Corporations

Fall 2015—Broughman

Chapter 1: Business Formation

- Choice of Entity, where to incorporate, filing the charter

Chapter 2: External obligations of business parties

- Liability to creditors and other third parties
o Agency law (liability under contract and tort)
o Limited liability and its exceptions—PCV

Chapter 3: Internal Governance of the Corporation

- Conflict between shareholders and management
o Fiduciary obligations (procedural enforcement and substance of the obligation)
o Voting rights
o Special duties that arise in takeovers

Chapter 4: Disclosure, Fairness, ands tock markets

- Overview of federal securities fraud (Rule 10b-5)

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Chapter 1: Business Formation
Choice of Entity
Where to Incorporate (Race-to-the-Top)
Filing the Charter

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 Conceptual Views of the Corporation
and its Constituents
Four Key Concepts
1. Limited Liability
2. Agency Conflicts
3. Equity holds a residual claim
4. Two types of corporations

**Theme through all four is investor protection: equity investor is protagonist in our story—we want to
see them succeed.
- Business Formation
o Entrepreneurs choose a business form that facilitates investment.
- External Obligation of Business Parties
o Limited liability encourages investment by shielding investors from corporate liabilities
- Internal Governance of the Corporation
o Fiduciary obligations and voting rights are designed to protect equity investors against
management
- Disclosure, Fairness, Stock Markets
o Provides investors with accurate information

Key Concept #1: Limited Liability

Shareholders are not personally liable for a corporation’s debt or liabilities.
- A shareholder may lose the value of his investment in that company, but nothing more (usually).
- Rationale: A corporation is a separate legal “person.”
- Compare two scenarios:
o M. Corp signs a catering contract with a client, but breaches by failing to deliver food on
time. Who is liable for the harm?
▪ M Corp, which signed contract through its agent (Manny)—acting as CEO, not
personally.
o Manny is working on a job and spills boiling hot coffee on a guest, causing 3rd degree
burns. Who is liable for the harm?
▪ Potentially both Manny and M. Corp. through respondeat superior.
▪ Key concept: Limited liability does not protect you from your own misdeeds. It
just protects you from the misdeeds of the corporation!

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Scenario: M Corp Hires an Employee
Limited liability becomes really important when you add employees!
- M Corp, not Manny, is liable for employee’s actions (through respondeat superior)

Illustration: Corporate Formation

Sole Proprietorship – simplest form of business! Corporate Entity – Manny and his imaginary
friend
Investors Manny - Creates separate legal entity: corporation
Board of Directors N/A can hold assets separately
Management/CEO Manny Changes liabilities – partitions Manny’s assets
Employee Manny and M. Corp.’s
Business Manny
Assets/Liabilities

Investors Manny
Board of Directors N/A
Management/CEO Manny
Employee Manny
Business M Corp
Assets/Liabilities

Key Concept #2: Agency Conflict

The problem of motivating a party (agent) to act on behalf of another (principal) is known as the
principal-agent problem.
- When an agent has different interests than the principal, this is referred to as an agency conflict.

Key: We have to find some way to motivate/bind the agent and get him to act for the betterment of his
investors (his principals).

Preventing Agency Conflicts

- Equity compensation
o Legal implementation: give employees equity stake in corporation
▪ But costly
- Performance bonuses
o Legal implementation: employment contract, commission on sales, etc.
- Imposing fiduciary duties
o Legal implementation: corporate law

Corporate Law: Three Conflicts

1. Conflicts between managers and shareholders,
2. Between controlling and minority shareholders, and
3. Between shareholders as a class and non-shareholder constituencies of the firm such as creditors
and employees.
**This class: mostly focusing on conflicts between managers and shareholders.

Illustration: M Corp Needs More Financing

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 Investors Manny = 51%
Sharon = 49%
Board of Directors Manny
Management/CEO Manny (CEO)
Employee Emily
Business M Corp
Assets/Liabilities

Hypothetical: Manny wants to be a famous chef and doesn’t care about the business.
- This is an agency conflict.
o Agent: Manny
o Principal: Sharon
- They might have conflicting interests because corporate law does not solve all problems (e.g.,
laziness)

Key Concept #3: Debt and Equity (Equity Holds Residual Claim)
Corporate law protects shareholders, creditors, because creditors get their own protections.
- Creditors rely on contract law to protect their investments.

Debt Equity
Types Loans, bonds, debentures, notes Common stock, preferred stock, stock
options
Holder Often a bank (may be called creditor, Shareholder, stockholder, equity-holder,
debt-holder, bondholder) etc.
Priority Paid first when firm is sold or liquidated Paid last when firm is sold or liquidated
Type of claim Fixed Residual
Primary legal Contract law Corporate law
protection

Jane gets initial investment from bank of

$1M, plus contributes $.5M herself.
Good outcome: Jane sells when the company is
worth $2.5 million. Bank gets $1M plus interest;
equity gets $1.4M.

Bad outcome: Jane sells when company is worth

$.9M. Equity gets nothing; bank gets $.9M (and
if Jane was required to personally guaranty loan,
she may be required to pay the rest herself)

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Illustration: M Corp Takes on Debt
Investors Manny = 51%
Sharon = 49%
Craig = Creditor
Board of Directors Manny
Management/CEO Manny (CEO)
Employee Emily
Business M Corp
Assets/Liabilities
- Primary protection for Craig: contract for
loan! (not corporate law)

Key Concept #4: Two Types of Corporations

Publicly Held Closely Held

Examples Google, Microsoft, Ford, Pfizer . . . Local restaurants, small construction
companies, early stage startups
Number of Thousands (unlimited) Very few
shareholders
Market for NYSE, NASDAQ, etc. Restricted
shares
Sources of State Corporate Law State Corporate Law
Law/Regulatio + (limited federal regulation)
n Federal Securities Regulation (SEC)
+
Exchange rules (e.g., NYSE)

Illustration: M Corp Goes Public (Shares Traded Over NYSE)

Investors Manny = 51%
Sharon = 49%
Craig = Creditor
Board of Directors Board of outside
directors
Management/CEO Manny (CEO)
Employee Emily (+ others)
Business M Corp
Assets/Liabilities

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 Conceptual View of the Corporation: Corporation as Contract?
Corporate governance is primarily a matter of law rather than contract, even though parties are free to
contract around the default corporate law rules.
- Two “types” of corporate rules:
o Default rules: can modify contractually (this is most of corporate law)
▪ Example: DGCL § 212 Voting rights of stockholders
▪ Parties could contract around this rule. Parties have a lot of flexibility in drafting
their charter
o Mandatory rules: parties can’t modify (or can only do so at significant cost)

Corporation and Contract

“The great bulk of corporate law deals with relationships among the owners and managers of firms. Those
relationships are, at bottom, contractual, in the sense that the parties involved enter into them voluntarily
and they do not directly affect third parties. This leads one naturally to ask why we need rules of law to
govern those relationships. Why is corporate governance a matter of law, rather than of contract?”

Charter as Private Constitution

Each corporation:
- Files a charter (certificate of incorporation) with the state of incorporation; and
- Drafts a set of bylaws that govern internal affairs of the business.

Charter + bylaws = private constitution

- When a person buys stock in a corporation, they consent to the terms of the Charter/Bylaws
(private constitution)
o Can a prospective shareholder negotiate for different charter terms?
▪ In most cases, no. But for smaller businesses, maybe—it depends on how badly
the corporation needs your investment.

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Corporate Law: Providing the Charter You Always Wanted to Write, but Never Had Time
To
Corporate law provides gap fillers when charter is incomplete.
- What happens if Manny files a charter for M Corp, but doesn’t specify any details?
o Business is still valid—default corporate law fills in the gaps.

Flexibility
- Business have broad freedom to specify the terms of their corporate charter.
o Can incorporate in any state
o Corporations are only one of many business forms (corporation, limited partnership,
general partnership, LLC, LLP, sole proprietorship, “S” corp, etc.)
- But for large, publicly traded firms, this flexibility is rarely exploited.
o This allows charters to evolve as state law changes
▪ There are high transaction costs associated with amending charters (
▪ Network effects compel standardization—it’s easier if everybody is on the same
footing (especially for valuing stock)
o Real argument, according to Hansmann: it’s too hard to change corporate charters, so
corporations prefer to have them evolve with state law
- Smaller firms are more likely to exercise freedom of contract.

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 Corporate Formation
Sources of Law
- Corporate law is a highly “statutized” area of law.
• Significant amounts of statutory interpretation!
- Some background common law rules
• Especially fiduciary duties, but some others
- Most corporate law is default rules
• However, it can be costly/difficult to contract out of default (may require changes in
central governing documents, e.g.)
- Principal focus: Delaware (DGCL)

Hierarchy of Corporate Law

Default Rules Mandatory Rules
Certificate of Incorporation
(Charter)
Corporate
Bylaws Statute

Corporate Statute (i.e., the default) Judicial

Decisions

Judicial decisions

Deciphering the Charter

Certificate of incorporation = charter.
- Publicly available document
- Filed with Secretary of State

Broad Structure
- Required Disclosure [DGCL § 102(a)]
- Optional information [DGCL § 102(b)]
• Contracting out of default provisions of DE law.

What can we learn about a firm from its charter?

- How many classes of stock? Number of authorized shares?
- Any special voting rights?
- Board composition?

Mandatory Terms – DGCL § 102(a)

1. Name of the corporation;
2. The address of the corporation’s registered office;
3. The purpose of the corporation;
4. The number of shares the corporation is authorized to issue;

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 5. The name and address of each incorporator; and
6. The name and address of the corporation’s initial directors (if they are specified).

Key Takeaways
- Easy to get lost in all of the details.
- General principles of corporate law interpretation:
• When dealing with a default rule of corporate law, check to see if there is a charter/bylaw
provision on point before looking elsewhere.
• Corporate law is based on a statute. Look at the statute before reading cases (which might
help direct you to cases if there is ambiguity in the statute)

Choosing Where to Incorporate

The majority of publicly traded corporations are incorporated in Delaware.
- Even privately held startup firms: absent other factors that would sway you to your home state,
you are overwhelmingly more likely to incorporate in Delaware.
- Why?
• High proportion of franchise tax revenue
• Constitutional supermajority requirement (promotes stability for risk-averse firms)
• Investment in legal capital

State Competition for Corporate Charters

Each state is basically selling a product: corporate law.
- Businesses pay with franchise taxes.

Race to the top: Designing a body of law that is good for shareholders.
- Race to the bottom: Designing a body of law that is good for managers.

Race to the Top Race to the Bottom

Minimal agency conflict (managers Big agency conflict (managers often
Assumptions
act in SH interests) act contrary to SH interests)
Who benefits from Shareholders (& society) Managers
choice
Evolution of Tends toward efficiency Giving managers more ways to
corporate law entrench and protect themselves
Policy Encourages state competition Encourages federal oversight
Study Romano reincorporation study: Subramanian study:
Value of companies/stock price Managers migrate to states that
tend to go up around DE provide anti-takeover protections
reincorporation event for managers
If you think it’s a race to the top, you don’t want federal standards involved because competition benefits
everybody.
- If you think it’s a race to the bottom: you think we need federal corporate law.

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Event Study: Delaware Reincorporation
- Share prices go up after firm reincorporates in Delaware; market must infer that DE law provides
some benefit
• This is evidence that it’s a race to the top
- But: it may have less to do with the quality of DE law and more with lawyers’ familiarity with it.

Choice of Law: Internal Affairs Doctrine

Internal affairs should only be regulated by the law of one state.
- If you choose to incorporate in Delaware, that choice doesn’t do you any good unless you have
some choice-of-law principles to back it up.

Rule: Corporation will be governed under the law of its state of incorporation.
- So choosing where to incorporate = making a choice of law decision!!
- Only applies to internal affairs of corporation (matters pertaining to the relationship among the
corp. and its officers, directors, and shareholders)
• Shareholder voting, fiduciary litigation, corporate dividends, approval of mergers, issuing
stock, etc.
- Does not apply to external affairs of corporation
• Labor laws, environmental laws, state taxation, contracts the firm enters into, etc.
(between firm and third parties)
- But note: sometimes the dividing line is unclear.
- EXCEPTION: shareholder right to inspection

Policy Issues
- Without the internal affairs doctrine:
• We would have a jumbled mess of multiple states being able to regulate.
• There are real benefits to being able to predict how the law will be applied – no internal
affairs doctrine is hard for planning purposes.
- IAD separates (i) choice of corporate law from (ii) location of business assets, shareholders, etc.
• Different from most jurisdictional issues in this sense.
• But IAD does not prevent federal regulation! Securities law, etc.  lots of overlap

VantagePoint v. Examen
- Facts: Board wanted to sell Examen; VantagePoint held 83% of Class A stock and didn’t want to
sell.
- Can VantagePoint block the merger?
• Transaction requires:
o Board authorization (which doesn’t help VantagePoint, since it doesn’t control
the board); AND
o Shareholder vote in favor of the sale.
- California law: each class of stock has to approve the merger (and VantagePoint controls Class A
stock)—CA law would override charter and allow VantagePoint to vote as a class
• Charter: preferred stock votes with common stock
- Charter is OK under Delaware law.
• But California Long-Arm Provision: extends certain “mandatory” provisions of CA
corporate law to ‘foreign’ corporations (regardless of where they are incorporated) f they
have significant ties to California.
o Forms quasi-California corporation

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- Race to the courthouse: notice how quickly DE decided this case (because DE has a strong
interest in asserting its authority)
- California wants to carve out what it thinks is a narrow exception.
• But really: it’s not. It covers really all of corporate law.
• And the choice of which state’s law to apply could change as shareholder composition
changes; we need to be able to predict what law is going to be applied.
- Reaches constitutional issue of commerce clause because DE wants to set up binding
constitutional law precedent that constraints CA.
• Otherwise, CA would not have put much weigh on DE court interpretation of CA law.

Choice of Entity
I. Two Primary Business Forms
a. Plus a lot of variations
II. Corporation
a. Pro: limited liability
b. Con: Entity level tax treatment
c. Variations:
i. C Corp (entity taxation)
ii. S Corp (pass through taxation)
1. Cannot have more than 100 owners
2. Can only issue one kind of stock
iii. Limited Liability Company
1. Pass through taxation + limited liability
III. Partnership
a. Con: Unlimited liability
i. Each partner has authority to bind the partnership
ii. Personally liable for partnership obligations
b. Pro: Pass-through taxation
i. No double tax penalty
ii. Better treatment of business losses
c. Variations:
i. General Partnership (GP)
ii. Limited Partnership
1. General partners bear full liability
2. Limited partners are passive investors and have limited liability
iii. Limited Liability Partnership
1. Law/accounting/medical firms, which cannot form LPs (law firms: can’t
have partners who aren’t lawyers)
2. Unlimited personal liability for own actions (malpractice), but only liable
for partner’s misdeeds to the extent of partnership’s assets
iv. Sole proprietorship (i.e., a one-person partnership)
IV. Other Alternatives
a. Traditional Non-Profit Entity
i. Mission statement + IRS filing [501(c)(3) status]
ii. No owners
b. “Benefit” corporations (B Corp) & Low-profit Limited Liability Corporation (L3C)
i. Has owners and can make profit, but explicit statement that business may pursue
other goals
c. Cooperatives

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 i. Business owned by the users of its service

Real choice is between corporation and LLC.

- Partnerships have been replaced by LLCs, because they provide all good things from partnership
law AND limited liability of corporation.
- Focus on corporations rather than LLC is based on pedagogical grounds.
• Not a lot of case law on LLCs, and states often look to corporate law by analogy when
deciding LLC cases.
• But don’t assume everything is the same!

Contrast: Partnership v. Corporation

Partnership Corporation
No (but contract may sometimes Yes (but creditors may seek guarantees)
Limited Liability
mimic LL)
Free transfer No (default) Yes (default)
Continuity At will (default) Indefinite (default)
Fiduciary duties Care/loyalty Care/loyalty
Management Decentralized (default) Centralized
Flexibility Excellent Sometimes awkward/hard
Formation Informal Formalities required
Tax Treatment “Pass-Through” Double on earnings; corporation only on
losses.
Variations General Partnership C-Corp [entity-taxation]
[sole proprietorship—GP with one S Corp [pass-through taxation; cannot
partner] have more than 100 owners; can only issue
Limited Partnership one class of stock
Limited Liability Partnership
HYBRID: Limited Liability Company
- Pass through taxation + limited liability
- No personal liability for LLC obligations, but still personally liable for
individual acts/omissions

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Sources of Law
Partnership Corporation LLC
Based in common law, but State code (primarily default LLC statute now available in all
- Most states have a terms) states (default terms)
general partnership and - Can be modified by - Modified by LLC
limited partnership act charter/contract operating agreement
(primarily default terms) (maximum contractual
- Can be modified by flexibility)
partnership agreement - Operating agreement is
very important to taking
advantage of the LLC
form

LLC Operating Agreement

Drafting an effective operating agreement (partnership agreement) can make LLC (partnership) more
costly than corporation.
- LLC statutes often do not provide good default provisions.
- Cost of forming an LLC has gone down substantially with automated operating agreements (e.g.,
Legal Zoom)
Formation/Disclosure
Filing with Secretary of State
Sole Proprietorship None Nothing required here because purpose of filing is to put third party
General on notice that they are dealing with limited liability entity; these
None
Partnership forms have no limited liability.
LP Yes Certificate (must list general partners)
LLP Yes Certificate
C Corp Yes Articles of Incorporation (Charter)
S Corp Yes Articles of Incorporation (Charter)
LLC Yes Articles of Organization + must draft operating agreement

Limited Liability
Limited Liability
Sole Proprietorship None
General Partners jointly and severally liable for partnership obligation, but
None
Partnership can provide indemnification and insurance
LP General partners: full liability
Limited partners: limited liability
Some
**Could protect general partner if general partner is an LLC (form
would triumph over substance)
LLP Unlimited liability for own actions, but limited liability for partners’
Some
misdeeds
C Corp Yes
Shareholders have limited liability, but creditors may ask for personal
S Corp Yes
guaranty and shareholders may be subject to veil piercing.
LLC Yes

Management and Control

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 Management
General Partners have equal voice and all participate in management (unless partnership
Partnership agreement says otherwise)
LP General partners manage (and limited partners may get to vote on extraordinary
events)
LLP Same as general partnership.
C Corp Management vested in board (separation of ownership and control)
S Corp Management vested in board (separation of ownership and control)
LLC - Member-Managed: all members engage in management (similar to
partnership)
- Manager-Manager: management delegated to “managers” (do not have
to be members) (closer to corporation)
Transferability of Ownership
Free Transferability of Ownership (Default Rules)
General Yes: can freely transfer financial interest in partnership
Partnership Yes/No No: Cannot transfer management role without consent of other
partners
LP General Partners: Same yes/no rule as general partnership
Yes/No//Yes
Limited Partners: Yes; interest is freely transferable
C Corp But, most close corporations restrict transferability through
Yes contract (shareholders want to know who they are doing
business with)
S Corp But, most close corporations restrict transferability through
Yes contract (shareholders want to know who they are doing
business with)
LLC The default rule varies from state to state; some states use
Varies
partnership-type rule, others allow full transferability
Taxation
Pass-Through Tax Separate Entity Tax
Sole Proprietorship Yes No
General
Yes No
Partnership
LP Yes No
LLP* Yes No
C Corp No Yes
S Corp Yes No
LLC* Yes No
*Technically, LLCs and LLPs get to choose whether they want pass-through or separate entity tax
treatment, but most choose pass through.
Main takeaway:
- Corporate tax is complicated and not the subject of this course.
- Just remember: LLC/partnerships generally have beneficial tax treatment, but the actual choice is
complicated.

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Chapter 2: External Obligations of
Business Parties
Liability to Creditors and other Third Parties:
Agency Law (Liability under Contract and Tort)
Limited Liability and PCV

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 Agency Law
Legal Concept of Agency determines:
- When can the actions of an ‘agent’ make the ‘principal’ (often a corporate entity) liable to a third
party for a contract or tort?
o Caution: economic concept of agency conflict different from legal concept of the agency
relationship.

Agency Conflict vs. Agency Relationship

Two distinct concepts:
1. Legal principal/agency relationship vs.
2. Economic principal/agency conflict

Law (relationship) Economic (conflict)

- A acts “on behalf of” P, and - A has different interests than P, and
- Under P’s “control,” - P does not control A
Which extends rights and obligations to third This is viewed from P’s perspective.
parties.
Contract vs. Tort
What does the definition of an agency relationship have to do with principal’s liability under (i) contract,
and (ii) tort?
- Restatement § 1: Agency is the relationship resulting from (i) the manifestation of consent by P to
A that; (ii) A shall act on P’s behalf; (iii) subject to P’s right of control; and (iv) A’s consent so to
act.

Contract Tort
Focus on the specific event/contract. Did A Focus on the relationship. Did P have sufficient
have authority (AEA, AIA, ApA, etc.) to enter control over A that the relationship falls into the
into the transaction/contract on P’s behalf? M/S category?
Ignore the general definition of an agency The general definition of an agency
relationship from RS 1. May or may not be relationship matters. You need:
satisfied. - Existence of P/A relationship AND
- AEA, AIA  Yes, P/A relationship - Extra emphasis on control
exists. In order for the relationship to be one of
- ApA  P/A relationship may not exist master/servant.
(equitable rule to protect third parties) Apparent Agency complicates things. Instead of
- R  P/A relationship did not exist at the proving master/servant relationship, tort victim
time of conduct. must prove:
1) Representation of P suggesting M/S
relationship, AND
2) Detrimental Reliance on such a
representation.

Types of Agency Relationship

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 Employer/Employee: Can bind in tort and contract

Independent Contractor: only in contract law; can’t bind

Creation of an Agency Relationship

Restatement of Agency § 1. Agency; Principal; Agent

(1) Agency is the fiduciary relation which results from the manifestation of consent by one person
to another that the other shall act on his behalf and subject to his control, and consent by the
other so to act.
(2) The one for whom the action is to be taken is the principal.
(3) The one who is to act is the agent.

Agency Defined: Gordon v. Doty

Where one undertakes to transact some business or manage some affair for another by authority and on
account of the latter, the relationship of principal and agent arises.
- Concerned about agency in this case because if there is an agency relationship, Doty may be
vicariously liable for Garst’s accident (school had sovereign immunity so couldn’t be sued)

Restatement of Agency § 219(1). When Master Is Liable for Torts of His Servants
(1) A master is subject to liability for the torts of his servants committed while acting in the scope of
their employment.

Agency exists if there is:

1. A manifestation of consent by Doty to Garst that Garst shall act
a. On Doty’s behalf
b. Subject to Doty’s control
2. And Garst consents so to act.

Manifestation of consent by Yes – she offers him the car.

principal to agent
On principal’s behalf Court says it doesn’t have to be solely for her benefit.
Subject to principal’s Yes – she set conditions on his use of the car (said that only he could
control drive it)
Agent’s consent Manifested through his actions, by driving the car

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Key Takeaways
- Not entering into a contract is not dispositive. Need to focus on conduct!
- Courts are usually quick to find respondeat superior when they can, because employers usually
have insurance, and courts want to protect innocent parties.

Consent and Control: A Gay Jenson Farms v. Cargill

A creditor who assumes control of his debtor’s business may be held liable as principal for the acts of the
debtor in connection with the business.

Manifestation of consent by Cargill has obviously consented to something. You don’t have to
Cargill to Warren consent to it being a principal-agent relationship as long as you
consent to the behavior!
On Cargill’s behalf Cargill had right of first refusal; obviously was making money on the
deal (and as business becomes more distressed, creditor looks more
and more like owner—think foreclosure)
Subject to Cargill’s control 1. Constant recommendations to Warren by phone
2. Cargill’s right of first refusal
3. Warren’s inability to enter into mortgages, purchase stock, or
pay dividends without Cargill’s approval
4. Cargill’s right of entry onto Warren’s premises to carry on
periodic checks and audits
5. Cargill’s correspondence and criticism regarding Warren’s
finances, officer salaries and inventory
6. Cargill’s determination that Warren needed “strong paternal
guidance”
7. Provision of drafts and forms to Warren upon which Cargill’s
name was imprinted
8. Financing of all Warren’s purchases of grain and operating
expenses
9. Cargill’s power to discontinue the financing of Warren’s
operations
Warren’s consent Accepted the line of credit from Cargill and sold grain to Cargill

When A Controlling Creditor  Principal

Suppose a bank (B) lends start-up capital to a business, but:
- Requires periodic audited financial statements to be sent to the bank;
- Requires veto rights on new projects, expansion, or improvements until note repaid)

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 Restatement of Agency § 14(O)
The point at which the creditor becomes a principal is that at which he assumes de facto control over
the conduct of his debtor.
Is bank a principal, and the business an agent?
- Bank is allowed to list a lot of “thou shalt nots” – but Cargill clearly went a lot further.
- Court here focuses on the nine factors that gave Cargill a lot of control over Warren
• If you’re a farmer and you see Cargill looking out for Warren like that, you’re more
likely to do business with Warren.
• Almost like a reliance argument: once Cargill is there (even as far as writing checks), the
farmers relied on that stability.

When a Purchaser  Principal

Restatement of Agency § 14(K)

One who contracts to acquire property from a third person and convey it to another is the agent of the
other only if it is agreed that he is to act primarily for the benefit of the other and not for himself.

Cargill just wore too many hats: owner and residual claimant; management; secured creditors; customers
- But Cargill frequently takes this position—they seem to like it.

Key Takeaways—Consent:
- There must be some manifestation of consent, but it doesn’t have to be consent to an agency
relationship.
Agency Liability Under Contract
Liability focuses on specific event/contractor: Did A have authority to enter into transaction on P’s
behalf?
- You can have more than one type of authority. As the plaintiff, you just want one: whichever is
the easiest to prove.

Types of Authority
1. Actual Authority
a. Actual express authority (AEA)
b. Actual implied authority (AIA)
2. Apparent Authority (ApA)
3. Ratification (R)
4. Inherent Agency Power (IAP) [applies primarily when there is a hidden principal]

Effect on Liability

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 - The type of authority only affects who the third
party can get money from.
- If A acted beyond his authority, principal can
recover from his misbehaving agent (but principal
bears the risk that agent will be able to indemnify)
- Agent is only at risk of liability if he acts beyond
scope of authority
- If agent has no authority of ANY kind and no
ratification: third party can sue A, but no principal.

**Note: in some jurisdictions, there is 6th type of

authority—estoppel—that we do not discuss

Agent’s Liability
- Tort: If an agent commits a tort, she is always liable to third party (and principal may be as well)
- Contract: more complicated

If principal is not liable under principles of agency, agent (or non-agent) may be liable to the third party
on one of two bases:
1. Common law fraud/deceit: Non-agent willfully/recklessly misrepresents facts of agency;
existence of agency is material; third party justifiably relies on misrepresentation;
misrepresentation actually induces third party to enter contract.
2. Warranty of Authority (Restatement § 329): Non-agent who purports to enter contract of
principal thereby becomes subject to an implied warranty of authority, unless agent manifests that
he does not make such warranty or the other party knows that the agent is not so authorized.

If principal is liable under principles of agency, agent’s exposure is more limited (but not completely
vitiated):
- Disclosed principal: A is (essentially) not liable
- Undisclosed/partially disclosed principal: A is liable as guarantor on the contract (even if A had
actual authority)
• Atlantic Salmon v. Curran: yes, you can be an agent for your own company:
o What sort of notice requirement seems to be applicable for identifying
principal? Seems like inquiry notice. If plaintiff had correctly identified
business as Marketing Designs, or if corporation had actually been
incorporated, plaintiffs might have been on notice of principal.
• Advice to Agents
o Disclose principal’s identity, especially if you have actual authority (e.g., sign
contracts: Jane Doe, CEO and agent of Doe, Inc.)

Who is better protected:

- Agent with AEA but hidden P (good silent A), or
- Unauthorized A acting under ApA for identified P (lousy loud A)?
**Law addresses this quandary by holding unauthorized A liable to P for breach of fiduciary duty
(indemnity)

Agent’s Duties to Principal: Fiduciary Duties

- An agency has a fiduciary duty to act loyally for the principal’s benefit in all matters connected
with the agency relationship.

21
 • No secret profits for agent.
• Agent cannot deal with principal as an adverse party.
• Agent may pursue personal opportunities with principal’s consent.
- Legal ethics is largely an application of agent fiduciary duties!

Actual Authority
Restatement § 2.02(1) – Scope of Actual Authority
(1) An agent has actual authority to take action designated or implied in the principal’s
manifestations to the agent and acts necessary or incidental to achieving the principal’s
objectives, as the agent reasonably understands the principal’s manifestations and
objectives when the agent determines how to act.

Both AEA and AIA look to communication (i.e.,

manifestation from P to A).
• Emphasis is on agent’s reasonable interpretation of
principal’s communication, which creates incentives for principal
to use very precise language if principal wants to avoid liability.
• Therefore, agent could act against principal’s interests and
still have actual authority (if principal did not give good
instructions)

Actual Express Authority

Actual authority can be created expressly—the most straightforward and simple way for a principal to
give an agent authority to act on her behalf is by stating it frankly and directly.

Actual Implied Authority

An agent has implied actual authority to take on such tasks that are necessary to accomplish the
principal’s express instructions.
- Based on whether the agent reasonably believes, based on conduct and the circumstances, that the
principal desired a certain task be done or that the agent had proper authority.
• Third party’s beliefs have no relevance!
- Example: Mill Street Church v. Hogan—handyman (Bill) had AEA to pain the church interior,
and in order to complete the task, he necessarily had to get some help (painting the building was
not a one-man job).
• The church had permitted Bill to hire helpers in the past and Bill could not realistically
finish the job by himself.

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Apparent Authority

Restatement § 8 – Apparent Authority

Apparent authority is the power to affect the legal relations of another person by transactions
with third persons, professedly as agent for the other, arising from and in accordance with the
other’s manifestations to such third persons.

Creating Apparent Authority

1) Manifestation from principal to third person (Rest. § 8),
2) Sufficient to create reasonable belief in third party that authority existed,
3) (in some jurisdictions) and which the third party actually believes/relies to her detriment. [much
harder to prove—easier to focus on reasonable belief]

ApA focuses on communication (i.e., manifestation) from

principal to third party.
• Emphasis is on third party’s reasonable interpretation of
principal’s manifestations.
• Agent can’t create this authority when P is silent—P must do
something
• Did P create some manifestation in the mind of the third party
that showed A could do what A did?

**If A acts with apparent, but not actual authority, P is bound to the
third party and has recourse against A.

Permissible Manifestations

3.
2. Through a reliable In limited situations, it come
1. Directly from agent to
intermediary (even the come through agent’s
third party
public—such as a communications to third party.
newspaper ad) to the But there still has to be
third party something that the third party
sees from principal (such as
prior conduct)
Examples: old school wax seal from
P on a letter that A gives to third
party; voicemail from P to A who
forwards to third party and
recognizes P’s voice

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ApA: Takeaways
Legal definition of “manifesting consent” under ApA can be quite broad:
- Explicit statements/communications;
- Assertive actions;
- Failure to correct mistaken assumptions;
- Conditional gifts;
- Job titles/descriptions

370 Leasing Corp. v. Ampex

- Facts: Joyce (370 Leasing) agreed to lease products to EDS, negotiating with Kays, a salesperson
for Ampex; Kays sent letter confirming sale. Ampex later reneged  Joyce did not have the
products to lease to EDS. Joyce argues there was clear offer and acceptance; court says signing
purchase agreement was only an offer. But did Kays have authority to accept the offer for
Ampex?
- A salesperson binds his employer to a sale if he agrees to that sale in a manner that would lead the
buyer to believe that a sale had been consummated.
- It was reasonable for Joyce to presume Kays had authority to bind Ampex.
• Title: salesman
• Mueller had said all communication would go through Kays
• We don’t expect someone like Joyce to know internal structure of Ampex—Ampex is the
cheapest cost avoider here.
Ratification
Restatement § 4.01 – Ratification Defined
(1) Ratification is the affirmance of a prior act done by another, whereby the act is given
effect as if done by an agent acting with actual authority.
(2) A person ratifies an act by
(a) Manifesting assent that an act shall affect the person’s legal relation, or
(b) Conduct that justifies a reasonable assumption that the person so consents.

No authority at time of execution of contract, but principal later assumes liability.

- Example: A acting without authority contracts to sell P’s car to third party. One day later P hears
about this and likes the price. P says to A: “I’m not happy you did this without talking to me first,
but I like the price and I am happy to go along with the deal.”
- Only effective if act occurs prior to P’s knowledge
- Has to ratify after the act (after A’s action)
- Can occur through things like affirmance/implied affirmance (silence/inaction when P receives
knowledge)
- Can’t wait to see if you get good news and then ratify if you get the news you’re looking for
- Just receiving profits not enough (unless you have knowledge of all material facts

Authority by Ratification
Occurs when:
- A person misrepresents his/her authority to act on behalf of principal (i.e. act is unauthorized), but
- The purported principal later ratifies (i.e., affirms) the unauthorized act.
**Key thing to watch for: 2 points in time (action, and then blessing)

Principal’s Affirmation
Can be express or implied.

24
 - But principal must know or have reason to know all material facts at the time of ratification

Timing of Ratification
Restatement § 4.05 – Timing of Ratification
A ratification of a transaction is not effective unless it precedes the occurrence of circumstances
that would cause the ratification to have adverse effects on the rights of third parties. These
circumstances include:
(1) Any manifestation of intention to withdraw from the transaction made by the third
party;
(2) Any material change in circumstances that would make it inequitable to bind the third
party, unless the third party chooses to be bound; and
(3) A specific time that determines whether a third party is deprived of a right or subjected
to a liability.
- Can’t wait for bad things to happen to third party before you ratify.
- Purpose: Need to make sure the principal is getting the same bargain the third party thinks they
are getting at the time they make a deal with the agent.

Botticello v. Stefanovicz
- Facts: Mr. and Mrs. S. own farmland as tenants in common; Mr. S negotiates to sell land to B
(which Mary expressly objects to). Husband enters into lease/sale K with B; B takes possession,
makes improvements, pays rent, and then tries to execute purchase option.
- Ratification requires acceptance of the results of the act with an intent to ratify, and with
full knowledge of all the material circumstances.
• Receipt of benefits on its own cannot constitute ratification unless the other requisites for
ratification are present! So if the original transaction was not purported to be done on
account of the principal, the fact that principal receives proceeds ≠ ratification.
- No AEA or AIA because she said she would not sell for that amount
- No ApA because Walter never said he was acting for his wife as her agent.
• Marital status on its own does not prove agency!
• Joint tenancy on its own does not prove agency!

Inherent Agency Power (IAP)

Restatement § 8A – Inherent Agency Power

Inherent agency power is a term used in the restatement of this subject to indicate the power of
an agent which is derived not from authority, apparent authority, or estoppel, but solely from
the agency relation and exists for the protection of persons harmed by or dealing with a servant
or other agent.

Restatement § 195. Acts of Manager Appearing to be Owner

An undisclosed principal who entrusts an agent with the management of his business is subject
to liability to third persons with whom the agent enters into transactions usual in such
businesses and on the principal’s account, although contrary to the directions of the principal.

- IAP created for second restatement; kind of a catch-all for cases that don’t seem to fit the other
categories, but where P is nonetheless liable to third party.

25
 - Exists for scenarios in which a manifestation from principal to third party is impossible because
the third party doesn’t know principal exists
- General rule: if there is a close call, the third party wins. Obligation is on either the principal or
the agent to disclose relationship—NOT on the third party to discover it.

Two Versions of IAP

1. Hidden Principal:
• A doesn’t inform third party about existence of P (third party thinks she is contracting solely with
A), and
• Inequitable result would happen if P is not liable.

2. General Agent:
• A is acting as a general agent for P;
• A’s actions are consistent with or incidental to transactions that this type of agent is usually
allowed to conduct (i.e., authority comes from the agent’s position); and
• Third party has no reason to believe A lacks authority.

Basic Elements for IAP in an “Undisclosed Principal” Case

1. Agent was a “general agent” for an undisclosed principal;
2. The transaction in question is usual or necessary in such a business;
3. Agent was acting on principal’s “account” (i.e., in P’s interest), although contrary to specific
directions of principal
**There also usually needs to be some kind of inequitable harm that would occur if the principal is not
liable.

Watteau v. Fenwick
- Facts: Fenwick purchased pub from Humble and retained Humble as manager; only authorized
Humble to purchase certain supplies. Humble purchased other items from Watteau for a long
period of time on credit. Fenwick argued that Humble had not been authorized to purchase from
Watteau on his behalf.
- No liability under AEA or AIA because Humble disregards Fenwick’s express instructions.
- No ApA because no manifestation from principal to third party.
• But note: a manager would normally have the authority to purchase such items (if there
had been a manifestation fro Fenwick to Watteau)
- How did court justify its “creation” of IAP?
• Analogizes to “dormant partnership”—keeping yourself hidden will not limit your
liability
- What purpose does the doctrine of IAP (at least this version) serve?
• Third party kind of gets second bite at the apple, but maybe business is only successful
because of hidden wealth of principal, which third party relied on.
- If IAP didn’t exist, does that mean that no one would be liable to Fenwick?
• No, agent is still liable to Fenwick—this just allows Fenwick to attach liability to
principal. Presumably agent could not be found.
- Hypotheticals Under § 195
• Would the outcome be different if the bar had been named “Earl’s Ale House” instead of
“Humble’s”?
o Might have put third party on notice of a possible principal.
• What if Humble had been purchasing real estate in neighboring counties for possible
future franchises?
o These transactions are not usual/necessary in his business.

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 • What if Humble had been pocketing the proceeds from the cigars/bovril?
o Then he is not acting in Fenwick’s general interest.

Liability under Tort

Tort liability focuses on relationship: Did principal have sufficient control over against agent that
relationship fell into master/servant category?
- How much control is necessary to create a principal/agent relationship? Minimal.
- How much control is needed to find a master/servant relationship? Extensive.

Elements to Prove Liability

Normal Rule: Master/Servant Relationship Apparent Agency
- All the elements of the tort, - All the elements of the tort,
- The existence of a P/A relationship, - Principal represents that another is his
- Sufficient “control” to classify as servant, and
master/servant relationship, - Such representation caused third party
- Action within scope of employment. justifiably to rely upon the apparent agent.

Master-Servant Relationship: Vicarious Liability

“For whoever employs another, is answerable for him, and
undertakes for his care to all that make use of him. The act
of a servant is the act of his master, where he acts by
authority of the master.” Jones v. Hart
- “Authority of the master”: not authority to commit tort—
but did the master have sufficient control over the servant
so that vicarious liability is reasonable?

Principal is only liable in Category 1 – and only when

agent is acting in scope of employment!!

**Vicarious liability does not protect the agent, who is always liable in tort. The difference is that the
principal may also be liable.

Two elements:
1) Existence of master/servant relationship (control); and
2) Servant was acting in the scope of employment.

Terminology

27
 Think about it in terms of a really strong
master/servant relationship.

Some employer/employee relationships may not

actually have sufficient control to qualify for
vicarious liability.

Restatement § 2. Master; Servant; Independent Contractor

(1) A master is a principal who employs an agent to perform service in his affairs and who
controls or has the right to control the physical conduct of the other in the performance
of the service.
(2) A servant is an agent employed by a master to perform service in his affairs whose
physical conduct in the performance of the service is controlled or is subject to the right
to the control by the master.
(3) An independent contractor is a person who contracts with another to do something for
him but who is not controlled by the other nor subject to the other’s right to control with
respect to his physical conduct in the performance of the undertaking. He may or may
not be an agent.

- Servant: controlled or subject to right of control by master

• The more control boss/business has, the more likely agent is servant.
- Independent Contractor: not controlled by or subject to control in physical conduct.
• IC might be an agent, but principal is not liable in tort
- Physical conduct: Not limited to type of work done by agent or even prescribing steps of the job.
Principal must have supervisory rights over how agent completes jobs/steps

Control Spectrum

Focus on control over physical conduct.

- Not limited to type of work done by agent or even prescribing steps of the job; principal must
have supervisory rights over how agent completes jobs/steps.
- But boundary between ordinary agent and employee/servant is hazy:
• Haziness is reflected/augmented by a multi-part test of “factors” that are neither
necessary nor sufficient for the existence of a master/servant relationship.

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Control does not actually have to be exercised—it just has to exist!!!

Indicia/Factors of Control over Physical Conduct (From Restatement § 220)

(a) extent of control which, by the agreement, the P may exercise over details of the work;
(b) whether or not the A is engaged in a distinct occupation or business;
(c) TRADE PRACTICE for the kind of occupation, with reference to whether, in the locality, the
work is usually done with or without supervision.
(d) the skill required in the particular occupation;
(e) whether P or A supplies the instrumentalities, tools; and the place of work for the person doing
the work;
(f) the length of time for which the person is employed;
(g) the method of payment, whether by the time or by the job;
(h) whether or not the work is a part of the regular business of the employer;
(i) whether or not the parties believe they are creating the relation of master and servant;
(j) whether the principal is or is not in business.

Measuring Extent of Control

- Direct Indicia
• Contractual allocation of principal’s control over agent’s physical conduct
• Course of performance—if principal practices control over agent’s physical conduct
• More like express conditions, instructions, etc.
- Indirect Indicia
• Less explicit, but may go toward showing nature of broader relationship. Examples:
o Lease rather than title to inventory/equipment
o Contingent rent
o Profit/loss-sharing, etc. (who bears risk?)

Example: Humble Oil & Refining v. Martin; Hoover v. Sun Oil

Element Humble Oil v. Martin Hoover v. Sun Oil
Products Title: principal; exclusive Title: agent; non-exclusive
Duration “at will” 30-day notice
Reports Required None; weekly visits
Appearance Signs/uniforms Signs/uniforms
Employees No control by principal No control by principal
Risk/Return Gas station: principal Managerial decisions: agent
Repair shop: agent Operating costs: agent/principal
Operating costs: principal
Humble is actually paying ¾ of Sun Oil has been more careful to make
operating expenses—agent isn’t really contract appear like agent had more control.
bearing any risk at all

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Scope of Employment
Demonstrating the existence of sufficient control to create a master/servant relationship is not enough!
You must also show that agent was acting “in the scope of” the master/servant relationship.

Restatement § 228. General Statement [of Scope of Employment Doctrine]

(1) Conduct of a servant is within the scope of employment if, but only if:
(a) It is of the kind he is employed to perform;
(b) It occurs substantially within the authorized time and space limits;
(c) It is actuated, at least in part, by a purpose to serve the master, and
(d) If force is intentionally used by the servant against another, the use of force is not
unexpectable by the master.
(2) Conduct of a servant is not in the scope of employment if it is too different in kind from
that authorized, far beyond the authorized time or space limits, or too little actuated by a
purpose to serve the master.

Tests for Determining Scope of Employment

Restatement’s Traditional Purpose Test

“Least Cost Risk Avoider/Bearer” Policy Based Test

Foreseeable Connection to Employment Test

- Harm is foreseeable; regardless of the fact that particular type of harm was unforeseeable or
principal took reasonable steps.
- Conduct by servant which does not create risks different from those attendant on the activities of
the community in general will not give rise to liability
- Conduct must relate to employment.

**These come from Bushey v. US

All three versions of this test are still used.

Liability Outside the Scope of Employment

Master is liable for servant’s torts outside the scope of employment if:
- Master intended the conduct/consequences; or
- Master him/herself was negligent or reckless; or
- The conduct violated a non-delegable duty of the master; or
- Servant purported to act on or to speak on behalf of the principal and there was reliance upon
apparent authority, or he was aided in accomplishing the tort by the existence of the agency
relation.

Franchising and Apparent Agency

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Franchises: Special Considerations
- Franchisers provide names, quality assurance, national advertising, and a system of operation, in
return for fees from franchisees.
- But franchisees own and operate the franchises.
• This distinction may help sever control because franchisee bears the risk and reward.
- Contract usually expressly denies that parties are principal-agent/master-servant.
• But you can’t disclaim an agency relationship that actually exists.
• Whether the franchisee is an agent/servant will depend on the actual relationship, not
what the contract says.

Murphy v. Holiday Inns

Holiday Inns was given no power to:
- Control daily maintenance;
- Control franchisee’s business expenditures, fix customer rates, or demand a share of the profits;
- Hire or fire employees, set wages, set standards for skills or productivity, supervise work
routines, or discipline employees
- **Key: Holiday Inns had no control to clean up spill.
o If tort were based on something Holiday Inn had control over, there might be more room
to argue that Holiday Inn is liable as a master.
- Would Murphy have had a chance at arguing that regardless of the franchise agreement, there was
an appearance that the franchisee was the servant of Holiday Inns, and that is enough to give rise
to tort liability?
o Possibly, under the theory of apparent agency.

Apparent Agency
Apparent Agency creates tort liability for the principal even though master-servant relationship
does not exist. (even in the absence of actual agency)
- This is the analogue to apparent authority in contract liability.

Many franchisors own and operate some of their retail units and franchise some.
- The problem is that the public will often not know which are owned by the company and which
are franchised by it.
- The trademark, uniformity, and standardization that undergirds a brand-name product or service
may also support a belief that the retail unit selling that product or service is operated by the
principal company rather than operating as an independently owned franchise.

Restatement § 267 – Apparent Agency

One who represents that another is his servant or other agent and thereby causes a third person
justifiably to rely upon the care or skill of such apparent agent is subject to liability to the third
person for harm caused by the lack of care or skill of the one appearing to be a servant or other
agent as if he were such.

How do you break “justifiable reliance”?

- Obvious/conspicuous signs
- No uniform franchise look

Miller v. McDonald’s

31
- Franchise agreement did not simply set standards; McDonald’s had the right to control the way in
which franchisee performed food handling and preparation.
• Plaintiff bit into a foreign object in her food.
- “Everything about the appearance and operation of the Tigard McDonald’s identified it with
defendant and with the common image for all McDonald’s restaurants that defendant has worked
hard to create through national advertising, common signs and uniforms, common menus,
common appearance, and common standards. The possible existence of a sign identifying 3K as
the operator does not alter the conclusion that there is an issue of apparent agency for the jury.”
- We don’t expect consumers to understand the intricacies of franchise relationships!!
• McDonald’s tried to argue that she relied on quality of individual franchises, not quality
warranted by the corporation itself. Unsuccessful argument!

32
 Limited Liability and “Piercing the
Corporate Veil”
Default rule: Can’t pierce the veil. Usually, you need to have done something wrong in order to pierce
the veil.

Liability for Pre-Incorporation Activity

General Fact Pattern: Promoter enters into contract on behalf of yet-to-be-formed corporation.
- Promoter: Someone who purports to act as an agent of the business prior to its incorporation

Legal Issues
1. Once the charter is filed, does the corporation become a party to the contract?
2. Once the charter is filed, is the promoter liable if the corporation breaches the contract?
3. If the charter is not filed, is the promoter liable on the contract?
4. If the charter is not filed or defectively filed, can the defectively formed entity (or individuals)
enforce the contract?

1. Once the charter is filed, does the corporation become a party to the contract?
Yes, but not automatically. The corporation must adopt the contract (which will be one of the
corporation’s first actions).
- Adoption can be effected:
• Expressly (typically by a novation); or
• Implicitly (e.g., ratification by acceptance of benefits)

2. Once the charter is filed, is the promoter liable if the corporation breaches the contract?
Yes. MBCA § 2.04: “All persons purporting to act as or on behalf of a corporation, knowing there was no
incorporation under this Act, are jointly and severally liable for all liabilities created while so acting.”
- Promoter is jointly and severally liable with corporation.

What if corporation adopts the contract? Is promoter released from liability?

- Not necessarily! Corporation cannot release its own founder from liability under a contract with
another party.
- Promoter can only be released from liability by the other party to the contract.

33
Illustration: Sole Proprietor Decides to Incorporate
Bilbo’s Cupcakes is a successful sole proprietorship. Bilbo has hired three employees. He leases a
storefront, and has several supply contracts for flour, sugar, etc. After two years, he decides that he wants
to incorporate his cupcake business.
- Suppose he forms a corporation “Cupcakes, Inc.” and sets up a bank account for the entity. He
pays wages and contract invoices out of the corporate account.
- Suppose Cupcakes, Inc. breaches one of the supply contracts. Who can the supplier sue?
• Supplier can sue Bilbo and corporation (which implicitly adopted the contract).
• What does this suggest about transitioning a sole proprietorship into a corporation?
o Bilbo should have gotten his vendors to sign new contracts with Cupcakes, Inc.

3. If the charter is not filed, is the promoter liable on the contract?

Yes. Absent an agreement to the contrary, the promoter remains liable on the contract if the corporation
never comes into existence. MBCA § 2.04.

4. If the charter is not filed or is defectively filed, can the defectively formed entity (or
individuals) enforce the contract?
Southern Gulf Marine v. Camcraft
A third party who deals with a firm as though it were a corporation and relied on the firm, not the
individual performance, is estopped from arguing that the firm is not a corporation.
- Corporation is seeking to enforce a contract made on its behalf before it was incorporated.
• But the corporation is defective: contract called for a Texas corporation, but firm
incorporated in Grand Caymans.
- Note the risk to Barrett in signing a contract before corporation had been formed: he’s on the
contract even if SGM does incorporate, unless Camcraft releases him!

De Facto Corporation vs. Corporation by Estoppel

De Facto Corporation Corporation by Estoppel
Treat firm as a corporation if the organizers: Treat firm as though it were a corporation if
1. In good faith tried to incorporate; the person dealing with the firm:
2. Had a legal right to do so; and 1. Thought it was a corporation all along;
3. Acted as a corporation. and
2. Would earn a windfall if now allowed to
argue that the firm is not a corporation.
Based on good-faith mistake of entrepreneurs. We don’t want to protect third parties who are
cleverly using non-existence of corporation to get
a windfall.
Example: Jamie tried to file incorporation Example: SGM v. Camcraft
documents, but due to processing error, her
business was never incorporated.
Note: Most states will not apply this doctrine to Note: The person doing business with the firm is
protect a person who was aware that the estopped from denying corporate status (e.g.,
incorporation effort at the time that they purported arguing promoters/SHs personally liable or no
to act on behalf of the corporation. party to the contract), but only applies to contract
claims, not tort claims. (You can’t consent to a
tort).

34
 Effect on Limited Liability: Grant shareholders Effect on Limited Liability: Grant shareholders
limited liability as though the corporation existed! limited liability as though the corporation existed
(if requirements of de facto corporation are met) as against contract creditors only (if the
requirements for estoppel for that creditor are
met)

Limited Liability
MBCA § 6.22(b)
Unless otherwise provided in the articles of incorporation, a shareholder of a corporation is not
personally liable for the acts or debts of the corporation except that he may become personally
liable by reason of his own acts or conduct.

In Praise of Limited Liability

- Limited liability encourages enterprise/financing innovation.
- Pretty well-recognized worldwide as good.

The Dark Side of Limited Liability

- Encourages excessively risky behavior
• Undermines incentives for precaution
• Undermines incentives for insurance
- Externalizes risk onto creditors, and possibly even to the public
• Consider 2008 financial instability

Bottom Line—Limited Liability:

- Encourages entrepreneurship and economic growth
- Facilitates a developed trading market for ownership
- Improves SHs’ abilities to diversify portfolios
- Improves creditors’ incentives to monitor corporate managers
- Decreases SHs’ incentive to monitor management
- Exposes third parties to unfair/inefficient externalities
But the good outweighs the bad.

Creditor Protection
- How can a creditor protect itself?
• Higher interest rate
• Demand personal guarantee
• Security interest (if collateral)
- Two types of creditors
• Voluntary: e.g., lenders
• Involuntary: tort victims
o E.g., BP didn’t have to pay money for oil spill; Deep Water Horizon was
limited liability entity on its own (did it out of political pressure)

Lending and Limited Liability

Trip to Vegas

35
You are about to go on a week-long trip to Vegas with your wealthy brother. Your brother offers $10,000
to help finance your gambling activities during the week. Two versions of the story: generous (but
foolish) brother, and stingy (but smart) brother.
- Generous Brother: Debt Stays in Vegas
• You must pay back the loan, but only out of your gambling funds.
• If you win money:
o You pay back $10,000 at the end of the week, but you get to keep your
winnings.
• If you lose money:
o you only need to give your brother back whatever you have left at the end of
the week; won’t have to pay him back out of other assets.
• Brother bears all of the risk! Which encourages you to take bigger risks.
• Takeaway: Limited liability externalizes risk.
- Stingy Brother: You Owe Me Your Soul
• You must pay back the loan regardless of how things unfold.
• Win or lose, you must pay back $10,000 (may have to dip into other assets)
- Suppose you are offered the following gamble:
• Put down $10,000 for a 10% chance of winning $80,000.
o Would you take it if you were with generous brother? Yes
o With stingy brother? No.

Small vs. Large Firm

Small Firms
- Significantly more likely to lose veil piercing motions.
- Judges seem to have trouble separating sole owner from corporate entity.
- Better predictor of outcomes than legal factors.

Large Firms
- No publicly traded firm has EVER lost a veil piercing claim.
- Blurring boundaries between corporation and thousands of shareholders is really hard!

Piercing the Corporate Veil

Alternative Approaches
- Agency law (respondeat superior)
• Was corporation an agent of defendant?
• Would have to show very strong level of control (and this is not how it would be handled
today)
• Plaintiff has to show tort + principal/agent relationship.
- Vertical Piercing (conventional)
• Allows you to reach the SH’s assets
• Basic question: did SH transgress SH-Corp boundaries?
• Plaintiff has to show: corporation is alter ego; blurred lines between shareholder and
corporation
• Common in small businesses
- Horizontal Piercing (enterprise liability)
• Allows you to reach sister corporations’ assets
• Basic question: did sister corporations transgress Corp-Corp boundaries?

36
 • Plaintiff has to show blurred lines between corporations.
- Reverse Piercing

Test for Piercing (Horizontal and Vertical)

(a) Unity of interest and ownership (alter ego), and

(b) Refusing to allow piercing would either
(i) Encourage fraud, or
(ii) Promote injustice.

Unity of Interest and Ownership

- Lack of corporate formalities
• No board meetings
• Never adopting bylaws
- Commingling of funds and assets
• No separate bank accounts
- Severe Under-Capitalization
• Running the corporation so that it has no money
- Treating corporate assets as one’s own
- Aggressive advertising  placing name on products, holding yourself as supporting the product
to increase confidence in product and sale.

Fraud or Injustice
- Need some kind of intent-like behavior.
- Don’t have to quite prove fraud, but you would have to show that not allowing piercing would
encourage fraud.
- An unpaid judgment is insufficient on its own (because otherwise, there would be no point to this
second prong)
- Some extra-equitable element (almost like blameworthiness—not just undercapitalization, but
intent to undercapitalize; it’s not just a coincidence)

Practice Pointers
It is hard to distinguish between the factors you need to prove “unity of interest” from those needed to
prove “injustice” prong.
- On a process level, what you need to prove is probably the same, but it’s so fact-based that it will
be hard to win on summary judgment.

Tort vs. Contract Claims: In re Silicon Breast Implants

Vertical Piercing Claim
- “Injustice” element not required in tort claims.
• Torts are not consensual. You can’t bargain for terms.
• Tort victims cannot protect themselves in the same way that parties to a contract can, so
we are more worried about fraud/injustice.

Vertical Piercing
Walkovszky v. Carlton
**Only contesting vertical piercing—not horizontal piercing

37
 - Facts: Each cab company had only two cabs registered in its name and each corporation carried
only the minimum liability insurance required by law; corporates basically operated as a single
entity re: financing, supplies, repairs, employees, and garaging; plaintiff trying to attach liability
to Carlton as the owner of all of them.
- Why is deliberate undercapitalization not enough to vertically pierce?
• Each corporation carried enough insurance to meet the statutory guidelines.
• Therefore, it can’t be the basis of attaching liability to shareholders; otherwise, every cab
owner who only carried the statutory minimum would always be personally liable.
• Corporate entities are not necessarily under-capitalized just because they don’t have
sufficient funds to cover a creditor’s claim!

Horizontal Piercing/Entity Liability

In re Silicon Breast Implants
(More a claim of direct liability—negligent provision of services that are necessary for protection of third
party)

- Many plaintiffs probably didn’t even know that Bristol-Myers wasn’t the manufacturer; B held
itself out as manufacturer and then was negligent in ensuring health/safety
- Many of the board members for the subsidiary didn’t even know that they were on a separate
board.
- Bristol-Myers needed to do more than look like a separate entity on paper; they needed to respect
corporate formalities in actuality.
• They shared counsel, members were not aware they were on the board, blurred finances
• Senior Bristol members of MEC board could not be outvoted.

**Note: plaintiffs could have also used theory of apparent agency/authority; they would have to prove a
lot of the same elements needed to pierce the veil.

Key Takeaways
- Courts are more willing to pierce the veil when pierce SH is corporation.
• The test is the same, but courts may be less rigorous with doctrinal requirements for
proof.
- Some have argued that this rule makes sense as a policy matter (entity theory of liability—not
yet embraced by US courts)
- If this is where PCV doctrine is evolving, is there any alternative organizational structure for a
firm that would be more resistant to piercing SH-corporation?
• What are the likely ex ante effects of entity liability?
o Buy more insurance
o Be less risky—spin off riskier product lines (bad news for plaintiff: likely to be
bought by corporation with no other assets and judgment-proof SHs)

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Reverse Piercing
Sea-Land v. Pepper Source
- Facts: Unable to recover on a default judgment against PS, SL sought to pierce corporate veil and
hold Marchese personally liable and pierce his other corporations.
- Not horizontal piercing because he wasn’t blurring lines between corporations.
• He wants to vertical pierce up to Marchese (who was blurring lines between himself and
his corporations) and then reverse-pierce his other corporations to get to their assets.
- Why was reverse piercing necessary?
• SL already entitled to all of Marchese’s personal assets, including his shares. What does
SL gain by reverse piercing?
o SL gains not just Marchese’s shares in TieNet, but the right to liquidate
the assets!
o Court must have felt that “innocent” third party shareholder in TieNet was not
entirely innocent.
• But the case for piercing Tie Net is not equally strong.
o Key takeaway: Reverse piercing and pulling out the assets puts SL ahead of
other creditors in bankruptcy proceedings (even though he had all of the shares
anyway once he vertically pierced).

Types of asset protection

Owner-shielding
- Standard account of limited liability. Protects the owner’s personal assets from business
liabilities.
• Nemesis: vertical piercing
- Another consideration: homestead/property exemptions
• Shows that maybe we don’t need owner shielding as much
• Example: Texas has unlimited homestead exemption; other states have it for other types
of property (tools of trade, livestock, etc.)

Entity shielding
- Protects the business assets from personal liabilities of individual shareholders
• If no entity shielding: we would get weird problems with not knowing how to value a
business; you would need to evaluate the credit-worthiness of its owners to understand
the business’s value.
- Nemesis: reverse piercing

39
 Chapter 3:
Internal Governance of the
Corporation
Conflicts Between Shareholders and Management:
Fiduciary Obligations (Procedural Enforcement & Substance of the Obligation)
Voting Rights
Special Duties that Arise in Takeovers

40
 The Problem: Agency Conflict
Agency Conflict: Basic Problem Motivating Corporate Law
“Corporate governance deals with the ways in which suppliers of finance to corporations assure
themselves of getting a return on their investment. . . . We want to know how investors get the managers
to give them back their money.”
- Shareholders know they are getting into this bargain. What kind of institutional setup can we
come up with that makes managers act in shareholders’ best interests?

Without Law…
Investment often occurs with minimal legal enforcement.
- Family/friend businesses:
• Reputational concerns. These are long-term relationships.
• This works very well in close-knit communities.
- Hostage exchanges to cement a business relationship
- Private enforcement (with threat of force)
• Mafia boss loans money to young entrepreneur; demands repayment, or else; etc.

Limitations on non-legal forms of corporate governance:

- Lack of predictability
- Limited # of investors
- Limited remedial methods

Key takeaway: Legal enforcement makes it easier to get investors!

So We Have: Private Contract

Ideal solution would be a full contract:
- “the financiers and the manager sign a contract that specifies what the manager does with the
funds, and how the returns are divided between him and the financiers. Ideally, they would sign a
complete contract, that specifies exactly what the manager does in all states of the world, and
how the profits are allocated.”
- Why would this be a problem?
• Too much is unforeseeable. The contract would have to be very long!

So corporate charters are imperfect contracts: they determine who gets to make decisions, not
substance of decisions.
- Gives managers lots of residual control rights.
• Possible problem that comes with discretion: controlling party may use position
opportunistically (e.g., managers deciding CEO pay)
- Alternative solution: give residual control to investors.
• But this would be like a full-time job for the investors, who invest because they don’t
want to be the boss!

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Which Gives Us Separation of Ownership and Control
Still causes problems, like:
- Outright theft by management
- Self-dealing by management
- Managerial entrenchment
- Bribes by management

Corporate law provides several “solutions” to these problems.

Solutions
1. Fiduciary Litigation
- Managers and directors owe a fiduciary obligation to shareholders. If managers fail to serve the
best interest of the corporation, they may be personally liable for breaching their fiduciary
obligation.
• This right can only be enforced by shareholders, who are more vulnerable than
employees or creditors.
o Employees are in high demand and have holdout powers.
o Creditors have other legal protections through, e.g., bankruptcy law.
• Shareholders have already sunk their capital!
o (To a certain extent, so have creditors, but see other legal protections)
o One solution: shareholders can “stage” their financing (common in Silicon
Valley)

2. Shareholder Voting/Governance
- Shareholders can also protect their interest by voting their shares or otherwise participating in the
firm’s governance. (e.g., electing new directors)
- Limitations
• Rational apathy: you are more likely to vote if you have a bigger interest
o But then we have problems with activist investors
• As Stalin noted, “it is important not how people vote, but who counts the votes.”
o Shareholders have the right to vote, but that right is only triggered by
management putting something up for a vote
o The vote is structured so that the only candidates you are voting for are the
ones management puts up

3. Hostile Takeovers
- If a firm is poorly managed, a hostile takeover can be used to improve governance. A hostile
takeover occurs when an acquirer buys all (or most) of a firm’s stock. The acquirer can then
replace the board of directors and fire the firm’s management team
o How might the threat of hostile takeover affect a manager’s behavior on day-to-day
basis?
▪ Note: if this threat worked, we would never see hostile takeovers.
o How could an acquirer make money off of this strategy?
▪ Buy low, sell high. If firm is poorly managed, stock price will be low. Replace
management ad sell high.

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 Solution 1: Fiduciary Litigation;
Procedural Enforcement of Fiduciary
Obligations
Two Dimensions of Fiduciary Law
The Goal: toward what end should the corporation operate?
- Goal is to act in shareholders’ interest.

Level of judicial scrutiny: how much discretion do managers and directors have?
- When will courts second-guess managerial decisions?

So the goal is to act in shareholders’ interests, but what we are really asking is: when will courts second-
guess a board’s decisions, and what level of scrutiny will we apply?
- This is the most important question in all of fiduciary law!

Direct vs. Derivative Suits

Direct Derivative
- Brought by shareholder in his or her own - Brought by a shareholder on corporation’s
name behalf
- Cause of action belonging to the - Cause of action belongs to the corporation
shareholder in his or her individual as an entity
capacity - Arises out of an injury done to the
- Arises from an injury directly to the corporation as an entity
shareholder

Conceptual Problem
To whom do corporate officers and directors owe a fiduciary obligation? The corporation.
- In other words, in a fiduciary lawsuit, who are the:
o “Real” plaintiff—corporation (primary economic interest)
o “Real” defendant(s)—board members
- Named plaintiff: shareholder
o Named defendant: corporation
- Who normally determines when/if a corporation engages in litigation? The board.
o So a derivative suit operates when the board has some disabling conflict and can’t bring
suit on behalf of corporation.

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Derivative Litigation: 2 Suits in 1
Historically two lawsuits:
- Suit 1: Equitable lawsuit by shareholders asking court to force corporation to sue its directors, and
- Suit 2: Lawsuit by corporation against directors/officers.
- The named parties in today’s derivative action come from the first historical suit. Today, the suits
are just combined.
- Why is the derivative action one in equity rather than at law?
o At law, shareholder cannot sue the wrongdoers because the wrong was to the corporation,
not to the shareholder. So the shareholder either does not have a cause of action or does
not have standing.
o In equity, however, the court is free to fashion a remedy to prevent injustice.
- The complaining shareholder’s actual role is to be like the champion who is running the lawsuit
on behalf of the corporation.

Derivative Suits vs. Class Actions (Direct)

A direct suit is often brought as a class action on behalf of a class of shareholders.
- A derivative suit is NOT a class action, even though the judgment benefits shareholders as a
group.
- Important distinction: a derivative suit is res judicata, even for shareholders who were unaware of
the litigation.
o So it’s especially important that the derivative suit is effectively argued on behalf of all
shareholders, that we get the right plaintiff running it, and that the suit makes sense.

Procedural Decision Tree

Direct or
Derivative?

Direct Derivative

Derivative suit Derivative suit

procedural hurdles procedural hurdles
do not apply do apply

Derivative Litigation Losing Steam?

Derivative litigation is designed as the primary mechanism for enforcing fiduciary obligations, but
direct/class action shareholder suits outnumber derivative suits by a wide margin. Derivative suits seem to
be losing ground in Delaware. Why?
- Structural Changes in Board Composition
o Trend since 1970s: more independent directors
o NYSE and NASDAQ 2003 rules require independent directors make up at least 50% of
board seats for listed companies
▪ These rules are status-based—definition of independence is based on who the
directors are and their relationship to management.
▪ But states use situation-based tests for independence.
o Still, this has an impact on Aronson/demand futility: demand is excused far less
frequently
- Plaintiff Incentives
o Plaintiff’s lawyer has some flexibility in designing complaint and choosing where to file.

44
 o Will likelier frame as direct suit or securities claim, or file outside of DE, or seek non-
fiduciary remedies (like securities regulation)
Traditional Tests
1. Who suffered the most direct injury?
a. If corporation, suit is derivative.
2. To whom did the defendant’s duty
run?
a. If corporation, suit is derivative.
**But note: sometimes a claim is “direct” even
though the slices are not re-arranged (e.g.,
Eisenberg).

Remedy will often help determine what

type of suit it is.
- Money damages: more likely to be derivative
o Financial recovery typically belongs to corporation.
- Equitable relief (voting rights, etc.): more likely to be direct.
o Voting right is a direct shareholder right; does not belong to corporation. Infringement of
voting rights can be used to reclassify case as direct.

Example: Eisenberg v. Flying Tiger

Plan of reorganization: Flying Tiger merged into Flying
Tiger Line, FTL took over operations, and Flying Tiger
shares were converted into an identical number of FTL
shares. Business operations were confined to a wholly
owned subsidiary of a holding company whose
shareholders were the former shareholders of Flying
Tiger.

Procedure
Eisenberg brings a direct lawsuit (class action) to block the reorganization; FT argues the suit should be
derivative
- FT wants it to be derivative because Eisenberg didn’t post the bond required for derivative suits,
so the case would be dismissed.
- Direct v. Derivative
o Eisenberg is hurt because shareholder voting rights changed.
o He’s not seeking damages for costs related to the reorganization.
▪ In fact, if he wanted that, it most likely would be a derivative action (waste hurts
corporation, not shareholders).
- So what does he hope to gain?
o He’s really trying to shake down the corporation; bridge troll rights

45
Hypotheticals
Example #1
ABC Corp entered into a contract with Jane Jones. Jones breached the contract, but ABC Corp has not
sued her for that breach. May a shareholder of ABC Corp sue Jones directly?
- No. Jones owed no duty to the shareholder. The breach did not injure the shareholder directly.
- Recovery would go to ABC. Hence, a shareholder suit against Jones must be brought as a
derivative action.
- Shareholder is not a party to the contract; his injury is derivative to the harm the corporation
suffers.

Example #2
ABC Corp’s treasurer embezzles all its money and absconds. Shareholders’ stock is now worthless. May
a shareholder of ABC sue treasurer directly?
- No. It’s not enough for a shareholder to allege that challenged conduct resulted in a drop in
corporation’s stock market price!
- The harm the shareholder/stock value suffers is derivative to harm corporation suffers, so only the
corporation can sue.

Example #3
Jill is 60% owner of ABC Corp and CEO/director causes ABC to issue additional shares to her at a very
low price, increasing her ownership to 80%. May a shareholder of ABC Corp sue Jill directly?
- Yes! Minority shareholders suffer direct harm—this is rearranging the slices of the pie.
- Jill, in her capacity as controlling shareholder, caused this to happen; owed a duty directly to
minority shareholders.
- This would be brought as a direct class action.
o Note: if this were derivative, Jill would be in a weird spot as both plaintiff and defendant
(part of the group that recovers as a shareholder but paying for it because she is
responsible)

Example #4
Jill is 60% owner of ABC Corp. and CEO causes ABC to sell assets to another business, XYZ Corp.,
solely owned by Jill. The assets are sold well below market value. May a minority shareholder of ABC
Corp. sue Jill directly?
- Harm is to corporation, so it’s probably derivative.
- BUT a clever plaintiff could get around that and re-classify the suit as direct by arguing that Jill
breached her fiduciary duty to minority shareholders as a controlling shareholder. That duty runs
directly to the shareholders.

Example #5
The board of XYZ Inc. agrees to sell 80% of its assets to an unaffiliated purchaser. Although a vote is
required by state law for the sale of “substantially all” of a corporation’s assets, no vote is schedule
because the board disputes the plaintiff’s claim that the sale amounts to to a disposition of “substantially
all” of XYZ’s assets. May shareholders bring direct suit to block asset sale?
- Yes. An action for an injunction against the sale is direct—it involves the plaintiff’s personal
voting rights. The right of a shareholder to vote is not a right of the corporation.
- Not a fiduciary obligation at all. Obligation does not run through the corporation.

Incentives in Derivative Litigation

Plaintiff Incentives Defendant Incentives

46
 Corporation must pay a successful plaintiff’s Law permits indemnification of individual
costs. Success includes settlement as well as defendants’ costs after a settlement, but not if
judgment. there is an adverse verdict. If director goes
through trial and loses, no indemnification, and
most insurance policies won’t pay at that point,
either.
Incentives for both party:
Settle the lawsuit quickly. Both parties get their costs covered that way.
Derivative suits are really suits on behalf of the corporation, so we do have some danger of frivolous
lawsuits.

Risk of Type I and Type II Errors

Strike Suit Meritorious Suit
Plaintiff Wins (or receives
False Positive
settlement larger than
(Type I error)
expected)
Defendant Wins (or pays
False Negative
settlement smaller than
(Type II Error)
expected)
If you have a strong suit, plaintiff’s lawyer becomes a problem; they run the risk that something goes
wrong.
- Type I error: settle for more than it’s worth
- Type II error: damages are not really adequate to compensate for the harm.

Combined Effect
Strike Suits Meritorious Suits
- Plaintiff’s counsel has incentive to bring. - Management has incentive to settle in
- Management has incentive to pay. ways that ensure indemnification.
- Plaintiff’s lawyer has incentive to settle
so as to get on to next case.
So, they are settled for less than they are
worth.

Do security fees/bonds address either problem?

- They help get rid of strike suits. But they do nothing to fix meritorious suits being settled too
lightly.

The other procedural hurdles are in place because courts are worried bout these perverse
incentives!

Judicial Approval of Settlements

To be approved, the settlement is supposed to be fair, reasonable, and adequate. The settlement must not
be collusive, but rather the product of arm’s length negotiations following adequate discovery. This might
solve problems of low settlements for good suits; judge can act as a check on perverse incentives.
- But, we can’t pretend that judges don’t also have incentives to approve settlements quickly (to
clear their dockets).
- Wide range of factors:
o Maximum and likely recovery;
o Complexity, expense, and duration of continued litigation;

47
 o Probability of success;
o Stage of proceedings;
o Ability of defendant to pay a larger judgment;
o Adequacy of settlement terms;
o Whether settlement vindicates important public policies;
o Whether settlement was approved by disinterested directors; and
o Whether other shareholders have objected.

Four Key Procedural Hurdles

1. Bond posting requirements (Eisenberg)

2. Special pleading requirements (FRCP 23.1; DE Chancery Court Rule 23.1)
3. Demand Requirements (Grimes v. Donald)
4. Special Litigation Committees (Auerbach v. Bennett; In re Oracle)

Hurdle #1: Bond Posting Requirements

To avoid strike suits—illegitimate claims brought by small SH hoping for an inflated settlement because
less expensive to settle

Eisenberg v. Flying Tiger: state statute requires plaintiff in a derivative suit to post security for
corporation’s costs

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Hurdle #2: Special Pleading Requirements
FRCP 23.1/DE Chancery Court Rule 23.1
In a derivative action brought by one or more shareholders or members to enforce a right of a
corporation or of an unincorporated association, the corporation or association having failed to
enforce a right which may properly be asserted by it, the complaint shall be verified and shall
allege (1) that the plaintiff was a shareholder or member at the time of the transaction of
which the plaintiff complains or that the plaintiff's share or membership thereafter
devolved on the plaintiff by operation of law, and (2) that the action is not a collusive one to
confer jurisdiction on a court of the United States which it would not otherwise have. The
complaint shall also allege with particularity the efforts, if any, made by the plaintiff to obtain the
action the plaintiff desires from the directors or comparable authority and, if necessary, from the
shareholders or members, and the reasons for the plaintiff's failure to obtain the action or for
not making the effort. The derivative action may not be maintained if it appears that the
plaintiff does not fairly and adequately represent the interests of the shareholders or
members similarly situated in enforcing the right of the corporation or association. The
action shall not be dismissed or compromised without the approval of the court, and notice of
the proposed dismissal or compromise shall be given to shareholders or members in such
manner as the court directs.

Additional Procedural Requirements

- Shareholder must have owned shares at the time the misconduct occurred to bring the derivative
action.
o Many states also require that shareholder continue to own throughout trial.
- What happens to SHs who fall into two groups?
o Owned at time of misconduct but not at trial:
▪ Yes, you suffer harm, but don’t get to recover. Remember that the harm is really
to the corporation.
o Bought shares after misconduct:
▪ Can’t bring the suit yourself, but yes, you get to recover (because this is not a
class action!)
- Fair and Adequate Representative: MBCA § 7.41(2) requires that the named plaintiff must be a
fair and adequate representative of the corporation’s interests
o On what grounds might one challenge a plaintiff’s fairness or adequacy?
▪ Conflicted interests, such as bringing suit for unrelated strategic purposes
▪ Unclean hands
• You cannot be the plaintiff if you somehow participated in the
wrongdoing!

Third Hurdle: Demand Requirement

Most states (including Delaware) require shareholders in derivative suits to first approach board of
directors and demand that board pursue legal action . . .
- UNLESS shareholder can claim a valid excuse as to why demand on the board would be pointless
/ FUTILE
- If demand is not excused, board has discretion to dismiss the lawsuit.
o BJR gives presumption of due care in decision to dismiss/not to pursue legal action.
- If demand is excused, board cannot cause dismissal on its own.
o But might still be able to move for dismissal, on advice of special litigation committee.

49
This gives the corporation the opportunity to remedy the problem before suit.

What is “Demand”?
Typically a letter from shareholder to board of directors.
- Must request that the board bring suit on the alleged cause of action.
- Must be sufficiently specific so the board can evaluate the nature and merits of the alleged cause
of action.
- “At a minimum, a demand must identify the alleged wrongdoers, describe the factual basis of the
wrongful acts and the harm caused to the corporation, and request remedial relief.”

Basic Policy Issues

When, if ever, should the corporation, acting through the board of directors, be permitted to prevent or
terminate a derivative action? Put another way, who gets to control the litigation: (1) the shareholder; or
(2) the corporation’s board of directors?
- The board should control the litigation unless its hands are so unclean that the board is too
conflicted.
o We want the board to have sufficient discretion to run the corporation—but also hold
them responsible for wrongdoing.

When is Demand “Futile”?

Demands on what the shareholder is challenging.
- Board decision: two-part Aronson test
- Non-board decision: one-party Rales test.

Two Basic Tests for Futility

Challenge to Non-Board Action (or action
Challenge to Board Action:
taken by previous board):
2-Part Test from Aronson
1-Part Test from Rales
Demand is deemed futile only if plaintiff can Demand is deemed futile only if the plaintiff can
allege particularized facts creating a reasonable allege particularized facts creating a reasonable
doubt that either: doubt that:

1. As of the time the complaint is filed, a 1. As of the time the complaint is filed, the
majority of the board is board of directors could have properly
disinterested/independent, OR exercised its independent and disinterested
business judgment in responding to demand.
2. The challenged transaction was otherwise the
product of a valid exercise of business
judgment.

Plaintiff can rely on corporation’s records, media, etc. to allege particularized facts.
- As shareholder, plaintiff has the right to inspect these records.
- The reasonable doubt standard is favorable to plaintiffs!

Hypothetical (Aronson v. Rales)

ABC Inc. has a 5-member board of directors. ABC owns a large plot of land that it is not using. The
board decides to sell this land and they sell it to themselves to develop a new subdivision. Shareholders

50
believe the sale price is well below market value and are furious; they launch a campaign to kick out the
existing directors. Six months later, at the next board meeting, the elect a slate of five new directors.
- Assume a shareholder wants to bring a derivative suit against the original directors. Which
standard (Aronson or Rales) should apply to determine whether demand is excused? Does it
matter when the suit is brought?
o Pre-new board meeting: Aronson standard
o Post-new board meeting: Rales standard
- When will the plaintiff have an easier time showing that demand is futile?
o Plaintiff will have an easier time casting doubt on the old board under the Aronson test,
since they are all “interested” in the challenged conduct. Plaintiff should file pre-new
board to get the benefit of Aronson standard.
o It will be harder to cast doubt on new board’s business judgment because they aren’t
interested/conflicted!!!

What sorts of things work (and don’t work) in surmounting Aronson test?
- Things that do not work:
o Suing all of the current board members / a majority of them
o Claim that “structural bias” among board members renders them ipso facto untrustworthy
- Things that do work:
o Allege with particularity that the board is “interested” in the outcome of the case
o Substantive case against them is plausible
o They have financial interest in outcome
o They are closely connected to interested parties
o Apparently independent board members are “dominated/controlled” by other interested
defendants
▪ Even if a particular board member is not conflicted, you might be able to show
that interested defendants effectively control non-interested board members.
▪ E.g., if you have people who report to the CEO on the board, it’s hard for them to
vote against board.

Hypotheticals
Agricorp Corp. is an agribusiness: it owns and operates many large farms. It has five directors, including
Alice Adams, who is the Chairman of the Board and CEO. Adams learns of an opportunity to purchase a
large farm in Indiana. Adams and two of the directors decide to buy the Indiana farm for themselves.
Assume that this constitutes self-dealing in violation of the duty of loyalty. A shareholder wants to sue. Is
this a direct or derivative lawsuit?
- Derivative—injury is to corporation, which lost an opportunity.
- Assuming the lawsuit is derivative in nature, is demand required or excused under DE law?
o EXCUSED. A majority of the board is directly self-interested in the challenged
transaction. Under both the Rales test and the Aronson test, this conflict makes demand
futile. The same would be true if they otherwise received a direct personal benefit
▪ Assume the board knew the lawsuit was about to be filed: what could the board
do (prior to the litigation) to make demand required?
• They could pack the board so that a majority is no longer interested, or
they could create a special litigation committee (which is really the same
thing).
• SH may not get official remedy, but new board members—in theory—
could sue the other board members.
- Suppose only Adams is going to buy the land. She discloses the opportunity to the other directors.
The other directors vote to have the corporation reject the opportunity and to approve Adams’s

51
 personal purchase of the land. A derivative suit is brought. Is demand required or excused under
DE law?
o The answer depends on whether the plaintiff can create a reasonable doubt as to whether
the directors who approved the transaction were controlled by Adams or that the decision
to approve was not a product of valid business judgment.
▪ As to the first prong, plaintiff must allege that through personal or other
relationships, the directors were beholden to Adams and directed the operation of
the corporation in such a way as to comport with the wishes or interests of the
controlling person.
- Suppose that the other directors had not voted on Adams’s purchase, but had merely acquiesced
in it. Is demand required or excused under DE law?
o Under DE law, Aronson test does not apply to cases in which the court is alleged to have
failed to exercise effective oversight.
▪ Instead, Rales applies.
▪ You could argue that board did not fully inform itself before acquiescing, but that
would still fall under Rales.
o Under NY law (similar facts), a court found that where a majority of the board knowingly
acquiesced in the challenged transaction, demand would be excused.

Demand Requirements Under Delaware Law: A Synopsis

Who makes each

decision?
- Demand required or
excused?
o Judge.
- Demand made/pled?
o Shareholder.
- Board/SLC
recommends pursuing?
o Board.
- SLC recommends
pursing?
o SLC.

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But, in practice
- Shareholders never make
demand,
- And SLCs typically recommend
dismissal.
- So we can simplify the
flowchart 

Other Notes
- If no SLC and demand is excused, plaintiff can just proceed.
- At the step of SLC recommendation, burden shifts to SLC to show its independence.
- If SLC does not recommend pursuing, remember Auerbach for example of non-DE law.

Consequences of Making Demand: Grimes v. Donald

Plaintiff cannot argue in the alternative: if he makes demand, he can’t later argue that it was excused
when the board refuses.
- Instead, have to argue that board wrongfully refused demand (but the board gets protection of
BJR here, so very hard to prove).

Director Abdication Claim

- DGCL § 141(a)  thought to be one of the few “immutable” rules in corporate law.
o Basically, an argument that the board gave away so much power that it abdicated its
authority.
o This would be a derivative claim; usual remedy is an injunction.
- Distinguish between delegation and abdication (§ 141(e) vs. (a)).
o Formalistic distinction here—court says they still retained the right to fire the CEO.
o A little unconvincing here, but oh well.
- Grimes loses here because he hasn’t pled with particularity.

Other Fiduciary Duty Claims: Waste; Duty of Loyalty; Duty of Care

These are all derivative claims, but Grimes waived the claim that demand was excused when he made
demand.
- So court never gets to the argument of whether demand was excused.
- In such a situation, is Grimes completely out of luck, or does he still have the ability to get his
claim into court?
o Must rely on doctrine of wrongful refusal. Very hard because he has to get through BJR.

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Consequences of Futility Determination
Demand Made Demand Not Made
SH waives futility claim; board Court will grant motion to dismiss
refusal to pursue litigation gets BJR by corporation.
Demand Required
protection. Plaintiff Loses.
Plaintiff Loses.
SH waives futility claim; may have Plaintiff still has a chance!
the right to claim “wrongful SH can proceed, unless SLC
Demand Excused
refusal” dismissal passes Zapata test (under
Plaintiff Loses. DE law).

Strategy: argue demand is excused, don’t make it, and hope the judge agrees with you.

Universal Demand (an alternative approach)

- Demand Required/Excused (NY, DE, and several other states)
o Here, demand is serving two purposes:
▪ Gives board a chance to take over litigation/oppose litigation
▪ Filters out strike suits/other non-meritorious litigation
- Universal Demand (MBCA; 11 or so states)
o Plaintiff always required to make demand on the board in derivative action.
o Here, demand primarily serves the first purpose above (giving the board a chance to take
over or oppose litigation), but not the second.
▪ After internal review, board can try to dismiss the case.
• Burden is on plaintiff if majority of board is independent.
• Burden is on defendant if majority of board is not independe.t

NY Demand Futility: Mark v. Akers

Gives three-prong disjunctive standard for showing futility of demand:
- Majority of directors interested challenged transaction
- Directors failed to inform themselves to degree reasonably appropriate
- Challenged transaction so egregious that it could not have been the product of sound business
judgment of the directors.

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Fourth Hurdle: Special Litigation Committees
SLC process is “the only instance in American
Jurisprudence where a defendant can free itself from suit
by merely appointing a committee to review the allegations
of the complaint.”
- The idea is that you take the untainted board members
and vest them will full power of the board; their decision
re: litigation is binding.
- So the question becomes, how much weight do we give
the SLC?

Demonstrating Independence: Auerbach v. Bennett (Non-Delaware)

Directors were paying “bribes” to get business in certain countries; special litigation committee decided
that the litigation wasn’t worth it because the defendants were not pocketing the money (this was just
probably how they had to do business in certain countries).

Key Takeaways
- If SLC is not “independent,” its recommendations are meaningless.
o Independence factors:
▪ non-defendants;
▪ no domination by named directors;
▪ full delegation of board’s authority to SLC;
▪ access to reasonable budget;
▪ access to counsel
o Note: decision is not clear here about who bears the burden of showing independence, but
suggest indirectly that burden is on derivative plaintiff to show that SLC is not
independent
- If SLC is independent, the procedures used by by SLC are scrutinized under (something
like) gross negligence standard; its substantive decisions get BJR protection.
o If process was inadequate, their judgment gets no weight.
- Two-Tiered Process (Tootsie Pop Defense)
o First Tier: Illegal Payments
▪ Not protected by BJR.
▪ Like the candy center of Tootsie Pop.
o Second Tier: Committee Recommendation
▪ Is protected by BJR, as long as process is adequate.
▪ Like the hard shell of a Tootsie Pop. Second tier may insulate first tier from
review!
o What does this suggest about plaintiffs who have a viable claim on the merits?
▪ They need to attack the SLC process.

Demonstrating Independence in Delaware: Zapata Test

Special litigation committee recommendation of dismissal will only be followed if it satisfied both of the
following:
1. Procedural inquiry: Did SLC act (1) independently; (2) in good faith; and (3) with a reasonable
investigation (burden of proof on defendant); AND
2. Substantive inquiry: Does dismissal pass independent judicial inquiry into business judgment?
Burden of proof is clearly on defendant to show independence!
- How does Zapata compare to Auerbach?
o DE listens to SLC, but regards its recommendation with great suspicion.

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 - The SLC enjoys no presumption of independence, good faith, and decision-making under
BJR. SLC must establish facts that show it is comprised of independent decision makers—
and then it gets BJR protection for its decision of whether or not to pursue litigation.

Example: In re Oracle
Prior tests of independence had really focused on whether directors had direct financial interest. This case
changes the law—we can focus on human interests and other factors that might affect independence!
- Basic test: We have to look at human factors; more than just Auerbach factors.
- Sets a very high standard for independence—threshold for Zapata: just have to cast doubt on
independence, and this does it.
- Effect of defective SLC: SH can finally proceed to litigation!

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Substance of the Fiduciary Obligation
- Duty not to waste: Regulates
decisions that destroy corporate assets
(corporation usually wins)
- Duty of care: Regulates thoroughness
and diligence in deliberations.
o *(Duty to act in good faith)
- Duty of loyalty: Regulates self-
dealing transactions by management
(conflicts of interest)

Concluding Thoughts: Fiduciary Law as

Social Reminder
Defendant directors/officers rarely lose.
- Risk of liability is very low, especially when we consider insurance/indemnification.

But fiduciary law may still serve a purpose.

- It may not be effective at compensating injured shareholders, but
- It may improve corporate governance practices.
o Sermon on “good” corporate conduct  shapes business norms
o Santa Claus: threat of coal in the stocking
o Increases formalities
o Cleanses conflicts of interest
- This may be the best the law can do—and we hope we are at least getting rid of the worse cases
of self-dealing!

Business Judgment Rule

BJR is a legal presumption that a corporate officer/director has exercised care and good faith in carrying
out her duties on behalf of the corporation.
- It places the burden on a party complaining of breached fiduciary duty to overcome it.
- Who gets the benefit of the BJR?
o Generally, all corporate fiduciaries (board members, executives, dominant shareholders)

BJR only applies IF

- There is no self-dealing; no fraud; and no illegality, AND
- Board actually exercises “judgment.”
o Relevant facts:
▪ Was board sufficiently informed prior to making decision?
▪ Did board deliberate?
▪ Did outside experts present a “fairness opinion” or other report that board could
rely on?

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Key: There must be some kind of decision (duty to monitor)

Business judgment rule protects (1) considered actions and (2) considered inactions, but it does not
protect unconsidered inactions!

Statutory Sources for the BJR

Never actually articulated in the DGCL, but usually inferred from § 141:
- § 141(a) board’s power to manage corporations’ affairs
- § 141(c) power of delegation to committees/experts
- § 141(e) board members are “fully protected” in relying on opinions and information generated
by committees or others competent to render such opinions/info

Key: If we didn’t have BJR, every decision could be second-guessed by court, so court would effectively
replace the board.

Mechanics of BJR
Disgruntled shareholders can argue around BJR by going
after duty of loyalty.

Waste/duty of care claims are blocked by BJR unless

shareholder can overcome the presumption of BJR.

So this is really just shifting the standard of

review. Being able to plead a conflict of
interest (breach of duty of loyalty) gives you
something more like strict scrutiny.

Legal Test for Procedural Challenges to BJR

- Prior to making the business decision, did the board take reasonable steps to inform themselves
of the material information relevant to the decision?
- Process judged on “gross negligence” basis.

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Two Conceptions of Business Judgment Rule
1. Doctrine of Judicial Abstention: doctrine prohibiting judicial review, absent conflicts of interest
(or certain other problems)
2. Alternative liability standard: assuming no conflicts of interest, court will still review board
actions, but will apply BJR-level review (i.e., rational basis review)

Doctrine of Judicial Abstention Alternative Liability Standard

Court will not review board’s decision, unless No liability for negligence. Instead, liability based
plaintiff can show: on:
- Fraud, - Fraud,
- Illegality, - Illegal conduct,
- Self-dealing, or - Self-dealing, or
- [grossly uninformed decision]? - Lack of any rational basis (i.e., criteria
More process-based: looking at how decision similar to gross negligence)
was made. More substance-based: Not a question of
whether will court will review, but by what
standard? (gross negligence—no sane person
would ever make same decision).

Strong Abstention Version:

Kamin v. American Express
“A complaint which alleges merely that some course of action other than that pursued by the Board of
Directors would have been more advantageous gives rise to no cognizable cause of action. Courts have
more than enough to do in adjudicating legal rights and devising remedies for wrongs. The directors’
room rather than the courtroom is the appropriate forum for thrashing out purely business
questions, competitive situations, or tax advantages.”
- Note that many of these cases are decided on motion to dismiss. Plaintiff has an uphill battle to
fight to make a “clear case” before a motion to dismiss pre-discovery! He has to plead facts to
survive MTD.

Policy Justifications for BJR

The BJR is sometimes seen as a tradeoff between authority and accountability.
- Does this seem like the balance is right to you?
- What is likely to happen if we reduce BJR protection and allow greater judicial scrutiny of board
actions? Pros and cons

Entire Fairness
“Entire fairness” standard shifts burden to the defendant to show that the transaction was fair—and the
defendant is on the hook for the difference between actual and fair price if not!

What is the test for determining entire fairness?

It’s both procedural and substantive. Factors from Cinerama v. Technicolor:
- Aggressive bargaining by fiduciary;

59
 - Fiduciary’s knowledge of business;
- Whether outside valuation advice sought from an expert investment bank;
- Magnitude of premium over market price;
- Whether lockups are so large as to preclude third parties from making competing bids

Basically comes down to whether you get a fair price.

- Key point: Once you get to this point, it is finally plaintiff-friendly! Shifting the burden to
defendant is protective of plaintiffs.

What is the effect of finding that a transaction was entirely fair?

It’s actually an affirmative defense—if you can prove it.
- But you never want to get to the point where you are relying on proving entire fairness!

Smith v. Van Gorkom

Case isn’t over once plaintiff wins at this level—cause remanded for determination of whether transaction
was “entirely fair”

Duty Not to Waste

History
- Modern descendant of Ultra Vires Doctrine
o Actions undertaken by officers or board that are contrary to the purpose of the
corporation (usually as stated in charter)
o When the business-purpose terms of charters were more specific, such claims were
common.
- Essentially, waste is ultra vires because you are exceeding the scope of what your charter says
you can do.
o But increasingly, charters are very broad, so it is harder for plaintiff to win/prove

Bottom Line
While BJR gives discretion to managers in deciding how to maximize SH profits…
- The “waste” limitation withholds such discretion for decisions about whether to pursue that
objective.
- Thus, in spite of BJR’s protection…
o Management must be able to articulate a rational basis for the decision! (which is often
relatively easy to to)

From Shlensky v. Wrigley:

Court will not review substance of business decision, unless plaintiff can show:
- Fraud,
- Illegality, or
- Conflict of Interest.
(Ford: some kind of bad faith in Ford’s motivations; nothing like that in Wrigley)

Hypotheticals
Assume Wrigley owned a 51% interest in Cubs and 80% interest in the White Sox. Assume he used a
day-time only schedule for the Cubs, and a night-time schedule for the White Sox.
- Here, there is an obvious conflict of interest; impossible to presume that he is acting in the best
interest of the corporation because he is taking advantage of his 80% interest and giving the
White Sox a better deal.

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AP Smith Mfg. v. Barlow
Shareholder claims:
- Corporation’s decision to make donation to Princeton was ultra vires
- NJ statutes authorizing corp. contributions with SH approval did not apply to APS because its
incorporation predated the statutes.

Court says:
- Statute applies retroactively to charter.
- Limits for future cases:
o Personal or pet charities = bad
o Be public and explain all donations

- Are APS shareholders actually hurt by the contributions?

o They got good publicity.
- Does this imply, then, that no corporate contribution to charities are subject to SH challenge?
o You would have to show conflict of interest/pet project or exceed statutory limit of
contributions.

Example of NO BJR: Dodge v. Ford Motor Co.

Ford had regularly given regular and special dividends. In 1916: paid no special dividend even though it
was the most profitable year yet. Dodge wanted to compel special dividend and block construction of new
plant (would have been world’s largest manufacturing complex)
- Note: Dodge really wanted it because they wanted to be able to cash in on their investment—
couldn’t publicly sell shares, and wanted to fund Dodge with special dividend
o And wanted to block plant because if it was successful, it would drive down the price of
cars.

Construction of New Plant: Ford Wins Special Dividend: Ford Loses

Does not enjoin the construction and doesn’t even Corporations are not required to pay them, but
question its potential profitability. Ford was very public about the real purpose of not
- One of the earliest statements of BJR paying them. A refusal to pay a dividend may be a
(courts are not business experts) breach of fiduciary duty (especially if it’s
arbitrary).
- And the fact that Ford had paid them year
after year hurt them.
- Note: we would be less concerned about
this for public companies (because SHs
can just sell their shares)

Problems with BJR in Ford

- “And let me say right here, that I do not believe that we should make such an awful profit on our
cars. A reasonable profit is right, but not too much. So it has been my policy to force the price of
the car down as fast as production would permit, and give the benefits to users and laborers, with
surprisingly enormous benefits to ourselves.”
o Problematic. It makes it hard to maintain presumption that he is acting in the best
interests of the corporation (which is the heart of the BJR).
▪ Even if it was actually in the best interests of Ford (which it could have been):

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 • Lowering prices of cars would have prevented market entry and
increased market share
• Increasing worker pay would have prevented absenteeism (and let to
smooth operation of assembly line)
• Cutting dividends: need capital for expansion in high growth industry;
would have hindered competition (Dodge brothers wanted dividends to
finance Dodge); would have saved shareholder taxes
• Building the plant: high growth industry so need to expand capacity and
control cost
- So why did Ford lose on the dividends issue but win on the plant construction decision?
o Under BJR, courts won’t scrutinize decisions about how to maximize profits, but
they will scrutinize decisions about whether to do so.
▪ If you make a decision not to do something, courts might look harder.
o Minority oppression/close corporation
▪ We are concerned about minority shareholders being able to cash out their
shares; dividend is a way for them to “get something” out of their investment
(since they can’t publicly trade their shares).

Compare with: Shlensky v. Wrigley

Chicago Cubs refused to install lights at Wrigley Field; minority SH brings derivative action for damages
and order compelling installation.
- But Wrigley actually argues he is acting in shareholder interests (which is enough to create BJR
presumption)
- Shlensky never gets to make his arguments on the merits because he never gets past BJR!
o Court will not review substance of business decision, unless plaintiff can show:
▪ Fraud,
▪ Illegality, or
▪ Conflict of interest.
o Distinguishes Ford: we saw some kind of bad faith there; can’t determine enough about
Wrigley’s interests/motive to assign that kind of bad faith.
- All Wrigley has to show is that it’s not NOT in the shareholders’ interests.
- Alternatives:
o Plaintiffs like Shlensky could argue that the decision-making process used to support a
daytime schedule was grossly negligent.

Application to Hobby Lobby

Hobby Lobby = closely held corporation (so really not going to see a challenge b/c SHs won’t complain)
- Refused on religious grounds to provide insurance coverage for birth control as mandated by
Obamacare.
- Fiduciary angle: board needed to affirmatively recommend breaking the law.
- Practice Pointers
o Put something in your charter about your mission being a little different than just making
profits.
o Argue that there is some benefit: maybe Hobby Lobby attracts a certain kind of customer.
Deliberate about that and include it in your minutes.

Duty of Care
A director has a fiduciary duty of care to the corporate entity  requires directors to make decisions that
are “reasonable” under the circumstances.

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 - But in reality, directors are never held to a standard of reasonableness; insulated from liability in
a variety of different ways.

In contrast to the standard of care, the standard of review by courts relevant to director decision-making is
very low: business judgment rule (see above sections).
- And whether the director is entitled to presumption of reasonable care under BJR almost never
turns on substance of decision; only important question for reviewing courts is whether the board
of directors had a reasonable process for evaluating its options.

Kamin v. American Express

Real complaint is that Amex lost tax savings by declaring “in-kind dividend” instead of selling the shares.
If they had sold the shares, they could have claimed the loss and saved on taxes.
Understanding the Complaint
Option 1: Declare “In-Kind” Dividend Option 2: Sell DLJ Stock; Declare $$ Dividend
AmEx Corp. Entity: AmEx Corp. Entity:
- Taxable income $100M - Taxable income (including loss on DLJ):
- After-tax income: $100M – 30% of $100 – 26 = $74 M
$100M = $70M - After-tax income: 100 – 30% of 70 =
$77.8M
Shareholders:
- Taxable dividend: $4M (FMV of stock) Shareholders:
- After-tax dividend: 60% of $4M = $2.4M - Taxable dividend: $4M (cash value)
- After-tax dividend: 60% of $4M = $2.4M
So shareholders get the same dividend. How are they hurt?
The share price should be lower if Amex pays out the “in kind” dividend, since the firm will have lost
$8M.

Explanation of Accounting
At the time of the case, securities were recorded at cost. If they sell, they were going to get less than
$30M for them and have to record the loss on their income statement. In-kind dividend makes it look like
it just went to shareholders.
- Today: they would record the securities loss of $4M no matter what; there would be a
corresponding entity to reduce equity.
- But really: the market is going to react to this no matter what. Even in 1976, Amex financials
would report in a footnote that they owned a large block of DLJ shares.

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Analysis: Avoiding BJR
The defendants were entirely aware that a sale rather than a distribution of the shares might result in
substantial tax savings, but they concluded that there were countervailing considerations, like the effect
that a sale  recording loss of $25M would have on net income figures.
- Plaintiff would have to show that there was no rational basis for the in-kind dividend.
- Plaintiff can’t show that the board neglected to make a choice.

Any other way plaintiff might have avoided BJR? Argue conflict of interest.
Four of the 20 directors were “insiders.” Would this have worked?
- Not really—it was only 4/20.
- And it was a unanimous decision.
- This sort of problem will show up whenever you have “insiders” on the board and decisions that
will affect stock prices (and any options they might have).
o Court does not want to get involved in debate about how markets respond to information.

Smith v. Van Gorkom

Really rare case where plaintiff gets through all procedural hurdles and gets to hold the board liable for
fiduciary breach!

Timeline
TransUnion (Van Gorkom = CEO)
- Held tax credits (about to expire) that could be offset against taxable revenue.
- Problem: TU revenues were insufficient to use tax credits, and they could not be transferred to
third party.
o TU had been trying to use the tax credits for years. Van Gorkom had lobbied for a law
change to make it easier to use them.

Possible Solution
Need to either:
- Come up with more revenues internally, or
- Sell the business to a third party with high revenues (effectively side-stepping the non-transfer
restriction on the tax credits).

Senior management discusses LBO v. MBO Options

- Leveraged buyout: Third party raises financing to buy out the shareholders; third party can use
tax credits on revenues from other businesses; acquirer = third person
- Management buyout: Management raises financing from other parties to buy out shareholders;
acquirer = management
o This doesn’t give them the opportunity to increase revenues  use tax credits.
- In either situation, the merger agreement forces all shareholders to sell at that price, once the
majority of SHs votes yes.

CFO Romans runs feasibility study.

- Easy at $50/share
- Hard at $60/share
- Van Gorkom: “I’d take $55”
o And he vetoes MBO—he is about to retire.
- So without informing the other members of the management, Van Gorkom contacts a possible
LBO acquirer.

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 o Why all the secrecy?
▪ Working with the board or making it public could actually cause the deal to fall
through.
▪ So it’s not as crazy as it might seem—but it still would have been better for him
to consult with a small number of members.

The Proposed Deal

The genius of an LBO is that you rely on the assets
of a company you don’t own yet as collateral to
repay the loan. Bank conditions the loan on the
deal going through.
- Problem: Pritzker gets 1.75M shares no
matter what!!! Even if somebody else
outbids him for LBO, he still makes a huge
profit (when the shares are ultimately sold,
which they will be).

Duty of Care: Procedural Challenge to BJR

Prior to making the business decision, did the board take reasonable steps to inform themselves of the
material information relevant to the decision?
- Did the board discharge its duty of care in Sept. 20 meeting?
o No. Reliance on reports is common defense, but the presentation doesn’t qualify.
Some investment bank should probably be giving the report.
- Did board’s subsequent actions cure the breach?
o No. Market test was not sufficient because there was no evidence that merger
agreement actually gave them the freedom to conduct a real market test.
- Did SH approval of deal “cleanse” the breach of duty of care?
o No, because nobody knew where the $55/share price came from. SH vote can’t cleanse
without disclosure of how the deal/negotiations came about.

Note on Reliance on Reports

Delaware corporate law allows directors to rely on professional or expert competence:
- 141(e): “A member of the board of directors … shall, in the performance of such member’s
duties, be fully protected in relying in good faith upon … upon such information, opinions,
reports or statements presented to the corporation by any of the corporation’s officers or
employees, … or by any other person as to matters the member reasonably believes are within
such other person’s professional or expert competence and who has been selected with
reasonable care by or on behalf of the corporation.”
- This is a standard defense used in fiduciary suits!

Why can’t the board rely on Van Gorkom’s presentation?

- Van Gorkom does not have “professional or expert” competence
- What about Roman’s feasibility analysis?
o

- What about the lawyer’s legal advice?

Note on Market Test
Board wants to rely on the market test to justify the $55/share price.
- What is the market test?

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 - Why doesn’t this protect board? What limitations did Pritzker insist on with regard to shopping
the company? (see page 316-317)
- Extra shares issued to Pritzker at $38/share are problematic—even if they go with somebody else,
he still makes a huge profit on those shares!

Extra Questions
- The Van Gorkom court refers to the board’s views about the “intrinsic” value of the shares of
stock of Trans Union. In the case of a publicly held corporation, what is the difference, if any,
between the “intrinsic” value and the market price?
- If $55/share was good enough for Van Gorkom, who held 75,000 shares, why was it not good
enough for the rest of the shareholders?
- What is the likely effect of this decision on the behavior of directors? On the welfare of
shareholders? On the welfare of lawyers and investment bankers?

The Twin Legacies of Van Gorkom

1. Caused widespread panic within defense bar.
- Director and Officer Liability insurance rates increased—and some stopped covering entirely for
a while (unsure of where DE law was going).
- Directors threatened to quit or decline appointment.
- These forces (or at least, perception of them) catalyzed passage of DGCL § 102(b)(7).

2. Began an era of greater focus on “fairness opinions” for all companies in merger and acquisition
context.

Van Gorkom Legacy #1: DGCL § 102(b)(7)

DGCL § 102(b)(7)
(b) [T]he certificate of incorporation may also contain…
(7) A provision eliminating or limiting the personal liability of a director to the corporation or its
stockholders for monetary damages for breach of fiduciary duty as a director, provided that
such provision shall not eliminate or limit the liability of a director: (i) For any breach of the
director's duty of loyalty to the corporation or its stockholders; (ii) for acts or omissions not in
good faith or which involve intentional misconduct or a knowing violation of law; (iii) under
§ 174 of this title [unlawful dividends/transactions in stock]; or (iv) for any transaction from
which the director derived an improper personal benefit… All references in this paragraph to a
director shall also be deemed to refer … to such other person or persons, if any, who, pursuant
to a provision of the certificate of incorporation in accordance with § 141(a) of this title, exercise
or perform any of the powers or duties otherwise conferred or imposed upon the board of
directors by this title.

This is really designed to protect outside members of the board who make honest mistakes. It really guts
the duty of care.
- UNLESS the director is also an employee and you can characterize breach as part of their duty as
an employee.

What does it not apply to?

- Does not apply to conflicts of interest, bad faith, etc.
- Does not protect officers! It only protects directors/outside directors (so it would not have helped
Van Gorkom).

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Van Gorkom Legacy #2: The Fairness Opinion
Fairness opinion: a report authored by an investment bank and addressed to a company’s board of
directors opining about the “fair price” for a company as a whole, a business unit, or owned assets.

How is it used?
- Bargaining leverage against negotiating partner
- Required pursuant to debt covenants (“transactions with affiliates”)
- De facto requirement in M&A context after Van Gorkom

What are its contents?

- Opinion letter from Investment Bank (short)
- Valuation analysis substantiating letter’s conclusions (significantly longer)

How does the investment bank do the valuation?

Usually opines about a range of fair valuation. (instead of a single price)
- But some investment banks (e.g., Goldman Sachs and UBS) don’t even give a range; instead,
provide only an assessment of whether proposed terms are fair).
- Multiple valuation approaches (beyond the scope of our class
o Comparable companies
o Comparable transactions
o Discounted cash flow (DCF)
o Option Pricing

Hypotheticals
Same facts as Van Gorkom, but Trans-Union board solicited an opinion from an investment bank before
it voted, saying that a “fair price” was in the range of $53-58/share.
- This would be a report the board could rely on.
- What if opinion said fair range was $58-63?
o Even if board sells for $55, board can make a judgment about whether to sell for a lower
price, as long as the deliberate.
o The key is not about whether $55 is a fair price; it’s about whether the process shows
sufficient deliberation to get BJR protection.

Same facts, but the opinion was solicited after the board vote but before the SH vote.
- If it’s disclosed to the SHs, vote may cleanse the breach of duty of care.

What if fairness opinion comes after both board and SH votes?

- It’s only helpful as ammunition in argument that price is entirely fair.

Same as first, but now suppose that the bank that issued the fairness opinion had also been hired as an out
side advisor in structuring the deal?
- The investment bank must not be conflicted! This would be a problem with process.

Duty to Monitor (duty of care)

Does board have an obligation to actively monitor management?

Francis v. United Jersey Bank

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 1. Who are the plaintiffs in this case (creditors in BK proceeding)? Why do they have standing to
sue?
a. This is like a bank, so we give them a right to enforce fiduciary obligations.
b. Normally, creditors would not have that right.
2. Why isn’t the lawsuit against the sons?
a. They are probably the beneficiaries of the estate.
3. Does the business judgment rule apply here? Why not?
a. No, because there was never a decision!
4. If this case arose today, and the bank had 102(b)(7) provision in its charter, would the mom be
liable?
a. No, she would be fully protected (unless you could classify this somehow as acting in bad
faith)
5. Does she have a conflict of interest in this case? Should this be adjudicated under the duty of
loyalty standards instead of the duty of care?
a. Clever—because her sons are actually benefitting from her inaction.

Hypotheticals
Suppose Ms. P reviewed the financial statements and blew the whistle on her deadbeat sons. But some
creditor thinks that she should have tried to handle it quietly. Whistleblowing allegedly caused panic and
led to bankruptcy. Protected by BJR?
- Yes—she informed herself and made a decision. We don’t care if it’s the right one.

Suppose she reviewed the financial statements, but decided not to blow the whistle on deadbeat sons, to
instead try to handle it quietly. It doesn’t work. BJR protection?
- First, claim that there is a conflict of interest.
- If that doesn’t work, odds are she does get BJR protection.

Caremark Claims
In re Caremark SH Litigation (Del. Ch. 1996)
Caremark = healthcare provider. Middle management uses company funds to bribe doctors (i.e.,
consulting contracts, research grants, etc.) for referral business.
- Breach of federal Anti-Referral Payments Law (ARPL)
- Federal government settles with Caremark for $250M fine.
- Shareholders then bring a derivative suit against directors to recover the fine that Caremark paid
to the Feds and for an injunction requiring them to implement a better monitoring system.

Shareholder allegations
- Board failed to monitor/prevent illegal conduct  breach of duty of care.

Court-approved Settlement
- $1M in attorneys’ fees and steps to prevent future bribes; no recovery to SHs.
- Court concludes that probability of plaintiff success is very low and thus approves slap-on-the-
wrist settlement.
o In part because board at least had protections in place to prevent this—their protections
just didn’t work.

**SEE Stone v. Ritter  duty of good faith? More relevant version of Caremark.

Duty of Loyalty

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If you can show a conflict of interest, and plead it
with particularity, you can sidestep BJR and get into
entire fairness review.

Basics
- Core duty of loyalty analysis—DGCL a.
o If plaintiff shows conflict  entire fairness.
o If defendant shows cleansing under § 144  BJR.
- Subcategories, Extensions, and exceptions
o Corporate opportunity doctrine (subcategory)
o Dominant shareholder fiduciary duties (extension)
o Special duties in closely held corporations (exception)

Historic Context of Duty of Loyalty

Late 19th Century

- Any shareholder could void a conflict of interested transaction for any reason (regardless of the
fairness of the transaction!)
- Tradeoff—made it easier for the courts, but you end up with a tyranny of the minority. One SH
could wreak havoc; you would need unanimity for every decision.
- Essentially, one SH had veto power; especially difficult for smaller businesses or family
businesses.

Now
Courts have become increasingly hospitable to conflict of interest transactions, ultimately leading to
DGCL § 144.
- Now, we allow good deals to go through without abusing self-dealing opportunities.

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Direct vs. Indirect Conflicts of Interest
Direct Indirect

Example: you are director of ACME and enter

into a contract with your own company.

More common!
Example: you are a director of ACME and have
some lesser connection to AJAX, and those two
corporations enter into a contract.

Bayer v. Beran
Directors win on the radio program contract because contract was entirely fair.
- Court basically placed itself in directors’ position and gets to the same decision.
- Even without connection between CEO and singer, the deal made sense:
o Pay was not unreasonable;
o Program was not designed to further her career;
o Company obtained its money’s worth from the radio campaign.
o And she was actually good!
- What about the process of board approval?
o What if other directors were disinterested? Would their approval help? What about
shareholder ratification?
o Maybe, but the deal was entirely fair, so the process doesn’t really matter!

KRB Problems P. 344

Susan Alexander is a “singer” who is trying to break into the bigtime opera circuit. A few years ago, she
took up with wealthy Charlie Kane, and has now married him. He would like to promote her career. Kane
is CEO and majority shareholder in the Chicago Inquirer. The shares are worth a total of $100M.
- Suppose that Inquirer’s BOD votes to make a $20M donation to start a Chicago City Opera Co.
Chicago community is eager to have this opera company, and the company thus stands to receive
much goodwill in the area.
o If Alexander does not sing with the company, is there a problem?
▪ Yes, the amount is probably too large, and the CCO seems like a pet charity of
Kane’s.
▪ Note: This type of transaction would generally be entitled to BJR protection. The
problem is whether the donation is so large that it would constitute “waste.” Hard
to say how a court would rule, but potentially problematic.
- Suppose that, out of appreciation for Kane, the music director of the CCO offers to star Alexander
as the lead soprano in a new production. Is there a problem? Suppose that, when offered the lead,
Alexander response: “Thanks, you’re so sweet. But Charlie is so rich, you know, and we really
don’t need more money. I’d love to sing the lead, but how would it be if I did it for free?”
o This may be viewed as a conflict, even if Alexander does not take any money, because
the performance itself may benefit her career.
o If you want to defend it: bring up Aronson—no direct financial interest
▪ But remember Oracle—we do need to consider non-financial “human” factors.

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 - Suppose that Kane owns 100% of the stock. Do your answers to the questions above change?
o It is his money—no other SH can complain.
- Suppose that Alexander is a genuine star, and the CCO offers her the “Rosebud” lead after
holding an audition at which the judges unanimously voted her the best lyric soprano.
o The audition process appears to sanitize the conflict, by suggesting “entire fairness”
under DGCL § 144(a)(3). (but you don’t want to get to this point!

DGCL § 144
a) No [self-dealing] transaction … shall be void or voidable solely for this reason … if:
1. The material facts [relating to the conflict of interest] are disclosed or are known to the
board of directors .. and the board … in good faith authorizes the contract or transaction
by the affirmative votes of a majority of the disinterested directors, even though the
disinterested directors be less than a quorum; or
2. The material facts [relating to the conflict of interest] are disclosed or are known to the
shareholders entitled to vote thereon, and the contract or transaction is specifically
approved in good faith by vote of the shareholders; or
3. The contract or transaction is fair as to the corporation as of the time it is authorized,
approved or ratified, by the board of directors, a committee or the shareholders.
b) Common or interested directors may be counted in determining the presence of a quorum at a
meeting of the board of directors or of a committee which authorizes the contract or transaction.

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Modern Duty of Loyalty Analysis

Working Through DGCL § 144

1. What constitutes disclosure under 144(a)(1) & (2)?

- Must be enough info so that they are aware of all material facts to make a meaningful decision.

2. Who is a disinterested director for 144(a)(1)?

- Not completely defined. Sometimes status-based, sometimes transaction-based.
- What about disinterested shareholders?
o It doesn’t say that SHs must be disinterested to vote/cleanse. But courts interpret “in god
faith” to mean that interested SHs can’t vote.
o So you need a majority of minority (disinterested SHs) to cleanse.

Delaware (transaction-
NYSE (status-based) definition
based) definition
By a 2003 NYSE rule change (and a similar one at NASDQ), the majority Lack of direct
of directors on each publicly held firm must be “independent.” Necessary financial interest in
conditions for independence: transaction
- No “material relationship” (supplier, customer, partner) (Aronson)
- No employees or close family members of employees
- Can’t receive more than $100K from company per year (excluding +
director fees or independent deferred comp/pension benefits)
- Can’t be an affiliate, employee, or family member of Structural bias
affiliate/employee of company’s external auditor (Oracle)
- Can’t be employed (or have family employed) at another company
where the listed company’s CEO serves on compensation
committee
- Can’t be an officer/employee (or have family members that are) of
another company that does significant business with listed company

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3. Is the case over if directors prove they have met the conditions of Rule 144(a)?
- No! This is just about what standard of review you get. If you satisfy 144(a), you get BJR
protection. SH could still someone prove waste and win, possibly.

Conflicts of Interest in M&A: Applying § 144 in Practice Problem

Company Y makes an offer to buy Company X. Both are publicly traded DE corporations. The board of
Company X comprises five directors: three inside directors—(1) the CEO, (2) the CFO, (3) the general
counsel—and two outside directors—(4) Sara, and (5) Ann. The inside directors also collectively own
30% of the Company X stock (a really large percentage for a publicly traded corporation) and various
other individuals and institutions own the remaining 70%.

To entice Company X board to agree to the acquisition, Company Y sweetens the bid by providing that
the inside directors will each receive a $30M severance package if they are replaced after the acquisition.
All directors are now told that the severance packages are part of the offer.

The Company X board votes on the acquisition as follows:

- Each of the inside directors as well as Sara votes yes (4).
- Ann votes no (1).
Given that a board acts by majority vote, the acquisition is approved by the Company X board and sent to
the shareholders for approval.

The shareholders are given documentation that reveals the severance agreements for the three inside
directors.
- The inside directors vote their 30% stock in favor of the acquisition.
- The other shareholders split evenly, with 35% voting in favor of the transaction and 35% voting
against it.
With a 65% total shareholder vote in favor of the acquisition, it is approved. After the acquisition, all of
the inside directors are replaced by Company Y and receive their severance packages.

A disgruntled shareholder files suit alleging a breach of the duty of loyalty against each of the inside
directors and seeks return of the severances. Apply § 144.
- Is this a conflicted transaction? Yes. So § 144 applies.
- Is the transaction cleansed?
o Director vote: No. Not a majority of disinterested directors, because 1 voted in favor and
1 voted against.
o Shareholder vote: No. Not a majority of disinterested shareholders (split evenly).
o Entire fairness: Probably not entirely fair. Is it fair to give $90M to these three?
Debatable.
- So this will probably be a pretty successful suit.

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Delaware Quorum Requirements
“Interested directors may be counted in determining the presence of a quorum at a
§ 144(b) meeting of the board of directors or of a committee which authorizes the contract or
transaction.”
“A majority of the total number of directors shall constitute a quorum for the
transaction of business unless the certificate of incorporation or the bylaws require a
greater number. . . .”
§ 141(b)
“The vote of the majority of the directors present at a meeting at which a quorum is
present shall be the act of the board of directors unless the certificate [or bylaws] shall
require a vote of a greater number.”
Basically, for a board vote to count, a majority must be present.
- § 141(b) tells you what a quorum is.

Applying the Quorum Rules: Variation on Bayer Facts

Five directors:
- Dr. Dreyfus (interested)
- Plus four disinterested:
o Alice Adams,
o Bob Brown,
o Charlie Conners, and
o Ed Edmond.

Assume that only three directors show up to the board meeting to approve the musician contracts.
- Do they have a quorum?
o Yes. See § 141(b)—they have 3/5 directors (majority).
- Does the fact that Dreyfus is one of the three directors present matter for quorum purposes?
o No. See § 141(b)—interested directors may count in determining the presence of a
quorum.
- Alice and Ed vote for transaction. Dreyfus abstains. Has it been approved?
o It has been approved for purposes of § 141(b), but it has not been cleansed for purposes
of § 144(a)(1).
o A majority of the directors present vote for the transaction—satisfying § 141(b)—but we
only have 2 out of 4 independent directors.
o We need one more independent director to satisfy 144(a)(1).

The action will go forward because it was approved, but you don’t get protection under § 144 for
the director vote.

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Quorum vs. Authorizing vs. Cleansing
Quorum Authorizing Cleansing
Definition: number of directors Definition: number of directorsDefinition: number of
who must be present at a board who must vote for an item for it
disinterested directors (or
meeting for it to be valid to count as a valid action of the
shareholders) who must vote for
board. action to remove conflict of
- Default: majority of interest
- Majority of all
directors present at meeting
with quorum. disinterested directors
(regardless if they attend
the meeting!!)
Statutory source: § 141(b) and Statutory source: § 141(b) Statutory source: § 144(a)(1)
§ 144(b) or (2)
You can have authorized action that is not cleansed!

Tentative Summary of “Cleansing”

Note: § 144 is used in other situations in which it isn’t binding. It’s only binding in the duty of loyalty
context.
Duty of Care Suit Duty of Loyalty Suit
(Director/Officer) (Director/Officer)
§ 144 NOT Binding! § 144 Binding!
(a) Informed Board Vote (a)(1) Informed Board Vote
- If truly informed and disinterested  BJR - If truly disinterested  BJR
- Interested  go to (a)(3)
(b) Informed Shareholder Vote
- Absolute defense (a)(2) Informed Shareholder Vote
- If disinterested  BJR
(c) Entire Fairness - If interested  go to (a)(3)
- Affirmative defense
- Burden on the defendant to show (a)(3) Entire Fairness
- Affirmative defense
- Burden on defendant to show
Corporate Opportunity Doctrine (Subcategory of Duty of Loyalty)
Part of the fiduciary duty of loyalty!
- Limits corp. fiduciary’s ability to pursue new business
prospects individually without first offering them to
corp.
- Can be seen as a special type of self-dealing—when
you take an opportunity to pursue something that
actually belongs to the corporation, you are
effectively stealing from corporation.
Applications of particular interest/salience:
- Firms with significant human capital components
(e.g., law)
- Corporations with overlapping directors (e.g., are you on multiple boards?)
- Parent/subsidiary context

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Basic Roadmap of the Corporate Opportunity Doctrine: Flowchart
Similar to basic § 144 analysis.
- Appropriation: has to be a unique opportunity!

Definition of Corporate Opportunity

(Step A in Flowchart)
Defenses
Alternative Tests
(Defendant typically bears
(Plaintiff bears burden of proof)
burden of proof)
1. Interest or expectancy (narrow test) 1. Corporate Incapacity
- Interest = the firm already had a preexisting contractual right to the - Corporation could not pursue
opportunity the opportunity because of
- Expectancy = though not a contractual entitlement, reasonable for financial limitations, legal
the firm to expect to receive the opportunity constraints, or other
considerations.
2. Line of Business (broader test) - Most effective when alleged
- More dynamic test; meant to capture the corporation’s expansion incapacity is observable to
potential. third parties!
- Not limited to the firm’s current interests or expectancies (Guth v.
Loft test) 2. Source
- Defendant became aware of
3. Hybrid Tests opportunity through his
- ALI holds corporate executives to a higher standard (interest or personal capacity, unrelated to
expectancy AND line of business) and outside directors only to his service to the firm.
interest or expectancy - Hard to prove!

4. Fairness 3. Corporation Renounces

- Focus on the fairness of holding the director/officer accountable for Opportunity
the outside activities. Very subjective - See DGCL § 122(17)

“Refuse-to-Deal”

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DGCL § 122
Every Corporation created under this chapter shall have power to….
(17) Renounce, in its certificate of incorporation or by action of its board of directors, any interest or
expectancy of the corporation in, or in being offered an opportunity to participate in, specified business
opportunities or specified classes or categories of business opportunities that are presented to the
corporation or one or more of its officers, directors or stockholders.

Basically, you can renounce certain corporate opportunities in advance!

When a Corporate Opportunity Exists: Broz v. CIS

Two companies, RFBC and CIS, both provide cell phone services. Broz served both corporations:
- RFBC = sole shareholder and president
- CIS = outside director.

Broz has opportunity to buy a cell phone license called Michigan-2—offered to him as president of RFBC
(important, because this makes it less likely to be CIS opportunity)
- It was not also offered to CIS because he did not consider it a viable purchaser b/c of financial
problems.
- Nonetheless, Broz informally clears opportunity with CIS CEO in addition to several other board
members at CIS
o In the end, this doesn’t matter, because it wasn’t a corporate opportunity.
- Issue: Does PriCellular’s negotiations to acquire CIS mean Broz owes a duty to PriCellular?
NO.

Factors that Support Existence of Corporate Opportunity

1. Corporation is financially able to take the opportunity
2. Opportunity is in the corporation’s line of business
3. Corporation has an interest or expectancy in the opportunity
4. Embracing the opportunity would create a conflict between director’s self-interest and that of the
corporation.
**At this point, unclear if this is a conjunctive/disjunctive test or merely a list of factors. The court
muddles together several different legal standards and questions…

KRB Problems 351–52

Suppose that RFBC had had shareholders other than Broz and that CIS had a potential interest in
Michigan-2, unknown to Rhodes (the broker for the seller). What should Broz have done? Was he
obligated only to inform CIS, or, rather, to allow CIS to proceed without competition from RFBC?
- This is a basic conflict; he can’t be a fiduciary to both entities.
- When Broz took position at CIS, he could have asked them to renounce the opportunity ahead of
time [DGCL § 122(17)]. Then he would have avoided the issue.

Was the court fair in treating CIS’s interest in Michigan-2 as separate from PriCellular? At what point
should PriCellular’s interests affect fiduciary obligations owed to CIS?
- Negotiations were uncertain.
- Maybe Broz had a duty to PriCellular once it was absolutely certain that the deal would go through.

Applying the Line of Business Test: In re eBay SH Litigation

****Guth v. Loft line of business test:

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 “Where a corporation is engaged in a certain business, and an opportunity is presented to it embracing an
activity as to which it has fundamental knowledge, practical experience and ability to pursue,
which, logically and naturally, is adaptable to its business having regard for its financial position, and is
one that is consonant with its reasonable needs and aspirations for expansion, it may be properly said
that the opportunity is in the line of the corporation’s business.”

Facts
- Goldman kind of bribes eBay CEO because it wants to keep/get eBay’s business.
- BUT: eBay wanted/could have had the opportunity!

Analysis
How does court analyze whether the IPO allocations should be treated as a corporate opportunity?
- Financial ability to invest: eBay could have done it
- Line of business: Is eBay a mutual fund?
o No, but it did have some equity investments.
- Source defense doesn’t work here—defendants argue that treating this as corporate opportunity
will mean that every investment opportunity that comes to an officer/director will be considered a
corporate opportunity.
o But he was approached because of his relationship with eBay!
- Alternative hypo: Assume Omidyar (eBay’s CEO) has personal investments with Morgan Stanley—
which has never done work for eBay. MS offers Omidyar an IPO allocation with a new firm. Is this
still a corporate opportunity of eBay?
o Depends—are they trying to get eBay’s business?

Questions KRB 353–54

Suppose the independent members of eBay’s board of directors had authorized the defendants to accept
the allocated shares. What result on such facts?
- Under Broz, rejection of a corporate opportunity by an independent board creates a safe
harbor. By analogy to the case law under DGCL § 144(a)(1), within this safe harbor, the standard of
review shifts to the BJR and plaintiff must prove waste.

Spinning of IPO shares in circumstances such as those alleged in the eBay case is widely regarded as
unethical and possibly illegal. Should these considerations factor into corporate opportunity analysis? If
so, how?

Consequences of Corporate Opportunity Status/Cleansing the Conflict

1. The fiduciary must generally disclose the existence of the corporate opportunity (and her conflict
of interest) to the board/shareholders.

2. Corporation has right of first refusal on the project.

- But the board can choose to give it to the fiduciary.
- Must disclosure/rejection be “formal”? What benefit could Broz have gained by formally
disclosing to the full board?
o They could have given him the opportunity.
o Under DE law, disclosure/rejection does not have to be formal

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 - Is it subject to same three “cleansing” criteria as for duty of loyalty under DGCL § 144?

- Rejection of a corporate opportunity by an independent board creates a safe harbor. By

analogy to case law under DGCL § 144(a)(1), within this safe harbor, standard of review shifts to
the BJR and plaintiff must prove waste.

3. Remedy: Gains-based (constructive trust)

- Injunctive relief and punitive damages also.

Beam ex rel. Martha Stewart

Plaintiff Beam raised a corporate opportunity claim:
- In January 2002, Stewart sold 3,000,000 shares of Martha Stewart Omnimedia (MSO) Class A
Stock to “ValueAct.” In march 2002, Doerr (a member of MSO’s board of directors) sold
1,999,403 shares of MSO to ValueAct.
- The amended complaint alleges that Stewart and Doerr breached their fiduciary duty of loyalty,
usurping a corporate opportunity by selling large blocks of MSO stock to Value Act.

In other words, plaintiff alleged that Stewart and Doerr took a corporate opportunity by selling some of
their MSO stock to a group of investors. The opportunity usurped from MSO was one of raising capital
by selling stock, which was preempted by Stewart’s and Doerr’s sales.
- Is this a corporate opportunity?
- Even if a court concludes that this is a corporate opportunity, how else could you defend Stewart
and Doerr?
o Stewart and Doerr have not “appropriated” the opportunity. MSO could still issue an
additional 5,000,000 shares and sell to the public.

Problems
George is Vice-President for marketing of ZapCo Enterprises, Inc., a manufacturer of video game
software used in arcades and home systems. One of George’s duties is to test competitor models. One day
George leaves work and travels to a near-by video arcade to test a new game. While visiting the arcade,
George meets two young computer software engineers who have developed a new voice recognition
program for personal computers. After further meetings with the engineers, George decides the program
has promise and offers to help market it. The two engineers set up a new corporation called “Wordco,
Inc.,” and hire George as a marketing consultant. George receives 10 percent of Wordco’s common stock
and also becomes entitled to a commission of $10 for every copy of the program sold by Wordco. Zapco
sues George for violating the corporate opportunity doctrine.

1. Assuming Zapco is incorporated in Delaware, has George violated the corporate opportunity doctrine?
- Probably not a corporate opportunity:
o No interest or expectancy; and
o Probably outside Zapco’s line of business (although this depends on how broadly we
define Zapco’s line of business, obviously)

2. What if the engineers had approached George at Zapco’s booth at a computer trade fair?

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 - It appears the engineers intended to offer the product to the company, not to George in his
individual capacity—so source defense is unavailable.

3. Would it be relevant to the outcome that the two engineers refused to work with Zapco, because they
refused to work with a mere game company?
- The “refuse to deal” defense is analogous to the capacity and financial incapacity defenses.

4. Assume that after meeting with the engineers, but before signing the contract with Wordco, George
approached Zapco’s CEO and told him about the project. The CEO said Zapco had no interest in the
project and no objection to George working for Wordco as long as it did not interfere with his Zapco
duties. Result?
- OK. Under Delaware law, formal consideration of the board is not required.

5. Suppose the transaction was a corporate opportunity. In perfect good faith, George takes it for himself.
He then mentions to the firm’s lawyer that he is working on this word-processing project on the side. The
lawyer sees that this is a corporate opportunity, which should have been offered to the company. Based on
the lawyer’s advice, George tells the board of directors about the opportunity, offers it to the corporation,
and asks the board to ratify his taking the opportunity. The board does so. Is George insulated from
liability?
- As long as the opportunity still exists and could still be pursued by Zapco, a vote of the board will
formally cleanse George’s actions, providing a safe harbor.
o Corporation can cleanse after fiduciary has already decided to pursue.
- But, plaintiff could still prevail by showing that the board made an uninformed decision or lacked
independence.

Fiduciary Duties of Dominant Shareholders (Extension of Duty of Loyalty)

Fiduciary duties owed by shareholders are an extraordinary measure.

Hypo: Suppose Google plans to acquire Microsoft. The agreement will be voted on my Microsoft’s board
and by Microsoft’s shareholders.

1. A Microsoft shareholder makes no effort to inform himself before voting. Any liability? What if it were
an uniformed director?
- Uninformed shareholder—no duty! You don’t owe a duty just by being a director.
- Uniformed director—yes!!

2. Assume a Microsoft shareholder owns a large number of Google shares. Can he still vote his Microsoft
shares?
- Yes, as long as it’s a small holding of stocks—even though hands/incentives are not clean.
- What if it were a Microsoft director with significant ties to Google?
o Directors are treated differently! This is a conflict of interest.

3. What if an individual owns 30% of Microsoft stock and 40% of Google stock? Does anything change?
- Yes! You have a large enough stake that you can actually affect the outcome—but there is no
bright-line rule about how much you need to own before we attach this liability/duty.

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Vertical vs. Horizontal Agency Conflict

When are we particularly worried about

horizontal conflicts?

Fiduciary Duties and Dominant Shareholders

What is a dominant shareholder (DSH)?
- SH can be dominant with less than 50% of shares (more than 50% = “CONTROLLING” SH)
- Courts usually presume dominance at 25% ownership.
- Minority shareholder complaints against DSHs predominantly focus on duty of loyalty issues.
o Not really about duty of care here.

Direct vs. Indirect Conflicts

- Direct: Dominant SH forced decision resulting in a non-pro rata distribution of corporate
“property” (e.g., cash; assets; info; corp. opportunities)
o Clearly illegal and clearly a conflict—no BJR protection!
o More common when you have multiple classes of stock.
- Indirect: Dominant SH forced a decision that didn’t result in a non-pro rata distribution, but still
favored the DSH’s outside business interests and not the minority SHs
o Much harder threshold to cross.

Multiple Classes of Stock

In firms with multiple classes of stock (i.e., common + preferred), plaintiffs often litigate based on
dominant shareholder fiduciary duties.
- Easier to classify as direct as opposed to derivative.
- Easier to show a conflict of interest (i.e., preferred stock has different financial rights than
common) and therefore avoid BJR.

“Cleansing” and Dominant Shareholders

DGCL § 144 gives only the requisite procedures for cleansing duty-of-loyalty transactions by
directors/officers, but it has become so routine that courts have begun to analogize it to other contexts,
such as:
- Duty of care (informed SH vote); and
- Interested transactions effected by dominant shareholders.

What problems would you expect in analogizing § 144 to the dominant SH?
- See Flieger v. Lawrence—must have a majority of the minority (MOM) clause (majority-vote
of the non-dominant shareholders) to cleanse.

Shareholder Ratification
In each case, all material facts must be disclosed to shareholders for ratification to have any effect.
- SH ratification of duty of care problem kills the claim
- SH ratification of a director conflict shifts the burden of proof to the plaintiff and the plaintiff
must show waste (i.e., no rational basis for the action)

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 - SH ratification of a dominating shareholder conflict shifts the burden of proof to the plaintiff,
but the plaintiff only needs to show that the transaction was unfair (i.e., no BJR).

Cross-Voting Game
Two companies—each has issued 10 shares of stock.
- Red Corp (acquirer)  worth $100 at start ($10/share)
- White Corp (target)  worth $100 at start ($10/share)

Red Corp offers to buy White Corp for $X.

- White Corp shareholders need to approve the merger by majority vote.
- Assume Red Corp offers $2/share (or $20 total) to acquire White Corp.
- If there are shareholders with both Red and White stock, they can manipulate the vote.
o E.g., SH with 6 white and all of red—they will vote for the merger because they stand to
gain more with their red shares.
o Whenever you hold more interest in the acquirer, your votes for the target will be
tainted.

Sinclair v. Levien
Three allegations:
1. Sinclair caused Sinven to pay “excess” dividends
2. Sinclair did not allocate development/exploration
opportunities outside Venezuela to Sinven
3. Sinclair caused Sinven to allow another Sinclair
subsidiary (Sinclair Int’l) to breach contracts with Sinven
without seeking damages.

Excess Dividends Claim

- 1960–66: Dividend payments of $108M ($38M more than earnings over same period)
- Legal basis for claim: duty of loyalty
o Why does it fail? Because Levien is still getting his 3% interest here.
- When does a conflict of interest exist?
o Direct: Dominant SH forced decision resulting in a non-pro rata distribution of corporate
“property” (e.g., cash; assets; info; corp. opportunities)
o Indirect: Dominant SH forced a decision that didn’t result in a non-pro rata distribution,
but still favored the DSH’s outside business interests and not the minority SHs

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Usurping Corporate Opportunity Claim
Sinclair expropriated oil exploration opportunities (Alaska, Canada, Paraguay) without giving to Sinven.
- Line of business: they define Sinven’s line of business very narrowly (they were only in
Venezuela and not entitled to opportunities elsewhere)
- Does it matter that Sinclair effectively chose how to divide up opportunities among its
subsidiaries?
o No—we don’t care that Sinclair is the one deciding Sinven’s line of business.
▪ Key: Decision that parent corporation makes about how to structure
subsidiary’s line of business  pretty much up to business (BJR)

Breach of Contract
Contract between Sinven and Sinclair Int’l (100% owned by Sinclair). Covered sale of all of Sinven’s oil
at defined prices.
- SI often paid Sinven late, and
- SI often failed to buy minimum amount of crude oil from Sinven.
- Clearly a violation of duty of loyalty—no BJR
o Sinclair benefits from Sinclair Int’l paying late, etc.
o For each dollar SI pays in full, Levien is supposed to get 3 cents. When SI fails/breaches,
Levien gets nothing and Sinclair had no incentive to enforce SI’s breach.

Questions KRB p 359

- Was the shareholder duty-of-loyalty analysis necessary to decide Sinclair? How might one have
resolved the case using only the law regarding the duty of loyalty of directors? Could you reach
the same outcome?
o It would be hard to get enough disinterested directors to insulate minority SHs.
o And by framing it this way, it can be a direct lawsuit.
- When corporation P owns a large percentage of the stock of corporation P, P almost inevitably
dominates S. However hard P tries to insulate S from P’s influence, S managers will know that P
can decide whether to fire them or promote them. Given that fact, how might P try to deal with
the risk that the minority shareholders in S may file fiduciary suits against it?
o Short-form merger: Cash out your minority SHs.
o Or, make sure you get enough minority SHs/disinterested directors to sign off on
everything.
- Hypothetical
o Change the facts—suppose that a third party oil company was interested in oil
exploration in international waters off the coast of Venezuela. Sends letter to Sinclair
board proposing a joint venture with entire Sinclair itself or Sinven. Can the CEO:
▪ Accept the opportunity on behalf of Sinclair without disclosing the offer to
Sinven board/SHs?
• Apparently no—see Zahn
▪ Disclose opportunity to Sinven board/SHs, but announce that Sinclair will use all
its power (even its majority stake in Sinven) to ensure that the joint venture goes
to Sinclair and not Sinven?
• Apparently yes: Thorpe v. CERBCO—but controlling SH may be liable
for damages incidental to breach of duty.

Zahn v. Transamerica

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 - Preferred: par value $100; dividends; no
voting rights; liquidated before common
- Class A: $3.20/share dividend; convertible to
B; can’t vote unless dividends aren’t paid; each
sahre gets twice as much as B when liquidated;
callable
- Class B: $1.60/share dividend; voting rights;
1:2 liquidation

Why this complex structure?

Probably at one point needed a separate class for
certain insiders—almost like a private equity firm.
Almost certainly more for financing than anything else.

The problem: Zahn (Class A) feels taken advantage of—Class B (of which Transamerica is 80% owner)
actually had control over the firm and took action that benefitted Class B at expense of Class A.
- Transamerica learns private info about the value of inventories and uses that information to
squeeze down Zahn/Class A!

Key Takeaways:
- Multiple classes of stock: You must disclose why you are calling the other class, if you do.
- Must favor common stock over preferred if given the choice!

Problem/Illustration Using Zahn Facts

- Assume following facts about Axton Fisher:
o $10M in debt outstanding
o Preferred shares have aggregate liquidation value of $5M
o 100,000 shares of Class A common stock outstanding (no unpaid dividends)
o 100,000 shares of Class B common stock outstanding
- The board of directors is controlled by the Class B stock (and Class A has no voting rights)
- Assume AF is liquidated/sold at one of the prices below. How much is paid out to (i) debt; (ii)
preferred stock; (iii) Class A; and (iv) Class B?
o Sale = $12M
▪ $10M to debt; $2M to preferred
o Sale = $21M
▪ $10M to debt; $5M to preferred; $4M to Class A; $2M to Class B
o Sale = $45M
▪ Depends on whether Class A shares are called and/or converted. This is the
problem in the case.
▪ Assuming neither: $10M to debt; $5M to preferred; $20M to Class A; $10M to
Class B
▪ Assuming called and converted: $10M to debt; $5M to preferred; $0 to A (all
converted to B); $30M to Class B
• All A would convert to B  giving 200,000 shares of B, and each share
of B would receive $150.

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Numbers in Zahn
Basically, if the merger/liquidation is below a certain amount, Class A gets paid more than B (if company
is not as successful). But if company IS successful, Class A (in theory) should all convert to Class B in
order to get the same deal as Class B.
- Class B will exercise the right to call Class A stock whenever Class A is set to get more than
$60/share.
- But if the company calls the As for redemption and the As know that the company has
$30,000, what will they do?
o If you are Class A, you should exercise your 60-day notice period and convert to Class
B—inferring that Class B will not call the stock unless it works out in its favor.
o So why didn’t the As convert? No idea.
- Will the fact that the corp calls the stock always signal to As that they would be better off
converting?
o Probably, but not necessarily. Suppose, for example, that the company is worth $10,000.
If it liquidates without redeeming the As, the As will get $66 and the Bs will get $33. If
the company redeems the As, the As will get $60 and the Bs will get $40.
▪ In this example, the Bs have an incentive to have the As redeemed, but the As do
not have an incentive to convert.

Analysis of the Dominant Shareholder Duty

- Who were the residual claimants?
o Could Transamerica have been sued by Class B shareholders if it had not called the Class
A shares when it discovered the value of the inventory?
▪ In theory—they probably do owe a duty. Call B common stock and A
preferred—A is more like junior preferred stock anyway.
▪ They do have an obligation to favor common stock over preferred when they can.
- If so, then what rights do Class A shareholders have under fiduciary duty law? How did TA
breach their duty to the Class A shareholders?
o The call itself is not the problem—it’s the failure to disclose and the fact that they sprung
the liquidation without disclosing.
o The board can and should favor Class B. But the board needs to specify why it is calling
the shares—then, Class A can protect itself.
o Class A needs to be given full info to be able to exercise its rights intelligently.
- How to cleanse:
o Board level: board members who were not Transamerica-elected would have to vote for
the action
o Shareholder level: majority of the minority would have to approve (without dominant
shareholders)

Protection of Minority Shareholders in Closely Held Firms (Exception to Duty of Loyalty)

- Why are minority shareholders more vulnerable in closely held firms?
- What are “freeze out” and “squeeze out” techniques?
o If you leave, you don’t get your salary, firm doesn’t have to pay dividends (because it’s
closely held), and you can’t sell your shares.
o Then, remaining shareholders can offer to buy your shares for too low of a price, and you
have no choice but to accept.
- Delaware law sees this as a business decision—whether to pay dividends. This is why it is
difficult to prevent “freeze out” under traditional principles of corporate law.

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Facebook
Storyline
- Time 1: Mark (CEO) designs website; Eduardo (CFO) puts up $18K
- Time 2: Mark moves out to Palo Alto; Eduardo stays behind (no longer an employee)
o Facebook gets VC financing and hires lots of new employees
- Time 3: Eduardo’s ownership diluted down to .03%
o Before: Mark was 70% and Eduardo was 30%
- Ends up being very successful suit.

Donahue v. Rodd
To protect minority shareholders, court imposes:
- Fiduciary duty of utmost good faith and loyalty between shareholders in closely held firms
o More like a partnership—right runs directly to shareholder.
▪ So you can’t win by showing fairness to the corporation. (duty not owed to
corporation!)
o Turns all shareholder/shareholder conflicts into direct
▪ In DE: just plead them as direct (some harm to a class of shareholders)
o Includes benefits often thought unconnected to rights as shareholder, like employment
positions
o Pulls out a lot of stuff that would get BJR normally in DE>
- Equal opportunity rule: minority shareholders must have equal opportunity to sell shares to
corporation on same terms as controlling shareholder
o Designed to prevent preferential distribution, but it might be fairly unworkable.
▪ What if you want to buy out a single employee because the relationship isn’t
working? You would have to make the same offer to every shareholder.
o So subsequent courts have reduced scope of this rule.
o And many closely held corporations will choose not to incorporate in MA.

**Note: NOT a Delaware court!!

Duty of Good Faith

Early Mention of Good Faith
Hints:
- Only directors who act in good faith are entitled to indemnification (DGCL § 145)
- Director reliance on records and papers from officers/advisors must be in good faith to be “fully
protected” against shareholder claims. (DGCL § 141(e))
- Related party transactions must be approved by the disinterested directors or shareholders in good
faith. (DGCL § 144(a)(1) & (2))
- BJR presumes that directors acted, inter alia, in good faith.

Yet, good faith was traditionally “subsumed into a court’s inquiry into the director’s satisfaction of her
duties of care and loyalty.”
- Cede v. Technicolor  first DE case to suggest that GF was a separate duty apart from care and
loyalty

Duty of Good Faith as Independent Fiduciary Duty

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In re Disney Shareholder Litigation

Earlier Case – Brehm v. Eisner

Supreme Court upheld dismissal, but without
prejudice, as the fiduciary duty claims regarding:
- Approving Ovitz’s contract
- Approving Ovitz’s non-fault termination

Brehm provided recipe for pleading these

allegations in new lawsuit:
- Directors didn’t rely on expert advice;
- Directors relied, but not in good faith
- Directors did not believe expert’s advice was
within expert’s professional competence
- Faulty process in selecting expert
- Patent deficiency in expert’s advice
- Board’s decision was unconscionably wasteful.

Points
- Have to give lawyer a bit of credit for not finding a
way to fire him for cause  pay severance
- Plaintiff lawyers are trying to argue that the contract gave Ovitz an incentive to get fired early.
- Expert advice at issue is the compensation report/recommendation!

Claims Against Ovitz—Time 1

Pre-contractual negotiation of package: Ovitz owed no de facto fiduciary duties to company when basic
terms were negotiated.
- De facto duties only work when you have an official start date but are in control earlier than that
(and use that control to negotiate your contract, e.g.)

NFT determination (edited out of KRB): Ovitz remained completely outside this decision—his
involvement actually would have created a conflict of interest problem anyway.
- Appropriate and consistent with fiduciary obligations for him not to have been involved.
- Can’t blame him for not being fired for cause!

Claims Against Board—Time 1 (Approval of Compensation Plan)

Duty of Care:
- Compensation committee, while not an exemplar of best practices, was adequately informed
about terms of OEA.
- Best practices not required to comply with duty of care.
o They had all of the information; they could have done the math themselves
o You can be somewhere in the middle and still meet the standard for duty of care!
(contrast with Van Gorkom)
- Board reasonably relied (§ 141(e)) on compensation committee’s approval of contract and
additional information.

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Duty of Good Faith:
- “Intentional dereliction of duty, a conscious disregard for responsibility . . . [d]eliberate
indifference and inaction in the fact of a duty to act.”
o But not a well-developed area of law.
- Describes categories of bad faith along spectrum

A Middle Ground on Bad Faith

- Bad faith ≠ gross negligence (not the same as duty of care)
- Bad faith ≠ conflict of interest (not the same as duty of loyalty)
- There are some things in the middle. Chancellor suggests three categories:
o Intentional act against corporation
o Intentionally causing corporation to violate law
o Intentionally failing to act in face of known duty to act
- But is there anything that is bad faith but not also a breach of duty of care or duty of loyalty?
o If you’re acting intentionally contrary to the corporation’s interests, you’re probably self-
dealing!
o **Note: you might have been able to prove bad faith by Ovitz if he was intentionally
trying to get fired
- So we don’t really know what the middle ground is. Maybe tax evasion?

Why argue bad faith?

May allow you to sidestep BJR and § 102(b)(7) without showing a conflict of interest.
- DGCL § 102(b)(7): expressly denies money damage exculpation for “acts or omissions not in
good faith or which involve intentional misconduct or a knowing violation of law”
o If acting in bad faith, this section no longer applies and you can hold director personally
liable!
- BJR: Our law presumes that “in making a business decision the directors of a corporation acted
in good faith, and in the honest belief that the action taken was in the best interests of the
company.”
o If you can show bad faith, no BJR.

Duty of Good Faith as Subsidiary of Duty of Loyalty

Key: whenever we see duty of loyalty on exam  CONFLICT OF INTEREST (unless it specifically says
it’s a bad faith claim!)
- This is an odd outlier area of law and plaintiffs just aren’t bringing these cases (necessary fact
pattern is too hard)

Stone v. Ritter
**SUBSEQUENT decision by Del. S. Ct.

More relevant version of Caremark claim! Nature of claim = failure to monitor money laundering.
- Background Violations:
o AmSouth managers failed to prevent company from being complicit in money laundering
scheme, despite suspicions of employees
o AmSouth paid $50M in fines and penalties to settle civil and criminal charges related to
money laundering.

- Derivative Lawsuit

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 o Plaintiff brings claim to recover the $50M in fines/penalties.
o Alleged that board failed to implement “monitoring, reporting, or information controls
that would have enabled defendant to learn of problems requiring their attention”

The Status of “Good Faith

- Case analyzed under legal doctrine of good faith.
o Court invokes Caremark decision as a test for failure to act in good faith.
- No such breach of duty of good faith here.
o Lack of proof regarding awareness of “red flags”
o Unclear whether Caremark requires deliberate failure to act (as opposed to gross
negligence)
▪ Gross negligence typically sufficient to show breach of duty of care, but bad faith
presumably requires more…
o Must show that the system they installed was deliberately inadequate—something more
than gross negligence; probably need some level of intent.
- Duty to act in good faith is not an independent fiduciary duty.
o Rather, it is a subsidiary of the fiduciary duty of loyalty.

Implications
- Sends signal that good faith is not a simple “end run” around § 102(b)(7) protections.
o Labeling good faith as subsidiary to duty of loyalty appears to raise the bar of proof
higher than gross negligence—i.e., plaintiff needs to show intent.
▪ But if you can get around it, you do get personal liability
- Appears to expand duty of loyalty to dover bad faith cases where there is no conflict of interest
(this is a benefit to plaintiffs!)
- Creates greater ambiguity in boundaries between fiduciary duties, and creates particular
confusion in understanding Caremark-type claims under the duty of loyalty
o Prevents exculpation under § 102(b)(7) (these are now duty of loyalty claims)
o Remedy may differ from typical duty of loyalty cases, as defendant directors may have
not received any ill-gotten gains.
o You cannot cleanse bad faith…

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 Solution 2: Shareholder Voting &
Governance
Shareholder Voting: Mandatory or Default Rule?
Two types of corporate rules:
- Default rules: parties can easily modify contractually
- Mandatory rules: parties can’t modify, or can only do so at significant cost

Is shareholder voting a mandatory or default rule of corporate law? Both.

- You can change a lot of things related to shareholder voting.
- But there are certain issues that you must have votes on.
- Default rule: DGCL § 212
o “Unless otherwise provided in the certificate of incorporation . . . each stockholder shall
be entitled to 1 vote for each share of capital stock.”
- But it is possible to have a class of stock with ten votes, e.g., for each share, or non-voting stock.
o There must be at least one class of shares that can vote on required matter (e.g.,
electing directors, voting on acquisitions, etc.)

Direct vs. Indirect vs. Advisory

Board controls majority of corporate decision-making; representational democracy. Shareholdrs typically
get to vote on three types of matters:
- Indirect: electing the directors
o Annual SH meeting (required once a year)
o Less meaningful thank it appears (only one set of candidates usually)
- Direct
o Get to vote directly on mergers, major asset sales, reorganizations, charter amendments,
and other matters in corporate charter
- Advisory
o Shareholder proposals and executive compensation
o New in last five years! Part of Dodd-Frank Act

Overview: Shareholder Voting/Governance

- Contractual Foundation of Shareholder Voting
o Basic existence of shareholder voting is mandatory, but
o Flexible in number of votes/share; thresholds; issues shareholders get to vote on; etc.
- Proxy Voting and Proxy Fights
o Proxy voting helps insure valid quorum, but
o Asymmetric cost to insurgents vs. incumbents  few actual proxy fights  voting is
largely a rubber stamp of current board
- Shareholder Proposals (publicly traded firms)
o Easy (and low cost) to get on the ballot, but generally precatory
o Exception: bylaw amendments (can indirectly be used to give SHs right to nominate
directors—Rule 14a-8(i)(8))

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 - Shareholder Inspection Rights
o Access to SH list (valuable in tender offer or proxy contest)
o Must have some corporate purposes for the request
- Control in Closely Held Firms
o Shareholders can contract over how they will

Proxy Voting
Typical Annual SH Meeting
- Nominating committee of the incumbent board of directors nominates a slate of directors to be
elected at next annual meeting
- Incumbent board identifies other issues to be put to vote
- At company expense:
o Management prepares proxy statement and card
o Management solicits shareholder votes (typically with aid of proxy solicitor)

Proxy Voting Rules

Two layers of regulation:
- State corporate law (see, e.g., DGCL § 212)
- Federal law: Securities Exchange Act (1934) and SEC rules (14a-1 to 14a-9)

The State Law Story

All corporations are required to have annual SH meeting, but they typically have low turnout.
- Why? If you don’t have enough shares to make it worth it, you won’t go.
- Creates problems with quorum: not enough SHs present  invalid vote
- Solution: proxy voting
o Because, normally, the shareholder vote is just a rubber stamp for the board’s decisions.
o So we allow shareholders to vote through the mail.

The Federal Story

If we are going to allow voting through proxy by mail, we are going to require that shareholders be
informed and that certain procedures are followed. Securities laws increase disclosure and ensure that
shareholders have accurate information.
- Section 14(a) of 1934 Act: regulates anyone who solicits a SH proxy vote (which may not just be
the board! Any SH can launch a proxy contest)
- If you solicit proxies, you must give each SH a proxy statement (14a-3 to 14a-5)
o More disclosure required for contested meetings
o Must file material with SEC (14a-6)

Proxy Card Requirements

What is included on a proxy card? [Rule 14a-4]
- Must identify each matter to be voted on
- May give discretionary authority to vote on other matters that may come before the meeting, but
not elections to office for which a bona fide nominee is not named
- For, Against, and Abstain boxes required for each matter other than election of directors
- For and Withhold Authority boxes for election of directors so that a shareholder may withhold
authority to vote for individual directors
- Proxies may be revoked and if more than one proxy is given, the latest proxy governs

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What happens if SH does not return the proxy card?
- Vote does not count! Can cause problems for quorum.
- But may SHs own stock indirectly through brokerage/pension/investment funds  fund manager
votes
o So, in reality, not hard to get a quorum for public corporations.

What happens if SH returns the proxy card but does not specify how he/she will vote on one or
more of the items?
- Shares count toward meeting the quorum.
- Proxy agent will vote the shares as specified in the DE14A filing.
o Default is whatever is recommended by corp on the card! Basically giving a blank check
to the proxy agent.

Sample Proxy Card

Proxy Contests
A shareholder (aka the insurgent) solicits votes in opposition to the incumbent board of directors.
- Electoral contests: insurgents run a slate of directors in opposition to slate nominated by
incumbent board

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 - Issue contests: shareholder solicits votes against some proposal
o E.g., shareholder urges fellow stockholders to vote “no” on a merger.

Reimbursement Rules: Basics from Levin and Rosenfeld

1. The corporation may not reimburse either party unless the dispute concerns questions of policy.
2. The firm may reimburse only reasonable and proper expenses.
• Probably get BJR protection re: what is reasonable
3. The firm may reimburse incumbents whether they win or lose.
4. The firm may reimburse insurgents only if they win, and only if shareholders ratify the payment.
• Risky move for insurgents and really stacked against them, so proxy fight may end up being
less of a tool than it seems at first.

But since most proxy fights can be classified as Proxy Expenses Reimbursed [Yes/No]
questions over “policy,” and expenses are (assuming (i) policy dispute and (ii) reasonable
generally treated as reasonable and proper, we can expenses)
simplify. Reimbursement depends on two Win Lose
factors:
Yes Yes
- Who won the proxy contest, and Incumbents
[Levin] [Rosenfeld]
- Identity of the party (insurgent or
No
incumbent). Yes, if ratified
Insurgents [Rosenfeld—by
[Rosenfeld]
implication]

Example Cases
Levin v. MGM
What do you think would happen to members of the O’Brien group if Levin were to win the proxy fight?
Would they just lose their board seats?
- No—they will also get fired.
- Does this create a conflict of interest?
o Management’s role does create a conflict, but all the O’Brien group has to do is show that
they made a business decision. They already have an advantage.
o If there is a legitimate business dispute behind the conflict, courts will ignore it.

Disagreement is over policy—important! Not about personality.

Rosenfeld v. Fairchild
Insurgents win proxy fight; take control of the board. Costs: Incumbents = $134,000; Insurgents =
$127,000. All costs (both sides) reimbursed by corporation—incumbents while in office, insurgents
ratified by SHs after the proxy fight.
- Plaintiff holds tiny shares of stock and loses because the dispute is over corporate policy and
expenses were reasonable.
o Even though there were 4 proxy solicitation companies hired.

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Proxy Fights vs. Tender Offers
- Awesome Corp. is worth $10M. You own 1% of the equity.
- Poorly managed; Value could be raised by 50% by firing the current
managers.
- Two options: proxy fight and tender offer. What do you choose?

Proxy Fight  Replace Board

- Would cost you $100,000 to wage effective proxy fight, with 50%
chance of success. Is this worth pursuing?
- You bear the risk that you will lose and have to pay the whole cost, and
you only get a 1% share in return (since you own only 1% of stock)

Tender Offer  Buy up Stock  Replace Board

- Suppose you need to pay a 30% premium to convince everyone to tender their shares. Is this
worth pursuing?
- You stand to get more benefits because you would capture all of the gains of turning the company
around!
Shareholder Proposals: Alternative to Proxy Voting and Tender Offer
Proxy fights and tender offers suffer a common problem: they are expensive (especially tender offers!)
- By contrast, a SH proposal can be fairly inexpensive.
- Qualifying SHs can add a proposal to a company’s proxy statement
o Expenses are thus borne by the company!
- Corporation gets to explain why shareholders should or should not vote for the SH proposal.

Who are Proponents?

- Hedge and private equity funds
- Pension funds
o Union (e.g., AFSCME)
o State and local employees (e.g., CALPERs)
- Individual activists
- Charities (religious groups)

Current Issues
CSR Governance
- Global human rights policies - Takeover defenses
- Contract supplier standards o Removal of poison pills
- Sexual orientation non-discrimination o De-stagger board of directors
o Gender identity non- (annual elections for all)
discrimination - Board diversity and independence
- Emissions reduction & energy efficiency - CEO compensation
reporting - Pay disparity
- Renewable energy sources - Say on pay
- Indigenous rights policy - Political construction disclosure
- Recycling - Separate CEO and chair
- Pesticides and other toxic chemicals
- Israeli-Palestinian conflict

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 Shareholder governance proposals typically get about 24% of the vote; “social” proposals typically
get about 7%.
But, they do tend to get a dialogue going (even if they aren’t very successful)

Company Responses to Proposals

1. Attempt to exclude on procedural or substantive grounds
• Must have specific reason to exclude that is valid under Rule 14a-8!!
• Corporation must file reasons for exclusion with SEC staff (seeking no-action letter) [Rule
14a-8(j)]
2. Include with opposing statement
3. Negotiate with proponent
• Wide range of possible compromises!!
4. Adopt proposal as submitted
Procedural Requirements

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Substantive Requirements
Reasons for Exclusion
1. Improper under state law 8. Director elections
2. Violation of law 9. Conflicts with the company’s proposal
3. Violation of proxy rules 10. Substantially implemented
4. Personal grievance; special interest 11. Duplication
5. Relevance 12. Resubmissions
6. Absence of power/authority 13. Specific amount of dividends
7. Management functions

Improper Under State Law: Rule 14-a-8(i)(1)

Rule 14a-8(i)(1)
(i) If I have complied with the procedural requirements, on what other bases may a company rely to
exclude my proposal?
(1) Improper under state law: If the proposal is not a proper subject for action by shareholders
under the laws of the jurisdiction of the company’s organization;
Note: depending on the subject matter, some proposals are not considered proper under state law
if they would be binding on the company if approved by state law. In our experience, most
proposals that are case as recommendations or requests that the board of directors take
specified action are proper under state law. Accordingly, we will assume that a proposal
drafted as a recommendation or suggestion is proper unless the company demonstrates otherwise.

Why so passive?
- Business has to be managed by the directors.
- Proposal has to comply with company laws.
- These are decisions that are properly before the board—SHs can’t force anything (can only
request/advise)

Exception—shareholder bylaws: Proposals to amend shareholder bylaws are not blocked by this rule!
Those are not business decisions—shareholders get to draft their own bylaws.
- Example: AFSCME v. AIG—shareholder proposal to amend bylaws to require AIG to include SH
nominated director candidates on AIG’s proxy statement
o Not blocked by this provision because it is a “rule of the game”—shareholders are
allowed to set up the general election process
- Bylaws are rules of governance, not specific actions!

Violation of Law: Rule 14a-8(i)(2)

(i) If I have complied with the procedural requirements, on what other bases may a company rely to
exclude my proposal?
(2) Violation of law: If the proposal would, if implemented, cause the company to violate any
state, federal, or foreign law to which it is subject. Note: We will not apply this basis for
exclusion to permit exclusion of a proposal on grounds that it would violate foreign law if
compliance with the foreign law would result in a violation of any state or federal law.

Violation of Proxy Rules: Rule 14a-8(i)(3)

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(i) If I have complied with the procedural requirements, on what other bases may a company rely to
exclude my proposal?
(3) Violation of proxy rules: If the proposal or supporting statement is contrary to any of the
Commission’s proxy rules, including Rule 14a-9, which prohibits materially false or misleading
statements in proxy soliciting materials

Personal Grievance; Special Interest: Rule 14a-8(i)(4)

(i) If I have complied with the procedural requirements, on what other bases may a company rely to
exclude my proposal?
(4) Personal grievance; special interest: If the proposal relates to the redress of a personal claim
or grievance against the company or any other person, or if it is designed to result in a benefit to
you, or to further a personal interest, which is not shared by the other shareholders at large

Relevance: Rule 14a-8(i)(5)

(i) If I have complied with the procedural requirements, on what other bases may a company rely to
exclude my proposal?
(5) Relevance: If the proposal relates to operations which account for less than 5% of the
company’s total assets at the end of its most recent fiscal year, and for less than 5% of its net
earnings and gross sales for its most recent fiscal year, and is not otherwise significantly related
to the company’s business

Conjunctive: interpreted in Lovenheim v. Iroquois Brands to mean that if it is significantly related to the
company’s business, we don’t have to worry about the economic significance.

Lovenheim v. Iroquois Brands

Proposal: form a committee to study methods by which French supplier produces foie gras. Iroquois
argues that foie gras accounts for less than 5% of total assets and net earnings/gross sales; court concludes
that even so, it significantly relates to the company’s business; cannot be excluded under Rule 14a-8(i)(5).
- But note: there could still be economic effects (customer goodwill, etc.), so you might be able to
argue that this is more than 5% even if they require it for the third part of this test
- Only advisory: important to the court that this was only advisory; Iroquois was not required to
do anything!
o Iroquois had contended that Lovenheim’s proposal might cause investors to conclude that
the company as involved in cruelty to animals.
Absence of Power/Authority: Rule 14a-8(i)(6)
(i) If I have complied with the procedural requirements, on what other bases may a company rely to
exclude my proposal?
(6) Absence of power/authority: If the company would lack the power or authority to implement
the proposal
Management Functions: Rule 14a-8(i)(7)
(i) If I have complied with the procedural requirements, on what other bases may a company rely to
exclude my proposal?
(7) Management functions: If the proposal deals with a matter relating to the company’s
ordinary business operations

Director Elections: Rule 14a-8(i)(8)

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(i) If I have complied with the procedural requirements, on what other bases may a company rely to
exclude my proposal?
(8) Director elections: If the proposal:
(i) Would disqualify a nominee who is standing for election;
(ii) Would remove a director from office before his or her term expired;
(iii) Questions the competence, business judgment, or character of one or more nominees or
directors;
(iv) Seeks to include a specific individual in the company’s proxy materials for election to the
board of directors; or
(v) Otherwise would affect the outcome of the upcoming election of directors.

AFSCME v. AIG
Shareholder proposal: Amend AIG bylaws  include SH nominated director candidates directly on
AIG’s proxy statement.
- Does not “relate to an election” because under this section because it was a more general election
process; can only exclude if it relates to a specific election! Shareholders are allowed to propose
bylaw amendments re: election procedure (this is a “rule of the game”)
- Note: SEC goes back to amend the rules after this case and essentially codifies this decision
- End result: AFSCME gets to put its candidates on the proxy.

Part of a BIG Corporate Governance Battle: Event Timeline

- 2003: SEC proposes Rule 14a-11, which would put SH nominated directors on corporate proxy
(automatically; no need for SH proposal to amend bylaws to require it)
- After AIG (2007): SEC considers revising 14a-8(i)(8) to reflect its 1990 interpretation (i.e. trying
to overturn AIG through agency rule making)
- Fall 2010: Rule 14a-8 amended to its current form and final Rule 14a-11 adopted, but…
o Oct. 4, 2010: SEC postpones adoption to hear legal challenge from business roundtable
▪ Rule 14a-11 would have allowed SHs holding at least 3% to have their director
nominees included on the corporate proxy as a director candidate
o Big gap between the 2003 proposal and what we have now—2003 proposal would have
done this automatically; what we have now just allows for SH proposal (it’s actually very
hard to amend bylaws)

Problems
PeopleAuto (PA) has long specialized in the production of small economy cars. Recently, it moved into
the low-end of the luxury car market with several fancy sports sedan models.
To increase consumer interest in its sporty models, PA acquired the long-abandoned Duesenberg marque,
and launched the Duesenberg Phaeton. The Phaeton produces 1001 horsepower, will (when driven by a
professional) hit 200 mph, and sells for $1,200,000. PA anticipates an initial production run of 48 cars. It
does not anticipate ever making money on the Phaeton. Instead, its managers believe that the Phaeton
increases the sales of its other models by consolidating its image as the producer of exciting cars. rights or
powers of its stockholders, directors, officers or employees.

PA (incorporated in DE) has received several shareholder proposals for this year’s annual meeting.
You are the firm’s in-house lawyer. Your boss asks you whether she can exclude them
- Proposal A: Resolved, that the company shall discontinue the Phaeton.
o Can exclude under Rule 14a-8(i)(1) because it is improper under state law—because it is
a business decision. Shareholders cannot alter business judgment of strategic business
decisions.

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 - Proposal B: Resolved, that the shareholders recommend that the company discontinue the
Phaeton.
o More like a recommendation (Lovenheim)
o Could make the Iroquois argument (economic)—but would probably lose.
- Proposal C: Resolved, that the by-laws of the Company are hereby amended to include the
following Section 12.2:
12.2 The Company shall produce no automobiles with a top speed of more than 100 mph.
o Trying to piggy back off of AFSCME, but this is really not a “big picture” rule of the
game—see (i)(7) [management functions!]

Conflicts with Company’s Proposal: Rule 14a-8(i)(9)

(i) If I have complied with the procedural requirements, on what other bases may a company rely to
exclude my proposal?
(9) Conflicts with company’s proposal: If the proposal directly conflicts with one of the
company’s own proposals to be submitted to shareholders at the same meeting. Note: A
company’s submission to the Commission under this section should specify the points of conflict
with the company’s proposal.

Substantially Implemented: Rule 14a-8(i)(10)

(i) If I have complied with the procedural requirements, on what other bases may a company rely to
exclude my proposal?
(10) Substantially implemented: If the company has already substantially implemented the
proposal

Duplication: Rule 14a-9(i)(11)

(i) If I have complied with the procedural requirements, on what other bases may a company rely to
exclude my proposal?
(11) Duplication: If the proposal substantially duplicates another proposal previously submitted
to the company by another proponent that will be included in the company’s proxy materials for
the same meeting

Resubmissions: Rule 14a-8(i)(12)

(i) If I have complied with the procedural requirements, on what other bases may a company rely to
exclude my proposal?
(12) Resubmissions: If the proposal deals with substantially the same subject matter as another
proposal or proposals that has or have been previously included in the company’s proxy materials
within the preceding 5 calendar years, a company may exclude it form its proxy materials for any
meeting held within 3 calendar years of the last time it was included if the proposal received:
(i) Less than 3% of the vote if proposed once within the preceding 5 calendar years;
(ii) Less than 6% of the vote on its last submission to shareholders if proposed twice previously
within the preceding 5 calendar years; or
(iii) Less than 10% of the vote on its last submission to shareholders if proposed three times or
more previously within the preceding 5 calendar years

Specific Amount of Dividends: Rule 14a-8(i)(13)

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(i) If I have complied with the procedural requirements, on what other bases may a company rely to
exclude my proposal?
(13) Specific amount of dividends: If the proposal relates to specific amounts of cash or stock
dividends

Say on Pay
Shareholder proposals are only one form of advisory voting: Since 2011 (implementation of Dodd-Frank
Act), publicly traded firms have to give shareholders an advisory vote on—
- Executive compensation (say on pay) and
- Golden parachutes (say on pay)
o **Golden parachute: “change in control” benefit; exec get benefits if corp is sold, they
lose their jobs, etc.
- Non-binding: These votes are non-binding and directors can completely ignore.
o But they are meant to rein in what has become a perception that top execs are paid too
much—and it does seem to rein in pay for failure.

Shareholder Inspection Rights

Not a topic shareholders get to vote on; more like a FOIA request for:
- Shareholder lists;
- Books & records;
- Minutes from board meetings, etc.

Uses
- SH voting contests—helps you rally support in a proxy contest! You can be strategic about
which shareholders you target.
- Duty of loyalty—this information may help you plead a conflict of interest pre-discovery.

Sources of Law
- Federal law: Rule 14a-7(1) provides that a corporation can choose a) to give out SH list or b)
mail the information themselves. Most corporations would prefer not to give the list.
- State law: most states provide inspection rights in their corporate laws!
o ***EXCEPTION TO INTERNAL AFFAIRS DOCTRINE—not necessarily governed
by state of incorporation
o Delaware standard:
▪ Must be shareholder;
▪ Must have proper purpose
o New York standard:
▪ Must be shareholder;
▪ Must own over 5% of stock (or hold shares for more than 6 months);
▪ Must have proper purpose

Proper Purpose
Tender Offers: Crane v. Anaconda
Crane wants to acquire Anaconda—Anaconda management is against it. So Crane goes straight to SHs
and launches a tender offer! Crane wants SH list to help them in their effort to push through the tender
offer. They ask twice—turned down the first time, launch litigation the second time.
- Legal standard in NY:

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 o Must be shareholder;
o Must own over 5% of stock (or hold shares for more than 6 months);
o Must have proper purpose
▪ And launching a tender offer = proper purpose!!

Pillsbury v. Honeywell
Purpose: wants to inspect to inform shareholders/shame shareholders about corporation’s activities in the
war efforts.
- Delaware standard:
o Must be shareholder;
o Must have proper purpose
- Must be shareholder:
o He is a shareholder, but a brand-new shareholder.
o The timing isn’t dispositive, but it is indicative of what his purpose is. You could imagine
a universe in which a brand-new shareholder could have a proper purpose, but that’s
obviously not the case here.
- Must have a proper purpose:
o Purpose is not at all proper—he wants to hurt the corporation!
o He should have framed it in terms of long-term shareholder values.
o Puts the court in a weird position of having to figure out shareholder
motivations/purposes—but this is a weird fact pattern.
o What if he had had more than one purpose? (i) making money for Honeywell and (ii)
stopping the production of fragmentation bombs? We probably would see a different
outcome here.

Control in Closely Held Corporations

Generally speaking, in closely held firms: Permissible Contracts
- Shareholders can contract over HOW they will vote - Vote-pooling
their shares, but - Voting trusts
- Directors cannot contract away their vote. - Share transfer
o By law, firm must be governed by the board;
restrictions/liquidity rights
you can’t entirely delegate that away.
(i.e., buy- sell arrangements)
Drag along rights in startups: whenever investors want to sell, they agree to vote their shares to sell.

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Solution 3: Mergers and Takeovers
A Brief Word about Tender Offers
- The basics—acquirer announces that it is wiling buy up to X shares at price of $Y/share
o X is often a high % of outstanding SHs, and
o Y is normally well above (e.g., a 30% premium) current trading price
- Tender offer is open from date A to date B (e.g. Nov. 12 to Dec. 28; sometimes period extended)
- SHs can choose to “tender” (i.e., sell) their shares at price Y during the offer period
- Tender offer is often contingent on some minimum number of share being tendered (i.e. acquirer
only wants to go through with the deal if at least 80% tender their shares)
- Subject to federal regulation (i.e., Williams Act)

The Big Picture

Three strategies to address agency conflict between shareholders and management:
- Fiduciary Litigation;
- Shareholder Voting/Governance;
- Hostile Takeovers.
o But not all takeovers are hostile! Most of them aren’t. But this helps us address agency
conflict.
o All of these are about solving agency conflict  getting management to act in the
interests of corporation/shareholders.

The 3 “M”s: Conceptual Dimensions of Mergers & Acquisitions

- Strategic: somebody in the same

industry; maybe you get patent rights,
for instance
- Financial: good deal if corporation is
undervalued
- Hostile: some key group of
management is not in favor of it—
question then becomes, can we go
around them and get shareholder
approval anyway?

Are M&A Deals in SHs’ Interests?

Overwhelmingly yes! Especially for targets
(usually get a big premium/abnormal return on investment)
- Acquirer Shareholders: May not do as well. Might have overpaid, and even if there is some
gain, it’s usually flowing to target SHs
o Management problem: manager of the acquirer wants to make firm bigger, and we have
a little bit of trouble disciplining that.
o Cash acquisitions more likely to produce positive returns: if you pay with your own stock
as opposed to paying cash, it shows a lack of confidence (i.e., you think your own stock
is overpriced)

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 ▪ Markets tend to view that as you trying to flood inflated stock on the market, and
we don’t know how to value that stock. We do know how to value stock.
- Target shareholders: overwhelmingly positive results.
o Gains coming from acquirer probably trimming some fat from the target company,
getting rid of competition, etc.
o May be job turnover, but also a lot of job creation
- If you happen to own both the target and acquirer, you win overall  these deals are creating
value for shareholders.

Menu: Alternative M&A Structures

Type Procedure Authorization Other
Target: board and If it’s a small
shareholders (majority acquisition, acquirer
Traditional merger: two of all outstanding) SHs may not need to
Statutory Merger
firms merged into one; vote at all.
[DGCL § 251] like fusion Acquirer: board and
shareholders
(generally)
Benefits:
Target: board and Subsidiary holds
Acquirer creates shareholders (same as liability of target
Triangular subsidiary corporation above) instead of acquirer.
Statutory Merger (Merger Co.); target Acquirer: No SH vote Board of acquirer
[DGCL § 251] than statutorily merged (and no appraisal controls vote instead of
into subsidiary rights); technically the acquirer’s shareholders.
parent corporation gets Often will end up
to vote the subsidiary’s leaving the subsidiary
shares. in place!
Target: board and Appraisal remedy may
shareholders (if deemed not be triggered by
Acquirer buys target’s
sale of “substantially asset sale (see DGCL §
assets directly. Target
all” assets) 262(c))
 shell company (has
Asset Acquisition no assets except cash). Acquirer: May need A lot of people used to
board if large deal (but argue that this wasn’t a
Cash is meant to be
no shareholders) merger at all and didn’t
distributed to SHs.
need a SH vote, but that
has changed.
Target: No board or No need for target vote
Acquirer buys stock shareholder vote because shareholders
directly from target needed; just need vote by selling their
SHs, typically through shareholders to sell! shares! Acquirer is
Stock Acquisition/ a tender offer (subject Acquirer is contracting contracting with
with shareholders. shareholders directly.
Tender Offer to federal disclosure
requirements). Don’t Acquirer: Board +
even need to approach needs to comply with
the board! tender offer rules
(Williams Act)

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 After acquiring a certain % of interest, parent can force out remaining target
SHs (no SH votes on either side!!!)
1. Make tender offer (and there will be a small percentage who don’t
tender)
Tender Offer +
2. Historically: needed 90% of stock to have the ability to squeeze out
Short-Form Merger minority shareholders with no vote.
(statutory) Now: in Delaware, you only need 50%!

**Main protection that shareholders get at this stage is appraisal: no vote,

but they can argue about valuation!

Freeze-Out Mergers
Freeze-Out vs. Squeeze-Out
- Freeze-out: transaction in which those in control of a corporation eliminate the equity ownership
of the non-controlling stockholders; insiders somehow legally force the outsiders to sell their
shares, or the insiders find some other way of eliminating the outsiders as common shareholders.
- Squeeze-out: Do not legally compel shareholders to give up their shares, but in a practical sense
coerce them into doing so [common in close corporation context]

Note on Fiduciary Duties in Freeze-Out Mergers Involving a Controlling SH

In Weinberger, the court suggests that the UOP board should have appointed a special committee
consisting of its independent directors to bargain with Signal. Suppose that had been done. Would the
transaction then have been reviewable under BJR, rather than entire fairness?
• The answer prior to 2013 was no, See Kahn v. Lynch Comm. (Del. 1994):
• “[T]he exclusive standard of judicial review in examining the propriety of an interested cash-out
merger transaction by a controlling or dominating shareholder is entire fairness. … The initial
burden of establishing entire fairness rests upon the party who stands on both sides of the
transaction. However, an approval of the transaction by an independent committee of directors or
an informed majority of minority shareholders shifts the burden of proof on the issue of fairness
from the controlling or dominating shareholder to the challenging shareholder-plaintiff.”
• But see In re MFW Shareholders Litigation (Del. 2013): Controlling stockholder’s upfront
commitment to both approval by special committee and majority-of-the-minority vote warrants
business judgment rule standard of review for freeze-out mergers

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Weinberger v. UOP
At 50.5% ownership, Signal is not just a dominant Timeline
shareholder but a controlling shareholder! This
case could also fit in with the fiduciary duties 1974 Signal sold assets for $420M
section (fiduciary duties of controlling shareholder) Looking for ways to spend $
1975 Bought 50.5% of UOP—tender offer
Feasibility Study $21/share (oversubscribed)
- Determined how much Signal should pay 1977 Decided to buy rest of UOP (cash-
for remaining 49.5% out merger)
- The rest of UOP directors/shareholders Signal Management asks Arledge &
didn’t know about it or what Signal was Chitiea (directors of UOP and
willing to pay (and Signal actually ends up managers @ Signal) to prepare
paying less) feasibility study
- No real negotiation by UOP CEO—just accepts the offer as “generous” (should not be your first
move if you are negotiated on behalf of a group!)

Merger Process
- Got Lehman Brothers to issue fairness opinion—but it wasn’t very thorough/diligent
- Approval of merger made contingent on:
o Majority of minority UOP shares (voted at SH meeting by proxy)
o Two-thirds majority of all outstanding UOP shares
o **Only simple majority is needed to authorize—lawyers are trying to put in extra
protection for UOP SHs, but it doesn’t help because the shareholders who voted were not
informed! A majority vote for it, but they have no idea about the feasibility study—
Signal would have paid $24/share.
- Two months later at UOP SH meeting:
o Proxy from board urges approval of merger
o Only 56% of minority shareholders voted (of these, over 90% voted for the merger)

Fiduciary Duty Analysis

Duty of loyalty: Members of board and Signal have divided loyalties—they want to do what’s best for
Signal, but they also owe a duty to UOP shareholders.
- Primary defendant: Signal, as dominant and controlling shareholder.
- Type of fiduciary duty: duty of loyalty (self-dealing
- Recast as modern DGCL § 144 analysis:
o (a)(1) or (2): would have needed to disclose material facts to members (need disclosure +
approval—right now, we just have approval)
▪ Material facts here: the feasibility study!
o (a)(3): entire fairness = fair dealing + fair price
- Even if Arledge & Chiteia had not been on UOP board, Signal still owes a duty as a
controlling/DSH to minority SHs. It’s really hard to cleanse something when you have this much
control and this many loyalties.

Appraisal Remedy
Holds that appraisal is exclusive remedy except in cases of fraud, misrepresentation, self-dealing,
deliberate waste, etc.
- And no more Delaware Block method! Instead, value taking into account all relevant factors

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Business Planning
As a controlling shareholder of UOP, Signal has conflicting fiduciary obligations:
- Signal’s board owes an obligation to its own shareholders to get the best price for UOP shares;
- And derivatively to the other UOP SHs as a controlling shareholder.
- How to fix this:
o They could have bought all the shares the first time around (they weren’t a dominant
shareholder at that point!)
o People wearing multiple hats should not be negotiating! If you negotiate on behalf of
UOP, e.g., you should be insulated from Signal.
o You would need some kind of special committee of UOP board members with no Signal
ties who can negotiate aggressively with Signal.
o But even if you do all this, there be no way to cleanse.

Appraisal Remedy
- Fairness = Fair Dealing + Fair Price
o Fair Dealing goes primarily to the same issues as § 144(a)(1) and (2): focus on
disclosure (or lack thereof)
o Fair Price: goal is to determine fair value taking “into account all relevant factors.”
Finance experts will be brought in to testify regarding the firm’s valuation.
▪ Old Delaware Block Method: Average all different methods of valuation—
doesn’t really make sense because some have nothing to do with actual value of
corporation (e.g., liquidation value)
• Ended up getting really low valuations
• Delaware gets rid of it in Weinberger v. UOP
- Exclusive Remedy: Appraisal is the plaintiff’s only remedy in cases like this! Plaintiff is forced
to give up her stock and cannot ask for an injunction, or block the merger in any way. Before
Weinberger, under Singer test, judges would often block deals altogether—the Weinberger court
says that courts should not be in the business of blocking huge deals! Instead, they make appraisal
a much stronger remedy (by beefing up valuation) Allowing plaintiff to block gives plaintiff a
huge amount of leverage!
o Exception: Appraisal may be inadequate in cases of fraud, misrepresentation, self-
dealing, deliberate waste, etc.
▪ In that case, DE might give you an injunction to block the merger.
o Other states: Other states might go farther than Delaware and say that appraisal is
always exclusive remedy, no matter what!
- Exercising the Right: Shareholder must
1. Hold onto shares throughout effective date of merger;
2. Perfect his right by sending written notice to the corporation prior to the vote;
3. Not vote in favor of the merger.
o Did plaintiff in Weinberger perfect? No—but court suggest an equitable solution
because they radically changed the law; so they let him ex post perfect his appraisal right.
- What happens if merger price is unfair but there are no procedural defects and plaintiff
fails to perfect appraisal rights? Plaintiff is out of luck—that’s the point of making it an
exclusive remedy.
- Public vs. private firms: Appraisal is much more of an important right in privately held firms.
There is no market to value the shares, so you have no idea how parties agreed on the price.
- Market as protection: Why should a court be allowed to use an appraisal valuation different
than the current price on NYSE? Because the shareholders don’t even get the choice to use
market as protection—it’s like eminent domain in the corporate context.

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 - Almost never used by acquirer SHs: Technically, the merger appraisal rights apply to both
target and acquirer SHs. But on the acquirer side, the dissenting shareholder would be the entity
itself—in the merger. This is mostly protection for target shareholders who are getting cashed
out!

Hostile Takeovers
Takeovers and Dating: The Lousy Boyfriend: Hostile takeovers are a solution to agency conflicts
between SHs and management. Analogy to high school dating—if they don’t do a good job, they face risk
of being replaced by the market!

Takeover Economics: Friendly and Hostile

Label is from board/management perspective.
- Friendly: with board/management blessing
- Hostile: without board/management blessing.
o In a hostile takeover, target board does not just sit and watch the tender offer unfold
o Defenses: greenmail, poison pill, staggered board, self-tender offers, etc.

History of Takeovers in the US

- 1960s and 1970s: Very little takeover activity—buying up shares in hopes of getting greenmail
offer was one of the only strategies (and rarely occurred)
o Managerial society: close network of elite business leaders  hostile takeover = social
taboo
▪ More importantly: only big companies had the resources to pull off a large
acquisition, and their managers were already part of the club  outsiders had no
way of financing large deals.
- 1980s—Takeover Frenzy: increased use of high yield corporate bonds (i.e., junk bonds (
o [Investment grade = AAA, AA, A, BBB; junk bond = worse than BBB  higher
likelihood of default]
o Hard to sell junk bonds prior to 1980. Milken noticed that the yield on junk bonds was
extremely high given their risk profile [still less risky than the stock market]
▪ Created a market for corporate junk bonds and helped corporate raiders raise
huge amounts of cash without having to come crawling to the manager’s club
• Bonds often paid off by target firm’s revenues post acquisition.
- Junk Bonds: Like a mortgage—lined up before deal goes through and contingent on deal
happening
o A high-interest bearing bond, usually of relatively low investment quality. In the takeover
context, junk bonds are issued by the bidder to help pay for the takeover; the bonds are
usually bought by insurance companies, managers of high-yield bond funds, and other
institutions who are attracted by the high interest rates that the bonds offer. Interest and
principal are repaid (if all goes well) by the earnings of the target, and the bond holders
get to look to the target’s assets for security.
o Who is really borrowing? Acquirer is causing target firm to borrow based on its future
revenues (have to be able to predict post-acquisition revenues—may limit how much you
can borrow)

Defensive Tactics

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Most anti-takeover tactics either:
1. Increase the cost to the acquirer, OR
2. Increase the time necessary to gain control.

Thought experiment: Imagine a world where all takeover defenses are forbidden.
- Whoever makes the first offer may be uncontested; no incentive/ability to get better price for
shareholders.

Now imagine a world where all takeover defenses are permitted at the discretion of management—these
could be misused/abused to the advantage of management at the expense of shareholders.

Summary of Types of Defensive Tactics

- Greenmail: The payment by a target to a bidder of
an above-market price for repurchase of shares in the
target owned by the bidder.
o In return for a chance to sell his shares back
to the target at a higher price, the bidder
usually agrees not to try to take the target
over again for some specified period.
o **Not used often anymore—tax penalties to
consider
- Classified/staggered boards: Not all seats up for
election each year, so it may take some time for acquirer to gain full control
- Poison pill: Variety of provisions that will discourage a hostile takeover by making the target
more expensive or less desirable
o Generally revocable by the target’s board, so they only block hostile, not friendly,
takeovers.
o Usual function is to pressure bidder into making a deal with the target’s board.
o ***EVERY firm today has one, active or latent. As long as you have authorized unissued
shares, board can unilaterally create one—you could plan to give all other SHs a bunch of
shares.
▪ So acquirers can’t just make tender offers to SHs because they need the
board to pull back the poison pill.
▪ Three ways to get board consent:
• Ballet box out—use proxy fight to replace board and then remove
poison pill [lengthy and delay if firm also has staggered board]
**Huge waste and takes a lot of time
• Trap the board via Unocal—make an offer so attractive that board
cannot (in good faith) satisfy threat prong
**Hard to prove that it isn’t a threat, though.
• Bribe (legally) management—get the board to go along!
**This is the status of takeover law today
- Self-Tender offers: Uncoal (Mesa exclusion provision)—offer to buy back shares yourself to
prevent the acquirer from being able to.

- Golden parachutes & “change of control” provisions: A contract between a company and its
senior executive, providing for very generous payments to be made to the executives in the event
the company is taken over and the executives are forced to leave the company.

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 o May have the benefit of persuading a target’s management to stop opposing a hostile
takeover and thus allow the target’s stockholders to be bought out at a higher price
- White knight: a suitor who is friendly to the target’s management, and who at that management’s
request acquirers the target so it won’t be acquired by the original unwelcome bidder.
o Lockup rights: An advantage given by the target to one bidder over the other present or
potential bidder to make it more likely that the favored bidder will win in the auction that
may arise, and to discourage other bidders.
o Crown Jewel Option: The target’s “crown jewels” are its most valuable businesses or
properties. If the target is desperate to prevent the original bidder from acquiring the
company, the target’s management may grant a third party (e.g., White Knight) the
option to acquire those crown jewels at an attractive price.
▪ This increased the attractiveness to the third party of making a bid but it also
makes the target less attractive to the original, feared bidder—even if that bidder
succeeds, he will be acquiring a target that no longer controls its most valuable
asset (or will have to buy out the White Knight)
o No-Shop clause: A provision in a merger agreement between a target and a bidder in
which the target (and its board) agree that the board will recommend the merger to
shareholders, and will not “shop around” for a more attractive offer.
- Pac-Man Defense: Fight fire with fire—a defense in which the target makes a hostile tender offer
for the bidder at the same time the bidder is tendering for the target.

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Judicial Ambivalence Toward Defensive Tactics
Why are we worried about defensive actions taken by management in the midst of hostile takeover?
- We are worried about management’s motivations—are they just trying to preserve their own
jobs? Or are they looking out for shareholders?

Reasons for Deference Reasons for Scrutiny

Boards are supposed to make decisions and plain Managers may have strong self-preservation
long-term strategy. incentives (private benefits of control)

Implicit decision: not to sell/bust up firm. If takeover attempt is “worth it,” it may be
because board/management is doing a poor job.
Or, if sell, obtain best price possible for SHs.

So we end up with some kind of intermediate scrutiny.

Takeover Law 1.0

BJR with burden of proof on directors
- NO presumption that board acted in shareholders’ interest.
- Instead, directors must affirmatively demonstrate:
o Reasonable investigation gave board grounds to perceive danger to corporate policy; and
o Good faith actions
▪ Example of bad faith: like if you had evidence in Cheff v. Mathes that the
directors just anted to keep their jobs.
- Cheff v. Mathes suggests that inside directors will be held liable to a higher standard.
o Why? Preserving a board seat is not that important, but inside directors stand to lose
their jobs.

Open Questions
- What counts as “threat to corporate policy or effectiveness”: Cheff v. Mathes seems to be
contemplating employees.
- Is bona fide “threat” sufficient to justify any defensive action? You have to INVESTIGATE
before you can call it a threat!

Cheff v. Mathes
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***Creeping tender offer: not making an official tender offer, but buying lots of small amounts.

Hostile takeover: he wants them to reduce # of

employees/use different sales methods.

Defensive tactic: greenmail—they offer to buy his

shares only for $14.40/share

Plaintiffs view this as them wanting to keep their own

positions—conflict is that he’s threatening to take over
and remove them from their positions.

Statutory Reforms Post-Cheff

- Greenmail: still legal, but tax penalty (Congress doesn’t exactly like it)
o IRC § 5881: 50% tax on income related to greenmail
o Defined as any consideration paid by corporation to purchase stock that has been held for
less than two years, if that selling SH had threatened a tender offer/takeover, and the
corporation did not offer the same terms to other shareholders.
- Williams Act (1968): Regulates tender offers!

Williams Act (1968)

- Insures disclosure in connection with any tender offers
- Purchasers of at least 5% must identify themselves to the company
- Also regulates the timing of tender offers (slows down the process so that company has a chance
to seek other offers or defend against the tender offer)

**Rules outlined in Sections 13 and 14 of the Exchange Act of 1934.

Who benefits from Williams Act?

- Shareholders benefit from auction effect: makes it harder for acquirer to make take-it-or-leave it
offer; gives target more leverage to get higher price.
- So conventional view is that it’s good for targets, bad for acquirers.
- But: if your company is over-valued, this gives more time for the market to realize that.

Pre-Williams Act Takeovers

Stockholders could be treated unfairly in two ways:
- Lack of information: Not given the information needed to make a rational decision about
whether to tender
- Pressure: Bidder could unfairly pressure the target’s stockholders; holders would feel pressure to
tender early
o Two-tiered tender offers: A tender offer that contains two parts.
▪ First: bidder pays a high cash price for most but not all of the target’s stock
▪ Second: Bidder acquires the remaining shares for a lower price (squeeze out
everybody else)
**Pressures target’s holders to tender into the offer; if they don’t, all their shares
will be acquired at lower back-end price.
▪ Post-Williams Act: required to disclose all of this up front.

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 o Purpose: Assume firm currently trading at $50/share; acquirer offers $60/share. You
might not sell because you can guess that they have a plan to increase the value—but if
every SH thinks like that, the acquiring firm will never be able to get a controlling
ownership interest. Nobody tenders, and the deal doesn’t go forward.
▪ Solution: Offer $65/share in stage one, and $55/share in stage 2. You are going
to be worried that if you don’t sell at $65/share, the deal will go through and you
will get stuck with $55/share on the back end.

Williams Act Requirements

- Disclosure for 5% owners: the Act requires anyone who purchases more than 5% of the stock of
a publicly held company to disclose that fact; even if the investor has no intention to make a
tender offer or otherwise seek control of the company [§ 13(d)(1)]
o Within 10 days: This disclosure must be made within 10 days of acquiring 5% or more.
So typically, an investor will try to purchase as much as he can within 10 days. The
investor has a 10-day window in which to make further purchase of the company’s stock
before the filing has to be made.
**Note: might be hard because there will probably not be enough sellers, and it might
send weird signals to market; price might skyrocket (if market is thin)
- 20-day minimum: The offer must be held open for at least 20 days!! **Probably the most
important part of the Williams Act [Rule 14e-1(a)]
o Designed to create an auction; gives other potential bidders a chance to compete for
price.
- Pro rata rule: If the bidder offers to buy only a portion of the outstanding shares of the target,
and holders tender more than the number the bidder has offered to buy, the bidder must buy in the
same proportion from each shareholder. [§ 14(d)(6)]
o Prevents bidder from making a tender offer on a “first come, first served” basis for less
than all of the shares, a device that used to be used to coerce stockholders into tendering
immediately and to prevent rivals from shaping up
- “Cookies for everyone”: If the bidder raises the price, he must pay the higher amount
retroactively to the people who tendered early. [§ 14(d)(7)]
- “All holders, best price”: all shareholders have to get the same deal! The bidder can’t give one
shareholder a better price than any others.
o Exception—employment compensation, etc.: “All holders, best price” rule does not
prohibit “the negotiation, execution, or amendment of an employment compensation,
severance or other employee benefit . . .” provided that the amount (i) is being paid or
granted as “compensation for past services performed, future services to be performed, or
future services to be refrained from performing, by the security holder,” and (ii) is not
calculated based on the number of securities tendered.
▪ Amendment in 2006 to encourage friendly tender offers! Might allow for things
like lucrative retention contracts for CEOs, etc. (otherwise, one SH—CEO—
would be getting a valuable retention K that other SHs don’t get, in violation of
“all holders, best price”).—changed because people were using merger instead of
tender offers to get around this obstacle.
***Doesn’t change the fact that there may be a duty of loyalty issue here!

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Takeover Law 2.0: The Unocal 2-Prong Test

“Threat Prong” “Proportionality” Prong

Board acting independently, in good faith, and
Action must be reasonable in relation to threat
with due care, has reasonable grounds to conclude
posed.
that a danger exists to corporate policy and
[Can’t just do anything! Must be proportional to
effectiveness.
the threat.]
[Have to convince themselves that a threat/danger
does actually exist.]
Gives court the power to review substance of
board’s action: SIGNIFICANT DEPARTURE
from business judgment rule!
**But not well-defined in Unocal or subsequent
What constitutes a threat to corporate policy
cases. You would want the board to deliberate
and effectiveness? Must be a policy conflict—not
about why their response is proportionate.
personal. It can’t just be that they want to remain
directors.
[Unitrin—cannot be “draconian,” “preclusive,” or
“coercive”; if not “draconian, then inquiry
surrounds whether response is in “range of
reasonableness]
Was Unocal’s self-tender reasonable? Why was
Is this limited to protecting SHs, or can board
it reasonable to exclude Mesa? Mesa created the
act to protect other constituencies? At this
threat—it’s reasonable to exclude them (even
point, they can also think about employees,
though, normally, you have to offer to SHs pro
creditors, etc.
rata)
What constituencies was the court really
Threat in Unocal: Inadequate price, and threat of protecting? Might have actually protected current
busting up the company. management—Mesa increased the value of the
company.
Revlon duties: They get a lot of flexibility about how to define the threat, but once the breakup is
inevitable, the duties are different. Once breakup becomes inevitable, they have to act in the best
interests of shareholders. “Constituencies” collapses to JUST shareholders!

Unocal v. Mesa

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Unocal faced with a hostile tender offer by Mesa. Tender offer was two-tiered—following consultations
with financial professionals, directors of Unocal approved a defensive tactic.
- Defensive tactic: Issued an exchange offer for its own stock, at an amount higher than that offered
by Mesa. Mesa was specifically excluded from the offer.
- **Mesa started at 13% ownership—why? He probably tried to acquire as much as he could in ten
days (Williams Act)
o And why does he want control? He wants Unocal’s assets—oil—because they are worth
more than the whole company.
- Self-tender offer: Will buy up to 50 million shares at $72/share; forced to reduce exploratory
drilling in order to fund it. Two conditions:
o Mesa Exclusion: Mesa COULD NOT PARTICIPATE
o Mesa Purchase Condition: Tender only kicked in if Mesa acquired a controlling interest
[eventually got rid of this because it would never happen; logically inconsistent]

Takeover Law 2.1: Revlon Duties

You get some business judgment rule

protection re: threat prong.

Once takeover is inevitable, it moves

closer to entire fairness.
- When choosing between two
offers: you have to justify why
you think one is more than the
other!!

- If a sale/breakup is not inevitable: apply the standard Unocal test (threat + proportionality)
- If sale/breakup is inevitable: duty is to get highest price for shareholders (board becomes
auctioneer)
o Referred to as Revlon duties
- Key issue is determining when “Revlon duties” are triggered.

Revlon v. MacAndrews and Forbes

- June 1985: Bergerac & Perelman meet; Bergerac is not a fan of Perelman buying Revlon.
- Early August 1985: Pantry Pride authorized tender offer. $42–43/share if friendly; $45/share if
hostile. Note that he’s willing to pay more if it’s hostile: signal to Bergerac to negotiate for a
golden parachute.
- August 19, 1985: Revlon board meets and authorizes 1) share buyback and 2) poison pill.
o Poison Pill: triggered by anyone amassing larger than 20% interest (in this deal—but
corporation can choose). Also called shareholder rights plan.
▪ Right: assets will go to all shareholders except Perelman—trading in their shares
for $65/share.
▪ Perelman will end up acquiring the entire company, but it will be worthless!
o **There are a lot of different ways to set this up. Just know that it’s a way to cause a
bunch of assets to leave the corporation and go to all shareholders except the acquirer.
Functionally, it’s the same thing as an exclusive tender offer!
- August 23, 1985: Pantry Pride tender offer at $47.50/share; Revlon retaliates. Perelman not
actually expecting shareholders to go for it, but it sends a signal to the board: take away the

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 poison pill, and they will pay $47.50/share. (conditional tender offer—perfectly legal, but it does
put a lot of pressure on the board)
- October 3, 1985: Revlon Board approaches Forstmann about MBO (looking for a white knight—
know they are going to sell, but they would rather sell to him because he will keep management
in place)
- October 1985: Negotiations and bidding between Forstmann and Perelman. Forstmann has
access to all financial info; Perelman is bidding blind, but he knows that Forstmann is smart, so
he just keeps bidding incrementally more.
- Forstmann’s October 12 offer:
o Statutory cash-out merger for $57.25/share AND support trading price of notes. In return,
Revlon promises 3 “lock ups”:
▪ No-shop provision
▪ $25M cancellation fee
▪ Call option on Revlon’s “crown jewels”—Vision Care and National Health
Laboratories
o These defensive measures don’t encourage more bidding—they’ve made it too expensive
to pay off Forstmann (Perelman would have to buy Revlon AND pay him off!
Contractual remedies for call option on crown jewels otherwise, and if Forstmann ends
up buying them, Perelman will have a company that is missing its most valuable assets)

Barbarians at the Gate/RJR

Why could they take the offer that paid less per share? The $112/share offer was not really $112/share
because it came with a lot of unsecured debt.
- So the $109/share offer was not actually less! Which is why they were allowed to take it. [had the
advice of lawyers, investment bankers, etc.]

Revlon “Contraction” of Constituencies/Time Horizon

Unocal/Pre-Revlon Revlon Duties Triggered
[breakup not inevitable] [breakup inevitable]

“Today”: can think about all kinds of

constituencies—shareholders, creditors,
employees, customers, surrounding community, Collapses to just shareholders at this point!
etc.

When is Revlon duty triggered?

When it becomes inevitable that the firm will either be:
- Broken up, OR
- Experience a change in control [i.e., control of firm will shift from a loose aggregation of SHs
into the hands of a single entity or unified group.

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Impact of Revlon on Friendly Deals
Aqua Corp and Targon Inc. have agreed to basic terms whereby Aqua would acquire Targon for $200M.
Targon is privately-held and incorporated in Delaware. After authorizing the transaction (but prior to
shareholder vote) another suitor steps forward. Bidsy Corp. offers to acquire Targon for $240M. The
Targon directors prefer the offer from Aqua Corp, since Aqua has promised to retain most of the Targon
employees (including several key executives). By contrast, Bidsy has not made any such promises. The
Targon board believes the retention contracts may be worth as much as $40 million in aggregate,
suggesting the two deals are similarly priced.
- Do fiduciary obligations require Targon to accept one offer over another? What level of
fiduciary review is most relevant?
o Yes—because one is $240M directly to shareholders! You have to maximize SH value.
Revlon talks about it like a duty of loyalty issue, but this is not something that can be
cleansed.
- What if there is no second bidder? Does Revlon place any obligation on the target firm
when trying to sell the company?
o This is the more common situation. Can try to solicit other bids, negotiate aggressively,
get IB to say price is fair, etc. [Revlon enhances all of these duties]
o But in reality, hard case for shareholders to prove with no second bidder—especially if
they do negotiate aggressively and try to solicit other bids.

Takeover Law Today: CEO Side Payments

Evolution of Hostile Deals
- 1960s: few takeovers (manager’s club)
- 1980s: Explosion in number of hostile deals
- 1990s: Death of the “hostile” deal
o Takeover defenses well-established and judicially blessed [Unocal 2-prong test]
o Revlon limits use of takeover defenses in auction contests, or other settings where sale is
imminent
▪ **A lot of the argument post-Revlon comes from arguing that sale is not
imminent
- 2000s+: Aggressive use of CEO side-payments and golden parachutes

CEO Side Payments

Example: Preliminary discussion of $24-27/share; final offer is $25/share + $10M side payment to CEO
(who is the primary negotiator)
- This helps the acquirer overcome resistance
- Disclosure: SEC requires that these be disclosed when SHs vote (but hard for shareholders to say
no because of what they get—there’s no line-item veto)
- Conflict: you feel like there is some; is the CEO saying yes because it’s good for shareholders, or
god for him?
- Different from golden parachute: happens in the middle of negotiations; golden parachute is up
front, ex ante; built into employment contract

Two Hypotheses
- Incentive Alignment: Conflict of interest regarding sale
o Target CEO may lose her job and related perks
o Difficult to acquire firm over CEO objections [efficient offer may be blocked]

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 o Side payment resolves these incentives and encourages the CEO to act in shareholders’
interest to negotiate a good deal
- Rent Extraction: CEO may sacrifice SH premium
o CEO is typically the primary party negotiating for target
o Acquirer and target CEO have incentive to collude
▪ CEO gets 100% of $$ allocated to side payment, but
▪ Only small fraction of $$ allocated to merger premium.

“Cleansing”
Why do target SHs approve deals that include rent extraction side payments?
- Analogy to legislative riders: [popular bill + rider; because it’s attached to a popular bill, it gets
pushed through committee because their choice is to kill the popular bill or just accept the
unpopular rider]
o Acquirer and CEO have gatekeeping power—like legislative committees. They take
something popular [merger with a premium] and attach it to something that might be
unpopular.
o SHs see it, it’s disclosed to them, but they don’t have a line-item veto—so it gets voted
for with the whole package.
- So have we effectively “cleansed” the side payment?
o You bundle one vote with another and you can’t really get around it.
o Technically/legally, yes, this has been cleansed—and courts are saying right now that the
disclosure and vote does cleanse it.
▪ But does that really mean they’ve approved the side payment.
- Revlon duties: Should we be worried that the side payments are keeping the amount given to the
shareholders lower?
o It’s a problem of proof—if you don’t have any other bidders.
o Maybe the $10M is actually good for SHs.
o Bottom line: judges do not want to adjudicate these messes at the moment.

Existing Legal Protections

- Auction Constraint: Second Bidder—can give same price but eliminate side payments and just
give it ALL to shareholders
o Board will have to take it under Revlon.
o Caveat: most deals won’t have a second bidder.
- Tax Penalty: penalty on payments > 3x annual compensation
- Disclosure: SEC requires disclosure of side payments, but still in the best interests of
shareholders to vote yes for the entire package [legislative rider]
- Advisory SH vote on side payments: But weak, non/binding, etc. [Dodd-Frank]
- Fiduciary duties under corporate law: but not perfect because of bundling problem (these get
bundled with the vote for the entire merger and courts are saying the duty of loyalty problem is
cleansed with informed SH vote for merger + side payments, even if SHs don’t actually approve
of the side payments.

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118
 Chapter 4:
Disclosure, Fairness, and Stock
Markets
Overview of Federal Securities Fraud

119
 Disclosure & Insider Trading
Roadmap
Is investment a security?
If yes  triggers Rule 10b-5 obligations!!
Federal Securities Law
Introduction
Origins of Federal Securities Law
Stock market crash of 1929: bad  Great Depression: much worse.
- Depression blamed in part on deceptive/fraudulent trading!
-  federal regulation (1933 and 1934 Acts)

Federal Securities Law: Two Statues

Securities Act of 1933 Securities Exchange Act of 1934
Regulates the offering and sale of new securities Regulates secondary market activity of registered
(IPO) companies
Periodic reporting:
- Form 10-K (annual)
- Form 10-Q (quarterly)
File: registration statement with SEC - Form 8-K (episodic)

Anti-fraud provision: § 10(b)

 SEC Rule 10b-5

Purpose of Securities Law

- Full disclosure: make sure that investors have all of the information they need to make informed
decisions
- Prevention of fraud: insures accuracy of disclosed information

The SEC
1934 Securities Exchange Act created the Securities and Exchange Commission (aka SEC)
- Independent agency
- Enforce the securities laws
- Promulgates rules and regulations to implement those laws more effectively.
What is a Security?
Securities Act § 2(a)(1): “The term ‘security’ means any note, stock, . . . bond, debenture, . . . investment
contract . . . or, in general, any interest or instrument commonly known as a security.
- Listed instruments: note, stock, . . . bond, debenture, etc.
- General catch-all terms: investment contract, etc.

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 Per Se Securities Rarely Securities Case-by-Case Securities
Stock [and other listed General partnership Unclear what counts as an “investment
instruments] interest [because contract”—see four-factor Howey Test:
**Membership partners have a legal
interest in right to control the [1] a contract, transaction, or scheme whereby
corporation: this IS an firm] a person invests money
agreement to purchase [2] in a common enterprise,
stock [3] is led to expect profits
[4] solely* from the efforts of the promoter or a
third parties
*”solely” is downplayed now—all but eliminated
**Membership interest in LLC: might not
automatically be stock; apply these factors
[Robinson v. Glynn]

Consequence of Being a Security

If an instrument is deemed a security, two important consequences:
1. Triggers SEC registration (1933 Act) and periodic reporting (1934 Act)
• Unless an exemption applies—there are numerous exemptions from SEC registration (this is
why not every private corporation which sells stock to an investor would need to be
registered with SEC and file periodic reports)

2. Triggers Securities Antifraud Rule (Rule 10b-5)

• Applies to all securities!! No exceptions like there are for registration and reporting
requirements.
• If not a security: just have state common-law fraud claims. Federal securities law is more
plaintiff-friendly.
o **But key that you would still have a right to something—plaintiffs just prefer
securities regulations. [Robinson v. Glynn]
Rule 10b-5
It shall be unlawful for any person, directly or indirectly, by the use of any means or
instrumentality of interstate commerce, or of the mails or of any facility of any national
securities exchange,
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to state a material fact
necessary in order to make the statements made, in the light of the circumstances under
which they were made, not misleading, or
(c) To engage in any act, practice, or course of business which operates or would operate as
a fraud or deceit upon any person,
in connection with the purchase or sale of any security.

Incredibly broad!!! On purpose.

- Drafted very broadly to catch all kinds of things.
- Didn’t give much guidance in rule itself—almost like federal common law; SEC just lets the
courts interpret it.
- But must be in connection with sale/purchase of a security!!!

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Example of the reach of securities law: Randy Newsom—offered to let people buy a right to a
percentage of future MLB earnings; would have had to register entire business with SEC.

Two applications:
1. Disclosure liability
2. Insider trading liability
**Obligations are different for public and privately held companies.

Origins of Rule 10b-5

In response to a company president who contacted his SHs and offered to repurchase their stock, without
disclosing that his company had just landed a valuable government contract. Not prohibited under
common law fraud because he wasn’t lying to them
- [corporate officials do not owe a duty directly to shareholders  could trade based off of this
information; cannot lie to shareholders if asked a direct question about certain events, but no
general duty to disclose]
- Authority comes from § 10(b) of 1934 Act (but not promulgated as a rule until 1942)

Early Case Law under Rule 10b-5

- 1961: In re Cady Roberts & Co.—imposed on “corporate insiders” an affirmative duty of
disclosure when dealing in securities
o Insider aware of material non-public information must either abstain or disclose
- 1968: SEC v. Texas Gulf Sulphur Co.—insiders liable for buying up TGS stock after ore strike
o But corporation also liable for misleading press release, even though it did not actually
trade in its own shares—held liable for maintaining the accuracy of its information!
Big development.
- Private actions: later cases give private plaintiffs/shareholders the right to bring their own suit;
you don’t need SEC enforcement action
o Usually done through class action lawsuit

Primary Markets vs. Secondary Markets

Two basic types of stock trades—
1. PRIMARY MARKET: corporation is direct party to the transaction—selling directly to (or
buying from) an investor.
• Examples: IPO; self-tender

2. SECONDARY MARKET: corporation is not a party to the transaction—shares bought and sold
by two investors.
• Examples: most transactions over NYSE or NASDAQ.

**Rule 10b-5 applies in both markets! But the nature of the risk varies.

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 Primary Market Secondary Market
Does corporation have a
Yes No * [may have an indirect interest]
financial interest?
Type of company in the Both publicly and privately held
market? companies [when issuing new Publicly held only
stock/buying back its own stock]
When do corporate
Only when company is ALWAYS! [disclosure = constant
disclosures need to be
buying/selling stock [disclosure = stream of info]
accurate [i.e., when does
snapshot]
Rul1 10b-5 apply]?
Assume a large privately held company issues shares to a group of investors, At time of sale, investors
are given documents truthfully disclosing material risks. Two months later, CEO goes on NPR and
makes false/misleading statements.
- NO liability under Rule 10b-5 because sale has already happened—the statements were not
made in connection with purchase/sale of a security [nobody was trading on her statements]
But if publicly held: disclosures must ALWAYS be accurate!

Application of Rule 10b-5 to Publicly Held and Privately Held Companies

- Privately held: only need to worry about Rule 10b-5 when buying/selling own stock in the
primary market
o [Relevant but limited risk of liability]
o You are privately held if your stock is not being traded on secondary market.
- Publicly held: Need to constantly comply with Rule 10b-5 requirements. Secondary market
activity is a daily occurrence!
o Need to closely monitor ALL corporate disclosures. Executives need to be informed of
risks before making any public statements. BIG RISK of liability!

Disclosure: Elements of a 10b-5 Lawsuit

Courts have inferred the traditional elements of fraud under the common law. Plaintiff must show each of
these elements:
- SCIENTER: Defendant acted with an intent to deceive, manipulate, or defraud.
o [Negligence does not suffice, but recklessness is generally sufficient]
- CAUSATION: the misstatement caused the damage
o Loss causation: you lost money because they lied and you relied on it
o Transaction causation: more like you relied and it caused you to enter into transaction
o **PSLRA—plaintiff MUST allege loss causation in complaint!
- MATERIALITY: reasonable investor would consider the misstatement important.
o [Often blurred with causation—if it’s not material, it’s probably not going to cause loss]
o **Basic adopts “reasonable investor” approach: materiality depends on the probability
that uncertain event will occur and magnitude if it does
▪ Will almost always need to disclose merger negotiations—magnitude will almost
always be high enough to require it unless probability is < 1%
- RELIANCE: Pre-Basic plaintiff must show that she relied on affirmative misrepresentations. But
even prior to Basic, courts had adopted rebuttable presumption of reliance in omission cases
[omission usually involves an SEC-required disclosure that you didn’t make—like accountants
failing to put something in statements—then it becomes a question of scienter]
o [Often gets blurred with causation]

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The Legacy of Basic v. Levinson
**Most important business law decision of 20th century!
Basic makes it easier for plaintiffs:
- To show materiality;
- To show reliance; and
- To certify a large class of plaintiffs
Coupled with the fact that 10b-5 applies to any purchase/sale of stock, even if corporation is not
buying/selling.
 Very large damages [often > $100M]
 Created the modern securities class action lawsuit
 Made many plaintiffs’ lawyers very rich

Defining a Plaintiff Class

Plaintiff class is a group of investors who either sold or bought stock subject to false/misleading
information.
- Sellers when company hid good news and they sold for too little
- Buyers when company hid bad news and they paid too much

Class period defined by two dates:

- Beginning date—when false/misleading info first appears
- End date—when false/misleading info is corrected
o **Does not need to be corrected by the corporation itself: once it’s public, the market has
“learned” and will correct itself

Defining Plaintiff Class in Basic

Defining a class can be complicated if there are multiple false/misleading disclosures or partial
corrections.
- Unclear if all plaintiffs should be in the same class in Basic—are the investors who sold after date
2 in the same class as those who sold between date 1 and 2?
- Fraud-on-the-market theory creates rebuttable presumption of reliance. Without that, it would
be impractical to certify the class—you would have to prove that each member actually saw that
issue of the newspaper, read it, and traded on it!
- Strategic tradeoff: plaintiff typically wants a big class, but you don’t want a class full of people
who weren’t actually harmed [although some of this can probably get sorted out at damages
phase]

Materiality
Two conflicting standards of materiality:
1. Preliminary merger negotiations are immaterial as a matter of law; or
2. Preliminary merger discussions are factual issue like any other event: material if a reasonable
investor would have considered the information important.
• Basic adopts reasonable investor approach: materiality depends on the probability that
uncertain event will occur and magnitude if it does.
o [standard cost-benefit analysis]
• Need to disclose if the probability is high in relation to potential dangers.
• Merger negotiations: almost a presumption that merger negotiations are material; magnitude
will almost always be high enough to disclose, unless probability <1%

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“No Comment” Policy
Secrecy concerns—companies argue that there are valid business reasons to keep preliminary merger
discussions secret [don’t want deal to fall through, drive up price, etc.]
- Can adopt a no comment policy related to merger negotiations [Rule 10b-5 allows silence as
long as it does not cause another affirmative statement to become misleading]
- But the trick is that you must always have one!! Otherwise, people will see through it (if you
sometimes deny and sometimes say no comment)
o No comment policy must be in place before discussions arise.

Reliance: Fraud on the Market

Fraud on the market: Shareholders rely on the current market price being “fair price” that reflects all
known information. Simply buying/selling based on the market price is relying on fraud/misstatements.

Haliburton Co. v. Erica P. John Fund, Inc.—presumption of reliance still valid, but defendant can try to
rebut the presumption at the class certification stage by introducing evidence that there was no price
movement

Reactions to Basic
Private Securities Litigation Reform Act [PSLRA]—1995
Designed to limit frivolous securities lawsuits.
- Prior to PSLRA, plaintiffs could proceed with minimal evidence of fraud and then use pretrial
discovery to seek further proof
- Heightened pleading requirements:
o Fraud/misleading statements must be pleaded “with particularity”
o Pleading must create a “strong inference” of scienter
o Plaintiff must allege loss causation in its complaint

SCOTUS debating Fraud-on-the-Market

Had the chance in Haliburton Co. v. Erica P. John Fund, Inc. to overturn Basic.
- Unanimous decision to uphold, but defendants can try to rebut presumption of reliance at class
certification stage by introducing evidence that there was no price movement!!

Fiduciary Litigation vs. Securities Fraud

Basic created an explosion of securities fraud lawsuits under Rule 10b-5.
- Contrast with BJR: defending a 10b-5 suit by saying you didn’t have scienter is different than
defense of BJR in fiduciary litigation.
- Sometimes the same set of facts may give rise to both securities fraud and breach of fiduciary
duties. [example: freeze-out merger in Weinberger)—so bring both sides

Insider Trading
Why cover it?
- Lawyers are often the parties found guilty of it! They have access to a lot of confidential
information.

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Rule 10b-5
Not mentioned anywhere in Rule 10b-5—it’s an INTERPRETATION of Rule 10b-5 based on an
omission of material information while trading.
- People will be reluctant to trade on the market if they think others have more advantages.

Roadmap
- Insider Trading Law 1.0: Abstain or Disclose [SEC v.
Texas Gulf Sulphur]
- Classical Theory
o Insider Trading Law 2.0: Permanent Insiders
[Chiarella v. United States]
o Insider Trading Law 2.1: Temporary Insiders &
Tippees [Dirks v. SEC]
- Misappropriation Theory
o Insider Trading Law 3.0: Outsider Liability
[United States v. Hagan]

Abstain or Disclose: Insider Trading Law 1.0

When [anyone] possesses material nonpublic information, must ABSTAIN or DISCLOSE.
- Need to disclose before you buy/sell stock
- Alternatively, you can abstain from trading.
Set forth in SEC v. Texas Gulf Sulphur Co.—equal access test [trying to create a level playing field]
- Too broad: it didn’t matter how you got the information; it applies to everyone.
o E.g., you see a corporation buying up land, you put 2+2 together and figure there must be
something valuable going on, and you trade on it.

Insider Trading 2.0 [Chiarella v. United States]

When insiders possess material nonpublic information, must ABSTAIN or DISCLOSE
Unclear who counts as an “insider.”
- Permanent insiders: officers and directors of target company
- Temporary insiders: lawyers, accountants, underwriters, investment bankers, etc. working for
target company  sometimes counts
- Tippees: i.e., received trading tip from insider  potentially counts
- Outsiders: acquiring company executives or advisors  sometimes counts

Insider Trading Law 2.1 [Dirks v. SEC]

When [__________] possesses material nonpublic information, must ABSTAIN OR DISCLOSE
- Permanent insiders,
- Temporary insiders [with confidential information], OR
- Tippees, if:
1. Insider breached fiduciary duty by tipping, and
2. Tippee knows of breach
**This is classical insider trading liability

Insider Trading Law 3.0: Misappropriation Theory and Outsider Liability

When [____________] possesses material nonpublic information, must ABSTAIN or DISCLOSE

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 - Permanent insiders;
- Temporary insiders;
- Tippees, if
1. Insider breached fiduciary duty by tipping, and
2. Tippee knows of breach;
- Outsiders, if breach of duty owed to SOURCE of information.
o Law is still abstain or disclose, but not allowed to misappropriate (i.e., trade based on)
confidential information
o O’Hagan: source of information was his employer
o Meant to pull in people who have a duty to the source but NOT true outsiders!

Classical vs. Misappropriation

Classical theory premises liability on fiduciary duty breach by permanent or temporary insider.
- Tippee liability only extends this to outsiders if:
o The info ultimately came from insider, and
o Insider breached fiduciary duty by tipping.
- As noted in O’Hagan: “it makes scant sense to hold lawyers like O’Hagan a § 10(b) violator if he
works for a law firm representing the target of a tender offer, but not if he works for a law firm
representing the bidder”
o [But under classical theory, you owe no duty to acquirer if you are trading in target
company’s stock—and this doesn’t make sense from a policy perspective]

Classical theory [IT Law 2.0 & 2.1]—duty to abstain or disclose arises from fiduciary obligations owed
to a corporation & its shareholders
- Applies primarily to insiders

Misappropriation theory [IT Law 3.0]—separate duty owed to the “source” of the information
- Potentially extends liability to outsiders

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