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com/doc/16459948/Business-Organizations-Outline-Spring-2009
BUSINESS ASSOCIATIONS OUTLINE
Business Associations
Southwestern University School of Law – SCALE I and II
Ted Finamore
Text: Business Associations 5th Edition by Klein, Ramseyer & Bainbridge
Table of Contents
I. Overview of Business Associations.........................................................................................5
A. Are Corporate Lawyers Necessary?.......................................................................................5
B. The Transaction Cost Trade-Off.............................................................................................6
C. Structuring a Business Association........................................................................................6
D. Summary: Introduction to Business Associations..................................................................7
II. AGENCY – THE BUILDING BLOCK OF FIRMS.......................................................................8
I. Who is an Agent?.......................................................................................................................8
II. Liability of Principal to Third Parties in Contract...................................................................9
B. AUTHORITY..........................................................................................................................9
C. Apparent Authority.................................................................................................................9
D. Inherent Authority.................................................................................................................10
E. Authority Summary...............................................................................................................13
F. Ratification............................................................................................................................14
G. Estoppel...............................................................................................................................15
H. Agent’s Liability on Contract.................................................................................................16
I. Summary – Agency Relationship/Liability of Principal in Contracts.......................................16
III. Liability of Principal to Third Parties in Tort........................................................................17
J. What is the Justification for Imposing Liability?.....................................................................17
K. Servant Versus Independent Contractor..............................................................................18
L. Tort Liability and Apparent Agency.......................................................................................19
M. Scope of Employment..........................................................................................................20
N. Statutory Claims...................................................................................................................22
O. Liability for Torts of Independent Contractors......................................................................22
IV. FIDUCIARY OBLIGATIONS OF AGENTS.............................................................................23
P. Duties During Agency...........................................................................................................23
Q. Duties During and After Termination of Agency: Herein of “Grabbing and Leaving”Agency
.....................................................................................................................................24
R. Recap of Agents’ Fiduciary Duties: Miracle on 34th Street.................................................24
S. Summary - Liability of Principal in Torts/Fiduciary Duties of Agents.....................................25
III. PARTNERSHIPS.....................................................................................................................26
A. What is a Partnership? And Who Are the Partners?...........................................................26
B. Partners Compared With Employees...................................................................................30
C. Partners Compared With Lenders........................................................................................32
D. PARTNERSHIP BY ESTOPPEL..........................................................................................34
IV. II. The Fiduciary Obligations of Partners............................................................................34
A. Introduction..........................................................................................................................34
B. After Dissolution...................................................................................................................36
C. Grabbing and Leaving..........................................................................................................36
D. Expulsion.............................................................................................................................37
D. Change in Control................................................................................................................87
E. Capital Structure Terminology..............................................................................................89
F. Special Types of Securities: Preferred Shares.....................................................................89
G. Special Types of Securities: Convertible Bonds..................................................................90
H. Special Types of Securities: Warrants.................................................................................91
XIII. Introduction to the Corporation: Overview of Issues.......................................................92
A. Forming the Corporation......................................................................................................92
B. Independent Legal Personality.............................................................................................92
C. Separation of Ownership and Control..................................................................................92
D. One last BA type: The Limited Liability Company 1/12/2005...............................................92
E. Hierarchy of Legal Sources .................................................................................................92
F. Governance of the Corporation: Separation of Ownership & Control..................................93
G. Corporate Powers ...............................................................................................................93
H. Corporate Purpose ..............................................................................................................93
I. Stakeholders in the Corporation ...........................................................................................94
J. Centralized Management and the Business Judgment Rule................................................94
XIV. Comparing Partnerships and Corporations: Development of the LLC.........................97
B. Piercing the LLC Veil ...........................................................................................................99
C. LLC Dissolution..................................................................................................................100
D. Duty of Care.......................................................................................................................101
E. Knipprath Fiduciary Duty Summary Review ......................................................................112
F. Duty of Loyalty....................................................................................................................112
G. Corporate Opportunity.......................................................................................................114
H. Ratification.........................................................................................................................116
I. Rule 10b-5 of Exchange Act 1934.....................................................................................117
J. Duty of Care........................................................................................................................119
K. Duty of Loyalty...................................................................................................................122
L. Dominant Shareholders and Parent-Subsidiary Dealings...................................................124
M. Intermediate Standard in Takeover context.......................................................................127
N. Prüfungsaufbau..................................................................................................................128
XV. DISCLOSURE AND FAIRNESS: FEDERAL SECURITIES REGULATION........................128
A. Definition of a Security.......................................................................................................128
B. Registration process...........................................................................................................130
C. Liability under 1933 Act......................................................................................................132
D. Rule 10b-5 of Exchange Act 1934......................................................................................134
E. Insider Trading...................................................................................................................141
F. Short-Swing Profits.............................................................................................................146
XVI. INDEMNIFICATION AND INSURANCE ............................................................................148
XVII. §7. The Question of Corporate Control.........................................................................153
A. PROXY FIGHTS.................................................................................................................153
B. Strategic Use of Proxies.....................................................................................................154
C. Private Actions for Proxy-Rule Violations...........................................................................155
D. Shareholder Proposals.......................................................................................................155
E. Shareholder Inspection Rights Cases................................................................................157
XVIII. PROBLEMS OF CONTROL.............................................................................................158
A. Shareholders Voting Control..............................................................................................158
B. Controlling Shareholders/Transfer of Control.....................................................................158
C. General authorization of transfer of control, except fraud, bad faith or looting:..................159
D. Limitation on transfers of control involving sacrifice of some of the corporation’s assets...160
E. Limitation On Transfers Of Control Made Without Any Compelling Business Purpose At The
Expense Of The Minority...........................................................................................161
F. Illegal Sale of Office without Sale of Control.......................................................................161
G. Control Problems in Close Corporations...........................................................................162
H. Ex Ante Solutions: Contractual Provisions/Agreements....................................................163
I. Long-Term Shareholder Tenure and Salary Agreements....................................................164
J. Comprehensive Shareholder Agreements..........................................................................165
K. Ex Post Solutions: Heightened Fiduciary Duties among Shareholders..............................167
L. Wilkes Doctrine...................................................................................................................168
M. ABUSE OF CONTROL IN CLOSELY HELD CORPORATIONS.......................................170
N. Squeeze-out Merger..........................................................................................................170
O. Control of the corporation..................................................................................................170
XIX. COUNTERMEASURES – CONTROL, DURATION & STATUTORY DISSOLUTION........172
A. Constructive Dividends as an Equitable Remedy...............................................................172
B. Statutory Dissolution..........................................................................................................172
XX. MERGERS AND ACQUISITIONS........................................................................................174
A. Mergers 1/26/2005............................................................................................................174
B. Sale of Assets....................................................................................................................175
C. Tender Offer/Takeover.......................................................................................................177
D. Appraisal Remedy..............................................................................................................177
E. Defacto Merger..................................................................................................................177
F. Defacto Non-Merger?.........................................................................................................178
G. Freezouts...........................................................................................................................178
H. Weinberger Analysis Method For Freeze Out Mergers......................................................181
XXI. Organic Changes in Corporations...................................................................................182
A. Mergers..............................................................................................................................182
B. Asset Sales & Liquidations.................................................................................................183
B. Freeze Out Mergers: Bus. Justification Coggins v. New England Patriots.........................189
C. Law in Delaware................................................................................................................189
D. Parent-Subsidiary Merger (Short Form).............................................................................192
C. Recapitalizations................................................................................................................193
XXII. Policy Issues....................................................................................................................194
A. Liability Issues/Remedies...................................................................................................195
XXIII. Takeovers/Tender Offers 1/24/2005..............................................................................195
A. Policy Issues......................................................................................................................195
B. Bidder Tactics....................................................................................................................196
C. Target Tactics....................................................................................................................198
D. Liability Issues....................................................................................................................199
E. Federal and State Regulation of Takeovers.......................................................................213
F. Preemption Review............................................................................................................214
G. Dormant Commerce Clause Review..................................................................................215
XXIV. CORPORATE DEBT........................................................................................................219
XXV. New Class: Business Transactions...............................................................................221
A. Forms of Business Entities:................................................................................................221
B. Comparing Partnerships and Corporations (Knipprath Analysis).......................................224
XXVI. Federal Securities Law...................................................................................................225
A. Financial Markets Do 3 Things...........................................................................................225
B. Different Markets................................................................................................................225
C. Equity Markets...................................................................................................................227
D. Regulatory Framework.......................................................................................................229
E. Distribution of Securities.....................................................................................................230
F. Public Offerings vs. Private Offerings.................................................................................232
XXVII. DISCLOSURE AND FAIRNESS: FEDERAL SECURITIES REGULATION...................234
A. Definition of a Security.......................................................................................................234
B. § 17 Anti Fraud Provision...................................................................................................244
XXVIII. III. Liability under 1933 Act...........................................................................................245
A. 1. Section 11......................................................................................................................245
B. 2. Section 12(a)(1) .............................................................................................................246
C. 3. Section 12(a)(2).............................................................................................................246
3. Capital
• Comparing investments – Rate of Return calculations
• Comparing Debt and Equity Capital
• Divergence of interests among capital contributors: Creditors want conservative
management of the firm; equity owners prefer to take more risks.
3. Agent Test
1) Manifestation by the principal that the agent will act for him;
2) Acceptance by the agent of the undertaking
3) Understanding between the parties that the principal will be in control of the undertaking
Gorton v. Doty (p.1) – Mom, a teacher, lends car to High School football coach. Coach is
driving to game w/ student, has accident, is killed. Student in car sues Mom, claiming coach was
agent of Mom. Analyze this agency case.
Parties
Agent Coach
Principal Mom / Teacher /Car Owner
Third Party (3P) Injured Party / Π
Insurance only defends you up to the limits of your policy. And you are not covered for crimes
and torts.
Consent – she consented to use of the car.
Control – she conditioned use of her car on the coach driving.
The Court makes a point of her failure to tell the coach that she was “loaning” the car. Perhaps if
there had been a formalization of a borrowing, then perhaps she would have been excused.
Form vs. Substance – is this a form or a substance case? I think it’s a form case because
substantively I don’t think the mom and coach had a principal / agent relationship.
Case law in Idaho presumes that a driver is agent of the owner unless rebutted.
Mrs. Doty should have had a rental agreement w/ the coach which placed no conditions upon his
use of the car and control is his and disclaiming liability and requiring him to represent that he had
his own insurance and that he will indemnify her if there is an accident.
C. Apparent Authority
Apparent authority is the power to affect the legal relations of another person by
transactions with third persons, professedly as agent for the other, arising from and in
accordance with the other's manifestations to such third persons.
To determine whether apparent authority exists we look at the principal's manifestation of consent
from the point of view of the third party, as made clear in § 27 of the Restatement:
Read sections 8 and 27 together: To create apparent authority a principal must write, say, or do
something that the third person could reasonably interpret as giving the (apparent) agent
authority to act on the principal's behalf. Apparent authority might exist even when there is no
agency relationship between the principal and the person who appears to be an agent of the
principal.
D. Inherent Authority
transaction was not actually or apparently authorized and there is no tort, contract, or restitutional
theory upon which the liability can be grounded.
Issue 2: Did Humble have authority to purchase cigars and Bovril from Fenwick?
Actual Express Authority? No.
Actual Implied Authority? No. It was specifically prohibited.
Apparent Authority? No. Fenwick did not even know of Watteau’s connection to Humble at the
time of the transaction.
Inherent Authority? Apparently, yes.
Fenwick thought he was dealing with Humble, and gave him credit without checking his financial
situation and asking for guarantees of payment. Now, seemingly in a windfall, he gets Watteau
as a ‘guarantor’. Justifications for this rule?
in such businesses and on the principal’s account, although contrary to the directions of the
principal.”
FACTS: Kidd signed recital tour. Edison’s agent not authorized to contractually bind Kidd for
regular non-Tone-test recitals. Kidd assumed that he was so authorized and detrimentally relied
on that assumption.
Hand’s characterization liability for acts of agents arises from status and not authority.
HELD: This is not an apparent authority argument. There has been no communication between
the principal and the 3rd party. No statement of “Fuller’s our man; deal with him.”
Instead this case deals with inherent authority. If the corporation puts someone out there as
its agent, the corporation bears a risk as principal that It has clothed its representatives
with a certain status so that it becomes liable for the actions its representatives takes that
would seem to be within that authority. This is how it was always done in that business. So,
Edison had to compensate Kidd for failing to give her the tour she expected. Merely putting an
agent out in the field is indirect communication to a 3rd party, thereby distinguishing it from
apparent authority’s direct communication between principal and the third party. If P has
reasonable grounds that is sufficient for agent to bind principal (customary in business, incidental
to transaction)
Kidd could have called the company and checked out Fuller’s status. Find out who had
authorization from the Board of Directors. Edison could have printed form agreements in
advance stating the limitations of the agreement.
What if PR knows agent is flaky & may bind co in undesirable way? Form K & tie bonus to use of
K or consider if risk of hiring ee is worth it thereby recognizing that PR responsible for agents
actions
Edison hired Fuller to engage singers for promotions of its phonograph records. Maxwell, an
Edison’s employee, told Fuller that Edison would act as a booking agent and guarantee payment
of the dealers who will agree to hire the singers for recitals, as well as cover the singers’ travel
expenses. Maxwell was also told to contract with the singers himself, and not bring them to
Maxwell. Fuller engaged Kidd, but Kidd proved that Fuller offered her a singing tour.
The usual custom in the industry was to promise a full singing tour (as Kidd claimed Fuller
promised her).
NSC loses for procedural reasons. But this case is useful to understand subtleties between
apparent and inherent authority. What sort of evidence would support apparent authority?
Inherent Authority? Terpenning could have asked for a signature from a higher-up at ARCO.
What Sort Of Evidence Would Support Apparent Authority? Inherent Authority?
Apparent Authority
Statements from Tucker’s superiors stating that Tucker is the person with whom to make the
deal; Evidence of other people who dealt with Tucker in similar deals and knew or believed he
had authority.
Inherent Authority
Prove it is an industry custom that agents such as Tucker have the authority to grant modest
price discounts (such as the one NSC got).
Why did NSC appeal the case just to contend the failure to instruct the jury on inherent authority?
To keep their options open.
What do you need to show with inherent agency? Because inherent agency allows you to cast a
broader net and look at industry standard. You are no longer limited to what the principal did or
represented in that same deal. You can now look at other service stations in the same area and
see what kind of discount that they got. Π wants to show that persons in Tucker’s position
normally have authority to give such discounts. You want to look for statements by ARCO that
Tucker was their “go to” guy for these affairs.
E. Authority Summary
Actual authority -- the agent reasonably interpreted manifestations of consent form the principal
that the act was authorized;
3. Inherent Authority
1) Restatement, §8A: “Inherent agency power is a term used… to indicate the power of an agent
which is derived not from authority, apparent authority or estoppel, but solely from the agency
relation and exists for the protection of persons harmed by or dealing with a servant or other
agent.
2) Inherent authority requires an agency relationship, but doesn’t look to the principal at all as a
source for authority.
F. Ratification
1. § 82Ratification Defined
Restatement §82: The affirmance by a person of a prior act which did not bind him but which
was done or proffessedly done on his account. Ratification requires acceptance of the results of
the act with an intent to ratify, and with full knowledge of all the material circumstances.
2. Ratification Test
1) Was the act done on the party’s behalf?
2) Did the party accept the act or the benefits of the act?
3) Did the party have full knowledge of all the material circumstances?
3. Ratification Questions
What types of acts constitute an affirmation by the principal?;
What affect should we give to that affirmation?
1. Ratification requires acceptance of the results of the act with an intent to ratify, and with full
knowledge of the material circumstances.
2. Examples Of Affirmance:
a. Express Affirmance;
b. Implied Affirmance By:
i. acceptance of benefits of the transaction at a time in which it is possible to
decline the benefits; also,
ii. no implied affirmance if principal has reasonable claim to the benefits other
than due to the transaction;
iii. Implied affirmance through silence or inaction;
iv. Implied affirmance through bringing a lawsuit to enforce the contract.
ownership. After lease, ∆ refused to transfer title due to wife’s refusal. Trial court ruled that
husband was agent of wife and that wife ratified. Appellate court reversed because the wife
manifested no intent to have the husband act on her behalf nor did she manifest any intent to
ratify.
G. Estoppel
1. §8B Estoppel Defined:
1) A person who is not otherwise liable as a party to a transaction purported to be done on his
account is nevertheless subject to liability to persons who have changed their positions
because of their belief that the transaction was entered into by or for him, if:
a. he intentionally or carelessly caused such belief, or
b. knowing of such belief and that others might change their positions because of it, he
did not take reasonable steps to notify them of the facts.
2) An owner of property who represents to third persons that another is the owner of the
property or who permits the other so to represent, or who realizes that third persons believe
that another is the owner of the property, and that he could easily inform the third persons of
the facts, is subject to the loss of the property if the other disposes of it to third persons who,
in ignorance of the facts, purchase the property or otherwise change their position with
reference to it.
3) Change of position… indicates payment of money, expenditure of labor, suffering a loss or
subjection to legal liability.”
1. Justifications
1) Make injured party whole
2) Deep Pockets – Principal may be more solvent than agent
3) Risk Spreading – Even if the principal is not more solvent than the agent, two pockets are
bigger than one.
4) Mitigate likelihood of future injuries by creating incentives for an efficient level of care
5) Control – Insolvent agents are out of tort law’s reach and are thus undeterred; but if P is
able to control A, he could force A to be careful (affects A’s level of care);
6) Interest in or familiarity with A – P is likely better able to prevent A’s torts, or recoup for
A’s negligence, than the injured party (affects P’s level of care);
7) Appearances – Liability if principal creates appearance of responsibility (affects injured
party’s level of care).
Barone made no written reports to Sunoco, and assumed overall risk of loss. He determined
the hours of operation (and was held o be liable, where in Humble Schneider did not control
hours of operation and Humble was responsible), pay scale and working conditions, and it was
his name listed as the proprietor.
HELD: Barone is an independent contractor, because Sunoco had no control over the details
of the day to day operation.
CARNEY: A strong point can be made for Sunoco’s control. Sunoco does not explicitly reserve
the right to tell Barone what to do, but they can still “strongly” suggest things, and Barone will
jump.
The contract (independent contractor) is intentionally written so that language is at odds with the
relationship (master-servant) which the company wants.
third party that the alleged agent is authorized to bind the principal create an apparent
agency…franchisee is the agent of the franchisor.
FACTS: The banquet direct of Brandywine Hilton Inn wrongfully attempted to extort funds in
addition to those previously paid by Plaintiffs for the use of one of the Inn’s ballrooms (by
inadequately heating the ballroom…).
ISSUE: Did a principal/ agency relationship existed between The Brandywine Hilton Inn and the
Hilton Corporation?
HELD: Because of ample evidence of authority, franchisee was the agent of the franchisor.
This evidence for actual authority is: a corporate manual, regulating advertisement, office and
cleaning staff procedures, financial records, inspection of hotel by franchisor. More substantial
evidence for apparent authority includes, the Hilton logo and sign displayed exclusively, and more
importantly, the reliance of the plaintiffs for the quality of the Hilton name. There can not be
apparent authority to commit a tort. This is not, in the realm of tort, a principal-agent relationship,
but a master-servant relationship. Therefore it is important to determine how much physical
control Hilton Inc. had over Brandywine Hilton.
If Hilton wanted to disassociate themselved from the Brandywine they could have taken steps to
vertify a certain level of quality, but retain indivudally owned franchises through such steps as not
requiring uniform appearance (like Great Western).
*Similar to oil corp case which depends on control of day to day operations
Class Notes 1/16/04
Issue is control. Control was used in Holiday Inn case to discuss the nature of the relationship.
Similar to Cargill. So, nothwithstanding the way you’ve structured your documents, you are
liable. That was in Holiday Inn and Cargill. But, in this case, the form of the relationship seems
more important to the court. The Court is worried about how customers viewed the agent
relationship and concludes that most customers thought they were at a Hilton hotel and that
Hilton was in charge. So, the question was, what did Hilton do to manifest its relationship as
master over Magness.. These are different questions from the past two cases which focused on
whether there was enough day-to-day control. Here, it’s all about what the public perceives and
whether Hilton actively fostered the public perception. Apparent authority is the key issue.
M. Scope of Employment
1. General Rule
1) Restatement §228(1): A’s conduct is within the scope of employment if:
a. It is of the kind A is employed to perform;
b. It occurs substantially within the authorized time and space limits (if not - it is a
“frolic and detour”);
c. It is actuated, at least in part, by a purpose to serve P;
d. If force is intentionally used by A against another, the use of force is not
unexpectable by P.
2) Restatement §229(1): “To be within the scope of the employment, conduct must be of the
same general nature as that authorized, or incidental to the conduct authorized.”
3) An act may be within the scope of employment even if it is:
a. Forbidden or done in a forbidden manner (Restatement §230);
b. Consciously criminal or tortious (Restatement §231).
2.
3. Ira S. Bushey & Sons, Inc. v. United States p. 61 (Whoops, I Sank The Tamaroa)
PURPOSE OF SERVING THE PRINCIPAL TEST for agency (p. 63): An employer may be
held liable for an employee’s actions if the actions were taken in a motivated by serving
the company interests.
FORSEEABILITY TEST for agency (p. 64): A subset of respondeat superior. If an
employee acts in a foreseeable manner for which the employer could have taken
reasonable preventive measures but failed to do so, the employer is liable for the
employee’s actions.
p. 61. Drunken sailor returning from leave turns valves, floods drydock, sinks ship in drydock,
causing major damage. Π sues, alleging sailor was agent of United States Coast Guard and
therefore principal is liable for his actions. Court says no, because it was not conceivably in the
scope of the sailor’s duties. They also said “no” to the motivation test. But, the court said that the
Coast Guard was still liable because it is reasonably foreseeable that a drunken sailor would
come back and mess with the valves.
Class update 1/16/04
The forseability is not tortious, like as in negligence. More like in workers’ compensation. Not like
burning a bar in town which is not something in the scope of a sailor’s employment that the Navy
could protect against. But, the sailor had to walk past the valves to get back to the ship. So
he was in the scope of his employmen to walk past the valves and therefore it’s pretty easy
to forsee that some drunk sailors would walk by those valves.
7. §219(2): Liability of Principal for Servant’s Actions When Not Within Scope of
Employment
A master is not subject to liability for the torts of his servants acting outside the scope of their
employment, unless:
1) The master intended the conduct or the consequences; or
2) The master was negligent or reckless; or
3) The conduct violated a non-delegable duty of the master; or
4) The servant purported to act or to speak on behalf of the principal and there was reliance
upon apparent authority, or he was aided in accomplishing the tort by the existence of the
agency relation.
N. Statutory Claims
1. Arguello v. Conoco p. 69 (Racist Comments by Store Clerks)
Employee acts taken in response to customer conduct interfereing with the employee’s
performance of his work are acts for which the employer is liable.
Two types of allegations of racial discrimination against Conoco:
1) Smith, a cashier at a Conoco-owned store, refused to recognize customers’ ID, and
in argument uttered racial slurs and obscenities at one group of the plaintiffs.
a. Conoco’s defense: employee animated by personal prejudices and therefore
acting outside scope of employment.
b. Court rejects non-delegable duty argument [see Rest. §219(2)(c)], but finds
summary judgment dismissal inappropriate. Duty not to discriminate is non-
delegable so that Conoco cannot be liable for franchisee’s failing to control
discrimination.
c. Π also argued that by not firing the employees who made the racist comments,
that Conoco had ratified the conduct. But, the employees were counseled so the
ratification argument did not work; the court said no on that theory.
d. Compare to the intentional torts line of cases (Manning/Lyon/Haddon).
2) Employees at Conoco-branded (but not owned) stores refused to serve minority
customers and insulted them.
a. Conoco’s defense: No agency relationship with Conoco-branded stores.
b. Court agrees. Affirms grant of summary judgment.
c. Compare analysis to Humble Oil/Sun Oil.
unmolested. Court made a big point of the difference between agency service which merely
provides an opportunity for money which is OK. Example: being stationed in Cairo might give
the Sgt. a chance to trade in Egyptian art and make money doing so. That would be OK. But
service as shown by the uniform was the only reason that the Sgt. got the deal.
III. PARTNERSHIPS
A. What is a Partnership? And Who Are the Partners?
1. Partnership Defined
RUPA § 101(6): “Partnership” means an association of two or more persons to carry on as co-
owners a business for profit formed under § 202, predecessor law, or comparable law of another
jurisdiction.
2. Formation of Partnership
RUPA § 202:
(a) Except as otherwise provided in subsection (b), the association of two or more persons to
carry on as co-owners a business for profit forms a partnership, whether or not the persons intend
to form a partnership.
(b) An association formed under a statute other than this [Act], a predecessor statute, or a
comparable statute of another jurisdiction is not a partnership under this [Act].
(1) Joint tenancy, tenancy in common, tenancy by the entireties, joint property, common
property, or part ownership does not by itself establish a partnership, even if the co-owners share
profits made by the use of the property.
(2) The sharing of gross returns does not by itself establish a partnership, even if the
persons sharing them have a joint or common right or interest in property from which the returns
are derived.
(iii) of rent;
(v) of interest or other charge on a loan, even if the amount of payment varies
with the profits of the business, including a direct or indirect present or future ownership of the
collateral, or rights to income, proceeds, or increase in value derived from the collateral; or
(vi) for the sale of the goodwill of a business or other property by installments or
otherwise.
4. Person Defined
RUPA § 101: "Person" means an individual, corporation, business trust, estate, trust, partnership,
association, joint venture, government, governmental subdivision, agency, or instrumentality, or
any other legal or commercial entity.
UPA § 2: "Person" includes individuals, partnerships, corporations, and other associations.
(a) Jointly and severally for everything chargeable to the partnership under sections 13 and 14.
(b) Jointly for all other debts and obligations of the partnership; but any partner may enter into a
separate obligation to perform a partnership contract.
The rights and duties of the partners in relation to the partnership shall be determined, subject to
any agreement between them, by the following rules:
1) Each partner shall be repaid his contributions, whether by way of capital or advances to the
partnership property and share equally in the profits and surplus remaining after all liabilities,
including those to partners, are satisfied; and must contribute towards the losses, whether of
capital or otherwise, sustained by the partnership according to his share in the profits.
2) The partnership must indemnify every partner in respect of payments made and personal
liabilities reasonably incurred by him in the ordinary and proper conduct of its business, or for
the preservation of its business or property.
3) A partner, who in aid of the partnership makes any payment or advance beyond the amount
of capital which he agreed to contribute, shall be paid interest from the date of the payment or
advance.
4) A partner shall receive interest on the capital contributed by him only from the date when
repayment should be made.
5) All partners have equal rights in the management and conduct of the partnership business.
6) No partner is entitled to remuneration for acting in the partnership business, except that a
surviving partner is entitled to reasonable compensation for his services in winding up the
partnership affairs.
7) No person can become a member of a partnership without the consent of all the partners.
8) Any difference arising as to ordinary matters connected with the partnership business may be
decided by a majority of the partners; but no act in contravention of any agreement between
the partners may be done rightfully without the consent of all the partners.
• There is no definitive test which courts apply to determine whether a PARTNERSHIP exists.
Courts look to all the attendant facts and circumstances.
• See Wood v. Phillips, 2001 WL 1637293 (Ala. 2001) (no settled test for determining the
existence of a partnership; determination is made by reviewing all the attendant
circumstances, including the right to manage and control the business).
• When examining the facts and circumstances, courts look at the following elements:
Example 1
X, a third party, entered into a contract with a business (run by ANT). X would like to collect the
money owing under the contract, unfortunately, the business is not paying, and ANT has no
money. X knows that BUG (who has money) has a business relationship with ANT. Can X
recover the money from BUG?
X will allege that the business relationship between ANT and BUG is a PARTNERSHIP If ANT
and BUG are PARTNERS, BUG is personally liable for the debts of the PARTNERSHIP .
BUG may claim that the business relationship she has with ANT is not a PARTNERSHIP, rather
that ANT runs a SOLE PROPRIETORSHIP, and the relationship with BUG is that of:
There is a PARTNERSHIP, BUG is liable for the debt even though it was an
INADVERTENT PARTNERSHIP.
ANT and BUG had a DEBTOR - CREDITOR relationship, BUG (creditor) is not liable for
ANT's debt (debtor).
ANT and BUG had a FRANCHISEE - FRANCHISOR relationship. BUG (franchisor) is not
generally liable for the debts of ANT (the independent franchisee).
ANT and BUG and a LESSEE - LESSOR relationship, BUG (lessor) is not liable for ANT's
debt (lessee).
Example 2
2. CAT, wanting a bigger share of the profits, may claim she is a PARTNER and is therefore
entitled to share profits with DOG.
b. he is a SOLE PROPRIETORSHIP that borrowed money from CAT with a fixed rate of
return establishing a DEBTOR - CREDITOR relationship.
a. a PARTNERSHIP, absent an express agreement otherwise, CAT and DOG share profits
equally.
b. a DEBTOR - CREDITOR relationship, CAT is not entitled to more than the fixed rate of
return agreed upon in the debt contract.
c. a FRANCHISEE - FRANCHISOR relationship, CAT is not entitled to more than the fixed
license fee agreed upon in the franchise contract.
5) He put up all the capital, she did not own any assets.
6) When it dissolved it was the same as if she just quit, b/c the business continued to
function.
7) Risk -Fenwick ; Return - F 80%/20%; control- Fen; Duration - @ will
Class
Fenwick did the deal this was b/c Cheshire would have been his 8th employee and therefore he
would have been required to pay unemployment tax. The UCC did not care what Fenwick’s
intentions were. They just wanted a ruling on the employment status of Cheshire.
The best solution for Fenwick is to set up a partnership agreement and tie management voting to
the amount of capital contributed. Her salary would be her contribution. So now it’s an 80-20
partnership. Voting share percentage can be changed by vote under the rules back then.
Who disputed the existence of a partnership? Why?
• Unemployment Compensation Commission claimed Chesire was an employee, not a
partner, bringing the number of employees in the beauty shop past the threshold above
which the business must pay the unemployment comp fund.
What does Fenwick claim? What’s his best argument?
• Fenwick claims Chesire is a partner, based on UPA §7(4)
• UPA §7(4): The receipt by a person of a share of the profits of a business is prima facie
evidence that he is a partner in the business…”
• “…but no such inference shall be drawn if such profits were received in payment: …(b)
As wages of an employee…”
What’s the Commission’s argument? Why?
Commission argues that Chesire is an employee, not a partner. She is not a partner because,
despite shared profits, there is no shared control. Court agrees, based on the following criteria:
(a) Intention of parties: No change in business’ operation;
(b) Right to share in profits: Chesire gets 20% ;
(c) Obligation to share in losses: Chesire not obligated;
(d) Ownership and control of property and business: Fenwick retains;
(e) Community of power in administration: Chesire not involved;
(f) Language in agreement: Language excluded Chesire from control rights;
(g) Conduct of the parties toward third parties: Didn’t hold themselves out as partners;
(h) Rights of parties on dissolution: Chesire’s dissolving the agreement similar to quitting a
job.
An Exercise in Constructing Transactions [1]
A key reason for the court’s ruling was that ‘partnership agreement’ gave Chesire no
management rights. How would you structure an agreement that would give her formal
management rights but still allow Fenwick to ‘run the show’?
(a) “The partners shall confer on all business decisions and, in the event of disagreement, shall
vote.”
(b) Elsewhere in the agreement, state that “the number of votes each partner shall have will
equal the percentage of the partner’s share of the profits.”
(c) Another option: Make Fenwick the managing partner or general manager, while Chesire
manages receptionist activities.
An Exercise in Constructing Transactions [2]
The court considered the fact that Chesire did not share in the losses. How could you mitigate
this factor without increasing Chesire’s risk?
(a) Losses will be shared in proportion to each partner’s share of the profits.
(b) Losses will be charges against the partners’ capital accounts.
(c) In the event of dissolution of the partnership, all liabilities beyond the assets of the
partnership will be borne by Fenwick alone, and he will not have a right to recover any sum
from Chesire by virtue of her membership in the partnership or by virtue of any negative
amount in her capital account.
An Exercise in Constructing Transactions [3]
Suppose Fenwick decides to hire Chesire as an independent contractor instead of making her
partner or employee. What’s the key issue you need to address? How would you draft an
agreement to reach this result without changing the substance of the relationship)?
(a) The key issue is that F will have no control over the physical conduct of C’s job; otherwise
she will be a servant.
(b) C is hired to provide receptionist services. She will have the right to supply a person other
than herself, and the contract would describe generally her tasks, but would state that the
manner in which the tasks are performed will be determined by her, not by F. However, the
contract could be terminated within a short notice. This will likely allow F significant influence.
• Hall let his friends at PPF down. Despite the terms of the agreement, he speculated in
foreign currency, lost large amounts of money, and KNK became insolvent.
• KNK’s creditors claim that PPF are partners in KNK (they share profits and the terms of
the agreement may amount to shared control).
• How does this case compare with Cargill?
• The court decides they were not partners, but it’s a close call. How much did PPF think
they were risking in this venture?
• $2.5 million.
• How much were they actually risking?
2. Southex Exhibitions v. Rhode Island Builders Assn. p. 102 (Trade Show Promoter
Case)
Partnership Existence: Totality of Circumstances Test.
Π asserts partnership based on 1974 Agreement
Factors FOR Partnership
1) 55% - 45% profit sharing
2) mutual control over operations such as:
a. show dates
b. admission proces
c. choice of exhibitors
d. partnershp bank accounts
3) Respective contributions of valuable property to the partnership by the partners
4) Partners are designates as such in the agreement
5) Sharing profits (prima facie evidence)
Factors AGAINST Partnership
1) No partnership tax returns
2) Sherman (manager of SEM) referred to himself as producer – not partner
3) Title is just “agreement”
4) No partnership name
5) No jointly owned property
6) Only made reference to “partner” once in contract
7) Agreement for term
8) Management control to SEM mostly
9) No losses for RIBA
D. PARTNERSHIP BY ESTOPPEL
1. Young v. Jones p. 107 (PWC Audit Letter)
Partnership by Estoppel: Detrimental Reliance Test.
Π lost $550k when bank failed; sued PWC claiming that he only put money in bank b/c of PWC –
Bahamas clean audit opinion. PWC is an organization of shareholder corporations with a parent
company in Bermuda. Π alleged PWC-USA and PWC-Bahamas were partners in fact and
therefore responsbile for debts of the partnership. No paper trail to prove actual partnership; so Π
also alleged Partnership by estoppel by virtue of :
1. PWC promotes its image as a worldwide organization;
2. Common knowledge that PWC operates as a partnership;
3. Firm brochure asserts PWC is a “worldwide” organization;
4. Cross v. PWC – 1980 case found PWC-US liable for Bahamas
But the argument didn’t work because:
1. Cross decision was later vacated;
2. Π admitted that PWC brochures and assertions were not relied upon in making the
investment.
Rationale: There was no evidence that Plaintiff’s relied on any act or statement by any PW-US
partner which indicated the existence of a partnership with the Bahamian partnership. There was
no evidence, nor was there a single allegation that any member of the U.S. partnership had
anything to do with the audit letter complained of by Plaintiffs, or any other act related to
investment transaction.
Class:
Did PWC do anything that would lead someone to reasonably believe that PWC-US authorized
PWC-Bahamas? If so, then a good argument for apparent authority. Could have argued this
theory as well as the partnership theory. Would have been much easier to prove; web site,
brochures, etc.
b. Had he have done so, he may or may not been able to pursue it on your own.
4) Dissent: Distinguished the relationship as being within a single deal and thus a joint
venture. Therefore the business transaction in this case was not properly in the scope of
that relationship and the fiduciary obligations did not accrue.
5) Causation Issue
a. Reliance: How can Partner show he was injured by MP’s failure to disclose when
he looked into extending the business
i. Partner did not act on his own because he was properly relying on MP to
take care of such matters.
b. Loss Causation
i. MP argument that partner should have to demonstrate that he could do
the deal if it was presented to him is rejected.
ii. After the fact arguments in regard to lack of opportunity to do a deal it
was presented are not accepted to exculpate initial denial of an
opportunity.
iii. “If you knew nothing could be done, why did you keep silent?” On this
basis we do not believe you and we think you felt you had an advantage
and that advantage is what we penalize you for.
c. Remedy – The partner who is wronged is entitled to the same interest he had in
the new business as he had initial business.
i. MP is given an extra share in the new corp. so he can maintain
managerial control over the company.
1) Cardozo (p. 114): “Salmon has put himself in a position in which thought of self was to be
renounced, however hard the abnegation.”
a. If each partner abandons ‘thought of self’, who is going to benefit from the
business opportunities?
b. “You first.” “No, no. After you...”
c. Judge Andrews’ dissent focuses on the parties’ intent to limit the partnership to
20 years.
2) Fiduciary duty is a majoritarian default rule. What rule would most partners want? In
other words, if Meinhard & Salmon would have addressed this issue before the beginning
of their partnership, what would they put in the partnership agreement?
a. Probably not duty to have to stay together forever.
b. But probably not forcing Salmon to forfeit the opportunities to Meinhard.
c. Also, probably not allowing Salmon to keep Meinhard in the dark (S would
expend resources hiding things from M, and M – discovering what S is hiding).
d. Finally, probably not having the two compete against each other.
3) What does that leave us with?
a. Possibly, Salmon would have to tell Meinhard of the opportunity, and since they
don’t want to compete, one would buy off the other with a side payment.
4) Would we have the same rule if Salmon was hired solely as a manager, not also as a
partner?
a. Hence the difference in fiduciary duties between shareholders and directors
5) Compare with RUPA §404(b) and §103(b).
4) In some cases we have a ‘third party check’ – the third party offering the opportunity to
the agent knows about the principal. If the principal can do it, the third party would like
the competition, and inform the principal of the opportunity.
5) So, we may want to know whether the third party (in Meinhard v. Salmon, this is Gerry)
knew about Meinhard and yet made the offer only to Salmon.
B. After Dissolution
1. Bane v. Ferguson p. 117 (Retired Law Partner Loses Pension When Firm Goes
Bust)
Fiduciary duties to partners ends when partnership relationship ends.
Bane was a corporate law partner at an old Chicago law firm. He retired to Florida to draw his
pension. Shortly thereafter, the firm entered into an ill-conceived merger with another large and
successful Chicago law firm. As a result of the merger, the combined firm failed and was
dissolved without successor less than three years later.
Bane sued the firm’s management council for negligent mismanagement. Judge Posner denied
the claim, noting that the defendants owed no fiduciary duty to former partners. Notwithstanding
his retirement draw against firm earnings, π is still not a partner. The partners who ruined the
firm are subject to the business judgment rule. Cardozo would be concerned about selfishness
causing a breach of trust and a breach of fiduciary duty. But here, Judge Posner is not willing to
go that far.
Compare to Town & Country: In T&C, fiduciary duty was breached while defendants were still
employees of the firm.
D. Expulsion
1. Lawlis v. Kightlinger & Gray p. 127 (Drunken Law Partner Gets Voted Off the
Island)
Absent a showing of bad faith, partners may expel members under the terms of a
partnership agreement mutually agreed upon and executed by the partners, even when
such agreement provides for the “guillotine method” of immediate separation.
Alcoholic partner hid condition for several months. Sought treatment, violated treatment
guidelines, eventually recovered after several unproductive years. As a condition of remaining
duing treatment, his partnership share was reduced. Upon recovery, he asked for re-instatement
of full shares. Partners voted him off the island. He sued and said the dismissal was predatory –
designed to improve profits of other partners. Court said no, all partners agreed to the method of
involuntarily dismissing partners. Good reasons for guillitone method, including expediency.
Partnership carried him in the lean years and bent over backwards to ensure that he’d have some
level of transitional salary instead of the mandated “guillitone” separation pay were all signs that
they were not being predatory.
1) Lawlis makes two arguments against his dismissal:
a. Expulsion requires 2/3 vote, but his expulsion was effected by one partner’s notice.
b. Court: No, this was just a notice of intent; expulsion effected appropriately in partners’
vote. Lawlis was present at and voted in his expulsion vote.
2) Expulsion was intended to increase other partners’ draw. This breaches their fiduciary duty
to him.
a. Court: Lawlis presented no evidence to support this. But whatever the intent, the
partnership agreement let them dissolve the partnership for any reason by a 2/3 vote.
Partners would have only violated fiduciary duty if they withheld money due to the
expelled partner.
3) This seems to indicate a qualification to the fiduciary duty: the partnership agreement can
empty the fiduciary duty of much of its content. How does this fit with RUPA §103(b)?
1. Putnam v. Shoaf p. 134 (“Of All The Gin Joints, In All the World …)
Fiduciary Duty – former partners have no rights in assets (or liabilities) recovered or
discovered after their separation from the partnership.
Frog Jump Gin Company – two married couples were partners in money losing Tennessee gin
mill. Death of spouse led widow to sell partnership share in order to avoid partnership liability on
bank note. Subsequent to sale of her interest, it was discovered that the bookkeeper of many
years had been embezzling for many years. Recover from bank was effected (failure to stop
payment on fraudulently endorsed checks); widow sues partnership to recover her share of the
recovery. No dice says the court – you wouldn’t be so quick to jump in if there was a big liability
attached. You wanted out, and out you got.
2) Rights in specific partnership property are not assignable except in connection with the
assignment of rights of all the partners in the same property.
B. Liability in a Partnership
2.
On the other hand, if a partnership is not a separate entity, but a relationship between partners,
then partnership property is an aggregate of assets belonging to the partners. Therefore, a claim
arising from the property will become a separate personal property belonging to the partners.
Which approach does the court in Putnam v. Shoaf endorse?
RUPA §201(a): “A partnership is an entity distinct from its partners.”
RUPA §203: “Property acquired by the partnership is property of the partnership and not of the
partners individually.”
Division of Losses
Default rule: Losses divided the same way as profits. [UPA §18(a), RUPA §401(b)]
Partnership agreement can change this default. There need not be symmetry between division of
profits and losses.
If the partnership offered points at their actual value ($500), it would need to issue 1,000 points to
raise $500,000. With this money it will complete the building, sell it for $10 million, pay off the $9
million debt, and divide the surplus between the 2,000 points (1,000 original points and 1,000 new
points), distributing $500 ($1,000,000/2,000) per point.
This may be too close a margin for some partners – if there are any additional costs, the value of
a point will drop below $500, so why buy additional points? To attract the partners to do so, a
partnership may offer the new points at a discount from their expected value. For example, offer
2,000 new points for $250 each. Since the expected value of the points is $500, this is a good
deal for each partner.
This is sometimes called a “penalty dilution”, because a partner that does not buy the reduced
price points may lose some of the value of her investment. The intuition is this: A partnership
interest is like a slice of the “partnership pie” (the pie is the total assets of the partnership).
Issuing a new point reduces the size of each slice in the partnership, because the pie is divided
into one more part. But the money for which the point was purchased increases the partnership
assets, so it makes the pie larger.
Raising Additional Capital “Penalty Dillution” – Intuitive Explanation
Suppose a partnership issued 4 points when it was formed. Each point represents a slice of the
partnership assets.
Size of each slice (i.e., value of point) = size of pie/number of slices (i.e., total partnership
assets/number of points)
Now the partnership has issued another point. Another slice was added to the partnership pie,
making the relative size of each slice smaller. But the price of the point was added to the
partnership assets, making the pie larger.
Is each slice in the lower pie larger or smaller than a slice in the higher pie?
When a point is bought for exactly its value, the size of each slice doesn’t change – the increase
to the size of the pie (money paid for the point) is equal to the size of the new “slice”.
If a point is sold below its value, this means that the increase to the size of the pie was less than
the size of the new slice. Therefore, the other slices become smaller.
Purchasing a point below its value results in a transfer of wealth from the owners of the existing
points to the owner of the new point. This is called “dilution” of the existing partners.
If the owners of the existing points buy the all of the newly issued points pro rata (i.e., at the same
proportions as their current ownership), then the wealth will be transferred from them (as the
owners of the existing points) to… them (as the owners of the newly issued points). In other
words, they will not be diluted – they will neither gain nor lose from buying the new points.
Meanwhile, the partnership will raise more capital.
There are two problems with this method of raising capital:
1. A partner that doesn’t have available money to invest will lose value (“be diluted”)
Example: Alice owns two of the four points (50%) in ABC law firm (which is a partnership). ABC
offers its partners 6 new points, pro rata (i.e., Alice has the right to purchase 50% of the new
points, that is 3 points) for a price of $10,000 a point. Alice does not have $40,000 in cash. She
has to decline the offer. Brian purchases the 3 points offered to him, plus the 3 points that Alice
declined.
He now has 8 of the 10 points, which gives him both a larger stake in the profits and possibly
control of the partnership.
Suppose Brian wanted to take over the partnership. He could wait until Alice has no money and
then have the partnership issue new points.
2. A partner who does not want to invest more in the partnership, either because he is
dissatisfied with the partnership or because he wants to diversify his investments, will lose some
of the value of his investment.
Example: Alice owns two of the four points (50%) in ABC law firm (which is a partnership). ABC
offers its partners 6 new points, pro rata (i.e., Alice has the right to purchase 50% of the new
points, that is 3 points) for a price of $10,000 a point. Alice has the cash, but she fears that
investing all of it in the firm would be irresponsible. She prefers to invest the $40,000 in
government bonds, in case the firm does poorly. If she declines the offer, Brian will purchase the
3 points offered to him, plus the 3 points that Alice declined, and will dilute Alice (who will now
have two of ten points, or 20%).
1. Hypo
Andy and Barbara form a partnership, and state in the partnership agreement that Andy and
Barbara will each receive a specified monthly compensation for managing the partnership (Andy’s
salary is three times that of Barbara). The agreement also states that Andy will have the right to
decide every aspect of the partnership management except for adding additional partners,
dismissing existing partners, and changing the partners’ compensation. On these three issues,
unanimous consent is needed.
Under UPA:
1) Dissolution does not terminate the partnership [UPA §30]. Rather, it limits all partners’
authority to act for the partnership [UPA §33-35], and prompts the “winding up” of the
partnership.
2) “Winding up” consists of disposing of the partnership’s assets/business, then dividing
between the partners the remaining assets or the liability for remaining losses.
3) Subject to certain limitations, some partners may pay off other partner and continue the
partnership after dissolution [UPA §38(2)(b)].
Under RUPA:
1) Triggering event is “disassociation” [RUPA §601]. After that:
2) Business may be continued under Article 7
3) Purchase of disassociated partner’s interest [RUPA §701]
4) Disassociated partner not automatically released from liability [RUPA §703]
5) Business may be dissolved (and “wound up”) under Article 8
6) Not every event allowing disassociation also allows dissolution [cf. §801 w/§601]
7) Limitation on partner’s authority to act for the partnership [RUPA §804]
1. RUPA § 603
(a) If a partner's dissociation results in a dissolution and winding up of the partnership business,
Article 8 applies; otherwise, Article 7 applies.
Section 603(a) indicates that one of two things can happen when a partner dissociates.
(1) It can result in a dissolution and winding up of the partnership business, in which case Article
8 applies.
(2) If it does not result in a dissolution of the partnership, Article 7 applies. Article 7, as we will
see, provides for a buyout of the dissociated partner.
But how do you know which one of those two happens? The answer lies in Section 801,
which indicates that "A partnership is dissolved, and its business must be wound up, only upon
the occurrence of any of the following events: . . ." Section 801, in other words, tells us when
dissolution occurs. If the partner's dissociation is an event listed in section 801, there's a
dissolution and Article 8 applies. If the partner's dissociation is not an event listed in section 801,
there's no dissolution, and Article 7 applies.
A partnership is dissolved, and its business must be wound up, only upon the occurrence of any
of the following events:
(1) in a partnership at will, the partnership's having notice from a partner, other than a partner
who is dissociated under Section 601(2) through (10), of that partner's express will to withdraw
as a partner [as of the time of the notice], or on a later date specified by the partner;
(i) within 90 days after a partner's dissociation by death or otherwise under Section
601(6) through (10) or wrongful dissociation under Section 602(b), the express will of at least
half of the remaining partners to wind up the partnership business, for which purpose a
partner's rightful dissociation pursuant to Section 602(b)(2)(i) constitutes the expression of that
partner's will to wind up the partnership business;
(ii) the express will of all of the partners to wind up the partnership business; or
(3) an event agreed to in the partnership agreement resulting in the winding up of the
partnership business;
(4) an event that makes it unlawful for all or substantially all of the business of the
partnership to be continued, but a cure of illegality within 90 days after notice to the partnership
of the event is effective retroactively to the date of the event for purposes of this section;
(ii) another partner has engaged in conduct relating to the partnership business which
makes it not reasonably practicable to carry on the business in partnership with that partner; or
or
(i) after the expiration of the term or completion of the undertaking, if the partnership was
for a definite term or particular undertaking at the time of the transfer or entry of the charging
order that gave rise to the transfer; or
(ii) at any time, if the partnership was a partnership at will at the time of the transfer or
entry of the charging order that gave rise to the transfer.
In a shopping center partnership, Sheffel and Iger each own 42.5% of the interests; Prentiss
owns the remaining 15%. Prentiss claims he was “frozen out” (kept out of the decision making
process to force him to sell his interest below its value), and refuses to contribute his share of the
operating deficit. S and I sue for dissolution. Court orders an auction of the property. S & I make
highest bid. P appeals, claiming S & I can’t bid since they have an unfair advantage of using
“paper dollars” (their interest in the partnership equity).
“Paper Dollars”
Let’s assume the partnership has assets (and goodwill) worth $1,000,000, and has no debt. S & I,
jointly, have an 85% interest; P has 15%.
If S & I value the partnership at $1,000,000, their out of pocket expenses are $150,000 (15% of
$1,000,000), paid to P.
If P values the partnership at the same value, his out of pocket expenses (paid to S&I) are
$850,000 (85% of $1,000,000).
If a third party values the partnership at the same value, her out of pocket expenses (paid to S, I
& P) are $1,000,000.
Therefore, P claims S & I have an unfair advantage – they incur much lower out of pocket
expenses to buy the partnership. Why does that happen?
Third parties are also likely to be concerned about hidden problems with the partnership, and
lower their bids to account for this risk. That’s gives S&I an advantage over third parties. Would
prohibiting S&I from bidding result in a higher winning bid? Why does P want to prohibit their
participation?
Freeze-outs and “Coat-tailing”
Why does P want to prohibit their participation?
• Animosity
• A low third party bid hurts S&I more than it hurts P (since they get 85% of the bid). To
prevent that from happening, they’ll offer P a sweeter buy-out deal.
• If S&I know they can’t bid (and thus lose the partnership when they oust P), they might be
deterred from freezing-out P.
• Court rules that S&I are allowed to bid. If P wanted protection from being bought out, he
should have addressed that in the partnership agreement.
• Prentiss is unhappy that he can be forced to take cash for his interest in the partnership.
S&I’s fiduciary duty probably requires them to pay P for the value of any new
opportunities/fortunes they are aware of. So why does P prefer to tag along on their
coat-tails?
• If S&I did know of a new opportunity, why would they tell? S&I: “Do as we say, not as we
do.” Later, it will be hard for P to prove the opportunity existed when he cashed out. He
is in an informational disadvantage, so he prefers to imitate those who know more.
Similar to the Carney laundry case where the laundry started making money so then the
one partner tried to dissolve and take over.
Continuation Per Agreement (After Dissolution)
Effect on the partnership
• Technically, this creates a new partnership (confusing treatment in Putnam v. Shoaf)
• Creditors of former partnership automatically become creditors of the new partnership
[UPA §41]
Effect on the departing partner(s)
• Departing partner entitled to an accounting
• Fair value of the partnership, plus interest from the date of dissolution in the event of an
unreasonable delay in payment.
• Departing partner remains liable on all firm obligations unless released by creditors [UPA
§36, RUPA §703]
Effect on a new partner
A new partner that joins the partnership when it continues after dissolution is liable to old debts,
but his liability can only be satisfied out of the partnership assets (i.e., he has no personal liability)
[UPA §41(1), RUPA §306(B)].
Continuation Following Wrongful Dissolution
D. Buy-out agreements
Exit Mechanisms
Buyout agreements replace (or fill with detailed content) the default rules of UPA/RUPA and the
court’s discretion. Effective buy-out clauses allow disagreements to be solved by the exiting of
one of the partners.
Selling partnership interest to third parties
May have limited value if market is very thin;
Raises issues regarding undesirable partners.
3.
General partnership may convert to LLP. Conversion does not cause a dissolution [RUPA
§201(b)]
Liability – RUPA §306(c): “An obligation of [a limited liability partnership]… is solely an obligation
of the partnership… A partner is not personally liable… solely by reason of being… a partner.”
Some states restrict the liability limitation to tort actions, and leave contract liability unlimited.
The ruling seems to say that you should act in one manner behind the scenes and in another to
the public. As de Escamilla’s attorney, you should recommend that he resign.
Knipprath: Partners have limited liability for the negligent act of their co-partners. It gives more
protection to the partners than the GP, but less than the LP. Usually used by professionals.
Lawyers don’t want to be liable for the mistakes of their partners. The liability limitation applies to
the acts of your co-partners and employees.
X. THE CORPORATION
Corporations are generally optimized for a larger number of participants, greater discrepancy in
business interests, and larger volume of business.
The corporation has two main characteristics:
Independent legal personality
Separation of ownership and control
Units of equity in a corporation are called shares (similar to “points” in a partnership). Owners of
equity in the corporation are called shareholders (“SH”).
“Republican” form of control (i.e., control by delegates of the SH, not by direct vote of the SH):
Shareholders - nominal owners, but usually no direct control
Board of Directors – elected by shareholders; oversight of corporation
Officers – appointed by Board of Directors; day-to-day management
A. Main Attributes
1. Publicly-held (“Public”)
A public secondary market in which the corporation’s shares are listed and traded.
E. Applicable Law
Corporations are incorporated according to state law. Therefore, the first issue is choosing the
state of incorporation.
Over 300,000 companies are incorporated in Delaware including 58% of Fortune 500 firms, and
over 50% of publicly-traded companies. Therefore, familiarity with the Delaware General
Corporation Law (DGCL) is important.
Refer to the ABA’s Model Business Corporation Act (1984) (MBCA).
Cases 2-3:
Principal-Agent Sales: Art buys land for $125K. Paula hires him as an agent to buy
that land, and he sells to Paula for $200,000. Paula sues to recover $75,000.
Paula can disgorge Art’s profit (even if land is actually worth $200K), because agent
breaches fiduciary duty by secret dealing with principal. Art should have disclosed
relevant information to avoid liability.
Same rule applies whether principal is an individual or a corporation.
Case 4:
Promoter Sales: A promoter is an agent of the corporation he forms, and owes it a
fiduciary duty.
Approach (a): Art forms corporation C, sells C’s stock to Paula, and then (as part of
an integrated transaction) sells land he owns to C, without disclosing his interest in it.
If the sale was part of the same transaction as forming C, Art is C’s agent and has
made a secret profit, which he must disgorge to C.
Approach (b): Art sells land he owns to Paula. Paula then forms C, and gives the
land to C (which she owns 100%).
Art is not a promoter of C. No fiduciary duty to C.
Alternative Approach (b): Art forms C, sells C’s stock to Paula, and then sells land he
owns to Paula. She gives the land to C.
Art did not transact with C (which is his principal), so he breached no duties to C.
Is there a substantive difference between approaches (a) and (b)? Probably not, but
formalities matter, especially in corporations.
Approach (c): Art forms C, buys its stock for 200K, then has C pay the $200K to buy
the land he owns (which he bought for $125). Finally, he sells C’s stock to Paula,
without disclosing the price for which he initially purchased the land.
Courts are split regarding A’s liability in this case (Old Dominion).
If A breached a duty to C in selling the land for $200K, then Paula could have C sue
A for the breach of duty (déjà vu from Putnam v. Shoaf?)
But A owned C and (as a director) approved the purchase. A knew what he paid, so
there was full disclosure to C. Thus, A breached no duty to C
The only difference between approach (a) and (c) is that in the former, A didn’t
control C when he sold the land. He was promoter but not owner, so he owed
fiduciary duties yet couldn’t act for C and approve the sale.
Again, a slight difference in form results in a big difference in liability.
2. Case 4:
Promoter Pam contracts with third party Tom, on behalf of C Corp., a corporation not
yet formed.
If Pam later forms C, can C become party to the contract? Yes. C can unilaterally
adopt the contract. If the contract was worded properly, C may even automatically be
a third-party beneficiary.
If Pam later forms C, can Pam avoid liability? Pam must receive Tom’s consent
(either in the original contract or later). Absent an agreement, a promoter, as agent
of a yet to be formed corporation, is liable on the contract.
Who is liable if C is never formed? What happens if Pam forms a different
corporation than the one contemplated in the contract? Pam is liable (see above).
Are the investors who were to form C liable? If they share profits and control, they
may be partners and liable as such to the actions of any of the partners. Also, courts
formed doctrines to recognize a “defective corporation” (one that has not
incorporated as planned).
H. “Defective Corporations”
1. De facto Corporation:
2/12/04A court may treat an improperly incorporated firm as a corporation IF organizers:
1) Acted in good faith to incorporate;
2) Had the legal right to incorporate; and
3) Acted as if they were incorporated.
2. Corporation by Estoppel:
A court will also treat a firm improperly incorporated as a corporation IF third parties:
1) Thought business was a corporation; and
2) Would earn a windfall if it were now allowed to deny that the business was a
corporation.
4. Southern-Gulf Marine Co. No. 9 v. Camcraft, Inc., p. 201 (The Ship Price)
If a third party treats an entity as if it is a corporation, the party is estopped from
denying its corporate existence at a later time.
Contract to sell a vessel signed by Camcraft (represented by Bowman) and Barrett,
who signs individually and on behalf of Southern-Gulf Marine, a Texas corporation. At
the time, SGM was not formed.
SGM then incorporated in the Cayman Islands (rather than Texas). Barrett informs
Bowman of the decision to incorporate elsewhere and of SGM’s decision to ratify and
adopt the agreement signed by Barrett. Bowman signs the letter.
Price of the vessel rises, and Camcraft reneges on the contract.
Appellate Court enters judgment for SGM. SGM’s status as a non-Texan corporation did
not cause Camcraft any substantive problems, and Bowman was informed of the
Cayman incorporation and accepted it. Camcraft is estopped from raising issue of
SGM’s incorporations.
Suppose you are Bowman’s lawyer and are now drafting the agreement with Barrett.
1) How would you mitigate the risk of SGM not being formed as contemplated?
2) How would you mitigate the risk of SGM not being formed as contemplated?
State that Barrett is personally liable, at least until SGM is formed;
Have Barrett commit to form SGM in compliance with certain key requirements (e.g.,
specified capitalization, state of incorporation). State that failure to do so is a
material breach of the contract;
Have Barrett or SGM’s investors post a bond;
Demand progress payments from SGM (and state that failure to pay any installment
is a material breach);
Require that SGM be formed by a certain date (and state that failure to do so is a
material breach);
Specify whether there is to be a new agreement between the two corporations when
SGM is formed;
Specify what happens if SGM is not formed or, if formed, does not adopt the
agreement.
Why does the plaintiff have this weird name? Why “…No. 9”?
I. Enterprise Liability
Enterprise liability occurs when: (1) there is such a high degree of unity of interest between
two (or more) entities, that their separate existence had de facto ceased; and (2) treating the
entities as separate would sanction fraud or promote injustice.
In Olympic Financial Ltd. V. Consumer Credit Corp. (S.D. Tex.), the court examined
whether the corporations had:
1. Common employees;
2. Common record keeping;
3. Centralized accounting;
4. Payment of wages by one corp. to another corp.’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;
11. The same telephone number.
J. Agency
1. SH Would Be Liable As A Principal To The Corporation’s Torts If:
1) The corporation was under SH’s control;
2) The corporation acted on SH’s behalf;
3) And the corporation consented to do so.
1. Presents the black-letter law for PCV in Illinois [quoting Van Dorn]:
“Such unity of interest and ownership that the separate personalities of the corporation
and the individual [or other corporation] no longer exist”
1. Failure to maintain adequate corp. records or to comply w/corp. formalities
2. Commingling of funds and assets
3. Undercapitalization
4. One corporation treating the assets of another corporation as its own
5. “[C]ircumstances must be such that adherence to the fiction of separate
corporate existence would sanction a fraud or promote injustice.”
6. Prospect of unsatisfied judgment does not satisfy this prong of the test
7. But Sea-Land court endorses Kreisman (SH defaulted on debt for purchasing equipment,
and used this equipment for several years), in which “unjust enrichment” satisfied the 2nd
prong requirement.
8. Sea-Land court suggests that 2nd prong will be satisfied if SH used corp. to avoid
responsibilities to creditors, or if one of the corporations will be “unjustly enriched”
unless liability is shared by all corporations.
Tort Creditors
1) Does a tort creditor care about SH’s respect for corp. formalities?
2) Does a tort creditor care about corporation’s undercapitalization?
If SH doesn’t respect corporation’s independent entity, why should a creditor?
1) Other than issues discussed above, does the SH respect or lack of respect to the
corporation’s independent entity matter to a creditor?
1. Is the unity of interst and ownership such that the separate personalities of the
corporation and the individual shareholder no longer exist? AND
2. Would an equitable result occur if the acts are treated as those of the corporation alone?
3. Third prong not applicable.
Why a different test for PCV in contract cases versus tort cases? In contract cases the
parties have plenty of opportunities to check on the parties they were doing business
with. But, in tort cases you don’t necessarily have those opportunities. You run the risk
of the other side 67avourab when you do business. You need the element of fraud. In
tort cases you don’t have as much opportunity to check out the other side. Example:
Walkovszky. There was nothing that Walkovsky could have done to impact the liability
of Seon Corp.
In re Silicone Gel Breast Implants Products Liability Litigation, (1995) page 221
Summary
1. Creditor: Tort (But is it really a contract case? Did consumers have a choice?)
2. Lack of formalities: Yes. But not fraudulent.
3. Undercapitalization: No; in fact, parent company saved subsidiary money (forgone
dividends and provided subsidiary with free services)
4. Suggested result according to our rationale: No PCV (but is there apparent agency
from Bristol Myers’ name and logo in MEC’s promotions?)
5. Court: PCV
Defendant parent corporation filed a motion for summary judgment in plaintiff victims’
multidistrict silicone gel breast implant products liability litigation. It asserted that the
evidence was inadequate for plaintiffs to support any of their claims against it, whether
based on piercing the corporate veil or on a theory of direct liability. The district court,
considering the law of the transferor states, denied the motion. It held that under the
corporate control theory, there was ample evidence from which a jury could find
that defendant’s subsidiary, the manufacturer of the breast implants was
defendant’s alter ego.
This included evidence that they
1. shared directors;
2. that the manufacturer was part of defendant’s health care group and used its legal,
auditing, and communications departments;
3. that they filed consolidated federal tax returns; and
4. that defendant prepared consolidated financial reports.
As for the direct liability claims, by allowing its name to be placed on breast implant
packages and product inserts, defendant held itself out as supporting the product, and
thus could not deny its potential liability on a theory of negligent undertaking.
2. PCV Recap
1. 1½ out of 5. Our rationale is not a very good predictor…
2. No bright-line rule in PCV. Policy arguments may help, but it is important to argue
based on two-prong test (or equivalent in the relevant state), study similar case law
and analogize/make distinctions.
3. Alternatives to PCV: Direct liability (re Silicone Gel), commercial misrepresentation,
fraudulent transfer, targeted legislation (e.g., toxic waste, taxis)
When a corporation suffers harm, SH are indirectly harmed by the decrease in their
shares’ value. But this is indirect harm, similar to Sarah’s harm in the above hypo.
To repair the harm, the corporation must sue. Is there any reason for us to think the
corporation wouldn’t sue when it has a strong claim?
B. Derivative Actions
1. Hypo
Danny, David and Dana, C Corp.’s three directors, embezzle $1 million from C Corp.’s
treasury. Steve, a shareholder in C, wants to sue the three, but is told by his lawyer that the
cause of action is the corporations’, not his. He therefore writes an angry letter to the
corporation, demanding that it sue the directors. The board convenes to decide on Steve’s
request, and after very short deliberation votes 3-0 not to sue.
Can’t the shareholders just vote the directors out?
Danny, David and Dana together may own 51% of C’s stock.
Or, most shareholders might have too small a stake to bother.
What can Steve do?
Steve can sue C Corp., requesting the court to order C to sue the three directors.
Such a suit is called a derivative action.
Derivative suits are dismissed if they do not comply with certain requirements,
including:
SH needs to post bond to cover corp’s legal costs in case of frivolous suit;
In many cases, SH needs to ask the corporation to sue before he can sue
derivatively.
Therefore, we need a rule to determine which suits may be filed directly, and
which have to be derivative. In other words: whether a given cause of action is the
shareholder’s (direct suit), or the corporation’s (derivative suit).
Suppose the three directors did not embezzle money from the corporation.
Instead, they reconfigured the rights of preferred stock to the advantage of the common
stock owners. Steve owns preferred stock.
Did the reconfiguration harm the corporation?
Preferred stock holders are harmed, but the corporation is not. The cause of
action is Steve’s, not the corporation’s, and Steve may commence a direct suit.
2. Derivative Actions –
1. In a Derivative Action (a suit in equity or law depending on remedy) by a SH or group of
that has self-appointed himself to try to get the court to force the corporation to file
another suit against the officer or directorsimultaneous suits in equity by a SH against
corp. to compel it to sue another (usually officer or director and rarely a trade person), the
actual suit by corp. against that other party
2. Most time, named as one SH against the corp (or officers too if that SH is arguing both
the individual and derivative)
3. B/c the SH is suing “in right” of corporation, any remedy from principal suit goes to
corporation; the corporation is required to pay for SH’s attorneys’ fees if suit is successful
(or often if it settles
4. Derivative versus Direct Actions – lots of borderline cases, so may be able to take your
choice how you want to take, but must plead your case why bringing it as one and not the
other
Direct – Wrong complained of constitutes injury to SH directly
(1) Force payment of declared dividend (if paid, goes directly to SH);
(2) Enjoin activities that are ultra vires;
(3) Claims of securities fraud/blue sky laws (b/c individual claims to damages);
(4) Protecting participatory rights for SHs
Derivative – The wrong is where the wrong complained of primarily involves an injury to
corp. and indirectly to the SH
(1) Breach of DoC
(2) Breach of DoL
(3) Enjoin Management Retrenching Practices (activities where managers try to
avoid takeover b/c they don’t want to be fired by takeover firm)
5. Why does the distinction matter?
Advantages of Derivative Suits – more attractive fee allocation (One way fee shifting if SH
wins)
Disadvantages of Derivative suits – procedural hurdles. Damages on other remedies
usually go to corp. and not SH.
2. Demand Req’ts:
At times must first demand to BoD that corp. pursue litigation. There are times
when demand is futile (excused form formally demanding BoD sue itself)
(Cohen owned 150 shares of Beneficial against corp. that had million shares issued; he
filed in federal court claiming waste; beneficial moved to require posting of bond)
(1) Relevant Stat: Required that to avoid bond, must own 5% of voting shares w/in
collective voting trust (small stake SHs team up to vote together)
(2) Erie says that applicable state law used in matters of substantive law
(3) Is the security for expenses statute a procedural rule or substantive rule?
(4) Court finds it is a substantive rule of law, and even though no federal req’t to post
security, the court applies state law. It does not violate due process concerns
(5) What’s peculiar about the holding? Under Internal Affairs Doctrine you should
apply state of incorporation’s substantive law and in this case, it should be Delaware
law. But this is an exception to the internal affairs doctrine. Inspection rights of SHs
also fall outside doctrine and follow state where corp. resides instead of where
incorporated.
(6) What is it about SH derivative actions that make “strike suits” a potential
problem? It lets lawyer and BoD agree to settlement. Does NY’s remedy this
problem?
(7) Suppose Cohen posted the requisite security, the claims will be analyzed under
Delaware law.
(8) What alternatives are there for SH that doesn’t have the money to post security?
1. Make his lawyer front it. 2. Get some other SHs in that state and form a voting
trust. 3. Sue in state of incorporation. 4. Sue as a Direct Action (likely not here b/c
this is mismanagement claim)
(9) Because the statute only 73avourab payment of reasonable expenses, the Court
deemed that it was NOT a due process violation.
(10)Application of statute to shareholders with <$50k invested was NOT an equal
protection violation because it applied to everyone in that class and it was a
reasonable measure to further the state’s legitimate goal in limiting strike suits.
2. Eisenberg v. FTL (No Need to Post Security for Direct Action Suit)
(Flying Tiger created Flying Tiger Corp. that then created FTL; then Flying Tiger merged
w/FTL; Flying Tiger SHs shares would be exchanged for FTL shares. Thus, the subsidiary
would end up owning and controlling the corp. b/c of the merger; Eisenberg brought a
direct action suit claiming he lost his voting rights for Flying Tiger in the transaction. This
was a direct right he had individually. But he can still vote in the Flying Tiger Corp. stuff.
The arg is that they are ruining his investments.
(1) FTL’s counterarg: His claim is derivative, he must post security under NY Law
(2) Trial court: He was req’d to post as per the NY Law, he refused to pay and the
complaint was dismisses
Cohen teaches that such statutes are presumptively substantive parts of state law, and thus
apply to diversity SH litigation
But if state law itself says that its own bonding statute is procedural, then the question of posting
security is once again a federal one …and under federal law. No security-for-expenses statutes
exist.
Most States Require Shs In Derivative Suits First To Approach Bod And Demand That
They Pursue Legal Action
Demand Usually Takes The Form Of A Letter
Can Get Out Of It If You Can Establish That Demand Would Be Futile (Two Part Aronson
Test From Brehm)
2. Eisenberg v. Flying Tiger (2nd Cir. 1971) (No Need to Post Security for Direct Action
Suit)
What is Eisenberg asking of the court?
To determine that his suit is direct, so as to avoid NY law’s requirement that a plaintiff in a
derivative suit post security for the corporation’s costs.
Eisenberg’s claim: Reorganization deprived him and other FT shareholders from voting
on the operating company’s affairs. Since it only affected Eisenberg and/or a very small
number of shareholders, it was not a derivative action. In-other-words, since the
corporation was not harmed, it is a derivative action. Maybe it has 74avourabl to do with
the small number of shareholders affected, but Epstein is not clear on this point.
Possible rules for determining type of suit:
Is the injury one to the plaintiff (as a SH) individually, and not to the corp?
Court: This rule isn’t useful to decide borderline cases.
Who does the defendant owe a duty? [Gordon v. Elliman]
If directors have a duty not to merge, they owe that duty to the corporation
Court: this sweeps away the distinction between representative & derivative
actions.
Is suit aimed to force corporation to procure a judgment “in its favor”?
Armand Hammer was the CEO of Occidental Petroleum Company. Over the years he
acquired an extensive art collection. He induced Occidental to expend $89 million to
build and operate the “Hammer Museum”, which will contain his art, next to its office
building (Occidental’s net profit that year was $256 million).
Two derivative suits were filed, one led by Khan, another led by Sullivan. Occidental
settled with Sullivan (in a way that had the effect of settling Khan’s action as well).
The court approved a settlement: that allowed the museum to be created:
Its name is to be changed to the “Occidental Petroleum Center Building”;
Occidental would have representation on the museum board;
A limit was placed on future support of the museum;
Hammer agreed to donate the art collection to the museum upon his death.
Occidental will pay Sullivan’s lawyers $800,000 (occidental offered to pay $1.4 million,
but the court reduced this sum). Khan’s lawyers get zero.
Why did the court approve the settlement? Courts don’t like making decisions contrary to
the parties where the parties have already agreed to settle. BJR sets default to faith in
management.
Busy judges prefer not to dwell on suits when both parties agree to settle.
The prospect for Khan’s suit to succeed on the merits was poor, due to the Business Judgment Rule.
2. This Is A Tough Presumption To Rebut; Tougher Still If The Plaintiff Is Not Entitled
To Discovery
Plaintiff can use “tools at hand”, such as information from the media or the government (e.g.,
SEC), or a shareholder’s right to inspect books and records (8 Del C. §220).
But how likely is it that evidence on self-interest would be found there?
(1) A majority of the board is independent for the purpose of responding to the
demand; or
(2) The challenged transaction is protected by the BJR; or
(3) Carelessness and waste
Exam Prep: Build a Chart to show how I would justify each state’s approach?
2. SLCs
(1) MBCA: Not relevant (because demand requirement is universal).
(2) New York: Court defers to SLC’s decision unless P proves SLC was not
independent or did not conduct an adequate investigation.
(3) Delaware: Court examines independence & good faith of SLC and bases
supporting SLC’s recommendations, but may also apply own bus. Judgment.
BOTTOM LINE: Easier for Π to get past SLC in Delaware than NY.
nts
Is Suit Direct or Derivative?
Derivative? me
re
Direct Derivative qui
S/H Suit Allowed
Re
nd
Universal Demand Non-Universal Demand
ma
(MCBA §7.42) (Delaware/NY) De
#2:
e
Did Board Find Suit Is Demand Futile?
NOT in Corp’s Best DelawareTest
rdl
Interest? (Aronson)NY Test Hu
(Marx)Reasonable Doubt That:Π Shows That:Maj. Of Board is ion
Independent; or
Yes No
BJR applies; or Act
Carelessness & WasteMaj. Of Board has a direct interest in the ve
challenged trans; or is controlled by an interested party; or
S/H Suit Directors failed to reasonably inform themselves; or
ati
Allowed Challenged transaction so egregious that it could not have been of riv
sound business judgment. De
Was Decision Based on
Good Faith or Reasonable Yes No
Investigation?
Board Takes
Control of S/H
S/H Suit S/H Suit Suit.
Allowed Dismissed
P. Derivatives Recap
Cohen v. Beneficial (241, Sup. Ct. 1949),
upholding constitutionality of NJ bonding statute because it called for payment of
reasonable fees; and it was substantive Delaware law and under Erie, the
Court imposed Delaware law.
Applicability in federal courts: such statutes are both procedural and substantive
substance provided by creation of liability—in that it requires s/h to post
bond and potentially incur liability for corp’s costs should he lose
procedure provided by requirement that s/h post the bond
1. Table Of DL Law:
creation and delegation of power to SLCs valid under most state statutes
but out of fairness, SLCs usually comprise disinterested Directors not involved in
the offending tx (or new Directors who weren’t around when the offending tx
occurred)
concern with SLCs is problem of structural bias: SLCs’ reluctance to effectively pass
judgment on other Directors with whom they closely work
courts recognize the decisions of SLCs (Auerbach, infra: business judgment doctrine—
essentially, using the BJR as a sword rather than a shield—justified corp’s allocation
of power to, and deference to decisions of, SLCs)
Auerbach v. Bennett
Facts: Corporation had engaged in paying bribes to foreign officials and companies and
board members had participated in such payments. Based on an internal investigation
Shareholder sued derivatively. Because demand was probably excused, Board appointed
a Special Litigation Committee, made up of impartial members to determine whether to
continue the suit. Committee decided not to and Shareholder appealed the decision and
lost.
Analysis: Business Judgement Rule shields the decisions of a Special Litigation Committee if
they use proper procedures to insure that the deliberations were complete and done in
good faith.
- If the Special Litigation Committee is independent then there are two types of
scrutiny:
o Procedures used by the board to become informed ➜ Courts are well
positioned to scrutinize procedures.
o Substantive decision of the Special Litigation Committee given the info
acquired is subject to the Business Judgement Rule and extreme court
deference.
- If members of the Special Litigation Committee were interested themselves,
then demand is still excused
o This is not the case here because all the members of the Special
Litigation Committee joined the board after the alleged wrongs.
Zapata v. Maldonado
Facts: Shareholder brought a Derivative Suit alleging breach of fiduciary duty by the
board, and stated demand futility (no demand was made). The board set up a
Special Litigation Committee to review the case and determine whether such a suit
should be pursued. The Special Litigation Committee concluded the suit was not in
the Corporate interest, and the Corporation moved to dismiss. The court held that the
Special Litigation Committee appointed by a tainted board has the power to press
dismissal.
Analysis: In cases where demand is excused, Corporate power to control the suit
continues and will be respected if delegated to a disinterested committee.
However the decision of the Special Litigation Committee will be somewhat scrutinized
because:
Special Litigation Committee is more suspect because if demand is excused
either a majority of the board is interested or no Business Judgement Rule
Β legitimately invested in the suit.
Β is allowed limited discovery to look into the independence and good faith of the
Special Litigation Committee and the basis supporting its conclusions.
s/h derivative actions are effective means of exercising s/h control, but procedurally they
can be nearly impossible to get going!
Epstein 3/25/2004 – What is the purpose of the corporation? Why do we have corporations?
Profit is one possibility.
Bonds
A firm’s capital structure is the set of claims to its assets and future earnings. In corporations,
most of these claims are attached to ownership of securities:
Shares – These are securities attached to equity capital (equivalent to “points” in a partnership).
Shares entail certain voting rights in the firm, rights to dividends (distribution of profits to
shareholders), and rights to the residual assets of the firm after all debts have been paid.
Bonds – These are securities attached to debt capital. Bonds entail rights to payment of interest
and principal, often specify collateral, and in some cases gives some rights to control (e.g.,
Cargill).
A corporation may have several different classes of shares/bonds, with each class conveying
different rights.
Very few individual investors in this market
Investment Grade or Junk Bonds
Knipprath: he couldn’t sell a bond because no one would want it; even a junk bond.
A trustee of a trust could probably invest in first trust deeds; not too much risk. But, 2nd or 3rd trust
deeds are riskier. Used to be not allowed; now it’s just not recommended. But the trustee can
make a decision.
Stock may be certificated or not; but it must be authorized and issued. Can come in different
classes (preferred or common).
Preferred is any stock with a preference over common. Can have more than one class of
common.
Common shares vote. Can have another class of common that does not vote; but at least one
class must vote. Classifications of voting stock can complement an estate planning device.
If you want to transfer stock to your children, you might create a non-voting class of stock to give
them. Can be a way to transfer wealth and avoid certain estate taxes. No death tax but a
recapture credit. Other states might have a death tax. So different classes of stock could can
aid in estate planning.
cumulative, you can pile all your votes onto one candidate if you so choose. Only applies to
director voting. Not proposal voting which is just “yes” or “no.”
Up to state law; some states require cumulative voting.
Only available in voting for directors to help minority SHs get representation on the board
Must have an annual election of directors.
This won’t help a coalesced minority defeat the majority
But, it is useful to help a minority SH get on the board. These are typically looking out for their
own self interests. Greenmail. Knipprath says this is why cumulative voting is no longer very
popular.
2. Appraisal Right
You have the value of your shares appraised, the company pays you that amount. It’s the right to
be bought out in a merger.
Knipprath says you might not need it with publicly traded shares where there is a ready market
for the shares.
It can also be used as an equitable remedy.
It’s up to state law.
The parallel right is the preemptive right.
Usually depends on the form of the merger, whether your shares are in the surviving or target
company.
Voting Trusts
(1) SH might appoint a trustee to vote the shares according to their direction.
(2) Big difference: Voting Trust is more likely the most honest
(3) Must be in writing
(4) Usually subject to a 10 year limit.
6. Shareholder Lists
Subject to management limitation by mailing the proxy for you
D. Change in Control
1. Proxy Solicitation
a. Go to SH’s
b. Get proxy (right) to vote shares
c. No consideration being exchanged No $$; it is not a proxy coupled with an
interest
d. If successful, get control of board of directors
e. The person soliciting the proxy has NO fiduciary duty unless they ultimately wind
up on the board of directors.
f. SH can vote out the Board on the next vote if they are unhappy
g. SH can sell shares if they are unhappy
h. SH position remains same as before the proxy solicitation
1. Dividend preferences.
Example: A company issues 100 regular shares and 100 preferred shares, which receive
a $3/share dividend preference. The company decides to distribute $500 in dividends.
The preferred shareholders first receive $3 a share.
This leaves $200 to be distributed among all 200 shares (preferred and
regular). Each share receives $1, so the holder of each preferred share receives
a total of $4, while a holder of a regular share receives $1.
Decision to issue dividends is up to the Board and is protected by the
BJR.
The preference protects the preferred SH against the Board giving
dividends to CSH before them. Usually the dividend preference is fixed.
Example: 5% of par.
3. Disadvantages of PS
Not Preferred Over Secure Creditors,
No Guarantee Of Dividends,
No Participation In Appreciation Of Corporation
6. Restricted Shares
Will cover in securities law portion of the course.
7. Par Value
• Can have no par
• Accounting Device
• No relationship to market price
Would it make sense for a bondholder to convert it if the price of a share went up to
$12/share?
Benefits for the bondholder: Convertible bonds give the creditor the security of a bond
(guaranteed interest and priority over shareholders in claim from the corp. assets), while
they also have some of the upside of rising stock prices.
Benefits for the corporation: The company needs to pay a lower interest rate on the bond.
Reducing transaction costs (benefit to both parties): Remember the conflict of interests
between bondholders and shareholders? What effect do convertible bonds have on that?
1. Limited Liability
2. Derivative Actions
1. Capital Structure
2. Centralized Management
1. GmBH in Germany
2. Designed to provide liability protection to all members but still allow partnership
taxation
1. Corporation
Applicable Federal/State Laws
Articles of Incorporation
Bylaws [MBCA §2.06]
Board of Directors’ Decisions
Decisions of Officers
2. Country
Laws of Physics
Constitution
Laws/Regulations
Presidential Directive
2. Board of Directors
Directors control the corporation
MBCA §8.01(b):
(1) “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.” [See also DGCL §141]
3. Hierarchy of Employees
G. Corporate Powers
MBCA § 3.02:
(1) “Unless its articles provide otherwise, every corporation has perpetual duration…
and has the same powers as an individual to do all things necessary or
convenient to carry out its business and affairs…” [Also see Del. GCL §121-2]
(2) “… including without limitation power: … (13) to make donations for the public
welfare or for charitable, scientific, or educational purposes.” [Also see Del. GCL
§122(9)]
2. U of C Hypo
All three directors of Acme are alumni of the University of California. They make the corporation
donate $100,000 to the U of C. Alice, a shareholder of Acme and a Yale alum, sues Acme in
order to have half the donation go to Yale. Bob, another shareholder, sues Acme in order to
enjoin the donation and make Acme distribute the $100,000 as dividends.
Acme’s directors respond by pointing to MBCA §3.02(13), in combination with MBCA §8.01(b).
Do these sections authorize the directors’ actions?
H. Corporate Purpose
MBCA §3.02 states the corporation’s powers, not the corporation’s purpose.
(1) MBCA §3.02(1) adds the power “to sue and be sued”; MBCA §3.02(7) adds the
power “to make contracts”. But obviously not every suit and every contract the
directors decide on is automatically immune of judicial scrutiny. If it were so,
what would keep the directors accountable?
(2) A corporation’s powers determine what the corporation can do. But directors are
to use those powers to advance the corporation’s purpose. MBCA 3.01 states
that a corporation “has the purpose of engaging in any lawful business unless a
more limited purpose is set forth in the articles of incorporation.”
(3) This doesn’t provide a lot of guidance. For whose benefit should the corporation
operate (SH, creditors, employees, the community)? Which groups can protect
4. Shareholders
Own a residual claim on the corp’s assets – hard to define entitlement.
Have most interest in corp’s prosperity (own both “upside” and “downside”), except when corp is
insolvent (because then they only own the “upside”).
Therefore, it makes most sense that corp would operate for benefit of SH, subject to contractual
and legislative protection of the interests of the other stakeholders.
But If Ford’s Policies Create Value For SH, Why Are The Dodge Brothers Unhappy About Them?
(1) The Dodge brothers own the Dodge company, which competes with Ford.
(a) If Ford’s cars are cheaper, Dodge loses sales and profits.
(b) If Ford raises salaries, Dodge has to follow suit or get less reliable
employees.
(c) Dodge is strapped for cash to invest in new plants, and they want to invest
the dividends from FMC into Dodge.
(2) Ford is not a saint, either. Knowing that his competitors need cash to compete
with FMC, he denies them dividends. But this isn’t a conflict of interests (for BJR
purposes) since Ford’s interests are identical to FMC’s.
(3) Another possible reason for cutting dividends: Top bracket of federal income tax
rates rose from 7% in 1913 to 73% in 1920. Ford is likely in top bracket. Maybe
Dodge bros. are not.
(a) Problem of differing SH interests due to taxation does not exist in
partnerships.
(4) Note on dividends: often the problem is the reverse; SH distribute too many
dividends, risking insolvency (which harms creditors). Some states have
statutory limits on the maximum dividend a firm can issue.
Preferred stock has some of the indicia of K; it is preferred in bankruptcy proceedings.
Shlensky v. Wrigley
(5) Shlensky is a minority SH in corporation that owns the Chicago Cubs and
operates Wrigley Field. Wrigley, who owns 80%, refuses to install lights (that
would enable Cubs to play night games).
(6) Shlensky alleges that Cubs are losing money because of poor home attendance,
which was possibly due to lack of night games (for people who work during the
day).
(7) Wrigley rejects night games because he believes baseball is a day-time sport,
and night baseball might negatively impact the neighborhood surrounding
Wrigley Field.
(8) Court goes out of its way to find SH benefit – night games may increase crime in
area, and deter attendance, thus harming SH.
(9) BJR – No evidence of fraud, illegality or conflict of interest, so court does not
second guess Wrigley’s judgment, despite evidence Shlensky wants to present
showing that night games will increase profits.
(10)Instead of arguing for a lack of business justification (in the face of the BJR),
Shlensky might have been better off trying to argue that Wrigley refused to
investigate option of night games, and thus did not make an informed business
decision to which the BJR can apply.
(11)Epilogue: Ownership of the Cubs and Wrigley Field eventually passed to the
Chicago Tribune, which tried to install lights. Local residents complained, and
the Cubs ultimately got lights, but were limited in the number of night games they
could play.
Application of Dodge v. Ford suggests BJR may not apply in Bob’s suit, if $100K is a large
portion of Acme’s assets, since this suggests directors are determining the ends for which the
corporation is run, not just the means to reach those ends. Courts tend to be receptive to
business justifications for charity donations (e.g., long-term benefits to SH from PR). If gift were
anonymous, though, Bob may have a stronger case.
2. Formation
File Articles of Organization In The Designated State Office [ULLCA §202(a)]
(1) Required terms: §203(a); Optional terms: §203(b). Mandatory terms: §103(b).
(2) Pay filing fees and franchise tax.
(3) Choose and register name [ULLCA §105(a)].
(4) Designate office and agent for service of process.
Draft Operating Agreement
(1) Relationship between AoO & OA [ULLCA §203(c)]: When they conflict -
(a) OA controls as to managers, members & members’ transferees.
(b) AoO control as to any other person, who reasonably relied on the articles to
their detriment.
Conversion of Existing Entities
(1) Partnerships - ULLCA §902 authorizes conversion of GP/LP to LLC.
(a) ULLCA §903(b)(2) converts GP/LP debts to LLC debts. To protect creditors
from limited liability, should make conversion an event of default.
(2) Corporations – No provision for conversion [Can convert by merging the
Corporation into a newly-formed LLC; §904 would then govern procedure].
6. Limited Liability
LLC is liable for member’s or manager’s conduct if it is in the ordinary course of business of the
LLC or with authority of the LLC [ULLCA §302].
ULLCA §303(a): Members’/managers’ liability limited to their contribution to the LLC (i.e., no
personal liability).
(1) Exception [ULLCA §303(c)]: If AoO allows personal liability and member
consented in writing.
2. 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.”
(1) No explicit exception that opens the door to piercing the veil.
(2) Cf. Minn. Stat. §322B.302(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.”
Tom Thumb Food Markets, Inc. v. TLH Properties, LLC (Minn App. 1999) (Another Grocery
Store Case)
The practice of piercing the corporate veil is generally a creditor’s remedy used to
reach an individual who has used a corporation as an instrument to defraud
creditors. Absent injustice or fundamental unfairness, Courts will refuse to pierce
the corporate veil.
Developer signs lease agreement with Tom Thumb, appellant. Lease agreement
contains integration clause stating that there are no other contingencies to the lease.
Later, Bank checks credit of lessee (Thumb) and finds he has a negative net worth.
Because the proposed tenant doesn’t qualify, bank refuses to finance the developer and
the true land owner takes a walk; the deal collapses.
Thumb sues the developer for breach of contract (not leasing him the land). Then Thumb
discovers that the developer did not really own the land, so he moves to amend his
complaint to add a claim that Hartmann (the developer) should be held personally liable
under the theory of piercing the corporate veil. The district court allowed the amendment
and concluded after trial that Hartmann was personally liable. The district court found that
Hartmann breached the lease and Tom Thumb was entitled to 12 years of lost profits at a
present value of $492,000.
Appellate Court rejected Hartman’s theory that the lease deal was contingent upon
financing; the integration clause proved otherwise. However, Hartman was not trying to
defraud Thumb, he was trying to do business with him. It was Thumb’s insolvency and
stalling that caused the bank to withdraw financing. Far from creating the company to
perpetrate a fraud, the undisputed testimony was that the company was formed to
achieve development of a Tom Thumb store. Furthermore, a party seeking equity “must
come with clean hands.” As such, the Court would be sanctioning an “inequitable result”
if benefit to party whose conduct forced other party to breach contract); piercing denied.
C. LLC Dissolution
1. Dissociation v. Dissolution
Similar to RUPA – Dissociation events [§601] result in withdrawal or expulsion of members, but
not necessarily to winding up of LLC. Dissolution events [§801] result in winding up of LLC.
Dissociated member’s interest must be purchased by LLC [§701]
(1) Judicial appraisal proceeding available [§702]
Member’s right to participate in LLC management terminates upon dissociation [§603(b)(1)].
(1) Exception: participation in a post-dissolution winding up process [§603(b)(2)]
New Horizons Supply Cooperative v. Haack, (WI 1999) (Failure to Follow Dissolution
Rules)
Liquidation distributions are subject to reclamation by creditors if LLC not
properly dissolved.
Facts
(1) Brother and sister form LLC freight company.
(2) LLC collapses in debt; brother disappears.
(3) Brother & Sister did not observe formalities of LLC and few records were
available and admitted into evidence.
(4) LLC was treated as a partnership for tax return purposes
(5) TC used this fact as basis for piercing LLC veil
Key Points
(1) Tax treatment not proper basis for piercing LLC veil
(2) Failure to observe LLC dissolution rules subjects members to liability for LLC
debts
Conclusion
D. Duty of Care
1. BJR and Fiduciary Duties
Business Judgment Rule (BJR) – Absent fraud, illegality or conflict of interest, the board’s
business judgment is not second guessed by the court.
So, the court defers to the BoD’s decisions, unless:
Directors breach their Duty of Loyalty, because their decision is tainted by fraud, illegality, or
conflict of interest.
(1) We have seen this in Agency & Partnership
(2) We are looking for conflicts of interest.
Directors breach their Duty of Care, because they do not conduct sufficient investigation or
deliberation to make a business judgment.
(1) Applies to directors, officers, and – in certain cases -- dominant shareholders
(2) Similar to a negligence action; it is an allegation of shirking by those with the duty
of care
Directors are liable for Waste of Assets, the flip side of which is the Business Judgment Rule;if
they do something egregious enough that a Court would believe faild the BJR.
(1) Jay spots an apartment building that he expects will rise significantly in value. At
current rent levels, renting the apartments will yield $90,000/year. Jay plans to
get a mortgage, buy the building and rent the rooms, then pay the interest on the
mortgage from the rent income.
(2) Suppose that Jay can get a mortgage at 10% interest. How much money can he
borrow, if he uses the rent income (and only it) to pay the interest on the
mortgage?
(3) Jay adds $100K of his own money, and buys the building for $1M.
Risk & Reward in an LBO
(1) Suppose the value of the building goes up 10%:
(a) Jay sells house for $1.1 M
(b) Jay pays $900K debt
(c) Jay keeps $200K.
(d) His investment (the amount of his own money he risked) was $100K.
(e) His RoR: +100%
(f) Investment up 10%; Jay’s profits up 100%.
(2) Suppose the value of the building goes down 10%:
(a) Jay sells house for $900K
(b) Jay pays $900K debt
(c) Jay is left with nothing.
(d) His investment (the amount of his own money he risked) was $100K.
(e) His RoR: -100%
(f) Investment down 10%; Jay’s profits down 100%.
Leveraged Buyout (LBO) The Business Structure of the Deal
(1) Hypo: Jay (Pritzker) spots Trans Union, a company he expects will rise
significantly in value. TU’s annual profits are $90,000. TU has 20,000 shares
outstanding. Jay plans to get a loan, buy all of TU’s shares and pay the interest
on the loan from TU’s profits.
(2) Suppose that Jay can get a loan at 10% interest. How much money can he
borrow, if he uses TU’s income (and only it) to pay the interest on the loan?
(3) To make his offer more attractive, Jay adds $200K of his own money, for a total
purchase price of $1.1M. He offers to purchase TU shares at $55
($1.1M/20,000).
(4) Hypo is similar to calculations Romans made in Van Gorkom
(a) At $50/share – easy to finance LBO
(b) At $60/share – hard to finance LBO
(c) Van Gorkom splits the difference: “I’d take $55”. Does this reflect TU’s
value?
Value of the Firm
(1) TU’s shares were selling at the time for $38/share. Pritzker agreed to buy the
shares for $55 (~45% premium).
(2) Why isn’t the market price accepted as an indicator of the firm’s true value? Is
there something Pritzker would get in a buyout that he won’t get by buying
shares on the market?
(3) Market price of shares assumes buyer purchases one share. If buyer purchases
a large number of shares, price will move upwards.
(4) The value of a share is composes of two parts: Economic rights (rights to
dividends and Corp’s assets in dissolution), and Voting rights (rights to control
the company). A single share’s voting rights are usually worth close to zero.
(5) Acme has 100 shares outstanding. Alice holds 51, and Becky holds 49. What’s
the value of Becky’s voting rights? Is this unfair to Becky?
(6) Market price usually reflects only economic rights, since you can’t get control by
buying a single share. Exception: Control fights – when a large number of
shares are acquired in the market, price rises to reflect control premium.
SH Pritzker SH Pritzker
to other bidders (the board claimed it rejected the latter demand). What effect do
these demands have?
(a) Pritzker also tells Van Gorkom he “would serve as a ‘stalking horse’ for an
‘auction contest’” only if TU agrees to sell to Pritzker 1.75M shares [later
negotiated down to 1M shares] at current market price [$38], which he may
sell to third parties.
(b) Does P profit from this if someone else makes a higher bid? Does P profit
from the reduced price shares if his bid wins?
(c) Why did Romans say this “would inhibit other offers”?
(d) If another bidder wins, P receives a value of $17M [$55-38 x 1M shares] from
TU, reducing TU’s value by $17M. For P the reduced price shares don’t
change the valuation – he buys his own reduced price shares. P could
therefore offer up to $17M more than a rival that values TU the same.
Knowing P’s advantage, others may be reluctant to bid.
August-September: Internal Management Discussions
(1) Sept. 13-19: Van Gorkom negotiates with Pritzker an agreement under which
Pritzker would buy TU in a Leveraged Buyout (LBO).
(2) Sept. 20: Senior management meeting.
(3) Senior management’s reaction: Very hostile. Why?
(4) Sept. 20: TU BoD approves merger after a two-hour meeting.
Smith v. Van Gorkom What Should the Board Have Done?
(1) Attempt to investigate what TU is worth specifically to P
(a) Board expected to get best possible price, not just ‘fair price’.
(2) More supervision and control of the CEO
(a) Examine: valuation, course of negotiations, review actual contract.
(b) Both the Sept. 20 and Oct. 8 approvals were done based on representations
of VG and other senior management. Very little documentation or outside
support.
(c) DGCL §141(e) provides a defense for directors who rely on reports from
officers. Why didn’t this section apply here?
(i) Board has duty to inquire – can’t rely solely on CEO’s representations.
(d) Problem is particularly severe since VG is about to retire (endgame problem).
(3) Consult with experts
(a) Romans, who prepared the feasibility study, didn’t regularly do such studies.
But how independent are the ‘experts’?
(b) TU hired Salomon Brothers (an investment banker) to find better offers, and
Solomon Bros. found only one possible buyer (GE Credit), who conditioned
its bid on rescinding TU’s agreement with P (P refused this).
(4) Judge McNeilly did not find these shortcomings convincing, and dissented. What
were his reasons?
August-September: Internal Management Discussions
(1) Sept. 13-19: Van Gorkom negotiates with Pritzker an agreement under which
Pritzker would buy TU in a Leveraged Buyout (LBO).
(2) Sept. 20: Senior management meeting.
(3) Sept. 20: TU BoD approves merger after a two-hour meeting.
(4) Van Gorkom signs agreement w/ Pritzker during a party at the Opera House.
(5) Oct. 8: TU BoD approves revised deal (conceding to senior management)
(6) Oct. 10: P adds in revised deal limitations on TU’s ability to shop. VG signs.
(7) Oct. 21-Jan. 21: Salomon Bros. try to find alternative suitor; find one candidate
(GE Credit), who later withdraws.
(8) Early December: KKR, the only other concern to make a firm offer for TU,
withdraws its offer.
(9) Feb. 10: TU’s SH approve merger by 69.9% to 7.25% (22.85% abstain).
(10)Why didn’t court see this as ratifying the directors’ decision (and as an indicator
(1) Trans Union’s management seems to have cash that they can invest, but cannot
find an investment that is good enough. What can they do with the spare cash?
(a) Buy other businesses (or enter new line of business)
(i) But TU’s BoD could not find good investments.
(b) Sell the firm to someone who can better use the cash (and tax credits).
(i) This is what Van Gorkom and TU’s board opted for.
(c) Pay spare money to SH as dividends.
(i) Repurchase stock with the spare cash.
A Note on Smith v. Van Gorkom Dividends and Repurchases
(1) Acme has assets and goodwill worth $100, and $100 in cash (so its total value is
$200). It has 100 shares outstanding. Jim owns 5 shares. How much is each
share worth? How much is Jim’s interest in Acme worth?
(2) Alternative (a): Acme pays $100 in dividends.
(a) After dividend payment, Acme is worth $100. There are still 100 shares
outstanding. How much is each share worth now?
(b) How much are Jim’s shares worth? How much did he receive in dividends?
What’s the total of the two?
(3) Alternative (b): Acme uses the $100 to repurchase its shares.
(4) What’s the share price? How many shares can it purchase? How many shares
left?
(5) After repurchasing shares, Acme is worth $100 (repurchased shares have zero
value to Acme). How much is each share worth now? If Jim still has 5 shares,
how much is their total worth?
(6) Conclusion – Repurchases and dividends do not change SH wealth (this point
was made by Modigliani & Miller). Exceptions include:
(7) Tax considerations
(8) SH and Corp. have different RoR on investments.
Legislative Response to Smith and Van Gorkum 1/21/2005
(1) P. 338 Delaware Legislature enacts Del.Gen.Corp.Law § 102(b)(7) which allows
any Delaware corp. to limit its director liability by adding such limits to its
certificate of incorporation except in instances of:
(a) Breach of Loyalty
(b) Bad faith or illegal acts
(c) § 174 violations of dividend policy
(d) Self-dealing
(2) So, after § 102(b)(7) can there still be a duty of care in Delaware? Yes, because
even if the company does impose this limitiations, you can still be on the hook if
your duty of care breach involves a breach of the duty of loyalty.
Defenses to Breach of Duty of Loyalty (Knipprath)
Disclosure and approval of Board
Brehm v. Eisner
Facts:
(1) Disney BoD hires Ovitz as President
(2) Salary of $1M + bonus + stock options on 5M shares.
(3) In the event of non-fault termination:
(4) Discounted present value of 5 years’ salary
(5) $10 million severance payment
(6) Immediate vesting of options on 3M shares.
(7) Total value: $140M
(8) Ovitz was non-fault terminated after 14 months
(9) Actions by Ovitz could have been construed as de facto resignation or
termination for fault, but Disney did not try to argue this.
Brehm alleges:
(1) Old BoD violated duty of care & committed corporate waste when it approved the
compensation package.
(2) New BoD violated duty of care & committed corporate waste when it approved
non-fault termination.
(3) Court affirms dismissal of allegations.
Brehm v. Eisner Can Courts Consider BoD’s Decision Substantively?
(1) Corporate Waste: A transaction “that is so one-sided that no business person of
ordinary, sound judgment could conclude that the corporation has received
adequate consideration.” Does the court consider the substance of the BoD’s
decision to determine whether it indicates ordinary, sound judgment?
(2) Brehm court answers “no”. It considers “process due care” only. This is similar
to Shlensky v. Wrigley, where Shlensky was not permitted to present evidence of
Wrigley’s lack of concern to SH interests.
(3) In another Delaware decision, Technicolor, the court states that directors who
violate their duty of care do not get the protections of the BJR, and that the BJR
is rebutted by a showing that directors violated their fiduciary duty of “due care”.
This may indicate authority of the court to assess substantive due care.
What’s the big deal in limiting substantive review?
(1) If the court gets to second guess the substance of BoD’s decision, BoD loses its
authority to the court, resulting either in decentralized management, or in
management of the corporation by the court.
(2) Harder for SH to predict quality of random judge’s business judgment than that of
the directors they elected (compare to limited scope of suit in Page v. Page).
(3) Directors can plan their actions to comply with procedural standards, but can’t
predict (and accommodate) a random judge’s substantive business judgment.
Brehm sets ‘irrationality’ as the ‘outer limit’ of the BJR.
(1) “Irrationality” may be an exception allowing substantive review; or
(2) “Irrationality” may be a proxy for conflict of interests.
6. Directors’ Duty to Monitor Compliance with Law & The Sarbanes-Oxley Act
Following Enron and other recent financial scandals, Congress passed the Sarbanes-Oxley Act,
which:
(1) Makes it easier to prosecute securities fraud;
(2) Imposes greater responsibility on senior management and directors (mainly
independent directors and audit committee members), by requiring them to take
a substantially more proactive role in overseeing and monitoring the financial
reporting process.
(3) No change to common law duty of care, but increased civil and criminal
enforcement authority over conduct of corporate officers/directors will very likely
increase potential liability.
We can expect increased litigation (and possibly expansion of director duties) regarding
compliance with S-Ox Act and similar laws.
F. Duty of Loyalty
1. Directors and Managers
The duty of loyalty requires a fiduciary to act in the best interest of the corporation and in
good faith. Knipprath emphasizes that the BoD’s owes its duty to the corporation, not to the
individual SH. It usually focuses on situations in which the fiduciary has a conflict of
interest with the corporation, suggesting that personal interests may be advanced over
corporate interests. While the duty of care involves poor decision-making or lack of attention,
but no personal benefit, the duty of loyalty seeks to prevent directors from acting in such a
way as to reap a personal benefit unavailable to other shareholders. Such self-dealing raises
the specter of corruption and personal profit at the expense of shareholders.
In order to prove a breach, must show a prima facie conflict of interest. When the duty of
loyalty applies, there is a duty of complete candor. There is also greater judicial scrutiny
of both the fairness of the process and the substance of the decision. The business judgment
rule and its presumption that the directors acted in the best interests of the corporation does
not apply. The burden of proof shifts to the directors to demonstrate the transaction’s
good faith and inherent fairness to the corporation (Bayer v. Beran).
N.B.: A more modern version of the test of intrinsic fairness is the entire fairness standard
(1994, Kahn v. Lynch Communications). The entire fairness standard requires
(1) fair dealing (manner in which the transaction is negotiated),
(2) fair price and
(3) shift of the burden of proof.
The classic duty of loyalty defendant is a fiduciary who contracts or transacts with her
own corporation, receiving a benefit that is not equally shared with the other shareholders.
Examples:
• An officer or director sells personal property to the corporation
• a fiduciary’s corporation contracts with another corporation or business entity in which the
fiduciary has a significant financial interest (e.g.: corp. A sells property to corp. B and a
director of A is the controlling shareholder of B)
• two corporations have common directors (interlocking directors), even if there is no
significant financial interest in either
• a parent corporations contracts with its subsidiaries, that it controls, and there are other
shareholders in the subsidiaries
Following the duty of loyalty standard, courts in these cases generally focus on the fairness of
the process and substance of the transaction. Generally, the process requires full disclosure
and approval by either disinterested directors or shareholders. The contract itself needs to
be fair, and the burden of proof will be placed on the fiduciary. Therefore, the fiduciary
must prove that he bargained with the corporation at arm’s length. Some cases suggest that
lack of disclosure alone is a grounds for voiding a contract without regard to its fairness.
Employees owe a duty of loyalty to their employers; can’t steal office supplies. Knipprath
says that full disclosure and Board approval are the ways to defend against breach of duty of
loyalty. If you don’t fully disclose, then you have to show that the company could not have
availed itself of the opportunity. That is a tough case to argue.
Courts sometimes look at the fairness of the transaction. Procedural fairness, substantive
fairness, combined fairness. It varies by jurisdiction. Procedural fairness looks to full and fair
disclosure. The substantive fairness looks to fairness to the corporation. Could the
corporation have taken advantage of the opportunity? Conflict of interest between an officer’s
position in companies (making a deal that’s good for one and not the other and he is an
officer of both); or where the directors are setting their own compensation. Did they act fairly
compared to the market, other similar companies, etc.?
Fairness test is sometimes used to see if the duty of loyalty has been breached through
either conflict of interest, or self-dealing. Same crap in agency and partnership.
Common to have family members fighting with each other.This case came up after many
years because the π didn’t realize his losses until he tried to cash out his shares.
G. Corporate Opportunity
4/16/2004 1/14/2005 If an investment opportunity is viewed as belonging to the corporation (i.
e. a corporate opportunity), the corporation should be given the opportunity to invest in it. A
director may not take advantage of a corporate opportunity. Similar to the loyalty concept in
Meinhard v. Salmon and GM v. Singer. Although, Cardozo would not have viewed simply
informing the others as sufficient expression of loyalty. Usurping a corporate opportunity.
Usually this applies to officers & directors.
and purchases from Sinven. The court held that self-dealing in the parent-subsidiary
setting required, like in all other cases of interested transactions, exclusion (i. e. the
parent receives a benefit not received by the minority through the contract) and an
additional showing of detriment (which was here the breach of contract). Therefore, in
the parent-subsidiary context, plaintiff must show both exclusion and detriment before the
intrinsic fairness standard applies.
H. Ratification
Fliegler v. Lawrence (Del. SC 1976) p. 396
Ratification of an interested transaction by a majority of independent, fully
informed s/h shifts the burden of proof to the objecting shareholder to
demonstrate that the terms of the transaction are so unequal as to amount
to a gift or a waste of corporate assets, i.e. that the transaction was
intrinsically unfair.
Del. C. § 144:
(a) No contract or transaction between a corporation and 1 or more of its directors or
officers, or (…), shall be void or voidable solely for this reason, or solely because the
director or officer is present at or participates in the meeting of the board or
committee which authorizes the contract or transaction, or solely because his or their
votes are counted for such purpose, if:
(1) The material facts as to his relationship or interest and as to the contract
or transaction are disclosed or are known to the board of directors or the
committee, and the board of directors or committee in good faith authorizes the
contract or transaction by the affirmative votes of the disinterested directors,
even though the disinterested directors be less than a quorum; or
(2) The material facts as to his relationship or interest and as to the contract
or transaction are disclosed or are known to the shareholders entitled to vote
thereon, and the contract or transaction is specifically approved in good faith by
vote of the shareholders; or
“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,
1) To employ any device, scheme, or artifice to defraud,
2) 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
3) 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”.
General comments:
Courts have recognized a private right of action under § 10(b) of the Exchange Act and Rule
10b-5.
§ 10(b) applies to any security, including securities of closely held corporations not subject to the
Exchange Act.
The Supreme Court has held in Central Bank of Denver v. First Interstate Bank (1994) that there
was no implied right of action against those who aid and abet violations of Rule 10b-5.
1. Standing
However, the plaintiff need not be in any relationship of privity with the defendant
charged with misrepresentation. There is no obligation to disclose under § 10(b)
so long as insiders stay out of the market, but if they choose to speak, they are
not free to lie. There is no need under § 10(b) to show some special relationship
of trust and confidence to establish standing
2. Materiality
There can be liability under 10b-5 only if there is non-disclosure or misrepresentation of material
facts.
Thus, materiality depends on the significance the reasonable investor would place on the
withheld or misrepresented information.
J. Duty of Care
1. Standard of Care
The courts, in determining liability, will distinguish between inside and outside
directors. Inside directors are held to a higher standard of care, because they are more
involved and aware of the business. Moreover, the distinction is often justified by the
need to attract outside directors who would be unwilling to serve if their liability were the
same as that of inside directors.
Generally, breach of duty of care can occur in two different situations: when the directors
have acted in a negligent manner (i. e. malfeasance) and where is a failure to act when a
loss could have been prevented (i. e. nonfeasance)
Knipprath says that the standard may vary based on responsibilities. Which is pretty
much what I already said. Trustee distinguished from a director; different fiduciary duties.
Shareholders want directors to make decisions and take risks to produce gain even
though mistakes may lose money. If the directors would be liable for every imprudent or
mistaken decision, they would become overly cautious, resulting in reduced shareholder
value. Shareholder undertake the risks of bad business judgments by buying shares as
opposed to other less risky investments. In addition, after the fact litigation cannot replace
the situation that took place when the decision was made. Therefore, liability is rarely
imposed upon corporate directors or officers simply for bad judgment and this reluctance
to impose liability for unsuccessful business decisions has been doctrinally labeled as the
Business Judgment Rule (Joy v. North, 2nd Cir.1981). In a purely business corporation
the authority of the directors in the conduct of the business of the corporation must be
regarded as absolute when they act within the law, and the court is without authority to
substitute its judgment for that of the directors (Shlensky v. Wrigley, Ill App. 1968).
Knipprath says director will argue: (a) good faith; (b) reasonable investigation.
The business judgment rule only applies to malfeasance (i. e. when directors are
accused of violating their duty of care by making a negligent or ill advised decision), not
to nonfeasance cases (i. e. when there is a failure to act when a loss could have been
prevented).
In malfeasance cases, the duty of care sets the standard of conduct while the
business judgment rule limits judicial inquiry into business decisions and protects
directors who are not negligent in the decision making process. Under the rule
the courts will only examine whether the director acted negligently in the decision
making process, i. e. whether they acted on an informed basis. Delaware courts
have suggested that gross negligence is the appropriate standard in
determining whether a business judgment was an informed one. Under the rule,
courts will not review the outcome of the decision, even if it is a wrong or poor
decision. In Delaware, the business judgment rule provides a presumption that in
making a decision directors were informed, acted in good faith and honestly
believed that the decision was in the best interests of the corporation. The party
attacking a directorial decision as uninformed must rebut the presumption that its
business judgment was an informed one (Smith v. Van Gorkom), or that the
business judgment rule does not apply. However, once the presumption is
rebutted, the burden shifts to the defendant to prove entire fairness, and a duty of
loyalty standard is applied (Cinerama v. Technicolor)
significant tax benefit (8 mill USD) to the corporation because the loss could have
been used to offset other taxable gains.
In Kamin, the court found no self dealing and it held that dividend decisions are
normally business decisions left to the board. The board was not negligent in
making its decision because it had acted in an informed manner after due
consideration of the alternatives. Even if the decision was imprudent or mistaken
that is not what is important since a breach of duty of care focuses on neglect of
duty, not on the decision itself.
3. . Causation
If a director has acted negligently, this does not end the inquiry, because for
there to be liability, the negligence must be the proximate cause of the loss. The
plaintiff usually has the burden of proof and must show the amount of loss or
damages caused by the negligence.
Finding such a link between damages and loss is particularly difficult in
nonfeasance cases, because there are no actual actions to relate to the losses.
Therefore, the plaintiff must prove that if the director had done her duty there
would not be damage. Since there cannot be certainty about what would have
occurred if the director had acted diligently, the standard is whether it is
reasonable to conclude that the failure to act would have produced a particular
result. Thus, in nonfeasance cases, courts first have to determine the reasonable
steps a diligent director would have taken, and thereafter, whether theses steps,
as a matter of common sense, would have prevented the damage caused to the
defendant. In Francis, the court found that directors can have a duty to stop the
wrongdoing of other management members, including the duty to hire an
attorney and sue them (note: Francis was a case involving a trust-like business
with heightened fiduciary duties).
However, also in malfeasance cases loss causation is difficult to prove.
Generally, the plaintiff carries the burden of proof. In Cinerama however, the
Delaware Supreme Court held that proof of injury by the plaintiff is unnecessary
once the business judgment rule is rebutted, because then the burden of proving
entire fairness would shift to the defendant. Therefore, he would also have to
prove that there was no loss caused to the plaintiff by his negligent behavior.
K. Duty of Loyalty
The duty of loyalty requires a fiduciary to act in the best interest of the corporation and in
good faith. It usually focuses on situations in which the fiduciary has a conflict of
interest with the corporation, suggesting that personal interests may be advanced over
corporate interests. While the duty of care involves poor decision-making or lack of
attention, but no personal benefit, the duty of loyalty seeks to prevent directors from
acting in such a way as to reap a personal benefit unavailable to other shareholders.
Such self-dealing raises the specter of corruption and personal profit at the expense of
shareholders.
When the duty of loyalty applies, there is a duty of complete candor. There is also
greater judicial scrutiny of both the fairness of the process and the substance of the
decision. The business judgment rule and its presumption that the directors acted in the
best interests of the corporation does not apply. The burden of proof shifts to the
directors to demonstrate the transaction’s good faith and inherent fairness to the
corporation (Bayer v. Beran).
N.B.: A more modern version of the test of intrinsic fairness is the entire fairness
standard (1994, Kahn v. Lynch Communications). The entire fairness standard
requires (1) fair dealing (manner in which the transaction is negotiated), (2) fair
price and (3) shift of the burden of proof.
The classic duty of loyalty defendant is a fiduciary who contracts or transacts with her
own corporation, receiving a benefit that is not equally shared with the other
shareholders.
Examples:
o An officer or director sells personal property to the corporation
o a fiduciary’s corporation contracts with another corporation or business entity in
which the fiduciary has a significant financial interest (e.g.: corp. A sells property
to corp. B and a director of A is the controlling shareholder of B)
o two corporations have common directors (interlocking directors), even if there is
no significant financial interest in either
o a parent corporations contracts with its subsidiaries, that it controls, and there are
other shareholders in the subsidiaries
Following the duty of loyalty standard, courts in these cases generally focus on the
fairness of the process and substance of the transaction. Generally, the process requires
full disclosure and approval by either disinterested directors or shareholders. The
contract itself needs to be fair, and the burden of proof will be placed on the
fiduciary. Therefore, the fiduciary must prove that he bargained with the corporation at
arm’s length. Some cases suggest that lack of disclosure alone is a grounds for voiding
a contract without regard to its fairness.
Generally, shareholders are expected and allowed to act according to their self-interest.
However, a shareholder who controls the corporations, because of the potential abuse of
the corporation, owes a fiduciary duty to the minority shareholders. A controlling
shareholder is expected to act fairly in a manner that will not exploit or oppress the
minority. (see more below: “Problems of Control”)
voting rights. AF owned leaf tobacco that was listed in its books with a value of $
6 million, but in fact was worth about $ 20 million. Transamerica had acquired a
majority of stock in AF and controlled its board of directors. Transamerica then
decided that it would acquire the tobacco by having the board eliminate the Class
A shares by having them redeemed. It would then liquidate AF and appropriate
the tobacco. There was no disclosure of this plan to the Class A shareholders.
The court held that there was a breach of the duty of loyalty by
Transamerica, because it was not only acting as shareholder, but through its
control of AF’s directors. Directors must act for the benefit of all, not just
some shareholders. Controlling shareholders may not use their control to self-
deal with assets of the corporation.
The directors were under a duty to disclose their plans to the Class A
shareholders and let them decide if they wanted to accept the redeem-offer or
convert their shares into Class B, and participate in the liquidation of the
corporation. The appropriate remedy was, therefore, to have them shared in the
liquidation value 1/1 (i. e. treat them as if they had converted into Class B).
1. Executive Compensation
2. Corporate Opportunity
Corporate Opportunity:
6. Del. C. § 144:
(b) No contract or transaction between a corporation and 1 or more of its
directors or officers, or (…), shall be void or voidable solely for this reason, or
solely because the director or officer is present at or participates in the
meeting of the board or committee which authorizes the contract or
transaction, or solely because his or their votes are counted for such
purpose, if:
(4) The material facts as to his relationship or interest and as to the
contract or transaction are disclosed or are known to the board of
directors or the committee, and the board of directors or committee in
good faith authorizes the contract or transaction by the affirmative votes
of the disinterested directors, even though the disinterested directors be
less than a quorum; or
(5) The material facts as to his relationship or interest and as to the
contract or transaction are disclosed or are known to the shareholders
entitled to vote thereon, and the contract or transaction is specifically
approved in good faith by vote of the shareholders; or
(6) The contract or transaction is fair as to the corporation as of the
time it is authorized, approved or ratified, by the board of directors, a
committee, or the shareholders.
Issues:
• The transaction can be void or voidable because of reasons, other than
the breach of the duty or loyalty.
Courts have interpreted § 144(a)2 in the sense that the approving
shareholders have to the disinterested (Flieger v. Lawrence (Del. SC 1976) p.
77
• The disclosure to disinterested directors [§ 144(a)1] or disinterested
shareholders [§ 144(a)2] will shift the burden of proof to the plaintiff and sets
the standard on BJR, limiting judicial review to issues of gift or waste (In re
Wheelabrator Technologies, Del. Ch. 1995, p. 385).
• If there is no disclosure of the material facts of the conflict of interest the
burden of proof will be on the defendant and the standard will be entire
fairness.
There is a tension between the judicial hands off approach reflected by the business judgment
rule and the extensive judicial scrutiny of a fairness enquiry. Thus, Delaware courts have
developed an intermediate standard (proportionality test) in reviewing directors’ defensive tactics
against a hostile tender offer, recognizing that battles for control involve both important business
decisions as well as possible conflicts of interest by directors protecting their positions.
N. Prüfungsaufbau
A. Definition of a Security
“The term “security” means any note, stock, treasury stock, bond, debenture, evidence of
indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-
trust certificate, preorganization certificate or subscription, transferable share, investment
contract, voting- trust certificate, certificate of deposit for a security, fractional undivided interest in
oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security,
certificate of deposit, or group or index of securities (including any interest therein or based on the
value thereof), or any put, call, straddle, option, or privilege entered into on a national securities
exchange relating to foreign currency, or, in general, any interest or instrument commonly known
as a “security”, or any certificate of interest or participation in, temporary or interim certificate for,
receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing”.
Requires with very few exceptions all publicly traded companies to register their securities with
the SEC. Part of that registration is a prospectus.
Many people don’t read them b/c they are long and boring and full of boilerplate language
disclosing risks.
The company is selling security which is a piece of paper representing an ownership interest in
the enterprise. It is different from a partnership agreement b/c shareholders or security holders
don’t have a management role in the company.
Howey Test – how much control do you have? This will tell us if it is a security.
Landreth – stock is automatically a security
It is tough to tell if it is a security if there is no writing.
Was it disclosed.
2. Investment Contract
The Supreme Court has interpreted it broadly to reach “novel, uncommon or irregular devices,
whatever they appear to be”.
“A general partnership or joint venture interest can be designated a security if the investor
can establish, for example, that
(i) An agreement among the parties leaves so little power in the hands of partner or
venturer that the arrangement in fat distributes power as would a limited
partnership; or
(ii) The partner or venturer is so inexperienced and unknowledgeable in business
affairs that he is incapable of intelligently exercising his partnership or venture
powers; or
(iii) The partner or venturer is so dependent on some unique entrepreneurial or
managerial ability of the promoter or manager that he cannot replace the
manager of the enterprise or otherwise exercise meaningful partnership or
venture powers.”
In determining whether the investors relied on the efforts of others, we look not only to the
partnership agreement itself, but also to other documents structuring the investment, to
promotional materials, to oral representations made by the promoters at the time of the
investment and to the practical possibility of the investors exercising the powers they
possessed pursuant to the partnership agreement.
3. Options
B. Registration process
(a) Unless a registration statement is in effect as to a security, it shall be unlawful for any
person, directly or indirectly—
(1) to make use of any means or instruments of transportation or communication in
interstate commerce or of the mails to sell such security through the use or medium
of any prospectus or otherwise; or
(2) to carry or cause to be carried through the mails or in interstate commerce, by any
means or instruments of transportation, any such security for the purpose of sale or
for delivery after sale.
(b) It shall be unlawful for any person, directly or indirectly—
(1) to make use of any means or instruments of transportation or communication in
interstate commerce or of the mails to carry or transmit any prospectus relating to
any security with respect to which a registration statement has been filed under
this title, unless such prospectus meets the requirements of section 10; or
(2) to carry or cause to be carried through the mails or in interstate commerce any such
security for the purpose of sale or for delivery after sale, unless accompanied or
preceded by a prospectus that meets the requirements of subsection (a) of section
10.
I It shall be unlawful for any person, directly or indirectly, to make use of any means or
instruments of transportation or communication in interstate commerce or of the mails to offer to
sell or offer to buy through the use or medium of any prospectus or otherwise any security,
unless a registration statement has been filed as to such security, or while the registration
statement is the subject of a refusal order or stop order or (prior to the effective date of the
registration statement) any public proceeding or examination under section 8.
The Securities Act prohibits under § 5, the sale of securities unless the company issuing the
securities has registered them with the SEC.
§ 5 imposes 3 basic rules:
- a security may not be offered for sale through the mails or by use of other means of interstate
commerce unless a registration statement has been filed with the SEC;
- securities may not be sold until the registration statement has become effective;
- a prospectus (disclosure document) must be delivered to the purchaser before a sale.
The issuers can use these safe harbors to come within the private-placement exemption and
avoid or reduce their required disclosure.
♦ Rule 504: if an issuer raises no more than $1 million through the securities, it may sell them
to an unlimited number of buyers without registering them.
♦ Rule 505: if an issuer raises no more than $5 million through the securities, it may sell them
to 35 buyers without registering them.
♦ Rule 506: if an issuer raises more than $5 million through the securities, it may sell them to
no more than 35 buyers without registering them, and each buyer must pass
various tests of financial sophistication. The limits on the number of buyers do
not apply to accredited investors (banks, brokers, wealthy buyers).
♦ Rule 144: the buyer may resell stock he acquired in a Regulation D offering if he first holds
if for 2 years and then resell it in limited volumes.
COMMENT: Regulation D and §4(2) exempt only the initial sale. So most buyers can resell
the securities only if they find another exemption.
BUT 504 may allow a public distribution; public advertising, no restriction on resale. As long as
<$1mm.
1. 1. Section 11
Amy Says:
Escott v. Barchris Construction Co. (pg457)—Bowling alley builder went bankrupt.
33 ACT §11--A false or misleading statement must be material under Section 11. “Matters which
the average prudent investor out to reasonably be informed” about.
The errors on the balance sheet are an example of material false statements.
EDITOR'S ANALYSIS: To successfully assert the due diligence defense under $ 11, newly
elected directors and outside counsel cannot rely on corporate officers and directors as to the
accuracy of statements. They must conduct a reasonable investigation of the accuracy of these
statements. These may include reviewing corporate documents and speaking with employees.
QUICKNOTES
DEBENTURES - Long-term unsecured debt securit~es ~ssued by a corporation
DUE DILIGENCE - The standard of care as would be laken by a reasonable person n accordance w~th the attendant
facts and crcumstances
MATERIALITY - Importance thedegreeof relevance or necess~ty tothe partcular matter
SECURITIES ACT tj 11 - Makes t mlawful to make untrue statements In reg~stration statements
2. Section 12(a)(1)
It imposes strict liability on sellers of securities for offers or sales made in violation of § 5,
i. e. when the sellers improperly fails to register the securities, to deliver a statutory prospectus,
violates the gun-jumping rule. The term seller also encompasses persons who successfully solicit
offers to purchase securities motivated at least in part by a desire to serve their own financial
interests or for those of the securities’ owner. Main remedy: rescission, unless the buyer is no
longer the owner of the securities then damages.
3. Section 12(a)(2)
It is a general civil liability provision for fraud and misrepresentation. Liability under this
section may be imposed where defendant made oral statements, used written selling materials
containing a material misrepresentation or omission. Liability may generally also be imposed in
exempt offerings, but after Gustafson only if the sale occurred in a public offering, i. e not in
secondary market nor privately negotiated transactions. Liability is limited to the seller of a
security (like § 12(a)(1)).
“It shall be unlawful for any person, directly or indirectly, by the use of any means or
instrumentality of interstate commerce, or of the mails or of any facility of any national securities
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”.
General comments:
Courts have recognized a private right of action under § 10(b) of the Exchange Act and Rule
10b-5.
§ 10(b) applies to any security, including securities of closely held corporations not subject to the
Exchange Act.
The Supreme Court has held in Central Bank of Denver v. First Interstate Bank (1994) that there
was no implied right of action against those who aid and abet violations of Rule 10b-5.
§10b of the 1934 Act authorizes SEC Rule 10(b)(5) Omnibus Fraud Provision.
§16b is another rule we will cover – short swing trades. (Insider trading).
Elements of 10(b)(5)
1. Need a Statement or Omission
2. In connection to purch or sale of a security
3. With 4 provisos:
a. Stmt is material
b. Scienter
c. Causation
d. Reliance
1. Standing
2. Materiality
There can be liability under 10b-5 only if there is non-disclosure or misrepresentation of material
facts.
Thus, materiality depends on the significance the reasonable investor would place on the
withheld or misrepresented information.
What is material? Is a key person leaving? Is your key person 90 years old? Usually the
disclosures are very thorough; they try to include every possible risk.
Epstein example: disclosure for acquisition; he discovered underground storage tanks that had
not been disclosed. Too much liability; due diligence led him to kill the deal.
If they still wanted to do the deal, then he would have to disclose everything. Like “this deal could
put us out of business”
No one cares whether it’s a good deal; it’s all about the disclosure. CYA through disclosure.
Risk disclosure under the ’33 Act is a negligence standard; written in reaction to widespread
corporate malfeasance.
The government will regulate the disclosure, but not the risk. No matter how crappy your
business plan, if you disclose everything, you’re OK.
S1 Registration Statement is most common registration form under ’33 Act. If the company is
deemed to be selling securities, and they did not make these disclosures, then they are liable
under the Act.
3. Manipulation or Deception
The claim of fraud and fiduciary breach states a cause of action under any part of rule 10b-5 only
if the conduct alleged can be fairly viewed as “manipulative or deceptive”.
to ∆ FMV was $125 per share but π ’s insist that it’s $775 per share. π ’s say
that there are all kinds of factors that could lead to a much higher analysis.
This is not fraud; there is a system here and the corporation followed it. If you
don’t like our valuation, go get your own appraisal. No manipulation or deception
involved.
Hypo #2 p 472: What if they used a short form merger but issued a misleading
statement to the minority shareholders? Epstein: What would it cause the
minority shareholders to do? They could not claim that it caused them to do the
transaction, but they might argue that the misleading statement caused them to
not get a separate appraisal as was their right under state law. Remember
Robert F. Broz: minority shareholders can be a real pain in the neck.
N.B.:
The philosophy of the Act is full disclosure, and the court is reluctant to recognize a cause of
action to serve at best a subsidiary purpose, i.e. fairness.
The Delaware Legislature has supplied minority shareholders with a cause of action in the
Delaware Court of Chancery to recover the fair value of the shares allegedly undervalued in a
short-form merger.
Corporations are creatures of state law, and investors commit their funds to corporate directors
on the understanding that, except where federal law expressly requires certain responsibilities of
directors with respect to stockholders, state law will govern the internal affairs of the corporation.
Congress by § 10(b) did not seek to regulate transactions, which constitute no more than internal
corporate mismanagement.
Non-disclosure is usually essential to the success of a manipulative scheme.
5. Causation
Two types of causation:
Transaction causation: But for the misrepresentation, plaintiff would not have
purchased (or sold) the securities.
This is closely related to the reliance element. When reliance is presumed,
courts would also assume transaction causation. E.g.:
Omissions [Litton v. Lehman Bros.];
Fraud on the Market.
Loss causation: The misrepresentation caused the loss.
Courts do not presume loss causation.
Examples of reasons for lack of loss causation:
Market did not believe the misrepresentation;
Market price changed due to general stock market trends [e.g., Fed raises or
decreases the interest rate].
6. Scienter
Mere negligence is not enough. To establish a claim for damages under Rule 10b-5, it must be
proven that the defendant acted with scienter
“Scienter”: A mental state consisting in an intent to deceive, manipulate or defraud.
Recklessness is generally sufficient.
Reliance is an element of a rule 10b-5 cause of action, because it provides the requisite causal
connection between a defendant’s misrepresentation and a plaintiff’s injury.
An investor who buys or sells stock at the price set by the market does so in reliance on the
integrity of that market price. According to the Efficient Capital Market Hypothesis, most publicly
available information is reflected in market price. The market is performing a substantial part of
the valuation process performed by the investor in a face-to-face transaction. The market is
acting as the unpaid agent of the investor, informing him that given all the information available to
it, the value of the stock is worth the market price. An investor’s reliance on any public
material misrepresentations, therefore, may be presumed for purposes of a rule 10b-5
action.
The presumption may be rebutted, in fact any showing that severs the link between the alleged
misrepresentation and either the price received or paid by the plaintiff, or his decision to trade at a
fair market price, will be sufficient to rebut the presumption of reliance (Basic v. Levinson).
Fluctuation of the stock price at the time of the false disclosure tells you that people were relying
on the false disclosure.
To avoid the presumption of reliance, they must show that their misrepresentation did not affect
the stock price. So, if ppp accuses, then you have to show that the market makers did not rely on
the price, you might break the causal chain.
Some discrepancy between whether it’s the loss causation or the transaction causation. In other
words, did you lose $ or is your loss just the fact that you did the transaction?
Rebuttal example: you bought months in advance; or if you can prove in some way that the ∆
bought for a different reason. OR, the stock price changed for a different reason.
E. Insider Trading
The rule resulting from 10b-5 in relation to insider trading is DISCLOSE OR ABSTAIN FROM TRADING (In
re Cady, Roberts and SEC v. Texas Gulf Sulphur (2nd cir. 1968) p. 480). The rationale is that
Rule 10b-5 does not require any kind of disclosure and sometimes the latter might be premature
or against the corporation’s best interest. By this token, the insider must either disclose the
information or abstain from trading.
Standing
Standing is limited to purchasers or sellers of securities to which the insider trading relates at the
time of the insider trading: Blue Chip Stamps v. Manor Drug Stores. Potential purchasers and
non-seller stockholders do not have standing ⇒ Birnbaum doctrine. But buyers of options can:
Deutschmann v Beneficial Corp.!
Materiality depends on the significance the reasonable investor would place on the withheld
or misrepresented information; probability/magnitude test (see above)
Epstein: Theory for insider trading: If you are an insider and you trade on the information,
you can never really deny the materiality of the information. To the extent there is a reaction
to this information, it also has to be material to the other person.
The Rule 10b-5 traditional theory holds an insider liable for trading securities of his corporation
based on relevant, non-public information. Such trading is viewed as a deception due to the
relationship of trust and confidence reposed in the insider by virtue of his position. The
duty applies to officers and directors, as well as anyone else who acts in a fiduciary capacity
towards the corporation, i.e. Attorneys, accountants and consultants.
The duty to “disclose or abstain” only applies to those who have some kind of fiduciary
relationship of trust and confidence with the company, by means of which they have had access
to the material non public information: insiders, constructive insiders, tippees or misappropriators.
Chiarella v. US
Trading with inside information will only violate Rule 10b-5 when the trader has violated,
or knowingly benefited from another’s violation of, a fiduciary duty. Epstein says 14(e)(3)
would catch Chiarella. It was written in response to this case.
Epstein: Whereas common law is not clear about the question whether directors owe fiduciary
duties to someone who is not yet a shareholder, but rather becomes one through the
questionable transaction, Rule 10b-5 is clear as to this point: if you finally bought the shares you
can sue! This constitutes a certain asymmetry.
• Insider: One who obtains inside information by virtue of his employment with the company
whose stock he trades in.
4. Constructive Insider:
• One who is entrusted with inside information by virtue of professional relation with the
company whose stock he trades in (e.g. attorneys; outside counsel) See footnote 14 on p.
495.
5. Tippee:
• One who receives inside information from an insider/tipper. The tippee will only violate Rule
10b-5
(1) if the insider/tipper has consciously violated his fiduciary duties to the company
whose stock the tippee trades in
(2) For his (insider/tipper) own personal direct or indirect gain. The insider/tipper must
receive some benefit or at least, must have intended to make a pecuniary gift to the
tippee.
6. Misappropriator:
• One who misappropriates information by breaching a fiduciary relationship with the source of
the information.
West v. Prudential Securities: No loss causation when the alleged misrepresentation was not
public. This is because an increase in the price of stock, with no publicly-known information to
justify it, would result in the stock seeming too expensive, and some SH selling it, bringing price
back
Jurisdiction
The defendant must have used the phone or mail, or some national security exchange in
connection with his trade.
1. Stock Parking
a. Stock parking occurs when the first party, who is the true owner of the stock,
arranges w/ a second party (the nominal owner) to hold the stock in the
nominal owner's name. Under such an arrangement, any profits and losses
that the nominal owner has are later transferred to the real owner.
b. Why would you park stock?
i. Margin rules limit the amount that can be borrowed to buy stock; if a
stock owner exceeded or is about to exceed that limit the owner can
temporarily sell (park) the stock so it won't apply to the margin limit
ii. Avoid taxes (sell some stock at a loss w/ the agreement to buy it back
later)
F. Short-Swing Profits
For the purposes of preventing the unfair use of information which may have been
obtained by such beneficial owner, director, or officer by reason of his relationship to
the issuer, any profit realized by him from any purchase and sale, or sale and
purchase of any equity security of such issuer (other than an exempted security) within a
period of less than six months ... shall inure to and be recoverable by the issuer,
irrespective of any intention on the part of such beneficial owner, director, or officer in
entering into such transaction of holding the security purchased or of not repurchasing
the security sold for a period exceeding six months. Do it and disgorge.
...
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 the
purchase, of the security involved, or any transaction or transactions which the
Commission by rules and regulations may exempt as not comprehended within the
purpose of this subsection.
The term “such beneficial owner” refers to one who owns “more than 10 per centum of
any class of any equity security (other than exempted security) which is registered
pursuant to §12 of this title.
2. Elements of § 16(b):
Director, officer or such beneficial owner:
The rationale of this provision is that directors, officers and 10% beneficial owners are likely to
have material 146avourable information by virtue of their relation with the issuer. Any type of
director, it doesn’t matter if you have a special fiduciary duty. It’s based on your position in the
Company.
• Directors and officers are insiders at the time of the sale or purchase (not necessarily both).
• 10% Beneficial Owners must be insiders at both the time of sale and the time of purchase.
3. Exam Approach:
Set up a timeline
Mark activities and status of parties at time of each transaction
Must be above the threshold at the time of the transaction.
If the transaction puts you over the 10%, it doesn’t count.
|__________^_______________________^__________^___________|
Take highest price of selling and lowest price of buying to determine maximum possible profits.
Any profit:
Any profit is ambiguous. Courts have interpreted the maximum possible profits within a six
months period.
Purchase and sell, or sale and purchase:
Unorthodox or borderline transactions courts will decide to include or exclude it as a sale on the
basis of whether the transaction is likely to serve as a vehicle for insider trading, which Congress
intended to prevent.
It was held that neither accrual of the right to exchange recently acquired shares
for shares in the survivor of a merger, nor the granting of an option to buy the
shares received in exchange, constitute a sale within the meaning of s.16(b),
absent any abuse, or potential for abuse, of inside information.
Here, Occidental, as the former tender offeror, had no say in the Old Kern-
Tenecco merger negotiations. There is no indication that the option agreement
between Occidental and Tenecco created a potential for speculative abuse of
inside information.
Any equity security registered under the Exchange Act §12.
§16(b) is only applicable to equity securities (stock and convertible debt) of public traded
companies. In contrast with Rule 10b-5 that is applicable to any security (including pure debt)
registered or not registered.
Six months.
Recoverable by the issuer.
The plaintiff must be always the issuer, whether in a direct or a derivative action. The issuer will
collect the judgment.
P. 523, problem 1.
Corporations often enter into indemnification agreements in an effort to recruit key employees or
retain them. These agreements, however, are criticized by some as leading to irresponsible
actions by the employees. This is because the employee would not really be personally liable for
anything except intentional misconduct.
1. Proxy Contest
Entails gaining control of X corporation thru the SH voting mechanism (“proxy machine”)
The Proxy Machine: Mostly passive; SHs appoint someone as agent/proxy to vote for the
SH
Akin to absentee ballot; fully controlled by insiders
How: B acquires 1 or more shares, puts a proposition to vote by other SHs
Problem is that no single SH has access to the machinery so you have to go thru the
corporation itself; Ds will likely reject & refuse to put it on D’s slate on ballot
of expenses was ultra vires, then must be ratified by unanimous vote of shareholders.
Otherwise, simple majority is sufficient.
(8) Regulatory Scheme ⇒ Section 14(a) of 1934 Act (requires proxy statement be sent to every
shareholder containing relevant information and gives management a choice between mailing
insurgent group’s material or giving them a list of shareholders).
(9) Economics of Proxy Fights: Tender offers are a more efficient and cost-effective way to
gain control of corporation because of the enormous expense of putting up a proxy fight,
which will either be at the cost of the individual if the fight is unsuccessful, or from the
corporation if it is successful. With tender offers, all of the increased earnings can be
captured without a lot of overhead or transaction costs.
HOLDING: There is an implied private right of action for violation of § 14(a) [Borak].
However, a shareholder must establish that the defect was of such a character that it would
have a significant propensity to affect the voting process. “Where there has been a finding
of Materiality, a shareholder has made a sufficient showing of casual relationship
between the violation and the injury for which he seeks relief if the shareholder can
establish that the proxy solicitation established an essential link in effectuating the
transaction.” The shareholders have showed enough to sustain their cause of action.
Note: “Where there has been a finding of materiality, a shareholder has made a
sufficient showing of causal relationship between the violation and the injury for which
he seeks redress, if, as here, he proves that the proxy solicitation itself, rather than the
(1) Loss Causation = the transaction caused harm to the plaintiff (relatively easy to
demonstrate) e.g. in Borak, the shareholders got less for their shares than the shares were
worth.
(2) Transaction Causation = requires the plaintiff to show that the defendant’s violation
caused the company to engage in the transaction in question (harder to prove) e.g. in Mills
the loss was occasioned by the merger and the merger was caused by the solicitation of
proxies to secure sufficient votes for its approval.
Epstein: it’s all about materiality. As long as the proxy solicitation itself, rather than the defect
152avour was a essential link: Need 2 things:
Defective Proxy
Material impact of defect
Epstein says it was a hollow victory b/c on remand the 7 th Circuit something happened which I
have no idea. It was material and essential but they could have done it anyway. You had to have
needed to proxy solicitation to get what you needed. This tends to limit matters because the
company had a right to do some things without a proxy.
1. Reimbursement of Costs
2. Elements of Action
d. Misrepresentation or omission
e. Statement of opinions, motives or reasons – Board’s
statement of its reasons for approving a merger can be
actionable.
(i) Virginia Bankshares, Inc. v. Sandberg (KRB, 530–37)
(S.Ct. ’91) – A statement of opinion, motives or reasons is
not actionable just because a shareholder did not believe
what the board said. Shareholder must prove:
Speaker believes his opinion to be correct and
Speaker has some basis for making it or Speaker
knows of nothing contradicting it.
(ii) An opinion by the Board must both misstate the board’s true
beliefs and mislead about the subject matter of the
statement, such as the value of the shares in a merger.
f. Materiality– The challenged misrepresentation must be “with
respect to a material fact.”
g. Culpability – Scienter is not required.
h. Reliance – Complaining shareholders do not need to show they
actually read and relied on the alleged misstatement.
i. Causation – Federal courts require that the challenged
transaction have caused harm to the shareholder. (Virginia
Bankshares)
(i) Loss causation: Easy to show if shareholders of the
acquired company claim the merger price was less than
what their shares were worth.
(ii) Transaction causation – No recovery if the transaction did
not depend on the shareholder vote.
j. Prospective or retrospective relief – Federal courts can enjoin
the voting of proxies obtained through proxy fraud, enjoin the
shareholders’ meeting, rescind the transaction or award
damages.
k. Attorney fees – Attorneys’ fees available under Mills (S.Ct.).
(11) Stahl v. Girbralter Financial Corporation (KRB, 537–40) –
Shareholders who do not vote their proxies in reliance on alleged
misstatements have standing to sue under SEC §14(a), both before and
after the vote is taken.
D. Shareholder Proposals
(12) Rule 14a-8 Procedures
Crane v. Anaconda
(a) Facts: Crane made a tender offer for Anaconda stock offering Corporate debt.
Upon acquiring 11% of the firm, Crane requested a copy of the
Shareholder list under state Corporate law. Corporation denied the list
alleging the requirements of the statute had not been met. Crane sued
and lost but was reversed on appeal and affirmed.
(b) Analysis: The court rejected the Corporation’s argument that the request was
not related to the business of the firm, because the transfer of effective
control will have a substantial effect on firm profitability and therefore
impacts all Shareholder’s welfare.
1. The statute was liberally construed based on an interest in Shareholder
welfare with respect to the value of the stock when a buy out is
attempted.
(c) Class: this is NY Law; it is all about what the s/h list will be used for. §1315
provides access to s/h list under NY law. NY law says you can refuse
the s/h list if you refuse to sign and 157avourabl saying you want the
list for purposes other than s/h interst.
1. Court sayst that trying to take control of a company is part of company
business.
Pillsbury v. Honeywell
(d) Facts: Shareholder was a member of an anti-war group that purchased stock
in the Corporation for the purpose to oppose the manufacturing by the
Corporation of fragmentation bombs. Shareholder requested access to
Shareholder lists and Corporate records. Corporation refused the
request, and the Shareholder sued. Trial court held for the Corporation
and was affirmed.
(e) Analysis: Shareholder purpose must be germane to their interest as
Shareholders, and these interest are not moral, they are based on
profit.
1. The court viewed the power of inspection as similar to a weapon of
Corporate warfare, and only Shareholders with a proper interest (i.e.
the benefit of the Corporation itself) should be able to exercise that
power.
(f) Alternatives for Shareholders:
1. Be more choosy in their investments, and only invest in Corporations that
adhere to certain moral values
There are both advantages and risks for shareholders in a corporation with a control group. The
advantage is that the control group will closely monitor the managers to assure that they are
running the business effectively. Therefore, agency costs may be reduced. The risks are that
there might be conflicts of interest between the controlling and the minority shareholders. Many of
the controlling devices existing when there is a separation of ownership and control are not
available when there is a control bloc. The possibility of proxy fights or hostile takeovers is
diminished. Moreover, the directors may not be independent of the controlling group. Therefore,
the minority shareholders must rely more on disclosure and fiduciary duty rules.
Controlling shareholders owe a duty of loyalty to the minority shareholders. Therefore, they must
prove intrinsic fairness whenever a conflict of interest arises (Zahn and Sinclair; above under
“Duty of Loyalty).
Sale of control raises the issue of whether a rule of equal treatment of the shareholders should
be a goal of corporate law. A response to the problem could be to require buyers to give the
minority an equal opportunity to either buy the shares pro rata or to buy 100% of the shares. But
a requirement of equal opportunity would make acquisitions more difficult and more
expensive.
Epstein: Two possible outcomes: Wilport decides to stop the interest free
loans in which case the shares of Newport won’t be worth as much, or
Wilport decides to continue the loans with Newport and everyone is
happy.
Remedy: Tragedy is that the remedy in a derivative suit pays damages
back into the corporate coffers, so that Wilport gets much of the damages
back. Here, Plaintiff recovered for his own right, not derivatively p. 686.
Best to wait and see if the loans continue. If yes, you are fine, if no, you
can still sue.
(even though these interest free loans are “unpatriotic” and “unethical”
they are still a corporate opportunity which cannot be squandered)
Note: very broad statement pro fiduciary duty in control transactions; could be
viewed in a more limited fashion because corporation could be seen as a close
corporation (see below). Epstein didn’t like the outcome.
When a sale of control takes place, the directors usually resign and select the designated
nominees of the purchaser to replace them as directors. While the purchaser could arrange for a
shareholder vote, they prefer to act quickly and without the expense.
Note: Someone purchasing a control premium should be able to put his ideas into place asap
rather than sitting around waiting for the next round of elections. It makes no sense to have
directors who no longer hold shares and have no interest in the company. Payment of a control
premium implies confidence that he can do better than a premium.
These resignations raise an issue of whether an illegal sale of office has occurred. Courts
recognize the reality that if the purchaser has actual or de facto control the replacements are
legitimate. The problem occurs when the purchaser buys less than 51%. At what point does the
ownership interest assure that if there is an election they will be able to replace the directors?
General rule: controlling s/h as holder of management control cannot benefit from selling
such control to the detriment of minority s/h
Friendly: not legal … in such a case, purchasing s/h should have to call
s/h meeting and elect board majority
Epstein: what if he’s only selling 3% of the corporate stock with the same idea of
control of the board. It’s not only about having 51% to have control. With
control you may be able to transfer control of the board.
Under Friendly, you’d need at least 50% of the shares so that the change
in board would be a „mere formality.“
Under Lumbard it would be ok unless the person protesting could prove
that the purchasing s/h would not be able to elect a board
majority.
Existence
Transferability
Solutions for the close corporation problems:
- ex ante by contractual provisions: voting and pooling agreements, irrevocable proxies,
voting
trusts, class voting, cumulative voting
- ex post by special legal remedies: heightened fiduciary duties among shareholders
similar
to those among partners
Edith and Aubrey have a pooling agreement to vote for the same 5 directors of a 7
director board.
If North can come up with 882 shares or more he wins. But he can on I have NO
FUCKING IDEA.
1103 1102
John 863 864 863
This was the easieset way to ensure that Robert could be president of Ringling Brothers.
He got it, put up a crappy tent in Connecticut, it burned down, killed a few hundred
people, North went to jail b/c Robert took a powder, but when he got out of the slammer,
John regained control and built the circus up to the current glory and eventually sold the
circus in the 1960’s.
NEW YORK LAW ON 620 AND DELAWARE GENERAL LAW ON 621 IS ON FINAL
S/H AGREEMENTS OK AS LONG AS DIRECTORS’ INDEPENDENCE NOT IMPAIRED
i. Facts: 2 bros own drug company; they enter into a SH agreement, which says
each family gets 2 board seats, mandated dividends and mandated benefits; one
bro dies, and the other refuses to perform the agreement; wife sues to enforce
agreement
ii. Holding: agreement was valid, and unanimity not required if:
1. corp is closely held
2. minority SH doesn’t object
3. terms are reasonable
iii. Remedy: I and R must account, and presumably pay to Emma back dividends
1. they could’ve had a provision that would allow surviving bro buy out
deceased bro’s share; way of creating separation in the corp when
somebody dies (b/c even though two people might be able to work
together, their families may not)
2. Or life insurance policy (keyman insurance) to pay off Emma.
b. Ramos v. Estrada
i. FACTS: A merger between two Spanish language TV stations (so they could get
a hard to obtain FCC license) resulted in a merger agreement in which the two
groups of shareholders would vote for directors which the majority had agreed to.
The Estrades missed a meeting, were not elected and refused to recognize the
agreement.
ii. HELD: The Estrada’s violated the valid pooling agreement. They were
sophisticated business people who knew the arrangement they were getting into.
Their actions constituted an election to sell their shares but since the stock is that
of a closed corp. and is therefore not marketable specific performance (votes
cancelled) is ordered.
purpose and provisions for minimum earned surplus req’t and salary
continuation are valid means of protecting a corp.’s interests
- This K was not a unanimous one but there were no objecting
shareholders
- A minority shareholder must protest and show injury in order to
void this K
Quinn to pay a higher price than Quinn had anticipated. Bad blood developed.
Quinn then persuaded the other shareholders to freeze Wilkes out of active
participation in the business and to cut off payments to him. They removed
Wilkes from the board and from his officer position, and eliminated his salary as
an employee-manager. Wilkes sued for reinstatement.
The court ruled in favor of Wilkes.
L. Wilkes Doctrine
1. S/H in closely held Corp owe each other a duty of strict good faith
2. If challenged by a minority s/h the controlling group must show a legitimate
business objective for its action
3. A π minority s/h can nonetheless prevail if it can show that the controlling
group could have achieved its goal in a manner less harmful to the π.
Epstein’s commentaries:
• Whenever there is this sort of self-dealing, appraisal is absolutely necessary.
• Even though closely held corporations operate like partnerships, they do not
dissolve like a partnership when one of the partners sues.
• Remedy: The court shouldn’t be in the business of forcing corporations to appoint
officers it doesn’t want.
• Pro-rata salaries being drawn here were clearly dividends in the form of salaries
to avoid double taxation. This sort of arrangement may draw IRS attention.
• Other ways Springside might have been set up:
o Partnership would involve the same fiduciary duties, better tax regime
and when they want to terminate, they just dissolve.
o Joint tenancy – They could have continued on until they wanted and
gotten partition and settlement.
• Wilkes could have brought a derivative suit for over-compensating the other
partners and demanded a dividend.
• The corporate form is a limitation on the alienability of the business and the
flexibility of the owners. Courts should not be in the business of drafting or
imagining provisions for the dissolution of companies, particularly with complex
tax implications involved.
• Courts are worried about a “freeze out” where the minority shareholders in a
closely held corporation get ripped off by the dominant shareholder.
1. Summary
Estate Tax – Shares are assets which are taxed. Option is a buyback, selling to outsiders,
planning in advance, life insurance policies, or advance plans for power shifts.
Business Side – buyouts
What triggers buyouts – death, decision to leave.
Does the corporation buy or do the other shareholders buy.
Corporation will make things run more smoothly and not upset balances of power.
Best solution for buyout is arbitration; use some formula of multiples of something.
Dividend regulations –
Dividends are paid when a certain amount of income is paid.
Different classes of stock, some with lower risk
Separate attorneys for all members of the family
Solutions by law.
Appraisal remedy is typically only available for fraud and deception.
Forced sales even when legally feasible are not desirable.
Business judgment shields most business decisions including dividends (exception Smith)
and hiring.
N. Squeeze-out Merger
1. Disclosure Rules
**Jordan v. Duff & Phelps, Inc. (KRB, 660) (7th Cir. ’87)
Close corporations buying their own stock have a fiduciary duty to disclose
material facts. Where π sold his stock in ignorance of facts that would have
established a higher value, failure to disclose an important beneficent event is a
violation even if things later go sour. A π must establish that, upon learning of
merger negotiations, he would not have changed jobs, stayed for another year,
and finally received payment from the leveraged buyout. A jury was entitled to
conclude that the π would have stuck around. This case is sort of the inverse of
Page v. Page, the linen supply case in partnership. In that case, the Court relied
on an the at will employment nature to rule that his brother could dissolve the
partnership. **Epstein loves this case. Another „The perfect Storm“.
(2) Epstein: It’s Wilkes duties + 10(b)(5) duties all combined in a closely
combined corporation. So Jordan sues under 10(b)(5) saying that he
would not have sold back his shares had he known of the merger talks.
Jordan was an „“at will“ employee and could be fired at any time and be
forced to sell back his shares.
(3) Franchik resolution to keep shares for 5 years dealt w/ an employee
who was fired.
(4) TSC Industries Inc. Is the default materiality case. Ex Ante does not
count. Materiality is not measured ex ante. Rationale is just like the
Palmer v. Medtest case. But why should this not be material? Because
the value of the stock wasn’t tied to his leaving. Presumably if he’d
known of the planned sale, he would not have quit. But it won’t make
much difference because the buy back clause only entitles him to book
value as of 12/31. So he presumably would not have reaped any
windfall. So, Epstein says it’s still material, because it might have
changed his decision; but he would not have gained anything more.
(5) Easterbrook v Posner:
a. Easterbrook: abstain or disclose – see Texas Gulf Sulphur.
Applies whenever a s/h can respond. Jordan might have
changed his mind if he’d known. Wilkes like duties would have
prevented Phelps from firing Jordan if he decided to stay.
Therefore the 10(b)(5) rule required Phelps to disclose.
b. Posner: 10(b)(5) doesn’t apply because there was a
stockholder agreement. That agreement gave Jordan no rights.
He was an at will employee. That trumps any Wilkes duties.
Just like Ingal v Glamor. If they wanted to fire him they could
have. Posner says why should Phelps be penalized for being
nice to the guy and letting him work through the end of the year?
Besides, he could not have used the information.
c.
B. Statutory Dissolution
1. Proper motivation:
increasing overall firm value: 3 + 4 = > 7
2. Improper motivations:
- justify higher management’s compensation through expansion
- satisfy management’s ego
- control group tries to take advantage of its position by engaging in self
dealing and by acquiring another firm under its control at an unfair price
A. Mergers 1/26/2005
3. Statutory Merger
AInc. Acquires BInc. by BInc. merging into AInc.; BInc. loses its existence
drafting of a plan of merger which is approved initially by boards of directors of both
companies, followed by a vote of both shareholder bodies
Knipprath: basic exchange of stock. Alpha and Beta trade stock. It is a negotiated
deal between management of the two companies.
The survival of Alpha and the liquidation of Beta is planned in the deal. The Beta shares
cancel out and the Beta SH are now Alpha SH. Alpha has assumed both assets and
liabilities, including contingent liabilities.
Beta SH are the most drastically affected; they are now in the hands of Alpha. How can
they be forced to do this? Easy. Management of Alpha and Beta entered into a contract.
As compared to a tender offer which requires each SH to vote, a statutory merger
involves a management contract which is binding upon the SH; it’s not up to each SH to
decide whether they want in or out. The merger binds all SH. Injunctive relief to
dissenting SH is unlikely b/c they can always just sell and cash out. So, even if some SH
dissent, the merger is final if the majority consents.
While there is some argument that Alpha is the surviving corporation so their SH don’t
need to vote, the general rule is that they do get to vote. SH of both corporations get to
vote on the merger. Alpha SH right to vote goes back to the preemptive rights
argument; trying to protect their % of ownership.
If the merger involves an issuance of new stock the Alpha SH would have to vote
anyway.
Appraisal remedy: FMV of stock determined by arbitration or judicial decision.
Based on FMV immediately before the merger.
No factoring in of the control value: the minority SH don’t get extra $ just cuz they don’t
have control.
Assuming that the proportionate ownership is being reduced, appraisal rights are
something like the flip side or adjunct to the preemptive rights doctrine. Why would you
give appraisal rights to Alpha? There is still a market for their shares and proportional
ownership is not really a big issue in corporate law today. So, Knipprath says, in the
absence of fraud or other breach of fiduciary duty of the Board, there isn’t a reason for
appraisal rights. Market speculation could affect share price which would mean that
market wouldn’t reflect true fair value. Or, there might not be a market for the shares.
Tender offers usually involve a premium over market. This is b/c the company’s assets
may be undervalued. Could be due to poor management. Example: oil company with
huge untapped reserves not reflected in share price. Other reasons include economies
of scale, synergy, etc. But, in such case, why would you need an appraisal remedy?
Tax law, other regulatory laws must be considered. Securities laws? Yes, a merger is
stock-for-stock and may require issuance of new shares, thereby invoking securities laws.
4. Consolidation
both, AInc. + BInc. merge into a new company = CInc.; both are loosing their separate
existence
B. Sale of Assets
A Inc acquires substantially all of the assets of B Inc; BInc may remain in existence as a
holding company or may be liquidated
Under state law usually the boards of both corporations must approve the deal, but
generally only shareholders of B Inc have the right to vote on the sale when it
involves all or substantially all of B Inc’s assets. 1/24/2005: Argument would be that the
sale of all the shares results changes the corporate form; it’s an extraordinary transaction
resulting in dissolution. Argument against treating it as a dissolution and requiring a SH
vote: the company still exists, SH position is unchanged, assets were exchanged for
cash.
What does the raider receive? Assets, inventory, machinery, land, etc. Whatever the
assets are. Intangibles, patents, etc. What do you give? Whatever they’ll take. Cash,
stock, etc. But, could be a note or bond.
SH position is changed -- Acme s/h have changed in relation to Acme. Acme looks
different now. Let’s say ?Acme gets $ for the sale of the assets. Now they can reinvest
that cash into something else; the sh still hold shares in Acme.
X inc $ to Acme
X sh still have x stock. Acme still has Acme stock
X has stuff. Acme has cash
Acme can go out an dbuy other stuff
They can also pay off debts or pass the $ to the sh with an extraordinary dividend
This is a classic sale of assets and subsequent dissolution.
Purchase of Liabilities
X is not required to buy the liabilities but can if they want to.
You might do this because it could reduce the purchase price.
Contingent Liabilities
Theoretically you don’t buy these
You are just buying assets.
You will pay a higher price if you buy assets only with no liabilities.
Example: X pays $15mm with no liabilities. Acme can use the excess cash to pay off the
creditors. Or X pays $10mm and ACME deals with its liabilities problems
If we acquire the assets of Acme by issuing stock, Acme Inc holds shares in X Inc. So
they are stockholders in X. Acme SH hold Acme shares. Acme isn’t doing anything but
holding a bunch of stock. But Acme value is tied to the value of the X stock that they now
are tied to.
SH approval required when new stock is issued. X may issue stock for the acquisition
price in order to make Acme SH happy. The ACME SH now hold stock in X. Acme then
dissolves. X survives.
C. Tender Offer/Takeover
AInc makes an offer directly to the shareholders of BInc to buy all their shares. If AInc is
able to buy at least 51% of the shares, AInc will control BInc and BInc will become a
subsidiary of AInc. Target of takeover is usually a publicly traded corporation. Only board
approval of AInc to make the offer is required (see below)
1. Liability Issues
The directors must act in good faith and in an informed manner in making the decision
whether to sell the corporation Otherwise, the directors may breach their fiduciary duty.
Directors defending a hostile tender offer by trying to keep the public shareholders from
responding to the offer can also breach their fiduciary duty.
Acquisitions may involve self dealing when the managers or controlling shareholders
use their power to receive a benefit which excludes the minority
D. Appraisal Remedy
Under state law shareholders who dissent from the merger are granted an appraisal remedy, i. e.
the right to sell their shares back to the corporation at a price determined by the court and
reflecting the fair value of the shares
How to determine value? Delaware approach: market value, net asset value and earnings must
be weighed; and valuation techniques generally acceptable in the financial community
Note: some jurisdictions eliminate the appraisal remedy if the shares trade in the stock market;
Arg: market value substitutes for a judicial valuation
E. Defacto Merger
1/21/2005
It is common law; judge made. Legal appraisal rights result from mergers. Equitable appraisal
rights may be awarded by a Court. See TransAmerica (the tobacco case).
If an acquisition is structured in a way that it tries to preclude shareholders voting/appraisal rights
(e. g. state law provides voting and appraisal only for merger, but not for asset deals):
- some states will look at the substance of the transaction, as opposed to its form, in order to
determine if it is effect a merger with the right of appraisal for the shareholders, i. e. a “defacto
merger”, see: Farris v. Glen Alden
- other states, including Delaware, view each statutory rule as independent from the other;
therefore, an asset deal need only comply with the statutory provisions dealing with asset deals,
even if it looks and smells like a merger; see: Hariton v. Arco Electronics
instead. List transfers all assets in exchange for Glen stock, List liquidates and Glen is
renamed List Alden. Π (SH Farris) wanted ct to cast this as a de facto merger so that he
could exercise his appraisal rights because he claims his share are being diluted due to
differences in book value (Glen is a losing corp with deb and high book value, while List
is a profitable corp with low book value). But this has nothing to do with real value.
Nonetheless, Ct ignores a statute that says asset acquisition should not be treated
as mergers and Π wins. Ct didn’t like corps trying to evade formalities. After this case
legislature passes another statute to clarify that acquisitions are not mergers.
List did not want to give the appraisal rights. Knipprath says that even if they agree to a
choice-of-law clause, the SH rights are still controlled by state law. In a merger there
would be appraisal rights for GA and probably for List.
PA law provided the appraisal remedy but DE did not. So, if List acquired the assets of
GA, then GA SH would get appraisal rights. Substance over form was Farris’ argument.
Knipprath says the key is that it was all done in a single transaction. In an asset sale,
you have two steps: sale of assets and then either a distribution or liquidation. In this
case, it was all done at once; there was no step two. See page 723 - the legislative
intent was to get rid of this kind of dissent. But the Court said that the Bar Committee
comments were not binding on the Court.
F. Defacto Non-Merger?
In Rauch v. RCA the plaintiff urged adoption of, and the Delaware court, following its doctrine of
independent legal significance rejected, what might be called a “defacto non-merger doctrine”; the
transaction took the form of a merger but the plaintiff argued that it was in substance a sale of
assets followed by a redemption of shares.
G. Freezouts
Freezouts involve controlling shareholders forcing the minority shareholders to relinquinsh their
equity position in the corporation. Usually, the minority shareholders receive cash (or other
shares) for their shares (special form of freezout: MBO).
5. Standard of scrutiny:
Entire fairness (the regular standard when controlling SH who exercise control are at a conflict of
interest, e.g., Sinclair).
Compare with Van Gorkom and Unocal, Revlon (next class’ cases).
6. Burden of proof:
If SH approved the merger:
(1) Defendant must show that all material facts relevant to the transaction were
disclosed.
(a) If defendant shows that, BoP is on the plaintiff to show that the transaction
was unfair to the minority;
(b) If the defendant does not show that, BoP on defendant to show that the
transaction was fair to the minority.
If SH did not approve the merger
(1) Plaintiff must show evidence of fraud, misrepresentation or misconduct relating to
the merger.
(2) If plaintiff did so, BoP on defendant to show that merger was fair.
(3) So, if the SH did not vote against the merger, then no appraisal remedy.
Who had BoP in Weinberger? Why?
2. Business Purpose
Under Weinberger, mergers do not need to meet a business-purpose test as long as they are fair
(fair process and fair price).
3. Entire Fairness
Transaction terms should be similar to those reached in an arms-length transaction (i.e., with a
disinterested, independent BoD).
Entire fairness in a freeze out merger consists of:
(1) Fair dealing (Procedural); and
(2) A fair price. (Substantive)
4. Fair Dealing
What did Signal do wrong?
(1) Lack of arms length bargaining;
(a) E.g., Crawford (who’s affiliated with Signal) arranged for the fairness opinion
(2) Misused confidential UOP information (for the valuation memo);
(3) Lacked candor (did not disclose its valuation memo).
What should Signal have done?
(1) Keep UOP’s interested directors out of any studies and discussions of Signal’s
strategy;
(a) If Arledge & Chitiea disclosed the report to UOP, they may violate DoC to
Signal; But probably not if it’s neutral information. So, probably a good idea
to have the Signal directors who have UoP seats sit in on the UoP board
meetings, even if they can’t vote. Then all the information is shared.
(2) Keep Crawford out of the negotiations;
(3) Have UOP appoint a special committee consisting of its independent directors to
bargain with Signal;
(4) Have special committee get a fairness opinion from outside financial advisor.
(5) Inform UOP SH of all material information relevant to the transaction.
Would a decision of an independent special committee be reviewed under BJR or the entire
fairness standard?
(1) Kahn v. Lynch Community Systems (Del. 1994)
(2) Approval of the transaction by an independent committee or an informed majority
of minority SHs shifts the BoP on the issue of fairness to the plaintiffs.
(a) BoP shifted only if the independent committee had “real bargaining power
that it can exercise with the majority shareholder on an arms length basis”
(quoting Rabkin).
(3) But even a decision by an independent committee (regarding cash-out) mergers
is subject to an entire fairness standard.
(a) Concern about undetected influence by the majority SH;
(b) Final period problem for the independent directors.
For next class read don’t read the steel case; but read cheffe v mathis; then read through Revlon
and Paramount.
8) Consolidations
Neither of the initial entities survives; both dissolve into a newly created corp. Rarer
than mergers b/c SHs prefer safety of one of the corps surviving. May choose
this if want a new state of incorp
Note: Any consideration of either corporation is permissible to the SHs of the
merging corporations, so it can be
$, $+ stock: X’s SH A can be totally bought out or retain some control/hard
goods (any identifiable interest in the corporation)
stock + debt of acq’ing corporation (in which case X’s owner would continue
on as a SH & board member);
4. Economics of a Merger (Appraisal Rights)
These are the outer edges of the spectrum: Cash merger = basically an outright
purchase; Joint Venture: 50/50 split of original 2 companies
Appraisal Rights: Right to a judicial determination of fair market V if acquired stock
Most states: Don’t actually have to vote against it, just have to not vote for
merger
e.g.: C= 20% owner of X; A = 80%; wants to merge with Y corporation. C
cannot resist merger because A has outright majority but can assert
appraisal rights
Import: This dissenters right = major transactional burden because gives
dissenting SHs signif. pull esp. in corporations w. relatively small interests &
that are privately-held
SH voting rights = Another major transactional burden → would be a serious
problem for large, publicly traded diversified corporation
e.g. P%G wants to acquire privately held X corporation, could do a drop-down
X retains itself, A gets P&G stock; then P&G could contribute newly formed
subsid in exchange for stock (this deal doesn’t help eliminate P&G’s
taking in of X’s liabilities tho)
Solution: State corporation laws always retain right of acq’d corporation’s SHs to
vote BUT significantly limit the voting rights of the acqing corporation, esp. where
it’s really large
Del. § 251(f): Where the V of the acq’d corporation = 20% or less of the acq’ing
corporation, then no vote of acq’ing corporation SHs is req’d NOR do they
have appraisal rights. → if acq’ing corporation is 5x or larger the size of
acq’d, no vote.
Del. § 262(b): Curtails the appraisal rights of SHs of acq’d corporation in some
situations (but not voting rights) if the target is either (a) publicly traded or
(b) has >2000 shares (even if not publicly traded) & (c) if no SH vote req’d for
merger (if all-stock deal). DL § 262(b)(1)
Justification: Open-market remedy (selling stock) is available.
P P stock A P
S Merger
X S
P P stock A P
S Merger
X X
X
C I B
40% 60% Stock or cash
X X stock Y
2nd Stage = “Squeeze Out Merger” –Y creates a subsid & as parent merges S
into that. All C can do is dissent and get appraisal rights. Effectuates Y’s intent
to get X despite objections of incumbent C.
Y stock or cash
C Y
Also disposed of the DL block method for determining the appropriate price
of appraisal. Instead rely on techniques generally used in the financial
community.
In two-step cash out merger, control premia paid in initial step are not
considered in appraisal remedies. However, value added in interim is
considered. Cede and Co v Technicolor, Inc (DL 1996), p739.
1/31/2005 Burden of proof for breach of fiduciary duty is on π to show that a
duty existed and it was breached. So, here, π must show that the
directors of UOP owed a fiduciary obligation; if Signal owed a duty as a
majority SH, it must prove that too. π must establish a prima facie case:
there was an opportunity, in the company’s line of business, and the
company could have exploited it.
C. Law in Delaware
1. Singer v. Magnavox (Del. 1977) – Court finds merger is
impermissibly because it lacks a business purpose.
2. Tanzar v. International General Industries (Del. 1977) – A business
purpose relating to the majority SH alone sufficed.
So, Sullivan’s purpose of having the company assume his debt suffices.
3. Weinberger – Expressly rejects the need for a business purpose. If
the merger is fair to the cashed-out minority, that ends the inquiry.
rights. Similar to Farris and Hariton (follows Hariton). (mirror image of Farris).
Notes 2/12 (in binder).
Amy Says: —Π says this is just like redemption—a “de facto redemption”. Court rejects this on
the same theory as a de facto merger. See analysis afterwards, pg755.
L: Court refuses to judicially create a new protection for preferred SH
Could you give the entire premium to the common SH? To the preferred? Split it? Yes, probably
to all of them. No definitive answer here.
BOF, pg206 that Weinberger forecloses an injunction in cases where full disclosure is made and
the board has satisfied its duties of good faith, loyalty, and due care, or the board has been able
to prove the entire fairness of the transaction. Appraisal remains the only remedy (but BOF
points out that each individual SH must perfect its appraisal remedy, but under a class action,
they just have to not opt-out to get protection. Difficult to prefect, and expensive to get your own
lawyer, etc.)
Knipprath says: Board votes first. Then the SH depending on jdx. For certain, the common SH
of the target co get to vote.
4. RCA has two classes of stock: common and preferred. The preferred stock has a
$3.50 dividend preference and is redeemable at the option of the corporation, for
$100.
What might be the purpose of the redemption clause?
5. GE offers to acquire RCA in a cash-out triangular merger: RCA would merge with
Gesub (a GE subsidiary), RCA common SH would receive $66.50/share, and RCA
preferred SH would receive $40.
How is it that preferred shares are worth less than common shares?
6. Rauch, an RCA preferred SH, claims that despite dressing the deal as a merger, it
is in fact a redemption of preferred shares, so she should get $100, not $40.
Does Hariton v. Arco Electronics apply?
If this is a merger, what are Rauch’s rights?
(1) The rights of preferred shares (and all other shares) should be stated in RCA’s
AoI. The case doesn’t quote the AoI on this issue, but footnote 3 indicates
preferred shares may not have voted (court rejects Rauch’s claim that a class
vote was necessary because the merger changed the AoI in a way that impaired
her preferential rights.
10. Even if preferred SH had the right to demand $100/share to allow the merger to
commence, it would be in their best interest to waive this right.
Suppose that RCA has an equal number of preferred and common shares, and that common
trade for $61 while preferred trade for $35 (so, it’s $96 for one of each). GE is willing to offer a
10% premium (pay $106).
If preferred SH insist on receiving $100, this would leave $6/share for the common SH ($106-
$100). Since they can sell their shares for $61, they gain nothing from the merger and will vote
against it, causing the preferred SH to lose the $65 premium ($100-$35).
The common SH would vote for the merger only if they get over $61. This leaves premium SH
with under $45. Premium SH would block the merger (by not waiving their right of redemption)
unless they get over $35 (common SH get <$71).
(1) $71 < Common Share < $61
(2) $45 < Preferred Share < $35
(a) GE’s offer, at $66.50/common & $40/preferred, is within this range.
(b) This is why Rauch asks for redemption rather than appraisal.
Corporation has right to redeem PSH at any time; CSH have a position in the company. This
allows the corporation to control the value of the PS. If there is a drop in interest rates and it’s
cheaper to issue debt, then the company can just call the PS. The preference helps PSH if
company goes bankrupt. Otherwise, it’s not applicable.
E
P
90% 10%
P can merge into X itself and provide cash for outside SHs instead of a
proportional part of X assets, or can give P shareholders stock.
Most corporation laws have a special provision for this type of merger.
DL § 253 (allows merger of subsidiary into parent if parent holds ≥ 90%
of subsidiary stock ⇒ no formality needed (no shareholder vote, may
be done through unilateral action of directors of P without notice
to E). However, E must be informed of his appraisal remedy before
actual merger is executed but after merger is entered into. Just a
letter would be sufficient .
Fiduciary rules apply to parent as controlling shareholder in a squeeze
out.
Incentive for squeezing out minority shareholders is that they present a
barrier to possible economies of scales gains that might be realized
by combining the parent with the subsidiary. With the separate
parent/subsidiary relationship, the parent’s investors are required to bear
greater risk for no increase in return.
Outstanding minority group with substantial %age of shares.
Corporate Norm: Unilateral redemption of corporate stock is beyond
corporate power. (But see Ingle below re: explicit buy-sell agreements)
So although B cannot redeem A unilaterally, what can’t be done directly
can happen via merger.
B A
B can drop a subsidiary and enact a merger between X and Y. A has been
squeezed out of the corporation (despite need for shareholder approval)
and can only receive money for his X shares.
B A
100% 80%
20%
X
Y
cash
merger
C. Recapitalizations
1) Definition
Involves a single entity & enterprise & = a change in the financial structure.
Nature of: In form, = a set of redemptions, can’t occur without voluntariness, usually
requires unanimous consent → shareholder consent is required because of
changes to their claims to the corporation’s assets and earnings
Classic pref. stock recap req’s high degree of coop. so only works in family
owned businesses (small <3 SHs, closely held) –couldn’t do with large
publicly owned corporation because SHs wouldn’t want their risk modified
unilaterally.
Simple recapitalizations ⇒ Replace debt with common stock or combination of
common and preferred. If A and B hold equal proportions of common stock and
debt, then simply convert into equal shares of common stock and preferred stock
in recapitalization
Insignificant: Two SHs with propor. stock & debt→ exchange the debt for pref.
stock
Effect: no shift in control, no shift in priority between A &B claims; BUT
probably improves credit (because no lender would want to give $ to
corporation with so much debt in cap structure)
Significant: Preferred Stock Recapitalization
A= 80% CS; B=20% CS → exchange A’s CS for pref. stock
Effect: A who had corporate control & governance & greatest risk now has
something more akin to constant income stream; B has become the
entrepenuerial partner, reaps the high upside and high downside effects
(esp. if pref. stock ≠ voting rights)
When Happens: Transfer of control from older to younger generations;
typically a family-owned business
Typically there are large arrearages of dividends for preferred stockholders
which makes corporation less attractive to creditor. Thus,
recapitalization must take place. May be done as a byproduct of a
merger, or may be the main reason for a merger or other combination.
See Bove v Community Hotel (RI 1969).
1. 2) Recapitalization as Practical Effect as Merger Byproduct: Bove
a) Bove v. Community Hotel (RI 1969)
i) Held that a parent can merge with its subsidiary for the sole purpose of
recapitalization. Corporation wants to recapitalize to eliminate claims of
preferred shareholders without requirement of unanimous vote (merger
only requires supermajority).
ii) Characteristics: downstream merger of corporation into a predominantly
owned subsidiary.
iii) No one wants to lend $ to a corporation that has large latent obligations to
PSHs; most recaps involve pref. stock usually involving cos with long-term
mediocre performances (e.g. large overhang of dividends in arrears)
iv) Court: Unhappy PSH should assert their appraisal rights if unhappy
XXII.Policy Issues
1st position: beneficial to shareholders and society as a whole
- shareholders usually receive premium over current market price
- eliminating minority ownership saves agency costs because higher incentives to run
corporation efficiently if managers have a major equity position
- economies of scale if subsidiary is taken over by parent
- more flexibility in decision making without minority shareholders
2nd position: conflict of interest and potential unfairness to shareholders; violation of fiduciary
duties
- e. g. “going private”: control group first takes advantage of a strong market to go public
and then of a weak market to eliminate the minority public shareholders and go private
again. This can be seen as a perversion of the whole process of public financing
- Combination of takeover and freezout can be unfair if tender offer price to acquire
majority position is higher than price offered to minority shareholders in following freezout
A. Liability Issues/Remedies
i. e. approval by board and shareholder vote (compliance with state merger provisions)
must comply with fiduciary duties
a question arises whether an appraisal is the appropriate and exclusive remedy for the minority
shareholders, or whether the courts may grant other remedies based upon fiduciary principles.
Generally, the minority shareholders prefer using the state fiduciary doctrine to enjoin the
transaction or seek damages greater than the limited appraisal remedy. The courts followed the
fiduciary duties approach and granted equitable relief under certain conditions. While the
Delaware courts initially held that a freezout merger, besides meeting the burden of proving entire
fairness, must pursue a business purpose other than the sole elimination of the minority positions,
in Weinberger they eliminated the requirement of a business purpose and concentrated on the
concept of entire fairness. When directors are on both sides of the transaction they must
demonstrate their utmost good faith and the most scrupulous inherent fairness in the bargain. The
court clarified that entire fairness in this context meant fair dealing and fair price.
Fair dealing requires full disclosure of share value, as well as other process issues such as
timing, initiation, negotiations and structure of the deal. In Weinberger there was a lack of full
disclosure of the share value because a report prepared on the highest price that would be paid
for the minority shares was not disclosed to the minority.
Fair price relates to all the factors which affect the value of the shares.
Under Weinberger appraisal is not appropriate for cases involving fraud, misrepresentation,
self dealing, deliberate waste of corporate assets, or gross and obvious overreaching. It is
generally not appropriate if there is a lack of fair dealing. In these cases the minority shareholders
are not restricted to appraisal remedies, but can receive rescissory damages in equity, not
restricted to the fair value of the shares at the time of their sale, but including a share of the
benefits that resulted from the merger.
A. Policy Issues
Tender Offers have raised numerous policy issues, not only if they were beneficial to the
companies involved and the economy as a whole, but also of what motivated a bidder to pay a
premium over the market price for shares of the target, whether those premiums represented
gains and, if they did, the source of these gains.
1. Proponents
Hostile tender offers are beneficial because they represent a market solution to the problems of
corporate mismanagement. Market based competitive solutions are ultimately the most efficient
and, therefore, the market for corporate control should be encouraged and facilitated. This
“market of corporate control” theory is based upon the efficient capital market hypothesis, which
assumes that by using all publicly available information the trading markets were informationally
efficient in pricing shares at levels that best represented the value of their corporations.
Therefore, any failure by management to maximize the value of a company would be reflected in
its shares’ price. These management failures would attract bidders to offer premiums over the
current market price for a controlling interest in the corporation, in the belief that the bidder itself
could run the business more efficiently and achieve benefits that would exceed the premium paid.
This possibility of a tender offer serves as an incentive for managers to run the corporation
efficiently, because if they do not they could face a hostile offer which would replace them. In this
view, tender offers are one of several market mechanisms to ensure companies are run efficiently
and in the best interests of their shareholders.
2. Opponents
- Hostile tender offers are harmful to shareholders because the future value of the corporation is
higher than the bidder’s offer. Thus, the bidder usurps shareholders gains.
- Dynamics of hostile tender offers tend to force shareholders to accept the offer, because if they
do not they are facing the risk of being left as a very small minority in an otherwise wholly owned
corporation, likely to be bought out later on unfavourable terms.
- Managers are forced to place too much emphasis on short-term profit making than on long-term
performance in order to keep the stock price high enough, so that the company would not
become the target of a hostile tender offer
- stock markets are not truly efficient; premium reflects undervaluation by the stock market rather
than mismanagement
3. Conclusion
Tender offers have produced significant gains to target shareholders by paying them large
premiums over the market value of their shares prior to the offer. On the other hand, in many
cases the bidder’s shares have not gained from the acquisition, but rather lost value. However,
since the overall amount of gain by target shareholders is much greater than the losses incurred
by bidder shareholders, some direct gains have resulted from tender offers. Asking for the
sources of these gains, it can be assumed that takeovers have finally resulted in value
maximizing efficiencies in the form of synergy gains and reduction of agency costs by replacing
inefficient management.
B. Bidder Tactics
A bidder wants to gain control, i. e. acquire at least 51%. However, it does not know how many
shareholders will accept its offer, and it does not want to end up with owning a large percentage
without the benefits of control. In order to avoid that, the bidder may set conditions for its
acceptance of the tendered shares, such as receipt of a certain percentage of the shares.
A bidder is generally not required to bid for all of the shares of a corporation, however, the
shareholders are entitled to an equal opportunity to tender their shares in the offer. If more shares
are tendered than the bidder wants, the shares tendered are purchased from the tendering
shareholders on a pro rata basis.
Bidders tend to offer cash as consideration because it is easier to value and does not require
registration under the Securities Act of 1933.
Bidders usually want complete control of the target. In order to achieve that goal, the bidder can
acquire the shares of shareholders who did not accept the tender offer in a second-step freezout
merger after the first-step tender offer is complete.
A very controversial bidder tactic is the so called front-loaded two-tier tender offer, geared to
attract as many sellers as possible in the first step tender offer: If the targets shares are selling for
$ 20 and the bidder is willing to pay $ 25 per share for all the shares, it will offer a cash premium
of $ 30 for only 51% of the shares. At the same time the bidder announces that, after the tender
offer will be successfully completed, it will use its control to merge the target and buy out the
minority shareholder at a lower price, e.g. $ 20. Since shareholders do not know how the other
shareholders are planning to respond, they have to tender their shares for fear of losing the
premium on at least 51% of their shares. Thus, this tactic has a coercive character.
At times, bidders have bought target’s shares and threatened a tender offer in order to make the
target’s management buy back the shares at a premium, so called “greenmail”. This tactic raises
issues of whether the directors are benefiting the corporation or themselves by precluding the
tender offer (Cheff v Mathes 752).
1/24/2005 Knipprath says you can’t discriminate against SH. So, if the solicitation is
oversubscribed, you have to reduce your tender only x% of each share.
SH position is now changed; you are a SH in a new company. It might still be good for the SH
because it might be more economically feasible. Also, shares in newco might be more liquid. So
that’s a case where you might want to get stock in the raiding company instead of $.
If you don’t tender, you don’t get dilution, you just are subject to the whims of the new
management. But, if you take shares, you might be in a more diluted position.
Why would you get preemptive rights? Assuming no fraud in the tender offer, you chose to be
diluted, you can’t turn around and complain about dilution.
But, the old shareholders of the acquiring (raiding) company could claim dilution.
Need to comply with Rule 14e-3
Also 13d and 14d on 5% disclosure
Not sure if there is a private right of enforcement
Those rules are to ensure notice of intention by raider.
Also need to consider anti trust laws.
Short swing profits could be an issue as well. Look at Kern County Petroleum.
Tax laws: Is it realized and recognized income? What’s the nature of the exchange?
Fraud is always a concern
SH who tendered don’t get any appraisal right
Argument for Appraisal Remedy: SH who don’t tender will argue for appraisal rights based on
decreased of liquidity after the tender; they will be trapped. They can’t sell on the market. The
tender was too low.
Argument Against Appraisal Remedy: You had your chance and chose not to take it. There’s
still a market for your share.
The Law: No Appraisal Remedy. Appraisal remedy is limited to statutory mergers.
So, if you’re against the tender and don’t want to tender, you have to make an equity argument
unless you can prove de facto merger. So, you are looking to prove fraud.
Debtor-Creditor Law: do you need to worry about that in a tender offer?
Presumably the debts of the target company are built into the stock price at the time of the tender.
But, becoming a majority shareholder doesn’t make the raider liable for it’s obligations.
Raider company votes on whether to make the tender
Target company board votes
Raiding company’s SH only have to vote if NEW shares are issued
Wednesday, 02 February 2005
Form over substance; substance over form. Handout on Time-Warner merger. Tension between
objectives of stability and predictability in the law and the desire to find ways around those rules.
C. Target Tactics
1. Tactics that require Amendments to the Corp. Articles and, therefore, a
Shareholder Vote
- staggering the terms of directors delays the bidder from taking immediate control and, therefore,
raises the cost of the bid and creates uncertainty
- an amendment to the corporate articles can require a super-majority or disinterested
shareholder vote before a successful bidder can sell assets to finance the bid
- a recapitalization of the corporation through amending the articles to create two classes of
shares from an existing single class with one supervoting class that holds the significant voting
power. If those shares are owned by the management, a hostile tender offer is virtually
impossible
3. Poison Pills
The most significant defensive tactic is the shareholder right plan or “poison pill”: at some
triggering event, usually the purchase of a certain percentage of the target’s shares by an
outsider, the target shareholders are given rights to obtain securities (equity or debt) at a
substantial discount. These securities can be from the bidder (“flip over” plan) or from the
target (“flip in” plan). These rights have the effect of making the hostile tender offer more
expensive for the bidder by adversely affecting either the target or the bidder itself. Prior to the
triggering event, the target directors can redeem the rights, but after the event the rights become
non-redeemable. Pac Man defense: launch a counter attack and tender for all their shares.
Golden parachute: employment severance, etc. Can be a conflict of interest. Will this put you in
the position of looking out for the SH? So if it’s triggered on a change in control, it will add to the
acquisition cost. So a portion of the value of the corporation has been moved from the SH to
management.
Monday, 07 February 2005
Flip over is older and less useful. If anybody acquires a certain % of T’s shares, there is a
further offer of shares and holders of T’s shares can acquire shares in B’s shares at deep
discount, thereby diluting the B’s shares. I’m flipping over my shares in T for shares in B; but in a
massively discounted cost, thereby diluting B’s shares. Knipprath says it’s just a warrant to buy
shares if a merger occurs. It’s like saying to B, “If you want to buy my car, you can, but then you’ll
have to pay the full college tuition for my next kid; and he’s the smart one.” These can often be
redeemed pre-merger by vote of the majority of independent board members or independent SH.
These plans were upheld in Moran v. Household International, Inc. (Del. 1985).
How to Defeat A Flip Over: Of course, failure to complete the merger will defeat a flip-over plan.
Or, a requirement that the flip over rights be redeemed prior to the merger. This could keep T
from being able to attract a white knight because the flip over right is already out there. The white
knight doesn’t want to be stuck with the rights which will dilute his shares. Redemption right
allows Board to negotiate highest price available for the shares. Approval of seller’s SH depends
on state law; their circumstances are changing so strong argument. Less strong for B’s SH.
In a negotiated merger, like Glen Alden, you need agreement of both Boards and the T’s SH.
See p. 784
Who votes on merger agreements?
D. Liability Issues
07/02/2005
When the target’s management and directors institute actions to defend the corporation from the
takeover, they are usually faced with a charge of breach of fiduciary duty to the corporation and
its shareholders. Fiduciary duty is generally divided between the duty of care, and, when there is
a conflict of interest, the duty of loyalty. With the duty of care, directors are liable only for
neglecting their duties, not for misjudgements and, thus, any judicial inquiry focuses on the
decision-making process, not the decision itself. The decisions are generally protected by the
business judgement rule, which presumes that directors have acted in good faith and in the
corporation’s best interests. Duty of loyalty generally applies when the directors are in a conflict
of interest. The important distinction between the two duties is that in a duty of loyalty analysis,
the directors usually have the burden of proof as to the fairness of their decision and thus, the
courts scrutinize the decision with a greater possibility of liability.
Those who favor hostile tender offers have argued that the target’s defensive tactics place
directors in a conflict of interest, because they are concerned with keeping their positions, and,
thus, the business judgement rule should not apply. Those who oppose hostile takeovers view
the implementation of defensive tactics as similar to other business decisions protected by the
business judgement rule. In fact, in most cases, the use of defensive tactics have resulted in a
third test involving a modified business judgement rule or proportionality test under Unocal
v. Mesa Petroleum.
Cheff v. Mathes
Rule: If the board had a good faith belief that it was acting for a proper purpose to serve
the corporation, business judgment presumptions apply in reviewing actions taken.
In Cheff a Delaware Court was faced with a greenmail case, in which the directors of the potential
target had voted to purchase the shares of a potential bidder for a premium so that the bidder
would not acquire the corporation. The potential bidder was buying shares of the corporation on
the market and seeking a seat on the board while criticizing the target’s management. The
target’s purchase of shares from the bidder was challenged in a derivative suit alleging it was a
perpetuation of control by the directors.
The decision recognized the director’s need to defend proper business practices, but also
recognized the potential conflict of interest when directors are primarily acting to perpetuate
their control. Thus it did not apply the traditional business judgement rule nor the duty of loyalty
standard. Instead it applied an intermediate standard that focused more on the motive for the
defensive measures: The court shifted the burden to the defendant directors to show whether
there were reasonable grounds to believe that the hostile tender offer constituted a danger to
corporate policy or effectiveness. This burden was satisfied by a showing of good faith and
reasonable investigation.
a. Cheff v. Mathes (Del. 1964)
Board must meet, consider, disclose, investigate, ensure independent evaluation. Board and
perhaps maj SH have fiduciary duty nto to sell to a looter to ruin it. But, no evidence here that
this was his objective. No broad fiduciary duty to employees; so if they are going to get fired but it
helps the company, then it’s OK.
Does the share price reflect the market information about the company? If yes, then insider
trading is OK. This is one argument. You are relying on the collective wisdom of the
marketplace. Very few people are involved in insider trading. Argument is that it poisons the
market. Differentiate from fraud. Not churning or manipulation. Not Enron. Just inside trading.
(2) that the defensive tactic was reasonable to the threat posed
This test differs from the normal application of the business judgement rule by placing the initial
burden on the directors and allowing some scrutiny of not just the process but also the substance
of the decision.
The first step focuses on the directors acting in good faith after reasonable investigation. The
second step allows the court to balance the defense tactic with the threat. Thus, the courts do not
employ a fairness test following the duty of loyalty standard, but rather a modified business
judgement rule in form of a proportionality test. The directors, on the one hand, are given some
latitude to defend against tender offers, the courts, on the other hand, may exercise closer judicial
scrutiny than in the ordinary case of business decisions.
Pickens’ offer seems like an attempt to extort greenmail.
1. Unocal Corp. v. Mesa Petroleum Co. (Del. 1985) (p.885)
a. Facts: At issue is the validity of a corporation’s self-tender for its
own shares which excludes from participation a stockholder making a hostile tender offer
for the company’s stock. The directors acted in good faith in concluding, after reasonable
investigation, that Mesa’s two-step tender offer was both inadequate and coercive.
Unocal’s objective was to either defeat the tender offer, or compensate shareholder’s at
the back-end of Mesa’ proposal. Including Mesa would defeat that goal.
b. Holding: The selective exchange offer is reasonable in relation to
the threat posed by Mesa’s coercive two-tiered tender offer, therefore the board acted in
the proper exercise of sound business judgment. The Court will not substitute its views
for those of the board if that decision can be “attributed to any rational business purpose.”
c. Note:
1. In the acquisition of its shares, a corporation may deal selectively
with its stockholders, provided that the directors have not acted for the purpose of
entrenching themselves.
2. Enhanced Scrutiny
a. because of the possibility that the board may be acting in its
own interests, there is an enhanced duty which calls for judicial examination at
the threshold before the protections of the business judgment rule apply
3. For the Business Judgment Rule to apply:
a. First, the defensive measure must be reasonable in
relation to the threat posed. (Unocal)
1. possible concerns:
a. inadequacy of the price offered
b. nature and timing of the offer
c. questions of illegality
d. the impact on “constituencies” other than
shareholders
e. risk of the deal falling through
f. quality of securities offered as consideration
b. Second, directors must show good faith and a reasonable
belief that the raider will thwart corporate policy and effectiveness. Their showing
is materially strengthened by the approval of a board comprised mainly of outside
independent directors.
4. Summary: Once it is shown that the defensive measure is
reasonably related to the threat posed, if the directors are disinterested and acted in
good faith (which is plaintiff’s burden to prove otherwise), its decision in the absence
of an abuse of discretion will be upheld as a proper exercise of business judgment.
Friday, 04 February 2005
Mesa tenders for first tier to gain control. Mesa tells SH up front that they will be cashed out at
the back end with various debt instruments valued at $54 / share (same value as cash paid up
front). Mesa planned to get a majority interest, merge Unocal into Mesa and force out the
remaining SH. How can they do that? Once they have 51%, they can vote their controlling
interest. No super-majority voting requirement as in Weinberger. Minority SH might have right of
appraisal; but if Mesa gains control, they will be calling all the shots. Majority SH basically
decides whether merger is approved, absent a Weinberger type of limitation.
This is a hostile takeover. Some § of the ’34 Act apply. The Williams Act Amendment of 1968. §
16. Before the Williams Act.
In response, Unocal launched a self-tender. How would a self-tender protect self control?
The deep discount on the back end shares makes Pickens’ total offer less than it seems.
Pickens can make an immediate tender for all the shares at a cash to avoid the Unocal defense.
Court says deal must be fair; sort of like an independent judgment of the Court. Pickens had a lot
of bad press. Argument the other way is that Pickens would make the company more efficient.
Board has an obligations to the SH.
Think about Amazon, Google, or eBay. They have no hard assets; that’s not the value of the
company. Normally, businesses are worth much more as going concerns than by breaking them
up and selling the pieces. Pickens will make money by the arbitrage. If there’s no positive
spread he won’t do it. So where’s the hidden value? Economies of scale; synergies. Unocal
stock value went up when Pickens’ offer was tendered. Total restructuring of the company after
this ordeal; management woke up. Stock value went up. So the failed tender increased SH
value.
Problem of apparent conflict of interest by management who oppose deal when approving deal
will improve SH value. Bidder will argue entrenchment. But older state law cases about looters
say that management has a duty to protect SH from inadequate offers, destructive offers, break
up of the company. So, we want a defensive measure that is reasonable in response to the bid
they are defending against.
Paramount v. Time
In Time the target’s directors defended their company against a cash tender offer from
Paramount that climbed to $ 200 at a time where Time’s shares were trading at $ 126. Time had
originally negotiated a merger with Warner Bros. to pursue a strategic plan of expansion before
Paramount made its bid. Time’s officers feared that the shareholders would vote against the
merger because of Paramount’s substantial cash offer. Therefore, Time changed the transaction
from the original merger with Warner to Time making a friendly cash tender offer for 51% of
Warner’s shares. In contrast to a merger, there was no shareholder vote required for the tender
offer. The remaining 49% of Warner would be acquired later. Paramount argued that the original
Unocal criteria were not met because there were no reasonable grounds to believe Paramount’s
offer posed a threat and the response was unreasonable, intended solely to keep Time
management’s position. Moreover, it argued that there was a duty under Revlon to auction Time
since it was effectively put up for sale by the original merger agreement.
As to the first part of the Unocal test (the threat) the court held that inadequate value or
coercive tactics were not the only threats a target faces. There were other threats to justify
Time’s tender offer for Warner. One threat was Time’s concern that its shareholders would tender
to Paramount without an understanding of the proposed plan with Warner. Paramount’s offer had
conditions which created uncertainty and made a comparative analysis between that offer and
Time’s plan difficult. Paramount’s offer was eventually designed to upset the initial vote for the
merger with Warner and to confuse shareholders.
As to the second part of the Unocal test the reasonableness of the defense depended on the
threat. The court held that the directors had some latitude in the selection of a time frame for
achievement of corporate goals and, therefore, held the response reasonable.
The court also rejected the use of Revlon in this context. The negotiations with Warner did not
mean that a dissolution or breakup of Time was inevitable. After all, Time was allowed to pursue
its long-term strategy of combining with Warner.
Time gave a great deal of deference to directors in both identifying a threat and determining what
was the reasonable response. Time made clear that there is no general obligation to sell a
corporation just because there is a premium offered to shareholders at a fair price, when such
sale would upset a business plan. The difference to Revlon was that there was no planned
breakup of Time.
Missed Class Feb 9 - Get Nancy’s Notes
February 9, 2005
a couple more points about Revlon --- ct creates a duty on the directors…
in some ways, their actions are more confined…
in the ordinary case, they can consider what to when they want to sell, what terms… but there
comes a time in court, when the duty becomes to maximize shareholder value
the case seems to say that the point is when the sale of the company is inevitable, and the
sale is likely to break up the company
at some point, there is a duty to simply auction off the company…
white knight, in order to save you from the bitter clutches, may also require you to sell off a
desirable asset of the company… does that trigger Revlon duties?
By the directors going out and picking out a white knight for selling off assets, may trigger Revlon
duties.
If there are companies coming out of the woodwork, bidding for the corporation --- if it’s likely
that the company will be sold, and there will be a break up of the company --- even though
the company has not actively sought out a white knight, REVLON DUTIES are still
TRIGGERED!!! Just because they didn’t do anything, doesn’t mean that there are no Revlon
duties.
They should realize that the escalation of events create possible Revlon duties because the
company may be sold and chopped up.
The problem of the change in control --- Revlon duties may also be triggered here.
What do we mean by change in control? A owning the company rather than B…..
What is it that absent the scenario of the auction, what else might trigger Revlon duties when
there is a change in control?
Authors go through transaction fee --- that the lock up provision, termination fee, in particular,
were ways that a bidder might recoup some start up costs… this can be more than compensation
for the start up costs…
Courts have said that these are not per se illegal... --- look a the analysis section on page 796 for
some examples…
Do boards of directors have a fiduciary duty to the creditors? Note holders are just creditors.
General rule is NO DUTY of fiduciary obligation
However, there are K’s obligation..
And there are basic non fraudulent requirements.
Del takes the position that if a company is insolvent --- at that point, there is a fiduciary obligation
to the creditors as well as to the shareholders.
So theoretically --- INSOLVENCY creates duties to both creditors and shareholders that aren’t
normally there.
have Revlon duties… that the company is likely to sell / break up. The no shop provision
establishes that the sale was just to be for time and warner --- not for all different people to come
and buy warner…
Unexpectedly, Paramount Communications (P) announced an all-cash offer to purchase
Time (D) for $175 per share. ALL SHARES!!! Notice how the value of the Time shares to
Paramount was VERY HIGH. Why? The value of the Time stock was undervalued in the Warner
deal, OR there are different synergies at work… but how are they going to recoup the cost? Sell
off the assets they don’t want.
This led to a restructuring of the proposed Time (D)-Warner (D) merger into a cash and
securities acquisition. --- which meant that the new plan would lead to time creating a huge debt
in buying up warner stock. Making themselves less attractive to Paramount. Time's (D) board,
citing concerns about Paramount's (P) acquisition posing a threat to Time's (D) corporate culture,
continually rejected Paramount's (P) overtures, which eventually increased to an offer of $200 per
share.
The original Time (D)-Warner (D) agreement had included a "no shop" clause which
prevented Time's (D) board from considering other options. Both Paramount (P) and various
shareholders of Time (D) filed suit, alleging breach of fiduciary duty by Time's (D) board.
The chancery court rejected the claims and dismissed. An appeal was taken.
Time shareholders were asserting Revlon duties: they base their arguments on the fact
that warner shareholders receipt of 62% of the combined company and the defensive maneuvers
time directors used to cover up the fact that Time was for sale… ---- they held in favor of Time
here, that there were no duties of Revlon triggered…there was NO change in control --- that there
was just a fluid aggregation of unaffiliated shareholders representing a voting majority…. There
was no change in control, it was just a joining of shareholders. There may have been dilution of
the position of the shareholders, but think of the numbers we’re talking about ---- we’re talking
about hundreds of thousands of shareholders…
The other claim that could have been made was that the Revlon duties were raised when
Paramount came into the picture… but time argues that this was different from Revlon’s case…
there was 2 companies trying to break up in that case, here it was just one.
Paramount asserts a Unocal claim. Paramount also argues that they are NOT a threat ---
that it was an all cash tender, no coercion like in the Unocal case (good faith, reason able
investigation, and proportional to threat). It’s not a two tier offer that they made, and this threat of
an all shares, all cash… was not the case either.
Prevention of the shareholders from voting: if it was a merger, they all had to vote on it…
but as a tender offer, only the target corporation’s shareholders would have to vote.
Paramount is arguing that Time was consciously preventing the shareholders from
voting… threat was in regards to the value of the shareholder’s investment. The court doesn’t
buy this…
Why does the court say that there is no Revlon duties that applied here? there was a
plan all along by time… was the court sympathetic to Paramount? Not really… because
Paramount came in at the last second… why did they wait till the last second? Everyone knew
what was going on… Maybe paramount was riding on the work of others, reflecting valuation in
the market, knowing what the other companies was doing…
The shareholders are not particularly sympathetic either --- because they weren’t
complaining about the lack of value before, not till paramount came in… and they had remedies
prior to paramount, they had appraisal remedies…
Proceeding with the Waner transaction was okay under the basic BJR principles
Courts in the subsequent page goes through the Unocal’s argument --- reasonableness
of the action… valuation of the corporate threat, measures of protection, etc. Court basically
holds that it’s not up to the shareholders to decide what is best… the fact that the board changed
from the stock to stock offer, to change to the cash for stock… depriveing the stockholders the
chance to vote, does not amt to a bad action… .because it’s within the discretion / business
judgment of the shareholders…
Therefore, the shareholders didn’t lose anything that they had a right to… because the
board always had the right to do a cash for stock offer… in fact, that’s originally what they wanted
to do in the first place!!!!
ISSUE: May directors of a corporation involved in an ongoing business enterprise take into
account all long-term corporate objectives in responding to an offer to take over the corporation?
HOLDING AND DECISION: [Judge not stated in casebook excerpt.] Yes. Directors of a
corporation involved in an ongoing business enterprise may take into account all long-term
corporate objectives in responding to an offer to take over the corporation. When a corporation is
an ongoing enterprise, and is not effectively "up for sale," directors are more than a mere
auctioneer trying to obtain the highest price possible. A board's decision to reject a takeover
offer will be upheld under the business judgment rule if the directors can show that their
decision was not dictated by a selfish desire to retain their jobs, but rather was in the best
interests of the corporation. Share price is a component of this analysis, but is not the sole
criterion. If the directors arrived at the decision to reject an offer after appropriate analysis and
consideration of legitimate factors, a court will not substitute its judgment for that of the directors.
Here, the directors elected to continue with a deliberately conceived corporate plan for long-term
growth rather than accept an opportunity for short term profits, which is a legitimate decision. The
acts of Time's (D) board were therefore appropriate. Affirmed.
EDITOR'S ANALYSIS: The court here applied what is know as the "Unocal" analysis, after the
case Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985). In that opinion, the
Delaware Supreme Court established the rule that a board's defensive tactics will not be given
the deferential business judgment rule test, but will be subject to a higher level of scrutiny due to
the possibility of self-interest
Paramount v. QVC
In QVC Paramount agreed to be acquired by Viacom and put several defensive tactics against
competing bidders in place. Although Paramount’s shareholders would own equity in the
new company, the controlling shareholder of Viacom would hold 70% of this new
company. Then, QVC came and offered a price for Paramount that was $ 1.3 billion higher than
the Viacom bid. Paramount’s directors did not give up their defensive tactics. QVC sued to enjoin
the defensive tactics. Paramount’s directors relied on the Time decision on the basis that it too
had a strategic merger, that there was no planned break-up of the company, and that the merger
with Viacom fitted best in Paramount’s long term business plan
Defensive Measures Adopted by Paramount:
1. No Shop Provision
2. Termination Fee of $100mm
3. Stock Option Agreement
a. 29% of Paramount’s CS @ $69
b. Not a cash deal; sr. subordinated debentures
i. Cash for options
ii. Current creditors of Viacom will be senior to Paramount’s
would be restricted to far fewer bidders; and (c) SH value was lost b/c the bid was $200 and TW
lost a big chunk of its valuation when the deal failed.
So, there’s a control premium being lost by Paramount SH that they can never recover. But
Knipprath says that the control premium has not really been lost. If there is really an impact in a
large publicly traded SH of having a dominant SH; presumably the buyer could have just bought
the controlling SH. In other words, doesn’t it all work out. If the stock is cheaper at Viacom b/c it
has a dominant SH, then presumably the Paramount SH got more when they receive their
Viacom shares than they would have if the Viacom corp did not have a control premium
depressing its price.
Van Gorkum duty to properly investigate might have been a better fit for the Court rationale than
Revlon. But maybe Van Gorkum was too controversial (it spurred many director protection
statutes immediately after).
1. Knipprath’s Hypo
How does a board maximize SH value if Revlon is invoked? The board could put the company
up for sale and try to attract bidders. Then they have a Van Gorkum duty to stay informed. Then
they should try to run up the bids.
Does the Board have to take the highest cash bid? No. Contingent financing, debt financing,
other considerations as to the quality of the offers. Maximize SH value; but value is not just the
offer price. Value of corporate culture may matter in a potential break up.
Summary
When shareholders challenge the actions of directors there are generally three levels of review:
(1) business judgement rule, (2) Unocal’s enhanced scrutiny test, and (3) the duty of loyalty.
In the takeover context, under Unocal, the initial burden is on the directors, and the courts look
first at the reasonableness test that focuses on the good faith determination of the threat to the
target. The threat is often based on the belief that the bidder has offered insufficient value, but
other threats are possible. It could involve the hostile bid depriving target shareholders of a
superior alternative, treating non-tendering shareholders differently and distorting their choice
(factual coercion).
The second test looks at the proportionality of the target’s response to the threat. If the
defense tactic is viewed as draconian, i. e. either preclusive to tender offers or coercive to
shareholders, it will be closely scrutinized and will likely fail. If the response is less than
draconian, then the judicial scrutiny looks at the range of reasonableness, i. e. whether the
tactic was proper and proportionate. In that case, there will be judicial restraint and the court
will not usually substitute its judgement for that of the directors.
If the corporation seeks to sell itself, abandons a long-term strategy and seeks alternatives that
include the break-up of the business (Revlon), or attempts to effect a change of control (QVC),
then the Revlon duty of getting the best price for the shareholders applies. Without a change of
control or break-up, there appears to be no general obligation to sell the corporation, even if
a substantial premium that reflects a fair price is offered by the bidder. This is especially true
when the tender offer upsets a business plan.
The level of scrutiny will be higher if directors unilaterally and unduly interfere with shareholder
voting and corporate democracy. On the other hand, it will be lower if shareholders are involved
in the approval of the defensive tactics.
Knipprath says: the no-shop provision included an inclusion of the fiduciary duty of the board; a
recognition that the board’s no-shop provision was more nuanced than in past cases.
Hilton v. ITT
1) Facts: In response to a hostile tender, ITT split up the firm into 3 firms with 1 of
them having 90% of the old assets which were the best assets. Crown
Jewel Because this created a new Corporation, the board was able to
rewrite the Certificate of Incorporation, and classified the board so that it
takes 80% vote to declassify. This was done 2 months before an annual
meeting. All of the old ITT board was on the board of the new Corporation.
2) Analysis: Purposefully disenfranchising Shareholders such as changing the
consequences of a Shareholder vote so that Shareholders cannot throw
out the old board requires a compelling interest.
(a) There was no such compelling interest here so the classification was
enjoined.
(b) This is distinguished from the Time where board took the power of approval
from the Shareholders because in Time Shareholders vote still had its
basic quality even though they were not able to exercise the vote.
3) Unitrin – Board action that affects Shareholder vote consequence may be
thrown out, even if the change is not preclusive of future deals.
Knipprath says: Sale of a crown jewel ≠ a break up and does not necessarily invoke Revlon.
Does a staggered Board hinder all takeovers? Don’t staggered Boards ensure stability of the
Board? What if a bidder is successful but there is a staggered board. So the Buyer has 3 on the
board and the other 6 are entrenched. So, they only need to turn 2 of the 6 existing directors to
get control. That shouldn’t be too hard. Once you get some of your people on the board, you
start throwing your economic weight around and the psychological reaction is to cooperate;
especially if you are an outside director. They will bribe the inside directors with more benefits,
job title, etc.
Amy Says:
Hilton Hotels Co. v. ITT Co. (supp107)—As a defensive mechanism, ITT created 3 subsidiaries
w/o SH approval. Hilton challenges the action, and that implicates Unocal (because it was action
taken in response to a takeover bid). Was there a threat here? Directors said the price was
inadequate. Ct took a substantive view and analyzed the price (DE wouldn’t have done that).
Assumes the threat and goes to part 2, reasonableness of the action. Is the response excessive?
Holding: yes. Blasius is about increasing the board size—court thinks this is Blasius, is it? ∆ s
have to show a compelling justification, which is a difficult hurdle, so they lose.
L: Is the sale to 3 different co. all of your assets? Court didn’t reach it, assumes ITT can
do it.
What is Blasius? Go over this entire case again.: It’s Unocal (BJR+)
Good Faith (Unocal)
Reasonably Proportionate Response (Unocal)
Compelling Interest (Blasius)
(3) (2) that the defensive tactic was reasonable to the threat posed
Revlon
(1) If Company sale or break up is inevitable, or change in control, Board must
maximize SH value
Paramount v. QVC
(1) examine critically the offers
(2) act in good faith
(3) obtain and act with due care
(4) negotiate actively and in good faith with both Viacom and QVC.
Blasius /Unitrin
(1) Board cannot unilaterally act to disenfranchise the SH without a compelling
interest; this is strict scrutiny
SEE CORPORATE REGULATION (WILLIAMS ACT) BELOW.
CTS v. Dynamics (pg767, n93, SC)—IN enacted a statutory scheme requiring SH approval prior
to significant shifts in corporate control. The practical effect of this requirement is to condition
acquisition of control of a corporation on approval of a majority of disinterested SH (what exactly
is a disinterested SH?)
Holding: This statute is constitutional. Entities can comply with both the Williams Act and the
Indiana Act, and the purpose of the Williams Act is not frustrated by it. The IL statute that was
struck down in MITE was different because it gave the company an advantage in communicating
with SH, while the IN statute just protects SH against both sides in a takeover. The additional
delay in the IN act is not fatal unless it is unreasonable. And the IN statute doesn’t go against the
commerce clause. Hindering tender offers is not enough reason to invalidate the statute
Concurrence: Statute may not be wise, but as long as it doesn’t discriminate against out of state
interests, then it is fine.
Dissent: It undermines the Williams Act.
Control thresholds suspend voting rights unless the majority of disinterested SH.
See analysis, pg777, Should DE be dictating the law for half of the US corporations?
b) XL Corp. made a hostile bid for Capital Re and Capital Re discussed terms with XL, in
violation of no-talk clause
c) ACE brought suit to enjoin Capital Re from doing so
d) Court ruled against ACE on grounds that no-talk clause required Capital Re directors not
to maximize shareholder value by discussing another more profitable merger with XL,
in violation of duty to shareholders, and was thus illegal
e) ACE ended up winning ensuing auction
r uling makes it very difficult for a company that has been trying to sell itself for a long time
and that finally finds a buyer to grant that buyer restrictive terms if such are necessary to
get the buyer to go ahead with the deal
d.
B. Takeovers
(1) Introduction
a. Williams Act:
(i) 5%+ – Requires disclosures of stock accumulations of more
than 5% of a target’s equity securities so the stock market
can react to the possibility of a change in control;
(ii) Tender offers – By anyone who makes a tender offer for a
company’s equity stock so shareholders can make buy-sell-
hold decisions; and
(iii) Structure of tender offers – Regulates the structure of any
tender offer so shareholders are not stampeded into
tendering.
(iv) Same price - Tender offeror must give same price to all
shareholders, and that must be the highest price ever
offered.
b. De GCL § 203 – Directed at 2-stage freeze-outs
(i) A controlling shareholder of a corporation that has recently
acquired an interest in the corporation must wait 3 years
from the time he created the interest to the second stage
squeeze-out.
Exceptions: If the controlling shareholder has over 85%
of the co. or without 85%, if 2/3 of the other 49%
shareholders vote, the 2d stage squeeze out may
proceed.
Incumbent waiver – Incumbents can waive these
requirements under §203.
(2) Greenmail.
a. Cheff v. Mathes (KRB, 743–51) (Del ’64) – Corporate fiduciaries
may not use corporate funds to perpetuate their control of the
corporation Corporate funds must be used for the good of the
corporation, although activities undertaken for the good of the
corporation that incidentally function to maintain directors’ control
are permissible. But acts effected for no other reason than to
maintain control are invalid.
C. Takeover Defenses
(1) Dominant Motive Review
a. Under this standard, courts readily accepted almost any
business justification for defensive tactics. The target board only
had to identify a policy dispute between the bidder and
management. (Cheff v. Mathes)
Reason: provide target, its shareholders and market with notice of a possible takeover attempt.
Prevent secret accumulations of control.
Once a tender offer has commenced bidder must file a similar, but more extensive disclosure
statement with the SEC and distribute it to the shareholders. Target management must make a
recommendation to the shareholders regarding the tender offer.
Tender offer must remain open for at least 20 business days in order to give shareholders
enough time to make an informed decision. Shareholders who tender have the right to withdraw
their shares at any time while the tender offer remains open. This enables them to tender into a
competing bid during the time the offer remains open.
Section 14 (e) prohibits material misstatements, omissions, manipulation and fraudulent practices
in connection with any tender offer. Very broad, major source of litigation. Usual claim that parties
have failed to fully disclose all material facts.
Knipprath says that cash offers can be launched much more quickly. Bidders can try to buy any
shares available on the open market before they launch their hostile tender. Bidder can move
stealthily if it has the time to do so. The Cash gives you a high ability to hide in a way that a
stock-for-stock tender would not. So, 13d and 14d of the Williams Act were passed to force
disclosure of acquisitions in excess of determined levels. Under 14d, if you have plans to launch
a tender offer, even if you have less than 5%, you must disclose your intentions. Cheff v. Mathes
- Maremount acquired his holdings by simply buying on the open market. But, this was pre-
Williams. Creeping acquisition.
§ 14 requires that if you have a tender offer pending, and then you decide to adjust the price; you
must retroactively compensate anyone who has already tendered. The small piece of stock block
you need to get over the 50% mark and gain control might be worth a lot more than the cost of
the initial acquisitions. So, disclosure can raise the acquisition cost. Choice was cash versus
junk bonds. Junk bonds need to be valued so you can factor in the risk and adjust for it.
Implied right of private action: Target Board could bring a private action. But then, what’s the
remedy? Notify us? An SEC warning?
Tender offer must be held open for 20 days in order to avoid the stamped effect.
2. State Regulations
Many states have enacted statutes that generally have the effect of restricting hostile tender
offers. This raises the question of how these state regulations relate to the federal law and
the Constitution. One question is whether the federal takeover regulation preempts state
regulation under the Constitution’s supremacy clause. Since congress did not explicitly preempt
state law, the issue becomes whether compliance with both federal and state law is impossible or
the state law is an obstacle to the purpose of the federal law. The other question is whether state
statutes violate the Constitution’s commerce clause by unreasonably burdening interstate
commerce:
CTS v. Dynamics
In CTS the supreme court dealt with an Indiana statute that had the practical effect of limiting a
bidder’s ability to conduct a hostile tender offer. Although the statute did not legally prohibit one
from trying to acquire control, it provided that if anyone bought more than a certain percentage of
shares, constituting “control shares”, they would need to get shareholder approval from the other
disinterested shareholders in order to have voting rights in those shares. Without voting rights, an
acquisition of even a majority of the shares does not procure control.
The court upheld the statute. It rejected the preemption argument because the statute did not
favor either side in the tender offer, but instead protected shareholders, which was also the basic
purpose of the Williams Act. The statute was also found not to unreasonably burden interstate
commerce because voting rights were a traditional state corporate law concern. So long as both
residents and nonresidents had equal access to shares, the court would not interfere with state
regulation of corporations internal affairs. CTS means that most tender offer statutes that do not
directly regulate the tender offer and that involve only corporations incorporated in the state will
not be found unconstitutional. Opposite argument is that Williams Act is an anti-takeover act and
that therefore the Indiana statute was favoring management and was thus in violation of the
Williams act.
F. Preemption Review
Fed Const ↓ Fed Const Fed Const↓
Fed Statute↓ Fed Statute↓
State Statute↑ State Statute↑ State Statute↑
How do you find preemption conflicts?
3. III. Did Congress Intend to Keept the States Out of This Field?
a) Assuming that both federal and state laws occupy the same field, is it apparent that Congress
intended to preempt a state law in that area? Usually a judicial determination.
4. IV. Has Congress Implied Its Intent To Occupy The Field By Pervasive Regulation?
a)Is there a comprehesive and pervasive pattern of regulation in the field?
Depends on how you define “the field.” Securites law - yes. But takeovers is a narrow field and
there is not a comprehensive and pervasive pattern of federal legislation on takeovers.
5. Is there such a need for NATIONAL UNIFORMITY that any act by congress means
they intend to occupy it?
No, because the historically states are allowed to regulate corporations. No historical national
regulation. National Uniformity Not required.
a. state law requireing all trucks in state use curved mudguards to prevent
spatter and enhance road safety was unconstituitonal.
b. Straight mudguards were legal in 45 other states and curved mudguards
were illegal in one other state.
c. Burden on interstate commerce too great.
The law just says that 10% of the shares are in Indiana. So the law touches a lot of out-of-state
SH.
CONCURRENCE: (Scalia, J.) As long as a state's corporation law governs only its own
corporations and does not discriminate against out-of-state-interests. it should survive this Court's
corporate anti-takeover law. scrutiny under the Commerce Clause.
Amy says:
CTS v. Dynamics (pg767, n93, SC)—IN enacted a statutory scheme requiring SH approval prior
to significant shifts in corporate control. The practical effect of this requirement is to condition
acquisition of control of a corporation on approval of a majority of disinterested SH (what exactly
is a disinterested SH?)
Holding: This statute is constitutional. Entities can comply with both the Williams Act and the
Indiana Act, and the purpose of the Williams Act is not frustrated by it. The IL statute that was
struck down in MITE was different because it gave the company an advantage in communicating
with SH, while the IN statute just protects SH against both sides in a takeover. The additional
delay in the IN act is not fatal unless it is unreasonable. And the IN statute doesn’t go against the
commerce clause. Hindering tender offers is not enough reason to invalidate the statute
Concurrence: Statute may not be wise, but as long as it doesn’t discriminate against out of state
interests, then it is fine.
Dissent: It undermines the Williams Act.
Control thresholds suspend voting rights unless the majority of disinterested SH.
See analysis, pg777, Should DE be dictating the law for half of the US corporations?
interstate commerce are only incidental, it will be upheld unless the burden
imposed on such commerce is clearly excessive in relation to the putative
local benefits. If a legitimate local purpose is found, then the question
becomes one of degree. And the extent of the burden that will be tolerated
will of course depend on the nature of the local interest involved, and on
whether it could be promoted as well with a lesser impact on interstate
activities.
B. Rational Relationship to a Legitimate State Purpose
1 Legitimate State Purpose: Under their police powers the states may regulate and
tax for the health, safety, morals, and general welfare of the public.
2 Economic Protectionism: DCC bars a state from seeking to benefit its people by
shielding them from the economic consequences of free trade among the states
(strict scrutiny)
3 Rational Relation: Under the rational basis test it is assumed that facts were known
to the legislature that would make the challenged law a reasonable way of
achieving the state’s ends (Rarely struck down on these grounds)
C. Market Configurations
1 Market Configurations: The Commerce Clause protects interstate dealers or
traders from state discrimination designed to insulate in-state competitors, but it
does not protect particular configurations or arrangements or the market.
a) Exxon Corp. v. Maryland (292) FACTS: Court upheld a law prohibiting
producers or refiners of petroleum products, all of whom were out-of-staters,
from operating retail service stations in Maryland. Since no producers or
refiners in Maryland, in-state dealers would have no competitive advantage
over out-of-state dealers. HELD: 1) Not invalid simply because it causes some
business to shift from a predominantly out-of-state industry to a predominantly
in-state industry.
b) Minnesota v. Clover Leaf Creamery (293) FACTS: Upheld a state law that
banned the retail sale of milk products in plastic non-returnable containers but
permitted sales in non-returnable containers, mainly made of pulpwood.
Pulpwood was a major instate product. HELD: 1) Does not effect simple
protectionism, but regulates evenhandedly by prohibiting all milk retailers from
selling their products in plastic, regardless of state. 2) Most dairies package in
more than one type of container 2) Out-of-state pulpwood may still benefit
2 Business entry and regulation of corporate affairs
a) CTS Corp v. Dynamics Corp. of America (295) FACTS: Indiana law
providing that a purchaser who acquired “control shares” in an Indiana
corporation could acquire voting rights only to the extent approved by a
majority vote of the prior disinterested stockholders HELD: 1) On its face, the
Indiana Act evenhandedly determines the voting rights of shares of Indiana
corporations. 2) To the limited extent that the Act affects interstate commerce
(M&A), this is justified by the State’s interests in defining the attributes of
shares in its corporations and in protecting shareholders.
b) Bendix Autolite v. Midwesco Enterprises (299) FACTS: Struck down an
Ohio law providing for unlimited tolling of the statute of limitations wrt entities
located outside of Ohio that had not designated an Ohio agent for service of
process. HELD: 1) Places an unreasonable burden on commerce 2) Leave
balancing approach to negative commerce clause cases and legislative
judgments to Congress
D. Market Participant Exception
1 If a state enters the marketplace as a participant, its actions are treated as being
like those of a private party, and the state is exempt from the restraints of the
dormant Commerce Clause
a) Applies when state engages in the buying, selling, or dispensing of goods or
services
2 Reeves, Inc. v. Stake (1980) South Dakota was a market participant when, in
selling cement from a state-owned cement plant, it restricted sales to residents of
South Dakota
3 Exception to the market participant exception: Applies only to a state’s
activities in the particular market, narrowly defined, in which it is a participant. A
state may not impose conditions that have substantial regulatory effects outside, or
“downstream” of the market in which it is participating.
South-Central Timber v. Wunnicke (301) FACTS: Special provision to Alaska timber sale
contracts requiring the purchaser to partially process the timber in Alaska before shipping out of
state. Alaska participated in sale of timber, but not processing. HELD: 1) If a State is acting as a
market participant, rather than as a market regulator, the dormant Commerce Clause places no
limitation on its activities 2) When a state imposes “downstream” conditions, restrictions on resale
or use, it no longer acts as a market participant but as a regulator 3) Restricts what purchaser
does after it makes purchase from State, when State no longer has an interests in transaction 4)
Within virtual-per-se rule of invali
FOR FEB 14: OVERVIEW OF SECURITIES MARKETS; THEN GET INTO SECURITIES
REGULATION. DO FIRST 3 CASES OF SECURITIES REGULATIONS PACKETS.
EXAM ALERT: LOOK FOR PREEMPTION AND DORMANT
COMMERCE
Williams Act was intended to protect. Thus statutes that affect tender offers but do not directly
interfere with the tender offer itself, and that limit their application to corporations incorporated in
their state, should be constitutional.
Note: from a law and economics standpoint these state regulations have an adverse effect
because they have a limiting affect on the market for corporate control.
Katz v. Oak
Oak had issued long-term debt. Katz held some of the debt securities issued by Oak. Being in
severe financial problems, Oak made certain restructuring and recapitalization efforts. Among
them, Oak made Payment Certificate Exchange Offers (PCEO).
The PCEO is an any and all offer. Under its terms, a payment certificate with a cash value of
under the face but above the market value is offered in exchange for the debt securities. The
PCEO is subject to a couple of conditions. Among those is that one may not tender unless at the
time one consents to certain amendments to the underlying indentures that would have the effect
of removing certain significant negotiated protections to holders of Oak’s debt securities including
deletion of all financial covenants. These modifications may have adverse effect to debt holders
who decide not to tender pursuant to either exchange offer.
Katz alleged that this condition to consent to the amendments constituted a breach of contract
because rational bondholders in fact had no choice but were forced to tender and, therefore, to
accept the amendments to the indentures. Failure to do so would face a bondholder with the risk
of owning a security stripped of all financial covenant protections and for which it is likely that
there would be no ready market. Furthermore, Katz complained that the purpose and effect of the
exchange offers is to benefit Oak’s common stockholders at the expense of the holders of its
debt.
The court rejected Katz’ claim. First, since there are no fiduciary duties between
the corporation/directors and its debtholders, but between them and the shareholders, it is not
unusual and does not itself constitute a breach of duty if the directors are acting in favor of the
shareholders.
The other issue was if the exchange offer was wrongfully coercive. The court
acknowledged that there is a duty between parties to a contract to act with good faith towards the
other with respect to the subject matter of the contract. It stated further that this duty would have
been breached if it would be clear from what had been expressly agreed upon that the parties
would have agreed to proscribe the act later complained of as a breach of this duty.
The court held that this was not the case here. There were nothing in the indenture
provisions granting the bondholders power to veto proposed modifications in the relevant
indenture. In the court’s words, such an implication would be wholly inconsistent with the strictly
commercial nature of the relationship.
Under another provision of the original indenture Oak was not allowed to vote debt
securities held in its own possession. Katz urged that the conditioned offer had the effect of
subverting the purpose of that provision. It permitted Oak to “dictate” the vote on securities which
it could not vote itself. The court held that this provision was designed to prevent the issuer to
vote as a bondholder on modifications that would benefit it as an issuer, but be detrimental to the
other bondholders. However, here only bondholders other than the issuer were offered to
exchange their shares and therefore vote on the amendments.
Another provision granted to Oak the power to redeem the securities at a price set
by the relevant indentures. Katz asserted that the attempt to force all bondholders to tender their
securities at less than the redemption price constitutes a breach of the contractual good faith
duties. However, the court held that the present exchange offer was not functional equivalent to a
redemption. Redemption is unilateral; bondholders have no choice. Here, however, they have;
the success of the offer depends ultimately of the financial attractiveness of the offer, i. e. the
premium offered over the current market value.
1. Corporations
Shield of liability is prime advantage of a corporation.
Officers, Directors, Employees, generally shielded from liability
3rd parties dealing with a corporation, such as tort victims, had no recourse in the old days.
Review rights of shareholders in original notes above.
Centralized management structure
Taxed as a separate legal entity
No Constructive Receipt issues; you can retain cash
2. General Partnerships
Can be a voluntary partnership based on intent.
Can also arise as a function of law.
2 or more persons in association for profit.
Co-ownership
(1) Control is shared; profit is shared
(2) Different from agency relationship.
(3) Agency must be intentional.
(4) Liability is shared
(5) Tax: Partnership files an informational return but they are taxed at the individual
level of the partners.
(a) Partners receive K-1’s.
(b) Constructive Receipt: you pay taxes on funds you fail to disburse.
(6) Raising Capital:
(a) Add more partners
(b) Capital Call
(c) Debt
3. Joint Venture
Almost always the same as a general partnership
Partnership is a bit more open-ended; thought of as on-going
JV - more of a limited term
5. Sole Proprietorships
Advantage is complete control;
liability is a downside.
Access to capital markets is limited
No real tax advantage
7. Professional Corporations
Less likely to be used today
Used to be for doctors and lawyers who couldn’t use traditional corporate form due to restrictions
on investors (couldn’t have non-lawyer financing a law firm).
Liability Shield
(1) Traditionally, NO. No shield from a PC. The states would typically would not
allow a PC to shield the principals from acts of negligence.
(2) Might protect you from slip-n-fall or other light liability, like debts
(3) Other states required liability insurance up to a limit, beyond which the liability
shield kicked in.
(a) Knipprath says this is similar to piercing the corporate veil. Example: you
set up an explosives company. Explosives explode, so it’s foreseeable that
you might have an accident. Therefore, if you set up a company that is
undercapitalized such that it can’t meet foreseeable liability claims, you could
pierce the corporate veil.
(b) If you practice law without malpractice insurance, aren’t you running an
undercapitalized business? So the legislature just makes it a law.
Advantages of a P.C. -- Tax and Pension Planning
(1) Partnerships were pretty much limited to IRA contributions
(2) Keogh plans (HR 10)
(3) But corporate pension plans were much better
(4) In the ‘80’s, Reagan imposed greater non-discrimination requirements on
corporate pension plans which limited their attractiveness.
9. Limited Partnership
Centralized Management similar to a corp
Investment vehicle; not a mechanism for people to work together
Separation of management and investment functions
Caps on number of limited partners have largely been abandoned.
Decent vehicle to raise capital for a small-medium project
Typically, the GP is the promoter
Investors’ roles are proportionate to the amount of their investments
Beyond their economic investments, limited partners can influence management; but, the GP
runs the day-to-day operations.
LP acts (ULPA and RULPA) blurs the roles of the general and limited partners to meet the
desires of many of the investors who want to have limited liability but at the same time not be
restricted as much from participating in management.
Be sure to have a limited partnership agreement
As a practical matter, the GP drafts the agreement, so he will be sure the LP’s don’t have too
much power
Thus, the legal blurring of the lines between lp and gp are not much of a problem.
Liability:
(1) Varies directly with control. Less control = less liability.
(a) GP has most liability. He is fully personally liable.
(b) LP has least liability. He is liable for the amount of his investment +
unanswered calls.
(c) This call right can be limited by the partnership agreement. So, if GP does
not call, the LP can be personally liable for unanswered calls.
Management
(1) Very similar to partnership but GP has most power.
(2) Quasi-centralized management; not as centralized as a corporation, but more
than a partnership.
Existence
(1) Can’t just “happen”
(2) Formalities of formation required
(3) Worst case - Court could declare it a partnership
(4) If other GP’s exist, the LP continues to exist even if the LP’s die
(5) If the last GP dies, it must be wound up unless the LP’s elect a new GP within
the statutory time period
(6) Thus, you could have perpetual existence if the LP’s keep meeting and voting in
a new GP each time one dies
Transferabilty
(1) Not easily alienable shares
(2) No real public market for LP’s
(3) Right of first refusal typical protection
(4) If a LP sells his interest, the buyer is a mere assignee unless the other LP’s
agree to accept the new owner as a partner. LP’s only sell their right to share
profits, not their actual partnership interests.
(5) Partnership is a voluntary association and you must be invited in.
2. Management
4. Transferability
Hard to transfer a partnership interest
Can’t sell partnership interest without approval of other partners.
But can sell the economic right to receive profits
Easy to sell stock
Access to Capital Markets
3. Provide Liquidity
B. Different Markets
Social Security Fund invests in federal securities. Government uses the Social Security $ and
replaces the case with government securities. Taxes will generate cash to pay the obligations as
they come due.
Big loss potential; almost unlimited risk. With options, you lose your option premium. But with
futures, you need to deliver full cash value of the promised future. Example: You sell a future in
the S&P 500; you have to pay the value of that index at the time of delivery x $500. So, you sell
an index future. Today it’s at $250. I promise to deliver it at $250. If it goes down to $248 at the
time of delivery, it goes down $2. I just lost $2. If it’s $500 for each point drop, I need to come up
with $1,000.
How do I know which way the stock will move? I can get caught in a squeeze. Some argue that
it’s just pure gambling. The point is that it allows you to hedge against stock price fluctuations. It
just cushions (hedges) the loss; it does not prevent or equalize the loss.
(7) Currency Futures
Same concept.
Note: you can get a margin of 25%; and if you register as a speculator, you can get an 11%
margin. So, even if you are a futures trader, you can’t leverage it as much as stock futures
because index futures are much riskier.
7. New Markets
Pollution rights
Energy Contracts
Insurance Futures to stabilize health care costs
C. Equity Markets
1. Primary Issuer Market
Far more (30:1) volume than secondary market. Those companies may not trade on
secondary transactions. They might not have a lot of trading in their stocks.
Venture Capital Market:
Can provide private placement money to new firms with no track record that would
allow them to participate in an IPO.
Venture Capitalist will invest directly in the firm and assume some form of
management control. Their objective is to make $, profit. May have veto rights or
ability to limit management salaries.
VC - they make their $ on the transaction, especially if the company launches an
IPO. VC don’t normally take debt instruments; they expect a profit on the future
offering.
(1) Preferred Shares
So, they will use preferred shares. The company probably won’t have dividends
as a start up. But later, when they do have the $ to pay dividends, the PSH have
a preference.
(2) Convertible PS
Allows VC to cover if the IPO looks good and they want to capture the market
gain.
Knipprath asks: why would anyone else take CS? The answer is that if you
don’t do it the way the VC wants, you won’t do it at all b/c you probably have a
really risky idea that no bank or other traditional lender will finance.
Types of Venture Capital Firms
2. Secondary Markets
Auction Markets
(1) Concept of Auction Markets
NYSE is a secondary market. They are auction markets. Example: Rocky
Mountain Exchange; very risky auction market.
(2) Specialist Markets
These are known as specialist markets. Every stock has a specialist assigned to
it with a seat on the exchange. It is these specialists who auction the stocks.
The more the stock is traded, the easier it is to match buyer and seller. You can
buy at market (get it now) or you can have a limit order (cap and floor on
purchase).
(3) Duty of Specialists To Maintain Stable Market
In some cases, the specialist might have to become a market maker because he
has a responsibility to maintain a stable market. At some point the specialist may
have to step in and sell from its own shares. At that point, the specialist
becomes a dealer in the stock.
(4) Risk of Default Minimized - Faith In Markets Increased
By stepping in and making a market by selling its own shares, the specialist
helps reduce the risk of default by one of the parties thusfar unable to match a
buy or sell requirement.
Dealer Markets
(1) Preeminent is the NASDAQ
Not every transaction is included. The index only tracks dealer trades. There
are a few firms listed both on the NASDAQ and the NYSE. The NYSE tends to
be dominated by older, more traditional firms. NASDAQ is more high tech,
newer companies.
(2) Dealer and Auction Market Movement
Usually move in same direction; but sometimes go in different directions. When
tech stock suffer, the NASDAQ usually leads the movement before the NYSE.
(3) Role of the Dealer
Buyer buys or sells directly to a dealer in those securities. The dealer can also
be a brokerage firm for other transactions. Dealer will have a bid-ask range for
the stock.
(4) Best Execution and Market Efficiency Theory
You can be a dealer, selling a security, and you have a price quotation. But
another dealer may quote a different price. So how does the investor know the
price difference between dealers? Your broker might be able to get quotes more
easily than you can. Broker has a legal duty of best execution. Idea is that inter-
dealer competition on the bid-ask spread will maximize market efficiency. The
spread today after the introduction of the decimal system in 1998, is down to 3
cents. Also, due in part to SEC reforms after dealer collusion investigation.
Electronic Direct Markets (Non-Dealer Markets)
Used to be limited to institutional investors dealing directly in the stock. In such
cases, you have known actors and the risk of default is less. The difficulty is that you
can’t really move large blocks of stock through non-dealer markets.
D. Regulatory Framework
SEC is an indepent non-partisan agency of 5 members, no more than 3 members from either
party. Sometimes jurisdictional gray areas between SEC and CFTC. Also, between the SEC and
the NYSE or NASDAQ. And there are the state securities commissioners.
1. SEC
SEC acts pursuant to several statutes. Really set up under the ’34 act; but also functions
under the ’33 act for issuer transactions. ’34 act deals with secondary transactions; has
been amended by the Williams Act, Insider Trading Act, blah blah blah. Safe harbour
provisions of ’95 legislation for private …
Sarbanes Oxley Statute
Draconian rules regarding regulation of accounting profession and corporate
reporting. Enhanced liability for corporate CEO’s and CFO’s. Faster § 16b (insider
transaction) reporting; restrictions on corporate loans; restrictions on compensation
and bonuses during periods where earnings were misstated.
Other Influential Acts
SEC works subject to a shitload of statutes, including the APA (from admin law).
Criticisms of the SEC
Influence of special interest groups. Desire to expand bureaucratic turf. Lawyers
complain that the SEC avoids bright lines in order to entrench their positions.
Example: SEC has never defined “insider trading.”
avoid states with tough Blue Sky laws. But, what if it’s California, with 12% of the
nation’s capital?
(4) State - Federal Coordination
(a) Federal Registration Must Be Honored
§ 18 of the ’33 Act: if you are listed on the NASDAQ, and you want to issue
another security, states cannot require a new registration.
(b) Federal Exemption Must Be Honored
E. Distribution of Securities
Intel could simply market and distribute its own stock if it wanted to. Sometimes companies
actually do that. Could be to save a lot of money on transaction costs. Example: you might
be marketing your shares to your employees as part of a retirement plan. Since you are only
targeting your employees, you market directly.
But, normally, companies are not very good at marketing securities and they leave it to the
professionals.
1. Underwriters
Dealers in securities who are large enough to handle the chore and risk of marketing a
security on behalf of a corporation. Investors like the system because they trust the
underwriters. Underwriters have a name that they have made; a reputation. They can
get compensated based on that kind of position they have; the trust they have earned.
Most people who buy initial issue distributions are large institutional investors or high
wealth individuals. Often these are parties who deal frequently with the broker-dealer.
Liability of Underwriter
Liable if fraud and there is a lack of due diligence in discovering.
Various Types of Offerings
Direct issuer offering (pension plan scenario). This might become more common in
the future b/c so much more investing is now done through the internet. And the
political parties have shown that one can raise a lot of $ through the internet. So, if
you’re a start-up company, there might be a chance to raise $ here. The SEC is
looking into potential abuses here. Requirements of the law still apply; it’s just a
different device that allows the issuer to avoid the cost of using an underwriter.
Preemptive Rights Doctrine
To buy a proportional share of what they had prior to the offering; today this is seen
as an interference in marketability. Sometimes a company can make a deal that
because they may not have access to a large public, but they do know who their s/h
are
Dutch Auction
The company offers the security at a minimum price. Buyer may bid for any number
of shares. So, if buyer #1 bids for 100 shares, #2 for 1000 shares, etc. If the
issuance is over-subscribed, a bidding will develop and the price rises accordingly.
Final price is the maximum price at which all shares can be sold. And all shares will
be sold at that price. So if you’re trying to sell 1,000 shares and you get an offer of
$35 for 900 shares and $42 for 300 shares; you end up selling all 1,000 shares at
$35. Shares are issue proportionally. This is common in the U.K. You still need an
underwriter. The benefit of it is that it puts the initial appreciation into the pocket of
the issuer, not the underwriter. In a traditional issue, $ left on the table go to the
underwriter.
There is one market in the U.S. where this type of market is used: U.S. Treasury
securities.
7. Direct Ant Fraud Provisions: § 17A of ’33 Act; § 10b of ’34 Act
§ 5(c) unlawful for any person to directly or indirectly make use of the use of the mail or
instrumentality of interstate commerce offer to sell or buy through any means unless
registration has been filed. Not supposed to do anything to arouse interest in the offering. Under
§ 5(a) says you can’t sell until registration statement is in effect; but you can start making offers.
This helps regional underwriters meet their due diligence duties; the road show gives them a
chance to ask questions. Caution at these presentations: investors will care about return. Are
you making projections or promises? Be careful not to disclose any non-public information. Can
also disseminate information through certain newsletters, etc.
§ 5(b) says no mailing of prospectus unless meets requirements of § 10. Under § 2, a prospectus
includes just about everything (written, by radio or television). Only allowed oral communication.
§ 10(b) Short, Summary “Red Herring” prospectus; cannot contain price. Why not? When issuer
goes touting an offer w/o price then it’s not an offer. Under common law, this is a solicitation; an
invitation to bid. Real reason they don’t talk about price is b/c this is the first time the issuer has
had direct communication w/ the public. Issuer wants to gauge interest. Also, if the issuer puts a
price on the issue at this early stage, there might be a big change in the market and you won’t be
able to sell the deal. Price goes in at the last moment.
Knipprath asks: is email OK? Yes, cause written. But maybe a chat session is not? The SEC
position is that as long as it’s a brief exchange, it will be treated like a telephone conversation.
But, if you have a document attached to the email, it’s a prospectus.
§ 5(b) tells you it’s unlawful to sell a security unless it’s accompanied or preceded by a
prospectus that meets the full prospectus requirements of § 10(a).
Final terms sheet per 430A bridges the preliminary and final prospectus.
One problem is the problem of soft information. Soft information is the whisper quote.
Projections and forecasts and expected rates of return. But, that is what investors most want.
The judgment of investors as to what it most likely to happen. Many investors view prospectus’s
without soft information as borderline irrelevant. So, today, MD&A is allowed. Rule 175 issued in
1979 encouraged the use of forward looking statements unless issued without reasonable basis.
Courts have become very tolerant of forward looking statements. π has burden of proof on claim
of insufficient basis for projections. Investors are expected to know there is inherent ambiguity
and risk in projections. Investors in these types of offerings are likely to be sophisticated. ’33 Act
was added to include safe harbors for such projections as long as meaningful cautionary
statement was included. § 17A. safe harbor only applies to § 12 (exchange traded) companies.
So, no safe harbor for IPOs.
Few more points to cover on registration process and then we will discuss what is a security.
Plain English Rule: One other SEC requirement is the “plain English” requirement; short
sentences, definite concrete every day language, active voice, simplification of complex materials
into tables, avoid multiple negatives, no legal jargon or technical business language. Applies only
to front, back, summary, and risk analysis and projections.
A. Definition of a Security
“The term “security” means any note, stock, treasury stock, bond, debenture, evidence of
indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-
trust certificate, preorganization certificate or subscription, transferable share, investment
contract, voting- trust certificate, certificate of deposit for a security, fractional undivided interest in
oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security,
certificate of deposit, or group or index of securities (including any interest therein or based on the
value thereof), or any put, call, straddle, option, or privilege entered into on a national securities
exchange relating to foreign currency, or, in general, any interest or instrument commonly known
as a “security”, or any certificate of interest or participation in, temporary or interim certificate for,
receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing”.
Requires with very few exceptions all publicly traded companies to register their securities with
the SEC. Part of that registration is a prospectus.
Many people don’t read them b/c they are long and boring and full of boilerplate language
disclosing risks.
The company is selling security which is a piece of paper representing an ownership interest in
the enterprise. It is different from a partnership agreement b/c shareholders or security holders
don’t have a management role in the company.
Howey Test – how much control do you have? This will tell us if it is a security.
Landreth – stock is automatically a security
It is tough to tell if it is a security if there is no writing.
Was it disclosed.
2. Investment Contract
The Supreme Court has interpreted it broadly to reach “novel, uncommon or irregular devices,
whatever they appear to be”.
“A general partnership or joint venture interest can be designated a security if the investor
can establish, for example, that
(iv) An agreement among the parties leaves so little power in the hands of partner or
venturer that the arrangement in fat distributes power as would a limited
partnership; or
(v) The partner or venturer is so inexperienced and unknowledgeable in business
affairs that he is incapable of intelligently exercising his partnership or venture
powers; or
(vi) The partner or venturer is so dependent on some unique entrepreneurial or
managerial ability of the promoter or manager that he cannot replace the
manager of the enterprise or otherwise exercise meaningful partnership or
venture powers.”
In determining whether the investors relied on the efforts of others, we look not only to the
partnership agreement itself, but also to other documents structuring the investment, to
promotional materials, to oral representations made by the promoters at the time of the
investment and to the practical possibility of the investors exercising the powers they
possessed pursuant to the partnership agreement.
Get Amy’s notes from today, 2/18/2005, b/c I’m not listening.
“security”
Under §2(1).
Investment contract:
1. common enterprise
2. profits solely from the efforts of others
“prospectus”
any prospectus, notice circular, advertisement, letter, or communication written or by radio, television which offers any
security for sale or confirms the sale of any security. Lambert: prospectus is a selling doc, but really it is a disclosure doc.
Who does it really protect? Not the buyer, but the issuer. It is unrealistic to think that buyers make decisions based on
prospectuses (Yahoo’s said in bold type “ this is a shitty risk, we don’t have any capital and we are not making any
promises”)
“Stock”
Stock is a security, but just because you call something “stock” does not make it a security (United Housing Foundation v.
Forman)
§2(3): The term “sale” or “sell” shall include every contract of sale or disposition of a security or interest in a security for
value. The term “offer to sell”. . . shall include every attempt or offer to dispose of, or solicitation of an offer to buy, a
security or interest in a security for value. . . etc. . .
§2(4): The term “issuer” means every person who issues or proposes to issue any security. . .
§2(11): The term “underwriter” means any person who has purchased from an issuer with a view to, or offers or sells for
an issuer in connection with, the distribution of any security. . . etc. . .
§ 3(a)(11) ??
Administrative safe harbor exemptions to protect issuers of small issues. What is this all about? Why are we talking
about § 3? They have many similarities to transactional exemptions; but they are not. They are admnistrative
exemptions.
i Koscot: Cosmetics sales in a pyramid scheme. There were 3 levels. Level I sold
cosmetics and recruited. Levels II & III got cosmetics at a discounted rate
& sold to the lower levels.
Analysis: The crts found that levels II & III had vertical commonality. They were
dependant on the success of the co to get more people to sign up. The
people who bought in brought in potential recruits but the co. took over
from there. Script & sales pitch. Level II & III profits were tied in
SUBSTANTIALLY from the efforts/profits of the co.
Conclusion: A security.
i Howey: Fl orange grove sold off segments to mostly out-of-state patrons of the Howey
Hotel. They also sold a service K to cultivate & harvest the crops. All but 15%
bought the svc K.
Analysis: the crt thought the 15% was insignificant & looked at this situation as an
investment of money, in a common enterprise since the crop sales were pooled
and from the efforts of others since most of the owners were out of state.
Conclusion: This investment K was a security.
i Forman: Selling shares in a coop. People were buying a rt to get a low income apt from a
nonprofit corp. They paid a deposit & then pay rental fees. No dividends. Can
only sell to Coop for cost plus what you've paid down on mortgage or someone
approved by Coop.
Analysis: Just cuz called a stock doesn't mean it's a stock. No free transferability cuz can't
bequeath it, can't hypothecate it, don't get a voting rt proportionate to your share
from it but rather you get a place to live.
Conclusion: not a stock even though it's called a stock.
ii Landreith Timber: If someone buys all the stock in a co. from someone else. Does that
come under SEC? It's called a stock.
Analysis: Appellate court said, NO cuz people can't get exploited since they are in control.
Supremes said that it doesn't matter cuz if you look at the instrument itself, it is
a stock, voting rights, dividends, transferable, etc.
Conclusion: Look at it functionally, so a stock.
Issuer Registration
Exempted Securities Public
Distribution / Sales
Before you can have any resales you have to know the issuer.
Transactional exemptions talk about the issuer.
§ 4(1) is not an issuer exemption.
§ 4(2) is.
§ 5 does not involve transactions by an issuer
Issue $4.75
Before SEC Disc $4.00
Before Public Disc $3.25
After Discl to date of suit $3.50
issuer's price subsequently declined, and, after a public disclosure of the mistake, the price rose.
Plaintiffs alleged that the error rendered defendant issuer liable for the stock price decline.
The court dismissed parts of the appeal for lack of appellate jurisdiction, affirmed
summary judgment for defendants on the Securities Act claims, and remanded. Defendants
established that the error in the prospectus did not cause the stock price decline. The
misstatement was an innocent bookkeeping error, and the prospectus had expressly stated
that the issuer expected the subsidiary's sales to decline. Plaintiffs lacked privity to maintain
an action against defendant issuer because § 12(2) of the Securities Act granted standing only to
the person who purchased securities from the seller. Title to the securities had passed from
defendant issuer to defendant underwriters and then from defendant underwriters to plaintiffs.
Thus, defendant issuer was not in privity with plaintiffs for purposes of § 12(2).
OUTCOME: The court dismissed parts of the appeal for lack of jurisdiction. The court affirmed the
judgment for defendants on plaintiffs' Securities Act claims where defendants established that an
error in the prospectus did not cause a stock price decline and where plaintiffs lacked privity to
maintain the action against defendant communications company as a securities issuer. Finally,
the court remanded case.
So, if Pinter can estalish that Dahl was a seller, then Pinter limits his liability as a seller to only
Dahl and not all the people Dahl sold to. Then, he (pinter) can claim that since Dahl has unclean
hands he should not be allowed to recover.
This is like a best efforts underwriter, not a firm commitment. Pinter confers title so he’s for sure
a seller. To bring Dahl in under 12(a)(2) you need scienter which is like an aider & abetter
argument.
Pinter defends against the aider & abetter allegation by asserting unclean hands (in pari delicto).
SC says they don’t know if the parties were equally culpable, so they remand for determination.
a. ISSUES:
1) Whether the CL in pari delicto defense is available in private action
under 12(1) for the rescission of the sale of unregistered securities and
2) whether one must intent to confer a benefit on himself or on a third
party in order to qualify as a seller within the meaning of 12(1) (was
Dahl a seller and liable under 12(1)).
b. FACTS: Pinter finds Dahl and Dahl solicited others to invest. venture fails. investors want
$ back or rescission. Pinter alleges Dahl has unclean hands (in pari delicto). As a defense,
Pinter wants contribution from Dahl if Pinter has to pay
c. Holding:
1) Yes in pari delicto defense available, remand to see if works
here. Nothing in statute prohibits it and statute denies recovery to
ppl that viol the law. (Note Bateman Eichler defnse available in
10(b))
2) Seller under 12(1)= one who passes title; one who
particpiates in sale for value (broker participates and gets
commission) Ct rejected substantial factor defense - one who
participates in deal and was a substantial factor to getting deal
done. (so Lawyers who drafted deal aren’t liable based on this
particular theory)
d. Notes:
1) subsequent cases held that the decision applies equally to
an action under 12(2) as to one under 12(1). no aider and abettor
liablilty under 12(2).
2) ftnt 8 - ct expressed no view as to whether equitable defense
of estoppel is avilable in 12(1).
3) ftnt 9 Unlike section 11, §12 does not expressly provide for
contribution. ct expresses no view.
4) the terms” offers or sells” may or may not be the same for
12(1) &12(2)
5) ftnt 21 - §12(1) (and 12(2)) imposes liability on only the
buyer’s immediate seller; remote purchasers are precluded from
bringing actions ag remote sellers. Thus a buyer cannot recover ag
his seller’s seller. no privity Therefore, can’t leapfrog over
underwriter to reach issuer uinder §12(1).
a) Collins 3rd cir - held the issuer in a firm commitment
underwriting is not liable to the investors under 12(2) bec the issuer
sells to the underwrtiers who in turn resell simultaneously to
selected dealers or ultimate investors and therefore the ultimate
investors do not purchase from the issuer.
b) o
6) §12(2) does cover private placements of securities
Pinter v. Dahl [SCt. 1988]: Pinter had an oil and gas venture. Dahl purchased shares in the
venture and then recommended to his friends that they buy shares. Venture failed, investors
sued Pinter for recission. Pinter tries to get Dahl on the hook, too. Question was whether Dahl
himself was an offeror or just gratuitous promoter. Blackmun Held: Anyone who solicits for their
financial interest is a seller (broker etc). Giving gratuitous advice doesn’t make one a seller.
I) In Pinter v. Dahl, the Court applied the Bateman analysis to ALL securities laws, not just
10b5.
A) Note that the in pari delicto defense is unavailable to 12(1) suits where Π is an investor.
It remains available if Π was a promoter.
12(b) applies to both portions of the section. The bad guy’s actions must have
caused the loss and the bad guy will be liable only for the loss which he caused.
So if market changes caused the loss, the bad guy can escape or reduce
damages. But in 12(a)(1) it’s strict liability; so by its terms 12(b) won’t cover it.
So, 12(b) does NOT apply to 12(a)(1).
Primary liability flows only to a seller – to a person who sells a security. The
following case extends this language to include those who solicit with intent to
benefit themselves
In Pinter v. Dahl, Pinter, an oil and gas producer and registered securities
dealer, sold unregistered securities consisting of fractional undivided
interests in oil and gas leases to respondent Dahl, a real estate broker
and investor who was experienced in oil and gas ventures. Dahl touted
the venture to the other respondents--his friends, family, and business
associates--and assisted them in completing subscription agreement
forms. Interests were being sold without the benefit of registration under
the Securities Act, in reliance on SEC Rule 506 (exemption for limited
offerings – still requires notice of sale be filed). The venture and buyers
sought rescission under 12(a)(1). Pinter argued that Dahl was a seller
and should be liable. Court says that a “seller”: is not just limited to a
person who passes title but also includes persons who solicit offers.
Solicitation can render a person liable if there is an actual sale and the
person who successfully solicits must be motivated by a desire to serve
his own financial interests or those of the securities owners. (Court
remands for a determination as to Dahls motivation/interests in soliciting
the others) So Knipprath wants to know if there is an agency argument
here; was Dahl an agent of Pinter?
The following case addresses the question of whether section 12(a)(2) applies
only to initial sales of securities by issuers or also to secondary trading
transactions:
The court holds that 12(a)(2) does not reach secondary trading,
moreover it does not even apply to initial offerings unless they are made
publically by means of a statutory prospectus. Thus, there is no liability
under the ’33 Act for written or oral misstatements in offerings which are
exempt from that Act’s registration requirements
Potentially liable person under §11 have a “due diligence” defense if they
conducted a reasonable investigation
Under §12, the seller has an affirmative defense if he can establish that he did
not know, and in the exercise of reasonable care could not have known, of the
untruth or omission
Court says that the application of the test is the same, regardless of the difference in wording.
Exercise of reasonable care is the requirement. Court balancing restrictive versus expansive
readings.
§ 17(a)(1) SCIENTER
§ 17(a)(2) NO SCIENTER
§ 17(a)(3) PROBABLY NO SCIENTER
Negligence standard applies because the potential problems are limited due to only the SEC
being able to bring aaction for injunction; you aren’t exposed to $ damages in private suits.
Agency can’t act ultra vires. The statute does not apply a scienter requirement so it can’t be
expanded.
§ 16 -- only cares if you are an insider; not if you traded on inside information. Liability is
premised on 10b and 14(e)(3).
§ 10b liability - see Santa Fe Industries v. Green (ordinary breach of fiduciary duty is not a federal
action under 10b; 10b only deals with fraud and stock manipulation.) Reputational injury to the
corporation. Then fraud on the market theory. So what’s the liability? 10b insider trading liability:
who can bring action? SEC, dept of treasury. Private right of action is implied. But there is a
purchaser or seller requirement. § 20A said you can have contemporaneous purchasers bringing
private rights of action. STANDING IS HARD TO ESTABLISH SO THAT’S WHY THE ACTION
IS USUALLY BROUGHT BY THE SEC. Courts don’t like private actions under 10b.
Potential defendants:
Did you have a fiduciary duty to the corporation whose shares were bought or sold? If you’re an
insider, then for sure you have this duty. Even a mere employee owes a fiduciary duty to the
corporation.
A. 1. Section 11
(ix) As to defendant other than the issuer, the degree of fault required is
essentially a negligence standard.
(x) No need to prove scienter, the defendant’s state of mind is irrelevant.
(xi) Due diligence defenses: §11 (b) (3) have you left no stone unturned?
Due diligence is not an affirmative obligation.
Escott v. BarChris Construction (SDNY 1968), p.80
Distinctions expertised non-expertised information Insider/outsiders
B. 2. Section 12(a)(1)
It imposes strict liability on sellers of securities for offers or sales made in violation of § 5,
i. e. when the sellers improperly fails to register the securities, to deliver a statutory prospectus,
violates the gun-jumping rule. The term seller also encompasses persons who successfully solicit
offers to purchase securities motivated at least in part by a desire to serve their own financial
interests or for those of the securities’ owner. Main remedy: rescission, unless the buyer is no
longer the owner of the securities then damages.
C. 3. Section 12(a)(2)
It is a general civil liability provision for fraud and misrepresentation. Liability under this
section may be imposed where defendant made oral statements, used written selling materials
containing a material misrepresentation or omission. Liability may generally also be imposed in
exempt offerings, but after Gustafson only if the sale occurred in a public offering, i. e not in
secondary market nor privately negotiated transactions. Liability is limited to the seller of a
security (like § 12(a)(1)).
• Pinter sells fractional undivided shares in oil well. Dahl invests his own money, and
gets his friends to invest as well.
• Offering to Dahl’s friends/relatives is under Rule 146 – w/o reg’n st’nt
• Pinter’s defense: sec’s don’t have to be registered, bec under Sec 4(2) it’s not a
public offering
• Then Pinter is suing Dahl for contribution
it is undecided whether there is right to contribution under Sec 12
• Another issue: Pinter says that Dahl is also in violation of Sec 12(1), bec they both
sold sec’s
• Dahl’s threshold defense: doctrine of in pari delicto positiv defendentis potrir
est: bet persons w/equal fault, the position of D is stronger. Dahl says: if I violated
Sec 12, so did Pinter – I can’t be sued. Dist ct said that doctrine doesn’t apply
• Ct of App reversed on that issue: it applies, but only to persons w/approximately
equal fault
• Under Sec 12(1), if you still own the sec, you can rescind
• Who transferred ownership of leases (title) to Ps – Pinter. Dahl’s defense: you can’t
rescind trans’n ag person w/whom you didn’t deal. Court: disapproves this transfer
of title test – 12(1) includes solicitation – under 12(1), any person who offers or sells
in violation of Sec 5 is liable
• Other cts of app: liability ran ag smb who was a subst’l factor in a sale. Court
disapproves subst’l factor test.
• S.Ct remands the case to determine whether Dahl was trying to get money or was
just being a nice guy
Sec 2(3)
“Sale” – every K of sale or disposition of a security or interest in a security, for value.
“Offer to sell” – every attempt or offer to dispose of, or solicitation of an offer to buy, a
security or interest in a security, for value.
• Issue: whether one must intend to confer a benefit on himself or on 3rd party in order to qualify
as a “seller” w/n the meaning of Sec 12(a) – solicitation has to be for value (for financial
gain)
• Sale of unregistered sec’s (fractional undivided interests in oil and gas leases)
• Pinter sold those sec’s to Dahl (real estate broker and investor) and his friends and family:
Dahl invested, then recommended investment to others. Each investor completed the
subscription-agreement form – that participating interests were being sold w/o the benefit of
reg st’nt under Rule 146 of 33Act.
• Venture failed; investors brought suit ag Pinter, seeking rescission under Sec 12(1) of 33 Act
for unlawful sale of unregistered sec’s
• Pinter argued that Dahl fraudulently induced Pinter to sell sec’s, that he assured Pinter that
he would provide sophisticated investors
• Dist ct: for investors – Pinter had not proved that oil and gas interests were entitled to
private-offering exemption from reg’n – so rescission under Sec 12(1)
• Ct of App: whether Dahl was himself a “seller” w/n meaning of Sec 12(1). If he was, he
could be held liable in contribution for other Ps’ claims ag Pinter. Seller is
(1) one who parts w/title to sec’s in exchange for consideration or
(2) one whose participation in the buy-sell trans’n is a subst’l factor in causing the trans’n
to take place
here, Dahl conduct – yes, subst’l factor
but still Dahl – not seller w/n 12(1)
Court refined the test to include a threshold req’nt that one who acts as a promoter be motivated
by a desire to confer a direct or indirect benefit on someone other than the person he has advised
to purchase
Here, Dahl didn’t seek or receive any fin benefit in return for his advice – so, not seller –
no liability
• Cert:
• At the very least, 12(1) contemplates a buyer-seller relationship not unlike trad’l
K-tual privity – it imposes liability on owner who passed title, or other interest in the
security, to the buyer for value
Dahl – not a seller in this sense – not liable
• Sec 2(3) defines “sale” as “K of sale of sec for value”: range of persons
potentially liable under 12(1) is not limited to persons who pass title –
also person who engages in solicitation (not only actual owner)
• Plus, P has to purchase sec’s from D/seller – purchase req’nt confines Sec 12
liability to those sit’ns in which sale has taken place; but it doesn’t exclude solicitation
from the category of activities that may render a person liable when a sale has taken
place
statutory seller includes at least some persons who urged the buyer to purchase
broker can be such seller
• Solicitation of a buyer is perhaps the most critical stage of the selling trans’n – it’s
the stage at which investor is most likely to be injured – by being persuaded to
purchase sec’s w/o full and fair info
• But Congress did not intend to impose rescission based on strict liability on a
person who urges the purchase but whose motivation is solely to benefit the buyer
Liability extends only to person who successfully solicits the purchase, motivated at least in
part by a desire to serve his own fin interests or those of the sec’s owner
• Pinter argues for subst’l factor test – too broad – wrong. Plus: it might expose professionals
to liability. Plus, it reaches participants in sales trans’n who don’t fit w/n definitions in Sec
2(3). This test – not sufficient to render D liable under 12(1).
• S.Ct: unable to determine whether Dahl may be held liable as a statutory seller under 12(1).
Gustafson v. Alloyd Sec 12(2) claims can only arise out of the initial stock
offerings
(S.Ct 1995) Stock purchase agr’nt here is not prospectus w/n 33 Act
be right and provided for liquidated damages. So, for them it plainly didn’t
make a difference – not material. Here – far too low standard of materiality.
• In 1933, no one questioned that 12(2) covers any sec’s trans’n. Then 1 case held
that 12(2) only covers public offerings – obviously wrongly decided. S.Ct granted
Cert in this case.
• Massive error from the outset of the opinion: Court first looks at architecture of the
statute w/o reference to definition (unorthodox) + doesn’t get it right
Court says: “Sec 11 provides for liability on account of false registration st’nts;
Sec 12(2) for liability based on misstatements in prospectuses.”
But Sec 11 applies to defective info in a prospectus – complete
misunderstanding of structure of the Act
• S.Ct: Sec 12(2) only applies to public offerings; public offerings that are
exempt are also covered by Sec 12(2) (prospectus is not provided when exempt
sec’s – but still covered)
• S.Ct: the only oral communication covered by 12(2) is oral communication that
relates to prospectus. Slain: there is no basis for that.
• J. Thomas’s dissent is right; Majority opinion is wrong.
• J. Ginsburg’s dissent: heavy reliance on leg history, so Slain is less supportive of it.
• Both Thomas and Ginsburg say: start w/definition to figure out what smth in the
statute means. Slain: right. Here, definition is clear and plainly covers this trans’n.
Other issues:
• Basis for saying that there is no implied right of action under 17(a) has always been
that conduct which is made illegal under 17(a) is made actionable under 12(2) – that
died w/this case, bec it narrowly reads 12(2).
• Definition of prospectus expressly covers confirmation. You can’t send confirmation
w/o final prospectus. Does this survive this opinion? S.Ct – w/o selling doc’nt, you
don’t have a prospectus – reads confirmation out of prospectus – can send
confirmation w/o final prospectus, bec confirmation is not a selling document.
• What if make a false “oral communication” not related to prospectus? Salin: you
should be able to bring action under 12(2). But S.Ct seems to restrict it as oral
communication relating to a prospectus.
• J. Thomas is right in saying that court started w/bias in favor of narrow reading, and
then justified it
In sum:
• S.Ct limited 12(2)’s application to public offerings by issuers or their
controlling s/hs. Thus, 12(2) may be invoked only by purchasers in registered
offerings under 33 Act and perhaps by purchasers in Sec 3 exempt offerings
provided that such exempt offerings take on a public nature.
• 12(2) does not extend to the secondary market other than public offerings by
controlling s/hs.
• Oral communication must relate to prospectus.
• By interpreting the term “prospectus” as “a term of art referring to a document that
describes a public offering of sec’s by an issuer or controlling s/h”, S.Ct significantly
limited the scope of 12(2).
• 12(2) applies only to public offerings.
• Issue: whether right of rescission under 12(2) extends to a private, secondary trans’n, on the
theory that recitations in the purchase agr’nt are part of a prospectus – No.
• Gustafson and other were the sole s/hs of Alloyd, Inc. Wind Point Partners agreed to buy
subst’ly all stock through Alloyd Holdings – new corp formed to effect the sale of Alloyd’s
stock. K of sale was executed. Then the year-end audit of Alloyd revealed that Alloyd’s
actual earnings for 1989 were lower than estimates. Under K, buyer had the right to recover
the adjustment amount from sellers. But buyers brought suit, seeking outright rescission of K
under 12(2) of 33 Act.
• Buyers said that K of sale was a prospectus, so any misstatements there gave rise to liability
under 12(2).
• Dist ct: sum j’nt for sellers: Sec 12(2) claims can only arise out of the initial stock
offerings. Private sale agr’nt cannot be compared to initial offering bec purchasers had
direct access to fin and other co doc’s, and had the opp’ty to inspect seller’s property.
• 7th Cir: decision in Pacific Dunlop: the term “communication” in definition of “prospectus” –
includes all written communications that offered sale of sec. Held: 12(2) right of action for
rescission applies to any communication which offers any sec for sale, including stock
purchase agr’nt in the present case.
S.Ct: Reverse – for Ds.
• Assuming stock purchase agr’nt contained material miss’nts of fact made by sellers and that
D would not sustain its burden of proving due care, P would have right to obtain rescission if
those misst’nts were made by means of prospectus or oral communication. Issue: whether K
here is prospectus w/n 33 Act - No.
• 17(a) does not contain the word “prospectus” – broad construction. In contrast, 12(2)
contains limiting language (“by means of prospectus or oral communication) that limits 12(2)
to public offerings – narrow construction
• Held: the work “prospectus” is a term of art referring to a doc’nt that describes a
public offering of sec’s by an issuer or controlling s/h. The K of sale, and its
recitations, were not held out to the public and were not a prospectus as the term is
used in 33 Act.
Thomas dissent:
• Begin with 12(2), and then turn to 2(10), before consulting structure of the Act as a whole.
12(2) should apply to secondary or private sales of sec as well as to initial public offerings.
• Majority is motivated by policy references – that Congress could never have intended to
impose liability on sellers engaged in secondary trans’ns. But Congress did so w/r/t 17(a) of
33 Act and 10(b) of 34 Act.
• Yes, can be increase in sec’s litigation, but that’s for Congress to resolve.
Ginsburg dissent:
• Drafting history: 12(2), like 17(a), is not limited to public offerings.
• Drafters borrowed from British Companies Act of 1929, but didn’t include “offering to the
public” w/n definition of “prospectus”
public offering of securities by an issuer or controlling shareholder. Since the contract of sale at
issue was a private, secondary transaction, the right of recission did not extend to respondents.
If no registration statement, can’t violate § 11 of ’33 act b/c that only deals with registration
violations.
Tipper: must breach fiduciary duty and reasonably should have foreseen that tipee would trade
on the information.
Exam
Essay
2 1 hr essays
is solely on the ’33 Act.
Registration
Exemption
Civil Liability 11, 12, 17
Previous Case materials
Mergers
Appraisal Rights
DeFacto Merger
Take Over Cases
Ordinary Businsess Judgment in Light of the Smith v Van Gorkem test
Unocal
Revlon
Multiple Choice
Anything said in class
1 hour
Review
Mergers
Statutory:
• 1 corp acquires stock of another corp pursuant to an agreement
• S/H must vote
♦ UNLESS you have a controlling S/H in the bidder; so now you are a S/H in a
large corp dominated by a single S/H
♦ Your potential to sell your shares is diminshed
♦ CONTROL PREMIUM
Review the exemptions diagram
Get from issuance to public distribution
Go through elements regarding private right of action and prima facie case for § 11 &
12
Also look at ’34 act and § 17
Send questions to: swconlaw@netscape.net
Up to 3:00 on Sunday he will call you with the answer; leave name,number,and question.