Download BUSINESS ASSOCIATIONS OUTLINE Chapter 1: The Law of

BUSINESS ASSOCIATIONS OUTLINE
CHAPTER 1: THE LAW OF AGENCY
Creation of the Agency Relationship
 An agent is person who is authorized to act on behalf of another person (the “principal”)
 Agency is the fiduciary relationship that arises when one person (a “principal”) manifests assent to another person
(an “agent”) that the agent shall act on the principal’s behalf and subject to the principal’s control, and the agent
manifests assent or otherwise consents so to act. Restatement (Third) Agency §1.01.
o An agency relationship is a matter of law. Required Components (See Cyberheat):
 Mutual Assent: this may not include assenting to an agency relationship  intent is not required to
enter into an agency relationship
 Benefit: principal profits from the relationship
 Control: the right to control – greater control, greater risk of liability
 Legal Consequences of Agency:
o Inward-Looking: relate to the relationship between the principal & the agent. Governed by contracts
between the parties & the law of fiduciary duties
o Outward-Looking: relate to the relationship among the principal, agent, & a third party
 U.S. v. Cyberheat: creation of an agency relationship turns on the parties’ intention as demonstrated by express
agreement or inferred by actions
o A principal will be held liable for contractor or agent’s wrongdoing upon matters which the principal might
reasonably expect would be the subject of representations, provided the other party has no notice that the
representations are unauthorized (outward looking consequences)
Agent’s Fiduciary Duties to Principal
 Agent’s Duties To Principal: contractual obligations, care, competence, diligence, obedience, disclosure & loyalty
o Duty of Care:
1. Duty to perform in accordance with express & implied terms of contract with principal.
Restatement §8.07
2. To act with care, competence & diligence normally exercised by similar agents. Restatement
§8.08
3. Duty to act only within scope of actual authority and to comply with lawful instructions from
principal to those designated by principal to instruct agent. Restatement §8.09
4. Duty to act in such a way as to not bring principal into disrepute. Restatement §8.10
5. Duty to provide information that the agent knows, or has reason to know, or should know when
the agent knows or has reason to know that the principal would wish to know the information.
Restatement §8.11
6. Duties regarding Principal’s Property: identification, segregation, record keeping, & accounting.
Restatement §8.12
o Duty of Loyalty: An agent has a fiduciary duty to act loyally for the principal’s benefit in all matters
connected with the agency relationship. Restatement §8.01. Components
1. Duty not to acquire a material benefit from a third party in connection with the agency.
Restatement §8.02
2. Duty not to deal with the principal as or on behalf of an adverse party. Restatement §8.03
3. Duty to refrain from competing with the principal. Restatement §8.04
4. Duty not to use or disclose confidential information. Restatement §8.05
Food Lion v. ABC: employees owe a duty of loyalty to their employers, breach creates tort liability
o Principal’s Consent: conduct otherwise constituting a breach does not constitute a breach of duty if the
principal consents to the conduct. Restatement §8.06. To obtain consent, the agent must
 Act in good faith
 Disclose all material facts
 Otherwise fairly deal with the principal
o Principal’s Duties to Agent:
o Duty to perform in accordance with express & implied terms of contract with the agent. Restatement §8.13
o Duty to deal with the agent fairly and in good faith, including a duty to provide agent with information
about the risks or physical harm or pecuniary loss present in the agent’s work which are unknown to the
agent, but the principal knows, has reason to know, or should know
o Duty to indemnify agent:
1. In accordance with contract with agent
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2.
3.
4.
When agent makes payment within scope of agent’s agent authority
When agent makes payment hat is beneficial to principal unless the agent acts officiously in
making the payment
When agent suffers a loss that fairly should be borne by the principal in light of their relationship
Principles of Attribution: outward looking consequences come about because principals can be held liable for the tortuous
actions of their agents, and can be required to fulfill contracts into which their agents have entered because the principal has
the ability to select and control the agent and to terminate the agency relationship
 Actual Authority: created by principal’s manifestation to an agent, as reasonably understood by the agent,
expresses the principal’s assent that the agent take action on the principal’s behalf. Restatement §1.03
o An agent acts with actual authority when, at the time of taking action that has legal consequences for the
principal, the agent reasonably believes, in accordance with the principal’s manifestations to the agent, that
the principal wishes the agent to act. Restatement §2.01
 Express: what the principal actual conveyed to the agent
 Implied: power to do those things necessary to fulfill the agency
 Castillo v. Case Farms: authority to recruit migrant workers includes the implied authority to transport &
house the workers. These activities were within the scope of employment.
 Actual authority includes the implied authority to do what is necessary & proper to complete the
actual authority
 Apparent Authority: one person may bind another in a transaction with a third person, even in the absence of
actual authority, when the third person reasonably believes – based on manifestations of the purported principal –
that the actor is authorized to act on behalf of the purported principal. Components:
1. Power to affect the legal relations of another person by transactions with third person, professedly as an
agent for the other, arising from and in accordance with the other’s manifestations to such third persons.
Restatement §8
 Implied direct communication between the principal & the third party
2. Power held by an agent or other actor to affect a principal’s legal relations with third parties when a third
party reasonably believes the actor has authority to act on behalf of the manifestations. Restatement §2.03
 Implies that apparent authority may be created without any communication made directly to the
third person. Custom may create apparent authority.
 Scope of authority depends on the third party’s reasonable interpretation of the manifestation
o Manifestation: a person manifests consent or intention through written or spoken words or other conduct.
Restatement §1.03.
 Apparent authority is created when the manifestation reaches the third party (through an
intermediary) as long as the manifestation can be tracked back to the principal
 Principal should take reasonable steps to inform the third party of any misplaced reliance due to a
manifestation of a purported agent
- Bethany Pharmacal v. QVC: principal corrected misrepresentations made by a third
party (non-agent).
 It was unreasonable to rely on the non-agent’s statements in light of the
principal’s manifestations.
 An “agent” cannot unilaterally create apparent agency through her
communications. The manifestation must come from the principal
o Apparent authority rises when:
 One person appears to be an agent of another even though no agency relationship exists – i.e.
apparent agency
 An actual agent exceeds the scope of his or her authority
o Apparent and actual authority may co-exist
 Apparent authority may survive the termination of the agency relationship
o Estoppel: not an agency doctrine, but similar to apparent authority. Differences:
 Estoppel requires detrimental reliance
 Restatement says estoppel is for situations that do not involve manifestations
 Estoppel does not bind the third party, only the principal. Compare with apparent authority that
can bind the third party and the principal
 Respondeat Superior: master-servant or employee-employer liability – employer responsible for the torts of his
employee due to his control over his employee
o Tortuous conduct must occur in the course of employment
o Employer must have the opportunity to select employees (Ware v. Timmons)
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CHAPTER 2: PARTNERSHIPS*
Formation
 Partnership: an association of two or more persons to carry on as co-owners of a business. UPA §6; RUPA §202(a)
o Governed by UPA & RUPA
o General Principles:
 One partner may be bound to third parties by the action of another partner – each partner is an
agent of the partnership!
 Partners are personally liable for the obligation of the partnership
o Deal Points: partners assume risks and in exchange gain control
 Risk of Loss: from investments in or operation of business
 Return: fixed claims (salaries, interests) and residual claims (profits, incentives)
 Control: who has the right to make which sort of business decisions?
 Duration: how long? How terminated? Transferable?
 No formalities are required to form a general partnership. Can be formed in the absence of a written agreement,
conscious intent to form a partnership or knowledge that a partnership is formed. RUPA §202(a)
o Formation at issue when an individual is attempting to avoid liability
 Intend to do the thing which constitute a partnership determines whether individuals are partners
regardless of their intent to create/avoid the relationship (Holmes v. Lerner)
- Many partnerships are inadvertent
 Usually if a partner intended to receive a share of profits of the business, he is a partner. Except:
- Employees or creditors who are paid for their services out of profits
o LLPs favored because they’re easy to form and provide limited liability
 Partnerships v. Corporations:
o Partnership Shortcoming: no limited liability
o Partnership Advantages: simple to form, flexible in organization, & subject to pass through taxation
Management
 Partnership Decision-making:
o All partners have equal rights in management and control
o If partners disagreement, majority vote controls.
 Problematic if only two partners due to likelihood of deadlock
 One partner cannot reduce the power of another partner
 Conflicting Views: (1) Nabisco is a suit by a third party. Summers is a suit between parties and
(2) Freeman (Nabisco) was acting in the ordinary course of business. Summers was “changing the
status quo” by hiring another person.
- Nabisco v. Stroud: absent agreement to the contrary, partnership decisions are governed
by majority vote of the partners. If there is not a vote to end a partner’s actual authority
to carry out business (purchasing bread for store), then the partnership will be bound by
his actions, leaving the partnership and the individual partners liable.
- Summers v. Dooley: a partner does not have majority vote when he carries out
“deadlocked” partnership business (hiring an employee)
o Unanimous consent is required to:
 Authorize amendments to partnership agreement
 Add a new partner
 In extraordinary situations – i.e. acts outside of the ordinary course of partnership business
 RUPA is the default rule unless the parties agree to change the rules
Fiduciary Duties
 Duty of Loyalty: RUPA is the default rule but can be altered by agreement. Partners may specify acceptable
activities if not manifestly unreasonable
o Anti-theft: appropriation of partnership opportunity. RUPA §404(b)(1)
o Self-dealing: partner is on both sides of a transaction. RUPA §404(b)(2)
o Competition: only applies prior to dissolution. RUPA §404(b)(3)
 Duty of Care: limited to engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing
violation of law. Partners may not unreasonably reduce this duty, but it can be altered by contract.
o High standard to plead!
 Duty of Good Faith & Fair Dealing: implied, but undefined in RUPA
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Duty to Disclose Partnership Opportunities: required because opportunities are extensions of the current
agreement between partners (Meinhard v. Salmon)
Duties when Dissociating from Partnership:
o Gibbs v. Breed, Abbott & Morgan: breach of duty of loyalty when supplying future employer with
confidential personnel information. However, taking desk copies when leaving does not breach duty.
 Partners in law firm must not abuse her possession of information the firm lack (her impending
departure) and may not take unfair advantage of that information – can’t ask clients to go with you
to new firm without providing notice to firm
 Other partners are treated differently than employees because (1) partners have right to dissociate.
RUPA §103(6) and (2) duty of employees of partnership – employee would have duty to report
Financial Attributes
 Partnership Accounting: governed by UPA §§501-502
o Capital Account: tracks each partner’s ownership claim against the partnership. Determined by:
 Contributions made by each partner
 Each partner’s share in profits/losses from partnership operations
- Equal shares is the default rule but can be changed by contract
- Phelps v. Frampton: partnership agreement controls when disbursing profits even if one
partner will benefit more than others if the agreement is not ambiguous and the result was
contemplated by the partners
 Any withdrawals of funds from the partnership
 Each partner’s gains or losses upon sale of the partnership assets
o Draws: a type of withdrawal - earnings that are removed from the partnership akin to salary/wages.
Partnerships attempt to calibrate the amount of a partner’s draw to the partner’s share of partnership profits
 Sharing Profits & Losses Among Partners
o Allocations of profits & losses is determined by each partner’s interest in the partnership
o Profits are paid out annually. Capital contributions are normally repaid when a partner withdraws form the
partnership or when the partnership terminates
o Partnership assets are used to pay liabilities in the following order:
1. Amount owed to creditors of the partnership who are not partners
2. Amount owed to partners other than for capital accounts & profits
3. Amount owed to partners for repayment of capital
4. Amount owed to partners for any remaining profits
 Liability of Partners to Third Parties
o Partners may be forced to fulfill partnership obligations to third parties out of their personal funds
 Entity View: partners as contributors to the partnership having an obligation to the partnership to
furnish it with the necessary funds to meet its obligations to third person, but that those having
claims against the partnership have no claims against the partners
- Result: partnership creditors are forced to first exhaust the assets of the partnership &
then begin new proceedings to attach the claims of the partnership against the partners as
contributors
 Aggregate View: adopted by UPA – partners jointly liable for all partnership debts & obligations
except wrongfully acts or breaches of trust of one of the partners, for which the other partners are
jointly & severally liable
- Individual liability of a partner may not be altered by agreement among partners because
it would affect the rights of third parties
- RUPA Changes: partners are jointly & severally liable in all matters; exhausting
requirement is omitted (partners can be indemnified by partnership)
o Can be liable for debts of the partnership that existed before you joined the partnership
 In re Keck, Mahin & Cate: liable for wrongful acts or omissions that occurred while you were a
partner because wrongful act triggers liability of all partners that a partner cannot escape by
leaving the partnership after the malpractice is committed but before the client wins/settles
- Dissolution of the partnership doesn’t discharge existing liability of any partners
- Partners cannot release one another from liability to third parties. Third party consent is
required to release a partner from liability
 Limited Liability Partnerships: general partnerships that have registered with the state and as a result of
registration obtain a certain level of limited liability protection for partners
o Protects the person assets of partners from risk of negligence/malpractice of another partner
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
o
Partners in LLPs aren’t personally liable for any obligation of the partnership unless the partner is
personally liable as a result of their own conduct or have participated or supervised wrongful acts
Dow v. Jones: a partner can bind the partnership even during dissolution if he has apparent authority (firm
letterhead, meetings at offices, no notice to client).
 Lacked actual authority to retain client but firm held him out as partner  partnership by estoppel
- RUPA §308 allowed partnership by estoppel
- Purported partner is someone that has not consented to being a partner, but they are
estopped from denying partnership if there is the holding out and reliance by a third party
 Partner can bind the partnership after the dissolution if the third party doesn’t have notice of the
dissolution  creates unlimited liability for partner’s actions
Dissolution: departure of a partner from the partnership, the process of liquidating & winding up a partnership or the
completion of that process
 Partners can still bind the partnership in the winding up process (Dow v. Jones)
 Under UPA, a change in the relations of partners caused by any partner leaving caused dissolution
o Dissolution: point in time when the partners cease to carry on business together
o Termination: point in time when all partnership affairs are wound up
o Dissolution doesn’t result in immediate termination – terminates the legal entity, but not the partnership
business
 Under RUPA, departure of a partner does not cause dissolution. It’s a dissociation.
o Dissolutions commonly caused by dissociations – may breach partnership agreement
o Dissociating partner must be bought out:
 Rightful Dissociation: when it is accomplished without violating the agreement between partners.
RUPA §601
 Wrongful Dissociation: when a partner breaches the express/implied partnership agreement or
before the expiration of the term of completion of the undertaking. Creates liability to the
partnership and other partners. RUPA §602
 Types of Partnerships: statutes provide partners with an absolute right to leave the partnership at any time (after
paying any damages that they might cause by leaving).
o At-will
o Limited Duration
o Particular Undertaking: more likely that a partner who leaves will be found to have left wrongfully. This
can effectively make it very expensive for a partners to leave
 Fischer v. Fischer: one partner cannot unilaterally dissolve the partnership rightfully before the
undertaking was completed. Damages available for this form of breach.
*RUPA says partnerships are entities separate from the partners themselves rather than the aggregate. Partnership property
belongs to the entity, not to the individual partners.
CHAPTER 3: LIMITED LIABILITY COMPANIES
Birth & Development of LLCs
 Investors in corporations have limited liability – only limited to the amount of their investment
 Kintner Factors: corporate norms
o Centralized management (Board of Directors)
o Continuity of life
o Free transferability of voting rights
o Limited liability
 Double Taxation: corporate profits are taxed once at the corporate level and then again at the level of the individual
shareholder after payment of dividends
o Contrast with pass through tax entities (general partnerships) that only tax partners for profits
o Exception for corporations that have:
 Fewer than 75 shareholders
 Only one class of stock – cannot have both common & preferred shares
 Individual shareholders may only be US citizens or resident aliens
o LLCs are treated as partnerships for tax purposes
o General Utilities Doctrine: permitted a corporation to distribute appreciated property to its shareholders
without realizing taxable gain, thus avoiding double taxation. Popularity of LLCs grew a
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
Limited Partnerships (LPs): hybrid entity – corporation & partnership qualities
o Provided tax shelters – investors used LPs’ losses to shelter other income form federal taxes
o Characteristics: must have at least one general partner who exercises management responsibilities and at
least one limited partner, who is a passive investor
 Requires only one partner to be subject to unlimited personal liability
 Control Rule: limited partner who participates in the control of business is liable to persons who
transact business with the LP reasonably believe based on the limited partner’s conduct, that the
limited partner is a general partner (later rejected)
o Importance of LPs is declining
Formation
 Formed through a formal filing of a Certificate of Organization or the Articles of Incorporation
o Operating Agreement: agreement re: members
o Conflicting Agreements:
 When operating agreement & articles of incorporation conflict, the agreement controls with
respect to members, dissociated members, transferees and managers while the Articles of
Incorporation controls with respect to third parties who reasonably rely on it
 If an operating agreement or articles of incorporation conflict with a statute, the statute controls
with respect to mandatory provisions but the agreement between the parties prevail with respect to
non-mandatory provisions
 LLCs cannot be created informally.
o Doctrines that prevent inequality due to failed incorporation attempts:
 De facto corporation: if a person (promoter) attempted to incorporate but failed to follow the
proper formalities, courts might conclude that the corporation existed in fact (de facto), eve if not
in law (de jure). Recognition of limited liability to protect the promoter for personal liability
- Stone v. Jetmar Properties: voids this principle. Incorporation process is so simple that
protection shouldn’t be available for those who fail to incorporate
- If there is a genuine attempt to incorporate, this doctrine may still be invoked
 Corporation by estoppel: recognition of limited liability vis-à-vis third parties who deal with a
promoter on the assumption that the promoter represents an existing corporation, even if the
corporation has not been formed.
o RULE: all persons purporting to act as or on behalf of a corporation, knowing there was no incorporation
under this Act, are jointly and severally liable for all liabilities created while so acting. Exceptions:
 Where a corporate organizer reasonably & honestly believes that the articles have been filed, but
in fact they have not been due, for example, attorney neglect;
 Where the articles have been mailed or deliver for filing, but not received by the secretary of state
through no fault of the corporate organizer;
 Where the third party knows the articles have not been field and looks only to the corporation in
formation;
 Where the third party relies on the corporation’s credit even though no corporation exists, and the
corporation organizers knows that ; or
 Where inactive investors have not authorized the commencement of business without the
protection of the corporate shield and business is commenced without their knowledge. MBCA
§2.04
o Promoter Liability: promoters are personally liable on all pre-incorporation contracts
 All persons purporting to act as or on behalf of a corporation, knowing there was no incorporation
under this Act, are jointly and severally liable for all liabilities created while so acting. MBCA
§2.04
 However, if one party urges another to sign in the name of the corporation, even though both
know it does not exist, estoppel may prevail
Management
 Types of Management:
o Member-Managed LLC: (default rule) members have equal management rights & decide all ordinary
business matters by a majority of members
 Runs like a partnership – ordinary matters are decided by majority vote of members &
extraordinary matters generally require unanimous consent
 Gottsacker v Monnier: members with a material conflicts of interest are usually allowed to vote
but are required to deal fairly with the conflicted member.
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- Common law rule: any transaction with a conflict of interest would be voidable
Manager-Managed LLC: managers have exclusive management rights & decide all ordinary business
matters by a majority of managers
 All members must consent to:
- Sell, lease, exchange or otherwise dispose of all, or substantially all, of the company’s
property, without goodwill and outside the ordinary course of the company’s activities
- Approve a merger, conversion, or domestication under Article 10
- Undertake any other act outside the ordinary course of the company’s activities
- Amend the operating agreement
 Unanimity favored because LLCs are likely to be closely held. Members are likely to want veto
power over extraordinary transactions
 Unanimity disfavored because: obtaining consent may be costly because it may require individual
negotiations, the veto power may not be justified in an LLC as it is in a general partnership
because members cannot impose unlimited liability for their actions on each other, and a
disgruntled member has the right to withdraw and be paid for his interested in the LLC
 Taghipour v. Jerez: LLC can attempt to limit power of manager by operating agreement but the
manager may still be able to bind the corporation (apparent authority issue).
Management provisions are default rules that can be altered by the operating agreement
o

Limited Liability
 Default Rule: every member of LLC has equal management rights (member managed) unless they provide for
centralized management (manager managed) in the organizing documents. Both structures provide limited liability
 Piercing the Corporate Veil: circumventing limited liability & holding shareholders personally liable for the
obligations of the corporation
o Designed to impose personal liability on shareholders when they have failed to treat the corporation as a
separate entity
o In corporations, courts look to formalities to determine if the corporate veil should be pierced (board
meetings, separate bank accounts, etc.). But, LLCs do not have these formalities  harder to pierce the
corporate veiling in LLCs!
o D.R. Horton v. Dynastar: New Jersey courts use a test to determine if corporate veil should be pierced:
 Plaintiff must prove subsidiary was a mere instrumentality or alter ego of its owner; and
 Plaintiff must prove that parent/owner has abused the business form to perpetuate a fraud,
injustice, or otherwise circumvent the law.
o Veiling piercing usually employed when there is not a real distinction, perceived or real, between the owner
and the firm and its difficult to separate them
 Requires showing of domination and control of both entity’s policy & business practices
 Rarely used
o Look for personal liability of defendant before attempting to pierce because direct actions are more likely
to be successful
Fiduciary Duties
 Imposed on LLC managers; owed to the LLC and individual members
o Can’t oppress a minority member because fiduciary duties are owed to each member
o Statutes impose the duties of care & loyalty on managers (Purcell v. Southern Hills)
o Duties can be altered by operating agreement but cannot be eliminated under RULLCA.
 DE’s LLC statute allows for complete waiver of these duties
 Types of Lawsuits:
o Derivative: enforcement of fiduciary duties in an action which shareholders of a corporation sue on behalf
of the corporation to enforce fiduciary duties against the managers of the corporation
 Harm caused to the corporation – i.e. mismanagement or theft of corporate funds – harm to
shareholders derives from the harm to the corporation
 Harder to sustain
o Direct: shareholders act on their own behalf
 Harm caused to the shareholders – i.e. depriving shareholders of mandatory dividends based on
shareholder agreement
 With LLCs, sometimes direct actions allowed for matters that would normally be considered
derivative actions if a corporation was involved
Dissolution
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
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Statutes often impose requirements on LLCs and its members prior to dissolution
Dissolution much more complicated in LLC context than partnership context
LLCs are a creature of contract so courts will often hold parties to the provisions they agreed to
o Compare with Hadley v. Talcott: judicial dissolution granted to break deadlock between two 50% members
of the LLC because exist mechanism was inadequate. Exit would have left one member responsible for the
mortgage of the other with no control over the LLC
CHAPTER 4: ORGANIZATION & STRUCTURE OF A CORPORATION
Corporate Governance Roles:
 Officers: in charge of the day-to-day operations of the corporation
 Directors: elected by shareholders to supervise the officers  shareholders’ representatives within corporation
o Do not act as individuals; act collectively as the Board of Directors
 Shareholders: owners of the corporation possessing control rights.
Ownership Structures:
 Public Corporation: shares are owned by a large number of investors & are traded in the public securities market
o Roles: officers, directors & shareholders are three distinct groups  results in conflicts of interest
o Control: formal mechanisms are exercised by the Board of Directors; shareholders elect directors
 Separation of ownership (shareholders) & control (management)
o Federal Securities Laws: demanding set of disclosure requirements 0 must make quarterly reports and
annual disclosure of large quantities of specified information
o Market for Corporate Control: hostile takeovers – public corporations are subject to the threat of being
taken over by another company gaining control of a majority of the corporation’s outstanding stock
o Commonly incorporated under Delaware law – about ½ of all Fortune 500 companies incorporated in DE
 DE selected because of its specialized courts and pro-business statutes. Provides predictability
o Exit options easy  sell your shares BUT in exchange for an easy exit, voice (control) rights are limited
 Closely-held Corporations: shares are owned by a small number of shareholders without access to the public
securities markets
o Roles: officers, directors & shareholders’ roles often overlap
o Control: formal mechanisms of control are exercised by shareholders
 Contracts between shareholders govern actions
 May eliminate the Board of Directors
o Federal Securities Laws: no requirements
o Commonly incorporated in the state of principal place of business because cost of incorporation is cheaper.
 State law doesn’t matter as much because contract governs most issues
o No market for shares of the corporation making it harder to exit, so shareholders are given more control
 Corporate Law: governed by statutes enacted by states
o Internal Affairs Doctrine: rules governing the relations between officers, directors and shareholders are
taken form the state of incorporation, commonly Delaware. In DE, the DGCL governs.
o Model Business Corporation Act (MBCA)
Incorporation: process by which a separate legal entity is formed
 Incorporation Process:
o Draft articles of incorporation
 Called the certificate of incorporation in DE
 Generic term for articles is the charter
o One or more persons may act as the incorporator or incorporators of a corporation by delivering articles of
incorporation to the secretary of state for filing. MBCA §2.01
o The corporate existence begins when the articles of incorporation are filed. MBCS §2.03
o Formalities must be adhered to in order to avoid future problems (Grant v. Mitchell)
 Each corporation must have a Board of Directors. MBCA §8.01(a)
 Shareholder agreement may eliminate the board of directors or restrict the discretion or powers of
the board of directors. MBCA §7.32(a)(1)
 Drafting a Charter: all corporations are presumed to be perpetual unless the Articles provide otherwise
o Statutory Requirements: no minimal capital requirements
 Name: indicate corporate status, MBCA §4.01
 Number of shares: check MBCA §6.01
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Registered office and registered agent: MBCA §5.01
Incorporator name and address
Corporate purpose: statement that articulates purpose can be very general – i.e. “to engage in any
lawful purpose for which a corporation may be organized.” (only required in DE)
 Ultra vires (beyond powers) actions have been eliminated in most modern statutes
o Agents can act ultra vires
o Corporations act ultra vires when they act outside of the law (illegal acts)
 Limitations on purpose can be enforced by:
o Shareholder suit against the corporation
o Suit by the corporation against directors/officers for actions beyond the purpose
o An involuntary judicial dissolution proceeding by the attorney general
o Optional Items: management provisions, bylaw provision, director liability, indemnification, etc.
 Some items may be effective only if they appear in charter (e.g. limitation on director liability)
 Most option items could appear in the bylaws or a board resolution; place them in the charter only
if you want to insulate them from change
Post-Incorporation:
o Incorporator usually elects directors, who complete the organization process. MBCA §2.05
 Adopt bylaws
 Appoint officers
 Issue stock
o The existence of the corporation does not depend on the maintenance of corporate formalities. BUT, the
benefits of limited liability may depend on the maintenance of formalities (see piercing the corporate veil)
Capital Structure
 Types of Claims Sold:
o Equity: power & control, usually by voting, and the right to receive the fruits of the business through
dividends, distributions, and liquidation
 Common: unlimited voting rights (including especially the right to vote for directors) and the right
to the residual assets of the corporation (after payment of all corporate liabilities)
 Preferred: shares that have some preference or priority in payment over common shares
- Set out in Articles of a separate document called a certificate of designations
 Preference in dividends
 Preferred rights during the winding up stages
 Can be used to enhance voting rights
- Blank Check Preferred: board of directors may designate the attributes of a class or
series of shares in an amendment to the articles not requiring shareholder approval
 Types of Equity Schemes:
- One Class: all equity holders have the same rights
- Multiple Classes: equity holders with different rights
- Series within a Class: make distinctions within the class of equity holders
 All equity interests are the capital stock of the corporation
- Individual units of capital stock are called shares
 Shares are issued when they are sold
 Shares are outstanding as long as shareholders hold them
 Shares that are unissued are authorized shares
 Treasury Shares: repurchased and held by the corporation – not voted by the
corporation and may be resold for any price determined by the board (eliminated
by the MBCA)
- To know the percentage of ownership one owner has would require knowledge of: (1)
what percentage of shears of the entire class our stockholder owns and (2) what the rights
are of that class of shares
- Grimes v. Alteon: DGCL gives directors a lot of control over the issuance of stock and
may require such transactions to be in writing. Court refused to recognize oral promise to
offer shares to avoid diluting Grimes’ interest with new issuance.
o Debt: fixed obligation of repayment independent of the success of failure of the business
 Not described in Articles of Incorporation  laid out in contracts
 Bonds: promise to repay a specific sum of money at a definite time, with periodic payments of
interest. Bond Terms:
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Registered vs. Bearer: (a) Registered: have the holder’s name and address in the registry
and payments are made to whomever is listed in the registry; (b) Bearer: have coupons
attached and payments are made to whoever presents the coupons
- Redemption: corporation may repurchase the debt securities for the owners at a price
specified in the indenture
- Priority: indentures define the payment priority of the debt securities in relation to
existing and future debt securities
- Conversion: debt securities may be convertible into capital stock of the corporation at a
price and time specified in the indenture
- Rations: debt securities issued to the public are rated by various rating organizations –
i.e. S&P
 Contract is the indenture containing provisions re: procedures of issuance, payment, redemption,
and discharge. Also contains convents:
- Perform certain acts & refrain from other actions
- Specifies events of default that will allow bondholders to accelerate payment
- Defines special terms of debt
 Tax advantages of debt:
- Interest payments on debt are deductible to the company, but dividends the company pay
to stockholders are not
- Repayment of principal is nontaxable return of capital to an investor, but dividends are
ordinarily income to the investor
- If the company fails, bad debt may be an ordinary loss but loss of stock is capital loss to
the investor
 Risk of debt: requires repayment of fixed amounts at fixed intervals regardless of success or
failure of the business. Equity requires payment of dividends only when the business is successful
Stockholders who have large holdings (over 10% of outstanding shares) in publicly traded corporations may have to
make various disclosures as required by securities laws
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Directors & Shareholders
 Statutory power to manage a corporation rests with the Board of Directors
o Modern statutes don’t specify qualifications for directors but corporations can prescribe qualifications in
their charter or bylaws
o Board usually has 3+ members but only needs one member to operate. MBCA §8.03(a)
 Note: closely held corporations may decide to do away with board of directors
o Number of directors (or a range) is usually fixed by the charter or a bylaw. MBCA §8.03(c)
 Role of the Board: manage or supervise the management of the corporation via hiring, advising, supervising and
firing the CEO of the corporation
 Inside vs. Outside Directors:
o Inside: people who are employed full time by the corporation as corporate officers in addition to their role
on the board of directors
o Outside: people who don’t work for the corporation, other than as members of the board. If outside
directors do not have any other financial relationship with the corporation, they are termed independent
 Enhances board’s decision-making due to independence but may be forced to rely on inside
information due to lack of knowledge of business
 Election of Directors:
o Directors elected at annual meeting of shareholders - MBCA §8.03(d). Directors hold office until their
successors are elected and qualified
 Staggered: always a majority of directors who are continuing without need for re-election
- Anti-takeover device because it’s hard to get enough people on the board to complete a
hostile takeover (multi-year project)
- Restricts shareholders’ ability to monitor board action
- Governed by MBCA §8.06
 Classified: board that allows for classes of directors to be elected for multiple year terms
 Removal: directors may be removed from the board by shareholders, with or without cause, unless the charter
provides that cause is required. MBCA §8.08(a)
o If a specific class of shares elects a director, only those shares may remove the director. MBCA §8.08(b)
o Special rules for cumulative voting. MBCA §8.08(c)
o Directors may be removed in a judicial proceeding for bad behavior, if the court finds that removal is in the
best interests of the corporation. MBCA §8.09
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DE Provisions: directors may always be removed for cause. But, removal of directors in staggered board is
only for cause. DGCL §141(k)(1)
Vacancies: caused by death, removal, or resignation. Directors may resign at any time by delivering written notice
of resignation. Vacancies may be filed by the remaining directors or by shareholders
o Creation of a new directorship is functionally the same as a vacancy
o Shareholders or director may fill vacancies or new directorships. MBCA §8.10; DGCL §223
Board Meetings: members will be considered present if the director participates in the meeting by telephone
o Directors can act without holding a meeting (unless the charter or bylaws provide otherwise) but written
consent of all of the directors is required. MBCA §8.21(a)
o Special meeting requires notice of date, time, and place but not purpose
o A majority of directors must be present to satisfy the statutory quorum requirement but charter or bylaws
may alter the quorum requirement to specify more or less than majority. MBCA §8.24(a)-(b)
o Meetings of the Board:
 Directors act at regular or special meetings of the board. MBCA §8.20(a)
 Board acts by majority vote, unless the charter or bylaws require a supermajority. MBCA §8.24(c)
Board Committees: the board of directors may act through committees comprised of fewer than the total number of
directors. MBCA §8.25(a)
o Rules governing meetings of the board also govern meetings of committees. MBCA §8.25(c)
o Committees may be authorized to act on behalf of the whole bard. MBCA §8.25(d)
o Stock exchange rules may require committees and certain composition of the committee – i.e. audit
committee have at least one financial expert
o Federal regulation also has focused on committees (S-OX)
o Cannot delegate all matters to the committee – actions that will need to be put to a shareholder vote may
not be delegated to committee, nor may a committee adopt, amend, or repeal bylaws of the corporation.
Shareholder Voting: default rules can be altered by charters or bylaws
o Each outstanding share of common stock is entitled to one vote on each matter voted on at a shareholder
meeting. MBCA §7.21(a)
o Allowed to vote on election of directors and fundamental transactions:
 Electing directors: MBCA §8.03(d)
 Removing directors: MBCA §8.08
 Amending the charter: MBCA §10.03
 Amending the bylaws: MBCA §10.20
 Approving a merger: MBCA §11.03
 Approving sale of all the company’s assets: MBCA §12.02
 Approving dissolutions: MBCA §14.02
 Ratifying conflict-of-interest transactions: MBCA §8.16(b)(2)
o Can vote at shareholder meeting in person or by proxy. MBCA §7.22(a)
 Proxy Voting: common in publicly traded companies
- Proxy is the authorization given by a shareholder to another person to vote the
shareholder’s shares.
- Proxy is an agent subject to the control of the shareholder and has fiduciary duties to the
shareholder
Voting Rights: two systems
o Straight Voting: each shareholder votes all of his shares with respect to each open seat on the board
 Default rule but companies can opt for cumulative voting by amending bylaws or charter
 Favors majority shareholders
o Cumulative Voting: allows shareholders to concentrate their voting power by cumulating all of the votes
associated with their shares and voting them in a block for a limited number of nominees
 Effect is that minority shareholders’ representation on the board is in proportion to their voting
strength  guarantees board representation
 Common in closely held corporations
Shareholder Meetings: shareholder act via voting at annual meetings which are a statutory requirement.
o Types of Meetings:
 Annual: MBCA §7.01(a): in accord with bylaws (if silent, presumably by board); DGCL §211(a):
in accord with charter or bylaws (if silent by board)
 Special: MBCA §7.02: called by board or other person authorized by charter or bylaws; 10%
shareholders (or a different percentage not in excess of 25%) may demand; DGCL §211(d); called
by board or other person authorized by charter or bylaws
o Modern statutes also allow for written consent:
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 MBCA §7.04(a) – unanimous
 DGCL §228 – number of votes required in a meeting
Setting an Annual Meeting Date:
 MBCA §7.01(a): in accord with bylaws
- Court may order if meeting is not held within 6 months of the end of the fiscal year or 15
months after its last annual meeting. MBCA §7.03(a)(1)
 DGCL §211(b): in accord with bylaws
- If not held within 30 days after the designated date, the court may order a meeting.
DGCL §221(c)
- If no date is designated and 13 months have passed since the last annual meeting (or
written consent in lieu thereof), the court may order a meeting. DGCL §211(c)
Setting a Special Meeting Date:
 MBCA: board must give notice no fewer than 10 days nor more than 60 days before the meeting
date. MBCA §7.05(a)
- Court may order if notice is not given within 30 days of shareholder demand or the
meeting was not held. MBCA §7.03(a)(2)
- Board has 90 days after shareholder demand to hold the meeting
 DGCL: board must give notice no fewer than 10 nor moth than 60 days before the meeting date.
DGCL §222(b)
- Shareholders’ right to call special meetings is not provided in DGCL §211(d), so date
regulations are less critical
Fiduciary Limits on Setting the Meeting Date:
 General principle: directors must act in the interest of shareholders, not for the purpose of
entrenchment
 Two situations:
- Setting the date: boards are given broad discretion
- Changing the date: courts want specific evidence of shareholder benefit
 Fiduciary duties fill gaps left by the statute & organizational documents
Acting on Consent: shareholders can act without a meeting, by written consent
 Designed to make action by shareholders in closely held corporation easier but is used by about ½
of public corporations
 Significance: In DE, can be used to allow majority coalition of shareholders to act without being
subject to the board’s tactical decisions to delay calling a special meeting. Not as significant in
MBCA jurisdictions because unanimous shareholder consent is required.
Notice: proper notice must be complied with for all meetings
 If insufficient notice, actions taken at the meeting can be voided by shareholders who didn’t attend
- Attendance waives improper notice objection
 Notice of meeting is provided to all shareholder who own shares as of a record date which is filed
by the board of directors
- Record Dates: date on which the right to vote is determined
 MBCA §7.07(a): in accord with bylaws; absent bylaw provision the board sets a
future date
 Not more than 70 days before the meeting. MBCA §7.07(b)
 If no date is set, it is the day before notice of the meeting
 DGCL §213(a): board fixes record date
 Cannot precede the date of the board resolution
 Not more than 60 nor less than 10 days before meeting
 If no date is set, it is the day before notice of the meeting
 Alderstein v. Wertheimer: fairness requires notice. Board actions voidable if notice is not
properly observed
CHAPTER 5: FINANCIAL RIGHTS OF SHAREHOLDERS
Dividends & Distributions
 Types of Dividends:
o Dividend: payment, usually in cash, from a corporation to its shareholders. Timing and amount are
determined by the board of directors
o Repurchases: redemption of shares reduces the number of outstanding shares but doesn’t change the fact
that the shares that remain outstanding own 100% of the residual value of the corporation
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Limits on Distributions:
o Solvency Test: prohibits distributions that would result in solvency
 Insolvency: condition in which the corporation is unable to pay its debts as they become due in the
ordinary course of business
 DE does not adhere to this test
 MBCA §6.40(c)(1) – the corporation would not be able to pay its debts as they become due in the
usual course of business
 Valuation: MBCA §6.40(d) – values under balance sheet and solvency tests may be based on
financial statements or on a fair valuation or other method that is reasonable under the
circumstances
o Balance Sheet Test: measured by financial statements. Two types:
 Impairment of Capital: permit distribution out of surplus, which means all capital in excess of the
aggregate par values of the issue shares plus any amounts the board has elected to add to its capital
account
- Delaware: DGCL §170: directors may declare dividends out of surplus
 DGCL §154: surplus = net assets – capital
 Net assets = total assets – total liabilities
 Capital = aggregate par value of the shares
 Technical Insolvency Test: prohibits distributions that would result in total assets being
insufficient to pay the sum o the corporation’s liability and any liquidation preferences that would
be owning if the corporation dissolved at the time of the distribution
- MBCA: eliminates par value. Under MBCA §6.21(c), a board of directors must
determine what consideration is adequate, and the shareholder is obligated by contract to
pay that amount and no more
- MBCA §6.40(c)(2): the corporation’s total assets would be less than the sum of its
liabilities plus…the amount that would be needed, if the corporation were to be dissolved
at the time of the distribution, to satisfy the preferential rights upon dissolution of
shareholders whose preferential rights are superior to those receiving the distribution
o Debt holders have priority if a business fails and there’s a bankruptcy proceeding – limits on dividends to
protect creditors
Par Value & Legal Capital:
o Par Value: initially was equivalent to the sales prices of shares (no longer relevant)
o Legal Capital: par value per share times the number of shares outstanding. Distribution that exceed the
surplus result in a impairment of capital
Disconnecting Par Value & Price:
o No law required par value to equal issue price
o Promoters were reluctant to lower par values because they didn’t want their corporations to appear as
penny stocks
 Once that inhibition was overcome, par values and issue prices began to separate
 Today par values are set a trivial amount (usually $.01 or less)
o In absence of par value, the board of directors specifies a stated capital
Klang v. Smith’s Food & Drug Centers, Inc.: Smith didn’t impair capital despite the negative amount on the
balance sheet. Balance sheet is not outcome determinative because Smith has an opportunity to revalue assets &
liabilities to show economic value the company may borrow against
o When assets were revalued, capital was not impaired
o Must revalue assets & liabilities in good faith, on the basis of acceptable data, by methods that they
reasonably believe reflect present values, and arrive at a determination of the surplus that is not so far off
the mark as to constitute actual or constructive fraud. Gives directors ability to calculate own insolvency
o Business Judgment Rule: courts will not second guess the business judgment of a company
Limited Liability, Piercing the Corporate Veil, & Related Doctrines
 Advantages of Limited Liability:
o Enables shareholder to diversify more efficiently because investors made fully liable for the debts of a
corporation would expose themselves to too much less. Less important in close corporations because
investors don’t tend to invest to diversify (corporation is source of employment)
o Permits the free transfer of shares in public markets
o Reduces monitoring costs: (1) it decreases the need to monitor managers and (2) it reduces costs of
monitoring other shareholders
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Effects of Limited Liability:
o Increases the cost of debt and decreases the cost of equity to the corporation – shareholders must pay
creditors to assume some of the risk of business failure
o Incentive to engage in riskier than optimal activities because they are not forced to bear the total costs of
such behavior
 Voluntary Creditors: firm forced to pay for the freedom to engage in risky activities – society
bears no extra cost
 Involuntary Creditors: (tort victims) some social cost of limited liability is incurred – corporation
doesn’t internalize all costs
Parent & Subsidiary Relationship:
o Wholly Owned Subsidiary: legal entity separately incorporated form the parent corporation, but where the
parent owns 100% of the stock of the subsidiary
o Whole Enterprise Theories: treat the parent & subsidiary as one legal entity – REJECTED
Piercing the Corporate Veil: in some instances courts will require shareholders to pay the entire amount of a
contract/judgment on a tort claim, beyond the amount of the shareholders’ investment
o Decision to pierce is an effort to balance the benefits of limited liability against its costs to society
o Close Corporations v. Public Corporations: in close corporations, investors are usually manages, limiting
the monitoring costs and if given limited liability managers would capture more of any potential gains.
Courts often pierce in a close corporation context but not in a public corporation context.
o Parent Corporation v. Individual Shareholder: courts more likely to pierce when corporation is sole
shareholder because allowing creditors to reach the assts of parent corporation doesn’t create unlimited
liability for any individual
o Contract v. Tort: courts are more likely to pierce in tort cases than in contract cases because corporations
pay for risk ex ante under contracts but not under torts. More likely to impose ex post costs in tort
o Undercapitalization: common source of piercing, especially in tort causes because the high transaction
costs preclude ex ante negotiations
o THRESHOLD QUESTIONS:
1. Whether liability may attach to the shareholder directly by reason of the shareholder’s own actions
instead of recognizing the liability as a corporate liability that must be paid by the shareholder
personally because of the piercing analysis
2. If no personal liability – whether corporate formalities have been carefully observed. If observed,
courts will rarely pierce
3. Beyond showing the corporate formalities were not maintained, most courts require a showing of
injustice/unfairness to link the wrongdoing to the harm. Types of injustice: (a) where the disregard
for the corporate entity has been visible to a third party and that third party has reason to be
confused about whether he was dealing with a corporation or an individual or (b) where the
shareholder has disregarded the separateness of the corporation’s funds & treated them as her own
o Soerries v. Dancause: corporate veil pierced to reach club owner for negligence at his club because
corporate form was abused – comingling of funds and confusing third parties as to who (corporation or
individual) is responsible.
o Enterprise Liability: rather than pursuing a remedy against the corporation’s stockholder, the plaintiff
seeks recovery from the assets of a sister corporation (treating multiple entities as one)
o Reverse Piercing: an attempt to reach assets in a corporation in order to meet financial obligations of
the corporation’s shareholders
 In re Phillips: a corporation may be liable for the debts of a controlling shareholder or other
corporate insider where the shareholder or insider treated the corporation as his alter ego to
perpetuate fraud or defeat a rightful claim and an equitable result is achieved by piercing
 Doctrine more likely to be used where other shareholders are not entirely innocent
 FACTORS: (1) the controlling insider and the corporation were alter egos for other each, (2)
justice requires recognizing the substance of the relationship over the form because the
corporate fiction is utilized to perpetuate a fraud or defeat a rightful claim, and (3) an
equitable result is achieved by piercing.
- Inside: allow a shareholder to disregard the corporate form of which he/she is a part
- Outside: involve a corporate outsider seeking to obligate a corporation for the debts
of a dominant shareholder or other corporate insider
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CHAPTER 6: CONTROL OF THE CLOSELY HELD FIRM
Shareholder Agreements
 Contract among shareholder to protect minority shareholders. Routinely enforced today.
 Voting Pool: minority shareholders seek representation on the board via voting pool agreements obligating
shareholders to vote together as a single block
Transfer Restrictions: widely used to control selection of business associates, to provide certainty in estate planning, and to
ensure that the corporation complies with close corporation statutes, S corporation regulation, or securities act exemptions
 Valid if: (1) restrictions comply with the formal requirements relating to adoption of the restriction and
conspicuously noted on the share certificates and (2) restrictions must be for a proper purpose judge be
“reasonableness” of purpose.
 General Types of Transfer Restrictions: flat prohibitions frowned upon
o Option: shareholder must offer the corporation or other shareholders the option to purchase the shares,
either at a price specified by prior agreement or at the price offered by the prospective third-party purchaser
o Buy-Sell Agreement: corporation or other shareholders are obligated to purchase shares
 Most common transfer restriction. Solves many problems:
- Provides liquidity for shareholders who wish to withdraw
- Determines the price of the shares at a time when none of the parties to the agreement
know which of them will be sellers/purchasers
- Allows the principals or the corporation to plan with some certainty
o Prior Approval: corporation or other shareholders must approve the transfer of shares
 Determining Price:
o Fixed: must be updated constantly to reflect he current values of shares
o Book: (most popular) based on historical costs and may not reflect true underlying value
o Appraisal: parties decide beforehand on what basis the business should be appraised
o Formula: complicated system
 Capital Group v. Armour: in a closely held corporation, restrictions on transfer must be reasonable because
minority shareholders are locked in. It is reasonable to restrict transfer of interest because it advances a legitimate
business purpose – limiting the number of shareholders to avoid the expense of SEC disclosure statements and, by
limiting shareholders to employees, aligning interests of employees with the corporation
o Reasonableness is assessed on the face of the document, not as applied to an individual
o Court will be deferential on reasonableness inquiry when asked to invalidate a stock transfer restriction –
burden is one the party seeking invalidation
Voting Trusts: enforceable unless contrary to public policy
 Created to overcome rules against irrevocable proxies
o In voting trust, legal title to shares is transferred from shareholders to voting trustees
o Shareholders retain financial rights but trustees possess exclusive voting power over shares
o Voting trustees issue voting trust certificates to the beneficial owners of the shares. Certificates can be
traded
o Voting trusts ensure continuity of management – often used in reorganization plans or to prevent dissension
among various factions of shareholders
 Limited to 10 years and voting trust must comply with formal requirements.
o If an agreement is determined to be a de facto voting trust, the agreement inevitably will have failed to
comply with the formal requirements of voting trusts and will be invalid
Classified Shares: create of more than one class of shares with each class having unique rights
 Purpose: allocate control among various classes of shareholders
 If a class of stockholders’ rights is going to be adversely impacted, they have a right to vote.
o Benchmark Capital v. Vague: merger didn’t adversely impact the rights of a class of shareholders enough
to require a vote
 There is a presumption against creating a voting right when it is not explicitly included in the
parties’ agreement.
o Independent Legal Significance Doctrine: even if the substantive effect of applying one clause of the
contract is adverse to the intent of the second provision of the contract/statute, it has no legal significance.
 Result: look at each provision or subchapter and determine the independent effect, not the
substantive effect. Form over substance!
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 Used in Delaware
Cumulative Voting: method of counting shareholder votes in director elections in which each shareholder is entitled to cast
a number of votes equal to the product of the number of such shareholders’ shares time the number of directors to be elected
 Purpose: increases minority participation on the board. Goal can also be achieved through Shareholder Agreement
or entitling special classes of stock to “x” number of directors.
 Staggered voting defeats the effect of cumulative voting
 Must be provided for in charter
Supermajority Requirements
 Protects minority shareholders by giving them veto powers over corporate decision without offending corporate
norms because corporate statutes allow high quorum and voting requirements
 Adoption of Supermajority Requirement:
o Delaware: majority vote
o MBCA: adopted by same vote as required by the proposed supermajority
 Amending Rules:
o Delaware: in charter, they can be amended or repealed only be the greater vote specified in the charter
provision. But, there’s no statutory restriction on the amendment or repeal of supermajority voting
requirements in bylaws
o MBCA: amendment or repeal requires supermajority vote
 Options: can apply to all transactions or only certain transactions (merger or sale). If applies to all transactions,
likelihood of deadlock increases.
Preemptive Rights: rights of a shareholder to subscribe to the portion of any increase in a corporation’s capital stock
necessary to maintain the shareholder’s relative voting power as against other shareholders
 Not considered inherent in capital stock – granted/denied in Articles of Incorporation
 Types of Preemptive Right Provisions:
o Opt-In: (most frequently used) default rule is against preemptive rights but a corporation may provide for
preemptive rights by including a provision in its Articles
o Opt-Out: reflects skepticism about the value of preemptive rights and a recognition that from the
corporation’s standpoint, preemptive rights simply complicate the issuance of new shares
 Rarely used in public companies but common in closely held corporations
 Can be waived as a class (Kimberlin v. Ciena)
Deadlock: occurs when shareholder vote is divided
 Usually leads to dissolution of the corporation, which requires shareholder and director approval. If approval
doesn’t occur and deadlock persists, the corporation may be judicially dissolved upon a showing of deadlock
o Conklin v. Perdue: day deadlock first occurred is the day of dissolution. All actions taken after that date
are independent of the former entity. Judicial dissolution
 Buyouts are a common remedy
CHAPTER 7: OPPRESSION OF MINORITY SHAREHOLDERS
The Plight of the Minority Shareholder
 Pressure Points in Closely-Held Corporations:
o Benefits of stock ownership include:
 Dividends
 Participation in management
 Employment: termination may be equivalent to withholding the benefits of stock ownership
o Why close corporations pay salaries, not dividends:
 Reasonable salaries are deductible as expenses
 Dividends are not deductible (double taxation)
 Will of majority shareholders governs the business, but directors have a fiduciary duty to serve all shareholders
o Vulnerability of Minority: in closed corporations minority are vulnerable because they have both
investment and employment in the company. Loss of employment leaves few options on how to get the
proper return on investment. Minority shareholders cannot get out!
o Freeze-Out: terminate minority shareholder’s employment, remove the minority shareholder from the
board, refuse to declare dividends, increase salaries and employment-related perquisites to majority
shareholders, buy the minority shareholder’s shares at a discounted price (squeeze out price)
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Response:
- Judicial: fiduciary law  allows direct suits because of partnership-like duties
- Legislative: special dissolution statutes
 Broaden the grounds to include “oppression”
 Provide additional remedies for dissolution, including buyout, appointment of a
custodian, ordering a dividend, or other equitable remedy
Addressing Minority Oppression:
o Donahue v. Rodd (Mass.): closely held corporation is like a partnership
 Heightened fiduciary duty comparable to duty that partners owe each other exists in closely held
corporations
 Equal Opportunity Rule: if the stockholder whose shares were repurchased was a member of the
controlling group, the controlling stockholders must cause the corporation to offer each
stockholder an equal opportunity to sell a ratable number of his shares to the corporation at an
identical price
o Nixon v. Blackwell (De.): parties are bound by what they contracted for – minority shareholder knew he
was going to be in the minority and could’ve protected his interest through a definitive stockholder
agreement and decided not to…court won’t protect him now.
o Wilkes v. Springside Nursing (Mass.): response to Donahue
 Nervous about the untempered application of Donahue will result in the imposition of limitations
on legitimate action by the controlling group in a close corporation which will unduly hamper its
effectiveness in managing the corporation in the best interests of all concerned
 Refining Donahue: whether the controlling group can demonstrate a legitimate business purpose
for its action is determinative. When an asserted business purpose for the action is advance by the
majority, it is open to the minority to demonstrate that the same legitimate objective could have
been achieved through an alternative course of action less harm to the minority’s interest
- Flexibility need to establish business policy of corporation necessary in declaring of
withhold dividends, deciding whether to merge or consolidate, establishing salaries of
corporate officers, dismissing directors without or without cause, hiring/firing employees
- Legitimate Business Purpose: courts have cited various purposes as legitimate:
 Misconduct by minority shareholders
 Incompetence of the minority shareholder
 Poor business or economic conditions
 Change in technology or business plan
- Courts have rarely allowed a minority shareholder to show an alternative course of action
would be less harmful. Nevertheless, it suggests that courts should balance the interests
of the parties
o Riblet Products v. Nagy (De.): Wilkes is REJECTED in Delaware!
o Elmalen v. Barlow: heightened fiduciary duties are only owed in closely held corporations
 Shareholders owe no obligations to each other. There are no fiduciary duties. Exceptions:
- Controlling shareholders owe fiduciary obligations to other shareholders
- Shareholders in a closely held corporation owe each other the highest form of fiduciary
obligation
 Basis for increased obligation:
- Small number of shareholders: fewer than 21 shareholders
- No ready market for the corporate stock
- Substantial majority shareholder participation in management, direction, and operations
of the corporation
o Leslie v. Boston Software: utmost good faith requirement due to enhanced status as an owner required
 The were less harmful alternatives: Leslie’s administrative functions could have been modified
such that he could have been insulated from direct contact with BSC employees, etc.
 Remedy:
- Returning to work is not a desirable remedy
- Buyout: there is not market for shares – illogical remedy
- Three attributes of an equitable remedy:
 Fair compensation for loss of employment
 Fair compensation for any amounts received by Khayter & Goulart in the nature
of a dividend
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
Provision for Leslie, for so long as he remains a shareholder, to be able to
monitor the management of BSC and participate in the returns to shareholders,
without interfering unduly therein
Remedies for Minority Oppression
 Judicial Dissolution: based on oppressive conduct by the majority shareholder
 Buy-Out: most common alternative remedy to judicial dissolution – permits corporation or the shareholder to
purchase the shares of a shareholder petitioning for dissolution. The purpose is to ensure that minority shareholder
do not use judicial dissolution strategically
 Other Remedies:
o Canceling/altering charter, bylaws,
o Directing or prohibiting any act of the corporation, shareholders, directors, officers or other persons
o Selling all the proper and franchises of the corporation to a single purchaser
o Paying dividends/damages
CHAPTER 8: CONTROL OF THE PUBLICLY HELD FIRM
Shareholder Voting
 Shareholder control is a reactive power – shareholders react to the management’s decisions
 State v. Federal Requirements: state corporate law identifies the types of issues that shareholders may/must vote
on. Federal law sets out the procedures by which voting occurs and explains the information that must be provided
to shareholders prior to their votes. Voting Rights:
o Right to determine who will be on the board of directors
o Right to vote on fundamental transactions
o Right to vote on amendments to the charter/bylaws
o Right o vote on shareholders’ proposals
 Proxy Process: a proxy is an authorization given by a shareholder to another person to vote the shareholder’s
shares. Often given to incumbent management but management must indicate to shareholders how they will vote on
every item coming up on the agenda as part of the process of soliciting proxy authority
 Poison Pill: rights extended to existing shareholders to buy shares at a discount if a hostile acquiror tries to take
over the company. The existence of a pill make companies much more expensive and difficult to take over
o Unisuper v. News Corp.: board resolutions are revocable at will, but if the policy had an effect greater than
a resolution, the board may be contractual bound to keep it (sunsetting the poison pill).
 Shareholders can exercise their right to vote in order to assert control over the business affairs of a
corporation, despite the board’s ability to manage day-to-day affairs.
 Market for corporate control will replace inefficient management. Takeover threat frightens
management, forcing them to act more efficiently or lose their jobs
o Blasius v. Atlas: directors added members to the board to prevent a hostile takeover attempt. The court
found that although the actions were taken in good faith, the board failed to act as an agent for the
shareholders, breaching the duty of loyalty
 Shareholders have power to delegate director authority. Shareholder voting must be respected;
therefore, the business judgment rule does not apply to shareholder votes.
- Shareholders can’t tell the board what to, but can make recommendations to the board
- Board can’t negatively impact the franchise of shareholders
- Expansion of the board requires a compelling justification
 Board can protect itself through other means, such as notifying the shareholders
Federal Proxy Regulation: proxy solicitation is regulated by securities laws
 Securities Act of 1933: transaction-specific statute regulating the sale of stocks/bond to the public on the market
o Defines the kinds of information that must be available about companies, about new securities being
offered, and about the underwriting arrangements prior to sales to the public being allowed
o Liability Provisions: whenever issuers or underwriters participate in sales that involve material
misstatements or material omissions of fact
 Securities Exchange Act of 1934: more comprehensive – regulates secondary market transactions – purchases &
sales of securities among investors in the trading markets and exchanges
o Regulates NYSE, ASE & regional exchanges
o Regulates the actions of brokers/dealers in trading venues
o Delegates power to SEC to regulate proxy process
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o

Mandatory disclosure requirements: decided not to directly regulate corporations but instead give
shareholders all of the information they need to make informed decisions
 Disclosure is a continuous process, being required at fixed times throughout the year and upon the
occurrence of important transactions
 While much the required disclosure of financial info., there is a lot of pure corporate governance
information that is required to be disclosed
Purpose of Proxy Regulation: provide shareholders with information needed to make informed voting decisions
o Proxy statements are provided directly to each shareholder whenever shareholders have the right to vote
o Proxy Solicitation: SEC Schedule 14A – usually occurs in preparation for the annual meeting
o Shareholder Resolutions: shareholder proposals for items of business to be added to the agenda of the
annual meeting; 500 word statement asking the company to include the resolution and supporting statement
in the company’s proxy statement

Definition of Proxy Solicitation: regulations promulgated pursuant to §14(a) of the 1934 Act apply only to
shareholder communications defined as proxy solicitation (seeking voting authority)
o Must be sent to all shareholders

Liability for Misleading Proxy Disclosure:
o Rule 14a09: SEC defined a cause of action for false or misleading proxy statements and shareholders have
an implied private right of action to bring claims under this rule
 It’s a violation of Rule 14a-9 for a company to make a false statement of material fact or omit to
state material facts in its proxy statements
 Material Fact: info. a reasonable shareholder would consider important in deciding how to vote
- Fact-specific inquiry
- Usually financial facts concerning the value of securities/transaction

Shareholder Proposals: Introduction to Rule 14a-8
o Shareholder Proposals: proposing action at the annual shareholders’ meeting and requiring the company
to include the resolution on its proxy statement
 Social Activist Proposals: ask the board to study or disclose social, environmental, etc. issues.
Usually brought by members of a socially responsible investment (SRI) community, which
evaluates companies on both financial, social and environmental grounds
 Corporate Governance Proposals: seek changes in company’s bylaws. Generally brought by nonSRI institutional investment community
o Rule 30b1-4: requires mutual fund managers to disclose how they voted on every shareholder proposal in
every company in their portfolio
 Exposes conflicts of interest: mutual fund managers often vote the company’s management even if
it is contrary to the represented shareholder
o Rules 14a-7 & 14a-8: forcing company to include their proposal and supporting statement in the company’s
proxy statement under 14a-8 or requiring shareholder list and mailing its proposal out separately (costly)
under 14a-7
o Requirements to Make a Proposal: proponent must own at least $2,000 in stock or 1% of outstanding
shares for a minimum of 1 year. Shareholder resolution must be submitted 120 days before the proxy
statement is released to shareholders
o Acceptable Exclusions from Proxy:
 Shareholders can’t command directors act –limited to recommendations
 If a proposal relates to less than 5% of a company’s total assets or less than 5% of its net earnings,
it can be excluded, unless it raises significant social policy issues related to the company’s
business
 Companies may exclude proposal nominating candidates to the board or relating to elections
o No Action Procedure: method by which SEC staff members provide guidance to companies on the SEC’s
interpretation of its rules (similar to advisory opinions). These are not precedents on which parties can rely
because they are the decisions of staff members, not the SEC as a whole
 Apache Corp. v. Nycers: companies refusal to include resolution against sexual orientation
discrimination was acceptable because, when viewed as a whole, it deals with the company’s
ordinary business operations
- Courts won’t allow shareholders to micro-manage
- Some deference will be given to SEC No-Action Letters
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
Shareholder Proposals: Bylaw Resolutions
o Wall Street Rule: if you don’t like the company’s policies/strategies, don’t try to change the company, sell
your shares – less following than previously
o CA, Inc. v. AFSCME: shareholder proposal suggesting amending bylaws to provide for reimbursement of
funds expended in nomination process if shareholder is elected to board would violate prohibition against
contractual arrangements that commit the board to a course of action that would preclude them from fully
discharging their fiduciary duties to the corporation and its shareholders
 Procedural mandates are subject to shareholder approval but if a bylaw negatively impacts the
board’s ability to exercise its duty of loyalty it is impermissible
 Takes away management of business affairs (reimbursement of expenses) from board

Shareholder Proposals: Nomination of Directors
o AFSCME v. American International: a shareholder proposal that seeks to amend the corporate bylaws to
establish a procedure by which shareholder-nominated candidates may be included on the corporate ballot
does not relate to an election within the meaning of the Rule and therefore cannot be excluded from
excluded from corporate proxy materials under that regulation
 SEC is bound to its earlier stance that allowed procedural election challenges to be included on
proxy statement because it offered no reason why it broke from 16 years of precedent to adopt its
current rule
CHAPTER 9: DUTY OF CARE
Directors’ Duty of Care and the Business Judgment Rule
 Duty of Care: act with the care of an ordinarily prudent person
 Corporate directors are agents but he principal may be (1) the corporation, (2) the shareholders, or (3) a combination
of the corporation & its shareholders
 In the absence of facts showing self-dealing or improper motive, a corporate officer or director is not legally
responsible to the corporation for losses that may be suffered as a result of a decision that an officer made or that
directors authorized in good faith
 Business Judgment Rule: presumption that in making a business decision the directors of a corporation acted on an
informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company.
(Aronson v. Lewis)
o Rule provides that where a director is independent and disinterested, there can be no liability for corporate
loss, unless the facts are such that no person could possibly authorize such a transaction if he/she were
attempting in good faith to meet their duty
o Gagliardi v. Trifoods: need to allege a conflict of interest or improper motive to state a claim on which
relief can be granted
 Shareholders wanted their portfolio companies to take risks (protected through diversification) but
directors have little upside from risky decisions
 It is in the shareholders’ economic interest to offer sufficient protection to directors from liability
for negligence, etc. to allow directors to conclude that, as a practical matter, there is no risk that, if
they act in good faith and meet minimal proceduralist standards of attention, they can face liability
as a result of a business loss
 Directors’ business judgment was faulty, but that isn’t sufficient to justify imposing liability
The Decision Making Context
 Courts Suspicious of Board Decisions:
o When directors are subject of a conflict of interest with respect to the challenged decision, courts review
the decision under the standards developed under the duty of loyalty
o When directors fail to gather the requisite information to make the challenged decision, courts review the
decision under the gross negligence standard
 Smith v. Van Gorkom: informational gathering deficiency triggers a gross negligence standard of liability
o Director has a duty to act in an informed and deliberate manner in determining whether to approve an
agreement of merger before submitting the proposal to stockholders
o Counter-Arguments: substantial premium over stock price, market test & director experience and expertise
o Defects in information can be cured
The Oversight Context
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


Business judgment rule does not apply to inaction
Usually corresponds with failure to properly exercise oversight when a employee is engaging in illegal activity or
when settling with third parties form claims arising from illegal activities
o Breached their duty of care to the corporation by failing to ensure that the corporation had an effective law
compliance system and that the directors’ failure caused the economic losses to the corporation
o Can’t use lack of knowledge needed to exercise the requisite degree of care to defeat a breach of care claim
Oversight Duties: read materials including financial statements, attend board meetings, ask questions.
o Expanded under Sarbanes-Oxley: ensure that there is reason to believe the company’s financial reporting is
accurate, and ensure that the company has a functioning compliance structure
o Some companies include risk management evaluation in oversight duties
In re Caremark: it is a breach of duty of care/attention when the loss eventuates not from a decision but from
unconsidered inaction.
o Board’s responsibility to assure that the organization functions within the law to achieve its purposes
o Graham Court: Absent cause for suspicion there is no duty upon the directors to install and operate a
corporate system of espionage to ferret out wrongdoing, which they have no reason to suspect. Absent
grounds to suspect deception, neither corporate boards nor senior officers can be charged with wrongdoing
simply for assuming the integrity of employees and the honesty of their dealings on the company’s behalf
o Standard of Conduct: it is important that the board exercise a good faith judgment that the corporation’s
information and reporting system is in concept and design adequate to assure the board that appropriate
information will come to its attention in a timely manner as a matter of ordinary operations, so that it may
satisfy its responsibility
o Standard of Liability: a sustained or systematic failure of the board to exercise oversight – such as an utter
failure to attempt to assure a reasonable information and reporting system exists will establish the lack of
good faith that is a necessary condition to liability
The Waste Standard: similar to rationality of Board’s decision – tied into business judgment rule
 Often arises under executive compensation
 Decisions can be so bad that the board may be sued on a theory of waste
The Role of Good Faith
 Bad Faith: sustains breach of duty of care and overcomes exculpatory clauses that eliminate director liability to the
corporation for breach of duty of care. Directors can’t contract out of liability for bad faith acts.
o Traditional bad faith actions:
 Illegal: corporations cannot act in violation of law
 Fraudulent: bad faith with respect to a third party or shareholders
 Ultra Vires: corporation acting beyond its authorized powers (illegal acts)
 Ovitz v. Disney: theories of cause of action – waste & breach of care
o Bad Faith: DGCL §102(b)(7): in addition to matters required to be set forth in the certificate of
incorporation by subsection (a) of this section, the certification of incorporation may also contain any or all
of the following matters: (7) A provision eliminating or limiting the personal liability of a director to the
corporation or its stockholders fro monetary damages for breach of fiduciary duty as a director, provided
that such provision shall not eliminate or limit the liability of a director: (i) For any breach of the director’s
duty of loyalty to the corporation or its stockholders; (ii) for acts or omissions not in good faith or which
involve intentional misconduct or a knowing violation of law.
 Bad faith as substantive due care is a possible source of liability for egregious decisions
 Bad faith as irrationality
o Rebutting the Business Judgment Rule:
 Before Trial: allege facts sufficient to support a finding that the board of directors violated the
duty of care, the duty of loyalty, or the duty of good faith
- Must allege more than a breach of the duty of care duty to exculpatory provisions to
survive a motion to dismiss in DE
 Trial: prove facts sufficient to support a finding that the board of directors violated the duty of
care, the duty of loyalty, or the duty of good faith
- If evidentiary burden unmet, the business judgment rule operates as a substantive
protection for directors’ decisions
o If the Business Judgment Rule is Rebutted:
 Before Trial: compliant withstands a motion to dismiss
 At Trial: burden shifts to the defendants to show that the challenged transaction was entirely fair
Business Associations 21
Disney made it to trial but it was determined the board’s action in hiring Ovitz was negligent but not in bad
faith
Bad Faith Defined:
o Substantive bad faith: actual intent to do harm
o Lack of due care: failure to exercise good faith
o Intentional dereliction of duty: a conscious disregard for one’s responsibilities
 Conduct that does not involve disloyalty but is qualitatively more culpable than gross negligence
 DGCL 102(b)(7)
o Actions must be in good faith to avoid derivative liability
Stone v. Ritter: good faith is subsidiary element of the duty of loyalty
o The fiduciary duty of loyalty is not limited to aces involving a financial or other cognizable fiduciary
conflict of interest. It also encompasses cases where the fiduciary fails to act in good faith
 Where directors fail to act in the face of a known duty to act, thereby demonstrating a conscious
disregard for their responsibilities, they breach their duty of loyalty by failing to discharge that
fiduciary obligation in good faith
o Caremark Revisited: We hold that Caremark articulates the necessary conditions predicate for director
oversight liability: (a) the directors utterly failed to implement any reporting or information system or
controls; or (b) having implemented such a system or controls, consciously failed to monitor or oversee its
operations thus disabling themselves from being informed of risks or problems requiring their attention. In
either case, imposition of liability requires a showing that the directors knew that they were not discharging
their fiduciary obligations. Where directors fail to act in the face of a known duty to act, thereby
demonstrating a conscious disregard for their responsibilities, they breach their duty of loyalty by failing to
discharge that fiduciary obligation in good faith.
o


The Shareholder Primacy Norm
 Dodge v. Ford: a business corporation is organized and carried on primarily for the profit of the stockholders. The
powers of the directors are to be employed for that end. Cannot deprive shareholders of dividends without sufficient
business reason
o Compare with Shlensky-Wrigley: long-term goals can justify withholding dividends
o Directors must favor the interests of shareholders over non-shareholders
 Shareholder Capitalism: overriding goal of the company, beyond producing needed goods and services, is to
maximize shareholder wealth.
o But see, Kahn v. Sullivan: charitable contributions can be in the corporation’s best interest despite the fact
that shareholder return will be smaller as a result
 Competing policies: shareholder primacy v. creation of good will
 Philanthropic investments: must be in the zone of reasonableness. Tax deductions may make
charitable actions reasonable
CHAPTER 10: DUTY OF LOYALTY
Conflict-of-Interest Transactions Generally
 Duty of Loyalty: requires that directors serve the interests of the corporation over their self-interest
o Higher scrutiny than duty of care cases because directors’ self-interest is involved
o Directors don’t benefit from the business judgment rule
 Law tolerates conflict of interest transactions because the benefits of such transactions often are high
o Conflicts common due to directors’ diverse financial interests
o Need to allow conflict of interest transactions because otherwise people wouldn’t want to be directors
o Corporate law attempts to identify bad transactions – those that are unfair to the company and its
shareholders – while allowing good transactions – those that are fair to go forward
 Self-dealing occurs when the corporation enters into a transaction with a director. DGCL §144
o Varied transactions ranging from the sale of property to provision of services
o May be direct or indirect (indirect includes transactions with relatives, other entities in which the director
has a financial interest, and interlocking directorates)
o Includes cases where executive demines her own compensation
o Fundamental principle is that decision-making process is tainted
o Two possible solutions: cleanse the process or look at substance
 Hollinger v. Black: Black failed to adhere to the duty of loyalty via self-dealing
o Corporate Opportunity: taking the company’s opportunity for one’s own benefit
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o
Black’s Misconduct:
 Purposely denying the International board the right to consider fairly and responsibly a strategic
opportunity within the scope of its strategic process and diverting that opportunity to himself
 Misleading his fellow directors about his conduct and failing to disclose his dealings with
Barclays, under circumstances in which full disclosure was obviously expected
 Improperly using confidential information belonging to International to advance his own personal
interests and not those of International, without authorization from his fellow directors
 Urging Barclays to pressure Lazard with improper inducements to get it to betray its client,
International, in order to secure the board’s assent to the Barclays transaction
Majority or Controlling Shareholders:
 Majority or controlling shareholders are fiduciaries of the corporation and have duties to the corporation and its
minority shareholders
o Can’t make the corporation act in a manner than would benefit the fiduciary at the expense of minority
shareholders
o Majority Shareholder: owns more than 50% of a corporation’s outstanding voting rights
 Entire Fairness: fairness of the procedure developed to approve a transaction and the fairness of the price of the
transaction
 Williamson v. Cox Communications: establishes that a controlling shareholder owes fiduciary duties
o Controlling Shareholder: established when (1) a shareholder owns more than 50% of the voting power in
a corporation or (2) if she exercises control over the business affairs of the corporation
o If controlling status is established, entire fairness standard (instead of business judgment rule) applies.
Control evidenced by:
 Designation of directors or entering into business agreements with an investee
 Veto power
o Control Premium: those seeking control will pay a premium for their shares because they are receiving
control in exchange for increased price
Procedural Mechanisms to Limited Judicial Review
 In re Wheelabrator: ratification of breach of loyalty
o The effect of the informed shareholder vote was to extinguish a due care claim. The vote did not operate
either rot extinguish the duty of loyalty claim or shift to the plaintiffs the burden of proving the merger was
unfair, and the effect of the shareholder vote in this case is to invoke the business judgment standard, which
limits review to issues of gift or waste with the burden of proof resting on the plaintiffs
o Extinguishment Doctrine: fully informed vote extinguishes due care claim but does not extinguish breach
of loyalty claim. Extinguishment applies to:
 Directors act in good faith, but exceed the board’s de jure authority or
 Where the directors fail to reach an informed business judgment in approving transaction.
Ratification decisions involving the duty of loyalty:
 Interested Transactions: cases between corporation and its directors  ratification
invokes the business judgment rule
 Controlling Shareholder: cases involving a transaction between the corporation and its
controlling shareholder  ratification invokes the entire fairness standard in which the
burden to prove the merger was unfair shifts to the plaintiffs
o Merger didn’t involve an interested and controlling shareholder, therefore the business judgment rule
applies. Only interested stockholder = business judgment
Corporate Opportunities
 Corporate Opportunity Doctrine: diversion of corporate opportunities for the benefit of a corporate
director/manager. Competition between the corporation and the director/manager (Hollinger v. Black)
o Plaintiff must prove the opportunity belonged to the corporation. Tests:
 Interest or Expectancy Test: precludes acquisition by corporation officers of the property of a
business opportunity in which the corporation has a beachhead in the sense of a legal or equitable
interest or expectancy growing out of a preexisting right or relationship
 Line of Business Test: characterizes an opportunity as corporate whenever a managing officer
becomes involved in an activity intimately or closely associated with the existing or prospective
activities of the corporation
 Fairness Test: determines the existence of a corporate opportunity by applying ethical standards
of what is fair and equitable under the circumstances
Business Associations 23
Traditionally, courts won’t allow managers to take a corporate opportunity for themselves unless they could
prove the corporation consents or was unable to take advantage of the opportunity because of lack of cash
Broz v. Cellular Information: determining if a corporate fiduciary has usurped a corporate opportunity is factintensive and turns on, inter alia, the ability of the corporation to make use of the opportunity and the company’s
intent to do so
o While presentation of a purported corporation opportunity to the board and the board’s refusal thereof may
serve as a shield to liability, there is no per se rule requiring presentation to the board prior to acceptance of
the opportunity
 Presenting opportunity to board creates a safe harbor
 DE: board doesn’t have to formally decide it doesn’t want the opportunity
o Cannot take business opportunity for your own if:
 The corporation is financially able to exploit the opportunity
 The opportunity is within the corporation’s line of business
 The corporation has an interest or expectancy in the opportunity
 By taking the opportunity for your own, the corporate fiduciary will thereby be placed in a
position inimical to your duties to the corporation
o Can take business opportunity for your own if:
 The opportunity is presented to the director/officer in his individual and not his corporate capacity
 The opportunity is not essential to the corporation
 The corporation holds no interest or expectancy in the opportunity
 The director/officer has not wrongfully employed the resources of the corporation in pursuing or
exploiting the opportunity
o Corporate opportunity inquiry looks to circumstances that exist at the time the opportunity is presented.
It’s not necessary to consider speculative facts
Entire Fairness: components fair dealing and fair price.
o Fair Dealing: when the transaction was timed, how it was initiated, structured, negotiated, disclosed to the
directors, and how the approvals of the directors and the stockholders were obtained.
o Fair Price: economic and financial considerations of the proposed merger, including all relevant factors:
assets, market value, earnings, future prospects, and any other elements that affect the intrinsic or inherent
value of a company's stock
o


CHAPTER 11: LITIGATION TO ENFORCE DIRECTORS’ DUTIES*
Derivative or Direct:
 Distinction must turn solely on the following questions:
o Who suffered the alleged harm (the corporation or the suing stockholders, individually)?
o Who would receive the benefit of any recovery or other remedy (the corporation or the stockholder,
individually)?
 The Discredited (but easiest to understand) Test for Direct Injury
o Special Injury: a special injury is a wrong that is separate and distinct from that suffered by other
shareholders or a wrong involving a contractual right of a shareholder, such as the right to vote, or to assert
majority control, which exists independently of any right of the corporation
o Supreme Court; the special injury concept can be confusing in identifying the nature of the action as
directly or indirectly injuring the shareholders
 Compensation Problem in Derivative Litigation:
o In a traditional lawsuit:
 Plaintiff bears all costs of enforcement
 Plaintiff compensated for the harm
o In derivative litigation, the corporation is compensated for the harm done to it
 Results in a free rider problem
 Fixed by providing plaintiffs’ attorneys’ fees for convening a substantial benefit
 Strike Suits: pursuit of attorneys’ fees encourages bad claims
o Procedural hurdles
 Contemporaneous ownership & standing
 Demand requirement: in making a demand, the shareholder acknowledges the board’s
independence
- Demand is futile if a reasonable doubt that a majority of the board could have acted
independently in responding to the demand
- Independence:
Business Associations 24


Lack of independence: director is so beholden to an interested director that
his/her discretion would be sterilized
 Personal friendship: to render a director unable to consider demand, a
relationship must be of a bias-producing nature. Allegations of mere personal
friendship or mere outside business relationship, standing alone, are insufficient
to raise a reasonable doubt about a director’s independence
- Independent Committee: created if board as a whole is not independent
Court supervision
*We did not read this chapter. Notes are from powerpoint slide.
CHAPTER 12: FRIENDLY MERGER & ACQUISITIONS
Structuring an Acquisition: types of acquisitions  FORM MATTERS!
 Classifying the Transaction:
o Friendly Acquisitions: target’s board supports the transaction
 Deal Risks:
- Risk of third-party bid (Van Gorkom): addressed by contractual terms.
- Regulatory risks (ADS)
- Risk of adverse change (Hexion)
o Hostile Acquisition: target’s board resists the transaction
 Fiduciary Duties: does board have a valid reason to resist the transaction
 Conflict: shareholders want to sell if price is right; board wants to avoid takeover to keep their job
 Merger or Consolidation: all assets & liabilities of the company(ies) being merged out of existence transfer
automatically when (a) the boards of both companies approve a plan or merger, (b) the shareholders with voting
rights approve the plan of merger, (c) the surviving company files the pan of the merger in its state of incorporation
o Merger: one company is entirely subsumed by another through the operations of law. The surviving
company is one of the two companies that entered the process
o Consolidation: two companies use the statutory merger procedure to combine to form a new company
o Consideration for merger/consolidation is tock of the acquiring company, bonds, cash, securities of
another company or a combination of all of the above
 If stocks/bonds > 50% of the merger consideration, then it’s a nontaxable transaction for the
acquiring corporation, for the selling corporation and for the seller’s shareholders
 If cash > 50% of the merger consideration, then it is a taxable transaction
o Shareholder Vote: target company’s shareholders have right to vote because a merger/consolidation is a
fundamental change to the corporation; acquiror shareholders may have the right to vote if:
 Charter of the surviving company will be amended by the merger
 Rights/privileges attached to shares or the surviving company will be changed by the merger
 Surviving company is going to issue new shares of stock equal to 20% or more of the common
stock outstanding prior to the merger in order to pay for the merger
 Vote often avoided to protect the deal (time consuming & expensive)
o Triangular Merger: surviving co. establishes a wholly owned subsidiary and capitalizes the subsidiary
with the merger consideration. The subsidiary and the selling company then enter into a merger agreement,
which both boards approve, and the selling company’s shareholders vote on the plan. Now the only
shareholder of the acquiror that has voting rights is the parent company itself  eliminates acquiror
shareholder voting
o Short-Form Merger: parent company owns 90% or more of the stock of the target corporation. The
parent is allowed to merge the subsidiary into itself using simplified procedures  avoids vote of target
company’s shareholders
 Procedures: notify minority shareholders of target company that the merger has occurred, offer
them the merger consideration for their shares that the parent has determined is fair, and notify any
dissenting shareholders of their right to an appraisal
 Purchase of Assets: negotiated transaction to purchase specified assets and liabilities of another company
o Assets and liabilities do not automatically transfer – must be negotiated
o Procedure: both boards adopt resolutions authorizing the transaction. Once the shareholders have approved
the sale, the assets/liabilities agreed to in negotiations are transferred in exchange for merger consideration.
The selling board adopts a resolution dissolving the company, paying any creditors that have not agreed to
the substitution of a new debtor, cancelling the outstanding stock, and distributing any remaining proceeds
from the merger consideration to the selling company’s shareholders
Business Associations 25
o


Shareholder Vote: if selling company is selling substantially all of its assets, then its shareholders have the
right to vote to approve the sale
 Substantially All: neither voting rights nor appraisal rights are available if the company will be
left with at least 25% of its presale assets and either 25% of after-tax operating income or 25% of
revenues (MBCA) or sale of assets quantitatively vital to the operation of the corporation and is
out of the ordinary and substantially affects the existence and purpose of the corporation (DGCL)
 Dissenting shareholders in seller company have right to appraisal except if their shares are
publicly traded and they are receiving either cash or publicly traded shares (appraisal rights don’t
exist in DE)
 Purchasing company’s shareholders don’t have voting rights in purchase of assets transactions
o A sale of assets for cash is a taxable transaction for the selling shareholders (the cash will be treaded as a
dividend), while a sale of assets for stock is nontaxable
Purchase of Stock: (hostile or friendly) triggers the Williams Act
o Tender Offer: acquiror gains control of a majority or even all of the shares by making a tender offer
directly to shareholders to purchase their shares for a premium
 No shareholder vote required because shareholders are acting individually when tendering
 Usually successful
o Self-Tenders: corporation busy its own stock if a controlling shareholder attempts to buy stock by
squeezing out or cashing out minority shareholders
 Usually try to launch a tender offer in hope of obtaining >90% of shares (short-form trigger)
 If <90%, effect cash out merger of minority shareholders by getting board to adopt resolution
approving the agreement to merge. Puts merger to shareholder vote
o Williams Act: federal regulation of tender offers & stock purchases. Regulates:
 Disclosure of stock holdings
 Disclosure of tender offers
 Rules regarding the tender offer process
Appraisal: right to challenge the merger price
o Procedure: shareholders vote against the transaction, notify the company within specified time that they
will assert their appraisal rights, then assert rights within proper time
o Exception: shareholders have right to vote on a merger but start out with stock of a publicly held company
and end up with stock of another publicly held company. Wall Street rule applies.
Fiduciary Duties in Friendly Transactions: directors must fulfill the duties of care and loyalty in evaluating and approving
the transaction and must act in good faith. Also must disclose all material facts to the shareholders in a proxy statement
soliciting shareholders’ votes, or in the notice the company sends out describing the transaction (short-form merger)
 The Entire Fairness Standard: procedural fairness (fair dealing) and substantive fairness (fair price)
 The Independent Board Committees: used to protect controlling shareholder from taint of self interest
o Kahn v. Lynch Communications: can be a controlling shareholder without own 50% of a corporation if
you exercise domination over corporate affairs
 Domination triggers entire fairness review which must be proved by defendant unless an
independent, arms length transaction (approved by a special committee) occurs. This shifts the
burden of proving the merger was unfair to the plaintiffs
 Test re: Effectiveness of Special Committee:
- The majority shareholder must not dictate the terms of the merger
- The special committee must have real bargaining power that it can exercise with the
majority shareholder on an arms length basis
 Majority-of-the-Minority Provisions: increases the perceived fairness of the deal
 Tender Offers
o In re Pure Resources: differences in fiduciary duties between negotiated merger structure or tender offer
structure
 Tender offer was coercive because the majority of the minority provision included interested
members. Coercion forces stockholders to tend at the wrong price to avoid and even worse fate
later on.
 Going private: treated differently because of power (lack thereof) of shareholders
- Negotiated Merger: entire fairness standard (Lynch v. Cox Communications)
- Tender Offer: business judgment rule (Solomon)
o Tender is Non Coercive if:
 It is subject to a non-waivable majority of the minority tender condition
Business Associations 26


The controlling shareholder promises to consummate a prompt §253 merger at the same price if it
obtains more than 90% of shares
The controlling shareholder has made no retributive threats
Business Associations 27
CHAPTER 13: DEFENDING AGAINST HOSTILE TAKEOVERS
A Brief History of Hostile Takeovers
 Shark Repellents: defensive strategies to hostile takeover attempts
o Poison Pills: usually involve the distribution of rights to existing shareholders. Rights allow shareholder to
buy shares of the acquiring company or the target company at a deep discount if any bidder acquires a
certain percentage of the target’s shares without the board’s approval
 Immediately dilutes bidders stake in company by allow shareholders to buy more shares
 Impossible to buy control in tender offer
 Importance: can be adopted by board in response to identified threat and can be redeemed by
board by paying a nominal amount to the shareholders to allow a merger with a favored
acquisition partner
 Result: must negotiate with board or engage in proxy fight to elect a board that is committed to
replacing the current board and redeeming the pill
o Staggered Board: take two years to secure a majority coalition on the board because of the for cause
removal implications of a staggered board
o Supermajority Voting Requirements: used in fundamental transactions
o No Shop Clause: target board agrees not to solicit other bids or negotiate with other bidders. Rare because
it’s at odds with board’s fiduciary duty to get best deal for shareholders (Revlon duties)
o Window Shop Clause: target board agrees not to solicit other bids, but may negotiate with unsolicited
bidders. Still runs risk of violating Revlon duties
o Go Shop Clause: allows target board to solicit other bids for a specified period
 If board finds better deal, pay termination fee & accept deal
 Provides target board with evidence this was best available price
o Other Common Deal Protection Measures:
 Break-up fees & stock options
 Stockholder & management share lock-ups
 Force the vote provisions
 Tender Offer: bidder offers to buy enough shares in the target company directly from existing shareholders to exert
voting control and uses that control to elect its own directors
o Offers to buy shares at a premium and is made to all shareholders in their individual capacity
o Federal securities laws apply – bidders must buy shares pro rata from shareholders rather than buying
shares on a first-come, first-served basis, and that bidders must pay every shareholder who tends the
highest price in the tender offer
o Regulations seek to slow down the process and provide information to shareholders to make good choice
and allow shareholder to avoid feeling pressured to tender early
 Proxy Contest: bypasses board but needs to persuade a majority of shareholders to vote for the acquiror’s slate in
order to be successful
 Anti-Takeover Legislation: has slowed the number of hostile takeovers – used disclosure obligations, state
regulatory agencies that had to approve takeover bids, etc.
 Types of Takeovers:
o Bust-Up Takeovers: a company was purchased at a premium and then the different subsidiaries or
operating divisions were sold to pay off the debt incurred in buying the company
 Financed by junk bonds – takeovers go forward with little money of the purchaser (less than 10%)
and lots of debt
 Provided more money than banks would lend. Repayment depended on companies’ uncertain
future
o Leveraged Buyouts (LBOs): transactions with junk bonds called LBOs because of highly leveraged
financial structure
o Management Buyours (MBOs): similar to LBOs but with management funding the buyout – creates
special fiduciary duty issues because of conflict of interest
Delaware’s Intermediate Scrutiny of Defensive Measures
 Unocal v. Mesa Petroleum:
o Applicable when directors adopt defensive mechanisms against hostile takeovers
o Directors must demonstrate a reasonable basis for perceiving a threat to corporate policies or effectiveness
o The defensive measures taken must bear a reasonable relationship to the threat and not be coercive or
unduly preclusive
 Unocal Applied
Business Associations 28
Omnicare as application: “The NCS directors must first establish that the merger deal protection devices
adopted in response to the threat were not ‘coercive’ or ‘preclusive,’ and then demonstrate that their
response was within a ‘range of reasonable responses’ to the threat perceived.”
o “Deal protection measures must be reasonable in relation to the threat and neither preclusive nor
coercive. The action of the NCS board fails to meet those standards because, by approving the Voting
Agreements, the NCS board assured shareholder approval, and by agreeing to a provision requiring
that the merger be presented to the shareholders, the directors irrevocably locked up the merger. In
the absence of a fiduciary out clause, this mechanism precluded the directors from exercising their
continuing fiduciary obligation to negotiate a sale of the company in the interest of the shareholders.”
o Paramount v. Time as application: “defensive devices adopted by the board to protect the original merger
transaction must withstand enhanced judicial scrutiny under the Unocal standard of review, even when that
merger transaction does not result in a change of control”
Revlon applies when:
o When a corporation initiates an active bidding process seeking to sell itself or to effect a business
reorganization involving a clear break-up of the company;
o Where, in response to a bidder’s offer, a target abandons its long-term strategy and seeks an alternative
transaction involving the break-up of the company
o When approval of a transaction results in a “sale or change of control.” [[There is no “sale or change in
control” when “‘[c]ontrol of both [companies] remain[s] in a large, fluid, changeable and changing
market.’”]]
o Then, Directors have the enhanced burden of achieving the highest value reasonably available for
stockholders
Revlon Duties:
o Revlon requires the board to get the best price for the shareholders once the board has decided to sell the
Company
o There is no “blueprint” as to how the board obtains the “best price”. An active auction is not necessarily
mandated. [Barkan v Amstad] The board can adopt any “reasoned” course of action to maximize
shareholder value.
o Must be a reasonable uninhibited market check. Must not be conflicted or prejudiced against a competing
offer.
o Go Shop provisions allow the Target Company to negotiate a sale of the Company, and still fulfill its
Revlon duties, subject to receiving a better offer during a “Go Shop” period.
Difference between Revlon & Unocal:
o Revlon: Obligation to Maximize Value
o Unocal: Obligation not to Preclude Competitive Bids
o



Refining Intermediate Scrutiny
 Intermediate Scrutiny: board isn’t given the benefit of the business judgment rule at the outset but also isn’t under
a burden to prove the entire fairness of the transaction at the outset
o Analysis: (1) threat analysis: the board must show that it had reasonable grounds to believe there was a
threat to an important corporate policy from an offer and (2) proportionality review: the board must show
that the means used to defend against the threat were proportionate to the threat
o Threat: did the board act in good faith and pursuant to a reasonable investigation in determining that there
was a threat posed to the shareholders or to an important corporate policy by the takeover bid?
 Burden of proof is shifted to defendants under Unocal
 Directors almost always prevail on this part
o Proportionality Review: substantive review of board decisions by the court
 Were the challenged defensive actions coercive or preclusive?
 Coercive: if it is aimed at cramming down on its shareholders a management-sponsored
alternative to an outside bid
 Preclusive: if it prevents any bidder from being able to successfully take over the
company, including by using a proxy contest
 If the board’s action is neither coercive nor preclusive, the court must still evaluate the action to
determine whether it falls within the range of reasonableness?
 In determining the range of reasonableness, courts defer to board decisions
 Hard for plaintiffs to meet the burden in light of the business judgment deference
 Reconciling Blasius & Unocal: when the primary purpose of a board’s defensive measure is to
interfere with or impede the effective exercise of the shareholder franchise in a contested election
Business Associations 29

for directors, the board must first demonstrate a compelling justification for such action as a
condition precedent to any judicial consideration of reasonableness and proportionality
Omincare v. NCS Healthcare: deal protection devices adopted interfered with the shareholders’ right to vote
because they were designed to coerce the consummation of the merger and preclude the consideration of any
superior transaction
o Directors’ actions weren’t within a range of reasonableness to the threat of losing the Genesis offer. Deal
protection devices are unenforceable
o Board didn’t negotiate a fiduciary out
 Waives a no shop or similar provision when a counsel advises that board of a risk that a court will
later find that the agreement was unreasonable
 Allows the board to not recommend a deal when it no longer believes that transaction is in the best
interests of shareholders
 A reasonable termination fee is permissible. Court will review the reasonableness of the fee as
liquidated damages.
o Not a change of control action – Revlon does not apply
Change-of-Control Transactions
 Paramount v. Time: applies Unocal & Revlon to a merger
o Time’s decision that Paramount’s offer posed a threat to corporate policy and effectiveness did not lack
good faith nor was dominated by motives of either entrenchment or self-interest. Actions weren’t aimed at
cramming down on its shareholders a management-sponsored alternative, but rather had as its goal the
carrying forward of a pre-existing transaction in an altered form
o Board can pursue long-term goals over short-term value because corporate action has no time frame
o Revlon duties don’t apply because no change of control will occur. Warner negotiations didn’t result in the
inevitable break up of Time
o Unocal Applies: threat to Time’s culture; no-shop clause is a reasonable response to the threat
 Paramount v. QVC: sale of control implicates enhanced judicial scrutiny of board conduct under Unocal & Revlon.
The conduct of Paramount was not reasonable because it didn’t pursue the highest valued transaction
o The business judgment rule applies but it must satisfy enhanced scrutiny because it involves:
 Approval of a transaction resulting in the sale of control
 The adoption of defensive measures in response to a threat of corporate control
o Enhanced Scrutiny Justified:
 Threatened diminution of the current stockholder’s voting power
 The fact that an asset belonging to public stockholders (control premium) is being sold and may
never be available again
 The traditional concern for actions which impair or impede stockholder voting rights
o Sale of control  obligation to get the highest value for your shareholders!
 Must be informed to get the highest value
 Cannot consider non-monetary issues (strategic vision) because you won’t be in control to ensure
that it occurs (rejects Time)
 Must evaluate each offer
 Defensive measures improperly designed to deter potential bidders do not meet the reasonableness
test. Board can’t contract out of its fiduciary duties!
State Anti-Takeover Legislation
 Other Constituency Statutes: in the exercise of their fiduciary duties, when considering defensive measures,
directors may consider the potential impact of a takeover not only on shareholders, but also on employees, creditors,
consumers, and communities
o 2/3 of states have adopted these statutes
o DE doesn’t have one, but provides the same discretion through its decisions (See Time)
 Moratorium Statutes: impose a moratorium on a business combination where the bidder busy a specified level of
the target’s stock, unless the merger was initially approved by the target’s board
o DE: trigger is 15% of stock & a moratorium of 3 years, unless the bidder acquires 85% of the stock at the
same time it crosses the 15% threshold, in which case the statute does not apply. Only applies to mergers
o NY: trigger is 20% of stock & a moratorium of 5 years. Business combination includes mergers,
liquidations, or substantial sale of assets.
 Control Share Statutes: provide that a majority of disinterested shareholders must approve the acquisition of a
control block of shares, usually 20%. Corporations may opt out of this statute
Business Associations 30


Fair Price Statutes: require either a supermajority vote for the second step in a two-step merger between the target
and an interested party (purchaser of 10% of shares or more), or require that the price paid in the second step be as
high as the highest price paid in the first step. Corporations may opt out of this statute with a charter amendment
approved by a supermajority vote
CTS v. Dynamic Corp: upheld Indiana’s control share acquisition statute
o Inquiry: whether the state law stood as an obstacle to the accomplishment of the Congressional purpose
underlying the Williams Act
 Purpose of Williams Act: protect independent shareholders from both the offeror and target
management
 Protects shareholders from the coercive aspects of certain tender offer tactics, especially an unfair
or inadequate two-tier offer
o Dissent: Act was intended to protect investors, as opposed to shareholders
 Each investor should have the right to make his/her own decision. Statute removes this right
because it considers shareholders as a group. This frustrates the will of individual shareholders in
violation of the Williams Act
o In response DE passed DGCL §203: a DE target may not engage in a business combination for a period of
three years after an offeror becomes an interested stockholder.
 When the Three-Year Freeze is Applicable:
- Prior to the date on which the bidder crosses the 15% threshold, the business combination
or the triggering acquisition is approved by the target’s board of directors; OR
- The bidder, in a single transaction, goes from less than 15% to more than 85% of the
target’s voting stock (not counting shares owned by inside directors or by employee stock
plans in which the employees do not have the right to determine confidentially whether
shares held by the plan will be tendered); OR
- During the three year freeze period, the transaction is approved by the board of directors
and by the two-thirds of the outstanding shares not owned by the bidder; OR
- The target’s board of directors approves a “white knight” transaction.
 No restrictions once freeze period ends
 Fewer restrictions on bidder’s use of target assets to finance an acquisition in connection with
older business combination statutes
 Constitutionality: states must preserve a meaningful opportunity for hostile offers to succeed
CHAPTER 14: REGULATION OF DISCLOSURE, FRAUD, AND INSIDER TRADING
Section 10(b) & Rule 10-5
 §14(a) & Rule 14a-9: private cause of action for any material misstatement or omission in a proxy communication
 §10(b) & Rule 10b-5: cause of action for fraud for any material misstatement or omission in connection with the
purchase or sale of securities that has caused damages
o Includes statements in: (1) required disclosures – annual reports, (2) public statement of a company’s
authorized agent – press releases
o Often deals with insider trading
o Security: any investment using money or other considerations
 Elements of a Cause of Action: (1) misstatement or omission of a (2) material fact on which the plaintiff (3) relied
(4) in connection with the (5) purchase or sale of securities, (6) causing (7) damages.
o Interpreted to deal with the accuracy of disclosure and not corporate governance or enforcing fiduciary
duties - See Santa Fe v. Green (1977)
o Increasing importance in corporate governance because disclosure brings to light conflicts of interest and
enhances shareholder power
 Sarbanes-Oxley federalizes some aspects of corporate governance
o Proxy statements must be full & complete. The hard thing to show is that the misstatement or omission is
material.
 Misstatements & Omissions
o Plaintiffs must first show that the defendant misstated a material fact or omitted to state a material fact
necessary to make the statements that were made not misleading
 Omissions challenging because silence, absent a duty to speak, is not misleading under Rule 10b5. Don’t always have a duty to speak about all things.
 Duty to Speak: arises because a company is selling new securities and needs to file a prospectus
(disclosure statement)
Business Associations 31
-


Governed by Rule 408: requires additional disclosure necessary to make the statements
not misleading that are made in response to line-item disclosure under Regulation S-K
- Other times speech is required: (1) filing quarterly reports, (2) repurchasing stock, etc.
- Failure to speak creates liability!
o No duty to disclose every material event immediately
 Form 8-K: required disclosure within four business days of an event
 SOX §409: requires continuous disclosure
o Gallagher v. Abbott Laboratories: there’s no continuous disclosure requirement. Duty to disclose
information only when firms are issuing securities or when periodic reports are due (annually/quarterly)
Materiality & Reliance
o Material: a fact a reasonable investor would consider significant in the total mix of information available
about a company
 Fact and context-specific
 Concern over speculative or future facts – protection of investment
 Rule 10b-5 has an outcome determinative test – would it influence a shareholder
o Fraud: (common law) plaintiffs must show that they relied upon a material misstatement of fact to their
economic detriment
 §10(b) expands the scope of common law fraud
 PROBLEMS: (1) reliance is based on a face-to-face transaction and (2) how can one rely on an
omission?
o Basic v. Levinson: An investor who buys or sells stock at the price set by the market does so in reliance on
the integrity of the at price. Because most publicly available information is reflected in market price, an
investor’s reliance on any public material misrepresentations therefore, may be presumed for purposes of a
Rule 10b-5 action.
 Court adopted materiality standard for Rule 10b-5: an omitted fact is material if there is a
substantial likelihood that a reasonable shareholder would consider it important in deciding
how to vote
 Theories of Materiality:
- Agreement-in-Principle: preliminary merger discussions do not become material
until agreement in principle as to the price and structure of the transaction has been
reached – theory rejected!
1. Too much information overwhelms investors & makes them overly
optimistic the merger will be completed – rejected! Investors aren’t dumb.
SEC rules promote caveat emptor, not paternalism!
2. Secrecy is necessary to complete mergers – rejected! Confidentiality
doesn’t justify depriving investors of material information re: mergers
3. Bright-line rule favored – rejected! Ease of disclosure for managers
doesn’t justify depriving investors of information
- Probability/Magnitude: balance the magnitude of the event in the corporation’s life
v. the probability it will go through. The greater magnitude or probability, the earlier
material information must be disclosed. This is a fact-specific inquiry!
 Standard Adopted: materiality depends on the significance the reasonable investor would
place on the withheld or misrepresented information.
 Fraud-on-the-Market: price of a company’s stock is determined by the available material
information regarding the company and its business. Misleading statements will therefore
defraud purchasers of stock even if the purchasers do not directly rely on the misstatements.
Treat market reliance like direct reliance of misrepresentation
- Explains how class could be certified – all relied therefore no individualized facts to
establish direct, personal reliance
- Today’s business takes place on the market, reliance reasonable  market acts as
agent of investor
- This presumption is adopted!
 Rebutting the Presumption: any showing that severs the link between the alleged
misrepresentation and either the price received (or paid) by the plaintiff, or his decision to
trade at a fair market price, will be sufficient
Scienter: defendant’s omission or misstatement of material fact was made with the intent to deceive
o §10(b) requires knowing or intentional misconduct: don’t want to impose liability for wholly faultless
conduct where such conduct harms investors
 Fraud > negligence
Business Associations 32
 Recklessness sufficient for §10(b) purposes
Private Securities Litigation Reform Act: amended regulations to make §10(b) actions harder to bring
 Pleading Requirement: plaintiffs must state facts that provide a strong inference that the
defendants acted with the required mental state to set out a cause of action
o Tellabs v. Makor Issues: inference of scienter must be more than merely plausible or reasonable – it must
be cogent and at least as compelling as any opposing inference of nonfraudulent intent
 Pleading standard: (1) specify each statement alleged to have been misleading and the reason or
reasons why the statement is misleading and (2) state with particularity facts giving rise to a strong
inference that the defendant acted with the required state of mind
In Connection With
o SEC v. Zandford: expands scope of in connection with
 SEC complaint describes a fraudulent scheme in which the securities transactions and breaches of
fiduciary duty coincide. Those breaches were therefore “in connection with” securities sales
within the meaning of §10(b).
- Flexible reading of SEC rules justified to protect investors
- Must be narrow enough so every common-law fraud isn’t a violation of §10(b) but broad
enough to protect investors
Causation: plaintiffs must allege and prove that the defendant’s misstatement or omission caused the financial loss
of which plaintiff’s complain
o Transaction Causation: refers to the requirement that plaintiff allege and ultimately prove that the
misstatement or omission caused the plaintiff to engage in the transaction in the first place
 Subsumed in the reliance element of Rule 10b-5 See Basic v. Levinson
o Loss Causation: refers to the requirement that plaintiff allege and ultimately prove that her financial loss
was caused by the misstatement or omission
 Met by showing the stock price dropped after the true facts about the company emerged
o Dura Pharm. V. Broudo: law requires the plaintiff to prove the defendant’s misrepresentation proximately
caused the economic loss. Must show price was effected by disclosure
 Difference in purchase & sale price doesn’t prove economic loss
 Securities laws aren’t investment insurance
o


Insider Trading
 The Classical Theory: corporation insiders’ unfair use of corporation information to make a profit at the expense of
outsiders who couldn’t possibly, by dint of hard work, discover the information
o Prohibition anchored to fiduciary duty that was imported to securities law
 Duty to disclose or abstain
 SEC v. Texas Gulf Sulpher: company bought land when it discovered minerals on local lands.
Insiders purchased stock knowing when the discovery went public, stock prices would increase.
This violated §10(b). Anyone in possession of material inside information must either disclose it
to the investing public, or must abstain from trading.
o Misappropriation: prohibits some people outside the firm from trading without disclosure of material,
non-public information where that information has been misappropriated in violation of fiduciary duties to
the source of the information
o United States v. Smith: Rejects the knowing possession standard for insider trading violations in favor of a
use standard. Rule 10b-5 requires that the government (or the SEC) demonstrate the suspected insider
trader actually used material nonpublic information in consummating his transaction.
 Under Basic v. Levinson, information is material if a reasonable investor would have considered it
useful or significant  forecasts are material.
 Soft, forward-looking information can be material based on the probability/magnitude test
 Use v. Possession:
- Use: 11th Circuit – adopted by the 9th Circuit in this case  must use the information
under the classical theory to establish liability
- Possession: adopted by SEC & 2nd Circuit – possession is sufficient to establish scienter
because it comports with the duty to disclose or abstain and it’s likely an insider who
trades will unconsciously use information even if not intentional
 Use is required because it comports with the requirement of scienter (deceptive/manipulative)
requires use. Knowing possession is < scienter.
 The Misappropriation Theory
o For insiders, the duty to disclose arises from the fiduciary duty every agent owes his principal. But,
outsiders to a company owe fiduciary duties to the company, not the shareholders individually.
Business Associations 33
o
o
Grounds for liability on deception based on a breach of fiduciary duty between an agent and a principal, not
on a breach of a fiduciary duty of disclosure between a company insider and the buyer and seller of stock
United States v. O’Hagan: endorses the misappropriation theory – criminal liability under §10(b) may be
predicated by the misappropriation theory
 Deceiving the principal (law firm) by using its confidential information in connection with the
purchase of securities
 Disclosure is an affirmative defense
Regulation FD
 Insider Trading Sanctions Act of 1984: makes it illegal to trade options and other derivative securities in
circumstances where it would be illegal to trade the underlying security
 Insider Trading & Securities Fraud Enforcement Act of 1988: mended the Exchange Act to provide a remedy
for contemporaneous traders against any person who violates any provision of this title or the rules or regulations
thereunder by purchasing or selling a security while in possession of material, nonpublic information
o Requiring insiders to disgorge any profits from short swings in their company’s stock – purchase followed
within 6 mo. by a sale or vice versa
 Regulation Fair Disclosure: states that if a company discloses material, nonpublic information to brokers or
dealers, investment advisers, securities analysts, etc. it must publicly disclose the same information either
simultaneously, in the case of intentional disclosure, or promptly, in the case of non-intentional disclosure
o SEC attempting to create a level playing field for all investors and close loophole created by Dirks v. SEC
(1983), allowed tippee to avoid liability if he didn’t breach fiduciary duty to the company or personal
benefit from the disclosure (discussing with securities analysts). There’s no breach by tipper and thus no
derivative breach by the tippee
 SEC v. Siebel Systems: comments privately made but based on publicly disclosed information do not violate
Regulation FD.
o SEC shouldn’t be nit-picky or it will result in a chilling effect which will undermine the regulation
o Don’t need to repeat information privately that has already been publicly disclosed
o Material Matters:
 Earnings information
 Mergers, acquisitions, tender offers, joint ventures, or changes in assets
 New products or discoveries
 Changes in control/management
 Change in auditors or auditor notification that the issuer may not longer rely on an auditor’s report
 Events regarding the issuer’s securities
 Bankruptcies & receiverships
Fiduciary Duty of Disclosure under State Law
 Duty of Disclosure/Candor: can’t protect shareholder right to vote unless shareholders are informed prior to vote
o Complete candor is required in conflict of interest situations
o Breached if there is a failure to disclose all material information that a reasonable stockholder would
consider important in voting
 PLSRA & DE Law:
o PLSRA increased pleading standard making it harder to bring a disclosure action in federal court. In
contrast, DE doesn’t require proof of reliance, causation, or quantifiable monetary damages.
o DE provides damages for almost any breach of fiduciary duty of disclosure  undermines PLSRA
o Securities Litigation Uniform Standards Act of 1998 (SLUSA): purpose was to preempt state securities
fraud class actions.
 DE Carve Outs: federal government refused to preempt all DE law in this are. DE Courts went
on to determine directors have a fiduciary duty to speak honestly any time they disclose
information to shareholders
 DE courts refuse to recognize fraud on the market – See Malone
 State Fiduciary Law – Action Requested: duty of disclosure in the context of a request for shareholder action.
Obligation to provide the shareholders with accurate and complete information material to a transaction or other
corporation event that is being presented to them for action
o Duty of disclosure is a term of art that does not apply to all situations when disclosure is at issue
 State Fiduciary Law – No Action Requested: directors owe a fiduciary duty even when no shareholder action is
requested
Business Associations 34
o

When directors disseminate information to stockholders when no stockholder action is sought, the fiduciary
duties of care, loyalty and good faith apply. Dissemination of false information could violate one or more
of those duties
Merrill Lynch v. Dabit: SLUSA preempts state class actions for securities fraud resulting from failure to disclose.
PLSRA & SLUSA shouldn’t be used to avoid federal court.
o All class actions preempted – avoids parallel actions
Business Associations 35