Basic Corporate Law Outline

Corporations Outline Economic and Legal Aspects of the Firm – Chapter 1 I. Basic Concepts a. The Classical Firm i. The Entrepreneur ii. The Coasean Firm b. The Business Association c. Modern Corporation and the Berle-Means Critique d. Return of the Free Market Ideology e. Separation of Ownership and Control and Agency Costs II. Organizing the Firm: Selecting a Value-Maximizing Governance Structure a. Planning b. Informed Rational Choice i. Comparative Search for Best Investments ii. Risk and Return c. Transaction Costs and Choice of Organizational Form i. Factors ii. Discrete and Relational Contracting iii. Deciding to Organize as a Firm d. State-Provided Governance Structures i. Entity and Employment Law as Standard Form Contracts ii. Default Versus Immutable Rules iii. Tailored, Majoritarian, and Penalty Default Rules e. Non-judicial Mechanisms That Supplement and Reinforce Private Ordering i. The Governance Role of Markets ii. The Role of Trust iii. The Role of Norms III. The Firm and the Law of Agency a. Agency Law and the Choice of Sole Proprietorship Form b. Fiduciary Limits on Agent’s Right of Action i. CCS v. Reilly ii. Hamburger v. Hamburger c. Limits on the Firm’s Right to Discharge an Employee at Will i. Foley v. Interactive Data d. Agency Law and Relations with Creditors i. Blackburn v. Witter ii. Sennot v. Rodman & Renshaw Partnerships – Chapter 2 I. Intro a. Traditional Non-corporate Business Associations i. The General Partnership – associations that are formed by the simple expression of will to associate as co-owners of a business for profit. Once association occurs, general partnership law

determines the partners’ relative rights and duties (standard form contract). 1. Equal sharing of ownership and management functions a. Each partner is a residual claimant, has a full and equal right to participate in management of the firm, and has an equal right to act as an agent of the partnership b. No person can become a partner unless all current partners agree c. Ordinary matters are resolved by majority rule while changes in the partnership agreement or any extraordinary decisions must be made unanimously 2. Individual partner’s adaptability to changed circumstances favored over firm’s continuity and adaptability 3. Unlimited personal liability 4. Fiduciary duty reduces the likelihood that one or more partners will misuse their ownership powers or rights 5. UPA § 103 6. UPA § 202 – the association of two or more persons to carry on as co-owners a business for profit forms a partnership, regardless of intent 7. UPA § 301 – each partner is an agent of the partnership for the purpose of its business 8. UPA § 306 – all partners are liable jointly and severally for all obligations of the partnership unless otherwise agreed by the claimant (and a partner is not liable for any partnership obligation incurred before the person’s admission as a partner) 9. UPA § 401 – partner’s rights and duties 10. UPA § 601 – events causing partner’s dissociation 11. UPA § 801 – events causing dissolution and winding up of partnership business ii. Joint Ventures 1. Less permanent and less complete merging of assets and interests than a general partnership (although not a bright line between the two) iii. The Limited Partnership 1. Separation of ownership and management functions 2. Limited liability a. Limited partners are not personally liable b. General partners are personally liable 3. Firm’s continuity and adaptability to changed circumstances favored over individual’s adaptability 4. ULPA § 107 – supplemental principles of law; rate of interest

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5. ULPA § 110 – effect of partnership agreement; nonwaivable provisions 6. ULPA § 301 – becoming a limited partner 7. ULPA § 302 – no right or power as limited partner to bind limited partnership 8. ULPA § 303 – no liability as limited partner for limited partnership obligations 9. ULPA § 401 – becoming a general partner 10. ULPA § 402 – general partner agent of limited partnership 11. ULPA § 403 – limited partnership liable for general partner’s actionable conduct 12. ULPA § 404 – general partner’s liability 13. ULPA § 603 – dissociation as general partner 14. ULPA § 604 – person’s power to dissociate as general partner; wrongful dissociation b. Emergence of Additional Limited Liability Entities as the Norm i. Impetus for New Forms 1. Although the limited partnership and corporation protect investors from personal liability, these forms provide centralized management structures that many smaller firms find unnecessary or ill-suited to their close-knit relationships ii. The Limited Liability Partnership 1. UPA § 1001 – statement of qualifications 2. ULPA § 404(c) – an obligation of a limited partnership while the limited partnership is a limited liability limited partnership is solely the obligation of the limited partnership c. Determining the Legal Nature of the Relationship i. UPA § 203 – property acquired by a partnership is property of the partnership and not of the partners individually ii. Byker v. Mannes iii. Hynansky v. Vietri d. Sharing Profits and Losses i. In the archetypal general partnership, where two pwersons each contribute equal amounts of money and services to the business, the default rules are consonant with what most persons would presumably have bargained for – an equal sharing of profits and losses. ii. Kovacik v. Reed iii. Shamloo v. Ladd The Partner as Fiduciary a. The Common Law Duty of Loyalty i. UPA § 404 – general standards of partner’s conduct 1. To account to the partnership and hold as trustee for it any property, profit, or benefit derived by the partner in the

conduct and winding up of the partnership business or derived from a use by the partner of partnership property, including the appropriation of a partnership opportunity; 2. To refrain from dealing with the partnership in the conduct or winding up of the partnership business as or on behalf of a party having an interest adverse to the partnership; and 3. To refrain from competing with the partnership in the conduct of the partnership business before the dissolution of the partnership. 4. Refrain from engaging in grossly negligent or reckless conduct, intentional misconduct or a knowing violation of law ii. Relations between partners or joint venturers governed by higher standards than contract iii. Meinhard v. Salmon 1. “If Salmon had received a proposition to lease a building at a location far removed, he might have held for himself the privilege thus acquired, or so we shall assume. Here the subject-matter of the new lease was an extension and enlargement of the subject-matter of the old one.” b. Self-Dealing i. Vigneau v. Storch Engineers 1. Partners in engineering consulting frim, Merluzzo and Vigneau, establish side business developing real estate 2. Merluzzo and Vigneau negotiated fees with Storch in secret, dual roles 3. What fiduciary duties did they violate and what is the remedy? a. Capital contributions are not a form of liquidated damages to which partners can resort in the event of breach b. The measure of damages for fiduciary breach clearly includes any profits earned as a result of the breach 4. Everything was going well (with the improprieties) until the Grandford project came around 5. c. Fiduciary Duty and Management of the Partnership’s Business and Affairs i. UPA 401(f) – Each partner has equal rights in the management and conduct of partnership business ii. UPA 401(j) – differences as to ordinary matters connected with partnership business may be decided by a majority of the partners. However, no act in contravention of an agreement between the partners may be done rightfully without the consent of all partners. Also, disagreements about extraordinary matters must be decided unanimously

iii. Covalt v. High 1. When there are only 2 partners there is no majority and the rights of each are equal. If the partners are unable to agree and if the partnership agreement does not provide an acceptable means for settlement of this disagreement, the only course of action is to dissolve the partnership d. Contracting for Absolute Discretion i. Starr v. Fordham 1. P breaks from law firm Foley Hoag to establish new firm 2. P registers hesitation to join a partnership agreement that allocates profits based on “rain-making” 3. Partners ultimately allocate 6.3% of profits to P and he sues 4. P billed 11% of the profits but only received 6.3%, so he gets the difference 5. Business judgment rule: the test to be applied when one partner alleges that another partner has violated his duty of strict faith is whether the allegedly violating partner can demonstrate a legitimate business purpose for his action a. Does not apply if the plaintiff can demonstrate selfdealing on the part of the allegedly wrongdoing partner i. Judge concluded that the business judgment rule did not apply because founding partners engaged in self-dealing e. The Duty of Care i. Ferguson v. Williams 1. Real estate joint venture goes south under the management of two of three partners 2. Third partner alleges negligence against mismanaging partners 3. Trial court finds for Williams but appellate court reverses. Why? a. As a general partner, he was responsible for knowing what was going on in the partnership i. He had access to information ii. He should have chosen his partners more carefully iii. Courts should not be in the role of refereeing partnership disputes b. Negligence in the management of the affairs of a general partnership or joint venture does not create any right of action against that partner by other members of the partnership. Only when there is a breach of trust, such as when one partner or joint venturer holds property or assets belonging to the

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partnership or venture, and converts such to his own use, would such action lie Dissolution and Disassociation a. Fiduciary Limits on Dissolution “At Will” i. Page v. Page b. Fiduciary Limits on Expulsion of Unwanted Partners i. Bohatch v. Butler & Binion 1. Law firm partner “blows the whistle” on another law firm partner for overbilling 2. Law firm begins process of increased oversight of the whistleblowing partner 3. Law firm eventually votes whistleblowing partner out 4. The firm did not owe Bohatch a duty not to expel her for reporting suspected overbilling by another partner 5. The majority feels that if they imposed the duty to report unprofessional responsibility would create too much animosity between attorneys – the partners would start to look at each other with suspicion c. Contracting to Prevent Opportunistic Withdrawal: The Fiduciary Duties Owed by Withdrawing Partners i. Meehan v. Shaughnessy 1. Law firm partners leave to start their own firm 2. Meehan denied three times that he was leaving Parker Coulter 3. Meehan and Boyle secretly communicated to current clients and delayed disclosure of their communications to PC 4. Could have retained office space in advance, prepare lists of possible clients 5. Attorneys are in a better position than the firm to prove the established relationships 6. Plaintiff former law partners left defendant law firm to start their own firm. Plaintiffs initiated action against defendant to recover amounts owed to them under the partnership agreement with defendant. Defendant contended that plaintiffs violated the agreement when they left the firm. The trial court granted judgment in favor of plaintiffs, and defendant sought review. Mass. Gen. Laws ch. 108A, § 29 (1986) gave plaintiffs the power to dissolve a partnership at any time and allowed them to design their own methods of dividing assets. The court held that plaintiffs owed defendant a fiduciary duty of the utmost good faith and loyalty and that they must have refrained from acting for purely private gain. The court held that the trial court erred in deciding that plaintiffs acted properly in acquiring consent to remove clients and cases from defendant. The

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court held that plaintiffs failed to establish their burden of proving no causal connection between their breach of duty and defendant's loss of clients. The court reversed and remanded a judgment of the trial court. Partners as Agents – Allocating the Risk of Loss in Transactions with Third Parties a. A partner’s Apparent and Inherent Authority i. P.A. Properties, Inc. v. B.S. Moss’ Criterion Center Corp. 1. Joint venture formed between United Artists and Moss Venturers, an umbrella for several different entities 2. UA managed the JV and entered into a consulting agreement with PAP 3. PAP sued UA for breach of K; UA declared bankruptcy and “settled” its liability to PAP in bankruptcy without prejudice to PAP’s ability to sue Moss ii. Haymond v. Lundy 1. Lundy, without his partner’s consent, agreed to pay a large referral fee for a personal injury case 2. The partnership agreement limited discretionary actions like Lundy’s to assets valued at or below $10,000 3. b. Partnership Authority and the Limited Liability Partnership i. Dow v. Jones 1. Dow is a DJ and mayoral candidate who allegedly engaged in criminal acts with a minor 2. Dow pays SJWGE a $1,000 retainer as well as agreeing to pay a flat fee for the representation 3. SJWGE appears to be negligent in their representation 4. The law firm was organized as a registered limited liability partnership (LLP). The state court had denied the law firm's motion for summary judgment, and the remaining defendants removed the case to the federal district court, and the district court denied defendants' motion to dismiss or, in the alternative, transfer the case, and denied plaintiff's motion for entry of default judgment. Plaintiff argued that the court should apply the law of the case doctrine, and uphold the state court's denial of the law firm's prior summary judgment motion. The court found that plaintiff presented specific evidence that raised genuine issues as to material fact governing the law firm's liability for any legal malpractice committed by one partner. Plaintiff had raised genuine factual disputes as to whether the law firm formed an attorney-client relationship with plaintiff, under a theory of apparent authority or partnership by estoppel. Plaintiff also had raised genuine factual disputes as to whether the law firm remained liable for any malpractice that occurred

after the LLP's dissolution, based on the rules governing winding up of partnership affairs and providing notice of dissolution. The Corporate Form and the Specialized Roles of Shareholders, Directors, and Officers – Chapter 3 I. The Corporate Form a. Overview i. Shareholders -> Board of Directors -> Corporation (officers) ii. Constitution -> Corporate statute (judge-made law) -> Articles of Incorporation -> By-laws iii. Corporations are like an individual (right to due process, jury trial, etc.) iv. Liability is limited to the entity itself (statutorily) v. Ownership interest much more liquid than partnership vi. Cannot transfer management rights (residual responsible agents are the directors and they cannot transfer those responsibilities under state law) b. Directors i. State law authorizes the directors to run the corporation – but the directors almost always hire/appoint officers to run the corporation c. Officers i. Agents of the directors d. Shareholders i. Own the corporation but do not manage the corporation (unless a close corporation – they can manage) ii. Cannot bind the corporation II. The Formation of the Corporation and the Governance Expectations of the Initial Participants a. Where to Incorporate: State Corporation Laws as Competing Sets of Standard Form Rules i. Delaware is the jurisdiction of preference for many corporations because of the commitment of its bar, its legislature and its judiciary to laws accommodating corporate interests ii. Delaware race to the TOP 1. Best achieves the balance of conflicting interests of management and shareholders iii. Delaware race to the BOTTOM 1. Critics claim that Delaware unfairly skewed its corporation laws in favor of management interests at the expense of shareholders in order to capture charter business 2. The only hope for eventual equity is a federal corporations code b. Formation: the Articles of Incorporation i. How do you incorporate? What must you do? 1. Name

a. Proper form of name (MBCA 4.01) b. Purposes (MBCA 3.01) c. Powers (MBCA 3.02) 2. Shares authorized (MBCA 6.01) a. Importance of shares to balance management and investment interests b. Par value i. Diminished in importance, but not irrelevant ii. Affects franchise tax iii. In OK, you cannot sell shares below par value 3. Registered office and agent a. Who can be a registered agent? b. Why is registered office/agent required? 4. Incorporator a. Who are the directors, officers, and shareholders? b. Can liability of directors, officers, and shareholders be specified? c. Determining Shares to Issue i. Common and preferred shares 1. Common shares can both vote and share in profits/dividends 2. Preferred shares may be entitled to financial benefit, but no vote 3. Shares of stock of the same class are treated equally (MBCA 6.01, 18 OS 1032) d. Determining Voting Rights: Using Articles and Bylaws to Change Legal Norms i. Overview of Normal Rules of Shareholder Voting for Election of Directors: Straight Voting 1. Default Rules: Directors elected by plurality vote on a onevote per share basis a. Plurality = if there are 1000 votes available, and you get 300 and no one else gets more than 300, you win (not a majority, just have to have more than anyone else) 2. Fundamental tension in 3. Corporate planners can change the number of votes so as to respond to the needs of particular investors ii. Cumulative Voting 1. A shareholder can cast a total number of votes equal to the number of shares multiplied by the number of positions to be filled, and these votes can be spread among as many candidates as there are seats to be filled or concentrated in as few as one candidate

2. Formula: X = S * d / (D+1) + fraction (From slide, check page 167) a. X = # of shares required b. S = # of shares at meeting c. d = # of directors wanted d. D = # of directors to be elected iii. Class Voting, Including Dual-Class Voting Schemes 1. Normally, power to elect directors rests with the voting shareholders as a whole. However, a corporation may, in its articles of incorporation, divide its shares into classes and permit each class to select a specified number of directors. 2. Dual-Class a. Separates shareholders into two classes and gives one class disproportionate voting power as compared to their capital contribution iv. A Classified Board with Staggered Terms – Adaptability Versus Stability 1. Almost all state corporation codes provide as a norm that directors shall be elected annually. However, these laws expressly allow corporations to adopt longer and staggered terms for directors 2. The terms of all directors are staggered so that the term of only one group expires each year. Staggered terms theoretically ensure that a corporation will always have experienced directors in office 3. Operates as a constraint on the majority shareholders’ ability to adapt to changed circumstances by quickly naming new directors e. Looking Ahead: Shareholder Action After Electing Directors i. The Annual Meeting and Other Forums for Shareholder Action 1. The corporate default rules promote adaptability to changed circumstances. If directors are managing poorly or selfishly, the shareholders can replace them at the next meeting or remove them prior to that time if permitted by the state law, articles, and bylaws. Alternatively, shareholders can sell their shares to a new team of managers who will use their purchased majority power to supplant the old managers. 2. To minimize the risk that directors will act unfairly, corporation statutes specify in detail the substance of shareholders’ voting and meeting rights, as well as the procedural rules that safeguard the shareholders’ exercise of these rights a. The annual meeting and election of directors b. Special shareholders’ meetings

i. Difference in MBCA and Delaware as to the ability of shareholders to call a special meeting 1. MBCA requires only a 10% shareholder vote requirement to call a special meeting 2. Delaware does not like shareholders calling special meetings, and require unanimity c. Action by written consent d. Record date: determining shareholders entitled to vote 3. Hoschett v. TSI International Software, Ltd. a. Hoschett attempts to compel TSI to hold an annual shareholder meeting b. DGCL § 211(b) then in effect contained an unequivocal requirement that a corporation hold an annual meeting of shareholders c. Small group of TSI shareholders elected directors under DGCL § 228 d. The corporation had less than 40 shareholders of record and it had never held an annual meeting for the election of directors. The corporation argued that it had received a written consent representing a majority of the voting power of the corporation, which elected directors of the corporation, and thus it had satisfied the need to hold an annual meeting for the election of directors. The court held that the mandatory requirement that an annual meeting of shareholders be held was not satisfied by shareholder action pursuant to section 228 of the DGCL purporting to elect a new board or to re-elect an old one. Delaware courts had long recognized the central role of annual meetings in the scheme of corporate governance. The purposes served by the annual meeting included affording to shareholders an opportunity to bring matters before the shareholder body, such as bylaw changes. These other matters of possible business were not necessarily made irrelevant by a consent designation of directors. The shareholder here had established a prima facie case for the relief he sought. ii. Removal of Directors and Other Midstream Private Ordering 1. The normal rule today allows shareholders to remove directors with or without cause by majority vote, that rule

cannot be fully understood apart from the common law norms the rule replaces, and the statutory rules that allow variance from the new norm 2. At common law, directors had a vested right to serve out their full term, and shareholders could remove directors only for good cause 3. Two dominant approaches to statutory rules that limit or eliminate shareholders’ removal power when the corporation has instituted cumulative voting, staggered terms for directs, or class election of directors a. MBCA – there are no restrictions on shareholders’ power to remove directors if the corporation has staggered the board onto staggered terms. However, if the corporation has cumulative voting, shareholders cannot remove a director if the votes cast against removal would have been sufficient to elect that director. And, if a director is elected by a particular class of shareholders, that director can be removed only by a majority vote of that class, even if the majority of the shareholders of all classes are in favor of removal b. Delaware – differs from MBCA in 3 respects: i. It adds members of staggered boards to the list of directors protected from removal – they can only be removed for cause ii. Preserves the shareholders’ power to remove even protected directors if done for cause, although it is a daunting task iii. A majority retains the ability to change the default rules and thereby permit removal in any of these situations by amending the articles to permit a without cause removal for a staggered board or to remove cumulative voting itself 4. Campbell v. Loew’s, Inc. a. Stockholders have the inherent right between annual meetings to fill newly created directorships b. Stockholders do have inherent power to remove directors for cause even where there is a provision for cumulative voting i. There must be notice of charges opportunity to defend charges ii. Opportunity must be provided such directors to present their defense to stockholders in company proxy mailing f. Protecting Changes Made to the Statutory Default Rules

i. Varying statutory norms to diminish majority power requires careful planning to protect against later amendment by the majority ii. Centaur Partners v. National Intergroup 1. Centaur is 16.53% shareholder in National and believes all or part of its businesses should be sold 2. Centaur proposes by-law amendment to increase board from 9 to 15 3. Centaur argues that the written consent of a majority of shareholder votes is needed (as opposed to 80%) and brings declaratory judgment action g. Initial Issuance of Securities i. The Securities Act of 1933 and Its Requirement of Extensive Disclosure 1. Passed in response to widespread improprieties and fraud leading up to the stock market crash of 1929 a. Securities laws focus on disclosure of material information rather than underlying merit 2. Federal and state law governance converge and diverge on specific areas of securities regulation, with federal law more likely to focus on larger issuers’ disclosures 3. Protection of investors was necessary to ensure that the securities markets were efficiently allocating capital resources to produce the most productive and innovative economy a. Primary mechanisms to protect investors has been full and fair disclosure of material facts concerning securities, to tell the investor what stands behind the paper b. The second major aim is to deal with fraud in the sale of securities 4. About the SEC a. First basic objective is to require that investors receive financial and other significant information concerning securities being offered for public sale b. Second basic objective is to prohibit deceit, misrepresentations, and other fraud in the sale of securities ii. What Transactions are Covered? 1. SEC v. Edwards a. Charles Edwards offers individuals opportunity to buy contracts for the leasing and use of payphones b. These contracts guarantee a specific return regardless of performance c. Are these securities …? d. Definition of “security” i. SEC v. Howey

1. Investment of money in a collective enterprise with expectation of profits from the efforts [primarily] of others e. Under the sale and leaseback agreements, purchasers of payphones received fixed monthly amounts and the seller operated and maintained the payphones and collected coin revenues from the payphones. The seller contended that the agreements were not investment contracts subject to regulation as securities, since the purchasers did not participate in the earnings of the enterprise, but rather received a fixed rate of return, and had a contractual entitlement to the return which was thus not derived solely from the efforts of others. The United States Supreme Court held, however, that the provision for a fixed rate of return did not preclude the agreements from being investment contracts and thus securities subject to federal regulation. While an investment contract required profits to come solely from the efforts of others, such profits were the return the purchasers sought on their investments, and not the profits of the scheme in which they invested. Further, the fact that the purchasers bargained for a return on their investments did not mean that the return was not also expected to come solely from the efforts of others. iii. Exemption from Registration 1. SEC v. Ralston Purina a. The Commission filed an action against the corporation to enjoin it from offering unregistered shares of its stock to certain employees. The corporation made authorized, but unissued, common shares available to some of its employees, claiming that it was not required to register such securities because they were private within the scope of the private offering exemption of § 4 of the Securities Act of 1933, 15 U.S.C.S. § 77(d). Reversing the lower court, the Court held that whether the § 4 exemption applied turned on the particular class of persons affected so that persons who were able to fend for themselves did not need the protection of § 4. Absent a showing of special circumstances, employees were members of the investing public. The Court held that the corporation's employees did not have access to the

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information that would have been found in a registration statement. Thus, they needed the protection offered by the registrations statements. Shareholder Investment and Governance in Publicly Held Corporations and the Impact of Federal Law a. How Publicly Held Corporations Are Different i. The Market for Shares and the Efficient Market Hypothesis 1. Securities markets provide three important services to publicly traded corporations and their shareholders: a. Liquidity b. Valuation c. Monitoring of managers 2. Efficient market hypothesis a. The current market price is unbiased in that it already incorporated the value of information from past prices, and whatever causes the price to move tomorrow will be because of new info 3. Semi-strong-form hypothesis (most accepted) a. You cannot develop a trading strategy that will beat the market by using publicly available information relevant to the value of traded stocks 4. Strong-form hypothesis a. Even if your trading strategy were based on nonpublic information, you would not be able to beat the market ii. The Shareholder Census: The Emergence of Institutional Investors 1. In 1961, institutional investors held 10% of the outstanding shares in companies traded on the NYSE. In the early 21st century institutional investors held 60% or more of those shares 2. Politically active institutional investors and allied “active investors” can use their large shareholdings both to carry out traditional shareholder responsibilities and to engage in corporate management in a sustained conversation about how corporations should be managed 3. Institutions are likely to be more knowledgeable than individual investors, largely as a result of greater and less expensive access to information 4. Even though institutional shareholders hold a clear majority of the shares in most publicly traded corporations, the percentage of shares held by activist institutional shareholders and allied investors is generally much less than a majority iii. Proxy Voting 1. By executing a simple agreement appointing a proxy to act on his behalf, a shareholder need not be physically present

to participate in a meeting. Moreover, the proxy provides a means for institutional or other significant investors to collect voting power from smaller investors or each other in advance of an actual election, and thus is a valuable tool even for the active shareholder 2. The SEC plays a significant role in setting the rules for the proxy and shareholders’ meeting process and in settling disputes between management and shareholders concerning the conduct of that process iv. Federal Regulation of Publicly Held Companies b. Shareholder Governance in the Public Corporation Setting i. Introduction 1. The evolution over several decades of federal proxy rules permitting persuasive communication by shareholders under federal Rule 14a-8 aimed at influencing directors to change corporate policies; 2. More recent shareholder use of precatory, persuasive communication, coupled with newly effective institutional shareholder use of voting to elect or remove directors; 3. Very recent shareholder use of the power to amend bylaws to act for the corporation, a process that has involved a combination of both state and federal law; 4. Federal legislation or rule-making to change the role of shareholders, a change that raises long-standing federalism issues; and 5. Use of traditional shareholders rights under state law to inspect documents. ii. Federal Rules Providing Shareholders Access to Persuasive Communication: Rule 14a-8 1. Lovenheim v Iroquois Brands a. Plaintiff brought suit to enjoin defendant from excluding the materials he requested from the proxy materials to be sent out to shareholders. Defendant challenged claiming that service was process was insufficient, and the court had no jurisdiction. The defendant also claimed that 17 C.F.R. § 240.14a-8 and the Securities Exchange Act of 1934, 15 U.S.C.S. § 78n(a) were not applicable to this case. The court first found that both jurisdiction and service of process was sufficient to maintain the case. The court also found that 17 C.F.R. § 240.148(c)(5) did not contain an economic significance test and therefore the social significance of the plaintiff's proposal excluded it from the exception. The court further found that the public and the plaintiff's interests would be

irreparably harmed without the relief sought, while ordering the relief would not unduly prejudice the defendant. The court granted plaintiff's motion for injunctive relief. iii. Persuasive Communication with Punch: Rule 14a-8 Proposals Linked with Use of Shareholder Authority to Elect/Remove Directors 1. The most influential proposals strike at the heart of practices that insulate management from removal from office, or give the corporation’s CEO what shareholders see as too much power or compensation. Recent topics include shareholder say on executive’s pay, confidentiality for shareholder votes, and separation of the roles of CEO and chair of the board. iv. Using Shareholder Authority to Change the Bylaws 1. CA v. AFSCME Employees Pension Plan a. The bylaw directed the board to reimbursement proxy expenses. The current bylaws and certificate of incorporation did not address the issue, but the certificate tracked Del. Code Ann. tit. 8, § 141(a). The certified question, the first the SEC submitted under the amended constitution, sought a determination of whether the bylaw was a proper subject for stockholder action and whether any law would be violated if the bylaw were adopted. The court found that both the board and the shareholders, independently and concurrently, had the power to adopt, amend and repeal the bylaws; and that shareholders' statutory power to adopt, amend or repeal bylaws was not coextensive with the board's concurrent power and was limited by the board's management prerogatives under § 141(a). The court concluded that the bylaw fell within the scope of Del. Code Ann. tit. 8, § 109 and was a proper matter for stockholder action, but that the bylaw, as drafted, violated the prohibition derived from § 141(a) against contractual arrangements that committed a board to a course of action that would preclude them from fully discharging their fiduciary duties to the corporation and its shareholders. 2. Kistefos AS v. Trico Marine Services a. 22% shareholder wages its own proxy contest to remove, replace and change board of directors b. Kistefos argues that corporation’s majority vote rule allows a director that does not obtain requisite votes to continue serving

c. Delaware Court of Chancery permits the shareholder vote, but the vote falls short of the supermajority required v. Federal Rules to Enhance Shareholder Power – Shareholder Ability to Nominate Directors vi. Shareholder Access to Corporate Records and Shareholder List 1. Conservative Caucus v. Chevron a. Virtually unfettered right to list of shareholders b. Plaintiff non-profit corporation was the owner of shares of stock of defendant corporation. It sought a stockholder list in order to communicate with other stockholders about alleged economic risks of defendant's business activity in Angola and about a related resolution which was proposed to be submitted at the next annual meeting of defendant. After a trial the court found that plaintiff was a registered owner of shares of stock of defendant, had made a proper demand for a stockholder list, and that defendant had not borne its burden of showing that the purpose for which plaintiff sought a stockholder list was improper. Plaintiff therefore was entitled to the list. Defendant urged a number of reasons why the plaintiff's purpose was improper, but the court held that once a proper purpose was proven all other reasons were irrelevant. 2. City of Westland Police & Fire v. Axcelis Technologies a.

The Corporation as a Device to Allocate Risk – Chapter 7 I. Piercing the Veil a. Introduction i. PCV factors 1. Close vs. public corporation 2. Fail to observe formalities 3. Commingling personal and business 4. Inadequate capitalization 5. Active participation ii. Why limited liability? 1. Encourage investment 2. Foster diversification 3. Encourage management risk-taking 4. Facilitate public trading markets iii. Cons of limited liability

1. Discourage extension of credit 2. Insider opportunism 3. Externalization of risks 4. Shareholder irresponsibility iv. PCV in tort cases 1. Enterprise liability 2. Corporate shareholders v. PCV in contract cases 1. Abuse of form 2. Assumption of risk vi. PCV in corporate groups 1. “Normal” parent-sub relationship 2. Corporate confusion vii. Three factors that may affect the likelihood that veil piercing will occur: 1. Distinction between Ps suing to enforce contract claims and those suing to enforce tort claims a. K claimants have an opportunity to bargain with the corporation, where tort claimants have not consented to tortious conduct 2. Identity of the person behind the veil a. Courts should be more willing to pierce the veil to reach other corporations rather than a real person 3. Distinction between closely held and publicly held corporations a. Unlikely courts would find it equitable or efficient to hold public shareholders personally liable for a corporation’s debts b. Piercing the Corporate Veil to Reach Real Persons i. Contract Cases 1. Consumer’s Co-op v. Olsen a. The trial court entered judgment in favor of plaintiff creditor against defendant shareholder. On appeal, the court reversed the trial court's judgment and directed that judgment be entered in favor of defendant. The court held that the trial court erred when it pierced the corporate veil of a corporation in which plaintiff was a shareholder. The court found that the corporation was adequately capitalized when it was formed and that plaintiff's actions in continuing to extend credit to the corporation once it became delinquent on its account waived any right of plaintiff to assert a claim that the corporation subsequently became undercapitalized as a result of increased business. The court also held that there was inadequate

evidence to establish that the corporation had no separate mind of its own or that the corporation disregarded corporate formalities. 2. K.C. Roofing Center v. On Top Roofing a. The suppliers obtained judgments against the roofing contractor for unpaid invoices. They filed an action against the roofing contractor, the corporate insider, and his wife to enforce their judgments against the roofing contractor against the assets of the corporate insider and his wife on the ground that he had used the corporate form to perpetrate a fraud on his creditors. The trial court entered a judgment against the corporate insider. On appeal, he contended that that it was error to admit evidence of other corporate entities and that the suppliers had not proven the elements necessary to pierce the corporate veil. The court affirmed because there was substantial evidence to support the trial court's finding that the three-part test for piercing the corporate veil was satisfied. The corporate insider exercised control, he and his wife were the sole shareholders, the corporation was used as a subterfuge, and the scheme had damaged the suppliers. In addition, evidence of involvement with other corporate entities was relevant to demonstrate a pattern or scheme used to defraud creditors. ii. Tort Cases 1. Western Rock Co. v. Davis a. Blasting company owners made aware that operations are damaging neighboring properties b. Western Rock’s insurer informs owners that there is probably no coverage for the blasting damage c. Neighbors sue to collect from owners – should the veil be pierced? d. Appellee property owners brought an action in a Jack County trial court for damages sustained to their homes and business properties because of alleged negligent blasting operations conducted in a rock quarry near Jacksboro by appellants, corporation and its directors. Appellants entered separate pleas of privilege to be sued in Dallas County. The trial court overruled the pleas of privilege. On appeal, the court affirmed. Appellees' cause of action against appellant directors was based upon ample proof that they were the

dominating force behind appellant corporation, a shell corporation, which had no assets and was in financial difficulty. The corporation served as a device through which they could carry on destructive blasting activities at the expense of the property owners of Jacksboro and at the same time be personally insulated from legal and financial responsibility. All of the venue facts were supported by ample evidence. The evidence was adequate to support the judgment of the court that appellant directors were legally responsible, individually and jointly, for negligent conduct that was a proximate cause of damages sustained in Jack County. 2. Baatz v. Arrow Bar a. Plaintiffs injured by an allegedly drunken, uninsured, judgment proof motorist, Roland McBride b. Arrow Bar allegedly serving McBride alcohol after visible intoxication in violation of South Dakota law c. Plaintiffs sue bar owners under a veil-piercing theory d. The injured parties were riding a motorcycle when the driver's car swerved over the center lane and hit them causing serious injuries to the injured parties. The injured parties filed an action against the bar where the driver had been earlier in the evening of the accident and its owners and associated individuals, claiming that the bar's negligence in serving the driver alcohol when he was already intoxicated contributed to the accident. The trial court granted summary judgment in favor of the bar owners and the associated individual. On appeal, the court affirmed, finding that there was no indication that the bar owners or the associated individual had personally served an alcoholic beverage to the driver on the day of the accident. Nor was there any evidence indicating that the bar owners treated the corporation in any way that would produce the injustices and inequitable consequences necessary to justify piercing the corporate veil. In fact, the court found that the only evidence offered was otherwise. 3. Walkovsky v. Carlton (page 633) a. Walkovsky claims that because the corporation uses a structure that maximizes the externalization of the

business risks on the public, the court should pierce the corporate veil to reach the parent company/owner b. The court agrees, but says that they cannot do anything about it and that the legislature needs to address the problem (corporation had the necessary insurance under the legislature) c. Enterprise liability allows the P to sue the entire business (as an enterprise) because the “enterprise” disaggregated itself, the risk is spread out and the P should still be able to recover c. Piercing the Corporate Veil to Reach Incorporated Shareholders i. Craig v. Lake Asbestos 1. Appellees, employee and his wife, brought a personal injury action in Pennsylvania state court against asbestos manufacturers and suppliers for injuries suffered as a result of exposure to asbestos fibers. A defendant impleaded appellant holding company and its subsidiaries as thirdparty defendants upon removal to federal court. All original defendants settled with appellees and a district court found that appellant was liable for the tort obligations of its subsidiary based on a piercing the corporate veil theory. On appeal, the court reversed and remanded, holding that appellant was not involved in the affairs of the subsidiary on a constant or day-to-day basis necessary to rise to the high degree of domination required by New Jersey state law to pierce the corporate veil. The court found that appellant and its subsidiary maintained separate financial and managerial operations and affairs. The court concluded that merely the potential for control was insufficient, especially if appellant's actual amount of control was not enough. 2. CORPORATE FORMALITIES WERE THE MOST IMPORTANT FACTOR IN NOT PIERCING THE VEIL ii. United States v. Bestfoods 1. US Government sees reimbursement for pollution clean up costs under CERCLA 2. US Supreme Court does not focus on the relationship between corporation and subsidiary, but rather on the control of the statutory “facility” 3. By enacting CERCLA, Congress probably did not want corporation shielding tactics to prevent companies from being sued 4. Liability can be attached to the parent in three ways: a. Parent OPERATES

b. Parent’s board and subsidiaries board are the same so 100-percent ownership c. Individual does not have a hat except for the hat of the parent’s company i. Court would require that the burden be shifted to D to prove that they are not acting in the interests of the parent 1. Put in subsidiary articles that the subsidiary directors do “x,y, and z” (not the same as the parent’s company 5. A chemical plant generated industrial waste for many years. The chemical plant significantly polluted the soil and ground water. Respondents, succeeding parent corporations, purchased the chemical plant's assets. Petitioner, federal EPA, filed suit to recover funds for the clean up of the hazardous waste site. The district court found respondents directly liable to pay clean up costs as operators. The lower appellate court reversed ruling that respondents maintained separate personalities and did not improperly utilize the subsidiary corporate form. The court vacated and remanded holding that a participation-andcontrol test looking to the parent corporation's supervision over a subsidiary could not be used to identify operation of a facility resulting in direct parental liability. Any parent corporation liability as an operator, stemmed directly from its control over a polluting plant. d. Piercing in LLCs i. Veil piercing principles apply to LLCs just as they do to corporations ii. Kaycee Land and Livestock v. Flahive 1. The question presented was limited to whether, in the absence of fraud, the remedy of piercing the veil was available against a company formed under the Wyoming Limited Liability Company Act (Act), Wyo. Stat. Ann. §§ 17-15-101 to -144 (LexisNexis 2001). Because each case involving the disregard of the separate entity doctrine was governed by the special facts of that case, the court was reluctant to reach a conclusion that the equitable doctrine of piercing the veil could never be employed in the LLC context. The court first reviewed the development of the piercing the veil doctrine in the corporate context and then reviewed the legislative history of the Act in Wyoming. The court concluded that nothing in the Act's history indicated a legislative intent to prevent application of the doctrine in the LLC context. However, because the issue

was presented as a certified question in the abstract with little factual context, the court determined that a remand was appropriate to allow the district court to complete a fact intensive inquiry and exercise its equitable powers to determine whether piercing the veil was appropriate under the circumstances of the instant case. iii. Gilbert v. Security Finance Corporation of OK 1. South Carolina payday lender operating through Oklahoma subsidiaries urges incapacitated plaintiff to roll over smallincrement loans at high fees 2. Plaintiff’s guardian (brother) sues under common law causes of action: fraud, breach of fiduciary duty, breach of covenant of good faith and fair dealing 3. Ds argue that you do not get a jury on a veil piercing trial because it is an equitable action 4. The resident defendants challenged the constitutionality of Okla. Stat. tit. 23, § 9.1 (Supp. 2002) pertaining to punitive damages and the non-resident defendants contest the district court's exercise of in personam jurisdiction. On appeal, the court held that Okla. Stat. tit. 23, § 9.1 (Supp. 2002) did not violate defendants' due process rights and was facially constitutional, but that the amount awarded did not comply with § 9.1 and was excessive based on the evidence presented. The court found that the trial court only instructed the jury on 2 options for punitive damages under § 9.1 and did not follow the uniform instruction that provided 3 options. The court found that the trial court erred in exercising jurisdiction over the holding company because there was no evidence that it had the required minimum contacts in Oklahoma. However, the court found that the parent company had continuous contacts and the jury was properly instructed on the alter-ego theory. The court found that the trial court erred in awarding the borrower costs under Okla. Stat. tit. 12, § 3237(C) and failed to follow proper procedures in sanctioning the parent company under Okla. Stat. tit. 23, § 103. Fiduciary Duty, Shareholder Litigation, and the Business Judgment Rule – Chapter 4 I. Introduction to the Role of Fiduciary Duty and the Business Judgment Rule a. Overview i. It is an actionable wrong for an officer or director to compete with her corporation or divert to personal use assets or opportunities belonging to her corporation

ii. The business judgment rule is a judicial presumption that the directors have acted in accordance with their fiduciary duties of care, loyalty, and good faith 1. Provides protection by much greater pleading and evidentiary burden placed upon plaintiffs seeking to hold directors liable for allegedly breaching their fiduciary duties while engaged in official conduct for the corporation b. Discretion to Determine General Business Policies i. Shelnsky v. Wrigley 1. The stockholder filed a stockholders' derivative suit against the directors for negligence and mismanagement. The stockholder sought damages and he prayed for an order that required the corporate directors to install lights at the baseball field owned by the corporation, and requested that they schedule night baseball games. The lower court held that the stockholder's amended complaint did not state a cause of action. The court affirmed, maintaining that courts should not interfere in a corporation's management unless fraud or a breach of faith existed. The decision at issue was one properly before the corporation's directors, and the motives alleged in the amended complaint showed no fraud, illegality, or conflict of interest in their making of that decision. The allegations in the stockholder's amended complaint were mere conclusions, which were insufficient to except the directors from the business judgment rule. c. Discretion to Consider Interests of Non-Shareholder Constituencies i. Directors may consider the interests of other constituencies if there is “some rationally related benefit accruing to the stockholders” 1. Directors may consider the interest of suppliers, employees, customers, and affected communities ii. Dodge v. Ford Motor Co. 1. Defendant corporation's directors decided to exercise their discretion and hold back part of the company's capital earnings for reinvestment, thereby denying certain expected dividend payments to plaintiffs. Plaintiffs contended that the reason defendant corporation was holding back dividends, partially to reinvest in the company and bring down the ultimate cost of buying a car, was semihumanitarian and was not authorized by the company's charter. The trial court held that defendant corporation was entitled to reinvest surplus capital gains at their discretion and did not order further dividends paid out. The appellate court reversed that decision and held that the accumulation of so large a surplus established that there was an arbitrary refusal to distribute funds to stockholders as dividends and

II.

ordered that such dividends, plus interest, should be paid by defendant corporation. iii. Problem 4-1 The Fiduciary Duty of Loyalty a. Introduction i. Two Settings: 1. Circumstances in which a director personally takes an opportunity that the corporation later asserts rightfully belonged to it 2. Transactions between the corporation and the director, commonly called “conflicting interest transactions” ii. Whenever a director confronts a situation that involves a conflict between her personal interests and those of the corporation, courts will carefully scrutinize not only whether she has unfairly favored her personal interest in that transaction, but also whether she has been completely candid with the corporation and its shareholders b. The Corporate Opportunity Doctrine i. The American Law Institute and MBCA Approaches 1. Northeast Harbor Golf Club, Inc. v. Harris a. While she was in office, the president purchased land that adjoined the corporation and subsequently applied for a subdivision permit. She informed the corporation after she purchased the land for her benefit. The corporation brought an action against the president for breach of fiduciary duty. When the trial court found in favor of the president, the corporation sought review. The court found that corporate fiduciaries were required to discharge their duties in good faith with a view toward furthering the interests of the corporation. A fiduciary was required to disclose information concerning any potential conflict of interest. The court adopted a rule to determine whether a fiduciary had improperly taken a corporate opportunity. A corporate officer was required to offer the opportunity to the corporation and it must have been formally rejected. The court reasoned that corporate opportunity included opportunities closely related to a business in which the corporation was engaged. 2. Guth “line of business” test a. If there is presented to a corporate officer or director a business opportunity which the corporation is financially able to undertake, is, from its nature, in the line of the corporation’s business and is of practical advantage to it, is one in which

the corporation has an interest or a reasonable expectancy, and, by embracing the opportunity, the self-interest of the officer or director will be brought into conflict with that of his corporation, the will not permit him to seize the opportunity for himself i. The question whether a particular activity is within a corporation’s line of business is conceptually difficult to answer ii. Includes as an element the financial ability of the corporation to take advantage of the opportunity 3. Durfee “fairness test” a. The true basis of governing doctrine rests on the unfairness in the particular circumstances of a director, whose relation to the corporation is fiduciary, taking advantage of an opportunity [for her personal profit] when the interest of the corporation justly calls for protection. This calls for application of ethical standards of what is fair and equitable in particular set of facts i. Calls for a broad-ranging, intensely factual inquiry ii. Suffers even more than Guth test from a lack of principled content 4. ALI test a. The central feature of the ALI test is the strict requirement of full disclosure prior to taking advantage of any corporate opportunity 5. Problem 4-2 a. No b. Yes i. Helped her ii. Helped her iii. Hurt her iv. Helped her 6. Problem 4-3 ii. The Delaware Approach 1. Broz v. Cellular Information Systems, Inc. a. Broz is the CEO of RFBC, Inc., whose principal business is providing cellular phone service in rural Michigan b. Broz is a director of CIS, a publicly held Delaware corporation c. Broz acquires for RFBC “Michigan-2” FCC license to offer cellular services immediately adjacent to RFBC’s existing service area

d. What is Broz prohibited from doing as a director of CIS? e. After appellant corporate director purchased a cellular telephone service license for the benefit of appellant corporation, appellee corporation brought an action against appellants that sought equitable relief on the grounds that the purchase constituted a usurpation of a corporate opportunity that allegedly belonged to appellee. The trial court ruled in favor of appellee and imposed a constructive trust against the agreement, and appellant sought review. On appeal, the court held that the lower court erred as a matter of law when it held that appellant corporate director had a duty to formally present the purchase opportunity to appellee's board. The court also held that the trial court erred in its application of the corporate opportunity doctrine under the facts of the case, where appellee had no interest or financial ability to acquire the opportunity. The court held that appellant corporate director was not required to consider the contingent and uncertain plans of a third party that sought to acquire appellee in reaching his determination of how to proceed. c. Conflicting Interest Transactions i. At Common Law 1. In the 19th century, courts were in substantial agreement that transactions between a corporation and one or more of its directors were void or voidable simply because a conflict of interest existed 2. By the 20th century, conflicting interest transactions were voidable only if the transaction or the conduct of conflicted directors was unfair to the corporation. 3. Globe Woolen Co. v. Utica Gas & Electric Co a. John Maynard is controlling shareholder, CEO and Chair of the Board of Directors of Globe Woolen which operates two mills in Utica, NY b. Director and Chair of the Board of Utica c. If a conflict arises between the two, it will be difficult to act with requisite loyalty to Utica d. The company, which operated mills, brought this action against the electric company to compel the specific performance of contracts to supply electricity to the mills. The electric company argued that the contracts were made under the dominating influence of a common director and that their terms were unfair and oppressive. The trial court held in

favor of the electric company and annulled the contracts, and the appellate court affirmed. In affirming this judgment, the court held that the common director's refusal to vote on the contracts did not nullify the influence and predominance that he had exerted in arranging the contracts. The court found that as a result of the contracts, the electric company was losing large amounts of money and that such consequence was foreseeable to the common director who stood by and said nothing while the contracts were presented to the other directors of the electric company as a mere formality.. ii. Transactions with a Controlling Shareholder or Director 1. The common law viewed all conflicting interest transactions with suspicion, but particularly those between a corporation and a person in control of the corporation 2. In circumstances constituting “self-dealing,” transactions between the corporation and the controlling person were subject to heightened judicial scrutiny to protect the interests of the corporation and its non-controlling shareholder 3. Sinclair Oil Corp. v. Levien a. Plaintiff, stockholder of a subsidiary corporation, brought a derivative action against the parent corporation for an accounting of excessive dividends and a breach of contract between two subsidiaries. The court granted the order to plaintiff. The supreme court reversed the order as to dividends because the dividends were paid fairly to all stockholders, and it affirmed the order as to breach of contract because the intrinsic fairness standard applies to dealings between subsidiaries. b. The standard of intrinsic fairness involves both a high degree of fairness and a shift in the burden of proof. Under this standard the burden is on Sinclair to prove, subject to careful judicial scrutiny, that its transactions with Sinven were objectively fair c. In order to show self-dealing, you much show strong harm to minority shareholder iii. The Intersection of the Common Law and Conflicting Interest Statutes 1. Delaware G.C.L. § 144 provides that no conflicting interest transaction shall be void or voidable solely by reason of the conflict if the transaction is (1) authorized by a majority of the disinterested directors, or (2) approved in good faith by

the shareholders, or (3) fair to the corporation at the time authorized. 2. Delaware G.C.L. § 144 and similar statutes leave significant gaps (burden of proof, interests that constitute a conflict, standard of judicial review, and what constitutes disinterestedness) that must be filled by courts 3. Shapiro v. Greenfield a. Appellee minority shareholders filed a derivative suit against appellant corporation, officers, and directors after one appellant, an operating officer, proposed a joint venture to redevelop an underperforming corporate property. A special meeting was called to consider a resolution authorizing the corporation to enter into the joint venture. Advanced notice included a description of the proposed joint venture. Appellees did not attend the meeting. The shareholders present unanimously voted for it. Appellees protested that none of the directors voting were disinterested directors. Following a trial and a report by a special master, the trial court found appellants usurped a corporate opportunity and appointed a receiver. Appellants challenged that holding. The court vacated the judgment. The court held appellants had not usurped a corporate opportunity, but that remand was required to determine whether interested directors were involved, and if so, whether the transaction was nevertheless fair and reasonable to the corporation. The court also held the trial court was entitled to examine whether appellees acquiesced, ratified, or participated in the transaction. b. An interested director transaction statute applies where a director seeks to transact business with the corporation c. A transaction should be analyzed under the corporate opportunity doctrine where a director seeks to take an opportunity from the corporation 4. Problem 4-5 5. Problem 4-6 iv. The Special Problem of a Director’s “Self-Compensation” 1. If directors set their own compensation without ratification by disinterested shareholders, the rule is that this is subject to an affirmative showing that the compensation arrangements are fair to the corporation 2. Stock options are subject to heightened judicial scrutiny

III.

because although no corporate assets are distributed to the optionees at the time of grant, the value of other shareholders’ equity may be severely diluted by options that are ultimately exercised at prices far below thenprevailing market prices The Fiduciary Duty of Care a. Policy Arguments for Limiting the Reach of the Duty of Care i. A director must carry out her duties “with the care that a person in a like position would reasonably believe appropriate under similar circumstances.” 1. Although this looks like a negligence standard, liability for breach of the duty of care has always been rare, and has occurred in circumstances where the director’s conduct was egregious 2. Actually a gross negligence standard 3. Two main components: a. Informed decision-making b. Oversight of internal corporate matters ii. Joy v. North 1. Banking corporation’s board of directors authorized loans to an unsecured developer that exceeded a federal statutory limit and resulted in losses to the corporation and the corporation’s shareholders 2. Shareholder Joy brought a derivative suit for breach of fiduciary duty of good faith against both inside and outside directors iii. Former Delaware Chancellor Allen argues that most corporate directors typically have a very small proportionate ownership interest in their corporations and little or no incentive compensation. Thus, they enjoy only a very small proportion of any upside gains earned by the corporation on risky investment projects (page 327) b. Duty of Care in the Decisional Setting i. Smith v. Van Gorkom 1. Plaintiffs challenged a judgment of the Court of Chancery (Delaware) in favor of defendants in an action seeking rescission of a cash-out merger of one defendant corporation into another, or in the alternative, damages against defendant directors. 2. Plaintiffs argued that defendant directors' decision to approve a cash-out merger of their corporation into another violated Del. Code Ann. tit. 8, § 251, and did not warrant business judgment rule protection. The court agreed, finding that defendant directors based their decision on one person's representations, which did not constitute a report on which they could reasonably rely under Del. Code Ann.

tit. 8, § 141(e), and that they did not seek documentation of either the merger terms or the adequacy of the proposed price per share. The court also found defendant directors were grossly negligent in permitting the agreement to be amended in a way they had not authorized. Finally, the court found that the stockholders' vote did not ratify the action, because the stockholders weren't aware of the lack of valuation information, and because defendant directors' statements were misleading. 3. The court reversed the judgment, holding that defendant directors' decision to approve the merger was not the product of an informed business judgment, that efforts to amend the merger agreement were ineffectual, and that defendant directors had not disclosed all material facts to the stockholders. ii. Problem 4-7 c. Statutory Exculpation Provisions i. The articles of incorporation may set forth a provision eliminating or limiting the liability of a director to the corporation or its shareholders for money damages for any action taken, or any failure to take any action, as a director, except liability for (A) the amount of a financial benefit received by a director to which he is not entitled; (B) an intentional infliction of harm on the corporation or the shareholders; (C) a violation of section 8.33; or (D) an intentional violation of criminal law – MBCA § 2.02(b)(4) ii. Malpiede v. Townson 1. Frederick’s of Hollywood hires investment bank to advise on sale of business 2. Investment bank initiates merger talks with Knightsbridge Capital, which makes an offer 3. Knightsbridge’s offer sets off a bidding war with two other private equity groups 4. After one round of bidding, Frederick’s directors enter contract with Knightsbridge which creates insuperable obstacles to additional bidding 5. The shareholders' claims alleged: (1) breaches of defendant target corporation's board members' duty of loyalty or their disclosure duties; and (2) aiding and abetting or tortious interference by defendant acquiring corporation. The supreme court ruled that: (1) the amended complaint did not adequately allege a breach of the board members' duty of loyalty or their disclosure duty; (2) the exculpatory provision in the charter of the target corporation authorized by Del. Code Ann. tit. 8, § 102(b)(7) operated to bar claims for money damages against the board members caused by the alleged breach of their duty of care; and (3) the

amended complaint did not provide adequate support for the shareholders' claims against the acquiring corporation for aiding and abetting a breach of fiduciary duty by the target corporation's board members or for tortious interference with a prospective business opportunity. d. The Intersection of the Fiduciary Duties of Care and Loyalty (Including the Duty of Good Faith) i. Introduction ii. Care, Good Faith, and Directors’ Oversight Responsibilities 1. In re Caremark International, Inc. Derivative Litigation a. A motion pursuant to Del. Ch. Ct. R. 23.1 was before the court to approve as fair and reasonable a proposed settlement of a consolidated derivative action on behalf of corporation in a suit involving claims that board members breached their fiduciary duty of care to corporation. b. The derivative action alleged that members of the corporation's board of directors breached their fiduciary duty of care to the corporation in connection with alleged violations by the corporation's employees of federal and state laws and regulations applicable to health care providers. The suit purported to seek recovery of losses from individual defendants who constituted the board of directors of the corporation. The parties proposed that the suit be settled. The court stated that the record did not support the conclusion that defendants either lacked good faith in the exercise of their monitoring responsibilities or conscientiously permitted a known violation of law by the corporation to occur, and that the claims asserted against them had to be viewed as very weak. Despite the weakness of plaintiffs' claims, the court concluded that the proposed settlement appeared to be an adequate, reasonable, and had a beneficial outcome for all parties, and thus approved the settlement. c. The settlement agreement was approved on the ground that, despite the weakness of plaintiffs' claims against defendants, individual members of the corporation's board of directors, the settlement was an adequate, reasonable, and had a beneficial outcome for all parties. 2. Problem 4-8 a. Compare the problem with Graham and Caremark b. What is the comparative risk that directors will be

liable for breach of the duty of care? iii. The Role and Nature of Substantive Review 1. Waste Doctrine allows courts to find directors liable where direct proof of lack of care or loyalty is lacking, but the substantive decision seems explainable only as a product of the directors’ failure to carry out their fiduciary duties 2. Stages of the Disney litigation: a. Disney I – complaint b. Disney II – amended complaint c. Disney III – trial 3. Brehm v. Eisner a. Shareholders of the Walt Disney Company claim that executive compensation package to Michael Ovitz was “waste.” b. Ovitz received stock options and severance payments totaling $140 million – after 14 months of inept service i. Employment agreement was unilaterally negotiated by Eisner and approved by the Old Board ii. Required Ovitz “devote his full time and best efforts exclusively to the Company” c. What must a shareholder do to bring a derivative suit in Delaware? i. Demand Requirement. “To proceed with their derivative claims, Plaintiffs must set forth in their complaint particularized facts that create a reasonable doubt that 1. A majority of the members of Disney’s board of directors are disinterested and independent or 2. The challenged transaction was otherwise the product of a valid exercise of business judgment.” d. Plaintiff shareholders appealed a New Castle County Court of Chancery (Delaware) order that dismissed their shareholder derivative suit with prejudice for failure to comply with Del. Chancery Ct. R. 23.1 pleading standards. e. Plaintiffs, shareholders of a publicly traded entertainment corporation, appealed the dismissal with prejudice of their derivative suit against defendants, former and current corporate directors and officers, for failure to properly plead particularized facts creating a reasonable doubt that director defendants were disinterested and

independent or that their conduct in approving an extravagant and wasteful employment agreement for the president, and the subsequent agreement to a non-fault termination of that agreement, was protected by the business judgment rule. The court affirmed, except as to the non-fault termination claim, remanding to allow plaintiffs to replead facts creating a reasonable doubt that the decision allowing non-fault termination was protected by the business judgment rule. The court applied de novo review, holding that plaintiffs failed to meet Del. Chancery Ct. R. 23.1 stringent pleading requirements of factual particularity with respect to lack of due care in decision-making and for waste of corporate assets. f. Order affirmed in part, reversed in part, and remanded to allow plaintiffs to replead facts creating a reasonable doubt that a board of directors' decision allowing non-fault termination was protected by the business judgment rule. The dismissal with prejudice was affirmed in all other respects. iv. Directors’ Duty of Good Faith Explicated 1. In re Walt Disney Company Derivative Litigation a. Appellant shareholders brought derivative actions on behalf of appellee corporation against appellees, the corporation's former president and directors who served at the time of the events complained of. The Court of Chancery of the State of Delaware, in and for New Castle County, ruled in favor of appellees, finding that the director defendants did not breach their fiduciary duties or commit waste. Appellants challenged that judgment. b. The shareholders claimed that a decision to approve the president's employment agreement and a decision to terminate him on a non-fault basis resulted from various breaches of fiduciary duty by the president and the corporate directors. The supreme court disagreed. No reasonably prudent fiduciary in the president's position would have unilaterally called a board meeting to force the corporation's chief executive officer to reconsider his termination and the terms thereof, with that reconsideration for the benefit of shareholders and potentially to the president's detriment. The decisions to approve the president's employment

IV.

agreement, to hire him as president, and then to terminate him on a no-fault basis were protected business judgments, made without any violations of fiduciary duty. Having so concluded, it was unnecessary to reach the shareholders' contention that the directors were required to prove that the payment of severance was entirely fair. Because the shareholders failed to show that the approval of the no-fault termination terms of the employment agreement was not a rational business decision, their corporate waste claim failed. c. The judgment was affirmed. 2. Problem 4-9 v. Officers’ Oversight and Reporting Duties 1. MBCA § 8.42 a. An officer, when performing in such capacity, has the duty to act: (1) in good faith, and (2) with the care that a person in a like position would reasonably exercise under similar circumstances. b. The duty of an officer includes the obligation to … Special Aspects of Derivative and Direct Litigation a. Derivative Litigation and the Demand Requirement i. The theoretical device does not play out as expected – the shareholders do not recover anything (the recovery goes back to the corporation), and the attorneys make big bucks ii. Aronson v. Lewis 1. Failure to make demand may be excused if a plaintiff can raise a reason to doubt that: a. (1) a majority of the board is disinterested or independent or b. (2) the challenged acts were the product of the board’s valid exercise of business judgment 2. Meyers Parking gives its CEO (and 47% shareholder) a sweetheart employment and retirement package 3. Shareholder Lewis claims this is waste. Why is this a derivative suit? 4. Who controls the corporations litigation decisions? Why doesn’t Lewis ask the board to sue? 5. Defendant directors appealed a decision in favor of plaintiff shareholder from the Court of Chancery (Delaware) which held that plaintiff sufficiently alleged a complaint of demand futility under Del. Ch. Ct. R. 23.1. 6. Plaintiff shareholder alleged that certain transactions conducted by defendant directors in connection with a subsidiary corporation violated the business judgment rule. Specifically, plaintiff asserted that defendants involved the

corporation in providing unjustified benefits to a financial consultant. Defendants responded by moving to dismiss the claim in its entirety. The chancery court denied the motion and held that under Del. Ch. Ct. R. 23.1, plaintiff successfully alleged demand futility in that he allowed defendants to correct the alleged wrong. The court reversed and remanded, holding that plaintiff's failure to allege facts implicating director bias, lack of independence, or involvement in activities contrary to corporate interest acted as a bar to meeting the requirement of demand futility. Accordingly, plaintiff was granted an opportunity to amend his complaint. 7. The court reversed and remanded to the chancery court, holding that plaintiff's complaint alleging demand futility was fatally deficient since he did not allege sufficient facts to implicate defendant directors for bias. Plaintiff was thus allowed to amend his complaint. b. Fiduciary Duty and Aronson’s First Prong i. In re The Limited, Inc. Shareholders Litigation 1. Wexner, who is The Limited’s CEO and controls 25% of its outstanding common shares, is also the trustee of the Wexner Children’s Trust that owns 18,750,000 common shares 2. The Limited holds a “call” option that provides it with the right to purchase the trusts common shares for $25.07 per share at anytime during a six-month period commencing July 31, 2006 3. In May 1999, The Limited common shares are trading at $40 per share. Thus The Limited’s option to purchase the Trust’s shares is “in the money” to the tune of $280,000,000 4. The Trust holds a “put” option pursuant to which it can force The Limited to purchase its shares for $18.75 at anytime prior to January 31, 2006. The Limited is required to keep $350,000,000 in a restricted account as security for this obligation to repurchase the Trust’s shares 5. The Limited rescinds the Stock Redemption Agreement as part of a share buy back ii. Problem 4-10 c. Demand Futility Under Aronson’s Second Prong or Under the Rales Test i. Rales Test – to excuse demand, “a court must determine whether or not the particularized factual allegations of a derivative stockholder complaint create a reasonable doubt that, as of the time the complaint is filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand”

ii. Ryan v. Gifford 1. Plaintiff shareholder filed a derivative action against defendants, the corporate board and compensation committee members, for an alleged breach of their duties of due care and loyalty in approving or accepting backdated options in violation of a stock option plan and stock incentive plan. The members moved to stay the action in favor of earlier filed federal actions in California; alternatively, they moved to dismiss the action on its merits. 2. The shareholder alleged that grants of stock options to the founder of the corporation were backdated, as the grants were too fortuitously timed to be explained as coincidence. The compensation committee which approved the transactions was composed of three of the six corporate directors under Del. Code Ann. tit. 8, § 141. The court found that the stay request was to be denied as Delaware had an overwhelming interest in resolving questions of first impression under Delaware law and the doctrine of forum non conveniens did not require the stay. Additionally, the shareholder provided sufficient particularity in the pleading to survive a motion to dismiss for failure to make demand under Del. Ch. Ct. R. 23.1. Further, there were sufficient allegations to raise a reason to doubt the disinterestedness of the board. In addition, the complaint alleged bad faith and, thus, a breach of the duty of loyalty sufficient to rebut the business judgment rule and survive a motion to dismiss. However, the shareholder lacked standing under Del. Code Ann. tit. 8, § 327 to assert claims arising before he became a shareholder. Finally, the action was not time-barred under Del. Code Ann. tit. 10, § 8106. 3. The court granted the motion to dismiss all claims arising before the shareholder became a shareholder by way of a merger. The court denied the remainder of the motion to stay or dismiss. d. Demand Futility in the Contest of Caremark Claims i. Stone v. Ritter 1. “In the absence of red flags, good faith in the context of oversight must be measured by the directors’ actions to assure a reasonable information and reporting system exists and not by second-guessing after the occurrence of employee conduct that results in an unintended adverse outcome” 2. Bank Secrecy Act: complicit and failure to notice Ponzi scheme - $50 million fine 3. Issue: demand futility? How likely that directors liable for

oversight of BSA compliance program? 4. Holding: approving and applying Caremark, no “sustained or systematic” oversight failure since “reasonable” compliance program existed 5. Plaintiff shareholders appealed a judgment of the Court of Chancery of the State of Delaware, in and for New Castle County, which granted defendant current and former corporate directors' motion to dismiss the shareholders' derivative action alleging a violation of the directors' duty of good faith regarding banking law violations. The chancery court dismissed the derivative complaint under Del. Ch. Ct. R. 23.1. 6. The bank and corporation paid fines and civil penalties for the bank's failure to file Suspicious Activity Reports in violation of the Bank Secrecy Act, 31 U.S.C.S. § 5318(g), in relation to a money laundering scheme. The shareholders alleged that the directors failed to implement any statutorily required monitoring, reporting, or information controls that would have enabled them to learn of the problems. On a appeal, the court found that the chancery court applied the correct standard. A necessary condition for director oversight liability was a sustained or systematic failure of the board of directors to exercise oversight. A consultant's report reflected that the directors not only discharged their oversight responsibility to establish an information and reporting system but also proved that the system was designed to permit the directors to periodically monitor the bank's compliance with regulations. Although there were ultimately failures by employees to report deficiencies, there was no basis for an oversight claim seeking to hold the directors personally liable for such failures by the employees. 7. The court affirmed the judgment. e. Dismissal of Derivative Litigation at the Request of an Independent Litigation Committee of the Board i. Zapata Corp. v. Maldonado 1. Appellant corporation brought an interlocutory appeal from an order entered by the Court of Chancery (Delaware) denying the corporation's motions to dismiss or for summary judgment in appellee stockholder's derivative action. 2. The stockholder brought derivative actions in state and federal court, alleging that the corporation's officers and directors had breached their fiduciary duty. The stockholder did not first demand that the board members bring the action, alleging that such a demand would have been futile

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as all of the directors were defendants. After replacement of some board members, the new board created an investigation committee. The committee determined that each action against the corporation should be dismissed. The chancery court denied the corporation's motion for summary judgment or dismissal, holding that the "business judgment" rule was not appropriate for dismissal of a stockholder's derivative suit. On an interlocutory appeal, the court reversed and remanded, holding that a court should inquire into the independence and good faith of an independent committee and the bases supporting its conclusions. The chancery court was then directed to determine, applying its own independent business judgment, whether the motion should be granted. 3. The chancery court's judgment denying the motions was reversed and the case was remanded for the chancery court's reconsideration of the motions. ii. Problem 4-11 Indemnification and Insurance a. Owens Corning v. National Fire Insurance Co.

Mergers and Other “Friendly” Control Transactions – Chapter 8 I. Introduction II. The Statutory Template a. Mergers i. Hewlett v. Hewlett-Packard Co. 1. HP agrees to merge with Compaq computers in an effort to remain competitive with Dell, IBM and others 2. Significant HP shareholder challenges the purported benefits of the merger based on 1) erroneous projections made by management and 2) “buying off” an investment bank/major shareholder b. Dissenter’s Rights i. If a shareholder dissents when asked to approve a merger and if the transaction nonetheless obtains the requisite approval, the dissenting shareholder may demand that his shares be repurchased by the corporation for fair value ii. Problem 8-1 III. Contracting Around Appraisal and Voting Rights a. Use of Alternative Transactional Forms i. Introductory Note 1. There are significant tax, accounting, and liability reasons to consider in choosing between the traditional merger form and one of the alternative forms ii. Sale of Assets

1. Advantage is more ability to theoretically leave liabilities with the acquired corporation (but sometimes the law will impose the liability on the acquiring corporation) 2. 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) 3. The selling corporation need not transfer all of its assets, as will occur in a merger 4. The liabilities of the selling corporation will not necessarily pass to the purchasing corporation by operation of law iii. Triangular Mergers 1. Forward – the acquired corporation merges into the acquiring subsidiary 2. Reverse – the acquiring subsidiary merges into the acquired corporation 3. Principal reason is to eliminate the voting and appraisal rights that the shareholders of the acquiring parent would otherwise have iv. Compulsory Share Exchanges 1. Permits one corporation to acquire all the shares of another while leaving the acquired corporation in existence v. Tender Offer 1. Bidding corporation offers cash/stock/etc. to the shareholders in exchange for the target’s shares (directly from the shareholder) 2. Most expensive because directly communicating with shareholders and federal law governs all of the communication and proxy materials b. “De Facto” Mergers i. Applestein v. United Board of Carton Corp. 1. Epstein, who had been the sole shareholder of Interstate, obtained effective control of the combined business (even though he received only 40% of United’s shares) 2. Under the transaction form used to achieve this corporate combination, United shareholders were not entitled to voting or appraisal rights 3. United shareholders filed suit seeking among other things, to have the transaction re-characterized as a merger, so that they would receive appraisal rights or equivalent relief 4. Plaintiff stockholders and defendant corporation filed cross-motions for partial summary judgment on the issue of the validity of an agreement that amounted to a merger that entitled dissenting stockholders to an appraisal of their stock. 5. Plaintiff stockholders challenged the proposed transfer of all shares and assets of first defendant corporation to

second defendant corporation, which would have included an assumption of all liabilities, a pooling of interests, total absorption of the first corporation and dissolution of it, joinder of officers and directors from both corporations, retention of some personnel, and a surrender by the first corporation's sole stockholder of his stock in exchange for newly issued shares in the second corporation. The parties filed cross-motions for summary judgment, and the sole issue before the court was whether the action constituted a merger. The court held that the corporate combination of both defendant corporations was a practical or de facto merger within the protective purview of N.J. Stat. Ann. § 14:12-7, and therefore plaintiffs were entitled to have been notified and advised of their statutory rights of dissent and appraisal. The court further held that the failure of defendant's corporate officers to have taken those steps and to have obtained stockholder approval of the agreement rendered the proposed corporate action invalid. 6. The court granted partial summary judgment and held that the corporate combination of two defendant corporations was a practical or de facto merger and because plaintiff stockholders were entitled to be notified and advised of their statutory rights of dissent and appraisal but defendants' corporate officers failed to take those steps, the corporate action was invalid. ii. Hariton v. Arco Electronics, Inc. 1. Arco first sold all of its assets to Loral in exchange for Loral stock 2. Second, Arco liquidated, distributing the Loral stock to its shareholders 3. As a result, the former Arco assets are owned by Loral and Arco’s former shareholders have become shareholders of Loral. The Arco shareholders received voting rights under Delaware § 271 because, in form, this was a sale of substantially all of Arco’s assets, but dissenting shareholders do not get the appraisal rights that they would have received if the transaction had been cast as a merger 4. Plaintiff shareholder appealed Court of Chancery for New Castle's (Delaware) grant of summary judgment for defendant corporation and dismissal of plaintiff's complaint, arguing sale of assets under Del. Code Ann. tit 8, § 271, dissolution and distribution of shares, a de facto merger, was illegal. 5. Plaintiff shareholder sued defendant corporation to enjoin consummation of a plan to sell defendant's assets under Del. Code Ann. tit. 8, § 271, dissolve pursuant to Del. Code

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Ann. tit. 8, § 275, and distribute the purchasing corporation's stock to shareholders. Plaintiff contended that the sale of assets and dissolution statutes could not be legally combined, and that the plan constituted a de facto merger without affording shareholders rights provided in the merger statute. The trial court granted summary judgment for defendant and dismissed plaintiff's complaint. The court affirmed, holding the combination of the sale of assets and dissolution statutes was legal. Although defendant's actions did accomplish a de facto merger, the sale of assets and merger statutes were independent and the validity of actions taken pursuant to one statute did not depend on the other. 6. The court affirmed; although defendant corporation's actions did have same result as a merger, combining sale of assets statute and mandatory plan of dissolution and distribution was legal. iii. Problem 8-2 The Intersection Between the Appraisal Remedy and Fiduciary-Duty-Based Judicial Review a. Cash-Out Mergers and the Business Purpose Test i. You can get rid of minority shareholders as long as there is a legitimate business purpose ii. Coggins v. New England Patriots Football Club, Inc. 1. Billy Sullivan forced out as president of Patriots in 1974 despite controlling 20% of the corporation’s stock 2. Together with family members and banks, puts together financing to purchase outstanding stock to regain control 3. When he regains control, establishes new entity to absorb the old corporation so that earnings can be used to service debt 4. Massachusetts law requires majority vote by each class of affected stock (although the shareholders in the class owned a non-voting class of stock) 5. Plaintiff, Vietnam veteran, sues alleging that the transaction is unfair and illegal 6. Plaintiff representing minority shareholders in a class action appealed from a dismissal of plaintiff's claim for waste of corporate assets and a decision of the Middlesex Superior Court (Massachusetts) that a freeze-out merger should not be undone. 7. Plaintiff representing minority shareholders brought a class action on behalf of himself and certain other stockholders of defendant corporation, following a freeze-out merger by the majority stockholder. The freeze-out was designed for the majority shareholder's own personal benefit to eliminate

the interests of the minority stockholders and did not further the interests of the corporation. The merger was a violation of fiduciary duty to minority stockholders, and therefore impermissible. Although rescission is the normal remedy, the court determined it would be inequitable and remanded for a determination of the present value of the nonvoting stock, as though the merger were rescinded. Those plaintiffs who did not turn in their shares and did not perfect their appraisal rights were entitled to receive damages in the amount their stock would be currently worth, plus interest at the statutory rate. Plaintiffs from a related federal court action were not permitted to intervene. 8. The case was remanded for further proceedings to determine damages in the amount of the present value of the nonvoting stock, as though the merger were rescinded. The claim for waste of corporate assets brought against individual defendants was reinstated. iii. Problem 8-3 b. The Weinberger Approach i. Weinberger v. UOP, Inc. 1. The concept of fairness has two basic aspects: fair dealing and fair price: a. The former embraces questions of when the transaction was timed, how it was initiated, structured, negotiated, disclosed to the directors, and how the approvals of the directors and the stockholders were obtained b. The latter aspect of fairness relates to the economic and financial considerations of the proposed merger, including assets, market value, earnings, future prospects… 2. Any time there are directors on both sides of the transactions, the test is entire fairness, not business judgment 3. Plaintiff appealed from decision of the Court of Chancery of the State of Delaware in and for New Castle County awarding judgment in favor of defendants in action brought by plaintiff that challenged the elimination of defendant's minority shareholders by cash-out merger between defendant and its majority owner. 4. Action was brought by plaintiff class challenging the elimination of defendant corporation's minority shareholders by a cash-out merger between defendant corporation and its majority owner. The lower court held that the terms of the merger were fair to plaintiff and the other minority shareholders of defendant corporation. On

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appeal, the court held that the record did not establish that the transaction satisfied any reasonable concept of fair dealing, as the matter of disclosure to the defendant's directors was wholly flawed by conflicts of interest raised in feasibility study, and the minority shareholders were denied critical information; thus, the vote of the minority shareholders was not an informed one. The court further held that the standard "Delaware block" or weighted average method of valuation, should not control. Rather, the court endorsed a more liberal approach requiring consideration of all relevant factors pursuant to Del. Code Ann. tit. 8, § 262(h). 5. The court reversed the judgment and remanded the matter for further proceedings. Appraisal and Entire Fairness Review After Weinberger a. Valuation Under Statutory Appraisal i. Cede & Co. v. Technicolor, Inc. 1. This was an appeal from a judgment of the Court of Chancery of the State of Delaware, in and for New Castle County, that appraised the fair value of appellee's shares in connection with a cash-out merger. 2. A majority of appellee corporation's shareholders approved a two step merger of another corporation into appellee. Appellants, dissenting minority shareholders, sought a valuation of the fair value of their shares. The court held that the only elements of value that could be excluded from the appraisal were speculative elements that arose from the accomplishment or expectation of the merger. The value added following the change in majority control between the first and second steps of the two step merger was attributable to the going concern on the date of the merger and was not speculative; thus, the value was required to be included in the appraisal process. The trial court's failure to include the added value resulted in an understatement of appellee's fair value. 3. The judgment was reversed and remanded because the value added following the change in majority control between the first and second steps of the two step merger was attributable to the going concern on the date of the merger, and the court had to consider it in calculating appellant's fair value in the stock. ii. Problem 8-5 b. Appraisal as the Exclusive Remedy i. In Delaware 1. Glassman v. Unocal Exploration Corp. a. Plaintiffs, a subsidiary corporation's minority

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shareholders, filed a class action against defendants, the parent corporation and its directors, alleging that the directors breached their fiduciary duties of entire fairness and full disclosure. The Court of Chancery, New Castle County (Delaware), held that the minority shareholders' exclusive remedy was appraisal and the shareholders appealed. b. A board of directors of a corporation which owned approximately 96 percent of the stock of another corporation and the subsidiary corporation's board of directors established committees to study a possible merger. The subsidiary corporation's committee consisted of three directors who, although also directors of the parent corporation, were not officers or employees of the parent company. The subsidiary corporation also retained financial and legal advisors to assist it during the review process and, after several meetings, its directors agreed to the merger at an exchange ratio of .54 shares of the parent corporation's stock for each share of the subsidiary corporation's stock. The state supreme court held that, in a short-form merger conducted pursuant to Del. Code Ann. tit. 8, § 253, the parent corporation did not have to establish entire fairness, and, absent fraud or illegality, appraisal was the only recourse for minority stockholders who were dissatisfied with the merger consideration. c. The state supreme court affirmed the chancery court's judgment. c. Litigating Entire Fairness – Lynch Claims i. In re Emerging Communications, Inc. Shareholders Litigation ii. Problem 8-8 iii. Problem 8-9 d. Lynch Claims and the Siliconix Transaction: The Impact of the Common Law on Deal Structuring i. In re Cox Communications, Inc. Shareholders Litigation Transfer of Control for a Premium a. Fundamental Principles i. Sale of Control Block 1. Tryon v. Smith

Changes in Control: Hostile Acquisitions – Chapter 9 I. The Market for Corporate Control a. Coffee, Regulating the Market for Corporate Control: A Critical Assessment of the Tender Offer’s Role in Corporate Governance

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b. Black, Bidder Overpayment in Takeovers: Manager Ignorance and the Winner’s Curse c. Kraakman, Taking Discounts Seriously: The Implications of “Discounted” Share Prices Judicial Review of Tender Offer Defenses a. Traditional Review i. Cheff v. Mathes 1. Holland sells home furnaces through a direct-employment sales method 2. Arnold Maremont begins purchasing Holland shares and threatens to change the business structure of Holland 3. Concerned about the threat posed by Maremont (and the corporations he controlled), the Holland directors vote to purchase the shares Maremont holds above market price 4. Shareholders sue – under what theory? 5. Defendant corporate directors appealed a judgment from the trial court (Delaware) in favor of plaintiff shareholders in a derivative suit. The trial court held that defendants were liable for losses allegedly resulting from the improper use of corporate funds to purchase shares of the company. 6. Plaintiff shareholders filed a derivative suit against defendant corporate directors, alleging that purchases of company stock with corporate funds were made for the purpose of ensuring the perpetuation of control by the incumbent directors. The trial court agreed with plaintiffs' allegations and found that the directors acted with the improper desire to maintain control. Defendants appealed. In reversing the lower court, the court noted that the evidence indicated that the directors' decisions were based upon direct investigation, receipt of professional advice, and personal observations of the company attempting a takeover. Based upon their information, the board of directors believed, with justification, that there was a reasonable threat to the corporation's continued existence. The question was thus one of business judgment and furnished no justification for holding the directors personally liable for losses even though, in hindsight, their decisions might not have been the best for the business. 7. The matter was reversed and remanded with instructions to enter a judgment for defendants as defendants met their burden of proof by establishing that they acted in good faith and after reasonable investigation. ii. Problem 9-1 b. The Enhanced Scrutiny Framework i. Introduction ii. The Unocal Doctrine

1. Unocal Corp. v. Mesa Petroleum Co. a. Defendant corporation appealed from decision of the Court of Chancery (Delaware) granting a preliminary injunction to plaintiffs and enjoining an exchange offer of defendant for its own stock. b. The lower court granted a preliminary injunction to plaintiffs, enjoining an exchange offer of the defendant for its own stock, concluding that such an offer was legally impermissible. The court on appeal was faced with the issue of whether defendant board of directors had the power and duty to oppose a takeover threat it reasonably perceived as being harmful to the corporate enterprise, and, if so, whether the action taken was entitled to protection of business judgment rule. The court held that there was directorial power to oppose plaintiffs' tender offer and to undertake a selective stock exchange made in good faith and upon a reasonable investigation pursuant to a clear duty to protect the corporate enterprise. The court further held that the repurchase plan chosen by defendant was reasonable in relation to the perceived threat and was entitled to be measured by business judgment rule. c. The court reversed the judgment and vacated the preliminary injunction vacated. 2. Problem 9-2 iii. Poison Pills 1. Moran v. Household International, Inc. a. Appellant dissenting director sought review of a ruling of the Court of Chancery (Delaware) that appellee corporation's preferred share purchase rights plan, a tool to defend against corporate takeover, was a legitimate exercise of appellee directors' business judgment. b. The directors voted to institute a preferred share purchase rights plan designed to defend the corporation from any hostile takeover. The dissenting director brought suit. The lower court ruled in favor of appellees. On appeal, the court affirmed. Sufficient authority for the plan existed in Del. Code Ann. tit. 8, § 157. The plan did not prevent stockholders from receiving tender offers, and the change to the corporation's structure was less than that resulting from the implementation of other permissible defensive mechanisms. The plan's

effect on proxy contests would be minimal. The directors were informed about the plan and adopted it in the good faith belief that it was necessary to protect the corporation. The plan was reasonable in relation to the threat posed. Therefore, the directors were entitled to receive the benefit of the business judgment rule. c. The court affirmed the lower court's ruling, finding that the adoption of the plan was within the directors' authority and was a reasonable defensive mechanism adopted in the good faith belief that it was necessary to protect the corporation from coercive acquisition techniques. Protecting Participants’ Expectations in a Closely Held Business: Corporations and LLCs – Chapter 5 I. Introduction a. Closely held businesses are fundamentally different form those that are publicly held in ways that are more dependent on the business environment than they are on law i. Closely held businesses are more intimate enterprises, lacking the separation of function that the corporate form permits with its distinct roles for shareholders, officers, and directors ii. No market exists for the ownership interests of these enterprises b. Separation of ownership as found in the corporate form supports specialized investment of human and money capital. The anticipated result of this separation norm is that: i. Shareholders are able to provide money capital while investing human capital elsewhere ii. Officers are able to specialize in day-to-day management without making money capital investments in the firm iii. The board of directors serves as a check on officers’ diligence and loyalty and as a buffer against shareholders’ inefficient interference in management c. In a close corporation, the statutory norms of centralized control and majority rule, when combined with the lack of a public market for shares, leave a minority shareholder vulnerable in a way that is distinct from risks faced by investors in public corporations II. Contracting as a Device to Limit the Majority’s Discretion a. As to Directors Decisions i. Zion v. Kurtz 1. Cross-appeals from the Appellate Division of the Supreme Court in the First Judicial Department (New York), which denied in part plaintiffs' motion for summary judgment in plaintiffs' action alleging that defendants violated a stockholders' agreement.

2. Plaintiffs filed an action for declaratory and injunctive relief, asking that interest and escrow agreements executed without plaintiff principal shareholder's consent be declared in violation of the stockholders' agreement and annulled, and that the formation of subsidiaries be declared in violation of the agreement and that they be dissolved. On appeal, the court held that when all of the stockholders of a corporation agree that no business or activities of the corporation shall be conducted without the consent of a minority stockholder, the agreement is, as between the original parties to it, enforceable even though all formal steps required by the statute have not been taken. The agreement made by the defendants was violated when the corporation entered into two agreements without the minority stockholder's consent but was not violated by the formation of two subsidiaries, the minority stockholder's consent having been obtained. 3. The court affirmed in part the denial of plaintiffs' motion for summary judgment in plaintiffs' action alleging defendants violated a stockholders' agreement, since the provision proscribing corporate action without the consent of a minority stockholder was not against public policy and was enforceable. b. Voting Agreements as to Shareholder Decisions i. Ramos v. Estrada 1. Defendant shareholders sought review of an order from the Superior Court of Ventura County (California) awarding judgment to plaintiff shareholders in an action alleging that defendants breached a written corporate shareholder voting agreement. 2. Plaintiff shareholders sued defendant shareholders for breach of a written corporate shareholder voting agreement. The trial court awarded judgment to plaintiffs, finding that defendants materially breached the agreement. The trial court ordered defendants' shares sold in accordance with the specific enforcement provisions of the voting agreement. On appeal, the court affirmed, finding that the corporate shareholders' voting agreement was valid even though the corporation was not technically a close corporation. The court further found that the agreement, including its buy/sell provisions, was unanimously executed after defendants had a full and fair opportunity to consider it in its entirety. Finally, the court found that defendants violated the agreement voluntarily, aware of the consequences of their acts, and that they were provided full compensation, per the agreement.

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3. The order awarding judgment to plaintiff shareholders in their action alleging that defendant shareholders violated a written corporate shareholder voting agreement was affirmed. The court found that the voting agreement was valid even though the corporation was technically not a close corporation. Fiduciary Duty and Threat of Dissolution as a Check on Opportunistic Majority Action a. Traditional Judicial Deference to Majority’s Discretion i. Zidell v. Zidell 1. Defendants, corporations and individual directors, sought review of decrees from Circuit Court, Multnomah County (Oregon), which ordered each of the corporations to declare additional dividends. The decrees also directed the payment of plaintiff minority shareholder's attorney fees out of those dividends. 2. The minority shareholder, who held stock in four related, closely held corporations, sought to compel the directors of those corporations to declare dividends. He alleged that the corporations could afford to pay additional dividends, that he had left the corporate payroll, that those shareholders who were working for the corporations were receiving generous salaries and bonuses, and that there was hostility between himself and the other major shareholders. The court held that the evidence in support of these allegations was insufficient to meet the minority shareholder's burden of proof to show bad faith. The court found that a considerable amount of credible evidence had been introduced to explain the conservative dividend policy. The court further found that the minority shareholder had left his corporate employment voluntarily and was not forced out. 3. The court reversed and remanded the judgments for the minority shareholder with directions to enter decrees of dismissal. b. The Partnership Analogy as a Basis for Enhancing Minority Shareholders’ Rights i. Donahue v. Rodd Electrotype Co. 1. For many years, H. Rodd (80%) and Donahue (20%) were the shareholders of Rodd Electrotype Co. 2. From 1955 to 1970, the underlying team evolved and adapted to changed circumstances. 3. Gradually, the services of Rodd and Donahue became less critical to the firm’s success. C. Rodd became a director in 1963 and succeeded his father as President and general manager in 1965. In 1964, F Rodd, another of Harry’s sons,

replaced Donahue as plant superintendent. And H. Rodd gave a majority of his shares to his three children. 4. On March 30, 1971, the Donahues learned that the corporation had repurchased 45 shares from H. Rodd for $800 per share. When the Donahues requested that their 50 shares be repurchased for a like amount, the corporation refused, claiming financial inability. 5. Plaintiff, a minority shareholder in a close corporation, appealed from a decree of the Superior Court (Massachusetts), which dismissed plaintiff's suit for rescission of a purchase, by defendant purchasers, of a controlling shareholder's stock. 6. The controlling shareholder sold his stock to defendants; however, defendants refused to purchase plaintiff's stock. The trial court dismissed plaintiff's suit, because the initial transaction had been carried out in good faith. On appeal, the court held that in a close corporation, all shareholders owed one another a strict duty of utmost good faith and loyalty. Further, the court held that a controlling shareholder could not utilize its position to create an exclusive market for its shares. In this case, defendants had created a market for the controlling shareholder but refused to extend that market to plaintiff, thereby excluding her. Therefore, the court reversed and held that either the initial sale had to be rescinded or defendants had to offer to purchase plaintiff's stock at the same price agreed upon in the initial sale. 7. The decree was reversed, and the case was remanded for entry of a judgment. ii. Wilkes v. Springside Nursing Home, Inc. 1. Plaintiff minority shareholder brought an action against defendants, a corporation and its majority shareholders, in which he sought a declaratory judgment and damages. The court granted direct review of a judgment confirming a final report from a master of the Probate Court for the County of Berkshire (Massachusetts), which dismissed plaintiff's action on the merits. 2. Plaintiff and individual defendants entered into a partnership agreement. Plaintiff filed a bill in equity for declaratory judgment and damages in the amount of salary he would have received under the agreement had he continued as a director of the business, a nursing home. The judge of the probate court referred the matter to a master who, after lengthy hearing, issued his final report. Plaintiff argued that he should recover damages for breach of the alleged partnership agreement or should recover damages

because defendants, as majority stockholders, breached their fiduciary duty to him, as a minority stockholder. The court concluded that the master's findings were warranted by the record and the final report was properly confirmed. However, the court reversed that portion of the judgment that dismissed plaintiff's complaint and then remanded the case to the probate court for entry of judgment against defendants for breach of fiduciary duty with respect to the freeze-out of plaintiff. 3. The court concluded that the master's findings were warranted by the record and the final report was properly confirmed. However, the court reversed the part of the judgment that dismissed plaintiff's complaint and the court remanded the matter for entry of judgment against defendants for breach of fiduciary duty with respect to their freeze-out of plaintiff. iii. Problem 5-2 iv. Nixon v. Blackwell 1. Defendant directors of a closely-held corporation appealed from the decision of the Court of Chancery of the State of Delaware in and for New Castle County holding that defendants breached their fiduciary duties to plaintiffs by maintaining a discriminatory policy that unfairly favored employee stockholders over plaintiffs. 2. The Vice Chancellor held that defendants had treated plaintiffs unfairly by establishing employee stock ownership plan (ESOP) that favored employee, Class A stockholders, over plaintiffs, non-employee Class B stockholders. The court, applying the entire fairness standard, held that the Vice Chancellor erred as a matter of law in concluding that substantially equal treatment was required as to plaintiffs, because it was well-established that stockholders need not always be treated equally for all purposes. There was support in the record for the fact that ESOP was a corporate benefit and was established to benefit the corporation. The court held that defendants had met their burden of establishing entire fairness of dealings with plaintiffs, because the record was sufficient to conclude that plaintiffs' claim that defendant directors had maintained a discriminatory policy of favoring Class A employee stockholders over Class B non-employee stockholders was without merit. 3. The judgment was reversed and the matter remanded for proceedings consistent with the opinion on the grounds that defendants had met their burden of establishing the entire fairness of their dealings with plaintiff non-employee Class

B stockholders. c. The Modern Approach to Involuntary Dissolution i. MBCA § 14.34 1. Grants the defendant corporation the right to avoid a courtordered involuntary dissolution by electing to repurchase the complaining minority’s shares for fair value. It gives the majority rather than the minority the right to determine whether buyout will occur. It allows the majority to act opportunistically without risk that involuntary dissolution will result. ii. Thompson, The Shareholder’s Cause of Action for Oppression iii. In re Kemp & Beatley, Inc. 1. Appellants, corporation and its majority shareholders, sought review of Appellate Division of the Supreme Court, First Judicial Department (New York) decision affirming lower court's decision to grant petitioners' application for the judicial dissolution of appellant corporation unless the corporation or any shareholder elected to purchase petitioners' shares at fair value. 2. Appellants, corporation and majority shareholders, sought review of appellate court decision affirming the lower court's decisions to grant petitioners' application for dissolution of appellant corporation unless the corporation or any shareholder elected to purchase petitioners' shares at fair value within 45 days. The court affirmed, holding there was sufficient evidence supporting the lower court's conclusion that majority shareholders had altered a longstanding policy to distribute corporate earnings on the basis of stock ownership, as against petitioners only. Furthermore, the court reasonably determined this change in policy amounted to an attempt to exclude petitioners from gaining any return on their investment and no error occurred in determining that this conduct constituted "oppressive action." Moreover, no abuse of discretion occurred in concluding that dissolution was the only means by which petitioners could gain a fair return on their investment. The court merely modified judgment by permitting additional 30-day extension for exercising option to purchase petitioners' shares. 3. Lower court's decisions granting petitioners' application for judicial dissolution of appellant corporation modified to permit an additional 30-day extension to purchase petitioners' shares. No abuse of discretion occurred in concluding dissolution was only way petitioners could gain fair returns on investments as they were subjected to oppressive conduct of majority.

IV.

iv. Gimpel v. Bolstein 1. Plaintiff shareholder believed that the conduct of defendant fellow shareholders oppressed him. The shareholder filed a petition to dissolve defendant corporation, under N.Y. Bus. Corp. Law § 1104-a, and a derivative action, under § 626. The corporation and the fellow shareholders filed a motion to consolidate and dismiss both suits for failure to state a cause of action. 2. After the shareholder was discharged from the family corporation for embezzlement, he received no benefits from his ownership position. He alleged that he was excluded from corporate participation, that the profits only were paid out in salaries and not dividends, and that he was excluded from examining the corporate books. The court applied the reasonable expectations of the parties' test for oppressiveness and found that the facts did not warrant dissolution. The court also applied the lack of fair dealing test of oppressiveness and found that the shareholder's discharge and his later exclusion from corporate management were not oppressive. The corporation's policy of not paying dividends was firmly established and it was not required to change its policy. However, the court found that the corporation must allow the shareholder full access to the corporate records and they must either alter the corporate financial structure, start paying dividends, or buy out the shareholder's interest. In the derivative action, the court directed the corporation to allow the shareholder full access to the books and declined to interfere in the business judgment decisions of the corporation. 3. The court granted summary judgment to the shareholder on the petition for dissolution only to the extent that an injunction covers the corporation's future conduct. In the derivative action, the court denied summary judgment as to the waste allegation, it severed the claim of no access to the books and granted the summary judgment to allow the shareholder full access to the books. The court denied the motion to consolidate. Share Repurchase Agreements a. Concord Auto Auction, Inc. v. Rustin i. Three entrepreneurial siblings – brother Cox, sister Thomas and sister Powell – invest in the exciting and glamorous business of auto auctioning ii. They want an agreement to provide liquidity on death. If you were drafting for them, what issues should you address in the agreement? 1. Who buys? Corporation or the shareholders? First-refusal /

contingencies – death, withdrawal 2. Kind of right – “must/may”? Call or put? Contingencies – withdrawal, outside offer, death 3. Price? Book value, annual re-set, arbitration/appraisal 4. How funded? Insurance/self-funded, payment in installments? Repurchase account iii. Plaintiff close corporations filed an action for the specific performance of a stock purchase and restriction agreement against defendant administrator and contended that the administrator failed to effect the repurchase of the deceased's stock holdings as provided by the agreement. iv. The corporate bylaws called for an annual meeting at which a revaluation of share price was to be conducted. The shareholders signed a repurchase agreement providing that upon the death of a shareholder the shares held by him or her would be tendered to the corporations for repurchase. The administrator contended that because the corporations failed to hold the annual meeting, the court should intercede to set the share price. The court granted summary judgment in favor of the corporations and dismissed the administrator's counterclaims. The court found that neither the remaining shareholders nor the corporations had a duty to call the annual meeting and that they could not be held responsible for breaching a duty that did not exist. The court found no evidence of willfulness intent to deceive, or knowing manipulation on the part of the corporations or remaining shareholders. The court found that the share prices had been carefully set, were fair when they were established, and that they were evidenced by an agreement that bound all parties equally to the same terms. The court held that the administrator was obligated to tender the decedent's shares for repurchase. v. The court entered judgment as a matter of law in favor of the corporations and ordered that the repurchase agreement be specifically enforced. The court dismissed the administrator's counterclaims. b. Gallagher v. Lambert i. Executive employee of real estate brokering business agrees to stock ownership benefit with buyback provision specifying two different formulas based on length of service ii. Employer fires employee shortly before more beneficial formula applies iii. What’s the problem? 1. iv. Plaintiff former employee appealed from an order of the Appellate Division of the Supreme Court in the First Judicial Department (New York), which modified and, as modified, affirmed an order denying a motion by defendant close corporation for summary

judgment dismissing the first three causes of action of plaintiff's complaint and directing specific performance of a stockholders' agreement. v. Plaintiff former employee purchased stock in the defendant close corporation with which he was employed. The purchase of his interest was subject to a mandatory buy-back provision: if the employment ended for any reason before a certain date, the stock would return to the corporation for book value. The corporation fired plaintiff prior to the fulcrum date, after which the buy-back price would have been higher. The court considered whether the former employee's dismissed causes of action, seeking the higher repurchase price based on an alleged breach of a fiduciary duty, should be reinstated. The court concluded that the causes should not be reinstated and affirmed the dismissal. The court found that there was no cognizable breach of any fiduciary duty owed to the former employee under the plain terms of the parties' repurchase agreement. vi. Order denying defendants' motion for summary judgment dismissing the first three causes of action of plaintiff's complaint, and directing specific performance of the stockholders' agreement was affirmed, and the certified question was answered in the affirmative. The Limited Liability Company – Chapter 6 I. Introduction a. Elf Atochem North America, Inc. v. Jaffari i. Plaintiff brought a purported derivative suit on behalf of a Delaware limited liability company (LLC) calling into question whether: (1) the LLC, which did not itself execute the LLC agreement in this case (Agreement) defining its governance and operation, was nevertheless bound by the Agreement; and (2) contractual provisions directing that all disputes be resolved exclusively by arbitration or court proceedings in California were valid under the Delaware Limited Liability Company Act (Act). The lower court granted defendants' motion to dismiss based on lack of subject matter jurisdiction. The lower court held that plaintiff's claims arose under the Agreement, or the transactions contemplated by the agreement, and were directly related to actions as manager of defendant LLC. On appeal, the court held that (1) the Agreement was binding on defendant LLC as well as the members; and (2) since the Act did not prohibit the members of an LLC from vesting exclusive subject matter jurisdiction in arbitration proceedings (or court enforcement of arbitration) in California to resolve disputes, the contractual forum selection provisions must govern. The court affirmed. II. Planning for the Limited Liability Company

III.

IV.

a. Olson v. Halvorsen i. b. Problem 6-1 Fiduciary and Contractual Duties a. In General i. Bay Center Apartments Owner, LLC v. Emery Bay PKI, LLC 1. Nevis is funneling money from Emery Bay Member, LLC to pay the A&D Loan so that his personal guarantee is not triggered on the A&D Loan 2. Delaware courts take a narrow interpretation of the duties that an LLC can exculpate themselves from that the Delaware legislation have laid out b. Conflicting Interest Transactions i. Kahn v. Portnoy 1. Judicial Dissolution a. Legal Standard i. Fisk Ventures, LLC v. Segal 1. Doctor seeks to exploit immunological methods for cancer treatment 2. Forms Maryland LLC and interests private investor who provides capital subject to formation of Delaware LLC and “put option” for Class B interests 3. Business begins to fail and Fisk seeks judicial dissolution ii. Haley v. Talcott read for class on Monday (11/26) 1. Plaintiff manager member sued defendants, the limited liability company (LLC) and the investor member, for dissolution of the limited liability company under Del. Code Ann. tit. 6, § 18-802. The manager member moved for summary judgment. 2. The manager member and the investor member formed the LLC to own property upon which the manager member managed a restaurant that the investor member owned. The members each owned 50 percent of the LLC and gave a personal guaranty for the LLC's debt to a bank. After the members had a falling out, the manager member alleged that pursuant to Del. Code Ann. tit. 6, § 18-802 the court had to exercise its discretion and dissolve the LLC because it was not reasonably practicable for it to continue the business of the company in conformity with the LLC agreement. The investor member responded that the manager member was limited to a contractually-provided exit mechanism in the LLC agreement, by which he could buy out the manager member. The court found that it was not reasonably practicable for the LLC to continue to carry on business in conformity with the LLC agreement.

Further, the exit mechanism was not a reasonable alternative, as it was not sufficient to provide an adequate remedy to the manager member under the circumstances, as he would then be personally liable for the LLC's debt. Therefore, the manager member was entitled to a judicial dissolution of the LLC. 3. The motion for summary judgment was granted, and the parties were directed to confer and, within four weeks, submit a plan for the dissolution of the LLC. b. Waiver i. R&R Capital, LLC v. Buck & Doe Run Valley Farms, LLC 1. Balancing Equitable Discretion and Respect for Private Ordering in Other Contexts

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