Business Associations Outline
Economic and Legal Aspects of the Firm
I.
Introduction to Business Associations
a. Factors Involved in Choice of Organizational Form
i. Making the investment decision
1. If you’ve got money in your pocket, there’s a lot you can do
with it
2. It is assumed you’d want to make the most from it
3. Rate of return
a. Low risk/low return and vice versa
4. You should split up your investment – diversify
ii. Two main kinds of capital
1. Money capital
2. Human capital
a. Brains, muscle, time, willingness to work
iii. Transaction cost factors
1. Bounded rationality
2. Opportunism
3. Team-specific investment
II.
Agency Law
a. Principle of agency
i. There are lots of relationships that fall into this category
1. At least two people (principal and agent)
2. Employment relationship
ii. Deals with two kinds of relationships
1. Relationship among people inside the business association
2. Relationship between business association and third parties
b. Agent’s Fiduciary Duty
i. Fiduciary limits on agent’s right of action
1. The agent is to prefer the principal’s interests to his own
2. The duty substitutes for an express contractual specification of
exactly what an agent may or may not do
ii. Fiduciary duty
1. Imposes a general obligation to act fairly
2. Obliges the fiduciary to act in the best interests of his client or
beneficiary and to refrain from self-interested behavior not
specifically allowed by the employment contract
3. Socially optimal fiduciary rules approximate the bargain that
investors and agents would strike if they were able to dicker at
no cost
iii. Duty of loyalty
1. It’s a one way duty
1
a. The agent owes it to the principal but the principal
doesn’t owe it to the agent
2. The law describes the relationship in broad terms
a. You have a duty to be loyal to the principal
[Community Counseling Serivce, Inc. v. Reilly: After Reilly decided to quit but before he actually stopped
working for CCS, he went out and solicited current and potential CCS clients for his future similar
business. There was no explicit contract saying he couldn’t do this. Court held that he breached his duty of
loyalty to CCS.]
iv. Employment at Will
1. Default rule - employer can fire at any time for any reason
2. In the employment context, factors apart from consideration
and express terms may be used to ascertain the existence and
content of an employment agreement, including:
a. The personnel policies or practices of the employer,
b. The employee’s longevity of service,
c. Actions or communications by the employer reflecting
assurances of continued employment,
d. The practices of the industry in which the employee is
engaged
[Foley v. Interactive Data Corp.: IDC had written termination guidelines that set forth express grounds for
discharge and a mandatory seven-step pretermination procedure. It was Foley’s understanding that the
guidelines applied to him as well as those he supervised. After Foley blew the whistle on his supervisor, he
was moved from position to position before being given the option of resigning or getting fired. Foley
brought suit for wrongful termination, alleging the guidelines altered the at-will employment relationship.
Appellate court allowed breach of employment contract claim to proceed to trial.]
c. Vicarious Liability: Firm’s Relation to Outsiders via Agents
i. The agent’s actions will bind the principal only if the principal has
manifested his assent to such actions
1. Actual authority
a. The principal manifests his consent directly to the agent
b. The manifestation of consent may be implied by the
conduct of the principal
c. If actual authority exists, the principal is bound by the
agent’s authorized actions, even if the party with whom
the agent deals is unaware that the agent has actual
authority and even if it would be unusual for an agent to
have such authority
2. Apparent authority (also known as ostensible authority)
a. When the principal intentionally or negligently causes
or allows a third party to reasonably believe the agent
possesses the authority
b. A third party will be able to bind the principal on the
basis of apparent authority only if the third party
reasonably believed that the agent was authorized
2
i. If the third party knows the agent has no actual
authority – no apparent authority
ii. If the principal’s manifestations constitute an
insufficient foundation for forming a reasonable
belief that the agent is authorized – no apparent
authority
3. Inherent authority
a. Springs from the desire to protect the reasonable
expectations of outsiders who deal with an agent
b. A gap-filling device used by courts to achieve fair and
efficient allocation of the losses from an agent’s
unauthorized actions
ii. Disputes between principals and third parties over the authority of
agents – two categories:
1. Cases in which an agent exceeds her authority in an attempt to
further the interests of the principal
2. Cases involving totally opportunistic action, where the agent
intentionally misleads both principal and the third party
[Blackburn v. Witter: Long, an agent of Dean Witter, advised widow Blackburn to invest in a nonexistent
company. B brought suit against W under a vicarious liability theory. The court entered judgment in favor
of B on the theory of ostensible (apparent) authority.]
General Partnership and Other Noncorporate Business Associations
III.
Overview
a. From Sole Proprietorship to Joint Ownership
i. Sole Proprietorship
1. One person owns everything and runs everything
2. External relations – owner pays taxes and is liable for debt
a. Entitled to all the profits
3. Owner has residual claimant status
4. This is the default if one person is the owner
ii. General Partnership
1. Default rules (can be changed by contract)
a. Profits/losses/control split equally
b. Withdrawal at will
i. If one partner withdraws, the partnership is over
ii. Great deal of flexibility for partners to exit
c. Fiduciary duty owed between and among partners
2. External relationships
a. Agency relationship – vicarious liability between
partners
b. Unlimited personal liability
i. Creditors can go after personal assets of partners
3. The default rule is that if you are co-owners of a business, you
are partners
a. Joint ownership is equally sharing profits/losses/control
3
iii. Limited Partnership
1. To be in an LP, you have to formally declare it and register
with the state
2. Internal Relationships
a. The relationship between members is different
b. Two kinds of partners
i. Limited partners
1. One step removed from partners (less
identified with the business)
2. Can withdraw without dissolving the
partnership
3. Have rights to profits and losses but no
right to control
4. Fiduciary duties don’t really apply to
limited partners because they are
forbidden from controlling the
partnership
5. Passive partner
ii. General partners
1. If the general partner withdraws, the
partnership is over
2. Like a partner in a general partnership
and has rights to profits/losses/control
3. Owes fiduciary duties to the limited
partners
a. Has responsibility to run business
for the benefit of the partnership
3. External relationships
a. Limited partners have limited personal liability
i. Liability for the amount of money they put in
ii. If limited partner takes part in control, they give
up their limited liability
iii. If you want to act like a general partner, you
have to accept the terms
b. General partner has unlimited personal liability
iv. Joint Venture
1. A partnership for a limited purpose
2. The same things apply but the scope of the partnership is
limited
3. Think car companies getting together and working on fuel cell
technology off of I-80
a. If Ford wants to work on a solar car, Toyota is not
liable for that – only the fuel cell stuff
b. Choice of Standard Forms
i. For organization, states have provided standard forms of governance
rules
4
1. Corporation
2. General partnership
3. Limited partnership
4. Limited liability companies
5. Limited liability partnerships
ii. Analogize these as form contracts
1. These forms of organization have default aspects and
mandatory or immutable aspects
a. Default aspects
i. Have to abide by them unless you change them
b. Mandatory (immutable) aspects
i. Have to abide by them regardless – can’t change
them
ii. Usually for public policy reasons
c. Different business entities are taxed differently and that can affect what type
of business is chosen
IV.
Fiduciary Duty of Partners
a. Traditional Framework
i. Fiduciaries must carry the burden of proving by clear and convincing
evidence that they have fulfilled their fiduciary obligations
ii. In a limited partnership, the general partner will have a heavier duty of
loyalty because she will control the information and the business
[Meinhard v. Salmon: M and S had a de facto limited partnership in a building lease with S as the
managing partner. As the lease neared its end, S secretly negotiated with the owner for a new lease
excluding M. When M discovered the plan, he insisted on being part of it but was refused, so he brought
suit. Court held that S breached his duty of loyalty and awarded M ½ interest in the venture.]
b. Standard Duties and Partnership Agreement
i. The partnership agreement will determine the extent of disclosure
required between partners and whether a failure of disclosure
constitutes fraud or breach of the agreement
1. Partners may alter the standard form fiduciary duties to suit
their particular relationship
ii. Some jurisdictions say you can’t opt out of fiduciary duty but trend is
towards allowing opt out
[Exxon Corp. v. Burglin: Limited partnership in AK oil drilling with E as general partner and B and others
as limited partners. Partnership agreement required E to disclose only nonconfidentail information. One of
the well results looked promising and E offered to buy limited partners out. Offer gave option of
independent consultant to make assessment of offer. The limited partners accepted without getting the
evaluation. The results turned out to be extremely productive and the limited partners brought suit alleging
E breached its fiduciary duty by failing to disclose all information. Court held for E because of partnership
agreement.]
iii. Fiduciary duty has two aspects
5
1. Duty of loyalty
2. Duty of care
c. Duty of Care
i. There is a duty of care but it only extends to gross negligence or
intentional conduct
ii. Negligence in the management of the affairs of a general partnership
or joint venture does not create any right of action against that partner
by other members of the partnership
iii. Limited partners are owed more of a duty of care from general partners
[Ferguson v. Williams: F&W purchased two buildings with the intention of making a profit. When they
were running low on cash, they got Williams to invest of ¼ th interest. He helped them getting an initial loan
and offered his employees to get the project ready. When final funding fell through and the venture was
abandoned, Williams sued F&W to recover his losses on allegations of negligence. Court held that it
wasn’t a limited partnership and negligence didn’t create right of action.]
V.
Power of a Partner to Manage and Bind the Partnership
a. External – authority to bind the partnership
i. Partners are jointly and severally liable for the tortious acts of other
partners if they have authorized those acts or if the wrongful acts are
committed in the ordinary course of the business of the partnership
ii. The partnership is liable for the acts of the partners that are done in the
scope of the partners’ authority
iii. The ability of a partner to bind the partnership is great
iv. Apparent Authority
1. A partner acting in the apparent scope of the partnership is
within the authority (RUPA § 301)
a. Then the partnership is liable unless there is no actual
authority and the other party knew there was no
authority
2. If a third person reasonably believes that the services he has
requested of a member of the partnership is undertaken as a
part of the partnership business, the partnership should be
bound for a breach of trust
[Roach v. Mead: M and B formed law partnership. M handled R’s business deals and B did R’s tax returns.
When R sold his business and had $20K to invest, he sought M’s counsel. M offered to take the money at
15% and R agreed. R considered M’s advice to be legal advice. When M defaulted and declared
bankruptcy, R sued partnership, so liability would fall on B. Court found for R under apparent authority
doctrine.]
b. Internal – power to manage and control
i. One partner, one vote
1. Problem when there is an even number of partners
2. Favors status quo
ii. Partner doesn’t always have to vote for something that would benefit
the partnership
6
[Covalt v. High: C and H were corporate officers and shareholders in CSI. They orally agreed to form a
partnership and bought real estate upon which they constructed an office and warehouse. CSI leased the
building from the partnership for a 5-year term. Upon the expiration of the term, CSI remained a tenant and
orally agreed to certain rental increases. C resigned from CSI but remained a partner with H. C demanded
that the monthly rent for CSI be increased $1K. H did not agree and took no action to renegotiate the
amount of the monthly rent payable. C brought suit. Appellate court held for H because conflict of interest
known at formation of partnership.]
c. Limited Partner’s Role
i. Limited partners are passive investors more akin to lenders than to
general partners
1. As long as they act like lenders and not like general partners,
limited partners are not personally liable for the firm’s debts
ii. A limited partner shall not become liable as a general partner, unless,
in addition to the exercise of his rights and powers as a limited partner,
he takes part in the control of the business
iii. RULPA § 303
1. Was there control?
2. Did the creditor reasonably rely on the belief that the limited
partner was actually a general partner?
a. States that haven’t adopted RULPA don’t have this
second step
[Holzman v. De Escamilla: R, A, and D formed a limited partnership for a farm business with D as general
partner and R and A as limited partners. The three conferred as to what crops to plant. R and A overruled D
as to certain crop choices. D had no power to withdraw money without the signature of either A or R.
When the partnership went bankrupt, the trustee went after R and A as general partners. The court held that
R and A were general partners because they took part in the control of the business.]
VI.
Dissolution
a. Leaving and ending a partnership
i. A partnership agreement may specify terms of dissociation or
dissolution
1. Ex. partnership will last 5 years or partnership will last until
such and such is completed
2. Absent such provisions, the partnership is at will
a. Free to dissociate
b. Don’t need a reason
c. Have right to force judicial sale
ii. Dissociation
1. Leaving the partnership
2. Default rule – partnerships are at-will and one can disassociate
whenever he feels
3. Lawful dissolution gives each partner the right to have the
business liquidated and his share of the surplus paid in cash
4. Default rule – dissociation leads to dissolution
a. Can contract around this
7
b. Can waive right to force dissolution and termination
5. Dissociation by death does not cause a dissolution of the
partnership and does not trigger wind up or sale of partnership
assets
6. If a partner is dissociated from the partnership without
resulting in a dissolution and wind up of the partnership
business, then the partnership must purchase the dissociated
partner’s interest at a statutorily defined buyout price
iii. Dissolution
1. When one partner dissociates, it triggers a dissolution
2. This is a phase not an event
3. Partnership exists during dissolution but only for wind-up
business
a. Because it exists for winding-up, you’re still partners
and own fiduciary duties
[Hurwitz v. Padden: H and P formed a two-person law firm, but failed to enter into a written partnership
agreement. They shared all firm proceeds on a 50-50 basis and reported all income as partnership income.
After 5 years, P notified H that he wanted to dissolve their professional relationship. They successfully
resolved all business issues involving their relationship, except for the division of attorney fess from
several of the firm’s contingency fee cases. Court held that pre-dissolution contingency fee files remain
assets of a law firm following its dissolution in the absence of a contrary agreement.]
4. First you have to marshal the assets and most likely to be
liquidated and divided
a. Throughout the process, you keep track of what each
partner has contributed and/or owes the partnership
(partnership account)
i. Don’t forget human capital
[Kovacik v. Reed: K was a licensed building contractor and R was a job superintendent and estimator. K
told R that he had a job in San Francisco. He would put up $10K if R would do the work. Profit would be
split 50/50. There was no discussion about loss. R agreed and contributed only his labor. K maintained all
the financial records. After some time, K told R that the venture wasn’t profitable and demanded that R
take on a half share of the losses. R refused to pay and K brought suit. Appellate court held for R, stating
that by their agreement to share equally in profits, agreed that the value of their contributions – the money
on the one hand and the labor on the other – were likewise equal.]
b. Creditors get paid first
c. What is left over after creditors and settling partnership
accounts, is profit and is split between partners
i. If nothing is left over or if there are still losses –
that is split between partners
d. Default rule is to split profits and losses equally
e. Cash v. in-kind distribution
i. Default = everyone has right to equal share in
cash
1. Partners have to agree to in-kind
distribution
8
ii. In-kind distribution absent an agreement by all
partners is limited to situations where:
1. There are no creditors
2. Ordering a sale would be senseless since
no one other than the partners would be
interested in the assets of the business
3. It is fair to all partners
[Dreifuerst v. Dreifuerst: Three brothers formed partnership to operate two feed mills. The plaintiffs
served the defendant with a notice of dissolution and wind-up of the partnership. The parties were unable to
agree to a winding-up of the partnership. The defendant requested that the partnership be sold such that the
plaintiffs could bid on the entire property and continue to run the business under a new partnership and the
defendant’s partnership equity could be satisfied in cash. The trial court denied the request and instead
divided the partnership assets in-kind according to the valuation presented by the plaintiffs. The appellate
court reversed, holding court could not order in-kind distribution without agreement among all partners.]
iv. Termination
1. End of partnership
2. End of dissolution process and wind-up is done
b. Wrongful Dissolution and Continuity
i. If a partner dissociates from the partnership before completion of the
agreed term or undertaking, such dissociation will be wrongful
1. Under RUPA, the partnership is not dissolved
2. Non-dissociating partners have the option of continuing the
partnership’s business without the consent of the wrongfully
dissociating partner
a. Still have to pay off the guy leaving
3. The wrongfully dissociating partner must compensate other
partners for damages resulting from the wrongful dissociation
ii. RUPA defines ‘wrongful’ as including dissociation that is in breach of
an express provision of the partnership agreement
iii. All partnerships are ordinarily entered into with the hope that they will
be profitable, but that alone does not make them all partnerships for a
term and obligate the partners to continue in the partnership until all of
the losses over a period of many years have been recovered
[Page v. Page: The parties were partners in a linen supply business. Within the first two years, each
contributed about $43K for business expenses. For the first 8 years, the business was not profitable, losing
about $62K. The partnership’s major creditor is a corporation, wholly owned by  that supplies the linen
and machinery necessary for the day-to-day operation of the business. This corporation holds a $47K
demand note of the partnership. The partnership turned its first profit in 1958. Despite this improvement, 
wanted to terminate the partnership. Court held it to be a partnership-at-will.]
iv. RUPA § 602 was drafted after Page and has different take
1. Makes it harder to find wrongfulness in a dissociation or
dissolution
2. Dissociation is wrongful only if:
a. Breach of express provision of partnership agreement
b. In a partnership for a term or undertaking…
9
i. Leaving early
ii. Get expelled by judicial determination (§
601[5])
1. Partner does bad things
a. Other partners go to judge to get
the bad guy kicked out
iii. Bankruptcy
iv. If corporate partner dissolves
3. Rejects idea that there is a general duty to do good
[Monteleone v. Monteleone: N, L, and J formed an oral partnership to own and operate an automobile
body repair business named Monte Auto Body Shop. There was a dispute as to whom among them caused
the dissolution. J brought suit requesting dissolution and judicial sale and alleging that N and L failed to
conclude partnership business but rather were operating the shop under a new partnership. N and L
counterclaimed alleging that it was J’s wrongful conduct that had caused the dissolution of the partnership.
They requested that they be permitted to purchase J’s interest and to continue the partnership business.
Appellate court remanded for trial on issue of J’s wrongful termination.]
c. Contractual Approaches to Dissolution Issues
i. Expulsion
1. No clean rule on how to get rid of lousy partner
2. You can contract regarding expulsion
3. Partnership may expel a partner for purely business reasons.
4. A partnership can expel a partner to protect relationships both
within the firm and with clients.
5. A partnership can expel a partner without breaching any duty
in order to resolve a ‘fundamental schism.’
6. The fiduciary duty that partners owe one another does not
encompass a duty to remain partners or else answer in tort
damages.
[Bohatch v. Butler & Binion: After Bohatch brought forth allegations that the managing partner was
overbilling a major client, the firm voted to expel her. Court held that the fiduciary relationship did not
create a whistleblower exception with regard to expulsion from the at-will nature of partnerships.]
ii. Contracting to prevent opportunistic withdrawal
1. Meehan v. Shaughnessy – see class notes pg. 20
Corporate Form and the Separate Roles of Shareholders and Managers
VII. Introduction to Corporate Form
a. General corporation characteristics
i. Separates ownership and management functions
1. Directors
a. Agent of shareholders
b. Owe fiduciary duty to shareholders
c. Make major policy decisions
d. Acts as a unit via majority rule
10
2. Officers
a. Execute the policies of the directors and provide day-today management
3. Shareholders
a. Owner and principal
b. Provide capital and elect directors
c. No management role
d. Acts as a unit via majority rule
ii. Limited liability
1. Shareholders’ liability limited to investment
2. Convinces shareholders to give up control
iii. Adaptability/durability
1. Adaptability of corporation: separate functions, officers make
decision and shareholders have no control
2. Durability of corporation: shareholders can not dissolve the
corporation, but the shareholders can dissociate easily by
selling their rights to someone else on the open market
iv. Legal deference to directors
1. Courts generally don’t question if decision made in good
faith—business judgment rule – courts won’t ask if it was a
good business decision
b. Rules for corporation
i. Corporation code
1. Law of state of incorporation
2. Default law
3. Courts look to the laws of the incorporating state to determine
the basic rights and duties applicable to a particular corporation
4. One shareholder meeting per year
a. Default rule that cannot be changed
ii. Articles of incorporation/corporate charter/certificate
1. Private contract, set out at the outset
2. Think of it as a constitution, difficult to change, public
document
3. Not required to do anything but create the corporation
4. Can say other things and vary the background law but it
doesn’t have to
iii. Bylaws
1. Private K,
2. Specific re: implementation, easy to change, private documents
3. Think of this as legislation
4. Can also vary the background laws but not all of them
5. The bylaws may contain any provisions, not inconsistent with
law or with the certificate of incorporation.
6. Where a bylaw provision is in conflict with a provision of the
charter, the by-law provision is a nullity
11
c. The law recognizes the corporation as an entity separate from the directors,
officers, and shareholders who make it up
i. A corporation will be granted the same legal rights and responsibilities
as a person
ii. Has the potential for perpetual duration, at least until a majority of
directors and shareholders decide to end its existence
VIII. Corporate Form and the Stock Market
a. Shares of stock
i. Corporate ownership is broken up into little pieces (and a whole lot of
them)
ii. Entitle the holder to a certain percentage of the firm’s profits and net
assets when the corporation dissolves and winds up its business
iii. Purchaser inherits all voting power and other rights possessed by the
selling shareholder
iv. Creating classes of shares
1. There must be a class of shares that carry authority to elect
directors and exercise all other shareholder voting rights
2. There must be a class of shares that entitles the bearer to
receive the corporation’s net assets upon dissolution
3. All shares of a given class will be fungible
a. They will have identical rights, preferences, and
limitations which supports an expectation that the
common shares of all corporations will possess similar
rights
b. Fungibility + active trading = liquidity = reasonable
valuation
4. Common shares
a. Shares that combine both residual claimant status and
voting rights
5. Preferred shares
a. Might be granted a dividend or liquidation preference
over common shares
b. Often coupled with a limitation or denial of voting
rights
v. Consequences
1. Very easy to get people to invest in the corporation
2. Can buy and sell them very easily
b. Proxy
i. The legal relationship under which one party is given the power to
vote the shares of another
ii. The person or entity given the power to vote
iii. The tangible document that evidences the relationship
c. Securities market
i. Centralized matching of buyers and sellers
ii. Three important services
12
1. Liquidity
2. Valuation
3. Monitoring of managers
iii. Reduces transaction costs to near zero
d. Efficient Market Hypothesis
i. Weak form efficient
1. Current stock market prices instantaneously reflect all relevant
information that can be gleaned from studying past prices
ii. Semi-strong form efficient
1. Stock markets instantaneously reflect all publicly available
information relevant to the value of traded stocks
2. This is what economists and policy-makers have believed that
our securities markets are
iii. Strong form efficient
1. Stock market prices instantaneously reflect both publicly
available and non-publicly available information about traded
securities
IX.
Shareholder’s Role in Corporate Governance
a. Shareholder role in governance
i. Election (and removal) of directors
ii. Approval (not initiation) of
1. Article amendments
2. Fundamental changes
a. Ex. mergers, dissolution
iii. Amendments of bylaws
1. But can’t interfere with management
iv. Nonbinding suggestions (“precatory proposals”)
b. Corporation as Political Forum
i. State corporate law statutory norms entrust management of corporate
affairs to the directors
1. Shareholders do have the right to suggest that the directors take
a particular action or adopt a new policy
2. Both the MBCA and the Delaware law require that
amendments to the articles be initiated by the board of directors
ii. Shareholder role in corporate governance analogous to role of a voter
in a democracy
iii. One shareholder gets a vote per share
1. If you’ve got a large chunk, you get a large say
iv. Required to have an annual meeting of shareholders for election of
directors
1. Can’t contract around – mandatory
2. The purposes served by the annual meeting include affording
to shareholders an opportunity to bring matters before the
shareholder body
13
v. Judges exercise equitable power to prevent management from
manipulating corporate procedures or from unfairly disenfranchising
shareholders (see squib cases – pg. 28 reading notes)
[Hoschett v. TSI Int’l Software Ltd.: TSI had never held an annual meeting because it had received written
consent from a majority of its shareholders to elect the slate of directors. H, a stockholder, sued to compel
TSI to hold an annual meeting. The trial court held that TSI was required to hold an annual meeting.]
c. Election of Directors
i. Normal rule
1. Directors are annually elected by plurality rule, according to
votes cast on a one vote per share basis
2. Straight voting
a. A shareholder has one vote per share or such other
number as may be permitted
b. The shareholder can cast his total number of votes for
as many candidates as there are seats to be filled
i. Ex. 100 shares and three directors – 100 votes
each for three candidates
ii. Modification of defaults
1. Classes of shares with different voting power
a. Voting classes – some classes get more/less voting
power for their shares
2. Variations from plurality (majority) rule
a. Supermajority
b. Cumulative voting
i. A shareholder can cast a total number of votes
equal to the number of shares multiplied by the
number of positions to be filled, and these votes
can be spread among as many candidates as the
shareholder desires
Formula to determine
1. Ex. 100 shares and 3 directors – 300
> SX / (D+1)
votes to be divided among however
S = total number of shares
many candidates he chooses (300 to one
being voted
or 150 to two or 100 and 200 to two,
X = total number of seats you
etc.)
want to control
ii. Creates the possibility for the minority
D = total number of seats up
shareholders to select directors
for election
iii. Not a winner take all system
iv. In CA cumulative voting is the default rule
(with some modifications)
3. Staggered terms (“classified board”)
[Centaur Partners, IV v. Nat’l Intergroup, Inc.: N amended its articles to stagger the board and require an
80% supermajority to amend. C didn’t like the way the business was being run and wanted to amend the
bylaws to add 6 more board members so that at the next election it could elect a new majority. C wanted to
do this with written consent of a majority of outstanding shares; argued a supermajority was necessary.
Court held Board couldn’t be enlarged without an 80% supermajority.]
14
d. Removal of Directors
i. Normal rule
1. Removal (without cause) by majority of all shares entitled to
vote
ii. Exception to default rule
1. Staggered (classified) Board
a. Can be removed by a majority but only for cause
2. Board elected by cumulative voting
a. The majority can remove the entire board but there are
limits on removing individual director
i. If ‘no’ removal votes would have been enough
to elect the single director, he gets to stay
iii. If a director has actual or implied notice that his right to hold office
may be extinguished, he has no vested right in his position
[Roven v. Cotter: R was a member of Citadel’s classified board of directors. The initial bylaws of Citadel,
rather than its certificate of incorporation, provided for a classified board of directors. Soon after he was
reelected for a three-year term, a rift developed between R and a majority of the board. At a special board
meeting, a resolution was adopted recommending that the shareholders amend the certificate of
incorporation to allow for directors to be removed without cause. Shareholders would be able to vote to
remove the current directors and/or declassify the board when the charter amendment became effective.
Court held the action proper.]
[Dolgoff v. Projectavision, Inc.: The seven-member board was classified into three classes with D in Class
3. By 1995, the relationship between D and M had soured to the point where D’s employment at P was
terminated. The board proposed to have the 1996 meeting in February nominating a replacement for D. The
proxy statement was disseminated to shareholders. D brought suit claiming the s inequitably manipulated
the electoral process in their effort to remove him from the board. Court held that the refusal of the board
to renominate him is not legally a ‘removal’ and does not implicate the provisions of law dealing with the
removal of directors from a staggered board.]
X.
Shareholder Proposal and Other Shareholder Communication
a. Overview of Federal Regulation
i. SEC rules seem designed to ensure that the proxy process allows
shareholders to communicate with each other and the corporation as
through all of the shareholders were gathered in a large town hall on
meeting day
ii. The main idea behind the statutes is disclosure
1. Looking for informed voters/investors
2. Disclosure, disclosure, disclosure
iii. Rules Primarily Regulating Shareholder Access to Effective Means of
Communication with Other Shareholders
1. 14a-7 – requires a corporation that is itself soliciting
shareholders in connection with a meeting to provide specified
proxy solicitation assistance to requesting shareholders
a. Two options
15
i. Provide the requesting shareholder with an
accurate list of those shareholders and financial
intermediaries from whom the corporation
intends to solicit a proxy
ii. Directly mail the requesting shareholder’s proxy
material to shareholders and financial
intermediaries
b. Shareholder must defray the cost of postage and
handling
b. Socially Significant Proposals
i. 14a-8 – a qualifying shareholder may require her corporation to
include a shareholder proposal and an accompanying supporting
statement in the company’s proxy materials
1. Qualifying shareholder – owns at least $2K of stock or 1% of
company for at least one year
2. Attempts to accommodate proposals from shareholders
primarily interested in reform of the corporation’s management
practices or structures, as well as proposals from shareholders
interested in broader social goals
ii. Rule 14a-8(i) (“Question 9”)
1. On what grounds may corporation management refuse to
include a shareholder proposal in the corporation proxy?
a. (1) Beyond shareholder power under state law
i. Ex. enact article
ii. This is the reason why proposals are precatory
b. (5) <5% of assets and of earnings and is “not otherwise
significantly related to the company’s business”
c. (6) Would be beyond management’s power
d. (7) Relates to “ordinary business”
i. No micromanaging proposals
e. (8) Relates to the election of Ds
[Lovenheim v. Iroquois Brands, Ltd.: L requested I to include his resolution in the proxy materials. His
resolution called for a committee to study the methods by which I’s French supplier produced paté and to
discontinue distribution of the product if it turned out they used force feeding. Paté sales constituted less
than .05% of I assets and none of its net earnings. There was no evidence offered that the French supplier
did this. I refused under the economic irrelevance test. In requiring I to include resolution, court held that
there should be inclusion where the proposal has raised policy questions important enough to be
considered ‘significantly related’ to the issuer’s business, not just economic relativity of a proposal.]
c. Governance-Related Proposals; Independent Proposals
i. 14a-7 – independent proposal
1. Can control the framing of the issue
2. Have to pay for mailing it out yourself
ii. A shareholder may confer such discretionary authority with respect to
matters which the company does not know, a reasonable time before
the solicitation is to be represented at the annual meeting
iii. UNITE v. May (pg. 35 reading notes)
16
d. Regulating Shareholder Communications
i. Solicitation
1. Definition
a. Any request for a proxy
b. Any request to execute or not to execute, or to revoke a
proxy
c. The furnishing of a form of proxy or other
communications to security holders under
circumstances reasonably calculated to result in the
procurement, withholding, or revocation of a proxy
2. Has been judicially interpreted to apply not only to
communications transparently falling within the rule but also to
preliminary discussions or public announcements that may
pave the way to the ultimate success of a later, more obvious
solicitation
3. Exceptions
a. 14a-2(b)(2) – exempts any solicitation not on behalf of
the corporation, where the number of persons solicited
is ten or fewer
b. 14a-1(l)(2)(iv) – exempts from the definition of
solicitation any communication by a shareholder that
states how the shareholder intends to vote and the
reasons therefore
i. Requirements
1. The shareholder does not herself engage
in a proxy solicitation
2. The communication is by means of
public speeches or press releases, or is
directed at persons to whom the
shareholder owes a fiduciary duty
4. The test is whether the communication is reasonably calculated
to influence shareholders
[Long Island Lighting Co. v. Barbash: M purchased shares of LILCO to force shareholders’ meeting and
requested list of stockholders to communicate with them regarding board elections and potential sale to the
county. Around same time, Citizens group placed ad claiming mismanagement and arguing for sale to
county. LILCO sued both M and Citizens alleging they acted in concerted fashion to influence exercise of
proxies by shareholders. Court remanded for determination whether challenged communication, seen in the
totality of circumstances, was reasonably calculated to influence shareholders’ vote.]
e. Shareholder Access to Corporate Records and Shareholder Lists
i. Process for 14a-7 independent proxy solicitation
1. Any shareholder desiring to make a proxy solicitation at an
upcoming meeting may inform the corporation in writing of the
planned solicitation and ask the corporation to provide 14a-7
assistance
2. The corporation may either
17
a. Mail the proxy material for the shareholder (at
shareholder’s expense)
i. Most corporations chose this option so as to
keep control of the lists
b. Provide the shareholder with a list of shareholders
ii. State corporation laws generally provide shareholders with access to a
shareholders’ list on demand not only for use in connection with proxy
solicitations, but for other proper purposes
[Conservative Caucus v. Chevron Corp.: CC made a demand under oath for a copy of Chevron’s
stockholder list in order to communicate with other stockholders about the alleged economic risks of
Chevron’s business activity in Angola, and about a resolution which is proposed to be submitted in
connection with the next annual meeting. Chevron refused, alleging that the CC did not have a proper
purpose in making the demand. In holding for CC, the court stated that a proper purpose shall mean a
purpose reasonably related to such person’s interest as a stockholder.]
Fiduciary Duties of Officers and Directors
XI.
Duties of Corporate Fiduciaries
a. Fiduciary duty for directors
i. Instructs directors to be absolutely fair and candid in pursuing personal
interests
ii. Duty of loyalty makes it wrongful for a director unfairly to compete
with her corporation or unfairly to divert corporate resources or
opportunities to her personal use
iii. Describes the bounds of acceptable conduct for directors in carrying
out their individual and collective duty to manage the corporation
b. Normally, directors owe fiduciary duties to the corporation, not to individual
shareholders
i. The corporation, acting through its officers and directors, has primary
responsibility for instituting and controlling fiduciary litigation
ii. There are circumstances where courts allow shareholders to initiate
and control fiduciary litigation
1. Any recovery will belong to the corporation
c. There are important circumstances in which managers and the corporation
owe fiduciary duties directly to the corporation’s shareholders
i. A shareholder may enforce ‘directly owed’ fiduciary duties via an
individual action, or if class certification is appropriate, as a class
action on behalf of all similarly affected shareholders
1. Any recovery in these ‘direct’ actions goes to the plaintiff
shareholders
d. Fiduciary duty and derivative litigation
i. State-provided governance structures designed to protect the
investment expectations of both shareholders and directors
1. Prospective directors will invest their human capital in other
endeavors if fiduciary rules are unrealistically stringent
e. Business Judgment Rule
18
i. Judicial presumption that directors acted properly
ii. A rebuttable presumption that directors are better equipped than the
courts to make business judgments and that the directors acted without
self-dealing or personal interest and exercised reasonable diligence and
acted with good faith
iii. Court will presume managers have done the right thing
1. Presume good faith – no fraud, illegality, or conflict of interest
2. Court doesn’t ask if it was a good or even non-negligent
decision
3. If you are only asserting negligence, you don’t have a cause of
action
iv. To overcome the business judgment rule, you have to show fraud,
illegality, or conflict of interest
[Shlensky v. Wrigley: S alleged that the corporation’s losses were attributed to the lack of lighting and
night games at Wrigley Field. He brought suit claiming negligence on the part of the directors. Court
dismissed claim on business judgment rule grounds.]
v. Judges have traditionally granted business judgment rule protections
only when directors act in the best interests of ‘the corporation’
vi. Directors may consider the interests of other constituencies if there is
some rationally related benefit accruing to the stockholders or if so
doing bears some reasonable relation to general shareholder interests
[Dodge v. Ford Motor Co.: D challenged the company’s actions in refusing to pay dividends while
expanding the company’s facilities and lowering the price of its cars. Court refused to interfere with the
company.]
vii. Reasons for Business Judgment Rule
1. Shareholder assumes risk
2. Institutional competence
3. Incentives to directors
4. It is easy to be a Monday morning quarterback but it’s not fair
viii. The business judgment rule extends only as far as the reasons which
justify its existence.
ix. It does not apply in cases in which the corporate decision
1. Lacks a business purpose
2. Is tainted by a conflict of interest
3. Is so egregious as to amount to a no-win decision
4. Results from an obvious and prolonged failure to exercise
oversight or supervision
XII.
Fiduciary Duty of Care
a. Duty of Care
i. The role of the fiduciary duty of care in ensuring that a corporation’s
directors carry out their managerial responsibilities with reasonable
care and diligence
19
ii. Liability for breach of duty of care has always been rare
1. When it has been found, it is where the director’s conduct was
egregious
iii. Dual setting in which directors’ duties arise
1. Decisional setting
a. Directors collectively consider whether to authorize a
particular course of action, activity or transaction
b. If directors are found to have acted in a grossly
negligent manner, then they will not be protected by the
business judgment rule
2. Oversight
a. Directors are responsible for monitoring the
corporation’s business
b. Directors and officers are charged with knowledge of
those things which it is their duty to know and
ignorance is not a basis for escaping liability.
c. Where suspicions are aroused, or should be aroused, it
is the directors’ duty to make necessary inquiries
[Hoye v. Meek: Chairman Meek left son in charge while he went off into semi-retirement. Son made bad
investments and company went into bankruptcy. Trustee brought action against Meek for breach of
fiduciary duty of care (oversight). Court held essence of Meek’s breach of duty was his failure to monitor
the company’s activities.]
iv. Doctrine of procedural due care
1. Directors’ performance is assessed by looking directly at how
they reached a particular decision rather than by looking at the
substance of the decision itself
2. To satisfy their procedural due care obligations, directors must
carry out a decision-making process calculated to provide them
with information sufficient to reach a rational judgment
v. There is no protection for directors who have made an unintelligent or
unadvised judgment
[Smith v. Van Gorkom: The directors started playing with numbers for a leveraged buyout. Without
actually looking at the value of the company, they decided that $55/share sounded fair. VG, soon to be
retired, thought a management buyout was a conflict of interest so he took the deal to P who agreed on the
condition that his offer be accepted in one week. Senior Management thought the offer was too low. VG,
having not read the agreement, did a 20-minute presentation before the board, which had no copies of the
agreement and who voted to submit the offer to the shareholders. Appellate court held that directors
violated their duty of care by not informing themselves of all material information reasonably available to
them prior to making the business decision.]
vi. If the plaintiff carries his burden of proving that the directors acted
without requisite care in approving a merger or other major decision,
the defendants then have the burden of proving that the transaction or
decision was intrinsically or entirely fair to the corporation
vii. Two basic aspects of fairness
1. Fair dealing
20
a. When the transaction was timed
b. How it was initiated, structured, negotiated, disclosed to
the directors
c. How the approvals of the directors and stockholders
were obtained
2. Fair price
a. Relates to the economic and financial considerations of
the proposed merger, including all relevant factors:
i. Assets
ii. Market value
iii. Earnings
iv. Future prospects
v. Any other elements that affect the intrinsic or
inherent value of a company’s stock
b. Statutory Exculpation
i. Charter option statutes (DE and 30 other states)
1. Authorizes a corporation to adopt a provision eliminating or
limiting the personal liability of a director to the corporation or
its stockholders for monetary damages for breach of fiduciary
duty as a director
2. Exceptions
a. Breach of the director’s duty of loyalty to the
corporation or its stockholders
b. Acts or omissions not in good faith
c. Intentional misconduct
d. Knowing violation of law
e. Improper distributions
f. Any transaction from which the director derived an
improper personal benefit
3. Does not apply to suits by third parties
ii. Self-executing statutes (IN, OH, FL, WI, ME)
1. A director is liable only if
a. The director has breached or failed to perform his
duties in compliance with the statutory standard of care
b. The breach or failure to perform constitutes willful
misconduct or recklessness
iii. Cap on money damages (Virginia)
c. Substantive Due Care
i. Uses the substantive indefensibility of a decision or course of action as
the basis for finding that directors acted in a grossly negligent manner
ii. A breach of substantive due care occurs when a challenged action,
viewed ex post, seems so outrageous or inherently risky that it is
simply impossible to imagine how the directors could have reached
that decision other than as a result of lack of due care or skill
1. Was it ridiculously unreasonable?
2. Think of it as res ipsa loquitur in the business context
21
3. If the substance is a lose-lose situation, then you ask how the
directors got the company in that position
4. Substance is so bad that it should trigger the court’s suspicion
iii. See squib cases (pg. 48 of reading notes)
d. Duty to Monitor
i. Failure to monitor (inaction)
ii. Technically speaking, there wasn’t a business decision to analyze
iii. Directors are entitled to rely on the honesty and integrity of their
subordinates until something occurs to put them on suspicion that
something is wrong.
iv. If such occurs and goes unheeded, then liability of the directors might
well follow.
v. Absent cause for suspicion there is no duty upon the directors to install
and operate a corporate system of espionage to ferret out wrongdoing
which they have no reason to suspect exists.
vi. The law will cast the burden of liability on a corporate director if he
has:
1. Recklessly reposed confidence in an obviously untrustworthy
employee
2. Refused or neglected cavalierly to perform his duty as a
director
3. Ignored either willfully or through inattention obvious danger
signs of employee wrongdoing
vii. A director’s obligation includes a duty to attempt in good faith to
assure that a corporate information and reporting system, which the
board concludes is adequate, exists.
viii. No duty to spy on employees
ix. DE Corp. Code § 141(e)
1. A member of the board of directors shall be fully protected in
relying in good faith upon the records of the corporations and
upon such information, opinions, reports, or statements
presented to the corporation by any of the corporation’s
officers or employees, or committees of the board of directors,
or by any other person as to matters the member reasonably
believes are within such other person’s professional or expert
competence and who has been selected with reasonable care
by or on behalf of the corporation
[In re Caremark International Inc.: Some employees had practice of paying doctors to use their drugs and
refer patients to C facilities. C was reprimanded and had to pay fines. Shareholders sued directors for
letting this happen (failure to monitor). Court approved empty settlement because it found directors didn’t
breach duty because had system of monitoring in place.]
XIII. Fiduciary Duty of Loyalty
a. Core of duty of loyalty
i. Requirement that a director favor the corporation’s interests over her
own whenever those interests conflict
22
ii. There is also a duty of candor
b. Corporate Opportunity
i. Circumstances in which a director personally takes an opportunity that
the corporation later asserts rightfully belonged to it
ii. Line of business test
1. A corporate officer or director may not take a business
opportunity for his own if:
a. The corporation is financially able to exploit the
opportunity
b. The opportunity is within the corporation’s line of
business
c. The corporation has an interest or expectancy in the
opportunity
d. By taking the opportunity for his own, the corporate
fiduciary will thereby be placed in a position inimical to
his duties to the corporation
2. A director or officer may take a corporate opportunity if:
a. The opportunity is presented to the director or officer in
his individual and not his corporate capacity
b. The opportunity is not essential to the corporation
c. The corporation holds no interest or expectancy in the
opportunity
d. The director or officer has not wrongfully employed the
resources of the corporation in pursuing or exploiting
the opportunity
iii. Fairness test
1. The true basis of governing doctrine rests on the unfairness in
the particular circumstances of a director, whose relation to the
corporation is fiduciary, taking advantage of an opportunity
[for her person profit] when the interest of the corporation
justly call[s] for protection
2. This calls for application of ethical standards of what is fair
and equitable in particular sets of facts
iv. ALI approach
1. Strict requirement of full disclosure prior to taking advantage
of any corporate opportunity
2. The corporation must formally reject the opportunity
3. Corporate opportunity includes not only opportunities closely
related to a business in which the corporation is engaged but
also any opportunities that accrue to the fiduciary as a result of
her position within the corporation.
v. A director’s right to appropriate an opportunity depends on the
circumstances existing at the time it presented itself to him without
regard to subsequent events
[Northeast Harbor Golf Club, Inc. v. Harris: H was president of the Club of which a golf course was the
only asset. She purchased land near the course and disclosed the purchases to the board afterwards. She
23
began to make plans for a subdivision on the land. After H resigned, the Club authorized a lawsuit against
her for the breach of her fiduciary duty to act in the best interests of the corporation and simultaneously
resolved that the proposed development was contrary to the best interests of the corporation. The Club
would not have been able to acquire the properties because of financial difficulties but there was evidence
that it was successful at fundraising. The court held H didn’t breach her fiduciary duty.]
[Broz v. Cellular Information Systems, Inc.: B was president and sole stockholder of RFB. He was also an
outside director of CIS, which was a competitor of RFB. He was approached with offer to sell license. He
spoke with other CIS directors informally about his intention to bid and they said that CIS wouldn’t be
interested because of financial position (bankruptcy). Around same time, P made overtures to acquire CIS.
P was also bidding on the license. B won the auction. When P took over CIS and replaced management,
CIS brought suit against B for usurpation of a corporate opportunity belonging to CIS (also should have
considered P’s interest as potential acquiror). Court held for B, stating that fiduciary duty does not require
a director to formally present to the corporation an opportunity which had come to the director
individually and independent of his relationship with the corporation.]
c. Conflict of Interest
i. Transactions between the corporation and the director, commonly
called “conflicting interest transactions”
1. Where director stands on both sides of the transaction
2. Ex. voting to raise directors’ salaries, selling property to
corporation
ii. In what situations would it be okay for a director to look out for his
own interest?
1. Del. GCL § 144: Conflict of Interest (CA has similar 3 part
statute)
a. Conflict alone does not void a transaction if
i. After full disclosure to Board, it is authorized by
a majority of the disinterested directors; OR
ii. After full disclosure to shareholders, it is
approved in good faith by shareholders; [No
fairness inquiry: Vogelstein]; OR
iii. It is fair to the corporation at the time
shareholders or directors authorize, approve, or
ratify [D’s burden to prove fairness: Oberly]
b. If disclosure is defective, then the authorization is void
iii. A director’s ownership of stock in his own corporation does not give
rise to a conflict of interest unless the director somehow contrives to
favor his own interests over those of other stockholders
[Oberly v. Kirby: K set up the Foundation to support charitable activities. His son, A, started up Alleghany.
His son, F, was on both boards and was in control. The Foundation board was comprised of either Ks or
other Alleghany stockholders. A left a large bequeath to the Foundation of Alleghany shares such that that
investment made up a large portion of the Foundation’s assets. Alleghany acquired a major chunk of shares
in AmEx. Because of tax laws, the Foundation needed to divest itself of the Alleghany stock. F and the
boards of the two corporations decided to swap the Foundation’s Alleghany stock for Alleghany’s AmEx
stock. Instead of getting outside investment consultants, the Foundation’s board used its long-time attorney,
W. Alleghany got ML to represent it in negotiations. ML wanted a discount while W wanted a premium. In
the end of negotiations, it was decided to exchange stock at market values. The Foundation did not retain
outside consultants to determine whether it was a fair deal. The plaintiffs brought suit alleging that Fred
24
violated his fiduciary duty because he and the other board members had interest in the transaction. Court
found transaction intrinsically fair because W had negotiated vigorously.]
iv. The Effect of Disinterested Approval
1. Disinterested approval reinstates the business judgment rule
2. Even with business judgment rule defenses in place, a
conflicting interest transaction may be challenged as a gift or
waste of corporate assets
v. Four possible effects of shareholder ratification
1. Complete defense
2. Directors don’t have burden to prove fairness
3. Shareholders have burden to prove unfairness
4. No effect
vi. What is the waste standard?
1. The directors had exchanged corporate assets for consideration
so small that no reasonable person would have assented to it
2. Giving something for nothing
3. Exchange is grossly disproportionate
4. Also called a ‘gift’
5. This is kind of like substantive due care – lose-lose situation
[Lewis v. Vogelstein: The plaintiffs challenged a stock option compensation plan for the directors of
Mattel, Inc. which was approved or ratified by the shareholders of the company at its 1996 Annual Meeting
of Shareholders. They asserted that the grants of options actually made under the 1996 Plan did not offer
reasonable assurance to the corporation that it would receive adequate value in exchange for such grants,
and that such grants represent excessively large compensation for the directors in relation to the value of
their services to Mattel. They alleged that the granting of the option constituted a breach of fiduciary duty.
Court held that waste standard should be applied to interested board decisions that are ratified by the
shareholders.]
25
Breach of fiduciary duty
Breaches of duty of loyalty
Usurpation of corp. opportunity
Breaches of duty of care
Conflict
of
interest
Breach of
Procedural
Care
Breach of
Duty to
Monitor
“Waste”
(a.k.a.
Substantive
Due Care)
Directors
ultimately
monitor
Balancing test:
officers and
1.
Corporation
employees
has financial ability
Extreme
Corporate
on behalf of
2. Within corporation’s line of Conflict failure to
assets given shareholders.
business
alone is be
for
However,
3. Corporation has interest or
not a
informed
consideration Directors
expectancy
breach
before
so low no
must
4. Will put director in conflict if
acting
reasonable
delegate:
with his duties to the
cleansed
person
esp. in larger
corporation
(Del. §
(Ex. Smith would have
corporations,
144)
v. Van
agreed
the duty is to
(ex. Guth v. Loft, Broz v. Celluar)
Gorkom)
establish
monitoring
procedures,
not spy on
employees
(ex.
Caremark)
d. Conflict of Interest – Controlling Shareholders
i. Transactions between a parent corporation and a partially-owned
subsidiary may raise the possibility of abuse of power by a majority
shareholder to the disadvantage of a minority shareholder
ii. Self-dealing occurs when the parent, by virtue of its domination of the
subsidiary, cause the subsidiary to act in such a way that the parent
receives something from the subsidiary to the exclusion of, and
detriment to, the minority stockholders of the subsidiary
[Sinclair Oil Corp. v. Levien: S owned 97% of Sinven. It elected the board (all S employees), caused
Sinven to issue dividends, and contract with I, a wholly-owned S subsidiary. When I breached the contract,
S prevented Sinven from suing on the breach. L, a minority shareholder, sued S for breach of fiduciary duty
of loyalty for both the breach of contract and dividends. Appellate court held S accountable for breach of
contract but not dividends.]
26


Conflict of Interest and Self-Dealing Compared
Conflict
Self-Dealing
D acts for corporation and stands to
 “Controlling Shareholder”
gain personally
influences directors to act for
corporation and stands to gain
Fairness review, Director’s burden
personally
[unless ‘cleansed’ (§ 144)]
 AND excludes other shareholders
from gain
 Fairness review, controlling
shareholder’s burden
XIV. Derivative Suits
a. Derivative suit
i. Involves two actions brought by an individual shareholder:
1. An action against the corporation for failing to bring a
specified suit
2. An action on behalf of the corporation for harm to it identical
to the one which the corporation failed to bring
ii. If the lawsuit is successful, the money collected will go to the
corporation
b. Demand on Directors
i. A shareholder-controlled derivative suit is a usurpation of the
directors’ normal power to manage the business and affairs of a
corporation
1. Justifiable only in circumstances where the directors are unable
or unwilling to handle the litigation in the best interests of the
corporation
ii. A shareholder is required to make a pre-suit demand on the board,
explaining the claims which he wishes investigated and remedied
1. The board the considers how to deal with the matters brought
to their attention in the demand letter
2. If the board reaches a decision not to pursue the claim via
litigation, the shareholder may challenge the decision as a
breach of fiduciary duty
a. Shareholder has no right to directly pursue the original
claim that was the subject of his demand, unless the
directors’ action in refusing to institute litigation is
found not to be protected by the business judgment rule
iii. Demand futility exception (DE)
1. Excuses shareholders from making pre-suit demand in
circumstances where demand would be futile
2. Ex. when the directors lack the independence to impartially
consider a demand
3. MBCA had adopted a universal demand requirement
27
a. Premised on belief that allowing exceptions to pre-suit
demand imposes excessive additional litigation costs
iv. Aronson test for demand futility
1. Was the Board interested, or
2. Was the underlying transaction a protected business judgment
3. Not clear whether underlying logic regarding disinterestedness
is based on underlying transaction or the decision to sue to
directors
a. Argue both ways
v. Directorial interest exists whenever:
1. Divided loyalties are present
2. A director has received, or is entitled to receive, a personal
financial benefit from the challenged transaction which is not
equally shared by the stockholders
3. A corporate decision will have a materially detrimental impact
on a director, but not on the corporation and the stockholders
[Aronson v. Lewis: Plaintiff alleged that since he was suing the board, it was futile to think they would
agree to sue themselves. Court rejected that argument as an endrun around the demand requirement.]
[Rales v. Blasband: Rs, brothers, were directors and majority shareholders of E. The E board sold $100
million of its Notes at a public offering. The prospectus stated that the proceeds would be used for general
corporate purposes. Instead, the board bought junk bonds through Drexel who was a good friend of Rs. He
had underwritten the public offering of the Notes. The investments substantially declined. E merged with
D, another company of Rs. They remained directors. B brought suit alleging E board had misused the
proceeds of the Note sale and the demand was futile because of Rs. Court held, under facts alleged,
demand was futile.]
vi. By making demand, the plaintiff concedes that he cannot satisfy the
demand futility doctrine at that time
1. Court will look into whether board was disinterested in
refusing the demand
a. I.e. if there was a special committee that was supposed
to make the decision, plaintiff could argue that the
whole board, including the interested members, were
involved in the decision
b. Business judgment rule applies
[Scattered Corporation v. Chicago Stock Exchange, Inc.: The plaintiffs alleged that they were witness to,
or made aware of, systematic corruption, including bribery, of the Exchange by members of the Board of
Directors. The plaintiffs made a demand that the Board investigate and remedy the abuses. The Chairman
advised the plaintiffs that a Special Committee had investigated the claims and after careful consideration
determined there was no basis upon which to take further action with respect to the demand. The plaintiffs
filed a derivative action alleging the same acts of wrongdoing stated in the demand, presumably invoking
the doctrine of wrongful refusal of the demand. Court held that, by making the demand, the plaintiffs
conceded the disinterest and independence of the board such that the only issues to be decided was the
good faith and reasonableness of the board’s investigation of the claims articulated in the demand.]
28
vii. Demand Requirement Flowchart (Del.)
Shareholder wants to sue D for violation of fiduciary duty
Shareholder sues D on behalf of corp.
without demand. Board moves to dismiss
Shareholder demands that Board bring
corp. suit against D
Granted
Board brings suit
(rarely happens)
Sharehol
der gives
up
Denied
Board will not sue
Was shareholder demand
futile?
(Aronson test)
Shareholder sues
director anyway
Board moves to
dismiss
Demand waives
futility
BJR applies
(Scattered)
Yes; Demand
excused
Suit can
proceed
(Rales)
Board allows
suit to go on
No; not
excused
Suit is
dismissed
(Aronson)
Board appoints Special
Litigation Committee
SLC recommends
dismissal
Shareholder opposes dismissal
Court applies Zapata test to SLC
1. Was SLC independent?
2. Court’s own business
judgment
c. Dismissal by Committee
i. If demand is excused, board will often appoint a Special Litigation
Committee which will (surprise...surprise) usually bring back
recommendation of dismissal
ii. Two step test to motion for summary judgment based on committee
decision
1. Inquire into the independence and good faith of the committee
and the bases supporting its conclusions
29
a. Corporation has burden of proving
2. If the court is satisfied that the committee was independent and
acted in good faith, it can, in its own discretion, determine,
applying its own independent business judgment, whether the
motion should be granted
[Zapata Corp. v. Maldonado: M instituted a derivative action against the directors and officers of Z
alleging breaches of fiduciary duty relating to a tax benefit. He did not make a demand first, stating that it
would be futile because all directors were named defendants and allegedly participated in the acts specified.
The defendants appointed two new outside directors to the board. They then created an “Independent
Investigation Committee” comprised solely of the two new directors to investigate Maldonado’s actions
and determine whether the corporation should continue any or all of the litigation. The Committee’s
determination was stated to be “final, not subject to review by the Board of Directors and in all respects
binding upon the Corporation.” Following an investigation, the Committee concluded each action should be
dismissed. Court decided that the independence of the Committee must be determined.]
Special Issues of Governance and Control of Close Corporations
XV. Close corporation
a. Differences with closely held corporations
i. Small number of participants actively involved in the business, with no
rigid division between those contributing money capital and those
putting in human capital
ii. Business relationship often overlaps family or other close, personal
ties that both adds another layer of expectations and creates various
means of interaction beyond those provided by the structures of
corporate law
iii. No market exists for the shares of these enterprises
1. No liquidity for one’s investment
2. No check on those in control
iv. Potential for majority opportunism
b. DE says you have to have 30 shareholders or less to fall under special laws
(Chapter 14 corporation)
i. Close corporation (Del. Subch. XIV, § 342)
1. Corporation whose certificate provides that:
a. Stock may be held by only a specified maximum
number of shareholders, no more than 30;
b. Stock may be transferred only to corporation,
shareholders, or other specified classes of persons;
c. Corporation may not offer stock publicly
c. MA close corporation
i. Small number of shareholders
ii. No ready market for shares
iii. Overlap of function
iv. This is harder than in DE because there is no bright line rule – don’t
know if you are a close corporation until you go to court and it tells
you so
30
XVI. Modifying Governance Rules by Contract
a. Traditional Approach
i. Directors can’t give away their fiduciary duties to other shareholders
[McQuade v. Stoneham: S sold minority interest to M. To prevent being pushed out, M puts a clause in the
contract in which S promises not to fire him. S promised to use majority power as director to appoint and
retain M as an officer and majority power as shareholder to make M a director. M got fired and brought
suit. Court invalidated the contract because directors may not abrogate (sell) their independent judgment
since they can’t give away fiduciary duties to other shareholders.]
ii. In some situations, though, it is okay to sell director’s duty
1. Has to be fair
[Clark v. Dodge: Similar situation as in McQuade except that C and D were the only shareholders. Court
enforced contract because there was no issue about protecting other persons.]
[Zion v. Kurtz: Z and K were the only shareholders of the Group. As part of the transactions surrounding
Zs purchase of a minority interest in Group, Z and K entered into a shareholders’ agreement providing that
Group would not engage in any business or activities without Z’s consent. Despite this agreement, K
caused the corporation to take certain actions without Z’s consent. Court held that the agreement was
valid.]
b. Contracting Around Law
i. Most rules in corporate governance are default rules and can be
changed
ii. Director Control
1. Sterilization agreement
a. Shareholders agree to limit director discretion
b. In a statutory close corporation, sterilizing agreements
are allowed if the shareholders agree
c. Only allowed in close corporations
[Blout v. Taft: Corp. controlled by three families – two were needed to control. They unanimously changed
bylaws to create committee where each family had one vote and which was to have exclusive authority
regarding employment (unanimous consent required). T tried to change the bylaw because B wasn’t voting.
B alleged that the bylaw was a shareholder agreement and should be enforced. Court held that it was a
shareholder agreement but, since it was a bylaw, it was presumed that it could be changed by majority vote
under another bylaw.]
iii. Shareholder Voting Agreements
1. Shareholders agree to votes a certain way
2. Allowed in any corporation
3. Bylaws which are unanimously enacted by all the shareholders
of a corporation are also shareholders’ agreements
a. But can be changed pursuant to other bylaws unless
deviation explicitly stated
31
4. Corporate codes provide and regulate several mechanisms by
which shareholders enter into agreements to affect their actions
as shareholders
a. Voting trusts
b. Irrevocable proxies
c. Shareholder pooling agreements
5. Remain useful when:
a. The agreement is made by fewer than all of the
corporation’s shareholders
b. Shareholders desire to agree with creditors as to who
will be the corporation’s directors during the term of an
outstanding loan
[Ramos v. Estrada: Broadcast and Ventura merged with B given majority control. In order to maintain,
both groups of shareholders were required to execute shareholder agreements to vote in blocks. Failure to
adhere to the agreement constituted an election by the shareholder to sell shares to rest of block. E, a B
shareholder and director, defected and voted to remove two B officers. The B group met and agreed to
nominate another slate of directors which didn’t include E. E refused to recognize the vote and declared the
agreement null and void. B sued E for breach. Court held that E breached the agreement, not when she
voted to remove the officers, but when she refused to vote with the block.]
XVII. Control of Majority by Fiduciary Duty and Threat of Dissolution
a. Traditional Deference to Majority
i. Corporation law provides two principal avenues for minority
shareholders’ suits
1. Petition for involuntary dissolution
2. Direct or derivative suit for breach of fiduciary duty
ii. Direct shareholder suit
1. Challenge unfair dividend policies
2. To protect voting or contractual rights
3. To protect other rights owed directly to them by the
corporation
iii. Those in control of corporate affairs have fiduciary duties of good
faith and fair dealing toward the minority shareholders
iv. Majority shareholders get benefit of business judgment rule
v. Minority shareholders need to prove bad faith
vi. The essential test of bad faith is to determine whether the policy of the
directors is dictated by their personal interests rather than the corporate
welfare
1. The following facts are relevant to the issue of bad faith and
are admissible:
a. Intense hostility of the controlling faction against the
minority
b. Exclusion of the minority from employment by the
corporation
c. High salaries, or bonuses or corporate loans made to the
officers in control
32
d. The fact that the majority group may be subject to high
personal income taxes if substantial dividends are paid
e. The existence of a desire by the controlling directors to
acquire the minority stock interests as cheaply as
possible
2. If they are not motivating causes though, they do not constitute
‘bad faith’ as a matter of law
[Zidell v. Zidell: Two brothers, E and A, control the family business with R owned 25%. The business
didn’t pay dividends but all shareholders were officers and drew salaries. R sold his interest to E’s son, J,
so E and J had majority control. A demanded a salary increase and quit when he didn’t get it. He demanded
a dividend and complained that it was too small compared with the salaries E and J were getting. Court
held that it wasn’t an oppressive force-out because A left voluntarily.]
vii. A critical factor in dividend-related cases is the corporation’s
accumulation of an unreasonably large cash reserve – a reserve that
can only be explained by the controlling majority’s bad faith
b. Partnership Analogy
i. Analysis based on the partnership analogy asserts that the expectations
and internal governance needs of shareholders in typical closely held
corporations are similar to those of partners in a typical partnership
1. But shareholders now have freedom to contract around the
majoritarian bias of traditional corporate norms
ii. If the stockholder whose shares were purchased was a member of the
controlling group, the controlling stockholders must cause the
corporation to offer each stockholder an equal opportunity to sell a
ratable number of his shares to the corporation at an identical price
iii. Why no contract?
1. Trust
2. Other benefits of corporation
3. Lack of bargaining power
[Donahue v. Rodd Electrotype Co.: Rodd (Majority) and Donahue (minority) families control company.
The corp. purchased Harry Rodd’s shares at $800/share. Donahues offered $200/share but wanted to be
bought out at same rate as Harry. Rodds said no. Court said that the corp. had to buy out Donahues at same
price as Harry.]
iv. Delaware rejected the partnership analogy in Nixon
1. Stockholders need not always be treated equally for all
purposes
[Nixon v. Blackwell: Barton bequeathed all of the Class A voting stock and 14% of the Class B non-voting
stock to his employees and a trust for their benefit. The rest was split between his family members. The
corp. offered to buy out the family and all but two accepted. The corp. started a employee stock ownership
plan (profit sharing). Terminating and retiring employees were entitled to receive their interest in the ESOP
by taking Class B stock or cash in lieu of stock. Most employees chose cash so the ESOP provided
employee Class B stockholders with a substantial measure of liquidity not available to non-employee
stockholders. The Corporation paid low dividends and had a high level of retained earnings. The remaining
children brought suit alleging that the ESOP constituted a breach of the Board’s fiduciary duty since they
33
benefited only employee stockholders to the detriment of the non-employee minority stockholders. Court
held that the ESOP did not constitute a breach of fiduciary duty.]
c. Contrasting Views
i. Heatherton & Dooley proposal (pg. 506)
1. Give minority mandatory buyout right by statute
a. Has to offer entire interest – not just part of it
i. That way the minority shareholder can get out
and not be oppressed anymore
ii. Buyout at fair price
b. If majority refuses buyout, minority can seek
dissolution
2. BUT Mutually assured destruction may give minority
shareholder too much power
d. Involuntary Dissolution and Buyouts
i. Modern approach to involuntary dissolution
1. Grants the defendant corporation the right to avoid a courtordered involuntary dissolution by electing to repurchase the
complaining minority’s shares for fair value
2. Gives the majority rather than the minority the right to
determine whether buyout will occur
3. Allows majority to act opportunistically without risk that
involuntary dissolution will result
4. Liberalized minority right to seek dissolution
5. Corporation or majority can avoid dissolution by buying out
minority shareholder
6. The court has the power to order the dissolution of a
corporation where:
a. The directors or those in control of the corporation have
been guilty of illegal, fraudulent, or oppressive actions
toward the complaining shareholders
b. The property or assets of the corporation are being
looted, wasted, or diverted for non-corporate purposes
by its directors, officers, or those in control
ii. Most American jurisdictions now permit a shareholder to petition for
dissolution on a variety of reasons
1. Illegality
2. Fraud
3. Misapplication of assets
4. Waste
5. Oppressive conduct by the majority or controlling shareholder
6. Relief is necessary to protect the rights or interests of
complaining shareholders or if a close corporation participant’s
reasonable expectations have been frustrated
34
[In re Kemp & Beatley, Inc.: Corp. had practice of distributing earnings according to stockholdings, in
form of dividends or extra compensation. Also had established buy-out policy by which it would purchase
the stock of employee shareholders upon their leaving its employ. D and G owned 20% when they left
employ under unhappy circumstances. They considered themselves to be frozen out of the company when
they no longer received any distribution of the company’s earnings and were not offered a buyout. Court
held that board’s actions were oppressive and ordered involuntary dissolution unless corp. bought out D
and G.]
iii. Delaware doesn’t allow involuntary dissolution
1. Only avenue is to have shareholder agreement sterilizing
directors, be a statutory close corporation
iv. Two definitions of “oppression”
1. A violation by the majority of the ‘reasonable expectations’ of
the minority
v. Burdensome, harsh, and wrongful conduct; a lack of probity and fair
dealing in the affairs of a company to the prejudice of some of its
members; or a visible departure from the standards of fair dealing, and
a violation of fair play on which every shareholder who entrusts his
money to a company is entitled to rely
vi. Even if an original participant had had a reasonable expectation of
personal employment, after his death the surviving shareholders would
not be bound to employ any dolt who happened to inherit his stock
1. Heirs would have no reasonable expectations so oppression
will have to based on bad conduct
[Gimpel v. Bolstein: R was a minority shareholder in his family’s dairy farm; his brother and cousin owned
the rest of the shares. He was employed by the company until 1974, when he was discharged due to
allegations that he had embezzled. No dividends had ever been paid. Since that time, he received no
benefits from his ownership position even though the company was profitable. The company continued to
not pay dividends, while other stockholders received substantial sums as salary, benefits, and perquisites.
The only opportunity R had to gain from his interest came in 1980 when, the other shareholders offered to
buy out his shares at a figure which he rejected as inadequate. R brought an action asking for dissolution.
Court order company to buyout R’s shares, not because he had reasonable expectations, but rather
because it had treated him so shabbily.]
Buyout and Dissolution
H&D Proposal
“Modern Approach”
 Minority can demand buyout by
 Minority has broader rights to as
majority
court for dissolution
 If majority does not buy out,
 If court orders dissolution, majority
minority can dissolve
can avoid by buying out minority
XVIII. Share Repurchase Agreements
a. Specifies in advance the conditions on which the corporation (or perhaps
continuing shareholders) will repurchase the shares of a non-continuing
shareholder
b. Treated as fully contingent contracts
35
i. Courts will generally enforce the terms of a share repurchase
agreement, even if event subsequent to execution make the purchase
price substantially less than the then fair value of the to-be-acquired
shares, unless there is some compelling equitable reason not to enforce
the agreement
c. The validity of share repurchase agreements will be upheld absent any fraud,
overreaching, undue influence, duress, or mistake at the time the deceased
entered into the agreement, these conditions rendering the agreement void.
d. Specific performance of an agreement to convey will not be refused merely
because the price is inadequate or excessive.
[Concord Auto Auction, Inc. v. Rustin: Sibling stockholders of two closely held corporations entered into
a stock purchase and restriction agreement, which set the price at which the corporation would purchase the
shares at death. The price was to be reviewed at the annual meeting. Cox died accidentally the next year
and his administrator refused to tender his shares because there hadn’t been meeting and the price in the
agreement was about half the actual price. The court specifically enforced the agreement.]
[Gallagher v. Lambert: G was employed by EA. In 1981, EA offered all its executive employees an
opportunity to purchase stock subject to a mandatory buy-back provision, which provided that upon
voluntary resignation or other termination prior to January 31, 1985, an employee would be required to
return the stock for book value. After that date, the formula for the buyback price was keyed to the
company’s earnings. G purchased 8.5% interest in EA subject to the buyback provision. On January 10,
1985, G was fired by EA. He did not contest the firing but demanded payment for his shares calculated on
the post-January 31, 1985 buyback formula. The court enforced the agreement because G got what he
bargained for.]
e. In a closely held corporation, the nature of the employment of a shareholder
may create a reasonable expectation by the employee-owner that his
employment is not terminable at will
[Pedro v. Pedro: TPC was owned in equal shares by three brothers, including A. They had worked in the
company for all or most of their adult lives. In 1968, they executed a stock retirement agreement which was
designated to facilitate the purchase of a shareholder’s stock upon death, or when a living shareholder
wished to sell his stock. In 1979, they modified the SRA which reduced the purchase price to 75% of net
book value. In 1987, Alfred discovered there was $330K missing. He was told to forget about the
discrepancy or be fired. At the end of 1987, Alfred was informed that he was fired and all his pay and
benefits were discontinued. He brought suit requesting dissolution. The court awarded damages for breach
of fiduciary duty and for wrongful termination of lifetime employment.]
Corporate Form and Allocation of Risk between Insiders and Outsiders
XIX. The “Equity Cushion”
a. Dividends and Distributions
i. Limited liability is a risk shifting device
1. Risk falls on creditors
ii. Statutes require that corporations hold a certain amount of cash as a
cushion to pay creditors
1. Options
a. Legal capital
36
i. Setting a certain number that corporation can’t
go below
b. Insolvency
i. The idea of saying that the corporation has
enough to pay the bills
ii. Assets have to be greater than liability
iii. Can’t go into insolvency
iii. A corporation that was adequately capitalized when formed but which
subsequently suffers financial reverses is not undercapitalized
XX.
Disregarding the Corporate Form: Piercing the Corporate Veil
a. Piercing the Corporate Veil
i. A corporation’s veil will be pierced whenever corporate form is
employed to evade an existing obligation, circumvent a statute,
perpetrate fraud, commit a crime, or work an injustice
ii. Powell test for parent/subsidiary relationship (but used in other
situations as well)
1. In order to pierce the veil:
a. The parent must completely control and dominate the
subsidiary
b. The parent’s conduct in using the subsidiary was unjust,
fraudulent, or wrongful toward the plaintiff
c. The plaintiff must have actually suffered some harm as
a result
iii. Factors that indicate injustices and inequitable consequences and allow
a court to pierce the corporate veil are:
1. Fraudulent representation by corporation directors
2. Undercapitalization
3. Failure to observe corporate formalities
4. Absence of corporate records
5. Payment by the corporation of individual obligations
6. Use of the corporation to promote fraud, injustice, or
illegalities
b. Contract
i. Those who deal with the corporation can adjust their price and terms
according to the degree of security that the corporation provides
ii. Piercing the corporate veil in contract cases becomes a search for the
factors that lead courts not to trust the bargaining relationship
iii. Both inadequate capitalization and disregard of corporate formalities
are significant to a determination of whether the corporation has a
separate existence such that shareholders can claim the accoutrement
of incorporation: non-liability for corporate debts
iv. Instrumentality or alter ego doctrine: Requires proof of:
1. Control
37
a. Did shareholder have complete domination and control
(corporation was not separate entity, but alter ego of
shareholder)?
2. Fraud
a. Did the shareholder use control of corporate form in
unjust, fraudulent, or wrongful way?
3. Causation
a. Did shareholder’s conduct cause actual harm to
plaintiff?
i. The unjust conduct
[Consumer’s Co-op v. Olsen: In 1977, O opened a personal charge account with CC. In 1980, he
incorporated ECO with a total initial capitalization of over $7K. He changed the charge account to a
corporate charge account and there were no personal charges made to that account thereafter. Abundant
measures were taken to assure that all corporate business was done in the corporation’s name. ECO failed
to remain current in monthly payments to CC in the middle of 1983. CC continued to extend credit until
mid-1984 even though its policy was to terminate credit after 60 days. No dividends were ever paid and
substantial personal assets were used to subsidize the operation of the corporation in the form of
unprofitable leasing agreements and foregone salaries and rent. When ECO filed for bankruptcy, CC sued
O in an attempt to pierce the corporate veil. Court held O hadn’t abused the corporate form and CC did
part of the harm to itself by continuing to extend credit.]
v. Where a corporation is used for an improper purpose and to perpetrate
injustice by which it avoids its legal obligations, equity will step in,
pierce the corporate veil, and grant appropriate relief.
vi. A court may pierce the corporate veil or disregard the separate legal
entity of the corporation and the individual where the separateness is
used as a subterfuge to defraud a creditor.
[KC Roofing Center v. On Top Roofing, Inc.: Between 1977 and 1991, R had five construction
corporations. It was his history to get a new corporation, receive materials from suppliers on credit, and
then dissolve the corporation and form a new one when the debt got too high. It was his way of getting a
fresh start. He had a practice of only paying creditors that were secured by his personal guarantee or had
loans against his house. Creditors sued R. Court held that under the under the instrumentality/alter ego
doctrine, R was liable for the debts.]
vii. Equitable subordination
1. Comes into play when creditors and shareholders assert
competing claims to corporate assets
2. When equitable, courts will subordinate the shareholder’s
claim to that of the creditor
3. Less drastic remedy that piercing the corporate veil, because
shareholders lose only what they have voluntarily placed at ri
c. Tort
i. Tort cases are different in part because the corporate entity has never
provided insulation for an individual committing a tortious act even if
the individual purported to be acting as an officer or otherwise in the
name of a corporation
38
[Western Rock Co. v. Davis: F and S owned WR. The physical assets of WR were leased from F. S
supervised the blasting activities and was in daily contact with F. S started to get complaints that the
blasting was causing property damage. F and S decided to continue the blasting. When the homeowners
won judgment against WR, F repossessed the assets so WR had nothing. The homeowners went after F
alleging WR was a shell corp. and F was the dominating force such that he should be liable. Court held that
F exercised such control that he was liable.]
ii. When an individual treats a corporation as an instrumentality through
which he is conducting his personal business, a court may disregard
the corporate entity.
iii. The mere failure upon occasion to follow all the forms prescribed by
law for the conduct of corporate activities will not justify disregarding
the corporate entity
[Baatz v. Arrow Bar: Kenny and Peggy were seriously injured in 1982 when McBride crossed the center
line of the street with his car and struck them while they were riding a motorcycle. McBride was uninsured
and judgment proof. They alleged that Arrow Bar served alcohol to McBride prior to the accident while he
was already intoxicated. They also sued Edmond, LaVella, and Lacquette Neuroth who were shareholders
and managers in the corporation. Edmond and LaVella personally guaranteed payment of corporate debt to
obtain bank financing. Arrow Bar did not carry dram shop liability insurance. Court held that the personal
guarantee of a loan could not be enlarged to impose tort liability.]
d. Parent and Subsidiary Corporations
i. In order to determine whether the corporate veil should be pierced, the
plaintiff must demonstrate
1. The parent so dominated the subsidiary that it had no separate
existence but was merely a conduit for the parent
a. More than mere majority or complete stock control but
rather complete domination, not only of finances but of
policy and business practice in respect to the transaction
attacked so that the corporate entity as to this
transaction had at the time no separate mind, will, or
existence of its own.
b. Potential control is not enough.
2. The parent has abused the privilege of incorporation by using
the subsidiary to perpetrate a fraud or injustice, or otherwise to
circumvent the law
3. Is the proximate cause of plaintiff’s alleged injury
[Craig v. Lake Asbestos: Asbestos suit. One of the defendants, LAQ, settled conditionally, so as to
maintain its right to receive contribution from Cape, which had owned all of the stock of NAAC, and from
Charter which owned a majority of Cape’s shares. Charter elected three of the 14 Cape directors. Cape
worked it so that, as an English company, it had no American assets to attach and was essentially judgment
proof in America. LAQ went after Charter as the parent corporation of both Cape and NAAC. Court held
that Charter didn’t have complete control and didn’t abuse it but only acted like a shareholder was
supposed to so no liability.]
ii. It is entirely appropriate for directors of a parent corporation to serve
as directors of its subsidiary, and that fact alone may not serve to
expose the parent corporation to liability for its subsidiary’s acts
39
[United States v. Bestfoods: US went after B for CERCLA liability because its wholly-owned subsidiary,
Ott, owned and operated a hazardous facility that needed cleanup. The two corps shared several officers
and directors. B had employee (didn’t work for Ott) onsite to deal with polluting emanations. SCOTUS held
there was liability.]
XXI. Personal Liability for Nonexistent Corporations
a. Liability when there is no corporation
i. When a party is acting for a proposed corporation, he cannon bind it
by anything he does, at the time, but he may:
1. Take on its behalf an offer from the other which, being
accepted after the formation of the company, becomes a
contract
2. Make a contract at the time binding himself, with the
stipulation or understanding, that if the company is formed it
will take his place and that then he shall be relieved of
responsibility
3. Bind himself personally without more and look to the proposed
company, when formed, for indemnity
b. If a promoter signs contract on behalf of corporation, he will be liable unless
and until the corporation is in existence and ratifies the contract
[RKO-Stanley-Waner Theatres, Inc. v. Graziano: Corp. wasn’t formed at time J and G entered into
contract of sale with RKO. Contract had clause that said, once corp. was formed, contract would be
understood to be between RKO and corp. J and G incorporated but they failed to complete settlement on
the last scheduled date. RKO filed a complaint in equity seeking judicial enforcement of the agreement of
sale against J and G. They alleged that the contract provision and subsequent filing of incorporation papers
released them from any personal liability resulting from the non-performance of the agreement. Court held
that, since the contract didn’t have express liability release, J and G were still on the hook.]
c. Liability when incorporation is defective
i. Equitable de facto incorporation rule (traditional)
1. If creditor believed the biz was a corporation, then shareholders
have limited liability
2. Focuses on creditor’s expectations
3. If shareholder was tried in good faith to incorporate but there
was a minor defect such that the incorporation wasn’t valid, the
creditor couldn’t go after shareholder
ii. Bright-line rule (old MBCA, Timberline)
1. No limited liability
2. Creditor can reach active shareholder
a. Passive shareholders still have limited liability
[Timberline Equipment v. Davenport: B defectively incorporated AF which then entered into rental
contracts with T. When T wasn’t paid for the rentals, it brought suit against B. In addition to making a
general denial, B alleged as a defense that the rentals were to AF, a de facto corporation, of which he was
an incorporator, director, and shareholder. He also alleged the plaintiff was estopped from denying the
40
corporate nature of the organization to whom the plaintiff rented the equipment. The court held that since
there was no corporation, there was no limited liability.]
iii. MBCA’s de facto incorporation rule (MBCA, Richmond)
1. De facto rule applies unless shareholder knew of the faulty
incorporation
2. Focuses on shareholder’s knowledge
[Richmond Wholesale Meat Co. v. Hughes: D and H owned WBF 60/40. In December 1983, the Secretary
of State of IL dissolved WBF for failure to pay franchise taxes. The bill, warning, and notice of dissolution
were sent to WBF’s registered agent and copies were sent to D. He denied having received anything and
denied knowledge of the dissolution. He did know that the taxes had to be paid periodically but failed to
ask the manager about payment. After WBF was dissolved, they continued to do business under that name.
During the period of dissolution, RWM sold some meat to the business. When it didn’t get paid, RWM
brought suit against D and H. Court held that shareholders would be liable if they knew or should have
known that there was no corporation.]
Friendly Transfers of Control and Fundamental Changes
XXII. Mergers and Other Fundamental Changes
a. “Friendly” – connotes transactions that are supported by the directors of the
corporation experiencing the change in control
b. Fundamental changes (shareholder vote required)
i. Amendment of articles of incorporation
ii. Dissolution
iii. Sale of all or substantially all assets
iv. Merger/consolidation
c. In merger, shareholders have two rights
i. Vote
ii. Appraisal
d. More than half the states require an absolute majority of all shares entitled to
vote, not just a majority of votes cast at a particular meeting
i. Exceptions
1. De minimus change exception
a. Denies voting rights to shareholders of the surviving
corporation in a merger the terms of which will not
significantly affect the pre-merger shareholders’ voting
or equity rights, nor require a change in the
corporation’s articles of incorporation
2. Short form merger
a. A procedure that allows a corporation that owns most
of the shares of another corporation (the subsidiary) to
merge with that subsidiary by director action alone
e. Dissenters may not want to be part of new company
i. They have an appraisal right
1. Corporation has to cash out dissenters’ shares
2. If they can’t agree on fair price, court will decide
41
a. Court may determine that the fair value is less than
what the corporation was offering – tough luck
3. Shareholder gets nothing until end of proceeding, and may be
assessed court costs if fair value is less than original offer
ii. There is usually a greater concern for dissenters whose shares are
being acquired than for dissenters in the acquiring corporation
f. Transactional alternatives to the statutory merger
i. Triangular merger
1. Acquiring corporation creates wholly owned subsidiary (only
assets are shares of A) which merges with the target
corporation
a. In general, the act of making a subsidiary does not
require shareholder vote
b. May need shareholder vote in order to issue more
shares if the number of shares authorized by articles of
incorporation has been exhausted
ii. Sale/purchase of assets
1. Acquiring firm can just buy all of target firm’s assets
2. The shareholders of selling firm get a vote if all or substantially
all assets are being sold
a. Acquiring shareholders get no vote
g. De Facto Merger
i. Shareholders denied voting or appraisal rights may ask the courts to
intervene and re-characterize the transaction as a merger
ii. Delaware follows the doctrine of independent legal significance
instead
[Hariton v. Arco Electronics, Inc.: A and L corps. negotiated for an amalgamation of the companies. The
plan was for A to sell all its assets to L in exchange for shares of L. A would voluntarily dissolve and then
distribute the L shares to its stockholders. At the A stockholders meeting, all the stockholders voting (about
80%) approved the plan and it was thereafter consummated. The plaintiff, a stockholder who did not vote
at the meeting, sued to enjoin the consummation of the plan on the grounds that it was illegal. He argued
that it was a de facto merger and he should have appraisal rights. DE court held that the sale-of-assets
statute and the merger statute were separate and entitled to independent legal significance.]
iii. CA’s approach
1. Has list of transactions that give voting and appraisal rights but
it’s a longer list that DE
2. Doesn’t go off the list
3. Courts don’t look behind form to see what is really going on
h. If you have ability to avoid voting and appraisal rights, you can use it to get
rid of shareholders that you don’t like – all cash buyout
[In the Matter of the Appraisal of Ford Holdings, Inc. Preferred Stock: H was a subsidiary of Ford which
owned all of the common stock but H had released several types of preferred stock. The certificates of
designations setting forth the terms, preferences, and limitations of each stock were not identical. All had
liquidation preferences in the event of a merger. H merged with its subsidiary, C. In the merger, all of H’s
preferred stock was eliminated and converted to a right to receive cash. As a holder of Series D preferred
42
stock, B did not accept the merger consideration. It dissented and filed suit seeking appraisal rights. Court
held that preferred stock was a contractual relationship and holders get what they bargained for.]
XXIII. Dissenting Shareholder’s Remedies
a. Dissenting Shareholders’ Appraisal Right
i. If shareholder votes against merger, shareholder can demand that
corporation repurchase shares at ‘fair value’
ii. Shareholder gets fair value as determined by court (even if it is less
than original offer)
iii. Shareholder gets nothing until end of proceeding, and may be assessed
court costs if fair value is less than original offer
iv. Exception to appraisal rights
1. If purchase is being done with cash, acquiring shareholders
don’t get to appraisal
2. If there is a public market for the shares, no appraisal rights if
they are getting publicly traded shares
b. Business Purpose Doctrine
i. In DE, it is okay to have a merger just to kick people out the door
1. Appraisal is the only remedy
ii. Other jurisdictions require business purpose
1. Dissenting stockholders are not limited to the statutory remedy
of judicial appraisal where violations of fiduciary duties are
found
[Coggins v. New England Patriots Football Club, Inc.: S created corp. A and sold non-voting stock to the
public. He was forced out. He purchased all of the voting stock through bank financing. He created corp. B
and merged A into B, cashing out the non-voting stock. The only reason he did this was because he owed a
fiduciary duty to the non-voting stock and therefore wouldn’t be able to have the corp. take on his loans.
Shareholder sued claiming the merger was illegal and unfair. Court held he was entitled to rescissory
damages.]
Unfriendly Transfers of Control: Hostile Acquisition
XXIV. The Market of Corporate Control
a. Hostile takeovers
i. The target corporation’s management doesn’t want it to happen
ii. The acquiror and target don’t like each other
iii. The acquiror will probably try to do it in a friendly way but is rebuked
by the target
b. Key concept
i. Fundamental transactions, merger or takeover, require shareholder
approval
1. But can’t be initiated by shareholders, only management
a. Management is like the gatekeeper
c. Two ways to takeover
i. Dollars
1. Tender offer
43
a. Conditional offer – I will buy shares at $100/share but
only if I get 51%
b. Have to make full disclosure
ii. Democracy
d. Why are directors trying to derail the plan?
i. Several reasons
ii. Fiduciary duty
iii. Job security concerns
e. Two-tiered tender offer
i. In the first step, the bidder acquires a controlling interest in the target
via a tender offer, usually for cash
ii. In the second step, the remaining shares are acquired through merger
XXV. Glossary of defensive tactics
a. Bidder or raider
i. Acquiring company
b. Bust-up takeover
i. Seeking to break up target and sell it off in pieces
c. Junk bonds
i. Bonds that are higher risk and therefore bear a higher interest rate
ii. Financing for many raiders
d. Target
i. Company sought to be acquired
e. White knight
i. Second bidder, thought to be friendly to target management, who
makes an offer to rescue the target from a hostile bidder
f. White squire
i. A friendly party who does not acquire control but acquires a large
block of target stock with the acquiescence of target management
g. Arbs or arbitragers
i. Regular market participants who seek to make money by short-term
purchases or sales of stock
ii. When arbs determine that a company is ‘in play’ as a potential target,
they will purchase large blocks of the target stock hoping to sell out
for the higher takeover price
h. Front-end loaded tender offer
i. The consideration in the tender offer is worth more than the
consideration in the second-step merger
i. Golden parachutes
i. Lucrative compensation and fringe benefits given to target
management to ease their descent if they are fired after a hostile
takeover
ii. Promoted as a means of keeping needed executives when a company is
‘in play’
j. Tin parachutes
44
k.
l.
m.
n.
o.
p.
i. Contracts extended to a larger number of lower-level employees
Greenmail
i. Target’s repurchase of its own shares from a raider where the target
pays a premium for the shares to induce the unwanted suitor to go
away
ii. Some corporations have passed charter provisions forbidding the
payment of greenmail
Lock-ups and termination fees
i. The white knight may ask for termination fees or stock options at a
bargain price designed to compensate the white knight for serving as a
stalking horse in the auction contest
ii. Lock-up option – gives the white knight a right to purchase the
corporations most valuable assets – its crown jewels
1. Makes other bids unlikely because many of the key assets are
now promised to the white knight
Poison pills
i. Stock rights or warrants issued to a potential target’s shareholders
prior to a takeover
ii. Makes the acquisition particularly painful for the bidder to digest
iii. The target shareholders get the right to redeem their shares in the
target company for a price well above market price or the target
shareholders get the right to purchase shares of the acquiring company
at a reduced price after a follow-up merger between the two companies
Recapitalizations and leveraged buyouts (LBOs) by management (MBOs)
i. Target management may seek to respond to the bidder’s offer by
providing shareholders a rearranged financial package that offers
shareholders an immediate cash payment for their shares, often
financed by huge additional borrowings by the corporation
Shark repellent amendments (or porcupine provisions) to the corporation’s
charter and/or bylaws
i. Supermajority amendments
1. Raise vote required to effect a merger or similar transaction
form the simple majority or 2/3rds normally required by
corporate law to a figure as high as 90%
ii. Fair price amendments
1. Waive the supermajority vote if the second-step transaction
offers a ‘fair price’ as defined in the provision
2. Definition of fair price is often elaborate and can be designed
so it exceeds any price offered for the stock in the first stage
Staggered board amendments
i. If a corporation divided its board into three classes serving staggered
three-year terms, the shareholder with a newly acquired majority of
shares may only be able to elect ⅓ of the board at the next annual
meeting and thus be denied control of the assets for which it has just
invested a substantial sum of money
45
ii. DE law allows directors serving staggered terms to be removed only
for cause
1. Designed to make takeovers more difficult
q. Dual-class capitalization
i. Management can gain insulation beyond their actual share ownership
if their shares have multiple votes per share or the public shares have
fractional votes per share
ii. In 1994, NYSE, the American Stock Exchange, and NASDAQ agreed
to adopt rules that substantially limit listed companies’ ability to depart
from a one-share, one-vote capital structure
XXVI. Judicial Review of Defensive Tactics against Takeovers
a. Traditional Review
i. Historically common defense mechanism
1. Directors cause the corporation to purchase the outsider’s
stock, generally at a price above the prevailing market price of
the corporation’s shares
2. Courts had accorded directors less deference than if business
judgment rule presumptions were in place, but more deference
than if the transaction involved traditional self-dealing
ii. If the board has acted solely or primarily because of the desire to
perpetuate themselves in office, the use of corporate funds for such
purpose is improper.
1. The burden is on the directors to justify that the purchase of
shares with corporate funds was primarily in the corporate
interest.
[Cheff v. Mathes: HF had a board with lots of family (big shareholders) and two outside directors. The
biggest shareholder was HB, which was owned by the family. HF did business in an unusual way with lots
of salespeople. M’s initial friendly overture rejected so he secretly bought up a bunch of shares (17%). He
demanded to be put on the board. That was rejected so he offered to sell the shares to HB, sort of
greenmail. HF board purchased the shares at a premium. The plaintiff shareholder sued, alleging the motive
behind the board’s action was perpetuation of control. Court held directors not liable because that showed
reasonable grounds to believe a danger to corporate policy and effectiveness existed by the presence of M
stock ownership.]
b. Enhanced Scrutiny under Unocal; Poison Pills
i. Unocal analysis
1. Was there a threat?
2. Was defense in good faith and reasonably proportionate?
ii. Examples of concerns may include:
1. Inadequacy of price offered
2. Nature and timing of the offer
3. Questions of illegality
4. Impact on constituencies other than shareholders (i.e. creditors,
customers, employees, and general community)
46
a. But shareholders considered most important
constituency
b. Concern for other constituents are okay as long as there
are rationally related benefits for shareholders
5. Risk of noncomsumption
6. Quality of securities being offered in the exchange
[Unocal Corp. v. Mesa Petroleum Co.: M made a two-tier front loaded cash tender offer (described as
coercive). The first tier – 37% of stock for $54/share; second tier – merger and then use junk bonds to get
rid of rest of shares. U’s board get advice to reject offer as too low and counter with a selective self-tender
at $72/share. The board wanted to make sure the back-end shareholders were adequately compensated so
the tender offer included an exclusion of M. M challenged the self-tender with the exclusionary provision.
The court held that the board met its burden to prove that there was a threat and that its response was
reasonable and proportional.]
c. Revlon v. MacAndrews
i. The directors basically became auctioneers and have to solicit the best
price for the shareholders
1. As soon as sale becomes inevitable, this duty arises
ii. Two circumstances which may implicate Revlon duties:
1. When a corporation initiates an active bidding process seeking
to sell itself or to effect a business reorganization involving a
clear breakup of the company
2. When, in response to a bidder’s offer, a target abandons its
long-term strategy and seeks an alternative transaction
involving the breakup of the company
iii. See Case (pg. 79 CN, 110 RN)
d. Time/Warner
i. If the board’s reaction to a hostile tender offer is found to constitute
only a defensive response and not an abandonment of the corporation’s
continued existence, Revlon duties are not triggers, though Unocal
duties attach.
ii. Directors are not obliged to abandon a deliberately conceived
corporate plan for a short-term shareholder profit unless there is
clearly no basis to sustain the corporate strategy
[Paramount Communications, Inc. v. Time, Inc.: Time and Warner were in merger talks. It was important
to Time to preserve its culture. Paramount announced hostile tender offer to buy Time. Time put itself $710 billion in debt to buy 51% of Warner. Paramount and Time shareholders brought suit to enjoin Time’s
tender offer. Court held that Time was not required to abandon its long term strategic plans and Time was
not for sale so Revlon duties did not apply, though Unocal duties did.]
e. QVC
i. In the sale of control context, the directors must focus on one primary
objective – to secure the transaction offering the best value reasonably
47
available for the stockholders – and they must exercise their fiduciary
duties to further that end
ii. The need for adequate information is central to the enlightened
evaluation of a transaction that a board must make
1. Directors have burden of showing
iii. Contract provisions, such as a no-shop provision, may not validly
define or limit the directors’ fiduciary duties
[Paramount Communications, Inc. v. QVC Network, Inc.: Paramount and Viacom were going to merge.
In the agreement, Viacom demanded a no-shop provision, termination fee ($100 million), and a stock
option agreement in which V could pay with notes or demand cash difference. After agreement was
announced, QVC announced tender offer for 51% of P’s shares which was $10 higher than V’s offer. Even
though P was in a much better bargaining position when V came to negotiate new terms, the board did
nothing to get rid of the more noxious terms of the merger agreement with V. P’s board refused to negotiate
with QVC, claiming the no-shop provision in its agreement with V prevented such talks. After another
round of raises, the P board met to discuss QVC’s offer. The only document circulated was one
summarizing the conditions and uncertainties of the QVC offer which gave a very negative impression. The
Paramount Board determined that the QVC offer was not in the best interests of its stockholders. QVC
brought suit. The court held that Revlon applied because control of P was for sale.]
Federal Law Affecting Corporate Transactions
XXVII.
Disclosure; Initial Issuance of Securities
a. Federal securities law is pretty new (New Deal)
i. Securities play a key role in national economy
ii. Two related purposes
1. Protect investors
2. Strengthen markets
a. If people think markets are a clean game, they will be
more confident
b. Disclosure
i. Primary unifying purpose of securities laws
ii. If you tell investors all the relevant information, they can make up
their own mind whether it is a good investment
iii. Important part of fiduciary duty
c. 1933 Act governs initial issuance
i. Required to register security with SEC if you’re going to sell it on the
national market
ii. Registration requires but does not guarantee the accuracy of the facts
represented
1. SEC doesn’t check information that is submitted
d. Common law tort action of deceit
i. Principal remedy for inadequate disclosure before 1933
ii. Elements
1. Plaintiff had to show:
a. A misrepresentation (or an omission in those areas
where the law imposed a duty to speak)
b. Of a material fact
48
c. Made by the speaker with scienter
d. On which the plaintiff relied
e. Causing damage as a consequence
e. 1933 Act required not only affirmative disclosure beyond what existed at
common law, but it also substantially reduced the elements that a plaintiff
must show to recover, as compared to what would have been required at
common law
i. If a misstatement appears in a prospectus, it is usually not necessary
for the plaintiff to show reliance
1. The issuer is strictly liable with no showing of intent or other
scienter required
2. Directors and other defendants can escape liability if they show
due diligence
a. Difficult burden for many insiders
ii. Plaintiffs do not have to prove any causation but defendants can seek
to prove that damages occurred for reasons other than the
misrepresentation
XXVIII.
Liability under Federal Proxy Rules
a. 1934 Act governs securities after issuance
i. The Exchange Act cannot be understood to include regulation of an
issue that is so far beyond matters of disclosure and of the
management and practices of SROs, that is concededly a part of
corporate governance traditionally left to the states
ii. The goal of federal proxy regulation was to improve communications
with potential absentee voters and thereby enable proxy voters to
control the corporation as effectively as they might have by attending a
shareholder meeting
[Business Roundtable v. SEC: NYSE wanted to change its one vote/share of common stock rule and filed
a proposal with the SEC. The SEC did not approve the rule change but responded with one of its own. It
adopted Rule 19c-4, barring national securities exchanges and national securities associations, together
known as self-regulatory organizations (SROs), from listing stock of a corporation that takes any corporate
action with the effect of nullifying, restricting, or disparately reducing the per share voting rights of
existing common stockholders. The rule prohibited such disenfranchisement even where approved by a
shareholder vote conducted on 1 share/1 vote principles. Court held that rule was beyond the SEC’s scope
and authority because its relationship to disclosure was too attenuated.]
b. Rule 14a-9
i. § 14a authorizes the SEC to regulate proxy solicitations as necessary
or appropriate in the public interest or for the protection of investors
ii. Rule 14a-9 supplements the express disclosure obligations (Rule 14a3) with a broad prohibition against any false or misleading statement
of a material fact or any omission necessary to make an included
statement not misleading or to correct a statement that has become
misleading
c. Rule 14a-9 Private Action
49
i. Implied private cause of action
1. Courts have viewed Rule 14a-9 as an antifraud provision and
turned to the law of common law fraud or the tort of deceit
[J.I. Case Co. v. Borak: B brought suit seeking to enjoin a proposed merger between Case and ATC on
various grounds, including misrepresentations contained in the material circulated to obtain proxies. He
alleged that if the proxy materials had not been misleading the merger, which passed on a small margin,
would not have been approved and Case stockholders were damaged thereby. SCOTUS held that lawsuit
was consistent with purpose of 14a-9.]
XXIX. Rule 10b-5
a. 1934 Act § 10(b); 1934 Act Rule 10b-5
i. Sec. 10. Manipulative and Deceptive Devices
1. 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
exchanges –
2. B. To use or employ, in connection with the purchase or sale of
any security …any manipulative or deceptive device or
contrivance 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
ii. Rule 10b-5 Employment of Manipulative and Deceptive Devices
1. It shall be unlawful…
a. To employ any device, scheme, or artifice to defraud,
b. To make any untrue statement of a material fact or 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
c. To engage in any act, practice, or course of business
which operates or would operate as a fraud or deceit
upon any person,
2. In connection with the purchase or sale of any security
b. Standing: “In Connection with” Purchase or Sale
i. In order to have standing, plaintiff class is limited to actual purchasers
and sellers of securities
[Blue Chip Stamps v. Manor Drug Stores: As part of the settlement of a government antitrust action, B
agreed to offer a substantial number of its shares to its customers. Two years after the offering, , an
offeree who did not buy, filed suit alleging that B’s prospectus was overly pessimistic in order to
discourage  from accepting. SCOTUS held  lacked standing because it was not a purchaser or seller of
securities.]
ii. The claim of fraud and fiduciary breach states a cause of action under
any part of Rule 10b-5 only if the conduct alleged can be fairly viewed
as ‘manipulative or deceptive’ within the meaning of the statute
50
1. A breach of fiduciary duty, without any deception,
misrepresentation, or nondisclosure, does not violate the statute
or the Rule
[Santa Fe Industries, Inc. v. Green: SF wanted to get rid of minority shareholders (5%) in K so it used a
short form merger (DE). SF obtained independent appraisals of K’s assets. Based on those appraisals, SF
offered $150/share and gave shareholders appraisal info. Plaintiffs brought suit alleging that SF’s conduct
amounted to a violation 10b-5. SCOTUS held that there was no fraud so there was no cause of action under
10b-5.]
c. Misrepresentation and Omission of Material Fact
i. In the proxy-solicitation context, an omitted fact is material if there is
a substantial likelihood that a reasonable shareholder would consider it
important in deciding how to vote
ii. To fulfill the materiality requirement that there must be a substantial
likelihood that the disclosure of the omitted fact would have been
viewed by the reasonable investor as having significantly altered the
‘total mix’ of information made available
iii. Materiality will depend at any given time upon a balancing of both the
indicated probability that the event will occur and the anticipated
magnitude of the event in light of the totality of the company activity
[Basic Inc. v. Levinson: B was in merger discussions with C. It made three public statements denying it
was engaged in negotiations. B asked NYSE to suspend trading in its shares and issued a statement it had
approved C’s offer. Plaintiffs were former B shareholders who had sold stock after B’s 1 st public statement
and before the suspension of trading. They claimed the 3 statements were false and misleading and
constituted violations of 10b-5. The plaintiffs alleged that they were injured by selling shares at artificially
depressed prices in a market affected by B’s misleading statements and in reliance thereon. SCOTUS held
that statements would be material if there was a substantial likelihood that a reasonable shareholder would
consider it important in deciding to buy or sell.]
iv. Once you open your mouth, you are required to disclose but you’re not
required to open your mouth
1. A duty to disclose arises whenever secret information renders
prior public statements materially misleading, not merely when
that information completely negates the public statements
[In re Time Warner, Inc. Securities Litigation: In order to clear debt, TW embarked on a highly
publicized campaign to find international strategic partners who would infuse billions of dollars of capital
into the company. The campaign only succeeded in producing two partnerships and not for billions of new
capital. Faced with a multi-billion dollar balloon payment on the debt, TW was forced to seek an alternative
method of raising capital – a new stock offering that substantially diluted the rights of the existing
shareholders. After the announcement of the stock offering on June 6 th, the stock price dropped from $117
to $89.75 (almost 25% decline). The complaint alleged that a series of statements from Time Warner
officials during the class period were materially misleading in that they misrepresented the status of the
ongoing strategic partnership discussions and failed to disclose consideration of the stock-offering
alternative. The parties classified the challenged statements into two categories: (1) press releases and
public statements from the individual defendants; (2) statements to reporters and security analysts
emanating form sources within the company but not attributed to any identified individual. Court held that,
since TW publicly hyped the strategic alliances, it may have come under a duty to disclose facts that would
place those statements in a materially different light.]
51
v. When do omissions become actionable?
1. If you fail to disclose something necessary to fix a false or
misleading statement
2. Silence is not actionable unless you have a duty to speak
vi. Safe harbor for projections
1. Projections are protected – no cause of action if projections
prove inaccurate as long as the projections are qualified when
they are made with meaningful cautionary statements
a. No duty to update the projections
d. Scienter
i. A defendant’s mental state regarding a proscribed act
ii. 10b-5 does not include negligent behavior
iii. Needed: More than negligence, knowledge or intentional misconduct
is definitely actionable
1. Courts are split as to whether recklessness or gross negligence
is adequate
[Ernst & Ernst v. Hochfelder: The plaintiffs brought suit against Ernst & Ernst which was based on the
firm’s alleged negligence in aiding and abetting the fraud committed by the president of a small brokerage
firm whose books were audited by Ernst & Ernst. SCOTUS held that mere negligence was not enough
under 10b-5.]
e. Reliance & Causation
i. When the alleged wrongdoing occurs in a market setting rather than
face to face and is an omission rather than a misstatement:
1. All that is necessary is that the facts withheld be material in the
sense that a reasonable investor might consider them important
in the making of this decision
2. This obligation to disclose and the withholding of a material
fact establishes the requisite element of causation in fact
ii. Rebuttable presumption
1. If (fraudulent) statement is made, presumed that price of stock
is affected
a. Efficient market theory
b. Price reflects all information – even false public
information
c. Only works for widely publicly traded stocks
iii. How can defendant rebut the presumption?
1. Show misrepresentation didn’t affect price
2. Plaintiffs would have sold stock regardless
f. Measure of Recovery
i. Out-of-pocket measure of damages (Green)
1. Fixes recovery at the difference between the purchase price and
the value of the stock at the date of purchase
2. Value of misrepresentation only
ii. Rescissory measure of damages
52
1. The difference between the purchase price and the value of the
stock as of the date of disclosure
2. Value of misrepresentation plus consequential market loss
iii. See CN pg. 90, RN pg. 127
XXX. Rule 10b-5 and Insider Trading
a. Insider Trading as Fraud
i. People who are in the know shouldn’t be allowed to make money on
stocks based on the unfair advantage
ii. A corporate insider who has material nonpublic information about the
enterprise is under a duty either to:
1. Abstain from trading
2. First disclose the nonpublic information
iii. Obligation rests on two principles:
1. The existence of a relationship giving access, directly or
indirectly, to information intended to be available only for a
corporate purpose, and not for the personal benefit of anyone
2. The inherent unfairness involved where a party takes advantage
of such information knowing that it is unavailable to those with
whom he is dealing
[SEC v. Texas Gulf Sulpher Co.: TSG geologists discovered a significant ore deposit. The vice president
of TSG told them to keep it under wraps while more conclusive tests were being done. During that time
period, officers, employees, and those they tipped off purchased large quantities of TSG stock and calls.
When rumors started circulating that TSG had discovered a substantial ore deposit, a TSG officer in the
know drafted a press release downplaying the rumors. More TSG officers and tippees purchased stock.
When news of the ore strike was finally released, the price of TSG stock skyrocketed. The SEC brought
this action against TSG and the officers, directors, and employees who used the information to profit on
stock. Court holds that 10b-5 requires investors be on equal footing.]
b. Evolving Definition of Fraud
i. The party charged with failing to disclose market information must be
under a duty to disclose it
[Chiarella v. United States: C worked for a printing company which printed announcements of takeover
bids. The names were blacked out but he figured out what companies were involved and bought stock. He
was convicted of a 10b-5 violation. SCOTUS reversed because C had no duty to disclose.]
ii. Constructive or temporary insider
1. Those who receive information from the insider or the
corporation for an appropriate purpose
iii. Tippees
1. Those whom the insider tips for an improper purpose
2. Two things need to be established for tippee liability
a. Insider breached fiduciary duty by disclosing
i. Insider benefited
53
1. Benefit could be similar to giving gift to
friend or family
b. Tippee knew there was a breach
[Dirks v. SEC: S, an insider, approached D with information that EFA was engaged in fraudulent corporate
policies. S asked D to verify the fraud and disclose it publicly. D did find evidence of fraud and tried to get
the WSJ to do a story. At the same time, he told his clients about his investigation and they sold their EFA
stock. When fraud was finally publicly uncovered, EFA stock plummeted. SEC alleged that D violated
10b-5 when he disclosed the allegations to his clients. SCOTUS held no violation because S did not breach
a fiduciary duty by disclosing to D.]
c. Misappropriation and Rule 14e-3
i. Rule 14e-3 derives its statutory authority from §14e, an antifraud
provision regulating tender offers in which an acquiring company
purchases shares directly from the shareholders of a target in contrast
to a merger when the acquisition occurs by a vote of the directors and
shareholders
ii. Misappropriation theory
1. A person commits fraud in connection with a securities
transaction when he misappropriates confidential information
for securities trading purposes, in breach of a duty owed to the
source of the information.
2. Premises liability on a fiduciary-turned-trader’s deception of
those who entrusted him with access to confidential
information
3. Designed to protect the integrity of the securities markets
against abuses by outsiders to a corporation who have access to
confidential information that will affect the corporation’s
security price when revealed, but who owe no fiduciary or
other duty to that corporation’s shareholders
4. Focuses on vertical duties
iii. A company’s confidential information qualifies as property to which
the company has a right of exclusive use
iv. Full disclosure forecloses liability under the misappropriation theory
because the deception essential to the theory involves feigning fidelity
to the source of the information
[United States v. O’Hagan: O was a partner at D&W. GM retained D&W as local counsel regarding
potential tender offer for P. O, who didn’t work on the GM representation, heavily invested in P, making a
$4.3 million profit after the tender offer announcement. SEC indicted O under misappropriation theory.
SCOTUS affirmed the conviction because O didn’t disclose to D&W he was going to use the information.]
54