← I.

AGENCY
Restatement 2d § 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.

Restatement 3d § 1.10
Agency is the fiduciary relationship that arises when one person (a “principal”)
manifests assent to another person (an “agent”) that the agent shall act on the
principal’s behalf and subject to the principal’s control, and the agent manifests
assent or otherwise consents so to act.

§1.03: Manifestation
A person manifests assent or intention through written or spoken words or other
conduct.

Think about: the PAT triangle:

If we find an agency relationship between P and A
Then we examine A’s dealings with T which determine legal liability of P to T (and vice-
versa)
Section 1: WHO IS AGENT?
← Gordon v. Doty
Agency exists if:
A manifestation of consent by Doty to Garst that Garst shall act
on Doty’s behalf
Subject to Doty’s control

Garst’s consent to so act

Evidence?
Doty made Garst’s driving the car a condition precedent to its use
How on her behalf?
Dissent’s point?
How subject to her control?
Dissent’s point?
Implied from the fact that he drove car
 Equal dignities rule
Does an agency agreement have to be in writing?
• Common law rule: an agency agreement only has to be in writing to be
enforceable if the contracts the agent is authorized to sign thereunder must
be in writing under the SOF.
Restatement 3d § 3.02
If the law requires a writing or record signed by the principal to evidence an
agent’s authority to bind a principal to a contract or other transaction, the principal
is not bound in the absence of such a writing or record.
Restatement 3d § 3.02
A principal may be estopped to assert the lack of such a writing or record when a
third party has been induced to make a detrimental change in position by the
reasonable belief that an agent has authority to bind the principal that is traceable
to a manifestation made by the principal.
Restatement 3d §1.02
An agency relationship arises only when the elements stated in §1.01 are
present. Whether a relationship is characterized as agency in an agreement
between parties or in the context of industry or popular usage is not controlling.

Gay Jenson Farms Co. v. Cargill

Restatement § 144: P is subject to liability upon contracts made by A acting within his
authority if made in proper form and with the understanding that P is a party.
§6.01: Agent for a disclosed principal:
When an agent acting with actual or apparent authority makes a contract on behalf of a
disclosed principal,
(1) the principal and the third party are parties to the contract; and
(2) the agent is not a party to the contract unless the agent and the third party agree
otherwise.
Holding
Cargill argued that its relationship with Warren was purely contractual. In contrast, the
plaintiff farmers argued that the web of contracts between Cargill and Warren had
become so strong that their relationship had evolved into an agency relationship
comparable to a sole proprietorship.
Holding?

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 That an agency relationship did exist between the defendants.

Controlling Creditor
Restatement § 14 O: When does a creditor become a principal?
A creditor who assumes control of his debtor's business for the mutual benefit of
himself and his debtor, may become a principal, with liability for the acts and
transactions of the debtor in connection with the business.
Creditor becomes a principal at that point at which it assumes de facto control
over the conduct of the debtor
Nine factors re control
Comment a to Restatement § 14 O
A security holder who merely exercises a veto power over the business acts of his
debtor by preventing purchases or sales above specified amounts does not
thereby become a principal.

However, if he takes over the management of the debtor's business either in person or
through an agent, and directs what contracts may or may not be made, he
becomes a principal, liable as any principal for the obligations incurred thereafter in
the normal course of business by the debtor who has now become his general
agent.

The point at which the creditor becomes a principal is that at which he assumes de
facto control over the conduct of his debtor, whatever the terms of the formal
contract with his debtor may be.

NOTE: Restatement (Third) has no counterpart to Restatement (Second) § 14O. The

“Parallel Table” for Restatement (Second) to Restatement (Third) cites, as parallels
to § 14O, Restatement (Third) § 1.01, comments (f)(1) and (g).

Comment (f)(1) states (Vol. 1, page 44), “In the debtor-creditor context, most courts are
reluctant to find relationships of agency on the basis of provisions in agreements
that protect creditors’ interests. … An unusual example to the contrary is A. Gay
Jenson Farms, Inc. v. Cargill … .”

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← -Disclosed principal: a principal is disclosed if when an agent and a third party
interact, the third party has notice that the agent is acting for a principal and the third
party.
← -Undisclosed principal: when an agent and 3rd party interact, the 3rd party has no
notice that the agent is acting for a principal.
← -Unidentified (partially disclosed) principal: 3rd party knows there’s a principal, but
does not know who it is.
-Ways to create an agency:
• By agreement
• Ratification – the authority comes after the contract is signed.
• Estoppel – when a principal negligently or intentionally allows a 3rd party to
believe there is an agency when there isn’t.
-Agents acting with authority may bind principals
• Authority is the starting point for analysis of contract actions.
• Authority also is an element in vicarious liability-based tort actions against the
principal.

Section 2: LIABILITY OF PRINCIPAL TO THIRD PARTIES IN CONTRACT

The Agent’s Authority

-Actual Authority: § 2.01: An agent acts with actual authority when, at the
time of taking action that has legal consequences for the principal, the agent
reasonably believes, in accordance with the principal’s manifestations to the
agent, that the principal wishes the agent so to act.
• §3.01: Creation of actual authority:Actual authority, as defined in § 2.01, is
created by a principal’s manifestation to an agent that, as reasonably
understood by the agent, expresses the principal’s assent that the agent take
action on the principal’s behalf.
• Actual Express Authority: Principal intentionally confers on Agent.
• Actual Implied Authority (incidental authority): Principal can’t always think of
everything that it would authorize Agent to do.
o Policy: AIA carefully places the incentive to draft good instructions on
the right party. If P wants A to do X, but to do it only in a certain
idiosyncratic manner, AIA gives it the incentive to draft its authorization
carefully.

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-AA: Apparent authority [aka ostensible authority] AA depends on the
communication between P and TP (though this may be accomplished through an
agent, by authorizing the agent to make any statement to TP, creating apparent
authority, that the principal might have made directly).

Restatement § 8: “the power to affect the legal relations of another person by

transactions with third persons, professedly as an agent for the other, arising from
and in accordance with the other’s manifestations to such third persons.”

Restatement § 8 makes the issue of apparent authority turn on P’s “manifestations.”

What does that even mean?
In practice all that is required is that the principal allow the agent to represent his or her
own authority, which is a peculiar notion of “manifestation.”

Comment c to the Restatement (Second) of Agency § 8 states: “Apparent authority

exists only to the extent that it is reasonable for the third person dealing with the
agent to believe that the agent is authorized. Further, the third person must believe
the agent to be authorized.”

§ 2.03: Apparent Authority:

Apparent authority is the power held by an agent or other actor to affect a principal’s
legal relations with third parties when a third party reasonably believes the actor has
authority to act on behalf of the principal and that belief is traceable to the principal’s
manifestations.

Comment (b) to Restatement (Third) § 3.03 :

• A principal may also make a manifestation by placing an agent in a defined
position in an organization or by placing an agent in charge of a transaction or
situation. …
• A principal may also create apparent authority by actually or apparently
authorizing an agent to make representations to third parties concerning the
agent’s own authority or position, even though the agent’s representations by
themselves would be insufficient.

-Quick test to determine actual v. apparent authority: did P communicate his

consent for A to act for him to A or to TP? If to A, AEA; if to TP, AA. Typically,

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 both AEA and AA are present.
A requirement for AA is that TP justifiably relies on P’s communication
of consent for A to act on his behalf.

Mill Street Church v. Hogan

§ 1.04(8) Subagent:
A subagent is a person appointed by an agent to perform functions that the agent has
consented to perform on behalf of the agent’s principal and for whose conduct the
appointing agent is responsible to the principal. The relationship between an
appointing agent and a subagent is one of agency, created as stated in § 1.01.

Holding: What kind of authority did Bill have?

• Bill DID NOT HAVE actual express authority to hire Sam
• Bill had actual implied authority as an agent to hire him, based on need and
past experience in hiring helpers for work for the Church;
• Bill had apparent authority based on Sam’s past experience in having been
hired to work with Bill. [remember to look from P to TP for AA, not from P to
A.]
Holding
Rationale?
Court says: Implied authority “includes such powers as are reasonably necessary
to carry out the duties”
Different kind of implied authority: Did agent believe based on present or past
conduct that he had authority?

Restatement § 26:
authority to do an act can be created by written or spoken words or other conduct of the
principal which, reasonably interpreted, causes the agent to believe that the
principal desires him so to act on the principal’s account

“Finally, in this case, Sam Hogan believed that Bill Hogan had the authority to hire him
as had been the practice in the past. To now claim that Bill Hogan could not hire
Sam Hogan as an assistant, especially when Bill Hogan had never been told this
fact, would be very unfair to Sam Hogan.”
-Dweck v. Nasser

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 • Issue: does an attorney not on the record have lawful authority to settle a
lawsuit on behalf of the client/principal, as an agent?
• Who is the attorney of record here, Shiboleth or Heyman? Did Shiboleth have
apparent authority?
• Holding: Court finds apparent authority by evidence from Shiboleth’s letter to
Nasser. Finds implied authority given Nasser’s directions to Shiboleth to settle
the action and the close personal business relationship shared.

Apparent authority: 370 Leasing Analysis

Three-Seventy Leasing Corporation v. Ampex Corporation
What should Ampex have done to protect itself?
• Train its agents and give notice to potential third parties.
• Form contract requiring approval by contract manager.
Holding: Kays’ letter creates apparent authority to accept Joyce’s offer on behalf of
Ampex.

Termination of authority: Comment a to § 3.06

• Agreement of P and A either at the time of agreement or upon the future
occurrence of specified circumstances
• Unilateral termination by either P or A by manifestation to the other
• P’s death, loss of legal capacity
• A’s death
Termination of authority- former Employees
• Al was Pam’s agent; Al negotiated many contracts of various sorts for Pam.
Pam fires Al, terminating his actual authority
• What should Pam do to ensure that Al no longer has apparent authority?
o Actual notice to all TP who dealt with the agent as agent;
o Constructive notice to all other TPs.

Ratification

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.
A person ratifies an act by:
Manifesting assent that the act shall affect the person’s legal relations, or
Conduct that justifies a reasonable assumption that the person so consents.

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Ratification does not occur unless:
• The act is ratifiable as stated in § 4.03,
• The person ratifying has capacity as stated in § 4.04
• The ratification is timely as stated in 4.05, and
• The ratification encompasses the act in its entirety as stated in § 4.07

Restatement § 82: Ratification is the affirmance by a person of a prior act which did not
bind him but which was done or professedly done on his account, whereby the act,
as to some or all persons, is given as if orignially authorized by him.
Restatement § 83: Affirmance is either (a) manifestation of an election by one on
whose account an unauthorized act has been done to treat the act as authorized,
or (b) conduct by him justifiable only if there were such an election.

Ratification
• A acts without authority (of any kind) and there are no grounds for estoppel
o we will talk about estoppel in the next case- but in brief, it is conduct
leading TP to believe A has AA- if there were grounds for estoppel, you
wouldn’t need an ex post authorization – the law would impose an
agency to protect the TP.
P will only be bound if P ratifies the contract
How does P ratify?
• Must be a contract or act that would have been valid if authorized initially
[can’t be illegal, for example]
o P must have been in existence when the unauthorized act was done
o Ratification must be effected with the same formalities that would have
been necessary for the unauthorized act – equal dignities rule
How does P ratify?
• Affirmation
o Principal must know or have reason to know all material facts
[including that A purported to act for him]
o Can be express or implied [harder to prove]

How does P ratify?

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(1) express affirmation by the principal;
(2) implied affirmance through acceptance of the benefits of the transaction at a time
when it is possible to decline to accept such benefits
How does P ratify?
(3) implied affirmance through silence or inaction—a principal can’t wait forever before
repudiating an unauthorized transaction, a rule based largely on notions of
economic fairness; we don’t give the principal a put;
(4) implied affirmation through bringing a lawsuit to enforce the contract.

How does P ratify?

• Ratification will be denied legal effect where necessary to protect the rights of
innocent third party
o No intervening events: TP withdraws, P loses capacity, change in
circumstances, lapse of time. TP is treated as an offeror, who can
withdraw anytime prior to acceptance [absent option contract, part
performance or promissory estoppel]

Boticello v. Stefanovicz
• Husband and wife own farm as tenants in common. H offers to lease, with
option to purchase, to Plaintiff. W states that she would not sell the property
for less than agreed upon price. P unaware of wife’s ownership share. P does
not do title search, and makes improvements on property. P elects to take
option. H&W refuse. P sues for specific performance.
• Issue: Did H act as W’s authorized agent? If not, did W ratify?
• Holding: no agency found. Wife did not ratify.

Agency by Estoppel

Restatement §8B: a person not a party to a transaction purportedly done on his

account can be held liable if he either intentionally or carelessly caused the belief
[AA] or failed to correct the belief, and the TP reasonably relies on the belief.
§2.05: Estoppel to Deny Existence of agency relationship
A person who has not made a manifestation that an actor has authority as an agent and
who is not otherwise liable as a party to a transaction purportedly done by the actor
on that person’s account is subject to liability to a third party who justifiably is

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 induced to make a detrimental change in position because the transaction is
believed to be on the person’s account, if

§2.05: Estoppel to Deny Existence of agency relationship

The person intentionally or carelessly caused such belief, or
Having notice of such belief and that it might induce others to change their positions, the
person did not take reasonable steps to notify them of the facts.

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 Section 4: RAISING ADDITIONAL CAPITAL

Section 5: THE RIGHTS OF PARTNERS IN MANAGEMENT

-Statutory Review
• §103(a): UPA sets out the default rules “to the extent the partnership
agreement does not otherwise provide.” The parties can, for the most part,
provide whatever terms they want.
Exceptions are listed in § 103(b), including:
o the partnership agreement cannot restrict the right to access for books
and records under §403(b);
o can’t eliminate the duty of loyalty under §404(b), but can curtail it;
o unreasonably reduce the duty of care under §404(c) eliminate the
obligation of good faith and fair dealing under § 404(d), etc.
• § 301: sets out agency power of partners to bind the partnership to third
parties: each partner is an agent for the partnership for the purpose of its
business, and each partners’ acts for apparently carrying on in the ordinary
course of the partnership business binds the partnership, unless the partner
had no authority and the third party had notice of this fact.

Partner’s Authority
• UPA (1914) § 9(1): “Every partner is an agent of the partnership for the
purpose of its business, and the act of every partner, including the execution
in the partnership name of any instrument, for apparently carrying on in the
usual way the business of the partnership of which he is a member binds the
partnership, unless the partner so acting has in fact no authority to act for the
partnership in the particular matter, and the person with whom he is dealing
has knowledge of the fact that he has no such authority”
• § 401: sets out partner’s rights and duties between and among
themselves only- not third parties: Some of the default rules [imposed
unless the parties agree otherwise] that we have talked about include:
o (b) profits are split equally, losses like profits;

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 o (c) partnership must reimburse/indemnify partners for liabilities in the
ordinary course of the partnership;
o (f) each partner has equal rights in the management and conduct of
the business.
o (j) In the absence of an agreement to the contrary, matters arising in
the ordinary course of the business may be decided by a majority of
the partners.
o Amendments to the partnership agreement and matters outside the
ordinary course of the partnership business require unanimous
consent of the partners.

Deadlock: National Biscuit v. Stroud

• Stroud and Freeman formed a partnership to run a grocery store. Stroud told
National Biscuit that he would not be personally liable for any more bread it sold
to the store. Freeman ordered more bread, National Biscuit delivered it, and
National Biscuit sued Stroud for payment.
o Remember: partners have full personal liability for debts of the
partnership. If the partnership is liable on the contract, so is Stroud.
• The court’s logic:
o Under UPA § 301(1): every partner is an agent for the partnership for the
purpose of its business.
o So Freeman and Stroud are agents for the partnership Stroud’s Food
Center, for the purpose of its business, which is to sell groceries.
o Under UPA § 301(1), acts of the partners for apparently carrying on in the
ordinary course of the partnership business bind the partnership, unless
the partner had no authority to act for the partnership on this, the third
party involved had notice.
o So the partnership is bound on the contract Freeman made with Nabisco,
unless he lacked authority and Nabisco had notice. Here, there is no
evidence of any limitation on his authority, so we don’t need to examine
any notice issues- there was no lack of authority to notify Nabisco about.
o Under UPA § 306(a), partners are jointly and severally liable for all
partnership obligations.
o Under UPA § 401(f), all partners have equal rights of management

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 o Under UPA § 401(j), in the absence of an agreement to the contrary,
matters arising in the ordinary course of the business may be decided by a
majority of the partners.

Deadlock: Summers v. Dooley

• Summers and Dooley had equal stakes in a trash-collection partnership. Dooley
couldn’t work, so he hired his own replacement. Summers decided that they
needed a third man, but Dooley disagreed. Summers went ahead and hired a
third man anyway, and tried to bill the partnership for the cost. Held?
o Summers loses. Partnership matters are (absent an agreement to the
contrary) decided by majority vote, this requires a majority vote, and
Summers doesn’t control a majority.

• Under UPA § 301(1): every partner is an agent for the partnership for the
purpose of its business.
• So Summers and Dooley are agents for the partnership, for the purpose of its
business, which is a trash collection business.
• Under UPA § 301(1), acts of the partners for apparently carrying on in the
ordinary course of the partnership business bind the partnership, unless the
partner had no authority to act for the partnership on this, and the third party
involved had notice.
• Summers could argue that hiring a new worker is within the ordinary course of
the partnership business, and so he had authority to act for the partnership, and
so the partnership is bound on his contract with the new worker.
• Under UPA § 401(f), all partners have equal rights of management
• Under UPA § 401(j), in the absence of an agreement to the contrary, matters
arising in the ordinary course of the business may be decided by a majority of the
partners.
• Dooley would counter that he refused to consent to the hiring of additional help,
and that here, a majority of the partners did not authorize Summers to hire the
new worker.

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 ← National Biscuit ← Summers v. Dooley
← ←

← “Any difference arising as to ordinary ← “business differences must be

matters connected with the partnership decided by a majority of the partners
business may be decided by a majority of provided no other agreement between the
the partners” partners speaks to the issues”
← ←

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← Contract binding because: “Stroud ← Contract not binding because “a
was not, and could not be, a majority of the majority of the partners did not consent to
partners” the hiring of the third man”
← ←

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Day v. Sidley & Austin
• Former senior partner seeks damages claiming a substantial loss of income,
damage to his professional reputation and personal embarrassment, which
resulted from his forced resignation.
• Two different firms, S&A and Liebman. Day was in charge of S&A. Two firms
merged and Day has to share chairmanship of merged office with another
person.

Section 6: PARTNERSHIP DISSOLUTION

• Expiration of the partnership term §31(1)(a)

• Act of one or more of the partners in a partnership at will § 31(1)(b)
• Agreement of all partners § 31(1)(c)
• Expulsion of a partner § 31(1)(d)
• Subsequent illegality of the partnership purpose § 31(3)
• Death of a partner – terminates by operation of law § 31(4)
• Bankruptcy of any partner or the partnership § 31(5)
• Court decree § 31(6) [incompetence; incapacity; misconduct; impracticality; other
equitable circumstances].

Dissolution v. Going out of Business

Dissolution is not the same as going out of business:
• A dissolution is simply the “change in relationship of the partners caused by any
partner ceasing to be associated in the carrying on” of the firm’s business. UPA
(1914) § 29.
• It’s a legal status – nothing more

Dissolution: Effect on Partnership

• After dissolution, the partnership must be wound up, absent agreement among
the partners to carry on the business.
• Assuming that the business will not be continued, the winding up process
generally contemplates that the firm’s assets will be distributed to the partners.
• “Winding up”: The process of shutting down post-dissolution

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 • Upon dissolution, the authority of partners to act on behalf of partnership is
terminated except in connection with winding up of partnership business. UPA
(1914) § 33; UPA (1997) § 804.

Continuation per Agreement:

Effect on Partnership
• When the parties decide to continue the partnership under § 802:
o Technically creates a new partnership
o Creditors of former partnership automatically become creditors of new
partnership. UPA (1914) § 41.
Effect on Departing Partner
• Departing partner entitled to accounting
• Fair value of partnership
• Interest from date of dissolution in event of unreasonable failure to pay
• Departing partner remains liable on all firm obligations incurred while he was a
partner UPA (1914) § 36; UPA (1997) § 703.
• For future partnership debts, departing partner must provide appropriate notice to
TPs to cut of his personal liability – actual for existing creditors, constructive for
all other TPs
• Either kind of debt can be released with a novation.

Effect on New Partners

• If a new partner joins the firm when it continues after a dissolution, the new
partner is also liable for the firm’s old debts, but such liability can only be satisfied
out of partnership property. UPA (1914) § 41(1); UPA (1997) § 306(B).
o The new partner can not be held personally liable for the old debts, unless
he or she expressly agrees to be so held.

The Right to Dissolve

• Explicit term
o Duration specified in partnership agreement
o Specific purpose/object specified in partnership agreement
• Implicit term
o Example: When a partner loans money to the firm, to be repaid from
profits, the partnership is for a term until the loan is repaid

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o Page v. Page
 “George was asked: ‘[W]as there any discussion with reference to
the continuation of the business in the event of losses?’ He replied,
‘Not that I can remember.’ He was then asked, ‘Did you have any
understanding with Mr. Page, your brother, the plaintiff in this
action, as to how the obligations were to be paid if there were
losses?’ He replied, ‘Not that I can remember. I can't remember
discussing that at all. We never figured on losing, I guess.’ ”
 No implied term. Why not?
• Parties’ hope to repay start-up loan out of partnership profits
not enough
o Owen v. Cohen
 Implied term found. Why?
• When a partner loans money to the firm, to be repaid from
profits, the partnership is for a term until the loan is repaid
 Why a dissolution?
• Dissolution is an appropriate remedy because of Cohen’s
misconduct
• See UPA § 32(1)(c) and (d), which provide that a
partnership may be judicially dissolved where a partner’s
conduct prejudices the carrying on of the business or where
the partner willfully and persistently breaches the agreement
or where he conducts himself in such a way as to make it
impractical to carry on the business with him
 Why Sue?
• Judicial determination of status of loan required
• Receiver probably needed for orderly liquidation
• Potential for wrongful dissolution
 UPA (1914) § 31(1)(b) v. § 31(2)
 Dissolution of a “term partnership” (a.k.a. “partnership
for a term”) prior to expiration of the term is “wrongful”
 Adverse consequences; see UPA (1914) § 38(c)
 Hence, “there always exists the power, as
opposed to the right, of dissolution”
 Proper to repay loan before distributing profits?

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 • UPA § 40(b), the following order is observed: (1) The claims
of the firm’s creditors are paid; (2) Claims of a partner other
than those for capital and profits
• So Owen is entitled to repayment of his loan before Cohen
gets anything

The Consequenses of Dissolution

 An event of dissolution is a change in the legal process of the partnership.

Prentiss v. Sheffel
 Three-man partnership. 2 powerful partners exclude third partner from
management and affairs. Try to expel third partner by seeking dissolution.
 Issue: is there liability that goes along with the court’s finding that there was a
dissolution?

The Sharing of Losses

Kovacik v. Reed
 K and R enter into agreememt to remodel some kitchens. K invested $10,000. R
would superintend and estimate the jobs and share profits 50-50. K did not ask R
to share in losses.
 K&R incurred losses. K dissolves the partnership due to non-profitability. K sues
R for half of losses.
 Appellate court finds R not liable. K lost capital, R lost labor.

Section 6: LIMITED PARTNERSHIPS

Holzman v. De Escamilla
 Partnership went into bankruptcy and Holzman was appointed as trustee of
estate.
 Holzman brings action to determine that Russell and Andrews (who were general
partners in limited partnership of Hacienda Farms)

III. CORPORATIONS

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Section 1: PROMOTERS AND THE CORPORATE ENTITY

Categories of Corporations

Public (aka publicly held)

 Characterized by a public secondary market in which shares of the company
are listed for traded
Close (aka Closely held)
 Characterized by absence of a secondary market for its stock
 Often (but not always) a relatively small number of shareholders who actively
participate in the firm’s management
 May display many characteristics of partnerships
o Some are, in a sense, incorporated partnerships

5 critical attributes of a corporation:

1. Separate legal entity

 Separate from whom?
2. Limited liability:
 For whom?
 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.”
3. Separation of ownership and control:
 MBCA § 8.01(b): “All corporate powers shall be exercised by or under the
authority of, and the business and affairs of the corporation managed by or under
the direction of, its board of directors….”
Shareholders entitled to vote on:
 Election of directors (MBCA §§ 8.03-.04)
 Any amendments to the articles of incorporation and, generally speaking, by-laws
(MBCA §§ 10.03, 10.20)
 Fundamental transactions (e.g., mergers; MBCA § 11.04)
 Odds and ends, such as approval of independent auditors

4. Liquidity

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5. Flexible capital structure:
 The permanent and long-term contingent claims on the corporation’s assets and
future earnings issued pursuant to formal contractual instruments called
securities
 Many ways to package such claims; e.g., stocks and bonds

Difference between debt and equity securities:

Debt securities (a.k.a. bonds, debentures, notes) typically consist of two distinct
rights:
 The bondholder is entitled to receive a stream of payments in the form of interest
over a period of time
 At the end of the bond’s prescribed term (i.e., at maturity), the bondholder is
entitled to the return of the principal
Bondholders are creditors, not owners

Equity securities (a.k.a. shares) represent “the units into which the proprietary
interests in the corporation are divided”
 Residual claimants: equal right to participate in distributions of the firm’s earnings
and, in the event of liquidation, to share equally in the firm’s assets remaining
after all prior claims have been satisfied
 A limited right to participate in corporate decisionmaking by electing directors and
voting on major corporate decisions

Capital structure terminology:

 Authorized shares: The articles must specify the maximum number of shares
the corporation is authorized to issue.
 Issued shares: sold to shareholders
 Outstanding shares: The number of shares the corporation has sold/issued and
not repurchased.
o Authorized but unissued shares are shares that are authorized by the
charter but which have not been sold by the firm.
 Treasury shares were once issued and outstanding, but have been repurchased
by the corporation
 Issued shares – outstanding shares = Treasury shares

21
Issuance of stock:

Board of directors prerogative.

 Shareholders involved only if:
o Board wants to sell more shares than are presently authorized in its
charter – charter amendment requires shareholder approval
o Board of directors wants to issue a new class of shares not authorized in
the charter

 If the charter authorizes the class of shares in question and there are sufficient
authorized but unissued shares, the board is free to sell shares for “any valid
purpose” as long as the corporation receives adequate consideration for the
shares.

Choosing a state of incorporation: Delaware’s dominance:

o No minimum capital requirements
o The need for only one incorporator (a corporation may be the incorporator)
o Favorable franchise tax in comparison to other states.
o For companies doing business outside of Delaware:
o no corporation income tax
o no sales tax, personal property tax or intangible property tax on
corporations
o no taxation upon shares of stock held by non-residents and no inheritance
tax upon non-resident holders

Process of incorporation:
o File articles with SOS – under MBCA § 2.03, that starts the corporation’s life
o Post incorporation:
o Draft bylaws (MBCA § 2.06)
o Organizational meeting (MBCA § 2.05)
o Issue stock

Promoters and pre-incorporation liability:

22
 o Promoter: Someone who purports to act as an agent of the business prior to its
incorporation
o Promoter retains liability on pre-incorporation contracts unless and until promoter
gets a novation

Pre-incorporation contracts
Possible outcomes for pre-incorporation contracts signed by a promoter:
o Promoter retains liability, corporation has none
o Promoter and corporation both have liability
o Promoter has no liability, corporation has liability

De jure v. de facto corporations

o De jure corporation: a corporation in good standing under the law
o De facto corporation: acting like a corporation while not fulfilling legal
requirements.
o Focuses on the efforts of the defendant:
 Treat firm as a corporation if the organizers:
• in good faith tried to incorporate
• had a legal right to do so [the existence of a statute allowing
incorporation of the venture]
• some action as a corporation
o Fine distinction to be drawn between de facto corporation
 [often used in place of "actual" to show that the court will treat as a
fact authority being exercised or an entity acting as if it had
authority, even though the legal requirements have not been met]
o and corporation by estoppel

Corporation by estoppel
o Treat firm as though it were a corporation if the [TP plaintiff] person dealing
with the firm:
(1) thought it was a corporation all along and
(2) would earn a windfall if now allowed to argue that the firm was not a
corporation
o This doctrine has nothing to do with the defendant making a good try. It comes
from the injustice created when you try to gain an advantage by changing your
story as to the existence of a fact or legal relationship.

23
Southern-Gulf Marine Co., No. 9, Inc. v. Camcraft, Inc.

Southern-Gulf Marine Co., No. 9,

Inc. v. Camcraft , Inc.
IOU Southern Gulf
Camcraft
$1.35 million Marine Co. #
9

IOU
Boat

Bowman Barrett

Holding:
o Camcraft is estopped to deny SGM’s corporate status
o Hence, SGM may sue to enforce the contract
Rule of law:
o A third party who dealt with the firm as though it were a corporation and relied on
the firm, not the individual defendant, for performance is estopped
Reasoning:
o On the estoppel claim the court finds that in order to weasel out of a contract due
to the “character of the organization to which it is obligated” the defendant would
need to show its substantial rights might thereby be affected, which it was unable
to do.
o SGM is not a de jure Texas corporation as stated in the contract, but that fact
hasn’t caused Camcraft any substantive problems and Bowman was informed of
the Cayman Islands incorporation and accepted it. So they are estopped from
asserting the plaintiff’s lack of corporate capacity when the Vessel Construction
Agreement was signed.

24
When does estoppel apply?
1. After a defective attempt to incorporate, the participants in the venture themselves
cite their defective incorporation in an effort to escape liability on the contract with
plaintiff;
o the court will estop them from asserting the corporation did not exist and
therefore the contract is not enforceable when the contract was made
supposedly on their behalf.
o This would apply in SGM if it were SGM who was trying to avoid liability on
the contract.
2. The more difficult application of the concept is to our actual SGM facts. The
participants in the venture [SGM] ask the court to estop a third party they have dealt
with from denying the existence of the corporation. Seems pretty straight forwards, at
first glance.
o The TP agreed to deal with a corporation, and is trying to weasel out based on
facts that really don't impact it- they are just looking for an excuse to avoid
liability. If they were permitted to deny the existence of the corporation on these
facts, they would get more than they bargained for - a windfall.

Limited Liability
o MBCA § 6.22(b): “… a shareholder of a corporation is not personally liable for
the acts or debts of the corporation except that he may become personally liable
by reason of his own acts or conduct”
o Shareholder losses limited to the amount the shareholder has invested in
the firm—the amount initially paid by the shareholder to purchase his or
her stock
o A corollary of the corporation’s status as a separate legal person; in the
eyes of the law, it is the corporation that incurs the debt or commits the
tort and the corporation which must bear the responsibility for its actions
o Encompasses “piercing the corporate veil”
o Tips to avoid PCV:
 Avoid “unity of interest” – respect the separate existence of the
corporation, and your clients probably won’t need to be concerned
about personal liability.

25
 Hold your statutorily required meetings, keep minutes, elect

officers, etc., but, most important, keep corporate funds and
transactions separate from individual funds and transactions and
not constantly shift money in and out of the corporate account.
Substantial compliance is probably enough.
So what do we need to PCV?
(1) a total disregard for the separate existence of the corporation
(2) Most of the cases and the commentators state that there is a second element that
must be proved: injustice or some such concept.
o Do all courts require that second element?
o No; for some courts, however, a total disregard for the separate existence
of the corporation is enough, on the theory that if the shareholder ignored
the separate existence it would be unjust for the creditor to be required to
respect it.

CERCLA – nothing in our text on this

 Under CERCLA a parent corporation may be liable under traditional piercing the
corporate veil principles. It may also be liable for its direct participation in operating a
hazardous waste site, where its agents directly operate, or participate in operating,
the facility on its behalf.

Veil Piercing

Carlton (controlling shareholder)

Section 2: THE CORPORATE ENTITY AND LIMITED LIABILITY
Limited liability

Walkovsky v. Carlton
S e o n C a b C o r p . A B C C o r p . X Y Z C o r p .

Enterprise liability: :
Òonly a larger corporate
entity would be held
financially responsible Ó
26
Walkovsky
1
Enterprise liability
• All 10 corporations were alleged to be part of a single enterprise that actually
conducts the business, so plaintiff ought to be able to recover from any or all
of the 10 in the enterprise.
• What does enterprise liability depend on?
o It depends on proof that Carlton did not respect the separate identities
of the corporations—for example, here are some factors to consider in
determining whether two or more corporations have been operated as
a single business enterprise include whether the corporations had:
(1) common employees;
(2) common record keeping;
(3) centralized accounting;
(4) payment of wages by one corporation to another corporation’s
employees;
(5) a common business name;
(6) services rendered by the employees of one corporation on behalf of another;
(7) undocumented transfers between corporations;
(8) unclear allocation of profits and losses between the corporations;
(9) the same officers;
(10) the same shareholders; and
(11) the same telephone number

The Formalities Issue

27
 Many of these cases place great emphasis on factors like failure to comply with
corporate formalities. Why are such factors relevant?
o Is it enough that the creditor will be unable to collect the full amount owed
unless the court pierces the veil?

Sea-Land Services, Inc. v. Pepper Source

← Under Illinois law [the Van Dorn test], to pierce the corporate veil, a court must
find:
(a) a unity of interest and ownership between corporation and shareholder, AND
(b) a situation where failing to PCV would either
(i) sanction fraud [don’t need proof of intent to defraud creditors]; or
(ii) promote injustice.
← To determine whether (a) exists, courts look at four factors:
← (w) the lack of corporate formalities,
← (x) the commingling of funds and assets,
← (y) under-capitalization, and
← (z) the use by one corporation of assets of another [which sounds to me a lot like
commingling]

Section 3: SHAREHOLDER DERIVATIVE ACTIONS

Introduction

Derivative suit:
 A suit in equity against a corporation to compel it to sue a third party.
 The quintessential derivative suit is a suit by a shareholder to force the firm to sue a
manager for fraud.
Direct Derivative
 Alleges a direct loss to the  Alleges a loss to the
shareholder
Direct and Derivative Suits shareholder that derives
 Brought by the shareholder from a loss to the
in her own name corporation.
 Cause of action belonging  Brought by a
to the shareholder in her shareholder on
individual capacity corporation’s behalf
 Arises from an injury  Cause of action belongs
directly to the shareholder to the corporation as an
entity
 Arises out of an injury 28
done to the corporation
as an entity
MBCA § 7.41(1):
 A shareholder may not commence or maintain a derivative proceeding unless
the shareholder:
o was a shareholder of the corporation at the time of the act or omission
complained of or became a shareholder through transfer by operation of
law from one who was a shareholder at that time;
 So creditors may not bring derivative suit.
MBCA § 7.41(2): Plaintiff Qualifications: Fair and Adequate Representative
 A shareholder may not commence or maintain a derivative proceeding unless
the shareholder:
o Fairly and adequately represents the interests of the corporation in
enforcing the rights of the corporation.
MBCA § 7.42: more support that plaintiff must be a shareholder:
No shareholder may commence a derivative proceeding until:
 Written demand has been made upon the corporation to take suitable action;
and
 90 days have expired from the date the demand was made unless the
shareholder has earlier been notified that the demand has been rejected by the
corporation or unless irreparable injury to the corporation would result by waiting
for the expiration of the 90-day period.

Role of shareholder in derivative suit:

 the shareholder is in a fiduciary role – he is a “self chosen representative” and so
courts find it reasonable to impose standards of “responsibility, liability, and
accountability.”

What do bond posting statues add to this and how do they work?

29
  These statutes create liability for the corporation’s reasonable expenses if the
suit fails by requiring posting of security for the reasonable expenses by
shareholders owning less than some set percentage or dollar amount of shares
who brings a derivative suit.

Cohen v. Beneficial Industrial Loan Corp.

←
← Choice of law is critical
 New Jersey has a security for expenses statute
 Neither Delaware code nor FRCP 23.1 requires security for expenses
Why doesn’t this disparate treatment of otherwise similar shareholders violate
the due process clause?
 Since the statute requires the payment only of the corporation’s reasonable
expenses, it does not offend the Due Process Clause. The application of the
statute only to those whose shares are worth $50,000 or less is not a denial of
equal protection.

Eisenberg v. Flying Tiger Line, Inc.  In the reorganization, FT organized a wholly-

owned subsidiary called FTC.
FTC in turn organized its wholly-owned
The Eisenberg transaction 
subsidiary called FTL.
 In a three party transaction, FT then merged
with and into its sub-sub/grandson FTL
 FTL renamed itself FT and took over
operations.
Flying Tiger Flying Tiger Corp.  The shareholders of old FT received an
identical number of FTC shares.
 Thus, the shareholders of FT wound up with
Flying Tiger Corp. Flying Tiger Line
shares of a holding company, FTC that
owned the operating company FTL now
Flying Tiger Line
called FT.

Plaintiff Argues:
o the series of corporate maneuvers were designed to dilute his voting rights
and his ability to control the air freight company
o the reshuffling deprived him and other shareholders of their voting rights
with respect to the operating company (FTL, then renamed FT).
o HOW? Is Eisenberg really hurt by the reorganization?
o Before the merger, he could vote on fundamental changes to FT and elect

30
 the FT board.
o Now, he can vote on fundamental changes to FTC (the holding company
his FT stock was converted into) and elect the directors of FTC.
o Because FTC wholly owns FT (the new operating company), and those
FTC directors vote the FT stock, they vote on the fundamental changes to
FT and elect its directors.
o Eisenberg’s interest is a bit more indirect than before, but not by much.
o Eisenberg has not lost much by way of voting rights.
o Moreover, Eisenberg could not muster the 1/3 necessary to challenge the
reorganization anyway.
o If he could not contest this reorganization, he could hardly hope to
accomplish much with a direct vote on the operating company.
Defendant Argues
o FT claimed that Eisenberg’s suit was derivative, and moved for him to be
required to post security for the corporation’s costs.
o Why did defendant do that instead of answering the merits?
 A procedural hurdle that they wouldn’t lose anything to try.
Issue: Direct or Derivative?
 Court finds action to be personal and not derivative.

What about the note and question on individual recover in the Wyoming
derivative action on page 241- Lynch v. Patterson?
 Unusual fact pattern: in stockholder derivative action, trial court did not
err in awarding judgment in favor of minority stockholder as an individual
rather than to corporate treasury, as corporate recovery would simply
return funds to control of wrongdoers, and as ordering payment to
corporate treasury would risk necessitating subsequent suit by minority
stockholder to compel directors to declare dividend or apply the funds to
legitimate corporate purposes.
 The court said: Direct recovery assures that Patterson will reap
some benefit from his lawsuit. We refuse to order payment into the
corporate treasury in this case and risk necessitating a subsequent suit by
Patterson to compel the directors to declare a dividend or apply the funds
to legitimate corporate purposes.
 How can they just do that?
 They can do it because it is an equitable procedure;

31
The Requirement of Demand on the Directors

Demand
 Most states require plaintiffs in derivative suits to approach the board and
demand that it sue the alleged wrongdoers.
 If demand is required, the failure to make demand is a procedural barrier and the
suit will be dismissed [unless and until the demand is met]
 Marx: NY Law
o According the Marx court [which sets the standard for demand excusal
under NY law], the purpose of the demand requirement is:
 to relieve courts from deciding matters of internal corporate
governance by giving the directors the opportunity to correct the
alleged abuse
 provide corporate boards with reasonable protections from
harassment suits on matters within the board’s discretion
 discouraging strike suits commenced by shareholders for personal
gain and not for the benefit of the corporation
 According to the Grimes court [which sets the standard for demand refusal under
Delaware law], the purpose of the demand requirement is:
o “by requiring an exhaustion of intercorporate remedies, the demand
requirement invokes a species of alternative dispute resolution procedure
which might avoid litigation altogether.”
o If litigation is beneficial, the corporation, not the shareholder, can control
the proceedings.
o If demand is excused or wrongfully refused, the stockholder can control
the litigation.

Arguments FOR the corporation controlling the litigation:

 derivative suits can act as a mechanism of managerial accountability; there
is a potential for bias in interested director transactions – the directors cannot
realistically be expected to sue themselves
 the cause of action belongs to corporation - like all assets, any litigation is
under control of BoD
 the shareholder may have interests diverse from those of corporation -
shareholders’ lawyer often real party in interest

32
  Therefore BoD should have some say in whether to go forward

What Exactly is “The Demand”?

 Typically a letter from shareholder to the board of directors.
o Must request that the board bring suit on the alleged cause of action;
o Must be sufficiently specific as to apprise the board of the nature of the
alleged cause of action and to evaluate its merits.
 State your case with particularity:
o “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.” Allison v. Gen. Motors Corp.,
604 F. Supp. 1106, 1117 (D. Del.), aff’d mem., 782 F.2d 1026 (3d Cir
1985).

Demand futility
o What is the most accepted excuse for not making a demand?
o What is standard for demand futility?
o Del: Grimes v. Donald
o NY: Marx v. Akers
o Both the Delaware and New York approaches to the demand futility
inquiry boil down the following inquiry:
o Is the board of directors so clearly disabled by conflicted interests
that its judgment cannot be trusted?
 If so, absent intervention by a special litigation committee,
the shareholder should be permitted to go forward.
 If not, the board should be allowed to decide whether the
litigation should proceed.
Statutory authority re: the demand:
o we looked at this statute already for the proposition that shareholder standing is
required to bring a derivative suit. But it also sets out the concept of “universal
demand.”
o MBCA § 7.42: Universal demand: “No shareholder may commence a derivative
proceeding until … a written demand has been made … and 90 days have
expired from the date the demand was made … unless irreparable injury to the
corporation would result by waiting for the expiration of the 90-day period”
o FRCP 23.1: The complaint shall allege “the efforts, if any, made by the plaintiff to

33
 obtain the action the plaintiff desires from the directors … and the reasons for the
plaintiff's failure to obtain the action or for not making the effort
o Implies that demand itself may be waived –
o Law in most states excuses demand if futile
o What mechanism is there in the MBCA that provides for internal corporate
review of a demand?
o MBCA § 7.44 provides two alternatives for internal corporate review
of the demand:
o A derivative proceeding shall be dismissed by the court on motion by the
corporation if one of the groups specified in subsection (b) or subsection
(e) has determined in good faith, after conducting a reasonable inquiry
upon which its conclusions are based, that the maintenance of the
derivative proceeding is not in the best interest of the corporation.
o Unless a panel is appointed pursuant to subsection (e), the determination
in subsection (a) shall be made by:
o A majority of qualified directors present at a meeting of the board of
directors if the qualified directors constitute a quorum; or
o A majority vote of a committee consisting of two or more qualified directors
appointed by majority vote of qualified directors present at a meeting of
the board of directors, regardless of whether such qualified directors
constitute a quorum.
Bottom line:
o If the independent (i.e., disinterested) directors constitute a quorum,
the demand may be reviewed by the board. Whether or not the
independent directors constitute a quorum, the independent directors
may appoint by majority vote a committee of two or more independent
directors.
o If either the board or committee determined in good faith after
conducting a reasonable investigation upon which its conclusions are
based that the maintenance of the derivative proceeding is not in the
best interests of the corporation the court shall dismiss the complaint.
o Under the MBCA’s version in 7.44(e), upon motion by the
corporation, the court may appoint a panel of one or more independent
persons to determine whether the suit should go forward. If that person
recommends dismissal, the court shall dismiss the action unless
plaintiff can prove the independent panel failed to act in good faith or

34
 failed to conduct a reasonable inquiry upon which its conclusions were
based.
o Who has the burden of proof on this issue?
 If a majority of the board was independent at the time
that determination was made, the burden of proof with
respect to the board’s independent disinterest and the
adequacy of its investigation is on plaintiff.
 If a majority of the board was not independent, the
burden of proof is on the defendant.

Grimes v. Donald
Direct v. Derivative:
o The initial issue was whether Grimes’ complaint was derivative or direct.
o The court tells us that “although tests have been articulated many times, it is
often difficult to distinguish between a derivative and an individual action…. The
distinction depends on “the nature of the wrong alleged and the relief, if any,
which could result if plaintiff were to prevail.”
o Were plaintiff’s claims direct or derivative?
o The complaint alleged:
 abdication by the board of its duties [direct claim] as per the court,
but is the court correct?
 breach of the duty of care [derivative claim],
 waste via excess compensation [derivative claim].
 Plaintiff’s abdication claim: the severe financial costs [penalties]
that the corporation will incur if it tries to interfere in Donald’s
management will “inhibit and deter the Board from exercising its
duties under § 141(a).”
 With respect to the abdication claim, Grimes sought only to have
the agreements declared invalid and, as such, that claim was
deemed direct.
o Court used standard of Business Judgement rule
o Quick and dirty on the BJR: courts should not second-guess the
business judgment of the directors; the principal function of the business
judgment rule is, or at least ought to be, to protect officers and directors
from liability for violation of their DOC.
o Under the BJR, a board decision to incur the risk of such a financial

35
 penalty in order to attract a senior manager was entitled to protection.
o “If an independent and informed board, acting in good faith, determines
that the services of a particular individual warrant large amounts of money,
whether in the form of current salary or severance provisions, the board
has made a business judgment… [that] will normally receive the
protection of the BJR unless the facts show that such amounts, compared
with the services to be received in exchange, constitute waste or could not
otherwise be the product of a valid exercise of business judgment.”
o “If demand is made and rejected, the board rejecting the demand is
entitled to the presumption of the BJR unless the stockholder can allege
facts with particularity creating a reasonable doubt that the board is
entitled to the benefit of the presumption.”
o “If there is a reason to doubt that the board acted independently or with
due care in responding to the demand, the stockholder may have the
basis ex post to claim wrongful refusal. The stockholder then has the right
to bring the underlying action with the same standing which the
stockholder would have had, ex ante, if demand had been excused as
futile.”
o Problem for plaintiffs from the BJR presumption:
 1. Under Delaware law, where demand is made the plaintiff is
deemed to have conceded that the demand was required
[waiver of any claim that demand is excused],
 2. which, in turn makes the decision of the board on whether to
dismiss a matter of business judgment,
 3. which, in turn means that the plaintiff loses.
o Under Delaware law, can plaintiff’s demand ever be excused?
Plaintiff must allege particularized facts showing why he was justified in
not making the demand.
 Grimes test for demand futility:
The three usual bases for excusing demand as futile are:
(1) a majority of the board has a material or familial interest in the challenged
transaction;
(2) a majority of the board is incapable of acting independently, maybe
because it is dominated or controlled by the alleged wrongdoer; or
(3) the challenged transaction was not the product of a valid business
judgment.

36
  As a result, well-advised plaintiffs in Delaware almost never make demand, since
the board always says no and the BJR presumption supports the board.
 So the issue to be litigated is whether demand is excused.
 Aronson v. Lewis (1984) OLD LAW – MODIFIED AND BUILT INTO GRIMES
o Aronson introduces the concept of “reasonable doubt” into this analysis. The case
creates a test for trial courts to see if the failure to make a demand was justified by using
discretion to determine whether the particularized facts alleged in the complaint create a
reasonable doubt that:
 the directors are disinterested and independent for purposes of responding to the
demand; ;
 OR [Aronson court says and, but acts like it’s or; and the NY courts in Marx
specifically interpret the branches of this test as “disjunctive”]
 the challenged transaction was otherwise the product of a valid exercise of
business judgment [and thus protected under the BJR
o Self interest, for these purposes, is defined in terms of direct financial
interest in the challenged transaction;
o the fact that a majority of directors voted to approve the transaction—and
therefore are named as defendants—does not constitute self-interest and
will not excuse demand.
SUMMARY
 If demand is required and made, it will invariably be refused;
 then BJR applies to the decision to dismiss the lawsuit and plaintiff
loses.
 Demand may be excused if plaintiff’s allegations raise reasonable
doubt about self interest or the protection of the business judgment
rule, but then the directors can appoint a special litigation committee
as in Zapata [see footnote 13].
 where demand is excused, the corporation may still move to dismiss
Marx v. Akers
the suit as not in the best interests of the corporation. The
 What recommendation
is this court’s viewmay come from
on derivative a special
actions committee of independent
in general?
directors, as in Zapata.
o “By their very nature, shareholder derivative actions infringe upon the
managerial discretion of corporate boards… Consequently, we have
historically been reluctant to permit shareholder derivative suits, noting
that the power of the courts to direct the management of the corporation’s
affairs should be ‘exercised with restraint.’”
o “the object is for the court to chart the course for the corporation which the
directors should have selected, and which it is presumed that they would
have chosen if they had not been actuated by fraud or bad faith. Due to

37
 their misconduct, the court substitutes its judgment ad hoc for that of the
directors in the conduct of its business.”
 Rule of law: under NYBCL § 626(c), plaintiff has to “set forth with particularity
the efforts of the plaintiff to secure the initiation of such action by the board, or
the reasons for not making such effort.”
 Three prong disjunctive standard:
o Majority of directors interested in challenged transaction
o Directors failed to inform themselves to degree reasonably appropriate
o Challenged transaction so egregious that it could not have been the
product of sound business judgment of the directors

Derivative Litigation Decision Derivative Litigation Decision

Tree Tree
Direct or Derivative?
Demand Made?
Direct Derivative No
Yes
Marx Analysis
Demand Refused? Q4
¹ sues Is demand futile? No Yes
If no, demand
required BOD sues Refusal wrongful?
Yes
If yes, demand No
excused and¹ sues Was demand
Made? Stop; no suit ¹ sues

1
1

The Task - SLC The Demand Requirement as Filter

Òpreserving the Òpermitting shareholders
discretion of directors to bring claims on behalf Delaware standard:
of the corporation when it
n NY standard: n
Reasonable doubt as to:
to manage a
corporation without is evident that directors ¨ Majority of directors ¨ Majority of board has
undue interferenceÓÐ will wrongfully refuse to interested; or material interest; or
Marx v. Akers bring such claimsÓÐ Marx ¨ Majority of the board lacks
¨ Directors failed to independence; or
inform themselves; or ¨ Challenged transaction not
¨ Challenged product of valid exercise of
business judgment
Needed: A filter to separate cases in which the board transaction could not
have been the product
is disabled by conflicts of interest from making an
of sound business
independent decision in good faith judgment
1
1

38
Auerbach v. Bennett
 “we confront a special instance of the application of the BJR and inquire whether
it applies in its full vigor to shield from judicial scrutiny the decision of a three
person minority committee of the board acting on behalf of the full board not to
prosecute a shareholder’s derivative action.”
 “As all parties and both courts below recognize, the disposition of this case on
the merits turns on the proper application of the business judgment doctrine, in
particular to the decision of a specially appointed committee of disinterested
directors acting on behalf of the board to terminate a shareholders' derivative
action. . . . In this instance our inquiry, to the limited extent to which it may be
pursued, has a two-tiered aspect.”
 Does court agree?
o Ultimate decision covered by business judgment rule
o But judicial inquiry permitted with respect to:
 Disinterested independence
 Adequacy of investigation
o Burden of proof?
o On plaintiff
 While the court may properly inquire as to the adequacy and appropriateness of
the committee’s investigative procedures and methodologies, it may not under
the guise of consideration of such factors trespass in the domain of
business judgment.”
 Demand really excused?
o Court assumes demand excused, but was it?
 Marx v. Akers test:
• Majority of BOD Interested?
• BOD failed to inform itself?
• Transaction egregious?
Zapata v. Maldonado
 The lower court opinion found BJR does not confer power on BOD to terminate a
derivative suit.
 How does the BJR apply to this case?
o Here, the evaluation of the Committee/BOD decision not to sue only
becomes relevant when plaintiff protests it. The BJR then is raised as a
defense to the attack on the decision.

39
 This court views the case as having 3 focuses:
o Whether the lower court was right in finding that the shareholder had an
individual right to maintain the derivative action.
o What is the corporate power under Delaware law of an authorized board
committee to cause the dismissal of litigation instituted on behalf of the
corporation.
o What is the role of the Court of Chancery in resolving conflicts between
stockholders and SLCs?
 ISSUE #1: the lower court found that once a shareholder made a demand and it
was refused, the shareholder somehow had an independent individual right to
continue the derivative action over the objections of the corporation- is this an
accurate statement of the law?
 ISSUE #2: What is the corporate power under Delaware law of an authorized
board committee to cause the dismissal of litigation instituted on behalf of the
corporation?
 ISSUE #3: What is the role of the Court of Chancery in resolving conflicts
between stockholders and SLCs?
o Rule of law: Delaware standard for reviewing SLC recommendations is a
two step approach:
 Delaware standard for reviewing SLC recommendations?
o Zapata Two-Step
 Step 1:Inquiry into the independence and good faith of the
committee
• Inquire into the bases supporting the committee’s
recommendations
• The corporation has the burden of proving independence,
good faith, and a reasonable investigation
 Step 2: Court may go on to apply its own business judgment as to
whether the case is to be dismissed
• The court will undertake an independent inquiry into whether
the suit should be dismissed.
• The court can consider matters of law and public policy in
addition to the corporation’s best interests.
 Zapata far more intrusive judicial review than usual. Why?
o Context: Demand was excused because board disabled from acting due
to conflicted interests

40
 o Committee appointed by the disabled board
o Potential for structural bias – “there but for the grace of God, go I”

IV. THE LIMITED LIABILITY COMPANY

• Cross between partnership and corporation
• Tax advantages of partnerships
• Limited liability of corporations
• None of the restrictions (e.g., number and type of shareholders) applicable to S
corporations

History
• LLCs introduced in Wyoming in 1977
• LLC is the first new legal business concept since the S corp (1950s)
• Created as a vehicle for ownership of real estate and development of oil, gas and
other mineral rights

Tax Treatment
• The IRS initial position [pre-1988] was that LLCs should not be treated as a
partnership [i.e., taxable entities]
• In 1988, IRS ruled that LLC could qualify for partnership-like tax treatment
• In 1997, IRS further liberalized with “check the box” regulations that give
unincorporated associations the ability to choose their tax status without regard
to the entity’s nontax legal characteristics

Why so popular?
• They provide a standard form contract that incorporates many of the most
attractive features of partnerships and corporations.
• The LLC is an unincorporated business organization that can provide its
members with pass through tax treatment, limited liability, and the ability to
actively participate in firm management.
Funding
• Members typically contribute capital
• Capital contribution may be cash, property, services rendered, a promissory
note, or other obligation to contribute cash, property, or to perform services. See
ULLCA § 401.
Liability

41
 • Members stand to lose capital contributions, but their personal assets are not
subject to attachment

Tax Consequenses
• Income and losses pass through to members
• LLC does not pay taxes at the entity level, so profits are not subject to double
taxation
• Capital gains flow through to owners and retain their tax attributes (i.e., are
subject to lower rates)

Financial Interests
Profit and Loss Sharing
• Absent contrary agreement, most LLC statutes allocate profits and losses on the
basis of the value of members' contributions
• Compare partnership law’s equal division default rule
Withdrawal
• Member may withdraw and demand payment of his/her interest upon giving the
notice specified in the statute or the LLC's operating agreement

Assignment of LLC Interest

• Unless otherwise provided in the LLC's operating agreement, a member may
assign his financial interest in the LLC
o An assignee of a financial interest in an LLC may acquire other rights only
by being admitted as a member of the company if all the remaining
members consent or the operating agreement so provides. See ULLCA §
501-503
• Analogous to partnership rules

Management Rights
o absent contrary agreement, each member has equal rights in the management of
the LLC; see ULLCA §404(a)(1)
o Most matters decided by majority vote, see ULLCA § 404(a)(2)
o Significant matters require unanimous consent, see ULLCA § 404(c)
o E.g., merger, admission of new member, dissolution, etc...
o Two Flavors
o Manager-managed LLCs: see ULLCA § 404(b)

42
 o Member-managed LLCs: see ULLCA § 404(a)

o Derivative actions:
 Member may bring an action on behalf of the LLC to recover a
judgment in its favor if the members with authority to bring the
action refuse to do so

Liabilities: Section 303

o No member or manager of a limited liability company is obligated personally for
any debt, obligation, or liability of the limited liability company solely by reason of
being a member or acting as a manager of the limited liability company

Section 1: FORMATION
 File articles of organization the designated State office. ULLCA § 202(a)

43
 o Required and optional contents set forth in ULLCA § 203
o Filing fees plus minimum franchise tax
o Other formation tasks:
o Choose and register name: LLC statutes generally require the name of the
LLC to include the words limited liability company, the abbreviation LLC,
or similar phrases. ULLCA § 105
 Effect of, see Water, Waste & Land v. Lanham
o Designate office and agent for service of process
o Draft operating agreement – the basic contract governing the affairs of a limited
liability company and stating the various rights and duties of the members

Default Rules for LLCs

o Typical LLC statutes provide default rules, but with flexibility.
o The default rule is comparable to the general partnership form, (1) vesting
management in the LLC’s members, (2) except that the number of votes cast by
each member is voting is determined by their proportional share in the book
value of the membership interests.
o In general, both of these rules are subject to any contrary provisions of the
articles of organization and operating agreement.
o The LLC thus provides substantial flexibility in structuring the firm’s decision
making processes.

Water, Waste & Land, Inc. d/b/a Westec v. Lanham

o What is the significance of Clark telling Westec to send a written proposal to
Lanham?
o Puts Westec on notice that Lanham exists. Sounds like Clark is an agent
of Lanham.
o What’s the bottom line at the trial court [county court] level?
o Found that Clark was an agent of Lanham and PPI with authority to
obligate. Westec understood Clark to be Lanham’s agent and therefore
Clark is not personally liable.
o What’s the holding at the district court level?
o Reversed county court decision.
o What is the result of the district court decision?

44
 o The Col. SC holds: “the statutory notice provision applies only where a TP seeks
to impose liability on an LLC’s members or managers, simply due to their status
as members or managers of the LLC. When a TP sues a manager or a member
of an LLC under an agency theory, the principles of agency law apply
notwithstanding the LLC Act’s statutory notice rules.”
o How does these facts work out under standard agency law?
o Under common law agency rules, A has liability on a partially disclosed
agency – to avoid liability, A must fully disclose both the agency and the
identity of P.
o How is this a partially disclosed agency? It sounds undisclosed - and both
Clark and Lanham are agents for the undisclosed LLC!
o The court tells us that the partially disclosed agency exists because Clark
and Lanham failed to disclose the existence OR identity of the LLC.
o Yikes. This sounds much more like an undisclosed agency. The court
seems a little mixed up on the definition of partially disclosed agency, as
evidenced by this language from the full opinion:
 “For these reasons, we conclude that where an agent fails to
disclose either the fact that he is acting on behalf of a principal or
the identity of the principal, the notice provision of our LLC Act,
section 7- 80-208, cannot relieve the agent of liability to a third
party.
 When a third party deals with an agent acting on behalf of a limited
liability company, the existence and identity of which has been
disclosed, the third party is conclusively presumed to know that the
entity is a limited liability company and not a partnership or some
other type of business organization.
 Where the third party does not know the identity of the principal
entity, however, the situation is fundamentally different because the
third party is without notice and the law does not contemplate that
he has any way of finding the relevant records.”

Section 2: THE OPERATING AGREEMENT

45
Elf Atochem North America, Inc. v. Jaffari
o Can the parties say whatever they want in their LLC Agreement?
o As long as they are not violating any law, they can.
o Does plaintiff claim direct or derivative claims?
o Can LLCs be sued derivatively, like corporations?

Section 3: PIERCING THE “LLC” VEIL

o PCV [in the corporate context]: we typically need:
o (1) a total disregard for the separate existence of the corporation
o (2) Most of the cases and the commentators state that there is a second
element that must be proved: injustice or some such concept.
o § 302. Limited Liability Company Liable for Member’s or Manager’s
Actionable Conduct:
o A limited liability company is liable for loss or injury caused to a person, or
for a penalty incurred, as a result of a wrongful act or omission, or other
actionable conduct, of a member or manager acting in the ordinary course
of business of the company or with authority of the company.
o § 303. Liability of Members and Managers.
o (a) Except as otherwise provided in subsection (c), the debts, obligations,
and liabilities of a limited liability company, whether arising in contract, tort,
or otherwise, are solely the debts, obligations, and liabilities of the
company. A member or manager is not personally liable for a debt,
obligation, or liability of the company solely by reason of being or acting as
a member or manager.
o (b) The failure of a limited liability company to observe the usual company
formalities or requirements relating to the exercise of its company powers
or management of its business is not a ground for imposing personal
liability on the members or managers for liabilities of the company.
o (c) All or specified members of a limited liability company are liable in their
capacity as members for all or specified debts, obligations, or liabilities of
the company if:
 (1) a provision to that effect is contained in the articles of
organization; and
 (2) a member so liable has consented in writing to the adoption of
the provision or to be bound by the provision.

46
Kaycee Land and Livestock v. Flahive
 Issue: “in the absence of fraud, is a claim to pierce the LL entity veil or disregard
the LLC entity in the same manner as a court would pierce the corporate veil,…
an available remedy against a Wyoming LLC…”
 Wyoming law: Section 17-15-113: “Neither the members of a limited liability
company nor the managers of a limited liability company managed by a manager
or managers are liable under a judgment, decree or order of a court, or in any
other manner, for a debt, obligation or liability of the limited liability company.”
 ULLCA § 303(a): “A member or manager is not personally liable for a debt,
obligation, or liability of the company solely by reason of being or acting as a
member or manager.”
 Cf.: MBCA § 6.22(b): “… a shareholder of a corporation is not personally liable
for the acts or debts of the corporation except that he may become personally
liable by reason of his own acts or conduct”
 Minn. Stat. § 322B.303(2): “case law that states the conditions and
circumstances under which the corporate veil of a corporation may be pierced
under Minnesota law also applies to limited liability companies.”

Section 4: FIDUCIARY OBLIGATION

McConnell v. Hunt Sports

Issue:
 Is it a breach of fiduciary duty to compete with your LLC?
 Can the members limit the fiduciary duties they owe to each other and to the
LLC?
 Is Section 3.3 of the Agreement “clear and unambiguous” in its meaning, and
why does this matter?
Is Section 3.3 of the Agreement
ÒManifestly Unreasonable
Ó?
n ULLCA ¤ 103(b)(2): n Section 3.3 of the operating
operating agreement agreement:ÒMembers May
Compete. Members shall not
may notÒeliminate the in any way be prohibited
duty of loyalty
Óbut may from or restricted in
Òidentify specific types engaging or owning an
or categories of interest in any other
activities that do not business venture of any
nature, including any
violate the duty of venture which might be
loyalty, if not manifestly competitive with the
unreasonable ....Ó business of the Company.
Ó

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1
Section 4: DISSOLUTION
By operation of law:
 Upon the happening of any event specified in LLC operating agreement
 Vote of members (as specified in operating agreement)
 It becomes unlawful to carry on the business
Upon court order:
 Economic purpose frustrated
 Misconduct by members

New Horizons Supply Cooperative v. Haack

← V. THE DUTIES OF OFFICERS, DIRECTORS, AND OTHER INSIDERS

Two Ways of Thinking about the
Business Judgment Rule
n As a standard of liability to
measure D&O conduct
¨ No liability for negligence
¨ Instead liability based on
things like:
n Fraud
n Illegal conduct
n Self-dealing
n As an abstention
doctrine for the courts
¨ Court willnot review
BoD decision if:
¨ Preconditions:
n No fraud
n No illegality
n No self-dealing

Section 1: THE OBLIGATIONS OF CONTROL: DUTY OF CARE

What is the duty of care?

 MBCA § 8.30(a): “Each member of the board of directors, when discharging the
duties of a director, shall act: (1) in good faith, and (2) in a manner the director
reasonably believes to be in the best interests of the corporation”
What is the duty of loyalty?
 Directors and officers have a fiduciary duty to put the interests of the corporation
ahead of their own.

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Kamin v. American Express
Complaint?
 If the company had sold the stock, it would have recognized a $26 million tax
loss that could have been offset against its taxable income.
o When it issued the DLJ stock as a dividend, it lost that tax benefit.
o The shareholders recognized dividend income equal to the fair market
value ($4 million) of the DLJ stock, and got a basis in the DLJ stock equal
to that amount.
 Plaintiffs calculated the cost of the company’s scheme at $8 million.
Direct or derivative?
o Derivative
Demand made?
o yes, but it was rejected.

 “The only hint of self-interest which is raised … is that four of the twenty directors
were officers and employees of American Express and members of its Executive
Incentive Compensation Plan. Hence, it is suggested, by virtue of the action
taken earnings may have been overstated and their compensation affected
thereby. Such a claim is highly speculative ….
 “the court will not interfere unless the powers have been illegally or
unconscientiously executed; or unless it be made to appear that the acts were
fraudulent or collusive, and destructive of the rights of the stockholders.”
 “Mere errors of judgment are not sufficient grounds for equity interference, for the
powers of those entrusted with corporate management are largely discretionary.”
 “The Court will not interfere unless a clear case is made out of fraud, oppression,
arbitrary action, or breach of trust.”
Court states:
 “The minutes of the special meeting indicate that the defendants were fully
aware that a sale rather than a distribution of the DLJ shares might result in
the realization of a substantial income tax saving. Nevertheless, they
concluded that there were countervailing considerations primarily with respect
to the adverse effect such a sale, realizing a loss of $25 million, would have on
the net income figures in the American Express financial statement. Such a
reduction of net income would have a serious effect on the market value of
the publicly traded American Express stock.”

49
What if defendant directors had failed to inform themselves about the adverse tax
consequences?
 Then there would be a duty of care issue.

Strong Abstention Version of BJR:

 Court says: “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 which will have an impact on
profits, market prices, competitive situations, or tax advantages.”

Smith v. Van Gorkom

The Deal: Legal Structure

P r i t z k e r E n t i t i e s

Trans Union J a y P r i t z k e r

Merger
M a r m o n G r o u p , I n c .

Timeline N e w C o , I n c .

 Trans Union stock ~ $38

 Sept. 5: CFO Romans runs feasibility study –not a valuation study- difference? 1

o “The work consisted of a preliminary study of the cash which could be

generated by the Company if it participated in a LBO.”
 Sept 13-19: Van Gorkom approaches Pritzker with a proposal based on
Peterson’s calculations, [which had built into them the assumption that the
appropriate share price was $55] and negotiates leveraged buyout at $55 per
share with Pritzker.
 VG wanted TU to be free to take any offer better than the $55, to validate the $55
price. Of course Pritzker objected.
 They finally came to terms, and Pritzker accepted with certain conditions:
o Pritzker would be allowed to buy 1.75 [later reduced to 1.0] million shares
at $38 [75 cents above the 9/19 market price] via a lock up agreement
o So if the company were sold to someone else for $56 per share, Pritzker
would have a profit of $18 times 1 million shares, or $18 million, which

50
 would, in effect, be paid by the competing bidder.
 There was some limitation on the freedom of Trans Union to shop around for a
better offer.
 There was a dispute about what this limitation was, but the court ultimately
concludes that Trans Union was not completely free to engage in what is referred
to as a market test of the $55 price.
 Sept 20: Senior management meeting
 Sept 20: BOD meeting
 What paperwork was provided??

Opinion
 “The record is not clear as to the terms of the Merger Agreement. The
Agreement, as originally presented to the Board on September 20, was never
produced by defendants despite demands by the plaintiffs. Nor is it clear that the
directors were given an opportunity to study the Merger Agreement before voting
on it. All that can be said is that Brennan [corporate counsel] had the Agreement
before him during the meeting.”
The BOD decision was “based solely” on:
 VG’s oral presentation
 TU’s president Chelberg’s supporting representations
 Brennan’s legal advice
 BOD’s knowledge of the market history of TU’s stock
 Oct 1: First public wrinkle: within 10 days of the press release, key executive
officers threatened to resign.
 VG meets with Pritzker who agrees to some modifications as long as VG could
convince the dissidents to stay on the TU payroll for 6 months after the deal
closed
 Oct 8: TU BoD approves revised deal
 VG gets the senior management team calmed down and back in favor of the
deal; they agree to hire Salomon Bros. to solicit other offers for TU, and they
approved the proposed amendments to the Merger Agreement which had not yet
even been drafted.
 Oct 10: amendment to merger agreement delivered to VG and signed by VG,
apparently without reading them
 Dec. 19: this litigation was filed, and within 4 weeks, 8 of the 10 BOD were
deposed

51
  Jan. 26: BOD has “lengthy” meeting and votes to proceed with the merger
 Jan. 27: BOD approves supplement to proxy statement detailing the merger
 Feb 10: TU shareholders approve merger by 69.9% to 7.25% (22.85%
abstained)
What Happened to the Old Trans Union Shareholders?
 DGCL § 251(b)(5):The plan of merger shall specify “the manner of converting the
shares of each of the constituent corporations into … cash … securities of any
other corporation or entity which the holders of such shares are to receive in
exchange for [their] shares”
Trial court decision
 BOD did not “act recklessly or improvidently in determining on a course of action
which they believed to be in the best interests of the stockholders of TU.” BJR –
holds for corporation
 looking at market value of TU [$55 was higher than recent historical prices];
business acumen of BOD [116 combined years of experience with TU]; premium
over market price; prospect of other bidders [apparently viewed as unlikely,
although with the no shop, hard to tell].
 The trial court somehow concludes that TU was free to accept other offers and
that no legally binding agreement was reached until 1/26/81.
The court decides BOD failed to make an informed decision at its 9/20 BOD meeting
about:
VG’s role forcing the sale and creating the share price;
the intrinsic value of TU –the company they sat on the board of, some for many years
What about § 141(e)
 A member of the BOD or a member of any committee designated by the BOD
shall in the performance of such member’s duties be fully protected in relying in
good faith upon the records of the corporation and upon such information,
opinions, reports or statements presented to the corporation by any of the
corporation’s officers or employees, or committees of the BOD, or by any other
person as to matters that the person 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.
Legal standard from the Smith v. Van Gorkom
 What do BOD need to show to be informed?
o Directors need to gather all material information “reasonably available” to
them

52
 o The “reasonably available” standard requires an in-depth study:
 Valuation study
 Discussion of course of the negotiations
 Review of actual contract
 information about the terms of the offer and their fairness

ALI Principles of Corporate Governance § 4.01(c)(2):

 The ALI standard only requires directors to be informed to the extent that they
reasonably believe to be appropriate under the circumstances
 How does the ALI standard differ from the court’s standard?
o The ALI approach permits directors to make decisions on less than all
reasonable available information, if they reasonably believe doing so is
appropriate given the situation.
AFTERMATH: Business Judgment Rule post-Van Gorkom: page 324
 The case was settled for $23 million [$10 million from insurance; $11 million from
Pritzkers and the rest from the directors, mostly from Van Gorkom.

Section 2: DUTY OF LOYALTY

Directors and Managers

Corporate Opportunities

Dominant Shareholders

53
Zahn v. Transamerica

Transamerica owned a controlling block of the Class B shares and dominated the management of
Axton-Fisher. Transamerica had elected majority of the board

54
  Dividend preference: Class A was entitled to a cumulative annual dividend of
$3.20, then the Class B was entitled to $1.60 and then the two classes shared
equally any excess dividend.
 Redemption/conversion preference: company could call the Class A shares
for redemption upon 60 days’ notice at $60 per share plus accumulated
dividends, but Class A shareholders could convert each Class A share into one
share of Class B instead. The B shares are not convertible or callable.
 Liquidation preference: upon liquidation, the division of assets was 2:1 in favor
of the Class A.
 Voting rights: All the votes were in the class B except when dividends had not
been paid for four successive quarters, then the classes of stock with the
defaulted dividends pick up voting rights like class B (not an issue in the case).
 The redemption provision was included to benefit the B shareholders in
situations in which the value of the company had risen to the point where
redemption would force conversion.

In re Wheelabrator Technologies, Inc. Shareholders Litigation

Issues:
(i) that the proxy disclosure was inadequate
(ii) that the directors violated their duty of care
(iii) that the directors violated their duty of loyalty.

Duty of Care
(i) Disclosure. The plaintiffs argued that the proxy material was materially
misleading because it didn’t disclose that the board meeting lasted only three hours.
(ii) Duty of care. Even if (hypothetically) the board didn’t exercise due care, the
shareholders ratified the merger after full disclosure. That’s enough to kill the claim.
(iii) Duty of Loyalty. Even if (hypothetically) the board violated its duty of
loyalty in voting for the merger, ratification changes the burden of proof. But nothing
is simple here. The court sets out a two-part standard:
a. Does it matter whether the shareholders are interested or not? And
what about the language of § 144(a)(2) -- does it require
DISINTERESTED shareholders?

55
 i. No. The section provides that an interested transaction is not void if
(a) there is full disclosure and the disinterested directors ratify it, (b)
there is full disclosure and the shareholder ratify it, or (c) it is fair.
The drafters inserted a requirement of disinterest in (a) but not in
(b).
b. Accordingly, ratification ought to be effective to shift the burden of
proof of unfairness to the plaintiffs (under § 144(a)), even if the
shareholders are not disinterested;
i. Courts have held otherwise.
ii. Although perhaps not faithful to the statutory language the
decision does appeal to common sense.

Section 3: THE OBLIGATION OF GOOD FAITH

What is good faith?
 It’s part of the so-called “triad” of fiduciary duties: good faith, DOL and DOC.
 Only directors who act in “good faith” are entitled to indemnification for legal
expenses under Del Section 145.
 Only directors who rely in good faith on corporate records and experts can be
relieved of liability under Del Section 141(e).
 Only disinterested director and/or shareholder approval of interested director
transactions can insulate interested director transactions from judicial review.

Compensation

In re The Walt Disney Co. Derivative Litigation

3 options to end Ovitz’s appointment:

(1) Initial term expires, no renewal offered – triggers a $10 million termination payment
(2) Prior to expiration of the initial term: Disney could terminate Ovitz for “good cause”
[gross negligence or malfeasance] triggering no termination payment or
(3) Ovitz could resign [without cause] triggering payment of the PV of his remaining
salary through the first 5 year term, plus $7.5 million for each fiscal year remaining
under the agreement, and the immediate vesting of the A options.

 If measured in terms of the documentation that would have been generated if

“best practices” had been followed, the record leaves much to be desired. The

56
 Chancellor acknowledged that, and so do we.
 But, the Chancellor also found that despite its imperfections, the evidentiary
record was sufficient to support the conclusion that the compensation committee
had adequately informed itself of the potential magnitude of the entire severance
package including the options, that Ovitz would receive in the event of an early
NFT.

So is good faith a predicate for BJR protection? And what are the categories of
“bad faith”?
 Subjective bad faith: conduct motivated by actual intent to do harm which
clearly constituted bad faith
 Lack of due care: does this rise to the level of bad faith? It’s gross negligence
without malevolent intent. This is NOT bad faith.
 Intentional dereliction of duty: a conscious disregard for your responsibilities –
this is a non exculpable nonindemnifiable violation of the duty fiduciary duty to
act in good faith, so it’s Bad Faith.

Waste
 A plaintiff who fails to rebut the BJR presumptions is not entitled to any remedy
unless the transaction constitutes waste…
 [if] the exchange was so one sided that no business person of ordinary, sound
judgment could conclude that the corporation has received adequate
consideration….
 The court tells us that the “payment of a contractually obligated amount cannot
constitute waste, unless the contractual obligation itself is wasteful.”

Oversight
 A rudimentary understanding of the firm’s business and how it works
 To stay informed about the firm’s activities
 To engage in general monitoring of corporate affairs
 Attend BOD meetings regularly
 Routinely review financial statements

What is a classic “Caremark” claim?

 When a director liability claim is predicated on ignorance of liability-creating
activities within the corporation, only a sustained or systemic failure of the BOD

57
 to exercise oversight will establish the lack of good faith needed for liability.
What is an example of such a sustained or systemic failure?
 An utter failure to attempt to assure a reasonable information and reporting
system exists.

Graham: absent cause for suspicion, there is not duty on the BOD to install and operate
a corporate system of espionage to ferret out wrongdoing which they have no reason to
suspect exists.
Caremark: absent grounds to suspect deception, neither corporate boards nor senior
officers can be charged with wrongdoing simply for assuming the integrity of employees
and the honesty of their dealings on the company’s behalf.

Does acting in bad faith trigger an independent basis of liability under Delaware
corporate law?
 No;“although good faith may be described colloquially as part of a ‘triad’ of
fiduciary duties that includes the duties of care and loyalty, the obligation to act in
good faith does not establish an independent fiduciary duty that stands on the
same footing as the duties of care and loyalty. Only the latter two duties, where
violated, may directly result in liability, whereas a failure to act in good faith may
do so, but indirectly.”

Section 4: DISCLOSURE AND FAIRNESS

Definition of a Security

Primary and secondary markets:

 primary markets/issuer transactions: sale of securities to investors by issuers
seeking to raise capital for their businesses. Private placements are the most
common form of transaction. But these sales can be in public markets or through
private placements in negotiated transactions.
 secondary markets/trading transactions: buy-sale transactions among
investors of already-issued securities.

Function of securities markets:

(1) capital formation: bringing together investors and businesses through the issuance
of equity and debt;

58
(2) liquidity: the ability to readily sell an investment instrument- providing an exit
strategy; and
(3) risk management: permits diversification and hedging of investments

Participants in the securities markets:

 investors: seek a return on their investment; they own securities, either directly
or indirectly; the trend has been towards indirect ownership of securities by
institutional investors.
 issuers of securities: make a financial commitment to provide a return in the
form of (1) dividends, (2) interest payments, (3) appreciation and/or (4) liquidation
rights;
 Financial intermediaries: bring issuers and investors together; they come in
various forms:
o Dealer: when a firm buys and sells securities for its own account, taking
title itself.
o Broker: when a firm buys and sells as an intermediary for a customer.
o Market maker: a dealer who keeps an inventory of a particular company’s
securities and holds itself open as a willing buyer and seller of those
securities.
o Underwriter: when a firm helps a company sell securities through an
offering registered under the 1933 Act

Overview of securities law – state and federal

 Securities regulation is designed to protect investors, whether they are buying
securities from an issuer, trading in the securities markets, exercising their voting
rights or selling in a tender offer.
 For the most part, securities regulation in the United States is a matter of federal
law, based on the idea that:
o (1) mandatory disclosure [Make sure that investors have all the
information they need to make informed decisions] and
o (2) anti fraud liability will equip securities investors and securities
markets with the information to move capital to its optimal uses.
 So the laws have an affirmative component, through disclosure obligations on
issuers and insiders; and
 a negative component, with prohibitions via the anti fraud rules -- no material
misrepresentations or omissions in connection with the sale of securities.

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Definition of a Security § 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’.”
 Why does this definition matter?
o In order to come within the registration requirements of §5 of the 33 Act,
the offer or sale of a property interest must constitute the offer or sale of a
“security.” And once you have a class of securities registered under § 5,
you must provide the SEC and the market with continuous disclosure
under the periodic disclosure system of the 1934 Act.
o If the item in question is NOT a security as defined in §2(1) of the 33 Act,
then the registration requirements of § 5 are not applicable.
o So your first line of inquiry is to see if you are dealing with a security.
o If so, look to see if there are any exemptions from the registration
requirements available.

Seven statutes:
Only 2 matter for us
 Securities Act of 1933: regulates the sale of securities to the public – primary
market
o The 1933 Act defines 3 categories of securities:
 (1) any interest or instrument commonly known as a security: things
like bonds, stock, notes, debentures and warrants
 (2) types of securities specifically mentioned in the Act: things like
pre-organization subscriptions; fractional, undivided interests in oil,
gas or other mineral rights
 (3) investment contracts and certificates of participation: the two
most important clauses in §2(1) are its broad, catch-all phrases
“investment contract” and “certificates of interest or participation in
any profit-sharing agreement.” The SEC and the courts have
applied these phrases to include many financial schemes not
specifically mentioned by the Act as “securities.”
 Most of the case law has arisen in connection with the phrase “investment
contract” and, to a lesser extent, to the phrase “unless the context otherwise
requires”.
 The courts have fleshed out the concept of the investment contract to cover any

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 investment scheme that triggers the investor’s need for the protection of the
federal securities laws.

 Securities Exchange Act of 1934: establishes the SEC to administer the

securities laws and to regulate practices in the purchase and sale of securities –
secondary market
o The 1934 Act establishes the SEC to administer the securities laws and to
regulate practices in the purchase and sale of securities – secondary
market
 Independent agency
 Enforce the securities laws
 Promulgate rules and regulations to implement those laws more
effectively
Both the 1933 and 1934 Act definitions have a laundry list of examples
and categories, plus a catch-all at the end. The purpose of this two-part
test is to include in the definition all of the many types of instruments
that in our commercial world fall within the ordinary concept of a
security.
Both sections start with “unless the context otherwise requires” which
allows instruments that would otherwise fall within the definitions to be
carved out, if the context otherwise requires.

 State blue sky laws

o The states had already begun to legislate in this area, before the market
crash in 1929, with the first state blue sky law in 1911.
o The blue sky laws are named because they protect the investors from
having nothing standing behind their investment besides water or blue
sky.
o The various state blue sky laws vary, but all contain the following three
ideas:
 (1) anti fraud provisions: the state’s attorney general is
empowered under the statute to investigate fraud in the
advertisement, purchase or sale of a “security” and has the
authority to undertake criminal prosecutions and get injunctive
relief. Individual investors are entitled to sue civilly as well.
 (2) disclosure provisions: the statutes requires pre-approval of
the offering circular or prospectus, all advertising and any other
information in connection with the sale or purchase of securities

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  (3) licensing and registration provisions for securities and
brokers and dealers of securities: the laws provide for the
registration of securities offered for sale in that state, and for all
persons selling securities

Robinson v. Glynn
 “The parties have vigorously urged us to rule broadly in this case, asking that we
generally classify interests in LLCs as investment contracts (Robinson’s view) or
non-securities (Glynn’s view).”
 What is an Investment Contract - SEC v. Howey (US 1946):
o The Howey test seeks to identify transactions in which investors are
counting on others to manage the enterprise that will produce financial
returns on their investments.
o The definition isolates transactions in which ownership is separated from
control, suggesting the importance of mandatory disclosure and higher
liability standards to ensure that investors allocate capital to its highest-
valued uses.
o SEC v. Howey (US 1946): “a contract, transaction or scheme whereby a
person invests money, in a common enterprise, and is led to expect profits
solely from the efforts of the promoter or a third party”
 1. Investment of money: the investment can be cash or non cash
consideration, like checks or money orders or credit. The
investment part is satisfied if you put out consideration with the
hope of some financial return -- producing income or profit. This
excludes the purchase of a consumable commodity or service.
• Anything constituting legal consideration for purposes of
contract law should satisfy the first prong of the Howey test
 2. Commonality/common enterprise: This prong focuses on the
question of the extent to which the success of the investor’s interest
rises and falls with others involved in the enterprise. Courts have
developed two tests, depending on the circuit:
• horizontal commonality [between investors]: looks to the
relationship between the individual investor and the other
investors who put money into the scheme. Requires

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 investors share the risk of the enterprise, usually through a
pooling of their funds; e.g., shareholders of a corporation.
• Multiple investors have interrelated interests in a
common scheme - they must share in a single pool of
assets; the investors’ fortunes are interwoven - they pool
resources, share profits and share losses pro rata.
• vertical commonality [between an investor and the
promoter]: looks to the relationship between the investor
and the promoter of the scheme. Requires the promoter and
at least one investor share the risk; a single investor has a
common interest with the manager of his investment;
• this requires a profit sharing arrangement between the
promoter and each investor -- the investor’s fortunes are
inextricably interwoven with and dependent on the fortunes
of the promoter/manager of the enterprise.
 3. Expectation of profit from the efforts of others: the expected
return must come from earnings of the enterprise, not merely
additional contributions, and this return must be the principle
motivation for the investment.
• Howey says that the profits must be SOLELY from the
efforts of others; lower courts wrestle with whether “solely”
means only or predominantly or substantially. There is a
split in the circuits about whether to go with the more flexible
interpretation.
• According to the 4th Circuit: The “Supreme Court has
endorsed relaxation of the requirement that an investor rely
only on others’ efforts, by omitting the word “solely” from its
restatement of the Howey test. And neither our court nor our
sister circuits have required that an investor like Robinson
expect profits “solely” from the efforts of others.
• Requiring investors to rely wholly on the efforts of others
would exclude from the protection of the securities laws any
agreement that involved even slight effort from investors
themselves. It would also exclude any agreement that
offered investors control in theory, but denied it to them in
fact. Agreements do not annul the securities laws by

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 retaining nominal powers for investors unable to exercise
them…”

What are the characteristics typically associated with common stock?

• the right to receive dividends contingent upon the apportionment of profits [this
says shareholders are entitled to their share of any distributed dividends, not that
they are entitled to dividends per se].
• negotiability
• the ability to be pledged or hypothecated
• the conferring of voting rights in proportion to the number of shares owned; and
• the capacity to appreciate in value.

What does the court’s discussion of Landreth Timber Co. v.

Landreth add to this?
• Landreth Timber Co. v. Landreth holds that real stock is always a
security: Landreth deals with whether a single individual who buys all
the stock of a company and has the power to actively manage it could
state a claim for fraud in his purchase.
• The 9th Circuit used the Howey test to support its holding that when he
purchased all the stock, he was really buying a business, and the
“economic reality” of the transaction was that he was buying a
business and not an investment in a security.
Landreth Timber
• The Supreme Court reversed, holding that it would be burdensome to
apply the Howey test to traditional stock. If something is called stock,
and has the 5 common elements from Forman, it’s stock and there is
no need to get into the investment contract analysis.

So a nice rule is: stock is always a security, except where stock is not really stock,
in which case it might still be a security if it’s an investment contract

Selling Securities under the

Securities Act of 1933
Registration Registration
Statement Filed with Statement Effective
SEC

Offers permitted but

no sales Sales allowed
No selling
activity SEC review: Prospectus
adequacy of must be
disclosure, not delivered
merits 64

1
 • § 5 prohibits the offer and sale of “securities” through the mail or via
interstate commerce without filing a disclosure document called a
registration statement with the SEC;
• § 5 requires that the securities can’t be sold until the registration statement
is declared effective by the SEC; and
• § 5 requires the delivery of a prospectus to everyone who actually buys
the securities, as well as to anyone just offered the securities.

• Because the registration process is costly in financial and time terms, we

try to avoid it if possible. There are two primary ways:
o to sell an exempt security -- that by its nature not subject to
registration OR
o to sell a security that would otherwise have to be registered in an
exempt transaction.

Exempt securities
• §3: Exempt securities: ALWAYS exempt from registration, both when
issued and later when traded.
• These securities were thought to be inappropriate subjects of regulation either
because they were already regulated by some other governmental authority or
because of the intrinsic nature of the securities themselves.
• Exempt offerings remain subject to the anti fraud provisions of the securities laws;
so the SEC can take action against any seller of securities under §17 - the general
anti fraud provisions for the offer and sale of securities, primarily used by the SEC
and the US Justice Department in criminal actions.
• Just because a security is exempt under FEDERAL registration requirements
doesn’t necessarily mean it is exempt from state blue sky registration, and state anti
fraud rules and liabilities.

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§3: Exempted securities:
• Burden of proving exemption: is on the person claiming the exemption; if
the burden is not met, the exemption is lost, and if they were counting on the
exemption, they have probably now violated §5 which requires registration with
automatic liability for selling unregistered securities under §12(a)(1).
• Exempt securities included:
• Government securities: are those issued or guaranteed by governmental
organizations under §3(a)(2) like U.S. and state notes and bonds
• Commercial paper: short term commercial paper [with a maturity of less
than 9 months] is exempt –they tend to be high quality, negotiable notes
issued for current business operations and typically purchased by banks
and other institutional sophisticated institutional investors, not the general
public.
• Securities subject to non- SEC regulation: some securities are
exempted on the theory that other regulation offers adequate protection to
investors, including:
o §3(a)(2): securities issued by banks;
o §3(a)(5): securities issued by federally or state-regulated S&Ls;
o §3(a)(2): insurance policies and annuity contracts issued by state-
regulated insurance companies
• Securities issued by not for profit issuers: available to for
organizations that operate for religious, educational, benevolent, fraternal,
charitable or reformatory purposes.
Exempt transactions
§ 4: Exempt transactions: these are one-time exemptions based on the type of
transaction -- the way you sell the security. So on resale, the security may need to be
registered, absent some exemption.
• § 4(1): market trading exemption: exemption for persons other than an issuer,
underwriter or dealer for ordinary trading transactions like on stock exchanges or
between investors.
• § 4(2): “private placement exemption” exempts from registration any offering
“by an issuer not involving a public offering” – of course the laws don’t define
“public offering.”
o Under SEC v. Ralston Purina, the court holds that the application of this
exemption turns on whether the particular class of persons affected
needed the protection of the Act. An offering to those who are shown to

66
 be able to fend for themselves is a transaction “not involving any public
offering.”
Reg. D:
• really 3 separate exemptions [Rules 504, 505 and 506] for private and small
offerings. The exemptions are available only to the issuer who files an
informational notice called a Form D with the SEC within 15 days of the first sale.
• Which rule you use turns on (1) the dollar amount of the offering; (2) the number
and kind of investors [NOT OFFEREES]; (3) whether the Reg. D offering is part
of some other larger offering; (4) the kind of advertising used; (5) the kind of
information provided to investors.
• Reg. D offerings have a prohibition on “general solicitation” and “general
advertising”
• Reg. D offerings have resale restrictions

Liabilities under the 1933 Act:

• Before the 1933 act, defrauded investors had to prove the elements of common
law fraud: material misrepresentation, scienter, causation, reliance and injury.
This was hard to do if the misrepresentation was an omission not an affirmative
misstatement.
• Also, causation can be hard to demonstrate – how much of the loss was from the
misstatement, and how much from other factors, such as general market
conditions?

Important Civil Liabilities:

• 1933 Act § 11 provides private rights of action for investors who bought under a
materially misleading registration statement.
• §11 creates an express right of action for securities purchasers when a
registration statement contains untrue statements of material facts or omissions
of material facts.
• So this is a remedy for someone who purchased a registered security either in
the offering or on a post offering trading market as long as they can show the
securities were part of the block sold in the offering.
1933 Act § 11:
• Possible defendants: this section imposes express liability on everyone who
prepares or signs the registration statement [§6 tells us who has to sign] --
[issuer, CEO, CFO, chief accounting officer]; all directors [even those who didn’t

67
 sign the registration statement]; underwriters, and experts like lawyers,
accountants, investment bankers who have consented to be named as experts –
their liability is limited to the information prepared or certified by them, and
certainly, most of them would prefer not to have any liability.
• § 11 liability is broader than a common law fraud action. All a purchaser
has to do to succeed on a § 11 action is to show :
o (1) that he bought the security in the offering; and
o (2) that there was a material misrepresentations in the registration
statement.
• The plaintiff does NOT have to show scienter, causation or reliance on the
misstatement.

Defenses:
• We should think of the registration statement as having two parts (the parts
prepared by certified experts, and everything else), and the potential
defendants as constituting two groups (the experts, and everyone else). The
defenses available for a misleading registration statement vary according to
those two variables.

Issuers are strictly liable unless they can show one of these affirmative defenses:
• (1) the purchaser knew of the untruth or omission when they bought the security;
OR
• (2) the untruth or omission is not material; OR
• (3) the statute of limitations has run.

For non issuers, there are 3 additional affirmative defenses [their standard is
essentially a negligence standard but they must show they were NOT negligent]:
• resign or take steps to resign and tell the issuer and the SEC in writing that
they have done so, and disclaiming all responsibility for the relevant sections of
the registration statement;
• (2) if the registration statement has already gone effective, written notice to the
SEC and reasonable public notice; and
• (3) due diligence/reasonable investigation defense -- absolves defendants
from liability if they had reasonable grounds for believing and did believe that
there was no omission or material misstatement.
o § 11(c) gives, as a test for reasonable investigation and reasonable belief,

68
 the level of care that a prudent person would exercise if his or her own
money were at stake.
o The due diligence defense is popular, but not always successful. The
court will look at the defendant’s knowledge, expertise and status
with regard to the issuer, its affiliates and underwriters, and the
degree of participation by the defendant in the actual registration
process and preparation of the materials.

The Registration Process

Doran v. Petroleum Mgmt Co.

• Petroleum Mgmt. Co. organized a limited partnership to drill for oil
• It contacted a few people, but only Doran bought an interest
• Doran agreed to assume one of the firm’s debts
• The business started losing money and eventually defaulted on the note that
Doran guaranteed
• Doran sued for rescission

Private Placement Test:

• Four factors:
o Number of offerees and relationship to issuer
o Number of units offered
o Size of the offering
o Manner of offering

Escott v. BarChris Construction Corp.

• What are convertible subordinated debentures?
o They are unsecured debt instruments that can be converted into
something else- presumably common stock. They are subordinated,
meaning they are not in a priority position- there is some other debt ahead
of them.
• Integrated Disclosure System:
o Both the 1933 and the 1934 Acts require disclosure; the 1933 Act requires
disclosure with respect to a particular transaction. Thereafter, the 1934
Act requires disclosure about a particular issuer, on a continual basis.

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Rule 10b-5

Section 10(b):
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.—
(b) To use or employ, in connection with the purchase or sale of any
security registered on a national securities exchange or any security not
so registered, any manipulative or deceptive device or contrivance
in contravention of such rules and regulations as the Commission may
prescribe as necessary or appropriate in the public interest or for the
protection of investors.

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.

Elements
• Jurisdictional nexus
o 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,
• Transactional nexus
o 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

70
 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,
o in connection with the purchase or sale of any security.
• Material misrepresentation or omission
o 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,
o in connection with the purchase or sale of any security.
• Reliance
o It is a showing of the causal connection between a defendant’s misrep and
the plaintiff’s injury.
o How can this reliance be demonstrated?
 One way is to show a breach of a duty to disclose material
information; the SC has held that the necessary nexus between
plaintiff’s injury and defendant’s wrongful conduct is established
due to the breach.
o Traditionally, courts bifurcated the reliance test.
 If the case involved an affirmative misrepresentation, courts
required the plaintiff to show that he relied on the
misrepresentation.
 If it involved a failure to disclose, they adopted a rebuttable
presumption: absent proof by the defendant to the contrary, they
presumed that the plaintiff relied.

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 o How can defendant rebut fraud on the market presumption?
• Defendant needs to sever the link between the misrep and either the
price of the stock paid to/received by plaintiff or the decision to trade at
the fair market price.
o Market not deceived
o Corrective statements
o Specific plaintiffs would have sold anyway
• Causation
o Plaintiff must show that the misstatement caused the damage. If the
corporation issued an overly optimistic press release, for example, the
plaintiff must show that the statement raised the price of the security.
o The defendant could then try to rebut the claim with evidence that the
misstatement nonetheless did not contribute to the plaintiff’s loss.
• Scienter
o Plaintiff must show that the defendant acted with an intent to deceive,
manipulate, or defraud. Reckless disregard of falsity of statement will
satisfy this requirement too.
o Negligence does not suffice, though numerous subsequent lower court
decisions cases hold that recklessness does

Basic Inc. v. Levinson

 Combustion had been negotiating a merger with Basic for 2 years
 Rumors about the deal persistently circulated, but Basic consistently denied them
o Denial 1: October 21, 1977 (stock price at $20)
o Denial 2: September 25, 1978
o Denial 3: November 6, 1978
 Merger announced December 19, 1978 – priced at $46

Materiality
 General standard of materiality?
o “whether there is a substantial likelihood that a reasonable shareholder
would consider the fact important” – TSC Indus., Inc. v. Northway Inc.
(1976)
 But how do we apply when faced with uncertain and contingent
facts?
 The SC takes “a highly fact-dependent probability/magnitude balancing

72
 approach”based on the 2nd circuit rule in SEC v. Texas Gulf Sulphur [the
materiality of speculative events will depend at any given time upon a balancing
of both the indicated probability that the event will occur and the anticipated
magnitude of the event in light of the totality of the company activity.]

Options for disgruntled shareholders

1. Statutory right of dissent and appraisal: any minority shareholder
dissatisfied with the terms of the offer can (1) reject the terms; (2) obtain an
independent judicial appraisal of the value of her shares; (3) receive that value in
cash instead of the consideration offered in the cash merger transaction.
 “market out” exception: no appraisal rights in a stock for stock merger if the
corporation’s shares are traded on a public market before and after the
merger; the disgruntled shareholders can cash out on their own, assuming
the market price is a good approximation of “fair value”
2. Injunction: before the consummation of the deal, a dissenting shareholder can
bring a lawsuit, seeking to have the transaction halted. Grounds include lack of
authority [shareholder vote], lack of compliance with statutory requirements, fraud
and/or abuse of power, violation of mandatory disclosure provisions under applicable
federal securities laws.
3. Rescission: after the deal has been consummated, a dissenting shareholder
can bring a lawsuit for rescission. The transaction must be voidable due to lack of
authority, fraud or abuse of power. Or under §12, there is a one year put back to the
seller for fraud in the sale of securities.

Short-form Merger
 No shareholder approval needed
 Board of parent corporation approves
 Copy of articles of merger filed with Secretary of State and mailed to each
shareholder of subsidiary corporation
 Parent must own at least 90% of each class of stock of the subsidiary
corporation
 Give notice within 10 days of the effective date of the merger
 Shareholders can seek statutory appraisal rights

Santa Fe Indus. v. Green

 Santa Fe Industries held 95 percent of the stock of Kirby Lumber Corp.

73
 o Santa Fe merged Kirby Lumber into itself (at $150/share) using the
Delaware short-form merger statute
 No shareholder vote required
 Shareholders can get appraisal rights
 Shareholders claim fair price = $772
 Plaintiffs claims merger violated Rule 10b-5 because:
o Merger was effected without prior notice to the minority shareholders and
was done without any legitimate business purpose
o Their shares had been unfairly undervalued
 Were plaintiffs deceived?
o No omission or misstatement in merger documentation
o Plaintiffs are not claiming that they were lied to; rather, they are claiming a
breach of duty because the transaction was unfair
o Breach of fiduciary duty without fraud not a violation of Rule 10b-5

Manipulation
What is manipulation?
 Practices that artificially affect market activity for the purpose of misleading
investors
Examples:
 Wash sales
o Manipulator enters a purchase order and a sale order at the same time
through the same stockbroker
 Ownership of the stock does not change but creates the
appearance of activity in a security
 Matched orders
o Manipulator enters a purchase order with one stockbroker and a sale
order, at the same time and at the same price, with a different broker
 Sometimes involves multiple manipulators acting together (so-
called “cross sales”)
 Matched purchase and sale transactions create the false
appearance of active trading

No “Federal Fiduciary Principle”

 What was the Congressional intent?
o Congress’ purpose for the 1934 Act was to assure full disclosure

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 o Once full and fair disclosure is made, the fairness of the transaction is a
non-issue under federal law
o Creating a federal cause of action here thus would not serve any of the
central purposes of the Act
 Implied private right of action
o Courts generally should not create an implied federal cause of action
where the matter is one traditionally relegated to state law
o Here the conduct in question was a breach of fiduciary duty, a matter
clearly the subject of state corporate law
 Federalism
o Allowing Rule 10b-5 to reach reach “transactions which constitute no more
than internal corporate mismanagement” would displace state law
o Corporations are creatures of state law
o Courts should not use Rule 10b-5 to preempt state corporate law

Deutschman v. Beneficial Corp.

o What’s a call option?
o right to buy: call option gives the owner the right, but not the obligation, to
buy a specified number of shares at a specified price
o Call: Suppose you have the right to buy stock at $25 on June 1. You
make money if the market price goes to $30, since you could then buy
under the call and immediately resell at the market price and pocket a $5
gain. If the market price is under $25 on June 1, you lose the amount you
paid for the call.
o What’s a put option?
o right to sell: put option gives the owner the right, but not the obligation, to
sell a specified number of shares at a specified price
o Put: Suppose you have the right to sell stock at $25 on June 1 and you
don’t own the stock. You have a “naked” put.
o You make money if the market price goes to $20, since you could then
buy at the market price and immediately resell under the put and pocket a
$5 gain. If the market price is above $25 on June 1, you lose the amount
you paid for the put.
o If you own the stock, the put merely protects you from a decline in the
value of the stock below $25. It is like an insurance policy.
o What is the option premium?

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 o The price paid to purchase an option
o What is the strike or exercise price?
o The price specified in the option contract at which the underlying stock can
be bought or sold
o The issuer of the option need not be the issuer or even a holder of the
stock itself

Section 5: INSIDE INFORMATION

o Insider trading is simply trading on non-public information by someone with a
duty not to trade.
o The insider can exploit his advantage whether the information is good or bad.
Two primary forms of insider trading:
o Classical insider trading: Typically, a corporate insider trades [buys or sells]
shares of his corporation, using material, non public information obtained through
his position as an insider.
o The insider exploits his informational advantage [which is a corporate
asset] at the expense of the corporation’s shareholders.
o This constitutes a deceptive device for §10(b) and triggers the disclose or
abstain rule which we will get to soon.
o The classical theory applies to traditional insiders [directors, officers, 10%
shareholders] AND to temporary fiduciaries as described in Footnote 14 to
Dirks which we will also get to soon.
o Misappropriation/outsider trading:
o Misappropriation or outsider trading prohibitions target the trading based
on non public information by someone in breach of the duty he owed to
the source of his information.
o an insider can also exploit an informational advantage by trading in other
companies’ stocks when he learns that his firm [or a related firm] will do
something that affects the value of another company’s stock, and trades
on this material non public information.
o The insider “misappropriates” the information at the expense of his firm,
through a breach of trust or confidence.
o The crux of this application centers not on a fiduciary relationship between
the insider and the purchaser or seller of security, but on the fiduciary-
turned trader's deception of the folks who entrusted him with the

76
 information in the first place.
o The fiduciary's undisclosed, self-serving use of a principal's information to
buy or sell securities, in breach of his duty of loyalty and confidentiality
owed to his principal, defrauds the principal of the exclusive use of that
information.

Securities and Exchange Commission v. Texas Gulf Sulphur Co.

o The SEC, seeking an injunction and other remedies, sued the company for
issuing a misleading press release and the officers for insider trading.
o If TGS wanted the information kept confidential, did insiders have a right to
disclose it?
o Agency Restatement § 395: Unless otherwise agreed, an agent is
subject to a duty to the principal not to use ... information confidentially
given him by the principal or acquired by him during the course of or on
account of his agency or in violation of his duties as agent, in competition
with or to the injury of the principal, on his own account or on behalf of
another ....”
o The Corporate Defendant
o Why was TGS charged with violating 10b-5? TGS was not a purchaser or
seller
o Status as such is only relevant to private party plaintiff standing to sue.
o The court looks to the dominant congressional purposes underlying the 34
Act:
o to promote free and open public securities markets, and to protect the
investing public from suffering inequities in trading, including, specifically,
inequities that follow from trading that has been stimulated by the
publication of false or misleading corporate information releases.
o What standard does the court use to determine materiality here?
o The court applies the balancing test [the indicate probability that the
event will occur and the anticipated magnitude of the event, in light of the
totality of the company activity] and find that the results were material.
o The court announced a reasonable investor standard for materiality:
information is material if a reasonable investor would consider it important.
Such an investor will consider information important if it might affect the
value of the stock.

77
Big question: what can insiders do or not do with the stock of their firm, and
when can they do it?
o First question- who are insiders? The court refers to § 16(b)- what is that all
about?
§ 16 of the 1934 Act restricts the conduct of officers, directors and 10%
shareholders. §16(b) deals with short swing profits, a concept we will come back to.
Are insiders always prohibited from investing in their own company, because of
their access to inside information?
o Of course not. The court is very clear on this: insiders duty to abstain or disclose
ONLY arises “in those situations which are essentially extraordinary in nature and
which are reasonably certain to have substantial effect on the market price of the
security if [the extraordinary situation is] disclosed.”
When can an insider trade on inside information?
Insiders must wait to trade until the information has been effectively
disseminated, until the information is effectively disclosed in a manner sufficient to
insure its availability to the investing public. Thus, those who traded before the April
16th announcement
Where an insider violated
hasRule 10b-5. nonpublic information the insider
material
must either disclose such information before trading or abstain
from trading until the information has been disclosed

o So: if a company decides not to disclose (so that, for example, it can purchase land
cheaply), insiders must not buy stock.
o Where an insider has material nonpublic information the insider must either
disclose such information before trading or abstain from trading until the
information has been disclosed

Why do we regulate insider trading?

o Information parity
o Integrity of the trading markets
o Operational concerns

Remedies for insider trading

o SEC injunctions
o Disgorgement

78
 o Civil penalties
o Criminal sanctions

Chiarella v. United States

Client
Chiarella

Pandick Press Target

Chiarella Investor
Trade

o Foreshadowing of O’Hagan
o The government1
then argued the idea of misappropriation- that he
o The SC reversed the court
had violated a duty to ofthe
appeals andby
acquiror found no 10b-5 violation
misappropriating the
since Chiarella was The
information. not an insider
court of the
declined totarget.
hear that issue, since it had not
o Since been
there submitted
was no relationship
to the jury.at They
all, letdid
alone
takea itrelationship
up later on ofin trust
O’Hagan
between
whichthewe
target’s shareholders
will get to soon. and Chiarella, the target’s
o employee,
Problems he hadthe
from no Chiarella
duty to abstain or disclose.
holding: it’s hard to police tipees who
o “Not every instance of financial unfairness
trade on inside information, since the tipee has no constitutes
independent fiduciary
fraudulent activity
duty to the corporation. under Section 10(b)”
o From
o Dirks: “onlya some
SEC response: tipee persons, under
inherits the some obligation
fiduciary circumstances,to thewill be
barred from trading
shareholders while
whenever heinreceives
possession
insideof information
material nonpublic
from an insider.
information.”
Tipping

Insider
Corporation Investor
Tip

Trade

Tippee
1

o So the world of folks who can’t freely trade on non public

information break down into:
o INSIDERS: These folks obtain material non public information
because of their role in the corporation [officer, director,
employee, controlling shareholder] 79
o They have a 10b-5 duty not to trade [abstain or disclose…]
Who is a constructive/temporary insider?
o certain professionals can become fiduciaries of the shareholders because of the
special confidential relationship, and because of their access to information.
o these folks are temporary [or constructive] insiders, and they are
prohibited temporarily from trading in the company stock where they are
temporary insiders.
o They become temp insiders when they (1) obtain material nonpublic
information from the issuer with (2) an expectation on the part of the
corporation that the outsider will keep the disclosed information
confidential and (3) the relationship at least implies such a duty

Outsiders
o Outsiders [no relationship to the corporation] under O’Hagan have an abstain or
disclose duty when they are aware of material nonpublic information that they got
from a relationship of trust or confidence.

Tippees
o Both inside and outside traders who have this confidentiality duty can be liable as
participants in illegal trading if they knowingly make improper tips.
o So tippees are liable for trading after obtaining material, non public information
that he/she knows or has reason to know came from someone who breached a
duty of confidentiality

80
Dirks v. Securities & Exchange Commission
o In general, the tippee’s liability is derivative of the tipper’s, “arising from his role
as a participant after the fact in the insider’s breach of a fiduciary duty.”
o A tippee therefore can be held liable only when:
o The tipper breached a fiduciary duty by disclosing information to the
tippee, and
o The tippee knows or has reason to know of the breach of duty
o Supreme Court rejects the SEC view that anyone who obtains information from
an insider picks up the insider’s duty
o They divided people who receive inside information into 3 categories:
o Temporary FN 14 [to Dirks] insiders: lawyers and accountants who
enter into confidential relationships with corporations and are given access
to inside information for corporate purposes.
o Tipees who receive information from an insider/tipper in breach of the
insider/tipper’s duty to refrain from profiting on undisclosed information
and who expects that the tippee will buy/sell based on that information
o non-temporary insiders, non-tippees: this group can trade freely.
o Everybody else: non tippee non temporary insiders:
o Strangers with no relationship to the source of the material non public
information have no 10b-5 duty to abstain or disclose.
o Doesn’t matter whether they overhear the material non public information
or develop it themselves.
1. Why did the court absolve Secrist of wrongdoing?
o The Court views § 10(b) as an anti-fraud provision, not as a provision designed
more broadly to ensure that all participants in the market have equal access to
information or that there is a level playing field.
o There is no fraud, says the Court, because Secrist violated no fiduciary
duty in tipping.
o He violated no fiduciary duty because he received no personal benefit.

2. What is the scope of the Court’s doctrine on breaches of fiduciary duty?

o The Court requires some personal benefit to Secrist (presumably a tangible
benefit—that is, something other than that he feels good about what he did).
o If Secrist and Dirks routinely exchanged stock tips, their exchange would
violate Rule 10b-5 since the tipper would be receiving a benefit (future
information).

81
 o If Secrist tipped Dirks out of revenge, whether S would have received a
benefit (and therefore violated a fiduciary duty) is less clear.
o If S carelessly discussed the fraud in the elevator, that would not
constitute a fiduciary duty breach under Dirks.

Rule 14e-3:
o Historical background: Chiarella and Dirks created significant gaps in
the insider trading prohibition’s coverage.
o Rule 14e-3 dealing with tender offers was the SEC’s immediate response
to Chiarella, but the rule’s scope is very limited. It is not triggered until the
offeror has taken substantial steps towards making the offer and, more
important, is limited to information relating to a tender offer.
o As a result, most types of inside information remained subject to the duty-
based analysis of Chiarella and its progeny.
o The misappropriation theory filled part of the gap, although it too is limited
in that it requires a breach of fiduciary duty before trading on inside
information becomes unlawful.
o It is not unlawful, for example, to trade on the basis of inadvertently
overheard information

United States v. O’Hagan OÕHagan

Grand Met

Issues:
o Is a person who trades in securities for personal profit using confidential
Investor
information misappropriated in breach
OÕHagan
of fiduciary duty to the source of that
information liable under Rule 10b-5 and § 10(b)?
o Also, did the SEC exceed its rulemaking authority under § 14(e) by adopting rule
1

14e3(a) which prohibits trading on inside information in a tender offer, even

absent a duty to disclose?
Holding
o The misappropriation theory is a valid basis on which to impose insider trading
liability.
o A fiduciary’s undisclosed use of information belonging to his principal, without
disclosure of such use to the principal, for personal gain constitutes fraud in
connection with the purchase or sale of a security and thus violates Rule 10b-5.

82
 o The SEC had authority to adopt Rule 14e-3 as a prophylactic measure against
insider trading in connection with a tender offer.
o So is O'Hagan an insider trader or an outside trader?
o He is an outside trader in Pillsbury. He owed no duty to Pillsbury or its
shareholders. But he did owe a duty of trust and confidence to his law
firm, and to the firm's client.
o So the court says this misappropriation is properly the subject of a §10(b)
action since it meets the statutory requirement that there be deceptive
conduct in connection with securities transactions.

Tippers can be liable EVEN IF THEY DON’T TRADE, as long as a tippee down the
line eventually trades.
o Tipees: those with no confidentially duty will INHERIT an abstain or disclose duty
IF they knowingly trade on improper tips. If tippee knows or should know the info
came from a person who breached a duty in sharing, tippee is liable for trading.
Section 16(b)Ditto for sub tippees.
“any profit
o Who realized
are we NOT by [such
talking beneficial
about? owner, director, or officer]
from any purchaseo Strangers and sale, or any sale and purchase, of any equity
with no relationship to the source of the material, non public
security of such issuer . . . within any period of less than six
months . . . shall information
inure to – they
andhave
be NO duty to disclose
recoverable or abstain
by the issuer”and can freely
Insiders trade.
o The section
o Okay, backapplies only to officers,
to misappropriation: Under directors,
O’Hagan, weor seeshareholders
that there can be no
with more than 10% of ANY class of stock.
10b-5 insider trading liability if there is no breach of trust or confidence.
o This is a smaller group of insiders than under Rule 10b-5. (which covers
any “person”)
The statute
oSection applies to officers
6: SHORT-SWING PROFITS and directors if they are officers or
directors at either he purchase or sale;
o it applies to a 10% shareholder only if he or she held more than 10% at
Sectionboth16(a)
the purchase and the sale [which we will come back to in the
“Every person who is directly
Foremost-McKesson case in or indirectly
a few minutes]. the beneficial owner of
more
o No than 10 per
tipping centum
liability, of any class of liability,
no misappropriation any equity security . .insiders
no constructive . or
who is a director
– only TRUE insideror an officer of the issuer of such security . . . within
tenCompanies
days after the close of each calendar month . . . shall file with the
Commission
o The section . . . aapplies
statement onlyindicating
to firms that his must
ownership at the
register under closetheof
the calendar month and such changes in his ownership as have
1934 Act.
occurred during such calendar month”
o This, too, is a smaller group than under Rule 10b-5 which covers public
and private companies - covers all issuers
o § 12: companies must register under the 1934 Act...
 If they have a class of stock trading on a national exchange, or
they have 500 or more shareholders and assets of at least $10
million
 Under § 12(a), all securities traded on a national exchange need
to be registered [which triggers the periodic disclosure system,
proxy regulation, insider trading, take over regulation] 83
Section 16(b) (cont’d)
Equity securities:
 The section applies only to equity securities and convertible debt.
 Again, this is narrower than under Rule 10b-5 which covers any security
as defined in the statute, including investment contracts.

Sale and purchase:

 The section applies whether the sale follows the purchase or vice versa.
 It thus does not require that the trader earn his or her gains from
buying and selling specific shares of stock. Instead, if the trader
unloads 10 shares of stock and buys back 10 different shares of stock
in the same company at a cheaper price, he or she is liable.
 Six-month period:
o The sale and purchase must be within a six-month period.
 Disgorgement:
o Any recovery goes to the company.
o Shareholders can sue derivatively, and a shareholder's lawyer
can get a contingent fee out of any recovery or settlement. So
the lawyers make their living on § 16(b) suits.

Maximize gains
 Courts interpret the statute to maximize the gains the company
recovers - the court will match the highest and the lowest trade.

Form and substance:

 Form almost always triumphs over substance in § 16(b) cases.
 § 16(b) may take the profit out of trades on inside information, though
not very effectively, but may also apply to innocent trades and thereby
will discourage executives from the desirable action of investing in the
shares of their own companies. This is the downside of § 16(b)’s
“protection.”

84
Reliance Electric Co. v. Emerson Electric Co.
 So how did Emerson get rid of the Dodge stock?
 After consulting with counsel, and as part of an integrated transaction, it sold
3.24% and then the remaining 9.96%, both within 6 months of the initial
purchase.
 6/16: buys 13.2% [becoming an insider>10%]
 8/28: sells 37,000 shares --- down to 9.96% [no longer an insider < 10%]
 9/11: sells remaining 9.96%
 What was the status of Emerson just before each transaction?
o NOT AN INSIDER on 6/16 when it buys 13.2%
o INSIDER on 8/28 when it sells 37,000 shares
o NOT AN INSIDER on 9/11 when it sells remaining 9.96%

Foremost-McKesson v. Provident Securities

 Oct 20: Provident acquires debentures convertible into > 10% of Foremost stock
 Oct 24: Provident distributes some debentures to shareholders
 Oct 28: Provident sells remaining debentures
 Issue: whether a person whose purchase of securities puts his holdings over
10% is a beneficial owner for § 12(b) at the time of such purchase [triggering §
16(b) liability on profits on the sale of these securities within 6 months].
 Easier way to state the issue: does "at the time of purchase" mean before the

85
 purchase or immediately after the purchase?
 Can we match Oct 20 acquisition with Oct 24 disposition? Is that Oct.20th a
matchable transaction?
o Note: This is issue left open in Reliance
 Statutory issue: “This subsection shall not be construed to cover any
transaction where such beneficial owner was not such both at the time of the
purchase and sale, or the sale and purchase, of the security involved”
 Holding?
o In a purchase-sale sequence, the transaction by which the shareholder
crosses the 10% threshold is not a matchable purchase
o Only purchases effected after one becomes a 10% shareholder are
matchable

Section 7: INDEMNIFICATION AND INSURANCE

Indemnification
 Saying a director is not liable for X gets you to the same place as saying that the
director is liable for X but that the corporation will indemnify the director against
X.
 Saying a director is not liable for X likewise gets you to the same place as buying
insurance against that liability.

Liability Limitation Statutes

 DGCL §102(b)(7) provides that a corporation's articles of incorporation may (but
need not) contain:
o 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:
o (i) For any breach of the director's duty of loyalty to the corporation or its
stockholders;
o (ii) for acts or omissions not in good faith or which involve intentional
misconduct or a knowing violation of law;
o (iii) under §174 of this title [relating to liability for unlawful dividends];
o or (iv) for any transaction from which the director derived an improper

86
 personal benefit
 Noteworthy Points
o Applies only to directors.
 Although officers also are subject to a duty of care, they are denied
exculpation by charter provision.
• Arnold v. Society for Savings Bancorp, Inc. (Del.): As to a
defendant who is both a director and an officer, a §102(b)(7)
provision applies only to actions taken solely in his capacity
as a director.
o Limits only the monetary liability of directors—equitable remedies are still
available
o A §102(b)(7) provision is an affirmative defense for a suit for breach of
duty

Delaware Law: Mandatory versus Permissive Indemnification

• Under §145(c), the corporation must indemnify a director or officer who "has
been successful on the merits or otherwise."
• Under §145(e), the corporation may advance expenses to the officer or director
provided the latter undertakes to repay any such amount if it turns out he is not
entitled to indemnification.

← Vi. PROBLEMS OF CONTROL

Section 1: PROXY FIGHTS

Shareholder Meetings
• Annual: at a time a place proscribed in the bylaws; the shareholders vote on
matters such as electing directors. Most corporate statutes require that a
corporation hold a shareholders meeting at least annually.
o MBCA § 7.01
• Special: outside the ordinary schedule of meetings.
o MBCA § 7.02
• voting lists: prepared by the corporation prior to each shareholders’ meeting.
• record date: cut off date for ownership determination
• notice:
o written announcement that is sent a reasonable length of time prior to the

87
 date of the meeting.
o Notice of the special meetings must include a statement of the purpose of
the meeting; business transacted is limited to the stated purpose.
• resolutions:
o corporate business matters are presented in the form of resolutions, which
shareholders vote to approve or disapprove.
 Practical reality: action without a meeting
• Typical Annual Meeting
o Nominating committee of the incumbent board of directors nominates a
slate of directors to be elected at next annual meeting
o Incumbent board identifies other issues to be put to vote
o At company expense:
 Management prepares proxy statement and card
 Management solicits shareholder votes (typically with aid of proxy
solicitor)
• Voting at annual (or special) meetings
o Most matters require a majority of shares present at a meeting at which
there is a quorum
o quorum: the minimum number of shareholders required to transact
business. This is usually satisfied by the presence, in person or by proxy,
of 50% of the outstanding shares present, either in person or by proxy.
o simple v. super majority: at times, more than a simple majority will be
required either by statute or by the corporate charter. Typical examples
include mergers and dissolution and charter amendments.
o What is cumulative voting?
 a method of voting designed to allow minority shareholders
representation on the board of directors. When cumulative voting is
permitted or required, the number of members of the board of
directors to be elected is multiplied by the total number of voting
shares.
 The result equals the number of votes a shareholder has and this
total can be cast for one or more nominees for directors. All
nominees stand for election at the same time. When cumulative
voting is not required either by statute or under the articles of
incorporation, the entire board can be elected by a majority of
shares at a shareholders’ meeting.

88
  Example: a corporation has 10,000 shares issued and outstanding.
The minority shareholders hold only 3,000 shares, and the majority
shareholders hold the other 7,000 shares. Three members of the
board are to be elected. The majority shareholders’ nominees are
Allan, Burns and Caleb. The minority shareholders’ nominees is
Davis.
 Can Davis be elected to the board by the minority shareholders?
• If cumulative voting is not allowed, the answer is no.
• If cumulative voting is allowed, the answer is yes. The
minority shareholders have 9,000 votes among them [the
number of directors to be elected times the number of
shares equals 3 times 3,000 which totals 9,000 votes].
• All of these votes can be cast to elect Davis. The majority
shareholders have 21,000 votes [3 times 7,000 = 21,000
votes], but these votes have to be distributed among their
three nominees.
 The principle of cumulative voting is that no matter how the
majority shareholders cast their votes, they will not be able to
elect all three directors if the minority shareholders cast all of
their 9,000 votes for Davis.
o Proxies: a shareholder (as principal) can appoint someone else (as
agent) to vote on his or her behalf at the shareholders’ meeting. Because
it is not usually practical for owners of only a few shares of stock to attend
shareholders meetings, such shareholders normally give third parties
written authorization to vote their shares at the meeting.
 As a practical matter, they are necessary to insure a quorum.
o Proxy voting:
 Shareholder appoints a proxy (a.k.a. proxy agent) to vote his/her
shares at the meeting
 Appointment effected by means of a proxy (a.k.a. proxy card)
• Can specify how shares to be voted or give agent discretion
• Revocable
o Proxy contests
 A shareholder (a.k.a. the insurgent) solicits votes in opposition
to the incumbent board of directors
• Electoral contests: Insurgent runs a slate of directors in

89
 opposition to slate nominated by incumbent board
• Issue contests: Shareholder solicits votes against some
proposal

Proxy fights are costly:

• you own 10% of a firm worth $8 million that you think is badly
managed. You think you can increase the value of the firm by 20%
[$1.6 million] by replacing the BOD.
• You can make a tender offer for all the shares or wage a proxy fight:
• Tender: you need $7.2 million to buy the remaining 90% of the stock
of an $8 million firm; you will then capture all the gains from the
increase in value.
• You could also just tender for another 41% and become a majority
shareholder, and get 51% of the gains from the increase in value.
• Proxy fight: if you can replace the BOD, and the value does in fact
increase by 20%, your holdings too will increase by 20%. And when
you are successful, the firm may reimburse you for your reasonable
expenses. If you are NOT successful, you pay the whole ticket.

Securities Exchange Act §14(a)

• It shall be unlawful for any person, by use of the mails or by
any means or instrumentality of interstate commerce or of
any facility of a national securities exchange or otherwise, in
contravention of such rules and regulations as the
Commission may prescribe as necessary or appropriate in the
public interest or for the protection of investors, to solicit …
any proxy … in respect of any security … registered pursuant
to Section 12 of this title

SEC Proxy Rules

• 14a-3: Incumbent directors must provide annual report before soliciting proxies
for annual meeting
• Anyone who “solicits” a proxy must provide a written proxy statement BEFORE
soliciting the proxy.

What is a Solicitation?
• “Solicit” includes not only “direct requests to furnish, revoke or withhold proxies,

90
 but also ... communications which may indirectly accomplish such a result or
constitute a step in a chain of communications designed ultimately to accomplish
such a result.”—Long Island Lighting Co. v. Barbash, 779 F.2d 793, 796 (2d
Cir.1985).
• Rule 14a-1(l)(2)(iv) exempts public statements of how the shareholder intends to
vote and its reasons for doing so
• Rule 14a-2(b)(1), subject to numerous exceptions, exempts persons who do not
seek "the power to act as proxy for a security holder" and do not furnish or solicit
"a form of revocation, abstention, consent or authorization”
o Consequently, for example, a newspaper editorial advising a vote against
incumbent managers is now definitively exempted
Proxy Statement: a document in which the solicitor discloses information that may be
relevant to the decision the shareholder must make: annual report; disclosure of conflict
of interests; issues that solicitor plans to raise at the meeting
What goes into a proxy statement?
• Information about the meeting
• Background information directly related to issues to be voted on
o Biographical information about candidates for director vacancies
o Financial data about merger partners (if any)
Other proxy statement rules
• Rule 14a-6(b) re filing with SEC: solicitors must file proxy materials with the SEC
• Rule 14a-7 re mailing: management gets a choice: mail the materials for the
solicitor, at solicitor’s cost, or provide a list of shareholders.
• Rule 14a-9 re fraud

Cost of soliciting proxies:

• Uncontested meeting: Because corporate statutes require firms to hold
meetings of shareholders, the law allows managers to charge the firm (and thus
the shareholders) for the cost of acquiring the proxies necessary to ensure a
quorum at an uncontested meeting.
• Contested meeting: Under current law, incumbent managers also may charge
the costs to the firm when an insurgent group contests their control.

25 mul choice (2 pts)

91
1 essay with four parts
first 16
second 10
third 12
fourth 12
limit of 4500 characters each.

Use agency rest. 3. Difference between 2 and 3 is 3 gets rid of

master-servant

92