· Web viewObligation that allows you to protect or manage against the risk of holding a security Gets its value from the risk of another security Value stems from some other enterprise

CHOICE OF ENTITY

Two documents to be filed by a corporation when it goes publico Certificate of incorporation (aka “articles” or “charter”)o By-laws

Operating agreement of the corporation Corporate law is driven by statutes and case law

o In order to properly structure a document from a model, you must understand the nuances of corporate law to write the provisions to your liking

Other than the SC, DE is the most important court in terms of corporate lawo DE court system is well-versed in corporate law

Cynics…DE is keen on protecting its corporate interest So long as you are chartered in a specific state, that is the law that applies, not

where the corporation is headquartered

“business” … a broad term describing all kinds of profit-making conduct businesses are divided in those that are closely held and those that are publicly held

o CH firm…a business with relatively few owners whose ownership interests are not publicly traded on an establish market (e.g., a law partnership or a local air condition corporation)

Generally 5 or fewer shareholderso PH firm…a business that typically has a large number of owners with ownership

interests that are routinely bought and sold on a public market (e.g. Wal-Mart) Unlike subjects such as property and torts, the subject of business associations is largely

governed by statutes

CHOOSING ENTITIES

Issues…Type of entity you want to create will depend on how you want to manage these issues Ownership/Profits

o General partnership Each general partner owns an equal share of the ownership and profits

o Limited partnership Each general partner owns an equal share of the ownership and profits

o Corporation Ownership and profits are determined by how many shares you own

o Equal split is a default rule for all types, you can always contract around this to create different percentages

Discussion is of default rules within this entire context, you can always contract around them though

Liabilityo GP

All general partners are completely liable for the business’s debtso LP

LPs shielded from liability

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o Corporation Shareholder…shielded from liability Director/officer…shielded unless engaging personal affairs

o Corporation is the best shield for liability GP is the worst

Management/Controlo GP

Every partner gets to participate in the management of the businesso LP

Only general partners manageo C

Separation of management and ownership Owners (shareholders) could potentially have no involvement in management

Shareholders could become directors or officerso If you have someone you think may go from in and out of management, the LP is the

worst choice Limited partners are shielded from liability, and if they engage in management

they lose this protection Taxation

o Taxes drive almost everything Business forms, business transactions People will jump through hoops to avoid taxes

o GP Flow through tax treatment

Tax flows through the entity and only the individual partners get taxed Partnerships prepares an income statement and the amounts that would be

divvyed up Even if the case is that all money is being funneled back into business,

and is not being distributed to the partnerso Partnership is still seen as the best route for avoiding taxes

Tradeoff for nice tax treatment is poor liability structure

o LP Flow through tax treatment

Tax flows through the entity and only the individual partners get taxed Partnerships prepares an income statement and the amounts that would be

divvyed up Even if the case is that all money is being funneled back into business,

and is not being distributed to the partnerso Partnership is still seen as the best route for avoiding taxes

Tradeoff for nice tax treatment is poor liability structure

o C Double tax

Tax on the entity level, and shareholders get taxed when the corporation distributes money

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o However, the second tax only comes about when money is distributed

Not to way to go if looking to avoid taxes Tradeoff for poor tax treatment is nice liability structure

Transfer/Liquidateo GP

Will last as long as partners want it to Very difficult to transfer/very easy to liquidate

o LP Easy to transfer…no managerial right Relatively easy to liquidate unless you have a situation where you don’t have

enough limited partners (all you need is one)o C

Meant to last in perpetuity Shares…easy to transfer Very hard to liquidate

PARTNERSHIPS

ESTABLISHING A PARTNERSHIP

Partnership formation Agreement…two people who go into business together with the intention of making a profit

o Does not need to be written, nor do the people involved even need to intend to create a partnership

Written agreement is not needed, but highly recommended Protect against malpractice Avoid disputes and trouble spots Statute of frauds issue

o Oral agreement would be trumped by written partnership rules Many firms do not write down agreement, often because the issues are

so complexo No public filingo Default form of businesso Enterprise of choice for most professional organizationso Family businesses are generally partnerships

Often times they do not write down the agreement

SHARING PROFITS AND LOSSES

Joint venture…partnership based around a single enterprise for legal rule purposes, joint ventures and partnerships are not different

o courts use the terms interchangeably How many people do you need to create a partnership?

o 2 or more peopleo 1…sole proprietorship

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How is a partnership dissolved?o Good thing about partnership…easy in/easy outo Partnership dissolves upon the death, withdraw, or bankruptcy of a partner

Sometimes its hard to tell if a person has withdrawn Any withdraw changes the partnership

If 1 partner walks away from a 3-person partnership, the partnership is technically dissolved

Management of the partnero Every partner gets to participate in the management of the business

Profits and losses dividedo Unless there is a rule, profits are divided up equallyo Losses follow profits

Remember: you can always agree around the rules Liability

o Each partner is personally liableo You can go after all of a partner’s personal assets to satisfy debts

Taxationo Tax is on the distribution

The important question is whether the situation can be considered a sharing of profits or not

o One argument to make within the loan context is that the loaner did not expect to receive any part of the profits

Some management oversight of the business may be acceptable for a loaner so as to make sure that the loan will be paid back

This can be done still without making a partnershipo A business may then be thus characterized as a sole

proprietorship, and the other individual may be characterized as a creditor rather than a partner

Kessler No question as to whether these two people are in a partnership Kessler: 498, 917

o Capital contribution Sale: 420, 000 Three different possibilities for divvying up

o Default rule The financial partner gets paid their capital contribution before they get paid

their profits UPA 18(a)

This means Kessler would get paid the whole 420, 000 Shortfall: 78,917

o Courts deem this as a lost Antinora would pay 50% of 78, 917 under the default rule, unless there is an

agreement about losses or profits (which losses then follow) 40% + interest = 65, 000

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If you are in a partnership and you make a capital contribution, and the partnership doesn’t make enough money to pay you back, then the leftover is deemed a loss and that is split amongst the partners.

Even though A worked for 3 years, he gets nothing As a general rule, you do not get compensated for being a partner

o One thing lawyers write around is compensation Calculation

Kessler: 498,917 Sale: 420, 000 [78, 917] 50% A = 40%, K= 60%

o 50%, 50%...without agreemento California Rule (exception to the default rule)

Exception…default rule does not apply when one party contributes the money and the other the labor

not all courts recognize this exception and apply the default rule Split the profits 60% and 40% The DR does not put any value on A’s services, while K gets paid for making

a contribution CA says that services are presumed to be valued at the same amount as the

contribution Profits are split…capital contributions are not given preference as

they are in the default rule Would CA rule apply if A had been paid for his services?

CA rule only applies if the service partner has no arrangement made with regards to how he will get compensated for his labor

CA rule assumes that with no agreement the arrangement values the service in the same way as the capital contribution

Calculation 420,000

o 60%, 40% 50%, 50%...without agreement

o Kessler Court says the agreement controls It is clear from the agreement that the amount to be paid back to K is to

be out of the sale Not exactly clear in the agreement because the agreement does not

explicitly addresses losseso The lower court acknowledged this

Nobody will be responsible for the $78, 917 Calculation

420,000…Kessler 78,917 is not considered

Fairness considerationso Fairness problem is at the core of the CA Rule

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o What is the default rule? Some people draft statutes to encourage people to write around the

default provision/rules Drafters want you to create a written agreement

o But, many people do not want to think about losses when going into business

Rationale for default rule Ensures that service partner is managing the money properly

o The financial partner may not have direct oversight of the management of money

Remember: losses always follow profits Quick recap

o If there is a written agreement with regards to losses, thatagreement applies.  If there is no written agreement, the default ruleapplies and the split is 50/50.  If there is a written agreement withregards to profits, the default rule applies, but losses followprofits and the split is whatever was designated with regards to theprofit breakdown.

MANAGEMENT & AUTHORITY

CREATION OF THE AGENCY RELATIONSHIP AND ACTUAL AUTHORITY

Partners have agency and their business decisions bind all partners Decisions of an agent bind a principal so long as the agent acts within the scope of her

authority Two critical types of authority

o Actual authority Type of authority that runs from the principal to the agent The principal, through her words or conduct, leads the agent to reasonably

believe she has been authorized P…A Actual authority could be express or implied Actual authority will bind the partnership, so long as the decision made is

within the scope of the authority giveno Apparent authority

Principal creates the impression of authority in a third party What would be reasonable for a third-party to believe based on the words and

actions of the principal? P…TP You can have both actual and apparent authority at the same time Even if the agent isn’t acting with actual authority, he may be acting with

apparent authority And all you need is one to have the decision to be binding

o Actual authority is no stronger than apparent authority Two threshold questions

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o What kind of authority is given?o Does the decision fall within the scope of the authority given them?o Remember: authority and scope of authority problems are sometimes one and

the same You should still address both questions, even if you are just saying that you

addressing them together Each individual partner is an agent acting on behalf of a principal, in this case the

principal is the partnership

Stroud Clue…

o Whenever you have a renegade partner doing something, you are dealing with an authority issue.

Review…o Default rule…

No sweat equity Stroud gets his money back, and the amount they are short is split

o CA So long as Freeman does not get paid, we split the 30k equally If he gets paid, we go back to the default rule

What kind of authority does Freeman have?o Actual authority

Source of authority Written agreement; or, Through the nature of the business

o F has actual authority by implicationo Partners have equal shares and thus equal ability to manage the business and bind the

businesso When talking about actual authority, it doesn’t matter what Nabisco thinks in terms of

agency Why doesn’t it matter that S told Nabisco that they don’t want their bread?

o The idea in the partnership is you have one vote, regardless of the split of the profitso If there were more partners…

Three partners 2…no bread 1…ordered bread

Questions What type of authority?

o Here, actual authority Focus on what the agent reasonably believes

o Notice to a third party only matters when discussing apparent authority

If, two people came to the third party and told them the deal is off, that could destroy apparent authority

But, it may not destroy actual authority

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Can S restrict F’s authority? o The only way to change the authority of the partners is by agreement of the majority

And because one vote is only 50%, one partner cannot restrict the authority of another partner in a two person partnership

If it were a three person partnership, and two people restricted the authority of one partner, the one partner can no longer reasonably believe he has authority to act

Apparent authorityo How can a third-party have a reasonable impression to act if there is a disagreement

between two partners? This level of confusion could be enough to defeat the apparent authority

o If there was no clear dispute and business was conducted as usual, apparent authority will likely stand

o What if F orders 4 times as much bread? Does this increase fall within the scope of F’s authority to purchase?

What do they do about this?o How can the authority distribution change?

When you have a two-person partnership, there is no way to stop the other partner’s actual authority, until the business is dissolved

Apparent authority continues until notice is provided to the third parties that there has been a withdraw

Only a real problem with these two-person partnerships

APPARENT AUTHORITY & ESTOPPEL

Agency relationshipo Principal…entity

Principal acting…partnership doing something E.g.,, principal may make an impression of agency on a third party and

create apparent authority o Agent…one of the partners

Stroud…actual authority Today…apparent authority All you need is one form of agency to bind principal/partnership Actual authority

o Questions to ask in determining whether there is actual authority to bind: Source Scope Revoke; limited

o Acquiescence (form of actual authority)…creation of “actual authority after the fact”

Questions to ask in determining whether there is actual authority to bind: Notice Non-objection Remove/limit

o Majority of partners must be doing something in order to act

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Apparent authority o Sourceo Scopeo Notice

Is the third party on notice that there has somehow been a change in the nature of the authority given the principal by the agent.

Apparent authorityo Lying partner is a complication

With regards to actual authority, if you are lying about the nature of your actual authority, it does not matter because either you have actual authority or you do not

o In the case of apparent authority, the principal, NOT THE AGENT, must create the reasonable impression in the mind of the third party

Instruments of impression (cars, stationary, etc.) Instruments of impression may create the notion that what the agent is

saying is coming from the partnership/principal.o This TP claim is valid if it looks like the agent is speaking

for the principal E.g., if the agent gives off the impression he is the

managing partner What if a troublesome cousin unrelated to business is using

instruments of impression?o What if the principal has taken steps to prevent the theft of

instruments of impression? For the most part, the court will say that if there has

been diligence asserted, the third party’s claim will not be valid

Even though this all looks the same to the TP The claim made by the third party must have

some sort of argument suggesting that there has been some degree of laxness, rather than diligence

Similar past dealings…nature of business TP’s apparent authority argument is strengthened if TP has knowledge

that the principal in the past has authorized D to act as an agent in similar past dealings

o Some courts say that it doesn’t matter if E has particularized knowledge of these similar past dealings, it is about how the partnership presents itself

Similar past dealings…course of dealing Has contact within the course of dealing created a reasonable

impression? Custom

What if custom in NC is to have all or a majority of the partners at big transactions? And custom in DC is to send only one major partner?

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o If TP only believes one partner exists, they cannot come back and sue the whole partnership because they did not believe other partners exist

Question about what custom controls because one party is from NC and one party is from DC

Power of position (title) D is a managing partner

o Broader ability to act to ink deals Courts sometimes talk of the power of position

o Impressions given by a person’s titleo Partnership has given this title to the person

o Scope question Proximity of prices Fair market value If L sent down a letter to NC with her drop down price (unlikely move in

negotiations though) If D exceeds said price, no apparent authority as E was on notice

o Aside: fiduciary duty is at its highest in the partnership context because partners can bind you

o Footnote Lying and engagement in an illegal act can overcome an authority analysis,

even actual authority If D sneakily overcharges for cupcakes, court will rule that he still has

actual authority even though he engaged in illegal behavior (assuming that the illegal behavior is not so radical)

o Courts have said whether or not something is reasonable depends on the contexto To go out and get the best you have to do something extraordinary

Sometimes courts say look at it in contexto To get someone extraordinary, you have to do something extraordinary…from this

perspective the deal here looks more reasonable o Courts have been more willing to sign off on offers like these when a renegade partner makes

a partner AND the person relies on the offero If law student rejects her other offers

Strengthens our argument for her reasonable assessment of the offer Reliance becomes and important factor

Quick Recapo If you can show actual, actual after the fact, or apparent authority you can bind the

partnership

RECAP Actual authority

o Reasonable impressions that the agent could have If agent is lying, there is no way they could have a reasonable impression

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Apparent authorityo Reasonable impression that the third party, as conveyed by the principal

E.g, principal’s giving of a title even if the agent is lying about the responsibilities of the title could provide a reasonable impression to the third party

Reasonable for the third party to assume what a person of the title does customarily, reasonably under the circumstances (context or course of dealing)

Something that the principal has done either explicitly or implicitly Random person who is lying will not have any apparent authority

because the partnership has not vested anything into him Unless, as in the case of the cousin, the principal was lax enough

for the cousin to create such an impressiono Constructive knowledge allowing someone else to carry out

the business in the name of their enterprise Traceable back to something that the principal/partnership has done to

create apparent authority Other issues

Scope Notice

o If it is known in the community that a principal is lax with its protocol, then you may be on notice

E.g., Home Depot aprons are known just to be sitting around

Analysiso Actual authority

Hardest to defeato Apparent authority

Anything that weakens your reasonable impression may be enough to defeat your apparent authority

DUTIES OF PARTNERS TO EACH OTHER

MeinhardFiduciary Duty Generally the case that soon as a judge cites to Meinhard, the partner trying to get out of its

duty is going to lose Fiduciary duty

o You have to act in the best interest of the entityo You are not supposed to be thinking of your self

No-self dealing Subordinate self-interest in the interest of furthering the enterprise

o Fiduciary duty is highest in the partnership This doctrine is designed to constrain lying (think authority issues) and

promote trust in the partnership A partnership, more than any other entity, is founded on trust

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What if they decided to part ways when making losses?o By agreement, they would have to split the costs equally…losses have to follow

whatever the profit split is (sometimes this is 50/50, sometimes it is not)…no agreement results in a 50/50 split

Aside: when a partnership ends, actual authority ends, but you have to do something to end apparent authority

o Capital contribution in the splitting of losses Default rule

Funds go to capital contribution, then the losses leftover are split in the way the profits are split

o Managing partner could end up at a loss if there is no agreement

CA rule Split profits/losses

Aside: If you don’t know that there is a partnership, then apparent authority goes out the window

o Doesn’t even know that there is somebody else that he could be acting on behalf Fiduciary duty

o Main problem is exclusion… Does S need to tell M?…notification is probably needed

Would going forth with the transaction after notification be okay? Does S have additional duty to vouch for M to G?

Why does G know S? S is managing partner M financed the ability for S to be a managing partner S was building relationships on behalf on the business

o S cannot then take these personal relationships with him when he decided he wants to leave

o M could not have formed these relationships, then how he is supposed to compete

Competition question However, this joint venture (remember: not a partnership) was about to

end S should be able to move on without M piggybacking

o What is S supposed to do? Mere notice may not have been enough Is notice and opportunity to compete sufficient?...maybe

Argument that M asserts S would not have been able to compete without him, and he should thus be given the opportunity to compete

What if G knows M? G wants to deal with S and leave M out S may be able to argue that G did not want to be bother with M, and

this is not a partnership opportunityo What the court is trying to say that this is a partnership

opportunity, and the opportunity to compete must be provided to the partnership

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If S could argue that it is not a partnership opportunity, this may cut in has favor

o Question about the venture ending S…venture is getting ready to end and does not want any lag time before his

next venture Most people don’t change their lines of business

What if G approaches S and says he wants to do this venture thing? S says why don’t you talk to me in 4 months

o Problems with withholding information from M while still partners…issues of secrecy; loyalty; self-interest

Is this a partnership opportunity, or an opportunity for S?

What if he gets the call 1 day after the JV (joint venture) ends? Does your duty end? 2 years…no he does not need to call M 1 day…questionable

Partnership opportunity… Key distinction This blurs the FD line

1 day after seems too close What about a building in a different part of town?

Same line of business, different location No connection to the first lease

o G approaches S during the term of the partnership G knows S because M financed S to create relationship

What if the business is associated with taxis? Probably no FD Do not want to have to open up the door for S having to tell M

everything Lease in CA?

Same line of business, really different location BIG QUESTION…What is the scope of your FD?

o “Nexus” question Courts as a nexus even if it far exceeds your original agreement Same business, same location…FD

“same business” in 1902 may not be the same todayo cross town may now be international today

Same business, different location…maybe FD FD is of the highest duty (Cardozo)

Different purpose…important FD factor What if G approaches M?

o Does M have the same FD as S?o G wants money from Mo S cannot say the reason why M knows G is because he financed the business enabling

him to make relationshipso Courts say that the managing partner has a heightened FD obligation

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MP is the face of the business Most likely the ones to be confronted with these opportunities MP is given opportunity to make relationships by FP (financial partner) so

they have to report back with opportunity offers that they have receivedo There is a sentiment that the FP does not have nearly as high a FD

Can this duty be weighed?o FD cannot be weighedo However, you can carve out things in advance that will not be considered a

breach of a FD Partnership needs trust and future opportunities may not be certain

Meinhard dutyo Factors

Nexus People and relationships involved Use of partnership property Use of logos and indicia of the partnership

Remember, MP is the face of the partnership…indicia If in doubt, you should probably find a breach of FD

The duty is really high Did you offer the opportunity? Did you provide notice?

PARTNERSHIP DISSOLUTION

Aside: Even partners who are locked in an irreconcilable dispute usually manage to agree to some plan which enables one or all of them to exit gracefully, because whatever settlement the feuding individuals can work out is likely to prove more economical than court-ordered dissolution, a procedure which typically results in the partnership property being disposed of for considerably less then its actual value.

o this is what Fairfax was talking about when she said she had to force people to think about what they would do in partnership dissolution situations just as they are getting ready to do business.

Partnership Dissolution 3 part process

o (1) formal dissolutiono (2) winding up of partnership affairso (3) termination of the partnerships

Triggering dissolutiono Act of one of the partners

Express will of the partners By virtue of agreement Term

Death of a partner Bankruptcy of a partner

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o Decree Court shall dissolve…

If partner willfully commits a breach of partnership agreement If partner conducts himself in away in which it is no longer reasonable

to run the business for a profit Other reasons of equity

Court has discretion to decide here Winding up

o Closing up transactions, bookso Can take quite a lot of time

Termination of the partnership…legal end of the partnershipo Distribute remaining assets

Line of distributions…creditors then partnerso As a general rule, assets are liquidated and profits are then distributed to creditors

then partners Sometimes liquidation is problematic Sometimes assets are more valuable in total

Sometimes partners agree to keep assets intact Court will sometimes order liquidation Sometimes assets have particular individual value to the partners

Fiduciary duties during dissolutiono Still exists in the wind up phase

Maybe even heightenedo Sometimes this duty can linger even after this partnership has dissolved or come to an

end Liability during dissolution

o Formal dissolution does not discharge liability Liability exists during wind up

Liability ends when the partnership legally ends Why three stages?

o You can have a formal dissolution event, and the partnership can continue E.g., law firm partner dies, but firm may continue on

o Rather than winding up, partners may continue on with the business It is technically a different partnership

o Liability If a business is continued after liability, then the partner who withdrew is

personally liable only for things occurring while she was at the partnership And a new partner stepping in is liable for things occurring after

joining the partnershipo Generally, one makes a partnership contribution

Liability is not discharged during wind up Liability ends when the partnership legally ends

o Authority Dissolution terminates all actual authority

Actual authority may still exist during wind up Apparent authority

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Not terminated until third parties are given notice that the partnership is no longer in business

o Thus, notification to third parties is key when going out of business

o Partnership interests If you continue a partnership after dissolution, the partner withdrawing is

entitled to the value of his partnership share at the dissolution of the partnership + (1) profits related to his share OR (2) interest on his share

Profits or interest accumulates from the point of dissolution to the point of settlement

Hypo….What if you were a partner with Bill Gates before he made his money?

Dissolutiono Deatho Withdraw

Express withdraw is a definite dissolution of the partnership

o Bankruptcy Things you have the show…

o Was there a partnership? You do not have to make money to be determined a

partnership, you need to go into the business with the intention of making money

Can be formed implicitly o Was there a dissolution of it?

When would you choose option 2?o Choose profits when there are profits, choose interest when

there are no profits Interest 20 years later may turn out to be quite a bit

Once you step out of a partnership, you become a sort of creditor who needs to be compensated

o Most Courts impose no statute of limitations How can a business avoid this?

o Settle up at dissolution Possible that partner may owe money if partnership is

operating at a losso You cannot really contract around owing somebody

The law does not force the withdrawing partner to do anything, the onus is on the partnership

o Did you have a partnership?o Was there dissolution?

If the answer to both is yes, then the above formula kicks in

If partnership is valid and not dissolved, the allegedly withdrawn partner may in fact be a partner

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Partners will argue that there is no partnership or that if there was it dissolved

Departing partner is not liable for any losses

Collins Facts

o Financial backing from Collins; managerial support for cafeteria from Lewis Very common structure for businesses

o Cost Collins way more than was planned C did not want to pump in any more cash

Holdingo Collins may not have the right, but always has the power to dissolve the

partnership Anytime a partner wants to, he can walk away Difference between a power and a right

Right…dissolve without further liability Power…dissolve; may have liability

Can Lewis dissolve the partnership?o Every partner has the power to dissolveo Does L have the right?

He is being interfered with by C’s lack of financing L may have a strong argument for the right to dissolve

o Question is whether the courts thinks C cannot do this Why does Lewis not dissolve?

o Agreement suggests L will owe C something if he walks away o Why would L dissolve?

He has a decent thing going He was trying to get other backing

Why would he give up the situation he has?o This case legitimizes the default rule of losses/profits…IMPORTANT

Managing partner may run up bills on financial partner Kessler/Default rule issue

o all profits of business, aside from L’s salary, are used to pay C, and profits are split after…personal guarantee for C

L…managing partner C…financial partner

o Is CA Rule applicable here? CA Rule would only apply if there has been no agreement about

compensation of the service partner CA Rule not applicable here because L is getting a salary

o Rationale: compensation for service viewed as same as capital contribution in CA rule

o No, CA Rule, so default rule or agreement applies? Default rule…

L owes C any shortfall

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Because there was an agreement suggesting that C would not be responsible, agreement could be seen as controlling

Losses follows talk of profits Kessler court would probably decide that the agreement would

controlo However, one could argue for the application of the default

rule as losses were not explicitly contemplatedo Talk of mortgage...L must repay C, or C gets to take L’s interest

L did not repay C or abide by the agreement Rather than funneling revenues back to C, L pumped them back into

the business Why can’t C say L defaulted?

C is acting in bad faith and interfering and won’t be rewarded by the Court for his interference/bad faith

o C may be the source of L’s misbehavior If C did not interfere, and L defaulted on his agreement, the Court may be

more likely to reward C C may have both a right and power here

C made a mistake in not getting a financial cap Reasons why a court must dissolve if you petition?

o Interference with a business so that a business can no longer go on or be profitable

It is not easy to prove that a business can no longer go on or be profitableo Reasons of equity o Courts do not like to get involved in partnership issues

They think the parties should handle it themselveso When a court “has to dissolve,” it does so on behalf of the person who has been

wronged C was petitioning for dissolution, but was in the wrong…in these situations, the court

will usually not find for dissolution

RECAP ON PARTNERSHIPS Formation

o Could be implicito Threshold question…

Has a partnership formed? You can mess up forming another entity and become a

partnership by defaulto Other entities require filings

Exam…if entity is explicitly stated by Fairfax Interests

o Equal ownership and ability to share in losses/profits Not equal split, losses follow profits

o Capital contributions Default rule CA rule

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Agreement Management and control

o Decisions by majorityo Authority

Actual acquiesance

Apparent Questions…

Type of authority? Source? Scope? Actual…limited?; Apparent…notice?

Exam…Walk through roadmap Duties

o Meinhard dutieso Determining what is a partnership opportunity?

Factors Who you are? Nature of partnership? Geography Scope/nexus of business? Use of partnership property?

o Partnership opportunity…sharing ensues Liability

o Differences in personal liability for withdrawing and newly arriving partners Dissolution

o Has there been a dissolution event?o What does this dissolution mean in terms of duties and with regards to partners?

OTHER BUSINESS FORMS

HANDOUT…chart comparing the various business forms

As a general matter, the more Ls the better People were search for an entity that would give the best of both worlds

o LLC…the perfect entity Corporations is a square and partnerships are triangles

GP The term “partnership” = GP Only entity that can be created without a formal filing

o Required filing in all other situations means you must be aware of the filing requirements

Improper filing may cause a failure to create your entity For other entities, letters (LLP, etc.) follow the name

Exam purposes, she will not explicitly state entity, but put letters down

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LLGP Creature of the general partnership Differences between LLP and GP…the liability protection and need for a formal filing

o Supervisory liability GPs are personally liable only if they or person they supervise commits

wrongful act Partial-shield liability

o Protection for tort (malpractice, negligence, etc.) acts, no protection for contract acts

Full-shield liabilityo Protection for tort and contract actso More common form today

Not in the interest of partners to supervisor or manage What do we mean by supervisory liability?

Vehicle created specifically for law firms LLP does not have its own statute

o Information can often be found in GP statutes LLP is really a GP

LP Great deal of difference between LP and LLP need for at least one limited partner and one general partner Codification of managing partner/finance partner relationship FP is usually the LP; MP is usually GP Roles are designated at filing GP has all the management responsibilities Limited partner has very limited roles

o Participation in the control of the business will cause you to lose your liability protection

Limited role in company will shield you with regards to personal liability, but not what you financed

GP has general GP roleo Authority…can bind GP

Limited partner has no (not much at least) actual authority May have ability to enter into contracts relating to their role in the

limited partnership Dividing line

o Are you managing the day-to-day operations of the business? Once you lose your liability protection, there is a way to regain it

o The liability question is transaction-specifico 2-part analysis

(1) Are you involved in the day-to-day operations of the business? (2) Were you involved in the given transaction? Does the person trying to sue

believe you are a GP?

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o You can be subject to liability and protected at the same time…sense of roving liability

You do not lose your status, but you can lose your protection (and later regain it)

Better protection than LLPo So long as you maintain your role, your liability should remain intact

If no agreement, limited partner can withdraw with notice; LP withdrawal does not trigger dissolution unless last LP. GP can withdraw with notice; withdrawal triggers dissolution.

o Notice…usually 60 dayso Avoid dissolution…90 days to establish a new limited partnero Some statutes approach GPs in the way they approach LPs…GP withdrawal only

dissolves if it is the last GP. Remember: have to have one LP and one GP The idea is the business will not be able to continue running without a GP

A corporate general partner helps you get around this because the corporation is supposed to have perpetual existence (it is a fictional entity…board managers may change, yet this is not a GP withdrawing)

o Remember: members can be entities Fiduciary duty with corporate general partners

Director owes a duty to the partnership over the shareholders

LLLP not used very often sibling to LP more Ls…more liability protection Liability…

o GP gets supervisory liability Same as GP in LLP

o LP is shielded so long as they do not participate in the control of the business

LLC Flexible management

o Can run it like a partnership (active management) or corporation (passive management…board)

Terminology o Members (more like partnership)/Board of Managers (more like a corporation)

Shielded from liability o Like a corporation

Dissolution o Like a corporation

LLC, like a corporation, does not immediately dissolveo Supposed to have a perpetual existence; need a voteo Harder to dissolve

LLC is the most popular business form

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o People are also forming more partnership entities (mostly LLCs) than corporate entities

Why not an LLC?o LLCs are occasionally avoided because the law concerning them is still

undevelopedo LLCs may also be avoided for tax reasons

Lose tax advantages (and many of the benefits of the LLC) if you are going to go public

If you know you are going to go public, there is no reason to set up as an LLC

o The operating agreements are not publicly filed so there is no real standard in terms of how such agreements operate

o If you want a LLC to engage in financial transaction beyond the relatively simple, you need the help of a tax lawyer, which could get expensive

RELATIONSHIP TO TAX RULES

Partnershipo Flow-through tax treatment

Corporationo Dual Tax at both entity and shareholder levels

Method for tax treatment:o Check the box method

You choose the method by which you will be taxed The whole point of the LLC is to avoid corporate treatment and get flow-through tax

treatment S Corp

o You get modified flow-through tax treatmento Most corporations are subject to double tax…C Corp

We are going to talk about C Corpso There are limitations on establishing an S Corp

Gateway Partnership set up as a LP

o Potato farming business Structure

o GB (LP) --- S (LP) --- Sun Corp (GP) S (LP) --- K --- Gateway

Authority (establish authority before moving to liability…flow down the handout)o Actual authority…what the agent believes they have the ability to do

Sun Corp…GP of limited partnership should believe they have the ability to enter into contract

Also, this contract seems to fall right into the scope What if there was an agreement restricting the GP’s actual authority?

Could we then make a case for apparent authority?

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o Apparent authority…reasonable impression in the mind of Gateway created by the entity

Here, agent is lyingo It always has to be something that the partnership is doing…

not the corporation, i.e. the partner, i.e. the agent LP did in fact appoint GP as a GP of a general

partnership You would have to look to history, custom, etc.

o Apparent authority may be reasonably established? Was the GP doing what a GP generally does? Was the GP’s authority being limited?

o Third party is put on notice if he is aware of the disagreement between partners

Liabilityo Jurisdiction has not updated the model statuteo Model act…LP could potentially be held liable when they participate/control in the

business, and will in fact be held liable for transactions with people operating under the reasonable belief that the LP was a GP

o AZ law…bifurcated structure if you act in substantially same way as a GP, that will be enough to hold you

liable similar to model act

Not acting like a GP, but the third party has some actual knowledge/direct contact with the LP that their conduct suggests them to be a GP

The rest of their actions may not be like a GP, but in this particular instance, they may be acting like one

Here, no direct contacto Here…

Is an LP participating in control of the business?...threshold question Involved in the day-to-day activities v. protecting your assets (not

controlling)o Look for participation in details

Contract negotiations, etc. What can an LP do?

o Attending meetings, approving fundamental transactions, dissolution of the business, change in nature of the business, removal of employee, giving advice

LP…o limited to her contribution, unless

participate in control…day-to-day v. yes or no (fundamental decisions) its about what she has done, not whether she been suckered into L is always the LP, she may lose this protection in certain

situationso It is transaction-specific

o there is a safe harbor for advising/consulting (as opposed to joint acting)

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a recommendation is outside this safe harbor if it is not clear that the other partner is not really free to ignore it

o If the LP agreement contemplated that LP would be part of the day-to-day control, then this is problematic because it seems as though the LP was never a LP

o Who gets to sue? First rule…

Reasonable belief Second rule…

Substantially similar to GP Third rule…

Not substantially similar, but P has actual knowledge that LP is a GPo AZ…direct contact

RECAP Hot button issues: authority and liability Need for a filing (except for GP and SP)

You can have a one member LLCo GP and LLP

Difference in liability structureo LP and LLLP

Difference in liability structure Authority changes how the entity is run The only way to hold an entity liable, is to show the acting party had authority to act,

and then to find out who is liable within the entity we turn to finding out what entity we are dealing with

o Limited partners can only be found to have apparent authority Exam key issues

o Changes in authority across entitieso Changes in liability across entities

FORMATION OF A CORPORATION

THE PROCESS OF INCORPORATION

Corporation shareholders…residual interest owners managers…directors and/or officers running the C for the benefit of the shareholders

(fiduciary relationship there)

Partnership v. Cs separation of ownership

o its possible that managers may have no ownership interest of a Co concern…people in control will operate the C in a way that does not benefit it

How do we make sure the controllers are not taking advantage of the owners?

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Formation (1) Decide where you incorporate

o DE or home state If local business, and not going public, incorporate in home state

Incorporation requires paying feeso Incorporation in one state and principle business in the other

will create two sets of fees Very key reasons why you would want to be in DE

Complexity of business law found in DE (2) File a certificate

o nameo something that represents you’re a corporation (Inc., etc.)o registered agento authorized share amount

ceiling different from amount issued

o if dividing shares, you have to set forth the rights associated with each class of stock o address of incorporationo resident agent (if you’re out of state)

usually general counselo name of a director

number of directors can be pushed off to the bylaws you do not have to state the purpose of the corporation, but a lot of companies do opt-in and opt-out provisions (after the above required provisions)

o opt-in provision (Article IX…limits the types of claims that shareholders can bring ) if you do not have it in your charter, then it doesn’t apply to this corporation

not in general corporate codeo opt-out provision (Article X)

if its not in the charter, then it applies to you opting out of the general corporate code

(3) create the bylaws after filingo operating agreement of the Co unanimous consent achieved at initial meetingo after bylaws adoption…you have established a corporation

THE (DECLINE OF) THE ULTRA VIRES DOCTRINE

ULTRA VIRES Latin for “beyond the power”

o Cs cannot act beyond their powero You can think of this in terms of authority

Asbury Mechanical engineering enters into contract to own and operate railway line C repudiates contract in the middle of performance

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The purpose clause of a C used to actually put forth the purpose of the Co The purpose was mechanical engineering; operation of railway was outside of the

purpose…therefore, the C has no authority and the contract was void Shareholders (or directors) cannot ratify the contract in the face of this oppositional purpose

clauseo The purpose clause would have to be changed through the amendment of the charter

Why should the C be able to void out a contract that is otherwise legal?o (1) You could say that it is fair, but the company doing business with the C should

have been on notice…notice piece You can go check the charter

People may be deemed to be on notice of anything in the chartero However, this is not realistic, as most people will not check the

chartero (2) Protect the shareholders for the whimsical actions of directors…protection piece

Remember there is a split between ownership and management o (3) The charter is a license from the start and when you stray from the C’s licensed

activity you are outside the scope of allowed behavior…licensing piece UV did not seem to be fair because it would let Cs out of contracts, etc.

o Courts begin to make stretching arguments to get around UV

King’s Highway Would not be good under Asbury New rule

o Three circumstances for brining a UV action (1) In an action brought by a shareholder to enjoin a corporate act; or (2) In an action by or in the right of a corporation against an incumbent or

former officer or director of the corporation; or (3) in an action or special proceeding brought by the Attorney General

o C cannot set aside a contract outside of these three; however, a shareholder can set aside a contract it made as a director

Why are the modern purpose clauses not specific about the nature of the businesses?o Combat the UV problem

Exam…specific purpose clause…UV problemo Even companies with more specific purpose clauses, will follow them up with a

broader statement UV was dying, then got revitalized…Sullivan

Sullivan Rebirth of the UV doctrine Potential UV arguments…

o The giving of the gift itself. The scope of the gift given. C organized to make money (they are for profit), not make charitable gifts

(non-profit) Argument is really about waste…

o a breach of the director’s fiduciary duty

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Important: Charitable giving trips two potential doctrines: fiduciary duty claims and UV claims of waste

You have to show that the gift is somewhat reasonable, rather than wasteful, to combat UV

o Cs are now granted some power to make reasonable charitable gifts

What is the reasonableness test here? (i) The power of good will piece…

o The giving of a charitable gift, even though speculative, could benefit a C…the power of the good will…

Settlement talks about renaming of the building Use of the company’s name, rather than the

individual’s name, may play a roleo What if the name of the person is linked

to the name of the company? E.g., Microsoft/Bill Gates

o Power of naming rightso Sometimes charitable gifts are anonymous

What’s the good will? Employees may feel good Appeal of company may rise Productivity may increase

o What about the geographical nexus? Here, the museum was next door

Power of good will…next door to the company Founder’s name may not draw the same type of

associational impact if the building is further away from the C

o Counter…maybe the building being elsewhere will make the company go national

o The power of good will…albeit speculative, is there any way a charitable gift will increase profit-making

Courts are usually lax here because they think charitable donations are good

There is a great amount of elasticity in terms of reasonableness here

(ii) The money piece o business judgment rule…there is a presumption that

boards act in good faith, and you would have to overcome the presumption to show that the action was unreasonable

o Would it matter if the C only had assets of $50 million? Probably Donations (or executive compensation) must be

defined as reasonable or unreasonable in relation to their total assets

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o Settlement agreement creates a cap. Why does this matter? In order to limit the potential for the donation to

become unreasonable over time. Courts like some kind of backstop when

determining future payments. (iii) Self-dealing

o BELOW

CupcakeLove L wants to put her name on a building at her alma matter What it matter is L is a legend at the school? And what if L’s name is immediately

associated with the business? What if the alma mater is far away from the C? Could L approve the transaction herself?

o UV does not come up in the partnership setting UV…dealing with a corporation

o L seems to be solidifying her legendary status at the school with corporate money

Self-dealing How to avoid self-dealing…She should not be too involved in the

process or there should be benefits other than those connected with her achievement of legendary status

Citizens Unitedo Holding: Cs could contribute to political campaigns in the form of unlimited

advertising supporto Another reason UV lives on

Harder case to make the charitable giving Political donations are given in hopes of receiving a return Shareholders will surely push back though

Shareholders are really pushing back not in terms of the elimination of political donations, but the disclosure of those political donations

Recap on UV In the past, could be used to void any contract outside of a specific purpose clause 2 developments that changed the course of the UV doctrine

o (1) Statutes allowing for general purpose clauseo (2) Limitations on who could bring UV claims

Today, utility of UV still exists in spaces where the expenditure of funds is not in the interest of the C

o Charitable donations and political donations arenas Saying this, courts seem favorable to finding reasonableness

PREMATURE COMMENCEMENT OF BUSINESS

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Putting this unit in contexto C does not hold individuals personally liable (limited liability)

Exceptions…where you get at people for the debts and liabilities of the corporation

Promoters Defect in the attempts at corporation Piercing the corporation

o Winning this kind of personal liability claim is a kind of uphill battle

PROMOTERS

Promotero Take the initiative to organize the companyo Engage in organizational activities before the C is formed

Engagement in pre-incorporation activities signals a promotero Promoters have a fiduciary responsibility

Primary obligations of the promotero Aside from setting up and organizingo Fiduciary duty

Duty to act in good faith Duty of care

Loyalty duty Duty to act not in the benefit of yourself Duty not to engage in self-interested transactions

Key in promoter’s duty…disclose personal interestso Once you disclose, and the C says its okay, you do not have to share the profits

you also have the duty to make sure the cost is at fair market value, etc.o One thing that may force you to pay is if the business never gets set up and someone

construed you as a partner Who gets to sue the promoter?

o Corporation gets to sue the promoter The promoter’s duty is to the corporate entity

o The C and the initial and subsequent shareholders can sue promoters

Stanley Promoter signed a contract on behalf of a company that has yet to form Contract signed on behalf of a C. Why isn’t this enough to demonstrate that the C will be

ultimately liable?o On the day the contract is sign, there is a question created about who is liable

Focus on the “present obligor” Would we have a different result if the promoter signed it on behalf of the C and the C

already existed?o You look to the C and not the individual people (officers, etc.)

Would we have a different result if the promoter lied and signed it on behalf of the C, and it looked like the C existed, but in fact the C did not exist?

Default rule about promoter liability…P is liable and C is not…

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o Promoters are personally liable on the contracts that they make because the C is not in existence…unless there is some other agreement or understanding between the two parties that changes the liability question…

…How could a promoter or corp be held liable?...liability in the promoter contexto (1) revocable offer

revocable offer to C to enter into a K neither P nor C is bound because you have to wait for C to exist and accept

the offer gets P and C out of liability

o (2) irrevocable/best efforts a promise by the P to use his best efforts to form C and get C to accept offer promoter will be liable only if they breach their promise in general: in terms of corporate liability, the corporation always has to

do something explicitly or implicitly to be liable for the promoter’s contract

o (3) promoter…corp (novation) most common form P is liable until the C is set up and accepts the obligation of the contract

Not liable at the same timeo (4) promoter + corp (guarantor)

both P and C are liable together P is liable as a surety/guarantor if C cannot cover costs

Insurance for the C’s debt You need to look to the agreement in order for P to get out from under liability

o When does (1) apply? No contract is supposed to be signed nor services are supposed to be

performed The K is revocable and the decision is the C’s The P is not supposed to do anything

Here, work started, so this offer cannot be revocable The P did more than “give him his card”

The occurrence of performances means you have pretty much foreclosed (1)

P has to make sure the builder does not begin to perform services the key is that nothing should be happening

o When does (2) apply? Performance should not start either Revocable…not saying anything

Best efforts…going to do something for the persono P will vouch for that builder

Liability C will never be liable unless they do something

In (2), unlike revocable offer, a promise is made… Promise is two-fold…

o (1) best efforts to set-up Co (2) best efforts to get you the K

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with (1) and (2) the performances are not supposed to have occurred yeto When does (3) apply?

Explicit novation…actual authority Directors come and sign the contract

o This will not happen on the exam Implicit novation

Acquiescence after the fact; apparent authority If people in the C who have the authority to ratify have acquiesced

to the Ko Here, 3 directors

1 is excited 2 is on notice because he lives near the hotel and could

see the constructiono actual authority after the fact

when directors are on notice and the P continues to act because he thinks he has actual authority

o apparent authority…2 of 3 directors are on notice and they have not said anything to anybody

apparent authority is okay when the C is set up and gives off some kind of signal

informing a third party that a P is a P relieves a C of liability

Novation cuts off the P’s liability at the point where you think the novation occurred

Likely the answer that Stanley will wanto Important…The third party usually wants to get the C for

its resources rather than the individual A novation wipes out the best efforts claim

It is likely that you got the C because the novation is supposed to relieve the P of liability, even if you think there was a breach of the P’s promise of best efforts

o When does (4) apply? Always the case or understanding that P would step in if C did not honor

the obligation Go through all 4 on exam…go through all analysis prongs on exam Here, the court said Boss was held liable under (4)

o The C did not have assetso Could have just as easily been the default, but court was convinced that when K

was signed it was does so “on behalf of” the C What did Boss intend?

o Probably (3). Novation What did Stanley intend?

o Probably (4) Signature line

o When you sign a K on behalf of a C…the first signature block should be the C’s name

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The name of the company should come first this way the K appears to be made on behalf of the C and the C will

become liable

DEFECTIVE INCORPORATION

We are continuing with personal liability in the corporate context Before, we dealt with promoters

o Default rule…promoters are liable, unless there is another agreement Either default rule or one of four exceptions

Defective Incorporation Key thing to remember:

o Are you dealing with a promoter? At the execution of the K was there a presumption that there was a C and the

actor was acting properly on behalf of the C? Defective incorporation context…At the time of the execution of the

K, it is assumed that there is a corporation in existence and the C will be held liable.

In the promoter context, everyone knows that there is no C in existence. Can you hold the individuals liable when they were supposedly working on behalf of a

C?o Three (four…if you effectively incorporate and shareholders are entitled to

limited liability, unless we come across a piercing situation) different doctrines: (1) De facto

(i) law (corporate statute)o easy to comply with

(ii) good faith attempt to comply with the lawo someone made a good faith attempt to file the articleso depends on the mistakeo sometimes courts find in favor directors as not responsible

for filing the charter and find against directors as not filing in good faith

(iii) operating as a corporate form and you are doing so in good faitho you have to be operating the C under the belief that you are

a C if you comply with these three factors, you are shielded from

liability o may protection some but not everybody, depending on their

good faith (2) Estoppel

if you are interacting with the C and you believe the C was incorporated, then it will estopp you from denying the C’s existence

equitable doctrine

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a lot of states reject this doctrine because they feel like its too messy and inappropriate

the whole point of the C, if to file as a C 1 and 2 may allow you to use the corporate shield without being a C (3) Bright-Line Test

By statute (as is the case here in the D.C. Court), you are not a C until your articles are accepted

o Could be a window of time between filing and rejection where you are not a C

In other states and the mbca, you become a C upon filingo if the statute provides that the corporation is effective on the

filing date, then you assume that your corporation has come into being unless you receive some notice from the state suggesting that there has been a defect, in which case you generally will have some time to cure the defect before the state will say that you have not been incorporated

This is the second doctrine that will subject you to liability even though you are operating under the corporate form

PIERCING THE CORPORATE VEIL

The third and last doctrine that will subject you to liability even though you are operating the corporate form

Different from the other two doctrines because it is not centered around the time of incorporation, but can happen at any time

Piercing the corporate veil (1) Going behind the C to get at the shareholders of the C or (2) going behind the C to

get to the parent corporation of the C (and even double piercing through to the directors of the parent corporation)

o Individual shareholders may own all the shares of a Co A parent C may own all the shares of C, a subsidiary

50% corporate ownership of a C…the C is a subsidiary wholly owned subsidiary…100% corporate ownership of a C

The idea is that you have a C that does not have the money to pay its obligations Aside (we will consider later):

o You can also pierce the veil and find other subsidiaries of the parent C liableo You can also reverse pierce by going through the sub to find the parent liableo You can be creative about piercing the veil so long as you can prove the elements

GENERAL DOCTRINE

Bartle sub defaulted on payments to creditor; and creditor wants to get to parent C

o no relationship is needed between the creditor and the parent Piercing situations…

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o if using the C for illegal actions…the court will pierceo if using the C to perpetrate a fraud…the court will pierceo misrepresentation is at the core of the piercing doctrine

in order to pierce, you will have to show misrepresentation the parent has misrepresented itself in ways that make it apparent

that the C was not being used for its true purpose Misrepresentation issue here

o Companies are supposed to be set up to make a profit and here the company is set up so as it cannot make a profit

o Arguments Asserting that they incorporated to avoid liability will not work

The idea behind incorporating is to avoid liability Courts will often pierce due to confusion…notion of maintaining separate

identities The parent is dominating the sub so greatly as to create confusion as to

who the people are actually dealing witho Directors may be flowing between both entities

Observing corporate formalities will cut against piercing Overlap of the officers and directors

o Increases the possibility of confusion Siphoning

o Are you draining the C or assets?o If you can prove the parent is draining the assets of a sub, it

doesn’t matter if you are dealing with a creditor or tort You should not have to assume that siphoning will

occur Undercapitalization

o Company does not have enough assets to met its obligations Financial picture of the company very important

when determining whether to pierce Courts will look to see whether the person trying to pierce is a someone

contracting with the C or a tort victim If you are a contractor (creditor, etc.), you not only assume the risk

that the C will not be able to pay you, but you are also aware or could become aware of the fact that Cs are not observing corporate formalities

o You should know how the business is operating Tort victim does not have this option This will sometimes make a difference, equitably speaking

What happens if the court decides to pierce here?o If you pierce, you get to the assets of the parent C

You have to keep in mind the practicalities of the situation…does the parent C have assets?

Dewitt What are we looking for in figuring out how to pierce?

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o Other factors to add to above (the last case)… Substantial ownership (90% here)

On its own, substantial, even wholly owned, this factor is not enougho However, this is where courts start…

Substantial ownership + (something) Intermingling of officers

Director seems to be operating the company to benefit only himself the 90% shareholder

One-man C There does not seem to be anybody else in this company Lessens accountability You are supposed to take minutes and keep record for a one-man C.

A key corporate formality is the keeping of books You should have record of the election of officers, stockholder

records, etc. The fact that you cannot tell us these factors suggests you are not

keeping good corporate records Keeping records and maintaining corporate formalities are different, but

intertwined issues. The court really wants you to just play along with the corporate

formalities. Undercapitalization

The amount of money in the capital was never enough or will be enough to meet the obligations that the company was to engage in

o Both tort and contract obligations There should be enough assets to meet tort risks if they

are present and contracts if they exist Dividends

o Do you have enough resources to pay dividends? You don’t have to pay them, but could you?

Withdrawal (in this case)o Goes back to the formalities situationo You need to have record of what you are doing and why you

are doing Authority problem…we do not know if he was allowed

to withdraw because there are no records Siphoning problem…he took out all of the funds for his

salary Siphoning brings problems of misrepresentation

as shareholders assume the C they are investing in will have money

Should the fact that these people voluntarily contracted make a difference in this case?

Most courts more easily pierce for torts rather than contracts because contractors are more likely to be able to see dubious practices and state of corporate finances

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o However, contract victims are more vulnerable to financial misrepresentation, siphoning, or personal financial guarantees

Personal financial guarantees will not get you a contract remedy here because of statute of frauds, but it may still allow you to pierce in order to get a corporate remedy

Highlights of this caseo Doctrine focused on equities and resultso It is most important just to run through the factors….

Substantial ownership…most important Undercapitalization…second most important Observe formalities/corporate records…third important Overlapping…important Siphoning…important Tort v. contract…tiebreaker

Some courts cut in favor of torts because of lack of knowledge Some courts cut in favor of contractor because that obligation is to be

honored The trend is usually in favor of torts

o Fact…no public company has even been pierced A public company will be very highly counseled and piercing is about

sloppiness Closely held companies do not engage in corporate formalities

This is when the piercing cases are most salient Piercing means you are going to get at the personal assets of whatever is behind the

corporation Piercing will occur whenever debt is not fully satisfied

o Cuts to undercapitalization factor as it shows the business was not running in a way that could allow it to satisfy its debts

Piercing sibling companies Parent company with multiple subs

o Subs are known as “sister companies”

CCL L creates a holding company (a company that doesn’t operate, but holds assets)

o The only purpose of this parent company is to contract with its subsidiaries Each sub owns two delivery trucks Type of insurance on a vehicle depends on how many vehicles you own

o Two or less trucks…10k L set up the subs so they could only own 2 trucks and purchase the minimum amount of

liability insurance Subs have different directors and officers; trucks are under different names; subs are

managed differently; minutes and records kept Truck hits a group of people in a crowd 10k liability insurance is woefully insufficient

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L has relatively normal assets, she is just buying and selling the cupcakes Turns out that each of the other subs have a significant amount of assets, plenty to cover the

accident problems What is the likelihood that the accident victims of company A could pierce and get to

the sibling companies?o Ownership

Ownership + (something)…most piercing cases control

Proving something is an alter ego (mere instrumentality) What you’re trying to show is that someone is controlling the

entity to such an extent that you should be able to merge their identities and hold the sibling personally liable

o Here, if you’re trying to pierce up to the parent, you have no real problem, but in actually you do have a problem because you are trying to pierce a sibling

Sharing a common owner is not enough to get to the siblings You need to be able to show that the siblings are all operating as one,

that they’re maintain the same identityo Enough overlap could overcome the ownership hurdle

here, there is not enough overlap Keep in mind that parents set up subs because they realize some

companies will engage in riskier activities than others, and the others’ assets need to be protected

o Reverse piercing You would have to show that the sub is controlling the parent in someway

Unlikely It is more likely that a parent is controlling a sub

o Big hurdle in these cases We are not talking about the parent, we are talking about the sisters There is no ownership/control connection between the sisters

The ownership prong is not thereo You need the ownership to show you have the potential to

control the direction of the other company What else cuts against them?

o Records are clean; no overlap of directors; no apparent siphoning; organization seems purposeful.

o With regards to liability… The companies were abiding by the law

However, maybe we should look more at what the business needs

The minimum may not suggest that they have met their capital obligation

Avoiding liability is one of the reasons for a corporation

o Do we think this business is undercapitalized? Do you have enough resources to meet your contract and tort obligations?

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Here, probably not. Piercing to the parent does not allow you to get to its subs or the shareholders behind

the parent Strongest case here

o Go with undercapitalization; liability reserved for tort victims; organizational structure; tort victim

o Likely not enough to pierce the veil and find sibling company liable Theoretically this could work, but in practice it rarely, if ever, works

Possibility was recognized in the taxi cab cases Sibling liability aka enterprise liability

o The theory you are trying to advance is that this thing is operating as one enterprise and you should be able to get the assets of the whole enterprise

TORT VICTIMS All things being equal, a court is more likely in favor to pierce in favor of tort victim

rather than a contractor/creditor

Arrow Bar All things being equal, we like to pierce in favor of the tort victims Purposefully incorporating to avoid liability is not going to be a winning argument for

victims Factors

o Proper formalitieso Use of the corporate name

The fact that the official name wasn’t used of every single form is not enough of to pierce the veil

Official name is to be on official papers and purportedly contracts…you can use other name (usually with “inc.”) elsewhere

Last ditch efforto Personal guarantee to repay borrowed money

Shows capitalization Shows formalities It could be problematic if a company is guaranteeing the personal debts of

shareholders “Are you taking money out of the cash register and not paying back?”

o using the company as your alter ego this cuts the other way here

o Beyond ownership/control, the second most critical factor is undercapitalization Bar is operating using a lot of debt financing

No “equity” Starting company by borrowing money from a bank Should we make a distinction between companies financed by

borrowed money and companies financed by equity?o Courts recognize this difference between debt financing

and equity financing Borrowed money must be repaid with interest

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o An understanding of capital structure can shed light into the workings and capitalization of a company

Should the bar have purchased dram shop insurance? Law did not appear to apply to bars beforehand…new law did not

seem to apply to company when insurance was purchased How do we think of insurance with regards to capitalization?

o If you are operating a business that requires insurance, you should have an adequate amount of insurance

Do you have sufficient resources to meet your obligations? This is what capitalization is all about.

o Whether you need insurance is not that hard of a question, whether you have sufficient funds is a more difficult question

Is the minimum enough? Usually. You have to make a very egregious

decision. All things equal, pierce in favor of tort victim. All things not being equal, you may not

pierce in favor of tort victim.o Factors cut in favor of bar owners here.

Telecom Three factors for piercing the veil

o (1) control more than just ownership

o (2) control was used to permit some kind of wrong or injustice where undercapitalization comes in

o (3) proximate cause test is not really different

o don’t worry about this MO test for exam, you should do the same overarching test still the same set of factors

No ties/minimum contact of parent with the sub so no PJ unless you can prove an alter ego scenario

We have to get shared ownership + something else What is the something else?

o Same board? Thinking as one big entity Potential overlap is not enough on its own

There are some companies who maintain a separate identity with same directions

One director could be really important if he is really influential in the subo What if the parent got to approve all of the major subsidiaries major transactions?

Depends what engagement is Shareholder cannot engage in day-to-day actions of the company, but may

operate as a check More nuanced transactions may show inappropriate domination

This goes back to the shareholder overstepping its role

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o What if what sub made went into parent-controlled bank account? Into an account and never seen again…problematic

Siphoning Comingling of assets…comingling cuts in favor of piercing

o Another factor to look at Taking money out of the register for lunch

You have to be very careful when doing this to make sure you note the assets are not being comingled or siphoned

After ownership, the next important question is (under)capitalizationo Insurance is covered

Interestingly enough if you don’t have actual money, but have the insurance to cover, you might be okay

o Capitalization can change over time Growth/expansion may make you undercapitalized

Overall…piercing Strive to prove that something is an alter ego Ownership + undercapitalization are the key factors; others do come into play

though…unless, you can get the court to buy the sibling doctrineo Capitalization factors

Nature of capital Timing of capital Insurance

Do you have it? Is it adequate? When will piercing come into play?

o Contractor or tort victim will look to pierce when the company it faces has no moneyo Before piercing, you have to ask is the company liable for the debt?

IMPORTANT Issues of agency

FINANCIAL MATTERS

C creates capital by raising shares When a C raises money by issuing shares to the public…public offering Companies issue equity shares Rights of shareholders are determined by each C

o You do have to ensure shareholders the ability to protect equity This is why they get voting rights

Accountability mechanismo Key to a C is the separation between ownership and control

Control over election of managers through voting Debt

o Company raises money by borrowing fundso Many ways:

Lines of credit

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Loans from third parties Loans from shareholders Issue debt obligations

Bondso Distinct from a shareo Holder of bonds

People holding bonds hold a C’s promise to repay them over time with interest

Equity v. debto Debt…entitled to repayment

Have K with company to get repaido Equity…not entitled to payment

Can be paid back through dividendso Debt holders…right of repayment

Generally do not have voting rightso Equity holders…right to participate in corporate earnings

Given voting right because they have no right to repayment Given voting rights because they are last in line

Derivativeso Obligation that allows you to protect or manage against the risk of holding a

securityo Gets its value from the risk of another security

Value stems from some other enterprise Securities

o Equity, debt securities, derivativeso We are focusing on equity securities and their rights and obligationso Articles have to describe the types and class of securitieso Articles have to provide for a class of stock that can vote for directors and a class

with liquidation rights Could be the same stock or could be different

o you should always authorize more stock than you think you needo authorized stock in the charter is the ceiling

you don’t want to have to continually amend your charter however, amount you have to pay to file charter is contingent on the number

of shareso rights of equity shares

dividends…payments based on the earnings of the company cash, property, stock, any form really

o just has to be authorized by the board liquidation

distribution when the company dissolves not debt holders though, cannot sue company if it dissolves

voting right election of directors key governance matters

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important because it protects their junior interest in the company

Different types of equity shares first level distinction…common v. preferred

o preferred preference over common will get something before payout governed by K

bundle of different rights you can give PSs (note: generally not the case, but you can make a class of common with additional rights as well)

o depends on what they bargain for voting preference

PSs don’t usually get the right to vote, but may get the right to vote based on some trigger event…i.e. the C violates some right given to stockholders

Dividend preference Right to receive a fixed dividend Dividend are paid at the right of the board So, when a company pays dividends, you are to

receive this fixed amount Companies cannot pay dividends when it

otherwise couldn’t settle its debts…also FD laws come into play

Different types of dividends…learn by example…

(i) Cumulative o year 1

no payment ($2)o year 2

$4o Partially cumulative

Year 1…no payment Year 2…some percentage rolls

over (ii) Noncum

o year 1 no payment

o year 2 $2

(iii) Cum. Participatingo year 1

no pay out

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(50%)…usually participating is at some percentage of the common shares

o year 2 $4 + .50…$4 is paid first, then

$.50 once they pay out the common (participation share is paid along with the common shareholders)

o strongest and most expensive here participating rights allows you to

get your fixed interest, and reap the benefits if the company is doing well

its all about K negotiations, you get the rights you pay for

(iv) Non-Cum. Part.o year 1

no pay out (50%)

o year 2 $2 + .50

(v) Commono year 1

no pay outo year 2

$1 pay out…common shareholders are not guaranteed dividends, let alone a price at which to be paid out…no one is entitled to dividends

liquidation preference preference, usually at a fixed amount, for

getting paid before common stockholderso usually unpaid dividends to date are

wrapped in with the liquidation preference

redemption rights call

o right of a C to call back the shares of preferred shareholders

o Cs like this right because when a C is desperate for capital in the beginning they give out more rights…they want to limit rights later

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o Ability to call usually depends on some trigger efforts

o Have to be bought back at a price or formula that is attractive

Puto Force the C to buy back their shareso Gamble on company…company shows

no upside…exercise your put…key exit strategy

Conversion rights Right to convert from one share to another

o Conversion occurs at a formulao You have to make sure your articles

provide for enough common shares if there is a conversion

Downstream conversions…most commono from PS to CSo company may be doing so well that the

common dividends are coming out way higher than P dividends

o Cs often negotiate that preferred shares automatically converted with there is a public offering

People may be hesitant to buy stock in a company with stockholders preferred to them

Conversion extinguishes preferred rights Upstream conversion…rare

o C shareholders generally don’t pay for conversion rights

o Antidilution protection Protects your shares in case something occurs that

would decrease your percentage interest At all times you continue to hold your percentage

interest preemptive right

allows an owner to maintain their proportionate interest in the company

requires C to offer to all of the existing shareholders to purchase more to maintain their ownership interest whenever it issues more shares

o pay for the shares at market priceo you can decline the shares

the preemptive right is no longer presumed

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o if charter does not mention PRs then you do not have them

o you have to opt-into PRs, which most Cs do not today

opt-in preemptive rights are for common stockholders and preferred stockholders whose shares can become common

…the rationale for this is that preferred shareholders negotiate their rights via contract, and hence they have the ability to negotiate for such a right if they choose, while common shareholders do not…PSs could negotiate for preemptive rights in their Ks

people pay more for preferred shares because it gives them some kind of preference

the amount they will pay depends on the rights giveno this depends on the state the company is in

PSs are cheaper when there are more risks involved PSs will always be better than CSs

“better than sitting in the nosebleeds”o common

last in line can have different classes of CSs

different classeso different rights associated with a stock will force them to be separated into different

classeso you have to identify the different rights in the chartero distinctions in types of stock should show the difference in the rights associated with

those stocks

Other issues with regards to shares Par value

o The stated value of the shareso No connection whatsoever with the amount you pay for the shareso Of little or no relevance today

Except you cannot issue shares for less than par value You can, however, issue shares without a par values to get around

this Most companies have par values that are just nominal

o Watered stock Shares issued for less than par value

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If watered stock is issued, the difference between the purchase price and par can be recouped by the corporation and creditors

Value of shareso Outside of the public, where the market determines the share value, directors

conclusively determine the price of shareso You can pay in any way deemed appropriate by board members

Debt financingo A company can issue debt securitieso You can essentially loan a company money to be repaid to youo Debt securities are usually memorialized in some agreement – called indenture

Separate K determines the rights and obligations…this is why you don’t see these terms in the charter

o Two types of debt securities Bond

Secured long-term debt instrument secured by a corporate asset Debt holders typically do not have voting rights because there debt is

secured to be repaid Deventure

Unsecured long-term debt instrumento Debt not secured by the C

o Leverage Notion that when you generate capital for the company some of the capital is

through equity and some of the capital is through debt Highly-leveraged company

Company is highly funded by debt Usually, you try to have a balanced debt to equity ratio

Leveraged buy-out A buyout that is financed by debt

DISTRIBUTIONS

Gottfried Courts will say that they are not going to step into the shoes of directors

o In the business realm, it is very difficult to hold directors liable in breach of FD Courts have a very deferential standard in order to afford directors flexibility

in business judgments Even if the directors are acting stupidly However, when it comes to dividends, courts are slightly less

deferential Rule: cannot withhold dividends in bad faith What do we mean by bad faith? Courts will be divided between closely held and publicly held

o Closely held are often family held Closely held hold unique challenges

Types of stocko Common Class A

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o Common o Preferredo …Situation…

Dividends paid on P and A, but not CS There can be many situations where you pay your first and even

second orders without paying the CS The only way you can pay the CS dividends is by paying the more

senior stock first Rule: The board has discretion to pay out dividends if there is no surplus

o Rule: if there is a surplus, you cannot withhold it…there must be dividends Rule: you cannot pay out a dividend if you otherwise could not meet your

debts and obligations Here, there is a surplus

o You cannot withhold a surplus in bad faith Factors to consider in determining bad faith

o Dividends paid no bad faith

o Have to bring a lawsuit to get dividends All things being equal, courts may find the lawsuit to cut in favor of finding

bad faitho Excessive salarieso Advances of loans to directorso Freeze-out

Minority shareholders facing marginalization in corporate actions Majority shareholders disallow participation in the business

Salary determinations, dividends, loans, etc.o Genuine reasons for not paying dividends

Pumping money back into the business, etc.o Size of the surpluso Key: You have to show that a concerted policy is linked to the lack of dividend

payments You have to show that they are not paying dividends because of these

things… I.e., bad blood, etc. led to the failure to pay dividend

o You have to have a majority of the board or a really influential board member (i.e., chairman) indicating the concerted policy leading the failure to pay dividends

Then you look to all the other factors on top of these thingso I.e., freezing-out, etc.

Take awayo Courts really do not like to compel payment of dividendso Not an exclusive list of factors

No big surplus is keyo Some elements of bad faith

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The elements are nice, but you have to clearly establish the link because courts do not like to get involved in these kinds of decisions…you need a “smoking gun”

Even though, courts are more likely to compel dividend payments than other business decisions

o Remember: the C is not your piggybank If you need a loan, go to the bank Not a policy courts are likely to look favorably on

Dodge A case about dividends and FD Rule

o A court will force you to pay dividends when there is an adequate surplus and you are withholding the dividends in bad faith

Adequate surplus…surplus is the net You must take into account debts and obligations

o Here, the surplus is so large that it virtually cannot be deemed inadequate Ford argues that the huge cash balance is needed for future expenditures

o Dividends do not need to be paid immediately, but the surplus is so large here that it seems unwarranted to hold back dividends

Bad faith analysiso Court says that the bad faith to fail to run a for-profit company for profito If a C has breached an obligation to pay out dividends, its doesn’t matter if the other

shareholders are interested in suing What is Ford doing?

o Not paying dividendso Opening plants without regard for whether or not they will make money

You have to run a business C to maximize profits However, others say you cannot read the case this way because the C

refuses to stop the expansion planned by Ford Is there a profit related reason for what Ford is doing here?

Potential business motive behind what Ford is doing Herein lies the problem here…

“I do not believe we should make such an awful profit on our car.”o Ford quote from news, which sentiment was later echoed in

testimony “smoking gun”

this is how you show a concerted policy…Ford’s policy is the company’s policy

o …we are not paying dividends and this is why… you cannot show just the lack of dividends and potential indices of bad faith,

you have to show the link between concerted policy and the lack of dividends Dodge brothers

o Held 10% of shareso Dividend was paid, just not a special dividendo While Ford may have been sounding altruistic, he may in fact have been really

disallowing the Dodges from using their dividends to start a competing company

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Tax reasonso You may not want to pay out a dividend because they will get taxed at the highest tax

brackets If the reason why you are holding dividends is so that specific

shareholders can catch tax breaks this is bad faith This is because this is personal

Would the case have come out differently if Ford didn’t have a track record for paying out special dividends?

o Track record is important because it makes the tie between the policy and lack of dividends payment even more clear

The court is saying now that you have stopped paying them, you must show why it is not in bad faith

o The track record also allows for the court to calculate how much is owed The court really does not want to make this calculation…availability of the

track record here made the case easier to rule in favor of the Ps

Big take aways from todayo Adequate surplus…cannot avoid paying dividendso You have to link failure to provide dividends to bad faith

FIDUCIARY DUTIES OF OFFICERS AND DIRECTORS

DUTY OF CARE AND THE BUSINESS JUDGMENT RULE

Boards and their FDso Shareholders purchase shares in a Co Board has responsibility for running the C

Boards are pretty much overseers for what management doeso Boards have FD

Two primary duties of boardso (1) Duty of care

Encompasses the way in which they are to conduct themselves when engaged in business transactions

o (2) Duty of loyalty Encompasses the way in which boards are to conduct themselves when facing

a conflict of interest Exam analysis…when analyzing a breach of a director’s FD…

o Is this about a duty of loyalty? … then ask…o Is this about a duty of care?

Wrigley Similar to Dodge…Wrigley is putting his principles before profit Alleged that there was negligence in management…really a FD claim Case is brought as a shareholder derivative suit

o Direct suit Aimed at remedying a wrong to them personally

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E.g., dividend suito Derivative suit

Action brought to remedy a wrong to the C In a derivative suit damages flow back to the C

o A FD suit is a derivative suit because the board has obligations to the C

How is this case different from Dodge?o Court in Dodge finds bad faith…engaging in acts not designed to further the primary

interest of the Co Some argue that this is not different from Dodge

Wrigley did not care about club/profits, he said he cared about the community Like Dodge, we can conceive of a profit-making excuse

o It was just that the court in Wrigley was more willing to find a profit-making excuse

Here, court is really honing in on the business judgment rule and the extreme discretion given to the board

Standard: Court says that you do not have to be motivated by short term profitso Making sure the neighborhood doesn’t deteriorate may have a long term profitability

of the teamo Anything may go if this is the standard

Importance that 19 out of 20 other teams have lights?o Court says that they have not provided evidence that every other teams is more

profitable because they play at nighto Important…court does not force anybody to be a follower

Business judgment rule…extreme discretion/deference Businesses are best when they are innovative

o Two prongs (a) link to the profitability (b) courts will rarely force you to follow the leader

What if you could show that there is no real profit related reason for helping out the neighborhood?

o No net financial or other benefit You will always have competing studies though

o Hard standard to meet…extremely broad standard

Business judgment rule FD of care

o In order to prove this duty to have been breached, you have to overcome the BJR The overwhelming presumption of the BJR is that what you are doing is

okay Very wide discretion so long as what you are doing is rational

o Pretty much so long as there is no smoking gun evidence of bad faith

o Near impossible to find directors liable for a breach of FD of care

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FD of loyaltyo No BJR presumption

Van Gorkom Shocker of a case…one of the most important cases of corporate law

o In DEo Breach of a FD duty of care

Three background thingso Deal involved a leverage buy out

LBO…transaction pursuant to which you are borrowing a lot of money to purchase shares to buy out the company

Important to the ultimate transactionso Structured as a triangular merger

New companies are sometimes set up solely for purposes of the merger Done to ensure you get full control of the company

o Avoids shareholders holding out and causing complicationso Tax credits

Investment tax credits…deduct money from taxable income Appreciation deductions are so large that they are wiping out their income, so

by the time they are trying to use them they can’t So, they were acquiring companies in a way to increase income, so as to get

enough money generated to be able to use their tax credits On to the meat of the case…

o VG is 65 years old and approaching mandatory requirement Might be leaving the company soon

Questionable motives…trying to exit this company with a lot of cash…Is he acting in good faith?

o What is at stake here? What if directors lose this suit for breach of their FD? … they do lose

Damages…difference between merger price and whatever the court thinks is fair value…millions of value

o Shocking in a care case because the people subject to millions of dollars of liability did not get anyone financial benefit

No case like this has come to trial before this or after this

Breach of loyalty is different from care because it involves directors getting a personal windfall

Rule…o Boards need to make informed decisions to invoke the BJR

Two different ways to overcome the BJR (1) process prong (VG)

o decision not well-informed (2) substance prong

o the substance of your decision is wastefulo harder prong

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Factorso Beginning of the problems is the start of the negotiations without involving the

board Nothing is wrong per se, but it all can add up

o Arranges board meetings and does not tell them why it was organized Board have no notice of offer

This is the board’s problem, not VG’so The decision should not be made this way

o What goes on at the meeting? Nothing given in written…no documentation

Multiple oral presentations and some discussion, at the end of which they vote

Meeting lasted only 2 hours Though the court says there is no magic number this along with no documentation makes things look a little flippant

o board meetings are thoroughly documented nowo Reliance on officers/employees

Court says the reliance is not reasonable here because the officers asked no questions or at least there is no record of this fact

Should we take into consideration that these are smart, high-powered people with things to do?

We can’t we presume that their vote was in good faith This is a board decision, not just a VG decision

Sometimes you have to assess whether this person is someone we can rely on

o Is VG reliant? Maybe not because he seems to have some kind of conflict of interest.

What if the board is not sophisticated? How does this cut?

o It is not okay for a board member to sit there and not understand

There is a lawyer in the room Can the board reasonably rely on their counsel? …

o Lawyer is recently hired…cannot rely on him for a business deal

Lawyer is not in the same place, so this cuts against being able to rely on him

Expertise is critical for reliance The agreement was memorialized elsewhere (the opera)

Problematic because there was no concrete understanding of the key terms of the memorialized deal

Above factors were important, but price is the key here…o VG came to the other company with the price

Thus, the company does not have to offer higher…this is a problemo Where does the $55 come from?

From LBO

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When you borrow money to purchase, it has to be repaido Thus comes corporate debt

You have to have enough money in the treasury to pay off the loan with interest

Price was driven all by structure…problematic Buy-out was created in a way in which someone was not thinking

solely about the companyo Stock was trading at $38, and they got a buyer at $55

This court says this is not enough Anyone who wants to take over a company must offer more than the

premium The court says $55 is not enough

o The problem is that the board had no idea where it came from Nothing was said about the price being structured

around the LBO…this is the most critical problem…

No questions were asked…o you need to get comfort on the price

you need to know where the price came from… You cannot simply think “that sounds about right” or even “that sounds better than I thought”? … its about being well-informed

o Is this question about some support for the valuation? Do we need some additional support?

Some study or independent report?

RECAP Under VG, we see how achieving protection by the BJR is attained by following certain

procedures

Con’t with VG Why isn’t looking around for other potential offers a sufficient cure?

o VG finds out that there people out there willing to pay moreo VG did not give a genuine attempt to see what else the market had to offer

Lock-upso Lock-ups do two things…

Keep someone in when there is a strong likelihood of accepting them, but you are scared that they will walk away

Also a lock-up serves to drive up the priceo Are lock-ups consistent with the best interest of the company?

A lock-up in and of itself is not a breach of FD Must look at it amidst other factors

o Do later actions cure the breach of FD here? … no No more information attained

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No more information received from the “fishing for other offers” In a merger, a board cannot approve of the transactions alone, shareholders also have

to approveo 70% shareholders approve of the transaction here…Why does this not provide a

cure? Shareholders cannot validate a price by themselves

Do they have any more info? A boards recommendation implies something…shareholders generally

follow it Thus, the shareholders following of the board (who have no real new

info) cannot serve as a basis for curing this kind of defective decision The BJR, at least in this case, is all about having the info to be comfortable in the

decision you made, not so much the decision.o You want some assurances that the price is a good price.

Studies, independent reports, evaluations, fairness opinions, etc. In the 1980s, during a takeover battle, speed was everything

o The real world is you make quick decisions and move on This is another reason that this case was so stunning

o What does this case say about timing? Court does not exactly seem to be asking companies to slow down…

Perhaps the court could ask for an extension. Instead, it seems to be asking that you make a decision with the best info

you have at that time. Here, even though under a restricted amount of time, the Ds could

have looked at more readily available info. BJR, at least most of it, is about process

o Not going to look to much into the substance…the courts are not business experts Here, the court did not know if the price was right, but the court purported that

the company’s decision making procedures were not sufficient o The substance is not as important as the process

The final decision does not matter, the process of arriving at that decision is what matters

o The court is not making a judgment about the price, the court is saying they will lose the protection of the BJR if they engage without being adequately informed

Adequately informed…presumption of good faith two prongs as seen in Disney

o (1) procedureo (2) waste

no rational business person would ever make such a decision safety valve…very difficult standard to meet

Post-VGo How did lawyers counsel? … create a process

Document everything Ask questions Keep lengths of meetings

Final Judgment

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o Whole board held liableo Millions of dollars in liability

How much do you think was paid personally by the directors? Nothing…due to indemnification; insurance

o VG settled inside the insurance parameters Whereas, Enron did not fall within the insurance

parameters and directors had to pay out of their pockets Other fallout of VG…102(b)(7)…

DEL. GEN. CORP. LAW § 102(b)(7)

Prohibits shareholders from seeking monetary damages from directors of a corporation Meaning of provision…

o You have to opt-in to this type of provision in your chartero There are exceptions/carve-outs

(i) for any breach of the director’s duty of loyalty to the corporation or its stockholders,

(ii) for acts or omissions not in good faith or which involve the intentional misconduct or a knowing violation of the law,

(iii) under section 174 of this Title [which refers to the liability of directors for unlawful dividends and stock repurchases or redemptions], or

(iv) for any transaction from which the director derived an improper personal benefit.

No such provision shall eliminate or limit the liability of a director for any act or omission occurring prior to the date when such provision becomes effective.

o Duty of care is covered However, you can still bring non-monetary damages for duty of care claims…

i.e., injunctions, etc. If you are a shareholder, it is in your (monetary) interest to find a duty of loyalty or

duty of oversight breach so as to get pass the dismissal stage It is very hard to bring shareholder suits against directors…three tiers of protection

o Statutory protectiono Indemnification

Board has to indemnify directorso Insurance

Eisner Is E independent?

o Court holds that there was no breach of the duty of loyalty When courts look at what constitutes an (conflict of) interest to trigger a

duty of loyalty, they think in terms of economics, not friendship, etc. Why isn’t the hiring problematic?

o O had no experience and apparently was highly sought after No process problem…they knew everything about him and still hired

him…clear here, but what else

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The court said the process was “causal, if not sloppy and perfunctory”

o How is such a process protected by the BJR? BJR is a broad rule

Eisner essentially handled the hiring unilaterallyo Went to the board hoping they would rubber stamp his decision

v. VGo Unlike VG, the board at least was somewhat prepared and

active in the decision o Also, it wasn’t a takeover offer, but rather just a hiring decision

Hiring decisions are uniquely executive decisions The board doesn’t need to know every fact

Takeover decisions are much more important than hiring decisions

More at stake, more info you need to know So, you have to prove waste…was hiring him irrational?

Hard standard to overcome Severance package

o No one knew This is undisputed

o In thinking through the severance package… You need to have info You must do the calculations

o Allegations… You would have to show that the original board made some sort of

procedural errors in the decision making. The court said that ideally what they would have done was have some

sort of payout chart. In order to comply with the BJR, you have to be reasonably

informed…o And to be reasonably informed, you have to have all the

materially available info needed to properly make the decision

Here, even though the Board was shocked by the numbers, they had the formula to figure out how they got to the crazy number

o VG did not even know how they got to $55 Wastefulness (goes to the substance)

No. The New Board was contractually bound to pay it. One of the important things is that in order to get someone

extraordinary you have to beat the market.o Also, you have to consider the person you are trying to hire is

going to have to break another contract and lose money doing so.

Standard… “no rational person”o “A risky transaction is not a wasteful transaction”

Today, any sophisticated person goes in discussing severance

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o “golden parachutes have mushroomed” Fairfax thinks executive compensation will never really come under

control Reliance

Why is the reliance on Crystal reasonable?o What if Crystal messed up the compensation for the last five

clients he worked for? Reliance is all about whether the reliance is reasonable

o In VG, no one was really an experto Here, there was an compensation expert (and the company had

no reason to believe that this expert was incompetent) Board can’t crunch all the numbers Analysis…

You have to ask is there history of the expert’s unreliability?

o Company must hire a reliable expert. If there is history, why don’t they know?

o Company must be responsible in hiring. No Fault Termination

O could left under fault clause with no severance or under no-fault clause with a package

Shareholders argued a duty was breached in settling with him and allowing him to leave under NF…

o Court holds that the board made a rational decision to get cut their losses and get this over with in order to avoid litigation

The board may decide which risk they would rather take

The way in which the agreement itself is written incentivized O to perform poorly

Court doesn’t buy this argument. Court noted O’s major reputation in the industry to uphold. He will

not tank this job purposely. Also, he has a great friendship with Eisner.

…in the end, there are reasons the transaction is structured the way it is Interesting puzzle…Disney was a DE Corp. that at the time of this suit had a 102(b)(7)

provision prohibiting shareholders from getting monetary damages from directorso So, why are we in court?

The are trying to argue that there was bad faith, and the DE statute does not allow for protection of bad faith (one of the exceptions).

o Creation of a third duty…duty of good faith…somewhere in between duty of care and duty of loyalty…but there really is not three duties out there (spoiler alert)

This outlandish move to force litigation was done because DE was feeling the heat from Enron and corporate threats to overtake regulation of corporate law

RECAP

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Duty of care breacheso (1) processo (2) substance

waste…extremely hard to prove harmonize VG and B

o VG…end of life (of the C) decisiono B…just a hiring decision

DUTY OF LOYALTY

Marciano The intrinsic fairness analysis is different from the standard care analysis used to over come

the BJR presumption When we are talking about a duty of loyalty, we are talking about “self-dealing” or a

“conflict of interest” in a transactiono Three types of “conflict of interest” transactions

(1) Director and corporation (2) Corporation with someone else a director has a material relationship (e.g.,

a spouse…important for exam) (3) Corporation with another corporation where a director has a material

interest In “self-dealing” transactions there is a potential for a breach of FD

o BJR rule presumption is not provided when analyzing a “self-dealing” transaction

A “self-dealing” or “conflict of interest” transaction could also benefit the corporationo A SD or COI transaction involves a transaction benefiting someone at the

exclusion of other shareholders Aside…exam analysis for FD claims

o Start with duty of loyalty analysiso Follow with duty of care analysis

How do we know this transaction is self-interested?o Their loan deal is benefiting them to the exclusion of the shareholders

Section 144 analysis…o No COI transactions are voidable solely because they are COI…COI

transactions are not voidable if (1) board approval, or (2) shareholders approval, or (3) fairness

Court could not apply this test hereo Could not get approval prongs because there were no majorities o Because it was not ratified, cannot use the fairness prong

Court says no to per se voidibility ruleo SD and COI transactions may benefit the C even if they involve some kind of COI

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o Statute is not the exclusive way to validate or void a COI transaction…Common law…intrinsic fairness (ITF)

144 … OR … CL 144 prong 3 v. ITF

o Same test ITF has been incorporated in prong 3 of 144

In a DOL case, it is very important who is voting and their relationship to the transaction

o For first prong, you have to first knock out all of the interested folkso The majority of the disinterested directors must vote in favor of the transactiono Does it matter that everyone voted at the meeting?

Quorum…number of people you need present at the meeting for business to be engaged

Usually a majority You can count interested members in striving to reach quorum Doesn’t matter who votes, its about how people voted

Vote must be in good faith Cannot pressure/harass disinterested directors to make whatever

decisiono The goal is to use their own judgment to make a decision

regarding the transaction Relationships must be disclosed (or the board must know about it)

What happens once the board approves the transaction?o Then the transaction is not void…then we analyze the transaction…

If you get disinterested board approval, then the transaction will be analyzed under the BJR (presumption)

o 144 is an either/or test…you don’t have to satisfy all three prongso if you don’t get a majority approval...then you move to try to get a shareholder

approval …shareholder approval

o if you get majority shareholder approval that is enough to move that transaction from the voidibility range…then we analyze the transaction…

analysis majority of disinterested shareholders approved transaction

o BJR applies If the majority of the disinterested shareholders reject the

transaction…o DE courts are split…

(i) It will be subject to the ITF (ii) BJR applies

no shareholder vote or majority shareholder approval… ...ITF

o no factors associated…the question is just is the transaction intrinsically fair?o Look to…

Does it benefit the company?

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Does company need loan? Does company need property?

Is the transaction on market terms? Are the loan rates at market value? Substantively and procedurally, is it a transaction that you would have

struck with somebody else? What is the rate was pulled out of the sky, not knowing whether it

was the market rate? o In ITF (CL) world, not BJR (like above, with the approval

prongs)o This is key becasue is it has to be fair at the time of

approval Guessing about fairness will not fly because

knowledge of fairness will not be hado If something will not pass muster under the BJR, than it

won’t pass muster under the ITF ITF is a higher standard because the presumption

that officers are acting in the C’s interest does not exist when there is a COI

Court will actually second guess under the ITF

The court’s selection to analyze under the duty of care as opposed to the duty of loyalty can determine the success of a FD claim

o BJR v. ITF Important distinction

Exam…o Figure out what prong you fall under and then do the substantive analysiso 144 is an either/or test

DUTY OF OVERSIGHT

There are two primary dutieso Duty of careo Duty of loyalty

When someone brings a breach of FD claim, you want to ask…o First, what duty is implicated?

Which, thus implicates the BJR or the ITF And, whether monetary damages can be obtained

Today’s caseso Create uncertainty and then clarity with regards to…

The duty of oversight The duty of good faith

Caremark Involves a litigation settlement, which the court must approve

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o When you settle, you have to give up your right to future claims C is a Chancery Court decision that seems to be trying to overturn a supreme court decision

o Precedential value is suspect The oversight claim that C is talking about is now referred to as the “Caremark duty” Shareholders’ claim

o The board has neglected its oversight/monitoring responsibility They did not do anything affirmatively wrong, but they were asleep when

other people were doing things wrong Any time there is some kind of improper conduct in the company, the claim

the shareholders will bring is the C claim The claim is the one of the most common FD claims…it is usually not

the directors acting wronglyo The directors have allowed a negative situation to develop and

continue The court says this is one of the most difficult theories to advance

Directors have to be able to rely on their subordinateso How can you say the board should be liable given the corporate

reality (the need to rely on subordinates)? Two ways you can violate the duty of oversight

o (1) negligence not just negligence, it is really approaching gross negligence

we respect business decisionso we want our business people to take risks and innovate

as opposed to how we would want doctors to performo judges and juries are not in the best position to make these

hindsight determinations Shareholders picked these board members and could remove them.

So, they should really have no right to attack them after they exercised the discretion that they afforded them.

o You can still bring a waste claim, even though it is very hard Decision simply needs to be rational

o (2) failure to act in reasonable way…failure to monitor even if there are not any red flags, boards have a responsibility to set up a

system were information flows back to them internal control system

o system designed to get information to the board so that the board cannot say that they didn’t know

o allows you to know what’s happening in your company, and thus allows you to properly exercise your monitoring ability

it is no longer the case that your duty is only triggered when there is a red flag

What does an unconsidered failure to act mean? When you knew or should have known something that needed to

be acted upon

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C imposes on board an obligation for the board to put a system in place to provide timely and accurate information allowing them to make proper decisions

o if you do not have such a system in place, then you have breached this oversight responsibility

What if the people bringing you info are not doing so properly?o No control system is going to be perfect…system failure does

not mean that the actions weren’t reasonable.o People lying to you and providing wrong information should

not be enough to show that there is something wrong with the system

However, at a certain level, does your system account for liars, cheaters, and stealers…it should

In order to show a breach of the oversight duty you must show a “sustained and systematic failure”

o Seems like an impossible standard…but the court wants this standard is hard, but not impossible

o To the extent that the system is faulty, there must be some time to fix it

Red flagso If there is no red flags, there is still a duty to monitoro But when there is red flags, you must act, or risk “conscious

disregard” of your responsibility After C…

o C claims were coming up under the duty of care thus, C claims fall under 102(b)(7)

so they are not as attractive as they may appear to be

Stone Duty of good faith

o not a separate and independent duty (important)o so, where does it lie?

Under the duty of loyalty Because when you engage in bad faith, you are being disloyal

Duty of oversighto not a separate and independent duty (important)o so, where does it lie?

A separate FD, not a part of the duty of good care, but rather the duty of loyalty

Thus…under the duty of loyalty is…o The duty of good faitho The duty of oversight

The duty of oversighto (1) no systemo (2) failure to monitor the system

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The duty of good faitho one way to violate the duty of good faith is to violate the duty of oversight

indeed, good faith is not an independent and separate standard, it is actually linked to the duty of oversight

o this case actually eviscerates the whole good faith thing you engage in bad faith when you fail to maintain oversight, self-dealing

Oversight is not really about your own conduct, but the conduct of others

Where are we…(keep the three things separate, but know where the duty of oversight lies)

o Duty of careo Duty of loyalty

Self-dealing context Duty of oversight

(1) utter failure to have a system…either you have system or you don’t

(2) conscious disregard…having put a system in place, did the board fail to monitor it

Hypoo Do we think that all this amounts to a breach of their oversight duty? It is true

that if you create a system that is not reasonably designed to give you information…breach

Is this system reasonable designed?o Because there is a bunch of stuff in place doesn’t mean that is a

system designed reasonably.o You have to have some kind of independent, disinterested

check. Is this system industry standard?

No at all. While we encourage innovations…there are industry standards for

internal control systems…o Random site visitso Multiple people checking the invoices

Verify addresses and information on the invoices Do you meet the standards or achieve the goals in some other way?

Red flags Doubling sales Kerry Lawsuit

o Even if they escape the liability now, they have to do something

DERIVATIVE SUITS AND THE DEMAND SYSTEM

What we have been looking at up until today is the substantive analysis of the lawsuit However, before you get to court, there is litigation as to whether you can get to court

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o Today and next week’s decisions concern whether a board’s motion to have a shareholders’ suit dismissed will be honored by the court

FLOW CHART…Delaware Demand System (this system is unique to DE)o Shareholders bring a derivative suit on behalf of the Co Board moves to dismisso Court will rule on the dismissalo The standard that the shareholders use in the case can be determinative of the court’s

decision Stricter standard…lower chance of winning for shareholders; lower

standard…higher chance of winning for shareholderso EXAM…

If a shareholder brings a derivative action and a C brings a motion to dismiss…

You must analyze the dismissal before doing any substantive analysiso derivative suits….

(1) analyze demand…procedural (2) analyze substance

If a shareholder brings a derivative action and a C does not bring a motion to dismiss…IMPORTANT

Skip the procedural analysis and analyze substance If there is some injury to the C, boards generally have the power to file suit However, shareholder derivative actions…lawsuits against the board (FD)

o Action is brought on behalf of the corporation Board usually does this

o So, these cases are about whether the lawsuit should be in the hands of the board or the shareholders

When we trust the board will do the right thing we will make the decision to allow them to control the suit

Analysis…A-Z…Aronson to Zapatao A is the threshold question

Before shareholders can bring suit on behalf of the corporation, they need to make demand on the corporation, unless demand is excused for reasons of futility

o When a shareholder makes a demand on the corporation, the shareholders are conceding that a demand was required

Demando Written demand that the board take some action against officers

Zapata Shareholders have a right to initiate an action in one of two settings

o (1) No demand because you think it would be futile, and you initiate the suito (2) Make a demand, board decides that it does not want to go along with the suit, and

the decision to dismiss the suit is wrongful Wrongful…decision to dismiss does not pass the BJR

Court takes for granted that demand is futile/excused hereo Why would demand be futile here?

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This was basically a self-interested transaction One way you can show demand would be futile…entire board is

self-interestedo Demand may not be futile …

if other shareholders stand to benefit remember: self-interest… “at the exclusion” of

others in order to prove that the board is interested in order to

excuse demand, you have to show the majority of the board is interested

144 voting analysis is not relevant here here, we are just trying to decide whether the

majority of the board is interested Two prong test in order for court to grant motion to dismiss and terminate suit…C

must meet pass each prongo (1) directors must be disinterested, independent, and drew reasonable conclusions

from an investigation in good faith…burden on directors keys

interestedness of the directors reasonableness of conclusions of the investigation

o (2) court exercises its own independent judgment about whether or not this suit should go forward

Failure of either prong…move onto substantive analysis (duty of care/loyalty/oversight) Committee

o A board committee’s power to terminate lawsuits... Anything the board can do, a committee of the board can basically do

The committee can make a decision on behalf of a board Doesn’t matter if there is no committee, you will analyze the decision of

whatever body to determine if the shareholders will get their day in court Why do we force shareholders to make a demand?

o The whole point is we want them to exhaust their internal resourceso Also, business decisions may be too complex for the courtso …we don’t want you to run to the courts

Prongs…o (1) Independence of the committee

How do you show the independence of the committee? just because you were picked by an interested member, we do not

assume that they could not use independent judgment What if the members participated in approving in the decision?

as a general matter, this may not affect their independence Here, committee’s decision was not subject to board review

Rule of thumb is that the committee’s decision should be bindingo Important piece of the process

o (2) The court looking at whether the decision was reasonable

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remember: in order to get to Z, there is some allegation some where that there is something wrong because demand was excused

pretty big deal for courts to shut down shareholders hereo but, courts still like the benefits of internal decision making

courts will look at the reasons of the conclusion…notions of fairness courts will look to public policy

Problem with Zapata…too lenient…not enough deference given to BJR

Aronson Two prong test…

o A prior demand can be excused only where facts are alleged with particularity that creates a reasonable doubt that

(1) directors were disinterested/independent, or (2) transaction was valid under the BJR

First prong…interested directors?o Claim that Fink dominated and controlled the board did not raise reasonable

doubts We presume that people will exercise their independent judgment,

notwithstanding their employment position Mere majority ownership of a company does not overcome this

presumptiono There must be coupled with the allegation of control such facts

as would demonstrate that through personal or other relationships the directors are beholden to the controlling person

You cannot exercise your independent judgment when the suit is about someone who pays your salary

o However, here, it is just about people who Fink appointed to the board

Which the court does not find enough to pass muster Merely alleging the prior loyalties of the

individual board members does not indicate that the BJR may not apply

o Naming a director in a lawsuit is not enough to compromise directors The court says not this is not enough to compromise someone Courts have held that when the lawsuit is not against the board as a general

matter, but rather against particular members for egregious conduct the naming of a director may be enough to find that they would be unable to exercise independent judgment

o What if all the directors are interested? Doubts are raised about the protection of the BJR because you are dealing

with issues of self-dealing and COI Here, just Fink being interested does not raise a reasonable doubt

Second prong…valid under the BJR?o BJR is extremely deferentialo Employment decisions are within the discretion of the board

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Even if the numbers don’t appear to make sense to youo What if the man you hired just had a major stroke?

Waste is more clear Here, there is no evidence that Fink can’t perform

o Without any evidence that he can’t perform, you have to assume that he can

Burden is on the shareholders in Ao Shareholders have to show with some particularized facts that either (1) the directors

were interested, OR (2) the transaction was invalid under the BJR Prove either one of these two prongs, then you get to Zapata

o Pass one…demand is not neededo Fail both…demand is required and the BJR is needed

Third type of case…duty of oversighto In second prong you would have to prove to reasonable doubt that you could

prove both elements of the duty of oversight

Putting it all together When you bring a shareholders derivative action

o Most shareholders in DE will not make a demand, because you are conceding a demand is required, and thus the BJR rule applies, which is no good

Board moves to dismiss Court’s analysis of motion

o Futile demand…Zo Not futile, demand required…BJR

Whether demand was required or excusedo Shareholders are raising reasonable doubt with respect to the board on whom

they have made a demand Likely not the group of people considered at the dismissal stage

Usually a committee derived from the board at the dismissal stage A

o Directors Majority must be disinterested

o Not valid under BJR Majority of the board is interested

Falls under the first prong Duty of oversight claim…both prongs

All you have to do is raise a doubt Traditional BJR

Process defects; waste Exam tips

o In the second prong in A, do not going into doubt much substantive details Raise doubts…red flags

Enough flags will lead to a reasonable doubto The second prong of A has parallels to the substantive suit

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Zo About the dismissal decisiono If motion is granted, BJR applies

Burdens of proofo A…on shareholderso Z…on corporation (in first prong)

DEMAND SYSTEM IN CONTEXT

if a shareholder brings a derivative action, and the board moves to dismiss, then ensues a two-part analysis

o (1) proceduralo (2) substantive

A committee – at least in this committee -- is a committee of the board of directorso You have to actually be a directoro Even if appointed, they are directors for that limited timeo They owe all the duties directors oweo Committee members act with the full authority of directorso A public company will generally have three standing committees (made up of

directors) Audit committee

Responsible for C’s financial statements being consistent with disclosure requirements

Oversees the work of accountants, etc. Nominating committee

Receive nominations for board of directors and determine the nominating process

Receive recommendations from shareholders Compensation committee

Responsible for setting the compensation for the executives Allow for the avoidance of the self-dealing problem

o When undergoing compliance checks, special litigation committees are created The vast majority of SLCs find that the motion to dismiss should be granted SLCs may pursue the action themselves or pursue some kind of settlement

with the board Neevetheless, an SLC is a committee of the board of directors

“interest” and “independence” (in A and Z)o interested director

a director who has a financial or personal stake in the outcome of the decision interested in the outcome of the transaction

v. disinterestedo non-independent director

cannot make an objective decision with respect to the person who has a financial interest

to the degree where this person’s judgment can no longer be trusted

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o for A and Z, you can add “interested” directors and those lacking in “independence” together to get you to the majority of the board being tainted

Hypothetical timelineo May 1…transactiono May 10…shareholder (Sh) suit without demand

Demand excused (A question…[remember: A to Z) Would demand have been excused on the day you made the

demand? Question asked with respect to the directors in office on this date

o July 1…SLC motion to dismiss (Z question) Question asked with respect to the directors in office on this date

Oracle Derivative suit based on directors who allegedly participated in insider trading

o Directors saved money on selling their stock before a stock drop Are these four directors interested?

o Yes. Clearly. In order to get pass A you have to show a majority of the board as being interested or

lacking independenceo Showing only half creates a problem because you have to show a reasonable

doubt Benefit of BJR here?

o Probably not, but there seems to be reasonable doubt as to their loyalty (loyalty violation).

Zapatao You have to be careful with the way in which you screen

It would be wrong if they selected directors who were inclined to agree with the C even though they new none of the facts

o Selected committeemen would get paid more than the other directors There is some concern over greater compensation Getting compensated for being a director is not enough to compromise your

independence Most courts say you can pay them a different fee because they are doing a

different serviceo What if the two directors were on the board at the time of the transaction?

Would this compromise their independence? Does not make them any more interested unless they had stock and engaged in

the trades too Does not compromise independence …general rule of thumb is to appoint two outsiders

o What if one of the SLC members did not have tenure? Lack of tenure puts you in a much more precarious situation with the

university President generally has to agree to tenure Court will see as troubling some kind of impact on an individual’s

financial livelihood

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o The role of fundraising When it is about money courts are more likely to see the interdependence

connection There are great concerns in dealing with board members who had given

money in the past. There could also be concerns about board members who could potentially give money in the future.

o …Oracle considered all these factors Professors are tenured

have no financial ties to the people that they will pass judgments on Professors are not fundraising deans Professors willing to take a pay cut

o …Courts still held them to lack independence people were shocked first time court focused on “social ties”

post-Enron…DE was playing hardballo In determining “independence,” you will have to go director by director until

you get to your number Boskin…could the SLC pass judgment on him?

Teaches in a completely separate part of the university as the SLC (the directors)

However,o Taught Grundfesto Sat on the same board

Argued that they traveled in the same circleso You may not know them, but you know people who know

them Not about economics, but social ties

Things all put together create the problematic nature of the ties What if the person is a law professor elsewhere?

o What if they taught in the same subject area?o Probably travel more in the same circles as university

professors who barely know each other Lucas

Contributed to SLS Ellison

Potential large gift to Stanfordo Would it have made a difference if the “special ties” had been disclosed in the

report? Maybe it would have made it better Would have at least suggested that they were acting in good faith However, no one thought the court would care about these social ties Yet, in the end, if you want to court to give you the benefit of the doubt, you

should at least put the ties out there Could help you at the margins

Court…

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o Regardless of sound conclusions in report, court finds that they fail the independence piece of the first prong because of their social ties

Disinterestedness and drawing of reasonable conclusions do not matter if you fail the independence piece

o Shareholders got their day in court, but eventually lost on the merits

Beam Issue…

o Is demand on this board futile or not? In order to show demand futility, over a majority of the board must be

shown to be interested or lacking independence (tie goes to the SHs though…IMPORTANT)

o Board members… Stewart…interested

Just naming someone in the compliant doesn’t make them interested. Aronson.

She is the one being alleged to have engaged in the wrongs.o Potential for liability is so strong that she must be interested.

She engaged in insider trading with shares in another company.o The claim was that her insider trading in another company’s

stock harmed her company because her name was so intertwined with the company so as to cause it harm.

Novel theory Patrick…lacking independence

Patrick’s connection to Stewarto Not the personal connection, but the employment connectiono We are asking the COO and President to take action against the

CEO who owns 96% of the companyo Patrick may be a little bit leery of passing judgment on the

person who may have a role in his employment Two types of directors…

Inside…director with employment with the company (as officers, etc.)

o Not every inside director is lacking independence

Depends on nature of the position, etc.

Here, we are talking about a second in command having to past judgment on the head

Outside…director without employment with company

o More common nowadays Other directors…

o Martinez Long-standing personal friend

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Served on other boards, thus it was important for him to maintain his professional reputation

Are his ties with Stewart so strong as to be willing to compromise his professional reputation?

o What if M was S’s best friend since high school?

Might be enough to raise a reasonable doubt that he could not exercise independent, objective judgment

Attending a wedding reception togethero Mooreo Seligman

Court…o As a general matter, social and personal ties standing alone are not going to be

enough to have compromising ties Distinction with Oracle

SLC is a unique creature O is about the inquiry in Z

o This makes sense because in A it is the shareholder’s burden to prove lack of independence and disinterestedness

o In Z, the standard is much lower because there is already suspicion afoot

o Take away Someone can be deemed independent and disinterested for A purposes,

but not Z purposes If allegations of personal ties is all that you have you will probably never

even get to Z because you will not be able to overcome A

Hypo

MANAGEMENT AND CONTROL OF THE CORPORATION

Moving from derivative control to management issues We will see issues of authority that we dealt with in the partnership context beforehand Authority in the corporate context

o (1) directors every C must be managed by and under the control of the board of directors all power resides with the directors boards used to manage day-to-day affairs

not really the case anymore today, boards have more of an oversight or managerial role

o when people are brining FD cases they are normally concerned oversight and monitoring

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it has become the norm that boards have the initial power, but that power is usually distributed to officers

o (2) officers high officers are appointed by the board the MBCA really only requires an officer that can take minutes

other statutes require a president and a secretary most times, a company’s highest level officers will be situated in a company’s

bylaws it is important to know someone’s position in a C because the position

often determines that person’s level of authorityo (3) shareholders

terminology o management

generally refers to officers and board as a collective boards act by majority

o quorum in order to conduct business, a majority of the directors must be present

boards no longer really meet together in-persono conference calls, etc. allowed by unanimous consent/waiver

directors cannot vote by proxy very difficult to hold directors liable for the acts they take while in office directors often operate by committee

o they have both committee and annual meetings three committees that public companies have to have

audit; compensation; nominating typically one or two inside directors sit on the board

o depicts the movement toward having independent directors independent directors provide greater protection

AUTHORITY OF OFFICERS

Typifies the tension between the authority of directors and the authority of officers Aside:

o Duty of care analysis Process

Van Gorkum Substance…waste

Disney Authority issues and FD issues may be coupled together

o FD issues usually come later

Lee Authority

o (1) actual authority between the principal (the board in the corporate context) and agency for Cs, look at the charter or bylaws

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explicit authority if the board signals that a behavior is reasonable, then actual authority may

exist what would a reasonable officer believe is within his scope of

authority o assuming that the officer is acting reasonably in and of itselfo the test is an objective test

i.e., if the same action had been taken multiple times before and the board never stopped it…actual authority after the fact

o implied authority o (2) apparent authority

from the reasonable belief of the third party based on what the C has done assuming that the third party is acting reasonably in and of itself the test is an objective test

ordinary authority v. extraordinary authority ordinary…reasonable for third party to believe that C gave them the

power extraordinary…less likely to be reasonable for third party to believe

that C gave them the power ordinary v. extraordinary must be understood within the context,

rather than in the abstracto here, the context suggests that the transaction is not

extraordinary pension was not extraordinary because it is not

extraordinary to give someone a reasonable fringe benefit

the salary offered was also reasonable considering the effort needed to get this candidate

o levels of pensions, salaries, fringe benefits, etc. may lie in the scope of authority…you may only have the authority to offer so high

consider how badly you need the person, but at the same time you cannot act too outlandishly regardless

at what point should the third party realize the situation and ask for permission from a higher up

o may depend how extraordinary the deal appears to be the larger or more extraordinary the deal the more

reasonable it becomes to ask for permission from a higher up

o may depend on who the third party is dealing with what if we were dealing with a VP?

Ask…o What exactly does the VP do?o How many VPs are there?

o May depend where you are doing the dealing The place and the context

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o If a third party were to make their assumption that the agent had authority as a result of consultation with some kind of publication or outside source it will usually not bode well in their favor

However, one may take into account the publication or outside source in making their argument

We’ve dealt with this stuff alreadyo But, with Cs, we are dealing with a renegade director and a challenge from the

board on authority grounds. This challenges comes even before the shareholders would make a FD claim on the board.

AUTHORITY OF SHAREHOLDERS

4 spheres of power for shareholders (shareholders have limited powers) (1) Power over director elections

o Quite limited Manner in which directors are elected

Pre-Disneyo Plurality voting structure

The nominees for available directorships who receive the highest number of affirmative votes cast are elected irrespective of how small the number of affirmative votes is in comparison to the total number of shares voted (i.e., all affirmative votes and withheld votes).  Theoretically, a nominee could be elected as a director with one affirmative vote and several million withheld votes under the plurality voting system. 

Shareholders in public corporations vote by proxy

o Shareholders cannot vote against a candidate, then can only withhold

Majority voting campaign post-Disneyo Post-2005, most public companies have this kind of voting

system in place (majority voting)o if majority voting were required for the election of directors, a

nominee would typically be required to receive the affirmative vote of a majority of the total votes cast for and against such nominee in the election.

o Shareholders get a say Vote by proxy…proxy access

Proxy statement is generated by the corporation Only-management supported director nominees were on the corporate

proxy statement Shareholders would have to create their own proxy statement and

compete with the corporate proxy statement

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o In reality, shareholders had no chance at getting the proxy statement through

Proxy access movemento Shareholders could provide nominations on the corporate

proxy statemento Not pushed through yet

Ability to call special meetings Shareholders are generally not allowed to call special meetings

o The only way you can remove a director midstream is through calling a special meeting

(2) Power to amend the charters/bywayso Also, most Cs allows shareholders to propose amendments o Beginning of the life

(3) Power to approve fundamental transactionso M & As, liquidation, etc.

(4) Power to approve conflict of interest transactionso Can sanitize these transactions

In short, shareholders power is limited and deals generally with approving and rejecting transaction rather than creating transactions

McQuade It is dangerous to enter into these kinds of agreements with friends Agreement

o You need to be able to analyze each part because the parts are severable Some parts may be okay and some may not

Parts of this agreemento Can shareholders agree to elect each other as directors? … not a problematic

provision Yes. If the agreement falls within one of the 4 spheres, without doing the further

type of analysis we will see later. When shareholders have agreements concerning directors, courts will

recognize their authority here. This is a way in which smaller shareholders get their say in

There is a higher chance that if this agreement is not honored, the director may be reinstated

The claim is valid Could you enforce it under specific enforcement?

o Maybe. But if not, at least damages. The majority shareholder gets to elect the board. The only way other

smaller shareholders can get their candidates through is by getting the majority shareholder to agree.

o Can shareholders agree to appoint each other as officers? … problematic The problem with this is rooted in policy concerns put forth for by the Court

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The agreement is void on public policy grounds because directors govern the C and choose the officers

To take away their discretion by having shareholders electing officers is bad public policy

o You don’t want to tie directors hands The board has a FD, not the shareholders

o Thus, they cannot lose discretion when acting for the benefit of the C

We are not acting for the benefit of the shareholders This is issue is two-fold

Discretion over type of officers put in and discretion over salary determination

o Who is this rule aimed at protecting? Potential harm to creditors

Don’t want shareholders running the C behind the sceneso They have no idea what’s going on

Potential harm to other minority shareholders (shareholders with smaller number of shares and also shareholders not subject to this agreement)

Shareholders can bring suit, but here there isn’t much chance of success

Shareholders often know that these agreements existso Even if they do, and they agree with the agreement,

paternalistic notions may assert that shareholders do not know what is good for them

o Can shareholders restrict the changing of the bylaws? … problematic This is completely within the discretion of the directors You don’t expect shareholders to participate in the governance of the C Goes against public policy

Don’t want to tie directors hand Don’t want to hurt creditors by shielding them from the knowledge of

who is really running the show behind the scenes (shareholders) Upshot

o M stands for the proposition that shareholders have very limited grounds for authority

o Shareholders cannot overstep into the discretion of directorso These notions are set on public policy grounds

Protection of creditors/public Maintain the discretion needed by the directors to properly run

the show Protection of minority shareholders

Characteristics of a close corporationo C in legal form, but business is run like a partnership

(1) Often times people are often playing the role of shareholder, director, and officer

(2) There is a small number of shares

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not an exact science, but maybe around 10 shares Close corporations do not mean “not public”

o There can be very large not public Cs (3) There is no real market for the shares

cannot just go out and sell their shareso if their livelihood is affected, there is no way to get out

this is compounded by the fact that people who are holding large portions of shares

o you can have 45% and a lot of money tied up in the C, but you are still subject to the 51% shareholder

Other issues to considero Shareholders agreement that goes outside of the 4 spheres of their powero Three pre-conditions for this kind of shareholders’ agreement

(1) closely held C (2) no objecting minority interest

Do you have to have all of the shareholders sign the agreement?o No. We determine if there is harm to shareholders if there is

no objecting minority interest. We are talking about those who didn’t sign For people who did sign, their objection does not come

into play You signed it, so you abide by it This is the case here as the objector is the

defendant (3) cannot be detrimental to creditors/public

creditors need to know what’s going on…directors need discretion

Galler Provisions here

o Bylaws have to state a board of 4 directors…not problematic Under M, probably okay

Falls under one of the 4 spheres…power to amend charter Under G, okay under M, so no need to look under the 3 pre-conditions

o Agreement to vote for certain people as officer Under M, not okay Under G

Under closely held C Harm to shareholders

o Usually comes down to any non-signatory objectingo Not the case here

Harmful to creditors/publico Court says that the public isn’t harm

What if only shareholders had the power to remove? Wouldn’t fly under G

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Courts are okay with the limited intrusion of who will be elected, but courts are not okay with the complete eliminate of director discretion vis-à-vis retaining the removal power within the shareholders

This case does not mention removal power at all Courts say if these agreements are silent about removal, then we will

assume that directors have the power to remove However, if shareholders explicitly retain power to remove

o Not okay under M or Go Agreement for certain dividends to be paid

Outside of 4 things, not okay under M What do we know about dividends?

o They are not guaranteedo There are legal restrictions to their pay-out

Under G, this agreement is okay because there are restraints Without restrains, such an agreement is not okay under G the key is you have to have some kind of limitation

o the limitation here is that dividends are only in excess of a surplus

o Agreement for a salary continuation Court is focusing on the relationship to tax deductions Whenever there is a provision about expenditure of funds or appointment

of specific officers, there must be some limit so as to avoid the undermining of director discretion and thus the notion of FD

Undermining the director would go against public policy in that could cut against the public and/or creditors

G v. Mo G…modern understanding of shareholder authority o M…historic understanding of shareholder authority

Post-Go Creation of state close corporation statutes (courts don’t really like shareholder

agreements, so they provide a framework for them) Statutory framework that you have to elect into General corporation statute (Section 7.32…dealing with how shareholders

agreements can be held valid) Section that handles shareholders agreement that deviate from the

norm Meeting of two conditions:

o (1) all original shareholders have to agree to sign it into the charter/bylaws, OR all shareholders sign and make it known to the corporation

o (2) limited to 10 years if you have a shareholder agreement that eliminates the board or gives

shareholders control, the FD will shift to the shareholders Just because such a structure exists does not mean that you could

pierce the corporate veilo You must continue to follow corporate formalities

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When a company goes public, these agreements are no longer valid If you purchase your shares in a company and you have no knowledge

of this shareholders agreement, then you have a certain period of time to renege

o This does not apply when the agreement is in the certificate, it only applies to the second part of (1)

Shareholders agreements have to be run through 3 regimeso 7.32

(1) all original shareholders have to agree to sign it into the charter/bylaws, OR all shareholders sign and make it know to the corporation

(2) limited to 10 yearso M

4 spheres, outside those is void as against public policy director elections; charter; fundamental transactions; COI

o G Closely held Shareholder harm

Objecting shareholder Public harm

RECAP

The broadest and easiest way to sanction a SH agreement is 7.32, then M, then G You can have provisions that are valid and some that are not…IMPORTANT

o Thus a remedy may be quite nuanced SH agreements act to allow minority SH to exercise some voice in the company

o Especially important in close Cs Minority interest could be 49%

Thus, SH try a variety of way to maximize their voteso (1) SH agreementso (2) Pooling agreements – Ringlingo (3) Cumulative voting….

SHAREHOLDER VOTING AND AGREEMENTS

Cumulative Voting Straight vote

o You get your amount of stock to vote for each directoro Enables for majority owners to control the board because they own more shares every

time Cumulative vote

o Aggregate votingo You can divide your votes any way you want

Example on the portal

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o Theory behind all of this is so that minority shareholders get some representation on the board and thus have some impacts on board policy going forward (e.g., who gets to be an officer, etc.)

There is a flip side to this Do you want somebody to hold out? Do your minority SHs to have this kind of power? Also, remember that you have to get the math right

o The default rule in most states in straight voting In CA, the default rule is cumulative voting

o Cumulative voting is only about the election of directorso In straight voting states, you have to notify if you intend to cumulate your votes

Ringling First case that validates pooling agreements Breakdown of the votes on the portal With CV or pooling, we can act to defeat majority victory in the election of every officer Pooling agreement…an agreement to vote your shares together

o Pooling agreement v. shareholders agreement PA…act in concert in all things together; SA…agreement on particular things,

a lot of which you do not have the authority to do PAs are presumptively valid

They are not doing anything disallowed When you finish reading a SA, you will know exactly what you are

supposed to do, but with a PA, you will know that you are pooling votes together but you will not know what

Voting trustso you can give your shares in trust to whoever you want

the trustee will exercise the voting authority often done for minors

concern is that you divide up the final right with the voting right courts are mindful of this problem and have thus established trust rules

o e.g., trusts may only exist for a limited amount of time Why doesn’t the court honor the way the arbitrator (from their PA here) suggests the

votes turn out?o Agreement is binding and if they disagree they will get an arbitrator, whose decision

will be bindingo The Court suggests that the agreement is somewhat defective in that it failed to take

an extra step What was the extra step?

There needs to be a mechanism in the pooling agreement telling us what to do with the other person’s votes when she fails to comply with Loos’s instructions

o Loos does not own any shares so he really has no authority in the matter and we do not recognize his vote

What can you do?o Compel specific performance

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o Provision for damages o Create a situation where failure to comply with arbitrator’s

instruction will lead to the implication of a temporary proxy If you want this to happen you better put it in your

agreement Because it is only temporary (it only takes a minute

to vote) a court will not construe it as voting trust How does the court come out on the votes?

o Loos’s shares are rejected There was nothing about him being a proxy in the agreement

o Haley’s shares are rejected You can reject their votes because they are inconsistent with a valid

agreement that they have signed Partial compliance with the PA does not even fly

o As seen here The same thing is true in a SA, if you are subject to a valid SA, if

you cast your votes contrary to the agreement, your votes will not be counted

Even if there is no enforceability mechanism, we will nevertheless reject any votes that we find contrary to a valid PA/SA

So, what next?o We recognize Edith and Robert…not subject to the PAo We recognize John because he did what he was supposed to do under the agreemento There is a director seat left open

There is one seat left So, cumulative voting does not matter

o The courts failure to recognize certain votes leads to a completely differently structured power regime

Take awayo CV is done through vote divisiono CV is orchestrated by what is the maximum number of nominees they can

successfully electo PA

PAs are presumptively valid Some SAs have pooling provisions in them

o And those provisions at least are valid If you are subject to a valid PA or SA, if you cast your shares or take

actions inconsistent with the agreement, those actions will be rejected from the court if challenged

Enforceability How do you determine what you do affirmatively?

o Negatively…you take the votes awayo Do you need an enforceability mechanism in conjunction

with a SA?

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Hypoo Agreement

Provisions Directors

o SA…specificso M…okay

Officerso SAo If okay, okay under G

Dividend paymentso SAo If okay, okay under G

Acting in concerto PA…presumptively valid (Ringling)

o Assume validity, how did people vote? Assume they voted incorrectly, otherwise we wouldn’t have a lawsuit

You do not need an enforceability agreement in a SA In a SA agreement you can read the agreement and know what

everybody intended to do You do need an enforceability agreement in a PA

In a PA agreement you cannot read the agreement and know what everybody intended to do

Big take awayo Agreements

(1) Decide whether PA or SA PA…act in concert agreement

o Can be freestandingo Can be inside of a SA

SA…agreement to act in particular, identifiable ways (2) Difference between the two comes in how you determine their validity

PA…presumptively valid SA…only valid after you analyzed it to figure out if each of its

provisions are valid (3) How do I analyze the votes of people subject to the his agreement?

If valid all or in part, all votes/actions inconsistent are invalido You know at this point someone is bringing suit

Take out invalid voteso Comply with agreement…votes stando Not complying with agreement…votes rejectedo Not in the agreement…votes stand

If outcome of proper votes is against the wants of the objectors, what happens?

o Answer depends on…

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People whose votes are recognized are against you, you are out of luck, unless the court decides there is some kind of enforceability provision (PA)

Caveat (SA) E.g….director election

o ABC C supposed to be director and

CEO A and B don’t comply A and B appoint D If SA is valid, vote for D is

invalid Thus, when the dust settles D

gets kicked out because he is there invalidly and C may get reinstated

o ABC; E (not part of agreement) C supposed to be director and

CEO A and B don’t comply A, B, E appoint D If SA is valid, we have a problem

with A and B votes But, when the dust settles we

have a problem because we cannot discount E’s vote as he was not part of the agreement…problematic

PUBLIC OFFERINGS (SECURITIES ACT OF 1933)

The remainder of the course will focus on securities laws and transactions under the Securities Act…

PUBLIC OFFERINGS

Regulation of securities issuance is dealt with by federal securities laws Securities Act of 1933 is not merit-based, but rather disclosure-based Congress enacted the Securities Exchange Act of 1934 1933…regulates offer and sale of securities to the public 1934…regulates everything else

o created SEC both acts promulgated under the Commerce Clause

Securities Act of 1933 disclosure regime

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o argued to be the best way to protect SHo we are not talking about a merit-based regime at allo SEC passes on whether the disclosure with respect to the security is good, not

whether the security itself is good State security laws (aka “blue sky laws”)

o Most are preempted by federal lawo However, it is important to be aware of additional state security laws

Some state security laws are actually merit-based Structure of the Act

o You have the Act and then rules promulgated under the Acto Most of the changes under the Act do not happen with the Act itself, the changes

occur with the rules passed under the Acto One of the key sections for our purposes

Section 5…circumstances under which you can sell securities There are rules and regulations under Section 5 that allow for

exemptionso For compliance, you look at the Section and the Section’s rules and regulationso Section 5

It is unlawful to sell securities without registering with the SEC You have to file a registration statement

o Of which there are many typeso Includes:

(1) Registration statement To SEC

(2) Prospectus (within the registration statement) To the public Any person issued shares Designed to entice people to purchase shares

Why have public offerings?o Raise moneyo Brings a certain type of prestige to the companyo Disadvantages (+ other stuff)

Costs Production of required documents for registration is extremely costly

and time consuming Once you become a public company there are tremendous public hurdles you

have to comply with Once you become a 33 Act company, you become a 34 Act company

Thus, you have to be diligent about keeping your financial records You have to determine how to have your shares traded

Exchanges themselves have rules Fees are charged by these exchanges annually and for public offerings

You have to abide by governance rules Independent directors, committees, etc.

Many people are on board in this process

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Lawyers Corporate counsel Underwriter

o Most companies issue their shares through an intermediary, an UW

UWs turn around and sell their shares to the public, and they do that all for a fee

Fee…price sold to the UW by the company – price sold to the public by the UW

o UW… Investment banks helping to underwrite the agreement Various levels of underwriters Lead UW

Primarily responsible for drafting the document and monitoring thereafter

Usually get a fee on the top for taking responsibility, and then their allotment

If public does not want to buy, then it is the UW that is taking the hit

The company in essence does not have to care anymore after selling to the UW

Many people involved in the UW process Accountants (experts), lawyers (various

counsel), etc. Section 5…have to register before offering shares to the public

o Three stages of registration (the public offering process): (1) Pre-filing

period starts 30 days prior to the time you file your registration statement

o 30 days between getting ready to register and filing your preliminary registration statement

key prohibitions during this 30 day periodo (1) you can’t make an offer or sale of securitieso (2) you can’t condition the market in any way

is it something you think that will make people more or less likely for people to buy your securities?

E.g., commercials, advertisement, etc. Things that make you feel good about the

product, will make you feel good about the securities

Do nothing without checking with your lawyers first? Do nothing new

o Changes in marketing, advertising, strategy, etc.

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o Changes in who you market to or how you market, even if it’s the same commercial

Regularly released factual information is okayo You have to be doing this beforehand

Forward looking statementso Predicative…harder to figure out

accuracyo Companies doing I (initial…first) PO…

no forward looking statementso Companies already regulated by

securities laws…regularly released forward looking statements…okay here

o Well known, seasoned issuer…doesn’t matter what kind of info they released

Online advertisingo Whatever you have done before is

generally considered okay Sometimes its bad to stop doing

somethingo New companies cannot make any future

statementso You are responsible not only for the

info on your page, but also the sources where your pages link to

The rationales behind this 30 day period o we assume that people are not sophisticated o timing

things that happen close in time take on greater magnitude

investors would not have time to digest info is such a close period of time to the public offering

we want everyone to get the same information (2) Waiting

time between filing preliminary registration statement and final registration statement

o preliminary registration statement (along with preliminary prospectus)

a lot of numbers not filed in aka “red herring” or “red” SEC gets a chance to review and issue a comment

letter and lawyers will respond Lawyers will say they are wrong or make

changeso After back and forth with SEC, you will come up with a date

where you will go effective

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o Road-show Company and UW go on the road to determine level of

interest in securities During the waiting period you can make oral and

written offers, but you cannot finalize sales (you cannot even engage in offers during the pre-filing period)

UW go out to build a book and get indications of interest in the shares and at what price…

o …After this you should be able to fill in all the numbers missing in the preliminary report and you should be to produce a final report and become effective

(3) Post-effective Send final prospectus with the sale of any securities

o Liability and available defendants Actions

Any person who purchased a security can sue under Section 5 any violation allows any SH to rescind their shares underwriters are stuck with their shares

Liability for gun-jumping…failure to comply with rules associated with particular stages

Liability generally incurred by the UW, but potentially the issuer as well

Proving this kind of liability o Pre-filing (watch here the most)

No offers; no sales No conditioning of the market

o Waiting No sales

o Post-effective Send final prospectus with the sale of any securities

Material misstatements Issuer…strict liability signors of the registration statement; directors (even if they don’t

sign); experts (counsel, accountants, etc.); every UW…liable to the extent that they have a good due diligence

o things you say yourselfo things in the registration statement that you don’t have a good

due diligence defense for you have to show the necessary background to prove

that you could not have known These people are subject to individual liability, not in

the capacity as a company representative

Ralston Section 4 of the Securities Act

o Talks about offerings that are exempted

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o Two types of exemption Section 3 exempts particular kinds of securities in their entirety

E.g., securities issued by government; religious organizations Section 4 exempts securities within the context of a given transaction

4(2)…transaction where there is no public offeringo public offering v. private placement…key distinction

private placement…do not have to worry about whole gun jumping regime

but, you still have to be concerned with securities fraud laws

PO v. PPo purpose of the offering does not matter, it only matters who you offer to

if you offer to all employees = PO here, the offer was only to key employees

Principle of Ro PO…made to people who need the protection of the securities laws, i.e. disclosureo PP…made to people who don’t need the protection of the securities law

People alleged to not need disclosure here seems kind of suspecto Can you avoid securities laws by holding some kind of one day seminar for these

people? Probably not. By giving them the disclosure, they are conceding that those people need it.

o You cannot cure your transaction by giving people disclosure. SEC says that they cannot decide what kind of disclosure is needed

They have already created this frameworko What if they offer to all these people, but the only people who purchase are

sophisticated? Section 5 encompassed both offers AND sales A lone offer to an unsophisticated person could ruin everything

Who could they have offered to and have been okay?o In order to have a good PP, you don’t want to go by categories, e.g., people in a

managerial position Describing someone under the category key, executive, managerial

o Probably no good for an “office manager,” probably okay for CEO, etc. The higher up you are, the more likely that you will have access to the

kind of info that would be put in a registration statement o CEO, etc. should generally be okay

What if the CEO was just a figure head and did no day-to-day interactions? The exemption turns on (1) having the knowledge OR (2) the

access to the knowledgeo thus, protection of the securities laws would not be neededo remember: the title will not always be enough

What if CEO is married, could you issue to the CEO and her husband? They do not have the knowledge or the title But it seems as though this would be allowed because they would have

the access

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Remember: an offering to just one person could be considered a PO, if that person needs that kind of disclosure

What if it is determined that CEO’s husband requires disclosure, then CEO buys and sells to husband two weeks later?

Violation of Section 5 PP is only good if you offer to people who don’t need the protection of

the securities laws, and you can’t get it around it by simply quickly flipping the shares

Anybody who purchases shares and turns around and sells them quickly is deemed to be an UW

o And liability attaches to this transaction UWs are subject to liability in the same way the

company can Also, this situation becomes problematic for the company because

such a quick sale violation will destroy your entire transaction as a PP…exemption revoked

How do we know if you purchased to resell?o Safe harbor…fixed time period will be provided in which you

must hold the securities so as to not violate the PPo If you can’t get protection under the safe harbor provisions,

you will have a hard time proving that you were not purchasing to resell

Courts say that you should have enough liquid assets to protect yourself from economic changes so that you don’t have to sell your securities

o People with an understanding of basic business sense If these people were to get info about the company, they would be able to read

it and understand Some general business concepts are transferrable

There is no clear definition of who is “sophisticated”o People with money

They may not be sophisticated, but they have the money to hire advisors to make them so

Also, they have resources where this failing venture would not be a huge deal to them

They can bear the risk They can hold the securities for some time

Old money v. new money does not mattero Note:

Issuing to a thousand billionaires…PP Issuing to one high school teacher…PO Doesn’t turn on the number, turns on whether the people you are issuing

shares to need the protection/disclosure provided by securities law Other points

o Its about who you offer and sell too Difficulty about R statutory exemption

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If someone resells, your exemption could be ruinedo There are many ways to ruin the PP, so the SEC came up with safe harbor

provisions (Section B) Safe harbor provisions provide you with greater certainty about your

transaction If you issue to credit investors should be okay The rules are also based on the total size of the offer

o As a lawyer, you want to focus on having a good exemption Registration can be a pain, so people want to avoid it

o Companies want to engage in PP, they do not want provide disclosure

SECURITIES FRAUD

Rule 10b-5 and Section 10 are the applicable laws hereo Both under the 34 Acto Both under the Commerce Clause

CC is very broad, so it is virtually impossible for you not to be under fed law when engaging in securities

o Private right of action…individuals can bring an action that there has been a securities fraud violation

In order to bring a securities fraud violation you have to purchase shares Simply holding the shares because someone lied to you about a

company is not enougho Rationale: too hard to prove

Basic Focus on issues of materiality As a general matter companies have no general duty to disclose

o As a general matter, you’re silence is not actionable, unless there is a dutyo The problem is that once you open your mouth and speak, you have a duty to

speak truthfully You could always say “no comment”

Some courts have said if you always say “no comment” when something is going on and always say “the truth” when nothing is going on this could present material misstatement issues

o But this does not hold true in most courts Always say “no comment”

Even though most CEOs don’t listen to this advice and some make mistakes

Materiality test (TSC Industries test)o All things considered, a material fact is a fact that a reasonable investor would

want to know Does not have to change a reasonable investor’s mind

o Many courts conceptualize that it has to alter the overall, total mix of information received

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If it is information that it is already, in the marketplace, then it won’t alter the overall, total mix of information received and thus will not be material

Material Misstatement o Assume misstatement…o Many courts accept that information, though false, is still immaterial if the

general investing public knows that it is not a true statement You can get away with a lie, so long as it is a big lie

Big lie…people discount it in significant numberso You do not even have to pull the record to know that there is

no truth to the statement Not material because it is not a misstatement, but rather

because there is no belief in it to begin with You cannot get away with a lie, if everyone does not know that it is a lie

o You must intentionally make a misstatement Can you lie in order to support the business, a la BJR/duty of care?

Courts do not buy this argument. It is not in the best interest of the company for someone to commit a securities fraud.

o Only ways to get out of intentional misstatements… Big lie…

people don’t take you seriously (whether or not you are actually telling the truth)

there is enough information out there on the subject of the lie where everyone should know that it is a lie

o Securities fraud always involves material misstatements The Basic test for materiality

o Balance the probability of the event occurring with the magnitude of the event occurring

o When do you use this test? … as opposed to the TSC test The way in which you prove TSC when you have a contingent or

speculative event (really important in mergers) TSC…event is in the past

o The event already occurred Basic…event is speculative/contingent

o Information about speculative events can still be material

RECAP TSC is the standard

o Basic is to be used to the extent that something is contingent Analysis

o Start with probability/magnitude of Basico Then, make the call as to whether this is something that is to affect the mindset of a

reasonable investor

What do we have to look for to figure out the probability issue?o How close are you?

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How far back is it? timing

How many more steps need to be taken? Is there interest at the highest levels?

Are executives involved? How many discussions has there been? To what extent have experts been hired?

o Outside counsel? Other experts? What do we have to look for to figure out the magnitude issue?

o How important is this in the life of the company? In many ways it is about money?

Relative to the company End of life transactions are generally important

Merger Liquidation

What is the nature of the decision that we are talking about? For securities fraud, there are civil and criminal penalties

THE TAKEOVER MOVEMENT

the underlying purpose of a takeovers is to gain control of the company

Proxy fight takeovers public shareholders generally vote in general elections by proxy

o you need to establish quorum by proxy 34 Act, Regulation 14(a)

o system asserting that you cannot solicit any proxy before filing a proxy statement with the SEC

registration system information statement related to the matters that you want SHs to vote on anything the SH vote is required for, you will have to solicit proxies

o any communication with SH were found to be trying to solicit SH proxy and thus will be viewed as a solicitation

e.g., something so simple as trying to get a list of SH nameso there are some exemptions that allow you to avoid the expensive process of

creating a proxy statement the overarching one is that you do not have to file a proxy statement if you are

not intending to request a proxy 14(a)-8

o when issuing a proxy statement, only management-supported directors have to be included in nominations

Proxy contest/fight Very expensive proposition

o Some argue that the expense prohibits SHs from nominating candidates of their choice

Essentially the battle of two proxy forms

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o Always includes to proxy cards (ballots) of a different color Company’s…white Other’s…another color

o There is a rule providing for certain circumstances where the company must include proxy nominations

This rule has been limited though However, many SH do not even want to include SH candidates

because SHs are limited in the amount of words they can use in the proxy statement

Also, many SH do not want proxies to have control of the solicitation process

Short Slate campaigno Try to take a certain percentage of the board’s seats (usually a majority) by

nominating only a certain number of candidates As a opposed to a full slate campaign

No limitation on the number of proxy contests at one timeo You can round out your slate by referring to other people’s slate

Benefits of the proxy contesto Gain control of the board

Proxy contests are generally not as costly as a full takeover battle Cons of the proxy contest

o It is difficult to gain control of the board Staggered board terms

Only a percentage of the directors come up for reelection in a given cycle

o It will be difficult to achieve takeover over two cycles Also, you have to consider the increased difficulty

raised just by the extended waiting period Existing SH are often skeptical

All they know is what you are telling them The last five years…

o Huge increase in the number of proxy battleso Huge increase in the number of proxy battles ending in settlement

Sometimes board positions are granted in exchange for stopping the proxy battles

Tender offer A public invitation to SH to tender their shares

o Done by public announcement Purpose is to gain control Not every TO is hostile; some are done with the full support of the board…but many are not;

hostile TOs Most TOs are accomplished through LBOs (leveraged buy-outs)…aka bootstrap transactions

o The person purchasing the shares will do so on borrowed funds The key is that you are borrowing funds that the company will have to

pay backo Most of the money is not coming out of the personal funds

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TO is started by offering money over the market price Oversubscribed offers

o More shares then you want have been tendered Many companies will only make an offer to purchase 51% of the shares

Beforehand, tender offers were not regulated o Saturday Night Specials

Quick tender offers Often included statements where 51% of the shares would be bought and the

rest will be cashed out (at a price way lower than the TO) Often first-come, first-serve

Two-step TO processo (1) gain enough shares to gain control of companyo (2) merge your company

old company has no board, so they have no say in being cashed out at a price lower than the TO

another reason why everybody wants out at the first price Generally, hostile takeovers suggest management has an incentive to slow down the TO

o Options (1) white knight

savior another person who is supporting the company and who will offer

another TO lock-up…promise you make to pull/keep someone in the game (you

need an incentive)o win or lose, you offer the white knight some kind of benefit

(e.g., buying shares at some low-price)o you lock-up some asset

(2) stalking horse there to get other people interested in purchasing the company same lock-up, incentive structure here

(3) sale of the assets (maybe just the crowned jewel) if everyone is after one key asset, management could sell it

(4) scorched earth defense company sells all assets company may condition this sale of assets if bidder is successful on

their TO (5) mgmt buy-out…mgmt can do its own takeover

come up with their own funds maybe SHs would prefer “the devil they know”

(6) green mail SH accumulates shares and says it will do a takeover unless the

company buy the shares back at a premiumo Sometimes intentional by the SH, sometimes just a company’s

response Many companies were caught unaware in the 1980s, and these tactics did not always

work

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o So companies put measures in place to prevent takeover Shark repellants…articles or provisions in the bylaws to prevent takeover

Staggered voting terms Supermajority votes for mergers

o Thus, the amount of shares you’d have to buy in step 1 can become astronomically high

Fair price provisiono In second step merger, you have to cash out second stage SH at

a fair price (usually a very high price) Also, you’d have to make provisions that allows only the existing board to

alter the provisions Golden parachutes

o Very generous severance package once takeover is achieved Also, makes takeovers that much more expensive and unattractive

SR and GP didn’t work…so lawyers went with the “poison pill” in an attempt to stop takeovers

Poison pillo Aka “shareholder rights plan”o Freestanding or stand aloneo Poison pill…

Preferred stock or some other option, right, or security that is convertible once the tender offer takes place

Rights will be issued to current SHs to purchase shares in the existing or new company

Upon a shareholder purchasing a certain number of shares and offering a tender offer, the poison pill becomes activated and exercisable

The trigger event is usually someone trying to takeover Once the trigger happens every existing SH, except the one

attempting to takeover, has a right to buy shares at some low priceo The share pool becomes diluted and thus it becomes

virtually impossible to take over the company as your percentage interest is radically reduced

The existing board can redeem the pill from you for some nominal amounto The impact of the poison pill

No one has ever triggered it Note that SHs are not required to buy these shares bought at a premium If you are someone who wants to takeover a company with a poison pill in

place, you have only two options: (1) negotiate with management to get them to redeem the pill

o this is huge because it puts power back in the management (2) go to court

o management’s refusal to redeem the pill is a failure of the FD

o a company can institute a poison pill without the consent of its SHs this is a big issue in shareholder rights movements creation of a poison pill has been found within a board’s FD

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why?o Because takeovers could be coerciveo Because takeovers could have negative impacts

Williams Act (1968)o Requirements on companies and SHs when engaging in a takeover

(1) accumulation of above 5% of a company’s stock requires you to file a disclosure statement with the SEC to let them know what your intentions are

how do we count the 5%?o Do we add derivatives?o Do we count two people’s shares together if they are acting

together? (2) TOs have to be held open for at least 20 days + and people must be able to

withdraw no more Saturday Night Specials

(3) oversubscriptions lead to pro-rata treatment of SHs, rather than first-come, first-serve

(4) all SHs have to get the highest price no more tiered pricing

(5) once confronted with a takeover, a company has an obligation to respond company could

o be for or against a takeovero remain neutralo or say that they cannot take a position

(6) 14(b)(3)…unlawful for someone to buy or sell securities, when they have material information about a takeover

Takeovers there is a lot of tension over whether takeovers are good or not takeovers provide the possibility to buy low and sell high some argue that takeover fights are a good thing as it ups the profit that SHs make

o Important question…How long should the board delay a takeover? A delayed takeover suggests that the profit of the SHs will be higher

Downside of takeovers o For board/directors/officers, it usually signals that the management will be losing

their jobso Also, usually signals broad layoffs, closing of plants, severe impact on the

communityo Existing creditors get left holding worthless debt that cannot be repaid

Result of the takeover battle…o Legislatures got involved

Statutes allowed for greater board defense of takeovers One of the key issues with regard to takeovers, is how should courts respond in

analyzing the board’s defenses? … the next two cases answer…

Unocal

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Mesa offers enough to get them control of the company, then offers the remain SHs $54 worth of securities

Any shareholder that doesn’t participate with Mesa, Unocal offers $72 in senior debt securities for those people M is trying to target in their second round

Two impacts:o If takeover goes through, company will be full of senior SHs with senior securitieso The company will be laden with debt that M will have to pay back

M intends to force people to tendero U response has the opposite effect

At all times, you have to comply with your FD U two part test for determining whether directors’ action complies with their FD:

o (1) There must be reasonable grounds to believe that is a threat to the C’s policies or effectiveness

o (2) defensive measure must be reasonable in relation to the threat Take note: in the takeover realm, determining whether or not a board has breached

their FD is not a duty of care analysiso The only way a board will be found not to have breach their FD in the context of a

takeover defense is to met the U factors There is a higher standard in the context of a takeover

o The court is concerned that the ordinary presumptions don’t make sense/applyo The board may not be motivated by the best interests of the company

We see this in the self-dealing contexto What about the takeover creates this concern?

We do not give this presumption because takeovers usually indicated the board losing their jobs

Thus, we need a heightened test We no longer trust the directors to totally do the right thing

(1) Reasonable grounds to believe that there is a threato Here, it is M’s offer. What is it about this takeover that is threatening C policy or

effectiveness? Coercion (threats in bold)

Tiered offer We don’t want our SHs to do something that they do not want

Greenmail Threat that M will buy up a sizeable chunk of the shares and force the

company to buy back their shares at a premium Junk bonds to be dispersed in the second step

Inadequacyo How was M to know that the securities are worth $54?

Something worth $54 today could be a $1 tomorrow This is complicated by the fact that we are

talking about junk bonds – low quality securities o Also, cash is liquid, securities are not

This is cause for some concerno Could a board respond by saying that a threat is that the other company could not get

the money together?

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There is a range of people in the middle who may have some money and need to pull together some loans

a threat could be the risk of non-consummation the other company will not be able to deliver

o What if the company said they were going to offer all cash, have banks’ commitment letters, and will offer $72 a share for 100% of the shares? But, the promise they will fire 80% of the workforce when they takeover the company.

The tension here is that it is hard to say that this isn’t good for the SHs Can the board say we don’t care that the SHs will profit, our duty to the C as a

whole including protecting the employees? in considering what constitutes a threat, the DE courts note that you

can consider “other constituents” a threat under Uo employees; the community

keep in mind, SHs don’t care about the employees they are walking away from the company and thus no longer care

about their reputation however, there is a contrasting softer reading of U focused on the rights of the

SHso figuring out the threat:

inadequacy of the price coercion non-shareholding constituencies

o Can the threat be that they are getting rid of management? Here, we may be concerned that the board is not acting in the C’s interest

The courts let slide the board’s newfound “concern” in the employees Here, the courts have to be careful The threat cannot be characterized that they are going to change the board,

management This is self-interested and focused on their own desire to remain in office The threat must be reasonable

If the takeover person is know for gutting the company…threat If the takeover person is know for changing management…probably

not much of a threat Threats can be legitimate with regards to the removal of management if

the removal with undermine the C’s nature Courts have recognized non-monetary threats like this as legitimate

o Who is trying to perform the takeover is a possible threato If a board says the threat is the takeover will somehow undermine corporate

policy? Reasonable belief of threat…yes Reasonable response

Just saying no … poison pill is usually in placeo Is this consistent with the board’s FDo Is just saying no reasonable?

Legitimate threat and there is no way to overcome it…just say no is probably okay

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We have a takeover artist who fired the workforce every other time…just saying no may be okay

Its okay to make the takeover more difficult, but some think just saying no is going too far

Some think that there should be some room for the takeover to occur

you can put in quality control provisionso e.g., you keep the same board

Reasonable response, hereo Powerful response…almost seems like saying no

Court says the response here was reasonableo U’s measure preventing M from taking place in the responsive exchange offeringo With regard to a TO or takeover, boards don’t have to treat all SHs the same,

they have to act in favor of the C Why treat these SHs different here?

They are the threat and we have to guard against themo Also, we do not want to subsidize their threatening behavior

After this decision, the SEC came down with a rule that a TO must be made available to all SHs of the same class

o Cannot do the tiered offer done here

Revlon Revlon goes with a “white knight” defense In order to fulfill your duty to your SHs you need to induce or offer a better price When you are in the takeover realm, you analyze the board’s FD under U or R

o At some point, you move from U to R…you hit the R zone Here, the very first offer the board replies to as inadequate

That step and that counterstep is analyzed under Uo When you get to R, your duty changes to trying to get the maximum value

(VALUE, not necessarily price) for the SH Once you hit R, you cannot consider extraneous interests unless it may have

some impact on the value of the company E.g., maybe if the SH are getting securities, so the company has to stay

valueo How do you know your in R?

When the sale is inevitable You have become an auctioneer, simply looking for the best price for

SHs When the break-up is inevitable

Here, this part was easy because they offered the white knight a division of the company at a lower price

You cannot both say we want to protect the corporate enterprise and then hand out such an agreement

Can the board block a takeover when the sale is made more attractive to the SHs, but the takeover people express that dissolution is inevitable?

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The question is outcome-determinativeo If you are in R, block is not appropriateo If you are in U, block is appropriate

In Time, the court said that both the sale AND break-up must be inevitable to enter the Revlon zone

Ro Bringing in white knight…sale inevitableo Offering white knight the lock-up…break-up inevitable

Method of analysis If when you start negotiations for sale, you are trying to keep the

company together and protect non-SH interest…in U If when you start negotiations for sale, you don’t care about

keeping the company together and protecting non-SH interest…in R

o as soon as the sale of the company becomes okay without strings attached (e.g., not breaking up to company)…in R

Better to think of R as focused on getting the best value for SH overall, rather than getting the best price

Offer will generally be made on a combination of cash and securities

o Look above…securities in the company promotes the need to keep the company’s value high

Barbarians at the Gate

INSIDER TRADING

There is some sentiment that insider trading should not be violative of securities laws at all The theory behind finding insider trading violative is that when you trade on inside info it is

a fraudulent practiceo You have access to certain types of info that the market is not and you use that info to

your advantages When do you engage in insider trading?

o When you purchase or sell securities on the basis of material, nondisclosed info in violation of a duty

Your holding of a security is not an insider trading violation 4 elements

o (1) material; TSC Basic…contingent event

Magnitude v. probabilityo (2) non-public;o (3) duty; and,

traditional (Chiarella)

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misappropriation o (4) breach

trade without disclosure passing for personal benefit

tippee

Texas Gulf the problem with insider trading is that you leave a trail Do they have any obligation to tell the people that they are buying the land from that

they are sitting on a wealth of mineral deposits?o No. Not at all.o It is never a problem to trade on the basis of material, non-public info when you do

not owe a duty to anyone Silence is never actionable, unless you have a corresponding duty.

Insider trading doctrine makes certain silences actionable However, when you break your silence, you have to speak truthfully

Press releaseo Is downplaying the discovery in the press release a material misstatement?

TSC…is this something a reasonable investor would want to know? Aerial survey…four years prior to the ground efforts

o Suppose you purchased a big chunk of stock after this…is the info material? We are in Basic

Basic isn’t just about mergers… Magnitude and probability

o Mergers are generally of high magnitude because they are life and death scenarios of the company

o Courts give some weight to the number of trades 10 people see it, and 10 people trade and tell their 20

neighbors this suggests something of high magnitude (even if

there is a low probability) or high probability (even if there is a low magnitude)

o Here, four years out and 15,000 feet up is fairly speculativeo But, they also begin to acquire land

This may something about magnitude Here, info is probably not material Remember…materiality is considered within the considered timeframe.

You must refrain from engaging in presentism. Ground survey

o 2 months before chemical testo soil sampleso still uncertain, even though the degree of certainty is highero the court reverses the lower court here and holds that the info from the ground

survey is material because magnitude and probability are ticked up dramatically

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o What happens that after the ground survey you purchase shares, but it turns out that the ground survey is wrong?

Probably yes. The materiality is judged at the time of the trade. However, you would not have made any money and no red flags have been

raised. SEC could nevertheless bring an action even though you made no

money. What is the rule once we know that you are in possession of material, non-public info?

o You either have to abstain (from trading) or disclose Disclosure piece is critical because it gets you to the non-public piece

o To whom must you disclose? The investing public

These are the people who are potentially harmed by the fact that you are engaging in the trade

o What do you have to disclose? In order for something to be deemed public, it must be disclosed and in a

way that you think a market can understand and digest it You cannot simply put out some kind of scientific goobly gook

Disclosure has to be effective for you to be able to trade You have to disclosure and wait for the digestion

o After digestion, the market stabilizes and fully adjusts to the news…and there is no longer any real room for profit

The market has processed the information that the stock price now reflects the dissemination of new info

Disclosure is not what it used to be…it is much more rapid The burden is on the discloser

Some things that happen… What about the person who calls his broker and tells him to execute

the trade at 10:15 (assuming a 10:00 meeting)?o Courts will say that we will judge the timing of your action

on the order, rather than the execution What about if someone had a standing order to purchase a stock at

regular intervals?o Judge it at the time of the order.

No violation here because there was no material, non-public info at the time of the order.

o What if she has the ability to stop it? Does she have an obligation to do so?

Yes.o The best protection is to put into the standing order a

provision disabling your ability to stop it.o Or, some companies put a halt on trading at certain times

before or after a public statement Standing orders are probably better

What is the problem with the stock options?o If the board issues stock options in and around the time a major event is to occur?

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Aside: stock options The right to purchase shares at a particular price

o If the stock jumps, you can receive a major windfallo The board routinely gives out stock optionso What are you to say to the board if you have inside info?

Conflicting duties FD/confidentiality v. insider trading

o If the board goes through, you have to keep in mind that you would be on the hook for insider trading

The Court doesn’t really wrestle with this You could let them issue it and cancel it out Go halfway and say it isn’t a good idea but you cannot say why No real good answer

o Most people would probably just disclose Not just the insiders…what about the trades made by people you told?

o You are in fact liable for the info you gave them, even though they themselves are not liable

o Damages? The profit you make from buying or selling with insider info – the profit you

would have made without the insider info Should insider trading be a violation of securities laws?

o The SEC originally discussed insider trading as an equity issueo Why can’t the response be…but I am the one that created the information

Isn’t it unfair for those laboring to dig out the minerals to be deprived of reaping profits?

o The response on the other side is you reward them with bonuses, etc. rather than some kind of back door trading

o The other argument on the other side is it is never the laborers’ information to begin with, it is the SHs’ and public’s information

Similar to the way in which a patent belongs to your institution rather than to you

Chiarella First criminal prosecution for insider trading

o A lot of people think this is why the Court came down the way it did Also, people consider that C was only a blue-collar worker who made $30,000

Who do traders in TGS owe a FD?o The SHs of the companyo Perhaps the public

Asideo Takeover context

Target Nabsico

Bidder KKR

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o In the insider info context, which company would you purchase shares in to profit post-takeover?

Go for the target The moneyshot is in the target

The traditional theory is that you violate insider trading if you purchase shares in a company in which you have relationship and owe a duty

o If CH purchased shares in the bidder’s stock, he would have a relationship with them through the printer, and thus a duty, and therefore could have engaged in insider trading

o But, here, CH purchased shares in the target, with whom he had no relationship, and thus no duty, and therefore could not have engaged in insider trading

Hypo…if janitor finds info in trash and buys shares…insider trading You just have to be able to draw the line

o It is not just the CEO engaging in insider trading, it is all employees and all these people with independent employee arrangements for C purposes

Hypo…if burglar or janitor’s sibling…no insider trading Does not matter if the info is attained illegally

Hypo…if C tells his cousin…no insider tradingo Remember:

The information must be material And material is an objective standard, not a subjective one

How do you breach a duty? You have to abstain from trading or disclose

To whom must you disclose?o Remember…trade with disclosure and you are fineo You disclose to the person to whom you owe the duty

The printer The company

The duty of the company is seen to run to its SHs And basically the duty to the SHs extends to the public

o SHs is not just the existing body, but the entire potential class of SHs

o The only way that you can get out of a duty to the entire company is if there is no duty owed to the company

E.g., the company tells the printer that his employees to do not have to disclose to them

Because CH owes no duty to the target he has no duty to disclose and thus there was no breach and therefore no insider trading

The disclosure eliminates an incentive to trade because you will not turn any real profit Material info here?

o Yes about a potential takeover that is on its way to happening (the papers are at the printer’s)

4 elements…this all 10b-5 (not 14b-3)o (1) material

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o (2) non-publico (3) duty

traditional theory (Chiarella) MT

o (4) breach trade pass for a personal benefit – financial or reputational/financial benefit (Dirks)

tipper tippee -- The tippee becomes liable if they know or should have known

that they were trading in violation of someone’s dutyo the tippee’s liability is derivative of the tipper’s liability

the tippee’s liability is an extension of the tipper’s liability

the tipper must be liable in order to hold the tippee liable

liability is focused on “the chain” … connections between people Chiarella leaves open a question about the “missapropriation theory”

o Two events bringing MT to the forefront “Heard it on the Street” column Rule 14b-3

O’Hagan Grand Met retained O’Hagan’s firm. But, O’Hagan was not on the case. Rumors circulating that Grand Met was going to acquire Pillsbury

o Was this info public? No. Rumors are not enough to make it public.

o O’Hagan knew that this was in the works. O’Hagan buys stocks after Grand Met met with their lawyers to talk about the tender offer

o Is this info material? Weigh probability and magnitude…info is material What if this was the first time they meet with the lawyers?

Might lessen the materiality of the info, but will not eliminate O’Hagan v. Chiarella

o The difference is in C the MT was not arguedo Would O be liable under the TT?

No he trades in the target company and is thus outside of his chain of employment.

Same situation as C.o Except O made a lot more money.

MTo Show that there is a breach of the duty to the source of the informationo What if O’s firm had no confidentiality policy?

no duty you have to establish a relationship or trust and confidence the source must expect that you would keep the info confidential

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suppose there is a duty to the firm, and assuming the source is only the firm

O learns info, calls partners, and explains he is trading on the info and leaving the firm

o This kind of disclosure will free O of liability The breach is trading without disclosure to the entity to

whom you owe a duty Can O buy shares a month after the law firm stops representing Grand Met?

O still has a duty to the firm What if O leaves and the firm still represents Grand Met?

He still owes a duty to the source of the information, even he later leaves

The info taken from the context of that relationship is the controlling factor

o Here, the situation is more complicated because the firm has a client What if O leaves the firm?

Still has a duty to the client Take into account the fact that the duty runs to both clients

Why does he have a duty to the client? The client has an expectation that the info they give to the firm will be

kept confidential, and the firm has an expectation that the info they give to the lawyers will be kept confidential

o What if O finds out this info not from his firm, but from an outside source? One of the problems here is an evidentiary one

It will be hard to produce the outside source Its looks bad, but is it bad?

If you know your firm has an expectation about confidentiality and this is your firm’s client, then you are probably in pretty muddy waters

o Courts will most likely find that you owe a dutyo What if you find this info out from the firm, and you don’t buy or sell shares,

but rather go to the partner in charge and tell him that you want 20% of the profits or you will go public and ruin the tender offer?

You can actually use the info in bad ways and it will not be insider trading, but it may by something else

The key is that someone has to buy or sell securities in order to produce an insider trading violation

o Can you use the MT to hold the writer of “Heard it on the Street” (a column listing up and coming companies; before the column gets published, the writer tells the brokers what companies will be included for a fee; brokers make $700,000) and the brokers in violation of insider trading?

Analysis Start with the trader

o There is no relationship between the writer and the brokers for insider trading purposes

Who’s next up the chain?

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o ?o the writer is looking at public info, making a judgment, and

putting that judgment into writing Is the info that appears in the column non-public?

o Non-public aspect of the info…it is your prediction If you give info to someone with the express purpose for them to

trade on it…there is no duty]

There are no duties to the companies that they are trading on The writer owes an obligation to the newspaper under the MT

o The newspaper is not the source, but they provided the platform for the writer

Even though the writer gathered the info on his own, it is still ultimately the newspaper’s information

o Timing You have to trade on the basis of the information that you learn

On the basis of…awareness

14e-3 (1) material (2) non-public (3) tender offer (4) know or have reason to know that it comes from an insider or someone working on

the insider’s behalf …with respect to this information, you are liable if you trade or you tip no duty or breach elements

Objective standardo If a reasonable investor would know or expect that the material, non-public info

came from an insider 14e-3 broadens quite substantially insider trading violations with regards to takeover you could be trading in either the target or the bidder you can bring a 10b-5 along with a 14e-3 case when there is a takeover involved, but

you cannot bring a 14e-3 along with a 10b-5 outside of the takeover contexto 10b-5…harder to prove; broader scopeo 14b-3…easier to prove; narrower scope

you can prove a duty through the traditional route or the misappropriation route

Dirks Have the clients traded in violation of a duty they owed to someone?

o MT The notion of being deceptive

You are pretending to be someone’s friend when you are not Here, clearly D gave the info to his clients with the expectation that they

would trade on it, thus there is no duty under MT

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o TT No duty owed to the companies in which the trading

Is Dirks trading in violation of a duty he owed to someone?o MT

In order to get an insider trading violation, someone has to breach some duty D was given the info without an expectation of confidentiality

There is no MT duty between D and his Secristo S is telling D so that he could tell other people (blow the

whistle)o D does not trade, but rather passes (the information)

In order to find that D has violated insider trading, you have to show that he tips for a personal benefit

Personal benefit…financial benefit OR reputational benefit associated with some kind of financial implications

o The strongest benefit is always the financial oneo D has no duty, so we go a step up and look at whether S has a duty

Absolutely yes. S has a duty to the company. S was not passing for a personal benefit, he was passing to blow the whistle.

Personal benefit is considered at the time that the information is passed. S cannot unexpectedly become a lecturer on whistle blowing down the road and therefore be found to have benefited personally for passing the info.

You need to pass primarily for a personal benefit in order to be found in breach.

Problem… S is the one with the duty, but he does not pass for a personal

benefit o If S had passed for a personal benefit, who could you get?

Clients? The tippee becomes liable if they know or should have known that

they were trading in violation of someone’s dutyo You do not have to go chain by chain

You can get someone 8 people down the chain, even if you can’t get the 1st link

You get someone in the chain, then you can get anyone else down the chain if they knew or should have known that they were trading in violation of someone’s duty

How is that someone like D or S gets out from under this duty?o So, if S decides he is going to trade, he has to tell whoever he owes the duty to

Disclosure saves you in the trading realmo If you are passing for a personal benefit, you cannot avoid liability by disclosing

Disclosure does not save you in the tipper realm It could help if make the info public, and that could potentially knock

out one of the elements though o If you find the tipper liable, then you can get the tippee if they know or should have

known that they were trading in violation of someone’s duty

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Disclosure does not save you in the tippee realm

Insider trading (Rule 10b-5) (1) material (2) non-public (3) duty

o (a) traditionalo (b) misappropriation

(1) mutual agreement (2) a history or pattern of exchanging confidence that would lead both of

the parties to expect that the information exchange within the context of their would lead to confidentiality

(3) certain family categories create an assumption of confidence, unless the history or pattern of the relationship demonstrates otherwise

o two theories are used to prove the same thing you do not have to show both traditional theory…there is relationship to the company is whose stock they

trade (Chiarella) employment relationship

o insidero quasi-insider

broader than FD in the sense that we contemplated MT…owe a duty of trust and confidence to the source of your information

(O’Hagan) (4) breach

o (a) trade trade without disclosure

disclosure back to whomever you owe the duty avoid trade…disclosure

o (b) pass…tippee pass for a personal benefit

personal benefito mixed motive may get you thereo economic benefit will get you thereo reputational benefit with economic consequences will get you

thereo doing something completely selflessly will not get you there

benefit does not have to relate to the stock saleo a lot of times it is related to a quid pro quo

avoid pass problem…don’t pass for personal benefits disclosure with regards to passing has no impact on the breach however, info may become public and get you out of insider trading

tippee liability derivative of tipper liability

o cannot get tippee without tipper tippee 5th element

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o (5) the tippee knew or should have known that the tipper breached their duty

Do you have to know the identity of the tipper and their relationship to the company?

Specific evidenceo Stronger case

Do you have to simply appreciate that the info could not have came to you without a breach of duty?

Generalized evidenceo Weaker case

o Disclosure does not matter for the tippeeo The tippee has no defense except they did not know that the

info received was a result of a tipper’s breach of dutyo Tipper could be multiple people up the chain

Everyone after the tipper who passes for personal benefit is potentially derivatively liable as a tippee

Analysis for examo Start at the bottom of the chain

You can start at the top thougho Be mindful of who she asks us to get

all these cases really just help us fill out the chart

Chestman Ira…Shirley…Susan…Keith…Chestman Does Ira owe a duty to anyone?

o As a shareholder, you do not owe a fiduciary duty (no traditional Chiarella duty) Even if you are a controlling shareholder

o However, a controlling SH in a family owned company might establish a relationship Does Ira breach?

o Does Ira pass for a personal benefit? No, he seems to be telling the family (inner circle) in the context of telling

about the deal He is looking to help them facilitate the transaction

Ira no good. Does Shirley owe a duty to anyone?

o Shirley seems to be a part of the inner circleo She owes a duty not to the company, but to her brother Ira

Does she breach when she passes?o No personal benefit when she tells her daughter

Shirley no good. Does Susan owe a duty to anyone?

o Susan seems to be the break in the chain No relationship to the company or inner circle

o No duty

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Susan no good. If Ira or Shirley passed for personal benefit?

o Chestman could be held derivatively liability (1) liability on the tipper (2) Chestman knew or should have know

He knew Susan was the granddaughter of close familyo We just need to get somebody in the chain to find Chestman liable

Does Chestman owe a duty to anyone?o Does Chestman owe a duty to Keith?

It is not enough that people are in a relationship, it is…are they in a relationship with the expectation that they are not to use the info for the purpose of personal benefit/trading?

No duty for Chestman to breach because Keith provided the info to trade ono Does Chestman owe a duty to the family?

He is the broker to the family What if he were a lawyer to the family?

Akin to learning information about your client through someone else. If one family member discloses info, does the trader still have the obligation

as a whole? If going to trade, would he disclose to family as a whole?

Actually, Chestman is a broker to the junior members of the family Chestman is okay when he trades on the information

Chestman no good. Does Keith have a duty to the family?

o Traditional Not employed by the family…no duty

o MT To family

Not part of the inner circle…no duty To wife (immediate source)

Susan likely has no dutyo If Susan has a duty, does she breach by telling Keith?

No. She does not pass for a personal benefit. What if she told him with a wink and a nod?

This would be problematic. Because they are married, if he benefits she

benefits. What if she told her best friend?

Potential quid pro quo. Assume no quid pro quo. If you gift someone

information this could be a personal benefit in the same way that an economic benefit is.

o You could make the cases that she owes some obligation to Shirley or the broader family. However, the facts show that she did not pass info for a personal benefit.

Susan has no duty to breach, so we cannot get Keith as a tippee.

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Does Keith owe a duty to the wife?o The court seems to hold our classic notion of confidence in

marriage on its head by finding no duty here.o The court says without the continued exchange of confidential

business information no duty cannot be found here.o She apparently told Keith not tell anyone.

The court finds this to be unilateral. The entrance into confidentiality must be mutual. Keith needs to respond that he will not tell.

You have to wait until the other person consents to assume confidentiality

What did Chestman do?o Created problems for DOJ and SECo Problems establishing confidential relationships under MT

Marital relationships on their own will not establish Exchange of personal info will not establish Unilateral admonishment not to tell will not establish

So, the SEC changed the rules…

Rule 10b5-2o 3 non-exclusive categories that can satisfy the MT

(1) mutual agreement mutual agreement to maintain confidentially of the information solidifies C

(2) a history or pattern of exchanging confidence that would lead both of the parties to expect that the information exchange within the context of their would lead to confidentiality

business or personal overturns C

o C limited the exchange to business confidences (3) certain family categories create an assumption of confidence, unless

the history or pattern of the relationship demonstrates otherwise spouses parent siblings children overturns C

C (con’t) conviction under 14e-3 easily upheld because

o within the context of a tender offer, you do not have to show duty/breach

Cuban Does Cuban owe a traditional duty to Mamma?

o No traditional Chiarella type duty in the company whose stock he trades

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Duty can be established statutorily The relationship isn’t as high as the fiduciary-like duty Crux of the issue

o Cuban agreed to keep the information confidential Why isn’t this enough?

He is charged with trading on the information The court makes a distinction between agreeing not to pass and

agreeing not to tradeo Non-use v. non-disclosure

Focusing on the trade, why do we need both non-use and nondisclosure?

o You can satisfy your non-disclosure obligation and still trade

Rule 10b5-2(1) exceeds the scope of the SEC’s authority, thus they must establish an agreement of BOTH non-use and non-disclosure

o Rule 10b5-2 can only be used to show an agreement of non-disclosureo Previously, the law developed assuming that non-disclosure agreements implied non-

use There must be an explicit or implicit understanding that there is a agreement not to

tradeo Cuban’s dialogue

Why isn’t this enough to show an implicit understanding not to trade? It seems as though Cuban thought he could not trade as a result of his

promise to keep the info confidentialo It doesn’t matter what you subjectively think

This is almost unilaterally in this sense There is no agreement between the two We have no way of knowing whether the CEO

also had this expectation Fifth Circuit

o SEC’s complaint does enough to a establish an implicit duty of non-useo This is just one circuit

This will most likely go to the Supreme Court Analysis

o There is one district level (and one circuit that has not yet reversed) court suggesting you need an agreement not to trade

o The SEC continues to suggest that all you need is an agreement of confidentiality

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