MAF upped price. Brought suit anyway
1. Held: Directors were negligent in not informing themselves properly, but
didnt breach loyalty (were fair to company). No recisiory damages.
C. And using a reasonable doubt standard,
a. Arenson v. Lewis (DE): Not unless P raises a reasonable doubt that (1) Board was not
disinterested or (2) decision was grossly negligent.
i. Must be made in the complaint by well-pleaded facts, not allegations,
ii. without discovery
D. the court will not even review a decision made by the Board of Directors.
a. Board gets presumption
E. Alternative interpretation: ABA Corp Director Guidebook: (Textbook says best)
a. A decision constitutes a valid business judgment (and gives rise to no liability for
ensuring loss) when:
i. Made be financially disinterested directors/officers
ii. Who have become duly informed before exercising judgment and
iii. Who exercise judgment in a good faith effort to advance corporate interests
F. Rationale: to protect decisions made with reason, good faith, and best interest of corp.
a. Best alternative: Wants to ensure responsibly, but cant look to insutry standards
(Wrigley), result (Edsel), and theres no reasonable person standard.
b. Protects the value of authority
i. Maybe purpose is not to protect Board from SH, but to protect SH from
themselves to keep the decision-making process from unraveling (Gimbel)
c. Alternative Justifications (Dooley doesnt like):
i. Because the court not competent? No bad justification.
ii. To encourage directors to take risk? No.
1. Argued by ALI Governance Project
a. Judge Winter: Shareholders to a very real degree voluntarily
undertake the risk of bad business judgment, even if try to min.
Statutory Versions
ALIs Corporate Governance Project (No state has codified this rule)
o ALI 4.01(c): A director of officer who makes a business judgment in good faith fulfills the
duty under this Section if the director or officer:
is not interested . . . in the subject of the business judgment;
ii.
27
is informed with respect to the subject of the business judgment to the extent the
director or officer reasonably believes to be appropriate under the circumstances;
and
rationally believes that the business judgment is in the best interests of the
corporation.
Rationally believes: This aspect seems to call for a determination of the
reasonableness of the action. Or is the standard really just not irrational?
o Two inexplicable decisions that might have accounted for the ALI
rationality provision:
Litwin v. Allen p261 - did the Board bargain enough for the
consideration of some bonds that they purchased? This
wasnt really an irrational by the board.
Hun v. Cary p263 Board used whatever funds they had
left to erect a new luxurious bank on the theory that if they
looked rich they would become rich. This one was more
irrational.
o A few notes about 4.01(c):
Liability v. Review. This is a limitation on liability not a limitation on review.
Presumption v. Burden of Proof. No presumption of good faith from Aronson v.
Lewis. Just says burden of proof was on the plaintiff.
Dooley says doesnt shield as much
Duty of Care violation is never found if director meets 8.30, and if doesnt unless specified in
8.31 its still not likely: (Similar to many states) 8.30(a) of the Revised Model Act:
o A director shall discharge his duties as a member of a committee:
in good faith;
with the care an ordinarily prudent person in a like position would exercise under
similar circumstances; and
in a manner he reasonably believes to be in the best interests of the corporation.
o 8.31 details the circumstances under which directors may be held liable for breach of any
of their duties. Not codification of the BJR and only kicks in after state procedures
MD Notes:
o Stuck with rules found in the rhetoric of case law and so found few violations.
o Makes no sense; you cannot have negligence standard and violations of the duty of care;
means rule must shield more than just reasonable actions.
BJR has range of behavior that is sub-optimal but is still protected against liability
(but not all action which are much below the optimal behavior)
Focus should be on the BJR standard of review, rather than the liability rules .
But states have focused on liability rules
o (1) Backing away from the duty of care: Change standards of liability to things like willful
misconduct or insisting on clear and convincing evidence of violations.
o (2) Exculpatory charter provisions to limit/eliminate personal resp: most popular.
DE has led the way in this regard 102(b)(7),
This includes a list of unforgivable sins
o (i) breach of loyalty,
o (ii) lack of good faith,
o (iii) intentional misconduct,
o (iv) improper personal benefit
28
DE Problems:
o exception for any breach of the directors duty of loyalty.
o Technicolor exposes another possible hole in 102(b)(7)recall that
that case invoked good faith as of independent significance and
of equal rank with care and loyalty might mean that a grossly
negligent failure to obtain the highest price for shareholders in a
merger would suggest that they were not acting in good faith
VA did interesting things.
Provides a cap (100K or amount of cash compensation paid in last 12
months whichever is greater) as default rule in case no charter amendment.
N/A if the officer engaged in willful misconduct or a knowing violation of
the criminal law or of any federal or state securities law.
o Sandberg: smaller VA bank into a parent. Directors issued a proxy
statement that said that the price was fair. Didnt read the proxy
statement before they sent it out,
Held: Reckless includes of intentional; lose the statutory cap,
so liable for all the damages for the negligence counts that the
jury had already said was simple negligence.
MA: 2.02(b)(4)allows for provision eliminating or limiting the liability of a
director to the corporation or its shareholders for money damages for any action
taken or any failure to take any action.
Exceptions include:
o the amount of a financial benefit received by a director to which he is
not entitled,
o an intentional infliction of harm on the corporation or the
shareholders
o a violation of 8.33 (covering unlawful distributions)
o an intentional violation of criminal law.
The difference between the MA and VA is that violation has to be
intentional, and has to be violation of criminal law. Read carefully
Oversight Responsibility: Two Main Types
For both, must show sustained or systematic failure for oversight
o Ex: utter failure to assure reasonable info and reporting
o Stone v Ritter: Couple had scammed ppl, created an AmSouth trust account for investors.
One employee of AmSouth suspected; no notifying. AmSouth was investigated and a
compliance program was insufficient. S, a SH, filed. Stone acknowledged that R both did
not, and could not know of problem.
o Rationale: Triad of fiduciary duties at play (not really separate): care, loyalty, good faith
Inattention to Mismanagement.
o Must show not only of breach duty, must show but for causation and pervasive
incompetence. (J. Hand in Barnes v Andrews). Very high BJR, nearly impossible
Barnes v Andrews: co made airplane enginges; director and CEO dont get along,
and nothing gets done; company goes under
o Auditor violates when 1) recklessly fails to inquire into the corps financial activity
when 2) such inquiry is warranted
In the Matter of Michael Marchese: During an audit, a group of auditors found an
M&A to take place on date X; company wanted it to be different so they forged and
backdated some docs and then hired new auditors. Also hired a company that was
29
owned by CEO to provide consulting that never took place, but was charged for.
Marchese knew of everything but never looked into anything.
Dooley: doesnt go beyond red flag doctrine; it just alerts us to SEC being
involved
o SEC could have gone through criminal, bar from serving as officer,
o Good reason for independent audit, they should do the hiring/firing,
Inattention to Management Abuse. High BJR except if on notice.
o Must show 1) duty existed because they knew of management diversion (red flag), 2)
directors breached that duty, and 3) breach was proximate cause
Red Flag is automatic when:
on notice
Accounting systems
Amenable to audit-like control of
o employment records
o environmental
o regulated industry
Insider transactions
Francis v. United Jersey Bank
Facts: inherited interest in reinsurance broker (insurance for insurer), her
sons took out millions, she ignored everything and died. Bankruptcy trustee
filed suit for negligence
NOTE: directors dont usually owe duty to 3rd parties until insolvency
Dooley: did nothing, even though husband had warned about sons
o A corporate director who has no knowledge of suspicion of wrongdoing by employees
is not liable for such wrongdoing.
No liability if no notice
Not required to institute system of internal legal surveillance
Entitled to think that the people who work for them are honest
Graham v. Allis-Chalmers: Suit for illegal actions of employees (unfair pricing).
Derivative action brought against directors and four non-director employees,
seeking to recover damages.
Held: Not liable: (no knowledge of activity/no red flags), so no reason to act
o Directors and officers do not have fiduciary duty to monitor the personal, financial,
and legal affairs of other directors or officers to ensure their conduct doesnt harm
corp; in the absence of red flag
Beam v Martha Stewart: Marthas image was very much tied to her company, and
when she was being investigated, it harmed the company
ALI Perspective:
o If you can do it for accounting, you should do it for legal issues. Relies on Caremark
In re Caremark (DE): Healthcare co paying for referrals; illegal
Ct: Despite no knowledge, corps info system should have picked this up.
They should have responsibility (but dont cause MD comment)
MD: case is all dicta (was approval of a settlement of derivative litigation)
o Other Situations
(1) Accounting controls: everyone agrees with this.
(2) Regulated industry: lots of procedures and controls must be followed
30
But Chalmers is not in a regulated industry. We hold people secondarily
liable in only a few instances, and they are very carefully calibrated.
o E.g. Fed Sec Law 11 makes directors responsible for misstatements
in SEC filing but this is very limited.
(3) Matters that are observable by recordkeeping, i.e. employment practices or
environmental practices
What Both have in Common
o Rule built into both: automatic failure when (Caremark Standard)
Intentionally act with purpose other than the best interests of corp (loyalty)
Intent to violate law
Intentionally doesnt act when knows of duty to act
o Causation is a strong part to play (in negligence), and its very hard to show
Barnes v. Andrews (S.D.N.Y. 1924): Director of a new co didnt show up for
meetings or do job, just met with the president from time to time. GM and chief
engineer hated each other, and they would argue every day while all the employees
would wait to be told what to do.
Judge Hand: very stiff causation requirement the plaintiff must show that if
the director had done his duty, it would in fact have made a difference
This might have been bowled over by Technicolor.
Compare to Francis v United Jersey Bank
Suits: derivative and class action
Tooley: Must turn solely on the following question: 1) who suffered the alleged harm
(shareholders or corporation); and 2) who would receive the benefit of any recovery?
A Derivative suit is a corporate claim brought against an officer or director, charged with a
wrong to and benefit of, the corporation, brought by a SH
o Recovery goes back to corp (SH only has residual interest)
o Benefits insiders (protect own investment), big minority SH, and professionals
o Procedure: Must make demand (as defined below)
o Rationale:
ease the freeride of suits for SH
Now somewhat supplanted by Class Action suits
o Problems:
Incentives to settle: agency costs, dont want to find loyalty breach (so collect from
insurance), all $ except legal fees go to corp, not SH
Little incentive to monitor lawyer and usually only paid if win or corp is
substantially benefited/lawyer protected common fund (Fletcher v AJ)
Various suit issues:
Collusive suits btwn management and SH
Strike-suits (harassing, no merit, but corp will pay)
Meritorious (actual problem but corp wont make $)
Solutions to the Problems of Derivative Suits:
o Ex post solutions:
Judicial Oversight of Settlements
Contemporaneous Ownership SH at time of wrong, SH at time of the litigation.
VA: shareholder at the time of the wrong/before became publicly known.
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Ex ante solutions
Representative Shareholder P cannot have adverse interest to the corporation.
Shareholder Bond (i.e. security for expense requirements) If the SH loses,
corporation gets the bond to cover its legal fees. Designed to discourage strike suits.
NY: based upon the extent of shareholders. If less than 5% of shares.
CA: based on likely merits
Dooley: This is fading from view ALI and MA dont have this.
Demand must be made in compliance with R21
o Accepted then board takes over and case is over for the SH. Board then assumes full
control over lit and can compromise or do anything in name of corp
o Refused If for any valid reason, its over (BJR). Otherwise see below.
o Wrongfully Refused/Demand is Excused (Aronson v Lewis/Levine v Smith)
Using a reasonable doubt, that EITHER
No discovery, but SH can inspect corp books/records for any proper purpose
majority of BOD was not disinterested OR
Rales v Blasband: Board told SH they are going to buy gov bonds; bought
junk bonds. Then merged with Damahern
Issue: Defining this
o Without being influenced at all by improper consideration (Rales)
o no conflicting economic interest(?)
decision to dismiss was not a product of business judgment.
Majority: if P makes demand, majority of board is disinterested. So really
we are left with attacking the business judgment without the benefit of
discovery. Tough.
If the above standard is met, P gets to continue the lawsuit, unless an SLC has now
been created.
If a SLC now exists, then there are two methods Ct can pursue:
o 1) Ct reviews appropriateness of special lit comm decisions to
dismiss derivative suits (In DE and illustrated in Zapata v
Maldonado)
Zapata Test: (illustrated in Carlton Invest) Must show
recommendation to terminate derivative suit is supported by
demonstration that derivative action is more likely than not to
be against interests of corp (Joy v North)
Process: independence and good faith
o Uses limited discovery
o Hiding ties can be violation:
In Re Oracle: Fiduciary duty attacked
in suit; two members of lit comm were
profs at Stanford; while this was made
public, it wasnt revealed the
connection between board members
and the comm, and the huge donations
Oracle gave Stanford
o You should consider human relationships
(Chancelor Strine)
o Some states also have laws attempting to
define independence (MI)
o
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Substance: reasonableness
o May use own judicial business judgment.
Zapata v. Maldonado (DE): BOD was self-dealing, entire
Board is sued and thus demand is initially excused. During
litigation changeover in the Board and the new directors
make up the SLC.
Held: was a problem, but board has successfully
changed and now good
Carlton Investments v TLC Beatrice: SLC proposed
settlement for TLC Beatrice
o 2) Ct accepts decision and gives BJ deference of independence and
informed(NY)
Aurbach v Bennett (NY): Bribe on K. SLC determines suit
not best interests of corp, asks for sum judg.
Held: SLC has BJR, only looks to process issues:
whether the committee is independent and the
sufficiency of the report.
Strange application of BJR
o Levine v. Smith: Repurchase of GM from Perot. P wanted directors liable for amount of
payment saying he was insider. Entire board had agreed to pay.
GOOD LINGO FOR EXAM:
o First Tier: when reviewing the underlying transaction that was performed by Board
o Second Tier: when the action at issue is attributable to non-director managers or to a
minority of the board; (now reviewing the BJR not to pursue)
If Demand was not made, usually just a procedural error (Cayman v Financial Services)
o Demand requirement is just procedural; ensure its filed, but dont need to pay attention to it
If any of the following groups end up deciding its not in best interest of corp, case dismissed:
o Majority of independent members of board
o Majority of indepdent committee members of a special members
o If no qualified directors, ct to appoint individuals to make a committee to review this
Statutory Demand Requirements:
o ALI 7.03 universal demand unless it would irreparably injure the corporation.
o Model Act 7.42 Universal (absolute) requirement for demand there is no demand
excused. There must be (1) written demand and (2) 90 days unless (a) the shareholder has
been told that the demand will be denied or (b) 90 days would lead to irreparable harm.
Situations:
(1) Shareholder makes demand and BOD takes up case. Shareholder loses case
unless she can show that the BOD will not really do so, which is unlikely.
(2) BOD refuses demand. DE law is codified in this area. The shareholder
derivative suit shall be dismissed if either (1) the determination is made by a
majority vote of the boards independent directors which satisfies quorum or (2) a
committee of independent directors established by a majority vote of the board
which satisfies quorum.
To get around this there are a few requirements
o Complaint must be tested. The complaint must allege particular facts
creating doubts on either ground.
o Burden on pleading. Hearing occurs with burden of proof on the P to
prove that the recommendation of the independent majority of the
33
BOD was not in (1) good faith or (2) did not conduct a reasonable
investigation.
There is not a second step Zapata inquiry.
o Committee decision. If there is not a majority and an independent
committee then the burden switches to the D to show that the
investigation was in good faith and conducted a reasonable
investigation.
o What if there are no independent BOD members to have a
committee? Not sure look it up in model act. The idea is that the
BOD can appoint independent people so naming all members of
BOD in lawsuit would not eliminate demand requirement. Court can
appoint persons to do so but the burden is switched to D in this case.
MD thinks that the inquiry into how many independent directors you
have is an important question.
o Key distinction between DE law and model act has to do with status of board when filed:
In DE, if board is independent, P has burden of going forward
In Model Act, if suit is refused, P required to show Aranson; decision not
adequately informed
Basically, model act codifies DE law without demand required
NOTES: Should there Be a Demand Requirement At All?
o (1) Structural Bias: ALI said that the first tier is important, want the Board to pursue breach
of duty of loyalty. ALI said there was structural bias directors cant escape temptation to
be kind to their own, so independent directors are not enough.
Dooley: there is a connection between care and loyalty but ALI got it wrong. Board
is likely to feel betrayed if one of their own breached their duty of loyalty.
o
(2) Waste of Litigation Resources: The ALI said demand is collateral requirement; nothing
to do with the merits, and it is a complete waste of time for the courts, and the court should
focus on underlying cause of action and what board did and whether it was independent.
Judge Easterbrook in Kaymanthe court held that federal courts were free to
fashion a federal demand requirement in cases arising under federal law. The court
declined to apply the Maryland rule of demand futility and, instead, adopted a
universal demand requirement (after proposal in the ALI Governance Project)
According to Easterbrook, the demand futility exception had created gobs
of litigation on a collateral isse, and agreed with the ALI that the demand
issue should be severed from the question of judicial review of the boards
determination not to sue.
o Supreme Court reversed state law holds.
Indemnification
Because of the litigation issues, and cases in NY stating that directors are not agents, some
statutes specifically have indemnity provisions.
o Executive employees dont have to be EE are indemnified by ER at common law.
If a suit is successful, completely indenified by corp
o Includes when case doesnt get to the merits of the complaint (such as the SOL).
o In a suit by an outsider, corp may indemnify a director for expenses and for amounts paid
in judgment and criminal fines so long as the director meets a loose good faith requirement.
34
In a suit by or in the name of the corporation, the corporation may indemnify but only for
non-criminal and non-judgment expenses so long as the director meets good faith standard.
Attorneys Fees. BODs can get an advance for attorneys fees so long as the director meets the
loose good faith requirements and the advance can be made without an assessment of the directors
ability to pay it back. There is some insurance for this advance in the D&O policy.
Indemnity Insurance: almost always have it (except with Enron/World Com and Van Gorkom)
o
Shareholder Voting
Shareholders have right to elect and remove directors
Electing directors: (mandatory right)
One vote per share unless charter says diff
Common gets this cause lowest on totem pole so more valuable
Annual elections of board (though sometimes staggered)
Why does common stock get this right?
Removing directors:
At common law, could only remove for cause (undertmined deff)
Directors do have certain rights, that what they are is unclear;
Directors canot remove other directors unless shareholder authorization (even if
charter diff)
Arguments: Why Should Shareholders Vote?
o Dooley: check on managers
Even if costs lot to give info and they dont follow much themselves
What this doesnt explain is why you need to have full package of stock;
why not just right to vote?
Henry Manne Common stock is like a package of two bundles of rights: one is the
underlying economic interest, and the other is the right to vote. They bear and
inverse relationship to each other (the worse management, more valuable it is for
right to change them)
o Alchain and Demsetz: fundamental interests are common to all investors in corporation;
MD: empirically problematic because there is no non-voting stock
Stock with only voting rights (non-equity stock) is legal (also in Model Act states)
o MD: immediate problem with efficiency though since no incentive to increase profits
o Stroh v. Blackhawk: Started as insurance co, failed, changed business to importing wigs. SH
tried to oust incumbent management by saying that Class B (non-equity) is invalid.
Held: Its allowed.
o Problems with Stroh: equity, separating vote/equity & responsibility,
o Lerhman v Cohen (Stroh relied on it): two families founded Giant Food; 49% of the stock
each, and created a third class called AD stock, which was held by a lawyer. 2% to lawyer
to tie-break. Big difference is this was closely held, Stroh was major corp.
o
Proprietary doesnt mean economic
Cumulative Voting is allowed to protect minority SH
o Issue to remedy: Under one share-one vote, majority elect the entire board of directors.
o Allows cumulating all the possible votes allowed to pile on few candidates
o Cant use bad faith to alter how voting is performed
35
o
o
Coalition to Advocate Public Utility Responsibility, Inc. v. Engels: Cumulative voting is in
effect. C trying to elect a director; company staggers BOD elections to raise the number of
votes needed.
Held: rug-pulling elementthe rules are not being made in ignorance.
MD: timing is only problem here
Notes:
Optional in most states but some are opt-out default rules
Still allows Coalition strategy
Federal & State Regulation of Proxy Solicitation
o Federal trying to regulate securities markets and
securities issuers for investors not
securityholders or firms per se. (though often the same)
Differences between Federal Regulation and State Regulation:
o (1) Uniformity: Federal regulation is uniform (SEC) but states vary (so can choose).
o (2) Inflexibility:
State lot of enabling, default rules (can K around)
No alteration permissible in SEC forms/enforcement
o (3) A different assumption about the appropriate relationship between law and
markets/private ordering:
State statutes and common law have been built around the assumption that markets
work and private bargains should be respected;
SEC rules (FED) come from the stock market crash and depression.
Could be held liable for SEC violation, but not for state law
SEC is limited by the Commerce Clause
The Securities Exchange Act
From 1933:
o One shot transactional requirements for companies
From 1934:
o Applies to any publicly traded company
of significant size, not just cos traded on the
organized exchanges is affected. (12(g) amendment in 1964)
Permanently affected till reduce in size to the point where you are no longer
required to be registered with the SEC.
o Controlling Laws:
Periodic Reporting: annual (10k), quarterly(10q), and current reports(8k): 13(a)
Proxy Rules: Any solicitation of a proxy in respect of a registered security must
comply with Sections 14(a), (b) and (c) and regulations adopted thereunder.
Offer Rules: Any person, including the issuer, making a tender offer for a registered
equity security must comply wit the disclosure and substantive provisions of
Sections 13(d), 14(d) and (e),
Short swing profit provisions: Any person, directly or indirectly the beneficial
owner of more than 10 percent of any registered equity security, and any officer or
director of the issuer of such security, becomes subject to the reporting, forfeiture of
short-swing profits, and prohibition of short sales provision of Section 16(a)(c).
o Effect:
direct oversight over these exchanges.
Only transactional reports (disclosure) are proxy elections and tender offers.
no capacity to discover fraud in the documents
36
Was amended in 64 to include but most info had already been reported (periodic)
Essay of Market Induced v Mandated Disclosure
o MD: efficient capital market hypothesis works
SEC doesnt discover fraud anyway
Remedies/Enforcement: Not much explicit, led to implied
o Explicit Enforcement. The 1933 Act provides explicit civil remedies for incorrect
information in 11 and 12(2). 9(e) Issuers are strictly liable; underwriters and directors
were liable, unless not negligent. The 1934 Act provides some limited explicit civil
remedies. 16(b) against BOD or 10% shareholder for short-term gains on stock sale.
18(a) civil liability for false documents on which a reader relies.
o Implied Remedies. The fed cts implied civil causes of action and remedies under 14(a)
dealing with proxies and 10(b) dealing with fraud which covers nearly everything. It is
these implied causes of action that have made the 1934 Act so important in securities law.
The Proxy Rules: 14a, 14b, 14c
Federal Proxy Rules: There are three relevant sections in the 1934 Act: 14(a), (b) (c).
o 14(a) is the broadest form of delegation in the entire securities law; it provides: It shall be
unlawful for any person . . . in contravention of such rules and regulations as the
Commission may prescribe as necessary or appropriate in the public interest or for the
protection of investors, to solicit . . . any proxy or consent or authorization in respect of any
security . . . registered pursuant to section 12.
Proxies are used by shareholders to vote. In the solicitation process, the SEC would
clearly want to have regulations about the kind of information that has to be
disclosed when asking you to vote or suggesting that you vote a certain way.
Every proxy solicitation must be accompanied or preceded by a written proxy
statement. Disclosures include:
Conflicts of interest
Details of any compensation plan to be voted on
The compensation paid to the CEO and four highest paid officers
Details of any major corporate changes being voted on
Any documents that will be sent to shareholders as part of the solicitation
process must first be filed with the SEC before they are sent to stockholders.
Included in this filing is the proxy statement
While 14(a) allows very broad intervention by SEC, have largely stayed out.
Exceptions:
Attempt to improve SH democracy
o Tenure common stock (limiting transfers of common stock by
severely decreasing voting rights after exchange) was fought, Ct
overruled and Congress declined, but markets adopted anyway
Allow nominations of candidates to board without having to meet proxy
requirements, in certain circumstances
SEC now also requires compensation disclosure (compared to peers)
o 14(b) Beneficial Shareholders. Beneficial SH are persons who are not shareholders of
record but who really own the stock. Merrill Lynch sends the stockholders the proxy
statements and will then follow the voting instructions of the beneficial shareholders.
37
14(c) Controls Situations where Management Owns 51% of Shares. Must still give
shareholders notice of plans, supporting documents, and proxy material. Idea is that
minority shareholders could seek judicial intervention.
From 1992 (proxy changes only)
o Executive Compensation Amendment.
SEC requires executive compensation be approved by a committee, and disclose its
rationale for decisions (seems contrary to BJR)
Compensation comparisons to market and peer companies
o Shareholder Communication Amendment.
In time, the definition of proxy broadened. Under SEC Rule 14a-1(e), term includes
every proxy, consent or authorization . . .
In time, the definition of proxy solicitation broadened too. Under SEC Rule 14a1(k), term includes any communication reasonably calculated to result in
procurement, revocation, or withholding of resulting proxy
As a result of these broad definitions, SH halted from any sort of communications
among themselves. To address this issue, SEC passed Rule 14a-2(b)(1):
Exempts from most proxy rules, all communications from shareholders,
regardless of number of shareholders contacted, so long as:
o Shareholder communicating doesnt have substantial interest in issue
o Shareholder doesnt directly or indirectly seek proxy
Rule 14a-8. Shareholder Proposal Rules
o Eligibility and Basic Requirements: To be eligible to submit a proposal under 14a-8, the
shareholder must have owned at least 1% or $1K of stock for one year.
Proponents are limited to one proposal for per meeting, and the proponent or an
authorized representative must appear at the meeting to present the proposal or lose
the right to present any additional proposals for two calendar years.
The proposal and any supporting statement may not exceed 500 words in the
aggregate and must be submitted at least 120 days before the date on which proxy
materials were mailed for the previous years annual meeting.
Shareholder proposals are not subject to proxy rule requirements (except antifraud
provisions of 14-9) unless the proponent exceeds the limited role prescribed by 14a8 or otherwise solicits shareholder support for the proposal.
o Management Denials: Rule 14a-8(c) states that management may omit otherwise good
shareholder proposals on any of the following grounds: [more on pp. 42022].
(1) The proposal is, under the laws of the registrants domicile, not a proper subject
for action by security holders. (This is an issue for state law. Many states will only
allow advisory statement by shareholder so proposals that mandate BOD action
would be out.)
Cf. Pillbury and Conservative Caucus cases below.
(5) If the proposal relates to operations which account for less than 5% of the
registrants total assets and for less than 5% of net earnings and gross sales, and is
not otherwise significantly related to the companys business.
See Lovenheim v. Iroquois Branch (D.D.C. 1985) Shareholder seeks an
injunction to allow shareholder vote on proposition stopping the force
feeding of geese, when it is less than 5% of business. Company claims that
the exception (5) in Rule 41a-8(c) applied. Court disagrees and says that the
activity, while below the threshold amount, was otherwise significantly
o
38
related to the companys business because of ethical and social
significance.
o But note that getting out of the pate business for whatever reason
would be unchallengeable under the BJR; why is staying in any
different?
(6) If the proposal deals with a matter relating to the conduct of the ordinary
business operations of the business.
Theory: Importance of Proxy Contests in Governance. matter of much debate.
o Manne. Share values should increase upon the announcement of a contest (SH expect
better management). Two empirically studies back Manne up. Dodd/Warner find that
proxy contests (even losing ones) are associated with abnormally high returns to share
prices. DeAngelo find that proxy contests (even losing ones) force changes in top
management.
o Berle on Manne. Berle dismissed Mannes argument that the proxy contest should be
regarded as an economic mechanism of competition among potential management teams.
Enforcement of proxy rules
o While there is no explicit right for private investors to sue if proxy rules are violated, cts
have found implied right. (Borak)
J.I. Case Co. v. Borak: breach of duty to enjoin case with another case
Held: private enforcement of proxy rules is necessary supplement to SEC action.
Rationale: SEC examines over 2K proxy statements per yearSECs own
investigatory and enforcement mechanisms cannot prevent violations
o It is unclear whether damage must have occurred
Idea 1: SH have a right not to have violations committed, regardless of whether
there was harm. (Mills v Electric Auto-Lite)
o Mills v. Electric Auto-Lite: Mergenthaler and Electric Auto-Lite were to merge into a
new entity called Eltra. Mergenthaler is a controlling shareholder of Auto-Lite. E
recommends the consolidation; P argues that all of E directors were appointed by
Mergenthaler, and this fact was not revealed by the proxy statements, which was a
material defect.
o Held: Just have to show that misstatement was material (not fair)
Idea 2: must show fraud/false misstatement from the reporting had a material
effect (or essential link in Virginia Bankshare) on the merger
Reduced to significant effect on SH vote in TSC Industries v. Northway
Virginia Bank Shares v. Sandberg (U.S. 1991): While Court held that this
was a material misstatement, no causation: majority shareholder was the
parent corporation who was merging so it was impossible have a causal
impact on the decision to merge. Could not show that the misleading
solicitation was an essential link in the transaction that caused them injury
and thus could not prove causation of damages under section 14(a).
o Essay: Better for private or public enforcement of SEC?
Dooley prefers a private right of action in cases like Borak where:
(1) Nature of false or omitted information is firm specific.
o In Mills, information generic; (alleged misstatement is not unique to
the terms of this transaction).
(2) Victim has comparative advantage of detecting violation as they have
stake in transaction.
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In Mills, SEC had the comparative advantage
(3) Materiality of false or omitted information quantifiablepossible to
make an educated guess re effect of information on transaction value.
o In Mills, it was not; skirts the issue by asking whether a reasonable
shareholder thought this important.
(4) Remedy is compensatory.
o In Mills, plaintiffs were not actually harmed, but the Court grants
prospective damages void doesnt mean void but voidable
(5) Beneficiaries of action are shareholders of current corporation.
o In Mills, only beneficiaries were shareholders in a new corporation
that resulted from merger and perhaps shareholders of other similarly
situated firms (public good)
But generally, he likes SEC: notice, uniformity, and transparency
Legal Fees cannot be enforced by Ct except for civil rights cases
In Mills, J. Harlan assumed judicial authority to award attorneys fees under 14(a)
Overturned in Aleyska Pipeline v. Wilderness Society,.
o
o
Market Mechanisms of Corporate Control
Efficient Capital Market Hypothesis
The Efficiency of Markets: To an economist, market is efficient if current prices always and fully
reflect all relevant information about the commodity being traded.
o The ECMH is primarily concerned with informational efficiency.
Forms of the ECMH Theory:
o Weak form: Price changes in exchange traded securities are serially independent or random
in nature this has definitely been found to be true
The Random Walk (Drunken Sailor). Last position is an unbiased estimate of
current position. Why does this matter? It tells us that past movements of the stock
should not be indicator of the future of movement of the stock. The stock movement
is a random walk current price incorporates all past information and thus is useless
in predicting future movements.
This is an essential character of an efficient market: (1) it implies that all
information concerning historical prices is fully reflected in the current price and
that investors cannot profit by using past prices to predict future prices (2) current
price is an unbiased estimate of future price.
o Semi-strong form: Suggests that information that is public is immediately incorporated into
the market price of a stock this has largely been found to be true. Testing this theory
started with a study of stock splits where the price increased right up to the spilt. The idea
is that the market immediately incorporates all information and thus when the stock spilt
actually occurs there is no new information for companies who sent a good signal. Same
type of study with changing accounting methods market is not fooled. The market is
price.
o Strong-form: Suggests that even non-public insider information should be incorporated into
the market price of a stock. The idea is that insider information is going to get out and thus
the stock correct even for inside information.
MD frames it as: is there any identifiable group that has monopolistic access to
information such that it would be able to have above-market returns to investment?
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Mutual Funds: The prototypical sophisticated investor; would expect them
to outperform the market. The answer is no on average over time, they do
no better than the market generally. Occasionally would have a firm
outperform the market in a given year, but on average, dont outperform the
market.
Insiders: Under 16(a), all corporate insiders have to report any trade of
their own stock (this is not insider-information trading pre-established plan
or non-material information time trades). Insiders regularly out-perform the
market (by about 5%)
Notes.
Testing Problems.
Informational v. Fundamental Efficiency: (But MD says what else as alternative?)
o ECMH may explain why SH apathy is rational
o Managers monitor everything; maybe not best solution, but 2nd best
Legal Implications
o Mergers v. Tender-offers? There was a hypothesis that mergers will provide less $ for
shareholders than take-overs since the current managers need to be bought off. But Dooley
argues that if we dont categorize by merger or take-over, but rather by cash or stock buyout, then the disparity disappears.
Dont get rid of SEC, just simply reporting
o ECMH allows for calculations of damages for class actions? Under 10b-5 requires
proving damages. The ECMH allows us to test the effect of information on the stock price
and thus provides us with an idea of causation and damages. P need to prove (1)
materiality, (2) reasonable reliance, and (3) causation. How do we show the statement had
a causal effect on the price and that shareholders relied on it. The courts have responded by
coming up with a theory of fraud on the market which says that since the market is
efficient and new information is incorporated into price, that shareholders should be able to
rely on price and to the extent that the price has been artificially affected by false
information the shareholder has been defrauded.
Dooley states that this is a forensic proposition that is, would reasonable
person have thought that this information was important but fraud on the market
is a scientific proposition that is, did the market respond to this information. But
this can include random noise the forensic studies show that what is said is less
important than what is heard by the market since these do not necessarily go to
together since the market is not necessarily misled for instance by switching
accounting standards. So the market is not necessarily fooled.
Theory: Does change in ownership create value? Brudney & Chirelstein: 3 types
o
o
o
o
o
Two-step mergers. Since majority of SH must approve, cleanest. Arms-length dealing and any remaining
minority are assured of treatment like the selling majority.
o MD agrees: get assets and replace management
MBOs (management buyouts) absolutely valueless and should be eliminated
o MD: no inefficient management, no syngery gains
Parent-Subsidiary (Weinburger). can have some value from synergistic gains.
o MD: no synergistic gains: parent already controls, will see gains w/out merger.
Market for Corporate Control
Markets correct bad management through variety of methods
o Bankruptcy: poorly managed firms will eventually fail in a competitive market.
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Not satisfactory cause will likely consume excessive financial and human resources.
Outsiders: via market price signals
Market for corporate control does both for firms that dont respond to one or the other
Aspects of the market for control: Broadly understood, the market for corporate control
includes all strategies by which one person, group or firm (hereinafter, the bidder) can acquire
voting control of another firm (hereinafter the target). Several strategies are:
o Proxy contestsbidder solicits proxies from other shareholders (vote)
Disadv: expensive and person who does it doesnt get all the profits
o Purchase of controlling interest: cheaper than above (vote)
o Purchase assets of the target: (vote)
o Merge the target with itself or another firm (vote)
o Tender offer (no vote)
Tender offer: offer directly to SH to purchase their shares for a stated consideration (could be
cashwhich case it is called a tender offeror sharesin which case it is called a exchange
offer), and usually the offer is at a premium.
o Regulation of tender offer:
Federal
The Williams Act (1968) amendments to the 1934 Act:
o 13(d): Any person (whether making tender offer or not) who
directly or indirectly acquires more than 5% of any class of stock
in publicly held corporation must file statement of number of shares
purchased and intentions after acquiring with SEC within 10 days of
acquisition
o Regulation limits benefits that acquirer gets from purchasing initial
shares at price lower than eventual tender offer price
o Effectiveness limited because acquirer may still purchase shares
during 10 day window after 5% threshold is crossed
o 14(d): Requires comprehensive disclosure by any bidder of their
identity, financing, plans for the company if the bid is successful, and
other info. This is when you would implement the tender offer to get
around the window.
o 14(e): Forbids manipulation or deception in tender offers
State
Protecting Management: Federal regulation of tender offers is, in total,
designed to protect shareholders. However, 20-30 states have passed
supplementary tender offer regulations designed, in total, to protect
incumbent managementespecially by out-of-state bidders
3 basic types of state regulation of tender offers: (2nd generation)
o Control Share Statute. If party acquires X% of shares of target
without prior approval of Board, party is not permitted to vote on
those shares unless and until other shareholders permits party to do
so. Usually ineffective because shareholders will give party right to
vote to get the $.
o Business Combination Statute. If party acquires more than X% of
shares of target without prior approval of BOD, party is frozen for
specified period of time. Party may not merge, sell assets, etc.
Particularly effective against two-tier offers
o
o
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Other Constituency Statute. When considering whether to support or
oppose a tender offer (via poison pill, litigation, etc.), Board may
take into account interests of employees, creditors, community, etc.
as well as interests of shareholders
Defensive Tactics for Tender Offers
Board can hinder a tender offer or block it from reaching the companys
shareholders. A brief review of the various tactics:
State legislation (described above)
Control shares
Business combination
Other constituencies
Board Initiated Maneuvers (Beyond Poison Pills)
Charter amendments most effective in combo with a pill.
o Classified Board (Staggered elction of Board): This means that a
proxy contest to replace the board is effectively blocked.
o Removal for Cause: Can also try a provision giving shareholders
power to remove directors only for cause.
Messy acquisitions Acquiring another company for the sole purpose of
creating regulatory problems for the bidder uglification: like antitrust
(Marshall Field), or a company that has a requirement of prior state approval
(liquor distributors in Florida).
Additional moves under Delaware (and similar states) law
o White knight merger target can go out and arrange a merger with a
friendly company that will keep management in place.
o White squire issue issuance of blocking chunk of stock to a friendly
company. Issue new stock to a friendly company in order to maintain
managements majority of votes and have a standstill agreement
whereby the company (new shareholders) agrees to vote with
management for a given number of years.
o Poison pill/shareholder rights plan by far the most popular means;
adopted by the board in Moran.
Moran is the grandfather of all poison pill cases; this involves
two major players: Marty Lipton from Wachtell and Joe Flom
from Skadden, usually on opposite sides. Both firms got to be
prominent because of their participation in tender offer cases.
The older firms didnt like this kind of tender offer litigation,
and thought it wasnt gentlemanly.
Litigation under the 1934 Act used to be something of a showstopper
because under the Williams Act there was the ability to get damages or
punitive injunctive relief. Cant get punitive relief injunction anymore
(Piper Aircraft v. Crisscraft case in the USSC) so this is not as popular as it
sued to be. Now all you can get is corrective relief.
Types of Poison Pills:
The Flip-Over Pill: Allows current SH to convert an option to buy a
preferred class of shares convertible into common shares of the bidder.
o Only activated if there is a 2-step merger attempt.
o
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A two-step acquisition is where you get control through
acquisition, and merge the remainder. This is likewise very
effective against the LBO.
Otherwise, nothing to which rights can attach.
o Two key legal rights:
Poison pills are given to SHs as a right exercisable only if
there is a tender offer with a second stage merger.
All shares within the same class must have equal rights, but
these rights cannot be gained by the bidder.
Isnt this discriminatory treatment?
The Flip-In Pill. SH rights to shares of the target, declared by the Board
as a stock dividend. The rights are redeemable at any time by the Board for
a nominal fee (such as a nickel a share) way to defuse the bomb so to speak.
o Triggers: 15% acquisition, tender offer of 30% or more without
approval of Board.
o Exercise price: Set at theoretically what the board thinks the
company will be worth at the end of the rights plan.
o NOTE: Most rights agreements give the Board a 10-day period in
which they can still redeem the rights if they want to, but once that
period expires or once someone goes over 15%, the rights become
unredeemable (a doomsday machine).
Consequence: Forces bidders talk to current management.
The Business Judgment Rule Applied to Defensive Tactics (Regular)
o There is a right to create defensive measures for general prevention of takeovers
o From ability to create stock for any valid purpose (unless otherwise stated).
o Moran v Household Int.: H trying to block a two-tier tender offer (worried about a
bust-up merger) and so have a flip over. If a bidder makes a tender offer to Hs SH,
conditioned on redemption of the rights provision. Hs board refuses to redeem M sues
for an injunction (as a stockholder).
Held: Right derived (from above) and plan passed BJR
o UNOCAL v Mesa Petroleum: M (13% owner of U), made a 2-tier tender offer for U.
Offered $54 cash, then $54 in junk bonds. Board of 8 outsiders and 6 insiders found
offer to be way too low; Board then offered $72 to buy out own stock (thereby taking
on huge debt) except for Ms.
Held: M was trying coercing and scaring SHs; M had reputation for doing this.
If forced U to buyout M too, would be helping to subsidize this problem.
o But they must pass the standards of Moran Test:
o Threshold of BJR: Presume that Directors acted
an informed basis,
in good faith, with
honest belief that the action taken was in the best interests of the company/SH.
o If pass this rule, then allowed to make mistakes (Dooley: to ensure not being cute)
o D may then have burden to show:
Threat: reasonable belief that bidder is a threat to the corp (Cheff v Mathis)
Possible threats include structure, long-term plans, culture,
Can also include reputation of other co (UNOCAL)
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Proportionality: reasonably proportionally related to the threat. (UNOCAL)
In Moran, BOD passed UNOCAL so get BJR. Was proportional given
coercive tactics of the bidding company.
Once a change of control is inevitable, Board must cease all defensive measures and
concentrate solely on getting the best price for shareholders. Revlon Mode
Does include selling (QVC), restructuring (Time), MBO
Does not include when selling subsidiaries (Interco, Revlon)
Revlon: Pantry Pride made bid for R; CEO didnt want to sell to CEO of PP, and
instead he went to Forstman-Little to get a competing bid. PP kept beating
Forstmans bids and eventually said it would pay more than Forstman, whatever
their bid. Revlon decided to option its crown jewelthe eyewear divisionto
Forstman-Little for pittance as a Defensive Maneuver.
Held: Must act for SH; noteholders are secondary in decidning if bid is good.
o Issue: Doctrinal Problem: Defensive Tactics/Duty of Care/Duty of Loyalty
If the duty of care, must overcome BJR before directors examined.
If duty of loyalty, burden on directors to establish the fairness.
Problem w/ tender offers is that they raise both possibilities
Proposals:
Add on Reasonably believed for BJR
o Done in Cheff v. Mathis: reasonable grounds to think offer was threat
to corp policy
Proportionality: (Unocal) (already being instituted)
Academic proposals: What law should promote?
o On the view that the law should promote efficiency:
Easterbrook and Fischel: Board should always be passive.
Defensive tactics increase the bidders search costs,
and therefore discourages further searches.
No one wants to pay: first bidder would pay and
second would just use that research
Dooleys Critique of E&F:
Not all tender offs driven by mngmnt inefficiency
Impractical model: board is still in office when the
offer comes, and if they dont take action, guilty of
abdication of responsibility Board has an obligation
to investigate and evaluate an offer.
Gilson: Board perform a negotiating role only.
Closer to what the courts have done.
Ct doesnt want board to decide its own fate (can
negotiate, but not defeat, a tender offer)
Dooley Critique: in order to negotiate effectively, have to be
able to make a credible threat of walking away. Doesnt
o On the view that the law should promote equity:
Confusing overall: Ct looking at equity but only party worse
off by tender offers is management
Ex: City Capital v. Interco: I is target company offer from CC. Is response was to restructure
sell off subsidiary, borrow money, and then use to proceeds from the sale of assets and loans
to pay a huge dividend to its own shareholders. C offered $64/share, and I mgt wanted to give
o
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SH more than that in dividends. Would signifinctly lower value stock, but no change in control.
Also adopted poison pill to give time to perform these actions.
o Held: Does not trigger Revlon (no change of control), dividend is better than actually
buying for SH. Poison pill was protected by BJR, but not proportional to threat.
o On one hand suggests board should act as negotiating agent, but Allen also says may
have been conflict of interest
o How does the conflicted interest filter rule work?
Pretty well in Revlon.
Works in Interco if believe the plan is competitive, should let it go forward.
Works in Time business strategy, and when the Board had no possibility of conflict
of interest, decided to get into the video business and Warner is the best partner.
o Background:
Academics: SH should decide, although Gilson would permit the board to act as a
negotiating agent on their behalf.
Court: board gets initial choice when not self-interested.
UNOCAL is filter for self-interested (clears up Revlon and Interco) and
explains why look so much at non-management directors
BJR for defensive tactics (DE Style)
o Board has authority to decide unless doesnt pass Moran
Being part of a long term plan auto helps it pass the proportionality requirement
o BUT, Suggestive behavior is enough to strike a defensive tactic because there is a high
risk of conflicted behavior here. (Paramount v QVC)
Ct didnt have to prove there was actual conflicted behavior
Forced Revlon style auction
Paramount v. QVC: Viacom and Q both wanted to merger with P; P wants Q.
Bidding war, P refuses to revoke poison ps/other defense tactics. P argues that 1) it
wasnt up for sale and 2) part of a long-term strategic plan that Q is better partner.
Held: No long term plan (Q would own 72% of merged co., so no control)
o Cant stop just one bidder if trying to get another
Ex: motivated by dislike of CEO of Paramnnt and fear of losing job (QVC)
However price isnt the only factor can consider (Nabisco)
o FMV offer doesnt mean doesnt automatically trigger Revlon (Paramount v Time)
o Paramount v. Time: T bids to merge with Warner, part of long term plan. Needs Ts SH
approval. Then P offered bid for T. T, worrying about SH vote, changes the offer for
Warner to buyout so no vote needed stock.
o Held: Passes UNOCAL: reasonable, part of long term plan (so not response to
P). No indication of corruption.
In Other States:
o Legislative: can make tender offers easy or hard
Pennsylvania is pro-management; tough takeover laws.
Virginia is a model act state, just follows the DE case law. VA did change the
standard of care from a due care negligence standard of care to a good faith
business judgment standard.
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Conflicts of Interest and Property Rights
The Duty of Loyalty
Economically, issues of care or loyalty look the same; law penalizes loyalty breach more.
o Structural aspect: only a negative duty
o Rhetorical aspect: sends a signal (maybe deterrence)
o Detection aspect: Detecting it is more difficult than duty of care.
Categories of Duty of loyalty cases:
o (1) Bargain Policing Rules Was the process and the deal struck fair?
o (2) Property Rights Rules whos is it? (agent learns something in dealings)
Trying to balance Deterrence and Efficiency
Process and Duty of Loyalty:
o Once overcome BJR, duty of loyalty burden of proof shift applies to determining
damages in duty of care litigation which has overcome business judgment rule.
(Technicolor)
1) Show fair dealing and 2) fair price
Trans-Union rule is new way
Old Duty of Care: P still has to prove causation and damages (like any
contract or tort case)
Rationale: D has huge advantage in proving deal was fair
MD: only that person would have access to info on 1) what they took and 2)
how big it was overall (Ex: Weinburger)
Bargain Policing Rules (Directors Transactions)
Evolution of thinking:
o Early: no trustee can deal with his own trust beneficiary
o Middle: Ok for trustee/beneficiary if 1) beneficiary is competent, 2) full disclosure and 3)
fair; Still no trust and trustee
o By early 20th century ok for director and corp if 1) fair and 2) agreed by majority of
disinterested directors
Globe Woolen. v. Utica Gas & Electric: M owns two mills and also sits on the board of U. works
out a deal for U to supply electricity to Gs mills; very favorable to Globe Woolen.
Held: K is void; doesnt specify if fraud or mistake
Were no disclosure rules at this time, so Cardozo couldnt have considered them
Today, rules generally provided by statutes emphasize disclosure and fairness, in differing
degrees. An example is DE 144
Its so important because no longer are these transactions automatically void when conflict
DE 144. Interested Directors; Quorum
(a) No contract or transaction between a corporation and one of more of its directors or
officers . . . shall be void or voidable solely for this reason, or solely because the director or
officer is present at or participates in the meeting of the board or committee which authorizes
the contract, or solely because any such directors or officers votes are counted for such
purpose so long as:
(1) there is disclosure about conflicts and all material facts to the transaction, and it is
approved by majority of disinterested directors or shareholders, or
(2) there is disclosure to shareholders about conflicts and all material facts to the
transaction, and it is approved in good faith by vote of the shareholders, or
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(3) it is fair
(b) Common or interested directors may be counted in determining the presence of a quorum at
a meeting of the board of directors or of a committee which authorizes the contract or
transaction.
o Notes on 144:
Solely
even when inside transaction, if the director discloses the conflicts and all
material facts regarding the transaction and it is approved by a majority of
disinterested directors, then the transaction can go forward.
Note that there is a two step approval process here:
(1) the conflicted director can be counted toward the presence of a quorum
that is necessary for the transaction to be approved, but
(2) the transaction still needs to be cleansed by getting a majority of
disinterested directors.
What about fairness? If the transaction was approved by a majority of the directors
and was determined to be fair, would the failure to disclose make the contract
voidable?
o 144 supported by Cookies Food Products v Lakes Warehouse: good faith, honesty, and
fairness
Cookies: Director turned around company by using his other company to promote
business; financial success for both corps
What is conflict? RMBCA: Subchapter F ( 8.608.63) of Model Act tries to define
o Consider controversial
o Impt cause detailed and exclusive definition of a conflicting interest and its
specification of the permissible scope of judicial review. Whereas the common law and
previous statutory enactments can be seen as sacrificing predictability in favor of maximum
deterrence, subchapter F adopts a bright-line statutory approach
o Statutory Structure:
RMBCA 8.60 Definition of Conflict (p. 598) defines fairly specifically what a
conflicting interest is (includes financial or personal interests) and defines
directors conflicting interest transaction
RMBCA 8.61 Judicial Action (p. 600) states what valid judicial actions are:
cannot touch something that is not a directors conflicting interest
transaction
cannot touch anything that is not a directors interest transaction if:
o it was approved by directors under 8.62
majority of the qualified directors, if a majority, or
a majority of qualified directors of a committee provided that
the qualified directors themselves must choose the member of
the committee, and
the committee has at least two qualified directors.
o It was approved by the shareholders under 8.63
o it is otherwise fair to the corporation
Essays: Director Transactions
o MD: director only has an obligation to provide all material facts that she knows anything
that could have been discovered it is up to the rest of the directors to determine or discover.
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Dont have to say more than just what there conflict is (dont have to make them
better)
Melvin Eisenberg: Self Interested Transactions in Corp Law
Fairness of price isnt enough with full disclosure because it would remove decision
from corp hands and give it the court
o Ct looking at price can only say what would be FMV at arms length
Thus fairness test is needed because:
o Directors, because of camaraderie, will be unlikely to look at directors on
same board like they would a 3rd party
o Legal disinterested does not equal practical disinterested
o
Shareholders Transactions (Parent/Sub, Conflicts btwn classes, Final Period)
The tension between the demands for loyalty and respect for party autonomy is more apparent in
the case of shareholder transactions.
o Court recognizes the existence of competing concerns where shareholders are concerned.
o Since shareholders are the corporation, and in many cases the decisions of shareholders are
not reviewed; i.e. exercise of the franchise. However, where there is a majority shareholder
with decisive voting power, there is the possibility of differential treatment. In the case of
publicly held firms, the market restrains majority greed because any diminution in the value
of the minoritys shares diminishes the majoritys wealth proportionally.
The level of judicial review should depend largely on strength of market constraints on
majority behavior.
o We will look at three special situations below, where market forces may not constrain
majority shareholders all that wellparent and subsidiary transactions, conflicts among
classes, and the final period problem
Parent-Subsidiary Transactions
Must show self-dealing in order to get the entire fairness analysis
o Self Dealing: where the parent receives a benefit
(1) to the exclusion of and
(2) to the detriment of
the subsidiary.
o Entire Fairness:
Fair Dealing
Fair Price
If no self-dealing, the test is one of business judgment (any reasonable business
objective
Sinclair Oil v. Levien: S controlled Sinven, a subsidiary. S caused Sinven to pay out high
dividends to Sinclair to fund Ss expansion. P, a minority SH, claims hampered growth of
Sinven and caused another subsidiary to breach K with Sinven.
o Held: Not detriment of Sinven (no other opps shown), not to exclusion (all SH got
share of dividends). Did cause breach of K, couldnt prove was fair to minority SH
on this point.
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Conflicts Among Classes
When a controlling SH owns one class and the minority owns another class, the two
classes may have differing interests (Zahn v. Transamerica Corp.)
o Zahn v. Transamerica: T owns nearly all Axton-Fishers Class B. Public SH own Class A
stock. T exercises call on Class A. After Class A is gone, will liquidate Axton-Fishers tobacco
inventory and keep profits for itself. Z files for all SHs.
o Held: Duty to disclose all info to Class A
Controlling SH must make full disclosure to their fellow shareholders when they propose
a transaction with those fellow holders (i.e. a redemption)
The Final Period Problem Weinberger v. UOP, Inc and Takeout Mergers
Basic Merger (Buyer merges with Target) has 6 issues for complaints:
o (1) prudential (dont think the merger is a good idea).
o (2) price (we did not get enough money).
o (3) fairness (although in an arms length transaction, this is really about price as well)
o (4) statutory defect (merger did not meet the federal or internal corporate laws) or
o (5) fraud (B misrepresented its value; Borak, Mills).
o (6) no due care by Ts directors (our Board acted like in Technicolor, or Van Gorkom)
o For the first 3, Appraisal Rights are the only remedy:
Requires For SH to:
(1) vote against the merger,
(2) notify the company that you are dissenting, and
3) demand appraisal rights.
Procedure: There will then be a separate proceeding where the judicial body
determines your shares worth at the time immediately before the transaction. Any
appreciation from speculation about merger does not count towards your appraisal
price. The appraisal rights only kick-in if the merger goes through.
Rationale: Allows T SHs to be bought out if they do not wish to go along with the
merger. MD says in a closely held corporation, this makes sense because it would
be the only way for the shareholder to get out But not if the stock is publicly held.
o For the last 3, can file Class Actions or Derivative Suits to remedy
Takeout Mergers: A takeout (or freezeout or cashout) transaction eliminates minority
SH equity while preserving the interest of a controlling SH/other insider .
o Trying to gain complete control, like in Weinberger and other cases.
o This is a special case of a shareholder transaction that implicates the duty of loyalty:
Final Period Problem: after the takeout, there are no minority shareholders and
so the majority may be willing to give a raw deal.
o History: A statutory innovation, and along with the short-form and long-form mergers. This
allowed takeouts to occur at all.
1960: lots of private corps, wanting to be public
1972: market went bad, want to be private again
o Some argued was fraud, but SupCt rejected.
Santa Fe Industries v. Green (1977)
Refocused state law the DE courts decided Singer, then Weinberger, then Kahn.
State (DE) laws regarding Takeout Mergers: (MD says still fluxuating)
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Initial Rule: Minority can be eliminated so long as there is some colorable business
purpose, but the transaction is reviewable for fairness, and P is entitled to a fair price.
Singer, Roland, and Tanzer
Singer v. Magnavox: M made tender offer for Phillips that attracted 84+% of shares,
and then did a cashout merger of the rest for the same consideration. After merger,
Ps filed a complaint seeking recission and compensatory damages on the grounds
that this cash-out merger was done without a valid business purpose
Held: Violation of the fiduciary duty SH to merge for the sole purpose of
getting rid of the minority without a valid business purpose. (M was a
majority SH only for a few months).
o New Rule (Weinburger): Initial rule + buyer must have:
(1) A majority of the minority have to approve the deal, and
(2) the company must replicate arm-length bargaining.
Targets board must allow the indyt directors to negotiate the deal and
preferably hire indy counsel/I bankers to identify price and negotiate
o For a P to make a successful claim against a Takeout Merger:
Initial Burden. Allege some specific unfairness.
Entire Fairness Burden. If unfairness is established, burden shifts to D to
demonstrate the entire fairness. (See New Rule above).
The burden back on P if all of this happens:
A majority of the minority SH's approved (Weinberger)
Ds make showing of adequate disclosure of the transaction. (Weinberger)
Arms-length process for reps of the minority and majority negotiated.
o Usually by a committee of indy directors (but see Kahn where
coercive actions of board prevents this burden from being shifted).
o D has a Duty of Candor/Burden with minority SH of complete candor and disclosure
If dont meet, back on D to prove entire fairness
o The majority is supposed to share any gains from the freeze out with the minority
shareholders (Weinburger)
o Cases of Fluctuation:
Weinberger v. UOP: Signal trying to eliminate minority SH in UOP. Signal already
owned > 50% of UOP and wants rest of it because no good alternative investment
opportunities. Signal offers a price with a premium above the market pricethis
was negotiated with UOP management but Signal has appointed the BOD. There
was a provision that the buyout would not go through unless it was approved by a
majority of the minority shareholders.
Held: Procedurally, Signal did not allege business purpose and the DE SC
uses this opportunity to get rid of the business purpose test.
Kahn v. Lynch Communications: (Post-Weinburger) French company Alcatel
controls Lbut 6 of 11 members of the BOD are independent (not selected by L).
L proposes to acquire another company but Alcatel vetos, wants L to buy a
subsidiary of Alcatel. Independent BOD members veto; Alcatel offers to cash out
minority shares in L. Alcatel offers higher price and says will do tender offer if
dont accept; board accepts.
Held: Chancellor finds arms-length negotiation, DE SC reverses saying
Alcatel was coercive. Ultimately found to be fair.
o
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o
Kahn and the Status of Weinberger: Here the company purposely had a majority
independent BOD and still had to go through an entire fairness review.
MD: says that state of law is in flux the DE court has yet to find a case that fits the
requirements of Weinberger and minority SH can still challenge on unfairness.
Theory of Takeout Mergers
Evolution of DE SC Rule: Change from Singer to Weinburger is progression from one
regime to the other. Courts will change their minds to make the legal regimes better.
Business Purpose:
o High risk of cheating cause info asymmetries and lack of market restraints.
o Trying to limit end game/final period (no incentive to keep cooperating).
Takeouts do create value: (Following is the evidence)
o (1) Premiums paid in take-out transaction offer premiums similar to those in armslength transaction,
o (2) share price goes up with the announcement of a freeze-out transaction
o (3) the announcement of a cancellation of a freeze-out leads to a decline in value for
outstanding shares.
MD: Divide the bargain policing rules into two categories:
o Prohibitory Rules either out right prohibit the action or make the transaction very
costly. These rules are designed for transactions (a) that have a very high risk of
cheating and (b) in which the new value of the transaction in doubtful. The two of
these together makes us very worried that these will just be transfers of wealth from
the poorer to the richer with deadweight loss.
o Procedural Rules these rules cover transactions where there is (a) a risk of
cheating but the risk is low and (b) the transaction appears to create new value. It is
these types of transactions which we want to allow even when risk of cheating.
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Property Rights Rules and the Duty of Loyalty
At the beginning of this section we described how two types of loyalty cases tended to be lumped
togetherbargain policing cases, and property rights cases.
o Bargain policing: Not focusing on initial rights; concerned most about procedure and
facilitating the bargain (an efficiency concern).
o Property rights cases: concerned with the initial assignment of rights, and whether
subsequent transfer of the rights is permitted.
Most of the cases involve disputed claims to right to information.
The Information Property Rights of the Firm: Concerned with allowing use for firm, but
information is unlike other assets of the firm once information is given to agent or employee,
cant keep control over it. Also, transfers of valuable information may be contemplated as part of
the employees implicit compensation.
Led to the Corporate Opportunity Doctrine
o If manager is found to have taken for himself a corporate opportunity, the taking is
per se wrongful and corporation may recover any profits from it.
o Corporate Opportunity Doctrine Tests.
Line of Business. if closely related to the corps existing or prospective activities
Most common approach. Often includes fairness too
Miller v. Miller: Three brotherstwo work for the corporation and one does
not. The two run the company and develop other companies which develop
products which the initial corporation did not have the capacity to make, all
in are in the waste/lubricant businessone new product replaces all the
others. The lone bro says that proceeds of the other companies for the
benefit of the original company (which he owns stock in).
o Held: was fair to corp, no violation.
o MD: Line of Business Test and Fairness Test taken together or
separately are simply too broad!
Interest-Expectancy Test:
Interest: some contract right regarding the opportunity.
Expectancy: reasonably expects to take advantage of opportunity.
Used by itself, this is the least common test. Very narrow approach
Official Capacity Test. An opportunity is a corporate opportunity if corporations
agent was presented with the opportunity in his or her official capacity.
Delaware Test: Official Capacity test + Interest-Expectancy Test
Dooley thinks that this is the better approach because it best addresses the
issue of who has right to act on information about opportunity.
o Guth v. Loft: L has lots of candy stores and exclusive deal with Coke for syrup. G develops
Pepsi and uses Ls employees, assets, and capital to do so. Pepsi is not competitive with
Coke but is viable. The plaintiffs allege that the G did not compensate L for contribution to
the Pepsi.
Held: Give all of Gs interest in Pepsi.
Insider Trading(10b and rule 10b-5)
Developing the Prohibition on Insider Trading
Prior to 1934:
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o
o
No concern about insider trading.
20s had concern with some manipulation, passed Section 9 lists those practices which are
prohibited (e.g. wash sales) and also practices that are allowed, but only within limits.
1934:
o Passed SEC Act including 10(b); thought would be catch-all section. No real action
o Section 10(b) provided that it was unlawful To use . . . any manipulative of device . . . in
contravention of such rules and regulations as the Commission may prescribe . . . .
1942:
o In Boston an insider was going around and spreading false bad rumors and then buying up
stock on the cheap. The SEC created Rule 10b-5 to cover this.
o Created 10b
1961
o Till then, rarely invoked. But when it was invoked, it was with regards to an affirmative
misrepresentation in the purchase or sale of stock. Evolved for 10b-5 come to be associated
with insider trading?
o Texas Gulf Sulphur is an extension of the Cady Roberts rule. This is the grandfather of all
insider trading casesbut the facts are atypical and extreme. These are unusual because of
the incremental way in which the value of the information was revealed over time. See
footnote (a) which summarize dates.
Statutes and the violations
10b. Unlawful to use any manipulative or deceptive devise
10b-5: unlawful to defraud/make any untrue statement of a material fact or omit to
state a material fact or engage in any act that would cause fraud
Rule 10b5-1: defines trading on the basis of inside information; presumes that if have knowledge,
you are trading on it (resolved a previous circuit split)
Rule 10b5-2: when a relationship sufficient is when one person using information has breached
confidentiality for misappropriation purposes. (from Chestman)
In short, the violations are misrepresentation or insider trading
The Rules:
Derived from 3 theories of liability:
o Equal Access: a; traders owe duty to market to disclose/refrain from trading on non-public
corp info (Texas Gulf)
o Fiduciary Duty: liable if breach fiduciary duty to SH with whom you trade (Chiarella);
must have been pre-existing
o Misappropriation: liable if breach fiduciary duty with the source of the info unless you
disclose to person you will trade on it (OHagan)
Fraud: (until news is out (Texas Gulf))
o If you trade on the info and Have duty to the purchasers/sellers
It doesnt run to them solely because material nonpublic info is possessed.
Chiarella v. United States: C is a financial printer. Lawyers sent copies of bids to
him; he would then buys shares in the target after figuring out who the target was..
Held: No duty to the market. Fraud, for J. Powell, only includes non-disclosure
where fiduciary duty; if not such relationship, not affirmative duty to disclose.
o If you trade on the info and Have duty to source, unless you told the tippee
Liable under Misappropriation Theory
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United States v. OHagan (U.S.): O partner in law firm; trying to cover previous
embezzlement from other clients and putting money into trusts. Co that law firm is
representing is planning takeover of Pillsbury. O begins buying Pillsbury shares and
call options on Pillsbury so that he holds more calls than any other individual, which
is a huge red flag to the SEC. 8th Circuit said no 10(b)(5) violation because he had
no fiduciary duty to the target shareholders and did not accept the misappropriation
theory.
Held: No duty to Pillsbury SHs, but SupCt adopts misappropriation
Rationale: deception (pretended loyalty) w/ firm and co.
o If you pass on material info and
1) have fiduciary duty to SH w/whom trading OR source of info; AND
2) obtain personal benefit (direct or indirect)
Doesnt look to intent (but not speaking with analyst in Dirks)
o If you receive material info (tipee) and
Trade on shares
Tipper is liable or should have known they were liable
But may be able to get off if good faith (Scienter Requirement)
Texas Gulf says no; SCOTUS in Ernst and Ernst said yes
Material information when
o information to which a reasonable man would attach importance in determining his
choice of action in the transaction in question; but the Court states that the reasonable man
is really the sophisticated investor.
A misstatement about merger negotiations is material if there is a substantial likelihood
that the reasonable SH would consider it impt in deciding to buy/sell
o Basic v Levinson (U.S.): B was approached about merger, management kept denying until it
decided to merge. Appeal from suit.
Held: Violation existed
o SEC v. Texas Gulf Sulphur: T, a mining company, bought a mine and over time figured out
it was going to be big. Corporate insiders bought, gave tips to friends. Test done on Nov.
12; news on April 16.
Held: Start date should be 11/12 until 4/16.
Reliance on the material information is presumed(Basic v Levinson)
o Analysis: assumes that reflected in share-price and P relied on that
o Can be rebutted by showing:
Info wasnt reflected in share price (no one believed lie, didnt get to market, etc)
P/SH would have traded regardless of price (liquidity, hated CEO, etc)
o Rationale: Presumptions allow ct to manage situations where proof is difficult to get
Cases:
o Dirks v. SEC: Co pretended to do insurance, did fraud. Ron Secrist (employee of Equity
Funding) wanted the fraud exposed. He went to office of SEC in LA, insurance dept of
CA, NY Insurance Commission, and reporter at WSJ. All ignore. Reporter directs him to
Ray Dirks, a securities analyst. Dirks starts uncovering fraud, wants to publish in the WSJ,
but the Journal refuses. Dirks starts getting calls, he told them what he knew ,Equity
Funding's stock nosedives. SEC investigates brings criminal charges against Equity
Funding and civil charges against him.
Held: Dirks didnt violate; not in fiduciary capacity and no known violation by
Secrist revealing the secrets
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o Its the relationship between tipper and source of info that counts
o United States v. Chestman: Julia is matriarch - mother of Shirley and Ira (head of
Walbaums, a supermarket chain). Shirley is mother of Susan (married to Keith). Shirley is
not well, and doesn't get out much, so Susan calls her every day around the same time. One
day Susan called Shirley, and Shirley doesn't answer, so she calls again, still no answer. So
then Susan calls Julia, no answer. Finally gets in touch with Shirley, and Shirley, Julia, and
Ira had gone to the bank to sell family business to IRA, and they tell Susan to keep quiet
about the whole thing. Keith comes home, and Susan tells him about selling the family
business. Keith takes off, and he calls his pal and broker Chestman, and gives him some
reliable news that Walbaums is going to be sold at a favorable price.
Held: No 10b-5 violation: Keith had no fiduciary duty to Ira (would require that plus
Chestman knowing he had breached). But was 14e-3 violation (luckily was a
tender offer), since requires no fiduciary duty (just disclosure of info).
Policy: Tension is btwn encouraging investing and wanting price to reflect info
o Why not insider trading: If info is same as everyone else, no incentive to invest
o Why should you: communicate more, compensated more, can argue not unfair (outsiders
pay less cause possibility of insider), and enforcement is hard
Theory: The Costs of Insider Trading:
o Warehousing: bidder tips certain investors who purchase target stock, and once the tender
offer is announced, investors will tender to buyer. This looks like classic insider trading.
SEC says no authority to regulate: requires (1) insider information for a corporate
purpose and (2) unfairness to others.
o SH oppose insider trading cause erodes trust/confidentiality, not cause direct harm.
o Academics try to say its agency costs, but agency costs are illusory
Otherwise would see companies that allowed it trading for less.
Only exception is with law firms and financial printing, and this strengthens
this argument
Rule 14e-3: For Tender Offers Only
Cannot trade on basis of material nonpublic information of a pending tender offer if that
person knows, or has reason to know, the information has been acquired directly or
indirectly from an insider or agent to insider. (14e-3, Chestman)
o NO DUTY IS REQUIRED
o Must choose to disclose to everyone or abstain
Specialized insider trading rule applicable only to tender offers.
o Does not turn on fraud or breach of duty of any kind.
Some Points about Rule 14e-3
o Difference Between 14e-3 and 10b-5.
(1) 14(e) is self-executing where 10(b) is not.
(2) 14(e) is broad; permits the SEC to promulgate rules designed to prevent such
acts or practices that are fraudulent, misleading, or manipulative.
SC Limits in SchreiberTakes the fedgov out of any regulation of
defensive tactics with tender offers.
Fraud doesnt require active deceptionit is sufficient if you breach a fiduciary duty to keep
information confidential. (Post-Hagan)
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