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Business associations Section 2a: Firms – general concepts Prof. Amitai Aviram University of Illinois College of Law Copyright © Amitai.

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Presentation on theme: "Business associations Section 2a: Firms – general concepts Prof. Amitai Aviram University of Illinois College of Law Copyright © Amitai."— Presentation transcript:

1 Business associations Section 2a: Firms – general concepts Prof. Amitai Aviram University of Illinois College of Law Copyright © Amitai Aviram. All Rights Reserved F14D

2 1.Types of firms – Concepts common to different types of firms – The corporation – The partnership 2.Customizing the firm (private ordering) 3.Firms: external relationships Firms: general concepts Overview of Section 2a © Amitai Aviram. All rights reserved. 2

3 Business associations (BAs or firms) are legal concepts designed to allow multiple beneficiaries to conduct business jointly – In contrast, agency law is optimized for a single beneficiary (principal) conducting business through one or more actors (agents) – Agency law can govern co-principals (Rest. 3.16), but the legal issues that arise from having multiple beneficiaries are underdeveloped External relationships: with multiple Bs, no single person is the business – So Bs need to create an artificial being with an (independent) legal personality – Asset partitioning: separation of firms & Bs assets/liabilities (e.g., limited liability) Internal relationships: as artificial beings, firms must have human beings act on their behalf – So firms face an agency problem from whomever acts on their behalf: agents, organs (those who control the agents for the firm; i.e., the BoD), controllers (the Bs who control the organs) – Having multiple Bs requires changes to the agency solutions because of rational apathy: some/all Bs will lack ability/incentive to monitor actors efficiently Types of firms Comparing firms to agency © Amitai Aviram. All rights reserved. 3

4 Types of firms How firms are created Spontaneous creation (general partnerships & some business trusts) – Firm is created when SHs act in certain ways, even if they formally dont act to (or even want to) create a firm – Similar to agency (which is created when P&A satisfy Rest. §1.01 test) Creation by filing (corporations, limited partnerships, LLLPs, LLCs) – Firm is created when Secretary of State confirms that an entrepreneur (a SH or someone who will recruit SHs) filed certain documents Creation by conversion (firm of one type become another type) – Conversion through election (firm converts by filing some document) General partnership can convert into limited liability partnership or limited partnership; limited partnership can convert into general partnership – Conversion through merger (firm converts by merging into another firm of a different legal type) Requires statutory authorization (typically, conversion between corporation/limited partnership/LLLP/LLC authorized & conversion between general partnership/limited partnership are authorized) © Amitai Aviram. All rights reserved. 4

5 Types of firms Financial terminology To finance operations, firms receive money from investors in return for claims on its assets & future profits Capital can mean either side of this transaction – Firms money (& other resources, stated in terms of money value) – Investors claims on firms assets & future profits Capital is categorized as debt or equity, depending on nature of claim – Debt: Claim to a predetermined stream of money, unrelated to the firms performance (e.g., bonds, loans). Owner of claim is a creditor. – Equity: Claim to the remainder of the firms assets after paying all other claims. Owner of claim is a SH. Units of equity capital are called: shares (in MBCA) or stock (in DGCL) in a corporation ; (partners) interest in GP/LLP; distributional interest in LLC; units in some firms – Some types of capital are hybrids with characteristics of both debt & equity (e.g., convertible bonds) © Amitai Aviram. All rights reserved. 5

6 Types of firms Constitutional documents A firms constitutional documents regulate the firms legal internal relationships (between the firm, SHs & management) – Required: firm-specific info (e.g., name of firm, address, # of shares) – Optional: opting out & replacing default rules Two common models – A single document Private document: partnership agreement (in general partnerships) Public document: memorandum of association (some non-US corporations) – Two documents; one public (usually more difficult to change & less detailed), the other private (easier to change & more detailed) In US corporations – Charter – Articles of Incorporation (MBCA) / Certificate of Incorporation (DGCL) – public; must contain certain info, may contain more – Bylaws – private; easier to amend; cant contradict charter In LLCs: articles of organization / operating agreement In LLPs: statement of qualification / partnership agreement © Amitai Aviram. All rights reserved. 6

7 Country Laws of physics Constitution Laws/regulations Presidential directive Decisions of govt employees Types of firms Hierarchy of legal sources in a corporation © Amitai Aviram. All rights reserved. 7

8 Corporation Applicable federal/state laws Charter Bylaws BoDs resolutions Decisions of officers Country Laws of physics Constitution Laws/regulations Presidential directive Decisions of govt employees Types of firms Hierarchy of legal sources in a corporation © Amitai Aviram. All rights reserved. 8

9 Private firm (few SHs) – Direct control by SHs – Liberal dissolution (easy for dissenting SH to dissolve firm) – Restricted alienability (difficult to sell interest to 3 rd parties) – Contractual flexibility (parties can opt out of most rules) Public firm (many SHs) – Delegated control (firm controlled by a BoD that is elected by SHs) – Restrictive dissolution (difficult for dissenting SHs to dissolve the firm) – Liberal alienability (easy to sell shares to 3 rd parties) – Contractual rigidity (most rules are mandatory) Passive firm (often a single SH) – Firm owns assets but doesnt conduct active business – Firm structure used to benefit from some legal features (e.g., preferable tax treatment; limited liability, etc.) Types of firms Economic types of firms © Amitai Aviram. All rights reserved. 9

10 Partnership – General partnership (GP or partnership) – Limited liability partnership (LLP) – Limited partnership (LP) – Limited liability limited partnership (LLLP) Corporation (corp) – Public corporation – Close corporation Limited liability company (LLC) – Two defaults for governance: member-managed (similar to partnership) or manager-managed (similar to corporation) Business trust (BT) – Based on the common law concept of a trust Types of firms Legal types of firms © Amitai Aviram. All rights reserved. 10

11 Types of firms The corporation By default, the corporation is optimized to be a public firm – Delegated control – Liberal alienability/restricted dissolution – Contractual rigidity Some corporate laws have special rules for close corporations, which are optimized to be a private firm Public corporation (or publicly-traded corporation): corp that issued shares to the public, optimized to be a public firm – This is usually defined by Federal securities laws, not state corporate law Applicable law – Corporations are governed by state statutory law Less uniformity between states than in agency or partnership law Public corporations also subject to federal securities laws – ABA created a Model Business Corporation Act (MBCA) Serves as uniform law on which some states base their corporate law – Majority of publicly-traded companies incorporated in Delaware Delaware General Corporation Law (DGCL) is dominant for public corps © Amitai Aviram. All rights reserved. 11

12 The corporation Close corporations (DGCL) DGCL §342 allows corp to elect close corporation status, if: – Charter provides that it is a close corporation – Charter provides that it may have no more than 30 SH – Corporation didnt issue stock in a public offering – Stock is subject to one/more transfer restrictions specified in §202 DGCL rules unique to close corporations – Direct control/contractual flexibility DGCL §351: charter may have corp managed by SHs rather than directors DGCL §350: SH agreement between SHs who hold a majority of the outstanding voting stock may bind the parties even if it interferes with the BoDs discretion or power – Within this scope, directors are relieved from FD, which are imposed instead on the SHs party to the agreement – DGCL §354: Shields SH agreements from being voided because they operate corp as if it were a partnership – Liberal dissolution DGCL §355: Charter may give SHs a right to dissolve the corporation (at will or at the occurrence of a certain event) © Amitai Aviram. All rights reserved. 12

13 The corporation Close corporations MBCA – No formal election to be a close corp, but some rules apply when corps shares are not publicly traded – Liberal dissolution Judicial dissolution allowed in cases of deadlock/oppression, if corp is not listed on stock exchange, has <300 SHs & <$20M value [MBCA §14.30(b)] When judicial dissolution is allowed, SH may elect a buy-out in lieu of dissolution [MBCA §14.34] – Contractual flexibility Permits SH agreements (if all SHs are parties to it) [MBCA §7.32] Common-law close corporations – Case law in some states (e.g., Mass.) applies different rules when corp is closely-held; close corp still follows identical formalities to a public corp – Direct control FD analysis is more sensitive to risk of oppression of minority SHs – Liberal dissolution Courts are less reluctant to order judicial dissolution when relationship between SHs is dysfunctional © Amitai Aviram. All rights reserved. 13

14 The corporation Creating a corporation Choose the state of incorporation Draft Charter File Charter with the relevant states Secretary of State – The person filing the charter is the incorporator (DGCL § 107/MBCA §2.01) – State will process & certify the filing – Corporation has been created! (DGCL §106/MBCA §2.03) Draft bylaws (DGCL §109/MBCA §2.06) Organizational meeting (DGCL §108/MBCA §2.05) – Name directors – Adopt bylaws Directors convene & appoint officers Issue shares © Amitai Aviram. All rights reserved. 14

15 Corporation is created only when Secretary of State acknowledges that the charter was filed Exception – defective corporation: sometimes courts recognize a corporation even without Secretary of States certification of the charter being filed – De facto corporation – Corporation by estoppel The corporation Defective corporations © Amitai Aviram. All rights reserved. 15

16 An incorporator is an agent of the corporation – Owes the corporation FD – Until corporation is formed, incorporator is liable to T as an agent to a non-existent principal Hypo: Incorporator Inga signs contract with third party Tom, on behalf of C Corp., a corporation not yet created. Later, Inga creates C. How can C become party to the contract? Can C ratify the contract? (recall Rest. §4.04(1)(a)) Adoption (as opposed to ratification): – Does not relate back to time of contracts formation – Does not release A from liability The corporation Liability for pre-incorporation acts © Amitai Aviram. All rights reserved. 16

17 Types of firms The partnership By default, GP is optimized to be a private firm – Governed in most states by the Uniform partnership act (1997) (RUPA) – A few states still use the Uniform partnership act (1914) (UPA) Other variations of partnerships – Limited liability partnership (LLP): same as GP except partners have limited liability (governed by RUPA) – Limited partnership (LP) Two classes of partners: general & limited General partners have control rights & unlimited liability Limited partners have limited liability & very limited control rights Governed by Uniform Limited Partnership Act (ULPA) – Limited liability limited partnership (LLLP): same as LP except that all partners have limited liability (governed by ULPA) © Amitai Aviram. All rights reserved. 17

18 The partnership Creating a GP Definition of a GP – RUPA §§101(6), 202(a): an association of two or more persons to carry on as co-owners a business for profit – Co-owners means: Shared control of the business; and Shared profits of the business. – No formal creation requirements. Doing business as co-owners results in creation of partnership by operation of law. Fenwick [NJ 1945] – Fenwick owns a beauty shop; Chesire works as a receptionist – Chesire demands raise; Fenwick counters with offer to make her a partner, with a right to 20% of the profits (in addition to her salary). They sign an agreement. – Unemployment Compensation Commission disputes existence of a partnership. Why? What does Fenwick claim? Whats his best argument? Whats the Commissions argument? © Amitai Aviram. All rights reserved. 18

19 Fenwick courts analysis – Intention of parties: No change in business operation – Right to share in profits: Chesire gets 20% – Obligation to share in losses: Chesire not obligated – Ownership and control of property and business: Fenwick retains – Community of power in administration: Chesire not involved – Conduct of the parties toward 3 rd parties: Filed partnership tax returns, but didnt hold themselves out as partners to suppliers & Fenwick licensed their trade name personally – Rights of parties on dissolution: Chesires dissolution is similar to quitting a job How much shared control is enough? – According to Day v. Sidley & Austin (1975), Sidley & Austin was managed in the following way: Executive Committee decides on all matters, except for participation, admission & severance of partners The latter require the approval of partners holding a majority of partnership interests (not majority of partners) – This minimal shared control was seen as sufficient; S&A is a partnership The partnership Creating a GP © Amitai Aviram. All rights reserved. 19

20 The partnership Creating a GP: exercise Key reason for Fenwick courts ruling was that the agreement gave Chesire no management rights. Structure an agreement that would give her formal management rights but allow Fenwick to run the show Fenwick court noted Chesire didnt share in losses. Mitigate this factor while being sensitive to increasing Chesires risk Suppose Fenwick decides to hire Chesire as a non-employee agent instead of making her partner. Make Chesire a non-employee agent without changing the substance of the relationship © Amitai Aviram. All rights reserved. 20

21 1.Types of firms 2.Customizing the firm (private ordering) – Customizing via SH agreements – Customizing via constitutional documents 3.Firms: external relationships Firms: general concepts Overview of Section 2a © Amitai Aviram. All rights reserved. 21

22 Customizing the firm Customizing in public & private firms Rules governing a firm can be derived from the law or from contracts created by the stakeholders Public firms derive more rules from laws and fewer from contracts compared to private firms – More mandatory laws (that contracts cannot modify) – Opting out of defaults is done by manipulating the firms institutions (e.g., rights attached to shares, or to firm offices) rather than manipulating individual SHs rights Example: X wants double the voting rights of other SHs Private firm (e.g., partnership): partnership agreement provides that X has double voting rights Public firm: charter creates Class B shares with double voting rights as Class A shares; X receives Class B shares © Amitai Aviram. All rights reserved. 22

23 Customizing via SH agreements Why is agreement enforcement a major issue? SHs in a close corporation sign a SH agreement obligating them to vote in favor of a specified slate of directors – Directors favor expanding into the widget market Some SHs renege on the agreement; vote for directors who refuse to expand into widgets – As a result, Acme does not expand into widgets Other SHs sue for breach of the agreement – What are the damages? How easy is it to prove them? – How can you make the agreement easier to enforce? © Amitai Aviram. All rights reserved. 23

24 Customizing via SH agreements 1. Voting trust Title of shares transferred to a trust Agreement forming the trust gives trustee power to vote the shares Disadvantages? Statutory restrictions – Publicity: some states require the voting trust to be made public (e.g., DGCL §218), or to submit to the firm information on participating SHs (e.g., MBCA §7.30), which makes this info accessible to MSHs through SH inspection rights – Duration: some states limit the duration of voting trusts (MBCA used to have a 10-year limit, but no longer does) © Amitai Aviram. All rights reserved. 24

25 Customizing via SH agreements 2. Contractual enforcement a)Specific performance – DGCL §218(c) allows voting agreements, implicitly allows a remedy of specific performance – MBCA §7.31(b) states that voting agreements are specifically enforceable – Court may refuse to enforce due to oppression / violation of other SHs rights b)Irrevocable Proxies – Proxies usually revocable; can be made irrevocable if attached to an interest [MBCA §7.22(d)] – Being a party to a voting agreement is considered an interest [MBCA §7.22(d)(5)] – So, the proxy tends to be an enforcement mechanism that is ancillary to a voting agreement c)Is the SH agreement valid? – If it constrains discretion that isnt subject to FDs (e.g., appointing directors) Voting agreements generally permissible [DGCL §218(c); MBCA §7.31] – If it constrains discretion that is subject to FDs (e.g., appointing officers) Does it impermissibly constrain BoDs discretion? [McQuade/Clark] © Amitai Aviram. All rights reserved. 25

26 Customizing via SH agreements McQuade v. Stoneham [NY 1934] Stoneham owned a majority of the stock of the NY Giants McGraw (the Giants manager) & McQuade (a city magistrate) bought a small amount of stock from Stoneham The three signed a SH agreement – Agreed to do their best to elect each other as directors & appoint each other officers at specified salaries McQuade lost Stonehams favor & was fired – McQuade sues for specific performance Court: – BoD must exercise independent business judgment on behalf of all SHs – If directors agree in advance to constrain BoDs judgment, SH will not receive the benefits of their independence – Therefore, agreement is void as against public policy Protection in the SH agreement didnt save McQuade – How can he protect himself from being fired? © Amitai Aviram. All rights reserved. 26

27 Customizing via SH agreements McQuade v. Stoneham McQuade seems to offer a bright line rule ValidVoid But the rule is not so bright Constrain SH judgment Constrain director/officer judgment © Amitai Aviram. All rights reserved. 27

28 Customizing via SH agreements Clark v. Dodge [NY 1936] Clark knows a valuable secret formula. Dodge contributes money. They form two drug companies. Clark and Dodge sign an agreement: – Clark agrees to disclose his secret formula – Dodge agrees to invest the required money – Clark receives 25% of profits (salary & dividends) – Dodge would vote, both as SH & director, to assure that Clark would be a director & General Manager as long as his performance was faithful, efficient and competent – Why does Clark need the agreement? Why does Dodge? Clark discloses secret formula. Dodge eventually fires Clark. – Clark sues. Dodge claims SH agreement is void. – Apply the reasoning in McQuade to this case © Amitai Aviram. All rights reserved. 28

29 Customizing via SH agreements Clark v. Dodge Clark court: MSHs arent harmed by a commitment to keep someone as an officer as long as he is faithful, efficient and competent – I.e., SH agreements are valid if SH merely agree to do as directors what they could do validly anyway This contradicts the holding in McQuade – Also, SHs may be harmed by an obligation not to fire without cause (e.g., downsizing; better/cheaper candidate) Clark court: McQuade was designed to protect MSHs who were not parties to the agreement – In Clark, all SHs are parties to the SH agreement Clark creates an exception to McQuade when all SHs are parties to the SH agreement How can Dodge avoid the SH agreement (reach McQuade outcome)? © Amitai Aviram. All rights reserved. 29

30 Customizing via SH agreements Homemade McQuade The homemade McQuade Turning Clark… … into McQuade © Amitai Aviram. All rights reserved. 30

31 Customizing via SH agreements Homemade McQuade Preempting the Homemade McQuade – The company can prevent a Homemade McQuade by creating constructive knowledge of the agreement – including the agreement in the charter or printing a reference to the agreement on all stock certificates Another obstacle for Homemade McQuades – Galler v. Galler – In Galler, the court held that a SH agreement is valid even if not all SHs are parties to it, if: The corporation is closely-held The terms are reasonable (i.e., MSH should not object) The MSH does not object © Amitai Aviram. All rights reserved. 31

32 Customizing via SH agreements Caselaw summary McQuade: SH can commit to how they vote as SH, but cannot constrain their judgment (or others on their behalf) as directors Clark: SHs can constrain their judgment as directors, if all SH are parties to the SH agreement Galler: SHs can constrain their judgment as directors even when some SHs arent parties to SH agreement, if terms of agreement are reasonable and fair to those SHs (& those SHs dont complain) © Amitai Aviram. All rights reserved. 32

33 Customizing via constitutional docs Constitutional documents: contents Charter: mandatory terms [DGCL §102(a)] – Firms name – Address of firms registered office and name of its registered agent – Nature of the business to be conducted (any lawful act or activity) – Name/address of incorporators and initial directors – Specify if firm is not a stock corporation (in which case, conditions of membership must either be specified, or refer to bylaws) – A statement of the designations and the powers, preferences and rights, and the qualifications, limitations or restrictions [on firms stock] – Number of authorized shares & share par value Both authorized shares & par value will be explained in a few slides © Amitai Aviram. All rights reserved. 33

34 Customizing via constitutional docs Constitutional documents: contents Charter: optional terms [DGCL §102(b)] – Any provision for the management of the business and for the conduct of the affairs of the corporation, and any provision creating, defining, limiting and regulating the powers of the corporation, the directors, and the stockholders […] – Any provision which is required or permitted […] to be stated in the bylaws may instead be stated in the certificate of incorporation […] – SH preemptive rights – Supermajority requirements for SH or BoD votes – Opting out of limited liability or perpetual existence – Limits on directors fiduciary duty Bylaws [DGCL §109(b)] – The bylaws may contain any provision, not inconsistent with law or with the [charter], relating to the business of the corporation, the conduct of its affairs, and its rights and powers or the rights and powers of its stockholders, directors, officers or employees. © Amitai Aviram. All rights reserved. 34

35 Customizing via constitutional docs Constitutional documents: contents Creation of constitutional documents – Charter [DGCL §101(a)]: incorporator – Bylaws [DGCL §109] Until stock is issued – BoD After stock is issued – SHs, but charter may also authorize BoD to amend bylaws Amendment of constitutional documents – Charter [DGCL §242(b)] First, BoD must adopt the proposed amendment Then, SHs approve the proposed amendment (in some circumstances, SHs vote in separate groups [DGCL §242(b)(2)]) – Bylaws [DGCL §109] SHs always allowed to amend BoD not allowed to amend by default, but charter may authorize BoD to amend bylaws © Amitai Aviram. All rights reserved. 35

36 Customizing via constitutional docs Constitutional documents: assumptions for exam On the exam, assume that the corporations mentioned in the fact pattern have the following terms in their constitutional documents, unless the fact pattern states otherwise Charter – Corp. is a stock corporation, has limited liability & perpetual existence – Corp. may conduct any lawful act or activity – Director FD is limited to the maximum degree allowed under §102(b)(7) – BoD may amend bylaws Bylaws – Chairperson of BoD is authorized to call a BoD meeting – BoD is authorized to call both annual & special SH meetings © Amitai Aviram. All rights reserved. 36

37 Customizing via constitutional docs Constitutional documents: limits on bylaws Boilermakers Local 154 Retirement Fund v. Chevron Corp. [Del.Ch. 2013] – Chevron & FedEx BoDs amend bylaws to add a forum selection bylaw, which requires that derivative suits, fiduciary duty suits, DGCL suits and internal affairs suits involving the company will be adjudicated in Delaware courts. – The bylaw addresses venue (which court) not applicable law. What law would apply to fiduciary duty suits, internal affairs suits, etc. & why? Plaintiff SHs sue to invalidate the bylaws, claiming: – Bylaw does not have valid subject matter – Bylaw is not binding on SHs because BoD, not SHs, amended the bylaw – Bylaw should be invalidated because there are many circumstances in which it can be abused © Amitai Aviram. All rights reserved. 37

38 Customizing via constitutional docs Constitutional documents: limits on bylaws Valid subject matter – DGCL 109(a): bylaws may address any subject not inconsistent with law or with the certificate of incorporation, relating to the business of the corporation, the conduct of its affairs, and its rights or powers or the rights or powers of its stockholders, directors, officers or employees. 1.Bylaws are subordinate to the law & charter So, anything that the law says should be in the charter (e.g., number of authorized shares, rights of shares) is not valid bylaw subject matter 2.Valid subject matter includes Business/affairs of firm Rights/powers of firm, SHs, directors, officers & employees 3.Bylaws dictate process, not substantive decisions Court: [B]ylaws typically do not contain substantive mandates, but direct how the corporation, the board, and its stockholders may take certain actions. © Amitai Aviram. All rights reserved. 38

39 Customizing via constitutional docs Constitutional documents: limits on bylaws Effect of BoD-adopted bylaws – By law, SHs have the right to amend bylaws; BoD may amend bylaws only if the firms charter allows it – The charters of Chevron and FedEx allowed the BoD to amend bylaws – Court: Delaware law does not follow the vested rights doctrine, which prohibits a BoD from modifying bylaws in a way that diminishes SH rights without SH consent – Any SH who bought shares in the company knew of the authority BoD had to amend bylaws, had consented to being governed by the bylaws as may be amended by the BoD – SHs can always repeal a BoD-amended bylaw they dont like Potential for abuse – In an earlier case (CA, Inc. v. AFSCME Emps. Pension Plan [Del.2008]), the court said a bylaw is not valid because there are many potential situations in which it would mandate actions that would violate directors FD – Chevron court clarifies that CA was a unique case & doesnt represent Del. law – Bylaw is not invalidated because it can be abused; if a particular act abuses the bylaw, that act can be challenged © Amitai Aviram. All rights reserved. 39

40 Customizing via constitutional docs Stock specifications Delaware – DGCL §102(a)(4) allows corporations not to issue any stock (charter needs to state this & either specify conditions of membership or that these conditions are in the bylaws) – DGCL §151(a): Every corporation may issue 1 or more classes of stock or 1 or more series of stock within any class thereof, any and all of which classes… may have such voting powers, full or limited, or no voting powers, and such [economic rights]… as shall be stated… in the certificate of incorporation… or in [a BoD resolution] pursuant to authority expressly vested in it by its [charter]. – DGCL §151(b) allows the issuance of redeemable shares as long as after redemption there are still shares with full voting powers – DGCL §151(e) allows the issuance of convertible shares MBCA – MBCA §6.01(b) – Minimum requirements: At least one class of shares with unlimited voting rights At least one class of shares with a residual claim (i.e., the right to receive the net assets of the corporation upon dissolution) – doesnt have to be the class with unlimited voting rights – MBCA §6.01(c) – Authorizes non-voting stock, convertible stock, and other characteristics of stock © Amitai Aviram. All rights reserved. 40

41 Customizing via constitutional docs Stock specifications Authorized shares: Maximum # of shares corporation can have – BoD has authority to issue shares, up to the authorized number (DGCL §161) – What purpose do authorized shares serve? (Note: number of authorized shares must be specified in charter; changes to charter require both BoD & SH vote) Outstanding shares: # of shares corp issued (& not repurchased) Authorized but unissued shares: Shares that are authorized but have not been issued by the firm (or were issued & repurchased) – Example: Acmes charter says it has 1,000 authorized shares. Acmes BoD issues 200 shares to investors. Acme now has 1,000 authorized shares, 200 outstanding shares, 800 authorized but unissued shares Treasury shares (DGCL): shares that have been issued in the past, but later repurchased by the issuing corporation – Example: Acme Corp. now repurchases 50 of its 200 outstanding shares. After purchase, it has 1,000 authorized shares, 150 outstanding shares, 50 treasury shares, 800 authorized but unissued shares – MBCA classifies treasury shares as authorized but unissued shares (MBCA §6.31(a)) I.e., Acme has 1,000 authorized shares, 150 outstanding shares, 850 authorized but unissued shares © Amitai Aviram. All rights reserved. 41

42 Customizing via constitutional docs Policy on customizing control rights Hypo 1: Acme Corp. has only one class of stock. SHs are entitled to dividends (if BoD authorizes dividend distribution) & to Acmes net assets upon dissolution, but not entitled to vote – Is this permitted by MBCA §6.01? – Are there any risks to this capital structure? Hypo 2: Acme has instead two classes of stock – Class A shares are the same as in the above hypo (entitled to dividends & net assets upon dissolution, but not entitled to vote) – Class B shareholders have the same rights as Class A, except that each Class B share also has one vote – Is this permitted by MBCA §6.01? – Are there any risks to this capital structure? © Amitai Aviram. All rights reserved. 42

43 Customizing via constitutional docs Policy on customizing control rights Can the market protect itself? – Abe is offered Acme non-voting shares; economic value of 1 Acme share is $10 – Abe thinks Acmes directors are a bunch of thieves Abe estimates that they will steal $10M ($1/share) Abe agrees to buy a share for $9 ($10-$1 stolen) – If SH can assess the decrease in share value caused by the inability to keep BoD accountable, then theres no harm from non-voting shares SH pay a price proportionate to their (limited) rights Companies who want to raise capital more cheaply can give voting rights to SH & receive a higher price per share – Can SH assess the harm from an unaccountable BoD? Does FD suffice? – Suppose that there is no way to assess the discount for lacking the ability to keep the BoD accountable. Nonetheless, a BoD action that is not in SHs interest violates directors FD. – Isnt it enough to give SHs right to sue BoD for breach of FD? © Amitai Aviram. All rights reserved. 43

44 Customizing via constitutional docs Policy on customizing control rights If we cant trust the market to protect itself & we cant trust FD to protect nonvoting SHs, why not prohibit nonvoting shares? – Can still bypass with supervoting shares E.g., 1 class A share has 1 vote; 1 class B share has 1M votes – So why not require each share to have equal voting power (1 share, 1 vote)? Equal voting power: SECs attempt – In 1988, the SEC adopted Rule 19c-4, prohibiting any stock exchange or mutual securities association from listing any stock of a corporation that takes any action to the effect of nullifying, restricting or disparately reducing the per share voting rights of existing common SH. – The Business Roundtable v. SEC (D.C. Cir., 1990): Court vacates the rule on the ground that it exceeds SECs authority SEC instead informally pressures stock exchanges to adopt similar requirements in their listing rules But does an equal voting power rule solve the problem? © Amitai Aviram. All rights reserved. 44

45 Customizing via constitutional docs Policy on customizing control rights Hypo based on Stroh v. Blackhawk Holding Corp. [Ill. 1971]: Chris forms Blackhawk Corp., with two classes of shares: – Class A – Normal shares Chris buys 50,000 shares for $2/share (firm receives $100K) – Class B – Voting rights, but no econ rights (no rights to dividends or assets in dissolution) Chris buys 500K such shares for 0.1¢/share (firm receives $500) Blackhawk sells to public 500K Class A shares at $4/share (firm receives $2M) Do Blackhawks shares offer equal voting power? Yes (was required by the Illinois constitution at the time) Does this prevent a split between control & economic rights? No © Amitai Aviram. All rights reserved. 45 BuyerShares AcquiredCostVotesEconomic Rights Chris50K Class A$100K (~4.8%) 50K (~4.8%) 50K (~9%) Chris500K Class B$500 (~0%) 500K (~47.6%) 0 (0%) Public500K Class A$2M (~95.2%) 500K (~47.6%) 500K (~91%) Total$2,100,5001,050,000550,000

46 Customizing via constitutional docs Addressing SH right misappropriation Problem of watered stocks: Acme worth $100, has 10 shares outstanding – How much is each share of Acme worth? – Acmes BoD issues 10 new shares to Jill for $2/share ($20 total) – What is Acme worth now? – How many shares does Acme have now? – How much is one Acme share worth now? – Value of Jills shares? Value of other SHs shares? Legal solutions to the misappropriation 1.Limit the number of shares that BoD is allowed to issue without authorization from the existing shareholders Authorized shares: maximum number of shares that the firm can have Charter must specify the number of shares the corporation is authorized to issue (their number can only be changed by changing the charter) Both MBCA [§1.40(2)] & DGCL [§161] use this concept 2.Set a minimum price for the shares Par value is the minimum price for which a share can be issued (doesnt affect the price share is sold by the SH to a new SH) E.g., Acme has 1M common shares, with a par value of $1. If Acme issues a new share to Sarah, it must receive consideration of no less than $1. Sarah, however, is free to sell the share at any price (or give it as a gift). DGCL uses this concept [DGCL §153(a)]; MBCA does not © Amitai Aviram. All rights reserved. 46

47 Customizing via constitutional docs Addressing creditor right misappropriation Problem of siphoning assets to SHs: Acme has 10 shares outstanding, $100 in assets, no debt – Acme issues $50 of one-year bonds, bearing 10% interest Acmes net assets are now $150; it will need to pay $55 in 1 year A year later, Acme lost $70; it has $80 in assets ($150-70) How much are the bondholders entitled to? – Before bonds mature, Acme declares $8/share dividend SHs receive 100% of Acmes assets ($80); bondholders receive nothing – Instead of dividend, Acme repurchases 8 of its shares at $10 each 80% of SHs receive 100% of Acmes assets; bondholders & 20% of SHs receive nothing Legal solutions to the misappropriation 1.Contractual approach: bond agreement can create limits on dividends/repurchases or state that if certain financial ratios indicate firm approaches insolvency, firm must pay debt immediately 2.DGCL approach: specify a minimum amount of assets that dividends cannot compromise (legal capital) 3.MBCA approach: prohibit a dividend that causes insolvency © Amitai Aviram. All rights reserved. 47

48 Customizing the firm Review Controller Cass is creating a firm, and wants to own 60% of the control rights & 20% of the economic rights Methods 1-2 are suitable for private firms – Customizing via arrangements between SHs – Assume only other SH is minority SH Mary Methods 3-5 are suitable for public firms – Customizing via constitutional documents (share specifications) – Assume other SHs constantly change (the public) © Amitai Aviram. All rights reserved. 48

49 Customizing the firm Review: Method 1 (voting trust) 1 class of shares, 100 shares outstanding: Cass buys 20; Mary buys 80 Mary forms a trust with Cass as the trustee, and transfers to the trust legal title to 40 shares – Mary is the beneficial owner of the fruits of this trust (e.g., dividends), but Cass (as trustee) gets to vote them at his discretion Mary – 40 Trust – 40 Cass – 20 Control: 60% (20+40) Dividends: 80% (40+40) © Amitai Aviram. All rights reserved. 49

50 Customizing the firm Review: Method 2 (voting agreement) 1 class of shares, 100 shares outstanding: Cass buys 20; Mary buys 80 Cass & Mary sign a voting agreement (AKA vote pooling agreement) in which Mary promises to vote 40 of her shares as Cass instructs – Some voting agreements have a designated arbitrator would decide how to vote if parties disagree – To ensure that the agreement is specifically enforceable, Mary may give Cass an irrevocable proxy to vote a 40 of Marys shares Why does Cass need an irrevocable proxy? MBCA §7.22: Proxies are ordinarily revocable at the will of the SH, but a SH can give an irrevocable proxy. Usually, the proxy must be coupled with an interest. Acceptable interests include: – Proxy holder is a pledgee – Proxy holder has purchased/agreed to purchase the shares – Proxy holder is a creditor of the corporation who required the irrevocable proxy in order to extend it credit – Proxy holder is an employee of the corporation who required the irrevocable proxy in his employment contract – Proxy holder is a party to a voting agreement Proxy irrevocable only as long as proxy holder has an interest in firm © Amitai Aviram. All rights reserved. 50

51 Customizing the firm Review: Method 3 (dual-class; 1 share, 1 vote) As in Stroh – Class A shares have one vote per share, full economic rights – Class B shares have one vote per share, no economic rights Assuming firm plans to issue 2M A-shares to raise money – C buys, for a symbolic price (0.1¢) 2M B-shares – C also buys 20% of A-shares (400K shares) – Public buys remaining 80% of A-shares (1.6M shares) – Result: C has 60% of control rights (2.4M out of 4M votes) & 20% of economic rights (400K out of 2M A shares) © Amitai Aviram. All rights reserved. 51

52 Customizing the firm Review: Method 4 (dual-class; voting/non-voting) If non-voting common shares are permissible: – Class A shares are non-voting, full economic rights – Class B are voting, no economic rights C buys 20% of A-shares – Remaining A-shares sold to the public – Result: C has 20% of the economic rights C buys 60% of B-shares – Remaining B-shares sold to other investors who want to buy control rights and who are acceptable to the controller (typically, such investor would also buy A-shares to get economic rights, and will insist on sharing control rights via SH agreement with C) – Result: C has 60% of control rights © Amitai Aviram. All rights reserved. 52

53 Customizing the firm Review: Method 5 (class-specific rights) Design share classes as follows: – Class A shareholders (as a group) appoint 2 of the 5 directors & receive 80% of the economic rights – Class B shareholders appoint 3 directors & receive 20% of the economic rights Controller buys only Class B shares & issues to the public only Class A shares – Results: Controller has 60% of control rights (appoints 3 of the 5 directors), and receives 20% of the economic rights Example: Golden shares © Amitai Aviram. All rights reserved. 53

54 1.Types of firms 2.Customizing the firm (private ordering) 3.Firms: external relationships – Asset partitioning (limited liability) Benefits & costs of asset partitioning Legal analysis of PCV Problem with reverse piercing Asset partitioning in a GP – Legal personality – External claims & liabilities Firms: general concepts Overview of Section 2a © Amitai Aviram. All rights reserved. 54

55 Asset partitioning What is asset partitioning? Asset partitioning means that the property, rights & obligations of the firm are separate from those of the firms SHs Example: Abe owns 100% of the shares of AbeCo. AbeCo borrows money from a bank, but when the loan is due, AbeCo is insolvent – Abe does not need to pay the loan; AbeCos obligation is not his obligation © Amitai Aviram. All rights reserved. 55

56 Why didnt you say limited liability? Limited liability is one side of asset partitioning – the concept that a SH is not liable for the firms obligations – A related concept is that a SH does not have ownership rights in the assets of the firm The other side of asset partitioning is that an entity is not liable for the obligations of its SHs – E.g., John & Jane each own 50% of the shares of a corp running a small grocery store. John declares bankruptcy. The debtors cannot seize the stores inventory. What can they seize that relates to the grocery? Asset partitioning What is asset partitioning? © Amitai Aviram. All rights reserved. 56

57 Asset partitioning What is asset partitioning? Exceptions to asset partitioning Asset partitioning is so ubiquitous that its easier to study the exceptions than the rule – For limited liability (the rule that SHs are not liable for Cs obligations), the exception is called piercing the [corporate] veil (PCV) – For the rule that C is not liable for SHs obligations, the exception is called reverse piercing © Amitai Aviram. All rights reserved. 57

58 Asset partitioning What is asset partitioning? Exceptions to asset partitioning MBCA §6.22(b): Unless otherwise provided in the articles of incorporation, a shareholder of a corporation is not personally liable for the acts or debts of the corporation except that he may become personally liable by reason of his own acts or conduct. Distinguish between: – Direct liability: SHs acts create a legal cause of action against the SH, not just against corp Example: Ann, a shift manager at a restaurant owned by Pancake Corp., gets into an argument with Teresa, a customer who didnt like the food & wants her money back. Ann punches Teresa. Teresa sues Ann & Pancake Corp., but does not request to PCV (nor provides any evidence justifying PCV). Both Ann & Pancake corp. move to dismiss the suit against them. Is Pancake liable to Teresa? Is Ann liable to Teresa if theres no PCV? – PCV: SHs acts cause court to ignore limited liability, so SH becomes liable for the corporations obligations © Amitai Aviram. All rights reserved. 58

59 Asset partitioning Benefits Why have limited liability? Diversification – Diversification reduces risk because by dividing investment between many firms, exceptionally good & bad investments offset each other – Why is reducing risk (getting an average return on the investment instead of a chance of either great or terrible return) a good thing? But with unlimited liability, diversification actually increases risk – Example: Iris has $1,000 available for investment – Barbara offers Iris to buy shares in Barbaras restaurant business – Assuming unlimited liability, what is the largest loss Iris is exposed to if the business fails? – With unlimited liability, risk increases the more firms you invest in Limited liability facilitates smaller, more risk-averse, and minority (i.e., non-controlling) equity investments © Amitai Aviram. All rights reserved. 59

60 Asset partitioning Costs Do creditors unfairly carry the burden of limited liability? Voluntary creditors Involuntary creditors © Amitai Aviram. All rights reserved. 60

61 Asset partitioning Costs: voluntary creditors Laura wants to invest $1,000 in a debt investment; Betty offers that Laura will lend to BettyCo (Bettys corporation) – Assume Laura has $500K, diversified into 500 investments of $1K ea. – Laura checks BettyCos solvency & anticipates a high probability that BettyCo would repay the loan & interest, but some probability BettyCo would default – Current risk-free investment yield (e.g., FDIC-insured bank savings account): 5% – Will Laura agree to lend money to Bettys corporation at 5%? – Can Betty offer Laura terms that would make Laura lend to BettyCo? – Why does it matter that Laura is diversified? Can Laura contractually protect herself from default if: – Betty cooked the books of the firm (intentionally defrauded Laura)? – BettyCos accounts contain many unintentional inaccuracies (e.g., forgetting to reduce BettyCos available cash after BettyCo paid dividends to Betty, co- mingling Bettys assets with BettyCos assets) because Betty is absent-minded? © Amitai Aviram. All rights reserved. 61

62 Asset partitioning Costs: involuntary creditors How LL threatens tort liability Recall our discussion of externalities in sub-section 1a1 – A may impose negative externalities on B, which is inefficient because A does not consider cost imposed on B – Tort law internalizes this cost by forcing A to compensate B – But limited liability acts as an exemption from tort law © Amitai Aviram. All rights reserved. 62

63 Asset partitioning Costs: involuntary creditors Hypo: A owns Acme, a taxicab company – A regularly draws all profits out of Acme, so Acme has no assets other than the (used) cabs – Tort: As cab runs over B – B sues Acme, but Acme has no assets Tort law internalizes cost of accidents by forcing drivers to compensate accident victims – Causes drivers to drive carefully and maintain their cars But limited liability means SHs get the upside of business profits, while they can avoid costs that bankrupt the business – Activities that cause torts will be moved into poorly capitalized corporations that are undeterred & unable to compensate victim – Veil piercing is needed to address this loophole © Amitai Aviram. All rights reserved. 63

64 Asset partitioning Legal analysis of PCV SH Corp. Sister Corp. DebtorDefendant PCVCorp.SH Enterprise liabilityCorp.Sister Corp. Reverse piercingSHCorp. Legal test for all three: 1. Such unity of interest between [Debtor] and [Defendant] that their separate personalities no longer exist; and 2. Adherence to fiction of separate corporate existence would sanction fraud or promote injustice © Amitai Aviram. All rights reserved. 64

65 Asset partitioning Legal analysis: unity of interest Cant distinguish debtors assets/liabilities from defendants – Due to debtors failure to comply with corporate formalities (e.g., sloppy corporate records misrepresent debtors assets/liabilities) – Due to commingling of debtors & defendants assets Siphoning assets from debtor to defendant (tunneling) – Debtors assets gifted or sold below fair value to defendant (including through dividends) – Failure to respect debtors separate entity (e.g., defendant uses debtors assets as its own) © Amitai Aviram. All rights reserved. 65

66 Asset partitioning Legal analysis: unity of interest Example (enterprise liability) In one case, court considered whether the corporations had: – Common employees – Common record keeping – Centralized accounting – Same officers – Same shareholders – Same telephone number – A common business name – Services rendered by employees of one corporation on behalf of another – Payment of wages by one corp. to another corp.s employees – Unclear allocation of profits & losses between the corporations – Undocumented transfers between corporations © Amitai Aviram. All rights reserved. 66

67 Asset partitioning Legal analysis: injustice [C]ircumstances must be such that adherence to the fiction of separate corporate existence would sanction a fraud or promote injustice. – Sea-Land court: prospect of unsatisfied judgment does not satisfy this prong of the test – Court suggests that 2 nd prong will be satisfied if: SH used corp. to avoid responsibilities to creditors; or Corporation will be unjustly enriched © Amitai Aviram. All rights reserved. 67

68 Asset partitioning Legal analysis: criteria for injustice Contract (voluntary) creditors – To mitigate the risk of corporation defaulting, a contractual creditor can investigate corporations credit-worthiness and: Decline to lend Require higher interest to compensate for higher risk Require personal guarantees – Can contract creditor protect herself from being harmed by undercapitalization? – By failure to abide by formalities? – By moving assets between the firm & other firms/SH? By fraud? © Amitai Aviram. All rights reserved. 68

69 Asset partitioning Legal analysis: criteria for injustice Tort (involuntary) creditors – Does a tort creditor care about SHs respect for corporate formalities? – Does a tort creditor care about corporations undercapitalization? © Amitai Aviram. All rights reserved. 69

70 Asset partitioning Legal analysis: criteria for injustice PCV for a contract creditor: if unity of interest (failure to observe formalities or siphoning of assets) prevents creditor from acquiring contractual protection PCV for a tort creditor: if debtor was undercapitalized © Amitai Aviram. All rights reserved. 70

71 Asset partitioning Asset partitioning in a GP Firms liability for SH debts – Hypo: April, Bev & Chris are partners in ABC law firm. Dave has a judgment against Bev & wants to collect from ABC. – RUPA §501: A partner is not a co-owner of partnership property and has no interest in partnership property which can be transferred… – RUPA §502: A partners share of the profits & losses & partners right to receive distributions from the partnership (together, the partners transferable interest) is personal property, so creditor can seize Bevs transferable interest in ABC – RUPA §504: Allows a creditor to petition court to issue a charging order (a lien) against a partners transferable interest. Court may then order foreclosure (sale of the transferable interest to a third party, with proceeds used to pay debt to creditor) © Amitai Aviram. All rights reserved. 71

72 Asset partitioning Asset partitioning in a GP SHs liability for firms debts (unlimited liability) – Example: April, Bev & Chris are partners in ABC law firm. Dave has a judgment against ABC & wants to collect from Chris. – RUPA §306: All partners are liable jointly & severally for all obligations of the partnership unless: Otherwise agreed by the claimant Otherwise provided by law Partner admitted into partnership after obligation was incurred Obligation incurred while partnership is an LLP – RUPA §307(d): Creditor must first attempt & fail to collect the debt from the partnership (exhaust partnership assets), unless: Partnership is a debtor in bankruptcy Partner agreed that creditor need not exhaust partnership assets Court permitted collecting from partner because partnership assets are clearly insufficient to satisfy judgment or exhaustion of partnership assets is excessively burdensome Partner is directly liable for debt © Amitai Aviram. All rights reserved. 72

73 1.Basic concepts about firms 2.Types of firms 3.Firms: external relationships – Asset partitioning (limited liability) – Legal personality – External claims & liabilities Firms: general concepts Overview of Section 2a © Amitai Aviram. All rights reserved. 73

74 A corporation is a legal entity independent of the people creating it, acting on its behalf or owning rights in it – But does that make any sense? Hypo: A car hits a pedestrian & kills him – The investigation reveals that the driver took proper care in her driving, but the car brakes malfunctioned – Its the cars fault: the car is imprisoned for three years for negligent homicide It seems silly to make a non-living object a legal entity (capable of being punished), yet we give legal entity status to firms (which are not only non-living, but lack physical form) Why do we give firms an independent legal personality? Legal personality The logic of nonliving legal entities © Amitai Aviram. All rights reserved. 74

75 Legal personality makes asset partitioning easier – Without legal personality, the firm cant own assets, so we cant say that a particular asset belongs to the firm (and therefore cant be seized by creditors of a SH) – Without legal personality, the firm cant have legal obligations and therefore cant borrow; SHs must borrow for it But asset partitioning can be done contractually, without the firm having an independent personality – Non-recourse loans: SHs take a loan in which creditor agrees it can only collect interest & principal from specific assets & income related to the business of the firm (not from SHs other assets) – effect like limited liability – UPA created a special right in partnership property (tenancy in partnership), that was not alienable unless all partners agreed to sell it (so creditors of a SH cant seize that property) So there must be another reason for firms legal personality… Legal personality The logic of nonliving legal entities © Amitai Aviram. All rights reserved. 75

76 Legal personality The logic of nonliving legal entities Example 1: Small bakery requires two employees & one person to finance business – If organized as set of contracts: 2 relationships (2x1) 2 employment contracts w/financier; or 2 lending agreements w/employees – If organized as separate entity: 3 relationships (2+1) © Amitai Aviram. All rights reserved. 76

77 Legal personality The logic of nonliving legal entities Example 2: Mid-size supermarket requires 6 employees, 2 people to finance business – If organized as set of contracts: 12 relationships (6x2) – If organized as separate entity: 8 relationships (6+2) © Amitai Aviram. All rights reserved. 77

78 Legal personality The logic of nonliving legal entities Example 3: Large steel plant requires 600 employees, 200 people to finance – If organized as set of contracts: 120,000 relationships (600x200) – If organized as separate entity: 800 relationships ( ) © Amitai Aviram. All rights reserved. 78

79 Legal personality The logic of nonliving legal entities The tradeoff – Contracts allow modifications to address specific preferences of parties; separate entity uses standardized terms – The larger the number of legal relationships involved in an activity, the more difficult it is to manage the activity Businesses with a few stakeholders are likely to opt for the flexibility of contracts Businesses with a many stakeholders are likely to opt for the simplicity of the firm – Avoid dealing with 120,000 separate relationships © Amitai Aviram. All rights reserved. 79

80 Legal personality Legal personality by firm type Corporations – Always had a legal personality Partnerships – When UPA was created, a partnership was not considered to have a legal personality (a partnership was a contractual relationship between people, not a legal entity) Forced UPA to come up with some odd rules (e.g., ownership of partnership assets, issues with continuing partnership when one partner leaves or dies) Later case law moved towards recognizing legal personality – RUPA explicitly acknowledges independent legal personality RUPA §201(a): A partnership is an entity distinct from its partners. RUPA §203: Property acquired by the partnership is property of the partnership and not of the partners individually. © Amitai Aviram. All rights reserved. 80

81 1.Basic concepts about firms 2.Types of firms 3.Firms: external relationships – Asset partitioning (limited liability) – Legal personality – External claims & liabilities Firms: general concepts Overview of Section 2a © Amitai Aviram. All rights reserved. 81

82 External claims & liabilities Outsiders as plaintiffs Authority – Acts of firms agents: governed by agency law (Section 1b) – Acts of firms organs: If act is not authorized by law, firm is not bound by it – But DGCL §141 gives BoD plenary authority, so BoD is authorized by law to do any act on behalf of firm, unless case law/statutory law limits BoD authority If act is authorized by law, firm is bound by it – If act is ultra vires (authorized by law but prohibited by the charter): firm is bound unless SH or the AG sue to enjoin it, in which case T is compensated but doesnt get anticipated profits of contract [DGCL 124(1)] FD: outsiders cant sue for FD breach; not owed FD by firms actors – Exception: public benefit corporation laws in some states allow benefit enforcement proceedings against directors & officers (the equivalent of SH challenges to corporate actions) to be brought by SHs, directors, 10%+ SHs in the parent firm of the benefit company, and any other persons specified in the PBCs charter or bylaws © Amitai Aviram. All rights reserved. 82

83 External claims & liabilities Outsiders as defendants Outsiders can be sued by the firm based on contract law, torts, etc. Outsiders as such dont owe FD to firm or its SHs, but they may nonetheless be liable to the firm for aiding & abetting a breach of FD by the firms organs or agents Elements required (Morgan v. Cash): 1.Existence of a fiduciary relationship; 2.Breach of the fiduciary's duty; 3.Knowing participation in that breach by T; and 4.Damages proximately caused by the breach We know how to analyze FD (and approval, if relevant); here we will discuss the third element: knowing participation © Amitai Aviram. All rights reserved. 83

84 External claims & liabilities Morgan v. Cash [Del. Ch. 2010] Corp can have multiple classes of stock w/different rights – E.g.: Acme has 1,000 common shares & 1,000 preferred shares that each have a $1,000 liquidation preference and participate in any remaining liquidation value). Acme dissolves. – How much will each SH get if Acmes assets are worth: $500K? $5M? Voyence has common & preferred shares – Voyence agrees to be acquired by EMC for an amount that is below the liquidation preference (i.e., common SHs get nothing) – 4 of 5 directors represent preferred SHs; 5 th director (CEO Nash) is married to a partner in a preferred SH SH (and employee) Mary Morgan sues – – BoD for accepting this offer (claiming BoD should have held out for a better offer that gave common SHs some consideration) – EMC for aiding & abetting BoDs breach EMC moves to dismiss for failure to state a claim © Amitai Aviram. All rights reserved. 84

85 External claims & liabilities Morgan v. Cash Knowing participation: Malpiede v. Townson [Del. 2001] – T's acquisition of favorable terms through arm's-length negotiations is not knowing participation – T knowingly participates if T attempts to create or exploit conflicts of interest in A, or where T and A conspire in or agree to the FD breach – Conflicting authorities as to whether T can knowingly participate in a breach of DoC (i.e., when A doesnt intentionally breach FD) Morgans arguments: 1.EMC's offer of employment to Nash & Fortenberry induced them to support EMC's lowered offer price EMC has legitimate incentive to retain Voyences management to maintain Voyences value Offers were similar to what N&F were already receiving No evidence N&F influenced BoD decision to accept offer (BoD asked N&F to leave room during their deliberations) Susan Nash (CEO) Donald Fortenberry (CFO) © Amitai Aviram. All rights reserved. 85

86 External claims & liabilities Morgan v. Cash Morgans arguments: 2.EMC knew Voyence directors were designees of preferred SHs & exploited CoI between directors & common SHs Court: To knowingly participate, third party needs to either – – Buy off BoD in a side deal (no evidence EMC conspired w/BoD) – Actively exploit BoD conflicts to detriment of SHs (no conflict here, since pref SHs would have wanted higher offer) » Safe harbor: tough negotiating in arms length bargaining isnt aiding & abetting (not relevant here, since theres no conflict) H. Berry Cash (director)Dennis Gorman (BoD chairman)Skip Glass (director)Terry Rock (director)Susan Nash (director) © Amitai Aviram. All rights reserved. 86


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