Business Associations VERY LONG OUTLINE

Business Associations VERY LONG OUTLINE - LAW 230--BUSINESS...

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Unformatted text preview: LAW 230--BUSINESS ASSOCIATIONS AGENCY AND ITS CONSEQUENCES Assn 1 1) Forms of biz organizations a) Agency b) Partnership i) Limited partnership ii) Limited liability partnership c) Limited liability company d) Corporation i) Public (i.e. publicly held) ii) Close (i.e. closely held) 2) We spend the most time studying the corporation since they are the dominant economic actor in the economy, 89% of private sector GDP. 3) The Agency Relationship: a) In some sense much of corp law involves people acting as agents. b) An agency relationship: i) Common issues: (1) The PAT triangle: PAT (a) Does an agency relationship exist between P&A (b) What consequences follow to P from interaction between A& T? (2) Example: Cargill: (a) Background: Cargill needs ready access to grain and typically they don't own the land where the crops are grown but they will buy the crops but not directly from the farmers. Grain is centered around the concept of grain elevators. The grain elevator deals with farmers. Cargill then goes and buys the grain from the grain elevator. One of the realities of farming is that they are constantly dealing with case flow problems, so the farmers borrow from the grain elevator, and the grain elevator has its own creditor that it borrows money from, and then the farmer repays the loan. Grain elevators are local monopolies. Warran could have borrowed money from a bank, but that isn't how things work. Warren gets a revolving line of credit, and they loan it to the farmers and then pay it back. The problem with businesses that have substantial cash flow problems, is that Warren had a hard time paying so they started to cheat and they got caught and defaulted and didn't pay the farmers for the grain. They also defaulted to Cargill. So the farmers are out $2 million, and they wanted to sue Cargill. Cargill replies that they weren't party to the contracts and that they dealt only with Warren and that there is no relationship between farmers and Cargill. (b) Issue: did an agency relationship exist between Cargill and Warren? (i) Why did it matter to the farmers ? A principal is liable on Ks make by an agent on the principal's behalf. 1. Chief J Holt: the act of the servant is that act of his master, when he acts by authority of the master. i.e. respondeat superior, vicarious liability. 2. Servants and independent contractors. 1 (c) (d) (e) (f) Nine Factors for an agency relationship a. Why does the distinction matter?: vicarious liability depends not only on whether an agency relationship existed, but also on the kind of agency relationship involved. i. Master is liable for servants torts ii. Principal not liable for tort of ind contractor. b. What is the distinction: i. Servants physical conduct of the task is controlled or is subject to the right of control by the master ii. An indep contractors performance of the task is not subject to the principals control. (ii) Does the distinction between servant and independent contractor come up in Cargill? No, because a principal is liable on contracts made by an agent on the principals behalf, unlike torts. Define an agency relationship: (i) Restatement 1(1): A manifestation of consent by one person that the other party act on their behalf Can you form an agency relationship without realizing it? Yes. If you consent that A will act on your behalf subject to your control, that is enough. Don't need consideration for agency relationship: The Cargill Ct says there must be an agreement but not necessarily a contract between the parties. What does this mean? There doesn't have to be consideration, a meeting of the minds is enough. Holding: (i) An agency relationship did exist. (ii) Why? Apply the definition: 1. The definition required that there be a manifestation of consent by Cargill that Warren act on its behalf. a. What did Cargill want Warren to do? get grain. The Ct identifies 9 factors that Cargill controlled Warren. b. Nine factors: i. Cargill's constant recommendations to Warren by telephone; ii. Cargill's right of first refusal on grain; iii. Warren's inability to enter into mortgages, to purchase stock or to pay dividends without Cargill's approval; iv. Cargill's right of entry onto Warren's premises to carry on periodic checks and audits; v. Cargill's correspondence and criticism regarding Warren's finances, officers salaries and inventory; vi. Cargill's determination that Warren needed "strong paternal guidance"; vii. Provision of drafts and forms to Warren upon which Cargill's name was imprinted; viii.Financing of all Warren's purchases of grain and operating expenses; and ix. Cargill's power to discontinue the financing of Warren's operations. 2. Warrens consent to act: How? a. The Ct never mentions it. Oops. You can probably infer consent from the fact that W did act on As behalf, but the Ct never analyzed this like they 2 should have. 3. Controlling a Creditor: Restatement 14 O: Creditor becomes a principal at that point at which it assumes de facto control over the conduct of the debtor 4. Supplier: R14K: One who contracts to acquire property from a third person and convey it to another is the agent of the other only if it is agreed that he is to act primarily for the benefit of the other and not for himself. 5. Cargill court opines: "Under the Restatement approach, it must be shown that the supplier has an independent business before it can be concluded that he is not an agent." (p 31) a. Is this true? Where does the Ct get the idea about an independent business? What was the precedent in reaching this conclusion? It was the commentary to the R. see the bottom of page 30, factors: The Ct messed up since it isn't an essential element, but just a factor to consider. i. Fixed price ii. Acts in own name iii. Has indep business. (g) Policy behind holding Cargill liable: (i) The court will use liability as a way of creating incentives. Send signals to people about certain behavior the ct wants to deter or incentivize. 1. Might encourage people to buy insurance. 2. Also, might be local bias since Cargill was huge and was out of state. 3. Authority and accountability: Cargill had a lot of authority over Warren, and may have been trying to seek the benefits of ownership and control without paying the cost of ownership and control. (h) Planning question: If you were Cargills atty, and the ceo asks for recs of how Cargill should change the way it does business to avoid liability in the future. What would you say keeping in mind that your role is to offer alternatives, not to make decisions. (i) Reconsider any of the nine factors (ii) Approach: 1. What is Cargills goal? Look for what they have to do to win next time. What is Cargill in this relationship to accomplish. Why was Cargill in there? To get the grain. If Cargill has no relationship with Warren, what happens to that grain, it goes to another company. The tighter the relationship with the grain elevator the better access to the grain. Cargill is in the biz to have to option to get all the grain. With that in mind, which of the factors do we want Cargill to change. Remember that the problem in this case is that Cargill had too little control. Cargill is there to get the grain. The correct answer is that more control is more likely to get liability, but more control minimizes the probability that the next warren could get away with this. Prof thinks that it is in Cargills best interest to get sued and to exercise more control. They could exercise even more control by just becoming the owners but why don't they want to do that? It gives Cargill the option of refusing the grain if it's a bad year. 2. Don't reconsider the factors, make them even stronger. We should toughen it up. Send someone there and look at the books and compare. Don't just send criticism, but exercise strong paternal guidance. 3 PARTNERSHIPS Assn 2 1) Partnership law is a combo of common law and statute. Modern partnership law came from medieval law. a) UPA (1914): the commissioners on uniform state laws were eventually adopted by all the states and got uniformity over the decades. i) the commissioners decided we needed a new law, due to anachronisms, so they made a new law on 1994. many states adopted the 1994 version but many states kept the 1914 version. After this there was a revised version, every year they kept changing it. b) UPA (1997) (California): this is the most recent version and it is what CA adopted. The result is that partnership law has lost a lot of its uniformity. There is divergence between states although the basics are constant c) Partnership law is still largely a version of common law. Cts often look to precedent rather than statute. The two cases we study today don't really talk about the statutes but they are key cases. d) What is a partnership? i) UPA 19146(1) "partnership is an association of 2 or more persons to carry on as coowners a business for profit." (1) This doesn't seem very self evident, but it is more complex then it seems. Lets look at the specific terms. (a) "Association": implies continuity...an ongoing relationship between members of the partnership. Compare it to joint ventures. The line is very fuzzy. For most purposes the law of partnerships applies to joint ventures. The key distinction is the continuity of ongoing activity. The joint venture is typically a one time thing, even if it is a long one time thing, but it isn't continuous and has a single limited purpose. (b) "Two or more": corporations can have one shareholder but unincorporated business is a one person biz. (c) "Carry on": again connotes continuity. General application to distinguish from JV. (d) "CoOwners": this is the most imp. Look at 18of UPA, 18(e) says all partners have equal rights in the mngmt and conduct of the partnership biz. 18 provides that the rights and duties of the partners in relation to the partnership shall be determines, subject to any agreement between them. (i) Remember that form contracts that are developed over time are what is usually used. Think of the statutes are a form of standard form contract. They don't have to worry about everything that comes up since if something comes up they didn't cover, the statute will cover it. It is cheaper than starting from scratch. Partnership accommodates the recognition that we should be able to tweak rules. (ii) Also, look at 9: the act of a partner binds the partnership. Ownership is thus a defining characteristic--see Fenwick. (e) "Business for profit": there is no such thing as a non profit partnership. e) Fenwick v Unemployment Commission, 84: i) F operated a beauty shop, where C worked. C wanted more money and they make a contract. The issue: did F and C form a valid partnership? Who was contesting that there was a partnership? Why did it matter if F was an employee or a partner? There was an exemption from having to pay unemployment tax for small businesses and if C was an employee, he would have been liable for the tax. 4 ii) iii) iv) v) vi) (1) This is more important today due to modern civil rights law, and ADA ect. These statutes apply to employees but not to owners, or members of a partnership. So partners in law firms aren't covered by the ADA. Wow. (2) Factors for partnership : the Ct says they are elements, but they are factors. (a) Intention of the parteies (b) the right to share in profits; (c) the obligation to share in losses (Risk); (d) the community of power (Control); (e) the language of the agreement; (f) the conduct of the parties toward 3rd persons; & (g) the rights of the parties upon dissolution. Is an agreement necessary to form a partnership? Yes. you don't have to intend the legal consequences. Partnership is called the default, since if people don't affirmatively pick a form of organization, their relationship defaults to partnership. (1) "Partnership results from contract"...(Martin v Peyton, 93) (2) UPA (1914) 6(1): There must be an association of two or more parties to act as co owners of a business Is a written agreement necessary to create a partnership? (1) No. See Fenwick dicta, p 85. Is a written agreement determinative? (1) No. What was Fenwick's strongest argument? (1) Look at the statute. See UPA(1914) 7: (a) "In determining whether a partnership exists: ... (4) The receipt by a person of a share of the profits of a business is prima facie evidence that he is a partner in the business..." (b) If division of profits = prima facie partnership, why did the court treat Cheshire as an employee rather than a partner? (2) The 80/20% split of profit sharing. (a) Look at 18(a): the statute says that each partner should share equally. This doesn't matter since if they want a different split it is ok. (3) Sharing profits is a prima facie evidence that there is a partnership. Prima facie is a rebuttable presumption Planning: Q#3, p 88 (1) Why did the Ct decide there wasn't a partnership in the end? (a) C lacked control over the company that one would normally expect to see in a partner. (2) Assume that we are F and Ws lawyer and that we want to come up with an agreement. See pg 88, Q 3... A key finding of the court in the present case seems to have been that "Fenwick continued to have complete control of the management of the business." How might a lawyer draft a "partnership" agreement to make it appear that Cheshire had control consistent with the UPA. Without in fact depriving Fenwick of the dominant position that he would no doubt insist upon as a matter of business judgment? (3) Look at the 11 aspects of the agreement (GET FACTORS) (a) Profit sharing: isn't the profit sharing a little fishy since hers is a bonus, while F gets it automatically regardless of the needs of the biz while she doesn't. F is not subject to the needs of the business. 5 (b) 18(e): (c) remember when drafting the K we always want to have a story behind the way it is written. 80/20 would be a good way to structure the voting so that it is proportionate. This 80/20 voting still gives him total control. f) Martin v Peyton, 93: (no partnership) i) KNK engaged in speculation in foreign currency. PPF were going to invest in the firm to give them 2.5 mill, which KNK would use as collateral. In return, KNK agreed to give PPF dividends and 40% of the profits and the option to buy equity and the right to inspect and to veto. These provisions are common for loan agreements but when KNK continued to do poorly and go belly up, PPF were out their 2.5 mill and are being sued by KNKs other creditors on the theory of partnership. The other creditors said that PPF formed a partnership with KNK. (1) Why is it good for the creditors if there was a partnership? (a) UPA 1914 40: "In settling accounts between the partners after dissolution ...: (i) The liabilities of the partnership shall rank in order of payment, as follows: 1. Those owing to creditors other than partners, 2. Those owing to partners other than for capital and profits, (ii) Subordinates loans by partners (b) Two main reasons: (i) If PPF is a partner, then the PPF loan is subordinated to the others claims. So the other creditors would get paid back before PPF. (ii) Also, UPA 15 states that all partners are jointly and severally liable to the full extent of their net worth. This means that PPF would have to give money to the other creditors. 1. UPA (1914) 15: a. All partners are liable b. (a) Jointly and severally for everything chargeable to the partnership under sections 13 and 14. e.g., torts and breaches of fiduciary duty c. (b) Jointly for all other debts and obligations of the partnership. E.g., contracts ii) Analysis: (1) Did PPF and KNK intend to form a partnership? No, but that isn't dispositive. Don't have to make profit to form a partnership. (a) Division of profits doesn't equal a partnership. Why? Look at 7. they persuaded the court that the profit sharing was a reward for repayment of debt. iii) Planning: (1) Q.3: page 99: given the degree of risk to which PPF was exposed, what kind of protections would we expect them to want and what did they actually bargain for? In other words, given the risks they ran, were there any K terms that seem unreasonable? Is there any right they can give up consistent with the risks they have? (PPF loaned the money). (a) There are two rights that partners have that seem to be a problem for PPF. (i) UPA 18(a) says that the KNK have equal management rights, and (ii) UPA 9 in PPF, each partner is an agent and every partners actions are binding on them. The right of agency, meaning that the the partners actions are binding on the rest of the partnership. so the partnes are liable to each other, they cant hold the one guy liable who made the mistake. (b) Things they could have done: 6 (i) Was it unreasonable for them to want to have their friend be the managing partner? They should have had someone on the inside. (ii) The option to buy equity (to become partners) was an essential part of the return on the investment. This might even help them show they weren't partners. (2) Review: (a) Suppose you had been the lawyers for the creditors. You're trying to hold PPF liable for KNK's obligations. One argument is that PPF were partners in the KNK firm. But that's a loser. Do you have any other organization law argument that lead to the same outcome? (i) Agency, but that is a loser. 7 THE CORPORATION: FORMATION Assn 3 1) Forms of business organizations: a) Number of biz orgs in millions by type: i) 17 mill sole proprietorships ii) 1.7 mill partnerships, iii) Corporations although small in number are economically more significant b) The universe of corporations: Always ask if it is public or private and if it mattered to the Ct. i) Public: (1) Aka Publicly held, e.g. IBM, Microsoft (2) Characterized by public secondary market in which shares of co are listed and traded. (a) secondary markets have a huge impact since it allows the people to buy or sell its stock. Ability to exitLiquidity can have huge impact. A lot easier to switch then the fight. ii) Private: (1) Aka closely held. (2) Characterized by absence of secondary market for its stock. This means that there isn't an exit option, so it is more imp to be active in the mgmt of the firm. (3) Often (but not always) a relatively small number of shareholders who actively participate in the firm's management (4) May display many char of partnerships, some are in a sense incorporated partnerships. c) Five critical attributes of the corporation: i) Legal personality : the corp is viewed in the eyes of the law as entity that is a legal person. (1) This is a legal fiction but is useful. Reification is the term used to describe treating an abstraction as the real thing. There is no real thing, it is just a group of people who have relationships and have rights. Remember when we talk about corp as a thing it is a legal fiction and we need to care about the relationship between the people. (2) They have some constitutional rights and have property rights and are separate taxpayers. ii) Limited Liability : this used to be the great distinguishing char of the corpo. (1) Sole proprietors are fully liable as are partners. (2) See e.g. MBCA6.22(b): "Unless otherwise provided in the articles of incorporation, a shareholder of a corporation is not personally liable for the acts or debts of the corporation except that he may become personally liable by reason of his own acts or conduct." (3) This is an example of one of the default rules that corporate law operates on. The default rule is limited liability. But very rarely would anyone deviate from this. In some cases, like a small corp, a bank will ask a person to contract out of limited liability, but unless they had to, they wouldn't deviate from this default rule. (a) So if the company goes belly up, the creditors cant get from you. (b) Implication is that passive investment is made possible. (4) Cross reference Assignments 67: iii) Separation of ownership and control : (1) MBCA 8.01(b): "All corporate powers shall be exercised by or under the authority of, and the business and affairs of the corporation managed by or under the direction of, its board of directors...." 8 Debt and Equity Securities (a) The board is elected by shareholders and once elected, the directors run the company or delegate to employee the running of various aspects of the company. It is the board, not the shareholders that manage the company. Sorta like representative democracy. (i) Shareholders are reactive (at most), while the boards act. (ii) Shareholders entitled to vote on: 1. Election of directors (MBCA 8.03.04) 2. Any amendments to the art of incorpo and by laws. (MBCA 10.03, 10.20) 3. Fundamental transactions (e.g., mergers; MBCA 11.04) 4. Odds and ends, such as approval of independent auditors iv) Liquidity : (1) Secondary trading markets. (2) Eg NYSE and NASDAQ (3) Cross reference Assn 22. v) Flexible capital Structure : (1) corporations have flexible types of ownership interests unlike partnerships. They have variety of ways to package claims. (2) Capital structure : (a) The permanent and longterm contingent claims on the corporation's assets and future earnings issued pursuant to formal contractual instruments called securities (b) Many ways to package such claims; e.g., stocks and bonds d) Debt and equity securities: i) Bonds and other debt securities consist of two distinct rights: (1) The bondholder is entitled to receive a stream of payments in the form of interest over a period of years (2) At the end of the bond's prescribed term (i.e., at maturity), the bondholder is entitled to the return of the principal (3) Creditors, not owners. ii) Equity securities (aka shares) represent "the units into which the proprietary interests in the corporation are divided": (1) Residual claimants : equal right to participate in distributions of the firm's earnings and, in the event of liquidation, to share equally in the firm's assets remaining after all prior claims have been satisfied (2) A limited right to participate in corporate decisionmaking by electing directors and voting on major corporate decisions e) Capital structure terminology: i) Authorized shares : the articles must specify the $ of shares the corp is authorized to issue, they can do this all at once or at diff times. This means selling shares. ii) Outstanding shares : the number of shares that you have issued. These are imp b/c until they are issued, they are just pieces of paper and don't have any rights or receive dividends. Once they are issued, then the shareholder has rights iii) Authorized but not issued shares , are important b/c of the rights of shareholders to participate in the decision to issue more shares. (1) Suppose the charter authorizes the firm to issue up to 20,000 common shares. Suppose the firm sells 4,000 shares to investors. At that point it has 4,000 outstanding shares and 16,000 authorized but unissued shares. 9 iv) Treasury shares : were once issued and outstanding, but have been repurchased by the corporation (1) In our previous example, suppose the corporation bought back 1,000 of its outstanding shares. It would now have 3,000 outstanding shares, 16,000 authorized but unissued shares and 1,000 treasury shares. (2) The MBCA has eliminated the concept of treasury shares (which had importance mainly for purposes of certain accounting conventions), so that reacquired shares under the RMBCA are simply classified as authorized but unissued shares. (3) Thus, if our example took place in a state which has adopted the MBCA, after the firm bought back the 1,000 shares it would simply have 3,000 outstanding shares and 17,000 authorized but unissued shares. f) Issuance of stock: prerogative or directors i) Board of directors prerogative. (1) Shareholders involved if: only (a) Board wants to sell more shares than are presently authorized in its charter. (i) goes back to concept of autho but not issued shares. Suppose board wants to sell more than are authorized. In order to do that, have to amend the articles and have to get shareholder approval. (b) Board of directors wants to issue a new class of shares not authorized in the charter (i) if the board wants to issue a class of stock not authorized by the charter. Common stock is last in line and gets paid last, and preferred stock is above it. Suppose we have secured creditor and unsecured creditor, and the shareholder, the preferred gets paid first. The common S gets what is left over. Preferred S is a hybrid between debt and equity. If the charter authorizes common stock but not preferred stock, and the company wants to now issue preferred stock, they have to go to Shareholders and amend the articles to allow it. ii) So long as the charter authorizes the class of shares in question and there are sufficient authorized but unissued shares, the board is free to sell shares for "any valid purpose" as long as the corporation receives adequate consideration for the shares. 2) The incorporation process: a) The first thing we do is to get an incorporation service to handle the paperwork. The adv of these services is that they know how to do it and have good relationships with the gov services and can act quickly. A good one is CT corp. they handle the paperwork and serve as the registered agent The Incorporatio upon whom service of process may be made and they must have a registered office. n Process: b) Next, pick a state of incorporation . In Paul v VA, 1869 said that states couldn't exclude foreign corps from engaging in commerce in their states due to the Dormant commence clause so long as they engage in interstate commerce. i) Delaware is the state most corps choose. There are more than 300K corps incorporated in DE. 60% of the fortune 500, 50% of the companies listed on NY stock exchange. (1) Why DE? (a) Convenience: DE has no minimum capital requirement. Some states require start up Why capital but not DE. States Love (b) They only need one incorporator and the Corp can be it. Some states require 3 and require that it be a natural person. (c) Favorable franchise taxes compared to other states. Franchise taxes are those they pay to the state. DE gets by on volume. 10 (d) For companies that do biz outside of DE, but are inc there, there is no corp income tax, no sales tax, personal property tax or intangible prop tax on corpos, no tax on shares of stock held by non residents and no inheritance tax on non resident owners (e) Corps can keep they books and records and principal place of biz outside of the state. (f) Good case law and court system: They have a separate court of equity. Highly competent judiciary in company law and extensive and detailed case law on the subject. In DE, there is no statutory right to a jury in the Ct of Equity, just goes to the chancellor, who spend 50% of their time listening to corporate law cases. They are really fast. Takes less than month to give opinion compared to CA, which takes several months. ii) Next, draft articles of incorporation : (1) Contents: (a) Mandatory terms: MBCA 2.02(a) (b) Optional terms: MBCA2.02(b) (2) File articles with the Sec of State. Then you get s Certificate of incorporation and then a corporation has been formed. iii) Post Incorporation: (1) Draft bylaws, 2.06 (2) Organizational meeting, 2.05 (a) Name directors, if necessary. There are serious liability issues when being the board of directors and may create conflicts of issues. Avoid it. (3) Issue stock 3) Liability for preincorporation activity: a) Incorporating a biz ends up being the last thing that folks do since its easy and cheap. So there are biz people running around making biz transactions before they form the biz and are there biz consequences? Yes. b) The promoter : may be the same person as the incorporator but isn't usually. It is the person who acts as agent of the biz prior to its incorporation. They conduct biz on behalf of corp before its formed. 4) Incorporation Raises 4 legal issues: i) Once art are files, does corp become party to the K? (1) Yes, but not automatically, they must adopt the K. (a) Adoption can be effected either expressly (novation), or implicitly (e.g. ratification by acceptance of benefits). ii) Once articles are files, if promoter liable if corp breaches the K? (1) Look at 2.04: promoter will be jointly and severally liable for preincorporation activity. But the other party to the K can release the promoter and normally when there is a novation, the novation contains a release of the other party. This may not always happen to keep the promoter on the hook. iii) If articles not filed, is promoter liable on the K? (1) Yes. Absent an agreement to the contrary, the promoter remains liable on the contract if the corporation never comes into existence. MBCA 2.04. iv) If the art are not filed, or defectively files, can the defectively formed entity (or individuals) enforce the K? 11 Corporation by estoppel (1) Example : So Gulf Martine Co. 9 v Camcraft, 206: (dealing with a corp before incorporation) (a) Facts: To limit liability they made each boat a separate corporation. This meant that a creditor of one boat couldn't go after another boat. Camcraft was going to sell a boat, and So Gulf was going to pay 1.35 mill, but the boat changed value so Camcraft wanted to breach the K and sell boat for higher. Camcraft realized that Gulf didn't create the corporation and once it was incorporated they did so in the virgin islands so Camcraft said cant have a contract since there wasn't a corp. Issue: can the promoter enforce the K with a defectively formed corp? The model code doesn't speak to this issue only whether the promoter would be liable. (i) Wrinkle # 1: Here the corporation seeks to enforce a contract made on its behalf before it was incorporated (ii) Wrinkle # 2 : A defective incorporation: 1. Contract called for a Texas corporation, but firm incorporated in Grand Caymans (b) Result: Camcraft is estopped to deny SGMs corporate status. Hence, SGM can enforce the K. (i) Rule: A third party who dealt with the firm as though it were a corporation and relied on the firm, not the individual defendant, for performance is estopped 1. Bottom line if you deal with something as a corp, knowing its not yet a corp, the fact they don't get around to properly forming a K doesn't matter, can still enforce the K and you are estopped from using that failure as a defense. (ii) Fine distinction to be drawn between de facto corporation and corp by estoppel. 1. Defacto: good faith effort + actual exercise. 2. Corp by estoppel: if 3rd party treats it as a corporation. 12 LAW AND (NEW INSTITUTIONAL) ECONOMICS Assn 4 1) Two Questions: 1) why are there firms? And 2) what are the agency costs--where do they come from and why don't we eliminate them? a) Why are there firms? i) There are two ways we can conduct economic activity: (1) 1) across markets, or 2) within firms. (a) Cargill conducted econ. activity across market. If Cargil had bought warren they would have done it w/in firms. (2) How do firms decide to "buy or build?" (a) Oliver Williamson argues that transaction cost economics can explain this and the function of biz is to minimize transaction costs/friction. If you could reduce the amt of friction in transactions, biz activities will become more profitable. Everything biz does is to try to minimize friction. If that is what biz folks do, what do lawyers do? (i) "Transaction cost economics subscribes to ... the view that economizing is the core problem of economic organization" (ii) "The economic counterpart of friction is transaction cost" 1. Pie Division Example: if you go to get a pizza and there is a debate as to how many slices each should get. Once person says they need more slices than the smaller person, but the smaller person wants to gain weight. A lot of biz negotiation is about pie allocation, dividing up gains. But why would you hire a lawyer to help with this negotiation? If the parties each hire a lawyer then they will also take a slice of the pie, so there is less pie, so your lawyer needs to be even more better to justify hiring one. But, what if the lawyer could increase the size of the pie and add value to the transaction? Then it would make it worthwhile to the parties to hire a lawyer, and could justify the fees. The way they do this is to reduce transaction costs. Thus, the first duty of transactional atty is to ask how he can contribute to reduce transaction costs. So have to understand the economics of the deal and how it can be manipulated. ii) Transaction and Agency Cost Economics in the Courts: (1) "Corporations desire to minimize monitoring costs, which are termed `agency costs' in neoclassical economics." (2) "These costs, from a neoclassical economic perspective, would be the actual expenses of supervising and restricting management, as well as opportunity costs presented through each corporate action. In the corporate decisionmaking context, opportunity costs are the real value associated with the directors adopting the most desirable alternative. To a large extent, these opportunity costs would be lost profits." (Int'l Ins. V Johns) (3) "This argument is elaborated under the economic theory of agency costs [by] Dooley and Veasey [who] note that such `bonding' costs to the corporation of having independent directors can lower the `agency costs' of a firm as well as, and in many cases better than, the `monitoring costs' of stockholders' using derivative action." (Consumers Power Co. Derivative Litigation) (4) "There is no legal significance in this case to the fact that the sale was a private sale. That fact may have economic significance, however, because financial economists have posited 13 that a source of the value creation in LBO transactions is the elimination of costs that arise from the separation of ownership from control in a public corporation. To the extent one buys a private firm, such as MGM was at the time of the sale, it is less likely that additional value can easily be wrungout of the corporation by a reduction of agency costs thought necessarily to arise from public ownership." (Credit Lyonnais Bank Nederland v Pathe) (a) additional value can be wring out of the corp by reduction of agency cost. This is something that attys are good at. The ct recognizes that there is a source of value in the reduction of agency costs but it wasn't applicable in that situation. (5) "Agency and corporate law seek to reduce aberrant agent activities through principles such as fiduciary duties. For their part, principals can minimize agency costs not only by measuring or observing the behavior of the agent but also by controlling the agent's behavior through operating rules, compensation policies, budget restrictions and the like." Menichini v. Grant (6) Opportunity costs: (a) The opportunity cost is the next best use of ones time and giving up the opportunity to engage in that activity is the opp cost. Can measure it by calculating the value of that activity. (b) Example in business context : Walmart wants to acquire Safeway. They will spend time pursing this and if at the end of the day, Walmart loses, and there is the risk that Walmart will have spent a lot of time pursuing Safeway w/o a return. The opp cost is that they could have been pursuing someone else. It is a hidden cost, but it is very real. (i) Derivative litigation: agency cost analysis. How does this reduce agency costs w/in the firm? iii) Ronald Coase : The father of transactions costs. He laid the groundwork for the modern law of Coase economics. (1) Insight: If a worker moves from department X to Y within a firm he does so not because of a change in prices, but because he is ordered to do so. (a) markets work by a pricing mechanism and people determine their behavior in response to a change in prices. (2) Thesis: Firms arise when the transaction costs of conducting activity in a market exceed the costs associated with commandandcontrol (a) When there are costs associated with conducting activity across a Market by using command and control identifying these costs goes a long way. (3) Transaction costs: (a) Search and Bargaining: Don't have to look for them w/in firm Transaction (b) Uncertainty: Costs (i) cant predict the future. In a spot market you don't have to worry about uncertainty. But suppose you hire a caretaker to take care of estate for 2 years, there is uncertainty and cant know what the future is going to hold and have to give a lot of instruction. As the relationship lengthens, uncertainty becomes more of a problem. (c) Complexity: (i) at some point, dealing with uncertainty makes the K complex and more costly to deal with the problem via K. as they increase with the relationship, it is more imp to have a system of command and control. Instead of predicting the future and dealing with contingencies via K, you have a system that says what they have to 14 do. (d) Bounded rationality: (i) economics assumes that people act rationally to maximize utility. Bounded rationality means that there are limits on cognitive capacity limit contracting ability. (ii) Memory is an example of this . I may want to do so, but there are factors that limit my ability to act in the way I would be best of acting. So once you get uncertainty and complexity, and bounded rationality, Ks are necessarily incomplete and ex post governance becomes advantageous. (iii) Ex post gov : would be necessary even if people were good b/c there would be problems that would arise that we didn't anticipate, but have to introduce opportunism. Want to monitor the company after you make the deals. (e) Opportunism: (i) this is called agency cost. Agency cost economics driven by idea that people inevitably shirk. The prospect of opportunism becomes greater as Ks become even more incomplete. Can try to control opportunism by K. but if the K has gaps, one can find ways to wiggle out and the more gaps the more opportunity to take advantage, either by bargaining harder or working w/ someone else. b) What are agency costs? i) Agency costs: Defined as the sum of 3 sets of costs: (a) Monitoring expend by P, plus (i) The principal has to spend money to monitor employees. The question is how to do Agency we cut the chain to make someone do a good job monitoring w/o being watched Costs themselves? You can give them the incentive by giving them a residual claim. This explains sole proprietors, since they get the residual claim and have incentive to watch. 1. The problem in the corporation is the separation of ownership and control: the shareholders get the residue but they don't have the power to monitor the corporation. (b) Bonding expenditures by A, plus (i) Sometimes the agent finds it useful to promise to perform. The promise has to be credible commitment to perform. To make it credible, the agent bonds. This is incurred by the promisor. (c) Residual loss . (i) A lot of times, despite bonding, people still shirk. The sum of these are agency costs. (ii) A lot of times attys are charged with minimizing agency costs. (iii) Separation of Ownership and control: 1. The problem in the corporation is the separation of ownership and control: the shareholders get the residue but they don't have the power to monitor the Separation of corporation. The corporation wants to spend the money rather than give the Ownership & money/dividends to the shareholders. The person with the power to make Control decisions isn't the one with the residual claim. People have incentive to shirk and make decisions that pursue their own self interests at the expense of the group. 15 a. DGCL 141: "All corporate powers shall be exercised by or under the authority of, and the business and affairs of the corporation managed under the direction of, its board of directors . . . ." b. Boon or Bane?: "The separation of ownership from control produces a condition where the interests of owner and of ultimate manager may, and often do, diverge ...." Berle & Means (1932) (2) Consequences of Agency Costs: (a) Example: Value of firms as owned by sole proprietor is 1 million, and he decides to sell 50%. Will investors pay 500K? (i) not if they have common sense. From the proprietors perspective, he works up to the point of diminishing marginal utility of wealth, which means that the more money you have the less each additional dollar is worth. Dollar worth more to me than Bill Gates. Once the proprietor sells half the biz, each dollar they make, she only gets half of it and the rest goes to the shareholders so the Q is not proprietor, would you rather have extra dollar, but would you rather have extra 50 cents, and give 50 cents to the shareholders? She is more likely to shirk, since less reward goes to her. (ii) If that is true, then the investors know this and they wont be willing to pay full price. How much less? They will discount the price they pay by how much she will shirk. The problem is that how much she will shirk is uncertain and investors will have hard time determining. Investors are risk averse. This means that investor will discount price they will pay by how they think she will shirk, but they will also assume the worse case scenario and will pay to reflect that. If lawyers could determine a way for investors to more effectively monitor the proprietor so they don't shirk, then the investor will be willing to pay more. In other words we Shirking can expand the amount of the pie by reducing the agency costs. solutions: 1. Three kinds of people: remember the expected value of the gamble. Whether Bonding someone is risk preferrer or risk adverse may depend on the expected value. Monitoring a. Risk preferrer: b. Risk averse: c. Risk neutral: (b) Shirking: (i) Definition: Any action by a member of a production team that diverges from the interests of the team as a whole. a. Includes not only culpable cheating, but also negligence, oversight, incapacity, and even honest mistakes b. In other words, shirking is simply the inevitable consequence of bounded rationality and opportunism within agency relationships (ii) Why do agents shirk? 1. The value of the agent's productive labor goes mainly to the principal as profit a. Agent generated revenues Agent's compensation = Principal's profit 2. The nonpecuniary benefits of shirking are enjoyed by the agent and none of their value is realized by principal (iii) How do we solve shirking? Solutions. 1. Bonding, (eg financial auditsbut after Enron this doesn't work very well always) 16 2. Monitoring by principal 3. Why not just eliminate them by unifying ownership and control? a. Bc we cant since the thing that makes corporations work is passive ownership. i. Ex: AOL story. 3 people ganged up and Steve Case was forced out. The interesting thing is that this was the first time these owners unified to force a change in the co. even big investors like this are normally passive and the firm couldn't run any other way. (c) There are two ways people make decisions: consensus v authority (i) Consensus: Collective decision making (e.g. partnerships) 1. Requires constituents with: a. Similar interests i. Doesn't work well in context of corporations. Differing levels of interests. Diff interests with investors who may like Short term vs long Consens term. us b. Comparable access to information to make informed decisions. vs c. Minimal collective action issues : when you have 30 million investors, how do you get them to all agree? 2. Authority: central decision making body (E.g. pub corp.) a. Arises where constituents have: i. Differing interests Agency costs are ii. Unequal information inherent in iii. Collective action problems authority based b. Authoritybased decisionmaking is essential for public corporations decsionmaking i. Large number of constituencies with differing access to information structures & ii. Diverse constituencies with conflicting interest authority is iii. Intractable collective action problems necessary for public c. The problem is that this divorces decision making from the residual corporations!!! claimants. These folds have no power. In other words, cant get away from agency costs in large firm setting. (ii) Agency costs are inherent in authoritybased decisionmaking structures: 1. Tension between authority and accountability visvis board and managers 2. Market constraints important 3. A more important consideration: a. Power to hold to account is the power to decide b. We cannot make managers more accountable without limiting their authority since they are in constant tension. This is i. The more mechanisms for various constituencies to review what why directors do, the more you limit their authority. And a lot of the course BJR is deals with resolving this tradeoff and figuring out what the appropriate imp!!! tradeoff is. Example: See Bayer v Boran, pg 351. business jmt rule. Sometimes directors are held liable for negligence. Demonstrates the balance of this tradeoff. c. Given virtues of authoritybased decisionmaking , the null hypothesis should always be preservation of managerial discretion 17 THE CORPORATION AS NEXUS OF CONTRACTS Assn 5 1) Reification: a) Reify: To regard of treat an abstraction as if it had concrete or material existence: e.g. "ford has a getter idea" Ford is a legal fiction. Legal fictions don't have ideas, people have ideas. 2) Stakeholders aka constituencies: a) The traditional model: Reflected in a lot of legal principles, and two that are particularly important: (1) Shareholder primacy : (a) they make most of the important decisions and exercise ultimate control. (e.g. SH must be allowed to decide whether the corporation should be sold). The board as stewards Shareholde for SH. r (b) Shareholder primacy based on private property (i) Ownership connotes control. 1. Based on the concept of ownership that a corp is a thing capable of being owned and the board of owners is obliged to follow the interests of the owners. The directors were employed by the shareholders to run the corp as stewards of the biz. Protecting the interests of the shareholders. Feudal concept. 2. This doesn't make any sense since a corporation is a legal fiction. There are rights and there are assets. There are people who have rights based on those contracts but what about For can be owned. The firm in some sense is not a thing capable of being owned, but rather a legal fiction that describes a set of Ks between stakeholders. Shareholders provide equity capital and in return get the residual claim. Creditors get a fixed claim in return. Employees contribute human capital in exchange for salary. Communities contribute base of operation and tax benefits. An economist would call each of these groups a factor of production that are al important and needed. A corp represents a set of contractual rights between the various parties. This isn't enough since legal fictions themselves don't contract and since there must be in any org, a central decision making body that are binding on the group as a whole, it is useful to think of the board of directors in the middle of those set of contracts. The board is in the center of all the Ks, they are the nexus of all the Ks. SH Wealth (ii) Power to elect directors followed from ownership Maximizatio (iii) Ditto shareholder wealth maximization n Norm (2) Shareholder wealth maximization norm: (a) Directors are supposed to make decisions that maximize wealth. (i.e. the value of the residual claim). (b) Example: 286, Dodge v Ford Motor Co: (i) involves Henry Ford and his management of the co. the Dodge bros sued Ford alleging that decisions he made were motivated by concerns other than the concerns of shareholders. See page 290 at the bottom where the Ct says a biz corp is organized primarily for the profit of the stockholders and the power...the traditional model 18 b) Define a Contract: i) When an economist says that a firm is a nexus of K's, do they mean Ks as defined by law? Ie, a promise that the law will enforce? (1) No, they mean corp consists of also implicit voluntary, adaptive relationships but they Define a K: don't have a legally enforceable contract. (2) This segways to the next point. There are some folks who thing that there is something out there that can be owned. One arg they make is that many of the relationships within the corp are not bargained over. ii) Contracts and bargains: are all the Ks of which the firm is a nexus bargained for? (1) No but so what (2) A bargain can be understood in two distinct ways: as a process or as an outcome. And a bargain involving only an outcome is just as much a contract as a bargain involving both a process and an outcome. c) What are the implications of the contactatarian model: (both are based on Coase theorem). i) Normative implication : should there be mandatory or default rules, or should there be enabling laws. (1) Corp law is both enabling, but also, normatively ought to be enabling. Why? The justification comes from the coase theorem, since how you set the law doesn't matter since Implications parties can bargain out of it, and also has to do with the identify of the people who set the of the rules. Contractari (a) Staggered boards vs a board of directors that is elected annually. (b) Not all contracts are bargained for, but all are priced (i) Stock prices quickly and accurately reflect public information about firms (ii) Firms unable or unwilling to offer governance terms investors find attractive will fail due to high cost of capital (c) Government less likely to "get it right" than Darwinian selection in competitive markets (d) Law will be ineffectual if the parties can bargain around it. (e) Negative externalities . Imp to recognize that the mandatory and enabling discussion doesn't speak to questions of corporate responsibility. Corp law doesn't regulate env policies of corps, env law does that. ii) Positive implication : how should society choose legal rules? d) Exceptions when mandatory rules are approp: i) Latecomer terms : (1) where they change the rules of the game on you. Provisions adopted after the firm has been established, for which affected participants are not compensated. Example: The corp has When initial public offering, and most prefer they go public with single annually elected board, mandatory rules are but what if they went public with single annually elected board, but then after got more money, they changed the rules to have a staggered board. We don't let them do that kind of bait and switch. ii) Market cant price terms : (1) i.e. close corps without markets. iii) Information asymmetries : (1) need to make sure both sides are fully informed. Like mandatory disclosure. 19 e) So if law is mostly default rules, why do we need the law? i) If corporations are creatures of contract and if parties are free to bargain around the law, why have law? What is the function of law in contractarian theory? (1) If transaction costs are greater than zero, we cant depend on private ordering. But in our large nation, with many actors, transaction costs are higher. Examples: 1) High bargaining costs, 2) Collective action problems, 3) Free riding probs. ii) In these situations, law functions as a substitute for bargaining--sort of like a standard form K,. (1) Law as a standard form K: the LAX Example: (a) Imagine an LAX car rental lot--with a huge and growing line. Agent hands me a long and detailed standard form agreement Did I bargain over the agreement's terms? Did I even read the agreement? Standard form Ks reduce cost since parties don't have to negotiate. Saves bargaining costs. Means that they don't have to worry about incomplete Ks. iii) Assumption of corporate law is that more is better. The more we reduce transaction costs the better. (1) How do we do this? Basis contractarian methodology: (a) If law is to provide a set of "offtherack" rules, how do we pick the "right" rule? (b) Perform a thought experiment: "If the parties could costlessly bargain over the question, which rule would they adopt?" (c) This is known as the majoritarian default. f) Coase theorem i) If transaction costs are zero, or low, the content of legal rule doesn't matter. ii) Formal statement : "Given clear property rights and zero transactions costs, parties will bargain together and settle their disagreements by cooperation, so that their behavior will be economically efficient regardless of the initial distribution of property rights" (1) This means that what the law says is irrelevant to where the parties will end up. They will end up in economically efficient place regardless of where the law says. iii) Example: Railroad tracks run next to wheat field. Sparks from train burn crops. Lost crops cost farmer 1,000. RR could fix problem for 500. (1) If Tort law imposes $1,000 liability on railroad (a) How will railroad respond? Repair spark problem at cost of $500, saving $500 in legal damages (2) If Tort law imposes no liability on railroad (a) How will farmer respond? Pay railroad $500 (or a bit more) to repair problem. (3) Whether we assign the prop right to the farmer or the RR, the result is the same, but the person who pays is different. Distributional consequence. The assignment of property rights doesn't determine the efficient outcome, but rather, who will pay. Who should pay isn't cared about by economics. 20 LIMITED LIABILITY DOCTRINE Assn 6 1) MBCA 6.22(B): "Unless otherwise provided in the articles of incorporation, a shareholder of a corporation is not personally liable for the acts or debts of the corporation except that he may become personally liable by reason of his own acts or conduct" a) Lets breakdown the language of the Limited Liability Statute: i) "not personally liable": (1) Shareholder losses limited to the amount the shareholder has invested in the firm--the amount initially paid by the shareholder to purchase his or her stock. everyone gets paid before the SH. But they have only put at risk what they put in, unlike a sole proprietor or a partner, they aren't personally liable and creditors cant go after them. This is the critical thing that makes the corporation the dominant form of economic organization. (2) Limited Liability made it possible for people to put money into the corp w/o worrying about it, and they could diversify their investments. LL allows them to diversify portfolio, coupled with the liquidity of the stock market and ability to move investments other places, are what made the corporation possible. Put together a pool of capital that would permit substantial investments. (a) In praise of Limited liability: LL is the foundation of the modern economy. (i) "I weigh my words when I say that in my judgment the limited liability corporation is the greatest single discovery of modern times. . . . Even steam and electricity are far less important than the limited liability corporation, and they would be reduced to comparative impotence without it."President Nicholas Murray of Columbia University (1911) ii) "for the acts or debts of the corp" : (1) A corollary of the corporation's status as a separate legal person; in the eyes of the law, it is the corporation that incurs the debt or commits the tort and the corporation which must bear the responsibility for its actions. In the eyes of the law it is a separate person. It is the foundational principle. iii) "except that he many become personally liable by reason of his own conduct.": (1) This encompasses "piercing the corporate veil." (a) this is where the action takes place for attys. From a transactional planning perspective, this requires the atty to insure that the "veil will not be pierced." The key question is to understand the conditions of when the veil could be pierced. 2) Walkovsky v Carlton, 211: (corporate veil) a) Facts: Taxi cab injures W. he wants to get to the jury. The prob is that W has a claim against a driver of the cab company, who negligently injured W. He has standing to sue the Seon cab company. The problem is that there were only 2 cabs in the Seon cab co. there are two other assets that the person could collect. The Seon co had another asset that W could collect from, the insurance for 10K. this leaves W with 490K in damages to collect and can only get so much from Seon Cab co. W sees Carlton and says that if he could collect from C, he has lots of money. W tries to hold C personally liable. This would be easy if C was a sole proprietor or a partnership. But this was a corporation, so Ws efforts to get C, bump up against the corporate veil. The veil of the corporation is between him and C. so this limits him to the Seon cab co. W tries to pierce the corporate veil. 21 b) W advances two theories: Enterprise Liability: (1) P argues that all 10 corporations were part of a single enterprise. C chopped the biz up into separate corporations. The Ct responds that the fact that biz was separated isn't enough Enterprise Liability to break the veil. The Ct draws a distinction btnt two concepts: 1) veil piercing, 2) allows you to access enterprise liability. the assets of ALL the (a) Enterprise liability: only a larger corporate entity would be held financially other nominally responsible. If W could pierce the veil, he could get to C. but showing that the cabs separate were a single enterprise does help W b/c he could try to get the assets of the rest of the cabs too. This is what enterprise liability can get you. So W would get to hold the larger corporate entity liable and gets access to the nominally separate corporations. This doesn't do him so much good since all the cabs still didn't have too much value but there are a lot of cases where enterprise liability does a lot of good. (b) Proof of Enterprise liability : what would P have to show to recover under the enterprise theory? (i) was there respect for the separate identities of the corporations? Test: (ii) Factors: Factors 1. shared EEs, assignment of drivers for proof 2. commingling of assets of 3. corporate formalities Enterpris 4. separate numbers for the companies 5. ordering of supplies 6. single office 7. use of bank accounts. ii) Fraud on the public: (1) This was W's second argument: He argued that multiple corporate structure was an unlawful fraud on the public. Cts reaction: There was not fraud here. Fraud is the Definition deliberate misrepresentation made with intent to defraud upon which P relied to his of FRAUD detriment. (a) Does the intent to minimize liability translate to fraud? No, Ps injury unchanged by the ownership structure. (2) Generic Questions: (a) Is it improper to incorporate your business for the express purpose of avoiding personal liability? No (b) Is it improper to split a single business enterprise into multiple corporations so as to limit the liability exposure of each part of the business? [recall SouthernGulf Marine] No iii) Walkovskys Alter Ego Doctrine: (1) By what standard will the Walkovsky court decide whether to pierce the veil and hold Carlton liable? (a) "Where a shareholder uses control of the corporation to further his or her own, rather than the corporation's, business, he or she will be held liable for the corporation's acts and debts on a principalagent theory" (pg 212) (i) This is sometimes called the alter ego doctrine. The Ct lists some factors to look Alter at. What does that standard mean though? Unclear. Ego 1. the business is closely held corpo Factors 22 2. the P is involuntary (tort) creditor to "Pierce i) 3. the D is a corporate SH (as opposed to an individual) 4. insiders failed to follow corporate formalities 5. insiders commingled business assets/ affairs with individual assets/ affairs 6. insiders didn't adequately capitalize the business 7. the D actively participated in the business 8. insiders deceived creditors (b) The absurdity of the alter ego doctrine: (i) In a corporation with just one shareholder, who is going to make the important decisions? The owner 1. If the owner, what will be the most important factor in the owner's decisionmaking process? What his or her best interests are. Control alone is not enough 2. In such corporations, can one draw meaningful distinctions between the to pierce the owner's personal and corporate business? No; the firm's business is the corporate shareholder's business. Prof doesn't think you can make a meaningful veil! need distinction. C drained all the money out of these corps. As soon as any money fraud or unjust was in, he took it out. enrichment (2) Alter ego standing alone is not enough an adequate test. (a) It cant be what you are concerned with since there isn't a meaningful distinction. since the notion of the alter ego comes from the philosophy that they are separate, when often that is just a fiction. (b) Majority Rule: Most Cts say that control is not enough to pierce the corp veil, need something more, like fraud or unjust enrichment. (i) Is it enough that the creditor will be unable to collect the full amount owed unless the court pierces the veil? No. Sealand is especially explicit on that point. There must be something more: e.g., fraud or unjust enrichment. Was there fraud or other injustice in Walkovsky? Maybe a weak case for unjust enrichment if Carlton deliberately siphoned assets out of the corporation to avoid liability to victims of his taxi drivers. (c) What must P show besides control? (i) Sea Land standard: says that there are 2 elements to pierce the veil. 1. The corporation was the controlling shareholder's alter ego; and 2. Adherence to limited liability would "sanction a fraud or promote injustice" a. "It merely measures the rule by the length of the Chancellor's foot" (Harold Marsh) Actual b. Constructive fraud or actual fraud. Example: trustees are liable for fraud or committing fraud in the mngmt of the trust. Cts have said that certain constructiv trustee actions other than actual fraud, constitutes constructive fraud. Like e fraud! self dealing. (ii) Michaelson standard: 1. Undue domination and control of corporation by shareholder 2. The corporation was a device or sham used to disguise wrongs, perpetuate fraud, or conceal crime (d) Is there a difference between the Sea Land and Michaelson standard? (i) The Sea Land standard seems more vague. Michaelson emphasizes a particular type of conduct that it wants to condemn, contract cases. Michaelson was looking for particular kind of intentional misconduct. Why is it so important in a K case 23 compared to tort case to prove that there was fraud. Fraud is highly relevant to K cases. Why so important? (3) Factors relevant to Control prong: (a) Commingling of funds (b) Undercapitalization formalitie (c) Disregard for corporate formalities: (i) Failure to hold shareholder meetings (ii) Failure to hold board meetings (iii) Failure to keep minutes of said meetings (iv) Failure to keep separate books (v) Failure to issue stock (vi) Failure to appoint a board (vii) Failure to adopt charter or bylaws (d) California laundry list : (20 factors) Need "several" of the factors to be present. (i) Commingling of funds, failure to segregate funds of the separate entities, and the unauthorized diversion of corporate funds or assets to other than corporate uses (ii) the treatment by an individual of the assets of the corporation as his own; (iii) the failure to obtain authority to issue stock or to subscribe to or issue the same (iv) the holding out by an individual that he is personally liable for the debts of the corp (v) failure to maintain minutes or adeq. corp. records, and the confusion of the records Piercing the of the separate entities Veil & the (vi) the identical equitable ownership in the two entities Formalities (vii) one person owns all the stock Fetish (viii) same employees, office location, (ix) undercapitilization; [ (x) failure to maintain arm's length relationships among related entities (4) The Formalities Fetish: (a) (pg 213): where the Ct says that the complaint was barren of particularized statements ect....w/o regard to formalities. Many of these cases place great emphasis on factors like failure to comply with corporate formalities. Why are such factors relevant? Best guess: They inferentially indicate a potential disregard for creditors' interests if you play fast and lose with formalities, maybe we expect that you played fast and loose with your bills too. Lack of formalities was cited in 95% of cases where the veil was pierced. (i) What sort of formalities to we expect corporations to observe? 1. Board of directors. 2. Meetings 3. Issue stock. c) Planning: i) No brightline rules for deciding when courts will pierce the corporate veil. Keep client out of court in the first place ii) If Carlton is client, help him client set up the business so as to ensure he'll get the benefit of limited liability. Carlton asks: How do I avoid losing these cases and not being personally liable? I'd also like to avoid having my other corporations at risk. 24 (1) Alter ego: Avoiding Enterprise Liability harder than (a) What does Carlton need to do to avoid having the veil pierced and having Ps hold him personally liable. (i) Avoidance of personal liability is easy: respect the corporate formalities and take out the minimum insurance 1. Maintain adequate records and corporate formalities 2. Don't commingle funds or assets 3. Don't undercapitalize the corp 4. Don't let one corp treat the assets of another corp as its own. (2) Enterprise Liability" (a) Avoiding enterprise liability is more difficult. (i) Need separate books and bank accounts for each corporation, plus careful accounting for supplies, for borrowing of drivers, etc... (ii) There are concepts in which it might be worth it to split the business up and respect the differences, you can jmt proof your businesses. 25 LIMITED LIABILITY: ECONOMIC ANALYSIS Assn 7 1) Exceptions to the principle of Limited Liability: a) Two Prong test for Alter ego liability (piercing the corporate veil Sealand) i) The corporation was the controlling shareholder's alter ego (factor analysis); and ii) Adherence to limited liability would "sanction a fraud or promote injustice" (1) The status of the corp was such that that permitted the SH to do fraud or other injustice. This makes sense since it is hard to draw line btwn SH and the corp. (a) Personal piggy bank is not enough, need fraud. (b) Is it enough to meet this prong that the creditor would not be paid? (i) No, Sea Land said that you need some sort of fraud or unjust enrichment. (c) Back to Walkovsky: was there fraud of other injustice in Walkovsky? (i) See page 222, in Sea Land: unjustly enriched. Is there anything in Walkovsky we could show was using the corporate faade fraudulently? What did Carlton do with the money that came into the cab co? well, could argue that Carlton deliberately kept the corp undercapitalized by siphoning out money of the corp. the reason this is a weak arg is that the point of LL is to allow him to do this. But the best, albeit weak argument is that he siphoned. (ii) One of the problems of veil piercing is that there is no clear standards. No bright line rules. Lot of wiggle room. b) Two Prong test for Enterprise Liability : possible to hold affiliated corporations jointly liable as one (looks similar to veil piercing). i) Such a high degree of unity of interest between the two entities that their separate existence had de facto ceased (factor analysis) ii) Treating the two entities as separate would sanction fraud or promote injustice 2) The Dark side of Limited Liability : a) Externalities : i) permits SH to avoid some of the social cost of their activities. Carlton structured his biz so that tort victims had to bear some of the cost. This encourages excessive risk taking. b) Encourages excessive Risk Taking: i) Example : two investments. LL affects incentives to choose between them. In both investments, the corp borrows 2K from a bank and invests it. (1) Investment A : 10% chance that payoff is 3K; 80% chance of getting 2K, and 10% get 10K. In evaluating this business opportunity, we don't only look at the nominal payoff, but we look at the expected value. Expected value = nominal payoff * expected payoff. Expected value is 2K. (2) Investment B : 20% chance get 5K, and 60% get 2K, and 20% get 0. Expected value here is 2.2K. (a) This is the more risky investment. (i) This has a higher default risk than investment A. (ii) It also has a higher volatility risk, which is the uncertainty of outcome. The greater the spread of possible outcomes the greater the volatility risk. (b) Why does risk matter? Well risk is associated with return. The more risky the 26 investment, the more return you should demand on the investment. Why LL is the (i) If we lived in a world of unlimited liability, where SH are personally liable, the bank would be indifferent between the two investments. If the bank can collect between the firm and the SH, they don't care. (ii) If we live in world of LL, where the investor cant sue the SH and can out some money, they prefer the less risky investment, investment A since there is 90% chance they get their money back. 1. The SH prefers the investment B, since there is a higher expected value and the fact that there is 20% chance wont get anything doesn't affect her. 2. LL means that there is no downside to the SH. From the SH perspective, it is most beneficial to make risky high payoff investments. So what LL does is to change the incentives of SH and Cs. And to give them incentives to pursue diff investment strategies. And SH use this power to get the corp to pursue risky courses of action at the detriment of creditors. 3) Well if LL has problems, then why is LL the default? a) Methodology: We could sit everybody (tort and contract creditors, shareholders, etc...) down around a table and have them bargain and ask: What is the majoritarian default? What would the parties have done have done if they had thought to bargain over the issue and could have done so costlessly? b) Start with Publicly held corporations i) Characteristics: (1) Thousands of shareholders, each of whom owns a small percentage of the total stock (2) Thousands of contract creditors, such as: (a) Banks (b) Bondholders (c) Employees (3) Potentially thousands or even millions of involuntary creditors c) Why do SH in publicly held corporations want LL? i) Is it to avoid personal liability ? No, b/c how do we explain partnerships? ii) Monitoring costs ? Who would SH have to monitor under unlimited liability? They would have to have knowledge about the activities of the firm and expend greater effort learning about the firm and exercising control rights to limit the kinds of investments the firm makes to control their risk. (1) Have to monitor the firms: prevent risky investment (2) Monitor each other: ensure fellow SHs can help bear fair share of risk iii) Free riding problem: collective action problem. (1) Free riding makes it hard to extract contributions from a group (2) Free rider assumes: I need not contribute ... others will contribute enough (3) Suboptimal production of collective good (here monitoring) d) Why would creditors accept LL? i) Prohibitive Enforcement Costs: (1) They want to collect from SH, but this isn't really viable since there are prohibitive enforcement costs--Implications of joint and several liability. ii) Monitoring costs: (1) voluntary creditors can raise interests rate of take other precautions. iii) Pie Expansion: 27 (1) increases the size of the equity cushion. If the SH has incentive to put more investments in the corp, there is more money available to repay creditors. e) What about LL in the small firm setting? i) SH characteristics: (1) Few in number Why LL is (2) Actively involved in mnmg the default (3) Not well diversified in the ii) Creditor characteristics: small firm (1) Few (2) Low enforcement and monitoring costs (3) Smaller equity cushion (e.g. Walkovsky) iii) LL doesn't seem to be the right default rule in the small firm setting, but why doesn't the rule change for small firms? (1) Line drawing problem : where would LL kick in? 10 SH, 100 SH? (2) Investor choice : one choice fits all is a lie, people differ. If you say everyone has to fit into this form of contract, you encourage people to expend time bargaining. But if we gave them a lot of choices then they choose the one that is the best fit. The more we make organizational types look the same, the higher the transaction costs. (3) Penalty default : force parties to bargain. At least as to voluntary creditors, there is a solution. There is something else Carter could do. Ways a K creditor can protect themselves: (a) 1) representation and warranty provision: will only use the money for specific person. (b) 2) Use of proceeds clause in the loan. In Bonds, they have use of proceeds clauses. (c) 3) charge a higher interest rate to compensate for the high risk. (4) Contract Claimants: (a) This suggests that claims by contract creditors should be disfavored? Why? Contract creditors can and should bargain ex ante. (i) Exception: misrepresentation. See e.g. Michaelson. (5) Tort Claimants : (a) They cant protect themselves through bargaining: Veil Piecing (i) Veil piercing arg is strongest for tort Vs of small firms, since they cant protect ex argument ante from bargaining, and W externalized risk to pedestrians. strongest for (ii) But personally, prof thinks we should get rid of veil piercing altogether: [See tort victims of Professors Article that he assigned for us to read: Stephen Bainbridge, Abolishing small firms Veil Piercing, 26 J. Corp. L. 479 (2001)] 1. Veil piercing cannot achieve the goals set for it: a. The doctrine is vague b. The doctrine asks the wrong questions Prof Hates 2. The doctrine is routinely applied in unprincipled and arbitrary ways Veil 3. Veil piercing is a tax on the wary and a trap for the unwary Piercing a. Functions of Veil piercing: i. Tasks assigned veil piercing by commentators: ii. Induce shareholders to internalize risk iii. If Carlton complies with corporate formalities, on what basis could he "Functions" be held liable? Courts decline to pierce in 90% of cases in which formalities observed. Will Walkovsky feel better because Carlton kept of veil 28 minutes of board meetings? piercing Veil Piercing iv. While not deterring capital formation and economic growth v. While promoting economic democracy f) What can replace veil piercing? i) Direct liability: (1) Consistent with statutory text: MBCA 6.22(b) : "a shareholder of a corporation is not personally liable for the acts or debts of the corporation except that he may become personally liable by reason of his own acts or conduct" ii) Bargain Settings : (1) Commercial misrepresentation. Speaks to concern that creditors may rely on fraudulent statements (2) Fraudulent transfer. Speaks to concerns about siphoning iii) Tort Claims : (1) Primary liability (2) Fraudulent transfer law (3) General welfare legislation designed to deal with externalities (4) Targeted legislation directed at specific hazards (e.g., regulating taxis) 29 DUTY OF CARE AND THE BUSINESS JUDGMENT RULE: OPERATIONAL DECISIONS Assn 8 1) Shareholders elect directors that run the corporation. The directors then owe 1) care and 2) loyalty to the SH. 8.30 Standard of Conduct: "Each member of the board of directors, when discharging the duties of a director, shall act: (1) in good faith, and (2) in a manner the director reasonably believes to be in the best interests of the corporation" i) Issue: To what extent will the conduct be reviewed to see if the directors complied with this order? The cases we discuss answer this Q. 2) Dodge v Form Motor co, 286: Facts: FMC is hugely successful and has $10M of dividends on $2M investment. HF is dominant with 58% of the stock. HF cuts the dividend to $1.2M. On a $2M investment that's still 60% a year. Soon FMC has retained earnings > $50M. The Dodge Boys with 10% sue. They want to use the money to build competitor. Issue: what relief are the Dodge brothers seeking? i) To require FMC to issue special dividends ii) To enjoin the construction of the River Rouge plant Holding: FMC must issue the special dividends, but it can continue with its construction plans Rule of law: i) Rule of law regarding dividends: (1) What standard of review does Ct announce re dividend decisions? The dividend decision is discretionary. (a) Courts will generally leave dividends to the discretion of the directors (b) But will intervene if refusal to pay amounts to "such an abuse of discretion as would constitute a fraud, or breach of ... good faith" (2) Shareholder primacy: (a) Why was Fords decision re dividends an abuse of discretion? (i) Ford began to run the company for humanitarian reasons--to allow low income people to afford a car. What is wrong with this? His job was to maximize the profit of the SH. See page 290, the Discretion of the directors is to profit maximize..." (ii) "A business corporation is organized and carried on primarily for the profit of the stockholders. The powers of the directors are to be employed for that end." 1. Two competing views of responsibility of corporations: 1) Milton Freeman: job is to max profit. 2) Corporate social responsibility (iii) Limits on the "For the profit of the SH": 1. Law compliance : cant break the law, duh. See note on pg 296. 2. Charitable giving : 2.01: the objective and conduct of the corporation. ii) Rule of Law re Expansion: (1) Why did the Ct decline to enjoin the expansion of the plant? "judges are not business experts." implicates the BJR (a) Yah, but this is not a good answer. Are judges medical experts? Design experts? No but they make decisions on this all the time. 30 a) b) c) d) e) Dividend decisions are discretionary Ct will only review if there is "an abuse 3) The duty of care: f) MBCA 8.30(a): "Each member of the board of directors, when discharging the duties of a director, shall act: (1) in good faith, and (2) in a manner the director reasonably believes to be in the best interests of the corporation" i) Application of the duty of care to Ford: (1) Did Ford reasonably believe that building the plant was in the best interests of Ford? Duty We don't know, maybe. of (2) Could Ford have reasonably believed that cutting the dividend was in the best interests of Care the Ford co and the community of SH? Was there a legitimate reason to cut the dividend? (a) Possibly trying to cut of the competition from the Dodge brothers. Well if that was the real motive, then why didn't Ford just say that? That would violate antitrust. (3) Did the Ct even ask if Ford believed the decision to be in the best interests? g) Shlensky v Wrigley, i) Facts: S was a minority SH in corp that owned Chicago Cubs and operated Wrigley Field. W owned 80% oft the stock. W famously refused to install lights. S says both teams play weekend games in the day and attendance is the same, so Cubs and Whitesox are the same. The Whitesox have lights, the Cubs don't and this hurts their attendance. S says they lose money since don't have lights and he sues W. ii) Plaintiff., S's Allegations: (1) In 19611965, Cubs consistently lost money. Probably attributable to poor home attendance. Which was probably attributable to lack of night baseball (2) Wrigley refused to institute night baseball because he believed that baseball was a daytime sport and that night baseball might have a negative impact on the neighborhood surrounding Wrigley Field (a) ~Not motivated by profits iii) Held: (1) W Wins: Why? (a) Rule of Law: In the absence of a showing of fraud, illegality or selfdealing by the directors, their decision is final and not subject to review by the courts. This is the BJR Business Judgment Rule (b) Since the courts won't review such decisions, plaintiff has no standing to sue iv) Analysis of the Courts decision: (1) Did the Cubs benefit?: (a) Ct assumes decision benefited Cubs: (i) "the effect on the surrounding neighborhood might well be considered by a director" (ii) "the long run interest" of the firm "might demand" neighborhood efforts (b) But did W require to prove benefits ? No, the Ct said he didn't have to show anything. business judgment rule. The Ct admits that speculations about the benefits are irrelevant. (i) Duty to maximize profits but unless there is fraud, illegality, they wont look at it. Kind of ironic since on the one hand you say there is a duty, but they wont look at it. 4) Reconciling the DoC and the BJR h) The DoC tells directors don't be negligent i) BJR insulates directors from negligence liability liability only for fraud or selfdealing 31 j) 8.30 provides "standards of conduct" i) "Each member of the board of directors, when discharging the duties of a director, shall act: (1) in good faith, and (2) in a manner the director reasonably believes to be in the best interests of the corporation" k) 8.31 provides "standards of liability" i) (a) A director shall not be liable to the corporation or its shareholders for any decision to take or not to take action, or any failure to take any action, as a director, unless the party asserting liability in a proceeding establishes that: (1) (1) any provision in the articles of incorporation authorized by section 2.02(b)(4) or the protection afforded by section 8.61 for action taken in compliance with section 8.62 or 8.63, if interposed as a bar to the proceeding by the director, does not preclude liability; and (2) (2) the challenged conduct consisted or was the result of: (a) (i) action not in good faith; or (b) (ii) a decision (i) (A) which the director did not reasonably believe to be in the best interests of the corporation, or (ii) (B) as to which the director was not informed to an extent the director reasonably believed appropriate in the circumstances; or (c) (iii) a lack of objectivity due to the director's familial, financial or business relationship with, or a lack of independence due to the director's domination or control by, another person having a material interest in the challenged conduct ... (d) (v) receipt of a financial benefit to which the director was not entitled or any other breach of the director's duties to deal fairly with the corporation and its shareholders that is actionable under applicable law. l) What's the difference b/n DoC and BJR ?: i) there is a standard of conduct you are expected to reach but you can fall short of it w/o being penalized. There is an area in the middle where you can fall short of obligation but not be penalized. Standard of conduct is aspirational. Standard of liability is what gets you into legal trouble. [Prof thinks this is wrong.] ii) Remember that this case was decided on the pleadings . How at the pleadings stage before discovery, could you show fraud ect. That is why 8.31 provides substantial insulation from liability, perhaps not as much as the business judgment rule. iii) Still have to reconcile the distinction between the bjr and the doc. (1) They are really about the conduct of directors in their capacity as directors. We are ignoring the board of directors as a whole and focusing on the SH. This is unusual in DOC cases. Why are we focusing on the main SH rather than the board. m) Final Observation: i) MBCA 8.01(b): All corporate powers shall be exercised by or under the authority of, and the business and affairs of the corporation managed by or under the direction of, its board of directors.... ii) But neither Dodge nor Shlensky pays any attention to the BoD just to the dominant shareholder. (1) We will Revisit when we cover Van Gorkom 32 BUSINESS JUDGMENT RULE AND PORTFOLIO THEORY Assn 9 1) Review: a) Duty of care: i) This imposes a standard of conduct requiring (1) Good faith (2) Reasonable care ii) Exception: (See Assn 12) iii) Also: the BJR limits the Duty of care almost useless. b) Business Judgment Rule: i) The BJR almost renders useless the duty of care. (1) The business jmt rule shields directors from liability. (a) Some call it a standard of review, under which directors can be held liable for: (i) Fraud (ii) Illegal conduct (iii) Selfdealing (b) But Bainbridge calls it a rule of abstention: (i) Abstention: Merits of the board's decision are "beyond our [i.e., the court's] jurisdiction and ability" [Wrigley] (2) Why is the distinction between standard of review abstention and is important: (a) Bainbridge views the BJR as a prophylactic barrier to looking at the merits of the decision. (b) So one of the Qs we should think about is whether the cases we read are abstention of standard of review cases. Dodge and Wrigley are better seen as abstention cases. (i) "Liability is rarely imposed upon corporate directors ... simply for bad judgment ... And this reluctance is ... Labeled the BJR" Why? 1. Dodge:"The judges are not business experts" a. But judges aren't experts on lots of technical issues 2. Wrigley: No theory; just precedent. They just say that this is the rule and they will follow it. c) Joy v North, (BJR and duty to be informed) i) Facts: This case essentially arose out of related party transactions. The parties do business directly with entities or directors. Here Citytrust, loaned money to co called Katz, in which Citytrusts son worked. Defendant North was CEO of Citytrust. North dominated board and management. Citytrust made loans to a firm (Katz) at which North's son worked. Loans went bad. Shareholders sued (1) For North, this is a conflict of interests transaction since his son is involved. The BJR doesn't apply when there are conflict of interests, since they are form of self dealing. (2) The other directors who are involved don't have the self interest conflict. They are being changed with negligently allowing North to make these loans. They are charged with violating the duty of care. ii) Side Issue: Derivative litigation. (have to understand derivative litigation to understand the BJR and vice versa.) (1) Derivative litigation: Most lawsuits alleging vio of duty of care are required to be brought 33 in form of derivative suit. Special Litigatio n Comm. (SLC) (a) A special procedural device for certain types of shareholder litigation. In derivative litigating, the SH brings the suit on behalf of the corporation. Directors owe their duty of care to the corporation. They bring it to address a wrong. b/c this is the corps lawsuit, there are mechanisms that the Board can decide to terminate the litigation such as a special litigation committee. In this case, the special litigation committee said there was no reasonable possibility of holding them liable, since they presumed the BJR would apply. (b) In some cases, the board of directors can assume control of the litigation ... even terminate it (c) The special litigation committee (SLC) is one of the devices by which the board gets control of the litigation (d) See assignments 1417 (2) This presents 2 issues: (a) Derivative suit issue: must the Ct defer to the committee recommendation? In other words is the committee decision to terminate the lawsuit similar to Fords decision to build a plant? (i) No, but that's not today's issue (ii) See assn 1417 (b) Once the Ct decides to review merits of committee decision, what does the Ct think ? (i) The company recommended that the case be dismissed. The company presumably thought the BJR would apply and that there was no "reasonable possibility" of liability. They were wrong. (ii) Is BJR a standard of review or an abstention in this case? 1. More of a standard of review case. The Ct. looked at whether the directors made a negligent decision. The Ct doesn't simply defer to the committees recommendation (as it would if this were an abstention case) but rather it exercises its own indep jmt as to whether the lawsuit should go forward. Once they decide that the suit should go forward, will the Ct also substitute its jmt, as to the underlying decision that warranted the litigation, i.e. the decision to make the loans. Lack of 2. Why did the Ct disagree with the company on the merits? Oversight a. Quotes: and Duty i. Pg 302: "mistakes in jmt rarely will be found liable for damages... liability is rarely imposed simply for bad jmt..." ii. Pg 308: Litwin v Allen: An incredibly stupid decision that leaves corporation in a "classic `no win' situation" b. Directors failed to exercise oversight. i. Abdication of supervisory role to CEO. The directors had allowed North to make stupid decisions with no oversight and that was what the ct was pissed about. ii. See oversight cases in assn 12. c. Board was uninformed: i. The directors who were charged with the lack of oversight tried to say that they couldn't be charged since they didn't know. ii. The Ct said that the failure to be informed was a problem in and of Policy: itself. There is a duty to be informed. What the Ct is really doing is 4 3 Why do we have a developing a standard of review that goes beyond fraud, illegality and self dealing. So failure to inform yourself and to exercise jmt is problematic. Here the directors failed to inform themselves and were held liable. 3. How is this diff from gross negligence or recklessness? a. See assn 1012. 2) Policy: Why do we have a BJR? a) Shareholders voluntarily assume the risk b) Litigation by hindsight is imperfect : i) After the fact litigation is imperfect device to evaluate corporate business decisions. ii) So what? iii) Discourages Risk taking: Managers would have incentive to be risk averse and to do the safe thing so they don't get sued. Is that a bad thing? Why don't we want them to do the safe thing. c) SH can self protect through diversification (Modern Portfolio theory MPT) 3) Modern Portfolio Theory (MPT) in Brief: a) Investors need to be compensated to take risks, they are risk averse. This is why stock in tech co pays higher rate of return. i) Risk premium: Rate of return on risky asset minus the rate of return on a risk free asset. This risk premium reflects only one type of risk. There is distinction between systematic and unsystematic risk. (1) Unsystematic : firms specific, plant burns doesn't CEO dies (2) Systematic : Aka market, recession, tax changes, war. (this is what risk premium protects against.) ii) MPT states that the risk premium reflects systematic risks. (which is somewhat counterintuitive). (1) You can eliminate unsystematic risks by holding a diversified portfolio. (2) Cannot get rid of systematic risks by diversifying, that is why you need a risk premium. All companies will be affected by war, recession ect. They are market risks that cant be gotten rid of via diversification. (a) MPT recognizes that while you cant eliminate systematic risk from portfolio, you can make decision as to what exposure you have to Market specific risks since firms have Modern diff sensitivities to it. Portfolio (i) Example: Great depression. Two industries that were profitable during the great depression, 1) entertainment and 2) gold. Theory 1. During recessions, companies that manufacture cyclical durables like cars don't do as well since people don't buy cars as often. 2. During recessions, products like non durables go up, like beer and cookies, and cigarettes. And during recession people drink and smoke more. (ii) So while you cant eliminate it, you can choose portfolio that is less sensitive or more sensitive to market risk. The lesson in MPT is that diversification is essential. b) Law and Portfolio Theory: i) Judge Winter tries to use MPT to justify the BJR. (1) Portfolio theory and its corollaries (e.g., beta and CAPM) used to: (a) Evaluate disclosure rules what do investors really need to know? (b) Value securities in litigation 35 (c) Determine public policy towards mergers (d) Winter's theory of the BJR ii) What is it that Winter says about the risk of bad business jmt? Implicit in his analysis is that bad business jmt is unsystematic (since this is the only kind you can eliminate through diversification). (1) He treats negligence as a diversifiable risk. (a) Bt then why isn't fraud, illegality and self dealing also diversifiable? MPT treats (i) In fact, shouldn't these be more subject to being eliminated by diversification than negligence as negligent since negligence is so pervasive and we all do it every day. an (2) Risk is defined by reference to the variance of return: unsystematic (a) Mgmt misconduct erodes the expected return but doesn't change the variance of return. Therefore--it isn't a risk at all. Risk is something that makes the return on the investment more volatile, less certain, while negligence, fraud ect just erode the We don't expected return but don't affect the volatility of the investment. have an (i) So we don't have a theory that explains the BJR. The explanation that judges adequate are not business experts, AOR, and that litigation is imperfect doesn't explain the theory that cases, and MPT doesn't either. We don't have a good reason why BJR exists. (ii) The three policy reasons by J. Winter is bunk. In the next case we read, we learn the reason for the BJR. See page 322. 36 BJR AND THE REQUIREMENT OF AN INFORMED DECISION Assn 10 1) Review of what we've learned so far: a) Duty of Care i) A standard of conduct (1) Exception: see assignment 12 ii) Requires: (1) Good faith (2) Reasonable care b) Business Judgment Rule i) C.J. Winter in Joy v. North: ii) Directors not liable for bad judgment (1) "This reluctance ... labeled the BJR" c) Two ways of thinking about the BJR: i) As an abstention doctrine Court will not review BoD decision (1) Preconditions: (a) No fraud (b) No illegality (c) No selfdealing (d) Decision not egregious ii) As a standard of liability: No liability for negligence (1) Instead liability based on: (a) Fraud (b) Illegal conduct (c) Selfdealing (d) Egregious misconduct (?) Distinction between abstention and d) Distinction between the two doctrines : Fine but significant point for the psychology of Judicial Review. i) Abstention: (1) If we tell judges they cant look at the complaint unless the complaints says x,y, and x--we are telling judges two things: (2) Aren't supposed to look at the merits of the complaint : they aren't supposed to look at the complaint and what they do is very narrow, and (3) Use the pleadings without discovery: when you look at Brown v Eisner, one of the things you see is that the Ct makes a big deal that you are supposed to get rid of the BJR on the pleadings without discovery. Particularized factual allegations must be shown for the case to survive a motion to dismiss. ii) Standard of liability: (1) Abstention is diff from the standard of liability view of BJR which tells the Ct to affirmatively look at what the board did and this can open up a can or worms leading to Litman v Allen, and the Ct says that this was such a stupid business decision that the Ct imposed liability even though there wasn't fraud illegality and self dealing. (2) Also, more likely that the Ct will look at the merits of the boards actions. (3) Also more likely that the ct would allow limited discovery, which under abstention, 37 shouldn't happen. (4) Both abstention and standard of liability compete for being seen as the right way of viewing the BJR. The Prof likes the abstention view. 2) Smith v Van Gorkom, [this is the leading precedent on the BJR] a) Facts: Trans Union was a leasing company (RR cars) they bought assets and leased it to users. This business model had tax consequences. When TU bought a RR, it was a capital asset that could depreciate. Over time you can deduct depreciation, which reduces taxes. i) This was the time of stagflation, (recession and high inflation) so to stimulate business, the Congress passed an investment tax credit that allowed an additional investment tax credit. (1) This meant that you start off with GA minus a deduction for depreciation = taxable income. TI x tax rate = tax owed minus tax credits. (a) Tax credits are useful for decreasing overall tax burden on dollar for dollar basis. (b) The problem with tax credits is that they are only useful to you if you have tax that you owe, and TU was in situation where the deductions were larger than their GI, so they The leading owed zero tax owed, so the tax credits didn't help. The tax credits just sat there and case on the had a valuable life and were going to disappear before they could take advantage of it. BJR (2) BUT: if TU were to be purchased by another company who paid a lot of taxes, and structured the deal properly, TUs tax credits could be applied to reduce the buyers taxes. So the only way to realize the value of the asset was to buy TU. This is why they wanted to merge with a co that owed taxes. So to a prospective buyer of TU, they would be willing to pay a premium to acquire TU. (3) TU chairman Van Gorkum decided to sell the company. (a) Timeline: The timeline is important (i) Aug Sep, 1980: Internal mgmt discussions 1. TU stock at $38. 2. Considered management buyout (MBO) 3. CFO Romans runs feasibility study a. Easy at 50 b. Hard at 60 c. Van Gorkum: "I'd take 55." (ii) 1980: 1. AugSep: Internal management discussions. 2. Sept 1319: Van Gorkum negotiates leveraged buyout at 55 per share with Pritzker. a. What is a leveraged buyout? Borrowing to purchase an asset is called leveraging. The effect is that you end up with equity and debt. What leverage does is to increase the riskiness of the transaction and as a result significantly increase the return on the investment. Equity is associated with the claim on the asset. So the effect of leveraged buyout is to significantly increase the risk to the residual claimant. (b) The Deal: Legal Structure (i) Jay Pritzker owned Marmon Group who had a subsidiary called NewCo. Pritzker would be controlling SH. Here NewCo, is subsidiary of the Marmon Group. Marmon when to investment group and borrowed money and gave it to NewCo, in return, NewCo gave Marmon stock. Now NewCo is just a shell co, except that it 38 has 6 mill in cash in bank. NewCo then merges with TU, as a result, TU becomes part of Pritzker enterprise and remaining SH disappear having received the cash. 1. DGCL259(a): Legal Effect of a merger: a. "When any merger ... shall have become effective ..., for all purposes of the laws of this State the separate existence of all the constituent corporations ... except the one into which the other ... constituent corporations have been merged ... shall cease "and the [surviving] corporation [shall possess] all the rights, privileges, powers and franchises ..., and [be] subject to all the restrictions, disabilities and duties of each of such corporations so merged or consolidated ..."and all property, real, personal and mixed, and all debts due to any of said constituent corporations ... shall be vested in the corporation surviving ... from such merger ... but all rights of creditors ... of any of said constituent corporations shall be preserved unimpaired, and all debts, liabilities and duties of the respective constituent corporations shall thenceforth attach to said surviving ... corporation ..." i. In other words, all the assets combine to the benefit of the surviving entity. It smooshes two co. into one. 2. So, NewCo and TU merged, with TU being surviving entity, and TU becomes a wholly owned subsidiary of Marmon. a. What happened to the former TU SH's? i. DCGL 251: The plan of merger shall specify "the manner of converting the shares of each of the constituent corporations into ... cash ... securities of any other corporation or entity which the holders of such shares are to receive in exchange for [their] shares" ii. In other words, the plan of merger provides that the stock certificate, that prior to the merger, represented a proprietary interest, was transformed to an IOU. They used to have share of stock for $38, but they got IOU for $55. so the old shares of TU were transformed, and the old shares of New Co, were transferred to IOU for Marmon. So as a result, Marmon then ends up owning TU, and the former TU SH get cash and go away. 3. 1980: a. Aug Sep: Management discussions b. Sep 1319: Van Gorkom agrees to LBO c. Sep 20: Senior management meeting i. Reaction: very hostile. d. Sep 20: TU BoD approves the merger after 2 hour meeting. VG signs agreement during a party. VG goes and works out deal for P to buy co and pay SH for 55 per share. VG goes to managers of the co and the mngmt reaction was negative. e. The Board then approves the merger after 2 hour meeting. f. Oct 8: TU BoD approves the revised deal. 4. 1981: a. Feb 10: the merger was approved by SH by 69.9% to 7.25% (22.85 abstained). 39 (4) Evidence of Traditional BJR bases of liability: (a) BJR doesn't protect: (i) Fraud (ii) Illegality (iii) Self dealing: 1. might be able to argue that VG wants to retire and cash out. VGs atty would respond that it was good for everyone, not just him. (iv) Egregious misconduct ii) Legal rule: the BJR will not protect an uninformed decision. (1) The party attacking the boards decision has the burden of proof on this issue. (a) The party attacking the boards decision must prove: (i) the directors failed to inform themselves with "all material information that Test: was reasonably available to them." (ii) on the party challenging the boards decision. BoP: (iii) Standard: Gross negligence. 1. Negligence isn't enough, has to be gross negligence. What is the diff b/n the two? Very fuzzy. Somewhat worse than mere negligence. iii) BJR post Van Gorkum: (1) A standard of liability (a) Directors may be held liable for gross negligence in failing to make an informed decision (2) A rule of abstention (a) Will court review substance of BoD decision? (i) No (b) Will the court examine decisionmaking process? (i) The extent to which BoD made an informed decision (c) Realize that the Ct isn't asking whether 55 is the right price, they were asking whether the board used the appropriate process in coming up with the 55 number. iv) What did the board know? (1) The board knew Pritzker was willing to pay $17 premium over the prevailing market price. Why wasn't that enough? (a) BoD doesn't know how Van Gorkom set the price (b) BoD doesn't know price based on study of feasibility rather than value (i) Does a firm have an "intrinsic" value? (c) BoD doesn't know what control is worth to Pritzker (i) How do we figure out what stock is worth? (ii) Does Pritzker think he got good deal? (iii) The critical decision that the Board made was agreeing to the acquisition at the price the agreed to. (d) What didn't they know about the 55 share price? (i) What is intrinsic value compared to market value. (ii) They don't know how the 55 figure came about. 40 Duty to be informed of all mat. info. "reasonably available" to (iii) They don't know Pritzkers reservation price, which is the maximum price they will hold out for. (iv) They don't know about the nature of the control rights (from amt of shares owned) 1. Stock consists of two rights: economic and voting a. A single share of stock gives the owner little control over the company b. The market price of a share of stock thus reflects nothing more than the estimated present value of the future stream of dividends payable on that share i. The 17 dollar premium imply that Pritzker was willing to pay for control. But don't know the reservation price. ii. Is there anything in the facts that suggest how good a deal P thought he was getting? v) Why pay a control premium?: (1) Stock consists of two rights: economic and voting (a) Someone buying a controlling block of stock gets the ability to elect the entire board of directors (i) Assuming no cumulative voting Why pay a (b) Hence, purchaser can change corporate management and policies to make firm more control valuable premium? (i) For someone who owns single share of stock, the economic rights are more imp than the voting rights. The person with more stock will care more about the voting rights. 1. The voting rights for single share of stock will be essentially zero. (ii) Only econ rights are reflected in the marked price of single share. When we say marked price is 38, this means that stick market thought it was worth 38. (iii) When someone bys controlling block of stock, they get ability to elect entire BoD, this gives them value. 1. The value to P of control rights was at least 17. 2. The board doesn't know what Ps reservation price is. vi) TU Boards failure: (1) No effort to determine how much control would be worth to Pritzker (a) Absent such a determination, no basis for deciding whether the price was a fair one (i) so there are things the board should have know that would have suggested that they set the price too low. (b) Trans Union's own estimate suggested that a price of up to $60 per share would be feasible (i) Only a 5 dollar per share difference, but in total = about 63 million dollars--this is a big deal. (c) The feasibility study was prepared internally by somebody who doesn't do financing studies for a living (2) The Real Issues: (a) What is the firm worth to Pritzker? 41 (b) Did the board of directors do a good job in capturing that value on behalf of their shareholders? (i) There is even more striking evidence from which the board should have know that it was getting a bad deal. (3) Is there a reason to think TU got a bad deal? (a) Ps behavior suggests that someone things they are getting a good deal--a good deal for Pritzker. (i) Van Gorkom asked for a meeting, at which he said "if you'll pay $55, here's how you can finance the deal." (ii) Pritzker asked about $50, but quickly agreed to $55. 1. Suggests that Pritzker thought he was getting a bargain (iii) It is obvious that P wanted to discourage alternative bids. He gave them a deadline of the very next day. shouldn't this have alerted the board? 1. 251(b) , page 137: the BoD shall adopt resolution approving merger and declaring its advisability. a. The fact that VG negotiated the deal is legally unenforceable since the board has to do it. (4) Reliance on Van Gorkum: (a) DGCL 141(e) provides a defense for directors who rely on reports from officers. Why didn't 141(e) apply here? (i) Van Gorkom was uninformed (ii) BoD had a duty of inquiry ... can't rely blindly (b) Why didn't 141 (e) apply here? (i) The 20 minute presentation didn't qualify. Also VG didn't even know and probably didn't do all the reading and didn't inform himself of the terms of the K. (ii) Would it apply if they had an atty read the agreement and make a recommendation to the board (provided that the advice given was w/in expertise of atty ect). 1. Not necessarily, attys may not have the expert competence to determine that 55 is a fair price. Attys do not determine if prices are fair prices, that is what investment bankers are for. (iii) The BoD had a duty of inquiry...cant rely blindly. (5) What did the Board know? (a) The board knew that no one other than P had offered to buy the co. (i) The socalled market test defense (ii) There was no auction of TU. So they didn't know. There was the absence of competitng bids. (b) Why didn't absence of competing bids prove BoD made a good decision? (i) Terms of the agreement didn't permit fair market test (ii) TU could not solicit bids nor provide information to bidders (c) The BoD knew that it had amended the merger agreement in Oct. Why didn't those amendments help? (i) Again, they approved amendments sight unseen 42 (ii) Amendments actually made it harder for TU to accept competing bids ... needed to close competing deal (iii) Van Gorkom's conduct undermined potential competing bids by KKR and GE Credit vii) Evaluating the "reasonably available" Standard: (1) The "reasonably available" standard req in depth study: (a) Valuation study (b) Discussion of course of the negotiations (c) Review of actual contract (2) Is that appropriate standard? The problem is that information is costly, and at some point you will reach point of diminishing returns: (a) Risk taking : CJ Winter in Joy v North, says that BJR is designed to allow directors to take risks. (i) Would it be app for BoD to take the risk that they don't have all the relevant facts? Does the standard that they must get all the information conflict with BJR that wants to encourage risk taking? Would BoD be discouraged from taking a risk? 1. Example: C has oil wells in Iraq and Exxon wants to buy their oil wells and is willing to take the risk. The BoD has been wanted to get rid of the wells and are happy and want to act fast. They know that there is information that they should find out if they had the time, and this would be material information. But they want to act fast. Then Exxon takes the wells and they find out they are worth millions. Then the SH sue the BoD saying that they didn't get the info they should have. The information was available, but was it reasonably available. a. We could tweak the standard: the director must be informed of all material information to the extent the director reasonably believes approp under the circumstances. b. MBCA 8.31(a)(2)(ii.)(B.), pg 189: director shall not be liable for decision ... unless the party trying to establish liability shows that the challenged Prof likes this standard more conduct was the result of a decision that the director was not informed to than the DE standard. an extent the director reasonably believed to be appropriate in the circumstances. 3) An Alternative Explanation for the BJR: a) Built on the theory of the firm i) The board of directors as nexus of Ks ii) Agency costs b) Consensus v. Authority: i) Consensus (E.g., partnerships) (1) Collective decisionmaking (2) Requires constituents with: (a) Similar interests (b) Comparable access to information (c) Minimal collective action issues ii) Authority (E.g., public corporation_ 43 (1) Central decisionmaking body (2) Arises where constituents have: (a) Differing interests (b) Unequal information (c) Collective action problems (3) Authority is a transaction cost economizing device: "cheaper and more efficient to transmit ... information once to a central ... office to make the collective decision" Kenneth Arrow iii) Thesis: (1) Authoritybased decisionmaking is essential for public corporations (minimizes transaction costs). (a) Large number of constituencies with differing access to information (b) Diverse constituencies with conflicting interests (c) Intractable collective action problems (2) The problem is that the central decision maker may use its power to benefit itself rather than paying out dividends. This is what is referred to as the agency cost problem. Agency costs are inherent in authoritybased decisionmaking structures (a) Cannot reconcile authority and accountability. (b) Tension between authority and accountability visvis board and managers (i) Agency costs can only be eliminated by eliminating authority (ii) Market constraints important (iii) A more important consideration: 1. Power to hold to account is the power to decide (c) We have shifted the power to make decisions from the board to the court and that's a problem c) Business Judgment Rule Follows as Matter of Course i) BJR prevents shift in locus of decision making authority from boards to judges. Establishes prophylactic barrier against review. ii) SH would bargain for BJR b/c systematic costs of JR exceed the benefits of punishing directors misfeasance. (1) Why do we value preserving boards authority in the board context? B/c SH want it. (a) Costs result from JR: Benefits (i) Hindsight bias discourage risk taking of the (ii) Interference with internal governance BJR (iii) Judicial decisionmaking not subject to market discipline: 1. Firms whose managers make bad decisions are weeded out in Darwinian selection. d) Remaining Prob: How do we tweak the BJR to strike the right balance of authority and accountability? i) "To maintain the value of authority, [accountability] must be intermittent. ... Decisions are reviewed only when performance is sufficiently degraded from expectations." (Arrow) (1) Null hypothesis: respect board's authority absent selfdealing (2) Remember that authority and accountability are competing values. Ask which one is more imp. e) Why did Accountability Trump Authority in VG: i) Two Problems: 44 (1) Final period problem with high magnitude (a) In life one of the things constraining behavior is whether you expect to do biz with that person again. But suppose you know that is the last time you will interact, that is called the final period and the constraint of meeting again isn't there. So in final period transaction, accountability is really imp since e the other party doesn't have the ability to constrain your behavior. As long as TU was ongoing, BoD misconduct could be punished by SH in many ways, but in the final period, there is more risk of misconduct. (b) Board abdicated its role (i) Van Gorkom rests on the absence of a sufficient record of any deliberative process, rather than on failure to comply with some judicially imposed decision making model 45 BJR AND "GOOD" CORPORATE GOVERNANCE Assn 11 1) Brehm v Eisner a) The players: i) Mike Eisner: CEO and Chairman of Board of Disney. ii) Mike Ovitz: Head of CAA agency b) 1995: Disney hires Ovitz as President, with salary of 1 mill and bonus and stock option of 5 million shares. i) In event of nonfault termination, employment agreement gave Ovitz: (1) Discounted present value of remainder of 5 years salary (2) $10 million severance payment (3) Immediate vesting of options on 3 million shares (4) Total value: $140 million ii) Ovitz was nonfault terminated after 14 months. c) Stock Options: i) Stock options align the managers interest so that they want to act to help the shareholders since they benefit too!. ii) This case illustrates another perverse incentive of stock options. In event of nonfault termination, employment agreement gave Ovitz, Discountented present value of remainder of 5 years salary, 10 million severance payment, immediate vesting of options on 3 mill shares, total value of 140 million. (1) This means that if he got non fault termination he got more money than if he kept working. This gives bad incentives. d) P's allegations: i) Old board violated duty of care and committed waste in 1995 when it approved the new compensation package. ii) New board violated its duty of care and committed corporate waste in 1996 when it approved non fault termination. e) Waste and Due Care re compensation: i) What is waste : a transaction "that is so one sided that no biz person of ordinary, sound jmt could conclude that the corp has received adequate consideration." In other words, it is a gift Waste of corporate assets. The DE Chancery Ct bounced the case out on the pleadings with no opp for discovery. ii) When the P alleges waste and care violations, are the courts going to review the allegations for claims on the merits? In other words, did the Ct here get into the issue of whether of not the compensation that was paid to Ovitz was reasonable or constituted waste? (1) No: They don't look at the merits. They look at the process by which the decision was made: (a) "Process due care" only (b) at least absent irrationality, compensation is matter of business jmt and the court will not review the decision. (2) What did the P need to show to show process due care violation? (a) That the board was grossly negligent of failing to inform themselves of all material information reasonably available to it. Reasonably (3) Can the board consciously make a decision to take the risk that it lacks key information? available 46 (a) How do we interpret the phrase reasonably available? reasonable reach... very (i) The Ct says, that the board must inform itself of info w/in its "reasonable reach." this is an ambiguity in DE law and prof wishes they would clear it up. iii) "Process Due Care" by the old board: (1) Did the Old Board inform itself of all material info reasonably available to it? (a) No: (i) No ... didn't calculate the potential expense associated with a nonfault termination. Nothing in the opinion indicates there was a bidding war for Ovitz. (ii) Did anyone figure out how much they would have to pay Ovitz for a non fault firing? NO. testimony indicates that they didn't determine how big of payout that Ovitz would require. (b) But was the old board held liable for their gross negligence? NO. (i) The old board was grossly negligent but they weren't held liable. Why not? 1. 141(e): provides a rebuttable presumption against liability for directors 141(e) reasonably relying on good faith by an expert....who was selected with provides a reasonable care. rebuttable a. This is a rebuttable presumption independent of the BJR that directors presumptio are protected (not an affirmative defense). n i. This means a P has to get over two hurdles. 1) the BJR, and 2) independent 141(e). of the BJR 2. Did the board have to prove the Crystal was an expert in order to get the 141 defense? No, there is presumption that he is an expert that they are entitled to P has two rely. (thus, it is hard to be a P in DE Cts. Since DE Cts presume 141. 141 is not an affirmative defense but is a rebuttable presumption. 3. 141(e): Ct adds some preconditions to 141(e) defense: a. duty of inquiry b. possibility doesn't apply when decision is beyond the pale iv) Analysis: [Question 2 following the case]. (distinguish Van Gorken and Brehm) (1) Van Gorken involved final period problem. (Brehm involved a repeated game) the incentive to self deal is larger in final period problem. (2) Brehm involved much smaller amount in relative terms. 140 million compared to what they are worth. (3) Board wholly abdicated its role. (a) Van Gorkom rests on absence of sufficient record of any deliberative process. (b) In Brehm, the board at least hired an expert. (4) Van Gorken was an extraordinary, exceptional case, imp to remember. v) Questions to Ponder: What is the relationship between the BJR and the duty of care in this case? (1) Is this an abstention case or a standard of review case? (a) Note the standard of review versus of conduct distinction (i) Court states: "the law of corporate fiduciary duties and remedies for violation of those duties are distinct from the aspirational goals of ideal corporate governance practices." (b) How does the Ct seem to conceptualize its role? (i) Remember Kenneth Arrows quote: "If every decision of A is to be reviewed by B, then we make the Ct the ultimate deciosnmaker and that is undesirable." We think 47 (2) (3) (4) (5) there are benefits from abstention. Abstention prevents this shift in the locus of authority. This conception of the corporation is consistent with Brehm. But note the abstention--i.e., refusal to reach--with respect to "substantive due care issues": (a) "Courts do not measure, weigh or quantify directors' judgments. We do not even decide if they are reasonable in this context." (b) "To rule otherwise would invite courts to become superdirectors, measuring matters of degree in business decisionmaking and executive compensation." What is the distinction between substantive due care and process due care ? (a) Substantive due care: review of the merits of the boards decision (b) Process due care: how the decision was made. (i) this is very good for attys. Creates a market for atty services. looks at whether the board acted in a manner they were supposed to. They tried to inform themselves. Would the BJR protect an incredibly stupid decision? (a) "Irrationality is the outer limit of the BJR:" (i) What does irrationality mean? the Ct says that irrationality is the functional equivalent of the waste test or may show that the decision was not made in good faith. 1. Irrational doesn't mean stupid. Irrationality is used as a proxy for self dealing. The decision is so bad that nobody acting in good faith could have done it. This decision is so bad that there has to be self dealing. a. If that is right, then Cts will have to be careful and reserve determining that decision was irrational is few cases. This is a very rare occurrence. For next time: does Brehm shed light on Caremark? (a) Does Brehm confirm Allen's view re desirability of law compliance programs? (b) Doe Brehm confirm Allen's views re irrational (a/k/a egregious) decisions? 2) Flowchart: The BJR and the Duty of Care: f) Is there Fraud? i) Yes: BJR rebutted Fed or state fraud claims. ii) No: (1) Is there conflict of interest? (a) Yes: BJR rebutted Duty of Loyalty (b) No: Is there Illegality, No decision, Egregious decision, uninformed decision, or waste? (i) Yes: BJR rebutted: 1. did the D violate Duty of Care? a. Yes: Calculate damages. See Van Gorkom b. No: Defendants Win (ii) No: BJR applies. The Court will abstain. Flowchart based on abstention view of BJR. In most cases, the same facts relate to abstention as to DoC. There are circ. where the BJR doesn't apply, but the DoC, might still not have been violated. In other words, illegality BUT no decision. 48 DUTY OF CARE AND THE EXERCISE OF THE BJR Assn 12 3) Overview: g) The BJR is the central doctrine in corporate law. There are a number of preconditions for the BJR to protect directors from liability. 4) Francis v United Jersey Bank: h) Facts: Mrs. Prichard was a director of the co. but she was elderly, inactive, listless and an alcoholic. The Prichard sons were sons of the founder. They were dominant and active in management. They systematically embezzled large sums of money in the form of "loans". They called it a loan so they don't have to pay tax on loans and they didn't want the equity of the company to fall. When you make loans, you characterize the loan on the balance sheet of the company as an asset. i) Suppose the co had 100K in cash, and 50K in debt, then they have positive 50K. if the boys took 75K, then SH equity calls to (25K). Suppose that instead of taking the 75K out as loan instead of just money, then the 75K would appear on books as asset, so SH equity should still be positive 50K. why do the boys want it to show positive SH equity: (1) If they let the firm get into negative SH equity: (a) Companies with negative SH equity are called bankrupt. (b) This co was a regulated company and had to file with the insurance commissioner. i) United Jersey Bank is the Plaintiff and is the trustee in bankruptcy for Pritchard and Baird. The bankruptcy trustee represents creditors. i) Why do creditors have standing to sue Ms Prichard's estate for fiduciary duty breach? (1) One of the fx of the bankruptcy proceedings, is that unsecured creditors become holders of the equity credit in the firm. The unsecured creditors frequently receive stock in the firm, where the SH receive nominal stock. j) The litigation: i) P alleged breach of duty of care by Ms Prichard. ii) Role of the BJR ? (1) None. Rule has no application where directors have failed to exercise business judgment -- i.e., failed to make a decision iii) Is Prichard automatically liable b/c BJR doesn't apply? (1) No. P still has to show that Prichard breached her duty of care. iv) Did Prichard breach her duty of care ? (1) Yes inattentive facts that she was old, depressed, drunk, and ignorant of business were no defense v) What does the Ct expect of the director? (1) Duty to be informed: (a) "Obligation of basic knowledge and supervision" (314) (b) Read and understand financial statements (c) Object to misconduct and if necessary, resign. vi) Ms. Prichard was an accommodation director, and even an accommodation director has duty of care. (1) Liability of dissenting directors: (a) In most instances, a dissenting directors dissent is noted would be absolved after attempting to persuading directors to follow diff course of action. 5) In re Caremark Int'l 49 k) Caremark: a managed health company. l) Subject to the antireferral payments law: i) Prohibits managed case organizations that receive Medicare/Medicaid funds from paying doctors to refer patients to firm. ii) Caremark's business required that Caremark has access to patients and Drs are gatekeepers in the health care industry. This is the best way of getting business from the patients. The anti referral law said cant pay Drs for referral. Caremark made a way around it. They gave Drs consulting contracts so they could get around the statute. The Feds didn't agree. They prosecute and Caremark has to pay 250 mill. m) The litigation i) The Feds sue and prosecute Caremark civilly. Caremark pleads/settles and pays $250 million. ii) SH sues Caremark derivatively (see assn 14). They argued that if Caremark hadn't violated the law, they wouldn't have had to pay the money. iii) This is a derivative suit. (see assn 14). In derivative litigation, the judge must approve the settlement. (1) Caremark settles the SH case. The settlement provided that Caremark would provide assurances to the P that they will have a program to ensure that the company complies with the law in the future and other promises. The SH did not get money. The attys did since Caremark agreed to pay atty fees of 1 million. n) The Judge: William Allen--very esteemed judge. Oversight Case o) Rules of Law: BJR doesn't i) Does the BJR apply in Caremark? : (1) NO, since there is no exercise of jmt here. This was a lack of oversight case. There was no board decision. But next have to ask if the board violated the duty of care? ii) Did the Board violate its duty of care in Caremark? (1) He didn't have to decide whether they violated a duty of care due to the procedural posture. Probably not no evidence of "sustained failure to exercise ... oversight." But they do have to think a little bit about when deciding if the settlement was fair, how serious the misconduct was. This did require him to ask what he expects of directors in this context. (a) What does the duty of care require? (i) Does the board have a duty to adopt law compliance (internal system to make sure Law EEs comply with the law)? Compliance 1. Allen says yes: must "attempt in good faith to assure ... a corporate & the Duty of information and reporting system" (347) Care a. He doesn't think Graham is good law anymore and that yes, there must be an effort. So there is an obligation to set up a system. p) Federal Sentencing Guidelines: i) Allen cites: (1) Look at whether a company has an "effective program to prevent and detect violations of law." (2) Identify seven due diligence steps companies must take for compliance program to be considered effective. (a) Elements of a Law Compliance Program : (i) What would an adequate law compliance program include? Elements 1. Want to identify the relevant laws that employees could violate: 1) general of a Law laws like civil rights, and 2) specific laws. 50 Complianc 2. Could draft an employee policy manual. e Program q) A decision not to act is still a decision subject r) s) t) u) Sarbanes Oxley Act 3. Train employees. 4. Compliance audits. 5. Could have sanction employees for violations. 6. Provisions for self reporting of violations to regulators. Analysis: [Question 3 on 349]. Suppose the board of directors decided not to adopt a compliance program. Liability? i) Would the BJR protect directors who decided to commit an illegal act? No, b/c BJR doesn't cover Fraud, illegality, and self dealing. But they aren't necessarily liable if their decision was reasonable. [something to do with profitability]. ii) Say that its not the board that makes the decision to disregard the law, but they are aware that their employees violate the law. Say they are a don't ask don't tell kind of corporation since they think it is cheaper to pay the fines. Would they be liable for simply not setting up a law compliance program? (1) A decision not to act is itself a decision that is subject to the BJR. (a) Don't ask don't tell isn't really illegality, and if its profitable, it inst necessarily outrageous. (b) No liability as long as acted in good faith and followed rational process. (c) This is why the BJR is more of an abstention doctrine. Question 5 : Say the Ct awarded P atty fees and expenses of 1 mill. Would a Caremark SH feel they got their moneys worth? i) No monetary recovery ii) "Modest" governance benefits iii) Plaintiff lawyer fee paid by corporation i.e., by shareholders Illegality Problem 1 : (page 34950) i) What if board of directors orders drivers to break the law? (1) A decision to cause the corporation to violate the law is not protected by the BJR (a) If the BJR is a standard of liability, then directors are liable (b) But if the BJR is an abstention doctrine, then directors are not automatically liable. Instead, the court goes on to ask whether the decision was a reasonable one, ie, if it violated the DoC. (2) Was it? 6) New Federal Legislation: federalization of duty of oversight. This is the federalization of the duty of oversight. Instead of leaving it to the discretion of the board, the federal law is increasingly mandating that in certain situations have to have a program. Post Enron scandal, Congress passed SarbanesOxley act, which: i) The act: (1) Makes it easier to prosecute securities fraud, particularly financial fraud. (2) Imposes greater responsibility on senior management and directors, particularly independent directors and audit committee members, by requiring them to take a substantially more proactive role in overseeing and monitoring the financial reporting process, including disclosure and reporting systems and internal controls (3) Does not purport to change the common law duty of care, but increases civil and criminal enforcement authority over the conduct of corporate officers and directors, (4) No question that potential civil liability for directors will be greater after SarbanesOxley (5) Impose affirmative oversight duties. This is independent of the BJR and the duty of care. If you break these laws you go to jail regardless of the BJR. So its imp to recognize that 51 you could say adopt don't ask don't tell policy and there is no state law liability, but there might be federal liability. (6) This legislation requires corps to be proactive. Require that everyone have an audit committee. Also imposes specific obligations on the audit committee. (7) So always ask what federal regulations the company is subject to and they might trump cases like Caremark. ii) Section 301 of SarbanesOxley orders SEC to adopt rules mandating that: (1) The audit committee shall receive reports from the independent auditors regarding critical accounting polices and practices, discussions that have taken place with management regarding alternative treatments of financial information under GAAP, and any accounting disagreements and other material written communications between the auditors and management (2) The audit committee must establish procedures to receive and address complaints regarding accounting, internal control and audit issues, and to provide company employees an opportunity to make confidential, anonymous submissions regarding accounting and auditing matters v) Policy: i) What was the common law rule of tort law with respect to the liability of the owner of a dig that bit some one? (1) "Every dog gets one bite" (2) Owner had to be on notice that dog had a propensity to bite, which could be either because they had bitten someone before or they were a vicious breed ii) Relevance? w) Egregious board decisions: i) In Caremark, court limits liability for egregious decisions. When can directors be held liable for egregious decisions? (1) Only where directors acted in bad faith or followed an irrational decisionmaking process. ii) No "objective" review of substance of decision 52 INDEMNIFICATION Assn 13 1) Limited Liability Statutes for Directors102(b)(7): a) DE adopted 102(b)(7) and amended the indemnification provision in 145. i) 102(b)(7)(pg 94): provides that a corporations articles of incorporation This statute says: no may (but need not contain): pers. liab. for (1) A provision eliminating or limiting the personal liability of a director to the corporation or breaches of duty, but its stockholders for monetary damages for breach of fiduciary duty as a director .... Dir. remains liable for Breaches of duty of provided that such provision shall not eliminate or limit the liability of a director: loyalty (a) (i) For any breach of the director's duty of loyalty to the corporation or its stockholders; Acts or omiss. not in good faith that (b) (ii) for acts or omissions not in good faith or which involve intentional misconduct or a involve intent. knowing violation of law; miscon. or knowing (c) (iii) under 174 of this title [relating to liability for unlawful dividends]; illegality, Appr of illeg. distrib., (d) or (iv) for any transaction from which the director derived an improper personal benefit & ii) Noteworthy Points about the LL statute: (2) Applies only to directors. (a) Although officers also are subject to a duty of care, they are denied exculpation by charter provision. Applies (b) Arnold v. Society for Savings Bancorp, Inc. (Del.): As to a defendant who is both a only to director and an officer, a 102(b)(7) provision applies only to actions taken solely in his capacity as a director. Equitable (3) Limits only the monetary liability of directors--equitable remedies are still available remedies still (4) A 102(b)(7) provision is an affirmative defense. available! (a) This means a shift upward in the settlement value of cases. The director must assert it as an affirmative defense. The burden of proof is on director to show that exculpatory Statute gives measure applies and that none of the provisions are present. director an aff. (b) This means that unlike the BJR, where when its applicable, you can get case dismissed Defense on pleadings, here it is hard to get case dismissed on the pleadings since they have to make the prima facie case that the affirmative defense applies. Also increases the settlement (c) Also means that Ps will be less likely to settle since they can get into discovery. (5) Cannot limit violations for vio of duty of loyalty of improper personal benefit. (a) This is prob since DE sup Ct has reemphasized that in addition to duty of care vio, there was also disclosure violation. (b) Noteworthy Points: (i) Distinguishes self dealing ("improper personal benefit") from the duty of care. 1. Implication of this is that a 102(b)(7) exculp provision might not have saved the directors in Van Gorkum, the very case that triggered the statutes adoption. This exculpatory (Note the irony) provision is a. Chancellor Allen suggested that Van Gorkom itself can be interpreted as a LIMITED: loyalty case b. Delaware supreme court has opined that Van Gorkom included a It will not apply disclosure violation and implied that such violations have a loyalty when: 1) directors component. don't act in good c. So basically, in many situations the statutory exculpation may be illusory. faith, (Van Gorkum) When directors are held liable for carelessness, the real reason for liability and 2) when there is 53 (such as tacit approval of a managerial conflict of interest) suggests that statutes would not apply. In Van Gorkum, if the TU directors acceded to Van Gorkums "fast shuffle" they arguably "acted not in good faith" and wouldn't be protected under 102(b)(7). Also, exculpatory provisions may not cover disclosure violations, a theory of liability whenever a transaction involves SH voting (Zirn). 2. The DE sup Ct has essentially left this statute as a last ditch line of defense that you might raise b/c they got past everything else. Every state has this statute equiv. 2) Indemnification Statutes: a) At common law, corporate employees were entitled to indemnification for expenses incurred on the job, including certain legal liabilities, but directors were not. i) Today, all states have statutory provisions authorizing director indemnification to some degree. b) Delaware Law: Coverage: 145 Indemnification Statutes i) See DCGL145: indemnification (pg 104): At common law, corps could indemnify their EEs for expenses including legal expenses. They weren't allowed to indemnify directors at common law, but this has changed. (6) Indemnification in Direct Suits: 145(a) (a) As to direct suits, 145(a) authorizes the corporation to indemnify the director or officer for expenses plus "judgments, fines, and amounts paid in settlement" of both civil and criminal proceedings. (b) For 145(a) only have to indemnity if acted in good faith. (i) The negative implication of 145(a) is that if its not covered, then you don't have the power to do it. (7) Indemnification in derivative litigation: 145(b) (a) As to derivative litigation, 145(b) authorizes indemnification only for expenses, albeit including attorney's expenses. (i) If the director or officer was held liable to the corporation, moreover, he may only be indemnified with court approval. (b) 145(b) deals with indem connected to suit by or in the right of the corporation-- derivative litigation. This is more limited. 145(b) is (i) Don't get reimbursed for the judgment or the settlement only atty fees. more limited (ii) There is no indemnification as to claims to which the person shall have been than 145(a). adjusted to have been liable to the corp unless and...if you get sued derivatively you are going to get atty fees, and only if the ct approves it.. (8) Indemnification for directors successful on the merits:145(c): (a) the corporation must indemnify a director or officer who "has been successful on the merits or otherwise." note: there is no "good faith " limitation to this section, unlike 145(a)&(b). (i) If director is successful on merits, indemnification is mandatory. MUST, if Permissive the officer has been successful on the merits, or otherwise. versus (ii) If director is unsuccessful on the merits, indemnification is permissive, so long as Mandatory it is not precluded by statute. indemnification 1. You have to power to, but the option not to. (9) Advancement of legal expenses: 145(e): 54 (a) recognizes that legal proceedings can take a long time. That is why they allow an advancement of expenses. (i) Under 145(e), the corporation may advance expenses to the officer or director provided the latter undertakes to repay any such amount if it turns out he is not Current Hot entitled to indemnification. Issue of 1. SarbanesOxley prohibits loans by corporation to officers and directors. Some Litigation think this provision may affect advancement of expenses. a. Right now there is the issue of it prohibiting loans, expect litigation on this issue. (10) 145(f): written indemnification agreements: (a) authorizes the corporation to enter into written indemnification agreements with officers and directors that go beyond the statute: statutory indemnification rights "shall not be deemed exclusive of any other rights" to indemnification created by "bylaw, agreement, vote of the stockholders or disinterested directors or otherwise." (i) 145(f) clearly authorizes indemnification agreements mandating payment of expenses that the statute merely permits. (ii) 145(f) clearly authorizes indemnification agreements mandating advancement of expenses even though such advancement is merely permissive under 145(e). (iii) 145(f) likely allows indemnification of certain expenses not contemplated by the Questions statute. raised by 1. Waltuch held that 145(f) doesn't mean that the sky is the limit. A corporation 145(f) cant act to indemnify things that are inconsistent with 145(a). (11) 145(f) raises the Q of to what extent can you use this grant of authority to use power to grant indemnification where, 1) the stt is silent, 2) where the stt prohibits it, or appears to prohibit it. (a) Silence: Probably ok, if they indemnify for something not mentioned in the stt. (b) Where the stt prohibits it: This is the issue in Waltuch v Conti, 505 (i) Waltuch v Conti, 505: 1. Facts : the H bros tried to corner the market to control the supply and by withholding it, they drive up the price in 1979. they did drive the price of silver up. Conti was involved at the fringes in copying the H bros in trying to corner the mkt too. Cornering the mkt is illegal, it is called manipulation. W was sued by clients for fraud and market manipulation and also in a separate enforcement proceedings, but the Commodity Futures Trading Commission (CFTC). W settled to CFTC litigation, and spent 1 mill in legal fees. Conti paid 35 mill to settle private party litigation. W was dismissed from that litigation w/o having to make a monetary payment. W had to pay 1.2 mill in atty fees in connection with the private party litigation. W then sued under Article 9. 2. Article 9 of Conticommodity's articles on incorporation provided: a. Article Nine of The Corporation shall indemnify and hold harmless each of its incumbent or former directors, officers, employees and agents ... against expenses actually and necessarily incurred by him in connection with the defense of any action, suit or proceeding threatened, pending or completed, in which he is made a party, by reason of his serving in or having held such position or capacity, except in relation to matters as to which he shall be 55 3. 4. 5. 6. Acting illegally cannot be good faith 7. 8. adjudged in such action, suit or proceeding to be liable for negligence or misconduct in the performance of duty. Issue: a. 145(a) only authorizes indemnification of expenses incurred by a director or officer who "acted in good faith." i. Art 9, on the other hand, doesn't contain the good faith language. W says Art 9 falls under 145(f) and Art 9 mandates that he be indemnified regardless of good faith. Conticommodity claimed that Article Nine therefore was invalid, because it implicitly mandated indemnification of bad faith actions. b. Does 145(f) allow the corporation to enter into agreements by which they must indemnify directors or officers where statutory indemnification is not permitted? c. Waltuch Holding: indemnification not allowed. d. Standard: "Indemnification rights may be broader than those set out in the statute, but they cannot be inconsistent with the 'scope' of the corporation's power to indemnify, as delineated in the statute's substantive provisions." What the ct does is to say that 145(f) doesn't mean that the sky is the limit. There are limits and the limits are that you cant act inconsistent with 145(a). Which operative section applies: 145(a), (b) or (c)? 145(a). Would indemnification per Article 9 "be inconsistent with the 'scope' of the corporation's power to indemnify, as delineated in" 145(a)? Yes. a. Where the statute requires good faith, as it does in both subsections (a) and (b), an agreement that purports even by implication to authorize indemnification for nongood faith conduct is inconsistent with the scope of the statute. b. The holding doesn't mean that Art 9 is invalid, just to the extent it would permit indemnification outside of its scope. Why can't Waltuch try to prove he acted in good faith? a. Why cant W ask to remand the case to the lower court and try to argue that he was in good faith? b/c W entered into a binding agreement that he wouldn't argue good faith. that was a stupid move on W's behalf. A Note of good faith: a. Interpreting CA law, the fed 4th circuit has held that a director or officer who intentionally participates in illegal activity cannot be deemed to have acted in good faith even if the conduct benefits the corporation--hence no indemnification. (ii) The Private party litigation: 1. 145(c) mandates indemnification where the defendant was "successful on the merits or otherwise." a. Waltuch claimed he was "successful" because he was dismissed from the private party cases without having to contribute to the settlement. b. Conticommodity claimed Waltuch was dismissed as a direct result of its $35 million settlement. They claim that W free rode on the settlement of 56 the case and the private party litigants dismissed the suit as to everyone. 2. What does the court say about that? Although he wasn't morally vindicated the suit went away, so he still wins. a. Escape from adverse decision is determinative. As long as he can walk away without paying, he is vindicated. b. Holding: i. "The only question a court may ask is what the result [of the underlying litigation] was, not why it was." ii. Unlike subsections (a) and (b), there is no good faith limitation under 145(c). iii. Accordingly, success for purposes of subsection (c) does not require "moral exoneration." iv. It only requires escape. (12) Omission of the Good Faith Provision in 145(c): (a) Why did the legislature omit a requirement of good faith from the mandatory There is NO indemnification provision in Section 145(c)? (i) Do not chill directors from taking risks. good faith (ii) Encourage people to serve as directors of Delaware corporations, and thereby also limitation to encourage incorporators to incorporate in Delaware, by providing them with 145(c) maximum protection. unlike (iii) To limit collateral litigation . Don't want to have to litigate if the success in getting 145(a)&(b)! off meant good faith. Reduce litigation. Reducing the opp for litigation over whether indemnification is available is imp since there is a question over whether a director who has to sue for indemnification rights and then prevails is entitled to atty fees. This is referred to as fees for fees. (b) Fees for Fees: (i) If an officer or director is obliged to sue the corporation seeking indemnification, is a prevailing officer or director entitled not only to indemnification of attorneys fees Issue of incurred in the underlying litigation but also those fees incurred in the fees for indemnification suit? NY Ct says no. Baker v Health Mngt: New York fees indemnification statute bars recovery of "fees on fees," as that court called them. 1. But the New York statute authorizes corporations "to provide indemnification of fees on fees in bylaws, employment contracts or through insurance." (ii) The DE Sup Ct. in Stiffel v Cochran: 1. "An attorney representing a former director who is being denied statutorily authorized indemnification must seek compensation from his client or remain uncompensated, a result `inimical to the interests' of the former director and contrary to the express purpose of 145 to protect directors from personal liability for corporate expenses." 2. The Ct said the reason was that 145 is a remedial statute and it should be Opposing broadly interpreted. "The indemnification statute should be broadly Canons of interpreted to further the goals it was enacted to achieve." Statutory a. Opposing Canons of Statutory Construction: Constructio i. There are two opposing canons of SI for anything. (Karl Llewellyn) ii. Canon 1: rules in derogation of CL should by strictly construed iii. Canon 2: remedial statutes should be liberally construed to affect their purposes. (this is the one the DE Ct used). (Prof likes this approach). 57 DERIVATIVE LITIGATION SUITS Assn 14 1) Direct and Derivative Suits: a) Direct : i) Brought by the shareholder in his or her own name ii) Cause of action belonging to the shareholder in his or her individual capacity iii) Arises from an injury directly to the shareholder iv) Recall (from Assn 15) that the Grimes case means that in close cases the Ct will treat the claim as direct, provided that the P is seeking a non monetary relief. b) Derivative : i) Brought by a shareholder on corporation's behalf ii) Cause of action belongs to the corporation as an entity iii) Arises out of an injury done to the corporation as an entity c) Eisenberg and the tests to determine if suit is derivative or direct: i) The Ct identifies two types of tests to see if suit is direct or derivative: (1) Who suffered the most direct injury? (a) If the corporation suffered the injury, the suit is derivative. Test to (2) To whom did defendants duty run? determine (a) If duty ran to the corporation, the suit is derivative. if suit is (b) Called into question by Eisenberg. direct or (i) Eisenberg is minority though, it suggests that this is disfavored. (ii) Eisenberg overstated its objection to this prong. (iii) It would be useful to review the BJR cases and ask if it was direct or derivative cases. ii) Held: Eisenberg can sue the corporation directly. d) Examples of direct versus derivative litigation: (1) Example #1 : ABC Corp entered into K with Jones. Jones breached the K, but ABC corp has not sued her for that breach. May a SH of ABC corp sue directly? (a) No. Jones owed no duty to the shareholder as such. (b) Jones' breach did not injure the shareholder directly Must be able to (c) Hence, a shareholder suit against Jones must be brought as a derivative action characterize (d) We might say that the SHs injury was derivative of the Corporations injury...so this is suit as direct or derivative. With whom was Jones in privity? With Jones. So under both tests, this is derivative!!! Derivative derivative. suits subject (2) Example #2 : ABC Corp treasurer embezzles all its money and absconds. SH Stock is now to more worthless. May a SH sue treasurer directly? stringent (a) No. Not enough for a shareholder to allege that challenged conduct resulted in a drop in the corporation's stock market price (b) The treasurer is an agent of the corporation. The mere fact that a stock price went down, and the SH is injured b/c she has less money is not enough to make it a direct suit. b/c your loss is derivative of the co.'s loss, only the corporation can sue. 2) Plaintiff Qualifications: SH status: a) Must be a Shareholder . MBCA7.41 limits standing to SH's i) Albeit by negative implication 58 ii) Creditors may not bring derivative suits. b) Must have Contemporaneous ownership : i) Must be a SH at the time of the alleged wrongdoing. 7.41(1) (1) Devolution : what if they got the shares by will or something, can they tack? Yes, so if it is devolved, you still can sue so long as the donor had been SH at time of wrongdoing. (2) Continuing wrongs? : in Van Gorkum, when was the wrong? What do we do when a wrong is a sustained wrong over many years rather than over a concrete event? ii) Must have been a SH when suit commenced. 7.42 iii) Many states say you must also remain SH through final judgment. (1) This is the kicker, since some may want to bail completely. This makes sense though since we don't want to allow bad incentives for the SH to pocket money, bail and then sue. c) Must be Fair and Adequate Representative: i) Named P must be fair and adequate rep of the corporations interest. 741(2) ii) On what grounds could we challenge Ps fairness or adequacy: (1) Using the derivative suit as leverage in another adversarial suit--where they get a personal benefit. Grounds to (2) Conflict of interest, such as bringing suit for unrelated strategic purposes challenge P's (3) Only own one share fairness: (4) Unclean hands: or participated in the wrongdoing 3) Cohen v Beneficial Industrial Loan Co, a) This was a diversity proceeding: i) Suit filed in fed ct in NJ, and the Corp was incorp in DE. As a diversity suit, the first thing that was presented was a choice of law problem since they were in NJ, but this is DE corp. (1) Choice of Law: Who's law applies, NJ or DE? (a) The problem here is that NJ has a security for expenses statute. (this is why choice of Choice of law law is so important) problem (b) Neither the FRCP 23.1 or the DE code required security for expenses. (2) Security for Expenses Statute : (a) NJ provides that a shareholder who brings a derivative suit and who owns less than 5% Security of the stock or stock worth $50,000 is liable for the corporation's reasonable expenses for if suit fails expenses (b) Corporation can ask court to require such a plaintiff to post a bond to secure such expenses before suit goes forward (i) This requirement suggests that states don't always trust the SH. b) Policy concerns: i) To whom does a derivative suit belong? (1) Corporation. ii) Why didn't the corporation sue? (1) Maybe good business reason not to sue (2) But maybe directors or senior managers would be defendants, so possible conflicts of interest. iii) Conundrum of derivative litigation: allows accountability, but subject to abuse. (1) Derivative suits allow SH to hold directors accountable. (a) Sup Ct called it a "remedy borne of SH helplessness." It is a mechanism of accountability. Potenti (2) But it also has two potential abuses: al abuses (a) strike suits: non meritorious nuisance suits to extract settlement value. 59 of (b) meritorious suits: incentive to settle these suits too lightly. (i) Plaintiff side incentives : 1. Any recovery goes to corporate treasury, whether by settlement of trial victory. Since the benefit goes to the corp, the named representative doesn't get anything. a. lawyer is the real party in the interest. 2. Lawyer can get contingent fee out of any recovery. 3. BUT corporation also must pay Ps legal fees if there is a substantial nonmonetary benefit. a. Cts liberal in finding such benefit. E.g. Caremark. So Ps can get atty fees paid for easily. DERIVITIVE (ii) D Side incentives . LITIGATION 1. Strike suits. Settle go away POLICY 2. Meritorious suits against insider defendants: a. Indemnification: corporation must reimburse directors expenses if successful defense b. Settlement in which director doesn't pay anything deemed a success. If they can make suit go away, they don't have to prove good faith. (recall Conti). Success on the merits or otherwise. i. So if you have a suit where the directors did something really really bad, they know that if they settle to something that makes the directors not have to pay but instead the corp pays, then the wrongdoers get away. The P atty gets fees and moves on the next case with no risk. The wink wink win win scenario is bad. (3) Combined effect of the incentives with derivative litigation: (a) Strike Suits: (i) Ps counsel has incentive to bring (ii) Management has incentive to pay (iii) security for expense statutes only address the strike suit issue. (b) Meritorious suits: (i) Management has incentive to settle in ways that ensure indemnification (ii) Ps lawyer has incentive to settle so as to move onto the next case. hence, they are settled too lightly. iv) Cohen: choice of law: Which law do we apply? (1) Under Erie RR v Tomkins: (a) Fed law governs procedural issues (b) State law governs substantive issues. (2) Is the NJ security for expenses statute substantive or procedural? (a) Substantitive: since it creates a new liability for the SH who has to put up a bond and the bond can be lost if the suit is not meritorious. Also it implies a condition on standing. (b) Thus, state law applies. (3) Next we need to ask, which states laws apply ? The forum state, or the state of incorporation? DE doesn't have securities for expenses statute. (a) Whose law controls merits?: 60 (i) Plaintiff alleged breaches of fiduciary duty: theft, waste, and mismanagement (ii) Whose law applied to decide whether defendants breached duty? 1. A fed dist Ct sitting in diversity must apply the forum state choice of law. 2. NJ choice of law, (as with other states) applies the law of the state or incorporation to substantive merits (see also Eisenberg). (b) Is the securities for expenses, substantive or procedural for purposes of choice of law? For Erie purposes, state law applies. Now we are on Erie. NJ treats this statute as procedural for choice of law purposes. Thus, Cohen must post bond, (i) The oddity is that the statute is substantive for one purpose (Erie) but procedural for choice of law. (4) Take home lesson: (a) Policy. On the one hand we want an accountability mechanism, but on the other hand, since the incentives are all messed up, it isn't clear that derivative litigation is a good way to do this. (b) The issue is whether we can come up with a good structure. c) More on this from Examples and Explanations: i) Cts have held that state procedural requirements are "substantive" under the Erie doctrine. This means that even though not imposed by federal rule 23.1, state conditions such as the security for expense requirement apply in derivative actions brought under federal diversity jurisdiction actions. (310) (1) This means that if there is a federal suit based on diversity jurisdiction, Erie requires that the district Ct apply the substantive rules of the state where the suit is brought, including its choice of law rules. Security expense statutes are substantive and must be applied in diversity actions. (2) Examples and Explanations suggests that Cohen may have been wrongly decided, however. 61 THE DEMAND REQUIREMENT Assn 15 1) Basic Policy Issue: a) When, if ever, should the corporation, acting through the board of directors or a committee of directors, be permitted to prevent or terminate a derivative action? i) Put another way, who gets to control the litigation: the shareholder or the corporation's board of directors? b) To what extend should we allow BoD to terminate litigation by SH: i) Competing Policy Concerns: (1) Derivative suits a mechanism of managerial accountability (a) Potential for bias: (i) Directors cannot be expected to sue themselves (2) Cause of action belongs to corporation (a) Like all assets, litigation under control of BoD (3) Shareholder may have interests diverse from those of corporation (a) Therefore BoD should have some say (4) Balancing the need for accountability 2) Role of Demand Requirement: a) Innocuous procedural stem has become sieve to separate cases in which board is allowed to control suit from those in which SH (really the SH lawyer) is allowed to do so. It allows the board (even if the directors would be named defendants) a chance to take corrective action. i) Complex law ii) Law not uniform state to state iii) Need a roadmap b) SH must make demand before filing suit: i) MBCA 7.42: "No shareholder may commence a derivative proceeding until ... a written demand has been made ... and 90 days have expired from the date the demand was made ... unless irreparable injury to the corporation would result by waiting for the expiration of the 90day period" (1) Implies that only the waiting period can be waived. (2) Note the subtle difference with the FRCP 23.1. ii) FRCP: 23.1: The complaint shall allege "the efforts, if any, made by the plaintiff to obtain the action the plaintiff desires from the directors ... and the reasons for the plaintiff's failure to obtain the action or for not making the effort" (1) Under the FRCP must detail the demand, or if you didn't make demand, must detail why. (a) This implies that demand itself can be waived. Law in most states excuses demand if futile. This is the majority view. c) Basically the scenario looks like this: i) Demand required : board decides fate of claim, subject to review under the BJR. If the SH wants to challenge it, they must show the boards responds to the demand was selfinterested, dishonest, illegal or insufficiently informed. Usually demand required claim is lost. ii) Demand Excused : claim goes forward. Board cannot dismiss. Directors cant block a suit, they are silenced. d) When is demand excused? When it is futile. i) What is the standard for demand futility? (1) Del: Grimes v Donald 62 Demand excused when futile (a) DE has adopted two tests for demand futility. Demand is excused if the SH plaintiff can allege with particularity facts that create a reasonable doubt on either of two scores: (i) Doubt that a majority of the directors on whom demand would have been made are disinterested and independent, or, (ii) Doubt that the challenged transaction was protected by the BJR by showing a conflict of interest or grossly uninformed decision making. (2) NY: Marx v Akers 3) Grimes v Donald a) Alleged breach of fiduciary duty by BoD. i) Excessive compensation (1) This was a derivative claim, not direct: why? (a) Remember that in Grimes there was a third test: the nature of the relief being sought. (b) What was P seeking on the excess compensation claim: (i) He wants money. Also, any injury the P suffers is b/c his shares are worth less. (c) Grimes loses on procedure: defer discussion. (2) Abdication of board powers to managers: (a) Direct not derivative: Why? (b) All he was looking for was an injunction and the corp wouldn't get any monetary relief. So Grimes means that in close cases the Ct will treat the claim as direct, provided that the P is seeking a non monetary relief. Cts will let these slide. (c) Grimes loses on merits: Why? b) The effect of making a demand: i) The SH starts of making a demand before filing suit as required by the DE version of FRCP, this had a very significant consequence. (1) Legal effect of doing so? (a) Basically made a concession that demand was required. So he cant argue that he Stupid Move! wasn't required to make demand! Don't make (b) May no loner litigate the demand excusal issue. demand (c) Practical problem: he is almost certain to lose now. (d) See the derivative litigation tree on the next page. See Derivative Litigation Tree on next page 63 Derivative Litigation Decision Tree Direct or Derivative? Direct Derivative Demand Demand futility sues this is always the P's first choice of where they want to be. excused sues Demand Required making a presuit demand requirement puts a P on this track. this is the Ps second choice. The ballgame is the issue of whether demand is required. SLC Cases (once Board is disabled by some conflict, the Board can use Demand Made? Demand Refused? No If the Board accepts demand, the P is out of the Yes, once the P makes a demand, the board has to decide what do (demand is a letter Yes. Marx Analysis Q4 The judge would tell the person to make demand and then go forward. If demand is not made, Ct will stay the proceedings. No BOD sues 99.9 % of the time, the Board refuses. Refusal wrongful? if demand is required, P is almost certain to end up here. Standard is the BJR. No Yes sues Stop; no suit 64 c) The ballgame is the issue of whether demand is required. i) So why did it matter in Donald? He conceded that demand was required so he couldn't litigate the issue of demand futility. ii) P always wants Direct suit, then next choice is that no demand is required, since if demand is required, the BJR will apply. So the problem here is that he stuck himself in a bad spot. d) So the Rational P will never make demand before filing derivative suit: i) Consequences of not making demand trivial if required, slight delay while you make demand. ii) This is b/c you preserve your right to litigate the following issues. (1) Direct v derivative (2) Demand futility. e) DE Standard for Demand futility: i) P must allege particularized facts (prediscovery using the tools at hand) creating a reasonable doubt that the board is capable of making a good faith decision on suit: (1) What are the three things to excuse demand: DE standard for (a) Majority of the board has material financial or familial interest. Demand futility (b) Majority of board incapable of acting independently of the alleged wrongdoers (do the wrongdoers dominate and control the board?). (c) The challenged transaction not product of valid exercise of business jmt. ii) Hard to make particularized facts: (1) Can use: (a) SH inspection rights to inspect books and records (b) Media reports, SEC disclosure filings (c) Discovery from other cases. iii) What does reasonable doubt mean: (1) Prof thinks this is stupid standard. (2) Lead a reasonable person to believe that one of those three are present. (3) If you can allege particularized facts where someone could think one of those three factors are present, then demand is excused. 4) Marx w Akers a) Breach of fiduciary alleged i) Excessive director compensation ii) Excessive executive compensation b) Ct considers but rejects: i) MBCA universal demand ii) DE law. c) Demand Futility in NY under Barr and Marx: i) Three prong disjunctive standard: (1) Majority of directors interested in challenged transactions. The Ct defines interests One: to include personal financial state in the transaction, or you are controlled or dominated so NY standard for you are not independent. Demand futility (a) Question: suppose P alleges that all the Ds were involved and P sues all the Ds, does the mere fact that all the directors are named as Ds, standing alone, mean that majority of the board is interested such that demand is excused? (i) They obviously have an interest in how the litigation comes out but are they interested enough to dispel the demand requirement? Answer: NO--they must 65 have interest in the underlying transaction. Otherwise, P would always name all the BoD as Ds as a ploy. 1. This means that you can have cases where the directors decide to not go forward with suits where they are the Ds. (2) Two: Directors failed to inform themselves to degree reasonably appropriate (3) Three: Challenged transaction so egregious that it could not have been the product of sound business jmt. (a) Is this the same incredible stupidity standard exception to the BJR? (b) Also, what does this mean for all lack of oversight cases (eg Caremark): (i) Compare to old Barr formulation: "Failed to exercise their business jmt." (ii) Prof thinks almost certain demand will be excused in oversight cases. d) Application of the Demand futility standard to Marx: i) Executive compensation : (1) Maj of board disinterested and independent. their pay wasn't at issue. ii) Director compensation : (1) This presents diff issue since all directors have personal financial stake. So the Ct says the majority of the board is interested, and demand is excused. (a) Notice the incentives this created with respect to settlement. The rational P will never want to make demand since they lose 2 arrows. If there is reasonable prospect that P can get through procedural barriers to litigate the merits of the suit, the settlement value goes up. The motion of demand futility is the ballgame. There is incentive not to settle till demand futility has been litigated. If on other hand they lose on demand futility, this is ok for the D, b/c of the settlement incentives. (2) The P loses on the merits anyway though! 66 SPECIAL LITIGATION COMMITTEES Assn 16 1) Derivative litigation reflects the tension between authority and accountability a) Accountability : i) The derivative remedy, "born of stockholder helplessness, was long the chief regulator of corporate management and has afforded no small incentive to avoid at least grosser forms of betrayal" Cohen b) Authority : i) "If every decision of A is to be reviewed by B, then all we have really is a shift in the locus of authority from A to B" Arrow ii) "[T]he derivative action impinges on the managerial freedom of directors" Grimes c) The task: balancing both authority and accountability: i) "preserving the discretion of directors to manage a corporation without undue interference" Marx v. Akers ii) "permitting shareholders to bring claims on behalf of the corporation when it is evident that directors will wrongfully refuse to bring such claims" Marx iii) Needed: What we need is a filter to separate out cases where the ct should defer to mngmt discretion from cases where the ct needs to take a more intrusive look into decision board has made (b/c the board is disabled by conflicts of interest from making an independent decision in good faith. d) The Demand requirement as filter : the two standards basically look at the same thing, whether the maj of the board is disabled from objectively reviewing the decision. i) NY standard: (1) Majority of directors interested; or (2) Directors failed to inform themselves; or (3) Challenged transaction could not have been the product of sound business judgment ii) DE standard: (1) Reasonable doubt as to: (a) Majority of board has material interest; or (b) Majority of the board lacks independence; or (c) Challenged transaction not product of valid exercise of business judgment 2) SLC cases are another way for the board to reassert authority once demand has been excused. a) Historically when demand was excused, the case went forward on the merits with the P controlling the litigation. Following Watergate, there were series of corp scandals, that presented two Special problems, 1) there were lot of corps that made illegal contributions to dem and rep parties, and SH Litigation of those corp brought litigation. This morphed into 2) boarder scandal where Congress enacted Fed legislation called foreign corrupt payments act. This legislation passed in wake of Watergate and Commitee was regarded as unilateral disarmament. s i) A lot of corps had to acknowledge that they violated this statute. As result they settled cases paying fines, and then the SH sued as they did in Caremark. ii) In lot of cases, this was litigation in demand excused cases, even if it was questionable whether demand should have been excused. So there was a flood of litigation and the question was is there any way the board can reassert authority in this context? Hence the birth of the special litigation committee. (1) So once this SLC was created, the issue was to what extent is the Ct to defer to SLC recommendation? This is what Auerbach v Bennett addresses. 67 b) Auerbach v Bennett: (SLC's, New York) i) Facts: (1) GTE made ~ $11 million in illegal bribes and kickbacks (2) Four of directors had been personally involved in the misconduct (3) A GTE shareholder brought a derivative action against GTE, all of its directors, and its outside auditor for breaches of duties to the corporation (4) The board responded by appointing a special litigation committee. The board set up SLC and vested all its own powers in this committee. ii) Is demand really excused? (1) Ct assumes demand was excused, but was it? (**remember that today demand is harder to be excused than when this case took place.) (a) Marx v Akers test? Disjunctive standard (any one will satisfy it). (i) Majority of BoD interested? No, a majority was named as defendants. Being named wasn't enough, you have to have personal financial stake in underlying transaction or you are dominated by someone who does. Irrelevant that all were sued. Remember that although all were sued, only 4 participated. (ii) BoD failed to inform itself? The relevant inquiry is not the adequacy of the investigation, but the decision made to pay the bribes and kickbacks. The board didn't even know about it--this is an oversight case, there was no business judgment at all. (iii) Transaction egregious? Was it so egregious that the BJR doesn't apply? Remember that this is just oversight case. Illegality issue. iii) Special Litigation Committee: (1) The SLC committee concludes that none of the Ds had violated their statutory duty of care, none had profited personally from the incidents, and that the suits should be dismissed. (a) Normally the corp is thought of a party that must be joined, so the way a SH would bring a derivative suit is to name both as Ds. So the corporation starts out as a nominal defendant. (2) Issue: (a) How much deference should Ct accord SLC recommendation to dismiss suit? Relevance of the BJR? (b) "As all parties and both courts below recognize, the disposition of this case on the merits turns on the proper application of the business judgment doctrine, in particular to the decision of a specially appointed committee of disinterested directors acting on behalf of the board to terminate a shareholders' derivative action. . . . In this instance our inquiry, to the limited extent to which it may be pursued, has a two tiered aspect." (pg 267) (i) Notice that the Ct has set up the problem as the the BJR applies, not way whether the BJR applies, so we assume it does at least apply, so this starts us off with deference as opposed to asking what is the appropriate standard. (ii) What does the Ct mean by "a two tiered aspect"? 1. First tier: illegal payments 2. Second tier: committee recommendation. (iii) Why is this significant:? Effect of the 2nd tier decision: 1. What did the Ds argue w/ respect to effect of the second tier decision (the committee recommendation)? 68 a. BJR meant that Ct had to defer to committee (iv) Tootsie pop defense: 1. The second tier is the hard candy shell of the tootsie pop. The Second tier (the hard candy shell) insulates the first tier (candy center) from judicial scrutiny. 2. But does the Ct agree? a. Ultimate decision covered by business judgment rule b. But judicial inquiry permitted with respect to: i. Disinterested independence Second tier (candy shell) ii. Adequacy of investigation insulates first tier (candy c. Burden of proof? center) from jud. scrutiny i. On plaintiff (3) Application: Filing Cabinet Analogy (a) Factors considered re disinterested independence? (i) None of the committee members were members of the board when the illegal payments took place (ii) None had any prior affiliation with the firm (b) Factors considered re adequacy of procedures? (i) Completeness of areas and subjects of inquiry (ii) Good faith inquiry 1. Not halfhearted, proforma, shallow (c) Suppose the committee recommendation turned up a smoking gun? Ie, they knew they were doing something illegal to get a contract and did it. will the Ct evaluate in reaching their decision, the fact that the committee had in its possession, a smoking gun? (i) The Ct will review the adequacy of the procedures but NOT anything else. 1. This is similar to a filing cabinet analogy: a. The Ct will make sure that they have all the right paper record of Wo conducting a reasonable investigation, but cannot read the documents in w! the file and reach conclusions on the merits based on what is in the file. i. If the committee conducted adequate investigation, that is it, can't pierce the hard candy shell. This means that even if fraud, illegality, or self dealing was at the core, they don't look at that tier. (d) Policy: Remember that preserving the board's authority is the core value of corporate law and outweighs accountability. 3) Zapata v Maldonado, (excessive compensation case) a) This is classic excessive compensation case. b) Demand not made, demand excused as futile. c) Board responds by appointing SLC made up of new board members, and recommends dismissal. d) The Ct adopts the Zapata twostep, in which the Ct examines 2 distinct issues. i) Zapata two step test: (1) Step 1: this is distinct from Aurbach in subtle way. Only if committee wins on first step do we go to second step. (a) Inquiry into the independence and good faith of comm.. Unlike NY, in (b) Inquire into the bases supporting the committees recommendation. DE, the Ct can (i) How is it first step diff from Aurbach? "read the 69 1. Must show reasonable basis. documents" in the filing cabinet!!! 2. Unlike NY, where the Ct cant discuss reasonable basis, in DE this is essential part of analysis. a. Suppose that here there was the smoking gun memo: in DE, the Ct will ask given that they have the smoking gun, is this a reasonable decision. In DE you can actually read the papers in the filing cabinet. This is in contrast to the Aurbach case. i. So DE will have much less deferential review, and will have more JR, and it will be easier for SH P to go forward in demand excused case than in NY. (2) Step 2: the Ct determines in the exercise of its own independent business jmt whether the motion should be granted. This is an optional prong and they only go to it if they committee passes on the first step. This means that we have already concluded that the committee has reasonable basis for what they did, (a) the DE Ct suggests 2 questions that the DE chancery ct should ask in applying this prong of Zapata. The function of this step is to allow meritorious suits to go forward. Standards to guide the lower Ct: Zapata is much (i) First: does the corp have compelling interest in having suit dismissed? more intrusive than (ii) Second: "matters of law and public policy" Aurbach!!! In DE, (b) JR under DE law is so much more intrusive then we have seen in any other context. SLC's get much more Judicial See passage in Zapata where the Ct says, "the Q naturally arises... empathy .might not play a role...." how does that question relate? (i) Context : Demand was excused because board disabled from acting due to conflicted interests, (ii) Committee appointed by the disabled board (iii) Potential for structural bias 70 WRAP UP OF DERIVATIVE LITIGATION Assn 17 1) BJR applies to board decision to refuse demand. Therefore: a) "In a demandrequired case, therefore, the directors' decision will be conclusive unless bad faith is proven." 2) The Auerback v Bennett Tootsie Pop: Rule of thumb: the b) Ultimate decision covered by BJR law in the state of c) But judicial inquiry is permitted with respect to: incorporation is the i) Disinterested independence law that will apply. ii) Adequacy of investigation d) So NY ends up being very deferential. i) Let the real world creep in. if you said there was a smoking gun memo, and you are in NY, the judge may say that he has to apply Aurbach, judges are not blind or stupid, so Prof suspicion is that the judge will take a hard look at the adequacy and the judge may find a "process problem." This is somewhat what happened in Van Gorkum, where they did focus on process, but got to substance. In more marginal cases, NY cases will be deferential. 3) Zapata two step e) Steps: i) First: (1) The Ct must do the first step of asking if the committee was acting in the independence and good faith. Similar to Aurback but then the Ct will (2) inquire into the bases supporting the committees rec. reasonable basis, this is diff than Aurbach. ii) Second, even if pass the first test, the ct can apply its own business jmt as to whether the case is to be missed. This means that the Ct will "read the papers in the file." (1) Prof thinks this step is problematic. (2) There are two standards to guide lower CT (a) Does corporation have compelling interest in having suit dismissed? (i) When could a corporation have a "compelling" interest in having a "nonfrivolous" Joy v North suit dismissed? Zapata leaves this unanswered . The leading effort to give this tries to substantive content is Joy v North. answer this (b) "Matters of law and public policy" f) Joy v North: Connecticut i) Facts: (1) Defendant North was CEO of Citytrust (2) North dominated board and management (3) Citytrust made loans to a firm (Katz) at which North's son worked (4) Loans went bad (5) Shareholders sued ii) Follow NY or DE law ( Auerbach or Zapata )? (1) Judge thinks they would follow Zapata. (a) Rejects Auerbach (b) Looks like Zapata (c) Review of reasonableness of decision (2) Review of reasonableness of decision 71 iii) Why was committee's recommendation not reasonable? (1) High probability of substantial recovery (2) Likely recovery exceeded cost of litigation to corporation iv) The committee recommended that the case be dismissed (1) No "reasonable possibility" of liability (2) Presumably, assumed BJR applied (3) Dismiss if: (a) Litigation costs > probability of recovery x likely recovery. (i) But can we include or monetize the negative publicity, or time required to depose, or indemnification that corp may have to pay? What costs are appropriate to consider in applying this formula? 1. Indemnification . The ct makes a distinction. If the ct must indemnify, you can factor those costs in, but if it is discretionary, cant include. The other costs for the most part can be factored in. v) Noteworthy points: (1) It may be beating dead horse to ask, but the distinction between demand excused and demand not excused is so important. In Joy v North, Judge Winder says, "When there is a conflict of interest in the directors' decision not to sue because the directors themselves have profited from the transaction underlying the litigation or are named defendants, no demand need be made and shareholders can proceed directly with a derivative suit." Is this True? (a) FALSE. (i) Merely being names as a Defendant under NY or DE law doesn't excuse demand. Marx: "Not sufficient to name a majority of the directors as parties defendant" vi) Analysis of SLC and judicial review: (1) Zapata and Joy far more intrusive judicial review than usual. Why? (a) In Zapata, the ct is clear that they wont review the pleadings, but that the SLC issue is to be decided at the summary jmt stage and there will be an opportunity for discovery. (i) This contemplated discovery into the merits of the underlying transaction which is in sharp contrast to Wrigley. In Zapata and Joy, there is the idea that the Ct is to exercise its own business jmt, which is in contrast to the Ct saying they don't do that in the BJR cases. Why is this so much more intrusive? 1. Context: Demand was excused because board disabled from acting due to conflicted interests 2. Committee appointed by the disabled board 3. Potential for structural bias "there but for the grace of God, go I" (ii) We have situation where were dealing with demand excused cases, and the very nature of this is we conclude that we don't trust the board making an objective decisions. So in demand excused cases, there is analogy with duty of loyalty decision. Where we talk about director fidelity, loyalty, JR is more aggressive. (iii) Also remember that the SLC committee is appointed by the inflicted directors, so there is a question of structural bias. The first prong of Zapata is intended to weed out actual bias. The problem is, what about structural bias (inherent bias). If we are going to be a D in one of these suits, we will be careful choosing the committee member. Someone who is CEO of another company. 72 SEE NEXT PAGE FOR THE REST 73 4) So what is the bottom line with demand ? Compare NY and DE: g) Both NY and DE have high burden to excuse demand. If you clear this hurdle, in DE its easier for SH to go forward than in NY. The DE ct will be tougher and more likely the case will go forward w/o being terminated by SLC. i) Prof says : he likes this balance between authority and accountability. So demand req. is a sieve. In cases where we trust board, we ought to defer to the board, but if we decide there is reason we cant trust the board, then accountability concerns get bigger and we should be less deferential. NY protects directors too much. Deman d SLC New York This is too high a barrier protects directors too much. Demand is a sieve: Delaware Deman d This is better balance between authority and accountability SL C h) Rethinking derivative litigation i) Empirical evidence: (1) Derivative cases that go to trial: shareholderplaintiff's lose 90+% of the time (2) Most derivative suits settle (a) Only 50% entail money recovery by corporation or SH Most (i) Average recovery < $6 million derivativ (ii) 90+% of such settlements, legal fees > monetary recovery e suits (3) Derivative litigation has no positive effect on stock prices settle (a) Adoption of 102(b)(7) liability limitation provision does not have negative effect on stock prices. (4) So derivative litigation seems to benefit the attys. 74 DUTY OF LOYALTY Assn 18 1) Overview: a) Van Gorkum and Caremark are two cases that keep coming up. b) The obligation under Caremark to conduct oversight also comes up all the time, particularly in the post Enron Environment. c) There is also the BJR and procedural rules with derivative lit that create barriers for derivative litigation. d) Today we do something diff, allegations of breach of duty of loyalty. Self dealing is treated diff than negligence. The BJR at least initially has no place here, but can sneak in. 2) Duty of Loyalty : a) EE owe duty of loyalty to ER, even if there is a nocompete agreement i) Examples: (1) Competing while employed (2) Grabbing and leaving (a) I.e., "seducing" customers and employees (3) Referring business opportunities elsewhere (4) Taking kickbacks or bribes b) Another distinction between duty of care and duty of loyalty is the remedy: i) Liability: injunction, compensatory damages (lost profits, cost of replacement) forfeit salary and earnings, and punitive damages. ii) The remedy is harsh and almost gives the corporation a windfall. c) Duty of Loyalty in Corporations: i) No using corporate funds or confidential information for personal advantage: (1) Insider trading ii) No conflicts of interest: Duty of (1) Disclosure Loyalty in iii) No competing Corporation (1) Usurping corporate opp for your own benefit. d) General Automotive v Singer: (this is a paradigm duty of loyalty case) i) General Automotive: (1) Small incorporated automotive parts manufacturer and wholesaler ii) Singer (1) General manager (2) Expert machinist (3) In some cases, acted as a principal (e.g., placing orders) iii) Singers side line business: (1) His EE K: (a) He signed an employment contract that required him to work 5.5 days a week and that he would devote his "entire time, skill, labor and attention." (2) Side Line job: (a) Acted as a broker, placing customer orders with other machine shops. 64K profit. (b) Claims he did so only when General Automotive was unable to do the work. (c) This was not disclosed. (3) What would have been Singers best argument that what he was doing was right? Why was he doing it, if not for getting the fee? 75 (a) To preserve and uphold his reputation as an expert in the business. If he gives the job to his co and he botches it, it will hurt his rep and the company. iv) Analysis: Question 3 (1) Holding : Singer had a duty to "exercise good faith by disclosing to Automotive, all the facts regarding this matter" Disclosure and (2) Rationale? Breach of K? no, this was not a breach of contract issue. consent (a) No this was a fiduciary obligation issue. requirement (b) What does this mean? Why does this matter that the Ct discussed duty of loyalty opposed to breach of K analysis? (i) The duty of loyalty has an easier remedy the company doesn't have to show that they would have gotten the job. The contract claim would he harder to prove damages. (ii) Would the fact that Singer made disclosure cover him on a breach of loyalty claim? is disclosure enough? No, automotive would be the ones to ultimately decide. There is also a duty of obedience. 1. The real holding is that there is disclosure and consent required. (3) Breach of fiduciary duty : (a) Remedy : disgorgement (b) Moral condemnation: cross reference Meinhard v Salmon: "punctilio of an honor the most sensitive" v) Analysis Question 4: (1) Default rules are rules that apply in the absence of contrary agreement between the parties. Gap fillers They are gapfillers, if you will. vs (a) They are to be distinguished from mandatory rules, which would override a contrary mandatory agreement. rules (2) The judicial rhetoric on duty of loyalty reaches heights we rarely see. (a) See page 109: the second full paragraph: "many forms of conduct permissible in a workday worked for those acting at arms length, are forbidden ... Suggests that this (i) This suggests that it may be a default rule, but to be explicit to change the have may be the default language and have it upheld. rule, but have to be (3) The default rule : disclosure + consent of ER. explicit to change the (a) Is Singer the right rule? language and have it (i) distinguish btwn rules and standards. 1. Rules are bright line, standards are more ambiguous. a. Is this the majoritarian default? i. I.e., the rule most parties would pick if they could bargain about it costlessly Rules vs ii. Concept derives from Coase theorem and hypothetical bargain model Standards iii. Majoritarian default assumed to be transaction cost minimizing 2. We are dealing with standards, even though it looks like a rule. It is a standard b/c there is the initial question of whether the duty of loyalty even applies. (ii) Why might Cts be vague as to what conduct falls w/in the boundary of duty of loyalty? 1. Cardozo seems to think vagueness is good since vagueness discourages people 76 from testing the outer limits of duty of loyalty. (iii) Singer Is the right standard? The majoritarian default? 1. If Singer and GA sat down and bargained over the extent to which Singer would be allowed to have a sideline job, what do you think they would have agreed to? a. GA wouldn't have necessarily opposed Singer running a side line Is Singer consulting business. He had a good reputation and brought a lot to the the right table. GA needed Singer more than Singer needed GA. majoritari b. Singer may have a conflict of interest since he is also thinking about his long term occupation. He might have an incentive to send out work that GA was perfectly capable of doing since his brokerage fee can be larger than Gas commission fee. c. Most business would probably prefer that their directors not run a sideline business. (iv) Is Singer the right default rule? 1. Suppose courts have no way of knowing what rule most parties would prefer 2. In such cases, what is transaction cost minimizing rule? 3. Efficiency might be served by adopting a rule designed to encourage ex ante bargaining by the parties (a socalled "bargainforcing default") (v) One option is to enact bargain forcing default rules that create a penalty if you don't contract out of it. 1. Only Singer can know if he is engaged in side line. Create incentive for Singer to provide disclosure. 3) Grabbing and Leaving: Town & Country v Newberry: a) The parties: i) Town and country house and home service: small corporation engaged in house cleaning. ii) The defendants : former EEs who took customer lists when they left. they successfully solicited former customers. (1) Would you leave your law firm if you couldn't take your clients with you? (2) Real classified ad: "New partners should be able to support themselves and at least one associate (a minimum of $500,000 in portable business)" (3) Law firm grabbing and leaving Scenario 1: (a) You're going to leave great one law firm for another. Before quitting you call some clients for whom you have done work and you tell then that you are leaving firm #1 to Law Firm go to firm #2. you invite them to bring work to you at firm #2. Have you violated your Grabbing duty of loyalty? See RT2 395. & (i) If before you quit, you violate since the fact that they are an existing client is confidential information. (4) Law firm grabbing and leaving Scenario 2: (a) If after quitting you call clients and tell them your leaving and invite them to bring work to you at firm 2: (i) Have you violated your duty of loyalty? See Town & Country 1. Can't use the customer names since that is confidential. Town and country and the restatement suggest that that is a problem. 2. I DON'T GET THIS> I THOUGHT THIS WAS OK. (5) Is there an argument that lawyers ought to be treated differently than maids? (a) Professor doesn't know why the rules are different, but they are. 77 4) Town & Country : ? a) Town & Country holding: In Town and Country, the case goes off on trade secrets rather than fiduciary analysis. It was not necessary in T&C for a finding that the customer list was a trade secret. i) The Restatement makes clear that customer lists are trade secrets that the EE is not allowed to use to profit off. (1) Rationale? customers identified though "considerable effort and expense" by employer. (2) Having said that, most Cts these days analyze this not as breach of fiduciary duty but as trade secret issue. Trade secret law is one way we protect inventions. ii) Suppose not a trade secret. Still liable? (1) See Restatement (Second) of Agency 396(b): "Unless otherwise agreed, after the termination of the agency, the agent ... has a duty to the principal not to use ... written lists of names ... given to him only for the principal's use .... The agent is entitled to use ... the names of the customers retained in his memory...." b) Trade secret primer : i) Employee can't appropriate trade secrets or proprietary info even in absence of noncompete agreement (1) Common law ruleenforced by injunction & damages ii) There are 5 factors to decide if something is a trade secret : (1) Extent known by employees and those involved in employer's business--i.e., is it general or firmspecific human capital Factors for (2) Measures taken to guard secrecy of info trade (3) Value of info to employer and competitors (4) Money and effort expended to develop info (5) Ease or difficulty for others to acquire or duplicate c) In this case, the Ct said the EEs were not allowed to short circuit the process or taking their EEs customer list. 78 INTERESTED DIRECTOR TRANSACTIONS Assn 19 1) What are interested director transactions? Specific aspect of duty of loyalty--conflicted interest, self dealing b/t officers of corp and corp. a) Note: There is no business judgment rule presumption here! i) The BJR protects from personal liability disinterested directors who approve a self dealing transaction in good faith. Attention: BJR isn't a presumption in interested director transactions!!! 2) Two types of interested director transactions: a) Direct interested director transactions: when the director enters into K directly with the corporation. i) 8.60(1)(i): Self dealing occurs when the corporation and the director himself are parties to the same transaction. Examples include: (1) sales and purchases of property, including the corporations stock. (2) Loans to and from the corporation (3) The furnishing of services by a nonmanagement director (such as when the corporations outside lawyer, accountant or investment banker sits on the board). b) Indirect interested director transactions: when the corporate transaction is with another person or entity that the director has a strong personal or financial interest. i) This is when if is not the director themselves who enters into the K, but rather the 2 entities which directors is involved a/ enters into to K w/ each other. Why is this a problem? This is a prob b/c that director has a conflict of interest between the two corporations or the two parties. ii) Cts will generally look through the structure of the transaction iii) Bayer v Beran (indirect interested director transactions). (1) Facts: Cellanese is a textile corporation makes rayon. Cellanese had devoted lot of effort in creating a brand identification for its type of rayon that they sold as Celanese. The gov said that they had to market it as Celanese Rayon and the prob was that they managed to convince people that Celanese was good product while Rayon was bad. So they were concerned that their high end customers wouldn't buy it. the solution was to advertise it. they were going to do radio and to keep the upscale connotation of the program, they did classical type. The director's wife ends up singing. This is an indirect, interested director transaction so there is potential conflict of interest. How do you tell boss wife you don't like her singing. A SH sues. (2) The first Q : will the BJR protect the directors here? No. the BJR is inapplicable due to Doesn't this loyalty issues. quote seem (a) So where you have conflict of interest, the BJR doesn't apply. The ct said b/c there is similar to the potential for self dealing. BJR and does (b) Note strong focus on balancing authority and accountability: the same thing? But at the (i) "`To encourage freedom of action on the part of directors, or to put it another way, same time the Ct to discourage interference with the exercise of their free and independent says you cannot judgment, there has grown up what is known as the "business judgment rule.' ... cheat and cant Indeed, although the concept of `responsibility' is firmly fixed in the law, it is only self deal. This is in a most unusual and extraordinary case that directors are held liable for the balance we negligence in the absence of fraud, or improper motive, or personal interest. ... The 79 `business judgment rule,' however, yields to the rule of undivided loyalty. This great rule of law is designed `to avoid the possibility of fraud and to avoid the temptation of self interest.'" (3) BoP re breach of fiduciary duty . (a) Not clear: (i) "Rigorous scrutiny" suggests on directors (ii) "Evidence fails to show" suggests on plaintiff (b) Lets assume its on D to show? (i) That the "transaction was fair to the corporation." iv) Who wins on fiduciary duty issue? Dreyfus and the other directors. (1) Why? because: (a) Tennyson did not get unreasonable pay (b) The program was not designed to further her career (c) The company obtained its money's worth from the radio campaign (2) This is a Van Gorkum care question: why is the transaction deemed to be fair to Celanese then? She is the bosses wife and singing. (a) The deal looked fair: she wasn't over paid. She wasn't over displayed, she was paid less than other performers even. (b) 1) How do we measure the fairness of a transaction: 1. two elements: a. the fairness of the process --was she treated the same? b. fair price : how do we determine if her price was fair? we look at the FMV of other opera singers. Also compare what others would get paid, although they might be overpaid. v) Non fiduciary duty issue: (1) This was Ps second argument. For the corporation to make a decision they should have met in a meeting. See page 355, "it is urged that the expenditures were illegal since the radio expenditures.... The general rule....cannot bind....." (2) P argued that the transaction was ultra vires (illegal as beyond the corporations power) because no formal board action. (3) Holding: (a) very fact oriented analysis (b) a formal procedure is desirable but the informality was ok here. (i) Basically Cts are reluctant to invalidate agreements on ultra vires grounds especially when there is a defacto agreement and the corporation got the benefit of the transaction. Here, if the transaction had been invalidated, and the corp got the benefit for 18 mos, but wouldn't have to pay. c) Bayer variant: (hypo on interested director transactions) i) Facts: DE corp: 141, 144. 5 directors: Dr. Dreyfus, plus Alice Adams, Bob Brown, Charlie Conners, and Ed Edmond. Assume there are 1 million outstanding shared, each director owns 5,000. ii) Question #1 : Quorum issue: (1) Assume that only 3 of the directors show up at the meeting. Do they have a quorum? yes. (a) Have to have majority to have quorum. 80 (i) 141(b): (pg 99) quorum is a majority, although you can set it higher. Majority of total num of directors. Cant take action w/o quorum. 1. definition of a quorum: ". . . A majority of the total number of directors shall constitute a quorum for the transaction of business unless the certificate of incorporation or the bylaws require a greater number. . . ." Note the (b) Does Dreyfus have a conflict of interest? difference. 144 (i) 144(a): this is the conflicted interests statute under the DE code. will apply when there is conflict of 1. Is Tenneysons K with Cellanese, one that Dreyfus has an interest? yes. interest under Since his wife is involved. 8.60. a. The phrase financial interest, doesn't mean financial interest in the tranaction, but this wouldn't stop DE Cts. i. See 8.60 of MBCA , (198), which takes a much more espansie view of what constitutes conflicted interest K. it says, respecting a transaction if, the director knows at the time of commitment, that he or reltated person is a party to transaction. related person means the spouse. (2) Does the fact that Dreyfus, who has a conflict of interest, is one of the 3 director's present matter for quorum purposes in the statutes? No. (a) 144(b) "Common or interested directors may be counted in determining the presence of a quorum . . ." iii) Question #2 : Vote issue: (1) Alice and Ed vote for transaction. Dr. Dreyfus abstains. Has it been approved? No, because a majority of the disinterested directors didn't approve the transaction. Since this is a conflict on interest (8.60(3)) DE would analogize to 144 and make it apply. 2 out of 4 disinterested directors is not a "majority of the disinterested directors." It is approved for 141 purposes but not for 144. (a) 141(b): "The vote of the majority of the directors present at a meeting at which a quorum is present shall be the act of the board of directors unless the certificate of The disjunctive ("or") standard seems to incorporation or the bylaws shall require a vote of a greater number." just speaks to create safe harbor for contract claims, like ultra vires ect. selfdealing trans. (b) 144(a)(1): "the board or committee in good faith authorizes the contract or app'd (after full transaction by the affirmative votes of a majority of the disinterested directors, even disclos) by disint. dir. though the disinterested directors be less than a quorum." (safe harbor) or by maj of SH, but (i) what effect does approval under 144(a)(1) have? remember that in order for it to many Cts construe to have that effect, the transaction has to be approaved by 141(a)(1) maj of just remove the disinterested directors. (ii) What effect does it have to say that under 141(b) the vote of maj of dir when there is quorum, shall be the act of the BoD--what does that mean? in Beyer v Beran, there was issue of whether the K was legal w/o formal board action, 141(b) deals with the Q of whther there has been "Board action". The vote of maj of directors who are present at the meeting w/ quorum, is the rewuisite vote for there to be action, so the K is validly approved by the board. 1. this section doesn't speak to the validity of the K as a matter of K law . it says the K "shall not be void or voidable solely for the reason that a director is a party to a transaction is one of three things happens: 1) the material facts are disclosed to the board and a majority of disinterested directors authorizes the 81 transaction, or 2) the material facts are disclosed to the SH and the SH vote to approve the transaction (some require disinterested SH approval), or 3) a judge determines the transaction to be fair. (144). This blesses the K so the conflict of interest taint doesn't mean invalidity. This assumes you have an otherwise valid K but could be otherwise invalidated by confluct of interest. 2. History : in the 19th century, conflict of interests Ks involving director were void, then the law evolved to make them voidable at option of K, so an otherwise valid k would be avoided by corp due to conflict of interest. 141(b) just asks was there some agreement that was valid so its binding for K law. the corporate mind is the board of d, so its authorized. This doesn't speak to whether it will be insulated from viodable from 144(a)(1)): under this, it seems that the answer is no. so 2 out of 4 disinterested directors will not be enough to insulate transaction from scrutiny for fairness. a. Distinction b/n was it prop authoried so othersiw binding on corpo, from whether or not it can be avoided as tainted by conflict of interest. b. What 144 says that 141b doest is 144(a)(1) says maj of disinteresested directors, not maj of distinterested directors presently voting or those present--so that means if you want the effect of 144(a)(1), have to have majority of disinterested directors in hookup. c. there are no DE Cases on this since it never gets to court . Usually you get everyone together to make a vote. d. How could we solve this problem? Well we could just have a telephone conference per 141(i). e. Assume you tried to reach the directors but they were unavailable. Do you have to track them down to get them to vote? Req that they can hear each i. 141(i): no, you get them all on conference call. This would never get other. So to trial since attys would get them all to vote. Have to hear each other. AOL IM wont So email or instant messenger doesn't work. work.. (2) Variant number 2 All 5 directors are present in person or by phone. If Dreyfus, Alice, : Bob and Ed vote for the transaction and Charlie abstains, has it been approved? (a) 3 out of 4 disinterested directors is a "majority of the disinterested directors." (b) Does that fact that interested director voted taint the vote? (i) See 144: No, the fact that Dreyfus voted is not fatal, although it is not preferred as prudential matter. 1. Should dreyfus vote? No, the vote doesn't count anyway. 2. Do we even want him to show up and to be present? Yes. Remember there is the disclosure req for 141: we need all the material facts to be disclosed so How to get interested director transaction approved: he can tell them everything about the transaction and tell them about the 1. have all directors present in conflict. person or by phone a. he also has to be there to give a report on the transaction. This will affect 2. have interested director whether the board make an informed decision (CARE claim) such that the satisfy the disclosure req BJR should apply with respect to the care aspect of the transaction,. The and then leave (so the BJR bjr will protect them from care aspect of the transaction if they availed will apply) themselves of all the information. 3. Don't let him vote, b. Just b/c they satisfy duty of loyalty, the have to satisfy the CARE claims. 82 3. Take home message : He should make his pitch and then leave. It isn't required that he leave but it is prudent. d) What is the effect of ratification per 144(a)(1) or 144(a)(2): i) 144(a): "No contract or transaction between a corporation and 1 or 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 transaction, or solely because any such director's or officer's votes are counted Watch Out: Even for such purpose, if: if the measure is (1) (a)(1): approved by a majority of the disinterested directors properly (2) (a)(2) approved by a majority of the shareholders approved, the ii) Does the plain text of 144(a) preclude judicial review if properly approved? No. MBCA measure is not 8.61(b). insulated from (1) Whether the plain test of the statute clearly says something is irrelevant, since the justices always switch around from looking at the text and looking at totality of the circumstances. Sometimes they are strict and others they aren't. (2) The statute says the conflict wont void if one of the 3 conditions is met. But it doesn't say anything else, so on the plain text it leaves it possibly open to review. So, MBCA (3) Historical context : The statute historically was adopted to do one thingto overrule the 19th precludes JR, century cases that said a contract between corp and director is voidable solely due to but DCGL conflict of interest. The statute says it wont be voidable solely for the conflict of itnereste does NOT!!! if one of those 3 things is met, but can still review if you want. (4) Compare MBCA 8.61(b). ( page 199) "directors conflicted interest transaction ...may not be enjoined, or set aside if one of the three conditions are met..." the Model Act is clreatly intended to say, if you get SH approval, no more JR! if you get director of SH approval, no more JR, no injunction ect. (a) DE Cts say we can still go on to look at the merits (in contrast to the Model rules). (5) What effect does approval under rule 144(a)(1) or (a)(2) have? (a) This takes use to Fleigler and Wheelabrator. Wheelabrator was attempt to sort out the confusing state of the law. e) Wheelabrator: Effect of SH approval per 144(a)(2) (under DE law) the DE Sup Ct has addressed all of these, and came up w/ diff i) Duty of care claims: (1) Extinguished by an informed vote if all materieral facts are disclosed. ii) Conflicted interest transactions: SH approval doesn't (1) Duty of loyalty claims against directors : preclude JR, but it, (a) Fully informed vote shifts burden of proof to P to show waste. 1) changes the (i) What is the fx on JR of SH approval of conflicted interest transactions on the part standard from of the Board? Does it preclude JR and invoke the BJR? Remember in the fairness to waste, absence of SH approval, (Bayer) what is the standard of review? absent SH and 2) shifts the approval the standard of review is rigorous scrutiny to determine if it was fair, BoP from the with BoP on director. 1. What is the effect of SH ratification? if there is SH ratification, it shifts the BoP to the P to show that the transaction was so egregious that there was waste. 83 a. So it doesn't preclude JR, but it shifts the BoP and changes the nature of the standard from fairness to waste. This means P will have harder time proving transaction was invalid. (2) Duty of loyalty claims against controlling SH (a) Fully informed vote shifts the burden of proof to P to show unfairness to the corporation. f) Does approval by disinterested directors (BoD) under 144(a)(1) have similar effect? i) Duty of care claims? (1) Approval by disinterested directors under 144 doesn't preclude duty of care claims (unlike SH approval) (a) Need SH approval to preclude duty of care claims. (2) Approval by disinterested directors under 144 also doesn't preclude JR of conflicted interests claims involving controlling SH. (a) To get insulated need approval bvy disinterest SH. ii) Duty of loyalty claims against directors: (this is the one that is imp since has same effect as approval by dissinterestd SH) (1) Approval by disinterested directors under 144 a 1 does have same effect on duty of loyalty claims, as approval by disinterested SH under 144a 2 (a) If the transaction has been approved by maj of disinterested directors, P can still litigate, but the P has the BoP. (b) So getting approval of disinterested directors is imp to get protection from JR. With respect to the other claims, you do have to take it to SH. iii) Duty of loyalty claims against controlling SH: (1) Fully informed vote shifts to BoP to P to show unfairness. g) Variant: SH Approval with interested directors voting as SH. i) BoD decides to put issue to SH vote. 470,000 say yes, 460,000 say no. all five directors voted their shares "yes" recall that they have 5,000 shares each. Approved? Yes. Even if Only the 5 directors with 5,000 shares all vote, eliminating the votes on one director with his 5,000 disinterested SH shares (since interested votes don't count) still leaves a majority. votes count under 144(a): (1) Fleigler and Wheelabrator (a) These cases say that for a transaction to be app under 144(a) need, approval by If after "disinterested" SH. The Ct said, disinterested SH votes are the only ones that count. removing the (i) Is this correct? Or was the Ct exercising judicial activism? interested SH 1. 144(a)(1): "the board ... authorizes the contract ... by the affirmative votes of a (director) votes majority of the disinterested directors" 2. 144(a)(2): "the contract or transaction is specifically approved in good faith by vote of the (disinterested) shareholders" a. Judicial activism : The Ct implies disinterested shareholders only, even though it isn't in the text. h) Defective approval or ratification by the Board or the Shareholders: i) 144(a)(3): shields from voidability those transactions that are fair to the corporation "as of the time" they are approved or ratified by the board or SH. This covers situations where board or SH approval was obtained but in way that was inadequate for (a)(1) or (a)(2). (1) For example: 84 (a) this might apply when an interested director failed to disclose material facts, (b) OR where the approval was effected by the vote of interested parties. (c) Would approved by CEO satisfy? No: absent the director's conflict of interest, the transaction normally would be binding. However, this transaction didn't get board or SH approval. ii) The interested director bears the burden of proving the transactions fairness. (1) To measure the fairness of a transaction: (a) Terms of the deal were w/in the range of the fair value; and (b) The corporation wouldn't have gotten a better deal if the D's had come clean. 85 CORPORATE OPPORTUNITIES Assn 20 1) This issues arises where a director takes some benefit for himself that should have been available for someone else. This is litigated a lot only second to alter ego questions. a) Usurpation by an officer or director for personal gain of some prospective business venture or development in which the firm has a property right b) This is the flip side of interested director transactions, but note the potential for overlap if opport also involves a K with a firm. (can have both issues present in a transaction). i) Gooth : the D took for himself an opp to acquire Pepsi. He takes it for himself and sells ex Pepsi to the Soda chain. So this is taking of the corporate opportunity, and then he sold it back which raised interested director problems. 2) Delaware law: Corporate Opportunity c) Broz v PriCellular: i) This arose party b/c Broz wore two hats: (1) Hat 1 : Broz was the sole shareholder and President of RFB Cellular, Inc. (RFBC) (2) Hat 2 : Broz was also a member of the board of Cellular Information Systems, Inc. (CIS) This is a common situation, but is complicated since 1) CIS was in financial difficulty and 2) was in the process of being acquired, and ultimately was acquired, by PriCellular, Inc. (PriCellular) ii) Broz became aware of possibility to get Michigan 2. he wants to know if he should get this for RFBC, but he was cautious. He went and talked to CIS and asked if they wanted it and they say no. he also goes to CIS atty. What Broz did was good b/c he tried to diffuse the conflict of interest. (1) Broker named Rhodes offers Mich2 to Broz in latter's RFBC capacity (2) Wearing his RFBC hat, Broz buys Mich2 (3) CIS board did not formally clear purchase, although informal ok by CEO (4) Prof thins that the atty acted poorly since he was on the board of CIS (so it is questionable for the company atty to be member of BoD). The atty was both BoD and atty, and then he represented another board member in getting a biz that CIS potentially had an interest. iii) Broz outbids PriCell, who also bid on Mich2. PriCell then acquires CIS, and then has CIS sue Broz for corporate opportunity. (a) Notice, is this a derivative suit being brought by Pri? Did Pri bring this suit derivatively on behalf of CIS? If Pri brought it themselves, Pri would face Derivative procedural problem of bringing the derivative suit due to the contemporatuous litigation ownership requirement. They would have had to have been a SH at 3 points in time, time filed, when the wrong occurred, and time of jmt. iv) DE law: what is the test for corporate opportunity ?: (1) corporate opportunity exists where (quote from Guth v. Loft): th For the 4 element: (a) Corporation is financially able to take the opportunity Can have a "conflict (b) Opportunity is in the corporation's line of business of int." as long as it (c) Corporation has an interest or expectancy in the opportunity doesn't evolve into (d) Embracing the opportunity would create a conflict between director's selfinterest and state of pursuing your that of the corporation interests at expense (2) Are these factors or elements ? In Guth v Loth, the Ct seems to imply that this is conjunctive so in order to have corporate opp, you need all four, so they are elements. 86 This is where DE is an outlier Informal presentment is enough (3) (4) (5) (6) Interest or expectancy (a) The Ct goes on to suggest that the director officer can take the opportunity if 1 of the factors are not present. (i) "If the director or officer believes, based on one of the factors articulated above, that the corporation is not entitled to the opportunity, then he may take it for himself." (b) This is unclear as to what the Ct is saying but it is an element test. So have to have all four. Relevance of capacity?: (a) Not Dispositive (b) Lessens Ds burden by showing good faith. Relevance of board approval or lack theof?: (a) not required. (b) Board approval creates a safe harbor. (i) This is where DE is an outlier. (ii) Don't need rejection by the BoD, it was ok, that it was informal. Don't need formal presentation. The buzzword is presentment. Do we need presentment to the board? This ct says don't need formal presentment. Is informal presentment ok? Holding: Broz didn't usurp a corporate opp,. Why? for a corporate opportunity, all four prongs have to be met and here, the Ct only thought one prong was met. (a) The Ct didn't think the court didn't think the fourth prong was met. (i) If he has a conflict of interest, then why wasn't the fourth prong met? 1. What evidence did the Ct use to show the 4th prong wasn't met? He disclosed it and he got ok, and CIS didn't want the opp. A conflict of interest is not something you are guilty of, it is just a state of being. Broz was in the state of being, and the 4th prong really asks, not if you are in state of being, but whether your state of being has progressed into where you are pursing your interests over the corp's interest. He wasn't acting just for his personal gain. He wasn't guilty of anything. Interest or expectancy : (a) The third prong of the corporate opportunity test says that a corporate opportunity exists when: "the corporation has an interest or expectancy in the opportunity." (i) There is diff between interest and expectancy: but the Ct doesn't treat them differently. 1. Interest : Something to which the firm has a better right a. If officer bought land to which the corporation had a contractual right, the officer took an "interest" 2. Expectancy : takes something which, in the ordinary course of things, would come to the corporation a. If the officer took the renewal rights to a lease the corporation had, the officer took an "expectancy" (ii) Why didn't CIS have interest or expectancy in Mich2? 1. They were getting out of that business 2. They had sold off several similar franchises 3. Key players told Broz it was ok to go ahead 87 See the ALI approach to Corporate Opportunity on the next page.... 88 d) ALI Principals of Corporate Governance: i) From the ALI home page : "The product of 15 years of development and preparation ... this work combines cogent analysis of current legal requirements with carefully articulated recommendations for the clarifications or changes that it concludes are appropriate." (1) Called "principals of corporate governance" they have been modestly influential. DE and the model act is more imp. There are some states like PA and CA where they don't like Delaware's monopoly on this. (a) Notice: Much easier to find (i) Under Delaware 4prong test, venture is not a corporate opportunity if any one of corporate the four prongs not met opportunity (ii) Under ALI 3.5prong approach, venture is a corporate opportunity if any of the under the ALI prongs is met. this means that many more transactions will be corporate approach than opportunities under the ALI than in DE. ii) ALI 5.05: bifurcates the inquiry: (1) Was the opp in question a "corporate opportunity" as defined by 5.05(b)? (2) If so, was the corporate opportunity properly rejected by the appropriate corporate actor per 5.05(a)? Did George become aware iii) ALI approach and the Zapco Problem, p 371: of the bus opp in (1) Factual setting : George is Senior VP for VP making games for Zapco One of his jobs is to connection with his play competitor games to he can see how they go and to gauge customer reaction to games functions as a director or senior executive? Yea, when he is out, he meets two software engineers. he was out doing his job. (2) Zapco Problem: Question 2: **Might be diff if he met (a) Is it an opportunity? them on the bus. but is (i) First: parse out definition of a corporate opp'y under ALI: "being on route to work" 1. 5.05(b)(1) Any opportunity to engage in a business activity of which a connected w. his functions director or senior executive becomes aware, either: as a director or senior a. (A) [i]In connection with the performance of functions as a director or exec? vague How far can he get from his job senior executive, or [ii] under circumstances that should reasonably lead the director or senior executive to believe that the person offering the opportunity expects it to be offered to the corporation; or b. (B) Through the use of corporation information or property, if the resulting opportunity is one that the director or senior executive should reasonably be expected to believe would be of interest to the corporation; or Note: 5.05(b)(1) applies 2. 5.05(b)(2) Any opportunity to engage in a business activity of which a senior to both officers and executive becomes aware and knows is closely related to a business in which directors: This can be the corporation is engaged or expects to engage. significant if cases like Broz had been litigated a. Is a word processing program closely related to a company in which the using the ALI approach. company is engaged? Maybe. It would have been i. Can argue that G learned of it in connection with his performance of important if Broz was a work. director or a senior ii. Can argue that the two fields are closely related. ALI is designed to tilt iv) It matters a lot to George, whether he guesses right or wrong. incentive this is imp since many of the (1) Language from BROZ: "If the director believes that the Corp isn't entitled to the opp, then terms are vague, such Remedy: constructive trust he may take it for himself." Prof thinks George would still be dumb to take it. The 89 as "closely related" Company wouldn't have to prove that it was injured, and the remedy is not damages, But the conseq are so severe that the sensible person will v) The DE Ct doesn't even put Broz to this test. So if Broz came up under ALI, it would have been Corp Opp, and Broz would have BoP that the rejection by the (which are hard to prove) but a constructive trust, which means that all benefits derived from the opp, the fruit of the poisonous tree. (a) This makes it easy for the corporation to get money. They don't have the hard time of proving that they would have got the K and would have made money. They just get a cut of the profits. It this is a corporate opportunity, George must present it to the corporation and have it rejected. (1) What effect does rejection have under 5.05(a)? (a) How its rejected determines standard of review (b) Judicial review not foreclosed (i) Rejection by disinterested SH : if it was rejected by the disinterested SH, the rejection must not be equivalent to waste, so the Ct will review it to see if it amounted to waste. (ii) Rejection by CEO : The way he presents it to the CEO is important too, how should he run it by the person to show that they rejected it? if the CEO says not interested, and then George takes it for himself and makes profit. Then the Board accuses him of taking a corporate opp. 1. What would the standard of review be? a. George is a "a senior executive who is not a director" i. Hence, rejection by a "disinterested superior" is appropriate 5.05(a) (3)(B) b. Plaintiff has burden of proving that rejection did not satisfy BJR (2) Application of the ALI Broz to : (a) Since Broz was a director, he needs rejection by the disinterested directors. (i) Suppose that Broz says that Tribeck rejected it. Is he liable simply b/c he didn't get the disinterested directors to reject it? No. what can he defend on? 1. 3(a) will kick in. He doesn't have the proper rejection, but 5.05(3)(a)(3), says the rejection is ok, so long as Broz has rejection of the opp by someone with authority to make the rejection, he can get off if he can show that the rejection was fair to the corp. a. but he has the BoP in showing it was fair to the corp. 90 SHAREHOLDER TRANSACTIONS Assn 21 1) Overview: so far we have focused on fiduciary duties of corporate directors, and we have ignored obligations that SH acting in their capacity as SH, might owe fiduciary duties to their fellow SH. 2) Basic Principles: a) SH acting as SH owe one another no fiduciary duties b) Controlling SH owe fiduciary duty to minority i) They have power to elect the board of directors, that board knows which side the bread its butter is on. Think of this as analogous to vicarious liability. 3) Parent and subsidiary corporations: a) Where the parent owns all the stock of the subsidiary, it is called a "parent" and a "wholly owned patent subsidiary". i) Parents are allowed to own stock of its subsidiary by DGCL 123 b) There is also a "majority controlled subsidiary" and "minority controlled subsidiary" c) Owning a majority means you will get to elect the board of directors. i) However, you don't need a maj of the stock to have effective control over the corporation. (1) Ex: Rockefeller owned Standard oil, but only owned 14% of the stock, minority controlled subsidiary. 4) Transactions between Parent and Subsidiary Corporations: a) Sinclair Oil v Levin: i) In Sinclair Oil, they were the dominant SH of Sinven, (97%). Three percent was owned by other SH. One of those SH, Levin, objected to three things Sinclair Oil did. (1) Issue 1: Sinven's large dividends (got BJR) (2) Issue 2 : Sinven prevented from expanding (got BJR) (3) Issue 3: Contract between Sinven and another Sinclair subsidiary breached (got intrinsic fairness) ii) The issue with respect to all these three things was what standard of review was to be applied. (1) Two possible standard s (a) : BOB on P to rebut. BJR The diff standard, (b) Intrinsic fairness : BoP on D's to show the transaction was fair to Sinven. and BoP, will likely (i) If this standard applies, what is the standard of review? determine the outcome of the case 1. What Qs will the Ct ask and who has the BoP and what must they prove? most of the time, The Directors have the BoP and they have to prove the transactions were 99%. The BoP is objectively fair to the minority subject to close and exacting judicial scrutiny. (2) How does the ct select standard of review and decide between the 2 standards? (a) Intrinsic fairness used when parent has received a benefit to the exclusion of the Can't get minority shareholders of the subsidiary and at the expense of the minority shareholders more than of the subsidiary. Pro Rata (i) Have to analyze the transaction to see if the maj has benefited themselves at the share expense of the minority. The majority is allowed to benefit themselves and act in self interest, but are not allowed to get more than your pro rata share of the benefit. This is critical distinction in the first issue. (3) Issue 1: Dividend Policy: (a) Since Sinclair owns 97% of the stock, for every dollar they pay in dividends, they get 97%. 91 (b) Standard of review? BJR. (i) Why BJR? Because the minority SH got their pro rata share, 3 cents per every dollar. So they didn't benefit themselves at the expense of the minority. Example of when 1. If you are minority SH you might want to argue that yes you got pro rata share, intrinsic fairness but nevertheless, this still hurt them, since they would be better off if the co applies to decision invested the money, but this collapses the two issues into one. to give dividends. (ii) The Ct gave ex of when intrinsic fairness would apply to decision to give dividends: when you have two diff classes of stock, one being owned by parent might be just and other owned by minority and give dividends only to the class owned by the parent. Hypo on this: 1. XYZ Corp is an oil company mainly doing business in Texas a. XYZ owns 90% of the common stock of ABC Corp, a subsidiary oil company with operations in Louisiana b. XYZ also owns 100% of ABC's preferred stock c. ABC's board of directors, taking their orders from XYZ, cause ABC to pay dividends only on the preferred stock 2. What standard, what result, why? a. Intrinsic fairness i. Court used this example ii. Majority benefiting to exclusion of minority b. Hard to see how fair i. But see Zahn v. TransAmerica. Hard to square this dicta with Zahn. So is this really valid law? maybe no, just dicta. (4) Issue 2: Expansion Policy: (a) Sinclair used Sinven exclusively to develop Venezuela properties. Projects outside Venezuela developed by other subsidiaries. (i) Why as matter of biz policy did Sinclair limit Sinvens operations to Venezuela? there might have been legitimate business reasons to do what they did--hence a justification for the BJR. 1. What are they trying to do by having many subsidiaries in other parts of the Trying to world? They are segregating assets into diff areas so you get the benefit of minimize liability limited liability (piercing corp veil). exposure (like 2. If the gov of Ven took over the assets (eminent domain) of oil biz in Carlton and the Venezuela. So the more assets Ven can get if they nationalize Sinven. So this is called country risk. If there is revolution or nationalization, the rest of Want to assets are insulated. avoid (b) Plaintiff objects: country (i) Standard: BJR . Result? Why? 1. P could identify no opportunity that Sinclair usurped from Sinven. (ii) What would minority have to prove in order to get the intrinsic fairness test to the expansion issue? 1. Maybe expansion within Venezuala. What legal doctrine does this case remind us of that we have studies before? Corporate opportunity. Isn't this really Cross just an arg that Sinclair took biz opp that really should have gone to Sinven? reference But this means that we have to show that Sinclair usurped opp that should have corporate gone to Sinven. Interest or expectancy analysis. opportunit a. what else might have given Sinven an interest or expectancy such that they 92 could show Sinclair took a biz opp? hint: Zapco problem. When would George in Zapco be expected to turn opp over to Zapco. Suppose that Panamanian oil prospector figured out that there was oil under the Panama Canal; and went to Sinven and Sinclair says no, we will create a new subsidiary and let them do the drilling. Since the prospector brought the project to Sinven initially, they prob had interest and expectancy so the corp opp applies. (iii) Expansion Policy Hypo : If the Alaska project 1. XYZ Corp is an oil company mainly doing business in Texas was originally a. XYZ owns 90% of the common stock of ABC Corp, a subsidiary oil proposed to the ABC Board, and then, XYZ company with operations in Louisiana liquidated them and b. XYZ is presented with opportunity to develop oil field in Alaska gave pro rata share of c. XYZ causes liquidation of ABC and uses its share of proceeds to develop dividend, then intrinsic Alaska project fairness would apply 2. Standard? Result? Why? since an opportunity a. BJR: this is a pro rata liquidation dividend. No opportunity belonging to ABC was usurped. (5) Issue 3: Breach of K (a) Sinven sold its oil to International (another Sinclair subsidiary) (i) Int'l breached the K (ii) Sinven did nothing (b) Standard? Result? Why? (i) Intrinsic fairness was used. 1. The reason intrinsic fairness was used was that they got the money but didn't pay for it. so as a result intrinsic fairness. (c) Suppose nonenforcement of contract had been approved by a majority of the disinterested directors and then also by a majority of the disinterested shareholders (a.k.a. a "majority of the minority")? (i) as long as there is full disclosure of all material facts ect, and full disclosure of the nature of the situation, then this would be considered a ratification, and disinterested ratification of a situation involving transaction involving interested SH. this shifts the BoP to plaintiff to show transaction was unfair Wheelabrator. 1. Why have the DE Cts done this? Mostly accidental. Part of reason is that there is difference when you have one director with conflict of interest vs the majority SH, who is more suspect, so we don't give it as much of a blessing. (d) Suppose nonenforcement of K had been approved by majority of disinterested Remember they directors but there was no SH Action? were elected by the controlling SH!!! (i) Remember that with self dealing transactions. Wheelabrator doesn't apply to this. This has NO effect their decision making is tainted. They were elected by the controlling SH. So its helpful but not Dispositive. (e) Side note: see 718 of casebook, footnote 7. 5) Conflicts between two classes of stock : (Conflict of Classes) Prof a) Zahn v Transamerica (relevance of fiduciary obligation) likes i) historical context : In the WWII, the gov stood up to tobacco farmers and made them grow reg this case 93 crops so for companies that were sitting on inventories of tobacco, the value of their inventory b/c there is a brain teaser in skyrocketed, so the value of the company (AxtonFisher) increased. Transamerica was the controlling SH of AxtonFisher. (1) Classes of stock: they can be subdivided as much as we want. (a) Preferred stock: not relevant (b) Common stock (i) Class A stock: 2/3 owned by TransAmerica (ii) Class B: almost all owned by TransAmerica ii) Transamerica had elected majority of the board. iii) Different classes of Stock: Class A, Class B (1) Class A stock: (a) Annual dividend of $3.20 (b) Entitled to liquidation dividend 2x that of Class B (c) Convertible into Class B at option of holder (i) means you can exchange class A for class B. (d) Callable by corporation at $60/share plus accrued but unpaid dividends (i) means the company can take it back and redeem it and force a sale for $60/share plus accrued and unpaid dividends. (2) Class B Stock: (a) Annual dividend of $1.60 (b) Entitled to liquidation dividend that of Class A (c) Not convertible (d) Not callable iv) The Plot: (1) Transamerica caused Axton Fishers board to call the class A shares for redemption at $80. (a) $60 call price plus $20 in unpaid dividends. (b) they didn't have to call it before liquidation. But they exercised option to call it in. (2) Axton Fisher was then liquidated. (a) Allegedly to appropriate for Trans the increased value of the tobacco inventory. (3) The plaintiffs, the class A SH's claim that Class A would have received $240/share if it wasn't called in before the liquidation. so they sue for the $160/share difference. (a) The allegation is that Trans can get more of the pot by getting rid of A first, since they owned all of B, and only 2/3 of A. giving the A 240 means less left over for B. (4) AxtonFisher Board has three options: (a) What they did (i) Redeem without disclosing intent to liquidate (b) What plaintiff wanted (i) Liquidation without redemption (c) Redeem after giving notice of the material facts and their intent to liquidate (5) Did the plot violate the fiduciary duties of Transa? (a) Why? This is the kicker. Remember that Trans had three options. (i) Option 2 was what the P wanted. (ii) Option 3 was to inform and then allow some of A to convert their shares to become B shareholders. The question is which SH have to approve the liquidation? 1. To whom did the board of D ultimately owe the duty? Turn to page 290, Dodge v Ford. Directors operate to the ben of SH. Cant serve two masters. Cant They are forced with two masters, the A & the B. whatever they do affects the 94 serve two other. So to whom do the board owe their ultimate duty? masters at once... a. They owe it to the B. the fact that the B is not callable is important. The B SH and the board have option to call in the A if doing so means that B SH get more money. Moreover, the B shares aren't convertible. The fact that A was callable and convertible suggests that B is the true residual claimant who should be entitled to the leftovers. Implied covenant of b. There is one implied covenant that is required in every contract. The fairness and no self implied covenant of fairness and no self dealing. The A has contractual right to convert and it implies covenant of good faith, and that they make an informed choice. A needs to have the facts to see if they should stay or go. (iii) Three options with the stock options: 1. What they did: Redeem without disclosing intent to liquidate this was a breach of duty. 2. What plaintiff wanted: Liquidation without redemption. this cant be mandated. 3. Redeem after giving notice of the material facts and their intent to liquidate a. This was ok . Court in Speed says: "a disinterested board of directors of AxtonFisher would undoubtedly have exercised its powers to call the Class A stock before liquidation, disclosing the intention to liquidate together with full information as to the appreciated value of AxtonFisher's tobacco inventory" b) Things to ponder about the Zahn case: i) This case is really not a conflict b/n parent and subsidiary, but a conflict between classes of stock. (1) Prof reads Zahn and Speed with Dodge, to say that the board only has fiduciary duties to one CLASS just ONE , the class of stock at the back end of the line--the true residual claimant. What everyone else has are K rights, and are entitle to implied cov of good faith, but that is it. the BoD only has one master. It is for that class of stock for whom to BoD run the co. ii) Zahn calls the dicta from past case into question. iii) Also, do we really want to be class B or Class A stock if we were behind the Rawls veil of ignorance. probably want to be in the class to which the Board owes a fiduciary duty. iv) Prof wants us to read: Corporation Law and Economics: page 33542. 95 THE ECONOMICS OF CAPITAL MARKETS Assn 22 1) Overview: a) This material looks at the rights associated with corporate stocks and rights that arise in particular with the trading of corporate stock. So we should talk little about the markets for corporate stock an the rules that govern the sale of corporate stock 2) Capital markets : a) The Primary Market : Stock is a i) Issuers selling stock to investors security ii) Distinguish public offerings (including IPOs) from private placements claim on iii) Investment banks serve as underwriters the iv) No formal apparatus corporatio b) The Secondary market : (What we care about) ns i) Investors selling stock to each other residual ii) Minimal issuer involvement (record ownership) iii) Exchanges (e.g., NYSE) iv) Automated over the counter markets (e.g., NSADAQ) v) **For publicly held corp, there are no restriction on ability to sell them. You don't have any ability to restrict who becomes a SH. This means that investors in corporate securities are highly liquid, and NTSE and NASDAQ have grown to facilitate trade. 3) Two primary theories: a) Theory one: Efficient Capital Markets Hypothesis : (ECMH) i) Thesis: In an efficient market, current prices always and fully reflect all relevant information about the commodities being traded. (big assumption: Assumes that there are no information asymmetries and that price reflects all information) (1) This hypothesis takes 3 forms: (a) Weak form efficiency : (i) All information concerning historical prices is fully reflected in the current price Why is this called the 1. Put another way, price changes in securities are serially independent or weak form? Info. about historical prices random. is widely available & cheap a. Random changes means: if you have a coin and flip the coin and it comes --nobody is so smart they up tails, the first tail doesn't indicate that it will come up tails again. could take adv of such What happened yesterday has already been impounded in the price and widely avail info If could profit from such tells nothing about what will happen in the price tomorrow. weak info, doesn't make b. Proof Nobody has ever shown that technical analysis (a.k.a. "charting") is : sense to say that the market profitable, even though lots of people try to scam you selling information about past information. 2. Implication of the weak form : prices change only in response new information. this is what is important to us. Stocks change in response to new info. (b) Semi strong form efficiency : What do we know? (i) Current prices incorporate not only all historical information but also all current 1.the weak form is valid public information 2.the semi strong form is 1. Implication: If correct, investors cannot expect to profit from studying valid available information b/c the market will have already incorporated the 3.the strong form is not 96 information accurately to reflect price. So don't expect to profit from valid: mkts don't reflect info they don't know. BUT insider fundamental analysis; there are countless investors searching for new information and whenever they see new info, they make a quick trade. By the time the information gets to us, it has already been reflected in the price. (ii) Does the semi strong form test suggest that prices will not change when the company announces information? (c) Strong form efficiency : (i) Prices incorporate all information, whether publicly available or not 1. even confidential info that hasn't been announced. a. this doesn't seem to make sense now since the market is a collection of people and how can the market know stuff that hasn't been announced and respond to it? (ii) If true, no identifiable group can systematically earn positive abnormal returns from trading in securities in other words, nobody can outperform the market 1. Empirical analysis: a. Once adjustment is made for risks and survivorship bias, mutual funds don't outperform the market over time. b. But there are one group of investors who can beat the system. insider traders. i. Insiders do systematically beat the system. ii. Currently, insiders must report al trades they make every 48 hrs so we can study how profitable their transactions are. ii) Derivatively informed trading : (1) Sometimes mkts do behave as though it knows nonpublic information. (2) This is often the result of derivatively informed trading: (a) Some mkt participants observe insider activity and follow. Brokers that suspect something might be going on piggy back and follow. Leakage or observations of trading and the markets respond to observations of trading practices. (b) Volume and or price ticks attract other investors. (3) Policy questions: should we encourage insider trading to promote market efficiency? 97 iii) The mechanism of market efficiency: Remember that P Remember that P is just equilibrium is just equilibrium price, but what if price, but what if investors have investors have systematic systematic biases? biases? (assn 24) $ P. 1+ Supply Positive new info released at t= 1 Mkt reacts at t = 1+ P: 0 New D at t= 1+ In most cases, this adjustment is instantaneous Demand at t = 0 quantity (1) Explanation of the diagram : (a) The stock mkt price is just equilibrium price where B&S eval what the stock is worth. At T=0 we get price that reflects supply and demand. Supply is vertical since over the short term the supply of stock is fixed, while demand can change. (i) Suppose there is new info, and the public thinks stock is more valuable. This shifts the equilibrium price up. This change happens really fast. Up to 18 seconds! This means don't waste your time doing fundamental analysis. Survivorshi (ii) What about Peter Lynch and Warren Buffet? p bias: 1. No, this is called the law of large numbers and survivorship bias. So the fact Winners that they beat the mkt over the long term, the survivorship bias means that the mkt consists of winners and losers. Winners stick around and losers don't. so there are always new losers for them to beat. iv) Limitations and analysis: (1) Absolute vs relative efficiency: (a) The mkt is good at determining what the implications of world events are for stock Market prices. (b) There is reason to think that mkt is not very efficient in absolute sense, like whether coke is overpriced relative to gold or real estate ect. This is imp distinction. One of If the market isn't efficient over long the policy uses of efficient capital market theory is in disclosure. The SEC has term, might want to streamlined disclosure so you don't have to repeat info, since the mkt doesn't care. require more Well deregulating disclosure depends on how efficient we think the mkt is. If the mkt isn't efficient in overall sense, we might want to require more disclosure. (2) Anomalies that makes sense : (a) Price to earnings effect : (P/E effect) (i) Price/earnings ratio: this divides the current stock price by earnings per share. For every dollar of earnings that company has, the mkt is willing to pay this price. (ii) Cos with low p/e stocks show positive cumulative abnormal returns. 1. cumulative abnormal returns: AR = RE(R) Digression 98 a. where R is the realized return on a given date into Portfolio theory and CAPM b. E(R) is the expected return on that date (iii) Abnormal returns are measured by comparing the actual return on given date with the expected return on that date. 1. Market efficiency implies that CAR should not be statistically sig diff from zero absence of new info. Event studies are a. This means you can have an event study . An event study looks at CAR used all the time to over time and asks whether the CAR is statistically diff from 0 (positive or calculate damages negative), and if it isn't, that is instructive. in securities fraud i. E.g., measure impact of fraudulent statement for damages calculation in 10b5 cases. Might indicate that fraud changed the Market price ii. E.g., can measure impact of change in law. state antitakeover laws produced negative CARs. this means that the market thinks these statutes are bad for the market. 2. Measuring E(R): CAPM in English = the a. Most common methodology is to use the Capital Asset Pricing Model sum of the return on risk (CAPM) free investment + beta x the i. A component of portfolio theory return on a market portfolio ii. E(R) = Rrf + (Rm Rrf)) the return on the risk free b. What is Beta? It's a measurement of how sensitive a stocks returns have been to returns on an aggregate stock index. i. A beta of one means that the co has the same sensitivity to risk as the mkt as a whole. ii. Beta is calculated by plotting the return of the stock in question over Beta () is the time vs the return on mkt portfolio. Do a regression. Beta is the slope measurement of the of the regression plot. companies sensitivity c. Since we can calculate the expected return stock should give and we can to risk. see if it returned an abnormal return, we know that something funky (like = the slope on a information affecting the stock price) happened if the abnormal return is diff than 0. This is imp. Event studies are used all the time to calculate damages in securities fraud. This leads us to Portfolio Theories!!! b) Portfolio theories : i) Portfolio Theory in Brief: (1) Investors are risk averse (a) Hence, investors must be compensated for bearing risk (2) Risk premium : the return paid investors for bearing risk (a) Rate of return on risky asset minus rate of return on a risk free asset (b) Example of a risk free asset? Shortterm US government securities Unsystematic risks (3) According to Modern Portfolio Theory : Risk Premium does not reflect all risks. Reflects shouldn't matter only some risks. there are two risks, unsystematic and systematic: since we can diversify to cancel (a) Unsystematic : aka firm specific, like if a plant burns down or a CEO dies. 99 them out don't put all your eggs in one basket!! (i) can minimize these risks with diversification. Example: during the Depression, entertainment stocks were high. (b) Systematic : aka Mkt as a whole, like recession, tax changes, war. (i) Only systematic risks should matter . We can get rid of unsystematic risks through diversification. ii) Law and portfolio theory: (1) Portfolio theory and its corollaries (e.g., beta and CAPM) used to: (a) Evaluate disclosure rules what do investors really need to know? (b) Value securities in litigation (c) Determine public policy towards mergers iii) Limitations and anomalies: (1) Absolute v. relative efficiency (2) Anomalies that makes sense " (a) P/E effect Price to earnings ratio Both (i) Low p/e stocks show positive cumulative abnormal returns dissipated 1. Lets go back to ECMH : basically the stock market is efficient in the weak and semi strong form, but there are anomalies such as low p/e stocks show positive CARs. This is surprising. (b) Small capitalization stocks: (i) they have also shown positive CARs, which should have been zero. (c) Explanation: What is going on with these two things? (i) Well there is a paradox. Markets are eff since investors are always searching out info and acting on it and ECMH tells us that noone can out perform the mkt on the Explanation whole, so in order for the mkt to be efficient, there have to be some in the mkt who of these don't believe in ECMH. The positive CARs indicate that you could earn profit by anomalies investing and getting info on those companies, and this makes some sense, since the characteristics of those positive CAR firms is that they have small # of investors. 1. Investors in those stocks were small scale investments, which meant we could These anomalies wait and see, which means that the mkt wasn't eff. But these anomalies have disappeared since the disappeared since they became public, and mutual funds targeted them. So gnomes in the they have become efficient. basement have (3) nomolies that don't make sense: A targeted them too! (a) Seasonal effects : stocks show significant positive CARs in January and on Fridays. No real good explanation (b) Super bowl effect : studies finding high CARs for years in which a NFC (or pre merger NFL) team wins the Super Bowl. Explanation: data mining. Randomly one will show anomaly. c) ECMH and Cognitive Psychology: i) Suppose you have a stock and the companies tell a lie and the market price changes. (1) The mkt responds to information, but cant tell if the information is truthful so if a reputable source like the co itself tells a lie, this affects the price. Investors can get injured by the companies fraud. Under common law, you couldn't have a claims since you didn't know they lied, but if you believe in ECMH, then you should presume that the investor was Presume 100 reliance! hurt by the lie, just as they had seen it. so the investor suffered injury. So presuming reliance is what we do. (a) The reason we do this, the Sup Ct case, Levinson decided that the mkt is efficient based on this idea. A atty took idea that mkt was efficient to stand for the proposition that investors that didn't rely could still recover. So that class of investors that could sue was bigger and helps attys. (2) Also use EMCH to calculate how much the lie fx the mkt price to measure damages . So what we should do is now that we have laid the groundwork, apply the applications to how we as attys ought to use the these theories. 101 FEDERAL SECURITIES LAW Assn 23 1) Overview: a) This is one of the critical areas for attys. Big topic for malpractice. b) Seven statutes: only 2 matter for us (passed after great depression to regulate the sale of securities to the public) i) Securities Act of 1933 : this is concerned with primary mkt transactions, regulating sale of securities. Regulates the owning and sale of new securities. ii) Securities Exchange Act of 1934 : concerned with trading in the secondary mkt, like insider trading, securities fraud ect. Regulates secondary Markey activity. (1) Created the SEC : Securities and Exchange commission: (a) Three diff functions: (i) Legislative function : it is an independent agency (ii) Enforcement function : they can bring civil suits. They are supposed to enforce securities laws (iii) Judicial function : they promulgate rules and regs to implement those laws more effectively. (b) SEC organization: consists of 5 commissioners: (i) No more than 3 can be from the same political party. (ii) They primary function is legislative. They have to approve rules and prosecutorial decisions. (iii) In the SEC, below the commissioner, there are number of divisions and offices. 1. Enforcement division: probably the most imp division. (iv) There are also 5 regional offices: the regional offices are like the step kids of the SEC 1. The pacific division in CA was very involved in regulating stuff in Silicon Valley. c) Purposes of the Securities law: US differs from i) Full disclosure : other countries. They check if (2) the US rejected merit based format that is used by other countries. Congress likes the the co. will be rotten egg version. Full disclosure is an alternative to merit based security regulation. Full profitable and if disclosure is less paternalistic. not, they don't (a) Just have to make sure that investors have all the info they need to make informed let them sell decisions. securities!!! ii) prevention of fraud: (3) Agency cost problem regarding disclosure: how to make a credible bond? the US does (a) There is info asymmetry with the issuer and investor. The issuer has credibility problem. So one of the functions of the securities law is to prevent fraud which is a bonding mechanism, to correct the agency cost problem. d) Disclosure: i) Securities Act: (4) Transactional (a) If a company is going to sell stock to the public, they must provide info to the investors. (i) What kind of info? Balance sheet with assets liabilities, income statement for 102 years, disclosure of the directors and officers and background, what you will do The Securities Exchange Act was created in response to this problem The purpose is to provide ongoing flow of info so investors can make informed decisions with the proceeds of the sale ect in a document called prospectus. This doc is part of larger doc called registration statement. This document is distributed to investors. (5) These documents are required in connection with any public sale. (6) Problem with the Securities Act: (a) The problem is that this provides investors with lot of info at the time they will buy, but after this transaction, the investors will be buying and selling securities amongst themselves on the secondary market. If the only disclosure we had was transactional, then investors would have problem in the secondary markets since they wouldn't have much info on which to base their decisions. (i) In response: the Securities Exchange Act was created. ii) Security Exchange Act: (7) Periodic (rather than transactional). (a) Form 10 (once) (b) Fork 10K (annual) (c) Form 10Q (quarterly) (d) Form 8K (episodic) (8) Only required of registered companies 2) Selling securities under the Securities Act of 1933 : a) The Process: i) Registration Statement Filed with SEC : Have to file a registrations statement with the SEC: this can take lot of time, several mos. So there is a long period of time when your selling activities are limited. (9) The SEC will then evaluate the statement, not on the merits, but they do look to see if the disclosures are adequate and has enough information. (a) During the review period, you can start selling activity, i.e. offering to sell security, and drumming up interest, but you cant actually make sales until the effective date. ii) Registration Statement Effective : Sales will be allowed. The Prospectus must be delivered. b) Important civil liabilities: i) Relevant Laws: (10) 1933 Act 11: says no fraud in the registration statement. (a) Due diligence defense. (11) 1933 Act 12(a)(1): creates strict liability in the event of an illegal sale. (a) Creates a rescission remedy. (i) Example : In Duran: they sold securities w/o disclosure. If Duran is right, he is entitled to rescission, they don't even care about negligence. If the co didn't register, they are liable for rescission. This makes the process of deciding to register one that is fraught with peril and can expose you to liability. (12) 1933 Act 12(a)2: fraud in the prospectus or in oral sales communication. ii) What we will spend time on is implied private rights of action: (13) Do the fed cts have the rights to make a remedy? There are 2 implied rights of action, where the Ct says you can sue under the statute. (a) 1934 Act 10(b) and SEC Rule 10b5. this is the principal anti fraud provision. (i) See Assn 2531 103 (b) 1934 Act 14(a) and proxy rules. Regulates SH voting c) Regulatory arbitrage in the primary mkt: i) Pub offerings can be useful. Especially in the IPO. They can raise lots of money, and creates secondary markets. Secondary mkts in your securities are good, b/c lets you have stock based exec compensation. So this can be wise dec. but not for all co's. costs lots of money (costs associated with the Transactio registration process: attys, accountants, printers, delay) nal (14) Disclosure cost. (a) Competitors get access to proprietary information (b) Subject to antifraud regime. (15) There is ongoing regulatory expense: (a) Periodic disclosure rules (b) Proxies ect. ii) So a lot of companies will say it is not worth it to go public, it will be better to raise the money other ways. d) Congress created 2 exceptions from the registration process: i) Exempt securities : like those that are issued by Churches. These, opposed to exempt transactions, are exempt permanently. ii) Exempt transactions : Most exemptions are transactional exemptions, which means that future sales have to show future exemption. (c) Securities Act 4: the Private placement exemption (i) "Section 4. The provisions of section 5 shall not apply to... In this case, they knew they had a security, but 1. (2) transactions by an issuer not involving any public offering...." thought they had a 2. The question then becomes, is this a public offering, since it isn't defined in the private placement statute. Doran case is a classic private placement case. exception. (d) Doran v Petroleum Mgmt Co. (i) Facts : Petroleum Mgmt. Co. organized a limited partnership to drill for oil. It contacted a few people, but only Doran bought an interest. Doran agreed to assume one of the firm's debts. The business started losing money and eventually defaulted on the note that Doran guaranteed. Doran sued for rescission (ii) Issue : was there a private placement? (iii) Private Placement Four Factor Test: 1. Number of offeree s and relationship to issuer [this is the factor this Ct focused Test for on] two sub issues: Private a. Offerees knowledge and sophistication Placement b. Offerees access to information Exception 2. Number of units offered 3. Size of the offering 4. Manner of offering a. No general advertising or solicitation (iv) The Ct focuses on the first factor: the number of offerees and the relationship to Rule of issuer. Thumb: 25 1. Number : offerees is the a. Here there were just a small number. dividing line b/ 2. Relationship to the issuer : there are 2 sub issues: a. Offerees knowledge and sophistication : 104 Even if a single offeree lacks knowledge, the exception doesn't apply everyone can rescind!! Two ways the information can be The idea goes back to a Sup Ct decision where the Ct said the basic issue is whether the investors can take care of themselves. The run of the mill investor needs assistance. But not all investors do. Some are really knowledgeable and can take care of themselves. The Ct wants to know if the relationship is such that this offeree can protect themselves. p 404 "there must e sufficient basis of accurate info upon which the sophisticate investor can exercise his skills". ii. Is this required of all investors or of all offerees? This is the critical issue. Offerees. This means that if Doran was really knowledgeable and had access to information, but there was a novice investor who was also offered, then this exception doesn't apply. This is strict liability: Everyone who bought can rescind, even if they were sophisticated and knowledgeable. Example: CEO rescinding b/c secretary was offered. b. Offerees access to information: i. How much information is required? "the information a registration statement would have afforded." ii. There are two ways the information can be provided. 1) Private placement memorandum: Through the registration statement: the advantage of this is that doesn't need SEC approval, usually shorter, cheaper. 2) Physical access method: If they can show that the offeree had access to the files and records and opportunity to ask questions. this method prob isn't going to be used that often for folks like Doran, this really applies to insiders, like senior executives. i. 105 RULE 10B5 Assn 25 1) Overview : a) So far we have focused on issues of corporate governance. Today we turn to the block of material from last time, which is in some sense a duty of candor, the duty of directors not to commit fraud. b) 10b5 is imp b/c. It is the principal statute that regulates insider trading. c) Elements of a 10b5 claim: i) Jurisdictional nexus ii) Transactional nexus iii) Material misrepresentation or omission Rule 10b5 is iv) Reliance "the Oak that grew from a v) Causation (see assn 26) little acorn" Rehnquist vi) Scienter (see assn 26) 2) The Statute: a) 10(B): i) It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange.-- (1) (b) To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, any manipulative or In other words, 10b isn't self deceptive device or contrivance in contravention of such rules and regulations as the executing, and Commission may prescribe as necessary or appropriate in the public interest or for the doesn't make protection of investors. anything ii) Rule 10b5: It shall be unlawful for any person, directly or indirectly, by the use of any means unlawful or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, (1) (a) To employ any device, scheme, or artifice to defraud, (2) (b) To make any untrue statement of a material fact or to to state a omit material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (3) (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, (4) in connection with the purchase or sale any security of . 3) Unpacking the language of 10b5: a) "It shall be unlawful for any person..." the rule doesn't say what happens if you violate the rule. The rule i) There are three possible antagonists, 1) the justice dept, 2) the SEC, 3) private parties? doesn't specify (1) Justice Dep't : Willful violations are a felony (see Securities Exchange Act 32(a). what happens (2) SEC: Bring civil action. if you violate (3) Private Parties: Is there a private party cause of action under the stt? There is no the rule express cause of action. The statute, doesn't says there is a private action, but over time Cts have implied a private cause of action. (a) Supreme Court implied private right of action in Superintendent of Insurance v. Implied Bankers Life & Casualty Co. (1971). private party 106 action. (b) "The existence of this implied remedy is simply beyond peradventure." Herman & MacLean v. Huddleston (1983). (c) so private parties may sue them for damages or equitable relief. b) Elements of a 10b5 claim : i) Jurisdictional Nexus : (1) by the use of any means or instrumentality of interstate commerce, or of the mails or " Jurisdictiona l nexus of any facility of any national securities exchange ": (a) this has been interpreted very broadly. (b) Some cts say that even in pure face to face transactions, it is captured. Transactional (c) The main thing this jurisdictional nexus comes up on is as a pleading requirement. Not nexus a big deal. ii) Transactional Nexus : (1) "In connection with the purchase or sale of any security" this is more imp than the : jurisdictional nexus. (a) "Purchase or sale": This is a standing limitation. Only purchasers or sellers have standing to sue. Blue Chip Stamps v Manor. (i) Blue Chip plaintiffs decided NOT to buy due to fraud, but that meant they didn't have standing. 1. if you aren't a purchaser or seller of a security, you might still get liability elsewhere but no 10b5 liability since doesn't meet the nexus. (b) "in connection with" : (i) This was the gist of White's dissent in Basic: How was fraudulent denial connected with purchase or sale? (ii) Fraud only needs to "touch and concern" a purchase or sale. 1. E.g. misappropriation theory of insider trading liability. Need only a fairly weak nexus to get liability. iii) Material Misrepresentation or Omission: there are a couple issues that need to unbundled: (1) Materiality : the key case is Basic Inc v Levinson: (a) Facts: (i) Combustion had been negotiating a merger with Basic for 2 years Mat misrep or omission (ii) Rumors about the deal persistently circulated, but Basic consistently denied them 1. Denial 1: October 21, 1977 (stock price at $20) 2. Denial 2: September 25, 1978 3. Denial 3: November 6, 1978 Recall: One explan. for (iii) Merger announced December 19, 1978 priced at $46 unusually high trading vol. is that someone who knows (iv) The company kept denying the merger. An interesting issue, fn 4 of the opinion, something is in the mkt. might have been presented. Derivatively informed 1. The latter 2 denials are different than the first one. The first one is ambiguous, trading. Brokers piggyback. but they don't know that the merger negotiations are the cause of the price activity. So in some sense, those statements are sort of a half truth. They left out that they cold have given a good guess. Would there have been liability for Half Truths: a half truth? If you say something that is the truth but you leave something issue not out. This issue wasn't addressed, since here the president made a flat out lie. addressed by the 2. Why did Basic deny the existence of the merger agreement? Basic and Ct since the Pres Combustion had agreed to keep deal secret at least till an agreement in made a flat out lie principal had been reached. Why? to avoid a bidding war and drive the 107 price up. If Basic announced it, they were afraid competitors would come and bid and drive the price up. (v) Plaintiff class: Investors who sold stock between October 21, 1977, and December 19, 1978 1. Claim they would have obtained a higher price had Basic not issued those denials (b) Issue: was there a material misrepresentation? (i) Side issue : Basic may not have had a duty to disclose based on these facts. Basic could have tried to defend by saying they had a deal not to announce this. What could Basic have done to avoid liability? The Ct, in fn 17 says something imp: there is a difference between an affirmative misrepresentation and omission. 1. Omission : With an omission, there is possibility to remain silent so long as you don't have a duty of disclosure. Duty to a. See footnote 4. Disclos b. The Ct didn't have to decide if Basic had a duty to disclose since he lied. c. Most cts would say there isn't a duty to disclose up till the point where Agency issue: why there is an agreement to merge, at least in principle. is company liable 2. In response to negotiations, the ct says you could always just say no comment, for President's then outsiders can't get signals, but this might not be a good strategy since it statement? B/c could get reporters mad at you. But it avoids liability and the signaling effect. he is an agent of (ii) Issues in Basic : the principal. 1. Were Basics statements materially false? 2. Is this a proper class action, when proof of reliance is an issue? (c) General standard of materiality? (i) "whether there is a substantial likelihood that a reasonable SH would consider the fact important. TSC Ind. V Northway. (ii) This test is very hard to apply when dealing with uncertain and contingent facts. 1. Example: In this case, there was a possibility that it might happen, but it isn't for sure. a. The Basic standard: "a highly factdependent probability magnitude balancing approach." Basic standard i. 1) probability: look to "indicia of interest in the transaction at the of materiality: highest corporate levels." Evidence such as "board resolution, very instructions to investment bankers and actual negotiations between subjective principals and intermediaries may show indicia of interest" 2) magnitude: mergers are important events. Magnitude has a relative and an absolute component. ii. this test is very subjective, the Ct never tells us how high probability or magnitude is required. (iii) When do we know that the probability has gotten so high that it is material? 1. Hypo: ABC Corporation is a small, struggling pharmaceutical firm working on Materialit a cure for baldness. Research shows that the cure works on bald monkeys. But y hypo there haven't been any human tests. So ABC hasn't applied for FDA approval. Magnitude? Probability? What sort of indicia of materiality would we look 108 Difference between affirmative misrepresentation Insider trading can show materialit at to see if the probability that this would happen is high enough that it would be deemed material in this hypo? a. Measuring probability : i. Whether they have done tests ii. Whether they have applied for approval iii. Fund raising : Reported it to the board, and the board went out and raised some money since the board thought this was high enough probability they wanted to raise some capital. iv. Did the insiders of the company go and buy stock in their company? Insider trading can be good measure of materiality. b. Measuring magnitude: i. Size of the profits and other things. ii. Assume the merger was material from Basics perspective. iii. Was it necessarily also material from Combustions perspective? iv) Reliance : the P must rely to his or her detriment. (1) Omission cases: (a) Reliance is presumed in omission cases. Affiliated Ute Citizens of Utah (i) If you buy a house and seller doesn't tell that there are termites, that is reliance. Reliance is (ii) The harder case is misrepresentation cases. Basic is a misrepresentation case. presumed in (2) Misreprentation cases: omission & (a) Fraud on the market theory: misrepresentation (i) What is the fraud on the market theory? Presumption that the investor relied cases under the on the integrity of the Market price so investor need not have seen fraud on the market misrepresentation. 1. Invoked when: Class a. material public misrepresentation b. Efficient market. action 2. Reasons for the presumption: problem a. A lot of Ps wouldn't be able to prove that they saw one of the denials . One of the denials was in the Cleveland plain dealers. This is different from the homebuyer who relied, since there people can prove if they relied on it. Rebutting the b. A fraudulent denial will have an effect in an efficient market whether or presumption of the not you saw it since the stock price can get driven down whether or not fraud on the market theory you saw it. c. most of these cases will be class actions If reliance must be . affirmatively proven, and if actual reliance is required, it will be hard getting class certification. (b) How can the D rebut the presumption of the fraud on the market theory? (i) Market not deceived : The market maker determines the price at which a transaction will be executed. The ct says that if the specialists that are the price setters, they will set the price at level of their expectation that a merger will happen. They knew the truth. (ii) Corrective statements : the company put out corrective statements. 109 (iii) Specific Ps would have sold anyway : how would they find this out? This is sorta bogus to Bainbridge. v) Analysis to Question 8: (1) Class who will recover? (a) Former SH of Basic who sold during class period (b) White says will include some who bought disbelieving denials. True? (2) Class who will pay? (a) Corporation will pay in the first instance. (i) The corporate execs who lied and denied don't have to pay. Basic the company pays. 1. What is wrong with that? If the company pays, that means there is less left over for Basics current SH. 2. Ultimately, Basic's current SH are the ones who pay. a. Why is that a problem? It allows the attys to be the ones to reap all the benefits since what this is a tax on investors for the benefit of attys. even though there are some deterrent effects and some reputation effects. b. So a SH might have to pay in one suit, but then get paid in another. We should keep in consideration whether it makes sense to hold the people who commit fraud liable instead of the company as whole. (3) Recovery here makes sense if investors diversified? 110 LIMITS OF RULE 10B5 Assn 26 1) Overview : There are a lot of ambiguous things in the statute and one the questions we want to think about are what are the limits on 10b5. 2) Elements of the 10b5 claim: a) Jurisdictional nexus: b) Transactional nexus c) Material misrep or omission d) Reliance e) Causation: i) Recall from tort law, that there are two main kinds of causation: "but for" and "proximate" showing that the P was that the person is both the but for and the proximate cause. (1) Transaction causation: Have to show both (a) Closely related to reliance types of causation. (b) but for the fraud the P wouldn't have invested, or sold, ect. Transaction (2) Where reliance is presumed, ct will also assume transaction causation causation is presumed when (c) Omissions reliance is presumed, (d) Fraud on the market but loss causation is (3) Loss causation: (e) This is similar to proximate cause. (f) Fraud caused the loss. (g) what the D said or omitted, caused the loss. This can be tricky. (i) This is really a battle of the economists, everyone disagrees. (h) Loss causation is not presumed in reliance cases (omissions and fraud on the market). (i) How would Basic Ps probe loss caution on remand? f) Scienter : i) State of mind: Sup Ct. hasn't said (1) Intent to defraud (Sup Ct) if recklessness (2) Reckless disregard of falsity of statement (all circuits) satisfies scienter (3) The issue that the Sup Ct ducked is whether there was intermediate state of requirement, but all mind, like recklessness that would give rise to liability? What if the P lower Cts say its recklessly disregarded facts that would be relevant? Every lower Ct say enough, don't have that recklessness satisfies the scienter requirement. Most people assume that recklessness satisfies and don't need pure intent. ii) Required in private party litigation. Ernst & Enrst v Hochfelder iii) Required in SEC Actions. Aaron v SEC. 3) Limits on 10b5 and state corporate law? this issue arose in Santa Fe v Green a) Santa Fe v Green i) Facts: (1) Santa Fe Industries held 95 percent of the stock of Kirby Lumber Corp. (i) Santa Fe merged Kirby Lumber into itself (at $150/share) using the Delaware short form merger statute (i) No shareholder vote required (ii) Shareholders can get appraisal rights 111 (iii) Shareholders claim fair price = $772 Hard to bring appraisal action in a class action--each class member has to bring their own, hence, 10b5 claims are more ii) Side Notes : (1) Side issue beyond scope of this class. Short form merger. Under this statute the parent may cause the subsidiary to merge into the parent. The minority SH don't get a vote, while in regular merger they do. (2) This case also introduced is the concept of appraisal. (j) Why was an appraisal right created ? one time, in the 19th century, mergers had to be approved unanimously, but the problem was that one SH could hold out to sweeten the pot. So the state legislature changed this from unanimous to majority. In recognition that the minority would get outvoted, they got some rights, appraisal rightswhich would ask a judge to appraise the fair value, which gives them some protection. (have Ct determine what the shares are with and force the co to pay) so the co can't low ball them. (i) In Santa Fe, the minority didn't get a vote, but they got appraisal rights. Instead, they filed a 10b5 case. Why did they do that? There is no good mechanism to bring appraisal as a class action, each class member has to bring their own. 1. There were also adv if you could get into fed ct. There was perception that DE Cts were pro mgnt and Fed Cts were more pro SH. iii) Plaintiffs allegations: (1) Plaintiffs claims merger violated Rule 10b5 because: (k) Merger was effected without prior notice to the minority shareholders and was done without any legitimate business purpose (l) Their shares had been unfairly undervalued (2) Basically the Ps argued, not that the Ds lied to them, but rather that the transaction was unfair. In other words, they argued that a breach of fiduciary duty gives rise to a 10b5 claim. iv) Issue: Does the implied private action reach this kind of case? v) Holding : What kind of conduct violate Rule 10b5? (1) Conduct only violates Rule 10b5 if it was manipulative or deceptive. There is no federal fiduciary principle. (m) Reasons the Ct held there was no federal fiduciary principle" (i) Leg history : what was the congressional intent? 1. Congress' purpose for the 1934 Act was to assure full disclosure a. Once full and fair disclosure is made, the fairness of the transaction is a nonissue under federal law. You can sell rotten eggs as long as you tell them it is a rotten egg. This becomes imp later when we talk about how you get around Santa Fe to file fed cause of action. b. Creating a federal cause of action here thus would not serve any of the central purposes of the Act 2. plain text of the statute. (ii) Implied private right of action : 1. Courts generally should not create an implied federal cause of action where the matter is one traditionally relegated to state law. it intrudes 10b5 into state corporate law. 2. Here the conduct in question was a breach of fiduciary duty, a matter clearly the subject of state corporate law. White says there shouldn't be a federal 112 corporate fiduciary principle. 3. File this away to when we discuss insider trading law. (iii) Federalism: Where does Santa Fe leave us? 1. Allowing Rule 10b5 to reach reach "transactions which constitute no more than internal corporate mismanagement" would displace state law. 2. Corporations are creatures of state law. 3. Courts should not use Rule 10b5 to preempt state corporate law. 4. The federal state balance: a. States: they get LL, SH liability, Corporate gov, director/ officer fiduciary duties, SH rights/duties (the first 21 assns in our class) Santa Fe draws a b. Federal: they handle periodic disclosure by public companies, and fraud bright line between "in connection with" security transactions. But that is as far as their job state and federal action goes. c. Side note: Santa fe is the unusual case. They stuck it to the minority, and they told them they were going to stick it to them. It may not matter as much these days, since DE seems to be pro SH these days. (2) Santa Fe says that a 10b5 claim arises only out of deception or manipulation. (n) Was there manipulation or deception ? (i) Was there deception? Deception requires misrepresentation or omission. Since Ps in Santa Fe got full disclosure, there was no misrepresentation or omission. No deception 1. There was no omission or misstatement in merger documentation. if there is full a. Ps don't claim they were lied to, they claim they're was a breach of duty disclosure since the transaction was unfair. 2. Ct says that a breach of duty w/o fraud is not a violation of Rule 10b5. (ii) was there manipulation? 1. Manipulation arises from conduct intended to mislead investors by artificially affecting market activity. Practices that materially affect Market activity. a. Justice White defines manipulation as a "term of art." 2. Examples: a. Wash sales : Manipulator enters a purchase order and a sale order at the same time through the same stockbroker. Ownership of the stock does Unfairly paying not change but creates the false appearance of active trading in a security. to low price is Notice that manipulation of this sort involves deception. The market not can't know that you are dealing with wash orders; the mkt thinks they are manipulation diff people--Manipulation has to involve this deception. Unfairly paying Evading Santa Fe: most Cts too low a price is not manipulation in this sense. Substantive see Santa Fe as something to b. Matched Sales : Manipulator enters a purchase order with one stockbroker fairness is evade rather than follow. and a sale order, at the same time and at the same price, with a different Some Cts allow 10b5 action broker. Sometimes involves multiple manipulators acting together (so where the nondisclosure led called "cross sales"). Matched purchase and sale transactions create the Ps to forgo pursuing an false appearance of active trading. available state remedy. 1. allows P to evade SF by 4) Evading Santa Fe : there may be some gray area. pointing to nondisclosure a) or misrep even though the May want to get around Santa Fe b/c you may want to get into fed Ct. Lower Cts treat Santa Fe as something to be evaded rather than something to be followed. bulk of their case goes to a breach if fiduciary duty. (iii) Hypo: 2. lower Cts impose liability for failing to disclose information relevant not 113 In omission cases, you also need a duty to 1. Acme makes a very popular product. Acme's annual report makes a great many glowing references to the product. Acme routinely ascribes Company X's stock market success to the success of the product. Unbeknownst to the shareholders, however, Acme's scientists have established that the product is dangerous and defective. Acme's management continues to manufacture the product. The defects are eventually discovered, massive liability suits ensue, the company goes bankrupt. Shareholders sue management. 2. State law claim a. Care b. This will be a derivative suit, so into was demand excused ect. c. Then they have to battle the BJR. 3. Who wins? a. BJR b. Derivative (iv) Perhaps the SH still want to sue, but under 10b5: 1. Why under 10b5? Worldwide service, can sue outside of DE and want to avoid the BJR and want to avoid derivative suit. But the problem with 10b5 claim is that, a factor in determining if Congress wanted to make this is if .... Gotta find a hook. (o) Where is the deception manipulation or in this case? 1. Allege that during the relevant time period (i.e., before public awareness of the risks posed by the product), management knew or recklessly disregarded the fact that the product was defective and failed to disclose those facts 2. The fact that they say that the product is very successful, while they don't state that the product doesn't work. That is the disclosure violation. (p) In order for the 10b5 claim to work, this claim is an omission claim, what do we need? (i) 1) Materiality, 2) Nexus, 3) Causation, 4) Reliance, 5) Scienter. (ii) But since this is an omission case, also need affirmative duty to disclose 1. What do we say is the duty to disclose here? a. You have omitted to state a fact that is necessary in light of the statements you made. By saying that the product was a success, they committed fraud by not disclosing that it didn't work. 114 INSIDER TRADING: STATE LAW Assn 27 1) Overview : Insider trading has evolved over time, so many of the cases we read first are the history of it. Therefore, with these next few assignments, be careful to identify the distinction b/t what the law was and what the law is today. a) Goodwin v. Agassiz i) Facts : Ds are directors and senior officers of Cliff Mining. They get info of a geologist's theory that there were substantial copper in Michigan. Through a related company they began Note: there was securing mineral rights potions on the relevant tracks of land. Corporate opportunity issue? also a corporate (1) Insiders trade : opportunity issue (a) Ds started buying Cliff Mining shares on the Boston Stock Exchange. that we ignored (b) P was a form SH who sold his shares contemporaneously. (i) P's shares apparently had been bought by Ds, although neither side knew of the other's identity. (2) P sues : "If the geologist's theory had been disclosed, I would not have sold." ii) Issue : Whether the defendants had a duty to disclose the theory before trading in the firm's securities. iii) Evolution of State Common Law: (1) This was in 1933 it is still a Q of state corporate law (same year as Securities Act of 1933). (2) "The doctrine that officers and directors are trustees of the stockholders . . . does not extend to their private dealings with stockholders or others, though in such dealings they take advantage of knowledge gained through their official position" 21 The American and English Encyclopedia of Law 898 (2d ed. 1902) (a) This was what was known as the "majority rule" insiders had no obligation to disclose when dealing w/a SH. This was uniformly the rule in 1902. (i) In 1909, things began to change: SCt decided a case Strong v. Repite Woman Special who was a sizeable SH was approached by someone to sell her stocks. She sold. circumstances rule: She later discovered that the person who bought her stocks was a straw man Where a director someone acting on behalf of another he was acting on behalf of a minority SH, seeks out a SH, who had just found out about a large gov't K. If she had known about the K, she "transaction will be wouldn't have sole. Similarly, if she had known who was approaching her, she closely scrutinized might have been suspicious. She sues in the Philippines. She appeals to US SCt and relief may be which adopted the special circumstances rule duty to disclose under special granted in approp circumstances: 1. What are special circumstances? a. Highly material info b. Concealment of identity or other active fraud c. Especially vulnerable P 2. : P had all 3, so SCt said there were special circumstances, and a duty to Held disclose in this case. (ii) Minority rule: Insiders have a duty of full disclosure of material info whenever they purchase shares from SHs. (3) If the CL rules applied to Goodwin, we would have asked if they were a minority, majority, or special circumstances state. 115 (a) By the time Goodwin was decided, the majority was no longer the majority states that followed either special circumstances or minority rule were greater, but the names still stuck. The trend in the 20s and 30s was to require disclosure at least where there were special circumstances, if not in all cases. (b) However, the CL rules were all cases of facetoface transactions. Goodwin was one of the first cases to involve a transaction that was effected on the stock exchange. (i) Does Goodwin suggest which rule MA would follow in face to face transactions? 1. Special circumstances: "where a director personally seeks out a SH, the transaction will be specially scrutinized." a. Neither majority or minority would scrutinize it, so we are somewhere in the middle special circumstances. (ii) But, this is a stock exchange case. With stock exchange transactions, you don't know who's on the other side of the deal. 1. B/c you don't know who's on the other side of the transaction, this puts the director in a difficult position. BUT, there are other things the director can do: a. Disclose the info to the public or b. Not buy or sell stock abstain. c. SO, it wouldn't necessarily put the directors in a difficult position. (c) What is this case saying then? (i) This was a theory nobody knew that the geologists theory was correct. It was just a hope/expectation it hadn't passed the nebulous stage. This information wasn't material! 1. You don't have any of the 3 elements to the special circumstances test: not material, concealment of identity (but this is for all, and you can't do anything about that), and not a vulnerable P. Therefore, this is really a special circumstances case. BUT, there are things that suggest that you can't have a special circumstances case on the stock market: (ii) : Ds had no duty to disclose before trading and are, therefore, not liable. Held (iii) Rationale? 1. Duty ran to the corporation rather than to its SHs 2. info was highly speculative (materiality) 3. transaction took place on the open securities market. (d) Why a different rule for exchange transactions? (i) General disclosure (ii) Require disclosure only of material information (e) Review: Would theory be material under Basic ? (i) Basic's test for materiality: a "highly factdependent `probability/magnitude' balancing approach" 1. 1) probability: look to "indicia of interest in the transaction at the highest corporate levels." Evidence such as "board resolution, instructions to investment bankers and actual negotiations between principals and intermediaries may show indicia of interest" 2) magnitude: mergers are important events. Magnitude has a relative and an absolute component. 2. this test is very subjective, the Ct never tells us how high probability or magnitude is required. b) Diamond v. Oreamuno 116 Facts : MAI's earnings were plummeting. Ds were officers of MAI and used their advance knowledge of earnings decline to bail out of the stock. Once the decline in earnings was made public, the shares market price dropped by over half. (1) : In Goodwin, Ds made a profit by selling early. Here, Ds didn't make a profit, but Note they avoided a loss. Notice, however, that this distinction is irrelevant using inside info to avoid a loss can send you to jail or require you to pay damages just as much as using inside info to make a profit can. ii) This is a SH derivative suit. (1) Why didn't we get into demand req, etc.? (a) It is b/c of procedural posture of case it was an appeal from a denial of a motion to dismiss for failure to state a claim, so they didn't really reach the demand stage. (i) If they had reached that stage, would this have been a demand excused or a demand required case? 1. Demand will probably be req'd b/c there is no reason to think a majority of the BOD would be conflicted in making the decision of whether to go after these directors (this case only involved 2 directors not the majority). (2) Ds conceded conduct was wrong. iii) : Corporate fiduciaries may not use confidential info entrusted to them by firm for personal Held profit. (1) This is true even if Ds avoided loss rather than made a profit. (2) Don't need proof that corporation was injured (a) This is a loyalty case, not a care case. You don't need proof of injury in order to bring a loyalty case. (b) Remedy : Constructive trust for corp on the amt of loss that you avoided. (3) We know that they are fiduciaries of the corporate entity. Suppose SHs who bought the stock brought suit against the D. Are the director's fiduciaries at the time they sell to these SHs? In the previous case, there was not a problem since it was directors and officers buying from a current SH. Here, they would not become SHs until after the transaction happened. (a) Insipient SH doctrine (Learned Hand): When a fiduciary deals w/someone, it isn't an arm's length transaction. The directors and officers owe the duty when the transaction involves someone becoming a SH. c) Diamond and Brophy i) Brophy v. Cities Services (1) Facts : EE knew co was about to repurchase its own stock. EE bought stock on market and then resold to corp at a higher price. (2) : Liable. Held (3) How is this case different from Diamond ? (a) There is actually, at least potentially, a monetary corp injury in Brophy he is competing w/the corp, which could drive stock prices up and cause the corp monetary injury. (b) In Diamond, it is hard to see how there is any injury to the corp. However, this is irrelevant b/c the corp doesn't need to be injured. (i) The court said there was potentially injury though: 1. The co's name would be dragged through the mud, this could hurt their reputation and cause them to loose market share. 117 i) a. This is a weak argument nobody notices: who's going to remember? Who knows the name of the president? 118 a) b) 1) The word insider doesn't appear in the text! 2) not self executing: gives SEC authority, but SEC must 1st use c) d) ORIGINS OF THE FEDERAL INSIDER TRADING PROHIBITION Assn 28 1) Overview: This is an area of law that has been federalized. Be careful that what we are learning is the history of the law, not all of this is current law. Rule 10b5 was promulgated in early 1940s but was never used significantly till 1961, where the Ct held something was inside trading. Katie Roberts was the first time the Ct said that something was insider trading. 2) Rule 10b5: Text: i) It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, (1) (a) To employ any device, scheme, or artifice to defraud, (2) (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (3) (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, ii) in connection with the purchase or sale of any security. Where does the phrase insider trading come from? i) There are catch all phrases in the rule that could capture insider tradings: ii) Omission prohibition: (1) insider trading liability is premised on an omission of material fact. (2) Problem: Liability for omission can only be imposed where D had a duty to disclose. (a) Remember that there is only liability when there is duty to speak, so the Q becomes when the insider trades, do they have duty to speak? Remember state law says no, but in Texas Gulf the Ct begins to put together a basis of finding that there is a duty to speak and insiders cant be silent when they trade. (b) Whence comes the insiders duty to speak? 3) The birth of insider trading law: e) Texas Gulf Sulpher: i) Facts: (1) Late 1950s: TGS begins exploring eastern Canada (2) 10/2930/63: Exploratory hole k551 drilled (a) Visual assay promising Be careful: (3) 11/12: Based on core sample results, TGS begins land acquisition not all of (a) President commands secrecy TGS is still (4) 11/12/63: TGS insiders begin acquiring shares good law!!! (5) 3/27/64: Land acquisition complete (6) 4/11: Unauthorized press reports (7) 4/12: Misleading press release issued (8) 4/16: Official statement made at 10 am (9) 4/16: News appeared on Dow Jones ticker tape at 10:54 am ii) Issue : 119 (1) Liability of the corporate defendant. Why was the corporate D charged with violating rule 10b5? What was the D charged with? (a) The corporate defendant: (i) was not a purchaser or seller: TGS 1. Status as such is only relevant to private party plaintiff standing to sue (ii) "In connection with" 1. Satisfied if the press release "would cause reasonable investors to rely thereon" Disclose or Abstain and "cause [such investors] to purchase or sell a corporation's securities." (b) Legal rule re insider trading? (i) Where an insider has material nonpublic information the insider must either disclose such information before trading or abstain from trading until the information has been disclosed. (c) Who does Congress think the laws were intended to reach? (i) Hypo 1 : What if we had a janitor cleaning the officer where the director works? What about the plain view rule? If its in plain view you can read it. what if the How would the gov. catch janitor, as EE of the co, is he covered by the rule? inside traders? (ii) Hypo 2: farmer is working and guy pulls up and says he represents TGS and that SEC has a prog called they are interested in acquiring mineral rights of the land. Then the farmer goes stock watch that monitors down to the feed store and finds out that the guy bought the mineral rights to lots of stock trading practices over other companies, an then the farmer goes and buys a lot of Texas Gulf stock. Is the time. If the company farmer a proper Defendant? sees a pattern, a spike in (iii) Answer to both hypos-- are they liable under ? TGS trading, they flag for 1. Probably , since TGS said that insider trading prohibition applies to "anyone in human investigation. possession of material inside info." Easier to catch the Janitor, 2. The prohibition applies to anyone who has "access, directly or indirectly, to than the professional investor, since a pattern confidential information if they know the information is unavailable to the will be easier to spot since investing public. so the inquiry will be factual turning on the state of mind. a janitor makes less trades. This is the part of that is no longer good law. TGS Ex: Bosky got caught only (d) Rationale for rule: b/c Levine ratted him out. 1. The federal insider trading prohibition was intended to assure that "all Bosky made so many investors trading on impersonal exchanges have relatively equal access to material information" 2. The Ct wants all "members of the investing public to be subject to identical market risks." a. Ct seems to imply level playing field. If that's what congress intended, how far down the ladder do we go? Who must disclose or abstain under TGS? ANYONE, who has material information. b. See pg 464: Insiders are bound by this rule, but it relates to "anyone in possession of material inside information must either disclose it to the investing public, or ... must abstain from trading." i. This seems to imply that this applies to the janitor and the farmer. ii. The Ct cant really mean "anyone" literally. There will always be info asymmetries. 120 iii. So broadly speaking the Ct seems to imply that if you have material non public info, can't trade or must disclose if you trade. disclose or abstain. (e) Do insiders really have an option to disclose? (i) Did TGS have a duty to disclose this information prior to April 16, 1964? Realistically: the disclose or abstain 1. Footnote 12: "We don't suggest that material facts must be disclosed rule is one of immediately; the timing of disclosure is a matter for the business jmt of the abstention, since officers".... "where a corporate purpose is thus served by withholding the news disclosure is of a material fact, officers ...must not give confidential information out to the usually not an public." (ii) If TGS wanted the information kept confidential, did insiders have a right to disclose it? Logically, they shouldn't have the right to disclose. See Restatement 395. 1. Agency Restatement 395 "[u]nless otherwise agreed, an agent is subject to a duty to the principal not to use or to communicate information confidentially given him by the principal or acquired by him during the course of or on account of his agency or in violation of his duties as agent, in competition with or to the injury of the principal . . . ." a. So this means that this is really a rule of abstention. Tells them that they cant trade, since realistically, they cant disclose. b. Disclosure by an insider who wishes to trade is only feasible if there is no legitimate corporate purpose for maintaining secrecy. (2) Who is an insider ? (a) Exchange Act 16(b): Officers, directors, and 10% shareholders (b) Rule 10b5: (i) TGS director Coates? (ii) TGS secretary Crawford? (iii) TGS geologist Drake? (iv) Janitor hypo? (v) Farmer hypo? (3) When may insiders trade? (a) ? Rule (i) Insiders must wait until the information is effectively disclosed in a manner sufficient to insure its availability to the investing public (ii) When does information become public? 1. It becomes public when its disseminated over the market over a medium of When does broad circulation. At that time, the broad tape; but today the internet, or information become CNBC would be adequate. At that point the info goes from private to public. public? a. What about the cases when there isn't a bright line moment when the info is announced? Well in those cases, you are taking your chances. b. How can you probe that the market knew this information? Pull in the market maker or the specialist in the stock, if they knew it probably everyone did. M (4)oWhat about Materiality? d(a) The Ct defines materiality as whether a "reasonable person would attach importance to 121 the information." e r n te (i) Re contingent facts: probability/magnitude balancing (Basic) (ii) Hypo: Now say you have a big area where you think there might be ore. Anomalies are normal since there might be some geological formation or something. So it doesn't mean that there is absolutely ore. So only one test sample doesn't tell you enough till you have samples from other areas. So the question is: is the one core test sample material between November and March? 1. One materiality factor is the company response. They stopped taking samples and told everyone to keep it secret. They more importantly, started "putting its money where its mouth is." So the company started spending money. Factors for 2. Market response: There is also bootstrapping. materiality 3. Remember that there are lots of insiders trading. 4. Industry practice is a key fact suggesting materiality: There was a broker who testified that if you have one positive core sample was a buy signal. That was the industry practice. f) Analysis Questions: (470) i) Eve is SH in Max Corp, a mining co with claims in Wyoming. Max Corp shares are traded Q 3: on the NYSE. While in Wy on vacation, she overheard a conversation b/n two Max Corp geologists and concluded that Max Corp discovered ore. She spent time looking around and confirmed it. she then approached her friend Bob and asked to buy his shares. Is Bob legally entitled to recover from Eve? (1) Liability at state common law? No b/c she has no fiduciary duty to Bob. She isn't a controlling SH or a director or officer. (2) Liability under Rule 10b5 ? well the info is material, it is non public, so YES. ii) Q 4a : Same facts about Max Corp. Carlos is CEO of corp and learned about the ore b/c of his position in the company. He called his broker to buy 1,000 shares at the market price of $10/share. Then he sold the shares at $18 for a profit. (1) Liability as state common law? no liability to the SH. As liability to the SH to whom he traded, this is Goodwin, and there is no liability. (2) Liability under Rule 10b5? the question is, is Carlos clearly covered by the rule? Yes, Carlos clearly is. So there clearly is liability. But, who was hurt by what the TX insiders did? iii) Q 4b : Suppose that the shares of Max Corp are not publicly traded. T here are 50 SH and only 2 or 3 purchases and sales each year. Carlos knew Wilma needed money and she sold. (1) Liability at common law? NO ? Liability under Rule 10b5? YES? 122 INSIDER TRADING: WHY DO WE CARE? Assn 29 1) Overview: a) Classical insider trading: where you have a director on an officer of EE of corporation who owes a fiduciary duty to both the entity and to individual investors, and that director trades w. an investor based on material non pub info. b) Outsider insider trading: (misappropriation): EE of investment bank which acts as investor of client that is planning a takeover but w/a target corp. EE has no connection with target corporation or investor he trades with. EE owes fid duty to investment bank, not to the person w whom he is trading. 2) The insider trading debate: a) Why is insider trading illegal? i) Does economic analysis suggest a theory that has both justificatory and explanatory power? ii) Or should we just repeal the whole thing? iii) Different arguments for and against insider trading: In the literature, there is deregulatory argument that says lets get rid of the whole thing and make the whole thing legal. (1) Regulatory arguments : (a) Fairness: (b) Property rights (2) Deregulatory Arguments : (a) Market Efficiency (b) Executive Compensation iv) Deregulatory args Manne's arg for deregulation: : (1) Market Efficiency: (a) Strongest arg : based on ECMH. We know the strong form of the ECMH is false, therefore, the mkt can't adjust prices when there is nonmaterial information. So when there is material, non public info, there will be distortion, but if there is insider trading, insider trading might have the tendency to move the stock price in the "right" direction. Society and firms benefit from correct pricing of securities. See diagram: Immediate Disclosure: Not going to happen--the company has legitimate interest in deferred disclosure $ Deferred Disclosure, with insider trading: moves the stock price in the right direction Deferred disclosure, no insider trading: Results in sustained pricing Time 123 (b) What Manne pointed out is that the yellow line is not going to happen since the company has legitimate interest in deferred disclosure. Also, we don't want to require Insider trading immediate disclosure it would discourage innovation and discovery by allowing free makes the riding behavior. Henry argued that if we care about stock mkt pricing accurately mkt act as if reflecting the value of the company, we would allow insider trading, since it will move it were the stock price in the correct direction since as insiders move based on their Strong form knowledge, definitely informed trading happens and the volume of stock goes up and efficient even as result the effect is that the price goes up too. So the fx of insider trading is to have mkt behave as if it were strong form efficient, even if it is not. This is kind of what happed in TGS, the price moved in the correct direction during insider trading, and if the insider trading can be credited with this, than Henry has a good point. (i) Limitations of Mannes Theory-- Does ECMH support Manne's Theory? Most : insider trading effects tend to be slow: 1. insider trading tends not to have impact on stock price unless the trading volume is large. a. This is b/c a security represents only a particular combo of expected return and systematic risk, for which there are vast substitutes. So the supply/demand effect of a relatively small amt of insider trades should not have a significant price effect. 2. derivatively informed trading takes a long time to play out--the broker has to make decisions, have to be observed, longer process to move price in right direction. It takes longer for derivatively informed trading to play out than insider trading. The market cant react as quick as insiders. (2) Executive Compensation thesis: Carlton & Fischel (a) Manne's second argument is that insider trading is efficient executive compensation invoke the Coase scheme. Creates incentives for manager to innovate. If mkt develops an innovative Theorem as a program, insider trading allows them to capture some of that value. refinement of Manne's (i) This is essentially the argument for stock options. But insider trading is arg: if insider trading fundamentally different than stock option trading. were so bad, firms (b) Problems with the Compensation thesis: would outlaw it by (i) Return to insider limited by ex ante wealth rather than value of innovation: private contract. Also 1. There is no correlation b/n the value of the innovation to the corp entity and the amt of profit the insider can make off trading. There is no guarantee there will be correlation b/n the value to the corporation and the reward. The size of the reward will really relate to their won wealth and ability to buy stock. (ii) Difficulty restricting insider trading to innovative entrepreneurs: 1. There will be free riders. Lack of linkage b/n reward and contribution (iii) Trading on bad news : 1. What interest do we have on incentivising trading on bad news. Remember the diamond case, there is no new value, innovation, but they had inventice to insider trade. No justification for this. (iv) Risk aversion by management : 1. Managers are risk averse. They know how to do their jobs specific to this firm. If they change jobs they lose this firm specific human capital. In the mngt 124 case, lots of mgt wealth is tied up in this particular firm, so they are risk averse, and they are non diversified in the stock of their ERs. Managers are even more risk averse than investors. Would a manager really trade a guaranteed bonus for right to insider trade? Prob not. The risk averse managers suggest insider trading compensation not so efficient. v) Pro regulatory args : (1) Fairness: Equality of information. (a) The purpose is to ensure nobody in mkt can profit from info asymmetries. The prob w. this arg is how far do we want to push it? do we really want the farmer who infers something to do to jail? If the fairness is the goal, and fairness is equal access to info, this bumps up against certainty, avoiding vague laws, ect. Prof doesn't like this. (i) This definition must be rejected in light of Chiarella's rejection of the TGS equal access standard. (ii) since fairness arguments collapse (since often hard to show SH injury), it is better to make proreg args based on economics. (2) SH injury : The SH will allege injury in two ways: 1) that they sold at the wrong price, and 2) that they were induced to make a bad sale or purchase. (a) Sold at the wrong price: i.e. they sold for $10, when they could have sold for $15 had they knew the information. (i) The investors arg is flawed : it is purely fortuitous that the insider was on the other side of the transaction. The fain corresponding to the SHs loss is reaped not just by insiders, but by all contemporaneous purchasers whether they had access to the undisclosed info or not. 1. Sure the investor might not have sold if he had the same info as the insider, but even so, the rules governing insider trading are not the source of his problem. 2. On an impersonal stock exchange, neither party knows the identity of the person with whom he is trading. There is no way to tell you are selling to an insider. Thus, the seller has made an indep decision to sell w/ knowing that an insider is buying; if the insider where not buying, the seller would sell anyway. It is thus, the nondisclosure that causes the harm, rather than the mere fact of trading. 3. The price increase might have induced the seller to enter the market. Yes, the insider traded by buying at that price, but the SH who sold to the insider was better off too since the insider trading increased the price of the stock. (b) Induced: Insider trading induced SH to make poorly advised transactions: (i) Response : its doubtful that insider trading creates the price effects necessary to induce SH trading. While derivatively informed trading can affect price, it is slow and sporadic, so price or volume changes resulting from insider trading will only rarely be of sufficient magnitude to induce trading. 1. many transactions would have taken place anyway since investors would have traded to get a price closer to the true price (thanks to insider trading). (ii) People will still play rigged games : Bainbridge doest buy the arg that people wont participate in a rigged market. 1. Japan doesn't prohibit insider trading, and only enforced it recently, the J Ex: stock market is one of the most liquid in the world and insider trading was 125 This is the only explanation for insider trading prohibition that holds up for rampant but investors kept investing. The investor class knows there is IT. people play rigged games all the time. (3) Property Rights arg : (a) Two ways of creating prop rights in information: 1) Allow the owner to enter into transactions w/o disclosing the info (Coke formula example.) or 2) Prohibit others from using the information (this is the one we care about). (i) Example : patents. To get patent application, have to tell the gov secret, but the gov gives monopoly to use invention for while. Once patent expires anyone can market that product. (ii) One way of thinking about insider trading is this way. Prohibiting others from using the info. Recall Diamond case that said the information that you trade belongs to the corporation. (b) Property rights analysis : (i) Where public policy argues for giving someone a property right, but the costs of enforcing such a right would be excessive, the state often uses its regulatory powers as a substitute for creating private property rights. Insider trading poses just such a situation. Example: he owns land with deer, that is too big to fence. Hunters trespass, he doesn't want them to. He could sue them for trespass. Same thing with insider trading. Could sue and say that someone converted my information, but how do we catch them? 1. Private enforcement of the insider trading laws is rare and usually parasitic on public enforcement proceedings. 2. The very nature of insider trading arguably makes public regulation essential precisely because private enforcement is almost impossible. (ii) Just like game laws. This is the state using its regulatory apparatus to enforce property rights. 1. The rationale for prohibiting insider trading is precisely the same as that for prohibiting patent infringement or theft of trade secrets; i.e.: a. Protecting the economic incentive to produce socially valuable information. b. A property right in information should be created when necessary to prevent conduct by which someone other than the developer of socially valuable information appropriates its value before the developer can recoup his sunk costs. 2. Rat trap ex: Once you start duplicating the trap, those costs are sunk costs. The prob with sunk costs is that you should ignore them. The lesson of sunk costs is if you don't want to lose them, don't make them in the first place. If you don't want someone to copy from you, you don't want to invent since don't want someone to steal it. if we want better mouse traps have to insure they can make profit off it, by giving patent. We incentives people to invest in new ideas. a. We do the same things with insider trading. (iii) Assigning the property rights: why does the corporation have the property rights instead of the individual? 1. Corporation : delay, leaks, perverse incentives re bad news. 2. Individual: not a sound compensation scheme 126 Insider trading is really about property rights and is a species of the duty of loyalty. 3. There are lots of ways insider trading could impact the value to the corporation. So between the corp and the individual, prof thinks the corp should have prop right in the information that would prohibit insider trading. this is Profs favorite argument. a. This arg is imp since the Sup Ct has premised insider trading liability on a fiduciary concept. i. Yes its security law, but they make it look like fiduciary duty. The Prof thinks this is funny since this is what it would look like if it was about property rights. Its illegal to use trade secret that you learn by stealing or by breach of fiduciary duty. This is essentially the same as insider trading. This means that insider trading is really about property rights and is a species of the duty of loyalty. (iv) Ways that insider trading can hurt the corporation: 1. Delay: create incentives for managers to delay the transmission if info to superiors. 2. interference with corporate plans : trading during the planning stage of acquisition is classic example of how insider trading might adversely interfere with corp plans. Make the takeover more expensive. Also risk of premature disclosure. Trigger other bids. 3. legal liability: Corporations have liability when their agents inside trade. 20(a) of SEA. 127 THE MODERN DISCLOSE OR ABSTAIN RULE Assn 30 1) Overview: a) There are essentially 2 options to regulate insider trading: i) State common law: think of it as self dealing so insider trading becomes part of the same problem as corporate opp, and interested corporate opportunity. It was the use of an asset of the corporation to make a personal profit. Violations of fiduciary duties. ii) Other alt: treat it as a problem of securities fraud . You have in connection with securities transaction an information asymmetry. So they must either disclose or abstain. On one hand, you are using asset that belongs to the company for your gain. On the other hand, if the corp goes into the mkt, its clear that as sec matter, the corp has duty to disclose, so why shouldn't insider? So the Q is not self evident which is the correct mode of reg--we have to consider broader Qs. (1) this is the path that Cady Roberts and TGS set insider trading prohibition down. (2) What is the purpose of federal securities laws? Can we reconcile Santa Fe Basic and ? (3) Well recent case suggests this is a securities problem. (a) This has effects: (i) Federalization (ii) Public, rather than private endorsement would be the norm. (iii) Legal theory moves from fiduciary duty to securities fraud. (4) The prob we ran into in the 1980s was the expansion of insider trading liability to meet the changing nature of insider trading. classical insider was easier to justify regulating since the insider had a fiduciary duty to the corporation and they made a trade. The problem arose when cases like Chiarella emerged. (a) Chiarella (handout) (i) if you know in advance that a corp takeover is coming up you can make lot of profit. Buy low and sell high. (ii) Pandick used code names to prepare tender offers. Chiarella broke the code since the code names had to be the same length as the real names or it would throw off pagination. The prob was that Chiarella didn't have a relationship with that company whose code it broke. Chiarella 1. So, one what theory does Chiarella have a duty to disclose? The 2nd circuit said anyone who has regular access to mkt information has a duty to disclose or abstain from trading. Recall the farmer hypo from yesterday. Farmer wouldn't have liability under the 2nd circ. Test. (iii) Market v Inside Information: 1. Inside information originates within the firm and relates to the firm's earning power or assets. a. Earnings, products, assets, plans and the like 2. Market information is everything else. Originates from sources other than the issuer and involves events or circumstances concerning or affecting the price or Markey for the issuers securities and doesn't concern the issuers assets or Under Chiarella and earning power. Dirks, liability for a. Chiarella was trading on mkt information: he traded based on plans of a insider trading is diff company to acquire a diff corporation. premised on a duty to disclose arising from a relationship of trust and confidence between parties to 128 b. The distinction b/n mkt and inside info was another way you could limit the TGS rule. There was some believe that the TGS rule only applied to inside information. c. The modern insider trading liability can be imposed for those who possess either type. (iv) Basis of prohibition: 1. What was the policy upon which TGS based the disclose or abstain rule? a. That all investors should have equal information 2. Does equality of access survive Chiarella Dirks and ? No. a. "A duty to disclose ... does not arise from the mere possession of nonpublic market information" b. so possession of non public information is not enough. 3. Under Chiarella Dirks and , when does a duty to disclose arise? a. Under them, Rule 10b5 liability for insider trading is now premised on a duty to disclose arising from a relationship of trust and confidence between parties to the transaction (v) To whom did Chiarella owe a duty? Recall he didn't have a relationship to the investors, so he walks. 1. Why is this the rule? Is Powell's analysis any more persuasive than was ? TGS a. Where does Powell get the idea that a breach of fiduciary duty is required? he looked at the Cady Roberts case. Pg 475, "in Cady Roberts, the SEC recognized that the law in some jurisdictions imposes on corporate insiders an affirmative duty to disclose " i. So should this bump up against Santa Fe ? Powell acknowledges this by saying "some jurisdictions." ii. There was nothing in the federal fiduciary law that suggests this. The Sup Ct made it up essentially. b. Did Chiarella steal the information? (vi) Analysis if the Chiarella holding: 1. in reversing Chiarella, the SupCt rejected the notion that 10b was intended to assure all investors equal access to information. 2. the Ct said it couldn't affirm the conviction w/o recognizing a general duty b/n all participants in market transactions to forgo trades based on material nonpublic info, and it refused to impose such a duty. 3. Chiarella makes clear that the disclose or abstain rule is not triggered merely b/c the trader possesses material nonpublic information. a. Where a 10b5 action is based on nondisclosure, "there can be no fraud absent a duty not to speak" and no such duty arises from the mere possession of nonpublic information. Instead, the disclose or abstain theory of liability for insider trading was premised on the inside trader subject to duty to disclose when the party on the other side of the transaction has a relationship of trust and confidence. 4. Chiarella radically limited the scope of TGS b) Who is an insider post Chiralla and Dirks? i) Exchange Act 16(b): Officers, directors, and 10% shareholders 129 ii) Rule 10b5: TGS director Coates? yes TGS secretary Crawford? yes TGS geologist Drake? maybe Janitor hypo? maybe. Is a janitor someone who you place your trust? No, but on the other hand, the janitor is a EE of the corp, so they are an agent. So if being an agent is enough the janitor is enough. (5) Farmer hypo? No. he is not an agent, not a fiduciary, and not someone whom investors would place their trust and confidence? No. (a) who someone w/ whom you place your trust and confidence? (i) in deciding if someone is a fiduciary, you ask if someone who is a beneficiary has placed your trust and confidence. So trust and confidence is synonym with fiduciary. iii) Who is an insider : Part II: Constructive Insiders : (1) based hypo: What if you are atty who is outside legal counsel for TGS? Pres of TGS TGS discloses find to Lorraine in Feb 1964. Lorraine trades in TGS stock. Liability? Yes. Due to constructive insider. (a) Dirks established a category of "constructive insiders" (i) When does someone become a constructive insider ? 1. FN 14: where they (1) obtain material nonpublic information from the issuer with (2) an expectation on the part of the corporation that the outsider will keep the disclosed information confidential and (3) the relationship at least implies such a duty (2) Hypo: Acme Mining and XYZ Corp are negotiating merger. During the negotiations, material nonpublic information about Acme is disclosed to XYZ. The merger negotiations fail. XYZ then begins buying stock on the open market in anticipation of making a hostile takeover bid for Acme (a) Is XYZ a constructive insider of ACME? They received confidential information. So you think ACME expected them to give the information confidential? Yes. Does the relationship at lease imply a duty to respect that expectation? Yes. Read fn 22 (479( to suggest that arms length relationship doesn't imply any obligation to respect the confidentiality of the information. (i) Disclosure didn't impose fiduciary duties on the recipient of insider info. "it was assumed the firm knew the info was confidential, but that it had been received in arms length negotiations. In the absence of fiduciary relationship, no tippee liability..." c) Tipping: Dirks i) We would all love to get insider info. The problem in Dirks is that the tippee isn't someone who has a fiduciary relationship; he is stranger. ii) What about tipping chains? (1) Tippee tips to tippee who tips to another tippee. What happened in Dirks is that in most tipping chains the tippees all trade, but in Dirks, Dirks doesn't trade, but he tipped one of his clients who then trades. He is then potentially liable as a tippee of a tipper who then tips. (a) Chain: tipper tells tippee #1, who tells tippee #2, who trades. Tippee #2 can be liable, so long as se knew or had reason to know that the ultimate source of the info had breached his fiduciary duties by disclosing. 130 (1) (2) (3) (4) iii) Holding re tipping? (1) In general, the tippee's liability is derivative of the tipper's, "arising from his role as a participant after the fact in the insider's breach of a fiduciary duty." this is derivative liability (2) A tippee therefore can be held liable only when: (a) 1) The tipper breached a fiduciary duty by disclosing information to the tippee, and 2) The tippee knows or has reason to know of the breach of duty (3) So we would have to prove that Dirks knew or should have known about the breach. What the Sup Ct makes clears is that liab under 10b5 can come from tipping or insider trading. The fact that he tips w/o trading doesn't matter. But in order for the second tipper in a tipping chain, they also have to know about the breach, and in most tipping chains at some point the chain breaks since the link becomes too attenuated. (4) Is the mere fact of a tip a sufficient breach? (A) NO the sup ct has said that not all tips are illegal. In order for a tip to be illegal, looking at objective criteria, the Cts must determine whether the insider personally will benefit, directly, or indirectly, from his disclosure. (i) What Dirks proscribes is not merely a breach of confidentiality by the insider, but rather the breach of a fiduciary duty of loyalty to refrain from profiting on info entrusted to the tipper. 1. Test for illegality is pecuniary gain; enhanced reputation that will translate into future profits or gifts. (ii) Example : Barry Switzer case. D argued that at most he was negligent in talking about it in public or something. Case threw out at first. The Ct will look at whether the tipper got a benefit from the tip. If they did, then the tipper is liable. Notice there can be a tipper liable without a tippee being liable since the tippee may not know that there is a breach. (5) Analysis of Dirks (a) Under TGS Dirks would easily be liable, but under Chiarella, the tipping prob was more complex since neither Dirks or any of his customers were agents, officers or directors of Equity Funding. Nor did they have any other relationship of trust and confidence with those with whom they traded. (b) : a tippee's liability is derivative of that of the tipper "arising from the tippees role Rule as a participant after the fact in the insiders breach of a fiduciary duty." A tippee can be liable only when the tipper breached a fiduciary duty by disclosing to the tippee, and the tippee knows or has reasons to know of the breach of duty. iv) Penalties: (1) Administrative hearings against defendants under the SEC's direct regulation (brokers, dealers, etc.) (2) Equitable relief in civil case brought by the SEC: (a) Injunctions; e.g., forbidding violator from being employed in the securities industry (b) Disgorgement of profits (c) Treble money sanction under ITSA (3) Criminal indictment: 20 years jail and up to $5 million fine for individuals and $25.5 million for corporate defendants per count (a) Exchange Act 32 makes it a felony 131 (4) Private suits--rare MISAPPROPRIATION Assn 31 1) Overview: a) Going down the securities fraud path. i) Recall the policy upon which TGS based the disclose or abstain rule: that investors should have equal information. ii) Chiralla: The Sup Ct established that a "duty to disclose didn't arise by the mere possession of nonpub info." Instead they said the "disclose or abstain rule arises due to relationship of trust and confidence." Since Chiarella didn't have a relationship with the investors with whom he traded, there can be no liability. (1) The problem is this left gaping hole in securities law since it meant than in case where someone was working for the bidder, rather than the target, they could legally engage in insider trading. (2) The SEC didn't like this, so they came up with missaprop theory of liability. b) Misappropriation theory and deception: i) O'Hagan. (1) Facts: Dorsey & Whitney was employed by Grand Met. Grand Met wanted to get control of Pillsbury. Pillsbury didn't want to be bought. w/in a law firm engaged in representing a client in a takeover situation, it is generally thought need to limit access to this info: "Erect a Chinese wall" in which the folks who know bout the deal are walled off from others in the firm. Depending on the nature of the deal, the wall can be high in limiting their interaction with the rest of the firm. One issue that arises is that you may not know what the deal is behind the wall, but you know the wall is there and if you can find out what is behind the wall, you can find out what the target is, you can use that to make money. O'Hagan did this. He found out about the deal and the computer noted that he bought lot of that stock. (2) O'Hagan didn't have a relationship of trust and confidence with the investors with whom he traded. He did have a relationship with his firm and his client, but that isn't the necessary fiduciary relationship under the Chiarella rule. (3) Why is it that OHagan is not liable under he disclose or abstain rile as a constructive insider? it's the wrong corporation. The constructive insider says you are insider and fiduciary of the company in whose stock you traded, but O'Hagan doesn't have that. He has no relationship with whose stock he traded. (a) Because he works for the bidder, but traded in target company stock: he therefore is not a constructive insider of the issuer of the securities in which he traded. (4) Missaprop gives liab based on diff relationship of trust and confidence. Grounded on breach of confidence to the source of information. The Sup Ct rejected the misappropriation theory in Chiarella. Why? it hadn't been presented to the jury. In his dissent Burger said you could have breach based on duty to the source of the information. Powell said that doesn't work though and have to have theory like that had so be presented to the jury. So it was a technicality. (a) Side case: (i) "Heard on the Street" column: gossip about the company and it would be in the column. There was a predictable stock market reaction to this column. Never lasted more than day or two since the info was already public, just hadn't been 132 made widespread, and also that there was a supply and demand effect, that Misappropriation theory on deception of the source of the information dummies would read it not realizing that the price had already traded on it and adjusted on it. 1. the person who wrote the column told his lover and then he would tell someone else and pool their money and then profit. 2. The Sup Ct was 4/4 with no precedential value. (5) OHagan Holding : (a) Misappropriation rule : (i) A fiduciary's undisclosed use of information belonging to his principal, without disclosure of such use to the principal, for personal gain constitutes fraud in connection with the purchase or sale of a security and thus violates Rule 10b5. (b) On what basis does Ginsburg uphold misappropriation ? (i) The Ct grounded liability under the misappropriation theory on deception of the source of the information. 1. Recall that 10b5 says it will be unlawful to commit fraud in connection with purchase of security. To extent he committed fraud, how is that "in connection with the transaction"? a fraud on the source of the information is a fraud in connection with the transaction. it is in the vicinity of the transaction but close enough to send someone to jail for 10 years. 2. "a fiduciaries undisclosed, self serving use of a principals info to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that information." so the misappropriation theory satisfies 10(b)s requirement that there be a "deceptive device or contrivance" used "in connection with" a "securities transaction." (c) Questions raised by O'Hagan's holding. (i) : To whom should O'Hagan have made disclosure? Just to D&W? Q4 O'Hagan has to tell both the parties with whom he is a fiduciary. Have to disclose to the source of information. 1. Does O'Hagan have to make a public disclosure to avoid liability? Would it be enough that he discloses to his firm, or Grand Met? 2. why might Grand Met say go ahead? Why might it be in Grand Mets interest for him to buy Pillsbury's stock? More stock in friendly hands before the acquisition going forward. Remember that Grand Met expects Pillsbury to resist, so the more they can get in friendly hands (called wherehousing), it helps the firm. In theory if Grand Met and Dorsey and Whitney said ok, no liability. (ii) Q6: Brazen misappropriation : what if O Hagan were a brazen misappropriate and tells them he is going to do it anyway. Liable? No. 1. this is how Ginsburg finesses Santa FE that held there was no federal fiduciary Merely requiring the duty. If O'Hagan tells D&W he is gonna trade and they say no and he does misappropriater to disclose anyway, there is no fraud. There may be a breach of loyalty, but there is no his intentions before trading fraud. (brazen) also provides weak a. The duty to disc lose arises out of fiduciary duty, but liability arises out of protection of the source of a non disclosure, so there is no fed liability since he disclosed. There may the info's property rights. be state liability. 133 b. This is odd, since it says the obligation to disclose about the source of the info arises out the source of your info but the basis of liability is based on nondisclosure. This point was to address Santa Fe. ii) Analysis Q: 2, p 488: (1) Ira Waldbaum was the president of the Walbaum grocery chain. (a) The chain was the target of a takeover bid. (2) Ira told his sister Shirley about the deal. (3) Shirley told her daughter Susan. (4) Susan told her husband Keith Loeb. (5) Keith told his broker, Robert Chestman. (6) Notice that this is not a tipping case like Dirks Separation of powers (a) The chain breaks at Ira. Notice that this is not a tipping case like Dirks. For tipping issue: Can the SEC adopt rules that go --the tipper must violate a fiduciary duty by disclosing and the tippee must know or around cases that the Ct have reason to know there is a duty. When Ira told sis, Ira was not breaching a has held? Unclear fiduciary duty he owes to Waldbaum. There is legitimate reason he might tell his sister what the 2nd circuit since she is a substantial SH and she might come under suspicion. He might want to would say. This is tell her to warn her not to buy or sell any stock. Only trading on the basis of info is attempt to reverse rule illegal, just standing pat isn't illegal. (7) So how are we gonna get Chestmun? (a) We can get Chestmun if Keith breached a fiduciary duty by making disclosure (Dirks), but in order for Keith to breach, he has to owe a duty to wife. Issue: are familial relationships fiduciary such that H breached? Ct says no. there are no fiduciary relations b/n family members. (i) In response to this, SEC adopted Rule 10b5(2): which provides a list of three situations where the person ahs a duty of trust of confidence for purposes of the misappropriation theory. 1. "where a person aggress to maintain info in confidence" (must be a confidentiality agreement) 2. where the person has a history, pattern and practice of keeping confidences, such that the person expects the info shall remain confidential. 3. learning info from spouse suffices. (this was put in to overturn Chestmum--to make him have duty to keep quiet). c) Rule 14e3: Tender Offers i) It has two prohibitions: (1) Prohibition of tipping: Rule 14e3 prohibits insiders of the bidder and target from divulging confidential information about a tender offer to persons who are likely to violate Tender offer: a the rule by trading on the basis of that information. public offer-- usually made the all (a) The rule does not prohibit the bidder from buying target shares, but it does prohibit him SH of the target from tipping his intentions to outsiders. corp, in which the (2) Prohibition of trading: The rule also prohibits any person who possesses material buyer offers to information relating to a tender offer by another person from trading in target company securities if the bidder has commenced or has taken substantial steps towards commencement of the bid. (a) Substantial steps include such things as voting on a resolution by the offering person's board of directors relating to the tender offer; the formulation of a plan or proposal to make a tender offer by the offering person; or activities which substantially facilitate 134 14e3 vs 10b5 the tender offer such as: arranging financing for a tender offer; preparing or directing or authorizing the preparation of tender offer materials. (b) The person possessing the information must know or have reason to know the information was acquired from the bidder or the target company or agents of either. (c) The person possessing the information must know or have reason to know that the information is nonpublic. ii) Under both prongs of the Rule there is no need for a showing that the trading party or his tipper was subject to any duty of confidentiality, and no need to show that the tipper personally benefited from the tip. (1) This is critical. Go back to Chiralla. This means that the lack of the relationship doesn't matter, and his liability doesn't require relationship, mere possession is enough to make liability. O'Hagan Ct upheld this. So in this sense 14e3 is broader than 10b5, but on the other hand its more narrow since it only applies to info about the tender offer. 135 SHORT SWING PROFITS Assn 32 1) Overview: Short Swing Profits a) We should spend a lot of time advising clients on 16 issues since if dealing with executives who own stocks in their companies, they face personal liability exposure. This liability is a form of SL, if you are liable, there are no defenses. i) Note: there are some la firms that make living tracking the 16(a) reports to look for matches to file lawsuits. ii) This is very easy to track. Imp for attys to make sure clients are up to date on 16 updates. 2) The statute: a) The statute has two different sections: i) Section 16(a): reporting requirement (1) "Every person who is directly or indirectly the beneficial owner of more than 10 per centum of any class of any equity security . . . or who is a director or an officer of the issuer of such security . . . within ten days after the close of each calendar month . . . shall file with the Commission . . . a statement indicating his ownership at the close of the calendar month and such changes in his ownership as have occurred during such calendar month" ii) Section 16(b): the kicker (1) "any profit realized by [such beneficial owner, director, or officer] from any purchase and sale, or any sale and purchase, of any equity security of such issuer . . . within any period of less than six months . . . shall inure to and be recoverable by the issuer" b) Highlights: and differences between 16(b) and 10b5 i) 16(b) apples only to real insiders. (1) What makes you insider ? (a) Officer is the tricky one. SEC defines officer in 2 ways. An officer is either 1) statutory officer like the CEO or 2) anyone who exercises significant policymaking functions. VPs and up. (i) Note: Smaller group on insiders than under Rule 10b5. ii) No tipping liability, no misappropriation liability, no constructive insiders. iii) 16(b) applies only to companies that must register under the 1934 Act (1) This means 16(b) is narrower than 10b5 since 10b5 applies to any security, any security of any company. 16(b) only applies to publicly held companies who are registered with the SEC. iv) Equity securities: 16 applies only to stocks and convertible debt (1) Compare Rule 10b5, which applies to all securities v) Shares and purchase: (1) 16(b) applies whether the sale follows the purchase or vice versa. Shares are fungible. (a) : suppose that on Jan 1, you buy 100 shares, on Jan 2, but 200 shares, and Jan 3, sell Ex 100 shares. (i) First instinct is that you match the two 100 shares on the 1st and the 3rd. but that is 1) Doesn't matter if the not necessarily true. sale follows the purchase or vice versa. (ii) Shares are fungible doesn't matter when you bought or sell or that you can prove that the shares you sold on Jan 3rd are with the Jan 2nd purchase. 2) Always match to 1. This is significant since if you bought on Jan 1 at 9, and Jan 2 at 11, and sold maximize liability. Jan 3 at 10, you cant argue that you didn't make profits since paid 11 and got 136 3) Form almost always only 10, this doesn't matter since we match the purchase at 9 with the sale at 11 and you got profit. 2. As long as there is a purchase and sale, we match no matter what. This leads to imp point, which is the first point of matching is maximizing. (b) Example: (i) Anna is CEO of Acme. She buys 1,000 Acme shares on Feb. 1. She sells 1,000 shares at $10 on May 1. She earned $2 profit per share that she must disgorge. (ii) Bill is senior VP of Ajax, Inc. He has owned 10,000 shares for many years. On June 1, he sells 1,000 shares at $10. On Sept 15, he buys 1,000 shares at $8/share. He must disgorge $2,000 to Ajax ($2/share times 1,000 shares). (2) Recovery: (a) Any recovery goes to the company (b) Shareholders can sue derivatively, and a shareholder's lawyer can get a contingent fee out of any recovery or settlement (c) Match shares in a way that results in maximum liability. (i) Example: Carla is president of Acme, Inc. Her transaction is as follows. 1. March 1: bought 100 shares/$10. 2. April 1: Sold 70 shares/$12. 3. May 1: bought 50 shares/ $9. 4. May 15: Sold 25 shares/ $13. 5. December 31: sold 35 shares/$20. a. The Dec. shares are not matchable since it is not w/in 6 mos. 6. The other shares are all matchable: match to maximize liability. a. First, Match the 25 shares sold May 15 with 25 of the shares bought on May 1, b/c they have the largest price differential. With a $4 profit per share ($13 minus $9), times 25 shares, Carla owes Acme $100. b. Next, match 25 of the shares sold on April 1 with the remaining 25 shares purchased on May 1 for a profit of $75 ($3 per share ($12 minus $9) times 25 shares). c. , match the remaining 45 shares sold April 1, with the 45 of the shares Last bought on March 1, for a profit of $90 ($2 per shares ($12 minus $10) times 45 shares). d. Thus, Carla owes a total of $265 to Acme. vi) Problem 1(a): 503, 504: (1) Bill is CEO of chain of law schools. Jan 1, buy 200,000, May 1 for $10, sell 200,000 shares for 50. he made profit, so we match. 8 mill liability. (a) (200,000)($50) (200,000)($10) = $8,000,000 (2) Problem 1(a) variation : Say Bill owns 200,000 shares for many years that he bought for $10. Jan 1, sells 200K shares at $50/share and on May 1, buys 200K shares at $10/share. Liability? yes. The fact the purchase follows the sale is irrelevant. As long as they can Make sure a be matched to make a profit, there is liability. So since a purchase and sale occurred w/in 6 purchase and mos he owes 8 mill. so it doesn't matter if you sell first and then buy later, if it is w/in 6 sale occur month period, you can be liable. w/in 6 mos! (a) Reason: in 1984 congress was mad that insiders were manipulating the stock of their companies to make a profit so Congress made this prophylactic barrier. This barrier is both over inclusive and under inclusive. 137 (i) See fn 1, on 491, for the purpose of preventing the unfair use of information, the profit goes back to co. Intent was that Congress was worried directors would use inside information for personal gain. vii) Prob 1(b) (1) Jan 1: Purchases 200,000 shares @ $10 (2) May 1: Sells 110,000 shares @ $50 (3) May 2: Sells 90,000 shares @ $50 (4) this is trick Q since it wants you to focus on the amount of shares he owns. Doesn't matter what percentage he owns since an officer who has liability w/o regard to how much shares he owns. viii) Prob 1(C): (1) Jan 1: Purchases 200,000 shares @ $10 (2) May 1: Sells 110,000 shares @ $50 (3) May 2: Sells 90,000 shares @ $50, after resigning from the company. (4) Liability ? Yes. When the basis of your liability is that you were an officer or director, it is enough that you were officer or director at the time of either the purchase or the sale, so Bills May 2nd sale is still matchable with the Jan 1 purchase even though he wasn't officer at the time of the sale. (a) This works the other way around too. If Bill buys 200K at 10, Jan 1, and March 1, he gets hired as the CEO, still subject. This is b/c the rule is designed to maximize liability. ix) Prob 2(a): (1) Renee owned 200K shares for many years. 10% holder? yes. (200,000 out of 1 million = 20%) (a) Many years: owned 200,000 shares (b) Jan 1: Sells 200,000 shares @ $50 (c) May 1: Buys 50,000 shares @ $10 (d) May 2: Buys 110,000 shares @ $10 (e) Liability? (i) No. Here we bump up against Sup Ct case where the Ct said: "This subsection shall not be construed to cover any transaction where such beneficial owner was not such both at the time of the purchase and sale, or the sale and purchase, of the security involved" c) Differing treatment of officers & directors and ten percent shareholders: i) An officer or director is liable under 16(b) if he is an officer or director at any time of the purchase or sale. In contrast, a SH has 16(b) liability only if she owned more than 10 percent of the company's shares both at the time of the purchase and at the time of the sale. (1) Reliance Elec v Emerson: (a) Facts: (i) June 16: Emerson buys 13.2% of Dodge (ii) Aug 28: Emerson sells some shares; reducing holdings to 9.96% (iii) Sep 11: Emerson sells remainder (b) Issue : (i) Was the June 16 purchase a "matchable " purchase? 1. Sup Ct declines to answer (ii) Assuming the June 16 purchase is matchable , can it be matched with the Sep 11 138 sale? 1. No. Emerson was not a 10% owner on 9/11 2. Cant match unless was both 10% owner at the same time. This is b/c the law is more lenient for 10% owners since there isn't as much risk as with the corporate insiders. 3. The Sup Ct basically recognized that law abiding people are benefited by bright line rules since they can plan. (c) Issue not addressed by Reliance: whether a purchase by which a SH crosses the 10% threshold can be matched with subsequent sales for 10b5 purposes. (i) Foremost McKesson v Provident: 1. Facts: a. Oct 20: Provident acquires debentures convertible into > 10% of Foremost Reliance v Emerson stock didn't address the b. Oct 24: Provident distributes some debentures to shareholders significant fact that c. Oct 28: Provident sells remaining debentures Emerson wasn't a 10 2. Issue: Can we match Oct 20 acquisition with Oct 24 disposition? percent SH before the 3. Statutory issue : "This subsection shall not be construed to cover any tender offer. transaction where such beneficial owner was not such both at the time of the purchase and sale, or the sale and purchase, of the security involved" 4. Held: a. In a purchasesale sequence, the transaction by which the shareholder crosses the 10% threshold is not a matchable purchase b. Only purchases effected after one becomes a 10% shareholder are matchable (ii) Examples: 1. Problem 2(a): Renee for many years: owned 200,000 shares of Acme. There are 1 mill shares outstanding. a. Jan 1: Sells 200,000 shares @ $50 b. May 1: Buys 50,000 shares @ $10 c. May 2: Buys 110,000 shares @ $10 d. Liability? i. Rene was a 10 percent shareholder when she sold, but not when she bought either block. Renee has no liability since there was no purchase at the time at which she was already a 10 percent SH. 2. Prob 2(b): a. Many years: owned 200,000 shares b. Jan 1: Sells 200,000 shares @ $50 (10%) c. May 1: Buys 110,000 shares @ $10 d. May 2: Buys 50,000 shares @ $10 (10%) e. Liability? i. Yes. Since she was a 10% holder on both Jan 1, and May 2, she is liable for her gain on 50,000 shares. ($50 x 50,000) ($10 x 50,000) = $2,000,000 3. Prob 2(c): a. Many years: owned 200,000 shares (10%) b. Jan 1: Sells 110,000 shares @ $50 c. Jan 2: Sells 90,000 shares @ $50 139 d. May 1: Buys 300,000 shares @ $10 e. Liability? no. i. Renee was not a 10% SH when she bought her stock. Accordingly, we cant match a purchase with her sale of her first 110K shares and she is not liable. (iii) Example : Darla is not an officer or director of Ajax. At all relevant times, Ajax has 1,000 shares outstanding. a. Jan 1: buys 50 shares/$10 b. Feb 1: buys 55 shares/ $10. c. April 1: buys 50 shares/$10. d. May 1: sells 60 shares/$15. e. May 2: sells 55 shares/$20. 2. Analysis : the Jan 1 purchase cant be matched with their sales since at that time she was not yet a 10% SH. The Feb 1 purchase can't be matched with either sale since it is the transaction at which she became a more than 10% SH. Only the April 1 purchase is potentially matchable, since only at the time of that purchase, did she own more than 10$ of the stock. a. As to the sales, only the May 1 sale can be matched with the April 1 purchase. On May 2, she owned less than 10 percent of Ajax stock. (iv) On June 16th you buy 13.2% at $10, June 19th, buy an additional 3.3% at $10. On August 28th, you sell 6.6%, which takes you from 16.5 to 9.9 percent ownership at $11. on Sep 11, you sell remainder 9.9% at 20. the first transaction at 13.2% gets wiped out McKesson and Reliance says once you are below the 10% threshold, cant match. (v) Problem 4: 1. Many years owned 5,000 debentures (convertible into 100 shares per debenture) 2. Mar 1: Buys 100 debentures @$800 3. Apr 1: Sells 100 debentures @ $900 4. Liability? a. Rene's debentures are convertible into 500,000 shares, so the total would be 1,500,000 and she would own 1/3. So she is treated as owner of more than 10 percent of the equity. Thus, she is liable for her $10,000 profit on the purchase and sale of the 100 debentures. 140 1) This statute reflects the idea that there are 2 sets of rights. This class can either be a single class that has both rights, or can separate it out. The MBCA is very liberal on this-- SHAREHOLDER VOTING Assn 33 Common Stock as a Bundle of Rights: a) Economic rights : i) Receive dividends (distribution of profits) when and as declared by the board of directors ii) Residual claim on assets in liquidation b) Voting rights : This what we focus on today. i) Right to elect directors ii) Approve some extraordinary matters iii) Who becomes the directors is really critical from SH perspective c) Packaging Rights : (have to give one class of stock voting rights) i) MBCA 6.01(b): Articles of incorporation must authorize: (1) At least one class with unlimited voting rights: (2) At least one class with residual claim: ii) MBCA6.01(c): authorizes nonvoting stock and other variants on one shareone vote. d) Voting rights : i) How SH vote: (1) Meetings (a) Annual : every corp must have one meeting annual meeting. (b) Special : corps may have these to act one something that cant wait for next meeting. Ex: Van Gorkum had a special meeting to vote on the merger. (i) Critical provision in this regard is who can call a special meeting. 1. 7.02(a): can call special meeting of SH when it is balled by BoD or parties who are authorized to do so in the bylaws. This isn't that problematic. Beware of 2. 7.02 (a)(2) authorizes SH acting together to call a special meeting. This is the difference b/n SH and more problematic. Even single holders who have large share of the stock can shares of call special meeting. stock!!! a. Suppose they amend the article to make 25%, then the SH can bind together till they make up the number. b. this can be a problem with hostile takeovers. The SH can try to remove the directors. Under the Model Act and the law of most states the Articles must allow SH to call a special meeting and the only flex is what percentage of stock you require them to hold, i.e. 10 or 30 %. (2) Action without meetings: SH may act w/o holding a meeting (aka written consents) MBCA 7.04 (a) must be unanimous: very onerous burden. (i) Compare DGCL 228(a)--action by consents okay if same number of shares Written consents consent as would be needed at a meeting. less onerous than the MBCA. are rare-- 1. the idea is that if some SH dissent they should have the opportunity to have meetings are meeting where they can talk others into their plan. So even if vote is 90/10, if easier some SH don't consent, they get to have a meeting where they can change the others mind. ii) Meeting rules: (1) what is default rule for quorum ? (a) MBCA 7.25(a): the holders of the majority of the shares entitled to be voted. Not Quorum: the counting people, but the number of shares people own. minimum 141 number of shares (not SH!) required to (i) Can have smaller of larger number? Yes . You can have in Articles of Incorporation something that says quorum will be 30% of the shares, i.e. you state that the quorum will be less than the majority. (2) Once you have quorum , what is default rule for approving corporate actions? (a) MBCA 7.25(c): Most decisions can be made by the vote of a majority of the shares present at the meeting in person or by proxy and voting on the issue. (i) yes votes that are cast must outweigh no votes that are cast. Abstentions don't count. (ii) Don't need majority of votes present, or total votes of shares. 1. Example: Suppose there are 1000 total shares and 800 shares are present. The vote is 395 yes, 394 no, and 9 abstain. Has the proposal been passed? Yes. The abstentions don't count. Yes votes must exceed no votes. (iii) Can you have a larger or smaller number? take a look at 7.25(a) but also at 7.27(a) and (b) and compare those two. 1. 7.25(c): most decisions can be made by the vote of a majority of the shares present at the meeting in person or by proxy and voting on the issue. a. This says can require larger approval, like 2/.3 rather than but not less. e) Stroh v Blackhawk: i) Facts: (1) P was an Illinois Co. (2) IL constitution prohibited nonvoting common stock. (a) Common stock without voting rights was common in 19th century since you could sell stock w/o losing control of the company. (i) So how does the planner deal with this provision to let the party keep control? They said, hey the Const. didn't say anything about voting only stock! So they sold the class with only voting rights just for themselves. (3) Two Classes of Stock: (a) Two classes of Blackhawk stock (i) Class A standard common stock with both economic and voting rights (ii) Class B common stock with no economic rights but with one vote per share 1. This meant that management had retained control even thought the public investors put lot more money into the company and have a larger equity interest. (4) NB: New Concepts (a) Par value: concept in legal capital, the issuance of stock. Par value is the minimum amt the corporation must receive when it sells the shares. If the Corp gets less, then creditors can go recover it from the SH. Don't have to have par value, the class B stock didn't. It is usually specified by the articles of incorporation. (b) Stock split: (i) Effected by changing par value through amendment to articles 1. Here par value cut from $1 to 50 (ii) New shares issued on 21 basis (iii) These are similar to stock dividends. Want to increase the number of shares out there w/o affecting the company. Why do companies do stock splits? Maybe the stock price got to high. 1. Stock transactions usually happen in round lot. If you want to buy an odd lot, 142 like only 10 shares, have to pay a larger broker commission, since round lots makes it easier to match shares and sales. Buy and sales need to be matched. Suppose the stock price gets to 100 a share, a round lot costs 10K. (5) Plaintiff's argument: (a) What did plaintiffs argue with regard to the validity of the Class B shares? (i) That the Class B shares were invalid because they lacked economic rights (ii) Plaintiffs said that shares represent the proprietary interests in the corporation (iii) Further, proprietary necessarily assumes an economic interest ii) Stroh Holding: (1) The Court rejected plaintiffs' argument, holding that the Class B shares were valid. Why? (a) Under an old statutory definition of "share" (adoption of the new definition caused no change in legal effect), shares mean the "units into which a shareholder's rights to participate in control of the corporation, in its surplus or earnings, or in the distribution of its assets, are divided" (b) Because that definition was in the disjunctive ("or"), a share could contain any of those three types of rights and still be valid (2) Is this persuasive statutory interpretation ? How can we allow a reading of the statute to have the same effect as something we don't allow? (a) Well, this is a substance/ form issue. The econ reality is not controlling, what controls is form. And the const. only prohibited one of two forms. (b) The court's analysis of the definition of a share permit a firm to issue nonvoting stock: stock would be valid as long as it has one of the three rights (c) But nonvoting stock was prohibited by the Illinois state constitution; perhaps inconsistent with an overall view of Illinois law (i) The constitutional prohibition of nonvoting common at least weakens the reliance on the disjunctive nature of the statute (3) Entrenchment Effect : (retaining control even though put in less money) (a) Management (i) 87,868 Class A shares at a cost of $298,751.20 (ii) 500,000 Class B votes at a cost of $1,250 (iii) 587,868 total votes at a cost of $300,001.20 1. ~ 60 per vote (b) Shareholders (i) 500,000 Class A votes at a cost of $2 million 1. Ignoring split and some odd shares 2. ~ $4 per vote (c) This means that in a way, the management is unaccountable to SH: (i) Is that such a bad thing here? Were the Ps injured? 1. IPO: Management had to disclose the control effects of the firm's capital structure a. Investors who don't want lesser voting rights stock simply won't buy it b. Accepted tradeoff. The SH took the skimming into account and decided still a fair price. (ii) Analysis Q4 : Is there another reason the SH might be willing to go along with this even if they can skim off the top? 1. might want to keep the guys who were there to start the company in charge. 2. the people who founded it had some unique entrepreneurial quality we don't 143 want to lose. 3. voting control is a way for SH to tie themselves to the mast so they aren't distracted by the short term profit when there is some future large profit to care about. Don't want to throw the directors over when things are rocky. f) Policy: why SH voting rights? i) SH "own" the corporation ii) Ensure maximum SH wealth maximization. "A rising tide lifts all ships." iii) SH have the most to lose iv) Authority v Accountability (1) Rational apathy (2) Transferability. (3) Think about the election: why does anyone vote? Recall that political parties send signals but we don't have that in corporate law. we have to learn everything for SH voting. Why do SH vote? 144 PROXY VOTING Assn 34 1) Overview : Most SH don't attend meeting and they vote via mail throuought the proxy system. a) Shareholder meetings: i) Annual (1) MBCA 7.01 ii) Special (1) MBCA 7.02 (2) Variations on who can call (a) Compare MBCA 7.02(a)(2) with DGCL 211(d) b) Proxy: how does it work? i) SH appoints a proxy (aka a proxy agent) to vote his shares at the meeting ii) Appt is effected by a document called a proxy (proxy card) (1) Can specify how shares to be voted or give agent discretion. (2) Revocable iii) PROXY REGULATION : Prior to 1934, the use or proxies was pretty much unregulated. But the SEA now regulates proxies. (1) SEC Exchange Act 14(a): (a) It shall be unlawful for any person, by use of the mails or by any means or instrumentality of interstate commerce or of any facility of a national securities exchange or otherwise, 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 ... in respect of any security ... registered pursuant to Section 12 of this title (i) Shall be unlawful : punishable by jail and fines one rule req. that the (ii) To solicit ... any proxy ...by use of the mails or by other means or instrumentality proxy had to list of interstate commerce ect: this means that any way to solicit proxies is subject to names of all the SH being unlawful. in the corp. but so (iii) In contravention of such rules and regs as the commission may prescribe : This is huge burden, so Congress punted it to not self executing. Just delegates responsibility to make the rules to another group the Commission. and makes it a violation to violate them. not self executing. (2) What rules did the SEC adopt? SEC Proxy Rules: (a) 14a3: incumbent directors must provide annual report before soliciting proxies for annual meeting. (i) The annual report contains detailed financial statements and a discussion by management of the firms business. (ii) Once the annual report is in the SH hands, the proxy solicitation process can begin. (b) What is a Solicitation ?: (i) "Solicit" includes not only "direct requests to furnish, revoke or withhold proxies, but also ... communications which may indirectly accomplish such a result or constitute a step in a chain of communications designed ultimately to accomplish such a result."--Long Island Lighting Co. v. Barbash, 779 F.2d 793, 796 (2d Cir.1985). 1. An environmentalist group ran newspaper and radio ads critical of the defendant electrical utility's management. Incumbent managers sued the 145 environmentalists, alleging that their ads constituted a proxy solicitation. (ii) Rule 14a1(l)(2)(iv) exempts public statements of how the shareholder intends to vote and its reasons for doing so. (iii) Rule 14a2(b)(1), subject to numerous exceptions, exempts persons who do not seek "the power to act as proxy for a security holder" and do not furnish or solicit "a form of revocation, abstention, consent or authorization." 1. Consequently, for example, a newspaper editorial advising a vote against incumbent managers is now definitively exempted. (iv) Rule 14a2(b)(2) exempts solicitations of 10 or fewer persons. (v) Rule 14a2(b)(3) exempts the furnishing of proxy voting advice by someone with whom the shareholder has a business relationship. (c) Anyone who "solicits" a proxy must provide a written proxy statement before soliciting the proxy. free writing generally permitted thereafter. (i) Where you have a contested SH election, the annual report is created by the incumbent BoD. The incumbents will solicit proxies in favor of their slate. 1. if the insurgent wants to challenge, they will nominate a counter slate and will send out proxies. But the insurgent doesn't have to sent out the annual report that is the job of the current BoD. a. : Compaq: Hewitt opposed the merger, so he solicited proxies to the Ex merger. Most contested things has to do w/ the slate of the BoD. (3) The Proxy Card : (a) 14a4: Form of Proxy. See the sample proxy card on pg 263 of the supp. (b) The proxy card is the document that solicits the SH vote. The SEC requires diff colors for contests. (c) Whenever you have a contested election, the SH usually send back proxies from both sides. (i) In that case, which proxy counts? See 264: The last dated proxy solicitation is the one that counts. Signing a subsequent proxy revokes the earlier ones. (ii) In their discretion the proxies are authorized to vote in any way that comes up in the meeting but it has to be in the text of the proxy. Beware of all the little picky parts. (4) Proxy Statement : SH must receive (a) In a contested election, mngt sends out the annual report, which begins the process. the annual Management can send the annual report an the proxy card all in one document. But the report either rule is that SH must receive the report before or simultaneous to them getting the before or annual report. simultaneous (i) What does a proxy statement look like ? recall Lucent's proxy statement. SEC regs contain forms that 1. Rule 14a6 filing obligation: say what info to provide the a. Preliminary proxy card and statement must be filed with the SEC at least SH in narrative form rather 10 calendar days before the proxies are first solicited. than just boxes to check. b. Filing of preliminary materials is not required, however, with respect to an Usually long--Starts off w/ uncontested annual meeting at which only basic matters such as selection notice of the annual of directors are to be decided. In that case, copes of the proxy card, proxy meeting, how to vote, ToC, statement, and other soliciting materials must be filed with the SEC no and most of the doc. is later than the day they are first used. disclosure of executive 2. Other Proxy Solicitation materials: compensation. Hard for SH a. Rule 14a6(b) re filing: (266 supp) 146 b. Rule 14a7 re mailing (269 supp) c. Rule 14a9 re fraud (276 supp) (5) Proxy Contests : (a) Reimbursement of expenses for incumbents. (i) Management : 1. Can management use corporate funds to pay for expenses they incur in conducting their proxy solicitation? Yes, as long as the amounts are "reasonable" and the contest involves "policy" questions rather than just a "purely personal power struggle"--Rosenfeld 2. How show policy contest? a. the board merely needs to have its lawyers parse the insurgents proxy materials for policy questions on which they differ. These are all ok 3. What would be reasonable expense? These are all ok. a. Disclosure statement to SH b. Phone solicitations c. In person visits to major SH i. Wining and dining ii. Private jet d. Giving corporate contract to major SH. you can't buy votes, but the fact that you simultaneously offer a K at the same time that is ok. (ii) Insurgent : 1. Can the insurgent use corporate funds to pay for funds to pay for expenses it incurs in connection their proxy solicitation? a. Only if approved by the SH. Rosenfeld b. Board must act first. i. So you basically have to win so that the Board will be inclined to put it toward a SH vote. c. Why would the Board ever pay the insurgents expenses ? the Board might agree to tell the insurgents that they will pay as soon as they sell all the stock they own. i. The little SH might sue them alleging waste if the Board buys them off. The Board will say in reply that they were trying to stop the negative publicity, and the disruption. Then the BJR will apply. So the SH will probably lose these cases. They never even got to the BJR, since this was a derivative suit. And demand was required so this case was filtered out. (b) Proxy Contests are relatively rare? Why? (i) The reason they are rare has to do with the economics of running a proxy contest. 1. They are costly. a. only reimbursed if they win SH are likely to b. most benefit goes to SH vote for current c. see note on economics of Proxy contests mngt even if that is d. For the ave. SH, the necessary investment of time and effort in making not the decision informed voting decisions is not worthwhile informed SH should make. Thus, 147 2. SH apathy insurgent risks laying out a. 100 votes out of 30 mill, so most SH holding are too small to have sig effect on the votes outcome b. opportunity cost of being informed: hard to read all the info in the proxy statements. c. why bother? d. Wall Street Rule: "Its easier to switch than to fight." 148 PROXY LITIGATION Assn 35 1) Overview: a) The following cases address issues where SH sue the incumbents alleging that incumbents violated proxy rules. While the suits involve claims against the incumbent, the net effect is to strengthen the incumbent's control of the co. b) JI Case v Borak: (handout): i) Case proposed to merge with American Tractor. Borak: owned 2000 shares of Case stock and Implied sough to enjoin the merger on the grounds that the company's proxy materials were false and private misleading. right of (1) See SEC 14a9 (2) Case argued that Borak had no standing to sue as the federal proxy rules provided no private party cause of action. ii) Issue: Does a private party cause of action exist under 14(a) and Rule 14a9? Yes. iii) Holding? 27 speaks of (1) Is there an express private right of action in the statute? No. liabilities (a) Is there any statutory basis for that holding? imposed by the (i) What section of the statute does J. Clark rely on ? He ends up relying on 27 of Act, but nothing the SEC that gives district Cts jurisdiction over "all suits in equity and actions at in 14(a) or the law brought to enforce any liability or duty" under the Act. He contended that "the rules thereunder power to enforce implies to power to make effective the right of recovery afforded creates such in the Act.....which implies the power to utilize any of the procedures of actions normally available to the litigant." this is a flawed analysis. 1. Dues 14 create a liability or duty owed to the SH? No. Nothing in 14a9, creates a duty or liability running to the SH. So J. Clark erects this arg that has no application to the case. This case is better 2. Instead what J. Clark relies on is legislative history and public policy. seen as an exercise (2) Policy reasons for an implied private right of action : of judicial fiat-- (a) Overview: Say you steal 100 and there is 1% chance of getting caught and have to pay not b/c Congress fine of 1000. If you get away with it, you get 100. if we just compared the nominal intended it, but b/c values, 100 v 1000, its not worth it. However, we don't consider nominal values, we the SupCt. said so. consider expected values. We discount by the probability. (b) Economics of deterrence: Thus, we explore Justice Clarks (i) Actor will be deterred when: policy reasons for 1. Expected sanction is greater than the expected benefit a. In other words, when the [Nominal sanction] x [probability of conviction] is greater than [Nominal benefit] x [Probability of avoiding conviction] 2. The expected sanction of stealing the 100 is 10, the expected benefit is the nominal benefit. The rational economic actor will steal the 100 since the Proxies : expected benefit exceeds the expected sanction. Nominal sanction is a. Is there some of this econ analysis lurking in Clarks opinion ? Yes, he high, but the identifies some reason to think that the expected sanction for violating probability of proxy rules will be less than the expected benefit. conviction is low. i. probability of detection is very low since the SEC has limited Thus, SEC resources. Most proxy litigation is parasitic of other litigation. So the enforcement alone will 149 odds are that the probability of conviction is very low, so this means that we need to have private atty generals to supplement the commission effort. Note: Bainbridge thinks that private atty gen is controversial. The idea is that private law enf would supplement public enforcement. the Sup Ct now, has created less private causes of action, but they aren't getting rid of the old ones. And 10b5 is well established. (c) Private attorneys general. (i) Private parties will serve as private attorneys general providing a necessary supplement to commission activity. (ii) The various forms of quitable and monetary releif made available by creating a private riht of action would increase the level of the nominal sanction. (iii) But SH are rationally apathetic. 1. If the Plaintiffs bar could be encouraged to act through the private atty general, then the probability of detection would increase dramatically. (iv) Private atty general: what is really going on here?: 1. Hint 1 : why did Borak insist that cause of action was derivative, rather than direct? a. To allow attys to represent all the shares simultaneously. W i. at the time, there was no viable class action procedure (pre FRCP ou 23.1). This meant very unlikely lawsuits would go forward since you ld wouldn't get a good atty for $40/claim. st ii. By calling the suit derivative, he creates an opportunity for atty to at represent all the shares simultaneously. e la b. To give the corporation standing to sue. i. If the suit was purely direct, only the SH would have standing to sue. w ii. If the corporation has standing to sue, who makes decision whether the corporation will sue? think back to MGM with the incumbent directors and there was a proxy contest to try to elect a new BoD. If the new BoD thought Levin violated the proxy rules, the corp could sue Levin. The BoD are the ones who make decision to sue, and if the BoD has the corporation joinedthe corporate entity pays the atty fees. Suing the insurgent using corporate funds, is reasonable expense. iii. Also, since the Ct in Borak held that proxy claims under 14(a) are both direct and derivative in nature, management has standing to sue the insurgent in the corporations name. This means that incumbent board has another weapon to fight off insurgents. They get the litigations costs reimbursed by the corporations deep pockets. 2. Hint #2 : what did Mills hold regarding attorney fees? a. Plaintiff counsel entitled to fees merely for finding a violation. 3. Hint #2: a. What did Mills hold re atty fees? i. When a SH sues to bring proxy vio to attn of the ct, can the SH get his atty fees paid by corp? yes, plaintiff counsel is entitled to fees merely for finding a violation. 150 SH must show in order to get fees paid in a suit for b. But what does SH have to show in order to get atty fees paid? One of two things: either 1) a common fund, monetary recovery, 2) there has been a substantial benefit to the corporation. i. The ct implies that merely finding a violation is a substantial benefit . Mills creates a ii. The Ct is essentially saying you can get atty fees merely for finding a powerful economic violation there is no requirement that the P ultimately prevail in the incentive for attys to sense of recovering damages. sue even when it is iii. The size of the atty fees may depend on the size of the return. See fn clear that no injury 13, on handout. iv. The judge wants attys enforcing the proxy rules and he is telling them they will get paid if they establish a violation. So what Clark really does is make inventive to develop expertise to sue. c) Key elements of the proxy cause of action: i) Mills v Electric Auto Lite: (1) Ps were SH of AutoLite, which was controlled by Mergenthaller Linotype, which was controleld by AMC. P alleged that the proxy materials used in connection with the SH vote on the merger b/n AutoLite and Mergenthaler were false and misleading b/c they failed to disclose that all of Auto Lites directors were Mergenthaler nominees. (2) P sought to enjoin the SH vote. Later sought to have the merger set aside and to obtain other "appropriate relief." (3) Materiality (a) Defined in Mills Information "might have been considered important by a reasonable : shareholder who was in the process of deciding how to vote"; in other words, the statement or omission must have "a significant propensity to affect the voting process." When Proxy lit (b) Modern definition of materiality? based on alleg of fraud--Four (i) "[O]mitted fact is material if there is a substantial likelihood that a reasonable Elements: shareholder would consider it important in deciding how to vote." TSC Industries 1. Violation: v. Northway (U.S. 1976) materiality of the (ii) Would that the omission would be deemed material under the modern standard? alleged misrep or omission 1. n the one hand O , the proxy statement did inform SH that Merganthaler owned over 50% of AutoLite and that the boards of both companies had approved the merger, so reasonable SH should have been able to figure out that all of Auto Lites directors were elected by Mergenthaler. a. Also, since 50% shares are held by Mergenthal, it isn't surprising he would In assessing the materiality nominate them since he gets big voice. of disclosures, Cts ignore the fact that most SH are 2. On the other hand , facts tending to show that the merger was approved by a rationally apathetic. board subject to a conflict of interest would likely be considered important by a reasonable SH. a. Isn't it possible that there is a loyalty claim? Where a controlling SH uses its control to make the corp act one way, might it be imp to know that all the directors were chosen by that SH, and if so, why? b. what might be the effect of having some directors not chosen by the controlling directors? Have we seen a case where having directors who weren't controlled by the controlling SH? Wheelebrator. Wouldn't it seem relevant that if the Board approved, how independent the board is? 151 (4) Causation: How proven?: P must show that the proxy solicitation itself (opposed to the defect) was an "essential link" in the accomplishment of the transaction. 1. See footnote 7. Funny Causation. This causation is diff than (ii) Bainbridge thinks this is strange type of causation. Under this standard, almost any but for or proximate violation causes an injury. In most transactions requiring SH approval, the proxy causation. solicitation will be an essential link in accomplishing the transaction, since the solicitation was necessary to obtain the requisite SH vote. 1. The causation element is really perfunctory, to plead that the proxy was essential to the transaction. (5) Remedies: (a) What type of relief do you get? (i) Prospective: (common remedy) 1. ex ante injunction against the SH vote. The prob here is that the Ct 2. corrective disclosure. below already determined 3. This is the most common remedy. that the merger was effected (ii) Retrospective. (rare remedy) at a fair price so how can 1. Damages. they show monetary a. Damages must be shown which means that P must establish a monetary damages? On remand injury. B/c the violation itself is not an injury, P must show some sort of they couldn't, so the attys actual loss or hard resulting from the violation. b. How do we measure damages? What price would I have gotten for my shares if you had told me the truth? 2. Rescission a. This option is chosen very rarely and is the most drastic measure. Remedy is rarely chosen i. Once the eggs are scrambled cant undue the omelette. ii. For example, in Mills, the merger could have been undone, and the two firms restored to their prior position as separate entities, but this would be very hard to do since there has already been so much commingling. iii. Cts will only set aside a merger when it is possible to do so w/o harming the overall value of the firms and no other remedy make parties whole. 152 SH PROPOSALS, Assn 36 1) Rule 14a8: SH Proposals: a) Allows qualifying SH to put a proposal before their fellow SH. Emerged b/c state law gave SH limited rights to raise issues at SH meetings. If the SH wanted to go to the meeting, she or he could but once they got there, the provision that says that the holders of the proxy are entitled to vote at their discretion. i) And have proxies solicited in favor of them in the companies statement. ii) Expenses thus borne by the company. This is a cheap way for SH to have something voted on. iii) During the proxy season, one of the high points are incumbent managements attempts to exclude SH proposals. iv) SEC Review: (1) If the corporate management believes the proposal can be excluded from the proxy statement, management must inform the SEC and a copy must be sent to the proponent. (2) The SEC will either agree or disagree. v) Eligibility: (1) Under Rule 14ab(b)(1): a SH proponent must have owned at least 1% or 2,000, (whichever is less) of the issuers voting securities for at least one year prior to the date on which the proposal is submitted. (a) What happens if an individual SH doesn't satisfy the req ? the SEC permits aggregation of shareholdings for purposes of meeting the dollar amounts but not the time limit. b) Procedural hurdles : i) Number of submissions : (1) Only one proposal per year. ii) Prior submissions : (1) A proponent can introduce the same proposal year after year provided the proposal annually receives a specified level of support. (a) A resubmitted proposal must be included if it was submitted: Must get increasing (i) once during the past 5 years and got 3% of the vote, level of support (ii) twice in the preceding five years and got 6% or more of the vote the last time it was submitted, or (iii) 3 or more times in the preceding five years and received 10% or more of the vote the last time it was submitted. iii) Showing up : (1) The proponent must show up at the meeting, otherwise Rule 14a8(h) bars the proponent from using the rule at the company for the following 2 years. iv) Timing: (1) The proposal must be submitted to the company at least 120 days before the date on which the proxy materials where mailed for the previous years annual SH meeting. (a) Example: if the firm mailed its proxy material on May 1, 2010, then they must have sent the material 120 days before May 1 to be included in the following years proxy. v) Length: (1) Proposal may not exceed 500 words in length. c) Substantive grounds for exclusion Rule 14a8([i]): 153 Most SH proposals are precatory (i.e. nonbinding) phrasing: (1) E.g. Dole: "shareholders request the Board of Directors to establish a committee . . . for the purpose of evaluating the impact of a representative cross section of the various health care reform proposals being considered by national policy makers . . . Further, the aforementioned committee should be directed to prepare a report of its findings." (2) Why are they precatory ? (a) Rule 14a8(i)(1): (i) A shareholder proposal must be a proper subject of action for security holders (ii) It must be an action which it is proper for shareholders to initiate. 1. Can SH instruct the BoD to take a particular course of action? No a. Look to state law to decide that question i. E.g., DGCL 141(a): the Board Acts and the SH react. Boards have the power of initiation. (iii) If shareholders not allowed to initiate, still ok if phrased as proposal (3) Rule 14a8(i)(1) Issues: (a) What happens if the precatory proposal passes and board refuses to act? (i) What legal basis would a SH have to sue based on this? there is nothing in federal law that would be implicated by their failure to accept your recommendation. (ii) So what is your state law cause of action? the SH may claim breach of the DoC, but remember, as long as the board makes an informed decision then the BJR would apply. (b) What may SH initiate? Compare DGCL 141(a) with 109(b) (i) Problem 1: (556) 1. Proposal A: resolved that the company shall discontinue making X product. a. this is not allowed since it encroaches what the directors are supposed to do. i. DGCL 141: SH are reactive, Boards act. 2. Proposal B : resolved that the SH recommend that the company discontinue the X product. a. this is allowed since it is a recommendation. 3. Proposal C : "resolved that the bylaws of X are hereby amended to include the following subsection 12: 12--the company shall produce only 4 door sedans. Unresolved issue: Can a. This is designed to take advantage or a wrinkle in the DGCL 109(a): the SH use the bylaws original bylaws may be amended by SH. This section is unique since it is under DGCL 109(b) the only section that allows the SH to initiate action. to get around DGCL b. There is open question in DE law as to whether the bylaw in proposal C would be a valid bylaw since its not clear if SH can use the bylaw to limit director discretion. i. If so, the SH could get around the req that most of these be recommendations. People think they can use the bylaws to get around. (4) Not otherwise significant: Rule 14a8(i)(5): (a) Rule 14a8(i)(5) allows exclusion of proposal that relates to operations which account for less than 5 percent of the firm's assets, earnings or sales, and is not otherwise significantly related to the firm's business (b) Lovenheim, 543: 154 i) (i) Facts: P wanted the company to study the impact of force feeding geese. The company refused, citing Rule 14a8(i)(5). 1. Pt operations economically "insignificant" a. $79,000 in revenues out of firmwide revenues of $141 million 2. Why is the proposal included? a. "Otherwise significantly related" includes ethical and/or social significance i. Bainbridge thinks this is clever. ii. How proven ? see fn 3: the humane treatment of animals is part of the 7 laws of Noah. This is imp point b/c of the distinction b/n how Compare how Lovenhem proved that what he did had ethical or social significance proven to Austin and what happened in Austin case, where the issue is not the ethical significance but the economic substance. 3. Basis for holding?: a. The rule itself is ambiguous b. The SEC before the 1983 amendments required inclusion of important policy questions even where less than one percent of the firm's assets or earnings were implicated by the question c. In adopting the five percent test, SEC said proposals that don't satisfy the five percent tests can still be included d. Medical Committee decision implied that proposals involving general political and social concerns were acceptable (5) Dole: (a) New York City employees' pension fund proposal that Dole study the impact of various national health care reform proposals (b) Dole tried to exclude it on grounds: (i) Significant Relation--Rule 14a8(i)(5): Involved matters with only an insignificant financial relation to the company 1. The Ct held that the health care reform had economic significance since heath insurance and care imposed large financial costs on Dole... "health insurance outlays constitutes more than 5 % of their income." a. They applied the test wrong : Rule 14a8(i)(5) doesn't mention expenses that represent more than 5% of income, the rule talks about business operations (like stuff they make) that represent 5% of the companies total business.. i. The SH could have won under this exception anyway by showing that the proposal was otherwise significantly related to its business. ii. If the proposal relates to operations the kind of things you make. Health care isn't operations. But the Ct applies the 5% test anyway. iii. Was there any evidence that they spent more than 5%? no the ct just presumed it. (ii) Beyond SH power to effectuate--Rule 14a8(i)(6): Involved matters beyond Dole's power to effectuate 1. Dole tired to exclude on this basis but doesn't get very far. NYCES real purpose? Lobbying. 155 All except EE compensation are includable 2. The Ct said it didn't go beyond their power since it asked the company to study effect, not to change nation They only looked at what the proposal said. 3. Why does Dole care? a. Business people are right wind coupon clipping plutocrats? b. CEOs don't like being bossed around? c. Dole doesn't want to be involved in the national debate? (iii) Ordinary Business Matters--Rule 14a8(i)(7): Involved ordinary business matters (employee benefit packages) 1. The Ct says the proposed report relates to Doles policy of social policy. Health W Care is a matter of great social significance. h 2. parallel to Rule 14a8(i)(5) social and ethical significance. y 3. Compare Austin. a. In Austin you have 3 individuals who are SH of consolidated Edison and d they were also union leaders of ConEds main union. The company had a o "rule of 75". The proposal suggests that the committee study changing the pension rights of the EE to allow EEs to retire at any age. b. company resisted on two grounds: i. (i)(4) this was personal grievance. (Bainbridge thinks this is where the case should be decided). The Ct didn't hold on this issue. ii. (i)(7) The proposal dealt with ordinary business. iii. Proposals relating to executive compensation have become common and they are allowed. iv. Why didn't this come in? the fact that it hadn't gotten as much "public attn" so does this mean that whether it comes in is whether it is on the news. Isn't that bad policy? 4. what is an ordinary business expense ?: a. Disinvestment in South Africa? Include b. Get out of tobacco business? Include c. Get out of nuclear power business? Include d. End affirmative action? Include e. Start affirmative action? Include f. Nondiscrimination on basis of sexual orientation? Include g. Nondiscrimination on basis of veteran status? Include h. Executive compensation? Include i. Employee compensation? NO 156 SHAREHOLDER INSPECTION RIGHTS Assn 37 1) Shareholder Inspection Rights: a) Policy Concerns: i) Why SH want inspection rights: (1) Deivitive suit issues: (a) In derivative litigation, under DE law, there must be particularized allegations showing that demand is excused. (i) Inspection rights are one way for SH to gather info w/o having access to discovery. So if a SH has reason to believe that there is corp wrongdoing, can investigate it (2) SH Contact: (a) May want to get names and contact info for fellow SH. Like tender offer, or want to solicit the SH to mail. (b) In both the proxy context and tender context, the federal rules entitle the SH to demand that the corporation mail the docs to SH, but they don't want that. (one reason is that they want to have their proxy signed last and they may want to direct lobby SHs). ii) Competing Interests: (1) Shareholders have a legitimate interest in using the proxy system to hold the board accountable (2) Nobody wants a junk mail distributor to get access to the shareholder list or a competitor to get access to the corporation's trade secrets and other proprietary information iii) The Statutory Framework: (1) Proper Purpose Requirement: DGCL 220(b) SH asserting inspection rights must make written demand setting forth a "proper purpose." This balances (a) proper purpose "reasonably related to such persons interest as a stakeholder." competing policy (i) Proper: concerns 1. Investigate alleged corporate mismanagement 2. Collecting information relevant to valuing shares If 3. A tender offeror stated a proper purpose in desiring to inform other SH or the pending offer and soliciting tenders from them (Crane) cor 4. Communicating with fellow shareholders in connection with a planned proxy p contest deni es (ii) Improper : 1. Attempting to discover proprietary business information for the benefit of a competitor 2. Secure prospects for personal business 3. Institute strike suits 4. Pursuing ones own social or political goals (Pillsbury) (2) Burden of Proof: 220(c) (a) Burden on Corp : If SH only seeks access to the SH list or stock ledger, the BoP is on the corporation to show that the SH is doing so for an improper reason. (b) Burden on SH : Where the SH seeks access to other corporate records, however, the SH must prove that he is doing so for the requisite proper purpose. (3) Case law: (a) Crane v Anaconda: 157 (i) Facts: Broad construction Narrow construction 1. Dealt w funny NY statute that said the SH was entitle to inspect for purpose that was in the interest of the buzienss. 2. Crane wanted to make a tender offer to buy Anaconda stock and wanted to communicate to SH. 3. Crane asked for the SH list. a. SEC rule would require Anaconda to mail. 4. Anaconda refused (ii) Holding: 1. Communicating with other shareholders about offer was a proper purpose (iii) Other imp issues: 1. Statutory interp : a. Anaconda tried to argue that said the statute on its face limits SH inspection rights to "purposes related to biz" of corp and this was not related to the business of the corporation--it is just a market transaction where SH tries to buy stock from others. b. The Ct rejects this: why? i. Emphasis on liberal interp of statute. Don't read statute literally. Want to read it to effect its broad purpose. ii. Contrast this with the approach in the Honeywell case. 2. Application of NY statute to foreign corporations: a. He will discuss later. (b) Pilsbury v Honeywell (i) Facts: 1. Plaintiff belonged to an antiwar group trying to stop Honeywell from producing antipersonnel fragmentation bombs for the military 2. After buying some Honeywell stock, plaintiff requested access to Honeywell's shareholder list and to corporate records relating to production of such bombs a. He did so with the idea or using either a proxy solicitation of SH proposal rule to encourage Honeywell to get out of that biz. (ii) : P lacks a proper purpose. Held 1. Pillsbury lacks a proper purpose for requesting the shareholder list or corporate records a. Proper purpose is that reasonably related to that persons interest as a SH. 2. Here, the purpose was based solely on Pillsbury's preexisting social and political views rather than any economic interest a. Contrast that to SH proposal rule where ethical reason is enough as long as there is some link. Here the social reason is irrelevant. b. Contrast this to the Sadler and Crane to interpreting the statute. Here the Ct is narrowly construing the language to deal with econ interest only. Interest as SH is limited to what your stock is worth, not social responsibility. (iii) Limitation: 1. "suit might be appropriate when a shareholder has a bona fide concern about the adverse effects of abstention from profitable war contracts on his investment in Honeywell." 158 Record list: list of nominees used by depository firms. CEDE list: identifies the brokerage firms on whose behalf the depository institutions nominee holds shares. NOBO list: pierces the street name by providing a list of the names and addresses of beneficial owners 2. What does this case do with respect to incentives of people like Pillsbury, primarily for purpose of communicating to SH on issue of corporate responsibility? a. Suppose in Lovenheim, SH wanted to communicate to SH and wanted access to SH list, how could he do this? i. He could just say: "the animal cruelty will develop rep for being animal unfriendly brand and people wont buy it." ii. Encourages lying. iii. Ex: tobacco: lots of people urging people to get out of biz of selling cigarettes. They usually own less stock to qualify for SH proposal. But they say they are concerned of impact of continuing blah blah blah. iv. The prevailing rule is that as long as can credibly asset that you have econ interest, that will suffice, even if you have secondary policy reason. (4) To what SH list is the P entitled? (a) Sadler v NCR Corp. (i) Overview of the mechanics of stock ownership: 1. In most cases, SH wont be the record owners of the stock (the name of the person who owns in in the corp list)--the person in privity with the issuer. The reason is that if you hold record, selling shares is harder. Record holder who sells has to have title ect. a. The broker, in turn then has account with the depository trust, b/c they don't want to have physical ownership of the stock. The depository trust is the record owners and they have privity. Their ownership is nominal, but they are the technical owners. b. This reduces the transaction costs with conducting stock sales. 2. What are the different lists available? a. record list i. clearly they can get the record list. ii. the prob is that if you look at record list, 90% is owned by depository trust, sicne they are the largest SH of record. b. CEDE list : i. This wont do lot of good since just tells which brokers that have accounts at depository trust hold accounts. Doesn't pierce identity of the brokers to get SH names. c. NOBO list : (non objecting beneficial owner list.) i. Brokers must prepare at request of issuer. If beneficial owner, doesn't want people to know you own stock, you can object and have name w/ held. Most investors don't object. ii. Why would investors object ? Might not want them to know you are buying them out. (ii) In this case, P argued they were entitled to NOBO list. 1. Facts: a. AT&T launched a tender offer for NCR i. NCR was a Maryland corporation that did business in New York 159 what is the internal affairs doctrine: Corp. gov. issues controlled by law of state of incorp. ii. AT&T had no right under either NY or Maryland law to a shareholders' list iii. Under NY but not under Maryland law, its ally Sadler had such a right b. In Sadler's name, AT&T asked for both a CEDE and a NOBO list 2. Choice of law issue : a. The NY statute permitted residents of NY to insist upon inspecting the books and records of foreign corporations (incorporated out of state corpo). NCR is foreign corp. Most states limit inspection rights to in state corps. But some state, like CA and NY authorize their citizens to allow them to inspect the books and records of copros out of state. NY is such a state. b. ATT had no right since they were not a NY resident and MD stt didn't geve access to list. So, ATT got the Sadlers who were residents to get the list. i. So is it legitimate for NY to apply its stt to a foreign corp ? this elevates this to a const. issue. Is it consistent with commerce clause? c. Holding on choice of law: MD or NY? i. New York: "Access to stockholder lists is a recognized exception to the internal affairs doctrine" ii. The Ct is saying that NY constitutionally may apply its stt to foreign corps since access to the list is exception to internal affairs doc. This implies that the internal affairs doctrine is of constitutional import. So absent the exception, a state couldn't apply its corporate governance law.... iii. CA has a stt that says forign corps that do biz here, must allow election of directors by cumulative voting. So if Sadler is right, this shouldn't be constitutionally permissible. Wow. 3. Which list are they entitled to? a. The prob is that here, NCR had a copy of the CEDE list, but not the NOBO list. Why? NCR if they didn't the list, they wouldn't have to give it out. (iii) List entitlement: 1. CEDE List: a. DE makes clear that corp must generate a CEDE list at req of SH. Why? i. in Arby Associates Chancellor Allen said a CEDE list tells you which broker owns how many shares via depository trust. Its ok to order corp to have CEDE list prepared. It is easy to do. b. The CEDE list does one thing for you: i. Suppose you are insurgent and want to communicate with SH. The issuer is supposed to mail to SH. But the issuer really gives copies to depository trist, who gives to borkers, and the brokers actually mail out. If you want to comm. with fellow SH, having the CEDE list means you don't have to go through issuer, can just go through the broker. 2. NOBO list: a. The NOBO list is more time consuming. BUT--the fact that NCR deliberately avoided having it indicates it is useful. 160 b. The NOBO list allows you to start calling SH up and lobbing directly, faxing, emailing, phone, personal visits. c. the NY Ct says ATT is entitled to both lists, which means that NCR must prepare a NOBO list and give to ATT. i. ? Liberal interpretation of statute "to facilitate shareholder Why communication" d. DE only requires preparation of the CEDE list. 161 SECTION 3 (PART A) CONTROL IN CLOSE CORPORATIONS ASSN 3839 1) Overview: a) Most close corpos look like partnerships, they are not merely investments, but rather your business, or your livelihood. The result is that closely held corps SH want to modify some characteristics of coporations. There might be more risks, like risk of deadlock, but more seriously, the risk of oppression, where maj use their maj position ot benefit themselves at excpese of minority. i) Here, they don't have exit mech, like pub SH. So wise close corp SH will structure agreements in advance to protect their interests. (1) Three main mechanisms to do this: (a) Voting trusts (b) Vote pooling (c) Agreements limiting authority of the Board. 2) Close Corporations: a) Galler v Galler: ii) "a close corporation is one in which the stock is held in a few hands, or in a few families, and wherein it is not at all, or only rarely, dealt in by buying or selling" I.e., no secondary market for shares (1) Most corporations are closely held, but almost everything we learned apply to both close and not close corps. (a) There are some special rules that deal only with close corpos. b) Deal points: that relate to allocation of control iii) How decisions will be made iv) Who will be directors v) Who will be officers (1) Who will do what work vi) Salaries and dividends vii) Termination viii) Bringing in new SH c) Investor passivity often not option: Control rights are very important ix) No Market exit x) Compensation (1) Close corporations don't pay dividends to avoid double taxation. So if you are going to get a return, it will be since you are empl there. xi) These two factors together both mean control rights are important since you are dependent on them to get out, and depend on them for livelihood. d) Potential decisionmaking probs: xii) Hypo: 4 friends want to form a close corpo. Issues? (1) Deadlock (22) (2) Oppression (31) e) Solutions: Mechanisms to allocate control rights in corps to deal with both these possibilities: xiii) Voting trusts : (rare) (1) An agreement among shareholders under which all of the shares owned by the parties are 162 transferred to a trustee, who becomes the nominal, record owner of the shares (a) The trustee votes the shares in accordance with the provisions of the trust agreement, if any, and is responsible for distributing any dividends to the beneficial owners of the shares (2) Advantages : eliminates the possibility of deadlock since all shares are held by trustee, and the trustee makes the decisions. They are the fiduciary. (3) Disadvantages : (a) Loss of control. Lost voting rights. (b) Duration: most states limit to 10 years. This is problematic. Could be advantageous to have perpetual voting trusts. (c) Still possible for board to oppress the minority. (i) Thus, voting trusts are rare. xiv)SH agreements regarding board election: VOTE POOLING : (1) Generally: (a) Valid? (b) Practical Problems? (i) director deadlock.. how solved? (ii) director oppression? (c) Enforceability? Specific performance. (2) Ringling Bros (shows how bad drafting is bad for the parties) (a) background: (i) regular voting. 1. Usually vote for a slate. Like a slate of 4. and vote for the slate you want. (ii) Cumulative voting: 1. A mechanism by which the minority gets to elect some directors 2. Directors are elected all at once. 3. Each shareholder gets number of votes = (number of board vacancies) times (number of shares owned). 4. May cast all votes for one (or more) member of the BOD. (b) Ringling and Haley family factions had a written agreement under which they were to vote together. (i) Effect of agreement: 1. North was able to elect only two directors 2. Ringling and Haley by combining votes were able to elect 5. (c) In the event of deadlock, the disagreement was to be determined by an arbitrator, Mr. Loss, their atty. (i) In 1946, there was a deadlock. (ii) When called upon to arbitrate the dispute, Loos decided that the Ringlings and Haleys should vote for two Ringlings, two Haleys, and a Mr. Dunn (iii) The Ringlings did so (iv) But the Haleys defected, casting all of their votes for the two Haleys 1. Defection was due to the circus fire and visitation. (d) Shares owned by each faction: Shares of stock of Ringling Bros. were owned as follows: Owner Shares Edith Conway Ringling 315 Aubrey B. Ringling Haley 315 Votes 2205 2205 163 John Ringling North 370 1,000 Votes = # shares X vacancies (7) 2590 7000 (i) If they voted the way atty said, Dunn would have gotten elected. 1. But when the Haley's defected, Dunn doesn't get elected. (ii) The trial Ct said they were supposed to vote the way the atty told them too. 1. Even if the trial ct ordered them to vote the way atty told them to, notice that now that Haleys came over to North faction, that the Norths have elected a maj Vote pooling is diff than of the board. given that they had a majority, why did they appeal? The voting trust in that there is no transfer of legal title Haley's wanted to go back to the votes cast and get 5 directors. But why to the stock in question. appeal when they had majo of 53? Hint, they wanted to make North appoint so the prejudice against President. But why do they need a 52 majority when they have a 43 maj? voting trusts wasn't if North is going to be President, will he want a salary? If he votes to approve extended to voting pools his salary, wouldn't that be self dealing? If he wants the protection of 144, he needs approval by maj of BoD. 2. Does this mean the K is void or voidable? if 33, is K voidable? what happens to K that has been approved by board by not by maj of disinterested Contested SH. If they get 144a approval, and SH challenged, the effect of disintereseted election: only approval is to insulates them from JR. so they need a 53 maj. remedy is to (e) What happens in the appeal? throw out the (i) The agreement is valid but the Haley votes were not counted. This case turns on technicality. The DE Sup Ct thinks the trial ct has discretion to adopt remedies, like specific performance to enforce the arbitration agreement in a regular lawsuit. But this was a contest of an election where the only remedy is to throw out the votes, so the only remedy they can order for vio of the agreement is to negate the Haleys votes. this means there is one vacancy due to a tie. But the Ct doesn't care. The problem was their choice of casue of action. (f) did Mrs. Ringling win or lose? (i) The agreement is valid, but the Haley votes were not counted ... six people are elected ... three North nominees, two Ringlings, and Dunn (ii) Vote pooling agreements have never been too problematic. This one was enforceable, but the reason they didn't the remedy they wanted, that was due to the cause of action they brought. 1. Do you think that was the result the parties intended? 2. If you were Loos, their lawyer, how would you have drafted the agreement? (iii) What did the atty do bad? 1. Represented both. 2. The K didn't require that they vote as the arbitrator created. 3. But what is the prob for Loos as a practical matter? hard to please both, one side will be mad and fire you. xv) SH agreements that constrain director discretion : (1) These are very common (a) Require certain persons as officers (b) Specify compensation and or dividend policy (c) Require SH approval or board action 164 (d) These agreements are also subject to more scrutiny than vote pooling agreements. (i) Example: 1. Agreement says: Abel will be President, Baker will be VP, Charlie will be Secretary, and Delta will be Treasurer R a. Spells out specific requirements visavis salary, dividends, pensions, u n tenure in office and the like. these are all things that are normally s decisions for the Board. But here the SH are spelling these out as matter of af contract law. o 2. Enforceable? a. Why care? Whether we care has varied over time. McQuade (2) Mcquade v Stoneham (a) Facts: (i) Stoneham owned a majority of the stock in the NY Giants (ii) McGraw and McQuade brought small equity interests in the Giants from Stoneham 1. SH agreement by which all agreed that they would each do their best to elect each other directors and appoint each other officers at specified salaries. 2. McQuade was fired, and he sued seeking specific performance of the McQuade pros and agreement. cons: (b) holding: PROS: 1. nexus of K: SH own (i) Directors must exercise their independent business judgment on behalf of all the residual, but not the shareholders corp itself, so how can 1. If directors agree in advance to limit that judgment, then shareholders do not they exercise ownership receive the benefit of their independence like rights of restricting (ii) Agreements that limit directors independence are therefore void as against public BoD discretion? policy 2. sep. of own, & control, 1. The Ct distinguished these agreements which they hated, from vote pooling and director primacy. agreements, which they thought were ok, "SH may combine to elect CONS: directors... the power to unite is, limited, however, to the election of directors 1. close corps are closer and does not extend to limiting power of directors." to being "inc. ptship" than a true corp. so (c) Is this rationale sensible? (i) Most corporate law rules are just default provisions off the rack rules which the parties are free to alter to meet their particular needs. (ii) When one is dealing with a close corporation, in which the shareholders naturally would want a greater voice than they would get in the case of a public corporation, parties should even greater flexibility in modifying the off the rack rules provided by the statute than normally accorded to public firms. (iii) Is there an externality? Concern for minority shareholders may be questionable. After all, on the facts of McQuade, Stoneham could, as a practical matter, with his controlling votes, put anyone he wanted into any office. If he can do it on his own, why would it be wrong to do it because he had agreed with another shareholder to do it? (d) Easily Evaded? (i) Have bylaws state that officers may be removed only for cause or by the unanimous vote of the directors. 1. Need to make sure that amending the bylaws requires unanimous director and/ or shareholder action. These two things (ii) Alternatively, employment contract coupled with stock buyout provision. make McQuade 165 1. If they fire him, he can get damages and require them to buy back his stock (so he's not stuck with his investment). (3) Clark v Dodge: (a) This case revisited McQuade and acknowledged that rules might be diff in closely held corps. (b) Held: (i) McQuade designed to protect minority shareholders who were not party to the agreement (ii) Where the corporation has no minority shareholders, the rule is unnecessary (ie when the K is unanimous) and will be enforced, even if it constrains the discretion of the directors. 1. But note limiting language; maybe invalid if goes beyond those limited items (iii) Clark should always receive of the pay, they cant fire him or cut his pay. if we treat close 1. The fact they cant fire the head of company or reduce his pay: there is a tag corps like line where the Ct says unanimous agreements are fine, but if the constraint was partnerships, the too excessive we might invalidate it. case for freedom of a. This is hard to determine. How do we measure? contract becomes i. The thrust of this case, was not on the tag line, but the general notion of freedom of K: they ought to be able to modify the default rule. The evolutionary trend was to liberalize the ability of SH to do so. (iv) Issue left open by Clark but addressed by Galler: Is unanimity required? (4) Galler v Galler; In (a) Facts: this (i) Brothers entered into SH agreement that said each fam gets 2 seats on the Board case and mandated dividends and mandated death benefits. , the (ii) Benjamin dies and Isadore refuses to perform the agreement. DE (iii) This agreement would be invalid under McQuade. In Clark v Dodge, it would be Ct, invalid since Rosenberg is not party to agreement. allo (b) Holding : (i) agreement is valid. (ii) Unanimity not req if: 1. The corporation is closelyheld 2. The minority shareholder does not object 3. The terms are reasonable a. Agreement didn't have unreasonable duration. b. Company has to pay dividends only if sufficient earned surplus. (legal capital--have to have SH equity) c. Death benefit was reasonable. (c) Agreement had a vote pooling agreement: (i) Valid? (ii) Why not deemed a voting trust? 1. no separate ownership of stock from ownership rights. (d) Remedy: (i) Corporation had been unable to pay mandated $50,000 annual dividends because Aaron's and Isadore's salaries exceeded those to which Emma had agreed 1. They must account 166 2. Presumably back dividends must be paid Specific Performance gives whip to the oppressed to get $$$ (ii) Emma and cohort on board? 1. Presumably (iii) The Ct says Emma and son are going to end up on BoD. (e) Where is this ct leaving the parties? (i) Have a board with 4 members, they will have to pay dividends, and salary to Isabella and arron, determine the proper dividend amt which will be determined by the Board. (ii) The agreement didn't talk about setting salaries, these are left to board discretion. (iii) Specific performance leaves us in situation where there is guaranteed deadlock over the issues that are left to the board. (f) What is the effect of specific performance in terms of the ultimate resolution? (i) What would have happened if Isabella had won? could have left Emma frozen. If Emma gets specific performance, she can at least offer to get bought out. And she can get a good price. This isn't about how runs the company, but how high is the buyout price. This specific performance give whip to the other party (not the oppressor). (g) Planning: (i) What should the parties have done ex ante in drafting their SH agreement? 1. include a buyout provision. Definite triggering activities. a. Two things buyout has to have nailed : i. what is the triggering event, and ii. what is the price, how do we value the company? 2. Why did Ben and Isadora sign w/o buyout provision? a. atty didn't think bout it b. analogy to marriage. 3. Why didn't Rosenberg object ? a. the SH agreement req the corp to pay high benefits to the surviving spouse. Prob due to the fact that Rosenberg was told he would be taken care of too. b. But the fact that Rosenberg is present as 5% owner, suggests another solution they could have tried instead of buyout provision. c. They could have said that Rosenberg would be elected to board to be tiebreaker. i. This solves deadlock, but is this a good choice? No. A tie breaker doesn't deal with the issue of oppression. If the tie breaker always sides with other party, there can still be oppression. ii. So the only real solution is the buyout solution. 167 ABUSE OF CONTROL: FIDUCIARY DUTIES, Assn 40 1) Intro: a) There is the risk of deadlock and there is risk of oppression. The particular risk in this context is b/ c of most close corps not paying dividends, there is desire of the minorities to have employment as source or return on investment. i) Where they fail to get such K or the K doesn't cover the issue that came up, you have to resort to fiduciary duties of SH, since in most of these cases it is action by controlling SH that did it even if hey did it in capacity as director. b) At early common law, SH had no fiduciary obligations to other SH. They were free to be self interested. Only director had fid obligations. We saw erosion of this in Sinclair v Levin in the public corporation context, and similarly, there has been erosion in the private corporation context. c) Fiduciary duties are one way to limit agency costs. 2) Massachusetts cases : a) The Partnership analogy : i) The MA line of cases that are founded on the notion that closely held corps are similar to partnership. So they move rules in direction of partnerships. Donahue was just like Partnerships, Wilks similar although a bit more retreated. ii) A prior case, Donahue v Rodd Elextrotype analogized close corps to partnerships. (109) Applied partnershiplike fiduciary duties to shareholders of close corporations (1) Explicitly invoked Cardozo's decision in Meinhard v. Salmon (2) Stated that the majority must always subordinate its interests to those of the minority. iii) Wilkes v Springside Nursing Home: Does partnership analogy survive Wilkes? (1) Facts: (a) Plaintiff: One of four shareholders in a close corporation (i) He had been a director and officer, receiving a regular salary (ii) Firm paid no dividends (b) Relations between Wilkes and the other shareholders deteriorated (i) Wilkes gave notice of intent to sell his shares (ii) He was then stripped of his salary and offices (iii) He sued, alleging breach of fiduciary duty (2) Holding: (a) Wilks was improperly frozen out. (b) Does Donahue survive? Must maj subordinate interests to the minority? (i) The Ct didn't disavow Donahue, but it did tweak it and limit it substantially. According to Wilks, there must be a balance b/n the fiduciary duty of the majority and its right to selfish ownership, which gives the controlling group "some room to maneuver" in setting policy. (3) Rule of law: The ct comes up wth 3 step approach: (a) Majority must have some legitimate business purpose (b) If so, burden shifts to minority to show less harmful alternative (i) Two pays the maj can give him a return on his investment: 1. Pay dividends 2. Buy him out at FMV (c) If so, court must balance the legitimate business purpose against the practicability of proposed alternative 168 (i) What might have been a legitimate business purpose in this case? If Wilkes had been negligent in failing to perform his duties or in failing to perform them with due care. 1. But Wilkes was competent and remained willing to perform his tasks. (4) What is the court's policy rationale for the RULE? (a) Greater degree of control : The majority presumably invested more in the corporation to purchase voting control, they should have a greater degree of control reflecting their investment. (b) Assumption of risk: The minority shareholder presumably knew of the existence of a controlling block of shareholders when he or she bought into the firm. (5) Analysis question 7 : How could the parties have arranged things ex ante to avoid this litigation? (a) Shareholder agreement to maintain each other in office. (i) Query re enforceability under Clark v Dodge and Galler v Galler (b) Employment agreement between corporation and Wilkes. (i) Would the parties agree ex ante to employment agreements that did not allow for termination for cause? 1. Note how this allows one to bypass McQuade. (c) Buyout agreement under which the parties are required to buy out a disgruntled investor. (i) This seems like the best alternative. (ii) What would a contractarian say? 1. Investors are heterogeneous. a. Some investors may prefer more flexibility and less stringent fiduciary standards, while others prefer stricter standards and less flexibility. i. Under preWilkes law, the former could incorporate, while the latter could form partnerships. 2. Courts maximize investor welfare by letting investors choose the form best suited to their business, which requires different legal rules for shareholders and partners. 3. When Cts make two diff types of orgs (partnerships and corps) resemble each other, cts are reducing the utility of choice, so it seems there is good arg that cts should be reluctant to shift the rules of corporations if you want investors to have a real choice. iv) Suganrman v Sugarman: (1) Facts: (a) Statler Corp. formed by three Sugarman brothers: Joseph, Samuel, and Myer (b) Leonard Sugarman, son of Myer, owned 61% (i) Leonard and Myer salaried employees--allegedly excessively compensated (c) Samuel's shares passed to his three grandchildren, Jon, James, and Marjorie Sugarman, who together owned another 21.8% (d) Marjorie wanted to work for the firm but Leonard would not hire her (e) Jon once worked for the firm but Leonard fired him (f) In count I, JJ&M sued derivatively for Leonard's excess compensation, but not at issue (g) Count II alleges a freezeout, in violation of Wilkes (what we focus on) 169 (i) Firm did not pay dividends (ii) Lowball offer: Leonard offered to buy Jon's and Marjorie's stock at a "grossly inadequate" price 1. HYPO : Suppose Leonard paid himself reasonable but generous salary, considered not to pay dividends for plausible biz reason, but he had not made Low ball offer: any buy out offer at all to the min SH. (if he doesn't make a lowball offer, is this a freezeout??) Liability? The low ball offer was a. Is a lowball offer required for liability? the key fact in this case, i. "The minority shareholder must first establish that the majority which means that shareholder employed various devices to ensure that the minority Leonard could have shareholder is frozen out of any financial benefits from the corporation avoided liability by through such means as the receipt of dividends or employment, and refraining to make a that the offer to buy stock at a low price is the `capstone of the lowball offer! This is majority plan' to freezeout the minority" ii. if a buyout is an essential factor, does that make sense ? No, since at least the Ps get something. (iii) The plight of the frozen in minority ? 1. See analysis Q 1: what is the approp remedy in this case? a. The court has taken care of the excessive salaries, but the minority shareholders are still locked in. Leonard can pay himself a reasonable salary and the court does not seem to suggest that he must pay dividends or hire Jon or Marjorie. 2. analysis Q#4: advice to Leonard re salary: What can L do to minimize risk that salary will be struck down as excessive? a. Have a disinterested and independent BoD. i. Interested directors transaction, standard of review is waste, with BoP. b. Might also want to hire an outside salary consultant. c. So as long as L can keep salary in reasonable range, he can insulate himself. Given that, does it really make sense to require a lowball offer? d. What is the appropriate remedy? i. The kids are better off with lowball offer than w no offer. 3. so what should the ct have done? a. Made clear that Wilkes applies even absent the "capstone" lowball offer b. Apply threeprong test (legitimate business purpose, less harmful alternative, balance) (iv) Real world impact: 1. Who has the whiphand in negotiating the buyout? a. Coase theorem predicts same result regardless of case outcome: Leonard will buy out kids b. Case outcome does have distributional consequences: i. Kids will get higher price after this case ii. Leonard would have driven harder bargain if he had won v) Smith v Atlantic (fiduciary duties of minority SH) (1) Overview of this case: (a) SH agreements may give minority SH considerable power too. (2) Facts: (3) SH agreements constraining director discretion: 170 (a) Requires shareholder approval of board actions by a supermajority (80%) vote (b) Because each shareholder owned 25% of the stock, each had an effective veto (4) Dispute arose as to how earnings should be expended (a) Majority wants to pay dividends (b) Wolfson (minority) wants to reinvest (i) Why? Tax implications. 1. Maximum marginal tax rate on ordinary income: a. 19541963: 90% b. post1963: 70% c. Dividends tax as ordinary income 2. Maximum capital gains tax rate: a. 25% b. Stepup basis at death 3. Accumulated earnings tax (5) Holding: (a) A minority shareholder, at least where he has a veto power over corporate action, has fiduciary duties to the majority (i) Wolfson's use of his veto power was inconsistent with that duty because it subjected the corporation to an unnecessary assessment of penalty taxes (b) Is this a sensible result? (i) Is this an approp case to apply that doctrine? Is this a case where W is oppressing fellow SH. 1. Well this is just a deadlock case, not an oppression case. By virtue of deadlock they expose corp to this tax. Seems that maj SH were at least as much at fault in this case as were W and hard to figure out why W loses. (ii) Why does W lose in this case given that fact? 1. Ws testimony was damaging. He said he had no intention of agreement to dividend payment. a. The other SH agree to make urgent repairs to blds, and W agrees to nothing in dividends. 2. What should W have done ? a. So if you are advising controlling SH have to have piece of paper showing you have leg biz purp. Even though it's a balancing test, if you have leg pur, youa re pretty much home free. 3) Delaware line of cases : a) Nixon v Blackwell: i) Rejects the MA line of cases (1) Rejects special close corporation fiduciary duties ii) Controlling shareholders subject to Sinclair Oil standard (1) Have they benefited themselves to the exclusion of the minority? (2) ESOP life insurance policies normal compensation; so no violation iii) The real Q here is burden of proof. (1) In MA, the BoP starts out on majority. We know that the party w/ burden has the much harder job. (2) Under DE law, the majority SH doesn't have BoP till there is showing that they benefited at expense. 171 (3) Overall though, although the tests are different, the results would probably be the same in DE and MA. (a) These cases typically involve situations where the maj SH have benefited themselves at the minorities' expense. In almost all cases, the maj SH are also directors or control the directors. (b) Given the absence of a disinterested decisionmaker and the presence of a majority on both sides of the transaction, DE Cts would apply the entire fairness standard to most cases litigated under the MA standard. iv) Facts: (1) The founder of the biz dealt with the prob of what to do with what to do with the next generation. Did so by creating two classes of stock. The class that had voting rights went to EEs and family got nonvoting stock. The EEs set up system of keyman life ins policies. (a) One way that companies use these ins policies is to help in buyouts. Death can trigger. If EE dies, want to keep ownership w current EEs so they had a rule saying that if EE died, the proceeds used to buy the EEs stock from the estate. Life insurance funded buyout agreement. The kids got no such buyout and had no exit since the corp didn't fund the buyout for them. They sued. Under MA they would have forced the controlling SH to show legitimate biz purp for this ins policy. (could they have shown a leg purpo for this>) DE ct rejects the MA line of cases and says no close corp, and public corp is the same thing. (b) Have they benefited themselves to benefit of themselves and exclusion of the minority. NO. There is valide reason, to maintain control of corp in hands o the EEs. (c) They say its normal compensation. (d) Note: this Probably came out same way in MA though 172 DISSOLUTION IN CLOSE CORPORATIONS assn 41. 1) Overview: a) One of the probs with the fiduciary duty as remedy for oppressive conduct is the Q of remedy. To what extent is the remedy gonna be reasonable for the plaintiff who is squeezed out of employment with the close corporation. they really just want to be bought out and at a fiar price, that is what the Alaska case is all about. 2) Agency costs in close corporations : i) Risk of oppression of minority interests by majority shareholders. ii) Limited by: (1) Imposition of expansive fiduciary duties. (a) Relatively high costs of judicial enforcement. (b) Often difficult to construct a remedy for breach of fiduciary duty. (i) How much damages are someone entitled to when they are squeezed out of employment with the close corporation? b) Alaska Plastics v Coppock: i) Facts: (1) Three investors had owned Alaska Plastics. (a) One transferred a l/6 interest in the firm to his exwife (Muir, who remarried and took the name Coppock) in a divorce settlement. (2) The three original owners paid themselves directors' fees and some personal expenses, but paid no dividends. (3) Muir sued, with ten individual and derivative causes of action. (4) The lower court required AP to buy her shares at their fair value. Holding on appeal? (a) Remanded. (b) None of the four main grounds for ordering a buyout are present on trial record. (i) Four main grounds for ordering buyout: 1. Buyout agreement 2. Buyout in lieu of dissolution 3. Appraisal 4. Remedy for breach of fiduciary duty a. This raises the Q of whether the ct could have ordered buyout for breach of duty in Sugarman. ii) Held: (1) Court said the directors may have breached their fiduciary duties to Muir under Donahue. (2) If so, what is the remedy? (a) Equal treatment " "-- require that the directors treat Muir equally with the other shareholders. (i) If the other shareholders received disguised dividends (e.g., directors' fees), Muir should receive them as well. (ii) Because the other shareholders did not have the right to sell their stock to the firm, equal treatment does not require the firm to buy Muir's stock. (iii) So instead of buyout being generic remedy for breach of fiduciary duty, it is just when there is inequality. 1. That knocks out categories where its ok for judge to order that the corp or other SH buyout other SH. Leaves us with dissolution; (b) Dissolution : 173 (i) All states have provisions under which a shareholder may seek an involuntary dissolution of the corporation. (ii) Dissolution leads to a winding up and liquidation of the firm, followed by a distribution of the firm's remaining assets to creditors and then to shareholders. (iii) Dissolution by BoD and SH (supp 224) 1. 14.02 provides mech for voluntary dissolution 2. 14.20 provides grounds for administrative dissolution 3. 14.30 is the most imp to us, that allows grounds for a Ct involuntrairy dissolving the company even if some SH want to keep comp going. (3) Is Muir entitled to dissolution? (a) If a plaintiff meets the requirements for dissolution, the courts have equitable power to order such a buyback instead. (i) To dissolve, however, the plaintiff must show oppression or fraud 1. In this case, the lower court made no such finding. Accordingly, remand need. (b) grounds for dissolution under AK stt: (i) Compare voluntary and administrative dissolution. (ii) As do most statutes, the Alaska law provided several grounds for involuntary dissolution: 1. Fraud, oppression, or illegality by the majority shareholders towards the minority. 2. Waste of corporate assets (iii) Most statutes provide two further grounds for dissolution: (MBCA 14.30) 1. deadlock at director level : mgmt: like Smith v Atlantic properties. Would the Ct have been able to grant involuntary dissolution on grounds? a. Three conditions: 1) Directors are in fact deadlocked (yes), 2) The SH are unable to resolve the deadlock by electing new directors (yes, in this case the SH were unable to vote out W), 3) Deadlock must threaten irreparable injury to the corporation or prevent the business of the corp from being conducted to adv of SH. if firm making a profit, then no dissolution remedy. 2. SH deadlock : a. two conditions: i. The shareholders must be evenly divided. ii. Because of their division the shareholders must be unable to elect a board of directors for two years running. 3. in this case, there was agreement b/n directors and SH to oppress Muir, so oppression is the real issue. (c) Opression : was Muir oppressed? (i) Directors may have breached fiduciary duties by paying themselves salaries and fees, but not providing any return to Muir. her ex got more than her even. (ii) They offered her an unacceptable price for her shares. Cf. Sugarman. (lowball offer isn't oppression) (iii) They didn't tell her about shareholder meetings. (4) What is oppression? substantially defeats the reasonable expectations of the SH. (more than mere disappointment the very reason for participating have been defeated.) 174 (a) What are reasonable expectations: iii) iv) v) vi) (i) Were reasonable under the circumstances. (ii) Known (or should have been known) to the majority. (iii) Central to the petitioner's decision to join the venture 1. how do we measure that when the person didn't decide to join the venture but got the shares from divorce settlement. 2. in Sugarman, whos expectations are relevant, the kids or the grandparents? Buyout in Lieu of Dissolution: (1) In some states, CA included, if entitled to dissolutiom, the Ct doesn't necessarily have to go forward with the dissolution, see MBCA 14.34: election to purchase in lieu of dissolution. (2) If Ms. Muir could prove that she was oppressed, the statutory remedy would be a dissolution and a liquidation. But the court said it was reluctant to order a dissolution. What remedy did the court propose to offer as an alternative? (a) An order requiring the corporation or the majority shareholders to purchase Muir's shares at a fair price. (b) In states where you have 14.34, there is no problem. (3) But the Ct sys they are reluctant to order dissolution, so the Ct as matter of equity says, even though the Alaska stt doesn't contain purchase in lieu of dissolution, they will permit it anyway. (a) Why was the ct reluctant to order dissolution ? the ct thinks the firm is worth more as going concern than if it were to be split up and sold in pieces. Why would a stock buyback be a more appropriate remedy? (1) The close corporation shareholder has no market for his or her shares and thus has no ready means of withdrawing from the firm. (2) The share repurchase option creates such a market by effectively coercing the majority into buying the minority's shares, while also preserving the going concern value of the firm. Is a buyout in Lieu of Dissolution Valid? Four QWs" (1) Necessary given the practical effect of dissolution order? (a) Suppose Muir goes to Ct and gets order to dissolve the corp. the corp inst automatically dissolved. What will undoubtedly happen is that Muir will show up with order to dissolve unless they buy her out. So not clear you need judicial order authorizing buyout. (b) On the other hand, what might be the benefit of having judicial supervision? To prevent her from trying to extort them. Judicial proceeding may be more fair. (2) Is appraisal or buyout any less disruptive than dissolution? (a) In many cases buyout will be very disruptive. (3) Liberal dissolution rights allow minority shareholders to threaten to dissolve the firm and thereby potentially extort additional benefits from the firm or the other shareholders? (4) Query whether its appropriate for court to create a remedy when the legislature didn't? What other rights might Muir had? (1) She could sue for the corporation to recover the fees (and other amounts) improperly paid to Stefano, Gillam, and Crowe. (a) Court disallows because no evidence corporation was harmed (excess comp cases are derivative in nature) (i) This is not really an excess compensation case, it is an unequal treatment case. She is really saying she wants her share. The prov is that what si the remedy? if she sues individually to get her share, Equal treatment. 175 1. What is equal treatments. How much, as much as Crow got? (2) She could bring an individual action against the corporation for her share of the "dividends" (the improper payments). (a) Query: is she entitled to the same share as Crowe (who owned 150 shares)? (3) Individual action against the other shareholders for her share of the "dividends" (the improper payments). (a) Because Muir's exhusband, Crowe, only owned onesixth of the shares, but received the same "dividend" as the other majority shareholders, who each owned onethird, maybe Muir's action should be against Crowe to recover from him the portion of his dividend that she was entitled to receive. 3) Transactional planning implication : a) Whos fault was this case? i) Best way to solve freeze out is to avoid it from the start (1) Role of buyout agreements ii) Muirs divorce atty should have never let her accept the shares as her settlement, w/o some sort of buyout agreement. b) What should Muir have done, assuming Crow lacks cash to buy shares immediately? i) The best bet would probably be to insist on an obligation on the part of Crowe to buy the shares over time. ii) Could you get the other shareholders to assist? Could you persuade them to have the corporation buy the shares? Why did they try to have corporation buy out Muir? c) What should the founders have done about the risk of divorce? i) Consider giving any shareholder the right to demand a buyout and giving the corporation the right to buy shares in the case of any transfer from any of the individual named shareholders (making clear that any substitution of a new person as a result of a marital claim is treated as a transfer). (1) The key then becomes the price for the buyout. ii) Some cts will have restrictions on transf. of the stock. They don't want other people becoming SHs. They get right of first refusal. This is potentially applic in divorce cases but its rare. 176 TABLE OF CONTENTS 177 1 10-b5.................................................................................106 A abstention...........................33, 34, 37, 38, 40, 47, 48, 51, 121 Abstentions.......................................................................142 Accountability.......................................................44, 67, 144 affirmative defense.......................................................47, 53 agency costs................................................13, 14, 15, 16, 17 Agency costs in close corporations...................................173 Agency Relationship.............................................................1 Alaska Plastics v Coppock................................................173 ALI Principals of Corporate Governance............................89 align the managers interest..................................................46 Alter Ego Doctrine..............................................................22 Anomalies that makes sense........................................98, 100 Application of the ALI........................................................90 appraisal....................................................................111, 112 Appraisal..........................................................................173 appraisal rights..........................................................111, 112 articles of incorporation.........................8, 11, 21, 32, 53, 142 audit committee............................................................51, 52 Auerbach v Bennett......................................................67, 68 Auerback v Bennett............................................................71 Austin...............................................................................156 Authority...............................................3, 17, 43, 44, 67, 144 Authorized but not issued shares..........................................9 Authorized shares.................................................................9 B bargain forcing default........................................................77 Barry Switzer....................................................................131 Basic..............62, 91, 107, 108, 109, 110, 111, 116, 122, 128 Basics test for materiality................................................116 Basis...................................................................20, 129, 155 Bayer v Beran.....................................................................79 Beta....................................................................................99 BJR..30, 31, 32, 33, 34, 35, 36, 37, 38, 40, 43, 44, 46, 47, 48, 49, 50, 51, 53, 58, 62, 63, 65, 66, 68, 71, 72, 75, 79, 83, 90, 91, 92, 93, 114 Bonding........................................................................15, 16 bottom line with demand....................................................74 Bounded rationality............................................................15 brazen...............................................................................133 Brazen misappropriation...................................................133 Breach of fiduciary duty.....................................................76 Brehm v Eisner...................................................................46 Brophy..............................................................................117 Brophy v. Cities Services..................................................117 BROZ.................................................................................89 Broz v PriCellular...............................................................86 Bundle of Rights...............................................................141 business judgment rule............................................31, 69, 79 Business Judgment Rule..............................30, 31, 33, 37, 44 buy or build........................................................................13 Buy-out.............................................................................169 Buyout in Lieu..................................................................175 buyout provision...............................................................167 Chestmum.........................................................................134 Chestmun..........................................................................134 Chiarella............................................125, 128, 129, 131, 132 Choice of Law....................................................................59 Choice of law issue...........................................................160 Clark v Dodge...........................................................166, 169 Coase................................................................14, 19, 20, 76 Cohen v Beneficial Industrial Loan....................................59 Common stock......................................................10, 94, 142 compensation......14, 16, 46, 48, 57, 63, 65, 66, 69, 104, 124, 125, 126 Compensation thesis.........................................................124 Complexity.........................................................................14 Consensus.....................................................................17, 43 Constructive fraud..............................................................23 constructive insider...................................................130, 132 Constructive Insiders........................................................130 Constructive trust..............................................................117 contactatarian model...........................................................19 contest of an election........................................................164 contingent fee..............................................................60, 137 contractarian...............................................................20, 169 control premium.................................................................41 corporate opportunity................................86, 87, 89, 90, 128 Corporate Opportunity........................................................86 corrective disclosure.........................................................152 country risk.........................................................................92 Crane v Anaconda.............................................................157 cumulative abnormal returns.......................................98, 100 Cumulative voting............................................................163 D C California laundry list.........................................................24 Canons of Statutory............................................................57 Capital Asset Pricing Model...............................................99 Capital markets...................................................................96 Capital structure terminology...............................................9 CAPM...................................................................35, 99, 100 Caremark.............................48, 49, 50, 51, 52, 60, 66, 67, 75 Cargill.....................................................................1, 2, 3, 13 Causation..................................................................106, 111 CEDE list..........................................................159, 160, 161 deadlock at director level..................................................174 Debt and equity securities.....................................................9 debt securities.......................................................................9 deceptive...........................................................106, 112, 133 decision not to act...............................................................51 Delaware line of cases......................................................171 Demand Excused................................................................62 demand futility..................................................62, 63, 65, 66 Demand futility.............................................................65, 66 Demand Requirement.........................................................62 depository trust.........................................................159, 160 Deregulatory Arguments...................................................123 derivative.....13, 33, 34, 50, 54, 58, 59, 60, 61, 62, 63, 65, 67, 68, 71, 72, 74, 75, 86, 114, 117, 131, 147, 150, 157, 173, 175 Derivative....................13, 14, 33, 34, 58, 59, 62, 67, 74, 114 Derivative litigation..........................................14, 33, 67, 74 Derivative Litigation.....................................................13, 58 derivative litigation tree......................................................63 derivative suit..................33, 50, 59, 65, 68, 72, 86, 114, 117 Derivative Suits..................................................................58 Derivatively informed trading.............................................97 Diamond...........................................................116, 117, 126 Diamond v. Oreamuno......................................................116 diff classes of stock.............................................................92 Different classes of Stock...................................................94 Direct....................................................29, 54, 58, 63, 65, 79 direct versus........................................................................58 Dirks.........................................................129, 130, 131, 134 disclose or abstain.............................120, 121, 128, 129, 132 disclosure violation.....................................................53, 114 discovery.................................21, 32, 37, 46, 53, 65, 72, 124 disinterested directors..........55, 68, 79, 81, 82, 83, 84, 90, 93 disjunctive...................................................................65, 143 Dissolution........................................................173, 174, 175 diversifiable........................................................................36 178 dividends..............2, 6, 9, 30, 41, 44, 53, 91, 92, 94, 141, 142 Dodge v Form Motor..........................................................30 doesnt speak to the validity of the K as a matter of K law. 81 Doran v Petroleum Mgmt.................................................104 Due diligence....................................................................103 duty of care........31, 33, 34, 46, 47, 49, 50, 51, 53, 68, 75, 84 duty of disclosure..............................................................108 Duty of Loyalty.............................................................48, 75 duty to be informed.......................................................33, 34 H Heard on the Street...........................................................132 History................................................................................82 I E earnings ratio......................................................................98 ECMH.........................................................96, 100, 123, 124 Economic rights................................................................141 Economics of deterrence...................................................149 Efficient Capital Markets Hypothesis.................................96 Egregious board decisions..................................................52 Eisenberg and the tests to determine if suit is derivative or direct..............................................................................58 Elements of a 10b-5 claim.........................................106, 107 Enterprise Liability.......................................................22, 26 Entrenchment Effect.........................................................143 equal access.......................................................120, 125, 129 Equality of information.....................................................125 Equity securities............................................................9, 136 Erie RR v Tomkins.............................................................60 estopped..............................................................................12 event study..........................................................................99 Evolution..........................................................................115 ex ante injunction..............................................................152 Exempt securities..............................................................104 Exempt transactions..........................................................104 Expansion Policy Hypo......................................................93 Expectancy.........................................................................87 Externalities........................................................................26 Illegal conduct..............................................................33, 37 implied private right of action...........................................149 incorporation process..........................................................10 Indemnification...........................................53, 54, 56, 60, 72 industry practice...............................................................122 insider....60, 97, 102, 106, 107, 113, 119, 120, 121, 123, 124, 125, 126, 127, 128, 129, 130, 131, 132, 136 Insurgent...........................................................................147 interest or expectancy..............................................86, 87, 92 Interest or expectancy...................................................87, 92 interested director........................................79, 80, 82, 84, 86 internal affairs doctrine.....................................................160 Intrinsic fairness......................................................91, 92, 93 J Janitor.......................................................................121, 130 JI Case v Borak.................................................................149 Joy v North........................................................33, 43, 71, 72 JR 44, 70, 72, 83, 84 judicial review..............................................................72, 83 Jurisdictional nexus..........................................................111 Jurisdictional Nexus..........................................................107 K Katie Roberts....................................................................119 Key elements of the proxy cause of action........................151 kicker....................................................................59, 94, 136 L Law and Portfolio Theory...................................................35 Law Compliance Program..................................................50 Learned Hand...................................................................117 legal expenses.....................................................................54 Legal personality..................................................................8 leveraged buyout.................................................................38 Limited Liability.................................................8, 21, 26, 53 Liquidity...........................................................................8, 9 LL in the small firm setting................................................28 Lovenheim................................................................154, 159 lowball offer.............................................................170, 174 Lowball offer....................................................................170 F face-to-face transactions...................................................116 Farmer...............................................................121, 128, 130 Federal Legislation.............................................................51 Fees for Fees.......................................................................57 Fenwick v Unemployment Commission...............................4 fiduciary duty 6, 49, 53, 60, 63, 78, 80, 91, 95, 112, 122, 123, 127, 128, 129, 131, 133, 134 filing cabinet analogy.........................................................69 Filing Cabinet Analogy.......................................................69 final period....................................................................45, 47 Final period problem...........................................................45 Fleigler and Wheelabrator...................................................84 Flexible capital Structure......................................................9 foreign corp......................................................................160 Foremost McKesson v Provident......................................139 Formalities Fetish...............................................................24 Francis v United Jersey Bank..............................................49 Fraud........................22, 24, 33, 37, 40, 48, 51, 107, 109, 111 fraud on the market...........................................................109 Fraud on the public.............................................................22 fraudulent denial.......................................................107, 109 Free riding....................................................................20, 27 Full disclosure..................................................................102 fungible.............................................................................136 M majoritarian default...........................................20, 27, 76, 77 Management..........................................39, 60, 143, 146, 147 mandatory rules............................................................19, 76 manipulation or deception.................................................113 Manne.......................................................................123, 124 Market response................................................................122 market test defense.............................................................42 Market v Inside Information.............................................128 Martin v Peyton................................................................5, 6 Marx w Akers.....................................................................65 Massachusetts cases..........................................................168 match.................................................136, 137, 139, 140, 143 match to maximize liability...............................................137 matchable..................................................137, 138, 139, 140 Matched Sales...................................................................113 material misrepresentation................................................108 Material Misrepresentation...............................................107 Materiality.........................................................107, 114, 121 Mcquade v Stoneham........................................................165 measure the fairness of a transaction...................................80 Meetings.....................................................................24, 141 Merganthaler.....................................................................151 179 meritorious suits............................................................60, 70 G Galler v Galler...................................................162, 166, 169 General Automotive v Singer.............................................75 good faith....30, 31, 32, 47, 48, 50, 51, 53, 54, 56, 57, 60, 65, 67, 69, 71, 76, 79, 81, 84, 87, 95 Goodwin...........................................................................116 Goodwin v. Agassiz..........................................................115 grabbing and leaving...........................................................77 Grabbing and Leaving........................................................77 Grimes v Donald...........................................................62, 63 Michaelson...................................................................23, 28 Mills v Electric Auto Lite.................................................151 misappropriation........................107, 123, 132, 133, 134, 136 Misappropriation..............................................................132 Misreprentation.................................................................109 Missapropriation rule........................................................133 Modern Portfolio Theory..............................................35, 99 Monitoring by principal......................................................17 monitoring costs............................................................13, 28 MPT..............................................................................35, 36 N Process due care............................................................46, 48 Process Due Care................................................................47 Prohibition of tipping........................................................134 Prohibition of trading........................................................134 promoter.......................................................................11, 12 proper purpose..........................................................157, 158 Property rights analysis.....................................................126 Property Rights arg...........................................................126 Proxy Contests..................................................................147 PROXY REGULATION..................................................145 Proxy Statement................................................................146 nexus.......................................................18, 19, 43, 106, 107 nexus of Ks........................................................................19 Nixon v Blackwell............................................................171 NOBO list.........................................................159, 160, 161 Normative implication........................................................19 Number of submissions....................................................153 Q quorum..........................................................80, 81, 141, 142 R O OHagen............................................................................132 Omission.............................................57, 107, 108, 109, 119 Opportunism.......................................................................15 Opportunity costs................................................................14 oppression or fraud...........................................................174 Opression..........................................................................174 ordinary business expense.................................................156 Ordinary Business Matters................................................156 Outstanding shares................................................................9 oversight..........................................16, 34, 50, 51, 66, 68, 75 P Packaging Rights..............................................................141 Par value...........................................................................142 Parent and subsidiary..........................................................91 particularized facts..............................................................65 partnership...................................................1, 4, 5, 6, 21, 104 Partnership analogy..........................................................168 passive ownership...............................................................17 PAT triangle.........................................................................1 pecuniary gain...................................................................131 Penalities..........................................................................131 Pie Division........................................................................13 piercing the corporate veil.............................................21, 26 piggy back..........................................................................97 Pilsbury v Honeywell........................................................158 plain view.........................................................................120 Plaintiff side incentives.......................................................60 Planning..................................................................3, 5, 6, 24 pleadings.....................................................32, 37, 46, 53, 72 plight of the frozen in minority.........................................170 Portfolio theories................................................................99 Positive implication............................................................19 pre-incorporation activity....................................................11 Preferred stock....................................................................94 presuming reliance............................................................101 price setters.......................................................................109 Price to earnings effect.......................................................98 Prichard..............................................................................49 Prior submissions..............................................................153 Private attorneys...............................................................150 private atty generals..........................................................150 Private party litigation........................................................56 Private placement exemption............................................104 Private Placement Four Factor Test..................................104 private property...........................................................18, 126 private right of action................................................106, 112 private rights of action......................................................103 Pro regulatory args............................................................125 probability magnitude.......................................................108 Procedural hurdles............................................................153 Rat trap.............................................................................126 rationally apathetic............................................................150 reactive.................................................................................9 reasonably available..........................................40, 43, 46, 47 rebut the presumption.......................................................109 rebut the presumption of the fraud on the market theory...109 rebuttable presumption....................................................5, 47 Reckless disregard............................................................111 Reconciling the DoC and the BJR......................................31 record list..........................................................................159 refuse demand.....................................................................71 regular voting....................................................................163 Regulatory arbitrage.........................................................104 Regulatory arguments.......................................................123 Reification......................................................................8, 18 Reimbursement of expenses for incumbents.....................147 Reliance.......................42, 106, 109, 111, 114, 138, 139, 140 replace veil piercing............................................................29 reporting requirement.......................................................136 reputation..............................................76, 77, 110, 117, 131 Rescission.........................................................................152 Residual claimants................................................................9 Residual loss.......................................................................15 rigged games.............................................................125, 126 Ringling Bros....................................................................163 Risk aversion by management..........................................124 Risk premium...............................................................35, 99 Risk taking....................................................................35, 43 Rule 14e-3........................................................................134 S Sadler v NCR Corp...........................................................159 safe harbor....................................................................81, 87 Santa Fe.....................................111, 112, 113, 128, 129, 134 Santa Fe v Green...............................................................111 Sarbanes..................................................................51, 52, 55 Scienter.............................................................106, 111, 114 Sea Land.......................................................................23, 26 Secondary market...............................................................96 secondary markets.................................................8, 103, 104 Securities Act of 1933.......................................102, 103, 115 Securities Exchange Act of 1934......................................102 security for expense......................................................60, 61 Security for Expenses Statute.............................................59 Self-dealing...................................................................33, 37 Semi strong form efficiency................................................96 Sentencing Guidelines........................................................50 separation of ownership and control...................................15 servant and independent contractor.......................................2 settlement value......................................................53, 59, 66 SH agreements that constrain director discretion..............164 SH deadlock......................................................................174 SH injury..........................................................................125 180 SH proposal rule...............................................................158 SH status.............................................................................58 Shareholder primacy.....................................................18, 30 Shareholder wealth maximization.......................................18 shirk..............................................................................15, 16 Shirking..............................................................................16 Shlensky v Wrigley.............................................................31 Short form merger.............................................................112 Short Swing Profits...........................................................136 Showing up.......................................................................153 Sinclair Oil v Levin............................................................91 Singer......................................................................75, 76, 77 SLC.......................................................34, 67, 68, 69, 72, 74 Smith v Atlantic........................................................170, 174 So Gulf Martine Co. 9 v Camcraft......................................12 Sold at the wrong price.....................................................125 special circumstances rule.................................................115 special litigation committee....................................34, 67, 68 Special Litigation Committees............................................67 specific performance.........................................164, 165, 167 Specific performance................................................163, 167 spouse...............................................................................134 standard form K..................................................................20 standard of liability...........................................37, 38, 40, 51 standard of review.....................30, 33, 34, 35, 47, 83, 90, 91 standing limitation............................................................107 Statutory interp.................................................................158 statutory interpretation......................................................143 Stock Options.....................................................................46 Stock split.........................................................................142 strike suits...........................................................................59 Stroh.........................................................................142, 143 Stroh v Blackhawk............................................................142 Strong form efficiency........................................................97 structural bias................................................................70, 72 substantial benefit.............................................................151 substantial likelihood................................................108, 151 Substantial steps...............................................................134 Substantive due care...........................................................48 substantive due care and process due care..........................48 successful on merits............................................................54 Suganrman v Sugarman....................................................169 Super bowl effect..............................................................100 survivorship bias...........................................................97, 98 Systematic...................................................................35, 100 Tort Claimants....................................................................28 touch and concern.............................................................107 Town & Country.................................................................77 Town & Country v Newberry.............................................77 Town and country...............................................................77 Trade secret primer.............................................................78 Trading on bad news.........................................................124 Transaction and Agency Cost Economics...........................13 transaction cost economics.................................................13 Transaction costs................................................................14 Transactional nexus..........................................................111 Transactional Nexus.........................................................107 Transactional planning implication...................................176 Treasury shares...................................................................10 two classes of stock............................................................93 U ultra vires............................................................................80 Uncertainty.........................................................................14 undercapitilization..............................................................24 uninformed..................................................34, 40, 42, 48, 63 Unsystematic................................................................35, 99 V Van Gorkom..................32, 38, 39, 40, 42, 43, 45, 47, 48, 53 Vote issue...........................................................................81 VOTE POOLING.............................................................163 Voting rights.....................................................................141 Voting trusts.....................................................................162 W Walkovsky..................................................21, 22, 23, 26, 28 Walkovsky v Carlton..........................................................21 Waltuch........................................................................55, 56 Wash sales........................................................................113 waste..............................................46, 48, 60, 83, 90, 98, 147 Waste..................................................................................46 Weak form efficiency.........................................................96 What is a Solicitation........................................................145 Wheelabrator................................................................83, 93 when intrinsic fairness would apply....................................92 wherehousing....................................................................133 Why are there firms............................................................13 Why are they precatory.....................................................154 Why do SH want LL...........................................................27 Wilkes v Springside Nursing Home..................................168 written indemnification agreements....................................55 T ten percent shareholders....................................................138 Tender Offers....................................................................134 Texas Gulf Sulpher...........................................................119 TGS............119, 120, 121, 124, 125, 128, 129, 130, 131, 132 The Demand requirement as filter.......................................67 The Proxy Card.................................................................146 Tipping.............................................................................130 tipping chains............................................................130, 131 Tootsie................................................................................71 Tootsie pop.........................................................................69 Z Zahn....................................................................................95 Zahn v Transamerica..........................................................93 Zapata two step...................................................................71 Zapata v Maldonado...........................................................69 Zapco Problem....................................................................89 141(e)...............................................................................47 181 182 ...
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Business Associations VERY LONG OUTLINE - LAW 230--BUSINESS...

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