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Professor Dan Danielsen
Tuesday, May 27, 2003 (Class 1)
- Take home exam distributed on last day of class, due last day of exam period (50% of evaluation).
- 3 very short papers (25% of evaluation).
- Group participation (25% of evaluation).
- Revised Modified Business Corporate Act and Delaware Law are only law we will study; RMBCA is only one needed for exam.
Purposes of Corporation
- Facilitate risk spreading
- Collect capital
- Limit liability
- Separate ownership from day-to-day operations
- Independent existence
- Generate revenue
- Enable state to regulate economic activities
- Facilitate public ownership -- sale of stock coupled with limited liability
- Common rules and expectations
- Governance structure: designed to structure relationship between shareholders and managers.
- Maximizes shareholder value/returns
- Can't do business with "corporation" per se; interact with managers, president, employees, etc.. Constituency may have complex motivations and interests may not be all aligned.
- Corporation has no existence outside of legal structure.
- Four primary characteristics of corporation:
- Separate entity with perpetual existence
- Limit investor liability to amount invested in business
- Centralized management (shareholders need not be involved in management)
- Transferability of ownership interests; corporation continues regardless of whether investors sell shares
William T. Allen, Our Schizophrenic Conception of the Business Corporation
[14 Cardozo L.Rev. 261] 1992
- Property conception: only to make money
- Social, institution conception: corporations control wealthy, structure relationships, have impact on people's lives, and thus are social institutions, and should be regulated in the public interest.
- Much of corporate law is managing tension between property and social institution conception.
History of corporate law
- Early corporations were charities, churches, etc..
- Charter needed to be signed by King
- Could be revoked at any time
- Business associations: originally took form of guilds (like ABA)
- If you met requirements, you could practice in guild for yourself.
- Quasi commercial corporations began to appear in early 17th century, focused on foreign trade
- License granted by King to carry out functions in foreign places, performed many public functions
- Evolved out of colonialism
- United States corporations followed history; started as quasi-public entities, including churches and charities, but also public-private partnerships: toll roads, canals, transportation lines.
- Corporations created on case-by-case basis by legislature.
- Granted monopoly.
- With railroads, corporations grew quickly, concern in state legislatures.
- State legislatures started to include special regulations in charter.
- Corruption between corporations and legislatures because of nature of legislative grant of exclusive rights.
- Populist rebellion: move from specific legislative grants to free incorporation (right rather than privilege).
- 1888: New Jersey passed bare minimum comprehensive corporation law.
- 1916: Woodrow Wilson, worried about corporate power, repealed much of New Jersey corporate law.
- 1899, amended after 1916: Delaware passed corporation law most 'open' to corporations.
- Delaware became predictable place to run a corporations, attracted many companies.
- Most statutes have moved in direction of Delaware: allow general corporations.
- Tension between goal of maximizing shareholder value and providing accountability between various constituencies and between corporation and society
- Some scholars argue that these goals are best achieved by minimizing regulation entirely
- How to regulate complicated socioeconomic, political, legal entity?
- Procedural or Structural (create the system and let things happen).
- Voting rights
- Separation of powers between shareholders and managers.
- Regulatory or punitive
- Criminal laws
- Fiduciary duties
- Liability for securities violations
- Exit vs. Voice (economist Herschman)
- Exit: If you are dissatisfied, you can leave--sell shares, which will punish company and encourage it to change its ways
- Those who argue for deregulation say all you need is to be able to exit.
- Voice: Stay in institution and express yourself. Depends on likelihood that someone will listen.
- Availability of exit decreases probability of using voice.
- Loyalty issue effects action as well.
Wednesday, May 28, 2003 (Class 2)
Hypothetical firm: "Omega"
- Separate existence, perpetual life
- Maximize total returns by maximizing efficiency, minimizing costs
- What incentives would be needed to make actors behave properly? Proper level of monitoring/accountability.
- What about installing surveillance system of cameras?
- If cost of surveillance system per month is $100, and loss to Omega from employee theft was $50, then Omega still shouldn't put in system.
- Corporate lawyer does not represent the shareholders, customers, employees, employers, etc.; instead represents the abstract entity known as corporation, and tries to advise on what is best for corporate entity.
- Assumption of alignment of interests--that investors, managers, employees all want to maximize long term value.
- One person owns business ("O"), doesn't want to work, and other person will work ("W").
- O's ability to metabolize risk/diversification
- What's at stake for each person
- Time horizon: long term or short term
- Obtaining returns
- Relationship between entities--sharing profits/sharing risks (allocation of responsibility and risk)
- Stage of life
- Product diversification
- Alternatives for O and W
- Risks: controllable vs. uncontrollable
Friday, May 30, 2003 (Class 3)
- Tuesday: Groups 1-5 on, groups 11-15 client'
- Wednesday: Groups 6-10 on, groups 1-5 client
- Friday: Groups 11-15 on, groups 6-10 client
Theory of Firm
- Analysis of motivations and risk tolerance of primary constituents of business
- Rational individual: each person is expected to maximize happiness, etc., and minimize loss
- Economic theory tries to build analogy between individual and firm
- Problem with theory: managers might not be able to tell what employees are doing; board might send instructions to management that are disregarded (versus analogy of individual--left hand, right hand, brain).
- Contracts and business regulation, from business perspective, to monitor to make sure all parts of business are acting together. Assumption is that parts work together; so regulation and contracts manage at margin.
- Even in simple case (wine grower and worker from last class) there are many variables and gaps in knowledge.
- In face of these uncertainties, economic model shifts from descriptive to predictive: note that everyone fits the model, but that most people do.
- Business and business law is about managing uncertainty left over from predictions.
- Business lawyer: use skills to advise business person how to implement predictions.
- When someone wants to do something that is illegal, business lawyer's job is not just to tell them that it is illegal, but to find way to do it legally.
- Questions to ask:
- What are client's business objectives?
- What are motivations for doing it?
- What are available strategies for achieving objectives?
- Which are legal?
- What are costs and benefits associated with each strategy?
Basic Concepts and Terms
- Four main sources of corporate law:
- State corporation statutes
- Case law
- Articles of Incorporation/Charter?
- Client influeces articles and bylaws, but not statute or case law
- Number of shares
- If there is more than one class of stock, needs to be specified
- Special voting requirements
- Restrictions on power of board
- Can be more stringent than statute but not less (e.g., require 2/3 majority for merger even if statute requires majority; but not vice-versa)
- Frequently harder to change than bylaws
- Procedural guidelines for governance of corporation
- Board is given fair amount of discretion, within limits of statute, case law, articles, and bylaws
- Common stock: residual interest in corporation on liquidation after all other creditors have been satisfied
- Authorized stock: how much stock can be issued
- Outstanding stock: actually issued
- Debt securities: bonds, etc..
- Sometimes difficult to tell difference between debt and equity
- Fiduciary duties: generally arise from case law
- Movement to include indemnification in statutes: if board is sued for breach of fiduciary duties and board wins, then legal costs are covered.
- Exculpation provision: need to be supernegligent to be held liable.
- These statutory provisions control articles and bylaws
Duty of Care
- Directors need to act is with same caution they would use in their own affairs.
- Directors are not insurers.
- Want to encourage risk-tasking.
- Must take "reasonable care"; broad latitude. Liability is incurred closer to "no care/self interest" on care spectrum.
- Business judgment rule: presumption that law won't hold directors liable for honest mistakes and good faith effort.
Duty of Loyalty
- Director owes full and complete loyalty to corporation; prohibits "self-dealing"
- Can't serve "two masters"
- Usually when director perceives conflict of interest, will disclose that to board and refrain from voting on matter
- If shareholder can demonstrate actual conflict of interest, court will apply strict scrutiny to board's actions.
Chesapeake Marine Hypothetical
- Firm with one director ("Apple") who owns more than 1/3rd of shares, as well as substantial stock of competitor, Lambert family owns remainder of stock, but no one more than 200 shares.
- Board wants to issue more shares to raise capital, Apple opposes.
- We represent "corporation": directors and shareholders can both be indicative of corporation's interest.
- Business judgment rule: as long as directors have acted in good faith with due diligence, unlikely to be fiduciary duty lawsuits.
- No fiduciary duty of shareholder to corporation
- Only duty is when majority shareholders abuse minority shareholders
Tuesday, June 3, 2003 (Class 4)
- Two handouts
- Chart comparing corporate entities
- Problem for Friday on Financial Accounting (replacing problem in casebook)
Chesapeake Marine Services Part I Cont'd
- As long as directors act in good faith and in the best interest of corporation, no risk of liability for breach of fiduciary duty.
- Reason for capping shares in Articles: protects shareholder control of company; keeps investment units at reasonable amount.
- Board has authority to sell authorized but unissued shares, thus diluting interest of current shareholders.
- Authority of corporation is vested in board; in certain extraordinary circumstances shareholders vote. When statute conflicts with articles, usually statute will control, but statute does not prevent more stringent requirements.
- If Apple votes against issuing stock, there should be no liability, because shareholders only vote their own self-interest. Exception: when majority abuses minority shareholders. No shareholder fiduciary duty.
- If Apple is acting in role of director, fiduciary duty would arise.
- Corporations are made up of multiple constitutencies; they can have good faith or bad faith motives; agendas can influence idea of what's in the best interest of corporation.
- Business judgment rule: allows boards to move almost with impunity. Even if they are completely wrong in their judgment, they're not liable.
- Board behavior circumscribed by fiduciary duties: if they act fraudulently against corporation (MCI-WorldCom?), or if they become too complacent (Enron).
- Since management doesn't bear risk of corporation, shareholders must bear risk.
- Doctrine requires parties acting in multiple roles to bifurcate their identity: when acting as board members, should think only about what is best for corporation.
Equitable Limitations of Legal Possibilities
- "Bookends" as to how creative you can be as a legal advisor
Schnell v. Chris-Craft Industries, Inc.
[285 A.2d 437] 1971 Delaware Superior Court (cb47)
- Group of unhappy shareholders sought to initiate proxy contests to replace board of directors
- Board amends bylaws to schedule annual meeting on different day, and then reschedule meeting a month earlier in difficult to access location.
- Shareholders challenge director's actions on equitable grounds
- No other business purpose for moving meeting other than to disrupt vote, thus not permissible.
Bove v. Community Hotel Corporation. of Newport, R.I.
[<<105 R.I. 36249 A.2d 89] 1969 Rhode Island Supreme Court (cb49)
- Preferred shareholders are due 24 years of unpaid dividends before corporation could pay dividends on common stock.
- Unanimity of preferred shareholders required to amend the charter.
- Directors created new corporation, merged old corporation into new to get rid of preferred stock.
- Independent legal significance: each provision of the corporate statute stands on its own. Just because something can be done under one section but not under another does not make it illegal.
- Schnell and Bove are "bookends" of permissible corporate active. In particular, when directors act to interfere with shareholders' voting rights, court might act equitably to prevent.
Chesapeake Marine Services Part II
- Financial aspects
- Value of Shipyard = fair market value of shipyard divison plus cash from stock sale = $150/share
- Lamberts purchased shares at $100/share
- Chesapeake price is $187.50/share
- Under Bove, wouldn't matter if directors have bad motives. As long as corporation is statutorily authorized to take action, then independent legal significance doctrine would allow them to do indirectly what they couldn't do indirectly.
- But from fiduciary duty perspective, motive would be examined: does it make sense for Chesapeake to pay nearly twice as much as Lamberts pay?
- If there is a conflict of interest, court will apply strict scrutiny, hard to justify difference in stock price.
Wednesday, June 4, 2003 (Class 5)
Chesapeake Marine Services Part II Continued
- Lamberts purchased stocks at nearly half the price as charged to Chesapeake, depending on how assets are valued. Using Fair Market Value for shipyard assets, Chesapeake pays $187.50 per share, while Lambert and investors pay $100 per share. If book value is used, then cost per share would be equal.
- Assessment of share prices is, itself, a business judgment.
- Business judgment rule protects decisions unless there is self-dealing.
- Advice to client: if you want to avoid litigation, need to restructure transaction:
- Increase number of shares given to Chesapeake, or decrease number of shares given to Lambert, to equalize numbers
- Bolster business judgment by showing value is less
- Offer shares to Apple at $100 per share--makes self dealing go away.
- Don't offer shares to Lambert or Apple, just sell shares to third party investors
- Used to be that shareholders had preemptive right to purchase new shares, rule is no longer in place.
- "Fairness" is relative--if Apple had opportunity, then all shareholders would be treated equally, even if price is "too low."
Choice of Organizational Form
- Need snapshot of present moment and idea of where business might go to pick organizational form.
- Example: want to start law firm. Major input is human capital. Unlikely to have future need for capital. General participation in management by partners may be desirable. Partners taxed on earnings whether distributed or not. Partnership is typical form.
- Manufacturing concern: needs regular and continuous investment in business. Ability to sell stock or debt securities could be important. Centralized management may be important. If company keeps earnings rather than distributing, no tax consequences to shareholders. Corporation form.
- Corporations generally cheaper to form because they can take "off the shelf" form.
- When stock in corporation is transferred, both ownership interest and voting/control rights are transferred.
- With other forms, economic interest can be separated from control interest.
- If all profits are given out (e.g., law firm), corporation would require "double taxation", thus partnership would be preferable.
- If law firm partners want to do additional real estate business, however, partnership would be bad because partners would be taxed on income when it came into partnership even if they don't actually get the money.
- S-Corporation: small, closely held corporation. Maximum of 35 shareholders, must be individuals. Only has one class of stock. Limited liability, but treated as partnership for tax purposes. Could convert to regular corporation later, unlike LLC.
Precision Tools Problem
- Business will operate at a loss early on
- Will need capital to expand business, probably from outside sources
- Bernie is retiring, probably wants limited liability.
- None of the investors can absorb large risk.
- Might want to be able to retain earnings to business without tax consequences to themselves. (but also see early losses).
Friday, June 6, 2003 (Class 6)
Continuation of Precision Tools: Which form to use?
- If company requires ongoing reinvestment of profits, some perform corporation, because earnings have no tax implications for shareholders.
- Limited Partnership (with corporation as general partner (Jessica and Michael as shareholders), and Bernie as limited partner)
- Limited liability
- Bernie liimted participation in management
- Flow through tax treatment--Bernie can take corporation losses against his income (does not necessarily benefit Jessica and Michael)
- Bernie can't make management decisions, or he will turn into a General Partner
- Partnership ends when general partner withdraws
- Bernie can transfer economic interest, but not control interest
- Limited Liability Corporation
- Flexibility in governance structure
- Continued Existence
- Choice of tax treatment
- If you elect corporate tax setup, usually chosing LLC for other reasons than tax.
- If you chose patnership tax setup, might be doing this for tax reasons... (?)
- Can be harder to find investors for LLC.
- Limited liability
- Bernie on board
- Easier to raise funds
- Quick and easy to set up
- Unlimited life
- Familiar form of doing business
- No flow through tax treatment
- Simplest form would be corporation; if Jessica and Michael want flow through treatment temporarily, they could form S corporation.
- LLC's: "Check the Box" tax treatment--whether you want tax flow through or not.
Introduction to Financial Accounting
- Although financial accounting seem to be all about numbers, in fact is much more art than science.
- Can't value things like Coca-Cola Trademark, so balance sheet often doesn't give information that you would otherwise want to know.
- Cable companies: appears to be just debt (to finance laying cable), but you don't see on balance sheet exclusive right to reach certain customers.
- Two fundamental ideas
- Balance sheet (snapshot at particular time)
- Income statement (finances over time, between balance sheets)
- Developed by management, audited by accountants
- Based on books of corporation that record every transaction
- Must comply with Generally Accepted Acounting Principles (GAAP).
- Building must depreciate over time, land remains at price purchased
- Financial recording as accurate as possible
- Reasonably reliable
- Prepare financial statements at a reasonable cost
- Record things at purchase price, and record depreciation, even if this doesn't accurately reflect situation.
- Balance sheet--fundamental equation: assets = liabilities + equity
- Equity is what business starts out with.
- Next Week
- Tuesday: do accounting problem, finish discussion of accounting, groups 11-15 continue to be on, 6-10 client.
- Wednesday: go back to old schedule. 6-10 on, 1-5 client.
Tuesday, June 10, 2003 (Class 7)
Relationship of Balance Sheet to Income Statement
- Balance sheet as snapshot
- Income statement as motion over time--transaction that happened between one balance sheet and the next
- Many believe income statement is more reliable than balance sheet in predicting future profits
- Many options within GAAP that manager has to make picture of company look better
- Might keep income in one year, and push expenses into the next
- Accrual accounting -- to avoid manipulation of times
- Realization Principle: income is generated in the period in which it was earned
- Matching Principle: always have to match costs of generating income in same period
- Accrual accounting is supposed to be less manipulable
- Still subject to manipulation
- Question: when is item sold for manufacturer?
- When order is made
- When items are manufactured and shipped
- When items are received and accepted
- Changing accounting practices requires board approval
- Cash Flows: Need to track cash as well as income because some payments may not be received.
- Balance sheet terms
- Assets: Everything, including fixed assets, cash, etc..
- Current assets: can be converted into cash within one year--cash, accounts receivable, marketable securities.
- Accounts receivable: moneys owed to the company for the sale of services or goods. Should reflect a reserve for bad debt--some percentage will not be collected. When accounts receivable increases, it might mean more sales, or it might mean harder time collecting on debt.
- Inventory: could use average cost method for item that remains fairly constant over time. For items like computers or fashion-related, inventory should be valued otherwise. First In First Out, Last In First Out, Average Cost methods, depending on practices for particular products.
- Prepaid expenses: e.g., car insurance for year, if paid up front. Show up as assets.
- Deferred charges: e.g., advertisements.
- Goodwill: if you buy a company and pay more than fair market value, goodwill is difference between price you pay and fair market value. Depreciates over 40 years. Lots of planning goes into avoiding transactions that generate goodwill.
Precision Tools Problem
- Good signs: net income is up, debt to equity ratio decreasing
- Potential trouble: accounts receivable are growing
- Liquidity Analysis
- If ratio is not good, might be harder to get more money.
- Current ratio: current assets divided by current liabilities. Assets that could be realized within one year idividied by liabilities that need to be paid within one year. 1996: 1.57, 1997: 1.64. People like to see 2:1 ratio. Could be lower if it's easy to collect on account receivables and inventory can easily be turned into cash.
- Liquidity ratio: quick assets divided by current liabilities. 0.87 for 1996 and 1997. High debt to available assets to pay. Should be at least 1:1.
- Debt-Equity Ratios
- Divide long-term debt by balance sheet equity; should be at most 1:1.
- 2.102 in 1996, 1.32 in 1997.
- Interest coverage ratio
- Net income divided by interest expense.
- 0.67 in 1996, 1.22 in 1997. Have more interest expense than profit in 1996, but better in 1997.
- Operating Margins
- Operating income divided by net sales--how much income generated off of sales.
- Increasing every year, partially because of decrease in R & D. Need to show that increase in sales is greater than increase in operating expenses.
- Return on Equity
- Last year's equity divided by this year's icome.
- 35% from 1996 to 1997. Looks like good return, but doesn't take into account the leveraging. Business has borrowed a lot of money to make profits.
- For tomorrow: what valuation methods would you apply, derived from Apple Tree example?
- Start Class 7--determining capital structure, groups 6-10 will be 'on'.
Wednesday, June 11, 2003 (Class 8)
Valuation of Company
- Price/earnings ratio--capitalization of earnings
- Compare return on investment versus less risky investments--e.g., bonds.
- If you want 30% return, divide 100 by desired return = 3.33:1. Use past earnings to determine likely return.
- Fair Market Value--what people are willing to pay
- What other similar businesses have sold for (substitute for Fair Market Value)
- Book Value--just value of assets--lowest possible value
- Discount cash flow--how much would I be willing to pay now for x earnings over time?
- Problem: over time, earnings become risky.
- Precision Tools Problem
- Working with historical data suggests low asking price, useful for bargaining with sellers
- Buyers expect market will take off, however, so they may be willing to pay much more
- Resulting price likely to be some medium between company valuation and hopes of buyers
- Financer is looking for three things
- Receive money from current operations
- Stockholder receiving dividends
- Debtholder receiving interests
- Share in proceeds if firm becomes insolvent, dissolves, or is sold
- Ability to monitor investment
- Controllable risks
- Uncontrollable risks
- Could be voting on certain transactions, special rights to dividends, etc..
- All these results come from security itself.
Debt vs. Equity
- Ownership interest in company.
- Residual interest after everyone else is paid off.
- No fixed rate of return.
- Generally investment for unlimited period of time, no right to get money back.
- Three way of getting money out:
- Business is sold
- Sell stock--usually to third party rather than company
- Highest risk investment
- Biggest chance of reward--everything which is left after everyone else is paid off.
- Risk is compensated by increased input into management
- No ownership stake
- No residual interest
- Fixed return--negotiated interest rate
- Fixed length of time
- Get paid before any equity holder
- Less risk, lower returns
- Less or no input into decisionmaking of business
- Common Stock
- Default type
- Comes with voting rights
- Last to receive payment
- Elects board
- Benefit from Board's fiduciary duties
- Preferred Stock (possible meanings--varies by stock--might be any of below)
- Right to dividends before common stock
- Special rights to dividend--e.g., fixed at 5% per year on amount invested
- Cumulative rights: dividends accrue with interest regardless of whether they're paid
- Participating preferred: get preferred dividend, and also common shareholder dividends
- Liquidation preference: preferred gets paid first. Often equal to price paid for shares plus any unpaid dividends.
- Redemption rights: rights to have company repurchase shares at some date in future. Usually equal to liquidation preference. Enables preferred to get capital back when there is no market for shares.
- Debtholders often have affirmative and restrictive covenants preventing company from paying dividends if they are behind on debt.
- Special voting rights: sometimes preferred stock permits election of board member, or majority of board; vote on fundamental changes; prevent company from taking on certain debt without vote.
- Can be converted into common stock.
- Rights to preferred shareholders will depend on how difficult it is for company to get money.
- Either secured or unsecured
- No fiduciary duties
- Have to pay interest and principal regardless of whether you have money.
- Debtholders usually have right to accelerate payment if payment is missed. E.g., if you miss mortgage payment, bank has right to make you pay the full amount immediately.
- Often "callable" by company itself--they can pay it in advance.
- Can have ability to convert debt to stock--allows debtholder to get some of benefit of equity without risk of equity.
- Sometimes if debtholders get too involved in governance, court will strike down priority for lender repayment. Looks too much like equity.
- Tension between debtholders and equity holders
- Increased risk doesn't benefit debtholders, even if produces lots of rewards for company
- From investors profile, choice between debt and equity will depend on individual situation/investment profile.
- From company's profile, depends on leverage.
- If company can borrow money and get returns higher than interest payment. If stockholders were added instead, then profit needs to be shared among more people.
- Borrowing increases shareholder risk because there is no discretion in paying and debtholders get paid first.
- When tax is considered, borrowing becomes even more attractive for company: interest payments are tax deductible.
- See example cb230-231 to see difference in borrowing and equity.
- If profit expectations turn out to be wrong, however, company is in trouble because it has to pay interest regardless.
- Other risks: recharacterization. You thought it was debt, but turns out to be equity.
Friday, June 13, 2003 (Class 9)
Precision Tools Part V
- All rights to Bernie, Jessica, Michael, Stern, and Starr are contractual--need to be specified.
- If company gives up a lot of rights at the beginning, it may be hard to give up fewer rights in later rounds of financing, unless company is doing so well that everyone wants to invest.
- Preemptive rights often have exemptions: e.g., employee stock plans.
- Still the law in Delaware and other jurisdictions
- 19th and early 20th century: par value and legal capital
- Par value: originally, price paid when stock issue stock
- Legal Capital: money from par value stocks--prohibited from being out. All dividends needed to come from subsequent profits.
- Par value has no relation to worth of company.
- Regulators did not allow companies to sell share for less than par value, thus companies set par value very low.
- Difference between market value and par value is par surplus.
- On Balance Sheet
- Paid-In Capital
- Legal Capital: par value times shares sold
- Surplus: difference between number of shares sold and price for shares
- Solutions used: Dividends can only be paid out of earned surplus, and if there are earned profits.
- RMBCA, two practical tests to see if dividend can be paid
- Equity insolvency test: board must look at financials as a whole, including debts, cash, when debt is due, and make determination that payment of dividend will not render company unable to pay debts when due. (more of a judgment call). Protected by business judgment rule.
- Balance sheet test: if dividend payment would make assets drop below liabilities, plus money owed to preferred shares (accrued but unpaid dividends), then no payment. (more of a mechanical test).
Tuesday, June 17, 2003 (Class 10)
- Three short papers assignment
Legal Capital, Par Value, and Dividends
- Par Value: Attempt to create protections for shareholders and creditors.
- Par Value = Share Price--amount company wanted to raise divided by number of shares it intended to issue
- If X company wants to raise $1000 selling 10 shares, par value and share price would be $100 per share.
- Corporate regulators made two rules:
- No shares can be sold for less than par value
- Avoids "watered stock"
- Promoters might present shares for $100 per share, and some people would purchase with property, etc., worth less than $100.
- Can't pay dividends if amount paid would diminish capital
- Capital: par value times shares sold
- Doesn't say anything about creditworthiness of business, however.
- Really "legal fiction"--capital can be used for anything except dividends.
- Par Value doesn't really have relationship to what shares are worth--market might value them for more or less.
- In response, companies set par value very low--a few cents.
- Capital calculated then becomes very low, no check on dividends.
- Regulatory response
- Delaware: Calculates surplus differently--assets minus liabilities, then subtract legal capital, anything left is surplus.
- Some other states: Only allow dividends paid out of earned surplus -- roughly equivalent to retained earnings.
- RMBCA §6.40--rejects both approaches, adopts pragmatic approach
- Does not require par value, irrelevant to dividends question
- Equity insolvency test: Board reviews financial statements, would payment of dividends make it difficult to pay debts of corporation when due? Usually, look at current assets and current liabilities (due in next year). Judgment call, protected by business judgment rule.
- Balance Sheet Test: can't pay dividend if total assets is less than total liabilities plus all amounts due to preferred shareholders.
- Don't need to use GAAP financials
- From standpoint of creditor, whether company pays dividend or repurchases share, same effect. Assets are being paid out to shareholders, diminishing available assets for repayment of liabilities. Corporation statutes treat them the same.
- If shareholders who received dividends or repurchase knew that payment was improper, Board can sue shareholders for contribution.
- Decisions to pay or not to pay dividends is protected by business judgment rule, thus usually fraud, self-dealing, or bad faith are needed to overcome business judgment rule. In small closely held companies, sometimes courts will intervene in equity.
Precisions Tools Problem Part VII
- Can PT pay $2000,000 dividend?
- In Delaware with $100 par value, subtract liabilities for assets, then subtract par value. Get $100,000. $200,000 not possible.
- For $1 par value, however, surplus is $595,000, thus $200,000 dividend is possible.
- Under Equity Insolvency Test: Current assets minus current liabilities, leaves $685,000.
- Balance Sheet Test: Total assets minus total liabilities, minus preferred shareholders. Seems okay here.
- Can shareholders buy back Bernie's shares to get rid of Bill Gould? Cost would be $500,000.
- Same treatment as dividend; not allowed in Delaware if par value is $100. Yes, at $1 par value.
- Under equity insolvency test, comes down to business judgment.
- For purpose of balance and equity insolvency test, assume debt is due all at once, thus it might make difference if money is borrowed to pay dividend or buy back shares.
- As long as Michael and Jessica are not acting in bad faith, it's unlikely that Bernie could force them to pay dividend.
Wednesday, June 18, 2003 (Class 11)
- Thus far, almost all regulation has been from state law, with exception of certain areas which supplement state law.
- Securities regulations, however, preempt state laws.
- Reasons to regulate Securities at federal law:
- Need safe, stable securities market to have markets at all
- Buyers can't inspect securities directly like real goods, need information to make purchases
- Given all information, buyers will make rational investment decision, capital will go to most deserving companies.
- Without information, people will make bad investment decisions, messes up market efficiency.
- Dubious as to whether securities market actually work in the way the securities laws assume (rationally).
- Focus is on disclosure. Laws make no assessments as to quality of product, etc., only degree and accuracy of disclosure.
- Default rule: all securities must be registered with SEC unless covered by exemption.
- Required documents: prospetus and supplement
- Examples of failure to comply
- Fail to register shares because you think it is not required
- Including false, misleading, or inaccurate information
- If company fails to comply, investors can demand money back.
Precision Tools Problem Part VIII
- Michael, Jessica, and Bernie decide they need to raise more capital, want $3 million.
- Company is already highly leveraged.
- First needs to decide whether things being issued are "securities".
- Would be difficult in this situation to establish that offering is not security.
- Reasons not to want to disclose
- May reveal negative information
- Might be subject to liability for error in disclosure documents
- Time consuming
- Why not negotiate with venture capital?
- Might be less funds available
- May have to give up more control
- Options for avoiding registration
- Could do intrastate offering
- Regulation D: safe habour for smaller offerings. Sell to accredited investors and up to 35 non-accredited.
- Can't advertise
- Other exceptions
- §4(1): applies to shareholders selling shares to other shareholders--can't apply here
- §4(2): private offering. Doran case gives guidance for how to determine if it is a public offering or not. Depends on number of purchasers, number of units sold. Need to make available information that people would have had in registration statement.
- Suggest §4(2) or Rule 506. Rule 506 has no dollar limit, but can only be sold to accredited investors.
- Rule 506 is absolute safe harbour, versus §4(2) which has to meet Doran test.
- Regulation A also allows company to "test the waters"; otherwise strict contact rules apply.
- Still subject to fraud requirements of securities laws, even if not required to register.
Friday, June 20, 2003 (Class 12)
- Outline of first journal entry assignment
Limits on Limited Liability
- When we looked at dividends, saw that corporate law tries to protect, to some extent, creditors of corporation.
- Equitable rules with respect to piercing the corporate veil: another way the law tries to protect entities other than the corporation.
- Issue arises when corporation has insufficient resources to satisfy claims, whether tort or contract.
- Scenarios--different factual proof requirements:
- One, or few, entities owning corporation. Creditor is trying to pierce through corporate form to shareholder.
- Creditor seeking assets of sister corporations, where same shareholder(s) own several corporations.
- Creditor seeking assets of parent corporation, where same shareholder(s) own parent corporation (which might also have several subidiaries).
- Economics question: who has deepest pocket to satisfy judgment?
- Terms of art when seeking to collect from shareholder: "Mere instrumentality", "alter ego", "dummy". No distinguishing shareholder from corporation.
- Three standard tests for shareholder liability (from Walkovszky)
- Corporate formalities
- Important, particularly in closely held corporations, to have board meetings, record minutes, keep books, etc., even if there is only one shareholder.
- Legitimate reason for setting up corporation or just to shield assets?
- Is business undercapitalized, where shareholder knew capital would be insufficient to meet potential liabilities?
- Equitable remedy--court made.
- When looking at sister companies, did one often pay debts of other, etc.; are there things to suggest corporate boundaries were not real? Separate meetings, insurance policies, bank accounts.
- Is all money in subsidiary immediately paid to parent?
- Is it abuse of corporate form to take advantage of key element--limited liability?
Walkovskzy v. Carlton
[223 N.E.2d 6] 1966 New York Superior Court (cb311)
Radaszewski v. Telecom Corp.
[981 F.3d 305] 1992 8th Circuit Court of Appeals (cb317)
- Relationship between insurance and undercapitalization--is insurance reasonable substitute for capital?
- Where does society want to place risk? If we want taxi drivers, can limit liability, shift costs to society as a whole, through insurance, government program, etc..
- Discourse today in piercing corporate veil is dominated by economics, shifting burden, placing risk, etc..
Precision Tools Problem Part IX
- PTC has long term customer, Higgins, which has business trouble, PTC extends credit, works with company to try to support it, ultimately company fails.
- Michael, Jessica, and Bernie purchase Higgins in proportion to stock ownership, set up new company, "New Higgins."
- $25,000 capital from MJB, $75,000 from bank, guaranteed by MJB. $50,000 loan to New Higgins as working capital. Market rate loans. New Higgins thus has $150,000 assets, of which $125,000 is debt.
- In third year, NH starts being profitable. In fourth year, MJB get dividend.
- Tort action: customer of New Higgins suffers fire, people are killed, customer sues New Higgins, MJB, and PTC.
- Contract action: same defendants, past due invoice.
- Should MJB settle claims with contract or tort plaintiffs?
Tuesday, June 24, 2003 (Class 13)
- Subsidiary company: owned by another company, in part or in whole. If parent company has controlling stake, usually have to consolidate accounting information.
- Focus in liability cases: actual control/domination of subsidiary.
- Issue arises when subsidiary have insufficient assets to satisfy creditors.
- Usually claimant is seeking assets of parent company, rather than shareholders of parent company.
- Test: totality of the circumstances, focus on:
- Whether parent exercised such complete and absolute domination and control of subsidiary so as to treat it, for liability purposes, as not a separate entity. No distinction between parent and subsidiary vis-a-vis third parties.
- Whether parent deployed subsidiary in such a way as to mislead creditors--abuse of corporate form.
- Domination and control
- Corporate formalities very important--was subsidiary treated as separate corporation?
- Sometimes involvement in subsidiary management is a good thing--Atex case. When company buys other company, it's usually to create synergies, manage it better, etc..
- Issue: how to tell whether involvement is good vs. absolute domination/alter egos?
- Some states, (e.g., Delaware), require only a showing of absolute domination.
- Courts usually look for bad consequences or wrongdoing to decide if there is absolute domination.
Fletcher v. Atex, Inc.
[68 F.3d 1451] 1995 2d Circuit Court of Appeals (cb339)
- Defendants propose complete domination/control because:
- Company used cash management system
- Not enough to show domination or control in Delaware, might be rational
- Parent company exercised control over sale of large asests, etc..
- But this is true of shareholders generally.
- Dominating presence on board of directors
- Not sufficient either--quite common for coordinating business strategies
- Subsidiary held itself out as branch of parent company
- Again, not enough, no attempt to mislead the market
In re Silicone Gel Breast Implants Products Liability Litigation
[887 F.Supp. 1447] 1995 North District Alabama (cb333)
- Court seems to focus on Bristol-Meyers (parent company) holding itself out to assure safety of MEC's products. Unlike Atex, here consumers may have relied on parent company name in making decision.
- Just when liability starts to hit, Bristol-Meyers take all assets other than breast implants out of MEC, then buys MEC's assets for a note.
- Although wrongdoing is never required, court again looks for wrongdoing and finds it and thus refuses to grant summary judgment to defendants on corporate veil issue.
Precision Tools Part IX
- Two companies--PTC and New Higgins--with same shareholders, but not parent-subsidiary.
- Tort and contract plaintifss trying to pierce veil both up to shareholders and sister company.
- Tort claim to shareholders
- Argument for piercing corporate veil
- Owners did not abide by all corporate formalities; made decisions not within formal board meetings. But then afterwards went back and ratified decisions in board meetings.
- Possibly violated dividend rules
- Many loans to start company; maybe company was undercapitalized
- For contract claim, how well could have creditor protected themselves in negotiation?
- To go after PTC's funds, would have to view PTC and New Higgins as parent-subsidiary relationship.
- Separate boards, individual loans, would go against parent-subsidiary idea.
Wednesday, June 25, 2003 (Class 14)
- Next up: Legal mechanisms for allocating authority within corporation itself
- RMBCA and State Corporate Statutes impose same requirements
- Business must be run by a Board of Directors
- Board doesn't have to make every day-to-day decision; though. Usually delegate responsibilities to staff.
- Treasurer and secretary roles
- Any set of officers is permissible--could be multiple CEO's, etc..--need to determine authority of officers.
- Certain responsibilities can't be delegated to board:
- Statutory responsibility to be finally responsible for management of business
- Principles of agency
- Principal and agent: agent is authorized to take certain functions and act on behalf of principal; agent can bind principal within scope of agent's authority.
- Agent has duty to follow principal's instructions: fiduciary relationship.
- Issue of when person is acting to bind corporation. Since all corporate action needs to be through agent; thus this area of law is dedicated to principles of agencies.
- Bases for authority
- Actual authority
- Express: words, written or spoken, by principal, to agent, as to what principal is entitled to do
- Implied: doesn't come directly from words of principal, but from deeds, circumstances, course of dealing, that give rise to reasonable belief on part of agent.
- Apparent Authority: when third parties are informed of authority, but agent isn't necessarily informed. Principal can't sue third parties but could possibly sue agent.
- Express: principal could suggest to third person directly that agent has authority.
- Implied: position of agent in company, course of dealing.
Lee v. Jenkins Brothers
[268 F.2d 357] 2d Circuit Court of Appeals (cb355)
- Lee is senior vice-president, promised lifetime pension if he stayed at company.
- Company claims president had no authority to enter into contract for pension.
- No question of actual authority, because no board vote that directly authorized president to make promise.
- President has authority to do things in usual and ordinary course of business, but not contracts of an extraordinary nature.
- Court finds distinction between e.g., lifetime employment contract, and future pension contract, where the former would be extraordinary, while the latter would not be.
- Gets more complicated when there are multiple levels of authority.
First Interstate Bank of Texas v. First National Bak of Jefferson
[928 F.2d 153] 1991 5th Circuit Court of Appeals (cb359)
- Another example where company is trying to get out of deal signed by agent, in this case Senior Vice President.
- Bond purchase agreement included provision for company to be forced to buy back bonds, company claims VP didn't have authority to sign agreement.
- Court looks to see if there were actions by president that authorized VP to enter into deal; would have first had to establish that president had authority as well.
- Court says third party can rely on apparent authority of agent, thus company must buy back bonds. Unless there is some red flag to indicate person does not have authority, then you can assume he does.
- Usually, as you move down the chain, away from the president, courts tend to require more diligence from third parties (not so in this case).
Problem: Agency Relations -- Part I
- Express actual authority.
- Implied actual authority. Apparent authority as well.
- No actual authority. Factual inquiry for apparent authority, but usually foreman has no authority to enter into contract, so probably no apparent authority.
- Ratification authority, and possibly apparent authority.
Problem: Agency Relations -- Part II
- Standard order: look for actual, then apparent, then ratification authority. Factual inquiry for latter two.
Friday, June 27, 2003 (Class 15)
- Can't give proxy for vote.
- Board must meet formally; or must have unanimity.
- Quorum can be adjusted, normally 50%, could be as low as 1/3rd, but not lower.
- Could have executive committee, reserve only major decisions to full board.
- Sarbaines-Oxley Act: Majority of outside directors (not management) and audit committee now required for publicly owned companies.
- Limitations on committees
- Can't delegate more power than board itself has
- Can't delegate powers that statute or bylaws require full board to decide
- Various exceptions to requirements:
- Could meet by conference call if everyone can speak and be heard
- Could communicate notice electronically
- Consider who is likely to complain if board formality is not met.
Problem -- Widget Corporation
- Arises out of agency relationship
- Over time, high trustee-like standard has been watered down to be "less than trustee."
- Two main kinds of fiduciary duties
- Duty of care
- Board is required to exercise reasonable care in supervising operation of corporation, and with respect to particular corporate decisions.
- Duty of loyalty
- Must place best interests of corporation above own personal interests.
- Also, duty of disclosure -- linked to other duties. Must disclose certain material information to other directors or shareholders.
- Board Functions
- Oversight of day-to-day operations of business
- Compliance with legal requirements
- Financial soundness, reporting
- Requirement of exercising due care in making important decisions
- RMBCA 8.30(a): due care requirement.
- Covers manner in which director makes decisions, not outcome.
- Looks at objective reasonableness.
- Contextualized to circumstances.
- Standard of behavior of ordinarily prudent person--not highly skilled, etc..
- Relationship of business judgment rule and other standards
- Discrete decisions: business judgment rule applies
- E.g., decide to make one product rather than another. Presumed to have been made in good faith and in the best interest of the corporation.
- Monitoring: measured by reasonableness standard; did directors exercise reasonable care?
- E.g., failure to read financial statement is not a business judgment.
- Next time: start with problem, with cases as examples.
Tuesday, July 1, 2003 (Class 16)
Francis v. United Jersey Bank
[432 A.2d 814] 1981 New Jersey Supreme Court (cb661)
- Mother director did nothing while sons made "shareholder loans" to themselves, taking away assets of corporation.
- Court hold mother's estate liable, even though she had no expert knowledge.
Graham v. Allis-Chalmers Manufacturing Co.
[188 A.2d 125] 1963 Delaware Chancery (cb667)
- Issue: how far does responsibility of Board run down chain of command to identify wrongdoing?
- Very large company, decentralized management.
- Company never admitted any wrongdoing in antitrust, but entered consent decree to avoid litigation.
- Court reject argument that responsibility runs all the way up to the board, if there was no knowledge or constructive knowledge of antitrust violations.
- Red flag test--unless there is a red flag, no duty to set up surveillance, etc..
In re Caremark International Inc. Derivative Litigation
[698 A.2d 959] 1996 Delaware Chancery (cb672)
- Can't identify a red flag unless there are sufficient monitoring and reporting systems so that Board could discover.
- Plaintiff needs to show that directors
- knew or should have known that misconduct was occurring
- should have known--need to show that failure to monitor isn't protected by business judgment rule
- failure resulted in losses
- If Board knowingly engages in bad acts, generally no protection for Board.
Fashion, Inc. Problem Part I
- Peters, fashion designer, asked to be on board of corporation she sold her company to.
- Two inside directors on board, also includes many prominent people.
- Peters wants to know what her duties are.
- Duty of care, duty of loyalty.
- Would need to know generally about regulatory, etc., rules, and know what monitoring is in place.
Fashion, Inc. Problem Part II
- Peters has joined Board, receives notice from CEO of emergency meeting to be held tomorrow.
- Emergency meeting to discuss acquisition of United Stores.
- Newspaper says United is in serious financial trouble, needs $500M new capital to avoid bankruptcy. Also knows CEO of United is good friend of CEO of Fashion.
- Worried that friendship might be interfering with decision to acquire United.
- Will see
- Report by CEO
- Financials prepared by acquisition target
- Analysis by Fashion's CFO
- Needs to decide immediately in order to get shareholder approval in time.
- Should review everything with critical eye
- Investigate how deal started--how does it relate to relationship of CEO's?
- Should see if there's a way to make the decision less quickly
- Need rational basis to believe that information was reliable
- Might want outside audit of financials unless financials were prepared for SEC.
- Decision to buy United would be protected by business judgment rule; plaintiffs would need to overcome presumption.
- If Peters determined that purchase was in best interest of corporation and it cannot be shown that there was a duty to inquiry along the lines of Van Gorkom.
- Should reflect any engaged discussion in minutes of meeting.
- Fact that shareholders ratified Board decision in Van Gorkom does not exculpate Directors; need to disclose all information to make informed decision first.
Wednesday, July 2, 2003 (Class 17)
- Fall-out from Van Gorkom and Caremark: looks like courts are dramatically expanding liability for fiduciary duties of directors.
- Concern that no one would want to serve on corporate boards any more
- Result: exculpation and indemnification
- Exculpation: forward looking--future conduct, you won't be liable if...
- Indemnification: company's agreement to cover cost of liability
- Amend corporate by-laws for indemnification.
- Some states changed standard to require higher degree of fault.
- Virginia: absolute cap on damages; ALI: floor on damages.
- Delaware: 102(b)7: company can amend charter to create exculpation for breaches of due care, except:
- Negligence or conflicts of interest
- Bad faith acts or omissions
- RMBCA: directors can be exculpated, even for breaches of duty of loyalty. Exclusions:
- Improperly received financial benefits
- Intentional infliction of harm
- ALI: should not absolve for breaches of fiduciary duty, but should not be liable to full extent.
- Argument that company and shareholders are better riskholders than directors--shareholders can diversify their holdings.
- May have to pay directors more in face of liability.
- Delaware indemnification statute 145:
- 145(a) Third party suits against directors. Indemnify directors for expenses, including attorney's fees, damages, or amounts paid in settlement.
- 145(b) Suits on behalf of corporation (shareholder derivative actions): only expenses, but not damages or settlement amounts (because then company would be paying itself).
- 145(c) if director wins: director is entitled to indemnification for expenses--mandatory.
- RMBCA 8.51: indemnify if conductor acted in good faith, no reasonable cause to believe conduct was unlawful.
- Delaware regime: advances on legal fees are permissible, but not required.
- RMBCA: 8.53 requires advances if two conditions are met:
- Director must affirm in writing that she acted in good faith, and met relevant standards for indemnification under rule
- Majority vote of disinterested directors or independent legal counsel or shareholders needed for indemnification--finding of entitlement.
- Used to be requirement in Delaware to post bond for legal fees.
- RMBCA: no requirement of security or other protection.
- Can't indemnify someone who acted in bad faith.
- By and large, indemnification agreements have to conform to statutes, but some latitude allowed.
- Both Delaware and RMBCA authorize "directors & officers liability insurance".
- Both statutes permit insurance to be significantly broader than what company could do through indemnification or exculpation.
Fashion, Inc. Problem -- Part III
- 8.53(c): Disinterested directors on board can vote to indemnify. Directors need to sign affirmation of good faith behavior.
- Directors must agree to pay back company if affirmation was wrong.
Tuesday, July 8, 2003 (Class 18)
Duty of Loyalty
- What happens when director brings transaction to board in which he or she has financial stake?
- Some interested transactions are good for company, however, so can't be blanket prohibition.
- Why doesn't the business judgment rule apply here as in other contexts?
- Business judgment rule requires indepedent decisionmaking on part of directors.
- Thus, self-interested director's decision is never protected by business judgment rule.
- What about when decision is approved by disinterested directors?
- Should fairness be measured vis-a-vis "arm's length transaction"?
- Common law viewed interested transactions as always voidable by complaining shareholder, absolute right.
- Later, rule adopted that interested transactions would not be voidable if it were approved by disinterested directors or shareholders, and transaction was fair.
- Later, transaction only needed to be fair to corporation.
- Procedural and substantive
Shlensky v. South Parkway Building Corp.
[166 N.E.2d 793] 1960 Illinois Supreme Court (cb756)
- Common law interpretation of procedural fairness. Courts often see statutory standard as codifying common law.
- Company spent $100,000 to purchase fixtures of tenant of building ("the Store"). Chairman of Building Corp. owned the Store.
- Under no circumstances can directors engage in transactions for personal gain; in case of apparent gain, court will examine with strict scrutiny for utmost fairness.
- Procedural mechanisms: disinterested vote of directors, shareholders
- Substantive mechanisms: was it fair to corporation, business value
- Doesn't require company to get better deal than market, needs only to be fair as arms-length market transaction.
- Fact that transaction is between two corporations does not absolve director of liability.
- Plaintiff must present prima facie case that there is conflict (personal gain on part of directors), then burden shifts to defendants to demonstrate utmost fairness.
- Court asks was there any business purpose to purchasing fixtures?
- Court also asks if there was any reason to give rent decrease? Defendants argue that they needed anchor tenant, court finds, however, that it would have been easy to rent space to another party at a significantly higher price.
- Many directors were also directors of the Store; court finds that none of the directors were disinterested.
- Director owned majority of stock of both companies, thus must be self-interested even with shareholder approval.
- Procedural fairness is not substitute for substantive fairness, just changes burden of proof.
- Delaware § 144, RMBCA § 8.31.
- Allows interested transactions when there is full disclosure and disinterested shareholder or director approval.
Remillard Brick Co. v. Remillard-Dandini Co.
[241 P.2d 66] 1952 Califorina Court of Appeals (cb761)
- Need to show that disinterested shareholders approved.
- Delaware § 144 as interpretted by courts:
- Plaintiff has burden of prima facie case of conflict
- Defendant then has opportunity to show procedural fairness
- Disinterested approval by directors or shareholders
- Then plaintiff has burden to show deal was unfair to company
- Otherwise burden remains on board to show that deal was fair to company
- Underlying issue: was deal fair to business?
Starcrest Corporation -- Part I
- Need to see if other inside directors are dominated by Adams.
- Procedural fairness
- Committee vote--two outside directors--one voted for, one voted against, and general counsel voted for, so question is whether general counsel is dominated.
- Board vote--three inside people voting for transaction, one outside voting for transaction, and one dissent. Only one to one if insiders are interested.
- Question of whether showing procedural fairness just shifts burden, or invokes business judgment rule.
- Shareholder vote: if Elizabeth's shares are removed, vote becomes closer; if family shares are removed, then it becomes 14% in favor and 22% against.
Wednesday, July 9, 2003 (Class 19)
- Special category of duty of loyalty
- Need to find 'optimum' balance--enough so that directors will do their best, but not so much that it constitutes waste.
- Main idea behind stock options: align director's intersts with shareholders.
- Accounting standards board determined that Board does not need to account for option grant until option is exercised, thus from accounting perspective, grant of options was "free".
- Option only has value if stock goes up; theoretically gives incentive to help grow company.
- In reality, directors have short term interest to maximize difference between market price and strike price, but not necessarily long term.
- Same requirements as other duty of loyalty cases for executive compensation--approve by outside/disinterested in committee, at board, and by shareholders.
- If procedural requirements have been met, then plaintiff would have to demonstrate waste (not fairness, as in other duty of loyalty cases).
- Directors and officers can't take opportunities from corporation, difficult to determine which opportunities are barred.
- If corporation has interest or reasonable expectancy in opportunity
- Was opportunity something corporation was relying on...?
- Opportunity is corporation's line of business
- More general... was corporation in business, did it have ability to be in business, was it expanding in that direction....
- Opportunity which corporation has financial wearwithal to undertake
- More controversial, hard to determine.
- Often arises as a defense.
- Opportunity is advantageous to corporation
- If board rejects opportunity, director is then free to pursue, corporation will be estopped from asserting claim.
Friday, July 11, 2003 (Class 20)
Starcrest Corporation Problem -- Part II
- Four Factors
- Interest or Expectancy
- Starcrest is already in Hotel Business, expressed interest in casino,
- But was Starcrest considering expanding beyond the United States?
- Expectations of White as director: did the recruit him because of his real estate connections, would expect him to bring in opportunities; alternatively, company may have known he would have outside transactions and not expect him to bring in opportunities that came to him.
- Line of Business
- Casino is often connected to restaurant and hotel
- Did White know what scope of Starcrest's business was? Maybe casino did not fit into Starcrest's business strategy.
- Advantageous to company
- Financial ability to invest
- Could Starcrest get money in time to make investment?
- Could arise as defense, or as requirement of proof.
- (General Fairness)
- ALI Rule--§5.05
- Focuses on disclosure
- Question: did opportunity come to director because of role with corporation? (b)(1)(A)
- More restrictive standard than other laws, easier to understand, but only adopted in two states
Rights of Shareholders
- Fact that shareholder can sue for breach of fiduciary duty is monitoring device
- Veto and exit rights--other alternatives.
- Shareholders can vote ("veto rights"):
- Charter Amendments -- including increasing authorized stock
- Sale of all assets
- Dissolution of company
- At Common Law, idea was that shareholders were investing in specific thing; required unanimity to change.
- Criticized as "tyranny of the minority," also failed to address changing dynamic economy.
- Legislature shifted requirements from unanimity to majority, or sometimes super-majority. In compensation, shareholders got "appraisal/dissenter's" rights. Can't block transaction, but instead, can cash out on investment.
- Appraisal rights vary across jurisdictions, also only available in very limited situations, always specified in statute.
- Always give right to exchange shares for cash at fair market value.
- Most frequently arises in merger context.
- Depends strongly on form of transaction, even if results are nearly identical.
- Forms of merger
- Statutory merger
- All of assets of T are combined with P, result is single corporation P+T, shareholders of P and T are shareholders of new company
- Triangular Merger
- S becomes wholly owned subsidiary of P; S gets consideration for purchasing T; then merger of S and T (or vice-versa for reverse triangular merger). Reverse merger is not considered to be transfer of assets for tax purposes. Parent company is shielded from liability.
- Share Exchange
- P gives stock to T, T gives stock to P, result is the same as statutory merger
- Asset sale
- P purchases all of T's assets with stock, taxable transaction, usually then T gives dividends of P stock to B and dissolves.
Tuesday, July 15, 2003 (Class 21)
- After effect of share exchange: T is wholly owned subsidiary of P, same as triangular merger.
- Tender Offer
- All other forms of merger, both companies agree to transaction, but not so in tender offer.
- Can be unsolicited.
- P offers to purchase shares from T's shareholders, either for cash or stock.
- Usually conditioned on purchasing at least 90% of shares.
- By purchasing 90% of shares, company can then merge without approval of minority shareholders (RMBCA §11.05).
- Can force remaining 10% to sell their share. They would have appraisal rights, but no veto rights.
- Also doesn't require approval of shareholders of purchasing company, unless new shares need to be authorized.
- Thus, result can be same as statutory merger, but no appraisal or veto rights.
- Chart with appraisal/veto rights--cb378.
- De Facto Merger Doctrine: very small exception--only really adopted in Pennsylvania--if result is same as statutory merger, then might be treated as merger for veto/appraisal rights.
- Appraisal rights most important when large minority shareholder could block transaction by threatening to exercise appraisal rights--if shareholder cashes out, not enough money would be left to consummate transaction.
Problem: LaFrance? Cosmetics -- Part I
- Four shareholders:
- Mimi 400,000
- Pierre 100,000
- Margaret 100,000
- Bank 400,000
- Mimi and Pierre want to purchase fragrance company, Margaret wants to sell company, Bank is on the fence.
- 1,000,000 authorized but unissued shares
- 400,000 proposed consideration to purchase fragrance company
- Can we limit shareholder vote, because if Bank votes with Margaret, then transaction won't go through; and how to deal with appraisal rights, because if Bank or Margaret objects, there won't be enough cash to do transaction.
- Triangular merger: need only approval of fragrance company, no problem here.
- Only difference in Delaware: no stock exchange transaction; no dissenters rights for asset sale.
- Shareholders have rights when board wants to sell all or substantially all assets of company
Gimbel v. Signal Companies, Inc.
[316 A.2d 599] 1974 Delaware Chancery (cb388)
- Signal started out as oil/gas exploration company, now diversified.
- Company wants to sell oil company because it is not generating much revenue
- To give shareholder rights, must go to "fundamental root cause" of business--doesn't occur here.
- Needs not only to be unusual transaction, but sale of assets must be quatitatively vital to the operation of the corporation.
- In this case, assets are less than half of corporation's assets, thus not "all or substantially all".
- RMBCA: sets out transactions where there is no shareholder vote (non-fundamental transactions). Tries to get rid of some ambiguity. Also sets out safe harbor--75% of assets and 25% of income or revenues.
Problem: LaFrance? Cosmetics -- Part II
- Transaction to purchase LaFrance? went ahead, has been disaster.
- LaFrance? accounts for a lot of revenue, but little profit.
- Margaret wants whole business to be sold, not just fragrance. Bank agrees.
Wednesday, July 16, 2003 (Class 22)
- RMBCA Standard
- Sets safe harbor with quantitative levels. If you haven't sold 75% of assets and 25% of income/revenue, then no investigation into qualitative nature of transaction.
- Possible to sell more than 75% of assets an still not meet requirement for shareholder vote.
- Qualitative investigation occurs between 75% and 100%.
Problem: LaFrance? Cosmetics -- Part II Continued
- Sweet Violet accounts for 2/3 of assets of LaFrance?, thus less than 75% of assets, safe under RMBCA.
- Under Delaware law (Gimbel analysis):
- Not ordinary transaction, thus might need approval
- Was substantially all of assets?
- Can determine clearly on quantitive level, must look at qualitative levels.
- Requirement for call to be issued for shareholder meeting.
- Special meetings must be initiated, determined by statute.
- Most statutes allow board members to call meeting, as board, acting as a whole, or shareholders holding more than 10% of shares, or other persons as described in by-laws (usually president or chairman can call meeting in company by-laws).
- Delaware statute does not have 10% shareholder right to call meeting.
- Possibility of waiver of notice of meeting at meeting itself.
- Powers not explicitly granted to shareholders are reserved to the board.
- Primary remedy for shareholders to reject management activities is to sell shares or vote out board.
Auer v. Dressel
[118 N.E.2d 590] 1954 New York Superior Court (cb395)
- Class A shareholders ask President of company to hold special meeting to vote on resolution endorsing prior President; to provide for vacancies to be filled by vote of shareholders; to remove Class A directors and elect successors; to reduce quorum requirement.
- President refused to call meeting, shareholders sue.
- While shareholders can't vote out President, they can put board on notice.
Campbell v. Loew's, Inc.
[134 A.2d 852] 1957 Delaware Chancery Court (cb398)
- Divided board in balance between dissident factions; some directors resign; majority remaining tries to replace vacancies with people on their side.
- Court holds action invalid because of lack of quorum.
- President tries to gain control by calling special shareholders meeting to increase board members, increase quorum, remove certain directors, and fill vacancies.
- Court strongly affirms inherent power of shareholders to remove directors for cause and fill vacancies.
- Possible valid causes for removing directors
- Systematic plan to harrass corporation--valid reason.
- Seeking to take over is not sufficient cause for removal.
- Holdings: shareholders can remove directors for cause; requires only disclosure, not full judicial process. Illegally removed directors can challenge removal in court.
- President could use corporate funds in attempt to oust rival through proxy; he was representing "status quo." Significant tilt in favor of incumbent management.
- RMBCA permits removal without cause; Delaware requires cause unless otherwise specified in by-laws.
Blasius Industries, Inc. v. Atlas Corp.
[564 A.2d 651] 1988 Delaware Chancery Court (cb403)
- Blasius wanted Atlas to borrow money for restructuring, acquired 9.1% of stock.
- Sent Atlas Board written consent requesting:
- Precatory resolution to restructure
- Amend by-laws to expand board from 7 to 15
- Electing 8 named persons to fill directorships (thus would take over board)
- Board responded by increasing board to 9 and filling vacancies, so as to prevent dissident shareholders from filling board.
- In this case, doesn't matter what motive was, still not permissible--cannot substitute judgment for shareholders judgment.
- Could have expended corporate funds convincing shareholders as to why Blasius proposal was bad.
Right of Inspection
- At Common Law, shareholders had right to access accounting books and shareholder list as part of ownership.
- Must have proper purpose, however.
- Interest must be articulated in economic terms.
State Ex Rel. Pillsbury v. Honeywell, Inc.
[191 N.W.2d 406] 1971 Minnesota Supreme Court (cb410)
- Court holds that wanted to access books to get company to stop making bombs was not proper purpose.
- Shareholder with bona fide investment interest, however, could have brought suit.
LaFrance? Cosmetics Problem -- Part III
- How can dissident shareholder disrupt transaction without being able to vote on transaction itself?
- Can shareholders demand special meeting compelling board to abandon sale of Sweet Violet? Adopting resolution to recommend?
- Probably can't compel board, but can adopt resolution.
- Unless in by-laws or statute, can't force special meeting
- Board might ignore resolution
- Can shareholders act at other than properly called meeting?
- If there is unanimous written consent, yes. But two directors want transaction to go through, so they probably won't consent.
- Can shareholders remove directors who support sale and replace them?
- RMBCA says they can be removed without cause, thus if they can get special meeting, then yes.
Friday, July 18, 2003 (Class 23)
LaFrance? Cosmetics Problem -- Part III Continued
- What can board do to prevent shareholders from calling meeting to amend bylaws?
- Board cannot interfere with franchise, but can use company funds to campaign for their interest.
- Could set meeting date very soon, to give dissidents little time to rally people to their position
- Could set meeting date after closing date for Sweet Violet transaction--but may be equitable limitation on this. Schnell case says boards can't interfere with franchise by moving meeting date; but on the other hand, shareholders are not entitled to vote on transaction, just on board, so perhaps wouldn't be a problem.
- Could also manipulate record date (date when shareholders who own stock on that day are counted for vote).
- Proxy is when shareholder is authorizing someone to vote on their behalf at meeting.
- Normally, agent is directed by principle to do something; in this case, agent is directing principle to vote.
- Subsequent proxies always supercede earlier ones, except in rare situation of irrevocable proxy.
- Window into complex reliationship between state and fedeal law.
- Substantive rules are generally state law.
- Need to understand federal securities and federal fraud laws.
- Self Regulatory Organizations (SRO): New York Stock Exchange, NASDAQ, etc..
- Federal law has disclosure requirements.
- Description of agenda (what will be decided), etc., all put together in draft proxy statement.
- Draft proxy is filed with SEC.
- Technical possible for alternative candidates to be considered at meeting, but almost always the case that election of directors is determined before meeting happens.
- Possibility of really doing somethig at meeting requires that alternative group also do a proxy solicitation.
- Federal requirement is accuracy and completeness.
- Proxy can't force shareholders to accept all directors as block, or all decisions as block; shareholders need to be able to vote on each matter separately.
- Overall process in cumbersome, time consuming, and expensive.
- §14(a) of Exchange Act regulates all solicitations of proxies.
- §14(a)(1) solicitation can be:
- any request for proxy whether or not accompanied by form of proxy (e.g., phone request can be solicitation)
- any request to execute, not execute, or revoke proxy
- furnishing of form or other communication to shareholders reasonably expected...
- e.g., letter to shareholders, advertisement in newspaper
- Never supposed to try to get shareholder to vote on something, or influence them to vote, without giving them full information
- At one point, SEC wanted everything to be categorized as solicitation.
- Low point: shareholder who hadn't held stock for 6 months as required by New York law to vote, went to get shareholder list, was considered by court to be a solicitation.
- Since then, courts have cut back on what will be considered solicitation.
- Tension in SEC between wanting adequate disclosure through proxy process and wanting companies to tell shareholders about important things as soon as possible.
Collective Action Problem
- Robert Clark: it might be in all shareholders interest to act in a certain way, but no individual shareholder has sufficient incentive to organize. "Rational apathy."
- SEC prohibited companies from being listed on public exchanges if the company limited shareholder voting through proxy, ultimately struck down by court. Business Roundtable v. Securities and Exchange Commission. Voting was province of State Law.
- Ultimately, exchanges made agreement that they would not list companies that diminished voting power of existing shares.
- Thus, new companies could enter with multiple classes of stock, but existing companies could not reduce voting power of existing shares.
Tuesday, July 22, 2003 (Class 24)
Universal Netware, Inc. -- Part I
- Company wants to reprice stock options at current price, as options granted to employees are worthless due to drop in stock price.
- Collective action problem/free riding--unless issue is brought to the forefront, and there isn't a diversity of opinion on it, probably will be approved.
- Issuance of press release--would this violate proxy rules?
- Does communication actively solicit proxy votes? If so, would be in violation of SEC rules.
- "Reasonably calculated to result in the procurement of a proxy or to influence shareholder's vote."
- What about reasonably calculated? Does this mean board had to intend to impact shareholder's votes? Or be reasonably likely to impact shareholder's votes?
- "Facts and circumstances" test--
- How soon is annual meeting? If it is soon, then it is more likely to count as solicitation.
- Dissident shareholder: can go ahead and publicize his views, say which way he will vote. Does not own $5M of stock, thus no notice requirement. As long as there is no personal benefit (not common to all shareholders), then no solicitation requirements.
- General rule: shareholders can put proposals on proxy statement that would proper for meeting
- Transamerica: proper subject for meeting is what would be proper in state of incorporation, federal mechanism to enforce state rights
- Proposal to have shareholder election of independent public auditors
- Proposal to amend bylaws with respect to procedure for bylaw amendment
- Proposal to require report of annual meeting to shareholders
- Federal anti-fraud provision requires all matters that come up at meeting to be in proxy; this is basis of rule requiring company to include these proposals in proxy.
- Originally, shareholder proposals were about corporate democracy; in 1970s, increasingly involved social issues.
- More recently, shareholder proposals generally involve anti-takeover measures, executive compensation.
- If proposal does not meet one of the exclusions in regulations, it must be included.
- Company decides not to include shareholder proposals, sends it to SEC, SEC staff decide whether or not to issue "no action" letter.
- No official status for "no action" letter, could be reversed by Commission, thus cannot sue on basis of "no action" letter.
- Three possible conclusions:
- SEC could say proposal is not excludable, and thus must be included
- SEC could say change in form is required (i.e., binding command vs. precatory resolution)
- "No action" letter--company can probably exclude proposal
- Private right of action under SEC rules to sue company for excluding proposal
- SEC can also bring action to injoin company to include proposal
- Substantive exclusions
- 14a-8(i)(1): improper under state law
- (i)(5): does not meet minimum economic test and is not otherwise significantly related to business
- (i)(7): ordinary business exclusion; shouldn't be decided by shareholders
- Frequently not a lot of state law on issue; thus decided on something like "federal common law."
Wednesday, July 23, 2003 (Class 25)
Universal Netware, Inc. Part II
- Students want to make shareholder proposal, have purchased 100 shares at $32 per share over a year ago.
- Rule 14a-8: no problem with being qualified shareholder, own more than $2000 for 1 year.
- Possible objections from Universal Netware:
- Less than 5% of overall revenue, potentially excludable under 14a-8(i)(5).
- (i)(7) management functions, ordinary business
- (i)(1) barred under state law
- Student group responses:
- Resolution can't be mandatory, must be precatory.
- Can't interfere with board's ordinary decision making.
- Requirement that corporation furnish impact statements: may be too extensive under Wal-mart.
Duty of Disclosure
- Potentially a new fiduciary duty, in addition to duty of loyalty and duty of care. Need to understand proxy process first.
- Disclosure is at core of other duties--e.g., need to disclose to shareholders to approve self-interested transaction.
- False or misleading proxy statement is violation of §14(a) of SEC Act.
- Federal government is supposed to scrutinize only disclosure, not fairness of underlying transactions.
- Direct actions vs. derivative actions
- Action for proxy violation--difficult to tell whether action is derivative or direct
- Injury from transaction going forward on false or misleading information harms corporation directly, harms shareholders indirectly, since they get burdens of bad deal.
- Shareholders are not harmed as individuals, but harmed as a proportion of their ownership of business--thus from this perspective proxy violation is derivative action.
- However, since each shareholder is impacted individually by being provided bad information; could argue that franchise has been harmed. From this perspective, §14(a) action should be direct action.
- If action is derivative action, plaintiff needs to put up bond for defendants' expenses, acts as jurisdictional block.
- No procedural hurdle to direct action, however.
- Also, scope of remedies: derivative actions usually produce relief and benefits to corporation.
- Prior to Borak, only prospective injunctive relief was available under Federal Securities laws--could only get injunction for full disclosure.
- But Federal Courts have exclusive jurisdiction for claims under proxy rules, thus you had to give up possibility of damages, could not litigate fiduciary duty claims. If you brought fiduciary duty claim, however, would bring it in state court, and could not litigate proxy claims.
J.I. Case Co. v. Borak
[377 U.S. 426] 1964 United States Supreme Court (cb831)
- Actions initiated under §14(a) are both derivative and direct.
- Right to bring proxy suit is federal right, thus federal procedure applies, no requirement to post bond.
- Implied private right of action is derived from broad purposes of Act.
- Even though State Law issues are effected, §14(a) is essentially Federal Right, Federal Courts have full range of discretion to craft remedy.
- Left several questions unanswered
- How do we know hen false or misleading statement is sufficient to give rise to remedy under §14a?
- Would shareholder have had to change vote based on information to be material?
- How to assess causation?
- How does shareholder show result would have been different with disclosure?
TSC Industries, Inc. v. Northway, Inc.
[426 U.S. 438] 1976 United States Supreme Court (cb838)
- Trying to resolve split in circuit on materiality questions
- "All facts a reasonable shareholder might consider important"
- "fact would have significant propensity to affect the voting process"
- Standard will be objective.
- Court doesn't want to overwhelm shareholders with information--wants board to select out important information.
- Omitted fact is material if reasonable shareholder would consider it important in deciding how to vote.
- Do not need to show that shareholder would have changed her mind, only that she would have considered it when deciding how to vote.
- Finally, is it ever appropriate to grant summary judgment in this area?
- Normally, materiality is factual inquiry.
- In certain circumstances, it is possible that omission would be so critical and important that summary judgment could be granted.
Friday, July 25, 2003 (Class 26)
- Relationship between Federal and State Law in securities regulations
- Reluctance at Federal level to scrutinize underlying fairness--should be done at state level
- TSC: Court is trying to encourage optimal level of disclosure, rather than avalanche of information.
Mills v. Electric Auto-Lite Co.
[396 U.S. 375] 1970 United States Supreme Court (cb846)
- TSC dealt with materiality, Mills deals with question of what needs to be shown to prove causation.
- District Court: first determine whether misrepresentation was material, next hold hearing to see on causation.
- District Court: don't need to show that material misrepresentation was outcome-determinative, instead show that people whose vote was needed to approve transaction would have cared about misrepresentation, then causation is proved.
- Appeals Court: looked at underlying fairness; if transaction was not fair, assume shareholders would not have approved transaction.
- Supreme Court: Federal Securities regulation is not about the underlying transaction.
- Might be cases where misrepresentation has nothing to do with fairness of underlying transaction. E.g., might have failed to disclose that Director had committed fraud in the past, has nothing to do with fairness of transaction.
- Causation rule
- First, look for material misrepresentation
- Did you need votes of shareholders who cared about material misrepresentation? If so, then causation is established.
- Fairness analysis only enters in at level of remedies
- Many reasons why plaintiffs might want to go to Federal Court, even if their concern is fairness of underlying transaction
- Federal Courts have exclusive jurisdiction over securities claim; may be issue and claim preclusion in Federal Court after litigating state court claims
- Footnote in Mills: left open question where directors hold majority of shares; or where misrepresentation is unrelated to proxy at all
- Underlying question is whether rules 10a or 14a will ultimately capture most fiduciary duty claims
Santa Fe Industries, Inc. v. Green
[430 U.S. 462] 1977 United States Supreme Court (cb855)
- Rule 10b-5 case
- Short-form merger--defendant parent owned 95% of stuck of Kirby Lumber Company, wanted to acquire remaining 5%
- §253 Delaware law provided that parent could complete merger without consent of minority shareholders
- Minority shareholders were entitled to appraisal rights
- Morgan Stanley determined that Kirby Lumber was worth $125 per share; Santa Fe offered $150 per share.
- Santa Fe notified shareholders that they were entitled to appraisal rights, sent them Morgan Stanley valuation, and assets appraisal.
- At assets appraisal, however, stock was worth $640 per share.
- Instead of objecting and demanding appraisal rights, minority shareholders brought suit in Federal Court, alleging per se violation of 10b-5 which regulates fraud in securities.
- Plaintiffs claim that there was no business purpose other than to take advantage of minority shareholders, and that this constitutes fraud.
- Supreme Court dismisses both of plaintiff's claims
- Wasn't sufficient to show deception in information provided under Rule 10(b)5. Defendants had provided asset values and other information.
- If you give shareholders all information they need to do analysis, do not need to say "this transaction is unfair."
- Idea of making things clear for shareholders: plain English rule, etc., but if facts are presented, unlikely to be held liable for misrepresentation.
Virginia Bankshares, Inc. v. Sandberg
[501 U.S. 1083] 1991 United States Supreme Court (cb862)
- Question of causation when you don't need vote of minority shareholders
- Plaintiffs claimed merger would not have gone through if information had been disclosed, even though they could not have changed vote.
- Possibly could have exercise appraisal rights, might have blocked transaction
- Bad press, other issues
- Could have made claim of breach of fiduciary duty
- Court holds that it was too speculative and uncertain to determine whether board would have gone through with transaction if minority group had dissented
- Possible voidability for conflict of interest that could have been insulated by minority approval; Court holds that ratification vote wouldn't count if minority shareholders were misinformed, thus they could have made state claim for breach of duty of loyalty/fiduciary duty.
- Directors said consideration had "high value" for transaction; Court holds that claim could be made iif Board knew claim was untrue. Unnecessary holding, because Court had already held there was no causation.
- Scalia dissent: difference between statement of opinion and assertion of truth. Wouldn't be actionable if claim was opinion.
- Question remains: what if shareholder has lost right to state remedy?
Wilson v. Great American Industries, Inc.
[979 F.2d 924] 1992 2d Circuit Court of Appeals (cb878)
- If shareholders have relied on proxy statement that misrepresented facts, and have lost appraisal rights, then misrepresentation is actionable under federal securities law, because shareholders have lost appraisal rights as a result of bad disclosure.
- Governing precedent, hasn't reached Supreme Court.
- No requirement to show ability to effect outcome of underlying transaction
- Precisely situation where minority shareholder can't change outcome is when they are most likely to be abused, thus should be protected.
- 14a claim can't be brought if proxy solicitation couldn't effect the outcome of underlying transaction (Virginia Bankshares), unless you've lost a state remedy (Wilson).
- Directors and majority shareholders don't need to disclose that transaction is unfair or dubious (Santa Fe), but must disclose sufficient information for shareholder to conclude transaction is unfair.
- If directors put forward views about fairness and value, must be demonstrably true, can't know it to be false.
Tuesday, July 29, 2003 (Class 27)
National Metal Products Problem
- Delaware corporation, listed on NYSE.
- Proxy contained all information required by SEC about merger and candidates.
- Statements included
- "Board recommends approval of merger. Based upon review of management's report and recommendations and financial statements of IPC. It is board's judgment...that merger is in best interests of company and shareholders."
- National's board meeting in approving merger was very brief. Board only had financial statements for 2 days. Discussion time was 30 minutes.
- Merger was unanimously approved.
- Acquisition problematic as result of price fixing scheme with IPC. No mention in proxy.
- National entered into settlement with environmental agencies regarding violations of rules. Fined $500,000. Board knew about risks but did not disclose risks.
- Rogers owns 1000 shares of common stuck, believes proxy was materially false and misleading in violation of Rule 14a-9.
- Possible state law claims
- Breach of fiduciary duty
- Breach of due care: directors didn't give proper consideration to potential merger
- Breach of due care for failing to monitor for price fixing after merger
- If there was evidence of personal benefit for CEOs, maybe duty of loyalty.
- Environmental issue: if directors knew it was illegal, could be liable; if not, might be protecting by business judgment rule.
- Assuming violation of 14a-9, can Rogers bring suit for relief?
- Borak private right of action to sue for proxy violations, both derivative and direct claims.
- Can possibly get both prospective relief and damages
- Recission of merger
- Determination of damages--difference of value had disclosure been made
- Is it likely that shareholder would have wanted to know?
- Statement can be material misrepresentation if board knows at the time that claim is false.
- Board used same review process three times in the past.
- Omission of prior bad acts of IPC with respect to price fixing: only CEO knew about price fixing.
- Sanford (National CEO) might not have elected to new board
- Mills: need to show that proxy was essential link in merger
- State law requires shareholder approval for merger
- Presume that management does not hold controlling share
- Might have exercised appraisal rights had shareholders known--but don't need to get to loss of state remedy unless you can't prove that vote was required link to approve merger
- Environmental issue: might be able to focus on election of director, if shareholder had known about environmental violation.
- No 10b-5 violation; there was no material misstatement, thus no violation of securities law (under 10b-5 or 14a-9).
- Only three states have passed proxy disclosure laws
- Two states have no private right of action
- Other state has not generated any litigation
- Common law duty to disclose, prominent in Delaware, is broader than proxy disclosure requirements.
- Generally duty to fiduciaries, not duty to public
- Tracks federal law on questions of materiality and causation
- Standard of liability is strict; what to disclose is not protected by business judgment rule
- Can't make business judgment to "mislead"
- Interesting question: how does this impact issue of availability of state remedy at federal level?
- Does it matter if you lost right to state appraisal rights, if there is a cause of action for disclosure at state level?
- Presupposition of securities market: if price reflected all information (both public and private) and that price represented best possible estimate of present value of security, three consequences
- Insider trading wouldn't be profitable
- Publication of false or misleading information about company would cause no harm
- Attemption to outperform market would be futile--every security would have its actual value
- Not true; however. Clearly this is some information that insiders have that is not public.
- Securities market react extremely quickly to information once it is disclosed
- Persons other than insiders with information cannot capitalize once information is public
- If you want to beat market, need to discover facts which people aren't taking into account
- Advantages should not include information that everyone cannot get
Wednesday, July 30, 2003 (Class 28)
- Different theories of insider trading have different ideas of who is the harmed party
- Possible Victims
- Would have traded at different price if they had known what insider knows
- But whether you trade or not won't change if insider's trading is prohibited
- Maybe disclosure is issue, not insider trading
- Insiders will delay disclosure in order to take advantage of their insider status
- Window of time between disclosure and action is very small, information is reflected in market almost immediately
- But there is no incentive to delay good news disclosure, and if there is bad news, insider sale will convey that information, which would not otherwise be disclosed.
- Increases cost of capital
- Investors can't tell who is going to engage in inside trading, thus need to discount all stock prices but expectation that there will be insider trading
- Depends on other theories of harm, however
- Could be fixed by companies themselves; could enact bylaws prohibiting insider trading if they wanted to, in order to attract investors
- Might be helpful to investors--encourage better management
- Might also stabilize stock prices, as information leaks out through insider trading
In re Cady, Roberts & Co.
[40 S.E.C. 907] 1961 Securities Exchange Commission (cb928)
- First SEC insider trading case
- Investor discovered that company was about to cut dividend because he was on board of company, sold stock short and sold stock for children.
- Corporate insider who possessed material nonpublic information obtained for corporate purposes could be held for trading on information prior to its disclosure
- If you get information just for corporate purposes and not for personal benefit, can't act on it or must disclose it.
- Held to be unfair.
- Normally, in a fraud case, there needs to be a one-to-one relationship between perpetrator and victim; SEC acknowledged that 10b-5 was more protective than common law fraud.
- 10b-5 must cover stock market, according to SEC, because most securities transaction are on stock market.
- 10b-5 had been on books since 1942, first time it was used.
- 10b-5: illegal to use manipulative or otherwise deceitful practice in sale of securities.
Securities and Exchange Commission v. Texas Gulf Sulphur Co.
[401 F.2d 833] 1969 2d Circuit Court of Appeals (cb930)
- SEC prosecuted officers, directors, and employees; one question is "who is insider?"
- Texas Gulf Sulphur was mining company, was looking for geological features in Canada indicating precious metals
- Company decides to engage in land acquisition, tries to keep discovery secret so property price doesn't go up.
- Several defendants purchased stocks or calls.
- Next year, board issued stock options to managers, but board was unaware of property discovery.
- Rumours started leaking out about possible discovery
- Defendant read about rumours in press, called up other defendants and decided to issue press release that understates discovery.
- Stock price then dips.
- Various trades between first press release and second press release announcing discovery.
- District Court found no 10b-5 violation for most defendants; information about mine did not become material until 4/12 press release.
- Defendant who traded between 4/12 press release and 4/16 press conference was found to be insider trader
- Defendant who traded after 4/16 conference was not, because information had been disclosed
- Court of Appeals decides that key question is materiality: when does information become sufficient material to constitute material insider information for the purposes of insider trading?
- Involves likelihood of truth of information and magnitude or importance of information.
- Was this the sort of information that it would effect investors decision to trade?
- Obviously it was, because everyone was buying up stock when they knew information.
- Court did not hold that information needed to be disclosed, but only that it couldn't be traded on until it was disclosed.
- Issue is not just when disclosure was made, but whether there was sufficient time for information to reach market.
- Thus, both defendants who traded before and after press conference were liable for 10b-5 violations.
- Insider is not only one who is liable; also people who find out from insiders.
- On remand, District Court found all defendants liable.
- Damages were equal to price after press conference--difference between how much insider paid and post-press conference price.
- Chiarella: only people with fiduciary relationship has duty not to disclose
- Dirks: could be "temporary" insider as lawyer, accountant, etc., without direct fiduciary relationship to shareholders
- Need to also know, as "tippee", that information is privileged, to be liable.
- O'Hagan: misappropriation theory. Lawyer in law firm representing acquirer in merger, told someone to buy stock in company to be acquired. Lawyer has no fiduciary relationship to company to be acquired. If you misappropriate material nonpublic information and use it for personal gain, then misappropriation is violation.
Friday, August 1, 2003 (Class 29)
Insider Trading Conclusion
- Private right of action against insiders or constructive insiders (lawyers, accountants), tippers, tippees, controlling persons.
- Liability for private actions under 20(a) is limited to actual profits--difference between what price of stock would have been had information been disclosed and price insider got.
- Rule 21a
- §32(a): Criminal penalties for insider trading.
- Designed by Judges to give shareholders mechanism for challenging management abuse when management itself is unlikely to challenge its own behavior
- Emerged from equitable doctrine
- As equitable remedy, intended for extraordinary situations.
- Seeks to balance board discretionary decisionmaking ability with shareholders' rights.
- Rationales for derivative suit
- Problems with shareholder's suits--collective action problem--fixed by derivative suit
- Private enforcement of fiduciary duties discourage government regulation
- Ability to obtain costs and attorneys fees permits single shareholder to engage in efficient monitoring
- Derivative actions may be bad surrogate; because ownership for shares changes all the time, shareholder at time of alleged bad act may not be shareholder at time of recovery
- Response: corporation has independent existence, why should it matter who recovers?
- Given that share of benefit for shareholder is so small, are incentives really proper?
- Usually, counsel chooses plaintiff for derivative suit.
- Counsel gets fees if case goes to settlement and it is deemed to be in best interest of corporation.
- Thus, Counsel may have incentive to settle earlier, while shareholder might want maximum recovery because portion of benefits is so small.
- Defendant is usually indemnified, and damages are covered by insurance. Thus, risk averse defendants are incentived to settle without admitting wrongdoing, in order to get costs covered.
Bangor Punta Operations, Inc. v. Bangor & Aroostook Railroad Co.
[417 U.S. 703] 1974 United States Supreme Court (cb1028)
- Claim involves harm to subsidiary (BAR) from parent corporation (BPO) which is subsidiary of BP.
- Amoskeag buys 99% of BAR after alleged harms.
- Issue is whether shareholder who did not own stock at time of injury has standing to sue.
- Derivative action by Amoskeag on behalf of BAR.
- Court holds that FRCP 23.1 requires contemparaneous ownership in order to have standing to bring derivative action
- Dissent: case could have been brought by 1% minority shareholder. Benefit is going to corporation, not to Amoskeag.
- Depends on whether you see issue as deterrence or compensation.
- Some suggestion that contemparaneous ownership rules are loosening up, in context of injuries to corporation which have a "continuing legal effect".
- Creditor standing: conceptual difference between debt and equity. General rule is that creditors have no standing to bring derivative actions on behalf of corporation.
- Demand requirement: derives from nature of derivative suit remedy. Claim is based on idea of direct injury to corporation, indirect injury to shareholders. Shareholders must make demand on corporation that they take up and correct aggrieving matter first.
- Exception to demand requirement: Futility exception.
- Rational board or not guilty board might actually sue, or could decide it's not worth it. Business judgment whether or not to bring derivative action.
Wednesday, August 6, 2003 (Class 30)
- State law claims
- Breach of fiduciary duty: duty of loyalty, duty of care
- Duty of care: consulting agreement with outgoing board members and chairman; increased compensation for incoming board; stock options granted to new members. Failed to talk to consultants, do study, to see industry standards. Presumption of business judgment rule and good faith.
- Duty of loyalty: New board members; would need to find some sort of conflict of interest.
- What was benefit to company of granting options that could be exercised immediately?
- Why did Willy, Jr. get 10x what his father got? Why does he father continue to get paid what he was paid when he was working? What is consideration for consulting agreements? Looks like self dealing.
- Doesn't consideration for Willy, Sr. look like compensation for past services, in which case it would be corporate waste?
- By granting immediately exercisable option, might look more like a transfer.
- May be a business purpose for consulting agreements.
- Procedural and substantive fairness.
- If plaintiffs can show self-dealing, defendants can rebut by demonstrating procedural fairness.
- "Common enterprise" idea -- board members agree to approve each other's compensation
- Could be approved by disinterested shareholders; board members own %47, Wentworth Charitable Foundation owns 5%. Question: was board member who heads up Wentworth Charitable Foundation able to influence vote of Foundation?
- If board shows procedural fairness, then plaintiff needs to demonstarte substantive unfairness
- Might be duty of disclosure under state law issue
- Federal claims
- Proxy statement problems
- Did board disclose sufficient information for a reasonable shareholder to piece together the fairness of the deal?
- Should board have disclosed comparative historical data?
- "Substantial likelihood that shareholder would have considered it important in voting."
- If board makes statement, it is weighed heavily; can't make statements they know to be false when they make them.
- "Compensation until consulting agreement is fair and reasonable." "Great value; significant access" etc.. Is this sufficient to show that board knew it to be false at time?
- Need to demonstrate materiality.
- Causation: was this something shareholders were entitled to vote on? No, not compensation; was their vote necessary for approval?
- Loss of state right?
- Injury: who was hurt by misrepresentations? After misrepresentation, stock value increased. Does stock value have to decrease again before injury can be proved? Or were people who bought stock at higher price injured?
- Press release as part of proxy solicitation--might be understood to be solicitation. Unlikely to prevail.
- Maybe 10b5 claim with respect to press release--misrepresentation in connection with purchase or sale of securities... who was harmed?
- Procedural hurdles
- Demand requirement: do we have obligation to make demand on board with respect to breach of fiduciary duty claims?
- Need to make demand unless it would be futile; look to Aronson test.
- Don't need to make demand requirement with respect to duty of loyalty claims.
- Problem: board that made decisions is different from sitting board now. Rails v. Blasband: if there has been a change of board, then look to see whether you could plead sufficient facts to demonstrate that the board was unlikely to be disinterested.
- Is Willy, Jr. disinterested or dominated by Willy, Sr.?
- Did new board members get any personal financial benefit from deal? (doesn't appear to be).
- If not, then new board members could make determination as to whether or not to bring suit, demand futility would fail.
- Use old Rule 8.31 for conflict of interest, not subchapter F from supplement.