Economic and Legal Aspects of the Firm

Introduction

Corporations, partnerships, and limited liability companies are special types of business firms or business associations.

The Economic Backdrop

Comparative search for best investment- rational individuals will choose to deploy their human and money capital in the least costly form, given the transaction costs of each business association form ex ante

Comparative measurement should be in terms of expected return

Transaction costs and Choice of Organizational Form

Assuming a venture between two parties who will each use their best efforts and divide profits based on relative contributions- six choices are presented:

market

long-term contract

sole proprietor and agent

partnership

limited liability company

corporation

Transaction Cost Factors in choosing:

bounded rationality- unable to anticipate plan for every contingency that might affect venture

opportunism- opportunistic individuals seek to further their own ends by taking advantage of information deficits of those with whom they deal.

Team-specific investment- when an asset has a higher value in its current team use than its value in its next best use

Limits on Organizing as an Implicit Team- when one party makes a large team-specific investment relative to the other team member, information asymmetries inherent in separate ownership and control combine to make opportunism possible.

discrete contracting: the parties have no preexisting obligations to each other. As they approach a contemplated venture, they negotiate a contract that anticipates and provides a rule governing all contingencies

relational contracting:

a response to the defects of discrete contracting.

Parties do not attempt to provide a contractual answer to all contingencies, opting instead to build a governance structure that will allow them to solve problems as they arise.

The goal is to reinforce the relation itself.

discrete long-term contracting creates 3 problems:

parties each have their own distinct business interests (rather than a team)

specification of rights and duties increases the risk of opportunistic refusal to renegotiate

extended duration makes it certain that original contract will not cover all future problems

Thus, organization as a firm is optimal

involves greater surrender of autonomy, but solves problems posed by bounded rationality and opportunism

sole proprietorship, partnership, corporation

Agency

Introduction- Agency law may be thought of as a set of standard form rules that provide a backdrop for contracts or market transactions among team members.

Agency Law and the Choice of Sole Proprietorship Form

A sole proprietorship is created simply by unifying the ownership and control of the team in the hands of one team member.

Common law- mutual assent creates the relationship of principal and agent. Unless otherwise agreed, this relationship is terminable at will by either party.

The law of agency imposes a fiduciary duty on agents, and the law of contract imposes some limits on the principal's right to discharge an employee.

Community Counselling Service, Inc. v. Reilly (4^th Cir. 1963) (15)

Facts: CCS is a professional fund raising organization. Reilly was employed by CCS as regional sales representative. R stole clients and sold his own services rather than P's services.

Holding: Until the employment relationship was terminated, Reilly owed a fiduciary duty. He violated this duty and the “fruit of that disloyal conduct Reilly may not retain.”

Note:

The usual rule is that a former employee, after termination of employment, may compete with his former employer, the only restraint being that he may not use confidential information or trade secrets obtained from former employer.

Employee has the highest duty of loyalty

Fiduciary duty requires employee to be candid with his employer and no information which would be useful to the employer in the protection and promotion of its interests may be withheld.

Fiduciary duty can be described as a device for economizing on transaction costs, imposing a general obligation to act fairly.

Formulations of Fiduciary Duty

Fiduciary duty 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.” -Anderson

“Socially optimal fiduciary duty rules approximate the bargain that investors and agents would strike if they were able to dicker at no cost.” -Easterbrook and Fischel

The sole proprietor is the firm's residual claimant.

she is entitled to any of the firm's remaining assets after all other claimants have been paid in full

she is responsible for making up the shortfall out of her personal estate if the firm's assets prove insufficient to satisfy other claimants.

Motivation for owner to use best efforts.

Agents don't share the risks of the principal, so they have an incentive to shirk.

At-will employment counters this incentive (Wood's Rule)

Foley v. Interactive Data Corp. (Cal.SC. 1988)(22): Foley was fired because he tried to report embezzlement of his superior.

no substantial public policy prohibits an employer from discharging an employee for reporting info relating to the employer's private interests.

However, under the relational view of contracts, Foley's employment was not terminable at will because the parties intended a continuing relationship (termination guideliness, etc.)

Common law- A third party who deals with an agent does so at his peril. The agent's actions will bind the principal only if the principal has manifested his assent to such actions.

Manifestations of Assent at Common Law

Actual authority- occurs when the principal manifests his consent directly to the agent.

Apparent authority- (ostensible authority) arises when an agent is without actual authority, but the principal manifests his consent directly to the third party who is dealing with the agent.

Modern Rule- Courts strain to protect the expectations of third parties even when the principal's manifestations of consent were illusory at best.

Liability must rest on ostensible agency since P was justified in believing that agent had authority.

“Ostensible authority is such as a principal, intentionally or by want of ordinary care, causes or allows a third person to believe the agent possesses.” -Civil Code § 2317

Witter was liable because of the actions of Long, its agent.

Should Widow Blackburn have been aware of the scam? No - Dean Witter is the one who is obligated to avoid this sort of behavior.

Partnerships and Other Noncorporate Business Associations

Noncorporate Business Associations

The General Partnership (UPA §§6, 9, 15, 18-22, 31)

Every state except Louisiana bases its partnership law on the Uniform Partnership Act (UPA) or the revised Uniform Partnership Act (RUPA)

Formation: Similar to the formation of the principal agent relationship, formation of a general partnership requires only a statutorily specified mutual manifestation of consent.

persons can associate as joint owners for profit and avoid being characterized as a general partnership by electing to be governed by different association law.

Can't avoid general partnership status just by labeling if you're associated as joint owners- statements that no partnership is intended are not conclusive

“If as a whole a contract contemplates an association of two or more persons to carry on as co-owners a business for profit, a partnership there is.”

Equal Sharing of ownership and management functions

Individual partner's adaptability to changed circumstances favored over firm's continuity and adaptability (partner who leaves at will receives cash value of his partnership interest)

Advantageous for a small venture pursued by a few players who know and trust each other

Common law courts distinguished between general partnerships (X & Y carry on a business as co-owners), and joint ventures (X & Y join to exploit a particular opportunity).

Defined: “the legal relationship between two or more persons, who, in some specific venture, seek a profit jointly without the existence between them of any actual partnership, corporation, or other business entity.”

joint right of control

joint proprietary interest in the subject matter of the venture

right to share profits

duty to share losses

An association of two or more persons to carry on as co-owners a business for profit

Must have at least one general partner and one limited partner

Separation of ownership and management functions- under state default rules, limited partners have no management power and no authority to act as agents

Limited liability- limited partners are not liable for the firm's obligations unless they take part in control. But general partners are jointly and severally liable.

Firm's continuity and adaptability to changed circumstances favored over individual's adaptability- General partners can withdraw at will, but a limited partner must give 6 months notice before withdrawal. Withdrawal does not cause dissolution.

Taxation as either a corporation or a partnership- normally taxed as a partnership, but has the option of corporate taxation.

formed by filing a “constitution,” usually termed articles of organization, with the secretary of state

Partnership-like, centralized management: members have powers similar to those of partners in a general partnership

“members” are the LLC's residual claimants

may stipulate separation of function by designating in the articles of organization that management will be by managers

Limited Liability- members may participate fully in management without forfeiting limited liability, unlike in limited partnership law

Adaptability- members may withdraw at will, causing a dissolution and liquidation of the LLC.

Taxation- Usually taxed as a partnership but can be adapted to qualify for treatment as a corp. when doing so is advantageous.

formation- an existing or newly created general partnership simply registers as an LLP.

Limited Liability- provides protection from vicarious liability for professional negligence

Limitations on Distributions: Unlike general partnership law, most LLP statutes prohibit distributions of partnership assets that would result in the LLP's insolvency

Otherwise, governance is in the form of general partnership norms

Must have no more than 35 SHs, none of whom can be other corps, and only one class of stock.

Has limited liab.

Treated differently for tax purposes under IRS code - taxed much like a partnership

Election to become S corp. requires unanimous action by shareholders

Attempts to achieve favorable tax treatment and limited liab.

“Double tax” - corp. is taxed and shareholders are taxed on dividends.

Can get around double tax by zeroing out taxable income in the form of salaries, etc.

IRS scrutinizes to ensure that they're not disguised dividends.

FIDUCIARY DUTY between Partners (UPA §§20-22; RUPA §§403-405)

The traditional framework

In the partnership setting, partners must deal with one another as fiduciaries in all matters affecting the partnership.

Meinhard v. Salmon (NY 1928) (CARDOZO) (p.72)

Facts: Salmon entered into a joint venture with Meinhard, whereby Meinhard supplied funding for Salmon's leasing of a building from Gerry. Salmon retained sole power to manage the property. Salmon later entered into a subsequent lease with Gerry, without informing Meinhard of the deal.

Holding: Salmon breached the fiduciary duty he owed to Meinhard.

Joint coadventurers, like copartners, owe to one another, while the enterprise continues, the duty of finest loyalty.

Dissociation and Dissolution

At-will Partnerships and the Dissolution Framework - once dissolution occurs, the partnership must wind up its business, pay off its debts, and settle accounts with partners

Settling Accounts - UPA §18(a) provides that absent agreement to the contrary, profits and losses are shared equally. Differing results when parties do not make equal contributions of capital and services and do not specify

Wrongful Dissociation

General Rule UPA §§31, 32, 38 - If a partner dissociates from the partnership before completion of the agreed term or undertaking, such dissociation will be wrongful. A wrongful dissociation causes dissolution of the partnership. Partners have the option of continuing the partnership's business without the consent of the wrongfully dissociating partner. Additionally, the wrongfully dissociating partner must compensate other partners for damages resulting from the wrongful dissociation.

Page v. Page FACTS: Oral partnership agreement, trying to say at-will partnership for dissolution purposes HELD: Partners owe one another a fiduciary duty of good faith, which applies to every aspect of the relationship, including the decision to end the relationship

Partner Expulsion UPA §31(1)(d) - In a term partnership, if the majority outs the deficient partner, this dissociation could be deemed “wrongful,” exposing the ousting partners to substantial liability. Unless otherwise provided, the right to expel will be governed by partnership law, including fiduciary duty.

Bohatch v. Butler & Binion (134) FACTS: Concerned with over-billing by managing partner, she raises the issue, and then is expelled from the partnership HELD: 1) A partnership exists solely because the partners choose to place personal confidence and trust in one another 2) Once such charges are made, partners may find it impossible to continue to work to their mutual benefit and the benefit of their clients.

The Corporate Form

Separation and Specialization of Ownership and Management Functions

Legal separation among shareholders, directors, and officers

Directors manage the corporation- they are responsible for determining basic corporate policies, appointing and monitoring the corporation's officers, and determining dividend distribution. Del G.C.L. § 141(a), MBCA § 8.01(b).

BUT management power must be exercised collectively, and individual directors are not given general agency power to deal with outsiders.

Compensated for services rendered but not entitled to share of the residual profits.

Outside directors - not simultaneously employed as an officer of the corp.

Inside directors - simultaneously employed as officers, so they're intimately familiar w/ corp's business, personnel, and markets.

They are the corporation's risk bearers and residual claimants

Authority- they may annually elect the corporation's directors and approve fundamental changes in the corporation's governing rules or structure, but their right to participate in daily management is very limited.

newer codes allow the corporation to specify names and duties of its officers in its by-laws.

An officer's power and authority is subject to the dictates of the board of directors.

Often, one person will be an officer, director, and shareholder

Hierarchical decision-making in executing corporate policy

Majority rule for significant decisions- Unlike partnership unanimity rule, the state corporation law norm is majority rule.

Exit rights from selling shares, which are liquid. No need to convert the firm's assets into cash.

Withdrawal or Expulsion of Officers or Directors does not Dissolve the Corporation- officers serve at the pleasure of the directors, and directors serve at the pleasure of the shareholders

Business Judgment Rule- courts and regulators do not like to substitute their own judgment for that of the board of directors

Shareholder agreements that are intended to sterilize director discretion

to be effective, must bind the shareholders in their roles as directors

may be invalidated for impermissibly encroaching on the director's duty to use independent judgment

Introduction

the securities markets serve as a quasi-monitor of the corporation's managers. If the corporation is being poorly managed, or if its assets would have a significantly higher value in another use, a new management team may seek to buy a majority of the corporation's shares and replace management.

Characteristics of Shares

Corporations must specify in articles of incorporation the number and characteristics comprising the corp

Within each class of shares, shareholders must have identical rights, preferences, and limitations.

Default rule: voting and residual claimant status are assumed to be automatically assigned to all corporate shares unless otherwise specified in the articles of incorporation. (Common shares)

Corporate norms mandate that there be a class of shares that is entitled to receive the corporation's net assets upon dissolution- residual claimants.

Another class of shares will have voting rights- including the election of directors.

Preferred Shares- differ from common stock as specified by the articles of incorporation. Preferred shares may be granted a dividend or liquidation preference over the common shares (but often with a limitation of voting rights)

Strong version: market price reflects all public and private info; speculators can profit only through luck.

Semi-strong version: market price reflects all public information affecting share value Assumes arbitrageurs are clearing the market to its efficient price at all times. However, room is left for inefficiency when the arbitrageurs themselves try to cash in on the common person's misguided speculation.

Weak form: market price reflect only historical information about a firm

Default rules in state corporation codes anticipate a passive, but important, governance role for shareholders.

Shareholder authority

annually elect the corporation's directors

approve amendments to the articles of incorporation, dissolution, a sale of substantially all of the corporation's assets, and other extraordinary matters

may individually or collectively suggest policy changes- enhanced by their power to remove and replace the directors at any time, with or without cause

Costs of participation in governance and the liquidity of stock provide a disincentive for shareholders to attempt to influence corporate policy

Berle and Means found that most publicly held corporations were “owned” by geographically dispersed, passive investors who simply rubber-stamped the officer's wishes, including election of directors aligned with management

Institutional Shareholders changed this view- the existence of a fairly concentrated and sophisticated majority block of institutional investors makes coordinated participation in decision-making at least plausible for members of that group.

The State Law Procedural Framework (§§7.01, 7.02, 7.04-7.07, 7.21, 7.22(a)-(c), 7.25, 7.26; §§211-213, 216, 222, 228, 229)

Two competing principles

the shareholder franchise is critical to the legitimacy of separation of function and the resulting delegation of power to corporate managers

the corporation's need to adapt to changed circumstances demands practicality and finality in the administration of shareholders' governance rights

Action by vote at formal meetings

normally, shareholders may exercise their power - such as electing or removing directors - only by voting at formally called meetings.

Annual meeting- All state corporation codes require the holding of an annual shareholders' meeting. MBCA § 7.01(a).

Special meeting- All state corporation codes also allow special meetings of shareholders, usually upon the call of the board or other persons specified in the articles or by-laws.

MBCA § 7.02- authorizes a special meeting called by holders of at least 10% of shares authorized to vote

Shareholder initiated right is omitted in Delaware and New York.

most state corporation codes now allow shareholders to act without a meeting, but only by unanimous written consent.

in effect, this requirement means that shareholders of public companies can act only by meeting

Delaware G.C.L. § 228 - the holders of the minimum number of shares that would be required to approve an action if a meeting were held and a vote taken may act by written consent.

Hoschett v. TSI International (179) HELD: mandatory requirement that an annual meting of shareholders be held is not satisfied by shareholder action pursuant to §228 purporting to elect a new board or to re-elect an old one. TSI ordered to hold annual meeting. (However, court may make order on power of own discretion)

Notice- shareholders are entitled to receive written notice of the date and location of any annual or special meeting

Quorum- Action may properly be taken only if there is a quorum present. A quorum typically is a simple majority of the shares entitled to vote.

Record Date- Only persons who own shares as of a record date set by the corporation are entitled to vote at, and receive notice of, the meeting.

Proxy voting

A shareholder need not be present to vote if he executes a simple agreement appointing a proxy to act on his behalf

The proxy designation may create an agency relationship that requires the proxy-holder to follow the shareholder's instructions

Essential to hold meetings in publicly held corporations; otherwise there would be no quorum.

Corporate law statutory norms entrust management of corporate affairs to the directors. MBCA §8.01, Delaware G.C.L. §141(a). (except as otherwise provided in the articles of incorporation)

Avenues for change:

amend the articles of incorporation to give shareholders the right to make a business decision or to prescribe directly whatever change is desired

difficult to attain necessary votes

amendment to the articles may be initiated only by the directors

because directors will not initiate an amendment to curb their own powers, §§ 8.01 and 141(a) effectively are immutable rules for corporations that do not opt out in the initial articles of incorporation

initiate a change in the corporations' by-laws.

normally, shareholders can't amend the by-laws to make ordinary business decisions or to establish corporate policies

management may rule out of order any shareholder's attempt to propose an amendment to the articles of incorporation that would intrude on management's authority to make ordinary business decisions or to establish corporate policies

Removal of Directors

The default rule of modern codes generally grants shareholders the right to remove directors with or without cause by simple majority vote.

Del. G.C.L § 141(k): can remove any or all directors without cause, except that:

If the directors are divided into classes with staggered terms, their must be cause for removal.

If there's cumulative voting, and less than the entire board is to be removed, director X can't be removed without cause if the votes cast against X would be sufficient to elect X (in a cumulative-vote election of the entire board or of the class of directors that includes X).

Roven v. Cotter (Del. Chanc. 1988) (pg. 204) HELD: Shareholders may amend a certificate of incorporation, thereby eliminating a bylaw establishing a classified board of directors, so that the stockholders can then remove a director without cause

Staggered Board w/ Cumulative Voting

Most codes allow replacement directors to be selected by either the shareholders or the directors. See Delaware G.C.L. §223

Securing a special meeting

Delaware G.C.L. §211(d) does not give shareholders any statutory right to call a meeting. But by-laws may allow one or more shareholders to do so.

If not empowered to call a special meeting, shareholders must

wait until the next annual meeting to remove directors, or

remove or replace directors via written consent in states that permit this on a less than unanimous basis

Requires service of specific charges, adequate notice, and full opportunity of meeting the accusation.

Show of cause requires notice and opportunity to respond; DPC

Campbell v. Loew's, Inc. (Del.Ct.Chan. 1957) (p.202)

Holding: The stockholders have the right between annual meetings to elect directors to fill newly created directorships.

Under Delaware law, the shareholders have the power to remove a director for cause. A “planned scheme of harassment” constitutes a legal basis for removing a director.

stockholders have the power to remove a director for cause in order to prevent the damage of an offending director; stockholders may remove a director for cause even where there is a provision for cumulative voting

A charge that the directors desired to take control over the corporation is not cause for removal. Nor is a charge of lack of cooperation

Introduction

§14(a) of the Securities Exchange Act of 1934 -- authorizes the SEC to make rules governing the proxy solicitation process and makes it unlawful for management or dissident shareholders to solicit proxies in contravention of such rules.

§14(a) applies to any proxy, consent, or authorization in respect of any security registered under §12:

any corporation whose shares are listed on the national securities exchange

any corporation that at the close of its fiscal year has both a class of equity securities held by 500 or more shareholders and more than $10 million in assets. ??

The goal is to prevent solicitation of proxies or consents by means of inadequate or deceptive disclosure.

prohibits any proxy solicitation unless the person solicited is first furnished a publicly filed preliminary or final proxy statement containing basic facts to inform voters: (Schedule 14A)

time, date, and place of the meeting to which the solicitation relates

revocability of the proxy

solicitor's identity and source of funds

identity and basic info about candidates for director

regulates the form of the proxy statement, ensuring readability

regulates the form of the proxy that solicitors ask shareholders to execute, imposing readability requirements and gives an opportunity to do more than grant the authority requested by the solicitor

must provide boxes whereby a shareholder may specify whether she approves, disapproves, or abstains with respect to each matter covered by the proxy

prohibits the making of false or misleading statements as to any material fact, or the misleading omission of a material fact, in connection with a proxy solicitation

Rule 14a-7 requires a corporation that is itself soliciting shareholders in connection with an annual or special meeting to provide specified proxy solicitation assistance to requesting shareholders. To do this, the corporation must (at the requesting shareholder's expense) either:

provide the requesting shareholder with an accurate list of those shareholders and financial intermediaries from whom the corporation intends to solicit a proxy

itself mail the requesting shareholder's proxy materials to shareholders and financial intermediaries

Under Rule 14a-8, if a qualifying shareholder notifies her corporation that she intends to present a proposal for action at a forthcoming shareholders' meeting, the corporation must include such proposal and an accompanying supporting statement in the corporation's proxy statement,

unless the proposal falls into a Rule 14a-8(c) exception.

Such proposal must be on the proxy card, with expenses borne by the corporation itself.

May make 1 proposal per meeting, and the supporting statement may not exceed 500 words.

To be a qualifying shareholder, at the time of the proposal:

proponent must be a record or beneficial owner of at least 1% or $2,000 (??) in market value of the corporation's voting stock for at least one year, and

she must continue to own such amount through the date of the shareholders' meeting

14a-8(i)(1) allows management to omit a proposal that is not a proper subject for shareholder action under the laws of the corporation's state of incorporation- this causes most proposals to be put in the form of a suggestion because the power to act is limited to directors

(i)(7) allows omission of proposals relating to conduct of a corporation's ordinary business

(i)(5) allows omission of proposals relating to corporate operations involving an insignificant portion of the corporation's assets and not otherwise significantly related to the registrant's business

(i)(8) requires dissident shareholders who wish to oppose management's nominees for director to do so through a separate proxy solicitation and at their own expense

(i)(12) allows the omission of any proposal that has been submitted for a shareholder vote at one or more meetings within the preceding 5 yrs, and hasn't garnered 3% (first submission), 6% (second), and 10% (all others)

Use of 14a-8

users of 14a-8 are primarily interested in effecting social change

Institutional investors effectively utilized 14a-8 to prevent anti-takeover policies

Lovenheim v. Iroquois Brands, Ltd. (p.222): Lovenheim proposed a resolution for research on whether company participates in the force-feeding of geese. Iroquois relied on 14a-8(i)(5)- only .05% of assets were implicated.

5% test of economic significance employed

rule isn't limited to economic significance because of “otherwise significantly related” clause.

Because of the ethical and social significance of plaintiff's proposal, he has shown a likelihood of prevailing on the merits, even though the resolution probably won't pass.

However, could not propose that company immediately cease production of pate - would be violation of 14a-8(i)(1) “management” and 14a-8(i)(7) “ordinary business”

New York City Employees' Retirement System v. SEC (p.220): SEC issued no-action letter regarding Cracker Barrel's 14a-8(c)(7) omission of anti-discrimination on the basis of sexual orientation, because such a policy related to the corporation's ordinary business, hiring and firing. This raised a furor and the SEC reversed itself and stated that it would return to a case-by-case approach:

“While we acknowledge that there is no bright-line test to determine when employment-related shareholder proposals raising social issues fall within the scope of the `ordinary business' exclusion, the staff will make reasoned distinctions in deciding whether to furnish “no-action” relief.”

the letter isn't binding, the SEC may still bring an enforcement action against Cracker Barrel based on its failure to include a proposal regarding an employment-related social issue.

Rule 14a-1(1): Definition of Solicitation

Rule 14a-2: Exceptions

Introduction (§8.30)

Officers and other corporate agents are subject to fiduciary duties

fiduciary duty instructs directors to be absolutely fair and candid in pursuing personal interests.

Fiduciary duty describes the bounds of acceptable conduct for directors in carrying out their individual and collective duty to manage the corporation

Duty of Loyalty: Must deal with the corporation candidly. Prohibits the director from unfairly competing with her corporation or unfairly diverting corporate resources or opportunities to her personal use.

Duty of Care: Requires directors to exercise that degree of skill, diligence, and care that a reasonably prudent person would exercise in similar circumstances.

Normally, directors owe fiduciary duties to the corporation, not to individual shareholders.

Limits on the scope and Impact of Fiduciary Duty

Business Judgment Rule- courts will not normally second-guess directors' business judgments.

exculpation provisions make fiduciary duty a default rule that can be contracted around

rules limiting a corporation's power to indemnify its officers and directors for wrongdoing in their official capacity

rules reducing the role of fiduciary duty as a regulator of conflicting interest transactions

regulation of derivative suits, including rules allowing directors under certain circumstances to take control of derivative litigation

Fiduciary Duty and Directors' Conduct of Official Duties

Duty to Monitor and Be Informed About Corporate Operations and to Prevent Misconduct by Others

Modern trend toward greater separation between officers and directors and a greater emphasis on the board's oversight function.

All directors have a fiduciary duty

to be reasonably informed about corporate affairs (attend meetings)

to participate actively in the monitoring and evaluation of the corporation's business (regular review of financial statements)

to take reasonable steps to ensure that corporate agents are acting diligently, lawfully, and faithfully.

Liability for negligence: If a corporation suffers a loss because of negligent or dishonest actions by corporate agents, and the directors could have prevented the loss through reasonable diligence, they will be liable for breach of fiduciary duty.

Proximate cause: a director will be liable only if he could have prevented the continuance of a corporate agent's negligent, fraudulent, or illegal conduct by effectively “blowing the whistle”

MBCA §8.30(b) - directors “shall discharge their duties with the care that a person in a like position would reasonably believe appropriate under similar circumstances.”

The Business Judgment Rule

Corporate statutory norms grant management power to directors.

§14 of the 1934 Act (??) supports this power by recognizing that shareholders have no power to make ordinary business decisions

the business judgment rule is a judicially created device that protects directors' management power and discretion

The rule is a rebuttable presumption that

directors are better equipped than the courts to make business judgments

the directors acted without self-dealing or personal interest

they exercised reasonable diligence and acted with good faith.

How can plaintiff rebut the BJR presumption?

Fraud

Illegality

Conflict of interest (Duty of Loyalty)

Gross negligence (Procedural Due Care)

A decision that is a no-win one for the corporation (Substantive Due Care)

Shlensky v. Wrigley (Ill.App.Ct. 1968) (p.262)

Facts: Derivative suit against the directors for negligence, claiming financial loss because of Wrigley's failure to install lights in Wrigley field in order to schedule night games.

Holding: Plaintiff did not show fraud, illegality, or conflict of interest sufficient to overcome the presumption that the decision to install lights was properly decided by the directors.

Unless the conduct of the defendants at least borders on fraud, illegality, or conflict of interest, the courts should not interfere with the business decisions of the directors.

Courts cannot require directors to forego their judgment because of the decisions of other companies; mere failure to follow the crowd does not show a dereliction of duty

Facts: From an initial loan of 250K to construct an office building, a bank poured in more money. The bank, in an effort to salvage its bad loan, poured in millions more, exceeding federal regulations preventing a bank from extending any one loan that would exceed 10% of its capital. Inside directors made the decision, prompted by the CEO, North, and the outside directors were uninformed.

Holding: the Committees' recommendation that litigation was not in the best interests of the corporation is not deferred to under the business judgment rule, given how negligently things were handled.

The Business Judgment Rule does not apply if the corporate decision

lacks a business purpose

is tainted by a conflict of interest

is so egregious as to amount to a no-win situation

results from an obvious or prolonged failure to exercise oversight or supervision

Outside directors may be liable for their ignorance of other's decisions, which they did not supervise and should have.

The Typical Basis for the Business Judgment Rule:

Shareholders, to a degree, voluntarily assume the risk of bad business judgment

After the fact litigation is an imperfect device to evaluate corporate business decisions

Because potential profit correlates to potential risk, it is not in the shareholder's interest for the law to create incentives for overly cautious corporate decisions

Delaware Approach

Some other states NY, PA have other constituent statutes

Dodge v. Ford Motor Co. (267) [1919] FACTS: Profitable company president decides to cut price of cars and cut dividends to shareholders, with plan to share profits back with the public. Argument is that this is not profitable choice and not in interest of shareholders, because company will loose money. HELD: 1) Business Judgment Rule 2) making a long-term investment in the reputation of the firm

Substantive due care: uses the substantive indefensibility of a decision or course of action as the basis for finding that directors acted in a grossly negligent manner. (akin to res ipsa loquitor)

Procedural due care: assesses how directors reached a particular decision. They must carry out a decision-making process calculated to provide them with information sufficient to reach a rational judgment.

Smith v. Van Gorkom (Del. 1985) (p.349)

Facts: Trans Union had a large cash flow, but even more tax credits that went unused. In order to capitalize on these credits, the sale of Trans Union was proposed. CEO and chair Van Gorkom stated he would sell his shares at $55, and was approaching mandatory retirement. Van Gorkom assembled a proposed price and financing structure without consulting the Board except Peterson. In negotiations with Pritzker, Van Gorkom stated that $55 was the best price and Pritzker agreed to buy provided that he first purchase 1.75 m shares at market price, and set a 3 day deadline for the Board to act with a 90 day market test for receipt of higher offers. No one investigated the price or was allowed to solicit counter-offers. The Board accepted Pritzker's terms.

Holding: Even though they acted in good faith, the Board of Directors did not reach an informed business judgment because they relied entirely on Van Gorkom's oral presentation

Under Delaware law, the business judgment rule applies as an offshoot of § 141(a)- but there is no protection for directors who have made an uninformed judgment.

The determination of whether a business judgment is an informed one turns on whether the directors have informed themselves prior to making a business decision, of all material information reasonably available to them.

Under § 141(e) directors are fully protected in relying in good faith on reports made by officers, but Van Gorkom's presentation didn't qualify.

The fact of a premium alone does not provide an adequate basis upon which to assess the fairness of an offering price -- especially since the market had consistently undervalued Trans Union. The company was never valued in terms of its cash flow.

Factors which may not overcome presumption

Demand for immediate approval, without more (i.e. emergency), is not sufficient

Relying on collective experience of directors in company is not sufficient

Relying on a substantial premium over prevailing and historical market prices is not sufficient

Indemnification, Insurance, and Statutory Exculpation Provisions

Because directors may incur substantial liability even when acting in good faith, they may be encouraged to be overly cautious in carrying out their duties, or may not want to serve at all.

Three modes of Protection for Directors

indemnification- traditionally, corporations would indemnify directors against liability

insurance- concerns about the reliability of indemnification prompted corporations to seek insurance policies insuring against liability for serving for the corporation

exculpation provisions- because of the increased cost of liability insurance following Van Gorkom, Delaware and other states authorized the limitation or elimination of directors' liability for negligent acts that is effected by inserting an appropriate provision in the corporation's articles of incorporation

Directors' and officers' indemnification rights are generally determined by provisions in either indemnification contracts or corporate by-laws.

Delaware G.C.L. § 145(c) requires a corporation to indemnify its officers and directors if they are “successful on the merits or otherwise in defense of any action, suit or proceeding” related in any way to their service as an officer or director.

GCL §102(b)(7) - Corporations may add to certificate of incorporation a provision eliminating or limiting personal liability for monetary damages, but shall not eliminate or limit the liability of a director: (i) for breach of duty of loyalty (ii) acts omissions not in good faith or intentional misconduct (iv) any transaction for improper personal benefit

The Duty of Loyalty

Corporate Opportunity

Any opportunity to engage in a business activity of which a director or senior executive becomes aware

Any opportunity which senior executive becomes aware and knows is closely related to a business in which the corporation is engaged or expects to engage (LINE OF BUSINESS ONLY APPLIES TO INSIDE DIRECTORS)

Facts: Broz is outside director of CIS. Also president and CEO of competitor RFP. Broz approached to purchase Michigan-2 license for RFP. CIS not considered because of current financial difficulties, bankruptcy proceedings, and selling to of similar licenses. Pricellular is seeking to acquire CIS and also bidding on license. PC acquires CIS, brings new directors and sues Broz claiming he is required to look not just at CIS, but at the articulated interests of PC.

Holding: 1) CIS was not financially capable of exploiting opportunity 2) Only required to consider the facts only as they existed at the time he determined to accept the offer 3) although within line of business, nor clear that they have a cognizable interest or expectancy 4) Broz sought only to compete with an outside entity 5) DISCLOSURE CREATES A SAFE HARBOR.

Broz TEST:

The opportunity is presented to the director or officer in his individual and not corporate capacity

The opportunity is not essential to the corporation

The corporation holds no interest or expectancy in the opportunity

The director or officer has not wrongfully employed the resources of the corporation in pursuing or exploiting the opportunity

Conflicting Interest Transactions

General: Disinterested approval reinstates the business judgment rule, but a conflicting interest transaction may still be challenged as a gift or waste of corporate assets.

Cleansing the Conflict

Disclosure + Approval by disinterested directors (do not need a quorum of disinterested directors; may count all directors for quorum pruposes, but only count votes of disinterested directors.) GCL§144(a)(1)

Disclosure + Approval by disinterested shareholders GCL §144(a)(2), or

Entire Fairness GCL §144(a)(3)

Lewis v. Vogelstein, Delaware Court of Chancery, 1997; (p. 373)

Conflict Transaction Flow Chart

Did majority of disinterested directors approve after full disclosure?

No - Defendant must prove entire fairness

Yes - Has challenger proven waste, gift, or otherwise overcome BJR?

Yes - Transaction Voidable

No - Transaction is OK

Did majority of disinterested shareholders approve after full disclosure?

Yes - Transaction is OK

NO - Has challenger proven waste, gift, or otherwise overcome BJR?

A controlling shareholder will owe a fiduciary duty to a controlled corporation if the controlling shareholder dominates and controls the directors so that they are not viewed as independent

Burden shifting in Parent-Subsidiary Transactions

Parent must receive something from the subsidiary to the exclusion of, and detriment to, minority shareholders of the subsidiary

Sinclair Oil Corp v. Levien (1971); p. 387

Shareholder ratification: Even when no coercion is intended, shareholders voting on a parent subsidiary merger might perceive that their disapproval could risk retaliation of some kind by the controlling stockholder. Thus, more difficult to show entire fairness of transaction, but it does not go all the way to a waste standard. Must show Entire Fairness.

S tock ownership alone, at least when it amounts to less than a majority, is not sufficient proof of dominant control. Even proof of majority ownership of a company does not strip the directors of the presumptions of independence. There must be coupled with the allegation of control such facts as would demonstrate that through personal or other relationships the directors are beholden to the controlling person.

Corporation's Right to Control Derivative Litigation

To ensure that the shareholder derivative suit is not used illegitimately to usurp directors' management power, shareholders are required to make a demand on directors as a precondition to filing a derivative suit. The demand must explain the claims which he wishes investigated and remedied.

Delaware excuses shareholders from making pre-suit demand in circumstances where demand would be futile, like where the directors lack the independence to impartially consider the demand.

Board determines whether demand is required or futile

If required, directors' decision not to go forward with litigation will be reviewed under the business judgment rule.

making demand on the board concedes its disinterestedness

if demand is made, business judgment rule standards apply

If futile, may get intrinsic fairness standard

however, defendants avoid this result by appointing a special litigation committee to consider the value of the litigation to the corporation, usually resulting in a recommendation for termination of suit.

The question then focuses on the level of judicial review- more intrusive than under business judgment rule

Facts: Fink owns 47% of company's outstanding shares. Fink had an employment agreement with Prudential which provided that upon retirement he was to become a consultant to that company for ten years. Claim of “over compensation” to Fink as waste of corporate assets and Fink too old to render services. Claim that since Fink controls the board, dominates the directors.

Holding: The plaintiff has failed to allege facts with particularity indicating that the directors were tainted by interest, lacked independence, or took action contrary to company's best interests in order to create a reasonable doubt as to the applicability of the business judgment rule. Only in the presence of such reasonable doubt may a demand be deemed futile.

The demand requirement exists to

insure that a stockholder exhausts his intra-corporate remedies

provide a safeguard against strike suits

Business Judgment can be claimed only by

disinterested directors whose conduct otherwise meets the tests of business judgment

no appearance on both sides of the transaction

no self-dealing

directors informed of all material information reasonably available to them.

the directors are disinterested and independent, and

the challenged transaction was otherwise the product of a valid exercise of a business judgment (court must explore the substantive nature of the transaction and the board's ratification of it (gift or waste))

MBCA §7.44

Zapata Corp. v. Maldonado (Del. 1981) (p.484) - INTERMEDIATE LEVEL SCRUTINY

Facts: P alleged breaches of fiduciary duty by 10 of D's officers and directors. P brought this suit without first demanding that the board bring it, on the ground that the demand would be futile since all directors were named as defendants. Several years later, the board appointed an independent investing committee. By this time, four of the defendants were off the board, and the remaining directors appointed two new outside directors. The new directors comprised the investigating committee, which recommended that the action be dismissed.

Held: There may be circumstances where the suit, although properly initiated, would not be in the corporation's best interests, and an independent committee possesses the power to seek termination of a derivative suit.

Even a board tainted by self-interest can legally delegate its authority to a committee of disinterested directors under Delaware GCL 141c. If the court is satisfied about the independence and good faith of the committee and the bases supporting its conclusions, it should apply

Tension: stockholder power to bring corporate causes of action must be balanced against the corporation's interest to rid itself of troublesome litigation

Court must perform a two-step inquiry:

Was the committee acting independently and in good faith, and were its conclusions logically based?

The Court should determine, applying its own business judgment, whether the motion should be granted.

ONLY GET TO ZAPATA IF DETERMINED THAT DEMAND IS FUTILE / DEMAND EXCUSED

Introduction

Differences Between Closely Held Corporations and Public Corporations

more intimate enterprises

no market exists for the shares of close corporations

most shareholders expect to eventually sell their shares back to the corporation, to other shareholders, or pass them to their children

Minority shareholders are more vulnerable because majority rules and there's no public market for their shares

Majority opportunism stems from majority rule, separation of function, lack of guaranteed employment and dividend rights for shareholders, and denial of unilateral dissolution rights to minority shareholders.

The norms that both ensure the firm's adaptability and protect the firm from minority opportunism create the risk of majority opportunism

limited liability

favorable tax treatment via a Subchapter S election

governance rules via ex ante contract and ex post judicial rules

Contracting as a Device to Limit the Majority's Discretion

As to Director Decisions (GCL §§141(a),(b), 350-354)

Evolution of the Rule

McQuade v. Stoneham (NY 1934): 1) An agreement among shareholders that attempts to divest the directors of their power to discharge an unfaithful employee of the corporation is illegal as against public policy 2) Stockholders may not, by agreement among themselves, control the directors in exercise of the judgment vested in them by virtue of their office to elect officers and fix salaries.

Clark v. Dodge (NY 1936): 1) Where the directors are the sole stockholders, there seems to be no objection to enforcing an agreement to vote for certain people as officers 2) Limitation of “faithful, efficient, and competent”

Rationale: 1) Since unanimous agreement, no third party (minority) shareholder is harmed 2) not complete divestment of director power, since may dismiss for cause

Meaning: Director Level Agreements valid so long as they are unanimous

Delaware G.C.L. §§ 341-356 - basically, any corporation with not more than 30 shareholders can come under these supplementary rules by simply indicating in its articles of incorporation that it is an electing close corporation.

§350 - specifically sanctions “sterilizing” shareholders' agreements.

§354 - strengthens shareholders' ability to avoid majority rule by directors by permitting agreements that attempt to treat the close corporation as a partnership

Zion v. Kurtz (NY 1980) (p.463)

Facts: Zion and Kurtz were the only shareholders. Zion and Kurtz entered into a shareholders' agreement providing that the corporation would not engage in any business or activities without Zion's consent. Despite this agreement, Kurtz caused the corporation to act without Zion's consent.

Holding: 1) May limit director's power in the articles of incorporation 2) under GCL §350, shareholders of close corporation may limit directors in shareholder agreements, but must register as close corporation first 3) However, since Kurtz agreed to do what is necessary to make Agreement enforceable - he is estopped to rely upon the absence of those amendments (registration) from the corporate charter

Rationale: 1) Not against public policy, as evidenced by statutes allowing such action 2) since unanimous among shareholders, no intervening third parties harmed

Dissent: 1) Statutory mechanisms there to provide notice, and cannot be ignored 2) permit deviations from the statutory norms for corporations only under controlled conditions 3) must protect potential shareholders and potential creditors

REJECTED IN DELAWARE: Nixon v. Blackwell - Delaware will not follow Zion v. Kurtz (create certainty and provide precedent in Court of Chancery)

Facts: §7 of the bylaws was unanimously adopted to create an executive committee, having exclusive control over employment. The by-laws were amended by a majority shareholders' agreement to form an Executive Committee, which may exercise all the authority of the Board of Directors, without the employment language. §4 of the by-laws permits their amendment by majority.

Holding: By incorporating the §7 shareholders agreement into the by-laws, the directors made it subject to majority amendment under §4, despite its original, unanimous adoption.

Shareholders' Agreement: Refers to any agreement among two or more shareholders regarding their conduct in relation to the corporation.

Bylaws which are unanimously enacted by all the shareholders of the corporation are also shareholders' agreements.

A shareholders' agreement may not be altered or terminated except as provided by the agreement, or by all parties, or by operation of law.

If a shareholders' agreement is made a part of the charter or bylaws, it will be subject to amendment as provided therein or, in the absence of an internal provision governing amendments, as provided by the statutory norms.

Delaware G.C.L. §350 allows majority agreements

MBCA §7.32 sanctions only unanimous shareholders' agreements

NY Business Corp Law §616(b) states that a supermajority provision in a certificate of incorporation may be amended by a 2/3 vote unless the certificate “specifically” provides otherwise.

Fiduciary Duty and Threat of Dissolution as a Check on Opportunistic Majority Action

Traditional Deference to Majority's Discretion

Corporation law provides 2 major avenues for minority shareholders' suits:

petition for involuntary dissolution

direct or derivative suit for breach of fiduciary duty

Shareholders may also sue in their own right to compel the payment of dividends or for other rights, but business judgment presumptions generally apply

Facts: Arnold Zidell, a minority shareholder in 4 corporations, sought to compel the directors of those corporations to pay higher dividends. Prior to Arnold's resignation as a director, the customary practice had been to retain all earnings in the business rather than to distribute profits as dividends.

Holding: The low dividends are not unreasonable in light of the corporations' projected financial needs, nor is their evidence of starvation tactics used to force the sale of the plaintiff's stock at an unreasonably low price.

Insofar as dividend policy is concerned, fiduciary duty is discharged if the decision is made in good faith and reflects legitimate business purposes rather than the private interests of those in control.

The complaining shareholder has the burden of proving that the directors' failure to issue a dividend is not the product of good faith, business judgment.

A controlling factor in dividend cases is the corporation's accumulation of an unreasonably large cash reserve that can be explained only by the majority's bad faith

Complaining minority shareholders face the same difficulty in challenging a closely held corporation's salary policy as do complaining shareholders in a publicly held corporation.

Donahue v. Rodd Electrotype Co. (Ma. 1975) (p.501)

Facts: Plaintiff seeks to rescind Rodd Electrotype's purchase of Mr. Rodd's shares because she was not offered a similar deal as a minority shareholder, despite her offer of sale.

Holding: To satisfy the strict good faith standard, 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.

A close corporation bears striking resemblance to a partnership. To succeed, the relationship among shareholders must be one of trust, confidence and absolute loyalty.

Because a minority shareholder cannot easily reclaim his capital via sale, freeze-outs trap minority shareholders into selling out at less than fair value.

Stockholders in a close corporation owe one another substantially the same fiduciary duty as partners: utmost good faith and loyalty.

Facts: Relations broke down between Quinn and Wilkes, and Wilkes asked to sell his shares after an appraisal of their value. He was severed from the payroll and not re-elected as an officer.

Holding: The action of the majority stockholders was designed “freeze-out” for which no legitimate business purpose has been suggested. Therefore, Quinn, Riche and Connor breached their fiduciary duty to Wilkes.

When minority shareholders in a close corporation bring suit, the court must ask: can the controlling group demonstrate a legitimate business purpose for its action?

If yes, can the minority stockholders demonstrate that the same legitimate business objective could have been achieved through some alternate, less harmful course?

Facts: Directors of a closely held corporation maintained a policy which favored employee stockholders by providing an employee stock ownership plan, key man insurance policies, and low dividends permitting higher compensation. Plaintiffs, Class B stockholders, claimed breach of a fiduciary duty by this discriminatory policy.

Holding: No breach because stockholders need not always be treated equally for all purposes, only fairly.

Employee Stock Ownership Plan: tax-qualified, profit-sharing plan whereby employees of the corporation are allocated a share of the assets held by the plan in proportion to their annual compensation, providing a substantial measure of liquidity (because retiring employees can take cash in lieu of stock) not available to non-employees.

Key Man Insurance Policy: Insured the life of key executives and directors, and funded the retirement of any unpaid principal and interest on Promissory Notes issued for Class A stock in company self-tender.

With respect to the ESOP and Key Man Plans, defendants were on both sides of the transaction so the entire fairness standard applies.

In terms of the squeeze-out problem, the minority purchaser should bargain for protection at the time of the purchase, and a court imposed buy-out would go beyond party expectations. The individual who buys into a minority position in a close corporation does so knowingly. (ex ante contracting to be preferred over ex post judging)

Courts view dissolution as a viable remedy for truly egregious conduct and are increasingly willing to order corporations to repurchase the complaining minority's shares in order to protect shareholders' reasonable expectations or to remedy oppression.

MBCA § 14.34: grants the defendant corporation the right to avoid a court ordered involuntary dissolution by electing to repurchase the complaining minority's shares for fair value.

In re Kemp & Beatley, Inc. (NY 1984) (p.531)

NY §1104-a provides a mechanism for the holders of at least 20% of the outstanding shares of a corporation whose stock is not traded on a securities market to petition for involuntary dissolution under special circumstances- for fraudulent, illegal, or oppressive conduct

Oppressive conduct is conduct that substantially defeats the “reasonable expectations” held by minority shareholders in committing their capital to the particular enterprise.

Once plaintiff has set forth a prima facie case for dissolution, the defendant may demonstrate an alternative, adequate remedy.

Every order of dissolution must be conditioned upon permitting any shareholder of the corporation to elect to purchase the complaining shareholder's stock at fair value.

Gimpel v. Bolstein (NY.Sup.Ct. 1984) (p.535)

Facts: Robert Gimpel embezzled from the corporation and now claims to be oppressed.

Holding: While the other shareholders need not return him to employment, they must provide some means for him to share in the profits. However, dissolution under §1104-a is discretionary and is not the appropriate remedy here.

RG must immediately get full access to corporate books, and the majority must either alter the corporate financial structure so as to start reasonable dividend payments, or they must make a reasonable offer to buy out RG's interest.

Two definitions of “Oppression”

a violation by the majority of the “reasonable expectations” of the minority

burdensome, harsh and wrongful conduct; a lack of probity and fair dealing in the affairs of the 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.

The “reasonable expectations” test is inappropriate where the founders who entered the venture are not parties to the lawsuit

Courts are now willing to tailor the relief to fit the circumstances.

The Corporation as a Device to Allocate Risk between Insiders and Outsiders

Piercing the Corporate Veil

Introduction: Suits in which creditors are allowed to impose personal liability on shareholders

General ambiguous rule: “The separateness of the corporate entity is normally to be respected. However, 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.”

Three-part Powell Test (applied in more than parent-sub cases)

the D shareholder dominated and controlled the corporation, so that corporation had no mind of its own

the parent's conduct in using the subsidiary was unjust, fraudulent, or wrongful toward the plaintiff, and

Actions or conduct were the proximate cause of the loss or injury

Factors considered in piercing the corporate veil:

Closely Held v. Publicly Held (strictly for closely held corporations)

Voluntary v. Involuntary Creditor (less willing when voluntary contract creditor, b/c of forseeability, contractual protections, access to information, etc. usually applies to involuntary creditors such as tort claimants)

Enterprise Liability (treats corporations under common ownership as one pool of assets if: (1) they are essentially part of a single business and (2) separate incorporation merely isolates risk [Walkovsky v. Carlton - each corporation has only 2 cabs and the minimum required insurance]

Failure to Observe Corporate Formalities (unusual for corporations to follow these formalities - so only produces a weak inference)

Commingling of Assets and Affairs (Almost certain liability - using corporate assets for personal affairs)

Under-Capitalization and Purposeful Insolvency (under-capitalization, without more, is not enough, measured from time of formation)

Active Corporate Participation (goes to show dominance)

Deception, Misrepresentation

Piercing the Corporate Veil to Reach Real Persons

Contract Cases

Consumer's Co-op v. Olsen (587)

Facts: Corporation formed by Chris, Jack and Nancy Olsen. Meetings routinely held, initial capitalization of $7000. Consumer's Coop charge account was maintained in the corporate name and all corporate business was done in the corporate name. The corporation suffered financial trouble and couldn't pay its debt, but Co-op kept extending more credit.

Holding: No piercing of the veil. Defendant lacked requisite control, and injustice was not present because the corporation was adequately capitalized at its inception. No improper mingling of personal and corporate assets.

Failure to observe corporate formality, will not pierce the veil unless fraud or injustice are also present.

Waiver and Estoppel- In a volitional contract case, if creditor had the opportunity to investigate the capital structure of the debtor and knowingly failed to exercise that right, he waives that right and is estopped from arguing that the corporation was undercapitalized = no piercing.

Inadequacy of capital is measured by the nature and magnitude of the corporate undertaking; must show clear inadequacy, at the time of the formation of the corporation.

Inadequate capital alone is not sufficient ground to pierce. Must also have failure to follow corporate formalities or other evidence of pervasive control.

K.C. Roofing Center v. On Top Roofing, Inc. (MI 1991) (p.596)

Facts: Through a chain of roofing companies, one after the other doing the same business, the Nugents avoided debt, but carried on the same business with a “fresh start” through incorporation and subsequent dissolution, observing no corporate formalities- playing the corporate shell game.

Holding: Veil is pierced. Through his domination and control over On Top, Nugent was using this corporate form for the unfair and inequitable purpose of avoiding their debts to plaintiffs.

A court may pierce the corporate veil and disregard the separate legal entity where the separateness is used as a subterfuge to defraud the creditor.

Three part test satsified

control- complete domination

control used to commit a wrong (Siphoning - large salary, large rent to disguise dividend payments; Confusion - use of same corporate name)

the wrong is the proximate cause of injury

Easterbrook and Fischel argue that courts should pierce in contract cases to remedy fraud and misrepresentation

Thompson's study: courts pierce in 92% of fraud cases, but 8% of the no-fraud cases, and 20% of undercapitalization cases (that are contract, not tort).

Equitable Subordination: comes into play when creditors and shareholders compete for corporate assets. Shareholders claim is subordinated to that of the creditor.

Tort Cases

Agency law- 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 the corporation

Facts: Plaintiffs were injured in a car accident by a drunk who was served by defendant, in violation of dram shop laws. The Neuroths did not individually serve him.

Holding: The D observed corporate formalities, and did not use it as an instrumentality to conduct personal business. Under-capitalization, without more, is not enough. So no piercing.

Factors that indicate piercing: fraudulent representation by corporation directors, undercapitalization, failure to observe corporate formalities, absence of corporate records, payment by the corporation of individual obligations, use of the corporation to promote fraud, injustice, or illegalities

the personal guarantee of their loan to the corporation cannot be enlarged to impose tort liability

Dissent: This allows circumvention of Dram Shop Act

Craig v. Lake Asbestos (3^rd Cir. 1988) (p.617)

Facts: D mined and distributed asbestos in the U.S. through its wholly owned subsidiaries. Through corporate shells, D avoided paying tort default judgments.

Holding: The involvement in D's financial and managerial affairs fails to rise to the high standard of domination necessary to pierce the corporate veil. (the two corporate groups maintained separate books, records, bank accounts, offices and staff, each consulted their own financial advisors, accountants, and stockbrokers).

Under NJ law, the corporate veil will not be pierced unless “the parent so dominated the subsidiary that it had no separate existence but was merely a conduit for the parent.”

Domination must be found to pierce: complete domination, not only of finances but of policy and business practices 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

Introduction

Mergers occur because:

the management team may desire to retire or move to another venture

combining the assets of two previously separate businesses may produce a new entity more valuable than the sum of its parts

the current management team may engage in “empire-building” that seeks to protect the value of their own human capital

an outside management team may believe they can use the assets of the enterprise more effectively than the current management.

Mergers ordinarily require a shareholder vote in addition to director approval.

Shareholders who dissent have appraisal rights by which they can require the corporation to buy their shares for “fair value.”

Control Transactions Requiring Corporate Action

Mergers and Consolidations (GCL §§251, 259-261)

In a statutory merger, the legal existence of all constituent corporations, other than the surviving corporation, ceases.

By operation of law, the assets and liabilities of all constituent corporations pass to the surviving corporation, and the outstanding shares of stock in the disappearing corporation are canceled.

The surviving entity is considered a newly created consolidated corporation.

The roles of directors and shareholders are dictated by corporate code

The board of directors of each constituent corporation must adopt a merger plan stating the terms of the merger, including

what consideration will be paid to the shareholders of the disappearing corporations in exchange for their shares

typically, shareholders in the disappearing corporation will receive shares of the surviving corporation in exchange for their canceled shares

modern corporation statutes allow any form of consideration, including stock, cash, and/or notes - a flexibility that leads to cash-out transactions.

what changes, if any, will be made in the articles of incorporation of the surviving corporation

The plan of merger is then submitted to the shareholders of each corporation for approval

early codes required unanimous shareholder approval for mergers

this was dropped in favor of a supermajority (often 2/3) of the shareholders of each corporation taking part in the merger

Now, more that half of the states require approval by only a majority of shareholders, although it must be an absolute majority of all shares entitled to vote

Many modern codes require no approval from shareholders of the corporation surviving the merger in relatively insignificant mergers (if the number of shares issued in connection with the merger does not increase the corporation's number of issued shares by more than 20%, shareholders equity and voting rights are not diluted by more than 20%, and the articles of incorporation of their corporation are not changed in the merger) (MBCA §11.03(g))

After approval, the plan of merger is filed with the state corporations commissioner and the merger becomes effective as set forth in the merger plan.

An alternative method of transferring ownership and control of corporate assets from one corporation to another is to convey title by one or more bills of sale.

Differences between assets sales and mergers

the corporation selling assets does not automatically go out of existence upon consummation of the sale (although it can, by following the asset sale with a dissolution)

the selling corporation need not transfer all of its assets, as will occur in a merger

the liabilities of the selling corporation will not necessarily pass to the purchasing corporation by operation of law (may contract out of liabilities; unforeseen liabilities of selling corporation do not follow)

However, an asset sale can be structured to achieve the same results as a merger

a corporation sells all of its assets to another corporation

the purchasing corporation assumes all liabilities of the selling corporation

the selling corporation dissolves simultaneously with the consummation of the sale

the disappearing corporation distributes to its shareholders the shares or other consideration received in the asset sale

If the directors of a corporation wish to sell substantially all of the corporation's assets, other than in the ordinary course of business (wholesalers don't count), they must submit the proposal to their shareholders for approval, normally by majority vote.

Delaware: shareholders of the selling corporation get a vote but are not provided appraisal rights

Shareholders of the acquiring corporation don't get a vote, and thus no appraisal either. (Delaware and MBCA)

Triangular Mergers

Triangular merger transactions leave the acquired corporation in existence (for tax, regulatory, or contractual reasons), but still permit the acquiring company to purchase the enterprise in one corporate transaction as opposed to many individual transactions.

Keeps liabilities of the subsidiary separate from the parent company. Must pierce the corporate veil in order to get to the assets of the parent company. Relatively easy transaction.

The Triangular Merger

First, the acquiring corporation incorporates a new entity as a wholly owned subsidiary, capitalizing the new entity with shares of the parent or other consideration that will be used in the acquisition.

Second, the new subsidiary merges into the target (the acquired company can also merge into the new subsidiary)

The shareholders of the acquiring corporation, not directly involved in the merger will not usually get voting or appraisal rights. (Since rights of subsidiary are indirect, those rights exercised by board.)

A compulsory share exchange is a new statutory proceeding that, like a reverse triangular merger (acquiring subsidiary merges into the acquired corporation), permits one corporation to acquire all the shares of another while leaving the acquired corporation in existence.

Accomplished by simple majority vote of shareholders of the acquired corporation, but needs board approval only from the acquiring corporation

Nonconsenting shareholders are forced to give up their shares subject to their appraisal rights.

Shareholders of the acquiring corporation do not receive appraisal rights.

Merger between parent and subsidiary - Allows parent to merge subsidiary into itself, as long as the parent owns 90% of the subsidiary's stock.

No vote or notice to the shareholders of the subsidiary is required, rather shareholders of subsidiary are guaranteed appraisal rights.

Dissenter's Right to Appraisal

Introduction (GCL §262)

If the shareholder dissents when asked to approve a merger or other covered transaction, and if the transaction nonetheless obtains the requisite shareholder approval, the dissenting shareholder may demand that her shares be repurchased by the corporation for fair value.

If the dissenting shareholder and the corporation cannot agree to a price, then fair value is determined by judicial proceeding.

Delaware G.C.L. §262 -- the shareholder will receive the judicially determined fair value, plus interest, even if that amount is less than what the corporation offered to shareholders as part of the terms of the merger. (court can award the corporation legal costs too)

Appraisal rights were the tradeoff for the loss of voting power caused from the move from unanimous to majority approval

Used as a check on conflicting interest transactions

Statutory Rules (GCL §262)

From a policy standpoint, appraisal should be given for transactions where

the merger will require the shareholder to invest in a fundamentally different enterprise or will constitute a cash out and final settling-up of the shareholder's investment

other protective devices (such as the market or fiduciary litigation) are likely to be ineffective or more costly in protecting shareholders' investment expectations

Delaware: Extends appraisal rights to mergers only, not to other control transaction.

Market exception: Delaware denies appraisal rights to shareholders that own shares (i) listed on a national securities exchange (ii) held of record by more than 2,000 holders (GCL §262(b)(1))

Exception to exception: If denied appraisal rights under (b)(1) shareholder may get appraisal rights back if she receives consideration other than (i) stock of surviving corporation (ii) publicly traded stock of some other corporation (iii) cash in lieu of fractional shares (i.e. merely cash or non-publicly traded shares) (GCL §262(b)(2))

Applies only for share-for-share exchanges, appraisal is available if a shareholder must take cash for stock.

The De Facto Merger Doctrine (gilberto: see p. 686-7)

Introduction

In a de facto merger case, shareholders who have been excluded from voting or appraisal rights ask courts to recharacterize a sale of assets, triangular merger, or other control transaction as a de facto merger requiring voting and appraisal rights.

Farris (Pa.1958)(p.742): illustration of substance over form

Does this contradict legislative intent, which has separate provisions worthy of equal respect?

REJECTED IN DELAWARE (Independent Legal Significance Doctrine)

Applestein (NJ.Superior. 1960) (p.687)

Facts: United entered into an agreement for an “exchange of Interstate stock for United stock,” not a merger. Through this exchange, United would wholly own Interstate, and Epstein, Interstate's sole shareholder, would acquire 40% of United stock, and become United's president and director, having “effective control.” United will assume all Interstate's assets and liabilities, and will be dissolved. United will increase its board from 7 to ll directors. The transaction was submitted for shareholder approval solely because of NYSE rules. No appraisal rights were granted to minority shareholders.

Holding: The transaction was a merger. The proposed corporate action is therefore invalid because it was not submitted for the required two-thirds approval.

Epstein argues that this was a purchase of all of Interstate's assets, followed by a merger of United with its subsidiary, Interstate- granting no appraisal rights.

General Rule: When a corporation buys the stock of another corporation, stockholder approval is not required, and objecting shareholders of the purchasing corporation have no appraisal rights. But when the transaction is a merger in substance, minority shareholders get appraisal rights.

Factors Indicating De Facto Merger:

a transfer of all the shares and all the assets

an assumption of liability

a “pooling of interests” of the two corporations

the absorption of the acquired company, and its dissolution

a joinder of officers and directors of both corporations on an enlarged board of directors

the present executive and operating personnel of the acquired company are retained

the shareholders of the absorbed corporation receive shares in the surviving corporation

There is no distinction in a merger between the acquired and the acquiring corporation

Rationale: Shareholders should not be forced against there will into something fundamentally different from that for which they bargained when they acquired their shares.

Hariton v. Arco Electronics, Inc. (Del. 1963) (p.749)

Facts: A sale of assets under Delaware G.C.L. §271 for shares of the purchasing corporation was effected. The agreement of sale dissolved the selling corporation and distributed the shares so received to stockholders of the seller, so as to accomplish the same result as a merger. Is the sale legal? This was done by:

Arco agrees to sell all its assets to Loral for shares of Loral

Arco calls a shareholder meeting to approve dissolution

Holding: The reorganization accomplished through §271 and a mandatory plan of dissolution (§275) is legal. This is so because the sale of assets statute and the merger statute are independent of each other. Independent Legal Significance Doctrine

The Intersection Between the Appraisal Remedy and Fiduciary Duty-Based Judicial Review

Controlling Shareholder Dominated Mergers

The Business Purpose Approach (§13.02(b))

Delaware, in 1977 (Magnavox) - held that the controlling shareholder cannot carry its burden of showing the entire fairness of the transaction if the merger was caused “for the sole purpose of eliminating a minority on a cash-out basis.”

Coggins v. New England Patriots　(Mass. 1986) (p.705)

Facts: To reorganize the Patriots and secure 100% ownership, Sullivan merged the Patriots into a new corporation, and eliminated the nonvoting stock on a cash-out basis. The merger was approved by each class of stock by majority. Coggins was upset that he was forced to sell.

Holding: No legitimate corporate purpose was served by freezing out the minority, nonvoting shareholders. The merger was used merely to facilitate the repaying of indebtedness by Sullivan individually (which he acquired in financing his bid for complete team ownership).

Judicial Review-- Fairness test applies because Sullivan was a director and controlling shareholder on both sides of the transaction in a freeze-out merger.

Step #1: Business Purpose Test - the elimination of public ownership must be in furtherance of a legitimate corporate purpose.

Step #2: the court should then proceed to determine if the transaction was fair to the minority by examining the totality of the circumstances.

Burden of Proving legitimate business purpose and fairness is on the defendants in a freeze out merger.

Rationale for Business Purpose: A director of a corporation violates his fiduciary duty when he uses the corporation for his or his family's personal benefit in a manner detrimental to the corporation.

The Weinberger Approach (gil, p. 712)

Delaware Block Method - in appraising “fair value,” this method requires the court to determine the corporation's asset value, appropriately weigh these values, and then add the weighted values together to arrive at a “fair value.”　(Tends to yield lower value)

When a fiduciary duty is breached, appraisal is not the sole remedy. A court may order an accounting, rescission, etc.

Weinberger v. UOP, Inc. (Del. 1983) (p.714)

Facts: Plaintiffs challenged the elimination of UOP's minority shareholders by a cash-out merger between UOP and it majority owner, The Signal Companies, Inc.

Holding: burden is on defendant to show entire fairness when on both sides of the transaction

D may push burden back to plaintiff by showing a disinterested ratification of INFORMED shareholders

dispenses with Delaware block method of appraisal in favor of a more liberal, flexible approach- any techniques or methods which are generally accepted in the financial community

appraisal is the exclusive remedy in a cash out merger, except where overreaching, waste, misrepresentation, or fraud is shown

eliminates the business purpose test used in Singer.

Fairness: encompasses both fair dealing and fair price

Effect: Trying to make valuation procedures the same in appraisal action and class action. However, recissionary damages are not available in appraisal proceedings. Weinburger allows recissionary damages by showing fraud, misrepresentation, illegality, or some other misconduct. Since shareholders must show fraud or misrepresentation in order to get the class action in the first place, it will be easy to show that shareholders should get recissionary damages. That means that the decision will have little effect on incentives to bring a class action.

Hostile Takeovers

The Market for Corporate Control

A potential acquirer who seeks control without the consent of the current control group can

make a tender offer seeking to buy sufficient shares to gain control of the board, or

launch a proxy fight seeking the authority to vote sufficient shares to gain control of the board of directors

Problems

In a large corporation where shareholders lack the ability or incentive to investigate an offer, there is the possibility of shareholders accepting inadequate offers.

The Williams Act and 1934 Act require increased disclosure to prevent outsiders from taking advantage of ill-informed decisions

Under §14(d)(1), a tender offeror must disclose

its identity and background

the source of funds used to make the purchase, and

the purpose of the purchase, including any plans to liquidate or change corporate structure.

a tender offer must remain open for 20 business days, blocking a bidder's effort to force hasty decisions. SEC Rule 14e-1(a).

if more shares are tendered than the bidder sought to purchase, the bidder must buy a pro rata portion from each shareholder. This prevents use of a first-come, first-served strategy to pressure shareholders. §14(d)(6) of the 1934 Act.

Bidder must pay the same price for all shares purchased. §14(d)(7).

Significant Premiums are Paid to shareholders of the acquired corporation

Coffee explains this in four ways:

Disciplinary hypothesis: replace inefficient management (creates wealth)

Synergy hypothesis: target has a unique value to the bidder in excess of its value to the market generally (creates wealth)

Empire building hypothesis: bigger is better. (transfers wealth)

Exploitation hypothesis: trap shareholders in prisoner's dilemma when stock price is depressed under its value- they sell rather than risk future declines. (transfers wealth)

Black has another view- Bidding leads to the winner's curse (bidders must offer substantially less than they think an asset is worth, and be prepared to have only a fraction succeed)

Kraakman- mispricing behavior introduced by market noise leads to “bubbles”

Parties

bidder/raider- the acquiring company

target- company sought to be acquired

white knight- a second bidder, thought to be friendly to target management, who makes an offer to rescue the target from a hostile bidder

white squire- a friendly party who acquires a large block of target stock with the acquiescence of target management, but who does not acquire control

Arb/arbitrageurs- regular market participants who seek to make money by short term purchase or sales of stock when a they deem a company to be “in play”

Bust-up takeover- bidder seeks to break up the target and sell it off in pieces

Junk bonds- used to finance raiders, they are highly risky and therefore offer a higher premium

Front-end loaded tender offer- Two tiered tender offer

step #1: the bidder acquires a controlling interest in the target via a tender offer, usually for cash

step #2: the remaining shares are acquired through merger, using the controlling interest to push it through

In a front-end loaded tender offer, the consideration in the tender offer is worth more than the consideration in the second-step merger.

Viewed as coercive because shareholders who do not tender in the first step will be forced to accept less for the untendered shares in the second step.

Golden parachutes/ tin parachutes

Greenmail- a 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. (courts uphold against claims of fiduciary duty. Cheff v. Mathes)

Lock-ups and termination fees.

Termination fees or stock options- to encourage a white knight to bid, these tools compensate the white knight for acting, even if the deal falls through. Also acts as a liability forced on a hostile bidder seeking acquisition.

Lock-ups- gives the white knight a right to purchase a corporation's most valuable assets, making other bids unlikely because many of the key assets are now promised to the white knight

Poison Pills- refers to stock rights or warrants issued to a potential targets' shareholders prior to a takeover. When hostile acquisition occurs, these shareholders may redeem their shares for prices well above market value or purchase shares in the acquiring company at a reduced price (flip over) after a follow up merger between the two companies.

Recapitalizations and leverages buyouts (LBOs) by management (MBOs)- to defend, management of the target may bid for its own shares, financed by heavy borrowings by the corporation or management.

Shark repellent amendments (porcupine provisions) to the corporation's charter and by-laws

supermajority amendments- raise required vote to effect a merger

fair price amendments- focus on 2^nd step, waiving supermajority provision if a fair price is tendered in 2^nd stage of takeover, usually “fair price” is high

staggered board amendments- prevents wholesale board replacement from occurring at once

dual-class capitalization- management shares have multiple votes or public shares have fractional votes, further entrenching current management

Judicial Review of Tender Offer Defenses

Traditional Business Judgment Review

Cheff v. Mathes (Del. 1964) (p. 820)

Facts: Target corporation defended takeover by buying back its own shares at a price above market, in order to prevent a raider from coming in and changing its furnace sale policies.

Holding: The board decided in good faith that corporate policy was threatened, so business rule applied.

Rule: If the board had a good faith belief that it was acting for a proper purpose to serve the corporation, business judgment presumptions apply in reviewing actions taken.

Business Purpose Test

if the actions of the Board were motivated by a good faith belief that the buying out of the dissident stockholder was necessary to maintain what the board believed to be proper business practices, the board will not be held liable for such decision, even though hindsight indicates the decision was not the wisest course

however, if the board has acted solely or primarily because of the desire to perpetuate themselves in office, the use of corporate funds for such purposes is improper.

Burden of Proof

Lies initially with Board of Directors, because it has a conflict of interest

burden is satisfied by a showing of reasonable grounds to believe there's a danger to corporate policy and effectiveness presented by hostile stock ownership. (i.e. good faith and reasonable investigation)

Summary

The Revlon duty to secure the best value reasonably available to shareholders attaches when there is:

a change in corporate control

a break-up of the corporate entity

If the Revlon duty does not attach, defensive measures are permitted if they satisfy the Unocal criteria:

reasonable grounds for believing that a danger to corporate policy and effectiveness existed (satisfied by demonstrating good faith and reasonable investigation)

defensive measure was reasonable in relation to the threat posed.

Non-Shareholder Constituencies: Directors may consider the interest of other constituencies if there is “some rationally related benefit accruing to the stockholders. Revlon

If Revlon duties do not attach, and the Unocal criteria are satisfied, use business judgment presumptions.

The Unocal Doctrine

Unocal Corp. v. Mesa Petroleum Co. (Del. 1985) (p.885)

Facts: At issue is the validity of a corporation's self-tender for its own shares which excludes from participation a stockholder making a hostile tender offer for the company's stock. The directors acted in good faith in concluding, after reasonable investigation, that Mesa's two-step tender offer was both inadequate and coercive. Unocal's objective was to either defeat the tender offer, or compensate shareholder's at the back-end of Mesa' proposal. Including Mesa would defeat that goal.

Holding: The selective exchange offer is reasonable in relation to the threat posed by Mesa's coercive two-tiered tender offer, therefore the board acted in the proper exercise of sound business judgment. The Court will not substitute its views for those of the board if that decision can be “attributed to any rational business purpose.”

Note:

In the acquisition of its shares, a corporation may deal selectively with its stockholders, provided that the directors have not acted for the purpose of entrenching themselves.

Enhanced Scrutiny

because of the possibility that the board may be acting in its own interests, there is an enhanced duty which calls for judicial examination at the threshold before the protections of the business judgment rule apply

For the Business Judgment Rule to apply:

First, the defensive measure must be reasonable in relation to the threat posed. (Unocal)

possible concerns:

inadequacy of the price offered

nature and timing of the offer

questions of illegality

the impact on “constituencies” other than shareholders

risk of the deal falling through

quality of securities offered as consideration

Second, directors must show good faith and a reasonable belief that the raider will thwart corporate policy and effectiveness. Their showing is materially strengthened by the approval of a board comprised mainly of outside independent directors.

Summary: Once it is shown that the defensive measure is reasonably related to the threat posed, if the directors are disinterested and acted in good faith (which is plaintiff's burden to prove otherwise), its decision in the absence of an abuse of discretion will be upheld as a proper exercise of business judgment.

Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc. (Del. 1986) (p.856)

Facts: Pantry Pride attempted to acquire Revlon with Forstmann acting as white knight. Pantry Pride and Forstmann entered into a bidding war for control of Revlon, whose breakup was inevitable. To defend against the hostile takeover, Revlon bought shares financed by notes. To protect against liability on the notes incurred if Revlon was sold to Pantry Pride, Revlon employed lock-up, termination fee, and no-shop agreements.

Holding: Because nothing remained for Revlon to protect, no rationally related benefit accrued to shareholders as a result of the auction-ending merger agreement with Forstmann. The principal benefit went to the directors who avoided liability to creditors at the expense of shareholders. The directors thereby breached their duty of loyalty. When the sale of a company is unavoidable, the duty of the Board shifts from preservation of the corporate entity to the maximization of the company's sale value for stockholders.

Paramount Communications, Inc. v. Time, Inc. (Del. 1990)(p.868)

Facts: Paramount made an all-cash offer for all the shares of Time. Both to implement a preexisting corporate strategy and to stave off Paramount, Time entered into a business combination with Warner. Paramount challenged the move.

Holding: The dissolution or breakup of Time was not inevitable, therefore no Revlon duties attach. Under Unocal, the board reasonably investigated and decided that Paramount's offer was not in its best interests. Time had researched and decided that Warner was the best fit, maintaining the “Time culture” while expanding into telecommunications. Time repeatedly maintained that it was not for sale. The Board felt that Paramount's bid threatened the Time culture.

Because it had a proper purpose to defend against Paramount, the act of carrying forward an existing transaction in another form was reasonably related to the threat. Therefore, business judgment presumptions apply.

Note:

The distinction of “long-term” vs. “short-term” values is irrelevant because directors must decide the corporation's best interests without a fixed investment horizon.

Without excluding other possibilities, two circumstances implicate Revlon duties:

when a corporation initiates an active bidding process seeking to sell itself or to effect a business reorganization involving a clear break-up of the company

where, 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. (this one happened in Revlon)

Revlon duties are not triggered, though Unocal duties are, if the board's reaction to a hostile bid is found to constitute only a defensive response and not an abandonment of the corporation's continued existence.

Paramount Communications, Inc. v. QVC Network, Inc (Del. 1993) (p.929)

Facts: Paramount entered into a merger agreement relinquishing corporate control to Viacom and agreed to no-shop, termination fee, and stock option provisions that were unusual and highly beneficial to Viacom. QVC made a tender offer for Paramount, but Paramount decided that QVC's bid was not in its best interests, and never used this leverage to modify its original agreement.

Holding: Both Revlon and Unocal duties are implicated. The Paramount board initiated an active bidding process to sell itself by agreeing to sell control of the corporation to Viacom. Paramount breached its duty to secure share value by giving insufficient attention to the potential consequences of the defensive measures demanded by Viacom, and doing nothing to remove these measures which were impeding the realization of the best value reasonably available to stockholders.

Note:

When bidders make relatively similar offers, or dissolution of the company becomes inevitable, the directors cannot fulfill their enhanced Unocal duties by playing favorites.

The Revlon duty to secure the best value available to shareholders attaches when there is:

a change in corporate control

a break-up of the corporate entity

Paramount director duties included:

to be diligent and vigilant in examining the Paramount-Viacom transaction and the QVC tender offers

to act in good faith and gather all relevant information necessary to provide the best value reasonably available to shareholders

to negotiate actively both with Viacom and QVC

Federal Law Affecting Corporate Transactions

Introduction

Disclosure makes the exercise of shareholder suffrage more informed

Disclosure is the key methodology used in federal law relating to corporate transactions

The 1933 Act requires substantial disclosure before the initial issuance of securities unless the transaction is exempt

The 1934 Act requires disclosure triggered by quarterly and annual reports [§13]; proxy solicitations [§14a]; tender offers [§14d]; acquisition of more than 5% of a company's stock by third parties [§13d] or the issuer [§13e]; or insider trading [§16 and Rule 10b-5].

The 1934 Act applies only to those corporations listed on a stock exchange or having more than $10 million in assets and a class of equity securities held by more than 500 shareholders (§12)

Exception: Rule 10b-5 applies to fraud in connection with the purchase or sale of any security

Liability Under the Proxy Rules

Coverage of §14(a)

Rule 14a-3 lists disclosure requirements

Rule 14a-4 describes the proxy form

Rule 14a-9 creates an implied private cause of action;

Rule 14a-9 prohibits solicitation by any proxy statement, notice of meeting, or other oral/written communication containing any materially misleading statement/omission

Rule 14a-8 provides shareholders the ability to communicate using the proxy

Rule 14a-9 prohibits 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

Relevant Statutes: SEC Act of 1934 §§14(a), 27

Rule 14a-9 does not expressly provide for a private cause of action

Rule 14a-9 is viewed as an antifraud provision and the elements of common law fraud or the tort of deceit have been used as guidance:

misrepresentation or omission

of a material fact

with scienter

on which plaintiff relies (causation)

damages

J.I. Case Co. v. Borak (1964) (p.1040)

Issue: Whether §27 of the 1934 Act creates a federal cause of action to a corporate stockholder with respect to a consummated merger authorized pursuant to the use of a proxy statement alleged to contain false and misleading statements violating §14(a) of the Act.

Holding: Private parties have a right under §27 to bring suit for violation of §14(a) of the Act.

This right of action exists both directly and derivatively.

The possibility of civil damages serves as an effective weapon in the enforcement of the proxy requirements of §14.

That state law questions must be decided doesn't preclude a federal question. Federal claims for a disclosure failing under §14 usually imply violation of fiduciary duty, which is also a state claim.

In Touche Ross v. Redington, the Supreme Court changed course to deny that §17(a) provides a private damages action on behalf of broker's customers. Plaintiff's rights must be found in the substantive provisions of the Act, not in §27.

Misrepresentations or Omissions of a Material Fact

TSC Industries, Inc. v. Northway, Inc. (1976) (p.1046)

Holding: 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 (or, would consider in important when deciding how to vote.)

Summary Judgment is rarely appropriate under this test.

Virginia Bankshares, Inc. v. Sandberg (1991) (p.1049)

Facts: Freeze out merger where 15% of the shares were held by minority shareholders. Investment bankers said that $42 would be a fair price. The proxy described this price as “high” and “fair.”

Holding: If the offer was not a “high” value for the shares, and the directors knew it, they're liable.

A statement of belief by corporate directors about the recommended course of action, or an explanation of their reasons for recommending it, can be material - there is a substantial chance that a reasonable shareholder would consider it important in deciding how to vote.

Shareholders know directors have superior knowledge

the directors act for the reasons given or hold the belief stated

conclusory terms in a commercial context are reasonably understood to rest on a factual basis.

BUT, when X falsely claims to believe Y, the deceit is actionable only when Y is objectively false - otherwise any statement would be subject to review on the basis of a director's skepticism (fear of strike suits)

The Second Circuit held that negligence was sufficient to establish liability under §14(a).

But in Ernst & Ernst v. Hochfelder the Supreme Court held that intentional conduct is necessary to establish liability under Rule 10b-5.

Rule 10b-5 as Applied to Corporate Transactions

Introduction (1934 Act §§10(b) and 18, and Rule 10b-5)

Rule 10b-5 remedies fraud only in connection with the purchase or sale of securities.

Implied private cause of action exists.

Rule 10b-5 Elements: Private Causes of Action

Standing; In Connection with a Purchase or Sale

Birnbaum v. Newport Steel Corp. (2^nd Cir. 1952) (p.1008)

Facts: D, as president and 40% shareholder, broke off a merger that would have been profitable for the P's, who allege D made fraudulent misrepresentations to the stockholders of Newport.

Held: Plaintiffs were neither purchasers nor sellers in Feldman's transaction, therefore Rule 10b-5 doesn't apply. 10b-5 doesn't cover corporate insiders who aren't buyers/sellers, nor does it cover fraudulent mismanagement of corporate affairs.

NOTE: “Fraudulent mismanagement of corporate affairs” goes to a breach of fiduciary duty. There is a cause of action under state law. Would only need to allow such claims in federal court if the state law procedures were not working. There is no indication of that. And, produces problems of federalism.

Superintendent of Insurance v. Bankers Life & Casualty Co. (1971) (p.1012)

Facts: investor Manhattan was injured by a deceptive device that deprived it of any compensation for the sale of a valuable block of securities.

Holding: 1) Manhattan was injured as an investor through a deceptive device which deprived it of any compensation for the sale of its valuable block of securities. 2) Section 10(b) must be read flexibly not technically and restrictively. Since there was a “sale” of a security and since fraud was used “in connection with,” it, there is redress under §10(b). 3) Crux of the present case is that Manhattan suffered an injury as a result of deceptive practices touching its sale of securities as an investor.

Blue Chip Stamps v. Manor Drug Stores (1975)(p.1016)

Facts: Alleged that Blue Chip intentionally made the prospectus overly pessimistic in order to discourage respondents, so that the rejected shares might later be offered to the public at a higher price.

Holding: A Rule 10b-5 private action is limited to actual purchasers and sellers of securities.

The Birnbaum rule bars 3 potential classes of plaintiffs:

Potential purchasers of shares who allege that they decided not to purchase because of an unduly gloomy representation or the omission of favorable material which made the issuer appear to be a less favorable investment vehicle than it actually was.

Actual shareholders who decided not to sell because of an unduly good representation.

Shareholders, creditors, and others who suffered loss in value due to corporate insider activities in connection with the purchase or sale of other securities.

Court is trying to limit potential abuse of Rule 10b-5; risk of uncorroborated oral evidence that a plaintiff decided not to sell because of a prediction that later turned out to be wrong.

Santa Fe Industries, Inc. v. Green (1977) (p.1022)

Facts: Delaware short form merger used by a majority shareholder to eliminate the minority interest. Minority shareholder claimed insufficient consideration was paid, but did not pursue their appraisal remedy in state court. No manipulation or deception was shown.

Holding: If a corporate manager breaches a fiduciary duty but without any misrepresentation, nondisclosure, or manipulation, he does not violate rule 10b-5.

§10(b)'s purpose was to promote full disclosure, once full disclosure made, the fairness of the transaction is of tangential concern.

State regulation governs fiduciary violations where fraud is absent.

Implied Elements of 10b-5 Cause of Action

Misrepresentation of Omission of a Material Fact

In re Time Warner, Inc. Securities Litigation (1993) (p.1041)

Scienter

Reliance and Causation

D's conduct plaintiff to act

Proximate (loss) causation - material omission or act is what actually caused the loss and not something else